diff --git a/raw/aaer/2018/AAER-3917.txt b/raw/aaer/2018/AAER-3917.txt new file mode 100644 index 0000000000000000000000000000000000000000..6494186f81744faedbc813d02f4942ea2e9f9f44 --- /dev/null +++ b/raw/aaer/2018/AAER-3917.txt @@ -0,0 +1 @@ +, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-3918 Jan. 22, 2018 Sweet, Brian, CPA , AAER-3919 Jan. 19, 2018 Justin Samuel Cary, CPA , 1 to 96 of 96 items Return to top SEC homepage About the SEC Budget & Performance Careers Commission Votes Contac \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3918.txt b/raw/aaer/2018/AAER-3918.txt new file mode 100644 index 0000000000000000000000000000000000000000..4c2f6b1abe024c6e852c6ef1a3cb1ade1d75e743 --- /dev/null +++ b/raw/aaer/2018/AAER-3918.txt @@ -0,0 +1 @@ +AAER-3921 Feb. 14, 2018 Brian S. Block, CPA , AAER-3920 Jan. 22, 2018 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , Jan. 22, 2018 Sweet, Brian, CPA , AAER-3919 Jan. 19, 2018 Justin Samuel Cary, CPA , AAER-3917 1 to 96 of 96 items \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3919.txt b/raw/aaer/2018/AAER-3919.txt new file mode 100644 index 0000000000000000000000000000000000000000..d9fdbadb9a6b30b3514eaf55b7565744e492aa57 --- /dev/null +++ b/raw/aaer/2018/AAER-3919.txt @@ -0,0 +1 @@ +, AAER-3920 Jan. 22, 2018 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-3918 Jan. 22, 2018 Sweet, Brian, CPA , Jan. 19, 2018 Justin Samuel Cary, CPA , AAER-3917 1 to 96 of 96 items Return to top SEC homepage About th \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3920.txt b/raw/aaer/2018/AAER-3920.txt new file mode 100644 index 0000000000000000000000000000000000000000..4b5278c7140b97cbb9eb3ec6c78492fa048a8b9c --- /dev/null +++ b/raw/aaer/2018/AAER-3920.txt @@ -0,0 +1 @@ +Feb. 16, 2018 Simcha Baer, CPA , AAER-3922 Feb. 14, 2018 Brian S. Block, et al. , AAER-3921 Feb. 14, 2018 Brian S. Block, CPA , Jan. 22, 2018 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-3918 Jan. 22, 2018 Sweet, Brian, CPA , AAER-3919 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3921.txt b/raw/aaer/2018/AAER-3921.txt new file mode 100644 index 0000000000000000000000000000000000000000..7686021ba4b3397efd038c4dbbac34d56d89ee81 --- /dev/null +++ b/raw/aaer/2018/AAER-3921.txt @@ -0,0 +1 @@ +See Also: Sharone Perlstein et al. , Jonathan Strum , Baer LLC Feb. 16, 2018 Simcha Baer, CPA , AAER-3922 Feb. 14, 2018 Brian S. Block, et al. , Feb. 14, 2018 Brian S. Block, CPA , AAER-3920 Jan. 22, 2018 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-3918 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3922.txt b/raw/aaer/2018/AAER-3922.txt new file mode 100644 index 0000000000000000000000000000000000000000..04b28d895a59a83fac2ba93cfcf0b74da6c4159c --- /dev/null +++ b/raw/aaer/2018/AAER-3922.txt @@ -0,0 +1 @@ +rlstein, et al., Jonathan Strum, Alan Weinberg, et al. , AAER-3923 See Also: Sharone Perlstein et al. , Jonathan Strum , Baer LLC Feb. 16, 2018 Simcha Baer, CPA , Feb. 14, 2018 Brian S. Block, et al. , AAER-3921 Feb. 14, 2018 Brian S. Block, CPA , AAER-3920 Jan. 22, 2018 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middend \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3923.txt b/raw/aaer/2018/AAER-3923.txt new file mode 100644 index 0000000000000000000000000000000000000000..eb7abad13cc53786c46ba0878a2ca405a1a336fe --- /dev/null +++ b/raw/aaer/2018/AAER-3923.txt @@ -0,0 +1 @@ +ministrative Summary Feb. 21, 2018 Alan Weinberg, CPA and Weinberg & Baer LLC , AAER-3924 Feb. 16, 2018 Sharone Perlstein, et al., Jonathan Strum, Alan Weinberg, et al. , See Also: Sharone Perlstein et al. , Jonathan Strum , Baer LLC Feb. 16, 2018 Simcha Baer, CPA , AAER-3922 Feb. 14, 2018 Brian S. Block, et al. , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3924.txt b/raw/aaer/2018/AAER-3924.txt new file mode 100644 index 0000000000000000000000000000000000000000..59472a29f09d15e0347623c95c05c55acfcaace1 --- /dev/null +++ b/raw/aaer/2018/AAER-3924.txt @@ -0,0 +1 @@ +. 34-82860, AAER-3927 March 9, 2018 Elbit Imaging Ltd. , AAER-3925 See Also: Administrative Summary Feb. 21, 2018 Alan Weinberg, CPA and Weinberg & Baer LLC , Feb. 16, 2018 Sharone Perlstein, et al., Jonathan Strum, Alan Weinberg, et al. , AAER-3923 See Also: Sharone Perlstein et al. , Jonathan Strum , Baer LLC Feb. 16, 2018 Sim \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3925.txt b/raw/aaer/2018/AAER-3925.txt new file mode 100644 index 0000000000000000000000000000000000000000..9ef74404bc80409ebcdee050284c32b9d8ba044c --- /dev/null +++ b/raw/aaer/2018/AAER-3925.txt @@ -0,0 +1 @@ +e No. 34-82859, AAER-3926 March 13, 2018 KPMG , AAER-3929 March 13, 2018 KPMG Inc. , AAER-3927 March 9, 2018 Elbit Imaging Ltd. , See Also: Administrative Summary Feb. 21, 2018 Alan Weinberg, CPA and Weinberg & Baer LLC , AAER-3924 Feb. 16, 2018 Sharone Perlstein, et al., Jonathan Strum, Alan Weinberg, et al. \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3926.txt b/raw/aaer/2018/AAER-3926.txt new file mode 100644 index 0000000000000000000000000000000000000000..8af2c8a31ae062ac18a6eff810a386b77a0682c1 --- /dev/null +++ b/raw/aaer/2018/AAER-3926.txt @@ -0,0 +1 @@ +Corporation , AAER-3930 March 13, 2018 Deloitte & Touche Chartered Accountants , AAER-3928 March 13, 2018 BDO Canada LLP (f/k/a BDO Dunwoody LLP) , March 13, 2018 KPMG , AAER-3929 March 13, 2018 KPMG Inc. , AAER-3927 March 9, 2018 Elbit Imaging Ltd. , AAER-3925 See Also: \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3927.txt b/raw/aaer/2018/AAER-3927.txt new file mode 100644 index 0000000000000000000000000000000000000000..97d15318f8cdadb756a5d9ba232e3b7c324cf00d --- /dev/null +++ b/raw/aaer/2018/AAER-3927.txt @@ -0,0 +1 @@ +3928 March 13, 2018 BDO Canada LLP (f/k/a BDO Dunwoody LLP) , AAER-3926 March 13, 2018 KPMG , AAER-3929 March 13, 2018 KPMG Inc. , March 9, 2018 Elbit Imaging Ltd. , AAER-3925 See Also: Administrative Summary Feb. 21, 2018 Alan Weinberg, CPA and Weinberg & Baer LLC , AAER-3924 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3928.txt b/raw/aaer/2018/AAER-3928.txt new file mode 100644 index 0000000000000000000000000000000000000000..77733a4ac175adbea8c098e2f445a53ecc8423a5 --- /dev/null +++ b/raw/aaer/2018/AAER-3928.txt @@ -0,0 +1 @@ +No. LR-24082, AAER-3931 See Also: SEC Complaint March 26, 2018 Kinross Gold Corporation , AAER-3930 March 13, 2018 Deloitte & Touche Chartered Accountants , March 13, 2018 BDO Canada LLP (f/k/a BDO Dunwoody LLP) , AAER-3926 March 13, 2018 KPMG , AAER-3929 March 13, 2018 KPMG Inc. , AAER \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3929.txt b/raw/aaer/2018/AAER-3929.txt new file mode 100644 index 0000000000000000000000000000000000000000..fd5e6ae3ee830982063eae06695356719ddb8568 --- /dev/null +++ b/raw/aaer/2018/AAER-3929.txt @@ -0,0 +1 @@ +8 Deloitte & Touche Chartered Accountants , AAER-3928 March 13, 2018 BDO Canada LLP (f/k/a BDO Dunwoody LLP) , AAER-3926 March 13, 2018 KPMG , March 13, 2018 KPMG Inc. , AAER-3927 March 9, 2018 Elbit Imaging Ltd. , AAER-3925 See Also: Administrative Summary Feb. 21, 2018 Alan Weinberg \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3930.txt b/raw/aaer/2018/AAER-3930.txt new file mode 100644 index 0000000000000000000000000000000000000000..ade203070f31bfc70c62d6e4ed337b9a9a19bd07 --- /dev/null +++ b/raw/aaer/2018/AAER-3930.txt @@ -0,0 +1 @@ +34-82950, AAER-3932 March 26, 2018 Akorn, Inc., Timothy Dick, and David Hebeda , AAER-3931 See Also: SEC Complaint March 26, 2018 Kinross Gold Corporation , March 13, 2018 Deloitte & Touche Chartered Accountants , AAER-3928 March 13, 2018 BDO Canada LLP (f/k/a BDO Dunwoody LLP) , AAER-3926 March 13, 2018 KPMG \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3931.txt b/raw/aaer/2018/AAER-3931.txt new file mode 100644 index 0000000000000000000000000000000000000000..0248e0af34f35b74df59bb596425e0d54a4a7c14 --- /dev/null +++ b/raw/aaer/2018/AAER-3931.txt @@ -0,0 +1 @@ +lease No. 33-10478, 34-83017, AAER-3933 March 27, 2018 Maxwell Technologies, Inc., et al. , 34-82950, AAER-3932 March 26, 2018 Akorn, Inc., Timothy Dick, and David Hebeda , See Also: SEC Complaint March 26, 2018 Kinross Gold Corporation , AAER-3930 March 13, 2018 Deloitte & Touche Chartered Accountants , AAER-3928 Ma \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3932.txt b/raw/aaer/2018/AAER-3932.txt new file mode 100644 index 0000000000000000000000000000000000000000..b011cb0552cfdcb5f221008e24f40720dde30a05 --- /dev/null +++ b/raw/aaer/2018/AAER-3932.txt @@ -0,0 +1 @@ +3-10482, 34-83036, AAER-3934 April 9, 2018 Philip John James, CA and Kevin Silverwood, CA , 34-83017, AAER-3933 March 27, 2018 Maxwell Technologies, Inc., et al. , 34-82950, March 26, 2018 Akorn, Inc., Timothy Dick, and David Hebeda , AAER-3931 See Also: SEC Complaint March 26, 2018 Kinross Gold Corporation , AAER-3930 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3933.txt b/raw/aaer/2018/AAER-3933.txt new file mode 100644 index 0000000000000000000000000000000000000000..d63659ec533310a9caf6a790943f652244c78683 --- /dev/null +++ b/raw/aaer/2018/AAER-3933.txt @@ -0,0 +1 @@ +inistrative Summary April 12, 2018 Li, Company, PC and Tony Zhicong Li, CPA , 34-83036, AAER-3934 April 9, 2018 Philip John James, CA and Kevin Silverwood, CA , 34-83017, March 27, 2018 Maxwell Technologies, Inc., et al. , 34-82950, AAER-3932 March 26, 2018 Akorn, Inc., Timothy Dick, and David Hebeda , AAER-3931 See Also: SEC Com \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3934.txt b/raw/aaer/2018/AAER-3934.txt new file mode 100644 index 0000000000000000000000000000000000000000..8b6385c4128ec13277616bd5ab49d5d1805aba82 --- /dev/null +++ b/raw/aaer/2018/AAER-3934.txt @@ -0,0 +1 @@ +19, 2018 Medifirst Solutions, Inc. and Bruce J. Schoengood , AAER-3935 See Also: Administrative Summary April 12, 2018 Li, Company, PC and Tony Zhicong Li, CPA , 34-83036, April 9, 2018 Philip John James, CA and Kevin Silverwood, CA , 34-83017, AAER-3933 March 27, 2018 Maxwell Technologies, Inc., et al. , 34-82950, AAER-3932 March \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3935.txt b/raw/aaer/2018/AAER-3935.txt new file mode 100644 index 0000000000000000000000000000000000000000..77ad71fba4d3a21d6ca36d6ea2d78a8d362bc3ce --- /dev/null +++ b/raw/aaer/2018/AAER-3935.txt @@ -0,0 +1 @@ +April 23, 2018 The Dun & Bradstreet Corporation , AAER-3936 See Also: Administrative Summary April 19, 2018 Medifirst Solutions, Inc. and Bruce J. Schoengood , See Also: Administrative Summary April 12, 2018 Li, Company, PC and Tony Zhicong Li, CPA , 34-83036, AAER-3934 April 9, 2018 Philip John James, CA and Kevin Silverwood, CA Release \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3936.txt b/raw/aaer/2018/AAER-3936.txt new file mode 100644 index 0000000000000000000000000000000000000000..d840577dba07b67e4a478928a4d074433061db67 --- /dev/null +++ b/raw/aaer/2018/AAER-3936.txt @@ -0,0 +1 @@ +Corporation , AAER-3938 April 24, 2018 Altaba Inc. and f/d/b/a Yahoo! Inc. , 34-83096, AAER-3937 April 23, 2018 The Dun & Bradstreet Corporation , See Also: Administrative Summary April 19, 2018 Medifirst Solutions, Inc. and Bruce J. Schoengood , AAER-3935 See Also: Administrative Summary April 12, 2018 Li, Company, \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3937.txt b/raw/aaer/2018/AAER-3937.txt new file mode 100644 index 0000000000000000000000000000000000000000..f4fccf4c37120f894b16688f9b3f4fad91c77c3b --- /dev/null +++ b/raw/aaer/2018/AAER-3937.txt @@ -0,0 +1 @@ +David T. Leboe, CPA , AAER-3941 April 30, 2018 Panasonic Corporation , AAER-3938 April 24, 2018 Altaba Inc. and f/d/b/a Yahoo! Inc. , 34-83096, April 23, 2018 The Dun & Bradstreet Corporation , AAER-3936 See Also: Administrative Summary April 19, 2018 Medifirst Solutions, Inc. and Bruce J. Schoengood , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3938.txt b/raw/aaer/2018/AAER-3938.txt new file mode 100644 index 0000000000000000000000000000000000000000..f265521e32287fc0988ecb10b5d0ae56b07f9a98 --- /dev/null +++ b/raw/aaer/2018/AAER-3938.txt @@ -0,0 +1 @@ +2018 Philip A. Pendergraft, et al. , AAER-3940 , AAER-3940 May 4, 2018 David T. Leboe, CPA , AAER-3941 April 30, 2018 Panasonic Corporation , April 24, 2018 Altaba Inc. and f/d/b/a Yahoo! Inc. , 34-83096, AAER-3937 April 23, 2018 The Dun & Bradstreet Corporation , AAER-3936 See Also: Administrative Summ \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3939.txt b/raw/aaer/2018/AAER-3939.txt new file mode 100644 index 0000000000000000000000000000000000000000..8385e65fbd177c5939aaf2f069e59af4630bd09b --- /dev/null +++ b/raw/aaer/2018/AAER-3939.txt @@ -0,0 +1 @@ +428, AAER-3943 See Also: Administrative Summary June 6, 2018 Michael J. Mona, Jr. , AAER-3942 May 4, 2018 Winter, Kloman, Moter & Repp, S.C., et al. , IA-4906, May 4, 2018 Philip A. Pendergraft, et al. , AAER-3940 , AAER-3940 May 4, 2018 David T. Leboe, CPA , AAER-3941 April 30, 2018 Panasonic Corporation Rel \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3940.txt b/raw/aaer/2018/AAER-3940.txt new file mode 100644 index 0000000000000000000000000000000000000000..308031c69c3c0379557fdd4e89a732d70c348442 --- /dev/null +++ b/raw/aaer/2018/AAER-3940.txt @@ -0,0 +1 @@ +r. , AAER-3942 May 4, 2018 Winter, Kloman, Moter & Repp, S.C., et al. , IA-4906, AAER-3939 May 4, 2018 Philip A. Pendergraft, et al. , , May 4, 2018 David T. Leboe, CPA , AAER-3941 April 30, 2018 Panasonic Corporation , AAER-3938 April 24, 2018 Altaba Inc. and f/d/b/a Yahoo! Inc. Release \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3941.txt b/raw/aaer/2018/AAER-3941.txt new file mode 100644 index 0000000000000000000000000000000000000000..4d4560ce429d5ddf0060df3261eab06387cb170b --- /dev/null +++ b/raw/aaer/2018/AAER-3941.txt @@ -0,0 +1 @@ +oter & Repp, S.C., et al. , IA-4906, AAER-3939 May 4, 2018 Philip A. Pendergraft, et al. , AAER-3940 , AAER-3940 May 4, 2018 David T. Leboe, CPA , April 30, 2018 Panasonic Corporation , AAER-3938 April 24, 2018 Altaba Inc. and f/d/b/a Yahoo! Inc. , 34-83096, AAER-3937 April 23, 2018 The Dun & Bradstree \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3942.txt b/raw/aaer/2018/AAER-3942.txt new file mode 100644 index 0000000000000000000000000000000000000000..b9d2adfba4ed781db253b8c3a132eac6013d9af1 --- /dev/null +++ b/raw/aaer/2018/AAER-3942.txt @@ -0,0 +1 @@ +R-3944 See Also: Administrative Summary June 14, 2018 RSM US LLP , AAER-3943 See Also: Administrative Summary June 6, 2018 Michael J. Mona, Jr. , May 4, 2018 Winter, Kloman, Moter & Repp, S.C., et al. , IA-4906, AAER-3939 May 4, 2018 Philip A. Pendergraft, et al. , AAER-3940 , AAER-3940 May 4, 2018 D \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3943.txt b/raw/aaer/2018/AAER-3943.txt new file mode 100644 index 0000000000000000000000000000000000000000..8d797e3fd8704f3a59f80434e81d38a3c632164f --- /dev/null +++ b/raw/aaer/2018/AAER-3943.txt @@ -0,0 +1 @@ +See Also: Administrative Summary July 2, 2018 Beam Inc., n/k/a Beam Suntory Inc. , AAER-3944 See Also: Administrative Summary June 14, 2018 RSM US LLP , See Also: Administrative Summary June 6, 2018 Michael J. Mona, Jr. , AAER-3942 May 4, 2018 Winter, Kloman, Moter & Repp, S.C., et al. , IA-4906, AAER-3939 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3944.txt b/raw/aaer/2018/AAER-3944.txt new file mode 100644 index 0000000000000000000000000000000000000000..d4a11364b06154614056efac8ff2e9b8811a3adc --- /dev/null +++ b/raw/aaer/2018/AAER-3944.txt @@ -0,0 +1 @@ +10516, 34-83578, AAER-3946 July 2, 2018 The Dow Chemical Company , AAER-3947 See Also: Administrative Summary July 2, 2018 Beam Inc., n/k/a Beam Suntory Inc. , See Also: Administrative Summary June 14, 2018 RSM US LLP , AAER-3943 See Also: Administrative Summary June 6, 2018 Michael J. Mona, Jr. , AAER-3 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3945.txt b/raw/aaer/2018/AAER-3945.txt new file mode 100644 index 0000000000000000000000000000000000000000..8a35b86deb0aa50d622a02ec2c2a5ae98a5a149d --- /dev/null +++ b/raw/aaer/2018/AAER-3945.txt @@ -0,0 +1 @@ +lease No. 33-10517, 34-83612, AAER-3949 See Also: Administrative Summary July 5, 2018 Credit Suisse Group AG , AAER-3948 July 2, 2018 Axesstel, Inc., et al. , See Also: SEC Complaint July 2, 2018 KBR, Inc. , 34-83578, AAER-3946 July 2, 2018 The Dow Chemical Company , AAER-3947 See Also: Administrative Su \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3946.txt b/raw/aaer/2018/AAER-3946.txt new file mode 100644 index 0000000000000000000000000000000000000000..c934edc13be35adbaf4bafd5b8a2bc660849dda8 --- /dev/null +++ b/raw/aaer/2018/AAER-3946.txt @@ -0,0 +1 @@ +sse Group AG , AAER-3948 July 2, 2018 Axesstel, Inc., et al. , AAER-3945 See Also: SEC Complaint July 2, 2018 KBR, Inc. , 34-83578, July 2, 2018 The Dow Chemical Company , AAER-3947 See Also: Administrative Summary July 2, 2018 Beam Inc., n/k/a Beam Suntory Inc. , AAER-3944 See Also: \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3947.txt b/raw/aaer/2018/AAER-3947.txt new file mode 100644 index 0000000000000000000000000000000000000000..7aded2affc3e8f47c0f676ab236cdadb42710de0 --- /dev/null +++ b/raw/aaer/2018/AAER-3947.txt @@ -0,0 +1 @@ +c., et al. , AAER-3945 See Also: SEC Complaint July 2, 2018 KBR, Inc. , 34-83578, AAER-3946 July 2, 2018 The Dow Chemical Company , See Also: Administrative Summary July 2, 2018 Beam Inc., n/k/a Beam Suntory Inc. , AAER-3944 See Also: Administrative Summary June 14, 2018 RSM US LLP \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3948.txt b/raw/aaer/2018/AAER-3948.txt new file mode 100644 index 0000000000000000000000000000000000000000..e49a0e1ec2a9c7a2b01e06aff143be42af52da01 --- /dev/null +++ b/raw/aaer/2018/AAER-3948.txt @@ -0,0 +1,4 @@ +PDF release URL: https://www.sec.gov/files/litigation/admin/2018/34-83948.pdf + +Respondents/context: +July 10, 2018 Advanced Drainage Systems, Inc. and Mark B. Sturgeon, CPA , 34-83612, AAER-3949 See Also: Administrative Summary July 5, 2018 Credit Suisse Group AG , July 2, 2018 Axesstel, Inc., et al. , AAER-3945 See Also: SEC Complaint July 2, 2018 KBR, Inc. , 34-83578, AAER-3946 July 2, 2018 The Dow Ch diff --git a/raw/aaer/2018/AAER-3949.txt b/raw/aaer/2018/AAER-3949.txt new file mode 100644 index 0000000000000000000000000000000000000000..3ccfa84c25d88ac6230a8ec12db745844ee4c56e --- /dev/null +++ b/raw/aaer/2018/AAER-3949.txt @@ -0,0 +1 @@ +& Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-3951 July 10, 2018 Advanced Drainage Systems, Inc. and Mark B. Sturgeon, CPA , 34-83612, See Also: Administrative Summary July 5, 2018 Credit Suisse Group AG , AAER-3948 July 2, 2018 Axesstel, Inc., et al. , AAER-3945 See Also: SEC Com \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3950.txt b/raw/aaer/2018/AAER-3950.txt new file mode 100644 index 0000000000000000000000000000000000000000..da00252f84c25c594314ddda4524443107016c7e --- /dev/null +++ b/raw/aaer/2018/AAER-3950.txt @@ -0,0 +1 @@ +Aug. 3, 2018 Kurt J. Bordian, CPA , AAER-3953 July 17, 2018 Jay C. Lake, CPA , 34-83655, AAER-3952 July 12, 2018 Patrick J. Gray , July 12, 2018 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-3951 July 10, 2018 Advanced Drainage Systems, Inc. and Mark B. Sturgeon, CPA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3951.txt b/raw/aaer/2018/AAER-3951.txt new file mode 100644 index 0000000000000000000000000000000000000000..11d417a944c709a7416ac1cf3f20e5d7bf1ab34b --- /dev/null +++ b/raw/aaer/2018/AAER-3951.txt @@ -0,0 +1 @@ +655, AAER-3952 July 12, 2018 Patrick J. Gray , AAER-3950 July 12, 2018 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , July 10, 2018 Advanced Drainage Systems, Inc. and Mark B. Sturgeon, CPA , 34-83612, AAER-3949 See Also: Administrative Summary July 5, 2018 Credit Suisse Group AG \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3952.txt b/raw/aaer/2018/AAER-3952.txt new file mode 100644 index 0000000000000000000000000000000000000000..c46ca40f1fd9d89c2efacb5fd30a7c6e3d2cdf51 --- /dev/null +++ b/raw/aaer/2018/AAER-3952.txt @@ -0,0 +1 @@ +Aug. 8, 2018 Daniel M. Fitzpatrick, CPA , AAER-3955 Aug. 3, 2018 Kurt J. Bordian, CPA , AAER-3953 July 17, 2018 Jay C. Lake, CPA , 34-83655, July 12, 2018 Patrick J. Gray , AAER-3950 July 12, 2018 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-3951 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3953.txt b/raw/aaer/2018/AAER-3953.txt new file mode 100644 index 0000000000000000000000000000000000000000..341091ab147e714d925b98972b6fb290cd1e43b6 --- /dev/null +++ b/raw/aaer/2018/AAER-3953.txt @@ -0,0 +1 @@ +Aug. 8, 2018 Kevin M. Modany, CPA , AAER-3954 Aug. 8, 2018 Daniel M. Fitzpatrick, CPA , AAER-3955 Aug. 3, 2018 Kurt J. Bordian, CPA , July 17, 2018 Jay C. Lake, CPA , 34-83655, AAER-3952 July 12, 2018 Patrick J. Gray , AAER-3950 July 12, 2018 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchm \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3954.txt b/raw/aaer/2018/AAER-3954.txt new file mode 100644 index 0000000000000000000000000000000000000000..117a873a4133f59db3789b42a0c9bc67185e4ea1 --- /dev/null +++ b/raw/aaer/2018/AAER-3954.txt @@ -0,0 +1 @@ +Aug. 15, 2018 Lauren Zarsky, CPA , AAER-3957 Aug. 8, 2018 Ernst & Young LLP, et al. , AAER-3956 Aug. 8, 2018 Kevin M. Modany, CPA , Aug. 8, 2018 Daniel M. Fitzpatrick, CPA , AAER-3955 Aug. 3, 2018 Kurt J. Bordian, CPA , AAER-3953 July 17, 2018 Jay C. Lake, CPA , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3955.txt b/raw/aaer/2018/AAER-3955.txt new file mode 100644 index 0000000000000000000000000000000000000000..96db3884c4c239911067af04d93a596279fa7266 --- /dev/null +++ b/raw/aaer/2018/AAER-3955.txt @@ -0,0 +1 @@ +Aug. 8, 2018 Ernst & Young LLP, et al. , AAER-3956 Aug. 8, 2018 Kevin M. Modany, CPA , AAER-3954 Aug. 8, 2018 Daniel M. Fitzpatrick, CPA , Aug. 3, 2018 Kurt J. Bordian, CPA , AAER-3953 July 17, 2018 Jay C. Lake, CPA , 34-83655, AAER-3952 July 12, 2018 Patrick J. Gray , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3956.txt b/raw/aaer/2018/AAER-3956.txt new file mode 100644 index 0000000000000000000000000000000000000000..8508c0716ea9089d32d49ca43e567c75299fe94d --- /dev/null +++ b/raw/aaer/2018/AAER-3956.txt @@ -0,0 +1 @@ +959 Aug. 16, 2018 Citigroup Inc. , AAER-3958 Aug. 15, 2018 Lauren Zarsky, CPA , AAER-3957 Aug. 8, 2018 Ernst & Young LLP, et al. , Aug. 8, 2018 Kevin M. Modany, CPA , AAER-3954 Aug. 8, 2018 Daniel M. Fitzpatrick, CPA , AAER-3955 Aug. 3, 2018 Kurt J. Bordian, CPA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3957.txt b/raw/aaer/2018/AAER-3957.txt new file mode 100644 index 0000000000000000000000000000000000000000..95b143398250818eb91653e4f6ea4c26bc4f9d04 --- /dev/null +++ b/raw/aaer/2018/AAER-3957.txt @@ -0,0 +1 @@ +mary Aug. 17, 2018 Daniel H. Glick, CPA , AAER-3959 Aug. 16, 2018 Citigroup Inc. , AAER-3958 Aug. 15, 2018 Lauren Zarsky, CPA , Aug. 8, 2018 Ernst & Young LLP, et al. , AAER-3956 Aug. 8, 2018 Kevin M. Modany, CPA , AAER-3954 Aug. 8, 2018 Daniel M. Fitzpatrick, CPA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3958.txt b/raw/aaer/2018/AAER-3958.txt new file mode 100644 index 0000000000000000000000000000000000000000..67e924a62aa736d056bacddee86af3df54eaf5a2 --- /dev/null +++ b/raw/aaer/2018/AAER-3958.txt @@ -0,0 +1 @@ +oseph, CPA , AAER-3960 See Also: Administrative Summary Aug. 17, 2018 Daniel H. Glick, CPA , AAER-3959 Aug. 16, 2018 Citigroup Inc. , Aug. 15, 2018 Lauren Zarsky, CPA , AAER-3957 Aug. 8, 2018 Ernst & Young LLP, et al. , AAER-3956 Aug. 8, 2018 Kevin M. Modany, CPA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3959.txt b/raw/aaer/2018/AAER-3959.txt new file mode 100644 index 0000000000000000000000000000000000000000..a4605f3b8cd3a4a745ddc5c5af6674dfc5bbabb6 --- /dev/null +++ b/raw/aaer/2018/AAER-3959.txt @@ -0,0 +1 @@ +nc. , AAER-3961 Aug. 20, 2018 Jennings, Joseph, CPA , AAER-3960 See Also: Administrative Summary Aug. 17, 2018 Daniel H. Glick, CPA , Aug. 16, 2018 Citigroup Inc. , AAER-3958 Aug. 15, 2018 Lauren Zarsky, CPA , AAER-3957 Aug. 8, 2018 Ernst & Young LLP, et al. , AAE \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3960.txt b/raw/aaer/2018/AAER-3960.txt new file mode 100644 index 0000000000000000000000000000000000000000..a87a2403cf276d8d744727f6e26595ceb1c8b340 --- /dev/null +++ b/raw/aaer/2018/AAER-3960.txt @@ -0,0 +1 @@ +Aug. 29, 2018 David Michael Naylor, CPA , AAER-3962 Aug. 27, 2018 Legg Mason, Inc. , AAER-3961 Aug. 20, 2018 Jennings, Joseph, CPA , See Also: Administrative Summary Aug. 17, 2018 Daniel H. Glick, CPA , AAER-3959 Aug. 16, 2018 Citigroup Inc. , AAER-3958 Aug. 15, 2018 Lauren \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3961.txt b/raw/aaer/2018/AAER-3961.txt new file mode 100644 index 0000000000000000000000000000000000000000..f3c7262ba81bf15a8bfb3bee58942deba356d472 --- /dev/null +++ b/raw/aaer/2018/AAER-3961.txt @@ -0,0 +1 @@ +Aug. 30, 2018 Philip R. Jacoby, Jr. , AAER-3963 Aug. 29, 2018 David Michael Naylor, CPA , AAER-3962 Aug. 27, 2018 Legg Mason, Inc. , Aug. 20, 2018 Jennings, Joseph, CPA , AAER-3960 See Also: Administrative Summary Aug. 17, 2018 Daniel H. Glick, CPA , AAER-3959 Aug. 16, 2018 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3962.txt b/raw/aaer/2018/AAER-3962.txt new file mode 100644 index 0000000000000000000000000000000000000000..75ca0cc6a1e930c5610c722dc7bd0a2478b34e66 --- /dev/null +++ b/raw/aaer/2018/AAER-3962.txt @@ -0,0 +1 @@ +Sept. 4, 2018 Michael J. Kipp , AAER-3965 Aug. 30, 2018 Philip R. Jacoby, Jr. , AAER-3963 Aug. 29, 2018 David Michael Naylor, CPA , Aug. 27, 2018 Legg Mason, Inc. , AAER-3961 Aug. 20, 2018 Jennings, Joseph, CPA , AAER-3960 See Also: Administrative Summary Aug. 17, 2018 Dani \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3963.txt b/raw/aaer/2018/AAER-3963.txt new file mode 100644 index 0000000000000000000000000000000000000000..a36608f4819d07a003c8e500698371a944b28914 --- /dev/null +++ b/raw/aaer/2018/AAER-3963.txt @@ -0,0 +1 @@ +AAER-3964 Sept. 4, 2018 John Pierrard , AAER-3967 Sept. 4, 2018 Michael J. Kipp , AAER-3965 Aug. 30, 2018 Philip R. Jacoby, Jr. , Aug. 29, 2018 David Michael Naylor, CPA , AAER-3962 Aug. 27, 2018 Legg Mason, Inc. , AAER-3961 Aug. 20, 2018 Jennings, Joseph, CPA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3964.txt b/raw/aaer/2018/AAER-3964.txt new file mode 100644 index 0000000000000000000000000000000000000000..bbc9eeeef4e93f6707b93326e638526ad7e25e1d --- /dev/null +++ b/raw/aaer/2018/AAER-3964.txt @@ -0,0 +1 @@ +Sept. 6, 2018 Joohyun Bahn and a/k/a Dennis Bahn , AAER-3968 Sept. 4, 2018 Joanne K. Viard, CPA , AAER-3966 Sept. 4, 2018 Sanofi , Sept. 4, 2018 John Pierrard , AAER-3967 Sept. 4, 2018 Michael J. Kipp , AAER-3965 Aug. 30, 2018 Philip R. Jacoby, Jr. , AAER-3963 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3965.txt b/raw/aaer/2018/AAER-3965.txt new file mode 100644 index 0000000000000000000000000000000000000000..93ac341da1b560487ac3cdfba19358974cb44834 --- /dev/null +++ b/raw/aaer/2018/AAER-3965.txt @@ -0,0 +1 @@ +No. 34-84023, AAER-3966 Sept. 4, 2018 Sanofi , AAER-3964 Sept. 4, 2018 John Pierrard , AAER-3967 Sept. 4, 2018 Michael J. Kipp , Aug. 30, 2018 Philip R. Jacoby, Jr. , AAER-3963 Aug. 29, 2018 David Michael Naylor, CPA , AAER-3962 Aug. 27, 2018 Legg Mason, Inc. \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3966.txt b/raw/aaer/2018/AAER-3966.txt new file mode 100644 index 0000000000000000000000000000000000000000..12e84c6feecf7e62e7b118f9668c25fd364963bb --- /dev/null +++ b/raw/aaer/2018/AAER-3966.txt @@ -0,0 +1 @@ +kiewicz, CPA, and Sarah E. Adams, CPA , AAER-3969 Sept. 6, 2018 Joohyun Bahn and a/k/a Dennis Bahn , AAER-3968 Sept. 4, 2018 Joanne K. Viard, CPA , Sept. 4, 2018 Sanofi , AAER-3964 Sept. 4, 2018 John Pierrard , AAER-3967 Sept. 4, 2018 Michael J. Kipp , AAER-3965 Aug \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3967.txt b/raw/aaer/2018/AAER-3967.txt new file mode 100644 index 0000000000000000000000000000000000000000..38257748c4e4d8bbdf7043f22e45f698278117b4 --- /dev/null +++ b/raw/aaer/2018/AAER-3967.txt @@ -0,0 +1 @@ +34-84054, AAER-3968 Sept. 4, 2018 Joanne K. Viard, CPA , AAER-3966 Sept. 4, 2018 Sanofi , AAER-3964 Sept. 4, 2018 John Pierrard , Sept. 4, 2018 Michael J. Kipp , AAER-3965 Aug. 30, 2018 Philip R. Jacoby, Jr. , AAER-3963 Aug. 29, 2018 David Michael Naylor, CPA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3968.txt b/raw/aaer/2018/AAER-3968.txt new file mode 100644 index 0000000000000000000000000000000000000000..8f30f46a33dd08e3a0bf4c174d67b8134754f75d --- /dev/null +++ b/raw/aaer/2018/AAER-3968.txt @@ -0,0 +1 @@ +o: SEC Complaint Sept. 7, 2018 Ernst & Young LLP, Craig R. Fronckiewicz, CPA, and Sarah E. Adams, CPA , AAER-3969 Sept. 6, 2018 Joohyun Bahn and a/k/a Dennis Bahn , Sept. 4, 2018 Joanne K. Viard, CPA , AAER-3966 Sept. 4, 2018 Sanofi , AAER-3964 Sept. 4, 2018 John Pierrard , AAER-3967 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3969.txt b/raw/aaer/2018/AAER-3969.txt new file mode 100644 index 0000000000000000000000000000000000000000..899e45cef1eeb0f666f68e7a8b0307391a497978 --- /dev/null +++ b/raw/aaer/2018/AAER-3969.txt @@ -0,0 +1 @@ +Sept. 12, 2018 Adam C. Wasserman , AAER-3971 See Also: SEC Complaint Sept. 7, 2018 Ernst & Young LLP, Craig R. Fronckiewicz, CPA, and Sarah E. Adams, CPA , Sept. 6, 2018 Joohyun Bahn and a/k/a Dennis Bahn , AAER-3968 Sept. 4, 2018 Joanne K. Viard, CPA , AAER-3966 Sept. 4, 2018 Sanofi , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3970.txt b/raw/aaer/2018/AAER-3970.txt new file mode 100644 index 0000000000000000000000000000000000000000..c901c4b54b37887299d0fba40853a5a62f8d005f --- /dev/null +++ b/raw/aaer/2018/AAER-3970.txt @@ -0,0 +1 @@ +Bronson L. Quon, CPA , AAER-3976 Sept. 14, 2018 Wolf, Jennifer F., CPA , AAER-3972 Sept. 13, 2018 Holthouse Carlin & Van Trigt LLP , IA-5008, See Also: Administrative Summary Sept. 12, 2018 Adam C. Wasserman , AAER-3971 See Also: SEC Complaint Sept. 7, 2018 Ernst & Young LLP, Craig R. Fronckiewicz, CPA, and Sa \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3971.txt b/raw/aaer/2018/AAER-3971.txt new file mode 100644 index 0000000000000000000000000000000000000000..039e716c3cbc3331cba4d7f64c7fbfed54796373 --- /dev/null +++ b/raw/aaer/2018/AAER-3971.txt @@ -0,0 +1 @@ +. 34-84131, AAER-3972 Sept. 13, 2018 Holthouse Carlin & Van Trigt LLP , IA-5008, AAER-3970 See Also: Administrative Summary Sept. 12, 2018 Adam C. Wasserman , See Also: SEC Complaint Sept. 7, 2018 Ernst & Young LLP, Craig R. Fronckiewicz, CPA, and Sarah E. Adams, CPA , AAER-3969 Sept. 6, 2018 Joohyun Bahn and a/k/a Dennis Bahn Release \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3972.txt b/raw/aaer/2018/AAER-3972.txt new file mode 100644 index 0000000000000000000000000000000000000000..2e93bedd367da139942cf1c491f4e56c4a56df34 --- /dev/null +++ b/raw/aaer/2018/AAER-3972.txt @@ -0,0 +1 @@ +Sept. 19, 2018 Nasir Shakouri , AAER-3974 Sept. 19, 2018 Bronson L. Quon, CPA , AAER-3976 Sept. 14, 2018 Wolf, Jennifer F., CPA , Sept. 13, 2018 Holthouse Carlin & Van Trigt LLP , IA-5008, AAER-3970 See Also: Administrative Summary Sept. 12, 2018 Adam C. Wasserman , AAER-3971 See A \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3973.txt b/raw/aaer/2018/AAER-3973.txt new file mode 100644 index 0000000000000000000000000000000000000000..688d1c925a5cb2227a41a470739747836cf8c653 --- /dev/null +++ b/raw/aaer/2018/AAER-3973.txt @@ -0,0 +1 @@ +ett Business Services, Inc. and Mark Cannon, CPA , 34-84233, AAER-3977 Sept. 19, 2018 Robert Torino , AAER-3975 Sept. 19, 2018 Bruton, Karen, CPA , Sept. 19, 2018 Nasir Shakouri , AAER-3974 Sept. 19, 2018 Bronson L. Quon, CPA , AAER-3976 Sept. 14, 2018 Wolf, Jennifer F., CPA , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3974.txt b/raw/aaer/2018/AAER-3974.txt new file mode 100644 index 0000000000000000000000000000000000000000..5da679304a310ac1d189265e847d22f8b10cebab --- /dev/null +++ b/raw/aaer/2018/AAER-3974.txt @@ -0,0 +1 @@ +, AAER-3977 Sept. 19, 2018 Robert Torino , AAER-3975 Sept. 19, 2018 Bruton, Karen, CPA , AAER-3973 Sept. 19, 2018 Nasir Shakouri , Sept. 19, 2018 Bronson L. Quon, CPA , AAER-3976 Sept. 14, 2018 Wolf, Jennifer F., CPA , AAER-3972 Sept. 13, 2018 Holthouse Carlin & Van Trigt LLP Relea \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3975.txt b/raw/aaer/2018/AAER-3975.txt new file mode 100644 index 0000000000000000000000000000000000000000..ea200b80e4459fbf2004082307a08a6ac92d4d47 --- /dev/null +++ b/raw/aaer/2018/AAER-3975.txt @@ -0,0 +1 @@ +nologies, Inc. , AAER-3982 Sept. 20, 2018 Barrett Business Services, Inc. and Mark Cannon, CPA , 34-84233, AAER-3977 Sept. 19, 2018 Robert Torino , Sept. 19, 2018 Bruton, Karen, CPA , AAER-3973 Sept. 19, 2018 Nasir Shakouri , AAER-3974 Sept. 19, 2018 Bronson L. Quon, CPA , AAER \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3976.txt b/raw/aaer/2018/AAER-3976.txt new file mode 100644 index 0000000000000000000000000000000000000000..5ddfedff23453048ed0b7f4996f78a6d72b94cd3 --- /dev/null +++ b/raw/aaer/2018/AAER-3976.txt @@ -0,0 +1 @@ +3975 Sept. 19, 2018 Bruton, Karen, CPA , AAER-3973 Sept. 19, 2018 Nasir Shakouri , AAER-3974 Sept. 19, 2018 Bronson L. Quon, CPA , Sept. 14, 2018 Wolf, Jennifer F., CPA , AAER-3972 Sept. 13, 2018 Holthouse Carlin & Van Trigt LLP , IA-5008, AAER-3970 See Also: Administrative Summary \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3977.txt b/raw/aaer/2018/AAER-3977.txt new file mode 100644 index 0000000000000000000000000000000000000000..5493b298457e0dfa2bbd242d1aee3ed91e0e8b9e --- /dev/null +++ b/raw/aaer/2018/AAER-3977.txt @@ -0,0 +1 @@ +tion , AAER-3984 Sept. 21, 2018 Cool Technologies, Inc. , AAER-3982 Sept. 20, 2018 Barrett Business Services, Inc. and Mark Cannon, CPA , 34-84233, Sept. 19, 2018 Robert Torino , AAER-3975 Sept. 19, 2018 Bruton, Karen, CPA , AAER-3973 Sept. 19, 2018 Nasir Shakouri , AAER-3974 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3978.txt b/raw/aaer/2018/AAER-3978.txt new file mode 100644 index 0000000000000000000000000000000000000000..fb4c3877104b1245135a496520dd9f0fb6d71b03 --- /dev/null +++ b/raw/aaer/2018/AAER-3978.txt @@ -0,0 +1 @@ +tland Payment Systems, LLC, f/k/a Heartland Payment Systems, Inc. and Robert O. Carr , AAER-3980 See Also: Administrative Summary Sept. 21, 2018 Primoris Services Corporation , See Also: Administrative Summary Sept. 21, 2018 Infrax Systems, Inc. , AAER-3985 Sept. 21, 2018 Dasan Zhone Solutions, Inc. , AAER-3983 Sept. 21, 2 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3979.txt b/raw/aaer/2018/AAER-3979.txt new file mode 100644 index 0000000000000000000000000000000000000000..db34d5d293cf367f3f8c2bde66ff589473f381da --- /dev/null +++ b/raw/aaer/2018/AAER-3979.txt @@ -0,0 +1 @@ +See Also: SEC Complaint Sept. 21, 2018 Cardiff Lexington Corporation (f/k/a Cardiff International, Inc.) , AAER-3981 Sept. 21, 2018 Dennis W. Hamilton, CPA , Sept. 21, 2018 Heartland Payment Systems, LLC, f/k/a Heartland Payment Systems, Inc. and Robert O. Carr , AAER-3980 See Also: Administrative Summary Sept. 21, 2018 Primoris Services Cor \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3980.txt b/raw/aaer/2018/AAER-3980.txt new file mode 100644 index 0000000000000000000000000000000000000000..95c40c7050cb66a6d8bab0736468c2f5ea069469 --- /dev/null +++ b/raw/aaer/2018/AAER-3980.txt @@ -0,0 +1 @@ +84258, AAER-3981 Sept. 21, 2018 Dennis W. Hamilton, CPA , AAER-3979 Sept. 21, 2018 Heartland Payment Systems, LLC, f/k/a Heartland Payment Systems, Inc. and Robert O. Carr , See Also: Administrative Summary Sept. 21, 2018 Primoris Services Corporation , AAER-3978 See Also: Administrative Summary Sept. 21, 2018 Infrax Systems, Inc. Release \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3981.txt b/raw/aaer/2018/AAER-3981.txt new file mode 100644 index 0000000000000000000000000000000000000000..9d55ab7471ccce45a48c80f6405e755b71d4508f --- /dev/null +++ b/raw/aaer/2018/AAER-3981.txt @@ -0,0 +1 @@ +87 Sept. 21, 2018 James Douglas Miller , AAER-3986 See Also: SEC Complaint Sept. 21, 2018 Cardiff Lexington Corporation (f/k/a Cardiff International, Inc.) , Sept. 21, 2018 Dennis W. Hamilton, CPA , AAER-3979 Sept. 21, 2018 Heartland Payment Systems, LLC, f/k/a Heartland Payment Systems, Inc. and Robert O. Carr , AAER-3980 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3982.txt b/raw/aaer/2018/AAER-3982.txt new file mode 100644 index 0000000000000000000000000000000000000000..9ace0822cba48e7d2ce58e6c84fe327d3840631a --- /dev/null +++ b/raw/aaer/2018/AAER-3982.txt @@ -0,0 +1 @@ +1, 2018 Dasan Zhone Solutions, Inc. , AAER-3983 Sept. 21, 2018 First Hartford Corporation , AAER-3984 Sept. 21, 2018 Cool Technologies, Inc. , Sept. 20, 2018 Barrett Business Services, Inc. and Mark Cannon, CPA , 34-84233, AAER-3977 Sept. 19, 2018 Robert Torino , AAER-3975 Sept. 19, 2018 Bruton, Ka \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3983.txt b/raw/aaer/2018/AAER-3983.txt new file mode 100644 index 0000000000000000000000000000000000000000..d4510694da87282a3cbd7786317d7fdd6713aea4 --- /dev/null +++ b/raw/aaer/2018/AAER-3983.txt @@ -0,0 +1 @@ +, AAER-3978 See Also: Administrative Summary Sept. 21, 2018 Infrax Systems, Inc. , AAER-3985 Sept. 21, 2018 Dasan Zhone Solutions, Inc. , Sept. 21, 2018 First Hartford Corporation , AAER-3984 Sept. 21, 2018 Cool Technologies, Inc. , AAER-3982 Sept. 20, 2018 Barrett Business Services, Inc. and \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3984.txt b/raw/aaer/2018/AAER-3984.txt new file mode 100644 index 0000000000000000000000000000000000000000..ff03b52b34f516b3901eee0c410e2fe7d49905fb --- /dev/null +++ b/raw/aaer/2018/AAER-3984.txt @@ -0,0 +1 @@ +. 21, 2018 Infrax Systems, Inc. , AAER-3985 Sept. 21, 2018 Dasan Zhone Solutions, Inc. , AAER-3983 Sept. 21, 2018 First Hartford Corporation , Sept. 21, 2018 Cool Technologies, Inc. , AAER-3982 Sept. 20, 2018 Barrett Business Services, Inc. and Mark Cannon, CPA , 34-84233, AAER-3977 Sept. 19, 2018 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3985.txt b/raw/aaer/2018/AAER-3985.txt new file mode 100644 index 0000000000000000000000000000000000000000..b9a4637a31b28cfe8bf9cd536e34cfa599c7edce --- /dev/null +++ b/raw/aaer/2018/AAER-3985.txt @@ -0,0 +1 @@ +: Administrative Summary Sept. 21, 2018 Primoris Services Corporation , AAER-3978 See Also: Administrative Summary Sept. 21, 2018 Infrax Systems, Inc. , Sept. 21, 2018 Dasan Zhone Solutions, Inc. , AAER-3983 Sept. 21, 2018 First Hartford Corporation , AAER-3984 Sept. 21, 2018 Cool Technologies, Inc. Rel \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3986.txt b/raw/aaer/2018/AAER-3986.txt new file mode 100644 index 0000000000000000000000000000000000000000..472eca8cd41a805e4715bd29cde87b52f8523978 --- /dev/null +++ b/raw/aaer/2018/AAER-3986.txt @@ -0,0 +1 @@ +ept. 26, 2018 Dhru Desai , AAER-3988 Sept. 25, 2018 Lichter, Yu and Associates, Inc., et al. , AAER-3987 Sept. 21, 2018 James Douglas Miller , See Also: SEC Complaint Sept. 21, 2018 Cardiff Lexington Corporation (f/k/a Cardiff International, Inc.) , AAER-3981 Sept. 21, 2018 Dennis W. Hamilton, CPA , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3987.txt b/raw/aaer/2018/AAER-3987.txt new file mode 100644 index 0000000000000000000000000000000000000000..1b389b4997e31a3a885e42ac751132e4ec7f3d53 --- /dev/null +++ b/raw/aaer/2018/AAER-3987.txt @@ -0,0 +1 @@ +asilerio and S.A. - Petrobras , 34-84205, AAER-3989 Sept. 26, 2018 Dhru Desai , AAER-3988 Sept. 25, 2018 Lichter, Yu and Associates, Inc., et al. , Sept. 21, 2018 James Douglas Miller , AAER-3986 See Also: SEC Complaint Sept. 21, 2018 Cardiff Lexington Corporation (f/k/a Cardiff International, Inc.) , AA \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3988.txt b/raw/aaer/2018/AAER-3988.txt new file mode 100644 index 0000000000000000000000000000000000000000..04646389fc7a9e6567d704a138c7f90bdd20785d --- /dev/null +++ b/raw/aaer/2018/AAER-3988.txt @@ -0,0 +1 @@ +33-10564, AAER-3991 See Also: Administrative Summary Sept. 27, 2018 Petróleo Brasilerio and S.A. - Petrobras , 34-84205, AAER-3989 Sept. 26, 2018 Dhru Desai , Sept. 25, 2018 Lichter, Yu and Associates, Inc., et al. , AAER-3987 Sept. 21, 2018 James Douglas Miller , AAER-3986 See Also: SEC Complaint Sept. \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3989.txt b/raw/aaer/2018/AAER-3989.txt new file mode 100644 index 0000000000000000000000000000000000000000..71dfd0ad037972f5b4fd74013075b7937df14e30 --- /dev/null +++ b/raw/aaer/2018/AAER-3989.txt @@ -0,0 +1 @@ +Sept. 28, 2018 Mota Group, Inc. and Mota "Michael" Faro , AAER-3991 See Also: Administrative Summary Sept. 27, 2018 Petróleo Brasilerio and S.A. - Petrobras , 34-84205, Sept. 26, 2018 Dhru Desai , AAER-3988 Sept. 25, 2018 Lichter, Yu and Associates, Inc., et al. , AAER-3987 Sept. 21, 2018 James Douglas Miller Release N \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3990.txt b/raw/aaer/2018/AAER-3990.txt new file mode 100644 index 0000000000000000000000000000000000000000..bb074e11a30db0a8c8ff68affc965f446c650809 --- /dev/null +++ b/raw/aaer/2018/AAER-3990.txt @@ -0,0 +1 @@ +Oct. 12, 2018 Richard J. Bertuglia, CPA, John W. Green, CPA and Lev Nagdimov, CPA , AAER-3992 See Also: Administrative Summary Sept. 28, 2018 Stryker Corporation , Sept. 28, 2018 Mota Group, Inc. and Mota "Michael" Faro , AAER-3991 See Also: Administrative Summary Sept. 27, 2018 Petróleo Brasilerio and S.A. - Petrobras , \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3991.txt b/raw/aaer/2018/AAER-3991.txt new file mode 100644 index 0000000000000000000000000000000000000000..89e8fe74e8f708f506647290bb80b738b523a461 --- /dev/null +++ b/raw/aaer/2018/AAER-3991.txt @@ -0,0 +1 @@ +34-84419, AAER-3992 See Also: Administrative Summary Sept. 28, 2018 Stryker Corporation , AAER-3990 Sept. 28, 2018 Mota Group, Inc. and Mota "Michael" Faro , See Also: Administrative Summary Sept. 27, 2018 Petróleo Brasilerio and S.A. - Petrobras , 34-84205, AAER-3989 Sept. 26, 2018 Dhru Desai , AAER-3988 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3992.txt b/raw/aaer/2018/AAER-3992.txt new file mode 100644 index 0000000000000000000000000000000000000000..4e4dc47b44ec0d2c893a9689b82465aacb8f3fcb --- /dev/null +++ b/raw/aaer/2018/AAER-3992.txt @@ -0,0 +1 @@ +Nov. 9, 2018 Pyxus International, Inc. , AAER-3993 See Also: Administrative Summary Oct. 12, 2018 Richard J. Bertuglia, CPA, John W. Green, CPA and Lev Nagdimov, CPA , See Also: Administrative Summary Sept. 28, 2018 Stryker Corporation , AAER-3990 Sept. 28, 2018 Mota Group, Inc. and Mota "Michael" Faro , AAER-3991 See \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3993.txt b/raw/aaer/2018/AAER-3993.txt new file mode 100644 index 0000000000000000000000000000000000000000..d27120d17c668b527f9518c410b6ef4b9004abea --- /dev/null +++ b/raw/aaer/2018/AAER-3993.txt @@ -0,0 +1,4 @@ +PDF release URL: https://www.sec.gov/files/litigation/admin/2018/34-83993.pdf + +Respondents/context: +Administrative Summary Nov. 19, 2018 Vantage Drilling International , AAER-3994 See Also: Administrative Summary Nov. 9, 2018 Pyxus International, Inc. , See Also: Administrative Summary Oct. 12, 2018 Richard J. Bertuglia, CPA, John W. Green, CPA and Lev Nagdimov, CPA , AAER-3992 See Also: Administrative Summary Sept. 28, 2018 diff --git a/raw/aaer/2018/AAER-3994.txt b/raw/aaer/2018/AAER-3994.txt new file mode 100644 index 0000000000000000000000000000000000000000..84fc1d28c0b24297f6126b734a571d9d10a165bc --- /dev/null +++ b/raw/aaer/2018/AAER-3994.txt @@ -0,0 +1 @@ +o. 34-84763, AAER-3996 Dec. 4, 2018 KCAP Financial, Inc. , IC-33314, AAER-3995 See Also: Administrative Summary Nov. 19, 2018 Vantage Drilling International , See Also: Administrative Summary Nov. 9, 2018 Pyxus International, Inc. , AAER-3993 See Also: Administrative Summary Oct. 12, 2018 Richard J. Bertuglia, CPA, John W. Green \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3995.txt b/raw/aaer/2018/AAER-3995.txt new file mode 100644 index 0000000000000000000000000000000000000000..e7c83f0ce111dbdf4d6a4d8a5548ab4a44128fd0 --- /dev/null +++ b/raw/aaer/2018/AAER-3995.txt @@ -0,0 +1 @@ +11, 2018 The Hain Celestial Group, Inc. , AAER-3997 Dec. 10, 2018 Agria Corporation , AAER-3996 Dec. 4, 2018 KCAP Financial, Inc. , IC-33314, See Also: Administrative Summary Nov. 19, 2018 Vantage Drilling International , AAER-3994 See Also: Administrative Summary Nov. 9, 2018 Pyxus International, Inc. Rele \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3996.txt b/raw/aaer/2018/AAER-3996.txt new file mode 100644 index 0000000000000000000000000000000000000000..ef827643ab181d4625591349f16143de8a2746dd --- /dev/null +++ b/raw/aaer/2018/AAER-3996.txt @@ -0,0 +1 @@ +. 11, 2018 Eastgate Biotech Corporation , AAER-3999 Dec. 11, 2018 The Hain Celestial Group, Inc. , AAER-3997 Dec. 10, 2018 Agria Corporation , Dec. 4, 2018 KCAP Financial, Inc. , IC-33314, AAER-3995 See Also: Administrative Summary Nov. 19, 2018 Vantage Drilling International , AAER-3994 See Al \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3997.txt b/raw/aaer/2018/AAER-3997.txt new file mode 100644 index 0000000000000000000000000000000000000000..0ced4196672ccbacbce30f9e23da81f37055a2af --- /dev/null +++ b/raw/aaer/2018/AAER-3997.txt @@ -0,0 +1 @@ +echnology Development Corporation , AAER-4001 Dec. 11, 2018 Eastgate Biotech Corporation , AAER-3999 Dec. 11, 2018 The Hain Celestial Group, Inc. , Dec. 10, 2018 Agria Corporation , AAER-3996 Dec. 4, 2018 KCAP Financial, Inc. , IC-33314, AAER-3995 See Also: Administrative Summary Nov. 19, 2018 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3998.txt b/raw/aaer/2018/AAER-3998.txt new file mode 100644 index 0000000000000000000000000000000000000000..509cf02370d47f1c0fcd329beec70dc5d59568cb --- /dev/null +++ b/raw/aaer/2018/AAER-3998.txt @@ -0,0 +1 @@ +lease No. 34-84829, AAER-4002 See Also: Administrative Summary Dec. 11, 2018 Frontier Oilfield Services, Inc. , AAER-4000 Dec. 11, 2018 Auscrete Corporation , Dec. 11, 2018 Lotus Bio-Technology Development Corporation , AAER-4001 Dec. 11, 2018 Eastgate Biotech Corporation , AAER-3999 Dec. 11, 2018 The Hain Celesti \ No newline at end of file diff --git a/raw/aaer/2018/AAER-3999.txt b/raw/aaer/2018/AAER-3999.txt new file mode 100644 index 0000000000000000000000000000000000000000..7ec3096c673aa3ed19596aa618d16384307ed669 --- /dev/null +++ b/raw/aaer/2018/AAER-3999.txt @@ -0,0 +1 @@ +uscrete Corporation , AAER-3998 Dec. 11, 2018 Lotus Bio-Technology Development Corporation , AAER-4001 Dec. 11, 2018 Eastgate Biotech Corporation , Dec. 11, 2018 The Hain Celestial Group, Inc. , AAER-3997 Dec. 10, 2018 Agria Corporation , AAER-3996 Dec. 4, 2018 KCAP Financial, Inc. \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4000.txt b/raw/aaer/2018/AAER-4000.txt new file mode 100644 index 0000000000000000000000000000000000000000..bd341b3e1b67330bf675713b922704862133303d --- /dev/null +++ b/raw/aaer/2018/AAER-4000.txt @@ -0,0 +1 @@ +849, AAER-4003 Dec. 17, 2018 Santander Consumer USA Holdings Inc. , AAER-4002 See Also: Administrative Summary Dec. 11, 2018 Frontier Oilfield Services, Inc. , Dec. 11, 2018 Auscrete Corporation , AAER-3998 Dec. 11, 2018 Lotus Bio-Technology Development Corporation , AAER-4001 Dec. 11, 2018 Eastgate Biotech Corpora \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4001.txt b/raw/aaer/2018/AAER-4001.txt new file mode 100644 index 0000000000000000000000000000000000000000..cde2cb1a467b07c71e909b31a590b48b3f84b80b --- /dev/null +++ b/raw/aaer/2018/AAER-4001.txt @@ -0,0 +1 @@ +ier Oilfield Services, Inc. , AAER-4000 Dec. 11, 2018 Auscrete Corporation , AAER-3998 Dec. 11, 2018 Lotus Bio-Technology Development Corporation , Dec. 11, 2018 Eastgate Biotech Corporation , AAER-3999 Dec. 11, 2018 The Hain Celestial Group, Inc. , AAER-3997 Dec. 10, 2018 Agria Corporation Release \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4002.txt b/raw/aaer/2018/AAER-4002.txt new file mode 100644 index 0000000000000000000000000000000000000000..504fc60af648991060f0bab14c7ecb85e5ab352e --- /dev/null +++ b/raw/aaer/2018/AAER-4002.txt @@ -0,0 +1 @@ +ec. 18, 2018 Takeshi "Tyrone" Uonaga , AAER-4004 Dec. 18, 2018 Paul A. Margis , AAER-4003 Dec. 17, 2018 Santander Consumer USA Holdings Inc. , See Also: Administrative Summary Dec. 11, 2018 Frontier Oilfield Services, Inc. , AAER-4000 Dec. 11, 2018 Auscrete Corporation , AAER-3998 Dec. 11, \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4003.txt b/raw/aaer/2018/AAER-4003.txt new file mode 100644 index 0000000000000000000000000000000000000000..0c677122f656dd8437d70e4760335e6db197c5e9 --- /dev/null +++ b/raw/aaer/2018/AAER-4003.txt @@ -0,0 +1 @@ +ath LLP, Joseph C. Macina, CPA and Kevin V. Wydra, CPA , AAER-4007 Dec. 18, 2018 Takeshi "Tyrone" Uonaga , AAER-4004 Dec. 18, 2018 Paul A. Margis , Dec. 17, 2018 Santander Consumer USA Holdings Inc. , AAER-4002 See Also: Administrative Summary Dec. 11, 2018 Frontier Oilfield Services, Inc. , AAER-4000 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4004.txt b/raw/aaer/2018/AAER-4004.txt new file mode 100644 index 0000000000000000000000000000000000000000..d99627a2564a28027a67fbb6a48d1bcceadbaf34 --- /dev/null +++ b/raw/aaer/2018/AAER-4004.txt @@ -0,0 +1 @@ +CPA , AAER-4008 Dec. 21, 2018 Crowe Horwath LLP, Joseph C. Macina, CPA and Kevin V. Wydra, CPA , AAER-4007 Dec. 18, 2018 Takeshi "Tyrone" Uonaga , Dec. 18, 2018 Paul A. Margis , AAER-4003 Dec. 17, 2018 Santander Consumer USA Holdings Inc. , AAER-4002 See Also: Administrative Summary Dec. 11, 2 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4005.txt b/raw/aaer/2018/AAER-4005.txt new file mode 100644 index 0000000000000000000000000000000000000000..7ca31b120000914c59e1f8d8d2069e5dd6564688 --- /dev/null +++ b/raw/aaer/2018/AAER-4005.txt @@ -0,0 +1 @@ +nc. , AAER-4009 Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , AAER-4006 Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , Dec. 21, 2018 Mitchell J. Rubin, CPA and Michael Bernstein, CPA , AAER-4008 Dec. 21, 2018 Crowe Horwath LLP, Joseph C. Macina, CPA and Kevin V. Wydra, CPA , AAER-4007 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4006.txt b/raw/aaer/2018/AAER-4006.txt new file mode 100644 index 0000000000000000000000000000000000000000..5fbe20c208a2c052df9125372cd2fde9f3727f32 --- /dev/null +++ b/raw/aaer/2018/AAER-4006.txt @@ -0,0 +1 @@ +lease No. 34-84978, AAER-4011 See Also: Administrative Summary Dec. 26, 2018 ADT Inc. , AAER-4009 Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , AAER-4005 Dec. 21, 2018 Mitchell J. Rubin, CPA and Michael Bernstein, CPA , AAER-4008 Dec. 21, 2018 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4007.txt b/raw/aaer/2018/AAER-4007.txt new file mode 100644 index 0000000000000000000000000000000000000000..afd975fb07188734687ea01089705d21579ae4ca --- /dev/null +++ b/raw/aaer/2018/AAER-4007.txt @@ -0,0 +1 @@ +84911, AAER-4005 Dec. 21, 2018 Mitchell J. Rubin, CPA and Michael Bernstein, CPA , AAER-4008 Dec. 21, 2018 Crowe Horwath LLP, Joseph C. Macina, CPA and Kevin V. Wydra, CPA , Dec. 18, 2018 Takeshi "Tyrone" Uonaga , AAER-4004 Dec. 18, 2018 Paul A. Margis , AAER-4003 Dec. 17, 2018 Santander Consumer USA Holdings Inc. Release N \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4008.txt b/raw/aaer/2018/AAER-4008.txt new file mode 100644 index 0000000000000000000000000000000000000000..9358ae7c6f353b88f47740ee19e34adc92ec9d3f --- /dev/null +++ b/raw/aaer/2018/AAER-4008.txt @@ -0,0 +1 @@ +, AAER-4006 Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , AAER-4005 Dec. 21, 2018 Mitchell J. Rubin, CPA and Michael Bernstein, CPA , Dec. 21, 2018 Crowe Horwath LLP, Joseph C. Macina, CPA and Kevin V. Wydra, CPA , AAER-4007 Dec. 18, 2018 Takeshi "Tyrone" Uonaga , AAER-4004 Dec. 18, 2018 P \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4009.txt b/raw/aaer/2018/AAER-4009.txt new file mode 100644 index 0000000000000000000000000000000000000000..8c7e69d62c062dd566033cbaf88941f35f99ee0c --- /dev/null +++ b/raw/aaer/2018/AAER-4009.txt @@ -0,0 +1 @@ +973, AAER-4010 See Also: Administrative Summary Dec. 26, 2018 Polycom, Inc. , AAER-4011 See Also: Administrative Summary Dec. 26, 2018 ADT Inc. , Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , AAER-4006 Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , AAER-4005 Dec. 21, 2018 \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4010.txt b/raw/aaer/2018/AAER-4010.txt new file mode 100644 index 0000000000000000000000000000000000000000..846faf4ce8f511e541f12bba76ea0f64c4fe8f0b --- /dev/null +++ b/raw/aaer/2018/AAER-4010.txt @@ -0,0 +1,4 @@ +PDF release URL: https://www.sec.gov/files/litigation/admin/2018/34-84010.pdf + +Respondents/context: +. 31, 2018 Hertz Global Holdings, Inc. and the Hertz Corporation , 34-84979, AAER-4012 See Also: Administrative Summary Dec. 26, 2018 Centrais Elétricas Brasileiras S.A. , See Also: Administrative Summary Dec. 26, 2018 Polycom, Inc. , AAER-4011 See Also: Administrative Summary Dec. 26, 2018 ADT Inc. , AAER-4009 diff --git a/raw/aaer/2018/AAER-4011.txt b/raw/aaer/2018/AAER-4011.txt new file mode 100644 index 0000000000000000000000000000000000000000..12558b8780ce7d93d12b90e9020f3c1c4c0e8b8b --- /dev/null +++ b/raw/aaer/2018/AAER-4011.txt @@ -0,0 +1 @@ +lso: Administrative Summary Dec. 26, 2018 Centrais Elétricas Brasileiras S.A. , AAER-4010 See Also: Administrative Summary Dec. 26, 2018 Polycom, Inc. , See Also: Administrative Summary Dec. 26, 2018 ADT Inc. , AAER-4009 Dec. 21, 2018 Aesoph, John J., CPA Bennett, Darren M., CPA , AAER-4006 Dec. 21, \ No newline at end of file diff --git a/raw/aaer/2018/AAER-4012.txt b/raw/aaer/2018/AAER-4012.txt new file mode 100644 index 0000000000000000000000000000000000000000..853d680a82e0913bd0a35eb90c3c7bc3ac4da3bf --- /dev/null +++ b/raw/aaer/2018/AAER-4012.txt @@ -0,0 +1 @@ +eJulyAugustSeptemberOctoberNovemberDecember Date Sort descending Respondents Dec. 31, 2018 Hertz Global Holdings, Inc. and the Hertz Corporation , 34-84979, See Also: Administrative Summary Dec. 26, 2018 Centrais Elétricas Brasileiras S.A. , AAER-4010 See Also: Administrative Summary Dec. 26, 2018 Polycom, Inc. Release No \ No newline at end of file diff --git a/raw/aaer/2018/aaer_page.html b/raw/aaer/2018/aaer_page.html new file mode 100644 index 0000000000000000000000000000000000000000..5c0fab3c26dc7a1f37006a945ba9fbbaaee1c6be --- /dev/null +++ b/raw/aaer/2018/aaer_page.html @@ -0,0 +1,2710 @@ + + + + + + + + + + + + + + + SEC.gov | Accounting and Auditing Enforcement + + + + + + + + + + + + + + + + + + + + + + Skip to search field + + + + Skip to main content + + + + +
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The list below provides links to financial reporting related enforcement actions concerning civil lawsuits brought by the Commission in federal court and notices and orders concerning the institution and/or settlement of administrative proceedings. This list only highlights certain actions and is not meant to be a complete and exhaustive compilation of all of the actions that fall into this category.

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Date + + +Respondents
+ +
Hertz Global Holdings, Inc. and the Hertz Corporation
+
+ Release No. + 33-10601, 34-84979, AAER-4012 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Centrais Elétricas Brasileiras S.A.
+
+ Release No. + 34-84973, AAER-4010 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Polycom, Inc.
+
+ Release No. + 34-84978, AAER-4011 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
ADT Inc.
+
+ Release No. + 34-84956, AAER-4009 +
+
+ +
Aesoph, John J., CPA Bennett, Darren M., CPA
+
+ Release No. + 34-84912, AAER-4006 +
+
+ +
Aesoph, John J., CPA Bennett, Darren M., CPA
+
+ Release No. + 34-84911, AAER-4005 +
+
+ +
Mitchell J. Rubin, CPA and Michael Bernstein, CPA
+
+ Release No. + 34-84921, AAER-4008 +
+
+ +
Crowe Horwath LLP, Joseph C. Macina, CPA and Kevin V. Wydra, CPA
+
+ Release No. + 34-84920, AAER-4007 +
+
+ +
Takeshi "Tyrone" Uonaga
+
+ Release No. + 34-84850, AAER-4004 +
+
+ +
Paul A. Margis
+
+ Release No. + 34-84849, AAER-4003 +
+
+ +
Santander Consumer USA Holdings Inc.
+
+ Release No. + 34-84829, AAER-4002 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Frontier Oilfield Services, Inc.
+
+ Release No. + 34-84784, AAER-4000 +
+
+ +
Auscrete Corporation
+
+ Release No. + 34-84782, AAER-3998 +
+
+ +
Lotus Bio-Technology Development Corporation
+
+ Release No. + 34-84785, AAER-4001 +
+
+ +
Eastgate Biotech Corporation
+
+ Release No. + 34-84783, AAER-3999 +
+
+ +
The Hain Celestial Group, Inc.
+
+ Release No. + 34-84781, AAER-3997 +
+
+ +
Agria Corporation
+
+ Release No. + 34-84763, AAER-3996 +
+
+ +
KCAP Financial, Inc.
+
+ Release No. + 34-84718, IC-33314, AAER-3995 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Vantage Drilling International
+
+ Release No. + 34-84617, AAER-3994 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Pyxus International, Inc.
+
+ Release No. + 34-84562, AAER-3993 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Richard J. Bertuglia, CPA, John W. Green, CPA and Lev Nagdimov, CPA
+
+ Release No. + 34-84419, AAER-3992 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Stryker Corporation
+
+ Release No. + 34-84308, AAER-3990 +
+
+ +
Mota Group, Inc. and Mota "Michael" Faro
+
+ Release No. + 33-10564, AAER-3991 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Petróleo Brasilerio and S.A. - Petrobras
+
+ Release No. + 33-10561, 34-84205, AAER-3989 +
+
+ +
Dhru Desai
+
+ Release No. + 34-84291, AAER-3988 +
+
+ +
Lichter, Yu and Associates, Inc., et al.
+
+ Release No. + 34-84281, AAER-3987 +
+
+ +
James Douglas Miller
+
+ Release No. + LR-24282, AAER-3986 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Cardiff Lexington Corporation (f/k/a Cardiff International, Inc.)
+
+ Release No. + 34-84258, AAER-3981 +
+
+ +
Dennis W. Hamilton, CPA
+
+ Release No. + 34-84252, AAER-3979 +
+
+ +
Heartland Payment Systems, LLC, f/k/a Heartland Payment Systems, Inc. and Robert O. Carr
+
+ Release No. + 33-10558, AAER-3980 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Primoris Services Corporation
+
+ Release No. + 34-84251, AAER-3978 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Infrax Systems, Inc.
+
+ Release No. + 34-84263, AAER-3985 +
+
+ +
Dasan Zhone Solutions, Inc.
+
+ Release No. + 34-84261, AAER-3983 +
+
+ +
First Hartford Corporation
+
+ Release No. + 34-84262, AAER-3984 +
+
+ +
Cool Technologies, Inc.
+
+ Release No. + 34-84260, AAER-3982 +
+
+ +
Barrett Business Services, Inc. and Mark Cannon, CPA
+
+ Release No. + 33-10557, 34-84233, AAER-3977 +
+
+ +
Robert Torino
+
+ Release No. + 34-84206, AAER-3975 +
+
+ +
Bruton, Karen, CPA
+
+ Release No. + 34-84198, AAER-3973 +
+
+ +
Nasir Shakouri
+
+ Release No. + 34-84205, AAER-3974 +
+
+ +
Bronson L. Quon, CPA
+
+ Release No. + 34-84207, AAER-3976 +
+
+ +
Wolf, Jennifer F., CPA
+
+ Release No. + 34-84131, AAER-3972 +
+
+ +
Holthouse Carlin & Van Trigt LLP
+
+ Release No. + 34-84118, IA-5008, AAER-3970 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Adam C. Wasserman
+
+ Release No. + LR-24265, AAER-3971 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Ernst & Young LLP, Craig R. Fronckiewicz, CPA, and Sarah E. Adams, CPA
+
+ Release No. + 34-84055, AAER-3969 +
+
+ +
Joohyun Bahn and a/k/a Dennis Bahn
+
+ Release No. + 34-84054, AAER-3968 +
+
+ +
Joanne K. Viard, CPA
+
+ Release No. + 34-84023, AAER-3966 +
+
+ +
Sanofi
+
+ Release No. + 34-84017, AAER-3964 +
+
+ +
John Pierrard
+
+ Release No. + 34-84024, AAER-3967 +
+
+ +
Michael J. Kipp
+
+ Release No. + 34-84022, AAER-3965 +
+
+ +
Philip R. Jacoby, Jr.
+
+ Release No. + 34-84010, AAER-3963 +
+
+ +
David Michael Naylor, CPA
+
+ Release No. + 34-83993, AAER-3962 +
+
+ +
Legg Mason, Inc.
+
+ Release No. + 34-83948, AAER-3961 +
+
+ +
Jennings, Joseph, CPA
+
+ Release No. + 34-83889, AAER-3960 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Daniel H. Glick, CPA
+
+ Release No. + 34-83883, AAER-3959 +
+
+ +
Citigroup Inc.
+
+ Release No. + 34-83858, AAER-3958 +
+
+ +
Lauren Zarsky, CPA
+
+ Release No. + 34-83854, AAER-3957 +
+
+ +
Ernst & Young LLP, et al.
+
+ Release No. + 34-83807, AAER-3956 +
+
+ +
Kevin M. Modany, CPA
+
+ Release No. + 34-83805, AAER-3954 +
+
+ +
Daniel M. Fitzpatrick, CPA
+
+ Release No. + 34-83806, AAER-3955 +
+
+ +
Kurt J. Bordian, CPA
+
+ Release No. + 34-83772, AAER-3953 +
+
+ +
Jay C. Lake, CPA
+
+ Release No. + 33-10519, 34-83655, AAER-3952 +
+
+ +
Patrick J. Gray
+
+ Release No. + 34-83620, AAER-3950 +
+
+ +
Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA
+
+ Release No. + 34-83622, AAER-3951 +
+
+ +
Advanced Drainage Systems, Inc. and Mark B. Sturgeon, CPA
+
+ Release No. + 33-10517, 34-83612, AAER-3949 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Credit Suisse Group AG
+
+ Release No. + 34-83593, AAER-3948 +
+
+ +
Axesstel, Inc., et al.
+
+ Release No. + LR-24181, AAER-3945 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
KBR, Inc.
+
+ Release No. + 33-10516, 34-83578, AAER-3946 +
+
+ +
The Dow Chemical Company
+
+ Release No. + 34-83581, AAER-3947 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Beam Inc., n/k/a Beam Suntory Inc.
+
+ Release No. + 34-83575, AAER-3944 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
RSM US LLP
+
+ Release No. + 34-83428, AAER-3943 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Michael J. Mona, Jr.
+
+ Release No. + 34-83391, AAER-3942 +
+
+ +
Winter, Kloman, Moter & Repp, S.C., et al.
+
+ Release No. + 34-83168, IA-4906, AAER-3939 +
+
+ +
Philip A. Pendergraft, et al.
+
+ Release No. + 34-83169, AAER-3940 , AAER-3940 +
+
+ +
David T. Leboe, CPA
+
+ Release No. + 34-83170, AAER-3941 +
+
+ +
Panasonic Corporation
+
+ Release No. + 34-83128, AAER-3938 +
+
+ +
Altaba Inc. and f/d/b/a Yahoo! Inc.
+
+ Release No. + 33-10485, 34-83096, AAER-3937 +
+
+ +
The Dun & Bradstreet Corporation
+
+ Release No. + 34-83088, AAER-3936 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Medifirst Solutions, Inc. and Bruce J. Schoengood
+
+ Release No. + 34-83067, AAER-3935 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Li, Company, PC and Tony Zhicong Li, CPA
+
+ Release No. + 33-10482, 34-83036, AAER-3934 +
+
+ +
Philip John James, CA and Kevin Silverwood, CA
+
+ Release No. + 33-10478, 34-83017, AAER-3933 +
+
+ +
Maxwell Technologies, Inc., et al.
+
+ Release No. + 33-10472, 34-82950, AAER-3932 +
+
+ +
Akorn, Inc., Timothy Dick, and David Hebeda
+
+ Release No. + LR-24082, AAER-3931 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Kinross Gold Corporation
+
+ Release No. + 34-82946, AAER-3930 +
+
+ +
Deloitte & Touche Chartered Accountants
+
+ Release No. + 34-82861, AAER-3928 +
+
+ +
BDO Canada LLP (f/k/a BDO Dunwoody LLP)
+
+ Release No. + 34-82859, AAER-3926 +
+
+ +
KPMG
+
+ Release No. + 34-82862, AAER-3929 +
+
+ +
KPMG Inc.
+
+ Release No. + 34-82860, AAER-3927 +
+
+ +
Elbit Imaging Ltd.
+
+ Release No. + 34-82849, AAER-3925 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Alan Weinberg, CPA and Weinberg & Baer LLC
+
+ Release No. + 34-82744, AAER-3924 +
+
+ +
Sharone Perlstein, et al., Jonathan Strum, Alan Weinberg, et al.
+
+ Release No. + LR-24051, AAER-3923 +
+
+ See Also: + + + Sharone Perlstein et al. + +, + + Jonathan Strum + +, + + Baer LLC + + +
+
+ +
Simcha Baer, CPA
+
+ Release No. + 34-82736, AAER-3922 +
+
+ +
Brian S. Block, et al.
+
+ Release No. + LR-24046, AAER-3921 +
+
+ +
Brian S. Block, CPA
+
+ Release No. + 34-82710, AAER-3920 +
+
+ +
Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA
+
+ Release No. + 34-82556, AAER-3918 +
+
+ +
Sweet, Brian, CPA
+
+ Release No. + 34-82557, AAER-3919 +
+
+ +
Justin Samuel Cary, CPA
+
+ Release No. + 34-82554, AAER-3917 +
+
+ +
+
+ + +
+ 1 to 96 of 96 items +
+
+
+ +
+ +
+ +
+
+ + +
+ + +
+ + + + + + + + + + + + + + diff --git a/raw/aaer/2019/AAER-4013.txt b/raw/aaer/2019/AAER-4013.txt new file mode 100644 index 0000000000000000000000000000000000000000..cb04a4bff0771996e04b2e7aecc82849da5efd92 --- /dev/null +++ b/raw/aaer/2019/AAER-4013.txt @@ -0,0 +1 @@ +2019 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , AAER-4014 See Also: Administrative Summary Jan. 9, 2019 Katz, Sapper & Miller, LLP and Scott C. Price, CPA , IA-5100, 1 to 97 of 97 items Return to top SEC homepage About the SEC Budget & Performance Careers Commission Votes Contac \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4014.txt b/raw/aaer/2019/AAER-4014.txt new file mode 100644 index 0000000000000000000000000000000000000000..8a416cc9c7e4ac94913410fe7dc914fac4948dea --- /dev/null +++ b/raw/aaer/2019/AAER-4014.txt @@ -0,0 +1 @@ +19 Grupo Simec S.A.B. de C.V. , AAER-4017 Jan. 29, 2019 CytoDyn Inc. , AAER-4015 Jan. 14, 2019 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , See Also: Administrative Summary Jan. 9, 2019 Katz, Sapper & Miller, LLP and Scott C. Price, CPA , IA-5100, AAER-4013 1 to 97 of 97 items \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4015.txt b/raw/aaer/2019/AAER-4015.txt new file mode 100644 index 0000000000000000000000000000000000000000..992cebdc6a95cb7d558b2560f485437ce5cceed1 --- /dev/null +++ b/raw/aaer/2019/AAER-4015.txt @@ -0,0 +1 @@ +18 Jan. 29, 2019 Lifeway Foods, Inc. , AAER-4016 Jan. 29, 2019 Grupo Simec S.A.B. de C.V. , AAER-4017 Jan. 29, 2019 CytoDyn Inc. , Jan. 14, 2019 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , AAER-4014 See Also: Administrative Summary Jan. 9, 2019 Katz, Sapper & Miller, LLP and Scott C. Price, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4016.txt b/raw/aaer/2019/AAER-4016.txt new file mode 100644 index 0000000000000000000000000000000000000000..99417ef1031678d4557d5999b47b746c433ceb58 --- /dev/null +++ b/raw/aaer/2019/AAER-4016.txt @@ -0,0 +1 @@ +h S., CPA Remus, Michael T., CPA Remus Michael, CPA , AAER-4019 Jan. 29, 2019 Digital Turbine, Inc. , AAER-4018 Jan. 29, 2019 Lifeway Foods, Inc. , Jan. 29, 2019 Grupo Simec S.A.B. de C.V. , AAER-4017 Jan. 29, 2019 CytoDyn Inc. , AAER-4015 Jan. 14, 2019 LBB & Associates Ltd., LLP Lopez, Carlos, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4017.txt b/raw/aaer/2019/AAER-4017.txt new file mode 100644 index 0000000000000000000000000000000000000000..ea4518cc45183729c876dcbd31e9b3beed10e085 --- /dev/null +++ b/raw/aaer/2019/AAER-4017.txt @@ -0,0 +1 @@ +Jan. 29, 2019 Digital Turbine, Inc. , AAER-4018 Jan. 29, 2019 Lifeway Foods, Inc. , AAER-4016 Jan. 29, 2019 Grupo Simec S.A.B. de C.V. , Jan. 29, 2019 CytoDyn Inc. , AAER-4015 Jan. 14, 2019 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , AAER-4014 See Also: Administrative Summary Jan \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4018.txt b/raw/aaer/2019/AAER-4018.txt new file mode 100644 index 0000000000000000000000000000000000000000..9d83174441bdd6dd6c10b1f1b016f7025d9d6d3f --- /dev/null +++ b/raw/aaer/2019/AAER-4018.txt @@ -0,0 +1 @@ +agaki , AAER-4020 Feb. 8, 2019 Amundsen, Joseph S., CPA Remus, Michael T., CPA Remus Michael, CPA , AAER-4019 Jan. 29, 2019 Digital Turbine, Inc. , Jan. 29, 2019 Lifeway Foods, Inc. , AAER-4016 Jan. 29, 2019 Grupo Simec S.A.B. de C.V. , AAER-4017 Jan. 29, 2019 CytoDyn Inc. , AA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4019.txt b/raw/aaer/2019/AAER-4019.txt new file mode 100644 index 0000000000000000000000000000000000000000..823a8463b5fde077e21100fac1a3923df8dbca5b --- /dev/null +++ b/raw/aaer/2019/AAER-4019.txt @@ -0,0 +1 @@ +21 Feb. 13, 2019 Deloitte Touche Tohmatsu LLC, Futomichi Amano and Yuji Itagaki , AAER-4020 Feb. 8, 2019 Amundsen, Joseph S., CPA Remus, Michael T., CPA Remus Michael, CPA , Jan. 29, 2019 Digital Turbine, Inc. , AAER-4018 Jan. 29, 2019 Lifeway Foods, Inc. , AAER-4016 Jan. 29, 2019 Grupo Simec S.A.B. de C.V. \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4020.txt b/raw/aaer/2019/AAER-4020.txt new file mode 100644 index 0000000000000000000000000000000000000000..399247dc1da42b794b80340bda7929a6af5e2560 --- /dev/null +++ b/raw/aaer/2019/AAER-4020.txt @@ -0,0 +1 @@ +No. 34-85159, AAER-4022 Feb. 15, 2019 Cognizant Technology Solutions Corporation , AAER-4021 Feb. 13, 2019 Deloitte Touche Tohmatsu LLC, Futomichi Amano and Yuji Itagaki , Feb. 8, 2019 Amundsen, Joseph S., CPA Remus, Michael T., CPA Remus Michael, CPA , AAER-4019 Jan. 29, 2019 Digital Turbine, Inc. , AAER-4018 Jan. 29, 2019 Li \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4021.txt b/raw/aaer/2019/AAER-4021.txt new file mode 100644 index 0000000000000000000000000000000000000000..a6213d982dd124d6b52bb5301fc133f46c72ffb6 --- /dev/null +++ b/raw/aaer/2019/AAER-4021.txt @@ -0,0 +1 @@ +Order Instituting Proceedings) , AAER-4023 Feb. 15, 2019 Jeffrey M. Mattich , AAER-4022 Feb. 15, 2019 Cognizant Technology Solutions Corporation , Feb. 13, 2019 Deloitte Touche Tohmatsu LLC, Futomichi Amano and Yuji Itagaki , AAER-4020 Feb. 8, 2019 Amundsen, Joseph S., CPA Remus, Michael T., CPA Remus Michael, CPA , AA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4022.txt b/raw/aaer/2019/AAER-4022.txt new file mode 100644 index 0000000000000000000000000000000000000000..12557a2b6aba503aa8657ad19f99a7f5cd71967f --- /dev/null +++ b/raw/aaer/2019/AAER-4022.txt @@ -0,0 +1 @@ +ase No. 34-85237, AAER-4026 Feb. 21, 2019 David Pruitt, CPA (Order Denying Motion to Amend the Order Instituting Proceedings) , AAER-4023 Feb. 15, 2019 Jeffrey M. Mattich , Feb. 15, 2019 Cognizant Technology Solutions Corporation , AAER-4021 Feb. 13, 2019 Deloitte Touche Tohmatsu LLC, Futomichi Amano and Yuji Itagaki , AAER-4020 Feb \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4023.txt b/raw/aaer/2019/AAER-4023.txt new file mode 100644 index 0000000000000000000000000000000000000000..d24738bf8f05b840fa1bbfa7ead3a673d433fd6f --- /dev/null +++ b/raw/aaer/2019/AAER-4023.txt @@ -0,0 +1 @@ +Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , AAER-4026 Feb. 21, 2019 David Pruitt, CPA (Order Denying Motion to Amend the Order Instituting Proceedings) , Feb. 15, 2019 Jeffrey M. Mattich , AAER-4022 Feb. 15, 2019 Cognizant Technology Solutions Corporation , AAER-4021 Feb. 13, 2019 Deloitte Touche Tohmatsu LLC \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4024.txt b/raw/aaer/2019/AAER-4024.txt new file mode 100644 index 0000000000000000000000000000000000000000..122eaaf88e9b5cfabdb825797e199482c3602bdc --- /dev/null +++ b/raw/aaer/2019/AAER-4024.txt @@ -0,0 +1 @@ +ease No. 34-85250, AAER-4027 March 1, 2019 Arthur Viola , AAER-4025 See Also: Administrative Summary March 1, 2019 DLL CPAS, LLC and Debra Lee Lindaman, CPA , See Also: Administrative Summary March 1, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , AAER-4026 Feb. 21, 2019 David Pruitt, CPA (Order Denying M \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4025.txt b/raw/aaer/2019/AAER-4025.txt new file mode 100644 index 0000000000000000000000000000000000000000..753d6ac4b565d53811a7153439c591ad5db33e10 --- /dev/null +++ b/raw/aaer/2019/AAER-4025.txt @@ -0,0 +1 @@ +5261, AAER-4028 March 5, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , AAER-4027 March 1, 2019 Arthur Viola , See Also: Administrative Summary March 1, 2019 DLL CPAS, LLC and Debra Lee Lindaman, CPA , AAER-4024 See Also: Administrative Summary March 1, 2019 Joseph S. Amundsen, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4026.txt b/raw/aaer/2019/AAER-4026.txt new file mode 100644 index 0000000000000000000000000000000000000000..3419c72867ca6f9a502b5fe6a13024897fa15d85 --- /dev/null +++ b/raw/aaer/2019/AAER-4026.txt @@ -0,0 +1 @@ +CPAS, LLC and Debra Lee Lindaman, CPA , AAER-4024 See Also: Administrative Summary March 1, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , Feb. 21, 2019 David Pruitt, CPA (Order Denying Motion to Amend the Order Instituting Proceedings) , AAER-4023 Feb. 15, 2019 Jeffrey M. Mattich , AAER-4022 Feb. 1 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4027.txt b/raw/aaer/2019/AAER-4027.txt new file mode 100644 index 0000000000000000000000000000000000000000..79266edc78083e9ccf203f81c2e6f5a1f725df9c --- /dev/null +++ b/raw/aaer/2019/AAER-4027.txt @@ -0,0 +1 @@ +4029 March 6, 2019 Mobile TeleSystems PJSC , AAER-4028 March 5, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , March 1, 2019 Arthur Viola , AAER-4025 See Also: Administrative Summary March 1, 2019 DLL CPAS, LLC and Debra Lee Lindaman, CPA , AAER-4024 See Also: \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4028.txt b/raw/aaer/2019/AAER-4028.txt new file mode 100644 index 0000000000000000000000000000000000000000..6bacddab5d8ac260e5fb1fb7cf37ad6bfca7b173 --- /dev/null +++ b/raw/aaer/2019/AAER-4028.txt @@ -0,0 +1 @@ +ase No. 34-85310, AAER-4030 March 11, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , AAER-4029 March 6, 2019 Mobile TeleSystems PJSC , March 5, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , AAER-4027 March 1, 2019 Arthur Viola , AAER-4025 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4029.txt b/raw/aaer/2019/AAER-4029.txt new file mode 100644 index 0000000000000000000000000000000000000000..800feaad56fe424d928ec81a3f7b6c4e1cde8d16 --- /dev/null +++ b/raw/aaer/2019/AAER-4029.txt @@ -0,0 +1 @@ +CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , AAER-4030 March 11, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , March 6, 2019 Mobile TeleSystems PJSC , AAER-4028 March 5, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , AAER \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4030.txt b/raw/aaer/2019/AAER-4030.txt new file mode 100644 index 0000000000000000000000000000000000000000..a4e85c6de54da7f1f00546adf8044ba2f892ffbc --- /dev/null +++ b/raw/aaer/2019/AAER-4030.txt @@ -0,0 +1 @@ +March 22, 2019 Judson F. "Rick" Hoover, CPA , AAER-4031 March 13, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , March 11, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , AAER-4029 March 6, 2019 Mobile TeleSystems PJSC , AAER-4028 March \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4031.txt b/raw/aaer/2019/AAER-4031.txt new file mode 100644 index 0000000000000000000000000000000000000000..5c1a7b3b01b12d16ffa0bcc465c4ef2951526bbf --- /dev/null +++ b/raw/aaer/2019/AAER-4031.txt @@ -0,0 +1 @@ +March 26, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Notice Regarding Correspondence) , AAER-4032 March 22, 2019 Judson F. "Rick" Hoover, CPA , March 13, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) , AAER-4030 March 11, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Mic \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4032.txt b/raw/aaer/2019/AAER-4032.txt new file mode 100644 index 0000000000000000000000000000000000000000..1f4a85b6566684dc3e665d057dcef72706093fa8 --- /dev/null +++ b/raw/aaer/2019/AAER-4032.txt @@ -0,0 +1 @@ +March 29, 2019 Fresenius Medical Care AG & Co. KGaA , AAER-4033 March 26, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Notice Regarding Correspondence) , March 22, 2019 Judson F. "Rick" Hoover, CPA , AAER-4031 March 13, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence) \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4033.txt b/raw/aaer/2019/AAER-4033.txt new file mode 100644 index 0000000000000000000000000000000000000000..450b5fad377e93bb133d1c576a85483f245dc1a2 --- /dev/null +++ b/raw/aaer/2019/AAER-4033.txt @@ -0,0 +1 @@ +, 2019 Kevin E. Brooks, CPA , AAER-4035 April 1, 2019 Wolf, Jennifer F., CPA , AAER-4034 March 29, 2019 Fresenius Medical Care AG & Co. KGaA , March 26, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Notice Regarding Correspondence) , AAER-4032 March 22, 2019 Judson F. "Rick" Hoover, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4034.txt b/raw/aaer/2019/AAER-4034.txt new file mode 100644 index 0000000000000000000000000000000000000000..6fdb81ff2b43b85b90cda7a01bc1d212cace3a4d --- /dev/null +++ b/raw/aaer/2019/AAER-4034.txt @@ -0,0 +1 @@ +April 3, 2019 Evan R. Kita, CPA , AAER-4036 April 2, 2019 Kevin E. Brooks, CPA , AAER-4035 April 1, 2019 Wolf, Jennifer F., CPA , March 29, 2019 Fresenius Medical Care AG & Co. KGaA , AAER-4033 March 26, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Notice Regarding Correspondence) \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4035.txt b/raw/aaer/2019/AAER-4035.txt new file mode 100644 index 0000000000000000000000000000000000000000..f114a61a1ceb6bec92f19fdd82a8972b5cc8e463 --- /dev/null +++ b/raw/aaer/2019/AAER-4035.txt @@ -0,0 +1 @@ +April 4, 2019 Evan R. Kita, et al. , AAER-4038 April 3, 2019 Evan R. Kita, CPA , AAER-4036 April 2, 2019 Kevin E. Brooks, CPA , April 1, 2019 Wolf, Jennifer F., CPA , AAER-4034 March 29, 2019 Fresenius Medical Care AG & Co. KGaA , AAER-4033 March 26, 2019 Joseph S. Amundsen, CPA, Mic \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4036.txt b/raw/aaer/2019/AAER-4036.txt new file mode 100644 index 0000000000000000000000000000000000000000..5120667506432823021fa4273a252ab4a23f53c9 --- /dev/null +++ b/raw/aaer/2019/AAER-4036.txt @@ -0,0 +1 @@ +er, CPA , AAER-4037 See Also: Administrative Summary April 4, 2019 Evan R. Kita, et al. , AAER-4038 April 3, 2019 Evan R. Kita, CPA , April 2, 2019 Kevin E. Brooks, CPA , AAER-4035 April 1, 2019 Wolf, Jennifer F., CPA , AAER-4034 March 29, 2019 Fresenius Medical Care AG & Co. KGaA Rel \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4037.txt b/raw/aaer/2019/AAER-4037.txt new file mode 100644 index 0000000000000000000000000000000000000000..692e8b5c2e5177c8c7e0d3ba2e464c381ae201ee --- /dev/null +++ b/raw/aaer/2019/AAER-4037.txt @@ -0,0 +1 @@ +34-85630, IA-5222, AAER-4040 April 10, 2019 Adam C. Derbyshire , 34-85582, AAER-4039 April 5, 2019 KLJ & Associates, LLP, Kent L. Jensen, CPA and Ronald A. Burgmeier, CPA , See Also: Administrative Summary April 4, 2019 Evan R. Kita, et al. , AAER-4038 April 3, 2019 Evan R. Kita, CPA , AAER-4036 April 2, 2019 Kevi \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4038.txt b/raw/aaer/2019/AAER-4038.txt new file mode 100644 index 0000000000000000000000000000000000000000..ead90c93d59724d54d48721096696725c4ad6f78 --- /dev/null +++ b/raw/aaer/2019/AAER-4038.txt @@ -0,0 +1 @@ +April 5, 2019 KLJ & Associates, LLP, Kent L. Jensen, CPA and Ronald A. Burgmeier, CPA , AAER-4037 See Also: Administrative Summary April 4, 2019 Evan R. Kita, et al. , April 3, 2019 Evan R. Kita, CPA , AAER-4036 April 2, 2019 Kevin E. Brooks, CPA , AAER-4035 April 1, 2019 Wolf, Jennifer F., CPA , \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4039.txt b/raw/aaer/2019/AAER-4039.txt new file mode 100644 index 0000000000000000000000000000000000000000..05797eee678ae876709c81f8e551664343f5561d --- /dev/null +++ b/raw/aaer/2019/AAER-4039.txt @@ -0,0 +1 @@ +85703, AAER-4042 April 11, 2019 Karen Bruton and Hope Advisors, LLC (Order Regarding Further Proceedings) , IA-5222, AAER-4040 April 10, 2019 Adam C. Derbyshire , 34-85582, April 5, 2019 KLJ & Associates, LLP, Kent L. Jensen, CPA and Ronald A. Burgmeier, CPA , AAER-4037 See Also: Administrative Summary April 4, 2019 Evan R. Kita, et al. \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4040.txt b/raw/aaer/2019/AAER-4040.txt new file mode 100644 index 0000000000000000000000000000000000000000..c124878352dd9f41cc586c3e997ac79f6d31cc4f --- /dev/null +++ b/raw/aaer/2019/AAER-4040.txt @@ -0,0 +1 @@ +10632, 34-85702, AAER-4041 April 22, 2019 David M. Martin CPA , AAER-4042 April 11, 2019 Karen Bruton and Hope Advisors, LLC (Order Regarding Further Proceedings) , IA-5222, April 10, 2019 Adam C. Derbyshire , 34-85582, AAER-4039 April 5, 2019 KLJ & Associates, LLP, Kent L. Jensen, CPA and Ronald A. Burgmeier, CPA , AAER-4037 See Also: \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4041.txt b/raw/aaer/2019/AAER-4041.txt new file mode 100644 index 0000000000000000000000000000000000000000..40ad1736a7251070211719f4d06c688d8989b4fe --- /dev/null +++ b/raw/aaer/2019/AAER-4041.txt @@ -0,0 +1 @@ +ael Remus CPA. (Order) , AAER-4044 April 23, 2019 Michael F. Cronin, CPA , AAER-4043 April 22, 2019 Dov Zaidman, CPA, and ZBS Group LLP , 34-85702, April 22, 2019 David M. Martin CPA , AAER-4042 April 11, 2019 Karen Bruton and Hope Advisors, LLC (Order Regarding Further Proceedings) , IA-5222, AAER-4040 Apri \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4042.txt b/raw/aaer/2019/AAER-4042.txt new file mode 100644 index 0000000000000000000000000000000000000000..fec68fc262550dc210b43de23df0df0e8b59c4b8 --- /dev/null +++ b/raw/aaer/2019/AAER-4042.txt @@ -0,0 +1 @@ +Michael F. Cronin, CPA , AAER-4043 April 22, 2019 Dov Zaidman, CPA, and ZBS Group LLP , 34-85702, AAER-4041 April 22, 2019 David M. Martin CPA , April 11, 2019 Karen Bruton and Hope Advisors, LLC (Order Regarding Further Proceedings) , IA-5222, AAER-4040 April 10, 2019 Adam C. Derbyshire , 34-85582, AAER-4039 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4043.txt b/raw/aaer/2019/AAER-4043.txt new file mode 100644 index 0000000000000000000000000000000000000000..2eee25ea1fd439985ab91b3444e38f3943456e0a --- /dev/null +++ b/raw/aaer/2019/AAER-4043.txt @@ -0,0 +1 @@ +3-10636, 34-85767, AAER-4045 April 25, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , AAER-4044 April 23, 2019 Michael F. Cronin, CPA , April 22, 2019 Dov Zaidman, CPA, and ZBS Group LLP , 34-85702, AAER-4041 April 22, 2019 David M. Martin CPA , AAER-4042 April 11, 2019 Karen Bruton and Hope \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4044.txt b/raw/aaer/2019/AAER-4044.txt new file mode 100644 index 0000000000000000000000000000000000000000..84a306f3b5024a63e94b5e69aca11ed8ff3baa1a --- /dev/null +++ b/raw/aaer/2019/AAER-4044.txt @@ -0,0 +1 @@ +ive Summary May 3, 2019 GT Advanced Technologies Inc. , 34-85767, AAER-4045 April 25, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , April 23, 2019 Michael F. Cronin, CPA , AAER-4043 April 22, 2019 Dov Zaidman, CPA, and ZBS Group LLP , 34-85702, AAER-4041 April 22, 2019 David M. Martin CP \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4045.txt b/raw/aaer/2019/AAER-4045.txt new file mode 100644 index 0000000000000000000000000000000000000000..03df86f0ecb6d58862e9766a929015616d063bd7 --- /dev/null +++ b/raw/aaer/2019/AAER-4045.txt @@ -0,0 +1 @@ +No. 34-85847, AAER-4047 May 9, 2019 Telefônica Brasil S.A. , AAER-4046 See Also: Administrative Summary May 3, 2019 GT Advanced Technologies Inc. , 34-85767, April 25, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order) , AAER-4044 April 23, 2019 Michael F. Cronin, CPA , AAER-4043 April \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4046.txt b/raw/aaer/2019/AAER-4046.txt new file mode 100644 index 0000000000000000000000000000000000000000..e4a3d49cfc2df5e83d293cbe94e9eeb554cd73ae --- /dev/null +++ b/raw/aaer/2019/AAER-4046.txt @@ -0,0 +1 @@ +ER-4049 June 4, 2019 Rand, Michael T. , AAER-4048 May 13, 2019 Bryan B. Long, CPA , AAER-4047 May 9, 2019 Telefônica Brasil S.A. , See Also: Administrative Summary May 3, 2019 GT Advanced Technologies Inc. , 34-85767, AAER-4045 April 25, 2019 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Or \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4047.txt b/raw/aaer/2019/AAER-4047.txt new file mode 100644 index 0000000000000000000000000000000000000000..1e3faa78232eab1ef38478c61ce6f6c4ec329085 --- /dev/null +++ b/raw/aaer/2019/AAER-4047.txt @@ -0,0 +1 @@ +Pinnacle Accountancy Group, PLLC and Douglas W. Child, CPA , AAER-4049 June 4, 2019 Rand, Michael T. , AAER-4048 May 13, 2019 Bryan B. Long, CPA , May 9, 2019 Telefônica Brasil S.A. , AAER-4046 See Also: Administrative Summary May 3, 2019 GT Advanced Technologies Inc. , 34-85767, AAER-4045 Apr \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4048.txt b/raw/aaer/2019/AAER-4048.txt new file mode 100644 index 0000000000000000000000000000000000000000..00bf452ddd8bbb9a7c177c150de113a737715ce9 --- /dev/null +++ b/raw/aaer/2019/AAER-4048.txt @@ -0,0 +1 @@ +David Vogel, CPA , AAER-4050 June 5, 2019 Pinnacle Accountancy Group, PLLC and Douglas W. Child, CPA , AAER-4049 June 4, 2019 Rand, Michael T. , May 13, 2019 Bryan B. Long, CPA , AAER-4047 May 9, 2019 Telefônica Brasil S.A. , AAER-4046 See Also: Administrative Summary May 3, 2019 GT Adv \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4049.txt b/raw/aaer/2019/AAER-4049.txt new file mode 100644 index 0000000000000000000000000000000000000000..bc7a743fdce9f65631ae16134d4d0dfa36237708 --- /dev/null +++ b/raw/aaer/2019/AAER-4049.txt @@ -0,0 +1 @@ +en D. Cheaney, CPA , AAER-4052 June 14, 2019 David Vogel, CPA , AAER-4050 June 5, 2019 Pinnacle Accountancy Group, PLLC and Douglas W. Child, CPA , June 4, 2019 Rand, Michael T. , AAER-4048 May 13, 2019 Bryan B. Long, CPA , AAER-4047 May 9, 2019 Telefônica Brasil S.A. , AAER-40 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4050.txt b/raw/aaer/2019/AAER-4050.txt new file mode 100644 index 0000000000000000000000000000000000000000..a65f8402aae7228e8bde35c0044cbae85f02fe8e --- /dev/null +++ b/raw/aaer/2019/AAER-4050.txt @@ -0,0 +1 @@ +MG LLP , AAER-4051 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , AAER-4052 June 14, 2019 David Vogel, CPA , June 5, 2019 Pinnacle Accountancy Group, PLLC and Douglas W. Child, CPA , AAER-4049 June 4, 2019 Rand, Michael T. , AAER-4048 May 13, 2019 Bryan B. Long, CP \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4051.txt b/raw/aaer/2019/AAER-4051.txt new file mode 100644 index 0000000000000000000000000000000000000000..d045ccb0b810341951bd4352e98de9e984571574 --- /dev/null +++ b/raw/aaer/2019/AAER-4051.txt @@ -0,0 +1 @@ +Walmart Inc. , AAER-4054 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , AAER-4053 June 17, 2019 KPMG LLP , June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , AAER-4052 June 14, 2019 David Vogel, CPA , AAER-4050 June 5, 2019 Pinn \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4052.txt b/raw/aaer/2019/AAER-4052.txt new file mode 100644 index 0000000000000000000000000000000000000000..b805fdbf6259910f9a9f5a5856954e13a639a474 --- /dev/null +++ b/raw/aaer/2019/AAER-4052.txt @@ -0,0 +1 @@ +. Cheaney, CPA , AAER-4053 June 17, 2019 KPMG LLP , AAER-4051 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , June 14, 2019 David Vogel, CPA , AAER-4050 June 5, 2019 Pinnacle Accountancy Group, PLLC and Douglas W. Child, CPA , AAER-4049 June 4, 2019 Rand, Michael T. \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4053.txt b/raw/aaer/2019/AAER-4053.txt new file mode 100644 index 0000000000000000000000000000000000000000..5fbbac538982cc45189deb9a3bff04ceb7edaa72 --- /dev/null +++ b/raw/aaer/2019/AAER-4053.txt @@ -0,0 +1 @@ +Jones, CPA , AAER-4056 June 20, 2019 Walmart Inc. , AAER-4054 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , June 17, 2019 KPMG LLP , AAER-4051 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , AAER-4052 June 14, 2019 David Vogel \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4054.txt b/raw/aaer/2019/AAER-4054.txt new file mode 100644 index 0000000000000000000000000000000000000000..76850ba9441c571c58e13faf6ae858e4c8ee07bc --- /dev/null +++ b/raw/aaer/2019/AAER-4054.txt @@ -0,0 +1 @@ +R-4057 June 28, 2019 R. Gordon Jones, CPA , AAER-4055 June 28, 2019 S. Jeffrey Jones, CPA , AAER-4056 June 20, 2019 Walmart Inc. , June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , AAER-4053 June 17, 2019 KPMG LLP , AAER-4051 June 17, 2019 Rodney A. S \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4055.txt b/raw/aaer/2019/AAER-4055.txt new file mode 100644 index 0000000000000000000000000000000000000000..924e0eb39d7b323bdb35cac7c0a6b8433f845f23 --- /dev/null +++ b/raw/aaer/2019/AAER-4055.txt @@ -0,0 +1 @@ +y July 10, 2019 Thomas H. Laws, CPA , AAER-4058 July 1, 2019 Thomas Chang, CPA , AAER-4057 June 28, 2019 R. Gordon Jones, CPA , June 28, 2019 S. Jeffrey Jones, CPA , AAER-4056 June 20, 2019 Walmart Inc. , AAER-4054 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4056.txt b/raw/aaer/2019/AAER-4056.txt new file mode 100644 index 0000000000000000000000000000000000000000..acb30b7b61d86a208ab6966b97da304956cb1a98 --- /dev/null +++ b/raw/aaer/2019/AAER-4056.txt @@ -0,0 +1 @@ +58 July 1, 2019 Thomas Chang, CPA , AAER-4057 June 28, 2019 R. Gordon Jones, CPA , AAER-4055 June 28, 2019 S. Jeffrey Jones, CPA , June 20, 2019 Walmart Inc. , AAER-4054 June 17, 2019 Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA , AAER-4053 June 17, 2019 KPMG LL \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4057.txt b/raw/aaer/2019/AAER-4057.txt new file mode 100644 index 0000000000000000000000000000000000000000..a667838cf4fedfcb5a87d2c271b136ff4e626576 --- /dev/null +++ b/raw/aaer/2019/AAER-4057.txt @@ -0,0 +1 @@ +Co., CPA , AAER-4059 See Also: Administrative Summary July 10, 2019 Thomas H. Laws, CPA , AAER-4058 July 1, 2019 Thomas Chang, CPA , June 28, 2019 R. Gordon Jones, CPA , AAER-4055 June 28, 2019 S. Jeffrey Jones, CPA , AAER-4056 June 20, 2019 Walmart Inc. , AAER-4 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4058.txt b/raw/aaer/2019/AAER-4058.txt new file mode 100644 index 0000000000000000000000000000000000000000..f53d50321b50ce21d2f99cfb3acac2656bc6271f --- /dev/null +++ b/raw/aaer/2019/AAER-4058.txt @@ -0,0 +1 @@ +4060, AAER-4060 July 16, 2019 Dov Weinstein, CPA and Dov Weinstein & Co., CPA , AAER-4059 See Also: Administrative Summary July 10, 2019 Thomas H. Laws, CPA , July 1, 2019 Thomas Chang, CPA , AAER-4057 June 28, 2019 R. Gordon Jones, CPA , AAER-4055 June 28, 2019 S. Jeffrey Jones, CPA , AA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4059.txt b/raw/aaer/2019/AAER-4059.txt new file mode 100644 index 0000000000000000000000000000000000000000..1213cd2b681ec39b13162a950c75ec4f6cbcbf13 --- /dev/null +++ b/raw/aaer/2019/AAER-4059.txt @@ -0,0 +1 @@ +rty Group Inc. , AAER-4061 July 26, 2019 Nevanna Sacks, CPA , AAER-4060, AAER-4060 July 16, 2019 Dov Weinstein, CPA and Dov Weinstein & Co., CPA , See Also: Administrative Summary July 10, 2019 Thomas H. Laws, CPA , AAER-4058 July 1, 2019 Thomas Chang, CPA , AAER-4057 June 28, 2019 R. Gor \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4060.txt b/raw/aaer/2019/AAER-4060.txt new file mode 100644 index 0000000000000000000000000000000000000000..0137c38722e0ce0c46cd0f59e8951c9576f56983 --- /dev/null +++ b/raw/aaer/2019/AAER-4060.txt @@ -0,0 +1 @@ +Aug. 5, 2019 Nandu Thondavadi , AAER-4062 Aug. 1, 2019 Brixmor Property Group Inc. , AAER-4061 July 26, 2019 Nevanna Sacks, CPA , , July 16, 2019 Dov Weinstein, CPA and Dov Weinstein & Co., CPA , AAER-4059 See Also: Administrative Summary July 10, 2019 Thomas H. Laws, CPA , AAER-4058 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4061.txt b/raw/aaer/2019/AAER-4061.txt new file mode 100644 index 0000000000000000000000000000000000000000..762e0563edb79652694a2b478164bdead9fc5f91 --- /dev/null +++ b/raw/aaer/2019/AAER-4061.txt @@ -0,0 +1 @@ +Esq. , AAER-4063 See Also: Litigation Release Aug. 5, 2019 Nandu Thondavadi , AAER-4062 Aug. 1, 2019 Brixmor Property Group Inc. , July 26, 2019 Nevanna Sacks, CPA , AAER-4060, AAER-4060 July 16, 2019 Dov Weinstein, CPA and Dov Weinstein & Co., CPA , AAER-4059 See Also: Administrative Summar \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4062.txt b/raw/aaer/2019/AAER-4062.txt new file mode 100644 index 0000000000000000000000000000000000000000..e5081f6cb122606d87bf02e33e688ff522032c82 --- /dev/null +++ b/raw/aaer/2019/AAER-4062.txt @@ -0,0 +1 @@ +See Also: Administrative Summary Aug. 7, 2019 Thomas W. Avent, Jr., CPA, Esq. , AAER-4063 See Also: Litigation Release Aug. 5, 2019 Nandu Thondavadi , Aug. 1, 2019 Brixmor Property Group Inc. , AAER-4061 July 26, 2019 Nevanna Sacks, CPA , AAER-4060, AAER-4060 July 16, 2019 Dov Weinstein, CPA and Dov Weins \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4063.txt b/raw/aaer/2019/AAER-4063.txt new file mode 100644 index 0000000000000000000000000000000000000000..cb3c89b513c7994be52ed9017bfe2048c57eeb08 --- /dev/null +++ b/raw/aaer/2019/AAER-4063.txt @@ -0,0 +1 @@ +mary Aug. 21, 2019 Michael Filkoski, CPA and Scott Magnuson, CPA , AAER-4064 See Also: Administrative Summary Aug. 7, 2019 Thomas W. Avent, Jr., CPA, Esq. , See Also: Litigation Release Aug. 5, 2019 Nandu Thondavadi , AAER-4062 Aug. 1, 2019 Brixmor Property Group Inc. , AAER-4061 July 26, 2019 Ne \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4064.txt b/raw/aaer/2019/AAER-4064.txt new file mode 100644 index 0000000000000000000000000000000000000000..fdada96ce04de66579aab5dcf290d8d8f9c75f23 --- /dev/null +++ b/raw/aaer/2019/AAER-4064.txt @@ -0,0 +1 @@ +0, IA-5331, AAER-4066 Aug. 22, 2019 Deutsche Bank AG , AAER-4065 See Also: Administrative Summary Aug. 21, 2019 Michael Filkoski, CPA and Scott Magnuson, CPA , See Also: Administrative Summary Aug. 7, 2019 Thomas W. Avent, Jr., CPA, Esq. , AAER-4063 See Also: Litigation Release Aug. 5, 2019 Nandu Thondavadi \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4065.txt b/raw/aaer/2019/AAER-4065.txt new file mode 100644 index 0000000000000000000000000000000000000000..62af6a90bbf9ff7c0281a451e4cd40f1462c24e2 --- /dev/null +++ b/raw/aaer/2019/AAER-4065.txt @@ -0,0 +1 @@ +. 27, 2019 Alan G. Heide, CPA , AAER-4067 Aug. 27, 2019 RSM US LLP (f/k/a McGladrey LLP) , IA-5331, AAER-4066 Aug. 22, 2019 Deutsche Bank AG , See Also: Administrative Summary Aug. 21, 2019 Michael Filkoski, CPA and Scott Magnuson, CPA , AAER-4064 See Also: Administrative Summary Aug. 7, 2019 Thomas W. Avent, Jr. \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4066.txt b/raw/aaer/2019/AAER-4066.txt new file mode 100644 index 0000000000000000000000000000000000000000..21b9de6bd8f022becf28627f07e355a94effbb7d --- /dev/null +++ b/raw/aaer/2019/AAER-4066.txt @@ -0,0 +1 @@ +o. 34-86812, AAER-4069 See Also: Administrative Summary Aug. 27, 2019 Alan G. Heide, CPA , AAER-4067 Aug. 27, 2019 RSM US LLP (f/k/a McGladrey LLP) , IA-5331, Aug. 22, 2019 Deutsche Bank AG , AAER-4065 See Also: Administrative Summary Aug. 21, 2019 Michael Filkoski, CPA and Scott Magnuson, CPA , AAER-4064 See \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4067.txt b/raw/aaer/2019/AAER-4067.txt new file mode 100644 index 0000000000000000000000000000000000000000..3496c94fd9706955d2145894d5845579f537321c --- /dev/null +++ b/raw/aaer/2019/AAER-4067.txt @@ -0,0 +1 @@ +myth , AAER-4068 Aug. 29, 2019 Juniper Networks, Inc. , AAER-4069 See Also: Administrative Summary Aug. 27, 2019 Alan G. Heide, CPA , Aug. 27, 2019 RSM US LLP (f/k/a McGladrey LLP) , IA-5331, AAER-4066 Aug. 22, 2019 Deutsche Bank AG , AAER-4065 See Also: Administrative Summary Aug \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4068.txt b/raw/aaer/2019/AAER-4068.txt new file mode 100644 index 0000000000000000000000000000000000000000..ee815e2bd974a5f4e42bca56500b726937fa347b --- /dev/null +++ b/raw/aaer/2019/AAER-4068.txt @@ -0,0 +1 @@ +1 See Also: Administrative Summary Sept. 5, 2019 Daniel Khesin , 34-86889, AAER-4070 See Also: Administrative Summary Aug. 29, 2019 Robin Smyth , Aug. 29, 2019 Juniper Networks, Inc. , AAER-4069 See Also: Administrative Summary Aug. 27, 2019 Alan G. Heide, CPA , AAER-4067 Aug. 27, 2019 R \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4069.txt b/raw/aaer/2019/AAER-4069.txt new file mode 100644 index 0000000000000000000000000000000000000000..c1c259d573784b6cb22c7ae9a64cb287f36a0fd2 --- /dev/null +++ b/raw/aaer/2019/AAER-4069.txt @@ -0,0 +1 @@ +n , 34-86889, AAER-4070 See Also: Administrative Summary Aug. 29, 2019 Robin Smyth , AAER-4068 Aug. 29, 2019 Juniper Networks, Inc. , See Also: Administrative Summary Aug. 27, 2019 Alan G. Heide, CPA , AAER-4067 Aug. 27, 2019 RSM US LLP (f/k/a McGladrey LLP) , IA-5331, AAER-4066 A \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4070.txt b/raw/aaer/2019/AAER-4070.txt new file mode 100644 index 0000000000000000000000000000000000000000..2cea4541e56c3e9fac8a04c7001e5fb8773b5555 --- /dev/null +++ b/raw/aaer/2019/AAER-4070.txt @@ -0,0 +1 @@ +, AAER-4072 Sept. 6, 2019 Abner Silva , 34-86900, AAER-4071 See Also: Administrative Summary Sept. 5, 2019 Daniel Khesin , 34-86889, See Also: Administrative Summary Aug. 29, 2019 Robin Smyth , AAER-4068 Aug. 29, 2019 Juniper Networks, Inc. , AAER-4069 See Also: Administrative Sum \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4071.txt b/raw/aaer/2019/AAER-4071.txt new file mode 100644 index 0000000000000000000000000000000000000000..0ca34f1d30140c35b76a9614675d33b78ed425aa --- /dev/null +++ b/raw/aaer/2019/AAER-4071.txt @@ -0,0 +1 @@ +Sept. 11, 2019 Robert D. Hesselgesser, CPA , AAER-4073 Sept. 9, 2019 Beamish, Adrian D., CPA , AAER-4072 Sept. 6, 2019 Abner Silva , 34-86900, See Also: Administrative Summary Sept. 5, 2019 Daniel Khesin , 34-86889, AAER-4070 See Also: Administrative Summary Aug. 29, 2019 Robin Smyth , A \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4072.txt b/raw/aaer/2019/AAER-4072.txt new file mode 100644 index 0000000000000000000000000000000000000000..6c2b05c12256b8453cfa9ebfc828a17afef9fb9f --- /dev/null +++ b/raw/aaer/2019/AAER-4072.txt @@ -0,0 +1 @@ +, AAER-4075 See Also: Administrative Summary Sept. 11, 2019 Robert D. Hesselgesser, CPA , AAER-4073 Sept. 9, 2019 Beamish, Adrian D., CPA , Sept. 6, 2019 Abner Silva , 34-86900, AAER-4071 See Also: Administrative Summary Sept. 5, 2019 Daniel Khesin , 34-86889, AAER-4070 See Also: Adminis \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4073.txt b/raw/aaer/2019/AAER-4073.txt new file mode 100644 index 0000000000000000000000000000000000000000..a9bfa29979080b9ec3abec153fd52d0dc67f3140 --- /dev/null +++ b/raw/aaer/2019/AAER-4073.txt @@ -0,0 +1 @@ +d/b/a Daniloff Capital Management, LLC and Elliot Daniloff a/k/a Ilya Olegovich Danilov , AAER-4075 See Also: Administrative Summary Sept. 11, 2019 Robert D. Hesselgesser, CPA , Sept. 9, 2019 Beamish, Adrian D., CPA , AAER-4072 Sept. 6, 2019 Abner Silva , 34-86900, AAER-4071 See Also: Administrative Summary Sept. 5, 2019 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4074.txt b/raw/aaer/2019/AAER-4074.txt new file mode 100644 index 0000000000000000000000000000000000000000..9bab1b2331de4eb938eb2f75a4a7e833b41098aa --- /dev/null +++ b/raw/aaer/2019/AAER-4074.txt @@ -0,0 +1 @@ +e No. LR-24599, AAER-4077 See Also: SEC Complaint Sept. 16, 2019 Marvell Technology Group, Ltd. , 34-86971, AAER-4076 Sept. 13, 2019 Sridhar Thiruvengadam , See Also: Administrative Summary Sept. 13, 2019 ED Capital Management, LLC d/b/a Daniloff Capital Management, LLC and Elliot Daniloff a/k/a Ilya Olegovich Danilov , AAER-4075 See Also: Adminis \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4075.txt b/raw/aaer/2019/AAER-4075.txt new file mode 100644 index 0000000000000000000000000000000000000000..67c4a6b13a2f2516fd261947fcc2530d2cddb42d --- /dev/null +++ b/raw/aaer/2019/AAER-4075.txt @@ -0,0 +1 @@ +, AAER-4074 See Also: Administrative Summary Sept. 13, 2019 ED Capital Management, LLC d/b/a Daniloff Capital Management, LLC and Elliot Daniloff a/k/a Ilya Olegovich Danilov , See Also: Administrative Summary Sept. 11, 2019 Robert D. Hesselgesser, CPA , AAER-4073 Sept. 9, 2019 Beamish, Adrian D., CPA , AAER-4072 Sept. 6, \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4076.txt b/raw/aaer/2019/AAER-4076.txt new file mode 100644 index 0000000000000000000000000000000000000000..4e47892d3ea1e20658ca97b4938b3e0a1bcc4208 --- /dev/null +++ b/raw/aaer/2019/AAER-4076.txt @@ -0,0 +1 @@ +ease No. 34-87032, IA-5357, AAER-4079 Sept. 17, 2019 Tom Simeo , AAER-4077 See Also: SEC Complaint Sept. 16, 2019 Marvell Technology Group, Ltd. , 34-86971, Sept. 13, 2019 Sridhar Thiruvengadam , AAER-4074 See Also: Administrative Summary Sept. 13, 2019 ED Capital Management, LLC d/b/a Daniloff Capital Management, LLC and Elliot Daniloff a/ \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4077.txt b/raw/aaer/2019/AAER-4077.txt new file mode 100644 index 0000000000000000000000000000000000000000..47f501ec1ea96a6e97ba5599d359ef898977c539 --- /dev/null +++ b/raw/aaer/2019/AAER-4077.txt @@ -0,0 +1 @@ +Sept. 19, 2019 Kevyn N. Rakowski, CPA , AAER-4078 Sept. 19, 2019 David R. Gibson , IA-5357, AAER-4079 Sept. 17, 2019 Tom Simeo , See Also: SEC Complaint Sept. 16, 2019 Marvell Technology Group, Ltd. , 34-86971, AAER-4076 Sept. 13, 2019 Sridhar Thiruvengadam , AAER-4074 See Also: \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4078.txt b/raw/aaer/2019/AAER-4078.txt new file mode 100644 index 0000000000000000000000000000000000000000..b85ec48f4d583d7db1e012ebe655634e21d94b19 --- /dev/null +++ b/raw/aaer/2019/AAER-4078.txt @@ -0,0 +1 @@ +See Also: Administrative Summary Sept. 20, 2019 The Bancorp, Inc. , AAER-4081 See Also: Administrative Summary Sept. 19, 2019 Kevyn N. Rakowski, CPA , Sept. 19, 2019 David R. Gibson , IA-5357, AAER-4079 Sept. 17, 2019 Tom Simeo , AAER-4077 See Also: SEC Complaint Sept. 16, 2019 Marvell Tech \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4079.txt b/raw/aaer/2019/AAER-4079.txt new file mode 100644 index 0000000000000000000000000000000000000000..0be11d506ec3e122423696c4deae1b43a0800494 --- /dev/null +++ b/raw/aaer/2019/AAER-4079.txt @@ -0,0 +1 @@ +, AAER-4081 See Also: Administrative Summary Sept. 19, 2019 Kevyn N. Rakowski, CPA , AAER-4078 Sept. 19, 2019 David R. Gibson , IA-5357, Sept. 17, 2019 Tom Simeo , AAER-4077 See Also: SEC Complaint Sept. 16, 2019 Marvell Technology Group, Ltd. , 34-86971, AAER-4076 Sept. 13, 2019 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4080.txt b/raw/aaer/2019/AAER-4080.txt new file mode 100644 index 0000000000000000000000000000000000000000..090355627175c9b028ab3dba0b0ce3f321df0b4d --- /dev/null +++ b/raw/aaer/2019/AAER-4080.txt @@ -0,0 +1 @@ +s David Hilty , AAER-4082 See Also: Administrative Summary Sept. 20, 2019 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , Sept. 20, 2019 Donald F. Mcgraw, Jr. , AAER-4083 See Also: Administrative Summary Sept. 20, 2019 The Bancorp, Inc. , AAER-4081 See Also: Administrat \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4081.txt b/raw/aaer/2019/AAER-4081.txt new file mode 100644 index 0000000000000000000000000000000000000000..7b88d0a1216d35f10de1128e8b4fae2e3f3adf51 --- /dev/null +++ b/raw/aaer/2019/AAER-4081.txt @@ -0,0 +1 @@ +CPA , AAER-4080 Sept. 20, 2019 Donald F. Mcgraw, Jr. , AAER-4083 See Also: Administrative Summary Sept. 20, 2019 The Bancorp, Inc. , See Also: Administrative Summary Sept. 19, 2019 Kevyn N. Rakowski, CPA , AAER-4078 Sept. 19, 2019 David R. Gibson , IA-5357, AAER-4079 Sept. 17, 20 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4082.txt b/raw/aaer/2019/AAER-4082.txt new file mode 100644 index 0000000000000000000000000000000000000000..dd9f700e01e8987958e547cf7a95548de68ebb9f --- /dev/null +++ b/raw/aaer/2019/AAER-4082.txt @@ -0,0 +1 @@ +plc. , AAER-4087 See Also: Administrative Summary Sept. 23, 2019 Brandon Sprankle, CPA , AAER-4085 Sept. 20, 2019 James David Hilty , See Also: Administrative Summary Sept. 20, 2019 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-4080 Sept. 20, 2019 Donald F. \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4083.txt b/raw/aaer/2019/AAER-4083.txt new file mode 100644 index 0000000000000000000000000000000000000000..f358efb902e58abac6e58e155a5dedba37d8880f --- /dev/null +++ b/raw/aaer/2019/AAER-4083.txt @@ -0,0 +1 @@ +ary Sept. 20, 2019 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-4080 Sept. 20, 2019 Donald F. Mcgraw, Jr. , See Also: Administrative Summary Sept. 20, 2019 The Bancorp, Inc. , AAER-4081 See Also: Administrative Summary Sept. 19, 2019 Kevyn N. Rakowski, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4084.txt b/raw/aaer/2019/AAER-4084.txt new file mode 100644 index 0000000000000000000000000000000000000000..0d846b3a3e3e57dc220897866bab7819b0a72c25 --- /dev/null +++ b/raw/aaer/2019/AAER-4084.txt @@ -0,0 +1 @@ +, CPA Ridenour, Jon, CPA Ortego, Ben, CPA , AAER-4089 Sept. 23, 2019 Nissan Motor Co., Ltd. , AAER-4086 Sept. 23, 2019 PricewaterhouseCoopers LLP , Sept. 23, 2019 Subramanian Krishnan (CPA)(Corrected) , AAER-4090 Sept. 23, 2019 TechnipFMC plc. , AAER-4087 See Also: Administrative Summary Sept. \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4085.txt b/raw/aaer/2019/AAER-4085.txt new file mode 100644 index 0000000000000000000000000000000000000000..52105bee9a0f6468b2d873a0d81ce839b30a556f --- /dev/null +++ b/raw/aaer/2019/AAER-4085.txt @@ -0,0 +1 @@ +ected) , AAER-4090 Sept. 23, 2019 TechnipFMC plc. , AAER-4087 See Also: Administrative Summary Sept. 23, 2019 Brandon Sprankle, CPA , Sept. 20, 2019 James David Hilty , AAER-4082 See Also: Administrative Summary Sept. 20, 2019 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, To \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4086.txt b/raw/aaer/2019/AAER-4086.txt new file mode 100644 index 0000000000000000000000000000000000000000..2dfbad185f7365af33a165c3f32ced6768cf294b --- /dev/null +++ b/raw/aaer/2019/AAER-4086.txt @@ -0,0 +1 @@ +rthur, CPA Griffith, Jason, CPA Whetman, Chris, CPA Zhang, Philip, CPA M&K CPAs, PLLC Manis, Matt, CPA Ridenour, Jon, CPA Ortego, Ben, CPA , AAER-4089 Sept. 23, 2019 Nissan Motor Co., Ltd. , Sept. 23, 2019 PricewaterhouseCoopers LLP , AAER-4084 Sept. 23, 2019 Subramanian Krishnan (CPA)(Corrected) , AAER-4090 Sept. 23, 2019 TechnipFMC plc. R \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4087.txt b/raw/aaer/2019/AAER-4087.txt new file mode 100644 index 0000000000000000000000000000000000000000..8dc3bfa4066fed749a5992457fe51d4c68f9517a --- /dev/null +++ b/raw/aaer/2019/AAER-4087.txt @@ -0,0 +1 @@ +2019 PricewaterhouseCoopers LLP , AAER-4084 Sept. 23, 2019 Subramanian Krishnan (CPA)(Corrected) , AAER-4090 Sept. 23, 2019 TechnipFMC plc. , See Also: Administrative Summary Sept. 23, 2019 Brandon Sprankle, CPA , AAER-4085 Sept. 20, 2019 James David Hilty , AAER-4082 See Also: Administrat \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4088.txt b/raw/aaer/2019/AAER-4088.txt new file mode 100644 index 0000000000000000000000000000000000000000..3564e5affc6305f07664ca1c32157f51bf1698a7 --- /dev/null +++ b/raw/aaer/2019/AAER-4088.txt @@ -0,0 +1 @@ +2019 Comscore, Inc. , 34-87069, AAER-4091 Sept. 24, 2019 Serge Matta , 34-87070, AAER-4092 Sept. 23, 2019 Carlos Ghosn and Gregory L. Kelly , See Also: SEC Complaint Sept. 23, 2019 Briner, John, Esq. Dalmy, Diane. Esq. De Joya Griffith, LLC De Joya, Arthur, CPA Griffith, Jason, CPA Whetman, Chris, CPA Zhang, Philip, CPA M&K CPAs, PLLC Manis, Matt, CPA Ridenour, Jon, \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4089.txt b/raw/aaer/2019/AAER-4089.txt new file mode 100644 index 0000000000000000000000000000000000000000..775cff96ac09efd726231c87215d964f53963c6b --- /dev/null +++ b/raw/aaer/2019/AAER-4089.txt @@ -0,0 +1 @@ +Sept. 23, 2019 Briner, John, Esq. Dalmy, Diane. Esq. De Joya Griffith, LLC De Joya, Arthur, CPA Griffith, Jason, CPA Whetman, Chris, CPA Zhang, Philip, CPA M&K CPAs, PLLC Manis, Matt, CPA Ridenour, Jon, CPA Ortego, Ben, CPA , Sept. 23, 2019 Nissan Motor Co., Ltd. , AAER-4086 Sept. 23, 2019 PricewaterhouseCoopers LLP , AAER-4084 Sept. 23, 2019 Subramanian Krishnan (CPA)(Corrected) \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4090.txt b/raw/aaer/2019/AAER-4090.txt new file mode 100644 index 0000000000000000000000000000000000000000..b51b385e0dcc5c7b15b2faa567496d04d8c6d661 --- /dev/null +++ b/raw/aaer/2019/AAER-4090.txt @@ -0,0 +1 @@ +Nissan Motor Co., Ltd. , AAER-4086 Sept. 23, 2019 PricewaterhouseCoopers LLP , AAER-4084 Sept. 23, 2019 Subramanian Krishnan (CPA)(Corrected) , Sept. 23, 2019 TechnipFMC plc. , AAER-4087 See Also: Administrative Summary Sept. 23, 2019 Brandon Sprankle, CPA , AAER-4085 Sept. 20, 2019 Ja \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4091.txt b/raw/aaer/2019/AAER-4091.txt new file mode 100644 index 0000000000000000000000000000000000000000..2186488465b0e19bb50d91a761ffbeb480c640ab --- /dev/null +++ b/raw/aaer/2019/AAER-4091.txt @@ -0,0 +1 @@ +ease No. 33-10701, 34-87129, AAER-4094 See Also: Administrative Summary Sept. 25, 2019 Toups, Michael P. , AAER-4093 Sept. 24, 2019 Comscore, Inc. , 34-87069, Sept. 24, 2019 Serge Matta , 34-87070, AAER-4092 Sept. 23, 2019 Carlos Ghosn and Gregory L. Kelly , AAER-4088 See Also: SEC Complaint Sept. 23, 2 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4092.txt b/raw/aaer/2019/AAER-4092.txt new file mode 100644 index 0000000000000000000000000000000000000000..c283498f1811532e720469bd8b546a4a39aa638f --- /dev/null +++ b/raw/aaer/2019/AAER-4092.txt @@ -0,0 +1 @@ +Sept. 25, 2019 Toups, Michael P. , AAER-4093 Sept. 24, 2019 Comscore, Inc. , 34-87069, AAER-4091 Sept. 24, 2019 Serge Matta , 34-87070, Sept. 23, 2019 Carlos Ghosn and Gregory L. Kelly , AAER-4088 See Also: SEC Complaint Sept. 23, 2019 Briner, John, Esq. Dalmy, Diane. Esq. De Joya Griffith, LLC De Joya, Arthur, CPA Gr \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4093.txt b/raw/aaer/2019/AAER-4093.txt new file mode 100644 index 0000000000000000000000000000000000000000..c5a93b2e9060e8053b58bfc86d8db9222afd0059 --- /dev/null +++ b/raw/aaer/2019/AAER-4093.txt @@ -0,0 +1 @@ +o. 33-10706, 34-87134, AAER-4095 Sept. 26, 2019 PPG Industries, Inc. , 34-87129, AAER-4094 See Also: Administrative Summary Sept. 25, 2019 Toups, Michael P. , Sept. 24, 2019 Comscore, Inc. , 34-87069, AAER-4091 Sept. 24, 2019 Serge Matta , 34-87070, AAER-4092 Sept. 23, 2019 Carlos Ghosn and Gregory L. Kelly R \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4094.txt b/raw/aaer/2019/AAER-4094.txt new file mode 100644 index 0000000000000000000000000000000000000000..c69dc9ab71fcfe63d2bed81b44e8bb8e756adb7b --- /dev/null +++ b/raw/aaer/2019/AAER-4094.txt @@ -0,0 +1 @@ +96 See Also: SEC Complaint Sept. 27, 2019 FCA US LLC and Fiat Chrysler Automobiles N.V. , 34-87134, AAER-4095 Sept. 26, 2019 PPG Industries, Inc. , 34-87129, See Also: Administrative Summary Sept. 25, 2019 Toups, Michael P. , AAER-4093 Sept. 24, 2019 Comscore, Inc. , 34-87069, AAER-4091 Sept. 24, 2019 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4095.txt b/raw/aaer/2019/AAER-4095.txt new file mode 100644 index 0000000000000000000000000000000000000000..e3e8adc0c320cf757d742d79dbaa53a761be01a5 --- /dev/null +++ b/raw/aaer/2019/AAER-4095.txt @@ -0,0 +1 @@ +. 34-87157, AAER-4097 Sept. 27, 2019 Mylan N.V. , AAER-4096 See Also: SEC Complaint Sept. 27, 2019 FCA US LLC and Fiat Chrysler Automobiles N.V. , 34-87134, Sept. 26, 2019 PPG Industries, Inc. , 34-87129, AAER-4094 See Also: Administrative Summary Sept. 25, 2019 Toups, Michael P. , AAER-4093 Sept. 24, 2 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4096.txt b/raw/aaer/2019/AAER-4096.txt new file mode 100644 index 0000000000000000000000000000000000000000..6c6c53ee5bdddd35648076e48baa53d6118e6d3c --- /dev/null +++ b/raw/aaer/2019/AAER-4096.txt @@ -0,0 +1 @@ +CPA , AAER-4098 Sept. 30, 2019 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , AAER-4097 Sept. 27, 2019 Mylan N.V. , See Also: SEC Complaint Sept. 27, 2019 FCA US LLC and Fiat Chrysler Automobiles N.V. , 34-87134, AAER-4095 Sept. 26, 2019 PPG Industries, Inc. , 34-87129, AA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4097.txt b/raw/aaer/2019/AAER-4097.txt new file mode 100644 index 0000000000000000000000000000000000000000..49c331d3def8cdec1c4838de8581688a9a78ddf1 --- /dev/null +++ b/raw/aaer/2019/AAER-4097.txt @@ -0,0 +1 @@ +2019 Marla P. Manowitz, CPA, Thomas R. Vreeland, CPA and Kenneth J. Gralak, CPA , AAER-4098 Sept. 30, 2019 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , Sept. 27, 2019 Mylan N.V. , AAER-4096 See Also: SEC Complaint Sept. 27, 2019 FCA US LLC and Fiat Chrysler Automobiles N.V. , 34-87134, AAER-4095 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4098.txt b/raw/aaer/2019/AAER-4098.txt new file mode 100644 index 0000000000000000000000000000000000000000..44f55c41d5c5ca9f0d33c3bb4d825ccb381a5649 --- /dev/null +++ b/raw/aaer/2019/AAER-4098.txt @@ -0,0 +1 @@ +19 Northwest Biotherapeutics, Inc. , AAER-4099 See Also: Administrative Summary Sept. 30, 2019 Marla P. Manowitz, CPA, Thomas R. Vreeland, CPA and Kenneth J. Gralak, CPA , Sept. 30, 2019 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , AAER-4097 Sept. 27, 2019 Mylan N.V. , AAER-4096 See Also: SEC Comp \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4099.txt b/raw/aaer/2019/AAER-4099.txt new file mode 100644 index 0000000000000000000000000000000000000000..2d2ee5227e6efe84ea90688de8ba2708072108b5 --- /dev/null +++ b/raw/aaer/2019/AAER-4099.txt @@ -0,0 +1 @@ +Nov. 7, 2019 Pruitt, David, CPA , AAER-4101 Oct. 11, 2019 John Busshaus, CPA , AAER-4100 Oct. 10, 2019 Northwest Biotherapeutics, Inc. , See Also: Administrative Summary Sept. 30, 2019 Marla P. Manowitz, CPA, Thomas R. Vreeland, CPA and Kenneth J. Gralak, CPA , AAER-4098 Sept. 30, 2019 Schulman Lobel Zand Katzen Williams \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4100.txt b/raw/aaer/2019/AAER-4100.txt new file mode 100644 index 0000000000000000000000000000000000000000..a2b5e3bb85189bfa1b9914647228d88e33bb09a7 --- /dev/null +++ b/raw/aaer/2019/AAER-4100.txt @@ -0,0 +1 @@ +ers, L.P. , AAER-4102 See Also: Administrative Summary Nov. 7, 2019 Pruitt, David, CPA , AAER-4101 Oct. 11, 2019 John Busshaus, CPA , Oct. 10, 2019 Northwest Biotherapeutics, Inc. , AAER-4099 See Also: Administrative Summary Sept. 30, 2019 Marla P. Manowitz, CPA, Thomas R. Vreeland, CPA and Kenneth J. Gralak, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4101.txt b/raw/aaer/2019/AAER-4101.txt new file mode 100644 index 0000000000000000000000000000000000000000..42c64a1f36714575c557f7d63c407ff80d129766 --- /dev/null +++ b/raw/aaer/2019/AAER-4101.txt @@ -0,0 +1 @@ +No. 34-87642, AAER-4103 Nov. 25, 2019 Calumet Specialty Products Partners, L.P. , AAER-4102 See Also: Administrative Summary Nov. 7, 2019 Pruitt, David, CPA , Oct. 11, 2019 John Busshaus, CPA , AAER-4100 Oct. 10, 2019 Northwest Biotherapeutics, Inc. , AAER-4099 See Also: Administrative Summary Sept. 30, 2 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4102.txt b/raw/aaer/2019/AAER-4102.txt new file mode 100644 index 0000000000000000000000000000000000000000..4f8cd4c1d4ae17a91d5836ae3212fcb4a1592ff5 --- /dev/null +++ b/raw/aaer/2019/AAER-4102.txt @@ -0,0 +1 @@ +Nov. 29, 2019 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-4103 Nov. 25, 2019 Calumet Specialty Products Partners, L.P. , See Also: Administrative Summary Nov. 7, 2019 Pruitt, David, CPA , AAER-4101 Oct. 11, 2019 John Busshaus, CPA , AAER-4100 Oct. 10, 2019 Northw \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4103.txt b/raw/aaer/2019/AAER-4103.txt new file mode 100644 index 0000000000000000000000000000000000000000..42381a54a3ed901a7a5f486306df02ff108bc5ec --- /dev/null +++ b/raw/aaer/2019/AAER-4103.txt @@ -0,0 +1 @@ +4, 2019 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , AAER-4104 Nov. 29, 2019 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , Nov. 25, 2019 Calumet Specialty Products Partners, L.P. , AAER-4102 See Also: Administrative Summary Nov. 7, 2019 Pruitt, David, CPA , AAER-4101 Oc \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4104.txt b/raw/aaer/2019/AAER-4104.txt new file mode 100644 index 0000000000000000000000000000000000000000..360c07f2b964656be57e223d274db7010586cc37 --- /dev/null +++ b/raw/aaer/2019/AAER-4104.txt @@ -0,0 +1 @@ +AAER-4106 See Also: Administrative Summary Dec. 5, 2019 Warren Clamen, CPA , 34-87661, AAER-4105 Dec. 4, 2019 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , Nov. 29, 2019 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-4103 Nov. 25, 2019 Calumet Specialty Products Partners, L.P. Release No \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4105.txt b/raw/aaer/2019/AAER-4105.txt new file mode 100644 index 0000000000000000000000000000000000000000..d72cecac76ab8966e6bfbe84d4e39b745e72d9c3 --- /dev/null +++ b/raw/aaer/2019/AAER-4105.txt @@ -0,0 +1 @@ +Administrative Summary Dec. 5, 2019 Jatindar Kapur, CPA , 34-87670, AAER-4106 See Also: Administrative Summary Dec. 5, 2019 Warren Clamen, CPA , 34-87661, Dec. 4, 2019 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , AAER-4104 Nov. 29, 2019 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA Releas \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4106.txt b/raw/aaer/2019/AAER-4106.txt new file mode 100644 index 0000000000000000000000000000000000000000..e1890908d40edab0d25f642847abb036b4d8f778 --- /dev/null +++ b/raw/aaer/2019/AAER-4106.txt @@ -0,0 +1 @@ +5, AAER-4108 Dec. 12, 2019 Stonemor Partners L.P. and Stonemor GP LLC , AAER-4107 See Also: Administrative Summary Dec. 5, 2019 Jatindar Kapur, CPA , 34-87670, See Also: Administrative Summary Dec. 5, 2019 Warren Clamen, CPA , 34-87661, AAER-4105 Dec. 4, 2019 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , AAER-4104 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4107.txt b/raw/aaer/2019/AAER-4107.txt new file mode 100644 index 0000000000000000000000000000000000000000..65f21b710e2075d5a33109aa45671232e77986dd --- /dev/null +++ b/raw/aaer/2019/AAER-4107.txt @@ -0,0 +1 @@ +AAER-4110 See Also: Administrative Summary Dec. 16, 2019 Tim Leissner , IA-5418, IC-33715, AAER-4108 Dec. 12, 2019 Stonemor Partners L.P. and Stonemor GP LLC , See Also: Administrative Summary Dec. 5, 2019 Jatindar Kapur, CPA , 34-87670, AAER-4106 See Also: Administrative Summary Dec. 5, 2019 Warren Clamen, CPA \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4108.txt b/raw/aaer/2019/AAER-4108.txt new file mode 100644 index 0000000000000000000000000000000000000000..a9e31f93967eca10cb2d586221385c4592d3ac3a --- /dev/null +++ b/raw/aaer/2019/AAER-4108.txt @@ -0,0 +1 @@ +Sort descending Respondents Dec. 20, 2019 Quantum Corporation , AAER-4110 See Also: Administrative Summary Dec. 16, 2019 Tim Leissner , IA-5418, IC-33715, Dec. 12, 2019 Stonemor Partners L.P. and Stonemor GP LLC , AAER-4107 See Also: Administrative Summary Dec. 5, 2019 Jatindar Kapur, CPA , 34-87670, AAER-4106 \ No newline at end of file diff --git a/raw/aaer/2019/AAER-4110.txt b/raw/aaer/2019/AAER-4110.txt new file mode 100644 index 0000000000000000000000000000000000000000..10ae1b4009f69c28c9e9e478b69f974010b93fbb --- /dev/null +++ b/raw/aaer/2019/AAER-4110.txt @@ -0,0 +1 @@ +View All-JanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember Date Sort descending Respondents Dec. 20, 2019 Quantum Corporation , See Also: Administrative Summary Dec. 16, 2019 Tim Leissner , IA-5418, IC-33715, AAER-4108 Dec. 12, 2019 Stonemor Partners L.P. and Stonemor GP LLC , AAER-4107 \ No newline at end of file diff --git a/raw/aaer/2019/aaer_page.html b/raw/aaer/2019/aaer_page.html new file mode 100644 index 0000000000000000000000000000000000000000..fb91a682b75adfa093b26b9dfc291da5151bcf35 --- /dev/null +++ b/raw/aaer/2019/aaer_page.html @@ -0,0 +1,2726 @@ + + + + + + + + + + + + + + + SEC.gov | Accounting and Auditing Enforcement + + + + + + + + + + + + + + + + + + + + + + Skip to search field + + + + Skip to main content + + + + +
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The list below provides links to financial reporting related enforcement actions concerning civil lawsuits brought by the Commission in federal court and notices and orders concerning the institution and/or settlement of administrative proceedings. This list only highlights certain actions and is not meant to be a complete and exhaustive compilation of all of the actions that fall into this category.

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Date + + +Respondents
+ +
Quantum Corporation
+
+ Release No. + 34-87812, AAER-4110 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Tim Leissner
+
+ Release No. + 34-87750, IA-5418, IC-33715, AAER-4108 +
+
+ +
Stonemor Partners L.P. and Stonemor GP LLC
+
+ Release No. + 34-87732, AAER-4107 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Jatindar Kapur, CPA
+
+ Release No. + 33-10731, 34-87670, AAER-4106 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Warren Clamen, CPA
+
+ Release No. + 33-10730, 34-87661, AAER-4105 +
+
+ +
Raymon Holmdahl, CPA and Kanako Matsumoto, CPA
+
+ Release No. + 34-87657, AAER-4104 +
+
+ +
Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA
+
+ Release No. + 34-87642, AAER-4103 +
+
+ +
Calumet Specialty Products Partners, L.P.
+
+ Release No. + 34-87611, AAER-4102 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Pruitt, David, CPA
+
+ Release No. + 34-87484, AAER-4101 +
+
+ +
John Busshaus, CPA
+
+ Release No. + 33-10718, AAER-4100 +
+
+ +
Northwest Biotherapeutics, Inc.
+
+ Release No. + 34-87281, AAER-4099 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Marla P. Manowitz, CPA, Thomas R. Vreeland, CPA and Kenneth J. Gralak, CPA
+
+ Release No. + 34-87159, AAER-4098 +
+
+ +
Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP
+
+ Release No. + 34-87157, AAER-4097 +
+
+ +
Mylan N.V.
+
+ Release No. + LR-24621, AAER-4096 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
FCA US LLC and Fiat Chrysler Automobiles N.V.
+
+ Release No. + 33-10706, 34-87134, AAER-4095 +
+
+ +
PPG Industries, Inc.
+
+ Release No. + 33-10701, 34-87129, AAER-4094 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Toups, Michael P.
+
+ Release No. + 34-87102, AAER-4093 +
+
+ +
Comscore, Inc.
+
+ Release No. + 33-10692, 34-87069, AAER-4091 +
+
+ +
Serge Matta
+
+ Release No. + 33-10693, 34-87070, AAER-4092 +
+
+ +
Carlos Ghosn and Gregory L. Kelly
+
+ Release No. + LR-24606, AAER-4088 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Briner, John, Esq. Dalmy, Diane. Esq. De Joya Griffith, LLC De Joya, Arthur, CPA Griffith, Jason, CPA Whetman, Chris, CPA Zhang, Philip, CPA M&K CPAs, PLLC Manis, Matt, CPA Ridenour, Jon, CPA Ortego, Ben, CPA
+
+ Release No. + 34-87063, AAER-4089 +
+
+ +
Nissan Motor Co., Ltd.
+
+ Release No. + 34-87054, AAER-4086 +
+
+ +
PricewaterhouseCoopers LLP
+
+ Release No. + 34-87052, AAER-4084 +
+
+ +
Subramanian Krishnan (CPA)(Corrected)
+
+ Release No. + 34-87068, AAER-4090 +
+
+ +
TechnipFMC plc.
+
+ Release No. + 34-87055, AAER-4087 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Brandon Sprankle, CPA
+
+ Release No. + 34-87053, AAER-4085 +
+
+ +
James David Hilty
+
+ Release No. + 34-87037, AAER-4082 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA
+
+ Release No. + 34-87033, AAER-4080 +
+
+ +
Donald F. Mcgraw, Jr.
+
+ Release No. + 34-87038, AAER-4083 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
The Bancorp, Inc.
+
+ Release No. + 34-87036, AAER-4081 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Kevyn N. Rakowski, CPA
+
+ Release No. + 34-87007, AAER-4078 +
+
+ +
David R. Gibson
+
+ Release No. + 34-87032, IA-5357, AAER-4079 +
+
+ +
Tom Simeo
+
+ Release No. + LR-24599, AAER-4077 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Marvell Technology Group, Ltd.
+
+ Release No. + 33-10684, 34-86971, AAER-4076 +
+
+ +
Sridhar Thiruvengadam
+
+ Release No. + 34-86963, AAER-4074 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
ED Capital Management, LLC d/b/a Daniloff Capital Management, LLC and Elliot Daniloff a/k/a Ilya Olegovich Danilov
+
+ Release No. + IA-5344, AAER-4075 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Robert D. Hesselgesser, CPA
+
+ Release No. + 34-86924, AAER-4073 +
+
+ +
Beamish, Adrian D., CPA
+
+ Release No. + 34-86903, AAER-4072 +
+
+ +
Abner Silva
+
+ Release No. + 33-10681, 34-86900, AAER-4071 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Daniel Khesin
+
+ Release No. + 33-10680, 34-86889, AAER-4070 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Robin Smyth
+
+ Release No. + 34-86804, AAER-4068 +
+
+ +
Juniper Networks, Inc.
+
+ Release No. + 34-86812, AAER-4069 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Alan G. Heide, CPA
+
+ Release No. + 34-86771, AAER-4067 +
+
+ +
RSM US LLP (f/k/a McGladrey LLP)
+
+ Release No. + 34-86770, IA-5331, AAER-4066 +
+
+ +
Deutsche Bank AG
+
+ Release No. + 34-86740, AAER-4065 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Michael Filkoski, CPA and Scott Magnuson, CPA
+
+ Release No. + 34-86720, AAER-4064 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Thomas W. Avent, Jr., CPA, Esq.
+
+ Release No. + 34-86594, AAER-4063 +
+
+ See Also: + + + Litigation Release + + +
+
+ +
Nandu Thondavadi
+
+ Release No. + 34-86564, AAER-4062 +
+
+ +
Brixmor Property Group Inc.
+
+ Release No. + 34-86538, AAER-4061 +
+
+ +
Nevanna Sacks, CPA
+
+ Release No. + 34-86495, AAER-4060, AAER-4060 +
+
+ +
Dov Weinstein, CPA and Dov Weinstein & Co., CPA
+
+ Release No. + 34-86385, AAER-4059 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Thomas H. Laws, CPA
+
+ Release No. + 34-86350, AAER-4058 +
+
+ +
Thomas Chang, CPA
+
+ Release No. + 34-86252, AAER-4057 +
+
+ +
R. Gordon Jones, CPA
+
+ Release No. + 34-86239, AAER-4055 +
+
+ +
S. Jeffrey Jones, CPA
+
+ Release No. + 34-86240, AAER-4056 +
+
+ +
Walmart Inc.
+
+ Release No. + 34-86159, AAER-4054 +
+
+ +
Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA
+
+ Release No. + 34-86124, AAER-4053 +
+
+ +
KPMG LLP
+
+ Release No. + 34-86118, AAER-4051 +
+
+ +
Rodney A. Smith, Michael Santicchia, CPA, and Stephen D. Cheaney, CPA
+
+ Release No. + 34-86123, AAER-4052 +
+
+ +
David Vogel, CPA
+
+ Release No. + 34-86107, AAER-4050 +
+
+ +
Pinnacle Accountancy Group, PLLC and Douglas W. Child, CPA
+
+ Release No. + 34-86034, AAER-4049 +
+
+ +
Rand, Michael T.
+
+ Release No. + 34-86028, AAER-4048 +
+
+ +
Bryan B. Long, CPA
+
+ Release No. + 34-85847, AAER-4047 +
+
+ +
Telefônica Brasil S.A.
+
+ Release No. + 34-85819, AAER-4046 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
GT Advanced Technologies Inc.
+
+ Release No. + 33-10636, 34-85767, AAER-4045 +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order)
+
+ Release No. + 34-85717, AAER-4044 +
+
+ +
Michael F. Cronin, CPA
+
+ Release No. + 34-85709, AAER-4043 +
+
+ +
Dov Zaidman, CPA, and ZBS Group LLP
+
+ Release No. + 33-10632, 34-85702, AAER-4041 +
+
+ +
David M. Martin CPA
+
+ Release No. + 34-85703, AAER-4042 +
+
+ +
Karen Bruton and Hope Advisors, LLC (Order Regarding Further Proceedings)
+
+ Release No. + 34-85630, IA-5222, AAER-4040 +
+
+ +
Adam C. Derbyshire
+
+ Release No. + 33-10627, 34-85582, AAER-4039 +
+
+ +
KLJ & Associates, LLP, Kent L. Jensen, CPA and Ronald A. Burgmeier, CPA
+
+ Release No. + 34-85518, AAER-4037 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Evan R. Kita, et al.
+
+ Release No. + LR-24441, AAER-4038 +
+
+ +
Evan R. Kita, CPA
+
+ Release No. + 34-85496, AAER-4036 +
+
+ +
Kevin E. Brooks, CPA
+
+ Release No. + 34-85483, AAER-4035 +
+
+ +
Wolf, Jennifer F., CPA
+
+ Release No. + 34-85478, AAER-4034 +
+
+ +
Fresenius Medical Care AG & Co. KGaA
+
+ Release No. + 34-85468, AAER-4033 +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Notice Regarding Correspondence)
+
+ Release No. + 34-85423, AAER-4032 +
+
+ +
Judson F. "Rick" Hoover, CPA
+
+ Release No. + 34-85398, AAER-4031 +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence)
+
+ Release No. + 34-85310, AAER-4030 +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order)
+
+ Release No. + 34-85284, AAER-4029 +
+
+ +
Mobile TeleSystems PJSC
+
+ Release No. + 34-85261, AAER-4028 +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA (Notice Regarding Correspondence)
+
+ Release No. + 34-85250, AAER-4027 +
+
+ +
Arthur Viola
+
+ Release No. + 34-85234, AAER-4025 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
DLL CPAS, LLC and Debra Lee Lindaman, CPA
+
+ Release No. + 34-85233, AAER-4024 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus CPA. (Order)
+
+ Release No. + 34-85237, AAER-4026 +
+
+ +
David Pruitt, CPA (Order Denying Motion to Amend the Order Instituting Proceedings)
+
+ Release No. + 34-85171, AAER-4023 +
+
+ +
Jeffrey M. Mattich
+
+ Release No. + 34-85159, AAER-4022 +
+
+ +
Cognizant Technology Solutions Corporation
+
+ Release No. + 34-85149, AAER-4021 +
+
+ +
Deloitte Touche Tohmatsu LLC, Futomichi Amano and Yuji Itagaki
+
+ Release No. + 34-85115, AAER-4020 +
+
+ +
Amundsen, Joseph S., CPA Remus, Michael T., CPA Remus Michael, CPA
+
+ Release No. + 34-85081, AAER-4019 +
+
+ +
Digital Turbine, Inc.
+
+ Release No. + 34-84998, AAER-4018 +
+
+ +
Lifeway Foods, Inc.
+
+ Release No. + 34-84995, AAER-4016 +
+
+ +
Grupo Simec S.A.B. de C.V.
+
+ Release No. + 34-84996, AAER-4017 +
+
+ +
CytoDyn Inc.
+
+ Release No. + 34-84994, AAER-4015 +
+
+ +
LBB & Associates Ltd., LLP Lopez, Carlos, CPA
+
+ Release No. + 34-84983, AAER-4014 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Katz, Sapper & Miller, LLP and Scott C. Price, CPA
+
+ Release No. + 34-84980, IA-5100, AAER-4013 +
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+ 1 to 97 of 97 items +
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+ + + + + + + + + + + + + + diff --git a/raw/aaer/2020/AAER-4111.txt b/raw/aaer/2020/AAER-4111.txt new file mode 100644 index 0000000000000000000000000000000000000000..46ed2a7436d618384661d72f48135dcab7d4b8fa --- /dev/null +++ b/raw/aaer/2020/AAER-4111.txt @@ -0,0 +1 @@ +ER-4112 Jan. 15, 2020 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-4113 Jan. 3, 2020 Robert A. Karmann, CPA , 1 to 91 of 91 items Return to top SEC homepage About the SEC Budget & Performance Careers Commission Votes Contac \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4112.txt b/raw/aaer/2020/AAER-4112.txt new file mode 100644 index 0000000000000000000000000000000000000000..52604f14dac99e93c4be2359181d063ef33a4531 --- /dev/null +++ b/raw/aaer/2020/AAER-4112.txt @@ -0,0 +1 @@ +d Order Granting Petitions for Review and Scheduling Briefs) , AAER-4114 Jan. 15, 2020 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , Jan. 15, 2020 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-4113 Jan. 3, 2020 Robert A. Karmann, CPA , AAER-41 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4113.txt b/raw/aaer/2020/AAER-4113.txt new file mode 100644 index 0000000000000000000000000000000000000000..6c9f2afaae8de77bf50b3abbc88ebb91254a1802 --- /dev/null +++ b/raw/aaer/2020/AAER-4113.txt @@ -0,0 +1 @@ +iddendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-4112 Jan. 15, 2020 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , Jan. 3, 2020 Robert A. Karmann, CPA , AAER-4111 1 to 91 of 91 items Return to top SEC homepage About the \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4114.txt b/raw/aaer/2020/AAER-4114.txt new file mode 100644 index 0000000000000000000000000000000000000000..580a0abc4cc4f6415341000e02ae78c738dd685c --- /dev/null +++ b/raw/aaer/2020/AAER-4114.txt @@ -0,0 +1 @@ +ven M. Des Champs, CPA , AAER-4115 Jan. 16, 2020 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus, CPA (Corrected Order Granting Petitions for Review and Scheduling Briefs) , Jan. 15, 2020 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA , AAER-4112 Jan. 15, 2020 Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4115.txt b/raw/aaer/2020/AAER-4115.txt new file mode 100644 index 0000000000000000000000000000000000000000..2ba71816b420f91ea658667badce6db377496ac1 --- /dev/null +++ b/raw/aaer/2020/AAER-4115.txt @@ -0,0 +1 @@ +ve Summary Feb. 6, 2020 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , AAER-4116 See Also: Administrative Summary Jan. 27, 2020 Steven M. Des Champs, CPA , Jan. 16, 2020 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus, CPA (Corrected Order Granting Petitions for Review and Scheduling Briefs) , AAER-4114 Jan. 15, 2020 Holder, Cynthia, CP \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4116.txt b/raw/aaer/2020/AAER-4116.txt new file mode 100644 index 0000000000000000000000000000000000000000..94c680d3540306fa3b7082e2f3757bfbb5364ff2 --- /dev/null +++ b/raw/aaer/2020/AAER-4116.txt @@ -0,0 +1 @@ +4118 Feb. 26, 2020 RSM US LLP (f/k/a/ Mcgladrey LLP) , AAER-4117 See Also: Administrative Summary Feb. 6, 2020 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , See Also: Administrative Summary Jan. 27, 2020 Steven M. Des Champs, CPA , AAER-4115 Jan. 16, 2020 Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus, CPA (Corrected Order \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4117.txt b/raw/aaer/2020/AAER-4117.txt new file mode 100644 index 0000000000000000000000000000000000000000..0134c9b4c605a6c1bec06d1155a675f8d733d448 --- /dev/null +++ b/raw/aaer/2020/AAER-4117.txt @@ -0,0 +1 @@ +h 12, 2020 David G. Dreslin, CPA , AAER-4119 Feb. 28, 2020 Cardinal Health, Inc. , AAER-4118 Feb. 26, 2020 RSM US LLP (f/k/a/ Mcgladrey LLP) , See Also: Administrative Summary Feb. 6, 2020 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , AAER-4116 See Also: Administrative Summary Jan. 27, 2020 Steven M. Des Champs \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4118.txt b/raw/aaer/2020/AAER-4118.txt new file mode 100644 index 0000000000000000000000000000000000000000..76ace0189c9cd835d3e78e090fd0c4c776e6b4c3 --- /dev/null +++ b/raw/aaer/2020/AAER-4118.txt @@ -0,0 +1 @@ +March 20, 2020 Ronald Emma, CPA , AAER-4120 March 12, 2020 David G. Dreslin, CPA , AAER-4119 Feb. 28, 2020 Cardinal Health, Inc. , Feb. 26, 2020 RSM US LLP (f/k/a/ Mcgladrey LLP) , AAER-4117 See Also: Administrative Summary Feb. 6, 2020 LBB & Associates Ltd., LLP Lopez, Carlos, CPA , AAER \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4119.txt b/raw/aaer/2020/AAER-4119.txt new file mode 100644 index 0000000000000000000000000000000000000000..bdc5f0f0a5b7973c2e960550db00e4d1d49cfcb3 --- /dev/null +++ b/raw/aaer/2020/AAER-4119.txt @@ -0,0 +1 @@ +ordes et al. , AAER-4121 See Also: SEC Complaint March 20, 2020 Ronald Emma, CPA , AAER-4120 March 12, 2020 David G. Dreslin, CPA , Feb. 28, 2020 Cardinal Health, Inc. , AAER-4118 Feb. 26, 2020 RSM US LLP (f/k/a/ Mcgladrey LLP) , AAER-4117 See Also: Administrative Summary Feb. 6 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4120.txt b/raw/aaer/2020/AAER-4120.txt new file mode 100644 index 0000000000000000000000000000000000000000..00c3b16cd498927ef22cc30db1e2020fa9a4ba2e --- /dev/null +++ b/raw/aaer/2020/AAER-4120.txt @@ -0,0 +1 @@ +Lobel LLP , AAER-4122 April 8, 2020 Jeffrey D. Cordes et al. , AAER-4121 See Also: SEC Complaint March 20, 2020 Ronald Emma, CPA , March 12, 2020 David G. Dreslin, CPA , AAER-4119 Feb. 28, 2020 Cardinal Health, Inc. , AAER-4118 Feb. 26, 2020 RSM US LLP (f/k/a/ Mcgladrey LLP) Releas \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4121.txt b/raw/aaer/2020/AAER-4121.txt new file mode 100644 index 0000000000000000000000000000000000000000..1015c4a2affcf40c775614b9c62e55a5ca254722 --- /dev/null +++ b/raw/aaer/2020/AAER-4121.txt @@ -0,0 +1 @@ +ase No. 34-88659, AAER-4123 April 15, 2020 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , AAER-4122 April 8, 2020 Jeffrey D. Cordes et al. , See Also: SEC Complaint March 20, 2020 Ronald Emma, CPA , AAER-4120 March 12, 2020 David G. Dreslin, CPA , AAER-4119 Feb. 28, 2020 Cardinal \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4122.txt b/raw/aaer/2020/AAER-4122.txt new file mode 100644 index 0000000000000000000000000000000000000000..abd195d30432351bf594f908bf3fcb455fdd1b84 --- /dev/null +++ b/raw/aaer/2020/AAER-4122.txt @@ -0,0 +1 @@ +April 16, 2020 Frazer Frost LLP Woo, Susan, CPA Suen, Miranda, CPA , AAER-4123 April 15, 2020 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , April 8, 2020 Jeffrey D. Cordes et al. , AAER-4121 See Also: SEC Complaint March 20, 2020 Ronald Emma, CPA , AAER-4120 March 12, 2020 David \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4123.txt b/raw/aaer/2020/AAER-4123.txt new file mode 100644 index 0000000000000000000000000000000000000000..fb4e766185aa76df17e813935986673528ba5830 --- /dev/null +++ b/raw/aaer/2020/AAER-4123.txt @@ -0,0 +1 @@ +di, CPA , AAER-4125 April 17, 2020 James Arthur Young III , IA-5481, AAER-4125 April 16, 2020 Frazer Frost LLP Woo, Susan, CPA Suen, Miranda, CPA , April 15, 2020 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , AAER-4122 April 8, 2020 Jeffrey D. Cordes et al. , AAER-4121 See Also: \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4124.txt b/raw/aaer/2020/AAER-4124.txt new file mode 100644 index 0000000000000000000000000000000000000000..e8af1f8608decfac85cafed95ce2dd77a44e107e --- /dev/null +++ b/raw/aaer/2020/AAER-4124.txt @@ -0,0 +1 @@ +0775, 34-88720, AAER-4127 April 22, 2020 Berman & Company, P.A., and Elliot Berman CPA, Berman, Elliot R., CPA Berman & Company, P.A. , AAER-4130 April 17, 2020 Eni S.p.A. , See Also: Administrative Summary April 17, 2020 Brian Robert Sodi, CPA , AAER-4125 April 17, 2020 James Arthur Young III , IA-5481, AAER-4125 April \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4125.txt b/raw/aaer/2020/AAER-4125.txt new file mode 100644 index 0000000000000000000000000000000000000000..b80a35881e52394a9597cb8c6d90f3d1019fedfc --- /dev/null +++ b/raw/aaer/2020/AAER-4125.txt @@ -0,0 +1 @@ +se No. 34-88679, AAER-4124 See Also: Administrative Summary April 17, 2020 Brian Robert Sodi, CPA , April 17, 2020 James Arthur Young III , IA-5481, April 16, 2020 Frazer Frost LLP Woo, Susan, CPA Suen, Miranda, CPA , AAER-4123 April 15, 2020 Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP , \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4126.txt b/raw/aaer/2020/AAER-4126.txt new file mode 100644 index 0000000000000000000000000000000000000000..b9f7d30fd58ea7f06eeeb99eb4379b597e82db90 --- /dev/null +++ b/raw/aaer/2020/AAER-4126.txt @@ -0,0 +1 @@ +April 22, 2020 Robert J. Jesenik , April 22, 2020 Kenneth D. Shifrin, CPA , AAER-4128 April 22, 2020 N. Scott Gillis, CPA , April 22, 2020 Brian M. Storms , AAER-4129 April 22, 2020 Brian L. Ferdinand , 34-88720, AAER-4127 April 22, 2020 Berman & Company, P.A., and Elliot Berman \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4127.txt b/raw/aaer/2020/AAER-4127.txt new file mode 100644 index 0000000000000000000000000000000000000000..b509d57f6c82b518690ad5d933b2e3646e9b5b6c --- /dev/null +++ b/raw/aaer/2020/AAER-4127.txt @@ -0,0 +1 @@ +April 22, 2020 N. Scott Gillis, CPA , AAER-4126 April 22, 2020 Brian M. Storms , AAER-4129 April 22, 2020 Brian L. Ferdinand , 34-88720, April 22, 2020 Berman & Company, P.A., and Elliot Berman CPA, Berman, Elliot R., CPA Berman & Company, P.A. , AAER-4130 April 17, 2020 Eni S.p.A. , AAER-4124 See Also \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4128.txt b/raw/aaer/2020/AAER-4128.txt new file mode 100644 index 0000000000000000000000000000000000000000..0c7d3d960bfc8295900600d5c5f251705c2fd923 --- /dev/null +++ b/raw/aaer/2020/AAER-4128.txt @@ -0,0 +1 @@ +Sue , AAER-4131 See Also: Administrative Summary April 22, 2020 Robert J. Jesenik , AAER-4126 April 22, 2020 Kenneth D. Shifrin, CPA , April 22, 2020 N. Scott Gillis, CPA , AAER-4126 April 22, 2020 Brian M. Storms , AAER-4129 April 22, 2020 Brian L. Ferdinand , 34-8 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4129.txt b/raw/aaer/2020/AAER-4129.txt new file mode 100644 index 0000000000000000000000000000000000000000..61065ebd86fb19df42eee4ab94d155633d8b7f27 --- /dev/null +++ b/raw/aaer/2020/AAER-4129.txt @@ -0,0 +1 @@ +April 22, 2020 Kenneth D. Shifrin, CPA , AAER-4128 April 22, 2020 N. Scott Gillis, CPA , AAER-4126 April 22, 2020 Brian M. Storms , April 22, 2020 Brian L. Ferdinand , 34-88720, AAER-4127 April 22, 2020 Berman & Company, P.A., and Elliot Berman CPA, Berman, Elliot R., CPA Berman & Company, P.A. , AAER-41 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4130.txt b/raw/aaer/2020/AAER-4130.txt new file mode 100644 index 0000000000000000000000000000000000000000..ff21f566c3b4473658722662b4a2fb3f9ac4a31d --- /dev/null +++ b/raw/aaer/2020/AAER-4130.txt @@ -0,0 +1 @@ +ER-4129 April 22, 2020 Brian L. Ferdinand , 34-88720, AAER-4127 April 22, 2020 Berman & Company, P.A., and Elliot Berman CPA, Berman, Elliot R., CPA Berman & Company, P.A. , April 17, 2020 Eni S.p.A. , AAER-4124 See Also: Administrative Summary April 17, 2020 Brian Robert Sodi, CPA , AAER-4125 April 17, 2020 James \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4131.txt b/raw/aaer/2020/AAER-4131.txt new file mode 100644 index 0000000000000000000000000000000000000000..25acd15dc4c545badc76c62c4dd4b260d2a6d463 --- /dev/null +++ b/raw/aaer/2020/AAER-4131.txt @@ -0,0 +1 @@ +l 24, 2020 PLS,, CPA a Professional Corporation Pls a/k/a, CPAS Park, Chang G., CPA Park, a/k/a Changgeun Lee, Joseph Yongyun, CPA Lee, a/k/a Yong Yun Lee, Juchi, CPA Fernandez, a/k/a Juchi Lee Lee, Ju-Chi Lee, Ju Chi Lee, Sue , See Also: Administrative Summary April 22, 2020 Robert J. Jesenik , AAER-4126 April 22, 2020 Kenneth D. Shifrin, CPA , AAER-4128 April 22, 2020 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4132.txt b/raw/aaer/2020/AAER-4132.txt new file mode 100644 index 0000000000000000000000000000000000000000..d6b605beaeaada83942eb4cf87c3d56a43e8e4ea --- /dev/null +++ b/raw/aaer/2020/AAER-4132.txt @@ -0,0 +1 @@ +ee Also: SEC Complaint April 28, 2020 Ross, Sinclaire & Associates, LLC and Murray Sinclaire, Jr. , April 28, 2020 William M. Aisenberg, CPA (Corrected) , April 24, 2020 PLS,, CPA a Professional Corporation Pls a/k/a, CPAS Park, Chang G., CPA Park, a/k/a Changgeun Lee, Joseph Yongyun, CPA Lee, a/k/a Yong Yun Lee, Juchi, CPA Fernandez, a/k/a Juchi Lee Lee, Ju-Chi Lee, Ju Chi Lee, Sue Releas \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4133.txt b/raw/aaer/2020/AAER-4133.txt new file mode 100644 index 0000000000000000000000000000000000000000..139d92bcc61a6ce4f77573975ef689081c3a183a --- /dev/null +++ b/raw/aaer/2020/AAER-4133.txt @@ -0,0 +1 @@ +2020 PLS, CPA, et al. (Order Regarding Service) , AAER-4136 April 28, 2020 Penn West Petroleum Ltd., d/b/a Obsidian Energy Ltd., Todd H. Takeyasu, Jeffery A. Curran, and Waldemar Grab , See Also: SEC Complaint April 28, 2020 Ross, Sinclaire & Associates, LLC and Murray Sinclaire, Jr. , AAER-4132 April 28, 2020 William M. Aisenberg, CPA (Corrected) \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4134.txt b/raw/aaer/2020/AAER-4134.txt new file mode 100644 index 0000000000000000000000000000000000000000..e89c3c01bd374cfd11c965a8c848152a488e4172 --- /dev/null +++ b/raw/aaer/2020/AAER-4134.txt @@ -0,0 +1 @@ +May 11, 2020 PLS, CPA, et al. (Order) , AAER-4139 May 5, 2020 Jeffery A. Curran, CA , AAER-4138 May 1, 2020 Todd H. Takeyasu, CA , May 1, 2020 PLS, CPA, et al. (Order Regarding Service) , AAER-4136 April 28, 2020 Penn West Petroleum Ltd., d/b/a Obsidian Energy Ltd., Todd H. Takeyasu, Jeffery A. Curran, and Waldemar Grab Rel \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4136.txt b/raw/aaer/2020/AAER-4136.txt new file mode 100644 index 0000000000000000000000000000000000000000..d1b1f8cb1e119cf341767b410913f8ce552655df --- /dev/null +++ b/raw/aaer/2020/AAER-4136.txt @@ -0,0 +1 @@ +, 2020 Jeffery A. Curran, CA , AAER-4138 May 1, 2020 Todd H. Takeyasu, CA , AAER-4134 May 1, 2020 PLS, CPA, et al. (Order Regarding Service) , April 28, 2020 Penn West Petroleum Ltd., d/b/a Obsidian Energy Ltd., Todd H. Takeyasu, Jeffery A. Curran, and Waldemar Grab , AAER-4133 See Also: SEC Complaint April 28, 2020 Ross, Si \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4138.txt b/raw/aaer/2020/AAER-4138.txt new file mode 100644 index 0000000000000000000000000000000000000000..b81d6726e3d84302f65e0b73fc37f5b483966f40 --- /dev/null +++ b/raw/aaer/2020/AAER-4138.txt @@ -0,0 +1 @@ +t Group Corp. and TCA Global Credit Fund GP, Ltd. , AAER-4140 May 11, 2020 PLS, CPA, et al. (Order) , AAER-4139 May 5, 2020 Jeffery A. Curran, CA , May 1, 2020 Todd H. Takeyasu, CA , AAER-4134 May 1, 2020 PLS, CPA, et al. (Order Regarding Service) , AAER-4136 April 28, 2020 Penn West Petroleum Ltd., d/b \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4139.txt b/raw/aaer/2020/AAER-4139.txt new file mode 100644 index 0000000000000000000000000000000000000000..ab166918eb0cfb3444cbd9f0e8b8cfa68a1ed186 --- /dev/null +++ b/raw/aaer/2020/AAER-4139.txt @@ -0,0 +1 @@ +PA , AAER-4142 May 12, 2020 TCA Fund Management Group Corp. and TCA Global Credit Fund GP, Ltd. , AAER-4140 May 11, 2020 PLS, CPA, et al. (Order) , May 5, 2020 Jeffery A. Curran, CA , AAER-4138 May 1, 2020 Todd H. Takeyasu, CA , AAER-4134 May 1, 2020 PLS, CPA, et al. (Order Regarding Service) Relea \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4140.txt b/raw/aaer/2020/AAER-4140.txt new file mode 100644 index 0000000000000000000000000000000000000000..01f68b1a96cd697a3010f48854376692b5eeeb8c --- /dev/null +++ b/raw/aaer/2020/AAER-4140.txt @@ -0,0 +1 @@ +y, CPA , AAER-4141 May 18, 2020 Michael Bellach, CPA , AAER-4142 May 12, 2020 TCA Fund Management Group Corp. and TCA Global Credit Fund GP, Ltd. , May 11, 2020 PLS, CPA, et al. (Order) , AAER-4139 May 5, 2020 Jeffery A. Curran, CA , AAER-4138 May 1, 2020 Todd H. Takeyasu, CA , \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4141.txt b/raw/aaer/2020/AAER-4141.txt new file mode 100644 index 0000000000000000000000000000000000000000..35e2ef75c349131418ef448faee3a9a8252ca4f0 --- /dev/null +++ b/raw/aaer/2020/AAER-4141.txt @@ -0,0 +1,1670 @@ + + + + + + + + + + + + + + + + SEC.gov | What's New + + + + + + + + !function(){var e=navigator.userAgent,a=document.documentElement,n=a.className;n=n.replace("no-js","js"),/iPad|iPhone|iPod/.test(e)&&!window.MSStream&&(n+=" ua-ios"),a.className=n}(); + {"path":{"baseUrl":"\/","pathPrefix":"","currentPath":"node\/963296","currentPathIsAdmin":false,"isFront":false,"currentLanguage":"en","currentQuery":{"tag":"36681,36691,36696,36686,36411,34141,35221,34916,36706,321801,334846,36146,335756","type":"news,secarticle,link"}},"pluralDelimiter":"\u0003","suppressDeprecationErrors":true,"gtag":{"tagId":"","consentMode":false,"otherIds":[],"events":[],"additionalConfigInfo":[]},"ajaxPageState":{"libraries":"eJxtUUFywyAM_BAOp76HkUHF1AJ5JEjivr4UO5k004tGu1rQsvgVQ6osH26jFlNxG_jVpRKwVDcT-9W-AuMJVHc7g-Kjz6gKEdV4FrSFJQOlbzR4r5TKaoO0DehyQhOZI6GrEG3s5R1f4Avuf8lsCHZu3UJLFFCcb1o59x1iI_EMNGnd--XxIQxJPV9RdssFPZNR9A5CTsU-zkJNXHQa5AQlTHXBjEN4SBylWUASqvVnSK6VwG5B2lCGEkMEsZpBqlME8cugBQl7QPq2bMyuCW_uM1Ht7zgit__TT7U-BfrryeiuFfPxBU1vQc-ETzDq0XdP_vQwnUF5fZ0tCGF6i_BYOeolc2iEP6ZW2Cg","theme":"uswds_sec","theme_token":null},"ajaxTrustedUrl":{"\/newsroom\/whats-new":true},"gtm":{"tagId":null,"settings":{"data_layer":"dataLayer","include_classes":false,"allowlist_classes":"","blocklist_classes":"","include_environment":false,"environment_id":"","environment_token":""},"tagIds":["GTM-TD3BKV"]},"data":{"extlink":{"extTarget":false,"extTargetAppendNewWindowDisplay":true,"extTargetAppendNewWindowLabel":"(opens in a new window)","extTargetNoOverride":false,"extNofollow":false,"extTitleNoOverride":false,"extNoreferrer":false,"extFollowNoOverride":false,"extClass":"0","extLabel":"(link is external)","extImgClass":false,"extSubdomains":true,"extExclude":".*\\.gov|http:\/\/www.xbrl.org\/utr\/2013-05-17\/utr.xml|http:\/\/www.xbrl.org\/dtr\/type\/numeric-2009-12-16.xsd|http:\/\/www.xbrl.org\/dtr\/type\/nonNumeric-2009-12-16.xsd|https:\/\/secir.secure.force.com\/ombudsman\/OMMSForm","extInclude":"","extCssExclude":".data-exempt","extCssInclude":"","extCssExplicit":"","extAlert":true,"extAlertText":"You are now leaving the SEC Website. 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(Order) , AAER-4139 May 5, 2020 J \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4143.txt b/raw/aaer/2020/AAER-4143.txt new file mode 100644 index 0000000000000000000000000000000000000000..e3e940cce2af809edf7213e5dbc76fbd037063ba --- /dev/null +++ b/raw/aaer/2020/AAER-4143.txt @@ -0,0 +1 @@ +, AAER-4145 May 22, 2020 TSP Capital Management Group, LLC , AAER-4144 See Also: Administrative Summary May 18, 2020 John Donovan, CPA , May 18, 2020 Timothy Daly, CPA , AAER-4141 May 18, 2020 Michael Bellach, CPA , AAER-4142 May 12, 2020 TCA Fund Management Group Corp. and TCA Global Credit \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4144.txt b/raw/aaer/2020/AAER-4144.txt new file mode 100644 index 0000000000000000000000000000000000000000..ec9ffed589ca30140c7e94b52051d5643f7ec77d --- /dev/null +++ b/raw/aaer/2020/AAER-4144.txt @@ -0,0 +1 @@ +Group International Holdings, Ltd. , AAER-4146 June 3, 2020 Christopher D. Larson (CPA) , AAER-4145 May 22, 2020 TSP Capital Management Group, LLC , See Also: Administrative Summary May 18, 2020 John Donovan, CPA , AAER-4143 May 18, 2020 Timothy Daly, CPA , AAER-4141 May 18, 2020 Michael Be \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4145.txt b/raw/aaer/2020/AAER-4145.txt new file mode 100644 index 0000000000000000000000000000000000000000..614dd39670c0c5fae5d24c202f607db16968889e --- /dev/null +++ b/raw/aaer/2020/AAER-4145.txt @@ -0,0 +1 @@ +4-89023, AAER-4147 See Also: Administrative Summary June 4, 2020 Argo Group International Holdings, Ltd. , AAER-4146 June 3, 2020 Christopher D. Larson (CPA) , May 22, 2020 TSP Capital Management Group, LLC , AAER-4144 See Also: Administrative Summary May 18, 2020 John Donovan, CPA , AAER-4143 May 18, 2020 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4146.txt b/raw/aaer/2020/AAER-4146.txt new file mode 100644 index 0000000000000000000000000000000000000000..b29375711c72723f7ab19de01404d0e81ab6a8f0 --- /dev/null +++ b/raw/aaer/2020/AAER-4146.txt @@ -0,0 +1 @@ +No. 34-89099, AAER-4148 June 5, 2020 Jana Faith Kiena, CPA , AAER-4147 See Also: Administrative Summary June 4, 2020 Argo Group International Holdings, Ltd. , June 3, 2020 Christopher D. Larson (CPA) , AAER-4145 May 22, 2020 TSP Capital Management Group, LLC , AAER-4144 See Also: Administrative Summary May \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4147.txt b/raw/aaer/2020/AAER-4147.txt new file mode 100644 index 0000000000000000000000000000000000000000..d612df1cf3bf06e9e36972c5be113e8da5d6db2f --- /dev/null +++ b/raw/aaer/2020/AAER-4147.txt @@ -0,0 +1 @@ +ase No. 33-10793, 34-89133, AAER-4149 See Also: Administrative Summary June 18, 2020 PLS, CPA, et al. (Order) , AAER-4148 June 5, 2020 Jana Faith Kiena, CPA , See Also: Administrative Summary June 4, 2020 Argo Group International Holdings, Ltd. , AAER-4146 June 3, 2020 Christopher D. Larson (CPA) , AAER-4145 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4148.txt b/raw/aaer/2020/AAER-4148.txt new file mode 100644 index 0000000000000000000000000000000000000000..a9020f74fa8aabb2a1e4c8eda43d6cf55080d67e --- /dev/null +++ b/raw/aaer/2020/AAER-4148.txt @@ -0,0 +1 @@ +, AAER-4150 June 23, 2020 Vereit, Inc. , 34-89133, AAER-4149 See Also: Administrative Summary June 18, 2020 PLS, CPA, et al. (Order) , June 5, 2020 Jana Faith Kiena, CPA , AAER-4147 See Also: Administrative Summary June 4, 2020 Argo Group International Holdings, Ltd. , AAER-4146 Ju \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4149.txt b/raw/aaer/2020/AAER-4149.txt new file mode 100644 index 0000000000000000000000000000000000000000..2341d45ae306c1cb5f0d88bff12f2e5f53e2de3f --- /dev/null +++ b/raw/aaer/2020/AAER-4149.txt @@ -0,0 +1 @@ +July 2, 2020 Alexion Pharmaceuticals, Inc. , AAER-4151 June 25, 2020 Novartis AG , AAER-4150 June 23, 2020 Vereit, Inc. , 34-89133, See Also: Administrative Summary June 18, 2020 PLS, CPA, et al. (Order) , AAER-4148 June 5, 2020 Jana Faith Kiena, CPA , AAER-4147 See Also: Adminis \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4150.txt b/raw/aaer/2020/AAER-4150.txt new file mode 100644 index 0000000000000000000000000000000000000000..87b5078c6e6b8e0fd893273da44b45f7b9b9dbe2 --- /dev/null +++ b/raw/aaer/2020/AAER-4150.txt @@ -0,0 +1 @@ +53 July 15, 2020 Paul J. Konigsberg , AAER-4152 July 2, 2020 Alexion Pharmaceuticals, Inc. , AAER-4151 June 25, 2020 Novartis AG , June 23, 2020 Vereit, Inc. , 34-89133, AAER-4149 See Also: Administrative Summary June 18, 2020 PLS, CPA, et al. (Order) , AAER-4148 June 5, 2020 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4151.txt b/raw/aaer/2020/AAER-4151.txt new file mode 100644 index 0000000000000000000000000000000000000000..53a4a987913dce296e133cf55d11bcff488fec61 --- /dev/null +++ b/raw/aaer/2020/AAER-4151.txt @@ -0,0 +1 @@ +n/k/a Bausch Health Companies Inc. , 34-89442, AAER-4153 July 15, 2020 Paul J. Konigsberg , AAER-4152 July 2, 2020 Alexion Pharmaceuticals, Inc. , June 25, 2020 Novartis AG , AAER-4150 June 23, 2020 Vereit, Inc. , 34-89133, AAER-4149 See Also: Administrative Summary June 18, 2020 PLS, CPA \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4152.txt b/raw/aaer/2020/AAER-4152.txt new file mode 100644 index 0000000000000000000000000000000000000000..a6f1af9272cc490c9d6fc2ce638b40df0f2361a7 --- /dev/null +++ b/raw/aaer/2020/AAER-4152.txt @@ -0,0 +1 @@ +34-89445, AAER-4155 July 31, 2020 Valeant Pharmaceuticals International, Inc. and n/k/a Bausch Health Companies Inc. , 34-89442, AAER-4153 July 15, 2020 Paul J. Konigsberg , July 2, 2020 Alexion Pharmaceuticals, Inc. , AAER-4151 June 25, 2020 Novartis AG , AAER-4150 June 23, 2020 Vereit, Inc. , 34-89133 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4153.txt b/raw/aaer/2020/AAER-4153.txt new file mode 100644 index 0000000000000000000000000000000000000000..44071cbba53690f607cc2b6d78548c8b8b4b522a --- /dev/null +++ b/raw/aaer/2020/AAER-4153.txt @@ -0,0 +1 @@ +AER-4154 July 31, 2020 Tanya R. Carro, CPA , 34-89445, AAER-4155 July 31, 2020 Valeant Pharmaceuticals International, Inc. and n/k/a Bausch Health Companies Inc. , 34-89442, July 15, 2020 Paul J. Konigsberg , AAER-4152 July 2, 2020 Alexion Pharmaceuticals, Inc. , AAER-4151 June 25, 2020 Novartis AG , AA \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4154.txt b/raw/aaer/2020/AAER-4154.txt new file mode 100644 index 0000000000000000000000000000000000000000..7414885b2a9e091b09af7683d5d30a2ec4ad195e --- /dev/null +++ b/raw/aaer/2020/AAER-4154.txt @@ -0,0 +1 @@ +57 Aug. 4, 2020 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-4156 July 31, 2020 J. Michael Pearson , 34-89443, July 31, 2020 Tanya R. Carro, CPA , 34-89445, AAER-4155 July 31, 2020 Valeant Pharmaceuticals International, Inc. and n/k/a Bausch Health Companies Inc. , 34-89442, AAER-415 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4155.txt b/raw/aaer/2020/AAER-4155.txt new file mode 100644 index 0000000000000000000000000000000000000000..9f3feeba2cac10d2e5f6af8c8a1d4963586b03e8 --- /dev/null +++ b/raw/aaer/2020/AAER-4155.txt @@ -0,0 +1 @@ +ung, Georgia, CPA Shek, Tommy, CPA , AAER-4156 July 31, 2020 J. Michael Pearson , 34-89443, AAER-4154 July 31, 2020 Tanya R. Carro, CPA , 34-89445, July 31, 2020 Valeant Pharmaceuticals International, Inc. and n/k/a Bausch Health Companies Inc. , 34-89442, AAER-4153 July 15, 2020 Paul J. Konigsberg , AAER-4152 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4156.txt b/raw/aaer/2020/AAER-4156.txt new file mode 100644 index 0000000000000000000000000000000000000000..17e6267abee833eb5e4979716949672fb2dee722 --- /dev/null +++ b/raw/aaer/2020/AAER-4156.txt @@ -0,0 +1 @@ +AAER-4158 Aug. 5, 2020 Dittman, Scott M., CPA , AAER-4157 Aug. 4, 2020 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , July 31, 2020 J. Michael Pearson , 34-89443, AAER-4154 July 31, 2020 Tanya R. Carro, CPA , 34-89445, AAER-4155 July 31, 2020 Valeant Pharmaceuticals Interna \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4157.txt b/raw/aaer/2020/AAER-4157.txt new file mode 100644 index 0000000000000000000000000000000000000000..0a76551ce08b305876c40b966b306e1394fcffc1 --- /dev/null +++ b/raw/aaer/2020/AAER-4157.txt @@ -0,0 +1 @@ +, AAER-4159 See Also: Administrative Summary Aug. 6, 2020 World Acceptance Corporation , AAER-4158 Aug. 5, 2020 Dittman, Scott M., CPA , Aug. 4, 2020 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-4156 July 31, 2020 J. Michael Pearson , 34-89443, AA \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4158.txt b/raw/aaer/2020/AAER-4158.txt new file mode 100644 index 0000000000000000000000000000000000000000..2a28d63a6489ffe0c35309765f0eb906ef04d46c --- /dev/null +++ b/raw/aaer/2020/AAER-4158.txt @@ -0,0 +1 @@ +See Also: SEC Complaint Aug. 13, 2020 Brian Dee Matlock, CPA , AAER-4159 See Also: Administrative Summary Aug. 6, 2020 World Acceptance Corporation , Aug. 5, 2020 Dittman, Scott M., CPA , AAER-4157 Aug. 4, 2020 Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA , AAER-4156 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4159.txt b/raw/aaer/2020/AAER-4159.txt new file mode 100644 index 0000000000000000000000000000000000000000..b51368924e7f08657ce35af0a70a920f6d546a5b --- /dev/null +++ b/raw/aaer/2020/AAER-4159.txt @@ -0,0 +1 @@ +ard Hideshima , AAER-4162 Aug. 14, 2020 Mark P. Frissora , AAER-4160 See Also: SEC Complaint Aug. 13, 2020 Brian Dee Matlock, CPA , See Also: Administrative Summary Aug. 6, 2020 World Acceptance Corporation , AAER-4158 Aug. 5, 2020 Dittman, Scott M., CPA , AAER-4157 Aug. 4, 2020 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4160.txt b/raw/aaer/2020/AAER-4160.txt new file mode 100644 index 0000000000000000000000000000000000000000..51f449c7b9964fb1bcef374f86ae9c37af21cbd3 --- /dev/null +++ b/raw/aaer/2020/AAER-4160.txt @@ -0,0 +1 @@ +656, AAER-4161 Aug. 25, 2020 Charles Liang , AAER-4163 Aug. 25, 2020 Howard Hideshima , AAER-4162 Aug. 14, 2020 Mark P. Frissora , See Also: SEC Complaint Aug. 13, 2020 Brian Dee Matlock, CPA , AAER-4159 See Also: Administrative Summary Aug. 6, 2020 World Acceptance Corporation \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4161.txt b/raw/aaer/2020/AAER-4161.txt new file mode 100644 index 0000000000000000000000000000000000000000..42c440ee8b17693f9a902eb432fd29ffd33dd207 --- /dev/null +++ b/raw/aaer/2020/AAER-4161.txt @@ -0,0 +1 @@ +. 28, 2020 Herbalife Nutrition Ltd. , AAER-4165 Aug. 26, 2020 BorgWarner Inc. , AAER-4164 Aug. 25, 2020 Super Micro Computer, Inc. , 34-89656, Aug. 25, 2020 Charles Liang , AAER-4163 Aug. 25, 2020 Howard Hideshima , AAER-4162 Aug. 14, 2020 Mark P. Frissora , AAER-4160 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4162.txt b/raw/aaer/2020/AAER-4162.txt new file mode 100644 index 0000000000000000000000000000000000000000..150f2b30f01aaf37c8b361da84525dbb11e90499 --- /dev/null +++ b/raw/aaer/2020/AAER-4162.txt @@ -0,0 +1 @@ +Aug. 25, 2020 Super Micro Computer, Inc. , 34-89656, AAER-4161 Aug. 25, 2020 Charles Liang , AAER-4163 Aug. 25, 2020 Howard Hideshima , Aug. 14, 2020 Mark P. Frissora , AAER-4160 See Also: SEC Complaint Aug. 13, 2020 Brian Dee Matlock, CPA , AAER-4159 See Also: Administrative Summa \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4163.txt b/raw/aaer/2020/AAER-4163.txt new file mode 100644 index 0000000000000000000000000000000000000000..6701fcee0b9b2ffe7bd569c837421779f4505a43 --- /dev/null +++ b/raw/aaer/2020/AAER-4163.txt @@ -0,0 +1 @@ +Aug. 26, 2020 BorgWarner Inc. , AAER-4164 Aug. 25, 2020 Super Micro Computer, Inc. , 34-89656, AAER-4161 Aug. 25, 2020 Charles Liang , Aug. 25, 2020 Howard Hideshima , AAER-4162 Aug. 14, 2020 Mark P. Frissora , AAER-4160 See Also: SEC Complaint Aug. 13, 2020 Brian Dee Matloc \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4164.txt b/raw/aaer/2020/AAER-4164.txt new file mode 100644 index 0000000000000000000000000000000000000000..f8899e740ae7fef57e75f0054b94c29ca7966c28 --- /dev/null +++ b/raw/aaer/2020/AAER-4164.txt @@ -0,0 +1 @@ +t, LLC , AAER-4166 See Also: Administrative Summary Aug. 28, 2020 Herbalife Nutrition Ltd. , AAER-4165 Aug. 26, 2020 BorgWarner Inc. , Aug. 25, 2020 Super Micro Computer, Inc. , 34-89656, AAER-4161 Aug. 25, 2020 Charles Liang , AAER-4163 Aug. 25, 2020 Howard Hideshima \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4165.txt b/raw/aaer/2020/AAER-4165.txt new file mode 100644 index 0000000000000000000000000000000000000000..61e34d485b4544f50cd0f7e149a08bd8d40b3b59 --- /dev/null +++ b/raw/aaer/2020/AAER-4165.txt @@ -0,0 +1 @@ +, AAER-4167 Sept. 4, 2020 SQN Capital Management, LLC , AAER-4166 See Also: Administrative Summary Aug. 28, 2020 Herbalife Nutrition Ltd. , Aug. 26, 2020 BorgWarner Inc. , AAER-4164 Aug. 25, 2020 Super Micro Computer, Inc. , 34-89656, AAER-4161 Aug. 25, 2020 Charles Liang \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4166.txt b/raw/aaer/2020/AAER-4166.txt new file mode 100644 index 0000000000000000000000000000000000000000..c85fef0b7856cecfd46060a2400cc798d9c70203 --- /dev/null +++ b/raw/aaer/2020/AAER-4166.txt @@ -0,0 +1 @@ +, AAER-4168 See Also: Administrative Summary Sept. 14, 2020 Henry Seth Brock, CPA , AAER-4167 Sept. 4, 2020 SQN Capital Management, LLC , See Also: Administrative Summary Aug. 28, 2020 Herbalife Nutrition Ltd. , AAER-4165 Aug. 26, 2020 BorgWarner Inc. , AAER-4164 Aug. 25, 2020 Su \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4167.txt b/raw/aaer/2020/AAER-4167.txt new file mode 100644 index 0000000000000000000000000000000000000000..87047f2942a62e81d18a609ee2c5cf53fe8ce047 --- /dev/null +++ b/raw/aaer/2020/AAER-4167.txt @@ -0,0 +1 @@ +, AAER-4169 Sept. 21, 2020 Steven L. Jenkins, CPA , AAER-4168 See Also: Administrative Summary Sept. 14, 2020 Henry Seth Brock, CPA , Sept. 4, 2020 SQN Capital Management, LLC , AAER-4166 See Also: Administrative Summary Aug. 28, 2020 Herbalife Nutrition Ltd. , AAER-4165 Aug. 26, 2 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4168.txt b/raw/aaer/2020/AAER-4168.txt new file mode 100644 index 0000000000000000000000000000000000000000..a2ba689b2efa75b9610b8f184d8bb8f67b79971a --- /dev/null +++ b/raw/aaer/2020/AAER-4168.txt @@ -0,0 +1 @@ +lease No. LR-24915, AAER-4170 See Also: SEC Complaint Sept. 24, 2020 Power Solutions International, Inc. , AAER-4169 Sept. 21, 2020 Steven L. Jenkins, CPA , See Also: Administrative Summary Sept. 14, 2020 Henry Seth Brock, CPA , AAER-4167 Sept. 4, 2020 SQN Capital Management, LLC , AAER-4166 See Also: Adm \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4169.txt b/raw/aaer/2020/AAER-4169.txt new file mode 100644 index 0000000000000000000000000000000000000000..a9f6ffa94295e2d0a98c758d0d65068c0644ee72 --- /dev/null +++ b/raw/aaer/2020/AAER-4169.txt @@ -0,0 +1 @@ +ary Sept. 24, 2020 Revolution Lighting Technologies, Inc., et al. , AAER-4170 See Also: SEC Complaint Sept. 24, 2020 Power Solutions International, Inc. , Sept. 21, 2020 Steven L. Jenkins, CPA , AAER-4168 See Also: Administrative Summary Sept. 14, 2020 Henry Seth Brock, CPA , AAER-4167 Sept. 4, 2020 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4170.txt b/raw/aaer/2020/AAER-4170.txt new file mode 100644 index 0000000000000000000000000000000000000000..5c6cf3479b82b8b78f39048d4843983ac9be2280 --- /dev/null +++ b/raw/aaer/2020/AAER-4170.txt @@ -0,0 +1 @@ +Summary Sept. 25, 2020 Aeon Global Health Corp. , AAER-4171 See Also: Administrative Summary Sept. 24, 2020 Revolution Lighting Technologies, Inc., et al. , See Also: SEC Complaint Sept. 24, 2020 Power Solutions International, Inc. , AAER-4169 Sept. 21, 2020 Steven L. Jenkins, CPA , AAER-4168 See Also: \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4171.txt b/raw/aaer/2020/AAER-4171.txt new file mode 100644 index 0000000000000000000000000000000000000000..f406e3630e9726d7e28769fa65099f93ebd74293 --- /dev/null +++ b/raw/aaer/2020/AAER-4171.txt @@ -0,0 +1 @@ +See Also: Administrative Summary Sept. 25, 2020 Lam D. Ha, CPA , AAER-4173 See Also: Administrative Summary Sept. 25, 2020 Aeon Global Health Corp. , See Also: Administrative Summary Sept. 24, 2020 Revolution Lighting Technologies, Inc., et al. , AAER-4170 See Also: SEC Complaint Sept. 24, 2020 Power Solutions Interna \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4172.txt b/raw/aaer/2020/AAER-4172.txt new file mode 100644 index 0000000000000000000000000000000000000000..4d41a140bc594ee90d0e3b12b5d3f115b27754e0 --- /dev/null +++ b/raw/aaer/2020/AAER-4172.txt @@ -0,0 +1 @@ +Fulton Financial Corporation , AAER-4174 Sept. 28, 2020 Interface, Inc., et al. , 34-90018, AAER-4175 Sept. 25, 2020 James L. Thompson, CPA , See Also: Administrative Summary Sept. 25, 2020 Lam D. Ha, CPA , AAER-4173 See Also: Administrative Summary Sept. 25, 2020 Aeon Global Health Corp. \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4173.txt b/raw/aaer/2020/AAER-4173.txt new file mode 100644 index 0000000000000000000000000000000000000000..614bf2b0337834e3750f6a55bced1cd309306e4b --- /dev/null +++ b/raw/aaer/2020/AAER-4173.txt @@ -0,0 +1 @@ +, 34-90018, AAER-4175 Sept. 25, 2020 James L. Thompson, CPA , AAER-4172 See Also: Administrative Summary Sept. 25, 2020 Lam D. Ha, CPA , See Also: Administrative Summary Sept. 25, 2020 Aeon Global Health Corp. , AAER-4171 See Also: Administrative Summary Sept. 24, 2020 Revolution Lighting Technologies, Inc. \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4174.txt b/raw/aaer/2020/AAER-4174.txt new file mode 100644 index 0000000000000000000000000000000000000000..830a126f478930d1312525e81742792237ab55bb --- /dev/null +++ b/raw/aaer/2020/AAER-4174.txt @@ -0,0 +1 @@ +Inc. , 34-90042, AAER-4177 Sept. 28, 2020 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , AAER-4176 Sept. 28, 2020 Fulton Financial Corporation , Sept. 28, 2020 Interface, Inc., et al. , 34-90018, AAER-4175 Sept. 25, 2020 James L. Thompson, CPA , AAER-4172 See Also: Administrative Summary Sep \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4175.txt b/raw/aaer/2020/AAER-4175.txt new file mode 100644 index 0000000000000000000000000000000000000000..2712af225b0a91cf71acf08d898ecec533f6583d --- /dev/null +++ b/raw/aaer/2020/AAER-4175.txt @@ -0,0 +1 @@ +PA and Kanako Matsumoto, CPA , AAER-4176 Sept. 28, 2020 Fulton Financial Corporation , AAER-4174 Sept. 28, 2020 Interface, Inc., et al. , 34-90018, Sept. 25, 2020 James L. Thompson, CPA , AAER-4172 See Also: Administrative Summary Sept. 25, 2020 Lam D. Ha, CPA , AAER-4173 See Also: Administrativ \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4176.txt b/raw/aaer/2020/AAER-4176.txt new file mode 100644 index 0000000000000000000000000000000000000000..5b329cd3d0327b66dd581df96058d1c604cc1292 --- /dev/null +++ b/raw/aaer/2020/AAER-4176.txt @@ -0,0 +1 @@ +, 34-90044, AAER-4179 Sept. 29, 2020 Manitex International, Inc. , 34-90042, AAER-4177 Sept. 28, 2020 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , Sept. 28, 2020 Fulton Financial Corporation , AAER-4174 Sept. 28, 2020 Interface, Inc., et al. , 34-90018, AAER-4175 Sept. 25, 2020 James L. Thompson, CPA \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4177.txt b/raw/aaer/2020/AAER-4177.txt new file mode 100644 index 0000000000000000000000000000000000000000..65d03237ea1aada781819ba47e1cff75328ec82e --- /dev/null +++ b/raw/aaer/2020/AAER-4177.txt @@ -0,0 +1 @@ +Andrew Rooke , 34-90043, AAER-4178 Sept. 29, 2020 Stephen Harrison , 34-90044, AAER-4179 Sept. 29, 2020 Manitex International, Inc. , 34-90042, Sept. 28, 2020 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , AAER-4176 Sept. 28, 2020 Fulton Financial Corporation , AAER-4174 Sept. 28, 2020 Interface, \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4178.txt b/raw/aaer/2020/AAER-4178.txt new file mode 100644 index 0000000000000000000000000000000000000000..70b65e1799da9dbfda24417a42c02a7cbd0100b4 --- /dev/null +++ b/raw/aaer/2020/AAER-4178.txt @@ -0,0 +1 @@ +pt. 30, 2020 HP Inc. , 34-90060, AAER-4183 Sept. 29, 2020 Michael Schneider, CPA , 34-90045, AAER-4180 Sept. 29, 2020 Andrew Rooke , 34-90043, Sept. 29, 2020 Stephen Harrison , 34-90044, AAER-4179 Sept. 29, 2020 Manitex International, Inc. , 34-90042, AAER-4177 Sept. 28, 2020 Raymon Holmdahl, CPA a \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4179.txt b/raw/aaer/2020/AAER-4179.txt new file mode 100644 index 0000000000000000000000000000000000000000..f22850582c7029a913cac5b920e1b66c6a56cf88 --- /dev/null +++ b/raw/aaer/2020/AAER-4179.txt @@ -0,0 +1 @@ +020 Michael Schneider, CPA , 34-90045, AAER-4180 Sept. 29, 2020 Andrew Rooke , 34-90043, AAER-4178 Sept. 29, 2020 Stephen Harrison , 34-90044, Sept. 29, 2020 Manitex International, Inc. , 34-90042, AAER-4177 Sept. 28, 2020 Raymon Holmdahl, CPA and Kanako Matsumoto, CPA , AAER-4176 Sept. 28, 2020 Fu \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4180.txt b/raw/aaer/2020/AAER-4180.txt new file mode 100644 index 0000000000000000000000000000000000000000..ea8fd0f51b56f5c5e77ac519dcde7214e1e214b1 --- /dev/null +++ b/raw/aaer/2020/AAER-4180.txt @@ -0,0 +1 @@ +2020 Hilton Worldwide Holdings Inc. , AAER-4182 Sept. 30, 2020 HP Inc. , 34-90060, AAER-4183 Sept. 29, 2020 Michael Schneider, CPA , 34-90045, Sept. 29, 2020 Andrew Rooke , 34-90043, AAER-4178 Sept. 29, 2020 Stephen Harrison , 34-90044, AAER-4179 Sept. 29, 2020 Manitex International, Inc. Rele \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4181.txt b/raw/aaer/2020/AAER-4181.txt new file mode 100644 index 0000000000000000000000000000000000000000..f148861a3e5e2c20b8ba4cbc0510a645803526ba --- /dev/null +++ b/raw/aaer/2020/AAER-4181.txt @@ -0,0 +1 @@ +2020 Hill International, Inc. et al. , AAER-4185 Oct. 5, 2020 Nicholas Tornello, CPA , AAER-4184 Sept. 30, 2020 BGC Partners, Inc. , 34-90050, See Also: Administrative Summary Sept. 30, 2020 Hilton Worldwide Holdings Inc. , AAER-4182 Sept. 30, 2020 HP Inc. , 34-90060, AAER-4183 Sept. 29, 2 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4182.txt b/raw/aaer/2020/AAER-4182.txt new file mode 100644 index 0000000000000000000000000000000000000000..e496bae4708a9ea3c026c2d466538e83d9cac6a9 --- /dev/null +++ b/raw/aaer/2020/AAER-4182.txt @@ -0,0 +1 @@ +. 34-90089, AAER-4184 Sept. 30, 2020 BGC Partners, Inc. , 34-90050, AAER-4181 See Also: Administrative Summary Sept. 30, 2020 Hilton Worldwide Holdings Inc. , Sept. 30, 2020 HP Inc. , 34-90060, AAER-4183 Sept. 29, 2020 Michael Schneider, CPA , 34-90045, AAER-4180 Sept. 29, 2020 Andrew Rooke \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4183.txt b/raw/aaer/2020/AAER-4183.txt new file mode 100644 index 0000000000000000000000000000000000000000..f501e711b37ab223a250493640105694ec4b4aaa --- /dev/null +++ b/raw/aaer/2020/AAER-4183.txt @@ -0,0 +1 @@ +o. 33-10867, 34-90050, AAER-4181 See Also: Administrative Summary Sept. 30, 2020 Hilton Worldwide Holdings Inc. , AAER-4182 Sept. 30, 2020 HP Inc. , 34-90060, Sept. 29, 2020 Michael Schneider, CPA , 34-90045, AAER-4180 Sept. 29, 2020 Andrew Rooke , 34-90043, AAER-4178 Sept. 29, 2020 Stephen Harrison Release N \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4184.txt b/raw/aaer/2020/AAER-4184.txt new file mode 100644 index 0000000000000000000000000000000000000000..557549d14a6765ec65cc119b075f128c49d290fe --- /dev/null +++ b/raw/aaer/2020/AAER-4184.txt @@ -0,0 +1 @@ +S, S.A., Joesley Batista, Wesley Batista , AAER-4189 Oct. 5, 2020 Hill International, Inc. et al. , AAER-4185 Oct. 5, 2020 Nicholas Tornello, CPA , Sept. 30, 2020 BGC Partners, Inc. , 34-90050, AAER-4181 See Also: Administrative Summary Sept. 30, 2020 Hilton Worldwide Holdings Inc. , AAER-4182 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4185.txt b/raw/aaer/2020/AAER-4185.txt new file mode 100644 index 0000000000000000000000000000000000000000..531c557b90b1e31f6c85117f407189f01cf001c6 --- /dev/null +++ b/raw/aaer/2020/AAER-4185.txt @@ -0,0 +1 @@ +, AAER-4186 Oct. 14, 2020 J&F Investimentos, S.A., JBS, S.A., Joesley Batista, Wesley Batista , AAER-4189 Oct. 5, 2020 Hill International, Inc. et al. , Oct. 5, 2020 Nicholas Tornello, CPA , AAER-4184 Sept. 30, 2020 BGC Partners, Inc. , 34-90050, AAER-4181 See Also: Administrative Summary Sept. 30, \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4186.txt b/raw/aaer/2020/AAER-4186.txt new file mode 100644 index 0000000000000000000000000000000000000000..dd2a17350d49733f8739dba3bf3b6db1ecb7de3f --- /dev/null +++ b/raw/aaer/2020/AAER-4186.txt @@ -0,0 +1 @@ +90208, AAER-4190 Oct. 14, 2020 Daniel O'Neal , AAER-4187 Oct. 14, 2020 Allen Garner , AAER-4188 Oct. 14, 2020 James DePalma, CPA , Oct. 14, 2020 J&F Investimentos, S.A., JBS, S.A., Joesley Batista, Wesley Batista , AAER-4189 Oct. 5, 2020 Hill International, Inc. et al. , AAER-4185 Oct. 5, 20 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4187.txt b/raw/aaer/2020/AAER-4187.txt new file mode 100644 index 0000000000000000000000000000000000000000..b33b95d4ae06f147c871cbb81f3c2b06d4d579cb --- /dev/null +++ b/raw/aaer/2020/AAER-4187.txt @@ -0,0 +1 @@ +chs Group, Inc. , AAER-4191 See Also: Press Oct. 15, 2020 Andeavor LLC , AAER-4190 Oct. 14, 2020 Daniel O'Neal , Oct. 14, 2020 Allen Garner , AAER-4188 Oct. 14, 2020 James DePalma, CPA , AAER-4186 Oct. 14, 2020 J&F Investimentos, S.A., JBS, S.A., Joesley Batista, Wesle \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4188.txt b/raw/aaer/2020/AAER-4188.txt new file mode 100644 index 0000000000000000000000000000000000000000..e1fb9bbfdf97aa5b598984e11c7458784e0340bf --- /dev/null +++ b/raw/aaer/2020/AAER-4188.txt @@ -0,0 +1 @@ +elease No. 2020-265 Oct. 15, 2020 Andeavor LLC , AAER-4190 Oct. 14, 2020 Daniel O'Neal , AAER-4187 Oct. 14, 2020 Allen Garner , Oct. 14, 2020 James DePalma, CPA , AAER-4186 Oct. 14, 2020 J&F Investimentos, S.A., JBS, S.A., Joesley Batista, Wesley Batista , AAER-4189 Oct. 5, 2020 Hill \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4189.txt b/raw/aaer/2020/AAER-4189.txt new file mode 100644 index 0000000000000000000000000000000000000000..248b122157c10ab49e4465ceb61f3f56ab575360 --- /dev/null +++ b/raw/aaer/2020/AAER-4189.txt @@ -0,0 +1 @@ +Garner , AAER-4188 Oct. 14, 2020 James DePalma, CPA , AAER-4186 Oct. 14, 2020 J&F Investimentos, S.A., JBS, S.A., Joesley Batista, Wesley Batista , Oct. 5, 2020 Hill International, Inc. et al. , AAER-4185 Oct. 5, 2020 Nicholas Tornello, CPA , AAER-4184 Sept. 30, 2020 BGC Partners, Inc. \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4190.txt b/raw/aaer/2020/AAER-4190.txt new file mode 100644 index 0000000000000000000000000000000000000000..8db3003cc76c78eab36c639eb57e0aff9d204179 --- /dev/null +++ b/raw/aaer/2020/AAER-4190.txt @@ -0,0 +1 @@ +, AAER-4192 Oct. 22, 2020 The Goldman Sachs Group, Inc. , AAER-4191 See Also: Press Oct. 15, 2020 Andeavor LLC , Oct. 14, 2020 Daniel O'Neal , AAER-4187 Oct. 14, 2020 Allen Garner , AAER-4188 Oct. 14, 2020 James DePalma, CPA , AAER-4186 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4191.txt b/raw/aaer/2020/AAER-4191.txt new file mode 100644 index 0000000000000000000000000000000000000000..c6fe62034ed705f2f6a5716a0d35fc77fca2dddd --- /dev/null +++ b/raw/aaer/2020/AAER-4191.txt @@ -0,0 +1 @@ +Nov. 6, 2020 Frank G. Mueller , AAER-4193 Oct. 29, 2020 Steven L. Henning, CPA , AAER-4192 Oct. 22, 2020 The Goldman Sachs Group, Inc. , See Also: Press Oct. 15, 2020 Andeavor LLC , AAER-4190 Oct. 14, 2020 Daniel O'Neal , AAER-4187 Oct. 14, 2020 Allen Garner \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4192.txt b/raw/aaer/2020/AAER-4192.txt new file mode 100644 index 0000000000000000000000000000000000000000..fb6d75c1a2acd7992990d8ef39639bc7b556d943 --- /dev/null +++ b/raw/aaer/2020/AAER-4192.txt @@ -0,0 +1 @@ +Dec. 9, 2020 General Electric Company , 34-90620, AAER-4194 Nov. 6, 2020 Frank G. Mueller , AAER-4193 Oct. 29, 2020 Steven L. Henning, CPA , Oct. 22, 2020 The Goldman Sachs Group, Inc. , AAER-4191 See Also: Press Oct. 15, 2020 Andeavor LLC , AAER-4190 Oct. 14, 2020 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4193.txt b/raw/aaer/2020/AAER-4193.txt new file mode 100644 index 0000000000000000000000000000000000000000..3142bca8e5c8f95c399eedb1af3a8d9cf66cff95 --- /dev/null +++ b/raw/aaer/2020/AAER-4193.txt @@ -0,0 +1 @@ +, AAER-4195 See Also: Administrative Summary Dec. 9, 2020 General Electric Company , 34-90620, AAER-4194 Nov. 6, 2020 Frank G. Mueller , Oct. 29, 2020 Steven L. Henning, CPA , AAER-4192 Oct. 22, 2020 The Goldman Sachs Group, Inc. , AAER-4191 See Also: Press Oct. \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4194.txt b/raw/aaer/2020/AAER-4194.txt new file mode 100644 index 0000000000000000000000000000000000000000..f8f9a2ea5b0208b45039f2e6123158bb70ffb14b --- /dev/null +++ b/raw/aaer/2020/AAER-4194.txt @@ -0,0 +1 @@ +: Administrative Summary Dec. 10, 2020 Mark E. Watson III , AAER-4195 See Also: Administrative Summary Dec. 9, 2020 General Electric Company , 34-90620, Nov. 6, 2020 Frank G. Mueller , AAER-4193 Oct. 29, 2020 Steven L. Henning, CPA , AAER-4192 Oct. 22, 2020 The Goldman Sachs Group, Inc. \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4195.txt b/raw/aaer/2020/AAER-4195.txt new file mode 100644 index 0000000000000000000000000000000000000000..097ade12d7cdfd34bd2907bada9b3af849e9d68e --- /dev/null +++ b/raw/aaer/2020/AAER-4195.txt @@ -0,0 +1 @@ +nistrative Summary Dec. 14, 2020 Belden Inc. and Dennis Wiser, CPA , 34-90664, AAER-4196 See Also: Administrative Summary Dec. 10, 2020 Mark E. Watson III , See Also: Administrative Summary Dec. 9, 2020 General Electric Company , 34-90620, AAER-4194 Nov. 6, 2020 Frank G. Mueller , AAER-4193 Oct. 29, 202 \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4196.txt b/raw/aaer/2020/AAER-4196.txt new file mode 100644 index 0000000000000000000000000000000000000000..91895a7c940a131719057798b0e267573de55634 --- /dev/null +++ b/raw/aaer/2020/AAER-4196.txt @@ -0,0 +1 @@ +dministrative Summary Dec. 17, 2020 Mancera, et al. , AAER-4198 See Also: Administrative Summary Dec. 14, 2020 Belden Inc. and Dennis Wiser, CPA , 34-90664, See Also: Administrative Summary Dec. 10, 2020 Mark E. Watson III , AAER-4195 See Also: Administrative Summary Dec. 9, 2020 General Electric Company \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4197.txt b/raw/aaer/2020/AAER-4197.txt new file mode 100644 index 0000000000000000000000000000000000000000..95c6c12ed9522fd31869ca7c2ed4495c7e1965c7 --- /dev/null +++ b/raw/aaer/2020/AAER-4197.txt @@ -0,0 +1 @@ +te Sort descending Respondents Dec. 17, 2020 Apex Global Brands Inc. , 34-90714, AAER-4199 See Also: Administrative Summary Dec. 17, 2020 Laksha Bohra , Dec. 17, 2020 Jason Boling, CPA , AAER-4200 See Also: Administrative Summary Dec. 17, 2020 Mancera, et al. , AAER-4198 See Also: Administrative Summ \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4198.txt b/raw/aaer/2020/AAER-4198.txt new file mode 100644 index 0000000000000000000000000000000000000000..d37224caf3c2b5313bf72207f3ed56d3b08e75b2 --- /dev/null +++ b/raw/aaer/2020/AAER-4198.txt @@ -0,0 +1 @@ +Laksha Bohra , AAER-4197 Dec. 17, 2020 Jason Boling, CPA , AAER-4200 See Also: Administrative Summary Dec. 17, 2020 Mancera, et al. , See Also: Administrative Summary Dec. 14, 2020 Belden Inc. and Dennis Wiser, CPA , 34-90664, AAER-4196 See Also: Administrative Summary Dec. 10, 2020 Mark E. Watson III \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4199.txt b/raw/aaer/2020/AAER-4199.txt new file mode 100644 index 0000000000000000000000000000000000000000..db45396ddd21a3ef27bbf99ef774eb75fe37a7bd --- /dev/null +++ b/raw/aaer/2020/AAER-4199.txt @@ -0,0 +1 @@ +anuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember Date Sort descending Respondents Dec. 17, 2020 Apex Global Brands Inc. , 34-90714, See Also: Administrative Summary Dec. 17, 2020 Laksha Bohra , AAER-4197 Dec. 17, 2020 Jason Boling, CPA , AAER-4200 See Also: Administrative Summary \ No newline at end of file diff --git a/raw/aaer/2020/AAER-4200.txt b/raw/aaer/2020/AAER-4200.txt new file mode 100644 index 0000000000000000000000000000000000000000..0c7c3278ac32cffab4d4f1b9db179c3f0752116e --- /dev/null +++ b/raw/aaer/2020/AAER-4200.txt @@ -0,0 +1 @@ +Inc. , 34-90714, AAER-4199 See Also: Administrative Summary Dec. 17, 2020 Laksha Bohra , AAER-4197 Dec. 17, 2020 Jason Boling, CPA , See Also: Administrative Summary Dec. 17, 2020 Mancera, et al. , AAER-4198 See Also: Administrative Summary Dec. 14, 2020 Belden Inc. and Dennis Wiser, CPA Release No \ No newline at end of file diff --git a/raw/aaer/2020/aaer_page.html b/raw/aaer/2020/aaer_page.html new file mode 100644 index 0000000000000000000000000000000000000000..70fd1928923b63d51784e101bc919d45945eb181 --- /dev/null +++ b/raw/aaer/2020/aaer_page.html @@ -0,0 +1,2639 @@ + + + + + + + + + + + + + + + SEC.gov | Accounting and Auditing Enforcement + + + + + + + + + + + + + + + + + + + + + + Skip to search field + + + + Skip to main content + + + + +
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The list below provides links to financial reporting related enforcement actions concerning civil lawsuits brought by the Commission in federal court and notices and orders concerning the institution and/or settlement of administrative proceedings. This list only highlights certain actions and is not meant to be a complete and exhaustive compilation of all of the actions that fall into this category.

+
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+ + +
+ + + + +Accounting and Auditing Enforcement Releases RSS Feed + + +
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+ +
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+
+ + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + +
Date + + +Respondents
+ +
Apex Global Brands Inc.
+
+ Release No. + 33-10907, 34-90714, AAER-4199 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Laksha Bohra
+
+ Release No. + 34-90696, AAER-4197 +
+
+ +
Jason Boling, CPA
+
+ Release No. + 34-90716, AAER-4200 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Mancera, et al.
+
+ Release No. + 34-90699, AAER-4198 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Belden Inc. and Dennis Wiser, CPA
+
+ Release No. + 33-10903, 34-90664, AAER-4196 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Mark E. Watson III
+
+ Release No. + 34-90630, AAER-4195 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
General Electric Company
+
+ Release No. + 33-10899, 34-90620, AAER-4194 +
+
+ +
Frank G. Mueller
+
+ Release No. + 34-90369, AAER-4193 +
+
+ +
Steven L. Henning, CPA
+
+ Release No. + 34-90281, AAER-4192 +
+
+ +
The Goldman Sachs Group, Inc.
+
+ Release No. + 34-90243, AAER-4191 +
+
+ See Also: + + Press Release No. 2020-265 + + +
+
+ +
Andeavor LLC
+
+ Release No. + 34-90208, AAER-4190 +
+
+ +
Daniel O'Neal
+
+ Release No. + 34-90167, AAER-4187 +
+
+ +
Allen Garner
+
+ Release No. + 34-90168, AAER-4188 +
+
+ +
James DePalma, CPA
+
+ Release No. + 34-90166, AAER-4186 +
+
+ +
J&F Investimentos, S.A., JBS, S.A., Joesley Batista, Wesley Batista
+
+ Release No. + 34-90170, AAER-4189 +
+
+ +
Hill International, Inc. et al.
+
+ Release No. + LR-24939, AAER-4185 +
+
+ +
Nicholas Tornello, CPA
+
+ Release No. + 34-90089, AAER-4184 +
+
+ +
BGC Partners, Inc.
+
+ Release No. + 33-10867, 34-90050, AAER-4181 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Hilton Worldwide Holdings Inc.
+
+ Release No. + 34-90052, AAER-4182 +
+
+ +
HP Inc.
+
+ Release No. + 33-10868, 34-90060, AAER-4183 +
+
+ +
Michael Schneider, CPA
+
+ Release No. + 33-10863, 34-90045, AAER-4180 +
+
+ +
Andrew Rooke
+
+ Release No. + 33-10861, 34-90043, AAER-4178 +
+
+ +
Stephen Harrison
+
+ Release No. + 33-10862, 34-90044, AAER-4179 +
+
+ +
Manitex International, Inc.
+
+ Release No. + 33-10860, 34-90042, AAER-4177 +
+
+ +
Raymon Holmdahl, CPA and Kanako Matsumoto, CPA
+
+ Release No. + 34-90025, AAER-4176 +
+
+ +
Fulton Financial Corporation
+
+ Release No. + 34-90017, AAER-4174 +
+
+ +
Interface, Inc., et al.
+
+ Release No. + 33-10854, 34-90018, AAER-4175 +
+
+ +
James L. Thompson, CPA
+
+ Release No. + 34-90008, AAER-4172 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Lam D. Ha, CPA
+
+ Release No. + 34-90010, AAER-4173 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Aeon Global Health Corp.
+
+ Release No. + 34-90003, AAER-4171 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Revolution Lighting Technologies, Inc., et al.
+
+ Release No. + LR-24915, AAER-4170 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Power Solutions International, Inc.
+
+ Release No. + 34-89984, AAER-4169 +
+
+ +
Steven L. Jenkins, CPA
+
+ Release No. + 34-89936, AAER-4168 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Henry Seth Brock, CPA
+
+ Release No. + 34-89861, AAER-4167 +
+
+ +
SQN Capital Management, LLC
+
+ Release No. + IA-5573, AAER-4166 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Herbalife Nutrition Ltd.
+
+ Release No. + 34-89704, AAER-4165 +
+
+ +
BorgWarner Inc.
+
+ Release No. + 34-89677, AAER-4164 +
+
+ +
Super Micro Computer, Inc.
+
+ Release No. + 33-10822, 34-89656, AAER-4161 +
+
+ +
Charles Liang
+
+ Release No. + 34-89658, AAER-4163 +
+
+ +
Howard Hideshima
+
+ Release No. + 34-89657, AAER-4162 +
+
+ +
Mark P. Frissora
+
+ Release No. + LR-24869, AAER-4160 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Brian Dee Matlock, CPA
+
+ Release No. + 34-89552, AAER-4159 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
World Acceptance Corporation
+
+ Release No. + 34-89489, AAER-4158 +
+
+ +
Dittman, Scott M., CPA
+
+ Release No. + 33-10816, AAER-4157 +
+
+ +
Anton & Chia, LLP Wahl, Gregory A., CPA Deutchman, Michael, CPA Chung, Georgia, CPA Shek, Tommy, CPA
+
+ Release No. + 34-89475, AAER-4156 +
+
+ +
J. Michael Pearson
+
+ Release No. + 33-10810, 34-89443, AAER-4154 +
+
+ +
Tanya R. Carro, CPA
+
+ Release No. + 33-10812, 34-89445, AAER-4155 +
+
+ +
Valeant Pharmaceuticals International, Inc. and n/k/a Bausch Health Companies Inc.
+
+ Release No. + 33-10809, 34-89442, AAER-4153 +
+
+ +
Paul J. Konigsberg
+
+ Release No. + 34-89326, AAER-4152 +
+
+ +
Alexion Pharmaceuticals, Inc.
+
+ Release No. + 34-89214, AAER-4151 +
+
+ +
Novartis AG
+
+ Release No. + 34-89149, AAER-4150 +
+
+ +
Vereit, Inc.
+
+ Release No. + 33-10793, 34-89133, AAER-4149 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
PLS, CPA, et al. (Order)
+
+ Release No. + 34-89099, AAER-4148 +
+
+ +
Jana Faith Kiena, CPA
+
+ Release No. + 34-89023, AAER-4147 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Argo Group International Holdings, Ltd.
+
+ Release No. + 34-89009, AAER-4146 +
+
+ +
Christopher D. Larson (CPA)
+
+ Release No. + 34-88998, AAER-4145 +
+
+ +
TSP Capital Management Group, LLC
+
+ Release No. + IA-5508, AAER-4144 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
John Donovan, CPA
+
+ Release No. + 34-88897, AAER-4143 +
+
+ +
Timothy Daly, CPA
+
+ Release No. + 34-88895, AAER-4141 +
+
+ +
Michael Bellach, CPA
+
+ Release No. + 34-88896, AAER-4142 +
+
+ +
TCA Fund Management Group Corp. and TCA Global Credit Fund GP, Ltd.
+
+ Release No. + LR-24815, AAER-4140 +
+
+ +
PLS, CPA, et al. (Order)
+
+ Release No. + 34-88851, AAER-4139 +
+
+ +
Jeffery A. Curran, CA
+
+ Release No. + 34-88808, AAER-4138 +
+
+ +
Todd H. Takeyasu, CA
+
+ Release No. + 34-88791, AAER-4134 +
+
+ +
PLS, CPA, et al. (Order Regarding Service)
+
+ Release No. + 34-88796, AAER-4136 +
+
+ +
Penn West Petroleum Ltd., d/b/a Obsidian Energy Ltd., Todd H. Takeyasu, Jeffery A. Curran, and Waldemar Grab
+
+ Release No. + LR-24809, AAER-4133 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Ross, Sinclaire & Associates, LLC and Murray Sinclaire, Jr.
+
+ Release No. + 34-88762, AAER-4132 +
+
+ +
William M. Aisenberg, CPA (Corrected)
+
+ Release No. + 34-88763, AAER-4132 +
+
+ +
PLS,, CPA a Professional Corporation Pls a/k/a, CPAS Park, Chang G., CPA Park, a/k/a Changgeun Lee, Joseph Yongyun, CPA Lee, a/k/a Yong Yun Lee, Juchi, CPA Fernandez, a/k/a Juchi Lee Lee, Ju-Chi Lee, Ju Chi Lee, Sue
+
+ Release No. + 34-88739, AAER-4131 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Robert J. Jesenik
+
+ Release No. + IA-5482, AAER-4126 +
+
+ +
Kenneth D. Shifrin, CPA
+
+ Release No. + 34-88723, AAER-4128 +
+
+ +
N. Scott Gillis, CPA
+
+ Release No. + IA-5484, AAER-4126 +
+
+ +
Brian M. Storms
+
+ Release No. + 34-88724, AAER-4129 +
+
+ +
Brian L. Ferdinand
+
+ Release No. + 33-10775, 34-88720, AAER-4127 +
+
+ +
Berman & Company, P.A., and Elliot Berman CPA, Berman, Elliot R., CPA Berman & Company, P.A.
+
+ Release No. + 34-88731, AAER-4130 +
+
+ +
Eni S.p.A.
+
+ Release No. + 34-88679, AAER-4124 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Brian Robert Sodi, CPA
+
+ Release No. + 34-88686, AAER-4125 +
+
+ +
James Arthur Young III
+
+ Release No. + 34-88680, IA-5481, AAER-4125 +
+
+ +
Frazer Frost LLP Woo, Susan, CPA Suen, Miranda, CPA
+
+ Release No. + 34-88659, AAER-4123 +
+
+ +
Schulman Lobel Zand Katzen Williams & Blackman, LLP a/k/a Schulman Lobel LLP
+
+ Release No. + 34-88653, AAER-4122 +
+
+ +
Jeffrey D. Cordes et al.
+
+ Release No. + LR-24792, AAER-4121 +
+
+ See Also: + + + SEC Complaint + + +
+
+ +
Ronald Emma, CPA
+
+ Release No. + 34-88432, AAER-4120 +
+
+ +
David G. Dreslin, CPA
+
+ Release No. + 34-88377, AAER-4119 +
+
+ +
Cardinal Health, Inc.
+
+ Release No. + 34-88303, AAER-4118 +
+
+ +
RSM US LLP (f/k/a/ Mcgladrey LLP)
+
+ Release No. + 34-88287, AAER-4117 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
LBB & Associates Ltd., LLP Lopez, Carlos, CPA
+
+ Release No. + 34-88140, AAER-4116 +
+
+ See Also: + + Administrative Summary + + +
+
+ +
Steven M. Des Champs, CPA
+
+ Release No. + 34-88048, AAER-4115 +
+
+ +
Joseph S. Amundsen, CPA, Michael T. Remus, CPA and Michael Remus, CPA (Corrected Order Granting Petitions for Review and Scheduling Briefs)
+
+ Release No. + 34-88001, AAER-4114 +
+
+ +
Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA
+
+ Release No. + 34-87969, AAER-4112 +
+
+ +
Holder, Cynthia, CPA Wada, Jeffrey, CPA Middendorf, David, CPA Whittle, Thomas, CPA Britt, David, CPA
+
+ Release No. + 34-87970, AAER-4113 +
+
+ +
Robert A. Karmann, CPA
+
+ Release No. + 34-87884, AAER-4111 +
+
+ +
+
+ + +
+ 1 to 91 of 91 items +
+
+
+ +
+ +
+ +
+
+ + +
+ + +
+ + + + + + + + + + + + + + diff --git a/raw/filings/0000001750/2018/0001047469-18-004978/filing.txt b/raw/filings/0000001750/2018/0001047469-18-004978/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..8f070bfb8070c84bac1900cd771893f2483d8897 --- /dev/null +++ b/raw/filings/0000001750/2018/0001047469-18-004978/filing.txt @@ -0,0 +1,8850 @@ +10-K +1 +a2236183z10-k.htm +10-K +Use these links to rapidly review the document +TABLE OF CONTENTS +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +(Mark One) +ý +Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the fiscal year ended May 31, 2018 +or +o +Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For +the transition period from to +Commission file number 1-6263 +AAR CORP. +(Exact name of registrant as specified in its charter) +Delaware +(State or other jurisdiction of +incorporation or organization) +36-2334820 +(I.R.S. Employer Identification No.) +One AAR Place, 1100 N. Wood Dale Road, Wood Dale, Illinois 60191 +(Address of principal executive offices, including zip code) +Registrant's +telephone number, including area code: (630) 227-2000 +Securities +registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock, $1.00 par value +New York Stock Exchange +Chicago Stock Exchange +Securities +registered pursuant to Section 12(g) of the Act: None +Indicate +by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ý No o +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. +Yes o No ý +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of +1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o +Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be +submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such +files). Yes ý No o +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, +to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this +Form 10-K. o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an +emerging growth company. See definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.(Check +one): +Large accelerated filer ý +Accelerated filer o +Non-Accelerated filer o +(Do not check if a +smaller reporting company) +Smaller reporting company o +Emerging growth company o +If +an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period prior to complying with any new or revised financial +accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). +Yes o No ý +The aggregate market value of the registrant's voting stock held by nonaffiliates was approximately $1,344 million (based upon the closing price of the +Common Stock at November 30, 2017 as reported on the New York Stock Exchange). +On +June 29, 2018, there were 34,740,330 shares of Common Stock outstanding. +Documents Incorporated by Reference +Portions of the Company's proxy statement for the Company's 2018 Annual Meeting of Stockholders, to be held October 10, 2018, are incorporated by reference +in Part III of this report. +Table of Contents +TABLE OF CONTENTS +Page +PART I +Item 1. +Business +2 +Item 1A. +Risk Factors +7 +Item 1B. +Unresolved Staff Comments +13 +Item 2. +Properties +13 +Item 3. +Legal Proceedings +14 +Item 4. +Mine Safety Disclosures +15 +Supplemental Item—Executive Officers of the Registrant +15 +PART II +Item 5. +Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +16 +Item 6. +Selected Financial Data +18 +Item 7. +Management's Discussion and Analysis of Financial Condition and Results of Operations +20 +Item 7A. +Quantitative and Qualitative Disclosures about Market Risk +33 +Item 8. +Financial Statements and Supplementary Data +34 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +76 +Item 9A. +Controls and Procedures +76 +Item 9B. +Other Information +79 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +79 +Item 11. +Executive Compensation +79 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +80 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +80 +Item 14. +Principal Accounting Fees and Services +80 +PART IV +Item 15. +Exhibits, Financial Statement Schedules +81 +Item 16. +Form 10-K Summary +87 +SIGNATURES +88 +1 +Table of Contents +PART I +ITEM 1. BUSINESS +General +AAR CORP. and its subsidiaries are referred to herein collectively as "AAR," "Company," "we," "us," and "our" unless the context indicates +otherwise. AAR was founded in 1951, organized in 1955 and reincorporated in Delaware in 1966. We are a diversified provider of products and services to the worldwide aviation and government and +defense markets. +Beginning +in fiscal 2015, we implemented a comprehensive strategic plan to narrow our strategy to focus on our best-in-class aviation and expeditionary services through our two business +segments: Aviation Services and Expeditionary Services. We sold our Telair Cargo Group for cash of $714 million, resulting in pre-tax gains of $198.6 million in the fourth quarter of +fiscal 2015 (and $27.7 million in the first quarter of fiscal 2016 from the receipt of contingent consideration). We used the proceeds from the sale in fiscal 2015 to reduce our total debt and +return capital to shareholders through common stock repurchases and dividends. +Through +execution of our strategic plan over the last three years, we have succeeded in expanding customer relationships and securing new flight hour component inventory management and +repair programs work with multiple international commercial customers and government customers. We also invested in our rotable assets to support these programs and continued our focus on expanding +our business development resources. These investments in our supply chain activities have allowed us to increase market share, expand our customer base, and enlarge our geographic footprint. +In +fiscal 2018, we began the ramp-up for the 15-year, U.S. Air Force Landing Gear Performance-Based Logistics One program. Under the program, we are providing total supply chain +management including purchasing, distribution and inventory control to support all landing gear components for the U.S. Air Force's fleet of C-130, KC-135 and E-3 aircraft. +In +fiscal 2018, we also began providing services to the U.S. Department of State ("DoS") under the INL/A Worldwide Aviation Support Services ("WASS") contract. This contract leverages +our capabilities in aviation services, including flight operations, supply chain logistics, and other services. We are the prime contractor on this 10-year performance-based contract to globally +operate and maintain the DoS fleet of fixed and rotary-wing aircraft. We successfully completed the transition and phase-in of +the WASS program in June 2018. We have full operational capability at all contract sites, which include Afghanistan, Iraq, Panama, Peru, and Patrick Air Force Base as well as support locations in +Brevard County, Florida. +Our +long-term strategy continues to emphasize the return of capital to shareholders. Over the past three years, we have returned $82.6 million to shareholders through common stock +repurchases of $51.7 million and dividends of $30.9 million. +We +remain in a strong financial position to further execute on our strategy in fiscal 2019. Both our commercial and government businesses are executing on our many contract wins and will +continue to deliver growth in fiscal 2019. Our cash on hand plus unused capacities on our Revolving Credit Facility and accounts receivable financing program was $473 million at May 31, +2018. We expect to invest opportunistically in expanding our comprehensive suite of services to the global commercial aviation and government and defense markets. We continue to have the flexibility +in our balance sheet allowing us to invest in our growth. As we generate positive cash flow, we will continue our strategy of returning capital to our shareholders without hampering our future +operating flexibility. +2 +Table of Contents +Business Segments +Aviation Services +The Aviation Services segment provides aftermarket support and services for the commercial aviation and government and defense markets and +accounted for 93% of our sales in fiscal 2018, 2017, and 2016. In this segment, we also provide inventory management and distribution services, maintenance, repair and overhaul ("MRO"), and +engineering services. Business activities in this segment are primarily conducted through AAR Supply Chain, Inc.; AAR Government Services, Inc.; AAR Aircraft & Engine +Sales & Leasing, Inc.; AAR Aircraft Services, Inc.; AAR Allen Services, Inc.; AAR Landing Gear LLC; and AAR International, Inc. +We +sell and lease a wide variety of new, overhauled and repaired engine and airframe parts and components and aircraft to our commercial aviation and government/defense customers. +We +provide customized flight hour component inventory and repair programs, warranty claim management, and outsourcing programs for engine and airframe parts and components in support of +our airline and government customers' maintenance activities. The types of services provided under these programs include material planning, sourcing, logistics, information and program management, +and parts and component repair and overhaul. We are also an authorized distributor for more than 70 product lines across over 25 leading aviation product manufacturers. +We +also provide customized performance-based supply chain logistics programs in support of the U.S. Department of Defense ("DoD") and foreign governments. The types of services provided +under these programs include material planning, sourcing, logistics, information and program management, airframe maintenance and maintenance planning, and component repair and overhaul. +We +provide major airframe inspection, maintenance, repair and overhaul, painting services, line maintenance, airframe modifications, structural repairs, avionic service and installation, +exterior and interior refurbishment, and engineering services and support for many types of commercial and military aircraft. We also repair and overhaul various components, landing gears, wheels, and +brakes for commercial and military aircraft. +We +operate seven airframe maintenance facilities and one landing gear overhaul facility. Our landing gear overhaul facility is in Miami, Florida, where we repair and overhaul landing +gear, wheels, brakes, and actuators for different types of commercial and military aircraft. Our U.S. airframe maintenance facilities are in Indianapolis, Indiana; Oklahoma City, Oklahoma; Duluth, +Minnesota; Miami, Florida; and Rockford, Illinois and our Canadian airframe maintenance facilities are in Trois Rivieres, Quebec and Windsor, Ontario. In addition, we also announced a joint venture +with Indamer Aviation which will develop and operate an airframe maintenance facility in India. The facility is currently under construction and is expected to begin operations in fiscal 2019. +The +majority of our product sales are made pursuant to standard commercial purchase orders. Government sales are generally made under standard types of government contracts which can +include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified services or the delivery of specified +products under indefinite delivery/indefinite quantity ("ID/IQ") arrangements. Certain inventory supply and management and performance-based logistics program agreements reflect negotiated terms and +conditions. +To +support activities within the Aviation Services segment, we acquire aviation parts and components from domestic and foreign airlines, independent aviation service companies, aircraft +leasing companies, +and original equipment manufacturers ("OEM"s). We have ongoing arrangements with OEMs that provide us access to parts, repair manuals, and service bulletins in support of parts manufactured by +them. Although the terms of each arrangement vary, they typically are made on standard OEM terms as to +3 +Table of Contents +duration, +price, and delivery. From time to time, we purchase engines for disassembly into individual parts and components. These engines may be leased to airlines on a short-term basis prior to +disassembly. +Expeditionary Services +The Expeditionary Services segment consists of businesses that primarily provide products and services supporting the movement of equipment and +personnel by the U.S. and foreign governments and non-governmental organizations. The Expeditionary Services segment accounted for 7% of our sales in fiscal 2018, 2017, and 2016. Business activities +in this segment are primarily conducted through AAR Airlift Group, Inc.; AAR Manufacturing, Inc. and Brown International Corporation. +We +provide fleet management and operations of customer-owned aircraft for the DoS under the INL/A WASS contract. We are the prime contractor on this ten-year performance-based contract +to globally operate and maintain the DoS fleet of fixed- and rotary-wing aircraft. +We +also design, manufacture, and repair transportation pallets and a wide variety of containers and shelters used in support of military and humanitarian tactical deployment activities. +The containers and shelters are used in numerous mission requirements, including armories, supply and parts storage, refrigeration systems, tactical operation centers, briefing rooms, laundry and +kitchen facilities, water treatment, and sleeping quarters. Shelters include both stationary and vehicle-mounted applications. +We +also provide engineering, design, and system integration services for specialized command and control systems and design and manufacture advanced composite materials for commercial, +business and military aircraft. +Sales +in this segment are generally made to customers pursuant to standard commercial purchase orders and contracts. Government sales are generally made under standard types of +government contracts which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified services +or the delivery of specified products under ID/IQ arrangements, however, the majority of our products and services are procured via definite contracts. +Raw Materials +Although we generated 60% of our fiscal 2018 sales from the sale of products, our businesses are generally engaged in limited manufacturing +activities and have minimal exposure to fluctuations in both the availability and pricing of raw materials. We purchase raw materials for our manufacturing operations, including steel, aluminum, +extrusions, balsa, and other necessary supplies from several vendors. Where necessary, we have been able to obtain raw materials and other inventory items from numerous sources for each segment at +competitive prices, terms, and conditions, and we expect to be able to continue to do so. +Terms of Sale +We generally sell our products and services under standard 30-day payment terms. On occasion, certain customers, principally foreign customers, +will negotiate extended payment terms of 60-90 days. Except for customary warranty provisions, customers neither have the right to return products nor do they have the right to extended +financing. Our government contracts may extend several years and include one or more base years and one or more option years. The government generally has the right not to exercise options to extend +or expand our contracts and may otherwise terminate, cancel, or modify some contracts at its convenience. +Customers +The principal customers for our products and services in the Aviation Services segment are domestic and foreign commercial airlines, domestic +and foreign freight airlines, regional and commuter airlines, +4 +Table of Contents +business +and general aviation operators, OEMs, aircraft leasing companies, aftermarket aviation support companies, the DoD and its contractors, and foreign military organizations or governments. In +the Expeditionary Services segment, our principal customers include the DoS, DoD and its contractors, foreign military organizations or governments, defense organizations, and OEMs. +Sales +of aviation products and services to our commercial airline customers are generally affected by such factors as the number, type and average age of aircraft in service, the levels +of aircraft utilization (e.g., frequency of schedules), the number of airline operators, the general economy, and the level of sales of new and used aircraft. Sales to the DoD and other +government agencies are subject to a number of factors, including the level of troop deployment worldwide, government funding, competitive bidding, and requirements generated by worldwide geopolitical +events. +We +primarily market and sell products and services through our own employees. In certain markets outside of the United States, we rely on foreign sales representatives to assist in the +sale of our products and services. +Sales to Government and Defense Customers +Sales to global government and defense customers (including sales to branches, agencies, and departments of the U.S. government) were +$428.8 million (24.5% of consolidated sales), $438.7 million (27.6% of consolidated sales) and $489.4 million (32.1% of consolidated sales) in fiscal 2018, 2017 and 2016, +respectively. Sales to branches, agencies, and departments of the U.S. government and their contractors were $304.3 million (17.4% of consolidated sales), $321.5 million (20.2% of +consolidated sales), and $366.1 million (24.0% of consolidated sales) in fiscal 2018, 2017, and 2016, respectively. +Sales +to government and defense customers are reported in each of our reportable segments (See Note 13 of Notes to Consolidated Financial Statements). Since such sales are +subject to competitive bidding and government funding, no assurance can be given that such sales will continue at levels previously experienced. The majority of our U.S. government sales are for +products and services supporting the DoD logistics and mobility strategy. Thus, our government contracts have changed, and may continue to change, with fluctuations in defense and other governmental +agency spending. Our government contracts are also subject to termination by the customer; in the event of such a +termination, we are entitled to recover all allowable costs incurred by us through the date of termination. +Government Regulation and Certificates +The Federal Aviation Administration ("FAA") regulates the manufacture, repair, and operation of all aircraft and aircraft parts operated in the +United States. Similar rules and regulatory authorities exist in other countries. The inspection, maintenance and repair procedures for the various types of aircraft and equipment are prescribed by +these regulatory authorities and can be performed only by certified repair facilities utilizing certified technicians. The FAA requires that various maintenance routines be performed on aircraft +engines, certain engine parts, and airframes at regular intervals based on take off and landing cycles or flight time. Our businesses which sell defense products and services directly to the U.S. +government or through its contractors can be subject to various laws and regulations governing pricing and other factors. +We +have 13 FAA certificated repair stations in the United States, Canada, and Europe. Of the 13 certificated FAA repair stations, seven are also European Aviation Safety Agency +("EASA") and four are also Transport Canada Civil Aviation ("TCCA") certificated repair stations. Such certificates, which are ongoing in duration, are required for us to perform authorized +maintenance, repair and overhaul services for our customers and are subject to revocation by the government for non-compliance with applicable regulations. Of the 13 FAA certificated repair stations, +12 are in the Aviation Services segment and one is held by our Contractor-Owned, Contractor-Operated business ("COCO") which is classified as a discontinued operation as the COCO business is currently +held for sale. The EASA and TCCA certificated +5 +Table of Contents +repair +stations are in the Aviation Services segment. We also hold a FAR Part 135 certificate to operate aircraft for our expeditionary airlift services business. We are also Commercial Airlift +Review Board certified with the DoD. We believe that we possess all licenses and certifications that are material to the conduct of our business. +Competition +Competition in each of our markets is based on quality, ability to provide a broad range of products and services, speed of delivery, and price. +Competitors in our Aviation Services segment include OEMs, the service divisions of large commercial airlines, and other independent suppliers of parts, repair, and overhaul services to the commercial +and defense markets. Our Expeditionary Services segment competes with domestic and foreign contracting companies and a number of divisions of large corporations and other large and small companies. +Although certain of our competitors have substantially greater financial and other resources than we do, we believe that we have maintained a satisfactory competitive position through our +responsiveness to customer needs, our attention to quality, and our unique combination of market expertise and technical and financial capabilities. +Backlog +Backlog represents the amount of revenue that we expect to derive from unshipped orders or signed contracts. At May 31, 2018, backlog was +approximately $1,053 million compared to $519 million at May 31, 2017 which reflects the significant new commercial and government contract awards received over the last twelve +months. Approximately $510 million of our May 31, 2018 backlog is expected to be filled in fiscal 2019. +Employees +At May 31, 2018, we employed approximately 5,000 employees worldwide, of which approximately 155 employees are subject to a +collective bargaining agreement. We also retain approximately 775 contract workers, the majority of whom are located at our airframe maintenance facilities. +Available Information +For additional information concerning our business segments, see Item 7, "Management's Discussion and Analysis of Financial Condition and +Results of Operations" and "Business Segment Information" in Note 13 of Notes to Consolidated Financial Statements under Item 8, "Financial Statements and Supplementary Data." +Our +internet address is www.aarcorp.com. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable +after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Information contained on our web site is not a part of this report. +6 +Table of Contents +ITEM 1A. RISK FACTORS +The following is a description of the principal risks inherent in our business. +We are affected by factors that adversely impact the commercial aviation industry. +As a provider of products and services to the commercial aviation industry, we are greatly affected by overall economic conditions of that +industry. The commercial aviation industry is historically cyclical and has been negatively affected in the past by geopolitical events, high fuel and oil prices, lack of capital, and weak economic +conditions. As a result of these and other events, from time to time certain of our customers have filed for bankruptcy protection or ceased operation. The impact of instability in the global +financial markets may lead airlines to reduce domestic or international capacity. In addition, certain of our airline customers have in the past been impacted by tight credit markets, which limited +their ability to buy parts, services, engines, and aircraft. +A +reduction in the operating fleet of aircraft both in the U.S. and abroad will result in reduced demand for parts support and maintenance activities for the type of aircraft affected. +Further, tight credit conditions negatively impact the amount of liquidity available to buy parts, services, engines, and aircraft. A deteriorating airline environment may also result in additional +airline bankruptcies, and in such circumstances we may not be able to fully collect outstanding accounts receivable. Reduced demand from customers caused by weak economic conditions, including tight +credit conditions and customer bankruptcies, may adversely impact our financial condition or results of operations. +Our +business, financial condition, results of operations, and growth rates may be adversely affected by these and other events that impact the aviation industry, including the +following: +• deterioration in the financial condition of our existing and potential customers; +• reductions in the need for, or the deferral of, aircraft maintenance and repair services and spare parts support; +• retirement of older generation aircraft, resulting in lower prices for spare parts and services for those aircraft; +• reductions in demand for used aircraft and engines; +• increased in-house maintenance by airlines; +• lack of parts in the marketplace; +• acts of terrorism; +• future outbreaks of infectious diseases; and +• acts of God. +Our U.S. government contracts may not continue at present sales levels, which may have a material adverse +effect on our financial condition and results of operations. +Our sales to branches, agencies and departments of the U.S. government and their contractors were $304.3 million (17.4% of consolidated +sales) in fiscal 2018 (See Note 13 of Notes to Consolidated Financial Statements). The majority of our U.S. government sales is for products and services supporting DoD logistics and mobility +strategy and is, therefore, subject to changes in defense and other governmental agency funding and spending. Our contracts with the U.S. government and their contractors are typically agreements to +provide products and services at a fixed price and have a term of one year or less, frequently subject to extension for one or more additional periods of one year at the option of the government +customer. Sales to agencies of the U.S. government and their contractors are subject to a number of +7 +Table of Contents +factors, +including the level of troop deployment worldwide, competitive bidding, U.S. government funding, requirements generated by world events, and budgetary constraints. +U.S. +government programs are subject to annual congressional budget authorization and appropriation processes. In recent years, U.S. government appropriations have been affected by +larger U.S. government budgetary issues and related legislation, including the statutory limit on the amount of permissible federal debt (the "debt ceiling"). These issues could negatively affect the +timely collection of our U.S. government invoices. +Future +congressional appropriation and authorization of defense spending and the application of sequestration remain marked by significant debate and an uncertain schedule. The federal +debt limit continues to be actively debated as plans for long-term national fiscal policy are discussed. The outcome of these debates could have a significant impact on defense spending broadly and +programs we support in particular. +If +there are funding delays and constraints, we may be required to continue to perform for some period of time on certain of our U.S. government contracts even if the U.S. government is +unable to make timely payments. Future budget cuts, including cuts mandated by sequestration, or future procurement decisions could result in reductions, cancellations, and/or delays of existing +contracts or programs which could adversely affect our results of operations and financial condition. +We face risks of cost overruns and losses on fixed-price contracts. +We sell certain of our products and services to our commercial, government, and defense customers under firm contracts providing for fixed unit +prices, regardless of costs incurred by us. The cost of producing products or providing services may be adversely affected by increases in the cost of labor, materials, fuel, overhead, and other +unknown variants, including manufacturing and other operational inefficiencies and differences between assumptions used by us to price a contract and actual results. Increased costs may result in cost +overruns and losses on such contracts, which could adversely affect our results of operations and financial condition. +Success at our airframe maintenance facilities is dependent upon continued outsourcing by the airlines. +We currently perform airframe maintenance, repair and overhaul activities at seven leased locations. Revenues at these facilities fluctuate +based on demand for maintenance which, in turn, is driven by the number of aircraft operating and the extent of outsourcing of maintenance activities by airlines. In addition, certain airlines operate +certain new fleet types and/or newer generation aircraft and we may not have contractual arrangements to service these aircraft nor technicians trained and certified to perform the required airframe +maintenance, repair and overhaul activities. If either the number of aircraft operating or the level of outsourcing of maintenance activities declines, we may not be able to execute our operational +and financial plans at our maintenance, repair and overhaul facilities, which could adversely affect our results of operations and financial condition. +We operate in highly competitive markets, and competitive pressures may adversely affect us. +The markets for our products and services to our commercial, government, and defense customers are highly competitive, and we face competition +from a number of sources, both domestic and international. Our competitors include aircraft manufacturers, aircraft component and parts manufacturers, airline and aircraft service companies, other +companies providing maintenance, repair and overhaul services, other aircraft spare parts distributors and redistributors, and other expeditionary airlift service providers. Some of our competitors +have substantially greater financial and other resources than we have and others may price their products and services below our selling prices. These competitive markets also create pressure on our +ability to hire and retain qualified technicians and other skilled labor needs. We believe that our +8 +Table of Contents +ability +to compete depends on superior customer service and support, on-time delivery, sufficient inventory availability, competitive pricing and effective quality assurance programs. +Our +government customers, including the DoD, may turn to commercial contractors, rather than traditional defense contractors, for certain work, or may utilize small business contractors +or determine to source work internally rather than use us. We are also impacted by bid protests from unsuccessful bidders on new program awards. Bid protests could result in significant expense for +us, contract modifications, or the award decision being overturned and loss of the contract award. Even where a bid protest does not result in the loss of an award, the resolution can extend the time +until the contract activity can begin, and delay earnings. These competitive pressures, with potential impacts on both our +commercial and government business, could adversely affect our results of operations and financial condition. +We are subject to significant government regulation and may need to incur significant expenses to comply with +new or more stringent governmental regulation. +The aviation industry is highly regulated by the FAA in the United States and equivalent regulatory agencies in other countries. Before we sell +any of our products that are to be installed in an aircraft, such as engines, engine parts and components, and airframe and accessory parts and components, they must meet certain standards of +airworthiness established by the FAA or the equivalent regulatory agencies in certain other countries. We operate repair stations that are licensed by the FAA and the equivalent regulatory agencies in +certain other countries, and hold certificates to operate aircraft. Specific regulations vary from country to country, although regulatory requirements in other countries are generally satisfied by +compliance with FAA requirements. New and more stringent governmental regulations may be adopted in the future that, if enacted, may have an adverse impact on us. +If +any of our material licenses, certificates, authorizations, or approvals were revoked or suspended by the FAA or equivalent regulatory agencies in other countries, our results of +operations and financial condition may be adversely affected. +If we fail to comply with government procurement laws and regulations, we could lose business and be liable +for various penalties or sanctions. +We must comply with laws and regulations relating to the formation, administration, and performance of U.S. government contracts. These laws and +regulations include the Federal Acquisition Regulations, Defense Federal Acquisition Regulations, the Truth in Negotiations Act, Cost Accounting Standards, and laws, regulations, and orders +restricting the use and dissemination of classified information under the U.S. export control laws and the export of certain products and technical information and safeguarding of contractor +information systems. Certain government contracts provide audit rights by government agencies, including with respect to performance, costs, business systems, internal controls and compliance with +applicable laws and regulations. In complying with these laws and regulations, we may incur significant costs, and non-compliance may result in the imposition of fines and penalties, including +contractual damages. If we fail to comply with these laws and regulations or if a government audit, review, or investigation uncovers improper or illegal activities, we may be subject to civil +penalties, criminal penalties, or administrative sanctions, including suspension or debarment from contracting with the U.S. government. Our reputation could suffer harm if allegations of impropriety +were made or found against us, which could adversely affect our operating performance and may result in additional expenses and possible loss of revenue. +9 +Table of Contents +We are exposed to risks associated with operating internationally. +We conduct our business in a number of foreign countries, some of which are politically unstable or subject to military or civil conflicts. +Consequently, we are subject to a variety of risks that are specific to international operations, including the following: +• military conflicts, civil strife, and political risks; +• export regulations that could erode profit margins or restrict exports; +• compliance with the U.S. Foreign Corrupt Practices Act, United Kingdom ("UK") Anti-bribery Act, and other anti-bribery and anti-corruption +laws; +• the burden and cost of compliance with foreign laws, treaties, and technical standards and changes in those regulations; +• contract award and funding delays; +• potential restrictions on transfers of funds; +• import and export duties and value added taxes; +• foreign exchange risk; +• transportation delays and interruptions; +• uncertainties arising from foreign local business practices and cultural considerations; and +• changes in U.S. policies on trade relations and trade policy, including implementation of or changes in trade sanctions, tariffs, and +embargoes. +In +addition, the UK held a referendum in 2016 in which voters approved an exit from the European Union ("EU"). On March 29, 2017, the UK government commenced the exit process +under Article 50 of the Treaty of the EU by notifying the European Council of the UK's intention to leave the EU. This notification started a two-year time period for the UK and the remaining +EU countries to negotiate a withdrawal agreement. The final terms of the UK's potential exit from the EU have yet to be determined and it is possible there will be greater restrictions on imports and +exports between the UK and EU countries along with increased regulatory complexities. +While +we have adopted and will continue to adopt measures to reduce the potential impact of losses resulting from the risks of doing business internationally, such measures may not be +adequate, and the +regions in which we operate might not continue to be stable enough to allow us to operate profitably or at all. +Acquisitions expose us to risks, including the risk that we may be unable to effectively integrate acquired +businesses. +We have completed multiple acquisitions over the past few years and we have discussions with third parties regarding acquisitions on a regular +basis. Acquisitions involve risks, including difficulties in integrating the operations and personnel, the effects of amortization of any acquired intangible assets and the potential impairment of +goodwill, and the potential loss of key employees of the acquired business. In addition, acquisitions often require substantial management resources and have the potential to divert our attention from +our existing business. For any businesses we may acquire in the future, we may not be able to execute our operational, financial, or integration plans for the acquired businesses, which could +adversely affect our results of operations and financial condition. +10 +Table of Contents +Market values for our aviation products fluctuate and we may be unable to recover our costs incurred on +engines, rotable components and other aircraft parts. +We make a number of assumptions when determining the recoverability of rotable components, engines, and other assets which are on lease, +available for lease, or supporting our long-term programs. These assumptions include historical sales trends, current and expected usage trends, replacement values, current and expected lease rates, +residual values, future demand, and future cash flows. Reductions in demand for these assets or declining market values, as well as differences between actual results and the assumptions utilized by +us when determining the recoverability of our aircraft, engines, and other assets could result in impairment charges in future periods, which would adversely affect our results of operations and +financial condition. +We may need to reduce the carrying value of our assets. +We own and distribute a significant amount of engines, aircraft parts and components, and manufacturing facilities and related equipment. The +removal of aircraft from service or recurring losses in certain operations could require us to evaluate the recoverability of the carrying value of those assets and record an impairment charge through +earnings to reduce the carrying value. During the second quarter of fiscal 2018, we recognized impairment charges of $54.2 million related to assets included in our COCO business which is +classified as a discontinued operation. In addition, if aircraft or engines for which we offer replacement parts or supply repair and overhaul services are retired and there are fewer aircraft that +require these parts or services, our revenues may decline. +We +make a number of assumptions when determining the recoverability of our assets including historical sales trends, current and expected usage trends, replacement values, current and +expected lease rates, residual values, future demand, and future cash flows. Differences between actual results and the assumptions utilized by us when determining the recoverability of our assets +could result in impairment charges in future periods, which would adversely affect our results of operations and financial condition. +We +have recorded goodwill and other intangible assets related to acquisitions. If we are unable to achieve the projected levels of operating results, it may be necessary to record an +impairment charge to reduce the carrying value of goodwill and related intangible assets. During the third quarter of fiscal 2018, we recognized a goodwill impairment charge of $9.8 million +related to our COCO business. Similarly, if we were to lose a key customer or one of our airframe maintenance or landing gear facilities were to lose its authority to operate, we might be required to +record an impairment charge. +We are dependent upon continued availability of financing to manage our business and to execute our business +strategy, and additional financing may not be available on terms acceptable to us. +Our ability to manage our business and to execute our business strategy is dependent, in part, on the continued availability of debt and equity +capital. Access to the debt and equity capital markets may be limited by various factors, including the condition of overall credit markets, general economic factors, state of the aviation industry, +our financial performance, and credit ratings. Debt and equity capital may not continue to be available to us on favorable terms, or at all. Our inability to obtain financing on favorable terms could +adversely affect our results of operations and financial condition. +Our existing debt includes restrictive and financial covenants. +Certain financing arrangements, including our Revolving Credit Facility and our accounts receivable financing program, require us to comply with +various restrictive covenants and some contain financial covenants that require us to comply with specified financial ratios and tests. Our failure to meet these covenants could result in default +under these loan and debt agreements and may result in a cross-default under other debt agreements. In the event of a default and our inability to obtain a waiver of the default, all amounts +outstanding under our debt agreements could be declared immediately due and payable. Our +11 +Table of Contents +failure +to comply with these covenants could adversely affect our results of operations and financial condition. +Our industry is susceptible to product and other liability claims, and claims not adequately covered by +insurance may adversely affect our financial condition. +Our business exposes us to possible claims for property damage and bodily injury or death which may result if an engine, engine part or +component, airframe part or accessory, or any other aviation product which we have sold, manufactured, or repaired fails, or if an aircraft we operated, serviced, or in which our products are +installed, crashes. We carry substantial liability insurance in amounts that we believe are adequate for our risk exposure and commensurate with industry norms. However, claims may arise in the +future, and our insurance coverage may not be adequate to protect us in all circumstances. Additionally, we might not be able to maintain adequate insurance coverage in the future at an acceptable +cost. Any liability claim not covered by adequate insurance could adversely affect our results of operations and financial condition. +Our business could be negatively affected by cyber or other security threats or other disruptions. +Our businesses depend heavily on information technology and computerized systems to communicate and operate effectively. The Company's systems +and technologies, or those of +third parties on which we rely, could fail or become unreliable due to equipment failures, software viruses, cyber threats, ransomware attacks, terrorist acts, natural disasters, power failures or +other causes. These threats arise in some cases as a result of our role as a defense contractor. +Cyber +security threats are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to our sensitive information, ransomware attacks, +including our customers, suppliers, subcontractors, and joint venture partners, and other electronic security breaches that could lead to disruptions in mission critical systems, unauthorized release +of confidential or otherwise protected information, and corruption of data. +The +procedures and controls we utilize to monitor and mitigate these threats may not be sufficient to prevent security threats from materializing. If any of these events were to +materialize, the costs related to cyber or other security threats or disruptions may not be fully insured or indemnified and could have a material adverse effect on our reputation, operating results, +and financial condition. +Moreover, +expenditures incurred in implementing and maintaining cyber security and other procedures and controls could adversely affect our results of operations and financial condition. +We must comply with extensive environmental requirements, and any exposure to environmental liabilities may +adversely affect us. +Federal, state, and local requirements relating to the discharge and emission of substances into the environment, the disposal of hazardous +wastes, the remediation and abatement of contaminants, and other activities affecting the environment have had and may continue to have an impact on our operations. Management cannot assess the +possible effect of compliance with future environmental requirements or of future environmental claims for which we may not have adequate indemnification or insurance coverage. If we were required to +pay the expenses related to any future environmental claims for which neither indemnification nor insurance coverage were available, these expenses could have an adverse impact on our results of +operations and financial condition. +Future +environmental regulatory developments in the United States and abroad concerning environmental issues, such as climate change, could adversely affect our operations and increase +operating costs and, through their impact on our customers, reduce demand for our products and services. Actions may be taken in the future by the U.S. government, state governments within the United +States, foreign +12 +Table of Contents +governments, +the International Civil Aviation Organization, or by signatory countries through a new global climate change treaty to regulate the emission of greenhouse gases by the aviation industry. +The precise nature of any such requirements and their applicability to us and our customers are difficult to predict, but the impact to us and the aviation industry would likely be adverse and could +be significant, including the potential for increased fuel costs, carbon taxes or fees, or a requirement to purchase carbon credits. +We may need to make significant capital expenditures to keep pace with technological developments in our +industry. +The industries in which we participate are constantly undergoing development and change, and it is likely that new products, equipment, and +methods of repair and overhaul services will be introduced in the future. We may need to make significant expenditures to purchase new equipment and to train our employees to keep pace with any new +technological developments. These expenditures could adversely affect our results of operations and financial condition. +Our operations would be adversely affected by a shortage of skilled personnel or work stoppages. +We are dependent on an educated and highly skilled workforce because of the complex nature of many of our products and services. Furthermore, we +have a collective bargaining agreement covering approximately 155 employees. Our ability to operate successfully and meet our customers' demands could be jeopardized if we are unable to attract and +retain a sufficient number of skilled personnel, including qualified licensed mechanics, to conduct our business, or if we experience a significant or prolonged work stoppage. These and similar events +may adversely affect our results of operations and financial condition. +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not Applicable. +ITEM 2. PROPERTIES +In the Aviation Services segment, we conduct parts supply activities from our headquarters in Wood Dale, Illinois, which we own. In addition to +warehouse space, this facility includes executive, sales and administrative offices. Our principal maintenance, repair, overhaul, engineering and other service activities for this segment are +conducted at U.S. facilities leased by us in Indianapolis, Indiana; Oklahoma City, Oklahoma; Miami, Florida; Duluth, Minnesota; and Rockford, Illinois and at Canadian facilities leased by us in Trois +Rivieres, Quebec and Windsor, Ontario. +We +also lease facilities in Garden City, New York; Jacksonville, Florida; Brussels, Belgium; Singapore, Republic of Singapore; London, England; and Crawley, England, and own a building +near Schiphol International Airport in the Netherlands to support activities in the Aviation Services segment. +Our +principal activities in the Expeditionary Services segment are conducted at facilities we lease in Melbourne, Florida; Huntsville, Alabama; and Sacramento, California and own in +Cadillac, Michigan; Clearwater, Florida; and Goldsboro, North Carolina. +We +also operate sales offices which support all our activities and are leased in London, England; Crawley, England; Paris, France; Rio de Janeiro, Brazil; Shanghai, China; Singapore, +Republic of Singapore; and Abu Dhabi, UAE. +We +believe that our owned and leased facilities are suitable and adequate for our operational requirements. +13 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS +DynCorp International LLC v. AAR Airlift Group, Inc. +On September 5, 2015, DynCorp International LLC ("DynCorp") filed a complaint in the United States District Court for the Middle +District of Florida, Orlando Division (the "District Court"), accusing AAR Airlift Group, Inc. ("Airlift"), a wholly-owned subsidiary of AAR CORP., of misappropriation of DynCorp information, +including trade secrets, and other related allegations, in connection with the submission of proposals in response to the solicitation issued by the U.S. Department of State ("DoS") Bureau of +International Narcotics and Law Enforcement Affairs, Office of Aviation in support of the Worldwide Aviation Support Services program ("WASS"). +On +October 19, 2015, DynCorp filed an amended complaint with the District Court. On January 14, 2016, the District Court granted Airlift's motion to dismiss DynCorp's +amended complaint. On February 2, 2016, DynCorp appealed the District Court's order to the United States Court of Appeals for the Eleventh Circuit (the "Eleventh Circuit"). +On +November 21, 2016, the Eleventh Circuit reversed in part the District Court's dismissal of the amended complaint and remanded the case to the District Court for further +proceedings. +On +January 31, 2018, Airlift and DynCorp filed a joint notice of settlement, advising the District Court that they had reached an agreement in principle to resolve DynCorp's +lawsuit and that they expected to file a stipulation of dismissal with prejudice within 14 days. +On +February 1, 2018, the District Court entered an order dismissing the DynCorp lawsuit without prejudice, subject to the right of any party within 60 days to move the +court for the purpose of entering a stipulated form of a final order or judgment or, on good cause shown, to reopen the case for further proceedings. +On +June 20, 2018, the parties entered into a confidential settlement agreement to dismiss the lawsuit with prejudice without the payment of any money by either party. On +June 26, 2018, the District Court entered an order dismissing the lawsuit with prejudice. +Appeals Proceeding Relating to the INL/A WASS Contract Award +On September 1, 2016, the DoS awarded the WASS contract to Airlift. On December 20, 2016, the U.S. Government Accountability +Office ("GAO") denied a protest filed by DynCorp and confirmed the award of the WASS contract to Airlift. +On +December 28, 2016, DynCorp filed a further protest with the U.S. Court of Federal Claims ("COFC"). On October 31, 2017, the COFC denied DynCorp's protest. On +November 20, 2017, DynCorp filed an emergency motion for interim relief pending appeal with the COFC. On December 13, 2017, the COFC issued an order denying DynCorp's motion. +On +November 14, 2017, DynCorp filed notice of appeal of the denial by the COFC of its protest to the U.S. Court of Appeals for the Federal Circuit (the "Court of Appeals"). On +December 15, 2017, DynCorp filed a motion for injunction pending appeal with the Court of Appeals. On January 17, 2018, the Court of Appeals denied DynCorp's motion for injunction. The +appeal on the merits before the Court of Appeals has been fully briefed by the parties, with no scheduled date for a decision. +Department of Justice Investigation +The U.S. Department of Justice ("DoJ"), acting through the U.S. Attorney's Office for the Southern District of Illinois, is conducting an +investigation of Airlift under the federal civil False Claims Act ("FCA"). The investigation relates to Airlift's performance of several contracts awarded by the U.S. Transportation Command concerning +the operations and maintenance of rotary-wing and fixed-wing +14 +Table of Contents +aircraft +in Afghanistan and Africa, as well as several U.S. Navy contracts. In June 2018, the DoJ informed Airlift that part of the investigation was precipitated by a lawsuit filed under the qui tam +provisions of the FCA by a former employee of Airlift. That lawsuit remains under seal. Airlift is cooperating with the DoJ investigation. +ITEM 4. MINE SAFETY DISCLOSURES +Not Applicable. +Supplemental Item: +EXECUTIVE OFFICERS OF THE REGISTRANT +Information concerning each of our executive officers is set forth below: +Name +Age +Present Position with the Company +John M. Holmes +41 +Chief Executive Officer and President, Director +Michael D. Milligan +55 +Vice President and Chief Financial Officer +Robert J. Regan +60 +Vice President, General Counsel and Secretary +Eric S. Pachapa +45 +Vice President, Controller and Chief Accounting Officer +Mr. Holmes is Chief Executive Officer and President, having served in that capacity since June 2018. From June 2017 to May 2018, +Mr. Holmes served as President and Chief Operating Officer. From February 2015 to June 2017, Mr. Holmes served as Chief Operating Officer—Aviation Services. Prior to that, +Mr. Holmes served as Group Vice President, Aviation Services—Inventory Management and Distribution from 2012 to 2015, General Manager and Division President of our Allen Asset +Management business from 2003 to 2012, and in various other positions since joining the Company in September 2001. Mr. Holmes has been a director of the Company since 2017. +Mr. Milligan is Vice President and Chief Financial Officer, having served in that capacity since September 2017. Prior to joining +AAR, he was Senior Vice President and Chief Financial Officer of NES Rentals Holdings, Inc. since 2005. Mr. Milligan was previously Executive Vice President and Chief Financial Officer +of Telenisus Corporation from 1999 to 2001 and, prior thereto, was a partner with Pricewaterhouse Coopers LLP. +Mr. Regan is Vice President, General Counsel and Secretary, having served in that capacity since June 2009. From 2008 to June 2009, +Mr. Regan served as Vice President and General Counsel and, prior to that, Associate General Counsel since joining AAR in February 2008. Prior to joining AAR, he was a partner at the law firm +of Schiff Hardin LLP since 1989. +Mr. Pachapa is Vice President, Controller and Chief Accounting Officer, having served in that capacity since July 2016. +Mr. Pachapa previously served as Controller since October 2015 and Senior Director of Accounting and Reporting since April 2014. Prior to joining the Company, he was with Glanbia plc +from 2011 to 2014, and with Ernst & Young LLP from 1996 to 2011. +Each +executive officer is elected annually by the Board of Directors. Executive officers continue to hold office until their successors are duly elected or until their death, +resignation, termination or reassignment. +15 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is traded on the New York Stock Exchange and the Chicago Stock Exchange under the symbol "AIR." On June 29, 2018, there +were approximately 900 holders of common stock, including participants in security position listings. +The +following table shows the range of prices for our common stock and the amount of dividends declared per share during each quarter of our last two fiscal years: +Fiscal 2018 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Full Year +Market price +High +$ +37.64 +$ +41.58 +$ +43.95 +$ +47.70 +$ +47.70 +Low +34.00 +34.54 +37.39 +41.41 +34.00 +Dividends declared +0.075 +0.075 +0.075 +0.075 +0.30 +Fiscal 2017 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Full Year +Market price +High +$ +25.04 +$ +38.67 +$ +38.31 +$ +36.01 +$ +38.67 +Low +22.06 +26.21 +31.49 +32.74 +22.06 +Dividends declared +0.075 +0.075 +0.075 +0.075 +0.30 +Stockholder Return Performance Graph +The following graph compares the total return on a cumulative basis of $100 invested, and reinvestment of dividends in our common stock on +May 31, 2013 to the Standard and Poor's ("S&P") 500 Index and the Proxy Peer Group. +16 +Table of Contents +The +S&P 500 Index is comprised of domestic industry leaders in four major sectors: Industrial, Financial, Utility, and Transportation, and serves as a broad indicator of the +performance of the U.S. equity market. The Company's Fiscal 2018 Proxy Peer Group companies are listed as follows: +Aerojet Rocketdyne Holdings, Inc. +KLX Inc. +Barnes Group Inc. +Moog Inc. +CACI International Inc +Rockwell Collins, Inc. +Crane Co. +Science Applications International Corporation +Cubic Corporation +Teledyne Technologies Incorporated +Curtiss-Wright Corporation +TransDigm Group Incorporated +Esterline Technologies Corporation +Triumph Group, Inc. +Heico Corporation +Wesco International, Inc. +Hexcel Corporation +Woodward, Inc. +Kaman Corporation +The +Company annually revisits the composition of the peer group to ensure that the Company's performance is measured against those of comparably-sized and situated companies. The mix of +the Company's commercial and defense businesses presents a challenge in constructing a peer group, given that many defense contractors have substantially greater resources than the Company. No changes +were made to the composition of the peer group for fiscal 2018. +Issuer Purchases of Equity Securities +We did not purchase any shares of our common stock during the quarter ended May 31, 2018. Our Board of Directors authorized a stock +repurchase program on July 10, 2017 providing for the repurchase of up to $250 million of our common stock with no expiration date. The remaining number of shares available for +repurchase under that authorization is $237 million. +17 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +(In millions, except per share amounts) +For the Year Ended May 31, +2018 +2017 +2016 +2015 +2014 +RESULTS OF OPERATIONS 1 +Sales +$ +1,748.3 +$ +1,590.8 +$ +1,525.4 +$ +1,448.0 +$ +1,415.5 +Gross profit 2 +294.6 +263.4 +233.1 +152.8 +204.3 +Operating income (loss) 2 +86.0 +82.3 +75.5 +(31.2 +) +53.8 +Loss on extinguishment of debt 3 +— +— +(0.4 +) +(44.9 +) +— +Interest expense +8.0 +5.3 +6.4 +27.2 +29.4 +Income (Loss) from continuing operations +73.7 +52.0 +45.5 +(67.4 +) +19.7 +Income (Loss) from discontinued operations 4 +(58.1 +) +4.5 +2.2 +77.6 +53.2 +Net income +15.6 +56.5 +47.7 +10.2 +72.9 +Share data: +Earnings per share—basic: +Earnings (Loss) from continuing operations +$ +2.14 +$ +1.53 +$ +1.30 +$ +(1.73 +) +$ +0.50 +Earnings (Loss) from discontinued operations +(1.70 +) +0.13 +0.07 +1.99 +1.35 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic +$ +0.44 +$ +1.66 +$ +1.37 +$ +0.26 +$ +1.85 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted: +Earnings (Loss) from continuing operations +$ +2.11 +$ +1.51 +$ +1.30 +$ +(1.73 +) +$ +0.49 +Earnings (Loss) from discontinued operations +(1.70 +) +0.13 +0.07 +1.97 +1.34 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted +$ +0.41 +$ +1.64 +$ +1.37 +$ +0.24 +$ +1.83 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash dividends declared per share +$ +0.30 +$ +0.30 +$ +0.30 +$ +0.30 +$ +0.30 +Weighted average common shares outstanding—basic +34.2 +33.9 +34.4 +39.1 +38.6 +Weighted average common shares outstanding—diluted +34.6 +34.3 +34.6 +39.4 +39.1 +May 31, +2018 +2017 +2016 +2015 +2014 +FINANCIAL POSITION 1 +Total cash and cash equivalents +$ +31.1 +$ +10.3 +$ +31.2 +$ +54.7 +$ +89.2 +Working capital +609.4 +553.4 +540.3 +456.9 +645.4 +Total assets +1,524.7 +1,504.1 +1,456.0 +1,454.1 +2,159.8 +Total debt 3 +178.9 +156.2 +145.3 +154.0 +634.0 +Equity 5 +936.3 +914.2 +865.8 +845.1 +1,000.7 +Number of shares outstanding at end of year 5 +34.7 +34.4 +34.5 +35.4 +39.6 +Book value per share of common stock +$ +26.98 +$ +26.58 +$ +25.10 +$ +23.87 +$ +25.27 +Notes: +1 During +the third quarter of fiscal 2018, we decided to pursue the sale of our Contractor-Owned, Contractor-Operated ("COCO") business previously included +in our Expeditionary Services segment. The Results of Operations and Financial Position data has been recast to reflect the classification of our COCO business as a discontinued operation for all +periods presented. +2 In +fiscal 2015, we recognized $61.5 million in impairment charges and other losses related to product lines and inventories identified as +underperforming or not part of our strategy going forward. These actions included aircraft in our aircraft lease portfolio and inventory in our supply chain and MRO +18 +Table of Contents +operations. +We also recognized impairment charges of $25.6 million related to our composite manufacturing operations. +3 In +fiscal 2015, we redeemed our $325 million 7.25% Senior Notes due 2022 for $370.6 million. We recognized a loss on extinguishment of debt +of $44.9 million comprised of a make-whole premium of $45.6 million and unamortized deferred financing costs of $6.2 million, partially offset by an unamortized net premium of +$6.9 million. +4 In +fiscal 2015, we sold our Telair Cargo Group for $725 million resulting in a $198.6 million pre-tax gain. We also recognized impairment +charges of $31.9 million in fiscal 2015 to reduce the carrying value of our metal machining business's net assets to their expected value at the time of sale. +In +fiscal 2016, we received contingent consideration from the sale of Telair Cargo Group and recognized a pre-tax gain of $27.7 million. +In +fiscal 2018, we recognized asset impairment charges of $64.0 million related to our COCO business. +5 On +May 29, 2015, we repurchased 4,185,960 shares of our common stock at a price of $31.90 per share pursuant to a tender offer utilizing +$133.5 million cash on hand. Fees and expenses of $1.2 million were incurred related to the tender offer and were recorded in treasury stock. +19 +Table of Contents +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +(Dollars in millions) +Forward-Looking Statements +Management's Discussion and Analysis of Financial Condition and Results of Operations contain certain statements relating to future results, +which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on the beliefs of management, as well +as assumptions and estimates based on information available to us as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties that could cause actual +results to differ materially from those anticipated, depending on a variety of factors, including those factors discussed under Item 1A, "Risk Factors." Should one or more of those risks or +uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. Those events and uncertainties are +difficult or impossible to predict accurately and many are beyond our control. We assume no obligation to update any forward-looking statements to reflect events or circumstances after the date of +such statements or to reflect the occurrence of anticipated or unanticipated events. +General Overview +We report our activities in two business segments: Aviation Services comprised of supply chain +and maintenance, repair and overhaul ("MRO") activities and Expeditionary Services comprised of airlift and mobility activities. +The +Aviation Services segment consists of aftermarket support and services businesses that provide spares and maintenance support for aircraft operated by our commercial and +government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components and +aircraft to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance based logistics programs, aircraft component repair +management services, and aircraft modifications. The segment also includes MRO of aircraft, landing gear and components. Cost of sales consists principally of the cost of product, direct labor, and +overhead. +The +Expeditionary Services segment consists of businesses that provide products and services supporting the movement of equipment and personnel by the U.S. and foreign governments and +other non-governmental organizations. Sales in the Expeditionary Services segment are derived from fleet management and operations of customer-owned aircraft and the design and manufacture of pallets, +shelters, and containers used to support the U.S. military's requirements for a mobile and agile force. We also design and manufacture advanced composite materials for commercial, business and +military +aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead. +Our +chief operating decision making officer (Chief Executive Officer) evaluates performance based on the reportable segments and utilizes gross profit as a primary profitability measure. +Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments. Our reportable segments are +aligned principally around differences in products and services. +Beginning +in fiscal 2015, we implemented a comprehensive strategic plan to narrow our strategy to focus on our best-in-class aviation and expeditionary services through our two business +segments: Aviation Services and Expeditionary Services. We sold our Telair Cargo Group for cash of $714 million, resulting in pre-tax gains of $198.6 million in the fourth quarter of +fiscal 2015 (and $27.7 million in the first quarter of fiscal 2016 from the receipt of contingent consideration). We used the proceeds from the sale in fiscal 2015 +20 +Table of Contents +to +reduce our total debt and return capital to shareholders through common stock repurchases and dividends. +Through +execution of our strategic plan over the last three years, we have succeeded in expanding customer relationships and securing new flight hour component inventory management and +repair programs work with multiple international commercial customers and government customers. We also invested in our rotable assets to support these programs and continued our focus on expanding +our business development resources. These investments in our supply chain activities have allowed us to increase market share, expand our customer base, and enlarge our geographic footprint. +In +fiscal 2018, we began the ramp-up for the 15-year, U.S. Air Force Landing Gear Performance-Based Logistics One program. Under the program, we are providing total supply chain +management including purchasing, distribution and inventory control to support all landing gear components for the U.S. Air Force's fleet of C-130, KC-135 and E-3 aircraft. +In +fiscal 2018, we also began providing services to the U.S. Department of State ("DoS") under the INL/A Worldwide Aviation Support Services ("WASS") contract. This contract leverages +our capabilities in aviation services, including flight operations, supply chain logistics, and other services. We are the prime contractor on this 10-year performance-based contract to globally +operate and maintain the DoS fleet of fixed and rotary-wing aircraft. We successfully completed the transition and phase-in of +the WASS program in June 2018. We have full operational capability at all contract sites, which include Afghanistan, Iraq, Panama, Peru, and Patrick Air Force Base as well as support locations in +Brevard County, Florida. +Our +long-term strategy continues to emphasize the return of capital to shareholders. Over the past three years, we have returned $82.6 million to shareholders through common stock +repurchases of $51.7 million and dividends of $30.9 million. +Business Trends and Outlook for Fiscal 2019 +Consolidated sales for fiscal 2018 increased $157.5 million or 9.9% compared to the prior year primarily due to an increase in sales of +$133.5 million or 9.0% in our Aviation Services segment. This increase was driven by strong growth in our aviation supply chain activities including our recent contract awards for component +inventory management and repair programs for commercial and government customers. This growth was partially offset by the impact from the wind-down of our KC-10 program. Our principal services under +the KC-10 program were completed in January 2017 with the wind-down completed in fiscal 2018. Sales for the KC-10 program during fiscal 2017 were $110.6 million compared to $29.1 million +in fiscal 2018. Sales in the Expeditionary Services segment increased $24.0 million or 22.8% over the prior year primarily due to the start of our services on the WASS program on +November 1, 2017. +For +fiscal 2019, we expect to see continued strength in our Aviation Services segment given its leadership positions in value-added services to both commercial and government and defense +customers. Long-term aftermarket growth trends are favorable and our comprehensive suite of integrated services will continue to drive growth across our diverse base of customers. +We +remain in a strong financial position to further execute on our strategy in fiscal 2019. Both our commercial and government businesses are executing on our many contract wins and will +continue to deliver growth in fiscal 2019. Our cash on hand plus unused capacities on our Revolving Credit Facility and accounts receivable financing program was $473 million at May 31, +2018. We expect to invest opportunistically in expanding our comprehensive suite of services to the global commercial aviation and government and defense markets. We continue to have the flexibility +in our balance sheet to invest in our growth. As we generate positive cash flow, we will continue our strategy of returning capital to our shareholders without hampering our future operating +flexibility and our growth plans. +21 +Table of Contents +For +fiscal 2019, we expect the Company's consolidated sales in the range of $2.1 to $2.2 billion. Diluted earnings per share from continuing operations for fiscal 2019 is expected +to be in the range of $2.50 to $2.80. +Results of Operations—Fiscal 2018 Compared with Fiscal 2017 +Sales and gross profit for our two business segments for the two years ended May 31, 2018 and 2017 were as follows: +For the Year Ended May 31, +2018 +2017 +% Change +Sales: +Aviation Services +Commercial +$ +1,281.9 +$ +1,114.9 +15.0 +% +Government and Defense +337.0 +370.5 +(9.0 +)% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,618.9 +$ +1,485.4 +9.0 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +37.5 +$ +37.1 +1.1 +% +Government and Defense +91.9 +68.3 +34.6 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +129.4 +$ +105.4 +22.8 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2018 +2017 +% Change +Gross Profit: +Aviation Services +Commercial +$ +203.8 +$ +183.1 +11.3 +% +Government and Defense +68.1 +62.9 +8.3 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +271.9 +$ +246.0 +10.5 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +8.3 +$ +8.2 +1.2 +% +Government and Defense +14.4 +9.2 +56.5 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +22.7 +$ +17.4 +30.5 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services Segment +Sales in the Aviation Services segment increased $133.5 million or 9.0% over the prior year due to a $167.0 million or 15.0% +increase in sales to commercial customers. The increase in sales to commercial customers was primarily attributable to higher volumes in aviation supply chain activities driven by new contract awards. +During +fiscal 2018, sales in this segment to government and defense customers decreased $33.5 million or 9.0% from the prior year. The decrease was primarily due to the wind-down +of our KC-10 program. +Changes +in estimates and assumptions related to our programs accounted for using the percentage-of-completion method are recorded using the cumulative catch-up method of accounting. In +fiscal 2018, we recognized favorable and unfavorable cumulative catch-up adjustments of $11.6 million and $8.0 million, respectively, compared to favorable and unfavorable cumulative +catch-up adjustments of $9.2 million and $0.7 million, respectively, in fiscal 2017. When considering these adjustments on a net +22 +Table of Contents +basis, +we recognized favorable cumulative catch-up adjustments of $3.6 million and $8.5 million for fiscal 2018 and 2017, respectively. These adjustments primarily relate to our +long-term, power-by-the-hour programs where we provide component inventory management and repair services. +Cost +of sales in Aviation Services increased $107.6 million or 8.7% over the prior year which was in line with the sales increase discussed above. Gross profit in the Aviation +Services segment increased $25.9 million or 10.5% over the prior year. Gross profit on sales to commercial customers increased $20.7 million or 11.3% over the prior year primarily driven +by the higher volumes in aviation supply +chain activities. The gross profit margin on sales to commercial customers was 15.9% compared to 16.4% in the prior year and was largely attributable to labor challenges at our airframe maintenance +hangars. +Gross +profit in this segment on sales to government and defense customers increased $5.2 million or 8.3% from the prior year primarily driven by improved profitability on new +contract awards. The gross profit margin increased from 17.0% to 20.2% primarily due to these new contract awards. +Expeditionary Services Segment +Sales in the Expeditionary Services segment increased $24.0 million or 22.8% over the prior year primarily due to the start of our +services on the WASS program on November 1, 2017. Gross profit in the Expeditionary Services segment increased $5.3 million over the prior year due to the addition of the WASS program in +fiscal 2018. +Selling, General and Administrative Expenses +Selling, general and administrative expenses increased $27.5 million in fiscal 2018 or 15.2% from the prior year primarily attributable +to supporting our sales growth, including increased personnel-related costs and business development activities. +Interest Expense +Interest expense increased $2.7 million in fiscal 2018 over the prior year primarily as a result of higher borrowings and higher interest +rates on our Revolving Credit Facility. We entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender (the "Credit Agreement") on October 18, 2017. The Credit +Agreement provided a Canadian $31 million term loan with the proceeds used to fund the acquisition of two MRO facilities in Canada from Premier Aviation. +Income Taxes +On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act (the "Tax Reform Act") which +significantly reduced the corporate federal income tax rate to 21% from 35%. The income tax rate reduction in the Tax Reform Act results in a blended federal statutory tax rate for the Company of +29.2% in fiscal 2018 compared to 35.0% in fiscal 2017. Due to the reduction in our tax rate in fiscal 2018 and in future years, we re-measured our deferred tax assets and liabilities based on the tax +rate at which they are expected to reverse in the future which resulted in an income tax benefit of $14.1 million in fiscal 2018. +Effective +June 1, 2017, we adopted Accounting Standards Update ("ASU") 2016-09 which requires excess tax benefits or deficiencies for restricted shares and stock options to be +recognized as income tax expense or benefit in the period shares vest or options are exercised rather than within equity. We recognized $2.9 million of excess tax benefits as an income tax +benefit during fiscal 2018. +Our +fiscal 2018 effective income tax rate for continuing operations was 4.5% compared to 32.6% in the prior year. In addition to the tax benefits discussed above, we also recognized a +tax benefit in fiscal 2018 of $2.1 million related to the reversal of certain state valuation allowances based on the recoverability +23 +Table of Contents +of +the net operating losses and other state deferred tax assets. The effective income tax rate for fiscal 2017 includes a benefit of $2.2 million related to recognition of previously +unrecognized uncertain tax positions. +Discontinued Operations +During the third quarter of fiscal 2018, we decided to pursue the sale of our Contractor-Owned, Contractor-Operated business ("COCO") business +previously included in our Expeditionary Services segment. Due to this strategic shift, the assets, liabilities, and results of +operations of our COCO business have been reported as discontinued operations for all periods presented. +Loss +from discontinued operations was $58.1 million in fiscal 2018 compared to income of $4.5 million in the prior year. The decrease of $62.6 million was primarily +due to goodwill and other asset impairment pre-tax charges of $65.2 million in fiscal 2018 and the completion of certain long-term customer contracts in the second quarter of fiscal 2018. +Results of Operations—Fiscal 2017 Compared with Fiscal 2016 +Sales and gross profit for our two business segments for the two years ended May 31, 2017 and 2016 were as follows: +For the Year Ended May 31, +2017 +2016 +% Change +Sales: +Aviation Services +Commercial +$ +1,114.9 +$ +1,003.5 +11.1 +% +Government and Defense +370.5 +421.5 +(12.1 +)% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,485.4 +$ +1,425.0 +4.2 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +37.1 +$ +32.1 +15.6 +% +Government and Defense +68.3 +68.3 +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +105.4 +$ +100.4 +5.0 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2017 +2016 +% Change +Gross Profit: +Aviation Services +Commercial +$ +183.1 +$ +157.2 +16.5 +% +Government and Defense +62.9 +72.3 +(13.0 +)% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +246.0 +$ +229.5 +7.1 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +8.2 +$ +3.2 +156.3 +% +Government and Defense +9.2 +0.4 +nm +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +17.4 +$ +3.6 +383.3 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +nm —Percentage change is not meaningful. +24 +Table of Contents +Aviation Services Segment +Sales in the Aviation Services segment increased $60.4 million or 4.2% over the prior year due to a $111.4 million or 11.1% +increase in sales to commercial customers. The increase in sales to commercial customers was primarily attributable to higher volumes in aviation supply chain activities driven by new contract awards. +During +fiscal 2017, sales in this segment to government and defense customers decreased $51.0 million or 12.1% from the prior year. The decrease was primarily due to the wind-down +of our KC-10 program. +Changes +in estimates and assumptions related to our programs accounted for using the percentage-of-completion method are recorded using the cumulative catch-up method of accounting. In +fiscal 2017, we recognized favorable and unfavorable cumulative catch-up adjustments of $9.2 million and $0.7 million, respectively, compared to favorable and unfavorable cumulative +catch-up adjustments of $6.1 million and $2.4 million, respectively, in fiscal 2016. When considering these adjustments on a net basis, we recognized favorable cumulative catch-up +adjustments of $8.5 million and $3.7 million for fiscal 2017 and 2016, respectively. These adjustments primarily relate to our long-term, power-by-the-hour programs where we provide +component inventory management and repair services. +Cost +of sales in Aviation Services increased $43.9 million or 3.7% over the prior year which was in line with the sales increase discussed above. Gross profit in the Aviation +Services segment increased $16.5 million or 7.1% over the prior year. Gross profit on sales to commercial customers increased $25.9 million or 16.5% over the prior year primarily driven +by the higher volumes in aviation supply chain activities. The gross profit margin on sales to commercial customers increased to 16.4% compared to 15.7% in the prior year and was largely attributable +to strong profitability growth in aviation supply chain activities. +Gross +profit in this segment on sales to government and defense customers decreased $9.4 million or 13.0% from the prior year primarily driven by the reduced services under our +KC-10 program. The gross profit margin decreased from 17.2% to 17.0% primarily due to these decreased volumes. +Expeditionary Services Segment +Sales in the Expeditionary Services segment increased $5.0 million or 5.0% over the prior year primarily due to higher demand for our +mobility products; however, these levels are still significantly below historical levels of performance for this business. +Gross +profit in the Expeditionary Services segment increased $13.8 million over the prior year due to improved profitability for mobility products. During the first quarter of +fiscal 2017, we sold certain assets related to our temperature-controlled container product line to Sonoco Protective Solutions, Inc. which resulted in a gain of $2.6 million. +Selling, General and Administrative Expenses +Selling, general and administrative expenses increased $23.5 million in fiscal 2017 or 14.9% from the prior year primarily attributable +to incremental investments in business development activities, including legal costs related to our defense of the INL/A WASS contract award. +Interest Expense +Interest expense decreased $1.1 million in fiscal 2017 from the prior year primarily as a result of the retirement of our remaining +convertible notes in fiscal 2016. +25 +Table of Contents +Income Taxes +Our fiscal 2017 effective income tax rate for continuing operations was 32.6% compared to 34.0% in the prior year. The effective income tax rate +for fiscal 2017 includes a benefit of $2.2 million related to recognition of previously unrecognized uncertain tax positions. The effective income tax rate for fiscal 2016 includes a benefit of +$1.3 million related to the correction of prior year immaterial errors. +Liquidity, Capital Resources and Financial Position +Our operating activities are funded and commitments met through the generation of cash from operations. In addition to operations, our current +capital resources include an unsecured Revolving Credit Facility and an accounts receivable financing program. Periodically, we may also raise capital through common stock and debt financings in the +public or private markets. We continually evaluate various financing arrangements, including the issuance of common stock or debt, which would allow us to improve our liquidity position and finance +future growth on commercially reasonable terms. Our continuing ability to borrow from our lenders and issue debt and equity securities to the public and private markets in the future may be negatively +affected by a number of factors, including the overall health of the credit markets, general economic conditions, airline industry conditions, geo-political events, and our operating performance. Our +ability to generate cash from operations is influenced primarily by our operating performance and changes in working capital. +At +May 31, 2018, our liquidity and capital resources included cash of $31.1 million and working capital of $609.4 million. +We +maintain a Revolving Credit Facility with various financial institutions, as lenders and Bank of America, N.A., as administrative agent for the lenders which provides the Company an +aggregate revolving credit commitment amount of $500 million. The Company, under certain circumstances, has the ability to request an increase to the revolving credit commitment by an aggregate +amount of up to $250 million, not to exceed $750 million in total. +Borrowings +under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 100 to 200 basis points based on certain financial measurements if a Eurodollar Rate +loan, or at the offered fluctuating Base Rate plus 0 to 100 basis points based on certain financial measurements if a Base Rate loan. +Borrowings +outstanding under the Revolving Credit Facility at May 31, 2018 were $130.0 million and there were approximately $16.7 million of outstanding letters of +credit, which reduced the availability of this facility to $353.3 million. There are no other terms or covenants limiting the availability of this facility. We also had $9.9 million +available under foreign lines of credit at May 31, 2018. +On +October 18, 2017, we entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender. The Credit Agreement provided a Canadian $31 million term +loan with the proceeds used to fund the acquisition of two maintenance, repair, and overhaul facilities in Canada from Premier Aviation. The term loan is due in full at the expiration of the Credit +Agreement on November 1, 2021 unless terminated earlier pursuant to the terms of the Credit Agreement. Interest is payable monthly on the term loan at the offered fluctuating Canadian Dollar +Offer Rate plus 125 to +225 basis points based on certain financial measurements if a Bankers' Acceptances loan, or at the offered fluctuating Prime Rate plus 25 to 125 basis points based on certain financial measurements, +if a Prime Rate loan. +On +February 23, 2018, we entered into a Purchase Agreement with Citibank N.A. ("Purchaser") for the sale, from time to time, of certain accounts receivable due from certain +customers (the "Purchase Agreement"). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million. The term of the Purchase Agreement runs through +February 22, 2019, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual +terms unless either party provides advance notice +26 +Table of Contents +that +they do not intend to extend the term. During fiscal 2018, we sold $239.6 million of receivables under the Purchase Agreement and remitted $167.9 million to the Purchaser on their +behalf. As of May 31, 2018, we have collected cash of $10.5 million which has not yet been remitted to the Purchaser and has been classified as Restricted cash on our Consolidated +Balance Sheet. +At +May 31, 2018, we complied with all financial and other covenants under each of our financing arrangements. +Cash Flows—Fiscal 2018 Compared with Fiscal 2017 +Cash Flows from Operating Activities +Net cash provided from operating activities—continuing operations was $55.8 million in fiscal 2018 compared to a use of cash +of $13.5 million in fiscal 2017. The increase of $69.3 million was primarily attributable to the new Purchase Agreement entered into during the third +quarter of fiscal 2018 for the sale of certain accounts receivable. During fiscal 2018, we sold $239.6 million of receivables to the Purchaser and collected $178.4 million on behalf of +the Purchaser. +Cash Flows from Investing Activities +Net cash used in investing activities—continuing operations was $38.6 million in fiscal 2018 compared to $33.9 million +in fiscal 2017. In fiscal 2018, we acquired the outstanding shares of two MRO facilities in Canada owned by Premier Aviation for approximately $24.8 million which included $22.9 million +paid at closing. During fiscal 2017, we acquired the trading business of ACLAS Global Limited ("ACLAS") for $12.0 million paid at closing with $3.0 million in deferred consideration +payable over the next three years. +Cash Flows from Financing Activities +Net cash provided from financing activities—continuing operations was $11.7 million in fiscal 2018 compared to cash used of +$10.4 million in fiscal 2017. The additional cash provided of $22.1 million was primarily attributable to proceeds from a new term loan of $24.8 million to finance the acquisition +of the two Canadian MRO facilities previously discussed. +Cash Flows—Fiscal 2017 Compared with Fiscal 2016 +Cash Flows from Operating Activities +Net cash used in operating activities—continuing operations was $13.5 million in fiscal 2017 compared to cash provided by +operating activities—continuing +operations of $46.0 million in fiscal 2016. The decrease of $59.5 million was primarily attributable to greater investments in rotable assets supporting long-term programs in fiscal +2017. These investments primarily support new government program awards such as the U.S. Navy's C-40A fleet as well as new flight hour component inventory management and repair programs with +commercial airline customers including South African Airways, Air New Zealand, and other operators. +Cash Flows from Investing Activities +Net cash used in investing activities—continuing operations was $33.9 million in fiscal 2017 compared to cash used of +$43.8 million in fiscal 2016. The decrease of $9.9 million over the prior year was attributable to less capital expenditures in fiscal 2017. +27 +Table of Contents +Cash Flows from Financing Activities +Net cash used in financing activities—continuing operations was $10.4 million in fiscal 2017 compared to $38.4 million +in fiscal 2016. The reduction in cash used in financing activities of $28.0 million was primarily attributable to an increase in net borrowings in fiscal 2017 compared to the prior year. +Contractual Obligations and Off-Balance Sheet Arrangements +A summary of contractual cash obligations and off-balance sheet arrangements as of May 31, 2018 is as follows: +Payments Due by Period +Total +Due in +Fiscal +2019 +Due in +Fiscal +2020 +Due in +Fiscal +2021 +Due in +Fiscal +2022 +Due in +Fiscal +2023 +After +Fiscal +2024 +On Balance Sheet: +Bonds +$ +25.0 +$ +25.0 +$ +— +$ +— +$ +— +$ +— +$ +— +Bank borrowings +153.9 +— +— +— +153.9 +— +— +Interest 1 +15.4 +4.5 +4.5 +4.5 +1.9 +— +— +Off Balance Sheet: +Facilities and equipment operating leases +94.8 +17.5 +16.3 +13.0 +10.8 +10.0 +27.2 +Purchase obligations 2 +253.9 +203.4 +43.8 +6.0 +— +— +0.7 +Pension contribution 3 +2.9 +2.9 +— +— +— +— +— +Notes: +1 Interest +associated with variable rate debt was determined using the interest rate in effect on May 31, 2018. +2 Purchase +obligations arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts, +and components, as well as equipment to support the operations of our business. +3 We +anticipate contributing approximately $2.9 million to our pension plans during fiscal 2019 compared to contributions of $8.4 million in +fiscal 2018. Our additional contributions in fiscal 2018 were completed to provide the benefits of lower premiums incurred with the Pension Benefit Guaranty Corporation and an increased tax deduction +in advance of the expected enactment of the Tax Reform Act. Required contributions for future years depend on factors that cannot be determined at this time. +4 The +above table excludes any tax liability payments, including any payments related to unrecognized tax benefits. +We +routinely issue letters of credit and performance bonds in the ordinary course of business. These instruments are typically issued in conjunction with insurance contracts or other +business requirements. The total of these instruments outstanding at May 31, 2018 was $16.7 million. +Critical Accounting Policies and Significant Estimates +Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States. Management +has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare the Consolidated Financial Statements. The most +significant estimates made by management include those related to assumptions used in assessing goodwill impairment, adjustments to reduce the value of inventories and certain rotable assets, revenue +recognition, and assumptions used in determining pension plan obligations. +28 +Table of Contents +Accordingly, +actual results could differ materially from those estimates. The following is a summary of the accounting policies considered critical by management. +Goodwill +Under accounting standards for goodwill and other intangible assets, goodwill and other intangible assets deemed to have indefinite lives are +not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, +or more frequently if circumstances indicate that impairment is possible. +The +accounting standards for goodwill allow for either a qualitative or quantitative approach for the annual impairment test. Under the qualitative approach, factors such as +macroeconomic conditions, industry and market conditions and company-specific events or circumstances are assessed to determine whether it is more likely than not that the fair value of a reporting +unit is less than its carrying amount. For the quantitative approach, we compare the fair value of each reporting unit with the carrying value of the reporting unit, including goodwill. If the +estimated fair value of the reporting unit is less than +the carrying value of the reporting unit, we would be required to recognize an impairment loss for the excess carrying value of the reporting unit's assets. +As +of May 31, 2018, we have five reporting units as defined by Accounting Standards Codification ("ASC") 350, Intangibles—Goodwill and +Other with only four of the reporting units' assigned goodwill. Our four reporting units with goodwill include two in our Aviation Services segment (Aviation Supply Chain and +Maintenance, Repair, and Overhaul) and two in our Expeditionary Services segment (Airlift and Mobility). +We +performed an interim goodwill impairment test over our Airlift reporting unit as a result of a decision to exit our Contractor-Owned, Contractor-Operated ("COCO") business. The COCO +business was reclassified to discontinued operations and goodwill was allocated to the COCO business based on its relative fair value to the reporting unit. The fair value of the reporting unit was +determined based on a combination of the expected net proceeds upon sale and a discounted cash flow analysis. As the fair value of the COCO business was below its carrying value, a goodwill impairment +charge of $9.8 million was recorded in the third quarter of fiscal 2018. +For +our annual impairment test as of May 31, 2018, we utilized the qualitative assessment approach for all reporting units. Under this approach, we considered the overall industry +and market conditions related to the aerospace and government/defense markets as well as conditions in the global capital markets. We also considered the long-term forecasts for each reporting unit +which incorporated specific opportunities and risks, working capital requirements, and capital expenditure needs. +Upon +completion of the annual qualitative analysis as of May 31, 2018 for our reporting units, we concluded it was more likely than not that the fair value of each reporting unit +exceeded its carrying values, and thus no impairment charge was recorded. +Inventories +Inventories are valued at the lower of cost or market (estimated net realizable value). Cost is determined by the specific identification, +average cost or first-in, first-out methods. Write-downs are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions. We have utilized +certain assumptions when determining the market value of inventories, such as inventory quantities and aging, historical sales of inventory, current and expected future aviation usage trends, +replacement values, expected future demand, and historical scrap recovery rates. Reductions in demand for certain of our inventories or declining market values, as well as differences between actual +results and the assumptions utilized by us when determining the market value of our inventories, could result in the recognition of impairment charges in future periods. +29 +Table of Contents +Revenue Recognition +Certain supply chain management programs that we provide to our customers contain multiple elements or deliverables, such as program and +warehouse management, parts distribution and maintenance and repair services. We recognize revenue for each element or deliverable that can be identified as a separate unit of accounting at the time +of delivery based upon the relative fair value of the products and services. +Sales +and related cost of sales for certain large airframe maintenance contracts and performance-based logistics programs are recognized using contract accounting under the percentage of +completion method in accordance with ASC 605-35, Construction—Type and Production—Type Contracts . In applying the percentage of +completion method, we use the cost-to-cost method based on the ratio of actual costs incurred to total estimated costs to be incurred. +In +connection with these contracts and programs, we are required to make certain judgments and estimates, including estimated revenues and costs, as well as inflation and the overall +profitability of the program and the relative fair value of each element of the arrangement. Key assumptions involved in our contract accounting include future labor costs and efficiencies, overhead +costs, and ultimate timing of product delivery. Differences may occur between the judgments and estimates made by management and actual program results. +Changes +in estimates and assumptions related to our programs accounted for using the percentage-of-completion method are recorded using the cumulative catch-up method of accounting. In +fiscal 2018, we recognized favorable and unfavorable cumulative catch-up adjustments of $11.6 million and $8.0 million, respectively. When considering these adjustments on a net basis, +we recognized net favorable cumulative catch-up adjustments of $3.6 million in fiscal 2018. These adjustments primarily relate to our long-term, power-by-the-hour programs where we provide +component inventory management and repair services. +Impairment of Long-Lived Assets +We are required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset +may not be recoverable from its undiscounted cash flows. When applying accounting standards addressing impairment to long-lived assets, we have utilized certain assumptions to estimate future +undiscounted cash flows, including current and future sales volumes or lease rates, expected changes to cost structures, lease terms, residual values, market conditions, and trends impacting future +demand. Differences between actual results and the assumptions utilized by us when determining undiscounted cash flows could result in future impairments of long-lived assets. During the second +quarter of fiscal 2018, we recognized impairment charges of $54.2 million related to assets included in our COCO business which is classified as a discontinued operation. +We +maintain a significant inventory of rotable parts and equipment to service customer aircraft and components. Portions of that inventory are used parts that are often exchanged with +parts removed from aircraft or components, and are reworked to a useable condition. We may have to recognize an impairment of our rotable parts and equipment if we discontinue using or servicing +certain aircraft models or if an older aircraft model is phased-out in the industry. +Pension Plans +The liabilities and net periodic cost of our pension plans are determined utilizing several actuarial assumptions, the most significant of which +are the discount rate and the expected long-term rate of return on plan assets. +AAR +uses discount rates to measure our benefit obligation and net periodic benefit cost for our pension plans. We used a broad population of Aa-rated corporate bonds as of May 31, +2018 to determine +30 +Table of Contents +the +discount rate assumption. All bonds were denominated in U.S. Dollars, with a minimum outstanding of $50.0 million. This population of bonds was narrowed from a broader universe of over 500 +Moody's Aa-rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10 th percentile and the bottom 40 th percentile to adjust +for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension plan liabilities. This portfolio of bonds was used to generate a yield +curve and associated spot rate curve to discount the projected benefit payments for the domestic plans. The discount rate is the single level rate that produces the same result as the spot rate curve. +We +establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market, as well as +analysis of current market and economic information and future expectations. The current asset return assumption is supported by historical market experience for both our actual and target asset +allocation. In calculating the net pension cost, the expected return on assets is applied to a calculated value on plan assets, which recognizes changes in the fair value of plan assets in a +systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to +amortization in the future. +New Accounting Pronouncements +Revenue from Contracts with Customers +In May 2014, the FASB issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with +Customers , which provides guidance for revenue recognition. This ASU affects any entity that either enters into contracts with customers to transfer goods or services or enters +into contracts for the transfer of non-financial assets. This ASU will supersede the revenue recognition requirements in ASC 605, Revenue +Recognition , and most industry-specific guidance. This ASU will also supersede certain cost guidance included in Subtopic 605-35, Revenue +Recognition-Construction-Type and Production-Type Contracts . In August 2015, the FASB issued ASU No. 2015-14 which deferred the effective date of the new standard by one +year so that it will be effective for us beginning June 1, 2018. +We +will adopt this ASU using the modified retrospective transition method in the first quarter of fiscal 2019. Under this method, we will be required to recognize the cumulative effect +of adopting this ASU as of June 1, 2018. We have substantially completed our assessment of the new ASU and are finalizing the quantification of our adoption adjustments as well as preparing the +new required disclosures for the first quarter of fiscal 2019. +We +have identified three areas where the new ASU will impact our revenue recognition. First, we have certain contracts under which we manufacture products with no alternative use and the +Company has an enforceable right to payment from the customer. As a result, the Company will be required to record revenue for these contracts over time as opposed to at the time of shipment which is +our current policy today. Second, we have contracts under which we perform repair services on customer-owned assets which will also transition to an over time approach compared to our current policy +of recognizing revenue at the time of shipment. +Third, +we have certain contracts in which revenue is recognized using the percentage of completion method over the expected term of the contract. The new ASU will result in the reduction +of the contract term used for revenue recognition as certain contracts include unexercised customer option years or include customer rights to terminate the contract without significant penalty. +We +expect the cumulative effect for the adoption of the new ASU will result in a decrease to retained earnings of approximately $20 million as of June 1, 2018. We will +establish new Contract asset and Contract liability balance sheet accounts and will reclassify certain amounts from Accounts receivable, Inventories, Other non-current assets, and Other liabilities +and deferred income into these new accounts. +31 +Table of Contents +Other New Accounting Pronouncements +In February 2016, the FASB issued ASU 2016-02, Leases . This ASU amends the existing accounting +standards for lease accounting, including requiring lessees to recognize most leases on their balance sheets, including those classified as operating leases under the current accounting guidance. In +addition, this ASU will require new qualitative and quantitative disclosures about the Company's leasing activities. This new standard will be effective for us beginning June 1, 2019, with +early adoption permitted. This ASU requires a modified retrospective transition approach for all leases +existing at, or entered into after, the date of initial application, with an option to use certain transition relief. We are in the preliminary phases of assessing the effect of this ASU on our +portfolio of leases. While this assessment continues, we have not yet selected a transition date nor have we determined the effect of this ASU on our consolidated financial statements. +In +March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting , which amends ASC Topic 718, Compensation—Stock Compensation . This ASU requires excess tax benefits or deficiencies for share-based payments to be recorded in the period +shares vest as income tax expense or benefit, rather than within equity. Cash flows related to excess tax benefits are now included in operating activities and are no longer classified as a financing +activity. We adopted this ASU on June 1, 2017 and recognized excess tax benefits of $2.9 million as an income tax benefit in fiscal 2018. We have also presented the excess tax benefits +within operating activities in the consolidated statement of cash flows for fiscal 2018. As permitted, we adopted the statement of cash flow presentation guidance on a prospective basis with no +adjustments to the previously reported amounts. +In +November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash . This ASU requires restricted cash to +be included within beginning and ending total cash amounts reported in the consolidated statements of cash flows as well as increased disclosure requirements. As permitted, we have early adopted this +ASU in fiscal 2018. The ASU is required to be adopted on a retroactive basis; however, we did not have restricted cash in our prior periods reported. +In +February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects +from Accumulated Other Comprehensive Income . This ASU permits the reclassification of tax effects stranded in accumulated other comprehensive income to retained earnings as a +result of the Tax Reform Act. This new standard will be effective for us beginning June 1, 2019 with early adoption permitted. We are currently evaluating the impact of this new standard on our +consolidated financial statements. +In +March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and +Net Periodic Postretirement Benefit Cost . This ASU requires an employer to report the service cost component of net periodic pension benefit cost in the same line item as other +compensation costs for those related employees. Other components of net pension cost, including interest, expected return on plan assets, and actuarial gains and losses are to be presented outside of +operating income. This new standard requires retrospective treatment for the classification of pension costs and will be effective for us beginning June 1, 2018. With the majority of our +pension plans frozen and total service cost, including administrative expenses, of $2.4 million and $2.5 million in fiscal 2018 and 2017, respectively, this ASU is not expected to have a +material impact on our consolidated financial statements. +32 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Our exposure to market risk includes fluctuating interest rates under our credit agreements, changes in foreign exchange rates, and credit +losses on accounts receivable. See Note 1 of Notes to Consolidated Financial Statements for a discussion on accounts receivable exposure. +We +are exposed to the risk that our earnings and cash flows could be adversely impacted by fluctuations in interest rates. A 10 percent increase in the average interest rate +affecting our financial instruments, including the average outstanding balance of our debt obligations would not have had a significant impact on our pre-tax income during fiscal 2018. +Revenues +and expenses of our foreign operations are translated at average exchange rates during the year, and balance sheet accounts are translated at year-end exchange rates. Balance +sheet translation adjustments are excluded from the results of operations and are recorded in stockholders' equity as a component of accumulated other comprehensive loss. A hypothetical +10 percent devaluation of the U.S. dollar against foreign currencies would not have had a material impact on our financial position or continuing operations during fiscal 2018. +33 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Report of Independent Registered Public Accounting Firm +The +Board of Directors and Stockholders +AAR CORP.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of AAR CORP. and subsidiaries (the Company) as of May 31, 2018 and 2017, and +the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the years in the three-year period ended May 31, 2018, and the related notes +(collectively, the Consolidated Financial Statements). In our opinion, the Consolidated Financial Statements present fairly, in all material respects, the financial position of the Company as of +May 31, 2018 and 2017, and the results of their operations and their cash flows for each of the years in the three-year period ended May 31, 2018, in conformity with U.S. generally +accepted accounting principles. +We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting +as of May 31, 2018, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of +Sponsoring Organizations of the Treadway Commission, and our report dated July 11, 2018, expressed an unqualified opinion on the effectiveness of the Company's internal control over financial +reporting. +Basis for Opinion +These Consolidated Financial Statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these +Consolidated Financial Statements +based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and +the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We +conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the +Consolidated Financial Statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the +Consolidated Financial Statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the +amounts and disclosures in the Consolidated Financial Statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating +the overall presentation of the Consolidated Financial Statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ KPMG LLP +We have served as the Company's auditor since 1985. +Chicago, Illinois +July 11, 2018 +34 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Year Ended May 31, +2018 +2017 +2016 +(In millions, except per share data) +Sales: +Sales from products +$ +1,040.7 +$ +944.8 +$ +930.1 +Sales from services +707.6 +646.0 +595.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1,748.3 +1,590.8 +1,525.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Costs and operating expenses: +Cost of products +840.5 +787.5 +785.3 +Cost of services +613.2 +539.9 +507.0 +Selling, general and administrative +208.6 +181.1 +157.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1,662.3 +1,508.5 +1,449.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating income +86.0 +82.3 +75.5 +Other expenses +(0.9 +) +— +(0.4 +) +Interest expense +(8.0 +) +(5.3 +) +(6.4 +) +Interest income +0.1 +0.1 +0.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations before provision for income taxes +77.2 +77.1 +68.9 +Provision for income taxes +3.5 +25.1 +23.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations +73.7 +52.0 +45.5 +Income (Loss) from discontinued operations, net of tax +(58.1 +) +4.5 +2.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net income +$ +15.6 +$ +56.5 +$ +47.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic: +Earnings from continuing operations +$ +2.14 +$ +1.53 +$ +1.30 +Earnings (Loss) from discontinued operations +(1.70 +) +0.13 +0.07 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic +$ +0.44 +$ +1.66 +$ +1.37 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted: +Earnings from continuing operations +$ +2.11 +$ +1.51 +$ +1.30 +Earnings (Loss) from discontinued operations +(1.70 +) +0.13 +0.07 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted +$ +0.41 +$ +1.64 +$ +1.37 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +35 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +For the Year Ended May 31, +2018 +2017 +2016 +(In millions) +Net income +$ +15.6 +$ +56.5 +$ +47.7 +Other comprehensive income, net of tax: +Currency translation adjustments, net of tax +2.0 +(0.6 +) +— +Unrecognized pension and post retirement costs, net of tax expense (benefit) of $2.4 in 2018, $2.8 in 2017, and ($2.1) in 2016 +5.9 +5.1 +(4.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive income (loss), net of tax +7.9 +4.5 +(4.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Comprehensive income +$ +23.5 +$ +61.0 +$ +43.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +36 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +May 31, +2018 +2017 +(In millions, except share data) +Current assets: +Cash and cash equivalents +$ +31.1 +$ +10.3 +Restricted cash +10.5 +— +Accounts receivable, net +202.0 +234.5 +Inventories +460.7 +433.4 +Rotable assets and equipment on or available for short-term lease +87.2 +70.7 +Assets of discontinued operations—current +125.0 +120.4 +Other current assets +26.2 +19.1 +​ +​ +​ +​ +​ +​ +​ +​ +Total current assets +942.7 +888.4 +​ +​ +​ +​ +​ +​ +​ +​ +Property, plant and equipment, at cost: +Land +4.5 +4.3 +Buildings and improvements +107.4 +97.5 +Equipment and furniture and fixtures +235.7 +222.9 +​ +​ +​ +​ +​ +​ +​ +​ +347.6 +324.7 +Accumulated depreciation +(214.4 +) +(207.5 +) +​ +​ +​ +​ +​ +​ +​ +​ +133.2 +117.2 +​ +​ +​ +​ +​ +​ +​ +​ +Other assets: +Goodwill +118.7 +105.6 +Intangible assets, net +27.8 +30.6 +Rotable assets supporting long-term programs +183.4 +159.6 +Assets of discontinued operations—non-current +— +97.8 +Other non-current assets +118.9 +104.9 +​ +​ +​ +​ +​ +​ +​ +​ +448.8 +498.5 +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,524.7 +$ +1,504.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +37 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND EQUITY +May 31, +2018 +2017 +(In millions, except share data) +Current liabilities: +Current maturities of long-term debt +$ +— +$ +0.1 +Accounts and trade notes payable +170.0 +164.2 +Accrued liabilities +138.3 +139.9 +Liabilities of discontinued operations +25.0 +30.8 +​ +​ +​ +​ +​ +​ +​ +​ +Total current liabilities +333.3 +335.0 +​ +​ +​ +​ +​ +​ +​ +​ +Long-term debt, less current maturities +177.2 +154.1 +Deferred tax liabilities +15.7 +37.2 +Other liabilities and deferred income +62.2 +63.6 +​ +​ +​ +​ +​ +​ +​ +​ +255.1 +254.9 +​ +​ +​ +​ +​ +​ +​ +​ +Equity: +Preferred stock, $1.00 par value, authorized 250,000 shares; none issued +— +— +Common stock, $1.00 par value, authorized 100,000,000 shares; +issued 45,300,786 and 45,175,302 shares at cost, respectively +45.3 +45.2 +Capital surplus +470.5 +460.8 +Retained earnings +733.2 +727.9 +Treasury stock, 10,585,165 and 10,820,844 shares at cost, respectively +(280.7 +) +(279.8 +) +Accumulated other comprehensive loss +(32.0 +) +(39.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total equity +936.3 +914.2 +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,524.7 +$ +1,504.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +38 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +FOR THE THREE YEARS ENDED MAY 31, 2018 +(In millions) +Common +Stock +Capital +Surplus +Retained +Earnings +Treasury +Stock +Accumulated +Other +Comprehensive +Income (Loss) +Total +Equity +Balance, May 31, 2015 +$ +44.9 +$ +442.6 +$ +644.3 +$ +(246.3 +) +$ +(40.4 +) +$ +845.1 +Net income +— +— +47.7 +— +— +47.7 +Cash dividends +— +— +(10.4 +) +— +— +(10.4 +) +Stock option activity +— +4.4 +— +2.3 +— +6.7 +Restricted stock activity +— +4.5 +— +(4.8 +) +— +(0.3 +) +Repurchase of shares +— +— +— +(18.8 +) +— +(18.8 +) +Other +— +(0.2 +) +— +— +— +(0.2 +) +Other comprehensive loss, net of tax +— +— +— +— +(4.0 +) +(4.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, May 31, 2016 +$ +44.9 +$ +451.3 +$ +681.6 +$ +(267.6 +) +$ +(44.4 +) +$ +865.8 +Net income +— +— +56.5 +— +— +56.5 +Cash dividends +— +— +(10.2 +) +— +— +(10.2 +) +Stock option activity +— +3.1 +— +8.9 +— +12.0 +Restricted stock activity +0.3 +6.4 +— +(1.3 +) +— +5.4 +Repurchase of shares +— +— +— +(19.8 +) +— +(19.8 +) +Other comprehensive income, net of tax +— +— +— +— +4.5 +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, May 31, 2017 +$ +45.2 +$ +460.8 +$ +727.9 +$ +(279.8 +) +$ +(39.9 +) +$ +914.2 +Net income +— +— +15.6 +— +— +15.6 +Cash dividends +— +— +(10.3 +) +— +— +(10.3 +) +Stock option activity +— +0.9 +— +11.2 +— +12.1 +Restricted stock activity +0.1 +8.8 +— +1.0 +— +9.9 +Repurchase of shares +— +— +— +(13.1 +) +— +(13.1 +) +Other comprehensive income, net of tax +— +— +— +— +7.9 +7.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, May 31, 2018 +$ +45.3 +$ +470.5 +$ +733.2 +$ +(280.7 +) +$ +(32.0 +) +$ +936.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +39 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In millions) +For the Year Ended +May 31, +2018 +2017 +2016 +Cash flows provided from operating activities: +Net income +$ +15.6 +$ +56.5 +$ +47.7 +Less: Income (Loss) from discontinued operations +(58.1 +) +4.5 +2.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations +73.7 +52.0 +45.5 +Adjustments to reconcile income to net cash provided from (used in) operating activities: +Depreciation and intangible amortization +40.5 +35.7 +33.2 +Amortization of stock-based compensation +15.3 +11.0 +6.5 +Deferred tax provision (benefit) +(12.9 +) +12.5 +5.5 +Gain on sale of product line +— +(2.6 +) +— +Changes in certain assets and liabilities, net of acquisitions: +Accounts receivable +35.9 +(14.7 +) +(2.2 +) +Inventories +(25.8 +) +(23.3 +) +(19.5 +) +Rotable spares and equipment on or available for short-term lease +(16.6 +) +(3.1 +) +2.8 +Rotable assets supporting long-term programs +(38.5 +) +(82.5 +) +(10.2 +) +Accounts and trade notes payable +1.8 +19.6 +13.8 +Accrued and other liabilities +8.0 +6.5 +(31.1 +) +Other +(25.6 +) +(24.6 +) +1.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from (used in) operating activities—continuing +operations +55.8 +(13.5 +) +46.0 +Net cash provided from (used in) operating activities—discontinued +operations +8.5 +35.3 +(13.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from operating activities +64.3 +21.8 +32.1 +Cash flows used in investing activities: +Property, plant and equipment expenditures +(22.0 +) +(25.2 +) +(40.1 +) +Proceeds from asset disposals +8.6 +6.5 +0.1 +Payments for acquisitions +(22.9 +) +(12.5 +) +(4.8 +) +Other +(2.3 +) +(2.7 +) +1.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash used in investing activities—continuing operations +(38.6 +) +(33.9 +) +(43.8 +) +Net cash provided from (used in) investing activities—discontinued +operations +(4.3 +) +3.8 +26.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash used in investing activities +(42.9 +) +(30.1 +) +(16.9 +) +Cash flows provided by (used in) financing activities: +Short-term borrowings (repayments), net +(1.0 +) +21.0 +60.0 +Proceeds (Repayments) on long-term borrowings +24.8 +(10.0 +) +(70.6 +) +Cash dividends +(10.3 +) +(10.2 +) +(10.4 +) +Purchase of treasury stock +(13.1 +) +(19.8 +) +(18.8 +) +Stock option exercises +11.6 +8.5 +1.8 +Other +(0.3 +) +0.1 +(0.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from (used in) financing activities—continuing +operations +11.7 +(10.4 +) +(38.4 +) +Net cash used in financing activities—discontinued operations +(1.7 +) +(1.7 +) +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from (used in) financing activities +10.0 +(12.1 +) +(38.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Effect of exchange rate changes on cash +(0.1 +) +(0.5 +) +(0.3 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Increase (Decrease) in cash and cash equivalents +31.3 +(20.9 +) +(23.5 +) +Cash, cash equivalents, and restricted cash at beginning of year +10.3 +31.2 +54.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash, cash equivalents, and restricted cash at end of year +$ +41.6 +$ +10.3 +$ +31.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +40 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies +Description of Business +AAR CORP. is a diversified provider of services and products to the worldwide commercial aviation and government and defense markets. Services +and products include: aviation supply chain and parts support programs; maintenance, repair and overhaul of airframes, landing gear, and certain other airframe components; design and manufacture of +specialized pallets, shelters, and containers; airlift services; aircraft modifications and aircraft and engine sales and leasing. We serve commercial, defense and governmental aircraft fleet +operators, original equipment manufacturers, and independent service providers around the world, and various other domestic and foreign military customers. +Principles of Consolidation +The accompanying Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries after elimination of +intercompany accounts and transactions. The equity method of accounting is used for investments in other companies in which we have significant influence; generally this represents common stock +ownership of at least 20% and not more than 50%. +Revenue Recognition +Sales and related cost of sales for product sales are generally recognized upon shipment of the product to the customer. Our standard terms and +conditions provide that title passes to the customer when the product is shipped to the customer. Sales of certain defense products are recognized upon customer acceptance, which includes transfer of +title. Sales from services and the related cost of services are generally recognized when customer-owned material is shipped back to the customer. We have adopted this accounting policy because at the +time the customer-owned material is shipped back to the customer, all services related to that material are complete as our service agreements generally do not require us to provide services at +customer sites. Furthermore, serviced units are typically shipped to the customer immediately upon completion of the related services. Sales and related cost of sales for certain large airframe +maintenance contracts and performance-based logistics programs are recognized by the percentage of completion method, based on the relationship of costs incurred to date to the estimated total costs. +Net favorable cumulative catch-up adjustments recognized during fiscal 2018, 2017, and 2016 were $3.6 million, $8.5 million, and $3.7 million, respectively, resulting from changes +to the estimated profitability of these contracts. +Lease +revenues are recognized as earned. Income from monthly or quarterly rental payments is recorded in the pertinent period according to the lease agreement. However, for leases that +provide variable rents, we recognize lease income on a straight-line basis. In addition to a monthly lease rate, some engine leases require an additional rental amount based on the number of hours the +engine is used in a particular month. Lease income associated with these contingent rentals is recorded in the period in which actual usage is reported to us by the lessee, which is normally the month +following the actual usage. +Certain +supply chain management programs we provide to our customers contain multiple elements or deliverables, such as program and warehouse management, parts distribution, and +maintenance and repair services. We recognize revenue for each element or deliverable that can be identified as a separate unit of accounting at the time of delivery based upon the relative fair value +of the products and services. +41 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +In +June 2016, the U.S. Air Force awarded the new contract for the KC-10 Extender Contractor Logistics Support Program ("KC-10 Program") to a competitor. Our principal services under the +prior contract for the KC-10 Program were completed in January 2017; however, we have provided limited services since that date. Sales for the KC-10 Program during fiscal 2018, 2017 and 2016 were +$29.1 million, $110.6 million, and $148.1 million, respectively. Gross profit for the KC-10 Program during fiscal 2018, 2017 and 2016 was $4.8 million, $8.7 million, +and $16.0 million, respectively. +Allowance for Doubtful Accounts +We maintain an allowance for doubtful accounts to reflect the expected uncollectibility of accounts receivable based on past collection history +and specific risks identified among uncollected accounts. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, +and our customers' current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to +undergo an extensive credit check prior to delivery of products or services. +Goodwill and Other Intangible Assets +In accordance with Accounting Standards Codification ("ASC") 350, Intangibles—Goodwill and +Other , goodwill and other intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill +and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, or more frequently if circumstances indicate that impairment is possible. Our annual goodwill +impairment test over the last three years has used a combination of the qualitative approach and the two-step quantitative approach to evaluate goodwill for impairment. +As +of May 31, 2018, we have five reporting units with only four of the reporting units assigned goodwill. Our four reporting units with goodwill include two in our Aviation +Services segment (Aviation Supply Chain and Maintenance, Repair, and Overhaul) and two in our Expeditionary Services segment (Airlift and Mobility). We utilized the qualitative assessment approach for +all reporting units. +We +performed the annual qualitative analysis as of May 31, 2018 for the four reporting units with assigned goodwill and concluded it was more likely than not that the fair value +of each reporting unit exceeded its carrying value, and thus no impairment charge was recorded. +Changes +in the carrying amount of goodwill by segment for fiscal 2018 and 2017 are as follows: +Aviation +Services +Expeditionary +Services +Total +Balance as of May 31, 2016 +$ +66.3 +$ +41.2 +$ +107.5 +Foreign currency translation adjustments +(1.9 +) +— +(1.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2017 +64.4 +41.2 +105.6 +Acquisition +12.5 +— +12.5 +Foreign currency translation adjustments +0.6 +— +0.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2018 +$ +77.5 +$ +41.2 +$ +118.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +42 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Intangible +assets with finite useful lives are amortized on a straight-line basis over their estimated useful lives. Intangible assets, other than goodwill, are comprised of the +following: +May 31, 2018 +Gross +Accumulated +Amortization +Net +Amortizable intangible assets: +Customer relationships +$ +26.3 +$ +(13.9 +) +$ +12.4 +Developed technology +9.1 +(5.9 +) +3.2 +Lease agreements +22.5 +(12.6 +) +9.9 +FAA certificate +1.9 +(0.9 +) +1.0 +Trademarks +0.2 +— +0.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +60.0 +(33.3 +) +26.7 +Unamortized intangible assets: +Trademarks +1.1 +— +1.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +61.1 +$ +(33.3 +) +$ +27.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, 2017 +Gross +Accumulated +Amortization +Net +Amortizable intangible assets: +Customer relationships +$ +24.4 +$ +(11.6 +) +$ +12.8 +Developed technology +8.8 +(4.7 +) +4.1 +Lease agreements +22.5 +(11.2 +) +11.3 +FAA certificate +1.9 +(0.8 +) +1.1 +Trademarks +0.2 +— +0.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +57.8 +(28.3 +) +29.5 +Unamortized intangible assets: +Trademarks +1.1 +— +1.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +58.9 +$ +(28.3 +) +$ +30.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Customer +relationships are being amortized over 10-20 years, developed technology is being amortized over 7-15 years, lease agreements are being amortized over +5-18 years, and the FAA certificate is being amortized over 20 years. Amortization expense recorded during fiscal 2018, 2017 and 2016 was $4.7 million, $4.2 million, and +$4.4 million, respectively. The estimated aggregate amount of amortization expense for intangible assets in each of the next five fiscal years is $4.1 million in 2019, +$3.7 million in 2020, $3.7 million in 2021, $2.9 million in 2022 and $2.3 million in 2023. +Foreign Currency +Our foreign subsidiaries utilize the local currency as their functional currency. All balance sheet accounts of foreign subsidiaries transacting +business in currencies other than the U.S. dollar are translated +43 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +at +year-end exchange rates. Revenues and expenses are translated at average exchange rates during the year. Translation adjustments are excluded from the results of operations and are recorded in +stockholders' equity as a component of accumulated other comprehensive loss until such subsidiaries are liquidated. +Cash +Cash and cash equivalents consist of highly liquid instruments which have original maturities of three months or less when purchased. Restricted +cash represents cash on hand required to be set aside by a contractual agreement related to receivable securitization arrangements. Generally, +the restrictions related to the receivable securitization arrangements lapse at the time we remit the customer payments collected by us as servicer of previously sold customer receivables to the +purchaser. +Financial Instruments and Concentrations of Market or Credit Risk +Financial instruments that potentially subject us to concentrations of market or credit risk consist principally of trade receivables. While our +trade receivables are diverse and represent a number of entities and geographic regions, the majority are with the U.S. government and its contractors and entities in the aviation industry. Accounts +receivable due from the U.S. government were $33.0 million and $29.4 million at May 31, 2018 and 2017, respectively. We perform regular evaluations of customer payment experience, +current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, letters of credit, and/or obligation guarantees from financial institutions for +transactions executed on other than normal trade terms. +The +carrying amounts of cash and cash equivalents, accounts receivable, and accounts and trade notes payable approximate fair value because of the short-term maturity of these +instruments. The carrying value of long-term debt bearing a variable interest rate approximates fair value. +Fair +value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates are subjective in nature and involve +uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. +Inventories +Inventories are valued at the lower of cost or market (estimated net realizable value). Cost is determined by the specific identification, +average cost, or first-in, first-out methods. From time-to-time, we purchase aircraft and engines for disassembly to individual parts and components. Costs are assigned to these individual parts and +components utilizing list prices from original equipment manufacturers and recent sales history. +44 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +The +following is a summary of inventories: +May 31, +2018 +2017 +Aircraft and engine parts, components and finished goods +$ +383.5 +$ +362.6 +Raw materials and parts +45.1 +45.0 +Work-in-process +32.1 +25.8 +​ +​ +​ +​ +​ +​ +​ +​ +$ +460.7 +$ +433.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rotable Assets and Equipment under Leases +Lease revenue is recognized as earned. The cost of the asset under lease is the original purchase price plus overhaul costs. Depreciation is +computed using the straight-line method over the estimated service life of the equipment. The balance sheet classification of equipment under lease is generally based on lease term, with fixed-term +leases less than twelve months generally classified as short-term and all others generally classified as long-term. +Equipment +on short-term lease includes aircraft engines and parts on or available for lease to satisfy customers' immediate short-term requirements. The leases are renewable with fixed +terms, which generally vary from one to twelve months. +Future +rent due to us under non-cancelable leases during each of the next five fiscal years is $26.2 million in 2019, $25.7 million in 2020, $25.0 million in 2021, +$24.5 million in 2022, and $24.5 million in 2023. +Rotable Assets Supporting Long-Term Programs +Rotable assets supporting long-term programs consists of rotable component parts used to support long-term supply chain programs. The assets are +being depreciated on a straight-line basis over their estimated useful lives. +Property, Plant and Equipment +We record property, plant and equipment at cost. Depreciation is computed on the straight-line method over useful lives of 10-40 years +for buildings and improvements and 3-10 years for equipment, furniture and fixtures, and capitalized software. Leasehold improvements are amortized over the shorter of the estimated useful life +or the term of the applicable lease. +Repair +and maintenance expenditures are expensed as incurred. Upon sale or disposal, cost and accumulated depreciation are removed from the accounts, and related gains and losses are +included in results of operations. +In +accordance with ASC 360, Property, Plant and Equipment , we are required to test for impairment of long-lived assets whenever +events or changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows. We utilize certain assumptions to estimate future +45 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +undiscounted +cash flows, including demand for our services, future market conditions and trends, business development pipeline of opportunities, current and future lease rates, lease terms, and +residual values. +Income Taxes +We are subject to income taxes in the U.S., state, and several foreign jurisdictions. In the ordinary course of business, there can be +transactions and calculations where the ultimate tax determination is uncertain. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been +included in the financial statements or tax returns in accordance with applicable accounting guidance for accounting for income taxes, using currently enacted tax rates in effect for the year in which +the differences are expected to reverse. +We +record a valuation allowance when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets are reduced by a valuation allowance if, based on +the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Both positive and negative evidence are considered in forming our +judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. Valuation allowances are reassessed whenever there are changes in +circumstances that may cause a change in judgment. +The +accounting for uncertainty in income taxes requires a more-likely-than-not threshold for financial statement recognition of tax positions taken or expected to be taken in a tax +return. Where necessary, we record a liability for the difference between the benefit recognized for financial statement purposes and the tax position taken or expected to be taken on our tax return. +To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. +Supplemental Information on Cash Flows +Supplemental information on cash flows is as follows: +For the Year Ended +May 31, +2018 +2017 +2016 +Interest paid +$ +7.2 +$ +4.4 +$ +4.7 +Income taxes paid +17.0 +12.7 +35.7 +Income tax refunds and interest received +0.1 +1.3 +1.3 +During +fiscal 2018, treasury stock increased $0.9 million reflecting the repurchase of common shares of $13.1 million, restricted stock activity of $1.0 million and +the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $11.2 million. +During +fiscal 2017, treasury stock increased $12.2 million reflecting the repurchase of common shares of $19.8 million, restricted stock grants of $1.3 million and +the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $8.9 million. +46 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +During fiscal 2016, treasury stock increased $21.3 million reflecting the repurchase of common shares of $18.8 million, restricted stock grants of $4.8 million and +the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $2.3 million. +Use of Estimates +We have made estimates and utilized certain assumptions relating to the reporting of assets and liabilities and the disclosures of contingent +liabilities to prepare these Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States. Actual results could differ from those estimates. +New Accounting Pronouncements +Revenue from Contracts with Customers +In May 2014, the FASB issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with +Customers , which provides guidance for revenue recognition. This ASU affects any entity that either enters into contracts with customers to transfer goods or services or enters +into contracts for the transfer of non-financial assets. This ASU will supersede the revenue recognition requirements in ASC 605, Revenue +Recognition , and most industry-specific guidance. This ASU will also supersede certain cost guidance included in Subtopic 605-35, Revenue +Recognition-Construction-Type and Production-Type Contracts . In August 2015, the FASB issued ASU No. 2015-14 which deferred the effective date of the new standard by one +year so that it will be effective for us beginning June 1, 2018. +We +will adopt this ASU using the modified retrospective transition method in the first quarter of fiscal 2019. Under this method, we will be required to recognize the cumulative effect +of adopting this ASU as of June 1, 2018. We have substantially completed our assessment of the new ASU and are finalizing the quantification of our adoption adjustments as well as preparing the +new required disclosures for the first quarter of fiscal 2019. +We +have identified three areas where the new ASU will impact our revenue recognition. First, we have certain contracts under which we manufacture products with no alternative use and the +Company has an enforceable right to payment from the customer. As a result, the Company will be required to record revenue for these contracts over time as opposed to at the time of shipment which is +our current policy today. Second, we have contracts under which we perform repair services on customer-owned assets which will also transition to an over time approach compared to our current policy +of recognizing revenue at the time of shipment. +Third, +we have certain contracts in which revenue is recognized using the percentage of completion method over the expected term of the contract. The new ASU will result in the reduction +of the contract term used for revenue recognition as certain contracts include unexercised customer option years or include customer rights to terminate the contract without significant penalty. +We +expect the cumulative effect for the adoption of the new ASU will result in a decrease to retained earnings of approximately $20 million as of June 1, 2018. We will +establish new Contract asset and Contract liability balance sheet accounts and will reclassify certain amounts from Accounts receivable, Inventories, Other non-current assets, and Other liabilities +and deferred income into these new accounts. +47 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Other New Accounting Pronouncements +In February 2016, the FASB issued ASU 2016-02, Leases . This ASU amends the existing accounting +standards for lease accounting, including requiring lessees to recognize most leases on their balance sheets, including those classified as operating leases under the current accounting guidance. In +addition, this ASU will require new qualitative and quantitative disclosures about the Company's leasing activities. This new standard will be effective for us beginning June 1, 2019, with +early adoption permitted. This ASU requires a modified retrospective transition approach for all leases existing at, or entered into after, the date of initial application, with an option to use +certain transition relief. We are in the preliminary phases of assessing the effect of this ASU on our portfolio of leases. While this assessment continues, we have not yet selected a transition date +nor have we determined the effect of this ASU on our consolidated financial statements. +In +March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting , which amends +ASC Topic 718, Compensation—Stock Compensation . This ASU requires excess tax benefits or deficiencies for share-based payments +to be recorded in the period shares vest as income tax expense or benefit, rather than within equity. Cash flows related to excess tax benefits are now included in operating activities and are no +longer classified as a financing activity. We adopted this ASU on June 1, 2017 and recognized excess tax benefits of $2.9 million as an income tax benefit in fiscal 2018. We have also +presented the excess tax benefits within operating activities in the consolidated statement of cash flows for fiscal 2018. As permitted, we adopted the statement of cash flow presentation guidance on +a prospective basis with no adjustments to the previously reported amounts. +In +November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash . This ASU requires restricted cash to +be included within beginning and ending total cash amounts reported in the consolidated statements of cash flows as well as increased disclosure requirements. As permitted, we have early adopted this +ASU in fiscal 2018. The ASU is required to be adopted on a retroactive basis; however, we did not have restricted cash in our prior periods reported. +In +February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects +from Accumulated Other Comprehensive Income . This ASU permits the reclassification of tax effects stranded in accumulated other comprehensive income to retained earnings as a +result of the Tax Cuts and Jobs Act (the "Tax Reform Act"). This new standard will be effective for us beginning June 1, 2019 with early adoption +permitted. We are currently evaluating the impact of this new standard on our consolidated financial statements. +In +March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and +Net Periodic Postretirement Benefit Cost . This ASU requires an employer to report the service cost component of net periodic pension benefit cost in the same line item as other +compensation costs for those related employees. Other components of net pension cost, including interest, expected return on plan assets, and actuarial gains and losses are to be presented outside of +operating income. This new standard requires retrospective treatment for the classification of pension costs and will be effective for us beginning June 1, 2018. With the majority of our +pension plans frozen and total service cost, including administrative expenses, of $2.4 million and $2.5 million in fiscal 2018 and 2017, respectively, this ASU is not expected to have a +material impact on our consolidated financial statements. +48 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +2. Discontinued Operations +During the third quarter of fiscal 2018, we decided to pursue the sale of our Contractor-Owned, Contractor-Operated ("COCO") business previously included in our Expeditionary Services +segment. Due to this strategic shift, the assets, liabilities, and results of operations of our COCO business have been reported as discontinued operations for all periods presented. Goodwill was +allocated to this business based on its relative fair value to the reporting unit. The fair value of the reporting unit was determined based on a combination of the expected net proceeds upon sale and +a discounted cash flow analysis. As the fair value of the COCO business was below its carrying value, a goodwill impairment charge of $9.8 million, representing the estimated loss on disposal, +was recorded in the third quarter of fiscal 2018. +Our +COCO business completed certain contracts in the second quarter of fiscal 2018. As the aircraft supporting these contracts were not placed on new contracts combined with the +continued decline in operational tempo within the U.S. Department of Defense ("DoD") and an excess supply of aircraft assets in the market, we determined there was an impairment triggering event and +tested the recoverability of our COCO assets. As a result, we recognized impairment and other charges of $54.2 million in the second quarter of fiscal 2018. The fair value of the aircraft and +related assets was based on available market data for similar assets. +In +the first quarter of fiscal 2016, we recognized a gain of $27.7 million net of expenses representing the receipt of the contingent consideration related to the sale of our +Telair Cargo Group. +Discontinued +operations also includes the results of our former metal machining operation which was shutdown in the first quarter of fiscal 2017. +No +amounts for general corporate overhead or interest expense were allocated to discontinued operations during the periods presented. Unless otherwise noted, amounts and disclosures +throughout these Notes to Consolidated Financial Statements relate to our continuing operations. +Operating +results for discontinued operations were comprised of the following: +For the Year Ended May 31, +2018 +2017 +2016 +Sales +$ +96.3 +$ +176.9 +$ +184.9 +Cost of sales +(101.4 +) +(165.1 +) +(184.2 +) +Asset impairments +(65.2 +) +— +— +Selling, general and administrative expenses +(11.8 +) +(16.1 +) +(18.5 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating loss from discontinued operations +(82.1 +) +(4.3 +) +(17.8 +) +Gain on sale of Telair Cargo Group +— +— +27.7 +Provision for income taxes (benefit) +(24.0 +) +(8.8 +) +7.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income (Loss) from discontinued operations +$ +(58.1 +) +$ +4.5 +$ +2.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +During +the third quarter of fiscal 2016, we recognized $2.8 million of income tax expense in discontinued operations related to changes in estimates associated with tax provision +to federal income tax return filing differences. During the fourth quarter of fiscal 2017, we recognized an income tax +benefit in discontinued operations of $6.7 million for an effective settlement of a previously reserved tax position. +49 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +2. Discontinued Operations (Continued) +The +carrying amounts of the major classes of assets and liabilities for our discontinued operations are as follows: +May 31, +2018 +2017 +Inventory, rotable assets, and equipment +$ +106.1 +$ +183.7 +Accounts receivable, net +14.7 +17.0 +Goodwill +— +9.8 +Other assets +4.2 +7.7 +​ +​ +​ +​ +​ +​ +​ +​ +Assets of discontinued operations +$ +125.0 +$ +218.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Liabilities—current +$ +25.0 +$ +30.8 +Liabilities—non-current +— +2.6 +​ +​ +​ +​ +​ +​ +​ +​ +Liabilities of discontinued operations +$ +25.0 +$ +33.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +3. Sale of Receivables +On February 23, 2018, we entered into a Purchase Agreement with Citibank N.A. ("Purchaser") for the sale, from time to time, of certain accounts receivable due from certain +customers (the "Purchase Agreement"). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million. The term of the Purchase Agreement runs through +February 22, 2019, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual +terms unless either party provides advance notice that they do not intend to extend the term. +We +have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the +Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing , and de-recognize the sold receivables from +our Consolidated Balance Sheet. +During +fiscal 2018, we sold $239.6 million of receivables under the Purchase Agreement and remitted $167.9 million to the Purchaser on their behalf. As of May 31, +2018, we have collected cash of $10.5 million which has not yet been remitted to the Purchaser and has been classified as Restricted cash on our Consolidated Balance Sheet. During fiscal 2018, +we incurred purchase discount and other fees of $0.9 million which are recognized as Other expenses on our Consolidated Statements of Income. +50 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +4. Financing Arrangements +Debt Outstanding +A summary of the carrying amount of our debt is as follows: +May 31, +2018 +2017 +Revolving Credit Facility expiring November 1, 2021 with interest payable monthly +$ +130.0 +$ +131.0 +Term loan due November 1, 2021 with interest payable monthly +23.9 +— +Industrial revenue bond (secured by property, plant and equipment) due August 1, 2018 with interest payable monthly +25.0 +25.0 +Capital lease obligations +— +0.2 +​ +​ +​ +​ +​ +​ +​ +​ +Total debt +178.9 +156.2 +Current maturities of debt +— +(0.1 +) +Debt issuance costs, net +(1.7 +) +(2.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +Long-term debt +$ +177.2 +$ +154.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +At +May 31, 2018, our variable rate and fixed rate debt had a fair value that approximates its carrying value and are classified as Level 2 in the fair value hierarchy. +On +October 18, 2017, we entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender (the "Credit Agreement"). The Credit Agreement provided a Canadian +$31 million term loan with the proceeds used to fund the acquisition of two maintenance, repair, and overhaul ("MRO") facilities in Canada from Premier Aviation. The term loan is due in full at +the expiration of the Credit Agreement on November 1, 2021 unless terminated earlier pursuant to the terms of the Credit Agreement. Interest is payable monthly on the term loan at the offered +fluctuating Canadian Dollar Offer Rate plus 125 to 225 basis points based on certain financial measurements if a Bankers' Acceptances loan, or at the offered fluctuating Prime Rate plus 25 to +125 basis points based on certain financial measurements, if a Prime Rate loan. +We +maintain a Revolving Credit Facility with various financial institutions, as lenders and Bank of America, N.A., as administrative agent for the lenders which provides the Company an +aggregate revolving credit commitment amount of $500 million. The Company, under certain circumstances, has the ability to request an increase to the revolving credit commitment by an aggregate +amount of up to $250 million, not to exceed $750 million in total. +On +November 1, 2016, we entered into an amendment to our Revolving Credit Facility which extended the maturity of the Revolving Credit Facility to November 1, 2021, +eliminated the condition of no material adverse change for credit extensions and modified certain other provisions. +Borrowings +under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 100 to 200 basis points based on certain financial measurements if a Eurodollar Rate +loan, or at the offered fluctuating Base Rate plus 0 to 100 basis points based on certain financial measurements if a Base Rate loan. +51 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +4. Financing Arrangements (Continued) +The +industrial revenue bond that matures on August 1, 2018 has been classified as a long-term liability due to our intent and ability to refinance this bond on a long-term basis +using our Revolving Credit Facility. +Our +financing arrangements also require us to comply with leverage and interest coverage ratios, maintain a minimum net working capital level, and comply with certain affirmative and +negative covenants, including those relating to financial reporting and notification, payment of indebtedness, cash dividends, taxes and other obligations, compliance with applicable laws, and +limitations on additional liens, indebtedness, acquisitions, investments and disposition of assets. The Revolving Credit Facility also requires our significant domestic subsidiaries, and any +subsidiaries that guarantee our other indebtedness, to provide a guarantee of payment under the Revolving Credit Facility. At May 31, 2018, we were in compliance with the financial and other +covenants in our financing agreements. +Borrowing +activity under the Revolving Credit Facility during fiscal 2018, 2017 and 2016 is as follows: +For the Year Ended May 31, +2018 +2017 +2016 +Maximum amount borrowed +$ +275.0 +$ +217.0 +$ +200.0 +Average daily borrowings +214.1 +175.5 +134.2 +Average interest rate during the year +2.52 +% +1.77 +% +1.41 +% +We +also have $9.9 million available under foreign lines of credit. +5. Stock-Based Compensation +We have granted stock-based awards under the AAR CORP. 2013 Stock Plan (the "2013 Stock Plan") and the AAR CORP. Stock Benefit Plan ("Stock Benefit Plan") each of which has been approved +by our stockholders. No further awards will be made under the Stock Benefit Plan. Under the 2013 Stock Plan, we are authorized to issue stock options to employees and non-employee directors that allow +the +grant recipients to purchase shares of common stock at a price not less than the fair market value of the common stock on the date of grant. Generally, stock options awarded expire ten years from the +date of grant and are exercisable in three, four or five equal annual increments commencing one year after the date of grant. In addition to stock options, the 2013 Stock Plan also provides for the +grant of time-based restricted stock awards and performance-based restricted stock awards. The number of performance-based awards earned, subject to vesting, is based on achievement of certain +Company-wide or segment financial goals or stock price targets. The 2013 Stock Plan also provides for the grant of stock appreciation units and restricted stock units; however, to date, no such awards +have been granted. +Restricted +stock grants (whether time-based or performance-based) are designed, among other things, to align employee interests with the interests of stockholders and to encourage the +recipient to build a career with us. Restricted stock typically vests over periods of one to five years from date of grant. Restricted stock grants may be performance-based with vesting to occur over +periods of three to five years. All restricted stock that has been granted and, if performance-based, earned according to performance criteria carries full dividend and voting rights, regardless of +whether it has vested. +Substantially +all stock options and restricted stock are subject to forfeiture prior to vesting if the employee's employment terminates for any reason other than death, disability or +retirement. Since +52 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +5. Stock-Based Compensation (Continued) +inception, +a total of 11,149,000 shares have been granted under the Stock Benefit Plan. We have granted a total of 2,669,000 shares under the 2013 Stock Plan. All future stock awards will be made +under the 2013 Stock Plan. There were 2,128,238 shares available for grant under the 2013 Stock Plan as of May 31, 2018. +Stock Options +During fiscal 2018, 2017, and 2016, we granted stock options with respect to 463,140 shares, 687,000 shares and 488,767 shares, respectively. +The weighted average fair value per share of stock options granted during fiscal 2018, 2017 and 2016 was $9.29, $6.50 and $7.48, respectively. The fair value of each stock option grant was estimated +on the date of grant using the Black-Scholes option pricing model using the following weighted average assumptions: +Stock Options Granted +In Fiscal Year +2018 +2017 +2016 +Risk-free interest rate +1.8 +% +1.0 +% +1.6 +% +Expected volatility of common stock +31.7 +% +36.8 +% +36.1 +% +Dividend yield +0.9 +% +1.3 +% +1.1 +% +Expected option term in years +4.3 +4.0 +4.2 +The +risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on historical volatility of our common stock, and +the expected option term represents the period of time that the stock options granted are expected to be outstanding based on historical exercise trends. The dividend yield represents our anticipated +cash dividends at the grant date over the expected option term. +A +summary of stock option activity for the three years ended May 31, 2018 consisted of the following (shares in thousands): +2018 +2017 +2016 +Shares +Weighted +Average +Exercise Price +Shares +Weighted +Average +Exercise Price +Shares +Weighted +Average +Exercise Price +Outstanding at beginning of year +2,334 +$ +23.02 +2,096 +$ +22.17 +1,857 +$ +21.05 +Granted +463 +$ +35.33 +687 +$ +24.10 +489 +$ +26.62 +Exercised +(704 +) +$ +20.04 +(396 +) +$ +20.07 +(122 +) +$ +20.61 +Cancelled +(11 +) +$ +29.50 +(53 +) +$ +25.42 +(128 +) +$ +24.47 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Outstanding at end of year +2,082 +$ +26.72 +2,334 +$ +23.02 +2,096 +$ +22.17 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Options exercisable at end of year +883 +$ +23.81 +910 +$ +21.97 +837 +$ +21.21 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +total fair value of stock options that vested during fiscal 2018, 2017, and 2016 was $4.9 million, $3.5 million, and $2.7 million, respectively. The total +intrinsic value of stock options exercised during fiscal 2018, 2017, and 2016 was $14.2 million, $4.7 million, and $1.0 million, respectively. The aggregate intrinsic value of +options outstanding was $37.4 million and $27.8 million as of May 31, 2018 and 2017, respectively. The tax benefit realized from stock options exercised during fiscal 2018, 2017, +and 2016 was $2.9 million, +53 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +5. Stock-Based Compensation (Continued) +$1.2 million, +and $0.2 million, respectively. Expense recognized in selling, general and administrative expenses for stock options during fiscal 2018, 2017, and 2016 was +$5.1 million, $4.6 million, and $3.5 million, respectively. As of May 31, 2018, we had $4.6 million of unrecognized compensation expense related to stock options +that will be amortized over an average period of 0.7 years. +The +following table provides additional information regarding stock options outstanding as of May 31, 2018 (shares in thousands): +Options Outstanding +Options Exercisable +Option +Exercise +Price Range +Number +Outstanding as +of 5/31/18 +Weighted-Average +Remaining Contractual +Life in Years +Weighted- +Average Exercise +Price +Number +Exercisable as +of 5/31/18 +Weighted- +Average Exercise +Price +$12.00 - $20.00 +160 +3.2 +$ +14.51 +160 +$ +14.51 +$20.01 - $26.00 +1,041 +6.8 +$ +24.63 +447 +$ +24.93 +$26.01 - $38.70 +881 +7.9 +$ +31.41 +276 +$ +27.37 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2,082 +7.0 +$ +26.72 +883 +$ +23.81 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Restricted Stock +We provide executives and other key employees an opportunity to be awarded performance-based and time-based restricted stock. The +performance-based awards are contingent upon the achievement of certain performance objectives, including cumulative net income and average return on capital over a three-year performance period. +During fiscal 2018, 2017, and 2016, we granted 108,440, 212,583, and 119,929 of performance-based restricted shares, respectively. Time-based +restricted shares of 24,425, 39,100, and 42,557 were granted to executives and key employees during fiscal 2018, 2017, and 2016, respectively. We also award time-based restricted stock to our +non-employee directors as part of their annual compensation. Time-based restricted shares of 55,000, 50,625, and 47,083 were granted to members of the Board of Directors during fiscal 2018, 2017, and +2016, respectively. +The +fair value of restricted shares is the market value of our common stock on the date of grant. Expense recognized in selling, general and administrative expenses for all restricted +share programs during fiscal 2018, 2017, and 2016 was $10.2 million, $6.4 million, and $3.2 million, respectively. +Restricted +share activity during the fiscal year ended May 31, 2018 was as follows (shares in thousands): +Number of +Shares +Weighted Average +Fair Value +on Grant Date +Nonvested at May 31, 2017 +595 +$ +25.93 +Granted +188 +$ +35.35 +Vested +(91 +) +$ +25.08 +Forfeited +(8 +) +$ +26.43 +​ +​ +​ +​ +​ +​ +​ +​ +Nonvested at May 31, 2018 +684 +$ +27.89 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +54 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +5. Stock-Based Compensation (Continued) +As of May 31, 2018 we had $4.1 million of unearned compensation related to restricted shares that will be amortized to expense over a weighted average period of +2.5 years. +6. Income Taxes +On December 22, 2017, the Tax Reform Act was enacted which significantly revised the U.S. corporate income tax system. The Tax Reform Act, among other things, reduced the current +corporate federal income tax rate to 21% from 35%, changed bonus depreciation regulations and limited deductions for executive compensation. The income tax rate reduction in the Tax Reform Act is +effective January 1, 2018 which results in a blended federal statutory tax rate of 29.2% in fiscal 2018. +We +re-measured our deferred tax assets and liabilities based on the tax rate at which they are expected to reverse in the future, which is either at a federal rate of 29.2% for reversals +in fiscal 2018 or 21% for reversals in fiscal 2019 and subsequent years. During the third quarter of fiscal 2018, we recognized +an income tax benefit of $13.0 million for the re-measurement impact on a provisional basis as permitted under Staff Accounting Bulletin No. 118, which allows the use of a measurement +period, similar to that used in business combinations, to account for the impacts of the Tax Reform Act. In the fourth quarter of fiscal 2018, we completed our assessment and recognized an additional +income tax benefit of $1.1 million resulting in a total income tax benefit of $14.1 million in fiscal 2018 for the re-measurement impact. +The +provision for income tax on income from continuing operations includes the following components: +For the Year Ended +May 31, +2018 +2017 +2016 +Current: +Federal +$ +14.6 +$ +9.3 +$ +13.7 +State +0.1 +0.2 +0.4 +Foreign +1.7 +3.1 +3.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +16.4 +12.6 +17.9 +Deferred +(12.9 +) +12.5 +5.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +3.5 +$ +25.1 +$ +23.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +55 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +6. Income Taxes (Continued) +The +provision for income taxes on pre-tax income differs from the amount computed by applying the U.S. federal statutory income tax rate of 29.2% for fiscal 2018 and 35.0% for fiscal +2017 and 2016 to income from continuing operations before provision for income taxes due to the following: +For the Year Ended +May 31, +2018 +2017 +2016 +Provision for income tax (benefit) at the federal statutory rate +$ +22.5 +$ +27.0 +$ +24.1 +Deferred tax re-measurement from the Tax Reform Act +(14.1 +) +— +— +Excess tax benefits from stock-based compensation +(2.9 +) +— +— +State net operating losses +1.3 +5.7 +1.1 +Change in valuation allowance for state deferred tax assets +(3.4 +) +(5.7 +) +(1.1 +) +Prior period adjustments +— +— +(1.3 +) +Effective settlement of prior tax position +— +(2.2 +) +— +Other +0.1 +0.3 +0.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Provision for income tax +$ +3.5 +$ +25.1 +$ +23.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +During +the third quarter of fiscal 2016, we completed a reconciliation of our tax basis assets and liabilities and an analysis of our income tax payable which identified prior year +immaterial errors netting to $0.2 million with $1.5 million recognized as income tax expense in discontinued operations and $1.3 million recognized as income tax benefit within +income from continuing operations. +Income +before provision for income taxes includes the following components: +For the Year Ended +May 31, +2018 +2017 +2016 +Domestic +$ +58.7 +$ +57.7 +$ +55.7 +Foreign +18.5 +19.4 +13.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +77.2 +$ +77.1 +$ +68.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +56 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +6. Income Taxes (Continued) +Deferred +tax liabilities and assets result primarily from the differences in the timing of the recognition of transactions for financial reporting and income tax purposes. Our deferred +tax liabilities and assets consist of the following components: +May 31, +2018 +2017 +Deferred tax assets: +Inventory costs +$ +15.9 +$ +21.3 +Impairments +2.1 +5.6 +Postretirement benefits +2.2 +6.8 +Employee benefits +9.7 +12.3 +State net operating losses +8.6 +9.4 +Other +3.2 +3.4 +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax assets +41.7 +58.8 +Valuation allowance +(7.0 +) +(10.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax assets net of valuation allowance +34.7 +48.4 +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax liabilities: +Tangible and intangible assets +(50.2 +) +(85.5 +) +Other +(0.2 +) +(0.1 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax liabilities +(50.4 +) +(85.6 +) +​ +​ +​ +​ +​ +​ +​ +​ +Net deferred tax liabilities +$ +(15.7 +) +$ +(37.2 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As +of May 31, 2018, we have determined that the realization of our deferred tax assets is more likely than not and that a valuation allowance is not required except for certain +state deferred tax assets, including net operating losses. The change in the valuation allowance was primarily the result of the expected utilization of a portion of these state net operating losses. +Our net operating losses have carry forward periods that range from 5 to 20 years. Our history of operating earnings, our expectations for continued future earnings, the nature of certain of +our deferred tax assets and the scheduled reversal of deferred tax liabilities, primarily related to depreciation, support the recoverability of the majority of the deferred tax assets. +Income +tax receivable at May 31, 2018 was $1.0 million and was included in Other current assets on the Consolidated Balance Sheet. Income tax payable at May 31, 2017 +was $12.3 million and was included in Accrued Liabilities on the Consolidated Balance Sheet. +57 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +6. Income Taxes (Continued) +A +reconciliation of the beginning and ending amounts of unrecognized tax benefits was as follows: +For the Year Ended +May 31, +2018 +2017 +2016 +Balance, beginning of year +$ +4.4 +$ +12.9 +$ +2.2 +Additions for tax positions of prior years +— +0.4 +10.7 +Effective settlement of prior tax position +— +(8.9 +) +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, end of year +$ +4.4 +$ +4.4 +$ +12.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +In +fiscal 2017, the reserve for unrecognized tax benefits decreased primarily as a result of effective settlement of tax positions for prior tax years which occurred upon the settlement +of an IRS examination. Income tax expense in fiscal 2017 included a benefit of $2.2 million and discontinued operations included a benefit of $6.7 million for these effective +settlements. +All +of our unrecognized tax benefits as of May 31, 2018 and 2017 would be recorded as a component of income tax expense or income from discontinued operations, if recognized. We +accrue interest and penalties related to unrecognized tax benefits as a component of income tax expense. +Fiscal +years 2015 and subsequent are open for examination. Various states and foreign jurisdictions also remain open subject to their applicable statute of limitations. +7. Earnings Per Share +The computation of basic earnings per share is based on the weighted average number of common shares outstanding during each period. The computation of diluted earnings per share is +based on the weighted average number of common shares outstanding during the period plus, when their effect is dilutive, incremental shares consisting of shares subject to stock options, shares +issuable upon vesting of restricted stock awards and shares to be issued upon conversion of convertible debt. +In +accordance with ASC 260-10-45, Share-Based Payment Arrangements and Participating Securities and the Two-Class Method , our unvested +restricted stock awards are deemed participating securities since these shares are entitled to participate in dividends declared on common shares. During periods of net income, the calculation of +earnings per share for common stock excludes income attributable to unvested restricted stock awards from the numerator and excludes the dilutive impact of those shares from the denominator. During +periods of net loss, no effect is given to the participating securities because they do not share in the losses of the Company. +58 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +7. Earnings Per Share (Continued) +The +following tables provide a reconciliation of the computations of basic and diluted earnings per share information for each of the years in the three-year period ended May 31, +2018 (shares in millions). +For the Year Ended +May 31, +2018 +2017 +2016 +Basic and Diluted EPS: +Income from continuing operations +$ +73.7 +$ +52.0 +$ +45.5 +Less income attributable to participating shares +(0.6 +) +(0.5 +) +(0.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations attributable to common shareholders +73.1 +51.5 +45.1 +Income (Loss) from discontinued operations attributable to common shareholders +(58.1 +) +4.5 +2.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net income attributable to common shareholders for earnings per share +$ +15.0 +$ +56.0 +$ +47.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average common shares outstanding—basic +34.2 +33.9 +34.4 +Additional shares from assumed exercise of stock options +0.4 +0.4 +0.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average common shares outstanding—diluted +34.6 +34.3 +34.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic: +Earnings from continuing operations +$ +2.14 +$ +1.53 +$ +1.30 +Earnings (Loss) from discontinued operations +(1.70 +) +0.13 +0.07 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic +$ +0.44 +$ +1.66 +$ +1.37 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted: +Earnings from continuing operations +$ +2.11 +$ +1.51 +$ +1.30 +Earnings (Loss) from discontinued operations +(1.70 +) +0.13 +0.07 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted +$ +0.41 +$ +1.64 +$ +1.37 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +At +May 31, 2018, the average market price of our common shares was in excess of the exercise prices of all of our outstanding options. At May 31, 2017 and 2016, +respectively, outstanding options to purchase 11,200 shares and 1,374,200 shares of common stock were not included in the computation of diluted earnings per share, because the exercise price of these +options was greater than the average market price of the common shares for the period then ended. +8. Employee Benefit Plans +Defined Benefit Plans +Prior to January 1, 2000, the pension plan for domestic salaried and non-union hourly employees had a benefit formula based primarily on +years of service and compensation. Effective January 1, 2000, we converted our defined benefit plan for substantially all domestic salaried and certain hourly employees to a cash balance +pension plan. Under the cash balance pension plan, the retirement benefit is expressed as a dollar amount in an account that grows with annual pay-based credits and interest on the account balance. +The interest crediting rate under our cash balance plan is determined quarterly and is equal to 100% of the average 30-year treasury rate for the second month preceding the applicable quarter +published by the +59 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Internal +Revenue Service. The average interest crediting rate under our cash balance plan for the fiscal year ended May 31, 2018 was 4.46%. Effective June 1, 2005, the existing cash +balance plan was frozen and the annual pay-based credits were discontinued. Also effective June 1, 2005, the defined contribution plan was modified to include increased employer contributions +and an enhanced profit sharing formula. Defined pension benefits for certain union hourly employees are based primarily on a fixed amount per year of service and the plan was frozen in fiscal 2018. +We +also have a defined benefit pension plan covering certain employees in the Netherlands. Benefit formulas are based generally on years of service and compensation. +We +also have a benefit plan which provides benefits to certain retired outside directors. In fiscal 2001, we froze the plan for any new members of the Board of Directors and no current +directors participate in this plan. +The +change to our projected benefit obligation and the fair value of our plan assets for our pension plans was as follows: +May 31, +2018 +2017 +Change in projected benefit obligation: +Projected benefit obligation at beginning of year +$ +145.4 +$ +145.7 +Service cost +2.4 +2.5 +Interest cost +4.3 +4.2 +Participant contributions +0.4 +0.3 +Net actuarial gain +(2.3 +) +(2.0 +) +Benefits and administrative payments +(6.5 +) +(6.0 +) +Plan change +0.7 +— +Foreign currency translation adjustment +2.1 +0.7 +​ +​ +​ +​ +​ +​ +​ +​ +Projected benefit obligation at end of year +$ +146.5 +$ +145.4 +​ +​ +​ +​ +​ +​ +​ +​ +Change in the fair value of plan assets: +Fair value of plan assets at beginning of year +$ +118.8 +$ +111.0 +Actual return on plan assets +11.6 +9.9 +Employer contributions +8.4 +2.9 +Participant contributions +0.4 +0.3 +Benefits and administrative payments +(6.5 +) +(6.0 +) +Foreign currency translation adjustment +1.8 +0.7 +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of plan assets at end of year +$ +134.5 +$ +118.8 +​ +​ +​ +​ +​ +​ +​ +​ +Funded status at end of year +$ +(12.0 +) +$ +(26.6 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +60 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Amounts +recognized in the Consolidated Balance Sheets consisted of the following: +May 31, +2018 +2017 +Non-current assets +$ +0.5 +$ +— +Accrued liabilities +(1.2 +) +(2.7 +) +Other liabilities and deferred income +(11.3 +) +(23.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +Funded status at end of year +$ +(12.0 +) +$ +(26.6 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Amounts +recognized in accumulated other comprehensive loss at May 31, 2018 and 2017, respectively, consisted of the following: +May 31, +2018 +2017 +Actuarial loss +$ +50.5 +$ +58.8 +Prior service credit +(0.1 +) +(0.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +50.4 +$ +58.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For +our frozen defined benefit plan for domestic salaried and non-union hourly employees, plan assets exceeded both the projected benefit obligation and the accumulated benefit +obligation by $0.5 million. For all of our other pension plans, both the projected benefit obligation and the accumulated benefit obligation are in excess of the individual plans' assets. The +accumulated benefit obligation for all pension plans was $140.2 million and $140.0 million at May 31, 2018 and 2017, respectively. +Net Periodic Benefit Cost +Pension expense charged to the Consolidated Statements of Income includes the following components: +For the Year Ended +May 31, +2018 +2017 +2016 +Service cost +$ +2.4 +$ +2.5 +$ +2.5 +Interest cost +4.3 +4.2 +4.5 +Expected return on plan assets +(7.3 +) +(6.5 +) +(6.5 +) +Curtailment +0.3 +— +— +Amortization of prior service cost +— +— +0.1 +Recognized net actuarial loss +2.3 +2.4 +2.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +2.0 +$ +2.6 +$ +3.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +61 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +The +estimated amounts to be amortized from accumulated other comprehensive loss into expense during fiscal 2019 are as follows: +Net actuarial loss +$ +1.8 +Prior service cost +— +​ +​ +​ +​ +​ +Total +$ +1.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Assumptions +The assumptions used in accounting for our plans are estimates of factors including, among other things, the amount and timing of future benefit +payments. The following table presents the key weighted-average assumptions used in the measurement of our projected benefit obligations: +May 31, +2018 +2017 +Discount rate: +Domestic plans +4.05 +% +3.82 +% +International plan +1.90 +2.00 +Rate of compensation increase: +Domestic plans +n/a +2.50 +% +International plans +3.00 +% +3.00 +A +summary of the weighted-average assumptions used to determine net periodic pension expense is as follows: +For the Year Ended +May 31, +2018 +2017 +2016 +Discount rate: +Domestic plans +3.82 +% +3.83 +% +4.15 +% +International plan +2.00 +1.90 +1.90 +Rate of compensation increase: +Domestic plans +2.50 +% +2.50 +% +2.50 +% +International plan +3.00 +3.00 +3.00 +Expected long-term rate on plan assets: +Domestic plans +7.25 +% +7.25 +% +7.25 +% +International plan +4.00 +4.00 +4.00 +The +discount rate was determined by projecting the expected future benefit payments as defined for the projected benefit obligation, discounting those expected payments using a +theoretical zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, and solving for the single equivalent discount rate that resulted in the same +projected benefit obligation. +62 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Plan Assets +The following table sets forth the actual asset allocation and target allocations for our U.S. pension plans: +May 31, +Target Asset +Allocation +2018 +2017 +Equity securities +59 +% +62 +% +45 - 75 +% +Fixed income securities +22 +16 +15 - 45 +% +Other +19 +22 +0 - 25 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +100 +% +100 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +assets of U.S pension plans are invested in compliance with the Employee Retirement Income Security Act of 1974. The investment goals are to provide a total return that, over the +long term, optimizes the long-term return on plan assets at an acceptable risk, and to maintain a broad diversification across asset classes and among investment managers. We believe that there are no +significant concentrations of risk within our plan assets as of May 31, 2018. The use of derivatives for the purpose of speculation are not permitted. The assets of the U.S. pension plans are +invested primarily in equity and fixed income mutual funds, individual common stocks, and fund-of-funds hedge funds. The assets of the non-domestic plan are invested in funds-of-funds where each fund +holds a portfolio of equity and fixed income mutual funds. +To +develop our expected long-term rate of return assumption on domestic plans, we use long-term historical return information for our targeted asset mix and current market conditions. +The expected return for each asset class is weighted based on the target asset allocation to develop the expected long-term rate of return on plan assets assumption. While consideration is given to +recent performance, the assumption represents a long-term, prospective rate of return. +The +following table sets forth by level, within the fair value hierarchy, pension plan assets at their fair value as of May 31, 2018: +Level 1 1 +Level 2 2 +Level 3 3 +Total +Equity securities: +U.S. mutual funds +$ +32.8 +$ +— +$ +— +$ +32.8 +International mutual funds +10.4 +— +— +10.4 +Fixed income: +Government securities and corporate bond mutual funds +15.7 +— +— +15.7 +Funds-of-funds +— +53.6 +7.7 +61.3 +Hedge funds +— +— +4.4 +4.4 +Insurance annuities +— +— +7.8 +7.8 +Cash and cash equivalents +2.1 +— +— +2.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total investments +$ +61.0 +$ +53.6 +$ +19.9 +$ +134.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +63 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +The +following table sets forth by level, within the fair value hierarchy, pension plan assets at their fair value as of May 31, 2017: +Level 1 1 +Level 2 2 +Level 3 3 +Total +Equity securities: +U.S. mutual funds +$ +30.6 +$ +— +$ +— +$ +30.6 +International mutual funds +9.5 +— +— +9.5 +Fixed income: +Government securities and corporate bond mutual funds +10.1 +— +— +10.1 +Funds-of-funds +— +51.6 +7.3 +58.9 +Hedge funds +— +— +6.8 +6.8 +Cash and cash equivalents +2.9 +— +— +2.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total investments +$ +53.1 +$ +51.6 +$ +14.1 +$ +118.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1 Quoted +prices in active markets for identical assets that we have the ability to access as of the reporting date. +2 Inputs +other than quoted prices included within Level 1 that are directly observable for the asset or indirectly observable through corroboration +with observable market data. +3 Unobservable +inputs, such as internally developed pricing models or third party valuations for the asset due to little or no market activity for the +asset. +The +following table presents the reconciliation of Level 3 pension assets measured at fair value for the fiscal years ended May 31, 2018 and 2017: +Hedge Funds +Fund-of-funds +Insurance Annuities +Total +Balance as of May 31, 2016 +$ +6.6 +$ +7.5 +$ +— +$ +14.1 +Sales +— +(0.8 +) +— +(0.8 +) +Return on plan assets related to assets still held at May 31, 2017 +0.2 +0.6 +— +0.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2017 +6.8 +7.3 +— +14.1 +Purchases +— +— +7.8 +7.8 +Sales +(3.0 +) +— +— +(3.0 +) +Return on plan assets related to assets still held at May 31, 2018 +0.6 +0.4 +— +1.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2018 +$ +4.4 +$ +7.7 +$ +7.8 +$ +19.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Valuation Techniques Used to Determine Fair Value +Cash equivalents are investments with maturities of three months or less when purchased. The fair values are based on observable market prices +and categorized as Level 1. +64 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +With +respect to individually held equity securities, including investments in U.S. and international securities, the trustees obtain prices from pricing services, whose prices are +obtained from direct feeds from market exchanges, which we are able to independently corroborate. Equity securities held individually are primarily traded on exchanges that contain only actively +traded securities, due to the volume trading requirements imposed by these exchanges. Equity securities are valued based on quoted prices in active markets and categorized as Level 1. +Equity +and fixed income mutual funds are maintained by investment companies that hold certain investments in accordance with a stated set of fund objectives, which are consistent with +our overall +investment strategy. The values of some of these funds are publicly quoted. For equity and fixed income mutual funds which are publicly quoted, the funds are valued based on quoted prices in active +markets and have been categorized as Level 1. As certain of our funds-of-funds investments are also derived from quoted prices in active markets, we have categorized certain funds-of-funds +investments as Level 2. +Hedge +fund investments include those seeking to maximize absolute returns using a broad range of strategies to enhance returns and provide additional diversification. The fair value of +hedge funds is determined using net asset value or its equivalent subject to certain restrictions, such as a lock-up period. As we may be limited in our ability to redeem the investments at the +measurement date or within a reasonable period of time, the hedge fund investments are categorized as Level 3. Our other Level 3 investments require the utilization of unobservable +inputs resulting in Level 3 treatment in the fair value hierarchy. +Future Benefit Payments and Funding +The following table summarizes our estimated future pension payments by fiscal year: +Fiscal Year +2019 +2020 +2021 +2022 +2023 +2024 to +2028 +Estimated future pension payments +$ +8.0 +$ +6.2 +$ +6.0 +$ +6.5 +$ +6.9 +$ +34.2 +Our +contribution policy for the domestic plans is to contribute annually, at a minimum, an amount which is deductible for federal income tax purposes and that is sufficient to meet +actuarially computed pension benefits. For our Netherlands pension plan, our policy is to fund at least the minimum amount required by the local laws and regulations. We anticipate contributing +approximately $2.9 million to our pension plans during fiscal 2019. +Postretirement Benefits Other Than Pensions +We provide health and life insurance benefits for certain eligible retirees. The postretirement plan is unfunded and in fiscal 1995, we +completed termination of postretirement health and life insurance benefits attributable to future services of collective bargaining and other domestic employees. The unfunded projected benefit +obligation for this plan was $0.4 million and $0.7 million as of May 31, 2018 and 2017, respectively. We have omitted substantially all of the required disclosures +related to this plan because the plan is not material to our consolidated financial position or results of operations. +65 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Defined Contribution Plan +The defined contribution plan is a profit sharing plan that is intended to qualify as a 401(k) plan under the Internal Revenue Code. Under the +plan, employees may contribute up to 75% of their pretax compensation, subject to applicable regulatory limits. We may make matching contributions up to 5% of compensation as well as discretionary +profit sharing contributions. Our contributions vest on a pro-rata basis during the first three years of employment. We also provide profit sharing benefits for certain executives and key employees to +supplement the benefits provided by the defined contribution plan. Expense charged to the Consolidated Statements of Income for our matching contributions, including profit sharing contributions, was +$9.2 million in fiscal 2018, $11.6 million in fiscal 2017 and $10.3 million in fiscal 2016 for these plans. +9. Accumulated Other Comprehensive Loss +Changes in our accumulated other comprehensive loss ("AOCL") by component for each of the years in the three-year period ended May 31, 2018 were as follows (all +amounts are net of tax): +Currency +Translation +Adjustments +Pension +Plans +Total +Balance as of June 1, 2015 +$ +0.9 +$ +(41.3 +) +$ +(40.4 +) +Reclassifications within AOCL +(2.0 +) +2.0 +— +Other comprehensive loss before reclassifications +— +(5.6 +) +(5.6 +) +Amounts reclassified from AOCL +— +1.6 +1.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive loss +— +(4.0 +) +(4.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2016 +(1.1 +) +(43.3 +) +(44.4 +) +Other comprehensive income (loss) before reclassifications +(0.6 +) +3.5 +2.9 +Amounts reclassified from AOCL +— +1.6 +1.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive income (loss) +(0.6 +) +5.1 +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2017 +(1.7 +) +(38.2 +) +(39.9 +) +Other comprehensive income before reclassifications +2.0 +4.2 +6.2 +Amounts reclassified from AOCL +— +1.7 +1.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive income +2.0 +5.9 +7.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2018 +$ +0.3 +$ +(32.3 +) +$ +(32.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +10. Commitments and Contingencies +On October 3, 2003, we entered into a sale-leaseback transaction whereby we sold and leased back a facility located in Garden City, New York. The lease is classified as an +operating lease. Net proceeds from the sale of the facility were $14.0 million and the cost and related accumulated depreciation of the facility of $9.5 million and $4.6 million, +respectively, were removed from the Consolidated Balance Sheet at the time of sale. The gain realized on the sale of $9.1 million has been deferred and is being amortized over the 20-year lease +term. As of May 31, 2018 and 2017, the unamortized balance of the deferred gain was +66 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +10. Commitments and Contingencies (Continued) +approximately +$2.5 million and $2.9 million, respectively, and is included in Other liabilities and deferred income on the Consolidated Balance Sheet. +In +addition to the leases described above, we lease other facilities and equipment under agreements that are classified as operating leases that expire at various dates through 2034. +Future minimum payments under all operating leases at May 31, 2018 are as follows: +2019 +$ +17.5 +2020 +16.3 +2021 +13.0 +2022 +10.8 +2023 +10.0 +2024 and thereafter +27.2 +Rental +expense for facilities and equipment during fiscal years 2018, 2017, and 2016 was $23.5 million, $22.9 million, and $21.3 million, respectively. +We +enter into purchase obligations which arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts and components, +as well as equipment to support the operations of our business. The aggregate amount of purchase obligations due in each of the next five fiscal years is $203.4 million in 2019, +$43.8 million in 2020, $6.0 million in 2021, none in 2022 and none in 2023. +We +routinely issue letters of credit and performance bonds in the ordinary course of our business. These instruments are typically issued in conjunction with insurance contracts or other +business requirements. The total of these instruments outstanding at May 31, 2018 was approximately $16.7 million. +We +are involved in various claims and legal actions, including environmental matters, arising in the ordinary course of business. In the opinion of management, the ultimate disposition +of these matters will not have a material adverse effect on our consolidated financial condition or results of operations. +11. Other Noncurrent Assets +At May 31, 2018 and 2017, other noncurrent assets consisted of the following: +May 31, +2018 +2017 +Costs in excess of billings +$ +39.0 +$ +19.1 +Assets under deferred compensation plan +35.7 +32.1 +Cash surrender value of life insurance +16.8 +17.8 +License fees +10.6 +14.4 +Investments in joint ventures +7.6 +15.0 +Other +9.2 +6.5 +​ +​ +​ +​ +​ +​ +​ +​ +$ +118.9 +$ +104.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +67 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +11. Other Noncurrent Assets (Continued) +License Fees +In June 2011, we entered into a ten-year agreement with Unison Industries to be the exclusive worldwide aftermarket distributor for Unison's +electrical components, sensors, switches and other systems for aircraft and industrial uses. In connection with the agreement, we agreed to pay Unison Industries $20.0 million for the exclusive +distribution rights with $7.0 million paid in June 2011 and $1.3 million payable by January 31 of each calendar year beginning in January 2012 through 2021. +As +of May 31, 2018 and 2017, the unamortized balance of the license is $5.6 million and $7.2 million, respectively, and is being amortized over a ten-year period. +The current portion of the deferred payments of $1.3 million is recorded in Accrued liabilities and the long-term portion of $2.2 million is included in Other liabilities and deferred +income on the Consolidated Balance Sheet. +Investments in Joint Ventures +During fiscal 2018, we sold interests in two aircraft joint ventures which were accounted for under the equity method of accounting. We received +cash proceeds of $7.3 million and recognized a gain on the sale of $0.4 million. As of May 31, 2018, all of our remaining investments in aircraft joint ventures are accounted for +under the cost method. +Under +the terms of servicing agreements with certain of our aircraft joint ventures, we provide administrative services and technical advisory services, including aircraft evaluations, +oversight and logistical support of the maintenance process and records management. We also provide evaluation and inspection services prior to the purchase of an aircraft and remarketing services +with respect to the divestiture of aircraft by the joint ventures. During fiscal 2018, 2017, and 2016, we were paid $0.4 million, $1.2 million, and $0.9 million, respectively, for +such services. +Distributions +from joint ventures are classified as operating or investing activities in the Consolidated Statements of Cash Flows based upon an evaluation of the specific facts and +circumstances of each distribution. +12. Acquisitions +On September 19, 2017, we acquired the outstanding shares of two MRO facilities in Canada owned by Premier Aviation for approximately $24.8 million. The purchase price +includes $22.9 million paid at closing and deferred consideration of $1.9 million payable September 2018. This business is included in our Aviation Services segment. The amounts recorded +for certain assets are preliminary in nature and are subject to adjustment as additional information is obtained about their acquisition date fair value. The final determination of the fair values +will be completed within the one year measurement period. The preliminary fair value of assets acquired and liabilities assumed is as follows: +Current assets +$ +4.1 +Property and equipment +13.1 +Intangible assets, including goodwill +16.0 +Accounts payable and accrued liabilities +(8.4 +) +​ +​ +​ +​ +​ +$ +24.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +68 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +12. Acquisitions (Continued) +On April 10, 2017, we acquired the trading business of ACLAS Global Limited ("ACLAS"). In conjunction with the acquisition, we entered into a multi-year component support and +repair contract covering approximately 100 of ACLAS' aircraft. The purchase price of the acquisition was $12.0 million paid at closing with $3.0 million in deferred consideration payable +over the next three years. This business operates as part of our Aviation Services segment. The fair value of assets acquired is as follows: +Inventory +$ +5.0 +Equipment on or available for long-term lease +6.2 +Intangible assets +3.8 +​ +​ +​ +​ +​ +Assets acquired +$ +15.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +On +December 4, 2015, we acquired certain assets of Vantem Modular LLC, which designs, manufactures, and distributes modular shelters. The purchase price of the acquisition +was $4.8 million paid at closing with future royalties of up to $5.0 million. This business operates as part of our Expeditionary Services segment. The fair value of net assets acquired +is as follows: +Current assets +$ +1.5 +Equipment +0.5 +Intangible assets +3.5 +Contingent consideration +(2.0 +) +​ +​ +​ +​ +​ +Net assets acquired +3.5 +Goodwill +1.3 +​ +​ +​ +​ +​ +Purchase price +$ +4.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +13. Business Segment Information +Segment Reporting +Consistent with how our chief operating decision making officer (Chief Executive Officer) evaluates performance and the way we are organized +internally, we report our activities in two segments: Aviation Services comprised of supply chain and MRO activities and Expeditionary Services comprised +of airlift and mobility activities. +The +Aviation Services segment consists of aftermarket support and services businesses that provide spares and maintenance support for aircraft operated by our commercial and +government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components and +aircraft to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance based logistics programs, aircraft component repair +management services, and aircraft modifications. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of +product, direct labor, and overhead. +The +Expeditionary Services segment consists of businesses that provide products and services supporting the movement of equipment and personnel by the U.S. and foreign governments and +other +69 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +non-governmental +organizations. Sales in the Expeditionary Services segment are derived from fleet management and operations of customer-owned aircraft and the design and manufacture of pallets, +shelters, and containers used to support the U.S. military's requirements for a mobile and agile force. We also design and manufacture advanced composite materials for commercial, business and +military aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead. +The +accounting policies for the segments are the same as those described in Note 1. Our chief operating decision making officer (Chief Executive Officer) evaluates performance +based on the reportable segments and utilizes gross profit as a primary profitability measure. Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses +related to corporate activities are not allocated to the segments. Our reportable segments are aligned principally around differences in products and services. +Selected +financial information for each segment is as follows: +For the Year Ended May 31, +2018 +2017 +2016 +Net sales: +Aviation Services +$ +1,618.9 +$ +1,485.4 +$ +1,425.0 +Expeditionary Services +129.4 +105.4 +100.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,748.3 +$ +1,590.8 +$ +1,525.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2018 +2017 +2016 +Gross profit: +Aviation Services +$ +271.9 +$ +246.0 +$ +229.5 +Expeditionary Services +22.7 +17.4 +3.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +294.6 +$ +263.4 +$ +233.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +2018 +2017 +Total assets: +Aviation Services +$ +1,205.8 +$ +1,057.0 +Expeditionary Services +130.2 +122.8 +Corporate and discontinued operations +188.7 +324.3 +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,524.7 +$ +1,504.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +70 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +For the Year Ended May 31, +2018 +2017 +2016 +Capital expenditures: +Aviation Services +$ +18.6 +$ +15.0 +$ +16.4 +Expeditionary Services +2.1 +2.0 +1.6 +Corporate +1.3 +8.2 +22.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total continuing operations +22.0 +25.2 +40.1 +Discontinued operations +5.0 +8.4 +48.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +27.0 +$ +33.6 +$ +89.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2018 +2017 +2016 +Depreciation and amortization: 1 +Aviation Services +$ +34.6 +$ +30.8 +$ +26.2 +Expeditionary Services +4.6 +5.0 +6.8 +Corporate +16.6 +10.9 +6.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total continuing operations +55.8 +46.7 +39.7 +Discontinued operations +7.3 +17.2 +18.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +63.1 +$ +63.9 +$ +57.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1 Includes +depreciation and amortization of stock-based compensation. +The +following table reconciles segment gross profit to income from continuing operations before provision for income taxes. +For the Year Ended May 31, +2018 +2017 +2016 +Segment gross profit +$ +294.6 +$ +263.4 +$ +233.1 +Selling, general and administrative +(208.6 +) +(181.1 +) +(157.6 +) +Other expenses +(0.9 +) +— +(0.4 +) +Interest expense +(8.0 +) +(5.3 +) +(6.4 +) +Interest income +0.1 +0.1 +0.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations before provision for income taxes +$ +77.2 +$ +77.1 +$ +68.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +71 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +The +U.S. Department of Defense, other U.S. government agencies and their contractors are our only customers representing 10% or more of total sales in any of the last three fiscal years. +Sales by segment for these customers are as follows: +For the Year Ended May 31, +2018 +2017 +2016 +Aviation Services +$ +224.4 +$ +260.2 +$ +301.1 +Expeditionary Services +79.9 +61.3 +65.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +304.3 +$ +321.5 +$ +366.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Percentage of total sales +17.4 +% +20.2 +% +24.0 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Sales +by type of product/service was as follows: +For the Year Ended May 31, +2018 +2017 +2016 +Aviation supply chain +$ +1,066.0 +$ +998.7 +$ +903.2 +Maintenance, repair and overhaul services +552.9 +486.7 +521.8 +Mobility products +112.5 +105.4 +100.4 +Airlift +16.9 +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,748.3 +$ +1,590.8 +$ +1,525.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Geographic Data +May 31, +2018 +2017 +Long-lived assets: +United States +$ +393.1 +$ +369.1 +Europe +103.3 +108.5 +Other +85.6 +40.3 +​ +​ +​ +​ +​ +​ +​ +​ +Total continuing operations +582.0 +517.9 +Discontinued operations +— +97.8 +​ +​ +​ +​ +​ +​ +​ +​ +$ +582.0 +$ +615.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Sales +to unaffiliated customers in foreign countries (including sales through foreign sales offices of domestic subsidiaries) were approximately $694.0 million (39.7% of total +sales), $595.4 million (37.4% of total sales) and $498.0 million (32.6% of total sales) in fiscal 2018, 2017 and 2016, respectively. +72 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +14. Legal Proceedings +We are not a party to any material pending legal proceeding (including any governmental or environmental proceeding) other than routine litigation incidental to our business except for +the following: +DynCorp International LLC v. AAR Airlift Group, Inc. +On September 5, 2015, DynCorp International LLC ("DynCorp") filed a complaint in the United States District Court for the Middle +District of Florida, Orlando Division (the "District Court"), accusing AAR Airlift Group, Inc. ("Airlift"), a wholly-owned subsidiary of AAR CORP., of misappropriation of DynCorp information, +including trade secrets, and other related allegations, in connection with the submission of proposals in response to the solicitation issued by the U.S. Department of State ("DoS") Bureau of +International Narcotics and Law Enforcement Affairs, Office of Aviation in support of the Worldwide Aviation Support Services program ("WASS"). +On +October 19, 2015, DynCorp filed an amended complaint with the District Court. On January 14, 2016, the District Court granted Airlift's motion to dismiss DynCorp's +amended complaint. On February 2, 2016, DynCorp appealed the District Court's order to the United States Court of Appeals for the Eleventh Circuit (the "Eleventh Circuit"). +On +November 21, 2016, the Eleventh Circuit reversed in part the District Court's dismissal of the amended complaint and remanded the case to the District Court for further +proceedings. +On +January 31, 2018, Airlift and DynCorp filed a joint notice of settlement, advising the District Court that they had reached an agreement in principle to resolve DynCorp's +lawsuit and that they expected to file a stipulation of dismissal with prejudice within 14 days. +On +February 1, 2018, the District Court entered an order dismissing the DynCorp lawsuit without prejudice, subject to the right of any party within 60 days to move the +court for the purpose of entering a stipulated form of a final order or judgment or, on good cause shown, to reopen the case for further proceedings. +On +June 20, 2018, the parties entered into a confidential settlement agreement to dismiss the lawsuit with prejudice without the payment of any money by either party. On +June 26, 2018, the District Court entered an order dismissing the lawsuit with prejudice. +Department of Justice Investigation +The U.S. Department of Justice ("DoJ"), acting through the U.S. Attorney's Office for the Southern District of Illinois, is conducting an +investigation of Airlift under the federal civil False Claims Act ("FCA"). The investigation relates to Airlift's performance of several contracts awarded by the U.S. Transportation Command concerning +the operations and maintenance of rotary-wing and fixed-wing aircraft in Afghanistan and Africa, as well as several U.S. Navy contracts. In June 2018, the DoJ informed Airlift that part of the +investigation was precipitated by a lawsuit filed under the qui tam provisions of the FCA by a former employee of Airlift. That lawsuit remains under seal. Airlift is cooperating with the DoJ +investigation. +73 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +15. Selected Quarterly Data (Unaudited) +The unaudited selected quarterly data for fiscal years ended May 31, 2018 and 2017 is as follows: +Fiscal 2018 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Full +Year +Sales +$ +397.9 +$ +420.6 +$ +456.3 +$ +473.5 +$ +1,748.3 +Gross profit +61.6 +70.7 +77.6 +84.7 +294.6 +Income from continuing operations +11.0 +13.3 +31.3 +18.1 +73.7 +Loss from discontinued operations 1 +(0.4 +) +(35.8 +) +(15.8 +) +(6.1 +) +(58.1 +) +Net income (loss) +10.6 +(22.5 +) +15.5 +12.0 +15.6 +Earnings (Loss) per share—basic: 2 +Continuing operations +0.32 +0.39 +0.91 +0.53 +2.14 +Discontinued operations +(0.01 +) +(1.05 +) +(0.46 +) +(0.18 +) +(1.70 +) +Earnings per share—basic +0.31 +(0.66 +) +0.45 +0.35 +0.44 +Earnings (Loss) per share—diluted: 2 +Continuing operations +0.32 +0.38 +0.90 +0.52 +2.11 +Discontinued operations +(0.01 +) +(1.05 +) +(0.46 +) +(0.18 +) +(1.70 +) +Earnings per share—diluted +0.31 +(0.67 +) +0.44 +0.34 +0.41 +Fiscal 2017 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Full +Year +Sales +$ +361.8 +$ +371.3 +$ +407.2 +$ +450.5 +$ +1,590.8 +Gross profit +59.5 +59.5 +66.5 +77.9 +263.4 +Income from continuing operations +11.6 +9.7 +14.4 +16.3 +52.0 +Income (Loss) from discontinued operations +(2.1 +) +2.4 +(0.7 +) +4.9 +4.5 +Net income +9.5 +12.1 +13.7 +21.2 +56.5 +Earnings (Loss) per share—basic: 2 +Continuing operations +0.34 +0.28 +0.43 +0.48 +1.53 +Discontinued operations +(0.06 +) +0.07 +(0.02 +) +0.14 +0.13 +Earnings per share—basic +0.28 +0.35 +0.41 +0.62 +1.66 +Earnings (Loss) per share—diluted: 2 +Continuing operations +0.34 +0.28 +0.42 +0.48 +1.51 +Discontinued operations +(0.06 +) +0.07 +(0.02 +) +0.14 +0.13 +Earnings per share—diluted +0.28 +0.35 +0.40 +0.62 +1.64 +1 Loss +from discontinued operations in fiscal 2018 includes pre-tax aircraft and other asset impairment charges of $54.2 million in the second +quarter and a goodwill impairment charge of $9.8 million in the third quarter. +2 The +earnings-per-share computation for the year is a separate, annual calculation. Accordingly, the sum of the quarterly earnings-per-share amounts does +not necessarily equal the earnings per share for the year. +74 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +16. Allowance for Doubtful Accounts +May 31, +2018 +2017 +2016 +Balance, beginning of year +$ +4.9 +$ +3.3 +$ +4.8 +Provision charged to operations +0.5 +2.1 +0.3 +Recoveries, deductions for accounts written off and other reclassifications +2.1 +(0.5 +) +(1.8 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, end of year +$ +7.5 +$ +4.9 +$ +3.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +75 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not Applicable. +ITEM 9A. CONTROLS AND PROCEDURES +As required by Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the "Act"), we conducted an evaluation of the +effectiveness of the design and operation of our disclosure controls and procedures as of May 31, 2018. This evaluation was carried out under the supervision and with the participation of our +Chief Executive Officer and Chief Financial Officer. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures. Therefore, effective disclosure controls +and procedures can only provide reasonable assurance of achieving their control objectives. Based upon our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our +disclosure controls and procedures are effective as of May 31, 2018, ensuring that information required to be disclosed in the reports that are filed under the Act is recorded, processed, +summarized and reported in a timely manner. +There +were no changes in our internal control over financial reporting during the three-month period ended May 31, 2018 that have materially affected, or are reasonably likely to +materially affect, our internal control over financial reporting. +MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Management of AAR CORP. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is +defined in Rules 13a-15(f) and 15d-15(f) of the Act. The Company's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles. Internal control systems, no matter how well designed, have inherent +limitations. Therefore, even those systems which are determined to be effective provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of +any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or +procedures may deteriorate. +Management +assessed the effectiveness of its internal control over financial reporting based on criteria for effective internal control over financial reporting described in the Internal +Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +Based +on our assessment, management concluded that the Company maintained effective internal control over financial reporting as of May 31, 2018. +KPMG LLP, +our independent registered public accounting firm, has issued a report on the effectiveness of our internal control over financial reporting. That report appears below. +76 +Table of Contents +Report of Independent Registered Public Accounting Firm +The +Board of Directors and Stockholders +AAR CORP.: +Opinion on Internal Control Over Financial Reporting +We have audited AAR CORP. and subsidiaries' (the Company) internal control over financial reporting as of May 31, 2018, based on the +criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway +Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of May 31, 2018, based on the criteria established in Internal Control—Integrated +Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Consolidated Balance Sheets of the Company as of +May 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the years in the three-year period ended May 31, +2018, and the related notes (collectively, the Consolidated Financial Statements), and our report dated July 11, 2018, expressed an unqualified opinion on those Consolidated Financial +Statements. +Basis for Opinion +The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the +effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion +on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company +in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We +conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective +internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over +financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit +also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting +includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets +of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable +assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +77 +Table of Contents +Because +of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future +periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +Chicago, Illinois +July 11, 2018 +78 +Table of Contents +ITEM 9B. OTHER INFORMATION +Not applicable. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information required by this item regarding the Directors of the Company and nominees for election of the Board is incorporated by reference +to the information contained under the caption "Information about Our Director Nominees and Our Continuing Directors" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +The +information required by this item regarding the Executive Officers of the Company appears under the caption "Supplemental Item: Executive Officers of the Registrant" following +Part I, Item 4 above. +The +information required by this item regarding the compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the information contained +under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +The +information required by this item regarding the identification of the Audit Committee as a separately-designated standing committee of the Board and the status of one or more members +of the Audit Committee being an "audit committee financial expert" is incorporated by reference to the information contained under the caption "Corporate Governance—Board Committees" in +our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +The +information required by this item regarding our Code of Business Ethics and Conduct applicable to our directors, officers and employees is incorporated by reference to the +information contained under the caption "Corporate Governance—Code of Business Ethics and Conduct" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +There +have been no material changes to the procedures by which stockholders may recommend nominees to the Company's board of directors. The information regarding these procedures is +incorporated by reference to the information contained under the caption "Corporate Governance—Director Nominations and Qualifications" in our definitive proxy statement for the 2018 +Annual Meeting of Stockholders. +ITEM 11. EXECUTIVE COMPENSATION +The information required by this item is incorporated by reference to the information contained under the following captions: +(a) "Executive Compensation—Compensation Committee's Report on Executive Compensation for Fiscal 2018," (b) "Executive Compensation—Summary Compensation Table," +(c) "Executive Compensation—Fiscal 2018 Grants of Plan-Based Awards," (d) "Executive Compensation—Outstanding Equity Awards at Fiscal Year End Table," +(e) "Executive Compensation—Fiscal 2018 Option Exercises and Stock Vested," (f) "Executive Compensation—Fiscal 2018 Pension Benefits," (g) "Executive +Compensation—Fiscal 2018 Non-Qualified Deferred Compensation," (h) "Executive Compensation—Potential Payments Upon Termination of Employment or Change in Control of the +Company," (i) "Corporate Governance—Director Compensation," and (j) "Corporate Governance—Compensation Committee Interlocks and Insider Participation" in our +definitive proxy statement for the 2018 Annual Meeting of Stockholders. +79 +Table of Contents +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information required by this item regarding security ownership of certain beneficial owners and management is incorporated by reference to +the information contained under the caption "Security Ownership of Management and Others" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +The +information required by this item regarding equity compensation plan information is incorporated by reference to the information contained under the caption "Equity Compensation Plan +Information" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information required by this item is incorporated by reference to the information contained under the captions "Corporate +Governance—Director Independence" and "Corporate Governance—Related Person Transaction Policy" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information required by this item is incorporated by reference to the information contained under the caption "Independent Registered Public +Accounting Firm Fees and Services" in our definitive proxy statement for the 2018 Annual Meeting of Stockholders. +80 +Table of Contents +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a)(1) Financial Statements +Our consolidated financial statements are as set forth under Item 8 of this report on Form 10-K. +(a)(2) Financial Statement Schedules +All schedules are omitted because they are not applicable, not required, or the information is included in the consolidated financial statements. +(a)(3) Exhibits +Management contracts and compensatory arrangements have been marked with an asterisk (*) on the Exhibit Index which is contained below: +Index +Exhibits +3. +Articles of Incorporation and By-Laws +3.1 +Restated Certificate of Incorporation. 6 +3.2 +By-Laws, as amended and restated through July 9, 2008. 14 +4. +Instruments defining the rights of security holders +4.1 +Restated Certificate of Incorporation (see Exhibit 3.1). +4.2 +By-Laws, as amended and restated through July 9, 2008 (See Exhibit 3.2). +4.3 +Form of 2.25% Convertible Senior Note due 2016. 12 +4.4 +Indenture for 2.25% Convertible Senior Notes due 2016 between AAR CORP. and U.S. Bank National Association, as trustee, dated as of February 11, +2008. 12 +4.5 +Indenture providing for Issuance of Debt Securities between AAR CORP. as Issuer and U.S. Bank National Association, as Trustee dated as of December 1, +2010. 17 +4.6 +Indenture providing for Issuance of Subordinated Debt Securities between AAR CORP. as Issuer and U.S. Bank National Association, as Trustee dated as of +December 1, 2010. 17 +81 +Table of Contents +Index +Exhibits +4.7 +Credit Agreement dated April 12, 2011 among AAR CORP., Bank of America National Association, as administrative agent, and the various financial +institutions party thereto, 18 as amended August 26, 2011 and October 13, 2011, 20 and as further amended on April 8, 2013 and April 24, 2013 21 and as further amended on March 24, +2015 27 and as further amended on November 1, 2016 29 and as further amended on February 28, 2018. 31 +4.8 +Indenture dated as of February 14, 2013 governing $30,000,000 of 1.75% Convertible Senior Notes due 2015, by and between AAR CORP., as Issuer, and U.S. +National Bank National Association, as Trustee. 22 +4.9 +Form of 1.75% Convertible Senior Notes due 2015. 25 +Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, the Registrant is not filing certain documents. The Registrant agrees to furnish a copy of each such document upon the request of the Commission. +10. +Material Contracts +10.1* +Amended and Restated AAR CORP. Stock Benefit Plan effective October 1, 2001, 3 as amended June 27, 2003, 4 May 5, 2005, +7 July 12, 2005, 8 June 23, 2006, 10 January 23, 2007, 10 January 27, 2007, 13 and July 11, 2011. 19 +10.2* +AAR CORP. Directors' Retirement Plan, dated April 14, 1992, 1 amended May 26, 2000 and April 10, 2001. 2 +10.3* +AAR CORP. Supplemental Key Employee Retirement Plan, as Amended and Restated effective July 10, 2017. 32 +10.4* +AAR CORP. Nonemployee Directors' Deferred Compensation Plan, as Amended and Restated effective July 10, 2017. 32 +10.5 +Indenture dated October 3, 2003 between AAR Distribution, Inc. and iStar Garden City LLC. 5 +82 +Table of Contents +Index +Exhibits +10.6 +Lease Agreement dated October 3, 2003 between AAR Allen Services, Inc., as tenant and iStar Garden City LLC, as Landlord, and related +Guaranty dated October 3, 2003 from Registrant to iStar Garden City LLC. 5 +10.7 +Lease Agreement by and between Indianapolis Airport Authority and AAR Aircraft Services, Inc. dated as of December 19, +2014. 28 +10.8* +Form of Non-Employee Director Non-Qualified Stock Option Agreement. 24 +10.9* +Form of Fiscal 2019 Director Restricted Stock Agreement (filed herewith). +10.10* +Form of Split Dollar Insurance Agreement. 9 +10.11 +Confirmation of OTC Convertible Note Hedge Transaction for 2016 Notes, dated February 5, 2008, by and between AAR CORP., and Merrill Lynch Financial +Markets, Inc. 11 +10.12 +Confirmation of OTC Warrant Transaction for 2016 Notes, dated February 5, 2008, by and between AAR CORP., and Merrill Lynch Financial Markets, +Inc. 11 +10.13* +Form of Directors' and Officers' Indemnification Agreement. 15 +10.14* +Employment Agreement dated as of April 18, 2017 between Registrant and David P. Storch. 16 +10.15* +Form of Policy for Recoupment of Incentive Compensation. 23 +10.16* +Section 162(m) Annual Cash Incentive Plan. 28 +10.17* +AAR CORP. 2013 Stock Plan. 28 and as amended July 11, 2016. 30 +10.18* +Amended and Restated Severance and Change in Control Agreement dated as of October 11, 2017 between AAR CORP. and Robert J. +Regan. 33 +10.19* +Severance and Change in Control Agreement dated as of October 11, 2017 between AAR CORP. and Michael D. Milligan. 33 +83 +Table of Contents +Index +Exhibits +10.20 +Credit Agreement among AAR CORP., as parent guarantor, AAR Canada Holdings ULC, as borrower, and Canadian Imperial Bank of Commerce, as lender, dated +as of October 18, 2017. 34 +10.21 +Purchase Agreement dated February 23, 2018 by and among AAR CORP., as seller representative and servicer, the sellers time to time party thereto, and +Citibank, N.A., as buyer. 35 +10.22 +First Amendment to Purchase Agreement dated as of May 22, 2018 by and among AAR CORP., as seller representative and servicer, the sellers time to +time party thereto, and Citibank, N.A., as buyer. 36 +10.23* +Retirement Agreement dated May 24, 2018 between AAR CORP. and David P. Storch. 36 +10.24* +Post-Retirement Agreement dated May 24, 2018 between AAR CORP. and David P. Storch. 36 +10.25* +Amended and Restated Employment Agreement dated as of May 24, 2018 between AAR CORP. and John M. Holmes. 36 +10.26* +Form of AAR CORP. Fiscal 2018 Short-Term Incentive Plan. 37 +10.27* +Form of AAR CORP. Fiscal 2018 Non-Qualified Stock Option Agreement. 37 +10.28* +Form of AAR CORP. Fiscal 2018 Restricted Stock Agreement. 37 +10.29* +Form of AAR CORP. Fiscal 2018 Performance Restricted Stock Agreement. 37 +21. +Subsidiaries of the Registrant +21.1 +Subsidiaries of AAR CORP. (filed herewith). +23. +Consents of experts and counsel +23.1 +Consent of Independent Registered Public Accounting Firm (filed herewith). +31. +Rule 13a-14(a)/15(d)-14(a) Certifications +31.1 +Section 302 Certification dated July 11, 2018 of John M. Holmes, President and Chief Executive Officer of Registrant (filed herewith). +84 +Table of Contents +Index +Exhibits +31.2 +Section 302 Certification dated July 11, 2018 of Michael D. Milligan, Vice President and Chief Financial Officer of Registrant (filed herewith). +32. +Rule 13a-14(b)/15d-14(b) Certifications +32.1 +Section 906 Certification dated July 11, 2018 of John M. Holmes, President and Chief Executive Officer of Registrant (filed herewith). +32.2 +Section 906 Certification dated July 11, 2018 of Michael D. Milligan, Vice President and Chief Financial Officer of Registrant (filed herewith). +101. +Interactive Data File +101 +The following materials from the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2018, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at May 31, 2018 and 2017, +(ii) Consolidated Statements of Income for the fiscal years ended May 31, 2018, 2017 and 2016 , (iii) Consolidated Statements of Comprehensive Income for fiscal years ended May 31, 2018, 2017 and 2016 (iv) Consolidated +Statements of Cash Flows for the fiscal years ended May 31, 2018, 2017 and 2016 , (v) Consolidated Statement of Changes in Equity for the three years ended May 31, 2018 and (vi) Notes to Consolidated Financial +Statements.** +Notes: +** Pursuant +to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration +statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of +1934, as amended, and otherwise are not subject to liability under those sections. +1 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 1992. +2 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2001. +3 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 2001. +4 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2003. +5 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 2003. +85 +Table of Contents +6 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2004. +7 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2005. +8 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended February 28, 2006. +9 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2006. +10 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2007. +11 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 11, 2008. +12 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 14, 2008. +13 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended February 29, 2008. +14 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated July 11, 2008. +15 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 2008. +16 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated April 18, 2017. +17 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 2010. +18 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated April 14, 2011. +19 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 2011. +20 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 11, 2011. +21 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated April 24, 2013. +22 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 10-Q for the quarterly period ended February 28, 2013. +23 Incorporated +by reference to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2012. +24 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2012. +25 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2013. +86 +Table of Contents +26 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2014. +27 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated March 24, 2015. +28 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2015. +29 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated November 1, 2016. +30 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 11, 2016. +31 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 28, 2018. +32 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form S-8 dated July 20, 2017. +33 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 13, 2017. +34 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 18, 2017. +35 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 28, 2018. +36 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated May 25, 2018. +37 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q dated September 20, 2017. +ITEM 16. FORM 10-K SUMMARY +Not applicable. +87 +Table of Contents +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this annual +report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. +AAR CORP. +(Registrant) +Date: July 11, 2018 +BY: +/s/ JOHN M. HOLMES +John M. Holmes +President and Chief Executive Officer +Pursuant +to the requirements of the Securities Exchange Act of 1934, this annual report on Form 10-K has been signed below by the following persons on behalf of the Registrant and +in the capacities and on the dates indicated. +Signature +Title +Date +/s/ JOHN M. HOLMES +John M. Holmes +President and Chief Executive Officer; Director (Principal Executive Officer) +/s/ MICHAEL D. MILLIGAN +Michael D. Milligan +Vice President and Chief Financial Officer (Principal Financial Officer) +/s/ ERIC S. PACHAPA +Eric S. Pachapa +Vice President, Controller and Chief Accounting Officer (Principal Accounting Officer) +/s/ DAVID P. STORCH +David P. Storch +Chairman of the Board; Director +/s/ ANTHONY K. ANDERSON +Anthony K. Anderson +Director +/s/ NORMAN R. BOBINS +Norman R. Bobins +Director +/s/ MICHAEL R. BOYCE +Michael R. Boyce +Director +/s/ JAMES E. GOODWIN +James E. Goodwin +Director +July 11, 2018 +/s/ PATRICK J. KELLY +Patrick J. Kelly +Director +/s/ DUNCAN J. MCNABB +Duncan J. McNabb +Director +/s/ PETER PACE +Peter Pace +Director +/s/ JENNIFER L. VOGEL +Jennifer L. Vogel +Director +/s/ MARC J. WALFISH +Marc J. Walfish +Director +/s/ RONALD B. WOODARD +Ronald B. Woodard +Director +88 \ No newline at end of file diff --git a/raw/filings/0000001750/2018/0001047469-18-004978/filing_metadata.csv b/raw/filings/0000001750/2018/0001047469-18-004978/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..ebc6d0d10cadcfdda802e4f19901d6a80c09d95f --- /dev/null +++ b/raw/filings/0000001750/2018/0001047469-18-004978/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000001750,AIR,AAR CORP,2018,10-K,2018-07-11,2018-05-31,2018-07-11T20:59:41.000Z,0001047469-18-004978,a2236183z10-k.htm,10-K,15543624,1,0,https://www.sec.gov/Archives/edgar/data/1750/000104746918004978/a2236183z10-k.htm,https://www.sec.gov/Archives/edgar/data/1750/000104746918004978/ diff --git a/raw/filings/0000001750/2018/0001047469-18-004978/item1.txt b/raw/filings/0000001750/2018/0001047469-18-004978/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..2de55a19c1f80f2c2664391e9903e633226526b3 --- /dev/null +++ b/raw/filings/0000001750/2018/0001047469-18-004978/item1.txt @@ -0,0 +1,167 @@ +ITEM 1. BUSINESS +General +AAR CORP. and its subsidiaries are referred to herein collectively as "AAR," "Company," "we," "us," and "our" unless the context indicates +otherwise. AAR was founded in 1951, organized in 1955 and reincorporated in Delaware in 1966. We are a diversified provider of products and services to the worldwide aviation and government and +defense markets. +Beginning +in fiscal 2015, we implemented a comprehensive strategic plan to narrow our strategy to focus on our best-in-class aviation and expeditionary services through our two business +segments: Aviation Services and Expeditionary Services. We sold our Telair Cargo Group for cash of $714 million, resulting in pre-tax gains of $198.6 million in the fourth quarter of +fiscal 2015 (and $27.7 million in the first quarter of fiscal 2016 from the receipt of contingent consideration). We used the proceeds from the sale in fiscal 2015 to reduce our total debt and +return capital to shareholders through common stock repurchases and dividends. +Through +execution of our strategic plan over the last three years, we have succeeded in expanding customer relationships and securing new flight hour component inventory management and +repair programs work with multiple international commercial customers and government customers. We also invested in our rotable assets to support these programs and continued our focus on expanding +our business development resources. These investments in our supply chain activities have allowed us to increase market share, expand our customer base, and enlarge our geographic footprint. +In +fiscal 2018, we began the ramp-up for the 15-year, U.S. Air Force Landing Gear Performance-Based Logistics One program. Under the program, we are providing total supply chain +management including purchasing, distribution and inventory control to support all landing gear components for the U.S. Air Force's fleet of C-130, KC-135 and E-3 aircraft. +In +fiscal 2018, we also began providing services to the U.S. Department of State ("DoS") under the INL/A Worldwide Aviation Support Services ("WASS") contract. This contract leverages +our capabilities in aviation services, including flight operations, supply chain logistics, and other services. We are the prime contractor on this 10-year performance-based contract to globally +operate and maintain the DoS fleet of fixed and rotary-wing aircraft. We successfully completed the transition and phase-in of +the WASS program in June 2018. We have full operational capability at all contract sites, which include Afghanistan, Iraq, Panama, Peru, and Patrick Air Force Base as well as support locations in +Brevard County, Florida. +Our +long-term strategy continues to emphasize the return of capital to shareholders. Over the past three years, we have returned $82.6 million to shareholders through common stock +repurchases of $51.7 million and dividends of $30.9 million. +We +remain in a strong financial position to further execute on our strategy in fiscal 2019. Both our commercial and government businesses are executing on our many contract wins and will +continue to deliver growth in fiscal 2019. Our cash on hand plus unused capacities on our Revolving Credit Facility and accounts receivable financing program was $473 million at May 31, +2018. We expect to invest opportunistically in expanding our comprehensive suite of services to the global commercial aviation and government and defense markets. We continue to have the flexibility +in our balance sheet allowing us to invest in our growth. As we generate positive cash flow, we will continue our strategy of returning capital to our shareholders without hampering our future +operating flexibility. +2 +Table of Contents +Business Segments +Aviation Services +The Aviation Services segment provides aftermarket support and services for the commercial aviation and government and defense markets and +accounted for 93% of our sales in fiscal 2018, 2017, and 2016. In this segment, we also provide inventory management and distribution services, maintenance, repair and overhaul ("MRO"), and +engineering services. Business activities in this segment are primarily conducted through AAR Supply Chain, Inc.; AAR Government Services, Inc.; AAR Aircraft & Engine +Sales & Leasing, Inc.; AAR Aircraft Services, Inc.; AAR Allen Services, Inc.; AAR Landing Gear LLC; and AAR International, Inc. +We +sell and lease a wide variety of new, overhauled and repaired engine and airframe parts and components and aircraft to our commercial aviation and government/defense customers. +We +provide customized flight hour component inventory and repair programs, warranty claim management, and outsourcing programs for engine and airframe parts and components in support of +our airline and government customers' maintenance activities. The types of services provided under these programs include material planning, sourcing, logistics, information and program management, +and parts and component repair and overhaul. We are also an authorized distributor for more than 70 product lines across over 25 leading aviation product manufacturers. +We +also provide customized performance-based supply chain logistics programs in support of the U.S. Department of Defense ("DoD") and foreign governments. The types of services provided +under these programs include material planning, sourcing, logistics, information and program management, airframe maintenance and maintenance planning, and component repair and overhaul. +We +provide major airframe inspection, maintenance, repair and overhaul, painting services, line maintenance, airframe modifications, structural repairs, avionic service and installation, +exterior and interior refurbishment, and engineering services and support for many types of commercial and military aircraft. We also repair and overhaul various components, landing gears, wheels, and +brakes for commercial and military aircraft. +We +operate seven airframe maintenance facilities and one landing gear overhaul facility. Our landing gear overhaul facility is in Miami, Florida, where we repair and overhaul landing +gear, wheels, brakes, and actuators for different types of commercial and military aircraft. Our U.S. airframe maintenance facilities are in Indianapolis, Indiana; Oklahoma City, Oklahoma; Duluth, +Minnesota; Miami, Florida; and Rockford, Illinois and our Canadian airframe maintenance facilities are in Trois Rivieres, Quebec and Windsor, Ontario. In addition, we also announced a joint venture +with Indamer Aviation which will develop and operate an airframe maintenance facility in India. The facility is currently under construction and is expected to begin operations in fiscal 2019. +The +majority of our product sales are made pursuant to standard commercial purchase orders. Government sales are generally made under standard types of government contracts which can +include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified services or the delivery of specified +products under indefinite delivery/indefinite quantity ("ID/IQ") arrangements. Certain inventory supply and management and performance-based logistics program agreements reflect negotiated terms and +conditions. +To +support activities within the Aviation Services segment, we acquire aviation parts and components from domestic and foreign airlines, independent aviation service companies, aircraft +leasing companies, +and original equipment manufacturers ("OEM"s). We have ongoing arrangements with OEMs that provide us access to parts, repair manuals, and service bulletins in support of parts manufactured by +them. Although the terms of each arrangement vary, they typically are made on standard OEM terms as to +3 +Table of Contents +duration, +price, and delivery. From time to time, we purchase engines for disassembly into individual parts and components. These engines may be leased to airlines on a short-term basis prior to +disassembly. +Expeditionary Services +The Expeditionary Services segment consists of businesses that primarily provide products and services supporting the movement of equipment and +personnel by the U.S. and foreign governments and non-governmental organizations. The Expeditionary Services segment accounted for 7% of our sales in fiscal 2018, 2017, and 2016. Business activities +in this segment are primarily conducted through AAR Airlift Group, Inc.; AAR Manufacturing, Inc. and Brown International Corporation. +We +provide fleet management and operations of customer-owned aircraft for the DoS under the INL/A WASS contract. We are the prime contractor on this ten-year performance-based contract +to globally operate and maintain the DoS fleet of fixed- and rotary-wing aircraft. +We +also design, manufacture, and repair transportation pallets and a wide variety of containers and shelters used in support of military and humanitarian tactical deployment activities. +The containers and shelters are used in numerous mission requirements, including armories, supply and parts storage, refrigeration systems, tactical operation centers, briefing rooms, laundry and +kitchen facilities, water treatment, and sleeping quarters. Shelters include both stationary and vehicle-mounted applications. +We +also provide engineering, design, and system integration services for specialized command and control systems and design and manufacture advanced composite materials for commercial, +business and military aircraft. +Sales +in this segment are generally made to customers pursuant to standard commercial purchase orders and contracts. Government sales are generally made under standard types of +government contracts which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified services +or the delivery of specified products under ID/IQ arrangements, however, the majority of our products and services are procured via definite contracts. +Raw Materials +Although we generated 60% of our fiscal 2018 sales from the sale of products, our businesses are generally engaged in limited manufacturing +activities and have minimal exposure to fluctuations in both the availability and pricing of raw materials. We purchase raw materials for our manufacturing operations, including steel, aluminum, +extrusions, balsa, and other necessary supplies from several vendors. Where necessary, we have been able to obtain raw materials and other inventory items from numerous sources for each segment at +competitive prices, terms, and conditions, and we expect to be able to continue to do so. +Terms of Sale +We generally sell our products and services under standard 30-day payment terms. On occasion, certain customers, principally foreign customers, +will negotiate extended payment terms of 60-90 days. Except for customary warranty provisions, customers neither have the right to return products nor do they have the right to extended +financing. Our government contracts may extend several years and include one or more base years and one or more option years. The government generally has the right not to exercise options to extend +or expand our contracts and may otherwise terminate, cancel, or modify some contracts at its convenience. +Customers +The principal customers for our products and services in the Aviation Services segment are domestic and foreign commercial airlines, domestic +and foreign freight airlines, regional and commuter airlines, +4 +Table of Contents +business +and general aviation operators, OEMs, aircraft leasing companies, aftermarket aviation support companies, the DoD and its contractors, and foreign military organizations or governments. In +the Expeditionary Services segment, our principal customers include the DoS, DoD and its contractors, foreign military organizations or governments, defense organizations, and OEMs. +Sales +of aviation products and services to our commercial airline customers are generally affected by such factors as the number, type and average age of aircraft in service, the levels +of aircraft utilization (e.g., frequency of schedules), the number of airline operators, the general economy, and the level of sales of new and used aircraft. Sales to the DoD and other +government agencies are subject to a number of factors, including the level of troop deployment worldwide, government funding, competitive bidding, and requirements generated by worldwide geopolitical +events. +We +primarily market and sell products and services through our own employees. In certain markets outside of the United States, we rely on foreign sales representatives to assist in the +sale of our products and services. +Sales to Government and Defense Customers +Sales to global government and defense customers (including sales to branches, agencies, and departments of the U.S. government) were +$428.8 million (24.5% of consolidated sales), $438.7 million (27.6% of consolidated sales) and $489.4 million (32.1% of consolidated sales) in fiscal 2018, 2017 and 2016, +respectively. Sales to branches, agencies, and departments of the U.S. government and their contractors were $304.3 million (17.4% of consolidated sales), $321.5 million (20.2% of +consolidated sales), and $366.1 million (24.0% of consolidated sales) in fiscal 2018, 2017, and 2016, respectively. +Sales +to government and defense customers are reported in each of our reportable segments (See Note 13 of Notes to Consolidated Financial Statements). Since such sales are +subject to competitive bidding and government funding, no assurance can be given that such sales will continue at levels previously experienced. The majority of our U.S. government sales are for +products and services supporting the DoD logistics and mobility strategy. Thus, our government contracts have changed, and may continue to change, with fluctuations in defense and other governmental +agency spending. Our government contracts are also subject to termination by the customer; in the event of such a +termination, we are entitled to recover all allowable costs incurred by us through the date of termination. +Government Regulation and Certificates +The Federal Aviation Administration ("FAA") regulates the manufacture, repair, and operation of all aircraft and aircraft parts operated in the +United States. Similar rules and regulatory authorities exist in other countries. The inspection, maintenance and repair procedures for the various types of aircraft and equipment are prescribed by +these regulatory authorities and can be performed only by certified repair facilities utilizing certified technicians. The FAA requires that various maintenance routines be performed on aircraft +engines, certain engine parts, and airframes at regular intervals based on take off and landing cycles or flight time. Our businesses which sell defense products and services directly to the U.S. +government or through its contractors can be subject to various laws and regulations governing pricing and other factors. +We +have 13 FAA certificated repair stations in the United States, Canada, and Europe. Of the 13 certificated FAA repair stations, seven are also European Aviation Safety Agency +("EASA") and four are also Transport Canada Civil Aviation ("TCCA") certificated repair stations. Such certificates, which are ongoing in duration, are required for us to perform authorized +maintenance, repair and overhaul services for our customers and are subject to revocation by the government for non-compliance with applicable regulations. Of the 13 FAA certificated repair stations, +12 are in the Aviation Services segment and one is held by our Contractor-Owned, Contractor-Operated business ("COCO") which is classified as a discontinued operation as the COCO business is currently +held for sale. The EASA and TCCA certificated +5 +Table of Contents +repair +stations are in the Aviation Services segment. We also hold a FAR Part 135 certificate to operate aircraft for our expeditionary airlift services business. We are also Commercial Airlift +Review Board certified with the DoD. We believe that we possess all licenses and certifications that are material to the conduct of our business. +Competition +Competition in each of our markets is based on quality, ability to provide a broad range of products and services, speed of delivery, and price. +Competitors in our Aviation Services segment include OEMs, the service divisions of large commercial airlines, and other independent suppliers of parts, repair, and overhaul services to the commercial +and defense markets. Our Expeditionary Services segment competes with domestic and foreign contracting companies and a number of divisions of large corporations and other large and small companies. +Although certain of our competitors have substantially greater financial and other resources than we do, we believe that we have maintained a satisfactory competitive position through our +responsiveness to customer needs, our attention to quality, and our unique combination of market expertise and technical and financial capabilities. +Backlog +Backlog represents the amount of revenue that we expect to derive from unshipped orders or signed contracts. At May 31, 2018, backlog was +approximately $1,053 million compared to $519 million at May 31, 2017 which reflects the significant new commercial and government contract awards received over the last twelve +months. Approximately $510 million of our May 31, 2018 backlog is expected to be filled in fiscal 2019. +Employees +At May 31, 2018, we employed approximately 5,000 employees worldwide, of which approximately 155 employees are subject to a +collective bargaining agreement. We also retain approximately 775 contract workers, the majority of whom are located at our airframe maintenance facilities. +Available Information +For additional information concerning our business segments, see Item 7, "Management's Discussion and Analysis of Financial Condition and +Results of Operations" and "Business Segment Information" in Note 13 of Notes to Consolidated Financial Statements under Item 8, "Financial Statements and Supplementary Data." +Our +internet address is www.aarcorp.com. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable +after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Information contained on our web site is not a part of this report. +6 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000001750/2018/0001047469-18-004978/item13.txt b/raw/filings/0000001750/2018/0001047469-18-004978/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..7e663b95834b799039d5eeb0d609f3d98239026e --- /dev/null +++ b/raw/filings/0000001750/2018/0001047469-18-004978/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +80 \ No newline at end of file diff --git a/raw/filings/0000001750/2019/0001047469-19-004266/filing.txt b/raw/filings/0000001750/2019/0001047469-19-004266/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..e5d96010aca71a918b4e7fb3eca59dae4ac7e32f --- /dev/null +++ b/raw/filings/0000001750/2019/0001047469-19-004266/filing.txt @@ -0,0 +1,9590 @@ +10-K +1 +a2239223z10-k.htm +10-K +Use these links to rapidly review the document +TABLE OF CONTENTS +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +(Mark One) +ý +Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the fiscal year ended May 31, 2019 +or +o +Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the transition period +from to +Commission file number 1-6263 +AAR CORP. +(Exact name of registrant as specified in its charter) +Delaware +36-2334820 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer Identification No.) +One AAR Place, 1100 N. Wood Dale Road, Wood Dale, Illinois 60191 +(Address of principal executive offices, including zip code) +Registrant's +telephone number, including area code: (630) 227-2000 +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class +Trading Symbol(s) +Name of Each Exchange on Which Registered +Common Stock, $1.00 par value +AIR +New York Stock Exchange +Chicago Stock Exchange +Securities +registered pursuant to Section 12(g) of the Act: None +Indicate +by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ý No o +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. +Yes o No ý +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of +1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of +Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes ý No o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an +emerging growth company. See definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.: +Large accelerated filer ý +Accelerated filer o +Non-Accelerated filer o +Smaller reporting company o +Emerging growth company o +If +an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period prior to complying with any new or revised financial +accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). +Yes o No ý +The aggregate market value of the registrant's voting stock held by nonaffiliates was approximately $1,449 million (based upon the closing price of the +Common Stock at November 30, 2018 as reported on the New York Stock Exchange). +On +June 28, 2019, there were 34,826,115 shares of Common Stock outstanding. +Documents Incorporated by Reference +Portions of the Company's proxy statement for the Company's 2019 Annual Meeting of Stockholders, to be held September 24, 2019, are incorporated by +reference in Part III of this report. +Table of Contents +TABLE OF CONTENTS +Page +PART I +Item 1. +Business +2 +Item 1A. +Risk Factors +7 +Item 1B. +Unresolved Staff Comments +14 +Item 2. +Properties +14 +Item 3. +Legal Proceedings +15 +Item 4. +Mine Safety Disclosures +15 +Supplemental Item—Executive Officers of the Registrant +16 +PART II +Item 5. +Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +17 +Item 6. +Selected Financial Data +19 +Item 7. +Management's Discussion and Analysis of Financial Condition and Results of Operations +21 +Item 7A. +Quantitative and Qualitative Disclosures about Market Risk +36 +Item 8. +Financial Statements and Supplementary Data +37 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +83 +Item 9A. +Controls and Procedures +83 +Item 9B. +Other Information +88 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +88 +Item 11. +Executive Compensation +88 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +89 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +89 +Item 14. +Principal Accounting Fees and Services +89 +PART IV +Item 15. +Exhibits, Financial Statement Schedules +90 +EXHIBIT INDEX +Item 16. +Form 10-K Summary +96 +SIGNATURES +1 +Table of Contents +PART I +ITEM 1. BUSINESS +General +AAR CORP. and its subsidiaries are referred to herein collectively as "AAR," "Company," "we," "us," and "our" unless the context indicates +otherwise. AAR was founded in 1951, organized in 1955 and reincorporated in Delaware in 1966. We are a diversified provider of products and services to the worldwide aviation and government and +defense markets. +Fiscal +2019 was a year focused on growth and execution of a number of important programs and strategic initiatives. We succeeded in building customer relationships with multiple +international commercial and government customers. Our parts supply activities were extremely strong and we also invested to support our growth. +In +fiscal 2019, we completed the ramp-up of the INL/A Worldwide Aviation Support Services ("INL/A WASS") contract for the U.S. Department of State ("DoS"). This contract leverages our +capabilities in aviation services, including flight operations, supply chain logistics, and other services. We are the prime contractor on this 10-year performance-based contract to globally operate +and maintain the DoS fleet of fixed- and rotary-wing aircraft. We have full operational capability at all contract sites, which include Afghanistan, Iraq, Panama, Peru, Costa Rica and Patrick Air +Force Base as well as support locations in Brevard County, Florida. +We +also completed the ramp-up of the 15-year, U.S. Air Force Landing Gear Performance-Based Logistics One program. Under the program, we are providing total supply chain management +including purchasing, distribution, and inventory control to support all landing gear components for the U.S. Air Force's fleet of C-130, KC-135 and E-3 aircraft. +We +also entered into an agreement to sell certain contracts and assets of our Contractor-Owned, Contractor-Operated business ("COCO"), which is classified as a discontinued operation. We +expect the sale to close before the end of calendar 2019. The exit of this business is consistent with the realignment of our strategy. +Our +long-term strategy continues to emphasize investing in the business as well as returning capital to shareholders. Over the past three years, we have returned $74.2 million to +shareholders through common stock repurchases of $43.2 million and dividends of $31.0 million. Our cash on hand plus unused capacities on our Revolving Credit Facility and accounts +receivable financing program was $465 million at May 31, 2019. +Business Segments +Aviation Services +The Aviation Services segment provides aftermarket support and services for the commercial aviation and government and defense markets and +accounted for approximately 95% of our sales in fiscal 2019, 2018, and 2017. In this segment, we also provide inventory management and distribution services, maintenance, repair and overhaul ("MRO"), +and engineering services. Business activities in this segment are primarily conducted through AAR Supply Chain, Inc.; AAR Government Services, Inc.; AAR Aircraft & Engine +Sales & Leasing, Inc.; AAR Aircraft Services, Inc.; AAR Allen Services, Inc.; AAR Landing Gear LLC; AAR Airlift Group, Inc.; and AAR +International, Inc. +We +sell and lease a wide variety of new, overhauled and repaired engine and airframe parts and components and aircraft to our commercial aviation and government/defense customers. +We +provide customized flight hour component inventory and repair programs, warranty claim management, and outsourcing programs for engine and airframe parts and components in support of +our +2 +Table of Contents +airline +and government customers' maintenance activities. The types of services provided under these programs include some or all of the following functions: material planning, sourcing, logistics, +information and program management, and parts and component repair and overhaul. We are also an authorized distributor for more than 90 product lines across approximately 25 aviation original +equipment manufacturers ("OEM"s). +We +provide fleet management and operations of customer-owned aircraft for the DoS under the INL/A WASS contract. We are the prime contractor on this ten-year performance-based contract +to globally operate and maintain the DoS fleet of fixed- and rotary-wing aircraft. +We +also provide customized performance-based supply chain logistics programs in support of the U.S. Department of Defense ("DoD") and foreign governments. The types of services provided +under these programs include some or all of the following functions: material planning, sourcing, logistics, information and program management, airframe maintenance and maintenance planning, and +component repair and overhaul. +We +provide major airframe inspection, maintenance, repair and overhaul, painting services, line maintenance, airframe modifications, structural repairs, avionic service and installation, +exterior and interior refurbishment, and engineering services and support for many types of commercial and military aircraft. We also repair and overhaul various components, landing gears, wheels, and +brakes for commercial and military aircraft. +We +operate seven airframe maintenance facilities and one landing gear overhaul facility. Our landing gear overhaul facility is in Miami, Florida, where we repair and overhaul landing +gear, wheels, brakes, and actuators for different types of commercial and military aircraft. Our U.S. airframe maintenance facilities are in Indianapolis, Indiana; Oklahoma City, Oklahoma; Duluth, +Minnesota; Miami, Florida; and Rockford, Illinois and our Canadian airframe maintenance facilities are in Trois Rivieres, Quebec and Windsor, Ontario. During fiscal 2019, we repositioned certain +elements of our workforce across our network of airframe maintenance facilities to optimize staffing levels. In addition, we have a joint venture with Indamer Aviation to develop and operate an +airframe maintenance facility in India. The facility construction is expected to be completed in fiscal 2020. +The +majority of our product sales are made pursuant to standard commercial purchase orders. Government sales are generally made under standard types of government contracts, which can +include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. For cost plus fixed fee contracts, we typically receive reimbursement of our costs, to the extent +the costs are allowable under contractual and regulatory provisions, in addition to receiving a fixed fee. Some of our contracts call for the performance of specified services or the delivery of +specified products under indefinite delivery/indefinite quantity ("ID/IQ") arrangements. Certain inventory supply and management and performance-based logistics program agreements reflect negotiated +terms and conditions. +To +support activities within the Aviation Services segment, we acquire aviation parts and components from domestic and foreign airlines, independent aviation service companies, aircraft +leasing companies, +and OEMs. We have ongoing arrangements with OEMs that provide us access to parts, repair manuals, and service bulletins in support of parts manufactured by them. Although the terms of each +arrangement vary, they typically are made on standard OEM terms as to duration, price, and delivery. From time to time, we purchase airframes and engines for disassembly into individual parts and +components. Airframes and engines may also be leased to airlines on a short-term basis prior to disassembly or sale. +Expeditionary Services +The Expeditionary Services segment primarily consists of businesses that provide products and services supporting the movement of equipment and +personnel by the U.S. and foreign governments and non-governmental organizations. The Expeditionary Services segment accounted for approximately 5% of +3 +Table of Contents +our +sales in fiscal 2019, 2018, and 2017. Business activities in this segment are primarily conducted through AAR Manufacturing, Inc. and Brown International Corporation. +We +design, manufacture, and repair transportation pallets and a wide variety of containers and shelters used in support of military and humanitarian tactical deployment activities. The +containers and shelters are used in numerous mission requirements, including armories, supply and parts storage, refrigeration systems, tactical operation centers, briefing rooms, laundry and kitchen +facilities, water treatment, and sleeping quarters. Shelters include both stationary and vehicle-mounted applications. +We +also provide engineering, design, and system integration services for specialized command and control systems and design and manufacture advanced composite materials for commercial, +business and military aircraft. +Sales +in this segment are generally made to customers pursuant to standard commercial purchase orders and contracts. Government sales are generally made under standard types of +government contracts, which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified +services or the delivery of specified products under ID/IQ arrangements, however, the majority of our products and services are procured via definite contracts. +Raw Materials +Although we generated approximately 55% of our fiscal 2019 sales from the sale of products, our businesses are generally engaged in limited +manufacturing activities and have minimal exposure to fluctuations in both the availability and pricing of raw materials. We purchase raw materials for our manufacturing operations, including steel, +aluminum, extrusions, balsa, and other necessary supplies from several vendors. Where necessary, we have been able to obtain raw materials and other inventory items from numerous sources for each +segment at competitive prices, terms, and conditions, and we expect to be able to continue to do so. +Terms of Sale +We generally sell our products and services under standard 30-day payment terms. On occasion, certain customers will negotiate extended payment +terms of 60-90 days. Except for customary warranty provisions, customers neither have the right to return products nor do they have the right to extended financing. Our government contracts may +extend several years and include one or more base years and one or more option years. The government generally has the right not to exercise options to extend or expand our contracts and may otherwise +terminate, cancel, or modify some contracts at its convenience. +Customers +The principal customers for our products and services in the Aviation Services segment are domestic and foreign passenger airlines, domestic and +foreign cargo airlines, regional and commuter airlines, business and general aviation operators, OEMs, aircraft leasing companies, aftermarket aviation support companies, the DoD and its contractors, +the DoS, and foreign military organizations or governments. In the Expeditionary Services segment, our principal customers include the DoD and its contractors, foreign military organizations or +governments, defense organizations, and OEMs. +Sales +of aviation products and services to our commercial airline customers are generally affected by such factors as the number, type and average age of aircraft in service, the levels +of aircraft utilization +(e.g., frequency of schedules, flying hours, and take-off and landing cycles), the number of airline operators, the general economy, and the level of sales of new and used aircraft. Sales to +the DoD and other government agencies are subject to a number of factors, including the level of troop deployment +4 +Table of Contents +worldwide, +government funding, competitive bidding, and requirements generated by worldwide geopolitical events. +We +primarily market and sell products and services through our own employees. In certain markets outside of the United States, we rely on foreign sales representatives to assist in the +sale of our products and services. +Sales to Government and Defense Customers +Sales to global government and defense customers (including sales to branches, agencies, and departments of the U.S. government) were +$677.9 million (33.0% of consolidated sales), $428.9 million (24.5% of consolidated sales) and $438.8 million (27.6% of consolidated sales) in fiscal 2019, 2018 and 2017, +respectively. Sales to branches, agencies, and departments of the U.S. government and their contractors were $546.2 million (26.6% of consolidated sales), $304.3 million (17.4% of +consolidated sales) and $321.5 million (20.2% of consolidated sales) in fiscal 2019, 2018, and 2017, respectively. +Sales +to government and defense customers are reported in each of our reportable segments (See Note 13 of Notes to Consolidated Financial Statements). Since such sales are subject +to competitive bidding and government funding, no assurance can be given that such sales will continue at levels previously experienced. The majority of our U.S. government sales are for products and +services supporting the DoD logistics and mobility strategy and supporting DoS flight operations. Thus, our government contracts have changed, and may continue to change, with fluctuations in defense +and other governmental agency spending and requirements. Our government contracts are also often subject to termination for convenience by the customer; in the event of such a termination, we are +contractually entitled to recover all allowable costs incurred by us through the date of termination. +Government Regulation and Certificates +The Federal Aviation Administration ("FAA") regulates the manufacture, repair, and operation of all aircraft and aircraft parts operated in the +United States. Similar rules and regulatory authorities exist in other countries. The inspection, maintenance and repair procedures for the various types of aircraft and equipment are prescribed by +these regulatory authorities and can be performed only by certified repair facilities utilizing certified technicians. The FAA requires that various maintenance routines be performed on aircraft +engines, certain engine parts, and airframes at regular intervals based on take off and landing cycles or flight time. Our businesses, which sell defense products and services directly to the U.S. +government or through its contractors, can be subject to various laws and regulations governing pricing and other factors. +We +have 13 FAA certificated repair stations in the United States, Canada, and Europe. Of the 13 certificated FAA repair stations, seven are also European Aviation Safety Agency +("EASA") and four are also Transport Canada Civil Aviation ("TCCA") certificated repair stations. Such certificates, which are ongoing in duration, are required for us to perform authorized +maintenance, repair, and overhaul services for our customers and are subject to revocation by the government for non-compliance with applicable regulations. Of the 13 FAA certificated repair stations, +12 are in the Aviation Services segment and one is held by our COCO business, which is classified as a discontinued operation as it is currently held for sale. The EASA and TCCA certificated repair +stations are in the Aviation Services segment. Our COCO business also holds a FAR Part 135 certificate to operate aircraft for our expeditionary airlift services. We are also Commercial Airlift +Review Board certified with the DoD. We believe that we possess all licenses and certifications that are material to the conduct of our business. +Competition +Competition in each of our markets is based on quality, ability to provide a broad range of products and services, speed of delivery, and price. +Competitors in our Aviation Services segment include OEMs, +5 +Table of Contents +the +service divisions of large commercial airlines, and other independent suppliers of parts, repair, and overhaul services to the commercial and defense markets. Our Expeditionary Services segment +competes with domestic and foreign contracting companies and a number of divisions of large +corporations and other large and small companies. Although certain of our competitors have substantially greater financial and other resources than we do, we believe that we have maintained a +satisfactory competitive position through our responsiveness to customer needs, our attention to quality, and our unique combination of market expertise and technical and financial capabilities. +Backlog +Backlog represents the amount of revenue that we expect to derive from unshipped orders or signed contracts. At May 31, 2019, backlog was +approximately $1.5 billion and we expect that approximately 40% of this backlog will be recognized as revenue over the next 12 months, with the majority of the remaining balance +recognized as revenue over the next three years. +Employees +At May 31, 2019, we employed approximately 5,650 employees worldwide, of which approximately 200 employees are subject to a +collective bargaining agreement. We also retain approximately 900 contract workers, the majority of whom are located at our airframe maintenance facilities. +Available Information +For additional information concerning our business segments, see Item 7, "Management's Discussion and Analysis of Financial Condition and +Results of Operations" and "Business Segment Information" in Note 13 of Notes to Consolidated Financial Statements under Item 8, "Financial Statements and Supplementary Data." +Our +internet address is www.aarcorp.com. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable +after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Information contained on our web site is not a part of this report. +6 +Table of Contents +ITEM 1A. RISK FACTORS +The following is a description of the principal risks inherent in our business. +We are affected by factors that adversely impact the commercial aviation industry. +As a provider of products and services to the commercial aviation industry, we are greatly affected by overall economic conditions of that +industry. The commercial aviation industry is historically cyclical and has been negatively affected in the past by geopolitical events, high fuel and oil prices, lack of capital, and weak economic +conditions. As a result of these and other events, from time to time certain of our customers have filed for bankruptcy protection or ceased operation. The impact of instability in the global +financial markets may lead airlines to reduce domestic or international capacity. In addition, certain of our airline customers have in the past been impacted by tight credit markets, which limited +their ability to buy parts, services, engines, and aircraft. +A +reduction in the operating fleet of aircraft both in the U.S. and abroad will result in reduced demand for parts support and maintenance activities for the type of aircraft affected. +Further, tight credit conditions negatively impact the amount of liquidity available to buy parts, services, engines, and aircraft. A deteriorating airline environment may also result in additional +airline bankruptcies, and in such circumstances we may not be able to fully collect outstanding accounts receivable. Reduced demand from customers caused by weak economic conditions, including tight +credit conditions and customer bankruptcies, may adversely impact our financial condition or results of operations. +Our +business, financial condition, results of operations, and growth rates may be adversely affected by these and other events that impact the aviation industry, including the +following: +• deterioration in the financial condition of our existing and potential customers; +• reductions in the need for, or the deferral of, aircraft maintenance and repair services and spare parts support; +• retirement of older generation aircraft, resulting in lower prices for spare parts and services for those aircraft; +• reductions in demand for used aircraft and engines; +• increased in-house maintenance by airlines; +• lack of parts in the marketplace; +• acts of terrorism; +• future outbreaks of infectious diseases; and +• acts of God. +Our U.S. government contracts may not continue at present sales levels, which may have a material adverse +effect on our financial condition and results of operations. +Our sales to branches, agencies and departments of the U.S. government and their contractors were $546.2 million (26.6% of consolidated +sales) in fiscal 2019 (See Note 13 of Notes to Consolidated Financial Statements). The majority of our U.S. government sales is for products and services supporting DoD logistics and mobility +strategy and DoS flight operations and are, therefore, subject to changes in defense and other governmental agency funding and spending. Our contracts with the U.S. government and their contractors +are typically agreements to provide products and services at a fixed price and have a term of one year or less, frequently subject to extension for one or more additional periods of one year at the +option of the government customer. Sales to agencies of the U.S. government and their contractors are +7 +Table of Contents +subject +to a number of factors, including the level of troop deployment worldwide, competitive bidding, U.S. government funding, requirements generated by world events, and budgetary constraints. +U.S. +government programs are subject to annual congressional budget authorization and appropriation processes. In recent years, U.S. government appropriations have been affected by +larger U.S. government budgetary issues and related legislation, including the statutory limit on the amount of permissible federal debt (the "debt ceiling"). These issues could negatively affect the +timely collection of our U.S. government invoices. +Future +congressional appropriation and authorization of defense spending and the application of sequestration remain marked by significant debate and an uncertain schedule. The federal +debt limit continues to be actively debated as plans for long-term national fiscal policy are discussed. The outcome of these debates could have a significant impact on defense spending broadly and +programs we support in particular. +If +there are funding delays and constraints, we may be required to continue to perform for some period of time on certain of our U.S. government contracts even if the U.S. government is +unable to make timely payments. Future budget cuts, including cuts mandated by sequestration, or future procurement decisions could result in reductions, cancellations, and/or delays of existing +contracts or programs which could adversely affect our results of operations and financial condition. +If we fail to comply with government procurement laws and regulations, we could lose business and be liable +for various penalties or sanctions. +We must comply with laws and regulations relating to the formation, administration, and performance of government contracts. In the U.S., these +laws and regulations include the Federal Acquisition Regulations, Defense Federal Acquisition Regulations, the Truth in Negotiations Act, Cost Accounting Standards, and laws, regulations, and orders +restricting the use and dissemination of classified information under the U.S. export control laws and the export of certain products and technical information and safeguarding of contractor +information systems. +In +addition, we are subject to U.S. government inquiries and investigations, including periodic audits of costs that we determine are reimbursable under government contracts. U.S. +government agencies routinely audit government contractors to review performance under contracts, cost structure and compliance with applicable laws, regulations, and standards, as well as the +adequacy of and compliance with internal control systems and policies, including the contractor's purchasing, property, estimating, compensation and management information systems. Any costs found to +be misclassified or inaccurately allocated to a specific contract are not reimbursable, and to the extent already reimbursed, must be refunded. Also, any inadequacies in our systems and policies could +result in payments being withheld, penalties and reduced future business. +U.S. +government rules allow contracting officers to impose contractual withholdings at no less than certain minimum levels if a contracting officer determines that one or more of a +contractor's business systems have one or more significant deficiencies. If a contracting officer were to impose such a withholding on us or even one of our prime contractors, it would increase the +risk that we would not be paid in full or paid timely. If future audit adjustments exceed our estimates, our profitability could be adversely affected. +If +a government inquiry or investigation uncovers improper or illegal activities, we could be subject to civil or criminal penalties or administrative sanctions, including contract +termination, fines, forfeiture of fees, suspension of payment and suspension or debarment from doing business with government agencies, any of which could materially adversely affect our reputation, +business, financial condition and results of operations. +8 +Table of Contents +We use estimates when accounting for long-term contracts and face risks of cost overruns and losses on +fixed-price contracts. +We sell certain of our products and services to our commercial, government, and defense customers under firm contracts providing for fixed unit +prices, regardless of costs incurred by us. The cost of producing products or providing services may be adversely affected by increases in the cost of labor, materials, fuel, overhead, and other +unknown variants, including manufacturing and other operational inefficiencies and differences between assumptions used by us to price a contract and actual results. Increased costs may result in cost +overruns and losses on such contracts, which could adversely affect our results of operations and financial condition. +We +recognize revenue on our long-term contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the services are +delivered, which generally requires estimates of total costs at completion, fees earned on the contract, or both. This estimation process is complex and involves significant judgment related to +assumptions on flight hours, component repair costs, labor hours and rates, and contract penalties and incentives. Adjustments to estimates are often required as work progresses, experience is gained +and additional information becomes known, even though the scope of the work required under the contract may not change. Any adjustment as a result of a change in estimate is recognized as events +become known. Changes in the underlying assumptions, circumstances or estimates could result in adjustments that may adversely affect our future financial results. +If our subcontractors or suppliers fail to perform their contractual obligations, our contract profitability +and our ability to win new contracts may be adversely affected. +We rely on subcontractors to perform a portion of the services we agree to provide our customers, and our suppliers provide necessary inventory +and component parts. A failure by one or more of our subcontractors or suppliers to satisfactorily provide on a timely basis the agreed-upon services or supplies may affect our ability to perform our +contractual obligations. Deficiencies in the performance of our subcontractors and/or suppliers could result in liquidated damages or our customer terminating our contract for default. A termination +for default could expose us to liability and adversely affect our financial performance and our ability to win new contract awards. +We are subject to significant government regulation and may need to incur significant expenses to comply with +new or more stringent governmental regulation. +The aviation industry is highly regulated by the FAA in the United States and equivalent regulatory agencies in other countries. Before we sell +any of our products that are to be installed in an aircraft, such as engines, engine parts and components, and airframe and accessory parts and components, they must meet certain standards of +airworthiness established by the FAA or the equivalent regulatory agencies in certain other countries. We operate repair stations that are licensed by the FAA and the equivalent regulatory agencies in +certain other countries, and hold certificates to operate aircraft. Specific regulations vary from country to country; although regulatory requirements in other countries are generally satisfied by +compliance with FAA requirements. New and more stringent governmental regulations may be adopted in the future that, if enacted, may have an adverse impact on us. +If +any of our material licenses, certificates, authorizations, or approvals were revoked or suspended by the FAA or equivalent regulatory agencies in other countries, our results of +operations and financial condition may be adversely affected. +Success at our airframe maintenance facilities is dependent upon continued outsourcing by the airlines. +We currently perform airframe maintenance, repair, and overhaul activities at seven leased locations. Revenues at these facilities fluctuate +based on demand for maintenance which, in turn, is driven by the +9 +Table of Contents +number +of aircraft operating and the extent of outsourcing of maintenance activities by airlines. In addition, certain airlines operate certain new fleet types and/or newer generation aircraft and we +may not have contractual arrangements to service these aircraft nor technicians trained and certified to perform the required airframe maintenance, repair, and overhaul activities. If either the +number of aircraft operating or the level of outsourcing of maintenance activities declines, we may not be able to execute our operational and financial plans at our maintenance, repair, and overhaul +facilities, which could adversely affect our results of operations and financial condition. +Our operations would be adversely affected by a shortage of skilled personnel or work stoppages. +We are dependent on an educated and highly skilled workforce because of the complex nature of many of our products and services. Furthermore, we +have a collective bargaining agreement covering approximately 200 employees. Our ability to operate successfully and meet our customers' demands could be jeopardized if we are unable to attract and +retain a sufficient number of skilled personnel, including qualified licensed mechanics, to conduct our business, or if we experience a significant or prolonged work stoppage. These and similar events +may adversely affect our results of operations and financial condition. +We operate in highly competitive markets, and competitive pressures may adversely affect us. +The markets for our products and services to our commercial, government, and defense customers are highly competitive, and we face competition +from a number of sources, both +domestic and international. Our competitors include aircraft manufacturers, aircraft component and parts manufacturers, airline and aircraft service companies, other companies providing maintenance, +repair and overhaul services, other aircraft spare parts distributors and redistributors. Some of our competitors have substantially greater financial and other resources than we have and others may +price their products and services below our selling prices. These competitive markets also create pressure on our ability to hire and retain qualified technicians and other skilled labor needs. We +believe that our ability to compete depends on superior customer service and support, on-time delivery, sufficient inventory availability, competitive pricing, and effective quality assurance +programs. +Our +government customers, including the DoD and DoS, may turn to commercial contractors, rather than traditional defense contractors, for certain work, or may utilize set asides such as +small business, women-owned, or minority-owned contractors or determine to source work internally rather than use us. We are also impacted by bid protests from unsuccessful bidders on new program +awards and task orders. Bid protests could result in significant expense for us, contract modifications, or the award decision being overturned and loss of the contract award. Even where a bid protest +does not result in the loss of an award, the resolution can extend the time until the contract activity can begin, and delay earnings. These competitive pressures, with potential impacts on both our +commercial and government business, could adversely affect our results of operations and financial condition. +We are exposed to risks associated with operating internationally. +We conduct our business in a number of foreign countries, some of which are politically unstable or subject to military or civil conflicts. +Consequently, we are subject to a variety of risks that are specific to international operations, including the following: +• military conflicts, civil strife, and political risks; +• export regulations that could erode profit margins or restrict exports; +• compliance with the U.S. Foreign Corrupt Practices Act, United Kingdom ("UK") Anti-bribery Act, and other anti-bribery and anti-corruption +laws; +• the burden and cost of compliance with foreign laws, treaties, and technical standards and changes in those regulations; +10 +Table of Contents +• contract award and funding delays; +• potential restrictions on transfers of funds; +• import and export duties and value added taxes; +• foreign exchange risk; +• transportation delays and interruptions; +• uncertainties arising from foreign local business practices and cultural considerations; and +• changes in U.S. policies on trade relations and trade policy, including implementation of or changes in trade sanctions, tariffs, and +embargoes. +In +addition, the UK held a referendum in 2016 in which voters approved an exit from the European Union ("EU") referred to as Brexit. There continues to be substantial uncertainty +regarding the economic impact of the UK's potential exit from the EU. Potential adverse consequences of Brexit include global market uncertainty, volatility in currency exchange rates, greater +restrictions on imports and exports between the UK and other countries and increased regulatory complexities. +While +we have adopted and will continue to adopt measures to reduce the potential impact of losses resulting from the risks of doing business internationally, such measures may not be +adequate, and the regions in which we operate might not continue to be stable enough to allow us to operate profitably or at all. +Acquisitions expose us to risks, including the risk that we may be unable to effectively integrate acquired +businesses. +We have completed multiple acquisitions over the past few years and we have discussions with third parties regarding acquisitions on a regular +basis. Acquisitions involve risks, including difficulties in integrating the operations and personnel, the effects of amortization of any acquired intangible assets and the potential impairment of +goodwill, and the potential loss of key employees of the acquired business. In addition, acquisitions often require substantial management resources and have the potential to divert our attention from +our existing business. For any businesses we may acquire in the future, we may not be able to execute our operational, financial, or integration plans for the acquired businesses, which could +adversely affect our results of operations and financial condition. +Market values for our aviation products fluctuate and we may be unable to recover our costs incurred on +engines, rotable components and other aircraft parts. +We make a number of assumptions when determining the recoverability of rotable components, engines, and other assets which are on lease, +available for lease, or supporting our long-term programs. These assumptions include historical sales trends, current and expected usage trends, replacement values, current and expected lease rates, +residual values, future demand, and future cash flows. Reductions in demand for these assets or declining market values, as well as differences +between actual results and the assumptions utilized by us when determining the recoverability of our aircraft, engines, and other assets could result in impairment charges in future periods, which +would adversely affect our results of operations and financial condition. +We may need to reduce the carrying value of our assets. +We own and distribute a significant amount of engines, aircraft parts and components, as well as own manufacturing facilities and joint venture +investments. The removal of aircraft from service or recurring losses in certain operations could require us to evaluate the recoverability of the carrying value of those assets and record an +impairment charge through earnings to reduce the carrying value. During the third quarter of fiscal 2019 and second quarter of fiscal 2018, we recognized impairment charges of $74.1 million +11 +Table of Contents +and +$54.2 million, respectively, related to assets included in our COCO business which is classified as a discontinued operation. In addition, if aircraft or engines for which we offer +replacement parts or supply repair and overhaul services are retired and there are fewer aircraft that require these parts or services, our revenues may decline. +We +make a number of assumptions when determining the recoverability of our assets including historical sales trends, current and expected usage trends, replacement values, current and +expected lease rates, residual values, future demand, and future cash flows. Differences between actual results and the assumptions utilized by us when determining the recoverability of our assets +could result in impairment charges in future periods, which would adversely affect our results of operations and financial condition. +We +have recorded goodwill and other intangible assets related to acquisitions. If we are unable to achieve the projected levels of operating results, it may be necessary to record an +impairment charge to reduce the carrying value of goodwill and related intangible assets. During the third quarter of fiscal 2018, we recognized a goodwill impairment charge of $9.8 million +related to our COCO business. Similarly, if we were to lose a key customer or if a regulator were to terminate any of our repair certificates at our airframe maintenance or landing gear facilities, we +might be required to record an impairment charge if we were unable to operate. +We are dependent upon continued availability of financing to manage our business and to execute our business +strategy, and additional financing may not be available on terms acceptable to us. +Our ability to manage our business and to execute our business strategy is dependent, in part, on the continued availability of debt and equity +capital. Access to the debt and equity capital markets may be limited by various factors, including the condition of overall credit markets, general economic factors, state of the aviation industry, +our financial performance, and credit ratings. Debt and equity capital may not continue to be available to us on favorable terms, or at all. Our inability to obtain financing on favorable terms could +adversely affect our results of operations and financial condition. +LIBOR, +the London interbank offered rate, is the basic rate of interest used in lending between banks on the London interbank market and is widely used as a reference for setting the +interest rate on loans globally. Interest rates under our Revolving Credit Facility are based partly on the LIBOR rate. LIBOR is currently expected to phase out by the end of 2021. It is unclear if at +that time LIBOR will cease to exist or if new methods of calculating LIBOR will be established such that it continues to exist after 2021. If the method for calculation of LIBOR changes, if LIBOR is +no longer available or if lenders have increased costs due to changes in LIBOR, we may suffer from potential increases in interest rates on our borrowings. Further, we may need to renegotiate our +credit facilities or any other borrowings that utilize LIBOR as a factor in determining the interest rate to replace LIBOR with the new standard that is established. +Our existing debt includes restrictive and financial covenants. +Certain financing arrangements, including our Revolving Credit Facility and our accounts receivable financing program, require us to comply with +various restrictive covenants and some contain financial covenants that require us to comply with specified financial ratios and tests. Our failure to meet these covenants could result in default +under these loan and debt agreements and may result in a cross-default under other debt agreements. In the event of a default and our inability to obtain a waiver of the default, all amounts +outstanding under our debt agreements could be declared immediately due and payable. Our failure to comply with these covenants could adversely affect our results of operations and financial +condition. +12 +Table of Contents +Our industry is susceptible to product and other liability claims, and claims not adequately covered by +insurance may adversely affect our financial condition. +Our business exposes us to possible claims for property damage and bodily injury or death which may result if an engine, engine part or +component, airframe part or accessory, or any other aviation product that we have sold, manufactured, or repaired fails, or if an aircraft we operated, serviced, or in which our products are +installed, has an accident. We carry substantial liability insurance in amounts that we believe are adequate for our risk exposure and commensurate with industry norms. However, claims may arise in +the future, and our insurance coverage may not be adequate to protect us in all circumstances. Additionally, we might not be able to maintain adequate insurance coverage in the future at an acceptable +cost. Any liability claim not covered by adequate insurance could adversely affect our results of operations and financial condition. +Our business could be negatively affected by cyber or other security threats or other disruptions. +Our business depends heavily on information technology and computerized systems to communicate and operate effectively. The Company's systems +and technologies, or those of third parties on which we rely, could fail or become unreliable due to equipment failures, software viruses, cyber threats, ransomware attacks, terrorist acts, natural +disasters, power failures or other causes. These threats arise in some cases as a result of our role as a defense contractor. +Cyber +security threats are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to our sensitive information, business e-mail +compromises, ransomware attacks, and other electronic security breaches, including at our customers, suppliers, subcontractors, and joint venture partners, that could lead to disruptions in mission +critical systems, unauthorized release of confidential or otherwise protected information, and corruption of data. +The +procedures and controls we utilize to monitor and mitigate these threats may not be sufficient to prevent security threats from materializing. If any of these events were to +materialize, the costs related to cyber or other security threats or disruptions may not be fully insured or indemnified and could have a material adverse effect on our reputation, operating results, +and financial condition. +Moreover, +expenditures incurred in implementing and maintaining cyber security and other procedures and controls could adversely affect our results of operations and financial condition. +We must comply with extensive environmental requirements, and any exposure to environmental liabilities may +adversely affect us. +Federal, state, and local requirements relating to the discharge and emission of substances into the environment, the disposal of hazardous +wastes, the remediation and abatement of contaminants, and other activities affecting the environment have had and may continue to have an impact on our operations. Management cannot assess the +possible effect of compliance with future environmental requirements or of future environmental claims for which we may not have adequate indemnification or insurance coverage. If we were required to +pay the expenses related to any future environmental claims for which neither indemnification nor insurance coverage were available, these expenses could have an adverse impact on our results of +operations and financial condition. +Future +environmental regulatory developments in the United States and abroad concerning environmental issues, such as climate change, could adversely affect our operations and increase +operating costs and, through their impact on our customers, reduce demand for our products and services. Actions may be taken in the future by the U.S. government, state governments within the United +States, foreign governments, or the International Civil Aviation Organization to regulate the emission of greenhouse gases by the aviation industry. The precise nature of any such requirements and +their applicability to us and our customers are difficult to predict, but the impact to us and the aviation industry would likely be +13 +Table of Contents +adverse +and could be significant, including the potential for increased fuel costs, carbon taxes or fees, or a requirement to purchase carbon credits. +We may need to make significant capital expenditures to keep pace with technological developments in our +industry. +The industries in which we participate are constantly undergoing development and change, and it is likely that new products, equipment, and +methods of repair and overhaul services will be introduced in the future. We may need to make significant expenditures to purchase new equipment and to train our employees to keep pace with any new +technological developments. These expenditures could adversely affect our results of operations and financial condition. +We identified material weaknesses in our internal controls which, if not remediated appropriately or timely, +could affect the reliability of our financial reporting and result in loss of investor confidence and adversely impact our stock price. +During the fourth quarter of fiscal 2019, we identified material weaknesses in internal control over financial reporting. Refer to +Part II, Item 9A for additional information. We have been implementing and will continue to implement measures designed to ensure that the control deficiencies contributing to the +material weaknesses are remediated; however, we cannot provide assurance that these measures will be successful. If we are unable to remediate the material weaknesses or are unable to otherwise +maintain effective internal control over financial reporting, our ability to report financial information timely and accurately could be adversely affected. As a result, we could lose investor +confidence and become subject to litigation or investigations, which could adversely affect our business, operations, and financial condition and our stock price. +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not Applicable. +ITEM 2. PROPERTIES +In the Aviation Services segment, we conduct parts supply activities from our headquarters in Wood Dale, Illinois, which we own. In addition to +warehouse space, this facility includes executive, sales and administrative offices. Our principal maintenance, repair, overhaul, engineering and other service activities for this segment are +conducted at U.S. facilities leased by us in Indianapolis, Indiana; Oklahoma City, Oklahoma; Miami, Florida; Medley, Florida; Duluth, Minnesota; and Rockford, Illinois and at Canadian facilities +leased by us in Trois Rivieres, Quebec and Windsor, Ontario. +We +also lease facilities in Garden City, New York; Melbourne, Florida; Jacksonville, Florida; Brussels, Belgium; London, England; and Crawley, England, and own a building near Schiphol +International Airport in the Netherlands to support activities in the Aviation Services segment. +Our +principal activities in the Expeditionary Services segment are conducted at facilities we lease in Huntsville, Alabama and Sacramento, California and own in Cadillac, Michigan; +Clearwater, Florida; and Goldsboro, North Carolina. +We +also operate sales offices that support all our activities and are leased in London, England; Crawley, England; Paris, France; Rio de Janeiro, Brazil; Tokyo, Japan; Shanghai, China; +Singapore, Republic of Singapore; and Dubai, UAE. +We +believe that our owned and leased facilities are suitable and adequate for our operational requirements. +14 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS +Department of Justice Investigation +The U.S. Department of Justice ("DoJ"), acting through the U.S. Attorney's Office for the Southern District of Illinois, is conducting an +investigation of AAR Airlift Group, Inc. ("Airlift"), a wholly-owned subsidiary of AAR CORP., under the federal civil False Claims Act ("FCA"). The investigation relates to Airlift's +performance of several contracts awarded by the U.S. Transportation Command concerning the operations and maintenance of rotary-wing and fixed-wing aircraft in Afghanistan and Africa, as well as +several U.S. Navy contracts. In June 2018, the DoJ informed Airlift that part of the investigation was precipitated by a lawsuit filed under the qui tam provisions of the FCA by a former employee of +Airlift. That lawsuit remains under seal. Airlift is cooperating with the DoJ investigation. +Self-Reporting of Potential Foreign Corrupt Practices Act Violations +The Company retained outside counsel to investigate possible violations of the Company's Code of Conduct, the U.S. Foreign Corrupt Practices +Act, and other applicable laws, relating to the Company's activities in Nepal and South Africa. Based on these investigations, we self-reported these matters to the DoJ, the U.S. Securities and +Exchange Commission and the UK Serious Fraud Office. The Company will fully cooperate in any review by these agencies, although we are unable at this time to predict what action, if any, they may +take. +ITEM 4. MINE SAFETY DISCLOSURES +Not +Applicable. +15 +Table of Contents +Supplemental Item: +EXECUTIVE OFFICERS OF THE REGISTRANT +Information concerning each of our executive officers is set forth below: +Name +Age +Present Position with the Company +John M. Holmes +42 +Chief Executive Officer and President, Director +Sean M. Gillen +33 +Vice President and Chief Financial Officer +Robert J. Regan +61 +Vice President, General Counsel and Secretary +Chris Jessup +41 +Vice President, Chief Commercial Officer +Eric S. Pachapa +46 +Vice President, Controller and Chief Accounting Officer +Mr. Holmes is Chief Executive Officer and President, having served in that capacity since June 2018. From June 2017 to May 2018, +Mr. Holmes served as President and Chief Operating Officer. From February 2015 to June 2017, Mr. Holmes served as Chief Operating Officer—Aviation Services. Prior to that, +Mr. Holmes served as Group Vice President, Aviation Services—Inventory Management and Distribution from 2012 to 2015, General Manager and Division President of our Allen Asset +Management business from 2003 to 2012, and in various +other positions since joining the Company in September 2001. Mr. Holmes has been a director of the Company since 2017. +Mr. Gillen is Vice President and Chief Financial Officer, having served in that capacity since January 2019. Prior to joining AAR, +Mr. Gillen was Vice President and Treasurer of USG Corporation since 2017. Prior to USG, Mr. Gillen spent nine years in investment banking with Goldman Sachs, most recently as a Vice +President in their Global Industrials Group. +Mr. Regan is Vice President, General Counsel and Secretary, having served in that capacity since June 2009. From 2008 to June 2009, +Mr. Regan served as Vice President and General Counsel and, prior to that, Associate General Counsel since joining AAR in February 2008. Prior to joining AAR, he was a partner at the law firm +of Schiff Hardin LLP since 1989. As previously announced, Mr. Regan will retire from the Company on December 31, 2019. +Mr. Jessup is Vice President, Chief Commercial Officer, having served in that capacity since June 2017. Mr. Jessup +previously served as Chief Commercial Officer for the Company's Aviation Services segment since February 2015, and prior to that, he served in various capacities within the Company's Maintenance, +Repair and Overhaul business. Prior to joining the Company in 2008, Mr. Jessup was Vice President, Sales and Marketing at Avborne Heavy Maintenance, Inc. in Miami, Florida. +Mr. Pachapa is Vice President, Controller and Chief Accounting Officer, having served in that capacity since July 2016. +Mr. Pachapa previously served as Controller since October 2015 and Senior Director of Accounting and Reporting since April 2014. Prior to joining the Company, Mr. Pachapa was with +Glanbia plc from 2011 to 2014, and with Ernst & Young LLP from 1996 to 2011. +Each +executive officer is elected annually by the Board of Directors. Executive officers continue to hold office until their successors are duly elected or until their death, +resignation, termination or reassignment. +16 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is traded on the New York Stock Exchange and the Chicago Stock Exchange under the symbol "AIR." On June 28, 2019, there +were approximately 900 holders of common stock, including participants in security position listings. +Stockholder Return Performance Graph +The following graph compares the total return on a cumulative basis of $100 invested, and reinvestment of dividends in our common stock on +May 31, 2014 to the Standard and Poor's ("S&P") 500 Index and the Proxy Peer Group: +Comparison of Cumulative Five Year Total Return +The +S&P 500 Index is comprised of domestic industry leaders in four major sectors: Industrial, Financial, Utility, and Transportation, and serves as a broad indicator of the +performance of the U.S. equity market. The Company's Fiscal 2019 Proxy Peer Group companies are listed as follows: +Aerojet Rocketdyne Holdings, Inc. +Hexcel Corporation +Barnes Group Inc. +Kaman Corporation +CACI International Inc +KLX Inc. +Crane Co. +Moog Inc. +Cubic Corporation +Science Applications International Corporation +Curtiss-Wright Corporation +Teledyne Technologies Incorporated +Engility Holdings, Inc. a +Triumph Group, Inc. +Esterline Technologies Corporation +Wesco Aircraft Holdings, Inc. +Heico Corporation +a New +peer group company added for fiscal 2019 due to its business and financial comparability to the Company. +Three +companies were removed from the prior year's peer group: Rockwell Collins was acquired and Transdigm Group, Inc. and Woodward, Inc. were judged no longer to be +suitable comparator companies. +17 +Table of Contents +The +Company annually revisits the composition of the peer group to ensure that the Company's performance is measured against those of comparably-sized and situated companies. The mix of +the +Company's commercial and government/defense markets presents a challenge in constructing a peer group, given that many government/defense contractors have substantially greater resources than the +Company. +Issuer Purchases of Equity Securities +The following table provides information about purchases of shares of our common stock that we made during the quarter ended May 31, +2019: +Period +Total Number +of Shares +Purchased +Average +Price Paid +per Share +Total Number +of Shares +Purchased as +Part of +Publicly +Announced +Plans or +Programs 1 +Approximate +Dollar Value +of Shares that +May Yet Be +Purchased +Under the +Plans or +Programs 1 +3/1/2019 - 3/31/2019 +194,281 +$ +32.84 +194,281 +4/1/2019 - 4/30/2019 +96,238 +32.40 +96,238 +5/1/2019 - 5/31/2019 +— +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +290,519 +$ +32.69 +290,519 +$ +226,630,799 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1 On +July 10, 2017, our Board of Directors authorized a new stock repurchase program providing for the repurchase of up to $250 million of +our common stock, with no expiration date. +18 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +(In millions, except per share amounts) +For the Year Ended May 31, +2019 +2018 +2017 +2016 +2015 +RESULTS OF OPERATIONS +Sales 1 +$ +2,051.8 +$ +1,748.3 +$ +1,590.8 +$ +1,525.4 +$ +1,448.0 +Gross profit 2 +329.5 +294.6 +263.4 +233.1 +152.8 +Operating income (loss) 2 +98.3 +86.0 +82.3 +75.5 +(31.2 +) +Loss on extinguishment of debt 3 +— +— +— +(0.4 +) +(44.9 +) +Interest expense +9.5 +8.0 +5.3 +6.4 +27.2 +Income (Loss) from continuing operations +84.1 +73.7 +52.0 +45.5 +(67.4 +) +Income (Loss) from discontinued operations 4 +(76.6 +) +(58.1 +) +4.5 +2.2 +77.6 +Net income +7.5 +15.6 +56.5 +47.7 +10.2 +Share data: +Earnings per share—basic: +Earnings (Loss) from continuing operations +$ +2.42 +$ +2.14 +$ +1.53 +$ +1.30 +$ +(1.73 +) +Earnings (Loss) from discontinued operations 4 +(2.22 +) +(1.70 +) +0.13 +0.07 +1.99 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic +$ +0.20 +$ +0.44 +$ +1.66 +$ +1.37 +$ +0.26 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted: +Earnings (Loss) from continuing operations +$ +2.40 +$ +2.11 +$ +1.51 +$ +1.30 +$ +(1.73 +) +Earnings (Loss) from discontinued operations 4 +(2.19 +) +(1.70 +) +0.13 +0.07 +1.97 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted +$ +0.21 +$ +0.41 +$ +1.64 +$ +1.37 +$ +0.24 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash dividends declared per share +$ +0.30 +$ +0.30 +$ +0.30 +$ +0.30 +$ +0.30 +Weighted average common shares outstanding—basic +34.5 +34.2 +33.9 +34.4 +39.1 +Weighted average common shares outstanding—diluted +34.9 +34.6 +34.3 +34.6 +39.4 +May 31, +2019 +2018 +2017 +2016 +2015 +FINANCIAL POSITION +Cash and cash equivalents +$ +21.3 +$ +31.1 +$ +10.3 +$ +31.2 +$ +54.7 +Working capital +595.0 +609.4 +553.4 +540.3 +456.9 +Total assets +1,517.2 +1,524.7 +1,504.1 +1,456.0 +1,454.1 +Total debt +142.9 +178.9 +156.2 +145.3 +154.0 +Equity +905.9 +936.3 +914.2 +865.8 +845.1 +Number of shares outstanding at end of year +34.8 +34.7 +34.4 +34.5 +35.4 +Book value per share of common stock +$ +26.03 +$ +26.98 +$ +26.58 +$ +25.10 +$ +23.87 +Notes: +1 At +the beginning of fiscal 2019, we adopted Accounting Standards Update No. 2014-09, Revenue from Contracts with +Customers ("ASC 606") using a modified retrospective method and as a result, the comparative information for prior years has not been restated and is reported under accounting +standards in effect for those years. See Note 1 of Notes to Consolidated Financial Statements for additional information. +2 In +fiscal 2015, we recognized $61.5 million in impairment charges and other losses related to product lines and inventories identified as +underperforming or not part of our strategy going forward. These +19 +Table of Contents +actions +included aircraft in our aircraft lease portfolio and inventory in our supply chain and MRO operations. We also recognized impairment charges of $25.6 million related to our composite +manufacturing operations. +3 In +fiscal 2015, we redeemed our $325 million 7.25% Senior Notes due 2022 for $370.6 million. We recognized a loss on extinguishment of debt +of $44.9 million comprised of a make-whole premium of $45.6 million and unamortized deferred financing costs of $6.2 million, partially offset by an unamortized net premium of +$6.9 million. +4 In +fiscal 2015, we sold our Telair Cargo Group for $725 million resulting in a $198.6 million pre-tax gain. We also recognized impairment +charges of $31.9 million in fiscal 2015 to reduce the carrying value of our metal machining business's net assets to their expected value at the time of sale. +In +fiscal 2016, we received contingent consideration from the sale of Telair Cargo Group and recognized a pre-tax gain of $27.7 million. +We +recognized pre-tax asset impairment charges related to our Contractor-Owned, Contractor-Operated ("COCO") business of $64.0 million and $74.1 million in fiscal 2018 and 2019, +respectively. +20 +Table of Contents +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +(Dollars in millions) +Forward-Looking Statements +Management's Discussion and Analysis of Financial Condition and Results of Operations contain certain statements relating to future results, +which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on the beliefs of management, as well +as assumptions and estimates based on information available to us as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties that could cause actual +results to differ materially from those anticipated, depending on a variety of factors, including those factors discussed under Item 1A, "Risk Factors." Should one or more of those risks or +uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. Those events and uncertainties are +difficult or impossible to predict accurately and many are beyond our control. We assume no obligation to update any forward-looking statements to reflect events or circumstances after the date of +such statements or to reflect the occurrence of anticipated or unanticipated events. +General Overview +We report our activities in two business segments: Aviation Services comprised of supply chain +and maintenance, repair and overhaul ("MRO") activities and Expeditionary Services comprised of manufacturing activities. +In +the first quarter of fiscal 2019, we re-aligned the composition of our operating segments to leverage the full breadth of our operational expertise in Aviation Services. Our +government-owned, contractor-operated operations (which includes the INL/A WASS program) were previously included in our Expeditionary Services segment and are now reported within our Aviation +Services segment for all periods presented. +The +Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and +government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to +the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance based logistics programs, customer fleet management and operations, and +aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of +product, direct labor, and overhead. +The +Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support +the U.S. military's requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. This segment also designs and +manufactures advanced composite materials for commercial, business and military aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead. +Our +chief operating decision making officer (Chief Executive Officer) evaluates performance based on the reportable segments and utilizes gross profit as a primary profitability measure. +Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments. Our reportable segments are +aligned principally around differences in products and services. +21 +Table of Contents +At +the beginning of fiscal 2019, we adopted Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers ("ASC 606") using a modified retrospective method and as +a result, the comparative information has not been restated and is reported under accounting standards in effect for those years. See Note 1 of Notes to Consolidated Financial Statements for +additional information. +Fiscal +2019 was a year focused on growth and execution of a number of important programs and strategic initiatives. We succeeded in building customer relationships with multiple +international commercial and government customers. Our parts supply activities were extremely strong and we also invested to support our growth. +In +fiscal 2019, we completed the ramp-up of the INL/A WASS contract for the DoS. This contract leverages our capabilities in aviation services, including flight operations, supply chain +logistics, and other services. We are the prime contractor on this 10-year performance-based contract to globally operate and maintain the DoS fleet of fixed- and rotary-wing aircraft. We have full +operational capability at all contract sites, which include Afghanistan, Iraq, Panama, Peru, Costa Rica and Patrick Air Force Base as well as support locations in Brevard County, Florida. +We +also completed the ramp-up of the 15-year, U.S. Air Force Landing Gear Performance-Based Logistics One program. Under the program, we are providing total supply chain management +including purchasing, distribution and inventory control to support all landing gear components for the U.S. Air Force's fleet of C-130, KC-135 and E-3 aircraft. +We +also entered into an agreement to sell certain contracts and assets of our COCO business, which is classified as a discontinued operation. We expect the sale to close before the end +of calendar 2019 and our exit of this business is consistent with the realignment of our strategy. +Our +long-term strategy continues to emphasize investing in the business as well as returning capital to shareholders. Over the past three years, we have returned $74.2 million to +shareholders through common stock repurchases of $43.2 million and dividends of $31.0 million. +Business Trends and Outlook for Fiscal 2020 +Consolidated sales for fiscal 2019 increased $303.5 million or 17.4% over the prior year primarily due to an increase in sales of +$284.8 million or 17.4% in our Aviation Services segment. This increase was driven by strong growth in our aviation supply chain activities including the INL/A WASS program, which achieved full +operational capability in June 2018. +For +fiscal 2020, we expect to see continued strength in our Aviation Services segment given its offerings of value-added services to both commercial and government and defense customers. +We believe long-term aftermarket growth trends are favorable. +We +remain in a strong financial position to further execute on our strategy in fiscal 2020. Both our segments are executing on our many contract wins across the commercial and government +markets. Our cash on hand plus unused capacities on our Revolving Credit Facility and accounts receivable financing program was $465 million at May 31, 2019. We expect to invest +opportunistically in support of our businesses and customers. We continue to have the flexibility in our balance sheet to invest in our growth. +22 +Table of Contents +Results of Operations—Fiscal 2019 Compared with Fiscal 2018 +Sales and gross profit for our two business segments for the two years ended May 31, 2019 and 2018 were as follows: +For the Year Ended May 31, +2019 +2018 +% Change +Sales: +Aviation Services +Commercial +$ +1,342.3 +$ +1,281.9 +4.7 +% +Government and defense +578.3 +353.9 +63.4 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,920.6 +$ +1,635.8 +17.4 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +31.6 +$ +37.5 +(15.7 +)% +Government and defense +99.6 +75.0 +32.8 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +131.2 +$ +112.5 +16.6 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2019 +2018 +% Change +Gross Profit: +Aviation Services +Commercial +$ +195.4 +$ +203.8 +(4.1 +)% +Government and defense +117.9 +71.5 +64.9 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +313.3 +$ +275.3 +13.8 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +3.0 +$ +8.3 +(63.9 +)% +Government and defense +13.2 +11.0 +20.0 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +16.2 +$ +19.3 +(16.1 +)% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services Segment +Sales in the Aviation Services segment increased $284.8 million or 17.4% over the prior year primarily due to a $224.4 million or +63.4% increase in sales to government and defense customers. The increase in sales to government and defense customers was primarily attributable to the INL/A WASS program, which achieved full +operational capability in June 2018. +During +fiscal 2019, sales in this segment to commercial customers increased $60.4 million or 4.7% over the prior year. The increase was primarily due to increased demand in our +supply chain activities. +Changes +in estimates and assumptions related to our programs accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. In fiscal 2019, +we recognized favorable and unfavorable cumulative catch-up adjustments of $8.0 million and $2.1 million, respectively, compared to favorable and unfavorable cumulative catch-up +adjustments of $11.6 million and $8.0 million, respectively, in fiscal 2018. When considering these adjustments on a net basis, we recognized favorable cumulative catch-up adjustments of +$5.9 million and $3.6 million for fiscal 2019 and 2018, respectively. These adjustments primarily relate to our long-term programs where we provide component inventory management and/or +repair services. +Cost +of sales in Aviation Services increased $246.8 million or 18.1% over the prior year which was in line with the sales increase discussed above. Gross profit in the Aviation +Services segment increased +23 +Table of Contents +$38.0 million +or 13.8% over the prior year. Gross profit on sales to government and defense customers increased $46.4 million or 64.9% over the prior year primarily driven by the INL/A +WASS program. The gross profit margin increased to 20.4% from 20.2% in the prior year primarily due to as a result of the mix of products and services sold. +Gross +profit in this segment on sales to commercial customers decreased $8.4 million or 4.1% from the prior year primarily driven by labor shortages in our MRO activities as we +were not able to secure an adequate supply of labor to meet current demand from our customers. The gross profit margin on sales to commercial customers was 14.6% compared to 15.9% in the prior year +with the decreased margin largely attributable to labor challenges at our airframe maintenance hangars. +Expeditionary Services Segment +Sales in the Expeditionary Services segment increased $18.7 million or 16.6% over the prior year primarily due to stronger demand for our +mobility products. Gross profit in the Expeditionary Services segment decreased $3.1 million or 16.1% from the prior year and gross profit margin decreased to 12.3% from 17.2% both primarily as +a result of the mix of products sold with lower sales volumes from our commercial customers. +Selling, General and Administrative Expenses +Selling, general and administrative expenses increased $7.3 million over the prior year. As a percent of sales, selling, general and +administrative expenses decreased to 10.5% from 11.9% in the prior year reflecting improved leverage of our existing cost structure to support the sales growth. +Interest Expense +Interest expense increased $1.5 million in fiscal 2019 as a result of higher interest rates on our Revolving Credit Facility. +Income Taxes +On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act (the "Tax Reform Act") which +significantly revised the U.S. corporate income tax system. The Tax Reform Act, among other things, reduced the corporate federal income tax rate to 21% from 35%, changed bonus depreciation +regulations and limited deductions for executive compensation. The income tax rate reduction in the Tax Reform Act was effective January 1, 2018, which resulted in a blended federal statutory +tax rate of 29.2% in fiscal 2018 and the fiscal 2019 federal statutory tax rate of 21.0%. +In +fiscal 2018, we re-measured our deferred tax assets and liabilities based on the tax rate at which they are expected to reverse in the future, which was either at a federal rate of +29.2% for reversals expected in fiscal 2018 or 21% for reversals in fiscal 2019 and subsequent years. During fiscal 2018, we recognized an income tax benefit of $14.1 million for the +re-measurement impact from applying the provisions of the Tax Reform Act. +Our +fiscal 2019 effective income tax rate for continuing operations was 5.5% compared to 4.5% in the prior year. In addition to the Tax Reform Act impacts discussed above, we also +recognized tax benefits of $5.1 million and $2.1 million in fiscal 2019 and 2018, respectively, related to the reversal of certain state valuation allowances based on the recoverability +of the net operating losses and other state deferred tax assets. The effective income tax rate for fiscal 2019 also includes a benefit of $4.7 million related to the recognition of previously +unrecognized uncertain tax positions and a tax benefit of $1.8 million related to tax provision to federal income tax return filing differences. +24 +Table of Contents +Discontinued Operations +During the third quarter of fiscal 2018, we decided to pursue the sale of our COCO business previously included in our Expeditionary Services +segment. Due to this strategic shift, the assets, liabilities, and results of operations of our COCO business were reported as discontinued operations for all periods presented. +Loss +from discontinued operations was $76.6 million in fiscal 2019 compared to a loss of $58.1 million in the prior year. The increase of $18.5 million was primarily +due to higher pre-tax impairment charges of $74.1 million in fiscal 2019 as compared to $64.0 million in fiscal 2018. +Results of Operations—Fiscal 2018 Compared with Fiscal 2017 +Sales and gross profit for our two business segments for the two years ended May 31, 2018 and 2017 were as follows: +For the Year Ended May 31, +2018 +2017 +% Change +Sales: +Aviation Services +Commercial +$ +1,281.9 +$ +1,114.9 +15.0 +% +Government and defense +353.9 +370.5 +(4.5 +)% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,635.8 +$ +1,485.4 +10.1 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +37.5 +$ +37.1 +1.1 +% +Government and defense +75.0 +68.3 +9.8 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +112.5 +$ +105.4 +6.7 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2018 +2017 +% Change +Gross Profit: +Aviation Services +Commercial +$ +203.8 +$ +183.1 +11.3 +% +Government and defense +71.5 +62.9 +13.7 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +275.3 +$ +246.0 +11.9 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services +Commercial +$ +8.3 +$ +8.2 +1.2 +% +Government and defense +11.0 +9.2 +19.6 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +19.3 +$ +17.4 +10.9 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services Segment +Sales in the Aviation Services segment increased $150.4 million or 10.1% over the prior year due to a $167.0 million or 15.0% +increase in sales to commercial customers. The increase in sales to commercial customers was primarily attributable to higher volumes in aviation supply chain activities driven by new contract awards. +During +fiscal 2018, sales in this segment to government and defense customers decreased $16.6 million or 4.5% from the prior year. The decrease was primarily due to the wind-down +of our KC-10 program. +25 +Table of Contents +Changes +in estimates and assumptions related to our programs accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. In fiscal 2018, +we recognized favorable and unfavorable cumulative catch-up adjustments of $11.6 million and $8.0 million, respectively, compared to favorable and unfavorable cumulative catch-up +adjustments of $9.2 million and $0.7 million, respectively, in fiscal 2017. When considering these adjustments on a net basis, we recognized favorable cumulative catch-up adjustments of +$3.6 million and $8.5 million for fiscal 2018 and 2017, respectively. These adjustments primarily relate to our long-term programs where we provide component inventory management and/or +repair services. +Cost +of sales in Aviation Services increased $121.1 million or 9.8% over the prior year which was in line with the sales increase discussed above. Gross profit in the Aviation +Services segment increased $29.3 million or 11.9% over the prior year. Gross profit on sales to commercial customers increased $20.7 million or 11.3% over the prior year primarily driven +by the higher volumes in aviation supply chain activities. The gross profit margin on sales to commercial customers was 15.9% compared to +16.4% in the prior year and was largely attributable to labor challenges at our airframe maintenance hangars. +Gross +profit in this segment on sales to government and defense customers increased $8.6 million or 13.7% from the prior year primarily due to improved profitability on new +contract awards including the start of our services on the INL/A WASS program on November 1, 2017. The gross profit margin increased to 20.2% from 17.0% primarily due to these new contract +awards. +Expeditionary Services Segment +Sales in the Expeditionary Services segment increased $7.1 million or 6.7% over the prior year primarily due to stronger demand for our +mobility products. Gross profit in the Expeditionary Services segment increased $1.9 million over the prior year primarily due to these higher volumes. +Selling, General and Administrative Expenses +Selling, general and administrative expenses increased $29.1 million in fiscal 2018 or 16.3% from the prior year primarily attributable +to supporting our sales growth, including increased personnel-related costs and business development activities. +Interest Expense +Interest expense increased $2.7 million in fiscal 2018 over the prior year primarily as a result of higher borrowings and higher interest +rates on our Revolving Credit Facility. We entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender (the "Credit Agreement") on October 18, 2017. The Credit +Agreement provided a Canadian $31 million term loan with the proceeds used to fund the acquisition of two MRO facilities in Canada from Premier Aviation. +Income Taxes +The income tax rate reduction in the Tax Reform Act resulted in a blended federal statutory tax rate for the Company of 29.2% in fiscal 2018 +compared to 35.0% in fiscal 2017. Due to the reduction in our tax rate in fiscal 2018 and in future years, we re-measured our deferred tax assets and liabilities based on the tax rate at which they +are expected to reverse in the future which resulted in an income tax benefit of $14.1 million in fiscal 2018. +Effective +June 1, 2017, we adopted Accounting Standards Update ("ASU") 2016-09 which requires excess tax benefits or deficiencies for restricted shares and stock options to be +recognized as income tax expense or benefit in the period shares vest or options are exercised rather than within equity. We recognized $2.9 million of excess tax benefits as an income tax +benefit during fiscal 2018. +26 +Table of Contents +Our +fiscal 2018 effective income tax rate for continuing operations was 4.5% compared to 32.6% in the prior year. In addition to the tax benefits discussed above, we also recognized a +tax benefit in fiscal 2018 of $2.1 million related to the reversal of certain state valuation allowances based on the recoverability of the net operating losses and other state deferred tax +assets. The effective income tax rate for fiscal 2017 includes a benefit of $2.2 million related to recognition of previously unrecognized uncertain tax positions. +Discontinued Operations +Loss from discontinued operations was $58.1 million in fiscal 2018 compared to income of $4.5 million in the prior year. The +decrease of $62.6 million was primarily due to goodwill and other asset impairment pre-tax charges of $65.2 million in fiscal 2018 and the completion of certain long-term customer +contracts in the second quarter of fiscal 2018. +Liquidity, Capital Resources and Financial Position +Our operating activities are funded and commitments met through the generation of cash from operations. In addition to operations, our current +capital resources include an unsecured Revolving Credit Facility and an accounts receivable financing program. Periodically, we may also raise capital through common stock and debt financings in the +public or private markets. We continually evaluate various financing arrangements, including the issuance of common stock or debt, which would allow us to improve our liquidity position and finance +future growth on commercially reasonable terms. Our continuing ability to borrow from our lenders and issue debt and equity securities to the public and private markets in the future may be negatively +affected by a number of factors, including the overall health of the credit markets, general economic conditions, airline industry conditions, geo-political events, and our operating performance. Our +ability to generate cash from operations is influenced primarily by our operating performance and changes in working capital. +At +May 31, 2019, our liquidity and capital resources included cash of $21.3 million and working capital of $595.0 million. +We +maintain a Revolving Credit Facility with various financial institutions, as lenders and Bank of America, N.A., as administrative agent for the lenders, which provides the Company an +aggregate revolving credit commitment amount of $500 million and matures November 1, 2021. The Company, under certain circumstances, has the ability to request an increase to the +revolving credit commitment by an aggregate amount of up to $250 million, not to exceed $750 million in total. +Borrowings +under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 100 to 200 basis points based on certain financial measurements if a Eurodollar Rate +loan, or at the offered fluctuating Base Rate plus 0 to 100 basis points based on certain financial measurements if a Base Rate loan. +Borrowings +outstanding under the Revolving Credit Facility at May 31, 2019 were $120.0 million and there were approximately $20.1 million of letters of credit +outstanding, which reduced the availability of the Revolving Credit Facility to $359.9 million. There are no other terms or covenants limiting the availability of the Revolving Credit Facility. +As +of May 31, 2019, we also had other financing arrangements that did not limit our availability on the Revolving Credit Facility including outstanding letters of credit of +$11.6 million and foreign lines of credit of $9.5 million. +On +October 18, 2017, we entered into the Credit Agreement with the Canadian Imperial Bank of Commerce, as lender. The Credit Agreement provided a Canadian $31 million term +loan with the proceeds used to fund the acquisition of two maintenance, repair, and overhaul facilities in Canada from Premier Aviation. The term loan is due in full at the expiration of the Credit +Agreement on November 1, 2021 unless terminated earlier pursuant to the terms of the Credit Agreement. Interest is payable monthly +27 +Table of Contents +on +the term loan at the offered fluctuating Canadian Dollar Offer Rate plus 125 to 225 basis points based on certain financial measurements if a Bankers' Acceptances loan, or at the offered +fluctuating Prime Rate plus 25 to 125 basis points based on certain financial measurements, if a Prime Rate loan. +On +February 23, 2018, we entered into a Purchase Agreement with Citibank N.A. ("Purchaser") for the sale, from time to time, of certain accounts receivable due from certain +customers (the "Purchase Agreement"). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million. The term of the Purchase Agreement runs through +February 22, 2020, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual +terms unless either party provides advance notice that they do not intend to extend the term. +As +of May 31, 2019 and 2018, we had sold $66.4 million and $61.2 million, respectively, of receivables to the Purchaser for which we had not yet collected payment +from the customer via our role as servicer for the Purchaser's receivables. We have collected cash of $19.8 million and $10.5 million as of May 31, 2019 and 2018, respectively, +which has been collected on behalf of the Purchaser and not yet remitted to the Purchaser. This cash collected was classified as Restricted cash on our Consolidated Balance Sheets. +At +May 31, 2019, we complied with all financial and other covenants under each of our financing arrangements. +Cash Flows—Fiscal 2019 Compared with Fiscal 2018 +Cash Flows from Operating Activities +Net cash provided from operating activities—continuing operations was $60.5 million in fiscal 2019 compared to +$55.8 million in fiscal 2018. The increase of $4.7 million was primarily attributable to increased cash receipts on new government programs largely offset by increased investments in +inventory and rotable assets to support sales growth. +Cash Flows from Investing Activities +Net cash used in investing activities—continuing operations was $18.5 million in fiscal 2019 compared to $38.6 million +in fiscal 2018. In fiscal 2018, we acquired the outstanding shares of two MRO facilities in Canada owned by Premier Aviation for approximately $24.8 million which included $22.9 million +paid at closing. +Cash Flows from Financing Activities +Net cash used in financing activities—continuing operations was $47.3 million in fiscal 2019 compared to cash provided by +financing activities of $11.7 million in fiscal 2018. The additional cash used of $59.0 million was primarily attributable to increased debt service in fiscal 2019 which included the +retirement of our industrial revenue bonds for $25 million. In addition, fiscal 2018 included the proceeds from a new term loan of $24.8 million to finance the acquisition of the two +Canadian MRO facilities previously discussed. +Cash Flows—Fiscal 2018 Compared with Fiscal 2017 +Cash Flows from Operating Activities +Net cash provided from operating activities—continuing operations was $55.8 million in fiscal 2018 compared to a use of cash +of $13.5 million in fiscal 2017. The increase of $69.3 million was primarily attributable to the new Purchase Agreement entered into during the third quarter of fiscal 2018 for the sale +of certain accounts receivable. During fiscal 2018, we sold $239.6 million of receivables to the Purchaser and collected $178.4 million on behalf of the Purchaser. +28 +Table of Contents +Cash Flows from Investing Activities +Net cash used in investing activities—continuing operations was $38.6 million in fiscal 2018 compared to $33.9 million +in fiscal 2017. In fiscal 2018, we acquired the outstanding shares of two MRO facilities in Canada owned by Premier Aviation for approximately $24.8 million which included $22.9 million +paid at closing. During fiscal 2017, we acquired the trading business of ACLAS Global Limited ("ACLAS") for $12.0 million paid at closing with $3.0 million in deferred consideration +payable over the next three years. +Cash Flows from Financing Activities +Net cash provided from financing activities—continuing operations was $11.7 million in fiscal 2018 compared to cash used of +$10.4 million in fiscal 2017. The additional cash provided of $22.1 million was primarily attributable to proceeds from a new term loan of $24.8 million to finance the acquisition +of the two Canadian MRO facilities previously discussed. +Contractual Obligations and Off-Balance Sheet Arrangements +A summary of contractual cash obligations and off-balance sheet arrangements as of May 31, 2019 is as follows: +Payments Due by Period +Total +Due in +Fiscal +2020 +Due in +Fiscal +2021 +Due in +Fiscal +2022 +Due in +Fiscal +2023 +Due in +Fiscal +2024 +After +Fiscal +2025 +On Balance Sheet: +Bank borrowings +$ +120.0 +$ +— +$ +— +$ +120.0 +$ +— +$ +— +$ +— +Interest 1 +12.3 +5.1 +5.1 +2.1 +— +— +— +Off Balance Sheet: +Facilities and equipment operating leases +121.5 +21.6 +19.3 +16.5 +13.2 +11.0 +39.9 +Purchase obligations 2 +384.6 +322.3 +53.8 +7.8 +0.6 +0.1 +— +Pension contribution 3 +1.6 +1.6 +— +— +— +— +— +Notes: +1 Interest +associated with variable rate debt was determined using the interest rate in effect on May 31, 2019. +2 Purchase +obligations arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts, +and components, as well as equipment to support the operations of our business. +3 We +anticipate contributing approximately $1.6 million to our pension plans during fiscal 2020 compared to contributions of $2.6 million in +fiscal 2019. +4 The +above table excludes any tax liability payments, including any payments related to unrecognized tax benefits. +We +routinely issue letters of credit and performance bonds in the ordinary course of business. These instruments are typically issued in conjunction with insurance contracts or other +business requirements. The total of these instruments outstanding at May 31, 2019 was $31.7 million. +Critical Accounting Policies and Significant Estimates +Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States. Management +has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare the Consolidated +29 +Table of Contents +Financial +Statements. The most significant estimates made by management include those related to assumptions used in assessing goodwill impairment, adjustments to reduce the value of inventories and +certain rotable assets, revenue recognition, allowance for doubtful accounts, and assumptions used in determining pension plan obligations. Accordingly, actual results could differ materially from +those estimates. The following is a summary of the accounting policies considered critical by management. +Goodwill +Under accounting standards for goodwill and other intangible assets, goodwill and other intangible assets deemed to have indefinite lives are +not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, +or more frequently if circumstances indicate that impairment is possible. +The +accounting standards for goodwill allow for either a qualitative or quantitative approach for the annual impairment test. Under the qualitative approach, factors such as +macroeconomic conditions, industry and market conditions and company-specific events or circumstances are assessed to determine whether it is more likely than not that the fair value of a reporting +unit is less than its carrying amount. When the quantitative approach is utilized, we compare the fair value of each reporting unit with the carrying value of the reporting unit, including goodwill. +If the estimated fair value of the reporting unit is less than the carrying value of the reporting unit, we would be required to recognize an impairment loss for the excess carrying value of the +reporting unit's assets. +In +fiscal 2018, we performed an interim goodwill impairment test over our former Airlift reporting unit as a result of a decision to exit our COCO business. The COCO business was +reclassified to discontinued operations and goodwill was allocated to the COCO business based on its relative fair value to the reporting unit. The fair value of the reporting unit was determined +based on a combination of the expected net proceeds upon sale and a discounted cash flow analysis. As the fair value of the COCO business was below its carrying value, a goodwill impairment charge of +$9.8 million was recorded in the third quarter of fiscal 2018. +As +of May 31, 2019, we had three reporting units, which included two in our Aviation Services segment (Aviation Supply Chain and Maintenance, Repair, and Overhaul) and one +comprised of our +Expeditionary Services segment, which were evaluated for impairment Accounting Standards Codification ("ASC") 350, Intangibles — Goodwill and Other . +For +our annual impairment test as of May 31, 2019, we utilized the qualitative assessment approach for all reporting units. Under this approach, we considered the overall industry +and market conditions related to the aerospace and government/defense markets as well as conditions in the global capital markets. We also considered the long-term forecasts for each reporting unit, +which incorporated specific opportunities and risks, working capital requirements, and capital expenditure needs. +Upon +completion of the annual qualitative analysis as of May 31, 2019 for our reporting units, we concluded it was more likely than not that the fair value of each reporting unit +exceeded its carrying values, and thus no impairment charge was recorded. +Inventories +Inventories are valued at the lower of cost or market (estimated net realizable value). Cost is determined by the specific identification, +average cost or first-in, first-out methods. Write-downs are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions. We have utilized +certain assumptions when determining the market value of inventories, such as inventory quantities and aging, historical sales of inventory, current and expected future aviation usage trends, +replacement values, expected future demand, and historical scrap recovery rates. Reductions in demand for certain of our inventories or declining market values, as well as differences between actual +30 +Table of Contents +results +and the assumptions utilized by us when determining the market value of our inventories, could result in the recognition of impairment charges in future periods. +Revenue Recognition +Revenue is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on +behalf of third parties. We recognize revenue when we satisfy a performance obligation by transferring control over a product or service to a customer. +Our +unit of accounting for revenue recognition is a performance obligation included in our customer contracts. A performance obligation reflects the distinct good or service that we must +transfer to a customer. At contract inception, we evaluate if the contract should be accounted for as a single performance obligation or if the contract contains multiple performance obligations. In +some cases, our contract with the customer is considered one performance obligation as it includes factors such as whether the good or service being provided is significantly integrated with other +promises in the contract, whether the service provided significantly modifies or customizes another good or service or whether the good or service is highly interdependent or interrelated. If the +contract has more than one performance obligation, we determine the standalone price of each distinct good or service underlying each performance obligation and allocates the transaction price based +on their relative standalone selling prices. +The +transaction price of a contract, which can include both fixed and variable amounts, is allocated to each performance obligation identified. Some contracts contain variable +consideration, which could include incremental fees or penalty provisions related to performance. Variable consideration that can be reasonably estimated based on current assumptions and historical +information is included in the transaction price at the inception of the contract but limited to the amount that is probable that a significant reversal in the amount of cumulative revenue recognized +will not occur. Variable consideration that cannot be reasonably estimated is recorded when known. +Our +performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers. The majority of our +sales from products are recognized at a point in time upon transfer of control to the customer, which generally occurs upon shipment. In connection with certain sales of products, we also provide +logistics services, which include inventory management, replenishment, and other related services. The price of such services is generally included in the price of the products delivered to the +customer, and revenues are recognized upon delivery of the product, at which point the customer has obtained control of the product. We do not account for these services separate from the related +product sales as the services are inputs required to fulfill part orders received from customers. +For +our performance obligations that are satisfied over time, we measure progress in a manner that depicts the performance of transferring control to the customer. As such, we utilize +the input method of cost-to-cost to recognize revenue over time as this depicts when control of the promised goods or services are transferred to the customer. Revenue is recognized based on the +relationship of actual +costs incurred to date to the estimated total cost at completion of the performance obligation. We are required to make certain judgments and estimates, including estimated revenues and costs, as well +as inflation and the overall profitability of the arrangement. Key assumptions involved include future labor costs and efficiencies, overhead costs, and ultimate timing of product delivery. +Differences may occur between the judgments and estimates made by management and actual program results. +Changes +in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. These +changes are primarily adjustments to the estimated profitability for our long-term programs where we provide component inventory management and/or repair services. +31 +Table of Contents +Under +most of our U.S. government contracts, if the contract is terminated for convenience, we are entitled to payment for items delivered and fair compensation for work performed, the +costs of settling and paying other claims, and a reasonable profit on the costs incurred or committed. +We +have elected to use certain practical expedients permitted under ASC 606. Shipping and handling fees and costs incurred associated with outbound freight after control over a product +has transferred to a customer are accounted for as a fulfillment cost and are included in cost of sales in our Consolidated Statements of Income, and are not considered a performance obligation to our +customers. Our reported sales on our Consolidated Statements of Income are net of any sales or related non-income taxes. We also utilize the "as invoiced" practical expedient in certain cases where +performance obligations are satisfied over time and the invoiced amount corresponds directly with the value we are providing to the customer. +The +timing of revenue recognition, customer billings, and cash collections results in a contract asset or contract liability at the end of each reporting period. Contract assets consist +of unbilled receivables or costs incurred where revenue recognized over time using the cost-to-cost model exceeds the amounts billed to customers. Contract liabilities include advance payments and +billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of our performance obligations on the contract. These amounts are recorded as contract +liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. Contract assets and contract liabilities are +determined on a contract-by-contract basis. +Allowance for Doubtful Accounts +We maintain an allowance for doubtful accounts to reflect the expected uncollectibility of accounts receivable based on past collection history +and specific risks identified among uncollected accounts. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, +and our customers' current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to +undergo an extensive credit check prior to delivery of products or services. +We +perform regular evaluations of customer payment experience, current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, +letters of credit, and/or obligation guarantees from financial institutions for transactions executed on other than normal trade terms. We also maintain trade credit insurance for certain customers to +provide coverage, up to a certain limit, in the event of insolvency of some customers. +In +fiscal 2019, we recognized a provision for doubtful accounts of $12.4 million related to the bankruptcy of a European airline customer. The provision consisted of impairment of +non-current contract assets of $7.6 million, allowance for doubtful accounts of $3.3 million, and other liabilities of $1.5 million. +In +addition, we currently have past due accounts receivable owed by former commercial program customers primarily related to our exit from customer contracts in certain geographies, +including Colombia, Peru, and Poland. Our past due accounts receivable owed by these customers was $12.4 million as of May 31, 2019 which was net of allowance for doubtful accounts of +$8.2 million. +Impairment of Long-Lived Assets +We are required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset +may not be recoverable from its undiscounted cash flows. When applying accounting standards addressing impairment of long-lived assets, we have utilized certain assumptions to estimate future +undiscounted cash flows, including current and future sales volumes or lease rates, expected changes to cost structures, lease terms, residual values, market conditions, and trends impacting future +demand. Differences between actual results and the assumptions utilized by us when determining undiscounted cash flows could result in future impairments of long-lived assets. During +32 +Table of Contents +the +third quarter of fiscal 2019 and second quarter of fiscal 2018, we recognized pre-tax impairment charges of $74.1 million and $54.2 million, respectively, related to assets included +in our COCO business, which is classified as a discontinued operation. +We +maintain a significant inventory of rotable parts and equipment to service customer aircraft and components. Portions of that inventory are used parts that are often exchanged with +parts removed from aircraft or components, and are reworked to a useable condition. We may have to recognize an impairment of our rotable parts and equipment if we discontinue using or servicing +certain aircraft models or if an older aircraft model is phased-out in the industry. +Pension Plans +The projected benefit obligation for our benefit plans exceeds our plan assets by $19.3 million as of May 31, 2019. Our projected +benefit obligation exceeds our plan assets for both our U.S. plans and for our Netherlands plan with the U.S. benefit plans underfunded by $9.2 million and the Netherlands plan underfunded by +$10.1 million. +The +liabilities and net periodic cost of our pension plans are determined utilizing several actuarial assumptions, the most significant of which are the discount rate and the expected +long-term rate of return on plan assets. +AAR +uses discount rates to measure our benefit obligation and net periodic benefit cost for our pension plans. We used a broad population of Aa-rated corporate bonds as of May 31, +2019 to determine the discount rate assumption. All bonds were denominated in U.S. Dollars, with a minimum outstanding of $50.0 million. This population of bonds was narrowed from a broader +universe of over 500 Moody's Aa-rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10 th percentile and the bottom +40 th percentile to adjust for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension plan liabilities. This +portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments for the domestic plans. The discount rate is the single level rate that +produces the same result as the spot rate curve. +We +establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market, as well as +analysis of current market and economic information and future expectations. The current asset return assumption is supported by historical market experience for both our actual and target asset +allocation. In calculating the net pension cost, the expected return on assets is applied to a calculated value on plan assets, which recognizes changes in the fair value of plan assets in a +systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to +amortization in the future. +New Accounting Pronouncements Adopted +In March 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-09, Improvements to Employee +Share-Based Payment Accounting , which amends ASC Topic 718, Compensation—Stock Compensation . This ASU requires +excess tax benefits or deficiencies for share-based payments to be recorded in the period shares vest as income tax expense or benefit, rather than within equity. Effective with the adoption of this +ASU, cash flows related to excess tax benefits are now included in operating activities and are no longer classified as a financing activity. We adopted this ASU on June 1, 2017 and recognized +excess tax benefits of $2.7 million and $2.9 million as an income tax benefit in fiscal 2019 and 2018, respectively. We have also presented the excess tax benefits within operating +activities in the Consolidated Statements of Cash Flows for fiscal 2019 and 2018. As permitted, we adopted the statement of cash flow presentation guidance on a prospective basis with no adjustments +to fiscal 2017. +33 +Table of Contents +In +March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and +Net Periodic Postretirement Benefit Cost . This ASU requires an employer to report the service cost component of net periodic pension benefit cost in the same line item as other +compensation costs for those related employees. Other components of net pension cost, including interest, expected return on plan assets, and actuarial gains and losses and settlement charges are to +be presented outside of operating income. We adopted this ASU on June 1, 2018, which resulted in $1.0 million of pension income included in Other expense, net in the Consolidated +Statement of Income for fiscal 2019. The Consolidated Statements of Income for fiscal years 2018 and 2017 were not restated as the non-service cost components of pension expense were not material to +those fiscal years. +In +May 2014, the FASB issued ASC 606, which provides guidance for revenue recognition. ASC 606 superseded the revenue recognition requirements in ASC 605, Revenue +Recognition , and most industry-specific guidance. +We +adopted ASC 606 on June 1, 2018 using the modified retrospective method. Under that approach, prior periods were not restated and continue to be reported under the accounting +standards in effect for those periods. We elected to use the practical expedient allowing for the application of ASC 606 only to contracts that were not completed as of June 1, 2018. We +recognized the cumulative effect of initially applying ASC 606 as a decrease of $20.4 million to the opening balance of retained earnings as of June 1, 2018. +The +adoption of ASC 606 impacted us in three primary areas. First, we have certain contracts in which revenue is recognized using the percentage of completion method over the expected +term of the contract. Under ASC 606, the contract term used for revenue recognition purposes was shortened to exclude any unexercised customer option years or incorporate customer rights to terminate +the contract without significant penalty as we do not have any enforceable rights or obligations prior to the exercise of the underlying option. The impact of this change as of June 1, 2018 +resulted in the elimination of certain deferred costs and the establishment of accrued liabilities reflecting our estimated obligations under the contracts. For this change, we recognized a decrease +of $22.1 million to the opening balance of retained earnings as of June 1, 2018. +Second, +we have contracts under which we perform repair services on customer-owned assets whereby the customer simultaneously receives the benefits of the repair. These contracts also +transitioned to an over time revenue recognition model as of June 1, 2018 compared to our prior policy of recognizing revenue at the time of shipment. The impact of this change as of +June 1, 2018 resulted in the elimination of certain inventory and accounts receivable amounts and the establishment of a contract asset reflecting the over time revenue recognition treatment. +For this change, we recognized an increase of $1.3 million to the opening balance of retained earnings as of June 1, 2018. +Third, +we have certain contracts under which we manufacture products with no alternative use as the customer owns the underlying intellectual property and we have an enforceable right to +payment from the customer. As a result, we now recognize revenue for these contracts over time as opposed to at the time of shipment, which was our policy prior to June 1, 2018. The impact of +this change as of June 1, 2018 resulted in the elimination of certain inventory amounts and the establishment of a contract asset reflecting the over time revenue recognition treatment. For +this change, we recognized an increase of $0.4 million to the opening balance of retained earnings as of June 1, 2018. +New Accounting Pronouncements Not Yet Adopted +In February 2016, the FASB issued ASU 2016-02, Leases . This ASU amends the existing accounting +standards for lease accounting, including requiring lessees to recognize a right-of-use asset and lease liability on the balance sheet for most lease arrangements, including those classified as +operating leases under the current accounting guidance. In addition, this ASU will require new qualitative and quantitative disclosures about our leasing activities. This new standard will be +effective for us beginning June 1, 2019 +34 +Table of Contents +and +is required to be adopted using a modified retrospective approach. The new standard provides us an option to recognize the cumulative effect adjustment on retained earnings as of June 1, +2019 or as of the beginning of the earliest period presented. +We +have reviewed our lease portfolio and are finalizing implementation of the necessary processes and systems to comply with the requirements of this new ASU. This included the selection +and implementation of a third-party software solution to facilitate the accounting and reporting requirements of the new ASU. +We +will adopt this ASU in the first quarter of fiscal 2020 and apply it prospectively. We expect to elect the package of practical expedients, which permits us not to reassess under the +new ASU our prior conclusions about lease identification, lease classification and initial direct costs. In addition, we will implement accounting policy elections to not separate lease and non-lease +components for both lessee and lessor relationships and not capitalize any leases with terms of less than twelve months on our Consolidated Balance Sheet. +We +expect to recognize operating lease liabilities with corresponding right-of-use assets of approximately the same amount based on the present value of the remaining lease payments over +the lease term. We do not anticipate that adoption of the ASU will have a significant impact on our results of operations or cash flows. +In +February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects +from Accumulated Other Comprehensive Income . This ASU permits the reclassification of tax effects stranded in accumulated +other comprehensive income to retained earnings as a result of the Tax Reform Act. We continue to evaluate the impact of this ASU on our consolidated financial statements and expect to adopt this ASU +in the first quarter of fiscal 2020. +In +June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326), Measurement of Credit Losses on Financial +Instruments . This ASU requires a change in the measurement approach for credit losses on financial assets measured on an amortized cost basis from an incurred loss method to an +expected loss method, thereby eliminating the requirement that a credit loss be considered probable to impact the valuation of a financial asset measured on an amortized cost basis. This ASU also +requires the measurement of expected credit losses to be based on relevant information about past events, including historical experience, current conditions, and a reasonable and supportable forecast +of the collectability of the related financial asset. We continue to evaluate the impact of this ASU on our consolidated financial statements and expect to adopt this ASU on June 1, 2020. +35 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Our exposure to market risk includes fluctuating interest rates under our credit agreements, changes in foreign exchange rates, and credit +losses on accounts receivable. See Note 1 of Notes to Consolidated Financial Statements for a discussion on accounts receivable exposure. +We +are exposed to the risk that our earnings and cash flows could be adversely impacted by fluctuations in interest rates. A 10 percent increase in the average interest rate +affecting our financial instruments, including the average outstanding balance of our debt obligations would not have had a significant impact on our pre-tax income during fiscal 2019. +Revenues +and expenses of our foreign operations are translated at average exchange rates during the year, and balance sheet accounts are translated at year-end exchange rates. Balance +sheet translation adjustments are excluded from the results of operations and are recorded in stockholders' equity as a component of accumulated other comprehensive loss. A hypothetical +10 percent devaluation of the U.S. +dollar against foreign currencies would not have had a material impact on our financial position or continuing operations during fiscal 2019. +36 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Report of Independent Registered Public Accounting Firm +To +the Stockholders and Board of Directors +AAR CORP.: +Opinion on the Consolidated Financial Statements +We +have audited the accompanying consolidated balance sheets of AAR CORP. and subsidiaries (the Company) as of May 31, 2019 and 2018, the related consolidated statements of income, +comprehensive income (loss), changes in equity, and cash flows for each of the years in the three-year period ended May 31, 2019 and the related notes (collectively, the consolidated financial +statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of May 31, 2019 and 2018, and the results +of its operations and its cash flows for each of the years in the three-year period ended May 31, 2019, in conformity with U.S. generally accepted accounting principles. +We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of +May 31, 2019, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring +Organizations of the Treadway Commission, and our report dated July 18, 2019 expressed an adverse opinion on the effectiveness of the Company's internal control over financial reporting. +Change in Accounting Principle +As +discussed in Note 1 to the consolidated financial statements, the Company has changed its method of accounting for revenue from contracts with customers effective June 1, 2018 due to +the adoption of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) , and its subsequent amendments. +Basis for Opinion +These +consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. +We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules +and regulations of the Securities and Exchange Commission and the PCAOB. +We +conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated +financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated +financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and +disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall +presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ KPMG LLP +We +have served as the Company's auditor since 1985. +Chicago, Illinois +July 18, 2019 +37 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Year Ended May 31, +2019 +2018 +2017 +(In millions, except per share data) +Sales: +Sales from products +$ +1,124.3 +$ +1,040.7 +$ +944.8 +Sales from services +927.5 +707.6 +646.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2,051.8 +1,748.3 +1,590.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Costs and operating expenses: +Cost of products +915.0 +840.5 +787.5 +Cost of services +807.3 +613.2 +539.9 +Provision for doubtful accounts +15.8 +0.5 +2.1 +Selling, general and administrative +215.4 +208.1 +179.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1,953.5 +1,662.3 +1,508.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating income +98.3 +86.0 +82.3 +Other expense, net +(0.8 +) +(0.9 +) +— +Interest expense +(9.5 +) +(8.0 +) +(5.3 +) +Interest income +1.0 +0.1 +0.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations before provision for income taxes +89.0 +77.2 +77.1 +Provision for income taxes +4.9 +3.5 +25.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations +84.1 +73.7 +52.0 +Income (Loss) from discontinued operations, net of tax +(76.6 +) +(58.1 +) +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net income +$ +7.5 +$ +15.6 +$ +56.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic: +Earnings from continuing operations +$ +2.42 +$ +2.14 +$ +1.53 +Earnings (Loss) from discontinued operations +(2.22 +) +(1.70 +) +0.13 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic +$ +0.20 +$ +0.44 +$ +1.66 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted: +Earnings from continuing operations +$ +2.40 +$ +2.11 +$ +1.51 +Earnings (Loss) from discontinued operations +(2.19 +) +(1.70 +) +0.13 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted +$ +0.21 +$ +0.41 +$ +1.64 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash dividends declared per common share +$ +0.30 +$ +0.30 +$ +0.30 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +38 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Year Ended May 31, +2019 +2018 +2017 +(In millions) +Net income +$ +7.5 +$ +15.6 +$ +56.5 +Other comprehensive income (loss), net of tax: +Currency translation adjustments, net of tax +(2.4 +) +2.0 +(0.6 +) +Unrecognized pension and post retirement costs, net of tax expense (benefit) of $(1.7) in 2019, $2.4 in 2018, and $2.8 in 2017 +(6.5 +) +5.9 +5.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive income (loss), net of tax +(8.9 +) +7.9 +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Comprehensive income (loss) +$ +(1.4 +) +$ +23.5 +$ +61.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +39 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +May 31, +2019 +2018 +(In millions, except +share data) +Current assets: +Cash and cash equivalents +$ +21.3 +$ +31.1 +Restricted cash +19.8 +10.5 +Accounts receivable, net +197.8 +202.0 +Contract assets +59.2 +— +Inventories +523.7 +460.7 +Rotable assets and equipment on or available for short-term lease +65.3 +87.2 +Assets of discontinued operations +29.2 +125.0 +Other current assets +36.2 +26.2 +​ +​ +​ +​ +​ +​ +​ +​ +Total current assets +952.5 +942.7 +​ +​ +​ +​ +​ +​ +​ +​ +Property, plant and equipment, at cost: +Land +4.5 +4.5 +Buildings and improvements +111.9 +107.4 +Equipment and furniture and fixtures +248.2 +235.7 +​ +​ +​ +​ +​ +​ +​ +​ +364.6 +347.6 +Accumulated depreciation +(231.8 +) +(214.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +132.8 +133.2 +​ +​ +​ +​ +​ +​ +​ +​ +Other assets: +Goodwill +116.2 +118.7 +Intangible assets, net +22.2 +27.8 +Rotable assets supporting long-term programs +216.0 +183.4 +Other non-current assets +77.5 +118.9 +​ +​ +​ +​ +​ +​ +​ +​ +431.9 +448.8 +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,517.2 +$ +1,524.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +40 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND EQUITY +May 31, +2019 +2018 +(In millions, except +share data) +Current liabilities: +Accounts payable +187.8 +170.0 +Accrued liabilities +140.5 +138.3 +Liabilities of discontinued operations +29.2 +25.0 +​ +​ +​ +​ +​ +​ +​ +​ +Total current liabilities +357.5 +333.3 +​ +​ +​ +​ +​ +​ +​ +​ +Long-term debt +141.7 +177.2 +Deferred revenue on long-term contracts +83.8 +35.8 +Deferred tax liabilities +— +15.7 +Other liabilities +28.3 +26.4 +​ +​ +​ +​ +​ +​ +​ +​ +253.8 +255.1 +​ +​ +​ +​ +​ +​ +​ +​ +Equity: +Preferred stock, $1.00 par value, authorized 250,000 shares; none issued +— +— +Common stock, $1.00 par value, authorized 100,000,000 shares; issued 45,300,786 shares at cost +45.3 +45.3 +Capital surplus +479.4 +470.5 +Retained earnings +709.8 +733.2 +Treasury stock, 10,512,974 and 10,585,165 shares at cost, respectively +(287.7 +) +(280.7 +) +Accumulated other comprehensive loss +(40.9 +) +(32.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total equity +905.9 +936.3 +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,517.2 +$ +1,524.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +41 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +FOR THE THREE YEARS ENDED MAY 31, 2018 +(In millions) +Common +Stock +Capital +Surplus +Retained +Earnings +Treasury +Stock +Accumulated +Other +Comprehensive +Income (Loss) +Total +Equity +Balance, May 31, 2016 +$ +44.9 +$ +451.3 +$ +681.6 +$ +(267.6 +) +$ +(44.4 +) +$ +865.8 +Net income +— +— +56.5 +— +— +56.5 +Cash dividends +— +— +(10.2 +) +— +— +(10.2 +) +Stock option activity +— +3.1 +— +8.9 +— +12.0 +Restricted stock activity +0.3 +6.4 +— +(1.3 +) +— +5.4 +Repurchase of shares +— +— +— +(19.8 +) +— +(19.8 +) +Other comprehensive income, net of tax +— +— +— +— +4.5 +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, May 31, 2017 +$ +45.2 +$ +460.8 +$ +727.9 +$ +(279.8 +) +$ +(39.9 +) +$ +914.2 +Net income +— +— +15.6 +— +— +15.6 +Cash dividends +— +— +(10.3 +) +— +— +(10.3 +) +Stock option activity +— +0.9 +— +11.2 +— +12.1 +Restricted stock activity +0.1 +8.8 +— +1.0 +— +9.9 +Repurchase of shares +— +— +— +(13.1 +) +— +(13.1 +) +Other comprehensive income, net of tax +— +— +— +— +7.9 +7.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, May 31, 2018 +$ +45.3 +$ +470.5 +$ +733.2 +$ +(280.7 +) +$ +(32.0 +) +$ +936.3 +Cumulative effect adjustment upon adoption of ASC 606 on June 1, 2018 +— +— +(20.4 +) +— +— +(20.4 +) +Net income +— +— +7.5 +— +— +7.5 +Cash dividends +— +— +(10.5 +) +— +— +(10.5 +) +Stock option activity +— +3.5 +— +4.1 +— +7.6 +Restricted stock activity +— +5.4 +— +(0.8 +) +— +4.6 +Repurchase of shares +— +— +— +(10.3 +) +— +(10.3 +) +Other comprehensive loss, net of tax +— +— +— +— +(8.9 +) +(8.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, May 31, 2019 +$ +45.3 +$ +479.4 +$ +709.8 +$ +(287.7 +) +$ +(40.9 +) +$ +905.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +42 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In millions) +For the Year Ended May 31, +2019 +2018 +2017 +Cash flows provided from operating activities: +Net income +$ +7.5 +$ +15.6 +$ +56.5 +Less: Income (Loss) from discontinued operations +(76.6 +) +(58.1 +) +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations +84.1 +73.7 +52.0 +Adjustments to reconcile income to net cash provided from operating activities: +Depreciation and intangible amortization +42.8 +40.5 +35.7 +Amortization of stock-based compensation +13.5 +15.3 +11.0 +Provision for doubtful accounts +15.8 +0.5 +2.1 +Deferred tax provision (benefit) +(5.0 +) +(12.9 +) +12.5 +Gain on sale of product line +— +— +(2.6 +) +Changes in certain assets and liabilities, net of acquisitions: +Accounts receivable +(34.4 +) +35.4 +(16.8 +) +Contract assets +(9.7 +) +— +— +Inventories +(80.9 +) +(25.8 +) +(23.3 +) +Rotable spares and equipment on or available for short-term lease +21.5 +(16.6 +) +(3.1 +) +Rotable assets supporting long-term programs +(49.2 +) +(38.5 +) +(82.5 +) +Accounts payable +17.5 +1.8 +19.6 +Accrued and other liabilities +22.9 +8.0 +6.5 +Other +21.6 +(25.6 +) +(24.6 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from (used in) operating activities—continuing +operations +60.5 +55.8 +(13.5 +) +Net cash provided from operating activities—discontinued operations +6.9 +8.5 +35.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from operating activities +67.4 +64.3 +21.8 +Cash flows used in investing activities: +Property, plant and equipment expenditures +(17.4 +) +(22.0 +) +(25.2 +) +Proceeds from asset disposals +1.8 +8.6 +6.5 +Payments for acquisitions +(2.3 +) +(22.9 +) +(12.5 +) +Other +(0.6 +) +(2.3 +) +(2.7 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash used in investing activities—continuing operations +(18.5 +) +(38.6 +) +(33.9 +) +Net cash provided from (used in) investing activities—discontinued operations +(0.5 +) +(4.3 +) +3.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash used in investing activities +(19.0 +) +(42.9 +) +(30.1 +) +Cash flows provided by (used in) financing activities: +Short-term borrowings (repayments), net +(10.0 +) +(1.0 +) +21.0 +Proceeds (Repayments) on long-term borrowings +(25.0 +) +24.8 +(10.0 +) +Cash dividends +(10.5 +) +(10.3 +) +(10.2 +) +Purchase of treasury stock +(10.3 +) +(13.1 +) +(19.8 +) +Stock option exercises +8.5 +11.6 +8.5 +Other +— +(0.3 +) +0.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from (used in) financing activities—continuing operations +(47.3 +) +11.7 +(10.4 +) +Net cash used in financing activities—discontinued operations +(1.4 +) +(1.7 +) +(1.7 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net cash provided from (used in) financing activities +(48.7 +) +10.0 +(12.1 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Effect of exchange rate changes on cash +(0.2 +) +(0.1 +) +(0.5 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Increase (Decrease) in cash and cash equivalents +(0.5 +) +31.3 +(20.9 +) +Cash, cash equivalents, and restricted cash at beginning of year +41.6 +10.3 +31.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash, cash equivalents, and restricted cash at end of year +$ +41.1 +$ +41.6 +$ +10.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The accompanying notes to consolidated financial statements +are an integral part of these statements. +43 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies +Description of Business +AAR CORP. is a diversified provider of services and products to the worldwide commercial aviation and government and defense markets. Services +and products include: aviation supply chain and parts support programs; customer fleet management and operations; maintenance, repair and overhaul of airframes, landing gear, and certain other +airframe components; design and manufacture of specialized pallets, shelters, and containers; aircraft modifications and aircraft and engine sales and leasing. We serve commercial, government and +defense aircraft fleet operators, original equipment manufacturers, and independent service providers around the world, and various other domestic and foreign military customers. +Principles of Consolidation +The accompanying Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries after elimination of +intercompany accounts and transactions. +New Accounting Pronouncements Adopted +In March 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-09, Improvements to Employee Share-Based Payment +Accounting , which amends ASC Topic 718, Compensation—Stock Compensation . This ASU requires excess tax benefits or deficiencies for share-based payments to be +recorded in the period +shares vest as income tax expense or benefit, rather than within equity. Effective with the adoption of this ASU, cash flows related to excess tax benefits are now included in operating activities and +are no longer classified as a financing activity. We adopted this ASU on June 1, 2017 and recognized excess tax benefits of $2.7 million and $2.9 million as an income tax benefit +in fiscal 2019 and 2018, respectively. We have also presented the excess tax benefits within operating activities in the Consolidated Statements of Cash Flows for fiscal 2019 and 2018. As permitted, +we adopted the statement of cash flow presentation guidance on a prospective basis with no adjustments to fiscal 2017. +In +March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and +Net Periodic Postretirement Benefit Cost . This ASU requires an employer to report the service cost component of net periodic pension benefit cost in the same line item as other +compensation costs for those related employees. Other components of net pension cost, including interest, expected return on plan assets, and actuarial gains and losses and settlement charges are to +be presented outside of operating income. We adopted this ASU on June 1, 2018, which resulted in $1.0 million of pension income included in Other expense, net in the Consolidated +Statement of Income for fiscal 2019. The Consolidated Statements of Income for fiscal years 2018 and 2017 were not restated as the non-service cost components of pension expense were not material to +those fiscal years. +In +May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers ("ASC 606"), which provides guidance for +revenue recognition. ASC 606 superseded the revenue recognition requirements in Accounting Standards Codification ("ASC") 605, Revenue Recognition , and +most industry-specific guidance. +We +adopted ASC 606 on June 1, 2018 using the modified retrospective method. Under that approach, prior periods were not restated and continue to be reported under the accounting +standards in effect for +44 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +those +periods. We elected to use the practical expedient allowing for the application of ASC 606 only to contracts that were not completed as of June 1, 2018. We recognized the cumulative +effect of initially applying ASC 606 as a decrease of $20.4 million to the opening balance of retained earnings as of June 1, 2018. +The +impact of the adoption of ASC 606 on our Consolidated Balance Sheet was as follows: +As of +May 31, 2018 +ASC 606 +Adjustments +As of +June 1, 2018 +Accounts receivable, net +$ +202.0 +$ +(31.4 +) +$ +170.6 +Inventories +460.7 +(17.3 +) +443.4 +Contract assets—current +— +49.6 +49.6 +Other current assets +26.2 +(0.9 +) +25.3 +Other non-current assets +118.9 +(19.0 +) +99.9 +Accrued liabilities +138.3 +9.1 +147.4 +Deferred tax liabilities +15.7 +(6.6 +) +9.1 +Deferred revenue on long-term contracts +35.8 +(1.1 +) +34.7 +Retained earnings +733.2 +(20.4 +) +712.8 +The +adoption of ASC 606 impacted us in three primary areas. First, we have certain contracts in which revenue is recognized using the percentage of completion method over the expected +term of the contract. Under ASC 606, the contract term used for revenue recognition purposes was shortened to exclude any unexercised customer option years or incorporate customer rights to terminate +the contract without significant penalty as we do not have any enforceable rights or obligations prior to the exercise of the underlying option. The impact of this change as of June 1, 2018 +resulted in the elimination of certain deferred costs and the establishment of accrued liabilities reflecting our estimated obligations under the contracts. For this change, we recognized a decrease +of $22.1 million to the opening balance of retained earnings as of June 1, 2018. +Second, +we have contracts under which we perform repair services on customer-owned assets whereby the customer simultaneously receives the benefits of the repair. These contracts also +transitioned to an over time revenue recognition model as of June 1, 2018 compared to our prior policy of recognizing revenue at the time of shipment. The impact of this change as of +June 1, 2018 resulted in the elimination of certain inventory and accounts receivable amounts and the establishment of a contract asset reflecting the over time revenue recognition treatment. +For this change, we recognized an increase of $1.3 million to the opening balance of retained earnings as of June 1, 2018. +Third, +we have certain contracts under which we manufacture products with no alternative use as the customer owns the underlying intellectual property and we have an enforceable right to +payment from the customer. As a result, we now recognize revenue for these contracts over time as opposed to at the time of shipment, which was our policy prior to June 1, 2018. The impact of +this change as of June 1, 2018 resulted in the elimination of certain inventory amounts and the establishment of a contract asset reflecting the over time revenue recognition treatment. For +this change, we recognized an increase of $0.4 million to the opening balance of retained earnings as of June 1, 2018. +45 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +The +impact of the ASC 606 adoption on our Consolidated Financial Statements as of May 31, 2019 and for the fiscal year ended May 31, 2019 were as follows: +As of May 31, 2019 +As Reported +ASC 606 +Adjustments +Balances +Excluding +ASC 606 +Accounts receivable, net +$ +197.8 +$ +38.5 +$ +236.3 +Contract assets—current +59.2 +(59.2 +) +— +Inventories +523.7 +22.2 +545.9 +Other current assets +36.2 +(0.4 +) +35.8 +Other non-current assets +77.5 +25.3 +102.8 +Accrued liabilities +140.5 +(5.9 +) +134.5 +Deferred tax liabilities +— +6.6 +6.6 +Deferred revenue on long-term contracts +83.8 +5.2 +89.0 +Retained earnings +709.8 +20.5 +730.3 +Fiscal Year Ended May 31, 2019 +As Reported +ASC 606 +Adjustments +Balances +Excluding +ASC 606 +Sales +$ +2,051.8 +$ +(5.0 +) +$ +2,046.8 +Cost of sales +1,722.3 +(5.1 +) +1,717.2 +Operating income +98.3 +0.1 +98.4 +Provision for income taxes +4.9 +— +4.9 +Income from continuing operations +84.1 +0.1 +84.2 +Fiscal Year Ended May 31, 2019 +As Reported +ASC 606 +Adjustments +Balances +Excluding +ASC 606 +Cash flows provided from operating activities: +Net income +$ +7.5 +$ +0.1 +$ +7.6 +Income from continuing operations +84.1 +0.1 +84.2 +Accounts receivable +(34.4 +) +(7.1 +) +(41.5 +) +Contract assets +(9.7 +) +9.7 +— +Inventories +(80.9 +) +(4.9 +) +(85.8 +) +Accrued and other liabilities +22.9 +3.2 +26.1 +Other +21.6 +(1.0 +) +20.6 +Revenue Recognition for Fiscal 2019 +Revenue is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on +behalf of third parties. We recognize revenue when we satisfy a performance obligation by transferring control over a product or service to a customer. +46 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Our +unit of accounting for revenue recognition is a performance obligation included in our customer contracts. A performance obligation reflects the distinct good or service that we must +transfer to a customer. At contract inception, we evaluate if the contract should be accounted for as a single performance obligation or if the contract contains multiple performance obligations. In +some cases, our contract with the customer is considered one performance obligation as it includes factors such as whether the good or service being provided is significantly integrated with other +promises in the contract, whether the service provided significantly modifies or customizes another good or service or whether the good or service is highly interdependent or interrelated. If the +contract has more than one performance obligation, we determine the standalone price of each distinct good or service underlying each performance obligation and allocate the transaction price based on +their relative standalone selling prices. +The +transaction price of a contract, which can include both fixed and variable amounts, is allocated to each performance obligation identified. Some contracts contain variable +consideration, which could include incremental fees or penalty provisions related to performance. Variable consideration that can be reasonably estimated based on current assumptions and historical +information is included in the transaction price at the inception of the contract but limited to the amount that is probable that a significant reversal in the amount of cumulative revenue recognized +will not occur. Variable consideration that cannot be reasonably estimated is recorded when known. +Our +performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers. The majority of our +sales from products are recognized at a point in time upon transfer of control to the customer, which generally occurs upon shipment. In connection with certain sales of products, we also provide +logistics services, which include +inventory management, replenishment, and other related services. The price of such services is generally included in the price of the products delivered to the customer, and revenues are recognized +upon delivery of the product, at which point, the customer has obtained control of the product. We do not account for these services separate from the related product sales as the services are inputs +required to fulfill part orders received from customers. +For +our performance obligations that are satisfied over time, we measure progress in a manner that depicts the performance of transferring control to the customer. As such, we utilize +the input method of cost-to-cost to recognize revenue over time as this depicts when control of the promised goods or services are transferred to the customer. Revenue is recognized based on the +relationship of actual costs incurred to date to the estimated total cost at completion of the performance obligation. We are required to make certain judgments and estimates, including estimated +revenues and costs, as well as inflation and the overall profitability of the arrangement. Key assumptions involved include future labor costs and efficiencies, overhead costs, and ultimate timing of +product delivery. Differences may occur between the judgments and estimates made by management and actual program results. +Changes +in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. These +changes are primarily adjustments to the estimated profitability for our long-term programs where we provide component inventory management and/or repair services. For the fiscal year ended +May 31, 2019, we recognized favorable and unfavorable cumulative catch-up adjustments of $8.0 million and $2.1 million, respectively. +47 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Under +most of our U.S. government contracts, if the contract is terminated for convenience, we are entitled to payment for items delivered and fair compensation for work performed, the +costs of settling and paying other claims, and a reasonable profit on the costs incurred or committed. +Lease +revenues are recognized as earned. Income from monthly or quarterly rental payments is recorded in the pertinent period according to the lease agreement. However, for leases that +provide variable rents, we recognize lease income on a straight-line basis. In addition to a monthly lease rate, some engine leases require an additional rental amount based on the number of hours the +engine is used in a particular month. Lease income associated with these contingent rentals is recorded in the period in which actual usage is reported to us by the lessee, which is normally the month +following the actual usage. +We +have elected to use certain practical expedients permitted under ASC 606. Shipping and handling fees and costs incurred associated with outbound freight after control over a product +has transferred to a customer are accounted for as a fulfillment cost and are included in cost of sales in our Consolidated +Statement of Income, and are not considered a performance obligation to our customers. Our reported sales on our Consolidated Statement of Income are net of any sales or related non-income taxes. We +also utilize the "as invoiced" practical expedient in certain cases where performance obligations are satisfied over time and the invoiced amount corresponds directly with the value we are providing +to the customer. +Revenue Recognition for Fiscal 2018 and 2017 +Sales and related cost of sales for product sales are generally recognized upon shipment of the product to the customer. Our standard terms and +conditions provide that title passes to the customer when the product is shipped to the customer. Sales of certain defense products are recognized upon customer acceptance, which includes transfer of +title. Sales from services and the related cost of services are generally recognized when customer-owned material is shipped back to the customer. We have adopted this accounting policy because at the +time the customer-owned material is shipped back to the customer, all services related to that material are complete as our service agreements generally do not require us to provide services at +customer sites. Furthermore, serviced units are typically shipped to the customer immediately upon completion of the related services. Sales and related cost of sales for certain large airframe +maintenance contracts and performance-based logistics programs are recognized by the percentage of completion method, based on the relationship of costs incurred to date to the estimated total costs. +Net favorable cumulative catch-up adjustments recognized during fiscal 2018 and 2017 were $3.6 million and $8.5 million, respectively, resulting from changes to the estimated +profitability of these contracts. +Lease +revenues are recognized as earned. Income from monthly or quarterly rental payments is recorded in the pertinent period according to the lease agreement. However, for leases that +provide variable rents, we recognize lease income on a straight-line basis. In addition to a monthly lease rate, some engine leases require an additional rental amount based on the number of hours the +engine is used in a particular month. Lease income associated with these contingent rentals is recorded in the period in which actual usage is reported to us by the lessee, which is normally the month +following the actual usage. +Certain +supply chain management programs we provide to our customers contain multiple elements or deliverables, such as program and warehouse management, parts distribution, and +maintenance and +48 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +repair +services. We recognize revenue for each element or deliverable that can be identified as a separate unit of accounting at the time of delivery based upon the relative fair value of the products +and services. +Contract Assets and Liabilities +The timing of revenue recognition, customer billings, and cash collections results in a contract asset or contract liability at the end of each +reporting period. Contract assets consist of unbilled receivables or costs incurred where revenue recognized over time using the cost-to-cost model exceeds the amounts billed to customers. Contract +liabilities include advance payments and billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of our performance obligations on the contract. +These amounts are recorded as contract liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. Contract +assets and contract liabilities are determined on a contract-by-contract basis. +Net +contract assets and liabilities are as follows: +May 31, 2019 +June 1, 2018 +Change +Contract assets—current +$ +59.2 +$ +49.6 +$ +9.6 +Contract assets—non-current +17.0 +12.9 +4.1 +Deferred revenue—current +(12.6 +) +(9.4 +) +(3.2 +) +Deferred revenue on long-term contracts +(83.8 +) +(34.7 +) +(49.1 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net contract assets (liabilities) +$ +(20.2 +) +$ +18.4 +$ +(38.6 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Contract +assets—non-current is reported within Other non-current assets, and Contract liabilities—current is reported within Accrued Liabilities on our +Consolidated Balance Sheet. Changes in contract assets and contract liabilities primarily result from the timing difference between our performance of services and payments from customers. For the +fiscal year ended May 31, 2019, we recognized as revenue the entire opening balance of our contract liabilities as the timing between customer payment and our performance of the services is a +short period of time and generally no longer than three months. +Remaining Performance Obligations +As of May 31, 2019, we had approximately $1.5 billion of remaining performance obligations, also referred to as firm backlog, +which excludes unexercised contract options and potential orders under our indefinite-delivery, indefinite-quantity contracts. We expect that approximately 40% of this backlog will be recognized as +revenue over the next 12 months, with the majority of the remaining balance recognized over the next three years. The amount of remaining performance obligations that is expected to be +recognized as revenue beyond 12 months primarily relates to our long-term programs where we provide component inventory management and/or repair services. +49 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Allowance for Doubtful Accounts +We maintain an allowance for doubtful accounts to reflect the expected uncollectibility of accounts receivable based on past collection history +and specific risks identified among uncollected accounts. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, +and our customers' current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to +undergo an extensive credit check prior to delivery of products or services. +We +perform regular evaluations of customer payment experience, current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, +letters of credit, and/or obligation guarantees from financial institutions for transactions executed on other than normal trade terms. We also maintain trade credit insurance for certain customers to +provide coverage, up to a certain limit, in the event of insolvency of some customers. +In +fiscal 2019, we recognized a provision for doubtful accounts of $12.4 million related to the bankruptcy of a European airline customer. The provision consisted of impairment of +non-current contract assets of $7.6 million, allowance for doubtful accounts of $3.3 million, and other liabilities of $1.5 million. +The +change in our allowance for doubtful accounts was as follows: +May 31, +2019 +2018 +2017 +Balance, beginning of year +$ +7.5 +$ +4.9 +$ +3.3 +Provision charged to operations +15.8 +0.5 +2.1 +Recoveries, deductions for accounts written off and other reclassifications +(7.3 +) +2.1 +(0.5 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, end of year +$ +16.0 +$ +7.5 +$ +4.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Goodwill and Other Intangible Assets +In accordance with ASC 350, Intangibles—Goodwill and Other , goodwill and other +intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential +impairment at a minimum annually, on May 31, or more frequently if circumstances indicate that impairment is possible. +As +of May 31, 2019, we had three reporting units, which included two in our Aviation Services segment (Aviation Supply Chain and Maintenance, Repair, and Overhaul) and one +comprised of our Expeditionary Services segment. We utilized the qualitative assessment approach for all reporting units and concluded it was more likely than not that the fair value of each reporting +unit exceeded its carrying value at May 31, 2019, and thus no impairment charge was recorded. +50 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Changes +in the carrying amount of goodwill by segment for fiscal 2019 and 2018 are as follows: +Aviation +Services +Expeditionary +Services +Total +Balance as of May 31, 2017 +$ +86.3 +$ +19.3 +$ +105.6 +Acquisition +12.5 +— +12.5 +Foreign currency translation adjustments +0.6 +— +0.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2018 +99.4 +19.3 +118.7 +Finalization of purchase price allocation +(1.0 +) +— +(1.0 +) +Foreign currency translation adjustments +(1.5 +) +— +(1.5 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2019 +$ +96.9 +$ +19.3 +$ +116.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Intangible +assets with finite useful lives are amortized on a straight-line basis over their estimated useful lives. Intangible assets, other than goodwill, are comprised of the +following: +May 31, 2019 +Gross +Accumulated +Amortization +Net +Amortizable intangible assets: +Customer relationships +$ +25.5 +$ +(15.6 +) +$ +9.9 +Lease agreements +22.5 +(14.0 +) +8.5 +Other +3.4 +(0.7 +) +2.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +51.4 +(30.3 +) +21.1 +Unamortized intangible assets: +Trademarks +1.1 +— +1.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +52.5 +$ +(30.3 +) +$ +22.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, 2018 +Gross +Accumulated +Amortization +Net +Amortizable intangible assets: +Customer relationships +$ +26.3 +$ +(13.9 +) +$ +12.4 +Lease agreements +22.5 +(12.6 +) +9.9 +Other +11.2 +(6.8 +) +4.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +60.0 +(33.3 +) +26.7 +Unamortized intangible assets: +Trademarks +1.1 +— +1.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +61.1 +$ +(33.3 +) +$ +27.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Customer +relationships are being amortized over 5-20 years and lease agreements are being amortized over 5-18 years. Amortization expense recorded during fiscal 2019, 2018 +and 2017 was $3.9 million, $4.7 million, and $4.2 million, respectively. The estimated aggregate amount of amortization expense for +51 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +intangible +assets in each of the next five fiscal years is $3.7 million in 2020, $3.7 million in 2021, $2.8 million in 2022, $2.3 million in 2023 and $2.1 million in +2024. +Foreign Currency +Our foreign subsidiaries utilize the local currency as their functional currency. All balance sheet accounts of foreign subsidiaries transacting +business in currencies other than the U.S. dollar are translated at year-end exchange rates. Revenues and expenses are translated at average exchange rates during the year. Translation adjustments are +excluded from the results of operations and are recorded in stockholders' equity as a component of accumulated other comprehensive loss until such subsidiaries are liquidated. +Cash +Cash and cash equivalents consist of highly liquid instruments which have original maturities of three months or less when purchased. Restricted +cash represents cash on hand required to be set aside by a contractual agreement related to receivable securitization arrangements. Generally, the restrictions related to the receivable securitization +arrangements lapse at the time we remit the customer payments collected by us as servicer of previously sold customer receivables to the purchaser. +Financial Instruments and Concentrations of Market or Credit Risk +Financial instruments that potentially subject us to concentrations of market or credit risk consist principally of trade receivables. While our +trade receivables are diverse and represent a number of entities and geographic regions, the majority are with the U.S. government and its contractors and entities in the aviation industry. The +composition of our accounts receivable is as follows: +May 31, +2019 +2018 +U.S. Government contracts: +Trade receivables +$ +28.7 +$ +31.9 +Unbilled receivables +31.7 +13.4 +​ +​ +​ +​ +​ +​ +​ +​ +60.4 +45.3 +All other customers: +Trade receivables +92.5 +96.2 +Unbilled receivables +44.9 +60.5 +​ +​ +​ +​ +​ +​ +​ +​ +137.4 +156.7 +​ +​ +​ +​ +​ +​ +​ +​ +$ +197.8 +$ +202.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +In +addition, we currently have past due accounts receivable owed by former commercial program customers primarily related to our exit from customer contracts in certain geographies, +including Colombia, Peru, and Poland. Our past due accounts receivable owed by these customers was $12.4 million as of May 31, 2019 which was net of allowance for doubtful accounts of +$8.2 million. +52 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +The +carrying amounts of cash and cash equivalents, accounts receivable, and accounts and trade notes payable approximate fair value because of the short-term maturity of these +instruments. The carrying value of long-term debt bearing a variable interest rate approximates fair value. +Fair +value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates are subjective in nature and involve +uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. +Inventories +Inventories are valued at the lower of cost or market (estimated net realizable value). Cost is determined by the specific identification, +average cost, or first-in, first-out methods. From time-to-time, we purchase aircraft and engines for disassembly to individual parts and components. Costs are assigned to these individual parts and +components utilizing list prices from original equipment manufacturers and recent sales history. +The +following is a summary of inventories: +May 31, +2019 +2018 +Aircraft and engine parts, components and finished goods +$ +467.9 +$ +383.5 +Raw materials and parts +41.8 +45.1 +Work-in-process +14.0 +32.1 +​ +​ +​ +​ +​ +​ +​ +​ +$ +523.7 +$ +460.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rotable Assets and Equipment under Leases +The cost of the asset under lease is the original purchase price plus overhaul costs. Depreciation is computed using the straight-line method +over the estimated service life of the equipment. The balance sheet classification of equipment under lease is generally based on lease term, with fixed-term leases less than twelve months generally +classified as short-term and all others generally classified as long-term. +Equipment +on short-term lease includes aircraft engines and parts on or available for lease to satisfy customers' immediate short-term requirements. The leases are renewable with fixed +terms, which generally vary from one to twelve months. +Future +rent due to us under non-cancelable leases during each of the next five fiscal years is $29.4 million in 2020, $28.7 million in 2021, $28.2 million in 2022, +$28.0 million in 2023, and $28.0 million in 2024. +Rotable Assets Supporting Long-Term Programs +Rotable assets supporting long-term programs consist of rotable component parts used to support long-term supply chain programs. The assets are +being depreciated on a straight-line basis over their estimated useful lives. +53 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Property, Plant and Equipment +We record property, plant and equipment at cost. Depreciation is computed on the straight-line method over useful lives of 10-40 years +for buildings and improvements and 3-10 years for equipment, furniture and fixtures, and capitalized software. Leasehold improvements are amortized over the shorter of the estimated useful life +or the term of the applicable lease. +Repair +and maintenance expenditures are expensed as incurred. Upon sale or disposal, cost and accumulated depreciation are removed from the accounts, and related gains and losses are +included in results of operations. +In +accordance with ASC 360, Property, Plant and Equipment , we are required to test for impairment of long-lived assets whenever events or +changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows. We utilize certain assumptions to estimate future undiscounted cash flows, +including demand for our services, future market conditions and trends, business development pipeline of opportunities, current and future lease rates, lease terms, and residual values. +Investments +Investments where we have the ability to exercise significant influence, but do not control the entity, are accounted for under the equity +method of accounting. Significant influence generally exists if we have a 20% to 50% ownership interest in the investee. Our share of the net earnings or loss of our investees is included in operating +income in our Consolidated Statements of Income since the activities of the investees are closely aligned with our operations. Equity investments in entities over which we do not have the ability to +exercise significant influence and whose securities do not have a readily determinable fair value are carried at cost. +We +evaluate our investments for impairment whenever events or changes in circumstances indicate that the carrying amounts of such investments may be impaired. If a decline in the value +of an investment is determined to be other than temporary, a loss is recorded in earnings in the current period. +Our +investments are classified in Other non-current assets on our Consolidated Balance Sheets. Distributions from joint ventures are classified as operating or investing activities in +the Consolidated +Statements of Cash Flows based upon an evaluation of the specific facts and circumstances of each distribution. +Income Taxes +We are subject to income taxes in the U.S., state, and several foreign jurisdictions. In the ordinary course of business, there can be +transactions and calculations where the ultimate tax determination is uncertain. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been +included in the financial statements or tax returns in accordance with applicable accounting guidance for accounting for income taxes, using currently enacted tax rates in effect for the year in which +the differences are expected to reverse. +We +record a valuation allowance when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets are reduced by a valuation allowance if, based on +the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. +54 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +Both +positive and negative evidence are considered in forming our judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. +Valuation allowances are reassessed whenever there are changes in circumstances that may cause a change in judgment. +The +accounting for uncertainty in income taxes requires a more-likely-than-not threshold for financial statement recognition of tax positions taken or expected to be taken in a tax +return. Where necessary, we record a liability for the difference between the benefit recognized for financial statement purposes and the tax position taken or expected to be taken on our tax return. +To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. +Supplemental Information on Cash Flows +Supplemental information on cash flows is as follows: +For the Year +Ended May 31, +2019 +2018 +2017 +Interest paid +$ +8.8 +$ +7.2 +$ +4.4 +Income taxes paid +7.0 +17.0 +12.7 +Income tax refunds and interest received +6.4 +0.1 +1.3 +During +fiscal 2019, treasury stock increased $7.0 million reflecting the repurchase of common shares of $10.3 million, restricted stock activity of $0.8 million +partially offset by the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $4.1 million. +During +fiscal 2018, treasury stock increased $0.9 million reflecting the repurchase of common shares of $13.1 million, restricted stock activity of $1.0 million and +the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $11.2 million. +During +fiscal 2017, treasury stock increased $12.2 million reflecting the repurchase of common shares of $19.8 million, restricted stock grants of $1.3 million and +the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $8.9 million. +Use of Estimates +We have made estimates and utilized certain assumptions relating to the reporting of assets and liabilities and the disclosures of contingent +liabilities to prepare these Consolidated +Financial Statements in conformity with accounting principles generally accepted in the United States. Actual results could differ from those estimates. +New Accounting Pronouncements Not Yet Adopted +In February 2016, the FASB issued ASU 2016-02, Leases . This ASU amends the existing +accounting standards for lease accounting, including requiring lessees to recognize a right-of-use asset and lease liability on the balance sheet for most lease arrangements, including those +classified as operating leases under the current accounting guidance. In addition, this ASU will require new qualitative and quantitative +55 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +1. Summary of Significant Accounting Policies (Continued) +disclosures +about our leasing activities. This new standard will be effective for us beginning June 1, 2019 and is required to be adopted using a modified retrospective approach. The new +standard provides us an option to recognize the cumulative effect adjustment on retained earnings as of June 1, 2019 or as of the beginning of the earliest period presented. +We +have reviewed our lease portfolio and are finalizing implementation of the necessary processes and systems to comply with the requirements of this new ASU. This included the selection +and implementation of a third-party software solution to facilitate the accounting and reporting requirements of the new ASU. +We +will adopt this ASU in the first quarter of fiscal 2020 and apply it prospectively. We expect to elect the package of practical expedients, which permits us not to reassess under the +new ASU our prior conclusions about lease identification, lease classification and initial direct costs. In addition, we will implement accounting policy elections to not separate lease and non-lease +components for both lessee and lessor relationships and not capitalize any leases with terms of less than twelve months on our Consolidated Balance Sheet. +We +expect to recognize operating lease liabilities with corresponding right-of-use assets of approximately the same amount based on the present value of the remaining lease payments over +the lease term. We do not anticipate that adoption of the ASU will have a significant impact on our results of operations or cash flows. +In +February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain +Tax Effects from Accumulated Other Comprehensive Income . This ASU permits the reclassification of tax effects stranded in accumulated other comprehensive income to retained +earnings as a result of the Tax Cuts and Jobs Act (the "Tax Reform Act"). We continue to evaluate the impact of this ASU on our consolidated financial statements and expect to adopt this ASU in the +first quarter of fiscal 2020. +In +June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326), Measurement of Credit Losses on Financial +Instruments . This ASU requires a change in the measurement approach for credit losses on financial assets measured on an amortized cost basis from an incurred loss method to an +expected loss method, thereby eliminating the requirement that a credit loss be considered probable to impact the valuation of a financial asset measured on an amortized cost basis. This ASU also +requires the measurement of expected credit losses to be based on relevant information about past events, including historical experience, current conditions, and a reasonable and supportable forecast +of the collectability of the related financial asset. We continue to evaluate the impact of this ASU on our consolidated financial statements and expect to adopt this ASU on June 1, 2020. +56 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +2. Discontinued Operations +Our Contractor-Owned, Contractor-Operated ("COCO") business completed certain contracts in the second quarter of fiscal 2018. As the aircraft supporting these contracts were not placed +on new contracts, combined with the continued decline in operational tempo within the U.S. Department of Defense ("DoD") and an excess supply of aircraft assets in the market, we determined there was +an impairment triggering event and tested the recoverability of our COCO assets. As a result, we recognized impairment and other charges of $54.2 million in the second quarter of fiscal 2018. +The fair value of the aircraft and related assets was based on available market data for similar assets. +During +the third quarter of fiscal 2018, we decided to pursue the sale of our COCO business previously included in our Expeditionary Services segment. Due to this strategic shift, the +assets, liabilities, and results of operations of our COCO business have been reported as discontinued operations for all periods presented. Goodwill was allocated to this business based on its +relative fair value to the reporting unit. The fair value of the reporting unit was determined based on a combination of the expected net proceeds upon sale and a discounted cash flow analysis. As the +fair value of the COCO business was below its carrying value, a goodwill impairment charge of $9.8 million, representing the estimated loss on disposal, was recorded in the third quarter of +fiscal 2018. +On +March 15, 2019, we signed an agreement to sell certain contracts and assets of our COCO business. We expect the sale to close before the end of calendar 2019. In conjunction +with this agreement and other expected asset sales, we recognized an impairment charge in discontinued operations of $74.1 million during the third quarter of fiscal 2019 reflecting the +expected net proceeds to be received upon the completion of the sale transactions. +Discontinued +operations also includes the results of our former metal machining operation, which was shutdown in the first quarter of fiscal 2017. +No +amounts for general corporate overhead or interest expense were allocated to discontinued operations during the periods presented. Unless otherwise noted, amounts and disclosures +throughout these Notes to Consolidated Financial Statements relate to our continuing operations. +Operating +results for discontinued operations were comprised of the following: +For the Year Ended May 31, +2019 +2018 +2017 +Sales +$ +95.8 +$ +96.3 +$ +176.9 +Cost of sales +(106.1 +) +(101.4 +) +(165.1 +) +Asset impairments +(74.1 +) +(65.2 +) +— +Selling, general and administrative expenses +(12.1 +) +(11.8 +) +(16.1 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating loss from discontinued operations +(96.5 +) +(82.1 +) +(4.3 +) +Provision for income taxes (benefit) +(19.9 +) +(24.0 +) +(8.8 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income (Loss) from discontinued operations +$ +(76.6 +) +$ +(58.1 +) +$ +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +During +the fourth quarter of fiscal 2017, we recognized an income tax benefit in discontinued operations of $6.7 million for an effective settlement of a previously reserved tax +position. +57 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +2. Discontinued Operations (Continued) +The +carrying amounts of the major classes of assets and liabilities for our discontinued operations are as follows: +May 31, +2019 +May 31, +2018 +Accounts receivable, net +$ +16.2 +$ +14.7 +Inventory, rotable assets, and equipment +7.5 +106.1 +Other assets +5.5 +4.2 +​ +​ +​ +​ +​ +​ +​ +​ +Assets of discontinued operations +$ +29.2 +$ +125.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Liabilities of discontinued operations +$ +29.2 +$ +25.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +3. Sale of Receivables +On February 23, 2018, we entered into a Purchase Agreement with Citibank N.A. ("Purchaser") for the sale, from time to time, of certain accounts receivable due from certain +customers (the "Purchase Agreement"). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million. The term of the Purchase Agreement runs through +February 22, 2020; however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual +terms unless either party provides advance notice that they do not intend to extend the term. +We +have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the +Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing , and de-recognize the sold receivables from our +Consolidated Balance Sheet. +During +fiscal 2019 and 2018, we sold $744.2 million and $239.6 million, respectively, of receivables under the Purchase Agreement and remitted $729.7 million and +$167.9 million, respectively, to the Purchaser on their behalf. As of May 31, 2019 and May 31, 2018, we had collected cash of $19.8 million and $10.5 million, +respectively, which was not yet remitted to the Purchaser as of those dates and was classified as Restricted cash on our Consolidated Balance Sheets. +We +recognize discounts on the sale of our receivables and other fees related to the Purchase Agreement in Other expense, net on our Consolidated Statements of Income. During fiscal 2019 +and 2018, we incurred discounts on the sale of our receivables and other fees of $2.2 million and $0.9 million, respectively. +58 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +4. Financing Arrangements +Debt Outstanding +A summary of the carrying amount of our debt is as follows: +May 31, +2019 +2018 +Revolving Credit Facility expiring November 1, 2021 with interest payable monthly +$ +120.0 +$ +130.0 +Term loan due November 1, 2021 with interest payable monthly +22.9 +23.9 +Industrial revenue bond (secured by property, plant and equipment) due August 1, 2018 with interest payable monthly +— +25.0 +Capital lease obligations +— +— +​ +​ +​ +​ +​ +​ +​ +​ +Total debt +142.9 +178.9 +Current maturities of debt +— +— +Debt issuance costs, net +(1.2 +) +(1.7 +) +​ +​ +​ +​ +​ +​ +​ +​ +Long-term debt +$ +141.7 +$ +177.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +At +May 31, 2019, our variable rate and fixed rate debt had a fair value that approximates its carrying value and is classified as Level 2 in the fair value hierarchy. +The +industrial revenue bond was paid on August 1, 2018 using our Revolving Credit Facility. +On +October 18, 2017, we entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender (the "Credit Agreement"). The Credit Agreement provided a Canadian +$31 million term loan with the proceeds used to fund the acquisition of two maintenance, repair, and overhaul ("MRO") facilities in Canada from Premier Aviation. The term loan is due in full at +the expiration of the Credit Agreement on November 1, 2021 unless terminated earlier pursuant to the terms of the Credit Agreement. Interest is payable monthly on the term loan at the offered +fluctuating Canadian Dollar Offer Rate plus 125 to 225 basis points based on certain financial measurements if a Bankers' Acceptances loan, or at the offered fluctuating Prime Rate plus 25 to 125 +basis points based on certain financial measurements, if a Prime Rate loan. +We +maintain a Revolving Credit Facility with various financial institutions, as lenders, and Bank of America, N.A., as administrative agent for the lenders, which provides the Company an +aggregate revolving credit commitment amount of $500 million. The Company, under certain circumstances, has the ability to request an increase to the revolving credit commitment by an aggregate +amount of up to $250 million, not to exceed $750 million in total. +On +November 1, 2016, we entered into an amendment to our Revolving Credit Facility which extended the maturity of the Revolving Credit Facility to November 1, 2021, +eliminated the condition of no material adverse change for credit extensions and modified certain other provisions. +Borrowings +under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 100 to 200 basis points based on certain financial measurements if a Eurodollar Rate +loan, or at the offered fluctuating Base Rate plus 0 to 100 basis points based on certain financial measurements if a Base Rate loan. +59 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +4. Financing Arrangements (Continued) +The +industrial revenue bond that matured on August 1, 2018 was classified as a long-term liability due to our intent and ability to refinance this bond on a long-term basis using +our Revolving Credit Facility. +Our +financing arrangements also require us to comply with leverage and interest coverage ratios, maintain a minimum net working capital level, and comply with certain affirmative and +negative covenants, including those relating to financial reporting and notification, payment of indebtedness, cash dividends, taxes and other obligations, compliance with applicable laws, and +limitations on additional liens, indebtedness, acquisitions, investments and disposition of assets. The Revolving Credit Facility also requires our significant domestic subsidiaries, and any +subsidiaries that guarantee our other indebtedness, to provide a guarantee of payment under the Revolving Credit Facility. At May 31, 2019, we were in compliance with the financial and other +covenants in our financing agreements. +Borrowing +activity under the Revolving Credit Facility during fiscal 2019, 2018 and 2017 is as follows: +For the Year Ended May 31, +2019 +2018 +2017 +Maximum amount borrowed +$ +287.0 +$ +275.0 +$ +217.0 +Average daily borrowings +207.8 +214.1 +175.5 +Average interest rate during the year +3.41 +% +2.52 +% +1.77 +% +We +also have $9.5 million available under foreign lines of credit. +5. Stock-Based Compensation +We have granted stock-based awards under the AAR CORP. 2013 Stock Plan (the "2013 Stock Plan") and the AAR CORP. Stock Benefit Plan ("Stock Benefit Plan") each of which has been approved +by our stockholders. No further awards will be made under the Stock Benefit Plan. Under the 2013 Stock Plan, we are authorized to issue stock options to employees and non-employee directors that allow +the +grant recipients to purchase shares of common stock at a price not less than the fair market value of the common stock on the date of grant. Generally, stock options awarded expire ten years from the +date of grant and are exercisable in three annual increments commencing one year after the date of grant. In addition to stock options, the 2013 Stock Plan also provides for the grant of time-based +restricted stock awards and performance-based restricted stock awards. The number of performance-based awards earned, subject to vesting, is based on achievement of certain Company-wide or segment +financial goals or stock price targets. The 2013 Stock Plan also provides for the grant of stock appreciation units and restricted stock units; however, to date, no such awards have been granted. +Restricted +stock grants (whether time-based or performance-based) are designed, among other things, to align employee interests with the interests of stockholders and to encourage the +recipient to build a career with us. Restricted stock typically vests over periods of one to five years from date of grant. Restricted stock grants may be performance-based with vesting to occur over +periods of three to five years. All restricted stock that has been granted and, if performance-based, earned according to performance criteria carries full dividend and voting rights, regardless of +whether it has vested. +Substantially +all stock options and restricted stock are subject to forfeiture prior to vesting if the employee's employment terminates for any reason other than death, disability or +retirement. Since inception, a total of 11,149,000 shares have been granted under the Stock Benefit Plan. We have granted a +60 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +5. Stock-Based Compensation (Continued) +total +of 3,089,000 shares under the 2013 Stock Plan. All future stock awards will be made under the 2013 Stock Plan. There were 1,556,114 shares available for grant under the 2013 Stock Plan as of +May 31, 2019. +Stock Options +During fiscal 2019, 2018, and 2017, we granted stock options with respect to 300,240 shares, 463,140 shares and 687,000 shares, respectively. +The weighted average fair value per share of stock options granted during fiscal 2019, 2018 and 2017 was $13.60, $9.29 and $6.50, respectively. The fair value of each stock option grant was estimated +on the date of grant using the Black-Scholes option pricing model using the following weighted average assumptions: +Stock Options +Granted In +Fiscal Year +2019 +2018 +2017 +Risk-free interest rate +2.7 +% +1.8 +% +1.0 +% +Expected volatility of common stock +30.8 +% +31.7 +% +36.8 +% +Dividend yield +0.6 +% +0.9 +% +1.3 +% +Expected option term in years +4.5 +4.3 +4.0 +The +risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on historical volatility of our common stock, and +the expected option term represents the period of time that the stock options granted are expected to be outstanding based on historical exercise trends. The dividend yield represents our anticipated +cash dividends at the grant date over the expected option term. +A +summary of stock option activity for the three years ended May 31, 2019 consisted of the following (shares in thousands): +2019 +2018 +2017 +Shares +Weighted +Average +Exercise +Price +Shares +Weighted +Average +Exercise +Price +Shares +Weighted +Average +Exercise +Price +Outstanding at beginning of year +2,082 +$ +26.72 +2,334 +$ +23.02 +2,096 +$ +22.17 +Granted +300 +$ +47.84 +463 +$ +35.33 +687 +$ +24.10 +Exercised +(571 +) +$ +25.56 +(704 +) +$ +20.04 +(396 +) +$ +20.07 +Cancelled +(34 +) +$ +42.02 +(11 +) +$ +29.50 +(53 +) +$ +25.42 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Outstanding at end of year +1,777 +$ +30.37 +2,082 +$ +26.72 +2,334 +$ +23.02 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Options exercisable at end of year +981 +$ +25.28 +883 +$ +23.81 +910 +$ +21.97 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +total fair value of stock options that vested during fiscal 2019, 2018, and 2017 was $5.6 million, $4.9 million, and $3.5 million, respectively. The total +intrinsic value of stock options exercised during fiscal 2019, 2018, and 2017 was $12.2 million, $14.2 million, and $4.7 million, respectively. The aggregate intrinsic value of +options outstanding was $6.7 million and $37.4 million as of May 31, 2019 and 2018, respectively. The tax benefit realized from stock options exercised during fiscal 2019, 2018, +and 2017 was $2.7 million, +61 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +5. Stock-Based Compensation (Continued) +$2.9 million, +and $1.2 million, respectively. Expense recognized in selling, general and administrative expenses for stock options during fiscal 2019, 2018, and 2017 was +$4.1 million, $5.1 million, and $4.6 million, respectively. As of May 31, 2019, we had $4.2 million of unrecognized compensation expense related to stock options +that will be amortized over an average period of 1.3 years. +Restricted Stock +We provide executives and other key employees an opportunity to be awarded performance-based and time-based restricted stock. The +performance-based awards are contingent upon the achievement of certain objectives, which generally include cumulative net income, average return on capital, and relative total shareholder return over +a three-year performance period. During fiscal 2019, 2018, and 2017, we granted 43,680, 108,440, and 212,583 of performance-based restricted shares, respectively. Time-based restricted shares of +46,470, 24,425, and 39,100 were granted to executives and key employees during fiscal 2019, 2018, and 2017, respectively. We also award time-based restricted stock to our non-employee directors as +part of their annual compensation. Time-based restricted shares of 29,128, 55,000, and 50,625 were granted to members of the Board of Directors during fiscal 2019, 2018, and 2017, respectively. +The +fair value of restricted shares is the market value of our common stock on the date of grant. Expense recognized in selling, general and administrative expenses for all restricted +share programs during fiscal 2019, 2018, and 2017 was $9.4 million, $10.2 million, and $6.4 million, respectively. +Restricted +share activity during the fiscal 2019 was as follows (shares in thousands): +Number of +Shares +Weighted Average +Fair Value +on Grant Date +Nonvested at May 31, 2018 +684 +$ +27.89 +Granted +168 +$ +40.83 +Vested +(303 +) +$ +28.08 +Forfeited +(17 +) +$ +40.67 +​ +​ +​ +​ +​ +​ +​ +​ +Nonvested at May 31, 2019 +532 +$ +31.70 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As +of May 31, 2019 we had $7.1 million of unearned compensation related to restricted shares that will be amortized to expense over a weighted average period of +1.1 years. +6. Income Taxes +On December 22, 2017, the Tax Reform Act was enacted which significantly revised the U.S. corporate income tax system. The Tax Reform Act, among other things, reduced the +corporate federal income tax rate to 21% from 35%, changed bonus depreciation regulations and limited deductions for executive compensation. The income tax rate reduction in the Tax Reform Act was +effective January 1, 2018 which resulted in a blended federal statutory tax rate of 29.2% in fiscal 2018. +In +fiscal 2018, we re-measured our deferred tax assets and liabilities based on the tax rate at which they are expected to reverse in the future, which was either at a federal rate of +29.2% for reversals expected in fiscal 2018 or 21% for reversals in fiscal 2019 and subsequent years. During fiscal 2018, we +62 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +6. Income Taxes (Continued) +recognized +an income tax benefit of $14.1 million for the re-measurement impact from applying the provisions of the Tax Reform Act. +The +provision for income tax on income from continuing operations includes the following components: +For the Year Ended +May 31, +2019 +2018 +2017 +Current: +Federal +$ +4.8 +$ +14.6 +$ +9.3 +State +0.1 +0.1 +0.2 +Foreign +5.0 +1.7 +3.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +9.9 +16.4 +12.6 +Deferred +(5.0 +) +(12.9 +) +12.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +4.9 +$ +3.5 +$ +25.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +provision for income taxes on pre-tax income differs from the amount computed by applying the U.S. federal statutory income tax rate of 21.0% for fiscal 2019, 29.2% for fiscal 2018 +and 35.0% for fiscal 2017 to income from continuing operations before provision for income taxes due to the following: +For the Year Ended +May 31, +2019 +2018 +2017 +Provision for income tax at the federal statutory rate +$ +18.7 +$ +22.5 +$ +27.0 +Deferred tax re-measurement from the Tax Reform Act +— +(14.1 +) +— +Excess tax benefits from stock-based compensation +(2.7 +) +(2.9 +) +— +State net operating losses +(0.3 +) +1.3 +5.7 +Change in valuation allowance for state deferred tax assets +(6.9 +) +(3.4 +) +(5.7 +) +Effective settlement of prior tax positions +(4.7 +) +— +(2.2 +) +Other +0.8 +0.1 +0.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Provision for income tax +$ +4.9 +$ +3.5 +$ +25.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income +before provision for income taxes includes the following components: +For the Year Ended +May 31, +2019 +2018 +2017 +Domestic +$ +68.9 +$ +58.7 +$ +57.7 +Foreign +20.1 +18.5 +19.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +89.0 +$ +77.2 +$ +77.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +63 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +6. Income Taxes (Continued) +Deferred tax liabilities and assets result primarily from the differences in the timing of the recognition of transactions for financial reporting and income tax purposes. Our deferred +tax liabilities and assets consist of the following components: +May 31, +2019 +2018 +Deferred tax assets: +Employee benefits +$ +9.4 +$ +9.7 +State net operating losses +9.0 +8.6 +Deferred revenue +7.7 +1.1 +Inventory costs +4.9 +15.9 +Postretirement benefits +3.7 +2.2 +Other +4.8 +4.2 +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax assets +39.5 +41.7 +Valuation allowance +(0.1 +) +(7.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax assets net of valuation allowance +39.4 +34.7 +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax liabilities: +Tangible and intangible assets +(36.1 +) +(50.2 +) +Other +(0.2 +) +(0.2 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax liabilities +(36.3 +) +(50.4 +) +​ +​ +​ +​ +​ +​ +​ +​ +Net deferred tax assets (liabilities) +$ +3.1 +$ +(15.7 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As +of May 31, 2019, we have determined that the realization of our deferred tax assets is more likely than not and that a valuation allowance is not required except for certain +state deferred tax assets, including net operating losses. The change in the valuation allowance was primarily the result of the expected utilization of a portion of these state net operating losses. +Our net operating losses have carry forward periods that range from 5 to 20 years. Our history of operating earnings, our expectations for continued future earnings, the nature of certain of +our deferred tax assets and the scheduled reversal of deferred tax liabilities, primarily related to depreciation, support the recoverability of the majority of the deferred tax assets. Our net +deferred tax assets are included in Other non-current assets on our Consolidated Balance Sheet at May 31, 2019. +Income +tax receivable was $1.1 million and $1.0 million at May 31, 2019 and 2018, respectively, and was included in Other current assets on the Consolidated Balance +Sheet. +64 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +6. Income Taxes (Continued) +A +reconciliation of the beginning and ending amounts of unrecognized tax benefits was as follows: +For the Year Ended +May 31, +2019 +2018 +2017 +Balance, beginning of year +$ +4.4 +$ +4.4 +$ +12.9 +Additions for tax positions of prior years +— +— +0.4 +Effective settlement of prior tax position +(4.4 +) +— +(8.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance, end of year +$ +— +$ +4.4 +$ +4.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +reserve for unrecognized tax benefits decreased primarily as a result of effective settlement of tax positions for prior tax years, which occurred upon the settlement of IRS +examinations. Income tax expense in fiscal 2019 included a benefit of $4.4 million for these effective settlements. Income tax expense in fiscal 2017 included a benefit of $2.2 million +and discontinued operations included a benefit of $6.7 million for these effective settlements. +Fiscal +years 2016 and subsequent are open for examination. Various states and foreign jurisdictions also remain open subject to their applicable statute of limitations. +7. Earnings Per Share +The computation of basic earnings per share is based on the weighted average number of common shares outstanding during each period. The computation of diluted earnings per share is +based on the weighted average number of common shares outstanding during the period plus, when their effect is dilutive, incremental shares consisting of shares subject to stock options, shares +issuable upon vesting of restricted stock awards and shares to be issued upon conversion of convertible debt. +In +accordance with ASC 260-10-45, Share-Based Payment Arrangements and Participating Securities and the Two-Class Method , our unvested +restricted stock awards are deemed participating securities since these shares are entitled to participate in dividends declared on common shares. During periods of net income, the calculation of +earnings per share for common stock excludes income attributable to unvested restricted stock awards from the numerator and excludes the dilutive impact of those shares from the denominator. During +periods of net loss, no effect is given to the participating securities because they do not share in the losses of the Company. +65 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +7. Earnings Per Share (Continued) +The +following tables provide a reconciliation of the computations of basic and diluted earnings per share information for each of the years in the three-year period ended May 31, +2019 (shares in millions). +For the Year Ended +May 31, +2019 +2018 +2017 +Basic and Diluted EPS: +Income from continuing operations +$ +84.1 +$ +73.7 +$ +52.0 +Less income attributable to participating shares +(0.4 +) +(0.6 +) +(0.5 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations attributable to common shareholders +83.7 +73.1 +51.5 +Income (Loss) from discontinued operations attributable to common shareholders +(76.6 +) +(58.1 +) +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net income attributable to common shareholders for earnings per share +$ +7.1 +$ +15.0 +$ +56.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average common shares outstanding—basic +34.5 +34.2 +33.9 +Additional shares from assumed exercise of stock options +0.4 +0.4 +0.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average common shares outstanding—diluted +34.9 +34.6 +34.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic: +Earnings from continuing operations +$ +2.42 +$ +2.14 +$ +1.53 +Earnings (Loss) from discontinued operations +(2.22 +) +(1.70 +) +0.13 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—basic +$ +0.20 +$ +0.44 +$ +1.66 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted: +Earnings from continuing operations +$ +2.40 +$ +2.11 +$ +1.51 +Earnings (Loss) from discontinued operations +(2.19 +) +(1.70 +) +0.13 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share—diluted +$ +0.21 +$ +0.41 +$ +1.64 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +At +May 31, 2019 and 2017, respectively, outstanding options to purchase 273,400 and 11,200 shares of common stock were not included in the computation of diluted earnings per +share, because the exercise price of these options was greater than the average market price of the common shares for the year then ended. At May 31, 2018, the average market price of our +common shares was in excess of the exercise prices of all of our outstanding options. +8. Employee Benefit Plans +Defined Benefit Plans +Prior to January 1, 2000, the pension plan for domestic salaried and non-union hourly employees had a benefit formula based primarily on +years of service and compensation. Effective January 1, 2000, we converted our defined benefit plan for substantially all domestic salaried and certain hourly employees to a cash balance +pension plan. Under the cash balance pension plan, the retirement benefit is expressed as a dollar amount in an account that grows with annual pay-based credits and interest on the account balance. +The interest crediting rate under our cash balance plan is determined quarterly and is equal to 100% of the average 30-year treasury rate for the second month preceding the applicable quarter +published by the +66 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Internal +Revenue Service. The average interest crediting rate under our cash balance plan for the fiscal year ended May 31, 2019 was 4.46%. Effective June 1, 2005, the existing cash +balance plan was frozen and the annual pay-based credits were discontinued. Also effective June 1, 2005, the defined contribution plan was modified to include increased employer contributions +and an enhanced profit sharing formula. Defined pension benefits for certain union hourly employees are based primarily on a fixed amount per year of service and the plan was frozen in fiscal 2018. +We +also have a defined benefit pension plan covering certain employees in the Netherlands. Benefit formulas are based generally on years of service and compensation. +We +also have a benefit plan which provides benefits to certain retired outside directors. In fiscal 2001, we froze the plan for any new members of the Board of Directors and no current +directors participate in this plan. +The +change to our projected benefit obligation and the fair value of our plan assets for our pension plans was as follows: +May 31, +2019 +2018 +Change in projected benefit obligation: +Projected benefit obligation at beginning of year +$ +146.5 +$ +145.4 +Service cost +2.3 +2.4 +Interest cost +4.3 +4.3 +Participant contributions +0.4 +0.4 +Net actuarial loss (gain) +6.5 +(2.3 +) +Benefits and administrative payments +(6.9 +) +(6.5 +) +Settlements +(0.6 +) +— +Plan change +— +0.7 +Foreign currency translation adjustment +(3.3 +) +2.1 +​ +​ +​ +​ +​ +​ +​ +​ +Projected benefit obligation at end of year +$ +149.2 +$ +146.5 +​ +​ +​ +​ +​ +​ +​ +​ +Change in the fair value of plan assets: +Fair value of plan assets at beginning of year +$ +134.5 +$ +118.8 +Actual return on plan assets +2.8 +11.6 +Employer contributions +2.6 +8.4 +Participant contributions +0.4 +0.4 +Benefits and administrative payments, including settlements +(7.5 +) +(6.5 +) +Foreign currency translation adjustment +(2.9 +) +1.8 +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of plan assets at end of year +$ +129.9 +$ +134.5 +​ +​ +​ +​ +​ +​ +​ +​ +Funded status at end of year +$ +(19.3 +) +$ +(12.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +67 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Amounts +recognized in the Consolidated Balance Sheets consisted of the following: +May 31, +2019 +2018 +Other non-current assets +$ +— +$ +0.5 +Accrued liabilities +(0.4 +) +(1.2 +) +Other liabilities +(18.9 +) +(11.3 +) +​ +​ +​ +​ +​ +​ +​ +​ +Funded status at end of year +$ +(19.3 +) +$ +(12.0 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Amounts +recognized in accumulated other comprehensive loss at May 31, 2019 and 2018, respectively, consisted of the following: +May 31, +2019 +2018 +Actuarial loss +$ +58.7 +$ +50.5 +Prior service credit +— +(0.1 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +58.7 +$ +50.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For +all of our pension plans, both the projected benefit obligation and the accumulated benefit obligation are in excess of the individual plans' assets. The accumulated benefit +obligation for all pension plans was $142.4 million and $140.2 million at May 31, 2019 and 2018, respectively. +Net Periodic Benefit Cost +Pension expense charged to the Consolidated Statements of Income includes the following components: +For the Year Ended +May 31, +2019 +2018 +2017 +Service cost +$ +2.3 +$ +2.4 +$ +2.5 +Interest cost +4.3 +4.3 +4.2 +Expected return on plan assets +(7.1 +) +(7.3 +) +(6.5 +) +Curtailment +— +0.3 +— +Settlements +0.1 +— +— +Amortization of prior service credit +(0.1 +) +— +— +Recognized net actuarial loss +1.8 +2.3 +2.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1.3 +$ +2.0 +$ +2.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +estimated amount of net actuarial loss to be amortized from accumulated other comprehensive loss into expense during fiscal 2020 is $2.0 million. +68 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Assumptions +The assumptions used in accounting for our plans are estimates of factors including, among other things, the amount and timing of future benefit +payments. The following table presents the key weighted-average assumptions used in the measurement of our projected benefit obligations: +May 31, +2019 +2018 +Discount rate: +Domestic plans +3.67 +% +4.05 +% +International plan +1.50 +1.90 +Rate of compensation increase: +Domestic plans +n/a +n/a +International plans +3.00 +% +3.00 +% +A +summary of the weighted-average assumptions used to determine net periodic pension expense is as follows: +For the Year Ended +May 31, +2019 +2018 +2017 +Discount rate: +Domestic plans +4.05 +% +3.82 +% +3.83 +% +International plan +1.90 +2.00 +1.90 +Expected long-term rate on plan assets: +Domestic plans +7.25 +% +7.25 +% +7.25 +% +International plan +3.60 +4.00 +4.00 +The +discount rate was determined by projecting the expected future benefit payments as defined for the projected benefit obligation, discounting those expected payments using a +theoretical zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, and solving for the single equivalent discount rate that resulted in the same +projected benefit obligation. +Plan Assets +The following table sets forth the actual asset allocation and target allocations for our U.S. pension plans: +May 31, +Target Asset +Allocation +2019 +2018 +Equity securities +59 +% +59 +% +45 - 75 +% +Fixed income securities +22 +22 +15 - 45 +% +Other +19 +19 +0 - 25 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +100 +% +100 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +69 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +The +assets of U.S pension plans are invested in compliance with the Employee Retirement Income Security Act of 1974. The investment goals are to provide a total return that, over the +long term, optimizes the long-term return on plan assets at an acceptable risk, and to maintain a broad diversification across asset classes and among investment managers. We believe that there are no +significant concentrations of risk within our plan assets as of May 31, 2019. The use of derivatives for the purpose of speculation are not permitted. The assets of the U.S. pension plans are +invested primarily in equity and fixed income mutual funds, individual common stocks, and fund-of-funds hedge funds. The assets of the non-domestic plan are invested in funds-of-funds where each fund +holds a portfolio of equity and fixed income mutual funds. +To +develop our expected long-term rate of return assumption on domestic plans, we use long-term historical return information for our targeted asset mix and current market conditions. +The expected return for each asset class is weighted based on the target asset allocation to develop the expected long-term rate of return on plan assets assumption. While consideration is given to +recent performance, the assumption represents a long-term, prospective rate of return. +The +following table sets forth by level, within the fair value hierarchy, pension plan assets at their fair value as of May 31, 2019: +Level 1 1 +Level 2 2 +Level 3 3 +Total +Equity securities: +U.S. mutual funds +$ +31.1 +$ +— +$ +— +$ +31.1 +International mutual funds +8.4 +— +— +8.4 +Fixed income: +Government securities and corporate bond mutual funds +9.0 +5.9 +— +14.9 +Funds-of-funds +— +53.0 +7.9 +60.9 +Hedge funds +— +— +4.2 +4.2 +Insurance annuities +— +— +9.9 +9.9 +Cash and cash equivalents +0.5 +— +— +0.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total investments +$ +49.0 +$ +58.9 +$ +22.0 +$ +129.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +70 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +The following table sets forth by level, within the fair value hierarchy, pension plan assets at their fair value as of May 31, 2018: +Level 1 1 +Level 2 2 +Level 3 3 +Total +Equity securities: +U.S. mutual funds +$ +32.8 +$ +— +$ +— +$ +32.8 +International mutual funds +10.4 +— +— +10.4 +Fixed income: +Government securities and corporate bond mutual funds +15.7 +— +— +15.7 +Funds-of-funds +— +53.6 +7.7 +61.3 +Hedge funds +— +— +4.4 +4.4 +Insurance annuities +— +7.8 +7.8 +Cash and cash equivalents +2.1 +— +— +2.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total investments +$ +61.0 +$ +53.6 +$ +19.9 +$ +134.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1 Quoted +prices in active markets for identical assets that we have the ability to access as of the reporting date. +2 Inputs +other than quoted prices included within Level 1 that are directly observable for the asset or indirectly observable through corroboration +with observable market data. +3 Unobservable +inputs, such as internally developed pricing models or third party valuations for the asset due to little or no market activity for the +asset. +The +following table presents the reconciliation of Level 3 pension assets measured at fair value for the fiscal years ended May 31, 2019 and 2018: +Hedge +Funds +Fund-of- +funds +Insurance +Annuities +Total +Balance as of May 31, 2017 +$ +6.8 +$ +7.3 +$ +— +$ +14.1 +Purchases +— +— +7.8 +7.8 +Sales +(3.0 +) +— +— +(3.0 +) +Return on plan assets related to assets still held at May 31, 2018 +0.6 +0.4 +— +1.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2018 +4.4 +7.7 +7.8 +19.9 +Purchases +— +— +2.1 +2.1 +Return on plan assets related to assets still held at May 31, 2019 +(0.2 +) +0.2 +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2019 +$ +4.2 +$ +7.9 +$ +9.9 +$ +22.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Valuation Techniques Used to Determine Fair Value +Cash equivalents are investments with maturities of three months or less when purchased. The fair values are based on observable market prices +and categorized as Level 1. +71 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +With +respect to individually held equity securities, including investments in U.S. and international securities, the trustees obtain prices from pricing services, whose prices are +obtained from direct feeds from market exchanges, which we are able to independently corroborate. Equity securities held individually are primarily traded on exchanges that contain only actively +traded securities, due to the volume trading requirements imposed by these exchanges. Equity securities are valued based on quoted prices in active markets and categorized as Level 1. +Equity +and fixed income mutual funds are maintained by investment companies that hold certain investments in accordance with a stated set of fund objectives, which are consistent with +our overall investment strategy. The values of some of these funds are publicly quoted. For equity and fixed income mutual funds which are publicly quoted, the funds are valued based on quoted prices +in active markets and have been categorized as Level 1. As certain of our funds-of-funds investments are also derived from quoted prices in active markets, we have categorized certain +funds-of-funds investments as Level 2. +Hedge +fund investments include those seeking to maximize absolute returns using a broad range of strategies to enhance returns and provide additional diversification. The fair value of +hedge funds is determined using net asset value or its equivalent subject to certain restrictions, such as a lock-up period. As we may be limited in our ability to redeem the investments at the +measurement date or within a reasonable period of time, the hedge fund investments are categorized as Level 3. Our other Level 3 investments require the utilization of unobservable +inputs resulting in Level 3 treatment in the fair value hierarchy. +Future Benefit Payments and Funding +The following table summarizes our estimated future pension payments by fiscal year: +Fiscal Year +2020 +2021 +2022 +2023 +2024 +2025 to +2029 +Estimated future pension payments +$ +6.8 +$ +5.5 +$ +6.0 +$ +6.3 +$ +5.9 +$ +35.7 +Our +contribution policy for the domestic plans is to contribute annually, at a minimum, an amount which is deductible for federal income tax purposes and that is sufficient to meet +actuarially computed pension benefits. For our Netherlands pension plan, our policy is to fund at least the minimum amount required by the local laws and regulations. We anticipate contributing +approximately $1.6 million to our pension plans during fiscal 2020. +Postretirement Benefits Other Than Pensions +We provide health and life insurance benefits for certain eligible retirees. The postretirement plan is unfunded and in fiscal 1995, we +completed termination of postretirement health and life insurance benefits attributable to future services of collective bargaining and other domestic employees. The unfunded projected benefit +obligation for this plan was $0.4 million and $0.4 million as of May 31, 2019 and 2018, respectively. We have omitted substantially all of the required disclosures +related to this plan because the plan is not material to our consolidated financial position or results of operations. +72 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +8. Employee Benefit Plans (Continued) +Defined Contribution Plan +The defined contribution plan is a profit sharing plan that is intended to qualify as a 401(k) plan under the Internal Revenue Code. Under the +plan, employees may contribute up to 75% of their pretax compensation, subject to applicable regulatory limits. We may make matching contributions up to 5% of compensation as well as discretionary +profit sharing contributions. Our contributions vest on a pro-rata basis during the first three years of employment. We also provide profit sharing benefits for certain executives and key employees to +supplement the benefits provided by the defined contribution plan. Expense charged to the Consolidated Statements of Income for our matching contributions, including profit sharing contributions, was +$11.4 million in fiscal 2019, $9.2 million in fiscal 2018 and $11.6 million in fiscal 2017 for these plans. +9. Accumulated Other Comprehensive Loss +Changes in our accumulated other comprehensive loss ("AOCL") by component for each of the years in the three-year period ended May 31, 2019 were as follows (all +amounts are net of tax): +Currency +Translation +Adjustments +Pension Plans +Total +Balance as of June 1, 2016 +$ +(1.1 +) +$ +(43.3 +) +$ +(44.4 +) +Other comprehensive loss before reclassifications +(0.6 +) +3.5 +2.9 +Amounts reclassified from AOCL +— +1.6 +1.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive loss +(0.6 +) +5.1 +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2017 +(1.7 +) +(38.2 +) +(39.9 +) +Other comprehensive income (loss) before reclassifications +2.0 +4.2 +6.2 +Amounts reclassified from AOCL +— +1.7 +1.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive income (loss) +2.0 +5.9 +7.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2018 +0.3 +(32.3 +) +(32.0 +) +Other comprehensive income before reclassifications +(2.4 +) +(8.0 +) +(10.4 +) +Amounts reclassified from AOCL +— +1.5 +1.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total other comprehensive income +(2.4 +) +(6.5 +) +(8.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance as of May 31, 2019 +$ +(2.1 +) +$ +(38.8 +) +$ +(40.9 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +10. Commitments and Contingencies +On October 3, 2003, we entered into a sale-leaseback transaction whereby we sold and leased back a facility located in Garden City, New York. The lease is classified as an +operating lease. Net proceeds from the sale of the facility were $14.0 million and the cost and related accumulated depreciation of the facility of $9.5 million and $4.6 million, +respectively, were removed from the Consolidated Balance Sheet at the time of sale. The gain realized on the sale of $9.1 million has been deferred and is being amortized over the 20-year lease +term. As of May 31, 2019 and 2018, the unamortized balance of the deferred gain was +73 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +10. Commitments and Contingencies (Continued) +approximately +$2.0 million and $2.5 million, respectively, and is included in Other liabilities on the Consolidated Balance Sheets. +In +addition to the leases described above, we lease other facilities and equipment under agreements that are classified as operating leases. With the exception of a land lease for one of +our airframe maintenance facilities which expires in 2108, our operating leases expire at various dates through 2034. Future minimum payments under all operating leases at May 31, 2019 are as +follows: +2020 +$ +21.6 +2021 +19.3 +2022 +16.5 +2023 +13.2 +2024 +11.0 +2025 and thereafter +39.9 +Rental +expense for facilities and equipment during fiscal years 2019, 2018, and 2017 was $25.9 million, $23.5 million, and $22.9 million, respectively. +We +enter into purchase obligations, which arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts and components, +as well as equipment to support the operations of our business. The aggregate amount of purchase obligations due in each of the next five fiscal years is $322.3 million in 2020, +$53.8 million in 2021, $7.8 million in 2022, $0.6 in 2023 and $0.1 million in 2024. +We +routinely issue letters of credit and performance bonds in the ordinary course of our business. These instruments are typically issued in conjunction with insurance contracts or other +business requirements. The total of these instruments outstanding at May 31, 2019 was approximately $31.7 million which includes $11.6 million related to a guarantee of 40% of the +outstanding debt of our Indian joint venture. We have recognized a current liability of $4.8 million based on the fair value of our guarantee obligation. +We +are involved in various claims and legal actions, including environmental matters, arising in the ordinary course of business. In the opinion of management, the ultimate disposition +of these matters will not have a material adverse effect on our consolidated financial condition or results of operations. +74 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +11. Other Non-current Assets +At May 31, 2019 and 2018, other non-current assets consisted of the following: +May 31, +2019 +2018 +Contract assets +$ +17.0 +$ +39.0 +Cash surrender value of life insurance +15.6 +16.8 +Assets under deferred compensation plan +10.4 +35.7 +Investments in joint ventures +12.3 +7.6 +License fees +7.2 +10.6 +Other +15.0 +9.2 +​ +​ +​ +​ +​ +​ +​ +​ +$ +77.5 +$ +118.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Investments in Joint Ventures +During fiscal 2018, we sold interests in two aircraft joint ventures, which were accounted for under the equity method of accounting. We +received cash proceeds of $7.3 million and recognized a gain on the sale of $0.4 million. +Under +the terms of servicing agreements with certain of our aircraft joint ventures, we provide administrative services and technical advisory services, including aircraft evaluations, +oversight and logistical support of the maintenance process and records management. We also provide evaluation and inspection services prior to the purchase of an aircraft and remarketing services +with respect to the divestiture of aircraft by the joint ventures. During fiscal 2019, 2018, and 2017, we were paid $0.4 million, $0.4 million, and $1.2 million, respectively, for +such services. +Our +investments in joint ventures includes $6.3 million for our 40% ownership interest in our Indian joint venture with Indamer Aviation to develop and operate an airframe +maintenance facility in India. The investment balance includes $4.8 million related to the guarantee liability recognized in conjunction with our guarantee of 40% of the Indian joint venture's +debt. The Indian joint venture is accounted for using the equity method. In addition, each of the partners in the Indian joint venture have a loan to the joint venture proportionate to their equity +ownership. We have a loan to the joint venture of $2.8 million as of May 31, 2019. +12. Acquisitions +On September 19, 2017, we acquired the outstanding shares of two MRO facilities in Canada owned by Premier Aviation for approximately $24.8 million. The purchase price +includes $22.9 million paid at +75 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +12. Acquisitions (Continued) +closing +with the remaining deferred consideration paid in September 2018. This business is included in our Aviation Services segment. The fair value of assets acquired and liabilities assumed is as +follows: +Current assets +$ +4.4 +Property and equipment +15.1 +Intangible assets, including goodwill +14.6 +Accounts payable and accrued liabilities +(9.3 +) +​ +​ +​ +​ +​ +$ +24.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +On +April 10, 2017, we acquired the trading business of ACLAS Global Limited ("ACLAS"). In conjunction with the acquisition, we entered into a multi-year component support and +repair contract covering approximately 100 of ACLAS' aircraft. The purchase price of the acquisition was $12.0 million paid at closing with $3.0 million in deferred consideration payable +over the next three years. This business operates as part of our Aviation Services segment. The fair value of assets acquired is as follows: +Inventory +$ +5.0 +Equipment on or available for long-term lease +6.2 +Intangible assets +3.8 +​ +​ +​ +​ +​ +Assets acquired +$ +15.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +13. Business Segment Information +Segment Reporting +Consistent with how our chief operating decision making officer (Chief Executive Officer) evaluates performance and the way we are organized +internally, we report our activities in two segments: Aviation Services comprised of supply chain and MRO activities and Expeditionary Services comprised +of manufacturing activities. +In +the first quarter of fiscal 2019, we re-aligned the composition of our operating segments to leverage the full breadth of our operational expertise in Aviation Services. Our +government-owned, contractor-operated operations (which include the INL/A Worldwide Aviation Support Services ("INL/A WASS") program) were previously included in our Expeditionary Services segment and +are now reported within our Aviation Services segment for all periods presented. +The +Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and +government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to +the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance based logistics programs, customer fleet management and operations, and +aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of +product, direct labor, and overhead. +76 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +The +Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support +the U.S. military's requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. This segment also designs and +manufactures advanced composite materials for commercial, business and military aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead. +The +accounting policies for the segments are the same as those described in Note 1. Our chief operating decision making officer (Chief Executive Officer) evaluates performance +based on the reportable segments and utilizes gross profit as a primary profitability measure. Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses +related to corporate activities are +not allocated to the segments. Our reportable segments are aligned principally around differences in products and services. +Selected +financial information for each segment is as follows: +For the Year Ended May 31, +2019 +2018 +2017 +Net sales: +Aviation Services +$ +1,920.6 +$ +1,635.8 +$ +1,485.4 +Expeditionary Services +131.2 +112.5 +105.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +2,051.8 +$ +1,748.3 +$ +1,590.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2019 +2018 +2017 +Gross profit: +Aviation Services +$ +313.3 +$ +275.3 +$ +246.0 +Expeditionary Services +16.2 +19.3 +17.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +329.5 +$ +294.6 +$ +263.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +2019 +2018 +Total assets: +Aviation Services +$ +1,346.8 +$ +1,241.2 +Expeditionary Services +94.7 +94.8 +Corporate and discontinued operations +75.7 +188.7 +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,517.2 +$ +1,524.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +77 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +For the Year Ended May 31, +2019 +2018 +2017 +Capital expenditures: +Aviation Services +$ +15.1 +$ +18.9 +$ +15.0 +Expeditionary Services +1.4 +1.8 +2.0 +Corporate +0.9 +1.3 +8.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total continuing operations +17.4 +22.0 +25.2 +Discontinued operations +0.5 +5.0 +8.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +17.9 +$ +27.0 +$ +33.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +2019 +2018 +2017 +Depreciation and amortization: 1 +Aviation Services +$ +37.5 +$ +34.6 +$ +30.8 +Expeditionary Services +4.1 +4.6 +5.0 +Corporate +14.7 +16.6 +10.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total continuing operations +56.3 +55.8 +46.7 +Discontinued operations +— +7.3 +17.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +56.3 +$ +63.1 +$ +63.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +1 Includes +amortization of stock-based compensation. +The +following table reconciles segment gross profit to income from continuing operations before provision for income taxes. +For the Year Ended May 31, +2019 +2018 +2017 +Segment gross profit +$ +329.5 +$ +294.6 +$ +263.4 +Provision for doubtful accounts +(15.8 +) +(0.5 +) +(2.1 +) +Selling, general and administrative +(215.4 +) +(208.1 +) +(179.0 +) +Other expenses +(0.8 +) +(0.9 +) +— +Interest expense +(9.5 +) +(8.0 +) +(5.3 +) +Interest income +1.0 +0.1 +0.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations before provision for income taxes +$ +89.0 +$ +77.2 +$ +77.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +78 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +The +U.S. Department of Defense, U.S. Department of State, other U.S. government agencies and their contractors are our only customers representing 10% or more of total sales in any of +the last three fiscal years. Sales by segment for these customers are as follows: +For the Year Ended May 31, +2019 +2018 +2017 +Aviation Services +$ +455.9 +$ +241.3 +$ +260.2 +Expeditionary Services +90.3 +63.0 +61.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +546.2 +$ +304.3 +$ +321.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Percentage of total sales +26.6 +% +17.4 +% +20.2 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Sales +across the major customer markets for each of our operating segments for the fiscal years ended May 31, 2019, 2018 and 2017 were as follows: +For the Year Ended May 31, +2019 +2018 +2017 +Aviation Services: +Commercial +$ +1,342.3 +$ +1,281.9 +$ +1,114.9 +Government and defense +578.3 +353.9 +370.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,920.6 +$ +1,635.8 +$ +1,485.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services: +Commercial +$ +31.6 +$ +37.5 +$ +37.1 +Government and defense +99.6 +75.0 +68.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +131.2 +$ +112.5 +$ +105.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Sales +by type of product/service was as follows: +For the Year Ended May 31, +2019 +2018 +2017 +Aviation supply chain +$ +1,395.2 +$ +1,082.9 +$ +998.7 +Maintenance, repair and overhaul services +525.4 +552.9 +486.7 +Mobility products +131.2 +112.5 +105.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +2,051.8 +$ +1,748.3 +$ +1,590.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +79 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +13. Business Segment Information (Continued) +Geographic Data +Sales by geographic region for the fiscal years ended May 31, 2019, 2018 and 2017 were as follows: +For the Year Ended May 31, +2019 +2018 +2017 +Aviation Services: +North America +$ +1,426.8 +$ +1,131.4 +$ +1,077.4 +Europe/Africa +323.4 +325.9 +272.4 +Other +170.4 +178.5 +135.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +1,920.6 +$ +1,635.8 +$ +1,485.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services: +North America +$ +124.1 +$ +105.3 +$ +101.0 +Europe/Africa +5.8 +6.9 +4.3 +Other +1.3 +0.3 +0.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +131.2 +$ +112.5 +$ +105.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +2019 +2018 +Long-lived assets: +United States +$ +345.4 +$ +393.1 +Europe +108.7 +103.3 +Other +110.6 +85.6 +​ +​ +​ +​ +​ +​ +​ +​ +$ +564.7 +$ +582.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Sales +to unaffiliated customers in foreign countries (including sales through foreign sales offices of domestic subsidiaries) were approximately $661.8 million (32.3% of total +sales), $694.0 million (39.7% of total sales) and $595.4 million (37.4% of total sales) in fiscal 2019, 2018 and 2017, respectively. +14. Legal Proceedings +We are not a party to any material pending legal proceeding (including any governmental or environmental proceeding) other than routine litigation incidental to our business except for +the following: +Department of Justice Investigation +The U.S. Department of Justice ("DoJ"), acting through the U.S. Attorney's Office for the Southern District of Illinois, is conducting an +investigation of AAR Airlift Group, Inc. ("Airlift"), a wholly-owned subsidiary of AAR CORP., under the federal civil False Claims Act ("FCA"). The investigation relates to Airlift's +performance of several contracts awarded by the U.S. Transportation Command concerning the operations and maintenance of rotary-wing and fixed-wing aircraft in Afghanistan and Africa, as well as +several U.S. Navy contracts. In June 2018, the DoJ informed Airlift that part of the investigation was +80 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +14. Legal Proceedings (Continued) +precipitated +by a lawsuit filed under the qui tam provisions of the FCA by a former employee of Airlift. That lawsuit remains under seal. Airlift is cooperating with the DoJ investigation. +Self-Reporting of Potential Foreign Corrupt Practices Act Violations +The Company retained outside counsel to investigate possible violations of the Company's Code of Conduct, the U.S. Foreign Corrupt Practices +Act, and other applicable laws, relating to the Company's activities in Nepal and South Africa. Based on these investigations, we self-reported these matters to the DoJ, the U.S. Securities and +Exchange Commission and the UK Serious Fraud Office. The Company will fully cooperate in any review by these agencies, although we are unable at this time to predict what action, if any, they may +take. +15. Selected Quarterly Data (Unaudited) +The unaudited selected quarterly data for fiscal years ended May 31, 2019 and 2018 is as follows: +Fiscal 2019 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Full +Year +Sales 1 +$ +466.3 +$ +493.3 +$ +529.5 +$ +562.7 +$ +2,051.8 +Operating income +22.4 +16.8 +29.8 +29.3 +98.3 +Income from continuing operations +18.9 +11.2 +27.4 +26.6 +84.1 +Loss from discontinued operations 2 +(3.8 +) +(4.2 +) +(64.8 +) +(3.8 +) +(76.6 +) +Net income (loss) +15.1 +7.0 +(37.4 +) +22.8 +7.5 +Earnings (Loss) per share—basic: 3 +Continuing operations +0.54 +0.32 +0.79 +0.77 +2.42 +Discontinued operations +(0.11 +) +(0.12 +) +(1.87 +) +(0.11 +) +(2.22 +) +Earnings per share—basic +0.43 +0.20 +(1.08 +) +0.66 +0.20 +Earnings (Loss) per share—diluted: 3 +Continuing operations +0.54 +0.32 +0.78 +0.76 +2.40 +Discontinued operations +(0.11 +) +(0.12 +) +(1.86 +) +(0.11 +) +(2.19 +) +Earnings per share—diluted +0.43 +0.20 +(1.08 +) +0.65 +0.21 +81 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +15. Selected Quarterly Data (Unaudited) (Continued) +Fiscal 2018 +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Full +Year +Sales 1 +$ +397.9 +$ +420.6 +$ +456.3 +$ +473.5 +$ +1,748.3 +Operating income +17.1 +21.8 +24.3 +22.8 +86.0 +Income from continuing operations +11.0 +13.3 +31.3 +18.1 +73.7 +Loss from discontinued operations 4 +(0.4 +) +(35.8 +) +(15.8 +) +(6.1 +) +(58.1 +) +Net income +10.6 +(22.5 +) +15.5 +12.0 +15.6 +Earnings (Loss) per share—basic: 3 +Continuing operations +0.32 +0.39 +0.91 +0.53 +2.14 +Discontinued operations +(0.01 +) +(1.05 +) +(0.46 +) +(0.18 +) +(1.70 +) +Earnings per share—basic +0.31 +(0.66 +) +0.45 +0.35 +0.44 +Earnings (Loss) per share—diluted: 3 +Continuing operations +0.32 +0.38 +0.90 +0.52 +2.11 +Discontinued operations +(0.01 +) +(1.05 +) +(0.46 +) +(0.18 +) +(1.70 +) +Earnings per share—diluted +0.31 +(0.67 +) +0.44 +0.34 +0.41 +1 At +the beginning of fiscal 2019, we adopted ASC 606 using a modified retrospective method and as a result, the comparative information has not been +restated and is reported under accounting standards in effect for those years. See Note 1 for additional information. +2 On +March 15, 2019, we signed an agreement to sell certain contracts and assets of our COCO business. In conjunction with this agreement and other +expected asset sales, we recognized an impairment charge in discontinued operations of $74.1 million during the third quarter of fiscal 2019 reflecting the expected net proceeds to be received +upon the completion of the sale transactions. +3 The +earnings-per-share computation for the year is a separate, annual calculation. Accordingly, the sum of the quarterly earnings-per-share amounts does +not necessarily equal the earnings per share for the year. +4 Loss +from discontinued operations in fiscal 2018 includes pre-tax aircraft and other asset impairment charges of $54.2 million in the second +quarter and a goodwill impairment charge of $9.8 million in the third quarter. +82 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not Applicable. +ITEM 9A. CONTROLS AND PROCEDURES +Evaluation of Disclosure Controls and Procedures +We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in +Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Act"), as of May 31, 2019. This evaluation was carried out under the supervision and with the +participation of our Chief Executive Officer and Chief Financial Officer. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures. Therefore, effective +disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. +Based +upon our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of May 31, 2019 due +to material weaknesses related to (a) our controls over the existence of inventories included in our inventory cycle counting, (b) information technology general controls ("ITGCs"), and +(c) controls over vendor payment information, as discussed below. +We +have concluded the material weakness related to our controls over inventory also existed as of May 31, 2018 after re-evaluating these controls in light of a Public Company +Accounting Oversight Board inspection of our independent registered public accounting firm's audit of the year then ended. Notwithstanding the identified material weaknesses, management has concluded +that the Consolidated Financial Statements included in this Annual Report on Form 10-K present fairly, in all material respects, the Company's financial position, results of operations and cash +flows for the periods disclosed in conformity with U.S. generally accepted accounting principles (U.S. GAAP). +Management Report on Internal Control Over Financial Reporting +Management of AAR CORP. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is +defined in Rules 13a-15(f) and +15d-15(f) of the Act. The Company's internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer to provide +reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. GAAP and includes those policies and procedures that +(1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the Company; (2) provide reasonable +assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the Company are being +made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements. Internal control systems, no matter how well designed, have inherent limitations. +Therefore, even those systems which are determined to be effective provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any +evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or +procedures may deteriorate. +A +material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material +misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. +83 +Table of Contents +Management, +under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer and oversight of the Board of Directors, assessed the +effectiveness of our internal control over financial reporting as of May 31, 2019 based on the criteria for effective internal control over financial reporting described in Internal +Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +Based +on our assessment, management concluded that our internal control over financial reporting was not effective as of May 31, 2019 because of the effects of the material +weaknesses described below. +Controls over Inventory Cycle Counts +Management did not design, implement and operate an effective control to verify the existence of inventories subject to the Company's cycle +counting program. Specifically, a control +was not effectively designed, implemented and operated to verify that all inventories that should be subject to the cycle count program were included and counted regularly. This control deficiency +also existed in prior periods. +Information Technology and Safeguarding Controls +Management did not maintain effective information technology general controls ("ITGCs") over IT applications, networks, operating systems and +databases ("IT systems") that are relevant to the preparation of our financial statements. Specifically, the Company did not appropriately design, implement and operate (a) controls to restrict +and monitor system access to appropriate Company personnel resulting in end-user and privileged access to IT systems that was not approved and, in some cases, not revoked on a timely basis in +accordance with the Company's policies and (b) controls over changes to applications that are hosted by third-party service organizations. As a result of these ITGC deficiencies, certain +automated controls that depend on the effective operation of the ITGCs and certain manual business process controls that are dependent upon the completeness and accuracy of information derived from +affected IT systems across multiple financial reporting processes of the Company were also considered to be ineffective. +The +Company did not design, implement and operate effective controls over changes to its vendor data master file that are required to safeguard the Company's funds and prevent or timely +detect unauthorized payments. This control deficiency also existed in prior periods. +The +material weaknesses described above arose because the Company did not have an effective continuous risk assessment process that successfully identified and assessed risks of +misstatement, including risks of unauthorized acquisition, use or disposition of assets, to ensure controls were designed and implemented to respond to those risks. Additionally, the material +weaknesses in ITGCs and vendor payment information also arose due to ineffective training of our resources in the areas of IT and cyber security and the use of third-party service organizations. +These +control deficiencies did not result in any identified misstatements to the consolidated financial statements as of and for the year ended May 31, 2019. However, the control +deficiencies create a reasonable possibility that a material misstatement to our consolidated financial statements will not be prevented or detected on a timely basis and, therefore, we concluded that +the deficiencies represent material weaknesses in our internal control over financial reporting. +KPMG LLP, +our independent registered public accounting firm, has issued an adverse opinion on the effectiveness of our internal control over financial reporting as of +May 31, 2019. That report appears below following management's report and discussion. +Remediation Plan +The Company is in the process of updating its continuous risk assessment process in order to timely identify and assess risks of material +misstatement and ensure that the financial reporting processes and related internal controls are in place to respond to those risks in our financial reporting. +84 +Table of Contents +Controls Over Inventory Cycle Counts +The Company's cycle count program had been previously designed to achieve a minimum cycle count coverage based on dollar value of inventory held +at the end of the year. While our cycle counting covered a large portion of the Company's inventory in fiscal 2019, the design of our controls did not ensure that all inventory stocking locations were +counted, resulting in material amounts of inventory being excluded from our cycle counts. As part of remediation, we are designing and implementing controls over our cycle counting program so that all +inventory stocking locations are counted within a reasonable timeframe. We anticipate achieving full location-based cycle count coverage by August 31, 2019 with the material weakness remediated +by the end of fiscal 2020. +Information Technology and Safeguarding Controls +We have been implementing and continue to implement measures designed to ensure that control deficiencies contributing to the ITGC material +weakness are remediated. These actions include establishing and improving policies, procedures and controls associated with end-user and privileged access to certain IT applications, additional +training of IT personnel, and expansion of change management controls or other appropriate procedures related to third-party service organizations where timely and effective service organization audit +reports are not available. We anticipate completing our remediation of the ITGC material weakness by the end of fiscal 2020. +We +are taking a number of steps to address the deficiencies related to controls over changes to the vendor data master file. Among others, we are implementing a new process and controls +over vendor set-up and maintenance to facilitate appropriate monitoring and approval of changes made to our vendor data master file. In addition, we are enhancing training of our employees to increase +awareness around IT and cyber-security threats. We have also created and filled the position of Chief Information Security Officer. +The +material weaknesses will not be considered remediated until the applicable controls operate for a sufficient period of time and management has concluded, through testing, that the +controls are operating effectively. +Changes in Internal Control Over Financial Reporting +Effective June 1, 2018, we adopted the new revenue standard under ASC 606 using the modified retrospective method of adoption. We have +implemented certain changes to our internal controls over financial reporting to support the reporting and disclosure requirements of the new revenue standard. Except for our internal control changes +related to ASC 606 and the identification of and ongoing remediation of the material weaknesses described above (some of which occurred in early periods), there were no changes in our internal control +over financial reporting during the three-month period ended May 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial +reporting. +85 +Table of Contents +Report of Independent Registered Public Accounting Firm +To +the Stockholders and Board of Directors +AAR CORP.: +Opinion on Internal Control Over Financial Reporting +We have audited AAR CORP.'s and subsidiaries' (the Company) internal control over financial reporting as of May 31, 2019, based on +criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the +Treadway Commission. In our opinion, because of the effect of the material weaknesses, described below, on the achievement of the objectives of the control criteria, the Company has not maintained +effective internal control over financial reporting as of May 31, 2019, based on criteria established in Internal Control—Integrated Framework +(2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of +May 31, 2019 and 2018, the related consolidated statements of income, comprehensive income (loss), changes in equity, and cash flows for each of the years in the three-year period ended +May 31, 2019, and the related notes (collectively, the consolidated financial statements), and our report dated July 18, 2019 expressed an unqualified opinion on those consolidated +financial statements. +A +material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material +misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. Material weaknesses have been identified and included in management's +assessment related to the ineffective design, implementation and operation of (i) internal controls over the existence of inventories subject to the Company's cycle counting program; +(ii) information technology general controls (ITGCs) over IT applications, networks, operating systems and databases that are relevant to the preparation of the Company's financial statements; +and (iii) internal controls over changes to the Company's vendor data master file that are required to safeguard the Company's funds and prevent or timely detect unauthorized payments. The +material weaknesses described above arose because the Company did not have an effective continuous risk assessment process that successfully identified and assessed risks of misstatement, including +risks of unauthorized acquisition, use or disposition of assets, to ensure controls were designed and implemented to respond to those risks. Additionally, the material weaknesses in ITGCs and vendor +payment information also arose due to ineffective training of Company resources in the areas of IT and cyber security and the use of third-party service organizations. +The +material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2019 consolidated financial statements, and this report +does not affect our report on those consolidated financial statements. +Basis for Opinion +The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the +effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on +the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in +accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We +conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective +internal control +86 +Table of Contents +over +financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial +reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included +performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting +includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets +of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and +(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the +financial statements. +Because +of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future +periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +Chicago, +Illinois +July 18, 2019 +87 +Table of Contents +ITEM 9B. OTHER INFORMATION +Not applicable. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information required by this item regarding the Directors of the Company and nominees for election of the Board is incorporated by reference +to the information contained under the caption "Information about Our Director Nominees and Our Continuing Directors" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +The +information required by this item regarding the Executive Officers of the Company appears under the caption "Supplemental Item: Executive Officers of the Registrant" following +Part I, Item 4 above. +The +information required by this item regarding the compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the information contained +under the caption "Delinquent Section 16(a) Reports" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +The +information required by this item regarding the identification of the Audit Committee as a separately-designated standing committee of the Board and the status of one or more members +of the Audit Committee being an "audit committee financial expert" is incorporated by reference to the information contained under the caption "the Board's Role and Responsibilities—Role +and Responsibilities of the Board Committees" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +The +information required by this item regarding our Code of Business Ethics and Conduct applicable to our directors, officers and employees is incorporated by reference to the +information contained under the caption "Board Practices and Policies—Code of Business Ethics and Conduct" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +There +have been no material changes to the procedures by which stockholders may recommend nominees to the Company's board of directors. The information regarding these procedures is +incorporated by reference to the information contained under the caption "Our Strategy—Director Nominations and Qualifications" in our definitive proxy statement for the 2019 Annual +Meeting of Stockholders. +ITEM 11. EXECUTIVE COMPENSATION +The information required by this item is incorporated by reference to the information contained under the following captions: +(a) "Executive Compensation—Compensation Committee Fiscal 2019 Report on Executive Compensation," (b) "Executive Compensation—Compensation Discussion and +Analysis," (c) "Executive Compensation—Summary Compensation Table," (d) "Executive Compensation—Fiscal 2019 Grants of Plan-Based Awards," (e) "Executive +Compensation—Outstanding Equity Awards at Fiscal 2019 Year End," (f) "Executive Compensation—Fiscal 2019 Option Exercises and Stock Vested," (g) "Executive +Compensation—Retirement Plan," (h) "Executive Compensation—Non-Qualified Deferred Compensation (SKERP)," (i) "Executive Compensation—Tables of +Potential Payments Upon a Termination of Employment or Change-in-Control of the Company," (j) "Director Compensation—Director Compensation Table," and (k) "Director +Compensation—Compensation Committee Interlocks and Insider Participation" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +88 +Table of Contents +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information required by this item regarding security ownership of certain beneficial owners and management is incorporated by reference to +the information contained under the caption "Stock Ownership Information" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +The +information required by this item regarding equity compensation plan information is incorporated by reference to the information contained under the caption "Equity Compensation Plan +Information" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information required by this item is incorporated by reference to the information contained under the captions "Our +Strategy—Director Independence" and "Board Practices and Policies—Related Person Transaction Policy" in our definitive proxy statement for the 2019 Annual Meeting of +Stockholders. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information required by this item is incorporated by reference to the information contained under the caption "Independent Registered Public +Accounting Firm Fees and Services" in our definitive proxy statement for the 2019 Annual Meeting of Stockholders. +89 +Table of Contents +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a)(1) Financial Statements +Our consolidated financial statements are as set forth under Item 8 of this report on Form 10-K. +(a)(2) Financial Statement Schedules +All schedules are omitted because they are not applicable, not required, or the information is included in the consolidated financial statements. +(a)(3) Exhibits +Management contracts and compensatory arrangements have been marked with an asterisk (*) on the Exhibit Index which is contained below: +Index +Exhibits +3. +Articles of Incorporation and By-Laws +3.1 +Restated Certificate of Incorporation. 6 +3.2 +By-Laws, as amended and restated through July 9, 2008 14 and as amended July 9, 2018. 39 +4. +Instruments defining the rights of security holders +4.1 +Restated Certificate of Incorporation (see Exhibit 3.1). +4.2 +By-Laws, as amended and restated through July 9, 2008 (See Exhibit 3.2). +4.3 +Form of 2.25% Convertible Senior Note due 2016. 12 +4.4 +Indenture for 2.25% Convertible Senior Notes due 2016 between AAR CORP. and U.S. Bank National Association, as trustee, dated as of February 11, +2008. 12 +4.5 +Indenture providing for Issuance of Debt Securities between AAR CORP. as Issuer and U.S. Bank National Association, as Trustee dated as of December 1, +2010. 17 +4.6 +Indenture providing for Issuance of Subordinated Debt Securities between AAR CORP. as Issuer and U.S. Bank National Association, as Trustee dated as of +December 1, 2010. 17 +90 +Table of Contents +Index +Exhibits +4.7 +Credit Agreement dated April 12, 2011 among AAR CORP., Bank of America National Association, as administrative agent, and the various financial +institutions party thereto, 18 as amended August 26, 2011 and October 13, 2011, 20 and as further amended on April 8, 2013 and April 24, 2013 21 +and as further amended on March 24, 2015 27 and as further amended on November 1, 2016 29 and as further amended on February 28, 2018. 31 +4.8 +Indenture dated as of February 14, 2014 governing $30,000,000 of 1.75% Convertible Senior Notes due 2016, by and between AAR CORP., as Issuer, and U.S. +National Bank National Association, as Trustee. 22 +4.9 +Form of 1.75% Convertible Senior Notes due 2016. 25 +4.10 +Description of Common Stock (filed herewith) +Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, the Registrant is not filing certain documents. The Registrant agrees to furnish a copy of each such document upon the request of the Commission. +10. +Material Contracts +10.1* +Amended and Restated AAR CORP. Stock Benefit Plan effective October 1, 2001, 3 as amended June 27, 2003, 4 May 5, 2005, +7 July 12, 2005, 8 June 23, 2006, 10 January 23, 2007, +10 January 27, 2007, 13 and July 11, 2011. 19 +10.2* +AAR CORP. Directors' Retirement Plan, dated April 14, 1992, 1 amended May 26, 2000 and April 10, 2001. 2 +10.3* +AAR CORP. Supplemental Key Employee Retirement Plan, as Amended and Restated effective July 10, 2017 32 and as amended January 1, 2019 (filed herewith). +10.4* +AAR CORP. Nonemployee Directors' Deferred Compensation Plan, as Amended and Restated effective July 10, 2017 (filed herewith). +10.5 +Indenture dated October 3, 2003 between AAR Distribution, Inc. and iStar Garden City LLC. 5 +91 +Table of Contents +Index +Exhibits +10.6 +Lease Agreement dated October 3, 2003 between AAR Allen Services, Inc., as tenant and iStar Garden City LLC, as Landlord, and related +Guaranty dated October 3, 2003 from Registrant to iStar Garden City LLC. 5 +10.7 +Lease Agreement by and between Indianapolis Airport Authority and AAR Aircraft Services, Inc. dated as of December 19, +2015. 28 +10.8* +Form of Non-Employee Director Non-Qualified Stock Option Agreement. 24 +10.9* +Form of Fiscal 2020 Director Restricted Stock Agreement (filed herewith). +10.10* +Form of Split Dollar Insurance Agreement. 9 +10.11 +Confirmation of OTC Convertible Note Hedge Transaction for 2016 Notes, dated February 5, 2008, by and between AAR CORP., and Merrill Lynch Financial +Markets, Inc. 11 +10.12 +Confirmation of OTC Warrant Transaction for 2016 Notes, dated February 5, 2008, by and between AAR CORP., and Merrill Lynch Financial Markets, +Inc. 11 +10.13* +Form of Directors' and Officers' Indemnification Agreement. 15 +10.14* +Employment Agreement dated as of April 18, 2017 between Registrant and David P. Storch. 16 +10.15* +Form of Policy for Recoupment of Incentive Compensation. 23 +10.16* +Section 162(m) Annual Cash Incentive Plan. 28 +10.17* +AAR CORP. 2013 Stock Plan. 28 and as amended +July 11, 2016. 30 +10.18* +Amended and Restated Severance and Change in Control Agreement dated as of October 11, 2017 between AAR CORP. and Robert J. +Regan. 33 +10.19* +Severance and Change in Control Agreement dated as of January 7, 2019 between AAR CORP. and Sean M. Gillen (filed herewith). +92 +Table of Contents +Index +Exhibits +10.20 +Credit Agreement among AAR CORP., as parent guarantor, AAR Canada Holdings ULC, as borrower, and Canadian Imperial Bank of Commerce, as lender, dated +as of October 18, 2017. 34 +10.21 +Purchase Agreement dated February 23, 2018 by and among AAR CORP., as seller representative and servicer, the sellers time to time party thereto, and +Citibank, N.A., as buyer. 35 +10.22 +First Amendment to Purchase Agreement dated as of May 22, 2018 by and among AAR CORP., as seller representative and servicer, the sellers time to +time party thereto, and Citibank, N.A., as buyer. 36 +10.23* +Retirement Agreement dated May 24, 2018 between AAR CORP. and David P. Storch. 36 +10.24* +Post-Retirement Agreement dated May 24, 2018 between AAR CORP. and David P. Storch, 36 as amended May 31, 2019 38 and July 11, 2019 (filed herewith) . +10.25* +Amended and Restated Employment Agreement dated as of May 24, 2018 between AAR CORP. and John M. Holmes. 36 +10.26* +Form of AAR CORP. Fiscal 2019 Short-Term Incentive Plan. 37 +10.27* +Form of AAR CORP. Fiscal 2019 Non-Qualified Stock Option Agreement. 37 +10.28* +Form of AAR CORP. Fiscal 2019 Restricted Stock Agreement. 37 +10.29* +Form of AAR CORP. Fiscal 2019 Performance Restricted Stock Agreement. 37 +21. +Subsidiaries of the Registrant +21.1 +Subsidiaries of AAR CORP. (filed herewith). +23. +Consents of experts and counsel +23.1 +Consent of Independent Registered Public Accounting Firm (filed herewith). +31. +Rule 13a-14(a)/15(d)-14(a) Certifications +31.1 +Section 302 Certification dated July 18, 2019 of John M. Holmes, President and Chief Executive Officer of Registrant (filed herewith). +93 +Table of Contents +Index +Exhibits +31.2 +Section 302 Certification dated July 18, 2019 of Sean M. Gillen, Vice President and Chief Financial Officer of Registrant (filed herewith). +32. +Rule 13a-14(b)/15d-14(b) Certifications +32.1 +Section 906 Certification dated July 18, 2019 of John M. Holmes, President and Chief Executive Officer of Registrant (filed herewith). +32.2 +Section 906 Certification dated July 18, 2019 of Sean M. Gillen, Vice President and Chief Financial Officer of Registrant (filed herewith). +101. +Interactive Data File +101 +The following materials from the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2019, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at May 31, 2019 and 2018, +(ii) Consolidated Statements of Income for the fiscal years ended May 31, 2019, 2018 and 2017, (iii) Consolidated Statements of Comprehensive Income for fiscal years ended May 31, 2019, 2018 and 2017 (iv) Consolidated +Statements of Cash Flows for the fiscal years ended May 31, 2019, 2018 and 2017, (v) Consolidated Statement of Changes in Equity for the three years ended May 31, 2019 and (vi) Notes to Consolidated Financial +Statements.** +Notes: +** Pursuant +to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration +statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of +1934, as amended, and otherwise are not subject to liability under those sections. +1 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 1992. +2 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2001. +3 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 2001. +4 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2003. +5 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 2003. +94 +Table of Contents +6 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2004. +7 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2005. +8 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended February 28, 2006. +9 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2006. +10 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2007. +11 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 11, 2008. +12 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 14, 2008. +13 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended February 29, 2008. +14 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated July 11, 2008. +15 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 2008. +16 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated April 18, 2017. +17 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 2010. +18 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated April 14, 2011. +19 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 2011. +20 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 11, 2011. +21 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated April 24, 2013. +22 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 10-Q for the quarterly period ended February 28, 2014. +23 Incorporated +by reference to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2012. +24 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2012. +25 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2014. +95 +Table of Contents +26 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2014. +27 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated March 24, 2015. +28 Incorporated +by reference to Exhibits to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2015. +29 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated November 1, 2016. +30 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 11, 2016. +31 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 28, 2018. +32 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form S-8 dated July 20, 2017. +33 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 13, 2017. +34 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated October 18, 2017. +35 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated February 28, 2018. +36 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated May 25, 2018. +37 Incorporated +by reference to Exhibits to the Registrant's Quarterly Report on Form 10-Q dated September 27, 2018. +38 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated June 4, 2019. +39 Incorporated +by reference to Exhibits to the Registrant's Current Report on Form 8-K dated July 13, 2018. +ITEM 16. FORM 10-K SUMMARY +Not applicable. +96 +Table of Contents +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this annual +report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. +AAR CORP. +(Registrant) +Date: July 18, 2019 +BY: +/s/ JOHN M. HOLMES +John M. Holmes +President and Chief Executive Officer +Pursuant +to the requirements of the Securities Exchange Act of 1934, this annual report on Form 10-K has been signed below by the following persons on behalf of the Registrant and +in the capacities and on the dates indicated. +Signature +Title +Date +/s/ JOHN M. HOLMES +John M. Holmes +President and Chief Executive Officer; +Director (Principal Executive Officer) +/s/ SEAN M. GILLEN +Sean M. Gillen +Vice President and Chief Financial Officer +(Principal Financial Officer) +/s/ ERIC S. PACHAPA +Eric S. Pachapa +Vice President, Controller and Chief Accounting +Officer (Principal Accounting Officer) +/s/ DAVID P. STORCH +David P. Storch +Chairman of the Board; Director +/s/ ANTHONY K. ANDERSON +Anthony K. Anderson +Director +/s/ NORMAN R. BOBINS +Norman R. Bobins +Director +/s/ MICHAEL R. BOYCE +Michael R. Boyce +Director +/s/ JAMES E. GOODWIN +James E. Goodwin +Director +July 18, 2019 +/s/ PATRICK J. KELLY +Patrick J. Kelly +Director +/s/ DUNCAN J. MCNABB +Duncan J. McNabb +Director +/s/ PETER PACE +Peter Pace +Director +/s/ JENNIFER L. VOGEL +Jennifer L. Vogel +Director +/s/ MARC J. WALFISH +Marc J. Walfish +Director +/s/ RONALD B. WOODARD +Ronald B. Woodard +Director +97 \ No newline at end of file diff --git a/raw/filings/0000001750/2019/0001047469-19-004266/filing_metadata.csv b/raw/filings/0000001750/2019/0001047469-19-004266/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..523356990033f40f4753b0d78168f5d6b57bba11 --- /dev/null +++ b/raw/filings/0000001750/2019/0001047469-19-004266/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000001750,AIR,AAR CORP,2019,10-K,2019-07-18,2019-05-31,2019-07-18T21:29:33.000Z,0001047469-19-004266,a2239223z10-k.htm,10-K,16841195,1,0,https://www.sec.gov/Archives/edgar/data/1750/000104746919004266/a2239223z10-k.htm,https://www.sec.gov/Archives/edgar/data/1750/000104746919004266/ diff --git a/raw/filings/0000001750/2019/0001047469-19-004266/item1.txt b/raw/filings/0000001750/2019/0001047469-19-004266/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..7f8b60707770d281620379b6f925fd47a72c71cc --- /dev/null +++ b/raw/filings/0000001750/2019/0001047469-19-004266/item1.txt @@ -0,0 +1,165 @@ +ITEM 1. BUSINESS +General +AAR CORP. and its subsidiaries are referred to herein collectively as "AAR," "Company," "we," "us," and "our" unless the context indicates +otherwise. AAR was founded in 1951, organized in 1955 and reincorporated in Delaware in 1966. We are a diversified provider of products and services to the worldwide aviation and government and +defense markets. +Fiscal +2019 was a year focused on growth and execution of a number of important programs and strategic initiatives. We succeeded in building customer relationships with multiple +international commercial and government customers. Our parts supply activities were extremely strong and we also invested to support our growth. +In +fiscal 2019, we completed the ramp-up of the INL/A Worldwide Aviation Support Services ("INL/A WASS") contract for the U.S. Department of State ("DoS"). This contract leverages our +capabilities in aviation services, including flight operations, supply chain logistics, and other services. We are the prime contractor on this 10-year performance-based contract to globally operate +and maintain the DoS fleet of fixed- and rotary-wing aircraft. We have full operational capability at all contract sites, which include Afghanistan, Iraq, Panama, Peru, Costa Rica and Patrick Air +Force Base as well as support locations in Brevard County, Florida. +We +also completed the ramp-up of the 15-year, U.S. Air Force Landing Gear Performance-Based Logistics One program. Under the program, we are providing total supply chain management +including purchasing, distribution, and inventory control to support all landing gear components for the U.S. Air Force's fleet of C-130, KC-135 and E-3 aircraft. +We +also entered into an agreement to sell certain contracts and assets of our Contractor-Owned, Contractor-Operated business ("COCO"), which is classified as a discontinued operation. We +expect the sale to close before the end of calendar 2019. The exit of this business is consistent with the realignment of our strategy. +Our +long-term strategy continues to emphasize investing in the business as well as returning capital to shareholders. Over the past three years, we have returned $74.2 million to +shareholders through common stock repurchases of $43.2 million and dividends of $31.0 million. Our cash on hand plus unused capacities on our Revolving Credit Facility and accounts +receivable financing program was $465 million at May 31, 2019. +Business Segments +Aviation Services +The Aviation Services segment provides aftermarket support and services for the commercial aviation and government and defense markets and +accounted for approximately 95% of our sales in fiscal 2019, 2018, and 2017. In this segment, we also provide inventory management and distribution services, maintenance, repair and overhaul ("MRO"), +and engineering services. Business activities in this segment are primarily conducted through AAR Supply Chain, Inc.; AAR Government Services, Inc.; AAR Aircraft & Engine +Sales & Leasing, Inc.; AAR Aircraft Services, Inc.; AAR Allen Services, Inc.; AAR Landing Gear LLC; AAR Airlift Group, Inc.; and AAR +International, Inc. +We +sell and lease a wide variety of new, overhauled and repaired engine and airframe parts and components and aircraft to our commercial aviation and government/defense customers. +We +provide customized flight hour component inventory and repair programs, warranty claim management, and outsourcing programs for engine and airframe parts and components in support of +our +2 +Table of Contents +airline +and government customers' maintenance activities. The types of services provided under these programs include some or all of the following functions: material planning, sourcing, logistics, +information and program management, and parts and component repair and overhaul. We are also an authorized distributor for more than 90 product lines across approximately 25 aviation original +equipment manufacturers ("OEM"s). +We +provide fleet management and operations of customer-owned aircraft for the DoS under the INL/A WASS contract. We are the prime contractor on this ten-year performance-based contract +to globally operate and maintain the DoS fleet of fixed- and rotary-wing aircraft. +We +also provide customized performance-based supply chain logistics programs in support of the U.S. Department of Defense ("DoD") and foreign governments. The types of services provided +under these programs include some or all of the following functions: material planning, sourcing, logistics, information and program management, airframe maintenance and maintenance planning, and +component repair and overhaul. +We +provide major airframe inspection, maintenance, repair and overhaul, painting services, line maintenance, airframe modifications, structural repairs, avionic service and installation, +exterior and interior refurbishment, and engineering services and support for many types of commercial and military aircraft. We also repair and overhaul various components, landing gears, wheels, and +brakes for commercial and military aircraft. +We +operate seven airframe maintenance facilities and one landing gear overhaul facility. Our landing gear overhaul facility is in Miami, Florida, where we repair and overhaul landing +gear, wheels, brakes, and actuators for different types of commercial and military aircraft. Our U.S. airframe maintenance facilities are in Indianapolis, Indiana; Oklahoma City, Oklahoma; Duluth, +Minnesota; Miami, Florida; and Rockford, Illinois and our Canadian airframe maintenance facilities are in Trois Rivieres, Quebec and Windsor, Ontario. During fiscal 2019, we repositioned certain +elements of our workforce across our network of airframe maintenance facilities to optimize staffing levels. In addition, we have a joint venture with Indamer Aviation to develop and operate an +airframe maintenance facility in India. The facility construction is expected to be completed in fiscal 2020. +The +majority of our product sales are made pursuant to standard commercial purchase orders. Government sales are generally made under standard types of government contracts, which can +include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. For cost plus fixed fee contracts, we typically receive reimbursement of our costs, to the extent +the costs are allowable under contractual and regulatory provisions, in addition to receiving a fixed fee. Some of our contracts call for the performance of specified services or the delivery of +specified products under indefinite delivery/indefinite quantity ("ID/IQ") arrangements. Certain inventory supply and management and performance-based logistics program agreements reflect negotiated +terms and conditions. +To +support activities within the Aviation Services segment, we acquire aviation parts and components from domestic and foreign airlines, independent aviation service companies, aircraft +leasing companies, +and OEMs. We have ongoing arrangements with OEMs that provide us access to parts, repair manuals, and service bulletins in support of parts manufactured by them. Although the terms of each +arrangement vary, they typically are made on standard OEM terms as to duration, price, and delivery. From time to time, we purchase airframes and engines for disassembly into individual parts and +components. Airframes and engines may also be leased to airlines on a short-term basis prior to disassembly or sale. +Expeditionary Services +The Expeditionary Services segment primarily consists of businesses that provide products and services supporting the movement of equipment and +personnel by the U.S. and foreign governments and non-governmental organizations. The Expeditionary Services segment accounted for approximately 5% of +3 +Table of Contents +our +sales in fiscal 2019, 2018, and 2017. Business activities in this segment are primarily conducted through AAR Manufacturing, Inc. and Brown International Corporation. +We +design, manufacture, and repair transportation pallets and a wide variety of containers and shelters used in support of military and humanitarian tactical deployment activities. The +containers and shelters are used in numerous mission requirements, including armories, supply and parts storage, refrigeration systems, tactical operation centers, briefing rooms, laundry and kitchen +facilities, water treatment, and sleeping quarters. Shelters include both stationary and vehicle-mounted applications. +We +also provide engineering, design, and system integration services for specialized command and control systems and design and manufacture advanced composite materials for commercial, +business and military aircraft. +Sales +in this segment are generally made to customers pursuant to standard commercial purchase orders and contracts. Government sales are generally made under standard types of +government contracts, which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified +services or the delivery of specified products under ID/IQ arrangements, however, the majority of our products and services are procured via definite contracts. +Raw Materials +Although we generated approximately 55% of our fiscal 2019 sales from the sale of products, our businesses are generally engaged in limited +manufacturing activities and have minimal exposure to fluctuations in both the availability and pricing of raw materials. We purchase raw materials for our manufacturing operations, including steel, +aluminum, extrusions, balsa, and other necessary supplies from several vendors. Where necessary, we have been able to obtain raw materials and other inventory items from numerous sources for each +segment at competitive prices, terms, and conditions, and we expect to be able to continue to do so. +Terms of Sale +We generally sell our products and services under standard 30-day payment terms. On occasion, certain customers will negotiate extended payment +terms of 60-90 days. Except for customary warranty provisions, customers neither have the right to return products nor do they have the right to extended financing. Our government contracts may +extend several years and include one or more base years and one or more option years. The government generally has the right not to exercise options to extend or expand our contracts and may otherwise +terminate, cancel, or modify some contracts at its convenience. +Customers +The principal customers for our products and services in the Aviation Services segment are domestic and foreign passenger airlines, domestic and +foreign cargo airlines, regional and commuter airlines, business and general aviation operators, OEMs, aircraft leasing companies, aftermarket aviation support companies, the DoD and its contractors, +the DoS, and foreign military organizations or governments. In the Expeditionary Services segment, our principal customers include the DoD and its contractors, foreign military organizations or +governments, defense organizations, and OEMs. +Sales +of aviation products and services to our commercial airline customers are generally affected by such factors as the number, type and average age of aircraft in service, the levels +of aircraft utilization +(e.g., frequency of schedules, flying hours, and take-off and landing cycles), the number of airline operators, the general economy, and the level of sales of new and used aircraft. Sales to +the DoD and other government agencies are subject to a number of factors, including the level of troop deployment +4 +Table of Contents +worldwide, +government funding, competitive bidding, and requirements generated by worldwide geopolitical events. +We +primarily market and sell products and services through our own employees. In certain markets outside of the United States, we rely on foreign sales representatives to assist in the +sale of our products and services. +Sales to Government and Defense Customers +Sales to global government and defense customers (including sales to branches, agencies, and departments of the U.S. government) were +$677.9 million (33.0% of consolidated sales), $428.9 million (24.5% of consolidated sales) and $438.8 million (27.6% of consolidated sales) in fiscal 2019, 2018 and 2017, +respectively. Sales to branches, agencies, and departments of the U.S. government and their contractors were $546.2 million (26.6% of consolidated sales), $304.3 million (17.4% of +consolidated sales) and $321.5 million (20.2% of consolidated sales) in fiscal 2019, 2018, and 2017, respectively. +Sales +to government and defense customers are reported in each of our reportable segments (See Note 13 of Notes to Consolidated Financial Statements). Since such sales are subject +to competitive bidding and government funding, no assurance can be given that such sales will continue at levels previously experienced. The majority of our U.S. government sales are for products and +services supporting the DoD logistics and mobility strategy and supporting DoS flight operations. Thus, our government contracts have changed, and may continue to change, with fluctuations in defense +and other governmental agency spending and requirements. Our government contracts are also often subject to termination for convenience by the customer; in the event of such a termination, we are +contractually entitled to recover all allowable costs incurred by us through the date of termination. +Government Regulation and Certificates +The Federal Aviation Administration ("FAA") regulates the manufacture, repair, and operation of all aircraft and aircraft parts operated in the +United States. Similar rules and regulatory authorities exist in other countries. The inspection, maintenance and repair procedures for the various types of aircraft and equipment are prescribed by +these regulatory authorities and can be performed only by certified repair facilities utilizing certified technicians. The FAA requires that various maintenance routines be performed on aircraft +engines, certain engine parts, and airframes at regular intervals based on take off and landing cycles or flight time. Our businesses, which sell defense products and services directly to the U.S. +government or through its contractors, can be subject to various laws and regulations governing pricing and other factors. +We +have 13 FAA certificated repair stations in the United States, Canada, and Europe. Of the 13 certificated FAA repair stations, seven are also European Aviation Safety Agency +("EASA") and four are also Transport Canada Civil Aviation ("TCCA") certificated repair stations. Such certificates, which are ongoing in duration, are required for us to perform authorized +maintenance, repair, and overhaul services for our customers and are subject to revocation by the government for non-compliance with applicable regulations. Of the 13 FAA certificated repair stations, +12 are in the Aviation Services segment and one is held by our COCO business, which is classified as a discontinued operation as it is currently held for sale. The EASA and TCCA certificated repair +stations are in the Aviation Services segment. Our COCO business also holds a FAR Part 135 certificate to operate aircraft for our expeditionary airlift services. We are also Commercial Airlift +Review Board certified with the DoD. We believe that we possess all licenses and certifications that are material to the conduct of our business. +Competition +Competition in each of our markets is based on quality, ability to provide a broad range of products and services, speed of delivery, and price. +Competitors in our Aviation Services segment include OEMs, +5 +Table of Contents +the +service divisions of large commercial airlines, and other independent suppliers of parts, repair, and overhaul services to the commercial and defense markets. Our Expeditionary Services segment +competes with domestic and foreign contracting companies and a number of divisions of large +corporations and other large and small companies. Although certain of our competitors have substantially greater financial and other resources than we do, we believe that we have maintained a +satisfactory competitive position through our responsiveness to customer needs, our attention to quality, and our unique combination of market expertise and technical and financial capabilities. +Backlog +Backlog represents the amount of revenue that we expect to derive from unshipped orders or signed contracts. At May 31, 2019, backlog was +approximately $1.5 billion and we expect that approximately 40% of this backlog will be recognized as revenue over the next 12 months, with the majority of the remaining balance +recognized as revenue over the next three years. +Employees +At May 31, 2019, we employed approximately 5,650 employees worldwide, of which approximately 200 employees are subject to a +collective bargaining agreement. We also retain approximately 900 contract workers, the majority of whom are located at our airframe maintenance facilities. +Available Information +For additional information concerning our business segments, see Item 7, "Management's Discussion and Analysis of Financial Condition and +Results of Operations" and "Business Segment Information" in Note 13 of Notes to Consolidated Financial Statements under Item 8, "Financial Statements and Supplementary Data." +Our +internet address is www.aarcorp.com. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable +after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Information contained on our web site is not a part of this report. +6 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000001750/2019/0001047469-19-004266/item13.txt b/raw/filings/0000001750/2019/0001047469-19-004266/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..35bf4905b8bddf41869318b95f5cec0855a2deb0 --- /dev/null +++ b/raw/filings/0000001750/2019/0001047469-19-004266/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +89 \ No newline at end of file diff --git a/raw/filings/0000001750/2020/0001104659-20-085310/filing.txt b/raw/filings/0000001750/2020/0001104659-20-085310/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..5c87662dec014044db41d070a8e78d413500695c --- /dev/null +++ b/raw/filings/0000001750/2020/0001104659-20-085310/filing.txt @@ -0,0 +1,8715 @@ +0 0 0 0000001750 --05-31 2020 FY Common Stock, $1.00 par value AIR Preferred 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Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +​ +For the transition period from to +Commission file number 1-6263 +AAR CORP . +(Exact name of registrant as specified in its charter) +​ +​ +Delaware +(State or other jurisdiction of incorporation or organization) +36-2334820 +(I.R.S. Employer Identification No.) +​ +One AAR Place , 1100 N. Wood Dale Road , Wood Dale , Illinois 60191 +(Address of principal executive offices, including zip code) +Registrant’s telephone number, including area code: ( 630 ) 227-2000 +Securities registered pursuant to Section 12(b) of the Act: +​ +​ +​ +​ +​ +Title of Each Class +Trading Symbol(s) +Name of Each Exchange on Which Registered +Common Stock, $1.00 par value +​ +AIR +​ +New York Stock Exchange +​ +​ +​ +​ +Chicago Stock Exchange +Preferred Stock Purchase Rights +​ +AIR +​ +New York Stock Exchange +​ +​ +​ +​ +Chicago Stock Exchange +​ +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ⌧ No ◻ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ◻ No ⌧ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No ◻ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ⌧ No ◻ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company," and "emerging growth company” in Rule 12b-2 of the Exchange Act. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Large accelerated filer +☒ +Accelerated filer +☐ +Non-Accelerated filer +☐ +​ +Smaller reporting company +☐ +​ +​ +​ +​ +​ +​ +​ +Emerging growth company +☐ +​ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period prior to complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ⌧ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ⌧ +The aggregate market value of the registrant’s voting stock held by nonaffiliates was approximately $ 1,474 million (based upon the closing price of the Common Stock at November 29, 2019 as reported on the New York Stock Exchange). +On June 30, 2020, there were 35,155,371 shares of Common Stock outstanding. +Documents Incorporated by Reference +Portions of the Company’s proxy statement for the Company’s 2020 Annual Meeting of Stockholders, to be held October 7, 2020, are incorporated by reference in Part III of this report. +​ +​ +​ +​ +Table of Contents +TABLE OF CONTENTS +​ +​ +​ +​ +​ +Page +PART I +​ +​ +​ +​ +​ +Item 1. +Business +2 +​ +​ +​ +Item 1A. +Risk Factors +7 +​ +​ +​ +Item 1B. +Unresolved Staff Comments +14 +​ +​ +​ +Item 2. +Properties +15 +​ +​ +​ +Item 3. +Legal Proceedings +15 +​ +​ +​ +Item 4. +Mine Safety Disclosures +15 +​ +​ +​ +​ +Supplemental Item – Executive Officers of the Registrant +16 +​ +​ +​ +PART II +​ +​ +​ +​ +​ +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +17 +​ +​ +Item 6. +Selected Financial Data +19 +​ +​ +​ +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +21 +​ +​ +​ +Item 7A. +Quantitative and Qualitative Disclosures about Market Risk +32 +​ +​ +​ +Item 8. +Financial Statements and Supplementary Data +33 +​ +​ +​ +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +76 +​ +​ +​ +Item 9A. +Controls and Procedures +76 +​ +​ +​ +Item 9B. +Other Information +79 +​ +​ +​ +PART III +​ +​ +​ +​ +​ +Item 10. +Directors, Executive Officers and Corporate Governance +79 +​ +​ +​ +Item 11. +Executive Compensation +79 +​ +​ +​ +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +79 +​ +​ +​ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +79 +​ +​ +​ +Item 14. +Principal Accountant Fees and Services +80 +​ +​ +​ +PART IV +​ +​ +​ +​ +​ +Item 15. +Exhibits and Financial Statement Schedules +80 +​ +​ +​ +EXHIBIT INDEX +​ +​ +​ +​ +Item 16. +Form 10-K Summary +86 +​ +​ +​ +SIGNATURES +​ +​ +​ +​ +Table of Contents +PART I +ITEM 1. BUSINESS +General +AAR CORP. and its subsidiaries are referred to herein collectively as “AAR,” “Company,” “we,” “us,” and “our” unless the context indicates otherwise. AAR was founded in 1951, organized in 1955 and reincorporated in Delaware in 1966. We are a diversified provider of products and services to the worldwide aviation and government and defense markets. +Fiscal 2020 began with strategic initiatives focused on growth and execution across all of our activities in the commercial and government markets. Our momentum from a successful fiscal 2019 carried into the new year as we saw continued strength in our parts supply activities, as well as in government programs. We also realized the positive impact our efforts to attract and retain talent had in our maintenance, repair and overhaul (“MRO”) activities. +We succeeded in enhancing customer relationships with multiple commercial and government customers. In fiscal 2020, we were awarded a new $118 million contract from the Naval Air Systems Command in support of the U.S. Marine Corps for the procurement, modification and delivery of two C-40 aircraft. This award demonstrates the power of our integrated services model by combining the strengths of our parts supply, government programs, MRO, and engineering teams to deliver a creative solution to the U.S. Marine Corps. +We were also awarded new long-term contracts across our parts supply activities including multiple distribution agreements for new parts and our largest commercial agreement in Japan to date covering aftermarket engine components. Our strategy to exit the capital-intensive Contractor-Owned, Contractor-Operated (“COCO”) business was also completed in fiscal 2020 as all of its assets and contracts were sold. +As we continued to successfully execute on our recent contract awards over the last few years, we achieved strong sales growth through the first nine months of fiscal 2020 and were on track for a record year. Sales had increased $166.4 million or 11.2% over the prior year period primarily due to an increase in sales of $175.5 million or 12.5% in our Aviation Services segment reflecting the growth from new contract awards and successful execution across our Aviation Services activities. +Upon entering the fourth quarter in March, we began to see the impact of the COVID-19 pandemic on the commercial aviation industry. In response to the impact from COVID-19, we implemented significant actions to reduce fixed costs and overhead which included a freeze on new hiring, reducing or eliminating all non-essential spend, reducing compensation and benefits, furloughs, a reduction in force, and closure of an airframe maintenance facility. During the fourth quarter, we also exited underperforming contracts and assets across our operations and decided to exit our joint venture investment in a Malaysian landing gear wheel and brake facility. Additionally, in June 2020, we decided to sell our composites manufacturing business which is consistent with our multi-year strategy to focus our portfolio on our core services offerings. +We have also taken actions to preserve flexibility in our liquidity. In the fourth quarter, we elected to draw down our remaining available borrowings under our Revolving Credit Facility with the majority of that additional funding remaining in our cash accounts. We elected to borrow these additional amounts as a precautionary measure in light of economic and market uncertainty presented by COVID-19. +Over the long-term, we expect to see continued strength in our Aviation Services segment given its offerings of value-added services to both commercial and government and defense customers. We believe long-term commercial aftermarket growth trends are favorable although there is uncertainty in certain fleet types as commercial operators re-evaluate their structure. Our results of operations are affected by the amount of commercial aircraft flying and flight hours. The current COVID-19 pandemic has decreased the amount of commercial aircraft flying and flight hours and has created significant economic disruption. +2 +Table of Contents +Business Segments +Aviation Services +The Aviation Services segment provides aftermarket support and services for the commercial aviation and government and defense markets and accounted for approximately 95% of our sales in fiscal 2020, 2019, and 2018. In this segment, we also provide inventory management and distribution services, MRO, and engineering services. Business activities in this segment are primarily conducted through AAR Supply Chain, Inc.; AAR Government Services, Inc.; AAR Aircraft & Engine Sales & Leasing, Inc.; AAR Aircraft Services, Inc.; AAR Allen Services, Inc.; AAR Landing Gear LLC; AAR Airlift Group, Inc.; and AAR International, Inc. +We sell and lease a wide variety of new, overhauled and repaired engine and airframe parts and components and aircraft to our commercial aviation and government/defense customers. +We provide customized flight hour component inventory and repair programs, warranty claim management, and outsourcing programs for engine and airframe parts and components in support of our airline and government customers’ maintenance activities. The types of services provided under these programs include some or all of the following functions: material planning, sourcing, logistics, information and program management, and parts and component repair and overhaul. We are also an authorized distributor for more than 30 product lines which include parts from over 300 Federal Supply Class codes, which we source from over 25 leading aviation original equipment manufacturers (“OEM”s). +We provide fleet management and operations of customer-owned aircraft for the U.S. Department of State (“DoS”) under the INL/A WASS contract. We are the prime contractor on this ten-year performance-based contract which began in fiscal 2018. Our services under the contract include operating and maintaining the global DoS fleet of fixed- and rotary-wing aircraft. +We also provide customized performance-based supply chain logistics programs in support of the U.S. Department of Defense (“DoD”) and foreign governments. The types of services provided under these programs include some or all of the following functions: material planning, sourcing, logistics, information and program management, airframe maintenance and maintenance planning, and component repair and overhaul. +We provide major airframe inspection, maintenance, repair and overhaul, painting services, line maintenance, airframe modifications, structural repairs, avionics service and installation, exterior and interior refurbishment, and engineering services and support for many types of commercial and military aircraft. We also repair and overhaul various components, landing gears, wheels, and brakes for commercial and military aircraft. +We operate six airframe maintenance facilities and one landing gear overhaul facility. Our landing gear overhaul facility is in Miami, Florida, where we repair and overhaul landing gear, wheels, brakes, and actuators for different types of commercial and military aircraft. Our U.S. airframe maintenance facilities are in Indianapolis, Indiana; Oklahoma City, Oklahoma; Miami, Florida; and Rockford, Illinois and our Canadian airframe maintenance facilities are in Trois Rivieres, Quebec and Windsor, Ontario. In the fourth quarter of fiscal 2020, we announced our decision to close our airframe maintenance hangar in Duluth, Minnesota as the facility was only supporting a single customer and its location was not convenient for many of our customers' route networks. We recognized pretax closure costs of $4.3 million in the fourth quarter primarily related to severance costs and asset impairment charges. +In addition to our North American facilities, we also have an interest in a joint venture to develop and operate an airframe maintenance facility in India. The facility construction is expected to be completed in fiscal 2021. +The majority of our product sales are made pursuant to standard commercial purchase orders. Government sales are generally made under standard types of government contracts, which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. For cost plus fixed fee contracts, we typically receive reimbursement of our costs, to the extent the costs are allowable under contractual and regulatory provisions, in addition to receiving a fixed fee. Some of our contracts call for the performance of specified services or the delivery of specified products under indefinite delivery/indefinite quantity (“ID/IQ”) arrangements. Certain inventory supply and management and performance-based logistics program agreements reflect negotiated terms and conditions. +3 +Table of Contents +To support activities within the Aviation Services segment, we acquire aviation parts and components from domestic and foreign airlines, independent aviation service companies, aircraft leasing companies, and OEMs. We have ongoing arrangements with OEMs that provide us access to parts, repair manuals, and service bulletins in support of parts manufactured by them. Although the terms of each arrangement vary, they typically are made on standard OEM terms as to duration, price, and delivery. From time to time, we purchase airframes and engines for disassembly into individual parts and components. Airframes and engines may also be leased to airlines on a short-term basis prior to disassembly or sale. +Expeditionary Services +The Expeditionary Services segment primarily consists of businesses that provide products and services supporting the movement of equipment and personnel by the U.S. and foreign governments and non-governmental organizations. The Expeditionary Services segment accounted for approximately 5% of our sales in fiscal 2020, 2019, and 2018. Business activities in this segment are primarily conducted through AAR Manufacturing, Inc. and Brown International Corporation. +We design, manufacture, and repair transportation pallets and a wide variety of containers and shelters used in support of military and humanitarian tactical deployment activities. The containers and shelters are used in numerous mission requirements, including armories, supply and parts storage, refrigeration systems, tactical operation centers, briefing rooms, laundry and kitchen facilities, water treatment, and sleeping quarters. Shelters include both stationary and vehicle-mounted applications.We also provide engineering, design, and system integration services for specialized command and control systems. +We also design and manufacture advanced composite materials for commercial, business and military aircraft (“Composites”). On June 23, 2020, we entered into a definitive agreement to sell our Composites business as this divestiture is consistent with our multi-year strategy to focus our portfolio on our core services offerings. We expect the sale to close in the third quarter of calendar 2020 and will recognize a charge in the first quarter of fiscal 2021 of approximately $20 million in conjunction with the transaction. +Sales in this segment are generally made to customers pursuant to standard commercial purchase orders and contracts. Government sales are generally made under standard types of government contracts, which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified services or the delivery of specified products under ID/IQ arrangements, however, the majority of our products and services are procured via definite contracts. +Raw Materials +Although we generated approximately 55% of our fiscal 2020 sales from the sale of products, we are generally engaged in only limited manufacturing activities and have minimal exposure to fluctuations in both the availability and pricing of raw materials. We purchase raw materials for our manufacturing operations, including steel, aluminum, extrusions, balsa, and other necessary supplies from several vendors. Where necessary, we have been able to obtain raw materials and other inventory items from numerous sources for each segment at competitive prices, terms, and conditions, and we expect to be able to continue to do so. +Terms of Sale +We generally sell our products and services under standard 30-day payment terms. On occasion, certain customers will negotiate extended payment terms of 60-90 days. Except for customary warranty provisions, customers neither have the right to return products nor do they have the right to extended financing. Our government contracts may extend several years and include one or more base years and one or more option years. The government generally has the right not to exercise options to extend or expand our contracts and may otherwise terminate, cancel, or modify some contracts at its convenience. +Customers +The principal customers for our products and services in the Aviation Services segment are domestic and foreign passenger airlines, domestic and foreign cargo airlines, regional and commuter airlines, business and general aviation operators, OEMs, aircraft leasing companies, aftermarket aviation support companies, the DoD and its contractors, the DoS, and foreign military organizations or governments. In the Expeditionary Services segment, our principal customers include the DoD and its contractors, foreign military organizations or governments, defense organizations, and OEMs. +4 +Table of Contents +Sales of aviation products and services to our commercial airline customers are generally affected by such factors as the number, type and average age of aircraft in service, the levels of aircraft utilization (e.g., frequency of schedules, flying hours, and take-off and landing cycles), the number of airline operators, the general economy, and the level of sales of new and used aircraft. Sales to the DoD and other government agencies are subject to a number of factors, including the level of troop deployment worldwide, government funding, competitive bidding, and requirements generated by worldwide geopolitical events. +We primarily market and sell products and services through our own employees. In certain markets outside of the United States, we rely on foreign sales representatives to assist in the sale of our products and services. +Sales to Government and Defense Customers +Sales to global government and defense customers (including sales to branches, agencies, and departments of the U.S. government) were $778.8 million (37.6% of consolidated sales), $677.9 million (33.0% of consolidated sales) and $428.9 million (24.5% of consolidated sales) in fiscal 2020, 2019 and 2018, respectively. Sales to branches, agencies, and departments of the U.S. government and their contractors were $668.2 million (32.2% of consolidated sales), $546.2 million (26.6% of consolidated sales) and $304.3 million (17.4% of consolidated sales) in fiscal 2020, 2019, and 2018, respectively. +Sales to government and defense customers are reported in each of our reportable segments (See Note 14 of Notes to Consolidated Financial Statements). Since such sales are subject to competitive bidding and government funding, no assurance can be given that such sales will continue at levels previously experienced. The majority of our U.S. government sales are for products and services supporting the DoD logistics and mobility strategy and supporting DoS flight operations. Thus, our government contracts have changed, and may continue to change, with fluctuations in defense and other governmental agency spending and requirements. Our government contracts are also often subject to termination for convenience by the customer; in the event of such a termination, we are contractually entitled to recover all allowable costs incurred by us through the date of termination. +Government Regulation and Certificates +The Federal Aviation Administration (“FAA”) regulates the manufacture, repair, and operation of all aircraft and aircraft parts operated in the United States. Similar rules and regulatory authorities exist in other countries. The inspection, maintenance and repair procedures for the various types of aircraft and equipment are prescribed by these regulatory authorities and can be performed only by certified repair facilities utilizing certified technicians. The FAA requires that various maintenance routines be performed on aircraft engines, certain engine parts, and airframes at regular intervals based on take off and landing cycles or flight time. Our businesses, which sell defense products and services directly to the U.S. government or through its contractors, can be subject to various laws and regulations governing pricing and other factors. +We have 12 FAA certificated repair stations in the United States, Canada, and Europe. Of the 12 certificated FAA repair stations, seven are also European Aviation Safety Agency (“EASA”) and three are also Transport Canada Civil Aviation (“TCCA”) certificated repair stations. Such certificates, which are ongoing in duration, are required for us to perform authorized maintenance, repair, and overhaul services for our customers and are subject to revocation by the government for non-compliance with applicable regulations. Of the 12 FAA certificated repair stations, 11 are in the Aviation Services segment and one is held by Composites included in our Expeditionary Services segment, which is expected to be sold in third quarter of calendar 2020. The EASA and TCCA certificated repair stations are in the Aviation Services segment. We also have a FAR Part 135 certificate to operate aircraft, although the certificate is not active. We believe that we possess all licenses and certifications that are material to the conduct of our business. +Competition +Competition in each of our markets is based on quality, ability to provide a broad range of products and services, speed of delivery, and price. Competitors in our Aviation Services segment include OEMs, the service divisions of large commercial airlines, and other independent suppliers of parts, repair, and overhaul services to the commercial and defense markets. Our Expeditionary Services segment competes with a number of divisions of large corporations and other large and small companies. Although certain of our competitors have substantially greater financial and other resources than we do, we believe that we have maintained a satisfactory competitive position through our responsiveness to customer needs, our attention to quality, and our unique combination of market expertise and technical and financial capabilities. +5 +Table of Contents +Backlog +Backlog represents the amount of revenue that we expect to derive from unshipped orders or signed contracts. Backlog includes our remaining performance obligations based on the transaction price of firm orders for which work has not yet been performed as of May 31, 2020. Backlog excludes unexercised contract options and potential orders under contracts such as ID/IQ contracts. +At May 31, 2020, our firm backlog was approximately $1.0 billion and we expect that approximately 50% of this backlog will be recognized as revenue over the next 12 months, with the majority of the remaining balance recognized as revenue over the next three years. +Employees +At May 31, 2020, we employed approximately 5,400 employees worldwide, with approximately 1,200 of these employees on furlough as of that date due to our actions to mitigate the impact from COVID-19. Approximately 200 of our employees are subject to a collective bargaining agreement. We also retained approximately 170 contract workers as of May 31, 2020, the majority of whom are located at our airframe maintenance facilities. We retain these contract workers as they provide unique skill sets which are necessary at certain facilities as well as mitigate demand variability with our customers. +Available Information +For additional information concerning our business segments, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business Segment Information” in Note 14 of Notes to Consolidated Financial Statements under Item 8, “Financial Statements and Supplementary Data.” +Our internet address is www.aarcorp.com. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Information contained on our web site is not a part of this report. +​ +6 +Table of Contents +ITEM 1A. RISK FACTORS +The following is a description of the principal risks inherent in our business. +We are affected by factors that adversely impact the commercial aviation industry. +As a provider of products and services to the commercial aviation industry, we are greatly affected by overall economic conditions of that industry. The commercial aviation industry is historically cyclical and has been negatively affected in the past by geopolitical events, high fuel and oil prices, lack of capital, and weak economic conditions. As a result of these and other events, from time to time certain of our customers have filed for bankruptcy protection or ceased operation. The impact of instability in the global financial markets may lead airlines to reduce domestic or international capacity. In addition, certain of our airline customers have in the past been impacted by tight credit markets, which limited their ability to buy parts, services, engines, and aircraft. +A reduction in the operating fleet of aircraft both in the U.S. and abroad will result in reduced demand for parts support and maintenance activities for the type of aircraft affected. A deteriorating airline environment may also result in additional airline bankruptcies, and in such circumstances we may not be able to fully collect outstanding accounts receivable. Reduced demand from customers caused by weak economic conditions, including tight credit conditions and customer bankruptcies, may adversely impact our financial condition or results of operations. +Our business, financial condition, results of operations, and growth rates may be adversely affected by these and other events that impact the aviation industry, including the following: +● deterioration in the financial condition of our existing and potential customers; +● reductions in the need for, or the deferral of, aircraft maintenance and repair services and spare parts support; +● retirement of older generation aircraft, resulting in lower prices for spare parts and services for those aircraft; +● reductions in demand for used aircraft and engines; +● increased in-house maintenance by airlines; +● lack of parts in the marketplace; +● acts of terrorism; +● future outbreaks of infectious diseases; and +● acts of God. +The coronavirus pandemic has had a material adverse impact on the Company’s business, operating results, financial condition, and liquidity, and the duration and extent of the pandemic could prolong or increase the adverse impact. +In December 2019, an outbreak of COVID-19 originated in Wuhan, China, and in March 2020, the World Health Organization characterized COVID-19 as a pandemic. Many countries, including the United States, have declared states of emergency and taken steps to restrict air travel, and many companies have adopted policies prohibiting non-essential business travel by their employees. Even in the absence of formal restrictions and prohibitions, contagious illness and fear of contagion has adversely affected travel demand and travel behavior. Passenger airline traffic has declined significantly since March 2020, and the decrease had a material negative impact on the financial results for the fourth quarter of fiscal 2020. We expect to continue to see reduced demand in our non-cargo commercial businesses. Moreover, if the COVID-19 pandemic continues to result in decreased worldwide commercial activity, it could also adversely affect the demand for airline cargo services. Reduced numbers of aircraft flying or flight hours negatively impacts the demand for our services, and any prolonged reduction could materially and adversely affect our business, operating results, financial condition, and liquidity. +7 +Table of Contents +In addition, we source parts and components for our business from various suppliers around the world. Disruptions to our supply chain and business operations, or to our suppliers’ or customers’ supply chains and business operations, could have adverse effects on our ability to provide aftermarket support and services. Moreover, a prolonged epidemic or pandemic, or the threat thereof, could result in worker absences, lower productivity, voluntary closure of our offices and facilities, travel restrictions for our employees and other disruptions to our business. Any of these could have a material adverse effect on our business, financial condition or results of operations. +The Company has taken a number of actions in response to decreased demand. In addition to reducing operating expenditures for fiscal 2021 (including by implementing furloughs, eliminating certain employee and contractor positions, temporarily reducing senior employee and director compensation, consolidating facilities and eliminating non-essential spending), we have taken steps to improve our liquidity, including drawing down our Revolving Credit Facility and seeking financial assistance under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”). Certain subsidiaries of the Company have been approved to receive $57.2 million from the U.S. Treasury Department (“Treasury”) through the Payroll Support Program under the CARES Act. In connection with the financial assistance these subsidiaries expect to receive under the Payroll Support Program, they will be required to comply with certain provisions of the CARES Act, including the requirement that funds provided pursuant to the Payroll Support Program be used exclusively for the continuation of payment of employee wages, salaries and benefits; the requirement against involuntary terminations and furloughs and reductions in employee pay rates and benefits from the signing date of the Payroll Support Program agreement through September 30, 2020. In addition, those subsidiaries and the Company would be subject to provisions prohibiting the repurchase of common stock and the payment of common stock dividends through September 30, 2021; and limitations on the payment of certain employee compensation through March 24, 2022. These restrictions will materially affect the Company’s operations, and the Company may not be successful in managing these impacts for the duration of the restrictions. In particular, limitations on compensation may adversely impact the Company's ability to attract and retain senior management or attract other key employees during this critical time. Although the Company has submitted what it believes to be final CARES Act documents to Treasury for counter signature, we can provide no assurance as to the final timing, terms or receipt of any funds. +In addition, we cannot predict the impact that COVID-19 will have on our customers, suppliers, vendors, and other business partners, and each of their financial conditions; however, any material effect on these parties could adversely impact us. The impact of COVID-19 may also exacerbate other risks discussed in this “Risk Factors” section, any of which could have a material effect on us. +Our U.S. government contracts may not continue at present sales levels, which may have a material adverse effect on our financial condition and results of operations. +Our sales to branches, agencies and departments of the U.S. government and their contractors were $668.2 million (32.2% of consolidated sales) in fiscal 2020 (See Note 14 of Notes to Consolidated Financial Statements). The majority of our U.S. government sales is for products and services supporting DoD logistics and mobility strategy and DoS flight operations and are, therefore, subject to changes in defense and other governmental agency funding and spending. Our contracts with the U.S. government and their contractors are typically agreements to provide products and services at a fixed price and have a term of one year or less, frequently subject to extension for one or more additional periods of one year at the option of the government customer. Sales to agencies of the U.S. government and their contractors are subject to a number of factors, including the level of troop deployment worldwide, competitive bidding, U.S. government funding, requirements generated by world events, and budgetary constraints. +U.S. government programs are subject to annual congressional budget authorization and appropriation processes. In recent years, U.S. government appropriations have been affected by larger U.S. government budgetary issues and related legislation, including the statutory limit on the amount of permissible federal debt. These issues could negatively affect the timely collection of our U.S. government invoices. +Future congressional appropriation and authorization of defense spending and the application of sequestration remain marked by significant debate and an uncertain schedule. The federal debt limit continues to be actively debated as plans for long-term national fiscal policy are discussed. The outcome of these debates could have a significant impact on defense spending broadly and programs we support in particular. +8 +Table of Contents +If there are funding delays and constraints, we may be required to continue to perform for some period of time on certain of our U.S. government contracts even if the U.S. government is unable to make timely payments. Future budget cuts, including cuts mandated by sequestration, or future procurement decisions could result in reductions, cancellations, and/or delays of existing contracts or programs which could adversely affect our results of operations and financial condition. +In light of COVID-19, and the corresponding decrease in commercial airline activity, we anticipate that the percentage of our revenue that comes from government contracts will increase and become more important to our overall business, which would heighten the adverse effects on our results of operations and financial condition of any reduction in the sales levels of our U.S. government contracts. +If we fail to comply with government procurement laws and regulations, we could lose business and be liable for various penalties or sanctions. +We must comply with laws and regulations relating to the formation, administration, and performance of government contracts. In the U.S., these laws and regulations include the Federal Acquisition Regulations, Defense Federal Acquisition Regulations, the Truth in Negotiations Act, Cost Accounting Standards, and laws, regulations, and orders restricting the use and dissemination of classified information under the U.S. export control laws and the export of certain products and technical information and safeguarding of contractor information systems. +In addition, we are subject to U.S. government inquiries and investigations, including periodic audits of costs that we determine are reimbursable under government contracts. U.S. government agencies routinely audit government contractors to review performance under contracts, cost structure and compliance with applicable laws, regulations, and standards, as well as the adequacy of and compliance with internal control systems and policies, including the contractor’s purchasing, property, estimating, compensation and management information systems. Any costs found to be misclassified or inaccurately allocated to a specific contract are not reimbursable, and to the extent already reimbursed, must be refunded. Also, any inadequacies in our systems and policies could result in payments being withheld, penalties and reduced future business. +U.S. government rules allow contracting officers to impose contractual withholdings at no less than certain minimum levels if a contracting officer determines that one or more of a contractor’s business systems have one or more significant deficiencies. If a contracting officer were to impose such a withholding on us or even one of our prime contractors, it would increase the risk that we would not be paid in full or paid timely. If future audit adjustments exceed our estimates, our profitability could be adversely affected. +If a government inquiry or investigation uncovers improper or illegal activities, we could be subject to civil or criminal penalties or administrative sanctions, including contract termination, fines, forfeiture of fees, suspension of payment and suspension or debarment from doing business with government agencies, any of which could materially adversely affect our reputation, business, financial condition and results of operations. See Note 15 of Notes to Consolidated Financial Statements for information about certain pending proceedings. +We use estimates when accounting for long-term contracts and face risks of cost overruns and losses on these contracts. +We sell certain of our products and services to our commercial, government, and defense customers under firm contracts providing for fixed unit prices, regardless of costs incurred by us. The cost of producing products or providing services may be adversely affected by increases in the cost of labor, materials, fuel, overhead, and other unknown variants, including manufacturing and other operational inefficiencies and differences between assumptions used by us to price a contract and actual results. Increased costs may result in cost overruns and losses on such contracts, which could adversely affect our results of operations and financial condition. +We recognize revenue on our long-term contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the services are delivered, which generally requires estimates of total costs at completion, fees earned on the contract, or both. This estimation process is complex and involves significant judgment related to assumptions on flight hours, component repair costs, labor hours and rates, and contract penalties and incentives. Adjustments to estimates are often required as work progresses, experience is gained and additional information becomes known, even though the scope of the work required under the contract may not change. Any adjustment as a result of a change in estimate is recognized as events become known. Changes in the underlying assumptions, circumstances or estimates could result in adjustments that may adversely affect our future financial results. +9 +Table of Contents +If our subcontractors or suppliers fail to perform their contractual obligations, our contract profitability and our ability to win new contracts may be adversely affected. +We rely on subcontractors to perform a portion of the services we agree to provide our customers, and our suppliers provide necessary inventory and component parts. A failure by one or more of our subcontractors or suppliers to satisfactorily provide on a timely basis the agreed-upon services or supplies may affect our ability to perform our contractual obligations. Deficiencies in the performance of our subcontractors and/or suppliers could result in liquidated damages or our customer terminating our contract for default. A termination for default could expose us to liability and adversely affect our financial performance and our ability to win new contract awards. +We are subject to significant government regulation and may need to incur significant expenses to comply with new or more stringent governmental regulation. +The aviation industry is highly regulated by the FAA in the United States and equivalent regulatory agencies in other countries. Before we sell any of our products that are to be installed in an aircraft, such as engines, engine parts and components, and airframe and accessory parts and components, they must meet certain standards of airworthiness established by the FAA or the equivalent regulatory agencies in certain other countries. We operate repair stations that are licensed by the FAA and the equivalent regulatory agencies in certain other countries, and hold certificates to operate aircraft. Specific regulations vary from country to country; although regulatory requirements in other countries are generally satisfied by compliance with FAA requirements. New and more stringent governmental regulations may be adopted in the future that, if enacted, may have an adverse impact on us. +If any of our material licenses, certificates, authorizations, or approvals were revoked or suspended by the FAA or equivalent regulatory agencies in other countries, our results of operations and financial condition may be adversely affected. +Success at our airframe maintenance facilities is dependent upon continued outsourcing by the airlines. +We currently perform airframe maintenance, repair, and overhaul activities at six leased locations. Revenues at these facilities fluctuate based on demand for maintenance which, in turn, is driven by the number of aircraft operating and the extent of outsourcing of maintenance activities by airlines. In addition, certain airlines operate certain new fleet types and/or newer generation aircraft and we may not have contractual arrangements to service these aircraft nor technicians trained and certified to perform the required airframe maintenance, repair, and overhaul activities. If either the number of aircraft operating or the level of outsourcing of maintenance activities declines, we may not be able to execute our operational and financial plans at our maintenance, repair, and overhaul facilities, which could adversely affect our results of operations and financial condition. +Our operations would be adversely affected by a shortage of skilled personnel or work stoppages. +Our business has historically been dependent on educated and skilled aviation mechanics because of the complex nature of many of our products and services. Furthermore, we have a collective bargaining agreement covering approximately 200 employees. Beginning in April 2020, we furloughed a significant portion of our skilled workforce as a result of the negative impact the COVID-19 pandemic has had on the demand for our services. Although we are taking measures to maintain good relationships with our workforce, including by paying the employer and employee portion of the furloughed employees’ health insurance costs, there can be no assurance that the act of furloughing our employees will not damage employee relations or cause employees to seek work elsewhere. Should the demand for skilled personnel return to pre-COVID-19 levels, and if we are unable to quickly reassemble our skilled workforce and subsequently retain a sufficient number of skilled personnel, or we experience a significant or prolonged work stoppage in such an environment, our ability to secure new work and our results of operations and financial condition could be adversely affected. +We operate in highly competitive markets, and competitive pressures may adversely affect us. +The markets for our products and services to our commercial, government, and defense customers are highly competitive, and we face competition from a number of sources, both domestic and international. Our competitors include aircraft manufacturers, aircraft component and parts manufacturers, airline and aircraft service companies, other companies providing maintenance, repair and overhaul services, other aircraft spare parts distributors and redistributors. Some of our competitors have substantially greater financial and other resources than we have and others may price their products and services below our selling prices. These competitive markets also create pressure on our ability to hire and retain qualified technicians and other skilled labor needs. We believe that our ability to compete depends on superior customer service and support, on-time delivery, sufficient inventory availability, competitive pricing, and effective quality assurance programs. +10 +Table of Contents +Our government customers, including the DoD and DoS, may turn to commercial contractors, rather than traditional defense contractors, for certain work, or may utilize set asides such as small business, women-owned, or minority-owned contractors or determine to source work internally rather than use us. We are also impacted by bid protests from unsuccessful bidders on new program awards and task orders. Bid protests could result in significant expense for us, contract modifications, or the award decision being overturned and loss of the contract award. Even where a bid protest does not result in the loss of an award, the resolution can extend the time until the contract activity can begin, and delay earnings. These competitive pressures, with potential impacts on both our commercial and government business, could adversely affect our results of operations and financial condition. +We are exposed to risks associated with operating internationally. +We conduct our business in a number of foreign countries, some of which are politically unstable or subject to military or civil conflicts. Consequently, we are subject to a variety of risks that are specific to international operations, including the following: +● military conflicts, civil strife, and political risks; +● export regulations that could erode profit margins or restrict exports; +● compliance with the U.S. Foreign Corrupt Practices Act, United Kingdom (“UK”) Bribery Act 2010, and other anti-bribery and anti-corruption laws; see Note 15 of Notes to Consolidated Financial Statements for information about certain pending proceedings; +● the burden and cost of compliance with foreign laws, treaties, and technical standards and changes in those regulations; +● contract award and funding delays; +● potential restrictions on transfers of funds; +● import and export duties and value added taxes; +● foreign exchange risk; +● transportation delays and interruptions, including the inability to move personnel out of foreign jurisdictions due to COVID-19 travel restrictions; +● uncertainties arising from foreign local business practices and cultural considerations; and +● changes in U.S. policies on trade relations and trade policy, including implementation of or changes in trade sanctions, tariffs, and embargoes. +On January 31, 2020, the UK officially exited the European Union (“EU”) and entered a transition period during which it remains bound by EU rules and trade policy. There is significant uncertainty regarding the terms and the future relationship between the UK and the EU following the transition period. Potential adverse consequences of the UK’s exit include global market uncertainty, volatility in currency exchange rates, greater restrictions on imports and exports between the UK and other countries and increased regulatory complexities. +While we have adopted and will continue to adopt measures to reduce the potential impact of losses resulting from the risks of doing business internationally, such measures may not be adequate, and the regions in which we operate might not continue to be stable enough to allow us to operate profitably or at all. +11 +Table of Contents +Acquisitions expose us to risks, including the risk that we may be unable to effectively integrate acquired businesses. +We have completed acquisitions in the past few years and we have discussions with third parties regarding acquisitions on a regular basis. Acquisitions involve risks, including difficulties in integrating the operations and personnel, the effects of amortization of any acquired intangible assets and the potential impairment of goodwill, and the potential loss of key employees of the acquired business. In addition, acquisitions often require substantial management resources and have the potential to divert our attention from our existing business. For any businesses we may acquire in the future, we may not be able to execute our operational, financial, or integration plans for the acquired businesses, which could adversely affect our results of operations and financial condition. +Market values for our aviation products fluctuate and we may be unable to recover our costs incurred on engines, rotable components and other aircraft parts. +We make a number of assumptions when determining the recoverability of rotable components, engines, and other assets which are on lease, available for lease, or supporting our long-term programs. These assumptions include historical sales trends, current and expected usage trends, replacement values, current and expected lease rates, residual values, future demand, and future cash flows. Reductions in demand for these assets or declining market values, as well as differences between actual results and the assumptions utilized by us when determining the recoverability of our aircraft, engines, and other assets, could result in impairment charges in future periods, which would adversely affect our results of operations and financial condition. +We may need to reduce the carrying value of our assets. +We own and distribute a significant amount of engines, aircraft parts and components, as well as own manufacturing facilities and joint venture investments. Recurring losses in certain operations could require us to evaluate the recoverability of the carrying value of the related assets and recognize an impairment charge through earnings to reduce the carrying value. During fiscal 2020, 2019, and 2018, we recognized impairment charges of $11.8 million, $74.1 million, and $54.2 million, respectively, related to our COCO business which is classified as a discontinued operation. In addition, if aircraft or engines for which we offer replacement parts or supply repair and overhaul services are retired and there are fewer aircraft that require these parts or services, our revenues may decline. We recognized impairment charges of $11.0 million in fiscal 2020 related to the exit of certain product lines across our operations. +We make a number of assumptions when determining the recoverability of our assets, including historical sales trends, current and expected usage trends, replacement values, current and expected lease rates, residual values, future demand, and future cash flows. Differences between actual results and the assumptions utilized by us when determining the recoverability of our assets could result in impairment charges in future periods, which would adversely affect our results of operations and financial condition. +We have recorded goodwill and other intangible assets related to acquisitions. If we are unable to achieve the projected levels of operating results, it may be necessary to record an impairment charge to reduce the carrying value of goodwill and related intangible assets. During the third quarter of fiscal 2018, we recognized a goodwill impairment charge of $9.8 million related to our COCO business. Similarly, if we were to lose a key customer or if a regulator were to terminate any of our repair certificates at our airframe maintenance or landing gear facilities, we might be required to record an impairment charge if we were unable to operate. +We are dependent upon continued availability of financing to manage our business and to execute our business strategy, and additional financing may not be available on terms acceptable to us. +Our ability to manage our business and to execute our business strategy is dependent, in part, on the continued availability of debt and equity capital. Access to the debt and equity capital markets may be limited by various factors, including the condition of overall credit markets, general economic factors, state of the aviation industry, our financial performance, and credit ratings. Debt and equity capital may not continue to be available to us on favorable terms, or at all. Our inability to obtain financing on favorable terms could adversely affect our results of operations and financial condition. +12 +Table of Contents +LIBOR, the London interbank offered rate, is the basic rate of interest used in lending between banks on the London interbank market and is widely used as a reference for setting the interest rate on loans globally. Interest rates under our Revolving Credit Facility (as defined below) are based partly on LIBOR. LIBOR is currently expected to phase out by the end of 2021. It is unclear if at that time LIBOR will cease to exist or if new methods of calculating LIBOR will be established such that it continues to exist after 2021. The U.S. Federal Reserve has begun publishing a Secured Overnight Funding Rate which is currently intended to serve as an alternative reference rate to LIBOR. If the method for calculation of LIBOR changes, if LIBOR is no longer available or if lenders have increased costs due to changes in LIBOR, we may suffer from potential increases in interest rates on our borrowings. Further, we may need to renegotiate our credit facilities or any other borrowings that utilize LIBOR as a factor in determining the interest rate to replace LIBOR with the new standard that is established. +Our existing debt and expected government funding includes restrictive and/or financial covenants. +Certain financing arrangements, including our Revolving Credit Facility and our accounts receivable financing program, require us to comply with various restrictive covenants and some contain financial covenants that require us to comply with specified financial ratios and tests. Our failure to meet these covenants could result in default under these loan and debt agreements and may result in a cross-default under other debt agreements. In the event of a default and our inability to obtain a waiver of the default, all amounts outstanding under our debt agreements could be declared immediately due and payable. Our failure to comply with these covenants could adversely affect our results of operations and financial condition. +In addition, our expected receipt of funding under Payroll Support Program under the CARES Act would require us to comply with certain covenants. If we do not comply with these covenants, the government may require us to repay the support given to us. +We may not be able to pay or maintain dividends, or we may choose not to pay dividends, and the failure to pay or maintain dividends may adversely affect our share price. +On March 17, 2020, our Board of Directors declared a regular quarterly dividend of $0.075 per share, or an aggregate of $2.6 million, which was paid on April 9, 2020 to holders of record on March 30, 2020. This dividend may not be indicative of the amount of any future quarterly dividends. Specifically, the Payroll Support Program under the CARES Act prohibits the Company from paying stock dividends through September 30, 2021, accordingly no dividend will be paid by the Company prior to that time assuming the receipt of funding. +After the restrictions on paying the dividend under the CARES Act lapse, our ability to pay, maintain or increase cash dividends to our stockholders is subject to the discretion of our Board of Directors and will depend on many factors, including: our ability to comply with financial covenants, the economic condition of the commercial aviation industry, the level and timing of capital expenditures, principal repayments and other capital needs, maintaining our credit ratings, our results of operations, financial condition and liquidity, and legal restrictions on the payment of dividends, including government imposed restrictions. In the future, we may choose to not pay dividends or may not be able to pay dividends, maintain our current level of dividends, or increase them over time. The failure to maintain or pay dividends may adversely affect our share price. +Our industry is susceptible to product and other liability claims, and claims not adequately covered by insurance may adversely affect our financial condition. +Our business exposes us to possible claims for property damage and bodily injury or death, which may result if an engine, engine part or component, airframe part or accessory, or any other aviation product that we have sold, manufactured, or repaired fails, or if an aircraft we operated, serviced, or in which our products are installed, has an accident. We carry substantial liability insurance in amounts that we believe are adequate for our risk exposure and commensurate with industry norms. However, claims may arise in the future, and our insurance coverage may not be adequate to protect us in all circumstances. Additionally, we might not be able to maintain adequate insurance coverage in the future at an acceptable cost. Any liability claim not covered by adequate insurance could adversely affect our results of operations and financial condition. +13 +Table of Contents +Our business could be negatively affected by cyber or other security threats or other disruptions. +Our business depends heavily on information technology and computerized systems to communicate and operate effectively. The Company's systems and technologies, or those of third parties on which we rely, could fail or become unreliable due to equipment failures, software viruses, cyber threats, ransomware attacks, terrorist acts, natural disasters, power failures or other causes. These threats arise in some cases as a result of our role as a defense contractor. +Cyber security threats are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to our sensitive information, business e-mail compromises, ransomware attacks, and other electronic security breaches, including at our customers, suppliers, subcontractors, and joint venture partners, that could lead to disruptions in mission critical systems, unauthorized release of confidential or otherwise protected information, and corruption of data. +The procedures and controls we utilize to monitor and mitigate these threats may not be sufficient to prevent security threats from materializing. If any of these events were to materialize, the costs related to cyber or other security threats or disruptions may not be fully insured or indemnified and could have a material adverse effect on our reputation, operating results, and financial condition. +Moreover, expenditures incurred in implementing and maintaining cyber security and other procedures and controls could adversely affect our results of operations and financial condition. +We must comply with extensive environmental requirements, and any exposure to environmental liabilities may adversely affect us. +Federal, state, and local requirements relating to the discharge and emission of substances into the environment, the disposal of hazardous wastes, the remediation and abatement of contaminants, and other activities affecting the environment have had and may continue to have an impact on our operations. Management cannot assess the possible effect of compliance with future environmental requirements or of future environmental claims for which we may not have adequate indemnification or insurance coverage. If we were required to pay the expenses related to any future environmental claims for which neither indemnification nor insurance coverage were available, these expenses could have an adverse impact on our results of operations and financial condition. +Future environmental regulatory developments in the United States and abroad concerning environmental issues, such as climate change, could adversely affect our operations and increase operating costs and, through their impact on our customers, reduce demand for our products and services. Actions may be taken in the future by the U.S. government, state governments within the United States, foreign governments, or the International Civil Aviation Organization to regulate the emission of greenhouse gases by the aviation industry. The precise nature of any such requirements and their applicability to us and our customers are difficult to predict, but the impact to us and the aviation industry would likely be adverse and could be significant, including the potential for increased fuel costs, carbon taxes or fees, or a requirement to purchase carbon credits. +We may need to make significant capital expenditures to keep pace with technological developments in our industry. +The industries in which we participate are constantly undergoing development and change, and it is likely that new products, equipment, and methods of repair and overhaul services will be introduced in the future. We may need to make significant expenditures to purchase new equipment and to train our employees to keep pace with any new technological developments. These expenditures could adversely affect our results of operations and financial condition. +​ +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not Applicable. +​ +14 +Table of Contents +ITEM 2. PROPERTIES +In the Aviation Services segment, we conduct parts supply activities from our headquarters in Wood Dale, Illinois, which we own. In addition to warehouse space, this facility includes executive, sales and administrative offices. Our principal maintenance, repair, overhaul, engineering and other service activities for this segment are conducted at U.S. facilities leased by us in Indianapolis, Indiana; Oklahoma City, Oklahoma; Miami, Florida; Medley, Florida; and Rockford, Illinois and at Canadian facilities leased by us in Trois Rivieres, Quebec and Windsor, Ontario. +We also lease facilities in Garden City, New York; Jacksonville, Florida; Palm Bay, Florida; Rockledge, Florida; Brussels, Belgium; London, England; and Crawley, England, and own a building near Schiphol International Airport in the Netherlands to support activities in the Aviation Services segment. +Our principal activities in the Expeditionary Services segment are conducted at facilities we lease in Huntsville, Alabama and Sacramento, California and own in Cadillac, Michigan and Clearwater, Florida. +We also operate sales offices that support all our activities and are leased in London, England; Crawley, England; Paris, France; Rio de Janeiro, Brazil; Tokyo, Japan; Shanghai, China; Singapore, Republic of Singapore; and Dubai, UAE. +We believe that our owned and leased facilities are suitable and adequate for our operational requirements. +​ +ITEM 3. LEGAL PROCEEDINGS +Note 15 of the Notes to our Consolidated Financial Statements for the year ended May 31, 2020 contained in Item 8 of this Annual Report on Form 10-K includes information on legal proceedings that constitute material contingencies for financial reporting purposes that could have a material adverse effect on our consolidated financial position or liquidity if they were resolved in a manner that is adverse to us. The information in Note 15 is incorporated by reference in this Item 3. +There are no matters which constitute material pending legal proceedings to which we are a party other than those incorporated into this item by reference from Note 15 to our Consolidated Financial Statements for the year ended May 31, 2020 contained in this Annual Report on Form 10-K. +​ +ITEM 4. MINE SAFETY DISCLOSURES +Not Applicable. +​ +15 +Table of Contents +Supplemental Item: +EXECUTIVE OFFICERS OF THE REGISTRANT +Information concerning each of our executive officers is set forth below: +Name +Age +Present Position with the Company +John M. Holmes +​ +43 +​ +Chief Executive Officer and President, Director +Sean M. Gillen +​ +34 +​ +Vice President and Chief Financial Officer +Jessica A. Garascia +​ +41 +​ +Vice President, General Counsel and Secretary +Chris Jessup +​ +42 +​ +Vice President, Chief Commercial Officer +Eric S. Pachapa +​ +47 +​ +Vice President, Controller and Chief Accounting Officer +​ +Mr. Holmes is Chief Executive Officer and President, having served in that capacity since June 2018. From June 2017 to May 2018, Mr. Holmes served as President and Chief Operating Officer. From February 2015 to June 2017, Mr. Holmes served as Chief Operating Officer – Aviation Services. Prior to that, Mr. Holmes served as Group Vice President, Aviation Services – Inventory Management and Distribution from 2012 to 2015, General Manager and Division President of our Allen Asset Management business from 2003 to 2012, and in various other positions since joining the Company in September 2001. Mr. Holmes has been a director of the Company since 2017. +Mr. Gillen is Vice President and Chief Financial Officer, having served in that capacity since January 2019. Prior to joining AAR, Mr. Gillen was Vice President and Treasurer of USG Corporation since 2017. Prior to USG, Mr. Gillen spent nine years in investment banking with Goldman Sachs, most recently as a Vice President in their Global Industrials Group. +Ms. Garascia is Vice President, General Counsel and Secretary, having served in that capacity since February 2020. Prior to joining the Company, from September 2013 through February 2020, Ms. Garascia served in positions of increasing responsibility for USG Corporation, most recently as Deputy General Counsel. Prior to USG, Ms. Garascia was an attorney for the Museum of Science and Industry and the law firm of Jenner & Block. +Mr. Jessup is Vice President, Chief Commercial Officer, having served in that capacity since June 2017. Mr. Jessup previously served as Chief Commercial Officer for the Company’s Aviation Services segment since February 2015, and prior to that, he served in various capacities within the Company’s Maintenance, Repair and Overhaul business. Prior to joining the Company in 2008, Mr. Jessup was Vice President, Sales and Marketing at Avborne Heavy Maintenance, Inc. in Miami, Florida. +Mr. Pachapa is Vice President, Controller and Chief Accounting Officer, having served in that capacity since July 2016. Mr. Pachapa previously served as Controller since October 2015 and Senior Director of Accounting and Reporting since April 2014. Prior to joining the Company, Mr. Pachapa was with Glanbia plc from 2011 to 2014, and with Ernst & Young LLP from 1996 to 2011. +Each executive officer is elected annually by the Board of Directors. Executive officers continue to hold office until their successors are duly elected or until their death, resignation, termination or reassignment. +​ +​ +16 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is traded on the New York Stock Exchange and the Chicago Stock Exchange under the symbol “AIR.” On June 30, 2020, there were approximately 847 holders of common stock, including participants in security position listings. +Stockholder Return Performance Graph +The following graph compares the total return on a cumulative basis of $100 invested, and reinvestment of dividends in our common stock on May 31, 2015 to the Standard and Poor’s (“S&P”) 500 Index and the Proxy Peer Group: +​ +The S&P 500 Index is comprised of domestic industry leaders in four major sectors: Industrial, Financial, Utility, and Transportation, and serves as a broad indicator of the performance of the U.S. equity market. The Company’s Fiscal 2020 Proxy Peer Group companies are listed as follows: +​ +Aerojet Rocketdyne Holdings, Inc. +Kaman Corporation +Barnes Group Inc. +​ +Moog Inc. +CACI International Inc +​ +MSC Industrial Direct Co., Inc. (a) +Crane Co. +​ +Teledyne Technologies Incorporated +Cubic Corporation +​ +TriMas Corporation (a) +Curtiss-Wright Corporation +​ +Triumph Group, Inc. +Esterline Technologies Corporation +​ +Wesco Aircraft Holdings, Inc. +Heico Corporation +​ +Woodward, Inc. (a) +Hexcel Corporation +​ +​ +(a) New peer group company added for fiscal 2020 due to its business and financial comparability to the Company. +Three companies were removed from the prior year’s peer group: KLX Inc. was acquired, and Science Applications International Corporation and Engility Holdings, Inc. combined and the resulting company was judged to no longer be a suitable comparator company. +17 +Table of Contents +The Company annually revisits the composition of the peer group to ensure that the Company's performance is measured against those of comparably-sized and situated companies. The mix of the Company's commercial and government/defense markets presents a challenge in constructing a peer group, given that many government/defense contractors have substantially greater resources than the Company. +​ +Dividends +The declaration and payment of cash dividends is at the discretion of our Board of Directors and will be dependent upon our future earnings, cash flows, financial condition, capital requirements and any government restrictions. Specifically, the Payroll Support Program under the CARES Act would prohibit the Company from paying stock dividends through September 30, 2021, accordingly no dividend will be paid by the Company prior to that time assuming receipt of the funds. +​ +18 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +(In millions, except per share amounts) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +2017 +2016 +RESULTS OF OPERATIONS +​ +​ +​ +​ +​ +Sales 1 +​ +$ +2,072.0 +​ +$ +2,051.8 +​ +$ +1,748.3 +​ +$ +1,590.8 +​ +$ +1,525.4 +Gross profit +​ +269.2 +​ +329.8 +​ +294.1 +​ +263.6 +​ +233.4 +Operating income 2 +​ +41.3 +​ +98.3 +​ +86.0 +​ +82.3 +​ +75.5 +Interest expense +​ +9.3 +​ +9.5 +​ +8.0 +​ +5.3 +​ +6.4 +Income from continuing operations +​ +24.8 +​ +84.1 +​ +73.7 +​ +52.0 +​ +45.5 +Income (Loss) from discontinued operations 3 +​ +(20.4) +​ +(76.6) +​ +(58.1) +​ +4.5 +​ +2.2 +Net income +​ +4.4 +​ +7.5 +​ +15.6 +​ +56.5 +​ +47.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Share data: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share – basic: +​ +​ +​ +​ +​ +Earnings from continuing operations +​ +$ +0.71 +​ +$ +2.42 +​ +$ +2.14 +​ +$ +1.53 +​ +$ +1.30 +Earnings (Loss) from discontinued operations +​ +(0.59) +​ +(2.22) +​ +(1.70) +​ +0.13 +​ +0.07 +Earnings per share – basic +​ +$ +0.12 +​ +$ +0.20 +​ +$ +0.44 +​ +$ +1.66 +​ +$ +1.37 +Earnings per share – diluted: +​ +​ +​ +​ +​ +​ +Earnings from continuing operations +​ +$ +0.71 +​ +$ +2.40 +​ +$ +2.11 +​ +$ +1.51 +​ +$ +1.30 +Earnings (Loss) from discontinued operations +​ +(0.58) +​ +(2.19) +​ +(1.70) +​ +0.13 +​ +0.07 +Earnings per share – diluted +​ +$ +0.13 +​ +$ +0.21 +​ +$ +0.41 +​ +$ +1.64 +​ +$ +1.37 +Cash dividends declared per share +​ +$ +0.30 +​ +$ +0.30 +​ +$ +0.30 +​ +$ +0.30 +​ +$ +0.30 +Weighted average common +​ +​ +​ +​ +​ +shares outstanding – basic +​ +34.8 +​ +34.5 +​ +34.2 +​ +33.9 +​ +34.4 +Weighted average common +​ +​ +​ +​ +​ +shares outstanding – diluted +​ +35.0 +​ +34.9 +​ +34.6 +​ +34.3 +​ +34.6 +​ +​ +19 +Table of Contents +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +2018 +2017 +2016 +FINANCIAL POSITION +​ +​ +​ +​ +​ +Cash and cash equivalents 4 +​ +$ +404.7 +​ +$ +21.3 +​ +$ +31.1 +​ +$ +10.3 +​ +$ +31.2 +Working capital +​ +1,055.6 +​ +595.0 +​ +609.4 +​ +553.4 +​ +540.3 +Total assets 4 +​ +2,079.0 +​ +1,517.2 +​ +1,524.7 +​ +1,504.1 +​ +1,456.0 +Total debt +​ +602.0 +​ +142.9 +​ +178.9 +​ +156.2 +​ +145.3 +Equity +​ +902.6 +​ +905.9 +​ +936.3 +​ +914.2 +​ +865.8 +Number of shares outstanding at end of year +​ +35.1 +​ +34.8 +​ +34.7 +​ +34.4 +​ +34.5 +Book value per share of common stock +​ +$ +25.72 +​ +$ +26.03 +​ +$ +26.98 +​ +$ +26.58 +​ +$ +25.10 +Notes: +1 At the beginning of fiscal 2019, we adopted Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (“ASC 606”) using a modified retrospective method and, as a result, the comparative information for prior years has not been restated and is reported under accounting standards in effect for those years. See Note 1 of Notes to Consolidated Financial Statements for additional information. +2 In fiscal 2020, we recognized contract termination and restructuring charges of $31.3 across certain commercial power-by-the-hour contracts. The charges included a reduction in revenue of $17.3 million, the establishment of forward loss reserves of $5.4 million, and other related charges of $8.6 million. During fiscal 2020, we also recognized impairment charges of $11.0 million related to the exit of certain product lines across our operations and $4.9 million related to the closure of two facilities. To mitigate the impact of COVID-19 on our operations, we reduced our headcount and furloughed employees resulting in the recognition of severance and furlough costs of $5.0 million in fiscal 2020. +3 In fiscal 2016, we received contingent consideration from the sale of Telair Cargo Group and recognized a pre-tax gain of $27.7 million. +We recognized pre-tax asset impairment charges related to our Contractor-Owned, Contractor-Operated (“COCO”) business of $11.8 million, $74.1 million, and $64.0 million in fiscal 2020, 2019, and 2018, respectively. +4 In the fourth quarter of fiscal 2020, we elected to draw down our Revolving Credit Facility as a precautionary measure in light of economic and market uncertainty presented by COVID-19. These additional borrowings from our Revolving Credit Facility are largely being maintained in Cash and cash equivalents on our Consolidated Balance Sheet which were $404.7 million at May 31, 2020. +​ +​ +20 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +(Dollars in millions) +Background and Forward-Looking Statements +The following discussion and analysis of our financial condition and results of operations, and quantitative and qualitative disclosures about market risk should be read in conjunction with our consolidated financial statements and the related notes included in this Form 10-K, as well as Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended May 31, 2019, which provides additional information on comparisons of fiscal 2019 and 2018. +Management’s Discussion and Analysis of Financial Condition and Results of Operations contain certain statements relating to future results, which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on the beliefs of management, as well as assumptions and estimates based on information available to us as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties, including those factors discussed under Item 1A, “Risk Factors,” that could cause actual results to differ materially from those anticipated. Should one or more of those risks or uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. Those events and uncertainties are difficult or impossible to predict accurately and many are beyond our control. We assume no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. +General Overview +We report our activities in two business segments: Aviation Services comprised of supply chain and maintenance, repair and overhaul (“MRO”) activities and Expeditionary Services comprised of manufacturing activities. +The Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance based logistics programs, customer fleet management and operations, and aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of product, direct labor, and overhead. +The Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support the U.S. military’s requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. This segment also designs and manufactures advanced composite materials for commercial, business and military aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead. +Our chief operating decision making officer (Chief Executive Officer) evaluates performance based on the reportable segments and utilizes gross profit as a primary profitability measure. Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments. Our reportable segments are aligned principally around differences in products and services. +Business Trends and Outlook +Fiscal 2020 began with strategic initiatives focused on growth and execution across all of our activities in the commercial and government markets. Our momentum from a successful fiscal 2019 carried into the new year as we saw continued strength in our parts supply activities, as well as in government programs. We also realized the positive impact our efforts to attract and retain talent had in our MRO activities. +21 +Table of Contents +We succeeded in enhancing customer relationships with multiple commercial and government customers. In fiscal 2020, we were awarded a new $118 million contract from the Naval Air Systems Command in support of the U.S. Marine Corps for the procurement, modification and delivery of two C-40 aircraft. This award demonstrates the power of our integrated services model by combining the strengths of our parts supply, government programs, MRO, and engineering teams to deliver a creative solution to the U.S. Marine Corps. +We were also awarded new long-term contracts across our parts supply activities including multiple distribution agreements for new parts and our largest commercial agreement in Japan to date covering aftermarket engine components. Our strategy to exit the capital-intensive Contractor-Owned, Contractor-Operated (“COCO”) business was also completed in fiscal 2020 as all of its assets and contracts were sold. +As we continued to successfully execute on our recent contract awards over the last few years, we achieved strong sales growth through the first nine months of fiscal 2020 and were on track for a record year. Sales had increased $166.4 million or 11.2% over the prior year period primarily due to an increase in sales of $175.5 million or 12.5% in our Aviation Services segment reflecting the growth from new contract awards and successful execution across our Aviation Services activities. +Upon entering the fourth quarter in March, we began to see the impact of the COVID-19 pandemic on the commercial aviation industry. In response to the impact from COVID-19, we implemented significant actions to reduce fixed costs and overhead which included a freeze on new hiring, reducing or eliminating all non-essential spend, reducing compensation and benefits, furloughs, a reduction in force, and closure of an airframe maintenance facility. During the fourth quarter, we also exited underperforming contracts and assets across our operations and decided to exit our joint venture investment in a Malaysian landing gear wheel and brake facility. Additionally, in June 2020, we decided to sell our composites manufacturing business which is consistent with our multi-year strategy to focus our portfolio on our core services offerings. +We have also taken actions to preserve flexibility in our liquidity. In the fourth quarter, we elected to draw down our remaining available borrowings under our Revolving Credit Facility with the majority of that additional funding remaining in our cash accounts. We elected to borrow these additional amounts as a precautionary measure in light of economic and market uncertainty presented by COVID-19. +Over the long-term, we expect to see continued strength in our Aviation Services segment given its offerings of value-added services to both commercial and government and defense customers. We believe long-term commercial aftermarket growth trends are favorable although there is uncertainty in certain fleet types as commercial operators re-evaluate their structure. Our results of operations are affected by the amount of commercial aircraft flying and flight hours. The current COVID-19 pandemic has decreased the amount of commercial aircraft flying and flight hours and has created significant economic disruption. +Results of Operations – Fiscal 2020 Compared with Fiscal 2019 +Sales and gross profit for our two business segments for the two years ended May 31, 2020 and 2019 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +% Change +Sales: +​ +​ +​ +Aviation Services +​ +​ +​ +Commercial +​ +$ +1,268.9 +​ +$ +1,342.3 +(5.5) +% +Government and defense +​ +695.3 +​ +578.3 +​ +20.2 +% +​ +​ +$ +1,964.2 +​ +$ +1,920.6 +2.3 +% +Expeditionary Services +​ +​ +​ +Commercial +​ +$ +24.3 +​ +$ +31.6 +(23.1) +% +Government and defense +​ +83.5 +​ +99.6 +(16.2) +% +​ +​ +$ +107.8 +​ +$ +131.2 +(17.8) +% +​ +22 +Table of Contents +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +% Change +Gross Profit (Loss): +​ +​ +​ +Aviation Services +​ +​ +​ +Commercial +​ +$ +148.0 +​ +$ +195.7 +(24.4) +% +Government and defense +​ +119.3 +​ +117.9 +1.2 +% +​ +​ +$ +267.3 +​ +$ +313.6 +(14.8) +% +Expeditionary Services +​ +​ +​ +Commercial +​ +$ +(3.6) +​ +$ +3.0 +(220.0) +% +Government and defense +​ +5.5 +​ +13.2 +(58.3) +% +​ +​ +$ +1.9 +​ +$ +16.2 +(88.3) +% +​ +Aviation Services Segment +Sales in the Aviation Services segment increased $43.6 million or 2.3% over the prior year. Sales to government and defense customers increased $117.0 million or 20.2% primarily attributable to new contracts awarded recently, including the $118 million contract for the procurement, modification and delivery of two C-40 aircraft we received in early fiscal 2020. +During fiscal 2020, sales in this segment to commercial customers decreased $73.4 million or 5.5% from the prior year. We experienced an increase in sales to commercial customers of 7.2% over the first nine months of the year primarily due to higher volumes in our MRO activities as our actions to attract and retain the necessary skilled labor allowed us to capture the customer demand for these services. During the fourth quarter of fiscal 2020, the impact from COVID-19 significantly decreased our commercial sales across the majority of our operations. +Changes in estimates and assumptions related to our programs accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. In fiscal 2020, we recognized favorable and unfavorable cumulative catch-up adjustments of $6.1 million and $2.2 million, respectively, compared to favorable and unfavorable cumulative catch-up adjustments of $8.0 million and $2.1 million, respectively, in fiscal 2019. When considering these adjustments on a net basis, we recognized favorable cumulative catch-up adjustments of $3.9 million and $5.9 million for fiscal 2020 and 2019, respectively. These adjustments primarily relate to our long-term programs where we provide component inventory management and/or repair services. +Cost of sales in Aviation Services increased $89.9 million or 5.6% from the prior year which was largely in line with the sales increase of 2.3% discussed above. Gross profit in the Aviation Services segment decreased $46.3 million or 14.8% from the prior year. Gross profit in this segment on sales to commercial customers decreased $47.7 million or 24.4% from the prior year primarily driven by contract termination and restructuring charges of $31.3 million across certain power-by-the-hour contracts in fiscal 2020. The charges included a reduction in revenue of $17.3 million, the establishment of forward loss reserves of $5.4 million, and other related charges of $8.6 million. During fiscal 2020, we also recognized impairment charges of $6.9 million related to the exit of certain product lines across our operations and $4.3 million related to the closure of our Duluth airframe maintenance facility. +The gross profit margin on sales to commercial customers was 11.7% compared to 14.6% in the prior year with the decreased margin largely attributable to contract termination, restructuring, and impairment charges discussed above. +Gross profit on sales to government and defense customers increased $1.4 million or 1.2% over the prior year. Gross profit margin on sales to government and defense customers decreased to 17.2% from 20.4% as the gross profit margin on our recent contract awards is lower than our existing government and defense activity. +Expeditionary Services Segment +Sales in the Expeditionary Services segment decreased $23.4 million or 17.8% from the prior year primarily due to delays in contract awards for our mobility products. Gross profit in the Expeditionary Services segment decreased $14.3 million or 88.3% from the prior year and gross profit margin decreased to 1.8% from 12.3% both primarily as a result of restructuring actions and lower sales volumes. During fiscal 2020, we consolidated our mobility products operations into one core facility and exited certain product lines as part of the consolidation. We recognized charges of $2.8 million related to facility closure costs and impairment charges. +23 +Table of Contents +Provision for Doubtful Accounts +Provision for doubtful accounts decreased $10.4 million from the prior year primarily related to fewer bankruptcy charges in fiscal 2020. In the second quarter of fiscal 2019, we recognized a provision for doubtful accounts of $12.4 million related to the bankruptcy of a European airline customer. The provision included impairment of non-current contract assets of $7.6 million, allowance for doubtful accounts of $3.3 million, and other liabilities of $1.5 million. +Selling, General and Administrative Expenses +Selling, general and administrative expenses increased $5.2 million over the prior year. As a percent of sales, selling, general and administrative expenses remained relatively flat at 10.6% in fiscal 2020 compared to 10.5% in the prior year. +Interest Expense +Interest expense decreased $0.2 million in fiscal 2020 as the impact of higher average borrowings was more than offset by lower average borrowing rates on our Revolving Credit Facility. +Income Taxes +Our fiscal 2020 effective income tax rate for continuing operations was 18.4% compared to 5.5% in the prior year. In fiscal 2019, we recognized tax benefits of $5.1 million related to the reversal of certain state valuation allowances based on the recoverability of the net operating losses and other state deferred tax assets. The effective income tax rate for fiscal 2019 also includes a benefit of $4.7 million related to the recognition of previously unrecognized uncertain tax positions and a tax benefit of $1.8 million related to tax provision to federal income tax return filing differences. +Discontinued Operations +During the third quarter of fiscal 2018, we decided to pursue the sale of our COCO business previously included in our Expeditionary Services segment. Due to this strategic shift, the assets, liabilities, and results of operations of our COCO business were reported as discontinued operations for all periods presented. +Loss from discontinued operations was $20.4 million in fiscal 2020 compared to $76.6 million in the prior year. The reduced loss of $56.2 million was primarily due to lower pre-tax impairment charges of $11.8 million in fiscal 2020 as compared to $74.1 million in fiscal 2019. +Liquidity, Capital Resources and Financial Position +Our operating activities are funded and commitments met through the generation of cash from operations. In addition to operations, our current capital resources include an unsecured Revolving Credit Facility and an accounts receivable financing program. Periodically, we may also raise capital through common stock and debt financings in the public or private markets. We continually evaluate various financing arrangements, including the issuance of common stock or debt, which would allow us to improve our liquidity position and finance future growth on commercially reasonable terms. Our continuing ability to borrow from our lenders and issue debt and equity securities to the public and private markets in the future may be negatively affected by a number of factors, including the overall health of the credit markets, general economic conditions, airline industry conditions, geo-political events, and our operating performance. Our ability to generate cash from operations is influenced primarily by our operating performance and changes in working capital. +We maintain a Revolving Credit Facility with various financial institutions, as lenders, and Bank of America, N.A., as administrative agent for the lenders. On September 25, 2019, we entered into an amendment to our Revolving Credit Facility which extended the maturity of the Revolving Credit Facility to September 25, 2024, increased the revolving credit commitment by $100 million to $600 million, and modified certain other provisions. Under certain circumstances, we have the ability to request, but our lenders are not required to grant, an increase to the revolving credit commitment by an aggregate amount of up to $300 million. +24 +Table of Contents +Borrowings under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 87.5 to 175 basis points based on certain financial measurements if a Eurodollar Rate loan, or at the offered fluctuating Base Rate plus 0 to 75 basis points based on certain financial measurements if a Base Rate loan. +Borrowings outstanding under the Revolving Credit Facility at May 31, 2020 were $579.5 million and there were approximately $19.9 million of outstanding letters of credit, which reduced the availability of this facility to $0.6 million. There are no other terms or covenants limiting the availability of this facility. In the fourth quarter of fiscal 2020, we elected to draw down our Revolving Credit Facility as a precautionary measure in light of economic and market uncertainty presented by COVID-19. These additional borrowings from our Revolving Credit Facility are largely being maintained in Cash and cash equivalents on our Consolidated Balance Sheet which was $404.7 million at May 31, 2020. +On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted in the U.S. in response to the COVID-19 pandemic. Certain of our subsidiaries expect to receive $57.2 million from the U.S. Treasury Department through the Payroll Support Program under the CARES Act. These funds will be used to pay for the salaries and benefits of certain of those subsidiaries’ employees. Of the $57.2 million total amount we expect to receive, approximately $48.5 million will be a direct grant and approximately $8.7 million will be in the form of a low interest 10-year senior unsecured promissory note. +As of May 31, 2020, we also had other financing arrangements that did not limit availability on our Revolving Credit Facility including outstanding letters of credit of $11.6 million and foreign lines of credit of $9.3 million. +On October 18, 2017, we entered into the Credit Agreement with the Canadian Imperial Bank of Commerce, as lender. The Credit Agreement provided a Canadian $31 million term loan with the proceeds used to fund the acquisition of two maintenance, repair, and overhaul facilities in Canada from Premier Aviation. The term loan is due in full at the expiration of the Credit Agreement on November 1, 2021 unless terminated earlier pursuant to the terms of the Credit Agreement. Interest is payable monthly on the term loan at the offered fluctuating Canadian Dollar Offer Rate plus 125 to 225 basis points based on certain financial measurements if a Bankers’ Acceptances loan, or at the offered fluctuating Prime Rate plus 25 to 125 basis points based on certain financial measurements, if a Prime Rate loan. +On February 23, 2018, we entered into a Purchase Agreement with Citibank N.A. (“Purchaser”) for the sale, from time to time, of certain accounts receivable due from certain customers (the “Purchase Agreement”). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million and Purchaser may, but is not required to, purchase the eligible receivables we offer to sell. The term of the Purchase Agreement runs through February 22, 2021, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual terms unless either party provides advance notice that they do not intend to extend the term. +We have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing , and de-recognize the sold receivables from our Consolidated Balance Sheet. +Receivables sold under the Purchase Agreement during fiscal 2020, 2019, and 2018 were $746.4 million, $744.2 million, and $239.6, respectively. Amounts remitted to the Purchaser on their behalf during fiscal 2020, 2019, and 2018 were $758.3 million, $729.7 million, and $167.9, respectively. As of May 31, 2020 and May 31, 2019, we had collected cash of $20.0 million and $19.8 million, respectively, which was not yet remitted to the Purchaser as of those dates and was classified as Restricted cash on our Consolidated Balance Sheets. +At May 31, 2020, we complied with all financial and other covenants under each of our financing arrangements. +Cash Flows – Fiscal 2020 Compared with Fiscal 2019 +Cash Flows from Operating Activities +Net cash used in operating activities–continuing operations was $19.1 million in fiscal 2020 compared to cash provided of $60.5 million in fiscal 2019. The decrease of $79.6 million was primarily attributable to timing of our cash receipts and disbursements on long-term programs. +25 +Table of Contents +Cash Flows from Investing Activities +Net cash used in investing activities–continuing operations was $24.8 million in fiscal 2020 compared to $18.5 million in fiscal 2019. The increase from the prior year was primarily related to higher expenditures for property and equipment in the current year. +Cash Flows from Financing Activities +Net cash provided by financing activities–continuing operations was $444.5 million in fiscal 2020 compared to cash used of $47.3 million in fiscal 2019. In the fourth quarter of fiscal 2020, we elected to draw down our Revolving Credit Facility as a precautionary measure in light of economic and market uncertainty presented by COVID-19. These additional borrowings from our Revolving Credit Facility are largely being maintained in Cash and cash equivalents on our Consolidated Balance Sheet. +Contractual Obligations and Off-Balance Sheet Arrangements +A summary of contractual cash obligations and off-balance sheet arrangements as of May 31, 2020 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Payments Due by Period +​ +​ +​ +​ +​ +Due in +​ +Due in +​ +Due in +​ +Due in +​ +Due in +​ +After +​ +​ +​ +​ +​ +Fiscal +​ +Fiscal +​ +Fiscal +​ +Fiscal +​ +Fiscal +​ +Fiscal +​ +Total +2021 +2022 +2023 +2024 +2025 +2026 +On Balance Sheet: +​ +​ +​ +​ +​ +​ +​ +Bank borrowings +​ +$ +602.0 +​ +$ +— +​ +$ +22.5 +​ +$ +— +​ +$ +— +​ +$ +579.5 +​ +$ +— +Facilities and equipment operating leases +​ +99.2 +​ +16.5 +​ +14.5 +​ +12.7 +​ +10.7 +​ +8.3 +​ +36.5 +Interest 1 +​ +​ +30.1 +​ +​ +7.2 +​ +​ +7.0 +​ +​ +6.8 +​ +​ +6.8 +​ +​ +2.3 +​ +​ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Off Balance Sheet: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Purchase obligations 2 +​ +366.2 +​ +344.8 +​ +15.8 +​ +5.4 +​ +0.1 +​ +0.1 +​ +— +Pension contribution 3 +​ +3.1 +​ +3.1 +​ +— +​ +— +​ +— +​ +— +​ +— +Notes: +1 Interest associated with variable rate debt was determined using the interest rate in effect on May 31, 2020. +2 Purchase obligations arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts, and components, as well as equipment to support the operations of our business. +3 Our contribution policy for the domestic plans is to contribute annually, at a minimum, an amount which is deductible for federal income tax purposes and that is sufficient to meet actuarially computed pension benefits. For our Netherlands pension plan, our policy is to fund at least the minimum amount required by the local laws and regulations. We anticipate contributing approximately $3.1 million to our pension plans during fiscal 2021, which includes approximately $1.1 million of the Netherlands’ fiscal 2020 contribution which was deferred to fiscal 2021. +We routinely issue letters of credit and performance bonds in the ordinary course of business. These instruments are typically issued in conjunction with insurance contracts or other business requirements. The total of these instruments outstanding at May 31, 2020 was $31.5 million. +Critical Accounting Policies and Significant Estimates +Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States. Management has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare the Consolidated Financial Statements. The most significant estimates made by management include those related to assumptions used in assessing goodwill impairment, adjustments to reduce the value of inventories and certain rotable assets, revenue recognition, allowance for doubtful accounts, and assumptions used in determining pension plan obligations. Accordingly, actual results could differ materially from those estimates. The following is a summary of the accounting policies considered critical by management. +26 +Table of Contents +Goodwill +Under accounting standards for goodwill and other intangible assets, goodwill and other intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, or more frequently if circumstances indicate that impairment is possible. +The accounting standards for goodwill allow for either a qualitative or quantitative approach for the annual impairment test. Under the qualitative approach, factors such as macroeconomic conditions, industry and market conditions and company-specific events or circumstances are assessed to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. When the quantitative approach is utilized, we compare the fair value of each reporting unit with the carrying value of the reporting unit, including goodwill. If the estimated fair value of the reporting unit is less than the carrying value of the reporting unit, we would be required to recognize an impairment loss for the excess carrying value of the reporting unit’s assets. +In fiscal 2018, we performed an interim goodwill impairment test over our former Airlift reporting unit as a result of a decision to exit our COCO business. The COCO business was reclassified to discontinued operations and goodwill was allocated to the COCO business based on its relative fair value to the reporting unit. The fair value of the reporting unit was determined based on a combination of the expected net proceeds upon sale and a discounted cash flow analysis. As the fair value of the COCO business was below its carrying value, a goodwill impairment charge of $9.8 million was recorded in the third quarter of fiscal 2018. +As of May 31, 2020, we had three reporting units, which included two in our Aviation Services segment (Aviation Supply Chain and Maintenance, Repair, and Overhaul) and one comprised of our Expeditionary Services segment. In fiscal 2019 and 2018, we utilized the qualitative assessment approach for all reporting units. Under this approach, we considered the overall industry and market conditions related to the aerospace and government/defense markets as well as conditions in the global capital markets. We also considered the long-term forecasts for each reporting unit, which incorporated specific opportunities and risks, working capital requirements, and capital expenditure needs. We concluded it was more likely than not that the fair value of each reporting unit exceeded its carrying value at the respective measurement dates, and thus no impairment charges were recorded in those fiscal years. +In fiscal 2020, we elected to skip the qualitative assessment due to the unprecedented impact of COVID-19 and utilized a quantitative assessment approach for all reporting units. We estimated the fair value of each reporting unit using primarily an income approach based on discounted cash flows. The assumptions we used to estimate the fair value of our reporting units are based on historical performance, as well as forecasts used in our current business plan and require considerable management judgment in light of the impact of COVID-19. All three of our reporting units have been impacted by the reduced numbers of commercial aircraft flying and the overall decline in flight hours. We have incorporated a decline in demand from commercial airline customers for our next fiscal year followed by a multiple year recovery as passenger miles and flight hours progressively increase. +We used discount rates based on our consolidated weighted average cost of capital which is adjusted for each of our reporting units based on their specific risk, size, and industry characteristics. The fair value measurements used for our goodwill impairment testing use significant unobservable inputs, which reflect our own assumptions about the inputs that market participants would use in measuring fair value. The fair value of our reporting units is also impacted by our overall market capitalization and may be impacted by volatility in our stock price and assumed control premium, among other items. +Upon completion of the annual quantitative goodwill impairment analysis as of May 31, 2020 for our reporting units, we concluded the fair value of each reporting unit exceeded its carrying values, and thus no impairment charges were recorded. +We also evaluate the sensitivity of the discounted cash flow valuations by assessing the impact of changes in certain assumptions on the estimated fair value of each reporting unit by increasing the discount rates and/or adjusting our business plan assumptions including slower recovery of sales from COVID-19 and reduced profitability. All of our reporting units would have had fair values substantially in excess of their carrying values under all our sensitivity scenarios. +27 +Table of Contents +Inventories +Inventories are valued at the lower of cost or market (estimated net realizable value). Cost is determined by the specific identification, average cost or first-in, first-out methods. Write-downs are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions. We have utilized certain assumptions when determining the market value of inventories, such as inventory quantities and aging, historical sales of inventory, current and expected future aviation usage trends, replacement values, expected future demand, and historical scrap recovery rates. Reductions in demand for certain of our inventories or declining market values, as well as differences between actual results and the assumptions utilized by us when determining the market value of our inventories, could result in the recognition of impairment charges in future periods. +In conjunction with the decision to exit certain product lines and facilities, we recognized inventory impairment charges of $3.9 million in fiscal 2020. +Revenue Recognition +Revenue is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on behalf of third parties. We recognize revenue when we satisfy a performance obligation by transferring control over a product or service to a customer. +Our unit of accounting for revenue recognition is a performance obligation included in our customer contracts. A performance obligation reflects the distinct good or service that we must transfer to a customer. At contract inception, we evaluate if the contract should be accounted for as a single performance obligation or if the contract contains multiple performance obligations. In some cases, our contract with the customer is considered one performance obligation as it includes factors such as whether the good or service being provided is significantly integrated with other promises in the contract, whether the service provided significantly modifies or customizes another good or service or whether the good or service is highly interdependent or interrelated. If the contract has more than one performance obligation, we determine the standalone price of each distinct good or service underlying each performance obligation and allocate the transaction price based on their relative standalone selling prices. +The transaction price of a contract, which can include both fixed and variable amounts, is allocated to each performance obligation identified. Some contracts contain variable consideration, which could include incremental fees or penalty provisions related to performance. Variable consideration that can be reasonably estimated based on current assumptions and historical information is included in the transaction price at the inception of the contract but limited to the amount that is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Variable consideration that cannot be reasonably estimated is recorded when known. +Our performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers. The majority of our sales from products are recognized at a point in time upon transfer of control to the customer, which generally occurs upon shipment. In connection with certain sales of products, we also provide logistics services, which include inventory management, replenishment, and other related services. The price of such services is generally included in the price of the products delivered to the customer, and revenues are recognized upon delivery of the product, at which point the customer has obtained control of the product. We do not account for these services separate from the related product sales as the services are inputs required to fulfill part orders received from customers. +For our performance obligations that are satisfied over time, we measure progress in a manner that depicts the performance of transferring control to the customer. As such, we utilize the input method of cost-to-cost to recognize revenue over time as this depicts when control of the promised goods or services are transferred to the customer. Revenue is recognized based on the relationship of actual costs incurred to date to the estimated total cost at completion of the performance obligation. We are required to make certain judgments and estimates, including estimated revenues and costs, as well as inflation and the overall profitability of the arrangement. Key assumptions involved include future labor costs and efficiencies, overhead costs, and ultimate timing of product delivery. Differences may occur between the judgments and estimates made by management and actual program results. +Changes in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. These changes are primarily adjustments to the estimated profitability for our long-term programs where we provide component inventory management and/or repair services. +28 +Table of Contents +When contracts are modified, we consider whether the modification either creates new or changes the existing enforceable rights and obligations. Contract modifications that are for goods or services that are not distinct from the existing contract, due to the significant integration with the original goods or services provided, are accounted for as if they were part of that existing contract with the effect of the contract modification recognized as an adjustment to revenue on a cumulative catch-up basis. When the modifications include additional performance obligations that are distinct, they are accounted for as a new contract and performance obligation, which are recognized prospectively. +Under most of our U.S. government contracts, if the contract is terminated for convenience, we are entitled to payment for items delivered and fair compensation for work performed, the costs of settling and paying other claims, and a reasonable profit on the costs incurred or committed. +We have elected to use certain practical expedients permitted under ASC 606. Shipping and handling fees and costs incurred associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in Cost of sales on our Consolidated Statements of Income, and are not considered a performance obligation to our customers. Our reported sales on our Consolidated Statements of Income are net of any sales or related non-income taxes. We also utilize the “as invoiced” practical expedient in certain cases where performance obligations are satisfied over time and the invoiced amount corresponds directly with the value we are providing to the customer. +The timing of revenue recognition, customer billings, and cash collections results in a contract asset or contract liability at the end of each reporting period. Contract assets consist of unbilled receivables or costs incurred where revenue recognized over time using the cost-to-cost model exceeds the amounts billed to customers. Contract liabilities include advance payments and billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of our performance obligations on the contract. These amounts are recorded as contract liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. Contract assets and contract liabilities are determined on a contract-by-contract basis. +Allowance for Doubtful Accounts +We maintain an allowance for doubtful accounts to reflect the expected uncollectibility of accounts receivable based on past collection history and specific risks identified among uncollected accounts. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, and our customers’ current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to undergo an extensive credit check prior to delivery of products or services. +We perform regular evaluations of customer payment experience, current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, letters of credit, and/or obligation guarantees from financial institutions for transactions executed on other than normal trade terms. We also maintain trade credit insurance for certain customers to provide coverage, up to a certain limit, in the event of insolvency of some customers. +In fiscal 2019, we recognized a provision for doubtful accounts of $12.4 million related to the bankruptcy of a European airline customer. The provision consisted of impairment of non-current contract assets of $7.6 million, allowance for doubtful accounts of $3.3 million, and other liabilities of $1.5 million. +In addition, we currently have past due accounts receivable owed by former commercial program customers primarily related to our exit from customer contracts in certain geographies, including Colombia, Peru, and Poland. Our past due accounts receivable owed by these customers was $10.9 million as of May 31, 2020 which was net of allowance for doubtful accounts of $9.3 million. +Impairment of Long-Lived Assets +We are required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows. When applying accounting standards addressing impairment of long-lived assets, we have utilized certain assumptions to estimate future undiscounted cash flows, including current and future sales volumes or lease rates, expected changes to cost structures, lease terms, residual values, market conditions, and trends impacting future demand. Differences between actual results and the assumptions utilized by us when determining undiscounted cash flows could result in future impairments of long-lived assets. We recognized pre-tax asset impairment charges related to our COCO business of $11.8 million, $74.1 million, and $64.0 million in fiscal 2020, 2019, and 2018, respectively, related to assets included in our COCO business, which is classified as a discontinued operation. +29 +Table of Contents +We maintain a significant inventory of rotable parts and equipment to service customer aircraft and components. Portions of that inventory are used parts that are often exchanged with parts removed from aircraft or components, and are reworked to a useable condition. We may have to recognize an impairment of our rotable parts and equipment if we discontinue using or servicing certain aircraft models or if an older aircraft model is phased-out in the industry. In conjunction with the decision to exit certain product lines, we recognized rotable asset impairment charges of $1.9 million in fiscal 2020. +Pension Plans +The projected benefit obligation for our benefit plans exceeds our plan assets by $27.3 million as of May 31, 2020. Our projected benefit obligation exceeds our plan assets for both our U.S. plans and for our Netherlands plan with the U.S. benefit plans underfunded by $14.6 million and the Netherlands plan underfunded by $12.7 million. +The liabilities and net periodic cost of our pension plans are determined utilizing several actuarial assumptions, the most significant of which are the discount rate and the expected long-term rate of return on plan assets. +AAR uses discount rates to measure our benefit obligation and net periodic benefit cost for our pension plans. We used a broad population of Aa-rated corporate bonds as of May 31, 2020 to determine the discount rate assumption. All bonds were denominated in U.S. Dollars, with a minimum outstanding of $50.0 million. This population of bonds was narrowed from a broader universe of over 500 Moody’s Aa-rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10 th percentile and the bottom 40 th percentile to adjust for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension plan liabilities. This portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments for the domestic plans. The discount rate is the single level rate that produces the same result as the spot rate curve. +We establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market, as well as analysis of current market and economic information and future expectations. The current asset return assumption is supported by historical market experience for both our actual and target asset allocation. In calculating the net pension cost, the expected return on assets is applied to a calculated value on plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to amortization in the future. +New Accounting Pronouncements Adopted +In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (“ASC 842”), which amended the existing accounting standards for lease accounting. ASC 842 requires lessees to recognize a right-of-use (“ROU”) asset and lease liability on the balance sheet for most lease arrangements, including those classified as operating leases. In addition, ASC 842 requires new qualitative and quantitative disclosures about our leasing activities. +We adopted ASC 842 on June 1, 2019 using the modified retrospective transition approach. Under that approach, prior periods have not been restated and continue to be reported under the accounting standards in effect for those periods. A discussion of our revised accounting policy for leases is included in Note 11 of Notes to Consolidated Financial Statements. +We have elected the package of practical expedients, which must be elected as a package and applied consistently to all leases. This package permits us to not reassess our prior conclusions about lease identification, lease classification and initial direct costs. In addition, we have elected the practical expedients to not separate lease and non-lease components for both lessee and lessor relationships and to not apply the recognition requirements to leases with terms of less than twelve months. +Upon adoption of ASC 842 on June 1, 2019, we recognized operating lease ROU assets of $123.2 million and operating lease liabilities of $116.8 million on our Consolidated Balance Sheet. These amounts included operating lease ROU assets of $26.6 million and operating lease liabilities of $25.3 million related to our discontinued operations. In addition, we recognized the remaining unamortized deferred gains of $2.5 million, net of tax, associated with sale-leaseback transactions as a cumulative effect adjustment to the opening balance of retained earnings as of June 1, 2019. +The adoption of ASC 842 did not have a material impact on the Consolidated Statements of Operations or Cash Flows. +30 +Table of Contents +The impact of the adoption of ASC 842 on our Consolidated Balance Sheet was as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of May 31, 2019 +ASC 842 Adjustments +As of June 1, 2019 +Assets of discontinued operations +​ +$ +29.2 +​ +$ +26.6 +​ +$ +55.8 +Other current assets +​ +36.2 +​ +(0.5) +​ +35.7 +Intangible assets, net +​ +22.2 +​ +(8.5) +​ +13.7 +Operating lease ROU assets +​ +— +​ +96.6 +​ +96.6 +Other non-current assets +​ +77.5 +​ +(1.8) +​ +75.7 +Accrued liabilities +​ +140.5 +​ +10.0 +​ +150.5 +Liabilities of discontinued operations +​ +29.2 +​ +25.3 +​ +54.5 +Operating lease liabilities +​ +— +​ +77.7 +​ +77.7 +Other liabilities +​ +28.3 +​ +(3.1) +​ +25.2 +Retained earnings +​ +709.8 +​ +2.5 +​ +712.3 +​ +In May 2014, the FASB issued ASC 606, which provides guidance for revenue recognition. ASC 606 superseded the revenue recognition requirements in ASC 605, Revenue Recognition , and most industry-specific guidance. +We adopted ASC 606 on June 1, 2018 using the modified retrospective method. Under that approach, prior periods were not restated and continue to be reported under the accounting standards in effect for those periods. We elected to use the practical expedient allowing for the application of ASC 606 only to contracts that were not completed as of June 1, 2018. We recognized the cumulative effect of initially applying ASC 606 as a decrease of $20.4 million to the opening balance of retained earnings as of June 1, 2018. +The adoption of ASC 606 impacted us in three primary areas. First, we have certain contracts in which revenue is recognized using the percentage of completion method over the expected term of the contract. Under ASC 606, the contract term used for revenue recognition purposes was shortened to exclude any unexercised customer option years or incorporate customer rights to terminate the contract without significant penalty as we do not have any enforceable rights or obligations prior to the exercise of the underlying option. The impact of this change as of June 1, 2018 resulted in the elimination of certain deferred costs and the establishment of accrued liabilities reflecting our estimated obligations under the contracts. For this change, we recognized a decrease of $22.1 million to the opening balance of retained earnings as of June 1, 2018. +Second, we have contracts under which we perform repair services on customer-owned assets whereby the customer simultaneously receives the benefits of the repair. These contracts also transitioned to an over time revenue recognition model as of June 1, 2018 compared to our prior policy of recognizing revenue at the time of shipment. The impact of this change as of June 1, 2018 resulted in the elimination of certain inventory and accounts receivable amounts and the establishment of a contract asset reflecting the over time revenue recognition treatment. For this change, we recognized an increase of $1.3 million to the opening balance of retained earnings as of June 1, 2018. +Third, we have certain contracts under which we manufacture products with no alternative use as the customer owns the underlying intellectual property and we have an enforceable right to payment from the customer. As a result, we now recognize revenue for these contracts over time as opposed to at the time of shipment, which was our policy prior to June 1, 2018. The impact of this change as of June 1, 2018 resulted in the elimination of certain inventory amounts and the establishment of a contract asset reflecting the over time revenue recognition treatment. For this change, we recognized an increase of $0.4 million to the opening balance of retained earnings as of June 1, 2018. +New Accounting Pronouncements Not Yet Adopted +In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments . This ASU requires a change in the measurement approach for credit losses on financial assets measured on an amortized cost basis from an incurred loss method to an expected loss method, thereby eliminating the requirement that a credit loss be considered probable to impact the valuation of a financial asset measured on an amortized cost basis. This ASU also requires the measurement of expected credit losses to be based on relevant information about past events, including historical experience, current conditions, and a reasonable and supportable forecast of the collectability of the related financial asset. We plan to adopt this ASU on June 1, 2020 and the adoption is not expected to have a material impact on our consolidated financial statements. +​ +31 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Our exposure to market risk includes fluctuating interest rates under our credit agreements, changes in foreign exchange rates, and credit losses on accounts receivable. See Note 1 of Notes to Consolidated Financial Statements for a discussion on accounts receivable exposure. +We are exposed to the risk that our earnings and cash flows could be adversely impacted by fluctuations in interest rates. A 10 percent increase in the average interest rate affecting our financial instruments, including the average outstanding balance of our debt obligations would not have had a significant impact on our pre-tax income during fiscal 2020. +Revenues and expenses of our foreign operations are translated at average exchange rates during the year, and balance sheet accounts are translated at year-end exchange rates. Balance sheet translation adjustments are excluded from the results of operations and are recorded in stockholders’ equity as a component of accumulated other comprehensive loss. A hypothetical 10 percent devaluation of the U.S. dollar against foreign currencies would not have had a material impact on our financial position or continuing operations during fiscal 2020. +​ +32 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +​ +​ +Report of Independent Registered Public Accounting Firm +To the Stockholders and Board of Directors +AAR CORP.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of AAR CORP. and subsidiaries (the Company) as of May 31, 2020 and 2019, the related consolidated statements of income, comprehensive income (loss), changes in equity, and cash flows for each of the years in the three year period ended May 31, 2020, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of May 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three year period ended May 31, 2020, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of May 31, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated July 21, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Change in Accounting Principle +As discussed in Note 1 to the consolidated financial statements, the Company has changed its method of accounting for leases effective June 1, 2019 due to the adoption of Accounting Standards Update No. 2016-02, Leases , and its method of accounting for revenue recognition as of June 1, 2018, due to the adoption of Accounting Standards Codification Topic 606, Revenue from Contracts with Customers . +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +33 +Table of Contents +Assessment of the write-down of inventories +As discussed in Note 1 to the consolidated financial statements, the inventory balance as of May 31, 2020 was $623.1 million. The Company records inventory within the Aviation Services segment at the lower of cost or net realizable value. The write-down of slow moving inventory is recorded for excess or obsolete inventory based on certain inputs and assumptions used to determine the net realizable value. These assumptions include the number of days transpiring from the date the inventory was originally received, and the historical sales of inventory to determine recovery rates. Other inputs include current and expected future aviation usage trends, replacement values, expected future demand, and historical scrap recovery rates. +We identified the assessment of the write-down of inventories for a portion of the inventory within the Aviation Services segment as a critical audit matter. The primary inputs and assumptions used in determining the write-down of slow moving inventory include the historical recovery rates, which are based on the number of days transpiring from the date the inventory was originally received, the historical sales of inventory, and the identification of specific inventories used to service customers no longer under contract. The assessment of these inputs required a higher degree of subjective auditor judgment in evaluating the future customer demand for slow moving inventory. +The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s inventory process, including controls over the Company’s evaluation of the impact on the estimate of net realizable value based on 1) the number of days transpiring from the date the inventory was originally received, 2) historical sales of inventory, and 3) specific inventory used to service customers no longer under contract. We also tested relevant information technology application controls over the determination of the number of days transpiring from the date the inventory was originally received. We evaluated the write-down to determine that it was recorded using the Company’s policy based on the number of days transpiring from the date the inventory was originally received, and the recovery rates of existing inventory based on historical sales. We also assessed that the recovery rates applied to slow moving inventory were consistent with historical sales of these inventory items. We determined that the specific inventory items written down were valued at the lower of cost or net realizable value based on observable market prices. +Evaluation of the key inputs and assumptions used in the estimation of costs at completion of the performance obligations +As discussed in Note 1 to the consolidated financial statements, the Company recognizes revenue over time upon the satisfaction of component inventory management and repair services performance obligations based on the cost-to-cost input method, which is based on the relationship of costs incurred to date to the estimated total costs at completion of the performance obligation within the Aviation Services segment. The net favorable cumulative catch-up adjustments recognized during fiscal year 2020 associated with the Company’s component inventory management and repair services totaled $3.9 million, which resulted from changes in the estimated costs at completion of the performance obligations. +We identified the evaluation of the key inputs and assumptions used in the estimation of costs at completion of the inventory management and repair services performance obligations for certain contracts within the Aviation Services segment as a critical audit matter. The key inputs and assumptions used in determining the revenue to be recognized include current and future costs to support the program, and future labor costs. The testing of the inputs and assumptions required the application of subjective auditor judgment because of the estimation associated with the inputs and assumptions. +The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s revenue process, including controls over 1) the assessment of the estimated future costs, 2) actual costs incurred for each performance obligation that are used by the Company in their assessment of the measure of progress, and 3) the approval of costs recorded for each performance obligation to assess the allowability per the contract. We obtained the Company’s forecast for the cost of a selection of component inventory management and repair services and assessed that the measure of progress was determined using actual costs to date plus the estimated future costs to support the satisfaction of performance obligations. We selected a sample of contracts to test fiscal year 2020 program costs. We assessed the Company’s historical estimates to determine the consistency with the Company’s historical projected costs. +​ +​ +/s/ KPMG LLP +​ +​ +We have served as the Company’s auditor since 1985. +​ +​ +​ +Chicago, Illinois +​ +July 21, 2020 +​ +​ +​ +34 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +​ +​ +(In millions, except per share data) +Sales: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Sales from products +​ +$ +1,090.0 +​ +$ +1,124.3 +​ +$ +1,040.7 +Sales from services +​ +982.0 +​ +927.5 +​ +707.6 +​ +​ +2,072.0 +​ +2,051.8 +​ +1,748.3 +Costs and operating expenses: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cost of products +​ +900.0 +​ +915.0 +​ +840.5 +Cost of services +​ +902.8 +​ +807.0 +​ +613.7 +Provision for doubtful accounts +​ +​ +5.4 +​ +​ +15.8 +​ +​ +0.5 +Selling, general and administrative +​ +220.6 +​ +215.4 +​ +208.1 +​ +​ +2,028.8 +​ +1,953.2 +​ +1,662.8 +Earnings (Loss) from joint ventures +​ +​ +( 1.9 ) +​ +​ +( 0.3 ) +​ +​ +0.5 +Operating income +​ +41.3 +​ +98.3 +​ +86.0 +Other expense, net +​ +​ +( 2.1 ) +​ +​ +( 0.8 ) +​ +​ +( 0.9 ) +Interest expense +​ +( 9.3 ) +​ +( 9.5 ) +​ +( 8.0 ) +Interest income +​ +0.5 +​ +1.0 +​ +0.1 +Income from continuing operations before provision for income taxes +​ +30.4 +​ +89.0 +​ +77.2 +Provision for income taxes +​ +5.6 +​ +4.9 +​ +3.5 +Income from continuing operations +​ +​ +24.8 +​ +​ +84.1 +​ +​ +73.7 +Loss from discontinued operations, net of tax +​ +​ +( 20.4 ) +​ +​ +( 76.6 ) +​ +​ +( 58.1 ) +Net income +​ +$ +4.4 +​ +$ +7.5 +​ +$ +15.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share - basic: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from continuing operations +​ +$ +0.71 +​ +$ +2.42 +​ +$ +2.14 +Loss from discontinued operations +​ +​ +( 0.59 ) +​ +​ +( 2.22 ) +​ +​ +( 1.70 ) +Earnings per share - basic +​ +$ +0.12 +​ +$ +0.20 +​ +$ +0.44 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share – diluted: +​ +​ +​ +​ +​ +​ +Earnings from continuing operations +​ +$ +0.71 +​ +$ +2.40 +​ +$ +2.11 +Loss from discontinued operations +​ +​ +( 0.58 ) +​ +​ +( 2.19 ) +​ +​ +( 1.70 ) +Earnings per share – diluted +​ +$ +0.13 +​ +$ +0.21 +​ +$ +0.41 +​ +The accompanying notes to consolidated financial statements are an integral part of these statements. +​ +​ +​ +35 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +​ +​ +(In millions) +Net income +​ +$ +4.4 +​ +$ +7.5 +​ +$ +15.6 +Other comprehensive income (loss), net of tax: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Currency translation adjustments, net of tax +​ +0.1 +​ +( 2.4 ) +​ +2.0 +Unrecognized pension and post retirement costs, net of tax expense (benefit) of $( 1.0 ) in 2020, $( 1.7 ) in 2019, and $ 2.4 in 2018 +​ +( 3.8 ) +​ +( 6.5 ) +​ +5.9 +Total other comprehensive income (loss), net of tax +​ +( 3.7 ) +​ +( 8.9 ) +​ +7.9 +Comprehensive income (loss) +​ +$ +0.7 +​ +$ +( 1.4 ) +​ +$ +23.5 +​ +The accompanying notes to consolidated financial statements are an integral part of these statements. +​ +​ +​ +36 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +​ +​ +(In millions, except share data) +​ +​ +​ +​ +​ +​ +​ +Current assets: +​ +​ +​ +​ +Cash and cash equivalents +​ +$ +404.7 +​ +$ +21.3 +Restricted cash +​ +​ +20.0 +​ +​ +19.8 +Accounts receivable, net +​ +171.9 +​ +197.8 +Contract assets +​ +​ +49.3 +​ +​ +59.2 +Inventories +​ +623.1 +​ +523.7 +Rotable assets and equipment on or available for short-term lease +​ +69.6 +​ +65.3 +Assets of discontinued operations +​ +​ +22.9 +​ +​ +29.2 +Other current assets +​ +​ +77.2 +​ +​ +36.2 +Total current assets +​ +1,438.7 +​ +952.5 +​ +​ +​ +​ +​ +​ +​ +Property, plant and equipment, at cost: +​ +​ +​ +​ +​ +​ +Land +​ +4.5 +​ +4.5 +Buildings and improvements +​ +112.4 +​ +111.9 +Equipment and furniture and fixtures +​ +265.3 +​ +248.2 +​ +​ +382.2 +​ +364.6 +Accumulated depreciation +​ +( 246.5 ) +​ +( 231.8 ) +​ +​ +135.7 +​ +132.8 +​ +​ +​ +​ +​ +​ +​ +Other assets: +​ +​ +​ +​ +​ +​ +Goodwill +​ +115.7 +​ +116.2 +Intangible assets, net +​ +6.0 +​ +22.2 +Operating lease right-of-use assets, net +​ +​ +89.7 +​ +​ +— +Rotable assets supporting long-term programs +​ +​ +211.7 +​ +​ +216.0 +Other non-current assets +​ +81.5 +​ +77.5 +​ +​ +504.6 +​ +431.9 +​ +​ +$ +2,079.0 +​ +$ +1,517.2 +​ +The accompanying notes to consolidated financial statements are an integral part of these statements. +​ +37 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND EQUITY +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +​ +​ +(In millions, except share data) +​ +​ +​ +​ +​ +​ +​ +Current liabilities: +​ +​ +​ +​ +Accounts payable +​ +191.6 +​ +187.8 +Accrued liabilities +​ +161.6 +​ +140.5 +Liabilities of discontinued operations +​ +​ +29.9 +​ +​ +29.2 +Total current liabilities +​ +383.1 +​ +357.5 +​ +​ +​ +​ +​ +​ +​ +Long-term debt +​ +600.0 +​ +141.7 +Operating lease liabilities +​ +​ +70.9 +​ +​ +— +Deferred revenue on long-term contracts +​ +88.0 +​ +83.8 +Other liabilities +​ +34.4 +​ +28.3 +​ +​ +793.3 +​ +253.8 +Equity: +​ +​ +​ +​ +​ +​ +Preferred stock, $ 1.00 par value, authorized 250,000 shares; none issued +​ +— +​ +— +Common stock, $ 1.00 par value, authorized 100,000,000 shares; issued 45,300,786 shares at cost +​ +45.3 +​ +45.3 +Capital surplus +​ +478.6 +​ +479.4 +Retained earnings +​ +706.0 +​ +709.8 +Treasury stock, 10,203,437 and 10,512,974 shares at cost, respectively +​ +( 282.7 ) +​ +( 287.7 ) +Accumulated other comprehensive loss +​ +( 44.6 ) +​ +( 40.9 ) +Total equity +​ +902.6 +​ +905.9 +​ +​ +$ +2,079.0 +​ +$ +1,517.2 +​ +The accompanying notes to consolidated financial statements are an integral part of these statements. +​ +​ +38 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +FOR THE THREE YEARS ENDED MAY 31, 2020 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accumulated +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other +​ +​ +​ +​ +Common +​ +Capital +​ +Retained +​ +Treasury +​ +Comprehensive +​ +Total +​ +Stock +Surplus +Earnings +Stock +Income (Loss) +Equity +Balance, May 31, 2017 +​ +$ +45.2 +​ +$ +460.8 +​ +$ +727.9 +​ +$ +( 279.8 ) +​ +$ +( 39.9 ) +​ +$ +914.2 +Net income +​ +— +​ +— +​ +15.6 +​ +— +​ +— +​ +15.6 +Cash dividends +​ +— +​ +— +​ +( 10.3 ) +​ +— +​ +— +​ +( 10.3 ) +Stock option activity +​ +— +​ +0.9 +​ +— +​ +11.2 +​ +— +​ +12.1 +Restricted stock activity +​ +0.1 +​ +8.8 +​ +— +​ +1.0 +​ +— +​ +9.9 +Repurchase of shares +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 13.1 ) +​ +​ +— +​ +​ +( 13.1 ) +Other comprehensive income, net of tax +​ +— +​ +— +​ +— +​ +— +​ +7.9 +​ +7.9 +Balance, May 31, 2018 +​ +$ +45.3 +​ +$ +470.5 +​ +$ +733.2 +​ +$ +( 280.7 ) +​ +$ +( 32.0 ) +​ +$ +936.3 +Cumulative effect adjustment upon adoption of ASC 606 on June 1, 2018 +​ +​ +— +​ +​ +— +​ +​ +( 20.4 ) +​ +​ +— +​ +​ +— +​ +​ +( 20.4 ) +Net income +​ +— +​ +— +​ +7.5 +​ +— +​ +— +​ +7.5 +Cash dividends +​ +— +​ +— +​ +( 10.5 ) +​ +— +​ +— +​ +( 10.5 ) +Stock option activity +​ +— +​ +3.5 +​ +— +​ +4.1 +​ +— +​ +7.6 +Restricted stock activity +​ +— +​ +5.4 +​ +— +​ +( 0.8 ) +​ +— +​ +4.6 +Repurchase of shares +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 10.3 ) +​ +​ +— +​ +​ +( 10.3 ) +Other comprehensive income, net of tax +​ +— +​ +— +​ +— +​ +— +​ +( 8.9 ) +​ +​ +( 8.9 ) +Balance, May 31, 2019 +​ +$ +45.3 +​ +$ +479.4 +​ +$ +709.8 +​ +$ +( 287.7 ) +​ +$ +( 40.9 ) +​ +$ +905.9 +Cumulative effect adjustment upon adoption of ASC 842 on June 1, 2019 +​ +​ +— +​ +​ +— +​ +​ +2.5 +​ +​ +— +​ +​ +— +​ +​ +2.5 +Net income +​ +— +​ +— +​ +4.4 +​ +— +​ +— +​ +4.4 +Cash dividends +​ +— +​ +— +​ +( 10.7 ) +​ +— +​ +— +​ +( 10.7 ) +Stock option activity +​ +— +​ +3.1 +​ +— +​ +8.3 +​ +— +​ +11.4 +Restricted stock activity +​ +— +​ +( 3.9 ) +​ +— +​ +0.8 +​ +— +​ +( 3.1 ) +Repurchase of shares +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 4.1 ) +​ +​ +— +​ +​ +( 4.1 ) +Other comprehensive loss, net of tax +​ +— +​ +— +​ +— +​ +— +​ +( 3.7 ) +​ +​ +( 3.7 ) +Balance, May 31, 2020 +​ +$ +45.3 +​ +$ +478.6 +​ +$ +706.0 +​ +$ +( 282.7 ) +​ +$ +( 44.6 ) +​ +$ +902.6 +​ +The accompanying notes to consolidated financial statements are an integral part of these statements. +​ +​ +39 +Table of Contents +AAR CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Cash flows provided from (used in) operating activities: +​ +​ +​ +​ +​ +​ +Net income +​ +$ +4.4 +​ +$ +7.5 +​ +$ +15.6 +Less: Loss from discontinued operations +​ +​ +( 20.4 ) +​ +​ +( 76.6 ) +​ +​ +( 58.1 ) +Income from continuing operations +​ +​ +24.8 +​ +​ +84.1 +​ +​ +73.7 +Adjustments to reconcile income to net cash provided from (used in) operating activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and intangible amortization +​ +43.7 +​ +42.8 +​ +40.5 +Amortization of stock-based compensation +​ +7.3 +​ +13.5 +​ +15.3 +Provision for doubtful accounts +​ +​ +5.4 +​ +​ +15.8 +​ +​ +0.5 +Deferred tax provision (benefit) +​ +​ +0.5 +​ +​ +( 5.0 ) +​ +​ +( 12.9 ) +Loss (Earnings) from joint ventures +​ +​ +1.9 +​ +​ +0.3 +​ +​ +( 0.5 ) +Customer contract termination and restructuring costs +​ +​ +31.3 +​ +​ +— +​ +​ +— +Impairment charges +​ +8.1 +​ +— +​ +— +Changes in certain assets and liabilities, net of acquisitions: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accounts receivable +​ +14.8 +​ +( 34.4 ) +​ +35.4 +Contract assets +​ +​ +9.9 +​ +​ +( 9.7 ) +​ +​ +— +Inventories +​ +( 94.5 ) +​ +( 80.9 ) +​ +( 25.8 ) +Rotable spares and equipment on or available for short-term lease +​ +( 4.3 ) +​ +21.5 +​ +( 16.6 ) +Rotable assets supporting long-term programs +​ +( 22.1 ) +​ +( 49.2 ) +​ +( 38.5 ) +Accounts payable +​ +4.1 +​ +17.5 +​ +1.8 +Accrued and other liabilities +​ +0.5 +​ +​ +22.9 +​ +​ +8.0 +Deferred revenue on long-term programs +​ +​ +( 14.6 ) +​ +44.4 +​ +( 3.4 ) +Other +​ +( 35.9 ) +​ +( 23.1 ) +​ +( 21.7 ) +Net cash provided from (used in) operating activities—continuing operations +​ +( 19.1 ) +​ +60.5 +​ +55.8 +Net cash provided from (used in) operating activities—discontinued operations +​ +​ +( 17.0 ) +​ +​ +6.9 +​ +​ +8.5 +Net cash provided from (used in) operating activities +​ +​ +( 36.1 ) +​ +​ +67.4 +​ +​ +64.3 +Cash flows used in investing activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Property, plant and equipment expenditures +​ +( 23.6 ) +​ +( 17.4 ) +​ +( 22.0 ) +Proceeds from asset disposals +​ +1.6 +​ +1.8 +​ +8.6 +Payments for acquisitions +​ +​ +— +​ +​ +( 2.3 ) +​ +​ +( 22.9 ) +Other +​ +​ +( 2.8 ) +​ +​ +( 0.6 ) +​ +​ +( 2.3 ) +Net cash used in investing activities—continuing operations +​ +​ +( 24.8 ) +​ +​ +( 18.5 ) +​ +​ +( 38.6 ) +Net cash used in investing activities—discontinued operations +​ +​ +— +​ +​ +( 0.5 ) +​ +​ +( 4.3 ) +Net cash used in investing activities +​ +( 24.8 ) +​ +( 19.0 ) +​ +( 42.9 ) +Cash flows provided from (used in) financing activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Short-term borrowings (repayments), net +​ +459.5 +​ +( 10.0 ) +​ +( 1.0 ) +Proceeds (Repayments) on long-term borrowings +​ +— +​ +​ +( 25.0 ) +​ +​ +24.8 +Cash dividends +​ +( 10.7 ) +​ +( 10.5 ) +​ +( 10.3 ) +Purchase of treasury stock +​ +( 4.1 ) +​ +( 10.3 ) +​ +( 13.1 ) +Stock compensation activity +​ +1.1 +​ +8.5 +​ +11.6 +Other +​ +( 1.3 ) +​ +— +​ +( 0.3 ) +Net cash provided from (used in) financing activities—continuing operations +​ +444.5 +​ +( 47.3 ) +​ +11.7 +Net cash used in financing activities—discontinued operations +​ +​ +— +​ +​ +( 1.4 ) +​ +​ +( 1.7 ) +Net cash provided from (used in) financing activities +​ +​ +444.5 +​ +​ +( 48.7 ) +​ +​ +10.0 +Effect of exchange rate changes on cash +​ +— +​ +( 0.2 ) +​ +( 0.1 ) +Increase (Decrease) in cash and cash equivalents +​ +383.6 +​ +( 0.5 ) +​ +31.3 +Cash, cash equivalents, and restricted cash at beginning of year +​ +41.1 +​ +41.6 +​ +10.3 +Cash, cash equivalents, and restricted cash at end of year +​ +$ +424.7 +​ +$ +41.1 +​ +$ +41.6 +​ +The accompanying notes to consolidated financial statements are an integral part of these statements. +​ +​ +​ +40 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies +​ +Description of Business +AAR CORP. (the “Company”) is a diversified provider of services and products to the worldwide commercial aviation and government and defense markets. Services and products include: aviation supply chain and parts support programs; customer fleet management and operations; maintenance, repair and overhaul of airframes, landing gear, and certain other airframe components; design and manufacture of specialized pallets, shelters, and containers; aircraft modifications and aircraft and engine sales and leasing. We serve commercial, government and defense aircraft fleet operators, original equipment manufacturers, and independent service providers around the world, and various other domestic and foreign military customers. +Principles of Consolidation +The accompanying Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries after elimination of intercompany accounts and transactions. +New Accounting Pronouncements Adopted +In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, Leases ("ASC 842"), which amended the existing accounting standards for lease accounting. ASC 842 requires lessees to recognize a right-of-use ("ROU") asset and lease liability on the balance sheet for most lease arrangements, including those classified as operating leases. In addition, ASC 842 requires new qualitative and quantitative disclosures about our leasing activities. +We adopted ASC 842 on June 1, 2019 using the modified retrospective transition approach. Under that approach, prior periods have not been restated and continue to be reported under the accounting standards in effect for those periods. A discussion of our revised accounting policy for leases is included in Note 11. +We have elected the package of practical expedients, which must be elected as a package and applied consistently to all leases. This package permits us to not reassess our prior conclusions about lease identification, lease classification and initial direct costs. In addition, we have elected the practical expedients to not separate lease and non-lease components for both lessee and lessor relationships and to not apply the recognition requirements to leases with terms of less than twelve months. +Upon adoption of ASC 842 on June 1, 2019, we recognized operating lease ROU assets of $ 123.2 million and operating lease liabilities of $ 116.8 million on our Consolidated Balance Sheet. These amounts included operating lease ROU assets of $ 26.6 million and operating lease liabilities of $ 25.3 million related to our discontinued operations. In addition, we recognized the remaining unamortized deferred gains of $ 2.5 million, net of tax, associated with sale-leaseback transactions as a cumulative effect adjustment to the opening balance of retained earnings as of June 1, 2019. +The adoption of ASC 842 did not have a material impact on the Consolidated Statements of Operations or Cash Flows. +41 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +The impact of the adoption of ASC 842 on our Consolidated Balance Sheet was as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of +​ +ASC 842 +​ +As of +​ +May 31, 2019 +Adjustments +June 1, 2019 +Assets of discontinued operations +​ +$ +29.2 +​ +$ +26.6 +​ +$ +55.8 +Other current assets +​ +36.2 +​ +( 0.5 ) +​ +35.7 +Intangible assets, net +​ +22.2 +​ +( 8.5 ) +​ +13.7 +Operating lease ROU assets +​ +— +​ +96.6 +​ +96.6 +Other non-current assets +​ +77.5 +​ +( 1.8 ) +​ +75.7 +Accrued liabilities +​ +140.5 +​ +10.0 +​ +150.5 +Liabilities of discontinued operations +​ +29.2 +​ +25.3 +​ +54.5 +Operating lease liabilities +​ +— +​ +77.7 +​ +77.7 +Other liabilities +​ +28.3 +​ +( 3.1 ) +​ +25.2 +Retained earnings +​ +​ +709.8 +​ +​ +2.5 +​ +​ +712.3 +​ +In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (“ASC 606”), which provides guidance for revenue recognition. ASC 606 superseded the revenue recognition requirements in Accounting Standards Codification (“ASC”) 605, Revenue Recognition , and most industry-specific guidance. +We adopted ASC 606 on June 1, 2018 using the modified retrospective method. Under that approach, prior periods were not restated and continue to be reported under the accounting standards in effect for those periods. We elected to use the practical expedient allowing for the application of ASC 606 only to contracts that were not completed as of June 1, 2018. We recognized the cumulative effect of initially applying ASC 606 as a decrease of $ 20.4 million to the opening balance of retained earnings as of June 1, 2018. +Revenue Recognition for Fiscal 2020 and 2019 +Revenue is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on behalf of third parties. We recognize revenue when we satisfy a performance obligation by transferring control over a product or service to a customer. +Our unit of accounting for revenue recognition is a performance obligation included in our customer contracts. A performance obligation reflects the distinct good or service that we must transfer to a customer. At contract inception, we evaluate if the contract should be accounted for as a single performance obligation or if the contract contains multiple performance obligations. In some cases, our contract with the customer is considered one performance obligation as it includes factors such as whether the good or service being provided is significantly integrated with other promises in the contract, whether the service provided significantly modifies or customizes another good or service or whether the good or service is highly interdependent or interrelated. If the contract has more than one performance obligation, we determine the standalone price of each distinct good or service underlying each performance obligation and allocate the transaction price based on their relative standalone selling prices. +The transaction price of a contract, which can include both fixed and variable amounts, is allocated to each performance obligation identified. Some contracts contain variable consideration, which could include incremental fees or penalty provisions related to performance. Variable consideration that can be reasonably estimated based on current assumptions and historical information is included in the transaction price at the inception of the contract but limited to the amount that is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Variable consideration that cannot be reasonably estimated is recorded when known. +42 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +Our performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers. The majority of our sales from products are recognized at a point in time upon transfer of control to the customer, which generally occurs upon shipment. In connection with certain sales of products, we also provide logistics services, which include inventory management, replenishment, and other related services. The price of such services is generally included in the price of the products delivered to the customer, and revenues are recognized upon delivery of the product, at which point the customer has obtained control of the product. We do not account for these services separate from the related product sales as the services are inputs required to fulfill part orders received from customers. +For our performance obligations that are satisfied over time, we measure progress in a manner that depicts the performance of transferring control to the customer. As such, we utilize the input method of cost-to-cost to recognize revenue over time as this depicts when control of the promised goods or services are transferred to the customer. Revenue is recognized based on the relationship of actual costs incurred to date to the estimated total cost at completion of the performance obligation. We are required to make certain judgments and estimates, including estimated revenues and costs, as well as inflation and the overall profitability of the arrangement. Key assumptions involved can include customer volume, future labor costs and efficiencies, repair or overhaul costs, overhead costs, and ultimate timing of product delivery. Differences may occur between the judgments and estimates made by management and actual program results. For contracts that are deemed to be loss contracts, we establish forward loss reserves for total estimated costs that are in excess of total estimated consideration in the period in which they become known. +When contracts are modified, we consider whether the modification either creates new or changes the existing enforceable rights and obligations. Contract modifications that are for goods or services that are not distinct from the existing contract, due to the significant integration with the original goods or services provided, are accounted for as if they were part of that existing contract with the effect of the contract modification recognized as an adjustment to revenue on a cumulative catch-up basis. When the modifications include additional performance obligations that are distinct, they are accounted for as a new contract and performance obligation, which are recognized prospectively. +Under most of our U.S. government contracts, if the contract is terminated for convenience, we are entitled to payment for items delivered and fair compensation for work performed, the costs of settling and paying other claims, and a reasonable profit on the costs incurred or committed. +We have elected to use certain practical expedients permitted under ASC 606. Shipping and handling fees and costs incurred associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in Cost of sales on our Consolidated Statements of Income, and are not considered a performance obligation to our customers. Our reported sales on our Consolidated Statements of Income are net of any sales or related non-income taxes. We also utilize the “as invoiced” practical expedient in certain cases where performance obligations are satisfied over time and the invoiced amount corresponds directly with the value we are providing to the customer. +Revenue Recognition for Fiscal 2018 +Sales and related cost of sales for product sales are generally recognized upon shipment of the product to the customer. Our standard terms and conditions provide that title passes to the customer when the product is shipped to the customer. Sales of certain defense products are recognized upon customer acceptance, which includes transfer of title. Sales from services and the related cost of services are generally recognized when customer-owned material is shipped back to the customer. Furthermore, serviced units are typically shipped to the customer immediately upon completion of the related services. Sales and related cost of sales for certain large airframe maintenance contracts and performance-based logistics programs are recognized by the percentage of completion method, based on the relationship of costs incurred to date to the estimated total costs. +43 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +Certain supply chain management programs we provide to our customers contain multiple elements or deliverables, such as program and warehouse management, parts distribution, and maintenance and repair services. We recognize revenue for each element or deliverable that can be identified as a separate unit of accounting at the time of delivery based upon the relative fair value of the products and services. +Cumulative Catch-up Adjustments +Changes in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. These changes are primarily adjustments to the estimated profitability for our long-term programs where we provide component inventory management and/or repair services. +Favorable and unfavorable cumulative catch-up adjustments were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +2018 +Favorable cumulative catch-up adjustments +​ +$ +6.1 +​ +$ +8.0 +​ +$ +11.6 +Unfavorable cumulative catch-up adjustments +​ +( 2.2 ) +​ +( 2.1 ) +​ +( 8.0 ) +Net cumulative catch-up adjustments +​ +$ +3.9 +​ +$ +5.9 +​ +$ +3.6 +​ +Contract Assets and Liabilities +The timing of revenue recognition, customer billings, and cash collections results in a contract asset or contract liability at the end of each reporting period. Contract assets consist of costs incurred where revenue recognized over time using the cost-to-cost model exceeds the amounts billed to customers. Contract liabilities include advance payments and billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of our performance obligations on the contract. These amounts are recorded as contract liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. Contract assets and contract liabilities are determined on a contract-by-contract basis. +Net contract assets and liabilities are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +​ +​ +​ +2020 +​ +2019 +​ +Change +Contract assets – current +​ +$ +49.3 +​ +$ +59.2 +​ +$ +( 9.9 ) +Contract assets – non-current +​ +22.4 +​ +17.0 +​ +5.4 +Deferred revenue – current +​ +( 11.2 ) +​ +( 12.6 ) +​ +1.4 +Deferred revenue on long-term contracts +​ +( 88.0 ) +​ +( 83.8 ) +​ +( 4.2 ) +Net contract assets (liabilities) +​ +$ +( 27.5 ) +​ +$ +( 20.2 ) +​ +$ +( 7.3 ) +​ +Contract assets – non-current is reported within Other non-current assets, and Contract liabilities – current is reported within Accrued Liabilities on our Consolidated Balance Sheet. Changes in contract assets and contract liabilities primarily result from the timing difference between our performance of services and payments from customers. +44 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +During fiscal 2020, we terminated certain commercial power-by-the-hour (“PBH”) customer contracts and restructured another PBH contract. The restructured contract was deemed a loss contract requiring the establishment of forward loss reserves for the total estimated costs that are in excess of the total estimated consideration over the remainder of the contracts. The impact from these actions resulted in a charge of $ 31.3 million during fiscal 2020, which included a reduction in revenue of $ 17.3 million, the establishment of forward loss reserves of $ 5.4 million, and other related charges of $ 8.6 million. As of May 31, 2020, our Consolidated Balance Sheet included remaining forward loss reserves of $5.4 million with $ 3.1 million classified as current in Accrued liabilities and $ 2.3 million classified as long-term in Other liabilities. +Changes in our deferred revenue, after adoption of ASC 606 on June 1, 2018, were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year ended May 31, +​ +​ +2020 +​ +2019 +Deferred revenue at beginning of period +​ +$ +( 96.4 ) +​ +$ +( 44.1 ) +Revenue deferred +​ +( 417.2 ) +​ +( 364.7 ) +Revenue recognized +​ +410.5 +​ +306.6 +Other +​ +3.9 +​ +5.8 +Deferred revenue at end of period +​ +$ +( 99.2 ) +​ +$ +( 96.4 ) +​ +Remaining Performance Obligations +As of May 31, 2020, we had approximately $ 1.0 billion of remaining performance obligations, also referred to as firm backlog, which excludes unexercised contract options and potential orders under our indefinite-delivery, indefinite-quantity contracts. We expect that approximately 50 % of this backlog will be recognized as revenue over the next 12 months , with the majority of the remaining balance recognized over the next three years . The amount of remaining performance obligations, which is expected to be recognized as revenue beyond 12 months, primarily relates to our long-term, power-by-the-hour programs where we provide component inventory management and/or repair services. +Financial Instruments and Concentrations of Market or Credit Risk +Financial instruments that potentially subject us to concentrations of market or credit risk consist principally of trade receivables. While our trade receivables are diverse and represent a number of entities and geographic regions, the majority are with the U.S. government and its contractors and entities in the aviation industry. The composition of our accounts receivable is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +​ +2020 +​ +2019 +U.S. Government contracts: +​ +​ +​ +​ +​ +Trade receivables +​ +$ +33.9 +​ +$ +28.7 +Unbilled receivables +​ +27.4 +​ +31.7 +​ +​ +61.3 +​ +60.4 +All other customers: +​ +​ +Trade receivables +​ +81.7 +​ +92.5 +Unbilled receivables +​ +28.9 +​ +44.9 +​ +​ +110.6 +​ +137.4 +​ +​ +$ +171.9 +​ +$ +197.8 +​ +In addition, we currently have past due accounts receivable owed by former commercial program customers primarily related to our exit from customer contracts in certain geographies, including Colombia, Peru, and Poland. Our past due accounts receivable owed by these customers was $ 10.9 million as of May 31, 2020 which was net of allowance for doubtful accounts of $ 9.3 million. +45 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +The carrying amounts of cash and cash equivalents, accounts receivable, and accounts and trade notes payable approximate fair value because of the short-term maturity of these instruments. The carrying value of long-term debt bearing a variable interest rate approximates fair value. +Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. +Allowance for Doubtful Accounts +We maintain an allowance for doubtful accounts to reflect the expected uncollectibility of accounts receivable based on past collection history and specific risks identified among uncollected accounts. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, and our customers’ current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to undergo an extensive credit check prior to delivery of products or services. Our allowance for doubtful accounts also includes reserves for estimated product returns. +We perform regular evaluations of customer payment experience, current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, letters of credit, and/or obligation guarantees from financial institutions for transactions executed on other than normal trade terms. We also maintain trade credit insurance for certain customers to provide coverage, up to a certain limit, in the event of insolvency of some customers. +In fiscal 2019, we recognized a provision for doubtful accounts of $ 12.4 million related to the bankruptcy of a European airline customer. The provision consisted of impairment of non-current contract assets of $ 7.6 million, allowance for doubtful accounts of $ 3.3 million, and other liabilities of $ 1.5 million. +​ +The change in our allowance for doubtful accounts was as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +2018 +Balance, beginning of year +​ +$ +16.0 +​ +$ +7.5 +​ +$ +4.9 +Provision charged to operations +​ +5.4 +​ +15.8 +​ +0.5 +Recoveries, deductions for accounts written off and other reclassifications +​ +0.7 +​ +( 7.3 ) +​ +2.1 +Balance, end of year +​ +$ +22.1 +​ +$ +16.0 +​ +$ +7.5 +​ +Goodwill and Other Intangible Assets +In accordance with ASC 350, Intangibles–Goodwill and Other , goodwill and other intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, or more frequently if circumstances indicate that impairment is possible. +As of May 31, 2020, we had three reporting units, which included two in our Aviation Services segment (Aviation Supply Chain and Maintenance, Repair, and Overhaul) and one comprised of our Expeditionary Services segment. In fiscal 2019 and 2018, we utilized the qualitative assessment approach for all reporting units and concluded it was more likely than not that the fair value of each reporting unit exceeded its carrying value at the respective measurement dates, and thus no impairment charges were recorded. +46 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +In fiscal 2020, we elected to skip the qualitative assessment due to the unprecedented impact of the COVID-19 pandemic and utilized a quantitative assessment approach for all reporting units. We estimated the fair value of each reporting unit using primarily an income approach based on discounted cash flows. The assumptions we used to estimate the fair value of our reporting units are based on historical performance, as well as forecasts used in our current business plan and require considerable management judgment in light of the impact of COVID-19. We used discount rates based on our consolidated weighted average cost of capital which is adjusted for each of our reporting units based on their specific risk, size, and industry characteristics. The fair value measurements used for our goodwill impairment testing use significant unobservable inputs, which reflect our own assumptions about the inputs that market participants would use in measuring fair value. The fair value of our reporting units is also impacted by our overall market capitalization and may be impacted by volatility in our stock price and assumed control premium, among other items. +Upon completion of the annual quantitative goodwill impairment analysis as of May 31, 2020 for our reporting units, we concluded the fair value of each reporting unit exceeded its carrying values, and thus no impairment charges were recorded. +Changes in the carrying amount of goodwill by segment for fiscal 2020 and 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation +​ +Expeditionary +​ +​ +​ +​ +Services +Services +Total +Balance as of May 31, 2018 +​ +$ +99.4 +​ +$ +19.3 +​ +$ +118.7 +Finalization of purchase price allocation +​ +​ +( 1.0 ) +​ +​ +— +​ +​ +( 1.0 ) +Foreign currency translation adjustments +​ +( 1.5 ) +​ +​ +— +​ +​ +( 1.5 ) +Balance as of May 31, 2019 +​ +96.9 +​ +19.3 +​ +116.2 +Foreign currency translation adjustments +​ +​ +( 0.5 ) +​ +​ +— +​ +​ +( 0.5 ) +Balance as of May 31, 2020 +​ +$ +96.4 +​ +$ +19.3 +​ +$ +115.7 +​ +Intangible assets with finite useful lives are amortized on a straight-line basis over their estimated useful lives. Intangible assets, other than goodwill, are comprised of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, 2020 +​ +​ +​ +​ +​ +Accumulated +​ +​ +​ +Amortizable intangible assets: +Gross +Amortization +Net +Customer relationships +​ +$ +21.4 +​ +$ +( 16.5 ) +​ +$ +4.9 +Unamortized intangible assets: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Trademarks +​ +1.1 +​ +— +​ +1.1 +​ +​ +$ +22.5 +​ +$ +( 16.5 ) +​ +$ +6.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, 2019 +​ +​ +​ +​ +​ +Accumulated +​ +​ +​ +Amortizable intangible assets: +Gross +Amortization +Net +Customer relationships +​ +$ +25.5 +​ +$ +( 15.6 ) +​ +$ +9.9 +Lease agreements +​ +22.5 +​ +( 14.0 ) +​ +8.5 +Other +​ +​ +3.4 +​ +​ +( 0.7 ) +​ +​ +2.7 +​ +​ +51.4 +​ +( 30.3 ) +​ +21.1 +Unamortized intangible assets: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Trademarks +​ +1.1 +​ +— +​ +1.1 +​ +​ +$ +52.5 +​ +$ +( 30.3 ) +​ +$ +22.2 +​ +47 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +In conjunction with the adoption of ASC 842 on June 1, 2019, our intangible assets for lease agreements were re-classified to the ROU asset. During fiscal 2020, we recognized an impairment charge of $ 5.4 million related to the exit of certain product lines across both our Aviation Services and Expeditionary Services segments. +Customer relationships are being amortized over 5 - 20 years. Amortization expense recorded during fiscal 2020, 2019 and 2018 was $ 2.3 million, $ 3.9 million, and $ 4.7 million, respectively. The estimated aggregate amount of amortization expense for intangible assets in each of the next five fiscal years is $ 1.7 million in 2021, $ 1.0 million in 2022, $ 0.5 million in 2023, $ 0.3 million in 2024 and $ 0.3 million in 2025. +Foreign Currency +Our foreign subsidiaries utilize the local currency as their functional currency. All balance sheet accounts of foreign subsidiaries transacting business in currencies other than the U.S. dollar are translated at year-end exchange rates. Revenues and expenses are translated at average exchange rates during the year. Translation adjustments are excluded from the results of operations and are recorded in stockholders’ equity as a component of accumulated other comprehensive loss until such subsidiaries are liquidated. +Cash +Cash and cash equivalents consist of highly liquid instruments which have original maturities of three months or less when purchased. Restricted cash represents cash on hand required to be set aside by a contractual agreement related to receivable securitization arrangements. Generally, the restrictions related to the receivable securitization arrangements lapse at the time we remit the customer payments collected by us as servicer of previously sold customer receivables to the purchaser. +Inventories +Inventories are valued at the lower of cost or market (estimated net realizable value). Cost is determined by the specific identification, average cost, or first-in, first-out methods. From time-to-time, we purchase aircraft and engines for disassembly to individual parts and components. Costs are assigned to these individual parts and components utilizing list prices from original equipment manufacturers and recent sales history. +The following is a summary of inventories: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Aircraft and engine parts, components and finished goods +​ +$ +556.6 +​ +$ +467.9 +Raw materials and parts +​ +​ +45.9 +​ +​ +41.8 +Work-in-process +​ +20.6 +​ +14.0 +​ +​ +$ +623.1 +​ +$ +523.7 +​ +Rotable Assets and Equipment under Leases +The cost of the asset under lease is the original purchase price plus overhaul costs. Depreciation is computed using the straight-line method over the estimated service life of the equipment. The balance sheet classification of equipment under lease is generally based on lease term, with fixed-term leases less than twelve months generally classified as short-term and all others generally classified as long-term. +Equipment on short-term lease includes aircraft engines and parts on or available for lease to satisfy customers’ immediate short-term requirements. The leases are renewable with fixed terms, which generally vary from one to twelve months . +48 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +Property, Plant and Equipment and Other Non-Current Assets +We record property, plant and equipment at cost. Depreciation is computed on the straight-line method over useful lives of 10 - 40 years for buildings and improvements and 3 - 10 years for equipment, furniture and fixtures , and capitalized software . Leasehold improvements are amortized over the shorter of the estimated useful life or the term of the applicable lease. +Repair and maintenance expenditures are expensed as incurred. Upon sale or disposal, cost and accumulated depreciation are removed from the accounts, and related gains and losses are included in results of operations. +Rotable assets supporting long-term programs consist of rotable component parts used to support long-term supply chain programs. The assets are being depreciated on a straight-line basis over their estimated useful lives. +In accordance with ASC 360, Property, Plant and Equipment , we are required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows. We utilize certain assumptions to estimate future undiscounted cash flows, including demand for our services, future market conditions and trends, business development pipeline of opportunities, current and future lease rates, lease terms, and residual values. In conjunction with the decision to exit certain product lines, we recognized rotable asset impairment charges of $ 1.9 million in fiscal 2020. +Future rent due to us under non-cancelable leases during each of the next five fiscal years is $ 12.2 million in 2021, $ 11.6 million in 2022, $ 11.4 million in 2023, $ 11.3 million in 2024, and $ 11.3 million in 2025. +Investments +Investments where we have the ability to exercise significant influence, but do not control the entity, are accounted for under the equity method of accounting. Significant influence generally exists if we have a 20 % to 50 % ownership interest in the investee. Our share of the net earnings or loss of our investees is included in operating income on our Consolidated Statements of Income since the activities of the investees are closely aligned with our operations. Equity investments in entities over which we do not have the ability to exercise significant influence and whose securities do not have a readily determinable fair value are carried at cost. +We evaluate our investments for impairment whenever events or changes in circumstances indicate that the carrying amounts of such investments may be impaired. If a decline in the value of an investment is determined to be other than temporary, a loss is recorded in earnings in the current period. +Our investments are classified in Other non-current assets on our Consolidated Balance Sheets. Distributions from joint ventures are classified as operating or investing activities in the Consolidated Statements of Cash Flows based upon an evaluation of the specific facts and circumstances of each distribution. +Restructuring and Other Exit Costs +We recognize charges for restructuring and other exit costs such as product line exits and facility closures at their fair value when incurred. In cases where employees are required to render service until they are terminated in order to receive the termination benefits and will be retained beyond the minimum retention period, we record the expense ratably over the future service period. +During fiscal 2020, we incurred severance and furlough-related costs of $ 7.1 million which were included as a component of Cost of sales and services and Selling, general and administrative on our Consolidated Statements of Income. Our remaining liability for these costs as of May 31, 2020 was $ 5.5 million which is included in Accrued liabilities on the Consolidated Balance Sheet. +49 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +Income Taxes +We are subject to income taxes in the U.S., state, and several foreign jurisdictions. In the ordinary course of business, there can be transactions and calculations where the ultimate tax determination is uncertain. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns in accordance with applicable accounting guidance for accounting for income taxes, using currently enacted tax rates in effect for the year in which the differences are expected to reverse. +We record a valuation allowance when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Both positive and negative evidence are considered in forming our judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. Valuation allowances are reassessed whenever there are changes in circumstances that may cause a change in judgment. +The accounting for uncertainty in income taxes requires a more-likely-than-not threshold for financial statement recognition of tax positions taken or expected to be taken in a tax return. Where necessary, we record a liability for the difference between the benefit recognized for financial statement purposes and the tax position taken or expected to be taken on our tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. +Supplemental Information on Cash Flows +Supplemental information on cash flows is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Interest paid +​ +$ +8.6 +​ +$ +8.8 +​ +$ +7.2 +Income taxes paid +​ +14.3 +​ +7.0 +​ +17.0 +Income tax refunds and interest received +​ +7.0 +​ +6.4 +​ +0.1 +​ +During fiscal 2020, treasury stock decreased $ 5.0 million reflecting restricted stock activity of $ 0.8 million and the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $ 8.3 million partially offset by the repurchase of common shares of $ 4.1 million. +During fiscal 2019, treasury stock increased $ 7.0 million reflecting the repurchase of common shares of $ 10.3 million, restricted stock activity of $ 0.8 million partially offset by the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $ 4.1 million. +During fiscal 2018, treasury stock increased $ 0.9 million reflecting the repurchase of common shares of $ 13.1 million, restricted stock activity of $ 1.0 million and the re-issuance of shares upon exercise of stock options, net of shares withheld to satisfy statutory tax obligations, of $ 11.2 million. +Use of Estimates +We have made estimates and utilized certain assumptions relating to the reporting of assets and liabilities and the disclosures of contingent liabilities to prepare these Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States. Actual results could differ from those estimates. +50 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +1. Summary of Significant Accounting Policies (Continued) +​ +New Accounting Pronouncements Not Yet Adopted +​ +In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments . This ASU requires a change in the measurement approach for credit losses on financial assets measured on an amortized cost basis from an incurred loss method to an expected loss method, thereby eliminating the requirement that a credit loss be considered probable to impact the valuation of a financial asset measured on an amortized cost basis. This ASU also requires the measurement of expected credit losses to be based on relevant information about past events, including historical experience, current conditions, and a reasonable and supportable forecast of the collectability of the related financial asset. We plan to adopt this ASU on June 1, 2020 and the adoption is not expected to have a material impact on our consolidated financial statements. +​ +2. Discontinued Operations +Our Contractor-Owned, Contractor-Operated (“COCO”) business previously included in our Expeditionary Services segment completed certain contracts in the second quarter of fiscal 2018. As the aircraft supporting these contracts were not placed on new contracts, combined with the continued decline in operational tempo within the U.S. Department of Defense (“DoD”) and an excess supply of aircraft assets in the market, we determined there was an impairment triggering event and tested the recoverability of our COCO assets. As a result, we recognized impairment and other charges of $ 54.2 million in the second quarter of fiscal 2018. The fair value of the aircraft and related assets was based on available market data for similar assets. +During the third quarter of fiscal 2018, we decided to pursue the sale of our COCO business. Due to this strategic shift, the assets, liabilities, and results of operations of our COCO business have been reported as discontinued operations for all periods presented. Goodwill was allocated to this business based on its relative fair value to the reporting unit. The fair value of the reporting unit was determined based on a combination of the expected net proceeds upon sale and a discounted cash flow analysis. As the fair value of the COCO business was below its carrying value, a goodwill impairment charge of $ 9.8 million was recorded in the third quarter of fiscal 2018. +During fiscal 2019, we signed an agreement to sell our U.S. Department of Defense ("DoD") contracts and certain assets of our COCO business. In conjunction with this agreement and other expected asset sales, we recognized an impairment charge in discontinued operations of $ 74.1 million during the third quarter of fiscal 2019 reflecting the expected net proceeds to be received upon the completion of the sale transactions. +In fiscal 2020, we signed an agreement to sell the remaining operating contract of the COCO business and recognized an impairment charge of $ 11.8 million in the first quarter of fiscal 2020 related to the disposal of the remaining COCO assets. The sale of the DoD contracts and related assets was completed in the second quarter of fiscal 2020 and the sale of the remaining operating contract was completed in the fourth quarter of fiscal 2020 shortly after government approval. Our continuing involvement in the COCO business is limited to the lease of certain aircraft which is an obligation of the acquirer of the non-DoD contract. +No amounts for general corporate overhead or interest expense were allocated to discontinued operations during the periods presented. Unless otherwise noted, amounts and disclosures throughout these Notes to Consolidated Financial Statements relate to our continuing operations. +51 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +2. Discontinued Operations (Continued) +​ +Operating results for discontinued operations were comprised of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Sales +​ +$ +40.4 +​ +$ +95.8 +​ +$ +96.3 +Cost of sales +​ +( 45.4 ) +​ +( 106.1 ) +​ +( 101.4 ) +Asset impairments +​ +​ +( 11.8 ) +​ +​ +( 74.1 ) +​ +​ +( 65.2 ) +Selling, general and administrative expenses +​ +( 8.6 ) +​ +( 12.1 ) +​ +( 11.8 ) +Operating loss from discontinued operations +​ +​ +( 25.4 ) +​ +​ +( 96.5 ) +​ +​ +( 82.1 ) +Provision for income taxes +​ +​ +( 5.0 ) +​ +​ +( 19.9 ) +​ +​ +( 24.0 ) +Loss from discontinued operations +​ +$ +( 20.4 ) +​ +$ +( 76.6 ) +​ +$ +( 58.1 ) +​ +The carrying amounts of the major classes of assets and liabilities for our discontinued operations are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Accounts receivable, net +​ +$ +0.2 +​ +$ +16.2 +Inventory, rotable assets, and equipment +​ +​ +— +​ +​ +7.5 +Operating lease ROU assets +​ +21.9 +​ +— +Other assets +​ +0.8 +​ +5.5 +Assets of discontinued operations +​ +$ +22.9 +​ +$ +29.2 +​ +​ +​ +​ +​ +​ +​ +Accounts payable and accrued liabilities +​ +$ +8.0 +​ +$ +29.2 +Operating lease liabilities +​ +21.9 +​ +— +Liabilities of discontinued operations +​ +$ +29.9 +​ +$ +29.2 +​ +​ +3. Sale of Receivables +On February 23, 2018, we entered into a Purchase Agreement with Citibank N.A. (“Purchaser”) for the sale, from time to time, of certain accounts receivable due from certain customers (the “Purchase Agreement”). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $ 150 million and Purchaser may, but is not required to, purchase the eligible receivables we offer to sell. The term of the Purchase Agreement runs through February 22, 2021, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual terms unless either party provides advance notice that they do not intend to extend the term. +We have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing , and de-recognize the sold receivables from our Consolidated Balance Sheet. +Receivables sold under the Purchase Agreement during fiscal 2020, 2019, and 2018 were $ 746.4 million, $ 744.2 million, and $ 239.6 , respectively. Amounts remitted to the Purchaser on their behalf during fiscal 2020, 2019, and 2018 were $ 758.3 million, $ 729.7 million, and $ 167.9 , respectively. As of May 31, 2020 and May 31, 2019, we had collected cash of $ 20.0 million and $ 19.8 million, respectively, which was not yet remitted to the Purchaser as of those dates and was classified as Restricted cash on our Consolidated Balance Sheets. +We recognize discounts on the sale of our receivables and other fees related to the Purchase Agreement in Other expense, net on our Consolidated Statements of Income. During fiscal 2020, 2019 and 2018, we incurred discounts on the sale of our receivables and other fees of $ 1.8 million, $ 2.2 million and $ 0.9 million, respectively. +52 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +​ +4. Financing Arrangements +Debt Outstanding +A summary of the carrying amount of our debt is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Revolving Credit Facility expiring September 25, 2024 with interest payable monthly +​ +$ +579.5 +​ +$ +120.0 +Term loan due November 1, 2021 with interest payable monthly +​ +​ +22.5 +​ +​ +22.9 +Total debt +​ +602.0 +​ +142.9 +Current maturities of debt +​ +— +​ +— +Debt issuance costs, net +​ +​ +( 2.0 ) +​ +​ +( 1.2 ) +Long-term debt +​ +$ +600.0 +​ +$ +141.7 +​ +At May 31, 2020, our variable rate debt had a fair value that approximates its carrying value and is classified as Level 2 in the fair value hierarchy. +On October 18, 2017, we entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender (the “Credit Agreement”). The Credit Agreement provided a Canadian $ 31 million term loan with the proceeds used to fund the acquisition of two maintenance, repair, and overhaul (“MRO”) facilities in Canada from Premier Aviation. The term loan is due in full at the expiration of the Credit Agreement on November 1, 2021 unless terminated earlier pursuant to the terms of the Credit Agreement. Interest is payable monthly on the term loan at the offered fluctuating Canadian Dollar Offer Rate plus 125 to 225 basis points based on certain financial measurements if a Bankers’ Acceptances loan, or at the offered fluctuating Prime Rate plus 25 to 125 basis points based on certain financial measurements, if a Prime Rate loan. +On September 25, 2019, we entered into an amendment to our Revolving Credit Facility that extended the maturity of the Revolving Credit Facility to September 25, 2024, increased the revolving credit commitment to $ 600 million, and modified certain other provisions. Under certain circumstances, we have the ability to request, but our lenders are not required to grant, an increase to the revolving credit commitment by an aggregate amount of up to $ 300 million, not to exceed $ 900 million in total. +Borrowings under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 87.5 to 175 basis points based on certain financial measurements if a Eurodollar Rate loan, or at the offered fluctuating Base Rate plus 0 to 75 basis points based on certain financial measurements if a Base Rate loan. +Our financing arrangements also require us to comply with leverage and interest coverage ratios, maintain a minimum net working capital level, and comply with certain affirmative and negative covenants, including those relating to financial reporting and notification, payment of indebtedness, cash dividends, taxes and other obligations, compliance with applicable laws, and limitations on additional liens, indebtedness, acquisitions, investments and disposition of assets. The Revolving Credit Facility also requires our significant domestic subsidiaries, and any subsidiaries that guarantee our other indebtedness, to provide a guarantee of payment under the Revolving Credit Facility. At May 31, 2020, we were in compliance with the financial and other covenants in our financing agreements. +53 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +4. Financing Arrangements (Continued) +​ +Borrowing activity under the Revolving Credit Facility during fiscal 2020, 2019 and 2018 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Maximum amount borrowed +​ +$ +579.5 +​ +$ +287.0 +​ +$ +275.0 +​ +Average daily borrowings +​ +280.7 +​ +207.8 +​ +214.1 +​ +Average interest rate during the year +​ +2.62 +% +3.41 +% +2.52 +% +​ +We also have $ 9.3 million available under foreign lines of credit. +​ +5. Equity +Stock-Based Compensation +We have granted stock-based awards under the AAR CORP. 2013 Stock Plan (the “2013 Stock Plan”) and the AAR CORP. Stock Benefit Plan (“Stock Benefit Plan”) each of which has been approved by our stockholders. No further awards will be made under the Stock Benefit Plan. Under the 2013 Stock Plan, we are authorized to issue stock options to employees and non-employee directors that allow the grant recipients to purchase shares of common stock at a price not less than the fair market value of the common stock on the date of grant. Generally, stock options awarded expire ten years from the date of grant and are exercisable in three annual increments commencing one year after the date of grant. In addition to stock options, the 2013 Stock Plan also provides for the grant of time-based restricted stock awards and performance-based restricted stock awards. The number of performance-based awards earned, subject to vesting, is based on achievement of certain Company-wide or segment financial goals or stock price targets. The 2013 Stock Plan also provides for the grant of stock appreciation units and restricted stock units; however, to date, no such awards have been granted. +Restricted stock grants (whether time-based or performance-based) are designed, among other things, to align employee interests with the interests of stockholders and to encourage the recipient to build a career with us. Restricted stock typically vests over periods of one to five years from the date of grant. Restricted stock grants may be performance-based with vesting to occur over periods of three to five years . All restricted stock that has been granted and, if performance-based, earned according to performance criteria carries full dividend and voting rights, regardless of whether it has vested. +Substantially all stock options and restricted stock are subject to forfeiture prior to vesting if the employee’s employment terminates for any reason other than death, disability or retirement. Since inception, a total of 11,149,000 shares have been granted under the Stock Benefit Plan. We have granted a total of 3,656,000 shares under the 2013 Stock Plan. All future stock awards will be made under the 2013 Stock Plan. There were 646,088 shares available for grant under the 2013 Stock Plan as of May 31, 2020. +54 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +5. Equity (Continued) +​ +Stock Options +During fiscal 2020, 2019, and 2018, we granted stock options with respect to 414,460 shares, 300,240 shares and 463,140 shares, respectively. The weighted average fair value per share of stock options granted during fiscal 2020, 2019 and 2018 was $ 10.30 , $ 13.60 and $ 9.29 , respectively. The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option pricing model using the following weighted average assumptions: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Stock Options Granted +​ +​ +In Fiscal Year +​ +2020 +2019 +2018 +Risk-free interest rate +​ +1.9 +% +2.7 +% +1.8 +% +Expected volatility of common stock +32.0 +% +30.8 +% +31.7 +% +Dividend yield +0.8 +% +0.6 +% +0.9 +% +Expected option term in years +4.5 +​ +4.5 +​ +4.3 +​ +​ +The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on historical volatility of our common stock, and the expected option term represents the period of time that the stock options granted are expected to be outstanding based on historical exercise trends. The dividend yield represents our anticipated cash dividends at the grant date over the expected option term. +A summary of stock option activity for the three years ended May 31, 2020 consisted of the following (shares in thousands): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +​ +2019 +​ +2018 +​ +​ +​ +​ +Weighted +​ +​ +​ +Weighted +​ +​ +​ +Weighted +​ +​ +​ +​ +Average +​ +​ +​ +Average +​ +​ +​ +Average +​ +Shares +Exercise Price +Shares +Exercise Price +Shares +Exercise Price +Outstanding at beginning of year +​ +1,777 +​ +$ +30.37 +​ +2,082 +​ +$ +26.72 +​ +2,334 +​ +$ +23.02 +Granted +414 +​ +$ +37.66 +300 +​ +$ +47.84 +463 +​ +$ +35.33 +Exercised +( 300 ) +​ +$ +24.99 +( 571 ) +​ +$ +25.56 +( 704 ) +​ +$ +20.04 +Cancelled +( 40 ) +​ +$ +36.72 +( 34 ) +​ +$ +42.02 +( 11 ) +​ +$ +29.50 +Outstanding at end of year +1,851 +​ +$ +32.74 +1,777 +​ +$ +30.37 +2,082 +​ +$ +26.72 +Options exercisable at end of year +1,133 +​ +$ +28.32 +981 +​ +$ +25.28 +883 +​ +$ +23.81 +​ +The total fair value of stock options that vested during fiscal 2020, 2019, and 2018 was $ 3.7 million, $ 5.6 million, and $ 4.9 million, respectively. The total intrinsic value of stock options exercised during fiscal 2020, 2019, and 2018 was $ 6.2 million, $ 12.2 million, and $ 14.2 million, respectively. The aggregate intrinsic value of options outstanding was $ 0.5 million and $ 6.7 million as of May 31, 2020 and 2019, respectively. The tax benefit realized from stock options exercised during fiscal 2020, 2019, and 2018 was $ 2.1 million, $ 2.7 million, and $ 2.9 million, respectively. Expense recognized in selling, general and administrative expenses for stock options during fiscal 2020, 2019, and 2018 was $ 3.9 million, $ 4.1 million, and $ 5.1 million, respectively. As of May 31, 2020, we had $ 4.2 million of unrecognized compensation expense related to stock options that will be amortized over an average period of 1.3 years. +55 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +5. Equity (Continued) +​ +Restricted Stock +We provide executives and other key employees an opportunity to be awarded performance-based and time- based restricted stock. The performance-based awards are contingent upon the achievement of certain objectives, which generally include cumulative income, average return on capital, and relative total shareholder return over a three-year performance period. During fiscal 2020, 2019, and 2018, we granted 52,475 , 43,680 , and 108,440 of performance-based restricted shares, respectively. Time-based restricted shares of 56,535 , 46,470 , and 24,425 were granted to executives and key employees during fiscal 2020, 2019, and 2018, respectively. We also award time-based restricted stock to our non-employee directors as part of their annual compensation. Time-based restricted shares of 44,123 , 29,128 , and 55,000 were granted to members of the Board of Directors during fiscal 2020, 2019, and 2018, respectively. +The fair value of restricted shares is the market value of our common stock on the date of grant. Expense recognized in selling, general and administrative expenses for all restricted share programs during fiscal 2020, 2019, and 2018 was $ 3.4 million, $ 9.4 million, and $ 10.2 million, respectively. +Restricted share activity during fiscal 2020 was as follows (shares in thousands): +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted Average +​ +​ +Number of +​ +Fair Value +​ +Shares +on Grant Date +Nonvested at May 31, 2019 +532 +​ +$ +31.70 +Granted +279 +​ +$ +19.44 +Vested +( 412 ) +​ +$ +25.27 +Forfeited +( 14 ) +​ +$ +37.02 +Nonvested at May 31, 2020 +385 +​ +$ +31.70 +​ +As of May 31, 2020 we had $ 2.5 million of unearned compensation related to restricted shares that will be amortized to expense over a weighted average period of 1.6 years. +Stockholder Rights Plan +Pursuant to a limited duration stockholder rights plan adopted in 2020, each outstanding share of our common stock carries with it a right to purchase one one-thousandth of a share of Series A Junior Participating Preferred Stock (a “Preferred Share”) for $ 100.00 (the “Exercise Price”). The rights become exercisable when certain specified events occur, including the acquisition of 10% (or 20% in the case of passive investors who are eligible to, and do, report their holdings on Schedule 13G with the SEC) or more of the common stock by a person or group (an "Acquiring Person") or the commencement of a tender or exchange offer for 10% or more of the common stock without the approval of the Board of Directors. +In the event that an Acquiring Person acquires 10% or more of the common stock, or if we are the surviving corporation in a merger involving an Acquiring Person or if the Acquiring Person engages in certain types of self-dealing transactions, each right entitles the holder (other than the Acquiring Person) to purchase a Preferred Share for the Exercise Price. Similarly, if we are acquired in a merger or other business combination or 50% or more of our assets or earning power is sold, each right entitles the holder (other than the Acquiring Person) to purchase at the then-current exercise price that number of shares of common stock of the surviving corporation having a market value of two times the exercise price. The rights do not entitle the holder thereof to vote or to receive dividends. The rights will expire on February 28, 2021, and may be redeemed by us for $ .0001 per right under certain circumstances. +​ +56 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +6. Income Taxes +On December 22, 2017, the Tax Cuts and Jobs Act (the "Tax Reform Act") was enacted which significantly revised the U.S. corporate income tax system. The Tax Reform Act, among other things, reduced the corporate federal income tax rate to 21 % from 35 %, changed bonus depreciation regulations and limited deductions for executive compensation. The income tax rate reduction in the Tax Reform Act was effective January 1, 2018 which resulted in a blended federal statutory tax rate of 29.2 % in fiscal 2018. +In fiscal 2018, we re-measured our deferred tax assets and liabilities based on the tax rate at which they are expected to reverse in the future, which was either at a federal rate of 29.2 % for reversals expected in fiscal 2018 or 21 % for reversals in fiscal 2019 and subsequent years. During fiscal 2018, we recognized an income tax benefit of $ 14.1 million for the re-measurement impact from applying the provisions of the Tax Reform Act. +The provision for income tax on income from continuing operations includes the following components: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Current: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Federal +​ +$ +1.4 +​ +$ +4.8 +​ +$ +14.6 +State +​ +0.9 +​ +0.1 +​ +0.1 +Foreign +​ +2.8 +​ +5.0 +​ +1.7 +​ +​ +5.1 +​ +9.9 +​ +16.4 +Deferred +​ +0.5 +​ +( 5.0 ) +​ +​ +( 12.9 ) +​ +​ +$ +5.6 +​ +$ +4.9 +​ +$ +3.5 +​ +The provision for income taxes on pre-tax income differs from the amount computed by applying the U.S. federal statutory income tax rate of 21.0 % for fiscal 2020 and 2019, and 29.2 % for fiscal 2018 to income from continuing operations before provision for income taxes due to the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Provision for income tax at the federal statutory rate +​ +$ +6.4 +​ +$ +18.7 +​ +$ +22.5 +Deferred tax re-measurement from the Tax Reform Act +​ +​ +— +​ +​ +— +​ +​ +( 14.1 ) +Excess tax benefits from stock-based compensation +​ +​ +( 2.1 ) +​ +​ +( 2.7 ) +​ +​ +( 2.9 ) +State income taxes, net of federal benefit +​ +​ +1.1 +​ +​ +1.9 +​ +​ +1.5 +Change in valuation allowance for state deferred tax assets +​ +​ +( 0.1 ) +​ +​ +( 6.9 ) +​ +​ +( 3.4 ) +Effective settlement of prior tax positions +​ +— +​ +( 4.7 ) +​ +— +Other +​ +0.3 +​ +( 1.4 ) +​ +( 0.1 ) +Provision for income tax +​ +$ +5.6 +​ +$ +4.9 +​ +$ +3.5 +​ +Income before provision for income taxes includes the following components: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Domestic +​ +$ +23.6 +​ +$ +68.9 +​ +$ +58.7 +Foreign +​ +6.8 +​ +20.1 +​ +18.5 +​ +​ +$ +30.4 +​ +$ +89.0 +​ +$ +77.2 +​ +57 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +6. Income Taxes (Continued) +​ +Deferred tax liabilities and assets result primarily from the differences in the timing of the recognition of transactions for financial reporting and income tax purposes. Our deferred tax liabilities and assets consist of the following components: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Deferred tax assets: +​ +​ +​ +​ +Operating lease liabilities +​ +$ +24.9 +​ +$ +— +State net operating losses +​ +​ +9.4 +​ +​ +9.0 +Credits and incentives +​ +​ +8.2 +​ +​ +— +Employee benefits +​ +​ +8.0 +​ +​ +9.4 +Deferred revenue +​ +​ +2.3 +​ +​ +7.7 +Inventory costs +​ +2.8 +​ +4.9 +Postretirement benefits +​ +​ +5.3 +​ +​ +3.7 +Other +​ +4.0 +​ +4.8 +Total deferred tax assets +​ +​ +64.9 +​ +​ +39.5 +Valuation allowance +​ +​ +— +​ +​ +( 0.1 ) +Total deferred tax assets net of valuation allowance +​ +​ +64.9 +​ +​ +39.4 +Deferred tax liabilities: +​ +​ +​ +​ +​ +​ +Tangible and intangible assets +​ +​ +( 35.0 ) +​ +​ +( 36.1 ) +ROU operating lease assets +​ +( 26.2 ) +​ +— +Other +​ +( 0.2 ) +​ +( 0.2 ) +Total deferred tax liabilities +​ +​ +( 61.4 ) +​ +​ +( 36.3 ) +Net deferred tax assets +​ +$ +3.5 +​ +$ +3.1 +​ +As of May 31, 2020, we have determined that the realization of our deferred tax assets is more likely than not and that a valuation allowance is not required. Our net operating losses have carry forward periods that range from 5 to 20 years . Our history of operating earnings, our expectations for continued future earnings, the nature of certain of our deferred tax assets and the scheduled reversal of deferred tax liabilities, primarily related to depreciation, support the recoverability of the majority of the deferred tax assets. Our net deferred tax assets are included in Other non-current assets on our Consolidated Balance Sheets. +Income tax receivable was $ 7.9 million and $ 1.1 million at May 31, 2020 and 2019, respectively, and was included in Other current assets on the Consolidated Balance Sheets. +Our federal income tax returns for fiscal years 2017 and subsequent are open for examination. Various states and foreign jurisdictions also remain open subject to their applicable statute of limitations. +​ +58 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +7. Earnings Per Share +The computation of basic earnings per share is based on the weighted average number of common shares outstanding during each period. The computation of diluted earnings per share is based on the weighted average number of common shares outstanding during the period plus, when their effect is dilutive, incremental shares consisting of shares subject to stock options and shares issuable upon vesting of restricted stock awards. +In accordance with ASC 260-10-45, Share-Based Payment Arrangements and Participating Securities and the Two-Class Method , our unvested restricted stock awards are deemed participating securities since these shares are entitled to participate in dividends declared on common shares. During periods of net income, the calculation of earnings per share for common stock excludes income attributable to unvested restricted stock awards from the numerator and excludes the dilutive impact of those shares from the denominator. During periods of net loss, no effect is given to the participating securities because they do not share in the losses of the Company. +The following tables provide a reconciliation of the computations of basic and diluted earnings per share information for each of the years in the three-year period ended May 31, 2020 (shares in millions). +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Basic and Diluted EPS: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income from continuing operations +​ +$ +24.8 +​ +$ +84.1 +​ +$ +73.7 +Less income attributable to participating shares +​ +( 0.1 ) +​ +( 0.4 ) +​ +( 0.6 ) +Income from continuing operations attributable to common stockholders +​ +​ +24.7 +​ +​ +83.7 +​ +​ +73.1 +Loss from discontinued operations attributable to common stockholders +​ +​ +( 20.4 ) +​ +​ +( 76.6 ) +​ +​ +( 58.1 ) +Net income attributable to common stockholders for earnings per share +​ +$ +4.3 +​ +$ +7.1 +​ +$ +15.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average common shares outstanding - basic +​ +34.8 +​ +34.5 +​ +34.2 +Additional shares from assumed exercise of stock options +​ +​ +0.2 +​ +​ +0.4 +​ +​ +0.4 +Weighted average common shares outstanding - diluted +​ +​ +35.0 +​ +​ +34.9 +​ +​ +34.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share - basic: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from continuing operations +​ +$ +0.71 +​ +$ +2.42 +​ +$ +2.14 +Loss from discontinued operations +​ +( 0.59 ) +​ +( 2.22 ) +​ +( 1.70 ) +Earnings per share - basic +​ +$ +0.12 +​ +$ +0.20 +​ +$ +0.44 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings per share - diluted: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from continuing operations +​ +$ +0.71 +​ +$ +2.40 +​ +$ +2.11 +Loss from discontinued operations +​ +( 0.58 ) +​ +( 2.19 ) +​ +( 1.70 ) +Earnings per share - diluted +​ +$ +0.13 +​ +$ +0.21 +​ +$ +0.41 +​ +At May 31, 2020 and 2019 respectively, outstanding options to purchase 669,400 and 273,400 shares of common stock were not included in the computation of diluted earnings per share, because the exercise price of these options was greater than the average market price of the common shares for the year then ended. At May 31, 2018, the average market price of our common shares was in excess of the exercise prices of all of our outstanding options. +​ +59 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +8. Employee Benefit Plans +Defined Benefit Plans +Prior to January 1, 2000, the pension plan for domestic salaried and non-union hourly employees had a benefit formula based primarily on years of service and compensation. Effective January 1, 2000, we converted our defined benefit plan for substantially all domestic salaried and certain hourly employees to a cash balance pension plan. Under the cash balance pension plan, the retirement benefit is expressed as a dollar amount in an account that grows with annual pay-based credits and interest on the account balance. The interest crediting rate under our cash balance plan is determined quarterly and is equal to 100 % of the average 30-year treasury rate for the second month preceding the applicable quarter published by the Internal Revenue Service. The average interest crediting rate under our cash balance plan for the fiscal year ended May 31, 2020 was 4.46 %. Effective June 1, 2005, the existing cash balance plan was frozen and the annual pay-based credits were discontinued. Also effective June 1, 2005, the defined contribution plan was modified to include increased employer contributions and an enhanced profit sharing formula. Defined pension benefits for certain union hourly employees are based primarily on a fixed amount per year of service and the plan was frozen in fiscal 2018. +We also have a defined benefit pension plan covering certain employees in the Netherlands. Benefit formulas are based generally on years of service and compensation. +We also have a benefit plan which provides benefits to certain retired outside directors. In fiscal 2001, we froze the plan for any new members of the Board of Directors and no current directors participate in this plan. +The change to our projected benefit obligation and the fair value of our plan assets for our pension plans was as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Change in projected benefit obligation: +​ +​ +​ +​ +​ +​ +Projected benefit obligation at beginning of year +​ +$ +149.2 +​ +$ +146.5 +Service cost +​ +2.8 +​ +2.3 +Interest cost +​ +3.8 +​ +4.3 +Participant contributions +​ +0.3 +​ +0.4 +Net actuarial loss +​ +10.1 +​ +6.5 +Benefits and administrative payments +​ +( 4.9 ) +​ +( 6.9 ) +Settlements +​ +​ +( 2.2 ) +​ +​ +( 0.6 ) +Foreign currency translation adjustment +​ +— +​ +( 3.3 ) +Projected benefit obligation at end of year +​ +$ +159.1 +​ +$ +149.2 +​ +​ +​ +​ +​ +​ +​ +Change in the fair value of plan assets: +​ +​ +​ +​ +​ +​ +Fair value of plan assets at beginning of year +​ +$ +129.9 +​ +$ +134.5 +Actual return on plan assets +​ +8.6 +​ +2.8 +Employer contributions +​ +0.4 +​ +2.6 +Participant contributions +​ +— +​ +0.4 +Benefits and administrative payments, including settlements +​ +( 7.1 ) +​ +( 7.5 ) +Foreign currency translation adjustment +​ +— +​ +( 2.9 ) +Fair value of plan assets at end of year +​ +$ +131.8 +​ +$ +129.9 +Funded status at end of year +​ +$ +( 27.3 ) +​ +$ +( 19.3 ) +​ +60 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +8. Employee Benefit Plans (Continued) +​ +Amounts recognized in the Consolidated Balance Sheets consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Accrued liabilities +​ +$ +( 0.4 ) +​ +$ +( 0.4 ) +Other liabilities +​ +​ +( 26.9 ) +​ +​ +( 18.9 ) +Funded status at end of year +​ +$ +( 27.3 ) +​ +$ +( 19.3 ) +Accumulated other comprehensive loss +​ +$ +63.5 +​ +$ +58.7 +​ +For all of our pension plans, both the projected benefit obligation and the accumulated benefit obligation are in excess of the individual plans’ assets. The accumulated benefit obligation for all pension plans was $ 151.9 million and $ 142.4 million at May 31, 2020 and 2019, respectively. +Net Periodic Benefit Cost +Pension expense charged to the Consolidated Statements of Income includes the following components: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Service cost +​ +$ +2.8 +​ +$ +2.3 +​ +$ +2.4 +Interest cost +​ +3.8 +​ +4.3 +​ +4.3 +Expected return on plan assets +​ +( 6.8 ) +​ +( 7.1 ) +​ +( 7.3 ) +Curtailment +​ +​ +— +​ +​ +— +​ +​ +0.3 +Settlements +​ +​ +1.5 +​ +​ +0.1 +​ +​ +— +Amortization of prior service credit +​ +— +​ +( 0.1 ) +​ +— +Recognized net actuarial loss +​ +2.0 +​ +1.8 +​ +2.3 +​ +​ +$ +3.3 +​ +$ +1.3 +​ +$ +2.0 +​ +The estimated amount of net actuarial loss to be amortized from accumulated other comprehensive loss into expense during fiscal 2021 is $ 2.2 million. +​ +Assumptions +The assumptions used in accounting for our plans are estimates of factors including, among other things, the amount and timing of future benefit payments. The following table presents the key weighted-average assumptions used in the measurement of our projected benefit obligations: +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Discount rate: +​ +​ +​ +​ +​ +Domestic plans +2.83 +% +3.67 +% +International plan +1.20 +​ +1.50 +​ +​ +​ +​ +​ +​ +​ +Rate of compensation increase: +​ +​ +​ +​ +​ +Domestic plans +n/a +​ +n/a +​ +International plans +3.00 +% +3.00 +% +​ +61 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +8. Employee Benefit Plans (Continued) +​ +A summary of the weighted-average assumptions used to determine net periodic pension expense is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended +​ +​ +May 31, +​ +2020 +2019 +2018 +Discount rate: +​ +​ +​ +​ +​ +​ +​ +Domestic plans +3.67 +% +4.05 +% +3.82 +% +International plan +1.50 +​ +1.90 +​ +2.00 +​ +Expected long-term rate on plan assets: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic plans +7.25 +% +7.25 +% +7.25 +% +International plan +2.90 +​ +3.60 +​ +4.00 +​ +​ +The discount rate was determined by projecting the expected future benefit payments as defined for the projected benefit obligation, discounting those expected payments using a theoretical zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, and solving for the single equivalent discount rate that resulted in the same projected benefit obligation. +Plan Assets +The following table sets forth the actual asset allocation and target allocations for our U.S. pension plans: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +Target Asset +​ +​ +2020 +2019 +Allocation +​ +Equity securities +​ +60 +% +59 +% +45 – 75 +% +Fixed income securities +20 +​ +22 +​ +15 – 45 +% +Other +20 +​ +19 +​ +0 – 25 +% +​ +100 +% +100 +% +​ +​ +​ +The assets of U.S pension plans are invested in compliance with the Employee Retirement Income Security Act of 1974. The investment goals are to provide a total return that, over the long term, optimizes the long-term return on plan assets at an acceptable risk, and to maintain a broad diversification across asset classes and among investment managers. We believe that there are no significant concentrations of risk within our plan assets as of May 31, 2020. The use of derivatives for the purpose of speculation are not permitted. The assets of the U.S. pension plans are invested primarily in equity and fixed income mutual funds, individual common stocks, and fund-of-funds hedge funds. The assets of the non-domestic plan are invested in funds-of-funds where each fund holds a portfolio of equity and fixed income mutual funds. +To develop our expected long-term rate of return assumption on domestic plans, we use long-term historical return information for our targeted asset mix and current market conditions. The expected return for each asset class is weighted based on the target asset allocation to develop the expected long-term rate of return on plan assets assumption. While consideration is given to recent performance, the assumption represents a long-term, prospective rate of return. +62 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +8. Employee Benefit Plans (Continued) +​ +The following table sets forth by level, within the fair value hierarchy, pension plan assets at their fair value as of May 31, 2020: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Level 1 (1) +Level 2 (2) +Level 3 (3) +Total +Equity securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. mutual funds +​ +$ +31.5 +​ +$ +— +​ +$ +— +​ +$ +31.5 +International mutual funds +​ +7.6 +​ +​ +— +​ +— +​ +7.6 +Fixed income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Government securities and corporate bond mutual funds +​ +8.4 +​ +​ +4.7 +​ +— +​ +13.1 +Funds-of-funds +​ +— +​ +​ +54.6 +​ +8.5 +​ +63.1 +Hedge funds +​ +— +​ +​ +— +​ +4.3 +​ +4.3 +Insurance annuities +​ +​ +— +​ +​ +— +​ +​ +11.7 +​ +​ +11.7 +Cash and cash equivalents +​ +0.5 +​ +​ +— +​ +— +​ +0.5 +Total investments +​ +$ +48.0 +​ +$ +59.3 +​ +$ +24.5 +​ +$ +131.8 +​ +The following table sets forth by level, within the fair value hierarchy, pension plan assets at their fair value as of May 31, 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Level 1 (1) +Level 2 (2) +Level 3 (3) +Total +Equity securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. mutual funds +​ +$ +31.1 +​ +$ +— +​ +$ +— +​ +$ +31.1 +International mutual funds +​ +8.4 +​ +— +​ +— +​ +8.4 +Fixed income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Government securities and corporate bond mutual funds +​ +9.0 +​ +5.9 +​ +— +​ +14.9 +Funds-of-funds +​ +— +​ +53.0 +​ +7.9 +​ +60.9 +Hedge funds +​ +— +​ +— +​ +4.2 +​ +4.2 +Insurance annuities +​ +​ +— +​ +​ +— +​ +​ +9.9 +​ +​ +9.9 +Cash and cash equivalents +​ +0.5 +​ +— +​ +— +​ +0.5 +Total investments +​ +$ +49.0 +​ +$ +58.9 +​ +$ +22.0 +​ +$ +129.9 +(1) Quoted prices in active markets for identical assets that we have the ability to access as of the reporting date. +(2) Inputs other than quoted prices included within Level 1 that are directly observable for the asset or indirectly observable through corroboration with observable market data. +(3) Unobservable inputs, such as internally developed pricing models or third party valuations for the asset due to little or no market activity for the asset. +63 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +8. Employee Benefit Plans (Continued) +​ +The following table presents the reconciliation of Level 3 pension assets measured at fair value for the fiscal years ended May 31, 2020 and 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Hedge Funds +Fund-of-funds +Insurance Annuities +Total +Balance as of May 31, 2018 +​ +$ +4.4 +​ +$ +7.7 +​ +$ +7.8 +​ +$ +19.9 +Purchases +​ +— +​ +​ +— +​ +​ +2.1 +​ +​ +2.1 +Return on plan assets related to assets still held at May 31, 2019 +​ +​ +( 0.2 ) +​ +​ +0.2 +​ +​ +— +​ +​ +— +Balance as of May 31, 2019 +​ +4.2 +​ +​ +7.9 +​ +​ +9.9 +​ +​ +22.0 +Purchases +​ +​ +— +​ +​ +— +​ +​ +1.8 +​ +​ +1.8 +Sales +​ +​ +( 0.1 ) +​ +​ +— +​ +​ +— +​ +​ +( 0.1 ) +Return on plan assets related to assets still held at May 31, 2020 +​ +​ +0.2 +​ +​ +0.6 +​ +​ +— +​ +​ +0.8 +Balance as of May 31, 2020 +​ +$ +4.3 +​ +$ +8.5 +​ +$ +11.7 +​ +$ +24.5 +​ +Valuation Techniques Used to Determine Fair Value +Cash equivalents are investments with maturities of three months or less when purchased. The fair values are based on observable market prices and categorized as Level 1. +With respect to individually held equity securities, including investments in U.S. and international securities, the trustees obtain prices from pricing services, whose prices are obtained from direct feeds from market exchanges, which we are able to independently corroborate. Equity securities held individually are primarily traded on exchanges that contain only actively traded securities, due to the volume trading requirements imposed by these exchanges. Equity securities are valued based on quoted prices in active markets and categorized as Level 1. +Equity and fixed income mutual funds are maintained by investment companies that hold certain investments in accordance with a stated set of fund objectives, which are consistent with our overall investment strategy. The values of some of these funds are publicly quoted. For equity and fixed income mutual funds which are publicly quoted, the funds are valued based on quoted prices in active markets and have been categorized as Level 1. As certain of our funds-of-funds investments are also derived from quoted prices in active markets, we have categorized certain funds-of-funds investments as Level 2. +Hedge fund investments include those seeking to maximize absolute returns using a broad range of strategies to enhance returns and provide additional diversification. The fair value of hedge funds is determined using net asset value or its equivalent subject to certain restrictions, such as a lock-up period. As we may be limited in our ability to redeem the investments at the measurement date or within a reasonable period of time, the hedge fund investments are categorized as Level 3. Our other Level 3 investments require the utilization of unobservable inputs resulting in Level 3 treatment in the fair value hierarchy. +Future Benefit Payments and Funding +The following table summarizes our estimated future pension payments by fiscal year: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fiscal Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2026 to +​ +2021 +2022 +2023 +2024 +2025 +2030 +Estimated future pension payments +​ +$ +6.7 +​ +$ +6.1 +​ +$ +6.4 +​ +$ +5.8 +​ +$ +6.9 +​ +$ +35.4 +​ +64 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +8. Employee Benefit Plans (Continued) +​ +Our contribution policy for the domestic plans is to contribute annually, at a minimum, an amount which is deductible for federal income tax purposes and that is sufficient to meet actuarially computed pension benefits. For our Netherlands pension plan, our policy is to fund at least the minimum amount required by the local laws and regulations. We anticipate contributing approximately $ 3.1 million to our pension plans during fiscal 2021, which includes approximately $ 1.1 million of the Netherlands' fiscal 2020 contribution which was deferred to fiscal 2021. +Postretirement Benefits Other Than Pensions +We provide health and life insurance benefits for certain eligible retirees. The postretirement plan is unfunded and in fiscal 1995, we completed termination of postretirement health and life insurance benefits attributable to future services of collective bargaining and other domestic employees. The unfunded projected benefit obligation for this plan was $ 0.4 million and $ 0.4 million as of May 31, 2020 and 2019, respectively. We have omitted substantially all of the required disclosures related to this plan because the plan is not material to our consolidated financial position or results of operations. +Defined Contribution Plan +Our defined contribution plans are intended to qualify as a 401(k) plans under the Internal Revenue Code. Employees may contribute up to 75 % of their pretax compensation, subject to applicable regulatory limits and we may make discretionary matching contributions up to 5 % of employee compensation. We modified the contribution structure in fiscal 2020 to eliminate the profit sharing contribution for future years. Our contributions vest on a pro-rata basis during the first three years of employment. We also maintain a non-qualified retirement plan that makes up 401(k) benefits that would otherwise be lost as a result of Internal Revenue Code limits and provides additional employer contributions for certain executives and key employees to supplement the benefits provided by the defined contribution plans. +In response to the impact from COVID-19, we temporarily suspended our matching contributions to the defined contribution plans effective June 1, 2020. Expense charged to the Consolidated Statements of Income for our matching contributions, including profit sharing contributions, was $ 11.6 million in fiscal 2020, $ 11.4 million in fiscal 2019 and $ 9.2 million in fiscal 2018 for these plans. +65 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +9. Accumulated Other Comprehensive Loss +Changes in our accumulated other comprehensive loss (“AOCL”) by component for each of the years in the three-year period ended May 31, 2020 were as follows (all amounts are net of tax): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Currency +​ +​ +​ +​ +​ +​ +Translation +​ +Pension +​ +​ +​ +​ +Adjustments +​ +Plans +​ +Total +Balance as of June 1, 2017 +​ +$ +( 1.7 ) +​ +$ +( 38.2 ) +​ +$ +( 39.9 ) +Other comprehensive loss before reclassifications +​ +2.0 +​ +4.2 +​ +6.2 +Amounts reclassified from AOCL +​ +— +​ +1.7 +​ +1.7 +Total other comprehensive loss +​ +2.0 +​ +5.9 +​ +7.9 +Balance as of May 31, 2018 +​ +0.3 +​ +( 32.3 ) +​ +( 32.0 ) +Other comprehensive income (loss) before reclassifications +​ +( 2.4 ) +​ +​ +( 8.0 ) +​ +​ +( 10.4 ) +Amounts reclassified from AOCL +​ +— +​ +1.5 +​ +​ +1.5 +Total other comprehensive income (loss) +​ +( 2.4 ) +​ +( 6.5 ) +​ +​ +( 8.9 ) +Balance as of May 31, 2019 +​ +( 2.1 ) +​ +​ +( 38.8 ) +​ +​ +( 40.9 ) +Other comprehensive income before reclassifications +​ +0.1 +​ +​ +( 5.0 ) +​ +​ +( 4.9 ) +Amounts reclassified from AOCL +​ +— +​ +1.2 +​ +​ +1.2 +Total other comprehensive income +​ +0.1 +​ +​ +( 3.8 ) +​ +​ +( 3.7 ) +Balance as of May 31, 2020 +​ +$ +( 2.0 ) +​ +$ +( 42.6 ) +​ +$ +( 44.6 ) +​ +​ +10. Other Non-current Assets +​ +At May 31, 2020 and 2019, other non-current assets consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Contract assets +​ +$ +22.4 +​ +$ +17.0 +Investments in joint ventures +​ +​ +17.8 +​ +​ +12.3 +Cash surrender value of life insurance +​ +15.6 +​ +15.6 +Assets under deferred compensation plan +​ +​ +13.1 +​ +​ +10.4 +License fees +​ +​ +4.1 +​ +​ +7.2 +Other +​ +8.5 +​ +15.0 +​ +​ +$ +81.5 +​ +$ +77.5 +​ +Investments in Joint Ventures +​ +During fiscal 2018, we sold interests in two aircraft joint ventures, which were accounted for under the equity method of accounting. We received cash proceeds of $ 7.3 million and recognized a gain on the sale of $ 0.4 million. +​ +Under the terms of servicing agreements with certain of our aircraft joint ventures, we provide administrative services and technical advisory services, including aircraft evaluations, oversight and logistical support of the maintenance process and records management. We also provide evaluation and inspection services prior to the purchase of an aircraft and remarketing services with respect to the divestiture of aircraft by the joint ventures. During fiscal 2020, 2019, and 2018, we were paid $ 1.6 million, $ 0.4 million, and $ 0.4 million, respectively, for such services. +​ +Our investments in joint ventures include $ 12.6 million for our 40 % ownership interest in a joint venture in India to develop and operate an airframe maintenance facility. Facility construction is expected to be completed in fiscal 2021. +66 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +10. Other Non-current Assets (Continued) +​ +The investment balance as of May 31, 2020 includes $ 8.2 million related to the guarantee liability recognized in conjunction with our guarantee of 40 % of the Indian joint venture’s debt. The Indian joint venture is accounted for using the equity method. In addition, each of the partners in the Indian joint venture have a loan to the joint venture proportionate to its equity ownership. Our loan to the Indian joint venture under this arrangement was $ 3.0 million as of May 31, 2020. +In the fourth quarter of fiscal 2020, we decided to exit our joint venture which operates a landing gear wheel and brake repair and overhaul facility in Malaysia. In conjunction with the decision to exit the joint venture, we recognized an impairment charge of $ 1.9 million reflecting the anticipated net proceeds from our investment. The impairment charge is reported in Earnings (Loss) from joint ventures on the Consolidated Statement of Income. +License Fees +In June 2011, we entered into a ten-year agreement with Unison Industries (“Unison”) to be the exclusive worldwide aftermarket distributor for Unison’s electrical components, sensors, switches and other systems for aircraft and industrial uses. In June 2020, we entered into an extension and expansion of our agreement with Unison including a new termination date of December 31, 2031, an initial $ 25.0 million license fee paid in June 2020 to Unison, and annual license fees at a fixed percentage of our net sales of Unison products. The June 2020 payment of $ 25.0 million was capitalized and will be amortized on a straight-line basis over the term of the new agreement. +​ +11. Leases +We lease facilities, offices, vehicles, and equipment. We determine at inception whether an arrangement that provides us control over the use of an asset is a lease. ROU assets and lease liabilities are recognized on the Consolidated Balance Sheet at lease commencement date based on the present value of the future minimum lease payments over the lease term. Our lease agreements do not provide a readily determinable implicit rate nor is it available to us from our lessors. We estimate our incremental borrowing rate based on information available at lease commencement in order to discount lease payments to present value. +Our lease costs are allocated over the remaining lease term on a straight-line basis unless another systematic or rational basis is more representative of the pattern in which the underlying asset is expected to be used. ROU assets are evaluated for impairment in a manner consistent with the treatment of other long-lived assets. +Certain leases include options to renew or extend the terms of the lease, which are included in the determination of the ROU assets and lease liabilities when it is reasonably certain that the option will be exercised. Our leases may also include variable lease payments such as escalation clauses based on consumer price index rates, maintenance costs and utilities. Variable lease payments that depend on an index or a rate are included in the determination of ROU assets and lease liabilities using the index or rate at the lease commencement date, whereas variable lease payments that do not depend on an index or rate are recorded as lease expense in the period incurred. Our lease agreements do not contain any significant residual value guarantees or restrictive covenants. +​ +The summary of our operating lease cost is as follows: +​ +​ +​ +​ +​ +​ +Fiscal Year Ended +​ +​ +May 31, 2020 +Operating lease cost +​ +$ +18.4 +Short-term lease cost +​ +5.3 +Variable lease cost +​ +7.4 +​ +​ +$ +31.1 +​ +67 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +11. Leases (Continued) +​ +Rental expense for facilities and equipment during fiscal years 2019 and 2018 was $ 25.9 million and $ 23.5 million, respectively. +As a result of the COVID-19 pandemic, we entered into deferral agreements with our various landlords in the fourth quarter of fiscal 2020. Under these agreements, certain rent payments will be deferred or modified without penalty for various periods, generally for a minimum of three months . We have elected to account for lease concessions and deferrals resulting directly from COVID-19 as though the enforceable rights and obligations to the deferrals existed in the respective contracts at lease inception and will not account for the concessions as lease modifications. As of May 31, 2020, our total rent payments deferred under these arrangements was $ 0.6 million. +With the exception of a land lease for one of our airframe maintenance facilities that expires in 2108, our operating leases expire at various dates through 2034. Maturities of our operating lease payments as of May 31, 2020 are as follows: +​ +​ +​ +​ +​ +2021 +$ +16.5 +2022 +​ +14.5 +2023 +​ +12.7 +2024 +​ +10.7 +2025 +​ +8.3 +Thereafter +​ +36.5 +Total undiscounted payments +​ +99.2 +Less: Imputed interest +​ +( 14.6 ) +Present value of minimum lease payments +​ +84.6 +Less: Operating lease liabilities – current +​ +(13.7) +Operating lease liabilities – non-current +​ +$ +70.9 +​ +The current portion of operating lease liabilities are presented within Accrued liabilities on our Consolidated Balance Sheet. +As of May 31, 2020, the weighted average remaining lease term and discount rate for our operating leases were approximately 7.9 years and 3.5 %, respectively. +Supplemental cash flow information related to leases for the year ended May 31, 2020 was as follows: +​ +​ +​ +​ +​ +​ +Fiscal Year Ended +​ +​ +May 31, 2020 +Cash paid for amounts included in the measurement of lease liabilities +​ +$ +16.5 +Operating lease liabilities arising from obtaining ROU assets +​ +13.0 +​ +​ +12. Commitments and Contingencies +We enter into purchase obligations, which arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts and components, as well as equipment to support the operations of our business. The aggregate amount of purchase obligations due in each of the next five fiscal years is $ 344.8 million in 2021, $ 15.8 million in 2022, $ 5.4 million in 2023, $ 0.1 in 2024 and $ 0.1 million in 2025. +We routinely issue letters of credit and performance bonds in the ordinary course of our business. These instruments are typically issued in conjunction with insurance contracts or other business requirements. The total of these instruments outstanding at May 31, 2020 was approximately $ 31.5 million which includes $ 12.4 million related to a guarantee of 40 % of the outstanding debt of our Indian joint venture. We have recognized a current liability of $ 8.2 million based on the fair value of our guarantee obligation. +68 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +12. Commitments and Contingencies (Continued) +​ +We are involved in various claims and legal actions, including environmental matters, arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial condition or results of operations. +Government Actions to Mitigate COVID-19’s Impact +On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted in the U.S. in response to the COVID-19 pandemic. The CARES Act includes provisions relating to refundable payroll tax credits, deferral of the employer portion of certain payroll taxes, net operating loss carrybacks, and other areas. The payroll tax deferral requires that the deferred payroll taxes be paid over two years, with half of the amount required to be paid by December 31, 2021 and the other half by December 31, 2022. During the fourth quarter of fiscal 2020, we deferred $ 2.5 million of payroll taxes which are included in Other liabilities on our Consolidated Balance Sheet. +Certain subsidiaries of the Company expect to receive $ 57.2 million from the U.S. Treasury Department through the Payroll Support Program under the CARES Act. These funds will be used exclusively for the continuation of payment of employee wages, salaries and benefits for employees of those subsidiaries. Of the $57.2 million total amount expected to be received, approximately $ 48.5 million will be a direct grant and approximately $ 8.7 million will be in the form of a low interest 10-year senior unsecured promissory note. We expect that certain corporate restrictions will apply to us and those subsidiaries for approximately the next two years including restrictions on dividends, stock repurchases, employee compensation, and certain workforce actions. +Other countries have enacted similar legislation to provide relief and stimulus measures to assist companies in mitigating the financial impact from COVID-19 and supporting their employees. During the fourth quarter of fiscal 2020, our foreign subsidiaries recognized employment subsidies of $ 2.8 million from foreign governments which have been deducted from the related expenses on our Consolidated Statement of Income. +​ +13. Acquisition +On September 19, 2017, we acquired the outstanding shares of two MRO facilities in Canada owned by Premier Aviation for approximately $ 24.8 million. The purchase price includes $ 22.9 million paid at closing with the remaining deferred consideration paid in September 2018. This business is included in our Aviation Services segment. The fair value of assets acquired and liabilities assumed is as follows: +​ +​ +​ +​ +​ +Current assets +$ +4.4 +Property and equipment +​ +15.1 +Intangible assets, including goodwill +​ +14.6 +Accounts payable and accrued liabilities +​ +( 9.3 ) +​ +​ +$ +24.8 +​ +​ +14. Business Segment Information +Segment Reporting +Consistent with how our chief operating decision making officer (Chief Executive Officer) evaluates performance and the way we are organized internally, we report our activities in two segments: Aviation Services comprised of supply chain and MRO activities and Expeditionary Services comprised of manufacturing activities. +14. Business Segment Information (Continued) +​ +69 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +The Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance-based logistics programs, customer fleet management and operations, and aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of product, direct labor, and overhead. +The Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support the U.S. military’s requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. This segment also designs and manufactures advanced composite materials for commercial, business and military aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead. +The accounting policies for the segments are the same as those described in Note 1. Our chief operating decision making officer (Chief Executive Officer) evaluates performance based on the reportable segments and utilizes gross profit as a primary profitability measure. Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments. Our reportable segments are aligned principally around differences in products and services. +Selected financial information for each segment is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Net sales: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services +​ +$ +1,964.2 +​ +$ +1,920.6 +​ +$ +1,635.8 +Expeditionary Services +​ +107.8 +​ +131.2 +​ +112.5 +​ +​ +$ +2,072.0 +​ +$ +2,051.8 +​ +$ +1,748.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Gross profit: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services +​ +$ +267.3 +​ +$ +313.6 +​ +$ +274.8 +Expeditionary Services +​ +1.9 +​ +16.2 +​ +19.3 +​ +​ +$ +269.2 +​ +$ +329.8 +​ +$ +294.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Total assets: +​ +​ +​ +​ +​ +​ +Aviation Services +​ +$ +1,502.5 +​ +$ +1,346.8 +Expeditionary Services +​ +103.6 +​ +94.7 +Corporate and discontinued operations +​ +​ +472.9 +​ +​ +75.7 +​ +​ +$ +2,079.0 +​ +$ +1,517.2 +​ +70 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +14. Business Segment Information (Continued) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Capital expenditures: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services +​ +$ +16.9 +​ +$ +15.1 +​ +$ +18.9 +Expeditionary Services +​ +5.4 +​ +1.4 +​ +1.8 +Corporate +​ +1.3 +​ +0.9 +​ +1.3 +Total continuing operations +​ +​ +23.6 +​ +​ +17.4 +​ +​ +22.0 +Discontinued operations +​ +​ +— +​ +​ +0.5 +​ +​ +5.0 +​ +​ +$ +23.6 +​ +$ +17.9 +​ +$ +27.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Depreciation and amortization: 1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Aviation Services +​ +$ +39.2 +​ +$ +37.5 +​ +$ +34.6 +Expeditionary Services +​ +3.7 +​ +4.1 +​ +4.6 +Corporate +​ +8.1 +​ +14.7 +​ +16.6 +Total continuing operations +​ +​ +51.0 +​ +​ +56.3 +​ +​ +55.8 +Discontinued operations +​ +​ +— +​ +​ +— +​ +​ +7.3 +​ +​ +$ +51.0 +​ +$ +56.3 +​ +$ +63.1 +1 Includes amortization of stock-based compensation. +The following table reconciles segment gross profit to income from continuing operations before provision for income taxes. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Segment gross profit +​ +$ +269.2 +​ +$ +329.8 +​ +$ +294.1 +Provision for doubtful accounts +​ +​ +( 5.4 ) +​ +​ +( 15.8 ) +​ +​ +( 0.5 ) +Selling, general and administrative +​ +( 220.6 ) +​ +( 215.4 ) +​ +( 208.1 ) +Earnings (Loss) from joint ventures +​ +​ +( 1.9 ) +​ +​ +( 0.3 ) +​ +​ +0.5 +Other expenses +​ +​ +( 2.1 ) +​ +​ +( 0.8 ) +​ +​ +( 0.9 ) +Interest expense +​ +( 9.3 ) +​ +( 9.5 ) +​ +( 8.0 ) +Interest income +​ +0.5 +​ +1.0 +​ +0.1 +Income from continuing operations before provision for income taxes +​ +$ +30.4 +​ +$ +89.0 +​ +$ +77.2 +​ +The U.S. Department of Defense, U.S. Department of State, other U.S. government agencies and their contractors are our only customers representing 10% or more of total sales in any of the last three fiscal years. Sales by segment for these customers are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Aviation Services +​ +$ +588.7 +​ +$ +455.9 +​ +$ +241.3 +​ +Expeditionary Services +​ +79.5 +​ +90.3 +​ +63.0 +​ +​ +​ +$ +668.2 +​ +$ +546.2 +​ +$ +304.3 +​ +Percentage of total sales +​ +32.2 +% +26.6 +% +17.4 +% +​ +71 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +14. Business Segment Information (Continued) +​ +Sales across the major customer markets for each of our operating segments for the fiscal years ended May 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Aviation Services: +​ +​ +​ +Commercial +​ +$ +1,268.9 +​ +$ +1,342.3 +​ +$ +1,281.9 +Government and defense +​ +695.3 +​ +578.3 +​ +353.9 +​ +​ +$ +1,964.2 +​ +$ +1,920.6 +​ +$ +1,635.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services: +​ +​ +​ +Commercial +​ +$ +24.3 +​ +$ +31.6 +​ +$ +37.5 +Government and defense +​ +83.5 +​ +99.6 +​ +75.0 +​ +​ +$ +107.8 +​ +$ +131.2 +​ +$ +112.5 +​ +Sales by type of product/service was as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Aviation supply chain +​ +$ +1,434.3 +​ +$ +1,395.2 +​ +$ +1,082.9 +Maintenance, repair and overhaul services +​ +​ +529.9 +​ +525.4 +​ +552.9 +Mobility products +​ +​ +107.8 +​ +131.2 +​ +112.5 +​ +​ +$ +2,072.0 +​ +$ +2,051.8 +​ +$ +1,748.3 +​ +72 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +14. Business Segment Information (Continued) +​ +Geographic Data +Sales by geographic region for the fiscal years ended May 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +For the Year Ended May 31, +​ +2020 +2019 +2018 +Aviation Services: +​ +​ +​ +North America +​ +$ +1,505.6 +​ +$ +1,426.8 +​ +$ +1,131.4 +Europe/Africa +​ +330.8 +​ +323.4 +​ +325.9 +Other +​ +127.8 +​ +170.4 +​ +178.5 +​ +​ +$ +1,964.2 +​ +$ +1,920.6 +​ +$ +1,635.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Expeditionary Services: +​ +​ +​ +North America +​ +$ +98.4 +​ +$ +124.1 +​ +$ +105.3 +Europe/Africa +​ +9.0 +​ +5.8 +​ +6.9 +Other +​ +0.4 +​ +1.3 +​ +0.3 +​ +​ +$ +107.8 +​ +$ +131.2 +​ +$ +112.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +May 31, +​ +2020 +2019 +Long-lived assets: +​ +​ +​ +​ +United States +​ +$ +423.9 +​ +$ +345.4 +Europe +​ +102.1 +​ +108.7 +Other +​ +114.3 +​ +110.6 +​ +​ +$ +640.3 +​ +$ +564.7 +​ +Sales to unaffiliated customers in foreign countries (including sales through foreign sales offices of domestic subsidiaries) were approximately $ 591.8 million ( 28.6 % of total sales), $ 661.8 million ( 32.3 % of total sales) and $ 694.0 million ( 39.7 % of total sales) in fiscal 2020, 2019 and 2018, respectively. +​ +15. Legal Proceedings +We are not a party to any material pending legal proceeding (including any governmental or environmental proceeding) other than routine litigation incidental to our business except for the following: +Department of Justice Investigation +The U.S. Department of Justice (“DoJ”), acting through the U.S. Attorney’s Office for the Southern District of Illinois, is conducting an investigation of AAR Airlift Group, Inc. ("Airlift"), a wholly-owned subsidiary of AAR CORP., under the federal civil False Claims Act (“FCA”). The investigation relates to Airlift’s performance of several contracts awarded by the U.S. Transportation Command concerning the operations and maintenance of rotary-wing and fixed-wing aircraft in Afghanistan and Africa, as well as several U.S. Navy contracts. In June 2018, the DoJ informed Airlift that part of the investigation was precipitated by a lawsuit filed under the qui tam provisions of the FCA by a former employee of Airlift. That lawsuit remains under seal. +​ +73 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +15. Legal Proceedings (Continued) +​ +Airlift is cooperating with the DoJ investigation. In order to explore whether a negotiated resolution of the matter is possible, and in an effort to minimize continuing legal defense costs, Airlift has entered into settlement discussions with the DoJ. Airlift believes it has meritorious defenses and counter-arguments to the concerns raised by the DoJ; however, there is no assurance that any settlement will be achieved. If no settlement is reached, the DoJ and the qui tam plaintiff could pursue civil litigation under the FCA, which provides for the recovery of, among other amounts, treble damages and penalties. +​ +While we believe that it is probable that we will incur a loss from this matter, we cannot yet reasonably estimate the maximum amount of potential loss, nor can we provide any assurance that the ultimate resolution of the remaining exposure for this matter will not be material. +​ +Self-Reporting of Potential Foreign Corrupt Practices Act Violations +The Company retained outside counsel to investigate possible violations of the Company’s Code of Conduct, the U.S. Foreign Corrupt Practices Act, and other applicable laws, relating to the Company’s activities in Nepal and South Africa. Based on these investigations, we self-reported these matters to the DoJ, the U.S. Securities and Exchange Commission and the UK Serious Fraud Office. The Company is fully cooperating with the reviews by these agencies, although we are unable at this time to predict what action, if any, they may take. +​ +16. Sale of Composites Business +On June 23, 2020, we entered into an asset purchase agreement (the “Composites Sale Agreement”) for the sale of our aerostructures and aerospace products operations located in Clearwater, Florida and Sacramento, California (the “Composites”). The sale of Composites is consistent with our multi-year strategy to focus our portfolio on our core services offerings and the transaction will allow the Company to further prioritize its efforts in its principal businesses. The transaction is expected to close in the third quarter of calendar year 2020 and is subject to the satisfaction of customary closing conditions. +In connection with the entry into the Composites Sale Agreement, we anticipate recognizing an impairment charge of approximately $ 20 million in the first quarter of fiscal 2021. The impairment charge reduces the net assets of Composites to the estimated net proceeds we expect to receive, which is comprised of both cash received at closing of the transaction and the fair value of contingent consideration related to achievement of sales targets for Composites over the next three years . +​ +74 +Table of Contents +AAR CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) +(Dollars in millions, except per share amounts) +​ +17. Selected Quarterly Data (Unaudited) +The unaudited selected quarterly data for fiscal years ended May 31, 2020 and 2019 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +First +​ +Second +​ +Third +​ +Fourth +​ +Full +Fiscal 2020 +Quarter +Quarter +Quarter +Quarter +Year +Sales +​ +$ +541.5 +​ +$ +560.9 +​ +$ +553.1 +​ +$ +416.5 +​ +$ +2,072.0 +Operating income (loss) (1) +​ +22.8 +​ +28.1 +​ +5.3 +​ +( 14.9 ) +​ +41.3 +Income (Loss) from continuing operations +​ +17.1 +​ +20.1 +​ +2.6 +​ +( 15.0 ) +​ +24.8 +Loss from discontinued operations (2) +​ +( 12.7 ) +​ +( 5.9 ) +​ +( 0.3 ) +​ +( 1.5 ) +​ +( 20.4 ) +Net income (loss) +​ +​ +4.4 +​ +​ +14.2 +​ +​ +2.3 +​ +​ +( 16.5 ) +​ +​ +4.4 +Earnings (Loss) per share - basic : (3) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing operations +​ +​ +0.49 +​ +​ +0.58 +​ +​ +0.08 +​ +​ +( 0.43 ) +​ +​ +0.71 +Discontinued operations +​ +( 0.37 ) +​ +( 0.17 ) +​ +( 0.01 ) +​ +( 0.04 ) +​ +( 0.59 ) +Earnings (Loss) per share - basic +​ +0.12 +​ +0.41 +​ +0.07 +​ +( 0.47 ) +​ +0.12 +Earnings (Loss) per share - diluted : (3) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing operations +​ +​ +0.49 +​ +​ +0.57 +​ +​ +0.07 +​ +​ +( 0.43 ) +​ +​ +0.71 +Discontinued operations +​ +​ +( 0.36 ) +​ +​ +( 0.17 ) +​ +​ +( 0.01 ) +​ +​ +( 0.04 ) +​ +​ +( 0.58 ) +Earnings (Loss) per share - diluted +​ +​ +0.13 +​ +​ +0.40 +​ +​ +0.06 +​ +​ +( 0.47 ) +​ +​ +0.13 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +First +​ +Second +​ +Third +​ +Fourth +​ +Full +Fiscal 2019 +Quarter +Quarter +Quarter +Quarter +Year +Sales +​ +$ +466.3 +​ +$ +493.3 +​ +$ +529.5 +​ +$ +562.7 +​ +$ +2,051.8 +Operating income +​ +22.4 +​ +16.8 +​ +29.8 +​ +29.3 +​ +98.3 +Income from continuing operations +​ +​ +18.9 +​ +11.2 +​ +27.4 +​ +26.6 +​ +84.1 +Loss from discontinued operations (2) +​ +​ +( 3.8 ) +​ +( 4.2 ) +​ +( 64.8 ) +​ +( 3.8 ) +​ +( 76.6 ) +Net income +​ +15.1 +​ +​ +7.0 +​ +​ +( 37.4 ) +​ +​ +22.8 +​ +​ +7.5 +Earnings (Loss) per share - basic : (3) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing operations +​ +​ +0.54 +​ +​ +0.32 +​ +​ +0.79 +​ +​ +0.77 +​ +​ +2.42 +Discontinued operations +​ +​ +( 0.11 ) +​ +( 0.12 ) +​ +( 1.87 ) +​ +( 0.11 ) +​ +( 2.22 ) +Earnings (Loss) per share - basic +​ +​ +0.43 +​ +0.20 +​ +( 1.08 ) +​ +0.66 +​ +0.20 +Earnings (Loss) per share - diluted : (3) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing operations +​ +0.54 +​ +​ +0.32 +​ +​ +0.78 +​ +​ +0.76 +​ +​ +2.40 +Discontinued operations +​ +​ +( 0.11 ) +​ +​ +( 0.12 ) +​ +​ +( 1.86 ) +​ +​ +( 0.11 ) +​ +​ +( 2.19 ) +Earnings (Loss) per share - diluted +​ +0.43 +​ +​ +0.20 +​ +​ +( 1.08 ) +​ +​ +0.65 +​ +​ +0.21 +(1) We recognized charges of $ 24.7 million and $ 6.6 million during the third and fourth quarters of fiscal 2020, respectively, related to the termination and restructuring of commercial PBH contracts. +In fiscal 2020, we recognized impairment charges of $ 11.0 million related to the exit of certain product lines across our operations. We also recognized costs of $ 4.9 million related to the closure of two facilities and $ 5.0 million for workforce actions including severance and furlough costs in fiscal 2020. +(2) We recognized an impairment charge in discontinued operations of $ 74.1 million during the third quarter of fiscal 2019 related to our COCO business reflecting the expected net proceeds to be received upon the completion of the sale of our DoD contracts and related assets. We recognized an impairment charge of $ 11.8 million in the first quarter of fiscal 2020 related to the sale of the remaining COCO operating contract. +(3) The earnings-per-share computation for the year is a separate, annual calculation. Accordingly, the sum of the quarterly earnings-per-share amounts does not necessarily equal the earnings per share for the year. +​ +​ +75 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not Applicable. +​ +ITEM 9A. CONTROLS AND PROCEDURES +Evaluation of Disclosure Controls and Procedures +We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Act”), as of May 31, 2020. This evaluation was carried out under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures. Therefore, effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. +Based upon our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of May 31, 2020, ensuring that information required to be disclosed in the reports that are filed under the Act is recorded, processed, summarized and reported in a timely manner. +Management Report on Internal Control Over Financial Reporting +Management of AAR CORP. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Act. The Company’s internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. GAAP and includes those policies and procedures that (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. Internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems which are determined to be effective provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer and oversight of the Board of Directors, assessed the effectiveness of our internal control over financial reporting as of May 31, 2020 based on the criteria for effective internal control over financial reporting described in Internal Control–Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +As disclosed in Part II, Item 9A Controls and Procedures in our Annual Report on Form 10-K for the fiscal year ended May 31, 2019, during the fourth quarter of fiscal 2019 we identified material weaknesses in internal control related to (a) our controls over the existence of inventories included in our inventory cycle counting, (b) information technology general controls (“ITGCs”), and (c) controls over vendor payment information. +During fiscal 2020, management implemented our previously disclosed remediation plan. During the fourth quarter of 2020, we completed our testing of the operating effectiveness of the implemented controls and found them to be effective. As a result we have concluded the material weaknesses have been remediated as of May 31, 2020. Based on our assessment, management concluded that the Company maintained effective internal control over financial reporting as of May 31, 2020. +KPMG LLP, our independent registered public accounting firm, has issued a report on the effectiveness of our internal control over financial reporting. That report appears below. +76 +Table of Contents +Changes in Internal Control Over Financial Reporting +Effective June 1, 2019, we adopted ASC 842, which amended the existing accounting standards for lease accounting. We have implemented certain changes to our internal controls over financial reporting to support the reporting and disclosure requirements of the new lease standard. Other than changes related to our material weakness remediation efforts and the new accounting processes, systems, and controls for lease accounting, there were no other changes in our internal control over financial reporting during fiscal 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +​ +​ +77 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Stockholders and Board of Directors +AAR CORP.: +Opinion on Internal Control Over Financial Reporting +We have audited AAR CORP.’s and subsidiaries’ (the Company) internal control over financial reporting as of May 31, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of May 31, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of May 31, 2020 and 2019, the related consolidated statements of income, comprehensive income (loss), changes in equity, and cash flows for each of the years in the three-year period ended May 31, 2020, and the related notes (collectively, the consolidated financial statements), and our report dated July 21, 2020 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +​ +​ +​ +/s/ KPMG LLP +​ +​ +Chicago, Illinois +​ +July 21, 2020 +​ +​ +​ +​ +78 +Table of Contents +ITEM 9B. OTHER INFORMATION +Not applicable. +​ +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information required by this item regarding the Directors of the Company and nominees for election of the Board is incorporated by reference to the information contained under the caption “Information about Our Director Nominees and Our Continuing Directors” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +The information required by this item regarding the Executive Officers of the Company appears under the caption “Supplemental Item: Executive Officers of the Registrant” following Part I, Item 4 above. +The information required by this item regarding the compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the information contained under the caption “Delinquent Section 16(a) Reports” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +The information required by this item regarding the identification of the Audit Committee as a separately-designated standing committee of the Board and the status of one or more members of the Audit Committee being an “audit committee financial expert” is incorporated by reference to the information contained under the caption “the Board’s Role and Responsibilities – Role and Responsibilities of the Board Committees” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +The information required by this item regarding our Code of Business Ethics and Conduct applicable to our directors, officers and employees is incorporated by reference to the information contained under the caption “Board Practices and Policies – Code of Business Ethics and Conduct” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +There have been no material changes to the procedures by which stockholders may recommend nominees to the Company’s board of directors. The information regarding these procedures is incorporated by reference to the information contained under the caption “Our Strategy – Director Nominations and Qualifications” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +​ +ITEM 11. EXECUTIVE COMPENSATION +The information required by this item is incorporated by reference to the information contained under the captions ‘‘Executive Compensation” and ‘‘Director Compensation” of our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information required by this item regarding security ownership of certain beneficial owners and management is incorporated by reference to the information contained under the caption “Stock Ownership Information” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +The information required by this item regarding equity compensation plan information is incorporated by reference to the information contained under the caption “Equity Compensation Plan Information” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +​ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information required by this item is incorporated by reference to the information contained under the captions “Our Strategy – Director Independence” and “Board Practices and Policies – Related Person Transaction Policy” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +79 +Table of Contents +​ +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES +The information required by this item is incorporated by reference to the information contained under the caption “Independent Registered Public Accounting Firm Fees and Services” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders. +​ +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) (1) Financial Statements +Our consolidated financial statements are as set forth under Item 8 of this report on Form 10-K. +(a) (2) Financial Statement Schedules +All schedules are omitted because they are not applicable, not required, or the information is included in the consolidated financial statements. +(a) (3) Exhibits +Management contracts and compensatory arrangements have been marked with an asterisk (*) on the Exhibit Index which is contained below: +​ +​ +Index +​ +Exhibits +​ +​ +​ +​ +3. +Articles of Incorporation and By-Laws +3.1 +Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2004) +​ +​ +​ +​ +​ +​ +3.2 +By-Laws, as amended July 9, 2018 (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K dated July 13, 2018) +​ +​ +​ +​ +​ +​ +3.3 +Certificate of Designations for AAR CORP.’s Series A Junior Participating Preferred Stock (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K dated March 30, 2020) +​ +​ +​ +​ +4. +Instruments defining the rights of security holders +4.1 +Restated Certificate of Incorporation (see Exhibit 3.1). +​ +​ +​ +​ +​ +​ +4.2 +By-Laws, as amended and restated through July 9, 2008 (See Exhibit 3.2). +​ +​ +​ +​ +​ +​ +4.3 +Description of Capital Stock (filed herewith) +​ +​ +​ +​ +​ +​ +4.4 +Rights Agreement, dated as of March 30, 2020, by and between AAR CORP. and Computershare Trust Company, N.A., as Rights Agent (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K dated March 30, 2020) +​ +​ +​ +​ +​ +​ +4.5 +Indenture providing for Issuance of Debt Securities between AAR CORP. as Issuer and U.S. Bank +80 +Table of Contents +​ +Index +​ +Exhibits +​ +​ +​ +​ +National Association, as Trustee dated as of December 1, 2010 (incorporated by reference to Exhibit 4.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended November 30, 2010) +​ +​ +​ +​ +​ +​ +4.6 +Indenture providing for Issuance of Subordinated Debt Securities between AAR CORP. as Issuer and U.S. Bank National Association, as Trustee dated as of December 1, 2010 (incorporated by reference to Exhibit 4.2 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended November 30, 2010) +​ +​ +​ +​ +​ +​ +4.7 +Credit Agreement dated April 12, 2011 among AAR CORP., Bank of America National Association, as administrative agent, and the various financial institutions party thereto, as amended on September 25, 2019 (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K dated September 27, 2019) +​ +Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, the Registrant is not filing certain documents. The Registrant agrees to furnish a copy of each such document upon the request of the Commission. +​ +​ +​ +​ +81 +Table of Contents +​ +Index +​ +Exhibits +​ +​ +​ +​ +10. +Material Contracts +10.1* +Amended and Restated AAR CORP. Stock Benefit Plan effective October 1, 2001 (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended November 30, 2001) , as amended June 27, 2003 (incorporated by reference to Exhibit 10.1 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2003) , as amended May 5, 2005 (incorporated by reference to Exhibit 10.1 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2005) , as amended July 12, 2005 (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended February 28, 2006) , as amended June 23, 2006 (incorporated by reference to Exhibit 10.1 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2007) , as amended January 23, 2007 (incorporated by reference to Exhibit 10.1 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2007) , as amended January 27, 2007 (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended February 29, 2008) , and as amend July 11, 2011 (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended August 31, 2011) +​ +​ +​ +​ +​ +​ +10.2* +AAR CORP. Directors’ Retirement Plan, dated April 14, 1992 (incorporated by reference to Exhibits to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 1992), amended May 26, 2000 (incorporated by reference to Exhibit 10.5 to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2000) and April 10, 2001 (incorporated by reference to Exhibit 10.5 to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2001) +​ +​ +​ +​ +​ +​ +10.3* +AAR CORP. Supplemental Key Employee Retirement Plan, as Amended and Restated effective July 13, 2020 (filed herewith) +​ +​ +​ +​ +​ +​ +10.4* +AAR CORP. Nonemployee Directors’ Deferred Compensation Plan, as Amended and Restated effective July 10, 2017 (incorporated by reference to Exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended May 31, 2019) +​ +​ +​ +​ +​ +​ +10.5 +Indenture dated October 3, 2003 between AAR Distribution, Inc. and iStar Garden City LLC (incorporated by reference to Exhibit 10.16 to the +82 +Table of Contents +​ +Index +​ +Exhibits +​ +​ +​ +​ +Registrant’s Quarterly Report on Form 10-Q for the quarter ended November 30, 2003) +​ +​ +​ +​ +​ +​ +10.6 +Lease Agreement dated October 3, 2003 between AAR Allen Services, Inc., as tenant and iStar Garden City LLC, as Landlord, and related Guaranty dated October 3, 2003 from Registrant to iStar Garden City LLC (incorporated by reference to Exhibit 10.17 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended November 30, 2003) +​ +​ +​ +​ +​ +​ +10.7 +Lease Agreement by and between Indianapolis Airport Authority and AAR Aircraft Services, Inc. dated as of December 19, 2014 (incorporated by reference to Exhibit 10.9 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2015) +​ +​ +​ +​ +​ +​ +10.8* +Form of Non-Employee Director Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.13 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2012) +​ +​ +​ +​ +​ +​ +10.9* +Form of Fiscal 2021 Director Restricted Stock Agreement (filed herewith) +​ +​ +​ +​ +​ +​ +10.10* +Form of Split Dollar Insurance Agreement (incorporated by reference to Exhibit 10.24 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2006) +​ +​ +​ +​ +​ +​ +10.11* +Form of Directors’ and Officers’ Indemnification Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended August 31, 2008) +​ +​ +​ +​ +​ +​ +10.12* +Form of Policy for Recoupment of Incentive Compensation (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2012) +​ +​ +​ +​ +​ +​ +10.13* +Section 162(m) Annual Cash Incentive Plan (incorporated by reference to Exhibit 10.23 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2015) +​ +​ +​ +​ +​ +​ +10.14* +AAR CORP. 2013 Stock Plan (incorporated by reference to Exhibit 10.24 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2015) and as amended July 11, 2016 (incorporated by reference to Exhibit 10 to the +83 +Table of Contents +​ +Index +​ +Exhibits +​ +​ +​ +​ +Registrant’s Current Report on Form 8-K dated October 11, 2016) +​ +​ +​ +​ +​ +​ +10.15* +Form of Severance and Change in Control Agreement (filed herewith) +​ +​ +​ +​ +​ +​ +10.16 +Credit Agreement among AAR CORP., as parent guarantor, AAR Canada Holdings ULC, as borrower, and Canadian Imperial Bank of Commerce, as lender, dated as of October 18, 2017 (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated October 18, 2017) +​ +​ +​ +​ +​ +​ +10.17 +Purchase Agreement dated February 23, 2018 by and among AAR CORP., as seller representative and servicer, the sellers time to time party thereto, and Citibank, N.A., as buyer (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated February 28, 2018) +​ +​ +​ +​ +​ +​ +10.18 +First Amendment to Purchase Agreement dated as of May 22, 2018 by and among AAR CORP., as seller representative and servicer, the sellers time to time party thereto, and Citibank, N.A., as buyer (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated May 25, 2018) +​ +​ +​ +​ +​ +​ +10.19* +Retirement Agreement dated May 24, 2018 between AAR CORP. and David P. Storch (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K dated May 25, 2018) +​ +​ +​ +​ +​ +​ +10.20* +Post-Retirement Agreement dated May 24, 2018 between AAR CORP. and David P. Storch (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K dated May 25, 2018) , as amended May 31, 2019 (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated June 4, 2019) and July 11, 2019 (incorporated by reference to Exhibits to the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2019). +​ +​ +​ +​ +​ +​ +10.21* +Amended and Restated Employment Agreement dated as of May 24, 2018 between AAR CORP. and John M. Holmes (incorporated by reference to Exhibit 10.4 to the Registrant’s Current Report on Form 8-K dated May 25, 2018) +​ +​ +​ +​ +​ +​ +10.22* +Form of AAR CORP. Fiscal 2020 Short-Term Incentive Plan (incorporated by reference to Exhibit +84 +Table of Contents +​ +Index +​ +Exhibits +​ +​ +​ +​ +10.1 to the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2019) +​ +​ +​ +​ +​ +​ +10.23* +Form of AAR CORP. Fiscal 2020 Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2019) +​ +​ +​ +​ +​ +​ +10.24* +Form of AAR CORP. Fiscal 2020 Restricted Stock Agreement (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2019) +​ +​ +​ +​ +​ +​ +10.25* +Form of AAR CORP. Fiscal 2020 Performance Restricted Stock Agreement (incorporated by reference to Exhibit 10.4 to the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended August 31, 2019) +​ +​ +​ +​ +​ +​ +10.26* +Retirement Agreement and Supplemental Release between AAR CORP. and Robert J. Regan (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated October 11, 2019) +​ +​ +​ +​ +21. +Subsidiaries of the Registrant +21.1 +Subsidiaries of AAR CORP. (filed herewith) +​ +​ +​ +​ +​ +​ +​ +​ +23. +Consents of experts and counsel +23.1 +Consent of Independent Registered Public Accounting Firm (filed herewith) +​ +​ +​ +​ +31. +31.1 +Section 302 Certification dated July 21, 2020 of John M. Holmes, President and Chief Executive Officer of Registrant (filed herewith) +​ +​ +​ +​ +​ +​ +31.2 +Section 302 Certification dated July 2 1 , 2020 of Sean M. Gillen, Vice President and Chief Financial Officer of Registrant (filed herewith) +​ +​ +​ +​ +32. +32.1 +Section 906 Certification dated July 21, 2020 of John M. Holmes, President and Chief Executive Officer of Registrant (filed herewith) +​ +​ +​ +​ +​ +​ +32.2 +Section 906 Certification dated July 21, 2020 of Sean M. Gillen, Vice President and Chief Financial Officer of Registrant (filed herewith) +​ +​ +​ +​ +85 +Table of Contents +​ +Index +​ +Exhibits +​ +​ +​ +​ +101. +101 +The following materials from the Registrant’s Annual Report on Form 10-K for the fiscal year ended May 31, 2020, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at May 31, 2020 and 2019, (ii) Consolidated Statements of Income for the fiscal years ended May 31, 2020, 2019, and 2018 , (iii) Consolidated Statements of Comprehensive Income for fiscal years ended May 31, 2020, 2019, and 2018, (iv) Consolidated Statements of Cash Flows for the fiscal years ended May 31, 2020, 2019, and 2018, (v) Consolidated Statement of Changes in Equity for the three years ended May 31, 2020 and (vi) Notes to Consolidated Financial Statements.** +** Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections. +​ +ITEM 16. FORM 10-K SUMMARY +Not applicable. +​ +86 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this annual report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. +​ +​ +AAR CORP. +​ +(Registrant) +​ +​ +Date: July 21, 2020 +BY: +/s/ JOHN M. HOLMES +​ +​ +John M. Holmes +​ +​ +President and Chief Executive Officer +​ +Pursuant to the requirements of the Securities Exchange Act of 1934, this annual report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. +​ +Signature +Title +Date +​ +​ +​ +​ +​ +​ +/s/ JOHN M. HOLMES +​ +President and Chief Executive Officer; +​ +​ +​ +John M. Holmes +​ +Director (Principal Executive Officer) +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ SEAN M. GILLEN +​ +Vice President and Chief Financial Officer +​ +​ +​ +Sean M. Gillen +​ +(Principal Financial Officer) +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ ERIC S. PACHAPA +​ +Vice President, Controller and Chief Accounting +​ +​ +​ +Eric S. Pachapa +​ +Officer (Principal Accounting Officer) +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ DAVID P. STORCH +​ +Chairman of the Board; Director +​ +​ +​ +David P. Storch +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ ANTHONY K. ANDERSON +​ +Director +​ +​ +​ +Anthony K. Anderson +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ MICHAEL R. BOYCE +​ +Director +​ +​ +​ +Michael R. Boyce +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ H. JOHN GILBERTSON, JR. +​ +Director +​ +​ +​ +H. John Gilbertson, Jr. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +July 21, 2020 +/s/ JAMES E. GOODWIN +​ +Director +​ +​ +​ +James E. Goodwin +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ ROBERT F. LEDUC +​ +Director +​ +​ +​ +Robert F. Leduc +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ PATRICK J. KELLY +​ +Director +​ +​ +​ +Patrick J. Kelly +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ DUNCAN J. MCNABB +​ +Director +​ +​ +​ +Duncan J. McNabb +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ PETER PACE +​ +Director +​ +​ +​ +Peter Pace +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ JENNIFER L. VOGEL +​ +Director +​ +​ +​ +87 +Table of Contents +Signature +Title +Date +Jennifer L. Vogel +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ MARC J. WALFISH +​ +Director +​ +​ +​ +Marc J. Walfish +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ RONALD B. WOODARD +​ +Director +​ +​ +​ +Ronald B. Woodard +​ +​ +​ +​ +​ +​ +​ +88 \ No newline at end of file diff --git a/raw/filings/0000001750/2020/0001104659-20-085310/filing_metadata.csv b/raw/filings/0000001750/2020/0001104659-20-085310/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..e32381903f3a8d0c707e1b8ad32db3053e98eae8 --- /dev/null +++ b/raw/filings/0000001750/2020/0001104659-20-085310/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000001750,AIR,AAR CORP,2020,10-K,2020-07-21,2020-05-31,2020-07-21T21:19:15.000Z,0001104659-20-085310,air-20200531x10k.htm,10-K,17203985,1,1,https://www.sec.gov/Archives/edgar/data/1750/000110465920085310/air-20200531x10k.htm,https://www.sec.gov/Archives/edgar/data/1750/000110465920085310/ diff --git a/raw/filings/0000001750/2020/0001104659-20-085310/item1.txt b/raw/filings/0000001750/2020/0001104659-20-085310/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..fbd7e93f5fcd342a11d256d9384e74d957ae9812 --- /dev/null +++ b/raw/filings/0000001750/2020/0001104659-20-085310/item1.txt @@ -0,0 +1,62 @@ +ITEM 1. BUSINESS +General +AAR CORP. and its subsidiaries are referred to herein collectively as “AAR,” “Company,” “we,” “us,” and “our” unless the context indicates otherwise. AAR was founded in 1951, organized in 1955 and reincorporated in Delaware in 1966. We are a diversified provider of products and services to the worldwide aviation and government and defense markets. +Fiscal 2020 began with strategic initiatives focused on growth and execution across all of our activities in the commercial and government markets. Our momentum from a successful fiscal 2019 carried into the new year as we saw continued strength in our parts supply activities, as well as in government programs. We also realized the positive impact our efforts to attract and retain talent had in our maintenance, repair and overhaul (“MRO”) activities. +We succeeded in enhancing customer relationships with multiple commercial and government customers. In fiscal 2020, we were awarded a new $118 million contract from the Naval Air Systems Command in support of the U.S. Marine Corps for the procurement, modification and delivery of two C-40 aircraft. This award demonstrates the power of our integrated services model by combining the strengths of our parts supply, government programs, MRO, and engineering teams to deliver a creative solution to the U.S. Marine Corps. +We were also awarded new long-term contracts across our parts supply activities including multiple distribution agreements for new parts and our largest commercial agreement in Japan to date covering aftermarket engine components. Our strategy to exit the capital-intensive Contractor-Owned, Contractor-Operated (“COCO”) business was also completed in fiscal 2020 as all of its assets and contracts were sold. +As we continued to successfully execute on our recent contract awards over the last few years, we achieved strong sales growth through the first nine months of fiscal 2020 and were on track for a record year. Sales had increased $166.4 million or 11.2% over the prior year period primarily due to an increase in sales of $175.5 million or 12.5% in our Aviation Services segment reflecting the growth from new contract awards and successful execution across our Aviation Services activities. +Upon entering the fourth quarter in March, we began to see the impact of the COVID-19 pandemic on the commercial aviation industry. In response to the impact from COVID-19, we implemented significant actions to reduce fixed costs and overhead which included a freeze on new hiring, reducing or eliminating all non-essential spend, reducing compensation and benefits, furloughs, a reduction in force, and closure of an airframe maintenance facility. During the fourth quarter, we also exited underperforming contracts and assets across our operations and decided to exit our joint venture investment in a Malaysian landing gear wheel and brake facility. Additionally, in June 2020, we decided to sell our composites manufacturing business which is consistent with our multi-year strategy to focus our portfolio on our core services offerings. +We have also taken actions to preserve flexibility in our liquidity. In the fourth quarter, we elected to draw down our remaining available borrowings under our Revolving Credit Facility with the majority of that additional funding remaining in our cash accounts. We elected to borrow these additional amounts as a precautionary measure in light of economic and market uncertainty presented by COVID-19. +Over the long-term, we expect to see continued strength in our Aviation Services segment given its offerings of value-added services to both commercial and government and defense customers. We believe long-term commercial aftermarket growth trends are favorable although there is uncertainty in certain fleet types as commercial operators re-evaluate their structure. Our results of operations are affected by the amount of commercial aircraft flying and flight hours. The current COVID-19 pandemic has decreased the amount of commercial aircraft flying and flight hours and has created significant economic disruption. +2 +Table of Contents +Business Segments +Aviation Services +The Aviation Services segment provides aftermarket support and services for the commercial aviation and government and defense markets and accounted for approximately 95% of our sales in fiscal 2020, 2019, and 2018. In this segment, we also provide inventory management and distribution services, MRO, and engineering services. Business activities in this segment are primarily conducted through AAR Supply Chain, Inc.; AAR Government Services, Inc.; AAR Aircraft & Engine Sales & Leasing, Inc.; AAR Aircraft Services, Inc.; AAR Allen Services, Inc.; AAR Landing Gear LLC; AAR Airlift Group, Inc.; and AAR International, Inc. +We sell and lease a wide variety of new, overhauled and repaired engine and airframe parts and components and aircraft to our commercial aviation and government/defense customers. +We provide customized flight hour component inventory and repair programs, warranty claim management, and outsourcing programs for engine and airframe parts and components in support of our airline and government customers’ maintenance activities. The types of services provided under these programs include some or all of the following functions: material planning, sourcing, logistics, information and program management, and parts and component repair and overhaul. We are also an authorized distributor for more than 30 product lines which include parts from over 300 Federal Supply Class codes, which we source from over 25 leading aviation original equipment manufacturers (“OEM”s). +We provide fleet management and operations of customer-owned aircraft for the U.S. Department of State (“DoS”) under the INL/A WASS contract. We are the prime contractor on this ten-year performance-based contract which began in fiscal 2018. Our services under the contract include operating and maintaining the global DoS fleet of fixed- and rotary-wing aircraft. +We also provide customized performance-based supply chain logistics programs in support of the U.S. Department of Defense (“DoD”) and foreign governments. The types of services provided under these programs include some or all of the following functions: material planning, sourcing, logistics, information and program management, airframe maintenance and maintenance planning, and component repair and overhaul. +We provide major airframe inspection, maintenance, repair and overhaul, painting services, line maintenance, airframe modifications, structural repairs, avionics service and installation, exterior and interior refurbishment, and engineering services and support for many types of commercial and military aircraft. We also repair and overhaul various components, landing gears, wheels, and brakes for commercial and military aircraft. +We operate six airframe maintenance facilities and one landing gear overhaul facility. Our landing gear overhaul facility is in Miami, Florida, where we repair and overhaul landing gear, wheels, brakes, and actuators for different types of commercial and military aircraft. Our U.S. airframe maintenance facilities are in Indianapolis, Indiana; Oklahoma City, Oklahoma; Miami, Florida; and Rockford, Illinois and our Canadian airframe maintenance facilities are in Trois Rivieres, Quebec and Windsor, Ontario. In the fourth quarter of fiscal 2020, we announced our decision to close our airframe maintenance hangar in Duluth, Minnesota as the facility was only supporting a single customer and its location was not convenient for many of our customers' route networks. We recognized pretax closure costs of $4.3 million in the fourth quarter primarily related to severance costs and asset impairment charges. +In addition to our North American facilities, we also have an interest in a joint venture to develop and operate an airframe maintenance facility in India. The facility construction is expected to be completed in fiscal 2021. +The majority of our product sales are made pursuant to standard commercial purchase orders. Government sales are generally made under standard types of government contracts, which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. For cost plus fixed fee contracts, we typically receive reimbursement of our costs, to the extent the costs are allowable under contractual and regulatory provisions, in addition to receiving a fixed fee. Some of our contracts call for the performance of specified services or the delivery of specified products under indefinite delivery/indefinite quantity (“ID/IQ”) arrangements. Certain inventory supply and management and performance-based logistics program agreements reflect negotiated terms and conditions. +3 +Table of Contents +To support activities within the Aviation Services segment, we acquire aviation parts and components from domestic and foreign airlines, independent aviation service companies, aircraft leasing companies, and OEMs. We have ongoing arrangements with OEMs that provide us access to parts, repair manuals, and service bulletins in support of parts manufactured by them. Although the terms of each arrangement vary, they typically are made on standard OEM terms as to duration, price, and delivery. From time to time, we purchase airframes and engines for disassembly into individual parts and components. Airframes and engines may also be leased to airlines on a short-term basis prior to disassembly or sale. +Expeditionary Services +The Expeditionary Services segment primarily consists of businesses that provide products and services supporting the movement of equipment and personnel by the U.S. and foreign governments and non-governmental organizations. The Expeditionary Services segment accounted for approximately 5% of our sales in fiscal 2020, 2019, and 2018. Business activities in this segment are primarily conducted through AAR Manufacturing, Inc. and Brown International Corporation. +We design, manufacture, and repair transportation pallets and a wide variety of containers and shelters used in support of military and humanitarian tactical deployment activities. The containers and shelters are used in numerous mission requirements, including armories, supply and parts storage, refrigeration systems, tactical operation centers, briefing rooms, laundry and kitchen facilities, water treatment, and sleeping quarters. Shelters include both stationary and vehicle-mounted applications.We also provide engineering, design, and system integration services for specialized command and control systems. +We also design and manufacture advanced composite materials for commercial, business and military aircraft (“Composites”). On June 23, 2020, we entered into a definitive agreement to sell our Composites business as this divestiture is consistent with our multi-year strategy to focus our portfolio on our core services offerings. We expect the sale to close in the third quarter of calendar 2020 and will recognize a charge in the first quarter of fiscal 2021 of approximately $20 million in conjunction with the transaction. +Sales in this segment are generally made to customers pursuant to standard commercial purchase orders and contracts. Government sales are generally made under standard types of government contracts, which can include firm fixed-price contracts, cost plus fixed fee contracts, and time-and-materials contracts. Some of our contracts call for the performance of specified services or the delivery of specified products under ID/IQ arrangements, however, the majority of our products and services are procured via definite contracts. +Raw Materials +Although we generated approximately 55% of our fiscal 2020 sales from the sale of products, we are generally engaged in only limited manufacturing activities and have minimal exposure to fluctuations in both the availability and pricing of raw materials. We purchase raw materials for our manufacturing operations, including steel, aluminum, extrusions, balsa, and other necessary supplies from several vendors. Where necessary, we have been able to obtain raw materials and other inventory items from numerous sources for each segment at competitive prices, terms, and conditions, and we expect to be able to continue to do so. +Terms of Sale +We generally sell our products and services under standard 30-day payment terms. On occasion, certain customers will negotiate extended payment terms of 60-90 days. Except for customary warranty provisions, customers neither have the right to return products nor do they have the right to extended financing. Our government contracts may extend several years and include one or more base years and one or more option years. The government generally has the right not to exercise options to extend or expand our contracts and may otherwise terminate, cancel, or modify some contracts at its convenience. +Customers +The principal customers for our products and services in the Aviation Services segment are domestic and foreign passenger airlines, domestic and foreign cargo airlines, regional and commuter airlines, business and general aviation operators, OEMs, aircraft leasing companies, aftermarket aviation support companies, the DoD and its contractors, the DoS, and foreign military organizations or governments. In the Expeditionary Services segment, our principal customers include the DoD and its contractors, foreign military organizations or governments, defense organizations, and OEMs. +4 +Table of Contents +Sales of aviation products and services to our commercial airline customers are generally affected by such factors as the number, type and average age of aircraft in service, the levels of aircraft utilization (e.g., frequency of schedules, flying hours, and take-off and landing cycles), the number of airline operators, the general economy, and the level of sales of new and used aircraft. Sales to the DoD and other government agencies are subject to a number of factors, including the level of troop deployment worldwide, government funding, competitive bidding, and requirements generated by worldwide geopolitical events. +We primarily market and sell products and services through our own employees. In certain markets outside of the United States, we rely on foreign sales representatives to assist in the sale of our products and services. +Sales to Government and Defense Customers +Sales to global government and defense customers (including sales to branches, agencies, and departments of the U.S. government) were $778.8 million (37.6% of consolidated sales), $677.9 million (33.0% of consolidated sales) and $428.9 million (24.5% of consolidated sales) in fiscal 2020, 2019 and 2018, respectively. Sales to branches, agencies, and departments of the U.S. government and their contractors were $668.2 million (32.2% of consolidated sales), $546.2 million (26.6% of consolidated sales) and $304.3 million (17.4% of consolidated sales) in fiscal 2020, 2019, and 2018, respectively. +Sales to government and defense customers are reported in each of our reportable segments (See Note 14 of Notes to Consolidated Financial Statements). Since such sales are subject to competitive bidding and government funding, no assurance can be given that such sales will continue at levels previously experienced. The majority of our U.S. government sales are for products and services supporting the DoD logistics and mobility strategy and supporting DoS flight operations. Thus, our government contracts have changed, and may continue to change, with fluctuations in defense and other governmental agency spending and requirements. Our government contracts are also often subject to termination for convenience by the customer; in the event of such a termination, we are contractually entitled to recover all allowable costs incurred by us through the date of termination. +Government Regulation and Certificates +The Federal Aviation Administration (“FAA”) regulates the manufacture, repair, and operation of all aircraft and aircraft parts operated in the United States. Similar rules and regulatory authorities exist in other countries. The inspection, maintenance and repair procedures for the various types of aircraft and equipment are prescribed by these regulatory authorities and can be performed only by certified repair facilities utilizing certified technicians. The FAA requires that various maintenance routines be performed on aircraft engines, certain engine parts, and airframes at regular intervals based on take off and landing cycles or flight time. Our businesses, which sell defense products and services directly to the U.S. government or through its contractors, can be subject to various laws and regulations governing pricing and other factors. +We have 12 FAA certificated repair stations in the United States, Canada, and Europe. Of the 12 certificated FAA repair stations, seven are also European Aviation Safety Agency (“EASA”) and three are also Transport Canada Civil Aviation (“TCCA”) certificated repair stations. Such certificates, which are ongoing in duration, are required for us to perform authorized maintenance, repair, and overhaul services for our customers and are subject to revocation by the government for non-compliance with applicable regulations. Of the 12 FAA certificated repair stations, 11 are in the Aviation Services segment and one is held by Composites included in our Expeditionary Services segment, which is expected to be sold in third quarter of calendar 2020. The EASA and TCCA certificated repair stations are in the Aviation Services segment. We also have a FAR Part 135 certificate to operate aircraft, although the certificate is not active. We believe that we possess all licenses and certifications that are material to the conduct of our business. +Competition +Competition in each of our markets is based on quality, ability to provide a broad range of products and services, speed of delivery, and price. Competitors in our Aviation Services segment include OEMs, the service divisions of large commercial airlines, and other independent suppliers of parts, repair, and overhaul services to the commercial and defense markets. Our Expeditionary Services segment competes with a number of divisions of large corporations and other large and small companies. Although certain of our competitors have substantially greater financial and other resources than we do, we believe that we have maintained a satisfactory competitive position through our responsiveness to customer needs, our attention to quality, and our unique combination of market expertise and technical and financial capabilities. +5 +Table of Contents +Backlog +Backlog represents the amount of revenue that we expect to derive from unshipped orders or signed contracts. Backlog includes our remaining performance obligations based on the transaction price of firm orders for which work has not yet been performed as of May 31, 2020. Backlog excludes unexercised contract options and potential orders under contracts such as ID/IQ contracts. +At May 31, 2020, our firm backlog was approximately $1.0 billion and we expect that approximately 50% of this backlog will be recognized as revenue over the next 12 months, with the majority of the remaining balance recognized as revenue over the next three years. +Employees +At May 31, 2020, we employed approximately 5,400 employees worldwide, with approximately 1,200 of these employees on furlough as of that date due to our actions to mitigate the impact from COVID-19. Approximately 200 of our employees are subject to a collective bargaining agreement. We also retained approximately 170 contract workers as of May 31, 2020, the majority of whom are located at our airframe maintenance facilities. We retain these contract workers as they provide unique skill sets which are necessary at certain facilities as well as mitigate demand variability with our customers. +Available Information +For additional information concerning our business segments, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business Segment Information” in Note 14 of Notes to Consolidated Financial Statements under Item 8, “Financial Statements and Supplementary Data.” +Our internet address is www.aarcorp.com. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Information contained on our web site is not a part of this report. +​ +6 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000001750/2020/0001104659-20-085310/item13.txt b/raw/filings/0000001750/2020/0001104659-20-085310/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..9f5d4eda17fb74e28c5cfd554402365a73b794d5 --- /dev/null +++ b/raw/filings/0000001750/2020/0001104659-20-085310/item13.txt @@ -0,0 +1,6 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +79 +​ +​ +​ \ No newline at end of file diff --git a/raw/filings/0000001800/2018/0001047469-19-000624/filing.txt b/raw/filings/0000001800/2018/0001047469-19-000624/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..078a51a357354db18db56601ba0248499d914eb2 --- /dev/null +++ b/raw/filings/0000001800/2018/0001047469-19-000624/filing.txt @@ -0,0 +1,10398 @@ +10-K +1 +a2237733z10-k.htm +10-K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D. C. 20549 +FORM 10-K +(MARK ONE) +ý +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +OR +o +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2018 +Commission file number 1-2189 +Abbott Laboratories +An Illinois Corporation +36-0698440 +100 Abbott Park Road +Abbott Park, Illinois 60064-6400 +(I.R.S. employer identification number) +(224) 667-6100 +(telephone number) +Securities Registered Pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Shares, Without Par Value +New York Stock Exchange +Chicago Stock Exchange +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ý No o +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. +Yes o No ý +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities +Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing +requirements for the past 90 days. +Yes ý No o +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to +Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit +such files). +Yes ý No o +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this +chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this +Form 10-K or any amendment to this Form 10-K. ý +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or +an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer ý +Accelerated Filer o +Non-Accelerated Filer o +Smaller reporting company o +Emerging growth company o +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial +accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +Yes o No ý +The aggregate market value of the 1,710,210,374 shares of voting stock held by nonaffiliates of the registrant, computed by reference to the closing price +as reported on the New York Stock Exchange, as of the last business day of Abbott Laboratories' most recently completed second fiscal quarter (June 30, 2018), was $104,305,730,710. Abbott has +no non-voting common equity. Number of common shares outstanding as of January 31, 2019: 1,756,470,269 +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the 2019 Abbott Laboratories Proxy Statement are incorporated by reference into Part III. The Proxy Statement will be filed on or about +March 15, 2019. +PART I +ITEM 1. BUSINESS +GENERAL DEVELOPMENT OF BUSINESS +Abbott Laboratories is an Illinois corporation, incorporated in 1900. Abbott's* principal business is the discovery, development, manufacture, +and sale of a broad and diversified line of health care products. +NARRATIVE DESCRIPTION OF BUSINESS +Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Cardiovascular and +Neuromodulation Products. +On +October 3, 2017, Abbott completed the acquisition of Alere, Inc., a diagnostic device and service provider, for an aggregate consideration of approximately +$4.5 billion in cash. +On +February 27, 2017, Abbott completed the sale of Abbott Medical Optics, its vision care business, to Johnson & Johnson for $4.325 billion in cash. +On +January 4, 2017, Abbott completed the acquisition of St. Jude Medical, Inc., a global medical device manufacturer. Based on the closing Abbott share price on +January 4, 2017, the aggregate implied value of the consideration paid in connection with the acquisition was approximately $23.6 billion, including approximately $13.6 billion in +cash and approximately $10 billion in Abbott common shares. +Established Pharmaceutical Products +These products include a broad line of branded generic pharmaceuticals manufactured worldwide and marketed and sold outside the United States in +emerging markets. These products are generally sold directly to wholesalers, distributors, government agencies, health care facilities, pharmacies, and independent retailers from Abbott-owned +distribution centers and public +warehouses, depending on the market served. Certain products are co-marketed or co-promoted with, or licensed from, other companies. +The +principal products included in the broad therapeutic area portfolios of the Established Pharmaceutical Products segment are: +• gastroenterology products, including Creon™, for the treatment of pancreatic exocrine insufficiency associated with several +underlying conditions, including cystic fibrosis and chronic pancreatitis; Duspatal™ and Dicetel®, for the treatment of irritable bowel syndrome or biliary spasm; +Heptral™, Transmetil®, and Samyr®, for the treatment of intrahepatic cholestasis (associated with liver disease) or depressive symptoms; and Duphalac™, +for regulation of the physiological rhythm of the colon; +• women's health products, including Duphaston™, for the treatment of many different gynecological disorders; and +Femoston™, a hormone replacement therapy for postmenopausal women; +• cardiovascular and metabolic products, including Lipanthyl™ and TriCor®, for the treatment of dyslipidemia; +Teveten™ and Teveten™ Plus, for the treatment of essential hypertension, and Physiotens™, for the treatment of hypertension; and Synthroid™, for the +treatment of hypothyroidism; +• pain and central nervous system products, including Serc™, for the treatment of Ménière's disease and +vestibular vertigo; Brufen™, for the treatment of pain, fever, and inflammation, and Sevedol®, for the treatment of severe migraines; and +• respiratory drugs and vaccines, including the anti-infective clarithromycin (sold under the trademarks Biaxin®, +Klacid™, and Klaricid™); and Influvac™, an influenza vaccine. +* As +used throughout the text of this report on Form 10-K, the term "Abbott" refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and +its consolidated subsidiaries, as the context requires. +1 +The +Established Pharmaceutical Products segment directs its primary marketing efforts toward building a strong brand with key stakeholders, including consumers, pharmacists, physicians, +and other healthcare providers. Government agencies are also important customers. +Competition +in the Established Pharmaceutical Products segment is generally from other health care and pharmaceutical companies. In addition, the substitution of generic drugs for the +brand prescribed and introduction of additional forms of already marketed established products by generic or branded competitors may increase competitive pressures. +Diagnostic Products +These products include a broad line of diagnostic systems and tests manufactured, marketed, and sold worldwide. These products are generally +marketed and sold directly to blood banks, hospitals, commercial laboratories, clinics, physicians' offices, government agencies, alternate care +testing sites, and plasma protein therapeutic companies from Abbott owned distribution centers, public warehouses or third party distributors. +The +principal products included in the Diagnostic Products segment are: +• core laboratory systems in the areas of immunoassay, clinical chemistry, hematology, and transfusion, including the Alinity® family +of instruments, ARCHITECT®, ABBOTT PRISM®, and Cell-Dyn®, with assays used for screening and/or diagnosis for cancer, cardiac, metabolics, drugs of abuse, +fertility, general chemistries, infectious diseases such as hepatitis and HIV, and therapeutic drug monitoring; +• molecular diagnostics systems, including the m2000™, an instrument that automates the extraction, purification, and preparation of +DNA and RNA from patient samples, and detects and measures infectious agents including HIV, HBV, HCV, HPV, and CT/NG; and the Vysis® FISH product line of genomic-based tests; +• point of care systems, including the i-STAT® and next-generation i-STAT® Alinity® and cartridges for blood +analysis; +• rapid diagnostics systems in the areas of infectious disease, including respiratory illness such as influenza, HIV, and tropical diseases such +as malaria and dengue fever; molecular point-of-care testing for HIV, including the m-PIMA™ HIV-1/2 Viral Load Test, and for influenza A & B, RSV and strep A, including the ID +NOW™ rapid molecular system; cardiometabolic testing, including Afinion® and Cholestech™ platforms and tests; a toxicology business for drug and alcohol testing; +and remote patient monitoring and consumer self-testing; and +• informatics and automation solutions for use in laboratories, including laboratory automation systems, the RALS point of care solution, and +AlinIQ™, a suite of informatics tools and professional services. +The +Diagnostic Products segment's products are subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product +performance, laboratory efficiency, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid +product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors +introduce new products. +2 +Nutritional Products +These products include a broad line of pediatric and adult nutritional products manufactured, marketed, and sold worldwide. These products are +generally marketed and sold directly to consumers and to institutions, wholesalers, retailers, health care facilities, government agencies, and third-party distributors from Abbott-owned distribution +centers or third-party distributors. +The +principal products included in the Nutritional Products segment are: +• various forms of prepared infant formula and follow-on formula, including Similac®, Similac Pro-Advance®, +Similac® Advance®, Similac® Advance® Non-GMO, Similac Pro-Sensitive®, Similac Sensitive®, Similac Sensitive® +Non-GMO, Go&Grow by Similac®, Similac® NeoSure®, Similac® Organic, Similac® Special Care®, Similac Total Comfort®, +Similac® For Supplementation, Isomil® Advance®, Isomil®, Alimentum®, Gain™, Grow™, Similac En Mei Li™, +and Eleva™; +• adult and other pediatric nutritional products, including Ensure®, Ensure Plus®, Ensure® +Enlive®, Ensure® (with NutriVigor®), Ensure® Max Protein, Ensure® High Protein, Glucerna®, Glucerna Hunger Smart®, +ProSure®, PediaSure®, PediaSure SideKicks®, PediaSure® Peptide, EleCare®, Juven®, Abound®, Pedialyte® +and Zone Perfect®; and +• nutritional products used in enteral feeding in health care institutions, including Jevity®, Glucerna® 1.2 Cal, +Glucerna® 1.5 Cal, Osmolite®, Oxepa®, Freego® (Enteral Pump) and Freego® sets, Nepro®, and Vital®. +Primary +marketing efforts for nutritional products are directed toward consumers or to securing the recommendation of Abbott's brand of products by physicians or other health care +professionals. In addition, certain nutritional products sold as Similac®, Gain™, Grow™, Eleva™, PediaSure®, PediaSure +SideKicks®, Pedialyte®, Ensure®, Zone Perfect®, and Glucerna® are also promoted directly to the public by consumer marketing efforts in +select markets where appropriate. +Competition +for nutritional products in the segment is generally from other diversified consumer and health care manufacturers. Competitive factors include consumer advertising, +formulation, packaging, scientific innovation, price, retail distribution, and availability of product forms. A significant aspect of competition is the search for ingredient innovations. The +introduction of new products by competitors, changes in medical practices and procedures, and regulatory changes can result in product obsolescence. In addition, private label and local manufacturers' +products may increase competitive pressure. +Cardiovascular and Neuromodulation Products +These products include a broad line of rhythm management, electrophysiology, heart failure, vascular and structural heart devices for the +treatment of cardiovascular diseases, as well as neuromodulation devices for the management of chronic pain and movement disorders. These products are manufactured, marketed and sold worldwide. In the +United States, these products are generally marketed and sold directly to hospitals, ambulatory surgery centers, and physicians' offices from Abbott-owned distribution centers and public warehouses. +Outside the United States, sales are made either directly to customers or through distributors, depending on the market served. +The +principal products included in the Cardiovascular and Neuromodulation Products segment are: +• rhythm management products, including Assurity MRI® and Endurity MRI® pacemaker systems; Ellipse® and +Fortify Assura® implantable cardioverter defibrillators and Quadra Assura MP® implantable cardioverter defibrillator with cardiac resynchronization therapy and +MultiPoint® Pacing technology; +• electrophysiology products, including the TactiCath® family of ablation catheters and FlexAbility® irrigated ablation +catheters; Ampere® RF ablation generator; and EnSite Precision® cardiac +3 +mapping +system; Confirm Rx® implantable cardiac monitor; and the Advisor® HD Grid mapping catheter; +• heart failure related products, including the HeartMate™ left ventricular device family and the CardioMEMS® HF System +pulmonary artery sensor, a heart failure monitoring system; +• vascular products, including the XIENCE™ family of drug-eluting coronary stent systems developed on the Multi-Link +Vision® platform; StarClose SE® and Perclose ProGlide® vessel closure devices, TREK® coronary balloon dilatation products, Hi-Torque Balance +Middleweight Universal II® guidewires, Supera® Peripheral Stent System, a peripheral vascular stent system; Acculink®/Accunet® and +Xact®/Emboshield NAV6®, carotid stent systems; and the OPTIS® integrated system with the Dragonfly OPTIS® imaging catheter and PressureWire® +fractional flow reserve measurement systems; +• structural heart products, including MitraClip®, a percutaneous mitral valve repair system; Trifecta® Valve with +Glide™ Technology, a surgical tissue heart valve; Portico® transcatheter aortic heart valve, Regent™ mechanical heart valve, and AMPLATZER® PFO +occluders; and +• neuromodulation products, including spinal cord stimulators Proclaim™ Elite Recharge-free IPG and Prodigy MRI® IPG, +both with BurstDR® stimulation, and Proclaim® DRG IPG, a neurostimulation device designed for dorsal root ganglion therapy, for the treatment of chronic pain disorders; and the +Infinity® Deep Brain Stimulation System with directional lead technology for the treatment of movement disorders. +The +Cardiovascular and Neuromodulation Products segment's products are subject to competition in technological innovation, price, convenience of use, service, product performance, +long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory +changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +Other Products +The principal products in Abbott's other businesses include continuous glucose and blood glucose monitoring systems, including test strips, +sensors, data management decision software, and accessories for people with diabetes, under the FreeStyle® brand such as the FreeStyle Libre® system. These products are +marketed worldwide and generally sold directly to wholesalers, government agencies, private health care organizations, health care facilities, mail order pharmacies, and independent retailers from +Abbott-owned distribution centers and public warehouses. Some of these products are also marketed and distributed through distributors. Blood and continuous glucose monitoring systems are also +marketed and sold to consumers. These products are subject to regulatory changes and competition in technological innovation, price, convenience of use, service, and product performance. +INFORMATION WITH RESPECT TO ABBOTT'S BUSINESS IN GENERAL +Sources and Availability of Raw Materials +Abbott purchases, in the ordinary course of business, raw materials and supplies essential to Abbott's operations from numerous suppliers in the +United States and around the world. There have been no recent significant availability problems or supply shortages for raw materials or supplies. +Patents, Trademarks, and Licenses +Abbott is aware of the desirability for patent and trademark protection for its products. Accordingly, where possible, patents and trademarks +are sought and obtained for Abbott's products in the United States +4 +and +countries of interest to Abbott. Abbott owns or has licenses under a substantial number of patents and patent applications. Principal trademarks and the products they cover are discussed in the +Narrative Description of Business on pages 1 through 4. These, and various patents which expire during the period 2019 to 2039, in the aggregate, are believed to be of material importance in +the operation of Abbott's business. Abbott believes that no single patent, license, or trademark is material in relation to Abbott's business as a whole. +Seasonal Aspects, Customers, Backlog, and Renegotiation +There are no significant seasonal aspects to Abbott's business. Abbott has no single customer that, if the customer were lost, would have a +material adverse effect on Abbott. Orders for Abbott's products are generally filled on a current basis, and order backlog is not material to Abbott's business. No material portion of Abbott's +business is subject to renegotiation of profits or termination of contracts at the election of a government. +Environmental Matters +Abbott believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. +Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. Abbott's capital and operating +expenditures for pollution control in 2018 were not material and are not expected to be material in 2019. +Abbott +has been identified as one of many potentially responsible parties in investigations and/or remediations at several locations in the United States, including Puerto Rico, under +the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. Abbott is also engaged in remediation at several other sites, some of which are owned by Abbott, +in cooperation with the Environmental Protection Agency or similar agencies. While it is not feasible to predict with certainty the final costs related to those investigations and remediation +activities, Abbott believes that such costs, together with other expenditures to maintain compliance with applicable laws and +regulations concerning environmental protection, should not have a material adverse effect on Abbott's financial position, cash flows, or results of operations. +Employees +Abbott employed approximately 103,000 people as of December 31, 2018. +Regulation +The development, manufacture, marketing, sale, promotion, and distribution of Abbott's products are subject to comprehensive government +regulation by the U.S. Food and Drug Administration and similar international regulatory agencies. Government regulation by various international, supranational, federal and state agencies addresses +(among other matters) the development and approval to market Abbott's products, as well as the inspection of, and controls over, research and laboratory procedures, clinical investigations, product +approvals and manufacturing, labeling, packaging, supply chains, marketing and promotion, pricing and reimbursement, sampling, distribution, quality control, post-market surveillance, record keeping, +storage, and disposal practices. In addition, Abbott's clinical laboratories and associated testing services are subject to comprehensive government regulation, including registration, certification, +and licensure, by federal, state, and local agencies, such as the Centers for Medicare & Medicaid Services, the Drug Enforcement Administration, the Substance Abuse and Mental Health Services +Administration, and their respective foreign counterparts. Certain of these agencies require our clinical laboratories to meet quality assurance, quality control, and personnel standards and undergo +inspections. +5 +Abbott's +international operations are also affected by trade and investment regulations in many countries. These may require local investment, restrict Abbott's investments, or limit the +import of raw materials and finished products. +Abbott's +home monitoring services and related products and laboratories that provide Abbott and third-party medical devices to consumers in the United States are subject to additional +federal, state, and local laws and regulations applicable to health care providers and suppliers that submit claims for +reimbursement to third-party payors. Medicare, Medicaid, and other third-party payors may from time to time conduct inquiries, claims audits, investigations, and enforcement actions relating to the +claims or enrollment criteria. +Abbott +is subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback, anti-self-referral, and false claims laws in the United +States. Prescription drug, nutrition, and medical device manufacturers such as Abbott are also subject to taxes, as well as application, product, user, establishment, and other fees. Governmental +agencies can also invalidate intellectual property rights. +Compliance +with these laws and regulations is costly and materially affects Abbott's business. Among other effects, health care regulations substantially increase the time, difficulty, +and costs incurred in obtaining and maintaining approval to market newly developed and existing products. Abbott expects this regulatory environment will continue to require significant technical +expertise and investment to ensure compliance. Failure to comply can delay the release of a new product or result in regulatory and enforcement actions, the seizure or recall of a product, the +suspension or revocation of the authority necessary for a product's production and sale, suspension or revocation of billing privileges, and other civil or criminal sanctions, including fines and +penalties. Similarly, compliance with the laws and regulations governing clinical laboratories and testing services requires specialized expertise. Failure to comply with these regulatory requirements +can result in sanctions, including suspension, revocation, or limitation of a laboratory's certification, which is necessary to conduct business, as well as significant fines or criminal penalties. +Abbott's +business can also be affected by ongoing studies of the utilization, safety, efficacy, and outcomes of health care products and their components that are regularly conducted by +industry participants, government agencies, and others. These studies can call into question the utilization, safety, and efficacy of previously marketed products. In some cases, these studies have +resulted, and may in the future result, in the discontinuation of marketing of such products in one or more countries, and may give rise to claims for damages from persons who believe they have been +injured as a result of their use. +Access +to human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in many countries. A +major focus is cost containment. Efforts to reduce health care costs are also being made in the private sector, notably by health care payors and providers, which have instituted various cost +reduction and containment measures. Abbott expects insurers and providers will continue attempts to reduce the cost or utilization of health care products. Many countries control the price of health +care products directly or indirectly, through reimbursement, payment, pricing, or coverage limitations. Budgetary pressures on health care payors may also heighten the scope and severity of pricing +pressures on Abbott's products for the foreseeable future. +In +the United States, the federal government regularly evaluates reimbursement for medical devices, diagnostics, supplies, and other products, as well as the procedures in which these +products may be used. The government follows a diagnosis-related group (DRG) payment system for certain institutional +services provided under Medicare or Medicaid and has implemented a prospective payment system (PPS) for services delivered in hospital outpatient, nursing home, and home health settings. DRG and PPS +entitle a health care facility to a fixed reimbursement based on the diagnosis and/or procedure rather than actual costs incurred in patient treatment, thereby increasing the incentive for the +facility to limit or control expenditures for many health care products. Other payment methodology changes have been proposed and +6 +implemented +from time to time. For example, Medicare implemented a competitive bidding system for certain durable medical equipment (including diabetes products), enteral nutrition products, and +supplies. Additionally, the Protecting Access to Medicare Act establishes a new payment system for clinical laboratory tests, which became effective on January 1, 2018. +In +2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (together, the Affordable Care Act), imposed an excise tax on +Abbott and other medical device manufacturers and importers. The excise tax was subsequently suspended from January 1, 2016 through December 31, 2017 as part of the Consolidated +Appropriations Act of 2016. In January 2018, the excise tax was suspended for an additional two years. +The +Affordable Care Act also includes provisions known as the Physician Payments Sunshine Act, which requires manufacturers of drugs, devices, and medical supplies covered under Medicare +and Medicaid to record any transfers of value to physicians and teaching hospitals and to report this data to the Centers for Medicare & Medicaid Services for subsequent public disclosure. In +October 2018, the Substance Use Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act significantly expanded the types of healthcare providers for which +reporting is required, beginning with reports filed in 2022. Similar reporting requirements have also been enacted on the state level domestically, and an increasing number of governments worldwide +either have adopted or are considering similar laws requiring transparency of interactions with health care professionals. Failure to report appropriate data may result in civil or criminal fines +and/or penalties. +Policy +changes, including potential modification or repeal of all or parts of the Affordable Care Act, or implementation of new health care legislation, could result in significant +changes to the health care system. +The +regulation of data privacy and security, and the protection of the confidentiality of certain personal information (including patient health information and financial information), +is increasing. For example, the European Union has enacted stricter data protection laws, which took effect in 2018, that contain enhanced financial penalties for noncompliance. Similarly, the U.S. +Department of Health and Human Services has issued rules governing the use, disclosure, and security of protected health information, +and the U.S. Food and Drug Administration has issued further guidance concerning cybersecurity for medical devices. In addition, certain countries have issued or are considering "data localization" +laws, which limit companies' ability to transfer protected data across country borders. Failure to comply with data privacy and security laws and regulations can result in enforcement actions, which +could include civil or criminal penalties. Transferring and managing protected information will become more challenging as laws and regulations are enacted or amended, and Abbott expects there will be +increasing complexity in this area. +Governmental +cost containment efforts also affect Abbott's nutritional products business. In the United States, for example, under regulations governing the federally funded Special +Supplemental Nutrition Program for Women, Infants, and Children, all states must have a cost containment program for infant formula. As a result, through competitive bidding states obtain rebates from +manufacturers of infant formula whose products are used in the program. +Abbott +expects debate to continue at all government levels worldwide over the marketing, manufacture, availability, method of delivery, and payment for health care products and services, +as well as data privacy and security. Abbott believes that future legislation and regulation in the markets it serves could affect access to health care products and services, increase rebates, reduce +prices or reimbursements or the rate of price increases for health care products and services, change health care delivery systems, create new fees and obligations for the pharmaceutical, nutrition, +diagnostic, and medical device industries, or require additional reporting and disclosure. It is not possible to predict the extent to which Abbott or the health care industry in general might be +affected by the matters discussed above. +7 +INTERNET INFORMATION +Copies of Abbott's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments +to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through Abbott's investor relations website +( www.abbottinvestor.com ) as soon as reasonably practicable after Abbott electronically files the material with, or furnishes it to, the Securities and +Exchange Commission. These reports and other information are also available, free of charge, at www.sec.gov. +Abbott's +corporate governance guidelines, outline of directorship qualifications, code of business conduct and the charters of Abbott's audit committee, compensation committee, +nominations and +governance committee, and public policy committee are all available on Abbott's investor relations website ( www.abbottinvestor.com ). +8 +ITEM 1A. RISK FACTORS +In addition to the other information in this report, the following risk factors should be considered before deciding to invest in any of +Abbott's securities. Additional risks and uncertainties not presently known to Abbott, or risks Abbott currently considers immaterial, could also affect Abbott's actual results. Abbott's business, +financial condition, results of operations, or prospects could be materially adversely affected by any of these risks. +Abbott may acquire other businesses, license rights to technologies or products, form alliances, or dispose +of or spin-off businesses, which could cause it to incur significant expenses and could negatively affect profitability. +Abbott may pursue acquisitions, licensing arrangements, and strategic alliances, or dispose of or spin-off some of its businesses, as part of +its business strategy. Abbott may not complete these transactions in a timely manner, on a cost-effective basis, or at all, and may not realize the expected benefits. If Abbott is successful in making +an acquisition, the products and technologies that are acquired may not be successful or may require significantly greater resources and investments than originally anticipated. Abbott may not be able +to integrate acquisitions successfully into its existing business or transition disposed businesses efficiently, and could incur or assume significant debt and unknown or contingent liabilities. +Abbott could also experience negative effects on its reported results of operations from acquisition or disposition-related charges, amortization of expenses related to intangibles and charges for +impairment of long-term assets. These effects could cause a deterioration of Abbott's credit rating, result in increased borrowing costs and interest expense, and decrease liquidity. +Abbott is subject to cost containment efforts that could cause a reduction in future revenues and operating +income. +In the United States and other countries, Abbott's businesses have experienced downward pressure on product pricing. Cost containment efforts by +governments and private organizations are described in greater detail in the section captioned "Regulation." To the extent these cost containment efforts are not offset by greater patient access to +health care or other factors, Abbott's future revenues and operating income will be reduced. +Abbott is subject to numerous governmental regulations and it can be costly to comply with these regulations +and to develop compliant products and processes. +Abbott's products are subject to rigorous regulation by the U.S. Food and Drug Administration (FDA) and numerous international, supranational, +federal, and state authorities. The process of obtaining regulatory approvals to market a drug, medical device, or diagnostic product can be costly and time-consuming, and approvals might not be +granted for future products, or additional indications or uses of existing products, on a timely basis, if at all. Delays in the receipt of, or failure to obtain, approvals for future products, or new +indications and uses, could result in delayed realization of product revenues, reduction in revenues, and substantial additional costs. +In +addition, no assurance can be given that Abbott will remain in compliance with applicable FDA and other regulatory requirements once approval or marketing authorization has been +obtained for a product. These requirements include, among other things, regulations regarding manufacturing practices, product labeling, and advertising and postmarketing reporting, including adverse +event reports and field alerts. Many of Abbott's facilities and procedures and those of Abbott's suppliers are subject to ongoing regulation, including periodic inspection by the FDA and other +regulatory authorities. Abbott must incur expense and spend time and effort to ensure compliance with these complex regulations. Possible regulatory actions for non-compliance could include warning +letters, fines, damages, injunctions, civil penalties, recalls, seizures of Abbott's products, and criminal prosecution. +9 +These +actions could result in, among other things, substantial modifications to Abbott's business practices and operations; refunds, recalls, or seizures of Abbott's products; a total or +partial shutdown of production in one or more facilities while Abbott or Abbott's suppliers remedy the alleged violation; the inability to obtain future pre-market approvals or marketing +authorizations; and withdrawals or suspensions of current products from the market. Any of these events could disrupt Abbott's business and have a material adverse effect on Abbott's revenues, +profitability and financial condition. +Laws and regulations affecting government benefit programs could impose new obligations on Abbott, require +Abbott to change its business practices, and restrict its operations in the future. +Abbott's industry is subject to various international, supranational, federal, and state laws and regulations pertaining to government benefit +program reimbursement, price reporting and regulation, and health care fraud and abuse, including anti-kickback and false claims laws, and international and individual state laws relating to pricing +and sales and marketing practices. Violations of these laws may be punishable by criminal and/or civil sanctions, including, in some instances, substantial fines, imprisonment, and exclusion from +participation in government health care programs, including Medicare, Medicaid, and Veterans Administration health programs in the U.S. These laws and regulations are broad in scope and they are +subject to evolving interpretations, which could require Abbott to incur substantial costs associated with compliance or to alter one or more of its sales or marketing practices. In addition, +violations of these laws, or allegations of such violations, could disrupt Abbott's business and result in a material adverse effect on Abbott's revenues, profitability, and financial condition. +Changes in the health care regulatory environment may adversely affect Abbott's business. +Both in the U.S. and internationally, government authorities may enact changes in regulatory requirements, make legislative or administrative +reforms to existing reimbursement programs, make adverse decisions relating to our products' coverage or reimbursement, or make changes to patient access to health care, all of which could adversely +impact the demand for and usage of Abbott's products or the prices that Abbott's customers are willing to pay for them. +Further, +in the U.S., a number of the provisions of the U.S. Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 address access to +health care products and services and establish certain fees for the medical device industry. These provisions may be modified, repealed, or otherwise invalidated, in whole or in part. Future +rulemaking could affect rebates, prices or the rate of price increases for health care products and services, or required reporting and disclosure. Abbott cannot predict the timing or impact of any +future rulemaking or changes in the law. +For +additional information concerning health care regulation, see the discussion in "Regulation" under Item 1, "Business." +Abbott has incurred and assumed significant indebtedness, which has increased consolidated interest expense +and could decrease business flexibility. +Abbott incurred and assumed significant indebtedness in connection with the 2017 acquisitions of St. Jude Medical and Alere. As of +December 31, 2018, Abbott's consolidated indebtedness was approximately $19.6 billion. This consolidated indebtedness increased Abbott's consolidated interest expense and could have the +effect, among other things, of reducing Abbott's flexibility to respond to changing business and economic conditions, and reducing funds available for working capital, capital expenditures, +acquisitions, and other general corporate purposes. +Further, +Abbott may be required to raise additional financing for working capital, capital expenditures, future acquisitions or other general corporate purposes. Abbott's ability to +arrange additional financing or refinancing will depend on, among other factors, Abbott's financial position and performance, as well as prevailing market conditions and other factors beyond Abbott's +control. +10 +Consequently, +Abbott cannot assure that it will be able to obtain additional financing or refinancing on terms acceptable to Abbott or at all, which could adversely impact Abbott's ability to make +scheduled payments with respect to its consolidated indebtedness and its profitability and financial condition. +Additionally, +further borrowing could cause a deterioration of Abbott's credit rating. Abbott's credit ratings reflect each credit rating agency's then opinion of Abbott's financial +strength, operating performance, and ability to meet its debt obligations. Adverse changes in Abbott's credit ratings may result in increased borrowing costs for future long-term debt or short-term +borrowing facilities and may limit financing options, including access to the unsecured borrowing market. Abbott may also be subject to additional restrictive covenants that would reduce flexibility. +Abbott depends on sophisticated information technology systems and maintains protected personal data, and a +cyber attack or other breach affecting these information technology systems or protected data could have a material adverse effect on Abbott's results of operations. +Similar to other large multi-national companies, the size and complexity of the information technology systems on which Abbott relies for both +its infrastructure and products makes them susceptible to a cyber attack, malicious intrusion, breakdown, destruction, loss of data privacy, or other significant disruption. These systems have been +and are expected to continue to be the target of malware and other cyber attacks. In addition, third party hacking attempts may cause Abbott's information technology systems and related products, +protected data, or proprietary information to be compromised. A significant attack or other disruption could result in adverse consequences, including increased costs and expenses, problems with +product functionality, damage to customer relations, lost revenue, and legal or regulatory penalties. +Abbott +also collects, manages and processes protected personal data, including protected health information, in connection with certain medical products and service offerings. For +additional information concerning data privacy and security regulation, see the discussion in "Regulation" under Item 1, "Business." A breach of protected personal information could result in +adverse consequences, including regulatory inquiries or litigation, increased costs and expenses, reputational damage, lost revenue, and fines or penalties. +Abbott +invests in its systems and technology and in the protection of its products and data to reduce the risk of an attack or other significant disruption, and monitors its systems on +an ongoing basis for any current or potential threats and for changes in technology and the regulatory environment. There can be no assurance that these measures and efforts will prevent future +attacks or other significant disruptions to any of the systems on which Abbott relies or that related product issues will not arise in +the future. Any significant attack or other disruption on Abbott's systems or products could have a material adverse effect on Abbott's business. +The expiration or loss of patent protection and licenses may affect Abbott's future revenues and operating +income. +Many of Abbott's businesses rely on patent and trademark and other intellectual property protection. Although most of the challenges to Abbott's +intellectual property have come from other companies, governments may also challenge intellectual property protections. To the extent Abbott's intellectual property is successfully challenged, +invalidated, or circumvented or to the extent it does not allow Abbott to compete effectively, Abbott's businesses could suffer. To the extent that countries do not enforce Abbott's intellectual +property rights, Abbott's future revenues and operating income could be reduced. Any material litigation regarding Abbott's patents and trademarks is described in the section captioned "Legal +Proceedings." +11 +Competitors' intellectual property may prevent Abbott from selling its products or have a material adverse +effect on Abbott's future profitability and financial condition. +Competitors may claim that an Abbott product infringes upon their intellectual property. Resolving an intellectual property infringement claim +can be costly and time consuming and may require Abbott to enter into license agreements. Abbott cannot guarantee that it would be able to obtain license agreements on commercially reasonable terms. A +successful claim of patent or other intellectual property infringement could subject Abbott to significant damages or an injunction preventing the manufacture, sale or use of affected Abbott products. +Any of these events could have a material adverse effect on Abbott's profitability and financial condition. +Abbott's research and development efforts may not succeed in developing commercially successful products and +technologies, which may cause Abbott's revenue and profitability to decline. +To remain competitive, Abbott must continue to launch new products and technologies. To accomplish this, Abbott commits substantial efforts, +funds, and other resources to research and development. A risk of failure is inherent in the research and development of new products and technologies. Abbott must make ongoing substantial +expenditures without any assurance that its efforts will be commercially successful. Failure can occur at any point in the process, including after significant funds have been invested. +Promising +new products and technologies may fail to reach the market or may only have limited commercial success because of efficacy or safety concerns, failure to achieve positive +clinical outcomes, inability to obtain necessary regulatory approvals, limited scope of approved uses, excessive costs to manufacture, failure to establish or maintain intellectual property rights, or +infringement of the intellectual property rights of others. Even if Abbott successfully develops new products or enhancements or new generations of Abbott's existing products, they may be quickly +rendered obsolete by changing customer preferences, changing industry standards, or competitors' innovations. Innovations may not be accepted quickly in the marketplace because of, among other things, +entrenched patterns of clinical practice or uncertainty over third-party reimbursement. Abbott cannot state with certainty when or whether any of its products under development will be launched, +whether it will be able to develop, license, or otherwise acquire compounds or products, or whether any products will be commercially successful. Failure to launch successful new products or +technologies, or new indications or uses for existing products, may cause Abbott's products or technologies to become obsolete, causing Abbott's revenues and operating results to suffer. +New products and technological advances by Abbott's competitors may negatively affect Abbott's results of +operations. +Abbott's products face intense competition from its competitors' products. Competitors' products may be safer, more effective, more effectively +marketed or sold, or have lower prices or superior performance features than Abbott's products. Abbott cannot predict with certainty the timing or impact of the introduction of competitors' products. +The manufacture of many of Abbott's products is a highly exacting and complex process, and if Abbott or one +of its suppliers encounters problems manufacturing products, Abbott's business could suffer. +The manufacture of many of Abbott's products is a highly exacting and complex process, due in part to strict regulatory requirements. Problems +may arise during manufacturing for a variety of reasons, including equipment malfunction, failure to follow specific protocols and procedures, problems with raw materials, natural disasters, and +environmental factors. In addition, single suppliers are currently used for certain products and materials. If problems arise during the production of a lot or batch of product, those products may +have to be discarded. This could, among other things, lead to increased costs, lost revenue, damage to customer relations, time and expense spent investigating the cause and, depending on the cause, +12 +similar +losses with respect to other lots, batches or products. If problems are not discovered before the product is released to the market, recall and product liability costs may also be incurred. To +the extent Abbott or one of its suppliers experiences significant manufacturing problems, this could have a material adverse effect on Abbott's revenues and profitability. +Significant safety concerns could arise for Abbott's products, which could have a material adverse effect on +Abbott's revenues and financial condition. +Health care products typically receive regulatory approval based on data obtained in controlled clinical trials of limited duration. Following +regulatory approval, these products will be used over longer periods of time in many patients. Investigators may also conduct additional, and perhaps more extensive, studies. If new safety issues are +reported, Abbott may be required to amend the conditions of use for a product. For example, Abbott may be required to provide additional warnings on a product's label or narrow its approved intended +use, either of which could reduce the product's market acceptance. If serious safety issues arise with an Abbott product, sales of the product could be halted by Abbott or by regulatory authorities. +Safety issues affecting suppliers' or competitors' products also may reduce the market acceptance of Abbott's products. +In +addition, in the ordinary course of business, Abbott is the subject of product liability claims and lawsuits alleging that its products or the products of other companies that Abbott +promotes have resulted or could result in an unsafe condition for or injury to patients. Product liability claims and lawsuits, safety alerts or product recalls, and other allegations of product +safety or quality issues, +regardless of their validity or ultimate outcome, may have a material adverse effect on Abbott's business and reputation and on Abbott's ability to attract and retain customers. Consequences may also +include additional costs, a decrease in market share for the products, lower income or exposure to other claims. Product liability losses are self-insured. Product liability claims could have a +material adverse effect on Abbott's profitability and financial condition. +Fluctuation in foreign currency exchange rates may adversely affect our financial statements and Abbott's +ability to realize projected sales and earnings. +Although Abbott's financial statements are denominated in U.S. dollars, a significant portion of Abbott's revenues and costs are realized in +other currencies. Sales outside of the United States in 2018 made up approximately 65 percent of Abbott's net sales. Abbott's profitability is affected by movement of the U.S. dollar against +other currencies. Fluctuations in exchange rates between the U.S. dollar and other currencies may also affect the reported value of Abbott's assets and liabilities, as well as its cash flows. Some +foreign currencies are subject to government exchange controls. While Abbott enters into hedging arrangements to mitigate some of its foreign currency exposure, Abbott cannot predict with any +certainty changes in foreign currency exchange rates or its ability to mitigate these risks. +Information +on the impact of foreign exchange rates on Abbott's financial results is contained in the "Financial Review — Results of Operations" section in +Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations of this report. A discussion of the steps taken to mitigate the impact of foreign exchange is +contained in Item 7A, Quantitative and Qualitative Disclosures about Market Risk in Abbott's 2018 Form 10-K. Information on Abbott's hedging arrangements is contained in Note 12 +to the consolidated financial statements in this report. +Deterioration in the economic condition and credit quality of certain countries may negatively affect +Abbott's results of operations. +Unfavorable economic conditions in certain countries may increase the time it takes to collect outstanding trade receivables. Financial +instability and fiscal deficits in these countries may result in additional austerity measures to reduce costs, including health care. Deterioration in the quality of +13 +sovereign +debt, including credit downgrades, could increase Abbott's collection risk where a significant amount of Abbott's receivables in these countries are with governmental health care systems or +where Abbott's customers depend on payment by government health care systems. +The international nature of Abbott's business subjects it to additional business risks that may cause its +revenue and profitability to decline. +Abbott's business is subject to risks associated with managing a global supply chain and doing business internationally. Sales outside of the +United States in 2018 made up approximately 65 percent of Abbott's net sales. Additional risks associated with Abbott's international operations +include: +• differing local product preferences and product requirements; +• trade protection measures, including tariffs, import or export licensing requirements, and changes to international trade agreements; +• difficulty in establishing, staffing, and managing operations; +• differing labor regulations; +• potentially negative consequences from changes in or interpretations of tax laws; +• political and economic instability, including sovereign debt issues; +• restrictions on local currency conversion and/or cash extraction; +• price controls, limitations on participation in local enterprises, expropriation, nationalization, and other governmental action; +• inflation, recession, and fluctuations in interest rates; +• diminished protection of intellectual property; and +• potential penalties or other adverse consequences for violations of anti-corruption, anti-bribery, and other similar laws and regulations, +including the Foreign Corrupt Practices Act and the U.K. Bribery Act. +Events +contemplated by these risks may, individually or in the aggregate, have a material adverse effect on Abbott's revenues and profitability. +Other factors can have a material adverse effect on Abbott's future profitability and financial condition. +Many other factors can affect Abbott's profitability and its financial condition, including: +• changes in or interpretations of laws and regulations, including changes in accounting standards, taxation requirements, product marketing +application standards, product labeling, source and use laws, and environmental laws; +• differences between the fair value measurement of assets and liabilities and their actual value, particularly for pensions, retiree health +care, stock compensation, intangibles, goodwill, and contingent consideration; and for contingent liabilities such as litigation, the absence of a recorded amount, or an amount recorded at the +minimum, compared to the actual amount; +• changes in the rate of inflation (including the cost of raw materials, commodities, and supplies), interest rates, market value of Abbott's +equity investments, and the performance of investments held by Abbott or Abbott's employee benefit trusts; +• changes in the creditworthiness of counterparties that transact business with or provide services to Abbott or Abbott's employee benefit +trusts; +14 +• changes in business, economic, and political conditions, including: war, political instability, terrorist attacks, the threat of future +terrorist activity and related military action; global climate, extreme weather and natural disasters; widespread outbreaks of infectious diseases, the cost and availability of insurance due to any of +the foregoing events; labor disputes, strikes, slow-downs, or other forms of labor or union activity; and pressure from third-party interest groups; +• changes in Abbott's business units and investments and changes in the relative and absolute contribution of each to earnings and cash flow +resulting from evolving business strategies, changing product mix, changes in tax laws or tax rates both in the U.S. and abroad and opportunities existing now or in the future; +• changes in the buying patterns of a major distributor, retailer, or wholesale customer resulting from buyer purchasing decisions, pricing, +seasonality, or other factors, or other problems with licensors, suppliers, distributors, and business partners; and +• legal difficulties, any of which could preclude or delay commercialization of products or adversely affect profitability, including claims +asserting statutory or regulatory violations, and adverse litigation decisions. +CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS +This Form 10-K contains forward-looking statements that are based on management's current expectations, estimates, and projections. Words +such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," "forecasts," variations of these words, and similar expressions are intended to identify these forward-looking +statements. Certain factors, including but not limited to those identified under "Item 1A. Risk Factors" of this Form 10-K, may cause actual results to differ materially from current +expectations, estimates, projections, forecasts, and from past results. No assurance can be made that any expectation, estimate, or projection contained in a forward-looking statement will be achieved +or will not be affected by the factors cited above or other future events. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as the result of subsequent +events or developments, except as required by law. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +15 +ITEM 2. PROPERTIES +As of December 31, 2018, Abbott owned or leased properties totaling approximately 42 million square feet, of which approximately +70% is owned by Abbott. Abbott's principal corporate offices are located in Illinois and are owned by Abbott. +Abbott +operates 94 manufacturing facilities globally. Abbott's facilities are deemed suitable and provide adequate productive capacity. The manufacturing facilities are used by Abbott's +reportable segments as follows: +Reportable Segments +Manufacturing +Sites +Cardiovascular and Neuromodulation Products +25 +Diagnostic Products +23 +Established Pharmaceutical Products +30 +Nutritional Products +14 +Non-Reportable +2 +​ +​ +​ +​ +​ +Worldwide Total +94 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Abbott's +research and development facilities in the United States are primarily located in California, Illinois, Minnesota, New Jersey, and Ohio. Abbott also has research and development +facilities in various other countries, including China, Colombia, India, Singapore, Spain, and the United Kingdom. +There +are no material encumbrances on the properties. +ITEM 3. LEGAL PROCEEDINGS +Abbott is involved in various claims, legal proceedings and investigations. While it is not feasible to predict the outcome of such pending +claims, proceedings and investigations with certainty, management is of the opinion that their ultimate resolution should not have a material adverse effect on Abbott's financial position, cash flows, +or results of operations. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +16 +EXECUTIVE OFFICERS OF THE REGISTRANT +Executive officers of Abbott are elected annually by the board of directors. All other officers are elected by the board or appointed by the +chairman of the board. All officers are either elected at the first meeting of the board of directors held after the annual shareholder meeting or appointed by the chairman after that board meeting. +Each officer holds office until a successor has been duly elected or appointed and qualified or until the officer's death, resignation, or removal. Vacancies may be filled at any time by the board. +Any officer may be removed by the board of directors when, in its judgment, removal would serve the best interests of Abbott. Any officer appointed by the chairman of the board may be removed by the +chairman whenever, in the chairman's judgment, removal would serve the best interests of Abbott. A vacancy in any office appointed by the chairman of the board may be filled by the chairman. +Abbott's +executive officers, their ages as of February 22, 2019, and the dates of their first election as officers of Abbott are listed below. The executive officers' principal +occupations and employment for the past five years and the year of appointment to the earliest reported office are also shown. Unless otherwise stated, employment was by Abbott. There are no family +relationships between any corporate officers or directors. +Miles D. White, 63 +1999 +to present — Chairman of the Board and Chief Executive Officer, and Director. +Elected +Corporate Officer — 1993. +Robert B. Ford, 45 +2018 +to present — President and Chief Operating Officer. +2015 +to 2018 — Executive Vice President, Medical Devices. +2014 +to 2015 — Senior Vice President, Diabetes Care. +2008 +to 2014 — Vice President, Diabetes Care, Commercial Operations. +Elected +Corporate Officer — 2008. +Hubert L. Allen, 53 +2013 +to present — Executive Vice President, General Counsel and Secretary. +Elected +Corporate Officer — 2012. +Brian J. Blaser, 54 +2012 +to present — Executive Vice President, Diagnostics Products. +Elected +Corporate Officer — 2008. +John M. Capek, 57 +2015 +to present — Executive Vice President, Ventures. +2007 +to 2015 — Executive Vice President, Medical Devices. +Elected +Corporate Officer — 2006. +17 +Stephen R. Fussell, 61 +2013 +to present — Executive Vice President, Human Resources. +Elected +Corporate Officer — 1999. +Andrew H. Lane, 48 +2017 +to present — Executive Vice President, Established Pharmaceuticals. +2015 +to 2017 — Senior Vice President, Established Pharmaceuticals, Emerging Markets. +2014 +to 2015 — Divisional Vice President, Established Pharmaceuticals, Asia Pacific. +2011 +to 2014 — Vice President, Asia Pacific, Takeda Pharmaceutical Company Limited (a Japanese pharmaceutical company). +Elected +Corporate Officer — 2015. +Daniel Salvadori, 40 +2017 +to present — Executive Vice President, Nutritional Products. +2014 +to 2017 — Senior Vice President, Established Pharmaceuticals, Latin America. +2013 +to 2014 — Chief Executive Officer, Latin America, CFR Pharmaceuticals S.A. (a Latin American pharmaceutical company). +Elected +Corporate Officer — 2014. +Brian B. Yoor, 49 +2017 +to present — Executive Vice President, Finance and Chief Financial Officer. +2015 +to 2017 — Senior Vice President, Finance and Chief Financial Officer. +2013 +to 2015 — Vice President, Investor Relations. +Elected +Corporate Officer — 2013. +Roger M. Bird, 62 +2015 +to present — Senior Vice President, U.S. Nutrition. +2009 +to 2015 — Divisional Vice President and General Manager, China and Hong Kong, Nutritional Products. +Elected +Corporate Officer — 2015. +Sharon J. Bracken, 48 +2017 +to present — Senior Vice President, Rapid Diagnostics. +2013 +to 2017 — Vice President, Diagnostics, Abbott Point of Care. +Elected +Corporate Officer — 2013. +18 +Charles R. Brynelsen, 62 +2017 +to present — Senior Vice President, Abbott Vascular. +2016 +to 2017 — Managing Director, CB Business Advisors, Inc. (a medical device consulting firm). +2015 +to 2016 — Senior Vice President and President, Medtronic Early Technologies, Medtronic plc (a global medical device company). +2013 +to 2015 — President, Early Technologies, Covidien plc (a global healthcare products company). +Elected +Corporate Officer — 2017. +Jaime Contreras, 62 +2013 +to present — Senior Vice President, Core Laboratory Diagnostics, Commercial Operations. +Elected +Corporate Officer — 2003. +Robert E. Funck, 57 +2018 +to present — Senior Vice President, Finance and Controller. +2013 +to 2018 — Vice President, Controller. +Elected +Corporate Officer — 2005. +Sammy Karam, 57 +2019 +to present — Senior Vice President, Established Pharmaceuticals, Emerging Markets. +2014 +to 2019 — Divisional Vice President, Global Marketing Commercial Execution, Established Pharmaceuticals. +2010 +to 2014 — Regional Director Southern Europe, Russia, Ukraine, CIS, Australia and New Zealand, Omega Pharma NV (a Belgian healthcare products company). +Elected +Corporate Officer — 2019. +Joseph Manning, 50 +2017 +to present — Senior Vice President, International Nutrition. +2015 +to 2017 — Vice President, Nutrition, Asia Pacific. +2014 +to 2015 — General Manager, Indonesia, Nutritional Products. +2009 +to 2014 — General Manager, Russia, Nutritional Products. +Elected +Corporate Officer — 2015. +Michael J. Pederson, 57 +2017 +to present — Senior Vice President, CRM and AF/EP. +2015 +to 2017 — Divisional Vice President and General Manager, Abbott Electrophysiology. +2011 +to 2015 — Chief Executive Officer, VytronUS, Inc. (a medical device company focused on developing electrophysiology technologies). +Elected +Corporate Officer — 2017. +19 +Jared L. Watkin, 51 +2015 +to present — Senior Vice President, Diabetes Care. +2010 +to 2015 — Divisional Vice President, Technical Operations, Diabetes Care. +Elected +Corporate Officer — 2015. +Alejandro D. Wellisch, 44 +2017 +to present — Senior Vice President, Established Pharmaceuticals, Latin America. +2014 +to 2017 — General Manager, Argentina, Bolivia, Paraguay and Uruguay, Established Pharmaceuticals. +2012 +to 2014 — General Manager, Argentina, Bolivia, Paraguay and Uruguay, CFR Pharmaceuticals S.A. (a Latin American pharmaceutical company). +Elected +Corporate Officer — 2017. +20 +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Principal Market +The principal market for Abbott's common shares is the New York Stock Exchange under the symbol "ABT." Shares are also listed on the Chicago +Stock Exchange and traded on various regional and electronic exchanges. Outside the United States, Abbott's shares are listed on the SIX Swiss Exchange. +Shareholders +There were 42,827 shareholders of record of Abbott common shares as of December 31, 2018. +Tax Information for Shareholders +In 2001, the Illinois Department of Commerce and Economic Opportunity designated Abbott as an Illinois High Impact Business (HIB) for a period +not to exceed twenty years. Dividends paid by a corporation that is designated as a HIB and conducts business in a foreign trade zone may be eligible for a subtraction from base income for Illinois +income tax purposes. Abbott certified that the HIB requirements were met for the calendar year ending December 31, 2018. +If +you have any questions, please contact your tax advisor. +Issuer Purchases of Equity Securities +Period +(a) Total Number +of Shares +(or Units) +Purchased +(b) Average Price +Paid per Share +(or Unit) +(c) Total Number of +Shares (or Units) +Purchased as Part of +Publicly Announced +Plans or Programs +(d) Maximum Number (or +Approximate Dollar Value) of +Shares (or Units) that May +Yet Be Purchased Under the +Plans or Programs +October 1, 2018 — October 31, 2018 +0 +(1) +— +0 +$ +925,131,209 +(2) +November 1, 2018 — November 30, 2018 +13,140 +(1) +$ +68.580 +0 +$ +925,131,209 +(2) +December 1, 2018 — December 31, 2018 +1,886,483 +(1) +$ +68.856 +1,886,483 +$ +795,235,049 +(2) +Total +1,899,623 +(1) +$ +68.854 +1,886,483 +$ +795,235,049 +(2) +(1) These +shares include: +(i) the +shares deemed surrendered to Abbott to pay the exercise price in connection with the exercise of employee stock options — 0 in October, 812 in +November, and 0 in December; and +(ii) the +shares purchased on the open market for the benefit of participants in the Abbott Laboratories, Limited Employee Stock Purchase Plan — 0 in +October, 12,328 in November, and 0 in December. +These +shares do not include the shares surrendered to Abbott to satisfy tax withholding obligations in connection with the vesting of restricted stock or restricted stock units. +(2) On +September 11, 2014, Abbott announced that its board of directors approved the purchase of up to $3 billion of its common shares, from time to time. +21 +ITEM 6. SELECTED FINANCIAL DATA +Year Ended December 31 +2018 +2017 +2016 +2015 +2014 +Net sales (1) +$ +30,578 +$ +27,390 +$ +20,853 +$ +20,405 +$ +20,247 +Earnings from continuing operations (1) +2,334 +353 +1,063 +2,606 +1,721 +Net earnings +2,368 +477 +1,400 +4,423 +2,284 +Basic earnings per common share from continuing operations (1) +1.32 +0.20 +0.71 +1.73 +1.13 +Basic earnings per common share +1.34 +0.27 +0.94 +2.94 +1.50 +Diluted earnings per common share from continuing operations (1) +1.31 +0.20 +0.71 +1.72 +1.12 +Diluted earnings per common share +1.33 +0.27 +0.94 +2.92 +1.49 +Total assets +67,173 +76,250 +52,666 +41,247 +41,207 +Long-term debt, including current portion +19,366 +27,718 +20,684 +5,874 +3,448 +Cash dividends declared per common share +1.16 +1.075 +1.045 +0.98 +0.90 +(1) Amounts +reflect Abbott's developed markets branded generics pharmaceuticals, animal health and former research-based pharmaceuticals business as discontinued +operations. +22 +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Financial Review +Abbott's revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent +protection and licenses, technological and performance features, and inclusion of Abbott's products under a contract most impact which products are sold; price controls, competition and rebates most +impact the net selling prices of products; and foreign currency translation impacts the measurement of net sales and costs. Abbott's primary products are cardiovascular and neuromodulation products, +diagnostic testing products, +nutritional products and branded generic pharmaceuticals. Sales in international markets comprise approximately 65 percent of consolidated net sales. +Over +the last several years, Abbott proactively shaped the company with the strategic intent to deliver sustainable growth in all of its businesses. Significant steps over the last three +years included: +• In January 2017, Abbott acquired St. Jude Medical, Inc. (St. Jude Medical), a global medical device manufacturer, for +approximately $23.6 billion, including approximately $13.6 billion in cash and approximately $10 billion in Abbott common shares, based on Abbott's closing stock price on the +acquisition date. As part of the acquisition, Abbott assumed, repaid or refinanced approximately $5.9 billion of St. Jude Medical's debt. The acquisition provided expanded opportunities +for future growth and is an important part of the company's effort to develop a strong, diverse portfolio. The combined business competes in nearly every area of the $30 billion global +cardiovascular device market, as well as in neuromodulation which treats chronic pain and movement disorders. +• In October 2017, Abbott acquired Alere Inc. (Alere), a diagnostic device and service provider, for $51.00 per common share in cash, +which equated to a purchase price of approximately $4.5 billion. As part of the acquisition, Abbott also tendered for Alere's preferred shares for a total value of approximately +$0.7 billion and assumed and subsequently repaid approximately $3.0 billion of Alere's debt. The acquisition established Abbott as a leader in point of care testing, expanded Abbott's +global diagnostics presence and provided access to new products, channels and geographies. +• In February 2017, Abbott completed the sale of Abbott Medical Optics (AMO), its vision care business, to Johnson & Johnson for +$4.325 billion in cash and recognized an after-tax gain of $728 million. The operating results of AMO were included in Earnings from Continuing Operations up to the date of sale as the +business did not qualify for reporting as discontinued operations. +The +sales increase over the last three years reflects both the 2017 acquisitions of St. Jude Medical and Alere and volume growth across Abbott's businesses, most notably in the +Established Pharmaceuticals, Diabetes Care and Diagnostics businesses. Volume growth reflects the introduction of new products as well as higher sales of existing products. In 2017, the acquisitions +of St. Jude Medical and Alere, partially offset by the sale of AMO, contributed 26.5 percentage points of Abbott's total sales growth versus 2016. Sales in emerging markets, which +represent approximately 40 percent of total company +sales, increased 12.3 percent in 2018 and 13.9 percent in 2017, excluding the impact of foreign exchange. (Emerging markets include all countries except the United States, Western +Europe, Japan, Canada, Australia and New Zealand.) +Over +the last three years, Abbott's operating margin was positively impacted by margin improvements across various businesses, including Established Pharmaceuticals, Core Laboratory, and +Diabetes Care, partially offset by higher amortization and other costs associated with the acquisitions. In 2018, Abbott's operating margin increased by approximately 6 percentage points +primarily due to operating margin improvement in various businesses and lower inventory step-up amortization and integration costs associated with the acquisitions, partially offset by higher +intangible amortization. In 2017, Abbott's +23 +operating +margin decreased by approximately 9 percentage points primarily due to costs associated with the acquisitions, including higher intangible amortization expense, inventory step-up +amortization and integration costs, partially offset by operating margin improvement in various businesses. +Since +the beginning of the first quarter of 2017, the results of Abbott's Cardiovascular and Neuromodulation Products segment include Abbott's historical Vascular Products segment and +St. Jude Medical from the date of acquisition. Excluding the impact of foreign exchange, sales in the Cardiovascular and Neuromodulation Products segment increased 4.9 percent in 2018 +and 207.4 percent in 2017. The sales increase in 2018 was driven primarily by higher Structural Heart, Electrophysiology, and Neuromodulation sales. The sales increase in 2017 was driven by the +acquisition of St. Jude Medical. Excluding the impact of the acquisition, as well as the impact of foreign exchange, sales in the Cardiovascular and Neuromodulation Products segment were +essentially unchanged in 2017 versus the prior year. In 2017, higher structural heart and endovascular sales were offset by lower coronary stent sales and the comparison impact from the favorable 2016 +resolution of a third-party royalty agreement in Abbott's vascular business. +In +2018, operating earnings for this segment increased 9.9 percent. The operating margin profile declined from 35.8 percent of sales in 2016 to 31.7 percent in 2018 +primarily due to the mix of business resulting from the acquisition of St. Jude Medical and ongoing pricing pressures in the coronary business. Cost improvement initiatives contributed to an +improvement in the operating margin profile from 30.5 percent in 2017 to 31.7 percent in 2018. +In +2018, the Cardiovascular and Neuromodulation Products segment received approval or clearance from the U.S. Food and Drug Administration (FDA) for the following +products: +• the Advisor® HD Grid Mapping Catheter, Sensor Enabled™, which creates highly detailed maps of the heart and expands +Abbott's electrophysiology product portfolio, +• the next-generation version of Abbott's leading MitraClip® heart valve repair device, +• the HeartMate 3® Left Ventricular Assist Device (LVAD) as a destination (long-term use) therapy, and +• the XIENCE Sierra® Drug Eluting Stent System, which is the next generation of its drug-eluting coronary stent system. The XIENCE +Sierra Drug Eluting Stent System also received national reimbursement in Japan to treat people with coronary artery disease. +In +Abbott's worldwide diagnostics business, sales growth over the last three years reflected the acquisition of Alere in October 2017, as well as continued market penetration by the core +laboratory business in the U.S. and internationally. Alere's results are included in Abbott's Diagnostic Products reportable segment from the date of acquisition. Worldwide diagnostic sales increased +33.6 percent in 2018 and 16.7 percent in 2017, excluding the impact of foreign exchange. Excluding the impact of the Alere acquisition, as well as the impact of foreign exchange, sales +in the Diagnostic Products segment increased 6.5 percent in 2018 and 5.5 percent in 2017. This growth includes the continued roll-out of Alinity®, which is Abbott's +integrated family of next-generation diagnostic systems and solutions that are designed to increase efficiency by running more tests in less space, generating test results faster and minimizing human +errors while continuing to provide quality results. Abbott has regulatory approvals in the U.S., Europe, China, and other markets for the "Alinity c" and "Alinity i" instruments for clinical chemistry +and immunoassay diagnostics, respectively. In 2018, Abbott accelerated the launch of Alinity in Europe and other international markets after a broad range of assays obtained regulatory approval and +were added to the test menu. Abbott also continued the roll-out of "Alinity s" for blood and plasma screening. +Margin +improvement continued to be a key focus for the Diagnostics business in 2018 and 2017. While operating margins of 24.9 percent of sales in 2018 have remained relatively +unchanged from the 24.8 percent of sales reported in 2016, this reflects dilution to the operating margin profit from the +24 +acquisition +of Alere and the negative impact of foreign exchange, offset by the continued execution of efficiency initiatives in the manufacturing and supply chain functions. +In +Abbott's worldwide nutritional products business, sales over the last three years were positively impacted by demographics such as an aging population and an increasing rate of +chronic disease in developed markets and the rise of a middle class in many emerging markets, as well as by numerous new product introductions that leveraged Abbott's strong brands. In 2018, excluding +the impact of foreign exchange, the nutritional business experienced above-market growth in the worldwide pediatric business driven by market leading brands Similac® and +Pedialyte® in the U.S. as well as growth across several markets in Asia. Worldwide, adult nutrition sales increased in 2018 led by the growth of Ensure®, Abbott's +market-leading complete and balanced nutrition brand, and Glucerna®, Abbott's market-leading diabetes-specific nutrition brand. +In +2017, the nutritionals business experienced growth in the U.S. driven by above-market performance in Abbott's infant and toddler brands. Internationally, 2017 sales growth in China +and India was partially offset by challenging market conditions in the infant formula market in various emerging markets. With respect to the profitability of the nutritional products business, +manufacturing and distribution process changes, as well as other cost reductions, drove margin improvements across the business over the last three years although such improvements were offset by +inflation on commodity costs. The decrease in operating margins for this business from 24.1 percent of sales in 2016 to 22.9 percent in 2018 was primarily due to negative impact of +foreign exchange. +The +Established Pharmaceutical Products segment focuses on the sale of its products in emerging markets. Excluding the impact of foreign exchange, Established Pharmaceutical sales +increased 7.0 percent in 2018 and 9.5 percent in 2017. The sales increase in 2018 was driven by double-digit growth in India and China. The sales increase in 2017 was primarily driven by +double-digit growth in China and various countries in Latin America. Operating margins increased from 18.7 percent of sales in 2016 to 20.2 percent in 2018 primarily due to the continued +focus on cost reduction initiatives. +In +its diabetes business, Abbott received U.S. FDA approval for its FreeStyle Libre® 14 day sensor, making it the longest lasting wearable glucose sensor available. +The FreeStyle Libre system is the only continuous glucose monitoring system that does not require any user calibration. +In +conjunction with the funding of the St. Jude Medical and Alere acquisitions and the assumption of St. Jude Medical's and Alere's existing debt, Abbott's total short-term +and long-term debt increased +from approximately $9.0 billion at December 31, 2015 to $27.9 billion at December 31, 2017. At the beginning of 2018, Abbott committed to reducing its debt levels and in +2018 Abbott repaid approximately $8.3 billion of debt, net of borrowings, bringing its total debt to $19.6 billion. +Abbott +declared dividends of $1.16 per share in 2018 compared to $1.075 per share in 2017, an increase of approximately 8 percent. Dividends paid totaled $1.974 billion in +2018 compared to $1.849 billion in 2017. The year-over-year change in the amount of dividends paid reflects the increase in the dividend rate. In December 2018, Abbott increased the company's +quarterly dividend by approximately 14 percent to $0.32 per share from $0.28 per share, effective with the dividend paid in February 2019. +In +2019, Abbott will focus on continuing to invest in product development areas that provide the opportunity for strong sustainable growth over the next several years. In its diagnostics +business, Abbott will continue to focus on driving market adoption and geographic expansion of its Alinity suite of diagnostics instruments. In the cardiovascular and neuromodulation business, Abbott +will continue to focus on expanding its market position in various areas including electrophysiology, heart failure, and structural heart. In its nutritionals business, Abbott will continue to focus +on driving growth globally and further enhancing its portfolio with the introduction of several new science-based products. In the established pharmaceuticals business, Abbott will continue to focus +on growing its business with the depth and breadth +25 +of +its portfolio in emerging markets. In its diabetes care business, Abbott will focus on driving continued market adoption of its FreeStyle Libre continuous glucose monitoring system. +Critical Accounting Policies +Sales Rebates — In 2018, approximately 45 percent of Abbott's consolidated gross revenues were subject to various forms of rebates +and allowances that Abbott recorded as reductions of revenues at the time of sale. Most of these rebates and allowances in 2018 are in the Nutritional Products and Diabetes Care segments. Abbott +provides rebates to state agencies that administer the Special +Supplemental Nutrition Program for Women, Infants, and Children (WIC), wholesalers, group purchasing organizations, and other government agencies and private entities. Rebate amounts are usually based +upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of which products have been sold subject to a +rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current changes, Abbott estimates +the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate generally occurs from one to +six months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. Rebates and chargebacks charged +against gross sales in 2018, 2017 and 2016 amounted to approximately $3.0 billion, $2.8 billion and $2.5 billion, respectively, or 19.0 percent, 20.5 percent and +22.9 percent of gross sales, respectively, based on gross sales of approximately $16.0 billion, $13.9 billion and $10.7 billion, respectively, subject to rebate. A +one-percentage point increase in the percentage of rebates to related gross sales would decrease net sales by approximately $160 million in 2018. Abbott considers a one-percentage point +increase to be a reasonably likely increase in the percentage of rebates to related gross sales. Other allowances charged against gross sales were approximately $175 million, +$166 million and $160 million for cash discounts in 2018, 2017 and 2016, respectively, and $191 million, $204 million and $242 million for returns in 2018, 2017 and +2016, respectively. Cash discounts are known within 15 to 30 days of sale, and therefore can be reliably estimated. Returns can be reliably estimated because Abbott's historical returns are +low, and because sales returns terms and other sales terms have remained relatively unchanged for several periods. +Management +analyzes the adequacy of ending rebate accrual balances each quarter. In the domestic nutritional business, management uses both internal and external data available to +estimate the accruals. In the WIC business, estimates are required for the amount of WIC sales within each state where Abbott holds the WIC contract. The state where the sale is made, which is the +determining factor for the applicable rebated price, is reliably determinable. Rebated prices are based on contractually obligated agreements generally lasting a period of two to four years. Except +for a change in contract price or a transition period before or after a change in the supplier for the WIC business in a state, accruals are based on historical redemption rates and data from the U.S. +Department of Agriculture (USDA) and the states submitting rebate claims. The USDA, which administers the WIC program, has been making its data available for many years. Management also estimates the +states' processing lag time based on sales and claims data. Inventory in the retail distribution channel does not vary substantially. Management has access to several large customers' inventory +management data, which allows management to make reliable estimates of inventory in the retail distribution channel. At December 31, 2018, Abbott had WIC business in 27 states. +Historically, +adjustments to prior years' rebate accruals have not been material to net income. Abbott employs various techniques to verify the accuracy of claims submitted to it, and +where possible, works with the organizations submitting claims to gain insight into changes that might affect the rebate amounts. For government agency programs, the calculation of a rebate involves +interpretations of relevant regulations, which are subject to challenge or change in interpretation. +26 +Income Taxes — Abbott operates in numerous countries where its income tax returns are subject to audits and adjustments. Because Abbott +operates globally, the nature of the audit items is often very complex, and the objectives of the government auditors can result in a tax on the same income in more than one country. Abbott employs +internal and external tax professionals to minimize audit adjustment amounts where possible. In accordance with the accounting rules relating to the measurement of tax contingencies, in order to +recognize an uncertain tax benefit, the taxpayer must be more likely than not of sustaining the position, and the measurement of the benefit is calculated as the largest amount that is more than +50 percent likely to be realized upon resolution of the benefit. Application of these rules requires a significant amount of judgment. In the U.S., Abbott's federal income tax returns through +2016 are settled except for the federal income tax returns of the former Alere consolidated group which are settled through 2014 and the former St. Jude Medical consolidated group which are +settled through 2013. Undistributed foreign earnings remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining +undistributed foreign earnings not subject to the transition tax and additional outside basis difference in its foreign entities is not practicable. +Pension and Post-Employment Benefits — Abbott offers pension benefits and post-employment health care to many of its employees. Abbott +engages outside actuaries to assist in the determination of the obligations and costs under these programs. Abbott must develop long-term assumptions, the most significant of which are the health care +cost trend rates, discount rates and the expected return on plan assets. The discount rates used to measure liabilities were determined based on high-quality fixed income securities that match the +duration of the expected retiree benefits. The health care cost trend rates represent Abbott's expected annual rates of change in the cost of health care benefits and are a forward projection of +health care costs as of the measurement date. A difference between the assumed rates and the actual rates, which will not be known for years, can be significant in relation to the obligations and the +annual cost recorded for these programs. Low interest rates have significantly increased actuarial losses for these plans. At December 31, 2018, pretax net actuarial losses and prior service +costs and (credits) recognized in Accumulated other comprehensive income (loss) for Abbott's defined benefit plans and medical and dental plans were losses of $3.3 billion and +$198 million, respectively. Actuarial losses and gains are amortized over the remaining service attribution periods of the employees under the corridor method, in accordance with the rules for +accounting for post-employment benefits. Differences between the expected long-term return on plan assets and the actual annual return are amortized over a five-year period. Note 14 to the +consolidated financial statements describes the impact of a one-percentage point change in the health care cost trend rate; however, there can be no certainty that a change would be limited to only +one percentage point. +Valuation of Intangible Assets — Abbott has acquired and continues to acquire significant intangible assets that Abbott records at fair +value at the acquisition date. Transactions involving the purchase or sale of intangible assets occur with some frequency between companies in the health care field and valuations are usually based on +a discounted cash flow analysis. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, cost of capital, terminal values and market +participants. Each of these factors can significantly affect the value of the intangible asset. Abbott engages independent valuation experts who review Abbott's critical assumptions and calculations +for acquisitions of significant intangibles. Abbott reviews definite-lived intangible assets for impairment each quarter using an undiscounted net cash flows approach. If the undiscounted cash flows +of an intangible asset are less than the carrying value of an intangible asset, the intangible asset is written down to its fair value, which is usually the discounted cash flow amount. Where cash +flows cannot be identified for an individual asset, the review is applied at the lowest group level for which cash flows are identifiable. Goodwill and indefinite-lived intangible assets, which relate +to in-process research and development acquired in a business combination, are reviewed for impairment annually or when an event that could result in impairment occurs. At December 31, 2018, +goodwill amounted to $23.3 billion and net intangibles amounted to $18.9 billion. Amortization expense in continuing operations for intangible assets amounted to $2.2 billion in +2018, $2.0 billion in 2017 and $550 million in 2016. There was no significant reduction of goodwill relating to impairments in 2018, 2017 and 2016. +27 +Litigation — Abbott accounts for litigation losses in accordance with Financial Accounting Standards Board (FASB) Accounting Standards +Codification (ASC) No. 450, "Contingencies." Under ASC No. 450, loss contingency provisions are recorded for probable losses at management's best estimate of a loss, or when a best +estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are +refined each accounting period as additional information becomes known. Accordingly, Abbott is often initially unable to develop a best estimate of loss, and therefore the minimum amount, which could +be zero, is recorded. As information becomes known, either the minimum loss amount is increased, resulting in additional loss provisions, or a best estimate can be made, also resulting in additional +loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected. Abbott estimates the range +of possible loss to be from approximately $125 million to $165 million for its legal proceedings and environmental exposures. Accruals of approximately $145 million have been +recorded at December 31, 2018 for these proceedings and exposures. These accruals represent management's best estimate of probable loss, as defined by FASB ASC No. 450, "Contingencies." +28 +Results of Operations +Sales +The following table details the components of sales growth by reportable segment for the last two years: +Components of % Change +Total +% Change +Business +Acquisitions/ +Divestitures +Price +Volume +Exchange +Total Net Sales +2018 vs. 2017 +11.6 +4.9 +(1.0 +) +8.1 +(0.4 +) +2017 vs. 2016 +31.3 +26.5 +(0.6 +) +5.1 +0.3 +Total U.S. +2018 vs. 2017 +12.1 +8.0 +(1.1 +) +5.2 +— +2017 vs. 2016 +49.1 +46.9 +(0.9 +) +3.1 +— +Total International +2018 vs. 2017 +11.4 +3.2 +(1.0 +) +9.7 +(0.5 +) +2017 vs. 2016 +23.3 +17.3 +(0.4 +) +6.0 +0.4 +Established Pharmaceutical Products Segment +2018 vs. 2017 +3.2 +— +2.2 +4.8 +(3.8 +) +2017 vs. 2016 +11.1 +— +2.3 +7.2 +1.6 +Nutritional Products Segment +2018 vs. 2017 +4.4 +— +0.2 +4.7 +(0.5 +) +2017 vs. 2016 +0.4 +— +0.3 +0.3 +(0.2 +) +Diagnostic Products Segment +2018 vs. 2017 +33.5 +27.1 +(2.0 +) +8.5 +(0.1 +) +2017 vs. 2016 +16.7 +11.2 +(1.1 +) +6.6 +— +Cardiovascular and Neuromodulation Products Segment +2018 vs. 2017 +5.9 +— +(2.8 +) +7.7 +1.0 +2017 vs. 2016 +207.7 +207.2 +(4.3 +) +4.5 +0.3 +The +increase in Total Net Sales in 2018 reflects the acquisition of Alere, as well as volume growth across all of Abbott's businesses. The increase in Total Net Sales in 2017 reflects +the acquisitions of St. Jude Medical and Alere, as well as volume growth in the established pharmaceuticals and diagnostics businesses. The price declines related to the Cardiovascular and +Neuromodulation Products segment in 2018 and 2017 primarily reflect pricing pressure on drug eluting stents (DES) as a result of market competition in the U.S. and other major markets. +29 +A +comparison of significant product and product group sales is as follows. Percent changes are versus the prior year and are based on unrounded numbers. +(dollars in millions) +2018 +Total +Change +Impact of +Exchange +Total +Change +Excl. Exchange +Total Established Pharmaceuticals — +Key Emerging Markets +$ +3,363 +2 +% +(5 +)% +7 +% +Other +1,059 +8 +2 +6 +Nutritionals — +International Pediatric Nutritionals +2,254 +7 +— +7 +U.S. Pediatric Nutritionals +1,843 +4 +— +4 +International Adult Nutritionals +1,900 +7 +(1 +) +8 +U.S. Adult Nutritionals +1,232 +(2 +) +— +(2 +) +Diagnostics — +Core Laboratory +4,386 +8 +— +8 +Molecular +484 +5 +1 +4 +Point of Care +553 +— +— +— +Rapid Diagnostics +2,072 +n/m +n/m +n/m +Cardiovascular and Neuromodulation — +Rhythm Management +2,091 +(1 +) +1 +(2 +) +Electrophysiology +1,668 +21 +1 +20 +Heart Failure +646 +— +— +— +Vascular +2,929 +1 +1 +— +Structural Heart +1,239 +14 +1 +13 +Neuromodulation +864 +7 +— +7 +(dollars in millions) +2017 +Total +Change +Impact of +Exchange +Total +Change +Excl. Exchange +Total Established Pharmaceuticals — +Key Emerging Markets +$ +3,307 +14 +% +2 +% +12 +% +Other +980 +3 +1 +2 +Nutritionals — +International Pediatric Nutritionals +2,112 +(4 +) +— +(4 +) +U.S. Pediatric Nutritionals +1,777 +6 +— +6 +International Adult Nutritionals +1,782 +3 +(1 +) +4 +U.S. Adult Nutritionals +1,254 +(3 +) +— +(3 +) +Diagnostics — +Core Laboratory +4,063 +6 +— +6 +Molecular +463 +2 +1 +1 +Point of Care +550 +7 +— +7 +Rapid Diagnostics +540 +n/m +n/m +n/m +Cardiovascular and Neuromodulation — +Rhythm Management +2,103 +n/m +n/m +n/m +Electrophysiology +1,382 +n/m +n/m +n/m +Heart Failure +643 +n/m +n/m +n/m +Vascular +2,892 +14 +— +14 +Structural Heart +1,083 +208 +1 +207 +Neuromodulation +808 +n/m +n/m +n/m +n/m = +percent change is not meaningful. +Note: In +order to compute results excluding the impact of exchange rates, current year U.S. dollar sales are multiplied or divided, as appropriate, by the current year +average foreign exchange rates and then those amounts are multiplied or divided, as appropriate, by the prior year average foreign exchange rates. +30 +Total +Established Pharmaceutical Products sales increased 7.0 percent in 2018 and 9.5 percent in 2017, excluding the impact of foreign exchange. The Established +Pharmaceutical Products segment is focused on several key emerging markets including India, Russia, China and Brazil. Excluding the impact of foreign exchange, total sales in these key emerging +markets increased 7.4 percent in 2018 and 11.9 percent in 2017. Excluding the impact of foreign exchange, 2018 sales in India and China and 2017 sales in China and various countries in +Latin America experienced double-digit growth. Excluding the impact of foreign exchange, sales in Established Pharmaceuticals' other emerging markets increased 5.8 percent in 2018 and +2.2 percent in 2017. The 2017 sales growth for Established Pharmaceuticals' other emerging markets includes the unfavorable impact of Venezuelan operations. Excluding Venezuela and the effect +of foreign exchange, sales in other emerging markets increased 7.5 percent in 2017. +Total +Nutritional Products sales increased 4.9 percent in 2018 and 0.6 percent in 2017, excluding the unfavorable impact of foreign exchange. The increases in 2018 and 2017 +U.S. Pediatric Nutritional sales primarily reflect continued above-market performance in Abbott's infant and toddler brands, including Similac and Pedialyte. 2018 International Pediatric Nutritional +sales increased primarily due to growth in Asia and Latin America. The 2017 decrease in International Pediatric Nutritional sales was driven by challenging market conditions in the infant formula +market in various emerging markets, partially offset by growth in China and India. +The +2018 sales increase in the International Adult Nutritional business was led by growth of Ensure, Abbott's market-leading complete and balanced nutrition brand, and Glucerna, Abbott's +market-leading diabetes-specific nutrition brand in Asia and Latin America. U.S. Adult Nutritional business sales decreased in 2018 primarily driven by the wind down of a non-core product line. +Excluding the unfavorable impact of foreign exchange, the 2017 increase in International Adult Nutritional sales was due primarily to growth in Ensure, as well as volume growth in emerging markets and +continued expansion of the adult nutrition category internationally. U.S. Adult Nutritional revenues decreased in 2017 due to competitive and market dynamics. +Total +Diagnostic Products sales increased 33.6 percent in 2018 and 16.7 percent in 2017, excluding the impact of foreign exchange. The sales increases in 2018 and 2017 +included the acquisition of Alere, which was completed on October 3, 2017. Excluding the impact of the acquisition, as well as the impact of foreign exchange, sales in the Diagnostic Products +segment in 2018 and 2017 increased 6.5 and 5.5 percent, respectively. The 2018 increase in sales was primarily driven by above-market growth in Core Laboratory in the U.S. and internationally. +In 2018, Abbott accelerated the roll out of its Alinity systems for Core Laboratory in Europe. The 2017 increase in sales was primarily driven by share gains in the Core Laboratory markets globally, +as well as performance in Point of Care led by the continued adoption of Abbott's i-STAT® handheld system. +Excluding +the effect of foreign exchange, total Cardiovascular and Neuromodulation Products sales grew 4.9 percent in 2018. The 2018 sales increase was driven by growth in several +areas, including double-digit growth in Electrophysiology and Structural Heart. +The +growth in Electrophysiology in 2018 was led by higher sales in cardiac mapping and ablation catheters, as well as the U.S. launch of Abbott's Confirm Rx® Insertable +Cardiac Monitor (ICM), the world's first and only smartphone-compatible ICM designed to help physicians remotely identify cardiac arrhythmias. In May 2018, Abbott announced U.S. FDA clearance of the +Advisor HD Grid Mapping Catheter, Sensor Enabled, which creates detailed maps of the heart and expands Abbott's electrophysiology product portfolio. +Growth +in Structural Heart in 2018 was driven by several product areas including the MitraClip, Abbott's market-leading device for the minimally-invasive treatment of mitral +regurgitation and the AMPLATZER® PFO occluder, a device designed to close a hole-like opening in the heart. In July 2018, Abbott announced U.S. FDA approval for a next-generation version +of MitraClip. In September 2018, Abbott announced positive clinical results from its COAPT study, which demonstrated that MitraClip +31 +improved +survival and clinical outcomes for select patients with functional mitral regurgitation. In the fourth quarter of 2018, the COAPT study data was submitted to the U.S. FDA to request approval +of an expanded indication for MitraClip. +The +growth in Neuromodulation in 2018 reflects higher revenue for various products for the treatment of chronic pain and movement disorders. +In +Vascular, growth in imaging, vessel closure and other endovascular revenues in 2018 was partially offset by lower DES sales due to lower U.S. market share and price erosion in various +markets. During the second quarter of 2018, Abbott received approval from the U.S. FDA for the XIENCE Sierra Drug Eluting Stent System, the newest generation of its coronary stent system. During the +second quarter of 2018, the XIENCE Sierra Drug Eluting Stent System also received national reimbursement in Japan to treat people with coronary artery disease. In Rhythm Management, market share gains +in the new patient segment were offset by replacement cycle dynamics. In Heart Failure, international sales growth was offset by lower U.S. sales. In October 2018, the HeartMate 3 Left Ventricular +Assist Device (LVAD) received U.S. FDA approval as a destination therapy for people living with advanced heart failure. +In +2017, excluding the effect of foreign exchange, total Cardiovascular and Neuromodulation Products sales grew 207.4 percent. The increase in sales was primarily driven by the +acquisition of St. Jude Medical which was completed on January 4, 2017. Excluding the impact of the acquisition, as well as the impact of foreign exchange, sales in the vascular business +were essentially flat in 2017 versus the prior year as lower coronary stent sales and the comparison impact from the favorable 2016 resolution of a third-party royalty agreement were offset by higher +structural heart and endovascular sales. +Abbott +has periodically sold product rights to non-strategic products and has recorded the related gains in net sales in accordance with Abbott's revenue recognition policies as +discussed in Note 1 to the consolidated financial statements. Related net sales were not significant in 2018, 2017 and 2016. +The +expiration of licenses and patent protection can affect the future revenues and operating income of Abbott. There are no significant patent or license expirations in the next three +years that are expected to materially affect Abbott. +In +April 2017, Abbott received a warning letter from the U.S. FDA related to its manufacturing facility in Sylmar, CA which was acquired by Abbott on January 4, 2017 as part of +the acquisition of St. Jude Medical. This facility manufactures implantable cardioverter defibrillators, cardiac resynchronization therapy defibrillators, and monitors. The warning letter +relates to the FDA's observations from an inspection of this facility. Abbott has prepared a comprehensive plan of corrective actions which has been provided to the FDA. Execution of the plan is +progressing. +Operating Earnings +Gross profit margins were 51.3 percent of net sales in 2018, 47.5 percent in 2017 and 53.8 percent in 2016. In 2018, the +increase primarily reflects lower inventory step-up amortization related to the St. Jude Medical and Alere acquisitions and margin improvements in various businesses, partially offset by higher +intangible amortization expense. In 2017, the decrease primarily reflects higher +intangible amortization expense and inventory step-up amortization related to the St. Jude Medical and Alere acquisitions, partially offset by margin improvements in various businesses. +Research +and development expense was $2.3 billion in 2018, $2.3 billion in 2017, and $1.4 billion in 2016 and represented a 1.7 percent increase in 2018, and +a 56.2 percent increase in 2017. The 2018 increase in research and development expenses was primarily due to higher spending on various projects, partially offset by lower restructuring and +integration costs. The 2017 increase in research and development expenses was primarily due to the acquisition of the St. Jude Medical business. In 2018, research and development expenditures +totaled $1.0 billion for the Cardiovascular and Neuromodulation Products +32 +segment, +$585 million for the Diagnostic Products segment, $198 million for the Nutritional Products segment and $184 million for the Established Pharmaceutical Products segment. +Selling, +general and administrative expenses increased 6.1 percent in 2018 and 36.3 percent in 2017 versus the respective prior year. The 2018 increase was primarily due to +the impact of the acquisition of the Alere business in October 2017, as well as higher spending to drive continued growth and market expansion in various businesses, partially offset by lower +acquisition-related expenses. The 2017 increase was primarily due to the acquisition of the St. Jude Medical business, as well as the incremental expenses to integrate St. Jude Medical +with Abbott's existing vascular business, partially offset by the impact of cost improvement initiatives across various functions and businesses. +Business Acquisitions +On January 4, 2017, Abbott completed the acquisition of St. Jude Medical, a global medical device manufacturer, for approximately +$23.6 billion, including approximately $13.6 billion in cash and approximately $10 billion in Abbott common shares, which represented approximately 254 million shares of +Abbott common stock, based on Abbott's closing stock price on the acquisition date. As part of the acquisition, approximately $5.9 billion of St. Jude Medical's debt was assumed, repaid +or refinanced by Abbott. The acquisition provides expanded opportunities for future growth and is an important part of the company's ongoing effort to develop a strong, diverse portfolio of devices, +diagnostics, nutritionals and branded generic pharmaceuticals. The combined business competes in nearly every area of the cardiovascular device market, as well as in the neuromodulation market. +Under +the terms of the agreement, for each St. Jude Medical common share, St. Jude Medical shareholders received $46.75 in cash and 0.8708 of an Abbott common share. At an +Abbott stock price of $39.36, which reflected the closing price on January 4, 2017, this represented a value of approximately $81 per St. Jude Medical common share and total +purchase consideration of $23.6 billion. The cash portion of the acquisition was funded through a combination of medium and long-term debt issued in November 2016 and a $2.0 billion +120-day senior unsecured bridge term loan facility which was subsequently repaid. +The +final allocation of the fair value of the St. Jude Medical acquisition is shown in the table below. +(in billions) +Acquired intangible assets, non-deductible +$ +15.5 +Goodwill, non-deductible +13.1 +Acquired net tangible assets +3.0 +Deferred income taxes recorded at acquisition +(2.7 +) +Net debt +(5.3 +) +​ +​ +​ +​ +​ +Total final allocation of fair value +$ +23.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +goodwill is primarily attributable to expected synergies from combining operations, as well as intangible assets that do not qualify for separate recognition. The goodwill is +identifiable to the Cardiovascular and Neuromodulation Products reportable segment. The acquired tangible assets consist primarily of trade accounts receivable of approximately $1.1 billion, +inventory of approximately $1.7 billion, other current assets of $176 million, property and equipment of approximately $1.5 billion, and other long-term assets of approximately +$455 million. The acquired tangible liabilities consist of trade accounts payable and other current liabilities of approximately $1.1 billion and other non-current liabilities of +approximately $870 million. +In +2016, Abbott and St. Jude Medical agreed to sell certain businesses to Terumo Corporation for approximately $1.12 billion. The sale included the St. Jude Medical +Angio-Seal™ and Femoseal™ vascular closure and Abbott's Vado® Steerable Sheath businesses. The sale closed on January 20, 2017 and no gain or loss was +recorded in the Consolidated Statement of Earnings. +33 +On +October 3, 2017, Abbott acquired Alere, a diagnostic device and service provider, for $51.00 per common share in cash, which equated to a purchase price of approximately +$4.5 billion. As part of the acquisition, Abbott tendered for Alere's preferred shares for a total value of approximately $0.7 billion. In addition, approximately $3.0 billion of +Alere's debt was assumed and subsequently repaid. The acquisition establishes Abbott as a leader in point of care testing, expands Abbott's global diagnostics presence and provides access to new +products, channels and geographies. Abbott utilized a combination of cash on hand and debt to fund the acquisition. See Note 11 — Debt and Lines of Credit for further details +regarding the debt utilized for the acquisition. +The +final allocation of the fair value of the Alere acquisition is shown in the table below. +(in billions) +Acquired intangible assets, non-deductible +$ +3.5 +Goodwill, non-deductible +3.7 +Acquired net tangible assets +1.0 +Deferred income taxes recorded at acquisition +(0.4 +) +Net debt +(2.6 +) +Preferred stock +(0.7 +) +​ +​ +​ +​ +​ +Total final allocation of fair value +$ +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +goodwill is primarily attributable to expected synergies from combining operations, as well as intangible assets that do not qualify for separate recognition. The goodwill is +identifiable to the Diagnostic Products reportable segment. The approximate value of the acquired tangible assets consists of $430 million of trade accounts receivable, $425 million of +inventory, $225 million of other current assets, $540 million of property and equipment, and $210 million of other long-term assets. The approximate value of the acquired tangible +liabilities consists of $675 million of trade accounts payable and other current liabilities and $145 million of other non-current liabilities. +In +the third quarter of 2017, Alere entered into agreements to sell its Triage MeterPro cardiovascular and toxicology business and the assets and liabilities related to its B-type +Natriuretic Peptide assay business run on Beckman Coulter analyzers to Quidel Corporation (Quidel). The transactions with Quidel reflect a total purchase price of $400 million payable at the +close of the transaction, $240 million payable in six annual installments beginning approximately six months after the close of the transaction, and contingent consideration with a maximum +value of $40 million. In the third quarter of 2017, Alere entered into an agreement with Siemens Diagnostics Holding II B.V. (Siemens) to sell its subsidiary, Epocal Inc., for +approximately $200 million payable at the close of the transaction. Alere agreed to divest these businesses in connection with the review by the Federal Trade Commission and the European +Commission of Abbott's agreement to acquire Alere. The sale to Quidel closed on October 6, 2017, and the sale to Siemens closed on October 31, 2017. No gain or loss on these sales was +recorded in the Consolidated Statement of Earnings. +On +July 17, 2017, Abbott commenced a tender offer to purchase for cash the 1.77 million outstanding shares of Alere's Series B Convertible Perpetual Preferred Stock +at a price of $402 per share, plus accrued but unpaid dividends to, but not including, the settlement date of the tender offer. This tender offer was subject to the satisfaction of certain conditions, +including Abbott's acquisition of Alere and upon there being validly tendered (and not properly withdrawn) at the expiration date of the tender offer that number of shares of Preferred Stock that +equaled at least a majority of the Preferred Stock issued and outstanding at the expiration of the tender offer. All conditions to the offer were satisfied and Abbott accepted for payment the +1.748 million shares of Preferred Stock that were validly tendered (and not properly withdrawn). The remaining shares were cashed out for an amount equal to the $400.00 per share liquidation +preference of such shares, plus accrued but unpaid dividends, without interest. Payment for all of the shares of Preferred Stock was made in the fourth quarter of 2017. +34 +Restructurings +In 2017 and 2018, Abbott management approved restructuring plans as part of the integration of the acquisition of St. Jude Medical into +the Cardiovascular and Neuromodulation +Products segment and Alere into the Diagnostic Products segment, in order to leverage economies of scale and reduce costs. Abbott recorded charges, including one-time employee termination benefits, of +approximately $52 million in 2018 and $187 million in 2017. Approximately $5 million in 2018 and 2017 are recorded in Cost of products sold, approximately $10 million in +2018 is recorded in Research and development and approximately $37 million in 2018 and $182 million in 2017 in Selling, general and administrative expense. +From +2016 to 2018, Abbott management approved plans to streamline operations in order to reduce costs and improve efficiencies in various Abbott businesses including the nutritional, +established pharmaceuticals and vascular businesses. Abbott recorded employee-related severance and other charges of approximately $28 million in 2018, $120 million in 2017 and +$32 million in 2016. Approximately $10 million in 2018, $7 million in 2017 and $9 million in 2016 are recorded in Cost of products sold, approximately $2 million in +2018, $77 million in 2017 and $5 million in 2016 are recorded in Research and development and approximately $16 million in 2018, $36 million in 2017 and $18 million +in 2016 are recorded in Selling, general and administrative expense. Additional charges of approximately $2 million in 2017 and 2016 were recorded primarily for accelerated depreciation. +Interest Expense and Interest (Income) +In 2018, interest expense decreased primarily due to the net repayment of $8.3 billion of debt, partially offset by lower interest income +due to lower cash balances. In 2017, interest expense increased primarily due to the $15.1 billion of debt issued in November of 2016 related to the financing of the St. Jude Medical +acquisition which closed on January 4, 2017. In 2016, interest expense increased primarily due to the amortization of bridge financing fees related to the financing of the St. Jude +Medical and Alere acquisitions. Interest expense in 2016 also increased due to the $15.1 billion of debt issued in November 2016. +Debt Extinguishment Costs +On October 28, 2018, Abbott redeemed approximately $4 billion of debt, which included $750 million principal amount of its +2.00% Notes due 2020; $597 million principal amount of its 4.125% Notes due 2020; $900 million principal amount of its 3.25% Notes due 2023; $450 million principal amount of its +3.4% Notes due 2023; and $1.300 billion principal amount of its 3.75% Notes due 2026. Abbott incurred a net charge of $153 million related to the early repayment of this debt and the +unwinding of related interest rate swaps. +On +March 22, 2018, Abbott redeemed all of the $947 million principal amount of its 5.125% Notes due 2019, as well as $1.055 billion of the $2.850 billion +principal amount of its 2.35% Notes due 2019. Abbott incurred a net charge of $14 million related to the early repayment of this debt. +Other (Income) Expense, net +Other (income) expense, net, for 2018, 2017 and 2016 includes approximately $160 million of income in each year related to the +non-service cost components of the net periodic benefit costs associated with the pension and post-retirement medical plans. These amounts are being reported in other (income) expense as a result of +the adoption of the new accounting standard for recognizing pension cost. 2017 includes a pre-tax gain of $1.163 billion on the sale of AMO to Johnson & Johnson. 2016 includes +$947 million of expense to adjust Abbott's holding of Mylan N.V. ordinary shares due to a decline in the fair value of the securities which was considered by Abbott to be other than +temporary. +35 +Taxes on Earnings +The income tax rates on earnings from continuing operations were 18.8 percent in 2018, 84.2 percent in 2017 and +24.8 percent in 2016. +The +Tax Cuts and Jobs Act (TCJA) was enacted in the U.S. on December 22, 2017. The TCJA reduces the U.S. federal corporate tax rate from 35% to 21%, requires companies to pay a +one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. As of December 31, 2018, Abbott +has completed its accounting for all of the enactment date income tax effects of the TCJA. If additional regulations issued by the U.S. Department of the Treasury after December 31, 2018 result +in a change in judgment, the effect of such regulations will be accounted for in the period in which the regulations are finalized. +Effective +for fiscal years beginning after December 31, 2017, the TCJA subjects taxpayers to tax on global intangible low-taxed income (GILTI) earned by certain foreign +subsidiaries. In January 2018, the Financial Accounting Standards Board staff provided guidance that an entity may make an accounting policy election to either recognize deferred taxes related to +items that will give rise to GILTI in future years or provide for the tax expense related to GILTI in the year that the tax is incurred. Abbott has elected to treat the GILTI tax as a period expense +and provide for the tax in the year that the tax is incurred. +In +the fourth quarter of 2017, Abbott recorded an estimate of net tax expense of $1.46 billion for the impact of the TCJA, which was included in Taxes on Earnings from Continuing +Operations in the Consolidated Statement of Earnings. The estimate was provisional and included a charge of approximately $2.89 billion for the transition tax, partially offset by a net benefit +of approximately $1.42 billion for the remeasurement of deferred tax assets and liabilities, and a net benefit of approximately $10 million related to certain other impacts of the TCJA. +In 2018, Abbott recorded $130 million of additional tax expense which increased the final tax expense related to the TCJA to $1.59 billion. The $130 million of additional tax +expense reflects a $120 million increase in the transition tax from $2.89 billion to $3.01 billion and a $10 million reduction in the net benefit related to the +remeasurement of deferred tax assets and liabilities. +The +one-time transition tax is based on Abbott's total post-1986 earnings and profits (E&P) that were previously deferred from U.S. income taxes. The tax computation also requires the +determination of the amount of post-1986 E&P considered held in cash and other specified assets. As of December 31, 2018, the remaining balance of Abbott's transition tax obligation is +approximately $1.58 billion, which will be paid over the next eight years as allowed by the TCJA. +In +2018, taxes on earnings from continuing operations included $98 million of net tax expense related to the settlement of Abbott's 2014-2016 federal income tax audit in the U.S., +partial settlement of the former St. Jude Medical consolidated group's 2014 and 2015 federal income tax returns in the U.S. and audit settlements in various countries. In 2017, taxes on +earnings from continuing operations include $435 million of tax expense related to the gain on the sale of the AMO business. In 2016, taxes on earnings from continuing operations include the +impact of a net tax benefit of approximately $225 million, primarily as a result of the resolution of various tax positions from prior years, partially offset by the unfavorable impact of +non-deductible foreign exchange losses related to Venezuela and the adjustment of the Mylan N.V. equity investment, as well as the recognition of deferred taxes associated with the then pending +sale of AMO. +Exclusive +of these discrete items, tax expense was favorably impacted by lower tax rates and tax exemptions on foreign income primarily derived from operations in Puerto Rico, +Switzerland, Ireland, the Netherlands, Costa Rica, and Singapore. Abbott benefits from a combination of favorable statutory tax rules, tax rulings, grants, and exemptions in these tax jurisdictions. +See Note 15 to the consolidated financial statements for a full reconciliation of the effective tax rate to the U.S. federal statutory rate. +36 +Discontinued Operations +Earnings from discontinued operations, net of tax of $34 million, $124 million and $321 million, in 2018, 2017 and 2016, +respectively, were driven primarily by the recognition of net tax benefits as a result of the resolution of various tax positions pertaining to AbbVie's operations for years prior to the separation. +On January 1, 2013, Abbott completed the separation of AbbVie Inc. (AbbVie), which was formed to hold Abbott's research-based proprietary pharmaceuticals business. Abbott has retained +all liabilities for all U.S. federal and foreign income taxes on income prior to the separation, as well as certain non-income taxes attributable to AbbVie's business. AbbVie generally will be liable +for all other taxes attributable to its business. +Assets Held for Disposition +In September 2016, Abbott announced that it entered into a definitive agreement to sell Abbott Medical Optics (AMO), its vision care business, +to Johnson & Johnson for $4.325 billion in cash, subject to customary purchase price adjustments for cash, debt and working capital. The decision to sell AMO reflected Abbott's proactive +shaping of its portfolio in line with its strategic priorities. In February 2017, Abbott completed the sale of AMO to Johnson & Johnson and recognized a pre-tax gain of $1.163 billion +including working capital adjustments, which was reported in the Other (income) expense, net line of the Consolidated Statement of Earnings in 2017. Abbott recorded an after-tax gain of +$728 million in 2017 related to the sale of AMO. The operating results of AMO up to the date of sale continued to be included in Earnings from continuing operations as the business did not +qualify for reporting as discontinued operations. For 2017 and 2016, the AMO earnings (losses) before taxes included in Abbott's consolidated earnings were $(18) million and $30 million, +respectively. +As +discussed in the Business Acquisitions section, in conjunction with the acquisition of Alere, Abbott sold the Triage MeterPro cardiovascular and toxicology business and the assets and +liabilities related to its B-type Natriuretic Peptide assay business run on Beckman Coulter analyzers to Quidel. The legal transfer of certain assets related to these businesses did not occur at the +close of the sale to Quidel due to, among other factors, the time required to transfer marketing authorizations and other regulatory requirements in various countries. Under the terms of the sale +agreement with Abbott, Quidel is subject to the risks and entitled to the benefits generated by these operations and assets. The assets +presented as held for disposition in the Consolidated Balance Sheet as of December 31, 2018 and 2017, primarily relate to the businesses sold to Quidel. +The +following is a summary of the assets held for disposition as of December 31, 2018 and 2017: +(in millions) +December 31, +2018 +December 31, +2017 +Trade Receivables, net +$ +6 +$ +12 +Total inventories +3 +8 +​ +​ +​ +​ +​ +​ +​ +​ +Current assets held for disposition +9 +20 +​ +​ +​ +​ +​ +​ +​ +​ +Net property and equipment +— +56 +Intangible assets, net of amortization +— +18 +Goodwill +17 +102 +​ +​ +​ +​ +​ +​ +​ +​ +Non-current assets held for disposition +17 +176 +​ +​ +​ +​ +​ +​ +​ +​ +Total assets held for disposition +$ +26 +$ +196 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +37 +Research and Development Programs +Abbott currently has numerous pharmaceutical, medical devices, diagnostic and nutritional products in development. +Research and Development Process +In the Established Pharmaceuticals segment, the development process focuses on the geographic expansion and continuous improvement of the +segment's existing products to provide benefits to patients and customers. As Established Pharmaceuticals does not actively pursue primary research, development usually begins with work on existing +products or after the acquisition of an advanced stage licensing opportunity. +Depending +upon the product, the phases of development may include: +• Drug product development. +• Phase I bioequivalence studies to compare a future Established Pharmaceutical's brand with an already marketed compound with the same +active pharmaceutical ingredient (API). +• Phase II studies to test the efficacy of benefits in a small group of patients. +• Phase III studies to broaden the testing to a wider population that reflects the actual medical use. +• Phase IV and other post-marketing studies to obtain new clinical use data on existing products within approved indications. +The +specific requirements (e.g., scope of clinical trials) for obtaining regulatory approval vary across different countries and geographic regions. The process may range from one +year for a bioequivalence study project to 6 or more years for complex formulations, new indications, or geographic expansion in specific countries, such as China. +In +the Diagnostics segment, the phases of the research and development process include: +• Discovery which focuses on identification of a product that will address a specific therapeutic area, platform, or unmet clinical need. +• Concept/Feasibility during which the materials and manufacturing processes are evaluated, testing may include product characterization and +analysis is performed to confirm clinical utility. +• Development during which extensive testing is performed to demonstrate that the product meets specified design requirements and that the design +specifications conform to user needs and intended uses. +The +regulatory requirements for diagnostic products vary across different countries and geographic regions. In the U.S., the FDA classifies diagnostic products into classes (I, II, or +III) and the classification determines the regulatory process for approval. While the Diagnostics segment has products in all three classes, the vast majority of its products are categorized as +Class I or Class II. Submission of a separate regulatory filing is not required for Class I products. Class II devices typically require pre-market notification to the FDA +through a regulatory filing known as a 510(k) submission. Most Class III products are subject to the FDA's Pre-Marketing Approval (PMA) requirements. Other Class III products, such as +those used to screen blood, require the submission and approval of a Biological License Application (BLA). +In +the European Union (EU), diagnostic products are also categorized into different categories and the regulatory process, which is governed by the European In Vitro Diagnostic Medical +Device Directive, depends upon the category. Certain product categories require review and approval by an independent +38 +company, +known as a Notified Body, before the manufacturer can affix a CE mark to the product to show compliance with the Directive. Other products only require a self-certification process. +In +the Cardiovascular and Neuromodulation segment, the research and development process begins with research on a specific technology that is evaluated for feasibility and commercial +viability. If the research program passes that hurdle, it moves forward into development. The development process includes evaluation, selection and qualification of a product design, completion of +applicable clinical trials to test the product's safety and efficacy, and validation of the manufacturing process to demonstrate its repeatability and ability to consistently meet pre-determined +specifications. +Similar +to the diagnostic products discussed above, in the U.S., cardiovascular and neuromodulation products are classified as Class I, II, or III. Most of Abbott's cardiovascular +and neuromodulation products are classified as Class II devices that follow the 510(k) regulatory process or Class III devices that are subject to the PMA process. +In +the EU, cardiovascular and neuromodulation products are also categorized into different classes and the regulatory process, which is governed by the European Medical Device Directive +and the Active Implantable Medical Device Directive, varies by class. Each product must bear a CE mark to show compliance with the Directive. Some products require submission of a design dossier to +the appropriate regulatory authority for review and approval prior to CE marking of the device. For other products, the company is required to prepare a technical file which includes testing results +and clinical evaluations but can self-certify its ability to apply the CE mark to the product. Outside the U.S. and the EU, the regulatory requirements vary across different countries and regions. +After +approval and commercial launch of some cardiovascular and neuromodulation products, post-market trials may be conducted either due to a conditional requirement of the regulatory +market approval or with the objective of proving product superiority. +In +the second quarter of 2017, the EU adopted the new Medical Devices Regulation (MDR) and the In Vitro Diagnostic Regulation (IVDR) which replace the existing directives in the +EU for medical devices and in vitro diagnostic products. The MDR and IVDR will apply after a three-year and five-year transition period, respectively, and will impose additional premarket and +postmarket regulatory requirements on manufacturers of such products. +In +the Nutritional segment, the research and development process generally focuses on identifying and developing ingredients and products that address the nutritional needs of particular +populations (e.g., infants and adults) or patients (e.g., people with diabetes). Depending upon the country and/or region, if claims regarding a product's efficacy will be made, clinical +studies typically must be conducted. +In +the U.S., the FDA requires that it be notified of proposed new formulations and formulation or packaging changes related to infant formula products. Prior to the launch of an infant +formula or product packaging change, the company is required to obtain the FDA's confirmation that it has no objections to the proposed product or packaging. For other nutritional products, +notification or pre-approval from the FDA is not required unless the product includes a new food additive. In some +countries, regulatory approval may be required for certain nutritional products, including infant formula and medical nutritional products. +Areas of Focus +In 2019 and beyond, Abbott's significant areas of therapeutic focus will include the following: +Established +Pharmaceuticals — Abbott focuses on building country-specific portfolios made up of high-quality medicines that meet the needs of people in emerging markets. Over the +next several years, Abbott plans to expand its product portfolio in key therapeutic areas with the aim of being among the first to launch new off-patent and differentiated medicines. In addition, +Abbott continues to expand existing +39 +brands +into new markets, implement product enhancements that provide value to patients and acquire strategic products and technology through licensing activities. Abbott is also actively working on +the further development of several key brands such as Creon™, Duphaston™, Duphalac™ and Influvac™. Depending on the product, the activities focus on +development of new data, markets, formulations, delivery systems, or indications. +Cardiovascular +and Neuromodulation — Abbott's research and development programs focus on: +• Cardiac Rhythm Management — Development of next-generation rhythm management technologies, including enhanced patient +engagement and expanded magnetic resonance (MR)-compatibility. +• Heart Failure — Continued enhancements to Abbott's left ventricular assist systems and pulmonary artery heart failure +system, including enhanced connectivity, user-interfaces and remote patient monitoring. +• Electrophysiology — Development of next-generation technologies in the areas of ablation, diagnostic, mapping and +visualization and recording and monitoring. +• Vascular — Development of next-generation technologies for use in coronary and peripheral vascular procedures. +• Structural Heart — Development of minimally-invasive devices for the repair and replacement of heart valves and other +structural heart conditions. +• Neuromodulation — Development of next-generation technologies with enhanced patient and physician engagement and expanded +MR-compatibility to treat chronic pain, movement disorders and other indications. +Diabetes +Care — Develop enhancements and additional indications for the FreeStyle Libre continuous glucose monitoring system to help patients improve their ability to manage +diabetes. +Core +Laboratory Diagnostics — Abbott continues to commercialize its next-generation blood screening, immunoassay, clinical chemistry and hematology systems, along with assays, +including a focus on unmet medical need, in various areas including infectious disease, cardiac care, metabolics, oncology, as well as informatics and automation solutions to increase efficiency in +laboratories. +Molecular +Diagnostics — Several new molecular in vitro diagnostic (IVD) tests and "Alinity m", a next generation instrument system, are in various stages of development and launch. +Rapid +Diagnostics — Abbott's research and development programs focus on the development of diagnostic products for cardiometabolic disease, infectious disease and toxicology. +Nutritionals — +Abbott is focusing its research and development spend on platforms that span the pediatric and adult nutrition areas: gastro intestinal/immunity health, brain health, +mobility and metabolism, and user experience platforms. Numerous new products that build on advances in these platforms are currently under development, including clinical outcome testing, and are +expected to be launched over the coming years. +Given +the diversity of Abbott's business, its intention to remain a broad-based healthcare company and the numerous sources for potential future growth, no individual project is expected +to be material to cash flows or results of operations over the next five years. Factors considered included research and development expenses projected to be incurred for the project over the next +year relative to Abbott's total research and development expenses, as well as qualitative factors, such as marketplace perceptions and impact of a new product on Abbott's overall market position. +There were no delays in Abbott's 2018 research and development activities that are expected to have a material impact on operations. +40 +While +the aggregate cost to complete the numerous projects currently in development is expected to be material, the total cost to complete will depend upon Abbott's ability to +successfully finish each project, the rate at which each project advances, and the ultimate timing for completion. Given the potential for significant delays and the risk of failure inherent in the +development of medical device, diagnostic and pharmaceutical products and technologies, it is not possible to accurately estimate the total cost to complete all projects currently in development. +Abbott plans to manage its portfolio of projects to achieve research and development spending that will be competitive in each of the businesses in which it participates, and such spending is expected +to approximate 7.5 percent of total Abbott sales in 2019. Abbott does not regularly accumulate or make management decisions based on the total expenses incurred for a particular development +phase in a given period. +Goodwill +At December 31, 2018, goodwill recorded as a result of business combinations totaled $23.3 billion. Goodwill is reviewed for +impairment annually in the third quarter or when an event that could result in an impairment occurs, using a quantitative assessment to determine whether it is more likely than not that the fair value +of any reporting unit is less than its carrying amount. The +income and market approaches are used to calculate the fair value of each reporting unit. The results of the last impairment test indicated that the fair value of each reporting unit was substantially +in excess of its carrying value. +Financial Condition +Cash Flow +Net cash from operating activities amounted to $6.3 billion, $5.6 billion and $3.2 billion in 2018, 2017 and 2016, +respectively. The increase in Net cash from operating activities in 2018 was primarily due to higher segment operating earnings, continued improvements in working capital management, timing of pension +contributions and lower acquisition-related expenses. The increase in Net cash from operating activities in 2017 was primarily due to the favorable impact of improved working capital management, the +acquisition of the St. Jude Medical businesses, and higher segment operating earnings. The income tax component of cash from operating activities in 2018 includes the non-cash impact of the +$120 million adjustment to the transition tax associated with the TCJA. The income tax component of operating cash flow in 2017 includes the non-cash impact of $1.46 billion of net tax +expense related to the estimated impact of the TCJA. The income tax component of operating cash flow in 2016 includes $550 million of non-cash tax benefits primarily related to the favorable +resolution of various tax positions pertaining to prior years. +The +foreign currency loss related to Venezuela reduced Abbott's cash by approximately $410 million in 2016 and is included in the Effect of exchange rate changes on cash and cash +equivalents line within the Consolidated Statement of Cash Flows. Future fluctuations in the strength of the U.S. dollar against foreign currencies are not expected to materially impact Abbott's +liquidity. +While +a significant portion of Abbott's cash and cash equivalents at December 31, 2018, are reinvested in foreign subsidiaries, Abbott does not expect such reinvestment to affect +its liquidity and capital resources. Due to the enactment of the TCJA, if these funds were needed for operations in the U.S., Abbott does not expect to incur significant additional income taxes in the +future to repatriate these funds. +Abbott +funded $114 million in 2018, $645 million in 2017 and $582 million in 2016 to defined benefit pension plans. Abbott expects pension funding of approximately +$380 million in 2019 for its pension plans. Abbott expects annual cash flow from operating activities to continue to exceed Abbott's capital expenditures and cash dividends. +41 +Debt and Capital +At December 31, 2018, Abbott's long-term debt rating was BBB by Standard & Poor's Corporation and Baa1 by Moody's. Abbott expects +to maintain an investment grade rating. +Abbott +has readily available financial resources, including unused lines of credit that support commercial paper borrowing arrangements and provide Abbott with the ability to borrow up +to $5 billion on an unsecured basis. The lines of credit are part of a 2018 revolving credit agreement that expires in 2023. Abbott entered into this new revolving credit agreement and +terminated the 2014 revolving credit agreement on November 30, 2018. There were no outstanding borrowings under the 2014 revolving credit agreement at the time of its termination. Any +borrowings under the new revolving credit agreement will bear interest, at Abbott's option, based on either a base rate or Eurodollar rate, plus an applicable margin based on Abbott's credit ratings. +In +conjunction with the funding of the St. Jude Medical and Alere acquisitions and the assumption of St. Jude Medical's and Alere's existing debt, Abbott's total short-term +and long-term debt increased from approximately $9.0 billion at December 31, 2015 to $27.9 billion at December 31, 2017. The increase in debt included the following +transactions in 2016 and 2017: +• In April 2016, Abbott obtained a commitment for a 364-day senior unsecured bridge term loan facility for an amount not to exceed +$17.2 billion, comprised of $15.2 billion for a 364-day bridge loan and $2.0 billion for a 120-day bridge loan to provide financing for the acquisition of St. Jude Medical. +This facility has been terminated as further discussed below. +• In November 2016, Abbott issued $15.1 billion of medium and long-term debt to primarily fund the cash portion of the acquisition of +St. Jude Medical. Abbott also entered into interest rate swap contracts totaling $3.0 billion related to the new debt. The swaps have the effect of changing Abbott's obligation from a +fixed interest rate to a variable interest rate obligation on the related debt instruments. The $15.2 billion component of the commitment for a bridge term loan facility terminated in November +2016 when Abbott issued the $15.1 billion of long-term debt. +• In December 2016, Abbott formalized the $2.0 billion component of the bridge term loan facility and entered into a 120-day bridge term +loan facility that provided Abbott the ability to borrow up to $2.0 billion on an unsecured basis to partially fund the St. Jude Medical acquisition. On January 4, 2017, as part +of funding the cash portion of the St. Jude Medical acquisition, Abbott borrowed $2.0 billion under the 120-day senior unsecured bridge term loan facility. This facility was repaid +during the first quarter of 2017. +• In the first quarter of 2017, as part of the acquisition of St. Jude Medical, approximately $5.9 billion of St. Jude +Medical's debt was assumed, repaid, or refinanced by Abbott. This included the exchange of certain St. Jude Medical debt obligations with an aggregate principal amount of approximately +$2.9 billion for approximately $2.9 billion of debt issued by Abbott. Following this exchange, approximately $194.2 million of existing St. Jude Medical notes remained +outstanding. There were no significant costs associated with the exchange of this debt. In addition, during the first quarter of 2017, Abbott assumed and subsequently repaid approximately +$2.8 billion of various St. Jude Medical debt obligations. +• In 2017, Abbott borrowed $2.8 billion on an unsecured basis under a 5-year term loan agreement and borrowed $1.7 billion under +its lines of credit. Proceeds from such borrowings were used to finance the acquisition of Alere, to repay certain indebtedness of Abbott and Alere, and to pay fees and expenses in connection with the +acquisition. The borrowings bore interest based on a Eurodollar rate, plus an applicable margin based on Abbott's credit ratings. Abbott paid off the term loan in January 2018, ahead of its 2022 due +date and paid off $550 million of the line of credit in the fourth quarter of 2017 and the remaining $1.15 billion on January 5, 2018. In the fourth +42 +quarter +of 2017, in conjunction with the acquisition of Alere, Abbott assumed and subsequently repaid $3.0 billion of Alere's debt. +• In 2017, Abbott also paid off a $479 million yen-denominated short-term borrowing during the year and issued 364-day yen-denominated +debt, of which $199 million and $195 million was outstanding at December 31, 2018 and 2017, respectively. +In +2018 Abbott committed to reducing its debt levels and on February 16, 2018, the board of directors authorized the early redemption of up to $5 billion of outstanding +long-term notes. Redemptions under this authorization during 2018 included $0.947 billion principal amount of its 5.125% Notes due 2019 and $2.850 billion principal amount of its 2.35% +Notes due 2019. Abbott incurred a net charge of $14 million related to the early repayment of this debt. +On +September 17, 2018, Abbott repaid upon maturity the $500 million aggregate principal amount outstanding of the 2.00% Senior Notes due 2018. +On +September 27, 2018, Abbott's wholly owned subsidiary, Abbott Ireland Financing DAC, completed a euro debt offering of €3.420 billion of long-term debt. +The proceeds equated to approximately $4 billion. The notes are guaranteed by Abbott. +On +October 28, 2018, Abbott redeemed $4.0 billion principal amount of its outstanding long-term debt. This amount is in addition to the $5 billion authorization +discussed above. In conjunction with the redemption, Abbott unwound approximately $1.1 billion in interest rate swaps relating to the 3.40% Note due in 2023 and the 3.75% Note due in 2026. +Abbott incurred a net charge of $153 million related to the early repayment of this debt and the unwinding of related interest rate swaps. +The +2018 transactions described above, including the repayment of $2.8 billion under the 5-year term loan and $1.15 billion of borrowings under the lines of credit, +resulted in the net repayment of approximately $8.3 billion of debt. +On +January 25, 2019, Abbott notified the holders of its 2.80% Notes due 2020, that it will redeem the $500 million outstanding principal amount of these notes on +February 24, 2019. After the redemption of the 2.80% Notes, approximately $700 million of the $5 billion debt redemption authorized by Abbott's board of directors in 2018 will +remain available. +In +September 2014, the board of directors authorized the repurchase of up to $3.0 billion of Abbott's common shares from time to time. Under the program authorized in 2014, Abbott +repurchased 36.2 million shares at a cost of $1.7 billion in 2015, 10.4 million shares at a cost of $408 million in 2016 and 1.9 million shares at a cost of +$130 million in 2018 for a total of approximately $2.2 billion. +On +April 27, 2016, the board of directors authorized the issuance and sale for general corporate purposes of up to 75 million common shares that would result in proceeds of +up to $3 billion. No shares have been issued under this authorization. +Abbott +declared dividends of $1.16 per share in 2018 compared to $1.075 per share in 2017, an increase of approximately 8 percent. Dividends paid were $1.974 billion in +2018 compared to $1.849 billion in 2017. The year-over-year change in dividends paid reflects the impact of the increase in the dividend rate. +Working Capital +Working capital was $5.6 billion at December 31, 2018 and $11.2 billion at December 31, 2017. The decrease in +working capital in 2018 reflects the use of cash to repay long-term debt and dividends. +43 +Abbott +monitors the credit worthiness of customers and establishes an allowance against a trade receivable when it is probable that the balance will not be collected. In addition to +closely monitoring economic conditions and budgetary and other fiscal developments, Abbott regularly communicates with its customers regarding the status of receivable balances, including their +payment plans and obtains positive confirmation of the validity of the receivables. Abbott also monitors the potential for and periodically has utilized factoring arrangements to mitigate credit risk +although the receivables included in such arrangements have historically not been a material amount of total outstanding receivables. +Venezuela Operations +Since January 2010, Venezuela has been designated as a highly inflationary economy under U.S. GAAP. On February 17, 2016, the +Venezuelan government announced that its three-tier exchange rate system would be reduced to two rates renamed the DIPRO and DICOM rates. The DIPRO was the official rate for food and medicine imports +and was adjusted from 6.3 to 10 bolivars per U.S. dollar. The DICOM rate was a floating market rate published daily by the Venezuelan central bank, which at the end of the first quarter of 2016 was +approximately 263 bolivars per U.S. dollar. As a result of decreasing government approvals to convert bolivars to U.S. dollars to pay for +intercompany accounts, as well as the accelerating deterioration of economic conditions in the country, Abbott concluded that it was appropriate to move to the DICOM rate at the end of the first +quarter of 2016. As a result, Abbott recorded a foreign currency exchange loss of $480 million in 2016 to revalue its net monetary assets in Venezuela. After the revaluation, Abbott's +investment in its Venezuelan operations was not significant. +Capital Expenditures +Capital expenditures of $1.4 billion in 2018, $1.1 billion in 2017 and $1.1 billion in 2016 were principally for upgrading +and expanding manufacturing and research and development facilities and equipment in various segments, investments in information technology, and laboratory instruments placed with customers. +Contractual Obligations +The table below summarizes Abbott's estimated contractual obligations as of December 31, 2018. +Payments Due By Period +(dollars in millions) +Total +2019 +2020-2021 +2022-2023 +2024 and +Thereafter +Long-term debt, including current maturities +$ +19,626 +$ +7 +$ +4,658 +$ +3,105 +$ +11,856 +Interest on debt obligations +10,237 +668 +1,312 +1,102 +7,155 +Operating lease obligations +984 +218 +302 +193 +271 +Capitalized auto lease obligations +41 +14 +27 +— +— +Purchase commitments (a) +2,591 +2,454 +103 +21 +13 +Other long-term liabilities (b) +3,492 +— +1,288 +884 +1,320 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total (c) +$ +36,971 +$ +3,361 +$ +7,690 +$ +5,305 +$ +20,615 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Purchase +commitments are for purchases made in the normal course of business to meet operational and capital expenditure requirements. +(b) Other +long-term liabilities include estimated payments for the transition tax under the TCJA, net of applicable credits. +(c) Net +unrecognized tax benefits totaling approximately $465 million are excluded from the table above as Abbott is unable to reasonably estimate the period of +cash settlement with the respective taxing authorities on such items. See Note 15 — Taxes on Earnings from Continuing Operations for further +44 +details. +The company has employee benefit obligations consisting of pensions and other post-employment benefits, including medical and life, which have been excluded from the table. A discussion of +the company's pension and post-retirement plans, including funding matters is included in Note 14 — Post-employment Benefits. +Contingent Obligations +Abbott has periodically entered into agreements with other companies in the ordinary course of business, such as assignment of product rights, +which has resulted in Abbott becoming secondarily liable for obligations that Abbott was previously primarily liable. Since Abbott no longer maintains a business relationship with the other parties, +Abbott is unable to develop an estimate of the maximum potential amount of future payments, if any, under these obligations. Based upon past experience, the likelihood of payments under these +agreements is remote. In addition, Abbott periodically acquires a business or product rights in which Abbott agrees to pay contingent consideration based on attaining certain thresholds or based on +the occurrence of certain events. +Legislative Issues +Abbott's primary markets are highly competitive and subject to substantial government regulations throughout the world. Abbott expects debate to +continue over the availability, method of delivery, and payment for health care products and services. It is not possible to predict the +extent to which Abbott or the health care industry in general might be adversely affected by these factors in the future. A more complete discussion of these factors is contained in Item 1, +Business, and Item 1A, Risk Factors. +Recently Issued Accounting Standards +In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other +Comprehensive Income , which allows companies to reclassify stranded tax effects resulting from the TCJA, from accumulated other comprehensive income (loss) to retained earnings +(Earnings employed in the business). The standard would have become effective for Abbott beginning in the first quarter of 2019, with early adoption permitted. Abbott elected to adopt the new standard +at the beginning of the fourth quarter of 2018. As a result of the adoption of the new standard, approximately $337 million of stranded tax effects were reclassified from Accumulated other +comprehensive income (loss) to Earnings employed in the business. +In +August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities , which makes changes to the +designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. The standard would have become effective for Abbott beginning in the first quarter of +2019, with early adoption permitted. Abbott elected to early adopt ASU 2017-12 in the fourth quarter of 2018. The impact of adopting the standard is not significant to Abbott's Consolidated +Balance Sheet and Consolidated Statement of Earnings. +In +March 2017, the FASB issued ASU 2017-07, Compensation — Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic +Pension Cost and Net Periodic Postretirement Benefit Cost which changes the financial statement presentation requirements for pension and other postretirement benefit expense. +While service cost continues to be reported in the same financial statement line items as other current employee compensation costs, the ASU requires all other components of pension and other +postretirement benefit expense to be presented separately from service cost, and outside any subtotal of income from operations. The standard was adopted by Abbott beginning in the first quarter of +2018. The change in the presentation of the components of pension cost per year was applied retrospectively. As a result, approximately $160 million of net pension-related income per year was +moved from the operating lines of the Consolidated Statement of Earnings to non-operating income for 2017 and 2016. +45 +In +November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows: Restricted Cash , which requires that restricted cash be +included with cash and cash equivalents when reconciling the beginning and end-of-period total amounts shown on the statement of cash flows. Abbott adopted this standard beginning in the first quarter +of 2018, and applied the guidance retrospectively to all periods presented. Abbott did not have any restricted cash balances in the periods presented except for $75 million of restricted cash +acquired as part of the Alere acquisition in October 2017. The restrictions on this cash were eliminated prior to the end of 2017. +In +October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory , +which requires the recognition of the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer occurs. Abbott adopted the standard on +January 1, 2018, using a modified retrospective approach and recorded a cumulative catch-up adjustment to Earnings employed in the business in the Consolidated Balance Sheet that was not +significant. +In +August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments , +which clarifies how companies should present and classify certain cash receipts and cash payments in the statement of cash flows. The ASU became effective for Abbott in the first quarter of 2018 and +did not have a material impact to the Company's Consolidated Statement of Cash Flows. +In +February 2016, the FASB issued ASU 2016-02, Leases , which requires lessees to recognize assets and liabilities for most leases +on the balance sheet. The standard becomes effective for Abbott beginning in the first quarter of 2019. Abbott completed a detailed review of its leases. Abbott will use the modified retrospective +approach with the package of practical expedients which allows Abbott to carry forward the historical lease classification for existing or expired leases and to account for lease and non-lease +components as a single lease component for its lessee arrangements. Abbott does not expect the new lease accounting standard to have a material impact on the amounts reported in the Consolidated +Statement of Earnings. As a result of adopting ASU 2016-02, Abbott expects to record approximately $800 million to $900 million of right of use assets and lease liabilities for +operating leases on the Consolidated Balance Sheet. +In +January 2016, the FASB issued ASU 2016-01, Financial Instruments — Recognition and Measurement of Financial Assets and Financial +Liabilities , which provides new guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. Abbott adopted the standard on +January 1, 2018. Under the new standard, changes in the fair value of equity investments with readily determinable fair values are recorded in Other (income) expense, net within the +Consolidated Statement of Earnings. Previously, such fair value changes were recorded in other comprehensive income. Abbott has elected the measurement alternative allowed by ASU 2016-01 for +its equity investments without readily determinable fair values. These investments are measured at cost, less any impairment, plus or minus any changes resulting from observable price changes in +orderly transactions for an identical or similar investment of the same issuer. Changes in the measurement of these investments are being recorded in Other (income) expense, net within the +Consolidated Statement of Earnings. As part of the adoption, the cumulative-effect adjustment to Earnings employed in the business in the Consolidated Balance Sheet for net unrealized losses on equity +investments that +were recorded in Accumulated other comprehensive income (loss) as of December 31, 2017 was not significant. +In +May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers , which provides a single comprehensive model for +accounting for revenue from contracts with customers and supersedes nearly all previously existing revenue recognition guidance. The core principle of the ASU is that an entity should recognize +revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. +Abbott adopted the new standard as of January 1, 2018, using the modified retrospective approach +46 +method. +Under this method, entities recognize the cumulative effect of applying the new standard at the date of initial application with no restatement of comparative periods presented. The cumulative +effect of applying the new standard resulted in an increase to Earnings employed in the business in the Consolidated Balance Sheet of $23 million which was recorded on January 1, 2018. +The new standard has been applied only to those contracts that were not completed as of January 1, 2018. The impact of adopting ASU 2014-09 was not significant to individual financial +statement line items in the Consolidated Balance Sheet and Consolidated Statement of Earnings. +Private Securities Litigation Reform Act of 1995 — A Caution Concerning +Forward-Looking Statements +Under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, Abbott cautions investors that any forward-looking +statements or projections made by Abbott, including those made in this document, are subject to risks and uncertainties that may cause actual results to differ materially from those projected. +Economic, competitive, governmental, technological and other factors that may affect Abbott's operations are discussed in Item 1A, Risk Factors. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Financial Instruments and Risk Management +Market Price Sensitive Investments +The fair value of equity securities held by Abbott with a readily determinable fair value was approximately $13 million and +$11 million as of December 31, 2018 and 2017, respectively. These equity securities are subject to potential changes in fair value. A hypothetical 20 percent decrease in the share +prices of these investments would decrease their fair value at December 31, 2018 by approximately $3 million. Changes in the fair value of these securities are recorded in earnings. The +fair value of investments in mutual funds that are held in a rabbi trust for the purpose of paying benefits under a deferred compensation plan was approximately $307 million and +$363 million as of December 31, 2018 and 2017, respectively. Changes in the fair value of these investments are recorded in earnings. +Non-Publicly Traded Equity Securities +Abbott holds equity securities that are not traded on public stock exchanges. The carrying value of these investments was $211 million +and $228 million as of December 31, 2018 and 2017, respectively. No individual investment is recorded at a value in excess of $61 million. Abbott measures these investments at +cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. +Interest Rate Sensitive Financial Instruments +At December 31, 2018 and 2017, Abbott had interest rate hedge contracts totaling $2.9 billion and $4.0 billion, +respectively, to manage its exposure to changes in the fair value of debt. The effect of these hedges is to change the fixed interest rate to a variable rate for the portion of the debt that is +hedged. Abbott does not use derivative financial instruments, such as interest rate swaps, to manage its exposure to changes in interest rates for its investment securities. The fair value of +long-term debt at December 31, 2018 and 2017 amounted to $19.9 billion and $29.0 billion, respectively (average interest rates of 3.5% and 3.6% as of December 31, 2018 and +2017, respectively) with maturities through 2046. At December 31, 2018 and 2017, the fair value of current and long-term investment securities amounted to approximately $1.1 billion. A +hypothetical 100-basis point change in the interest rates would not have a material effect on cash flows, income or fair values. (A 100-basis point change is believed to be a reasonably possible +near-term change in rates.) +47 +Foreign Currency Sensitive Financial Instruments +Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange +rates for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts are designated as cash flow hedges of the variability of the +cash flows due to changes in foreign currency exchange rates and are marked-to-market with the resulting gains or losses reflected in Accumulated other comprehensive income (loss). Gains or losses +will be included in Cost of products sold at the time the products are sold, generally within the next twelve to eighteen months. At December 31, 2018 and 2017, Abbott held $5.1 billion +and $3.3 billion, respectively, of such contracts. Contracts held at December 31, 2018 will mature in 2019 or 2020 depending upon the contract. Contracts held at December 31, 2017 +matured in 2018 or will mature in 2019 depending upon the contract. +Abbott +enters into foreign currency forward exchange contracts to manage its exposure to foreign currency denominated intercompany loans and trade payables and third-party trade payables +and receivables. The contracts are marked-to-market, and resulting gains or losses are reflected in income and are generally offset by losses or gains on the foreign currency exposure being managed. +At December 31, 2018 and 2017, Abbott held $13.6 billion and $20.1 billion, respectively, of such contracts, which mature in the next 24 months. +In +March 2017, Abbott repaid its $479 million foreign denominated short-term debt which was designated as a hedge of the net investment in a foreign subsidiary. At +December 31, 2016, the value of this short-term debt was $454 million, and changes in the fair value of the debt up through the date of repayment due to changes in exchange rates were +recorded in Accumulated other comprehensive income (loss), net of tax. +The +following table reflects the total foreign currency forward contracts outstanding at December 31, 2018 and 2017: +2018 +2017 +(dollars in millions) +Contract +Amount +Weighted +Average +Exchange +Rate +Fair and +Carrying Value +Receivable/ +(Payable) +Contract +Amount +Weighted +Average +Exchange +Rate +Fair and +Carrying Value +Receivable/ +(Payable) +Primarily U.S. Dollars +to be exchanged for +the following currencies: +Euro +$ +11,630 +1.1938 +$ +13 +$ +16,877 +1.1861 +$ +(24 +) +Chinese Yuan +1,592 +6.9055 +(10 +) +1,221 +6.8128 +(33 +) +Japanese Yen +1,079 +108.2188 +6 +1,109 +110.5370 +15 +All other currencies +4,388 +n/a +10 +4,230 +n/a +(25 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +18,689 +$ +19 +$ +23,437 +$ +(67 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +48 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Consolidated Statement of Earnings +50 +Consolidated Statement of Comprehensive Income +51 +Consolidated Statement of Cash Flows +52 +Consolidated Balance Sheet +53 +Consolidated Statement of Shareholders' Investment +55 +Notes to Consolidated Financial Statements +56 +Management Report on Internal Control Over Financial Reporting +95 +Report of Independent Registered Public Accounting Firm +96 +Report of Independent Registered Public Accounting Firm +97 +49 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Earnings +(in millions except per share data) +Year Ended December 31 +2018 +2017 +2016 +Net Sales +$ +30,578 +$ +27,390 +$ +20,853 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cost of products sold, excluding amortization of intangible assets +12,706 +12,409 +9,094 +Amortization of intangible assets +2,178 +1,975 +550 +Research and development +2,300 +2,260 +1,447 +Selling, general and administrative +9,744 +9,182 +6,736 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Operating Cost and Expenses +26,928 +25,826 +17,827 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating Earnings +3,650 +1,564 +3,026 +Interest expense +826 +904 +431 +Interest income +(105 +) +(124 +) +(99 +) +Net foreign exchange (gain) loss +28 +(34 +) +495 +Debt extinguishment costs +167 +— +— +Other (income) expense, net +(139 +) +(1,413 +) +786 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from Continuing Operations Before Taxes +2,873 +2,231 +1,413 +Taxes on Earnings from Continuing Operations +539 +1,878 +350 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from Continuing Operations +2,334 +353 +1,063 +Earnings from Discontinued Operations, net of taxes +34 +124 +321 +Gain on sale of Discontinued Operations, net of taxes +— +— +16 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Earnings from Discontinued Operations, net of taxes +34 +124 +337 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Earnings +$ +2,368 +$ +477 +$ +1,400 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Common Share — +Continuing Operations +$ +1.32 +$ +0.20 +$ +0.71 +Discontinued Operations +0.02 +0.07 +0.23 +Net Earnings +$ +1.34 +$ +0.27 +$ +0.94 +Diluted Earnings Per Common Share — +Continuing Operations +$ +1.31 +$ +0.20 +$ +0.71 +Discontinued Operations +0.02 +0.07 +0.23 +Net Earnings +$ +1.33 +$ +0.27 +$ +0.94 +Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share +1,758 +1,740 +1,477 +Dilutive Common Stock Options +12 +9 +6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options +1,770 +1,749 +1,483 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Outstanding Common Stock Options Having No Dilutive Effect +— +— +5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +accompanying notes to consolidated financial statements are an integral part of this statement. +50 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Comprehensive Income +(in millions) +Year Ended December 31 +2018 +2017 +2016 +Net Earnings +$ +2,368 +$ +477 +$ +1,400 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Foreign currency translation gain (loss) adjustments +(1,460 +) +1,365 +(130 +) +Net actuarial gains (losses) and prior service cost and credits and amortization of net actuarial losses and prior service cost and credits, net of taxes +of $47 in 2018, $(61) in 2017 and $(125) in 2016 +132 +(243 +) +(326 +) +Unrealized gains (losses) on marketable equity securities, net of taxes of $(76) in 2017 and $(28) in 2016 +— +64 +(134 +) +Net gains (losses) on derivative instruments designated as cash flow hedges, net of taxes of $50 in 2018, $(43) in 2017 and $(4) in 2016 +136 +(134 +) +(15 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other Comprehensive Income (Loss) +(1,192 +) +1,052 +(605 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Comprehensive Income +$ +1,176 +$ +1,529 +$ +795 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Accumulated Other Comprehensive Income (Loss) Information, net of tax as of December 31: +Cumulative foreign currency translation (loss) adjustments +$ +(4,912 +) +$ +(3,452 +) +$ +(4,959 +) +Net actuarial (losses) and prior service (cost) and credits +(2,726 +) +(2,521 +) +(2,284 +) +Cumulative unrealized gains (losses) on marketable equity securities +— +(5 +) +(69 +) +Cumulative gains (losses) on derivative instruments designated as cash flow hedges +52 +(84 +) +49 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accumulated other comprehensive income (loss) +$ +(7,586 +) +$ +(6,062 +) +$ +(7,263 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +accompanying notes to consolidated financial statements are an integral part of this statement. +51 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Cash Flows +(in millions) +Year Ended December 31 +2018 +2017 +2016 +Cash Flow From (Used in) Operating activities: +Net earnings +$ +2,368 +$ +477 +$ +1,400 +Adjustments to reconcile earnings to net cash from operating activities — +Depreciation +1,100 +1,046 +803 +Amortization of intangible assets +2,178 +1,975 +550 +Share-based compensation +477 +406 +310 +Impact of currency devaluation +— +— +480 +Amortization of inventory step-up +32 +907 +— +Investing and financing losses, net +126 +47 +86 +Loss on extinguishment of debt +167 +— +— +Amortization of bridge financing fees +— +5 +165 +Gains on sale of businesses +— +(1,163 +) +(25 +) +Mylan N.V. equity investment adjustment +— +— +947 +Gain on sale of Mylan N.V. shares +— +(45 +) +— +Trade receivables +(190 +) +(207 +) +(177 +) +Inventories +(514 +) +249 +(98 +) +Prepaid expenses and other assets +23 +109 +113 +Trade accounts payable and other liabilities +747 +615 +(652 +) +Income taxes +(214 +) +1,149 +(699 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Cash From Operating Activities +6,300 +5,570 +3,203 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flow From (Used in) Investing Activities: +Acquisitions of property and equipment +(1,394 +) +(1,135 +) +(1,121 +) +Acquisitions of businesses and technologies, net of cash acquired +— +(17,183 +) +(80 +) +Proceeds from business dispositions +48 +6,042 +25 +Proceeds from the sale of Mylan N.V. shares +— +2,704 +— +Purchases of investment securities +(131 +) +(210 +) +(2,823 +) +Proceeds from sales of investment securities +73 +129 +3,709 +Other +48 +35 +42 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Cash From (Used in) Investing Activities +(1,356 +) +(9,618 +) +(248 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flow From (Used in) Financing Activities: +Proceeds from issuance of (repayments of) short-term debt and other +(26 +) +(1,034 +) +(1,767 +) +Proceeds from issuance of long-term debt and debt with maturities over 3 months +4,009 +6,742 +14,934 +Repayments of long-term debt and debt with maturities over 3 months +(12,433 +) +(8,650 +) +(12 +) +Payment of bridge financing fees +— +— +(170 +) +Purchase of Alere preferred stock +— +(710 +) +— +Acquisition and contingent consideration payments related to business acquisitions +— +(13 +) +(25 +) +Purchases of common shares +(238 +) +(117 +) +(522 +) +Proceeds from stock options exercised +271 +350 +248 +Dividends paid +(1,974 +) +(1,849 +) +(1,539 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Cash From (Used in) Financing Activities +(10,391 +) +(5,281 +) +11,147 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Effect of exchange rate changes on cash and cash equivalents +(116 +) +116 +(483 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Increase (Decrease) in Cash and Cash Equivalents +(5,563 +) +(9,213 +) +13,619 +Cash and Cash Equivalents, Beginning of Year +9,407 +18,620 +5,001 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash and Cash Equivalents, End of Year +$ +3,844 +$ +9,407 +$ +18,620 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Cash Flow Information: +Income taxes paid +$ +740 +$ +570 +$ +620 +Interest paid +845 +917 +181 +The +accompanying notes to consolidated financial statements are an integral part of this statement. +52 +Abbott Laboratories and Subsidiaries +Consolidated Balance Sheet +(dollars in millions) +December 31 +2018 +2017 +Assets +Current Assets: +Cash and cash equivalents +$ +3,844 +$ +9,407 +Investments, primarily bank time deposits and U.S. treasury bills +242 +203 +Trade receivables, less allowances of — 2018: $314; 2017: $294 +5,182 +5,249 +Inventories: +Finished products +2,407 +2,339 +Work in process +499 +472 +Materials +890 +790 +​ +​ +​ +​ +​ +​ +​ +​ +Total inventories +3,796 +3,601 +Other prepaid expenses and receivables +1,559 +1,667 +Current assets held for disposition +9 +20 +​ +​ +​ +​ +​ +​ +​ +​ +Total Current Assets +14,632 +20,147 +​ +​ +​ +​ +​ +​ +​ +​ +Investments +897 +883 +Property and Equipment, at Cost: +Land +501 +526 +Buildings +3,555 +3,613 +Equipment +10,756 +10,394 +Construction in progress +894 +732 +​ +​ +​ +​ +​ +​ +​ +​ +15,706 +15,265 +Less: accumulated depreciation and amortization +8,143 +7,658 +​ +​ +​ +​ +​ +​ +​ +​ +Net Property and Equipment +7,563 +7,607 +​ +​ +​ +​ +​ +​ +​ +​ +Intangible Assets, net of amortization +18,942 +21,473 +Goodwill +23,254 +24,020 +Deferred Income Taxes and Other Assets +1,868 +1,944 +Non-current Assets Held for Disposition +17 +176 +​ +​ +​ +​ +​ +​ +​ +​ +$ +67,173 +$ +76,250 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +53 +Abbott Laboratories and Subsidiaries +Consolidated Balance Sheet +(dollars in millions) +December 31 +2018 +2017 +Liabilities and Shareholders' Investment +Current Liabilities: +Short-term borrowings +$ +200 +$ +206 +Trade accounts payable +2,975 +2,402 +Salaries, wages and commissions +1,182 +1,187 +Other accrued liabilities +3,780 +3,811 +Dividends payable +563 +489 +Income taxes payable +305 +309 +Current portion of long-term debt +7 +508 +​ +​ +​ +​ +​ +​ +​ +​ +Total Current Liabilities +9,012 +8,912 +​ +​ +​ +​ +​ +​ +​ +​ +Long-term Debt +19,359 +27,210 +Post-employment obligations and other long-term liabilities +8,080 +9,030 +Commitments and Contingencies +Shareholders' Investment: +Preferred shares, one dollar par value Authorized — 1,000,000 shares, none issued +— +— +Common shares, without par value Authorized — 2,400,000,000 shares Issued at stated capital amount — Shares: 2018: 1,971,189,465; +2017: 1,965,908,188 +23,512 +23,206 +Common shares held in treasury, at cost — Shares: 2018: 215,570,043; 2017: 222,305,719 +(9,962 +) +(10,225 +) +Earnings employed in the business +24,560 +23,978 +Accumulated other comprehensive income (loss) +(7,586 +) +(6,062 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total Abbott Shareholders' Investment +30,524 +30,897 +Noncontrolling Interests in Subsidiaries +198 +201 +​ +​ +​ +​ +​ +​ +​ +​ +Total Shareholders' Investment +30,722 +31,098 +​ +​ +​ +​ +​ +​ +​ +​ +$ +67,173 +$ +76,250 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +accompanying notes to consolidated financial statements are an integral part of this statement. +54 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Shareholders' Investment +(in millions except shares and per share data) +Year Ended December 31 +2018 +2017 +2016 +Common Shares: +Beginning of Year +Shares: 2018: 1,965,908,188; 2017: 1,707,475,455; 2016: 1,702,017,390 +$ +23,206 +$ +13,027 +$ +12,734 +Issued under incentive stock programs +Shares: 2018: 5,281,277; 2017: 8,834,924; 2016: 5,458,065 +163 +242 +222 +Issued for St. Jude Medical acquisition +Shares: 2017: 249,597,809 +— +9,835 +— +Share-based compensation +479 +406 +311 +Issuance of restricted stock awards +(336 +) +(304 +) +(240 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +End of Year +Shares: 2018: 1,971,189,465; 2017: 1,965,908,188; 2016: 1,707,475,455 +$ +23,512 +$ +23,206 +$ +13,027 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Common Shares Held in Treasury: +Beginning of Year +Shares: 2018: 222,305,719; 2017: 234,606,250; 2016: 229,352,338 +$ +(10,225 +) +$ +(10,791 +) +$ +(10,622 +) +Issued under incentive stock programs +Shares: 2018: 8,870,735; 2017: 8,696,320; 2016: 5,398,469 +408 +400 +250 +Issued for St. Jude Medical acquisition +Shares: 2017: 3,906,848 +— +180 +— +Purchased +Shares: 2018: 2,135,059; 2017: 302,637; 2016: 10,652,381 +(145 +) +(14 +) +(419 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +End of Year +Shares: 2018: 215,570,043; 2017: 222,305,719; 2016: 234,606,250 +$ +(9,962 +) +$ +(10,225 +) +$ +(10,791 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings Employed in the Business: +Beginning of Year +$ +23,978 +$ +25,565 +$ +25,757 +Net earnings +2,368 +477 +1,400 +Cash dividends declared on common shares (per share — 2018: $1.16; 2017: $1.075; 2016: $1.045) +(2,047 +) +(1,947 +) +(1,547 +) +Effect of common and treasury share transactions +(90 +) +(117 +) +(45 +) +Impact of adoption of new accounting standards +351 +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +End of Year +$ +24,560 +$ +23,978 +$ +25,565 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accumulated Other Comprehensive Income (Loss): +Beginning of Year +$ +(6,062 +) +$ +(7,263 +) +$ +(6,658 +) +Business dispositions / separation +— +149 +— +Other comprehensive income (loss) +(1,192 +) +1,052 +(605 +) +Impact of adoption of new accounting standards +(332 +) +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +End of Year +$ +(7,586 +) +$ +(6,062 +) +$ +(7,263 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Noncontrolling Interest in Subsidiaries: +Beginning of Year +$ +201 +$ +179 +$ +115 +Noncontrolling Interests' share of income, business combinations, net of distributions and share repurchases +(3 +) +22 +64 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +End of Year +$ +198 +$ +201 +$ +179 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +accompanying notes to consolidated financial statements are an integral part of this statement. +55 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements +Note 1 — Summary of Significant Accounting Policies +NATURE OF BUSINESS — Abbott's principal business is the discovery, development, manufacture and sale of a broad line of health care products. +BASIS +OF CONSOLIDATION — The consolidated financial statements include the accounts of the parent company and subsidiaries, after elimination of intercompany +transactions. +USE +OF ESTIMATES — The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States and +necessarily include amounts based on estimates and assumptions by management. Actual results could differ from those amounts. Significant estimates include amounts for sales rebates; income taxes; +pension and other post-employment benefits, including certain asset values that are based on significant unobservable inputs; valuation of intangible assets; litigation; derivative financial +instruments; and inventory and accounts receivable exposures. +FOREIGN +CURRENCY TRANSLATION — The statements of earnings of foreign subsidiaries whose functional currencies are other than the U.S. dollar are translated into U.S. +dollars using average exchange rates for the period. The net assets of foreign subsidiaries whose functional currencies are other than the U.S. dollar are translated into U.S. dollars using exchange +rates as of the balance sheet date. The U.S. dollar effects that arise from translating the net assets of these subsidiaries at changing rates are recorded in the foreign currency translation +adjustment account, which is included in equity as a component of Accumulated other comprehensive income (loss). Transaction gains and losses are recorded on the Net foreign exchange (gain) loss line +of the Consolidated Statement of Earnings. +REVENUE +RECOGNITION — Revenue from product sales is recognized upon the transfer of control, which is generally upon shipment or delivery, depending on the delivery +terms set forth in the customer contract. Provisions for discounts, rebates and sales incentives to customers, and +returns and other adjustments are provided for in the period the related sales are recorded. Sales incentives to customers are not material. Historical data is readily available and reliable, and is +used for estimating the amount of the reduction in gross sales. Revenue from the launch of a new product, from an improved version of an existing product, or for shipments in excess of a customer's +normal requirements are recorded when the conditions noted above are met. In those situations, management records a returns reserve for such revenue, if necessary. In certain of Abbott's businesses, +primarily within diagnostics, Abbott participates in selling arrangements that include multiple performance obligations (e.g., instruments, reagents, procedures, and service agreements). The +total transaction price of the contract is allocated to each performance obligation in an amount based on the estimated relative standalone selling prices of the promised goods or services underlying +each performance obligation. Sales of product rights for marketable products are recorded as revenue upon disposition of the rights. +INCOME +TAXES — Deferred income taxes are provided for the tax effect of differences between the tax bases of assets and liabilities and their reported amounts in the +financial statements at the enacted statutory rate to be in effect when the taxes are paid. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject +to the transition tax related to the U.S. Tax Cuts and Jobs Act, or any additional outside basis differences that exist, as these amounts continue to be indefinitely reinvested in foreign operations. +Interest and penalties on income tax obligations are included in taxes on earnings. +EARNINGS +PER SHARE — Unvested restricted stock units and awards that contain non-forfeitable rights to dividends are treated as participating securities and are +included in the computation of earnings per share under the two-class method. Under the two-class method, net earnings are allocated between +56 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +common +shares and participating securities. Earnings from Continuing Operations allocated to common shares in 2018, 2017 and 2016 were $2.320 billion, $346 million and +$1.057 billion, respectively. Net earnings allocated to common shares in 2018, 2017 and 2016 were $2.353 billion, $468 million and $1.393 billion, respectively. +PENSION +AND POST-EMPLOYMENT BENEFITS — Abbott accrues for the actuarially determined cost of pension and post-employment benefits over the service attribution periods +of the employees. Abbott must develop long-term assumptions, the most significant of which are the health care cost trend rates, discount rates and the expected return on plan assets. Differences +between the expected long-term return on plan assets and the actual return are amortized over a five-year period. Actuarial losses and gains are amortized over the remaining service attribution +periods of the employees under the corridor method. +FAIR +VALUE MEASUREMENTS — For assets and liabilities that are measured using quoted prices in active markets, total fair value is the published market price per unit +multiplied by the number of units held without consideration of transaction costs. Assets and liabilities that are measured using significant other observable inputs are valued by reference to similar +assets or liabilities, adjusted for contract restrictions and other terms specific to that asset or liability. For these items, a significant portion of fair value is derived by reference to quoted +prices of similar assets or liabilities in active markets. For all remaining assets and liabilities, fair value is derived using a fair value model, such as a discounted cash flow model or +Black-Scholes model. Purchased intangible assets are recorded at fair value. The fair value of significant purchased intangible assets is based on independent appraisals. Abbott uses a discounted cash +flow model to value intangible assets. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, the cost of capital, terminal values and market +participants. Intangible assets are reviewed for impairment on a quarterly basis. Goodwill and indefinite-lived intangible assets are tested for impairment at least annually. +SHARE-BASED +COMPENSATION — The fair value of stock options and restricted stock awards and units are amortized over their requisite service period, which could be +shorter than the vesting period if an employee is retirement eligible, with a charge to compensation expense. +In +March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based +Payment Accounting . ASU 2016-09 modifies several aspects of the accounting for share-based payment transactions, including the accounting for income taxes and +classification on the statement of cash flows. Abbott adopted the standard in the first quarter of 2017 and the following changes were made to the presentation of Abbott's financial +statements: +• All excess tax benefits or tax deficiencies are now recognized as income tax benefit or expense as applicable. Previously, Abbott recorded the +benefits to Shareholders' Investment. The tax benefit recorded in Abbott's Consolidated Statement of Earnings for 2018 and 2017 was $90 million and $120 million, respectively. The +standard did not permit retrospective presentation of this benefit in prior years. +• The tax benefit or deficiency is required to be classified as an operating activity in the statement of cash flows. Previously, it was required +to be classified within financing activities. Abbott has adopted this standard on a prospective basis and has not revised the classification of the excess tax benefit in the 2016 Consolidated +Statement of Cash Flows. +57 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +LITIGATION — +Abbott accounts for litigation losses in accordance with FASB ASC No. 450, "Contingencies." Under ASC No. 450, loss contingency provisions +are recorded for probable losses at management's best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. Legal fees are recorded as incurred. +CASH, +CASH EQUIVALENTS AND INVESTMENTS — Cash equivalents consist of bank time deposits, U.S. government securities money market funds and U.S. treasury bills with +original maturities of three months or less. Abbott holds certain investments with a carrying value of approximately $325 million that are accounted for under the equity method of accounting. +Investments held in a rabbi trust and investments in publicly traded equity securities are recorded at fair value and changes in fair value are recorded in earnings. Investments in equity securities +that are not traded on public stock exchanges are recorded at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or +similar investments of the same issuer. Investments in debt securities are classified as held-to-maturity, as management has both the intent and ability to hold these securities to maturity, and are +reported at cost, net of any unamortized premium or discount. Income relating to these securities is reported as interest income. +TRADE +RECEIVABLE VALUATIONS — Accounts receivable are stated at their net realizable value. The allowance against gross trade receivables reflects the best estimate of +probable losses inherent in the receivables portfolio determined on the basis of historical experience, specific allowances for known troubled accounts and other currently available information. +Accounts receivable are charged off after all reasonable means to collect the full amount (including litigation, where appropriate) have been exhausted. +INVENTORIES — +Inventories are stated at the lower of cost (first-in, first-out basis) or net realizable value. Cost includes material and conversion costs. +PROPERTY +AND EQUIPMENT — Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. The following table shows +estimated useful lives of property and equipment: +Classification +Estimated Useful Lives +Buildings +10 to 50 years (average 27 years) +Equipment +3 to 20 years (average 11 years) +PRODUCT +LIABILITY — Abbott accrues for product liability claims when it is probable that a liability has been incurred and the amount of the liability can be +reasonably estimated based on existing information. The liabilities are adjusted quarterly as additional information becomes available. Receivables for insurance recoveries for product liability +claims are recorded as assets, on an undiscounted basis, when it is probable that a recovery will be realized. Product liability losses are self-insured. +RESEARCH +AND DEVELOPMENT COSTS — Internal research and development costs are expensed as incurred. Clinical trial costs incurred by third parties are expensed as the +contracted work is performed. Where contingent milestone payments are due to third parties under research and development arrangements, the milestone payment obligations are expensed when the +milestone results are achieved. +ACQUIRED +IN-PROCESS AND COLLABORATIONS RESEARCH AND DEVELOPMENT (IPR&D) — The initial costs of rights to IPR&D projects obtained in an asset acquisition are expensed +as +58 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +IPR&D +unless the project has an alternative future use. These costs include initial payments incurred prior to regulatory approval in connection with research and development collaboration agreements +that provide rights to develop, manufacture, market and/or sell pharmaceutical products. The fair value of IPR&D projects acquired in a business combination are capitalized and accounted for as +indefinite-lived intangible assets until completed and are then amortized over the remaining useful life. Collaborations are not significant. +CONCENTRATION +OF RISK AND GUARANTEES — Due to the nature of its operations, Abbott is not subject to significant concentration risks relating to customers, products or +geographic locations. Product warranties are not significant. +Abbott +has no material exposures to off-balance sheet arrangements; no special purpose entities; nor activities that include non-exchange-traded contracts accounted for at fair value. +Abbott has periodically entered into agreements in the ordinary course of business, such as assignment of product rights, with other companies, which has resulted in Abbott becoming secondarily liable +for obligations that Abbott was previously primarily liable. Since Abbott no longer maintains a business relationship with the other parties, Abbott is unable to develop an estimate of the maximum +potential amount of future payments, if any, under these obligations. Based upon past experience, the likelihood of payments under these agreements is remote. Abbott periodically acquires a business +or product rights in which Abbott agrees to pay contingent consideration based on attaining certain thresholds or based on the occurrence of certain events. +Note 2 — New Accounting Standards +Recently Adopted Accounting Standards +In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other +Comprehensive Income , which allows companies to reclassify stranded tax effects resulting from the 2017 Tax Cuts and Jobs Act, from accumulated other comprehensive income +(loss) to retained earnings (Earnings employed in the business). Abbott adopted the new standard at the beginning of the fourth quarter of 2018. As a result of the adoption of the new standard, +approximately $337 million of stranded tax effects were reclassified from Accumulated other comprehensive income (loss) to Earnings employed in the business. +In +August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities , which makes changes to the +designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. The standard would have become effective for Abbott beginning in the first quarter of +2019, with early adoption permitted. Abbott elected to early adopt ASU 2017-12 in the fourth quarter of 2018. The impact of adopting the standard is not significant to Abbott's Consolidated +Balance Sheet and Consolidated Statement of Earnings. +In +March 2017, the FASB issued ASU 2017-07, Compensation — Retirement Benefits (Topic 715): Improving the Presentation of Net +Periodic Pension Cost and Net Periodic Postretirement Benefit Cost which changes the financial statement presentation requirements for pension and other postretirement benefit +expense. While service cost continues to be reported in the same financial statement line items as other current employee compensation costs, the ASU requires all other components of pension and other +postretirement benefit expense to be presented separately from service cost, and outside any subtotal of income from operations. The standard was adopted by Abbott beginning in the first quarter of +2018. The change in the presentation of the components of pension cost per year was applied retrospectively. As a +59 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 2 — New Accounting Standards (Continued) +result, +approximately $160 million of net pension-related income per year was moved from the operating lines of the Consolidated Statement of Earnings to non-operating income for 2017 and 2016. +In +November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows: Restricted Cash , which requires that restricted cash be +included with cash and cash equivalents when reconciling the beginning and end-of-period total amounts shown on the statement of cash flows. Abbott adopted this standard beginning in the first quarter +of 2018, and applied the guidance retrospectively to all periods presented. Abbott did not have any restricted cash balances in the periods presented except for $75 million of restricted cash +acquired as part of the Alere Inc. (Alere) acquisition in October 2017. The restrictions on this cash were eliminated prior to the end of 2017. +In +October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than +Inventory , which requires the recognition of the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer +occurs. Abbott adopted the standard on January 1, 2018, using a modified retrospective approach and recorded a cumulative catch-up adjustment to Earnings employed in the business in the +Consolidated Balance Sheet that was not significant. +In +August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments , +which clarifies how companies should present and classify certain cash receipts and cash payments in the statement of cash flows. The ASU became effective for Abbott in the first quarter of 2018 and +did not have a material impact to the Company's Consolidated Statement of Cash Flows. +In +January 2016, the FASB issued ASU 2016-01, Financial Instruments — Recognition and Measurement of Financial Assets and Financial +Liabilities , which provides new guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. Abbott adopted the standard on +January 1, 2018. Under the new standard, changes in the fair value of equity investments with readily determinable fair values are recorded in Other (income) expense, net within the +Consolidated Statement of Earnings. Previously, such fair value changes were recorded in other comprehensive income. Abbott has elected the measurement alternative allowed by ASU 2016-01 for +its equity investments without readily determinable fair values. These investments are measured at cost, less any impairment, plus or minus any changes resulting from observable price changes in +orderly transactions for an identical or similar investment of the same issuer. Changes in the measurement of these investments are being recorded in Other (income) expense, net within the +Consolidated Statement of Earnings. As part of the adoption, the cumulative-effect adjustment to Earnings employed in the business in the Consolidated Balance Sheet for net unrealized losses on equity +investments that were recorded in Accumulated other comprehensive income (loss) as of December 31, 2017 was not significant. +In +May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers , which provides a single comprehensive model for +accounting for revenue from contracts with customers and supersedes nearly all previously existing revenue recognition guidance. The core principle of the ASU is that an entity should recognize +revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. +Abbott adopted the new standard as of January 1, 2018, using the modified retrospective approach method. Under this method, entities recognize the cumulative effect of applying the new standard +at the date of initial application with no restatement of comparative periods presented. The cumulative effect of applying the new standard resulted in an increase to Earnings employed in the business +in the +60 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 2 — New Accounting Standards (Continued) +Consolidated +Balance Sheet of $23 million which was recorded on January 1, 2018. The new standard has been applied only to those contracts that were not completed as of January 1, +2018. The impact of adopting ASU 2014-09 was not significant to individual financial statement line items in the Consolidated Balance Sheet and Consolidated Statement of Earnings. +Recent Accounting Standards Not Yet Adopted +In February 2016, the FASB issued ASU 2016-02, Leases , which requires lessees to +recognize assets and liabilities for most leases on the balance sheet. The standard becomes effective for Abbott beginning in the first quarter of 2019. Abbott completed a detailed review of its +leases. Abbott will use the modified retrospective approach with the package of practical expedients which allows Abbott to carry forward the historical lease classification for leases existing at, or +entered into after the beginning of the period of adoption and to account for lease and non-lease components as a single lease component for its lessee arrangements. Abbott does not expect the new +lease accounting standard to have a material impact on the amounts reported in the Consolidated Statement of Earnings. As a result of adopting ASU 2016-02, Abbott expects to record +approximately $800 million to $900 million of right of use assets and lease liabilities for operating leases on the Consolidated Balance Sheet. +Note 3 — Revenue +Abbott's revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent protection and licenses, technological and +performance features, and inclusion of Abbott's products under a contract most impact which products are sold; price controls, competition and rebates most impact the net selling prices of products; +and foreign currency translation impacts the measurement of net sales and costs. Abbott's products are generally sold directly to retailers, wholesalers, distributors, hospitals, health care +facilities, laboratories, physicians' offices and government agencies throughout the world. Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional +Products, and Cardiovascular and Neuromodulation Products. Diabetes Care is a non-reportable segment and is included in Other in the following table. +61 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +The +following tables provide detail by sales category: +2018 +2017 +(in millions) +U.S. +Int'l +Total +U.S. +Int'l +Total +Established Pharmaceutical Products — +Key Emerging Markets +$ +— +$ +3,363 +$ +3,363 +$ +— +$ +3,307 +$ +3,307 +Other +— +1,059 +1,059 +— +980 +980 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +— +4,422 +4,422 +— +4,287 +4,287 +Nutritionals — +Pediatric Nutritionals +1,843 +2,254 +4,097 +1,777 +2,112 +3,889 +Adult Nutritionals +1,232 +1,900 +3,132 +1,254 +1,782 +3,036 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +3,075 +4,154 +7,229 +3,031 +3,894 +6,925 +Diagnostics — +Core Laboratory +985 +3,401 +4,386 +921 +3,142 +4,063 +Molecular +152 +332 +484 +160 +303 +463 +Point of Care +432 +121 +553 +440 +110 +550 +Rapid Diagnostics +1,148 +924 +2,072 +296 +244 +540 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +2,717 +4,778 +7,495 +1,817 +3,799 +5,616 +Cardiovascular and Neuromodulation — +Rhythm Management +1,019 +1,072 +2,091 +1,030 +1,073 +2,103 +Electrophysiology +764 +904 +1,668 +609 +773 +1,382 +Heart Failure +467 +179 +646 +491 +152 +643 +Vascular +1,126 +1,803 +2,929 +1,180 +1,712 +2,892 +Structural Heart +488 +751 +1,239 +432 +651 +1,083 +Neuromodulation +690 +174 +864 +636 +172 +808 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +4,554 +4,883 +9,437 +4,378 +4,533 +8,911 +Other +493 +1,502 +1,995 +447 +1,204 +1,651 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +10,839 +$ +19,739 +$ +30,578 +$ +9,673 +$ +17,717 +$ +27,390 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Abbott +recognizes revenue from product sales upon the transfer of control, which is generally upon shipment or delivery, depending on the delivery terms set forth in the customer +contract. For maintenance agreements that provide service beyond Abbott's standard warranty and other service agreements, revenue is recognized ratably over the contract term. A time-based measure of +progress appropriately reflects the transfer of services to the customer. Payment terms between Abbott and its customers vary by the type of customer, country of sale, and the products or services +offered. The term between invoicing and the payment due date is not significant. +Management +exercises judgment in estimating variable consideration. Provisions for discounts, rebates and sales incentives to customers, and returns and other adjustments are provided +for in the period the related sales are recorded. Sales incentives to customers are not material. Historical data is readily available and reliable, and is used for estimating the amount of the +reduction in gross sales. Abbott +62 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +provides +rebates to government agencies, wholesalers, group purchasing organizations and other private entities. +Rebate +amounts are usually based upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of +which products have +been sold subject to a rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current +changes, Abbott estimates the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate +generally occurs from one to six months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. +Historically, adjustments to prior years' rebate accruals have not been material to net income. +Other +allowances charged against gross sales include cash discounts and returns, which are not significant. Cash discounts are known within 15 to 30 days of sale, and therefore +can be reliably estimated. Returns can be reliably estimated because Abbott's historical returns are low, and because sales return terms and other sales terms have remained relatively unchanged for +several periods. Product warranties are also not significant. +Abbott +also applies judgment in determining the timing of revenue recognition related to contracts that include multiple performance obligations. The total transaction price of the +contract is allocated to each performance obligation in an amount based on the estimated relative standalone selling prices of the promised goods or services underlying each performance obligation. +For goods or services for which observable standalone selling prices are not available, Abbott uses an expected cost plus a margin approach to estimate the standalone selling price of each performance +obligation. +Remaining Performance Obligations +As of December 31, 2018, the estimated revenue expected to be recognized in the future related to performance obligations that are +unsatisfied (or partially unsatisfied) was approximately $2.9 billion in the Diagnostic Products segment and approximately $410 million in the Cardiovascular and Neuromodulation Products +segment. Abbott expects to recognize revenue on approximately 60 percent of these remaining performance obligations over the next 24 months, approximately 16 percent over the +subsequent 12 months and the remainder thereafter. +These +performance obligations primarily reflect the future sale of reagents/consumables in contracts with minimum purchase obligations, extended warranty or service obligations related +to previously sold equipment, and remote monitoring services related to previously implanted devices. Abbott has applied the practical expedient described in Accounting Standards Codification +(ASC) 606-10-50-14 and has not included remaining performance obligations related to contracts with original expected durations of one year or less in the amounts above. +Assets Recognized for Costs to Obtain a Contract with a Customer +Abbott has applied the practical expedient in ASC 340-40-25-4 and records as an expense the incremental costs of obtaining contracts with +customers in the period of occurrence when the amortization period of the asset that Abbott otherwise would have recognized is one year or less. Upfront commission fees paid to sales personnel as a +result of obtaining or renewing contracts with customers are incremental +63 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +to +obtaining the contract. Abbott capitalizes these amounts as contract costs. Capitalized commission fees are amortized based on the contract duration to which the assets relate which ranges from two +to ten years. The amounts as of December 31, 2018, were not significant. +Additionally, +the cost of transmitters provided to customers that use Abbott's remote monitoring service with respect to certain medical devices are capitalized as contract costs. +Capitalized transmitter costs are amortized based on the timing of the transfer of services to which the assets relate, which typically ranges from eight to ten years. The amounts as of +December 31, 2018, were not significant. +Other Contract Assets and Liabilities +Abbott discloses Trade receivables separately in the Consolidated Balance Sheet at their net realizable value. Contract assets primarily relate +to Abbott's conditional right to consideration for work completed but not billed at the reporting date. Contract assets at the beginning and end of the period, as well as the changes in the balance, +were not significant. +Contract +liabilities primarily relate to payments received from customers in advance of performance under the contract. Abbott's contract liabilities arise primarily in the +Cardiovascular and Neuromodulation reportable segment when payment is received upfront for various multi-period extended service arrangements. Changes in the contract liabilities during the period are +as follows: +(in millions) +Contract Liabilities +Balance at January 1, 2018 +$ +198 +Unearned revenue from cash received during the period +304 +Revenue recognized that was included in contract liability balance at beginning of period +(243 +) +​ +​ +​ +​ +​ +Balance at December 31, 2018 +$ +259 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Note 4 — Discontinued Operations and Assets Held for Disposition +On February 27, 2015, Abbott completed the sale of its developed markets branded generics pharmaceuticals business to Mylan Inc. (Mylan) for 110 million ordinary +shares (or approximately 22 percent) of a newly formed entity (Mylan N.V.) that combined Mylan's existing business and Abbott's developed markets branded generics pharmaceuticals +business. +In +April 2015, Abbott sold 40.25 million of the 110 million ordinary shares of Mylan N.V. received in the sale of the developed markets branded generics +pharmaceuticals business to Mylan. In 2015, Abbott recorded a pretax gain of $207 million on $2.29 billion in net proceeds from the sale of these shares. In 2017, Abbott sold +69.75 million ordinary shares of Mylan N.V. and received $2.704 billion in proceeds. Abbott recorded a $45 million gain from the sale of these ordinary shares in 2017, +which was recognized in the Other (income) expense, net line of the Consolidated Statement of Earnings. Abbott no longer has an ownership interest in Mylan N.V. +On +February 10, 2015, Abbott completed the sale of its animal health business to Zoetis Inc. Abbott received cash proceeds of $230 million and reported an after tax +gain on the sale of approximately $130 million. In the first quarter of 2016, Abbott received an additional $25 million of proceeds due to the expiration of a holdback agreement +associated with the sale of this business and reported an after-tax gain of $16 million. +64 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 4 — Discontinued Operations and Assets Held for Disposition (Continued) +As a result of the disposition of the above businesses, the operating results of these businesses up to the date of sale are reported as part of discontinued operations on the Earnings +from Discontinued Operations, net of taxes line in the Consolidated Statement of Earnings. +On +January 1, 2013, Abbott completed the separation of AbbVie Inc. (AbbVie), which was formed to hold Abbott's research-based proprietary pharmaceuticals business. Abbott +has retained all liabilities for all U.S. federal and foreign income taxes on income prior to the separation, as well as certain non-income taxes attributable to AbbVie's business. AbbVie generally +will be liable for all other taxes attributable to its business. +The +net earnings of discontinued operations include income tax benefits of $39 million in 2018, $109 million in 2017 and $325 million in 2016. These tax benefits +primarily relate to the resolution of various tax positions related to AbbVie's operations for years prior to the separation. +In +September 2016, Abbott announced that it entered into a definitive agreement to sell Abbott Medical Optics (AMO), its vision care business, to Johnson & Johnson for +$4.325 billion in cash, subject to customary purchase price adjustments for cash, debt and working capital. The decision to sell AMO reflected Abbott's proactive shaping of its portfolio in +line with its strategic priorities. In February 2017, Abbott completed the sale of AMO to Johnson & Johnson and recognized a pre-tax gain of $1.163 billion including working capital +adjustments, which was reported in the Other (income) expense, net line of the Consolidated Statement of Earnings in 2017. Abbott recorded an after-tax gain of $728 million in 2017 related to +the sale of AMO. The operating results of AMO up to the date of sale continued to be included in Earnings from continuing operations as the business did not qualify for reporting as discontinued +operations. For 2017 and 2016, the AMO earnings (losses) before taxes included in Abbott's consolidated earnings were $(18) million and $30 million, respectively. +As +discussed in Note 7 — Business Acquisitions, in conjunction with the acquisition of Alere, Abbott sold the Triage MeterPro cardiovascular and toxicology +business and the assets and liabilities related to its B-type Natriuretic Peptide assay business run on Beckman Coulter analyzers to Quidel Corporation (Quidel). The legal transfer of certain assets +related to these businesses did not occur at the close of the sale to Quidel due to, among other factors, the time required to transfer marketing authorizations and other regulatory requirements in +various countries. Under the terms of the sale agreement with Abbott, Quidel is subject to the risks and entitled to the benefits generated by these operations and assets. The assets presented as held +for disposition in the Consolidated Balance Sheet as of December 31, 2018 and 2017, primarily relate to the businesses sold to Quidel. +65 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 4 — Discontinued Operations and Assets Held for Disposition (Continued) +The +following is a summary of the assets held for disposition as of December 31, 2018 and 2017: +(in millions) +December 31, +2018 +December 31, +2017 +Trade receivables, net +$ +6 +$ +12 +Total inventories +3 +8 +​ +​ +​ +​ +​ +​ +​ +​ +Current assets held for disposition +9 +20 +​ +​ +​ +​ +​ +​ +​ +​ +Net property and equipment +— +56 +Intangible assets, net of amortization +— +18 +Goodwill +17 +102 +​ +​ +​ +​ +​ +​ +​ +​ +Non-current assets held for disposition +17 +176 +​ +​ +​ +​ +​ +​ +​ +​ +Total assets held for disposition +$ +26 +$ +196 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Note 5 — Supplemental Financial Information +Other (income) expense, net, for 2018, 2017 and 2016 includes approximately $160 million of income related to the non-service cost components of the net periodic benefit costs +associated with the pension and post-retirement medical plans. These amounts are being reported in other (income) expense as a result of the adoption of the new accounting standard for recognizing +pension cost. Other (income) expense, net, for 2017 includes a pre-tax gain of $1.163 billion related to the sale of AMO to Johnson & Johnson. See Note 4 — +Discontinued Operations and Assets Held for Disposition for further discussion of this sale. In 2017, Abbott sold 69.75 million ordinary shares of Mylan N.V. and received +$2.704 billion in proceeds and recorded a $45 million pre-tax gain related to the sale of these ordinary shares. Other (income) expense, net, for 2016 includes expense of +$947 million to adjust Abbott's holding of Mylan N.V. ordinary shares due to a decline in the fair value of the securities which was considered by Abbott to be other than temporary. +The +detail of various balance sheet components is as follows: +(in millions) +December 31, +2018 +December 31, +2017 +Long-term Investments: +Equity securities +$ +856 +$ +797 +Other +41 +86 +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +897 +$ +883 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Abbott's +equity securities as of December 31, 2018 and December 31, 2017, include $307 million and $363 million, respectively, of investments in mutual funds that +are held in a rabbi trust acquired as part of the St. Jude Medical, Inc. (St. Jude Medical) business acquisition. These investments, which are specifically designated as available +for the purpose of paying benefits under a deferred compensation plan, are not available for general corporate purposes and are subject to creditor claims in the event of insolvency. +Abbott +also holds certain investments as of December 31, 2018 with a carrying value of approximately $325 million that are accounted for under the equity method of +accounting and other equity investments with a carrying value of $211 million that do not have a readily determinable fair value. The $211 million +66 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 5 — Supplemental Financial Information (Continued) +carrying +value includes an unrealized gain of approximately $50 million on an investment. The gain was recorded in the second quarter of 2018 and relates to an observable price change for a +similar investment of the same issuer. +(in millions) +December 31, +2018 +December 31, +2017 +Other Accrued Liabilities: +Accrued rebates payable to government agencies +$ +166 +$ +124 +Accrued other rebates (a) +608 +498 +All other +3,006 +3,189 +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +3,780 +$ +3,811 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Accrued +wholesaler chargeback rebates of $197 million and $178 million at December 31, 2018 and 2017, respectively, are netted in trade +receivables because Abbott's customers are invoiced at a higher catalog price but only remit to Abbott their contract price for the products. +(in millions) +December 31, +2018 +December 31, +2017 +Post-employment Obligations and Other Long-term Liabilities: +Defined benefit pension plans and post-employment medical and dental plans for significant plans +$ +2,040 +$ +2,169 +Deferred income taxes +2,056 +2,006 +All other (b) +3,984 +4,855 +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +8,080 +$ +9,030 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(b) 2018 +includes approximately $465 million of net unrecognized tax benefits, as well as approximately $65 million of acquisition consideration payable. +2017 includes approximately $835 million of net unrecognized tax benefits, as well as approximately $100 million of acquisition consideration payable. +Since January 2010, Venezuela has been designated as a highly inflationary economy under U.S. GAAP. On February 17, 2016, the Venezuelan government +announced that its three-tier exchange rate system would be reduced to two rates renamed the DIPRO and DICOM rates. The DIPRO was the official rate for food and medicine imports and was adjusted from +6.3 to 10 bolivars per U.S. dollar. The DICOM rate was a floating market rate published daily by the Venezuelan central bank, which at the end of the first quarter of 2016 was approximately 263 +bolivars per U.S. dollar. As a result of decreasing government approvals to convert bolivars to U.S. dollars to pay for intercompany accounts, as well as the accelerating deterioration of economic +conditions in the country, Abbott concluded that it was appropriate to move to the DICOM rate at the end of the first quarter of 2016. As a result, Abbott recorded a foreign currency exchange loss of +$480 million in 2016 to revalue its net monetary assets in Venezuela. After the revaluation, Abbott's investment in its Venezuelan operations was not significant. +67 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 6 — Accumulated Other Comprehensive Income (Loss) +The components of the changes in accumulated other comprehensive income (loss) from continuing operations, net of income taxes, are as follows: ( in +millions ) +Cumulative +Foreign +Currency +Translation +Adjustments +Net +Actuarial +Losses and +Prior Service +Costs and +Credits +Cumulative +Unrealized +Gains +(Losses) on +Marketable +Equity +Securities +Cumulative +Gains +(Losses) on +Derivative +Instruments +Designated as +Cash Flow +Hedges +Total +Balance at December 31, 2016 +$ +(4,959 +) +$ +(2,284 +) +$ +(69 +) +$ +49 +$ +(7,263 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Impact of business dispositions +142 +6 +— +1 +149 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other comprehensive income (loss) before reclassifications +1,365 +(333 +) +182 +(170 +) +1,044 +(Income) loss amounts reclassified from accumulated other comprehensive income (a) +— +90 +(118 +) +36 +8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net current period other comprehensive income (loss) +1,365 +(243 +) +64 +(134 +) +1,052 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance at December 31, 2017 +(3,452 +) +(2,521 +) +(5 +) +(84 +) +(6,062 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Impact of adoption of new accounting standards +— +(337 +) +5 +— +(332 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other comprehensive income (loss) before reclassifications +(1,488 +) +(18 +) +— +58 +(1,448 +) +(Income) loss amounts reclassified from accumulated other comprehensive income (a) +28 +150 +— +78 +256 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net current period other comprehensive income (loss) +(1,460 +) +132 +— +136 +(1,192 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance at December 31, 2018 +$ +(4,912 +) +$ +(2,726 +) +$ +— +$ +52 +$ +(7,586 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Reclassified +amounts for foreign currency translation adjustments are recorded in the Consolidated Statement of Earnings as Net Foreign exchange (gain) loss; gains +(losses) on marketable equity securities are recorded as Other (income) expense and gains/losses related to cash flow hedges are recorded as Cost of products sold. Net actuarial losses and prior +service cost is included as a component of net periodic benefit cost — see Note 14 for additional information. +Note 7 — Business Acquisitions +On January 4, 2017, Abbott completed the acquisition of St. Jude Medical, a global medical device manufacturer, for approximately $23.6 billion, including +approximately $13.6 billion in cash and approximately $10 billion in Abbott common shares, which represented approximately 254 million shares of Abbott common stock, based on +Abbott's closing stock price on the acquisition date. As part of the acquisition, approximately $5.9 billion of St. Jude Medical's debt was assumed, repaid or refinanced by Abbott. The +acquisition provides expanded opportunities for future growth and is an important part of the company's ongoing effort to develop a strong, diverse portfolio of devices, diagnostics, nutritionals and +branded generic pharmaceuticals. The combined business competes in nearly every area of the cardiovascular device market, as well as in the neuromodulation market. +68 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 7 — Business Acquisitions (Continued) +Under +the terms of the agreement, for each St. Jude Medical common share, St. Jude Medical shareholders received $46.75 in cash and 0.8708 of an Abbott common share. At an +Abbott stock price of $39.36, which reflects the closing price on January 4, 2017, this represented a value of approximately $81 per St. Jude Medical common share and total +purchase consideration of $23.6 billion. The cash portion of the acquisition was funded through a combination of medium and long-term debt issued in November 2016 and a $2.0 billion +120-day senior unsecured bridge term loan facility which was subsequently repaid. +The +final allocation of the fair value of the St. Jude Medical acquisition is shown in the table below. +(in billions) +Acquired intangible assets, non-deductible +$ +15.5 +Goodwill, non-deductible +13.1 +Acquired net tangible assets +3.0 +Deferred income taxes recorded at acquisition +(2.7 +) +Net debt +(5.3 +) +​ +​ +​ +​ +​ +Total final allocation of fair value +$ +23.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +goodwill is primarily attributable to expected synergies from combining operations, as well as intangible assets that do not qualify for separate recognition. The goodwill is +identifiable to the +Cardiovascular and Neuromodulation Products reportable segment. The acquired tangible assets consist primarily of trade accounts receivable of approximately $1.1 billion, inventory of +approximately $1.7 billion, other current assets of $176 million, property and equipment of approximately $1.5 billion, and other long-term assets of approximately +$455 million. The acquired tangible liabilities consist of trade accounts payable and other current liabilities of approximately $1.1 billion and other non-current liabilities of +approximately $870 million. +In +2016, Abbott and St. Jude Medical agreed to sell certain businesses to Terumo Corporation (Terumo) for approximately $1.12 billion. The sale included the St. Jude +Medical Angio-Seal™ and Femoseal™ vascular closure and Abbott's Vado® Steerable Sheath businesses. The sale closed on January 20, 2017 and no gain or loss +was recorded in the Consolidated Statement of Earnings. +On +October 3, 2017, Abbott acquired Alere, a diagnostic device and service provider, for $51.00 per common share in cash, which equated to a purchase price of approximately +$4.5 billion. As part of the acquisition, Abbott tendered for Alere's preferred shares for a total value of approximately $0.7 billion. In addition, approximately $3.0 billion of +Alere's debt was assumed and subsequently repaid. The acquisition establishes Abbott as a leader in point of care testing, expands Abbott's global diagnostics presence and provides access to new +products, channels and geographies. Abbott utilized a combination of cash on hand and debt to fund the acquisition. See Note 11 — Debt and Lines of Credit for further details +regarding the debt utilized for the acquisition. +69 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 7 — Business Acquisitions (Continued) +The +final allocation of the fair value of the Alere acquisition is shown in the table below. +(in billions) +Acquired intangible assets, non-deductible +$ +3.5 +Goodwill, non-deductible +3.7 +Acquired net tangible assets +1.0 +Deferred income taxes recorded at acquisition +(0.4 +) +Net debt +(2.6 +) +Preferred stock +(0.7 +) +​ +​ +​ +​ +​ +Total final allocation of fair value +$ +4.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +goodwill is primarily attributable to expected synergies from combining operations, as well as intangible assets that do not qualify for separate recognition. The goodwill is +identifiable to the Diagnostic Products reportable segment. The approximate value of the acquired tangible assets is $430 million of trade accounts receivable, $425 million of inventory, +$225 million of other current assets, $540 million of property and equipment, and $210 million of other long-term assets. The approximate value of the acquired tangible +liabilities is $675 million of trade accounts payable and other current liabilities and $145 million of other non-current liabilities. +In +the third quarter of 2017, Alere entered into agreements to sell its Triage MeterPro cardiovascular and toxicology business and the assets and liabilities related to its B-type +Natriuretic Peptide assay business run on Beckman Coulter analyzers to Quidel. The transactions with Quidel reflect a total purchase price of $400 million payable at the close of the +transaction, $240 million payable in six annual installments beginning approximately six months after the close of the transaction, and contingent consideration with a maximum value of +$40 million. In the third quarter of 2017, Alere entered into an agreement with Siemens Diagnostics Holding II B.V. (Siemens) to sell its subsidiary, Epocal Inc., for +approximately $200 million payable at the close of the transaction. Alere agreed to divest these businesses in connection with the review by the Federal Trade Commission and the European +Commission of Abbott's agreement to acquire Alere. The sale to Quidel closed on October 6, 2017, and the sale to Siemens closed on October 31, 2017. No gain or loss on these sales was +recorded in the Consolidated Statement of Earnings. +In +2017, consolidated Abbott results include $6.5 billion of sales and a pre-tax loss of approximately $1.3 billion related to the St. Jude Medical and Alere +acquisitions, including approximately $1.5 billion of intangible amortization and $907 million of inventory step-up amortization. The pre-tax loss excludes acquisition, integration and +restructuring-related costs. +If +the acquisitions of St. Jude Medical and Alere had occurred at the beginning of 2016, unaudited pro forma consolidated net sales would have been approximately +$28.9 billion and the unaudited pro forma consolidated net loss from continuing operations would have been approximately $485 million in 2016. This includes amortization of approximately +$940 million of inventory step-up and $1.7 billion of intangibles related to St. Jude Medical and Alere. For 2017, unaudited pro forma consolidated net sales would have been +approximately $28.9 billion and unaudited pro forma consolidated net earnings from continuing operations would have been approximately $750 million, which includes $225 million of +intangible amortization related to Alere. The unaudited pro forma consolidated net earnings from continuing operations for 2017 exclude inventory step-up amortization related to St. Jude +Medical and Alere of approximately $907 million which was recorded in 2017 but included in the 2016 unaudited pro +70 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 7 — Business Acquisitions (Continued) +forma +results as noted above. The unaudited pro forma information is not necessarily indicative of the consolidated results of operations that would have been realized had the St. Jude Medical +and Alere acquisitions been completed as of the beginning of 2016, nor is it meant to be indicative of future results of operations that the combined entity will experience. +On +July 17, 2017, Abbott commenced a tender offer to purchase for cash the 1.77 million outstanding shares of Alere's Series B Convertible Perpetual Preferred Stock +at a price of $402 per share, plus accrued but unpaid dividends to, but not including, the settlement date of the tender offer. This tender offer was subject to the satisfaction of certain conditions, +including Abbott's acquisition of Alere and upon there being validly tendered (and not properly withdrawn) at the expiration date of the tender +offer that number of shares of Preferred Stock that equaled at least a majority of the Preferred Stock issued and outstanding at the expiration of the tender offer. The tender offer expired on +October 3, 2017. All conditions to the offer were satisfied and Abbott accepted for payment the 1.748 million shares of Preferred Stock that were validly tendered (and not properly +withdrawn). The remaining shares were cashed out for an amount equal to the $400.00 per share liquidation preference of such shares, plus accrued but unpaid dividends, without interest. Payment for +all of the shares of Preferred Stock was made in the fourth quarter of 2017. +Note 8 — Goodwill and Intangible Assets +The total amount of goodwill reported was $23.3 billion at December 31, 2018 and $24.0 billion at December 31, 2017. The amounts reported at +December 31, 2018 and 2017 exclude goodwill reported in non-current assets held for disposition. In 2018, foreign currency translation adjustments decreased goodwill by approximately +$440 million. Purchase price accounting adjustments associated with the Alere acquisition decreased goodwill by $326 million in 2018. Goodwill increased by $17.2 billion in 2017 +due to the completion of the St. Jude Medical and Alere acquisitions, partially offset by a decrease of $1.5 billion due to the sale of certain businesses to Terumo, Quidel and Siemens. +Foreign currency translation increased goodwill by $653 million in 2017. The amount of goodwill related to reportable segments at December 31, 2018 was $3.0 billion for the +Established Pharmaceutical Products segment, $286 million for the Nutritional Products segment, $3.7 billion for the Diagnostic Products segment, and $15.3 billion for the +Cardiovascular and Neuromodulation Products segment. In 2018 and 2017, there were no significant reductions of goodwill relating to impairments. +The +gross amount of amortizable intangible assets, primarily product rights and technology was $25.7 billion and $25.6 billion as of December 31, 2018 and 2017, +respectively, and accumulated amortization was $10.4 billion and $8.1 billion as of December 31, 2018 and 2017, respectively. In 2018, purchase price allocation adjustments +increased intangible assets by $280 million and foreign currency translation adjustments decreased intangible assets by $281 million. In 2017, the gross amount of amortizable intangible +assets increased by approximately $14.5 billion due to the completion of the St. Jude Medical and Alere acquisitions, partially offset by a decrease of $210 million due to the +sale of certain businesses to Quidel and Siemens. +Indefinite-lived +intangible assets, which relate to in-process research and development acquired in a business combination, were approximately $3.6 billion and $3.9 billion +at December 31, 2018 and 2017, respectively. The decrease in indefinite-lived intangible assets in 2018 primarily relates to purchase price allocation adjustments associated with the Alere +acquisition. In 2017, in-process research and development increased by $4.5 billion due to the completion of the St. Jude Medical and Alere acquisitions, a portion of which became +amortizable during the year. In 2017, Abbott also recorded a $53 million impairment of an +71 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 8 — Goodwill and Intangible Assets (Continued) +in-process +research and development project related to the Cardiovascular and Neuromodulation Products segment. +The +estimated annual amortization expense for intangible assets recorded at December 31, 2018 is approximately $2.0 billion in 2019, $2.2 billion in 2020, +$2.1 billion in 2021, $2.0 billion in 2022 and $2.0 billion in 2023. Amortizable intangible assets are amortized over 2 to 20 years (weighted average 12 years). +Note 9 — Restructuring Plans +In 2017 and 2018, Abbott management approved restructuring plans as part of the integration of the acquisitions of St. Jude Medical into the Cardiovascular and Neuromodulation +Products segment, and Alere into the Diagnostic Products segment, in order to leverage economies of scale and reduce costs. Abbott recorded employee related severance and other charges of +approximately $52 million in 2018 and $187 million in 2017. Approximately $5 million in 2018 and 2017 is recorded in Cost of products sold, approximately $10 million in +2018 is recorded in Research and development, and approximately +$37 million in 2018 and $182 million in 2017 are recorded in Selling, general and administrative expense. Abbott also assumed restructuring liabilities of approximately +$23 million as part of the St Jude Medical and Alere acquisitions. The following summarizes the activity related to these actions and the status of the related accruals: +(in millions) +Liabilities assumed as part of business acquisitions +$ +23 +Restructuring charges +187 +Payments and other adjustments +(142 +) +​ +​ +​ +​ +​ +Accrued balance at December 31, 2017 +68 +Restructuring charges +52 +Payments and other adjustments +(79 +) +​ +​ +​ +​ +​ +Accrued balance at December 31, 2018 +$ +41 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +From +2016 to 2018, Abbott management approved plans to streamline operations in order to reduce costs and improve efficiencies in various Abbott businesses including the nutritional, +established pharmaceuticals and vascular businesses. Abbott recorded employee related severance and other charges of approximately $28 million in 2018, $120 million in 2017 and +$32 million in 2016. Approximately $10 million in 2018, $7 million in 2017, and $9 million in 2016 are recorded in Cost of products sold, approximately $2 million in +2018, $77 million in 2017 and $5 million in 2016 are recorded in Research and development and approximately $16 million in 2018, $36 million in 2017 and $18 million +in 2016 are recorded in Selling, general and administrative expense. Additional charges of approximately $2 million in 2017 and 2016 were recorded primarily for accelerated depreciation. +72 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 9 — Restructuring Plans (Continued) +The +following summarizes the activity for these restructurings: +(in millions) +Restructuring charges +$ +32 +Payments and other adjustments +(15 +) +​ +​ +​ +​ +​ +Accrued balance at December 31, 2016 +17 +Restructuring charges +120 +Payments and other adjustments +(18 +) +​ +​ +​ +​ +​ +Accrued balance at December 31, 2017 +119 +Restructuring charges +28 +Payments and other adjustments +(77 +) +​ +​ +​ +​ +​ +Accrued balance at December 31, 2018 +$ +70 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Note 10 — Incentive Stock Program +The 2017 Incentive Stock Program authorizes the granting of nonqualified stock options, restricted stock awards, restricted stock units, performance awards, foreign benefits and other +share-based awards. Stock options and restricted stock awards and units comprise the majority of benefits that have been granted and are currently outstanding under this program and a prior program. +In 2018, Abbott granted 5,760,221 stock options, 871,331 restricted stock awards and 8,093,546 restricted stock units under this program. +Under +Abbott's stock incentive programs, the purchase price of shares under option must be at least equal to the fair market value of the common stock on the date of grant, and the +maximum term of an option is 10 years. Options generally vest equally over three years. Restricted stock awards generally vest over 3 years, with no more than one-third of the award +vesting in any one year upon Abbott reaching a minimum return on equity target. Restricted stock units vest over three years and upon vesting, the recipient receives one share of Abbott stock for each +vested restricted stock unit. The aggregate fair market value of restricted stock awards and units is recognized as expense over the requisite service period, which may be shorter than the vesting +period if an employee is retirement eligible. Forfeitures are estimated at the time of grant. Restricted stock awards and settlement of vested restricted stock units are issued out of treasury shares. +Abbott generally issues new shares for exercises of stock options. As a policy, Abbott does not purchase its shares relating to its share-based programs. +In +April 2017, Abbott's shareholders authorized the 2017 Incentive Stock Program under which a maximum of 170 million shares were available for issuance. At December 31, +2018, approximately 144 million shares remained available for future issuance. +In +connection with the completion of the St. Jude Medical acquisition in the first quarter of 2017, unvested St. Jude Medical stock options and restricted stock units were +assumed by Abbott and converted into Abbott options and restricted stock units (as applicable) of substantially equivalent value, in accordance with the merger agreement. The number of shares +underlying the converted options was 7,364,571 at a weighted average exercise price of $30.50. The number of restricted stock units converted was 2,324,500 at a weighted average grant date fair value +of $37.69. +73 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 10 — Incentive Stock Program (Continued) +The +number of restricted stock awards and units outstanding and the weighted-average grant-date fair value at December 31, 2018 and December 31, 2017 was 15,952,602 and +$52.11 and 15,518,719 and $42.82, respectively. The number of restricted stock awards and units, and the weighted-average grant-date fair value, that were granted, vested and lapsed during 2018 were +8,964,877 and $60.10, 7,522,375 and $42.85 and 1,008,619 and $49.27, respectively. The fair market value of restricted stock awards and units vested in 2018, 2017 and 2016 was $458 million, +$348 million and $225 million, respectively. +Options Outstanding +Exercisable Options +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Life (Years) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Life (Years) +December 31, 2017 +35,813,800 +$ +36.85 +5.8 +22,216,890 +$ +34.54 +4.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Granted +5,760,221 +60.02 +Exercised +(7,690,569 +) +30.34 +Lapsed +(808,839 +) +44.77 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, 2018 +33,074,613 +$ +42.21 +6.3 +21,660,783 +$ +38.05 +5.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +aggregate intrinsic value of options outstanding and exercisable at December 31, 2018 were $996 million and $743 million, respectively. The total intrinsic value +of options exercised in 2018, 2017 and 2016 was $249 million, $233 million and $98 million, respectively. The total unrecognized compensation cost related to all share-based +compensation plans at December 31, 2018 amounted to approximately $364 million, which is expected to be recognized over the next three years. +Total +non-cash stock compensation expense charged against income from continuing operations in 2018, 2017 and 2016 for share-based plans totaled approximately $477 million, +$406 million and $310 million, respectively, and the tax benefit recognized was approximately $185 million, $242 million and $100 million, respectively. The decrease +in the tax benefit in 2018 primarily relates to the Tax Cuts and Jobs Act (TCJA), which reduces the U.S. federal corporate tax rate from 35% to 21%. The increase in the 2017 tax benefit primarily +relates to the $120 million of tax benefit recorded in income after the adoption of ASU 2016-09. Stock compensation cost capitalized as part of inventory is not significant. +The +fair value of an option granted in 2018, 2017 and 2016 was $10.93, $6.54, and $4.38, respectively. The fair value of an option grant was estimated using the Black-Scholes +option-pricing model with the following assumptions: +2018 +2017 +2016 +Risk-free interest rate +2.7 +% +2.1 +% +1.4 +% +Average life of options (years) +6.0 +6.0 +6.0 +Volatility +19.0 +% +18.0 +% +17.0 +% +Dividend yield +1.9 +% +2.4 +% +2.7 +% +The +risk-free interest rate is based on the rates available at the time of the grant for zero-coupon U.S. government issues with a remaining term equal to the option's expected life. The +average life of an option is based on both historical and projected exercise and lapsing data. Expected volatility is based on implied volatilities from traded options on Abbott's stock and historical +volatility of Abbott's stock over the expected life of the option. Dividend yield is based on the option's exercise price and annual dividend rate at the time of grant. +74 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit +The following is a summary of long-term debt at December 31: ( in millions ) +2018 +2017 +5.125% Notes, due 2019 +$ +— +$ +947 +2.35% Notes, due 2019 +— +2,850 +2.50% Line of credit borrowing due 2019 +— +1,150 +0.00% Notes, due 2020 +1,300 +— +2.80% Notes, due 2020 +500 +500 +4.125% Notes, due 2020 +— +597 +2.00% Notes, due 2020 +— +750 +2.90% Notes, due 2021 +2,850 +2,850 +2.55% Notes, due 2022 +750 +750 +2.62% Term loan due 2022 +— +2,800 +0.875% Notes, due 2023 +1,303 +— +3.25% Notes, due 2023 +— +900 +3.40% Notes, due 2023 +1,050 +1,500 +3.875% Notes, due 2025 +500 +500 +2.95% Notes, due 2025 +1,000 +1,000 +1.50% Notes, due 2026 +1,300 +— +3.75% Notes, due 2026 +1,700 +3,000 +4.75% Notes, due 2036 +1,650 +1,650 +6.15% Notes, due 2037 +547 +547 +6.00% Notes, due 2039 +515 +515 +5.30% Notes, due 2040 +694 +694 +4.75% Notes, due 2043 +700 +700 +4.90% Notes, due 2046 +3,250 +3,250 +Unamortized debt issuance costs +(102 +) +(119 +) +Other, including fair value adjustments relating to interest rate hedge contracts designated as fair value hedges +(148 +) +(121 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total, net of current maturities +19,359 +27,210 +Current maturities of long-term debt +7 +508 +​ +​ +​ +​ +​ +​ +​ +​ +Total carrying amount +$ +19,366 +$ +27,718 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +On +February 16, 2018, the board of directors authorized the early redemption of up to $5 billion of outstanding long-term notes. Redemptions under this authorization +include the following: +• $0.947 billion principal amount of its 5.125% Notes due 2019 — redeemed on March 22, 2018 +• $1.055 billion of the $2.850 billion principal amount of its 2.35% Notes due 2019 — redeemed on +March 22, 2018 +• $1.300 billion of the $1.795 billion outstanding principal amount of its 2.35% Notes due 2019 — redeemed on +June 22, 2018 +• $0.495 billion outstanding principal amount of its 2.35% Notes due 2019 — redeemed on September 28, 2018 +75 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit (Continued) +On +January 25, 2019, Abbott gave notice to the holders of its 2.80% Notes due 2020, that it will redeem the $500 million outstanding principal amount of these notes on +February 24, 2019. After the redemption of the 2.80% Notes, approximately $700 million of the $5 billion debt redemption authorization noted above will remain available. +Abbott +incurred a net charge of $14 million related to the March 22, 2018 early repayment of debt. +On +September 17, 2018, Abbott repaid upon maturity the $500 million aggregate principal amount outstanding of the 2.00% Senior Notes due 2018. +On +September 27, 2018, Abbott's wholly owned subsidiary, Abbott Ireland Financing DAC, completed a euro debt offering of €3.420 billion of long-term debt +consisting of €1.140 billion of non-interest bearing Senior Notes due 2020 at 99.727% of par value; €1.140 billion of 0.875% Senior Notes due 2023 at +99.912% of par value; and €1.140 billion of 1.50% Senior Notes due 2026 at 99.723% of par value. The proceeds equated to approximately $4 billion. The notes are +guaranteed by Abbott. +On +October 28, 2018, Abbott redeemed approximately $4 billion of debt, which included $750 million principal amount of its 2.00% Notes due 2020; $597 million +principal amount of its 4.125% Notes due 2020; $900 million principal amount of its 3.25% Notes due 2023; $450 million principal amount of its 3.4% Notes due 2023; and +$1.300 billion principal amount of its 3.75% Notes due 2026. These amounts are in addition to the $5 billion authorization discussed above. In conjunction with the redemption, Abbott +unwound approximately $1.1 billion in interest rate swaps relating to the 3.40% Note due in 2023 and the 3.75% Note due in 2026. Abbott incurred a net charge of $153 million related to +the early repayment of this debt and the unwinding of related interest rate swaps. +On +November 30, 2018, Abbott entered into a Five Year Credit Agreement (Revolving Credit Agreement) and terminated the 2014 revolving credit agreement. There were no outstanding +borrowings under the 2014 revolving credit agreement at the time of its termination. The Revolving Credit Agreement provides Abbott with the ability to borrow up to $5 billion on an unsecured +basis. Any borrowings under the Revolving Credit Agreement will mature and be payable on November 30, 2023. Any borrowings under the Revolving Credit Agreement will bear interest, at Abbott's +option, +based on either a base rate or Eurodollar rate, plus an applicable margin based on Abbott's credit ratings. +In +the first quarter of 2017, as part of the acquisition of St. Jude Medical, Abbott's long-term debt increased due to the assumption of outstanding debt previously issued by +St. Jude Medical. Abbott exchanged certain St. Jude Medical debt obligations with an aggregate principal amount of approximately $2.9 billion for debt issued by Abbott which +consists of: +Principal Amount +2.00% Senior Notes due 2018 +$ +473.8 million +2.80% Senior Notes due 2020 +$ +483.7 million +3.25% Senior Notes due 2023 +$ +818.4 million +3.875% Senior Notes due 2025 +$ +490.7 million +4.75% Senior Notes due 2043 +$ +639.1 million +Following +this exchange, approximately $194.2 million of existing St. Jude Medical notes remained outstanding across the five series of existing notes which have the same +coupons and maturities as those listed above. There were no significant costs associated with the exchange of debt. In addition, during the +76 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit (Continued) +first +quarter of 2017, Abbott assumed and subsequently repaid approximately $2.8 billion of various St. Jude Medical debt obligations. +On +January 4, 2017, as part of funding the cash portion of the St. Jude Medical acquisition, Abbott borrowed $2.0 billion under a 120-day senior unsecured bridge +term loan facility. This facility was repaid during the first quarter of 2017. +In +2017, Abbott issued 364-day yen-denominated debt, of which $199 million and $195 million was outstanding at December 31, 2018 and 2017, respectively. In 2017, +Abbott also paid off a $479 million yen-denominated short-term borrowing during the year. +On +July 31, 2017, Abbott entered into a 5-year term loan agreement that allowed Abbott to borrow up to $2.8 billion on an unsecured basis for the acquisition of Alere. On +October 3, 2017, Abbott borrowed $2.8 billion under this term loan agreement to finance the acquisition of Alere, to repay certain indebtedness of Abbott and Alere, and to pay fees and +expenses in connection with the acquisition. Borrowings under the term loan bore interest based on a Eurodollar rate, plus an applicable margin based on Abbott's credit ratings. Abbott paid off this +term loan on January 5, 2018. +On +October 3, 2017 Abbott borrowed $1.7 billion under its lines of credit. Proceeds from such borrowing were used to finance the acquisition of Alere, to repay certain +indebtedness of Abbott and Alere, and to pay fees and expenses in connection with the acquisition. These lines of credit were part of a 2014 revolving credit agreement that provided Abbott with the +ability to borrow up to $5 billion on an unsecured basis. Advances under the revolving credit agreement, including the $1.7 billion borrowing in October 2017, were scheduled to mature +and be payable on July 10, 2019. The $1.7 billion borrowing bore interest based on a Eurodollar rate, plus an applicable margin based on Abbott's credit ratings. Prior to +October 3, 2017, no amounts were previously drawn under the revolving credit agreement. In the fourth quarter of 2017, Abbott paid off $550 million on the revolving loan. Abbott paid off +the remaining balance on this revolving loan on January 5, 2018. +In +the fourth quarter of 2017, in conjunction with the acquisition of Alere, Abbott assumed and subsequently repaid $3.0 billion of Alere's debt. +In +November 2016, Abbott issued $15.1 billion of medium and long-term debt to primarily fund the cash portion of the acquisition of St. Jude Medical. Abbott issued +$2.85 billion of 2.35% Senior Notes due November 22, 2019; $2.85 billion of 2.90% Senior Notes due November 30, 2021; $1.50 billion of 3.40% Senior Notes due +November 30, 2023; $3.00 billion of 3.75% Senior Notes due November 30, 2026; $1.65 billion of 4.75% Senior Notes due November 30, 2036; and $3.25 billion of +4.90% Senior Notes due November 30, 2046. In November 2016, Abbott also entered into interest rate swap contracts totaling $3.0 billion related to the new debt, which have the effect of +changing Abbott's obligation from a fixed interest rate to a variable interest rate obligation on the related debt instruments. +In +February 2016, Abbott obtained a commitment for a 364-day senior unsecured bridge term loan facility for an amount not to exceed $9 billion in conjunction with its pending +acquisition of Alere. This commitment, which was automatically extended for up to 90 days on January 29, 2017, expired on +April 30, 2017 and was not renewed since Abbott did not need this bridge facility to finance the Alere acquisition. The fees associated with the bridge facilities were recognized in interest +expense. +77 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit (Continued) +Principal +payments required on long-term debt outstanding at December 31, 2018 are $7 million in 2019, $1.8 billion in 2020, $2.9 billion in 2021, +$750 million in 2022, $2.3 billion in 2023 and $11.8 billion in 2024 and thereafter. +At +December 31, 2018, Abbott's long-term debt rating was BBB by Standard & Poor's Corporation and Baa1 by Moody's. Abbott has readily available financial resources, +including lines of credit of $5.0 billion which expire in 2023 and support commercial paper borrowing arrangements. Abbott's weighted-average interest rate on short-term borrowings was 0.4% at +December 31, 2018, 0.3% at December 31, 2017 and 0.6% at December 31, 2016. +Note 12 — Financial Instruments, Derivatives and Fair Value Measures +Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates for anticipated intercompany purchases +by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts, with gross notional amounts totaling $5.1 billion at December 31, 2018, and +$3.3 billion at December 31, 2017, are designated as cash flow hedges of the variability of the cash flows due to changes in foreign exchange rates and are recorded at fair value. +Accumulated gains and losses as of December 31, 2018 will be included in Cost of products sold at the time the products are sold, generally through the next twelve to eighteen months. +Abbott +enters into foreign currency forward exchange contracts to manage currency exposures for foreign currency denominated third-party trade payables and receivables, and for +intercompany loans and trade accounts payable where the receivable or payable is denominated in a currency other than the functional currency of the entity. For intercompany loans, the contracts +require Abbott to sell or buy foreign currencies, primarily European currencies, in exchange for primarily U.S. dollars and European currencies. For intercompany and trade payables and receivables, +the currency exposures are primarily the U.S. dollar and European currencies. At December 31, 2018, 2017 and 2016, Abbott held gross notional amounts of $13.6 billion, +$20.1 billion and $14.9 billion, respectively, of such foreign currency forward exchange contracts. +In +March 2017, Abbott repaid its $479 million foreign denominated short-term debt which was designated as a hedge of the net investment in a foreign subsidiary. At +December 31, 2016, the value of this short-term debt was $454 million and changes in the fair value of the debt up through the date of repayment due to changes in exchange rates were +recorded in Accumulated other comprehensive income (loss), net of tax. +Abbott +is a party to interest rate hedge contracts totaling approximately $2.9 billion at December 31, 2018, $4.0 billion at December 31, 2017 and +$5.5 billion at December 31, 2016, to manage its exposure to changes in the fair value of fixed-rate debt. These contracts are designated as fair value hedges of the variability of the +fair value of fixed-rate debt due to changes in the long-term benchmark interest rates. The effect of the hedge is to change a fixed-rate interest obligation to a variable rate for that portion of the +debt. Abbott records the contracts at fair value and adjusts the carrying amount of the fixed-rate debt by an offsetting amount. +In +October 2018, Abbott unwound approximately $1.1 billion in interest rate swaps relating to the 3.40% Note due in 2023 and the 3.75% Note due in 2026. As a part of the +unwinding, Abbott paid approximately $90 million in cash, which was included in the Financing Activities section of the Consolidated Statement of Cash Flows in 2018. +78 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +In +the second quarter of 2017, Abbott unwound approximately $1.5 billion in interest rate swaps relating to the 2.00% Note due in 2020 and the 2.55% Note due in 2022. The proceeds +received were not significant. +In +December 2016, Abbott unwound approximately $1.5 billion in interest rate swaps relating to the 4.125% Note due in 2020 and the 5.125% Note due in 2019. As part of the +unwinding, Abbott received +approximately $55 million in cash, which was included in the Financing Activities section of the Consolidated Statement of Cash Flows in 2016. +The +following table summarizes the amounts and location of certain derivative financial instruments as of December 31: +Fair Value — Assets +Fair Value — Liabilities +(in millions) +2018 +2017 +Balance Sheet Caption +2018 +2017 +Balance Sheet Caption +Interest rate swaps designated as fair value hedges +$ +— +$ +— +Deferred income taxes and other assets +$ +100 +$ +93 +Post-employment obligations and other long-term liabilities +Foreign currency forward exchange contracts — +Hedging instruments +81 +21 +Other prepaid expenses and receivables +44 +106 +Other accrued liabilities +Others not designated as hedges +33 +117 +Other prepaid expenses and receivables +51 +99 +Other accrued liabilities +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +114 +$ +138 +$ +195 +$ +298 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +following table summarizes the activity for foreign currency forward exchange contracts designated as cash flow hedges, debt designated as a hedge of net investment in a foreign +subsidiary and certain other derivative financial instruments, as well as the amounts and location of income (expense) and gain (loss) reclassified into income. +Gain (loss) Recognized in +Other Comprehensive +Income (loss) +Income (expense) and +Gain (loss) Reclassified +into Income +Income Statement +Caption +(in millions) +2018 +2017 +2016 +2018 +2017 +2016 +Foreign currency forward exchange contracts designated as cash flow hedges +$ +73 +$ +(226 +) +$ +49 +$ +(114 +) +$ +(48 +) +$ +48 +Cost of products sold +Debt designated as a hedge of net investment in a foreign subsidiary +— +(25 +) +(15 +) +n/a +n/a +n/a +n/a +Interest rate swaps designated as fair value hedges +n/a +n/a +n/a +(97 +) +(24 +) +(127 +) +Interest expense +Losses +of $100 million and $64 million, and gains of $8 million were recognized in 2018, 2017 and 2016, respectively, related to foreign currency forward exchange +contracts not designated as hedges. These +amounts are reported in the Consolidated Statement of Earnings on the Net foreign exchange (gain) loss line. +The +interest rate swaps are designated as fair value hedges of the variability of the fair value of fixed-rate debt due to changes in the long-term benchmark interest rates. The hedged +debt is marked to market, offsetting the effect of marking the interest rate swaps to market. +The +carrying values and fair values of certain financial instruments as of December 31 are shown in the table below. The carrying values of all other financial instruments +approximate their estimated fair values. +79 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +The +counterparties to financial instruments consist of select major international financial institutions. Abbott does not expect any losses from nonperformance by these counterparties. +2018 +2017 +(in millions) +Carrying +Value +Fair +Value +Carrying +Value +Fair +Value +Long-term Investment Securities: +Equity securities +$ +856 +$ +856 +$ +797 +$ +797 +Other +41 +41 +86 +86 +Total Long-Term Debt +(19,366 +) +(19,871 +) +(27,718 +) +(29,018 +) +Foreign Currency Forward Exchange Contracts: +Receivable position +114 +114 +138 +138 +(Payable) position +(95 +) +(95 +) +(205 +) +(205 +) +Interest Rate Hedge Contracts: +(Payable) position +(100 +) +(100 +) +(93 +) +(93 +) +The +following table summarizes the bases used to measure certain assets and liabilities at fair value on a recurring basis in the balance sheet: +Basis of Fair Value Measurement +(in millions) +Outstanding +Balances +Quoted +Prices in +Active Markets +Significant Other +Observable +Inputs +Significant +Unobservable +Inputs +December 31, 2018: +Equity securities +$ +320 +$ +320 +$ +— +$ +— +Foreign currency forward exchange contracts +114 +— +114 +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Assets +$ +434 +$ +320 +$ +114 +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of hedged long-term debt +$ +2,743 +$ +— +$ +2,743 +$ +— +Interest rate swap financial instruments +100 +— +100 +— +Foreign currency forward exchange contracts +95 +— +95 +— +Contingent consideration related to business combinations +71 +— +— +71 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Liabilities +$ +3,009 +$ +— +$ +2,938 +$ +71 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, 2017: +Equity securities +$ +374 +$ +374 +$ +— +$ +— +Foreign currency forward exchange contracts +138 +— +138 +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Assets +$ +512 +$ +374 +$ +138 +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of hedged long-term debt +$ +3,898 +$ +— +$ +3,898 +$ +— +Interest rate swap financial instruments +93 +— +93 +— +Foreign currency forward exchange contracts +205 +— +205 +— +Contingent consideration related to business combinations +120 +— +— +120 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Liabilities +$ +4,316 +$ +— +$ +4,196 +$ +120 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +fair value of foreign currency forward exchange contracts is determined using a market approach, which utilizes values for comparable derivative instruments. The fair value of the +debt was determined based +80 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +on +the face value of the debt adjusted for the fair value of the interest rate swaps, which is based on a discounted cash flow analysis using significant other observable inputs. +Contingent +consideration relates to businesses acquired by Abbott. The fair value of the contingent consideration was determined based on independent appraisals, at the time of the +business acquisition, adjusted for the time value of money and other changes in fair value. The maximum amount for certain contingent consideration is not determinable as it is based on a percent of +certain sales. Excluding such contingent consideration, the maximum amount estimated to be due is approximately $480 million, which is dependent upon attaining certain sales thresholds or based +on the occurrence of certain events, such as regulatory approvals. +Note 13 — Litigation and Environmental Matters +Abbott has been identified as a potentially responsible party for investigation and cleanup costs at a number of locations in the United States and Puerto Rico under federal and state +remediation laws and is investigating potential contamination at a number of company-owned locations. Abbott has recorded an estimated cleanup cost for each site for which management believes Abbott +has a probable loss exposure. No individual site cleanup exposure is expected to exceed $4 million, and the aggregate cleanup exposure is not expected to exceed $10 million. +Abbott +is involved in various claims and legal proceedings, and Abbott estimates the range of possible loss for its legal proceedings and environmental exposures to be from approximately +$125 million to $165 million. The recorded accrual balance at December 31, 2018 for these proceedings and exposures was approximately $145 million. This accrual represents +management's best estimate of probable loss, as defined by FASB ASC No. 450, "Contingencies." Within the next year, legal proceedings may occur that may result in a change in the estimated loss +accrued by Abbott. While it is not feasible to predict the outcome of all such proceedings and exposures with certainty, management believes that their ultimate disposition should not have a material +adverse effect on Abbott's financial position, cash flows, or results of operations. +81 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits +Retirement plans consist of defined benefit, defined contribution and medical and dental plans. Information for Abbott's major defined benefit plans and post-employment medical and +dental benefit plans is as follows: +Defined Benefit +Plans +Medical and +Dental Plans +(in millions) +2018 +2017 +2018 +2017 +Projected benefit obligations, January 1 +$ +9,953 +$ +8,517 +$ +1,393 +$ +1,274 +Service cost — benefits earned during the year +293 +283 +26 +25 +Interest cost on projected benefit obligations +308 +287 +48 +45 +(Gains) losses, primarily changes in discount rates, plan design changes, law changes and differences between actual and estimated health care +costs +(1,044 +) +752 +(106 +) +149 +Benefits paid +(295 +) +(276 +) +(68 +) +(80 +) +Other, including foreign currency translation +(122 +) +390 +(1 +) +(20 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Projected benefit obligations, December 31 +$ +9,093 +$ +9,953 +$ +1,292 +$ +1,393 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Plan assets at fair value, January 1 +$ +9,298 +$ +7,542 +$ +419 +$ +416 +Actual return (loss) on plans' assets +(450 +) +1,107 +(20 +) +65 +Company contributions +114 +645 +12 +12 +Benefits paid +(295 +) +(276 +) +(60 +) +(74 +) +Other, including foreign currency translation +(114 +) +280 +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Plan assets at fair value, December 31 +$ +8,553 +$ +9,298 +$ +351 +$ +419 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Projected benefit obligations greater than plan assets, December 31 +$ +(540 +) +$ +(655 +) +$ +(941 +) +$ +(974 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Long-term assets +$ +583 +$ +563 +$ +— +$ +— +Short-term liabilities +(23 +) +(21 +) +(1 +) +(2 +) +Long-term liabilities +(1,100 +) +(1,197 +) +(940 +) +(972 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net liability +$ +(540 +) +$ +(655 +) +$ +(941 +) +$ +(974 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Amounts Recognized in Accumulated Other Comprehensive Income (loss): +Actuarial losses, net +$ +3,326 +$ +3,466 +$ +361 +$ +456 +Prior service cost (credits) +(2 +) +(9 +) +(163 +) +(208 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +3,324 +$ +3,457 +$ +198 +$ +248 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +projected benefit obligations for non-U.S. defined benefit plans was $2.7 billion and $3.0 billion at December 31, 2018 and 2017, respectively. The accumulated +benefit obligations for all defined benefit plans were $8.3 billion and $8.9 billion at December 31, 2018 and 2017, respectively. +82 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +For +plans where the accumulated benefit obligations exceeded plan assets at December 31, 2018 and 2017, the aggregate accumulated benefit obligations, the projected benefit +obligations and the aggregate plan assets were as follows: +(in millions) +2018 +2017 +Accumulated benefit obligation +$ +1,265 +$ +1,664 +Projected benefit obligation +1,362 +1,892 +Fair value of plan assets +375 +696 +The +components of the net periodic benefit cost were as follows: +Defined Benefit Plans +Medical and +Dental Plans +(in millions) +2018 +2017 +2016 +2018 +2017 +2016 +Service cost — benefits earned during the year +$ +293 +$ +283 +$ +263 +$ +26 +$ +25 +$ +26 +Interest cost on projected benefit obligations +308 +287 +288 +48 +45 +43 +Expected return on plans' assets +(680 +) +(613 +) +(565 +) +(33 +) +(33 +) +(35 +) +Amortization of actuarial losses +205 +163 +129 +33 +23 +16 +Amortization of prior service cost (credits) +1 +1 +— +(45 +) +(45 +) +(45 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total cost +$ +127 +$ +121 +$ +115 +$ +29 +$ +15 +$ +5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +In +2017, Abbott recognized a $10 million curtailment gain related to the sale of AMO. +Other +comprehensive income (loss) for each respective year includes the amortization of actuarial losses and prior service costs (credits) as noted in the previous table. Other +comprehensive income (loss) for each respective year also includes: net actuarial losses of $86 million for defined benefit plans and a gain of $53 million for medical and dental plans +in 2018; net actuarial losses of $247 million for defined benefit plans and $97 million for medical and dental plans in 2017; net actuarial losses of $571 million for defined +benefit plans and $20 million for medical and dental plans in 2016. +The +pretax amount of actuarial losses and prior service cost (credits) included in Accumulated other comprehensive income (loss) at December 31, 2018 that is expected to be +recognized in the net periodic benefit cost in 2019 is $130 million and $1 million of expense, respectively, for defined benefit pension plans and $24 million of expense and +$32 million of income, respectively, for medical and dental plans. +The +weighted average assumptions used to determine benefit obligations for defined benefit plans and medical and dental plans are as follows: +2018 +2017 +2016 +Discount rate +4.0 +% +3.4 +% +3.9 +% +Expected aggregate average long-term change in compensation +4.3 +% +4.4 +% +4.3 +% +83 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +The +weighted average assumptions used to determine the net cost for defined benefit plans and medical and dental plans are as follows: +2018 +2017 +2016 +Discount rate +3.4 +% +3.9 +% +4.3 +% +Expected return on plan assets +7.7 +% +7.6 +% +7.6 +% +Expected aggregate average long-term change in compensation +4.4 +% +4.3 +% +4.3 +% +The +assumed health care cost trend rates for medical and dental plans at December 31 were as follows: +2018 +2017 +2016 +Health care cost trend rate assumed for the next year +9 +% +9 +% +8 +% +Rate that the cost trend rate gradually declines to +5 +% +5 +% +5 +% +Year that rate reaches the assumed ultimate rate +2025 +2027 +2027 +The +discount rates used to measure liabilities were determined based on high-quality fixed income securities that match the duration of the expected retiree benefits. The health care +cost trend rates represent Abbott's expected annual rates of change in the cost of health care benefits and are forward projections of health care costs as of the measurement date. A one-percentage +point increase/(decrease) in the assumed health care cost trend rate would increase/(decrease) the accumulated post-employment benefit obligations as of December 31, 2018, by +$157 million /$(131) million, and the total of the service and interest cost components of net post-employment health care cost for the year then ended by approximately +$12 million/$(10) million. +84 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +The +following table summarizes the basis used to measure the defined benefit and medical and dental plan assets at fair value: +Basis of Fair Value Measurement +(in millions) +Outstanding +Balances +Quoted +Prices in +Active Markets +Significant +Other +Observable +Inputs +Significant +Unobservable +Inputs +Measured at +NAV (k) +December 31, 2018: +Equities: +U.S. large cap (a) +$ +2,168 +$ +1,319 +$ +5 +$ +— +$ +844 +U.S. mid and small cap (b) +515 +226 +— +— +289 +International (c) +1,671 +370 +— +— +1,301 +Fixed income securities: +U.S. government securities (d) +476 +51 +269 +— +156 +Corporate debt instruments (e) +1,150 +269 +701 +— +180 +Non-U.S. government securities (f) +405 +5 +— +— +400 +Other (g) +199 +15 +55 +— +129 +Absolute return funds (h) +1,684 +448 +— +— +1,236 +Commodities (i) +59 +— +— +4 +55 +Cash and Cash Equivalents +192 +123 +— +— +69 +Other (j) +385 +11 +— +— +374 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +8,904 +$ +2,837 +$ +1,030 +$ +4 +$ +5,033 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, 2017: +Equities: +U.S. large cap (a) +$ +2,506 +$ +1,600 +$ +— +$ +— +$ +906 +U.S. mid and small cap (b) +670 +243 +— +— +427 +International (c) +1,937 +448 +— +— +1,489 +Fixed income securities: +U.S. government securities (d) +510 +11 +286 +— +213 +Corporate debt instruments (e) +930 +107 +411 +— +412 +Non-U.S. government securities (f) +625 +222 +— +— +403 +Other (g) +216 +93 +27 +— +96 +Absolute return funds (h) +1,814 +135 +— +— +1,679 +Commodities (i) +60 +— +— +4 +56 +Cash and Cash Equivalents +178 +12 +— +— +166 +Other (j) +271 +7 +— +— +264 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +9,717 +$ +2,878 +$ +724 +$ +4 +$ +6,111 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) A +mix of index funds and actively managed equity accounts that are benchmarked to various large cap indices. +(b) A +mix of index funds and actively managed equity accounts that are benchmarked to various mid and small cap indices. +85 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +(c) A +mix of index funds and actively managed pooled investment funds that are benchmarked to various non-U.S. equity indices in both developed and emerging markets. +(d) A +mix of index funds and actively managed accounts that are benchmarked to various U.S. government bond indices. +(e) A +mix of index funds and actively managed accounts that are benchmarked to various corporate bond indices. +(f) Primarily +United Kingdom, Japan and Irish government-issued bonds. In 2017, included Netherlands bonds. +(g) Primarily +asset backed securities and an actively managed, diversified fixed income vehicle benchmarked to the one-month Libor / Euribor. +(h) Primarily +funds invested by managers that have a global mandate with the flexibility to allocate capital broadly across a wide range of asset classes and strategies +including, but not limited to equities, fixed income, commodities, interest rate futures, currencies and other securities to outperform an agreed upon benchmark with specific return and volatility +targets. +(i) Primarily +investments in liquid commodity future contracts and private energy funds. +(j) Primarily +investments in private funds, such as private equity, private credit and private real estate. +(k) In +accordance with ASU 2015-07, investments measured at fair value using the NAV practical expedient have not been classified in the fair value hierarchy. The fair +value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheet. +Equities +that are valued using quoted prices are valued at the published market prices. Equities in a common collective trust or a registered investment company that are valued using +significant other observable inputs are valued at the net asset value (NAV) provided by the fund administrator. The NAV is based on the value of the underlying assets owned by the fund minus its +liabilities. For approximately half of these funds, investments may be redeemed once per month, with a required 7 to 30 day notice period. For the remaining funds, daily redemption of an +investment is allowed. Fixed income securities that are valued using significant other observable inputs are valued at prices obtained from independent financial service industry recognized vendors. +Abbott did not have any unfunded commitments related to fixed income funds at December 31, 2018 and 2017. For the majority of these funds, investments may be redeemed either weekly or monthly, +with a required 2 to 14 day notice period. For the remaining funds, investments may be generally redeemed daily. +Absolute +return funds and commodities are valued at the NAV provided by the fund administrator. All private funds are valued at the NAV provided by the fund on a one-quarter lag adjusted +for known cash flows and significant events through the reporting date. Abbott did not have any unfunded commitments related to absolute return funds at December 31, 2018 and 2017. Investments +in these funds may be generally redeemed monthly or quarterly with required notice periods ranging from 5 to 45 days. For approximately $100 million of the absolute return funds, +redemptions are subject to a 25 percent gate. For commodities, investments in the private energy funds cannot be redeemed but the funds will make distributions through liquidation. The estimate +of the liquidation period for each fund ranges from 2019 to 2022. Abbott's unfunded commitments in these funds as of December 31, 2018 and 2017 were not +86 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +significant. +Investments in the private funds (excluding private energy funds) cannot be redeemed but the funds will make distributions through liquidation. The estimate of the liquidation period for +each +fund ranges from 2019 to 2028. Abbott's unfunded commitment in these funds was $518 million and $489 million as of December 31, 2018 and 2017, respectively. +The +investment mix of equity securities, fixed income and other asset allocation strategies is based upon achieving a desired return, as well as balancing higher return, more volatile +equity securities with lower return, less volatile fixed income securities. Investment allocations are made across a range of markets, industry sectors, capitalization sizes, and in the case of fixed +income securities, maturities and credit quality. The plans do not directly hold any securities of Abbott. There are no known significant concentrations of risk in the plans' assets. Abbott's medical +and dental plans' assets are invested in a similar mix as the pension plan assets. The actual asset allocation percentages at year end are consistent with the company's targeted asset allocation +percentages. +The +plans' expected return on assets, as shown above is based on management's expectations of long-term average rates of return to be achieved by the underlying investment portfolios. In +establishing this assumption, management considers historical and expected returns for the asset classes in which the plans are invested, as well as current economic and capital market conditions. +Abbott +funds its domestic pension plans according to IRS funding limitations. International pension plans are funded according to similar regulations. Abbott funded $114 million +in 2018 and $645 million in 2017 to defined pension plans. Abbott expects to contribute approximately $380 million to its pension plans in 2019. +Total +benefit payments expected to be paid to participants, which includes payments funded from company assets, as well as paid from the plans, are as follows: +(in millions) +Defined +Benefit Plans +Medical and +Dental Plans +2019 +$ +306 +$ +74 +2020 +317 +77 +2021 +333 +78 +2022 +351 +79 +2023 +369 +80 +2024 to 2028 +2,160 +418 +The +Abbott Stock Retirement Plan is the principal defined contribution plan. Abbott's contributions to this plan were $146 million in 2018, $79 million in 2017 and +$83 million in 2016. The 2018 contributions include amounts related to participants of the St. Jude Medical Retirement Plan which was terminated in January 2018. +Note 15 — Taxes on Earnings from Continuing Operations +Taxes on earnings from continuing operations reflect the annual effective rates, including charges for interest and penalties. Deferred income taxes reflect the tax consequences on +future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. +The +Tax Cuts and Jobs Act (TCJA) was enacted in the U.S. on December 22, 2017. The TCJA reduces the U.S. federal corporate tax rate from 35% to 21%, requires companies to pay a +one-time transition tax +87 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Taxes on Earnings from Continuing Operations (Continued) +on +earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. As of December 31, 2018, Abbott has completed its +accounting for all of the enactment date income tax effects of the TCJA. If additional regulations issued by the U.S. Department of the Treasury after December 31, 2018 result in a change in +judgment, the effect of such regulations will be accounted for in the period in which the regulations are finalized. +Effective +for fiscal years beginning after December 31, 2017, the TCJA subjects taxpayers to tax on global intangible low-taxed income (GILTI) earned by certain foreign +subsidiaries. In January 2018, the FASB staff provided guidance that an entity may make an accounting policy election to either recognize deferred taxes related to items that will give rise to GILTI +in future years or provide for the tax expense related to GILTI in the year that the tax is incurred. Abbott has elected to treat the GILTI tax as a period expense and provide for the tax in the year +that the tax is incurred. +In +the fourth quarter of 2017, Abbott recorded an estimate of net tax expense of $1.46 billion for the impact of the TCJA, which was included in Taxes on Earnings from Continuing +Operations in the Consolidated Statement of Earnings. The estimate was provisional and included a charge of approximately $2.89 billion for the transition tax, partially offset by a net benefit +of approximately $1.42 billion for the remeasurement of deferred tax assets and liabilities, and a net benefit of approximately $10 million related to certain other impacts of the TCJA. +In 2018, Abbott recorded $130 million of additional tax expense which increased the final tax expense related to the TCJA to $1.59 billion. The $130 million of additional tax +expense reflects a $120 million increase in the transition tax from $2.89 billion to $3.01 billion and a $10 million reduction in the net benefit related to the +remeasurement of deferred tax assets and liabilities. +The +one-time transition tax is based on Abbott's total post-1986 earnings and profits (E&P) that were previously deferred from U.S. income taxes. The tax computation also requires the +determination of the amount of post-1986 E&P considered held in cash and other specified assets. As of December 31, 2018, the remaining balance of Abbott's transition tax obligation is +approximately $1.58 billion, which will be paid over the next eight years as allowed by the TCJA. +In +2018, taxes on earnings from continuing operations includes $98 million of net tax expense related to the settlement of Abbott's 2014-2016 federal income tax audit in the U.S., +partial settlement of the former St. Jude Medical consolidated group's 2014 and 2015 federal income tax returns in the U.S. and audit settlements in various countries. In 2017, taxes on +earnings from continuing operations included $435 million of tax expense related to the gain on the sale of the AMO business. In 2016, taxes on earnings from continuing operations included the +impact of a net tax benefit of approximately $225 million, primarily as a result of the resolution of various tax positions from prior years, partially offset by the unfavorable impact of +non-deductible foreign exchange losses related to Venezuela and the adjustment of the Mylan N.V. equity investment, as well as the recognition of deferred taxes associated with the then pending +sale of AMO. +Undistributed +foreign earnings remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed +foreign earnings not subject to the transition tax and additional outside basis difference in its foreign entities is not practicable. In the U.S., Abbott's federal income tax returns through 2016 are +settled except for the federal income tax returns of the former Alere consolidated group which are settled through 2014 and the former St. Jude Medical consolidated group which are settled +through 2013. There are numerous other income tax jurisdictions for which tax returns are not yet settled, none of which are individually significant. Reserves for interest and penalties are not +significant. +88 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Taxes on Earnings from Continuing Operations (Continued) +Earnings from continuing operations before taxes, and the related provisions for taxes on earnings from continuing operations, were as follows: +(in millions) +2018 +2017 +2016 +Earnings From Continuing Operations Before Taxes: +Domestic +$ +(430 +) +$ +308 +$ +306 +Foreign +3,303 +1,923 +1,107 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +2,873 +$ +2,231 +$ +1,413 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Taxes on Earnings From Continuing Operations: +Current: +Domestic +$ +(812 +) +$ +2,260 +$ +71 +Foreign +606 +508 +406 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total current +(206 +) +2,768 +477 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Deferred: +Domestic +832 +(679 +) +(147 +) +Foreign +(87 +) +(211 +) +20 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred +745 +(890 +) +(127 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +539 +$ +1,878 +$ +350 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Differences +between the effective income tax rate and the U.S. statutory tax rate were as follows: +2018 +2017 +2016 +Statutory tax rate on earnings from continuing operations +21.0 +% +35.0 +% +35.0 +% +Impact of foreign operations +(5.4 +) +(16.3 +) +(17.8 +) +Impact of TCJA and other related items +6.3 +65.5 +— +Foreign-derived intangible income benefit +(1.9 +) +— +— +Domestic impairment loss +(2.1 +) +— +— +Excess tax benefits related to stock compensation +(3.1 +) +(5.4 +) +— +Research tax credit +(1.8 +) +(1.9 +) +(1.8 +) +Resolution of certain tax positions pertaining to prior years +3.4 +— +(16.1 +) +Mylan share adjustment +— +— +25.5 +State taxes, net of federal benefit +0.4 +0.5 +(1.3 +) +Federal tax cost on sale of Mylan N.V. shares +— +3.4 +— +All other, net +2.0 +3.4 +1.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Effective tax rate on earnings from continuing operations +18.8 +% +84.2 +% +24.8 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Impact +of foreign operations is primarily derived from operations in Puerto Rico, Switzerland, Ireland, the Netherlands, Costa Rica, and Singapore. +89 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Taxes on Earnings from Continuing Operations (Continued) +The +tax effect of the differences that give rise to deferred tax assets and liabilities were as follows: +(in millions) +2018 +2017 +Deferred tax assets: +Compensation and employee benefits +$ +829 +$ +881 +Other, primarily reserves not currently deductible, and NOL's and credit +carryforwards +2,546 +2,857 +Trade receivable reserves +196 +185 +Inventory reserves +97 +152 +Deferred intercompany profit +203 +249 +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax assets before valuation allowance +3,871 +4,324 +Valuation allowance +(1,363 +) +(1,355 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax assets +2,508 +2,969 +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax liabilities: +Depreciation +(226 +) +(200 +) +Other, primarily the excess of book basis over tax basis of intangible assets +(3,557 +) +(3,385 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total deferred tax liabilities +(3,783 +) +(3,585 +) +​ +​ +​ +​ +​ +​ +​ +​ +Total net deferred tax assets (liabilities) +$ +(1,275 +) +$ +(616 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Abbott +has incurred losses in a foreign jurisdiction where realization of the future economic benefit is so remote that the benefit is not reflected as a deferred tax asset. +The +following table summarizes the gross amounts of unrecognized tax benefits without regard to reduction in tax liabilities or additions to deferred tax assets and liabilities if such +unrecognized tax benefits were settled: +(in millions) +2018 +2017 +January 1 +$ +1,440 +$ +972 +Decrease in tax positions due to acquisitions +(13 +) +— +Increase in tax positions due to acquisitions +— +479 +Increase due to current year tax positions +164 +187 +Increase due to prior year tax positions +235 +76 +Decrease due to prior year tax positions +(611 +) +(176 +) +Settlements +(91 +) +(57 +) +Lapse of statute +(4 +) +(41 +) +​ +​ +​ +​ +​ +​ +​ +​ +December 31 +$ +1,120 +$ +1,440 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +The +total amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is approximately $1.02 billion. Abbott believes that it is reasonably +possible that the recorded amount of gross unrecognized tax benefits may decrease within a range of $125 million to $350 million, including cash adjustments, within the next twelve +months as a result of concluding various domestic and international tax matters. +90 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Segment and Geographic Area Information +Abbott's principal business is the discovery, development, manufacture and sale of a broad line of health care products. Abbott's products are generally sold directly to retailers, +wholesalers, hospitals, health care facilities, laboratories, physicians' offices and government agencies throughout the world. On January 4, 2017, Abbott completed the acquisition of +St. Jude Medical. Beginning with the first quarter of 2017, Abbott's cardiovascular and neuromodulation business includes the results of its historical Vascular Products segment and the results +of the businesses acquired from St. Jude Medical from the date of acquisition. On October 3, 2017, Abbott completed the acquisition of Alere. Beginning with the fourth quarter of 2017, +Abbott's Diagnostic Products reportable segment includes the results of Alere from the date of acquisition. +Abbott's +reportable segments are as follows: +Established Pharmaceutical Products — International sales of a broad line of branded generic pharmaceutical products. +Nutritional Products — Worldwide sales of a broad line of adult and pediatric nutritional products. +Diagnostic Products — Worldwide sales of diagnostic systems and tests for blood banks, hospitals, commercial laboratories and +alternate-care testing sites. For segment reporting purposes, the Core Laboratories Diagnostics, Rapid Diagnostics, Molecular Diagnostics and Point of Care divisions +are aggregated and reported as the Diagnostic Products segment. Rapid Diagnostics is the business acquired from Alere. +Cardiovascular and Neuromodulation Products — Worldwide sales of rhythm management, electrophysiology, heart failure, vascular, +structural heart and neuromodulation products. For segment reporting purposes, the Cardiac Arrhythmias & Heart Failure, Vascular, Neuromodulation and Structural Heart divisions are aggregated +and reported as the Cardiovascular and Neuromodulation segment. +Non-reportable +segments include AMO through the date of sale and Diabetes Care. +Abbott's +underlying accounting records are maintained on a legal entity basis for government and public reporting requirements. Segment disclosures are on a performance basis consistent +with internal management reporting. The cost of some corporate functions and the cost of certain employee benefits are charged to segments at predetermined rates that approximate cost. Remaining +costs, if any, are not allocated to segments. In addition, intangible asset amortization is not allocated to operating segments, and intangible assets and goodwill are not included in the measure of +each segment's assets. +91 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Segment and Geographic Area Information (Continued) +The +following segment information has been prepared in accordance with the internal accounting policies of Abbott, as described above, and are not presented in accordance with generally +accepted accounting principles applied to the consolidated financial statements. +Net Sales to External Customers (a) +Operating Earnings (a) +(in millions) +2018 +2017 +2016 +2018 +2017 +2016 +Established Pharmaceuticals +$ +4,422 +$ +4,287 +$ +3,859 +$ +894 +$ +848 +$ +723 +Nutritionals +7,229 +6,925 +6,899 +1,652 +1,589 +1,660 +Diagnostics +7,495 +5,616 +4,813 +1,868 +1,468 +1,194 +Cardiovascular and Neuromodulation +9,437 +8,911 +2,896 +2,990 +2,720 +1,037 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Reportable Segments +28,583 +25,739 +18,467 +$ +7,404 +$ +6,625 +$ +4,614 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other +1,995 +1,651 +2,386 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +30,578 +$ +27,390 +$ +20,853 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Net +sales were unfavorably affected by the relatively stronger U.S. dollar in 2018 and 2016. Operating earnings were unfavorably affected by the impact of foreign +exchange in 2018, 2017 and 2016. +(in millions) +2018 +2017 +2016 +Total Reportable Segment Operating Earnings +$ +7,404 +$ +6,625 +$ +4,614 +Corporate functions and benefit plans costs +(618 +) +(506 +) +(411 +) +Non-reportable segments +510 +306 +304 +Net interest expense +(721 +) +(780 +) +(332 +) +Loss on extinguishment of debt +(167 +) +— +— +Share-based compensation +(477 +) +(406 +) +(310 +) +Amortization of intangible assets +(2,178 +) +(1,975 +) +(550 +) +Other, net (b) +(880 +) +(1,033 +) +(1,902 +) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from Continuing Operations before Taxes +$ +2,873 +$ +2,231 +$ +1,413 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(b) Other, +net includes inventory step-up amortization, integration costs associated with the acquisition of St. Jude Medical and Alere, and restructuring charges +in 2018. In 2017, Other, net includes inventory step-up amortization, integration costs associated with the acquisition of St. Jude Medical and Alere, and restructuring charges, partially +offset by the gain on the sale of the AMO business. In 2016, Other, net includes the $947 million adjustment of the Mylan equity investment and $480 million of foreign currency exchange +loss related to operations in Venezuela. Charges for restructuring actions and other cost reduction initiatives were approximately $153 million in 2018, $384 million in 2017 and +$167 million in 2016. +92 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Segment and Geographic Area Information (Continued) +Depreciation +Additions to +Property, Plant +and Equipment (c) +Total Assets +(in millions) +2018 +2017 +2016 +2018 +2017 +2016 +2018 +2017 +2016 +Established Pharmaceuticals +$ +92 +$ +90 +$ +71 +$ +131 +$ +181 +$ +150 +$ +2,664 +$ +2,728 +$ +2,486 +Nutritionals +150 +164 +160 +86 +147 +199 +3,071 +3,160 +3,189 +Diagnostics +397 +300 +267 +609 +374 +379 +4,464 +4,226 +2,945 +Cardiovascular and Neuromodulation +248 +298 +69 +183 +206 +23 +4,910 +5,074 +1,425 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Reportable Segments +887 +852 +567 +1,009 +908 +751 +$ +15,109 +$ +15,188 +$ +10,045 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other +213 +194 +236 +385 +227 +370 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +$ +1,100 +$ +1,046 +$ +803 +$ +1,394 +$ +1,135 +$ +1,121 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(c) Amounts +exclude property, plant and equipment acquired through business acquisitions. +(in millions) +2018 +2017 +2016 +Total Reportable Segment Assets +$ +15,109 +$ +15,188 +$ +10,045 +Cash and investments +4,983 +10,493 +21,722 +Non-reportable segments +991 +740 +1,280 +Goodwill and intangible assets (d) +42,196 +45,493 +12,222 +All other (d) +3,894 +4,336 +7,397 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Assets +$ +67,173 +$ +76,250 +$ +52,666 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(d) Goodwill +and intangible assets related to AMO are included in the All other line in 2016. +Net Sales to External +Customers (e) +(in millions) +2018 +2017 +2016 +United States +$ +10,839 +$ +9,673 +$ +6,486 +China +2,311 +2,146 +1,728 +Germany +1,619 +1,366 +1,044 +India +1,333 +1,237 +1,114 +Japan +1,326 +1,255 +924 +Switzerland +1,005 +841 +766 +The Netherlands +930 +929 +830 +All Other Countries +11,215 +9,943 +7,961 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Consolidated +$ +30,578 +$ +27,390 +$ +20,853 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(e) Sales +by country are based on the country that sold the product. +Long-lived +assets on a geographic basis primarily include property, plant and equipment. It excludes goodwill, intangible assets, deferred tax assets, and financial instruments. At +December 31, 2018 and 2017, long-lived assets totaled $8.7 billion and $8.9 billion, respectively, and in the United States such assets totaled $4.3 billion and +$4.5 billion, respectively. Long-lived asset balances associated with other countries were not material on an individual country basis in either of the two years. +93 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 17 — Quarterly Results (Unaudited) +(in millions except per share data) +2018 +2017 +First Quarter +Continuing Operations: +Net Sales +$ +7,390 +$ +6,335 +Gross Profit +3,739 +2,751 +Earnings from Continuing Operations +409 +386 +Basic Earnings per Common Share +0.23 +0.22 +Diluted Earnings per Common Share +0.23 +0.22 +Net Earnings +418 +419 +Basic Earnings Per Common Share (a) +0.24 +0.24 +Diluted Earnings Per Common Share (a) +0.23 +0.24 +Market Price Per Share-High +64.60 +45.84 +Market Price Per Share-Low +55.58 +38.34 +Second Quarter +Continuing Operations: +Net Sales +$ +7,767 +$ +6,637 +Gross Profit +3,923 +3,056 +Earnings from Continuing Operations +718 +270 +Basic Earnings per Common Share +0.41 +0.15 +Diluted Earnings per Common Share +0.40 +0.15 +Net Earnings +733 +283 +Basic Earnings Per Common Share (a) +0.42 +0.16 +Diluted Earnings Per Common Share (a) +0.41 +0.16 +Market Price Per Share-High +63.85 +49.59 +Market Price Per Share-Low +56.81 +42.31 +Third Quarter +Continuing Operations: +Net Sales +$ +7,656 +$ +6,829 +Gross Profit +3,946 +3,452 +Earnings from Continuing Operations +552 +561 +Basic Earnings per Common Share +0.31 +0.32 +Diluted Earnings per Common Share +0.31 +0.32 +Net Earnings +563 +603 +Basic Earnings Per Common Share (a) +0.32 +0.34 +Diluted Earnings Per Common Share (a) +0.32 +0.34 +Market Price Per Share-High +73.58 +54.80 +Market Price Per Share-Low +60.32 +47.83 +Fourth Quarter +Continuing Operations: +Net Sales +$ +7,765 +$ +7,589 +Gross Profit +4,086 +3,747 +Earnings (Loss) from Continuing Operations +655 +(864 +) +Basic Earnings (Loss) per Common Share +0.37 +(0.50 +) +Diluted Earnings (Loss) per Common Share +0.37 +(0.50 +) +Net Earnings (Loss) +654 +(828 +) +Basic Earnings (Loss) Per Common Share (a) +0.37 +(0.48 +) +Diluted Earnings (Loss) Per Common Share (a) +0.37 +(0.48 +) +Market Price Per Share-High +74.92 +57.77 +Market Price Per Share-Low +65.44 +53.20 +(a) The +sum of the four quarters of earnings per share for 2018 and 2017 may not add to the full year earnings per share amount due to rounding and/or the use of +quarter-to-date weighted average shares to calculate the earnings per share amount in each respective quarter. +94 +Management Report on Internal Control Over Financial Reporting +The management of Abbott Laboratories is responsible for establishing and maintaining adequate internal control over financial reporting. +Abbott's internal control system was designed to provide reasonable assurance to the company's management and board of directors regarding the preparation and fair presentation of published financial +statements. +All +internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with +respect to financial statement preparation and presentation. +Abbott's +management assessed the effectiveness of the company's internal control over financial reporting as of December 31, 2018. In making this assessment, it used the criteria +set forth in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our assessment, we believe that, as of +December 31, 2018, the company's internal control over financial reporting was effective based on those criteria. +Abbott's +independent registered public accounting firm has issued an audit report on their assessment of the effectiveness of the company's internal control over financial reporting. +This report appears on page 97. +Miles +D. White +Chairman of the Board and Chief Executive Officer +Brian +B. Yoor +Executive Vice President, Finance and Chief Financial Officer +Robert +E. Funck +Senior Vice President, Finance and Controller +February +22, 2019 +95 +Report of Independent Registered Public Accounting Firm +To +the Shareholders and Board of Directors of Abbott Laboratories +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Abbott Laboratories and subsidiaries (the Company) as of December 31, +2018 and 2017, the related consolidated statements of earnings, comprehensive income, shareholders' investment and cash flows +for each of the three years in the period ended December 31, 2018, and the related notes (collectively referred to as the "consolidated financial statements"). In our opinion, the consolidated +financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for +each of the three years in the period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles. +We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting +as of December 31, 2018, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission (2013 framework), and our report dated February 22, 2019 expressed an unqualified opinion thereon. +Basis for Opinion +These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's +financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal +securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We +conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the +financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial +statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in +the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the +financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ +Ernst & Young LLP +We +have served as the Company's auditor since 2013. +Chicago, +Illinois +February 22, 2019 +96 +Report of Independent Registered Public Accounting Firm +To +the Shareholders and Board of Directors of Abbott Laboratories +Opinion on Internal Control over Financial Reporting +We have audited Abbott Laboratories and subsidiaries' internal control over financial reporting as of December 31, 2018, based on +criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). +In our opinion, Abbott Laboratories and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on +the COSO criteria. +We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of +December 31, 2018 and 2017, the related consolidated statements of earnings, comprehensive income, shareholders' investment and cash flows for each of the three years in the period ended +December 31, 2018, and the related notes of the Company and our report dated February 22, 2019 expressed an unqualified opinion thereon. +Basis for Opinion +The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the +effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on +the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in +accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We +conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective +internal control over financial reporting was maintained in all material respects. +Our +audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and +operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a +reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting +includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets +of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable +assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +97 +Because +of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future +periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ +Ernst & Young LLP +Chicago, +Illinois +February 22, 2019 +98 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +Evaluation of disclosure controls and procedures. The Chief Executive Officer, Miles D. White, and the Chief Financial Officer, Brian +B. Yoor, +evaluated the effectiveness of Abbott Laboratories' disclosure controls and procedures as of the end of the period covered by this report, and concluded that Abbott Laboratories' disclosure controls +and procedures were effective to ensure that information Abbott is required to disclose in the reports that it files or submits with the Securities and Exchange Commission under the Securities +Exchange Act of 1934 (the Exchange Act) is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms, and to ensure that information required +to be disclosed by Abbott in the reports that it files or submits under the Exchange Act is accumulated and communicated to Abbott's management, including its principal executive officer and principal +financial officer, as appropriate to allow timely decisions regarding required disclosure. +Internal Control Over Financial Reporting +Management's annual report on internal control over financial reporting. Management's report on Abbott's internal control over financial +reporting is +included on page 95 hereof. The report of Abbott's independent registered public accounting firm related to their assessment of the effectiveness of internal control over financial reporting is +included on page 96 hereof. +Changes in internal control over financial reporting. During the quarter ended December 31, 2018, there were no changes in +Abbott's internal +control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, Abbott's internal control +over financial reporting. +ITEM 9B. OTHER INFORMATION +None. +99 +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Incorporated herein by reference are "Nominees for Election as Directors," "Committees of the Board of Directors," "Section 16(a) +Beneficial Ownership Reporting Compliance," and "Procedure for Recommendation and Nomination of Directors and Transaction of Business at Annual Meeting" to be included in the 2019 Abbott Laboratories +Proxy Statement. The 2019 Proxy Statement will be filed on or about March 15, 2019. Also incorporated herein by reference is the text found under the caption, "Executive Officers of the +Registrant" on pages 17 through 20 hereof. +Abbott +has adopted a code of ethics that applies to its principal executive officer, principal financial officer, and principal accounting officer and controller. That code is part of +Abbott's code of business conduct which is available free of charge through Abbott's investor relations website ( www.abbottinvestor.com ). Abbott intends +to include on its website any amendment to, or waiver from, a provision of its code of ethics that applies to Abbott's principal executive officer, principal financial officer, and principal +accounting officer and controller that relates to any element of the code of ethics definition enumerated in Item 406(b) of Regulation S-K. +ITEM 11. EXECUTIVE COMPENSATION +The material to be included in the 2019 Proxy Statement under the headings "2018 Director Compensation" and "Executive Compensation" is +incorporated herein by reference. The 2019 Proxy Statement will be filed on or about March 15, 2019. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +(a) Equity Compensation Plan Information . +The +following table presents information as of December 31, 2018 about our compensation plans under which Abbott common shares have been authorized for issuance. +Plan Category +(a) +Number of +securities to be +issued upon +exercise of +outstanding +options, warrants +and rights +(b) +Weighted average +exercise price +of outstanding +options, warrants +and rights +(c) +Number of +securities remaining +available for +future issuance +under equity +compensation +plans (excluding +securities reflected +in column (a)) +Equity compensation plans approved by security holders (1) +30,425,425 +$ +43.23 +157,934,888 +Equity compensation plans not approved by security holders +0 +— +0 +Total (1)(2) +30,425,425 +$ +43.23 +157,934,888 +(1) +(i) +Abbott Laboratories 1996 Incentive Stock Program . Benefits under the 1996 Program include stock options intended to qualify for special tax treatment under Section 422 of the Internal Revenue Code, +stock options that do not qualify for that special tax treatment ("non-qualified stock options"), restricted stock, restricted stock units, stock appreciation rights, performance awards, and foreign qualified benefits. The shares that remain +available for issuance under the 1996 Program may be issued in connection with any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards may be satisfied only from treasury +shares). +100 +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 1996 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, +may again be used for new stock options, rights, or awards of any type authorized under the Abbott Laboratories 2009 Incentive Stock Program (the "2009 Program"). If shares are issued under any benefit under the 1996 Program and thereafter are +reacquired by Abbott pursuant to rights reserved upon their issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or +so reacquired, may not again be used for new stock options, rights, or awards of any type authorized under the 1996 Program. +In April 2009, the 1996 Program was replaced by the 2009 Program. No further awards will be granted under the 1996 Program. +(ii) +Abbott Laboratories 2009 Incentive Stock Program . Benefits under the 2009 Program include non-qualified stock options, restricted stock, restricted stock units, performance awards, other share-based +awards (including stock appreciation rights, dividend equivalents and recognition awards), awards to non-employee directors, and foreign benefits. The shares that remain available for issuance under the 2009 Program may be issued in connection with +any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards are satisfied from treasury shares). +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 2009 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, +may again be used for new stock options, rights, or awards of any type authorized under the Abbott Laboratories 2017 Incentive Stock Program (the "2017 Program"). If shares are issued under any benefit under the 2009 Program and thereafter are +reacquired by Abbott pursuant to rights reserved upon their issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or +so reacquired, may not again be used for new stock options, rights, or awards of any type authorized under the 2009 Program. +In April 2017, the 2009 Program was replaced by the 2017 Program. No further awards will be granted under the 2009 Program. +(iii) +Abbott Laboratories 2017 Incentive Stock Program . Benefits under the 2017 Program include non-qualified stock options, restricted stock, restricted stock units, performance awards, other share-based +awards (including stock appreciation rights, dividend equivalents and recognition awards), awards to non-employee directors, and foreign benefits. The shares that remain available for issuance under the 2017 Program may be issued in connection with +any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards are satisfied from treasury shares). +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 2017 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, +may again be used for new stock options, rights, or awards of any type authorized under the 2017 Program. If shares are issued under any benefit under the 2017 Program and thereafter are reacquired by Abbott pursuant to rights reserved upon their +issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or so reacquired, may not again be used for new stock options, +rights, or awards of any type authorized under the 2017 Program. +101 +(iv) +Abbott Laboratories Employee Stock Purchase Plan for Non-U.S. Employees . Eligible employees of participating non-U.S. affiliates of Abbott may participate in this plan. An eligible employee may +authorize payroll deductions at the rate of 1% to 10% of eligible compensation (in multiples of one percent) subject to a limit of US $12,500 during any purchase cycle. +Purchase cycles are generally six months long and usually begin on August 1 and February 1. On the last day of each purchase cycle, Abbott uses participant contributions to acquire Abbott common shares. The shares may be either authorized +but unissued shares, treasury shares, or shares acquired on the open market. The purchase price is typically 85% of the lower of the fair market value of the shares on the purchase date or on the first day of that purchase cycle. As the number of +shares subject to outstanding options is indeterminable, columns (a) and (b) of the above table do not include information on the Employee Stock Purchase Plan. As of December 31, 2018, an aggregate of 13,708,139 common shares were +available for future issuance under the Employee Stock Purchase Plan, including shares subject to purchase during the current purchase cycle. +In April 2017, the 2009 Employee Stock Purchase Plan for Non-U.S. Employees was amended and restated as the Abbott Laboratories 2017 Employee Stock Purchase Plan for Non-U.S. Employees. +(2) +Not included in the table: St. Jude Medical, Inc. Plans . In 2017, in connection with the acquisition of St. Jude Medical, Inc., options outstanding under the +St. Jude Medical, Inc. 2007 Stock Incentive Plan, as Amended and Restated (2014) were assumed by Abbott and converted into Abbott options of substantially equivalent value. As of December 31, 2018, 2,649,188 options remained +outstanding under these plans. These options have a weighted average purchase price of $30.42. No further awards will be granted under these plans. +For +additional information concerning the Abbott Laboratories 1996 Incentive Stock Program, the Abbott Laboratories 2009 Incentive Stock Program, the Abbott Laboratories 2017 Incentive Stock Program, +and the Abbott Laboratories 2017 Employee Stock Purchase Plan for Non-U.S. Employees, see the discussion in Note 10 entitled "Incentive Stock Program" of the Notes to Consolidated Financial +Statements included under Item 8, "Financial Statements and Supplementary Data." +(b) Information Concerning Security Ownership . Incorporated herein by reference is the material under the +heading "Security Ownership of Executive Officers and Directors" and "Information Concerning Security Ownership" in the 2019 Proxy Statement. The 2019 Proxy Statement will be filed on or about +March 15, 2019. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The material to be included in the 2019 Proxy Statement under the headings "The Board of Directors," "Committees of the Board of Directors," and +"Approval Process for Related Person Transactions" is incorporated herein by reference. The 2019 Proxy Statement will be filed on or about March 15, 2019. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The material to be included in the 2019 Proxy Statement under the headings "Audit Fees and Non-Audit Fees" and "Policy on Audit Committee +Pre-Approval of Audit and Permissible Non-Audit Services of the Independent Auditor" is incorporated herein by reference. The 2019 Proxy Statement will be filed on or about March 15, 2019. +102 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as part of this Form 10-K. +(1) Financial Statements: See Item 8, "Financial Statements and Supplementary Data," on +page 49 hereof, for a list of financial statements. +(2) Financial Statement Schedules: The required financial statement schedules are found on the pages +indicated below. These schedules should be read in conjunction with the Consolidated Financial Statements of Abbott Laboratories: +Abbott Laboratories Financial Statement Schedules +Page No. +Valuation and Qualifying Accounts (Schedule II) +115 +Schedules I, III, IV, and V are not submitted because they are not applicable or not required +Report of Independent Registered Public Accounting Firm +116 +Individual Financial Statements of businesses acquired by the registrant have been omitted pursuant to Rule 3.05 of +Regulation S-X +(3) Exhibits Required by Item 601 of Regulation S-K: The information called for by this +paragraph is set forth in Item 15(b) below. +(b) Exhibits filed. +10-K +Exhibit +Table +Item No. +2.1 +*Agreement and Plan of Merger dated as of January 30, 2016, among Alere Inc. and Abbott Laboratories, filed as Exhibit 2.1 to the Abbott +Laboratories Current Report on Form 8-K dated January 30, 2016. +2.2 +*Amendment to Agreement and Plan of Merger, dated as of April 13, 2017, among Alere Inc., Abbott Laboratories and Angel Sub, Inc., filed as +Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated April 14, 2017. +2.3 +*Agreement and Plan of Merger, dated as of April 27, 2016, by and among Abbott Laboratories, St. Jude Medical, Inc., Vault Merger Sub, +Inc. and Vault Merger Sub, LLC, filed as Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated April 27, 2016. +2.4 +*Stock Purchase Agreement, dated as of September 14, 2016, by and between Abbott Laboratories and Chace LLC and, solely for certain purposes, +Johnson & Johnson, filed as Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated September 14, 2016. +Certain schedules and exhibits have been omitted from these filings pursuant to Item 601(b)(2) of Regulation S-K. Abbott will furnish supplemental copies of any such schedules or exhibits to the U.S. Securities and Exchange Commission upon +request. +3.1 +*Articles of Incorporation, Abbott Laboratories, filed as Exhibit 3.1 to the Abbott Laboratories Quarterly Report on Form 10-Q for the quarter ended +March 31, 1998. +3.2 +*By-Laws of Abbott Laboratories, as amended and restated effective June 8, 2018, filed as Exhibit 3.1 to the Abbott Laboratories Current Report +on Form 8-K dated June 8, 2018. +103 +10-K +Exhibit +Table +Item No. +4.1 +*Indenture dated as of February 9, 2001, between Abbott Laboratories and The Bank of New York Mellon Trust Company, N.A. (as successor to J.P. Morgan +Trust Company, National Association, successor to Bank One Trust Company, N.A.) (including form of Security), filed as Exhibit 4.1 to the Abbott Laboratories Registration Statement on Form S-3 dated February 12, 2001. +4.2 +*Supplemental Indenture dated as of February 27, 2006, between Abbott Laboratories and The Bank of New York Mellon Trust Company, N.A. (as successor to +J.P. Morgan Trust Company, National Association), filed as Exhibit 4.2 to the Abbott Laboratories Registration Statement on Form S-3 dated February 28, 2006. +4.3 +*Form of $1,000,000,000 6.150% Note due 2037, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated November 6, +2007. +4.4 +*Actions of the Authorized Officers with respect to Abbott's 5.150% Notes due 2012, 5.600% Notes due 2017 and 6.150% Notes due 2037, filed as +Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated November 6, 2007. +4.5 +*Form of $1,000,000,000 6.000% Note due 2039, filed as Exhibit 99.5 to the Abbott Laboratories Current Report on Form 8-K dated February 26, +2009. +4.6 +*Actions of the Authorized Officers with respect to Abbott's 5.125% Note due 2019 and 6.000% Note due 2039, filed as Exhibit 99.3 to the Abbott +Laboratories Current Report on Form 8-K dated February 26, 2009. +4.7 +*Form of 2040 Note, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated May 27, 2010. +4.8 +*Actions of the Authorized Officers with respect to Abbott's 2.70% Notes, 4.125% Notes and 5.30% Notes, filed as Exhibit 99.3 to the Abbott +Laboratories Current Report on Form 8-K dated May 27, 2010. +4.9 +*Indenture, dated as of March 10, 2015, between Abbott Laboratories and U.S. Bank National Association (including form of Security), filed as +Exhibit 4.1 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +4.10 +*Form of 2.550% Note due 2022, filed as Exhibit 99.5 to the Abbott Laboratories Current Report on Form 8-K dated March 5, +2015. +4.11 +*Form of 2.950% Note due 2025, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated March 5, +2015. +4.12 +*Actions of the Authorized Officers with respect to Abbott's 2.000% Notes, 2.550% Notes and 2.950% Notes, filed as Exhibit 99.3 to the Abbott +Laboratories Current Report on Form 8-K dated March 5, 2015. +4.13 +*Form of 2.900% Notes due 2021, filed as Exhibit 4.3 to the Abbott Laboratories Current Report on Form 8-K dated November 22, +2016. +4.14 +*Form of 3.400% Notes due 2023, filed as Exhibit 4.4 to the Abbott Laboratories Current Report on Form 8-K dated November 22, +2016. +4.15 +*Form of 3.750% Notes due 2026, filed as Exhibit 4.5 to the Abbott Laboratories Current Report on Form 8-K dated November 22, +2016. +104 +10-K +Exhibit +Table +Item No. +4.16 +*Form of 4.750% Notes due 2036, filed as Exhibit 4.6 to the Abbott Laboratories Current Report on Form 8-K dated November 22, +2016. +4.17 +*Form of 4.900% Notes due 2046, filed as Exhibit 4.7 to the Abbott Laboratories Current Report on Form 8-K dated November 22, +2016. +4.18 +*Officers' Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 2.350% Notes due 2019, 2.900% Notes due 2021, 3.400% Notes +due 2023, 3.750% Notes due 2026, 4.750% Notes due 2036 and 4.900% Notes due 2046 (including forms of notes), filed as Exhibit 4.22 to the Abbott Laboratories 2016 Annual Report on Form 10-K. +4.19 +*Form of 2.800% Notes due 2020, filed as Exhibit 4.3 to the Abbott Laboratories Current Report on Form 8-K dated March 22, +2017. +4.20 +*Form of 3.875% Notes due 2025, filed as Exhibit 4.5 to the Abbott Laboratories Current Report on Form 8-K dated March 22, +2017. +4.21 +*Form of 4.75% Notes due 2043, filed as Exhibit 4.6 to the Abbott Laboratories Current Report on Form 8-K dated March 22, +2017. +4.22 +*Officers' Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 2.000% Notes due 2018, 2.800% Notes due 2020, 3.25% Notes due +2023, 3.875% Notes due 2025, and 4.75% Notes due 2043 (including form of notes), filed as Exhibit 4.7 to the Abbott Laboratories Quarterly Report on Form 10-Q for the period ended March 31, 2017. +4.23 +†Indenture, dated as of July 28, 2009, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank +National Association, as trustee, filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated July 28, 2009. +4.24 +†Fourth Supplemental Indenture, dated as of April 2, 2013, between St. Jude Medical, LLC (successor to St. Jude Medical, +Inc.) and U.S. Bank National Association, as trustee, relating to St. Jude Medical, LLC's 3.25% Senior Notes due 2023 and 4.75% Senior Notes due 2043 (including forms of notes), filed as Exhibit 4.1 to the St. Jude Medical, +Inc. Current Report on Form 8-K dated April 2, 2013. +4.25 +†Fifth Supplemental Indenture, dated as of September 23, 2015, between St. Jude Medical, LLC (successor to St. Jude Medical, +Inc.) and U.S. Bank National Association, as trustee, relating to St. Jude Medical, LLC's 2.000% Senior Notes due 2018, 2.800% Senior Notes due 2020 and 3.875% Senior Notes due 2025, filed as Exhibit 4.1 to the St. Jude +Medical, Inc. Current Report on Form 8-K dated September 23, 2015. +4.26 +†Sixth Supplemental Indenture, dated as of January 4, 2017, among St. Jude Medical, Inc., St. Jude Medical, LLC and U.S. +Bank National Association, as trustee, filed as Exhibit 4.1 to the St. Jude Medical, LLC Current Report on Form 8-K dated January 4, 2017. +4.27 +*Form of Seventh Supplemental Indenture between St. Jude Medical, LLC and U.S. Bank National Association, as trustee, filed as Exhibit 4.3 to +the Abbott Laboratories Registration Statement on Form S-4 dated February 21, 2017. +4.28 +*Indenture dated September 27, 2018, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor and U.S. Bank National +Association, as trustee, filed as Exhibit 4.1 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018. +105 +10-K +Exhibit +Table +Item No. +4.29 +*First Supplemental Indenture dated September 27, 2018, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor, U.S. Bank +National Association, as trustee, Elavon Financial Services DAC, U.K. Branch, as paying agent and transfer agent, and Elavon Financial Services DAC, as registrar, filed as Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K +dated September 27, 2018. +4.30 +*Form of 0.000% Note due 2020 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, +2018). +4.31 +*Form of 0.875% Note due 2023 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, +2018). +4.32 +*Form of 1.500% Note due 2026 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, +2018). +Other debt instruments are omitted in accordance with Item 601(b)(4)(iii)(A) of Regulation S-K. Copies of such agreements will be furnished to the Securities and Exchange Commission upon request. +10.1 +*Supplemental Plan Abbott Laboratories Extended Disability Plan, filed as an exhibit (pages 50-51) to the 1992 Abbott Laboratories Annual Report on Form 10-K.** +10.2 +*Abbott Laboratories Deferred Compensation Plan, as amended, filed as Exhibit 10.2 to the 2017 Abbott Laboratories Annual Report on +Form 10-K.** +10.3 +*Abbott Laboratories 401(k) Supplemental Plan, as amended and restated, filed as Exhibit 10.3 to the 2012 Abbott Laboratories Annual Report on +Form 10-K.** +10.4 +*Abbott Laboratories Supplemental Pension Plan, as amended and restated, filed as Exhibit 10.4 to the 2014 Abbott Laboratories Annual Report on +Form 10-K.** +10.5 +*1986 Abbott Laboratories Management Incentive Plan, as amended and restated, filed as Exhibit 10.5 to the 2014 Abbott Laboratories Annual Report on +Form 10-K.** +10.6 +*1998 Abbott Laboratories Performance Incentive Plan, as amended, filed as Exhibit 10.6 to the 2014 Abbott Laboratories Annual Report on +Form 10-K.** +10.7 +*Rules for the 1998 Abbott Laboratories Performance Incentive Plan, as amended and restated, filed as Exhibit 10.7 to the 2012 Abbott Laboratories +Annual Report on Form 10-K.** +10.8 +*Abbott Laboratories 1996 Incentive Stock Program, as amended and restated through the 6th Amendment February 20, 2009, filed as +Exhibit 10.11 to the Abbott Laboratories Quarterly Report on Form 10-Q for the quarter ended March 31, 2009.** +10.9 +*Abbott Laboratories 2009 Incentive Stock Program, as amended and restated, filed as Exhibit 10.9 to the 2014 Abbott Laboratories Annual Report on +Form 10-K.** +10.10 +*Abbott Laboratories 2017 Incentive Stock Program (incorporated by reference to Exhibit B of Abbott's Definitive Proxy Statement on +Schedule 14A filed with the Securities and Exchange Commission on March 17, 2017) +10.11 +*Abbott Laboratories Non-Employee Directors' Fee Plan, as amended and restated, filed as Exhibit 10.10 to the 2016 Abbott Laboratories Annual Report +on Form 10-K.** +10.12 +*Form of Non-Employee Director Restricted Stock Unit Agreement under Abbott Laboratories 1996 Incentive Stock Program, filed as Exhibit 10.2 to the +Abbott Laboratories Current Report on Form 8-K dated December 10, 2004.** +106 +10-K +Exhibit +Table +Item No. +10.13 +*Form of Employee Stock Option Agreement for a new Non-Qualified Stock Option under the Abbott Laboratories 1996 Incentive Stock Program granted on or +after February 18, 2005, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated February 18, 2005.** +10.14 +*Form of Non-Qualified Stock Option Agreement for an award of non-qualified stock options under the Abbott Laboratories 1996 Incentive Stock Program +granted on or after February 17, 2006, filed as Exhibit 10.4 to the Abbott Laboratories Current Report on Form 8-K dated February 16, 2006.** +10.15 +*Form of Non-Qualified Stock Option Agreement for an award of non-qualified stock options under the Abbott Laboratories 1996 Incentive Stock Program +granted on or after February 20, 2009, filed as Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated February 20, 2009.** +10.16 +*Form of Non-Employee Director Non-Qualified Stock Option Agreement, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K +dated April 24, 2009.** +10.17 +*Form of Non-Employee Director Restricted Stock Unit Agreement, filed as Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated +April 24, 2009.** +10.18 +*Form of Non-Qualified Stock Option Agreement (ratably vested), filed as Exhibit 10.5 to the Abbott Laboratories Current Report on Form 8-K dated +April 24, 2009.** +10.19 +*Form of Restricted Stock Unit Agreement (ratably vested), filed as Exhibit 10.37 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.20 +*Form of Restricted Stock Unit Agreement for foreign employees (ratably vested), filed as Exhibit 10.38 to the 2013 Abbott Laboratories Annual Report +on Form 10-K.** +10.21 +*Form of Performance Restricted Stock Unit Agreement for foreign employees (annual performance based), filed as Exhibit 10.39 to the 2013 Abbott +Laboratories Annual Report on Form 10-K.** +10.22 +*Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based), filed as Exhibit 10.40 to the 2013 +Abbott Laboratories Annual Report on Form 10-K.** +10.23 +*Form of Performance Restricted Stock Unit Agreement for foreign employees (interim performance based), filed as Exhibit 10.41 to the 2013 Abbott +Laboratories Annual Report on Form 10-K.** +10.24 +*Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based), filed as Exhibit 10.42 to the 2013 +Abbott Laboratories Annual Report on Form 10-K.** +10.25 +*Form of Restricted Stock Unit Agreement (cliff vested), filed as Exhibit 10.43 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.26 +*Form of Restricted Stock Unit Agreement for executive officers (cliff vested), filed as Exhibit 10.44 to the 2013 Abbott Laboratories Annual Report +on Form 10-K.** +10.27 +*Form of Restricted Stock Unit Agreement for foreign employees (cliff vested), filed as Exhibit 10.45 to the 2013 Abbott Laboratories Annual Report +on Form 10-K.** +107 +10-K +Exhibit +Table +Item No. +10.28 +*Form of Restricted Stock Unit Agreement for foreign executive officers (cliff vested), filed as Exhibit 10.46 to the 2013 Abbott Laboratories Annual +Report on Form 10-K.** +10.29 +*Form of Non-Employee Director Restricted Stock Unit Agreement, filed as Exhibit 10.47 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.30 +*Form of Non-Employee Director Restricted Stock Unit Agreement for foreign non-employee directors, filed as Exhibit 10.48 to the 2013 Abbott +Laboratories Annual Report on Form 10-K.** +10.31 +*Form of Restricted Stock Unit Agreement for Participants in France, filed as Exhibit 10.49 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.32 +*Form of Restricted Stock Agreement (ratably vested), filed as Exhibit 10.50 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.33 +*Form of Restricted Stock Agreement for executive officers (ratably vested), filed as Exhibit 10.51 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.34 +*Form of Performance Restricted Stock Agreement (annual performance based), filed as Exhibit 10.52 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.35 +*Form of Performance Restricted Stock Agreement for executive officers (annual performance based), filed as Exhibit 10.53 to the 2013 Abbott +Laboratories Annual Report on Form 10-K.** +10.36 +*Form of Performance Restricted Stock Agreement (interim performance based), filed as Exhibit 10.54 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.37 +*Form of Performance Restricted Stock Agreement for executive officers (interim performance based), filed as Exhibit 10.55 to the 2013 Abbott +Laboratories Annual Report on Form 10-K.** +10.38 +*Form of Restricted Stock Agreement (cliff vested), filed as Exhibit 10.56 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.39 +*Form of Restricted Stock Agreement for executive officers (cliff vested), filed as Exhibit 10.57 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.40 +*Form of Non-Qualified Stock Option Agreement, filed as Exhibit 10.58 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.41 +*Form of Non-Qualified Stock Option Agreement for executive officers, filed as Exhibit 10.59 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.42 +*Form of Non-Qualified Stock Option Agreement for foreign employees, filed as Exhibit 10.60 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.43 +*Form of Non-Qualified Stock Option Agreement for foreign executive officers, filed as Exhibit 10.61 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.44 +*Form of Non-Employee Director Non-Qualified Stock Option Agreement, filed as Exhibit 10.64 to the 2013 Abbott Laboratories Annual Report on +Form 10-K.** +10.45 +*Form of Non-Employee Director Non-Qualified Stock Option Agreement for foreign non-employee directors, filed as Exhibit 10.65 to the 2013 Abbott +Laboratories Annual Report on Form 10-K.** +108 +10-K +Exhibit +Table +Item No. +10.46 +*Form of Restricted Stock Unit Agreement (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.2 to the +Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.47 +*Form of Restricted Stock Unit Agreement for foreign employees (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.48 +*Form of Restricted Stock Unit Agreement (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.4 to the +Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.49 +*Form of Restricted Stock Unit Agreement for foreign employees (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.5 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.50 +*Form of Performance Restricted Stock Unit Agreement for foreign employees (annual performance based) under the Abbott Laboratories 2017 Incentive Stock +Program, filed as Exhibit 10.6 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.51 +*Form of Performance Restricted Stock Unit Agreement for foreign employees (interim performance based) under the Abbott Laboratories 2017 Incentive Stock +Program, filed as Exhibit 10.7 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.52 +*Form of Restricted Stock Agreement (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.8 to the Abbott +Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.53 +*Form of Restricted Stock Agreement (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.9 to the Abbott +Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.54 +*Form of Performance Restricted Stock Agreement (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.10 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.55 +*Form of Performance Restricted Stock Agreement (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.11 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.56 +*Form of Non-Qualified Stock Option Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.12 to the Abbott +Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.57 +*Form of Non-Qualified Stock Option Agreement for foreign employees under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.13 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.58 +*Form of Restricted Stock Unit Agreement for executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.14 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.59 +*Form of Restricted Stock Unit Agreement for foreign executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed +as Exhibit 10.15 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +109 +10-K +Exhibit +Table +Item No. +10.60 +*Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based) under the Abbott Laboratories 2017 +Incentive Stock Program, filed as Exhibit 10.16 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.61 +*Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based) under the Abbott Laboratories 2017 +Incentive Stock Program, filed as Exhibit 10.17 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.62 +*Form of Restricted Stock Agreement for executive officers (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.18 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.63 +*Form of Restricted Stock Agreement for executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.19 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.64 +*Form of Performance Restricted Stock Agreement for executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock +Program, filed as Exhibit 10.20 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.65 +*Form of Performance Restricted Stock Agreement for executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock +Program, filed as Exhibit 10.21 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.66 +*Form of Non-Qualified Stock Option Agreement for executive officers under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.22 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.67 +*Form of Non-Qualified Stock Option Agreement for foreign executive officers under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.23 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.68 +*Form of Non-Employee Director Restricted Stock Unit Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.24 to +the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.69 +*Form of Non-Employee Director Restricted Stock Unit Agreement for foreign non-employee directors under the Abbott Laboratories 2017 Incentive Stock +Program, filed as Exhibit 10.25 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.70 +*Form of Non-Employee Director Non-Qualified Stock Option Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as +Exhibit 10.26 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.71 +*Form of Non-Employee Director Non-Qualified Stock Option Agreement for foreign non-employee directors under the Abbott Laboratories 2017 Incentive Stock +Program, filed as Exhibit 10.27 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +10.72 +*Form of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), filed as +Exhibit 10.1 to the Abbott Laboratories Current Report on Form 8-K dated November 30, 2012.** +110 +10-K +Exhibit +Table +Item No. +10.73 +*Form of Extension of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than +Mr. White), extending the agreement term to December 31, 2018, filed as Exhibit 10.49 to the 2016 Abbott Laboratories Annual Report on Form 10-K.** +10.74 +Form of Extension of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), extending the agreement term to December 31, +2020.** +10.75 +*Form of Time Sharing Agreement between Abbott Laboratories, Inc. and M.D. White, filed as Exhibit 10.6 to the Abbott Laboratories Quarterly +Report on Form 10-Q for the quarter ended June 30, 2006.** +10.76 +*2004 Stock Incentive Plan, as amended and restated, filed as Exhibit 4.5 to the Abbott Laboratories Registration Statement on Form S-8 dated +March 20, 2009.** +10.77 +†St. Jude Medical, Inc. 2007 Stock Incentive Plan, as amended and restated (2014), filed as Exhibit 10.22 to St. Jude Medical, +Inc. Annual Report on Form 10-K for the year ended January 3, 2015 dated February 26, 2015.** +10.78 +†Form of Non-Qualified Stock Option Agreement (Global) and related Notice of Non-Qualified Stock Option Grant for stock options granted on or +after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.24 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012 dated +February 26, 2013.** +10.79 +†Form of Non-Qualified Stock Option Agreement for Non-Employee Directors and related Notice of Non-Qualified Stock Option Grant for stock options +granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.25 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, +2012, dated February 26, 2013.** +10.80 +†Form of Restricted Stock Units Award Agreement (Global) and related Restricted Stock Units Award Certificate for restricted stock units granted +on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.27 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012, +dated February 26, 2013.** +10.81 +*Management Savings Plan, as amended and restated, filed as Exhibit 10.83 to the 2017 Abbott Laboratories Annual Report on +Form 10-K.** +10.82 +Five Year Credit Agreement, dated as of November 30, 2018, among Abbott Laboratories, various financial institutions, as lenders, and JPMorgan Chase Bank, N.A., as administrative agent. +21 +Subsidiaries of Abbott Laboratories. +23.1 +Consent of Independent Registered Public Accounting Firm. +31.1 +Certification of Chief Executive Officer Required by Rule 13a-14(a) (17 CFR 240.13a-14(a)). +31.2 +Certification of Chief Financial Officer Required by Rule 13a-14(a) (17 CFR 240.13a-14(a)). +Exhibits 32.1 and 32.2 are furnished herewith and should not be deemed to be "filed" under the Securities Exchange Act of 1934. +111 +10-K +Exhibit +Table +Item No. +32.1 +Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101 +The following financial statements and notes from the Abbott Laboratories Annual Report on Form 10-K for the year ended December 31, 2018 filed on February 22, 2019, formatted in XBRL: (i) Consolidated Statement of Earnings; +(ii) Consolidated Statement of Comprehensive Income; (iii) Consolidated Statement of Cash Flows; (iv) Consolidated Balance Sheet; (v) Consolidated Statement of Shareholders' Investment; and (vi) the notes to the consolidated +financial statements. +* Incorporated +herein by reference. Commission file number 1-2189. +** Denotes +management contract or compensatory plan or arrangement required to be filed as an exhibit hereto. +† Incorporated +herein by reference. Commission file number 1-12441. +Abbott +will furnish copies of any of the above exhibits to a shareholder upon written request to the Secretary, Abbott Laboratories, 100 Abbott Park Road, Abbott Park, Illinois +60064-6400. +(c) Financial Statement Schedule filed (page 115 ). +ITEM 16. FORM 10-K SUMMARY +None. +112 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Abbott Laboratories has duly caused this +report to be signed on its behalf by the undersigned, thereunto duly authorized. +ABBOTT LABORATORIES +By +/s/ MILES D. WHITE +Miles D. White +Chairman of the Board and +Chief Executive Officer +Date: February 22, 2019 +Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Abbott Laboratories on February 22, +2019 in the capacities indicated below. +/s/ MILES D. WHITE +Miles D. White +Chairman of the Board, Chief Executive Officer +and Director of Abbott Laboratories +(principal executive officer) +/s/ BRIAN B. YOOR +Brian B. Yoor +Executive Vice President, Finance +and Chief Financial Officer +(principal financial officer) +/s/ ROBERT E. FUNCK +Robert E. Funck +Senior Vice President, Finance and Controller +(principal accounting officer) +/s/ ROBERT J. ALPERN, M.D. +Robert J. Alpern, M.D. +Director of Abbott Laboratories +/s/ ROXANNE S. AUSTIN +Roxanne S. Austin +Director of Abbott Laboratories +/s/ SALLY E. BLOUNT, PH.D. +Sally E. Blount, Ph.D. +Director of Abbott Laboratories +/s/ MICHELLE A. KUMBIER +Michelle A. Kumbier +Director of Abbott Laboratories +/s/ EDWARD M. LIDDY +Edward M. Liddy +Director of Abbott Laboratories +/s/ NANCY MCKINSTRY +Nancy McKinstry +Director of Abbott Laboratories +113 +/s/ PHEBE N. NOVAKOVIC +Phebe N. Novakovic +Director of Abbott Laboratories +/s/ WILLIAM A. OSBORN +William A. Osborn +Director of Abbott Laboratories +/s/ SAMUEL C. SCOTT III +Samuel C. Scott III +Director of Abbott Laboratories +/s/ DANIEL J. STARKS +Daniel J. Starks +Director of Abbott Laboratories +/s/ JOHN G. STRATTON +John G. Stratton +Director of Abbott Laboratories +/s/ GLENN F. TILTON +Glenn F. Tilton +Director of Abbott Laboratories +114 +ABBOTT LABORATORIES AND SUBSIDIARIES +SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS +FOR THE YEARS ENDED DECEMBER 31, 2018, 2017 AND 2016 +(in millions of dollars) +Allowances for Doubtful +Accounts and Product Returns +Balance +at Beginning +of Year +Provisions/ +Charges +to Income +Amounts +Charged Off +and Other +Deductions +Balance at +End of Year +2018 +$ +294 +$ +110 +$ +(90 +) +$ +314 +2017 +250 +105 +(61 +) +294 +2016 +337 +92 +(179 +) +250 +115 +Report of Independent Registered Public Accounting Firm +To +the Shareholders and Board of Directors of Abbott Laboratories +Opinion on the Financial Statement Schedule +We +have audited the consolidated financial statements of Abbott Laboratories and subsidiaries (the Company) as of December 31, 2018 and 2017, and for each of the three years in the period ended +December 31, 2018, and have issued our report thereon dated February 22, 2019 (included elsewhere in this Annual Report on Form 10-K). Our audits of the consolidated financial +statements included the financial statement schedule listed in Item 15(a)(2) of this Annual Report on Form 10-K (the "schedule"). This schedule is the responsibility of the Company's +management. Our responsibility is to express an opinion on the Company's schedule, based on our audits. +In +our opinion, the schedule presents fairly, in all material respects, the information set forth therein when considered in conjunction with the consolidated financial statements. +/s/ +Ernst & Young LLP +Chicago, +Illinois +February 22, 2019 +116 \ No newline at end of file diff --git a/raw/filings/0000001800/2018/0001047469-19-000624/filing_metadata.csv b/raw/filings/0000001800/2018/0001047469-19-000624/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..96fb01f4e41ea936cd7aa49586d6f6fa4e1549c5 --- /dev/null +++ b/raw/filings/0000001800/2018/0001047469-19-000624/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000001800,ABT,ABBOTT LABORATORIES,2018,10-K,2019-02-22,2018-12-31,2019-02-22T21:13:21.000Z,0001047469-19-000624,a2237733z10-k.htm,10-K,19514449,1,0,https://www.sec.gov/Archives/edgar/data/1800/000104746919000624/a2237733z10-k.htm,https://www.sec.gov/Archives/edgar/data/1800/000104746919000624/ diff --git a/raw/filings/0000001800/2018/0001047469-19-000624/item1.txt b/raw/filings/0000001800/2018/0001047469-19-000624/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..86532904c07742eb9678ebecf9e4d8213ed580b6 --- /dev/null +++ b/raw/filings/0000001800/2018/0001047469-19-000624/item1.txt @@ -0,0 +1,257 @@ +ITEM 1. BUSINESS +GENERAL DEVELOPMENT OF BUSINESS +Abbott Laboratories is an Illinois corporation, incorporated in 1900. Abbott's* principal business is the discovery, development, manufacture, +and sale of a broad and diversified line of health care products. +NARRATIVE DESCRIPTION OF BUSINESS +Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Cardiovascular and +Neuromodulation Products. +On +October 3, 2017, Abbott completed the acquisition of Alere, Inc., a diagnostic device and service provider, for an aggregate consideration of approximately +$4.5 billion in cash. +On +February 27, 2017, Abbott completed the sale of Abbott Medical Optics, its vision care business, to Johnson & Johnson for $4.325 billion in cash. +On +January 4, 2017, Abbott completed the acquisition of St. Jude Medical, Inc., a global medical device manufacturer. Based on the closing Abbott share price on +January 4, 2017, the aggregate implied value of the consideration paid in connection with the acquisition was approximately $23.6 billion, including approximately $13.6 billion in +cash and approximately $10 billion in Abbott common shares. +Established Pharmaceutical Products +These products include a broad line of branded generic pharmaceuticals manufactured worldwide and marketed and sold outside the United States in +emerging markets. These products are generally sold directly to wholesalers, distributors, government agencies, health care facilities, pharmacies, and independent retailers from Abbott-owned +distribution centers and public +warehouses, depending on the market served. Certain products are co-marketed or co-promoted with, or licensed from, other companies. +The +principal products included in the broad therapeutic area portfolios of the Established Pharmaceutical Products segment are: +• gastroenterology products, including Creon™, for the treatment of pancreatic exocrine insufficiency associated with several +underlying conditions, including cystic fibrosis and chronic pancreatitis; Duspatal™ and Dicetel®, for the treatment of irritable bowel syndrome or biliary spasm; +Heptral™, Transmetil®, and Samyr®, for the treatment of intrahepatic cholestasis (associated with liver disease) or depressive symptoms; and Duphalac™, +for regulation of the physiological rhythm of the colon; +• women's health products, including Duphaston™, for the treatment of many different gynecological disorders; and +Femoston™, a hormone replacement therapy for postmenopausal women; +• cardiovascular and metabolic products, including Lipanthyl™ and TriCor®, for the treatment of dyslipidemia; +Teveten™ and Teveten™ Plus, for the treatment of essential hypertension, and Physiotens™, for the treatment of hypertension; and Synthroid™, for the +treatment of hypothyroidism; +• pain and central nervous system products, including Serc™, for the treatment of Ménière's disease and +vestibular vertigo; Brufen™, for the treatment of pain, fever, and inflammation, and Sevedol®, for the treatment of severe migraines; and +• respiratory drugs and vaccines, including the anti-infective clarithromycin (sold under the trademarks Biaxin®, +Klacid™, and Klaricid™); and Influvac™, an influenza vaccine. +* As +used throughout the text of this report on Form 10-K, the term "Abbott" refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and +its consolidated subsidiaries, as the context requires. +1 +The +Established Pharmaceutical Products segment directs its primary marketing efforts toward building a strong brand with key stakeholders, including consumers, pharmacists, physicians, +and other healthcare providers. Government agencies are also important customers. +Competition +in the Established Pharmaceutical Products segment is generally from other health care and pharmaceutical companies. In addition, the substitution of generic drugs for the +brand prescribed and introduction of additional forms of already marketed established products by generic or branded competitors may increase competitive pressures. +Diagnostic Products +These products include a broad line of diagnostic systems and tests manufactured, marketed, and sold worldwide. These products are generally +marketed and sold directly to blood banks, hospitals, commercial laboratories, clinics, physicians' offices, government agencies, alternate care +testing sites, and plasma protein therapeutic companies from Abbott owned distribution centers, public warehouses or third party distributors. +The +principal products included in the Diagnostic Products segment are: +• core laboratory systems in the areas of immunoassay, clinical chemistry, hematology, and transfusion, including the Alinity® family +of instruments, ARCHITECT®, ABBOTT PRISM®, and Cell-Dyn®, with assays used for screening and/or diagnosis for cancer, cardiac, metabolics, drugs of abuse, +fertility, general chemistries, infectious diseases such as hepatitis and HIV, and therapeutic drug monitoring; +• molecular diagnostics systems, including the m2000™, an instrument that automates the extraction, purification, and preparation of +DNA and RNA from patient samples, and detects and measures infectious agents including HIV, HBV, HCV, HPV, and CT/NG; and the Vysis® FISH product line of genomic-based tests; +• point of care systems, including the i-STAT® and next-generation i-STAT® Alinity® and cartridges for blood +analysis; +• rapid diagnostics systems in the areas of infectious disease, including respiratory illness such as influenza, HIV, and tropical diseases such +as malaria and dengue fever; molecular point-of-care testing for HIV, including the m-PIMA™ HIV-1/2 Viral Load Test, and for influenza A & B, RSV and strep A, including the ID +NOW™ rapid molecular system; cardiometabolic testing, including Afinion® and Cholestech™ platforms and tests; a toxicology business for drug and alcohol testing; +and remote patient monitoring and consumer self-testing; and +• informatics and automation solutions for use in laboratories, including laboratory automation systems, the RALS point of care solution, and +AlinIQ™, a suite of informatics tools and professional services. +The +Diagnostic Products segment's products are subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product +performance, laboratory efficiency, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid +product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors +introduce new products. +2 +Nutritional Products +These products include a broad line of pediatric and adult nutritional products manufactured, marketed, and sold worldwide. These products are +generally marketed and sold directly to consumers and to institutions, wholesalers, retailers, health care facilities, government agencies, and third-party distributors from Abbott-owned distribution +centers or third-party distributors. +The +principal products included in the Nutritional Products segment are: +• various forms of prepared infant formula and follow-on formula, including Similac®, Similac Pro-Advance®, +Similac® Advance®, Similac® Advance® Non-GMO, Similac Pro-Sensitive®, Similac Sensitive®, Similac Sensitive® +Non-GMO, Go&Grow by Similac®, Similac® NeoSure®, Similac® Organic, Similac® Special Care®, Similac Total Comfort®, +Similac® For Supplementation, Isomil® Advance®, Isomil®, Alimentum®, Gain™, Grow™, Similac En Mei Li™, +and Eleva™; +• adult and other pediatric nutritional products, including Ensure®, Ensure Plus®, Ensure® +Enlive®, Ensure® (with NutriVigor®), Ensure® Max Protein, Ensure® High Protein, Glucerna®, Glucerna Hunger Smart®, +ProSure®, PediaSure®, PediaSure SideKicks®, PediaSure® Peptide, EleCare®, Juven®, Abound®, Pedialyte® +and Zone Perfect®; and +• nutritional products used in enteral feeding in health care institutions, including Jevity®, Glucerna® 1.2 Cal, +Glucerna® 1.5 Cal, Osmolite®, Oxepa®, Freego® (Enteral Pump) and Freego® sets, Nepro®, and Vital®. +Primary +marketing efforts for nutritional products are directed toward consumers or to securing the recommendation of Abbott's brand of products by physicians or other health care +professionals. In addition, certain nutritional products sold as Similac®, Gain™, Grow™, Eleva™, PediaSure®, PediaSure +SideKicks®, Pedialyte®, Ensure®, Zone Perfect®, and Glucerna® are also promoted directly to the public by consumer marketing efforts in +select markets where appropriate. +Competition +for nutritional products in the segment is generally from other diversified consumer and health care manufacturers. Competitive factors include consumer advertising, +formulation, packaging, scientific innovation, price, retail distribution, and availability of product forms. A significant aspect of competition is the search for ingredient innovations. The +introduction of new products by competitors, changes in medical practices and procedures, and regulatory changes can result in product obsolescence. In addition, private label and local manufacturers' +products may increase competitive pressure. +Cardiovascular and Neuromodulation Products +These products include a broad line of rhythm management, electrophysiology, heart failure, vascular and structural heart devices for the +treatment of cardiovascular diseases, as well as neuromodulation devices for the management of chronic pain and movement disorders. These products are manufactured, marketed and sold worldwide. In the +United States, these products are generally marketed and sold directly to hospitals, ambulatory surgery centers, and physicians' offices from Abbott-owned distribution centers and public warehouses. +Outside the United States, sales are made either directly to customers or through distributors, depending on the market served. +The +principal products included in the Cardiovascular and Neuromodulation Products segment are: +• rhythm management products, including Assurity MRI® and Endurity MRI® pacemaker systems; Ellipse® and +Fortify Assura® implantable cardioverter defibrillators and Quadra Assura MP® implantable cardioverter defibrillator with cardiac resynchronization therapy and +MultiPoint® Pacing technology; +• electrophysiology products, including the TactiCath® family of ablation catheters and FlexAbility® irrigated ablation +catheters; Ampere® RF ablation generator; and EnSite Precision® cardiac +3 +mapping +system; Confirm Rx® implantable cardiac monitor; and the Advisor® HD Grid mapping catheter; +• heart failure related products, including the HeartMate™ left ventricular device family and the CardioMEMS® HF System +pulmonary artery sensor, a heart failure monitoring system; +• vascular products, including the XIENCE™ family of drug-eluting coronary stent systems developed on the Multi-Link +Vision® platform; StarClose SE® and Perclose ProGlide® vessel closure devices, TREK® coronary balloon dilatation products, Hi-Torque Balance +Middleweight Universal II® guidewires, Supera® Peripheral Stent System, a peripheral vascular stent system; Acculink®/Accunet® and +Xact®/Emboshield NAV6®, carotid stent systems; and the OPTIS® integrated system with the Dragonfly OPTIS® imaging catheter and PressureWire® +fractional flow reserve measurement systems; +• structural heart products, including MitraClip®, a percutaneous mitral valve repair system; Trifecta® Valve with +Glide™ Technology, a surgical tissue heart valve; Portico® transcatheter aortic heart valve, Regent™ mechanical heart valve, and AMPLATZER® PFO +occluders; and +• neuromodulation products, including spinal cord stimulators Proclaim™ Elite Recharge-free IPG and Prodigy MRI® IPG, +both with BurstDR® stimulation, and Proclaim® DRG IPG, a neurostimulation device designed for dorsal root ganglion therapy, for the treatment of chronic pain disorders; and the +Infinity® Deep Brain Stimulation System with directional lead technology for the treatment of movement disorders. +The +Cardiovascular and Neuromodulation Products segment's products are subject to competition in technological innovation, price, convenience of use, service, product performance, +long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory +changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +Other Products +The principal products in Abbott's other businesses include continuous glucose and blood glucose monitoring systems, including test strips, +sensors, data management decision software, and accessories for people with diabetes, under the FreeStyle® brand such as the FreeStyle Libre® system. These products are +marketed worldwide and generally sold directly to wholesalers, government agencies, private health care organizations, health care facilities, mail order pharmacies, and independent retailers from +Abbott-owned distribution centers and public warehouses. Some of these products are also marketed and distributed through distributors. Blood and continuous glucose monitoring systems are also +marketed and sold to consumers. These products are subject to regulatory changes and competition in technological innovation, price, convenience of use, service, and product performance. +INFORMATION WITH RESPECT TO ABBOTT'S BUSINESS IN GENERAL +Sources and Availability of Raw Materials +Abbott purchases, in the ordinary course of business, raw materials and supplies essential to Abbott's operations from numerous suppliers in the +United States and around the world. There have been no recent significant availability problems or supply shortages for raw materials or supplies. +Patents, Trademarks, and Licenses +Abbott is aware of the desirability for patent and trademark protection for its products. Accordingly, where possible, patents and trademarks +are sought and obtained for Abbott's products in the United States +4 +and +countries of interest to Abbott. Abbott owns or has licenses under a substantial number of patents and patent applications. Principal trademarks and the products they cover are discussed in the +Narrative Description of Business on pages 1 through 4. These, and various patents which expire during the period 2019 to 2039, in the aggregate, are believed to be of material importance in +the operation of Abbott's business. Abbott believes that no single patent, license, or trademark is material in relation to Abbott's business as a whole. +Seasonal Aspects, Customers, Backlog, and Renegotiation +There are no significant seasonal aspects to Abbott's business. Abbott has no single customer that, if the customer were lost, would have a +material adverse effect on Abbott. Orders for Abbott's products are generally filled on a current basis, and order backlog is not material to Abbott's business. No material portion of Abbott's +business is subject to renegotiation of profits or termination of contracts at the election of a government. +Environmental Matters +Abbott believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. +Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. Abbott's capital and operating +expenditures for pollution control in 2018 were not material and are not expected to be material in 2019. +Abbott +has been identified as one of many potentially responsible parties in investigations and/or remediations at several locations in the United States, including Puerto Rico, under +the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. Abbott is also engaged in remediation at several other sites, some of which are owned by Abbott, +in cooperation with the Environmental Protection Agency or similar agencies. While it is not feasible to predict with certainty the final costs related to those investigations and remediation +activities, Abbott believes that such costs, together with other expenditures to maintain compliance with applicable laws and +regulations concerning environmental protection, should not have a material adverse effect on Abbott's financial position, cash flows, or results of operations. +Employees +Abbott employed approximately 103,000 people as of December 31, 2018. +Regulation +The development, manufacture, marketing, sale, promotion, and distribution of Abbott's products are subject to comprehensive government +regulation by the U.S. Food and Drug Administration and similar international regulatory agencies. Government regulation by various international, supranational, federal and state agencies addresses +(among other matters) the development and approval to market Abbott's products, as well as the inspection of, and controls over, research and laboratory procedures, clinical investigations, product +approvals and manufacturing, labeling, packaging, supply chains, marketing and promotion, pricing and reimbursement, sampling, distribution, quality control, post-market surveillance, record keeping, +storage, and disposal practices. In addition, Abbott's clinical laboratories and associated testing services are subject to comprehensive government regulation, including registration, certification, +and licensure, by federal, state, and local agencies, such as the Centers for Medicare & Medicaid Services, the Drug Enforcement Administration, the Substance Abuse and Mental Health Services +Administration, and their respective foreign counterparts. Certain of these agencies require our clinical laboratories to meet quality assurance, quality control, and personnel standards and undergo +inspections. +5 +Abbott's +international operations are also affected by trade and investment regulations in many countries. These may require local investment, restrict Abbott's investments, or limit the +import of raw materials and finished products. +Abbott's +home monitoring services and related products and laboratories that provide Abbott and third-party medical devices to consumers in the United States are subject to additional +federal, state, and local laws and regulations applicable to health care providers and suppliers that submit claims for +reimbursement to third-party payors. Medicare, Medicaid, and other third-party payors may from time to time conduct inquiries, claims audits, investigations, and enforcement actions relating to the +claims or enrollment criteria. +Abbott +is subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback, anti-self-referral, and false claims laws in the United +States. Prescription drug, nutrition, and medical device manufacturers such as Abbott are also subject to taxes, as well as application, product, user, establishment, and other fees. Governmental +agencies can also invalidate intellectual property rights. +Compliance +with these laws and regulations is costly and materially affects Abbott's business. Among other effects, health care regulations substantially increase the time, difficulty, +and costs incurred in obtaining and maintaining approval to market newly developed and existing products. Abbott expects this regulatory environment will continue to require significant technical +expertise and investment to ensure compliance. Failure to comply can delay the release of a new product or result in regulatory and enforcement actions, the seizure or recall of a product, the +suspension or revocation of the authority necessary for a product's production and sale, suspension or revocation of billing privileges, and other civil or criminal sanctions, including fines and +penalties. Similarly, compliance with the laws and regulations governing clinical laboratories and testing services requires specialized expertise. Failure to comply with these regulatory requirements +can result in sanctions, including suspension, revocation, or limitation of a laboratory's certification, which is necessary to conduct business, as well as significant fines or criminal penalties. +Abbott's +business can also be affected by ongoing studies of the utilization, safety, efficacy, and outcomes of health care products and their components that are regularly conducted by +industry participants, government agencies, and others. These studies can call into question the utilization, safety, and efficacy of previously marketed products. In some cases, these studies have +resulted, and may in the future result, in the discontinuation of marketing of such products in one or more countries, and may give rise to claims for damages from persons who believe they have been +injured as a result of their use. +Access +to human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in many countries. A +major focus is cost containment. Efforts to reduce health care costs are also being made in the private sector, notably by health care payors and providers, which have instituted various cost +reduction and containment measures. Abbott expects insurers and providers will continue attempts to reduce the cost or utilization of health care products. Many countries control the price of health +care products directly or indirectly, through reimbursement, payment, pricing, or coverage limitations. Budgetary pressures on health care payors may also heighten the scope and severity of pricing +pressures on Abbott's products for the foreseeable future. +In +the United States, the federal government regularly evaluates reimbursement for medical devices, diagnostics, supplies, and other products, as well as the procedures in which these +products may be used. The government follows a diagnosis-related group (DRG) payment system for certain institutional +services provided under Medicare or Medicaid and has implemented a prospective payment system (PPS) for services delivered in hospital outpatient, nursing home, and home health settings. DRG and PPS +entitle a health care facility to a fixed reimbursement based on the diagnosis and/or procedure rather than actual costs incurred in patient treatment, thereby increasing the incentive for the +facility to limit or control expenditures for many health care products. Other payment methodology changes have been proposed and +6 +implemented +from time to time. For example, Medicare implemented a competitive bidding system for certain durable medical equipment (including diabetes products), enteral nutrition products, and +supplies. Additionally, the Protecting Access to Medicare Act establishes a new payment system for clinical laboratory tests, which became effective on January 1, 2018. +In +2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (together, the Affordable Care Act), imposed an excise tax on +Abbott and other medical device manufacturers and importers. The excise tax was subsequently suspended from January 1, 2016 through December 31, 2017 as part of the Consolidated +Appropriations Act of 2016. In January 2018, the excise tax was suspended for an additional two years. +The +Affordable Care Act also includes provisions known as the Physician Payments Sunshine Act, which requires manufacturers of drugs, devices, and medical supplies covered under Medicare +and Medicaid to record any transfers of value to physicians and teaching hospitals and to report this data to the Centers for Medicare & Medicaid Services for subsequent public disclosure. In +October 2018, the Substance Use Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act significantly expanded the types of healthcare providers for which +reporting is required, beginning with reports filed in 2022. Similar reporting requirements have also been enacted on the state level domestically, and an increasing number of governments worldwide +either have adopted or are considering similar laws requiring transparency of interactions with health care professionals. Failure to report appropriate data may result in civil or criminal fines +and/or penalties. +Policy +changes, including potential modification or repeal of all or parts of the Affordable Care Act, or implementation of new health care legislation, could result in significant +changes to the health care system. +The +regulation of data privacy and security, and the protection of the confidentiality of certain personal information (including patient health information and financial information), +is increasing. For example, the European Union has enacted stricter data protection laws, which took effect in 2018, that contain enhanced financial penalties for noncompliance. Similarly, the U.S. +Department of Health and Human Services has issued rules governing the use, disclosure, and security of protected health information, +and the U.S. Food and Drug Administration has issued further guidance concerning cybersecurity for medical devices. In addition, certain countries have issued or are considering "data localization" +laws, which limit companies' ability to transfer protected data across country borders. Failure to comply with data privacy and security laws and regulations can result in enforcement actions, which +could include civil or criminal penalties. Transferring and managing protected information will become more challenging as laws and regulations are enacted or amended, and Abbott expects there will be +increasing complexity in this area. +Governmental +cost containment efforts also affect Abbott's nutritional products business. In the United States, for example, under regulations governing the federally funded Special +Supplemental Nutrition Program for Women, Infants, and Children, all states must have a cost containment program for infant formula. As a result, through competitive bidding states obtain rebates from +manufacturers of infant formula whose products are used in the program. +Abbott +expects debate to continue at all government levels worldwide over the marketing, manufacture, availability, method of delivery, and payment for health care products and services, +as well as data privacy and security. Abbott believes that future legislation and regulation in the markets it serves could affect access to health care products and services, increase rebates, reduce +prices or reimbursements or the rate of price increases for health care products and services, change health care delivery systems, create new fees and obligations for the pharmaceutical, nutrition, +diagnostic, and medical device industries, or require additional reporting and disclosure. It is not possible to predict the extent to which Abbott or the health care industry in general might be +affected by the matters discussed above. +7 +INTERNET INFORMATION +Copies of Abbott's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments +to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through Abbott's investor relations website +( www.abbottinvestor.com ) as soon as reasonably practicable after Abbott electronically files the material with, or furnishes it to, the Securities and +Exchange Commission. These reports and other information are also available, free of charge, at www.sec.gov. +Abbott's +corporate governance guidelines, outline of directorship qualifications, code of business conduct and the charters of Abbott's audit committee, compensation committee, +nominations and +governance committee, and public policy committee are all available on Abbott's investor relations website ( www.abbottinvestor.com ). +8 \ No newline at end of file diff --git a/raw/filings/0000001800/2018/0001047469-19-000624/item13.txt b/raw/filings/0000001800/2018/0001047469-19-000624/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..8a2f4767fc87a6af03dc9d1af7c01b723c210802 --- /dev/null +++ b/raw/filings/0000001800/2018/0001047469-19-000624/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The material to be included in the 2019 Proxy Statement under the headings "The Board of Directors," "Committees of the Board of Directors," and +"Approval Process for Related Person Transactions" is incorporated herein by reference. 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C. 20549 +FORM 10-K +​ +​ +(MARK ONE) +​ +☒ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +OR +☐ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +​ +For the fiscal year ended December 31, 2019 +Commission file number 1-2189 +​ +Abbott Laboratories +​ +​ +An Illinois Corporation +36-0698440 +100 Abbott Park Road +Abbott Park , Illinois 60064-6400 +(I.R.S. employer identification number) +( 224 ) 667-6100 +(telephone number) +​ +Securities Registered Pursuant to Section 12(b) of the Act: +​ +​ +​ +Title of Each Class +Trading Symbol(s) +Name of Each Exchange on Which Registered +Common Shares, Without Par Value +ABT +New York Stock Exchange +Chicago Stock Exchange , Inc. +​ +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ⌧ +No ◻ +​ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. +Yes ◻ +No ⌧ +​ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes ⌧ +No ◻ +​ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes ⌧ +No ◻ +​ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer ⌧ +Accelerated Filer ◻ +Non-Accelerated Filer ◻ +Smaller reporting company ☐ +Emerging growth company ☐ +​ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +Yes ☐ +No ☒ +​ +The aggregate market value of the 1,723,621,480 shares of voting stock held by nonaffiliates of the registrant, computed by reference to the closing price as reported on the New York Stock Exchange, as of the last business day of Abbott Laboratories’ most recently completed second fiscal quarter (June 28, 2019), was $ 144,956,566,468 . Abbott has no non-voting common equity. Number of common shares outstanding as of January 31, 2020: 1,763,433,243 +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the 2020 Abbott Laboratories Proxy Statement are incorporated by reference into Part III. The Proxy Statement will be filed on or about March 13, 2020. +​ +​ +​ +​ +​ +PART I +ITEM 1. BUSINESS +GENERAL DEVELOPMENT OF BUSINESS +Abbott Laboratories is an Illinois corporation, incorporated in 1900. Abbott’s* principal business is the discovery, development, manufacture, and sale of a broad and diversified line of health care products. +NARRATIVE DESCRIPTION OF BUSINESS +Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. +On October 3, 2017, Abbott completed the acquisition of Alere Inc., a diagnostic device and service provider, for an aggregate consideration of approximately $4.5 billion in cash. +On February 27, 2017, Abbott completed the sale of Abbott Medical Optics, its vision care business, to Johnson & Johnson for $4.325 billion in cash. +On January 4, 2017, Abbott completed the acquisition of St. Jude Medical, Inc., a global medical device manufacturer. Based on the closing Abbott share price on January 4, 2017, the aggregate implied value of the consideration paid in connection with the acquisition was approximately $23.6 billion, including approximately $13.6 billion in cash and approximately $10 billion in Abbott common shares. +Established Pharmaceutical Products +These products include a broad line of branded generic pharmaceuticals manufactured worldwide and marketed and sold outside the United States in emerging markets. These products are generally sold directly to wholesalers, distributors, government agencies, health care facilities, pharmacies, and independent retailers from Abbott-owned distribution centers and public warehouses, depending on the market served. Certain products are co-marketed or co-promoted with, or licensed from, other companies. +The principal products included in the broad therapeutic area portfolios of the Established Pharmaceutical Products segment are: +● gastroenterology products, including Creon™, for the treatment of pancreatic exocrine insufficiency associated with several underlying conditions, including cystic fibrosis and chronic pancreatitis; Duspatal™ and Dicetel™, for the treatment of irritable bowel syndrome or biliary spasm; Heptral™, Transmetil™, and Samyr™, for the treatment of intrahepatic cholestasis (associated with liver disease) or depressive symptoms; and Duphalac™, for regulation of the physiological rhythm of the colon; +● women’s health products, including Duphaston™, for the treatment of many different gynecological disorders; and Femoston™, a hormone replacement therapy for postmenopausal women; +● cardiovascular and metabolic products, including Lipanthyl™ and TriCor™, for the treatment of dyslipidemia; Teveten™ and Teveten™ Plus, for the treatment of essential hypertension, and Physiotens™, for the treatment of hypertension; and Synthroid™, for the treatment of hypothyroidism; +● pain and central nervous system products, including Serc™, for the treatment of Ménière’s disease and vestibular vertigo; Brufen™, for the treatment of pain, fever, and inflammation; and Sevedol™, for the treatment of severe migraines; and +● respiratory drugs and vaccines, including the anti-infective clarithromycin (sold under the trademarks Biaxin™, Klacid™, and Klaricid™); and Influvac™, an influenza vaccine. +* As used throughout the text of this report on Form 10-K, the term “Abbott” refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and its consolidated subsidiaries, as the context requires. +​ +1 +The Established Pharmaceutical Products segment directs its primary marketing efforts toward building strong brands with key stakeholders, including consumers, pharmacists, physicians, and other healthcare providers. Government agencies are also important customers. +Competition in the Established Pharmaceutical Products segment is generally from other health care and pharmaceutical companies. In addition, the substitution of generic drugs for the brand prescribed and introduction of additional forms of already marketed established products by generic or branded competitors may increase competitive pressures. +Diagnostic Products +These products include a broad line of diagnostic systems and tests manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to blood banks, hospitals, commercial laboratories, clinics, physicians’ offices, government agencies, alternate care testing sites, and plasma protein therapeutic companies from Abbott owned distribution centers, public warehouses or third party distributors. +The principal products included in the Diagnostic Products segment are: +● core laboratory systems in the areas of immunoassay, clinical chemistry, hematology, and transfusion, including the Alinity ® family of instruments, ARCHITECT ® , ABBOTT PRISM ® , and Cell-Dyn ® , with assays used for screening and/or diagnosis for cancer, cardiac, metabolics, drugs of abuse, fertility, general chemistries, infectious diseases such as hepatitis and HIV, and therapeutic drug monitoring; +● molecular diagnostics systems, including Alinity ® m and the m2000™ instruments that automate the extraction, purification, and preparation of DNA and RNA from patient samples, and detect and measure infectious agents including HIV, HBV, HCV, HPV, and CT/NG/TV/MG; and the Vysis ® FISH product line of genomic-based tests; +● point of care systems, including the i-STAT ® and next-generation i-STAT ® Alinity ® and cartridges for blood analysis; +● rapid diagnostics systems in the area of infectious diseases, including influenza, HIV, HCV, and tropical diseases such as malaria and dengue fever; molecular point-of-care testing for HIV, including the m-PIMA™ HIV-1/2 Viral Load Test, and for influenza A & B, RSV and strep A, including the ID NOW™ rapid molecular system; cardiometabolic testing, including Afinion ® and Cholestech™ platforms and tests; a toxicology business for drug and alcohol testing; and remote patient monitoring and consumer self-testing; and +● informatics and automation solutions for use in laboratories, including laboratory automation systems, the RALS point of care solution, and AlinIQ™, a suite of informatics tools and professional services. +The Diagnostic Products segment’s products are subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product performance, laboratory efficiency, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +Nutritional Products +These products include a broad line of pediatric and adult nutritional products manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to consumers and to institutions, wholesalers, retailers, health care facilities, government agencies, and third-party distributors from Abbott-owned distribution centers or third-party distributors. +The principal products included in the Nutritional Products segment are: +● various forms of prepared infant formula and follow-on formula, including Similac ®* , Similac Pro-Advance ®* , Similac ® Advance ® , Similac ® Advance ® Non-GMO, Similac Pro-Sensitive ®* , Similac Sensitive ® , Similac Sensitive ® Non-GMO, Go&Grow by Similac ®* , Similac ® NeoSure ® , Similac ® Organic, Similac ® Special Care ® , +2 +Similac Total Comfort ®* , Similac ® For Supplementation, Isomil ® Advance ® , Isomil ® , Alimentum ® , Gain™, Grow™, Similac En Mei Li™, and Eleva™; +● adult and other pediatric nutritional products, including Ensure ® , Ensure Plus ® , Ensure ® Enlive ® , Ensure ® (with NutriVigor ® ), Ensure ® Max Protein, Ensure ® High Protein, Glucerna ® , Glucerna Hunger Smart ® , ProSure ® , PediaSure ® , PediaSure SideKicks ® , PediaSure ® Peptide, EleCare ® , Juven ® , Abound ® , Pedialyte ® and Zone Perfect ® ; and +● nutritional products used in enteral feeding in health care institutions, including Jevity ® , Glucerna ® 1.2 Cal, Glucerna ® 1.5 Cal, Osmolite ® , Oxepa ® , Freego ® (Enteral Pump) and Freego ® sets, Nepro ® , and Vital ® . +* These products are available with 2'‐FL HMO (Human Milk Oligosaccharide) in several markets. +Primary marketing efforts for nutritional products are directed toward consumers or to securing the recommendation of Abbott’s brand of products by physicians or other health care professionals. In addition, certain nutritional products sold as Similac ® , Gain™, Grow™, Eleva™, PediaSure ® , PediaSure SideKicks ® , Pedialyte ® , Ensure ® , Zone Perfect ® , and Glucerna ® are also promoted directly to the public by consumer marketing efforts in select markets where appropriate. +Competition for nutritional products in the segment is generally from other diversified consumer and health care manufacturers. Competitive factors include consumer advertising, formulation, packaging, scientific innovation, price, retail distribution, and availability of product forms. A significant aspect of competition is the search for ingredient innovations. The introduction of new products by competitors, changes in medical practices and procedures, and regulatory changes can result in product obsolescence. In addition, private label and local manufacturers’ products may increase competitive pressure. +Medical Devices +These products include a broad line of rhythm management, electrophysiology, heart failure, vascular and structural heart devices for the treatment of cardiovascular diseases, and diabetes care products for people with diabetes, as well as neuromodulation devices for the management of chronic pain and movement disorders. Medical devices are manufactured, marketed and sold worldwide. In the United States, depending upon the product, medical devices are generally marketed and sold directly to wholesalers, hospitals, ambulatory surgery centers, physicians’ offices, and distributors from Abbott-owned distribution centers and public warehouses. Outside the United States, sales are made either directly to customers or through distributors, depending on the market served. +The principal products included in the Medical Devices segment are: +● rhythm management products, including Assurity MRI ® and Endurity MRI ® pacemaker systems; Ellipse ® and Fortify Assura ® implantable cardioverter defibrillators and Quadra Assura MP ® implantable cardioverter defibrillator with cardiac resynchronization therapy and MultiPoint ® Pacing technology; and Confirm Rx ® implantable cardiac monitor; +● electrophysiology products, including the TactiCath ® family of ablation catheters and FlexAbility ® irrigated ablation catheters; Ampere ® RF ablation generator; EnSite Precision ® cardiac mapping system; and the Advisor ® HD Grid mapping catheter; +● heart failure related products, including the HeartMate™ left ventricular device family and the CardioMEMS ® HF System pulmonary artery sensor, a heart failure monitoring system; +● vascular products, including the XIENCE™ family of drug-eluting coronary stent systems developed on the Multi-Link Vision ® platform; StarClose SE ® and Perclose ProGlide ® vessel closure devices, TREK ® coronary balloon dilatation products, Hi-Torque Balance Middleweight Universal II ® guidewires, Supera ® Peripheral Stent System, a peripheral vascular stent system; Acculink ® /Accunet ® and Xact ® /Emboshield NAV6 ® , carotid stent systems; and the OPTIS ® integrated system with the Dragonfly OPTIS ® imaging catheter and PressureWire ® fractional flow reserve measurement systems; +● structural heart products, including MitraClip ® , a percutaneous mitral valve repair system; Trifecta ® Valve with Glide™ Technology, a surgical tissue heart valve; Portico ® transcatheter aortic heart valve; Regent™ mechanical heart valve; AMPLATZER ® PFO occluders; and Tendyne ® Transcatheter Mitral Valve Implantation (TMVI) system; +3 +● continuous glucose and blood glucose monitoring systems, including test strips, sensors, data management decision software, and accessories for people with diabetes, under the FreeStyle ® brand such as the FreeStyle Libre ® system; and +● neuromodulation products, including spinal cord stimulators Proclaim ® Elite and Proclaim ® XR Recharge-free implantable pulse generators (IPG) and Prodigy MRI ® IPG, each with BurstDR ® stimulation, and Proclaim ® DRG IPG, a neurostimulation device designed for dorsal root ganglion therapy, for the treatment of chronic pain disorders; and the Infinity ® Deep Brain Stimulation System with directional lead technology for the treatment of movement disorders. +These products are subject to competition in technological innovation, price, convenience of use, service, product performance, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +INFORMATION WITH RESPECT TO ABBOTT’S BUSINESS IN GENERAL +Sources and Availability of Raw Materials +Abbott purchases, in the ordinary course of business, raw materials and supplies essential to Abbott’s operations from numerous suppliers in the United States and around the world. There have been no recent significant availability problems or supply shortages for raw materials or supplies. +Patents, Trademarks, and Licenses +Abbott is aware of the desirability for patent and trademark protection for its products. Accordingly, where possible, patents and trademarks are sought and obtained for Abbott’s products in the United States and countries of interest to Abbott. Abbott owns or has licenses under a substantial number of patents and patent applications. Principal trademarks and the products they cover are discussed in the Narrative Description of Business on pages 1 through 4. These, and various patents which expire during the period 2020 to 2040, in the aggregate, are believed to be of material importance in the operation of Abbott’s business. Abbott believes that no single patent, license, or trademark is material in relation to Abbott’s business as a whole. +Seasonal Aspects, Customers, Backlog, and Renegotiation +There are no significant seasonal aspects to Abbott’s business. Abbott has no single customer that, if the customer were lost, would have a material adverse effect on Abbott. Orders for Abbott’s products are generally filled on a current basis, and order backlog is not material to Abbott’s business. No material portion of Abbott’s business is subject to renegotiation of profits or termination of contracts at the election of a government. +Environmental Matters +Abbott believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. Abbott’s capital and operating expenditures for pollution control in 2019 were not material and are not expected to be material in 2020. +Abbott has been identified as one of many potentially responsible parties in investigations and/or remediations at several locations in the United States, including Puerto Rico, under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. Abbott is also engaged in remediation at several other sites, some of which are owned by Abbott, in cooperation with the Environmental Protection Agency or similar agencies. While it is not feasible to predict with certainty the final costs related to those investigations and remediation activities, Abbott believes that such costs, together with other expenditures to maintain compliance with applicable laws and regulations concerning environmental protection, should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +Employees +Abbott employed approximately 107,000 people as of December 31, 2019. +4 +Regulation +The development, manufacture, marketing, sale, promotion, and distribution of Abbott’s products are subject to comprehensive government regulation by the U.S. Food and Drug Administration (FDA) and similar international regulatory agencies. Government regulation by various international, supranational, federal and state agencies addresses (among other matters) the development and approval to market Abbott’s products, as well as the inspection of, and controls over, research and laboratory procedures, clinical investigations, product approvals and manufacturing, labeling, packaging, supply chains, marketing and promotion, pricing and reimbursement, sampling, distribution, quality control, post-market surveillance, record keeping, storage, and disposal practices. In addition, Abbott’s clinical laboratories and associated testing services are subject to comprehensive government regulation, including registration, certification, and licensure, by federal, state, and local agencies, such as the Centers for Medicare & Medicaid Services, the Drug Enforcement Administration, the Substance Abuse and Mental Health Services Administration, and their respective foreign counterparts. Certain of these agencies require our clinical laboratories to meet quality assurance, quality control, and personnel standards and undergo inspections. +Abbott’s international operations are also affected by trade and investment regulations in many countries. These may require local investment, restrict Abbott’s investments, or limit the import of raw materials and finished products. +Abbott’s laboratory facilities and home monitoring services, which provide services, related products and medical devices to consumers, are subject to additional laws and regulations applicable to health care providers and suppliers that submit claims for reimbursement to third-party payors. In the United States, Medicare, Medicaid, and other third-party payors may from time to time conduct inquiries, claims audits, investigations, and enforcement actions relating to the claims or enrollment criteria. +Abbott is subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback, anti-self-referral, and false claims laws in the United States. Prescription drug, nutrition, and medical device manufacturers such as Abbott are also subject to taxes, as well as application, product, user, establishment, and other fees. Governmental agencies can also invalidate intellectual property rights. +Compliance with these laws and regulations is costly and materially affects Abbott’s business. Among other effects, health care regulations and significant changes thereto (such as the introduction of the Medical Device Regulation and the In Vitro Diagnostic Medical Device Regulation in the European Union) substantially increase the time, difficulty, and costs incurred in developing, obtaining and maintaining approval to market, and marketing newly developed and existing products. Abbott expects this regulatory environment will continue to require significant technical expertise and investment to ensure compliance. Failure to comply can delay the release of a new product or result in regulatory and enforcement actions, the seizure or recall of a product, the suspension or revocation of the authority necessary for a product’s production and sale, suspension or revocation of billing privileges, and other civil or criminal sanctions, including fines and penalties. Similarly, compliance with the laws and regulations governing clinical laboratories and testing services requires specialized expertise. Failure to comply with these regulatory requirements can result in sanctions, including suspension, revocation, or limitation of a laboratory’s certification, which is necessary to conduct business, as well as significant fines or criminal penalties. +Abbott’s business can also be affected by ongoing studies of the utilization, safety, efficacy, and outcomes of health care products and their components that are regularly conducted by industry participants, government agencies, and others. These studies can call into question the utilization, safety, and efficacy of previously marketed products. In some cases, these studies have resulted, and may in the future result, in the discontinuation of marketing of such products in one or more countries, and may give rise to claims for damages from persons who believe they have been injured as a result of their use. +Access to human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in many countries. A major focus is cost containment. Efforts to reduce health care costs are also being made in the private sector, notably by health care payors and providers, which have instituted various cost reduction and containment measures. Abbott expects insurers and providers will continue attempts to reduce the cost or utilization of health care products. Many countries control the price of health care products directly or indirectly, through reimbursement, payment, pricing, or coverage limitations. Budgetary pressures on health care payors may also heighten the scope and severity of pricing pressures on Abbott’s products for the foreseeable future. In the United States, the federal government regularly evaluates reimbursement for medical devices, diagnostics, supplies, and other products, as well as the procedures in which these products may be used. The government follows a diagnosis-related group (DRG) +5 +payment system for certain institutional services provided under Medicare or Medicaid and has implemented a prospective payment system (PPS) for services delivered in hospital outpatient, nursing home, and home health settings. DRG and PPS entitle a health care facility to a fixed reimbursement based on the diagnosis and/or procedure rather than actual costs incurred in patient treatment, thereby increasing the incentive for the facility to limit or control expenditures for many health care products. Other payment methodology changes have been proposed and implemented from time to time. For example, Medicare implemented a competitive bidding system for certain durable medical equipment (including diabetes products), enteral nutrition products, and supplies. Additionally, the Protecting Access to Medicare Act establishes a new payment system for clinical laboratory tests, which became effective on January 1, 2018. +In 2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (together, the Affordable Care Act), imposed an excise tax on Abbott and other medical device manufacturers and importers. The excise tax was suspended from January 1, 2016 to December 31, 2019 and was repealed as of January 1, 2020 by the Further Consolidated Appropriations Act of 2020. +The Affordable Care Act also includes provisions known as the Physician Payments Sunshine Act, which requires manufacturers of drugs, devices, and medical supplies covered under Medicare and Medicaid to record any transfers of value to physicians and teaching hospitals and to report this data to the Centers for Medicare & Medicaid Services for subsequent public disclosure. In October 2018, the Substance Use Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act significantly expanded the types of healthcare providers for which reporting is required, beginning with reports filed in 2022. Similar reporting requirements have also been enacted on the state level domestically, and an increasing number of governments worldwide either have adopted or are considering similar laws requiring transparency of interactions with health care professionals. Failure to report appropriate data may result in civil or criminal fines and/or penalties. +Policy changes or implementation of new health care legislation could result in significant changes to health care systems. In the United States, this could include potential modification or repeal of all or parts of the Affordable Care Act. +The regulation of data privacy and security, and the protection of the confidentiality of certain personal information (including patient health information and financial information), is increasing. For example, the European Union, various other countries, and various U.S. states (e.g., California) have enacted stricter data protection laws that contain enhanced financial penalties for noncompliance. Similarly, the U.S. Department of Health and Human Services has issued rules governing the use, disclosure, and security of protected health information, and the FDA has issued further guidance concerning cybersecurity for medical devices. In addition, certain countries have issued or are considering “data localization” laws, which limit companies’ ability to transfer protected data across country borders. Failure to comply with data privacy and security laws and regulations can result in enforcement actions, which could include civil or criminal penalties. Transferring and managing protected information will become more challenging as laws and regulations are enacted or amended, and Abbott expects there will be increasing complexity in this area. +Governmental cost containment efforts also affect Abbott’s nutritional products business. In the United States, for example, under regulations governing the federally funded Special Supplemental Nutrition Program for Women, Infants, and Children, all states must have a cost containment program for infant formula. As a result, through competitive bidding states obtain rebates from manufacturers of infant formula whose products are used in the program. +Abbott expects debate to continue at all government levels worldwide over the manufacture, quality assurance requirements, marketing authorization processes, post-market surveillance requirements, availability, method of delivery, and payment for health care products and services, as well as data privacy and security. Abbott believes that future legislation and regulation in the markets it serves could affect the timing and expense associated with bringing health care products or services to market, access to health care products and services, increase rebates, reduce prices or reimbursements or the rate of price increases for health care products and services, change health care delivery systems, create new fees and obligations for the pharmaceutical, nutrition, diagnostic, and medical device industries, or require additional reporting and disclosure. It is not possible to predict the extent to which Abbott or the health care industry in general might be affected by the matters discussed above. +6 +INTERNET INFORMATION +Copies of Abbott’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through Abbott’s investor relations website ( www.abbottinvestor.com ) as soon as reasonably practicable after Abbott electronically files the material with, or furnishes it to, the Securities and Exchange Commission (the Commission). These reports and other information are also available, free of charge, at www.sec.gov. +Abbott’s corporate governance guidelines, outline of directorship qualifications, code of business conduct and the charters of Abbott’s audit committee, compensation committee, nominations and governance committee, and public policy committee are all available on Abbott’s investor relations website ( www.abbottinvestor.com ). +​ +7 +ITEM 1A. RISK FACTORS +In addition to the other information in this report, the following risk factors should be considered before deciding to invest in any of Abbott’s securities. Additional risks and uncertainties not presently known to Abbott, or risks Abbott currently considers immaterial, could also affect Abbott’s actual results. Abbott’s business, financial condition, results of operations, or prospects could be materially adversely affected by any of these risks. +Abbott may acquire other businesses, license rights to technologies or products, form alliances, or dispose of or spin-off businesses, which could cause it to incur significant expenses and could negatively affect profitability. +Abbott may pursue acquisitions, licensing arrangements, and strategic alliances, or dispose of or spin-off some of its businesses, as part of its business strategy. Abbott may not complete these transactions in a timely manner, on a cost-effective basis, or at all, and may not realize the expected benefits. If Abbott is successful in making an acquisition, the products and technologies that are acquired may not be successful or may require significantly greater resources and investments than originally anticipated. Abbott may not be able to integrate acquisitions successfully into its existing business or transition disposed businesses efficiently, and could incur or assume significant debt and unknown or contingent liabilities. Abbott could also experience negative effects on its reported results of operations from acquisition or disposition-related charges, amortization of expenses related to intangibles and charges for impairment of long-term assets. These effects could cause a deterioration of Abbott’s credit rating, result in increased borrowing costs and interest expense, and decrease liquidity. +Abbott is subject to cost containment efforts that could cause a reduction in future revenues and operating income. +In the United States and other countries, Abbott’s businesses have experienced downward pressure on product pricing. Cost containment efforts by governments and private organizations are described in greater detail in the section captioned “Regulation.” To the extent these cost containment efforts are not offset by greater patient access to health care or other factors, Abbott’s future revenues and operating income will be reduced. +Abbott is subject to numerous governmental regulations and it can be costly to comply with these regulations and to develop compliant products and processes. +Abbott’s products are subject to rigorous regulation by the FDA and numerous international, supranational, federal, and state authorities. The process of obtaining regulatory approvals to market a drug, medical device, or diagnostic product can be costly and time-consuming, and approvals might not be granted for future products, or additional indications or uses of existing products, on a timely basis, if at all. Delays in the receipt of, or failure to obtain, approvals for future products, or new indications and uses, could result in delayed realization of product revenues, reduction in revenues, and substantial additional costs. +In addition, no assurance can be given that Abbott will remain in compliance with applicable FDA and other regulatory requirements once approval or marketing authorization has been obtained for a product. These requirements include, among other things, regulations regarding manufacturing practices, product labeling, and advertising and postmarketing reporting, including adverse event reports and field alerts. Many of Abbott’s facilities and procedures and those of Abbott’s suppliers are subject to ongoing regulation, including periodic inspection by the FDA and other regulatory authorities. Abbott must incur expense and spend time and effort to ensure compliance with these complex regulations. Possible regulatory actions for non-compliance could include warning letters, fines, damages, injunctions, civil penalties, recalls, seizures of Abbott’s products, and criminal prosecution. +These actions could result in, among other things, substantial modifications to Abbott’s business practices and operations; refunds, recalls, or seizures of Abbott’s products; a total or partial shutdown of production in one or more facilities while Abbott or Abbott’s suppliers remedy the alleged violation; the inability to obtain future pre-market approvals or marketing authorizations; and withdrawals or suspensions of current products from the market. Any of these events could disrupt Abbott’s business and have a material adverse effect on Abbott’s revenues, profitability and financial condition. +8 +Laws and regulations affecting government benefit programs could impose new obligations on Abbott, require Abbott to change its business practices, and restrict its operations in the future. +Abbott’s industry is subject to various international, supranational, federal, and state laws and regulations pertaining to government benefit program reimbursement, price reporting and regulation, and health care fraud and abuse, including anti-kickback and false claims laws, and international and individual state laws relating to pricing and sales and marketing practices. Violations of these laws may be punishable by criminal and/or civil sanctions, including, in some instances, substantial fines, imprisonment, and exclusion from participation in government health care programs, including Medicare, Medicaid, and Veterans Administration health programs in the U.S. These laws and regulations are broad in scope and they are subject to evolving interpretations, which could require Abbott to incur substantial costs associated with compliance or to alter one or more of its sales or marketing practices. In addition, violations of these laws, or allegations of such violations, could disrupt Abbott’s business and result in a material adverse effect on Abbott’s revenues, profitability, and financial condition. +Changes in the health care regulatory environment may adversely affect Abbott’s business. +Both in the U.S. and internationally, government authorities may enact changes in regulatory requirements, make legislative or administrative reforms to existing reimbursement programs, make adverse decisions relating to our products’ coverage or reimbursement, or make changes to patient access to health care, all of which could adversely impact the demand for and usage of Abbott’s products or the prices that Abbott’s customers are willing to pay for them. +Further, in the U.S., a number of the provisions of the U.S. Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 address access to health care products and services. These provisions may be modified, repealed, or otherwise invalidated, in whole or in part. Future rulemaking could affect rebates, prices or the rate of price increases for health care products and services, or required reporting and disclosure. Abbott cannot predict the timing or impact of any future rulemaking or changes in the law. +For additional information concerning health care regulation, see the discussion in “Regulation” under Item 1, “Business.” +Abbott depends on sophisticated information technology systems and maintains protected personal data, and a cyber attack or other breach affecting these information technology systems or protected data could have a material adverse effect on Abbott’s results of operations. +Similar to other large multi-national companies, the size and complexity of the information technology systems on which Abbott relies for both its infrastructure and products makes them susceptible to a cyber attack, malicious intrusion, breakdown, destruction, loss of data privacy, or other significant disruption. These systems have been and are expected to continue to be the target of malware and other cyber attacks. In addition, third party hacking attempts may cause Abbott’s information technology systems and related products, protected data, or proprietary information to be compromised or stolen. A significant attack or other disruption could result in adverse consequences, including increased costs and expenses, problems with product functionality, damage to customer relations, lost revenue, and legal or regulatory penalties. +Abbott also collects, manages and processes protected personal data, including protected health information, in connection with certain medical products and service offerings. Abbott is subject to certain regional and local data protection laws that prohibit or restrict the transfer of protected data across country borders. For additional information concerning data privacy and security regulation, see the discussion in “Regulation” under Item 1, “Business.” A breach of protected personal information could result in adverse consequences, including regulatory inquiries or litigation, increased costs and expenses, reputational damage, lost revenue, and fines or penalties. +Abbott invests in its systems and technology and in the protection of its products and data to reduce the risk of an attack or other significant disruption, and monitors its systems on an ongoing basis for any current or potential threats and for changes in technology and the regulatory environment. There can be no assurance that these measures and efforts will prevent future attacks or other significant disruptions to any of the systems on which Abbott relies or that related product issues will not arise in the future. Any significant attack or other disruption on Abbott’s systems or products could have a material adverse effect on Abbott’s business. +9 +Abbott has significant indebtedness, which could adversely affect its business, including decreasing its business flexibility. +As of December 31, 2019, Abbott's consolidated indebtedness was approximately $18 billion. This consolidated indebtedness could have the effect, among other things, of reducing Abbott's flexibility to respond to changing business and economic conditions, and reducing funds available for working capital, capital expenditures, acquisitions, and other general corporate purposes. +Further, Abbott may be required to raise additional financing for working capital, capital expenditures, future acquisitions or other general corporate purposes. Abbott's ability to arrange additional financing or refinancing will depend on, among other factors, Abbott's financial position and performance, as well as prevailing market conditions and other factors beyond Abbott's control. Consequently, Abbott cannot assure that it will be able to obtain additional financing or refinancing on terms acceptable to Abbott or at all, which could adversely impact Abbott's ability to make scheduled payments with respect to its consolidated indebtedness and its profitability and financial condition. +Additionally, further borrowing could cause a deterioration of Abbott's credit ratings. Abbott's credit ratings reflect each credit rating agency's then opinion of Abbott's financial strength, operating performance, and ability to meet its debt obligations. Adverse changes in Abbott's credit ratings may result in increased borrowing costs for future long-term debt or short-term borrowing facilities and may limit financing options, including access to the unsecured borrowing market. Abbott may also be subject to additional restrictive covenants that would reduce flexibility. +The expiration or loss of patent protection and licenses may affect Abbott’s future revenues and operating income. +Many of Abbott’s businesses rely on patent and trademark and other intellectual property protection. Although most of the challenges to Abbott’s intellectual property have come from other companies, governments may also challenge intellectual property protections. To the extent Abbott’s intellectual property is successfully challenged, invalidated, or circumvented or to the extent it does not allow Abbott to compete effectively, Abbott’s businesses could suffer. To the extent that countries do not enforce Abbott’s intellectual property rights, Abbott’s future revenues and operating income could be reduced. Any material litigation regarding Abbott’s patents and trademarks is described in the section captioned “Legal Proceedings.” +Competitors’ intellectual property may prevent Abbott from selling its products or have a material adverse effect on Abbott’s future profitability and financial condition. +Competitors may claim that an Abbott product infringes their intellectual property. Resolving an intellectual property infringement claim can be costly and time consuming and may require Abbott to enter into license agreements. Abbott cannot guarantee that it would be able to obtain license agreements on commercially reasonable terms. A successful claim of patent or other intellectual property infringement could subject Abbott to significant damages or an injunction preventing the manufacture, sale or use of affected Abbott products. Any of these events could have a material adverse effect on Abbott’s profitability and financial condition. +Abbott’s research and development efforts may not succeed in developing commercially successful products and technologies, which may cause Abbott’s revenue and profitability to decline. +To remain competitive, Abbott must continue to launch new products and technologies. To accomplish this, Abbott commits substantial efforts, funds, and other resources to research and development. A risk of failure is inherent in the research and development of new products and technologies. Abbott must make ongoing substantial expenditures without any assurance that its efforts will be commercially successful. Failure can occur at any point in the process, including after significant funds have been invested. +Promising new products and technologies may fail to reach the market or may only have limited commercial success because of efficacy or safety concerns, failure to achieve positive clinical outcomes, inability to obtain necessary regulatory approvals, limited scope of approved uses, excessive costs to manufacture, failure to establish or maintain intellectual property rights, or infringement of the intellectual property rights of others. Even if Abbott successfully develops new products or enhancements or new generations of Abbott’s existing products, they may be quickly rendered obsolete by changing customer preferences, changing industry or regulatory standards, or competitors’ innovations. Innovations may not be accepted quickly in the marketplace because of, among other things, entrenched patterns of clinical practice or uncertainty over third-party reimbursement. Abbott cannot state with certainty when or whether any of its products under +10 +development will be launched, whether it will be able to develop, license, or otherwise acquire compounds or products, or whether any products will be commercially successful. Failure to launch successful new products or technologies, or new indications or uses for existing products, may cause Abbott’s products or technologies to become obsolete, causing Abbott’s revenues and operating results to suffer. +New products and technological advances by Abbott’s competitors may negatively affect Abbott’s results of operations. +Abbott’s products face intense competition from its competitors’ products. Competitors’ products may be safer, more effective, more effectively marketed or sold, or have lower prices or superior performance features than Abbott’s products. Abbott cannot predict with certainty the timing or impact of the introduction of competitors’ products. +The manufacture of many of Abbott’s products is a highly exacting and complex process, and if Abbott or one of its suppliers encounters problems manufacturing products, Abbott’s business could suffer. +The manufacture of many of Abbott’s products is a highly exacting and complex process, due in part to strict regulatory requirements. Problems may arise during manufacturing for a variety of reasons, including equipment malfunction, failure to follow specific protocols and procedures, problems with raw materials, natural disasters, and environmental factors. In addition, single suppliers are currently used for certain products and materials. If problems arise during the production of a lot or batch of product, those products may have to be discarded. If problems are not discovered before the product is released to the market, recall and product liability costs may also be incurred. Any of these events could, among other things, lead to increased costs, lost revenue, damage to customer relations, time and expense spent investigating the cause and, depending on the cause, similar losses with respect to other lots, batches or products. To the extent Abbott or one of its suppliers experiences significant manufacturing problems, this could have a material adverse effect on Abbott’s revenues and profitability. +Significant safety concerns could arise for Abbott’s products, which could have a material adverse effect on Abbott’s revenues and financial condition. +Health care products typically receive regulatory approval based on data obtained in controlled clinical trials of limited duration. Following regulatory approval, these products will be used over longer periods of time in many patients. Investigators may also conduct additional, and perhaps more extensive, studies. If new safety issues are reported, Abbott may be required to amend the conditions of use for a product. For example, Abbott may be required to provide additional warnings on a product’s label or narrow its approved intended use, either of which could reduce the product’s market acceptance. If serious safety issues arise with an Abbott product, sales of the product could be halted by Abbott or by regulatory authorities. Safety issues affecting suppliers’ or competitors’ products also may reduce the market acceptance of Abbott’s products. +In addition, in the ordinary course of business, Abbott is the subject of product liability claims and lawsuits alleging that its products or the products of other companies that Abbott promotes have resulted or could result in an unsafe condition for or injury to patients. Product liability claims and lawsuits, safety alerts or product recalls, and other allegations of product safety or quality issues, regardless of their validity or ultimate outcome, may have a material adverse effect on Abbott’s business and reputation and on Abbott’s ability to attract and retain customers. Consequences may also include additional costs, a decrease in market share for the products, lower income or exposure to other claims. Product liability losses are self-insured. Product liability claims could have a material adverse effect on Abbott’s profitability and financial condition. +Fluctuation in foreign currency exchange rates may adversely affect our financial statements and Abbott’s ability to realize projected sales and earnings. +Although Abbott’s financial statements are denominated in U.S. dollars, a significant portion of Abbott’s revenues and costs are realized in other currencies. Sales outside of the United States in 2019 made up approximately 64 percent of Abbott’s net sales. Abbott’s profitability is affected by movement of the U.S. dollar against other currencies. Fluctuations in exchange rates between the U.S. dollar and other currencies may also affect the reported value of Abbott’s assets and liabilities, as well as its cash flows. Some foreign currencies are subject to government exchange controls. While Abbott enters into hedging arrangements to mitigate some of its foreign currency exposure, Abbott cannot predict with any certainty changes in foreign currency exchange rates or its ability to mitigate these risks. +11 +Information on the impact of foreign exchange rates on Abbott’s financial results is contained in the “Financial Review — Results of Operations” section in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report. A discussion of the steps taken to mitigate the impact of foreign exchange is contained in Item 7A, Quantitative and Qualitative Disclosures about Market Risk in Abbott’s 2019 Form 10-K. Information on Abbott’s hedging arrangements is contained in Note 13 to the consolidated financial statements in this report. +Deterioration in the economic condition and credit quality of certain countries may negatively affect Abbott’s results of operations. +Unfavorable economic conditions in certain countries may increase the time it takes to collect outstanding trade receivables. Financial instability and fiscal deficits in these countries may result in additional austerity measures to reduce costs, including health care. Deterioration in the quality of sovereign debt, including credit downgrades, could increase Abbott’s collection risk where a significant amount of Abbott’s receivables in these countries are with governmental health care systems or where Abbott’s customers depend on payment by government health care systems. +The international nature of Abbott’s business subjects it to additional business risks that may cause its revenue and profitability to decline. +Abbott’s business is subject to risks associated with managing a global supply chain and doing business internationally. Sales outside of the United States in 2019 made up approximately 64 percent of Abbott’s net sales. Additional risks associated with Abbott’s international operations include: +● differing local product preferences and product requirements; +● trade protection measures, including tariffs, import or export licensing requirements, and changes to international trade agreements; +● difficulty in establishing, staffing, and managing operations; +● differing labor regulations; +● potentially negative consequences from changes in or interpretations of tax laws; +● political and economic instability, including sovereign debt issues; +● restrictions on local currency conversion and/or cash extraction; +● price controls, limitations on participation in local enterprises, expropriation, nationalization, and other governmental action; +● inflation, recession, and fluctuations in interest rates; +● diminished protection of intellectual property; and +● potential penalties or other adverse consequences for violations of anti-corruption, anti-bribery, and other similar laws and regulations, including the Foreign Corrupt Practices Act and the U.K. Bribery Act. +Events contemplated by these risks may, individually or in the aggregate, have a material adverse effect on Abbott’s revenues and profitability. +Other factors can have a material adverse effect on Abbott’s future profitability and financial condition. +Many other factors can affect Abbott’s profitability and its financial condition, including: +● changes in or interpretations of laws and regulations, including changes in accounting standards, taxation requirements, product marketing application standards, product labeling, source and use laws, and environmental laws; +● differences between the fair value measurement of assets and liabilities and their actual value, particularly for pensions, retiree health care, stock compensation, intangibles, goodwill, and contingent consideration; and for contingent liabilities such as litigation, the absence of a recorded amount, or an amount recorded at the minimum, compared to the actual amount; +12 +● changes in the rate of inflation (including the cost of raw materials, commodities, and supplies), interest rates, market value of Abbott’s equity investments, and the performance of investments held by Abbott or Abbott’s employee benefit trusts; +● changes in the creditworthiness of counterparties that transact business with or provide services to Abbott or Abbott’s employee benefit trusts; +● changes in business, economic, and political conditions, including: war, political instability, terrorist attacks, the threat of future terrorist activity and related military action; global climate, extreme weather and natural disasters; widespread outbreaks of infectious diseases; the cost and availability of insurance due to any of the foregoing events; labor disputes, strikes, slow-downs, or other forms of labor or union activity; and pressure from third-party interest groups; +● changes in Abbott’s business units and investments and changes in the relative and absolute contribution of each to earnings and cash flow resulting from evolving business strategies, changing product mix, changes in tax laws or tax rates both in the U.S. and abroad and opportunities existing now or in the future; +● changes in the buying patterns of a major distributor, retailer, or wholesale customer resulting from buyer purchasing decisions, pricing, seasonality, or other factors, or other problems with licensors, suppliers, distributors, and business partners; and +● legal difficulties, any of which could preclude or delay commercialization of products or adversely affect profitability, including claims asserting statutory or regulatory violations, and adverse litigation decisions. +CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS +This Form 10-K contains forward-looking statements that are based on management’s current expectations, estimates, and projections. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “forecasts,” variations of these words, and similar expressions are intended to identify these forward-looking statements. Certain factors, including but not limited to those identified under “Item 1A. Risk Factors” of this Form 10-K, may cause actual results to differ materially from current expectations, estimates, projections, forecasts, and from past results. No assurance can be made that any expectation, estimate, or projection contained in a forward-looking statement will be achieved or will not be affected by the factors cited above or other unknown or future events. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as the result of subsequent events or developments, except as required by law. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +​ +13 +ITEM 2. PROPERTIES +As of December 31, 2019, Abbott owned or leased properties totaling approximately 42 million square feet, of which approximately 70% is owned by Abbott. Abbott’s principal corporate offices are located in Illinois and are owned by Abbott. +Abbott operates 92 manufacturing facilities globally. Abbott’s facilities are deemed suitable and provide adequate productive capacity. The manufacturing facilities are used by Abbott’s reportable segments as follows: +​ +​ +​ +​ +​ +Manufacturing +Reportable Segments +​ +Sites +Medical Devices +27 +Diagnostic Products +23 +Established Pharmaceutical Products +28 +Nutritional Products +14 +Worldwide Total +92 +​ +Abbott’s research and development facilities in the United States are primarily located in California, Illinois, Minnesota, New Jersey, and Ohio. Abbott also has research and development facilities in various other countries, including China, Colombia, India, Singapore, Spain, and the United Kingdom. +There are no material encumbrances on the properties. +ITEM 3. LEGAL PROCEEDINGS +Abbott is involved in various claims, legal proceedings and investigations. While it is not feasible to predict the outcome of such pending claims, proceedings and investigations with certainty, management is of the opinion that their ultimate resolution should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +​ +14 +INFORMATION ABOUT OUR EXECUTIVE OFFICERS +Executive officers of Abbott are elected annually by the board of directors. Each executive officer holds office until a successor has been duly elected or appointed and qualified or until the officer’s death, resignation, or removal. Vacancies may be filled at any time by the board. Any executive officer may be removed by the board of directors when, in its judgment, removal would serve the best interests of Abbott. +Abbott’s executive officers, their ages as of February 21, 2020, and the dates of their first election as officers of Abbott are listed below. The executive officers’ principal occupations and employment for the past five years and the year of appointment to the earliest reported office are also shown. Unless otherwise stated, employment was by Abbott. There are no family relationships between any executive officers or directors. +Miles D. White will step down as Chief Executive Officer on March 31, 2020. The board of directors appointed Mr. White as Executive Chairman and Robert B. Ford as President and Chief Executive Officer, each effective March 31, 2020. Brian B. Yoor will retire as an officer of Abbott, effective February 29, 2020. The board of directors appointed Robert E. Funck, Jr. as Executive Vice President, Finance and Chief Financial Officer and Philip P. Boudreau as Vice President, Finance and Controller, each effective March 1, 2020. +Miles D. White, 64 +1999 to present — Chairman of the Board and Chief Executive Officer, and Director. +Elected Corporate Officer — 1993. +Robert B. Ford, 46 +2018 to present — President and Chief Operating Officer, and Director since 2019. +2015 to 2018 — Executive Vice President, Medical Devices. +2014 to 2015 — Senior Vice President, Diabetes Care. +Elected Corporate Officer — 2008. +Hubert L. Allen, 54 +2013 to present — Executive Vice President, General Counsel and Secretary. +Elected Corporate Officer — 2012. +John M. Capek, 58 +2015 to present — Executive Vice President, Ventures. +2007 to 2015 — Executive Vice President, Medical Devices. +Elected Corporate Officer — 2006. +Lisa D. Earnhardt, 50 +2019 to present — Executive Vice President, Medical Devices. +2008 to 2019 — President, CEO, and Director, Intersect ENT (a medical technology company focused on developing treatments for ear, nose and throat conditions). +Elected Corporate Officer — 2019. +John F. Ginascol, 61 +2019 to present — Executive Vice President, Core Diagnostics. +2008 to 2019 — Vice President, Nutrition, Supply Chain. +Elected Corporate Officer — 2008. +15 +Andrew H. Lane, 49 +2017 to present — Executive Vice President, Established Pharmaceuticals. +2015 to 2017 — Senior Vice President, Established Pharmaceuticals, Emerging Markets. +2014 to 2015 — Divisional Vice President, Established Pharmaceuticals, Asia Pacific. +Elected Corporate Officer — 2015. +Mary K. Moreland, 53 +2019 to present — Executive Vice President, Human Resources. +2013 to 2019 — Divisional Vice President, Compensation, Benefits and HR M&A. +Elected Corporate Officer — 2019. +Daniel Salvadori, 41 +2017 to present — Executive Vice President, Nutritional Products. +2014 to 2017 — Senior Vice President, Established Pharmaceuticals, Latin America. +Elected Corporate Officer — 2014. +Andrea Wainer, 51 +2019 to present — Executive Vice President, Rapid and Molecular Diagnostics. +2015 to 2019 — Vice President, Molecular Diagnostics. +Elected Corporate Officer — 2015. +Brian B. Yoor, 50 +2017 to present — Executive Vice President, Finance and Chief Financial Officer. +2015 to 2017 — Senior Vice President, Finance and Chief Financial Officer. +2013 to 2015 — Vice President, Investor Relations. +Elected Corporate Officer — 2013. +Roger M. Bird, 63 +2015 to present — Senior Vice President, U.S. Nutrition. +2009 to 2015 — Divisional Vice President and General Manager, China and Hong Kong, Nutritional Products. +Elected Corporate Officer — 2015. +Charles R. Brynelsen, 63 +2017 to present — Senior Vice President, Abbott Vascular. +2016 to 2017 — Managing Director, CB Business Advisors, Inc. (a medical device consulting firm). +2015 to 2016 — Senior Vice President and President, Medtronic Early Technologies, Medtronic plc (a global medical device company). +2013 to 2015 — President, Early Technologies, Covidien plc (a global healthcare products company). +Elected Corporate Officer — 2017. +16 +Jaime Contreras, 63 +2013 to present — Senior Vice President, Core Laboratory Diagnostics, Commercial Operations. +Elected Corporate Officer — 2003. +Michael D. Dale, 60 +2019 to present — Senior Vice President, Structural Heart. +2017 to 2019 — Vice President, Structural Heart. +2016 to 2017 — Divisional Vice President and General Manager, Structural Heart. +2014 to 2016 — President and Chief Executive Officer, GI Dynamics, Inc. (a medical device company focused on developing gastrointestinal therapies). +Elected Corporate Officer — 2017. +Robert E. Funck, Jr., 58 +2018 to present — Senior Vice President, Finance and Controller. +2013 to 2018 — Vice President, Controller. +Elected Corporate Officer — 2005. +Sammy Karam, 58 +2019 to present — Senior Vice President, Established Pharmaceuticals, Emerging Markets. +2014 to 2019 — Divisional Vice President, Global Marketing Commercial Execution, Established Pharmaceuticals. +Elected Corporate Officer — 2019. +Joseph Manning, 51 +2017 to present — Senior Vice President, International Nutrition. +2015 to 2017 — Vice President, Nutrition, Asia Pacific. +2014 to 2015 — General Manager, Indonesia, Nutritional Products. +Elected Corporate Officer — 2015. +Michael J. Pederson, 58 +2019 to present — Senior Vice President, Electrophysiology and Heart Failure. +2017 to 2019 — Senior Vice President, Cardiac Arrhythmias and Heart Failure. +2015 to 2017 — Divisional Vice President and General Manager, Abbott Electrophysiology. +2011 to 2015 — Chief Executive Officer, VytronUS, Inc. (a medical device company focused on developing electrophysiology technologies). +Elected Corporate Officer — 2017. +Christopher J. Scoggins, 50 +2019 to present — Senior Vice President, Rapid Diagnostics. +2015 to 2019 — Vice President, Diabetes Care, Commercial Operations. +2011 to 2015 — Divisional Vice President, EMEA Commercial Operations, ADC. +Elected Corporate Officer — 2015. +17 +Jared L. Watkin, 52 +2015 to present — Senior Vice President, Diabetes Care. +2010 to 2015 — Divisional Vice President, Technical Operations, Diabetes Care. +Elected Corporate Officer — 2015. +Alejandro D. Wellisch, 45 +2017 to present — Senior Vice President, Established Pharmaceuticals, Latin America. +2014 to 2017 — General Manager, Argentina, Bolivia, Paraguay and Uruguay, Established Pharmaceuticals. +Elected Corporate Officer — 2017. +Randel W. Woodgrift, 58 +2019 to present — Senior Vice President, CRM. +2017 to 2019 — Vice President, Global Operations, Cardiovascular and Neuromodulation. +2015 to 2017 — Vice President, Operations and R&D, Abbott Vascular. +Elected Corporate Officer — 2015. +​ +18 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Principal Market +The principal market for Abbott’s common shares is the New York Stock Exchange under the symbol “ABT.” Shares are also listed on the Chicago Stock Exchange and traded on various regional and electronic exchanges. Outside the United States, Abbott’s shares are listed on the SIX Swiss Exchange. +Shareholders +There were 38,990 shareholders of record of Abbott common shares as of December 31, 2019. +Tax Information for Shareholders +In 2001, the Illinois Department of Commerce and Economic Opportunity designated Abbott as an Illinois High Impact Business (HIB) for a period not to exceed twenty years. Dividends paid by a corporation that is designated as a HIB and conducts business in a foreign trade zone may be eligible for a subtraction from base income for Illinois income tax purposes. Abbott certified that the HIB requirements were met for the calendar year ending December 31, 2019. +If you have any questions, please contact your tax advisor. +Issuer Purchases of Equity Securities +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(c) Total Number of +(d) Maximum Number (or +​ +​ +(a) Total Number +​ +​ +​ +​ +Shares (or Units) +​ +Approximate Dollar Value) of +​ +​ +of Shares +​ +(b) Average Price +​ +Purchased as Part of +​ +Shares (or Units) that May +​ +​ +(or Units) +​ +Paid per Share +​ +Publicly Announced +​ +Yet Be Purchased Under the +Period +​ +Purchased +​ +(or Unit) +​ +Plans or Programs +​ +Plans or Programs +October 1, 2019 — October 31, 2019 +2,675,000 +(1) +$ +81.950 +2,675,000 +​ +$ +3,576,018,444 +(2) +November 1, 2019 — November 30, 2019 +1,786,605 +(1) +$ +82.928 +1,786,605 +​ +$ +3,427,858,606 +(2) +December 1, 2019 — December 31, 2019 +1,844,839 +(1) +$ +85.440 +1,844,839 +​ +$ +3,270,234,923 +(2) +Total +6,306,444 +(1) +$ +83.248 +6,306,444 +​ +$ +3,270,234,923 +(2) +(1) These shares do not include the shares surrendered to Abbott to satisfy tax withholding obligations in connection with the vesting of restricted stock or restricted stock units. +(2) On September 11, 2014, the board of directors authorized the repurchase of up to $3 billion of its common shares, from time to time (the “2014 Plan”). On October 11, 2019, the board of directors authorized the repurchase of up to $3 billion of Abbott common shares, from time to time (the “2019 Plan”). The 2019 Plan is in addition to the unused portion of the 2014 Plan. +ITEM 6. SELECTED FINANCIAL DATA +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2019 +2018 +2017 +2016 +2015 +Net sales +​ +$ +31,904 +​ +$ +30,578 +​ +$ +27,390 +​ +$ +20,853 +​ +$ +20,405 +Earnings from continuing operations +​ +3,687 +​ +2,334 +​ +353 +​ +1,063 +​ +2,606 +Net earnings +​ +3,687 +​ +2,368 +​ +477 +​ +1,400 +​ +4,423 +Basic earnings per common share from continuing operations +​ +2.07 +​ +1.32 +​ +0.20 +​ +0.71 +​ +1.73 +Basic earnings per common share +​ +2.07 +​ +1.34 +​ +0.27 +​ +0.94 +​ +2.94 +Diluted earnings per common share from continuing operations +​ +2.06 +​ +1.31 +​ +0.20 +​ +0.71 +​ +1.72 +Diluted earnings per common share +​ +2.06 +​ +1.33 +​ +0.27 +​ +0.94 +​ +2.92 +Total assets +​ +67,887 +​ +67,173 +​ +76,250 +​ +52,666 +​ +41,247 +Long‑term debt, including current portion +​ +17,938 +​ +19,366 +​ +27,718 +​ +20,684 +​ +5,874 +Cash dividends declared per common share +​ +1.32 +​ +1.16 +​ +1.075 +​ +1.045 +​ +0.98 +​ +​ +​ +19 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Financial Review +Abbott’s revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent protection and licenses, technological and performance features, and inclusion of Abbott’s products under a contract most impact which products are sold; price controls, competition and rebates most impact the net selling prices of products; and foreign currency translation impacts the measurement of net sales and costs. Abbott’s primary products are medical devices, diagnostic testing products, nutritional products and branded generic pharmaceuticals. Sales in international markets comprise approximately 64 percent of consolidated net sales. +Over the last several years, Abbott proactively shaped the company with the strategic intent to deliver sustainable growth in all of its businesses. Significant steps over the last three years included: +● In January 2017, Abbott acquired St. Jude Medical, Inc. (St. Jude Medical), a global medical device manufacturer, for approximately $23.6 billion. As part of the acquisition, Abbott also assumed, repaid or refinanced approximately $5.9 billion of St. Jude Medical’s debt. The acquisition provided expanded opportunities for future growth and is an important part of the company's effort to develop a strong, diverse portfolio. +● In October 2017, Abbott acquired Alere Inc. (Alere), a diagnostic device and service provider, for approximately $4.5 billion. As part of the acquisition, Abbott also tendered for Alere’s preferred shares for a total value of approximately $0.7 billion and assumed and subsequently repaid approximately $3.0 billion of Alere’s debt. The acquisition established Abbott as a leader in point of care testing, expanded Abbott’s global diagnostics presence and provided access to new products, channels and geographies. +● In February 2017, Abbott completed the sale of Abbott Medical Optics (AMO), its vision care business, to Johnson & Johnson for $4.325 billion in cash and recognized an after-tax gain of $728 million. +The increase in total sales over the last three years reflects both volume growth across Abbott’s businesses and the 2017 acquisitions of St. Jude Medical and Alere. Volume growth reflects the introduction of new products as well as higher sales of existing products. Sales in emerging markets, which represent approximately 40 percent of total company sales, increased 8.2 percent in 2019 and 12.3 percent in 2018, excluding the impact of foreign exchange. (Emerging markets include all countries except the United States, Western Europe, Japan, Canada, Australia and New Zealand.) +Over the last three years, Abbott’s operating margin was positively impacted by margin improvements in various businesses, including Established Pharmaceutical Products, Diabetes Care, Rapid Diagnostics, and Structural Heart. A reduction in the costs associated with the recent business acquisitions also drove the improvement in operating margins from 2017 to 2019. In 2019, Abbott’s operating margin increased by approximately 2 percentage points primarily due to lower intangible amortization expense and lower business integration and restructuring costs compared to 2018. In 2018, Abbott’s operating margin increased by approximately 6 percentage points primarily due to operating margin improvement in various businesses and lower inventory step-up amortization and integration costs associated with the acquisitions. +Beginning in the fourth quarter of 2019, the results of the Diabetes Care business, which had previously been included in the non-reportable segment category, were aggregated with the results of the businesses in the Cardiovascular and Neuromodulation segment to comprise the Medical Devices reportable segment. Historic periods have been adjusted to reflect this change. +Excluding the impact of foreign exchange, sales in the Medical Devices segment increased 10.5 percent in 2019 and 9.0 percent in 2018. The sales increase in 2019 was driven primarily by higher Diabetes Care, Structural Heart, Electrophysiology and Heart Failure sales. The sales increase in 2018 was driven primarily by higher Diabetes Care, Structural Heart, Electrophysiology, and Neuromodulation sales. +In 2019, operating earnings for this segment increased 7.7 percent. The operating margin profile increased from 29.2 percent of sales in 2017 to 30.8 percent in 2019 primarily due to sales volume growth and various cost improvement initiatives, partially offset by investment spending to drive the growth of new products. +20 +In 2019, in the Medical Devices segment, product approvals from the U.S. Food and Drug Administration (FDA) included: +● the TactiCath ® contact force ablation catheter, Sensor enabled™, which is designed to help physicians treat atrial fibrillation, a form of irregular heartbeat. +● a new, expanded indication for Abbott’s MitraClip ® heart valve repair device to treat clinically significant secondary mitral regurgitation (MR) as a result of underlying heart failure. This new indication expands the number of people with MR that can be treated with the MitraClip device. +● the next-generation version of the MitraClip device, which includes a new leaflet grasping enhancement, an expanded range of clip sizes and facilitation of procedure assessment in real time to offer doctors further options when treating mitral valve disease. +● the Proclaim XR recharge-free neurostimulation system for people living with chronic pain which works by using low doses of mild electrical pulses to change pain signals as they travel from the spinal cord to the brain. +In March 2019, Abbott announced new data from its MOMENTUM 3 clinical study, the largest randomized controlled trial to assess outcomes in patients receiving a heart pump to treat advanced heart failure, which demonstrated Abbott's HeartMate 3 ® Left Ventricular Assist Device (LVAD) improved survival and clinical outcomes in this patient population. In October 2018, the FDA approved HeartMate 3 as a destination (long-term use) therapy for patients living with advanced heart failure. +In December 2019, Abbott received CE Mark approval in Europe for its next-generation high-voltage implantable cardioverter defibrillator (ICD) and cardiac resynchronization therapy defibrillator (CRT-D) devices. +In January 2020, Abbott received CE Mark approval in Europe for its Tendyne Transcatheter Mitral Valve Implantation system for the treatment of significant MR in patients requiring a heart valve replacement who are not candidates for open-heart surgery or transcatheter mitral valve repair. +In Abbott’s worldwide diagnostics business, sales growth over the last three years reflected the acquisition of Alere in October 2017, as well as continued market penetration by the core laboratory business in the U.S. and internationally. Alere’s results are included in Abbott’s Diagnostic Products reportable segment from the date of acquisition. Worldwide diagnostic sales increased 5.9 percent in 2019 and 33.6 percent in 2018, excluding the impact of foreign exchange. Excluding the impact of the Alere acquisition, as well as the impact of foreign exchange, sales in the Diagnostic Products segment increased 6.5 percent in 2018. The 2019 and 2018 growth includes the continued adoption by customers of Alinity ® , which is Abbott’s integrated family of next-generation diagnostic systems and solutions that are designed to increase efficiency by running more tests in less space, generating test results faster and minimizing human errors while continuing to provide quality results. +Abbott has regulatory approvals in the U.S., Europe, China, and other markets for the “Alinity c” and “Alinity i” instruments and multiple assays for clinical chemistry and immunoassay diagnostics, respectively. Abbott has obtained regulatory approval for the “Alinity h” instrument for hematology in Europe and Japan. In 2019, Abbott continued the roll-out in Europe of its “Alinity s” blood and plasma screening system and received U.S. FDA approval for “Alinity s” and several testing assays. In 2019, Abbott also announced that it had obtained CE Mark for its “Alinity m” (molecular) diagnostics system and several testing assays. +In 2019, operating earnings for the Diagnostics segment increased 2.3 percent. The operating margin profile decreased from 26.1 percent of sales in 2017 to 24.8 percent in 2019 primarily due to dilution from the acquisition of Alere, the negative impact of foreign exchange, and costs to accelerate the roll-out of Alinity, partially offset by the continued focus on cost improvement. +21 +In Abbott’s worldwide nutritional products business, sales over the last three years were positively impacted by numerous new product introductions, including the roll-out of HMO in infant formula, that leveraged Abbott’s strong brands. Sales were also positively affected by demographics such as an aging population and an increasing rate of chronic disease in developed markets and the rise of a middle class in many emerging markets. In 2019, excluding the impact of foreign exchange, total adult nutrition sales increased 6.6 percent led by the continued growth of Ensure ® , Abbott’s market-leading complete and balanced nutrition brand, and Glucerna ® , Abbott’s market-leading diabetes-specific nutrition brand, across several countries, partially offset by the unfavorable impact of the discontinuation of a non-core product line in the U.S. In 2019, excluding the impact of foreign exchange, total pediatric nutrition sales increased 3.4 percent driven by the PediaSure ® and Pedialyte ® brands in the U.S. as well as infant and toddler product growth across several markets in Asia and Latin America, partially offset by challenging conditions in the Greater China market. +In 2018, excluding the impact of foreign exchange, the nutritional business experienced above-market growth in the worldwide pediatric business driven by the Similac ® and Pedialyte brands in the U.S. as well as growth across several markets in Asia. Worldwide, adult nutrition sales increased in 2018 led by the growth of Ensure and Glucerna. +The Established Pharmaceutical Products segment focuses on the sale of its products in emerging markets. Excluding the impact of foreign exchange, Established Pharmaceutical sales increased 7.3 percent in 2019 and 7.0 percent in 2018. The sales increase in 2019 was driven by growth in several geographies including China, Brazil, Russia and India. The sales increase in 2018 was driven by double-digit growth in India and China. Operating margins increased from 19.8 percent of sales in 2017 to 20.1 percent in 2019 primarily due to the continued focus on cost reduction initiatives, partially offset by the unfavorable impact of foreign exchange. +In conjunction with the funding of the St. Jude Medical and Alere acquisitions and the assumption of St. Jude Medical’s and Alere’s existing debt, Abbott’s total short-term and long-term debt increased from approximately $9.0 billion at December 31, 2015 to $27.9 billion at December 31, 2017. In 2018, Abbott repaid approximately $8.3 billion of debt, net of borrowings, bringing its total debt to $19.6 billion at December 31, 2018. In 2019, Abbott repaid approximately $1.6 billion of debt, net of borrowings, bringing its total debt to $18.1 billion at December 31, 2019. +Abbott declared dividends of $1.32 per share in 2019 compared to $1.16 per share in 2018, an increase of approximately 14 percent. Dividends paid totaled $2.270 billion in 2019 compared to $1.974 billion in 2018. The year-over-year change in the amount of dividends paid primarily reflects the increase in the dividend rate. In December 2019, Abbott increased the company’s quarterly dividend by approximately 12.5 percent to $0.36 per share from $0.32 per share, effective with the dividend paid in February 2020. +In 2020, Abbott will focus on continuing to invest in product development areas that provide the opportunity for strong sustainable growth over the next several years. In its diagnostics business, Abbott will continue to focus on driving market adoption and geographic expansion of its Alinity suite of diagnostics instruments. In the medical devices business, Abbott will continue to focus on expanding its market position in various areas including diabetes care, structural heart, electrophysiology, and heart failure. In its nutritionals business, Abbott will continue to focus on driving growth globally and further enhancing its portfolio with the introduction of several new science-based products. In the established pharmaceuticals business, Abbott will continue to focus on growing its business with the depth and breadth of its portfolio in emerging markets. +22 +Critical Accounting Policies +Sales Rebates — In 2019, approximately 44 percent of Abbott’s consolidated gross revenues were subject to various forms of rebates and allowances that Abbott recorded as reductions of revenues at the time of sale. Most of these rebates and allowances in 2019 are in the Nutritional Products and Diabetes Care businesses. Abbott provides rebates to state agencies that administer the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC), wholesalers, group purchasing organizations, and other government agencies and private entities. Rebate amounts are usually based upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of which products have been sold subject to a rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current changes, Abbott estimates the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate generally occurs from one to six months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. Rebates and chargebacks charged against gross sales in 2019, 2018 and 2017 amounted to approximately $3.1 billion, $3.0 billion and $2.8 billion, respectively, or 19.1 percent, 19.0 percent and 20.5 percent of gross sales, respectively, based on gross sales of approximately $16.3 billion, $16.0 billion and $13.9 billion, respectively, subject to rebate. A one-percentage point increase in the percentage of rebates to related gross sales would decrease net sales by approximately $163 million in 2019. Abbott considers a one-percentage point increase to be a reasonably likely increase in the percentage of rebates to related gross sales. Other allowances charged against gross sales were approximately $169 million, $175 million and $166 million for cash discounts in 2019, 2018 and 2017, respectively, and $192 million, $191 million and $204 million for returns in 2019, 2018 and 2017, respectively. Cash discounts are known within 15 to 30 days of sale, and therefore can be reliably estimated. Returns can be reliably estimated because Abbott’s historical returns are low, and because sales returns terms and other sales terms have remained relatively unchanged for several periods. +Management analyzes the adequacy of ending rebate accrual balances each quarter. In the domestic nutritional business, management uses both internal and external data available to estimate the accruals. In the WIC business, estimates are required for the amount of WIC sales within each state where Abbott holds the WIC contract. The state where the sale is made, which is the determining factor for the applicable rebated price, is reliably determinable. Rebated prices are based on contractually obligated agreements generally lasting a period of two to four years. Except for a change in contract price or a transition period before or after a change in the supplier for the WIC business in a state, accruals are based on historical redemption rates and data from the U.S. Department of Agriculture (USDA) and the states submitting rebate claims. The USDA, which administers the WIC program, has been making its data available for many years. Management also estimates the states' processing lag time based on sales and claims data. Inventory in the retail distribution channel does not vary substantially. Management has access to several large customers' inventory management data, which allows management to make reliable estimates of inventory in the retail distribution channel. At December 31, 2019, Abbott had WIC business in 26 states. +Historically, adjustments to prior years’ rebate accruals have not been material to net income. Abbott employs various techniques to verify the accuracy of claims submitted to it, and where possible, works with the organizations submitting claims to gain insight into changes that might affect the rebate amounts. For government agency programs, the calculation of a rebate involves interpretations of relevant regulations, which are subject to challenge or change in interpretation. +Income Taxes — Abbott operates in numerous countries where its income tax returns are subject to audits and adjustments. Because Abbott operates globally, the nature of the audit items is often very complex, and the objectives of the government auditors can result in a tax on the same income in more than one country. Abbott employs internal and external tax professionals to minimize audit adjustment amounts where possible. In accordance with the accounting rules relating to the measurement of tax contingencies, in order to recognize an uncertain tax benefit, the taxpayer must be more likely than not of sustaining the position, and the measurement of the benefit is calculated as the largest amount that is more than 50 percent likely to be realized upon resolution of the benefit. Application of these rules requires a significant amount of judgment. In the U.S., Abbott’s federal income tax returns through 2016 are settled except for the federal income tax returns of the former Alere consolidated group which are settled through 2015 and the former St. Jude Medical consolidated group which are settled through 2013. Undistributed foreign earnings remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in its foreign entities is not practicable. +23 +Pension and Post-Employment Benefits — Abbott offers pension benefits and post-employment health care to many of its employees. Abbott engages outside actuaries to assist in the determination of the obligations and costs under these programs. Abbott must develop long-term assumptions, the most significant of which are the health care cost trend rates, discount rates and the expected return on plan assets. The discount rates used to measure liabilities were determined based on high-quality fixed income securities that match the duration of the expected retiree benefits. The health care cost trend rates represent Abbott’s expected annual rates of change in the cost of health care benefits and are a forward projection of health care costs as of the measurement date. A difference between the assumed rates and the actual rates, which will not be known for years, can be significant in relation to the obligations and the annual cost recorded for these programs. Low interest rates have significantly increased actuarial losses for these plans. At December 31, 2019, pretax net actuarial losses and prior service costs and (credits) recognized in Accumulated other comprehensive income (loss) for Abbott’s defined benefit plans and medical and dental plans were losses of $4.1 billion and $434 million, respectively. Actuarial losses and gains are amortized over the remaining service attribution periods of the employees under the corridor method, in accordance with the rules for accounting for post-employment benefits. Differences between the expected long-term return on plan assets and the actual annual return are amortized over a five-year period. Note 15 to the consolidated financial statements describes the impact of a one-percentage point change in the health care cost trend rate; however, there can be no certainty that a change would be limited to only one percentage point. +Valuation of Intangible Assets — Abbott has acquired and continues to acquire significant intangible assets that Abbott records at fair value at the acquisition date. Transactions involving the purchase or sale of intangible assets occur with some frequency between companies in the health care field and valuations are usually based on a discounted cash flow analysis. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, cost of capital, terminal values and market participants. Each of these factors can significantly affect the value of the intangible asset. Abbott engages independent valuation experts who review Abbott’s critical assumptions and calculations for acquisitions of significant intangibles. Abbott reviews definite-lived intangible assets for impairment each quarter using an undiscounted net cash flows approach. If the undiscounted cash flows of an intangible asset are less than the carrying value of an intangible asset, the intangible asset is written down to its fair value, which is usually the discounted cash flow amount. Where cash flows cannot be identified for an individual asset, the review is applied at the lowest group level for which cash flows are identifiable. Goodwill and indefinite-lived intangible assets, which relate to in-process research and development acquired in a business combination, are reviewed for impairment annually or when an event that could result in impairment occurs. At December 31, 2019, goodwill amounted to $23.2 billion and net intangibles amounted to $17.0 billion. Amortization expense in continuing operations for intangible assets amounted to $1.9 billion in 2019, $2.2 billion in 2018 and $2.0 billion in 2017. There was no significant reduction of goodwill relating to impairments in 2019, 2018 and 2017. +Litigation — Abbott accounts for litigation losses in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) No. 450, “Contingencies.” Under ASC No. 450, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period as additional information becomes known. Accordingly, Abbott is often initially unable to develop a best estimate of loss, and therefore the minimum amount, which could be zero, is recorded. As information becomes known, either the minimum loss amount is increased, resulting in additional loss provisions, or a best estimate can be made, also resulting in additional loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected. Abbott estimates the range of possible loss to be from approximately $95 million to $130 million for its legal proceedings and environmental exposures. Accruals of approximately $110 million have been recorded at December 31, 2019 for these proceedings and exposures. These accruals represent management’s best estimate of probable loss, as defined by FASB ASC No. 450, “Contingencies.” +24 +Results of Operations +Sales +The following table details the components of sales growth by reportable segment for the last two years: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Components of % Change +​ +​ +Business +​ +​ +​ +​ +​ +Total +​ +Acquisitions/ +​ +​ +​ +​ +​ +​ +​ +​ +% Change +Divestitures +​ +Price +​ +Volume +​ +Exchange +Total Net Sales +2019 vs. 2018 +4.3 +— +0.2 +7.3 +(3.2) +2018 vs. 2017 +11.6 +4.9 +(1.0) +8.1 +(0.4) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total U.S. +2019 vs. 2018 +5.2 +— +(0.4) +5.6 +— +2018 vs. 2017 +12.1 +8.0 +(1.1) +5.2 +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total International +2019 vs. 2018 +3.9 +— +0.5 +8.3 +(4.9) +2018 vs. 2017 +11.4 +3.2 +(1.0) +9.7 +(0.5) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Established Pharmaceutical Products Segment +2019 vs. 2018 +1.4 +— +3.0 +4.3 +(5.9) +2018 vs. 2017 +3.2 +— +2.2 +4.8 +(3.8) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritional Products Segment +2019 vs. 2018 +2.5 +— +0.9 +3.9 +(2.3) +2018 vs. 2017 +4.4 +— +0.2 +4.7 +(0.5) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostic Products Segment +2019 vs. 2018 +2.9 +— +(0.5) +6.4 +(3.0) +2018 vs. 2017 +33.5 +27.1 +(2.0) +8.5 +(0.1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices Segment +2019 vs. 2018 +7.6 +— +(0.9) +11.4 +(2.9) +2018 vs. 2017 +10.1 +— +(2.7) +11.7 +1.1 +Note: +Diabetes Care sales, which had previously been reported in Other, are now included in the Medical Devices segment. Historic periods have been adjusted to reflect this change. +The increase in Total Net Sales in 2019 reflects volume growth across all of Abbott’s segments. The increase in Total Net Sales in 2018 reflects the acquisition of Alere, as well as volume growth across all of Abbott’s segments. The price declines related to the Medical Devices segment in 2019 and 2018 primarily reflect pricing pressures on drug eluting stents (DES) as a result of market competition in the U.S. and other major markets. +25 +A comparison of significant product and product group sales is as follows. Percent changes are versus the prior year and are based on unrounded numbers. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +​ +​ +​ +​ +​ +​ +Total +Impact of +Change +​ +(dollars in millions) +​ +2019 +​ +​ +2018 +​ +Change +​ +Exchange +Excl. Exchange +​ +Total Established Pharmaceuticals — +​ +​ +​ +​ +​ +Key Emerging Markets +​ +$ +3,392 +​ +$ +3,363 +1 +% +(7) +% +8 +% +Other +​ +1,094 +​ +​ +1,059 +3 +(3) +6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritionals — +​ +​ +​ +​ +​ +​ +​ +​ +​ +International Pediatric Nutritionals +​ +2,282 +​ +​ +2,254 +1 +(4) +5 +​ +U.S. Pediatric Nutritionals +​ +1,879 +​ +​ +1,843 +2 +— +2 +​ +International Adult Nutritionals +​ +2,017 +​ +​ +1,900 +6 +(5) +11 +​ +U.S. Adult Nutritionals +​ +1,231 +​ +​ +1,232 +— +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostics — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Core Laboratory +​ +4,656 +​ +​ +4,386 +6 +(4) +10 +​ +Molecular +​ +442 +​ +​ +484 +(9) +(3) +(6) +​ +Point of Care +​ +561 +​ +​ +553 +2 +— +2 +​ +Rapid Diagnostics +​ +2,054 +​ +​ +2,072 +(1) +(2) +1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rhythm Management +​ +2,144 +​ +​ +2,198 +(3) +(3) +— +​ +Electrophysiology +​ +1,721 +​ +​ +1,561 +10 +(3) +13 +​ +Heart Failure +​ +769 +​ +​ +646 +19 +(1) +20 +​ +Vascular (a) +​ +2,850 +​ +​ +2,929 +(3) +(3) +— +​ +Structural Heart +​ +1,400 +​ +​ +1,239 +13 +(3) +16 +​ +Neuromodulation +​ +​ +831 +​ +​ +864 +​ +(4) +​ +(2) +​ +(2) +​ +Diabetes Care +​ +​ +2,524 +​ +​ +1,933 +​ +31 +​ +(5) +​ +36 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Vascular Product Lines: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Coronary and Endovascular +​ +2,740 +​ +​ +2,778 +(1) +(2) +1 +​ +​ +​ +26 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +Impact of +​ +Change +(dollars in millions) +​ +2018 +​ +2017 +​ +Change +​ +Exchange +​ +Excl. Exchange +Total Established Pharmaceuticals — +​ +​ +​ +​ +​ +Key Emerging Markets +​ +$ +3,363 +​ +$ +3,307 +2 +% +(5) +% +7 +% +Other +​ +1,059 +​ +​ +980 +8 +2 +6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritionals — +​ +​ +​ +​ +​ +International Pediatric Nutritionals +​ +2,254 +​ +​ +2,112 +7 +— +7 +​ +U.S. Pediatric Nutritionals +​ +1,843 +​ +​ +1,777 +4 +— +4 +​ +International Adult Nutritionals +​ +1,900 +​ +​ +1,782 +7 +(1) +8 +​ +U.S. Adult Nutritionals +​ +1,232 +​ +​ +1,254 +(2) +— +(2) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostics — +​ +​ +​ +​ +​ +Core Laboratory +​ +4,386 +​ +​ +4,063 +8 +— +8 +​ +Molecular +​ +484 +​ +​ +463 +5 +1 +4 +​ +Point of Care +​ +553 +​ +​ +550 +— +— +— +​ +Rapid Diagnostics +​ +2,072 +​ +​ +540 +n/m +n/m +n/m +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices — +​ +​ +​ +​ +​ +Rhythm Management +​ +2,198 +​ +​ +2,132 +3 +1 +2 +​ +Electrophysiology +​ +1,561 +​ +​ +1,353 +15 +1 +14 +​ +Heart Failure +​ +646 +​ +​ +643 +— +— +— +​ +Vascular (a) +​ +2,929 +​ +​ +2,892 +1 +1 +— +​ +Structural Heart +​ +1,239 +​ +​ +1,083 +14 +1 +13 +​ +Neuromodulation +​ +​ +864 +​ +​ +808 +​ +7 +​ +— +​ +7 +​ +Diabetes Care +​ +​ +1,933 +​ +​ +1,414 +​ +37 +​ +2 +​ +35 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Vascular Product Lines: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Coronary and Endovascular +​ +2,778 +​ +​ +2,727 +2 +1 +1 +​ +n/m = percent change is not meaningful. +Note: +Insertable Cardiac Monitor (ICM) sales, which had previously been reported in Electrophysiology, are now included in Rhythm Management. Historic periods have been adjusted to reflect this change. +In order to compute results excluding the impact of exchange rates, current year U.S. dollar sales are multiplied or divided, as appropriate, by the current year average foreign exchange rates and then those amounts are multiplied or divided, as appropriate, by the prior year average foreign exchange rates. +Total Established Pharmaceutical Products sales increased 7.3 percent in 2019 and 7.0 percent in 2018, excluding the unfavorable impact of foreign exchange. The Established Pharmaceutical Products segment is focused on several key emerging markets including India, Russia, China and Brazil. Excluding the impact of foreign exchange, total sales in these key emerging markets increased 7.9 percent in 2019 due to growth in several geographies including China, Brazil, Russia and India. In 2018, excluding the impact of foreign exchange, total sales in these key emerging markets increased 7.4 percent as sales in India and China experienced double-digit growth. Excluding the impact of foreign exchange, sales in Established Pharmaceuticals’ other emerging markets increased 5.6 percent in 2019 and 5.8 percent in 2018. +Total Nutritional Products sales increased 4.8 percent in 2019 and 4.9 percent in 2018, excluding the impact of foreign exchange. In 2019, the 4.6 percent increase in International Pediatric Nutritional sales, excluding the effect of foreign exchange, was driven by growth across Abbott’s portfolio, including Similac and PediaSure in various countries in Asia and Latin America and Pedialyte in Latin America. This growth was partially offset by challenging market dynamics in the Greater China infant category. The 7.2 percent increase in 2018 International Pediatric Nutritional sales, excluding the effect of foreign exchange, was driven primarily by growth in Asia and Latin America. In the U.S. Pediatric Nutritional business, the 1.9 percent increase in 2019 sales reflects growth in Pedialyte and PediaSure. 2018 U.S. Pediatric Nutritional sales increased 3.7 percent primarily due to above-market performance in Abbott’s infant and toddler brands, including Similac and Pedialyte. +27 +In the International Adult Nutritional business, the 10.9 percent increase in 2019 sales, excluding the effect of foreign exchange, reflects continued growth of Ensure, Abbott’s market-leading complete and balanced nutrition brand, and Glucerna, Abbott’s market-leading diabetes-specific nutrition brand in several countries. In 2018, the 8.0 percent sales increase in the International Adult Nutritional business, excluding the effect of foreign exchange, was led by growth of Ensure and Glucerna in Asia and Latin America. In 2019, U.S. Adult Nutritional sales were unchanged from 2018 due to the impact of Abbott’s discontinuation of a non-core product line during the third quarter of 2018 that was offset by growth in other areas of the business. In 2018, the 1.7 percent decrease in U.S. Adult Nutritional was also primarily driven by the wind down of this non-core product line. +Total Diagnostic Products sales increased 5.9 percent in 2019 and 33.6 percent in 2018, excluding the impact of foreign exchange. The sales increase in 2019 was driven by above-market growth in Core Laboratory in the U.S. and internationally, where Abbott is achieving continued adoption of its Alinity family of diagnostic instruments. In July 2019, Abbott received U.S. FDA approval for its “Alinity s” blood and plasma screening system and several testing assays. The 6.3 percent decrease in 2019 Molecular sales, excluding the effect of foreign exchange, reflects the negative impact of lower non-governmental organization purchases in Africa. In March 2019, Abbott announced that it obtained CE Mark for its “Alinity m” molecular diagnostics system and several testing assays. In Rapid Diagnostics, sales growth in 2019 in various areas, including infectious disease testing in developed markets and cardio-metabolic testing, was mostly offset by lower than expected infectious disease testing sales in Africa. +In 2018, the increase in total Diagnostic Products sales included the acquisition of Alere, which was completed on October 3, 2017. Excluding the impact of the acquisition, as well as the impact of foreign exchange, sales in the Diagnostic Products segment in 2018 increased 6.5 percent. The 2018 increase in sales was primarily driven by above-market growth in Core Laboratory in the U.S. and internationally. In 2018, Abbott accelerated the roll out of its Alinity systems for Core Laboratory in Europe. +Excluding the effect of foreign exchange, total Medical Devices sales grew 10.5 percent and 9.0 percent in 2019 and 2018, respectively. The 2019 sales increase was driven by double-digit growth in Diabetes Care, Structural Heart, Electrophysiology and Heart Failure. The 2018 sales increase was driven by growth in several areas, including double-digit growth in Diabetes Care, Electrophysiology and Structural Heart. +The 2019 and 2018 growth in Diabetes Care revenue was driven by continued growth of FreeStyle Libre, Abbott’s continuous glucose monitoring system, internationally and in the U.S. In 2019, Freestyle Libre sales totaled $1.842 billion, which reflected a 69.8 percent increase over 2018 sales, excluding the effect of foreign exchange. In July 2018, Abbott received U.S. FDA approval of its FreeStyle Libre 14 day sensor, making it the longest lasting wearable glucose sensor available. In October 2018, Abbott obtained CE Mark for its Freestyle Libre 2 system, a next-generation product offering with optional real-time alarms. +The 2019 growth in Structural Heart revenue was broad-based across several areas of the business, including MitraClip, Abbott's market-leading device for the minimally invasive treatment of mitral regurgitation (MR), a leaky heart valve. During the first quarter of 2019, Abbott received U.S. FDA approval for a new, expanded indication for MitraClip to treat clinically significant secondary MR as a result of underlying heart failure. This new indication expands the number of people with MR that can be treated with the MitraClip device. In July 2019, Abbott received U.S. FDA approval of the next generation of its MitraClip device, which includes a new leaflet grasping enhancement, an expanded range of clip sizes and facilitation of procedure assessment in real time to offer doctors further options when treating mitral valve disease. In 2018, growth in Structural Heart was driven by several product areas including MitraClip and the AMPLATZER ® PFO occluder, a device designed to close a hole-like opening in the heart. In September 2018, Abbott announced positive clinical results from its COAPT study, which demonstrated that MitraClip improved survival and clinical outcomes for select patients with functional MR. In September 2019, Abbott announced additional data from its COAPT trial that shows that MitraClip is projected to increase life expectancy and quality of life compared to guideline-directed medical therapy alone in heart failure patients with secondary MR. +In 2019, the growth in Electrophysiology revenue reflects higher sales of cardiac diagnostic and ablation catheters in both the U.S. and internationally. In January 2019, Abbott announced U.S. FDA approval of its TactiCath ® contact force ablation catheter, Sensor Enabled™, which is designed to help physicians treat atrial fibrillation, a form of irregular heartbeat. In 2018, the growth in Electrophysiology was led by higher sales in cardiac mapping and ablation catheters. In May 2018, Abbott announced U.S. FDA clearance of the Advisor HD Grid Mapping Catheter, Sensor Enabled, which creates detailed maps of the heart and expands Abbott's electrophysiology product portfolio. +28 +In 2019, the growth in Heart Failure revenue was driven by rapid market adoption in the U.S. of Abbott's HeartMate 3 ® Left Ventricular Assist Device (LVAD) following FDA approval in October 2018 as a destination (long-term use) therapy for people living with advanced heart failure as well as higher sales of Abbott’s CardioMEMS ® heart failure monitoring system. In March 2019, Abbott announced new data from its MOMENTUM 3 clinical study, the largest randomized controlled trial to assess outcomes in patients receiving a heart pump to treat advanced heart failure, which demonstrated HeartMate 3 improved survival and clinical outcomes in this patient population. In 2018, growth in international Heart Failure sales was offset by lower U.S. sales. +In Vascular, excluding the effect of foreign exchange, sales in 2019 were flat as the 1.3 percent increase in coronary and endovascular product sales, which includes drug-eluting stents, balloon catheters, guidewires, vascular imaging/diagnostics products, vessel closure, carotid and other coronary and peripheral products, was offset by reductions in royalty and contract manufacturing revenue. In 2018, growth in Vascular imaging, vessel closure and other endovascular revenues was partially offset by lower DES sales due to lower U.S. market share and price erosion in various markets. During the second quarter of 2018, Abbott received approval from the U.S. FDA for the XIENCE Sierra Drug Eluting Stent System, the newest generation of its coronary stent system. During the second quarter of 2018, the XIENCE Sierra Drug Eluting Stent System also received national reimbursement in Japan to treat people with coronary artery disease. +In Rhythm Management, higher 2019 international sales, excluding the effect of foreign exchange, were offset by a 4.4 percent decrease in U.S. revenue. In 2018, market share gains in the new patient segment for Rhythm Management and the U.S. launch of Abbott’s Confirm Rx ® Insertable Cardiac Monitor (ICM), the world’s first and only smartphone-compatible ICM designed to help physicians remotely identify cardiac arrhythmias, were partially offset by replacement cycle dynamics. +In 2019, the 2.4 percent decline in Neuromodulation sales, excluding the effect of foreign exchange, reflects a 4.2 percent decline in U.S. sales. In 2018, the growth in Neuromodulation reflects higher revenue for various products for the treatment of chronic pain and movement disorders. +Abbott has periodically sold product rights to non-strategic products and has recorded the related gains in net sales in accordance with Abbott’s revenue recognition policies as discussed in Note 1 to the consolidated financial statements. Related net sales were not significant in 2019, 2018 and 2017. +The expiration of licenses and patent protection can affect the future revenues and operating income of Abbott. There are no significant patent or license expirations in the next three years that are expected to materially affect Abbott. +In April 2017, Abbott received a warning letter from the U.S. FDA related to its manufacturing facility in Sylmar, CA which was acquired by Abbott on January 4, 2017 as part of the acquisition of St. Jude Medical. This facility manufactures implantable cardioverter defibrillators, cardiac resynchronization therapy defibrillators, and monitors. The warning letter relates to the FDA’s observations from an inspection of this facility. Abbott has prepared a comprehensive plan of corrective actions which has been provided to the FDA. Abbott is continuing to execute the corrective actions in the plan. +Operating Earnings +Gross profit margins were 52.5 percent of net sales in 2019, 51.3 percent in 2018 and 47.5 percent in 2017. In 2019, the increase primarily reflects lower intangible amortization expense and lower integration and restructuring costs. In 2018, the increase primarily reflects lower inventory step-up amortization related to the St. Jude Medical and Alere acquisitions and margin improvements in various businesses. +Research and development (R&D) expense was $2.4 billion in 2019, $2.3 billion in 2018, and $2.3 billion in 2017 and represented a 6.1 percent increase in 2019, and a 1.7 percent increase in 2018. The increase in R&D spending in 2019 primarily reflects higher spending on the acquisition of R&D assets which were immediately expensed. In 2019, spending on R&D assets totaled $116 million and included the acquisition of an R&D asset valued at $102 million that was acquired in conjunction with the acquisition of Cephea Valve Technologies, Inc. In 2018, Abbott acquired R&D assets valued at $47 million which were also immediately expensed. The 2019 increase in R&D expense was also driven by higher R&D spending in various businesses, primarily in Medical Devices, partially offset by the favorable effect of foreign exchange. The 2018 increase in R&D expenses was primarily due to higher spending on various projects, partially offset by lower restructuring and integration costs. In 2019, R&D expenditures totaled $1.2 billion for the Medical Devices segment, $553 million for the Diagnostic Products segment, $193 million for the Nutritional Products segment and $185 million for the Established Pharmaceutical Products segment. +29 +Selling, general and administrative (SG&A) expenses were basically flat in 2019 and increased 6.1 percent in 2018 versus the respective prior year. In 2019, the favorable effect of foreign exchange and lower acquisition-related integration costs offset higher selling and marketing costs to drive continued growth across various businesses. The 2018 increase was primarily due to the impact of the acquisition of the Alere business in October 2017, as well as higher spending to drive continued growth and market expansion in various businesses, partially offset by lower acquisition-related expenses. +Business Acquisitions +On January 4, 2017, Abbott completed the acquisition of St. Jude Medical, a global medical device manufacturer, for approximately $23.6 billion, including approximately $13.6 billion in cash and approximately $10 billion in Abbott common shares, which represented approximately 254 million shares of Abbott common stock, based on Abbott’s closing stock price on the acquisition date. The cash portion of the acquisition was funded through a combination of medium and long-term debt issued in November 2016 and a $2.0 billion 120-day senior unsecured bridge term loan facility which was subsequently repaid. As part of the acquisition, approximately $5.9 billion of St. Jude Medical’s debt was assumed, repaid or refinanced by Abbott. The acquisition provides expanded opportunities for future growth and is an important part of the company's ongoing effort to develop a strong, diverse portfolio of devices, diagnostics, nutritionals and branded generic pharmaceuticals. The combined business competes in nearly every area of the cardiovascular device market, as well as in the neuromodulation market. +In 2016, Abbott and St. Jude Medical agreed to sell certain businesses to Terumo Corporation for approximately $1.12 billion. The sale included the St. Jude Medical Angio-Seal™ and Femoseal™ vascular closure and Abbott’s Vado ® Steerable Sheath businesses. The sale closed on January 20, 2017 and no gain or loss was recorded in the Consolidated Statement of Earnings. +On October 3, 2017, Abbott acquired Alere, a diagnostic device and service provider, for $51.00 per common share in cash, which equated to a purchase price of approximately $4.5 billion. As part of the acquisition, Abbott tendered for Alere’s preferred shares for a total value of approximately $0.7 billion. In addition, approximately $3.0 billion of Alere’s debt was assumed and subsequently repaid. The acquisition establishes Abbott as a leader in point of care testing, expands Abbott’s global diagnostics presence and provides access to new products, channels and geographies. Abbott utilized a combination of cash on hand and debt to fund the acquisition. See Note 11 — Debt and Lines of Credit for further details regarding the debt utilized for the acquisition. +In the third quarter of 2017, Alere entered into agreements to sell its Triage MeterPro cardiovascular and toxicology business and the assets and liabilities related to its B-type Natriuretic Peptide assay business run on Beckman Coulter analyzers to Quidel Corporation (Quidel). The transactions with Quidel reflect a total purchase price of $400 million payable at the close of the transaction, $240 million payable in six annual installments beginning approximately six months after the close of the transaction, and contingent consideration with a maximum value of $40 million. In the third quarter of 2017, Alere entered into an agreement with Siemens Diagnostics Holding II B.V. (Siemens) to sell its subsidiary, Epocal Inc., for approximately $200 million payable at the close of the transaction. Alere agreed to divest these businesses in connection with the review by the Federal Trade Commission and the European Commission of Abbott’s agreement to acquire Alere. The sale to Quidel closed on October 6, 2017, and the sale to Siemens closed on October 31, 2017. No gain or loss on these sales was recorded in the Consolidated Statement of Earnings. +On July 17, 2017, Abbott commenced a tender offer to purchase for cash the 1.77 million outstanding shares of Alere’s Series B Convertible Perpetual Preferred Stock at a price of $402 per share, plus accrued but unpaid dividends to, but not including, the settlement date of the tender offer. This tender offer was subject to the satisfaction of certain conditions, including Abbott’s acquisition of Alere and upon there being validly tendered (and not properly withdrawn) at the expiration date of the tender offer that number of shares of Preferred Stock that equaled at least a majority of the Preferred Stock issued and outstanding at the expiration of the tender offer. All conditions to the offer were satisfied and Abbott accepted for payment the 1.748 million shares of Preferred Stock that were validly tendered (and not properly withdrawn). The remaining shares were cashed out for an amount equal to the $400.00 per share liquidation preference of such shares, plus accrued but unpaid dividends, without interest. Payment for all of the shares of Preferred Stock was made in the fourth quarter of 2017. +30 +Restructurings +From 2017 to 2019, Abbott management approved restructuring plans as part of the integration of the acquisitions of St. Jude Medical into the Medical Devices segment, and Alere into the Diagnostic Products segment, in order to leverage economies of scale and reduce costs. Abbott recorded employee related severance and other charges of approximately $72 million in 2019, $52 million in 2018 and $187 million in 2017. Approximately $19 million in 2019, $5 million in 2018 and $5 million in 2017 are recorded in Cost of products sold, approximately $4 million in 2019 and $10 million in 2018 are recorded in Research and development, and approximately $49 million in 2019, $37 million in 2018 and $182 million in 2017 are recorded in Selling, general and administrative expense. Abbott also assumed restructuring liabilities of approximately $23 million as part of the St Jude Medical and Alere acquisitions. +From 2016 to 2019, Abbott management approved plans to streamline operations in order to reduce costs and improve efficiencies in various Abbott businesses including the nutritional, established pharmaceuticals and vascular businesses. Abbott recorded employee related severance and other charges of approximately $66 million in 2019, $28 million in 2018 and $120 million in 2017. Approximately $16 million in 2019, $10 million in 2018 and $7 million in 2017 are recorded in Cost of products sold, approximately $28 million in 2019, $2 million in 2018 and $77 million in 2017 are recorded in Research and development, and approximately $22 million in 2019, $16 million in 2018 and $36 million in 2017 are recorded in Selling, general and administrative expense. Additional charges of approximately $2 million in 2017 were recorded, primarily for accelerated depreciation. +Interest Expense and Interest (Income) +Interest expense decreased $156 million in 2019 due to the favorable impact of the euro debt financing in September 2018, as well as the repayment of debt in 2018 and the first quarter of 2019. In 2018, interest expense decreased primarily due to the net repayment of $8.3 billion of debt, partially offset by lower interest income due to lower cash balances. In 2017, interest expense increased primarily due to the $15.1 billion of debt issued in November of 2016 related to the financing of the St. Jude Medical acquisition which closed on January 4, 2017. +Debt Extinguishment Costs +On December 19, 2019, Abbott redeemed the $2.850 billion principal amount of its 2.9% Notes due 2021. Abbott incurred a charge of $63 million related to the early repayment of this debt. +On October 28, 2018, Abbott redeemed approximately $4 billion of debt, which included $750 million principal amount of its 2.00% Notes due 2020; $597 million principal amount of its 4.125% Notes due 2020; $900 million principal amount of its 3.25% Notes due 2023; $450 million principal amount of its 3.4% Notes due 2023; and $1.300 billion principal amount of its 3.75% Notes due 2026. Abbott incurred a net charge of $153 million related to the early repayment of this debt and the unwinding of related interest rate swaps. +On March 22, 2018, Abbott redeemed all of the $947 million principal amount of its 5.125% Notes due 2019, as well as $1.055 billion of the $2.850 billion principal amount of its 2.35% Notes due 2019. Abbott incurred a net charge of $14 million related to the early repayment of this debt. +Other (Income) Expense, net +Other (income) expense, net, for 2019, 2018 and 2017 includes approximately $225 million, $160 million, and $160 million of income in each year, respectively, related to the non-service cost components of the net periodic benefit costs associated with the pension and post-retirement medical plans. 2017 includes a pre-tax gain of $1.163 billion on the sale of AMO to Johnson & Johnson. +Taxes on Earnings +The income tax rates on earnings from continuing operations were 9.6 percent in 2019, 18.8 percent in 2018 and 84.2 percent in 2017. +31 +The Tax Cuts and Jobs Act (TCJA) was enacted in the U.S. on December 22, 2017. The TCJA reduces the U.S. federal corporate tax rate from 35% to 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. As of December 31, 2018, Abbott completed its accounting for all of the enactment date income tax effects of the TCJA. +Effective for fiscal years beginning after December 31, 2017, the TCJA subjects taxpayers to tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. In January 2018, the FASB staff provided guidance that an entity may make an accounting policy election to either recognize deferred taxes related to items that will give rise to GILTI in future years or provide for the tax expense related to GILTI in the year that the tax is incurred. Abbott has elected to treat the GILTI tax as a period expense and provide for the tax in the year that the tax is incurred. +In the fourth quarter of 2017, Abbott recorded an estimate of net tax expense of $1.46 billion for the impact of the TCJA, which was included in Taxes on Earnings from Continuing Operations in the Consolidated Statement of Earnings. The estimate was provisional and included a charge of approximately $2.89 billion for the transition tax, partially offset by a net benefit of approximately $1.42 billion for the remeasurement of deferred tax assets and liabilities, and a net benefit of approximately $10 million related to certain other impacts of the TCJA. In 2018, Abbott recorded $130 million of additional tax expense which increased the final tax expense related to the TCJA to $1.59 billion. The $130 million of additional tax expense reflects a $120 million increase in the transition tax from $2.89 billion to $3.01 billion and a $10 million reduction in the net benefit related to the remeasurement of deferred tax assets and liabilities. In 2019, taxes on earnings from continuing operations include an $86 million reduction to the transition tax. The $86 million reduction to the transition tax liability was the result of the issuance of final transition tax regulations by the U.S. Department of Treasury in 2019. This adjustment decreased the cumulative net tax expense related to the TCJA to $1.50 billion. +The one-time transition tax is based on Abbott’s total post-1986 earnings and profits (E&P) that were previously deferred from U.S. income taxes. The tax computation also requires the determination of the amount of post-1986 E&P considered held in cash and other specified assets. As of December 31, 2019, the remaining balance of Abbott’s transition tax obligation is approximately $1.33 billion, which will be paid over the next seven years as allowed by the TCJA. +In 2019, taxes on earnings from continuing operations included $68 million of tax expense resulting from tax legislation enacted in the fourth quarter of 2019 in India. In 2018, taxes on earnings from continuing operations included $98 million of net tax expense related to the settlement of Abbott’s 2014-2016 federal income tax audit in the U.S., partial settlement of the former St. Jude Medical consolidated group’s 2014 and 2015 federal income tax returns in the U.S. and audit settlements in various countries. In 2017, taxes on earnings from continuing operations include $435 million of tax expense related to the gain on the sale of the AMO business. +Exclusive of these discrete items, tax expense was favorably impacted by lower tax rates and tax exemptions on foreign income primarily derived from operations in Puerto Rico, Switzerland, Ireland, the Netherlands, Costa Rica, and Singapore. Abbott benefits from a combination of favorable statutory tax rules, tax rulings, grants, and exemptions in these tax jurisdictions. See Note 16 to the consolidated financial statements for a full reconciliation of the effective tax rate to the U.S. federal statutory rate. +Discontinued Operations +Earnings from discontinued operations, net of tax of $34 million and $124 million, in 2018 and 2017, respectively, were driven primarily by the recognition of net tax benefits as a result of the resolution of various tax positions pertaining to AbbVie’s operations for years prior to the separation. On January 1, 2013, Abbott completed the separation of AbbVie Inc. (AbbVie), which was formed to hold Abbott’s research-based proprietary pharmaceuticals business. Abbott has retained all liabilities for all U.S. federal and foreign income taxes on income prior to the separation, as well as certain non-income taxes attributable to AbbVie’s business. AbbVie generally will be liable for all other taxes attributable to its business. +32 +Business Disposition +In September 2016, Abbott announced that it entered into a definitive agreement to sell Abbott Medical Optics (AMO), its vision care business, to Johnson & Johnson for $4.325 billion in cash, subject to customary purchase price adjustments for cash, debt and working capital. The decision to sell AMO reflected Abbott's proactive shaping of its portfolio in line with its strategic priorities. In February 2017, Abbott completed the sale of AMO to Johnson & Johnson and recognized a pre-tax gain of $1.163 billion including working capital adjustments, which was reported in the Other (income) expense, net line of the Consolidated Statement of Earnings in 2017. Abbott recorded an after-tax gain of $728 million in 2017 related to the sale of AMO. The operating results of AMO up to the date of sale continued to be included in Earnings from continuing operations as the business did not qualify for reporting as discontinued operations. For 2017, the AMO loss before taxes included in Abbott’s consolidated earnings was $18 million. +Research and Development Programs +Abbott currently has numerous pharmaceutical, medical devices, diagnostic and nutritional products in development. +Research and Development Process +In the Established Pharmaceuticals segment, the development process focuses on the geographic expansion and continuous improvement of the segment’s existing products to provide benefits to patients and customers. As Established Pharmaceuticals does not actively pursue primary research, development usually begins with work on existing products or after the acquisition of an advanced stage licensing opportunity. +Depending upon the product, the phases of development may include: +● Drug product development. +● Phase I bioequivalence studies to compare a future Established Pharmaceutical’s brand with an already marketed compound with the same active pharmaceutical ingredient (API). +● Phase II studies to test the efficacy of benefits in a small group of patients. +● Phase III studies to broaden the testing to a wider population that reflects the actual medical use. +● Phase IV and other post-marketing studies to obtain new clinical use data on existing products within approved indications. +The specific requirements (e.g., scope of clinical trials) for obtaining regulatory approval vary across different countries and geographic regions. The process may range from one year for a bioequivalence study project to 6 or more years for complex formulations, new indications, or geographic expansion in specific countries, such as China. +In the Diagnostics segment, the phases of the research and development process include: +● Discovery which focuses on identification of a product that will address a specific therapeutic area, platform, or unmet clinical need. +● Concept/Feasibility during which the materials and manufacturing processes are evaluated, testing may include product characterization and analysis is performed to confirm clinical utility. +● Development during which extensive testing is performed to demonstrate that the product meets specified design requirements and that the design specifications conform to user needs and intended uses. +The regulatory requirements for diagnostic products vary across different countries and geographic regions. In the U.S., the FDA classifies diagnostic products into classes (I, II, or III) and the classification determines the regulatory process for approval. While the Diagnostics segment has products in all three classes, the vast majority of its products are categorized as Class I or Class II. Submission of a separate regulatory filing is not required for Class I products. Class II devices typically require pre-market notification to the FDA through a regulatory filing known as a 510(k) submission. Most Class III products are subject to the FDA’s Premarket Approval (PMA) requirements. Other Class III products, such as those used to screen blood, require the submission and approval of a Biological License Application (BLA). +33 +In the European Union (EU), diagnostic products are also categorized into different categories and the regulatory process, which has been governed by the European In Vitro Diagnostic Medical Device Directive, depends upon the category, with certain product categories requiring review and approval by an independent company, known as a Notified Body, before the manufacturer can affix a CE mark to the product to declare conformity to the Directive. Other products only require a self-certification process. In the second quarter of 2017, the EU adopted the new In Vitro Diagnostic Regulation (IVDR) which replaces the existing directive in the EU for in vitro diagnostic products. The IVDR will apply after a five-year transition period and imposes additional premarket and postmarket regulatory requirements on manufacturers of such products. +In the Medical Devices segment, the research and development process begins with research on a specific technology that is evaluated for feasibility and commercial viability. If the research program passes that hurdle, it moves forward into development. The development process includes evaluation, selection and qualification of a product design, completion of applicable clinical trials to test the product’s safety and efficacy, and validation of the manufacturing process to demonstrate its repeatability and ability to consistently meet pre-determined specifications. +Similar to the diagnostic products discussed above, in the U.S., medical devices are classified as Class I, II, or III. Most of Abbott’s medical device products are classified as Class II devices that follow the 510(k) regulatory process or Class III devices that are subject to the PMA process. +In the EU, medical devices are also categorized into different classes and the regulatory process, which has been governed by the European Medical Device Directive and the Active Implantable Medical Device Directive, varies by class. Each product must bear a CE mark to show compliance with the Directive. In the second quarter of 2017, the EU adopted the new Medical Devices Regulation (MDR) which replaces the existing directives in the EU for medical devices. The MDR will apply after a three to five-year (depending on product classification) transition period and imposes additional premarket and postmarket regulatory requirements on manufacturers of such products. +Some products require submission of a design dossier to the appropriate regulatory authority for review and approval prior to CE marking of the device. For other products, the company is required to prepare a technical file which includes testing results and clinical evaluations but can self-certify its ability to apply the CE mark to the product. Outside the U.S. and the EU, the regulatory requirements vary across different countries and regions. +After approval and commercial launch of some medical devices, post-market trials may be conducted either due to a conditional requirement of the regulatory market approval or with the objective of proving product superiority. +In the Nutritional segment, the research and development process generally focuses on identifying and developing ingredients and products that address the nutritional needs of particular populations (e.g., infants and adults) or patients (e.g., people with diabetes). Depending upon the country and/or region, if claims regarding a product’s efficacy will be made, clinical studies typically must be conducted. +In the U.S., the FDA requires that it be notified of proposed new formulations and formulation or packaging changes related to infant formula products. Prior to the launch of an infant formula or product packaging change, the company is required to obtain the FDA’s confirmation that it has no objections to the proposed product or packaging. For other nutritional products, notification or pre-approval from the FDA is not required unless the product includes a new food additive. In some countries, regulatory approval may be required for certain nutritional products, including infant formula and medical nutritional products. +Areas of Focus +In 2020 and beyond, Abbott’s significant areas of therapeutic focus will include the following: +Established Pharmaceuticals — Abbott focuses on building country-specific portfolios made up of high-quality medicines that meet the needs of people in emerging markets. Over the next several years, Abbott plans to expand its product portfolio in key therapeutic areas with the aim of being among the first to launch new off-patent and differentiated medicines. In addition, Abbott continues to expand existing brands into new markets, implement product enhancements that provide value to patients and acquire strategic products and technology through licensing activities. Abbott is also actively working on the further development of several key brands such as Creon™, Duphaston™, Duphalac™ and Influvac™. Depending on the product, the activities focus on development of new data, markets, formulations, delivery systems, or indications. +34 +Medical Devices — Abbott’s research and development programs focus on: +● Cardiac Rhythm Management – Development of next-generation rhythm management technologies, including enhanced patient engagement and expanded magnetic resonance (MR)-compatibility. +● Heart Failure – Continued enhancements to Abbott’s left ventricular assist systems and pulmonary artery heart failure system, including enhanced connectivity, user-interfaces and remote patient monitoring. +● Electrophysiology – Development of next-generation technologies in the areas of ablation, diagnostic, mapping and visualization and recording and monitoring. +● Vascular – Development of next-generation technologies for use in coronary and peripheral vascular procedures. +● Structural Heart – Development of minimally-invasive devices for the repair and replacement of heart valves and other structural heart conditions. +● Neuromodulation – Development of next-generation technologies with enhanced patient and physician engagement and expanded MR-compatibility to treat chronic pain, movement disorders and other indications. +● Diabetes Care – Develop enhancements and additional indications for the FreeStyle Libre platform of continuous glucose monitoring products to help patients improve their ability to manage diabetes. +Core Laboratory Diagnostics — Abbott continues to commercialize its next-generation blood screening, immunoassay, clinical chemistry and hematology systems, along with assays, including a focus on unmet medical need, in various areas including infectious disease, cardiac care, metabolics, and oncology, as well as informatics solutions to help optimize diagnostics laboratory performance and automation solutions to increase efficiency in laboratories. +Molecular Diagnostics — Several new molecular in vitro diagnostic (IVD) tests and ‘Alinity m’, a next generation instrument system, are in various stages of development and launch. +Rapid Diagnostics — Abbott’s research and development programs focus on the development of diagnostic products for cardiometabolic disease, infectious disease and toxicology. +Nutritionals — Abbott is focusing its research and development spend on platforms that span the pediatric and adult nutrition areas: gastro intestinal/immunity health, brain health, mobility and metabolism, and user experience platforms. Numerous new products that build on advances in these platforms are currently under development, including clinical outcome testing, and are expected to be launched over the coming years. +Given the diversity of Abbott’s business, its intention to remain a broad-based healthcare company and the numerous sources for potential future growth, no individual project is expected to be material to cash flows or results of operations over the next five years. Factors considered included research and development expenses projected to be incurred for the project over the next year relative to Abbott’s total research and development expenses, as well as qualitative factors, such as marketplace perceptions and impact of a new product on Abbott’s overall market position. There were no delays in Abbott’s 2019 research and development activities that are expected to have a material impact on operations. +While the aggregate cost to complete the numerous projects currently in development is expected to be material, the total cost to complete will depend upon Abbott’s ability to successfully finish each project, the rate at which each project advances, and the ultimate timing for completion. Given the potential for significant delays and the risk of failure inherent in the development of medical device, diagnostic and pharmaceutical products and technologies, it is not possible to accurately estimate the total cost to complete all projects currently in development. Abbott plans to manage its portfolio of projects to achieve research and development spending that will be competitive in each of the businesses in which it participates, and such spending is expected to approximate 7.0 percent of total Abbott sales in 2020. Abbott does not regularly accumulate or make management decisions based on the total expenses incurred for a particular development phase in a given period. +35 +Goodwill +At December 31, 2019, goodwill recorded as a result of business combinations totaled $23.2 billion. Goodwill is reviewed for impairment annually in the third quarter or when an event that could result in an impairment occurs, using a quantitative assessment to determine whether it is more likely than not that the fair value of any reporting unit is less than its carrying amount. The income and market approaches are used to calculate the fair value of each reporting unit. The results of the last impairment test indicated that the fair value of each reporting unit was substantially in excess of its carrying value. +Financial Condition +Cash Flow +Net cash from operating activities amounted to $6.1 billion, $6.3 billion and $5.6 billion in 2019, 2018 and 2017, respectively. The decrease in Net cash from operating activities in 2019 was primarily due to an increased investment in working capital, timing of pension contributions relative to 2018 and higher income tax payments, partially offset by the favorable cash flow impact of improved segment operating earnings and lower interest and acquisition-related expenses. The increase in Net cash from operating activities in 2018 was primarily due to higher segment operating earnings, continued improvements in working capital management, timing of pension contributions and lower acquisition-related expenses. The income tax component of cash from operating activities in 2018 includes the non-cash impact of the $120 million adjustment to the transition tax associated with the TCJA. The income tax component of operating cash flow in 2017 includes the non-cash impact of $1.46 billion of net tax expense related to the estimated impact of the TCJA. +While a significant portion of Abbott’s cash and cash equivalents at December 31, 2019, are reinvested in foreign subsidiaries, Abbott does not expect such reinvestment to affect its liquidity and capital resources. Due to the enactment of the TCJA, if these funds were needed for operations in the U.S., Abbott does not expect to incur significant additional income taxes in the future to repatriate these funds. +Abbott funded $382 million in 2019, $114 million in 2018 and $645 million in 2017 to defined benefit pension plans. Abbott expects pension funding of approximately $387 million in 2020 for its pension plans. Abbott expects annual cash flow from operating activities to continue to exceed Abbott’s capital expenditures and cash dividends. +Debt and Capital +At December 31, 2019, Abbott’s long-term debt rating was A- by Standard & Poor’s Corporation and A3 by Moody’s. Abbott expects to maintain an investment grade rating. +Abbott has readily available financial resources, including unused lines of credit that support commercial paper borrowing arrangements and provide Abbott with the ability to borrow up to $5 billion on an unsecured basis. The lines of credit are part of a 2018 revolving credit agreement that expires in 2023. Any borrowings under the current revolving credit agreement will bear interest, at Abbott’s option, based on either a base rate or Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. +In conjunction with the funding of the St. Jude Medical and Alere acquisitions and the assumption of St. Jude Medical’s and Alere’s existing debt, Abbott’s total short-term and long-term debt increased to $27.9 billion at December 31, 2017. The increase in debt included the following transactions: +● In the first quarter of 2017, as part of the acquisition of St. Jude Medical, approximately $5.9 billion of St. Jude Medical’s debt was assumed, repaid, or refinanced by Abbott. This included the exchange of certain St. Jude Medical debt obligations with an aggregate principal amount of approximately $2.9 billion for approximately $2.9 billion of debt issued by Abbott. Following this exchange, approximately $194.2 million of existing St. Jude Medical notes remained outstanding. There were no significant costs associated with the exchange of this debt. In addition, during the first quarter of 2017, Abbott assumed and subsequently repaid approximately $2.8 billion of various St. Jude Medical debt obligations. +36 +● In 2017, Abbott borrowed $2.8 billion on an unsecured basis under a 5-year term loan agreement and borrowed $1.7 billion under its lines of credit. Proceeds from such borrowings were used to finance the acquisition of Alere, to repay certain indebtedness of Abbott and Alere, and to pay fees and expenses in connection with the acquisition. The borrowings bore interest based on a Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. Abbott paid off the term loan in January 2018, ahead of its 2022 due date and paid off $550 million of the line of credit in the fourth quarter of 2017 and the remaining $1.15 billion on January 5, 2018. In the fourth quarter of 2017, in conjunction with the acquisition of Alere, Abbott assumed and subsequently repaid $3.0 billion of Alere’s debt. +● In 2017, Abbott also paid off a $479 million yen-denominated short-term borrowing during the year and issued 364-day yen-denominated debt, of which $201 million and $199 million was outstanding at December 31, 2019 and 2018, respectively. +In 2018, Abbott committed to reducing its debt levels and on February 16, 2018, the board of directors authorized the early redemption of up to $5 billion of outstanding long-term notes. Redemptions under this authorization during 2018 included $0.947 billion principal amount of its 5.125% Notes due 2019 and $2.850 billion principal amount of its 2.35% Notes due 2019. Abbott incurred a net charge of $14 million related to the early repayment of this debt. +On September 17, 2018, Abbott repaid upon maturity the $500 million aggregate principal amount outstanding of the 2.00% Senior Notes due 2018. +On September 27, 2018, Abbott’s wholly owned subsidiary, Abbott Ireland Financing DAC, completed a euro debt offering of €3.420 billion of long-term debt. The proceeds equated to approximately $4 billion. The notes are guaranteed by Abbott. +On October 28, 2018, Abbott redeemed $4.0 billion principal amount of its outstanding long-term debt. This amount is in addition to the $5 billion authorization discussed above. In conjunction with the redemption, Abbott unwound approximately $1.1 billion in interest rate swaps relating to the 3.40% Note due in 2023 and the 3.75% Note due in 2026. Abbott incurred a net charge of $153 million related to the early repayment of this debt and the unwinding of related interest rate swaps. +The 2018 transactions described above, including the repayment of $2.8 billion under the 5-year term loan and $1.15 billion of borrowings under the lines of credit, resulted in the net repayment of approximately $8.3 billion of debt. +On February 24, 2019, Abbott redeemed the $500 million outstanding principal amount of its 2.80% Notes due 2020. +In September 2019, the board of directors authorized the early redemption of up to $5 billion of outstanding long-term notes. This bond redemption authorization superseded the board’s previous authorization under which $700 million had not yet been redeemed. On December 19, 2019, Abbott redeemed the $2.850 billion outstanding principal amount of its 2.90% Notes due 2021. After redemption of the 2.90% Notes, $2.15 billion of the $5 billion debt redemption authorization remains available. +On November 19, 2019, Abbott’s wholly owned subsidiary, Ireland Financing DAC, completed a euro debt offering of €1.180 billion of long-term debt. The proceeds equated to approximately $1.3 billion. The Notes are guaranteed by Abbott. +On November 21, 2019, Abbott borrowed ¥59.8 billion under a 5-year term loan and designated the yen-denominated loan as a hedge of its net investment in certain foreign subsidiaries. The term loan bears interest at TIBOR plus a fixed spread, and the interest rate is reset quarterly. The proceeds equated to approximately $550 million. +The 2019 transactions described above resulted in the repayment of approximately of $1.6 billion of debt, net of borrowings, bringing Abbott’s total debt to $18.1 billion at December 31, 2019. +In September 2014, the board of directors authorized the repurchase of up to $3.0 billion of Abbott’s common shares from time to time. Under the program authorized in 2014, Abbott repurchased 36.2 million shares at a cost of $1.666 billion in 2015, 10.4 million shares at a cost of $408 million in 2016, 1.9 million shares at a cost of $130 million in 2018, and 6.3 million shares at a cost of $525 million in 2019 for a total of approximately $2.730 billion. In October 2019, the board of directors authorized the repurchase of up to $3 billion of Abbott’s common shares from time to time. The new authorization is in addition to the $270 million unused portion of the share repurchase program authorized in 2014. +37 +On April 27, 2016, the board of directors authorized the issuance and sale for general corporate purposes of up to 75 million common shares that would result in proceeds of up to $3 billion. No shares have been issued under this authorization. +Abbott declared dividends of $1.32 per share in 2019 compared to $1.16 per share in 2018, an increase of approximately 14 percent. Dividends paid were $2.270 billion in 2019 compared to $1.974 billion in 2018. The year-over-year change in dividends paid primarily reflects the impact of the increase in the dividend rate. +Working Capital +Working capital was $4.8 billion at December 31, 2019 and $5.6 billion at December 31, 2018. The decrease in working capital in 2019 reflects the presentation of $1.3 billion of Senior Notes due 2020 as current liabilities at December 31, 2019, partially offset by an overall net increase in working capital of approximately $485 million due to changes in accounts receivable, inventory and accounts payable associated with the growth of the business. +Abbott monitors the credit worthiness of customers and establishes an allowance against a trade receivable when it is probable that the balance will not be collected. In addition to closely monitoring economic conditions and budgetary and other fiscal developments, Abbott regularly communicates with its customers regarding the status of receivable balances, including their payment plans and obtains positive confirmation of the validity of the receivables. Abbott also monitors the potential for and periodically has utilized factoring arrangements to mitigate credit risk although the receivables included in such arrangements have historically not been a material amount of total outstanding receivables. +Capital Expenditures +Capital expenditures of $1.6 billion in 2019, $1.4 billion in 2018 and $1.1 billion in 2017 were principally for upgrading and expanding manufacturing and research and development facilities and equipment in various segments, investments in information technology, and laboratory instruments placed with customers. +Contractual Obligations +The table below summarizes Abbott’s estimated contractual obligations as of December 31, 2019. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Payments Due By Period +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2025 and +(dollars in millions) +Total +2020 +2021 ‑ 2022 +2023 ‑ 2024 +Thereafter +Long‑term debt, including current maturities +​ +$ +18,049 +​ +$ +1,278 +​ +$ +757 +​ +$ +3,527 +​ +$ +12,487 +Interest on debt obligations +​ +9,432 +​ +576 +​ +1,137 +​ +1,061 +​ +6,658 +Operating lease obligations +​ +1,138 +​ +238 +​ +352 +​ +195 +​ +353 +Purchase commitments (a) +​ +3,187 +​ +2,974 +​ +194 +​ +11 +​ +8 +Other long‑term liabilities (b) +​ +4,117 +​ +— +​ +1,885 +​ +1,178 +​ +1,054 +Total (c) +​ +$ +35,923 +​ +$ +5,066 +​ +$ +4,325 +​ +$ +5,972 +​ +$ +20,560 +(a) Purchase commitments are for purchases made in the normal course of business to meet operational and capital expenditure requirements. +(b) Other long-term liabilities include estimated payments for the transition tax under the TCJA, net of applicable credits. +(c) Net unrecognized tax benefits totaling approximately $580 million are excluded from the table above as Abbott is unable to reasonably estimate the period of cash settlement with the respective taxing authorities on such items. See Note 16 — Taxes on Earnings from Continuing Operations for further details. The company has employee benefit obligations consisting of pensions and other post-employment benefits, including medical and life, which have been excluded from the table. A discussion of the company’s pension and post-retirement plans, including funding matters is included in Note 15 — Post-employment Benefits. +38 +Contingent Obligations +Abbott has periodically entered into agreements with other companies in the ordinary course of business, such as assignment of product rights, which has resulted in Abbott becoming secondarily liable for obligations that Abbott was previously primarily liable. Since Abbott no longer maintains a business relationship with the other parties, Abbott is unable to develop an estimate of the maximum potential amount of future payments, if any, under these obligations. Based upon past experience, the likelihood of payments under these agreements is remote. In addition, Abbott periodically acquires a business or product rights in which Abbott agrees to pay contingent consideration based on attaining certain thresholds or based on the occurrence of certain events. +Legislative Issues +Abbott’s primary markets are highly competitive and subject to substantial government regulations throughout the world. Abbott expects debate to continue over the availability, method of delivery, and payment for health care products and services. It is not possible to predict the extent to which Abbott or the health care industry in general might be adversely affected by these factors in the future. A more complete discussion of these factors is contained in Item 1, Business, and Item 1A, Risk Factors. +Recently Issued Accounting Standards +In December 2019, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes , which among other things, eliminates certain exceptions in the current rules regarding the approach for intraperiod tax allocations and the methodology for calculating income taxes in an interim period, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard becomes effective for Abbott in the first quarter of 2021 and early adoption is permitted. Abbott does not expect adoption of this new standard to have a material impact on its consolidated financial statements. +In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income , which allows companies to reclassify stranded tax effects resulting from the 2017 Tax Cuts and Jobs Act, from Accumulated other comprehensive income (loss) to retained earnings (Earnings employed in the business). Abbott adopted the new standard at the beginning of the fourth quarter of 2018. As a result of the adoption of the new standard, approximately $337 million of stranded tax effects were reclassified from Accumulated other comprehensive income (loss) to Earnings employed in the business. +In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory , which requires the recognition of the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer occurs. Abbott adopted the standard on January 1, 2018, using a modified retrospective approach and recorded a cumulative catch-up adjustment to Earnings employed in the business in the Consolidated Balance Sheet that was not significant. +In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses, which changes the methodology to be used to measure credit losses for certain financial instruments and financial assets, including trade receivables. The new methodology requires the recognition of an allowance that reflects the current estimate of credit losses expected to be incurred over the life of the financial asset. The new standard will be effective for Abbott at the beginning of 2020. Adoption of the new standard will not have a material impact on the consolidated financial statements. +In February 2016, the FASB issued ASU 2016-02, Leases , which requires lessees to measure and recognize a lease asset and liability on the balance sheet for most leases, including operating leases. Abbott adopted the new standard as of January 1, 2019 using the modified retrospective approach and applied the standard’s transition provisions as of January 1, 2019. As a result, no changes were made to the December 31, 2018 Consolidated Balance Sheet. Abbott elected to apply the package of practical expedients related to transition. These practical expedients allowed Abbott to carry forward its historical assessments of whether any existing contracts are or contain leases, the lease classification for each lease existing at January 1, 2019, and whether any initial direct costs for such leases qualified for capitalization. +39 +The new lease accounting standard did not have a material impact on the amounts reported in the Consolidated Statement of Earnings but does have a material impact on the amounts reported in the Consolidated Balance Sheet. Adoption of the new standard resulted in the recording of approximately $850 million of new right of use (ROU) assets and additional liabilities for operating leases on the Consolidated Balance Sheet as of January 1, 2019. +In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Recognition and Measurement of Financial Assets and Financial Liabilities , which provides new guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. Abbott adopted the standard on January 1, 2018. Under the new standard, changes in the fair value of equity investments with readily determinable fair values are recorded in Other (income) expense, net within the Consolidated Statement of Earnings. Previously, such fair value changes were recorded in other comprehensive income. Abbott has elected the measurement alternative allowed by ASU 2016-01 for its equity investments without readily determinable fair values. These investments are measured at cost, less any impairment, plus or minus any changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Changes in the measurement of these investments are being recorded in Other (income) expense, net within the Consolidated Statement of Earnings. As part of the adoption, the cumulative-effect adjustment to Earnings employed in the business in the Consolidated Balance Sheet for net unrealized losses on equity investments that were recorded in Accumulated other comprehensive income (loss) as of December 31, 2017 was not significant. +In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers , which provides a single comprehensive model for accounting for revenue from contracts with customers and supersedes nearly all previously existing revenue recognition guidance. The core principle of the ASU is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Abbott adopted the new standard as of January 1, 2018, using the modified retrospective approach method. Under this method, entities recognize the cumulative effect of applying the new standard at the date of initial application with no restatement of comparative periods presented. The cumulative effect of applying the new standard resulted in an increase to Earnings employed in the business in the Consolidated Balance Sheet of $23 million which was recorded on January 1, 2018. The new standard has been applied only to those contracts that were not completed as of January 1, 2018. The impact of adopting ASU 2014-09 was not significant to individual financial statement line items in the Consolidated Balance Sheet and Consolidated Statement of Earnings. +Private Securities Litigation Reform Act of 1995 — A Caution Concerning Forward-Looking Statements +Under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, Abbott cautions investors that any forward-looking statements or projections made by Abbott, including those made in this document, are subject to risks and uncertainties that may cause actual results to differ materially from those projected. Economic, competitive, governmental, technological and other factors that may affect Abbott’s operations are discussed in Item 1A, Risk Factors. +​ +40 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Financial Instruments and Risk Management +Market Price Sensitive Investments +The fair value of equity securities held by Abbott with a readily determinable fair value was approximately $11 million and $13 million as of December 31, 2019 and 2018, respectively. These equity securities are subject to potential changes in fair value. A hypothetical 20 percent decrease in the share prices of these investments would decrease their fair value at December 31, 2019 by approximately $2 million. Changes in the fair value of these securities are recorded in earnings. The fair value of investments in mutual funds that are held in a rabbi trust for the purpose of paying benefits under a deferred compensation plan was approximately $346 million and $307 million as of December 31, 2019 and 2018, respectively. Changes in the fair value of these investments, as well as an offsetting change in the benefit obligation, are recorded in earnings. +Non-Publicly Traded Equity Securities +Abbott holds equity securities that are not traded on public stock exchanges. The carrying value of these investments was $158 million and $211 million as of December 31, 2019 and 2018, respectively. No individual investment is recorded at a value in excess of $61 million. Abbott measures these investments at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. +Interest Rate Sensitive Financial Instruments +At December 31, 2019 and 2018, Abbott had interest rate hedge contracts totaling $2.9 billion to manage its exposure to changes in the fair value of debt. The effect of these hedges is to change the fixed interest rate to a variable rate for the portion of the debt that is hedged. Abbott does not use derivative financial instruments, such as interest rate swaps, to manage its exposure to changes in interest rates for its investment securities. The fair value of long-term debt at December 31, 2019 and 2018 amounted to $20.8 billion and $19.9 billion, respectively (average interest rates of 3.3% and 3.5% as of December 31, 2019 and 2018, respectively) with maturities through 2046. At December 31, 2019 and 2018, the fair value of current and long-term investment securities amounted to approximately $1.2 billion and $1.1 billion, respectively. A hypothetical 100-basis point change in the interest rates would not have a material effect on cash flows, income or fair values. (A 100-basis point change is believed to be a reasonably possible near-term change in rates.) +Foreign Currency Sensitive Financial Instruments +Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts are designated as cash flow hedges of the variability of the cash flows due to changes in foreign currency exchange rates and are marked-to-market with the resulting gains or losses reflected in Accumulated other comprehensive income (loss). Gains or losses will be included in Cost of products sold at the time the products are sold, generally within the next twelve to eighteen months. At December 31, 2019 and 2018, Abbott held $6.8 billion and $5.1 billion, respectively, of such contracts. Contracts held at December 31, 2019 will mature in 2020 or 2021 depending upon the contract. Contracts held at December 31, 2018 matured in 2019 or will mature in 2020 depending upon the contract. +Abbott enters into foreign currency forward exchange contracts to manage its exposure to foreign currency denominated intercompany loans and trade payables and third-party trade payables and receivables. The contracts are marked-to-market, and resulting gains or losses are reflected in income and are generally offset by losses or gains on the foreign currency exposure being managed. At December 31, 2019 and 2018, Abbott held $9.1 billion and $13.6 billion, respectively, of such contracts, which mature in the next 13 months. +In November 2019, Abbott borrowed ¥59.8 billion under a 5-year term loan and designated the yen-denominated loan as a hedge of the net investment in certain foreign subsidiaries. From the date of the borrowing through December 31, 2019, the value of this long-term debt decreased approximately $4 million to $546 million due to foreign exchange rate changes. The change in the value was recorded in Accumulated other comprehensive income (loss), net of tax. In March 2017, Abbott repaid its $479 million yen-denominated short-term debt which was designated as a hedge of the net +41 +investment in a foreign subsidiary. At December 31, 2016, the value of this short-term debt was $454 million, and changes in the fair value of the debt up through the date of repayment due to changes in exchange rates were recorded in Accumulated other comprehensive income (loss), net of tax. +The following table reflects the total foreign currency forward exchange contracts outstanding at December 31, 2019 and 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +​ +2018 +​ +​ +​ +Weighted +Fair and +​ +​ +Weighted +Fair and +​ +​ +​ +​ +​ +Average +​ +Carrying Value +​ +​ +​ +​ +Average +​ +Carrying Value +​ +​ +Contract +​ +Exchange +​ +Receivable/ +​ +Contract +​ +Exchange +​ +Receivable/ +(dollars in millions) +​ +Amount +​ +Rate +​ +(Payable) +​ +Amount +​ +Rate +​ +(Payable) +Primarily U.S. Dollars to be exchanged for the following currencies: +​ +​ +​ +​ +Euro +​ +$ +7,085 +1.1189 +​ +$ +65 +​ +$ +11,630 +1.1938 +​ +$ +13 +Chinese Yuan +​ +2,177 +7.0216 +​ +4 +​ +1,592 +6.9055 +​ +(10) +Japanese Yen +​ +1,092 +106.8530 +​ +13 +​ +1,079 +108.2188 +​ +6 +All other currencies +​ +5,532 +n/a +​ +(23) +​ +4,388 +n/a +​ +10 +Total +​ +$ +15,886 +​ +$ +59 +​ +$ +18,689 +​ +$ +19 +​ +​ +​ +42 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +​ +​ +Page +Consolidated Statement of Earnings +​ +44 +Consolidated Statement of Comprehensive Income +​ +45 +Consolidated Statement of Cash Flows +​ +46 +Consolidated Balance Sheet +​ +47 +Consolidated Statement of Shareholders’ Investment +​ +49 +Notes to Consolidated Financial Statements +​ +50 +Management Report on Internal Control Over Financial Reporting +​ +86 +Report of Independent Registered Public Accounting Firm +​ +87 +Report of Independent Registered Public Accounting Firm +​ +90 +​ +​ +​ +43 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Earnings +(in millions except per share data) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2019 +2018 +2017 +Net Sales +​ +$ +31,904 +​ +$ +30,578 +​ +$ +27,390 +Cost of products sold, excluding amortization of intangible assets +​ +13,231 +​ +12,706 +​ +12,409 +Amortization of intangible assets +​ +1,936 +​ +2,178 +​ +1,975 +Research and development +​ +2,440 +​ +2,300 +​ +2,260 +Selling, general and administrative +​ +9,765 +​ +9,744 +​ +9,182 +Total Operating Cost and Expenses +​ +27,372 +​ +26,928 +​ +25,826 +Operating Earnings +​ +4,532 +​ +3,650 +​ +1,564 +Interest expense +​ +670 +​ +826 +​ +904 +Interest income +​ +( 94 ) +​ +( 105 ) +​ +( 124 ) +Net foreign exchange (gain) loss +​ +7 +​ +28 +​ +( 34 ) +Debt extinguishment costs +​ +​ +63 +​ +​ +167 +​ +​ +— +Other (income) expense, net +​ +( 191 ) +​ +( 139 ) +​ +( 1,413 ) +Earnings from Continuing Operations Before Taxes +​ +4,077 +​ +2,873 +​ +2,231 +Taxes on Earnings from Continuing Operations +​ +390 +​ +539 +​ +1,878 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from Continuing Operations +​ +3,687 +​ +2,334 +​ +353 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Earnings from Discontinued Operations, net of taxes +​ +— +​ +34 +​ +124 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Earnings +​ +$ +3,687 +​ +$ +2,368 +​ +$ +477 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Common Share -- +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing Operations +​ +$ +2.07 +​ +$ +1.32 +​ +$ +0.20 +Discontinued Operations +​ +— +​ +0.02 +​ +0.07 +Net Earnings +​ +$ +2.07 +​ +$ +1.34 +​ +$ +0.27 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diluted Earnings Per Common Share -- +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing Operations +​ +$ +2.06 +​ +$ +1.31 +​ +$ +0.20 +Discontinued Operations +​ +— +​ +0.02 +​ +0.07 +Net Earnings +​ +$ +2.06 +​ +$ +1.33 +​ +$ +0.27 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share +​ +1,768 +​ +1,758 +​ +1,740 +Dilutive Common Stock Options +​ +13 +​ +12 +​ +9 +Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options +​ +1,781 +​ +1,770 +​ +1,749 +Outstanding Common Stock Options Having No Dilutive Effect +​ +​ +61 +​ +— +​ +— +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +44 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Comprehensive Income +(in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2019 +2018 +2017 +Net Earnings +​ +$ +3,687 +​ +$ +2,368 +​ +$ +477 +Foreign currency translation gain (loss) adjustments +​ +( 12 ) +​ +( 1,460 ) +​ +1,365 +Net actuarial gains (losses) and prior service cost and credits and amortization of net actuarial losses and prior service cost and credits, net of taxes of $( 238 ) in 2019, $ 47 in 2018 and $( 61 ) in 2017 +​ +( 814 ) +​ +132 +​ +( 243 ) +Unrealized gains (losses) on marketable equity securities, net of taxes of $( 76 ) in 2017 +​ +— +​ +— +​ +64 +Net (losses) gains on derivative instruments designated as cash flow hedges, net of taxes of $( 17 ) in 2019, $ 50 in 2018 and $( 43 ) in 2017 +​ +( 53 ) +​ +136 +​ +( 134 ) +Other Comprehensive Income (Loss) +​ +( 879 ) +​ +( 1,192 ) +​ +1,052 +Comprehensive Income +​ +$ +2,808 +​ +$ +1,176 +​ +$ +1,529 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Accumulated Other Comprehensive Income (Loss) Information, net of tax as of December 31: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cumulative foreign currency translation (loss) adjustments +​ +$ +( 4,924 ) +​ +$ +( 4,912 ) +​ +$ +( 3,452 ) +Net actuarial (losses) and prior service (cost) and credits +​ +( 3,540 ) +​ +( 2,726 ) +​ +( 2,521 ) +Cumulative unrealized (losses) gains on marketable equity securities +​ +— +​ +— +​ +( 5 ) +Cumulative (losses) gains on derivative instruments designated as cash flow hedges +​ +( 1 ) +​ +52 +​ +( 84 ) +Accumulated other comprehensive income (loss) +​ +$ +( 8,465 ) +​ +$ +( 7,586 ) +​ +$ +( 6,062 ) +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +45 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Cash Flows +(in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2019 +2018 +2017 +Cash Flow From (Used in) Operating Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net earnings +​ +$ +3,687 +​ +$ +2,368 +​ +$ +477 +Adjustments to reconcile earnings to net cash from operating activities — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation +​ +1,078 +​ +1,100 +​ +1,046 +Amortization of intangible assets +​ +1,936 +​ +2,178 +​ +1,975 +Share-based compensation +​ +519 +​ +477 +​ +406 +Amortization of inventory step-up +​ +​ +— +​ +​ +32 +​ +​ +907 +Investing and financing losses, net +​ +​ +184 +​ +​ +126 +​ +​ +47 +Loss on extinguishment of debt +​ +​ +63 +​ +​ +167 +​ +​ +— +Amortization of bridge financing fees +​ +​ +— +​ +​ +— +​ +​ +5 +Gains on sale of businesses +​ +​ +— +​ +​ +— +​ +​ +( 1,163 ) +Gain on sale of Mylan N.V. shares +​ +​ +— +​ +​ +— +​ +​ +( 45 ) +Trade receivables +​ +( 275 ) +​ +( 190 ) +​ +( 207 ) +Inventories +​ +( 593 ) +​ +( 514 ) +​ +249 +Prepaid expenses and other assets +​ +( 138 ) +​ +23 +​ +109 +Trade accounts payable and other liabilities +​ +220 +​ +747 +​ +615 +Income taxes +​ +( 545 ) +​ +( 214 ) +​ +1,149 +Net Cash From Operating Activities +​ +​ +6,136 +​ +​ +6,300 +​ +​ +5,570 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flow From (Used in) Investing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Acquisitions of property and equipment +​ +( 1,638 ) +​ +( 1,394 ) +​ +( 1,135 ) +Acquisitions of businesses and technologies, net of cash acquired +​ +( 170 ) +​ +( 54 ) +​ +( 17,183 ) +Proceeds from business dispositions +​ +​ +48 +​ +​ +48 +​ +​ +6,042 +Proceeds from the sale of Mylan N.V. shares +​ +​ +— +​ +​ +— +​ +​ +2,704 +Purchases of investment securities +​ +( 103 ) +​ +( 131 ) +​ +( 210 ) +Proceeds from sales of investment securities +​ +21 +​ +73 +​ +129 +Other +​ +27 +​ +102 +​ +35 +Net Cash From (Used in) Investing Activities +​ +( 1,815 ) +​ +( 1,356 ) +​ +( 9,618 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flow From (Used in) Financing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Proceeds from issuance of (repayments of) short-term debt, net and other +​ +— +​ +( 26 ) +​ +( 1,034 ) +Proceeds from issuance of long-term debt and debt with maturities over 3 months +​ +1,842 +​ +4,009 +​ +6,742 +Repayments of long-term debt and debt with maturities over 3 months +​ +( 3,441 ) +​ +( 12,433 ) +​ +( 8,650 ) +Purchase of Alere preferred stock +​ +​ +— +​ +​ +— +​ +​ +( 710 ) +Acquisition and contingent consideration payments related to business acquisitions +​ +— +​ +— +​ +( 13 ) +Purchases of common shares +​ +( 718 ) +​ +( 238 ) +​ +( 117 ) +Proceeds from stock options exercised +​ +298 +​ +271 +​ +350 +Dividends paid +​ +( 2,270 ) +​ +( 1,974 ) +​ +( 1,849 ) +Net Cash From (Used in) Financing Activities +​ +( 4,289 ) +​ +( 10,391 ) +​ +( 5,281 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Effect of exchange rate changes on cash and cash equivalents +​ +( 16 ) +​ +( 116 ) +​ +116 +Net Increase (Decrease) in Cash and Cash Equivalents +​ +16 +​ +( 5,563 ) +​ +( 9,213 ) +Cash and Cash Equivalents, Beginning of Year +​ +3,844 +​ +9,407 +​ +18,620 +Cash and Cash Equivalents, End of Year +​ +$ +3,860 +​ +$ +3,844 +​ +$ +9,407 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Cash Flow Information: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income taxes paid +​ +$ +930 +​ +$ +740 +​ +$ +570 +Interest paid +​ +677 +​ +845 +​ +917 +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +46 +Abbott Laboratories and Subsidiaries +Consolidated Balance Sheet +(dollars in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31 +​ +2019 +2018 +Assets +​ +​ +​ +​ +​ +​ +Current assets: +​ +​ +​ +​ +​ +​ +Cash and cash equivalents +​ +$ +3,860 +​ +$ +3,844 +Investments, primarily bank time deposits and U.S. treasury bills +​ +280 +​ +242 +Trade receivables, less allowances of — 2019: $ 384 ; 2018: $ 314 +​ +5,425 +​ +5,182 +Inventories: +​ +​ +​ +​ +​ +​ +Finished products +​ +2,784 +​ +2,407 +Work in process +​ +560 +​ +499 +Materials +​ +972 +​ +890 +Total inventories +​ +4,316 +​ +3,796 +Other prepaid expenses and receivables +​ +1,786 +​ +1,568 +Total current assets +​ +15,667 +​ +14,632 +Investments +​ +883 +​ +897 +Property and equipment, at cost: +​ +​ +​ +​ +​ +​ +Land +​ +519 +​ +501 +Buildings +​ +3,702 +​ +3,555 +Equipment +​ +11,468 +​ +10,756 +Construction in progress +​ +1,110 +​ +894 +​ +​ +16,799 +​ +15,706 +Less: accumulated depreciation and amortization +​ +8,761 +​ +8,143 +Net property and equipment +​ +8,038 +​ +7,563 +Intangible assets, net of amortization +​ +17,025 +​ +18,942 +Goodwill +​ +23,195 +​ +23,254 +Deferred income taxes and other assets +​ +3,079 +​ +1,885 +​ +​ +$ +67,887 +​ +$ +67,173 +​ +​ +47 +Abbott Laboratories and Subsidiaries +Consolidated Balance Sheet +(dollars in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31 +​ +2019 +2018 +Liabilities and Shareholders’ Investment +​ +​ +​ +​ +​ +​ +Current liabilities: +​ +​ +​ +​ +​ +​ +Short-term borrowings +​ +$ +201 +​ +$ +200 +Trade accounts payable +​ +3,252 +​ +2,975 +Salaries, wages and commissions +​ +1,237 +​ +1,182 +Other accrued liabilities +​ +4,035 +​ +3,780 +Dividends payable +​ +635 +​ +563 +Income taxes payable +​ +226 +​ +305 +Current portion of long-term debt +​ +1,277 +​ +7 +Total current liabilities +​ +10,863 +​ +9,012 +Long-term debt +​ +16,661 +​ +19,359 +Post-employment obligations and other long-term liabilities +​ +9,062 +​ +8,080 +Commitments and contingencies +​ +​ +​ +​ +​ +​ +Shareholders’ investment: +​ +​ +​ +​ +​ +​ +Preferred shares, one dollar par value Authorized — 1,000,000 shares, none issued +​ +— +​ +— +Common shares, without par value Authorized — 2,400,000,000 shares +Issued at stated capital amount — Shares: 2019: 1,976,855,085 ; 2018: 1,971,189,465 +​ +23,853 +​ +23,512 +Common shares held in treasury, at cost — Shares: 2019: 214,351,838 ; 2018: 215,570,043 +​ +( 10,147 ) +​ +( 9,962 ) +Earnings employed in the business +​ +25,847 +​ +24,560 +Accumulated other comprehensive income (loss) +​ +( 8,465 ) +​ +( 7,586 ) +Total Abbott Shareholders’ Investment +​ +31,088 +​ +30,524 +Noncontrolling interests in subsidiaries +​ +213 +​ +198 +Total Shareholders’ Investment +​ +31,301 +​ +30,722 +​ +​ +$ +67,887 +​ +$ +67,173 +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +48 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Shareholders’ Investment +(in millions except shares and per share data) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2019 +2018 +2017 +Common Shares: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 1,971,189,465 ; 2018: 1,965,908,188 ; 2017: 1,707,475,455 +​ +$ +23,512 +​ +$ +23,206 +​ +$ +13,027 +Issued under incentive stock programs +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 5,665,620 ; 2018: 5,281,277 ; 2017: 8,834,924 +​ +209 +​ +163 +​ +242 +Issued for St. Jude Medical acquisition +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2017: 249,597,809 +​ +​ +— +​ +​ +— +​ +​ +9,835 +Share-based compensation +​ +521 +​ +479 +​ +406 +Issuance of restricted stock awards +​ +( 389 ) +​ +( 336 ) +​ +( 304 ) +End of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 1,976,855,085 ; 2018: 1,971,189,465 ; 2017: 1,965,908,188 +​ +$ +23,853 +​ +$ +23,512 +​ +$ +23,206 +Common Shares Held in Treasury: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 215,570,043 ; 2018: 222,305,719 ; 2017: 234,606,250 +​ +$ +( 9,962 ) +​ +$ +( 10,225 ) +​ +$ +( 10,791 ) +Issued under incentive stock programs +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 7,796,030 ; 2018: 8,870,735 ; 2017: 8,696,320 +​ +361 +​ +408 +​ +400 +Issued for St. Jude Medical acquisition +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2017: 3,906,848 +​ +​ +— +​ +​ +— +​ +​ +180 +Purchased +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 6,577,825 ; 2018: 2,135,059 ; 2017: 302,637 +​ +( 546 ) +​ +( 145 ) +​ +( 14 ) +End of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2019: 214,351,838 ; 2018: 215,570,043 ; 2017: 222,305,719 +​ +$ +( 10,147 ) +​ +$ +( 9,962 ) +​ +$ +( 10,225 ) +Earnings Employed in the Business: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +$ +24,560 +​ +$ +23,978 +​ +$ +25,565 +Impact of adoption of new accounting standards +​ +​ +— +​ +​ +351 +​ +​ +— +Net earnings +​ +3,687 +​ +2,368 +​ +477 +Cash dividends declared on common shares (per share — 2019: $ 1.32 ; 2018: $ 1.16 ; 2017: $ 1.075 ) +​ +​ +( 2,343 ) +​ +​ +( 2,047 ) +​ +​ +( 1,947 ) +Effect of common and treasury share transactions +​ +( 57 ) +​ +( 90 ) +​ +( 117 ) +End of Year +​ +$ +25,847 +​ +$ +24,560 +​ +$ +23,978 +Accumulated Other Comprehensive Income (Loss): +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +$ +( 7,586 ) +​ +$ +( 6,062 ) +​ +$ +( 7,263 ) +Impact of adoption of new accounting standards +​ +​ +— +​ +​ +( 332 ) +​ +​ +— +Business dispositions +​ +— +​ +— +​ +149 +Other comprehensive income (loss) +​ +( 879 ) +​ +( 1,192 ) +​ +1,052 +End of Year +​ +$ +( 8,465 ) +​ +$ +( 7,586 ) +​ +$ +( 6,062 ) +Noncontrolling Interests in Subsidiaries: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +$ +198 +​ +$ +201 +​ +$ +179 +Noncontrolling Interests’ share of income, business combinations, net of distributions and share repurchases +​ +15 +​ +( 3 ) +​ +22 +End of Year +​ +$ +213 +​ +$ +198 +​ +$ +201 +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +​ +49 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements +Note 1 — Summary of Significant Accounting Policies +NATURE OF BUSINESS — Abbott’s principal business is the discovery, development, manufacture and sale of a broad line of health care products. +BASIS OF CONSOLIDATION — The consolidated financial statements include the accounts of the parent company and subsidiaries, after elimination of intercompany transactions. +USE OF ESTIMATES — The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States and necessarily include amounts based on estimates and assumptions by management. Actual results could differ from those amounts. Significant estimates include amounts for sales rebates, income taxes, pension and other post-employment benefits, valuation of intangible assets, litigation, derivative financial instruments, and inventory and accounts receivable exposures. +FOREIGN CURRENCY TRANSLATION — The statements of earnings of foreign subsidiaries whose functional currencies are other than the U.S. dollar are translated into U.S. dollars using average exchange rates for the period. The net assets of foreign subsidiaries whose functional currencies are other than the U.S. dollar are translated into U.S. dollars using exchange rates as of the balance sheet date. The U.S. dollar effects that arise from translating the net assets of these subsidiaries at changing rates are recorded in the foreign currency translation adjustment account, which is included in equity as a component of Accumulated other comprehensive income (loss). Transaction gains and losses are recorded on the Net foreign exchange (gain) loss line of the Consolidated Statement of Earnings. +REVENUE RECOGNITION — Revenue from product sales is recognized upon the transfer of control, which is generally upon shipment or delivery, depending on the delivery terms set forth in the customer contract. Provisions for discounts, rebates and sales incentives to customers, and returns and other adjustments are provided for in the period the related sales are recorded. Sales incentives to customers are not material. Historical data is readily available and reliable, and is used for estimating the amount of the reduction in gross sales. Revenue from the launch of a new product, from an improved version of an existing product, or for shipments in excess of a customer’s normal requirements are recorded when the conditions noted above are met. In those situations, management records a returns reserve for such revenue, if necessary. In certain of Abbott’s businesses, primarily within diagnostics, Abbott participates in selling arrangements that include multiple performance obligations (e.g., instruments, reagents, procedures, and service agreements). The total transaction price of the contract is allocated to each performance obligation in an amount based on the estimated relative standalone selling prices of the promised goods or services underlying each performance obligation. Sales of product rights for marketable products are recorded as revenue upon disposition of the rights. +INCOME TAXES — Deferred income taxes are provided for the tax effect of differences between the tax bases of assets and liabilities and their reported amounts in the financial statements at the enacted statutory rate to be in effect when the taxes are paid. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the transition tax related to the U.S. Tax Cuts and Jobs Act, or any additional outside basis differences that exist, as these amounts continue to be indefinitely reinvested in foreign operations. Interest and penalties on income tax obligations are included in taxes on earnings. +EARNINGS PER SHARE — Unvested restricted stock units and awards that contain non-forfeitable rights to dividends are treated as participating securities and are included in the computation of earnings per share under the two-class method. Under the two-class method, net earnings are allocated between common shares and participating securities. Earnings from Continuing Operations allocated to common shares in 2019, 2018 and 2017 were $ 3.666 billion, $ 2.320 billion and $ 346 million, respectively. Net earnings allocated to common shares in 2019, 2018 and 2017 were $ 3.666 billion, $ 2.353 billion and $ 468 million, respectively. +​ +50 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +PENSION AND POST-EMPLOYMENT BENEFITS — Abbott accrues for the actuarially determined cost of pension and post-employment benefits over the service attribution periods of the employees. Abbott must develop long-term assumptions, the most significant of which are the health care cost trend rates, discount rates and the expected return on plan assets. Differences between the expected long-term return on plan assets and the actual return are amortized over a five - year period. Actuarial losses and gains are amortized over the remaining service attribution periods of the employees under the corridor method. +FAIR VALUE MEASUREMENTS — For assets and liabilities that are measured using quoted prices in active markets, total fair value is the published market price per unit multiplied by the number of units held without consideration of transaction costs. Assets and liabilities that are measured using significant other observable inputs are valued by reference to similar assets or liabilities, adjusted for contract restrictions and other terms specific to that asset or liability. For these items, a significant portion of fair value is derived by reference to quoted prices of similar assets or liabilities in active markets. For all remaining assets and liabilities, fair value is derived using a fair value model, such as a discounted cash flow model or Black-Scholes model. Purchased intangible assets are recorded at fair value. The fair value of significant purchased intangible assets is based on independent appraisals. Abbott uses a discounted cash flow model to value intangible assets. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, the cost of capital, terminal values and market participants. Intangible assets are reviewed for impairment on a quarterly basis. Goodwill and indefinite-lived intangible assets are tested for impairment at least annually. +SHARE-BASED COMPENSATION — The fair value of stock options and restricted stock awards and units are amortized over their requisite service period, which could be shorter than the vesting period if an employee is retirement eligible, with a charge to compensation expense. +LITIGATION — Abbott accounts for litigation losses in accordance with FASB ASC No. 450, “Contingencies.” Under ASC No. 450, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. Legal fees are recorded as incurred. +CASH, CASH EQUIVALENTS AND INVESTMENTS — Cash equivalents consist of bank time deposits, U.S. government securities money market funds and U.S. treasury bills with original maturities of three months or less. Abbott holds certain investments with a carrying value of $ 321 million that are accounted for under the equity method of accounting. Investments held in a rabbi trust and investments in publicly traded equity securities are recorded at fair value and changes in fair value are recorded in earnings. Investments in equity securities that are not traded on public stock exchanges are recorded at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. Investments in debt securities are classified as held-to-maturity, as management has both the intent and ability to hold these securities to maturity, and are reported at cost, net of any unamortized premium or discount. Income relating to these securities is reported as interest income. +TRADE RECEIVABLE VALUATIONS — Accounts receivable are stated at their net realizable value. The allowance against gross trade receivables reflects the best estimate of probable losses inherent in the receivables portfolio determined on the basis of historical experience, specific allowances for known troubled accounts and other currently available information. Accounts receivable are charged off after all reasonable means to collect the full amount (including litigation, where appropriate) have been exhausted. +INVENTORIES — Inventories are stated at the lower of cost (first-in, first-out basis) or net realizable value. Cost includes material and conversion costs. +​ +51 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +PROPERTY AND EQUIPMENT — Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. The following table shows estimated useful lives of property and equipment: +​ +​ +​ +​ +Classification +Estimated Useful Lives +Buildings +10 to 50 years +Equipment +3 to 20 years +​ +PRODUCT LIABILITY — Abbott accrues for product liability claims when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated based on existing information. The liabilities are adjusted quarterly as additional information becomes available. Product liability losses are self-insured. +RESEARCH AND DEVELOPMENT COSTS — Internal research and development costs are expensed as incurred. Clinical trial costs incurred by third parties are expensed as the contracted work is performed. Where contingent milestone payments are due to third parties under research and development arrangements, the milestone payment obligations are expensed when the milestone results are achieved. +ACQUIRED IN-PROCESS AND COLLABORATIONS RESEARCH AND DEVELOPMENT (IPR&D) — The initial costs of rights to IPR&D projects obtained in an asset acquisition are expensed as IPR&D unless the project has an alternative future use. These costs include initial payments incurred prior to regulatory approval in connection with research and development collaboration agreements that provide rights to develop, manufacture, market and/or sell pharmaceutical or medical device products. The fair value of IPR&D projects acquired in a business combination are capitalized and accounted for as indefinite-lived intangible assets until completed and are then amortized over the remaining useful life. Collaborations are not significant. +CONCENTRATION OF RISK AND GUARANTEES — Due to the nature of its operations, Abbott is not subject to significant concentration risks relating to customers, products or geographic locations. Product warranties are not significant. +Abbott has no material exposures to off-balance sheet arrangements; no special purpose entities; nor activities that include non-exchange-traded contracts accounted for at fair value. Abbott has periodically entered into agreements in the ordinary course of business, such as assignment of product rights, with other companies, which has resulted in Abbott becoming secondarily liable for obligations that Abbott was previously primarily liable. Since Abbott no longer maintains a business relationship with the other parties, Abbott is unable to develop an estimate of the maximum potential amount of future payments, if any, under these obligations. Based upon past experience, the likelihood of payments under these agreements is remote. Abbott periodically acquires a business or product rights in which Abbott agrees to pay contingent consideration based on attaining certain thresholds or based on the occurrence of certain events. +​ +Note 2 – New Accounting Standards +Recently Adopted Accounting Standards +In February 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income , which allows companies to reclassify stranded tax effects resulting from the 2017 Tax Cuts and Jobs Act, from Accumulated other comprehensive income (loss) to retained earnings (Earnings employed in the business). Abbott adopted the new standard at the beginning of the fourth quarter of 2018. As a result of the adoption of the new standard, approximately $ 337 million of stranded tax effects were reclassified from Accumulated other comprehensive income (loss) to Earnings employed in the business. +​ +52 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 2 – New Accounting Standards (Continued) +In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory , which requires the recognition of the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer occurs. Abbott adopted the standard on January 1, 2018, using a modified retrospective approach and recorded a cumulative catch-up adjustment to Earnings employed in the business in the Consolidated Balance Sheet that was not significant. +In February 2016, the FASB issued ASU 2016-02, Leases , which requires lessees to measure and recognize a lease asset and liability on the balance sheet for most leases, including operating leases. Abbott adopted the new standard as of January 1, 2019 using the modified retrospective approach and applied the standard’s transition provisions as of January 1, 2019. As a result, no changes were made to the December 31, 2018 Consolidated Balance Sheet. Abbott elected to apply the package of practical expedients related to transition. These practical expedients allowed Abbott to carry forward its historical assessments of whether any existing contracts are or contain leases, the lease classification for each lease existing at January 1, 2019, and whether any initial direct costs for such leases qualified for capitalization. The new lease accounting standard did not have a material impact on the amounts reported in the Consolidated Statement of Earnings but does have a material impact on the amounts reported in the Consolidated Balance Sheet. Adoption of the new standard resulted in the recording of approximately $ 850 million of new right of use (ROU) assets and additional liabilities for operating leases on the Consolidated Balance Sheet as of January 1, 2019. +In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Recognition and Measurement of Financial Assets and Financial Liabilities , which provides new guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. Abbott adopted the standard on January 1, 2018. Under the new standard, changes in the fair value of equity investments with readily determinable fair values are recorded in Other (income) expense, net within the Consolidated Statement of Earnings. Previously, such fair value changes were recorded in other comprehensive income. Abbott has elected the measurement alternative allowed by ASU 2016-01 for its equity investments without readily determinable fair values. These investments are measured at cost, less any impairment, plus or minus any changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Changes in the measurement of these investments are being recorded in Other (income) expense, net within the Consolidated Statement of Earnings. As part of the adoption, the cumulative-effect adjustment to Earnings employed in the business in the Consolidated Balance Sheet for net unrealized losses on equity investments that were recorded in Accumulated other comprehensive income (loss) as of December 31, 2017 was not significant. +In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers , which provides a single comprehensive model for accounting for revenue from contracts with customers and supersedes nearly all previously existing revenue recognition guidance. The core principle of the ASU is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Abbott adopted the new standard as of January 1, 2018, using the modified retrospective approach method. Under this method, entities recognize the cumulative effect of applying the new standard at the date of initial application with no restatement of comparative periods presented. The cumulative effect of applying the new standard resulted in an increase to Earnings employed in the business in the Consolidated Balance Sheet of $ 23 million which was recorded on January 1, 2018. The new standard has been applied only to those contracts that were not completed as of January 1, 2018. The impact of adopting ASU 2014-09 was not significant to individual financial statement line items in the Consolidated Balance Sheet and Consolidated Statement of Earnings. +​ +53 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 2 – New Accounting Standards (Continued) +Recent Accounting Standards Not Yet Adopted +In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes , which among other things, eliminates certain exceptions in the current rules regarding the approach for intraperiod tax allocations and the methodology for calculating income taxes in an interim period, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard becomes effective for Abbott in the first quarter of 2021 and early adoption is permitted. Abbott does not expect adoption of this new standard to have a material impact on its consolidated financial statements. +In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses , which changes the methodology to be used to measure credit losses for certain financial instruments and financial assets, including trade receivables. The new methodology requires the recognition of an allowance that reflects the current estimate of credit losses expected to be incurred over the life of the financial asset. The new standard will be effective for Abbott at the beginning of 2020. Adoption of the new standard will not have a material impact on the consolidated financial statements. +​ +Note 3 — Revenue +Abbott’s revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent protection and licenses, technological and performance features, and inclusion of Abbott’s products under a contract most impact which products are sold; price controls, competition and rebates most impact the net selling prices of products; and foreign currency translation impacts the measurement of net sales and costs. Abbott's products are generally sold directly to retailers, wholesalers, distributors, hospitals, health care facilities, laboratories, physicians' offices and government agencies throughout the world. Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. +54 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +The following tables provide detail by sales category: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +​ +2018 +​ +2017 +(in millions) +U.S. +Int'l +Total +U.S. +Int'l +Total +U.S. +Int'l +Total +Established Pharmaceutical Products — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Key Emerging Markets +​ +$ +— +​ +$ +3,392 +​ +$ +3,392 +​ +$ +— +​ +$ +3,363 +​ +$ +3,363 +​ +$ +— +​ +$ +3,307 +​ +$ +3,307 +Other +​ +— +​ +1,094 +​ +1,094 +​ +— +​ +1,059 +​ +1,059 +​ +​ +— +​ +​ +980 +​ +​ +980 +Total +​ +— +​ +4,486 +​ +4,486 +​ +— +​ +4,422 +​ +4,422 +​ +​ +— +​ +​ +4,287 +​ +​ +4,287 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritionals — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pediatric Nutritionals +​ +1,879 +​ +2,282 +​ +4,161 +​ +1,843 +​ +2,254 +​ +4,097 +​ +​ +1,777 +​ +​ +2,112 +​ +​ +3,889 +Adult Nutritionals +​ +1,231 +​ +2,017 +​ +3,248 +​ +1,232 +​ +1,900 +​ +3,132 +​ +​ +1,254 +​ +​ +1,782 +​ +​ +3,036 +Total +​ +3,110 +​ +4,299 +​ +7,409 +​ +3,075 +​ +4,154 +​ +7,229 +​ +​ +3,031 +​ +​ +3,894 +​ +​ +6,925 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostics — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Core Laboratory +​ +1,086 +​ +3,570 +​ +4,656 +​ +985 +​ +3,401 +​ +4,386 +​ +​ +921 +​ +​ +3,142 +​ +​ +4,063 +Molecular +​ +149 +​ +293 +​ +442 +​ +152 +​ +332 +​ +484 +​ +​ +160 +​ +​ +303 +​ +​ +463 +Point of Care +​ +438 +​ +123 +​ +561 +​ +432 +​ +121 +​ +553 +​ +​ +440 +​ +​ +110 +​ +​ +550 +Rapid Diagnostics +​ +1,214 +​ +840 +​ +2,054 +​ +1,148 +​ +924 +​ +2,072 +​ +​ +296 +​ +​ +244 +​ +​ +540 +Total +​ +2,887 +​ +4,826 +​ +7,713 +​ +2,717 +​ +4,778 +​ +7,495 +​ +​ +1,817 +​ +​ +3,799 +​ +​ +5,616 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rhythm Management (a) +​ +1,057 +​ +1,087 +​ +2,144 +​ +1,105 +​ +1,093 +​ +2,198 +​ +​ +1,043 +​ +​ +1,089 +​ +​ +2,132 +Electrophysiology (a) +​ +742 +​ +979 +​ +1,721 +​ +678 +​ +883 +​ +1,561 +​ +​ +596 +​ +​ +757 +​ +​ +1,353 +Heart Failure +​ +574 +​ +195 +​ +769 +​ +467 +​ +179 +​ +646 +​ +​ +491 +​ +​ +152 +​ +​ +643 +Vascular +​ +1,047 +​ +1,803 +​ +2,850 +​ +1,126 +​ +1,803 +​ +2,929 +​ +​ +1,180 +​ +​ +1,712 +​ +​ +2,892 +Structural Heart +​ +616 +​ +784 +​ +1,400 +​ +488 +​ +751 +​ +1,239 +​ +​ +432 +​ +​ +651 +​ +​ +1,083 +Neuromodulation +​ +660 +​ +171 +​ +831 +​ +690 +​ +174 +​ +864 +​ +​ +636 +​ +​ +172 +​ +​ +808 +Diabetes Care +​ +​ +678 +​ +​ +1,846 +​ +​ +2,524 +​ +​ +457 +​ +​ +1,476 +​ +​ +1,933 +​ +​ +332 +​ +​ +1,082 +​ +​ +1,414 +Total +​ +5,374 +​ +6,865 +​ +12,239 +​ +5,011 +​ +6,359 +​ +11,370 +​ +​ +4,710 +​ +​ +5,615 +​ +​ +10,325 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other (b) +​ +27 +​ +30 +​ +57 +​ +36 +​ +26 +​ +62 +​ +​ +115 +​ +​ +122 +​ +​ +237 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +$ +11,398 +​ +$ +20,506 +​ +$ +31,904 +​ +$ +10,839 +​ +$ +19,739 +​ +$ +30,578 +​ +$ +9,673 +​ +$ +17,717 +​ +$ +27,390 +(a) +Insertable Cardiac Monitor (ICM) sales, which had previously been reported in Electrophysiology, are now included in Rhythm Management. Historic periods have been adjusted to reflect this change. +(b) +Diabetes Care sales, which had previously been reported in Other, are now included in the Medical Devices segment. Historic periods have been adjusted to reflect this change. +Abbott recognizes revenue from product sales upon the transfer of control, which is generally upon shipment or delivery, depending on the delivery terms set forth in the customer contract. For maintenance agreements that provide service beyond Abbott’s standard warranty and other service agreements, revenue is recognized ratably over the contract term. A time-based measure of progress appropriately reflects the transfer of services to the customer. Payment terms between Abbott and its customers vary by the type of customer, country of sale, and the products or services offered. The term between invoicing and the payment due date is not significant. +​ +55 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +Management exercises judgment in estimating variable consideration. Provisions for discounts, rebates and sales incentives to customers, and returns and other adjustments are provided for in the period the related sales are recorded. Sales incentives to customers are not material. Historical data is readily available and reliable, and is used for estimating the amount of the reduction in gross sales. Abbott provides rebates to government agencies, wholesalers, group purchasing organizations and other private entities. +Rebate amounts are usually based upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of which products have been sold subject to a rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current changes, Abbott estimates the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate generally occurs from one to six months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. Historically, adjustments to prior years' rebate accruals have not been material to net income. +Other allowances charged against gross sales include cash discounts and returns, which are not significant. Cash discounts are known within 15 to 30 days of sale, and therefore can be reliably estimated. Returns can be reliably estimated because Abbott's historical returns are low, and because sales return terms and other sales terms have remained relatively unchanged for several periods. Product warranties are also not significant. +Abbott also applies judgment in determining the timing of revenue recognition related to contracts that include multiple performance obligations. The total transaction price of the contract is allocated to each performance obligation in an amount based on the estimated relative standalone selling prices of the promised goods or services underlying each performance obligation. For goods or services for which observable standalone selling prices are not available, Abbott uses an expected cost plus a margin approach to estimate the standalone selling price of each performance obligation. +Remaining Performance Obligations +As of December 31, 2019, the estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied (or partially unsatisfied) was approximately $ 3.3 billion in the Diagnostic Products segment and approximately $ 380 million in the Medical Devices segment. Abbott expects to recognize revenue on approximately 60 percent of these remaining performance obligations over the next 24 months , approximately 16 percent over the subsequent 12 months and the remainder thereafter. +These performance obligations primarily reflect the future sale of reagents/consumables in contracts with minimum purchase obligations, extended warranty or service obligations related to previously sold equipment, and remote monitoring services related to previously implanted devices. Abbott has applied the practical expedient described in Accounting Standards Codification (ASC) 606-10-50 -14 and has not included remaining performance obligations related to contracts with original expected durations of one year or less in the amounts above. +Assets Recognized for Costs to Obtain a Contract with a Customer +Abbott has applied the practical expedient in ASC 340-40-25-4 and records as an expense the incremental costs of obtaining contracts with customers in the period of occurrence when the amortization period of the asset that Abbott otherwise would have recognized is one year or less. Upfront commission fees paid to sales personnel as a result of obtaining or renewing contracts with customers are incremental to obtaining the contract. Abbott capitalizes these amounts as contract costs. Capitalized commission fees are amortized based on the contract duration to which the assets relate which ranges from two to ten years . The amounts as of December 31, 2019 and 2018 were not significant. +​ +56 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +Additionally, the cost of transmitters provided to customers that use Abbott’s remote monitoring service with respect to certain medical devices are capitalized as contract costs. Capitalized transmitter costs are amortized based on the timing of the transfer of services to which the assets relate, which typically ranges from eight to ten years . The amounts as of December 31, 2019 and 2018 were not significant. +Other Contract Assets and Liabilities +Abbott discloses Trade receivables separately in the Consolidated Balance Sheet at their net realizable value. Contract assets primarily relate to Abbott’s conditional right to consideration for work completed but not billed at the reporting date. Contract assets at the beginning and end of the period, as well as the changes in the balance, were not significant. +Contract liabilities primarily relate to payments received from customers in advance of performance under the contract. Abbott’s contract liabilities arise primarily in the Medical Devices reportable segment when payment is received upfront for various multi-period extended service arrangements. Changes in the contract liabilities during the period are as follows: +​ +​ +​ +​ +​ +(in millions) +​ +​ +Contract Liabilities +​ +​ +​ +Balance at January 1, 2018 +​ +$ +198 +Unearned revenue from cash received during the period +​ +​ +304 +Revenue recognized related to contract liability balance +​ +​ +( 243 ) +Balance at December 31, 2018 +​ +​ +259 +Unearned revenue from cash received during the period +​ +411 +Revenue recognized related to contract liability balance +​ +( 376 ) +Balance at December 31, 2019 +​ +$ +294 +​ +​ +Note 4 — Discontinued Operations and Business Dispositions +In February 2015, Abbott completed the sale of its developed markets branded generics pharmaceuticals business to Mylan Inc. (Mylan) for 110 million ordinary shares (or approximately 22 percent) of a newly formed entity (Mylan N.V.) that combined Mylan’s existing business and Abbott’s developed markets branded generics pharmaceuticals business. In April 2015, Abbott sold 40.25 million of the 110 million ordinary shares of Mylan N.V. and recorded a pretax gain of $ 207 million on $ 2.29 billion in net proceeds from the sale of these shares. In 2017, Abbott sold 69.75 million ordinary shares of Mylan N.V. and received $ 2.704 billion in proceeds. Abbott recorded a $ 45 million gain from the sale of these ordinary shares in 2017, which was recognized in the Other (income) expense, net line of the Consolidated Statement of Earnings. Abbott no longer has an ownership interest in Mylan N.V. +The net earnings of discontinued operations include income tax benefits of $ 39 million in 2018 and $ 109 million in 2017. These tax benefits primarily relate to the resolution of various tax positions related to AbbVie’s operations for years prior to the separation. Abbott completed the separation of AbbVie Inc. (AbbVie), which was formed to hold Abbott’s research-based proprietary pharmaceuticals business, in January 2013. Abbott has retained all liabilities for all U.S. federal and foreign income taxes on income prior to the separation, as well as certain non-income taxes attributable to AbbVie’s business. AbbVie generally will be liable for all other taxes attributable to its business. +​ +57 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 4 — Discontinued Operations and Business Dispositions (Continued) +In September 2016, Abbott announced that it entered into a definitive agreement to sell Abbott Medical Optics (AMO), its vision care business, to Johnson & Johnson for $ 4.325 billion in cash, subject to customary purchase price adjustments for cash, debt and working capital. The decision to sell AMO reflected Abbott's proactive shaping of its portfolio in line with its strategic priorities. In February 2017, Abbott completed the sale of AMO to Johnson & Johnson and recognized a pre-tax gain of $ 1.163 billion including working capital adjustments, which was reported in the Other (income) expense, net line of the Consolidated Statement of Earnings in 2017. Abbott recorded an after-tax gain of $ 728 million in 2017 related to the sale of AMO. The operating results of AMO up to the date of sale continued to be included in Earnings from continuing operations as the business did not qualify for reporting as discontinued operations. For 2017, the AMO loss before taxes included in Abbott’s consolidated earnings was $ 18 million. +​ +Note 5 — Supplemental Financial Information +Other (income) expense, net, for 2019, 2018 and 2017 includes approximately $ 225 million, $ 160 million and $ 160 million of income, respectively, related to the non-service cost components of the net periodic benefit costs associated with the pension and post-retirement medical plans. Other (income) expense, net, for 2017 includes a pre-tax gain of $ 1.163 billion related to the sale of AMO to Johnson & Johnson. In 2017, Abbott recorded a $ 45 million pre-tax gain related to the sale of the Mylan N.V. ordinary shares. See Note 4 — Discontinued Operations and Business Dispositions for further discussion of these 2017 sales. +The detail of various balance sheet components is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, +​ +December 31, +(in millions) +2019 +2018 +Long-term Investments: +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +836 +​ +$ +856 +Other +​ +47 +​ +41 +Total +​ +$ +883 +​ +$ +897 +​ +Abbott’s equity securities as of December 31, 2019 and December 31, 2018, include $ 346 million and $ 307 million, respectively, of investments in mutual funds that are held in a rabbi trust acquired as part of the St. Jude Medical, Inc. (St. Jude Medical) business acquisition. These investments, which are specifically designated as available for the purpose of paying benefits under a deferred compensation plan, are not available for general corporate purposes and are subject to creditor claims in the event of insolvency. +Abbott also holds certain investments as of December 31, 2019 with a carrying value of $ 321 million that are accounted for under the equity method of accounting and other equity investments with a carrying value of $ 158 million that do not have a readily determinable fair value. The $ 158 million carrying value includes an unrealized gain of approximately $ 50 million on an investment. The gain was recorded in the second quarter of 2018 and relates to an observable price change for a similar investment of the same issuer. +​ +58 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 5 — Supplemental Financial Information (Continued) +In the first quarter of 2019, in conjunction with the acquisition of Cephea Valve Technologies, Inc., Abbott acquired a research & development (R&D) asset valued at $ 102 million, which was immediately expensed. The $ 102 million of expense was recorded in the R&D line of Abbott's Consolidated Statement of Earnings. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, +​ +December 31, +(in millions) +2019 +2018 +Other Accrued Liabilities: +​ +​ +​ +​ +​ +​ +Accrued rebates payable to government agencies +​ +$ +212 +​ +$ +166 +Accrued other rebates (a) +​ +655 +​ +608 +All other +​ +3,168 +​ +3,006 +Total +​ +$ +4,035 +​ +$ +3,780 +(a) Accrued wholesaler chargeback rebates of $ 175 million and $ 197 million at December 31, 2019 and 2018, respectively, are netted in trade receivables because Abbott’s customers are invoiced at a higher catalog price but only remit to Abbott their contract price for the products. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, +​ +December 31, +(in millions) +2019 +2018 +Post-employment Obligations and Other Long-term Liabilities: +​ +​ +​ +​ +​ +​ +Defined benefit pension plans and post-employment medical and dental plans for significant plans +​ +$ +2,817 +​ +$ +2,040 +Deferred income taxes +​ +1,546 +​ +2,056 +Operating lease liabilities +​ +​ +755 +​ +​ +— +All other (b) +​ +3,944 +​ +3,984 +Total +​ +$ +9,062 +​ +$ +8,080 +(b) 2019 includes approximately $ 580 million of net unrecognized tax benefits, as well as approximately $ 68 million of acquisition consideration payable. 2018 includes approximately $ 465 million of net unrecognized tax benefits, as well as approximately $ 65 million of acquisition consideration payable. +​ +​ +59 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 6 — Accumulated Other Comprehensive Income (Loss) +The components of the changes in accumulated other comprehensive income (loss) from continuing operations, net of income taxes, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cumulative +​ +Cumulative +​ +​ +​ +​ +​ +​ +​ +Net Actuarial +​ +Unrealized +​ +Gains (Losses) +​ +​ +​ +​ +​ +Cumulative +​ +(Losses) +​ +Gains (Losses) +​ +on Derivative +​ +​ +​ +​ +​ +Foreign +​ +and Prior +​ +on +​ +Instruments +​ +​ +​ +​ +​ +Currency +​ +Service +​ +Marketable +​ +Designated as +​ +​ +​ +​ +​ +Translation +​ +(Costs) and +​ +Equity +​ +Cash Flow +​ +​ +​ +(in millions) +Adjustments +Credits +Securities +Hedges +Total +Balance at December 31, 2017 +​ +$ +( 3,452 ) +​ +$ +( 2,521 ) +​ +$ +( 5 ) +​ +$ +( 84 ) +​ +$ +( 6,062 ) +Impact of adoption of new accounting standards +​ +​ +— +​ +​ +( 337 ) +​ +​ +5 +​ +​ +— +​ +​ +( 332 ) +Other comprehensive income (loss) before reclassifications +​ +​ +( 1,488 ) +​ +( 18 ) +​ +— +​ +58 +​ +( 1,448 ) +(Income) loss amounts reclassified from accumulated other comprehensive income (a) +​ +​ +28 +​ +150 +​ +— +​ +78 +​ +256 +Net current period other comprehensive income (loss) +​ +​ +( 1,460 ) +​ +132 +​ +— +​ +136 +​ +( 1,192 ) +Balance at December 31, 2018 +​ +​ +( 4,912 ) +​ +​ +( 2,726 ) +​ +​ +— +​ +​ +52 +​ +​ +( 7,586 ) +Other comprehensive income (loss) before reclassifications +​ +​ +( 12 ) +​ +( 719 ) +​ +— +​ +2 +​ +( 729 ) +(Income) loss amounts reclassified from accumulated other comprehensive income (a) +​ +​ +— +​ +( 95 ) +​ +— +​ +( 55 ) +​ +( 150 ) +Net current period other comprehensive income (loss) +​ +​ +( 12 ) +​ +​ +( 814 ) +​ +​ +— +​ +​ +( 53 ) +​ +​ +( 879 ) +Balance at December 31, 2019 +​ +$ +( 4,924 ) +​ +$ +( 3,540 ) +​ +$ +— +​ +$ +( 1 ) +​ +$ +( 8,465 ) +(a) Reclassified amounts for foreign currency translation adjustments are recorded in the Consolidated Statement of Earnings as Net Foreign exchange (gain) loss and gains/losses related to cash flow hedges are recorded as Cost of products sold. Net actuarial losses and prior service cost is included as a component of net periodic benefit cost – see Note 15 for additional information. +​ +Note 7 — Business Acquisitions +On January 4, 2017, Abbott completed the acquisition of St. Jude Medical, a global medical device manufacturer, for approximately $ 23.6 billion, including approximately $ 13.6 billion in cash and approximately $ 10 billion in Abbott common shares, which represented approximately 254 million shares of Abbott common stock, based on Abbott’s closing stock price on the acquisition date. As part of the acquisition, approximately $ 5.9 billion of St. Jude Medical’s debt was assumed, repaid or refinanced by Abbott. The acquisition provides expanded opportunities for future growth and is an important part of the company's ongoing effort to develop a strong, diverse portfolio of devices, diagnostics, nutritionals and branded generic pharmaceuticals. The combined business competes in nearly every area of the cardiovascular device market, as well as in the neuromodulation market. +Under the terms of the agreement, for each St. Jude Medical common share, St. Jude Medical shareholders received $ 46.75 in cash and 0.8708 of an Abbott common share. At an Abbott stock price of $ 39.36 , which reflects the closing price on January 4, 2017, this represented a value of approximately $ 81 per St. Jude Medical common share and total purchase consideration of $ 23.6 billion. The cash portion of the acquisition was funded through a combination of medium and long-term debt issued in November 2016 and a $ 2.0 billion 120-day senior unsecured bridge term loan facility which was subsequently repaid. +​ +60 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 7 — Business Acquisitions (Continued) +In 2016, Abbott and St. Jude Medical agreed to sell certain businesses to Terumo Corporation (Terumo) for approximately $ 1.12 billion. The sale included the St. Jude Medical Angio-Seal™ and Femoseal™ vascular closure and Abbott’s Vado ® Steerable Sheath businesses. The sale closed on January 20, 2017 and no gain or loss was recorded in the Consolidated Statement of Earnings. +On October 3, 2017, Abbott acquired Alere, a diagnostic device and service provider, for $ 51.00 per common share in cash, which equated to a purchase price of approximately $ 4.5 billion. As part of the acquisition, Abbott tendered for Alere’s preferred shares for a total value of approximately $ 0.7 billion. In addition, approximately $ 3.0 billion of Alere’s debt was assumed and subsequently repaid. The acquisition establishes Abbott as a leader in point of care testing, expands Abbott’s global diagnostics presence and provides access to new products, channels and geographies. Abbott utilized a combination of cash on hand and debt to fund the acquisition. See Note 11 — Debt and Lines of Credit for further details regarding the debt utilized for the acquisition. +In the third quarter of 2017, Alere entered into agreements to sell its Triage MeterPro cardiovascular and toxicology business and the assets and liabilities related to its B-type Natriuretic Peptide assay business run on Beckman Coulter analyzers to Quidel. The transactions with Quidel reflect a total purchase price of $ 400 million payable at the close of the transaction, $ 240 million payable in six annual installments beginning approximately six months after the close of the transaction, and contingent consideration with a maximum value of $ 40 million. In the third quarter of 2017, Alere entered into an agreement with Siemens Diagnostics Holding II B.V. (Siemens) to sell its subsidiary, Epocal Inc., for approximately $ 200 million payable at the close of the transaction. Alere agreed to divest these businesses in connection with the review by the Federal Trade Commission and the European Commission of Abbott’s agreement to acquire Alere. The sale to Quidel closed on October 6, 2017, and the sale to Siemens closed on October 31, 2017. No gain or loss on these sales was recorded in the Consolidated Statement of Earnings. +In 2017, consolidated Abbott results include $ 6.5 billion of sales and a pre-tax loss of approximately $ 1.3 billion related to the St. Jude Medical and Alere acquisitions, including approximately $ 1.5 billion of intangible amortization and $ 907 million of inventory step-up amortization. The pre-tax loss excludes acquisition, integration and restructuring-related costs. +If the acquisitions of St. Jude Medical and Alere had occurred at the beginning of 2016, unaudited pro forma consolidated net sales would have been approximately $ 28.9 billion and the unaudited pro forma consolidated net loss from continuing operations would have been approximately $ 485 million in 2016. This includes amortization of approximately $ 940 million of inventory step-up and $ 1.7 billion of intangibles related to St. Jude Medical and Alere. For 2017, unaudited pro forma consolidated net sales would have been approximately $ 28.9 billion and unaudited pro forma consolidated net earnings from continuing operations would have been approximately $ 750 million, which includes $ 225 million of intangible amortization related to Alere. The unaudited pro forma consolidated net earnings from continuing operations for 2017 exclude inventory step-up amortization related to St. Jude Medical and Alere of approximately $ 907 million which was recorded in 2017 but included in the 2016 unaudited pro forma results as noted above. The unaudited pro forma information is not necessarily indicative of the consolidated results of operations that would have been realized had the St. Jude Medical and Alere acquisitions been completed as of the beginning of 2016, nor is it meant to be indicative of future results of operations that the combined entity will experience. +​ +61 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 7 — Business Acquisitions (Continued) +On July 17, 2017, Abbott commenced a tender offer to purchase for cash the 1.77 million outstanding shares of Alere’s Series B Convertible Perpetual Preferred Stock at a price of $ 402 per share, plus accrued but unpaid dividends to, but not including, the settlement date of the tender offer. This tender offer was subject to the satisfaction of certain conditions, including Abbott’s acquisition of Alere and upon there being validly tendered (and not properly withdrawn) at the expiration date of the tender offer that number of shares of Preferred Stock that equaled at least a majority of the Preferred Stock issued and outstanding at the expiration of the tender offer. The tender offer expired on October 3, 2017. All conditions to the offer were satisfied and Abbott accepted for payment the 1.748 million shares of Preferred Stock that were validly tendered (and not properly withdrawn). The remaining shares were cashed out for an amount equal to the $ 400.00 per share liquidation preference of such shares, plus accrued but unpaid dividends, without interest. Payment for all of the shares of Preferred Stock was made in the fourth quarter of 2017. +Note 8 — Goodwill and Intangible Assets +The total amount of goodwill reported was $ 23.2 billion at December 31, 2019 and $ 23.3 billion at December 31, 2018. Foreign currency translation adjustments decreased goodwill by approximately $ 103 million in 2019 and $ 440 million in 2018. Purchase price accounting adjustments associated with the Alere acquisition decreased goodwill by $ 326 million in 2018. The amount of goodwill related to reportable segments at December 31, 2019 was $ 3.0 billion for the Established Pharmaceutical Products segment, $ 286 million for the Nutritional Products segment, $ 3.7 billion for the Diagnostic Products segment, and $ 16.1 billion for the Medical Devices segment. There was no significant reduction of goodwill relating to impairments in 2019 and 2018. +The gross amount of amortizable intangible assets, primarily product rights and technology was $ 27.6 billion and $ 25.7 billion as of December 31, 2019 and 2018, respectively, and accumulated amortization was $ 11.9 billion and $ 10.4 billion as of December 31, 2019 and 2018, respectively. Foreign currency translation adjustments decreased intangible assets by approximately $ 71 million in 2019 and $ 281 million in 2018. In 2018, purchase price allocation adjustments increased intangible assets by $ 280 million. The estimated annual amortization expense for intangible assets recorded at December 31, 2019 is approximately $ 2.1 billion in 2020, $ 2.0 billion in 2021, $ 2.0 billion in 2022, $ 2.0 billion in 2023 and $ 1.9 billion in 2024. Amortizable intangible assets are amortized over 2 to 20 years . +Indefinite-lived intangible assets, which relate to in-process research and development acquired in a business combination, were approximately $ 1.3 billion and $ 3.6 billion at December 31, 2019 and 2018, respectively. The decrease is due to an in-process research and development intangible asset related to the Medical Devices segment that became amortizable at the end of 2019. In 2017, Abbott recorded a $ 53 million impairment of an in-process research and development project related to the Medical Devices segment. +62 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 9 — Restructuring Plans +From 2017 to 2019, Abbott management approved restructuring plans as part of the integration of the acquisitions of St. Jude Medical into the Medical Devices segment, and Alere into the Diagnostic Products segment, in order to leverage economies of scale and reduce costs. Abbott recorded employee related severance and other charges of approximately $ 72 million in 2019, $ 52 million in 2018 and $ 187 million in 2017. Approximately $ 19 million in 2019, $ 5 million in 2018 and $ 5 million in 2017 are recorded in Cost of products sold, approximately $ 4 million in 2019 and $ 10 million in 2018 are recorded in Research and development, and approximately $ 49 million in 2019, $ 37 million in 2018 and $ 182 million in 2017 are recorded in Selling, general and administrative expense. Abbott also assumed restructuring liabilities of approximately $ 23 million as part of the St Jude Medical and Alere acquisitions. +The following summarizes the activity related to these actions and the status of the related accruals: +​ +​ +​ +​ +​ +(in millions) +​ +​ +Liabilities assumed as part of business acquisitions +​ +$ +23 +Restructuring charges +​ +​ +187 +Payments and other adjustments +​ +​ +( 142 ) +Accrued balance at December 31, 2017 +​ +​ +68 +Restructuring charges +​ +52 +Payments and other adjustments +​ +( 79 ) +Accrued balance at December 31, 2018 +​ +​ +41 +Restructuring charges +​ +​ +72 +Payments and other adjustments +​ +​ +( 67 ) +Accrued balance at December 31, 2019 +​ +$ +46 +​ +From 2016 to 2019, Abbott management approved plans to streamline operations in order to reduce costs and improve efficiencies in various Abbott businesses including the nutritional, established pharmaceuticals and vascular businesses. Abbott recorded employee related severance and other charges of approximately $ 66 million in 2019, $ 28 million in 2018 and $ 120 million in 2017. Approximately $ 16 million in 2019, $ 10 million in 2018 and $ 7 million in 2017 are recorded in Cost of products sold, approximately $ 28 million in 2019, $ 2 million in 2018 and $ 77 million in 2017 are recorded in Research and development, and approximately $ 22 million in 2019, $ 16 million in 2018 and $ 36 million in 2017 are recorded in Selling, general and administrative expense. Additional charges of approximately $ 2 million in 2017 were recorded, primarily for accelerated depreciation. +The following summarizes the activity for these restructurings: +​ +​ +​ +​ +​ +(in millions) +​ +​ +Restructuring charges recorded in 2016 +​ +$ +32 +Payments and other adjustments +​ +​ +( 15 ) +Accrued balance at December 31, 2016 +​ +​ +17 +Restructuring charges +​ +​ +120 +Payments and other adjustments +​ +​ +( 18 ) +Accrued balance at December 31, 2017 +​ +​ +119 +Restructuring charges +​ +​ +28 +Payments and other adjustments +​ +​ +( 77 ) +Accrued balance at December 31, 2018 +​ +​ +70 +Restructuring charges +​ +​ +66 +Payments and other adjustments +​ +​ +( 57 ) +Accrued balance at December 31, 2019 +​ +$ +79 +​ +​ +63 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 10 — Incentive Stock Program +The 2017 Incentive Stock Program authorizes the granting of nonqualified stock options, restricted stock awards, restricted stock units, performance awards, foreign benefits and other share-based awards. Stock options and restricted stock awards and units comprise the majority of benefits that have been granted and are currently outstanding under this program and a prior program. In 2019, Abbott granted 4,579,283 stock options, 736,100 restricted stock awards and 6,628,009 restricted stock units under this program. +Under Abbott’s stock incentive programs, the purchase price of shares under option must be at least equal to the fair market value of the common stock on the date of grant, and the maximum term of an option is 10 years . Options generally vest equally over three years . Restricted stock awards generally vest over 3 years , with no more than one-third of the award vesting in any one year upon Abbott reaching a minimum return on equity target. Restricted stock units vest over three years and upon vesting, the recipient receives one share of Abbott stock for each vested restricted stock unit. The aggregate fair market value of options and restricted stock awards and units is recognized as expense over the requisite service period, which may be shorter than the vesting period if an employee is retirement eligible. Forfeitures are estimated at the time of grant. Restricted stock awards and settlement of vested restricted stock units are issued out of treasury shares. Abbott generally issues new shares for exercises of stock options. As a policy, Abbott does not purchase its shares relating to its share-based programs. +In April 2017, Abbott’s shareholders authorized the 2017 Incentive Stock Program under which a maximum of 170 million shares were available for issuance. At December 31, 2019, approximately 127 million shares remained available for future issuance. +In connection with the completion of the St. Jude Medical acquisition in the first quarter of 2017, unvested St. Jude Medical stock options and restricted stock units were assumed by Abbott and converted into Abbott options and restricted stock units (as applicable) of substantially equivalent value, in accordance with the merger agreement. The number of shares underlying the converted options was 7,364,571 at a weighted average exercise price of $ 30.50 . The number of restricted stock units converted was 2,324,500 at a weighted average grant date fair value of $ 37.69 . +The following table summarizes stock option activity for the year ended December 31, 2019 and the outstanding stock options as of December 31, 2019. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted +​ +Weighted +​ +​ +​ +​ +​ +​ +​ +Average +​ +Average +​ +​ +Aggregate +​ +​ +​ +​ +Exercise +​ +Remaining +​ +​ +Intrinsic +(intrinsic values in millions) +Options +Price +Life (Years) +Value +Outstanding at December 31, 2018 +​ +33,074,613 +​ +$ +42.21 +6.3 +​ +$ +996 +Granted +4,579,283 +​ +76.35 +​ +​ +​ +​ +​ +​ +Exercised +( 7,281,472 ) +​ +35.51 +​ +​ +​ +​ +​ +​ +Lapsed +( 494,509 ) +​ +60.06 +​ +​ +​ +​ +​ +​ +Outstanding at December 31, 2019 +29,877,915 +​ +$ +48.78 +6.2 +​ +$ +1,138 +Exercisable at December 31, 2019 +​ +20,555,321 +​ +$ +41.26 +​ +5.3 +​ +​ +$ +937 +​ +64 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 10 — Incentive Stock Program (Continued) +The following table summarizes restricted stock awards and units activity for 2019. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted +​ +​ +​ +​ +Average +​ +​ +​ +Grant-Date +​ +​ +Share Units +​ +Fair Value +Outstanding at December 31, 2018 +15,952,602 +​ +$ +52.11 +Granted +7,364,109 +​ +76.17 +Vested +( 7,750,049 ) +​ +48.52 +Forfeited +( 1,103,348 ) +​ +62.28 +Outstanding at December 31, 2019 +14,463,314 +​ +$ +65.51 +​ +The fair market value of restricted stock awards and units vested in 2019, 2018 and 2017 was $ 588 million, $ 458 million and $ 348 million, respectively. +The total intrinsic value of options exercised in 2019, 2018 and 2017 was $ 315 million, $ 249 million and $ 233 million, respectively. The total unrecognized compensation cost related to all share-based compensation plans at December 31, 2019 amounted to approximately $ 419 million, which is expected to be recognized over the next three years . +Total non-cash stock compensation expense charged against income from continuing operations in 2019, 2018 and 2017 for share-based plans totaled approximately $ 519 million, $ 477 million and $ 406 million, respectively, and the tax benefit recognized was approximately $ 197 million, $ 185 million and $ 242 million, respectively. The decrease in the tax benefit in 2018 primarily relates to the Tax Cuts and Jobs Act (TCJA), which reduces the U.S. federal corporate tax rate from 35 % to 21 %. Stock compensation cost capitalized as part of inventory is not significant. +The table below summarizes the fair value of an option granted in 2019, 2018 and 2017 and the assumptions included in the Black-Scholes option-pricing model used to estimate the fair value: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +2018 +2017 +​ +Fair value +​ +$ +14.50 +​ +$ +10.93 +​ +$ +6.54 +​ +Risk-free interest rate +​ +2.5 +% +​ +2.7 +% +​ +2.1 +% +Average life of options (years) +​ +6.0 +​ +​ +6.0 +​ +​ +6.0 +​ +Volatility +​ +19.8 +% +​ +19.0 +% +​ +18.0 +% +Dividend yield +​ +1.7 +% +​ +1.9 +% +​ +2.4 +% +​ +The risk-free interest rate is based on the rates available at the time of the grant for zero-coupon U.S. government issues with a remaining term equal to the option’s expected life. The average life of an option is based on both historical and projected exercise and lapsing data. Expected volatility is based on implied volatilities from traded options on Abbott’s stock and historical volatility of Abbott’s stock over the expected life of the option. Dividend yield is based on the option’s exercise price and annual dividend rate at the time of grant. +65 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit +The following is a summary of long-term debt at December 31: +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +0.00 % Notes, due 2020 +​ +$ +1,272 +​ +$ +1,300 +2.80 % Notes, due 2020 +​ +— +​ +500 +2.90 % Notes, due 2021 +​ +​ +— +​ +​ +2,850 +2.55 % Notes, due 2022 +​ +​ +750 +​ +​ +750 +0.875 % Notes, due 2023 +​ +​ +1,272 +​ +​ +1,303 +3.40 % Notes, due 2023 +​ +​ +1,050 +​ +​ +1,050 +5-year term loan due 2024 +​ +​ +546 +​ +​ +— +0.10 % Notes, due 2024 +​ +​ +658 +​ +​ +— +3.875 % Notes, due 2025 +​ +​ +500 +​ +​ +500 +2.95 % Notes, due 2025 +​ +​ +1,000 +​ +​ +1,000 +1.50 % Notes, due 2026 +​ +​ +1,272 +​ +​ +1,300 +3.75 % Notes, due 2026 +​ +​ +1,700 +​ +​ +1,700 +0.375 % Notes, due 2027 +​ +​ +658 +​ +​ +— +4.75 % Notes, due 2036 +​ +​ +1,650 +​ +​ +1,650 +6.15 % Notes, due 2037 +​ +547 +​ +547 +6.00 % Notes, due 2039 +​ +515 +​ +515 +5.30 % Notes, due 2040 +​ +694 +​ +694 +4.75 % Notes, due 2043 +​ +700 +​ +700 +4.90 % Notes, due 2046 +​ +​ +3,250 +​ +​ +3,250 +Unamortized debt issuance costs +​ +​ +( 90 ) +​ +​ +( 102 ) +Other, including fair value adjustments relating to interest rate hedge contracts designated as +fair value hedges +​ +( 6 ) +​ +( 141 ) +Total carrying amount of long-term debt +​ +17,938 +​ +19,366 +Less: Current portion +​ +1,277 +​ +7 +Total long-term portion +​ +$ +16,661 +​ +$ +19,359 +​ +On February 16, 2018, the board of directors authorized the early redemption of up to $ 5 billion of outstanding long-term notes. Redemptions under this authorization include the following: +● $ 0.947 billion principal amount of its 5.125 % Notes due 2019 – redeemed on March 22, 2018 +● $ 1.055 billion of the $ 2.850 billion principal amount of its 2.35 % Notes due 2019 – redeemed on March 22, 2018 +● $ 1.300 billion of the $ 1.795 billion outstanding principal amount of its 2.35 % Notes due 2019 – redeemed on June 22, 2018 +● $ 0.495 billion outstanding principal amount of its 2.35 % Notes due 2019 – redeemed on September 28, 2018 +● $ 0.500 billion outstanding principal amount of its 2.80 % Notes due 2020 – redeemed on February 24, 2019 +Abbott incurred a net charge of $ 14 million related to the March 22, 2018 early repayment of debt. +In September 2019, the board of directors authorized the early redemption of up to $ 5 billion of outstanding long-term notes. This bond redemption authorization supersedes the board’s previous authorization under which $ 700 million had not yet been redeemed. +​ +66 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit (Continued) +On November 19, 2019, Abbott's wholly owned subsidiary, Ireland Financing DAC, completed an offering of € 1.180 billion of long-term debt consisting of € 590 million of 0.10 % Notes due 2024 and € 590 million of 0.375 % Notes due 2027. The proceeds equated to approximately $ 1.3 billion. The Notes are guaranteed by Abbott. +On November 21, 2019, Abbott borrowed ¥ 59.8 billion under a 5 -year term loan and designated the yen-denominated loan as a hedge of its net investment in certain foreign subsidiaries. The term loan bears interest at TIBOR plus a fixed spread, and the interest rate is reset quarterly. The proceeds equated to approximately $ 550 million. +On December 19, 2019, Abbott redeemed the $ 2.850 billion principal amount of its 2.9 % Notes due 2021. Abbott incurred a charge of $ 63 million related to the early repayment of this debt. +On September 17, 2018, Abbott repaid upon maturity the $ 500 million aggregate principal amount outstanding of the 2.00 % Senior Notes due 2018. +On September 27, 2018, Abbott’s wholly owned subsidiary, Abbott Ireland Financing DAC, completed a euro debt offering of € 3.420 billion of long-term debt consisting of € 1.140 billion of non-interest bearing Senior Notes due 2020 at 99.727 % of par value; € 1.140 billion of 0.875 % Senior Notes due 2023 at 99.912 % of par value; and € 1.140 billion of 1.50 % Senior Notes due 2026 at 99.723 % of par value. The proceeds equated to approximately $ 4 billion. The notes are guaranteed by Abbott. +On October 28, 2018, Abbott redeemed approximately $ 4 billion of debt, which included $ 750 million principal amount of its 2.00 % Notes due 2020; $ 597 million principal amount of its 4.125 % Notes due 2020; $ 900 million principal amount of its 3.25 % Notes due 2023; $ 450 million principal amount of its 3.4 % Notes due 2023; and $ 1.300 billion principal amount of its 3.75 % Notes due 2026. These amounts are in addition to the $ 5 billion authorization in 2018 discussed above. In conjunction with the redemption, Abbott unwound approximately $ 1.1 billion in interest rate swaps relating to the 3.40 % Note due in 2023 and the 3.75 % Note due in 2026. Abbott incurred a net charge of $ 153 million related to the early repayment of this debt and the unwinding of related interest rate swaps. +On November 30, 2018, Abbott entered into a Five Year Credit Agreement (Revolving Credit Agreement) and terminated the 2014 revolving credit agreement. There were no outstanding borrowings under the 2014 revolving credit agreement at the time of its termination. The Revolving Credit Agreement provides Abbott with the ability to borrow up to $ 5 billion on an unsecured basis. Any borrowings under the Revolving Credit Agreement will mature and be payable on November 30, 2023. Any borrowings under the Revolving Credit Agreement will bear interest, at Abbott’s option, based on either a base rate or Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. +In the first quarter of 2017, as part of the acquisition of St. Jude Medical, Abbott’s long-term debt increased due to the assumption of outstanding debt previously issued by St. Jude Medical. Abbott exchanged certain St. Jude Medical debt obligations with an aggregate principal amount of approximately $ 2.9 billion for debt issued by Abbott which consists of: +​ +​ +​ +​ +​ +(in millions) +Principal Amount +2.00 % Senior Notes due 2018 +​ +$ +473.8 +2.80 % Senior Notes due 2020 +​ +​ +483.7 +3.25 % Senior Notes due 2023 +​ +​ +818.4 +3.875 % Senior Notes due 2025 +​ +​ +490.7 +4.75 % Senior Notes due 2043 +​ +​ +639.1 +​ +67 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Debt and Lines of Credit (Continued) +Following this exchange, approximately $ 194.2 million of existing St. Jude Medical notes remained outstanding across the five series of existing notes which have the same coupons and maturities as those listed above. There were no significant costs associated with the exchange of debt. In addition, during the first quarter of 2017, Abbott assumed and subsequently repaid approximately $ 2.8 billion of various St. Jude Medical debt obligations. +In 2017, Abbott issued 364-day yen-denominated debt, of which $ 201 million and $ 199 million was outstanding at December 31, 2019 and 2018, respectively. In 2017, Abbott also paid off a $ 479 million yen-denominated short-term borrowing during the year. +On July 31, 2017, Abbott entered into a 5-year term loan agreement that allowed Abbott to borrow up to $ 2.8 billion on an unsecured basis for the acquisition of Alere. On October 3, 2017, Abbott borrowed $ 2.8 billion under this term loan agreement to finance the acquisition of Alere, to repay certain indebtedness of Abbott and Alere, and to pay fees and expenses in connection with the acquisition. Borrowings under the term loan bore interest based on a Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. Abbott paid off this term loan on January 5, 2018. +On October 3, 2017 Abbott borrowed $ 1.7 billion under its lines of credit. Proceeds from such borrowing were used to finance the acquisition of Alere, to repay certain indebtedness of Abbott and Alere, and to pay fees and expenses in connection with the acquisition. These lines of credit were part of a 2014 revolving credit agreement that provided Abbott with the ability to borrow up to $ 5 billion on an unsecured basis. Advances under the revolving credit agreement, including the $ 1.7 billion borrowing in October 2017, were scheduled to mature and be payable on July 10, 2019. The $ 1.7 billion borrowing bore interest based on a Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. Prior to October 3, 2017, no amounts were previously drawn under the revolving credit agreement. In the fourth quarter of 2017, Abbott paid off $ 550 million on the revolving loan. Abbott paid off the remaining balance on this revolving loan on January 5, 2018. +In the fourth quarter of 2017, in conjunction with the acquisition of Alere, Abbott assumed and subsequently repaid $ 3.0 billion of Alere’s debt. +Principal payments required on long-term debt outstanding at December 31, 2019 are $ 1.3 billion in 2020, $ 5 million in 2021, $ 752 million in 2022, $ 2.3 billion in 2023, $ 1.2 billion in 2024 and $ 12.5 billion in 2025 and thereafter. +At December 31, 2019, Abbott’s long-term debt rating was A- by Standard & Poor’s Corporation and A3 by Moody’s. Abbott has readily available financial resources, including lines of credit of $ 5.0 billion which expire in 2023 and support commercial paper borrowing arrangements. Abbott’s weighted-average interest rate on short-term borrowings was 0.4 % at December 31, 2019, 0.4 % at December 31, 2018 and 0.3 % at December 31, 2017. +Note 12 — Leases +Leases where Abbott is the Lessee +Abbott has entered into operating leases as the lessee for office space, manufacturing facilities, R&D laboratories, warehouses, vehicles and equipment. Finance leases are not significant. Abbott’s operating leases generally have remaining lease terms of 1 to 10 years . Some leases include options to extend beyond the original lease term , generally up to 10 years and some include options to terminate early . These options have been included in the determination of the lease liability when it is reasonably certain that the option will be exercised. +For all of its asset classes, Abbott elected the practical expedient allowed under FASB ASC No. 842, “Leases” to account for each lease component (e.g., the right to use office space) and the associated non-lease components (e.g., maintenance services) as a single lease component. Abbott also elected the short-term lease accounting policy for all asset classes; therefore, Abbott is not recognizing a lease liability or ROU asset for any lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that Abbott is reasonably certain to exercise. +​ +68 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Leases (Continued) +As Abbott’s leases typically do not provide an implicit rate, the interest rate used to determine the present value of the payments under each lease typically reflects Abbott’s incremental borrowing rate based on information available at the lease commencement date. Abbott’s incremental borrowing rates at January 1, 2019 were used for operating leases that commenced prior to January 1, 2019. +The following table provides information related to Abbott’s operating leases: +​ +​ +​ +​ +​ +​ +​ +Year Ended +(in millions) +December 31, 2019 +Operating lease cost (a) +​ +$ +314 +​ +​ +​ +​ +Cash paid for amounts included in the measurement of operating lease liabilities +​ +$ +253 +​ +​ +​ +​ +ROU assets arising from entering into new operating lease obligations +​ +$ +310 +(a) +Includes short-term lease expense and variable lease costs, which were immaterial in the year ended December 31, 2019. +The weighted average remaining lease term and discount rate for operating leases as of December 31, 2019 were 8 years and 3.9 %, respectively. +Future minimum lease payments under non-cancellable operating leases as of December 31, 2019 were as follows: +​ +​ +​ +​ +​ +(in millions) +​ +​ +2020 +​ +$ +238 +2021 +​ +197 +2022 +​ +155 +2023 +​ +115 +2024 +​ +80 +Thereafter +​ +353 +Total future minimum lease payments – undiscounted +​ +1,138 +Less: imputed interest +​ +( 178 ) +Present value of lease liabilities +​ +$ +960 +​ +The following table summarizes the amounts and location of operating lease ROU assets and lease liabilities as of December 31, 2019: +​ +​ +​ +​ +​ +​ +​ +(in millions) +December 31, 2019 +Balance Sheet Caption +​ +​ +​ +​ +​ +​ +Operating Lease - ROU Asset +​ +$ +934 +Deferred income taxes and other assets +​ +​ +​ +​ +​ +​ +Operating Lease Liability: +​ +Current +​ +$ +205 +Other accrued liabilities +Non-current +​ +755 +Post-employment obligations and other long-term liabilities +Total Liability +​ +$ +960 +​ +69 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Leases (Continued) +Leases where Abbott is the Lessor +Certain assets, primarily diagnostics instruments, are leased to customers under contractual arrangements that typically include an operating or sales-type lease as well as performance obligations for reagents and other consumables. Sales-type leases are not significant. Contract terms vary by customer and may include options to terminate the contract or options to extend the contract. Where instruments are provided under operating lease arrangements, some portion or the entire lease revenue may be variable and subject to subsequent non-lease component (e.g., reagent) sales. The allocation of revenue between the lease and non-lease components is based on stand-alone selling prices. Operating lease revenue represented less than 3 percent of Abbott’s total net sales in the year ended December 31, 2019. +Assets related to operating leases are reported within Net property and equipment on the Consolidated Balance Sheet. The original cost and the net book value of such assets were $ 2.8 billion and $ 1.2 billion, respectively, as of December 31, 2019. +Note 13 — Financial Instruments, Derivatives and Fair Value Measures +Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates primarily for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts, with gross notional amounts totaling $ 6.8 billion at December 31, 2019, and $ 5.1 billion at December 31, 2018, are designated as cash flow hedges of the variability of the cash flows due to changes in foreign exchange rates and are recorded at fair value. Accumulated gains and losses as of December 31, 2019 will be included in Cost of products sold at the time the products are sold, generally through the next twelve to eighteen months . +Abbott enters into foreign currency forward exchange contracts to manage currency exposures for foreign currency denominated third-party trade payables and receivables, and for intercompany loans and trade accounts payable where the receivable or payable is denominated in a currency other than the functional currency of the entity. For intercompany loans, the contracts require Abbott to sell or buy foreign currencies, primarily European currencies, in exchange for primarily U.S. dollars and European currencies. For intercompany and trade payables and receivables, the currency exposures are primarily the U.S. dollar and European currencies. At December 31, 2019 and 2018, Abbott held gross notional amounts of $ 9.1 billion and $ 13.6 billion, respectively, of such foreign currency forward exchange contracts. +In November 2019, Abbott borrowed ¥ 59.8 billion under a 5 -year term loan and designated the yen-denominated loan as a hedge of the net investment in certain foreign subsidiaries. From the date of the borrowing through December 31, 2019, the value of this long-term debt decreased approximately $ 4 million to $ 546 million due to foreign exchange rate changes. The change in the value was recorded in Accumulated other comprehensive income (loss), net of tax. In March 2017, Abbott repaid its $ 479 million yen-denominated short-term debt which was designated as a hedge of the net investment in a foreign subsidiary. At December 31, 2016, the value of this short-term debt was $ 454 million and changes in the fair value of the debt up through the date of repayment due to changes in exchange rates were recorded in Accumulated other comprehensive income (loss), net of tax. +Abbott is a party to interest rate hedge contracts totaling approximately $ 2.9 billion at December 31, 2019 and 2018, to manage its exposure to changes in the fair value of fixed-rate debt. These contracts are designated as fair value hedges of the variability of the fair value of fixed-rate debt due to changes in the long-term benchmark interest rates. The effect of the hedge is to change a fixed-rate interest obligation to a variable rate for that portion of the debt. Abbott records the contracts at fair value and adjusts the carrying amount of the fixed-rate debt by an offsetting amount. +In October 2018, Abbott unwound approximately $ 1.1 billion in interest rate swaps relating to the 3.40 % Note due in 2023 and the 3.75 % Note due in 2026. As a part of the unwinding, Abbott paid approximately $ 90 million in cash, which was included in the Financing Activities section of the Consolidated Statement of Cash Flows in 2018. +​ +70 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 13 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +In the second quarter of 2017, Abbott unwound approximately $ 1.5 billion in interest rate swaps relating to the 2.00 % Note due in 2020 and the 2.55 % Note due in 2022. The proceeds received were not significant. +The following table summarizes the amounts and location of certain derivative financial instruments as of December 31: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair Value — Assets +​ +Fair Value — Liabilities +(in millions) +2019 +2018 +Balance Sheet Caption +2019 +2018 +Balance Sheet Caption +Interest rate swaps designated as fair value hedges +​ +$ +48 +​ +$ +— +Deferred income taxes and other assets +​ +$ +— +​ +$ +100 +Post-employment obligations and other long-term liabilities +Foreign currency forward exchange contracts: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Hedging instruments +​ +110 +​ +81 +Other prepaid expenses and receivables +​ +56 +​ +44 +Other accrued liabilities +Others not designated as hedges +​ +38 +​ +33 +​ +Other prepaid expenses and receivables +​ +33 +​ +51 +​ +Other accrued liabilities +Debt designated as a hedge of net investment in a foreign subsidiary +​ +​ +— +​ +​ +— +​ +n/a +​ +​ +546 +​ +​ +— +​ +Long-term debt +​ +​ +$ +196 +​ +$ +114 +​ +​ +​ +$ +635 +​ +$ +195 +​ +​ +​ +The following table summarizes the activity for foreign currency forward exchange contracts designated as cash flow hedges, debt designated as a hedge of net investment in a foreign subsidiary and certain other derivative financial instruments, as well as the amounts and location of income (expense) and gain (loss) reclassified into income. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Gain (loss) Recognized in +​ +Income (expense) and +​ +​ +​ +​ +Other Comprehensive +​ +Gain (loss) Reclassified +​ +​ +​ +​ +Income (loss) +​ +into Income +​ +Income Statement +(in millions) +2019 +2018 +2017 +2019 +2018 +2017 +Caption +Foreign currency forward exchange contracts designated as cash flow hedges +​ +$ +9 +​ +$ +73 +​ +$ +( 226 ) +​ +$ +79 +​ +$ +( 114 ) +​ +$ +( 48 ) +​ +Cost of products sold +Debt designated as a hedge of net investment in a foreign subsidiary +​ +4 +​ +— +​ +( 25 ) +​ +n/a +​ +n/a +​ +n/a +n/a +Interest rate swaps designated as fair value hedges +​ +n/a +​ +n/a +​ +n/a +​ +148 +​ +( 97 ) +​ +( 24 ) +Interest expense +​ +A gain of $ 75 million and losses of $ 100 million and $ 64 million were recognized in 2019, 2018 and 2017, respectively, related to foreign currency forward exchange contracts not designated as hedges. These amounts are reported in the Consolidated Statement of Earnings on the Net foreign exchange (gain) loss line. +The interest rate swaps are designated as fair value hedges of the variability of the fair value of fixed-rate debt due to changes in the long-term benchmark interest rates. The hedged debt is marked to market, offsetting the effect of marking the interest rate swaps to market. +​ +71 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 13 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +The carrying values and fair values of certain financial instruments as of December 31 are shown in the table below. The carrying values of all other financial instruments approximate their estimated fair values. The counterparties to financial instruments consist of select major international financial institutions. Abbott does not expect any losses from nonperformance by these counterparties. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +​ +2018 +​ +​ +Carrying +​ +Fair +​ +Carrying +​ +Fair +(in millions) +Value +Value +Value +Value +Long-term Investment Securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +836 +​ +$ +836 +​ +$ +856 +​ +$ +856 +Other +​ +47 +​ +47 +​ +41 +​ +41 +Total Long-term debt +​ +( 17,938 ) +​ +( 20,772 ) +​ +( 19,366 ) +​ +( 19,871 ) +Foreign Currency Forward Exchange Contracts: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Receivable position +​ +148 +​ +148 +​ +114 +​ +114 +(Payable) position +​ +( 89 ) +​ +( 89 ) +​ +( 95 ) +​ +( 95 ) +Interest Rate Hedge Contracts: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Receivable position +​ +48 +​ +48 +​ +— +​ +— +(Payable) position +​ +​ +— +​ +​ +— +​ +​ +( 100 ) +​ +​ +( 100 ) +​ +The fair value of the debt was determined based on significant other observable inputs, including current interest rates. +The following table summarizes the bases used to measure certain assets and liabilities at fair value on a recurring basis in the balance sheet: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basis of Fair Value Measurement +​ +​ +​ +​ +​ +Quoted +​ +Significant Other +​ +Significant +​ +​ +Outstanding +​ +Prices in +​ +Observable +​ +Unobservable +(in millions) +Balances +Active Markets +Inputs +Inputs +December 31, 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +357 +​ +$ +357 +​ +$ +— +​ +$ +— +Interest rate swap derivative financial instruments +​ +48 +​ +— +​ +48 +​ +— +Foreign currency forward exchange contracts +​ +148 +​ +— +​ +148 +​ +— +Total Assets +​ +$ +553 +​ +$ +357 +​ +$ +196 +​ +$ +— +Fair value of hedged long-term debt +​ +$ +2,890 +​ +$ +— +​ +$ +2,890 +​ +$ +— +Foreign currency forward exchange contracts +​ +89 +​ +— +​ +89 +​ +— +Contingent consideration related to business combinations +​ +68 +​ +— +​ +— +​ +68 +Total Liabilities +​ +$ +3,047 +​ +$ +— +​ +$ +2,979 +​ +$ +68 +December 31, 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +320 +​ +$ +320 +​ +$ +— +​ +$ +— +Foreign currency forward exchange contracts +​ +114 +​ +— +​ +114 +​ +— +Total Assets +​ +$ +434 +​ +$ +320 +​ +$ +114 +​ +$ +— +Fair value of hedged long-term debt +​ +$ +2,743 +​ +$ +— +​ +$ +2,743 +​ +$ +— +Interest rate swap derivative financial instruments +​ +100 +​ +​ +— +​ +​ +100 +​ +​ +— +Foreign currency forward exchange contracts +​ +95 +​ +— +​ +95 +​ +— +Contingent consideration related to business combinations +​ +71 +​ +— +​ +— +​ +71 +Total Liabilities +​ +$ +3,009 +​ +$ +— +​ +$ +2,938 +​ +$ +71 +​ +72 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 13 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +The fair value of foreign currency forward exchange contracts is determined using a market approach, which utilizes values for comparable derivative instruments. The fair value of the debt was determined based on the face value of the debt adjusted for the fair value of the interest rate swaps, which is based on a discounted cash flow analysis using significant other observable inputs. +Contingent consideration relates to businesses acquired by Abbott. The fair value of the contingent consideration was determined based on an independent appraisal adjusted for the time value of money and other changes in fair value. The maximum amount for certain contingent consideration is not determinable as it is based on a percent of certain sales. Excluding such contingent consideration, the maximum amount estimated to be due is approximately $ 470 million, which is dependent upon attaining certain sales thresholds or based on the occurrence of certain events, such as regulatory approvals. +Note 14 — Litigation and Environmental Matters +Abbott has been identified as a potentially responsible party for investigation and cleanup costs at a number of locations in the United States and Puerto Rico under federal and state remediation laws and is investigating potential contamination at a number of company-owned locations. Abbott has recorded an estimated cleanup cost for each site for which management believes Abbott has a probable loss exposure. No individual site cleanup exposure is expected to exceed $ 4 million, and the aggregate cleanup exposure is not expected to exceed $ 10 million. +Abbott is involved in various claims and legal proceedings, and Abbott estimates the range of possible loss for its legal proceedings and environmental exposures to be from approximately $ 95 million to $ 130 million. The recorded accrual balance at December 31, 2019 for these proceedings and exposures was approximately $ 110 million. This accrual represents management’s best estimate of probable loss, as defined by FASB ASC No. 450, “Contingencies.” Within the next year, legal proceedings may occur that may result in a change in the estimated loss accrued by Abbott. While it is not feasible to predict the outcome of all such proceedings and exposures with certainty, management believes that their ultimate disposition should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +73 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Post-Employment Benefits +Retirement plans consist of defined benefit, defined contribution and medical and dental plans. Information for Abbott’s major defined benefit plans and post-employment medical and dental benefit plans is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Defined Benefit +​ +Medical and +​ +​ +Plans +​ +Dental Plans +(in millions) +2019 +2018 +2019 +2018 +Projected benefit obligations, January 1 +​ +$ +9,093 +​ +$ +9,953 +​ +$ +1,292 +​ +$ +1,393 +Service cost — benefits earned during the year +​ +250 +​ +293 +​ +23 +​ +26 +Interest cost on projected benefit obligations +​ +337 +​ +308 +​ +52 +​ +48 +(Gains) losses, primarily changes in discount rates, plan design changes, law changes and differences between actual and estimated health care costs +​ +1,856 +​ +( 1,044 ) +​ +228 +​ +( 106 ) +Benefits paid +​ +( 302 ) +​ +( 295 ) +​ +( 76 ) +​ +( 68 ) +Other, including foreign currency translation +​ +4 +​ +( 122 ) +​ +37 +​ +( 1 ) +Projected benefit obligations, December 31 +​ +$ +11,238 +​ +$ +9,093 +​ +$ +1,556 +​ +$ +1,292 +Plan assets at fair value, January 1 +​ +$ +8,553 +​ +$ +9,298 +​ +$ +351 +​ +$ +419 +Actual return (loss) on plans’ assets +​ +1,622 +​ +( 450 ) +​ +65 +​ +( 20 ) +Company contributions +​ +382 +​ +114 +​ +12 +​ +12 +Benefits paid +​ +( 302 ) +​ +( 295 ) +​ +( 68 ) +​ +( 60 ) +Other, including foreign currency translation +​ +22 +​ +( 114 ) +​ +— +​ +— +Plan assets at fair value, December 31 +​ +$ +10,277 +​ +$ +8,553 +​ +$ +360 +​ +$ +351 +Projected benefit obligations greater than plan assets, December 31 +​ +$ +( 961 ) +​ +$ +( 540 ) +​ +$ +( 1,196 ) +​ +$ +( 941 ) +Long-term assets +​ +$ +687 +​ +$ +583 +​ +$ +— +​ +$ +— +Short-term liabilities +​ +( 26 ) +​ +( 23 ) +​ +( 1 ) +​ +( 1 ) +Long-term liabilities +​ +( 1,622 ) +​ +( 1,100 ) +​ +( 1,195 ) +​ +( 940 ) +Net liability +​ +$ +( 961 ) +​ +$ +( 540 ) +​ +$ +( 1,196 ) +​ +$ +( 941 ) +Amounts Recognized in Accumulated Other Comprehensive Income (loss): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Actuarial losses, net +​ +$ +4,131 +​ +$ +3,326 +​ +$ +529 +​ +$ +361 +Prior service cost (credits) +​ +( 2 ) +​ +( 2 ) +​ +( 95 ) +​ +( 163 ) +Total +​ +$ +4,129 +​ +$ +3,324 +​ +$ +434 +​ +$ +198 +​ +The projected benefit obligations for non-U.S. defined benefit plans was $ 3.3 billion and $ 2.7 billion at December 31, 2019 and 2018, respectively. The accumulated benefit obligations for all defined benefit plans were $ 10.2 billion and $ 8.3 billion at December 31, 2019 and 2018, respectively. +For plans where the accumulated benefit obligations exceeded plan assets at December 31, 2019 and 2018, the aggregate accumulated benefit obligations, the projected benefit obligations and the aggregate plan assets were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +Accumulated benefit obligation +​ +$ +1,985 +​ +$ +1,265 +Projected benefit obligation +​ +2,266 +​ +1,362 +Fair value of plan assets +​ +821 +​ +375 +​ +74 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Post-Employment Benefits (Continued) +The components of the net periodic benefit cost were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical and +​ +​ +Defined Benefit Plans +​ +Dental Plans +(in millions) +2019 +2018 +2017 +2019 +2018 +2017 +Service cost — benefits earned during the year +​ +$ +250 +​ +$ +293 +​ +$ +283 +​ +$ +23 +​ +$ +26 +​ +$ +25 +Interest cost on projected benefit obligations +​ +337 +​ +308 +​ +287 +​ +52 +​ +48 +​ +45 +Expected return on plans’ assets +​ +( 710 ) +​ +( 680 ) +​ +( 613 ) +​ +( 27 ) +​ +( 33 ) +​ +( 33 ) +Amortization of actuarial losses +​ +132 +​ +205 +​ +163 +​ +22 +​ +33 +​ +23 +Amortization of prior service cost (credits) +​ +1 +​ +1 +​ +1 +​ +( 32 ) +​ +( 45 ) +​ +( 45 ) +Total net cost +​ +$ +10 +​ +$ +127 +​ +$ +121 +​ +$ +38 +​ +$ +29 +​ +$ +15 +​ +In 2017, Abbott recognized a $ 10 million curtailment gain related to the sale of AMO. +Other comprehensive income (loss) for each respective year includes the amortization of actuarial losses and prior service costs (credits) as noted in the previous table. Other comprehensive income (loss) for each respective year also includes: net actuarial losses of $ 944 million for defined benefit plans and a loss of $ 190 million for medical and dental plans in 2019; net actuarial losses of $ 86 million for defined benefit plans and a gain of $ 53 million for medical and dental plans in 2018; net actuarial losses of $ 247 million for defined benefit plans and $ 97 million for medical and dental plans in 2017. The change in net actuarial losses in 2019 primarily relates to lower discount rates at December 31, 2019 compared to December 31, 2018, partially offset by the impact of actual 2019 asset returns in excess of expected returns. +The pretax amount of actuarial losses and prior service cost (credits) included in Accumulated other comprehensive income (loss) at December 31, 2019 that is expected to be recognized in the net periodic benefit cost in 2020 is $ 253 million and $ 1 million of expense, respectively, for defined benefit pension plans and $ 32 million of expense and $ 28 million of income, respectively, for medical and dental plans. +The weighted average assumptions used to determine benefit obligations for defined benefit plans and medical and dental plans are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +2018 +2017 +Discount rate +3.0 +% +4.0 +% +3.4 +% +Expected aggregate average long-term change in compensation +4.3 +% +4.3 +% +4.4 +% +​ +The weighted average assumptions used to determine the net cost for defined benefit plans and medical and dental plans are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +2018 +2017 +Discount rate +4.0 +% +3.4 +% +3.9 +% +Expected return on plan assets +7.5 +% +7.7 +% +7.6 +% +Expected aggregate average long-term change in compensation +4.3 +% +4.4 +% +4.3 +% +​ +The assumed health care cost trend rates for medical and dental plans at December 31 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +2018 +2017 +Health care cost trend rate assumed for the next year +9 +% +9 +% +9 +% +Rate that the cost trend rate gradually declines to +5 +% +5 +% +5 +% +Year that rate reaches the assumed ultimate rate +2025 +​ +2025 +​ +2027 +​ +​ +​ +75 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Post-Employment Benefits (Continued) +The discount rates used to measure liabilities were determined based on high-quality fixed income securities that match the duration of the expected retiree benefits. The health care cost trend rates represent Abbott’s expected annual rates of change in the cost of health care benefits and are forward projections of health care costs as of the measurement date. A one-percentage point increase/(decrease) in the assumed health care cost trend rate would increase/(decrease) the accumulated post-employment benefit obligations as of December 31, 2019, by $ 221 million /$( 179 ) million, and the total of the service and interest cost components of net post-employment health care cost for the year then ended by approximately $ 12 million/$( 9 ) million. +The following table summarizes the bases used to measure the defined benefit and medical and dental plan assets at fair value: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basis of Fair Value Measurement +​ +​ +​ +​ +​ +Quoted +​ +Significant +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Prices in +​ +Other +​ +Significant +​ +​ +​ +​ +​ +Outstanding +​ +Active +​ +Observable +​ +Unobservable +​ +Measured at +(in millions) +Balances +Markets +Inputs +Inputs +NAV (k) +December 31, 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large cap (a) +​ +$ +2,873 +​ +$ +1,647 +​ +$ +— +​ +$ +— +​ +$ +1,226 +U.S. mid and small cap (b) +​ +​ +648 +​ +​ +548 +​ +​ +4 +​ +​ +2 +​ +​ +94 +International (c) +​ +​ +2,202 +​ +​ +464 +​ +​ +— +​ +​ +— +​ +​ +1,738 +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. government securities (d) +​ +​ +562 +​ +​ +52 +​ +​ +357 +​ +​ +— +​ +​ +153 +Corporate debt instruments (e) +​ +​ +1,266 +​ +​ +362 +​ +​ +724 +​ +​ +— +​ +​ +180 +Non-U.S. government securities (f) +​ +​ +445 +​ +​ +3 +​ +​ +2 +​ +​ +— +​ +​ +440 +Other (g) +​ +​ +320 +​ +​ +69 +​ +​ +27 +​ +​ +— +​ +​ +224 +Absolute return funds (h) +​ +​ +1,557 +​ +​ +424 +​ +​ +— +​ +​ +— +​ +​ +1,133 +Commodities (i) +​ +​ +32 +​ +​ +— +​ +​ +— +​ +​ +1 +​ +​ +31 +Cash and Cash Equivalents +​ +​ +182 +​ +​ +84 +​ +​ +— +​ +​ +— +​ +​ +98 +Other (j) +​ +​ +550 +​ +​ +8 +​ +​ +— +​ +​ +— +​ +​ +542 +​ +​ +$ +10,637 +​ +$ +3,661 +​ +$ +1,114 +​ +$ +3 +​ +$ +5,859 +December 31, 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large cap (a) +​ +$ +2,168 +​ +$ +1,319 +​ +$ +5 +​ +$ +— +​ +$ +844 +U.S. mid and small cap (b) +​ +515 +​ +​ +226 +​ +​ +— +​ +​ +— +​ +​ +289 +International (c) +​ +1,671 +​ +​ +370 +​ +​ +— +​ +​ +— +​ +​ +1,301 +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. government securities (d) +​ +476 +​ +​ +51 +​ +​ +269 +​ +​ +— +​ +​ +156 +Corporate debt instruments (e) +​ +1,150 +​ +​ +269 +​ +​ +701 +​ +​ +— +​ +​ +180 +Non-U.S. government securities (f) +​ +405 +​ +​ +5 +​ +​ +— +​ +​ +— +​ +​ +400 +Other (g) +​ +199 +​ +​ +15 +​ +​ +55 +​ +​ +— +​ +​ +129 +Absolute return funds (h) +​ +1,684 +​ +​ +448 +​ +​ +— +​ +​ +— +​ +​ +1,236 +Commodities (i) +​ +59 +​ +​ +— +​ +​ +— +​ +​ +4 +​ +​ +55 +Cash and Cash Equivalents +​ +​ +192 +​ +​ +123 +​ +​ +— +​ +​ +— +​ +​ +69 +Other (j) +​ +385 +​ +​ +11 +​ +​ +— +​ +​ +— +​ +​ +374 +​ +​ +$ +8,904 +​ +$ +2,837 +​ +$ +1,030 +​ +$ +4 +​ +$ +5,033 +(a) A mix of index funds and actively managed equity accounts that are benchmarked to various large cap indices. +(b) A mix of index funds and actively managed equity accounts that are benchmarked to various mid and small cap indices. +(c) A mix of index funds and actively managed pooled investment funds that are benchmarked to various non-U.S. equity indices in both developed and emerging markets. +(d) A mix of index funds and actively managed accounts that are benchmarked to various U.S. government bond indices. +​ +76 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Post Employment Benefits (Continued) +(e) A mix of index funds and actively managed accounts that are benchmarked to various corporate bond indices. +(f) Primarily United Kingdom, Japan and Eurozone government bonds. +(g) Primarily asset backed securities and an actively managed, diversified fixed income vehicle benchmarked to the one-month Libor / Euribor. +(h) Primarily funds invested by managers that have a global mandate with the flexibility to allocate capital broadly across a wide range of asset classes and strategies including, but not limited to equities, fixed income, commodities, interest rate futures, currencies and other securities to outperform an agreed upon benchmark with specific return and volatility targets. +(i) Primarily investments in private energy funds. +(j) Primarily investments in private funds, such as private equity, private credit and private real estate. +(k) In accordance with ASU 2015-07, investments measured at fair value using the net asset value (NAV) practical expedient have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheet. +Equities that are valued using quoted prices are valued at the published market prices. Equities in a common collective trust or a registered investment company that are valued using significant other observable inputs are valued at the NAV provided by the fund administrator. The NAV is based on the value of the underlying assets owned by the fund minus its liabilities. For approximately half of these funds, investments may be redeemed once per month, with a required 7 to 30 day notice period. For the remaining funds, daily redemption of an investment is allowed. Fixed income securities that are valued using significant other observable inputs are valued at prices obtained from independent financial service industry recognized vendors. Abbott did not have any unfunded commitments related to fixed income funds at December 31, 2019 and 2018. Fixed income securities in a common collective trust or a registered investment company that are valued using significant other observable inputs are valued at the NAV provided by the fund administrator. For the majority of these funds, investments may be redeemed either weekly or monthly, with a required 2 to 14 day notice period. For the remaining funds, investments may be generally redeemed daily. +Absolute return funds and commodities are valued at the NAV provided by the fund administrator. All private funds are valued at the NAV provided by the fund on a one-quarter lag adjusted for known cash flows and significant events through the reporting date. Abbott did not have any unfunded commitments related to absolute return funds at December 31, 2019 and 2018. Investments in these funds may be generally redeemed monthly or quarterly with required notice periods ranging from 5 to 90 days . For approximately $ 235 million and $ 100 million of the absolute return funds, redemptions are subject to a 33 percent gate and a 25 percent gate, respectively, and $ 45 million is subject to a lock until 2022. For commodities, investments in the private energy funds cannot be redeemed but the funds will make distributions through liquidation. The estimate of the liquidation period for each fund ranges from 2020 to 2022. Abbott’s unfunded commitments in these funds as of December 31, 2019 and 2018 were not significant. Investments in the private funds (excluding private energy funds) cannot be redeemed but the funds will make distributions through liquidation. The estimate of the liquidation period for each fund ranges from 2020 to 2029. Abbott’s unfunded commitment in these funds was $ 571 million and $ 518 million as of December 31, 2019 and 2018, respectively. +​ +77 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Post-Employment Benefits (Continued) +The investment mix of equity securities, fixed income and other asset allocation strategies is based upon achieving a desired return, as well as balancing higher return, more volatile equity securities with lower return, less volatile fixed income securities. Investment allocations are made across a range of markets, industry sectors, capitalization sizes, and in the case of fixed income securities, maturities and credit quality. The plans do not directly hold any securities of Abbott. There are no known significant concentrations of risk in the plans’ assets. Abbott’s medical and dental plans’ assets are invested in a similar mix as the pension plan assets. The actual asset allocation percentages at year end are consistent with the company’s targeted asset allocation percentages. +The plans’ expected return on assets, as shown above is based on management’s expectations of long-term average rates of return to be achieved by the underlying investment portfolios. In establishing this assumption, management considers historical and expected returns for the asset classes in which the plans are invested, as well as current economic and capital market conditions. +Abbott funds its domestic pension plans according to IRS funding limitations. International pension plans are funded according to similar regulations. Abbott funded $ 382 million in 2019 and $ 114 million in 2018 to defined pension plans. Abbott expects to contribute approximately $ 387 million to its pension plans in 2020. +Total benefit payments expected to be paid to participants, which includes payments funded from company assets, as well as paid from the plans, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Defined +​ +Medical and +(in millions) +Benefit Plans +Dental Plans +2020 +​ +$ +315 +​ +$ +76 +2021 +​ +325 +​ +78 +2022 +​ +342 +​ +79 +2023 +​ +360 +​ +80 +2024 +​ +382 +​ +82 +2025 to 2029 +​ +2,219 +​ +421 +​ +The Abbott Stock Retirement Plan is the principal defined contribution plan. Abbott’s contributions to this plan were $ 158 million in 2019, $ 146 million in 2018 and $ 79 million in 2017. The 2018 contributions include amounts related to participants of the St. Jude Medical Retirement Plan which was terminated in January 2018. +Note 16 — Taxes on Earnings from Continuing Operations +Taxes on earnings from continuing operations reflect the annual effective rates, including charges for interest and penalties. Deferred income taxes reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. +The Tax Cuts and Jobs Act (TCJA) was enacted in the U.S. on December 22, 2017. The TCJA reduces the U.S. federal corporate tax rate from 35 % to 21 %, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. As of December 31, 2018, Abbott completed its accounting for all of the enactment date income tax effects of the TCJA. +Effective for fiscal years beginning after December 31, 2017, the TCJA subjects taxpayers to tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. In January 2018, the FASB staff provided guidance that an entity may make an accounting policy election to either recognize deferred taxes related to items that will give rise to GILTI in future years or provide for the tax expense related to GILTI in the year that the tax is incurred. Abbott has elected to treat the GILTI tax as a period expense and provide for the tax in the year that the tax is incurred. +​ +78 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Taxes on Earnings from Continuing Operations (Continued) +In the fourth quarter of 2017, Abbott recorded an estimate of net tax expense of $ 1.46 billion for the impact of the TCJA, which was included in Taxes on Earnings from Continuing Operations in the Consolidated Statement of Earnings. The estimate was provisional and included a charge of approximately $ 2.89 billion for the transition tax, partially offset by a net benefit of approximately $ 1.42 billion for the remeasurement of deferred tax assets and liabilities, and a net benefit of approximately $ 10 million related to certain other impacts of the TCJA. In 2018, Abbott recorded $ 130 million of additional tax expense which increased the final tax expense related to the TCJA to $ 1.59 billion. The $ 130 million of additional tax expense reflects a $ 120 million increase in the transition tax from $ 2.89 billion to $ 3.01 billion and a $ 10 million reduction in the net benefit related to the remeasurement of deferred tax assets and liabilities. In 2019, taxes on earnings from continuing operations include an $ 86 million reduction to the transition tax. The $ 86 million reduction to the transition tax liability was the result of the issuance of final transition tax regulations by the U.S. Department of Treasury in 2019. This adjustment decreased the cumulative net tax expense related to the TCJA to $ 1.50 billion. +The one-time transition tax is based on Abbott’s total post-1986 earnings and profits (E&P) that were previously deferred from U.S. income taxes. The tax computation also requires the determination of the amount of post-1986 E&P considered held in cash and other specified assets. As of December 31, 2019, the remaining balance of Abbott’s transition tax obligation is approximately $ 1.33 billion, which will be paid over the next seven years as allowed by the TCJA. +In 2019, taxes on earnings from continuing operations included $ 68 million of tax expense resulting from tax legislation enacted in the fourth quarter of 2019 in India. In 2018, taxes on earnings from continuing operations included $ 98 million of net tax expense related to the settlement of Abbott’s 2014-2016 federal income tax audit in the U.S., partial settlement of the former St. Jude Medical consolidated group’s 2014 and 2015 federal income tax returns in the U.S. and audit settlements in various countries. In 2017, taxes on earnings from continuing operations include $ 435 million of tax expense related to the gain on the sale of the AMO business. +Undistributed foreign earnings remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in its foreign entities is not practicable. In the U.S., Abbott’s federal income tax returns through 2016 are settled except for the federal income tax returns of the former Alere consolidated group which are settled through 2015 and the former St. Jude Medical consolidated group which are settled through 2013. There are numerous other income tax jurisdictions for which tax returns are not yet settled, none of which are individually significant. Reserves for interest and penalties are not significant. +Earnings from continuing operations before taxes, and the related provisions for taxes on earnings from continuing operations, were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +2017 +Earnings From Continuing Operations Before Taxes: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic +​ +$ +889 +​ +$ +( 430 ) +​ +$ +308 +Foreign +​ +3,188 +​ +3,303 +​ +1,923 +Total +​ +$ +4,077 +​ +$ +2,873 +​ +$ +2,231 +​ +79 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Taxes on Earnings from Continuing Operations (Continued) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +2017 +Taxes on Earnings From Continuing Operations: +​ +​ +​ +​ +​ +​ +Current: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic +​ +$ +291 +​ +$ +( 812 ) +​ +$ +2,260 +Foreign +​ +590 +​ +606 +​ +508 +Total current +​ +881 +​ +( 206 ) +​ +2,768 +Deferred: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic +​ +( 305 ) +​ +832 +​ +( 679 ) +Foreign +​ +( 186 ) +​ +( 87 ) +​ +( 211 ) +Total deferred +​ +( 491 ) +​ +745 +​ +( 890 ) +Total +​ +$ +390 +​ +$ +539 +​ +$ +1,878 +​ +Differences between the effective income tax rate and the U.S. statutory tax rate were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2019 +2018 +2017 +Statutory tax rate on earnings from continuing operations +21.0 +% +21.0 +% +35.0 +% +Impact of foreign operations +( 5.0 ) +​ +( 5.4 ) +​ +( 16.3 ) +​ +Impact of TCJA and other related items +​ +( 2.1 ) +​ +6.3 +​ +65.5 +​ +Foreign-derived intangible income benefit +​ +( 2.0 ) +​ +( 1.9 ) +​ +— +​ +Domestic impairment loss +​ +— +​ +( 2.1 ) +​ +— +​ +Excess tax benefits related to stock compensation +​ +( 2.5 ) +​ +( 3.1 ) +​ +( 5.4 ) +​ +Research tax credit +​ +( 1.2 ) +​ +( 1.8 ) +​ +( 1.9 ) +​ +Resolution of certain tax positions pertaining to prior years +— +​ +3.4 +​ +— +​ +State taxes, net of federal benefit +0.8 +​ +0.4 +​ +0.5 +​ +Federal tax cost on sale of Mylan N.V. shares +​ +— +​ +— +​ +3.4 +​ +All other, net +0.6 +​ +2.0 +​ +3.4 +​ +Effective tax rate on earnings from continuing operations +9.6 +% +18.8 +% +84.2 +% +​ +Impact of foreign operations is primarily derived from operations in Puerto Rico, Switzerland, Ireland, the Netherlands, Costa Rica, and Singapore. +​ +80 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Taxes on Earnings from Continuing Operations (Continued) +The tax effect of the differences that give rise to deferred tax assets and liabilities were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +Deferred tax assets: +​ +​ +​ +​ +​ +​ +Compensation and employee benefits +$ +982 +$ +829 +Other, primarily reserves not currently deductible, and NOL’s and credit carryforwards +​ +​ +2,227 +​ +​ +2,546 +Trade receivable reserves +​ +​ +190 +​ +​ +196 +Inventory reserves +​ +​ +110 +​ +​ +97 +Lease liabilities +​ +​ +209 +​ +​ +— +Deferred intercompany profit +​ +​ +259 +​ +​ +203 +Total deferred tax assets before valuation allowance +​ +​ +3,977 +​ +​ +3,871 +Valuation allowance +​ +​ +( 978 ) +​ +​ +( 1,363 ) +Total deferred tax assets +​ +​ +2,999 +​ +​ +2,508 +Deferred tax liabilities: +​ +​ +​ +​ +​ +​ +Depreciation +​ +​ +( 219 ) +​ +​ +( 226 ) +Right of Use lease assets +​ +​ +( 209 ) +​ +​ +— +Other, primarily the excess of book basis over tax basis of intangible assets +​ +​ +( 3,107 ) +​ +​ +( 3,557 ) +Total deferred tax liabilities +​ +​ +( 3,535 ) +​ +​ +( 3,783 ) +Total net deferred tax assets (liabilities) +$ +( 536 ) +$ +( 1,275 ) +​ +​ +Abbott has incurred losses in a foreign jurisdiction where realization of the future economic benefit is so remote that the benefit is not reflected as a deferred tax asset. +The following table summarizes the gross amounts of unrecognized tax benefits without regard to reduction in tax liabilities or additions to deferred tax assets and liabilities if such unrecognized tax benefits were settled: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +January 1 +​ +$ +1,120 +​ +$ +1,440 +Decrease in tax positions due to acquisitions +​ +​ +— +​ +​ +( 13 ) +Increase due to current year tax positions +​ +137 +​ +164 +Increase due to prior year tax positions +​ +75 +​ +235 +Decrease due to prior year tax positions +​ +( 117 ) +​ +( 611 ) +Settlements +​ +( 32 ) +​ +( 91 ) +Lapse of statute +​ +​ +( 8 ) +​ +​ +( 4 ) +December 31 +​ +$ +1,175 +​ +$ +1,120 +​ +The total amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is approximately $ 1.07 billion. Abbott believes that it is reasonably possible that the recorded amount of gross unrecognized tax benefits may decrease within a range of $ 220 million to $ 510 million, including cash adjustments, within the next twelve months as a result of concluding various domestic and international tax matters. +​ +81 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 17 — Segment and Geographic Area Information +Abbott’s principal business is the discovery, development, manufacture and sale of a broad line of health care products. Abbott’s products are generally sold directly to retailers, wholesalers, hospitals, health care facilities, laboratories, physicians’ offices and government agencies throughout the world. +Beginning in the fourth quarter of 2019, the results of the Diabetes Care business, which had previously been included in Other, were aggregated with the results of the businesses in the Cardiovascular and Neuromodulation segment to comprise the Medical Devices reportable segment. Historic periods have been adjusted to reflect this change. +On October 3, 2017, Abbott completed the acquisition of Alere. Beginning with the fourth quarter of 2017, Abbott’s Diagnostic Products reportable segment includes the results of Alere from the date of acquisition. +Abbott’s reportable segments are as follows: +Established Pharmaceutical Products —International sales of a broad line of branded generic pharmaceutical products. +Nutritional Products —Worldwide sales of a broad line of adult and pediatric nutritional products. +Diagnostic Products —Worldwide sales of diagnostic systems and tests for blood banks, hospitals, commercial laboratories and alternate-care testing sites. For segment reporting purposes, the Core Laboratories Diagnostics, Rapid Diagnostics, Molecular Diagnostics and Point of Care divisions are aggregated and reported as the Diagnostic Products segment. Rapid Diagnostics is the business acquired from Alere. +Medical Devices — Worldwide sales of rhythm management, electrophysiology, heart failure, vascular, structural heart, neuromodulation and diabetes care products. For segment reporting purposes, the Cardiac Arrhythmias & Heart Failure, Vascular, Neuromodulation, Structural Heart and Diabetes Care divisions are aggregated and reported as the Medical Devices segment. +Non-reportable segments include AMO through the date of its sale in February 2017. +Abbott's underlying accounting records are maintained on a legal entity basis for government and public reporting requirements. Segment disclosures are on a performance basis consistent with internal management reporting. The cost of some corporate functions and the cost of certain employee benefits are charged to segments at predetermined rates that approximate cost. Remaining costs, if any, are not allocated to segments. In addition, intangible asset amortization is not allocated to operating segments, and intangible assets and goodwill are not included in the measure of each segment’s assets. +The following segment information has been prepared in accordance with the internal accounting policies of Abbott, as described above, and are not presented in accordance with generally accepted accounting principles applied to the consolidated financial statements. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Sales to External Customers (a) +​ +Operating Earnings (a) +(in millions) +2019 +2018 +2017 +2019 +2018 +2017 +Established Pharmaceutical Products +​ +$ +4,486 +​ +$ +4,422 +​ +$ +4,287 +​ +$ +904 +​ +$ +894 +​ +$ +848 +Nutritional Products +​ +7,409 +​ +7,229 +​ +6,925 +​ +1,705 +​ +1,652 +​ +1,589 +Diagnostic Products +​ +7,713 +​ +7,495 +​ +5,616 +​ +1,912 +​ +1,868 +​ +1,468 +Medical Devices +​ +12,239 +​ +11,370 +​ +10,325 +​ +3,769 +​ +3,500 +​ +3,011 +Total Reportable Segments +​ +31,847 +​ +30,516 +​ +27,153 +​ +$ +8,290 +​ +$ +7,914 +​ +$ +6,916 +Other +​ +57 +​ +62 +​ +237 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +$ +31,904 +​ +$ +30,578 +​ +$ +27,390 +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Net sales were unfavorably affected by the relatively stronger U.S. dollar in 2019 and 2018. Operating earnings were unfavorably affected by the impact of foreign exchange in 2019, 2018 and 2017. +82 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 17 — Segment and Geographic Area Information (Continued) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +2017 +Total Reportable Segment Operating Earnings +​ +$ +8,290 +​ +$ +7,914 +​ +$ +6,916 +Corporate functions and benefit plan costs +​ +( 468 ) +​ +( 618 ) +​ +( 506 ) +Net interest expense +​ +( 576 ) +​ +( 721 ) +​ +( 780 ) +Loss on extinguishment of debt +​ +​ +( 63 ) +​ +​ +( 167 ) +​ +​ +— +Share-based compensation +​ +( 519 ) +​ +( 477 ) +​ +( 406 ) +Amortization of intangible assets +​ +( 1,936 ) +​ +( 2,178 ) +​ +( 1,975 ) +Other, net (b) +​ +( 651 ) +​ +( 880 ) +​ +( 1,018 ) +Earnings from Continuing Operations Before Taxes +​ +$ +4,077 +​ +$ +2,873 +​ +$ +2,231 +(b) Other, net includes integration costs associated with the acquisition of St. Jude Medical and Alere, and restructuring charges in 2019. Other, net includes inventory step-up amortization, integration costs associated with the acquisition of St. Jude Medical and Alere, and restructuring charges in 2018. In 2017, Other, net includes inventory step-up amortization, integration costs associated with the acquisition of St. Jude Medical and Alere, and restructuring charges, partially offset by the gain on the sale of the AMO business. Charges for restructuring actions and other cost reduction initiatives were approximately $ 215 million in 2019, $ 153 million in 2018 and $ 384 million in 2017. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Additions to +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Property, Plant +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation +​ +and Equipment (c) +​ +Total Assets +(in millions) +2019 +2018 +2017 +2019 +2018 +2017 +2019 +2018 +2017 +Established Pharmaceuticals +​ +$ +98 +​ +$ +92 +​ +$ +90 +​ +$ +109 +​ +$ +131 +​ +$ +181 +​ +$ +2,858 +​ +$ +2,664 +​ +$ +2,728 +Nutritionals +​ +139 +​ +150 +​ +164 +​ +141 +​ +86 +​ +147 +​ +3,274 +​ +3,071 +​ +3,160 +Diagnostics +​ +403 +​ +397 +​ +300 +​ +726 +​ +609 +​ +374 +​ +5,235 +​ +4,464 +​ +4,226 +Medical Devices +​ +266 +​ +294 +​ +338 +​ +532 +​ +408 +​ +276 +​ +6,640 +​ +5,886 +​ +5,799 +Total Reportable Segments +​ +906 +​ +933 +​ +892 +​ +1,508 +​ +1,234 +​ +978 +​ +$ +18,007 +​ +$ +16,085 +​ +$ +15,913 +Other +​ +172 +​ +167 +​ +154 +​ +160 +​ +160 +​ +157 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +$ +1,078 +​ +$ +1,100 +​ +$ +1,046 +​ +$ +1,668 +​ +$ +1,394 +​ +$ +1,135 +​ +​ +​ +​ +​ +​ +​ +​ +​ +(c) Amounts exclude property, plant and equipment acquired through business acquisitions. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2019 +2018 +2017 +Total Reportable Segment Assets +​ +$ +18,007 +​ +$ +16,085 +​ +$ +15,913 +Cash and investments +​ +5,023 +​ +4,983 +​ +10,493 +Goodwill and intangible assets +​ +40,220 +​ +42,196 +​ +45,493 +All other +​ +4,637 +​ +3,909 +​ +4,351 +Total Assets +​ +$ +67,887 +​ +$ +67,173 +​ +$ +76,250 +​ +​ +83 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 17 — Segment and Geographic Area Information (Continued) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Sales to External +​ +​ +Customers (d) +(in millions) +2019 +2018 +2017 +United States +​ +$ +11,398 +​ +$ +10,839 +​ +$ +9,673 +China +​ +2,346 +​ +2,311 +​ +2,146 +Germany +​ +​ +1,751 +​ +​ +1,619 +​ +​ +1,366 +Japan +​ +1,435 +​ +1,326 +​ +1,255 +India +​ +​ +1,397 +​ +​ +1,333 +​ +​ +1,237 +Switzerland +​ +​ +1,068 +​ +​ +1,005 +​ +​ +841 +The Netherlands +​ +975 +​ +930 +​ +929 +All Other Countries +​ +11,534 +​ +11,215 +​ +9,943 +Consolidated +​ +$ +31,904 +​ +$ +30,578 +​ +$ +27,390 +(d) Sales by country are based on the country that sold the product. +Long-lived assets on a geographic basis primarily include property, plant and equipment. It excludes goodwill, intangible assets, deferred tax assets, and financial instruments. At December 31, 2019 and 2018, long-lived assets totaled $ 10.2 billion and $ 8.7 billion, respectively, and in the United States such assets totaled $ 5.1 billion and $ 4.3 billion, respectively. Long-lived asset balances associated with other countries were not material on an individual country basis in either of the two years. +84 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 18 — Quarterly Results (Unaudited) +​ +​ +​ +​ +​ +​ +​ +​ +(in millions except per share data) +2019 +2018 +First Quarter +​ +​ +​ +​ +​ +​ +Continuing Operations: +​ +​ +​ +​ +​ +​ +Net Sales +​ +$ +7,535 +​ +$ +7,390 +Gross Profit +​ +3,889 +​ +3,739 +Earnings from Continuing Operations +​ +672 +​ +409 +Basic Earnings per Common Share +​ +0.38 +​ +0.23 +Diluted Earnings per Common Share +​ +0.38 +​ +0.23 +Net Earnings +​ +672 +​ +418 +Basic Earnings Per Common Share (a) +​ +0.38 +​ +0.24 +Diluted Earnings Per Common Share (a) +​ +0.38 +​ +0.23 +Second Quarter +​ +​ +​ +​ +​ +​ +Continuing Operations: +​ +​ +​ +​ +​ +​ +Net Sales +​ +$ +7,979 +​ +$ +7,767 +Gross Profit +​ +4,217 +​ +3,923 +Earnings from Continuing Operations +​ +1,006 +​ +718 +Basic Earnings per Common Share +​ +0.57 +​ +0.41 +Diluted Earnings per Common Share +​ +0.56 +​ +0.40 +Net Earnings +​ +1,006 +​ +733 +Basic Earnings Per Common Share (a) +​ +0.57 +​ +0.42 +Diluted Earnings Per Common Share (a) +​ +0.56 +​ +0.41 +Third Quarter +​ +​ +​ +​ +​ +​ +Continuing Operations: +​ +​ +​ +​ +​ +​ +Net Sales +​ +$ +8,076 +​ +$ +7,656 +Gross Profit +​ +4,234 +​ +3,946 +Earnings from Continuing Operations +​ +960 +​ +552 +Basic Earnings per Common Share +​ +0.54 +​ +0.31 +Diluted Earnings per Common Share +​ +0.53 +​ +0.31 +Net Earnings +​ +960 +​ +563 +Basic Earnings Per Common Share (a) +​ +0.54 +​ +0.32 +Diluted Earnings Per Common Share (a) +​ +0.53 +​ +0.32 +Fourth Quarter +​ +​ +​ +​ +​ +​ +Continuing Operations: +​ +​ +​ +​ +​ +​ +Net Sales +​ +$ +8,314 +​ +$ +7,765 +Gross Profit +​ +4,397 +​ +4,086 +Earnings from Continuing Operations +​ +1,049 +​ +655 +Basic Earnings per Common Share +​ +0.59 +​ +0.37 +Diluted Earnings per Common Share +​ +0.59 +​ +0.37 +Net Earnings +​ +1,049 +​ +654 +Basic Earnings Per Common Share (a) +​ +0.59 +​ +0.37 +Diluted Earnings Per Common Share (a) +​ +0.59 +​ +0.37 +(a) The sum of the four quarters of earnings per share for 2019 and 2018 may not add to the full year earnings per share amount due to rounding and/or the use of quarter-to-date weighted average shares to calculate the earnings per share amount in each respective quarter. +​ +​ +​ +85 +​ +Management Report on Internal Control Over Financial Reporting +The management of Abbott Laboratories is responsible for establishing and maintaining adequate internal control over financial reporting. Abbott’s internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements. +All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. +Abbott’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2019. In making this assessment, it used the criteria set forth in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, we believe that, as of December 31, 2019, the company’s internal control over financial reporting was effective based on those criteria. +Abbott’s independent registered public accounting firm has issued an audit report on their assessment of the effectiveness of the company’s internal control over financial reporting. This report appears on page 90. +Miles D. White +Chairman of the Board and Chief Executive Officer +Brian B. Yoor +Executive Vice President, Finance and Chief Financial Officer +Robert E. Funck, Jr. +Senior Vice President, Finance and Controller +February 21, 2020 +​ +86 +​ +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Abbott Laboratories +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Abbott Laboratories and subsidiaries (the Company) as of December 31, 2019 and 2018, the related consolidated statements of earnings, comprehensive income, shareholders’ investment and cash flows for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated February 21, 2020 expressed an unqualified opinion thereon. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +87 +​ +​ +​ +Evaluation of acquired in-process research & development intangible assets +Description of the Matter +​ +As described in Note 8 to the consolidated financial statements, acquired in-process research & development (“IPR&D”) intangible assets were approximately $1.3 billion at December 31, 2019. IPR&D intangible assets are assessed for impairment annually, or more frequently if impairment indicators suggest the fair value of the IPR&D intangible asset may be below its carrying value. Auditing the fair value estimate of IPR&D intangible assets is complex because the estimate involves making assumptions about the timing and amount of forecasted future net cash flows of the related IPR&D projects, as well as the risk associated with the forecasted future net cash flows. These significant assumptions are forward-looking and could be affected by future economic and market conditions. +How We Addressed the Matter in our Audit +​ +We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the Company’s IPR&D intangible asset impairment assessment, as well as its process for identification of events that indicate an IPR&D intangible asset may be impaired. This included controls over management's review of the valuation model and the significant assumptions (e.g., discount rate, projected research and development (“R&D”) costs, probability of technical success, projected revenues and product profitability) used to develop the prospective financial information (PFI). +To test the fair value of the Company’s IPR&D intangible assets, our audit procedures included, among others, evaluating the Company's use of the income approach, testing the significant assumptions described above used to develop the prospective financial information and testing the completeness and accuracy of the underlying data. For example, we compared certain significant assumptions to current industry, market and economic trends, historical results of the Company's business and other guideline companies within the same industry and to other relevant factors. We performed a sensitivity analysis of the significant assumptions to evaluate the change in the fair value of the IPR&D assets resulting from changes in the assumptions. We also involved our valuation specialists to assist in testing certain significant assumptions in the fair value estimate. In addition, to evaluate the probability of technical success, we considered the phase of development of the IPR&D project and the Company's history of obtaining regulatory approvals. +​ +​ +​ +Income taxes – Unrecognized tax benefits +Description of the Matter +​ +As described in Note 16 to the consolidated financial statements, unrecognized tax benefits were approximately $1.2 billion at December 31, 2019. Unrecognized tax benefits are assessed by management quarterly for identification and measurement, or more frequently if there are any indicators suggesting change in unrecognized tax benefits. Assessing tax positions involves judgement including interpreting tax laws of multiple jurisdictions and assumptions relevant to the measurement of an unrecognized tax benefit, including the estimated amount of tax liability that may be incurred should the tax position not be sustained upon inspection by a tax authority. These judgements and assumptions can significantly affect unrecognized tax benefits. +88 +​ +How We Addressed the Matter in our Audit +​ +We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the Company’s identification and measurement of unrecognized tax benefits, as well as its process for the assessment of events that may indicate a change in unrecognized tax benefits is warranted. For example, we tested controls over management’s review of the completeness of identified unrecognized tax benefits, as well as controls over management’s review of significant assumptions used within the measurement of unrecognized tax benefits. +With the support of our tax professionals and valuation specialists, among other audit procedures performed, we evaluated the reasonableness of management’s judgement with respect to the interpretation of tax laws of multiple jurisdictions by reading and evaluating management’s documentation, including relevant accounting policies, and by considering how tax law, including statutes, regulations and case law, affected management’s judgments. We tested the completeness of management’s assessment of the identification of unrecognized tax benefits and possible outcomes related to it including evaluation of technical merits of the unrecognized tax benefits. We also tested appropriateness and consistency of management’s methods and significant assumptions associated with the measurement of unrecognized tax benefits, including assessing the estimated amount of tax liability that may be incurred should the tax position not be sustained upon inspection by a tax authority. +​ +/s/ Ernst & Young LLP +We have served as the Company’s auditor since 2013. +Chicago, Illinois +February 21, 2020 +​ +89 +​ +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Abbott Laboratories +Opinion on Internal Control over Financial Reporting +We have audited Abbott Laboratories and subsidiaries’ internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Abbott Laboratories and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of earnings, comprehensive income, shareholders’ investment and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and our report dated February 21, 2020 expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. +Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ Ernst & Young LLP +Chicago, Illinois +February 21, 2020 +90 +​ +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +Evaluation of disclosure controls and procedures. The Chief Executive Officer, Miles D. White, and the Chief Financial Officer, Brian B. Yoor, evaluated the effectiveness of Abbott Laboratories’ disclosure controls and procedures as of the end of the period covered by this report, and concluded that Abbott Laboratories’ disclosure controls and procedures were effective to ensure that information Abbott is required to disclose in the reports that it files or submits with the Commission under the Securities Exchange Act of 1934 (the Exchange Act) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms, and to ensure that information required to be disclosed by Abbott in the reports that it files or submits under the Exchange Act is accumulated and communicated to Abbott’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. +Internal Control Over Financial Reporting +Management’s annual report on internal control over financial reporting. Management’s report on Abbott’s internal control over financial reporting is included on page 86 hereof. The report of Abbott’s independent registered public accounting firm related to their assessment of the effectiveness of internal control over financial reporting is included on page 90 hereof. +Changes in internal control over financial reporting. During the quarter ended December 31, 2019, there were no changes in Abbott’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, Abbott’s internal control over financial reporting. +ITEM 9B. OTHER INFORMATION +None. +​ +91 +​ +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Incorporated herein by reference are “Nominees for Election as Directors,” “Committees of the Board of Directors,” and “Procedure for Recommendation and Nomination of Directors and Transaction of Business at Annual Meeting” to be included in the 2020 Abbott Laboratories Proxy Statement. The 2020 Proxy Statement will be filed on or about March 13, 2020. Also incorporated herein by reference is the text found under the caption, “Information About Our Executive Officers” on pages 15 through 18 hereof. +Abbott has adopted a code of ethics that applies to its principal executive officer, principal financial officer, and principal accounting officer and controller. That code is part of Abbott’s code of business conduct which is available free of charge through Abbott’s investor relations website ( www.abbottinvestor.com ). Abbott intends to include on its website any amendment to, or waiver from, a provision of its code of ethics that applies to Abbott’s principal executive officer, principal financial officer, and principal accounting officer and controller that relates to any element of the code of ethics definition enumerated in Item 406(b) of Regulation S-K. +ITEM 11. EXECUTIVE COMPENSATION +The material to be included in the 2020 Proxy Statement under the headings “2019 Director Compensation” and “Executive Compensation” is incorporated herein by reference. The 2020 Proxy Statement will be filed on or about March 13, 2020. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +(a) Equity Compensation Plan Information . +The following table presents information as of December 31, 2019 about our compensation plans under which Abbott common shares have been authorized for issuance. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(c) +​ +​ +​ +​ +​ +​ +​ +Number of +​ +​ +(a) +​ +​ +​ +​ +securities remaining +​ +​ +Number of +​ +​ +​ +​ +available for +​ +​ +securities to be +​ +​ +(b) +​ +future issuance +​ +​ +issued upon +​ +Weighted average +​ +under equity +​ +​ +exercise of +​ +exercise price +​ +compensation +​ +​ +outstanding +​ +of outstanding +​ +plans (excluding +​ +​ +options, warrants +​ +options, warrants +securities reflected +Plan Category +​ +and rights +​ +and rights +in column (a)) +Equity compensation plans approved by security holders (1) +28,604,689 +​ +$ +49.59 +139,875,984 +Equity compensation plans not approved by security holders +0 +​ +— +0 +Total (1)(2) +28,604,689 +​ +$ +49.59 +139,875,984 +(1) +(i) +Abbott Laboratories 2009 Incentive Stock Program . Benefits under the Abbott Laboratories 2009 Incentive Stock Program (the “2009 Program”) include non-qualified stock options, restricted stock, restricted stock units, performance awards, other share-based awards (including stock appreciation rights, dividend equivalents and recognition awards), awards to non-employee directors, and foreign benefits. The shares that remain available for issuance under the 2009 Program may be issued in connection with any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards are satisfied from treasury shares). +​ +​ +​ +92 +​ +​ +​ +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 2009 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, may again be used for new stock options, rights, or awards of any type authorized under the Abbott Laboratories 2017 Incentive Stock Program (the “2017 Program”). If shares are issued under any benefit under the 2009 Program and thereafter are reacquired by Abbott pursuant to rights reserved upon their issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or so reacquired, may not again be used for new stock options, rights, or awards of any type authorized under the 2009 Program. +​ +​ +​ +​ +​ +In April 2017, the 2009 Program was replaced by the 2017 Program. No further awards will be granted under the 2009 Program. +​ +​ +​ +​ +(ii) +Abbott Laboratories 2017 Incentive Stock Program . Benefits under the 2017 Program include non-qualified stock options, restricted stock, restricted stock units, performance awards, other share-based awards (including stock appreciation rights, dividend equivalents and recognition awards), awards to non-employee directors, and foreign benefits. The shares that remain available for issuance under the 2017 Program may be issued in connection with any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards are satisfied from treasury shares). +​ +​ +​ +​ +​ +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 2017 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, may again be used for new stock options, rights, or awards of any type authorized under the 2017 Program. If shares are issued under any benefit under the 2017 Program and thereafter are reacquired by Abbott pursuant to rights reserved upon their issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or so reacquired, may not again be used for new stock options, rights, or awards of any type authorized under the 2017 Program. +​ +​ +​ +​ +(iii) +Abbott Laboratories Employee Stock Purchase Plan for Non-U.S. Employees . Eligible employees of participating non-U.S. affiliates of Abbott may participate in this plan. An eligible employee may authorize payroll deductions at the rate of 1% to 10% of eligible compensation (in multiples of one percent) subject to a limit of US $12,500 during any purchase cycle. +​ +​ +​ +​ +​ +Purchase cycles are generally six months long and usually begin on August 1 and February 1. On the last day of each purchase cycle, Abbott uses participant contributions to acquire Abbott common shares. The shares may be either authorized but unissued shares, treasury shares, or shares acquired on the open market. The purchase price is typically 85% of the lower of the fair market value of the shares on the purchase date or on the first day of that purchase cycle. As the number of shares subject to outstanding options is indeterminable, columns (a) and (b) of the above table do not include information on the Employee Stock Purchase Plan. As of December 31, 2019, an aggregate of 12,650,941 common shares were available for future issuance under the Employee Stock Purchase Plan, including shares subject to purchase during the current purchase cycle. +​ +​ +​ +​ +​ +In April 2017, the 2009 Employee Stock Purchase Plan for Non-U.S. Employees was amended and restated as the Abbott Laboratories 2017 Employee Stock Purchase Plan for Non-U.S. Employees. +​ +​ +​ +(2) +​ +Not included in the table: St. Jude Medical, Inc. Plans . In 2017, in connection with the acquisition of St. Jude Medical, Inc., options outstanding under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, as Amended and Restated (2014) were assumed by Abbott and converted into Abbott options of substantially equivalent value. As of December 31, 2019, 1,273,226 options remained outstanding under these plans. These options have a weighted average purchase price of $30.42. No further awards will be granted under these plans. +93 +​ +For additional information concerning the Abbott Laboratories 2009 Incentive Stock Program, the Abbott Laboratories 2017 Incentive Stock Program, and the Abbott Laboratories 2017 Employee Stock Purchase Plan for Non-U.S. Employees, see the discussion in Note 10 entitled “Incentive Stock Program” of the Notes to Consolidated Financial Statements included under Item 8, “Financial Statements and Supplementary Data.” +(b) Information Concerning Security Ownership . Incorporated herein by reference is the material under the heading “Security Ownership of Executive Officers and Directors” and “Information Concerning Security Ownership” in the 2020 Proxy Statement. The 2020 Proxy Statement will be filed on or about March 13, 2020. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The material to be included in the 2020 Proxy Statement under the headings “The Board of Directors,” “Committees of the Board of Directors,” and “Approval Process for Related Person Transactions” is incorporated herein by reference. The 2020 Proxy Statement will be filed on or about March 13, 2020. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The material to be included in the 2020 Proxy Statement under the headings “Audit Fees and Non-Audit Fees” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of the Independent Auditor” is incorporated herein by reference. The 2020 Proxy Statement will be filed on or about March 13, 2020. +​ +94 +​ +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as part of this Form 10-K. +(1) Financial Statements: See Item 8, “Financial Statements and Supplementary Data,” on page 43 hereof, for a list of financial statements. +(2) Financial Statement Schedules: The required financial statement schedules are found on the pages indicated below. These schedules should be read in conjunction with the Consolidated Financial Statements of Abbott Laboratories: +Abbott Laboratories Financial Statement Schedules +Page No. +Valuation and Qualifying Accounts (Schedule II) +​ +107 +Schedules I, III, IV, and V are not submitted because they are not applicable or not required +​ +​ +Report of Independent Registered Public Accounting Firm +​ +108 +Individual Financial Statements of businesses acquired by the registrant have been omitted pursuant to Rule 3.05 of Regulation S-X +​ +​ +​ +(3) Exhibits Required by Item 601 of Regulation S-K: The information called for by this paragraph is set forth in Item 15(b) below. +(b) Exhibits filed. +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +2.1 +* +Agreement and Plan of Merger dated as of January 30, 2016, among Alere Inc. and Abbott Laboratories, filed as Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated January 30, 2016. +​ +​ +​ +​ +​ +2.2 +* +Amendment to Agreement and Plan of Merger, dated as of April 13, 2017, among Alere Inc., Abbott Laboratories and Angel Sub, Inc., filed as Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated April 14, 2017. +​ +​ +​ +​ +​ +2.3 +* +Agreement and Plan of Merger, dated as of April 27, 2016, by and among Abbott Laboratories, St. Jude Medical, Inc., Vault Merger Sub, Inc. and Vault Merger Sub, LLC, filed as Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated April 27, 2016. +​ +​ +​ +​ +​ +2.4 +* +Stock Purchase Agreement, dated as of September 14, 2016, by and between Abbott Laboratories and Chace LLC and, solely for certain purposes, Johnson & Johnson, filed as Exhibit 2.1 to the Abbott Laboratories Current Report on Form 8-K dated September 14, 2016. +​ +​ +​ +​ +​ +​ +​ +Certain schedules and exhibits have been omitted from these filings pursuant to Item 601(b)(2) of Regulation S-K. Abbott will furnish supplemental copies of any such schedules or exhibits to the U.S. Securities and Exchange Commission upon request. +​ +​ +​ +​ +​ +3.1 +* +Articles of Incorporation, Abbott Laboratories, filed as Exhibit 3.1 to the Abbott Laboratories Quarterly Report on Form 10-Q for the quarter ended March 31, 1998. +​ +​ +​ +​ +​ +3.2 +* +By-Laws of Abbott Laboratories, as amended and restated effective November 12, 2019, filed as Exhibit 3.1 to the Abbott Laboratories Current Report on Form 8-K dated November 13, 2019. +​ +​ +​ +​ +​ +95 +​ +​ +10-K +Exhibit +Table +Item No. +​ +4.1 +* +Indenture dated as of February 9, 2001, between Abbott Laboratories and The Bank of New York Mellon Trust Company, N.A. (as successor to J.P. Morgan Trust Company, National Association, successor to Bank One Trust Company, N.A.) (including form of Security), filed as Exhibit 4.1 to the Abbott Laboratories Registration Statement on Form S-3 dated February 12, 2001. +​ +​ +​ +​ +​ +4.2 +* +Supplemental Indenture dated as of February 27, 2006, between Abbott Laboratories and The Bank of New York Mellon Trust Company, N.A. (as successor to J.P. Morgan Trust Company, National Association), filed as Exhibit 4.2 to the Abbott Laboratories Registration Statement on Form S-3 dated February 28, 2006. +​ +​ +​ +​ +​ +4.3 +* +Form of $1,000,000,000 6.150% Note due 2037, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated November 6, 2007. +​ +​ +​ +​ +​ +4.4 +* +Actions of the Authorized Officers with respect to Abbott’s 5.150% Notes due 2012, 5.600% Notes due 2017 and 6.150% Notes due 2037, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated November 6, 2007. +​ +​ +​ +​ +​ +4.5 +* +Form of $1,000,000,000 6.000% Note due 2039, filed as Exhibit 99.5 to the Abbott Laboratories Current Report on Form 8-K dated February 26, 2009. +​ +​ +​ +​ +​ +4.6 +* +Actions of the Authorized Officers with respect to Abbott’s 5.125% Note due 2019 and 6.000% Note due 2039, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated February 26, 2009. +​ +​ +​ +​ +​ +4.7 +* +Form of 2040 Note, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated May 27, 2010. +​ +​ +​ +​ +​ +4.8 +* +Actions of the Authorized Officers with respect to Abbott’s 2.70% Notes, 4.125% Notes and 5.30% Notes, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated May 27, 2010. +​ +​ +​ +​ +​ +4.9 +* +Indenture, dated as of March 10, 2015, between Abbott Laboratories and U.S. Bank National Association (including form of Security), filed as Exhibit 4.1 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.10 +* +Form of 2.550% Note due 2022, filed as Exhibit 99.5 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.11 +* +Form of 2.950% Note due 2025, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.12 +* +Actions of the Authorized Officers with respect to Abbott’s 2.000% Notes, 2.550% Notes and 2.950% Notes, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.13 +* +Form of 3.400% Notes due 2023, filed as Exhibit 4.4 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.14 +* +Form of 3.750% Notes due 2026, filed as Exhibit 4.5 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.15 +* +Form of 4.750% Notes due 2036, filed as Exhibit 4.6 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +96 +​ +​ +10-K +Exhibit +Table +Item No. +​ +4.16 +* +Form of 4.900% Notes due 2046, filed as Exhibit 4.7 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.17 +* +Officers’ Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 2.350% Notes due 2019, 2.900% Notes due 2021, 3.400% Notes due 2023, 3.750% Notes due 2026, 4.750% Notes due 2036 and 4.900% Notes due 2046 (including forms of notes), filed as Exhibit 4.22 to the Abbott Laboratories 2016 Annual Report on Form 10-K. +​ +​ +​ +​ +​ +4.18 +* +Form of 3.875% Notes due 2025, filed as Exhibit 4.5 to the Abbott Laboratories Current Report on Form 8-K dated March 22, 2017. +​ +​ +​ +​ +​ +4.19 +* +Form of 4.75% Notes due 2043, filed as Exhibit 4.6 to the Abbott Laboratories Current Report on Form 8-K dated March 22, 2017. +​ +​ +​ +​ +​ +4.20 +* +Officers’ Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 2.000% Notes due 2018, 2.800% Notes due 2020, 3.25% Notes due 2023, 3.875% Notes due 2025, and 4.75% Notes due 2043 (including form of notes), filed as Exhibit 4.7 to the Abbott Laboratories Quarterly Report on Form 10-Q for the period ended March 31, 2017. +​ +​ +​ +​ +​ +4.21 +† +Indenture, dated as of July 28, 2009, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank National Association, as trustee, filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated July 28, 2009. +​ +​ +​ +​ +​ +4.22 +† +Fourth Supplemental Indenture, dated as of April 2, 2013, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank National Association, as trustee, relating to St. Jude Medical, LLC’s 3.25% Senior Notes due 2023 and 4.75% Senior Notes due 2043 (including forms of notes), filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated April 2, 2013. +​ +​ +​ +​ +​ +4.23 +† +Fifth Supplemental Indenture, dated as of September 23, 2015, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank National Association, as trustee, relating to St. Jude Medical, LLC’s 2.000% Senior Notes due 2018, 2.800% Senior Notes due 2020 and 3.875% Senior Notes due 2025, filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated September 23, 2015. +​ +​ +​ +​ +​ +4.24 +† +Sixth Supplemental Indenture, dated as of January 4, 2017, among St. Jude Medical, Inc., St. Jude Medical, LLC and U.S. Bank National Association, as trustee, filed as Exhibit 4.1 to the St. Jude Medical, LLC Current Report on Form 8-K dated January 4, 2017. +​ +​ +​ +​ +​ +4.25 +* +Form of Seventh Supplemental Indenture between St. Jude Medical, LLC and U.S. Bank National Association, as trustee, filed as Exhibit 4.3 to the Abbott Laboratories Registration Statement on Form S-4 dated February 21, 2017. +​ +​ +​ +​ +​ +4.26 +* +Indenture dated September 27, 2018, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor and U.S. Bank National Association, as trustee, filed as Exhibit 4.1 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018. +​ +​ +​ +​ +​ +4.27 +* +First Supplemental Indenture dated September 27, 2018, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor, U.S. Bank National Association, as trustee, Elavon Financial Services DAC, U.K. Branch, as paying agent and transfer agent, and Elavon Financial Services DAC, as registrar, filed as Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018. +​ +​ +​ +​ +​ +97 +​ +​ +10-K +Exhibit +Table +Item No. +​ +4.28 +* +Second Supplemental Indenture dated November 19, 2019, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor, U.S. Bank National Association, as trustee, and Elavon Financial Services DAC, as paying agent, transfer agent and registrar, filed as Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated November 19, 2019. +​ +​ +​ +​ +​ +4.29 +* +Form of 0.000% Note due 2020 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018). +​ +​ +​ +​ +​ +4.30 +* +Form of 0.875% Note due 2023 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018). +​ +​ +​ +​ +​ +4.31 +* +Form of 1.500% Note due 2026 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018). +​ +​ +​ +​ +​ +4.32 +* +Form of 0.100% Note due 2024 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated November 19, 2019). +​ +​ +​ +​ +​ +4.33 +* +Form of 0.375% Note due 2027 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated November 19, 2019). +​ +​ +​ +​ +​ +​ +​ +Other debt instruments are omitted in accordance with Item 601(b)(4)(iii)(A) of Regulation S-K. Copies of such agreements will be furnished to the Securities and Exchange Commission upon request. +​ +​ +​ +​ +​ +4.34 +​ +Description of Registrant's Securities. +​ +​ +​ +​ +​ +10.1 +* +Supplemental Plan Abbott Laboratories Extended Disability Plan, filed as an exhibit (pages 50-51) to the 1992 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.2 +* +Abbott Laboratories Deferred Compensation Plan, as amended, filed as Exhibit 10.2 to the 2017 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.3 +* +Abbott Laboratories 401(k) Supplemental Plan, as amended and restated, filed as Exhibit 10.3 to the 2012 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.4 +* +Abbott Laboratories Supplemental Pension Plan, as amended and restated, filed as Exhibit 10.4 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.5 +* +1986 Abbott Laboratories Management Incentive Plan, as amended and restated, filed as Exhibit 10.5 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.6 +* +1998 Abbott Laboratories Performance Incentive Plan, as amended, filed as Exhibit 10.6 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.7 +* +Rules for the 1998 Abbott Laboratories Performance Incentive Plan, as amended and restated, filed as Exhibit 10.7 to the 2012 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.8 +* +Abbott Laboratories 2009 Incentive Stock Program, as amended and restated, filed as Exhibit 10.9 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +98 +​ +​ +10-K +Exhibit +Table +Item No. +​ +10.9 +* +Abbott Laboratories 2017 Incentive Stock Program (incorporated by reference to Exhibit B of Abbott’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 17, 2017).** +​ +​ +​ +​ +​ +10.10 +* +Abbott Laboratories Non-Employee Directors’ Fee Plan, as amended and restated, filed as Exhibit 10.10 to the 2016 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.11 +* +Form of Non-Employee Director Restricted Stock Unit Agreement under Abbott Laboratories 1996 Incentive Stock Program, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated December 10, 2004.** +​ +​ +​ +​ +​ +10.12 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated April 24, 2009.** +​ +​ +​ +​ +​ +10.13 +* +Form of Non-Employee Director Restricted Stock Unit Agreement, filed as Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated April 24, 2009.** +​ +​ +​ +​ +​ +10.14 +* +Form of Non-Qualified Stock Option Agreement (ratably vested), filed as Exhibit 10.5 to the Abbott Laboratories Current Report on Form 8-K dated April 24, 2009.** +​ +​ +​ +​ +​ +10.15 +* +Form of Restricted Stock Unit Agreement (ratably vested), filed as Exhibit 10.37 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.16 +* +Form of Restricted Stock Unit Agreement for foreign employees (ratably vested), filed as Exhibit 10.38 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.17 +* +Form of Performance Restricted Stock Unit Agreement for foreign employees (annual performance based), filed as Exhibit 10.39 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.18 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based), filed as Exhibit 10.40 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.19 +* +Form of Performance Restricted Stock Unit Agreement for foreign employees (interim performance based), filed as Exhibit 10.41 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.20 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based), filed as Exhibit 10.42 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.21 +* +Form of Restricted Stock Unit Agreement (cliff vested), filed as Exhibit 10.43 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.22 +* +Form of Restricted Stock Unit Agreement for executive officers (cliff vested), filed as Exhibit 10.44 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.23 +* +Form of Restricted Stock Unit Agreement for foreign employees (cliff vested), filed as Exhibit 10.45 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.24 +* +Form of Restricted Stock Unit Agreement for foreign executive officers (cliff vested), filed as Exhibit 10.46 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +99 +​ +​ +10-K +Exhibit +Table +Item No. +​ +10.25 +* +Form of Non-Employee Director Restricted Stock Unit Agreement, filed as Exhibit 10.47 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.26 +* +Form of Non-Employee Director Restricted Stock Unit Agreement for foreign non-employee directors, filed as Exhibit 10.48 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.27 +* +Form of Restricted Stock Unit Agreement for Participants in France, filed as Exhibit 10.49 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.28 +* +Form of Restricted Stock Agreement (ratably vested), filed as Exhibit 10.50 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.29 +* +Form of Restricted Stock Agreement for executive officers (ratably vested), filed as Exhibit 10.51 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.30 +* +Form of Performance Restricted Stock Agreement (annual performance based), filed as Exhibit 10.52 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.31 +* +Form of Performance Restricted Stock Agreement for executive officers (annual performance based), filed as Exhibit 10.53 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.32 +* +Form of Performance Restricted Stock Agreement (interim performance based), filed as Exhibit 10.54 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.33 +* +Form of Performance Restricted Stock Agreement for executive officers (interim performance based), filed as Exhibit 10.55 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.34 +* +Form of Restricted Stock Agreement (cliff vested), filed as Exhibit 10.56 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.35 +* +Form of Restricted Stock Agreement for executive officers (cliff vested), filed as Exhibit 10.57 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.36 +* +Form of Non-Qualified Stock Option Agreement, filed as Exhibit 10.58 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.37 +* +Form of Non-Qualified Stock Option Agreement for executive officers, filed as Exhibit 10.59 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.38 +* +Form of Non-Qualified Stock Option Agreement for foreign employees, filed as Exhibit 10.60 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.39 +* +Form of Non-Qualified Stock Option Agreement for foreign executive officers, filed as Exhibit 10.61 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.40 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement, filed as Exhibit 10.64 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.41 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement for foreign non-employee directors, filed as Exhibit 10.65 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +100 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +10.42 +* +Form of Restricted Stock Unit Agreement (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.43 +* +Form of Restricted Stock Unit Agreement for foreign employees (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.44 +* +Form of Restricted Stock Unit Agreement (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.4 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.45 +* +Form of Restricted Stock Unit Agreement for foreign employees (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.5 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.46 +* +Form of Performance Restricted Stock Unit Agreement for foreign employees (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.6 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.47 +* +Form of Performance Restricted Stock Unit Agreement for foreign employees (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.7 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.48 +* +Form of Restricted Stock Agreement (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.8 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.49 +* +Form of Restricted Stock Agreement (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.9 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.50 +* +Form of Performance Restricted Stock Agreement (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.10 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.51 +* +Form of Performance Restricted Stock Agreement (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.11 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.52 +* +Form of Non-Qualified Stock Option Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.12 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.53 +* +Form of Non-Qualified Stock Option Agreement for foreign employees under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.13 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +101 +​ +​ +10-K +Exhibit +Table +Item No. +​ +10.54 +* +Form of Restricted Stock Unit Agreement for executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.14 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.55 +* +Form of Restricted Stock Unit Agreement for foreign executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.15 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.56 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.16 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.57 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.17 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.58 +* +Form of Restricted Stock Agreement for executive officers (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.18 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.59 +* +Form of Restricted Stock Agreement for executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.19 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.60 +* +Form of Performance Restricted Stock Agreement for executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.20 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.61 +* +Form of Performance Restricted Stock Agreement for executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.21 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.62 +* +Form of Non-Qualified Stock Option Agreement for executive officers under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.22 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.63 +* +Form of Non-Qualified Stock Option Agreement for foreign executive officers under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.23 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.64 +* +Form of Non-Employee Director Restricted Stock Unit Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.24 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.65 +* +Form of Non-Employee Director Restricted Stock Unit Agreement for foreign non-employee directors under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.25 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +102 +​ +​ +10-K +Exhibit +Table +Item No. +​ +10.66 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.26 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.67 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement for foreign non-employee directors under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.27 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.68 +* +Form of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), filed as Exhibit 10.1 to the Abbott Laboratories Current Report on Form 8-K dated November 30, 2012.** +​ +​ +​ +​ +​ +10.69 +* +Form of Extension of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), extending the agreement term to December 31, 2020, filed as Exhibit 10.74 to the 2018 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.70 +* +Form of Time Sharing Agreement between Abbott Laboratories, Inc. and M.D. White, filed as Exhibit 10.6 to the Abbott Laboratories Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.** +​ +​ +​ +​ +​ +10.71 +† +St. Jude Medical, Inc. 2007 Stock Incentive Plan, as amended and restated (2014), filed as Exhibit 10.22 to St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended January 3, 2015 dated February 26, 2015.** +​ +​ +​ +​ +​ +10.72 +† +Form of Non-Qualified Stock Option Agreement (Global) and related Notice of Non-Qualified Stock Option Grant for stock options granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.24 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012 dated February 26, 2013.** +​ +​ +​ +​ +​ +10.73 +† +Form of Non-Qualified Stock Option Agreement for Non-Employee Directors and related Notice of Non-Qualified Stock Option Grant for stock options granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.25 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012, dated February 26, 2013.** +​ +​ +​ +​ +​ +10.74 +† +Form of Restricted Stock Units Award Agreement (Global) and related Restricted Stock Units Award Certificate for restricted stock units granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.27 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012, dated February 26, 2013.** +​ +​ +​ +​ +​ +10.75 +​ +Management Savings Plan, as amended and restated.** +​ +​ +​ +​ +​ +10.76 +* +Five Year Credit Agreement, dated as of November 30, 2018, among Abbott Laboratories, various financial institutions, as lenders, and JPMorgan Chase Bank, N.A., as administrative agent, filed as Exhibit 10.82 to the 2018 Abbott Laboratories Annual Report on Form 10-K. +​ +​ +​ +​ +​ +21 +​ +Subsidiaries of Abbott Laboratories. +​ +​ +​ +​ +​ +23.1 +​ +Consent of Independent Registered Public Accounting Firm. +​ +​ +​ +​ +​ +31.1 +​ +Certification of Chief Executive Officer Required by Rule 13a-14(a) (17 CFR 240.13a-14(a)). +​ +​ +​ +​ +​ +103 +​ +​ +10-K +Exhibit +Table +Item No. +​ +31.2 +​ +Certification of Chief Financial Officer Required by Rule 13a-14(a) (17 CFR 240.13a-14(a)). +​ +​ +​ +​ +Exhibits 32.1 and 32.2 are furnished herewith and should not be deemed to be “filed” under the Securities Exchange Act of 1934. +​ +​ +​ +​ +​ +32.1 +​ +Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +​ +​ +​ +​ +​ +32.2 +​ +Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +​ +​ +​ +​ +​ +101 +​ +The following financial statements and notes from the Abbott Laboratories Annual Report on Form 10-K for the year ended December 31, 2019 filed on February 21, 2020, formatted in Inline XBRL: (i) Consolidated Statement of Earnings; (ii) Consolidated Statement of Comprehensive Income; (iii) Consolidated Statement of Cash Flows; (iv) Consolidated Balance Sheet; (v) Consolidated Statement of Shareholders’ Investment; and (vi) the notes to the consolidated financial statements. +​ +​ +​ +​ +​ +104 +​ +Cover Page Interactive Data File (the cover page XBRL tags are embedded in the Inline XBRL document and included in Exhibit 101). +​ +* Incorporated herein by reference. +** Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit hereto. +† Incorporated herein by reference. +Abbott will furnish copies of any of the above exhibits to a shareholder upon written request to the Secretary, Abbott Laboratories, 100 Abbott Park Road, Abbott Park, Illinois 60064-6400. +(c) Financial Statement Schedule filed (page 107 ). +ITEM 16. FORM 10-K SUMMARY +None. +​ +104 +​ +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Abbott Laboratories has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +​ +​ +​ +​ +ABBOTT LABORATORIES +​ +​ +​ +​ +​ +​ +​ +By +/s/ MILES D. WHITE +​ +Miles D. White +Chairman of the Board and +Chief Executive Officer +​ +​ +​ +Date: +February 21, 2020 +​ +​ +105 +​ +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Abbott Laboratories on February 21, 2020 in the capacities indicated below. +/s/ MILES D. WHITE +/s/ BRIAN B. YOOR +Miles D. White +​ +Brian B. Yoor +Chairman of the Board and Chief Executive Officer, +and Director of Abbott Laboratories +(principal executive officer) +​ +Executive Vice President, Finance +and Chief Financial Officer +(principal financial officer) +​ +​ +​ +​ +​ +​ +/s/ ROBERT E. FUNCK, JR. +​ +​ +Robert E. Funck, Jr. +​ +​ +Senior Vice President, Finance and Controller +(principal accounting officer) +​ +​ +​ +​ +​ +​ +​ +​ +/s/ ROBERT J. ALPERN, M.D. +​ +/s/ ROXANNE S. AUSTIN +Robert J. Alpern, M.D. +​ +Roxanne S. Austin +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ SALLY E. BLOUNT +​ +/s/ ROBERT B. FORD +Sally E. Blount, Ph.D. +​ +Robert B. Ford +Director of Abbott Laboratories +​ +President and Chief Operating Officer, and +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ MICHELLE A. KUMBIER +​ +/s/ EDWARD M. LIDDY +Michelle A. Kumbier +Director of Abbott Laboratories +​ +Edward M. Liddy +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ DARREN W. MCDEW +​ +/s/ NANCY MCKINSTRY +Darren W. McDew +​ +Nancy McKinstry +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ PHEBE N. NOVAKOVIC +​ +/s/ WILLIAM A. OSBORN +Phebe N. Novakovic +​ +William A. Osborn +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ SAMUEL C. SCOTT III +​ +/s/ DANIEL J. STARKS +Samuel C. Scott III +​ +Daniel J. Starks +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ JOHN G. STRATTON +​ +/s/ GLENN F. TILTON +John G. Stratton +​ +Glenn F. Tilton +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +106 +​ +ABBOTT LABORATORIES AND SUBSIDIARIES +SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS +FOR THE YEARS ENDED DECEMBER 31, 2019, 2018 AND 2017 +(in millions of dollars) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Amounts +​ +​ +​ +​ +Balance +​ +Provisions/ +​ +Charged Off +​ +​ +​ +Allowances for Doubtful +​ +at Beginning +​ +Charges +​ +and Other +​ +Balance at +Accounts and Product Returns +​ +of Year +​ +to Income +​ +Deductions +​ +End of Year +2019 +​ +$ +314 +​ +$ +137 +​ +$ +( 68 ) +​ +$ +384 +2018 +​ +​ +294 +​ +​ +110 +​ +​ +( 90 ) +​ +​ +314 +2017 +​ +250 +​ +​ +105 +​ +​ +( 61 ) +​ +​ +294 +​ +​ +​ +107 +​ +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Abbott Laboratories +Opinion on the Financial Statement Schedule +We have audited the consolidated financial statements of Abbott Laboratories and subsidiaries (the Company) as of December 31, 2019 and 2018, for each of the three years in the period ended December 31, 2019, and have issued our report thereon dated February 21, 2020 (included elsewhere in this Annual Report on Form 10-K). Our audits of the consolidated financial statements included the financial statement schedule listed in Item 15(a)(2) of this Annual Report on Form 10-K (the “schedule”). This schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s schedule, based on our audits. +In our opinion, the schedule presents fairly, in all material respects, the information set forth therein when considered in conjunction with the consolidated financial statements. +/s/ Ernst & Young LLP +Chicago, Illinois +February 21, 2020 +​ +108 \ No newline at end of file diff --git a/raw/filings/0000001800/2019/0001104659-20-023904/filing_metadata.csv b/raw/filings/0000001800/2019/0001104659-20-023904/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..8d4f97fe7e8fd02ba7c8387449e14ec5a30feb36 --- /dev/null +++ b/raw/filings/0000001800/2019/0001104659-20-023904/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000001800,ABT,ABBOTT LABORATORIES,2019,10-K,2020-02-21,2019-12-31,2020-02-21T21:28:23.000Z,0001104659-20-023904,abt-20191231x10k59d41b.htm,10-K,20812248,1,1,https://www.sec.gov/Archives/edgar/data/1800/000110465920023904/abt-20191231x10k59d41b.htm,https://www.sec.gov/Archives/edgar/data/1800/000110465920023904/ diff --git a/raw/filings/0000001800/2019/0001104659-20-023904/item1.txt b/raw/filings/0000001800/2019/0001104659-20-023904/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..2a0aaa87fbd6541ed7f8a66f6d94d91efb51d3ae --- /dev/null +++ b/raw/filings/0000001800/2019/0001104659-20-023904/item1.txt @@ -0,0 +1,88 @@ +ITEM 1. BUSINESS +GENERAL DEVELOPMENT OF BUSINESS +Abbott Laboratories is an Illinois corporation, incorporated in 1900. Abbott’s* principal business is the discovery, development, manufacture, and sale of a broad and diversified line of health care products. +NARRATIVE DESCRIPTION OF BUSINESS +Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. +On October 3, 2017, Abbott completed the acquisition of Alere Inc., a diagnostic device and service provider, for an aggregate consideration of approximately $4.5 billion in cash. +On February 27, 2017, Abbott completed the sale of Abbott Medical Optics, its vision care business, to Johnson & Johnson for $4.325 billion in cash. +On January 4, 2017, Abbott completed the acquisition of St. Jude Medical, Inc., a global medical device manufacturer. Based on the closing Abbott share price on January 4, 2017, the aggregate implied value of the consideration paid in connection with the acquisition was approximately $23.6 billion, including approximately $13.6 billion in cash and approximately $10 billion in Abbott common shares. +Established Pharmaceutical Products +These products include a broad line of branded generic pharmaceuticals manufactured worldwide and marketed and sold outside the United States in emerging markets. These products are generally sold directly to wholesalers, distributors, government agencies, health care facilities, pharmacies, and independent retailers from Abbott-owned distribution centers and public warehouses, depending on the market served. Certain products are co-marketed or co-promoted with, or licensed from, other companies. +The principal products included in the broad therapeutic area portfolios of the Established Pharmaceutical Products segment are: +● gastroenterology products, including Creon™, for the treatment of pancreatic exocrine insufficiency associated with several underlying conditions, including cystic fibrosis and chronic pancreatitis; Duspatal™ and Dicetel™, for the treatment of irritable bowel syndrome or biliary spasm; Heptral™, Transmetil™, and Samyr™, for the treatment of intrahepatic cholestasis (associated with liver disease) or depressive symptoms; and Duphalac™, for regulation of the physiological rhythm of the colon; +● women’s health products, including Duphaston™, for the treatment of many different gynecological disorders; and Femoston™, a hormone replacement therapy for postmenopausal women; +● cardiovascular and metabolic products, including Lipanthyl™ and TriCor™, for the treatment of dyslipidemia; Teveten™ and Teveten™ Plus, for the treatment of essential hypertension, and Physiotens™, for the treatment of hypertension; and Synthroid™, for the treatment of hypothyroidism; +● pain and central nervous system products, including Serc™, for the treatment of Ménière’s disease and vestibular vertigo; Brufen™, for the treatment of pain, fever, and inflammation; and Sevedol™, for the treatment of severe migraines; and +● respiratory drugs and vaccines, including the anti-infective clarithromycin (sold under the trademarks Biaxin™, Klacid™, and Klaricid™); and Influvac™, an influenza vaccine. +* As used throughout the text of this report on Form 10-K, the term “Abbott” refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and its consolidated subsidiaries, as the context requires. +​ +1 +The Established Pharmaceutical Products segment directs its primary marketing efforts toward building strong brands with key stakeholders, including consumers, pharmacists, physicians, and other healthcare providers. Government agencies are also important customers. +Competition in the Established Pharmaceutical Products segment is generally from other health care and pharmaceutical companies. In addition, the substitution of generic drugs for the brand prescribed and introduction of additional forms of already marketed established products by generic or branded competitors may increase competitive pressures. +Diagnostic Products +These products include a broad line of diagnostic systems and tests manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to blood banks, hospitals, commercial laboratories, clinics, physicians’ offices, government agencies, alternate care testing sites, and plasma protein therapeutic companies from Abbott owned distribution centers, public warehouses or third party distributors. +The principal products included in the Diagnostic Products segment are: +● core laboratory systems in the areas of immunoassay, clinical chemistry, hematology, and transfusion, including the Alinity ® family of instruments, ARCHITECT ® , ABBOTT PRISM ® , and Cell-Dyn ® , with assays used for screening and/or diagnosis for cancer, cardiac, metabolics, drugs of abuse, fertility, general chemistries, infectious diseases such as hepatitis and HIV, and therapeutic drug monitoring; +● molecular diagnostics systems, including Alinity ® m and the m2000™ instruments that automate the extraction, purification, and preparation of DNA and RNA from patient samples, and detect and measure infectious agents including HIV, HBV, HCV, HPV, and CT/NG/TV/MG; and the Vysis ® FISH product line of genomic-based tests; +● point of care systems, including the i-STAT ® and next-generation i-STAT ® Alinity ® and cartridges for blood analysis; +● rapid diagnostics systems in the area of infectious diseases, including influenza, HIV, HCV, and tropical diseases such as malaria and dengue fever; molecular point-of-care testing for HIV, including the m-PIMA™ HIV-1/2 Viral Load Test, and for influenza A & B, RSV and strep A, including the ID NOW™ rapid molecular system; cardiometabolic testing, including Afinion ® and Cholestech™ platforms and tests; a toxicology business for drug and alcohol testing; and remote patient monitoring and consumer self-testing; and +● informatics and automation solutions for use in laboratories, including laboratory automation systems, the RALS point of care solution, and AlinIQ™, a suite of informatics tools and professional services. +The Diagnostic Products segment’s products are subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product performance, laboratory efficiency, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +Nutritional Products +These products include a broad line of pediatric and adult nutritional products manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to consumers and to institutions, wholesalers, retailers, health care facilities, government agencies, and third-party distributors from Abbott-owned distribution centers or third-party distributors. +The principal products included in the Nutritional Products segment are: +● various forms of prepared infant formula and follow-on formula, including Similac ®* , Similac Pro-Advance ®* , Similac ® Advance ® , Similac ® Advance ® Non-GMO, Similac Pro-Sensitive ®* , Similac Sensitive ® , Similac Sensitive ® Non-GMO, Go&Grow by Similac ®* , Similac ® NeoSure ® , Similac ® Organic, Similac ® Special Care ® , +2 +Similac Total Comfort ®* , Similac ® For Supplementation, Isomil ® Advance ® , Isomil ® , Alimentum ® , Gain™, Grow™, Similac En Mei Li™, and Eleva™; +● adult and other pediatric nutritional products, including Ensure ® , Ensure Plus ® , Ensure ® Enlive ® , Ensure ® (with NutriVigor ® ), Ensure ® Max Protein, Ensure ® High Protein, Glucerna ® , Glucerna Hunger Smart ® , ProSure ® , PediaSure ® , PediaSure SideKicks ® , PediaSure ® Peptide, EleCare ® , Juven ® , Abound ® , Pedialyte ® and Zone Perfect ® ; and +● nutritional products used in enteral feeding in health care institutions, including Jevity ® , Glucerna ® 1.2 Cal, Glucerna ® 1.5 Cal, Osmolite ® , Oxepa ® , Freego ® (Enteral Pump) and Freego ® sets, Nepro ® , and Vital ® . +* These products are available with 2'‐FL HMO (Human Milk Oligosaccharide) in several markets. +Primary marketing efforts for nutritional products are directed toward consumers or to securing the recommendation of Abbott’s brand of products by physicians or other health care professionals. In addition, certain nutritional products sold as Similac ® , Gain™, Grow™, Eleva™, PediaSure ® , PediaSure SideKicks ® , Pedialyte ® , Ensure ® , Zone Perfect ® , and Glucerna ® are also promoted directly to the public by consumer marketing efforts in select markets where appropriate. +Competition for nutritional products in the segment is generally from other diversified consumer and health care manufacturers. Competitive factors include consumer advertising, formulation, packaging, scientific innovation, price, retail distribution, and availability of product forms. A significant aspect of competition is the search for ingredient innovations. The introduction of new products by competitors, changes in medical practices and procedures, and regulatory changes can result in product obsolescence. In addition, private label and local manufacturers’ products may increase competitive pressure. +Medical Devices +These products include a broad line of rhythm management, electrophysiology, heart failure, vascular and structural heart devices for the treatment of cardiovascular diseases, and diabetes care products for people with diabetes, as well as neuromodulation devices for the management of chronic pain and movement disorders. Medical devices are manufactured, marketed and sold worldwide. In the United States, depending upon the product, medical devices are generally marketed and sold directly to wholesalers, hospitals, ambulatory surgery centers, physicians’ offices, and distributors from Abbott-owned distribution centers and public warehouses. Outside the United States, sales are made either directly to customers or through distributors, depending on the market served. +The principal products included in the Medical Devices segment are: +● rhythm management products, including Assurity MRI ® and Endurity MRI ® pacemaker systems; Ellipse ® and Fortify Assura ® implantable cardioverter defibrillators and Quadra Assura MP ® implantable cardioverter defibrillator with cardiac resynchronization therapy and MultiPoint ® Pacing technology; and Confirm Rx ® implantable cardiac monitor; +● electrophysiology products, including the TactiCath ® family of ablation catheters and FlexAbility ® irrigated ablation catheters; Ampere ® RF ablation generator; EnSite Precision ® cardiac mapping system; and the Advisor ® HD Grid mapping catheter; +● heart failure related products, including the HeartMate™ left ventricular device family and the CardioMEMS ® HF System pulmonary artery sensor, a heart failure monitoring system; +● vascular products, including the XIENCE™ family of drug-eluting coronary stent systems developed on the Multi-Link Vision ® platform; StarClose SE ® and Perclose ProGlide ® vessel closure devices, TREK ® coronary balloon dilatation products, Hi-Torque Balance Middleweight Universal II ® guidewires, Supera ® Peripheral Stent System, a peripheral vascular stent system; Acculink ® /Accunet ® and Xact ® /Emboshield NAV6 ® , carotid stent systems; and the OPTIS ® integrated system with the Dragonfly OPTIS ® imaging catheter and PressureWire ® fractional flow reserve measurement systems; +● structural heart products, including MitraClip ® , a percutaneous mitral valve repair system; Trifecta ® Valve with Glide™ Technology, a surgical tissue heart valve; Portico ® transcatheter aortic heart valve; Regent™ mechanical heart valve; AMPLATZER ® PFO occluders; and Tendyne ® Transcatheter Mitral Valve Implantation (TMVI) system; +3 +● continuous glucose and blood glucose monitoring systems, including test strips, sensors, data management decision software, and accessories for people with diabetes, under the FreeStyle ® brand such as the FreeStyle Libre ® system; and +● neuromodulation products, including spinal cord stimulators Proclaim ® Elite and Proclaim ® XR Recharge-free implantable pulse generators (IPG) and Prodigy MRI ® IPG, each with BurstDR ® stimulation, and Proclaim ® DRG IPG, a neurostimulation device designed for dorsal root ganglion therapy, for the treatment of chronic pain disorders; and the Infinity ® Deep Brain Stimulation System with directional lead technology for the treatment of movement disorders. +These products are subject to competition in technological innovation, price, convenience of use, service, product performance, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +INFORMATION WITH RESPECT TO ABBOTT’S BUSINESS IN GENERAL +Sources and Availability of Raw Materials +Abbott purchases, in the ordinary course of business, raw materials and supplies essential to Abbott’s operations from numerous suppliers in the United States and around the world. There have been no recent significant availability problems or supply shortages for raw materials or supplies. +Patents, Trademarks, and Licenses +Abbott is aware of the desirability for patent and trademark protection for its products. Accordingly, where possible, patents and trademarks are sought and obtained for Abbott’s products in the United States and countries of interest to Abbott. Abbott owns or has licenses under a substantial number of patents and patent applications. Principal trademarks and the products they cover are discussed in the Narrative Description of Business on pages 1 through 4. These, and various patents which expire during the period 2020 to 2040, in the aggregate, are believed to be of material importance in the operation of Abbott’s business. Abbott believes that no single patent, license, or trademark is material in relation to Abbott’s business as a whole. +Seasonal Aspects, Customers, Backlog, and Renegotiation +There are no significant seasonal aspects to Abbott’s business. Abbott has no single customer that, if the customer were lost, would have a material adverse effect on Abbott. Orders for Abbott’s products are generally filled on a current basis, and order backlog is not material to Abbott’s business. No material portion of Abbott’s business is subject to renegotiation of profits or termination of contracts at the election of a government. +Environmental Matters +Abbott believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. Abbott’s capital and operating expenditures for pollution control in 2019 were not material and are not expected to be material in 2020. +Abbott has been identified as one of many potentially responsible parties in investigations and/or remediations at several locations in the United States, including Puerto Rico, under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. Abbott is also engaged in remediation at several other sites, some of which are owned by Abbott, in cooperation with the Environmental Protection Agency or similar agencies. While it is not feasible to predict with certainty the final costs related to those investigations and remediation activities, Abbott believes that such costs, together with other expenditures to maintain compliance with applicable laws and regulations concerning environmental protection, should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +Employees +Abbott employed approximately 107,000 people as of December 31, 2019. +4 +Regulation +The development, manufacture, marketing, sale, promotion, and distribution of Abbott’s products are subject to comprehensive government regulation by the U.S. Food and Drug Administration (FDA) and similar international regulatory agencies. Government regulation by various international, supranational, federal and state agencies addresses (among other matters) the development and approval to market Abbott’s products, as well as the inspection of, and controls over, research and laboratory procedures, clinical investigations, product approvals and manufacturing, labeling, packaging, supply chains, marketing and promotion, pricing and reimbursement, sampling, distribution, quality control, post-market surveillance, record keeping, storage, and disposal practices. In addition, Abbott’s clinical laboratories and associated testing services are subject to comprehensive government regulation, including registration, certification, and licensure, by federal, state, and local agencies, such as the Centers for Medicare & Medicaid Services, the Drug Enforcement Administration, the Substance Abuse and Mental Health Services Administration, and their respective foreign counterparts. Certain of these agencies require our clinical laboratories to meet quality assurance, quality control, and personnel standards and undergo inspections. +Abbott’s international operations are also affected by trade and investment regulations in many countries. These may require local investment, restrict Abbott’s investments, or limit the import of raw materials and finished products. +Abbott’s laboratory facilities and home monitoring services, which provide services, related products and medical devices to consumers, are subject to additional laws and regulations applicable to health care providers and suppliers that submit claims for reimbursement to third-party payors. In the United States, Medicare, Medicaid, and other third-party payors may from time to time conduct inquiries, claims audits, investigations, and enforcement actions relating to the claims or enrollment criteria. +Abbott is subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback, anti-self-referral, and false claims laws in the United States. Prescription drug, nutrition, and medical device manufacturers such as Abbott are also subject to taxes, as well as application, product, user, establishment, and other fees. Governmental agencies can also invalidate intellectual property rights. +Compliance with these laws and regulations is costly and materially affects Abbott’s business. Among other effects, health care regulations and significant changes thereto (such as the introduction of the Medical Device Regulation and the In Vitro Diagnostic Medical Device Regulation in the European Union) substantially increase the time, difficulty, and costs incurred in developing, obtaining and maintaining approval to market, and marketing newly developed and existing products. Abbott expects this regulatory environment will continue to require significant technical expertise and investment to ensure compliance. Failure to comply can delay the release of a new product or result in regulatory and enforcement actions, the seizure or recall of a product, the suspension or revocation of the authority necessary for a product’s production and sale, suspension or revocation of billing privileges, and other civil or criminal sanctions, including fines and penalties. Similarly, compliance with the laws and regulations governing clinical laboratories and testing services requires specialized expertise. Failure to comply with these regulatory requirements can result in sanctions, including suspension, revocation, or limitation of a laboratory’s certification, which is necessary to conduct business, as well as significant fines or criminal penalties. +Abbott’s business can also be affected by ongoing studies of the utilization, safety, efficacy, and outcomes of health care products and their components that are regularly conducted by industry participants, government agencies, and others. These studies can call into question the utilization, safety, and efficacy of previously marketed products. In some cases, these studies have resulted, and may in the future result, in the discontinuation of marketing of such products in one or more countries, and may give rise to claims for damages from persons who believe they have been injured as a result of their use. +Access to human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in many countries. A major focus is cost containment. Efforts to reduce health care costs are also being made in the private sector, notably by health care payors and providers, which have instituted various cost reduction and containment measures. Abbott expects insurers and providers will continue attempts to reduce the cost or utilization of health care products. Many countries control the price of health care products directly or indirectly, through reimbursement, payment, pricing, or coverage limitations. Budgetary pressures on health care payors may also heighten the scope and severity of pricing pressures on Abbott’s products for the foreseeable future. In the United States, the federal government regularly evaluates reimbursement for medical devices, diagnostics, supplies, and other products, as well as the procedures in which these products may be used. The government follows a diagnosis-related group (DRG) +5 +payment system for certain institutional services provided under Medicare or Medicaid and has implemented a prospective payment system (PPS) for services delivered in hospital outpatient, nursing home, and home health settings. DRG and PPS entitle a health care facility to a fixed reimbursement based on the diagnosis and/or procedure rather than actual costs incurred in patient treatment, thereby increasing the incentive for the facility to limit or control expenditures for many health care products. Other payment methodology changes have been proposed and implemented from time to time. For example, Medicare implemented a competitive bidding system for certain durable medical equipment (including diabetes products), enteral nutrition products, and supplies. Additionally, the Protecting Access to Medicare Act establishes a new payment system for clinical laboratory tests, which became effective on January 1, 2018. +In 2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (together, the Affordable Care Act), imposed an excise tax on Abbott and other medical device manufacturers and importers. The excise tax was suspended from January 1, 2016 to December 31, 2019 and was repealed as of January 1, 2020 by the Further Consolidated Appropriations Act of 2020. +The Affordable Care Act also includes provisions known as the Physician Payments Sunshine Act, which requires manufacturers of drugs, devices, and medical supplies covered under Medicare and Medicaid to record any transfers of value to physicians and teaching hospitals and to report this data to the Centers for Medicare & Medicaid Services for subsequent public disclosure. In October 2018, the Substance Use Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act significantly expanded the types of healthcare providers for which reporting is required, beginning with reports filed in 2022. Similar reporting requirements have also been enacted on the state level domestically, and an increasing number of governments worldwide either have adopted or are considering similar laws requiring transparency of interactions with health care professionals. Failure to report appropriate data may result in civil or criminal fines and/or penalties. +Policy changes or implementation of new health care legislation could result in significant changes to health care systems. In the United States, this could include potential modification or repeal of all or parts of the Affordable Care Act. +The regulation of data privacy and security, and the protection of the confidentiality of certain personal information (including patient health information and financial information), is increasing. For example, the European Union, various other countries, and various U.S. states (e.g., California) have enacted stricter data protection laws that contain enhanced financial penalties for noncompliance. Similarly, the U.S. Department of Health and Human Services has issued rules governing the use, disclosure, and security of protected health information, and the FDA has issued further guidance concerning cybersecurity for medical devices. In addition, certain countries have issued or are considering “data localization” laws, which limit companies’ ability to transfer protected data across country borders. Failure to comply with data privacy and security laws and regulations can result in enforcement actions, which could include civil or criminal penalties. Transferring and managing protected information will become more challenging as laws and regulations are enacted or amended, and Abbott expects there will be increasing complexity in this area. +Governmental cost containment efforts also affect Abbott’s nutritional products business. In the United States, for example, under regulations governing the federally funded Special Supplemental Nutrition Program for Women, Infants, and Children, all states must have a cost containment program for infant formula. As a result, through competitive bidding states obtain rebates from manufacturers of infant formula whose products are used in the program. +Abbott expects debate to continue at all government levels worldwide over the manufacture, quality assurance requirements, marketing authorization processes, post-market surveillance requirements, availability, method of delivery, and payment for health care products and services, as well as data privacy and security. Abbott believes that future legislation and regulation in the markets it serves could affect the timing and expense associated with bringing health care products or services to market, access to health care products and services, increase rebates, reduce prices or reimbursements or the rate of price increases for health care products and services, change health care delivery systems, create new fees and obligations for the pharmaceutical, nutrition, diagnostic, and medical device industries, or require additional reporting and disclosure. It is not possible to predict the extent to which Abbott or the health care industry in general might be affected by the matters discussed above. +6 +INTERNET INFORMATION +Copies of Abbott’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through Abbott’s investor relations website ( www.abbottinvestor.com ) as soon as reasonably practicable after Abbott electronically files the material with, or furnishes it to, the Securities and Exchange Commission (the Commission). These reports and other information are also available, free of charge, at www.sec.gov. +Abbott’s corporate governance guidelines, outline of directorship qualifications, code of business conduct and the charters of Abbott’s audit committee, compensation committee, nominations and governance committee, and public policy committee are all available on Abbott’s investor relations website ( www.abbottinvestor.com ). +​ +7 \ No newline at end of file diff --git a/raw/filings/0000001800/2019/0001104659-20-023904/item13.txt b/raw/filings/0000001800/2019/0001104659-20-023904/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..4ad70dfc2bf6a19aab0f2ea721b5df42fc4bcc83 --- /dev/null +++ b/raw/filings/0000001800/2019/0001104659-20-023904/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The material to be included in the 2020 Proxy Statement under the headings “The Board of Directors,” “Committees of the Board of Directors,” and “Approval Process for Related Person Transactions” is incorporated herein by reference. 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C. 20549 +FORM 10-K +​ +​ +(MARK ONE) +​ +☒ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +OR +☐ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +​ +For the fiscal year ended December 31, 2020 +Commission file number 1-2189 +​ +Abbott Laboratories +​ +​ +An Illinois Corporation +36-0698440 +100 Abbott Park Road +Abbott Park , Illinois 60064-6400 +(I.R.S. employer identification number) +( 224 ) 667-6100 +(telephone number) +​ +Securities Registered Pursuant to Section 12(b) of the Act: +​ +​ +​ +Title of Each Class +Trading Symbol(s) +Name of Each Exchange on Which Registered +Common Shares, Without Par Value +ABT +New York Stock Exchange +Chicago Stock Exchange , Inc. +​ +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ⌧ +No ☐ +​ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. +Yes ☐ +No ⌧ +​ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes ⌧ +No ☐ +​ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes ⌧ +No ☐ +​ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer ⌧ +Accelerated Filer ☐ +Non-Accelerated Filer ☐ +Smaller reporting company ☐ +Emerging growth company ☐ +​ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +Yes ☐ +No ☒ +​ +The aggregate market value of the 1,727,625,764 shares of voting stock held by nonaffiliates of the registrant, computed by reference to the closing price as reported on the New York Stock Exchange, as of the last business day of Abbott Laboratories’ most recently completed second fiscal quarter (June 30, 2020), was $ 157,956,823,602 . Abbott has no non-voting common equity. Number of common shares outstanding as of January 31, 2021: 1,771,529,358 +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the 2021 Abbott Laboratories Proxy Statement are incorporated by reference into Part III. The Definitive Proxy Statement will be filed on or about March 12, 2021. +​ +​ +​ +​ +​ +PART I +ITEM 1. BUSINESS +GENERAL DEVELOPMENT OF BUSINESS +Abbott Laboratories is an Illinois corporation, incorporated in 1900. Abbott’s* principal business is the discovery, development, manufacture, and sale of a broad and diversified line of health care products. +NARRATIVE DESCRIPTION OF BUSINESS +Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. +Established Pharmaceutical Products +These products include a broad line of branded generic pharmaceuticals manufactured worldwide and marketed and sold outside the United States in emerging markets. These products are generally sold directly to wholesalers, distributors, government agencies, health care facilities, pharmacies, and independent retailers from Abbott-owned distribution centers and public warehouses, depending on the market served. Certain products are co-marketed or co-promoted with, or licensed from, other companies. +The principal products included in the broad therapeutic area portfolios of the Established Pharmaceutical Products segment are: +● gastroenterology products, including Creon™, for the treatment of pancreatic exocrine insufficiency associated with several underlying conditions, including cystic fibrosis and chronic pancreatitis; Duspatal™ and Dicetel™, for the treatment of irritable bowel syndrome or biliary spasm; Heptral™, Transmetil™, and Samyr™, for the treatment of intrahepatic cholestasis (associated with liver disease) or depressive symptoms; and Duphalac™, for regulation of the physiological rhythm of the colon; +● women’s health products, including Duphaston™, for the treatment of many different gynecological disorders; and Femoston™, a hormone replacement therapy for postmenopausal women; +● cardiovascular and metabolic products, including Lipanthyl™ and TriCor™, for the treatment of dyslipidemia; Teveten™ and Teveten™ Plus, for the treatment of essential hypertension, and Physiotens™, for the treatment of hypertension; and Synthroid™, for the treatment of hypothyroidism; +● pain and central nervous system products, including Serc™, for the treatment of Ménière’s disease and vestibular vertigo; Brufen™, for the treatment of pain, fever, and inflammation; and Sevedol™, for the treatment of severe migraines; and +● respiratory drugs and vaccines, including the anti-infective clarithromycin (sold under the trademarks Biaxin™, Klacid™, and Klaricid™); and Influvac™, an influenza vaccine. +The Established Pharmaceutical Products segment directs its primary marketing efforts toward building strong brands with key stakeholders, including consumers, pharmacists, physicians, and other healthcare providers. Government agencies are also important customers. +Competition in the Established Pharmaceutical Products segment is generally from other health care and pharmaceutical companies. In addition, the substitution of generic drugs for the brand prescribed and introduction of additional forms of already marketed established products by generic or branded competitors may increase competitive pressures. +* As used throughout the text of this report on Form 10-K, the term “Abbott” refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and its consolidated subsidiaries, as the context requires. +1 +Diagnostic Products +These products include a broad line of diagnostic systems and tests manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to blood banks, hospitals, commercial laboratories, clinics, physicians’ offices, retailers, government agencies, alternate care testing sites, and plasma protein therapeutic companies from Abbott owned distribution centers, public warehouses or third party distributors. +The principal products included in the Diagnostic Products segment are: +● core laboratory systems in the areas of immunoassay, clinical chemistry, hematology, and transfusion medicine, including the Alinity ® family of instruments, ARCHITECT ® , ABBOTT PRISM ® , and Cell-Dyn ® , with assays used for screening and/or diagnosis for cancer, cardiac, metabolics, drugs of abuse, fertility, general chemistries, infectious diseases such as hepatitis and HIV, therapeutic drug monitoring, and a suite of SARS-CoV-2 serology assays; +● molecular diagnostics polymerase chain reaction (PCR) instrument systems, including Alinity ® m and m2000™ that automate the extraction, purification, and preparation of DNA and RNA from patient samples, and detect and measure infectious agents including HIV, hepatitis, HPV, sexually transmitted infections, and SARS-CoV-2; and products for oncology with the Vysis ® FISH product line of genomic-based tests; +● point of care systems, including the i-STAT ® and next-generation i-STAT ® Alinity ® and cartridges for testing blood gas, chemistry, electrolytes, coagulation and immunoassay; +● rapid diagnostics lateral flow testing products in the area of infectious diseases, including respiratory viruses such as SARS-CoV-2 and influenza, HIV, hepatitis, and tropical diseases such as malaria and dengue fever; molecular point-of-care testing for HIV, including the m-PIMA ® HIV-1/2 Viral Load Test, and for SARS-CoV-2 and influenza A & B, RSV and strep A, including the ID NOW ® rapid molecular system; cardiometabolic testing, including Afinion ® and Cholestech™ platforms and tests; a toxicology business for drug and alcohol testing; and remote patient monitoring and consumer self-testing; and +● informatics and automation solutions for use in laboratories, including laboratory automation systems, the RALS ® point of care solution, and AlinIQ ® , a suite of informatics tools and professional services. +The Diagnostic Products segment’s products are subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product performance, laboratory efficiency, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +Nutritional Products +These products include a broad line of pediatric and adult nutritional products manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to consumers and to institutions, wholesalers, retailers, health care facilities, government agencies, and third-party distributors from Abbott-owned distribution centers or third-party distributors. +The principal products included in the Nutritional Products segment are: +● various forms of prepared infant formula and follow-on formula, including Similac ®* , Similac Pro-Advance ®* , Similac ® Advance ® , Similac ® Advance ® Non-GMO, Similac Pro-Sensitive ®* , Similac Sensitive ® , Similac Sensitive ® Non-GMO, Go&Grow by Similac ®* , Similac ® NeoSure ® , Similac ® Organic, Similac ® Special Care ® , Similac Total Comfort ®* , Similac ® For Supplementation, Isomil ® Advance ® , Isomil ® , Alimentum ® , Gain™, Grow™, Similac En Mei Li™, and Eleva™; +● adult and other pediatric nutritional products, including Ensure ® , Ensure Plus ® , Ensure ® Enlive ® , Ensure ® (with NutriVigor ® ), Ensure ® Max Protein, Ensure ® High Protein, Glucerna ® , Glucerna Hunger Smart ® , ProSure™, PediaSure ® , PediaSure SideKicks ® , PediaSure ® Peptide, EleCare ® , Juven ® , Abound™, Pedialyte ® and Zone Perfect ® ; and +2 +● nutritional products used in enteral feeding in health care institutions, including Jevity ® , Glucerna ® 1.2 Cal, Glucerna ® 1.5 Cal, Osmolite ® , Oxepa ® , Freego™ (Enteral Pump) and Freego™ sets, Nepro ® , and Vital ® . +* These products are available with 2'‐FL HMO (Human Milk Oligosaccharide) in several markets. +Primary marketing efforts for nutritional products are directed toward consumers or to securing the recommendation of Abbott’s brand of products by physicians or other health care professionals. In addition, certain nutritional products sold as Similac ® , Gain™, Grow™, Eleva™, PediaSure ® , PediaSure SideKicks ® , Pedialyte ® , Ensure ® , Zone Perfect ® , and Glucerna ® are also promoted directly to the public by consumer marketing efforts in select markets where appropriate. +Competition for nutritional products in the segment is generally from other diversified consumer and health care manufacturers. Competitive factors include consumer advertising, formulation, packaging, scientific innovation, price, retail distribution, and availability of product forms. A significant aspect of competition is the search for ingredient innovations. The introduction of new products by competitors, changes in medical practices and procedures, and regulatory changes can result in product obsolescence. In addition, private label and local manufacturers’ products may increase competitive pressure. +Medical Devices +These products include a broad line of rhythm management, electrophysiology, heart failure, vascular and structural heart devices for the treatment of cardiovascular diseases, and diabetes care products for people with diabetes, as well as neuromodulation devices for the management of chronic pain and movement disorders. Medical devices are manufactured, marketed and sold worldwide. In the United States, depending upon the product, medical devices are generally marketed and sold directly to wholesalers, hospitals, ambulatory surgery centers, physicians’ offices, and distributors from Abbott-owned distribution centers and public warehouses. Outside the United States, sales are made either directly to customers or through distributors, depending on the market served. +The principal products included in the Medical Devices segment are: +● rhythm management products, including Assurity MRI ® and Endurity MRI ® pacemaker systems; Ellipse ® , Fortify Assura ® , and Gallant™ implantable cardioverter defibrillators and Gallant and Quadra Assura MP ® implantable cardioverter defibrillator with cardiac resynchronization therapy and MultiPoint ® Pacing technology; and Confirm Rx ® implantable cardiac monitor; +● electrophysiology products, including the TactiCath ® family of ablation catheters and FlexAbility ® irrigated ablation catheters; Ampere ® RF ablation generator; EnSite ® family of cardiac mapping systems; and the Advisor ® HD Grid mapping catheter; +● heart failure related products, including the HeartMate™ left ventricular device family and the CardioMEMS ® HF System pulmonary artery sensor, a heart failure monitoring system; +● vascular products, including the XIENCE™ family of drug-eluting coronary stent systems developed on the Multi-Link Vision ® platform; StarClose SE ® and Perclose ProGlide ® vessel closure devices, TREK ® coronary balloon dilatation products, Hi-Torque Balance Middleweight Universal II ® guidewires, Supera ® Peripheral Stent System, a peripheral vascular stent system; Acculink ® /Accunet ® and Xact ® /Emboshield NAV6 ® , carotid stent systems; and the OPTIS ® integrated system with the Dragonfly OPTIS ® imaging catheter and PressureWire ® fractional flow reserve measurement systems; +● structural heart products, including MitraClip ® , a percutaneous mitral valve repair system; Trifecta ® Valve with Glide™ Technology, a surgical tissue heart valve; Portico ® transcatheter aortic heart valve; Regent™ mechanical heart valve; Amplatzer ® PFO occluders; Amplatzer Amulet ® occluder devices; the Tendyne ® Transcatheter Mitral Valve Implantation (TMVI) system; and the TriClip ® Transcatheter Tricuspid Valve Repair System; +● continuous glucose and blood glucose monitoring systems, including test strips, sensors, data management decision software, and accessories for people with diabetes, under the FreeStyle ® brand such as the FreeStyle Libre ® system; and +3 +● neuromodulation products, including spinal cord stimulators Proclaim ® Elite and Proclaim ® XR Recharge-free implantable pulse generators (IPG) and Prodigy MRI ® IPG, each with BurstDR ® stimulation, and Proclaim ® DRG IPG, a neurostimulation device designed for dorsal root ganglion therapy, for the treatment of chronic pain disorders; and the Infinity ® Deep Brain Stimulation System with directional lead technology for the treatment of movement disorders. +These products are subject to competition in technological innovation, price, convenience of use, service, product performance, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +INFORMATION WITH RESPECT TO ABBOTT’S BUSINESS IN GENERAL +Sources and Availability of Raw Materials +Abbott purchases, in the ordinary course of business, raw materials and supplies essential to Abbott’s operations from numerous suppliers in the United States and around the world. There have been no recent significant availability problems or supply shortages for raw materials or supplies. +Patents, Trademarks, and Licenses +Abbott is aware of the desirability for patent and trademark protection for its products. Accordingly, where possible, patents and trademarks are sought and obtained for Abbott’s products in the United States and countries of interest to Abbott. Abbott owns or has licenses under a substantial number of patents and patent applications. Principal trademarks and the products they cover are discussed in the Narrative Description of Business on pages 1 through 4. These, and various patents which expire during the period 2021 to 2041, in the aggregate, are believed to be of material importance in the operation of Abbott’s business. Abbott believes that no single patent, license, or trademark is material in relation to Abbott’s business as a whole. +Seasonal Aspects, Customers, and Renegotiation +There are no significant seasonal aspects to Abbott’s business. Abbott has no single customer that, if the customer were lost, would have a material adverse effect on Abbott. No material portion of Abbott’s business is subject to renegotiation of profits or termination of contracts at the election of a government. +Environmental Matters +Abbott believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. Abbott’s capital and operating expenditures for pollution control in 2020 were not material and are not expected to be material in 2021. +Abbott has been identified as one of many potentially responsible parties in investigations and/or remediations at several locations in the United States, including Puerto Rico, under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. Abbott is also engaged in remediation at several other sites, some of which are owned by Abbott, in cooperation with the Environmental Protection Agency or similar agencies. While it is not feasible to predict with certainty the final costs related to those investigations and remediation activities, Abbott believes that such costs, together with other expenditures to maintain compliance with applicable laws and regulations concerning environmental protection, should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +Human Capital +The sustainability of Abbott’s business depends on attracting, engaging and developing talented people with diverse backgrounds who share Abbott’s mission to help people live their healthiest possible lives. Abbott provides its employees opportunities to grow and develop their careers, market competitive compensation and benefit programs, and the satisfaction of being part of a global company dedicated to improving health in more than 160 countries. +4 +As of December 31, 2020, Abbott employed approximately 109,000 people, 70% of whom were employed outside of the U.S. Women represented 47% of Abbott’s U.S. workforce, 45% of its global workforce, and 39% of its managers. +Health and Safety +The health, safety and wellness of its employees is an Abbott priority embedded at every level of its business. Abbott’s integrated Environmental, Health and Safety organization governs health, safety and wellness at Abbott’s facilities. Abbott also maintains global policies and standards for managing employee health and safety. +Abbott takes a holistic approach to employee well-being. Abbott’s global wellness programs are designed to meet the unique needs of employees across businesses and geographies and offer a wide range of programs, including supporting the mental, financial and physical health of employees and their families. For example, for over 20 years, Abbott has annually offered Exercise Across Abbott, which is a four-week physical wellness program that encourages employees to team up with colleagues and track how many minutes they exercise each day. Over 22,000 Abbott employees across 72 countries took part in 2020. +During the COVID-19 pandemic, Abbott has taken aggressive steps to limit exposure and enhance the safety of facilities for its employees, including implementing mandatory temperature screening and social distancing, providing and requiring the use of personal protective equipment, and at most U.S. facilities, onsite COVID-19 testing. +Talent Management +Abbott has an integrated global talent management process that is designed to identify and assess talent across the organization and provide equal and consistent opportunities for employees to develop their skills. All levels of employees participate in Abbott’s annual performance management process to create development plans that support their particular career objectives, and Abbott provides a broad range of training, mentoring and other development opportunities to help its employees meet these objectives. The board of directors conducts an annual Talent Management Review, focusing on development of talent, diversity, and succession planning for critical positions. Similar reviews take place at every level of Abbott to develop talent and diversity across the organization. +Diversity and Inclusion +Abbott is committed to developing a workplace that is inclusive for all. Abbott ties executive compensation to human capital management, including diversity outcomes, to sustain an inclusive culture and the fair and balanced treatment of Abbott’s employees. +Abbott’s employee networks play an important role in building an inclusive culture across all Abbott operations. A member of Abbott’s senior management serves as a sponsor for each of these networks, helping to align their objectives with Abbott’s business strategies. Abbott has ten such networks, which are: Advancing Professionals Network (supporting early career employees), Asian Leadership and Cultural Network, Black Business Network, Flex Network (employees with part-time and flexible schedules), LA VOICE Network (supporting Hispanic and Latino employees), People with Disabilities Network, PRIDE (supporting LGBTQ employees), Veterans Network, Women Leaders of Abbott, and Women in STEM. +Abbott offers professional development programs, which provide recent college graduates the opportunity to rotate through different areas of Abbott, often with the chance to work outside their home country. In 2020, 52% of the participants were women. Also, Abbott hosts hundreds of college students for paid internships. In 2020, 55% of the U.S. interns were women and 39% were minorities. Further, Abbott has operated a STEM internship program for high school students in the U.S. since 2012. The program’s objective is to increase the number of students pursuing STEM-related careers and contribute to a more diverse talent pipeline for Abbott. In 2020, 58% of the STEM interns were women and 71% were minorities. +5 +Compensation and Benefits +Abbott is committed to building, retaining, and motivating a diverse talent pipeline that can meet the current and future needs of its businesses. To that end, Abbott provides market competitive compensation, healthcare benefits, pension and/or retirement savings plans, and several programs to facilitate employees building an ownership stake in Abbott, including a global long-term incentive program for employees generally beginning at the manager level. Abbott also has procedures and processes focused on providing employees equitable compensation, regardless of race or gender or other personal characteristics. +Regulation +The development, manufacture, marketing, sale, promotion, and distribution of Abbott’s products are subject to comprehensive government regulation by the U.S. Food and Drug Administration (FDA) and similar international regulatory agencies. Government regulation by various international, supranational, federal and state agencies addresses (among other matters) the development and approval to market Abbott’s products, as well as the inspection of, and controls over, research and laboratory procedures, clinical investigations, product approvals and manufacturing, labeling, packaging, supply chains, marketing and promotion, pricing and reimbursement, sampling, distribution, quality control, post-market surveillance, record keeping, storage, and disposal practices. In addition, Abbott’s clinical laboratories and associated testing services are subject to comprehensive government regulation, including registration, certification, and licensure, by federal, state, and local agencies, such as the Centers for Medicare & Medicaid Services, the Drug Enforcement Administration, the Substance Abuse and Mental Health Services Administration, and their respective foreign counterparts. Certain of these agencies require our clinical laboratories to meet quality assurance, quality control, and personnel standards and undergo inspections. +During the COVID-19 public health emergency, many pandemic-related products (including diagnostic tests) were authorized by regulators for emergency use solely during the pandemic. In addition, many governments enacted policies to expedite or promote access to health care in order to slow or stop the spread of the virus. Examples include expansion of telehealth coverages and increased reimbursements for diagnostic testing. It is uncertain when the public health emergency will end and to what extent these policies will continue or revert back to previous policies. +Abbott’s international operations are also affected by trade and investment regulations in many countries. These may require local investment, restrict Abbott’s investments, or limit the import of raw materials and finished products. +Abbott’s laboratory facilities and home monitoring services, which provide services, related products and medical devices to consumers, are subject to additional laws and regulations applicable to health care providers and suppliers that submit claims for reimbursement to third-party payors. In the United States, Medicare, Medicaid, and other third-party payors may from time to time conduct inquiries, claims audits, investigations, and enforcement actions relating to the claims or enrollment criteria. +Abbott is subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback, anti-self-referral, and false claims laws in the United States. Prescription drug, nutrition, and medical device manufacturers such as Abbott are also subject to taxes, as well as application, product, user, establishment, and other fees. Governmental agencies can also invalidate intellectual property rights. +Compliance with these laws and regulations is costly and materially affects Abbott’s business. Among other effects, health care regulations and significant changes thereto (such as the introduction of the Medical Device Regulation and the In Vitro Diagnostic Medical Device Regulation in the European Union) substantially increase the time, difficulty, and costs incurred in developing, obtaining and maintaining approval to market, and marketing newly developed and existing products. Abbott expects this regulatory environment will continue to require significant technical expertise and investment to ensure compliance. Failure to comply can delay the release of a new product or result in regulatory and enforcement actions, the seizure or recall of a product, the suspension or revocation of the authority necessary for a product’s production and sale, suspension or revocation of billing privileges, and other civil or criminal sanctions, including fines and penalties. Similarly, compliance with the laws and regulations governing clinical laboratories and testing services requires specialized expertise. Failure to comply with these regulatory requirements can result in sanctions, including suspension, revocation, or limitation of a laboratory’s certification, which is necessary to conduct business, as well as significant fines or criminal penalties. +6 +Abbott’s business can also be affected by ongoing studies of the utilization, safety, efficacy, and outcomes of health care products and their components that are regularly conducted by industry participants, government agencies, and others. These studies can call into question the utilization, safety, and efficacy of previously marketed products. In some cases, these studies have resulted, and may in the future result, in the discontinuation of marketing of such products in one or more countries, and may give rise to claims for damages from persons who believe they have been injured as a result of their use. +Access to human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in many countries. A major focus is cost containment. Efforts to reduce health care costs are also being made in the private sector, notably by health care payors and providers, which have instituted various cost reduction and containment measures. Abbott expects insurers and providers will continue attempts to reduce the cost or utilization of health care products. Many countries control the price of health care products directly or indirectly, through reimbursement, payment, pricing, or coverage limitations. Budgetary pressures on health care payors may also heighten the scope and severity of pricing pressures on Abbott’s products for the foreseeable future. In the United States, the federal government regularly evaluates reimbursement for medical devices, diagnostics, supplies, and other products, as well as the procedures in which these products may be used. The government follows a diagnosis-related group (DRG) payment system for certain institutional services provided under Medicare or Medicaid and has implemented a prospective payment system (PPS) for services delivered in hospital outpatient, nursing home, and home health settings. DRG and PPS entitle a health care facility to a fixed reimbursement based on the diagnosis and/or procedure rather than actual costs incurred in patient treatment, thereby increasing the incentive for the facility to limit or control expenditures for many health care products. Other payment methodology changes have been proposed and implemented from time to time. For example, Medicare implemented a competitive bidding system for certain durable medical equipment (including diabetes products), enteral nutrition products, and supplies. Additionally, the Protecting Access to Medicare Act established a new payment system for clinical laboratory tests in 2018. +The Patient Protection and Affordable Care Act (the Affordable Care Act) includes provisions known as the Physician Payments Sunshine Act, which requires manufacturers of drugs, devices, and medical supplies covered under Medicare and Medicaid to record any transfers of value to physicians and teaching hospitals and to report this data to the Centers for Medicare & Medicaid Services for subsequent public disclosure. In October 2018, the Substance Use Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act significantly expanded the types of healthcare providers for which reporting is required, beginning with reports filed in 2022. Similar reporting requirements have also been enacted on the state level domestically, and an increasing number of governments worldwide either have adopted or are considering similar laws requiring transparency of interactions with health care professionals. Failure to report appropriate data may result in civil or criminal fines and/or penalties. +Policy changes or implementation of new health care legislation could result in significant changes to health care systems. In the United States, this could include potential modification, including expansion or repeal of all or parts of the Affordable Care Act. +The regulation of data privacy and security, and the protection of the confidentiality of certain personal information (including patient health information, financial information and other sensitive personal information), is increasing. For example, the European Union, various other countries, and various U.S. states (e.g., California) have enacted stricter data protection laws that contain enhanced financial penalties for noncompliance. Similarly, the U.S. Department of Health and Human Services has issued rules governing the use, disclosure, and security of protected health information, and the FDA has issued further guidance concerning cybersecurity for medical devices. In addition, certain countries have issued or are considering “data localization” laws, which limit companies’ ability to transfer protected data across country borders. Failure to comply with data privacy and security laws and regulations can result in business disruption and enforcement actions, which could include civil or criminal penalties. Transferring and managing protected information will become more challenging as laws and regulations are enacted or amended, and Abbott expects there will be increasing complexity in this area. +Governmental cost containment efforts also affect Abbott’s nutritional products business. In the United States, for example, under regulations governing the federally funded Special Supplemental Nutrition Program for Women, Infants, and Children, all states must have a cost containment program for infant formula. As a result, through competitive bidding states obtain rebates from manufacturers of infant formula whose products are used in the program. +7 +Abbott expects debate to continue at all government levels worldwide over the manufacture, quality assurance requirements, marketing authorization processes, post-market surveillance requirements, availability, method of delivery, and payment for health care products and services, as well as data privacy and security. Abbott believes that future legislation and regulation in the markets it serves could affect the timing and expense associated with bringing health care products or services to market, access to health care products and services, increase rebates, reduce prices or reimbursements or the rate of price increases for health care products and services, change health care delivery systems, create new fees and obligations for the pharmaceutical, nutrition, diagnostic, and medical device industries, or require additional reporting and disclosure. It is not possible to predict the extent to which Abbott or the health care industry in general might be affected by the matters discussed above. +INTERNET INFORMATION +Copies of Abbott’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through Abbott’s investor relations website ( www.abbottinvestor.com ) as soon as reasonably practicable after Abbott electronically files the material with, or furnishes it to, the Securities and Exchange Commission (the Commission). These reports and other information are also available, free of charge, at www.sec.gov. +Abbott’s corporate governance guidelines, outline of directorship qualifications, code of business conduct and the charters of Abbott’s audit committee, compensation committee, nominations and governance committee, and public policy committee are all available on Abbott’s investor relations website ( www.abbottinvestor.com ). +​ +8 +ITEM 1A. RISK FACTORS +In addition to the other information in this report, the following risk factors should be considered before deciding to invest in any of Abbott’s securities. Additional risks and uncertainties not presently known to Abbott, or risks Abbott currently considers immaterial, could also affect Abbott’s actual results. Abbott’s business, financial condition, results of operations, or prospects could be materially adversely affected by any of these risks. +Business and Operational Risks +Abbott may acquire other businesses, license rights to technologies or products, form alliances, or dispose of or spin-off businesses, which could cause it to incur significant expenses and could negatively affect profitability. +Abbott may pursue acquisitions, licensing arrangements, and strategic alliances, or dispose of or spin-off some of its businesses, as part of its business strategy. Abbott may not complete these transactions in a timely manner, on a cost-effective basis, or at all, and may not realize the expected benefits. If Abbott is successful in making an acquisition, the products and technologies that are acquired may not be successful or may require significantly greater resources and investments than originally anticipated. Abbott may not be able to integrate acquisitions successfully into its existing business or transition disposed businesses efficiently, and could incur or assume significant debt and unknown or contingent liabilities. Abbott could also experience negative effects on its reported results of operations from acquisition or disposition-related charges, amortization of expenses related to intangibles and charges for impairment of long-term assets. These effects could cause a deterioration of Abbott’s credit rating, result in increased borrowing costs and interest expense, and decrease liquidity. +Abbott depends on sophisticated information technology systems and maintains protected personal data, and a cyber attack or other breach affecting these information technology systems or protected data could have a material adverse effect on Abbott’s results of operations. +Similar to other large multi-national companies, the size and complexity of the information technology systems on which Abbott relies for both its infrastructure and products makes them susceptible to a cyber attack, malicious intrusion, breakdown, destruction, loss of data privacy, or other significant disruption. These systems have been and are expected to continue to be the target of malware and other cyber attacks. In addition, third party hacking attempts may cause Abbott’s information technology systems and related products, protected data, or proprietary information to be compromised or stolen. A significant attack or other disruption could result in adverse consequences, including increased costs and expenses, manufacturing challenges or disruption, problems with product functionality, damage to customer relations, lost revenue, and legal or regulatory penalties. +Abbott also collects, manages and processes protected personal data, including protected health information, in connection with certain medical products and service offerings. Abbott is subject to certain regional and local data protection laws that prohibit or restrict the transfer of protected data across country borders. For additional information concerning data privacy and security regulation, see the discussion in “Regulation” under Item 1, “Business.” A breach of protected personal information could result in adverse consequences, including regulatory inquiries or litigation, increased costs and expenses, reputational damage, lost revenue, and fines or penalties. +Abbott invests in its systems and technology and in the protection of its products and data to reduce the risk of an attack or other significant disruption, and monitors its systems on an ongoing basis for any current or potential threats and for changes in technology and the regulatory environment. There can be no assurance that these measures and efforts will prevent future attacks or other significant disruptions to any of the systems on which Abbott relies or that related product issues will not arise in the future. Similarly, there can be no assurance that third party information technology providers with whom Abbott contracts will not suffer a significant attack or disruption that impacts customers like Abbott. Any significant breach, attack or other disruption involving Abbott’s systems or products could have a material adverse effect on Abbott’s business. +9 +Abbott’s research and development efforts may not succeed in developing commercially successful products and technologies, which may cause Abbott’s revenue and profitability to decline. +To remain competitive, Abbott must continue to launch new products and technologies. To accomplish this, Abbott commits substantial efforts, funds, and other resources to research and development. A risk of failure is inherent in the research and development of new products and technologies. Abbott must make ongoing substantial expenditures without any assurance that its efforts will be commercially successful. Failure can occur at any point in the process, including after significant funds have been invested. +Promising new products and technologies may fail to reach the market or may only have limited commercial success because of efficacy or safety concerns, failure to achieve positive clinical outcomes, inability to obtain necessary regulatory approvals, limited scope of approved uses, excessive costs to manufacture, failure to establish or maintain intellectual property rights, or infringement of the intellectual property rights of others. Even if Abbott successfully develops new products or enhancements or new generations of Abbott’s existing products, they may be quickly rendered obsolete by changing customer preferences, changing industry or regulatory standards, or competitors’ innovations. Innovations may not be accepted quickly in the marketplace because of, among other things, entrenched patterns of clinical practice or uncertainty over third-party reimbursement. Abbott cannot state with certainty when or whether any of its products under development will be launched, whether it will be able to develop, license, or otherwise acquire compounds or products, or whether any products will be commercially successful. Failure to launch successful new products or technologies, or new indications or uses for existing products, may cause Abbott’s products or technologies to become obsolete, causing Abbott’s revenues and operating results to suffer. +The manufacture of many of Abbott’s products is a highly exacting and complex process, and if Abbott or one of its suppliers encounters problems manufacturing products, Abbott’s business could suffer. +The manufacture of many of Abbott’s products is a highly exacting and complex process, due in part to strict regulatory requirements. Problems may arise during manufacturing for a variety of reasons, including equipment malfunction, failure to follow specific protocols and procedures, problems with raw materials, natural disasters, and environmental factors. In addition, single suppliers are currently used for certain products and materials. If problems arise during the production of a lot or batch of product, those products may have to be discarded. If problems are not discovered before the product is released to the market, recall and product liability costs may also be incurred. Any of these events could, among other things, lead to increased costs, lost revenue, damage to customer relations, time and expense spent investigating the cause and, depending on the cause, similar losses with respect to other lots, batches or products. To the extent Abbott or one of its suppliers experiences significant manufacturing problems, this could have a material adverse effect on Abbott’s revenues and profitability. +Abbott has significant indebtedness, which could adversely affect its business, including decreasing its business flexibility. +As of December 31, 2020, Abbott's consolidated indebtedness was approximately $18.7 billion. This consolidated indebtedness could have the effect, among other things, of reducing Abbott's flexibility to respond to changing business and economic conditions, and reducing funds available for working capital, capital expenditures, acquisitions, and other general corporate purposes. +Further, Abbott may be required to raise additional financing for working capital, capital expenditures, future acquisitions or other general corporate purposes. Abbott's ability to arrange additional financing or refinancing will depend on, among other factors, Abbott's financial position and performance, as well as prevailing market conditions and other factors beyond Abbott's control. Consequently, Abbott cannot assure that it will be able to obtain additional financing or refinancing on terms acceptable to Abbott or at all, which could adversely impact Abbott's ability to make scheduled payments with respect to its consolidated indebtedness and its profitability and financial condition. +Additionally, further borrowing could cause a deterioration of Abbott's credit ratings. Abbott's credit ratings reflect each credit rating agency's then opinion of Abbott's financial strength, operating performance, and ability to meet its debt obligations. Adverse changes in Abbott's credit ratings may result in increased borrowing costs for future long-term debt or short-term borrowing facilities and may limit financing options, including access to the unsecured borrowing market. Abbott may also be subject to additional restrictive covenants that would reduce flexibility. +10 +Legal and Regulatory Risks +Abbott is subject to numerous governmental regulations and it can be costly to comply with these regulations and to develop compliant products and processes. +Abbott’s products are subject to rigorous regulation by the FDA and numerous international, supranational, federal, and state authorities. The process of obtaining regulatory approvals to market a drug, medical device, or diagnostic product can be costly and time-consuming, and approvals might not be granted for future products, or additional indications or uses of existing products, on a timely basis, if at all. Delays in the receipt of, or failure to obtain, approvals for future products, or new indications and uses, could result in delayed realization of product revenues, reduction in revenues, and substantial additional costs. +In addition, no assurance can be given that Abbott will remain in compliance with applicable FDA and other regulatory requirements once approval or marketing authorization has been obtained for a product. These requirements include, among other things, regulations regarding manufacturing practices, product labeling, and advertising and postmarketing reporting, including adverse event reports and field alerts. Many of Abbott’s facilities and procedures and those of Abbott’s suppliers are subject to ongoing regulation, including periodic inspection by the FDA and other regulatory authorities. Abbott must incur expense and spend time and effort to ensure compliance with these complex regulations. Possible regulatory actions for non-compliance could include warning letters, fines, damages, injunctions, civil penalties, recalls, seizures of Abbott’s products, and criminal prosecution. +These actions could result in, among other things, substantial modifications to Abbott’s business practices and operations; refunds, recalls, or seizures of Abbott’s products; a total or partial shutdown of production in one or more facilities while Abbott or Abbott’s suppliers remedy the alleged violation; the inability to obtain future pre-market approvals or marketing authorizations; and withdrawals or suspensions of current products from the market. Any of these events could disrupt Abbott’s business and have a material adverse effect on Abbott’s revenues, profitability and financial condition. +Laws and regulations affecting government benefit programs could impose new obligations on Abbott, require Abbott to change its business practices, and restrict its operations in the future. +Abbott’s industry is subject to various international, supranational, federal, and state laws and regulations pertaining to government benefit program reimbursement, price reporting and regulation, and health care fraud and abuse, including anti-kickback and false claims laws, and international and individual state laws relating to pricing and sales and marketing practices. Violations of these laws may be punishable by criminal and/or civil sanctions, including, in some instances, substantial fines, imprisonment, and exclusion from participation in government health care programs, including Medicare, Medicaid, and Veterans Administration health programs in the U.S. These laws and regulations are broad in scope and they are subject to evolving interpretations, which could require Abbott to incur substantial costs associated with compliance or to alter one or more of its sales or marketing practices. In addition, violations of these laws, or allegations of such violations, could disrupt Abbott’s business and result in a material adverse effect on Abbott’s revenues, profitability, and financial condition. +Changes in the health care regulatory environment may adversely affect Abbott’s business. +Both in the U.S. and internationally, government authorities may enact changes in regulatory requirements, make legislative or administrative reforms to existing reimbursement programs, make adverse decisions relating to Abbott’s products’ coverage or reimbursement, or make changes to patient access to health care, all of which could adversely impact the demand for and usage of Abbott’s products or the prices that Abbott’s customers are willing to pay for them. +Further, in the U.S., a number of the provisions of the Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 address access to health care products and services. These provisions may be modified, expanded, repealed, or otherwise invalidated, in whole or in part. Future rulemaking could affect rebates, prices or the rate of price increases for health care products and services, or required reporting and disclosure. Abbott cannot predict the timing or impact of any future rulemaking or changes in the law. +For additional information concerning health care regulation, see the discussion in “Regulation” under Item 1, “Business.” +11 +The expiration or loss of patent protection and licenses may affect Abbott’s future revenues and operating income. +Many of Abbott’s businesses rely on patent and trademark and other intellectual property protection. Although most of the challenges to Abbott’s intellectual property have come from other companies, governments may also challenge intellectual property protections. To the extent Abbott’s intellectual property is successfully challenged, invalidated, or circumvented or to the extent it does not allow Abbott to compete effectively, Abbott’s businesses could suffer. To the extent that countries do not enforce Abbott’s intellectual property rights, Abbott’s future revenues and operating income could be reduced. Any material litigation regarding Abbott’s patents and trademarks is described in the section captioned “Legal Proceedings.” +Significant safety concerns could arise for Abbott’s products, which could have a material adverse effect on Abbott’s revenues and financial condition. +Health care products typically receive regulatory approval based on data obtained in controlled clinical trials of limited duration. Following regulatory approval, these products will be used over longer periods of time in many patients. Investigators may also conduct additional, and perhaps more extensive, studies. If new safety issues are reported, Abbott may be required to amend the conditions of use for a product. For example, Abbott may be required to provide additional warnings on a product’s label or narrow its approved intended use, either of which could reduce the product’s market acceptance. If serious safety issues arise with an Abbott product, sales of the product could be halted by Abbott or by regulatory authorities. Safety issues affecting suppliers’ or competitors’ products also may reduce the market acceptance of Abbott’s products. +In addition, in the ordinary course of business, Abbott is the subject of product liability claims and lawsuits alleging that its products or the products of other companies that Abbott promotes have resulted or could result in an unsafe condition for, or injury to, patients. Product liability claims and lawsuits, safety alerts or product recalls, and other allegations of product safety or quality issues, regardless of their validity or ultimate outcome, may have a material adverse effect on Abbott’s business and reputation and on Abbott’s ability to attract and retain customers. Consequences may also include additional costs, a decrease in market share for the products, lower income or exposure to other claims. Product liability losses are self-insured. Product liability claims could have a material adverse effect on Abbott’s profitability and financial condition. +Economic and Industry Risks +Abbott is subject to risks related to public health crises, such as widespread outbreaks of infectious diseases like the COVID-19 pandemic. +As a global healthcare company, public health crises, such as the widespread outbreaks of infectious diseases like the COVID-19 pandemic, may negatively impact Abbott's operations. Health concerns and significant changes in political or economic conditions caused by such outbreaks can cause significant reductions in demand for routine diagnostic testing and medical device procedures or increased difficulty in serving customers, disrupt manufacturing and supply chains, and negatively affect our operations as well as the operations of our suppliers, distributors and other third-party partners. Furthermore, such widespread outbreaks may impact the broader economies of affected countries, including negatively impacting economic growth, the proper functioning of financial and capital markets, foreign currency exchange rates, and interest rates. +With regard to the COVID-19 pandemic, the FDA issued Emergency Use Authorizations (EUAs) for several COVID-19 related products in 2020, including Abbott diagnostic tests. EUAs are authorized for the duration of the COVID-19 public health emergency unless sooner terminated or revoked. Abbott is actively pursuing the FDA’s customary regulatory approval process for these diagnostic tests which has uncertainty as discussed in “ Abbott is subject to numerous governmental regulations and it can be costly to comply with these regulations and to develop compliant products and processes. ” in “Legal and Regulatory Risks” under “Item 1A. Risk Factors.” +Due to the unpredictability of the duration and impact of the current COVID-19 pandemic, the extent to which the COVID-19 pandemic will have a material effect on Abbott’s business, financial condition or results of operations is uncertain. A more detailed discussion on the impact of the COVID-19 pandemic on Abbott’s business is contained in the “Financial Review” section in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report. +12 +Abbott is subject to cost containment efforts that could cause a reduction in future revenues and operating income. +In the United States and other countries, Abbott’s businesses have experienced downward pressure on product pricing. Cost containment efforts by governments and private organizations are described in greater detail in the section captioned “Regulation.” To the extent these cost containment efforts are not offset by greater patient access to health care or other factors, Abbott’s future revenues and operating income will be reduced. +Competitors’ intellectual property may prevent Abbott from selling its products or have a material adverse effect on Abbott’s future profitability and financial condition. +Competitors may claim that an Abbott product infringes their intellectual property. Resolving an intellectual property infringement claim can be costly and time consuming and may require Abbott to enter into license agreements. Abbott cannot guarantee that it would be able to obtain license agreements on commercially reasonable terms. A successful claim of patent or other intellectual property infringement could subject Abbott to significant damages or an injunction preventing the manufacture, sale or use of affected Abbott products. Any of these events could have a material adverse effect on Abbott’s profitability and financial condition. +New products and technological advances by Abbott’s competitors may negatively affect Abbott’s results of operations. +Abbott’s products face intense competition from competitive products. Competitors’ products may be safer, more effective, more effectively marketed or sold, or have lower prices or superior performance features than Abbott’s products. Abbott cannot predict with certainty the timing or impact of the introduction of competitors’ products. +Fluctuation in foreign currency exchange rates may adversely affect our financial statements and Abbott’s ability to realize projected sales and earnings. +Although Abbott’s financial statements are denominated in U.S. dollars, a significant portion of Abbott’s revenues and costs are realized in other currencies. Sales outside of the United States in 2020 made up approximately 62 percent of Abbott’s net sales. Abbott’s profitability is affected by movement of the U.S. dollar against other currencies. Fluctuations in exchange rates between the U.S. dollar and other currencies may also affect the reported value of Abbott’s assets and liabilities, as well as its cash flows. Some foreign currencies are subject to government exchange controls. While Abbott enters into hedging arrangements to mitigate some of its foreign currency exposure, Abbott cannot predict with any certainty changes in foreign currency exchange rates or its ability to mitigate these risks. +Information on the impact of foreign exchange rates on Abbott’s financial results is contained in the “Financial Review — Results of Operations” section in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report. A discussion of the steps taken to mitigate the impact of foreign exchange is contained in Item 7A, Quantitative and Qualitative Disclosures about Market Risk in Abbott’s 2020 Form 10-K. Information on Abbott’s hedging arrangements is contained in Note 12 to the consolidated financial statements in this report. +Deterioration in the economic condition and credit quality of certain countries may negatively affect Abbott’s results of operations. +Unfavorable economic conditions in certain countries may increase the time it takes to collect outstanding trade receivables. Financial instability and fiscal deficits in these countries may result in additional austerity measures to reduce costs, including health care. Deterioration in the quality of sovereign debt, including credit downgrades, could increase Abbott’s collection risk where a significant amount of Abbott’s receivables in these countries are with governmental health care systems or where Abbott’s customers depend on payment by government health care systems. +The international nature of Abbott’s business subjects it to additional business risks that may cause its revenue and profitability to decline. +Abbott’s business is subject to risks associated with managing a global supply chain and doing business internationally. Sales outside of the United States in 2020 made up approximately 62 percent of Abbott’s net sales. Additional risks associated with Abbott’s international operations include: +● differing local product preferences and product requirements; +13 +● trade protection measures, including tariffs, import or export licensing requirements, and changes to international trade agreements; +● difficulty in establishing, staffing, and managing operations; +● differing labor regulations; +● potentially negative consequences from changes in or interpretations of tax laws; +● political and economic instability, including sovereign debt issues; +● restrictions on local currency conversion and/or cash extraction; +● price controls, limitations on participation in local enterprises, expropriation, nationalization, and other governmental action; +● inflation, recession, and fluctuations in interest rates; +● diminished protection of intellectual property; and +● potential penalties or other adverse consequences for violations of anti-corruption, anti-bribery, and other similar laws and regulations, including the Foreign Corrupt Practices Act and the U.K. Bribery Act. +Events contemplated by these risks may, individually or in the aggregate, have a material adverse effect on Abbott’s revenues and profitability. +Other factors can have a material adverse effect on Abbott’s future profitability and financial condition. +Many other factors can affect Abbott’s profitability and its financial condition, including: +● changes in or interpretations of laws and regulations, including changes in accounting standards, taxation requirements, product marketing application standards, product labeling standards, source and use laws, and environmental laws; +● differences between the fair value measurement of assets and liabilities and their actual value, particularly for pensions, retiree health care, stock compensation, intangibles, goodwill, and contingent consideration; and for contingent liabilities such as litigation, the absence of a recorded amount, or an amount recorded at the minimum, compared to the actual amount; +● changes in the rate of inflation (including the cost of raw materials, commodities, and supplies), interest rates, market value of Abbott’s equity investments, and the performance of investments held by Abbott or Abbott’s employee benefit trusts; +● changes in the creditworthiness of counterparties that transact business with or provide services to Abbott or Abbott’s employee benefit trusts; +● changes in business, economic, and political conditions, including: war, political instability, terrorist attacks, the threat of future terrorist activity and related military action; global climate, extreme weather and natural disasters; the cost and availability of insurance due to any of the foregoing events; labor disputes, strikes, slow-downs, or other forms of labor or union activity; and pressure from third-party interest groups; +● changes in Abbott’s business units and investments and changes in the relative and absolute contribution of each to earnings and cash flow resulting from evolving business strategies, changing product mix, changes in tax laws or tax rates both in the U.S. and abroad and opportunities existing now or in the future; +● changes in the buying patterns of a major distributor, retailer, or wholesale customer resulting from buyer purchasing decisions, pricing, seasonality, or other factors, or other problems with licensors, suppliers, distributors, and business partners; and +● legal difficulties, any of which could preclude or delay commercialization of products or adversely affect profitability, including claims asserting statutory or regulatory violations, and adverse litigation decisions. +14 +CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS +This Form 10-K contains forward-looking statements that are based on management’s current expectations, estimates, and projections. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “forecasts,” variations of these words, and similar expressions are intended to identify these forward-looking statements. Certain factors, including but not limited to those identified under “Item 1A. Risk Factors” of this Form 10-K, may cause actual results to differ materially from current expectations, estimates, projections, forecasts, and from past results. No assurance can be made that any expectation, estimate, or projection contained in a forward-looking statement will be achieved or will not be affected by the factors cited above or other unknown or future events. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as the result of subsequent events or developments, except as required by law. +​ +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +​ +ITEM 2. PROPERTIES +As of December 31, 2020, Abbott owned or leased properties totaling approximately 43 million square feet, of which approximately 65% is owned by Abbott. Abbott’s principal corporate offices are located in Illinois and are owned by Abbott. +Abbott operates 93 manufacturing facilities globally. Abbott’s facilities are deemed suitable and provide adequate productive capacity. The manufacturing facilities are used by Abbott’s reportable segments as follows: +​ +​ +​ +​ +​ +Manufacturing +Reportable Segments +​ +Sites +Medical Devices +27 +Diagnostic Products +24 +Established Pharmaceutical Products +28 +Nutritional Products +14 +Worldwide Total +93 +​ +Abbott’s research and development facilities in the United States are primarily located in California, Illinois, Minnesota, New Jersey, and Ohio. Abbott also has research and development facilities in various other countries, including China, Colombia, India, Singapore, Spain, and the United Kingdom. +There are no material encumbrances on the properties. +​ +ITEM 3. LEGAL PROCEEDINGS +Abbott is involved in various claims, legal proceedings and investigations. While it is not feasible to predict the outcome of such pending claims, proceedings and investigations with certainty, management is of the opinion that their ultimate resolution should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +​ +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +​ +15 +INFORMATION ABOUT OUR EXECUTIVE OFFICERS +Executive officers of Abbott are elected annually by the board of directors. Each executive officer holds office until a successor has been duly elected or appointed and qualified or until the officer’s death, resignation, or removal. Vacancies may be filled at any time by the board. Any executive officer may be removed by the board of directors when, in its judgment, removal would serve the best interests of Abbott. +Abbott’s executive officers, their ages as of February 19, 2021, and the dates of their first election as officers of Abbott are listed below. The executive officers’ principal occupations and employment for the past five years and the year of appointment to the earliest reported office are also shown. Unless otherwise stated, employment was by Abbott. There are no family relationships between any executive officers or directors. +Miles D. White, 65 +2020 to present — Executive Chairman and Director. +1999 to 2020 — Chairman of the Board and Chief Executive Officer, and Director. +Elected Corporate Officer — 1993. +Robert B. Ford, 47 +2020 to present — President and Chief Executive Officer, and Director. +2018 to 2020 — President and Chief Operating Officer, and Director since 2019. +2015 to 2018 — Executive Vice President, Medical Devices. +Elected Corporate Officer — 2008. +Hubert L. Allen, 55 +2013 to present — Executive Vice President, General Counsel and Secretary. +Elected Corporate Officer — 2012. +John M. Capek, 59 +2015 to present — Executive Vice President, Ventures. +Elected Corporate Officer — 2006. +Lisa D. Earnhardt, 51 +2019 to present — Executive Vice President, Medical Devices. +2008 to 2019 — President, CEO, and Director, Intersect ENT (a medical technology company focused on developing treatments for ear, nose and throat conditions). +Elected Corporate Officer — 2019. +Robert E. Funck, Jr., 59 +2020 to present — Executive Vice President, Finance and Chief Financial Officer. +2018 to 2020 — Senior Vice President, Finance and Controller. +2013 to 2018 — Vice President, Controller. +Elected Corporate Officer — 2005. +16 +John F. Ginascol, 62 +2019 to present — Executive Vice President, Core Diagnostics. +2008 to 2019 — Vice President, Nutrition, Supply Chain. +Elected Corporate Officer — 2008. +Andrew H. Lane, 50 +2017 to present — Executive Vice President, Established Pharmaceuticals. +2015 to 2017 — Senior Vice President, Established Pharmaceuticals, Emerging Markets. +Elected Corporate Officer — 2015. +Mary K. Moreland, 54 +2019 to present — Executive Vice President, Human Resources. +2013 to 2019 — Divisional Vice President, Compensation, Benefits and HR M&A. +Elected Corporate Officer — 2019. +Daniel Salvadori, 42 +2017 to present — Executive Vice President, Nutritional Products. +2014 to 2017 — Senior Vice President, Established Pharmaceuticals, Latin America. +Elected Corporate Officer — 2014. +Andrea Wainer, 52 +2019 to present — Executive Vice President, Rapid and Molecular Diagnostics. +2015 to 2019 — Vice President, Molecular Diagnostics. +Elected Corporate Officer — 2015. +Gregory A. Ahlberg, 54 +2020 to present — Senior Vice President, Core Laboratory Diagnostics, Commercial Operations. +2017 to 2020 —Vice President, Diagnostics, Commercial Operations, Europe, Middle East and Africa. +2012 to 2017 — Divisional Vice President, USA, Abbott Diagnostics Division. +Elected Corporate Officer — 2017. +Roger M. Bird, 64 +2015 to present — Senior Vice President, U.S. Nutrition. +Elected Corporate Officer — 2015. +Charles R. Brynelsen, 64 +2017 to present — Senior Vice President, Abbott Vascular. +2016 to 2017 — Managing Director, CB Business Advisors, Inc. (a medical device consulting firm). +2015 to 2016 — Senior Vice President and President, Medtronic Early Technologies, Medtronic plc (a global medical device company). +Elected Corporate Officer — 2017. +17 +Michael D. Dale, 61 +2019 to present — Senior Vice President, Structural Heart. +2017 to 2019 — Vice President, Structural Heart. +2016 to 2017 — Divisional Vice President and General Manager, Structural Heart. +2014 to 2016 — President and Chief Executive Officer, GI Dynamics, Inc. (a medical device company focused on developing gastrointestinal therapies). +Elected Corporate Officer — 2017. +Sammy Karam, 59 +2019 to present — Senior Vice President, Established Pharmaceuticals, Emerging Markets. +2014 to 2019 — Divisional Vice President, Global Marketing Commercial Execution, Established Pharmaceuticals. +Elected Corporate Officer — 2019. +Joseph Manning, 52 +2017 to present — Senior Vice President, International Nutrition. +2015 to 2017 — Vice President, Nutrition, Asia Pacific. +Elected Corporate Officer — 2015. +Michael J. Pederson, 59 +2019 to present — Senior Vice President, Electrophysiology and Heart Failure. +2017 to 2019 — Senior Vice President, Cardiac Arrhythmias and Heart Failure. +2015 to 2017 — Divisional Vice President and General Manager, Abbott Electrophysiology. +Elected Corporate Officer — 2017. +Christopher J. Scoggins, 51 +2019 to present — Senior Vice President, Rapid Diagnostics. +2015 to 2019 — Vice President, Diabetes Care, Commercial Operations. +Elected Corporate Officer — 2015. +Jared L. Watkin, 53 +2015 to present — Senior Vice President, Diabetes Care. +Elected Corporate Officer — 2015. +Alejandro D. Wellisch, 46 +2017 to present — Senior Vice President, Established Pharmaceuticals, Latin America. +2014 to 2017 — General Manager, Argentina, Bolivia, Paraguay and Uruguay, Established Pharmaceuticals. +Elected Corporate Officer — 2017. +18 +Randel W. Woodgrift, 59 +2019 to present — Senior Vice President, CRM. +2017 to 2019 — Vice President, Global Operations, Cardiovascular and Neuromodulation. +2015 to 2017 — Vice President, Operations and R&D, Abbott Vascular. +Elected Corporate Officer — 2015. +Philip P. Boudreau, 48 +2020 to present — Vice President, Finance and Controller. +2017 to 2020 — Divisional Vice President, Controller, Medical Devices. +2012 to 2017 — Divisional Vice President, Controller and Commercial Support, Point of Care. +Elected Corporate Officer — 2020. +​ +​ +19 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Principal Market +The principal market for Abbott’s common shares is the New York Stock Exchange under the symbol “ABT.” Shares are also listed on the Chicago Stock Exchange and traded on various regional and electronic exchanges. Outside the United States, Abbott’s shares are listed on the SIX Swiss Exchange. +Shareholders +There were 37,450 shareholders of record of Abbott common shares as of December 31, 2020. +Tax Information for Shareholders +In 2001, the Illinois Department of Commerce and Economic Opportunity (DCEO) designated Abbott as an Illinois High Impact Business (HIB) for a period not to exceed twenty years. In 2020, the DCEO granted a two year extension for Abbott's HIB designation. Dividends paid by a corporation that is designated as a HIB and conducts business in a foreign trade zone may be eligible for a subtraction from base income for Illinois income tax purposes. Abbott certified that the HIB requirements were met for the calendar year ending December 31, 2020. +If you have any questions, please contact your tax advisor. +Issuer Purchases of Equity Securities +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(c) Total Number of +(d) Maximum Number (or +​ +​ +(a) Total Number +​ +​ +​ +​ +Shares (or Units) +​ +Approximate Dollar Value) of +​ +​ +of Shares +​ +(b) Average Price +​ +Purchased as Part of +​ +Shares (or Units) that May +​ +​ +(or Units) +​ +Paid per Share +​ +Publicly Announced +​ +Yet Be Purchased Under the +Period +​ +Purchased +​ +(or Unit) +​ +Plans or Programs +​ +Plans or Programs +October 1, 2020 — October 31, 2020 +0 +(1) +$ +0 +0 +​ +$ +3,270,234,923 +(2) +November 1, 2020 — November 30, 2020 +0 +(1) +$ +0 +0 +​ +$ +3,270,234,923 +(2) +December 1, 2020 — December 31, 2020 +1,600,411 +(1) +$ +107.999 +1,600,411 +​ +$ +3,097,391,913 +(2) +Total +1,600,411 +(1) +$ +107.999 +1,600,411 +​ +$ +3,097,391,913 +(2) +(1) These shares do not include the shares surrendered to Abbott to satisfy tax withholding obligations in connection with the vesting of restricted stock or restricted stock units. +(2) On September 11, 2014, the board of directors authorized the repurchase of up to $3 billion of its common shares, from time to time (the “2014 Plan”). On October 11, 2019, the board of directors authorized the repurchase of up to $3 billion of Abbott common shares, from time to time (the “2019 Plan”). The 2019 Plan is in addition to the unused portion of the 2014 Plan. +​ +​ +​ +​ +20 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Financial Review +Abbott’s revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent protection and licenses, technological and performance features, and inclusion of Abbott’s products under a contract most impact which products are sold; price controls, competition and rebates most impact the net selling prices of products; and foreign currency translation impacts the measurement of net sales and costs. Abbott’s primary products are medical devices, diagnostic testing products, nutritional products and branded generic pharmaceuticals. Sales in international markets comprise approximately 62 percent of consolidated net sales. +In 2020, the coronavirus (COVID-19) pandemic affected Abbott’s diversified health care businesses in various ways. As is further described below, some businesses have performed at the levels required to successfully meet new demands, others have faced challenges, and still others have been relatively less impacted by the pandemic. +Abbott’s Diagnostics business experienced the most significant change in sales from 2019 to 2020 as sales from new tests and other related products to detect COVID-19 more than outweighed the negative impact of COVID-19 on routine diagnostic testing volumes. Abbott mobilized its teams across multiple fronts to develop and launch the following new diagnostic tests for COVID-19 in 2020: +● In March, Abbott launched a molecular test using polymerase chain reaction (PCR) methods on its m 2000™ RealTi m e lab-based platform to detect COVID-19 pursuant to an Emergency Use Authorization (EUA) in the U.S. and CE Mark. +● In March, Abbott also launched a molecular test to detect COVID-19 on its ID NOW™ rapid point-of-care platform in the U.S. pursuant to an EUA. +● In April, Abbott launched an IgG (Immunoglobulin G) lab-based serology blood test on its ARCHITECT ® i1000SR and i2000SR ® laboratory instruments for the detection of an antibody to determine if someone was previously infected with the virus. The serology test was granted an EUA in the U.S. and CE Mark in April. +● In May, Abbott launched a lab-based serology blood test on its Alinity ® i system pursuant to an EUA in the U.S. and CE Mark. +● In May, Abbott also launched a molecular PCR test on its Alinity m system to detect COVID-19 pursuant to an EUA in the U.S. Abbott received CE Mark for this test in June. +● In June, Abbott launched a lateral flow COVID-19 rapid antibody test on its Panbio™ system in select countries pursuant to a CE Mark. This serology test detects an antibody to determine if someone was previously infected with the virus. +● In August, Abbott launched its AdviseDx SARS-CoV-2 IgM (Immunoglobulin M) lab-based serology test for use on its ARCHITECT and Alinity platforms pursuant to a CE Mark. Abbott was granted an EUA in the U.S. for this test in October. +● In August, Abbott launched its BinaxNOW™ COVID-19 Ag Card test, a portable, lateral flow rapid test to detect COVID-19 pursuant to an EUA in the U.S. +● In September, Abbott launched its Panbio rapid antigen test to detect COVID-19 pursuant to a CE Mark. In October, Abbott received approval by the World Health Organization for emergency use listing for the Panbio antigen test. +● In December, Abbott received CE Mark and launched its SARS-CoV-2-IgG II quantitative lab-based serology blood test for use on its ARCHITECT and Alinity i platforms. +● In December, Abbott received an EUA in the U.S. for virtually guided at-home use of its BinaxNOW COVID-19 Ag Card rapid test to detect COVID-19 and launched the product for at-home use. +● In December, Abbott launched its multiplex molecular test on its Alinity m system to detect COVID-19, flu A, flu B, and respiratory syncytial virus (RSV) pursuant to a CE Mark. +21 +In 2020, Abbott’s COVID-19 testing related sales totaled approximately $3.884 billion, led by sales related to Abbott’s BinaxNOW, Panbio and ID NOW rapid testing platforms. +In addition to negatively impacting routine core diagnostic testing volumes, the pandemic negatively affected the number of cardiovascular and neuromodulation procedures performed by health care providers globally, thereby reducing the demand for Abbott’s cardiovascular and neuromodulation devices and routine diagnostic tests in 2020. The decrease began in February in China as that country implemented quarantine restrictions and postponed non-emergency health care activities. The negative impact on cardiovascular and neuromodulation procedures and routine diagnostic tests expanded to other countries and geographic regions as COVID-19 spread geographically in the first half of 2020 and health care systems in these countries shifted their focus to fighting COVID-19. +The extent of the impact and the timing of a recovery in the number of procedures and routine testing in a particular country or geographic region depended upon the progression of COVID-19 cases in the country or region. The recovery in procedures and routine testing volumes in China began in March. In other parts of the world, such as the U.S. and Europe, volumes improved across Abbott’s hospital-based businesses as the second quarter progressed and the improvement continued in the third quarter. However, in the fourth quarter, the improving trends in the demand for procedures and routine testing flattened or were negatively impacted depending upon the business and the region as many countries experienced an increase in the number of COVID-19 cases and hospitalizations. +Abbott’s branded generic pharmaceuticals business was also negatively affected by the pandemic in 2020 as COVID-19 spread across emerging market countries in the second and third quarters of 2020. Abbott’s nutritional and diabetes care businesses were the least affected by the pandemic as is further discussed below. +Abbott is continually implementing business continuity plans in the face of the pandemic. Due to the critical nature of its products and services, Abbott was generally exempt from governmental orders issued during the first quarter of 2020 in the U.S. and other countries requiring businesses to cease operations. The majority of its office-based work was conducted remotely during the period of such governmental orders and the company implemented strict travel restrictions. As some governmental orders were lifted in May and June 2020, Abbott entered a new phase in its operations whereby some office-based employees started working at Abbott’s offices on a rotational basis. As various governmental orders and guidelines were modified in the fourth quarter to put in place new restrictions, Abbott continued to ensure that its guidance was aligned with such restrictions. Abbott has taken aggressive steps to limit exposure and enhance the safety of facilities for its employees. +Due to the unpredictability of the duration and impact of the current COVID-19 pandemic, the extent to which the COVID-19 pandemic will have a material effect on its business, financial condition or results of operations is uncertain. +While Abbott’s 2020 sales were most significantly affected by the COVID-19 pandemic, the increase in total sales over the last three years also reflects volume growth due to the introduction of new products across various businesses as well as higher sales of various existing products. Sales in emerging markets, which represent approximately 37 percent of total company sales, increased 2.0 percent in 2020 and 8.2 percent in 2019, excluding the impact of foreign exchange. (Emerging markets include all countries except the United States, Western Europe, Japan, Canada, Australia and New Zealand.) +Over the last three years, Abbott’s operating margin as a percentage of sales increased from 11.9 percent in 2018 to 14.2 percent in 2019 and 15.5 percent in 2020. The increase in 2020 reflects the sales volume increases in the rapid and molecular diagnostics businesses, partially offset by lower Medical Devices sales due to the impact of the pandemic and the unfavorable effect of foreign exchange. In addition, a reduction in the costs associated with business acquisitions and restructuring activities drove an improvement in operating margins from 2018 to 2020. In 2019, the increase in Abbott’s operating margin also reflects margin improvement in various businesses and lower intangible amortization expense compared to 2018. +With respect to the performance of each reportable segment over the last three years, sales in the Medical Devices segment excluding the impact of foreign exchange decreased 3.8 percent in 2020 and increased 10.5 percent in 2019. The sales decrease in 2020 was driven by Abbott’s cardiovascular and neuromodulation businesses due primarily to reduced procedure volumes as a result of the COVID-19 pandemic. These decreases were partially offset by double-digit growth in Diabetes Care. The sales increase in 2019 was driven primarily by higher Diabetes Care, Structural Heart, Electrophysiology and Heart Failure sales. +22 +In 2020, operating earnings for the Medical Devices segment decreased 19.4 percent. The operating margin profile decreased from 30.8 percent of sales in 2019 to 25.8 percent in 2020 primarily due to lower sales and manufacturing volumes as a result of the pandemic and pricing pressures on drug eluting stents (DES) as a result of market competition in the U.S. and other major markets. +In 2020, key product approvals in the Medical Devices segment included: +● CE Mark for Abbott’s Tendyne™ Transcatheter Mitral Valve Implantation system for the treatment of significant mitral regurgitation (MR) in patients requiring a heart valve replacement who are not candidates for open-heart surgery or transcatheter mitral valve repair, +● CE Mark for Abbott’s TriClip ® heart valve repair system, the world’s first minimally invasive, clip-based device for repair of a leaky tricuspid heart valve, +● U.S. Food and Drug Administration (FDA) clearance of FreeStyle ® Libre 2 as an integrated continuous glucose monitoring (iCGM) system for adults and children ages 4 and older with diabetes, +● CE Mark for Abbott’s FreeStyle Libre 3 system, which automatically delivers real time, up-to-the-minute glucose readings, 14-day accuracy and real-time glucose alarms, +● CE Mark for the Libre Sense™ Glucose Sport Biosensor that provides continuous glucose monitoring to help athletes better understand the efficacy of their nutrition choices on training and athletic performance, +● U.S. FDA approval of the next-generation Gallant™ implantable cardioverter defibrillator and cardiac resynchronization therapy defibrillator devices which help manage heart rhythm disorders and offer Bluetooth technology and a new patient smartphone app for improved remote monitoring and enhanced patient-physician engagement, +● CE Mark for MitraClip ® G4, Abbott’s next-generation MitraClip mitral valve repair device, +● CE Mark of EnSite™ X EP System, a next-generation 3D cardiac mapping platform used for ablation therapy to treat abnormal heart rhythms, +● U.S. FDA clearance and CE Mark of the IonicRF™ Generator, a non-surgical, minimally invasive device that uses heat to target specific nerves for the management of chronic pain, and +● U.S. FDA approval of updated labeling to allow Abbott’s HeartMate 3™ heart pump to be used in pediatric patients with advanced refractory left ventricular heart failure. +In Abbott’s worldwide diagnostics business, sales increased 40.6 percent in 2020 and 5.9 percent in 2019, excluding the impact of foreign exchange. As was discussed above, sales growth in 2020 was driven by demand for Abbott's portfolio of COVID-19 diagnostics tests across its rapid and lab-based platforms, partially offset by lower volumes of routine laboratory testing due to the pandemic. Growth in 2019 reflected continued market penetration by the core laboratory business in the U.S. and internationally. The 2019 growth included the continued adoption by customers of Alinity, which is Abbott’s integrated family of next-generation diagnostic systems and solutions that are designed to increase efficiency by running more tests in less space, generating test results faster and minimizing human errors while continuing to provide quality results. +Abbott has regulatory approvals in the U.S., Europe, China, and other markets for the “Alinity c” and “Alinity i” instruments and has continued to build out its test menu for clinical chemistry and immunoassay diagnostics. Abbott has obtained regulatory approval for the “Alinity h” instrument for hematology in Europe and Japan. Abbott has also obtained regulatory approvals in the U.S. and Europe for the “Alinity s” (blood screening) and “Alinity m” (molecular) instruments and several testing assays. +In 2020, operating earnings for the Diagnostics segment increased 94.8 percent. The operating margin profile increased from 24.9 percent of sales in 2018 to 34.5 percent in 2020 primarily due to higher sales in 2020 in Rapid Diagnostics and Molecular Diagnostics, partially offset by lower volumes of routine testing in Core Laboratory. +23 +In Abbott’s worldwide nutritional products business, sales over the last three years were positively impacted by numerous new product introductions, including the roll-outs of human milk oligosaccharide, or HMO, in infant formula and of high-protein Ensure ® , that leveraged Abbott’s strong brands. Sales were also positively affected by demographics such as an aging population and an increasing rate of chronic disease in developed markets and the rise of a middle class in many emerging markets. Excluding the impact of foreign exchange, total adult nutrition sales increased 10.3 percent in 2020 and 6.6 percent in 2019 led by the continued growth of Ensure, Abbott’s market-leading complete and balanced nutrition brand, and Glucerna ® , Abbott’s market-leading diabetes-specific nutrition brand, across several countries. The 2019 sales growth was partially offset by the unfavorable impact of the discontinuation of a non-core product line in the U.S. Excluding the impact of foreign exchange, total pediatric nutrition sales increased 0.3 percent in 2020 and 3.4 percent in 2019 driven by the PediaSure ® and Pedialyte ® brands in the U.S. as well as infant and toddler product growth across several markets in Asia and Latin America, partially offset by challenging market dynamics in the infant category in Greater China. The 2020 increase was also driven by higher Similac ® sales in the U.S. +The Established Pharmaceutical Products segment focuses on the sale of its products in emerging markets. Excluding the impact of foreign exchange, Established Pharmaceutical sales increased 1.9 percent in 2020 and 7.3 percent in 2019. The sales increases in 2020 and 2019 reflect higher sales in several geographies including India, China, Brazil and Russia. Operating margins decreased from 20.2 percent of sales in 2018 to 18.5 percent in 2020 primarily due to the unfavorable impact of foreign exchange, product mix and lower gross margins. +With respect to Abbott’s financial position, at December 31, 2020, Abbott’s cash and cash equivalents and short-term investments total approximately $7.1 billion compared to $4.1 billion at December 31, 2019. Abbott’s long-term debt and short-term borrowings total $18.7 billion and $18.1 billion at December 31, 2020 and 2019, respectively. +Abbott declared dividends of $1.53 per share in 2020 compared to $1.32 per share in 2019, an increase of approximately 16 percent. Dividends paid totaled $2.560 billion in 2020 compared to $2.270 billion in 2019. The year-over-year change in the amount of dividends paid primarily reflects the increase in the dividend rate. In December 2020, Abbott increased the company’s quarterly dividend by 25 percent to $0.45 per share from $0.36 per share, effective with the dividend paid in February 2021. +In 2021, Abbott will focus on continuing to meet the demand for COVID-19 tests and will continue to invest in product development areas that provide the opportunity for strong sustainable growth over the next several years. In its diagnostics business, Abbott will continue to focus on driving market adoption and geographic expansion of its Alinity suite of diagnostics instruments. In the medical devices business, Abbott will continue to focus on expanding its market position in various areas including diabetes care, structural heart, electrophysiology, and heart failure. In its nutritionals business, Abbott will continue to focus on driving growth globally and further enhancing its portfolio with the introduction of line extensions of its science-based products. In the established pharmaceuticals business, Abbott will continue to focus on growing its business with the depth and breadth of its portfolio in emerging markets. +24 +Critical Accounting Policies +Sales Rebates — In 2020, approximately 41 percent of Abbott’s consolidated gross revenues were subject to various forms of rebates and allowances that Abbott recorded as reductions of revenues at the time of sale. Most of these rebates and allowances in 2020 are in the Nutritional Products and Diabetes Care businesses. Abbott provides rebates to state agencies that administer the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC), wholesalers, group purchasing organizations, and other government agencies and private entities. Rebate amounts are usually based upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of which products have been sold subject to a rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current changes, Abbott estimates the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate generally occurs from one to six months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. Rebates and chargebacks charged against gross sales in 2020, 2019 and 2018 amounted to approximately $3.3 billion, $3.1 billion and $3.0 billion, respectively, or 20.1 percent, 19.1 percent and 19.0 percent of gross sales, respectively, based on gross sales of approximately $16.6 billion, $16.3 billion and $16.0 billion, respectively, subject to rebate. A one-percentage point increase in the percentage of rebates to related gross sales would decrease net sales by approximately $166 million in 2020. Abbott considers a one-percentage point increase to be a reasonably likely increase in the percentage of rebates to related gross sales. Other allowances charged against gross sales were approximately $207 million, $169 million and $175 million for cash discounts in 2020, 2019 and 2018, respectively, and $232 million, $192 million and $191 million for returns in 2020, 2019 and 2018, respectively. Cash discounts are known within 15 to 30 days of sale, and therefore can be reliably estimated. Returns can be reliably estimated because Abbott’s historical returns are low, and because sales returns terms and other sales terms have remained relatively unchanged for several periods. +Management analyzes the adequacy of ending rebate accrual balances each quarter. In the domestic nutritional business, management uses both internal and external data available to estimate the accruals. In the WIC business, estimates are required for the amount of WIC sales within each state where Abbott holds the WIC contract. The state where the sale is made, which is the determining factor for the applicable rebated price, is reliably determinable. Rebated prices are based on contractually obligated agreements generally lasting a period of two to four years. Except for a change in contract price or a transition period before or after a change in the supplier for the WIC business in a state, accruals are based on historical redemption rates and data from the U.S. Department of Agriculture (USDA) and the states submitting rebate claims. The USDA, which administers the WIC program, has been making its data available for many years. Management also estimates the states' processing lag time based on sales and claims data. Inventory in the retail distribution channel does not vary substantially. Management has access to several large customers' inventory management data, which allows management to make reliable estimates of inventory in the retail distribution channel. At December 31, 2020, Abbott had WIC business in 27 states. +Historically, adjustments to prior years’ rebate accruals have not been material to net income. Abbott employs various techniques to verify the accuracy of claims submitted to it, and where possible, works with the organizations submitting claims to gain insight into changes that might affect the rebate amounts. For government agency programs, the calculation of a rebate involves interpretations of relevant regulations, which are subject to challenge or change in interpretation. +Income Taxes — Abbott operates in numerous countries where its income tax returns are subject to audits and adjustments. Because Abbott operates globally, the nature of the audit items is often very complex, and the objectives of the government auditors can result in a tax on the same income in more than one country. Abbott employs internal and external tax professionals to minimize audit adjustment amounts where possible. In accordance with the accounting rules relating to the measurement of tax contingencies, in order to recognize an uncertain tax benefit, the taxpayer must be more likely than not of sustaining the position, and the measurement of the benefit is calculated as the largest amount that is more than 50 percent likely to be realized upon resolution of the benefit. Application of these rules requires a significant amount of judgment. In the U.S., Abbott’s federal income tax returns through 2016 are settled. Undistributed foreign earnings remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in its foreign entities is not practicable. +25 +Pension and Post-Employment Benefits — Abbott offers pension benefits and post-employment health care to many of its employees. Abbott engages outside actuaries to assist in the determination of the obligations and costs under these programs. Abbott must develop long-term assumptions, the most significant of which are the health care cost trend rates, discount rates and the expected return on plan assets. The discount rates used to measure liabilities were determined based on high-quality fixed income securities that match the duration of the expected retiree benefits. The health care cost trend rates represent Abbott’s expected annual rates of change in the cost of health care benefits and are a forward projection of health care costs as of the measurement date. A difference between the assumed rates and the actual rates, which will not be known for years, can be significant in relation to the obligations and the annual cost recorded for these programs. Low interest rates have significantly increased actuarial losses for these plans. At December 31, 2020, pretax net actuarial losses and prior service costs and (credits) recognized in Accumulated other comprehensive income (loss) were net losses of $4.6 billion for Abbott’s defined benefit plans and net losses of $419 million for Abbott’s medical and dental plans. Actuarial losses and gains are amortized over the remaining service attribution periods of the employees under the corridor method, in accordance with the rules for accounting for post-employment benefits. Differences between the expected long-term return on plan assets and the actual annual return are amortized over a five-year period. +Valuation of Intangible Assets — Abbott has acquired and continues to acquire significant intangible assets that Abbott records at fair value at the acquisition date. Transactions involving the purchase or sale of intangible assets occur with some frequency between companies in the health care field and valuations are usually based on a discounted cash flow analysis. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, cost of capital, terminal values and market participants. Each of these factors can significantly affect the value of the intangible asset. Abbott engages independent valuation experts who review Abbott’s critical assumptions and calculations for acquisitions of significant intangibles. Abbott reviews definite-lived intangible assets for impairment each quarter using an undiscounted net cash flows approach. If the undiscounted cash flows of an intangible asset are less than the carrying value of an intangible asset, the intangible asset is written down to its fair value, which is usually the discounted cash flow amount. Where cash flows cannot be identified for an individual asset, the review is applied at the lowest group level for which cash flows are identifiable. Goodwill and indefinite-lived intangible assets, which relate to in-process research and development acquired in a business combination, are reviewed for impairment annually or when an event that could result in impairment occurs. At December 31, 2020, goodwill amounted to $23.7 billion and net intangibles amounted to $14.8 billion. Amortization expense in continuing operations for intangible assets amounted to $2.1 billion in 2020, $1.9 billion in 2019 and $2.2 billion in 2018. There was no reduction of goodwill relating to impairments in 2020, 2019 and 2018. +Litigation — Abbott accounts for litigation losses in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) No. 450, “Contingencies.” Under ASC No. 450, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period as additional information becomes known. Accordingly, Abbott is often initially unable to develop a best estimate of loss, and therefore the minimum amount, which could be zero, is recorded. As information becomes known, either the minimum loss amount is increased, resulting in additional loss provisions, or a best estimate can be made, also resulting in additional loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected. Abbott estimates the range of possible loss to be from approximately $90 million to $120 million for its legal proceedings and environmental exposures. Accruals of approximately $105 million have been recorded at December 31, 2020 for these proceedings and exposures. These accruals represent management’s best estimate of probable loss, as defined by FASB ASC No. 450, “Contingencies.” +26 +Results of Operations +Sales +The following table details the components of sales growth by reportable segment for the last two years: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Components of % Change +​ +​ +Total +​ +​ +​ +​ +​ +​ +​ +% Change +Price +Volume +Exchange +Total Net Sales +2020 vs. 2019 +8.5 +(0.4) +10.2 +(1.3) +2019 vs. 2018 +4.3 +0.2 +7.3 +(3.2) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total U.S. +​ +​ +​ +​ +2020 vs. 2019 +14.2 +(1.1) +15.3 +— +2019 vs. 2018 +5.2 +(0.4) +5.6 +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total International +​ +​ +​ +​ +2020 vs. 2019 +5.3 +0.1 +7.2 +(2.0) +2019 vs. 2018 +3.9 +0.5 +8.3 +(4.9) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Established Pharmaceutical Products Segment +​ +​ +​ +​ +2020 vs. 2019 +(4.1) +2.7 +(0.8) +(6.0) +2019 vs. 2018 +1.4 +3.0 +4.3 +(5.9) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritional Products Segment +​ +​ +​ +​ +2020 vs. 2019 +3.2 +0.8 +3.9 +(1.5) +2019 vs. 2018 +2.5 +0.9 +3.9 +(2.3) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostic Products Segment +​ +​ +​ +​ +2020 vs. 2019 +40.1 +(0.8) +41.4 +(0.5) +2019 vs. 2018 +2.9 +(0.5) +6.4 +(3.0) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices Segment +​ +​ +​ +​ +2020 vs. 2019 +(3.7) +(1.9) +(1.9) +0.1 +2019 vs. 2018 +7.6 +(0.9) +11.4 +(2.9) +​ +The increase in Total Net Sales in 2020 reflects volume growth in the Diagnostics and Nutritional Products segments. In Medical Devices, the impact of COVID-19 on Abbott’s cardiovascular and neuromodulation businesses was partially offset by double-digit volume growth in Diabetes Care. The increase in Total Net Sales in 2019 reflects volume growth across all of Abbott’s segments. The price declines related to the Medical Devices segment in 2020 and 2019 primarily reflect DES pricing pressures as a result of market competition in the U.S. and other major markets. +27 +A comparison of significant product and product group sales is as follows. Percent changes are versus the prior year and are based on unrounded numbers. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +Impact of +Total Change +​ +​ +2020 +2019 +Change +Exchange +Excl. Exchange +​ +(dollars in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Established Pharmaceuticals — +​ +​ +​ +​ +​ +Key Emerging Markets +​ +$ +3,209 +​ +$ +3,392 +(5) +% +(8) +% +3 +% +Other +​ +1,094 +​ +​ +1,094 +— +1 +(1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritionals — +​ +​ +​ +​ +​ +​ +​ +​ +​ +International Pediatric Nutritionals +​ +2,140 +​ +​ +2,282 +(6) +(2) +(4) +​ +U.S. Pediatric Nutritionals +​ +1,987 +​ +​ +1,879 +6 +— +6 +​ +International Adult Nutritionals +​ +2,228 +​ +​ +2,017 +11 +(3) +14 +​ +U.S. Adult Nutritionals +​ +1,292 +​ +​ +1,231 +5 +— +5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostics — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Core Laboratory +​ +4,475 +​ +​ +4,656 +(4) +(1) +(3) +​ +Molecular +​ +1,438 +​ +​ +442 +225 +(1) +226 +​ +Point of Care +​ +516 +​ +​ +561 +(8) +— +(8) +​ +Rapid Diagnostics +​ +4,376 +​ +​ +2,054 +113 +1 +112 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rhythm Management +​ +1,914 +​ +​ +2,144 +(11) +— +(11) +​ +Electrophysiology +​ +1,578 +​ +​ +1,721 +(8) +1 +(9) +​ +Heart Failure +​ +740 +​ +​ +769 +(4) +— +(4) +​ +Vascular (a) +​ +2,339 +​ +​ +2,850 +(18) +— +(18) +​ +Structural Heart +​ +1,247 +​ +​ +1,400 +(11) +— +(11) +​ +Neuromodulation +​ +​ +702 +​ +​ +831 +​ +(16) +​ +— +​ +(16) +​ +Diabetes Care +​ +​ +3,267 +​ +​ +2,524 +​ +29 +​ +— +​ +29 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Vascular Product Lines: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Coronary and Endovascular +​ +2,263 +​ +​ +2,740 +(17) +— +(17) +​ +​ +28 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +Impact of +​ +Total Change +​ +2019 +2018 +Change +Exchange +Excl. Exchange +(dollars in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total Established Pharmaceuticals — +​ +​ +​ +​ +​ +Key Emerging Markets +​ +$ +3,392 +​ +$ +3,363 +1 +% +(7) +% +8 +% +Other +​ +1,094 +​ +​ +1,059 +3 +(3) +6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritionals — +​ +​ +​ +​ +​ +​ +​ +​ +​ +International Pediatric Nutritionals +​ +2,282 +​ +​ +2,254 +1 +(4) +5 +​ +U.S. Pediatric Nutritionals +​ +1,879 +​ +​ +1,843 +2 +— +2 +​ +International Adult Nutritionals +​ +2,017 +​ +​ +1,900 +6 +(5) +11 +​ +U.S. Adult Nutritionals +​ +1,231 +​ +​ +1,232 +— +— +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostics — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Core Laboratory +​ +4,656 +​ +​ +4,386 +6 +(4) +10 +​ +Molecular +​ +442 +​ +​ +484 +(9) +(3) +(6) +​ +Point of Care +​ +561 +​ +​ +553 +2 +— +2 +​ +Rapid Diagnostics +​ +2,054 +​ +​ +2,072 +(1) +(2) +1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices — +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rhythm Management +​ +2,144 +​ +​ +2,198 +(3) +(3) +— +​ +Electrophysiology +​ +1,721 +​ +​ +1,561 +10 +(3) +13 +​ +Heart Failure +​ +769 +​ +​ +646 +19 +(1) +20 +​ +Vascular (a) +​ +2,850 +​ +​ +2,929 +(3) +(3) +— +​ +Structural Heart +​ +1,400 +​ +​ +1,239 +13 +(3) +16 +​ +Neuromodulation +​ +​ +831 +​ +​ +864 +​ +(4) +​ +(2) +​ +(2) +​ +Diabetes Care +​ +​ +2,524 +​ +​ +1,933 +​ +31 +​ +(5) +​ +36 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Vascular Product Lines: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Coronary and Endovascular +​ +2,740 +​ +​ +2,778 +(1) +(2) +1 +​ +In order to compute results excluding the impact of exchange rates, current year U.S. dollar sales are multiplied or divided, as appropriate, by the current year average foreign exchange rates and then those amounts are multiplied or divided, as appropriate, by the prior year average foreign exchange rates. +Total Established Pharmaceutical Products sales increased 1.9 percent in 2020 and 7.3 percent in 2019, excluding the unfavorable impact of foreign exchange. The Established Pharmaceutical Products segment is focused on several key emerging markets including India, Russia, China and Brazil. Excluding the impact of foreign exchange, total sales in these key emerging markets increased 2.6 percent in 2020 and 7.9 percent in 2019 due to higher sales in several geographies including China, Brazil, India and Russia. Excluding the impact of foreign exchange, sales in Established Pharmaceuticals’ other emerging markets decreased 0.5 percent in 2020 and increased 5.6 percent in 2019. +Total Nutritional Products sales increased 4.7 percent in 2020 and 4.8 percent in 2019, excluding the impact of foreign exchange. In 2020, International Pediatric Nutritional sales, excluding the effect of foreign exchange, decreased 4.1 percent as growth across Abbott’s pediatric products in various countries in Southeast Asia was more than offset by challenging market dynamics in the infant category in Greater China. The 4.6 percent increase in 2019 International Pediatric Nutritional sales, excluding the effect of foreign exchange, was driven by growth across Abbott’s portfolio, including Similac and PediaSure in various countries in Asia and Latin America and Pedialyte in Latin America. This growth was partially offset by challenging market dynamics in the infant category in Greater China. In the U.S. Pediatric Nutritional business, sales increased 5.8 percent in 2020 and 1.9 percent in 2019, reflecting growth in Similac in 2020 and growth in PediaSure and Pedialyte in both years. +29 +In the International Adult Nutritional business, sales increased 13.6 percent and 10.9 percent in 2020 and 2019, respectively, excluding the effect of foreign exchange, due to continued growth of Ensure and Glucerna in several countries. In 2020 U.S. Adult Nutritional sales increased 4.9 percent, primarily due to growth of Ensure. In 2019, U.S. Adult Nutritional sales were unchanged from 2018 due to the impact of Abbott’s discontinuation of a non-core product line during the third quarter of 2018 that was offset by growth in other areas of the business. +In the Diagnostics segment, Core Laboratory sales decreased 2.8 percent in 2020, excluding the effect of foreign exchange, as the lower volume of routine testing performed in hospital and other laboratories due to COVID-19 was partially offset by sales of Abbott’s COVID-19 laboratory-based tests for the detection of the IgG and IgM antibodies, which determine if someone was previously infected with the virus. Core Laboratory antibody testing-related sales on Abbott’s ARCHITECT and Alinity i platforms were $268 million in 2020. The 225.7 percent increase in Molecular Diagnostics sales in 2020, excluding the effect of foreign exchange, reflects higher volumes due to demand for Abbott’s laboratory-based molecular tests for COVID-19 on its m2000 and Alinity m platforms. Abbott received U.S. FDA approval in March 2020 for its Alinity m molecular diagnostics system. Molecular Diagnostics COVID-19 testing-related sales were $1.023 billion in 2020. +In Rapid Diagnostics, sales increased 112.3 percent in 2020, excluding the effect of foreign exchange, due to strong demand for Abbott’s point-of-care COVID-19 molecular test on its ID NOW platform and its BinaxNOW COVID-19 Ag Card test in the U.S. as well as international demand for COVID-19 rapid tests on its Panbio system and increased testing in the first quarter for the flu in the U.S. These increases were partially offset by the unfavorable impact of COVID-19 on routine diagnostic testing. Rapid Diagnostics COVID-19 testing-related sales were $2.593 billion in 2020. +In the Diagnostics segment, the sales increase in 2019 was driven by above-market growth in Core Laboratory in the U.S. and internationally, where Abbott achieved continued adoption of its Alinity family of diagnostic instruments. The 6.3 percent decrease in 2019 Molecular sales, excluding the effect of foreign exchange, reflects the negative impact of lower non-governmental organization purchases in Africa. In Rapid Diagnostics, sales growth in 2019 in various areas, including infectious disease testing in developed markets and cardio-metabolic testing, was mostly offset by lower than expected infectious disease testing sales in Africa. +Excluding the effect of foreign exchange, total Medical Devices sales decreased 3.8 percent and increased 10.5 percent in 2020 and 2019, respectively. In 2020, double-digit growth in Diabetes Care was more than offset by decreases in Abbott’s cardiovascular and neuromodulation businesses due to the impact of COVID-19 and lower vascular sales in China in the fourth quarter of 2020 as a result of a new national tender program. The 2019 sales increase was driven by double-digit growth in Diabetes Care, Structural Heart, Electrophysiology and Heart Failure. +The 2020 and 2019 growth in Diabetes Care revenue was driven by continued growth of FreeStyle Libre, Abbott’s continuous glucose monitoring system, internationally and in the U.S. In 2020, FreeStyle Libre sales totaled $2.635 billion, which reflected a 42.6 percent increase over 2019, excluding the effect of foreign exchange. FreeStyle Libre sales in 2019 were $1.842 billion, which reflected a 69.8 percent increase, excluding the effect of foreign exchange, over 2018 when sales totaled $1.128 billion. +In 2019, growth in Structural Heart revenue was broad-based across several areas of the business, including MitraClip, Abbott's market-leading device for the minimally invasive treatment of mitral regurgitation (MR), a leaky heart valve. 2019 growth in Electrophysiology revenue reflects higher sales of cardiac diagnostic and ablation catheters in both the U.S. and internationally. The growth in Heart Failure revenue in 2019 was driven by rapid market adoption in the U.S. of Abbott's HeartMate 3 ® Left Ventricular Assist Device (LVAD) following FDA approval in October 2018 as a destination (long-term use) therapy for people living with advanced heart failure as well as higher sales of Abbott’s CardioMEMS ® heart failure monitoring system. In Vascular, excluding the effect of foreign exchange, sales in 2019 were flat as the 1.3 percent increase in coronary and endovascular product sales, which includes drug-eluting stents, balloon catheters, guidewires, vascular imaging/diagnostics products, vessel closure, carotid and other coronary and peripheral products, was offset by reductions in royalty and contract manufacturing revenue. In Rhythm Management, higher 2019 international sales, excluding the effect of foreign exchange, were offset by a 4.4 percent decrease in U.S. revenue. In 2019, the 2.4 percent decline in Neuromodulation sales, excluding the effect of foreign exchange, reflects a 4.2 percent decline in U.S. sales. +Abbott has periodically sold product rights to non-strategic products and has recorded the related gains in net sales in accordance with Abbott’s revenue recognition policies as discussed in Note 1 to the consolidated financial statements. Related net sales were not significant in 2020, 2019 and 2018. +30 +The expiration of licenses and patent protection can affect the future revenues and operating income of Abbott. There are no significant patent or license expirations in the next three years that are expected to materially affect Abbott. +In April 2017, Abbott received a warning letter from the U.S. FDA related to its manufacturing facility in Sylmar, CA which was acquired by Abbott on January 4, 2017 as part of the acquisition of St. Jude Medical, Inc. (St. Jude Medical). This facility manufactures implantable cardioverter defibrillators, cardiac resynchronization therapy defibrillators, and monitors. Abbott prepared and executed a comprehensive plan of corrective actions. On April 28, 2020, Abbott received a letter from the FDA indicating that, based on the FDA’s evaluation, it appeared that Abbott had addressed the items in the warning letter. As a result, the warning letter is considered closed. +Operating Earnings +Gross profit margins were 50.5 percent of net sales in 2020, 52.5 percent in 2019 and 51.3 percent in 2018. In 2020, the decrease primarily reflects the mix of sales across Abbott’s various businesses and operational inefficiencies due to the impact of COVID-19, as well as the increase in intangible asset amortization, the impairment of intangible assets and the unfavorable effect of foreign exchange on gross margin in 2020. In 2019, the increase primarily reflects lower intangible amortization expense and lower integration and restructuring costs. +Research and development (R&D) expenses were $2.4 billion in 2020 and 2019, and $2.3 billion in 2018. R&D spending in 2020 was relatively flat compared to 2019 as the impact of the immediate expensing in 2019 of an R&D asset valued at $102 million that was acquired in conjunction with the acquisition of Cephea Valve Technologies, Inc. (Cephea) was partially offset by the $55 million impairment of an in-process R&D intangible asset in 2020. R&D expense in 2020 also reflects lower integration and restructuring costs in 2020 related to R&D, partially offset by higher spending on various projects. R&D expenses in 2019 increased 6.1 percent, primarily reflecting the immediate expensing of the Cephea R&D asset as well as higher R&D spending in various businesses, primarily in Medical Devices, partially offset by the favorable effect of foreign exchange. In 2020, R&D expenditures totaled $1.3 billion for the Medical Devices segment, $608 million for the Diagnostic Products segment, $189 million for the Nutritional Products segment and $177 million for the Established Pharmaceutical Products segment. +Selling, general and administrative (SG&A) expenses were basically flat in 2020 and 2019 versus the respective prior years. In 2020, the favorable effect of foreign exchange, income of approximately $100 million from a litigation settlement in 2020, lower spending due to COVID-19 travel restrictions, and the impact of various cost saving initiatives were offset by higher spending to drive growth in various businesses. In 2019, the favorable effect of foreign exchange and lower acquisition-related integration costs offset higher selling and marketing costs to drive continued growth across various businesses. +Restructurings +From 2017 to 2020, Abbott management approved restructuring plans as part of the integration of the acquisitions of St. Jude Medical into the Medical Devices segment, and Alere Inc. (Alere) into the Diagnostic Products segment, in order to leverage economies of scale and reduce costs. As of December 31, 2017, the accrued balance associated with these actions was $68 million. From 2018 to 2020, Abbott recorded employee related severance and other charges totaling approximately $137 million, comprised of $13 million in 2020, $72 million in 2019 and $52 million in 2018. Approximately $30 million was recorded in Cost of products sold, approximately $15 million was recorded in Research and development, and approximately $92 million was recorded in Selling, general and administrative expense over the last three years. As of December 31, 2020, the accrued liabilities remaining in the Consolidated Balance Sheet related to these actions total $25 million and primarily represent severance obligations. +From 2016 to 2020, Abbott management approved plans to streamline operations in order to reduce costs and improve efficiencies in various Abbott businesses including the nutritional, established pharmaceuticals and vascular businesses. Abbott recorded employee related severance and other charges of approximately $36 million in 2020, $66 million in 2019 and $28 million in 2018. Approximately $6 million in 2020, $16 million in 2019 and $10 million in 2018 are recorded in Cost of products sold, approximately $2 million in 2020, $28 million in 2019 and $2 million in 2018 are recorded in Research and development, and approximately $28 million in 2020, $22 million in 2019 and $16 million in 2018 are recorded in Selling, general and administrative expense. +31 +Interest Expense and Interest (Income) +Interest expense, net decreased $76 million in 2020 due to a reduction in interest expense resulting from the favorable impact of the euro debt financing in November 2019, the repayment of debt in December 2019 and a lower interest rate environment in 2020. In 2019, interest expense, net decreased $145 million due to the favorable impact of the euro debt financing in September 2018, as well as the repayment of debt in 2018 and the first quarter of 2019. +Debt Extinguishment Costs +On December 19, 2019, Abbott redeemed the $2.850 billion principal amount of its 2.9% Notes due 2021. Abbott incurred a charge of $63 million related to the early repayment of this debt. +On October 28, 2018, Abbott redeemed approximately $4 billion of debt, which included $750 million principal amount of its 2.00% Notes due 2020; $597 million principal amount of its 4.125% Notes due 2020; $900 million principal amount of its 3.25% Notes due 2023; $450 million principal amount of its 3.4% Notes due 2023; and $1.300 billion principal amount of its 3.75% Notes due 2026. Abbott incurred a net charge of $153 million related to the early repayment of this debt and the unwinding of related interest rate swaps. +On March 22, 2018, Abbott redeemed all of the $947 million principal amount of its 5.125% Notes due 2019, as well as $1.055 billion of the $2.850 billion principal amount of its 2.35% Notes due 2019. Abbott incurred a net charge of $14 million related to the early repayment of this debt. +Other (Income) Expense, net +Other (income) expense, net, for 2020, 2019 and 2018 includes approximately $205 million, $225 million, and $160 million of income in each year, respectively, related to the non-service cost components of the net periodic benefit costs associated with the pension and post-retirement medical plans. Other (income) expense, net for 2020 also includes equity investment impairments that totaled approximately $115 million. +Taxes on Earnings +The income tax rates on earnings from continuing operations were 10.0 percent in 2020, 9.6 percent in 2019 and 18.8 percent in 2018. +In 2020, taxes on earnings from continuing operations include the recognition of approximately $170 million of tax benefits associated with the impairment of certain assets, approximately $140 million of net tax benefits as a result of the resolution of various tax positions related to prior years, and approximately $100 million in excess tax benefits associated with share-based compensation. In 2020, taxes on earnings from continuing operations also include a $26 million increase to the transition tax associated with the 2017 Tax Cuts and Jobs Act (TCJA). The $26 million increase to the transition tax liability was the result of the resolution of various tax positions related to prior years. This adjustment increased the cumulative net tax expense related to the TCJA to $1.53 billion. +In 2019, taxes on earnings from continuing operations included approximately $100 million in excess tax benefits associated with share-based compensation, an $86 million reduction of the transition tax and $68 million of tax expense resulting from tax legislation enacted in the fourth quarter of 2019 in India. The $86 million reduction to the transition tax liability was the result of the issuance of final transition tax regulations by the U.S. Department of Treasury in 2019. In 2018, taxes on earnings from continuing operations included $98 million of net tax expense related to the settlement of Abbott’s 2014-2016 federal income tax audit in the U.S., partial settlement of the former St. Jude Medical consolidated group’s 2014 and 2015 federal income tax returns in the U.S. and audit settlements in various countries as well as approximately $90 million in excess tax benefits associated with share-based compensation. In 2018, Abbott also recorded $130 million of additional tax expense related to the TCJA; the $130 million reflected a $120 million increase in the transition tax from $2.89 billion to $3.01 billion and a $10 million reduction in the net benefit related to the remeasurement of deferred tax assets and liabilities. +32 +Exclusive of these discrete items, tax expense was favorably impacted by lower tax rates and tax exemptions on foreign income primarily derived from operations in Puerto Rico, Switzerland, Ireland, the Netherlands, Costa Rica, Singapore, and Malta. Abbott benefits from a combination of favorable statutory tax rules, tax rulings, grants, and exemptions in these tax jurisdictions. See Note 15 to the consolidated financial statements for a full reconciliation of the effective tax rate to the U.S. federal statutory rate. +Discontinued Operations +The net earnings of discontinued operations include income tax benefits of $24 million in 2020 and $39 million in 2018. The 2020 tax benefits primarily relate to the resolution of various tax positions related to Abbott’s developed markets branded generic pharmaceuticals business which was sold to Mylan Inc. (Mylan) in 2015. The tax positions relate to years prior to the sale to Mylan. The 2018 tax benefits primarily relate to the resolution of various tax positions related to the operations of AbbVie Inc. (AbbVie) for years prior to the separation. Abbott completed the separation of AbbVie, which was formed to hold Abbott’s research-based proprietary pharmaceuticals business, in January 2013. Abbott retained all liabilities for all U.S. federal and foreign income taxes on income prior to the separation. +Research and Development Programs +Abbott currently has numerous pharmaceutical, medical devices, diagnostic and nutritional products in development. +Research and Development Process +In the Established Pharmaceuticals segment, the development process focuses on the geographic expansion and continuous improvement of the segment’s existing products to provide benefits to patients and customers. As Established Pharmaceuticals does not actively pursue primary research, development usually begins with work on existing products or after the acquisition of an advanced stage licensing opportunity. +Depending upon the product, the phases of development may include: +● Drug product development. +● Phase I bioequivalence studies to compare a future Established Pharmaceutical’s brand with an already marketed compound with the same active pharmaceutical ingredient (API). +● Phase II studies to test the efficacy of benefits in a small group of patients. +● Phase III studies to broaden the testing to a wider population that reflects the actual medical use. +● Phase IV and other post-marketing studies to obtain new clinical use data on existing products within approved indications. +The specific requirements (e.g., scope of clinical trials) for obtaining regulatory approval vary across different countries and geographic regions. The process may range from one year for a bioequivalence study project to 6 or more years for complex formulations, new indications, or geographic expansion in specific countries, such as China. +In the Diagnostics segment, the phases of the research and development process include: +● Discovery which focuses on identification of a product that will address a specific therapeutic area, platform, or unmet clinical need. +● Concept/Feasibility during which the materials and manufacturing processes are evaluated, testing may include product characterization and analysis is performed to confirm clinical utility. +● Development during which extensive testing is performed to demonstrate that the product meets specified design requirements and that the design specifications conform to user needs and intended uses. +33 +The regulatory requirements for diagnostic products vary across different countries and geographic regions. In the U.S., the FDA classifies diagnostic products into classes (I, II, or III) and the classification determines the regulatory process for approval. While the Diagnostics segment has products in all three classes, the vast majority of its products are categorized as Class I or Class II. Submission of a separate regulatory filing is not required for Class I products. Class II devices typically require pre-market notification to the FDA through a regulatory filing known as a 510(k) submission. Most Class III products are subject to the FDA’s Premarket Approval (PMA) requirements. Other Class III products, such as those used to screen blood, require the submission and approval of a Biological License Application (BLA). +In the European Union (EU), diagnostic products are also categorized into different categories and the regulatory process, which has been governed by the European In Vitro Diagnostic Medical Device Directive, depends upon the category, with certain product categories requiring review and approval by an independent company, known as a Notified Body, before the manufacturer can affix a CE mark to the product to declare conformity to the Directive. Other products only require a self-certification process. In the second quarter of 2017, the EU adopted the new In Vitro Diagnostic Regulation (IVDR) which replaces the existing directive in the EU for in vitro diagnostic products. The IVDR will apply after a five-year transition period and imposes additional premarket and postmarket regulatory requirements on manufacturers of such products. +In the Medical Devices segment, the research and development process begins with research on a specific technology that is evaluated for feasibility and commercial viability. If the research program passes that hurdle, it moves forward into development. The development process includes evaluation, selection and qualification of a product design, completion of applicable clinical trials to test the product’s safety and efficacy, and validation of the manufacturing process to demonstrate its repeatability and ability to consistently meet pre-determined specifications. +Similar to the diagnostic products discussed above, in the U.S., medical devices are classified as Class I, II, or III. Most of Abbott’s medical device products are classified as Class II devices that follow the 510(k) regulatory process or Class III devices that are subject to the PMA process. +In the EU, medical devices are also categorized into different classes and the regulatory process, which has been governed by the European Medical Device Directive and the Active Implantable Medical Device Directive, varies by class. Each product must bear a CE mark to show compliance with the Directive. In the second quarter of 2017, the EU adopted the new Medical Devices Regulation (MDR) which replaces the existing directives in the EU for medical devices and imposes additional premarket and postmarket regulatory requirements on manufacturers of such products. While the MDR was previously adopted to apply after a three year transition period, in 2020 the European Parliament postponed the date of application by one year. +Some products require submission of a design dossier to the appropriate regulatory authority for review and approval prior to CE marking of the device. For other products, the company is required to prepare a technical file which includes testing results and clinical evaluations but can self-certify its ability to apply the CE mark to the product. Outside the U.S. and the EU, the regulatory requirements vary across different countries and regions. +After approval and commercial launch of some medical devices, post-market trials may be conducted either due to a conditional requirement of the regulatory market approval or with the objective of proving product superiority. +In the Nutritional segment, the research and development process generally focuses on identifying and developing ingredients and products that address the nutritional needs of particular populations (e.g., infants and adults) or patients (e.g., people with diabetes). Depending upon the country and/or region, if claims regarding a product’s efficacy will be made, clinical studies typically must be conducted. +In the U.S., the FDA requires that it be notified of proposed new formulations and formulation or packaging changes related to infant formula products. Prior to the launch of an infant formula or product packaging change, the company is required to obtain the FDA’s confirmation that it has no objections to the proposed product or packaging. For other nutritional products, notification or pre-approval from the FDA is not required unless the product includes a new food additive. In some countries, regulatory approval may be required for certain nutritional products, including infant formula and medical nutritional products. +34 +Areas of Focus +In 2021 and beyond, Abbott’s significant areas of therapeutic focus will include the following: +Established Pharmaceuticals — Abbott focuses on building country-specific portfolios made up of high-quality medicines that meet the needs of people in emerging markets. Over the next several years, Abbott plans to expand its product portfolio in key therapeutic areas with the aim of being among the first to launch new off-patent and differentiated medicines. In addition, Abbott continues to expand existing brands into new markets, implement product enhancements that provide value to patients and acquire strategic products and technology through licensing activities. Abbott is also actively working on the further development of several key brands such as Creon™, Duphaston™, Duphalac™ and Influvac™. Depending on the product, the activities focus on development of new data, markets, formulations, delivery systems, or indications. One example includes the launch of Abbott’s quadrivalent influenza vaccination Influvac® Tetra in 12 markets and an expanded indication in 16 markets to cover children, adolescents and young adults from 3 to 17 years old. +Medical Devices — Abbott’s research and development programs focus on: +● Cardiac Rhythm Management – Development of next-generation rhythm management technologies, including advanced communication capabilities and leadless pacing therapies. +● Heart Failure – Continued enhancements to Abbott’s mechanical circulatory support and pulmonary artery pressure systems, including enhanced clinical performance and usability. +● Electrophysiology – Development of next-generation technologies in the areas of ablation, diagnostic, mapping, and visualization and recording. +● Vascular – Development of next-generation technologies for use in coronary and peripheral vascular procedures. +● Structural Heart – Development of minimally-invasive transcatheter and surgical devices for the repair and replacement of heart valves and other structural heart conditions. +● Neuromodulation – Development of additional clinical evidence and next-generation technologies leveraging digital health to improve patient and physician engagement to treat chronic pain, movement disorders and other indications. +● Diabetes Care – Develop enhancements and additional indications for the FreeStyle Libre platform of continuous glucose monitoring products to help patients improve their ability to manage diabetes and for use beyond diabetes. +Nutritionals — Abbott is focusing its research and development spend on platforms that span the pediatric and adult nutrition areas: gastro intestinal/immunity health, brain health, mobility and metabolism, and user experience platforms. Numerous new products that build on advances in these platforms are currently under development, including clinical outcome testing, and are expected to be launched over the coming years. +Core Laboratory Diagnostics — Abbott continues to commercialize its next-generation blood screening, immunoassay, clinical chemistry and hematology systems, along with assays, including a focus on unmet medical need, in various areas including infectious disease, cardiac care, metabolics, and oncology, as well as informatics solutions to help optimize diagnostics laboratory performance and automation solutions to increase efficiency in laboratories. +Molecular Diagnostics — Several new molecular in vitro diagnostic (IVD) tests are in various stages of development and launch. +Rapid Diagnostics — Abbott’s research and development programs focus on the development of diagnostic products for infectious disease, cardiometabolic disease and toxicology. +In addition, the Diagnostics Divisions are pursuing the FDA’s customary regulatory process for various COVID-19 tests for which an EUA was obtained in 2020. +35 +Given the diversity of Abbott’s business, its intention to remain a broad-based health care company and the numerous sources for potential future growth, no individual project is expected to be material to cash flows or results of operations over the next five years. Factors considered included research and development expenses projected to be incurred for the project over the next year relative to Abbott’s total research and development expenses, as well as qualitative factors, such as marketplace perceptions and impact of a new product on Abbott’s overall market position. There were no delays in Abbott’s 2020 research and development activities that are expected to have a material impact on operations. +While the aggregate cost to complete the numerous projects currently in development is expected to be material, the total cost to complete will depend upon Abbott’s ability to successfully finish each project, the rate at which each project advances, and the ultimate timing for completion. Given the potential for significant delays and the risk of failure inherent in the development of medical device, diagnostic and pharmaceutical products and technologies, it is not possible to accurately estimate the total cost to complete all projects currently in development. Abbott plans to manage its portfolio of projects to achieve research and development spending that will be competitive in each of the businesses in which it participates, and such spending is expected to approximate 7.0 percent of total Abbott sales in 2021. Abbott does not regularly accumulate or make management decisions based on the total expenses incurred for a particular development phase in a given period. +Goodwill +At December 31, 2020, goodwill recorded as a result of business combinations totaled $23.7 billion. Goodwill is reviewed for impairment annually in the third quarter or when an event that could result in an impairment occurs, using a quantitative assessment to determine whether it is more likely than not that the fair value of any reporting unit is less than its carrying amount. The income and market approaches are used to calculate the fair value of each reporting unit. The results of the last impairment test indicated that the fair value of each reporting unit was substantially in excess of its carrying value. +Financial Condition +Cash Flow +Net cash from operating activities amounted to $7.9 billion, $6.1 billion and $6.3 billion in 2020, 2019 and 2018, respectively. The increase in Net cash from operating activities in 2020 was primarily due to the favorable cash flow impact of higher segment operating earnings, lower payments related to interest, integration expenses, and restructuring actions, and the proceeds from a litigation settlement partially offset by an increased investment in working capital and higher income tax payments. The decrease in Net cash from operating activities in 2019 was primarily due to an increased investment in working capital, timing of pension contributions relative to 2018 and higher income tax payments, partially offset by the favorable cash flow impact of improved segment operating earnings and lower interest and acquisition-related expenses. +While a significant portion of Abbott’s cash and cash equivalents at December 31, 2020, are reinvested in foreign subsidiaries, Abbott does not expect such reinvestment to affect its liquidity and capital resources. Due to the enactment of the TCJA, if these funds were needed for operations in the U.S., Abbott does not expect to incur significant additional income taxes in the future to repatriate these funds. +Abbott funded $400 million in 2020, $382 million in 2019 and $114 million in 2018 to defined benefit pension plans. Abbott expects pension funding of approximately $410 million in 2021 for its pension plans. Abbott expects annual cash flow from operating activities to continue to exceed Abbott’s capital expenditures and cash dividends. +Debt and Capital +At December 31, 2020, Abbott’s long-term debt rating was A by Standard & Poor’s Corporation and A3 by Moody’s. Abbott expects to maintain an investment grade rating. +36 +Abbott has readily available financial resources, including unused lines of credit that support commercial paper borrowing arrangements and provide Abbott with the ability to borrow up to $5 billion on an unsecured basis. The lines of credit are part of a Five Year Credit Agreement (Revolving Credit Agreement) that Abbott entered into on November 12, 2020. At that time, Abbott also terminated its 2018 revolving credit agreement. There were no outstanding borrowings under the 2018 revolving credit agreement at the time of its termination. Any borrowings under the Revolving Credit Agreement will mature and be payable on November 12, 2025. Any borrowings under the Revolving Credit Agreement will bear interest, at Abbott’s option, based on either a base rate or Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. +In 2020, financing activities related to the issuance and repayment of long-term debt included the following: +● On June 24, 2020, Abbott completed the issuance of $1.3 billion aggregate principal amount of senior notes, consisting of $650 million of its 1.15% Notes due 2028 and $650 million of its 1.40% Notes due 2030. +● On September 28, 2020, Abbott repaid the €1.140 billion outstanding principal amount of its 0.00% Notes due 2020 upon maturity. The repayment equated to approximately $1.3 billion. +As of December 31, 2020, Abbott’s total debt is $18.7 billion. +In 2018 and 2019, Abbott committed to reducing its debt levels which had increased as part of the acquisitions of St. Jude Medical and Alere in 2017. In 2018, net repayments totaled approximately $8.3 billion of debt. +On February 24, 2019, Abbott redeemed the $500 million outstanding principal amount of its 2.80% Notes due 2020. +In September 2019, the board of directors authorized the early redemption of up to $5 billion of outstanding long-term notes. This bond redemption authorization superseded the board’s previous authorization under which $700 million had not yet been redeemed. On December 19, 2019, Abbott redeemed the $2.850 billion outstanding principal amount of its 2.90% Notes due 2021. $2.15 billion of the 2019 $5 billion redemption authorization remains available as of December 31, 2020. +On November 19, 2019, Abbott’s wholly owned subsidiary, Abbott Ireland Financing DAC, completed a euro debt offering of €1.180 billion of long-term debt. The proceeds equated to approximately $1.3 billion. The Notes are guaranteed by Abbott. +On November 21, 2019, Abbott borrowed ¥59.8 billion under a 5-year term loan and designated the yen-denominated loan as a hedge of its net investment in certain foreign subsidiaries. The term loan bears interest at TIBOR plus a fixed spread, and the interest rate is reset quarterly. The proceeds equated to approximately $550 million. +In total, these 2019 transactions resulted in the repayment of approximately of $1.6 billion of debt, net of borrowings. +In September 2014, the board of directors authorized the repurchase of up to $3.0 billion of Abbott’s common shares from time to time. Under the program authorized in 2014, Abbott repurchased 36.2 million shares at a cost of $1.666 billion in 2015, 10.4 million shares at a cost of $408 million in 2016, 1.9 million shares at a cost of $130 million in 2018, 6.3 million shares at a cost of $525 million in 2019, and 1.6 million shares at a cost of $173 million in 2020 for a total of approximately $2.9 billion. In October 2019, the board of directors authorized the repurchase of up to $3 billion of Abbott’s common shares from time to time. The 2019 authorization is in addition to the approximately $100 million unused portion of the share repurchase program authorized in 2014. +On April 27, 2016, the board of directors authorized the issuance and sale for general corporate purposes of up to 75 million common shares that would result in proceeds of up to $3 billion. No shares have been issued under this authorization. +Abbott declared dividends of $1.53 per share in 2020 compared to $1.32 per share in 2019, an increase of approximately 16 percent. Dividends paid were $2.560 billion in 2020 compared to $2.270 billion in 2019. The year-over-year change in dividends paid primarily reflects the impact of the increase in the dividend rate. +37 +Working Capital +Working capital was $8.5 billion at December 31, 2020 and $4.8 billion at December 31, 2019. The increase was due in large part to the higher level of cash and cash equivalents, which was due primarily to the increase in cash generated from operating activities, and the repayment of the current portion of long term debt after the issuance of new long term notes in 2020. Working capital also increased due to the higher levels of accounts receivable and inventory partially offset by an increase in accounts payable associated with the growth of the business. +Abbott monitors the credit worthiness of customers and establishes an allowance that reflects the current estimate of credit losses expected to be incurred over the life of the financial asset. Abbott considers various factors in establishing, monitoring, and adjusting its allowance for doubtful accounts, including the aging of the accounts and aging trends, the historical level of charge-offs, and specific exposures related to particular customers. Abbott also monitors other risk factors and forward-looking information, such as country risk, when determining credit limits for customers and establishing adequate allowances. +Capital Expenditures +Capital expenditures of $2.2 billion in 2020, $1.6 billion in 2019 and $1.4 billion in 2018 were principally for upgrading and expanding manufacturing and research and development facilities and equipment in various segments, investments in information technology, and laboratory instruments placed with customers. The 2020 increase in capital expenditures primarily reflects the building of capacity for the manufacture of COVID-19 diagnostics tests. +Contractual Obligations +The table below summarizes Abbott’s estimated contractual obligations as of December 31, 2020. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Payments Due By Period +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2026 and +(in millions) +Total +2021 +2022 ‑ 2023 +2024 ‑ 2025 +Thereafter +Long‑term debt, including current maturities +​ +$ +18,490 +​ +$ +7 +​ +$ +3,203 +​ +$ +2,802 +​ +$ +12,478 +Interest on debt obligations +​ +9,011 +​ +596 +​ +1,152 +​ +1,024 +​ +6,239 +Operating lease obligations +​ +1,315 +​ +272 +​ +405 +​ +231 +​ +407 +Purchase commitments (a) +​ +4,757 +​ +4,192 +​ +478 +​ +77 +​ +10 +Other long‑term liabilities (b) +​ +3,845 +​ +— +​ +1,959 +​ +1,266 +​ +620 +Total (c) +​ +$ +37,418 +​ +$ +5,067 +​ +$ +7,197 +​ +$ +5,400 +​ +$ +19,754 +(a) Purchase commitments are for purchases made in the normal course of business to meet operational and capital expenditure requirements. +(b) Other long-term liabilities include estimated payments for the transition tax under the TCJA, net of applicable credits. +(c) Net unrecognized tax benefits totaling approximately $740 million are excluded from the table above as Abbott is unable to reasonably estimate the period of cash settlement with the respective taxing authorities on such items. See Note 15 — Taxes on Earnings from Continuing Operations for further details. The company has employee benefit obligations consisting of pensions and other post-employment benefits, including medical and life, which have been excluded from the table. A discussion of the company’s pension and post-retirement plans, including funding matters is included in Note 14 — Post-employment Benefits. +​ +38 +Contingent Obligations +Abbott periodically acquires a business or product rights in which Abbott agrees to pay contingent consideration based on attaining certain thresholds or based on the occurrence of certain events. +Legislative Issues +Abbott’s primary markets are highly competitive and subject to substantial government regulations throughout the world. Abbott expects debate to continue over the availability, method of delivery, and payment for health care products and services. It is not possible to predict the extent to which Abbott or the health care industry in general might be adversely affected by these factors in the future. A more complete discussion of these factors is contained in Item 1, Business, and Item 1A, Risk Factors. +Recently Issued Accounting Standards +In December 2019, the FASB issued Accounting Standards Update (ASU) 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which among other things, eliminates certain exceptions in the current rules regarding the approach for intraperiod tax allocations and the methodology for calculating income taxes in an interim period, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard becomes effective for Abbott in the first quarter of 2021. Adoption of this new standard will not have a material impact on Abbott’s consolidated financial statements. +In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income , which allows companies to reclassify stranded tax effects resulting from the 2017 Tax Cuts and Jobs Act, from Accumulated other comprehensive income (loss) to retained earnings (Earnings employed in the business). Abbott adopted the new standard at the beginning of the fourth quarter of 2018. As a result of the adoption of the new standard, approximately $337 million of stranded tax effects were reclassified from Accumulated other comprehensive income (loss) to Earnings employed in the business. +In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory , which requires the recognition of the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer occurs. Abbott adopted the standard on January 1, 2018, using a modified retrospective approach and recorded a cumulative catch-up adjustment to Earnings employed in the business in the Consolidated Balance Sheet that was not significant. +In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses , which changes the methodology to be used to measure credit losses for certain financial instruments and financial assets, including trade receivables. The new methodology requires the recognition of an allowance that reflects the current estimate of credit losses expected to be incurred over the life of the financial asset. Abbott adopted the standard on January 1, 2020 and recorded a cumulative adjustment that was not significant to Earnings employed in the business in the Consolidated Balance Sheet. +Private Securities Litigation Reform Act of 1995 — A Caution Concerning Forward-Looking Statements +Under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, Abbott cautions investors that any forward-looking statements or projections made by Abbott, including those made in this document, are subject to risks and uncertainties that may cause actual results to differ materially from those projected. Economic, competitive, governmental, technological and other factors that may affect Abbott’s operations are discussed in Item 1A, Risk Factors. +​ +​ +39 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Financial Instruments and Risk Management +Market Price Sensitive Investments +The fair value of equity securities held by Abbott with a readily determinable fair value was approximately $20 million and $11 million as of December 31, 2020 and 2019, respectively. These equity securities are subject to potential changes in fair value. A hypothetical 20 percent decrease in the share prices of these investments would decrease their fair value at December 31, 2020 by approximately $4 million. Changes in the fair value of these securities are recorded in earnings. The fair value of investments in mutual funds that are held in a rabbi trust for the purpose of paying benefits under a deferred compensation plan was approximately $366 million and $346 million as of December 31, 2020 and 2019, respectively. Changes in the fair value of these investments, as well as an offsetting change in the benefit obligation, are recorded in earnings. +Non-Publicly Traded Equity Securities +Abbott holds equity securities that are not traded on public stock exchanges. The carrying value of these investments was $113 million and $158 million as of December 31, 2020 and 2019, respectively. No individual investment is recorded at a value in excess of $15 million. Abbott measures these investments at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. +Interest Rate Sensitive Financial Instruments +At December 31, 2020 and 2019, Abbott had interest rate hedge contracts totaling $2.9 billion to manage its exposure to changes in the fair value of debt. The effect of these hedges is to change the fixed interest rate to a variable rate for the portion of the debt that is hedged. Abbott does not use derivative financial instruments, such as interest rate swaps, to manage its exposure to changes in interest rates for its investment securities. The fair value of long-term debt at December 31, 2020 and 2019 amounted to $22.8 billion and $20.8 billion, respectively (average interest rates of 3.3% as of December 31, 2020 and 2019) with maturities through 2046. At December 31, 2020 and 2019, the fair value of current and long-term investment securities amounted to approximately $1.1 billion and $1.2 billion, respectively. A hypothetical 100-basis point change in the interest rates would not have a material effect on cash flows, income or fair values. +Foreign Currency Sensitive Financial Instruments +Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts are designated as cash flow hedges of the variability of the cash flows due to changes in foreign currency exchange rates and are marked-to-market with the resulting gains or losses reflected in Accumulated other comprehensive income (loss). Gains or losses will be included in Cost of products sold at the time the products are sold, generally within the next twelve to eighteen months. At December 31, 2020 and 2019, Abbott held $8.1 billion and $6.8 billion, respectively, of such contracts. Contracts held at December 31, 2020 will mature in 2021 or 2022 depending upon the contract. Contracts held at December 31, 2019 matured in 2020 or will mature in 2021 depending upon the contract. +Abbott enters into foreign currency forward exchange contracts to manage its exposure to foreign currency denominated intercompany loans and trade payables and third-party trade payables and receivables. The contracts are marked-to-market, and resulting gains or losses are reflected in income and are generally offset by losses or gains on the foreign currency exposure being managed. At December 31, 2020 and 2019, Abbott held $11.0 billion and $9.1 billion, respectively, of such contracts, which mature in the next 13 months. +40 +In November 2019, Abbott borrowed ¥59.8 billion under a 5-year term loan and designated the yen-denominated loan as a hedge of the net investment in certain foreign subsidiaries. The proceeds equated to approximately $550 million. The value of this long-term debt was approximately $577 million and $546 million as of December 31, 2020 and December 31, 2019, respectively. The change in the value of the debt, which is due to changes in foreign exchange rates, was recorded in Accumulated other comprehensive income (loss), net of tax. +The following table reflects the total foreign currency forward exchange contracts outstanding at December 31, 2020 and 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +​ +2019 +​ +​ +​ +Weighted +Fair and +​ +​ +Weighted +Fair and +​ +​ +​ +​ +​ +Average +​ +Carrying Value +​ +​ +​ +​ +Average +​ +Carrying Value +​ +​ +Contract +​ +Exchange +​ +Receivable/ +​ +Contract +​ +Exchange +​ +Receivable/ +(dollars in millions) +​ +Amount +​ +Rate +​ +(Payable) +​ +Amount +​ +Rate +​ +(Payable) +Primarily U.S. Dollars to be exchanged for the following currencies: +​ +​ +​ +​ +Euro +​ +$ +7,781 +1.1821 +​ +$ +(91) +​ +$ +7,085 +1.1189 +​ +$ +65 +Chinese Yuan +​ +2,401 +6.4900 +​ +(99) +​ +2,177 +7.0216 +​ +4 +Japanese Yen +​ +1,589 +105.3861 +​ +(20) +​ +1,092 +106.8530 +​ +13 +All other currencies +​ +7,369 +n/a +​ +(198) +​ +5,532 +n/a +​ +(23) +Total +​ +$ +19,140 +​ +​ +$ +(408) +​ +$ +15,886 +​ +$ +59 +​ +​ +​ +41 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +​ +​ +Page +Consolidated Statement of Earnings +​ +43 +Consolidated Statement of Comprehensive Income +​ +44 +Consolidated Statement of Cash Flows +​ +45 +Consolidated Balance Sheet +​ +46 +Consolidated Statement of Shareholders’ Investment +​ +48 +Notes to Consolidated Financial Statements +​ +49 +Management Report on Internal Control Over Financial Reporting +​ +81 +Report of Independent Registered Public Accounting Firm +​ +82 +Report of Independent Registered Public Accounting Firm +​ +84 +​ +​ +​ +42 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Earnings +(in millions except per share data) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2020 +2019 +2018 +Net Sales +​ +$ +34,608 +​ +$ +31,904 +​ +$ +30,578 +Cost of products sold, excluding amortization of intangible assets +​ +15,003 +​ +13,231 +​ +12,706 +Amortization of intangible assets +​ +2,132 +​ +1,936 +​ +2,178 +Research and development +​ +2,420 +​ +2,440 +​ +2,300 +Selling, general and administrative +​ +9,696 +​ +9,765 +​ +9,744 +Total Operating Cost and Expenses +​ +29,251 +​ +27,372 +​ +26,928 +Operating Earnings +​ +5,357 +​ +4,532 +​ +3,650 +Interest expense +​ +546 +​ +670 +​ +826 +Interest income +​ +( 46 ) +​ +( 94 ) +​ +( 105 ) +Net foreign exchange (gain) loss +​ +( 8 ) +​ +7 +​ +28 +Debt extinguishment costs +​ +​ +— +​ +​ +63 +​ +​ +167 +Other (income) expense, net +​ +( 103 ) +​ +( 191 ) +​ +( 139 ) +Earnings from Continuing Operations Before Taxes +​ +4,968 +​ +4,077 +​ +2,873 +Taxes on Earnings from Continuing Operations +​ +497 +​ +390 +​ +539 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings from Continuing Operations +​ +4,471 +​ +3,687 +​ +2,334 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Earnings from Discontinued Operations, net of taxes +​ +​ +24 +​ +​ +— +​ +​ +34 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Earnings +​ +$ +4,495 +​ +$ +3,687 +​ +$ +2,368 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Common Share -- +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing Operations +​ +$ +2.51 +​ +$ +2.07 +​ +$ +1.32 +Discontinued Operations +​ +0.01 +​ +— +​ +0.02 +Net Earnings +​ +$ +2.52 +​ +$ +2.07 +​ +$ +1.34 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diluted Earnings Per Common Share -- +​ +​ +​ +​ +​ +​ +​ +​ +​ +Continuing Operations +​ +$ +2.49 +​ +$ +2.06 +​ +$ +1.31 +Discontinued Operations +​ +0.01 +​ +— +​ +0.02 +Net Earnings +​ +$ +2.50 +​ +$ +2.06 +​ +$ +1.33 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share +​ +1,773 +​ +1,768 +​ +1,758 +Dilutive Common Stock Options +​ +13 +​ +13 +​ +12 +Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options +​ +1,786 +​ +1,781 +​ +1,770 +Outstanding Common Stock Options Having No Dilutive Effect +​ +​ +9 +​ +61 +​ +— +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +43 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Comprehensive Income +(in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2020 +2019 +2018 +Net Earnings +​ +$ +4,495 +​ +$ +3,687 +​ +$ +2,368 +Foreign currency translation gain (loss) adjustments +​ +65 +​ +( 12 ) +​ +( 1,460 ) +Net actuarial gains (losses) and prior service cost and credits and amortization of net actuarial losses and prior service cost and credits, net of taxes of $( 79 ) in 2020, $( 238 ) in 2019 and $ 47 in 2018 +​ +( 331 ) +​ +( 814 ) +​ +132 +Net (losses) gains on derivative instruments designated as cash flow hedges, net of taxes of $( 87 ) in 2020, $( 17 ) in 2019 and $ 50 in 2018 +​ +( 215 ) +​ +( 53 ) +​ +136 +Other Comprehensive Income (Loss) +​ +( 481 ) +​ +( 879 ) +​ +( 1,192 ) +Comprehensive Income +​ +$ +4,014 +​ +$ +2,808 +​ +$ +1,176 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Accumulated Other Comprehensive Income (Loss) Information, net of tax as of December 31: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cumulative foreign currency translation (loss) adjustments +​ +$ +( 4,859 ) +​ +$ +( 4,924 ) +​ +$ +( 4,912 ) +Net actuarial (losses) and prior service (cost) and credits +​ +( 3,871 ) +​ +( 3,540 ) +​ +( 2,726 ) +Cumulative (losses) gains on derivative instruments designated as cash flow hedges +​ +( 216 ) +​ +( 1 ) +​ +52 +Accumulated other comprehensive income (loss) +​ +$ +( 8,946 ) +​ +$ +( 8,465 ) +​ +$ +( 7,586 ) +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +44 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Cash Flows +(in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2020 +2019 +2018 +Cash Flow From (Used in) Operating Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net earnings +​ +$ +4,495 +​ +$ +3,687 +​ +$ +2,368 +Adjustments to reconcile earnings to net cash from operating activities - +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation +​ +1,195 +​ +1,078 +​ +1,100 +Amortization of intangible assets +​ +2,132 +​ +1,936 +​ +2,178 +Share-based compensation +​ +546 +​ +519 +​ +477 +Amortization of inventory step-up +​ +​ +— +​ +​ +— +​ +​ +32 +Investing and financing losses, net +​ +​ +425 +​ +​ +184 +​ +​ +126 +Loss on extinguishment of debt +​ +​ +— +​ +​ +63 +​ +​ +167 +Trade receivables +​ +( 924 ) +​ +( 275 ) +​ +( 190 ) +Inventories +​ +( 493 ) +​ +( 593 ) +​ +( 514 ) +Prepaid expenses and other assets +​ +( 627 ) +​ +( 138 ) +​ +23 +Trade accounts payable and other liabilities +​ +1,766 +​ +220 +​ +747 +Income taxes +​ +( 614 ) +​ +( 545 ) +​ +( 214 ) +Net Cash From Operating Activities +​ +​ +7,901 +​ +​ +6,136 +​ +​ +6,300 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flow From (Used in) Investing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Acquisitions of property and equipment +​ +( 2,177 ) +​ +( 1,638 ) +​ +( 1,394 ) +Acquisitions of businesses and technologies, net of cash acquired +​ +( 42 ) +​ +( 170 ) +​ +( 54 ) +Proceeds from business dispositions +​ +​ +58 +​ +​ +48 +​ +​ +48 +Purchases of investment securities +​ +( 83 ) +​ +( 103 ) +​ +( 131 ) +Proceeds from sales of investment securities +​ +10 +​ +21 +​ +73 +Other +​ +19 +​ +27 +​ +102 +Net Cash From (Used in) Investing Activities +​ +( 2,215 ) +​ +( 1,815 ) +​ +( 1,356 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flow From (Used in) Financing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Proceeds from issuance of (repayments of) short-term debt, net and other +​ +2 +​ +— +​ +( 26 ) +Proceeds from issuance of long-term debt and debt with maturities over 3 months +​ +1,281 +​ +1,842 +​ +4,009 +Repayments of long-term debt and debt with maturities over 3 months +​ +( 1,333 ) +​ +( 3,441 ) +​ +( 12,433 ) +Purchases of common shares +​ +( 403 ) +​ +( 718 ) +​ +( 238 ) +Proceeds from stock options exercised +​ +245 +​ +298 +​ +271 +Dividends paid +​ +( 2,560 ) +​ +( 2,270 ) +​ +( 1,974 ) +Other +​ +​ +( 11 ) +​ +​ +— +​ +​ +— +Net Cash From (Used in) Financing Activities +​ +( 2,779 ) +​ +( 4,289 ) +​ +( 10,391 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Effect of exchange rate changes on cash and cash equivalents +​ +71 +​ +( 16 ) +​ +( 116 ) +Net Increase (Decrease) in Cash and Cash Equivalents +​ +2,978 +​ +16 +​ +( 5,563 ) +Cash and Cash Equivalents, Beginning of Year +​ +3,860 +​ +3,844 +​ +9,407 +Cash and Cash Equivalents, End of Year +​ +$ +6,838 +​ +$ +3,860 +​ +$ +3,844 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Cash Flow Information: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Income taxes paid +​ +$ +970 +​ +$ +930 +​ +$ +740 +Interest paid +​ +549 +​ +677 +​ +845 +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +45 +Abbott Laboratories and Subsidiaries +Consolidated Balance Sheet +(dollars in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31 +​ +2020 +2019 +Assets +​ +​ +​ +​ +​ +​ +Current assets: +​ +​ +​ +​ +​ +​ +Cash and cash equivalents +​ +$ +6,838 +​ +$ +3,860 +Investments, primarily bank time deposits and U.S. treasury bills +​ +310 +​ +280 +Trade receivables, less allowances of — 2020: $ 460 ; 2019: $ 384 +​ +6,414 +​ +5,425 +Inventories: +​ +​ +​ +​ +​ +​ +Finished products +​ +3,030 +​ +2,784 +Work in process +​ +712 +​ +560 +Materials +​ +1,270 +​ +972 +Total inventories +​ +5,012 +​ +4,316 +Other prepaid expenses and receivables +​ +1,867 +​ +1,786 +Total current assets +​ +20,441 +​ +15,667 +Investments +​ +821 +​ +883 +Property and equipment, at cost: +​ +​ +​ +​ +​ +​ +Land +​ +538 +​ +519 +Buildings +​ +4,014 +​ +3,702 +Equipment +​ +12,884 +​ +11,468 +Construction in progress +​ +1,357 +​ +1,110 +​ +​ +18,793 +​ +16,799 +Less: accumulated depreciation and amortization +​ +9,764 +​ +8,761 +Net property and equipment +​ +9,029 +​ +8,038 +Intangible assets, net of amortization +​ +14,784 +​ +17,025 +Goodwill +​ +23,744 +​ +23,195 +Deferred income taxes and other assets +​ +3,729 +​ +3,079 +​ +​ +$ +72,548 +​ +$ +67,887 +​ +​ +46 +Abbott Laboratories and Subsidiaries +Consolidated Balance Sheet +(dollars in millions) +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31 +​ +2020 +2019 +Liabilities and Shareholders’ Investment +​ +​ +​ +​ +​ +​ +Current liabilities: +​ +​ +​ +​ +​ +​ +Short-term borrowings +​ +$ +213 +​ +$ +201 +Trade accounts payable +​ +3,946 +​ +3,252 +Salaries, wages and commissions +​ +1,416 +​ +1,237 +Other accrued liabilities +​ +5,165 +​ +4,035 +Dividends payable +​ +798 +​ +635 +Income taxes payable +​ +362 +​ +226 +Current portion of long-term debt +​ +7 +​ +1,277 +Total current liabilities +​ +11,907 +​ +10,863 +Long-term debt +​ +18,527 +​ +16,661 +Post-employment obligations and other long-term liabilities +​ +9,111 +​ +9,062 +Commitments and contingencies +​ +​ +​ +​ +​ +​ +Shareholders’ investment: +​ +​ +​ +​ +​ +​ +Preferred shares, one dollar par value Authorized — 1,000,000 shares, none issued +​ +— +​ +— +Common shares, without par value Authorized — 2,400,000,000 shares +Issued at stated capital amount — Shares: 2020: 1,981,156,896 ; 2019: 1,976,855,085 +​ +24,145 +​ +23,853 +Common shares held in treasury, at cost — Shares: 2020: 209,926,622 ; 2019: 214,351,838 +​ +( 10,042 ) +​ +( 10,147 ) +Earnings employed in the business +​ +27,627 +​ +25,847 +Accumulated other comprehensive income (loss) +​ +( 8,946 ) +​ +( 8,465 ) +Total Abbott Shareholders’ Investment +​ +32,784 +​ +31,088 +Noncontrolling interests in subsidiaries +​ +219 +​ +213 +Total Shareholders’ Investment +​ +33,003 +​ +31,301 +​ +​ +$ +72,548 +​ +$ +67,887 +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +47 +Abbott Laboratories and Subsidiaries +Consolidated Statement of Shareholders’ Investment +(in millions except shares and per share data) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31 +​ +2020 +2019 +2018 +Common Shares: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 1,976,855,085 ; 2019: 1,971,189,465 ; 2018: 1,965,908,188 +​ +$ +23,853 +​ +$ +23,512 +​ +$ +23,206 +Issued under incentive stock programs +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 4,301,811 ; 2019: 5,665,620 ; 2018: 5,281,277 +​ +181 +​ +209 +​ +163 +Share-based compensation +​ +​ +548 +​ +​ +521 +​ +​ +479 +Issuance of restricted stock awards +​ +​ +( 437 ) +​ +​ +( 389 ) +​ +​ +( 336 ) +End of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 1,981,156,896 ; 2019: 1,976,855,085 ; 2018: 1,971,189,465 +​ +$ +24,145 +​ +$ +23,853 +​ +$ +23,512 +Common Shares Held in Treasury: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 214,351,838 ; 2019: 215,570,043 ; 2018: 222,305,719 +​ +$ +( 10,147 ) +​ +$ +( 9,962 ) +​ +$ +( 10,225 ) +Issued under incentive stock programs +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 6,290,757 ; 2019: 7,796,030 ; 2018: 8,870,735 +​ +298 +​ +361 +​ +408 +Purchased +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 1,865,541 ; 2019: 6,577,825 ; 2018: 2,135,059 +​ +​ +( 193 ) +​ +​ +( 546 ) +​ +​ +( 145 ) +End of Year +​ +​ +​ +​ +​ +​ +​ +​ +​ +Shares: 2020: 209,926,622 ; 2019: 214,351,838 ; 2018: 215,570,043 +​ +$ +( 10,042 ) +​ +$ +( 10,147 ) +​ +$ +( 9,962 ) +Earnings Employed in the Business: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +$ +25,847 +​ +$ +24,560 +​ +$ +23,978 +Impact of adoption of new accounting standards +​ +​ +( 5 ) +​ +​ +— +​ +​ +351 +Net earnings +​ +​ +4,495 +​ +​ +3,687 +​ +​ +2,368 +Cash dividends declared on common shares (per share — 2020: $ 1.53 ; 2019: $ 1.32 ; +2018: $ 1.16 ) +​ +( 2,722 ) +​ +( 2,343 ) +​ +( 2,047 ) +Effect of common and treasury share transactions +​ +12 +​ +( 57 ) +​ +( 90 ) +End of Year +​ +$ +27,627 +​ +$ +25,847 +​ +$ +24,560 +Accumulated Other Comprehensive Income (Loss): +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +$ +( 8,465 ) +​ +$ +( 7,586 ) +​ +$ +( 6,062 ) +Impact of adoption of new accounting standards +​ +​ +— +​ +​ +— +​ +​ +( 332 ) +Other comprehensive income (loss) +​ +( 481 ) +​ +( 879 ) +​ +( 1,192 ) +End of Year +​ +$ +( 8,946 ) +​ +$ +( 8,465 ) +​ +$ +( 7,586 ) +Noncontrolling Interests in Subsidiaries: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Beginning of Year +​ +$ +213 +​ +$ +198 +​ +$ +201 +Noncontrolling Interests’ share of income, business combinations, net of distributions and share repurchases +​ +6 +​ +15 +​ +( 3 ) +End of Year +​ +$ +219 +​ +$ +213 +​ +$ +198 +​ +The accompanying notes to consolidated financial statements are an integral part of this statement. +​ +​ +48 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements +Note 1 — Summary of Significant Accounting Policies +NATURE OF BUSINESS — Abbott’s principal business is the discovery, development, manufacture and sale of a broad line of health care products. +BASIS OF CONSOLIDATION — The consolidated financial statements include the accounts of the parent company and subsidiaries, after elimination of intercompany transactions. +USE OF ESTIMATES — The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States and necessarily include amounts based on estimates and assumptions by management. Actual results could differ from those amounts. Significant estimates include amounts for sales rebates, income taxes, pension and other post-employment benefits, valuation of intangible assets, litigation, derivative financial instruments, and inventory and accounts receivable exposures. +FOREIGN CURRENCY TRANSLATION — The statements of earnings of foreign subsidiaries whose functional currencies are other than the U.S. dollar are translated into U.S. dollars using average exchange rates for the period. The net assets of foreign subsidiaries whose functional currencies are other than the U.S. dollar are translated into U.S. dollars using exchange rates as of the balance sheet date. The U.S. dollar effects that arise from translating the net assets of these subsidiaries at changing rates are recorded in the foreign currency translation adjustment account, which is included in equity as a component of Accumulated other comprehensive income (loss). Transaction gains and losses are recorded on the Net foreign exchange (gain) loss line of the Consolidated Statement of Earnings. +REVENUE RECOGNITION — Revenue from product sales is recognized upon the transfer of control, which is generally upon shipment or delivery, depending on the delivery terms set forth in the customer contract. Provisions for discounts, rebates and sales incentives to customers, and returns and other adjustments are provided for in the period the related sales are recorded. Sales incentives to customers are not material. Historical data is readily available and reliable, and is used for estimating the amount of the reduction in gross sales. Revenue from the launch of a new product, from an improved version of an existing product, or for shipments in excess of a customer’s normal requirements are recorded when the conditions noted above are met. In those situations, management records a returns reserve for such revenue, if necessary. In certain of Abbott’s businesses, primarily within diagnostics, Abbott participates in selling arrangements that include multiple performance obligations (e.g., instruments, reagents, procedures, and service agreements). The total transaction price of the contract is allocated to each performance obligation in an amount based on the estimated relative standalone selling prices of the promised goods or services underlying each performance obligation. Sales of product rights for marketable products are recorded as revenue upon disposition of the rights. +INCOME TAXES — Deferred income taxes are provided for the tax effect of differences between the tax bases of assets and liabilities and their reported amounts in the financial statements at the enacted statutory rate to be in effect when the taxes are paid. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the transition tax related to the U.S. Tax Cuts and Jobs Act (TCJA), or any additional outside basis differences that exist, as these amounts continue to be indefinitely reinvested in foreign operations. Effective for fiscal years beginning after December 31, 2017, the TCJA subjects taxpayers to tax on global intangible low-taxed income (GILTI) earned by certain foreign subsidiaries. Abbott treats the GILTI tax as a period expense and provides for the tax in the year that the tax is incurred. Interest and penalties on income tax obligations are included in taxes on earnings. +EARNINGS PER SHARE — Unvested restricted stock units and awards that contain non-forfeitable rights to dividends are treated as participating securities and are included in the computation of earnings per share under the two-class method. Under the two-class method, net earnings are allocated between common shares and participating securities. Earnings from Continuing Operations allocated to common shares in 2020, 2019 and 2018 were $ 4.449 billion, $ 3.666 billion and $ 2.320 billion, respectively. Net earnings allocated to common shares in 2020, 2019 and 2018 were $ 4.473 billion, $ 3.666 billion and $ 2.353 billion, respectively. +​ +49 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +PENSION AND POST-EMPLOYMENT BENEFITS — Abbott accrues for the actuarially determined cost of pension and post-employment benefits over the service attribution periods of the employees. Abbott must develop long-term assumptions, the most significant of which are the health care cost trend rates, discount rates and the expected return on plan assets. Differences between the expected long-term return on plan assets and the actual return are amortized over a five-year period. Actuarial losses and gains are amortized over the remaining service attribution periods of the employees under the corridor method. +FAIR VALUE MEASUREMENTS — For assets and liabilities that are measured using quoted prices in active markets, total fair value is the published market price per unit multiplied by the number of units held without consideration of transaction costs. Assets and liabilities that are measured using significant other observable inputs are valued by reference to similar assets or liabilities, adjusted for contract restrictions and other terms specific to that asset or liability. For these items, a significant portion of fair value is derived by reference to quoted prices of similar assets or liabilities in active markets. For all remaining assets and liabilities, fair value is derived using a fair value model, such as a discounted cash flow model or Black-Scholes model. Purchased intangible assets are recorded at fair value. The fair value of significant purchased intangible assets is based on independent appraisals. Abbott uses a discounted cash flow model to value intangible assets. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, the cost of capital, terminal values and market participants. Intangible assets are reviewed for impairment on a quarterly basis. Goodwill and indefinite-lived intangible assets are tested for impairment at least annually. +SHARE-BASED COMPENSATION — The fair value of stock options and restricted stock awards and units are amortized over their requisite service period, which could be shorter than the vesting period if an employee is retirement eligible, with a charge to compensation expense. +LITIGATION — Abbott accounts for litigation losses in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) No. 450, “Contingencies.” Under ASC No. 450, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. Legal fees are recorded as incurred. +CASH, CASH EQUIVALENTS AND INVESTMENTS — Cash equivalents consist of bank time deposits, U.S. government securities money market funds and U.S. treasury bills with original maturities of three months or less. Abbott holds certain investments with a carrying value of $ 277 million that are accounted for under the equity method of accounting. Investments held in a rabbi trust and investments in publicly traded equity securities are recorded at fair value and changes in fair value are recorded in earnings. Investments in equity securities that are not traded on public stock exchanges are recorded at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. Investments in debt securities are classified as held-to-maturity, as management has both the intent and ability to hold these securities to maturity, and are reported at cost, net of any unamortized premium or discount. Income relating to these securities is reported as interest income. +TRADE RECEIVABLE VALUATIONS — Accounts receivable are stated at the net amount expected to be collected. The allowance for doubtful accounts reflects the current estimate of credit losses expected to be incurred over the life of the accounts receivable. Abbott considers various factors in establishing, monitoring, and adjusting its allowance for doubtful accounts, including the aging of the accounts and aging trends, the historical level of charge-offs, and specific exposures related to particular customers. Abbott also monitors other risk factors and forward-looking information, such as country risk, when determining credit limits for customers and establishing adequate allowances. Accounts receivable are charged off after all reasonable means to collect the full amount (including litigation, where appropriate) have been exhausted. +INVENTORIES — Inventories are stated at the lower of cost (first-in, first-out basis) or net realizable value. Cost includes material and conversion costs. +​ +50 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 1 — Summary of Significant Accounting Policies (Continued) +PROPERTY AND EQUIPMENT — Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. The following table shows estimated useful lives of property and equipment: +​ +​ +​ +​ +Classification +Estimated Useful Lives +Buildings +10 to 50 years +Equipment +2 to 20 years +​ +PRODUCT LIABILITY — Abbott accrues for product liability claims when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated based on existing information. The liabilities are adjusted quarterly as additional information becomes available. Product liability losses are self-insured. +RESEARCH AND DEVELOPMENT COSTS — Internal research and development costs are expensed as incurred. Clinical trial costs incurred by third parties are expensed as the contracted work is performed. Where contingent milestone payments are due to third parties under research and development arrangements, the milestone payment obligations are expensed when the milestone results are achieved. +ACQUIRED IN-PROCESS AND COLLABORATIONS RESEARCH AND DEVELOPMENT (IPR&D) — The initial costs of rights to IPR&D projects obtained in an asset acquisition are expensed as IPR&D unless the project has an alternative future use. These costs include initial payments incurred prior to regulatory approval in connection with research and development collaboration agreements that provide rights to develop, manufacture, market and/or sell pharmaceutical or medical device products. The fair value of IPR&D projects acquired in a business combination are capitalized and accounted for as indefinite-lived intangible assets until completed and are then amortized over the remaining useful life. Collaborations are not significant. +CONCENTRATION OF RISK AND GUARANTEES — Due to the nature of its operations, Abbott is not subject to significant concentration risks relating to customers, products or geographic locations. Product warranties are not significant. +Abbott has no material exposures to off-balance sheet arrangements; no special purpose entities; nor activities that include non-exchange-traded contracts accounted for at fair value. Abbott periodically acquires a business or product rights in which Abbott agrees to pay contingent consideration based on attaining certain thresholds or based on the occurrence of certain events. +​ +​ +Note 2 – New Accounting Standards +Recently Adopted Accounting Standards +In February 2018, the FASB issued Accounting Standards Update (ASU) 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income , which allows companies to reclassify stranded tax effects resulting from the 2017 Tax Cuts and Jobs Act, from Accumulated other comprehensive income (loss) to retained earnings (Earnings employed in the business). Abbott adopted the new standard at the beginning of the fourth quarter of 2018. As a result of the adoption of the new standard, approximately $ 337 million of stranded tax effects were reclassified from Accumulated other comprehensive income (loss) to Earnings employed in the business. +​ +51 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 2 — New Accounting Standards (Continued) +In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory , which requires the recognition of the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer occurs. Abbott adopted the standard on January 1, 2018, using a modified retrospective approach and recorded a cumulative catch-up adjustment to Earnings employed in the business in the Consolidated Balance Sheet that was not significant. +In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses , which changes the methodology to be used to measure credit losses for certain financial instruments and financial assets, including trade receivables. The new methodology requires the recognition of an allowance that reflects the current estimate of credit losses expected to be incurred over the life of the financial asset. Abbott adopted the standard on January 1, 2020 and recorded a cumulative adjustment that was not significant to Earnings employed in the business in the Consolidated Balance Sheet. +Recent Accounting Standards Not Yet Adopted +In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes , which among other things, eliminates certain exceptions in the current rules regarding the approach for intraperiod tax allocations and the methodology for calculating income taxes in an interim period, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard becomes effective for Abbott in the first quarter of 2021. Adoption of this new standard will not have a material impact on Abbott’s consolidated financial statements. +​ +Note 3 — Revenue +Abbott’s revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent protection and licenses, technological and performance features, and inclusion of Abbott’s products under a contract most impact which products are sold; price controls, competition and rebates most impact the net selling prices of products; and foreign currency translation impacts the measurement of net sales and costs. Abbott's products are generally sold directly to retailers, wholesalers, distributors, hospitals, health care facilities, laboratories, physicians' offices and government agencies throughout the world. Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. +​ +52 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +The following tables provide detail by sales category: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +​ +2019 +​ +2018 +(in millions) +U.S. +Int’l +Total +U.S. +Int’l +Total +U.S. +Int’l +Total +Established Pharmaceutical Products — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Key Emerging Markets +​ +$ +— +​ +$ +3,209 +​ +$ +3,209 +​ +$ +— +​ +$ +3,392 +​ +$ +3,392 +​ +$ +— +​ +$ +3,363 +​ +$ +3,363 +Other +​ +— +​ +1,094 +​ +1,094 +​ +— +​ +1,094 +​ +1,094 +​ +​ +— +​ +​ +1,059 +​ +​ +1,059 +Total +​ +— +​ +4,303 +​ +4,303 +​ +— +​ +4,486 +​ +4,486 +​ +​ +— +​ +​ +4,422 +​ +​ +4,422 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Nutritionals — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pediatric Nutritionals +​ +1,987 +​ +2,140 +​ +4,127 +​ +1,879 +​ +2,282 +​ +4,161 +​ +​ +1,843 +​ +​ +2,254 +​ +​ +4,097 +Adult Nutritionals +​ +1,292 +​ +2,228 +​ +3,520 +​ +1,231 +​ +2,017 +​ +3,248 +​ +​ +1,232 +​ +​ +1,900 +​ +​ +3,132 +Total +​ +3,279 +​ +4,368 +​ +7,647 +​ +3,110 +​ +4,299 +​ +7,409 +​ +​ +3,075 +​ +​ +4,154 +​ +​ +7,229 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Diagnostics — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Core Laboratory +​ +1,166 +​ +3,309 +​ +4,475 +​ +1,086 +​ +3,570 +​ +4,656 +​ +​ +985 +​ +​ +3,401 +​ +​ +4,386 +Molecular +​ +621 +​ +817 +​ +1,438 +​ +149 +​ +293 +​ +442 +​ +​ +152 +​ +​ +332 +​ +​ +484 +Point of Care +​ +369 +​ +147 +​ +516 +​ +438 +​ +123 +​ +561 +​ +​ +432 +​ +​ +121 +​ +​ +553 +Rapid Diagnostics +​ +2,618 +​ +1,758 +​ +4,376 +​ +1,214 +​ +840 +​ +2,054 +​ +​ +1,148 +​ +​ +924 +​ +​ +2,072 +Total +​ +4,774 +​ +6,031 +​ +10,805 +​ +2,887 +​ +4,826 +​ +7,713 +​ +​ +2,717 +​ +​ +4,778 +​ +​ +7,495 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical Devices — +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Rhythm Management +​ +903 +​ +1,011 +​ +1,914 +​ +1,057 +​ +1,087 +​ +2,144 +​ +​ +1,105 +​ +​ +1,093 +​ +​ +2,198 +Electrophysiology +​ +660 +​ +918 +​ +1,578 +​ +742 +​ +979 +​ +1,721 +​ +​ +678 +​ +​ +883 +​ +​ +1,561 +Heart Failure +​ +547 +​ +193 +​ +740 +​ +574 +​ +195 +​ +769 +​ +​ +467 +​ +​ +179 +​ +​ +646 +Vascular +​ +853 +​ +1,486 +​ +2,339 +​ +1,047 +​ +1,803 +​ +2,850 +​ +​ +1,126 +​ +​ +1,803 +​ +​ +2,929 +Structural Heart +​ +540 +​ +707 +​ +1,247 +​ +616 +​ +784 +​ +1,400 +​ +​ +488 +​ +​ +751 +​ +​ +1,239 +Neuromodulation +​ +564 +​ +138 +​ +702 +​ +660 +​ +171 +​ +831 +​ +​ +690 +​ +​ +174 +​ +​ +864 +Diabetes Care +​ +​ +864 +​ +​ +2,403 +​ +​ +3,267 +​ +​ +678 +​ +​ +1,846 +​ +​ +2,524 +​ +​ +457 +​ +​ +1,476 +​ +​ +1,933 +Total +​ +4,931 +​ +6,856 +​ +11,787 +​ +5,374 +​ +6,865 +​ +12,239 +​ +​ +5,011 +​ +​ +6,359 +​ +​ +11,370 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other +​ +38 +​ +28 +​ +66 +​ +27 +​ +30 +​ +57 +​ +​ +36 +​ +​ +26 +​ +​ +62 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +$ +13,022 +​ +$ +21,586 +​ +$ +34,608 +​ +$ +11,398 +​ +$ +20,506 +​ +$ +31,904 +​ +$ +10,839 +​ +$ +19,739 +​ +$ +30,578 +​ +Abbott recognizes revenue from product sales upon the transfer of control, which is generally upon shipment or delivery, depending on the delivery terms set forth in the customer contract. For maintenance agreements that provide service beyond Abbott’s standard warranty and other service agreements, revenue is recognized ratably over the contract term. A time-based measure of progress appropriately reflects the transfer of services to the customer. Payment terms between Abbott and its customers vary by the type of customer, country of sale, and the products or services offered. The term between invoicing and the payment due date is not significant. +​ +53 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +Management exercises judgment in estimating variable consideration. Provisions for discounts, rebates and sales incentives to customers, and returns and other adjustments are provided for in the period the related sales are recorded. Sales incentives to customers are not material. Historical data is readily available and reliable, and is used for estimating the amount of the reduction in gross sales. Abbott provides rebates to government agencies, wholesalers, group purchasing organizations and other private entities. +Rebate amounts are usually based upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of which products have been sold subject to a rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current changes, Abbott estimates the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate generally occurs from one to six months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. Historically, adjustments to prior years' rebate accruals have not been material to net income. +Other allowances charged against gross sales include cash discounts and returns, which are not significant. Cash discounts are known within 15 to 30 days of sale, and therefore can be reliably estimated. Returns can be reliably estimated because Abbott's historical returns are low, and because sales return terms and other sales terms have remained relatively unchanged for several periods. Product warranties are also not significant. +Abbott also applies judgment in determining the timing of revenue recognition related to contracts that include multiple performance obligations. The total transaction price of the contract is allocated to each performance obligation in an amount based on the estimated relative standalone selling prices of the promised goods or services underlying each performance obligation. For goods or services for which observable standalone selling prices are not available, Abbott uses an expected cost plus a margin approach to estimate the standalone selling price of each performance obligation. +Remaining Performance Obligations +As of December 31, 2020, the estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied (or partially unsatisfied) was approximately $ 3.8 billion in the Diagnostic Products segment and approximately $ 430 million in the Medical Devices segment. Abbott expects to recognize revenue on approximately 60 percent of these remaining performance obligations over the next 24 months , approximately 17 percent over the subsequent 12 months and the remainder thereafter. +These performance obligations primarily reflect the future sale of reagents/consumables in contracts with minimum purchase obligations, extended warranty or service obligations related to previously sold equipment, and remote monitoring services related to previously implanted devices. Abbott has applied the practical expedient described in ASC 606-10-50 -14 and has not included remaining performance obligations related to contracts with original expected durations of one year or less in the amounts above. +Assets Recognized for Costs to Obtain a Contract with a Customer +Abbott has applied the practical expedient in ASC 340-40-25-4 and records as an expense the incremental costs of obtaining contracts with customers in the period of occurrence when the amortization period of the asset that Abbott otherwise would have recognized is one year or less. Upfront commission fees paid to sales personnel as a result of obtaining or renewing contracts with customers are incremental to obtaining the contract. Abbott capitalizes these amounts as contract costs. Capitalized commission fees are amortized based on the contract duration to which the assets relate which ranges from two to ten years . The amounts as of December 31, 2020 and 2019 were not significant. +​ +54 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 3 — Revenue (Continued) +Additionally, the cost of transmitters provided to customers that use Abbott’s remote monitoring service with respect to certain medical devices are capitalized as contract costs. Capitalized transmitter costs are amortized based on the timing of the transfer of services to which the assets relate, which typically ranges from eight to ten years . The amounts as of December 31, 2020 and 2019 were not significant. +Other Contract Assets and Liabilities +Abbott discloses Trade receivables separately in the Consolidated Balance Sheet at the net amount expected to be collected. Contract assets primarily relate to Abbott’s conditional right to consideration for work completed but not billed at the reporting date. Contract assets at the beginning and end of the period, as well as the changes in the balance, were not significant. +Contract liabilities primarily relate to payments received from customers in advance of performance under the contract. Abbott’s contract liabilities arise primarily in the Medical Devices reportable segment when payment is received upfront for various multi-period extended service arrangements. Changes in the contract liabilities during the period are as follows: +​ +​ +​ +​ +​ +(in millions) +​ +​ +Contract Liabilities +​ +​ +​ +Balance at December 31, 2018 +​ +$ +259 +Unearned revenue from cash received during the period +​ +​ +411 +Revenue recognized related to contract liability balance +​ +​ +( 376 ) +Balance at December 31, 2019 +​ +​ +294 +Unearned revenue from cash received during the period +​ +505 +Revenue recognized related to contract liability balance +​ +( 394 ) +Balance at December 31, 2020 +​ +$ +405 +​ +​ +Note 4 — Discontinued Operations and Business Dispositions +The net earnings of discontinued operations include income tax benefits of $ 24 million in 2020 and $ 39 million in 2018. The 2020 tax benefits primarily relate to the resolution of various tax positions related to Abbott’s developed markets branded generic pharmaceuticals business which was sold to Mylan Inc. (Mylan) in 2015. The tax positions relate to years prior to the sale to Mylan. The 2018 tax benefits primarily relate to the resolution of various tax positions related to the operations of AbbVie Inc. (AbbVie) for years prior to the separation. Abbott completed the separation of AbbVie, which was formed to hold Abbott’s research-based proprietary pharmaceuticals business, in January 2013. Abbott retained all liabilities for all U.S. federal and foreign income taxes on income prior to the separation. +​ +Note 5 — Supplemental Financial Information +Other (income) expense, net, for 2020, 2019 and 2018 includes approximately $ 205 million, $ 225 million and $ 160 million of income, respectively, related to the non-service cost components of the net periodic benefit costs associated with the pension and post-retirement medical plans. +55 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 5 — Supplemental Financial Information (Continued) +The following summarizes the activity for 2020 related to the allowance for doubtful accounts as of December 31, 2020: +​ +​ +​ +​ +​ +(in millions) +​ +​ +Allowance for Doubtful Accounts +​ +​ +​ +Balance at December 31, 2019 +​ +$ +228 +Impact of adopting ASU 2016-13 +​ +​ +7 +Provisions/charges to income +​ +88 +Amounts charged off and other deductions +​ +( 35 ) +Balance at December 31, 2020 +​ +$ +288 +​ +The allowance for doubtful accounts reflects the current estimate of credit losses expected to be incurred over the life of the accounts receivable. Abbott considers various factors in establishing, monitoring, and adjusting its allowance for doubtful accounts, including the aging of the accounts and aging trends, the historical level of charge-offs, and specific exposures related to particular customers. Abbott also monitors other risk factors and forward-looking information, such as country risk, when determining credit limits for customers and establishing adequate allowances. +The detail of various balance sheet components is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, +​ +December 31, +(in millions) +2020 +2019 +Long-term Investments: +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +776 +​ +$ +836 +Other +​ +45 +​ +47 +Total +​ +$ +821 +​ +$ +883 +​ +Abbott’s long-term investments as of December 31, 2020 declined versus the balance as of December 31, 2019 due primarily to investment impairments totaling approximately $ 115 million, recorded in Other (income) expense, net within the Consolidated Statement of Earnings, which was partially offset by approximately $ 35 million of additional investments during 2020. +Abbott’s equity securities as of December 31, 2020 and December 31, 2019, include $ 366 million and $ 346 million, respectively, of investments in mutual funds that are held in a rabbi trust acquired as part of the St. Jude Medical, Inc. (St. Jude Medical) business acquisition. These investments, which are specifically designated as available for the purpose of paying benefits under a deferred compensation plan, are not available for general corporate purposes and are subject to creditor claims in the event of insolvency. +Abbott also holds certain investments as of December 31, 2020 with a carrying value of $ 277 million that are accounted for under the equity method of accounting and other equity investments with a carrying value of $ 113 million that do not have a readily determinable fair value. The $ 113 million carrying value is net of an approximately $ 60 million impairment of an investment in 2020 for which Abbott had previously recorded an unrealized gain of approximately $ 50 million in 2018. +​ +56 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 5 — Supplemental Financial Information (Continued) +In 2019, in conjunction with the acquisition of Cephea Valve Technologies, Inc., Abbott acquired a research & development (R&D) asset valued at $ 102 million, which was immediately expensed. The $ 102 million of expense was recorded in the R&D line of Abbott's Consolidated Statement of Earnings. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, +​ +December 31, +(in millions) +2020 +2019 +Other Accrued Liabilities: +​ +​ +​ +​ +​ +​ +Accrued rebates payable to government agencies +​ +$ +316 +​ +$ +212 +Accrued other rebates (a) +​ +805 +​ +655 +All other +​ +4,044 +​ +3,168 +Total +​ +$ +5,165 +​ +$ +4,035 +(a) Accrued wholesaler chargeback rebates of $ 178 million and $ 175 million at December 31, 2020 and 2019, respectively, are netted in trade receivables because Abbott’s customers are invoiced at a higher catalog price but only remit to Abbott their contract price for the products. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, +​ +December 31, +(in millions) +2020 +2019 +Post-employment Obligations and Other Long-term Liabilities: +​ +​ +​ +​ +​ +​ +Defined benefit pension plans and post-employment medical and dental plans for significant plans +​ +$ +3,119 +​ +$ +2,817 +Deferred income taxes +​ +1,406 +​ +1,546 +Operating lease liabilities +​ +​ +902 +​ +​ +755 +All other (b) +​ +3,684 +​ +3,944 +Total +​ +$ +9,111 +​ +$ +9,062 +(b) Includes approximately $ 740 million and $ 580 million of net unrecognized tax benefits in 2020 and 2019, respectively. +​ +​ +57 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 6 — Accumulated Other Comprehensive Income (Loss) +The components of the changes in accumulated other comprehensive income (loss) from continuing operations, net of income taxes, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cumulative +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Gains (Losses) +​ +​ +​ +​ +​ +Cumulative +​ +Net Actuarial +​ +on Derivative +​ +​ +​ +​ +​ +Foreign +​ +(Losses) and +​ +Instruments +​ +​ +​ +​ +​ +Currency +​ +Prior Service +​ +Designated as +​ +​ +​ +​ +​ +Translation +​ +(Costs) and +​ +Cash Flow +​ +​ +​ +(in millions) +Adjustments +Credits +Hedges +Total +Balance at December 31, 2018 +​ +$ +( 4,912 ) +​ +$ +( 2,726 ) +​ +$ +52 +​ +$ +( 7,586 ) +Other comprehensive income (loss) before reclassifications +​ +​ +( 12 ) +​ +( 719 ) +​ +2 +​ +( 729 ) +(Income) loss amounts reclassified from accumulated other comprehensive income (a) +​ +​ +— +​ +( 95 ) +​ +( 55 ) +​ +( 150 ) +Net current period other comprehensive income (loss) +​ +​ +( 12 ) +​ +( 814 ) +​ +( 53 ) +​ +( 879 ) +Balance at December 31, 2019 +​ +​ +( 4,924 ) +​ +​ +( 3,540 ) +​ +​ +( 1 ) +​ +​ +( 8,465 ) +Other comprehensive income (loss) before reclassifications +​ +​ +65 +​ +( 523 ) +​ +( 140 ) +​ +( 598 ) +(Income) loss amounts reclassified from accumulated other comprehensive income (a) +​ +​ +— +​ +192 +​ +( 75 ) +​ +117 +Net current period other comprehensive income (loss) +​ +​ +65 +​ +​ +( 331 ) +​ +​ +( 215 ) +​ +​ +( 481 ) +Balance at December 31, 2020 +​ +$ +( 4,859 ) +​ +$ +( 3,871 ) +​ +$ +( 216 ) +​ +$ +( 8,946 ) +(a) (Income) loss amounts reclassified from accumulated other comprehensive income related to cash flow hedges are recorded as Cost of products sold. Net actuarial losses and prior service cost is included as a component of net periodic benefit cost – see Note 14 for additional information . +​ +​ +Note 7 — Goodwill and Intangible Assets +The total amount of goodwill reported was $ 23.7 billion at December 31, 2020 and $ 23.2 billion at December 31, 2019. Foreign currency translation adjustments increased goodwill by approximately $ 550 million in 2020 and decreased goodwill $ 103 million in 2019. The amount of goodwill related to reportable segments at December 31, 2020 was $ 3.0 billion for the Established Pharmaceutical Products segment, $ 286 million for the Nutritional Products segment, $ 3.8 billion for the Diagnostic Products segment, and $ 16.6 billion for the Medical Devices segment. There was no reduction of goodwill relating to impairments in 2020 and 2019. +The gross amount of amortizable intangible assets, primarily product rights and technology, was $ 27.8 billion and $ 27.6 billion as of December 31, 2020 and 2019, respectively, and accumulated amortization was $ 14.2 billion and $ 11.9 billion as of December 31, 2020 and 2019, respectively. Foreign currency translation adjustments increased intangible assets by approximately $ 67 million in 2020 and decreased intangible assets by $ 71 million in 2019. In 2020, asset impairments related to the Medical Devices segment decreased intangible assets by $ 148 million. The impairment was recorded in the Cost of products sold, excluding amortization of intangible assets line of Abbott’s Consolidated Statement of Earnings. The estimated annual amortization expense for intangible assets recorded at December 31, 2020 is approximately $ 2.0 billion in 2021, $ 2.0 billion in 2022, $ 1.9 billion in 2023, $ 1.9 billion in 2024 and $ 1.9 billion in 2025. Amortizable intangible assets are amortized over 2 to 20 years . +58 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 7 — Goodwill and Intangible Assets (Continued) +Indefinite-lived intangible assets, which relate to IPR&D acquired in a business combination, were approximately $ 1.2 billion and $ 1.3 billion at December 31, 2020 and 2019, respectively. The decrease is due to an IPR&D intangible asset related to the Medical Devices segment that became amortizable in 2020 and a $ 55 million impairment of an IPR&D intangible asset related to the Medical Devices segment that was recorded in the Research and development line of Abbott’s Consolidated Statement of Earnings in 2020. +​ +Note 8 — Restructuring Plans +From 2017 to 2020, Abbott management approved restructuring plans as part of the integration of the acquisitions of St. Jude Medical into the Medical Devices segment, and Alere Inc. (Alere) into the Diagnostic Products segment, in order to leverage economies of scale and reduce costs. As of December 31, 2017, the accrued balance associated with these actions was $ 68 million. From 2018 to 2020, Abbott recorded employee related severance and other charges totaling approximately $ 137 million, comprised of $ 13 million in 2020, $ 72 million in 2019 and $ 52 million in 2018. Approximately $ 30 million was recorded in Cost of products sold, approximately $ 15 million was recorded in Research and development, and approximately $ 92 million was recorded in Selling, general and administrative expense over the last three years. As of December 31, 2020, the accrued liabilities remaining in the Consolidated Balance Sheet related to these actions total $ 25 million and primarily represent severance obligations. +From 2016 to 2020, Abbott management approved plans to streamline operations in order to reduce costs and improve efficiencies in various Abbott businesses including the nutritional, established pharmaceuticals and vascular businesses. Abbott recorded employee related severance and other charges of approximately $ 36 million in 2020, $ 66 million in 2019 and $ 28 million in 2018. Approximately $ 6 million in 2020, $ 16 million in 2019 and $ 10 million in 2018 are recorded in Cost of products sold, approximately $ 2 million in 2020, $ 28 million in 2019 and $ 2 million in 2018 are recorded in Research and development, and approximately $ 28 million in 2020, $ 22 million in 2019 and $ 16 million in 2018 are recorded in Selling, general and administrative expense. +The following summarizes the activity for these restructurings: +​ +​ +​ +​ +​ +(in millions) +​ +​ +Accrued balance at December 31, 2017 +​ +$ +119 +Restructuring charges +​ +​ +28 +Payments and other adjustments +​ +​ +( 77 ) +Accrued balance at December 31, 2018 +​ +​ +70 +Restructuring charges +​ +​ +66 +Payments and other adjustments +​ +​ +( 57 ) +Accrued balance at December 31, 2019 +​ +​ +79 +Restructuring charges +​ +​ +36 +Payments and other adjustments +​ +​ +( 45 ) +Accrued balance at December 31, 2020 +​ +$ +70 +​ +​ +Note 9 — Incentive Stock Program +The 2017 Incentive Stock Program authorizes the granting of nonqualified stock options, restricted stock awards, restricted stock units, performance awards, foreign benefits and other share-based awards. Stock options and restricted stock awards and units comprise the majority of benefits that have been granted and are currently outstanding under this program and a prior program. In 2020, Abbott granted 4,015,420 stock options, 569,961 restricted stock awards and 5,239,575 restricted stock units under this program. +59 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 9 — Incentive Stock Program (Continued) +Under Abbott’s stock incentive programs, the purchase price of shares under option must be at least equal to the fair market value of the common stock on the date of grant, and the maximum term of an option is 10 years . Options generally vest equally over three years . Restricted stock awards generally vest over 3 years , with no more than one-third of the award vesting in any one year upon Abbott reaching a minimum return on equity target. Restricted stock units vest over three years and upon vesting, the recipient receives one share of Abbott stock for each vested restricted stock unit. The aggregate fair market value of options and restricted stock awards and units is recognized as expense over the requisite service period, which may be shorter than the vesting period if an employee is retirement eligible. Forfeitures are estimated at the time of grant. Restricted stock awards and settlement of vested restricted stock units are issued out of treasury shares. Abbott generally issues new shares for exercises of stock options. As a policy, Abbott does not purchase its shares relating to its share-based programs. +In April 2017, Abbott’s shareholders authorized the 2017 Incentive Stock Program under which a maximum of 170 million shares were available for issuance. At December 31, 2020, approximately 113 million shares remained available for future issuance. +The following table summarizes stock option activity for the year ended December 31, 2020 and the outstanding stock options as of December 31, 2020. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted +​ +​ +​ +​ +​ +​ +Weighted +​ +Average +​ +​ +​ +​ +​ +​ +Average +​ +Remaining +​ +Aggregate +(intrinsic values in millions) +Options +Exercise Price +Life (Years) +Intrinsic Value +Outstanding at December 31, 2019 +​ +29,877,915 +​ +$ +48.78 +6.2 +$ +1,138 +Granted +4,015,420 +​ +87.84 +​ +​ +​ +​ +​ +Exercised +( 4,872,830 ) +​ +39.62 +​ +​ +​ +​ +​ +Lapsed +( 100,619 ) +​ +75.22 +​ +​ +​ +​ +​ +Outstanding at December 31, 2020 +28,919,886 +​ +$ +55.65 +6.0 +$ +1,557 +Exercisable at December 31, 2020 +​ +20,390,745 +​ +$ +46.16 +​ +5.0 +​ +$ +1,291 +​ +The following table summarizes restricted stock awards and units activity for the year ended December 31, 2020. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted +​ +​ +​ +​ +Average +​ +​ +​ +Grant-Date +​ +​ +Share Units +​ +Fair Value +Outstanding at December 31, 2019 +14,463,314 +​ +$ +65.51 +Granted +5,809,536 +​ +87.83 +Vested +( 7,167,631 ) +​ +60.67 +Forfeited +( 612,351 ) +​ +75.16 +Outstanding at December 31, 2020 +12,492,868 +​ +$ +78.19 +​ +The fair market value of restricted stock awards and units vested in 2020, 2019 and 2018 was $ 631 million, $ 588 million and $ 458 million, respectively. +The total intrinsic value of options exercised in 2020, 2019 and 2018 was $ 279 million, $ 315 million and $ 249 million, respectively. The total unrecognized compensation cost related to all share-based compensation plans at December 31, 2020 amounted to approximately $ 407 million, which is expected to be recognized over the next three years . +60 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 9 — Incentive Stock Program (Continued) +Total non-cash stock compensation expense charged against income from continuing operations in 2020, 2019 and 2018 for share-based plans totaled approximately $ 546 million, $ 519 million and $ 477 million, respectively, and the tax benefit recognized was approximately $ 200 million, $ 197 million and $ 185 million, respectively. Stock compensation cost capitalized as part of inventory is not significant. +The table below summarizes the fair value of an option granted in 2020, 2019 and 2018 and the assumptions included in the Black-Scholes option-pricing model used to estimate the fair value: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +2019 +2018 +​ +Fair value +​ +$ +14.39 +​ +$ +14.50 +​ +$ +10.93 +​ +Risk-free interest rate +​ +1.3 +% +​ +2.5 +% +​ +2.7 +% +Average life of options (years) +​ +6.0 +​ +​ +6.0 +​ +​ +6.0 +​ +Volatility +​ +19.4 +% +​ +19.8 +% +​ +19.0 +% +Dividend yield +​ +1.6 +% +​ +1.7 +% +​ +1.9 +% +​ +The risk-free interest rate is based on the rates available at the time of the grant for zero-coupon U.S. government issues with a remaining term equal to the option’s expected life. The average life of an option is based on both historical and projected exercise and lapsing data. Expected volatility is based on implied volatilities from traded options on Abbott’s stock and historical volatility of Abbott’s stock over the expected life of the option. Dividend yield is based on the option’s exercise price and annual dividend rate at the time of grant. +​ +61 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 10 — Debt and Lines of Credit +The following is a summary of long-term debt at December 31: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +0.00 % Notes, due 2020 +​ +$ +— +​ +$ +1,272 +2.55 % Notes, due 2022 +​ +​ +750 +​ +​ +750 +0.875 % Notes, due 2023 +​ +​ +1,398 +​ +​ +1,272 +3.40 % Notes, due 2023 +​ +​ +1,050 +​ +​ +1,050 +5-year term loan due 2024 +​ +​ +577 +​ +​ +546 +0.10 % Notes, due 2024 +​ +​ +724 +​ +​ +658 +3.875 % Notes, due 2025 +​ +​ +500 +​ +​ +500 +2.95 % Notes, due 2025 +​ +​ +1,000 +​ +​ +1,000 +1.50 % Notes, due 2026 +​ +​ +1,398 +​ +​ +1,272 +3.75 % Notes, due 2026 +​ +​ +1,700 +​ +​ +1,700 +0.375 % Notes, due 2027 +​ +​ +724 +​ +​ +658 +1.15 % Notes, due 2028 +​ +​ +650 +​ +​ +— +1.40 % Notes, due 2030 +​ +​ +650 +​ +​ +— +4.75 % Notes, due 2036 +​ +​ +1,650 +​ +​ +1,650 +6.15 % Notes, due 2037 +​ +547 +​ +547 +6.00 % Notes, due 2039 +​ +515 +​ +515 +5.30 % Notes, due 2040 +​ +694 +​ +694 +4.75 % Notes, due 2043 +​ +700 +​ +700 +4.90 % Notes, due 2046 +​ +​ +3,250 +​ +​ +3,250 +Unamortized debt issuance costs +​ +​ +( 87 ) +​ +​ +( 90 ) +Other, including fair value adjustments relating to interest rate hedge contracts designated as fair value hedges +​ +144 +​ +( 6 ) +Total carrying amount of long-term debt +​ +18,534 +​ +17,938 +Less: Current portion +​ +7 +​ +1,277 +Total long-term portion +​ +$ +18,527 +​ +$ +16,661 +​ +On June 24, 2020, Abbott completed the issuance of $ 1.3 billion aggregate principal amount of senior notes, consisting of $ 650 million of its 1.15 % Notes due 2028 and $ 650 million of its 1.40 % Notes due 2030. +On September 28, 2020, Abbott repaid the € 1.140 billion outstanding principal amount of its 0.00 % Notes due 2020 upon maturity. The repayment equated to approximately $ 1.3 billion. +Abbott has readily available financial resources, including unused lines of credit that support commercial paper borrowing arrangements and provide Abbott with the ability to borrow up to $ 5 billion on an unsecured basis. The lines of credit are part of a Five Year Credit Agreement (Revolving Credit Agreement) that Abbott entered into on November 12, 2020. At that time, Abbott also terminated its 2018 revolving credit agreement. There were no outstanding borrowings under the 2018 revolving credit agreement at the time of its termination. Any borrowings under the Revolving Credit Agreement will mature and be payable on November 12, 2025. Any borrowings under the Revolving Credit Agreement will bear interest, at Abbott’s option, based on either a base rate or Eurodollar rate, plus an applicable margin based on Abbott’s credit ratings. +​ +62 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 10 — Debt and Lines of Credit (Continued) +In 2019, Abbott’s long-term borrowings and debt issuance included the following: +● On November 19, 2019, Abbott’s wholly owned subsidiary, Abbott Ireland Financing DAC, completed an offering of € 1.180 billion of long-term debt consisting of € 590 million of 0.10 % Notes due 2024 and € 590 million of 0.375 % Notes due 2027. The proceeds equated to approximately $ 1.3 billion. The Notes are guaranteed by Abbott. +● On November 21, 2019, Abbott borrowed ¥ 59.8 billion under a 5-year term loan and designated the yen-denominated loan as a hedge of its net investment in certain foreign subsidiaries. The term loan bears interest at TIBOR plus a fixed spread, and the interest rate is reset quarterly. The proceeds equated to approximately $ 550 million. +In 2019, Abbott’s repayment of long-term debt included the following: +● $ 0.500 billion outstanding principal amount of its 2.80 % Notes due 2020 – redeemed on February 24, 2019 +● $ 2.850 billion principal amount of its 2.9 % Notes due 2021 – redeemed on December 19, 2019. Abbott incurred a charge of $ 63 million related to the early repayment of this debt. +The 2.80 % Notes were redeemed under the board of directors’ 2018 bond redemption authorization discussed below. The 2.9 % Notes were redeemed under a bond redemption authorization approved by the board of directors in September 2019 for the early redemption of up to $ 5 billion of outstanding long-term notes. The 2019 bond redemption authorization superseded the board’s 2018 authorization. $ 2.15 billion of the $ 5 billion authorization remans available as of December 31, 2020. +On January 5, 2018, Abbott repaid $ 2.8 billion under a 5-year term loan agreement and $ 1.15 billion of borrowings under its lines of credit. +On February 16, 2018, the board of directors authorized the early redemption of up to $ 5 billion of outstanding long-term notes. 2018 redemptions under this authorization include the following: +● $ 0.947 billion principal amount of its 5.125 % Notes due 2019 – redeemed on March 22, 2018 +● $ 1.055 billion of the $ 2.850 billion principal amount of its 2.35 % Notes due 2019 – redeemed on March 22, 2018 +● $ 1.300 billion of the $ 1.795 billion outstanding principal amount of its 2.35 % Notes due 2019 – redeemed on June 22, 2018 +● $ 0.495 billion outstanding principal amount of its 2.35 % Notes due 2019 – redeemed on September 28, 2018 +Abbott incurred a net charge of $ 14 million related to the March 22, 2018 early repayment of debt. +On September 17, 2018, Abbott repaid upon maturity the $ 500 million aggregate principal amount outstanding of the 2.00 % Senior Notes due 2018. +On September 27, 2018, Abbott’s wholly owned subsidiary, Abbott Ireland Financing DAC, completed a euro debt offering of € 3.420 billion of long-term debt consisting of € 1.140 billion of non-interest bearing Senior Notes due 2020 at 99.727 % of par value; € 1.140 billion of 0.875 % Senior Notes due 2023 at 99.912 % of par value; and € 1.140 billion of 1.50 % Senior Notes due 2026 at 99.723 % of par value. The proceeds equated to approximately $ 4 billion. The notes are guaranteed by Abbott. +63 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 10 — Debt and Lines of Credit (Continued) +On October 28, 2018, Abbott redeemed approximately $ 4 billion of debt, which included $ 750 million principal amount of its 2.00 % Notes due 2020; $ 597 million principal amount of its 4.125 % Notes due 2020; $ 900 million principal amount of its 3.25 % Notes due 2023; $ 450 million principal amount of its 3.4 % Notes due 2023; and $ 1.300 billion principal amount of its 3.75 % Notes due 2026. These amounts were in addition to the $ 5 billion authorization in 2018 discussed above. In conjunction with the redemption, Abbott unwound approximately $ 1.1 billion in interest rate swaps relating to the 3.40 % Note due in 2023 and the 3.75 % Note due in 2026. Abbott incurred a net charge of $ 153 million related to the early repayment of this debt and the unwinding of related interest rate swaps. +Principal payments required on long-term debt outstanding at December 31, 2020 are $ 7 million in 2021, $ 753 million in 2022, $ 2.4 billion in 2023, $ 1.3 billion in 2024, $ 1.5 billion in 2025 and $ 12.5 billion in 2026 and thereafter. +At December 31, 2020, Abbott’s long-term debt rating was A by Standard & Poor’s Corporation and A3 by Moody’s. Abbott’s weighted-average interest rate on short-term borrowings was 0.4 %at December 31, 2020, 2019 and 2018. +​ +Note 11 — Leases +Leases where Abbott is the Lessee +Abbott has entered into operating leases as the lessee for office space, manufacturing facilities, R&D laboratories, warehouses, vehicles and equipment. Finance leases are not significant. Abbott’s operating leases generally have remaining lease terms of 1 to 10 years . Some leases include options to extend beyond the original lease term , generally up to 10 years and some include options to terminate early . These options have been included in the determination of the lease liability when it is reasonably certain that the option will be exercised. +For all of its asset classes, Abbott elected the practical expedient allowed under FASB ASC No. 842, “Leases” to account for each lease component (e.g., the right to use office space) and the associated non-lease components (e.g., maintenance services) as a single lease component. Abbott also elected the short-term lease accounting policy for all asset classes; therefore, Abbott is not recognizing a lease liability or right of use (ROU) asset for any lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that Abbott is reasonably certain to exercise. +As Abbott’s leases typically do not provide an implicit rate, the interest rate used to determine the present value of the payments under each lease typically reflects Abbott’s incremental borrowing rate based on information available at the lease commencement date. Abbott’s incremental borrowing rates at January 1, 2019 were used for operating leases that commenced prior to January 1, 2019 when ASC 842 was adopted. +​ +64 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Leases (Continued) +The following table provides information related to Abbott’s operating leases: +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions, except weighted averages) +2020 +2019 +​ +Operating lease cost (a) +​ +$ +329 +​ +$ +314 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash paid for amounts included in the measurement of operating lease liabilities +​ +​ +264 +​ +​ +253 +​ +​ +​ +​ +​ +​ +​ +​ +​ +ROU assets arising from entering into new operating lease obligations +​ +​ +396 +​ +​ +310 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average remaining lease term at December 31 (in years) +​ +​ +8 +​ +​ +8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted average discount rate at December 31 +​ +​ +3.2 +% +​ +3.9 +% +(a) Includes short-term lease expense and variable lease costs, which were immaterial in the years ended December 31, 2020 and 2019. +Future minimum lease payments under non-cancellable operating leases as of December 31, 2020 were as follows: +​ +​ +​ +​ +​ +(in millions) +​ +​ +2021 +​ +$ +272 +2022 +​ +228 +2023 +​ +177 +2024 +​ +131 +2025 +​ +100 +Thereafter +​ +407 +Total future minimum lease payments – undiscounted +​ +1,315 +Less: imputed interest +​ +( 172 ) +Present value of lease liabilities +​ +$ +1,143 +​ +The following table summarizes the amounts and location of operating lease ROU assets and lease liabilities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +December 31, 2020 +December 31, 2019 +Balance Sheet Caption +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating Lease - ROU Asset +​ +$ +1,101 +​ +$ +934 +​ +Deferred income taxes and other assets +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating Lease Liability: +​ +​ +​ +​ +​ +​ +Current +​ +$ +241 +​ +$ +205 +​ +Other accrued liabilities +Non-current +​ +902 +​ +​ +755 +​ +Post-employment obligations and other long-term liabilities +Total Liability +​ +$ +1,143 +​ +$ +960 +​ +​ +65 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 11 — Leases (Continued) +Leases where Abbott is the Lessor +Certain assets, primarily diagnostics instruments, are leased to customers under contractual arrangements that typically include an operating or sales-type lease as well as performance obligations for reagents and other consumables. Sales-type leases are not significant. Contract terms vary by customer and may include options to terminate the contract or options to extend the contract. Where instruments are provided under operating lease arrangements, some portion or the entire lease revenue may be variable and subject to subsequent non-lease component (e.g., reagent) sales. The allocation of revenue between the lease and non-lease components is based on stand-alone selling prices. Operating lease revenue represented less than 3 percent of Abbott’s total net sales in the years ended December 31, 2020 and 2019. +Assets related to operating leases are reported within Net property and equipment on the Consolidated Balance Sheet. The original cost and the net book value of such assets were $ 3.3 billion and $ 1.4 billion, respectively, as of December 31, 2020 and $ 2.8 billion and $ 1.2 billion, respectively, as of December 31, 2019. +​ +Note 12 — Financial Instruments, Derivatives and Fair Value Measures +Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates primarily for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts, with gross notional amounts totaling $ 8.1 billion at December 31, 2020, and $ 6.8 billion at December 31, 2019, are designated as cash flow hedges of the variability of the cash flows due to changes in foreign exchange rates and are recorded at fair value. Accumulated gains and losses as of December 31, 2020 will be included in Cost of products sold at the time the products are sold, generally through the next twelve to eighteen months . +Abbott enters into foreign currency forward exchange contracts to manage currency exposures for foreign currency denominated third-party trade payables and receivables, and for intercompany loans and trade accounts payable where the receivable or payable is denominated in a currency other than the functional currency of the entity. For intercompany loans, the contracts require Abbott to sell or buy foreign currencies, primarily European currencies, in exchange for primarily U.S. dollars and European currencies. For intercompany and trade payables and receivables, the currency exposures are primarily the U.S. dollar and European currencies. At December 31, 2020 and 2019, Abbott held gross notional amounts of $ 11.0 billion and $ 9.1 billion, respectively, of such foreign currency forward exchange contracts. +In November 2019, Abbott borrowed ¥ 59.8 billion under a 5 -year term loan and designated the yen-denominated loan as a hedge of the net investment in certain foreign subsidiaries. The proceeds equated to approximately $ 550 million. The value of this long-term debt was approximately $ 577 million and $ 546 million as of December 31, 2020 and December 31, 2019, respectively. The change in the value of the debt, which is due to changes in foreign exchange rates, was recorded in Accumulated other comprehensive income (loss), net of tax. +Abbott is a party to interest rate hedge contracts totaling approximately $ 2.9 billion at December 31, 2020 and 2019, to manage its exposure to changes in the fair value of fixed-rate debt. These contracts are designated as fair value hedges of the variability of the fair value of fixed-rate debt due to changes in the long-term benchmark interest rates. The effect of the hedge is to change a fixed-rate interest obligation to a variable rate for that portion of the debt. Abbott records the contracts at fair value and adjusts the carrying amount of the fixed-rate debt by an offsetting amount. +In October 2018, Abbott unwound approximately $ 1.1 billion in interest rate swaps relating to the 3.40 % Note due in 2023 and the 3.75 % Note due in 2026. As a part of the unwinding, Abbott paid approximately $ 90 million in cash, which was included in the Financing Activities section of the Consolidated Statement of Cash Flows in 2018. +​ +66 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +The following table summarizes the amounts and location of certain derivative financial instruments as of December 31: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair Value — Assets +​ +Fair Value — Liabilities +(in millions) +2020 +2019 +Balance Sheet Caption +2020 +2019 +Balance Sheet Caption +Interest rate swaps designated as fair value hedges +​ +​ +$ +210 +​ +$ +48 +Deferred income taxes and other assets +​ +$ +— +​ +$ +— +Post-employment obligations and other long-term liabilities +Foreign currency forward exchange contracts: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Hedging instruments +​ +​ +30 +​ +110 +Other prepaid expenses and receivables +​ +433 +​ +56 +Other accrued liabilities +Others not designated as hedges +​ +​ +60 +​ +38 +​ +Other prepaid expenses and receivables +​ +65 +​ +33 +​ +Other accrued liabilities +Debt designated as a hedge of net investment in a foreign subsidiary +​ +​ +​ +— +​ +​ +— +​ +n/a +​ +​ +577 +​ +​ +546 +​ +Long-term debt +​ +​ +​ +$ +300 +​ +$ +196 +​ +​ +​ +$ +1,075 +​ +$ +635 +​ +​ +​ +The following table summarizes the activity for foreign currency forward exchange contracts designated as cash flow hedges, debt designated as a hedge of net investment in a foreign subsidiary and certain other derivative financial instruments, as well as the amounts and location of income (expense) and gain (loss) reclassified into income. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Gain (loss) Recognized in +​ +Income (expense) and +​ +​ +​ +​ +Other Comprehensive +​ +Gain (loss) Reclassified +​ +​ +​ +​ +Income (loss) +​ +into Income +​ +​ +(in millions) +2020 +2019 +2018 +2020 +2019 +2018 +Income Statement Caption +Foreign currency forward exchange contracts designated as cash flow hedges +​ +$ +( 207 ) +​ +$ +9 +​ +$ +73 +​ +$ +102 +​ +$ +79 +​ +$ +( 114 ) +​ +Cost of products sold +Debt designated as a hedge of net investment in a foreign subsidiary +​ +( 31 ) +​ +4 +​ +— +​ +n/a +​ +n/a +​ +n/a +n/a +Interest rate swaps designated as fair value hedges +​ +n/a +​ +n/a +​ +n/a +​ +162 +​ +148 +​ +( 97 ) +Interest expense +​ +A loss of $ 171 million, a gain of $ 75 million and a loss of $ 100 million were recognized in 2020, 2019 and 2018, respectively, related to foreign currency forward exchange contracts not designated as hedges. These amounts are reported in the Consolidated Statement of Earnings on the Net foreign exchange (gain) loss line. +The interest rate swaps are designated as fair value hedges of the variability of the fair value of fixed-rate debt due to changes in the long-term benchmark interest rates. The hedged debt is marked to market, offsetting the effect of marking the interest rate swaps to market. +​ +67 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +The carrying values and fair values of certain financial instruments as of December 31 are shown in the table below. The carrying values of all other financial instruments approximate their estimated fair values. The counterparties to financial instruments consist of select major international financial institutions. Abbott does not expect any losses from nonperformance by these counterparties. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +​ +2019 +​ +​ +Carrying +​ +Fair +​ +Carrying +​ +Fair +(in millions) +Value +Value +Value +Value +Long-term Investment Securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +776 +​ +$ +776 +​ +$ +836 +​ +$ +836 +Other +​ +45 +​ +45 +​ +47 +​ +47 +Total Long-term debt +​ +( 18,534 ) +​ +( 22,809 ) +​ +( 17,938 ) +​ +( 20,772 ) +Foreign Currency Forward Exchange Contracts: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Receivable position +​ +90 +​ +90 +​ +148 +​ +148 +(Payable) position +​ +( 498 ) +​ +( 498 ) +​ +( 89 ) +​ +( 89 ) +Interest Rate Hedge Contracts: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Receivable position +​ +210 +​ +210 +​ +48 +​ +48 +(Payable) position +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +— +​ +The fair value of the debt was determined based on significant other observable inputs, including current interest rates. +68 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 12 — Financial Instruments, Derivatives and Fair Value Measures (Continued) +The following table summarizes the bases used to measure certain assets and liabilities at fair value on a recurring basis in the balance sheet: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basis of Fair Value Measurement +​ +​ +​ +​ +​ +Quoted +​ +Significant +​ +​ +​ +​ +​ +​ +​ +Prices in +​ +Other +​ +Significant +​ +​ +Outstanding +​ +Active +​ +Observable +​ +Unobservable +(in millions) +Balances +Markets +Inputs +Inputs +December 31, 2020: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +386 +​ +$ +386 +​ +$ +— +​ +$ +— +Interest rate swap derivative financial instruments +​ +210 +​ +— +​ +210 +​ +— +Foreign currency forward exchange contracts +​ +90 +​ +— +​ +90 +​ +— +Total Assets +​ +$ +686 +​ +$ +386 +​ +$ +300 +​ +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of hedged long-term debt +​ +$ +3,049 +​ +$ +— +​ +$ +3,049 +​ +$ +— +Foreign currency forward exchange contracts +​ +498 +​ +— +​ +498 +​ +— +Contingent consideration related to business combinations +​ +68 +​ +— +​ +— +​ +68 +Total Liabilities +​ +$ +3,615 +​ +$ +— +​ +$ +3,547 +​ +$ +68 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +December 31, 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equity securities +​ +$ +357 +​ +$ +357 +​ +$ +— +​ +$ +— +Interest rate swap derivative financial instruments +​ +​ +48 +​ +​ +— +​ +​ +48 +​ +​ +— +Foreign currency forward exchange contracts +​ +148 +​ +— +​ +148 +​ +— +Total Assets +​ +$ +553 +​ +$ +357 +​ +$ +196 +​ +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of hedged long-term debt +​ +$ +2,890 +​ +$ +— +​ +$ +2,890 +​ +$ +— +Foreign currency forward exchange contracts +​ +89 +​ +— +​ +89 +​ +— +Contingent consideration related to business combinations +​ +68 +​ +— +​ +— +​ +68 +Total Liabilities +​ +$ +3,047 +​ +$ +— +​ +$ +2,979 +​ +$ +68 +​ +The fair value of foreign currency forward exchange contracts is determined using a market approach, which utilizes values for comparable derivative instruments. The fair value of the debt was determined based on the face value of the debt adjusted for the fair value of the interest rate swaps, which is based on a discounted cash flow analysis using significant other observable inputs. +Contingent consideration relates to businesses acquired by Abbott. The fair value of the contingent consideration was determined based on an independent appraisal adjusted for the time value of money and other changes in fair value. The maximum amount for certain contingent consideration is not determinable as it is based on a percent of certain sales. Excluding such contingent consideration, the maximum amount estimated to be due is approximately $ 200 million, which is dependent upon attaining certain sales thresholds or based on the occurrence of certain events, such as regulatory approvals. +69 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 13 — Litigation and Environmental Matters +Abbott has been identified as a potentially responsible party for investigation and cleanup costs at a number of locations in the United States and Puerto Rico under federal and state remediation laws and is investigating potential contamination at a number of company-owned locations. Abbott has recorded an estimated cleanup cost for each site for which management believes Abbott has a probable loss exposure. No individual site cleanup exposure is expected to exceed $ 4 million, and the aggregate cleanup exposure is not expected to exceed $ 10 million. +Abbott is involved in various claims and legal proceedings, and Abbott estimates the range of possible loss for its legal proceedings and environmental exposures to be from approximately $ 90 million to $ 120 million. The recorded accrual balance at December 31, 2020 for these proceedings and exposures was approximately $ 105 million. This accrual represents management’s best estimate of probable loss, as defined by FASB ASC No. 450, “Contingencies.” Within the next year, legal proceedings may occur that may result in a change in the estimated loss accrued by Abbott. While it is not feasible to predict the outcome of all such proceedings and exposures with certainty, management believes that their ultimate disposition should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +​ +Note 14 — Post-Employment Benefits +Retirement plans consist of defined benefit, defined contribution and medical and dental plans. Information for Abbott’s major defined benefit plans and post-employment medical and dental benefit plans is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical and Dental +​ +​ +Defined Benefit Plans +​ +Plans +(in millions) +2020 +2019 +2020 +2019 +Projected benefit obligations, January 1 +​ +$ +11,238 +​ +$ +9,093 +​ +$ +1,556 +​ +$ +1,292 +Service cost — benefits earned during the year +​ +336 +​ +250 +​ +46 +​ +23 +Interest cost on projected benefit obligations +​ +300 +​ +337 +​ +42 +​ +52 +(Gains) losses, primarily changes in discount rates, plan design changes, law changes and differences between actual and estimated health care costs +​ +1,305 +​ +1,856 +​ +( 5 ) +​ +228 +Benefits paid +​ +( 327 ) +​ +( 302 ) +​ +( 73 ) +​ +( 76 ) +Other, including foreign currency translation +​ +277 +​ +4 +​ +1 +​ +37 +Projected benefit obligations, December 31 +​ +$ +13,129 +​ +$ +11,238 +​ +$ +1,567 +​ +$ +1,556 +Plan assets at fair value, January 1 +​ +$ +10,277 +​ +$ +8,553 +​ +$ +360 +​ +$ +351 +Actual return (loss) on plan assets +​ +1,463 +​ +1,622 +​ +46 +​ +65 +Company contributions +​ +400 +​ +382 +​ +12 +​ +12 +Benefits paid +​ +( 327 ) +​ +( 302 ) +​ +( 65 ) +​ +( 68 ) +Other, including foreign currency translation +​ +205 +​ +22 +​ +— +​ +— +Plan assets at fair value, December 31 +​ +$ +12,018 +​ +$ +10,277 +​ +$ +353 +​ +$ +360 +Projected benefit obligations greater than plan assets, December 31 +​ +$ +( 1,111 ) +​ +$ +( 961 ) +​ +$ +( 1,214 ) +​ +$ +( 1,196 ) +Long-term assets +​ +$ +824 +​ +$ +687 +​ +$ +— +​ +$ +— +Short-term liabilities +​ +( 29 ) +​ +( 26 ) +​ +( 1 ) +​ +( 1 ) +Long-term liabilities +​ +( 1,906 ) +​ +( 1,622 ) +​ +( 1,213 ) +​ +( 1,195 ) +Net liability +​ +$ +( 1,111 ) +​ +$ +( 961 ) +​ +$ +( 1,214 ) +​ +$ +( 1,196 ) +Amounts Recognized in Accumulated Other Comprehensive Income (loss): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Actuarial losses, net +​ +$ +4,559 +​ +$ +4,131 +​ +$ +486 +​ +$ +529 +Prior service cost (credits) +​ +( 5 ) +​ +( 2 ) +​ +( 67 ) +​ +( 95 ) +Total +​ +$ +4,554 +​ +$ +4,129 +​ +$ +419 +​ +$ +434 +​ +70 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +The $ 1.3 billion and $ 1.9 billion of defined benefit plan losses in 2020 and 2019, respectively, that increased the projected benefit obligations in those years, primarily reflect the year-over-year decline in the discount rates used to measure the obligations. The projected benefit obligations for non-U.S. defined benefit plans were $ 4.1 billion and $ 3.3 billion at December 31, 2020 and 2019, respectively. The accumulated benefit obligations for all defined benefit plans were $ 11.9 billion and $ 10.2 billion at December 31, 2020 and 2019, respectively. +For plans where the projected benefit obligations exceeded plan assets at December 31, 2020 and 2019, the projected benefit obligations and the aggregate plan assets were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +Projected benefit obligation +​ +$ +8,946 +​ +$ +7,585 +Fair value of plan assets +​ +7,010 +​ +5,936 +​ +For plans where the accumulated benefit obligations exceeded plan assets at December 31, 2020 and 2019, the aggregate accumulated benefit obligations, the projected benefit obligations and the aggregate plan assets were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +Accumulated benefit obligation +​ +$ +2,459 +​ +$ +1,985 +Projected benefit obligation +​ +2,773 +​ +2,266 +Fair value of plan assets +​ +965 +​ +821 +​ +The components of the net periodic benefit cost were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Medical and +​ +​ +​ +Defined Benefit Plans +​ +Dental Plans +(in millions) +2020 +2019 +2018 +2020 +2019 +2018 +Service cost — benefits earned during the year +​ +​ +$ +336 +​ +$ +250 +​ +$ +293 +​ +$ +46 +​ +$ +23 +​ +$ +26 +Interest cost on projected benefit obligations +​ +​ +300 +​ +337 +​ +308 +​ +42 +​ +52 +​ +48 +Expected return on plans' assets +​ +​ +( 770 ) +​ +( 710 ) +​ +( 680 ) +​ +( 28 ) +​ +( 27 ) +​ +( 33 ) +Amortization of actuarial losses +​ +​ +255 +​ +132 +​ +​ +205 +​ +​ +21 +​ +​ +22 +​ +​ +33 +Amortization of prior service cost (credits) +​ +​ +​ +1 +​ +​ +1 +​ +​ +1 +​ +​ +( 28 ) +​ +​ +( 32 ) +​ +​ +( 45 ) +Total net cost +​ +​ +$ +122 +​ +$ +10 +​ +$ +127 +​ +$ +53 +​ +$ +38 +​ +$ +29 +​ +Other comprehensive income (loss) for each respective year includes the amortization of actuarial losses and prior service costs (credits) as noted in the previous table. Other comprehensive income (loss) for each respective year also includes: net actuarial losses of $ 611 million for defined benefit plans and a gain of $ 23 million for medical and dental plans in 2020, net actuarial losses of $ 944 million for defined benefit plans and a loss of $ 190 million for medical and dental plans in 2019; net actuarial losses of $ 86 million for defined benefit plans and a gain of $ 53 million for medical and dental plans in 2018. The net actuarial losses in 2020 and 2019 are primarily due to the year-over-year decline in discount rates partially offset by the impact of actual asset returns in excess of expected returns in each of the period. +​ +71 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +The weighted average assumptions used to determine benefit obligations for defined benefit plans and medical and dental plans are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +2019 +2018 +Discount rate +2.3 +% +3.0 +% +4.0 +% +Expected aggregate average long-term change in compensation +4.3 +% +4.3 +% +4.3 +% +​ +The weighted average assumptions used to determine the net cost for defined benefit plans and medical and dental plans are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +2019 +2018 +Discount rate +3.0 +% +4.0 +% +3.4 +% +Expected return on plan assets +7.5 +% +7.5 +% +7.7 +% +Expected aggregate average long-term change in compensation +4.3 +% +4.3 +% +4.4 +% +​ +The assumed health care cost trend rates for medical and dental plans at December 31 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +2019 +2018 +Health care cost trend rate assumed for the next year +8 +% +9 +% +9 +% +Rate that the cost trend rate gradually declines to +5 +% +5 +% +5 +% +Year that rate reaches the assumed ultimate rate +2025 +​ +2025 +​ +2025 +​ +​ +The discount rates used to measure liabilities were determined based on high-quality fixed income securities that match the duration of the expected retiree benefits. The health care cost trend rates represent Abbott’s expected annual rates of change in the cost of health care benefits and are forward projections of health care costs as of the measurement date. +​ +72 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +The following table summarizes the bases used to measure the defined benefit and medical and dental plan assets at fair value: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basis of Fair Value Measurement +​ +​ +​ +​ +​ +Quoted +​ +Significant +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Prices in +​ +Other +​ +Significant +​ +​ +​ +​ +​ +Outstanding +​ +Active +​ +Observable +​ +Unobservable +​ +Measured at +(in millions) +Balances +Markets +Inputs +Inputs +NAV (j) +December 31, 2020: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large cap (a) +​ +$ +3,410 +​ +$ +2,202 +​ +$ +— +​ +$ +— +​ +$ +1,208 +U.S. mid and small cap (b) +​ +​ +775 +​ +​ +721 +​ +​ +— +​ +​ +3 +​ +​ +51 +International (c) +​ +​ +2,654 +​ +​ +542 +​ +​ +— +​ +​ +— +​ +​ +2,112 +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. government securities (d) +​ +​ +475 +​ +​ +23 +​ +​ +289 +​ +​ +— +​ +​ +163 +Corporate debt instruments (e) +​ +​ +1,408 +​ +​ +425 +​ +​ +908 +​ +​ +— +​ +​ +75 +Non-U.S. government securities (f) +​ +​ +523 +​ +​ +16 +​ +​ +— +​ +​ +— +​ +​ +507 +Other (g) +​ +​ +503 +​ +​ +159 +​ +​ +72 +​ +​ +— +​ +​ +272 +Absolute return funds (h) +​ +​ +1,618 +​ +​ +462 +​ +​ +— +​ +​ +— +​ +​ +1,156 +Cash and Cash Equivalents +​ +​ +281 +​ +​ +77 +​ +​ +— +​ +​ +— +​ +​ +204 +Other (i) +​ +​ +724 +​ +​ +9 +​ +​ +— +​ +​ +— +​ +​ +715 +​ +​ +$ +12,371 +​ +$ +4,636 +​ +$ +1,269 +​ +$ +3 +​ +$ +6,463 +December 31, 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Equities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large cap (a) +​ +$ +2,873 +​ +$ +1,647 +​ +$ +— +​ +$ +— +​ +$ +1,226 +U.S. mid and small cap (b) +​ +648 +​ +​ +548 +​ +​ +4 +​ +​ +2 +​ +​ +94 +International (c) +​ +2,202 +​ +​ +464 +​ +​ +— +​ +​ +— +​ +​ +1,738 +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. government securities (d) +​ +562 +​ +​ +52 +​ +​ +357 +​ +​ +— +​ +​ +153 +Corporate debt instruments (e) +​ +1,266 +​ +​ +362 +​ +​ +724 +​ +​ +— +​ +​ +180 +Non-U.S. government securities (f) +​ +445 +​ +​ +3 +​ +​ +2 +​ +​ +— +​ +​ +440 +Other (g) +​ +320 +​ +​ +69 +​ +​ +27 +​ +​ +— +​ +​ +224 +Absolute return funds (h) +​ +1,557 +​ +​ +424 +​ +​ +— +​ +​ +— +​ +​ +1,133 +Cash and Cash Equivalents +​ +​ +182 +​ +​ +84 +​ +​ +— +​ +​ +— +​ +​ +98 +Other (i) +​ +582 +​ +​ +8 +​ +​ +— +​ +​ +1 +​ +​ +573 +​ +​ +$ +10,637 +​ +$ +3,661 +​ +$ +1,114 +​ +$ +3 +​ +$ +5,859 +(a) A mix of index funds and actively managed equity accounts that are benchmarked to various large cap indices. +(b) A mix of index funds and actively managed equity accounts that are benchmarked to various mid and small cap indices. +(c) A mix of index funds and actively managed pooled investment funds that are benchmarked to various non-U.S. equity indices in both developed and emerging markets. +(d) A mix of index funds and actively managed accounts that are benchmarked to various U.S. government bond indices. +(e) A mix of index funds and actively managed accounts that are benchmarked to various corporate bond indices. +(f) Primarily United Kingdom, Japan and Eurozone government bonds. +(g) Primarily asset backed securities and an actively managed, diversified fixed income vehicle benchmarked to the one-month Libor / Euribor. +(h) Primarily funds invested by managers that have a global mandate with the flexibility to allocate capital broadly across a wide range of asset classes and strategies including, but not limited to equities, fixed income, commodities, interest rate futures, currencies and other securities to outperform an agreed upon benchmark with specific return and volatility targets. +73 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +(i) Primarily investments in private funds, such as private equity, private credit, private real estate and private energy funds. +(j) Investments measured at fair value using the net asset value (NAV) practical expedient have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheet. +Equities that are valued using quoted prices are valued at the published market prices. Equities in a common collective trust or a registered investment company are valued at the NAV provided by the fund administrator. The NAV is based on the value of the underlying assets owned by the fund minus its liabilities. For approximately half of these funds, investments may be redeemed once per month, with a required 7 to 30 day notice period. For the remaining funds, daily redemption of an investment is allowed. Fixed income securities that are valued using significant other observable inputs are valued at prices obtained from independent financial service industry recognized vendors. Abbott did not have any unfunded commitments related to fixed income funds at December 31, 2020 and 2019. Fixed income securities in a common collective trust or a registered investment company are valued at the NAV provided by the fund administrator. For the majority of these funds, investments may be redeemed either weekly or monthly, with a required 2 to 14 day notice period. For the remaining funds, investments may be generally redeemed daily. +Absolute return funds are valued at the NAV provided by the fund administrator. All private funds are valued at the NAV provided by the fund on a one-quarter lag adjusted for known cash flows and significant events through the reporting date. Abbott did not have any unfunded commitments related to absolute return funds at December 31, 2020 and 2019. Investments in these funds may be generally redeemed monthly or quarterly with required notice periods ranging from 5 to 90 days . For approximately $ 245 million and $ 110 million of the absolute return funds, redemptions are subject to a 33 percent gate and a 25 percent gate, respectively, and $ 60 million is subject to a lock until 2022. Investments in the private funds cannot be redeemed but the funds will make distributions through liquidation. The estimate of the liquidation period for each fund ranges from 2021 to 2030. Abbott’s unfunded commitment in these funds was $ 523 million and $ 579 million as of December 31, 2020 and 2019, respectively. +The investment mix of equity securities, fixed income and other asset allocation strategies is based upon achieving a desired return, as well as balancing higher return, more volatile equity securities with lower return, less volatile fixed income securities. Investment allocations are made across a range of markets, industry sectors, capitalization sizes, and in the case of fixed income securities, maturities and credit quality. The plans do not directly hold any securities of Abbott. There are no known significant concentrations of risk in the plans’ assets. Abbott’s medical and dental plans’ assets are invested in a similar mix as the pension plan assets. The actual asset allocation percentages at year end are consistent with the company’s targeted asset allocation percentages. +The plans’ expected return on assets, as shown above is based on management’s expectations of long-term average rates of return to be achieved by the underlying investment portfolios. In establishing this assumption, management considers historical and expected returns for the asset classes in which the plans are invested, as well as current economic and capital market conditions. +Abbott funds its domestic pension plans according to IRS funding limitations. International pension plans are funded according to similar regulations. Abbott funded $ 400 million in 2020 and $ 382 million in 2019 to defined pension plans. Abbott expects to contribute approximately $ 410 million to its pension plans in 2021. +74 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 14 — Post-Employment Benefits (Continued) +Total benefit payments expected to be paid to participants, which includes payments funded from company assets, as well as paid from the plans, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Defined +​ +Medical and +(in millions) +Benefit Plans +Dental Plans +2021 +​ +$ +340 +​ +$ +72 +2022 +​ +​ +355 +​ +​ +73 +2023 +​ +​ +373 +​ +​ +74 +2024 +​ +​ +395 +​ +​ +75 +2025 +​ +​ +415 +​ +​ +76 +2026 to 2030 +​ +​ +2,410 +​ +​ +394 +​ +The Abbott Stock Retirement Plan is the principal defined contribution plan. Abbott’s contributions to this plan were $ 164 million in 2020, $ 158 million in 2019 and $ 146 million in 2018. The 2018 contributions include amounts related to participants of the St. Jude Medical Retirement Plan which was terminated in January 2018. +​ +Note 15 — Taxes on Earnings from Continuing Operations +Taxes on earnings from continuing operations reflect the annual effective rates, including charges for interest and penalties. Deferred income taxes reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. +In 2020, taxes on earnings from continuing operations include the recognition of approximately $ 170 million of tax benefits associated with the impairment of certain assets, approximately $ 140 million of net tax benefits as a result of the resolution of various tax positions related to prior years, and approximately $ 100 million in excess tax benefits associated with share-based compensation. In 2020, taxes on earnings from continuing operations also include a $ 26 million increase to the transition tax associated with the 2017 TCJA. The $ 26 million increase to the transition tax liability was the result of the resolution of various tax positions related to prior years. This adjustment increased the cumulative net tax expense related to the TCJA to $ 1.53 billion. The one-time transition tax is based on Abbott’s total post-1986 earnings and profits (E&P) that were previously deferred from U.S. income taxes. The tax computation also requires the determination of the amount of post-1986 E&P considered held in cash and other specified assets. As of December 31, 2020, the remaining balance of Abbott’s transition tax obligation is approximately $ 805 million, which will be paid over the next six years as allowed by the TCJA. +In 2019, taxes on earnings from continuing operations included an $ 86 million reduction of the transition tax and $ 68 million of tax expense resulting from tax legislation enacted in the fourth quarter of 2019 in India. The $ 86 million reduction to the transition tax liability was the result of the issuance of final transition tax regulations by the U.S. Department of Treasury in 2019. In 2018, taxes on earnings from continuing operations included $ 98 million of net tax expense related to the settlement of Abbott’s 2014-2016 federal income tax audit in the U.S., partial settlement of the former St. Jude Medical consolidated group’s 2014 and 2015 federal income tax returns in the U.S. and audit settlements in various countries. In 2018, Abbott also recorded $ 130 million of additional tax expense related to the TCJA; the $ 130 million reflected a $ 120 million increase in the transition tax from $ 2.89 billion to $ 3.01 billion and a $ 10 million reduction in the net benefit related to the remeasurement of deferred tax assets and liabilities. +Undistributed foreign earnings remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in its foreign entities is not practicable. In the U.S., Abbott’s federal income tax returns through 2016 are settled. There are numerous other income tax jurisdictions for which tax returns are not yet settled, none of which are individually significant. Reserves for interest and penalties are not significant. +75 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Taxes on Earnings from Continuing Operations (Continued) +Earnings from continuing operations before taxes, and the related provisions for taxes on earnings from continuing operations, were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +2018 +Earnings From Continuing Operations Before Taxes: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic +​ +$ +1,588 +​ +$ +889 +​ +$ +( 430 ) +Foreign +​ +3,380 +​ +3,188 +​ +​ +3,303 +Total +​ +$ +4,968 +​ +$ +4,077 +​ +$ +2,873 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +2018 +Taxes on Earnings From Continuing Operations: +​ +​ +​ +​ +​ +​ +​ +Current: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic +​ +$ +39 +​ +$ +291 +​ +$ +( 812 ) +Foreign +​ +566 +​ +590 +​ +​ +606 +Total current +​ +605 +​ +881 +​ +​ +( 206 ) +Deferred: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Domestic +​ +( 18 ) +​ +( 305 ) +​ +​ +832 +Foreign +​ +( 90 ) +​ +( 186 ) +​ +​ +( 87 ) +Total deferred +​ +( 108 ) +​ +( 491 ) +​ +​ +745 +Total +​ +$ +497 +​ +$ +390 +​ +$ +539 +​ +Differences between the effective income tax rate and the U.S. statutory tax rate were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2020 +2019 +2018 +Statutory tax rate on earnings from continuing operations +21.0 +% +21.0 +% +21.0 +% +Impact of foreign operations +( 3.3 ) +​ +( 5.0 ) +​ +( 5.4 ) +​ +Impact of TCJA and other related items +​ +0.5 +​ +( 2.1 ) +​ +6.3 +​ +Foreign-derived intangible income benefit +​ +( 1.0 ) +​ +( 2.0 ) +​ +( 1.9 ) +​ +Domestic impairment loss +​ +( 2.7 ) +​ +— +​ +( 2.1 ) +​ +Excess tax benefits related to stock compensation +​ +( 1.9 ) +​ +( 2.5 ) +​ +( 3.1 ) +​ +Research tax credit +​ +( 1.0 ) +​ +( 1.2 ) +​ +( 1.8 ) +​ +Resolution of certain tax positions pertaining to prior years +( 2.8 ) +​ +— +​ +3.4 +​ +Intercompany restructurings and integration +​ +0.5 +​ +— +​ +— +​ +State taxes, net of federal benefit +0.5 +​ +0.8 +​ +0.4 +​ +All other, net +0.2 +​ +0.6 +​ +2.0 +​ +Effective tax rate on earnings from continuing operations +10.0 +% +9.6 +% +18.8 +% +​ +Impact of foreign operations is primarily derived from operations in Puerto Rico, Switzerland, Ireland, the Netherlands, Costa Rica, Singapore, and Malta. +​ +76 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 15 — Taxes on Earnings from Continuing Operations (Continued) +The tax effect of the differences that give rise to deferred tax assets and liabilities were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +Deferred tax assets: +​ +​ +​ +​ +​ +​ +Compensation and employee benefits +$ +1,003 +​ +$ +982 +Other, primarily reserves not currently deductible, and NOL’s and credit carryforwards +​ +​ +2,383 +​ +​ +2,378 +Trade receivable reserves +​ +​ +196 +​ +​ +190 +Inventory reserves +​ +​ +146 +​ +​ +110 +Lease liabilities +​ +​ +259 +​ +​ +209 +Deferred intercompany profit +​ +​ +254 +​ +​ +259 +Total deferred tax assets before valuation allowance +​ +​ +4,241 +​ +​ +4,128 +Valuation allowance +​ +​ +( 1,060 ) +​ +​ +( 978 ) +Total deferred tax assets +​ +​ +3,181 +​ +​ +3,150 +Deferred tax liabilities: +​ +​ +​ +​ +​ +​ +Depreciation +​ +​ +( 297 ) +​ +​ +( 219 ) +Right of Use lease assets +​ +​ +( 251 ) +​ +​ +( 209 ) +Other, primarily the excess of book basis over tax basis of intangible assets +​ +​ +( 2,876 ) +​ +​ +( 3,258 ) +Total deferred tax liabilities +​ +​ +( 3,424 ) +​ +​ +( 3,686 ) +Total net deferred tax assets (liabilities) +$ +( 243 ) +​ +$ +( 536 ) +​ +Abbott has incurred losses in a foreign jurisdiction where realization of the future economic benefit is so remote that the benefit is not reflected as a deferred tax asset. +The following table summarizes the gross amounts of unrecognized tax benefits without regard to reduction in tax liabilities or additions to deferred tax assets and liabilities if such unrecognized tax benefits were settled: +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +January 1 +​ +$ +1,175 +​ +$ +1,120 +Increase due to current year tax positions +​ +190 +​ +​ +137 +Increase due to prior year tax positions +​ +97 +​ +​ +75 +Decrease due to prior year tax positions +​ +( 144 ) +​ +​ +( 117 ) +Settlements +​ +( 27 ) +​ +​ +( 32 ) +Lapse of statute +​ +​ +( 81 ) +​ +​ +( 8 ) +December 31 +​ +$ +1,210 +​ +$ +1,175 +​ +The total amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is approximately $ 1.08 billion. Abbott believes that it is reasonably possible that the recorded amount of gross unrecognized tax benefits may decrease within a range of $ 70 million to $ 430 million, including cash adjustments, within the next twelve months as a result of concluding various domestic and international tax matters. +​ +77 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Segment and Geographic Area Information +Abbott’s principal business is the discovery, development, manufacture and sale of a broad line of health care products. Abbott’s products are generally sold directly to retailers, wholesalers, hospitals, health care facilities, laboratories, physicians’ offices and government agencies throughout the world. +Abbott’s reportable segments are as follows: +Established Pharmaceutical Products —International sales of a broad line of branded generic pharmaceutical products. +Nutritional Products —Worldwide sales of a broad line of adult and pediatric nutritional products. +Diagnostic Products —Worldwide sales of diagnostic systems and tests for blood banks, hospitals, commercial laboratories and alternate-care testing sites. For segment reporting purposes, the Core Laboratories Diagnostics, Rapid Diagnostics, Molecular Diagnostics and Point of Care divisions are aggregated and reported as the Diagnostic Products segment. +Medical Devices — Worldwide sales of rhythm management, electrophysiology, heart failure, vascular, structural heart, neuromodulation and diabetes care products. For segment reporting purposes, the Cardiac Rhythm Management, Electrophysiology and Heart Failure, Vascular, Neuromodulation, Structural Heart and Diabetes Care divisions are aggregated and reported as the Medical Devices segment. +Abbott's underlying accounting records are maintained on a legal entity basis for government and public reporting requirements. Segment disclosures are on a performance basis consistent with internal management reporting. The cost of some corporate functions and the cost of certain employee benefits are charged to segments at predetermined rates that approximate cost. Remaining costs, if any, are not allocated to segments. In addition, intangible asset amortization is not allocated to operating segments, and intangible assets and goodwill are not included in the measure of each segment’s assets. +The following segment information has been prepared in accordance with the internal accounting policies of Abbott, as described above, and are not presented in accordance with generally accepted accounting principles applied to the consolidated financial statements. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Sales to External Customers (a) +​ +Operating Earnings (a) +(in millions) +2020 +2019 +2018 +2020 +2019 +2018 +Established Pharmaceutical Products +​ +$ +4,303 +​ +$ +4,486 +​ +$ +4,422 +​ +$ +794 +​ +$ +904 +​ +$ +894 +Nutritional Products +​ +7,647 +​ +7,409 +​ +7,229 +​ +1,751 +​ +1,705 +​ +1,652 +Diagnostic Products +​ +10,805 +​ +7,713 +​ +7,495 +​ +3,725 +​ +1,912 +​ +1,868 +Medical Devices +​ +11,787 +​ +12,239 +​ +11,370 +​ +3,038 +​ +3,769 +​ +3,500 +Total Reportable Segments +​ +34,542 +​ +31,847 +​ +30,516 +​ +$ +9,308 +​ +$ +8,290 +​ +$ +7,914 +Other +​ +66 +​ +57 +​ +62 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +$ +34,608 +​ +$ +31,904 +​ +$ +30,578 +​ +​ +​ +​ +​ +​ +​ +​ +​ +(a) Net sales and operating earnings were unfavorably affected by the impact of foreign exchange in 2020, 2019 and 2018. +​ +78 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Segment and Geographic Area Information (Continued) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +2018 +Total Reportable Segment Operating Earnings +​ +$ +9,308 +​ +$ +8,290 +​ +$ +7,914 +Corporate functions and benefit plan costs +​ +​ +( 518 ) +​ +( 468 ) +​ +( 618 ) +Net interest expense +​ +​ +( 500 ) +​ +( 576 ) +​ +( 721 ) +Loss on extinguishment of debt +​ +​ +— +​ +​ +( 63 ) +​ +​ +( 167 ) +Share-based compensation +​ +​ +( 546 ) +​ +( 519 ) +​ +( 477 ) +Amortization of intangible assets +​ +​ +( 2,132 ) +​ +( 1,936 ) +​ +( 2,178 ) +Other, net (b) +​ +​ +( 644 ) +​ +( 651 ) +​ +( 880 ) +Earnings from Continuing Operations Before Taxes +​ +$ +4,968 +​ +$ +4,077 +​ +$ +2,873 +(b) Other, net includes integration costs associated with the acquisition of St. Jude Medical and Alere and restructuring charges in 2020, 2019 and 2018. Other, net in 2020 also includes costs related to asset impairments, partially offset by income from the settlement of litigation. Other, net in 2018 also includes inventory step-up amortization associated with the acquisition of Alere. Charges for restructuring actions and other cost reduction initiatives were approximately $ 125 million in 2020, $ 215 million in 2019 and $ 153 million in 2018. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Additions to +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation +​ +Property and Equipment +​ +Total Assets +(in millions) +2020 +2019 +2018 +2020 +2019 +2018 +2020 +2019 +2018 +Established Pharmaceuticals +​ +$ +88 +​ +$ +98 +​ +$ +92 +​ +$ +109 +​ +$ +109 +​ +$ +131 +​ +$ +2,888 +​ +$ +2,858 +​ +$ +2,664 +Nutritionals +​ +​ +143 +​ +139 +​ +150 +​ +201 +​ +141 +​ +86 +​ +3,478 +​ +3,274 +​ +3,071 +Diagnostics +​ +​ +488 +​ +403 +​ +397 +​ +1,263 +​ +726 +​ +609 +​ +7,696 +​ +5,235 +​ +4,464 +Medical Devices +​ +​ +281 +​ +266 +​ +294 +​ +402 +​ +532 +​ +408 +​ +6,893 +​ +6,640 +​ +5,886 +Total Reportable Segments +​ +​ +1,000 +​ +906 +​ +933 +​ +1,975 +​ +1,508 +​ +1,234 +​ +$ +20,955 +​ +$ +18,007 +​ +$ +16,085 +Other +​ +​ +195 +​ +172 +​ +167 +​ +218 +​ +160 +​ +160 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total +​ +$ +1,195 +​ +$ +1,078 +​ +$ +1,100 +​ +$ +2,193 +​ +$ +1,668 +​ +$ +1,394 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(in millions) +2020 +2019 +2018 +Total Reportable Segment Assets +​ +$ +20,955 +​ +$ +18,007 +​ +$ +16,085 +Cash and investments +​ +7,969 +​ +5,023 +​ +4,983 +Goodwill and intangible assets +​ +38,528 +​ +40,220 +​ +42,196 +All other +​ +5,096 +​ +4,637 +​ +3,909 +Total Assets +​ +$ +72,548 +​ +$ +67,887 +​ +$ +67,173 +​ +79 +Abbott Laboratories and Subsidiaries +Notes to Consolidated Financial Statements (Continued) +Note 16 — Segment and Geographic Area Information (Continued) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Sales to External +​ +​ +Customers (c) +(in millions) +2020 +2019 +2018 +United States +​ +$ +13,022 +​ +$ +11,398 +​ +$ +10,839 +Germany +​ +​ +2,108 +​ +​ +1,751 +​ +​ +1,619 +China +​ +1,965 +​ +2,346 +​ +2,311 +Japan +​ +1,386 +​ +1,435 +​ +1,326 +India +​ +​ +1,323 +​ +​ +1,397 +​ +​ +1,333 +Switzerland +​ +​ +1,140 +​ +​ +1,068 +​ +​ +1,005 +The Netherlands +​ +1,084 +​ +975 +​ +930 +All Other Countries +​ +12,580 +​ +11,534 +​ +11,215 +Consolidated +​ +$ +34,608 +​ +$ +31,904 +​ +$ +30,578 +(c) Sales by country are based on the country that sold the product. +Long-lived assets on a geographic basis primarily include property and equipment. It excludes goodwill, intangible assets, deferred tax assets, and financial instruments. At December 31, 2020 and 2019, long-lived assets totaled $ 11.7 billion and $ 10.2 billion, respectively, and in the United States such assets totaled $ 6.1 billion and $ 5.1 billion, respectively. Long-lived asset balances associated with other countries were not material on an individual country basis in either of the two years. +​ +​ +​ +80 +​ +Management Report on Internal Control Over Financial Reporting +The management of Abbott Laboratories is responsible for establishing and maintaining adequate internal control over financial reporting. Abbott’s internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements. +All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. +Abbott’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2020. In making this assessment, it used the criteria set forth in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, we believe that, as of December 31, 2020, the company’s internal control over financial reporting was effective based on those criteria. +Abbott’s independent registered public accounting firm has issued an audit report on their assessment of the effectiveness of the company’s internal control over financial reporting. This report appears on page 84. +Robert B. Ford +President and Chief Executive Officer +Robert E. Funck, Jr. +Executive Vice President, Finance and Chief Financial Officer +Philip P. Boudreau +Vice President, Finance and Controller +February 19, 2021 +​ +81 +​ +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Abbott Laboratories +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Abbott Laboratories and subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of earnings, comprehensive income, shareholders’ investment and cash flows for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated February 19, 2021 expressed an unqualified opinion thereon. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +82 +​ +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +​ +​ +Income taxes – Unrecognized tax benefits +Description of the +Matter +​ +As described in Note 15 to the consolidated financial statements, unrecognized tax benefits were approximately $1.2 billion at December 31, 2020. Unrecognized tax benefits are assessed by management quarterly for identification and measurement, or more frequently if there are any indicators suggesting change in unrecognized tax benefits. Assessing tax positions involves judgement including interpreting tax laws of multiple jurisdictions and assumptions relevant to the measurement of an unrecognized tax benefit, including the estimated amount of tax liability that may be incurred should the tax position not be sustained upon inspection by a tax authority. These judgements and assumptions can significantly affect unrecognized tax benefits. +How We Addressed +the Matter in our +Audit +​ +We obtained an understanding, evaluated the design and tested the operating effectiveness of controls over the Company’s identification and measurement of unrecognized tax benefits, as well as its process for the assessment of events that may indicate a change in unrecognized tax benefits is warranted. For example, we tested controls over management’s review of the completeness of identified unrecognized tax benefits, as well as controls over management’s review of significant assumptions used within the measurement of unrecognized tax benefits. +With the support of our tax professionals, among other audit procedures performed, we evaluated the reasonableness of management’s judgement with respect to the interpretation of tax laws of multiple jurisdictions by reading and evaluating management’s documentation, including relevant accounting policies, and by considering how tax law, including statutes, regulations and case law, affected management’s judgments. We tested the completeness of management’s assessment of the identification of unrecognized tax benefits and possible outcomes related to it including evaluation of technical merits of the unrecognized tax benefits. We also tested, with the support of our valuation specialists, appropriateness and consistency of management’s methods and significant assumptions associated with the measurement of unrecognized tax benefits, including assessing the estimated amount of tax liability that may be incurred should the tax position not be sustained upon inspection by a tax authority. +​ +/s/ Ernst & Young LLP +We have served as the Company’s auditor since 2013. +Chicago, Illinois +February 19, 2021 +​ +83 +​ +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Abbott Laboratories +Opinion on Internal Control over Financial Reporting +We have audited Abbott Laboratories and subsidiaries’ internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Abbott Laboratories and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2020 and 2019, the related consolidated statements of earnings, comprehensive income, shareholders' investment and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and our report dated February 19, 2021 expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. +Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ Ernst & Young LLP +Chicago, Illinois +February 19, 2021 +​ +84 +​ +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +​ +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +Evaluation of disclosure controls and procedures. The Chief Executive Officer, Robert B. Ford, and the Chief Financial Officer, Robert E. Funck, Jr., evaluated the effectiveness of Abbott Laboratories’ disclosure controls and procedures as of the end of the period covered by this report, and concluded that Abbott Laboratories’ disclosure controls and procedures were effective to ensure that information Abbott is required to disclose in the reports that it files or submits with the Commission under the Securities Exchange Act of 1934 (the Exchange Act) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms, and to ensure that information required to be disclosed by Abbott in the reports that it files or submits under the Exchange Act is accumulated and communicated to Abbott’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. +Internal Control Over Financial Reporting +Management’s annual report on internal control over financial reporting. Management’s report on Abbott’s internal control over financial reporting is included on page 81 hereof. The report of Abbott’s independent registered public accounting firm related to their assessment of the effectiveness of internal control over financial reporting is included on page 84 hereof. +Changes in internal control over financial reporting. During the quarter ended December 31, 2020, there were no changes in Abbott’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, Abbott’s internal control over financial reporting. +​ +ITEM 9B. OTHER INFORMATION +None. +​ +​ +85 +​ +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Incorporated herein by reference are “Nominees for Election as Directors,” “Committees of the Board of Directors,” and “Procedure for Recommendation and Nomination of Directors and Transaction of Business at Annual Meeting” to be included in the 2021 Abbott Laboratories Proxy Statement. The 2021 Definitive Proxy Statement will be filed on or about March 12, 2021. Also incorporated herein by reference is the text found under the caption, “Information About Our Executive Officers” on pages 16 through 19 hereof. +Abbott has adopted a code of ethics that applies to its principal executive officer, principal financial officer, and principal accounting officer and controller. That code is part of Abbott’s code of business conduct which is available free of charge through Abbott’s investor relations website ( www.abbottinvestor.com ). Abbott intends to include on its website any amendment to, or waiver from, a provision of its code of ethics that applies to Abbott’s principal executive officer, principal financial officer, and principal accounting officer and controller that relates to any element of the code of ethics definition enumerated in Item 406(b) of Regulation S-K. +​ +ITEM 11. EXECUTIVE COMPENSATION +The material to be included in the 2021 Proxy Statement under the headings “2020 Director Compensation” and “Executive Compensation” is incorporated herein by reference. The 2021 Definitive Proxy Statement will be filed on or about March 12, 2021. +​ +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +(a) Equity Compensation Plan Information . +The following table presents information as of December 31, 2020 about our compensation plans under which Abbott common shares have been authorized for issuance. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(c) +​ +​ +​ +​ +​ +​ +​ +Number of +​ +​ +(a) +​ +​ +​ +​ +securities remaining +​ +​ +Number of +​ +​ +​ +​ +available for +​ +​ +securities to be +​ +​ +(b) +​ +future issuance +​ +​ +issued upon +​ +Weighted average +​ +under equity +​ +​ +exercise of +​ +exercise price +​ +compensation +​ +​ +outstanding +​ +of outstanding +​ +plans (excluding +​ +​ +options, warrants +​ +options, warrants +securities reflected +Plan Category +​ +and rights +​ +and rights +in column (a)) +Equity compensation plans approved by security holders (1) +28,034,365 +​ +$ +56.45 +124,762,755 +Equity compensation plans not approved by security holders +0 +​ +— +0 +Total (1)(2) +28,034,365 +​ +$ +56.45 +124,762,755 +(1) +(i) +Abbott Laboratories 2009 Incentive Stock Program . Benefits under the Abbott Laboratories 2009 Incentive Stock Program (the “2009 Program”) include non-qualified stock options, restricted stock, restricted stock units, performance awards, other share-based awards (including stock appreciation rights, dividend equivalents and recognition awards), awards to non-employee directors, and foreign benefits. The shares that remain available for issuance under the 2009 Program may be issued in connection with any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards are satisfied from treasury shares). +​ +​ +​ +86 +​ +​ +​ +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 2009 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, may again be used for new stock options, rights, or awards of any type authorized under the Abbott Laboratories 2017 Incentive Stock Program (the “2017 Program”). If shares are issued under any benefit under the 2009 Program and thereafter are reacquired by Abbott pursuant to rights reserved upon their issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or so reacquired, may not again be used for new stock options, rights, or awards of any type authorized under the 2009 Program. +​ +​ +​ +​ +​ +In April 2017, the 2009 Program was replaced by the 2017 Program. No further awards will be granted under the 2009 Program. +​ +​ +​ +​ +(ii) +Abbott Laboratories 2017 Incentive Stock Program . Benefits under the 2017 Program include non-qualified stock options, restricted stock, restricted stock units, performance awards, other share-based awards (including stock appreciation rights, dividend equivalents and recognition awards), awards to non-employee directors, and foreign benefits. The shares that remain available for issuance under the 2017 Program may be issued in connection with any one of these benefits and may be either authorized but unissued shares or treasury shares (except that restricted stock awards are satisfied from treasury shares). +​ +​ +​ +​ +​ +If there is a lapse, expiration, termination, forfeiture or cancellation of any benefit granted under the 2017 Program without the issuance of shares or payment of cash thereunder, the shares subject to or reserved for that benefit, or so reacquired, may again be used for new stock options, rights, or awards of any type authorized under the 2017 Program. If shares are issued under any benefit under the 2017 Program and thereafter are reacquired by Abbott pursuant to rights reserved upon their issuance, or pursuant to the payment of the purchase price of shares under stock options by delivery of other common shares of Abbott, the shares subject to or reserved for that benefit, or so reacquired, may not again be used for new stock options, rights, or awards of any type authorized under the 2017 Program. +​ +​ +​ +​ +(iii) +Abbott Laboratories Employee Stock Purchase Plan for Non-U.S. Employees . Eligible employees of participating non-U.S. affiliates of Abbott may participate in this plan. An eligible employee may authorize payroll deductions at the rate of 1% to 10% of eligible compensation (in multiples of one percent) subject to a limit of US $12,500 during any purchase cycle. +​ +​ +​ +​ +​ +Purchase cycles are generally six months long and usually begin on August 1 and February 1. On the last day of each purchase cycle, Abbott uses participant contributions to acquire Abbott common shares. The shares may be either authorized but unissued shares, treasury shares, or shares acquired on the open market. The purchase price is typically 85% of the lower of the fair market value of the shares on the purchase date or on the first day of that purchase cycle. As the number of shares subject to outstanding options is indeterminable, columns (a) and (b) of the above table do not include information on the Employee Stock Purchase Plan. As of December 31, 2020, an aggregate of 11,611,818 common shares were available for future issuance under the Employee Stock Purchase Plan, including shares subject to purchase during the current purchase cycle. +​ +​ +​ +​ +​ +In April 2017, the 2009 Employee Stock Purchase Plan for Non-U.S. Employees was amended and restated as the Abbott Laboratories 2017 Employee Stock Purchase Plan for Non-U.S. Employees. +​ +​ +​ +(2) +​ +Not included in the table: St. Jude Medical, Inc. Plans . In 2017, in connection with the acquisition of St. Jude Medical, Inc., options outstanding under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, as Amended and Restated (2014) were assumed by Abbott and converted into Abbott options of substantially equivalent value. As of December 31, 2020, 885,521 options remained outstanding under these plans. These options have a weighted average purchase price of $30.46. No further awards will be granted under these plans. +​ +87 +​ +For additional information concerning the Abbott Laboratories 2009 Incentive Stock Program, the Abbott Laboratories 2017 Incentive Stock Program, and the Abbott Laboratories 2017 Employee Stock Purchase Plan for Non-U.S. Employees, see the discussion in Note 9 entitled “Incentive Stock Program” of the Notes to Consolidated Financial Statements included under Item 8, “Financial Statements and Supplementary Data.” +(b) Information Concerning Security Ownership . Incorporated herein by reference is the material under the heading “Security Ownership of Executive Officers and Directors” and “Information Concerning Security Ownership” in the 2021 Proxy Statement. The 2021 Definitive Proxy Statement will be filed on or about March 12, 2021. +​ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The material to be included in the 2021 Proxy Statement under the headings “The Board of Directors,” “Committees of the Board of Directors,” and “Approval Process for Related Person Transactions” is incorporated herein by reference. The 2021 Definitive Proxy Statement will be filed on or about March 12, 2021. +​ +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The material to be included in the 2021 Proxy Statement under the headings “Audit Fees and Non-Audit Fees” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of the Independent Auditor” is incorporated herein by reference. The 2021 Definitive Proxy Statement will be filed on or about March 12, 2021. +​ +88 +​ +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as part of this Form 10-K. +(1) Financial Statements: See Item 8, “Financial Statements and Supplementary Data,” on page 42 hereof, for a list of financial statements. +(2) Financial Statement Schedules: The required financial statement schedules are found on the pages indicated below. These schedules should be read in conjunction with the Consolidated Financial Statements of Abbott Laboratories: +​ +Abbott Laboratories Financial Statement Schedules +Page No. +Valuation and Qualifying Accounts (Schedule II) +​ +101 +Schedules I, III, IV, and V are not submitted because they are not applicable or not required +​ +​ +Report of Independent Registered Public Accounting Firm +​ +102 +Individual Financial Statements of businesses acquired by the registrant have been omitted pursuant to Rule 3.05 of Regulation S-X +​ +​ +​ +(3) Exhibits Required by Item 601 of Regulation S-K: The information called for by this paragraph is set forth in Item 15(b) below. +(b) Exhibits filed. +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +3.1 +* +Articles of Incorporation, Abbott Laboratories, filed as Exhibit 3.1 to the Abbott Laboratories Quarterly Report on Form 10-Q for the quarter ended March 31, 1998. +​ +​ +​ +​ +​ +3.2 +* +By-Laws of Abbott Laboratories, as amended and restated effective April 24, 2020, filed as Exhibit 3.1 to the Abbott Laboratories Current Report on Form 8-K dated February 21, 2020. +​ +​ +​ +​ +​ +4.1 +* +Indenture dated as of February 9, 2001, between Abbott Laboratories and The Bank of New York Mellon Trust Company, N.A. (as successor to J.P. Morgan Trust Company, National Association, successor to Bank One Trust Company, N.A.) (including form of Security), filed as Exhibit 4.1 to the Abbott Laboratories Registration Statement on Form S-3 dated February 12, 2001. +​ +​ +​ +​ +​ +4.2 +* +Supplemental Indenture dated as of February 27, 2006, between Abbott Laboratories and The Bank of New York Mellon Trust Company, N.A. (as successor to J.P. Morgan Trust Company, National Association), filed as Exhibit 4.2 to the Abbott Laboratories Registration Statement on Form S-3 dated February 28, 2006. +​ +​ +​ +​ +​ +4.3 +* +Form of $1,000,000,000 6.150% Note due 2037, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated November 6, 2007. +​ +​ +​ +​ +​ +4.4 +* +Actions of the Authorized Officers with respect to Abbott’s 5.150% Notes due 2012, 5.600% Notes due 2017 and 6.150% Notes due 2037, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated November 6, 2007. +​ +​ +​ +​ +​ +4.5 +* +Form of $1,000,000,000 6.000% Note due 2039, filed as Exhibit 99.5 to the Abbott Laboratories Current Report on Form 8-K dated February 26, 2009. +​ +​ +​ +​ +​ +4.6 +* +Actions of the Authorized Officers with respect to Abbott’s 5.125% Note due 2019 and 6.000% Note due 2039, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated February 26, 2009. +​ +89 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +4.7 +* +Form of 2040 Note, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated May 27, 2010. +​ +​ +​ +​ +​ +4.8 +* +Actions of the Authorized Officers with respect to Abbott’s 2.70% Notes, 4.125% Notes and 5.30% Notes, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated May 27, 2010. +​ +​ +​ +​ +​ +4.9 +* +Indenture, dated as of March 10, 2015, between Abbott Laboratories and U.S. Bank National Association (including form of Security), filed as Exhibit 4.1 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.10 +* +Form of 2.550% Note due 2022, filed as Exhibit 99.5 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.11 +* +Form of 2.950% Note due 2025, filed as Exhibit 99.6 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.12 +* +Actions of the Authorized Officers with respect to Abbott’s 2.000% Notes, 2.550% Notes and 2.950% Notes, filed as Exhibit 99.3 to the Abbott Laboratories Current Report on Form 8-K dated March 5, 2015. +​ +​ +​ +​ +​ +4.13 +* +Form of 3.400% Notes due 2023, filed as Exhibit 4.4 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.14 +* +Form of 3.750% Notes due 2026, filed as Exhibit 4.5 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.15 +* +Form of 4.750% Notes due 2036, filed as Exhibit 4.6 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.16 +* +Form of 4.900% Notes due 2046, filed as Exhibit 4.7 to the Abbott Laboratories Current Report on Form 8-K dated November 22, 2016. +​ +​ +​ +​ +​ +4.17 +* +Officers’ Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 2.350% Notes due 2019, 2.900% Notes due 2021, 3.400% Notes due 2023, 3.750% Notes due 2026, 4.750% Notes due 2036 and 4.900% Notes due 2046 (including forms of notes), filed as Exhibit 4.22 to the Abbott Laboratories 2016 Annual Report on Form 10-K. +​ +​ +​ +​ +​ +4.18 +* +Form of 3.875% Notes due 2025, filed as Exhibit 4.5 to the Abbott Laboratories Current Report on Form 8-K dated March 22, 2017. +​ +​ +​ +​ +​ +4.19 +* +Form of 4.75% Notes due 2043, filed as Exhibit 4.6 to the Abbott Laboratories Current Report on Form 8-K dated March 22, 2017. +​ +​ +​ +​ +​ +4.20 +* +Officers’ Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 2.000% Notes due 2018, 2.800% Notes due 2020, 3.25% Notes due 2023, 3.875% Notes due 2025, and 4.75% Notes due 2043 (including form of notes), filed as Exhibit 4.7 to the Abbott Laboratories Quarterly Report on Form 10-Q for the period ended March 31, 2017. +​ +​ +​ +​ +​ +90 +​ +​ +10-K +Exhibit +Table +Item No. +​ +4.21 +† +Indenture, dated as of July 28, 2009, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank National Association, as trustee, filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated July 28, 2009. +​ +​ +​ +​ +​ +4.22 +† +Fourth Supplemental Indenture, dated as of April 2, 2013, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank National Association, as trustee, relating to St. Jude Medical, LLC’s 3.25% Senior Notes due 2023 and 4.75% Senior Notes due 2043 (including forms of notes), filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated April 2, 2013. +​ +​ +​ +​ +​ +4.23 +† +Fifth Supplemental Indenture, dated as of September 23, 2015, between St. Jude Medical, LLC (successor to St. Jude Medical, Inc.) and U.S. Bank National Association, as trustee, relating to St. Jude Medical, LLC’s 2.000% Senior Notes due 2018, 2.800% Senior Notes due 2020 and 3.875% Senior Notes due 2025, filed as Exhibit 4.1 to the St. Jude Medical, Inc. Current Report on Form 8-K dated September 23, 2015. +​ +​ +​ +​ +​ +4.24 +† +Sixth Supplemental Indenture, dated as of January 4, 2017, among St. Jude Medical, Inc., St. Jude Medical, LLC and U.S. Bank National Association, as trustee, filed as Exhibit 4.1 to the St. Jude Medical, LLC Current Report on Form 8-K dated January 4, 2017. +​ +​ +​ +​ +​ +4.25 +* +Form of Seventh Supplemental Indenture between St. Jude Medical, LLC and U.S. Bank National Association, as trustee, filed as Exhibit 4.3 to the Abbott Laboratories Registration Statement on Form S-4 dated February 21, 2017. +​ +​ +​ +​ +​ +4.26 +* +Indenture dated September 27, 2018, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor and U.S. Bank National Association, as trustee, filed as Exhibit 4.1 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018. +​ +​ +​ +​ +​ +4.27 +* +First Supplemental Indenture dated September 27, 2018, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor, U.S. Bank National Association, as trustee, Elavon Financial Services DAC, U.K. Branch, as paying agent and transfer agent, and Elavon Financial Services DAC, as registrar, filed as Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018. +​ +​ +​ +​ +​ +4.28 +* +Second Supplemental Indenture dated November 19, 2019, among Abbott Ireland Financing DAC, as issuer, Abbott Laboratories, as guarantor, U.S. Bank National Association, as trustee, and Elavon Financial Services DAC, as paying agent, transfer agent and registrar, filed as Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated November 19, 2019. +​ +​ +​ +​ +​ +4.29 +* +Form of 0.875% Note due 2023 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018). +​ +​ +​ +​ +​ +4.30 +* +Form of 1.500% Note due 2026 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated September 27, 2018). +​ +​ +​ +​ +​ +4.31 +* +Form of 0.100% Note due 2024 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated November 19, 2019). +​ +​ +​ +​ +​ +4.32 +* +Form of 0.375% Note due 2027 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated November 19, 2019). +​ +91 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +4.33 +* +Officers’ Certificate Pursuant to Sections 3.1 and 3.3 of the Indenture with respect to 1.150% Notes due 2028 and 1.400% Notes due 2030, filed as Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated June 22, 2020. +​ +​ +​ +​ +​ +4.34 +* +Form of 1.150% Notes due 2028, filed as Exhibit 4.3 to the Abbott Laboratories Current Report on Form 8-K filed on June 24, 2020 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated June 22, 2020). +​ +​ +​ +​ +​ +4.35 +* +Form of 1.400% Notes due 2030, filed as Exhibit 4.4 to the Abbott Laboratories Current Report on Form 8-K filed on June 24, 2020 (included in Exhibit 4.2 to the Abbott Laboratories Current Report on Form 8-K dated June 22, 2020). +​ +​ +​ +​ +​ +​ +​ +Other debt instruments are omitted in accordance with Item 601(b)(4)(iii)(A) of Regulation S-K. Copies of such agreements will be furnished to the Securities and Exchange Commission upon request. +​ +​ +​ +​ +​ +4.36 +* +Description of Registrant's Securities, filed as Exhibit 4.34 to the 2019 Abbott Laboratories Annual Report on Form 10-K). +​ +​ +​ +​ +​ +10.1 +* +Supplemental Plan Abbott Laboratories Extended Disability Plan, filed as an exhibit (pages 50-51) to the 1992 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.2 +​ +Abbott Laboratories Deferred Compensation Plan, as amended.** +​ +​ +​ +​ +​ +10.3 +* +Abbott Laboratories 401(k) Supplemental Plan, as amended and restated, filed as Exhibit 10.3 to the 2012 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.4 +* +Abbott Laboratories Supplemental Pension Plan, as amended and restated, filed as Exhibit 10.4 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.5 +* +1986 Abbott Laboratories Management Incentive Plan, as amended and restated, filed as Exhibit 10.5 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.6 +* +1998 Abbott Laboratories Performance Incentive Plan, as amended, filed as Exhibit 10.6 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.7 +* +Rules for the 1998 Abbott Laboratories Performance Incentive Plan, as amended and restated, filed as Exhibit 10.7 to the 2012 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.8 +* +Abbott Laboratories 2009 Incentive Stock Program, as amended and restated, filed as Exhibit 10.9 to the 2014 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.9 +* +Abbott Laboratories 2017 Incentive Stock Program (incorporated by reference to Exhibit B of Abbott’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 17, 2017).** +​ +​ +​ +​ +​ +10.10 +* +Abbott Laboratories Non-Employee Directors’ Fee Plan, as amended and restated, filed as Exhibit 10.10 to the 2016 Abbott Laboratories Annual Report on Form 10-K.** +​ +92 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +10.11 +* +Form of Non-Employee Director Restricted Stock Unit Agreement under Abbott Laboratories 1996 Incentive Stock Program, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated December 10, 2004.** +​ +​ +​ +​ +​ +10.12 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated April 24, 2009.** +​ +​ +​ +​ +​ +10.13 +* +Form of Non-Employee Director Restricted Stock Unit Agreement, filed as Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated April 24, 2009.** +​ +​ +​ +​ +​ +10.14 +* +Form of Non-Qualified Stock Option Agreement (ratably vested), filed as Exhibit 10.5 to the Abbott Laboratories Current Report on Form 8-K dated April 24, 2009.** +​ +​ +​ +​ +​ +10.15 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based), filed as Exhibit 10.40 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.16 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based), filed as Exhibit 10.42 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.17 +* +Form of Restricted Stock Unit Agreement for executive officers (cliff vested), filed as Exhibit 10.44 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.18 +* +Form of Restricted Stock Unit Agreement for foreign executive officers (cliff vested), filed as Exhibit 10.46 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.19 +* +Form of Non-Employee Director Restricted Stock Unit Agreement, filed as Exhibit 10.47 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.20 +* +Form of Non-Employee Director Restricted Stock Unit Agreement for foreign non-employee directors, filed as Exhibit 10.48 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.21 +* +Form of Performance Restricted Stock Agreement for executive officers (annual performance based), filed as Exhibit 10.53 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.22 +* +Form of Performance Restricted Stock Agreement for executive officers (interim performance based), filed as Exhibit 10.55 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.23 +* +Form of Restricted Stock Agreement for executive officers (cliff vested), filed as Exhibit 10.57 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.24 +* +Form of Non-Qualified Stock Option Agreement, filed as Exhibit 10.58 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.25 +* +Form of Non-Qualified Stock Option Agreement for executive officers, filed as Exhibit 10.59 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.26 +* +Form of Non-Qualified Stock Option Agreement for foreign employees, filed as Exhibit 10.60 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +93 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +10.27 +* +Form of Non-Qualified Stock Option Agreement for foreign executive officers, filed as Exhibit 10.61 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.28 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement, filed as Exhibit 10.64 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.29 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement for foreign non-employee directors, filed as Exhibit 10.65 to the 2013 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.30 +* +Form of Restricted Stock Unit Agreement (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.2 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.31 +* +Form of Restricted Stock Unit Agreement for foreign employees (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.3 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.32 +* +Form of Restricted Stock Unit Agreement (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.4 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.33 +* +Form of Restricted Stock Unit Agreement for foreign employees (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.5 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.34 +* +Form of Performance Restricted Stock Unit Agreement for foreign employees (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.6 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.35 +* +Form of Performance Restricted Stock Unit Agreement for foreign employees (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.7 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.36 +* +Form of Restricted Stock Agreement (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.8 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.37 +* +Form of Restricted Stock Agreement (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.9 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.38 +* +Form of Performance Restricted Stock Agreement (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.10 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.39 +* +Form of Performance Restricted Stock Agreement (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.11 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.40 +* +Form of Non-Qualified Stock Option Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.12 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +94 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +10.41 +* +Form of Non-Qualified Stock Option Agreement for foreign employees under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.13 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.42 +* +Form of Restricted Stock Unit Agreement for executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.14 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.43 +* +Form of Restricted Stock Unit Agreement for foreign executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.15 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.44 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.16 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.45 +* +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.17 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.46 +* +Form of Restricted Stock Agreement for executive officers (ratably vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.18 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.47 +* +Form of Restricted Stock Agreement for executive officers (cliff vested) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.19 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.48 +* +Form of Performance Restricted Stock Agreement for executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.20 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.49 +* +Form of Performance Restricted Stock Agreement for executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.21 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.50 +* +Form of Non-Qualified Stock Option Agreement for executive officers under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.22 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.51 +* +Form of Non-Qualified Stock Option Agreement for foreign executive officers under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.23 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.52 +* +Form of Non-Employee Director Restricted Stock Unit Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.24 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +95 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +10.53 +* +Form of Non-Employee Director Restricted Stock Unit Agreement for foreign non-employee directors under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.25 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.54 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.26 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.55 +* +Form of Non-Employee Director Non-Qualified Stock Option Agreement for foreign non-employee directors under the Abbott Laboratories 2017 Incentive Stock Program, filed as Exhibit 10.27 to the Abbott Laboratories Current Report on Form 8-K dated April 28, 2017.** +​ +​ +​ +​ +​ +10.56 +​ +Form of Performance Restricted Stock Unit Agreement for foreign employees (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.57 +​ +Form of Performance Restricted Stock Unit Agreement for foreign employees (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.58 +​ +Form of Performance Restricted Stock Agreement (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.59 +​ +Form of Performance Restricted Stock Agreement (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.60 +​ +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.61 +​ +Form of Performance Restricted Stock Unit Agreement for foreign executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.62 +​ +Form of Performance Restricted Stock Agreement for executive officers (annual performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.63 +​ +Form of Performance Restricted Stock Agreement for executive officers (interim performance based) under the Abbott Laboratories 2017 Incentive Stock Program.** +​ +​ +​ +​ +​ +10.64 +* +Form of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), filed as Exhibit 10.1 to the Abbott Laboratories Current Report on Form 8-K dated November 30, 2012.** +​ +​ +​ +​ +​ +10.65 +* +Form of Extension of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), extending the agreement term to December 31, 2020, filed as Exhibit 10.74 to the 2018 Abbott Laboratories Annual Report on Form 10-K.** +​ +​ +​ +​ +​ +10.66 +​ +Form of Extension of Agreement Regarding Change in Control by and between Abbott Laboratories and its named executive officers (other than Mr. White), extending the agreement term to December 31, 2022.** +​ +​ +​ +​ +​ +10.67 +* +Form of Time Sharing Agreement between Abbott Laboratories Inc. and M.D. White, filed as Exhibit 10.6 to the Abbott Laboratories Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.** +​ +96 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +10.68 +​ +Form of Time Sharing Agreement between Abbott Laboratories Inc. and Robert B. Ford.** +​ +​ +​ +​ +​ +10.69 +† +St. Jude Medical, Inc. 2007 Stock Incentive Plan, as amended and restated (2014), filed as Exhibit 10.22 to St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended January 3, 2015 dated February 26, 2015.** +​ +​ +​ +​ +​ +10.70 +† +Form of Non-Qualified Stock Option Agreement (Global) and related Notice of Non-Qualified Stock Option Grant for stock options granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.24 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012 dated February 26, 2013.** +​ +​ +​ +​ +​ +10.71 +† +Form of Non-Qualified Stock Option Agreement for Non-Employee Directors and related Notice of Non-Qualified Stock Option Grant for stock options granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.25 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012, dated February 26, 2013.** +​ +​ +​ +​ +​ +10.72 +† +Form of Restricted Stock Units Award Agreement (Global) and related Restricted Stock Units Award Certificate for restricted stock units granted on or after December 10, 2012 under the St. Jude Medical, Inc. 2007 Stock Incentive Plan, filed as Exhibit 10.27 to the St. Jude Medical, Inc. Annual Report on Form 10-K for the year ended December 29, 2012, dated February 26, 2013.** +​ +​ +​ +​ +​ +10.73 +* +Management Savings Plan, as amended and restated, filed as Exhibit 10.75 to the 2019 Abbott Laboratories Annual Report on Form 10-K).** +​ +​ +​ +​ +​ +10.74 +​ +Abbott Overseas Managers Pension Plan, as amended and restated.** +​ +​ +​ +​ +​ +10.75 +​ +Five Year Credit Agreement, dated as of November 12, 2020, among Abbott Laboratories, as borrower, various financial institutions, as lenders, and JPMorgan Chase Bank, N.A., as administrative agent. +​ +​ +​ +​ +​ +21 +​ +Subsidiaries of Abbott Laboratories. +​ +​ +​ +​ +​ +23.1 +​ +Consent of Independent Registered Public Accounting Firm. +​ +​ +​ +​ +​ +31.1 +​ +Certification of Chief Executive Officer Required by Rule 13a-14(a) (17 CFR 240.13a-14(a)). +​ +​ +​ +​ +​ +31.2 +​ +Certification of Chief Financial Officer Required by Rule 13a-14(a) (17 CFR 240.13a-14(a)). +​ +​ +​ +​ +Exhibits 32.1 and 32.2 are furnished herewith and should not be deemed to be “filed” under the Securities Exchange Act of 1934. +​ +​ +​ +​ +​ +32.1 +​ +Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +​ +​ +​ +​ +​ +32.2 +​ +Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +​ +97 +​ +​ +10-K +Exhibit +Table +Item No. +​ +​ +​ +​ +​ +101 +​ +The following financial statements and notes from the Abbott Laboratories Annual Report on Form 10-K for the year ended December 31, 2020 filed on February 19, 2021, formatted in Inline XBRL: (i) Consolidated Statement of Earnings; (ii) Consolidated Statement of Comprehensive Income; (iii) Consolidated Statement of Cash Flows; (iv) Consolidated Balance Sheet; (v) Consolidated Statement of Shareholders’ Investment; and (vi) the notes to the consolidated financial statements. +​ +​ +​ +​ +​ +104 +​ +Cover Page Interactive Data File (the cover page XBRL tags are embedded in the Inline XBRL document and included in Exhibit 101). +​ +* Incorporated herein by reference. Commission file number 1-2189. +** Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit hereto. +† Incorporated herein by reference. Commission file number 1-12441. +Abbott will furnish copies of any of the above exhibits to a shareholder upon written request to the Secretary, Abbott Laboratories, 100 Abbott Park Road, Abbott Park, Illinois 60064-6400. +(c) Financial Statement Schedule filed (page 101 ). +​ +ITEM 16. FORM 10-K SUMMARY +None. +​ +​ +98 +​ +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Abbott Laboratories has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +​ +​ +​ +​ +​ +ABBOTT LABORATORIES +​ +​ +​ +​ +​ +​ +​ +By +/s/ ROBERT B. FORD +​ +Robert B. Ford +President and Chief Executive Officer +​ +​ +​ +Date: +February 19, 2021 +​ +​ +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Abbott Laboratories on February 19, 2021 in the capacities indicated below. +​ +/s/ ROBERT B. FORD +/s/ ROBERT E. FUNCK, JR. +Robert B. Ford +​ +Robert E. Funck, Jr. +President and Chief Executive Officer, +and Director of Abbott Laboratories +(principal executive officer) +​ +Executive Vice President, Finance +and Chief Financial Officer +(principal financial officer) +​ +​ +​ +​ +​ +​ +/s/ PHILIP P. BOUDREAU +​ +/s/ MILES D. WHITE +Philip P. Boudreau +​ +Miles D. White +Vice President, Finance and Controller +(principal accounting officer) +​ +Executive Chairman of the Board +​ +​ +​ +​ +​ +​ +/s/ ROBERT J. ALPERN +​ +/s/ ROXANNE S. AUSTIN +Robert J. Alpern, M.D. +​ +Roxanne S. Austin +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ SALLY E. BLOUNT +​ +/s/ MICHELLE A. KUMBIER +Sally E. Blount, Ph.D. +​ +Michelle A. Kumbier +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ EDWARD M. LIDDY +​ +/s/ DARREN W. MCDEW +Edward M. Liddy +Director of Abbott Laboratories +​ +Darren W. McDew +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ NANCY MCKINSTRY +​ +/s/ PHEBE N. NOVAKOVIC +Nancy McKinstry +​ +Phebe N. Novakovic +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +​ +​ +​ +/s/ WILLIAM A. OSBORN +​ +/s/ DANIEL J. STARKS +William A. Osborn +​ +Daniel J. Starks +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +99 +​ +​ +​ +​ +/s/ JOHN G. STRATTON +​ +/s/ GLENN F. TILTON +John G. Stratton +​ +Glenn F. Tilton +Director of Abbott Laboratories +​ +Director of Abbott Laboratories +​ +​ +​ +100 +​ +ABBOTT LABORATORIES AND SUBSIDIARIES +SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS +FOR THE YEARS ENDED DECEMBER 31, 2020, 2019 AND 2018 +(in millions of dollars) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Amounts +​ +​ +​ +​ +Balance +​ +Provisions/ +​ +Charged Off +​ +​ +​ +Allowances for Doubtful +​ +at Beginning +​ +Charges +​ +and Other +​ +Balance at +Accounts and Product Returns +​ +of Year +​ +to Income +​ +Deductions +​ +End of Year +2020 +​ +$ +384 +​ +$ +187 +​ +$ +( 111 ) +​ +$ +460 +2019 +​ +​ +314 +​ +​ +137 +​ +​ +( 68 ) +​ +​ +384 +2018 +​ +294 +​ +​ +110 +​ +​ +( 90 ) +​ +​ +314 +​ +​ +​ +101 +​ +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Abbott Laboratories +Opinion on the Financial Statement Schedule +We have audited the consolidated financial statements of Abbott Laboratories and subsidiaries (the Company) as of December 31, 2020 and 2019, for each of the three years in the period ended December 31, 2020, and have issued our report thereon dated February 19, 2021 (included elsewhere in this Annual Report on Form 10-K). Our audits of the consolidated financial statements included the financial statement schedule listed in Item 15(a)(2) of this Annual Report on Form 10-K (the “schedule”). This schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s schedule, based on our audits. +In our opinion, the schedule presents fairly, in all material respects, the information set forth therein when considered in conjunction with the consolidated financial statements. +/s/ Ernst & Young LLP +Chicago, Illinois +February 19, 2021 +​ +102 \ No newline at end of file diff --git a/raw/filings/0000001800/2020/0001104659-21-025751/filing_metadata.csv b/raw/filings/0000001800/2020/0001104659-21-025751/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..c941ea99229b73414fe79556785fe6ac9c5d4d74 --- /dev/null +++ b/raw/filings/0000001800/2020/0001104659-21-025751/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000001800,ABT,ABBOTT LABORATORIES,2020,10-K,2021-02-19,2020-12-31,2021-02-19T21:10:04.000Z,0001104659-21-025751,abt-20201231x10k.htm,10-K,21381769,1,1,https://www.sec.gov/Archives/edgar/data/1800/000110465921025751/abt-20201231x10k.htm,https://www.sec.gov/Archives/edgar/data/1800/000110465921025751/ diff --git a/raw/filings/0000001800/2020/0001104659-21-025751/item1.txt b/raw/filings/0000001800/2020/0001104659-21-025751/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..15b85db12fc381706ea109e764a9f2520116a522 --- /dev/null +++ b/raw/filings/0000001800/2020/0001104659-21-025751/item1.txt @@ -0,0 +1,96 @@ +ITEM 1. BUSINESS +GENERAL DEVELOPMENT OF BUSINESS +Abbott Laboratories is an Illinois corporation, incorporated in 1900. Abbott’s* principal business is the discovery, development, manufacture, and sale of a broad and diversified line of health care products. +NARRATIVE DESCRIPTION OF BUSINESS +Abbott has four reportable segments: Established Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Medical Devices. +Established Pharmaceutical Products +These products include a broad line of branded generic pharmaceuticals manufactured worldwide and marketed and sold outside the United States in emerging markets. These products are generally sold directly to wholesalers, distributors, government agencies, health care facilities, pharmacies, and independent retailers from Abbott-owned distribution centers and public warehouses, depending on the market served. Certain products are co-marketed or co-promoted with, or licensed from, other companies. +The principal products included in the broad therapeutic area portfolios of the Established Pharmaceutical Products segment are: +● gastroenterology products, including Creon™, for the treatment of pancreatic exocrine insufficiency associated with several underlying conditions, including cystic fibrosis and chronic pancreatitis; Duspatal™ and Dicetel™, for the treatment of irritable bowel syndrome or biliary spasm; Heptral™, Transmetil™, and Samyr™, for the treatment of intrahepatic cholestasis (associated with liver disease) or depressive symptoms; and Duphalac™, for regulation of the physiological rhythm of the colon; +● women’s health products, including Duphaston™, for the treatment of many different gynecological disorders; and Femoston™, a hormone replacement therapy for postmenopausal women; +● cardiovascular and metabolic products, including Lipanthyl™ and TriCor™, for the treatment of dyslipidemia; Teveten™ and Teveten™ Plus, for the treatment of essential hypertension, and Physiotens™, for the treatment of hypertension; and Synthroid™, for the treatment of hypothyroidism; +● pain and central nervous system products, including Serc™, for the treatment of Ménière’s disease and vestibular vertigo; Brufen™, for the treatment of pain, fever, and inflammation; and Sevedol™, for the treatment of severe migraines; and +● respiratory drugs and vaccines, including the anti-infective clarithromycin (sold under the trademarks Biaxin™, Klacid™, and Klaricid™); and Influvac™, an influenza vaccine. +The Established Pharmaceutical Products segment directs its primary marketing efforts toward building strong brands with key stakeholders, including consumers, pharmacists, physicians, and other healthcare providers. Government agencies are also important customers. +Competition in the Established Pharmaceutical Products segment is generally from other health care and pharmaceutical companies. In addition, the substitution of generic drugs for the brand prescribed and introduction of additional forms of already marketed established products by generic or branded competitors may increase competitive pressures. +* As used throughout the text of this report on Form 10-K, the term “Abbott” refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and its consolidated subsidiaries, as the context requires. +1 +Diagnostic Products +These products include a broad line of diagnostic systems and tests manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to blood banks, hospitals, commercial laboratories, clinics, physicians’ offices, retailers, government agencies, alternate care testing sites, and plasma protein therapeutic companies from Abbott owned distribution centers, public warehouses or third party distributors. +The principal products included in the Diagnostic Products segment are: +● core laboratory systems in the areas of immunoassay, clinical chemistry, hematology, and transfusion medicine, including the Alinity ® family of instruments, ARCHITECT ® , ABBOTT PRISM ® , and Cell-Dyn ® , with assays used for screening and/or diagnosis for cancer, cardiac, metabolics, drugs of abuse, fertility, general chemistries, infectious diseases such as hepatitis and HIV, therapeutic drug monitoring, and a suite of SARS-CoV-2 serology assays; +● molecular diagnostics polymerase chain reaction (PCR) instrument systems, including Alinity ® m and m2000™ that automate the extraction, purification, and preparation of DNA and RNA from patient samples, and detect and measure infectious agents including HIV, hepatitis, HPV, sexually transmitted infections, and SARS-CoV-2; and products for oncology with the Vysis ® FISH product line of genomic-based tests; +● point of care systems, including the i-STAT ® and next-generation i-STAT ® Alinity ® and cartridges for testing blood gas, chemistry, electrolytes, coagulation and immunoassay; +● rapid diagnostics lateral flow testing products in the area of infectious diseases, including respiratory viruses such as SARS-CoV-2 and influenza, HIV, hepatitis, and tropical diseases such as malaria and dengue fever; molecular point-of-care testing for HIV, including the m-PIMA ® HIV-1/2 Viral Load Test, and for SARS-CoV-2 and influenza A & B, RSV and strep A, including the ID NOW ® rapid molecular system; cardiometabolic testing, including Afinion ® and Cholestech™ platforms and tests; a toxicology business for drug and alcohol testing; and remote patient monitoring and consumer self-testing; and +● informatics and automation solutions for use in laboratories, including laboratory automation systems, the RALS ® point of care solution, and AlinIQ ® , a suite of informatics tools and professional services. +The Diagnostic Products segment’s products are subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product performance, laboratory efficiency, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +Nutritional Products +These products include a broad line of pediatric and adult nutritional products manufactured, marketed, and sold worldwide. These products are generally marketed and sold directly to consumers and to institutions, wholesalers, retailers, health care facilities, government agencies, and third-party distributors from Abbott-owned distribution centers or third-party distributors. +The principal products included in the Nutritional Products segment are: +● various forms of prepared infant formula and follow-on formula, including Similac ®* , Similac Pro-Advance ®* , Similac ® Advance ® , Similac ® Advance ® Non-GMO, Similac Pro-Sensitive ®* , Similac Sensitive ® , Similac Sensitive ® Non-GMO, Go&Grow by Similac ®* , Similac ® NeoSure ® , Similac ® Organic, Similac ® Special Care ® , Similac Total Comfort ®* , Similac ® For Supplementation, Isomil ® Advance ® , Isomil ® , Alimentum ® , Gain™, Grow™, Similac En Mei Li™, and Eleva™; +● adult and other pediatric nutritional products, including Ensure ® , Ensure Plus ® , Ensure ® Enlive ® , Ensure ® (with NutriVigor ® ), Ensure ® Max Protein, Ensure ® High Protein, Glucerna ® , Glucerna Hunger Smart ® , ProSure™, PediaSure ® , PediaSure SideKicks ® , PediaSure ® Peptide, EleCare ® , Juven ® , Abound™, Pedialyte ® and Zone Perfect ® ; and +2 +● nutritional products used in enteral feeding in health care institutions, including Jevity ® , Glucerna ® 1.2 Cal, Glucerna ® 1.5 Cal, Osmolite ® , Oxepa ® , Freego™ (Enteral Pump) and Freego™ sets, Nepro ® , and Vital ® . +* These products are available with 2'‐FL HMO (Human Milk Oligosaccharide) in several markets. +Primary marketing efforts for nutritional products are directed toward consumers or to securing the recommendation of Abbott’s brand of products by physicians or other health care professionals. In addition, certain nutritional products sold as Similac ® , Gain™, Grow™, Eleva™, PediaSure ® , PediaSure SideKicks ® , Pedialyte ® , Ensure ® , Zone Perfect ® , and Glucerna ® are also promoted directly to the public by consumer marketing efforts in select markets where appropriate. +Competition for nutritional products in the segment is generally from other diversified consumer and health care manufacturers. Competitive factors include consumer advertising, formulation, packaging, scientific innovation, price, retail distribution, and availability of product forms. A significant aspect of competition is the search for ingredient innovations. The introduction of new products by competitors, changes in medical practices and procedures, and regulatory changes can result in product obsolescence. In addition, private label and local manufacturers’ products may increase competitive pressure. +Medical Devices +These products include a broad line of rhythm management, electrophysiology, heart failure, vascular and structural heart devices for the treatment of cardiovascular diseases, and diabetes care products for people with diabetes, as well as neuromodulation devices for the management of chronic pain and movement disorders. Medical devices are manufactured, marketed and sold worldwide. In the United States, depending upon the product, medical devices are generally marketed and sold directly to wholesalers, hospitals, ambulatory surgery centers, physicians’ offices, and distributors from Abbott-owned distribution centers and public warehouses. Outside the United States, sales are made either directly to customers or through distributors, depending on the market served. +The principal products included in the Medical Devices segment are: +● rhythm management products, including Assurity MRI ® and Endurity MRI ® pacemaker systems; Ellipse ® , Fortify Assura ® , and Gallant™ implantable cardioverter defibrillators and Gallant and Quadra Assura MP ® implantable cardioverter defibrillator with cardiac resynchronization therapy and MultiPoint ® Pacing technology; and Confirm Rx ® implantable cardiac monitor; +● electrophysiology products, including the TactiCath ® family of ablation catheters and FlexAbility ® irrigated ablation catheters; Ampere ® RF ablation generator; EnSite ® family of cardiac mapping systems; and the Advisor ® HD Grid mapping catheter; +● heart failure related products, including the HeartMate™ left ventricular device family and the CardioMEMS ® HF System pulmonary artery sensor, a heart failure monitoring system; +● vascular products, including the XIENCE™ family of drug-eluting coronary stent systems developed on the Multi-Link Vision ® platform; StarClose SE ® and Perclose ProGlide ® vessel closure devices, TREK ® coronary balloon dilatation products, Hi-Torque Balance Middleweight Universal II ® guidewires, Supera ® Peripheral Stent System, a peripheral vascular stent system; Acculink ® /Accunet ® and Xact ® /Emboshield NAV6 ® , carotid stent systems; and the OPTIS ® integrated system with the Dragonfly OPTIS ® imaging catheter and PressureWire ® fractional flow reserve measurement systems; +● structural heart products, including MitraClip ® , a percutaneous mitral valve repair system; Trifecta ® Valve with Glide™ Technology, a surgical tissue heart valve; Portico ® transcatheter aortic heart valve; Regent™ mechanical heart valve; Amplatzer ® PFO occluders; Amplatzer Amulet ® occluder devices; the Tendyne ® Transcatheter Mitral Valve Implantation (TMVI) system; and the TriClip ® Transcatheter Tricuspid Valve Repair System; +● continuous glucose and blood glucose monitoring systems, including test strips, sensors, data management decision software, and accessories for people with diabetes, under the FreeStyle ® brand such as the FreeStyle Libre ® system; and +3 +● neuromodulation products, including spinal cord stimulators Proclaim ® Elite and Proclaim ® XR Recharge-free implantable pulse generators (IPG) and Prodigy MRI ® IPG, each with BurstDR ® stimulation, and Proclaim ® DRG IPG, a neurostimulation device designed for dorsal root ganglion therapy, for the treatment of chronic pain disorders; and the Infinity ® Deep Brain Stimulation System with directional lead technology for the treatment of movement disorders. +These products are subject to competition in technological innovation, price, convenience of use, service, product performance, long-term supply contracts, and product potential for overall cost-effectiveness and productivity gains. Some products in this segment can be subject to rapid product obsolescence or regulatory changes. Although Abbott has benefited from technological advantages of certain of its current products, these advantages may be reduced or eliminated as competitors introduce new products. +INFORMATION WITH RESPECT TO ABBOTT’S BUSINESS IN GENERAL +Sources and Availability of Raw Materials +Abbott purchases, in the ordinary course of business, raw materials and supplies essential to Abbott’s operations from numerous suppliers in the United States and around the world. There have been no recent significant availability problems or supply shortages for raw materials or supplies. +Patents, Trademarks, and Licenses +Abbott is aware of the desirability for patent and trademark protection for its products. Accordingly, where possible, patents and trademarks are sought and obtained for Abbott’s products in the United States and countries of interest to Abbott. Abbott owns or has licenses under a substantial number of patents and patent applications. Principal trademarks and the products they cover are discussed in the Narrative Description of Business on pages 1 through 4. These, and various patents which expire during the period 2021 to 2041, in the aggregate, are believed to be of material importance in the operation of Abbott’s business. Abbott believes that no single patent, license, or trademark is material in relation to Abbott’s business as a whole. +Seasonal Aspects, Customers, and Renegotiation +There are no significant seasonal aspects to Abbott’s business. Abbott has no single customer that, if the customer were lost, would have a material adverse effect on Abbott. No material portion of Abbott’s business is subject to renegotiation of profits or termination of contracts at the election of a government. +Environmental Matters +Abbott believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. Abbott’s capital and operating expenditures for pollution control in 2020 were not material and are not expected to be material in 2021. +Abbott has been identified as one of many potentially responsible parties in investigations and/or remediations at several locations in the United States, including Puerto Rico, under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. Abbott is also engaged in remediation at several other sites, some of which are owned by Abbott, in cooperation with the Environmental Protection Agency or similar agencies. While it is not feasible to predict with certainty the final costs related to those investigations and remediation activities, Abbott believes that such costs, together with other expenditures to maintain compliance with applicable laws and regulations concerning environmental protection, should not have a material adverse effect on Abbott’s financial position, cash flows, or results of operations. +Human Capital +The sustainability of Abbott’s business depends on attracting, engaging and developing talented people with diverse backgrounds who share Abbott’s mission to help people live their healthiest possible lives. Abbott provides its employees opportunities to grow and develop their careers, market competitive compensation and benefit programs, and the satisfaction of being part of a global company dedicated to improving health in more than 160 countries. +4 +As of December 31, 2020, Abbott employed approximately 109,000 people, 70% of whom were employed outside of the U.S. Women represented 47% of Abbott’s U.S. workforce, 45% of its global workforce, and 39% of its managers. +Health and Safety +The health, safety and wellness of its employees is an Abbott priority embedded at every level of its business. Abbott’s integrated Environmental, Health and Safety organization governs health, safety and wellness at Abbott’s facilities. Abbott also maintains global policies and standards for managing employee health and safety. +Abbott takes a holistic approach to employee well-being. Abbott’s global wellness programs are designed to meet the unique needs of employees across businesses and geographies and offer a wide range of programs, including supporting the mental, financial and physical health of employees and their families. For example, for over 20 years, Abbott has annually offered Exercise Across Abbott, which is a four-week physical wellness program that encourages employees to team up with colleagues and track how many minutes they exercise each day. Over 22,000 Abbott employees across 72 countries took part in 2020. +During the COVID-19 pandemic, Abbott has taken aggressive steps to limit exposure and enhance the safety of facilities for its employees, including implementing mandatory temperature screening and social distancing, providing and requiring the use of personal protective equipment, and at most U.S. facilities, onsite COVID-19 testing. +Talent Management +Abbott has an integrated global talent management process that is designed to identify and assess talent across the organization and provide equal and consistent opportunities for employees to develop their skills. All levels of employees participate in Abbott’s annual performance management process to create development plans that support their particular career objectives, and Abbott provides a broad range of training, mentoring and other development opportunities to help its employees meet these objectives. The board of directors conducts an annual Talent Management Review, focusing on development of talent, diversity, and succession planning for critical positions. Similar reviews take place at every level of Abbott to develop talent and diversity across the organization. +Diversity and Inclusion +Abbott is committed to developing a workplace that is inclusive for all. Abbott ties executive compensation to human capital management, including diversity outcomes, to sustain an inclusive culture and the fair and balanced treatment of Abbott’s employees. +Abbott’s employee networks play an important role in building an inclusive culture across all Abbott operations. A member of Abbott’s senior management serves as a sponsor for each of these networks, helping to align their objectives with Abbott’s business strategies. Abbott has ten such networks, which are: Advancing Professionals Network (supporting early career employees), Asian Leadership and Cultural Network, Black Business Network, Flex Network (employees with part-time and flexible schedules), LA VOICE Network (supporting Hispanic and Latino employees), People with Disabilities Network, PRIDE (supporting LGBTQ employees), Veterans Network, Women Leaders of Abbott, and Women in STEM. +Abbott offers professional development programs, which provide recent college graduates the opportunity to rotate through different areas of Abbott, often with the chance to work outside their home country. In 2020, 52% of the participants were women. Also, Abbott hosts hundreds of college students for paid internships. In 2020, 55% of the U.S. interns were women and 39% were minorities. Further, Abbott has operated a STEM internship program for high school students in the U.S. since 2012. The program’s objective is to increase the number of students pursuing STEM-related careers and contribute to a more diverse talent pipeline for Abbott. In 2020, 58% of the STEM interns were women and 71% were minorities. +5 +Compensation and Benefits +Abbott is committed to building, retaining, and motivating a diverse talent pipeline that can meet the current and future needs of its businesses. To that end, Abbott provides market competitive compensation, healthcare benefits, pension and/or retirement savings plans, and several programs to facilitate employees building an ownership stake in Abbott, including a global long-term incentive program for employees generally beginning at the manager level. Abbott also has procedures and processes focused on providing employees equitable compensation, regardless of race or gender or other personal characteristics. +Regulation +The development, manufacture, marketing, sale, promotion, and distribution of Abbott’s products are subject to comprehensive government regulation by the U.S. Food and Drug Administration (FDA) and similar international regulatory agencies. Government regulation by various international, supranational, federal and state agencies addresses (among other matters) the development and approval to market Abbott’s products, as well as the inspection of, and controls over, research and laboratory procedures, clinical investigations, product approvals and manufacturing, labeling, packaging, supply chains, marketing and promotion, pricing and reimbursement, sampling, distribution, quality control, post-market surveillance, record keeping, storage, and disposal practices. In addition, Abbott’s clinical laboratories and associated testing services are subject to comprehensive government regulation, including registration, certification, and licensure, by federal, state, and local agencies, such as the Centers for Medicare & Medicaid Services, the Drug Enforcement Administration, the Substance Abuse and Mental Health Services Administration, and their respective foreign counterparts. Certain of these agencies require our clinical laboratories to meet quality assurance, quality control, and personnel standards and undergo inspections. +During the COVID-19 public health emergency, many pandemic-related products (including diagnostic tests) were authorized by regulators for emergency use solely during the pandemic. In addition, many governments enacted policies to expedite or promote access to health care in order to slow or stop the spread of the virus. Examples include expansion of telehealth coverages and increased reimbursements for diagnostic testing. It is uncertain when the public health emergency will end and to what extent these policies will continue or revert back to previous policies. +Abbott’s international operations are also affected by trade and investment regulations in many countries. These may require local investment, restrict Abbott’s investments, or limit the import of raw materials and finished products. +Abbott’s laboratory facilities and home monitoring services, which provide services, related products and medical devices to consumers, are subject to additional laws and regulations applicable to health care providers and suppliers that submit claims for reimbursement to third-party payors. In the United States, Medicare, Medicaid, and other third-party payors may from time to time conduct inquiries, claims audits, investigations, and enforcement actions relating to the claims or enrollment criteria. +Abbott is subject to laws and regulations pertaining to health care fraud and abuse, including state and federal anti-kickback, anti-self-referral, and false claims laws in the United States. Prescription drug, nutrition, and medical device manufacturers such as Abbott are also subject to taxes, as well as application, product, user, establishment, and other fees. Governmental agencies can also invalidate intellectual property rights. +Compliance with these laws and regulations is costly and materially affects Abbott’s business. Among other effects, health care regulations and significant changes thereto (such as the introduction of the Medical Device Regulation and the In Vitro Diagnostic Medical Device Regulation in the European Union) substantially increase the time, difficulty, and costs incurred in developing, obtaining and maintaining approval to market, and marketing newly developed and existing products. Abbott expects this regulatory environment will continue to require significant technical expertise and investment to ensure compliance. Failure to comply can delay the release of a new product or result in regulatory and enforcement actions, the seizure or recall of a product, the suspension or revocation of the authority necessary for a product’s production and sale, suspension or revocation of billing privileges, and other civil or criminal sanctions, including fines and penalties. Similarly, compliance with the laws and regulations governing clinical laboratories and testing services requires specialized expertise. Failure to comply with these regulatory requirements can result in sanctions, including suspension, revocation, or limitation of a laboratory’s certification, which is necessary to conduct business, as well as significant fines or criminal penalties. +6 +Abbott’s business can also be affected by ongoing studies of the utilization, safety, efficacy, and outcomes of health care products and their components that are regularly conducted by industry participants, government agencies, and others. These studies can call into question the utilization, safety, and efficacy of previously marketed products. In some cases, these studies have resulted, and may in the future result, in the discontinuation of marketing of such products in one or more countries, and may give rise to claims for damages from persons who believe they have been injured as a result of their use. +Access to human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in many countries. A major focus is cost containment. Efforts to reduce health care costs are also being made in the private sector, notably by health care payors and providers, which have instituted various cost reduction and containment measures. Abbott expects insurers and providers will continue attempts to reduce the cost or utilization of health care products. Many countries control the price of health care products directly or indirectly, through reimbursement, payment, pricing, or coverage limitations. Budgetary pressures on health care payors may also heighten the scope and severity of pricing pressures on Abbott’s products for the foreseeable future. In the United States, the federal government regularly evaluates reimbursement for medical devices, diagnostics, supplies, and other products, as well as the procedures in which these products may be used. The government follows a diagnosis-related group (DRG) payment system for certain institutional services provided under Medicare or Medicaid and has implemented a prospective payment system (PPS) for services delivered in hospital outpatient, nursing home, and home health settings. DRG and PPS entitle a health care facility to a fixed reimbursement based on the diagnosis and/or procedure rather than actual costs incurred in patient treatment, thereby increasing the incentive for the facility to limit or control expenditures for many health care products. Other payment methodology changes have been proposed and implemented from time to time. For example, Medicare implemented a competitive bidding system for certain durable medical equipment (including diabetes products), enteral nutrition products, and supplies. Additionally, the Protecting Access to Medicare Act established a new payment system for clinical laboratory tests in 2018. +The Patient Protection and Affordable Care Act (the Affordable Care Act) includes provisions known as the Physician Payments Sunshine Act, which requires manufacturers of drugs, devices, and medical supplies covered under Medicare and Medicaid to record any transfers of value to physicians and teaching hospitals and to report this data to the Centers for Medicare & Medicaid Services for subsequent public disclosure. In October 2018, the Substance Use Disorder Prevention that Promotes Opioid Recovery and Treatment for Patients and Communities Act significantly expanded the types of healthcare providers for which reporting is required, beginning with reports filed in 2022. Similar reporting requirements have also been enacted on the state level domestically, and an increasing number of governments worldwide either have adopted or are considering similar laws requiring transparency of interactions with health care professionals. Failure to report appropriate data may result in civil or criminal fines and/or penalties. +Policy changes or implementation of new health care legislation could result in significant changes to health care systems. In the United States, this could include potential modification, including expansion or repeal of all or parts of the Affordable Care Act. +The regulation of data privacy and security, and the protection of the confidentiality of certain personal information (including patient health information, financial information and other sensitive personal information), is increasing. For example, the European Union, various other countries, and various U.S. states (e.g., California) have enacted stricter data protection laws that contain enhanced financial penalties for noncompliance. Similarly, the U.S. Department of Health and Human Services has issued rules governing the use, disclosure, and security of protected health information, and the FDA has issued further guidance concerning cybersecurity for medical devices. In addition, certain countries have issued or are considering “data localization” laws, which limit companies’ ability to transfer protected data across country borders. Failure to comply with data privacy and security laws and regulations can result in business disruption and enforcement actions, which could include civil or criminal penalties. Transferring and managing protected information will become more challenging as laws and regulations are enacted or amended, and Abbott expects there will be increasing complexity in this area. +Governmental cost containment efforts also affect Abbott’s nutritional products business. In the United States, for example, under regulations governing the federally funded Special Supplemental Nutrition Program for Women, Infants, and Children, all states must have a cost containment program for infant formula. As a result, through competitive bidding states obtain rebates from manufacturers of infant formula whose products are used in the program. +7 +Abbott expects debate to continue at all government levels worldwide over the manufacture, quality assurance requirements, marketing authorization processes, post-market surveillance requirements, availability, method of delivery, and payment for health care products and services, as well as data privacy and security. Abbott believes that future legislation and regulation in the markets it serves could affect the timing and expense associated with bringing health care products or services to market, access to health care products and services, increase rebates, reduce prices or reimbursements or the rate of price increases for health care products and services, change health care delivery systems, create new fees and obligations for the pharmaceutical, nutrition, diagnostic, and medical device industries, or require additional reporting and disclosure. It is not possible to predict the extent to which Abbott or the health care industry in general might be affected by the matters discussed above. +INTERNET INFORMATION +Copies of Abbott’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through Abbott’s investor relations website ( www.abbottinvestor.com ) as soon as reasonably practicable after Abbott electronically files the material with, or furnishes it to, the Securities and Exchange Commission (the Commission). These reports and other information are also available, free of charge, at www.sec.gov. +Abbott’s corporate governance guidelines, outline of directorship qualifications, code of business conduct and the charters of Abbott’s audit committee, compensation committee, nominations and governance committee, and public policy committee are all available on Abbott’s investor relations website ( www.abbottinvestor.com ). +​ +8 \ No newline at end of file diff --git a/raw/filings/0000001800/2020/0001104659-21-025751/item13.txt b/raw/filings/0000001800/2020/0001104659-21-025751/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..7f9d2f020f67d74e3155ad866475d0e5cec6c6aa --- /dev/null +++ b/raw/filings/0000001800/2020/0001104659-21-025751/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The material to be included in the 2021 Proxy Statement under the headings “The Board of Directors,” “Committees of the Board of Directors,” and “Approval Process for Related Person Transactions” is incorporated herein by reference. The 2021 Definitive Proxy Statement will be filed on or about March 12, 2021. +​ \ No newline at end of file diff --git a/raw/filings/0000002098/2018/0001026608-19-000011/filing.txt b/raw/filings/0000002098/2018/0001026608-19-000011/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..9cbba15b5baa6db2ce34a42034843a4dbd32b10a --- /dev/null +++ b/raw/filings/0000002098/2018/0001026608-19-000011/filing.txt @@ -0,0 +1,3003 @@ +10-K +1 +acu_10k123118.htm +10-K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D. C. 20549 +FORM 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended: December +31, 2018 +or +[_] +TRANSITION REPORT PURSUANT +TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from: +___________ to ___________ +Commission file number: 01-07698 +ACME UNITED CORPORATION +(Exact Name of Registrant as Specified +in Its Charter) +Connecticut +06-0236700 +State or Other Jurisdiction of +I.R.S. Employer Identification No. +Incorporation or Organization +55 Walls Drive, Fairfield, +Connecticut +06824 +Address of Principal Executive Offices +Zip Code +Registrant's telephone number, including +area code: (203) 254-6060 +Securities registered pursuant to Section +12(b) of the Act: +Title of each class +Name of each +exchange on which registered +$2.50 par value Common Stock +NYSE American +Securities registered pursuant to Section +12 (g) of the Act: None +(Title of Class) +Indicate by check mark whether the registrant +is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES [_] NO [X] +Indicate by check mark if the registrant +is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES [_] NO [X] +Indicate by check mark whether the registrant +(l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding +12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing +requirements for the past 90 days. YES +[X] NO [_] +Indicate by check mark whether the registrant +has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (sec. +232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit +such files). YES +[X] NO [_] +Indicate by check mark if disclosure of +delinquent filers pursuant to Item 405 of Regulation S-K (sec. 229.405) is not contained herein, and will not be contained, to +the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this +Form 10-K or any amendment to this Form 10-K. +1 +Indicate by check mark whether the +Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an +emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, +“smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act +(Check one). +Large accelerated filer [_] +Accelerated filer [X] +Non-accelerated filer [_] +Smaller Reporting Company [X] +Emerging growth company [_] +If an emerging growth company, indicate by +check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial +accounting standards provided pursuant to Section 13(s) of the Exchange Act [ _] +Indicate by check mark whether the registrant is a shell company +(as defined in Rule 12b-2 of the Exchange Act) . YES [_] NO [X] +The aggregate market value of the voting +and non-voting stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently +completed second fiscal quarter was $61,417,386. +Registrant had 3,350,833 shares of its +$2.50 par value Common Stock outstanding as of March 8, 2019. +DOCUMENTS INCORPORATE BY REFERENCE +(1) Certain +portions of the Company’s Proxy Statement for the Annual Meeting scheduled for April 22, 2019 are incorporated into the Company’s +Annual Report on Form 10-K for the fiscal year ended December 31, 2018, in Part III. +2 +Page +Part I +Item 1. Business +4 +Item 1A. Risk Factors +7 +Item 1B. Unresolved Staff Comments +12 +Item 2. Properties +13 +Item 3. Legal Proceedings +13 +Item 4. Mine Safety Disclosures +13 +Part II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +14 +Item 6. Selected Financial Data +14 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +14 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +20 +Item 8. Financial Statements and Supplementary Data +21 +Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +46 +Item 9A. Controls and Procedures +46 +Item 9B. Other Information +46 +Part III +Item 10. Directors, Executive Officers and Corporate Governance +47 +Item 11. Executive Compensation +49 +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +49 +Item 13. Certain Relationships and Related Transactions, and Director Independence +49 +Item 14. Principal Accounting Fees and Services +49 +Part IV +Item 15. Exhibits and Financial Statement Schedules +50 +Item 16. Form 10-K Summary +52 +Signatures +53 +3 +PART I +Item 1. Business +Overview +Acme United Corporation, a +Connecticut corporation (together, with its subsidiaries, the "Company"), is a leading worldwide supplier of +innovative safety solutions and cutting technology to the school, home, office, hardware, sporting goods and industrial +markets. It’s principal products sold across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid +kits, and safety related products. The Company sells its products primarily to wholesale, contract and retail +stationery distributors, office supply superstores, mass market and e-commerce retailers, industrial distributors, office +supply super stores, sporting goods stores, hardware changes and wholesale florists. +The Company's operations are in the United +States, Canada, Europe (located in Germany) and Asia (located in Hong Kong and China). The operations in the United States, Canada +and Europe are primarily involved in product development, marketing, sales, administrative, manufacturing and distribution activities. +The operations in Asia consist of sourcing, product development, production planning, quality control and sales activities. Total +net sales in 2018 were $137.3 million. The Company was organized as a partnership in l867 and incorporated in l882 under the laws +of the State of Connecticut. +The Company sources most of its products +from suppliers located outside the United States, primarily in Asia. The Company assembles its first aid kits at its facilities +in Vancouver, WA and Rocky Mount, NC. The components for the first aid kits are primarily sourced from U.S. suppliers. +Business Strategy +The Company’s business strategy +includes the following key elements: +· +a commitment to technological innovation achieved through consumer insight, creativity and speed to market; +· +a broad selection of products in both brand and private label; +· +prompt response; +· +superior customer service; and +· +value pricing. +Purchase of Property +On October 26, 2017, the Company exercised +its option to purchase its First Aid Only manufacturing and distribution center in Vancouver, WA for $4.0 million. The property +consists of 53,000 square feet of office, manufacturing, and warehouse space on 2.86 acres. The purchase was financed by a variable +rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Commencing on December 1, 2017, principal payments of +$22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. +Acquisitions +On February 1, 2017, the Company purchased +the assets of Spill Magic, Inc., located in Santa Ana, CA and Smyrna, TN. The Spill Magic products are leaders in absorbents that +encapsulate spills into dry powders that can be safely discarded. Customers, including many large retail chains, use Spill Magic +products to remove liquids from broken glass containers, oil and gas spills, bodily fluids, and solvents. The Company purchased +Spill Magic assets for $7.2 million in cash using funds borrowed under its revolving credit facility with HSBC. Additional information +concerning the acquisition of Spill Magic assets is set forth in Note 17 – Business Combinations, in the notes to consolidated +financial statements in this report. +Principal Products +The Company markets and sells under two main categories: i) Cutting, Sharpening and Measuring; and ii) First +Aid and Safety. The Cutting, Sharpening and Measuring category includes school, home and office products (Westcott® brand), +and Hardware, Industrial and Sporting Goods products (Clauss®, Camillus®, Cuda® and DMT® brands). The First Aid +and Safety Category includes first aid and safety products (First Aid Only®, PhysiciansCare®, Pac-Kit® and Spill Magic® +brands). +4 +CUTTING, SHARPENING AND MEASURING +School, Home and Office +Westcott +Westcott, with a history of +quality dating back to 1872, provides innovative cutting and measuring products for the school, home and office as well as +industrial safety cutting. Principal products under the Westcott brand include scissors, rulers, pencil sharpeners, paper +trimmers, lettering products, craft products and safety cutters. Westcott is one of the leading scissor and ruler brands in +North America. +Many of the Westcott branded cutting +products contain patented titanium bonding and proprietary non-stick coatings, making the blades more than three times harder than +stainless steel as well as reducing friction and corrosion. In 2018, Westcott continued to build on its safety knife launch with +the introduction of the Saber Safety Cutters as well as several new ceramic safety knives, allowing its customers to remain safer +on the job. Westcott also began to expand its innovation of scissors with the patent pending anti-friction fully adjustable Glide +scissor line. This new line allows the user to customize the scissor to the user’s specific application or preference. +Hardware, Industrial and Sporting +Goods +Clauss +Clauss, with its roots dating back to +1877, offers a line of quality cutting tools for professionals in the hardware & industrial, lawn & garden, food processing, +sewing and housewares channels. Many of the Clauss products are enhanced with the Company’s patented titanium and proprietary +non-stick coatings. +Camillus +Since 1876 Camillus has been supplying +innovative and high quality knives. The Camillus brand has a strong heritage in the hunting, sporting, survival +and tactical markets. The Company acquired the brand in 2007 and re-launched it in 2009 with an updated and innovative line of +fixed blade, folding knives, line of sight cutting tools and tactical tools. Many of the knives are enhanced with titanium carbonitride +coatings to increase the hardness of the blade of up to 10 times that of untreated stainless steel. +Cuda +We launched the Cuda line of fishing tools +and knives in 2014. Featuring titanium bonded German steels and alloys, Cuda tools provide world class hardness, corrosion and +adhesive resistance. In July of 2014, Cuda won Best of Show in the “Fish Smart” category at the ICast show in Orlando, +Florida. In January 2016, Cuda won six GOOD DESIGN awards from the Chicago Athenaeum, Museum of Architecture and Design. In 2017, +Cuda launched a line of cut and puncture resistant gloves which feature quadruple layered Kevlar® and a line of telescopic +landing nets featuring replaceable nets and a net containment system. In 2018, Cuda launched a Professional Series of knives, tools +and fishing gaffs that are directed towards the commercial fishing segment. +DMT +DMT products are leaders in diamond sharpening +tools for knives, scissors, chisels, skis, skates and many other edges that require sharpening. DMT was founded in 1976 by aerospace +engineers. The DMT products use a proprietary process of finely dispersed diamonds bonded to the surfaces of sharpeners and are +famous for providing diamond sharpeners with the flattest sharpening surface, greatest concentrated amount of diamonds and the +highest quality diamonds per sharpener. In 2017, DMT launched 12 new diamond sharpeners that include a gear-driven sharpener, +sonic sharpener and pull through sharpeners that provide a simple sharpening solution for beginners as well as sharpening experts. +FIRST AID AND SAFETY +First Aid & Safety +First Aid Only +The First Aid Only brand +offers first aid kits, refills, and safety products that meet regulatory requirements for a broad range of industries. +The Smart Compliance® first aid system is an effective tool for maintaining OSHA compliance. The Company’s +SafetyHub App technology streamlines the inspection and replenishment process for a broad range of Safety products and +provides data analytics to optimize costs. +5 +Pac-Kit +The Pac-Kit brand offers first aid kits, +industrial stations and refills, emergency medical travel and recreational kits of the industrial, safety, transportation and marine +markets. The brand has a long history dating back to the 19 th century. Although Pac-Kit’s products are similar +to the PhysiciansCare brand, the Pac-Kit brand is especially known for its customized products which are designed to meet customer +specifications. +PhysiciansCare +The PhysiciansCare brand offers a variety +of portable eyewash solutions and over-the counter medications, including the active ingredients aspirin, acetaminophen and ibuprofen. +Spill Magic +The Spill Magic brand is a leader in absorbents that encapsulate spills into dry powders that can safely be +discarded. The spill response system reduces slip & fall accidents in various venues, including grocery, retail, big box and +other stores; food service & hotel chains; municipal facilities; and industry-specific distributors in the U.S. and Europe. +Acquired in February 2017, we introduced additional Spill Magic products in 2017, including clean-up kits for bodily fluids and +blood-borne pathogen kits. +Product Development +The Company’s strong commitment to +understanding our consumers and defining products that fulfill their needs through innovation drives our product development +strategy, which we believe is and will be a key contributor to our success. The Company incurred research, development and +related costs of $734,000 in 2018 and $752,000 in 2017. +Intellectual Property +The Company owns many patents and trademarks +that are important to its business. The Company’s success depends in part on its ability to maintain patent protection for +its products, to preserve its proprietary technology and to operate without infringing upon the patents or proprietary rights of +others. The Company generally files patent applications in the United States and foreign countries where patent protection for +its technology is appropriate and available. The Company also considers its trademarks important to the success of its business. +The more significant trademarks include Westcott, Clauss, Camillus, PhysiciansCare, First Aid Only, Cuda, DMT, Pac-Kit and Spill +Magic. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period remaining +for intangible assets at December 31, 2018 was 10 years. +Product Distribution; Major Customers +Independent manufacturer representatives +and direct sales are primarily used to sell the Company’s line of consumer products to wholesale, contract and retail stationery +distributors, office supply super stores, school supply distributors, industrial distributors, wholesale florists, mass market +and ecommerce retailers and hardware chains (including through their websites). The Company also sells a limited selection of its +products directly to consumers through its own websites. The Company had one customer in 2018 and two customers in 2017 that individually +exceeded 10% of consolidated net sales. In 2018, net sales to this one customer were approximately 13%, of consolidated net sales. +In 2017, net sales to the two customers were approximately 16% and 11%, respectively. +Competition +The Company competes with many companies +in each market and geographic area. The Company believes that the principal points of competition in these markets are product +innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness +of delivery, conformity to customer specifications and post-sale support. The major competitors in the cutting category are 3M +and Fiskars Corporation. The major competitors in the measuring category are Maped and Staedtler. The major competitor in the pencil +sharpener category is Bostitch. The major competitors in the first aid & safety category are Honeywell, 3M and Johnson & +Johnson. +Seasonality +Traditionally, the Company’s sales +are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal +nature of the back-to-school market. +6 +Compliance with Environmental Laws +The Company believes that it is in compliance +with applicable environmental laws. The Company anticipates that no material adverse financial impact will result from compliance +with current environmental rules and regulations. +Employees +As of December 31, 2018, the Company employed +435 people, all of whom are full time and none of whom is covered by union contracts. Employee relations are considered good and +no foreseeable problems with the work force are evident. +Available Information +You may obtain +at no charge, a copy of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports +on Form 8-K and amendments to those reports on the Company’s website at http://www.acmeunited.com +or by contacting the Investor Relations Department at the Company’s corporate offices by calling (203) 254-6060. Such +reports and other information are made available as soon as reasonably practicable after such material is filed with or furnished +to the SEC. +Item 1A. Risk Factors +The Company is subject to a number of significant +operational risks that might cause the Company’s actual results to vary materially from its forecasts, targets or projections, +including: +· achieving planned revenue and profit growth in each of the Company's +business segments; +· changes in customer requirements and in the volume of sales to principal +customers; +· the ability of the Company to anticipate timing of orders and shipments +particularly in the ecommerce area; +· emergence of new competitors or consolidation of existing competitors; +and +· industry demand fluctuations. +The Company’s expectations for both +short and long-term future net revenues are based on the Company’s estimates of future demand. Orders from the Company’s +principal customers are ultimately based on demand from end-users and end-user demand can be difficult to predict. Low end-user +demand would negatively affect orders the Company receives from distributors and other principal customers which could, in turn +adversely affect the Company’s revenues in any fiscal period. If the Company’s estimates of sales are not accurate +and the Company experiences unforeseen variability in its revenues and operating results, the Company may be unable to adjust +its expense levels accordingly and its profit margins could be adversely affected. +Because our products are primarily +sold by third parties, our financial results depend in part on the financial health of these parties and any loss of a third party +distributor could adversely affect the Company’s revenues. +A large majority of the Company’s products +are sold through third-party distributors and large retailers. Some of our distributors also market products that compete with +our products. Changes in the financial or business conditions or the purchasing decisions of these third parties or their customers +could affect our sales and profitability. +Additionally, no assurances can be given that +any or all of such distributors or retailers will continue their relationships with the Company. Distributors and other significant +retail customers cannot easily be replaced and the loss of revenues and the Company’s inability to reduce expenses to compensate +for the loss of revenues could adversely affect the Company’s net revenues and profit margins. +7 +The ability to deliver products to our customers in a timely +manner and to satisfy our customers’ fulfillment standards are subject to several factors, some of which are beyond our control. +Customers place great emphasis on timely delivery +of our products for specific selling seasons, especially during our second and third fiscal quarters, and on the fulfillment of +consumer demand throughout the year. We cannot control all of the various factors that might affect product delivery to customers. +Vendor production delays, cybersecurity attacks on our vendors, difficulties encountered in shipping from overseas and customs +clearance delays are on-going risks of our business. We also rely upon third-party carriers for our product shipments from our +distribution centers to customers. Accordingly, we are subject to risks, including labor disputes, inclement weather, natural disasters, +cybersecurity attacks, possible acts of terrorism, availability of shipping containers, and increased security restrictions associated +with such carriers’ ability to provide delivery services to meet our shipping needs. Failure to deliver products to +our customers in a timely and effective manner, often under special vendor requirements to use specific carriers and delivery schedules, +could damage our reputation and brands and result in loss of customers or reduced orders. +Reliance on foreign suppliers could adversely +affect the Company’s business. +The Company sources its products from suppliers +located in Asia, Europe and the United States. The Company’s Asia vendors are located primarily in China, which subjects +the Company to various risks within the region including regulatory, political, economic and foreign currency changes. The Company’s +ability to select and retain reliable vendors and suppliers who provide timely deliveries of quality products efficiently will +impact its success in meeting customer demand for timely delivery of quality products. The Company’s sourcing operations +and its vendors are impacted by labor costs in China. Labor historically has been readily available at low cost relative to labor +costs in North America. However, as China is experiencing rapid social, political and economic changes, labor costs have risen +in some regions and there can be no assurance that labor will continue to be available to the Company in China at costs consistent +with historical levels or that changes in labor or other laws will not be enacted which would have a material adverse effect on +the Company’s operations in China. Interruption of supplies from any of the Company’s vendors, or the loss of one or +more key vendors, could have a negative effect on the Company’s business and operating results. +Changes in currency exchange rates +might negatively affect the profitability and business prospects of the Company and its overseas vendors. In particular, the Chinese +Renminbi has recently fluctuated against the U.S. Dollar, if the Chinese Renminbi continues to fluctuate with respect to the U.S. +Dollar in the future, the Company may experience cost increases on such purchases, and this can adversely impact profitability. +Future interventions by China may result in further currency appreciation and increase our product costs over time. The Company +may not be successful at implementing customer pricing or other actions in an effort to mitigate the related effects of the product +cost increases. +Additional factors that could adversely affect +the Company’s business include increases in transportation costs, new or increased import duties, transportation delays, +work stoppages, capacity constraints and poor quality. +The Company’s operations are increasingly +global in nature. Our business, financial condition and results of operations could be adversely affected by the political and +economic conditions in the countries in which we conduct business, by fluctuations in currency exchange rates and other factors +related to our international operations. +As our international operations and activities +expand, we face increasing exposure to the risks of operating in foreign countries. These factors include: +· +Changes generally in political, regulatory or economic conditions in the countries in which we conduct business. +· +Trade protection measures in favor of local producers of competing products, including government subsidies, tax benefits, changes in local tax rates, trade actions (such as anti-dumping proceedings) and other measures giving local producers a competitive advantage over the Company. +· +Changes in foreign currency exchange rates +which could adversely affect our competitive position, selling prices and manufacturing costs, and therefore the demand for our +products in a particular market. +8 +These risks could affect the cost of manufacturing +and selling our products, our pricing, sales volume, and ultimately our financial performance. The likelihood of such occurrences +and their potential effect on the Company vary from country to country and are unpredictable. +Continuing uncertainty in the global economy +could negatively impact our business. +Uncertainty in the global economy could adversely +affect our customers and our suppliers and businesses such as ours. In addition, any uncertainty could have a variety of negative +effects on the Company, such as reduction in revenues, increased costs, lower gross margin percentages, increased allowances for +doubtful accounts and/or write-offs of accounts receivable and could otherwise have material adverse effects on our business, results +of operations, financial condition and cash flows. +Changes in trade policies, including the imposition of tariffs +and their enforcement, may have a material adverse impact on our business, results of operations, and outlook. +On September 24, 2018, the United States levied a third round of +tariffs on the import of some products from China, which is an important source of many of the Company’s products. The first +two rounds targeted $50 billion of Chinese goods and applied a 25% tariff; these rounds had no impact on the Company. +The third round targeted an additional $200 billion of Chinese goods and applied a 10% tariff that was scheduled to increase +to 25% at the start of 2019 but has been delayed. This latest round affects approximately 10% of the Company’s product purchases +and will increase our costs of procurement. These tariffs affect certain measuring products, folding knives and first aid components. +In response to these tariffs, the Company has implemented a price increase on the affected products in order to offset their impact. +Tariff levels may be further increased and the types of products subject to tariffs may be expanded. Although the Company intends +to pass additional price increases on to our customers, such tariff-related developments could have a negative impact on customer +demand and adversely affect our business, financial condition and results of operations. In addition, we might have to modify our +current business practices, including potentially sourcing from alternative vendors. +The Company’s business is subject +to risks associated with seasonality which could adversely affect its cash flow, financial condition, or results of operations. +The Company’s business, historically, +has experienced higher sales volume in the second and third quarters of the calendar year, when compared to the first and fourth +quarters. The Company is a major supplier of products related to the “back-to-school” season, which occurs principally +during the months of May, June, July and August. If this typical seasonal increase in sales of certain portions of the Company’s +product line does not materialize in any year, the Company could experience a material adverse effect on its business, financial +condition and results of operations. +Failure to manage growth and continue to +expand our operations successfully could adversely affect our financial results. +Our business has experienced significant historical +growth over the years, and we expect our business to continue to grow organically and through strategic acquisitions. This growth +places significant demands on management and operational systems. If we cannot effectively manage our growth, it is likely to result +in operational inefficiencies and ineffective management of our business thus negatively impacting our operating results. To the +extent we grow through strategic acquisitions, our success will depend on selecting the appropriate targets, integrating such acquisitions +quickly and effectively and realizing any expected synergies and cost savings related to such acquisitions. +Loss of a major customer could result in +a decrease in the Company’s future sales and earnings. +Sales of our products are primarily concentrated +in a few major customers including office product superstores and mass market distributors. The Company had one customer in 2018 +and two customers in 2017 that individually exceeded 10% of consolidated net sales. In 2018, net sales to this one customer were +approximately 13%, of consolidated net sales. In 2017, net sales to the two customers were approximately 16% and 11%, respectively. +The Company anticipates that a limited number of customers may account for a substantial portion of its total net revenues for +the foreseeable future. The business risks associated with this concentration, including increased credit risks for these and other +customers and the possibility of related bad debt write-offs, could negatively affect our margins and profits. Additionally, the +loss of a major customer, whether through competition or consolidation, or a disruption in sales to such a customer, could result +in a decrease of the Company’s future sales and earnings. +9 +The loss of key management could adversely +affect the Company’s ability to run its business. +The Company’s success depends, to a large +extent, on the continued service of its executive management team, operating officers and other key personnel. The Company must +therefore continue to recruit, retain and motivate management and operating personnel sufficient to maintain its current business +and support its projected growth. The Company’s inability to meet its staffing requirements in the future could adversely +affect its results of operations. +Execution or the lack thereof, of our e-commerce business +may reduce our operating results. +Our e-commerce business constituted approximately +10% of our net sales in 2018 and has been our fastest growing distribution channel over the last several years. The continued +successful growth of our e-commerce business depends, in part, on third parties and factors over which we have limited +control, including difficulty forecasting demand, changing consumer preferences, and e-commerce buying trends, both domestically +and abroad, as well as promotional or other advertising initiatives employed by our customers or other third parties on their e-commerce sites. +Additionally, sales in our e-commerce distribution channel may also divert sales from our other customers. +Additionally, the success of our e-commerce business +depends, in part, on the timely receipt of our products by our customers and their end users. The efficient flow of our products +requires that our distribution facilities have adequate capacity to support increases in our e-commerce business. If we encounter +difficulties with forecasting and supply to our distribution facilities, we could face shortages of inventory, resulting in “out +of stock” conditions in the e-commerce sites operated by our customers or other third parties, and we could incur +significantly higher costs and longer lead times associated with distributing our products to our customers. +Our failure to successfully respond to +these risks and uncertainties might adversely affect the sales in our e-commerce business, as well as damage our brands. +Failure to protect the Company’s proprietary +rights or the costs of protecting these rights could adversely affect its business. +The Company’s success depends in part +on its ability to obtain patents and trademarks and to preserve other intellectual property rights covering its products and processes. +The Company has obtained certain domestic and foreign patents and intends to continue to seek patents on its inventions when appropriate. +The process of seeking patent protection can be time consuming and expensive. There can be no assurance that pending patents related +to any of the Company’s products will be issued, in which case the Company may not be able to legally prevent others from +producing similar and/or compatible competing products. If other companies were to sell similar and/or compatible competing products, +the Company’s results of operations could be adversely affected. Furthermore, there can be no assurance that the Company’s +efforts to protect its intellectual property will be successful. Any infringement of the Company’s intellectual property +or legal defense of such action could have a material adverse effect on the Company. +The Company is subject to intense competition +in all of the markets in which it competes. +The Company’s products are sold in highly +competitive markets including at mass merchants, high volume office supply stores and online. The Company believes that the principal +points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, +product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. Competitive +conditions may require the Company to match or better competitors’ prices to retain business or market shares. The Company +believes that its competitive position will depend on continued investment in innovation and product development, manufacturing +and sourcing, quality standards, marketing and customer service and support. The Company’s success will depend in part on +its ability to anticipate and offer products that appeal to the changing needs and preferences of our customers in the various +market categories in which it competes. The Company may not have sufficient resources to make the investments that may be necessary +to anticipate those changing needs and the Company may not anticipate, identify, develop and market products successfully or otherwise +be successful in maintaining its competitive position. In addition, there are numerous uncertainties inherent in successfully developing +and commercializing innovative new products on a continuing basis, and new product launches may not provide expected growth results. +There are no significant barriers to entry into the markets for most of the Company’s products. +10 +Compromises of our information systems or +unauthorized access to confidential information or our customers' or associates' personal information may materially harm our business +or damage our reputation. +Through our sales and marketing activities +and our business operations, we collect and store confidential information and certain personal information from our customers +and associates. We also process payment card information and check information. In addition, in the normal course of business, +we gather and retain personal information about our associates and generate and have access to confidential business information. +Although we have taken steps designed to safeguard such information, there can be no assurance that such information will be protected +against unauthorized access or disclosure. Computer hackers may attempt to penetrate our or our vendors' network security and, +if successful, misappropriate such information. An Acme United associate, contractor or other third-party with whom we do business +may also attempt to circumvent our security measures in order to obtain such information or inadvertently cause a breach involving +such information. We could be subject to liability for failure to comply with privacy and information security laws, for failing +to protect personal information, or for misusing personal information, such as use of such information for an unauthorized marketing +purpose. Any compromise of our systems or data could disrupt our operations, damage our reputation, and expose us to claims from +customers, financial institutions, regulators, payment card associations, employees and other persons, any of which could have +an adverse effect on our business, financial condition and results of operations. +The Company may not be able to maintain +or to raise prices in response to inflation and increasing costs. +Future market and competitive pressures may +prohibit the Company from raising prices to offset increased product costs, freight costs and other inflationary items or to offset +currency fluctuations. The inability to pass these costs through to the Company’s customers could have a negative effect +on its results of operations. +The Company may need to raise additional +capital to fund its operations. +The Company’s management believes that, +under current conditions, the Company’s current cash and cash equivalents, cash generated by operations, together with the +borrowing availability under its revolving loan agreement with HSBC Bank N.A., will be sufficient to fund planned operations for +the next twelve months. However, if the Company is unable to generate sufficient cash from operations, it may be required to find +additional funding sources. If adequate financing is unavailable or is unavailable on acceptable terms, the Company may be unable +to maintain, develop or enhance its operations, products and services, take advantage of future opportunities or adequately respond +to competitive pressures. +Changes +in interest rates could adversely affect us . +We +have exposure to increases in interest rates under our revolving credit loan agreement with HSBC, N.A. which presently +bears interest at a rate of LIBOR plus 1.75%. In +response to the last global economic recession, actions of the U.S. Federal Reserve and other central banking institutions, were +taken to create and maintain a low interest rate environment. However, in 2018, the U.S. Federal Reserve raised its benchmark interest +rate three times. Increases in interest rates would increase our interest costs on our variable-rate debt as well as any future +fixed rate debt, we may incur at higher interest rates, and interest which we pay reduces our cash available for working capital, +acquisitions, and other uses. +Product liability claims or regulatory actions +could adversely affect the Company's financial results and reputation. +Claims for losses or injuries allegedly caused +by some of the Company’s products arise in the ordinary course of its business. In addition to the risk of substantial monetary +judgments, product liability claims or regulatory actions could result in negative publicity that could harm the Company’s +reputation in the marketplace or the value of its brands. The Company also could be required to recall possible defective products, +which could result in adverse publicity and significant expenses. Although the Company maintains product liability insurance coverage, +potential product liability claims are subject to a deductible or could be excluded under the terms of the policy. +11 +The Company is subject to environmental +regulation and environmental risks. +The Company is subject to national, state, +provincial and/or local environmental laws and regulations that impose limitations and prohibitions on the discharge and emission +of, and establish standards for the use, disposal and management of, certain materials and waste. These environmental laws and +regulations also impose liability for the costs of investigating and cleaning up sites, and certain damages resulting from present +and past spills, disposals, or other releases of hazardous substances or materials. Environmental laws and regulations can be complex +and may change often. Capital and operating expenses required to comply with environmental laws and regulations can be significant, +and violations may result in substantial fines and penalties. In addition, environmental laws and regulations, such as the Comprehensive +Environmental Response, Compensation and Liability Act, or CERCLA, in the United States impose liability on several grounds for +the investigation and cleanup of contaminated soil, ground water and buildings and for damages to natural resources on a wide range +of properties. For example, contamination at properties formerly owned or operated by the Company, as well as at properties it +will own and operate, and properties to which hazardous substances were sent by the Company, may result in liability for the Company +under environmental laws and regulations. The costs of complying with environmental laws and regulations and any claims concerning +noncompliance, or liability with respect to contamination in the future could have a material adverse effect on the Company’s +financial condition or results of operations. +We cannot provide assurance that we will continue to pay +dividends or purchase shares of our common stock under our stock repurchase program. +We continue to pay and declare dividends +on a quarterly basis and we anticipate that we will continue to do so. However, there can be no assurance that we will have sufficient +cash or surplus under the law to be able to continue to pay dividends at our current level or purchase shares of our common stock +under our stock repurchase program. (At December 31, 2018, a total of 17,999 may be purchased in the future under the repurchase +program which the Company announced in 2010.) This may result from extraordinary cash expenses, actual expenses exceeding contemplated +costs, funding of capital expenditures, increases in reserves or lack of available capital. We may also suspend the payment of +dividends or our stock repurchase program if the Board deems such action to be in the best interests of our shareholders. If we +do not pay dividends or decrease the amount of dividends we pay, the price of our common stock would likely decrease. +Our shares of common stock are thinly traded +and our stock price may be volatile. +Because our common stock is thinly +traded, its market price may fluctuate significantly more than the stock market in general or the stock prices of other +companies listed on major stock exchanges. There were approximately 2,910,112 shares of our common stock held by +non-affiliates as of December 31, 2018. Thus, our common stock is less liquid than the stock of companies with broader +public ownership, and, as a result, the trading price for shares of our common stock may be more volatile. Among other +things, trading of a relatively small volume of our common stock may have a greater impact on the trading price for our stock +than would be the case if our public float were larger. +Item 1B. Unresolved Staff Comments +Not applicable. +12 +Item 2. Properties +Location +Square Footage +Purpose +Owned +Rocky Mount, NC +Vancouver, WA +Solingen, Germany +340,000 +53,000 +35,000 +Warehousing and distribution +Warehousing and distribution +Warehousing, distribution and administrative +428,000 +Leased +Fairfield, CT +15,400 +Administrative +Bentonville, AK +1,500 +Administrative +Marlborough, MA +28,000 +Manufacturing, warehousing and distribution +Santa Ana, CA +10,000 +Manufacturing, warehousing, distribution and administrative +Smyrna, TN +13,000 +Manufacturing, warehousing and distribution +Mount Forest, Ontario, Canada +42,500 +Warehousing and distribution +Orangeville, Ontario, Canada +2,850 +Administrative +Hong Kong, China +2,750 +Administrative +Guangzhou, China +3,500 +Administrative +Ningbo, China +1,800 +Administrative +121,300 +Total: +549,300 +The Company’s facilities located in the United States +and China are utilized by all of its segments. The Company’s facilities located in Canada and Germany are utilized +by its Canadian segment and its European segment, respectively. +Management believes that the Company's facilities, +whether leased or owned, are adequate to meet its current needs and should continue to be adequate for the foreseeable future. +Item 3. Legal Proceedings +There are no pending material legal proceedings +to which the Company is a party or, to the actual knowledge of the Company, contemplated by any governmental agency. +Item 4. Mine Safety Disclosures +Not applicable. +13 +PART II +Item 5. Market for Registrant's Common +Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company's Common Stock is traded on the NYSE American under +the symbol "ACU". +Issuer Purchases of Equity Securities +On November 22, 2010, the +Company announced a Common Stock repurchase program of up to a total 200,000 shares. The program does not have an expiration date. +During the twelve months ended December 31, 2018, the Company repurchased 23,228 shares of its Common Stock. As of December 31, +2018, a total of 17,999 shares may be purchased in the future under the repurchase program announced in 2010. +Item 6. Selected Financial +Data +As a registered smaller +reporting company, the Company is not required to provide this information. +Item 7. Management’s Discussion and Analysis of Financial +Condition and Results of Operations +Forward-Looking Information +The Company may from time to time make +written or oral “forward-looking statements” including statements contained in this report and in other communications +by the Company, which are made in good faith pursuant to the “safe harbor” provisions of the Private Securities Litigation +Reform Act of 1995. Such statements are based on our beliefs as well as assumptions made by and information currently available +to us. When used in this document, words like “may,” “might,” “will,” “except,” +“anticipate,” “believe,” “potential,” and similar expressions are intended to identify forward-looking +statements. Actual results could differ materially from our current expectations. +Forward-looking statements in this report, +including without limitation, statements related to the Company’s plans, strategies, objectives, expectations, intentions +and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. +Investors are cautioned that such forward-looking statements involve risks and uncertainties including, without limitation, the +following: (i) changes in the Company’s plans, strategies, objectives, expectations and intentions, which may be made at +any time at the discretion of the Company; (ii) the impact of uncertainties in global economic conditions, including the impact +on the Company’s suppliers and customers; (iii) changes in client needs and consumer spending habits; (iv) the impact of +competition and technological changes on the Company; (v) the Company’s ability to manage its growth effectively, including +its ability to successfully integrate any business it might acquire; (vi) currency fluctuations; (vii) increases in the cost of +borrowings resulting from rising interest rates; (viii) international trade policies and their impact on demand for our products +and our competitive position, including the imposition of new tariffs or changes in existing tariff rates; and (ix) other +risks and uncertainties indicated from time to time in the Company’s filings with the Securities and Exchange Commission. +For a more detailed discussion of these and other factors affecting the Company, see the Risk Factors set forth above in Item 1A +of this Annual Report on Form 10-K. +Critical +Accounting Policies +The following +discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial +statements, which have been prepared in conformity with generally accepted accounting principles in the United States of America. +The Company’s significant accounting policies are more fully described in Note 2 of the notes to consolidated financial +statements. Certain accounting estimates are particularly important to the understanding of the Company’s financial position +and results of operations and require the application of significant judgment by the Company’s management and can be materially +affected by changes from period to period in economic factors or conditions that are outside the control of management. The Company’s +management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those +estimates are based on historical operations, future business plans and projected financial results, the terms of existing contracts, +the observance of trends in the industry, information provided by customers and information available from other outside sources, +as appropriate. The following discusses the Company’s critical accounting policies and estimates: +14 +Estimates – Operating results +may be affected by certain accounting estimates. The most sensitive and significant accounting estimates in the financial statements +relate to customer rebates, valuation allowances for deferred income tax assets, obsolete and slow moving inventories, potentially +uncollectible accounts receivable, pension liability and accruals for income taxes. Although the Company’s management has +used available information to make judgments on the appropriate estimates to account for the above matters, there can be no assurance +that future events will not significantly affect the estimated amounts related to these areas where estimates are required. However, +historically, actual results have not been materially different than original estimates. +Revenue Recognition – The +Company recognizes revenues from the sale of products at a point in time, shipment or delivery, based on the terms of the underlying +contract with the customer. Customer program costs, including rebates, cooperative advertising, slotting fees and other sales related +discounts are recorded as a reduction to sales. Returns are also recognized as a reduction in sales and are immaterial in relation +to total sales. +In May 2014, the Financial Accounting +Standards Board (“FASB”) issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU +2014-09”), which amended the existing accounting standards for revenue recognition. ASU 2014-09 established principles for +recognizing revenue upon the transfer of promised goods or services to customers, in an amount that reflects the expected consideration +received in exchange for those goods or services. The Company adopted ASU 2014-09 in the first quarter of 2018 using the modified +retrospective approach. Because the Company’s primary source of revenues is from the sale of products which are recognized +at a point in time, the impact on its consolidated financial statements was not material. +Allowance for Doubtful Accounts – +The Company provides an allowance for doubtful accounts based upon a review of outstanding accounts receivable, historical collection +information and existing economic conditions. The allowance for doubtful accounts represents estimated uncollectible accounts receivables +associated with potential customer defaults on contractual obligations, usually due to potential insolvencies. The allowance includes +amounts for certain customers where a risk of default has been specifically identified. In addition, the allowance includes a provision +for customer defaults based on historical experience. The Company actively monitors its accounts receivable balances, and its historical +experience of annual accounts receivable write-offs has been negligible. +Customer Rebates – Customer +rebates and incentives are a common practice in the office products industry. We incur customer rebate costs to obtain favorable +product placement, to promote sell-through of products and to maintain competitive pricing. Customer rebate costs and incentives, +including volume rebates, promotional funds, catalog allowances and slotting fees, are accounted for as a reduction to gross sales. +These costs are recorded at the time of sale and are based on individual customer contracts. Management periodically reviews accruals +for these rebates and allowances, and adjusts accruals when appropriate. +Obsolete and Slow Moving Inventory – +Inventories are stated at the lower of cost, determined on the first-in, first-out method, or net realizable value. An allowance +is established to adjust the cost of inventory to its net realizable value. Inventory allowances are recorded for obsolete or slow +moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions +and specific identification of items, such as discontinued products. These estimates could vary significantly from actual requirements +if future economic conditions, customer inventory levels or competitive conditions differ from expectations. +Income Taxes – Deferred income +tax liabilities or assets are established for temporary differences between financial and tax reporting bases and are subsequently +adjusted to reflect changes in tax rates expected to be in effect when the temporary differences reverse. A valuation allowance +is recorded to reduce deferred income tax assets to an amount that is more likely than not to be realized. +15 +The Tax Act was signed into law +in December 2017 and legislation represents a fundamental and dramatic shift in U.S. taxation, with many provisions of the +Act differing significantly from previous U.S. tax law. With enactment occurring late in 2017, companies with calendar +reporting years have not had extensive time to analyze the impacts of the legislation. Applying the effects of a lower +corporate tax rate to deferred tax assets and liabilities, evaluating the one-time transition tax on undistributed earnings +of foreign operations, examining the implications of changes to net operating loss and other credit carryforwards and +considering other provisions of the Act in a relatively compressed time frame necessitates significant estimation and +judgment. Following the guidance of the U.S. Securities and Exchange Commission's Staff Accounting Bulletin (SAB) No. 118, we +have made reasonable estimates of the Act's provisions and have recorded a non-cash charge to fourth quarter of 2017 tax +expense of $1,245,000 to reflect these effects. As permitted by SAB 118, the Company has subsequently finalized its +accounting analysis based on the guidance, interpretations and data available as of December 31, 2018. There were no material +adjustments to the Company’s financial statements as a result. +Intangible Assets and Goodwill +– Intangible assets with finite useful lives are recorded at cost upon acquisition and amortized over the term of the related +contract, if any, or useful life, as applicable. Intangible assets held by the Company with finite useful lives include patents +and trademarks. The weighted average amortization period for intangible assets at December 31, 2018 was 10 years. The Company periodically +reviews the values recorded for intangible assets and goodwill to assess recoverability from +future operations whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. At +December 31, 2018 and 2017, the Company assessed the recoverability of its long-lived assets and goodwill and believed that there +were no events or circumstances present that would that would require a test of recoverability on those assets. As a result, there +was no impairment of the carrying amounts of such assets and no reduction in their estimated useful lives. +Pension +Obligation – The pension benefit obligation is based on various assumptions used by third-party actuaries in calculating +this amount. These assumptions include discount rates, expected return on plan assets, mortality rates and other factors. +Revisions in assumptions and actual results that differ from the assumptions affect future expenses, cash funding requirements +and obligations. Our funding policy is to fund the plan in accordance +with applicable requirements of the Internal Revenue Code and regulations. +These assumptions are reviewed annually +and updated as required. The Company has a frozen defined benefit pension plan. Two +assumptions, the discount rate and the expected return on plan assets, are important elements of expense and liability measurement. +We determine the discount rate used +to measure plan liabilities as of the December 31 measurement date. The discount rate reflects the current rate at which the +associated liabilities could be effectively settled at the end of the year. In estimating this rate, we look at rates of return +on fixed-income investments of similar duration to the liabilities in the plan that receive high, investment grade ratings by recognized +ratings agencies. Using these methodologies, we determined a discount rate of 3.87% to be appropriate as of December 31, 2018, +which is an increase of 0.73 percentage points from the rate used as of December 31, 2017. +The +expected long-term rate of return on assets considers the Company’s historical results and projected returns for similar +allocations among asset classes. In accordance with generally accepted accounting principles, actual results that differ from the +Company’s assumptions are accumulated and amortized over future periods and, therefore, affect expense and obligation in +future periods. For the U.S. pension plan, our assumption for the expected return on plan assets was 6.0% for 2018. For +more information concerning these costs and obligations, see the discussion in Note 6 – Pension and Profit Sharing, in the +notes to the Company’s consolidated financial statements in this report. +Accounting for Stock-Based Compensation +– Stock based compensation cost is measured at the grant date fair value of the award and is recognized as expense over the +requisite service period. The Company uses the Black-Scholes option - pricing model to determine fair value of the awards, which +involves certain subjective assumptions. These assumptions include estimating the length of time employees will retain their vested +stock options before exercising them (“expected term”), the estimated volatility of the Company’s common stock +price over the expected term (“volatility”) and the number of options for which vesting requirements will not be completed +(“forfeitures”). Changes in the subjective assumptions can materially affect estimates of fair value stock-based compensation, +and the related amount recognized on the consolidated statements of operations. Refer to Note 12 – Stock Option Plans, in +the notes to consolidated financial statements in this report for a more detailed discussion. +16 +Results of Operations 2018 Compared with 2017 +On February 1, 2017, the Company purchased +the assets of Spill Magic, Inc., located in Santa Ana, CA and Smyrna, TN. The Spill Magic products are leaders in absorbents that +encapsulate spills into dry powders that can be safely disposed. Customers, including many large retail chains, use the Spill Magic +products to remove liquids from broken glass containers, oil and gas spills, bodily fluids and solvents. The Company purchased +Spill Magic assets for $7.2 million in cash using funds borrowed under its revolving credit facility with HSBC. Additional information +concerning the acquisition of Spill Magic assets is set forth in Note 17 – Business Combinations, in the notes to consolidated +financial statements in this report. +Traditionally, the Company’s +sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the +seasonal nature of the back-to-school market. +Net Sales +In 2018, sales increased +by $6,771,000, or 5.2%, to $137,321,000 compared to $130,550,000 in 2017. +The U.S. segment sales increased +by $5,586,000, or 5%, in 2018 compared to 2017 due to strong sales of first aid and safety products as well as Camillus knives. +Sales in Canada increased 2% in U.S. dollars +and 1% in local currency compared to the same period in 2017. +Sales in Europe increased +13% in U.S. dollars and 9% in local currency compared to last year mainly due to new customers in the office products channel, +growth in sales of DMT sharpening products, and strong e-commerce demand for these products. +Gross Profit +Gross profit was 36.9% of net sales in 2018 +compared to 36.7% in 2017. +Selling, General and Administrative +Selling, general and administrative (“SG&A”) +expenses were $43,192,000 in 2018 compared with $40,016,000 in 2017, an increase of $3,176,000, or 8%. SG&A expenses were 31.5% +of net sales in 2018 compared to 30.7% in 2017. The increase in SG&A expenses was primarily due to costs relating to the addition +of sales and marketing personnel, which include compensation and recruiting costs, and higher freight and commission expense due +to higher sales. +Operating Income +Operating income was $7,457,000 +in 2018, compared with $7,883,000 in 2017. The decrease in operating income was primarily from additions of sales and marketing +personnel to support growth initiatives. Operating income in the U.S. decreased by approximately $685,000, primarily due to higher +selling, general and administrative expenses. Operating income in Canada increased by approximately $109,000, primarily due to +a better product mix and higher sales. Operating income in the European segment increased by approximately $150,000, primarily +due to higher sales. +Interest Expense, Net +Net interest expense for +2018 was $1,858,000, compared with $1,327,000 for 2017, an increase of $531,000. The increase in interest expense, net for 2018, +was primarily the result of a higher average interest rate during 2018. +Other Expense +Other expense was $67,000 +in 2018 compared to $63,000 in 2017. +17 +Income +Tax Expense +Income +tax expense was $933,000 in 2018, resulting in an effective tax rate of 17%. Excluding a special charge related to the Tax Act +in December 2017 in the U.S of $1,245,000, income tax expense was $1,196,000 in 2017, resulting in an effective tax rate of 18%. +Off-Balance Sheet Transactions +The Company did not engage +in any off-balance sheet transactions during 2018. +Liquidity and Capital Resources +During 2018, working capital decreased by approximately +$1.0 million compared to December 31, 2017. Inventory increased by approximately $1.2 million, or 3%, which corresponds mostly +to the increase in sales. The Company expects that changes in inventory levels will continue to be consistent with changes in sales, +including the seasonal impact on the Company’s revenue stream. Inventory turnover, calculated using a twelve month average +inventory balance, remained constant at 2.1 at December 31, 2018 as compared to December 31, 2017. The reserve for slow moving +and obsolete inventory was $538,354 at December 31, 2018 compared to $654,855 at December 31, 2017. We do not anticipate significant +increases in the allowance for slow moving and obsolete inventory in the ordinary course of business during 2019. +Receivables decreased by approximately +$0.9 million at December 31, 2018 compared to December 31, 2017. The average number of days sales outstanding in accounts receivable +was 66 days in 2018 compared to 65 days in 2017. Accounts payable and other current liabilities decreased by approximately $3.2 +million. +At +December 31, 2018, total debt outstanding under the Company’s revolving credit facility decreased by approximately $3.2 million +compared to total debt at December 31, 2017. As of December 31, 2018, $40,283,000 was +outstanding and $9,717,000 was available for borrowing under the Company’s revolving credit facility. +On May 24, 2018, the Company amended its revolving +loan agreement with HSBC Bank, N.A. The amendment lowered the interest rate to LIBOR plus 1.75%; interest is payable monthly. In +addition, the expiration date of the credit facility was extended to May 24, 2023. The prior interest rate was LIBOR plus 2%. The +amount available for borrowing remains unchanged at $50 million. The Company must pay a facility fee, payable quarterly, in an +amount equal to two tenths of one percent (.20%) per annum of the average daily unused portion of the revolving credit line. The +facility is intended to provide liquidity for growth, share repurchases, dividends, acquisitions, and other business activities. +Under the revolving loan agreement, the Company is required to maintain specific amounts of tangible net worth, a specified debt +to net worth ratio and a fixed charge coverage ratio and must have annual net income greater than zero, measured as of the end +of each fiscal year. At December 31, 2018, the Company was in compliance with the covenants then in effect under the loan agreement. +On October 26, 2017, the Company exercised +its option to purchase its First Aid Only manufacturing and distribution center in Vancouver, WA for $4.0 million. The property +consists of 53,000 square feet of office, manufacturing, and warehouse space on 2.86 acres. The purchase was financed by a variable +rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Commencing on December 1, 2017, principal payments of +$22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. The outstanding principal on December +31, 2018 was $3,711,112. +Capital expenditures during +2018 and 2017 were $2,850,993 and $3,146,194, respectively, which were, in part, financed with borrowings under the Company’s +revolving credit facility. +As a result of the Tax Cuts +and Jobs Act, we repatriated approximately $7.8 million in 2018. We used the proceeds to pay down debt and to finance expanded +production at our DMT, Spill Magic, and First Aid facilities in the U.S., as well as make enhancements to our Rocky Mount distribution +facility. +18 +The Company believes that cash on hand, and +cash generated from operating activities, together with funds available under its revolving credit facility, are expected, under +current conditions, to be sufficient to finance the Company’s planned operations for at least the next twelve months from +the issuance of this Form 10-K. +Recently Issued and Adopted Accounting +Standards +In August +2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. +2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date , which defers the effective date +of ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) , by one year. ASU 2015-14 is a comprehensive new revenue +recognition model requiring a company to recognize revenue to depict the transfer of goods or services to a customer at an amount +reflecting the consideration it expects to receive in exchange for those goods or services. The Company has adopted the new guidance +as of January 1, 2018 using the modified retrospective method. The adoption of the new guidance did not have a material effect +on the consolidated financial position, results of operations or cash flows of the Company beyond the increase in the level of +disclosures. Refer to Note 10 – Revenue from Contracts with Customers. +In March 2017, the FASB issued ASU No. 2017-07, Compensation—Retirement +Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU +No. 2017-07”), which requires employers to disaggregate the service cost component from other components of net periodic +benefit costs and to disclose the amounts of net periodic benefit costs that are included in each income statement line item. The +standard requires employers to report the service cost component in the same line item as other compensation costs and to report +the other components of net periodic benefit costs (which include interest costs, expected return on plan assets, amortization +of prior service cost or credits and actuarial gains and losses) separately and outside a subtotal of operating income. The service +cost component of net periodic pension cost is included in selling, general and administrative expenses in the accompanying consolidated +statements of operations and the other components of net periodic pension cost are included in other expense. The income statement +guidance requires application on a retrospective basis. The adoption of this ASU by the Company on January 1, 2018 did +not have a material effect on the consolidated financial position, results of operations or cash flows of the Company. Refer to +Note 6 – Pension and Profit Sharing. +In February 2016, the FASB issued +ASU 2016-02, Leases (Topic 842), associated with lease accounting. There have been further amendments, including +practical expedients, with the issuance of ASU 2018-11, Leases (Topic 842) Targeted Improvements, in July 2018, and +ASU 2018-20, Leases (Topic 842) Narrow Scope Improvements for Lessors, in December 2018. The amended guidance +requires the recognition of lease assets and lease liabilities on the balance sheet for those leases with terms in excess of +12 months and currently classified as operating leases. Disclosure of key information about leasing arrangements will +also be required. We elected the optional transition method which allows entities to continue to apply historical +accounting guidance in the comparative periods presented in the year of adoption. +At transition, lessees and lessors may +elect to apply a package of practical expedients permitting entities not to reassess: (i) whether any expired or existing contracts +are or contain leases; (ii) lease classification for any expired or existing leases; and (iii) whether initial direct costs for +any expired or existing leases qualify for capitalization under the amended guidance. These practical expedients must be elected +as a package and consistently applied. We have elected to apply the package of practical expedients upon adoption. +Upon adoption of the amended guidance, the +Company expects to record operating lease right-of-use assets and related liabilities of approximately $2.9 million, +primarily related to real estate leases. We currently do not expect the amended guidance to have any other material impacts on +our consolidated financial statements. +19 +In February +2018, the FASB issued ASU No. 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification +of Certain Tax Effects from Accumulated Other Comprehensive Income . ASU No. 2018-02 provides companies with an option to reclassify +stranded tax effects within accumulated other comprehensive income (“AOCI”) to retained earnings in each period in +which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) +is recorded. ASU No. 2018-02 also requires disclosure of a description of the accounting policy for releasing income tax effects +from AOCI and whether an election was made to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act. ASU No. +2018-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Companies +can adopt the provisions of ASU No. 2018-02 in either the period of adoption or retrospectively to each period (or periods) in +which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. For Acme, this ASU will be adopted effective January 1, 2019 and will result in a reclassification between +retained earnings and AOCI. The Company estimates that the impact from this ASU will increase retained earnings by approximately +$0.1 million, with an offsetting increase to accumulated other comprehensive loss for the same amount. +In June +2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment +Accounting . ASU 2018-07 aligns the accounting for share-based payment awards issued to employees and non-employees. ASU 2018-07 +is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period. The Company +does not expect the adoption of ASU 2018-07 to have a material impact on the consolidated financial statements. +In August +2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20), +Disclosure Framework - Changes to the Disclosures Requirements for Defined Benefit Plans Income Statement - Reporting Comprehensive +Income (Topic 220) . This ASU removes disclosures that no longer are considered cost beneficial, clarifies the specific requirements +of disclosures, and adds disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal years ending after +December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its consolidated financial +statements. +Item 7A. Quantitative and Qualitative +Disclosures about Market Risk +As a smaller reporting company, the Company is not +required to provide this information. +20 +Item 8. Financial Statements and Supplementary Data +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF OPERATIONS +For the years ended December 31, +2018 +2017 +Net sales +$ 137,321,395 +$ 130,550,349 +Cost of goods sold +86,672,413 +82,651,076 +Gross profit +50,648,982 +47,899,273 +Selling, general and administrative expenses +43,192,076 +40,016,220 +Operating income +7,456,906 +7,883,053 +Non operating items: +Interest: +Interest expense +(1,891,042 ) +(1,356,536 ) +Interest income +32,818 +29,376 +Interest expense, net +(1,858,224 ) +(1,327,160 ) +Other expense +(67,458 ) +(62,596 ) +Total other expense, net +(1,925,682 ) +(1,389,756 ) +Income before income tax expense +5,531,224 +6,493,297 +Income tax expense +932,874 +2,440,818 +Net income +$ 4,598,350 +$ 4,052,479 +Earnings per share: +Basic +$ 1.36 +$ 1.21 +Diluted +$ 1.30 +$ 1.09 +See accompanying Notes to Consolidated Financial Statements. +21 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +For the Years Ended +December 31, +2018 +2017 +Net income +$ 4,598,350 +$ 4,052,479 +Other comprehensive (loss) gain - +Foreign currency translation +(461,374 ) +614,741 +Change in net prior service credit +and actuarial gains, net of +income tax expense +37,388 +87,461 +Total other comprehensive (loss) income +(423,986 ) +702,202 +Comprehensive income +$ 4,174,364 +$ 4,754,681 +See accompanying Notes to Consolidated Financial Statements. +22 +Acme United Corporation and Subsidiaries +CONSOLIDATED BALANCE SHEETS +December 31, +December 31, +2018 +2017 +ASSETS +Current assets: +Cash and cash equivalents +$ 4,409,042 +$ 9,338,269 +Accounts receivable, less allowance +25,101,663 +26,012,368 +Inventories, net +41,332,137 +40,086,871 +Prepaid expenses and other current assets +2,149,295 +2,380,137 +Total current assets +72,992,137 +77,817,645 +Property, plant and equipment: +Land +1,422,785 +1,428,597 +Buildings +10,143,678 +9,561,692 +Machinery and equipment +18,244,038 +16,242,764 +Total property, plant and equipment +29,810,501 +27,233,053 +Less: accumulated depreciation +15,267,877 +13,504,914 +Net plant, property and equipment +14,542,624 +13,728,139 +Intangible assets, less accumulated amortization +17,044,400 +17,882,005 +Goodwill +4,696,370 +4,696,370 +Deferred income taxes +113,353 +509,646 +Other assets +88,902 +96,001 +Total assets +$ 109,477,786 +$ 114,729,806 +LIABILITIES +Current liabilities: +Accounts payable +$ 7,982,620 +$ 11,150,960 +Current portion of mortgage payable +266,667 +266,667 +Other accrued liabilities +5,115,400 +5,365,344 +Total current liabilities +13,364,687 +16,782,971 +Long-term debt +40,283,115 +43,450,348 +Mortgage payable, net of current portion +3,444,445 +3,711,111 +Other accrued liabilities - non current +53,128 +847,383 +Total liabilities +57,145,375 +64,791,813 +STOCKHOLDERS' EQUITY +Common stock, par value $2.50: authorized 8,000,000 +shares; issued - 4,838,071 shares in 2018 and in 2017, including treasury stock +12,094,413 +12,094,413 +Treasury stock, at cost, 1,487,238 shares in 2018 +and 1,464,010 shares in 2017 +(14,235,190 ) +(13,870,041 ) +Additional paid-in capital +8,981,523 +8,880,543 +Accumulated other comprehensive loss +(2,057,985 ) +(1,633,999 ) +Retained earnings +47,549,650 +44,467,077 +Total stockholders' equity +52,332,411 +49,937,993 +Total liabilities and stockholders' equity +$ 109,477,786 +$ 114,729,806 +See accompanying Notes to Consolidated Financial Statements. +23 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY +Outstanding Shares of Common Stock +Common Stock +Treasury +Stock +Additional Paid-In Capital +Accumulated +Other Comprehensive Loss +Retained Earnings +Total +Balances, December 31, 2016 +3,324,955 +$ 11,971,657 +$ (13,870,041 ) +$ 8,493,256 +$ (2,336,201 ) +$ 41,861,675 +$ 46,120,346 +Net income +4,052,479 +4,052,479 +Total other comprehensive income +702,202 +702,202 +Stock compensation expense +684,351 +684,351 +Distribution to shareholders +(1,447,077 ) +(1,447,077 ) +Issuance of common stock +49,106 +122,756 +526,466 +649,222 +Cash settlement of stock options +(823,530 ) +(823,530 ) +Balances, December 31, 2017 +3,374,061 +$ 12,094,413 +$ (13,870,041 ) +$ 8,880,543 +$ (1,633,999 ) +$ 44,467,077 +$ 49,937,993 +Net income +4,598,350 +4,598,350 +Total other comprehensive loss +(423,986 ) +(423,986 ) +Stock compensation expense +869,055 +869,055 +Distribution to shareholders +(1,515,777 ) +(1,515,777 ) +Cash settlement of stock options +(768,075 ) +(768,075 ) +Purchase of treasury stock +(23,228 ) +(365,149 ) +(365,149 ) +Balances, December 31, 2018 +3,350,833 +$ 12,094,413 +$ (14,235,190 ) +$ 8,981,523 +$ (2,057,985 ) +$ 47,549,650 +$ 52,332,411 +See accompanying Notes to Consolidated Financial Statements. +24 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the years ended December 31, +2018 +2017 +Operating activities: +Net income +$ 4,598,350 +$ 4,052,479 +Adjustments to reconcile net income to net +cash provided by operating activities +Depreciation +2,011,675 +1,722,568 +Amortization +1,217,525 +1,172,292 +Stock compensation expense +869,055 +684,351 +Deferred income taxes +396,233 +660,703 +Changes in operating assets and liabilities +Accounts receivable +807,988 +(5,230,159 ) +Inventories +(1,580,151 ) +(1,846,765 ) +Prepaid expenses and other current assets +573,604 +82,679 +Accounts payable +(3,066,106 ) +3,733,667 +Other accrued liabilities +(1,352,904 ) +(220,939 ) +Total adjustments +(123,081 ) +758,397 +Net cash provided by operating activities +4,475,269 +4,810,876 +Investing activities: +Purchase of property, plant and equipment +(2,850,993 ) +(3,146,194 ) +Purchase of intellectual property +(379,921 ) +— +Purchase of building +— +(4,000,000 ) +Acquisitions +— +(7,233,114 ) +Net cash used by investing activities +(3,230,914 ) +(14,379,308 ) +Financing activities: +Net (repayments) borrowings of long-term debt +(3,167,233 ) +10,514,417 +Borrowings on mortgage +— +4,000,000 +Repayments on mortgage +(266,667 ) +(22,222 ) +Distributions to shareholders +(1,484,829 ) +(1,408,428 ) +Cash settlement of stock options +(768,075 ) +(823,530 ) +Purchase of treasury stock +(365,149 ) +— +Issuance of common stock +— +649,231 +Net cash (used) provided by financing activities +(6,051,953 ) +12,909,468 +Effect of exchange rate changes +(121,629 ) +86,463 +Net (decrease) increase in cash and cash equivalents +(4,929,227 ) +3,427,499 +Cash and cash equivalents at beginning of year +9,338,269 +5,910,770 +Cash and cash equivalents at end of year +$ 4,409,042 +$ 9,338,269 +Supplemental cash flow information: +Cash paid for income taxes +$ 887,592 +$ 1,570,370 +Cash paid for interest expense +$ 1,855,356 +$ 1,255,190 +See accompanying Notes to Consolidated Financial Statements. +25 +Acme United Corporation and Subsidiaries +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. Operations +The operations of Acme United Corporation +(the “Company”) consist of three reportable segments. The operations of the Company are structured and evaluated based +on geographic location. The three reportable segments operate in the United States (including Asian operations), Canada and Europe. +Principal products across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid safety kits, and related +products which are sold primarily to wholesale, contract and retail stationery distributors, office supply super stores, mass market +retailers, industrial distributors, school supply distributors, drug store retailers, sporting goods stores, hardware chains and +wholesale florists. +2. Accounting Policies +Estimates – The preparation +of financial statements in conformity with generally accepted accounting principles in the United States requires management to +make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets +and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting +period. The most sensitive and significant accounting estimates relate to customer rebates, valuation allowances for deferred income +tax assets, obsolete and slow-moving inventories, potentially uncollectible accounts receivable, pension liability and accruals +for income taxes. Actual results could differ from those estimates. +Principles of Consolidation – +The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned by +the Company. All significant intercompany accounts and transactions are eliminated in consolidation. +Translation of Foreign Currency +– For foreign operations whose functional currencies are not U.S. dollars, assets and liabilities are translated at rates +in effect at the end of the year; revenues and expenses are translated at average rates in effect during the year. Resulting translation +adjustments are made directly to accumulated other comprehensive income. Foreign currency transaction gains and losses are recognized +in operating results. Included in other expense were foreign currency transaction losses of $7,458 in 2018 and foreign currency +transaction gains of $24,404 in 2017. +Cash Equivalents – Investments +with an original maturity of three months or less, as well as time deposits and certificates of deposit that are readily redeemable +at the date of purchase, are considered cash equivalents. +Accounts Receivable – Accounts +receivable are shown less an allowance for doubtful accounts of $462,132 at December 31, 2018 and $166,907 at December 31, 2017. +Inventories – Inventories +are stated at the lower of cost, or net realizable value, determined by the first-in, first-out method. +Property, Plant and Equipment, and +Depreciation – Property, plant and equipment is recorded at cost. Depreciation is computed by the straight-line method +over the estimated useful lives of the assets, which range from 3 to 30 years. +Intangible Assets – Intangible +assets with finite useful lives are recorded at cost upon acquisition, and amortized over the term of the related contract or useful +life, as applicable. Intangible assets held by the Company with finite useful lives include patents and trademarks. Patents and +trademarks are amortized over their estimated useful lives. The weighted average amortization period for intangible assets at December +31, 2018 was 10 years. The Company periodically reviews the values recorded for intangible +assets to assess recoverability from future operations whenever events or changes in circumstances indicate that their carrying +amounts may not be recoverable. At December 31, 2018 and 2017, the Company assessed the recoverability of its long-lived +assets and believed that there were no events or circumstances present that would that would require a test of recoverability on +those assets. As a result, there was no impairment of the carrying amounts of such assets and no reduction in their estimated useful +lives. +26 +Deferred Income Taxes – +Deferred income taxes are provided for the differences between the financial statement and tax bases of assets and liabilities, +and on operating loss carryovers, using tax rates in effect in years in which the differences are expected to reverse. +Revenue Recognition – Revenue +is recognized when the price is fixed, the title and risks and rewards of ownership have passed to the customer, and when collection +is reasonably assured. Depending on the contractual terms of each customer, revenue is recognized either at the time of shipment +or upon delivery. When revenue is recorded, estimates of returns are made and recorded as a reduction of revenue. Customer rebates +and incentives earned based on promotional programs in place, volume of purchases or other factors are also estimated at the time +of revenue recognition and recorded as a reduction of that revenue. Refer to Note 10 – +Revenue from Contracts with Customers. +Research and Development – +Research and development costs ($734,000 in 2018 and $752,000 in 2017) are expensed as incurred. +Shipping Costs – The costs +of shipping product to our customers ($7,553,410 in 2018 and $6,595,544 in 2017) are included in selling, general and administrative +expenses. +Advertising Costs – The Company +expenses the production costs of advertising the first time that the related advertising takes place. Advertising costs ($1,935,267 +in 2018 and $1,997,113 in 2017) are included in selling, general and administrative expenses. +Subsequent Events +– The Company has evaluated events and transactions subsequent to December 31, 2018 through the date the consolidated financial +statements were included in this Form 10-K and filed with the SEC. +Concentration – The Company +performs ongoing credit evaluations of its customers and generally does not require collateral for the extension of credit. Allowances +for credit losses are provided and have been within management's expectations. The Company had one customer in 2018 and two customers +in 2017 that individually exceeded 10% of consolidated net sales. In 2018, net sales to this one customer were approximately 13%, +of consolidated net sales. In 2017, net sales to the two customers were approximately 16% and 11%, respectively. +Recently Issued and Adopted Accounting +Standards +In August +2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. +2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date , which defers the effective date +of ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) , by one year. ASU 2015-14 is a comprehensive new revenue +recognition model requiring a company to recognize revenue to depict the transfer of goods or services to a customer at an amount +reflecting the consideration it expects to receive in exchange for those goods or services. The Company has adopted the new guidance +as of January 1, 2018 using the modified retrospective method. The adoption of the new guidance did not have a material effect +on the consolidated financial position, results of operations or cash flows of the Company beyond the increase in the level of +disclosures. Refer to Note 10 – Revenue from Contracts with Customers. +In March 2017, the FASB issued ASU No. 2017-07, Compensation—Retirement +Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU +No. 2017-07”), which requires employers to disaggregate the service cost component from other components of net periodic +benefit costs and to disclose the amounts of net periodic benefit costs that are included in each income statement line item. The +standard requires employers to report the service cost component in the same line item as other compensation costs and to report +the other components of net periodic benefit costs (which include interest costs, expected return on plan assets, amortization +of prior service cost or credits and actuarial gains and losses) separately and outside a subtotal of operating income. The service +cost component of net periodic pension cost is included in selling, general and administrative expenses in the accompanying consolidated +statements of earnings and the other components of net periodic pension cost are included in other expense. The income statement +guidance requires application on a retrospective basis. The adoption of this ASU by the Company on January 1, 2018 did +not have a material effect on the consolidated financial position, results of operations or cash flows of the Company. Refer to +Note 6 – Pension and Profit Sharing. +27 +In February 2016, the FASB issued ASU +2016-02, Leases , associated with lease accounting. There have been further amendments, including practical expedients, with +the issuance of ASU 2018-01, Leases (Topic 842): Land Easement Practical Expedient for +Transition to Topic 842, in January 2018, ASU 2018-11, Leases (Topic 842): Targeted Improvements, in July 2018 +and ASU 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors , in December 2018. The amended guidance +requires the recognition of lease assets and lease liabilities on the balance sheet for those leases with terms in excess of 12 months +and currently classified as operating leases. Disclosure of key information about leasing arrangements will also be required. We +elected the optional transition method which allows entities to continue to apply historical accounting guidance in the comparative +periods presented in the year of adoption. +At transition, lessees and lessors +may elect to apply a package of practical expedients permitting entities not to reassess: (i) whether any expired or existing +contracts are or contain leases; (ii) lease classification for any expired or existing leases; and (iii) whether initial +direct costs for any expired or existing leases qualify for capitalization under the amended guidance. These practical +expedients must be elected as a package and consistently applied. The Company has elected to apply the package of practical +expedients upon adoption. +Upon adoption of the +amended guidance, the Company expects to record operating lease right-of-use assets and related liabilities of +approximately $2.9 million, primarily related to real estate leases. The Company currently does not expect the amended +guidance to have any other material impacts on our consolidated financial statements. +In February +2018, the FASB issued ASU No. 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification +of Certain Tax Effects from Accumulated Other Comprehensive Income . ASU No. 2018-02 provides companies with an option to reclassify +stranded tax effects within accumulated other comprehensive income (“AOCI”) to retained earnings in each period in +which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) +is recorded. ASU No. 2018-02 also requires disclosure of a description of the accounting policy for releasing income tax effects +from AOCI and whether an election was made to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act. ASU No. +2018-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Companies +can adopt the provisions of ASU No. 2018-02 in either the period of adoption or retrospectively to each period (or periods) in +which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. For Acme, this ASU will be adopted effective January 1, 2019 and will result in a reclassification between +retained earnings and AOCI. The Company estimates that the impact from this ASU will increase retained earnings by approximately +$0.1 million, with an offsetting increase to accumulated other comprehensive loss for the same amount. +In June +2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment +Accounting . ASU 2018-07 aligns the accounting for share-based payment awards issued to employees and non-employees. ASU 2018-07 +is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period. The Company +does not expect the adoption of ASU 2018-07 to have a material impact on the consolidated financial statements. +In +August 2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic +715-20), Disclosure Framework - Changes to the Disclosures Requirements for Defined Benefit Plans Income Statement - Reporting +Comprehensive Income (Topic 220) . This ASU removes disclosures that no longer are considered cost beneficial, clarifies the +specific requirements of disclosures, and adds disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal +years ending after December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its +consolidated financial statements. +28 +3. Inventories +Inventories consisted of: +December 31, +2018 +2017 +Finished goods +$ 33,427,983 +$ 33,110,826 +Work in process +141,646 +193,557 +Materials and supplies +7,762,508 +6,782,488 +Inventories, net: +$ 41,332,137 +$ 40,086,871 +Inventories are stated net of valuation +allowances for slow moving and obsolete inventory of $538,354 as of December 31, 2018 and $654,855 as of December 31, 2017. +4. Intangible Assets and Goodwill +The Company’s intangible assets +and goodwill consisted of: +December 31, +2018 +2017 +First Aid Only Tradename +$ 3,410,000 +$ 3,410,000 +First Aid Only Customer List +5,500,010 +5,500,010 +DMT Trademarks +1,387,000 +1,387,000 +DMT Customer List +1,369,000 +1,369,000 +DMT Non-Compete +183,000 +183,000 +Slice License Agreement +379,921 +— +Patents +2,271,980 +2,271,980 +Trademarks +663,698 +663,698 +Pac-Kit Tradename, Customer List +1,500,000 +1,500,000 +Spill Magic Customer List +3,965,000 +3,965,000 +Spill Magic Trademarks +1,034,000 +1,034,000 +Spill Magic Non-Compete +67,111 +67,111 +C-Thru Customer List +1,050,000 +1,050,000 +Subtotal +22,780,720 +22,400,799 +Less: Accumulated Amortization +5,736,320 +4,518,794 +Subtotal Intangible Assets +17,044,400 +17,882,005 +Goodwill +4,696,370 +4,696,370 +Total: +$ 21,740,770 +$ 22,578,375 +Amortization +expense for patents and trademarks for the years ended December 31, 2018 and 2017 were $1,217,526 and $1,172,292, respectively. +The estimated aggregate amortization expense for each of the next five succeeding years, calculated on a similar basis, is as follows: +2019 - $1,241,417; 2020 - $1,236,796; 2021 - $1,234,971; 2022 - $1,231,686; and 2023 - $1,227,488. +29 +5. Other Accrued Liabilities +The Company’s other current and +long-term accrued liabilities consisted of: +December 31, +2018 +2017 +Customer Rebates +$ 3,395,511 +$ 3,733,472 +Pension Liability +147,099 +113,042 +Accrued Compensation +370,477 +339,474 +Dividend Payable +402,158 +371,207 +Other +853,283 +1,655,531 +Total: +$ 5,168,528 +$ 6,212,726 +6. Pension and Profit Sharing +United States employees, hired prior to +July 1, 1993, are covered by a funded, defined benefit pension plan. The benefits of this pension plan are based on years of service +and the average compensation of the highest three consecutive years during the last ten years of employment. In December 1995, +the Company's Board of Directors approved an amendment to the United States pension plan that terminated all future benefit accruals +as of February 1, 1996, without terminating the pension plan. +In accordance with the adoption of ASU +2017-07, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net +Periodic Postretirement Benefit Cost , the Company has retrospectively revised the presentation of the non-service components +of periodic pension cost of $87,000 to “Other expense” in the consolidated statement of operations for the twelve months +ended December 31, 2017, while service cost remains in “Selling, general and administrative expenses.” +The Company’s funding policy with +respect to its qualified plan is to contribute at least the minimum amount required by applicable laws and regulations. In 2018, +the Company contributed $25,107 to the plan. +The plan asset weighted average allocation +at December 31, 2018 and December 31, 2017, by asset category, were as follows: +Asset Category: +2018 +2017 +Equity Securities +65 % +67 % +Fixed Income Securities +33 % +32 % +Other Securities / Investments +2 % +1 % +Total: +100 % +100 % +The Company’s investment policy +for the pension plan is to minimize risk by balancing investments between equity securities and fixed income securities. Plan funds +are invested in long-term obligations with a history of moderate to low risk. +The pension plan asset information included +below is presented at fair value. ASC 820 establishes a framework for measuring fair value and requires disclosures about assets +and liabilities measured at fair value. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure +fair value into three levels as follows: +· Level 1 – Inputs to the valuation methodology based on unadjusted quoted market prices in +active markets that are accessible at the measurement date. +· Level 2 – Inputs to the valuation methodology that include quoted market prices that are +not considered to be active or financial instruments for which all significant inputs are observable, either directly or indirectly. +· Level 3 – Inputs to the valuation methodology are unobservable and significant to the fair +value measurement. +30 +The following tables present the pension +plan assets by level within the fair value hierarchy as of December 31, 2018 and 2017: +2018 +Level 1 +Level 2 +Level 3 +Total +Money Market Fund +$ 4 +$ 17,320 +$ — +$ 17,324 +Equity Common and Collected Funds +99,616 +564,341 +— +663,957 +Fixed Income Common and Collected Funds +83,211 +249,309 +— +332,520 +Total: +$ 182,831 +$ 830,970 +$ — +$ 1,013,801 +2017 +Level 1 +Level 2 +Level 3 +Total +Money Market Fund +$ — +$ 10,774 +$ — +$ 10,774 +Equity Common and Collected Funds +125,451 +711,143 +— +836,594 +Fixed Income Common and Collected Funds +100,430 +302,001 +— +402,431 +Total: +$ 225,881 +$ 1,023,918 +$ — +$ 1,249,799 +Other +disclosures related to the pension plan follow: +2018 +2017 +Assumptions used to determine benefit obligation: +Discount rate +3.87 % +3.14 % +Changes in benefit obligation: +Benefit obligation at beginning of year +$ (1,362,867 ) +$ (1,499,798 ) +Interest cost +(39,851 ) +(48,161 ) +Service cost +(33,000 ) +(36,000 ) +Actuarial gain (loss) +71,338 +(20,289 ) +Benefits and plan expenses paid +203,450 +241,381 +Benefit obligation at end of year: +$ (1,160,930 ) +$ (1,362,867 ) +Changes in plan assets: +Fair value of plan assets at beginning of year +$ 1,249,825 +$ 1,294,727 +Actual return on plan assets +(57,651 ) +196,479 +Employer contribution +25,107 +— +Benefits and plan expenses paid +(203,450 ) +(241,381 ) +Fair value of plan assets at end of year +1,013,831 +1,249,825 +Funded status: +$ (147,099 ) +$ (113,042 ) +Amounts recognized in Accumulated Other Comprehensive Income: +Net actuarial loss +$ 880,370 +$ 913,870 +Prior service cost +1,082 +1,625 +Total: +$ 881,452 +$ 915,495 +31 +Accrued +benefits costs are included in other accrued liabilities (non-current). +2018 +2017 +Assumptions used to determine net periodic benefit cost: +Discount rate +3.14 % +3.40 % +Expected return on plan assets +6.00 % +6.00 % +Components of net benefit expense: +Interest cost +$ 39,851 +$ 48,161 +Service cost +33,000 +36,000 +Expected return on plan assets +(67,547 ) +(69,465 ) +Amortization of prior service costs +543 +543 +Amortization of actuarial loss +87,360 +108,052 +Net periodic benefit cost: +$ 93,207 +$ 123,291 +The Company employs a building block +approach in determining the long-term rate of return for plan assets. Historical markets are studied and long-term historical +relationships between equity securities and fixed income securities are preserved consistent with the widely-accepted capital +market principle that assets with higher volatility generate higher returns over the long run. Our expected 6% long-term +rate of return on plan assets is determined based on long-term historical performance of plan assets, current asset allocation +and projected long-term rates of return. +The following table discloses the change +recorded in other comprehensive income related to benefit costs: +2018 +2017 +Balance at beginning of the year +$ 915,495 +$ 1,130,815 +Change in net loss +53,860 +(106,725 ) +Amortization of actuarial loss +(87,360 ) +(108,052 ) +Amortization of prior service cost +(543 ) +(543 ) +Change recognized in other comprehensive income +(34,043 ) +(215,320 ) +Total recognized in other comprehensive income +$ 881,452 +$ 915,495 +The Company anticipates that in +2019, net periodic benefit cost will include approximately $87,000 of net actuarial loss and $543 of prior service cost. +The following benefits are expected to +be paid: +2019 +$ 168,000 +2020 +152,000 +2021 +136,000 +2022 +122,000 +2023 +108,000 +Years 2024 - 2028 +387,000 +The Company also has a qualified, profit +sharing plan covering substantially all of its United States employees. Annual Company contributions to this profit sharing plan +are determined by the Company’s Compensation Committee. For the years ended December 31, 2018 and 2017, the Company contributed +50% of employee’s contributions, up to the first 6% contributed by each employee. Total contribution expense under this profit +sharing plan was $271,541 in 2018 and $236,993 in 2017. +32 +7. Income Taxes +The amounts of income tax expense (benefit) reflected in operations +is as follows: +2018 +2017 +Current: +Federal +$ (118,269 ) +$ 1,263,124 +State +44,315 +32,737 +Foreign +618,930 +693,297 +Total: +$ 544,976 +$ 1,989,158 +Deferred: +Federal +$ 311,608 +$ 431,454 +State +76,290 +20,206 +Total: +387,898 +451,660 +Total Income Tax Expense: +$ 932,874 +$ 2,440,818 +The current state tax provision was comprised +of taxes on income, the minimum capital tax and other franchise taxes related to the jurisdictions in which the Company's facilities +are located. +A summary of United States and foreign +income before income taxes follows: +2018 +2017 +United States +$ 1,928,627 +$ 2,477,871 +Foreign +3,602,597 +4,015,426 +Total: +$ 5,531,224 +$ 6,493,297 +As discussed in Note 11 below, for segment +reporting, direct import sales are included in the United States segment. However, the revenues are earned by our Hong Kong subsidiary +and related income taxes are paid in Hong Kong whose rate approximates 16.5%. As such, income of the Asian subsidiary is included +in the foreign income before taxes. +The following schedule reconciles the +amounts of income taxes computed at the United States statutory rates to the actual amounts reported in operations: +2018 +2017 +Federal income taxes at 21% +statutory rate +$ 1,083,174 +$ 2,322,741 +State and local taxes, net of federal +income tax effect +95,278 +39,783 +Permanent items +(75,022 ) +(370,978 ) +Transition tax on deemed repatriation +of foreign earnings +— +1,169,263 +Effect of federal rate change +on deferred taxes +(111,324 ) +74,462 +Foreign tax rate difference +(59,232 ) +(699,047 ) +Change in deferred income tax +valuation allowance +— +(95,406 ) +Provision for income taxes: +$ 932,874 +$ 2,440,818 +33 +The following summarizes deferred income +tax assets and liabilities: +2018 +2017 +Deferred income tax liabilities: +Plant, property and equipment +$ 847,162 +$ 563,289 +847,162 +563,289 +Deferred income tax assets: +Asset valuations +575,920 +506,993 +Pension +105,647 +96,098 +Other +278,948 +469,844 +960,515 +1,072,935 +Net deferred income tax asset: +$ 113,353 +$ 509,646 +The Tax Cuts and Jobs Act (the “Tax Act”) +was signed into law in December 2017 and includes a broad range of tax reforms, certain of which were required by GAAP to be recognized +upon enactment. The U.S. Securities and Exchange Commission has issued Staff Accounting Bulletin 118 (SAB 118), which provides +guidance on accounting for the tax effects of the Act. SAB 118 provides a measurement period that should not extend beyond one +year from the enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must +reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that +a company’s accounting for certain income tax effects of the Act is incomplete but it is able to determine a reasonable estimate, +it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included +in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect +immediately before the enactment of the Act. As permitted by SAB 118, the Company has subsequently finalized its accounting analysis +based on the guidance, interpretations and data available as of December 31, 2018. There were no material adjustments to the Company’s +financial statements as a result. +The Act introduced provisions that +fundamentally change the U.S. approach to taxation of foreign earnings. Under the Act, qualified dividends of foreign +subsidiaries are no longer subject to U.S. tax. Under the previously-existing tax rules, dividends from foreign operations +were subjected to U.S. tax, and if not considered permanently reinvested, the Company had recognized expense and recorded a +liability for the tax expected to be incurred upon receipt of the dividend of these foreign earnings. Although the Act +excludes dividends of foreign subsidiaries from taxation, it includes provisions for a mandatory deemed dividend of +undistributed foreign earnings at tax rates of 15.5% or 8% ("transition tax") depending on the nature of the +foreign operations' assets. Companies may utilize tax attributes (including net operating losses and tax credits) to offset +the transition tax. The estimated provisional net effect of applying the provisions of the Act on our 2017 results of +operations was a non-cash charge to tax expense of $1,170,000. This provisional amount could be revised as additional +guidance and interpretations are issued and as we continue to examine the details of the Act and the related +tax attributes. +On January 22, 2018, the FASB released guidance +on the accounting for tax on the global intangible low-taxed income (“GILTI”) provisions of the Act. The GILTI provisions +impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company considers any +potential GILTI as an expense in the period the tax is incurred. +Based on our historical +financial performance in the U.S., at December 31, 2017, the Company had a significant net deferred tax asset position. As +such, with the Act's reduction of the corporate tax rate from 35% to 21%, the Company re-measured its net deferred tax +assets at the lower corporate rate of 21% and recognized a $75,000 tax expense to adjust net deferred tax assets to the +reduced value. +The total effect in 2017 of applying the U.S. +tax reform provisions of the Act was tax expense of $1,245,000 increasing the effective rate for 2017 by 128%. +34 +In 2018, the Company evaluated its tax positions +for years which remain subject to examination by major tax jurisdictions, in accordance with the requirements of ASC 740 and as +a result, concluded no adjustment was necessary. The Company files income tax returns in the U.S. federal jurisdiction, and various +state and foreign jurisdictions. The Company’s evaluation of uncertain tax positions was performed for the tax years ended +December 31, 2015 and forward, the tax years which remain subject to examination by major tax jurisdictions as of December 31, +2018. +Due to the uncertain nature of the realization +of the Company's deferred income tax assets based on past performance of its German subsidiary and carry forward expiration dates, +the Company has recorded a valuation allowance for the amount of deferred income tax assets which are not expected to be realized. +This valuation allowance, all of which is related to deferred tax assets resulting from net operating losses of the Company’s +German subsidiary, is subject to periodic review, and, if the allowance is reduced, the tax benefit will be recorded in future +operations as a reduction of the Company's tax expense. +8. Long-Term Debt and Shareholders’ +Equity +On May 24, 2018, the Company amended its revolving +loan agreement with HSBC Bank, N.A. The amendment lowered the interest rate to LIBOR plus 1.75%; interest is payable monthly. In +addition, the expiration date of the credit facility was extended to May 24, 2023. The prior interest rate was LIBOR plus 2%. The +amount available for borrowing remains unchanged at $50 million. The Company must pay a facility fee, payable quarterly, in an +amount equal to two tenths of one percent (.20%) per annum of the average daily unused portion of the revolving credit line. The +facility is intended to provide liquidity for growth, share repurchases, dividends, acquisitions, and other business activities. +Under the revolving loan agreement, the Company is required to maintain specific amounts of tangible net worth, a specified debt +to net worth ratio and a fixed charge coverage ratio and must have annual net income greater than zero, measured as of the end +of each fiscal year. At December 31, 2018, the Company was in compliance with the covenants then in effect under the loan agreement. +Long +term debt consists of borrowings under the Company’s revolving loan agreement with HSBC Bank, N.A. As of December 31, 2018, +$40,283,000 was outstanding and $9,717,000 was available for borrowing under the Company’s revolving loan agreement. +On October 26, 2017, the Company +exercised its option to purchase its First Aid Only manufacturing and distribution center in Vancouver, WA for $4.0 million. +The property consists of 53,000 square feet of office, manufacturing, and warehouse space on 2.86 acres. The purchase was +financed by a variable rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Commencing on December 1, +2017, principal payments of $22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. +Minimum annual mortgage payments are due as follows: 2019 - $266,664; 2020 - $266,664; 2021 - $266,664; 2022 - $266,664; 2023 +- $266,664; and thereafter - $2,377,794. +During the twelve months ended December +31, 2018, the Company repurchased a total of 23,228 shares of its Common Stock. As of December 31, 2018, 17,999 shares may be purchased +in the future under the repurchase program announced in 2010. +9. Commitments and Contingencies +The Company leases certain office, manufacturing +and warehouse facilities and various equipment under non-cancelable operating leases. Total rent expense was $1,243,732 and $1,432,677 +in 2018 and 2017, respectively. Minimum annual rental commitments under non-cancelable leases with remaining terms of one year +or more as of December 31, 2018 are as follows: 2019 - $1,064,585; 2020 - $927,681; 2021 - $572,344; 2022 - $278,797; 2023 - $255,122; +and thereafter - $64,248. +There are no pending material legal proceedings +to which the Company is a party or, to the actual knowledge of the Company, contemplated by any governmental authority. +35 +10. Revenue from Contracts with Customers +On January 1, 2018, the Company adopted +ASC 606, Revenue from Contracts with Customers , using the modified retrospective method. The new revenue standard requires +recognition of revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration +to which the Company expects to be entitled in exchange for those goods or services. The adoption of this standard did not impact +the timing of revenue recognition for customer sales in the twelve months ended December 31, 2018. +Nature of Goods and Services +The Company recognizes revenue from the +sales of a broad line of products that are grouped into two main categories: (i) cutting, sharpening and measuring; and (ii) first +aid and safety. The cutting and sharpening category includes scissors, knives, paper trimmers, pencil sharpeners and other sharpening +tools. The first aid and safety category includes first aid kits and refills, over-the-counter medications and a variety of safety +products. Revenue recognition is evaluated through the following five steps: (i) identification of the contract or contracts with +a customer; (ii) identification of the performance obligations in the contract; (iii) determination of the transaction price; (iv) +allocation of the transaction price in the contract; and (v) recognition of revenue when or as a performance obligation is satisfied. +When Performance Obligations Are Satisfied +A performance obligation is a promise +in a contract to transfer a distinct good or service to the customer. A contract’s transaction price is allocated to each +distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Revenue is generated +by the sale of the Company’s products to its customers. Sales contracts (purchase orders) generally have a single performance +obligation that is satisfied at a point in time, with shipment or delivery, depending on the terms of the underlying contract. +Revenue is measured based on the consideration specified in the contract. The amount of consideration we receive and revenue we +recognize is impacted by incentives ("customer rebates"), including sales rebates, which are generally tied to sales +volume levels, in-store promotional allowances, shared media and customer catalog allowances and other cooperative advertising +arrangements; freight allowance programs offered to our customers; and allowance for returns and discounts. We generally recognize +customer rebate costs as a deduction to gross sales at the time that the associated revenue is recognized. +Significant Payment Terms +Payment terms for each customer are dependent +on the agreed upon contractual repayment terms. Typically between 30 and 90 days, but they vary dependent on the size of the customer +and its risk profile to the Company. Some customers receive discounts for early payment. +Product Returns +The Company accepts product returns in the normal course of business. +The Company estimates reserves for returns and the related refunds to customers based on historical experience. Reserves for returned +merchandise are included as a component of “Accounts receivables” in the consolidated balance sheets. +Practical Expedient Usage and Accounting Policy Elections +The Company has determined to utilize the modified +retrospective approach which requires cumulative effect adjustment to the opening balance of retained earnings in the current year. +This opening adjustment is determined based on the impact of the new revenue standard’s application on contracts that were +not completed as of January 1, 2018, the date of initial application of the standard. This election did not have an impact on the +Company’s consolidated financial statements. +For the Company’s contracts that have +an original duration of one year or less, the Company uses the practical expedient in ASC 606-10-32-18 applicable to such contracts +and accordingly, does not consider the time value of money in relation to significant financing components. The effect of applying +this practical expedient election did not have an impact on the Company’s consolidated financial statements. +36 +Per ASC 606-10-25-18B, the Company has elected +to account for shipping and handling activities that occur after the customer has obtained control as a fulfillment activity instead +of a performance obligation. Furthermore, shipping and handling activities performed before transfer of control of the product +also do not constitute a separate and distinct performance obligation. +The Company has elected to exclude from the +transaction price those amounts which relate to sales and other taxes that are assessed by governmental authorities and that are +imposed on and concurrent with a specific revenue-producing transaction and collected by the Company from a customer. +Applying the practical expedient in ASC 340-40-25-4 +– Other Assets and Deferred Costs , the Company recognizes the incremental costs of obtaining contracts as an expense +when incurred. These costs are included in “Selling, general and administrative expenses.” The effect of applying +this practical expedient did not have a material impact on the Company’s consolidated financial statements. +Disaggregation of Revenues +The following table represents external +net sales disaggregated by product category: +For the +twelve months ended December 31, 2018 +(amounts +in 000's) +US +Canada +Europe +Total +Cutting, Sharpening and Measuring +$ 64,271 +$ 6,973 +$ 9,103 +$ 80 ,347 +First Aid and Safety +56,974 +— +— +56,974 +Total Net Sales +$ 121,245 +$ 6,973 +$ 9,103 +$ 137,321 +11. Segment Information +The Company reports financial information based +on the organizational structure used by the Company’s chief operating decision makers for making operating and investment +decisions and for assessing performance. The Company’s reportable business segments consist of: (1) United States; (2) Canada; +and (3) Europe. As described below, the activities of the Company’s Asian operations are closely linked to those of the U.S. +operations; accordingly, the Company’s chief operating decision makers review the financial results of both on a consolidated +basis, and the results of the Asian operations have been aggregated with the results of the United States operations to form one +reportable segment called the “United States segment” or “U.S. segment”. Each reportable segment derives +its revenue from the sales of cutting devices, measuring instruments and safety products for school, office, home, hardware, sporting +and industrial use. +Domestic sales orders are filled +primarily from the Company’s distribution centers in North Carolina, Washington, Massachusetts, Tennessee and +California. The Company is responsible for the costs of shipping, insurance, customs clearance, duties, storage and +distribution related to such products. Orders filled from the Company’s inventory are generally for less than +container-sized lots. +Direct import sales are products sold by the +Company’s Asian subsidiary, directly to major U.S. retailers who take ownership of the products in Asia. These sales are +completed by delivering product to the customers’ common carriers at the shipping points in Asia. Direct import sales are +made in larger quantities than domestic sales, typically full containers. Direct import sales represented approximately 12% and +11% of the Company’s total net sales in 2018 and 2017, respectively. +The Chief Operating Decision Maker +evaluates the performance of each operating segment based on segment revenues and operating income. Segment revenues are defined +as total revenues, including both external customer revenue and inter-segment revenue. Segment operating earnings are defined as +segment revenues, less cost of goods sold and operating expenses. Identifiable assets by segment are those assets used in the respective +reportable segment’s operations. Inter-segment amounts are eliminated to arrive at consolidated financial results. +37 +The following table sets forth certain +financial data by segment for the fiscal years ended December 31, 2018 and 2017: +Financial data by segment: +(000’s omitted) +Year Ended December 31, 2018: +United States +Canada +Europe +Consolidated +Net sales +$ 120,993 +$ 7,040 +$ 9,288 +$ 137,321 +Operating income +6,103 +884 +470 +7,457 +Assets +99,720 +3,839 +5,918 +109,477 +Additions to property, plant and equipment +2,705 +83 +63 +2,851 +Depreciation and amortization +3,153 +9 +67 +3,229 +Year Ended December 31, 2017: +United States +Canada +Europe +Consolidated +Net sales +$ 115,407 +$ 6,935 +$ 8,208 +$ 130,550 +Operating income +6,788 +775 +320 +7,883 +Assets +104,431 +4,926 +5,373 +114,730 +Additions to property, plant and equipment +7,014 +19 +113 +7,146 +Depreciation and amortization +2,845 +8 +42 +2,895 +The following is a reconciliation of segment +operating income to consolidated income before taxes: +2018 +2017 +Total operating income +$ 7,457 +$ 7,883 +Interest expense, net +1,858 +1,327 +Other expense +67 +63 +Consolidated income before taxes +$ 5,532 +$ 6,493 +The table below presents revenue by geographic +area. Revenues are attributed to countries based on location of the customer. +Revenues +2018 +2017 +United States +$ 119,573 +$ 114,231 +International: +Canada +7,040 +6,935 +Europe +9,288 +8,208 +Other +1,420 +1,176 +Total International +$ 17,748 +$ 16,319 +Total Revenues +$ 137,321 +$ 130,550 +12. Stock Option Plans +The Company grants stock options under the +2012 Employee Stock Option Plan (the “2012 Employee Plan”) and under the 2017 Non-Salaried Director Stock Option Plan +(the “2017 Director Plan”). The Company also has two plans under which the Company no longer grants options but under +which certain options remain outstanding: the 2002 Employee stock Option Plan and the 2005 Non-Salaried Director Stock Option Plan +(the “2005 Director Plan”). +38 +The 2012 Employee Plan, which became +effective April 23, 2012, provides for the issuance of incentive and nonqualified stock options at an exercise price equal to +the fair market value of the Common Stock on the date the option is granted. The terms of the options granted are subject to the +provisions of the 2012 Employee Plan. Options granted under the 2012 Employee Plan vest 25% one day after the first anniversary +of the grant date and 25% one day after each of the next three anniversaries. As of December 31, 2018, the number of shares available +for grant under the 2012 Employee Plan was 65,000. Under the terms of the Employee Plan, no option may be granted under that plan +after the tenth anniversary of the adoption of the plan. Options outstanding under the Company’s 2002 Employee Stock Option +Plan have the same vesting schedule as the 2012 Employee Plan. +The 2017 Director Plan provides for the +issuance of stock options for up to a total of 60,000 shares of the Company's common stock to non-salaried directors. Under the +Director Plan, Directors elected after the effective date and at subsequent Annual Meetings who have not received any prior grant +under this or previous plans shall receive an initial grant of an option to purchase 5,000 shares of Common Stock (the “Initial +Option”). Each year, each elected Director not receiving an Initial Option will receive an option to purchase 5,000 shares +of Common Stock (the “Annual Option”). The Initial Option vests 25% on the date of grant and 25% on the anniversary +of the grant date in each of the following 3 years. Each Annual Option becomes fully exercisable one day after the date of grant. +The exercise price of each option granted equals the fair market value of the Common Stock on the date the option is granted, +and expires ten (10) years from the date of grant. As provided in the Director Plan, no options may be granted under the Director +Plan after the tenth anniversary of the adoption of the Plan, i.e., after April 24, 2027. As of December 31, 2018, the number +of shares available for grant under the 2017 Director Plan was 20,000. +The 2005 Director Plan, as amended, provided +for the issuance of stock options for up to a total of 180,000 shares of the Company's common stock to non-salaried directors. +Under the Director Plan, Directors elected on April 25, 2005 and at subsequent Annual Meetings who had not received any prior grant +under this or previous plans received an initial grant of an option to purchase 5,000 shares of Common Stock (the “Initial +Option”). Each year, each elected Director not receiving an Initial Option received a 5,000 share option (the “Annual +Option”). The Initial Option vested 25% on the date of grant and 25% on the anniversary of the grant date in each of the +following 3 years. Each Annual Option became fully exercisable one day after the date of grant. The exercise price of each option +granted equaled the fair market value of the Common Stock on the date the option was granted, and expired ten (10) years from the +date of grant. As provided in the Director Plan, no options could be granted under the Director Plan after the tenth anniversary +of the adoption of the Plan, i.e., after April 25, 2015. +The Company has amended certain of its stock +option plans for both employees and directors to permit options to be exercised on a net basis and receive either cash or shares +of the Company’s Common Stock. Specifically, optionees may, at the time of exercise of an option and subject to the consent +of the Company, elect either (i) to receive from the Company cash in an amount equal to the number of shares of Common Stock subject +to the option (or portion thereof) that is being exercised multiplied by the excess of (a) the fair market value per share over +(b) the exercise price per share of the option ( a “net cash settlement”); or (ii) to make payment of the exercise +price of the option by reduction in the number of shares of Common Stock otherwise deliverable upon exercise of such option by +the number of shares having an aggregate fair market value equal to the total exercise price of the option (or portion thereof). +In 2018, the Company paid a total of approximately $768,075 to optionees who had elected a net cash settlement of their respective +options. +39 +A summary of changes in options issued under the Company’s +stock option plans follows: +2018 +2017 +Options outstanding at the +beginning of the year +1,289,080 +1,088,278 +Options granted +232,200 +313,900 +Options forfeited +(11,500 ) +(4,000 ) +Options exercised +(75,500 ) +(109,098 ) +Options outstanding at +the end of the year +1,434,280 +1,289,080 +Options exercisable at the +end of the year +918,405 +814,180 +Common stock available for future grants at the end of the year +85,000 +62,700 +Weighted average exercise price per share: +Granted +$ 22.75 +$ 24.87 +Forfeited +23.07 +19.12 +Exercised +11.47 +13.13 +Outstanding +18.07 +16.87 +Exercisable +15.15 +13.38 +A summary of options outstanding as December 31, 2018 is as +follows: +Options Outstanding +Options Exercisable +Range of Exercise Prices +Number Outstanding +Weighted-Average Remaining Contractual Life (Years) +Weighted-Average Exercise Price +Number Exercisable +Weighted-Average Exercise Price +$7.30 to $10.74 +299,180 +3 +$ 9.88 +299,180 +$ 9.88 +$10.75 to $16.82 +262,750 +4 +13.62 +262,750 +13.62 +$16.83 to $22.08 +337,875 +7 +19.41 +244,625 +18.75 +$22.09 to $23.97 +228,200 +10 +22.79 +20,000 +22.66 +$23.98 to $28.20 +306,275 +9 +24.87 +91,850 +25.41 +1,434,280 +918,405 +The weighted average remaining contractual +life of all outstanding stock options is 6 years. +Stock-Based Compensation +Stock-based compensation cost is measured at +the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is generally +the vesting period. The Company uses the Black-Scholes option pricing model to determine the fair value of employee and non-employee +director stock options. The determination of the fair value of stock-based payment awards on the date of grant, using an option-pricing +model, is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. +These assumptions include estimating the length of time employees will retain their vested stock options before exercising them +(“expected term”), the estimated volatility of the Company’s Common Stock price over the expected term (“volatility”) +and the number of options that will not fully vest in accordance with applicable vesting requirements (“forfeitures”). +The Company estimates the expected term of +options granted by evaluating various factors, including the vesting period, historical employee information, as well as current +and historical stock prices and market conditions. The Company estimates the volatility of its common stock by calculating historical +volatility based on the closing stock price on the last day of each of the 60 months leading up to the month the option was granted. +The risk-free interest rate that the Company uses in the option valuation model is the interest rate on U.S. Treasury zero-coupon +bond issues with remaining terms similar to the expected term of the options granted. Historical information was the basis for +calculating the dividend yield. The Company is required to estimate forfeitures at the time of grant and to revise those estimates +in subsequent periods if actual forfeitures differ from those estimates. The Company used a mix of historical data and future assumptions +to estimate pre-vesting option forfeitures and to record stock-based compensation expense only for those awards that are expected +to vest. All stock-based payment awards are amortized over the requisite service periods of the awards, which are generally the +vesting periods. +40 +The assumptions used to value option grants +for the twelve months ended December 31, 2018 and December 31, 2017 were as follows: +2018 +2017 +Expected life in years +5 +5 +Interest rate +2.43 - 3.02% +1.82 - 1.95% +Volatility +.287 - .316 +.259 - .277 +Dividend yield +1.8 - 2.75% +1.5 - 1.6% +Total stock-based compensation recognized +in the Company’s consolidated statements of operations for the years ended December 31, 2018 and 2017 was $869,055 and $684,351, +respectively. At December 31, 2018, there was approximately $2,151,417 of unrecognized compensation cost, adjusted for estimated +forfeitures, related to non-vested stock-based payments granted to the Company’s employees. As of December 31, 2018, the +remaining unamortized expense is expected to be recognized over a weighted average period of 3 years. +The weighted average fair value at the +date of grant for options granted during 2018 and 2017 was $5.77 and $4.83 per option, respectively. The aggregate intrinsic value +of outstanding options was $1,566,625 at December 31, 2018. The aggregate intrinsic value of exercisable options was $1,566,625 +at December 31, 2018. The aggregate intrinsic value of options exercised during 2018 was $768,075. +13. Earnings Per Share +The calculation of earnings per share +follows: +2018 +2017 +Numerator: +Net income +$ 4,598,350 +$ 4,052,479 +Denominator: +Denominator for basic earnings per share: +Weighted average shares outstanding +3,370,744 +3,356,383 +Effect of dilutive employee stock options +171,166 +368,220 +Denominator for dilutive earnings per share +3,541,910 +3,724,603 +Basic earnings per share +$ 1.36 +$ 1.21 +Dilutive earnings per share +$ 1.30 +$ 1.09 +For 2018 and 2017, respectively, 692,600 +and 205,500 stock options were excluded from diluted earnings per share calculations because they would have been anti-dilutive. +14. Accumulated Other Comprehensive +Loss +The components of accumulated other comprehensive +loss follow: +Foreign currency translation adjustment +Net prior service credit and actuarial losses +Total +Balances, December 31, 2016 +$ (1,672,188 ) +$ (664,012 ) +$ (2,336,201 ) +Change in net prior service credit +and actuarial losses, net of tax +87,461 +87,461 +Translation adjustment +614,741 +614,741 +Balances, December 31, 2017 +$ (1,057,447 ) +$ (576,551 ) +$ (1,633,999 ) +Change in net prior service credit +and actuarial losses, net of tax +37,388 +37,388 +Translation adjustment +(461,374 ) +(461,374 ) +Balances, December 31, 2018 +$ (1,518,821 ) +$ (539,163 ) +$ (2,057,985 ) +41 +15. Financial Instruments +The carrying value of the Company’s bank +debt is a reasonable estimate of fair value because of the nature of its payment terms and maturity. +16. Quarterly Data (unaudited) +Quarters (000’s omitted, except +per share data): +2018 +First +Second +Third +Fourth +Total +Net sales +$ 31,709 +$ 39,751 +$ 34,731 +$ 31,130 +$ 137,321 +Cost of goods sold +19,585 +25,039 +22,281 +19,767 +86,672 +Gross profit +12,124 +14,712 +12,450 +11,363 +50,649 +Net income +764 +2,436 +807 +591 +4,598 +Basic earnings per share +$ 0.23 +$ 0.72 +$ 0.24 +$ 0.18 +$ 1.36 +Diluted earnings per share +$ 0.21 +$ 0.67 +$ 0.23 +$ 0.19 +$ 1.30 +Dividends per share +$ 0.11 +$ 0.11 +$ 0.11 +$ 0.12 +$ 0.45 +2017 +First +Second +Third +Fourth +Total +Net sales +$ 27,745 +$ 38,849 +$ 33,785 +$ 30,171 +$ 130,550 +Cost of goods sold +17,181 +24,366 +21,559 +19,545 +82,651 +Gross profit +10,564 +14,483 +12,226 +10,626 +47,899 +Net income +659 +2,846 +1,202 +(655 ) +4,052 +Basic earnings per share +$ 0.20 +$ 0.85 +$ 0.36 +$ (0.20 ) +$ 1.21 +Diluted earnings per share +$ 0.18 +$ 0.75 +$ 0.32 +$ (0.16 ) +$ 1.09 +Dividends per share +$ 0.10 +$ 0.11 +$ 0.11 +$ 0.11 +$ 0.43 +Earnings per share were computed +independently for each of the quarters presented. Therefore, the sum of the four quarterly earnings per share amounts may not +necessarily equal the earnings per share for the year. +17. Business Combinations +On February 1, 2017, the Company purchased +the assets of Spill Magic, Inc., located in Santa Ana, CA and Smyrna, TN. The Spill Magic products are leaders in absorbents that +encapsulate spills into dry powders that can be safely disposed. Customers, include many large retail chains, use Spill Magic products +to remove liquids from broken glass containers, oil and gas spills, bodily fluids and solvents. The Company purchased Spill Magic +assets for $7.2 million in cash using funds borrowed under its revolving credit facility with HSBC. +The purchase price was allocated to assets +acquired as follows (in thousands): +Assets: +Accounts Receivable +$ 684 +Inventory +453 +Equipment +296 +Intangible Assets +5,066 +Goodwill +748 +Total +assets +$ 7,247 +42 +Assuming Spill Magic assets were acquired on +January 1, 2017, unaudited pro forma combined net sales for the twelve months ended December 31, 2017 for the Company would have +been approximately $131.0 million. Unaudited pro forma combined net income for the twelve months ended December 31, 2017 for the +Company would have been approximately $3.9 million. +Net sales for the twelve months ended December +31, 2017 attributable to Spill Magic products were approximately $6.5 million. Net income for the twelve months ended December +31, 2017 attributable to Spill Magic products was approximately $0.8 million. +43 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING +FIRM +To the Shareholders and Board of Directors +of +Acme United Corporation +Opinion on the Financial +Statements +We have audited the accompanying +consolidated balance sheets of Acme United Corporation and Subsidiaries (the “Company”) as of December 31, 2018 and +2017, the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity and cash flows +for each of the two years in the period ended December 31, 2018, and the related notes (collectively referred to as the “financial +statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of +the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the two years in +the period ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the +standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company's internal control +over financial reporting as of December 31, 2018, based on the criteria established in Internal Control - Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013 and our report dated March 15, 2019 , +expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Basis for Opinion +These financial statements are the responsibility +of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. +We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance +with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the +PCAOB. +We conducted our audits in accordance with +the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether +the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures +to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures +that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures +in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made +by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a +reasonable basis for our opinion. +We have served as the Company’s auditor since 2008; such date +takes into consideration the acquisition of a portion of UHY LLP by Marcum LLP in April 2010. +New Haven, Connecticut +March 15, 2019 +44 +REPORT OF INDEPENDENT REGISTERED PUBLIC +ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING +To the Shareholders and Board of Directors of +Acme United Corporation +Opinion on Internal Control over Financial +Reporting +We have audited Acme United Corporation and +Subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2018, based on criteria +established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway +Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting +as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by +the Committee of Sponsoring Organizations of the Treadway Commission. +We have also audited, in accordance with +the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated +balance sheets as of December 31, 2018 and 2017 and the related consolidated statements of operations, comprehensive income, +changes in stockholders’ equity, and cash flows for the years then ended of the Company and our report dated March 15, +2019 expressed an unqualified opinion on those financial statements. +Basis for Opinion +The Company's management is responsible for +maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control +over financial reporting, included in the accompanying “Management Annual Report on Internal Control over Financial Reporting”. +Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are +a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance +with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the +PCAOB. +We conducted our audit in accordance with the +standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether +effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over +financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a +material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed +risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that +our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control +over Financial Reporting +A company’s internal control over financial +reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal +control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in +reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable +assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally +accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations +of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of the inherent limitations, internal +control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness +to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that degree +of compliance with the policies or procedures may deteriorate. +Marcum LLP +New Haven, Connecticut +March 15, 2019 +45 +Item 9. Changes In and Disagreements with Accountants on +Accounting and Financial Disclosure +There have been no disagreements with +accountants related to accounting and financial disclosures in 2018. +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision +and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness +of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange +Act of 1934) as of December 31, 2018. Based on and as of the time of such evaluation, our management, including the Chief Executive +Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of the end of the +period covered by this report to ensure that information required to be disclosed by us in the reports that we file or submit is +recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules +and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information +required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and +communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely +decisions regarding required disclosure. +Management's Report on Internal Control over Financial Reporting. +Management is responsible for establishing +and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and +15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief +Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December +31, 2018, based on the framework in Internal Control -Integrated Framework (2013) issued by the Committee of Sponsoring Organizations +of the Treadway Commission. Based on that evaluation our management concluded that our internal control over financial reporting +was effective as of December 31, 2018. The effectiveness of our internal control over financial reporting as of December 31, 2018 +has been audited by Marcum, LLP, an independent registered public accounting firm, as stated in its attestation report, which is +included in Item 8 and is incorporated into this Item 9A by reference. +Changes in Internal Control over Financial Reporting. +No changes in our internal control over financial reporting were +identified as having occurred during the quarter ended December 31, 2018 that have materially affected, or are reasonably likely +to materially affect, our internal control over financial reporting. +Item 9B. Other Information +None. +46 +PART III +Item 10. Directors, Executive Officers +and Corporate Governance +The following table sets forth certain +information with respect to the directors and executive officers of the Company. All directors of the Company hold office until +the next annual meeting of the shareholders or until their successors have been elected and qualified. Executive officers are elected +by the Board of Directors to hold office until their successors are elected and qualified. +Name +Age +Position Held with Company +Walter C. Johnsen +68 +Chairman of the Board and Chief Executive Officer +Brian S. Olschan +62 +President, Chief Operating Officer and Director +Paul G. Driscoll +58 +Vice President, Chief Financial Officer, Secretary and Treasurer +Rex L. Davidson +69 +Director +Richmond Y. Holden, Jr. +65 +Director +Susan H. Murphy +67 +Director +Stevenson E. Ward III +73 +Director +Walter C. Johnsen has served as Chairman +of the Board and Chief Executive Officer of the Company since January 1, 2007; President and Chief Executive Officer of the Company +from November 30, 1995 to December 31, 2006. Mr. Johnsen previously served as Vice Chairman and a principal of Marshall Products, +Inc., a medical supply distributor. Mr. Johnsen has served on the Board of TOMI Environmental Solutions, Inc., a publicly traded +company, since February 1, 2016. Mr. Johnsen’s qualifications to serve on the Board of the Company include the in-depth knowledge +of all facets of the Company’s business which he has gained during his more than twenty-one years of service as the Company’s +Chief Executive Officer. +Brian S. Olschan has served as President +and Chief Operating Officer of the Company since January 1, 2007; Executive Vice President and Chief Operating Officer of the Company +from January 1999 to December 31, 2006; Senior Vice President - Sales and Marketing of the Company from September 1996 to January +1999; Mr. Olschan previously served as Vice President and General Manager of the Cordset and Assembly Business of General Cable +Corporation, an electrical wire and cable manufacturer. Mr. Olschan’s qualifications to serve on the Board include his detailed +knowledge of the Company’s operations which he has gained in his capacity as a member of senior management for more than +eleven years, including as Chief Operating Officer since January 1999 and President since January 2007. +Paul G. Driscoll has served as +Vice President and Chief Financial Officer, Secretary and Treasurer since October 2, 2002. Mr. Driscoll joined Acme as Director +of International Finance on March 19, 2001. From 1997 to 2001, he was employed by Ernest and Julio Gallo Winery, including as Director +of Finance and Operations in Japan. Prior to Gallo he served in several increasingly responsible finance positions in Sterling +Drug Inc. in New York City and Sanofi S.A. in France. +Rex L. Davidson has served as Director +since 2006. Executive Director of the Helms Fund since 2013. The Helms Fund provides "gap financing" to socially +responsible business ventures for capital expenditures. Additionally, since 2009, Mr. Davidson has served as President of Rex Davidson +Associates, LLC, a management consulting service, and Executive Director of Las Cumbres Community Services, which provides developmental +disability and mental health services to children, adults and families in Northern New Mexico. From 1982 to 2009, he +served as President and Chief Executive Officer of Goodwill Industries of Greater New York and Northern New Jersey, Inc., and President +of Goodwill Industries Housing Corporation. Mr. Davidson’s qualifications to serve on the Board include significant management +experience at the highest level, having been responsible for the management of Goodwill Industries, an organization with over 2,000 +employees and revenues in excess of $100 million. Mr. Davidson’s experience in the areas of compensation of personnel at +all levels, his experience relating to retail matters, such as retail trends and pricing, and diversity policies are of significant +benefit to the Company. +47 +Richmond Y. Holden, Jr. has served as +Director since 1998. Mr. Holden served as President and CEO of INgageHub, a cloud based Marketing SaaS platform, from January 2015 +through early 2016; he continues to serve as a senior advisor to the company. From 2007 through 2014, Mr. Holden served in senior +executive positions at, School Specialty, Inc., a distributor of school supplies, equipment and curriculum products. He last served +as Executive Vice President of School Specialty, Inc., and President of the Curriculum Group, a division of School Specialty Inc., +from 2013 to December 2014. He was President of Educational Resources, a division of School Specialty, Inc., from 2010 to 2013. +He served as Chairman and Chief Executive Officer of J.L. Hammett Co., a reseller of educational, curriculum, equipment, and products +from 1992 to 2006. Mr. Holden served on the Board of Directors of Software Secure, Incorporated, a privately-held company headquartered +in Newton, MA, which focused on secure online educational testing technology, from 2007 until its sale in late 2016. He has served +on the Board of Directors of Codman Academy Charter Public School in Boston MA since 2012. The qualifications of Mr. Holden to +serve on the Board of the Company include his substantial senior executive management experience of large complex companies in +the educational markets. In particular, as a result of his experience with School Specialty Inc., then a $650 million publicly +held reseller of educational products, Mr. Holden has broad knowledge of educational markets and operational matters relating to +developmental strategy, finance, marketing, sales, technology, sourcing, pricing and distribution. +Susan H. Murphy has served as Director +since 2003. Vice President Emerita, Cornell University, from which Dr. Murphy retired in 2016 after a 38-year career, commencing +in 1978. She served as Dean of Admissions and Financial Aid from 1985 to 1994; Vice President of Student and Academic Services +from 1994 to June 2015, and thereafter she worked in Alumni Affairs and Development until her retirement. In 2013, Dr. Murphy became +a member of the Board of Trustees of Adelphi University, and, since July 2016, has served as Vice Chair of its Board of Trustees. +She also serves on the Board of Directors for Kendal at Ithaca, a not-for-profit continuing care retirement community (since April +2014); Tompkins County Community Foundation (since January 2015 and Chair of the Board of Directors commencing in 2018); and Let’s +Get Ready, an organization which provides low-income high school students with support services to help them gain admission to +and graduate from college (since September 2016). Dr. Murphy received a Ph.D. in Educational Administration from Cornell University. +Dr. Murphy has broad senior management level experience in a large, complex organization . In particular, her experience +in employee compensation matters and the development and implementation of diversity policies is helpful to the Company. +Stevenson E. Ward III has served as +Director since 2001. Mr. Ward served as Vice President and Chief Financial Officer of Triton Thalassic Technologies, Inc. from +2000 until his retirement in 2014. Triton’s technology controls and inactivates pathogens in the healthcare and industrial +industries. From 1998 through 2000, Mr. Ward served as Senior Vice President-Administration of Sanofi-Synthelabo, Inc., a major +multinational pharmaceutical company. He served as Executive Vice President (1996-1998), responsible for legal, tax, treasury, +employee benefits and other functions, and Chief Financial Officer (1994-1996) of Sanofi, Inc., the North American holding company +for Sanofi. He also served as Vice President-Finance and Administration, Pharmaceutical Group, Sterling Winthrop, Inc. (1992-1994). +Prior to joining Sterling, he was employed by General Electric Company in management positions in Purchasing, Corporate Audit and +Finance. Mr. Ward’s qualifications for service on the Board include his extensive experience in senior executive level positions +in finance, corporate audit and administration at two Fortune 100 multinational corporations. He also holds a Masters in Business +Administration (MBA) degree. +Code of Conduct +The Company has adopted a Code of Conduct that +is applicable to its employees, including the Chief Executive Officer, Chief Financial Officer and Controller. The Code of Conduct +is available in the investor relations section on the Company’s website at www.acmeunited.com. +If the Company makes any substantive amendments +to the Code of Conduct which apply to its Chief Executive Officer, Chief Financial Officer or Controller, or grants any waiver, +including any implicit waiver, from a provision of the Code of Conduct to the Company’s executive officers, the Company will +disclose the nature of the amendment or waiver on its website. +48 +Information regarding compliance with +Section 16(a) beneficial ownership reporting requirements and certain corporate governance matters is incorporated herein by reference +to the sections entitled (i) “Compliance with Section 16(a) of the Securities Exchange Act of 1934”, (ii) “Nominations +for Directors”, and (iii) “Audit Committee” contained in the Company’s Proxy Statement to be filed with +the Securities and Exchange Commission in connection with its 2019 Annual Meeting of Shareholders. +Item 11. Executive Compensation +Information with respect to executive +compensation is incorporated herein by reference to the section entitled “Executive Compensation” contained in the +Company’s Proxy Statement to be filed with the SEC in connection with the Company’s 2019 Annual Meeting of Shareholders. +Item 12. Security Ownership of Certain +Beneficial Owners and Management +Information regarding security ownership +of certain beneficial owners, directors and executive officers is incorporated herein by reference to the information in the section +entitled “Security Ownership of Directors and Officers” contained in the Company’s Proxy Statement to be filed +with the SEC in connection with its 2019 Annual Meeting of Shareholders. +Item 13. Certain Relationships and +Related Transactions, and Director Independence +Information regarding certain relationships +and related transactions is incorporated herein by reference to the information in the section entitled “Certain Relationships +and Related Transactions” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its +2019 Annual Meeting of Shareholders. +Information regarding director independence +is incorporated herein by reference to the section entitled “Independence Determinations” contained in the Company’s +Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company’s 2019 Annual Meeting +of Shareholders. +Item 14. Principal Accounting Fees +and Services +Information regarding principal accountant +fees and services is incorporated herein by reference to the section entitled “Fees to Auditors” contained in the Company’s +Proxy Statement to be filed with the SEC in connection with its 2019 Annual Meeting of Shareholders . +49 +PART IV +Item 15. Exhibits and Financial Statement +Schedules +(a)(1) Financial Statements. +· Consolidated Balance Sheets +· Consolidated Statements of Operations +· Consolidated Statements of Changes in Stockholders’ Equity +· Consolidated Statements of Cash Flows +· Notes to Consolidated Financial Statements +· Report of Independent Registered Public Accounting Firm +(a)(2) Financial Statement Schedules +· Schedules other than those listed above have been omitted because +of the absence of conditions under which they are required or because the required information is presented in the financial statements +or notes thereto. +(a)(3) The exhibits listed under Item +15(b) are filed or incorporated by reference herein. +(b) Exhibits. +The exhibits listed below are filed +as part of this Annual Report on Form 10-K. Certain of the exhibits, as indicated, have been previously filed and are incorporated +herein by reference. +Exhibit No. +Identification of Exhibit +2 +Asset Purchase Agreement with First Aid Only, Inc. dated as of June 2, 2014 (1) +3(i) +Certificate of Organization of the Company (2) +Amendment to Certificate of Organization of Registrant dated September 24, 1968 (2) +Amendment to Certificate of Incorporation of the Company dated April 27, 1971 (3) +Amendment to Certificate of Incorporation of the Company dated June 29, 1971 (3) +3(ii) +Bylaws (11) +4 +Specimen of Common Stock certificate (3) +10.3 +2002 Acme United Employee Stock Option Plan as amended (12) +10.4 +Severance Pay Plan dated September 28, 2004* (15) +10.5(a) +Salary Continuation Plan dated September 28, 2004, as amended (14)* +50 +10.6(a) +2005 Non-Salaried Director Stock Option Plan, amended (6) +10.6(b) +Amendment to the 2005 Non-Salaried Director Stock Option Plan (12) +10.7 +2017 Non-Salaried Director Stock Option Plan (9) +10.8 +Deferred Compensation Plan dated October 2, 2007* (16) +10.9(a) +2012 Acme United Employee Stock Option Plan (11) +10.9(b) +Amendment to the 2012 Acme United Employee Stock Option Plan* (12) +10.10(a) +Revolving Loan Agreement with HSBC, dated April 5, 2012 (13) +10.10(b) +Amendment No. 1 to Revolving Loan Agreement with HSBC Dated (14) +10.10(c) +Amended and restated secured revolving note (14) +10.10(d) +Amendment No. 2 to Revolving Loan Agreement with HSBC dated October 2013 (15) +10.10(e) +Amendment No. 4 to Revolving Loan Agreement with HSBC dated May 6, 2016 (12) +10.10(f) +Second amended and restated secured revolving note (12) +10.10(g) +Amendment No. 5 to Revolving Loan Agreement with HSBC dated January 2017 (16) +10.10(h) +Amendment No. 6 to Revolving Loan Agreement with HSBC dated March 2018 +10.11 +Change in Control Plan as amended dated February 24, 2011* (17) +21 +Subsidiaries of the Registrant +23.1 +Consent of Marcum LLP, Independent Registered Public Accounting Firm +31.1 +Certification of Walter Johnsen pursuant to Rule 13a-14(a) and 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002 +31.2 +Certification of Paul Driscoll pursuant to Rule 13a-14(a) and 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002 +32.1 +Certification of Walter Johnsen pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +32.2 +Certification of Paul Driscoll pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +* Indicates +a management contract or a compensatory plan or arrangement +(1) Previously filed as an Exhibit to the Company’s Form 8-K/A +filed on August 19, 2014. +(2) Previously filed in S-1 Registration Statement No. 230682 filed with +the Commission on November 7, 1968 and amended by Amendment No. 1 on December 31, 1968 and by Amendment No. 2 on January 31, 1969. +51 +(3) Previously filed as an exhibit to the Company’s Form 10-K filed +in 1971. +(4) Previously filed in the Company’s Form 8-K filed on March 3, +2006. +(5) Previously filed in the Company’s Proxy Statement for the 2005 +Annual Meeting of Shareholders. +(6) Previously filed in the Company’s Proxy Statement filed on +March 29, 2005. This plan expired in 2015. +(7) Previously filed in the Company’s Form 8-K filed on December +21, 2010. +(8) Previously filed as an exhibit to the Company’s Form 10-K filed +on March 17, 2005. +(9) Previously filed as an exhibit to the Company’s Proxy Statement +filed on March 22, 2017. +(10) Previously filed as an exhibit to the Company’s Form 10-K filed +on March 12, 2008. +(11) Previously filed as an exhibit to the Company’s Form 10-Q filed +on August 14, 2012. +(12) Previously filed as an exhibit to the Company’s Form 10-Q filed +on May 13, 2016. +(13) Previously filed as an exhibit to the Company’s Form 10-Q filed +on May 14, 2012. +(14) Previously filed as an exhibit to the Company’s Form 10-Q filed +on May 10, 2013. +(15) Previously filed as an exhibit to the Company’s Form 10-K filed +on March 6, 2014. +(16) Previously filed as an exhibit to the Company’s Form 10-Q filed +on August 4, 2017. +(17) Previously filed as an exhibit to the Company’s Form 10-K filed +on March 11, 2011. +Item 16. Form 10-K Summary +Not applicable. +52 +Pursuant to the requirements of Section 13 or 15(d) of the +Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized, on March 15, 2019. +ACME UNITED CORPORATION +(Registrant) +Signatures: +Titles: +/s/ Walter C. Johnsen +Walter C. Johnsen +Chairman and Chief Executive Officer +/s/ Brian S. Olschan +Brian S. Olschan +President, Chief Operating Officer and Director +/s/ Paul G. Driscoll +Paul G. Driscoll +Vice President, Chief Financial Officer, Secretary and Treasurer +/s/ Rex Davidson +Rex Davidson +Director +/s/ Richmond Y. Holden, Jr. +Richmond Y. Holden, Jr. +Director +/s/ Susan H. Murphy +Susan H. Murphy +Director +/s/ Stevenson E. Ward III +Stevenson E. Ward III +Director +53 \ No newline at end of file diff --git a/raw/filings/0000002098/2018/0001026608-19-000011/filing_metadata.csv b/raw/filings/0000002098/2018/0001026608-19-000011/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..65d86715f677d464aaf42ea02c76ae9ef207da2e --- /dev/null +++ b/raw/filings/0000002098/2018/0001026608-19-000011/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002098,ACU,ACME UNITED CORP,2018,10-K,2019-03-15,2018-12-31,2019-03-15T21:02:57.000Z,0001026608-19-000011,acu_10k123118.htm,10-K,4471630,1,0,https://www.sec.gov/Archives/edgar/data/2098/000102660819000011/acu_10k123118.htm,https://www.sec.gov/Archives/edgar/data/2098/000102660819000011/ diff --git a/raw/filings/0000002098/2018/0001026608-19-000011/item1.txt b/raw/filings/0000002098/2018/0001026608-19-000011/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..6723936f4b102a7a89974f476b72061b1c8c18c7 --- /dev/null +++ b/raw/filings/0000002098/2018/0001026608-19-000011/item1.txt @@ -0,0 +1,168 @@ +Item 1. Business +Overview +Acme United Corporation, a +Connecticut corporation (together, with its subsidiaries, the "Company"), is a leading worldwide supplier of +innovative safety solutions and cutting technology to the school, home, office, hardware, sporting goods and industrial +markets. It’s principal products sold across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid +kits, and safety related products. The Company sells its products primarily to wholesale, contract and retail +stationery distributors, office supply superstores, mass market and e-commerce retailers, industrial distributors, office +supply super stores, sporting goods stores, hardware changes and wholesale florists. +The Company's operations are in the United +States, Canada, Europe (located in Germany) and Asia (located in Hong Kong and China). The operations in the United States, Canada +and Europe are primarily involved in product development, marketing, sales, administrative, manufacturing and distribution activities. +The operations in Asia consist of sourcing, product development, production planning, quality control and sales activities. Total +net sales in 2018 were $137.3 million. The Company was organized as a partnership in l867 and incorporated in l882 under the laws +of the State of Connecticut. +The Company sources most of its products +from suppliers located outside the United States, primarily in Asia. The Company assembles its first aid kits at its facilities +in Vancouver, WA and Rocky Mount, NC. The components for the first aid kits are primarily sourced from U.S. suppliers. +Business Strategy +The Company’s business strategy +includes the following key elements: +· +a commitment to technological innovation achieved through consumer insight, creativity and speed to market; +· +a broad selection of products in both brand and private label; +· +prompt response; +· +superior customer service; and +· +value pricing. +Purchase of Property +On October 26, 2017, the Company exercised +its option to purchase its First Aid Only manufacturing and distribution center in Vancouver, WA for $4.0 million. The property +consists of 53,000 square feet of office, manufacturing, and warehouse space on 2.86 acres. The purchase was financed by a variable +rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Commencing on December 1, 2017, principal payments of +$22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. +Acquisitions +On February 1, 2017, the Company purchased +the assets of Spill Magic, Inc., located in Santa Ana, CA and Smyrna, TN. The Spill Magic products are leaders in absorbents that +encapsulate spills into dry powders that can be safely discarded. Customers, including many large retail chains, use Spill Magic +products to remove liquids from broken glass containers, oil and gas spills, bodily fluids, and solvents. The Company purchased +Spill Magic assets for $7.2 million in cash using funds borrowed under its revolving credit facility with HSBC. Additional information +concerning the acquisition of Spill Magic assets is set forth in Note 17 – Business Combinations, in the notes to consolidated +financial statements in this report. +Principal Products +The Company markets and sells under two main categories: i) Cutting, Sharpening and Measuring; and ii) First +Aid and Safety. The Cutting, Sharpening and Measuring category includes school, home and office products (Westcott® brand), +and Hardware, Industrial and Sporting Goods products (Clauss®, Camillus®, Cuda® and DMT® brands). The First Aid +and Safety Category includes first aid and safety products (First Aid Only®, PhysiciansCare®, Pac-Kit® and Spill Magic® +brands). +4 +CUTTING, SHARPENING AND MEASURING +School, Home and Office +Westcott +Westcott, with a history of +quality dating back to 1872, provides innovative cutting and measuring products for the school, home and office as well as +industrial safety cutting. Principal products under the Westcott brand include scissors, rulers, pencil sharpeners, paper +trimmers, lettering products, craft products and safety cutters. Westcott is one of the leading scissor and ruler brands in +North America. +Many of the Westcott branded cutting +products contain patented titanium bonding and proprietary non-stick coatings, making the blades more than three times harder than +stainless steel as well as reducing friction and corrosion. In 2018, Westcott continued to build on its safety knife launch with +the introduction of the Saber Safety Cutters as well as several new ceramic safety knives, allowing its customers to remain safer +on the job. Westcott also began to expand its innovation of scissors with the patent pending anti-friction fully adjustable Glide +scissor line. This new line allows the user to customize the scissor to the user’s specific application or preference. +Hardware, Industrial and Sporting +Goods +Clauss +Clauss, with its roots dating back to +1877, offers a line of quality cutting tools for professionals in the hardware & industrial, lawn & garden, food processing, +sewing and housewares channels. Many of the Clauss products are enhanced with the Company’s patented titanium and proprietary +non-stick coatings. +Camillus +Since 1876 Camillus has been supplying +innovative and high quality knives. The Camillus brand has a strong heritage in the hunting, sporting, survival +and tactical markets. The Company acquired the brand in 2007 and re-launched it in 2009 with an updated and innovative line of +fixed blade, folding knives, line of sight cutting tools and tactical tools. Many of the knives are enhanced with titanium carbonitride +coatings to increase the hardness of the blade of up to 10 times that of untreated stainless steel. +Cuda +We launched the Cuda line of fishing tools +and knives in 2014. Featuring titanium bonded German steels and alloys, Cuda tools provide world class hardness, corrosion and +adhesive resistance. In July of 2014, Cuda won Best of Show in the “Fish Smart” category at the ICast show in Orlando, +Florida. In January 2016, Cuda won six GOOD DESIGN awards from the Chicago Athenaeum, Museum of Architecture and Design. In 2017, +Cuda launched a line of cut and puncture resistant gloves which feature quadruple layered Kevlar® and a line of telescopic +landing nets featuring replaceable nets and a net containment system. In 2018, Cuda launched a Professional Series of knives, tools +and fishing gaffs that are directed towards the commercial fishing segment. +DMT +DMT products are leaders in diamond sharpening +tools for knives, scissors, chisels, skis, skates and many other edges that require sharpening. DMT was founded in 1976 by aerospace +engineers. The DMT products use a proprietary process of finely dispersed diamonds bonded to the surfaces of sharpeners and are +famous for providing diamond sharpeners with the flattest sharpening surface, greatest concentrated amount of diamonds and the +highest quality diamonds per sharpener. In 2017, DMT launched 12 new diamond sharpeners that include a gear-driven sharpener, +sonic sharpener and pull through sharpeners that provide a simple sharpening solution for beginners as well as sharpening experts. +FIRST AID AND SAFETY +First Aid & Safety +First Aid Only +The First Aid Only brand +offers first aid kits, refills, and safety products that meet regulatory requirements for a broad range of industries. +The Smart Compliance® first aid system is an effective tool for maintaining OSHA compliance. The Company’s +SafetyHub App technology streamlines the inspection and replenishment process for a broad range of Safety products and +provides data analytics to optimize costs. +5 +Pac-Kit +The Pac-Kit brand offers first aid kits, +industrial stations and refills, emergency medical travel and recreational kits of the industrial, safety, transportation and marine +markets. The brand has a long history dating back to the 19 th century. Although Pac-Kit’s products are similar +to the PhysiciansCare brand, the Pac-Kit brand is especially known for its customized products which are designed to meet customer +specifications. +PhysiciansCare +The PhysiciansCare brand offers a variety +of portable eyewash solutions and over-the counter medications, including the active ingredients aspirin, acetaminophen and ibuprofen. +Spill Magic +The Spill Magic brand is a leader in absorbents that encapsulate spills into dry powders that can safely be +discarded. The spill response system reduces slip & fall accidents in various venues, including grocery, retail, big box and +other stores; food service & hotel chains; municipal facilities; and industry-specific distributors in the U.S. and Europe. +Acquired in February 2017, we introduced additional Spill Magic products in 2017, including clean-up kits for bodily fluids and +blood-borne pathogen kits. +Product Development +The Company’s strong commitment to +understanding our consumers and defining products that fulfill their needs through innovation drives our product development +strategy, which we believe is and will be a key contributor to our success. The Company incurred research, development and +related costs of $734,000 in 2018 and $752,000 in 2017. +Intellectual Property +The Company owns many patents and trademarks +that are important to its business. The Company’s success depends in part on its ability to maintain patent protection for +its products, to preserve its proprietary technology and to operate without infringing upon the patents or proprietary rights of +others. The Company generally files patent applications in the United States and foreign countries where patent protection for +its technology is appropriate and available. The Company also considers its trademarks important to the success of its business. +The more significant trademarks include Westcott, Clauss, Camillus, PhysiciansCare, First Aid Only, Cuda, DMT, Pac-Kit and Spill +Magic. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period remaining +for intangible assets at December 31, 2018 was 10 years. +Product Distribution; Major Customers +Independent manufacturer representatives +and direct sales are primarily used to sell the Company’s line of consumer products to wholesale, contract and retail stationery +distributors, office supply super stores, school supply distributors, industrial distributors, wholesale florists, mass market +and ecommerce retailers and hardware chains (including through their websites). The Company also sells a limited selection of its +products directly to consumers through its own websites. The Company had one customer in 2018 and two customers in 2017 that individually +exceeded 10% of consolidated net sales. In 2018, net sales to this one customer were approximately 13%, of consolidated net sales. +In 2017, net sales to the two customers were approximately 16% and 11%, respectively. +Competition +The Company competes with many companies +in each market and geographic area. The Company believes that the principal points of competition in these markets are product +innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness +of delivery, conformity to customer specifications and post-sale support. The major competitors in the cutting category are 3M +and Fiskars Corporation. The major competitors in the measuring category are Maped and Staedtler. The major competitor in the pencil +sharpener category is Bostitch. The major competitors in the first aid & safety category are Honeywell, 3M and Johnson & +Johnson. +Seasonality +Traditionally, the Company’s sales +are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal +nature of the back-to-school market. +6 +Compliance with Environmental Laws +The Company believes that it is in compliance +with applicable environmental laws. The Company anticipates that no material adverse financial impact will result from compliance +with current environmental rules and regulations. +Employees +As of December 31, 2018, the Company employed +435 people, all of whom are full time and none of whom is covered by union contracts. Employee relations are considered good and +no foreseeable problems with the work force are evident. +Available Information +You may obtain +at no charge, a copy of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports +on Form 8-K and amendments to those reports on the Company’s website at http://www.acmeunited.com +or by contacting the Investor Relations Department at the Company’s corporate offices by calling (203) 254-6060. Such +reports and other information are made available as soon as reasonably practicable after such material is filed with or furnished +to the SEC. \ No newline at end of file diff --git a/raw/filings/0000002098/2018/0001026608-19-000011/item13.txt b/raw/filings/0000002098/2018/0001026608-19-000011/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..4d3daaa60e1cc122399b0086127e80709d68b748 --- /dev/null +++ b/raw/filings/0000002098/2018/0001026608-19-000011/item13.txt @@ -0,0 +1,2 @@ +Item 13. Certain Relationships and Related Transactions, and Director Independence +49 \ No newline at end of file diff --git a/raw/filings/0000002098/2019/0001564590-20-010850/filing.txt b/raw/filings/0000002098/2019/0001564590-20-010850/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..ce175cd0596fb5e032f449ba6190f26fd2cfe079 --- /dev/null +++ b/raw/filings/0000002098/2019/0001564590-20-010850/filing.txt @@ -0,0 +1,2273 @@ +10-K +1 +acu-10k_20191231.htm +10-K +acu-10k_20191231.htm +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D. C. 20549 +FORM 10-K +[X] +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended: December 31, 2019 +or +[_] +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from: ___________ to ___________ +Commission file number: 01-07698 +ACME UNITED CORPORATION +(Exact Name of Registrant as Specified in Its Charter) +Connecticut +06-0236700 +State or Other Jurisdiction of +I.R.S. Employer Identification No. +Incorporation or Organization +55 Walls Drive, Fairfield, Connecticut +06824 +Address of Principal Executive Offices +Zip Code +Registrant's telephone number, including area code: (203) 254-6060 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +$2.50 par value Common Stock +ACU +NYSE American +Securities registered pursuant to Section 12 (g) of the Act: None +(Title of Class) +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES [_] NO [X] +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES [_] NO [X] +Indicate by check mark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [_] +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (sec. 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). YES [X] NO [_] +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act (Check one). +Large accelerated filer [_] +Accelerated filer [X] +Non-accelerated filer [_] +Smaller Reporting Company [X] +Emerging growth company [_] +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act [ _] +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) . YES [_] NO [X] +The aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter was $66,303,009. +Registrant had 3,352,130 shares of its $2.50 par value Common Stock outstanding as of March 12, 2020. +DOCUMENTS INCORPORATE BY REFERENCE +(1) Certain portions of the Company’s Proxy Statement for the Annual Meeting scheduled for April 20, 2020 are incorporated into the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, in Part III. +Page +Part I +Item 1. Business +3 +Item 1A. Risk Factors +5 +Item 1B. Unresolved Staff Comments +10 +Item 2. Properties +10 +Item 3. Legal Proceedings +10 +Item 4. Mine Safety Disclosures +10 +Part II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +11 +Item 6. Selected Financial Data +11 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +12 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +15 +Item 8. Financial Statements and Supplementary Data +15 +Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +37 +Item 9A. Controls and Procedures +37 +Item 9B. Other Information +37 +Part III +Item 10. Directors, Executive Officers and Corporate Governance +38 +Item 11. Executive Compensation +39 +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +39 +Item 13. Certain Relationships and Related Transactions, and Director Independence +40 +Item 14. Principal Accounting Fees and Services +40 +Part IV +Item 15. Exhibits and Financial Statement Schedules +41 +Item 16. Form 10-K Summary +42 +Signatures +43 +2 +PART I +Item 1. Business +Overview +Acme United Corporation, a Connecticut corporation (together, with its subsidiaries, the "Company"), is a leading worldwide supplier of innovative safety solutions and cutting technology to the school, home, office, hardware, sporting goods and industrial markets. Its principal products sold across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid kits, and safety related products. The Company sells its products primarily to wholesale, contract and retail stationery distributors, office supply superstores, mass market and e-commerce retailers, industrial distributors, office supply super stores, sporting goods stores, hardware chains and wholesale florists. +The Company's operations are in the United States, Canada, Europe (located in Germany) and Asia (located in Hong Kong and China). The operations in the United States, Canada and Europe are primarily involved in product development, marketing, sales, administrative, manufacturing and distribution activities. The operations in Asia consist of sourcing, product development, production planning, quality control and sales activities. Total net sales in 2019 were $142.5 million. The Company was organized as a partnership in l867 and incorporated in l882 under the laws of the State of Connecticut. +The Company sources most of its products from suppliers located outside the United States, primarily in Asia. The Company assembles its first aid kits at its facilities in Vancouver, WA and Rocky Mount, NC. The components for the first aid kits are primarily sourced from U.S. suppliers. +Recent accomplishments and initiatives +The Company’s key business accomplishments and initiatives include the following elements: +• +Leader in innovative safety solutions and cutting technology; +• +Ten years of consecutive sales growth averaging 9%; +• +Innovation rate approaching 30%; +• +Premier and diversified customer base; +• +Successful history of acquisitions; +• +Diversified distribution network; strong growth in e-commerce channel; and +• +Reduced debt by 25% in 2019 +Acquisitions +On January 7, 2020, the Company purchased the assets of First Aid Central, located in Laval, Quebec, Canada. First Aid Central produces and sells a complete line of first aid kits, refills, and safety products to a broad range of industries and end users. Its products meet federal Health Canada and provincial regulatory requirements. The Company purchased First Aid Central assets for $2.1 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. Additional information concerning the acquisition of First Aid Central assets is set forth in Note 17 – Subsequent Events, in the notes to consolidated financial statements in this report. +Principal Products +The Company markets and sells under two main categories: i) cutting, sharpening and measuring; and ii) first aid and safety. The cutting, sharpening and measuring category includes school, home and office products (Westcott® brand), and hardware, industrial and sporting goods products (Clauss®, Camillus®, Cuda® and DMT® brands). The first aid and safety category includes first aid and safety products (First Aid Only®, PhysiciansCare®, Pac-Kit® and Spill Magic® brands). +CUTTING, SHARPENING AND MEASURING +School, Home and Office +Westcott +Westcott, with a history of quality dating back to 1872, provides innovative cutting and measuring products for the school, home and office as well as industrial safety cutting. Principal products under the Westcott brand include scissors, rulers, pencil sharpeners, paper trimmers, safety cutters, lettering products, glue guns and other craft products. Westcott is one of the leading scissor and ruler brands in North America. +3 +Many of the Westcott branded cutting products cont ain patented titanium bonding and proprietary non-stick coatings, making the blades more than three times harder than stainless steel as well as reducing friction and corrosion. In 2019, Westcott continu ed to build on its cutting line with an expanded ass ortment of the Saber and ceramic safety knives, allowing its customers to remain safer on the job. Also in the cutting line in 2019 , Westcott introduced the Glide technology scissor with its low friction fulcrum and adjustable tension. Westcott also conti nued to innovate in the glue gun category-launching a cordless lithium ion glue gun which heats up in 20 seconds and has a 30-minute run time. +Hardware, Industrial and Sporting Goods +Clauss +Clauss, with its roots dating back to 1877, offers a line of quality cutting tools for professionals in the hardware & industrial, lawn & garden, food processing, sewing and housewares channels. Many of the Clauss products are enhanced with the Company’s patented titanium and proprietary non-stick coatings. +Camillus +Since 1876 Camillus has been supplying innovative and high quality knives. The Camillus brand has a strong heritage in the hunting, sporting, survival and tactical markets. The Company acquired the brand in 2007 and re-launched it in 2009 with an updated and innovative line of fixed blade, folding knives, line of sight cutting tools and tactical tools. Many of the knives are enhanced with titanium carbonitride coatings to increase the hardness of the blade of up to 10 times that of untreated stainless steel. +Cuda +We launched the Cuda line of fishing tools and knives in 2014. Featuring titanium bonded German steels and alloys, Cuda tools provide world class hardness, corrosion and adhesive resistance. In July of 2014, Cuda won Best of Show in the “Fish Smart” category at the ICast show in Orlando, Florida. In January 2016, Cuda won six GOOD DESIGN awards from the Chicago Athenaeum, Museum of Architecture and Design. In 2017, Cuda launched a line of cut and puncture resistant gloves which feature quadruple layered Kevlar® and a line of telescopic landing nets featuring replaceable nets and a net containment system. In 2018, Cuda launched a Professional Series of knives, tools and fishing gaffs that are directed towards the commercial fishing market. +DMT +DMT products are leaders in diamond sharpening tools for knives, scissors, chisels, skis, skates and many other edges that require sharpening. DMT was founded in 1976 by aerospace engineers. The DMT products use a proprietary process of finely dispersed diamonds bonded to the surfaces of sharpeners and are famous for providing diamond sharpeners with the flattest sharpening surface, greatest concentrated amount of diamonds and the highest quality diamonds per sharpener. In 2017, DMT launched 12 new diamond sharpeners that include a gear-driven sharpener, sonic sharpener and pull through sharpeners that provide a simple sharpening solution for beginners as well as sharpening experts. +FIRST AID AND SAFETY +First Aid and Safety +First Aid Only +The First Aid Only brand offers first aid and safety solutions that meet regulatory requirements for a broad range of industries. The Smart Compliance® first aid system is an effective solution for maintaining OSHA compliance. The Company’s SafetyHub App technology digitizes the replenishment process for a broad range of Safety products and provides data analytics to manage costs. In 2019, we introduced our next generation SmartCompliance Complete ™ which offers a modular system that addresses first aid, bloodborne pathogen, bleed control, eyewash and OTC medication requirements for the most challenging workplace environments. +PhysiciansCare +The PhysiciansCare brand offers a variety of portable eyewash solutions and over-the counter medications, including the active ingredients aspirin, acetaminophen and ibuprofen. +Spill Magic +Spill Magic, an Acme United brand since 2017, is a leader in bodily fluid and spill clean-up solutions with a lightweight, absorbent powder that quickly encapsulates a spill. The Spill Response System provides all the necessary tools to effectively clean up spills, saving time, money and reducing slip & fall accidents in various venues, including grocery, retail, and big box stores; food service & hotel chains; municipal facilities; and industry-specific distributors in the U.S. +4 +Intellectual Property +The Company owns many patents and trademarks that are important to its business. The Company’s success depends in part on its ability to maintain patent protection for its products, to preserve its proprietary technology and to operate without infringing upon the patents or proprietary rights of others. The Company generally files patent applications in the United States and foreign countries where patent protection for its technology is appropriate and available. The Company also considers its trademarks important to the success of its business. The more significant trademarks include Westcott, Clauss, Camillus, PhysiciansCare, First Aid Only, Cuda, DMT, Pac-Kit and Spill Magic. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period remaining for intangible assets at December 31, 2019 was 10 years. +Product Distribution; Major Customers +Independent manufacturer representatives and direct sales are primarily used to sell the Company’s line of consumer products to wholesale, contract and retail stationery distributors, office supply super stores, school supply distributors, industrial distributors, wholesale florists, mass market and ecommerce retailers and hardware chains (including through their websites). The Company also sells a limited selection of its products directly to consumers through its own websites. The Company had one customer in 2019 and 2018 that individually exceeded 10% of consolidated net sales. Net sales to this one customer were approximately 17% and 16% of consolidated net sales in 2019 and 2018, respectively. +Competition +The Company competes with many companies in each market and geographic area. The Company believes that the principal points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. The major competitors in the cutting category are 3M and Fiskars Corporation. The major competitor in the pencil sharpener category is Bostitch and Elmers. The major competitors in the first aid and safety category are Honeywell and Cintas. +Seasonality +Traditionally, the Company’s sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the back-to-school market. +Compliance with Environmental Laws +The Company believes that it is in compliance with applicable environmental laws. The Company anticipates that no material adverse financial impact will result from compliance with current environmental rules and regulations. +Employees +As of December 31, 2019, the Company employed 441 people, all of whom are full time and none of whom is covered by union contracts. Employee relations are considered good and no foreseeable problems with the work force are evident. +Available Information +You may obtain at no charge, a copy of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports on the Company’s website at http://www.acmeunited.com or by contacting the Investor Relations Department at the Company’s corporate offices by calling (203) 254-6060. Such reports and other information are made available as soon as reasonably practicable after such material is filed with or furnished to the SEC. +Item 1A. Risk Factors +The Company is subject to a number of significant operational risks that might cause the Company’s actual results to vary materially from its forecasts, targets or projections, including: +• +achieving planned revenue and profit growth in each of the Company's business segments; +• +changes in customer requirements and in the volume of sales to principal customers; +• +the ability of the Company to anticipate timing of orders and shipments particularly in the ecommerce area; +• +emergence of new competitors or consolidation of existing competitors; and +• +industry demand fluctuations. +5 +The Company’s expectations for both short and long-term future net revenues are based on the Company’s estimates of future demand. Orders from the Company’s principal customers are ultimately based on demand from end-users and end-user demand can be difficult to predict. Low end-user demand would negatively affect orders the Company receives from distributors and other principal customers which could, in turn adversely affect the Company’s revenues in any fiscal period. If the Company’s estimates of sales are not accurate and the Company experiences unforeseen variability in its revenues and operating results, the Company may be unable to adjust its expense lev els accordingly and its profit margins could be adversely affected. +Because our products are primarily sold by third parties, our financial results depend in part on the financial health of these parties and any loss of a third party distributor could adversely affect the Company’s revenues. +A large majority of the Company’s products are sold through third-party distributors and large retailers. Some of our distributors also market products that compete with our products. Changes in the financial or business conditions or the purchasing decisions of these third parties or their customers could affect our sales and profitability. +Additionally, no assurances can be given that any or all of such distributors or retailers will continue their relationships with the Company. Distributors and other significant retail customers cannot easily be replaced and the loss of revenues and the Company’s inability to reduce expenses to compensate for the loss of revenues could adversely affect the Company’s net revenues and profit margins. +The ability to deliver products to our customers in a timely manner and to satisfy our customers’ fulfillment standards are subject to several factors, some of which are beyond our control. +Customers place great emphasis on timely delivery of our products for specific selling seasons, especially during our second and third fiscal quarters, and on the fulfillment of consumer demand throughout the year. We cannot control all of the various factors that might affect product delivery to customers. Vendor production delays, cybersecurity attacks on our vendors, difficulties encountered in shipping from overseas and customs clearance delays are on-going risks of our business. We also rely upon third-party carriers for our product shipments from our distribution centers to customers. Accordingly, we are subject to risks, including labor disputes, inclement weather, natural disasters, cybersecurity attacks, possible acts of terrorism, availability of shipping containers, and increased security restrictions associated with such carriers’ ability to provide delivery services to meet our shipping needs. Failure to deliver products to our customers in a timely and effective manner, often under special vendor requirements to use specific carriers and delivery schedules, could damage our reputation and brands and result in loss of customers or reduced orders. +Reliance on foreign suppliers could adversely affect the Company’s business. +The Company sources its products from suppliers located in Asia, Europe and the United States. The Company’s Asia vendors are located primarily in China, which subjects the Company to various risks within the region including regulatory, political, economic and foreign currency changes. The Company’s ability to select and retain reliable vendors and suppliers who provide timely deliveries of quality products efficiently will impact its success in meeting customer demand for timely delivery of quality products. The Company’s sourcing operations and its vendors are impacted by labor costs in China. Labor historically has been readily available at low cost relative to labor costs in North America. However, as China is experiencing rapid social, political and economic changes, labor costs have risen in some regions and there can be no assurance that labor will continue to be available to the Company in China at costs consistent with historical levels or that changes in labor or other laws will not be enacted which would have a material adverse effect on the Company’s operations in China. Interruption of supplies from any of the Company’s vendors, or the loss of one or more key vendors, could have a negative effect on the Company’s business and operating results. +Changes in currency exchange rates might negatively affect the profitability and business prospects of the Company and its overseas vendors. In particular, the Chinese Renminbi has recently fluctuated against the U.S. Dollar, if the Chinese Renminbi continues to fluctuate with respect to the U.S. Dollar in the future, the Company may experience cost increases on such purchases, and this can adversely impact profitability. Future interventions by China may result in further currency appreciation and increase our product costs over time. The Company may not be successful at implementing customer pricing or other actions in an effort to mitigate the related effects of the product cost increases. +Additional factors that could adversely affect the Company’s business include increases in transportation costs, new or increased import duties, transportation delays, work stoppages, capacity constraints and poor quality. +The Company’s operations are increasingly global in nature. Our business, financial condition and results of operations could be adversely affected by the political and economic conditions in the countries in which we conduct business, by fluctuations in currency exchange rates and other factors related to our international operations. +As our international operations and activities expand, we face increasing exposure to the risks of operating in foreign countries. These factors include: +• +Changes generally in political, regulatory or economic conditions in the countries in which we conduct business. +• +Trade protection measures in favor of local producers of competing products, including government subsidies, tax benefits, changes in local tax rates, trade actions (such as anti-dumping proceedings) and other measures giving local producers a competitive advantage over the Company. +• +Changes in foreign currency exchange rates which could adversely affect our competitive position, selling prices and manufacturing costs, and therefore the demand for our products in a particular market. +6 +These risks could affect the cost of manufacturing and selling our products, our pricing, sales volum e, and ultimately our financial performance. The likelihood of such occurrences and their potential effect on the Company vary from country to country and are unpredictable. +The Coronavirus could materially adversely affect our results +If a pandemic, epidemic or outbreak of an infectious disease occurs, our business may be adversely affected. For example, in December 2019, a new strain of the coronavirus (COVID-19) spread through China as well as other countries including the United States and countries in Europe, bringing the total to at least 100 countries worldwide with confirmed cases of COVID-19. The impact of the virus varies from region to region and from day to day and any significant additional spreading of the virus could adversely affect the Company’s business. +At the time of this filing, COVID-19 has not caused significant disruption in the Company’s business and the Company currently has sufficient inventory to meet anticipated demands in the near future. However, the outbreak of the COVID-19 virus is likely to have a further negative impact in 2020 on the global economy and, in the future, might impact the Company’s ability to manufacture, source or distribute its products both domestically and internationally or reduce demand for its products, any of which could have a significant negative impact on the Company’s financial results in 2020 and beyond. Given the dynamic nature of this outbreak, however, the extent to which the COVID-19 virus impacts the Company’s results will depend on future developments, which remain highly uncertain and cannot be predicted at this time. +Continuing uncertainty in the global economy could negatively impact our business. +Uncertainty in the global economy could adversely affect our customers and our suppliers and businesses such as ours. In addition, any uncertainty could have a variety of negative effects on the Company, such as reduction in revenues, increased costs, lower gross margin percentages, increased allowances for doubtful accounts and/or write-offs of accounts receivable and could otherwise have material adverse effects on our business, results of operations, financial condition and cash flows. +Changes in trade policies, including the imposition of tariffs and their enforcement, may have a material adverse impact on our business, results of operations, and outlook. +On September 24, 2018, the United States levied a third round of tariffs on the import of some products from China, which is an important source of many of the Company’s products. The first two rounds targeted $50 billion of Chinese goods and applied a 25% tariff; these rounds had no impact on the Company. The third round targeted an additional $200 billion of Chinese goods and applied a 10% tariff that was scheduled to increase to 25% at the start of 2019 but has been delayed. This latest round affects approximately 10% of the Company’s product purchases and will increase our costs of procurement. These tariffs affect certain measuring products, folding knives and first aid components. In response to these tariffs, the Company has implemented a price increase on the affected products in order to offset their impact. Tariff levels may be further increased and the types of products subject to tariffs may be expanded. Although the Company intends to pass additional price increases on to our customers, such tariff-related developments could have a negative impact on customer demand and adversely affect our business, financial condition and results of operations. In addition, we might have to modify our current business practices, including potentially sourcing from alternative vendors. +The Company’s business is subject to risks associated with seasonality which could adversely affect its cash flow, financial condition, or results of operations. +The Company’s business, historically, has experienced higher sales volume in the second and third quarters of the calendar year, when compared to the first and fourth quarters. The Company is a major supplier of products related to the “back-to-school” season, which occurs principally during the months of May through August. If this typical seasonal increase in sales of certain portions of the Company’s product line does not materialize in any year, the Company could experience a material adverse effect on its business, financial condition and results of operations. +Failure to manage growth and continue to expand our operations successfully could adversely affect our financial results. +Our business has experienced significant historical growth over the years, and we expect our business to continue to grow organically and through strategic acquisitions. This growth places significant demands on management and operational systems. If we cannot effectively manage our growth, it is likely to result in operational inefficiencies and ineffective management of our business thus negatively impacting our operating results. To the extent we grow through strategic acquisitions, our success will depend on selecting the appropriate targets, integrating such acquisitions quickly and effectively and realizing any expected synergies and cost savings related to such acquisitions. +7 +Loss of a major customer could result in a decrease in the Company’s future sales and earnings. +Sales of our products are primarily concentrated in a few major customers including office product superstores and mass market distributors. The Company had one customer in 2019 and 2018 that individually exceeded 10% of consolidated net sales. Net sales to this one customer were approximately 17% and 16% of consolidated net sales in 2019 and 2018, respectively. The Company anticipates that a limited number of customers may account for a substantial portion of its total net revenues for the foreseeable future. The business risks associated with this concentration, including increased credit risks for these and other customers and the possibility of related bad debt write-offs, could negatively affect our margins and profits. Additionally, the loss of a major customer, whether through competition or consolidation, or a disruption in sales to such a customer, could result in a decrease of the Company’s future sales and earnings. +The loss of key management could adversely affect the Company’s ability to run its business. +The Company’s success depends, to a large extent, on the continued service of its executive management team, operating officers and other key personnel. The Company must therefore continue to recruit, retain and motivate management and operating personnel sufficient to maintain its current business and support its projected growth. The Company’s inability to meet its staffing requirements in the future could adversely affect its results of operations. +Execution or the lack thereof, of our e-commerce business may reduce our operating results. +Our e-commerce business constituted approximately 12% of our net sales in 2019 and has been our fastest growing distribution channel over the last several years. The continued successful growth of our e-commerce business depends, in part, on third parties and factors over which we have limited control, including difficulty forecasting demand, changing consumer preferences, and e-commerce buying trends, both domestically and abroad, as well as promotional or other advertising initiatives employed by our customers or other third parties on their e-commerce sites. Additionally, sales in our e-commerce distribution channel may also divert sales from our other customers. +Additionally, the success of our e-commerce business depends, in part, on the timely receipt of our products by our customers and their end users. The efficient flow of our products requires that our distribution facilities have adequate capacity to support increases in our e-commerce business. If we encounter difficulties with forecasting and supply to our distribution facilities, we could face shortages of inventory, resulting in “out of stock” conditions in the e-commerce sites operated by our customers or other third parties, and we could incur significantly higher costs and longer lead times associated with distributing our products to our customers. +Our failure to successfully respond to these risks and uncertainties might adversely affect the sales in our e-commerce business, as well as damage our brands. +Failure to protect the Company’s proprietary rights or the costs of protecting these rights could adversely affect its business. +The Company’s success depends in part on its ability to obtain patents and trademarks and to preserve other intellectual property rights covering its products and processes. The Company has obtained certain domestic and foreign patents and intends to continue to seek patents on its inventions when appropriate. The process of seeking patent protection can be time consuming and expensive. There can be no assurance that pending patents related to any of the Company’s products will be issued, in which case the Company may not be able to legally prevent others from producing similar and/or compatible competing products. If other companies were to sell similar and/or compatible competing products, the Company’s results of operations could be adversely affected. Furthermore, there can be no assurance that the Company’s efforts to protect its intellectual property will be successful. Any infringement of the Company’s intellectual property or legal defence of such action could have a material adverse effect on the Company. +The Company is subject to intense competition in all of the markets in which it competes. +The Company’s products are sold in highly competitive markets including at mass merchants, high volume office supply stores and online. The Company believes that the principal points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. Competitive conditions may require the Company to match or better competitors’ prices to retain business or market shares. The Company believes that its competitive position will depend on continued investment in innovation and product development, manufacturing and sourcing, quality standards, marketing and customer service and support. The Company’s success will depend in part on its ability to anticipate and offer products that appeal to the changing needs and preferences of our customers in the various market categories in which it competes. The Company may not have sufficient resources to make the investments that may be necessary to anticipate those changing needs and the Company may not anticipate, identify, develop and market products successfully or otherwise be successful in maintaining its competitive position. In addition, there are numerous uncertainties inherent in successfully developing and commercializing innovative new products on a continuing basis, and new product launches may not provide expected growth results. There are no significant barriers to entry into the markets for most of the Company’s products. +8 +Compromises of our information systems or unauthorized access to confidential information or our customers' or associates' personal information may materially harm our business or damage our reputation. +Through our sales and marketing activities and our business operations, we collect and store confidential information and certain personal information from our customers and associates. We also process payment card information and check information. In addition, in the normal course of business, we gather and retain personal information about our associates and generate and have access to confidential business information. Although we have taken steps designed to safeguard such information, there can be no assurance that such information will be protected against unauthorized access or disclosure. Computer hackers may attempt to penetrate our or our vendors' network security and, if successful, misappropriate such information. An Acme United associate, contractor or other third-party with whom we do business may also attempt to circumvent our security measures in order to obtain such information or inadvertently cause a breach involving such information. We could be subject to liability for failure to comply with privacy and information security laws, for failing to protect personal information, or for misusing personal information, such as use of such information for an unauthorized marketing purpose. Any compromise of our systems or data could disrupt our operations, damage our reputation, and expose us to claims from customers, financial institutions, regulators, payment card associations, employees and other persons, any of which could have an adverse effect on our business, financial condition and results of operations. +The Company may not be able to maintain or to raise prices in response to inflation and increasing costs. +Future market and competitive pressures may prohibit the Company from raising prices to offset increased product costs, freight costs and other inflationary items or to offset currency fluctuations. The inability to pass these costs through to the Company’s customers could have a negative effect on its results of operations. +The Company may need to raise additional capital to fund its operations. +The Company’s management believes that, under current conditions, the Company’s current cash and cash equivalents, cash generated by operations, together with the borrowing availability under its revolving loan agreement with HSBC Bank N.A., will be sufficient to fund planned operations for the next twelve months from the issuance date of this report. However, if the Company is unable to generate sufficient cash from operations, it may be required to find additional funding sources. If adequate financing is unavailable or is unavailable on acceptable terms, the Company may be unable to maintain, develop or enhance its operations, products and services, take advantage of future opportunities or adequately respond to competitive pressures. +Changes in interest rates could adversely affect us . +We have exposure to increases in interest rates under our revolving credit loan agreement with HSBC Bank, N.A. which presently bears interest at the Prime Rate less 1.25%. In response to the last global economic recession, actions of the U.S. Federal Reserve and other central banking institutions, were taken to create and maintain a low interest rate environment. Increases in interest rates would increase our interest costs on our variable-rate debt as well as any future fixed rate debt, we may incur at higher interest rates, and interest which we pay reduces our cash available for working capital, acquisitions, and other uses. +Product liability claims or regulatory actions could adversely affect the Company's financial results and reputation. +Claims for losses or injuries allegedly caused by some of the Company’s products arise in the ordinary course of its business. In addition to the risk of substantial monetary judgments, product liability claims or regulatory actions could result in negative publicity that could harm the Company’s reputation in the marketplace or the value of its brands. The Company also could be required to recall possible defective products, which could result in adverse publicity and significant expenses. Although the Company maintains product liability insurance coverage, potential product liability claims are subject to a deductible or could be excluded under the terms of the policy. +The Company is subject to environmental regulation and environmental risks. +The Company is subject to national, state, provincial and/or local environmental laws and regulations that impose limitations and prohibitions on the discharge and emission of, and establish standards for the use, disposal and management of, certain materials and waste. These environmental laws and regulations also impose liability for the costs of investigating and cleaning up sites, and certain damages resulting from present and past spills, disposals, or other releases of hazardous substances or materials. Environmental laws and regulations can be complex and may change often. Capital and operating expenses required to comply with environmental laws and regulations can be significant, and violations may result in substantial fines and penalties. In addition, environmental laws and regulations, such as the Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, in the United States impose liability on several grounds for the investigation and cleanup of contaminated soil, ground water and buildings and for damages to natural resources on a wide range of properties. For example, contamination at properties formerly owned or operated by the Company, as well as at properties it will own and operate, and properties to which hazardous substances were sent by the Company, may result in liability for the Company under environmental laws and regulations. The costs of complying with environmental laws and regulations and any claims concerning noncompliance, or liability with respect to contamination in the future could have a material adverse effect on the Company’s financial condition or results of operations. +9 +We cannot provide assurance that we will continue to pay dividends or purchase shares of our common stock under our stock repurchase program. +We continue to pay and declare dividends on a quarterly basis and we anticipate that we will continue to do so. However, there can be no assurance that we will have sufficient cash or surplus under the law to be able to continue to pay dividends at our current level or purchase shares of our common stock under our stock repurchase programs. At December 31, 2019, a total of 217,999 may be purchased in the future under the repurchase programs which the Company announced in 2010 and 2019. This may result from extraordinary cash expenses, actual expenses exceeding contemplated costs, funding of capital expenditures, increases in reserves or lack of available capital. We may also suspend the payment of dividends or our stock repurchase program if the Board deems such action to be in the best interests of our shareholders. If we do not pay dividends or decrease the amount of dividends we pay, the price of our common stock would likely decrease. +Our shares of common stock are thinly traded and our stock price may be volatile. +Because our common stock is thinly traded, its market price may fluctuate significantly more than the stock market in general or the stock prices of other companies listed on major stock exchanges. There were approximately 2,936,360 shares of our common stock held by non-affiliates as of December 31, 2019. Thus, our common stock is less liquid than the stock of companies with broader public ownership, and, as a result, the trading price for shares of our common stock may be more volatile. Among other things, trading of a relatively small volume of our common stock may have a greater impact on the trading price for our stock than would be the case if our public float were larger. +Item 1B. Unresolved Staff Comments +Not applicable. +Item 2. Properties +Location +Square +Footage +Purpose +Owned +Rocky Mount, NC +Vancouver, WA +Solingen, Germany +340,000 +53,000 +35,000 +Warehousing and distribution +Warehousing and distribution +Warehousing, distribution and administrative +428,000 +Leased +Fairfield, CT +15,400 +Administrative +Bentonville, AK +1,500 +Administrative +Marlborough, MA +28,000 +Manufacturing, warehousing and distribution +Santa Ana, CA +10,000 +Manufacturing, warehousing, distribution and administrative +La Vergne, TN +56,000 +Manufacturing, warehousing and distribution +Mount Forest, Ontario, Canada +42,500 +Warehousing and distribution +Orangeville, Ontario, Canada +2,850 +Administrative +Hong Kong, China +2,750 +Administrative +Guangzhou, China +3,500 +Administrative +Ningbo, China +1,800 +Administrative +121,300 +Total: +549,300 +The Company’s facilities located in the United States and China are utilized by all of its segments. The Company’s facilities located in Canada and Germany are utilized by its Canadian segment and its European segment, respectively. +Management believes that the Company's facilities, whether leased or owned, are adequate to meet its current needs and should continue to be adequate for the foreseeable future. +Item 3. Legal Proceedings +There are no pending material legal proceedings to which the Company is a party or, to the actual knowledge of the Company, contemplated by any governmental agency. +Item 4. Mine Safety Disclosures +Not applicable. +10 +PART II +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company's Common Stock is traded on the NYSE American under the symbol "ACU". +Issuer Purchases of Equity Securities +On November 14, 2019, the Company announced a Common Stock repurchase program of up to a total 200,000 shares. During the twelve months ended December 31, 2019, the Company did not repurchase any shares of its Common Stock. As of December 31, 2019, a total of 17,999 shares may be purchased in the future under the repurchase program announced in 2010 and 200,000 may be purchased under the repurchase program announced in 2019. Neither the 2010 nor the 2019 program have an expiration date +Item 6. Selected Financial Data +As a smaller reporting company, the Company is not required to provide this information. +11 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +Forward-Looking Information +The Company may from time to time make written or oral “forward-looking statements” including statements contained in this report and in other communications by the Company, which are made in good faith pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements are based on our beliefs as well as assumptions made by and information currently available to us. When used in this document, words like “may,” “might,” “will,” “except,” “anticipate,” “believe,” “potential,” and similar expressions are intended to identify forward-looking statements. Actual results could differ materially from our current expectations. +Forward-looking statements in this report, including without limitation, statements related to the Company’s plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including, without limitation, the following: (i) changes in the Company’s plans, strategies, objectives, expectations and intentions, which may be made at any time at the discretion of the Company; (ii) the impact of uncertainties in global economic conditions, including the impact on the Company’s suppliers and customers; (iii) changes in client needs and consumer spending habits; (iv) the impact of competition and technological changes on the Company; (v) the Company’s ability to manage its growth effectively, including its ability to successfully integrate any business it might acquire; (vi) currency fluctuations; (vii) increases in the cost of borrowings resulting from rising interest rates; (viii) international trade policies and their impact on demand for our products and our competitive position, including the imposition of new tariffs or changes in existing tariff rates; and (ix) other risks and uncertainties indicated from time to time in the Company’s filings with the Securities and Exchange Commission. For a more detailed discussion of these and other factors affecting the Company, see the Risk Factors set forth above in Item 1A of this Annual Report on Form 10-K. +Critical Accounting Policies +The following discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in conformity with generally accepted accounting principles in the United States of America. The Company’s significant accounting policies are more fully described in Note 2 of the notes to consolidated financial statements. Certain accounting estimates are particularly important to the understanding of the Company’s financial position and results of operations and require the application of significant judgment by the Company’s management and can be materially affected by changes from period to period in economic factors or conditions that are outside the control of management. The Company’s management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical operations, future business plans and projected financial results, the terms of existing contracts, the observance of trends in the industry, information provided by customers and information available from other outside sources, as appropriate. The following discusses the Company’s critical accounting policies and estimates: +Estimates – Operating results may be affected by certain accounting estimates. The most sensitive and significant accounting estimates in the financial statements relate to customer rebates, valuation allowances for deferred income tax assets, obsolete and slow moving inventories, potentially uncollectible accounts receivable, pension liability and accruals for income taxes. Although the Company’s management has used available information to make judgments on the appropriate estimates to account for the above matters, there can be no assurance that future events will not significantly affect the estimated amounts related to these areas where estimates are required. However, historically, actual results have not been materially different than original estimates. +Revenue Recognition – Revenue is recognized when the price is fixed, the title and risks and rewards of ownership have passed to the customer, and when collection is reasonably assured. Depending on the contractual terms of each customer, revenue is recognized either at the time of shipment or upon delivery. When revenue is recorded, estimates of returns are made and recorded as a reduction of revenue. Customer rebates and incentives earned based on promotional programs in place, volume of purchases or other factors are also estimated at the time of revenue recognition and recorded as a reduction of that revenue. Refer to Note 9 – Revenue from Contracts with Customers +Allowance for Doubtful Accounts – The Company provides an allowance for doubtful accounts based upon a review of outstanding accounts receivable, historical collection information and existing economic conditions. The allowance for doubtful accounts represents estimated uncollectible accounts receivables associated with potential customer defaults on contractual obligations, usually due to potential insolvencies. The allowance includes amounts for certain customers where a risk of default has been specifically identified. In addition, the allowance includes a provision for customer defaults based on historical experience. The Company actively monitors its accounts receivable balances, and its historical experience of annual accounts receivable write-offs has been negligible. +Customer Rebates – Customer rebates and incentives are a common practice in the office products industry. We incur customer rebate costs to obtain favorable product placement, to promote sell-through of products and to maintain competitive pricing. Customer rebate costs and incentives, including volume rebates, promotional funds, catalog allowances and slotting fees, are accounted for as a reduction to gross sales. These costs are recorded at the time of sale and are based on individual customer contracts. Management periodically reviews accruals for these rebates and allowances and adjusts accruals when appropriate. +12 +Obsolete and Slow Moving Inventory – Inventories are stated at the lower of cost, determined on the first-in, first-out method, or net realizable value. An allowance is established to adjust the cost of inventory to its n et realizable value. Inventory allowances are recorded for obsolete or slow moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions and specific identification of items, such as disco ntinued products. These estimates could vary significantly from actual requirements if future economic conditions, customer inventory levels or competitive conditions differ from expectations. +Income Taxes – Deferred income tax liabilities or assets are established for temporary differences between financial and tax reporting bases and are subsequently adjusted to reflect changes in tax rates expected to be in effect when the temporary differences reverse. A valuation allowance is recorded to reduce deferred income tax assets to an amount that is more likely than not to be realized. +Intangible Assets and Goodwill – Intangible assets with finite useful lives are recorded at cost upon acquisition and amortized over the term of the related contract, if any, or useful life, as applicable. Intangible assets held by the Company with finite useful lives include patents and trademarks. The weighted average amortization period for intangible assets at December 31, 2019 was 10 years. The Company periodically reviews the values recorded for intangible assets and goodwill to assess recoverability from future operations whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. At December 31, 2019 and 2018, the Company assessed the recoverability of its long-lived assets and goodwill and believed that there were no events or circumstances present that would require a test of recoverability on those assets. As a result, there was no impairment of the carrying amounts of such assets and no reduction in their estimated useful lives. +Leases - The Company determines whether an arrangement is a lease at inception. Leases with an initial term of 12 months or less are not recorded on the balance sheet. All other leases are recorded on the balance sheet with right-of-use (“ROU”) assets representing the right to use the underlying asset for the lease term and lease liabilities representing the obligation to make lease payments arising from the lease. +ROU assets and lease liabilities are recognized at commencement date of the lease based on the present value of lease payments over the lease term and include options to extend or terminate the lease when they are reasonably certain to be exercised. Lease arrangements with lease and non-lease components are generally accounted for as a single lease component. +Pension Obligation – The pension benefit obligation is based on various assumptions used by third-party actuaries in calculating this amount. These assumptions include discount rates, expected return on plan assets, mortality rates and other factors. Revisions in assumptions and actual results that differ from the assumptions affect future expenses, cash funding requirements and obligations. Our funding policy is to fund the plan in accordance with applicable requirements of the Internal Revenue Code and regulations. +These assumptions are reviewed annually and updated as required. The Company has a frozen defined benefit pension plan. Two assumptions, the discount rate and the expected return on plan assets, are important elements of expense and liability measurement. +We determine the discount rate used to measure plan liabilities as of the December 31 measurement date. The discount rate reflects the current rate at which the associated liabilities could be effectively settled at the end of the year. In estimating this rate, we look at rates of return on fixed-income investments of similar duration to the liabilities in the plan that receive high, investment grade ratings by recognized ratings agencies. Using these methodologies, we determined a discount rate of 2.74% to be appropriate as of December 31, 2019, which is a decrease of 1.13 percentage points from the rate used as of December 31, 2018. +The expected long-term rate of return on assets considers the Company’s historical results and projected returns for similar allocations among asset classes. In accordance with generally accepted accounting principles, actual results that differ from the Company’s assumptions are accumulated and amortized over future periods and, therefore, affect expense and obligation in future periods. For the U.S. pension plan, our assumption for the expected return on plan assets was 6.0% for 2019. For more information concerning these costs and obligations, see the discussion in Note 6 – Pension and Profit Sharing, in the notes to the Company’s consolidated financial statements in this report. +Accounting for Stock-Based Compensation – Stock based compensation cost is measured at the grant date fair value of the award and is recognized as expense over the requisite service period. The Company uses the Black-Scholes option - pricing model to determine fair value of the awards, which involves certain subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of the Company’s common stock price over the expected term (“volatility”) and the number of options for which vesting requirements will not be completed (“forfeitures”). Changes in the subjective assumptions can materially affect estimates of fair value stock-based compensation, and the related amount recognized on the consolidated statements of operations. Refer to Note 11 – Stock Option Plans, in the notes to consolidated financial statements in this report for a more detailed discussion. +Results of Operations 2019 Compared with 2018 +Traditionally, the Company’s sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the back-to-school market. +13 +Net Sales +In 2019, sales increased by $5,135,947, or 4%, to $142,457,342 compared to $137,321,395 in 2018. +The U.S. segment sales increased by 4%, in 2019 compared to 2018 due to strong sales of first aid and safety products. +Sales in Canada decreased 5% in U.S. dollars and 3% in local currency compared to the same period in 2018 primarily due to lower sales in the office products market. +Sales in Europe increased 8% in U.S. dollars and 14% in local currency compared to last year mainly due to new customers in the office products channel, growth in sales of DMT sharpening products, and strong e-commerce demand for these products. +Gross Profit +Gross profit was 36.5% of net sales in 2019 compared to 36.9% in 2018. +Selling, General and Administrative +Selling, general and administrative (“SG&A”) expenses were $43,571,510 in 2019 compared with $43,192,076 in 2018, an increase of $379,434, or 1%. SG&A expenses were 30.6% of net sales in 2019 compared to 31.5% in 2018. The increase in SG&A expenses was primarily due to higher personnel related costs, which include compensation and recruiting costs. +Operating Income +Operating income was $8,429,348 in 2019, compared with $7,456,906 in 2018. Operating income in the U.S. segment increased by approximately $1,096,000, primarily due to higher sales. Operating income in Canada decreased by approximately $113,000, primarily due to lower sales. Operating income in the European segment decreased by approximately $11,000. +Interest Expense, Net +Net interest expense for 2019 was $1,788,512, compared with $1,858,224 for 2018, a decrease of $69,712. The decrease in interest expense, net for 2019, was primarily the result of a lower average borrowings partially offset by a higher average interest rate during 2019. +Other Expense +Other expense was $97,627 in 2019 compared to $68,458 in 2018. The increase in other expense is primarily related to foreign currency transactions. +Income Tax Expense +Income tax expense was $1,029,556 in 2019, resulting in an effective tax rate of 16% compared to $932,874, an effective tax rate of 17% in 2018. +Off-Balance Sheet Transactions +The Company did not engage in any off-balance sheet transactions during 2019. +Liquidity and Capital Resources +During 2019, working capital decreased by approximately $3.1 million compared to December 31, 2018. Inventory decreased by approximately $2.1 million, or 5%. The Company expects that changes in inventory levels will continue to be consistent with changes in sales, including the seasonal impact on the Company’s revenue stream. Inventory turnover, calculated using a twelve month average inventory balance, was 2.3 at December 31, 2019 as compared to 2.1 at December 31, 2018. The reserve for slow moving and obsolete inventory was $696,486 at December 31, 2019 compared to $538,354 at December 31, 2018. We do not anticipate significant increases in the allowance for slow moving and obsolete inventory in the ordinary course of business during 2020. +Receivables increased by approximately $0.4 million at December 31, 2019 compared to December 31, 2018. The average number of days sales outstanding in accounts receivable was 64 days in 2019 compared to 66 days in 2018. Accounts payable and other current liabilities increased by approximately $2.3 million. +Long-term debt consists of borrowings under the Company’s revolving loan agreement with HSBC Bank, N.A. The agreement provides for borrowings of up to $50 million at Prime Rate less 1.25%. The credit facility has an expiration date of May 24, 2023. The Company must pay a facility fee, payable quarterly, in an amount equal to two tenths of one percent (.20%) per annum of the average daily unused portion of the revolving credit line. The facility is intended to provide liquidity for growth, share repurchases, dividends, acquisition and other business activities. Under the revolving loan agreement, the Company is required to maintain specific amounts of tangible net worth, a specified debt to net worth ratio and a fixed charge coverage ratio and must have annual net income greater than zero, measured as of the end of each fiscal year. At December 31, 2019, the Company was in compliance with the covenants then in effect under the loan agreement. +14 +At December 31, 2019 , total debt outstanding under the Company’s revolving credit facility decreased by approximately $ 7 . 0 million compared to total debt at December 31, 2018 . As of December 31, 2019 , $33,240,407 was outstanding and $ 16,759,593 was available for borrowing under the Company’s revolving credit facility. +On October 26, 2017, the Company exercised its option to purchase its First Aid Only manufacturing and distribution center in Vancouver, WA for $4.0 million. The property consists of 53,000 square feet of office, manufacturing, and warehouse space on 2.86 acres. The purchase was financed by a variable rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Commencing on December 1, 2017, principal payments of $22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. The outstanding principal on December 31, 2019 was $3,444,445. +Capital expenditures during 2019 and 2018 were $1,680,479 and $2,850,993, respectively, which were, in part, financed with borrowings under the Company’s revolving credit facility. +The Company believes that cash on hand, and cash generated from operating activities, together with funds available under its revolving credit facility, are expected, under current conditions, to be sufficient to finance the Company’s planned operations for at least the next twelve months from the issuance of this Form 10-K. +Recently Issued and Adopted Accounting Standards +In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The update eliminates, clarifies and modifies certain guidance related to the accounting for income taxes. ASU 2019-12 is effective for annual reporting periods beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material effect on its consolidated financial statements. +In August 2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20), Disclosure Framework - Changes to the Disclosures Requirements for Defined Benefit Plans Income Statement - Reporting Comprehensive Income (Topic 220) . This ASU removes disclosures that no longer are considered cost beneficial, clarifies the specific requirements of disclosures, and adds disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its consolidated financial statements. +In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), associated with lease accounting. There have been further amendments, including practical expedients, with the issuance of ASU 2018-11, Leases (Topic 842) Targeted Improvements, in July 2018, and ASU 2018-20, Leases (Topic 842) Narrow Scope Improvements for Lessors, in December 2018. The amended guidance requires the recognition of lease assets and lease liabilities on the balance sheet for those leases with terms in excess of 12 months and currently classified as operating leases. Disclosure of key information about leasing arrangements will also be required. We elected the optional transition method which allows entities to continue to apply historical accounting guidance in the comparative periods presented in the year of adoption. +At transition, lessees and lessors may elect to apply a package of practical expedients permitting entities not to reassess: (i) whether any expired or existing contracts are or contain leases; (ii) lease classification for any expired or existing leases; and (iii) whether initial direct costs for any expired or existing leases qualify for capitalization under the amended guidance. These practical expedients must be elected as a package and consistently applied. We elected to apply the package of practical expedients upon adoption. +Upon adoption of the amended guidance, the Company recorded operating lease right-of-use assets and related liabilities of approximately $2.9 million, primarily related to real estate leases. The amended guidance did not have any other material impacts on our consolidated financial statements. +In February 2018, the FASB issued ASU No. 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income . ASU No. 2018-02 provides companies with an option to reclassify stranded tax effects within accumulated other comprehensive income (“AOCI”) to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) is recorded. ASU No. 2018-02 also requires disclosure of a description of the accounting policy for releasing income tax effects from AOCI and whether an election was made to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act. ASU No. 2018-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Companies can adopt the provisions of ASU No. 2018-02 in either the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. For Acme, this ASU was adopted effective January 1, 2019 and resulted in a reclassification between retained earnings and AOCI. The impact from this ASU increased retained earnings by approximately $0.1 million, with an offsetting increase to accumulated other comprehensive loss for the same amount. +In June 2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting . ASU 2018-07 aligns the accounting for share-based payment awards issued to employees and non-employees. ASU 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period. The adoption of ASU 2018-07 did not have a material impact on the consolidated financial statements. +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +As a smaller reporting company, the Company is not required to provide this information. +Item 8. Financial Statements and Supplementary Data +15 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF OPERATIONS +For the years ended December 31, +2019 +2018 +Net sales +$ +142,457,342 +$ +137,321,395 +Cost of goods sold +90,456,484 +86,672,413 +Gross profit +52,000,858 +50,648,982 +Selling, general and administrative expenses +43,571,510 +43,192,076 +Operating income +8,429,348 +7,456,906 +Non operating items: +Interest: +Interest expense +(1,828,408 +) +(1,891,042 +) +Interest income +39,896 +32,818 +Interest expense, net +(1,788,512 +) +(1,858,224 +) +Other expense +(97,672 +) +(67,458 +) +Total other expense, net +(1,886,184 +) +(1,925,682 +) +Income before income tax expense +6,543,164 +5,531,224 +Income tax expense +1,029,556 +932,874 +Net income +$ +5,513,608 +$ +4,598,350 +Earnings per share: +Basic +$ +1.65 +$ +1.36 +Diluted +$ +1.60 +$ +1.30 +See accompanying Notes to Consolidated Financial Statements. +16 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +For the Years Ended +December 31, +2019 +2018 +Net income +$ +5,513,608 +$ +4,598,350 +Other comprehensive gain (loss) - +Foreign currency translation +45,223 +(461,374 +) +Change in net prior service credit and actuarial gains, net of income +tax expense +143,906 +37,388 +Total other comprehensive income (loss) +189,129 +(423,986 +) +Comprehensive income +$ +5,702,737 +$ +4,174,364 +See accompanying Notes to Consolidated Financial Statements. +17 +Acme United Corporation and Subsidiaries +CONSOLIDATED BALANCE SHEETS +December 31, +December 31, +2019 +2018 +ASSETS +Current assets: +Cash and cash equivalents +$ +6,821,883 +$ +4,409,042 +Accounts receivable, less allowance +25,484,865 +25,101,663 +Inventories +39,261,105 +41,332,137 +Prepaid expenses and other current assets +1,578,248 +2,149,295 +Total current assets +73,146,101 +72,992,137 +Property, plant and equipment: +Land +1,420,104 +1,422,785 +Buildings +10,095,529 +10,143,678 +Machinery and equipment +19,111,801 +18,244,038 +Total property, plant and equipment +30,627,434 +29,810,501 +Less: accumulated depreciation +16,591,890 +15,267,877 +Net property, plant and equipment +14,035,544 +14,542,624 +Intangible assets, less accumulated amortization +15,792,738 +17,044,400 +Goodwill +4,696,370 +4,696,370 +Operating lease right-of-use asset, net +2,989,272 +- +Deferred income taxes +- +113,353 +Other assets +88,828 +88,902 +Total assets +$ +110,748,853 +$ +109,477,786 +LIABILITIES +Current liabilities: +Accounts payable +$ +6,692,692 +$ +7,982,620 +Operating lease liability - current portion +1,047,498 +- +Current portion of mortgage payable +266,667 +266,667 +Other accrued liabilities +8,576,248 +5,115,400 +Total current liabilities +16,583,105 +13,364,687 +Long-term debt +33,240,407 +40,283,115 +Mortgage payable, net of current portion +3,177,778 +3,444,445 +Operating lease liability - non-current portion +1,960,996 +- +Deferred income taxes +49,284 +- +Other non-current liabilities +32,302 +53,128 +Total liabilities +55,043,872 +57,145,375 +STOCKHOLDERS' EQUITY +Common stock, par value $2.50: authorized 8,000,000 shares; issued - +4,838,071 shares in 2019 and in 2018, including treasury stock +12,094,413 +12,094,413 +Treasury stock, at cost, 1,487,238 shares in 2019 and 2018 +(14,235,190 +) +(14,235,190 +) +Additional paid-in capital +8,262,208 +8,981,523 +Accumulated other comprehensive loss +(1,987,870 +) +(2,057,985 +) +Retained earnings +51,571,420 +47,549,650 +Total stockholders' equity +55,704,981 +52,332,411 +Total liabilities and stockholders' equity +$ +110,748,853 +$ +109,477,786 +See accompanying Notes to Consolidated Financial Statements. +18 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY +Outstanding +Shares of +Common Stock +Common Stock +Treasury +Stock +Additional +Paid-In Capital +Accumulated +Other +Comprehensive +Loss +Retained +Earnings +Total +Balances, December 31, 2017 +3,374,061 +$ +12,094,413 +$ +(13,870,041 +) +$ +8,880,543 +$ +(1,633,999 +) +$ +44,467,077 +$ +49,937,993 +Net income +4,598,350 +4,598,350 +Other comprehensive loss +(423,986 +) +(423,986 +) +Stock compensation expense +869,055 +869,055 +Distribution to shareholders +(1,515,777 +) +(1,515,777 +) +Cash settlement of stock options +(768,075 +) +(768,075 +) +Purchase of treasury stock +(23,228 +) +(365,149 +) +(365,149 +) +Balances, December 31, 2018 +3,350,833 +$ +12,094,413 +$ +(14,235,190 +) +$ +8,981,523 +$ +(2,057,985 +) +$ +47,549,650 +$ +52,332,411 +Net income +5,513,608 +5,513,608 +Other comprehensive income +189,129 +189,129 +Adoption of ASU 2018-02 +(119,014 +) +119,014 +- +Stock compensation expense +968,467 +968,467 +Distribution to shareholders +(1,610,852 +) +(1,610,852 +) +Cash settlement of stock options +(1,687,782 +) +(1,687,782 +) +Balances, December 31, 2019 +3,350,833 +$ +12,094,413 +$ +(14,235,190 +) +$ +8,262,208 +$ +(1,987,870 +) +$ +51,571,420 +$ +55,704,981 +See accompanying Notes to Consolidated Financial Statements. +19 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the years ended December 31, +2019 +2018 +Operating activities: +Net income +$ +5,513,608 +$ +4,598,350 +Adjustments to reconcile net income to net cash provided by operating activities +Depreciation +2,181,060 +2,011,675 +Amortization +1,251,662 +1,217,525 +Stock compensation expense +968,467 +869,055 +Deferred income taxes +162,637 +396,233 +Non-cash lease expense +19,222 +- +Provision for doubtful accounts +290,128 +156,000 +Changes in operating assets and liabilities +Accounts receivable +(784,562 +) +651,988 +Inventories +2,089,861 +(1,580,151 +) +Prepaid expenses and other current assets +666,070 +573,604 +Accounts payable +(1,525,060 +) +(3,066,106 +) +Other accrued liabilities +3,869,138 +(1,352,904 +) +Total adjustments +9,188,623 +(123,081 +) +Net cash provided by operating activities +14,702,231 +4,475,269 +Investing activities: +Purchase of property, plant and equipment +(1,680,479 +) +(2,850,993 +) +Purchase of intellectual property +- +(379,921 +) +Net cash used by investing activities +(1,680,479 +) +(3,230,914 +) +Financing activities: +Net repayments of long-term debt +(7,042,708 +) +(3,167,233 +) +Repayments on mortgage +(266,667 +) +(266,667 +) +Distributions to shareholders +(1,608,956 +) +(1,484,829 +) +Cash settlement of stock options +(1,687,782 +) +(768,075 +) +Purchase of treasury stock +— +(365,149 +) +Net cash used by financing activities +(10,606,113 +) +(6,051,953 +) +Effect of exchange rate changes +(2,799 +) +(121,629 +) +Net increase (decrease) in cash and cash equivalents +2,412,841 +(4,929,227 +) +Cash and cash equivalents at beginning of year +4,409,042 +9,338,269 +Cash and cash equivalents at end of year +$ +6,821,883 +$ +4,409,042 +Supplemental cash flow information: +Cash paid for income taxes +$ +422,339 +$ +887,592 +Cash paid for interest expense +$ +1,863,961 +$ +1,855,356 +See accompanying Notes to Consolidated Financial Statements. +20 +Acme United Corporation and Subsidiaries +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. Operations +The operations of Acme United Corporation (the “Company”) consist of three reportable segments. The operations of the Company are structured and evaluated based on geographic location. The three reportable segments operate in the United States (including Asian operations), Canada and Europe. Principal products across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid safety kits, and related products which are sold primarily to wholesale, contract and retail stationery distributors, office supply super stores, mass market retailers, industrial distributors, school supply distributors, drug store retailers, sporting goods stores, hardware chains and wholesale florists. +2. Accounting Policies +Estimates – The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most sensitive and significant accounting estimates relate to customer rebates, valuation allowances for deferred income tax assets, obsolete and slow-moving inventories, potentially uncollectible accounts receivable, pension liability and accruals for income taxes. Actual results could differ from those estimates. +Principles of Consolidation – The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned by the Company. All significant intercompany accounts and transactions are eliminated in consolidation. +Translation of Foreign Currency – For foreign operations whose functional currencies are not U.S. dollars, assets and liabilities are translated at rates in effect at the end of the year; revenues and expenses are translated at average rates in effect during the year. Resulting translation adjustments are made directly to accumulated other comprehensive income. Foreign currency transaction gains and losses are recognized in operating results. Included in other expense were foreign currency transaction losses of $38,988 in 2019 and foreign currency transaction gains of $7,458 in 2018. +Cash Equivalents – Investments with an original maturity of three months or less, as well as time deposits and certificates of deposit that are readily redeemable at the date of purchase, are considered cash equivalents. +Accounts Receivable – Accounts receivable are shown less an allowance for doubtful accounts of $522,560 at December 31, 2019 and $462,132 at December 31, 2018. +Inventories – Inventories are stated at the lower of cost, or net realizable value, determined by the first-in, first-out method. +Property, Plant and Equipment, and Depreciation – Property, plant and equipment is recorded at cost. Depreciation is computed by the straight-line method over the estimated useful lives of the assets, which range from 3 to 30 years. +Intangible Assets – Intangible assets with finite useful lives are recorded at cost upon acquisition and amortized over the term of the related contract or useful life, as applicable. Intangible assets held by the Company with finite useful lives include patents and trademarks. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period for intangible assets at December 31, 2019 was 10 years. The Company periodically reviews the values recorded for intangible assets to assess recoverability from future operations whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. At December 31, 2019 and 2018, the Company assessed the recoverability of its long-lived assets and believed that there were no events or circumstances present that would require a test of recoverability on those assets. As a result, there was no impairment of the carrying amounts of such assets and no reduction in their estimated useful lives. +Deferred Income Taxes – Deferred income taxes are provided for the differences between the financial statement and tax bases of assets and liabilities, and on operating loss carryovers, using tax rates in effect in years in which the differences are expected to reverse. +Leases - The Company determines whether an arrangement is a lease at inception. Leases with an initial term of 12 months or less are not recorded on the balance sheet. All other leases are recorded on the balance sheet with right-of-use (“ROU”) assets representing the right to use the underlying asset for the lease term and lease liabilities representing the obligation to make lease payments arising from the lease. +ROU assets and lease liabilities are recognized at commencement date of the lease based on the present value of lease payments over the lease term and include options to extend or terminate the lease when they are reasonably certain to be exercised. Lease arrangements with lease and non-lease components are generally accounted for as a single lease component. +21 +Revenue Recognition – Revenue is recognized when the price is fixed, the title and risks and rewards of ownership have passed to the customer, and when collection is reasonably assured. Depending on the contractual terms of each customer, revenue is recognized either at the time of shipment or upon delivery. When revenue is recorded, estimates of returns are made and recorded as a reduction of revenue. Customer rebates and incentives earned based on promotional programs in place, volume of purchases or other factors are also estimated at the time of revenue recognition and recorded as a reduction of that revenue. Refer to Note 9 – Revenue from Contracts with Customers. +Research and Development – Research and development costs ($596,000 in 2019 and $734,000 in 2018) are included in selling, general and administrative expenses and expensed as incurred. +Shipping Costs – The costs of shipping product to our customers ($6,695,223 in 2019 and $7,553,410 in 2018) are included in selling, general and administrative expenses. +Advertising Costs – The Company expenses the production costs of advertising the first time that the related advertising takes place. Advertising costs ($1,104,543 in 2019 and $1,935,267 in 2018) are included in selling, general and administrative expenses. +Subsequent Events – The Company has evaluated events and transactions subsequent to December 31, 2019 through the date the consolidated financial statements were included in this Form 10-K and filed with the SEC. +Concentration – The Company performs ongoing credit evaluations of its customers and generally does not require collateral for the extension of credit. Allowances for credit losses are provided and have been within management's expectations. The Company had one customer in 2019 and 2018 that individually exceeded 10% of consolidated net sales. Net sales to this customer were approximately 17% and 16% of consolidated net sales in 2019 and 2018, respectively. +Recently Issued and Adopted Accounting Standards +In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The update eliminates, clarifies and modifies certain guidance related to the accounting for income taxes. ASU 2019-12 is effective for annual reporting periods beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material effect on its consolidated financial statements. +In August 2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20), Disclosure Framework - Changes to the Disclosures Requirements for Defined Benefit Plans Income Statement - Reporting Comprehensive Income (Topic 220) . This ASU removes disclosures that no longer are considered cost beneficial, clarifies the specific requirements of disclosures, and adds disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its consolidated financial statements. +In June 2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting . ASU 2018-07 aligns the accounting for share-based payment awards issued to employees and non-employees. ASU 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period. The Company does not expect the adoption of ASU 2018-07 to have a material impact on its consolidated financial statements. +In February 2016, the FASB issued ASU 2016-02, Leases , associated with lease accounting. There have been further amendments, including practical expedients, with the issuance of ASU 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842, in January 2018, ASU 2018-11, Leases (Topic 842): Targeted Improvements, in July 2018 and ASU 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors , in December 2018. The amended guidance requires the recognition of lease assets and lease liabilities on the balance sheet for those leases with terms in excess of 12 months and currently classified as operating leases. Disclosure of key information about leasing arrangements will also be required. We elected the optional transition method which allows entities to continue to apply historical accounting guidance in the comparative periods presented in the year of adoption. +At transition, lessees and lessors may elect to apply a package of practical expedients permitting entities not to reassess: (i) whether any expired or existing contracts are or contain leases; (ii) lease classification for any expired or existing leases; and (iii) whether initial direct costs for any expired or existing leases qualify for capitalization under the amended guidance. These practical expedients must be elected as a package and consistently applied. The Company has elected to apply the package of practical expedients upon adoption. +Upon adoption of the amended guidance, the Company recorded operating lease right-of-use assets and related liabilities of approximately $2.9 million, primarily related to real estate leases. The Company currently does not expect the amended guidance to have any other material impact on our consolidated financial statements. +22 +In February 2018, the FASB issued ASU No. 2018-02, In come Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income . ASU No. 2018-02 provides companies with an option to reclassify stranded tax effects within accumulated other comprehensive income (“AOCI”) to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) is recorded. ASU No. 2018-02 also requires disclosure of a d escription of the accounting policy for releasing income tax effects from AOCI and whether an election was made to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act. ASU No. 2018-02 is effective for fiscal years beginning after Dece mber 15, 2018, and interim periods within those fiscal years. Companies can adopt the provisions of ASU No. 2018-02 in either the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corpor ate income tax rate in the Tax Cuts and Jobs Act is recognized. This ASU was adopted effective January 1, 2019 and result ed in a reclassification between retained earnings and accumulated other comprehensive loss . The impact from this ASU increase d retaine d earnings by approximately $0.1 million, with an offsetting increase to accumulated other comprehensive loss for the same amount. +3. Inventories +Inventories consisted of: +December 31, +2019 +2018 +Finished goods +$ +32,899,114 +$ +33,427,983 +Work in process +274,158 +141,646 +Materials and supplies +6,087,833 +7,762,508 +Inventories: +$ +39,261,105 +$ +41,332,137 +Inventories are stated net of valuation allowances for slow moving and obsolete inventory of $696,486 as of December 31, 2019 and $538,354 as of December 31, 2018. +4. Intangible Assets and Goodwill +The Company’s intangible assets and goodwill consisted of: +December 31, +2019 +2018 +First Aid Only Tradename +$ +3,410,000 +$ +3,410,000 +First Aid Only Customer List +5,500,010 +5,500,010 +DMT Trademarks +1,387,000 +1,387,000 +DMT Customer List +1,369,000 +1,369,000 +DMT Non-Compete +183,000 +183,000 +Slice License Agreement +379,921 +379,921 +Patents +2,271,980 +2,271,980 +Trademarks +663,698 +663,698 +Pac-Kit Tradename, Customer List +1,500,000 +1,500,000 +Spill Magic Customer List +3,965,000 +3,965,000 +Spill Magic Trademarks +1,034,000 +1,034,000 +Spill Magic Non-Compete +67,111 +67,111 +C-Thru Customer List +1,050,000 +1,050,000 +Subtotal +22,780,720 +22,780,720 +Less: Accumulated Amortization +6,987,982 +5,736,320 +Intangible Assets +$ +15,792,738 +$ +17,044,400 +Goodwill +$ +4,696,370 +$ +4,696,370 +Amortization expense for patents and trademarks for the years ended December 31, 2019 and 2018 were $1,251,662 and $1,217,525, respectively. The estimated aggregate amortization expense for each of the next five succeeding years, calculated on a similar basis, is as follows: 2020 - $1,236,796; 2021 - $1,234,971; 2022 - $1,231,686; 2023 - $1,227,488; and 2024 - $1,222,299. +23 +5. Other Accrued Liabilities +The Company’s other current and long-term accrued liabilities consisted of: +December 31, +2019 +2018 +Customer Rebates +$ +4,849,081 +$ +3,395,511 +Pension Liability +44,667 +147,099 +Accrued Compensation +1,695,464 +370,477 +Dividend Payable +402,318 +402,158 +Other +1,617,020 +853,283 +Total: +$ +8,608,550 +$ +5,168,528 +6. Pension and Profit Sharing +United States employees, hired prior to July 1, 1993, are covered by a funded, defined benefit pension plan. The benefits of this pension plan are based on years of service and the average compensation of the highest three consecutive years during the last ten years of employment. In December 1995, the Company's Board of Directors approved an amendment to the United States pension plan that terminated all future benefit accruals as of February 1, 1996, without terminating the pension plan. +The Company’s funding policy with respect to its qualified plan is to contribute at least the minimum amount required by applicable laws and regulations. In 2019, the Company contributed $14,413 to the plan. +The plan asset weighted average allocation at December 31, 2019 and December 31, 2018, by asset category, were as follows: +Asset Category: +2019 +2018 +Equity Securities +66 +% +65 +% +Fixed Income Securities +32 +% +33 +% +Other Securities / Investments +2 +% +2 +% +Total: +100 +% +100 +% +The Company’s investment policy for the pension plan is to minimize risk by balancing investments between equity securities and fixed income securities. Plan funds are invested in long-term obligations with a history of moderate to low risk. +The pension plan asset information included below is presented at fair value. ASC 820 establishes a framework for measuring fair value and requires disclosures about assets and liabilities measured at fair value. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three levels as follows: +• +Level 1 – Inputs to the valuation methodology based on unadjusted quoted market prices in active markets that are accessible at the measurement date. +• +Level 2 – Inputs to the valuation methodology that include quoted market prices that are not considered to be active or financial instruments for which all significant inputs are observable, either directly or indirectly. +• +Level 3 – Inputs to the valuation methodology are unobservable and significant to the fair value measurement. +The following tables present the pension plan assets by level within the fair value hierarchy as of December 31, 2019 and 2018: +2019 +Level 1 +Level 2 +Level 3 +Total +Money Market Fund +$ +31 +$ +16,763 +$ +— +$ +16,794 +Equity Common and Collected Funds +102,030 +580,839 +— +682,869 +Fixed Income Common and Collected Funds +82,670 +246,316 +— +328,986 +Total: +$ +184,731 +$ +843,918 +$ +— +$ +1,028,649 +2018 +Level 1 +Level 2 +Level 3 +Total +Money Market Fund +$ +4 +$ +17,320 +$ +— +$ +17,324 +Equity Common and Collected Funds +99,616 +564,371 +— +663,957 +Fixed Income Common and Collected Funds +83,211 +249,309 +— +332,520 +Total: +$ +182,831 +$ +831,000 +$ +— +$ +1,013,831 +24 +Other disclosures related to the pension plan follow : +2019 +2018 +Assumptions used to determine benefit obligation: +Discount rate +2.74 +% +3.87 +% +Changes in benefit obligation: +Benefit obligation at beginning of year +$ +(1,160,930 +) +$ +(1,362,867 +) +Interest cost +(41,841 +) +(39,851 +) +Service cost +(25,000 +) +(33,000 +) +Actuarial (loss) gain +(46,288 +) +71,338 +Benefits and plan expenses paid +200,743 +203,450 +Benefit obligation at end of year: +$ +(1,073,316 +) +$ +(1,160,930 +) +Changes in plan assets: +Fair value of plan assets at beginning of year +$ +1,013,831 +$ +1,249,825 +Actual return on plan assets +201,148 +(57,651 +) +Employer contribution +14,413 +25,107 +Benefits and plan expenses paid +(200,743 +) +(203,450 +) +Fair value of plan assets at end of year +1,028,649 +1,013,831 +Funded status: +$ +(44,667 +) +$ +(147,099 +) +Amounts recognized in accumulated other comprehensive income: +Net actuarial loss +$ +689,398 +$ +880,370 +Prior service cost +538 +1,082 +Total: +$ +689,936 +$ +881,452 +Accrued benefits costs are included in other accrued liabilities (non-current). +2019 +2018 +Assumptions used to determine net periodic benefit cost: +Discount rate +3.87 +% +3.14 +% +Expected return on plan assets +6.00 +% +6.00 +% +Components of net benefit expense: +Service cost +$ +25,000 +$ +33,000 +Interest cost +41,841 +39,851 +Expected return on plan assets +(54,330 +) +(67,547 +) +Amortization of prior service costs +544 +543 +Amortization of actuarial loss +90,442 +87,360 +78,497 +60,207 +Net periodic benefit cost: +$ +103,497 +$ +93,207 +The Company employs a building block approach in determining the long-term rate of return for plan assets. Historical markets are studied and long-term historical relationships between equity securities and fixed income securities are preserved consistent with the widely-accepted capital market principle that assets with higher volatility generate higher returns over the long run. Our expected 6% long-term rate of return on plan assets is determined based on long-term historical performance of plan assets, current asset allocation and projected long-term rates of return. +The following table discloses the change recorded in other comprehensive income related to benefit costs: +2019 +2018 +Balance at beginning of the year +$ +881,452 +$ +915,495 +Change in net loss +(100,530 +) +53,860 +Amortization of actuarial loss +(90,442 +) +(87,360 +) +Amortization of prior service cost +(544 +) +(543 +) +Change recognized in other comprehensive income +(191,516 +) +(34,043 +) +Total recognized in other comprehensive income +$ +689,936 +$ +881,452 +The Company anticipates that in 2020, net periodic benefit cost will include approximately $74,720 of net actuarial loss and $543 of prior service cost. +25 +The following benefits are expected to be paid: +2020 +$ +152,000 +2021 +135,000 +2022 +120,000 +2023 +106,000 +2024 +95,000 +Years 2025 - 2029 +332,000 +The Company also has a qualified, 401k plan covering substantially all of its United States employees. Annual Company contributions to this plan are determined by the Company’s Compensation Committee. For the years ended December 31, 2019 and 2018, the Company contributed 50% of employee’s contributions, up to the first 6% contributed by each employee. Total contribution expense under this 401k plan was $309,922 in 2019 and $271,541 in 2018. +7. Income Taxes +The amounts of income tax expense (benefit) reflected in operations is as follows: +2019 +2018 +Current: +Federal +$ +(82,673 +) +$ +(118,269 +) +State +109,593 +44,315 +Foreign +887,556 +618,930 +Total: +$ +914,476 +$ +544,976 +Deferred: +Federal +$ +92,446 +$ +311,608 +State +22,634 +76,290 +Total: +115,080 +387,898 +Total Income Tax Expense: +$ +1,029,556 +$ +932,874 +The current state tax provision was comprised of taxes on income, the minimum capital tax and other franchise taxes related to the jurisdictions in which the Company's facilities are located. +A summary of United States and foreign income before income taxes follows: +2019 +2018 +United States +$ +800,796 +$ +1,928,627 +Foreign +5,742,368 +3,602,597 +Total: +$ +6,543,164 +$ +5,531,224 +As discussed in Note 11 below, for segment reporting, direct import sales are included in the United States segment. However, the revenues are earned by our Hong Kong subsidiary and related income taxes are paid in Hong Kong whose rate approximates 16.5%. As such, income of the Asian subsidiary is included in the foreign income before taxes. +The following schedule reconciles the amounts of income taxes computed at the United States statutory rates to the actual amounts reported in operations: +2019 +2018 +Federal income taxes at 21% statutory rate +$ +1,365,124 +$ +1,146,673 +State and local taxes, net of federal income tax effect +109,593 +95,278 +Permanent items +(137,051 +) +(75,022 +) +Effect of federal rate change on deferred taxes +— +(111,324 +) +Foreign tax rate difference +(209,216 +) +(59,232 +) +Change in deferred income tax valuation allowance +(98,894 +) +(63,499 +) +Provision for income taxes: +$ +1,029,556 +$ +932,874 +26 +The following summarizes deferred income tax assets and liabilities: +2019 +2018 +Deferred income tax liabilities: +Plant, property and equipment +$ +1,022,898 +$ +847,162 +1,022,898 +847,162 +Deferred income tax assets: +Asset valuations +604,755 +575,920 +Pension +81,561 +105,647 +Other +287,115 +278,948 +973,431 +960,515 +Net deferred income tax (liability) asset: +$ +(49,467 +) +$ +113,353 +On January 22, 2018, the FASB released guidance on the accounting for tax on the global intangible low-taxed income (“GILTI”) provisions of the Act. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company considers any potential GILTI as an expense in the period the tax is incurred. +In 2019, the Company evaluated its tax positions for years which remain subject to examination by major tax jurisdictions, in accordance with the requirements of ASC 740 and as a result, concluded no adjustment was necessary. The Company files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. The Company’s evaluation of uncertain tax positions was performed for the tax years ended December 31, 2016 and forward, the tax years which remain subject to examination by major tax jurisdictions as of December 31, 2019. +Due to the uncertain nature of the realization of the Company's deferred income tax assets based on past performance of its German subsidiary and carry forward expiration dates, the Company has recorded a valuation allowance for the amount of deferred income tax assets which are not expected to be realized. This valuation allowance, all of which is related to deferred tax assets resulting from net operating losses of the Company’s German subsidiary, is subject to periodic review, and, if the allowance is reduced, the tax benefit will be recorded in future operations as a reduction of the Company's tax expense. +8. Long-Term Debt and Shareholders’ Equity +Long-term debt consists of borrowings under the Company’s revolving loan agreement with HSBC Bank, N.A. The agreement provides for borrowings of up to $50 million at Prime Rate less 1.25%. The credit facility has an expiration date of May 24, 2023. The Company must pay a facility fee, payable quarterly, in an amount equal to two tenths of one percent (.20%) per annum of the average daily unused portion of the revolving credit line. The facility is intended to provide liquidity for growth, share repurchases, dividends, acquisition and other business activities. Under the revolving loan agreement, the Company is required to maintain specific amounts of tangible net worth, a specified debt to net worth ratio and a fixed charge coverage ratio and must have annual net income greater than zero, measured as of the end of each fiscal year. At December 31, 2019, the Company was in compliance with the covenants then in effect under the loan agreement. +As of December 31, 2019, $33,240,407 was outstanding and $16,759,593 was available for borrowing under the Company’s revolving loan agreement. +On October 26, 2017, the Company exercised its option to purchase its First Aid Only manufacturing and distribution center in Vancouver, WA for $4.0 million. The property consists of 53,000 square feet of office, manufacturing, and warehouse space on 2.86 acres. The purchase was financed by a variable rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Commencing on December 1, 2017, principal payments of $22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. Minimum annual mortgage payments are due as follows: 2020 - $266,664; 2021 - $266,664; 2022 - $266,664; 2023 - $266,664; 2024 - $266,664; and thereafter - $2,111,130. +On November 14, 2019, the Company announced a Common Stock repurchase program of up to a total of 200,000 shares. The program does not have an expiration date. During the twelve months ended December 31, 2019, the Company did not repurchase any shares of its Common Stock. As of December 31, 2019, a total of 217,999 shares may be purchased in the future under the repurchase programs announced in 2010 and 2019. +9. Revenue from Contracts with Customers +Nature of Goods and Services +The Company recognizes revenue from the sales of a broad line of products that are grouped into two main categories: (i) cutting, sharpening and measuring; and (ii) first aid and safety. The cutting and sharpening category includes scissors, knives, paper trimmers, pencil sharpeners and other sharpening tools. The first aid and safety category includes first aid kits and refills, over-the-counter medications and a variety of safety products. Revenue recognition is evaluated through the following five steps: (i) identification of the contract or contracts with a customer; (ii) identification of the performance obligations in the contract; (iii) determination of the transaction price; (iv) allocation of the transaction price in the contract; and (v) recognition of revenue when or as a performance obligation is satisfied. +27 +When Performance Obligations Are Satisfied +A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Revenue is generated by the sale of the Company’s products to its customers. Sales contracts (purchase orders) generally have a single performance obligation that is satisfied at a point in time, with shipment or delivery, depending on the terms of the underlying contract. Revenue is measured based on the consideration specified in the contract. The amount of consideration we receive and revenue we recognize is impacted by incentives ("customer rebates"), including sales rebates, which are generally tied to sales volume levels, in-store promotional allowances, shared media and customer catalogue allowances and other cooperative advertising arrangements; freight allowance programs offered to our customers; and allowance for returns and discounts. We generally recognize customer rebate costs as a deduction to gross sales at the time that the associated revenue is recognized. +Significant Payment Terms +Payment terms for each customer are dependent on the agreed upon contractual repayment terms. Typically between 30 and 90 days, but they vary dependent on the size of the customer and its risk profile to the Company. Some customers receive discounts for early payment. +Product Returns +The Company accepts product returns in the normal course of business. The Company estimates reserves for returns and the related refunds to customers based on historical experience. Reserves for returned merchandise are included as a component of “Accounts receivables” in the consolidated balance sheets. +Practical Expedient Usage and Accounting Policy Elections +For the Company’s contracts that have an original duration of one year or less, the Company uses the practical expedient in ASC 606-10-32-18 applicable to such contracts and accordingly, does not consider the time value of money in relation to significant financing components. The effect of applying this practical expedient election did not have an impact on the Company’s consolidated financial statements. +Per ASC 606-10-25-18B, the Company has elected to account for shipping and handling activities that occur after the customer has obtained control as a fulfillment activity instead of a performance obligation. Furthermore, shipping and handling activities performed before transfer of control of the product also do not constitute a separate and distinct performance obligation. +The Company has elected to exclude from the transaction price those amounts which relate to sales and other taxes that are assessed by governmental authorities and that are imposed on and concurrent with a specific revenue-producing transaction and collected by the Company from a customer. +Applying the practical expedient in ASC 340-40-25-4 – Other Assets and Deferred Costs , the Company recognizes the incremental costs of obtaining contracts as an expense when incurred. These costs are included in “Selling, general and administrative expenses.” The effect of applying this practical expedient did not have a material impact on the Company’s consolidated financial statements. +Disaggregation of Revenues +The following table represents external net sales disaggregated by product category, by segment: +For the twelve months ended December 31, 2019 +(amounts in 000's) +United States +Canada +Europe +Total +Cutting, Sharpening and Measuring +$ +63,189 +$ +6,678 +$ +10,062 +$ +79,929 +First Aid and Safety +62,528 +— +— +62,528 +Total Net Sales +$ +125,717 +$ +6,678 +$ +10,062 +$ +142,457 +For the twelve months ended December 31, 2018 +(amounts in 000's) +United States +Canada +Europe +Total +Cutting, Sharpening and Measuring +$ +64,019 +$ +7,040 +$ +9,288 +$ +80,347 +First Aid and Safety +56,974 +— +— +56,974 +Total Net Sales +$ +120,993 +$ +7,040 +$ +9,288 +$ +137,321 +28 +1 0 . Segment Information +The Company reports financial information based on the organizational structure used by the Company’s chief operating decision makers for making operating and investment decisions and for assessing performance. The Company’s reportable business segments consist of: (1) United States; (2) Canada; and (3) Europe. As described below, the activities of the Company’s Asian operations are closely linked to those of the U.S. operations; accordingly, the Company’s chief operating decision makers review the financial results of both on a consolidated basis, and the results of the Asian operations have been aggregated with the results of the United States operations to form one reportable segment called the “United States segment” or “U.S. segment”. Each reportable segment derives its revenue from the sales of cutting devices, measuring instruments and safety products for school, office, home, hardware, sporting and industrial use. +Domestic sales orders are filled primarily from the Company’s distribution centers in North Carolina, Washington, Massachusetts, Tennessee and California. The Company is responsible for the costs of shipping, insurance, customs clearance, duties, storage and distribution related to such products. Orders filled from the Company’s inventory are generally for less than container-sized lots. +Direct import sales are products sold by the Company’s Asian subsidiary, directly to major U.S. retailers who take ownership of the products in Asia. These sales are completed by delivering product to the customers’ common carriers at the shipping points in Asia. Direct import sales are made in larger quantities than domestic sales, typically full containers. Direct import sales represented approximately 14% and 12% of the Company’s total net sales in 2019 and 2018, respectively. +The Chief Operating Decision Maker evaluates the performance of each operating segment based on segment revenues and operating income. Segment revenues are defined as total revenues, including both external customer revenue and inter-segment revenue. Segment operating earnings are defined as segment revenues, less cost of goods sold and operating expenses. Identifiable assets by segment are those assets used in the respective reportable segment’s operations. Inter-segment amounts are eliminated to arrive at consolidated financial results. +The following table sets forth certain financial data by segment for the fiscal years ended December 31, 2019 and 2018: +Financial data by segment: +(000’s omitted) +Year Ended December 31, 2019: +United States +Canada +Europe +Consolidated +Net sales +$ +125,717 +$ +6,678 +$ +10,062 +$ +142,457 +Operating income +7,199 +771 +459 +8,429 +Assets +98,577 +6,168 +6,003 +110,749 +Additions to property, plant and equipment +1,646 +2 +32 +1,680 +Depreciation and amortization +3,347 +16 +70 +3,433 +Year Ended December 31, 2018: +United States +Canada +Europe +Consolidated +Net sales +$ +120,993 +$ +7,040 +$ +9,288 +$ +137,321 +Operating income +6,103 +884 +470 +7,457 +Assets +99,721 +3,839 +5,918 +109,478 +Additions to property, plant and equipment +2,705 +83 +63 +2,851 +Depreciation and amortization +3,153 +9 +67 +3,229 +The following is a reconciliation of segment operating income to consolidated income before taxes: +2019 +2018 +Total operating income +$ +8,429 +$ +7,457 +Interest expense, net +1,789 +1,858 +Other expense +97 +68 +Consolidated income before taxes +$ +6,543 +$ +5,531 +29 +The table below presents revenue by geographic area. Revenues are attributed to countries based on location of the customer. +Revenues +2019 +2018 +United States +$ +124,059 +$ +119,573 +International: +Canada +6,678 +7,040 +Europe +10,062 +9,288 +Other +1,658 +1,420 +Total International +$ +18,398 +$ +17,748 +Total Revenues +$ +142,457 +$ +137,321 +11. Stock Option Plans +The Company grants stock options under the 2012 Employee Stock Option Plan (the “2012 Employee Plan”) and under the 2017 Non-Salaried Director Stock Option Plan (the “2017 Director Plan”). The Company also has two plans under which the Company no longer grants options but under which certain options remain outstanding: the 2002 Employee stock Option Plan and the 2005 Non-Salaried Director Stock Option Plan (the “2005 Director Plan”). +The 2012 Employee Plan, which became effective April 23, 2012, provides for the issuance of incentive and nonqualified stock options at an exercise price equal to the fair market value of the Common Stock on the date the option is granted. The terms of the options granted are subject to the provisions of the 2012 Employee Plan. Options granted under the 2012 Employee Plan vest 25% one day after the first anniversary of the grant date and 25% one day after each of the next three anniversaries. As of December 31, 2019, the number of shares available for grant under the 2012 Employee Plan was 44,875. Under the terms of the Employee Plan, no option may be granted under that plan after the tenth anniversary of the adoption of the plan. Options outstanding under the Company’s 2002 Employee Stock Option Plan have the same vesting schedule as the 2012 Employee Plan. +The 2017 Director Plan provides for the issuance of stock options for up to a total of 60,000 shares of the Company's common stock to non-salaried directors. Under the Director Plan, Directors elected after the effective date and at subsequent Annual Meetings who have not received any prior grant under this or previous plans shall receive an initial grant of an option to purchase 5,000 shares of Common Stock (the “Initial Option”). Each year, each elected Director not receiving an Initial Option will receive an option to purchase 5,000 shares of Common Stock (the “Annual Option”). The Initial Option vests 25% on the date of grant and 25% on the anniversary of the grant date in each of the following 3 years. Each Annual Option becomes fully exercisable one day after the date of grant. The exercise price of each option granted equals the fair market value of the Common Stock on the date the option is granted, and expires ten (10) years from the date of grant. As provided in the Director Plan, no options may be granted under the Director Plan after the tenth anniversary of the adoption of the Plan, i.e., after April 24, 2027. As of December 31, 2019, there were no shares available for grant under the 2017 Director Plan. +The 2005 Director Plan, as amended, provided for the issuance of stock options for up to a total of 180,000 shares of the Company's common stock to non-salaried directors. Under the Director Plan, Directors elected on April 25, 2005 and at subsequent Annual Meetings who had not received any prior grant under this or previous plans received an initial grant of an option to purchase 5,000 shares of Common Stock (the “Initial Option”). Each year, each elected Director not receiving an Initial Option received a 5,000 share option (the “Annual Option”). The Initial Option vested 25% on the date of grant and 25% on the anniversary of the grant date in each of the following 3 years. Each Annual Option became fully exercisable one day after the date of grant. The exercise price of each option granted equaled the fair market value of the Common Stock on the date the option was granted, and expired ten (10) years from the date of grant. As provided in the Director Plan, no options could be granted under the Director Plan after the tenth anniversary of the adoption of the Plan, i.e., after April 25, 2015. +The Company has amended certain of its stock option plans for both employees and directors to permit options to be exercised on a net basis and receive either cash or shares of the Company’s Common Stock. Specifically, optionees may, at the time of exercise of an option and subject to the consent of the Company, elect either (i) to receive from the Company cash in an amount equal to the number of shares of Common Stock subject to the option (or portion thereof) that is being exercised multiplied by the excess of (a) the fair market value per share over (b) the exercise price per share of the option (a “net cash settlement”); or (ii) to make payment of the exercise price of the option by reduction in the number of shares of Common Stock otherwise deliverable upon exercise of such option by the number of shares having an aggregate fair market value equal to the total exercise price of the option (or portion thereof). In 2019, the Company paid a total of approximately $1,687,782 and 160,586 shares to optionees who had elected a net cash settlement of their respective options. +30 +A summary of changes in options issued under the Company’s stock option plans follows: +2019 +2018 +Options outstanding at the beginning of the year +1,434,280 +1,289,080 +Options granted +120,000 +232,200 +Options forfeited +(26,500 +) +(11,500 +) +Options exercised +(164,086 +) +(75,500 +) +Options outstanding at the end of the year +1,363,694 +1,434,280 +Options exercisable at the end of the year +932,094 +918,405 +Common stock available for future grants at the end of the year +44,875 +85,000 +Weighted average exercise price per share: +Granted +$ +19.88 +$ +22.75 +Forfeited +23.29 +23.07 +Exercised +10.54 +11.47 +Outstanding +19.08 +18.07 +Exercisable +17.50 +15.15 +A summary of options outstanding as December 31, 2019 is as follows: +Options Outstanding +Options Exercisable +Range of Exercise Prices +Number +Outstanding +Weighted- +Average +Remaining +Contractual +Life (Years) +Weighted- +Average +Exercise +Price +Number +Exercisable +Weighted- +Average +Exercise +Price +$7.30 to $10.74 +156,969 +2 +$ +10.17 +156,969 +$ +10.17 +$10.75 to $16.82 +242,750 +3 +13.57 +242,750 +13.57 +$16.83 to $22.08 +448,250 +7 +19.52 +302,625 +19.23 +$22.09 to $23.97 +217,700 +9 +22.79 +69,425 +22.76 +$23.98 to $28.20 +298,025 +8 +24.87 +160,325 +25.07 +1,363,694 +932,094 +The weighted average remaining contractual life of all outstanding stock options is 6 years. +Stock-Based Compensation +Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is generally the vesting period. The Company uses the Black-Scholes option pricing model to determine the fair value of employee and non-employee director stock options. The determination of the fair value of stock-based payment awards on the date of grant, using an option-pricing model, is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of the Company’s Common Stock price over the expected term (“volatility”) and the number of options that will not fully vest in accordance with applicable vesting requirements (“forfeitures”). +The Company estimates the expected term of options granted by evaluating various factors, including the vesting period, historical employee information, as well as current and historical stock prices and market conditions. The Company estimates the volatility of its common stock by calculating historical volatility based on the closing stock price on the last day of each of the 60 months leading up to the month the option was granted. The risk-free interest rate that the Company uses in the option valuation model is the interest rate on U.S. Treasury zero-coupon bond issues with remaining terms similar to the expected term of the options granted. Historical information was the basis for calculating the dividend yield. The Company is required to estimate forfeitures at the time of grant and to revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company used a mix of historical data and future assumptions to estimate pre-vesting option forfeitures and to record stock-based compensation expense only for those awards that are expected to vest. All stock-based payment awards are amortized over the requisite service periods of the awards, which are generally the vesting periods. +The assumptions used to value option grants for the twelve months ended December 31, 2019 and December 31, 2018 were as follows: +2019 +2018 +Expected life in years +5 - 6 +5 +Interest rate +1.52 - 2.39% +2.43 - 3.02% +Volatility +.358 - .375 +.287 - .316 +Dividend yield +2.0 - 2.2% +1.8 - 2.75% +31 +Total stock-based compensation recognized in the Company’s consolidated statements of operations for the years ended December 31, 2019 and 2018 was $ 968,467 and $ 869,055 , respectively. At December 31, 2019 , there was approximately $ 1,410,872 of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based payments granted to the Company’s employees. As of December 31, 2019 , the remaining unamortized expense is expected to be recognized over a weighted a verage period of 3 years. +The weighted average fair value at the date of grant for options granted during 2019 and 2018 was $5.88 and $5.77 per option, respectively. The aggregate intrinsic value of outstanding options was $6,751,281 at December 31, 2019. The aggregate intrinsic value of exercisable options was $6,072,173 at December 31, 2019. The aggregate intrinsic value of options exercised during 2019 was $1,734,667. +12. Earnings Per Share +The calculation of earnings per share follows: +2019 +2018 +Numerator: +Net income +$ +5,513,608 +$ +4,598,350 +Denominator: +Denominator for basic earnings per share: +Weighted average shares outstanding +3,351,731 +3,370,744 +Effect of dilutive employee stock options +100,892 +171,166 +Denominator for dilutive earnings per share +3,452,623 +3,541,910 +Basic earnings per share +$ +1.65 +$ +1.36 +Dilutive earnings per share +$ +1.60 +$ +1.30 +For 2019 and 2018, respectively, 705,725 and 692,600 stock options were excluded from diluted earnings per share calculations because they would have been anti-dilutive. +13. Accumulated Other Comprehensive Loss +The components of accumulated other comprehensive loss follow: +Foreign currency +translation +adjustment +Net prior service +credit and +actuarial losses +Total +Balances, December 31, 2017 +$ +(1,057,448 +) +$ +(576,551 +) +$ +(1,633,999 +) +Change in net prior service credit and actuarial losses, net of tax +37,388 +37,388 +Translation adjustment +(461,374 +) +(461,374 +) +Balances, December 31, 2018 +$ +(1,518,822 +) +$ +(539,163 +) +$ +(2,057,985 +) +Change in net prior service credit and actuarial losses, net of tax +143,906 +143,906 +Adoption of ASU 2018-02 +(119,014 +) +(119,014 +) +Translation adjustment +45,223 +45,223 +Balances, December 31, 2019 +$ +(1,473,599 +) +$ +(514,271 +) +$ +(1,987,870 +) +14. Financial Instruments +The carrying value of the Company’s bank debt is a reasonable estimate of fair value because of the nature of its payment terms and maturity. +15. Quarterly Data (unaudited) +Quarters (000’s omitted, except per share data): +2019 +First +Second +Third +Fourth +Total +Net sales +$ +31,370 +$ +40,220 +$ +36,995 +$ +33,872 +$ +142,457 +Cost of goods sold +19,568 +25,449 +23,861 +21,578 +90,456 +Gross profit +11,802 +14,771 +13,134 +12,294 +52,001 +Net income +807 +2,671 +1,059 +978 +5,514 +Basic earnings per share +$ +0.24 +$ +0.80 +$ +0.32 +$ +0.29 +$ +1.65 +Diluted earnings per share +$ +0.24 +$ +0.77 +$ +0.30 +$ +0.29 +$ +1.60 +Dividends per share +$ +0.12 +$ +0.12 +$ +0.12 +$ +0.12 +$ +0.48 +32 +2018 +First +Second +Third +Fourth +Total +Net sales +$ +31,709 +$ +39,751 +$ +34,731 +$ +31,130 +$ +137,321 +Cost of goods sold +19,585 +25,039 +22,281 +19,767 +86,672 +Gross profit +12,124 +14,712 +12,450 +11,363 +50,649 +Net income +764 +2,436 +807 +591 +4,598 +Basic earnings per share +$ +0.23 +$ +0.72 +$ +0.24 +$ +0.18 +$ +1.36 +Diluted earnings per share +$ +0.21 +$ +0.67 +$ +0.23 +$ +0.17 +$ +1.30 +Dividends per share +$ +0.11 +$ +0.11 +$ +0.11 +$ +0.12 +$ +0.45 +Earnings per share were computed independently for each of the quarters presented. Therefore, the sum of the four quarterly earnings per share amounts may not necessarily equal the earnings per share for the year. +16. Leases +The Company has operating leases for office and warehouse space and equipment under various arrangements which provide the right to use the underlying asset and require lease payments for the lease term. The Company’s lease portfolio consists of operating leases which expire at various dates through 2024. +Certain of the Company’s lease arrangements contain renewal provisions, exercisable at the Company's option. The Company’s lease agreements do not contain any material residual value guarantees or material restrictive covenants. +The Company determines if an arrangement is an operating lease at inception. All other leases are recorded on the balance sheet with right-of-use (“ROU”) assets representing the right to use the underlying asset for the lease term and lease liabilities representing the obligation to make lease payments arising from the lease. +ROU assets and lease liabilities are recognized at commencement date based on the present value of lease payments over the lease term and include options to extend or terminate the lease when they are reasonably certain to be exercised. As most of our leases do not provide an implicit rate, the present value of lease payments is determined primarily using our incremental borrowing rate based on the information available at the lease commencement date. Lease agreements with lease and non-lease components are generally accounted for as a single lease component. The Company’s operating lease expense is recognized on a straight-line basis over the lease term. Operating lease cost was $1.1 million for the twelve-months ended December 31, 2019. For the twelve months ended December 31, 2019, $0.4 million was included in cost of goods sold and $0.7 million was included in selling, general and administrative expenses in the accompanying condensed consolidated statements of operations. +Information related to leases (in 000’s) : +Twelve months ended +December 31, 2019 +Operating lease cost +$ +1,121 +Operating lease - cash flow +$ +1,099 +December 31, 2019 +Weighted-average remaining lease term +4.0 years +Weighted-average discount rate +5 +% +Future minimum lease payments under non-cancellable leases as of December 31, 2019: +2020 +$ +1,108 +2021 +736 +2022 +467 +2023 +462 +2024 +278 +Thereafter +295 +Total future minimum lease payments +$ +3,345 +Less : imputed interest +(337 +) +Less : present value of lease liabilities - current +(1,047 +) +Present value of lease liabilities - non-current +$ +1,962 +33 +1 7 . Subsequent Event +On January 7, 2020, the Company purchased the assets of First Aid Central, located in Laval, Quebec, Canada, including a broad line of first aid kits, refills, and safety products which are sold to a wide range of industries and end users. Its products meet federal Health Canada and provincial regulatory requirements. The Company purchased First Aid Central assets for $2.1 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. +34 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Shareholders and Board of Directors of +Acme United Corporation +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Acme United Corporation and Subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income , changes in stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2019, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company's internal control over financial reporting as of December 31, 2019, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013 and our report dated March 12, 2020 , expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Basis for Opinion +These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +We have served as the Company’s auditor since 2008; such date takes into consideration the acquisition of a portion of UHY llp by Marcum llp in April 2010. +Marcum llp +New Haven, Connecticut +March 13, 2020 +35 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING +To the Shareholders and Board of Directors of +Acme United Corporation +Opinion on Internal Control over Financial Reporting +We have audited Acme United Corporation and Subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets as of December 31, 2019 and 2018 and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows and the related notes for each of the two years in the period ended December 31, 2019 of the Company, and our report dated March 12, 2020 expressed an unqualified opinion on those financial statements. +Basis for Opinion +The Company's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management Annual Report on Internal Control over Financial Reporting”. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of the inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that degree of compliance with the policies or procedures may deteriorate. +Marcum LLP +New Haven, Connecticut +March 13, 2020 +36 +Item 9. Changes In and Disagreements with Accou ntants on Accounting and Financial Disclosure +There have been no disagreements with accountants related to accounting and financial disclosures in 2019. +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of December 31, 2019. Based on and as of the time of such evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information required to be disclosed by us in the reports that we file or submit is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. +Management's Report on Internal Control over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2019, based on the framework in Internal Control -Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation our management concluded that our internal control over financial reporting was effective as of December 31, 2019. The effectiveness of our internal control over financial reporting as of December 31, 2019 has been audited by Marcum, LLP, an independent registered public accounting firm, as stated in its attestation report, which is included in Item 8 and is incorporated into this Item 9A by reference. +Changes in Internal Control over Financial Reporting. +No changes in our internal control over financial reporting were identified as having occurred during the quarter ended December 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +Item 9B. Other Information +None. +37 +PART III +Item 10. Directors, Executive Officers and Corporate Governance +The following table sets forth certain information with respect to the directors and executive officers of the Company. All directors of the Company hold office until the next annual meeting of the shareholders or until their successors have been elected and qualified. Executive officers are elected by the Board of Directors to hold office until their successors are elected and qualified. +Name +Age +Position Held with Company +Walter C. Johnsen +69 +Chairman of the Board and Chief Executive Officer +Brian S. Olschan +63 +President, Chief Operating Officer and Director +Paul G. Driscoll +59 +Vice President, Chief Financial Officer, Secretary and Treasurer +Rex L. Davidson +70 +Director +Richmond Y. Holden, Jr. +66 +Director +Susan H. Murphy +Brian K. Barker +68 +59 +Director +Director +Stevenson E. Ward III +74 +Director +Walter C. Johnsen has served as Chairman of the Board and Chief Executive Officer of the Company since January 1, 2007; President and Chief Executive Officer of the Company from November 30, 1995 to December 31, 2006. Mr. Johnsen previously served as Vice Chairman and a principal of Marshall Products, Inc., a medical supply distributor. Mr. Johnsen has served on the Board of TOMI Environmental Solutions, Inc., a publicly traded company, since February 1, 2016. Mr. Johnsen’s qualifications to serve on the Board of the Company include the in-depth knowledge of all facets of the Company’s business which he has gained during his tenure as the Company’s Chief Executive Officer. +Brian S. Olschan has served as President and Chief Operating Officer of the Company since January 1, 2007; Executive Vice President and Chief Operating Officer of the Company from January 1999 to December 31, 2006; Senior Vice President - Sales and Marketing of the Company from September 1996 to January 1999; Mr. Olschan previously served as Vice President and General Manager of the Cordset and Assembly Business of General Cable Corporation, an electrical wire and cable manufacturer. Mr. Olschan’s qualifications to serve on the Board include his detailed knowledge of the Company’s operations which he has gained in his capacity as a member of senior management for more than eleven years, including as Chief Operating Officer since January 1999 and President since January 2007. +Paul G. Driscoll has served as Vice President and Chief Financial Officer, Secretary and Treasurer since October 2, 2002. Mr. Driscoll joined Acme as Director of International Finance on March 19, 2001. From 1997 to 2001, he was employed by Ernest and Julio Gallo Winery, including as Director of Finance and Operations in Japan. Prior to Gallo he served in several increasingly responsible finance positions in Sterling Drug Inc. in New York City and Sanofi S.A. in France. +Rex L. Davidson has served as Director since 2006. Executive Director of the Helms Fund since 2013-2019. The Helms Fund provides "gap financing" to socially responsible business ventures for capital expenditures. Additionally, since 2009, Mr. Davidson has served as President of Rex Davidson Associates, LLC, a management consulting service, and Executive Director of Las Cumbres Community Services, which provides developmental disability and mental health services to children, adults and families in Northern New Mexico. From 1982 to 2009, he served as President and Chief Executive Officer of Goodwill Industries of Greater New York and Northern New Jersey, Inc., and President of Goodwill Industries Housing Corporation. Mr. Davidson’s qualifications to serve on the Board include significant management experience at the highest level, having been responsible for the management of Goodwill Industries, an organization with over 2,000 employees and revenues in excess of $100 million. Mr. Davidson’s experience in the areas of compensation of personnel at all levels, his experience relating to retail matters, such as retail trends and pricing, and diversity policies are of significant benefit to the Company. +Richmond Y. Holden, Jr. has served as Director since 1998. Mr. Holden served as President and CEO of INgageHub, a cloud-based Marketing SaaS platform, from January 2015 through early 2016; he continued to serve as a senior advisor to the company until 2019. From 2007 through 2014, Mr. Holden served in senior executive positions at, School Specialty, Inc., a distributor of school supplies, equipment and curriculum products. He last served as Executive Vice President of School Specialty, Inc., and President of the Curriculum Group, a division of School Specialty Inc., from 2013 to December 2014. He was President of Educational Resources, a division of School Specialty, Inc., from 2010 to 2013. He served as Chairman and Chief Executive Officer of J.L. Hammett Co., a reseller of educational, curriculum, equipment, and products from 1992 to 2006. Mr. Holden served on the Board of Directors of Software Secure, Incorporated, a privately held company headquartered in Newton, MA, which focused on secure online educational testing technology, from 2007 until its sale in late 2016. He has served on the Board of Directors of Codman Academy Charter Public School in Boston MA since 2012. The qualifications of Mr. Holden to serve on the Board of the Company include his substantial senior executive management experience of large complex companies in the educational markets. In particular, as a result of his experience with School Specialty Inc., then a $650 million publicly held reseller of educational products, Mr. Holden has broad knowledge of educational markets and operational matters relating to developmental strategy, finance, marketing, sales, technology, sourcing, pricing and distribution. +38 +Susan H. Murphy has served as Director since 2003. Vice President Emerita, Cornell University, from which Dr. Murphy retired in 2016 after a 38-year career, commencing in 1978. She served as Dean of Admissions and Financial Aid from 1985 to 1994; Vice President of Student and Academic Services from 1994 to June 2015, and thereafter she worked in Alumni Affairs and Development until her retirement. In 2013, Dr. Murphy became a member of the Board of Trustees of Adelphi University, and, since July 2016, has serve d as Vice Chair of its Board of Trustees. She also serves on the Board of Directors for Kendal at Ithaca, a not-for-profit continuing care retirement community (since 2014 and Vice Chair since 2019); Tompkins County Community Foundation (since January 201 5 and Chair of the Board of Directors, 2018-2019). and Let’s Get Ready, an organization which provides low-income high school students with support services to help them gain admission to and graduate from college (2016-2019). Dr. Murphy received a Ph.D. i n Educational Administration from Cornell University. Dr. Murphy has broad senior management level experience in a large, complex organization . In particular, her experience in employee compensation matters and the development and implementation of divers ity policies is helpful to the Company . +Brian K. Barker has been a founder and CEO of AntelopeAI, LLC an artificial intelligence and machine learning start-up since December 2018. He was a founder, director, and CEO of NorthBay Solutions, LLC, a big data and analytics company from 2010 to 2018, and continues to serve as a director. Mr. Barker was the General Manager of the xDoc business unit for Document Sciences Corporation, a document management and customer communications management solutions company, from 2007 until it was acquired by EMC Corporation, an information infrastructure solutions company, in 2008, and then continued as General Manager of the xDoc Business Unit until 2010. He previously was CEO of Cambridge Technology Vision, LLC, a merger and acquisition support software company, from 1997 to 2001, and was President of ClearSpring Technologies, Inc., an event-driven management software company, from 1989 to 1992. Mr. Barker is the co- inventor of Acquisition Trustee, which Intralinks Holdings, Inc. acquired to incorporate in its platform for secure document sharing. The qualifications of Mr. Barker to serve on the Board include his strong data analysis background, significant entrepreneurial achievements, and executive management experience at rapidly growing information technology companies. +Stevenson E. Ward III has served as Director since 2001. Mr. Ward served as Vice President and Chief Financial Officer of Triton Thalassic Technologies, Inc. from 2000 until his retirement in 2014. Triton’s technology controls and inactivates pathogens in the healthcare and industrial industries. From 1998 through 2000, Mr. Ward served as Senior Vice President-Administration of Sanofi-Synthelabo, Inc., a major multinational pharmaceutical company. He served as Executive Vice President (1996-1998), responsible for legal, tax, treasury, employee benefits and other functions, and Chief Financial Officer (1994-1996) of Sanofi, Inc., the North American holding company for Sanofi. He also served as Vice President-Finance and Administration, Pharmaceutical Group, Sterling Winthrop, Inc. (1992-1994). Prior to joining Sterling, he was employed by General Electric Company in management positions in Purchasing, Corporate Audit and Finance. Mr. Ward’s qualifications for service on the Board include his extensive experience in senior executive level positions in finance, corporate audit and administration at two Fortune 100 multinational corporations. He also holds a Masters in Business Administration (MBA) degree. +Code of Conduct +The Company has adopted a Code of Conduct that is applicable to its employees, including the Chief Executive Officer, Chief Financial Officer and Controller. The Code of Conduct is available in the investor relations section on the Company’s website at www.acmeunited.com. +If the Company makes any substantive amendments to the Code of Conduct which apply to its Chief Executive Officer, Chief Financial Officer or Controller, or grants any waiver, including any implicit waiver, from a provision of the Code of Conduct to the Company’s executive officers, the Company will disclose the nature of the amendment or waiver on its website. +Information regarding compliance with Section 16(a) beneficial ownership reporting requirements and certain corporate governance matters is incorporated herein by reference to the sections entitled (i) “Compliance with Section 16(a) of the Securities Exchange Act of 1934”, (ii) “Nominations for Directors”, and (iii) “Audit Committee” contained in the Company’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with its 2020 Annual Meeting of Shareholders. +Item 11. Executive Compensation +Information with respect to executive compensation is incorporated herein by reference to the section entitled “Executive Compensation” contained in the Company’s Proxy Statement to be filed with the SEC in connection with the Company’s 2020 Annual Meeting of Shareholders. +Item 12. Security Ownership of Certain Beneficial Owners and Management +Information regarding security ownership of certain beneficial owners, directors and executive officers is incorporated herein by reference to the information in the section entitled “Security Ownership of Directors and Officers” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its 2020 Annual Meeting of Shareholders. +39 +Item 13. Certain Relationships and Relate d Transactions, and Director Independence +Information regarding certain relationships and related transactions is incorporated herein by reference to the information in the section entitled “Certain Relationships and Related Transactions” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its 2020 Annual Meeting of Shareholders. +Information regarding director independence is incorporated herein by reference to the section entitled “Independence Determinations” contained in the Company’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company’s 2020 Annual Meeting of Shareholders. +Item 14. Principal Accounting Fees and Services +Information regarding principal accountant fees and services is incorporated herein by reference to the section entitled “Fees to Auditors” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its 2020 Annual Meeting of Shareholders . +40 +PART IV +Item 15. Exhibits and Financial Statement Schedules +(a)(1) Financial Statements. +• +Consolidated Balance Sheets +• +Consolidated Statements of Operations +• +Consolidated Statements of Changes in Stockholders’ Equity +• +Consolidated Statements of Cash Flows +• +Notes to Consolidated Financial Statements +• +Report of Independent Registered Public Accounting Firm +(a)(2) Financial Statement Schedules +• +Schedules other than those listed above have been omitted because of the absence of conditions under which they are required or because the required information is presented in the financial statements or notes thereto. +(a)(3) The exhibits listed under Item 15(b) are filed or incorporated by reference herein. +(b) Exhibits. +The exhibits listed below are filed as part of this Annual Report on Form 10-K. Certain of the exhibits, as indicated, have been previously filed and are incorporated herein by reference. +Exhibit No. +Identification of Exhibit +3(i) +Re-Stated Certificate of Incorporation July 1, 2005 (2) +3(ii) +Bylaws (4) +4 +Specimen of Common Stock certificate (18) (p) +4(vi) +Description of Common Stock +10.3 +2002 Acme United Employee Stock Option Plan as amended (12) +10.4 +Severance Pay Plan dated September 28, 2004* (15) +10.5(a) +Salary Continuation Plan dated September 28, 2004, as amended (3)* +10.6(a) +2005 Non-Salaried Director Stock Option Plan, amended (6) +10.6(b) +Amendment to the 2005 Non-Salaried Director Stock Option Plan (12) +10.7 +2017 Non-Salaried Director Stock Option Plan (9) +10.8 +Deferred Compensation Plan dated October 2, 2007* (16) +10.9(a) +2012 Acme United Employee Stock Option Plan (11) +10.9(b) +Amendment to the 2012 Acme United Employee Stock Option Plan* (12) +10.10(a) +Revolving Loan Agreement with HSBC, dated April 5, 2012 (13) +10.10(b) +Amendment No. 1 to Revolving Loan Agreement with HSBC Dated (14) +10.10(c) +Amended and restated secured revolving note (14) +10.10(d) +Amendment No. 2 to Revolving Loan Agreement with HSBC dated October 2013 (15) +10.10(e) +Amendment No. 4 to Revolving Loan Agreement with HSBC dated May 6, 2016 (12) +10.10(f) +Second amended and restated secured revolving note (12) +10.10(g) +Amendment No. 5 to Revolving Loan Agreement with HSBC dated January 2017 (16) +10.10(h) +Amendment No. 6 to Revolving Loan Agreement with HSBC dated March 2018 +10.11 +Change in Control Plan as amended dated February 24, 2011* (17) +21 +Subsidiaries of the Registrant +23.1 +Consent of Marcum LLP, Independent Registered Public Accounting Firm +41 +31.1 +Certification of Walter Johnsen pursuant to Rule 13a-14(a) and 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002 +31.2 +Certification of Paul Driscoll pursuant to Rule 13a-14(a) and 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002 +32.1 +Certification of Walter Johnsen pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +32.2 +Certification of Paul Driscoll pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +* +Indicates a management contract or a compensatory plan or arrangement +(1) +Previously filed as an Exhibit to the Company’s Form 8-K/A filed on August 19, 2014. +(2) +Previously filed in the Company’s Form 8-K filed on July 8, 2005. +(3) +Previously filed in the Company’s Form 8-K filed on February 9, 2005. +(4) +Previously filed in the Company’s Form 8-K filed on March 3, 2006. +(5) +Previously filed in the Company’s Proxy Statement for the 2005 Annual Meeting of Shareholders. +(6) +Previously filed in the Company’s Proxy Statement filed on March 29, 2005. This plan expired in 2015. +(7) +Previously filed in the Company’s Form 8-K filed on December 21, 2010. +(8) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 17, 2005. +(9) +Previously filed as an exhibit to the Company’s Proxy Statement filed on March 22, 2017. +(10) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 12, 2008. +(11) +Previously filed as an exhibit to the Company’s Form 10-Q filed on August 14, 2012. +(12) +Previously filed as an exhibit to the Company’s Form 10-Q filed on May 13, 2016. +(13) +Previously filed as an exhibit to the Company’s Form 10-Q filed on May 14, 2012. +(14) +Previously filed as an exhibit to the Company’s Form 10-Q filed on May 10, 2013. +(15) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 6, 2014. +(16) +Previously filed as an exhibit to the Company’s Form 10-Q filed on August 4, 2017. +(17) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 11, 2011. +(1 8 ) +Previously filed as an exhibit to the Company’s Form 10-K filed in 1971. +Item 16. Form 10-K Summary +Not applicable. +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 13, 2020. +42 +ACME UNITED CORPORATION +(Registrant) +Signatures: +Titles: +/s/ Walter C. Johnsen +Walter C. Johnsen +Chairman and Chief Executive Officer +/s/ Brian S. Olschan +Brian S. Olschan +President, Chief Operating Officer and Director +/s/ Paul G. Driscoll +Paul G. Driscoll +Vice President, Chief Financial Officer, Secretary and Treasurer +/s/ Rex Davidson +Rex Davidson +Director +/s/ Richmond Y. Holden, Jr. +Richmond Y. Holden, Jr. +Director +/s/ Susan H. Murphy +Susan H. Murphy +Director +/s/ Stevenson E. Ward III +Stevenson E. Ward III +Director +/s/ Brian K. Barker +Brian K. Barker +Director +43 \ No newline at end of file diff --git a/raw/filings/0000002098/2019/0001564590-20-010850/filing_metadata.csv b/raw/filings/0000002098/2019/0001564590-20-010850/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..842df5447d65d3f8570b0199e31be407295d2053 --- /dev/null +++ b/raw/filings/0000002098/2019/0001564590-20-010850/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002098,ACU,ACME UNITED CORP,2019,10-K,2020-03-13,2019-12-31,2020-03-13T20:31:41.000Z,0001564590-20-010850,acu-10k_20191231.htm,10-K,9747040,1,0,https://www.sec.gov/Archives/edgar/data/2098/000156459020010850/acu-10k_20191231.htm,https://www.sec.gov/Archives/edgar/data/2098/000156459020010850/ diff --git a/raw/filings/0000002098/2019/0001564590-20-010850/item1.txt b/raw/filings/0000002098/2019/0001564590-20-010850/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..4ab078456d0a60d1be995c140f54b4d784f20f1d --- /dev/null +++ b/raw/filings/0000002098/2019/0001564590-20-010850/item1.txt @@ -0,0 +1,63 @@ +Item 1. Business +Overview +Acme United Corporation, a Connecticut corporation (together, with its subsidiaries, the "Company"), is a leading worldwide supplier of innovative safety solutions and cutting technology to the school, home, office, hardware, sporting goods and industrial markets. Its principal products sold across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid kits, and safety related products. The Company sells its products primarily to wholesale, contract and retail stationery distributors, office supply superstores, mass market and e-commerce retailers, industrial distributors, office supply super stores, sporting goods stores, hardware chains and wholesale florists. +The Company's operations are in the United States, Canada, Europe (located in Germany) and Asia (located in Hong Kong and China). The operations in the United States, Canada and Europe are primarily involved in product development, marketing, sales, administrative, manufacturing and distribution activities. The operations in Asia consist of sourcing, product development, production planning, quality control and sales activities. Total net sales in 2019 were $142.5 million. The Company was organized as a partnership in l867 and incorporated in l882 under the laws of the State of Connecticut. +The Company sources most of its products from suppliers located outside the United States, primarily in Asia. The Company assembles its first aid kits at its facilities in Vancouver, WA and Rocky Mount, NC. The components for the first aid kits are primarily sourced from U.S. suppliers. +Recent accomplishments and initiatives +The Company’s key business accomplishments and initiatives include the following elements: +• +Leader in innovative safety solutions and cutting technology; +• +Ten years of consecutive sales growth averaging 9%; +• +Innovation rate approaching 30%; +• +Premier and diversified customer base; +• +Successful history of acquisitions; +• +Diversified distribution network; strong growth in e-commerce channel; and +• +Reduced debt by 25% in 2019 +Acquisitions +On January 7, 2020, the Company purchased the assets of First Aid Central, located in Laval, Quebec, Canada. First Aid Central produces and sells a complete line of first aid kits, refills, and safety products to a broad range of industries and end users. Its products meet federal Health Canada and provincial regulatory requirements. The Company purchased First Aid Central assets for $2.1 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. Additional information concerning the acquisition of First Aid Central assets is set forth in Note 17 – Subsequent Events, in the notes to consolidated financial statements in this report. +Principal Products +The Company markets and sells under two main categories: i) cutting, sharpening and measuring; and ii) first aid and safety. The cutting, sharpening and measuring category includes school, home and office products (Westcott® brand), and hardware, industrial and sporting goods products (Clauss®, Camillus®, Cuda® and DMT® brands). The first aid and safety category includes first aid and safety products (First Aid Only®, PhysiciansCare®, Pac-Kit® and Spill Magic® brands). +CUTTING, SHARPENING AND MEASURING +School, Home and Office +Westcott +Westcott, with a history of quality dating back to 1872, provides innovative cutting and measuring products for the school, home and office as well as industrial safety cutting. Principal products under the Westcott brand include scissors, rulers, pencil sharpeners, paper trimmers, safety cutters, lettering products, glue guns and other craft products. Westcott is one of the leading scissor and ruler brands in North America. +3 +Many of the Westcott branded cutting products cont ain patented titanium bonding and proprietary non-stick coatings, making the blades more than three times harder than stainless steel as well as reducing friction and corrosion. In 2019, Westcott continu ed to build on its cutting line with an expanded ass ortment of the Saber and ceramic safety knives, allowing its customers to remain safer on the job. Also in the cutting line in 2019 , Westcott introduced the Glide technology scissor with its low friction fulcrum and adjustable tension. Westcott also conti nued to innovate in the glue gun category-launching a cordless lithium ion glue gun which heats up in 20 seconds and has a 30-minute run time. +Hardware, Industrial and Sporting Goods +Clauss +Clauss, with its roots dating back to 1877, offers a line of quality cutting tools for professionals in the hardware & industrial, lawn & garden, food processing, sewing and housewares channels. Many of the Clauss products are enhanced with the Company’s patented titanium and proprietary non-stick coatings. +Camillus +Since 1876 Camillus has been supplying innovative and high quality knives. The Camillus brand has a strong heritage in the hunting, sporting, survival and tactical markets. The Company acquired the brand in 2007 and re-launched it in 2009 with an updated and innovative line of fixed blade, folding knives, line of sight cutting tools and tactical tools. Many of the knives are enhanced with titanium carbonitride coatings to increase the hardness of the blade of up to 10 times that of untreated stainless steel. +Cuda +We launched the Cuda line of fishing tools and knives in 2014. Featuring titanium bonded German steels and alloys, Cuda tools provide world class hardness, corrosion and adhesive resistance. In July of 2014, Cuda won Best of Show in the “Fish Smart” category at the ICast show in Orlando, Florida. In January 2016, Cuda won six GOOD DESIGN awards from the Chicago Athenaeum, Museum of Architecture and Design. In 2017, Cuda launched a line of cut and puncture resistant gloves which feature quadruple layered Kevlar® and a line of telescopic landing nets featuring replaceable nets and a net containment system. In 2018, Cuda launched a Professional Series of knives, tools and fishing gaffs that are directed towards the commercial fishing market. +DMT +DMT products are leaders in diamond sharpening tools for knives, scissors, chisels, skis, skates and many other edges that require sharpening. DMT was founded in 1976 by aerospace engineers. The DMT products use a proprietary process of finely dispersed diamonds bonded to the surfaces of sharpeners and are famous for providing diamond sharpeners with the flattest sharpening surface, greatest concentrated amount of diamonds and the highest quality diamonds per sharpener. In 2017, DMT launched 12 new diamond sharpeners that include a gear-driven sharpener, sonic sharpener and pull through sharpeners that provide a simple sharpening solution for beginners as well as sharpening experts. +FIRST AID AND SAFETY +First Aid and Safety +First Aid Only +The First Aid Only brand offers first aid and safety solutions that meet regulatory requirements for a broad range of industries. The Smart Compliance® first aid system is an effective solution for maintaining OSHA compliance. The Company’s SafetyHub App technology digitizes the replenishment process for a broad range of Safety products and provides data analytics to manage costs. In 2019, we introduced our next generation SmartCompliance Complete ™ which offers a modular system that addresses first aid, bloodborne pathogen, bleed control, eyewash and OTC medication requirements for the most challenging workplace environments. +PhysiciansCare +The PhysiciansCare brand offers a variety of portable eyewash solutions and over-the counter medications, including the active ingredients aspirin, acetaminophen and ibuprofen. +Spill Magic +Spill Magic, an Acme United brand since 2017, is a leader in bodily fluid and spill clean-up solutions with a lightweight, absorbent powder that quickly encapsulates a spill. The Spill Response System provides all the necessary tools to effectively clean up spills, saving time, money and reducing slip & fall accidents in various venues, including grocery, retail, and big box stores; food service & hotel chains; municipal facilities; and industry-specific distributors in the U.S. +4 +Intellectual Property +The Company owns many patents and trademarks that are important to its business. The Company’s success depends in part on its ability to maintain patent protection for its products, to preserve its proprietary technology and to operate without infringing upon the patents or proprietary rights of others. The Company generally files patent applications in the United States and foreign countries where patent protection for its technology is appropriate and available. The Company also considers its trademarks important to the success of its business. The more significant trademarks include Westcott, Clauss, Camillus, PhysiciansCare, First Aid Only, Cuda, DMT, Pac-Kit and Spill Magic. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period remaining for intangible assets at December 31, 2019 was 10 years. +Product Distribution; Major Customers +Independent manufacturer representatives and direct sales are primarily used to sell the Company’s line of consumer products to wholesale, contract and retail stationery distributors, office supply super stores, school supply distributors, industrial distributors, wholesale florists, mass market and ecommerce retailers and hardware chains (including through their websites). The Company also sells a limited selection of its products directly to consumers through its own websites. The Company had one customer in 2019 and 2018 that individually exceeded 10% of consolidated net sales. Net sales to this one customer were approximately 17% and 16% of consolidated net sales in 2019 and 2018, respectively. +Competition +The Company competes with many companies in each market and geographic area. The Company believes that the principal points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. The major competitors in the cutting category are 3M and Fiskars Corporation. The major competitor in the pencil sharpener category is Bostitch and Elmers. The major competitors in the first aid and safety category are Honeywell and Cintas. +Seasonality +Traditionally, the Company’s sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the back-to-school market. +Compliance with Environmental Laws +The Company believes that it is in compliance with applicable environmental laws. The Company anticipates that no material adverse financial impact will result from compliance with current environmental rules and regulations. +Employees +As of December 31, 2019, the Company employed 441 people, all of whom are full time and none of whom is covered by union contracts. Employee relations are considered good and no foreseeable problems with the work force are evident. +Available Information +You may obtain at no charge, a copy of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports on the Company’s website at http://www.acmeunited.com or by contacting the Investor Relations Department at the Company’s corporate offices by calling (203) 254-6060. Such reports and other information are made available as soon as reasonably practicable after such material is filed with or furnished to the SEC. \ No newline at end of file diff --git a/raw/filings/0000002098/2019/0001564590-20-010850/item13.txt b/raw/filings/0000002098/2019/0001564590-20-010850/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..ca5d40a11a0bfc73add3ab6f1cb9e7a81e5ec5c5 --- /dev/null +++ b/raw/filings/0000002098/2019/0001564590-20-010850/item13.txt @@ -0,0 +1,2 @@ +Item 13. 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+2020-12-31 +0000002098 +acu:MedNapLLCMember +2020-12-16 +2020-12-16 +0000002098 +acu:MedNapLLCMember +2020-12-16 +0000002098 +acu:FirstAidCentralMember +2020-01-07 +2020-01-07 +0000002098 +acu:FirstAidCentralMember +2020-01-07 +0000002098 +acu:FirstAidCentralMember +2019-01-01 +2019-12-31 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D. C. 20549 +FORM 10-K +☒ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended: December 31, 2020 +or +☐ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from: ___________ to ___________ +Commission file number: 01-07698 +ACME UNITED CORP ORATION +(Exact Name of Registrant as Specified in Its Charter) +Connecticut +06-0236700 +State or Other Jurisdiction of +I.R.S. Employer Identification No. +Incorporation or Organization +55 Walls Drive , Fairfield , Connecticut +06824 +Address of Principal Executive Offices +Zip Code +Registrant's telephone number, including area code: ( 203 ) 254-6060 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +$2.50 par value Common Stock +ACU +NYSE American +Securities registered pursuant to Section 12 (g) of the Act: None +(Title of Class) +Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (sec. 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act (Check one). +Large accelerated filer ☐ +Accelerated filer ☒ +Non-accelerated filer ☐ +Smaller Reporting Company ☒ +Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) . Yes ☐ No ☒ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 USC. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. Yes ☒ No ☐ +The aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter was $ 67,031,281 . +Registrant had 3,342,210 shares of its $2.50 par value Common Stock outstanding as of March 12, 2021. +DOCUMENTS INCORPORATE BY REFERENCE +(1) Certain portions of the Company’s Proxy Statement for the Annual Meeting scheduled for April 20, 2021 are incorporated into the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, in Part III. +Page +Part I +Item 1. Business +3 +Item 1A. Risk Factors +6 +Item 1B. Unresolved Staff Comments +13 +Item 2. Properties +13 +Item 3. Legal Proceedings +13 +Item 4. Mine Safety Disclosures +13 +Part II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +14 +Item 6. Selected Financial Data +14 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +15 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +19 +Item 8. Financial Statements and Supplementary Data +19 +Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +41 +Item 9A. Controls and Procedures +41 +Item 9B. Other Information +41 +Part III +42 +Item 10. Directors, Executive Officers and Corporate Governance +42 +Item 11. Executive Compensation +43 +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +43 +Item 13. Certain Relationships and Related Transactions, and Director Independence +44 +Item 14. Principal Accounting Fees and Services +44 +Part IV +Item 15. Exhibits and Financial Statement Schedules +45 +Item 16. Form 10-K Summary +46 +Signatures +47 +2 +PART I +Item 1. Business +Overview +Acme United Corporation, a Connecticut corporation (together, with its subsidiaries, the "Company"), is a leading worldwide supplier of innovative first aid and safety solutions and cutting technology to the school, home, office, hardware, sporting goods and industrial markets. Its principal products sold across all segments are first aid kits, and safety related products, scissors, shears, knives, rulers, pencil sharpeners and sharpening tools. The Company sells its products primarily to wholesale, contract and retail stationery distributors, office supply superstores, mass market and e-commerce retailers, industrial distributors, sporting goods stores, hardware chains and wholesale florists. +The Company's operations are in the United States, Canada, Europe (located in Germany) and Asia (located in Hong Kong and China). The operations in the United States, Canada and Europe are primarily involved in product development, marketing, sales, administrative, manufacturing and distribution activities. The operations in Asia consist of sourcing, product development, production planning, quality control and sales activities. Total net sales in 2020 were $164.0 million. The Company was organized as a partnership in l867 and incorporated in l882 under the laws of the State of Connecticut. +The Company sources most of its products from suppliers located outside the United States, primarily in Asia. The Company assembles its first aid kits at its facilities in Vancouver, WA and Rocky Mount, NC. The components for the first aid kits are primarily sourced from U.S. suppliers. In addition, the Company has manufacturing facilities in the U.S. at Smyrna, TN and Santa Ana, CA for Spill Magic absorbent products, Marlborough, MA for DMT sharpening tools, and Brooksville, FL for Med-Nap alcohol and BZK wipes. +Recent accomplishments and initiatives +The Company’s key business accomplishments and initiatives include the following elements: +• +Eleven years of consecutive sales growth averaging 10%; +• +Diversification of Product Lines – D uring the past five years, sales of first aid and safety products have grown to almost 50% of total sales. As a result, our reliance on sales of school and office products has declined, although such sales have remained steady; +• +Growth of eCommerce Sales – In 2020, sales in the eCommerce channel grew substantially and Amazon has become the Company’s second largest customer. The Company has taken a number of actions to support our growth in eCommerce, including the modification of its principal distribution center by upgrading its warehouse layout, installing a mezzanine to handle small packages, and installing new warehouse management software; +• +S uccessful acquisition of two businesses in our first aid and safety space in 2020. +- +The acquisition and successful integration of the business and assets of First Aid Central, a Montreal-based supplier of first aid kits and safety supplies acquired in January 2020; +- +The acquisition of the business and assets of Med-Nap LLC, a Florida-based manufacturer of antiseptic prep pad and towelette solutions in December 2020; +• +Successful Response to Pandemic – Commencing in 2020, the Company has taken decisive actions to respond to the unprecedented uncertainty and disruption caused by the pandemic. As a result, the Company has been able to continue to meet the needs of its customers in 2020 without interruption. These actions included: +- +taking steps to protect our global workforce, including travel restrictions, work-from-home requirements and preventative measures at our sites; +- +shifting its sales force to focus on eCommerce and retailers that it believed would be most able to serve its customers during the pandemic; also enhancing eCommerce content and search; +- +procuring large quantities of first aid products and components to meet the surge in demand for such products resulting from the pandemic; +- +adding additional inventory across its product lines and proactively managing its supply chains to minimize the impact of disruptions and potential disruptions and to ensure supply chain continuity; +- +managing through macroeconomic uncertainty created by the pandemic by preserving the Company’s liquidity, engaging in cash preservation initiatives, and cost control measures; +3 +• +Environmental Footprint - The Company continued in 2020 to take steps to improve its environmental footprint. It increased its efforts to use recycled cardboard, plastic, and steel in its products and has succeeded in reducing the use of cardboard and plastic packaging. In 2020, the Company commenced the installation of new software to reduce the size and usage of boxes for shipping, which not only saves packing material but also improves the efficiency of the delivery system. +Acquisitions +On December 16, 2020, the Company purchased the assets of Med-Nap LLC., located in Brooksville, Florida. Med-Nap is a leading manufacturer of alcohol prep pads, alcohol wipes, benzalkonium chloride wipes (BZK), antiseptic wipes, castile soap, and lens cleaning products. The Company purchased Med-Nap assets for $9.3 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. +On January 7, 2020, the Company purchased the assets of First Aid Central, located in Laval, Quebec, Canada. The First Aid Central line of first aid kits, refills, and safety products to a broad range of industries and end users. Its products meet federal Health Canada and provincial regulatory requirements. The Company purchased First Aid Central assets for $2.1 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. +Additional information concerning the acquisition of Med-Nap, LLC and First Aid Central assets is set forth in Note 17 – Business Combinations, in the Notes to Consolidated Financial Statements in this report. +Principal Products +The Company markets and sells under two main categories: i) first aid and safety; and ii) cutting, sharpening and measuring. The first aid and safety category includes first aid and safety products (First Aid Only®, PhysiciansCare®, Pac-Kit®, Spill Magic®, First Aid Central® and Med-Nap brands). The cutting, sharpening and measuring category includes school, home and office products (Westcott® brand), and hardware, industrial and sporting goods products (Clauss®, Camillus®, Cuda® and DMT® brands). +FIRST AID AND SAFETY +First Aid and Safety +First Aid Only +The First Aid Only brand offers first aid and safety solutions that meet regulatory requirements for a broad range of industries. The Smart Compliance® first aid system is an effective solution for maintaining OSHA compliance. The Company’s SafetyHub App technology digitizes the replenishment process for a broad range of Safety products and provides data analytics to manage costs. In 2019, we introduced our next generation SmartCompliance Complete ™ which offers a modular system that addresses first aid, bloodborne pathogen, bleed control, eyewash and OTC medication requirements for the most challenging workplace environments. +PhysiciansCare +The PhysiciansCare brand offers a variety of portable eyewash solutions and over-the counter medications, including the active ingredients aspirin, acetaminophen and ibuprofen. +Spill Magic +Spill Magic, an Acme United brand since 2017, is a leader in bodily fluid and spill clean-up solutions with a lightweight, absorbent powder that quickly encapsulates a spill. The Spill Response System provides all the necessary tools to effectively clean up spills, saving time, money and reducing slip & fall accidents in various venues, including grocery, retail, and big box stores; food service & hotel chains; municipal facilities; and industry-specific distributors in the U.S. +First Aid Central +First Aid Central has been a trusted provider and manufacturer of a wide variety of first aid kits and safety supplies since 2007. They assist Canadian businesses to stay compliant with federal & provincial first aid and safety regulations through their wide variety of first aid kits, refills, and safety supplies, including CPR kits, burn kits and automotive & emergency survival Kits. +Med-Nap +Med-Nap manufactures critical FDA regulated components found in first aid kits and used by healthcare facilities, including alcohol prep pads, alcohol wipes, benzalkonium chloride wipes (BZK), various antiseptic wipes, castile soap, and lens cleaning wipes. Med-Nap provides to the Company vertical integration advantages including shorter delivery times, lower total costs, and a secure U.S. source of supply during unprecedented healthcare challenges. The facilities offer a platform for future product expansion. +4 +CUTTING, SHARPENING AND MEASURING +School, Home and Office +Westcott +Westcott, with a history of quality dating back to 1872, provides innovative cutting and measuring products for the school, home and office as well as industrial safety cutting. Principal products under the Westcott brand include scissors, rulers, pencil sharpeners, paper trimmers, safety cutters, lettering products, glue guns and other craft products. Westcott is one of the leading scissor and ruler brands in North America. +Many of the Westcott branded cutting products contain patented titanium bonding and proprietary non-stick coatings, making the blades more than three times harder than stainless steel as well as reducing friction and corrosion. Westcott continues to build on its cutting line with an expanded assortment of the Saber and ceramic safety knives, allowing its customers to remain safer on the job. Also in the cutting line, Westcott has recently introduced the Glide technology scissor with its low friction fulcrum and adjustable tension. Westcott also continued to innovate in the glue gun category-launching a cordless lithium-ion glue gun which heats up in 20 seconds and has a 30-minute run time. +Hardware, Industrial and Sporting Goods +Clauss +Clauss, with its roots dating back to 1877, offers a line of quality cutting tools for professionals in the hardware & industrial, lawn & garden, food processing, sewing and housewares channels. Many of the Clauss products are enhanced with the Company’s patented titanium and proprietary non-stick coatings. +Camillus +Since 1876 Camillus has been supplying innovative and high-quality knives. The Camillus brand has a strong heritage in the hunting, sporting, survival and tactical markets. The Company acquired the brand in 2007 and re-launched it in 2009 with an updated and innovative line of fixed blade, folding knives, line of sight cutting tools and tactical tools. Many of the knives are enhanced with titanium carbonitride coatings to increase the hardness of the blade of up to 10 times that of untreated stainless steel. +Cuda +The Cuda line of fishing tools and knives was launched in 2014. Featuring titanium bonded German steels and alloys, Cuda tools provide world class hardness, corrosion and adhesive resistance. In 2014, Cuda won Best of Show in the “Fish Smart” category at the ICast show in Orlando, Florida. In 2016, Cuda won six GOOD DESIGN awards from the Chicago Athenaeum, Museum of Architecture and Design. In 2017, Cuda launched a line of cut and puncture resistant gloves which feature quadruple layered Kevlar® and a line of telescopic landing nets featuring replaceable nets and a net containment system. In 2018, Cuda launched a Professional Series of knives, tools and fishing gaffs that are directed towards the commercial fishing market. +DMT +DMT products are leaders in diamond sharpening tools for knives, scissors, chisels, skis, skates and many other edges that require sharpening. DMT was founded in 1976 by aerospace engineers. The DMT products use a proprietary process of finely dispersed diamonds bonded to the surfaces of sharpeners and are famous for providing diamond sharpeners with the flattest sharpening surface, greatest concentrated amount of diamonds and the highest quality diamonds per sharpener. In 2017, DMT launched 12 new diamond sharpeners that include a gear-driven sharpener, sonic sharpener and pull through sharpeners that provide a simple sharpening solution for beginners as well as sharpening experts. +Intellectual Property +The Company owns many patents and trademarks that are important to its business. The Company’s success depends in part on its ability to maintain patent protection for its products, to preserve its proprietary technology and to operate without infringing upon the patents or proprietary rights of others. The Company generally files patent applications in the United States and foreign countries where patent protection for its technology is appropriate and available. The Company also considers its trademarks important to the success of its business. The more significant trademarks include Westcott, Clauss, Camillus, PhysiciansCare, First Aid Only, Cuda, DMT, Pac-Kit, Spill Magic and First Aid Central. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period remaining for intangible assets at December 31, 2020 was 9 years. +Product Distribution; Major Customers +Independent manufacturer representatives and direct sales are primarily used to sell the Company’s line of consumer products to wholesale, contract and retail stationery distributors, office supply super stores, school supply distributors, industrial distributors, wholesale florists, mass market and ecommerce retailers and hardware chains (including through their websites). The Company also sells a limited selection of its products directly to consumers through its own websites. The Company had two customers in 2020 and one customer in 2019 that individually exceeded 10% of consolidated net sales. Net sales to these two customers were approximately 18% and 13% of consolidated net sales in 2020 and 17% in 2019. +5 +Competition +The Company competes with many companies in each market and geographic area. The Company believes that the principal points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. The major competitors in the cutting category are 3M and Fiskars Corporation. The major competitor in the pencil sharpener category are Bostitch and Elmers. The major competitors in the first aid and safety category are Honeywell and Cintas. +Seasonality +Traditionally, the Company’s sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the back-to-school market. +Compliance with Environmental Laws +The Company believes that it is in compliance with applicable environmental laws. The Company anticipates that no material adverse financial impact will result from compliance with current environmental rules and regulations. +Employees and Human Capital Considerations +As of December 31, 2020, the Company employed 552 people, all of whom are full time and none of whom is covered by union contracts. Employee relations are considered good and no foreseeable problems with the work force are evident. +Available Information +You may obtain at no charge, a copy of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports on the Company’s website at http://www.acmeunited.com or by contacting the Investor Relations Department at the Company’s corporate offices by calling (203) 254-6060. Such reports and other information are made available as soon as reasonably practicable after such material is filed with or furnished to the SEC. +Item 1A. Risk Factors +Ownership of the Company’s securities involves a number of risks and uncertainties. Potential investors should carefully consider the risks and uncertainties described below and the other information in this Annual Report on Form 10-K before deciding whether to invest in the Company’s securities. The Company’s business, financial condition or results of operations could be materially adversely affected by any of these risks. The risks described below are not the only ones facing the Company. Additional risks that are currently unknown to the Company or that the Company currently considers immaterial may also impair its business or adversely affect its financial condition or results of operations. +Industry and Operational Risks +The Company is subject to a number of significant operational risks that might cause the Company’s actual results to vary materially from its forecasts, targets or projections, including: +• +achieving planned revenue and profit growth in each of the Company's business segments; +• +changes in customer requirements and in the volume of sales to principal customers; +• +the ability of the Company to anticipate timing of orders and shipments particularly in the ecommerce area; +• +emergence of new competitors or consolidation of existing competitors; and +• +industry demand fluctuations. +The Company’s expectations for both short and long-term future net revenues are based on the Company’s estimates of future demand. Orders from the Company’s principal customers are ultimately based on demand from end-users and end-user demand can be difficult to predict. During the prior year, as a result of the COVID pandemic, the Company had difficulty in forecasting demand for its products. Low end-user demand would negatively affect orders the Company receives from distributors and other principal customers which could, in turn adversely affect the Company’s revenues in any fiscal period. If the Company’s estimates of sales are not accurate and the Company experiences unforeseen variability in its revenues and operating results, the Company may be unable to adjust its expense levels accordingly and its profit margins could be adversely affected. +6 +We have identified a material weakness in our internal control over financial reporting which could, if not remediated, result in material misstatements in our financial statements. +We have identified a material weakness in our internal control over financial reporting, as described below. A material weakness is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. In connection with the preparation of our annual report for the year ended December 31, 2020, we identified a deficiency related to the Company’s inventory cycle count program at our Rocky Mount, NC warehouse (the Warehouse). Specifically, the Company’s controls related to the existence of inventory at the Warehouse were not effective as the cycle count program used did not demonstrate inventory quantities were sufficiently counted. We have evaluated the processes, procedures and controls related to the Warehouse cycle count program and have commenced making changes as considered appropriate to address the control deficiency. We are in the process of implementing a new inventory management system and are allocating additional resources to the implementation of our inventory cycle count program. The actions deemed taken are subject to continued review, supported by monitoring and testing by management as well as audit committee oversight. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control are discovered or occur in the future, our ability to report our financial condition and results of operations in a timely and accurate manner may be materially adversely affected and investor confidence in the Company may be negatively impacted. +Because our products are primarily sold by third parties, our financial results depend in part on the financial health of these parties and any loss of a third-party distributor could adversely affect the Company’s revenues. +A large majority of the Company’s products are sold through third-party distributors and large retailers. Some of our distributors also market products that compete with our products. Changes in the financial or business conditions or the purchasing decisions of these third parties or their customers could affect our sales and profitability. +Additionally, no assurances can be given that any or all of such distributors or retailers will continue their relationships with the Company. Distributors and other significant retail customers cannot easily be replaced and the loss of revenues and the Company’s inability to reduce expenses to compensate for the loss of revenues could adversely affect the Company’s net revenues and profit margins. +The ability to deliver products to our customers in a timely manner and to satisfy our customers’ fulfillment standards are subject to many factors, some of which are beyond our control. These factors presently include the impact of the COVID-19 pandemic on the Company. +Customers place great emphasis on timely delivery of our products for specific selling seasons, especially during our second and third fiscal quarters, and on the fulfillment of consumer demand throughout the year. We cannot control all of the various factors that might affect product delivery to customers. Vendor production delays, cybersecurity attacks on our vendors, difficulties encountered in shipping from overseas and customs clearance delays are on-going risks of our business. We also rely upon third-party carriers for our product shipments from our distribution centers to customers. Accordingly, we are subject to risks, including labor disputes, inclement weather, natural disasters, cybersecurity attacks, possible acts of terrorism, availability of shipping containers, and increased security restrictions associated with such carriers’ ability to provide delivery services to meet our shipping needs. In 2020, the COVID-19 pandemic caused disruptions in our supply chain as a result of shortages of factory workers, travel restrictions, barriers to the movement of goods, and temporary closures of production facilities and distribution centers. Failure to deliver products to our customers in a timely and effective manner, often under special vendor requirements to use specific carriers and delivery schedules, could damage our reputation and brands and result in loss of customers or reduced orders. +The Company’s business is subject to risks associated with seasonality which could adversely affect its cash flow, financial condition, or results of operations. +The Company’s business, historically, has experienced higher sales volume in the second and third quarters of the calendar year, when compared to the first and fourth quarters. The Company is a major supplier of products related to the “back-to-school” season, which occurs principally during the months of May through August. If this typical seasonal increase in sales of certain portions of the Company’s product line does not materialize in any year for any reason, including the impact of the COVID-19 pandemic, the Company could experience a material adverse effect on its business, financial condition and results of operations. +Failure to manage growth and continue to expand our operations successfully could adversely affect our financial results. +Our business has experienced significant historical growth over the years including through two new strategic acquisitions in 2020. We expect our business to continue to grow organically and through strategic acquisitions both domestically and internationally. This growth places significant demands on management and operational systems. If we cannot effectively manage our growth, we would likely experience operational inefficiencies and incur unanticipated costs, thus negatively impacting our operating results. To the extent we grow through strategic acquisitions, our success will depend on selecting the appropriate targets, integrating such acquisitions quickly and effectively and realizing any expected synergies and cost savings related to such acquisitions. +7 +Unfavorable shifts in industry-wide demand for the Company’s products could result in inventory valuation risk. +The Company evaluates its ending inventories for excess quantities, impairment of value, and obsolescence. This evaluation includes analysis of sales levels by product and projections of future demand based upon input received from our customers, sales team, and management. If inventories on hand are in excess of demand or slow moving, appropriate write-downs may be recorded. In addition, the Company might have to write off inventories that are considered obsolete based upon changes in customer demand, product design changes, or new product introductions, which eliminate demand for existing products. Historically, the Company has not had to write down or write off product inventories. +Loss of a major customer could result in a decrease in the Company’s future sales and earnings. +Sales of our products are primarily concentrated in a few major customers including office product superstores and mass market distributors. The Company had two customers in 2020 and one customer in 2019 that individually exceeded 10% of consolidated net sales. Net sales to those customers were approximately 18% and 13% in 2020 and 17% in 2019, respectively. The Company anticipates that a limited number of customers may account for a substantial portion of its total net revenues for the foreseeable future. The business risks associated with this concentration, including increased credit risks for these and other customers and the possibility of related bad debt write-offs, could negatively affect our margins and profits. Additionally, the loss of a major customer, whether through competition or consolidation, or a disruption in sales to such a customer, could result in a decrease of the Company’s future sales and earnings. +The loss of key management could adversely affect the Company’s ability to run its business. +The Company’s success depends, to a large extent, on the continued service of its executive management team, operating officers and other key personnel. The Company must therefore continue to recruit, retain and motivate management and operating personnel sufficient to maintain its current business and support its projected growth. The Company’s inability to meet its staffing requirements in the future could adversely affect its results of operations. +Execution or the lack thereof, of our e-commerce business may reduce our operating results. +Our e-commerce business constituted approximately 16% of our net sales in 2020 and has been our fastest growing distribution channel over the last several years. The continued successful growth of our e-commerce business depends, in part, on third parties and factors over which we have limited control, including difficulty forecasting demand, changing consumer preferences, and e-commerce buying trends, both domestically and abroad, as well as promotional or other advertising initiatives employed by our customers or other third parties on their e-commerce sites. Additionally, sales in our e-commerce distribution channel may also divert sales from our other customers. +Additionally, the success of our e-commerce business depends, in part, on the timely receipt of our products by our customers and their end users. The efficient flow of our products requires that our distribution facilities have adequate capacity to support increases in our e-commerce business. If we encounter difficulties with forecasting demand and supply to our distribution facilities, we could face shortages of inventory, resulting in “out of stock” conditions in the e-commerce sites operated by our customers or other third parties, and we could incur significantly higher costs and longer lead times associated with distributing our products to our customers. +Our failure to successfully respond to these risks and uncertainties might adversely affect the sales in our e-commerce business, as well as damage our brands. +The Company is subject to intense competition in all of the markets in which it competes. +The Company’s products are sold in highly competitive markets including at mass merchants, high volume office supply stores and online. The Company believes that the principal points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. Competitive conditions may require the Company to match or better competitors’ prices to retain business or market shares. The Company believes that its competitive position will depend on continued investment in innovation and product development, manufacturing and sourcing, quality standards, marketing and customer service and support. The Company’s success will depend in part on its ability to anticipate and offer products that appeal to the changing needs and preferences of our customers in the various market categories in which it competes. The Company may not have sufficient resources to make the investments that may be necessary to anticipate those changing needs and the Company may not anticipate, identify, develop and market products successfully or otherwise be successful in maintaining its competitive position. In addition, there are numerous uncertainties inherent in successfully developing and commercializing innovative new products on a continuing basis, and new product launches may not provide expected growth results. There are no significant barriers to entry into the markets for most of the Company’s products. +Compromises of our information systems or unauthorized access to confidential information or our customers' or associates' personal information may materially harm our business or damage our reputation. +Through our sales and marketing activities and our business operations, we collect and store confidential information and certain personal information from our customers and associates. We also process payment card information and check information. In addition, in the normal course of business, we gather and retain personal information about our associates and generate and have access to confidential business information. Although we have taken steps designed to safeguard such information, there can be no assurance that such information will be +8 +protected against unauthorized access or disclosure. Computer hackers may attempt to penetrate our or our vendors' network security and, if successful, misappropriate such information. An employee of the Company, contractor or other third-party with whom we do business may also attempt to circumvent our security measures in order to obtain such information or inadvertently cause a breach involving such information. We could be subject to liability for failure to comply with privacy and information security laws, for failing to protect personal information, or for misusing personal information, such as use of such information for an unauthorized marketing purpose. Any compromise of our systems or data could disrupt our operations, damage our reputation, and expose us to claims from customers, financial institutions, regulators, payment card associations, employees , and other persons, any of which could have an adverse effect on our business, financial condition and results of operations. +The Company may not be able to maintain or to raise prices in response to increasing costs or inflation. +Future market and competitive pressures may prohibit the Company from raising prices to offset increased product costs, shipping costs and other inflationary items, whether due to increases in the costs of raw materials or components or to the COVID-19 pandemic, or to offset currency fluctuations. The inability to pass these costs through to the Company’s customers could have a negative effect on its results of operations. +The Company may need to raise additional capital to fund its operations. +The Company’s management believes that, under current conditions, the Company’s current cash and cash equivalents, cash generated by operations, together with the borrowing availability under its revolving loan agreement with HSBC Bank N.A., will be sufficient to fund planned operations for the next twelve months from the issuance date of this report. However, if the Company is unable to generate sufficient cash from operations, it may be required to find additional funding sources. If adequate financing is unavailable or is unavailable on acceptable terms, the Company may be unable to maintain, develop or enhance its operations, products, and services, take advantage of future opportunities or adequately respond to competitive pressures. +Changes in interest rates could adversely affect us . +We have exposure to increases in interest rates under our revolving credit loan agreement with HSBC Bank, N.A. which presently bears interest at the Prime Rate less 1.25%. In response to the last global economic recession, actions of the U.S. Federal Reserve and other central banking institutions were taken to create and maintain a low interest rate environment. Increases in interest rates would increase our interest costs on our variable-rate debt as well as any future fixed rate debt. Any increase in the interest which we pay would reduce our cash available for working capital, acquisitions, and other uses. +Legal and Regulatory Risks +Failure to protect the Company’s proprietary rights or the costs of protecting these rights could adversely affect its business. +The Company’s success depends in part on its ability to obtain patents and trademarks and to preserve other intellectual property rights covering its products and processes. The Company has obtained certain domestic and foreign patents and intends to continue to seek patents on its inventions when appropriate. The process of seeking patent protection can be time consuming and expensive. There can be no assurance that pending patents related to any of the Company’s products will be issued, in which case the Company may not be able to legally prevent others from producing similar and/or compatible competing products. If other companies were to sell similar and/or compatible competing products, the Company’s results of operations could be adversely affected. Furthermore, there can be no assurance that the Company’s efforts to protect its intellectual property will be successful. Any infringement of the Company’s intellectual property could have a material adverse effect on the Company. +If the Company is found to have infringed the intellectual property rights of others or cannot obtain necessary intellectual property rights from others, its competitiveness could be negatively impaired. +If the Company is found to have violated the trademark, trade secret, copyright, patent or other intellectual property rights of others, directly or indirectly, including through the use of third-party marks, ideas, or technologies, such a finding could result in the need to cease use of such mark, trade secret, copyrighted work or patented invention in the Company’s business, as well as the obligation to pay for past infringement. If rights holders are willing to permit the Company to continue to use such intellectual property rights, they could require a payment of a substantial amount for continued use of those rights. Either ceasing use or paying such amounts could cause the Company to become less competitive and could have a material adverse effect on the Company’s business, financial condition, and results of operations. +Even if the Company is not found to infringe a third party’s intellectual property rights, claims of infringement could adversely affect the Company’s business. The Company could incur significant legal costs and related expenses to defend against such claims, and the Company could incur significant costs associated with discontinuing to use, provide, or manufacture certain products, services or trademarks even if it is ultimately found not to have infringed such rights. +Product liability claims or regulatory actions could adversely affect the Company's financial results and reputation. +Claims for losses or injuries allegedly caused by some of the Company’s products could arise in the ordinary course of its business. In addition to the risk of substantial monetary judgments, product liability claims or regulatory actions could result in negative publicity that could harm the Company’s reputation in the marketplace or the value of its brands. The Company also could be required to recall possible defective products, which could result in adverse publicity and significant expenses. Although the Company maintains product liability insurance +9 +coverage, potential product liability claims are subject to a deductible or could be excluded under the terms of the policy. Historically, the Company has not experienced product liability claims or regulatory actions. +The Company’s businesses and operations are subject to regulation in the U.S. and abroad. +Changes in laws, regulations and related interpretations may alter the environment in which the Company does business. This includes changes in environmental, data privacy, competitive and product-related laws, as well as changes in accounting standards, taxation and other regulations. Accordingly, regulatory, tax and legal contingencies (including environmental, human resource, product liability, patent and other intellectual property matters), should they exist in the future, could require the Company to record significant reserves or pay significant fines or damages during a reporting period, which could materially impact the Company’s results. In addition, new regulations may be enacted in the U.S. or abroad that may require the Company to incur additional personnel-related, environmental or other costs on an ongoing basis, significantly restrict the Company’s ability to sell certain products, or incur fines or penalties for noncompliance, any of which could adversely affect the Company’s results of operations. +As a U.S.-based multinational company, the Company is also subject to tax regulations in the U.S. and multiple foreign jurisdictions, some of which are interdependent. For example, certain income that is earned and taxed in countries outside the U.S. may not be taxed in the U.S. until those earnings are actually repatriated or deemed repatriated. If these or other tax regulations should change, the Company’s financial results could be impacted. +Certain or our products and facilities are subject to regulation by the FDA and by analogous foreign regulators. +The FDA requires us to register certain of our products and manufacturing facilities. The FDA also inspects these facilities and products to confirm compliance with its requirements. There can be no assurance that we will be able to continue to comply with FDA requirements applicable to our current products and facilities or any product or facility we may establish in the future. The failure to address any concerns raised by the FDA could also lead to facility shutdown or the delay or withholding of product approval by the FDA, or product recalls, and could have a material adverse effect on our business, results of operations and financial condition +The Company is subject to environmental regulation and environmental risks. +The Company is subject to national, state, provincial and/or local environmental laws and regulations that impose limitations and prohibitions on the discharge and emission of, and establish standards for the use, disposal and management of, certain materials and waste. These environmental laws and regulations also impose liability for the costs of investigating and cleaning up sites, and certain damages resulting from present and past spills, disposals, or other releases of hazardous substances or materials. Environmental laws and regulations can be complex and may change often. Capital and operating expenses required to comply with environmental laws and regulations can be significant, and violations may result in substantial fines and penalties. In addition, environmental laws and regulations, such as the Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, in the United States impose liability on several grounds for the investigation and clean-up of contaminated soil, ground water and buildings and for damages to natural resources on a wide range of properties. For example, contamination at properties formerly owned or operated by the Company, as well as at properties it will own and operate, and properties to which hazardous substances were sent by the Company, may result in liability for the Company under environmental laws and regulations. The costs of complying with environmental laws and regulations and any claims concerning noncompliance, or liability with respect to contamination in the future could have a material adverse effect on the Company’s financial condition or results of operations. +Risks Related to Our Overseas Operations +Reliance on foreign suppliers could adversely affect the Company’s business. +The Company sources its products from suppliers located in Asia, Europe and the United States. The Company’s Asia vendors are located primarily in China, which subjects the Company to various risks within the region including regulatory, political, economic and foreign currency changes, and, commencing in 2020, the impact of the COVID-19 pandemic. The Company’s ability to continue to select and retain reliable vendors and suppliers who provide timely deliveries of quality products efficiently will impact its success in meeting customer demand for timely delivery of quality products. +The Company’s sourcing operations and its vendors are impacted by labor costs in China. Labor historically has been readily available at low cost relative to labor costs in North America. However, as China is experiencing rapid social, political and economic changes, labor costs have risen in some regions and there can be no assurance that labor will continue to be available to the Company’s suppliers in China at costs consistent with historical levels or that changes in labor or other laws will not be enacted which would have a material adverse effect on the Company’s operations in China. Interruption of supplies from any of the Company’s vendors, or the loss of one or more key vendors, could have a negative effect on the Company’s business and operating results. +Changes in currency exchange rates might negatively affect the profitability and business prospects of the Company and its overseas vendors. In particular, the Chinese Renminbi has recently fluctuated against the U.S. Dollar. If the Chinese Renminbi continues to fluctuate with respect to the U.S. Dollar in the future, the Company may experience cost increases on such purchases, and this can adversely impact profitability. Future interventions by China may result in further currency appreciation and increase our product costs over time. The Company may not be successful at implementing customer pricing or other actions in an effort to mitigate the related effects of the product cost increases. +10 +Additional factors that could adversely affect the Company’s business include increases in transportation costs, new or increased import duties, transportation delays, work stoppages, capacity constraints and poor quality; the possibility that the Company might experience any of these factors has been increased by the COVID-19 pandemic. +The Company’s operations are increasingly global in nature. Our business, financial condition and results of operations could be adversely affected by the political and economic conditions in the countries in which we conduct business, by fluctuations in currency exchange rates and other factors related to our international operations. +As our international operations and activities expand, we face increasing exposure to the risks of operating in foreign countries. These factors include: +• +Changes generally in political, regulatory or economic conditions in the countries in which we conduct business; +• +Trade protection measures in favor of local producers of competing products, including government subsidies, tax benefits, changes in local tax rates, trade actions (such as anti-dumping proceedings) and other measures giving local producers a competitive advantage over the Company; +• +Changes in foreign currency exchange rates which could adversely affect our competitive position, selling prices and manufacturing costs, and therefore the demand for our products in a particular market; and +• +The duration, severity, spread and recurrence of the COVID-19 pandemic in foreign countries, including through variant strains of the underlying virus. +These risks could affect the cost of manufacturing and selling our products, our pricing, sales volume, and ultimately our financial performance. The likelihood of such occurrences and their potential effect on the Company vary from country to country and are unpredictable. +Continuing uncertainty in the global economy could negatively impact our business. +Uncertainty in the global economy could adversely affect our customers and our suppliers and businesses such as ours. In addition, any uncertainty could have a variety of negative effects on the Company, such as reduction in revenues, increased costs, lower gross margin percentages, increased allowances for doubtful accounts and/or write-offs of accounts receivable and could otherwise have material adverse effects on our business, results of operations, financial condition and cash flows. +Changes in trade policies, including the imposition of tariffs and their enforcement, may have a material adverse impact on our business, results of operations, and outlook. +In 2018, the United States levied tariffs on the import of some products from China, which is an important source of many of the Company’s products. To date these tariffs have affected folding and fixed blade knives; paper trimmers and rotary cutters; metal cutting shears; instruments for hand measuring as well as a wide range of components used in first aid kit production. In order to offset the impact of to these tariffs, the Company has implemented price increases on the affected products. Tariff levels may be further increased and the types of products subject to tariffs may be expanded. Although the Company intends to continue to pass additional price increases on to our customers, such tariff-related developments could have a negative impact on customer demand and adversely affect our business, financial condition and results of operations. In addition, we might have to modify our current business practices, including potentially sourcing from alternative vendors, which could result in inefficiencies and delays in production and cause the Company to incur additional costs. +Pandemic Related Risks +The economic effects of the COVID-19 pandemic and measures taken to arrest its spread, as well as any emergency measures we have taken and continue to take in response to the pandemic, could adversely impact our business, including our operating results, financial condition and liquidity. +The outbreak and global spread of COVID-19, which has been declared a pandemic by the World Health Organization, has adversely impacted economic activity and conditions worldwide and is currently impacting our business operations. The extent to which COVID-19 will continue to impact our business is highly uncertain and will depend on future developments, including the efficacy and availability of vaccines, the spread of COVID-19 variants and the extent of federal, state, and local government responses affecting the economy. These impacts include, but are not limited to: +• +Significant weakness, reductions or volatility in demand for one or more of our products, which have been and may in the future be caused by, among other things: the temporary inability of consumers to purchase our products store closures, office closures, school closures or delayed opening for schools and other higher education programs, quarantine or other travel restrictions, or financial hardship among customers, retailers and consumers, shifts in demand away from one or more of our more discretionary or higher priced products to lower priced products, or prior stockpiling of goods; if prolonged, such impacts can further increase the difficulty in planning our operations, which may adversely impact our results, liquidity and financial condition; +11 +• +Inability to meet our customers’ needs and achieve cost targets due to disruptions in our manufacturing operations, supply arrangements as well as distribution centers caused by the disruption of essential manufacturing and supply elements such as raw materials or other finished product components, transportation, workforce, or other manufacturing and distribution capability; +• +Failure of third parties on which we rely, including our suppliers, manufacturers, distributors, contractors, commercial banks, external business partners, and customers to meet their obligations to the Company, or significant disruptions in their ability to do so, which may be caused by their own financial or operational difficulties. Any such failure or disruption may adversely impact our operations, liquidity and financial condition; or +• +Significant changes in the political and labor conditions in markets in which we manufacture, sell or distribute our products, including quarantines, governmental or regulatory actions, safety protocols or restrictions that limit or close our facilities; restrict our employees’ ability or willingness to travel or perform necessary business functions, or otherwise prevent our facilities or our suppliers or customers from sufficiently staffing operations, including operations necessary for the production, distribution, sale, and support of our products, which could adversely impact our results, liquidity and financial condition. +The ultimate impact of the COVID-19 pandemic is highly uncertain and subject to change. We do not yet know the full extent of the impacts on our business, our operations, or the global economy as a whole. Despite our efforts to manage and remedy these impacts to the Company, the ultimate impact of the COVID-19 pandemic could materially and adversely impact our business, results of operations, liquidity and financial condition, and depends on factors beyond our knowledge or control. In this regard, the extent of the impact of the pandemic on our business, operating results, cash flows, liquidity and financial conditions will be primarily driven by the duration and severity of the COVID-19 pandemic, its impact on the U.S. and global economies and the timing, scope and effectiveness of federal, state and local governmental plans to administer vaccines to the general public, especially in areas where conditions have recently worsened and lockdowns or travel bans have been reinstituted. +The Small Business Association’s review of our forgiveness application is ongoing and it is possible that our PPP Loan may not be forgiven. +On May 7, 2020, the Company received a loan (the “PPP Loan”) from HSBC Bank, N.A. in the amount of $3,508,047 under the Paycheck Protection Program established by the Coronavirus Aid, Relief and Economic Security Act. All or a portion of the PPP Loan may be eligible to be forgiven by the U.S. Small Business Administration (“SBA”) and the lender upon application by the Company, provided that the Company shall have used the loan proceeds for eligible purposes, including the payment of payroll, benefits, rent, mortgage interest and utilities, during the 24-week period beginning on the date of funding of the loan (the “covered period”). Not more than 40% of the amount forgiven may be for non-payroll costs. The PPP loan application required us to certify, among other things, that the then current economic uncertainty made the PPP loan request necessary to support our ongoing operations. While we made this certification in good faith, the required certification is not based on any specific objective criteria and is subject to interpretation. In early 2020, the SBA provided guidance that it would be unlikely that a public company with substantial market value and access to capital markets would be able to make the required certification in good faith, and such company should be prepared to demonstrate to the SBA, upon request, the basis for its certification. Further, the Secretary of the Treasury and the SBA Administrator announced that the government will conduct a full audit of all PPP loans of more than $2 million for which the borrower applies for forgiveness. While we believe that we have satisfied all eligibility requirements for the PPP loan, there is a risk that we may be deemed ineligible to have received the PPP loan or in violation of any of the laws or governmental regulations that apply to us in connection with the PPP loan. In such event, we may be required to repay the PPP loan in its entirety, and we could be subject to additional penalties. +The SBA reserves the right to audit any PPP loan, regardless of size. These audits may occur after forgiveness has been granted. Under the CARES Act, all borrowers are required to maintain their loan documentation for six years after the PPP loan was forgiven or repaid in full and to provide that documentation to the SBA upon request. +12 +Risks Related to Our Common Stock +We cannot provide assurance that we will continue to pay dividends or purchase shares of our common stock under our stock repurchase programs. +We continue to pay and declare dividends on a quarterly basis and we anticipate that we will continue to do so. However, there can be no assurance that we will have sufficient cash or surplus under the law to be able to continue to pay dividends at our current level or purchase shares of our common stock under our stock repurchase programs. At December 31, 2020, a total of 203,579 shares may be purchased in the future under the repurchase programs which the Company announced in 2010 and 2019. This may result from extraordinary cash expenses, actual expenses exceeding contemplated costs, funding of capital expenditures, increases in reserves or lack of available capital. We may also suspend the payment of dividends or our stock repurchase program if the Board deems such action to be in the best interests of our shareholders. If we do not pay dividends or decrease the amount of dividends we pay, the price of our common stock would likely decrease. +Our shares of common stock are thinly traded and our stock price may be volatile. +Because our common stock is thinly traded, its market price may fluctuate significantly more than the stock market in general or the stock prices of other companies listed on major stock exchanges. There were approximately 2,916,940 shares of our common stock held by non-affiliates as of December 31, 2020. Thus, our common stock is less liquid than the stock of companies with broader public ownership, and, as a result, the trading price for shares of our common stock may be more volatile. Among other things, trading of a relatively small volume of our common stock may have a greater impact on the trading price for our stock than would be the case if our public float were larger. +Item 1B. Unresolved Staff Comments +Not applicable. +Item 2. Properties +Location +Square +Footage +Purpose +Owned +Rocky Mount, NC +Vancouver, WA +Brooksville, FL +340,000 +53,000 +42,460 +Warehousing and distribution +Warehousing and distribution +Manufacturing, warehousing and distribution +Solingen, Germany +35,000 +Warehousing, distribution and administrative +470,460 +Leased +Fairfield, CT +15,400 +Administrative +Bentonville, AK +1,500 +Administrative +Marlborough, MA +28,000 +Manufacturing, warehousing and distribution +Santa Ana, CA +10,000 +Manufacturing, warehousing, and distribution +La Vergne, TN +56,000 +Manufacturing, warehousing and distribution +Mount Forest, Ontario, Canada +42,500 +Warehousing and distribution +Orangeville, Ontario, Canada +2,850 +Administrative +Laval, Quebec, Canada +14,500 +Manufacturing, warehousing, distribution and administrative +Hong Kong, China +2,750 +Administrative +Guangzhou, China +3,500 +Administrative +Ningbo, China +1,800 +Administrative +135,800 +Total: +606,260 +The Company’s facilities located in the United States and China are utilized by all of its segments. The Company’s facilities located in Canada and Germany are utilized by its Canadian segment and its European segment, respectively. +Management believes that the Company's facilities, whether leased or owned, are adequate to meet its current needs and should continue to be adequate for the foreseeable future. +Item 3. Legal Proceedings +There are no pending material legal proceedings to which the Company is a party or, to the actual knowledge of the Company, contemplated by any governmental agency. +Item 4. Mine Safety Disclosures +Not applicable. +13 +PART II +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company's Common Stock is traded on the NYSE American under the symbol "ACU". +Issuer Purchases of Equity Securities +On November 14, 2019, the Company announced a Common Stock repurchase program of up to a total 200,000 shares. During the twelve months ended December 31, 2020, the Company repurchased 14,420 shares of its Common Stock. As of December 31, 2020, a total of 3,579 shares may be purchased in the future under the repurchase program announced in 2010 and 200,000 may be purchased under the repurchase program announced in 2019. Neither the 2010 nor the 2019 program have an expiration date. +Item 6. Selected Financial Data +As a smaller reporting company, the Company is not required to provide this information. +14 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +Forward-Looking Information +Forward-looking statements in this report, including without limitation, statements related to the Company’s plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including the impact that the global COVID-19 pandemic has had and will continue to have on the Company’s business, operations and financial results. These include the duration, spread, severity, and any recurrence of the COVID-19 pandemic including through any new variant strains of the underlying virus; the effectiveness, availability, and public acceptance of vaccines; the duration and scope of pandemic-related government restrictions on commercial and other activities, including retail store, office, school and restaurant closures; the duration and scope of the Company’s actions to maintain employee health at our offices, production facilities and distribution centers; the extent of the impact of the COVID-19 pandemic on overall demand for the Company’s products; the effect of measures taken by the Company to protect the health of our employees at our offices and distribution centers the pace of recovery when an effective vaccine is widely available or when the pandemic otherwise subsides and the heightened impact the pandemic has on many of the risks described herein, including without limitation risks relating to the on-going world-wide economic downturn and disruptions in our supply chain, any of which could adversely impact the Company’s ability to manufacture, source or distribute its products, both domestically and internationally. +These risks and uncertainties further include, without limitation, the following: (i) changes in the Company’s plans, strategies, objectives, expectations and intentions, which may be made at any time at the discretion of the Company; (ii) the impact of uncertainties in global economic conditions, whether caused by COVID-19 or otherwise, including the impact on the Company’s suppliers and customers; (iii) changes in client needs and consumer spending habits, including COVID-19 related changes; (iv) the impact of competition; (v) the impact of technological changes including, specifically, the growth of online marketing and sales activity; (vi) the Company’s ability to manage its growth effectively, including its ability to successfully integrate any business it might acquire; (vii) the Company’s ability to effectively manage its inventory in a rapidly changing business environment, including additional inventory acquired to respond to COVID-19 related uncertainties; (viii) currency fluctuations; (ix) international trade policies and their impact on demand for our products and our competitive position, including the imposition of new tariffs or changes in existing tariff rates; and (x) other risks and uncertainties indicated from time to time in the Company’s filings with the Securities and Exchange Commission. +Critical Accounting Policies & Estimates +The following discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in conformity with generally accepted accounting principles in the United States of America. The Company’s significant accounting policies are more fully described in Note 2 of the notes to consolidated financial statements. Certain accounting estimates are particularly important to the understanding of the Company’s financial position and results of operations and require the application of significant judgment by the Company’s management and can be materially affected by changes from period to period in economic factors or conditions that are outside the control of management. The Company’s management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical operations, future business plans and projected financial results, the terms of existing contracts, the observance of trends in the industry, information provided by customers and information available from other outside sources, as appropriate. The following discusses the Company’s critical accounting policies and estimates: +Estimates – Operating results may be affected by certain accounting estimates. The most sensitive and significant accounting estimates in the financial statements relate to customer rebates, valuation allowances for deferred income tax assets, obsolete and slow-moving inventories, potentially uncollectible accounts receivable, intangibles, accruals for income taxes, and stock-based compensation. Although the Company’s management has used available information to make judgments on the appropriate estimates to account for the above matters, there can be no assurance that future events will not significantly affect the estimated amounts related to these areas where estimates are required. However, historically, actual results have not been materially different than original estimates. +Revenue Recognition – The Company's revenues result from the sale of goods or services and reflect the consideration to which the Company expects to be entitled. The Company records revenue based on a five-step model in accordance with Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"). For its contracts with customers, the Company identifies the performance obligations (goods or services), determines the transaction price, allocates the contract transaction price to the performance obligations, and recognizes the revenue when (or as) the performance obligation is transferred to the customer. A good or service is transferred when (or as) the customer obtains control of that good or service. Depending on the contractual terms of each customer, revenue is recognized either at the time of shipment or upon delivery. When revenue is recorded, estimates of returns are made and recorded as a reduction of revenue. Customer rebates and incentives earned based on promotional programs in place volume of purchases or other factors are also estimated at the time of revenue recognition and recorded as a reduction of that revenue. Refer to Note 9 – Revenue from Contracts with Customers, in the notes to consolidated financial statements in this report for a more detailed discussion. +Allowance for Doubtful Accounts – The Company provides an allowance for doubtful accounts based upon a review of outstanding accounts receivable, historical collection information and existing economic conditions. The allowance for doubtful accounts represents estimated uncollectible accounts receivables associated with potential customer defaults on contractual obligations, usually due to potential insolvencies. The allowance includes amounts for certain customers where a risk of default has been specifically identified. In addition, the allowance includes a provision for customer defaults based on historical experience. The Company actively monitors its accounts receivable balances, and its historical experience of annual accounts receivable write-offs has been negligible. +15 +Customer Rebates – Customer rebates and incentives are a common practice in the office products industry. We incur customer rebate costs to obtain favorable product placement, to promote sell-through of products and to maintain competitive pricing. Customer rebate costs and incentives, including volume rebates, promotional funds, catalog allowances and slotting fees, are accounted for as a reduction to gross sales. These costs are recorded at the time of sale and are based on individual customer contracts. Management periodically reviews accruals for these rebates and allowances and adjusts accruals when appropriate. +Obsolete and Slow Moving Inventory – Inventories are stated at the lower of cost, determined on the first-in, first-out method, or net realizable value. An allowance is established to adjust the cost of inventory to its net realizable value. Inventory allowances are recorded for obsolete or slow moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions and specific identification of items, such as discontinued products. These estimates could vary significantly from actual requirements if future economic conditions, customer inventory levels or competitive conditions differ from expectations. +Income Taxes – Deferred income tax liabilities or assets are established for temporary differences between financial and tax reporting bases and are subsequently adjusted to reflect changes in tax rates expected to be in effect when the temporary differences reverse. A valuation allowance is recorded to reduce deferred income tax assets to an amount that is more likely than not to be realized. +Intangible Assets and Goodwill – Intangible assets with finite useful lives are recorded at cost upon acquisition and amortized over the term of the related contract, if any, or useful life, as applicable. Intangible assets held by the Company with finite useful lives include patents and trademarks. The weighted average amortization period for intangible assets at December 31, 2020 was 9 years. The Company periodically reviews the values recorded for intangible assets and goodwill to assess recoverability from future operations whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. At December 31, 2020 and 2019, the Company assessed the recoverability of its long-lived assets and goodwill and believed that there were no events or circumstances present that would require a test of recoverability on those assets. As a result, there was no impairment of the carrying amounts of such assets and no reduction in their estimated useful lives. +Accounting for Stock-Based Compensation – Stock based compensation cost is measured at the grant date fair value of the award and is recognized as expense over the requisite service period. The Company uses the Black-Scholes option - pricing model to determine fair value of the awards, which involves certain subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of the Company’s common stock price over the expected term (“volatility”) and the number of options for which vesting requirements will not be completed (“forfeitures”). Changes in the subjective assumptions can materially affect estimates of fair value stock-based compensation, and the related amount recognized on the consolidated statements of operations. Refer to Note 11 – Stock Option Plans, in the notes to consolidated financial statements in this report for a more detailed discussion. +Results of Operations 2020 Compared with 2019 +Traditionally, the Company’s sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the back-to-school market. +COVID-19 Pandemic Related Considerations +As noted above in the “Forward-Looking Statements”, the spread of the coronavirus (COVID-19) through China, the United States, and other countries globally and the related ongoing economic downturn continue to present certain significant risks and uncertainties to the Company and its operations. Commencing late in the first quarter of the current fiscal year and continuing through the filing of this report, the COVID-19 pandemic has affected the Company’s financial results and business operations. During this period, we experienced, and continue to experience, a significant increase in demand for many of the Company’s first aid and safety products, as consumers and commercial enterprises stocked up on these products. On the other hand, while the Company gained market share in its Westcott craft products, it experienced weakness in the sales of its Westcott office and school supplies with the result that sales for fiscal year 2020 were approximately the same as fiscal year of 2019. The weakness in sales was due, in part, to pandemic-related continued or reimposed closures of retail stores, schools and offices and other COVID-19 related restrictions imposed in our domestic and international markets. The ultimate impact of these effects on the Company will depend on the duration, spread, and severity of the COVID-19 pandemic, and any recurrence of the COVID-19 pandemic including through any new variant strains of the underlying virus, the effectiveness, availability, and acceptance by the public of vaccines, the length of time it takes for normal economic and operating conditions to resume, whether commercial closures and other restrictions that have been imposed to date are extended or reimposed, and additional actions that may be taken by governmental authorities or by businesses or individuals of their own initiative in response to the pandemic. +Substantially all of our manufacturing facilities and distribution centers and those of our key suppliers currently remain open and continue to operate despite temporary closures. We monitor information on COVID-19 from the Centers for Disease Control and Prevention (“CDC”) and believe we are adhering to their recommendations regarding the health and safety of our personnel. To address the potential human impact of the virus, most of our administrative staff are telecommuting. For those administrative staff not telecommuting and our warehouse and domestic manufacturing employees, we have implemented social distancing and mask policies, instituted daily temperature checks and have increased facility cleaning at each location. Non-essential domestic and international travel for our employees has ceased. +16 +As a result of the COVID-19 pandemic, commencing late in the first quarter of 2020 and continuing through the end of 2020 and the date of this report , the Company (i) has had to acquire certain of its products at increased costs due to dramatic increases in demand for such products (while, to date, the Company has been successful in passing along such increased costs to its customers, there is no assurance that the Company will be able to continue to do so in the future); (ii) had to acquire additional inventory to minimize the impact of any potential disruption to our supply chain; (iii) has incurred increased labor costs as a result of the payment of additional compensation to employees at its warehouse and distribution centers; and (iv) has incurred costs associated with the additional cleaning and maintenance of its facilities including the temporary closures of facilities for those purposes. The Company continued to incur such costs as a result of these conditions in the fourth quarter and through the date of this report. In addition, the Company has increased reserves relating to outstanding receivables from approximately $ 522 ,000 at December 3 1 , 20 19 , to approximately $ 1,150 ,000 at December 3 1 , 2020, as a result of credit risks related to COVID -19 . (The Company continuously evaluates credit risks relating to its customers and may need to increase its reserves relating to its receivables further or even, in the event that one or more significant customers should cease operations or declares bankruptcy, write off a substantial amount of receivables.) +The Company has also experienced obstacles and inefficiencies resulting from a number of pandemic-related factors such as travel restrictions imposed by governmental authorities which, e.g., inhibit sales and marketing activities, and inefficiencies resulting from many of the Company’s personnel working remotely. In addition, the Company experienced inefficiencies in its manufacturing and distribution due to social distancing measures imposed in its facilities, COVID-19 related absenteeism, and higher than normal turnover and training of replacements, together with associated costs. +The increases and decreases in the demand for the Company’s products described above have continued to affect the Company’s operations through the end of fiscal year 2020 and continue to do so through the date of this report. They are likely to continue to do so in the immediate future. For example, a decrease could occur in the demand for its first aid and safety products as a result of market saturation potentially resulting from customers having stockpiled those products. While there is no certainty that the current high levels of demand for our first aid and safety products will continue, we have increased our short-term manufacturing and sourcing capacity for these products. We also increased manufacturing and sourcing of other key components and finished goods to minimize the impact of any disruption to our supply chain in the event of a resurgence of an outbreak of the coronavirus in any of our key manufacturing or distribution facilities. The Company anticipates that it has sufficient inventory of its products to meet anticipated demand. However, any prolonged increase in the duration or severity of the COVID-19 pandemic or a resurgence of the pandemic in the future, might adversely affect the Company’s ability to manufacture, source or distribute its products both domestically and internationally. The occurrence of any of these factors could have a material adverse effect on the Company’s business, operations and financial condition. +Net Sales +In 2020, sales increased by $21,545,698, or 15%, to $164,003,040 compared to $142,457,342 in 2019. +The U.S. segment sales increased by 12%, in 2020 compared to 2019 mainly attributable to strong sales of first aid and safety products, primarily due to continued market share gains in the industrial, safety, home improvement, mass market and e-commerce channels. Also contributing to the growth in first aid products was a surge demand related to the COVID-19 pandemic which had commenced late in the first quarter. These sales amounted to approximately $3.0 million in the twelve months ended December 31, 2020. +Net sales in Canada, excluding First Aid Central products, for the year ended December 31, 2020, decreased 4% in U.S. dollars and 3% in local currency compared to the same period in 2019. Sales of First Aid Central products were approximately $4.6 million for the year ended December 31, 2020. +European net sales for the year ended December 31, 2020 increased 25% in both U.S. dollars and local currency, compared with the period in 2019. The increase in net sales was primarily due to increased sales of Westcott cutting products and Camillus knives in the e-commerce channel as well as continued growth of DMT sharpening products. +Gross Profit +Gross profit was 36.3% of net sales in 2020 compared to 36.5% in 2019. +Selling, General and Administrative +Selling, general and administrative (“SG&A”) expenses were $48,182,050 in 2020 compared with $43,571,510 in 2019, an increase of $4,610,540, or 10.6%. SG&A expenses were 29.4% of net sales in 2020 compared to 30.6% in 2019. The increase in SG&A expenses was primarily due to higher personnel related costs, commissions and shipping costs related to higher sales, provision for bad debt primarily related to the impact COVID-19 on our customers, as well as added expenses related to the acquisition of First Aid Central, partially offset by lower travel and marketing expenses. +Operating Income +Operating income was $11,412,664 in 2020, compared with $8,429,348 in 2019, and increase of $2,983,316. Operating income in the U.S. segment increased by approximately $1,673,000, primarily due to higher sales. Operating income in Canada increased by approximately $561,000, primarily due to the acquisition of First Aid Central. Operating income in the European segment increased by approximately $750,000, primarily due to higher sales. +17 +Interest Expense, Net +Net interest expense for 2020 was $919,709, compared with $1,788,512 for 2019, a decrease of $868,803. The decrease in interest expense, net for 2020, was primarily the result of a lower average interest rate as well as lower average debt outstanding under the Company’s revolving credit facility. +Other Expense +Other expense was $666,227 in 2020 compared to $97,672 in 2019. The increase in other expense is primarily related to a one-time non-cash charge of approximately $750,000 related to the termination of the Company’s Defined Benefit Pension Plan. +Income Tax Expense +Income tax expense was $1,727,962 in 2020, resulting in an effective tax rate of 18% compared to 1,029,556, an effective tax rate of 16% in 2019. +Off-Balance Sheet Transactions +The Company did not engage in any off-balance sheet transactions during 2020. +Liquidity and Capital Resources +During 2020, working capital increased by approximately $6.9 million compared to December 31, 2019. Inventory (excluding the impact of acquisitions) increased by approximately $11 million, or 29%. The increase was primarily due to anticipated growth in our business as well as the acquisition of product to offset the impact of potential supply chain interruptions related to COVID-19. The Company expects that changes in inventory levels will continue to be consistent with changes in sales, including the seasonal impact on the Company’s revenue stream. Inventory turnover, calculated using a twelve month average inventory balance, was 2.4 at December 31, 2020 as compared to 2.3 at December 31, 2019. The reserve for slow moving and obsolete inventory was $1,471,925 at December 31, 2020 compared to $538,354 at December 31, 2019. We do not anticipate material increases in the allowance for slow moving and obsolete inventory in the ordinary course of business during 2021. +Receivables increased by approximately $1.7 million at December 31, 2020 compared to December 31, 2019. The average number of days sales outstanding in accounts receivable was 60 days in 2020 compared to 64 days in 2019. Accounts payable and other current liabilities increased by approximately $3.6 million. +Long-term debt consists of (i) borrowings under the Company’s revolving loan agreement with HSBC Bank, N.A. (ii) amounts outstanding under the Paycheck Protection Program (PPP) and (iii) amounts outstanding under the variable rate mortgage related on the Company’s manufacturing and distribution facility in Vancouver, WA. The revolving loan agreement provides for borrowings of up to $50 million at Prime Rate less 1.25%. The credit facility has an expiration date of May 24, 2023. The Company must pay a facility fee, payable quarterly, in an amount equal to two tenths of one percent (.20%) per annum of the average daily unused portion of the revolving credit line. The facility is intended to provide liquidity for working capital, growth, share repurchases, dividends, acquisition and other business activities. Under the revolving loan agreement, the Company is required to maintain specific amounts of tangible net worth, a specified debt to net worth ratio and a fixed charge coverage ratio and must have annual net income greater than zero, measured as of the end of each fiscal year. At December 31, 2020, the Company was in compliance with the covenants then in effect under the loan agreement. +At December 31, 2020, total debt outstanding under the Company’s revolving credit facility increased by approximately $5.5 million compared to total debt at December 31, 2019. As of December 31, 2020, $38,767,167 was outstanding and $11,232,833 was available for borrowing under the Company’s revolving credit facility. +On May 7, 2020, the Company received a loan (the “PPP Loan”) from HSBC Bank, N.A. in the amount of $3,508,047 under the Paycheck Protection Program established by the Coronavirus Aid, Relief and Economic Security Act. Subject to potential forgiveness, as described below, the PPP Loan matures in two years on May 8, 2022, bears interest at a rate of 1.00% per year and is evidenced by a promissory note dated May 7, 2020 (the “Note”). Monthly payments of principal and interest are deferred until after any application for forgiveness submitted by the Company has been acted upon, as described below. The PPP Loan is unsecured and federally guaranteed. The Note contains customary events of default relating to, among other things, failure to make payments of principal and interest and breaches of representations and warranties. The Company may prepay the PPP Loan at any time prior to maturity with no penalty. +All or a portion of the PPP Loan may be eligible to be forgiven by the U.S. Small Business Administration (“SBA”) and the lender upon application by the Company, provided that the Company shall have used the loan proceeds for eligible purposes, including the payment of payroll, benefits, rent, mortgage interest and utilities, during the 24 week period beginning on the date of funding of the loan (the “covered period”). Not more than 40% of the amount forgiven may be for non-payroll costs. +Consistent with the requirements of the PPP for loan forgiveness, the Company used the loan proceeds solely for payment of payroll and otherwise in a manner which it believes satisfy the requirements for loan forgiveness. In August 2020, the Company submitted an application for forgiveness of the entire amount of the PPP loan to HSBC Bank, N.A. (the Lender). The lender approved the forgiveness application and, on August 26, 2020, submitted the Company’s application to the SBA for its approval. The SBA subsequently asked the Company to provide certain additional information and documentation in connection with it review of the Company’s forgiveness application and the Company has done so. The application is presently pending. No assurance can be given that the Company’s application for loan forgiveness will be approved by the SBA, in whole or in part. +18 +The SBA reserves the right to audit any PPP loan, regardless of size. These audits may occur after forgiveness has been granted. Under the CARES Act, all borrowers are required to maintain their loan documentation for six years after the PPP loan was forgiven or repaid in full and to provide that documentation to the SBA upon request. +On April 28, 2020, the U.S. Department of the Treasury stated that the SBA will review each PPP loan over $2.0 million. In order to apply for the PPP Loan, we were required to certify, among other things, that the then current uncertainty made the PPP Loan request necessary to support our ongoing operations. We made this certification in good faith after analyzing, among other things, our financial situation and access to alternative sources of capital. Following this analysis, we believe that we satisfied all eligibility criteria for the PPP Loan, and that our receipt of the PPP Loan is consistent with the objectives of the PPP of the CARES Act. If it is later determined that we were ineligible to receive the PPP Loan, we may be required to repay the PPP Loan in its entirety and/or be subject to additional penalties, which could have a material adverse effect on our business, results of operations and financial condition. +The Company’s First Aid Only manufacturing and distribution center in Vancouver, WA was financed by a variable rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5%. Principal payments of $22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024. The outstanding principal on December 31, 2020 was $3,177,778. +Capital expenditures during 2020 and 2019 were $2,569,174 and $1,680,479, respectively, which were, in part, financed with borrowings under the Company’s revolving credit facility. +The Company believes that cash on hand, and cash generated from operating activities, together with funds available under its revolving credit facility, are expected, under current conditions, to be sufficient to finance the Company’s planned operations for at least the next twelve months from the issuance of this Form 10-K. +Recently Issued and Adopted Accounting Standards +In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The update eliminates, clarifies and modifies certain guidance related to the accounting for income taxes. ASU 2019-12 is effective for annual reporting periods beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material effect on its consolidated financial statements. +In August 2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20), Disclosure Framework - Changes to the Disclosures Requirements for Defined Benefit Plans Income Statement - Reporting Comprehensive Income (Topic 220) . This ASU removes disclosures that no longer are considered cost beneficial, clarifies the specific requirements of disclosures, and adds disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its consolidated financial statements. +In June 2018, the FASB issued ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting . ASU 2018-07 aligns the accounting for share-based payment awards issued to employees and non-employees. ASU 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period. The adoption of ASU 2018-07 did not have a material impact on the consolidated financial statements. +In February 2018, the FASB issued ASU No. 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income . ASU No. 2018-02 provides companies with an option to reclassify stranded tax effects within accumulated other comprehensive income (“AOCI”) to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) is recorded. ASU No. 2018-02 also requires disclosure of a description of the accounting policy for releasing income tax effects from AOCI and whether an election was made to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act. ASU No. 2018-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Companies can adopt the provisions of ASU No. 2018-02 in either the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. This ASU was adopted effective January 1, 2019 and resulted in a reclassification between retained earnings and accumulated other comprehensive loss. The impact from this ASU increased retained earnings by approximately $0.1 million, with an offsetting increase to accumulated other comprehensive loss for the same amount. +In January 2017 , the FASB issued ASU No. 2017 - 04 , Intangibles – Goodwill and Other (Topic 350 ): Simplifying the Test for Goodwill Impairment . The amendments in this update eliminate Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax-deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The Company adopted this standard on January 1, 2020 . The adoption of this standard did not have an impact to the financial statements of the Company. +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +As a smaller reporting company, the Company is not required to provide this information. +Item 8. Financial Statements and Supplementary Data +19 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF OPERATIONS +For the years ended December 31, +2020 +2019 +Net sales +$ +164,003,040 +$ +142,457,342 +Cost of goods sold +104,408,326 +90,456,484 +Gross profit +59,594,714 +52,000,858 +Selling, general and administrative expenses +48,182,050 +43,571,510 +Operating income +11,412,664 +8,429,348 +Non-operating items: +Interest: +Interest expense +( 944,363 +) +( 1,828,408 +) +Interest income +24,654 +39,896 +Interest expense, net +( 919,709 +) +( 1,788,512 +) +Other expense +( 666,227 +) +( 97,672 +) +Total other expense, net +( 1,585,936 +) +( 1,886,184 +) +Income before income tax expense +9,826,728 +6,543,164 +Income tax expense +1,727,962 +1,029,556 +Net income +$ +8,098,766 +$ +5,513,608 +Earnings per share: +Basic +$ +2.42 +$ +1.65 +Diluted +$ +2.31 +$ +1.60 +See accompanying Notes to Consolidated Financial Statements. +20 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +For the Years Ended +December 31, +2020 +2019 +Net income +$ +8,098,766 +$ +5,513,608 +Other comprehensive gain +Foreign currency translation +647,632 +45,223 +Change in net prior service credit and actuarial gains, net of income +tax expense +514,271 +143,906 +Total other comprehensive income (loss) +1,161,903 +189,129 +Comprehensive income +$ +9,260,669 +$ +5,702,737 +See accompanying Notes to Consolidated Financial Statements. +21 +Acme United Corporation and Subsidiaries +CONSOLIDATED BALANCE SHEETS +December 31, +December 31, +2020 +2019 +ASSETS +Current assets: +Cash and cash equivalents +$ +4,167,376 +$ +6,821,883 +Accounts receivable, less allowance +27,173,431 +25,484,865 +Inventories +50,704,197 +39,261,105 +Prepaid expenses and other current assets +1,640,904 +1,578,248 +Total current assets +83,685,908 +73,146,101 +Property, plant and equipment: +Land +1,770,453 +1,420,104 +Buildings +12,898,761 +10,095,529 +Machinery and equipment +24,524,045 +19,111,801 +Total property, plant and equipment +39,193,259 +30,627,434 +Less: accumulated depreciation +18,954,352 +16,591,890 +Net property, plant and equipment +20,238,907 +14,035,544 +Intangible assets, less accumulated amortization +18,721,423 +15,792,738 +Goodwill +4,799,829 +4,696,370 +Operating lease right-of-use asset, net +2,421,669 +2,989,272 +Other assets +- +88,828 +Total assets +$ +129,867,736 +$ +110,748,853 +LIABILITIES +Current liabilities: +Accounts payable +$ +7,601,123 +$ +6,692,692 +Operating lease liability - current portion +872,908 +1,047,498 +Current portion of mortgage payable +266,667 +266,667 +Other accrued liabilities +11,460,024 +8,576,248 +Total current liabilities +20,200,722 +16,583,105 +Long-term debt +38,767,167 +33,240,407 +Long-term debt-PPP Loan +3,508,047 +- +Mortgage payable, net of current portion +2,911,111 +3,177,778 +Operating lease liability - non-current portion +1,654,025 +1,960,996 +Deferred income taxes +110,221 +49,284 +Other non-current liabilities +- +32,302 +Total liabilities +67,151,293 +55,043,872 +STOCKHOLDERS' EQUITY +Common stock, par value $ 2.50 : authorized 8,000,000 shares; issued - +4,840,571 shares in 2020 and 4,838,071 in 2019, including treasury stock +12,100,663 +12,094,413 +Treasury stock, at cost, 1,501,658 in 2020 and 1,487,238 shares in 2019 +( 14,522,178 +) +( 14,235,190 +) +Additional paid-in capital +7,930,673 +8,262,208 +Accumulated other comprehensive loss +( 825,967 +) +( 1,987,870 +) +Retained earnings +58,033,252 +51,571,420 +Total stockholders' equity +62,716,443 +55,704,981 +Total liabilities and stockholders' equity +$ +129,867,736 +$ +110,748,853 +See accompanying Notes to Consolidated Financial Statements. +22 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY +Outstanding +Shares of +Common Stock +Common Stock +Treasury +Stock +Additional +Paid-In Capital +Accumulated +Other +Comprehensive +Loss +Retained +Earnings +Total +Balances, December 31, 2018 +3,350,833 +$ +12,094,413 +$ +( 14,235,190 +) +$ +8,981,523 +$ +( 2,057,985 +) +$ +47,549,650 +$ +52,332,411 +Net income +5,513,608 +5,513,608 +Other comprehensive Income +189,129 +189,129 +Adoption of ASU 2018-02 +( 119,014 +) +119,014 +- +Stock compensation expense +968,467 +968,467 +Distribution to shareholders +( 1,610,852 +) +( 1,610,852 +) +Cash settlement of stock options +( 1,687,782 +) +( 1,687,782 +) +Balances, December 31, 2019 +3,350,833 +$ +12,094,413 +$ +( 14,235,190 +) +$ +8,262,208 +$ +( 1,987,870 +) +$ +51,571,420 +$ +55,704,981 +Net income +8,098,766 +8,098,766 +Other comprehensive income +1,161,903 +1,161,903 +Stock compensation expense +1,259,079 +1,259,079 +Distribution to shareholders +( 1,636,934 +) +( 1,636,934 +) +Issuance of common stock +2,500 +6,250 +53,504 +59,754 +Cash settlement of stock options +( 1,644,118 +) +( 1,644,118 +) +Purchase of treasury stock +( 14,420 +) +( 286,988 +) +( 286,988 +) +Balances, December 31, 2020 +3,338,913 +$ +12,100,663 +$ +( 14,522,178 +) +$ +7,930,673 +$ +( 825,967 +) +$ +58,033,252 +$ +62,716,443 +See accompanying Notes to Consolidated Financial Statements. +23 +Acme United Corporation and Subsidiaries +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the years ended December 31, +2020 +2019 +Operating activities: +Net income +$ +8,098,766 +$ +5,513,608 +Adjustments to reconcile net income to net cash provided by operating activities +Depreciation +2,427,557 +2,181,060 +Amortization +1,324,423 +1,251,662 +Stock compensation expense +1,259,079 +968,467 +Deferred income taxes +60,937 +162,637 +Non-cash lease expense +86,042 +19,222 +Provision for doubtful accounts +778,869 +290,128 +Pension settlement +526,857 +— +Changes in operating assets and liabilities +Accounts receivable +( 2,028,341 +) +( 784,562 +) +Inventories +( 10,049,513 +) +2,089,861 +Prepaid expenses and other current assets +159,078 +666,070 +Accounts payable +460,179 +( 1,525,060 +) +Other accrued liabilities +2,617,103 +3,869,138 +Total adjustments +( 2,377,730 +) +9,188,623 +Net cash provided by operating activities +5,721,036 +14,702,231 +Investing activities: +Purchase of property, plant and equipment +( 2,569,174 +) +( 1,680,479 +) +Acquisition of Med-Nap +( 9,307,518 +) +— +Acquisition of First Aid Central +( 2,075,210 +) +— +Net cash used by investing activities +( 13,951,902 +) +( 1,680,479 +) +Financing activities: +Net borrowings (repayments) of long-term debt +5,526,760 +( 7,042,708 +) +Proceeds from PPP Loan +3,508,047 +— +Repayments on mortgage +( 266,667 +) +( 266,667 +) +Distributions to stockholders +( 1,604,706 +) +( 1,608,956 +) +Cash settlement of stock options +( 1,644,118 +) +( 1,687,782 +) +Purchase of treasury stock +( 286,988 +) +— +Issuance of common stock +58,754 +— +Net cash provided by (used in) financing activities +5,291,082 +( 10,606,113 +) +Effect of exchange rate changes +285,277 +( 2,799 +) +Net (decrease) increase in cash and cash equivalents +( 2,654,507 +) +2,412,841 +Cash and cash equivalents at beginning of year +6,821,883 +4,409,042 +Cash and cash equivalents at end of year +$ +4,167,376 +$ +6,821,883 +Supplemental cash flow information: +Cash paid for income taxes +$ +755,337 +$ +422,339 +Cash paid for interest expense +$ +930,357 +$ +1,863,961 +See accompanying Notes to Consolidated Financial Statements. +24 +Acme United Corporation and Subsidiaries +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. Operations +The operations of Acme United Corporation (the “Company”) consist of three reportable segments. The operations of the Company are structured and evaluated based on geographic location. The three reportable segments operate in the United States (including Asian operations), Canada and Europe. Principal products across all segments are scissors, shears, knives, rulers, pencil sharpeners, first aid safety kits, and related products which are sold primarily to wholesale, contract and retail stationery distributors, office supply super stores, mass market retailers, industrial distributors, school supply distributors, drug store retailers, sporting goods stores, hardware chains and wholesale florists. +2. Accounting Policies +Estimates – The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most sensitive and significant accounting estimates relate to customer rebates, valuation allowances for deferred income tax assets, obsolete and slow-moving inventories, potentially uncollectible accounts receivable, intangibles, accruals for income taxes and stock-based compensation. Actual results could differ from those estimates. +Principles of Consolidation – The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned by the Company. All significant intercompany accounts and transactions are eliminated in consolidation. +Translation of Foreign Currency – For foreign operations whose functional currencies are not U.S. dollars, assets and liabilities are translated at rates in effect at the end of the year; revenues and expenses are translated at average rates in effect during the year. Resulting translation adjustments are made directly to accumulated other comprehensive income. Foreign currency transaction gains and losses are recognized in operating results. Included in other expense were foreign currency transaction gains of $ 96,372 in 2020 and foreign currency transaction losses of $ 38,988 in 2019 . +Cash Equivalents – Investments with an original maturity of three months or less, as well as time deposits and certificates of deposit that are readily redeemable at the date of purchase, are considered cash equivalents. +Accounts Receivable – Accounts receivable are shown less an allowance for doubtful accounts of $ 1,151,715 at December 31, 2020 and $ 522,560 at December 31, 2019. +Inventories – Inventories are stated at the lower of cost, or net realizable value, determined by the first-in, first-out method. +Property, Plant and Equipment, and Depreciation – Property, plant and equipment is recorded at cost. Depreciation is computed by the straight-line method over the estimated useful lives of the assets. The range of estimated useful lives of these assets are as follows: buildings useful lives range from 10 to 39 years ; machinery and equipment useful lives range from 3 to 10 years . +Intangible Assets and Goodwill – Intangible assets with finite useful lives are recorded at cost upon acquisition and amortized over the term of the related contract, if any, or useful life, as applicable. Intangible assets held by the Company with finite useful lives include patents and trademarks. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period for intangible assets at December 31, 2020 was 9 years. The Company periodically reviews the values recorded for intangible assets and goodwill to assess recoverability from future operations whenever events or changes in circumstances indicate that its carrying amounts may not be recoverable. At December 31, 2020 and 2019, the Company assessed the recoverability of its long-lived assets and goodwill and believed that there were no events or circumstances present that would require a test of recoverability on those assets. As a result, there was no impairment of the carrying amounts of such assets and no reduction in their estimated useful lives. +Deferred Income Taxes – Deferred income taxes are provided for the differences between the financial statement and tax bases of assets and liabilities, and on operating loss carryovers, using tax rates in effect in years in which the differences are expected to reverse. +Leases – The Company determines if an arrangement is an operating lease at inception. Leases with an initial term of 12 months or less are not recorded on the balance sheet. All other leases are recorded on the balance sheet with right-of-use (“ROU”) assets representing the right to use the underlying asset for the lease term and lease liabilities representing the obligation to make lease payments arising from the lease. +Lessees and lessors may elect to apply a package of practical expedients permitting entities not to reassess: (i) whether any expired or existing contracts are or contain leases; (ii) lease classification for any expired or existing leases; and (iii) whether initial direct costs for any expired or existing leases qualify for capitalization under the amended guidance. These practical expedients must be elected as a package and consistently applied. The Company has elected to apply the package of practical expedients upon adoption. +25 +ROU assets and lease liabilities are recognized at commencement date of the lease based on the present value of lease payments over the lease term and include options to extend or terminate the lease when they are reasonably certain to be exercised. As most of our leases d o not provide an implicit rate, the present value of lease payments is determined primarily using our incremental borrowing rate based on the information available at the lease commencement date. The incremental borrowing rate is the rate of interest that we would have to pay to borrow on a collateralized basis over a similar term on an amount equal to the lease payments in a similar economic environment. Lease arrangements with lease and non-lease components are generally accounted for as a single lease component. The Company's operating lease expense is recognized on a straight-line basis over the lease term. +Revenue Recognition – The Company's revenues result from the sale of goods or services and reflect the consideration to which the Company expects to be entitled. The Company records revenue based on a five-step model in accordance with Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"). For its contracts with customers, the Company identifies the performance obligations (goods or services), determines the transaction price, allocates the contract transaction price to the performance obligations, and recognizes the revenue when (or as) the performance obligation is transferred to the customer. A good or service is transferred when (or as) the customer obtains control of that good or service. Depending on the contractual terms of each customer, revenue is recognized either at the time of shipment or upon delivery. When revenue is recorded, estimates of returns are made and recorded as a reduction of revenue. Customer rebates and incentives earned based on promotional programs in place volume of purchases or other factors are also estimated at the time of revenue recognition and recorded as a reduction of that revenue. Refer to Note 9 – Revenue from Contracts with Customers, in the notes to consolidated financial statements in this report for a more detailed discussion. +Research and Development – Research and development costs ($ 251,000 in 2020 and $ 596,000 in 2019) are included in selling, general and administrative expenses and expensed as incurred. +Shipping Costs – The costs of shipping product to our customers ($ 7,486,600 in 2020 and $ 6,695,223 in 2019) are included in selling, general and administrative expenses. +Advertising Costs – The Company expenses the production costs of advertising the first time that the related advertising takes place. Advertising costs ($ 1,084,261 in 2020 and $ 1,104,543 in 2019) are included in selling, general and administrative expenses. +Subsequent Events – The Company has evaluated events and transactions subsequent to December 31, 2020 through the date the consolidated financial statements were included in this Form 10-K and filed with the SEC. +Concentration – The Company performs ongoing credit evaluations of its customers and generally does not require collateral for the extension of credit. Allowances for credit losses are provided and have been within management's expectations. The Company had two customers in 2020 and one customer in 2019 that individually exceeded 10% of consolidated net sales. Net sales to these customers were approximately 18 % and 13 % of consolidated net sales in 2020 and 17 % in 2019. +Recently Issued and Adopted Accounting Standards +In December 2019, the Financial Accounting Standards Board (FASB) issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The update eliminates, clarifies and modifies certain guidance related to the accounting for income taxes. ASU 2019-12 is effective for annual reporting periods beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material effect on its consolidated financial statements. +In August 2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20), Disclosure Framework - Changes to the Disclosures Requirements for Defined Benefit Plans Income Statement - Reporting Comprehensive Income (Topic 220) . This ASU removes disclosures that no longer are considered cost beneficial, clarifies the specific requirements of disclosures, and adds disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its consolidated financial statements. +In June 2018, the FASB issued ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting . ASU 2018-07 aligns the accounting for share-based payment awards issued to employees and non-employees. ASU 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period. The adoption of ASU 2018-07 did not have a material impact on the consolidated financial statements. +26 +In February 2018, the FASB issued ASU No. 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income . ASU No. 2018-02 provides companies with an option to reclassify stranded tax effects within accumulated other comprehensive income (“AOCI”) to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) is recorded. ASU No. 2018-02 also requires disclosure of a description of the accounting policy for releasing income tax effects from AOCI and whether an election was made to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act. ASU No. 2018-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Companies can adopt the provisions of ASU No. 2018-02 in either the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. This ASU was adopted effective January 1, 2019 and result ed in a reclassification between retained earnings and accumulated other comprehensive loss . The impact from this ASU increase d retained earnings by approximately $0.1 million, with an offsetting increase to accumulated other comprehensive loss for the same amount. +In January 2017 , the FASB issued ASU No. 2017 - 04 , Intangibles – Goodwill and Other (Topic 350 ): Simplifying the Test for Goodwill Impairment . The amendments in this update eliminate Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax-deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The Company adopted this standard on January 1, 2020 . The adoption of this standard did not have an impact to the financial statements of the Company. +3. Inventories +Inventories consisted of: +December 31, +2020 +2019 +Finished goods +$ +40,287,710 +$ +32,899,114 +Work in process +67,208 +274,158 +Materials and supplies +10,349,279 +6,087,833 +Inventories: +$ +50,704,197 +$ +39,261,105 +Inventories are stated net of valuation allowances for slow moving and obsolete inventory of $ 1,471,925 as of December 31, 2020 and $ 696,486 as of December 31, 2019. +4. Intangible Assets and Goodwill +The Company’s intangible assets and goodwill consisted of: +December 31, +2020 +2019 +First Aid Only Tradename +$ +3,410,000 +$ +3,410,000 +First Aid Only Customer List +5,500,010 +5,500,010 +DMT Trademarks +1,387,000 +1,387,000 +DMT Customer List +1,369,000 +1,369,000 +DMT Non-Compete +183,000 +183,000 +Slice License Agreement +379,921 +379,921 +Patents +2,271,980 +2,271,980 +Trademarks +663,698 +663,698 +Pac-Kit Tradename, Customer List +1,500,000 +1,500,000 +Spill Magic Customer List +3,965,000 +3,965,000 +Spill Magic Trademarks +1,034,000 +1,034,000 +Spill Magic Non-Compete +67,111 +67,111 +C-Thru Customer List +1,050,000 +1,050,000 +FAC +1,332,963 +- +Med-Nap +2,920,145 +- +Subtotal +27,033,828 +22,780,720 +Less: Accumulated Amortization +8,312,405 +6,987,982 +Intangible Assets +$ +18,721,423 +$ +15,792,738 +Goodwill +$ +4,799,829 +$ +4,696,370 +Total: +$ +23,521,252 +$ +20,489,108 +27 +Amortization expense for patents and trademarks for the years ended December 31, 2020 and 2019 were $ 1,324,423 and $ 1,251,662 , respectively. The estimated aggregate amortization expense for each of the next five succeeding years, calculated on a similar basis, is as follows: 2021 - $ 1,305,088 ; 2022 - $ 1,301,802 ; 2023 - $ 1,297,605 ; 2024 - $ 1,292,415 ; and 2025 - $ 1,290,222 . +5. Other Accrued Liabilities +The Company’s other current and non-current accrued liabilities consisted of: +December 31, +2020 +2019 +Customer Rebates +$ +6,068,294 +$ +4,849,081 +Pension Liability +— +44,667 +Accrued Compensation +3,072,375 +1,695,464 +Dividend Payable +434,546 +402,318 +Income Taxes Payable +459,596 +261,539 +Other +1,425,213 +1,355,481 +Total: +$ +11,460,024 +$ +8,608,550 +6. Pension and Profit Sharing +United States employees, hired prior to July 1, 1993, are covered by a funded, defined benefit pension plan. The benefits of this pension plan are based on years of service and the average compensation of the highest three consecutive years during the last ten years of employment. In December 1995, the Company's Board of Directors approved an amendment to the United States pension plan that terminated all future benefit accruals as of February 1, 1996, without terminating the pension plan. +In 2020, the Company entered into agreements with an insurance company to transfer future benefit obligations and annuity administration for retirees (or their beneficiaries) in the Company’s defined benefit pension plan. As a result of this agreement, the Company recorded pension settlement charges of $ 793,524 . +The Company’s funding policy with respect to its qualified plan was to contribute at least the minimum amount required by applicable laws and regulations. In 2020, the Company contributed $ 222,857 to the plan. +The plan asset weighted average allocation at December 31, 2019, by asset category, were as follows: +Asset Category: +2019 +Equity Securities +66 +% +Fixed Income Securities +32 +% +Other Securities / Investments +2 +% +Total: +100 +% +The Company’s investment policy for the pension plan is to minimize risk by balancing investments between equity securities and fixed income securities. Plan funds are invested in long-term obligations with a history of moderate to low risk. +The pension plan asset information included below is presented at fair value. ASC 820 establishes a framework for measuring fair value and requires disclosures about assets and liabilities measured at fair value. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three levels as follows: +• +Level 1 – Inputs to the valuation methodology based on unadjusted quoted market prices in active markets that are accessible at the measurement date. +• +Level 2 – Inputs to the valuation methodology that include quoted market prices that are not considered to be active or financial instruments for which all significant inputs are observable, either directly or indirectly. +• +Level 3 – Inputs to the valuation methodology are unobservable and significant to the fair value measurement. +The following tables present the pension plan assets by level within the fair value hierarchy as of December 31, 2019: +2019 +Level 1 +Level 2 +Level 3 +Total +Money Market Fund +$ +31 +$ +16,763 +$ +— +$ +16,794 +Equity Common and Collected Funds +102,030 +580,839 +— +682,869 +Fixed Income Common and Collected Funds +82,670 +246,316 +— +328,986 +Total: +$ +184,731 +$ +843,918 +$ +— +$ +1,028,649 +28 +Other disclosures related to the pension plan follow: +2020 +2019 +Assumptions used to determine benefit obligation: +Discount rate +2.74 +% +2.74 +% +Changes in benefit obligation: +Benefit obligation at beginning of year +$ +( 1,073,316 +) +$ +( 1,160,930 +) +Interest cost +( 27,671 +) +( 41,841 +) +Service cost +( 30,195 +) +( 25,000 +) +Actuarial loss +( 160,884 +) +( 46,288 +) +Benefits and plan expenses paid +203,596 +200,743 +Curtailments, settlements and special termination benefits +1,088,470 +— +Benefit obligation at end of year: +$ +— +$ +( 1,073,316 +) +Changes in plan assets: +Fair value of plan assets at beginning of year +$ +1,028,649 +$ +1,013,831 +Actual return on plan assets +40,560 +201,148 +Employer contribution +222,857 +14,413 +Benefits and plan expenses paid +( 203,596 +) +( 200,743 +) +Settlements +( 1,088,470 +) +— +Fair value of plan assets at end of year +— +1,028,649 +Funded status: +$ +— +$ +( 44,667 +) +Amounts recognized in accumulated other comprehensive income: +Net actuarial loss +$ +— +$ +689,398 +Prior service cost +— +538 +Total: +$ +— +$ +689,936 +Accrued benefits costs are included in other accrued liabilities (non-current). +2020 +2019 +Assumptions used to determine net periodic benefit cost: +Discount rate +2.74 +% +3.87 +% +Expected return on plan assets +6.00 +% +6.00 +% +Components of net benefit expense: +Service cost +$ +30,195 +$ +25,000 +Interest cost +27,671 +41,841 +Expected return on plan assets +( 40,560 +) +( 54,330 +) +Settlement cost +793,524 +— +Amortization of prior service costs +538 +544 +Amortization of actuarial loss +56,739 +90,442 +837,912 +78,497 +Net periodic benefit cost: +$ +868,107 +$ +103,497 +The Company employed a building block approach in determining the long-term rate of return for plan assets. Historical markets are studied and long-term historical relationships between equity securities and fixed income securities are preserved consistent with the widely-accepted capital market principle that assets with higher volatility generate higher returns over the long run. Our expected 6 % long-term rate of return on plan assets is determined based on long-term historical performance of plan assets, current asset allocation and projected long-term rates of return. +The following table discloses the change recorded in other comprehensive income related to benefit costs: +2020 +2019 +Balance at beginning of the year +$ +689,936 +$ +881,452 +Change in net loss +( 617,800 +) +( 100,530 +) +Amortization of actuarial loss +( 71,598 +) +( 90,442 +) +Amortization of prior service cost +( 538 +) +( 544 +) +Change recognized in other comprehensive income +( 689,936 +) +( 191,516 +) +Total recognized in other comprehensive income +$ +— +$ +689,936 +29 +The Company also has a qualified, 401k plan covering substantially all of its United States employees. Annual Company contributions to this plan are determined by the Company’s Compensation Committee. For the years ended December 31, 2020 and 2019, the Company contributed 50 % of employee’s contributions, up to the first 6 % contributed by each employee. Total contribution expense under this 401k plan was $ 369,890 in 2020 and $ 309,922 in 2019. +7. Income Taxes +The amounts of income tax expense (benefit) reflected in operations is as follows: +2020 +2019 +Current: +Federal +$ +880,149 +$ +( 82,673 +) +State +159,909 +109,593 +Foreign +788,314 +887,556 +Total: +$ +1,828,372 +$ +914,476 +Deferred: +Federal +$ +( 59,801 +) +$ +92,446 +State +( 40,609 +) +22,634 +Total: +( 100,410 +) +115,080 +Total Income Tax Expense: +$ +1,727,962 +$ +1,029,556 +The current state tax provision was comprised of taxes on income, the minimum capital tax and other franchise taxes related to the jurisdictions in which the Company's facilities are located. +A summary of United States and foreign income before income taxes follows: +2020 +2019 +United States +$ +4,524,432 +$ +800,796 +Foreign +5,302,296 +5,742,368 +Total: +$ +9,826,728 +$ +6,543,164 +As discussed in Note 11 below, for segment reporting, direct import sales are included in the United States segment. However, the revenues are earned by our Hong Kong subsidiary and related income taxes are paid in Hong Kong whose rate approximates 16.5 %. As such, income of the Asian subsidiary is included in the foreign income before taxes. +The following schedule reconciles the amounts of income taxes computed at the United States statutory rates to the actual amounts reported in operations: +2020 +2019 +Federal income taxes at 21% statutory rate +$ +1,864,097 +$ +1,365,124 +State and local taxes, net of federal income tax effect +89,842 +109,593 +Permanent items +( 99,877 +) +( 137,051 +) +Foreign tax rate difference +( 126,100 +) +( 209,216 +) +Change in deferred income tax valuation allowance +— +( 98,894 +) +Provision for income taxes: +$ +1,727,962 +$ +1,029,556 +The following summarizes deferred income tax assets and liabilities: +2020 +2019 +Deferred income tax liabilities: +Plant, property and equipment +$ +1,556,398 +$ +1,022,898 +1,556,398 +1,022,898 +Deferred income tax assets: +Asset valuations +992,101 +604,755 +Pension +— +81,561 +Other +454,076 +287,298 +1,446,177 +973,614 +Net deferred income tax liability: +$ +110,221 +$ +49,284 +30 +On January 22, 2018, the FASB released guidance on the accounting for tax on the global intangible low-taxed income (“GILTI”) provisions of the Act. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company considers any potential GILTI as an expense in the period the tax is incurred. +In 2020, the Company evaluated its tax positions for years which remain subject to examination by major tax jurisdictions, in accordance with the requirements of ASC 740 and as a result, concluded no adjustment was necessary. The Company files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. The Company’s evaluation of uncertain tax positions was performed for the tax years ended December 31, 2017 and forward, the tax years which remain subject to examination by major tax jurisdictions as of December 31, 2020. +Due to the uncertain nature of the realization of the Company's deferred income tax assets based on past performance of its German subsidiary and net loss carry forward expiration dates, the Company has recorded a valuation allowance for the amount of deferred income tax assets which are not expected to be realized. This valuation allowance, all of which is related to deferred tax assets resulting from net operating losses of the Company’s German subsidiary, is subject to periodic review, and, if the allowance is reduced, the tax benefit will be recorded in future operations as a reduction of the Company's tax expense. +8. Long-Term Debt and Shareholders’ Equity +Long-term debt consists of borrowings under the Company’s revolving loan agreement with HSBC Bank, N.A. The agreement provides for borrowings of up to $ 50 million at Prime Rate less 1.25 % . The credit facility has an expiration date of May 24, 2023 . The Company must pay a facility fee, payable quarterly, in an amount equal to two tenths of one percent (. 20 %) per annum of the average daily unused portion of the revolving credit line. The facility is intended to provide liquidity for growth, share repurchases, dividends, acquisition and other business activities. Under the revolving loan agreement, the Company is required to maintain specific amounts of tangible net worth, a specified debt to net worth ratio and a fixed charge coverage ratio and must have annual net income greater than zero, measured as of the end of each fiscal year. December 31, 2020, the Company was in compliance with the covenants then in effect under the loan agreement. +As of December 31, 2020, $ 38,767,167 was outstanding and $ 11,232,833 was available for borrowing under the Company’s revolving loan agreement. +The Company’s First Aid Only manufacturing and distribution center in Vancouver, WA was financed by a variable rate mortgage with HSBC Bank, N.A. at an interest rate of LIBOR plus 2.5 % . Commencing on December 1, 2017, principal payments of $ 22,222 are due monthly, with all amounts outstanding due on maturity on October 31, 2024 . Minimum annual mortgage payments are due as follows: 2021 - $ 266,667 ; 2022 - $ 266,667 ; 2023 - $ 266,667 ; 2024 - $ 266,667 ; 2025 - $ 266,667 ; and thereafter - $ 1,844,443 . +On November 14, 2019, the Company announced a Common Stock repurchase program of up to a total of 200,000 shares. The program does not have an expiration date. During the twelve months ended December 31, 2020, the Company repurchased 14,420 shares of its Common Stock. As of December 31, 2020, a total of 203,579 shares may be purchased in the future under the repurchase programs announced in 2010 and 2019. +On May 7, 2020, the Company received a loan (the “PPP Loan”) from HSBC Bank, N.A. in the amount of $ 3,508,047 under the Paycheck Protection Program established by the Coronavirus Aid, Relief and Economic Security Act. Subject to potential forgiveness, as described below, the PPP Loan matures in two years on May 8, 2022 , bears interest at a rate of 1.00 % per year and is evidenced by a promissory note dated May 7, 2020 (the “Note”). Monthly payments of principal and interest are deferred until after any application for forgiveness submitted by the Company has been acted upon, as described below. The PPP Loan is unsecured and federally guaranteed. The Note contains customary events of default relating to, among other things, failure to make payments of principal and interest and breaches of representations and warranties. The Company may prepay the PPP Loan at any time prior to maturity with no penalty. +All or a portion of the PPP Loan may be eligible to be forgiven by the U.S. Small Business Administration (“SBA”) and the lender upon application by the Company, provided that the Company shall have used the loan proceeds for eligible purposes, including the payment of payroll, benefits, rent, mortgage interest and utilities, during the 24 week period beginning on the date of funding of the loan (the “covered period”). Not more than 40 % of the amount forgiven may be for non-payroll costs. +Consistent with the requirements of the PPP for loan forgiveness, the Company used the loan proceeds solely for payment of payroll and otherwise in a manner which it believes satisfy the requirements for loan forgiveness. In August 2020, the Company submitted an application for forgiveness of the entire amount of the PPP loan to HSBC Bank, N.A. (the Lender). The lender approved the forgiveness application and, on August 26, 2020, submitted the Company’s application to the SBA for its approval. The SBA subsequently asked the Company to provide certain additional information and documentation in connection with it review of the Company’s forgiveness application and the Company has done so. The application is presently pending. No assurance can be given that the Company’s application for loan forgiveness will be approved by the SBA, in whole or in part. +The SBA reserves the right to audit any PPP loan, regardless of size. These audits may occur after forgiveness has been granted. Under the CARES Act, all borrowers are required to maintain their loan documentation for six years after the PPP loan was forgiven or repaid in full and to provide that documentation to the SBA upon request +The carrying value of the Company’s bank debt is a reasonable estimate of fair value because of the nature of its payment terms and maturity. +31 +9. Revenue from Contracts with Customers +Nature of Goods and Services +The Company recognizes revenue from the sales of a broad line of products that are grouped into two main categories: (i) cutting, sharpening and measuring; and (ii) first aid and safety. The cutting and sharpening category includes scissors, knives, paper trimmers, pencil sharpeners and other sharpening tools. The first aid and safety category includes first aid kits and refills, over-the-counter medications and a variety of safety products. Revenue recognition is evaluated through the following five steps: (i) identification of the contract or contracts with a customer; (ii) identification of the performance obligations in the contract; (iii) determination of the transaction price; (iv) allocation of the transaction price in the contract; and (v) recognition of revenue when or as a performance obligation is satisfied. +When Performance Obligations Are Satisfied +A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Revenue is generated by the sale of the Company’s products to its customers. Sales contracts (purchase orders) generally have a single performance obligation that is satisfied at a point in time, with shipment or delivery, depending on the terms of the underlying contract. Revenue is measured based on the consideration specified in the contract. The amount of consideration we receive and revenue we recognize is impacted by incentives ("customer rebates"), including sales rebates, which are generally tied to sales volume levels, in-store promotional allowances, shared media and customer catalogue allowances and other cooperative advertising arrangements; freight allowance programs offered to our customers; and allowance for returns and discounts. The Company generally recognizes customer rebate costs as a deduction to gross sales at the time that the associated revenue is recognized. +Significant Payment Terms +Payment terms for each customer are dependent on the agreed upon contractual repayment terms. Typically between 30 and 90 days, but they vary dependent on the size of the customer and its risk profile to the Company. Some customers receive discounts for early payment. +Product Returns +The Company accepts product returns in the normal course of business. The Company estimates reserves for returns and the related refunds to customers based on historical experience. Reserves for returned merchandise are included as a component of “Accounts receivables” in the consolidated balance sheets. +Practical Expedient Usage and Accounting Policy Elections +For the Company’s contracts that have an original duration of one year or less, the Company uses the practical expedient in ASC 606-10-32-18 applicable to such contracts and accordingly, does not consider the time value of money in relation to significant financing components. The effect of applying this practical expedient election did not have an impact on the Company’s consolidated financial statements. +Per ASC 606-10-25-18B, the Company has elected to account for shipping and handling activities that occur after the customer has obtained control as a fulfillment activity instead of a performance obligation. Furthermore, shipping and handling activities performed before transfer of control of the product also do not constitute a separate and distinct performance obligation. +The Company has elected to exclude from the transaction price those amounts which relate to sales and other taxes that are assessed by governmental authorities and that are imposed on and concurrent with a specific revenue-producing transaction and collected by the Company from a customer. +Applying the practical expedient in ASC 340-40-25-4 – Other Assets and Deferred Costs , the Company recognizes the incremental costs of obtaining contracts as an expense when incurred. These costs are included in “Selling, general and administrative expenses.” The effect of applying this practical expedient did not have a material impact on the Company’s consolidated financial statements in the year ended December 31, 2020. +32 +Disaggregation of Revenues +The following table represents external net sales disaggregated by product category, by segment: +For the twelve months ended December 31, 2020 +(amounts in 000's) +United States +Canada +Europe +Total +Cutting, Sharpening and Measuring +$ +65,805 +$ +6,434 +$ +11,843 +$ +84,082 +First Aid and Safety +74,386 +4,552 +983 +79,921 +Total Net Sales +$ +140,191 +$ +10,986 +$ +12,826 +$ +164,003 +For the twelve months ended December 31, 2019 +(amounts in 000's) +United States +Canada +Europe +Total +Cutting, Sharpening and Measuring +$ +63,189 +$ +6,678 +$ +10,062 +$ +79,929 +First Aid and Safety +62,528 +— +— +62,528 +Total Net Sales +$ +125,717 +$ +6,678 +$ +10,062 +$ +142,457 +10. Segment Information +The Company reports financial information based on the organizational structure used by the Company’s chief operating decision makers for making operating and investment decisions and for assessing performance. The Company’s reportable business segments consist of: (1) United States; (2) Canada; and (3) Europe. As described below, the activities of the Company’s Asian operations are closely linked to those of the U.S. operations; accordingly, the Company’s chief operating decision makers review the financial results of both on a consolidated basis, and the results of the Asian operations have been aggregated with the results of the United States operations to form one reportable segment called the “United States segment” or “U.S. segment”. Each reportable segment derives its revenue from the sales of cutting devices, measuring instruments and safety products for school, office, home, hardware, sporting and industrial use. +Domestic sales orders are filled primarily from the Company’s distribution centers and facilities in North Carolina, Washington, Massachusetts, Tennessee, Florida and California. The Company is responsible for the costs of shipping, insurance, customs clearance, duties, storage and distribution related to such products. Orders filled from the Company’s inventory are generally for less than container-sized lots. +Direct import sales are products sold by the Company’s Asian subsidiary, directly to major U.S. retailers who take ownership of the products in Asia. These sales are completed by delivering product to the customers’ common carriers at the shipping points in Asia. Direct import sales are made in larger quantities than domestic sales, typically full containers. Direct import sales represented approximately 10 % and 14 % of the Company’s total net sales in 2020 and 2019, respectively. +The Chief Operating Decision Maker evaluates the performance of each operating segment based on segment revenues and operating income. Segment revenues are defined as total revenues, including both external customer revenue and inter-segment revenue. Segment operating earnings are defined as segment revenues, less cost of goods sold and operating expenses. Identifiable assets by segment are those assets used in the respective reportable segment’s operations. Inter-segment amounts are eliminated to arrive at consolidated financial results. +The following table sets forth certain financial data by segment for the fiscal years ended December 31, 2020 and 2019: +Financial data by segment: +(000’s omitted) +Year Ended December 31, 2020 +United States +Canada +Europe +Consolidated +Net sales +$ +140,191 +$ +10,986 +$ +12,826 +$ +164,003 +Operating income +8,872 +1,332 +1,209 +11,413 +Assets +113,831 +7,432 +8,605 +129,868 +Additions to property, plant and equipment +2,386 +34 +149 +2,569 +Depreciation and amortization +3,668 +95 +78 +3,841 +33 +Year Ended December 31, 2019 +United States +Canada +Europe +Consolidated +Net sales +$ +125,717 +$ +6,678 +$ +10,062 +$ +142,457 +Operating income +7,199 +771 +459 +8,429 +Assets +98,577 +6,168 +6,003 +110,749 +Additions to property, plant and equipment +1,646 +2 +32 +1,680 +Depreciation and amortization +3,347 +16 +70 +3,433 +The following is a reconciliation of segment operating income to consolidated income before taxes: +2020 +2019 +Total operating income +$ +11,413 +$ +8,429 +Interest expense, net +920 +1,789 +Other expense +666 +97 +Consolidated income before taxes +$ +9,827 +$ +6,543 +The table below presents revenue by geographic area. Revenues are attributed to countries based on location of the customer. +Revenues +2020 +2019 +United States +$ +138,921 +$ +124,059 +International: +Canada +10,986 +6,678 +Europe +12,826 +10,062 +Other +1,270 +1,658 +Total International +$ +25,082 +$ +18,398 +Total Revenues +$ +164,003 +$ +142,457 +11. Stock Option Plans +The Company grants stock options under the 2012 Employee Stock Option Plan (the “2012 Employee Plan”) and under the 2017 Non-Salaried Director Stock Option Plan (the “2017 Director Plan”). The Company also has two plans under which the Company no longer grants options but under which certain options remain outstanding: the 2002 Employee stock Option Plan and the 2005 Non-Salaried Director Stock Option Plan (the “2005 Director Plan”). +The 2012 Employee Plan, which became effective April 23, 2012, provides for the issuance of incentive and nonqualified stock options at an exercise price equal to the fair market value of the Common Stock on the date the option is granted. The terms of the options granted are subject to the provisions of the 2012 Employee Plan. Options granted under the 2012 Employee Plan vest 25% one day after the first anniversary of the grant date and 25% one day after each of the next three anniversaries. As of December 31, 2020, the number of shares available for grant under the 2012 Employee Plan was 79,375 . Under the terms of the 2012 Employee Plan, no option may be granted under that plan after the tenth anniversary of the adoption of the plan. Options outstanding under the Company’s 2002 Employee Stock Option Plan have the same vesting schedule as the 2012 Employee Plan. +The 2017 Director Plan provides for the issuance of stock options for up to a total of 50,000 shares of the Company's common stock to non-salaried directors. Under the 2017 Director Plan, Directors elected after the effective date and at subsequent Annual Meetings who have not received any prior grant under this or previous plans shall receive an initial grant of an option to purchase 5,000 shares of Common Stock (the “Initial Option”). Each year, each elected Director not receiving an Initial Option will receive an option to purchase 5,000 shares of Common Stock (the “Annual Option”). The Initial Option vests 25% on the date of grant and 25% on the anniversary of the grant date in each of the following 3 years. Each Annual Option becomes fully exercisable one day after the date of grant. The exercise price of each option granted equals the fair market value of the Common Stock on the date the option is granted, and expires ten (10) years from the date of grant. As provided in the Director Plan, no options may be granted under the 2017 Director Plan after the tenth anniversary of the adoption of the Plan, i.e., after April 24, 2027. As of December 31, 2020, there were 25,000 shares available for grant under the 2017 Director Plan. +The 2005 Director Plan, as amended, provided for the issuance of stock options for up to a total of 180,000 shares of the Company's common stock to non-salaried directors. Under the 2005 Director Plan, Directors elected on April 25, 2005 and at subsequent Annual Meetings who had not received any prior grant under this or previous plans received an initial grant of an option to purchase 5,000 shares of Common Stock (the “Initial Option”). Each year, each elected Director not receiving an Initial Option received a 5,000 share option (the “Annual Option”). The Initial Option vested 25% on the date of grant and 25% on the anniversary of the grant date in each of the following 3 years. Each Annual Option became fully exercisable one day after the date of grant. The exercise price of each option granted equaled the fair market value of the Common Stock on the date the option was granted, and expired ten (10) years from the date of grant. As provided in the Director Plan, no options could be granted under the 2005 Director Plan after the tenth anniversary of the adoption of the Plan, i.e., after April 25, 2015. +The Company has amended certain of its stock option plans for both employees and directors to permit options to be exercised on a net basis and receive either cash or shares of the Company’s Common Stock. Specifically, optionees may, at the time of exercise of an option and subject to the consent of the Company, elect either (i) to receive from the Company cash in an amount equal to the number of shares of +34 +Common Stock subject to the option (or portion thereof) that is being exercised multiplied by the excess of (a) the fair market value per share over (b) the exercise price per share of the option (a “net cash settlement”); or (ii) to make payment of the exercise price of the option by reduction in the number of shares of Common Stock otherwise deliverable upon exercise of such option by the number of shares having an aggregate fair market value equal to the total exercise price of the option (or portion thereof). In 20 20 and 2019 , the Company paid a total of approximately $ 1,644,118 and $ 1,687,782 respectively, to optionees who had elected a net cash settlement of their respective share options. +A summary of changes in options issued under the Company’s stock option plans follows: +2020 +2019 +Options outstanding at the beginning of the year +1,363,694 +1,434,280 +Options granted +280,750 +120,000 +Options forfeited +( 9,125 +) +( 26,500 +) +Options exercised +( 147,394 +) +( 164,086 +) +Options outstanding at the end of the year +1,487,925 +1,363,694 +Options exercisable at the end of the year +985,475 +932,094 +Common stock available for future grants at the end of the year +104,372 +44,875 +Weighted average exercise price per share: +Granted +$ +23.05 +$ +19.88 +Forfeited +21.72 +23.29 +Exercised +14.51 +10.54 +Outstanding +20.26 +19.08 +Exercisable +18.99 +17.50 +A summary of options outstanding as December 31, 2020 is as follows: +Options Outstanding +Options Exercisable +Range of Exercise Prices +Number +Outstanding +Weighted- +Average +Remaining +Contractual +Life (Years) +Weighted- +Average +Exercise +Price +Number +Exercisable +Weighted- +Average +Exercise +Price +$9.26 to $16.08 +290,200 +2 +$ +12.39 +290,200 +$ +12.39 +$16.09 to $21.35 +282,000 +6 +18.41 +204,500 +17.95 +$21.36 to $22.86 +350,375 +7 +22.14 +261,375 +21.97 +$22.87 to $23.97 +255,450 +9 +23.17 +11,350 +23.94 +$23.98 to $28.20 +309,900 +7 +24.80 +218,050 +24.94 +1,487,925 +985,475 +The weighted average remaining contractual life of all outstanding stock options is 6 years. +Stock-Based Compensation +Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is generally the vesting period. The Company uses the Black-Scholes option pricing model to determine the fair value of employee and non-employee director stock options. The determination of the fair value of stock-based payment awards on the date of grant, using an option-pricing model, is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of the Company’s Common Stock price over the expected term (“volatility”) and the number of options that will not fully vest in accordance with applicable vesting requirements (“forfeitures”). +The Company estimates the expected term of options granted by evaluating various factors, including the vesting period, historical employee information, as well as current and historical stock prices and market conditions. The Company estimates the volatility of its common stock by calculating historical volatility based on the closing stock price on the last day of each of the 60 months leading up to the month the option was granted. The risk-free interest rate that the Company uses in the option valuation model is the interest rate on U.S. Treasury zero-coupon bond issues with remaining terms similar to the expected term of the options granted. Historical information was the basis for calculating the dividend yield. The Company is required to estimate forfeitures at the time of grant and to revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company used a mix of historical data and future assumptions to estimate pre-vesting option forfeitures and to record stock-based compensation expense only for those awards that are expected to vest. All stock-based payment awards are amortized over the requisite service periods of the awards, which are generally the vesting periods. +35 +The assumptions used to value option grants for the twelve months ended December 31, 2020 and December 31, 2019 were as follows: +2020 +2019 +Expected life in years +6 +5 - 6 +Interest rate +.30 - 1.63% +1.52 - 2.39% +Volatility +.358 - .384 +.358 - .375 +Dividend yield +2.0 - 2.2% +2.0 - 2.2% +Total stock-based compensation recognized in the Company’s consolidated statements of operations for the years ended December 31, 2020 and 2019 was $ 1,259,079 and $ 968,467 , respectively. At December 31, 2020, there was approximately $ 1,853,873 of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based payments granted to the Company’s employees. As of December 31, 2020, the remaining unamortized expense is expected to be recognized over a weighted average period of 3 years. +The weighted average fair value at the date of grant for options granted during 2020 and 2019 was $ 6.59 and $ 5.88 per option, respectively. The aggregate intrinsic value of outstanding options was $ 14,681,187 at December 31, 2020. The aggregate intrinsic value of exercisable options was $ 10,974,625 at December 31, 2020. The aggregate intrinsic value of options exercised during 2020 was $ 1,743,568 . +12. Earnings Per Share +The calculation of earnings per share follows: +2020 +2019 +Numerator: +Net income +$ +8,098,766 +$ +5,513,608 +Denominator: +Denominator for basic earnings per share: +Weighted average shares outstanding +3,342,630 +3,351,731 +Effect of diluted employee stock options +166,867 +100,892 +Denominator for dilutive earnings per share +3,509,497 +3,452,623 +Basic earnings per share +$ +2.42 +$ +1.65 +Diluted earnings per share +$ +2.31 +$ +1.60 +For 2020 and 2019, respectively, 309,900 and 705,725 stock options were excluded from diluted earnings per share calculations because they would have been anti-dilutive. +13. Accumulated Other Comprehensive Loss +The components of accumulated other comprehensive loss follow: +Foreign currency +translation +adjustment +Net prior service +credit and +actuarial losses +Total +Balances, January 1, 2019 +$ +( 1,518,822 +) +$ +( 539,163 +) +$ +( 2,057,985 +) +Change in net prior service credit and actuarial losses, net of tax +— +143,906 +143,906 +Adoption of ASU 2018-02 +— +( 119,014 +) +( 119,014 +) +Translation adjustment +45,223 +— +45,223 +Balances, December 31, 2019 +$ +( 1,473,599 +) +$ +( 514,271 +) +$ +( 1,987,870 +) +Change in net prior service credit and actuarial losses, net of tax +— +514,271 +514,271 +Translation adjustment +647,632 +— +647,632 +Balances, December 31, 2020 +$ +( 825,967 +) +$ +— +$ +( 825,967 +) +14. Leases +The Company has operating leases for office and warehouse space and equipment under various arrangements which provide the right to use the underlying asset and require lease payments for the lease term. The Company’s lease portfolio consists of operating leases which expire at various dates through 2026. +Certain of the Company’s lease arrangements contain renewal provisions, exercisable at the Company's option. The Company’s lease agreements do not contain any material residual value guarantees or material restrictive covenants. +36 +The Company determines if an arrangement is an operating lease at inception. Leases with an initial term of 12 months or less are not recorded on the Balance Sheet . All other leases are recorded on the balance sheet with right-of-use (“ROU”) assets representing the right to use the underlying asset for the lease term and lease liabilities representing the obligation to make lease payments arising from the lease. +ROU assets and lease liabilities are recognized at commencement date based on the present value of lease payments over the lease term and include options to extend or terminate the lease when they are reasonably certain to be exercised. As most of our leases do not provide an implicit rate, the present value of lease payments is determined primarily using our incremental borrowing rate based on the information available at the lease commencement date. The incremental borrowing rate is the rate of interest that we would have to pay to borrow on a collateralized basis over a similar term on an amount equal to the lease payments in a similar economic environment. Lease agreements with lease and non-lease components are generally accounted for as a single lease component. The Company’s operating lease expense is recognized on a straight-line basis over the lease term. Operating lease cost was $ 1.1 million for the twelve-months ended December 31, 2020. For the twelve months ended December 31, 2020, $ 0.4 million was included in cost of goods sold and $ 0.7 million was included in selling, general and administrative expenses in the accompanying condensed consolidated statements of operations. +Information related to leases (in 000’s) : +Twelve months ended +December 31, 2020 +Operating lease cost +$ +1,186 +Operating lease - cash flow +$ +1,087 +December 31, 2020 +Weighted-average remaining lease term +4.0 years +Weighted-average discount rate +5 +% +Future minimum lease payments under non-cancellable leases as of December 31, 2020: +2021 +$ +916 +2022 +690 +2023 +569 +2024 +309 +2025 +220 +Thereafter +75 +Total future minimum lease payments +$ +2,779 +Less : imputed interest +( 252 +) +Less : present value of lease liabilities - current +( 873 +) +Present value of lease liabilities - non-current +$ +1,654 +15. Business Combinations +Med-Nap, LLC +On December 16, 2020, the Company purchased the assets of Med-Nap LLC., located in Brooksville, Florida for $ 9.3 million. Med-Nap is a leading manufacturer of alcohol prep pads, alcohol wipes, benzalkonium chloride wipes (BZK), antiseptic wipes, castile soap, and lens cleaning products. +The purchase price was allocated to assets acquired and liabilities assumed as follows (in thousands): +Assets: +Inventory +$ +591 +Prepaid expense +25 +Land & buildings +1,800 +Equipment +4,195 +Goodwill +149 +Intangible assets +2,882 +Total assets +$ +9,642 +Accounts payable +336 +Total considerations +$ +9,308 +The acquisition was accounted for as a business combination, pursuant to ASC 805 – Business Combinations . All assets acquired in the acquisition are included in the Company’s US segment. +First Aid Central: +37 +On January 7, 2020, the Company purchased the assets of First Aid Central, a Canadian first aid and safety supplier, based in Laval, Canada for approximately $ 2.1 million in cash. First Aid Central products consist of a broad line of first aid kits, refills, and safety products that are sold to a wide range of industries and end users. The products meet federal Health Canada and provincial regulatory requirements. +The purchase price was allocated to assets acquired as follows (in thousands): +Assets: +Accounts receivable +$ +232 +Inventory +440 +Prepaid Expense +47 +Equipment +45 +Intangible assets +1,310 +Total assets +$ +2,074 +The acquisition was accounted for as a business combination, pursuant to ASC 805 – Business Combinations . All assets acquired in the acquisition are included in the Company’s Canada segment. +Net sales for the year ended December 31, 2020 attributable to the sales of First Aid Central products were approximately $ 4.6 million. Net income for the year ended December 31, 2020 attributable to First Aid Central products was approximately $ 0.3 million. +Assuming First Aid Central assets were acquired on January 1, 2019, unaudited proforma combined net sales for the year ended December 31, 2019 for the Company would have been approximately $ 145.9 million. Unaudited proforma combined net income for the year ended December 31, 2019 for the Company would have been approximately $ 5.9 million. +38 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Shareholders and Board of Directors of +Acme United Corporation +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Acme United Corporation and Subsidiaries (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity and cash flows for each of the years in the period ended December 31, 2020 and 2019, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the period ended December 31, 2020 and 2019, in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company's internal control over financial reporting as of December 31, 2020, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013 and our report dated March 31, 2021, expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of the existence of a material weakness. +Basis for Opinion +These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +We have served as the Company’s auditor since 2008; such date takes into consideration the acquisition of a portion of UHY LLP by Marcum LLP in April 2010. +Marcum LLP +New Haven, Connecticut +March 31, 2021 +39 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING +To the Shareholders and Board of Directors of +Acme United Corporation +Adverse Opinion on Internal Control over Financial Reporting +We have audited Acme United Corporation and Subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2020 based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, because of the effect of the material weakness described in the following paragraph on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2020 based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +A material weakness is a control deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. The following material weakness has been identified and included in “Management's Annual Report on Internal Control over Financial Reporting”: The Company’s controls related to the existence of inventory at the Rocky Mount, NC warehouse were not effective as the cycle count program used did not demonstrate inventory quantities were sufficiently counted. +This material weakness was considered in determining the nature, timing and extent of audit tests applied in our audit of the consolidated financial statements for the year ended December 31, 2020, and this report does not affect our report dated March 31, 2021 on those consolidated financial statements. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets as of December 31, 2020 and 2019 and the related consolidated statements of operations and comprehensive income, changes in stockholders’ equity, and cash flows and the related notes for each of the two years in the period ended December 31, 2020, and our report dated March 31, 2021 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying "Management’s Annual Report on Internal Control over Financial Reporting." Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures, as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. +Because of the inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that degree of compliance with the policies or procedures may deteriorate. +Marcum llp +New Haven, Connecticut +March 31, 2021 +40 +Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +There have been no disagreements with accountants related to accounting and financial disclosures in 2020. +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures. +An evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of December 31, 2020. Based on and as of the time of such evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this report to ensure that information required to be disclosed by us in the reports that we file or submit is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. This conclusion was based on the identification of the deficiency in internal control over financial reporting described below. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Notwithstanding the deficiency that existed as of December 31, 2020, our Chief Executive Officer and Chief Financial Officer have concluded that the financial statements included in this Annual Report on Form 10-K present fairly, in all material respects, the financial position, results of operations and cash flows of the Company in conformity with accounting principles generally accepted in the United States of America. +Management's Report on Internal Control over Financial Reporting. +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements in accordance with United States Generally Accepted Accounting Principles (“GAAP”). Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Our management has identified a deficiency related to the Company’s inventory cycle count program, as described below. The deficiency was concluded to be a “material weakness”, which is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements would not be prevented or detected on a timely basis. Based on this material weakness identified in the management evaluation of internal controls over financial reporting, management has concluded that our internal control over financial reporting was not effective as of December 31, 2020. +The Company’s controls related to the existence of inventory at the Rocky Mount, NC warehouse (the “Warehouse”) were not effective as the cycle count program used did not demonstrate inventory quantities were sufficiently counted. This was the consequence of a number of factors, including the impact of COVID-19 on the Company’s operations, resulting in delays in the counting process. In order to attain the results of a full physical inventory, the C ompany counted $10 million of inventory in February and March of 2021, which resulted in a non-material increase to inventory of $18,000, or less than 0.1%. It should be noted that in the previous three years, inventory adjustments related to cycle counts amounted to approximately 0.2% annually. +The non-material adjustment to inventory did not require any change in the results reported by the Company in the earnings release for the Company’s fourth quarter and year end December 31, 2020 (Filed with the Company’s Form 8K on March 3, 2021). +Remediation +Based on the results of management’s evaluation of the effectiveness of the Company’s internal control over financial reporting, the Company determined to take a number of actions to remediate the control deficiency described above. The remediation actions include: +● The Company has evaluated the processes, procedures and controls related to the Warehouse cycle count program and has commenced making changes as considered appropriate to address the control deficiency. +● The Company is in the process of implementing a new inventory management system at the Warehouse, which is expected to be in place by the end of the second quarter 2021. The new software will allow the Company to conduct its inventory cycle count program more efficiently. +● The Company is allocating additional resources to the implementation of its inventory cycle count program, including the hiring of additional personnel who will participate in the conduct of the program. +We believe that these actions will remediate the material weakness. The material weakness will not be considered remediated, however, until the applicable controls operate for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively. We expect that the remediation of this material weakness will be completed prior to the end of fiscal 2021. +41 +Our independent registered public accounting firm, Marcum LLP, has issued an adverse attestation report on the effectiveness of our internal control over financial reporting as of December 31, 2020, as stated in their report which is included in the Financial Statements of this Annual Report on Form 10-K. Marcum LLP has also audited our consolidated financial statements at December 31, 2020, and for each of the two years in the period ended December 31, 2020, and its report dated March 31, 2021, expressed an unqualified opinion on our consolidated financial statements. +Inherent Limitation on Effectiveness of Controls +Internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by the board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP including those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets, (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that receipts and expenditures are being made only in accordance with authorizations of our management and directors, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies and procedures may deteriorate. +Changes in Internal Control over Financial Reporting. +Except for factors pertaining to the material weakness identified above, there have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth fiscal quarter ended December 31, 2020, to which this report relates, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +Item 9B. Other Information +None. +42 +PART III +Item 10. Directors, Executive Officers and Corporate Governance +The following table sets forth certain information with respect to the directors and executive officers of the Company. All directors of the Company hold office until the next annual meeting of the shareholders or until their successors have been elected and qualified. Executive officers are elected by the Board of Directors to hold office until their successors are elected and qualified. +Name +Age +Position Held with Company +Walter C. Johnsen +70 +Chairman of the Board and Chief Executive Officer +Brian S. Olschan +64 +President, Chief Operating Officer and Director +Paul G. Driscoll +60 +Vice President, Chief Financial Officer, Secretary and Treasurer +Rex L. Davidson +71 +Director +Richmond Y. Holden, Jr. +67 +Director +Susan H. Murphy +Brian K. Barker +69 +61 +Director +Director +Stevenson E. Ward III +75 +Director +Walter C. Johnsen has served as Chairman of the Board and Chief Executive Officer of the Company since January 1, 2007; President and Chief Executive Officer of the Company from November 30, 1995 to December 31, 2006. Mr. Johnsen previously served as Vice Chairman and a principal of Marshall Products, Inc., a medical supply distributor. Mr. Johnsen has served on the Board of TOMI Environmental Solutions, Inc., a publicly traded company, since February 1, 2016. Mr. Johnsen’s qualifications to serve on the Board of the Company include the in-depth knowledge of all facets of the Company’s business which he has gained during his more than twenty-five years of service as the Company’s Chief Executive Officer. +Brian S. Olschan has served as President and Chief Operating Officer of the Company since January 1, 2007; Executive Vice President and Chief Operating Officer of the Company from January 1999 to December 31, 2006; Senior Vice President - Sales and Marketing of the Company from September 1996 to January 1999. Mr. Olschan previously served as Vice President and General Manager of the Cordset and Assembly Business of General Cable Corporation, an electrical wire and cable manufacturer. Mr. Olschan’s qualifications to serve on the Board include his detailed knowledge of the Company’s operations which he has gained in his capacity as a member of senior management for more than 24 years, including as Chief Operating Officer since January 1999 and President since January 2007. +Paul G. Driscoll has served as Vice President and Chief Financial Officer, Secretary and Treasurer since October 2, 2002. Mr. Driscoll joined Acme as Director of International Finance on March 19, 2001. From 1997 to 2001, he was employed by Ernest and Julio Gallo Winery, including as Director of Finance and Operations in Japan. Prior to Gallo he served in several increasingly responsible finance positions in Sterling Drug Inc. in New York City and Sanofi S.A. in France. +Rex L. Davidson has served as Director since 2006. Executive Director of the Helms Fund, 2013-2019. The Helms Fund provides "gap financing" to socially responsible business ventures for capital expenditures. Additionally, since 2009, Mr. Davidson has served as President of Rex Davidson Associates, LLC, a management consulting service. From 2009 to 2019, Mr. Davidson served as Executive Director of Las Cumbres Community Services, which provides developmental disability and mental health services to children, adults and families in Northern New Mexico; from 2019 to 2020, he served as the Director of Special Initiatives. From 1982 to 2009, he served as President and Chief Executive Officer of Goodwill Industries of Greater New York and Northern New Jersey, Inc., and President of Goodwill Industries Housing Corporation. Mr. Davidson’s qualifications to serve on the Board include significant management experience at the highest level, having been responsible for the management of Goodwill Industries, an organization with over 2,000 employees and revenues in excess of $100 million. Mr. Davidson’s experience in the areas of compensation of personnel at all levels, his experience relating to retail matters, such as retail trends and pricing, and diversity policies are of significant benefit to the Company. +Richmond Y. Holden, Jr. has served as Director since 1998. Mr. Holden served as President and CEO of INgageHub, a cloud based Marketing SaaS platform, from January 2015 through early 2016; he continued to serve as a senior advisor to the company until 2019. From 2007 through 2014, Mr. Holden served in senior executive positions at School Specialty, Inc., a distributor of school supplies, equipment and curriculum products. He last served as Executive Vice President of School Specialty, Inc., and President of the Curriculum Group, a division of School Specialty Inc., from 2013 to December 2014. He was President of Educational Resources, a division of School Specialty, Inc., from 2010 to 2013. He served as Chairman and Chief Executive Officer of J.L. Hammett Co., a reseller of educational curriculum, equipment, furniture and products from 1992 to 2006. Mr. Holden served on the Board of Directors of Software Secure, Incorporated, a privately-held company headquartered in Newton, MA, which focused on secure online educational testing technology, from 2007 until its sale in late 2016. He has served on the Board of Directors of Codman Academy Charter Public School in Boston MA since 2012. The qualifications of Mr. Holden to serve on the Board of the Company include his substantial senior executive management experience of large complex companies in the educational markets. In particular, as a result of his experience with School Specialty Inc., then a $650 million publicly held reseller of educational products, Mr. Holden has broad knowledge of educational markets and operational matters relating to developmental strategy, finance, marketing, sales, technology, sourcing, pricing and distribution. +43 +Susan H. Murphy has served as Director since 2003. Vice President Emerita, Cornell University, from which Dr. Murphy retired in 2016 after a 38-year career, commencing in 1978. She served as Dean of Admissions and Financial Aid from 1985 to 1994; Vice President of Student and Academic Services from 1994 to June 2015, and thereafter she worked in Alumni Affairs and Development until her retirement. In 2013, Dr. Murphy became a member of the Board of Trustees of Adelphi University, and, since July 2016, has served as Vice Chair of its Board of Trustees. She also serves on the Board of Directors for Kendal at Ithaca, a not-for-profit continuing care retirement community (since 2014 and Vice Chair since 2019). Dr. Murphy is immediate past President of Tompkins County Community Foundation, and, since 2017, a member of its executive committee; she also served as Chair of the Board of Directors of the Foundation (2017 – 2019). Dr. Murphy received a Ph.D. in Educational Administration from Cornell University. Dr. Murphy has broad senior management level experience in a large, complex organization . In particular, her experience in employee compensation matters and the development and implementation of diversity policies is helpful to the Company. +Brian K. Barker has been a founder and CEO of AntelopeAI, LLC an artificial intelligence and machine learning start-up since December 2018. He was a founder, director, and CEO of NorthBay Solutions, LLC, a big data and analytics company from 2010 to 2018, and continues to serve as a director. Mr. Barker was the General Manager of the xDoc business unit for Document Sciences Corporation, a document management and customer communications management solutions company, from 2007 until it was acquired by EMC Corporation, an information infrastructure solutions company, in 2008, and then continued as General Manager of the xDoc Business Unit until 2010. He previously was CEO of Cambridge Technology Vision, LLC, a merger and acquisition support software company, from 1997 to 2001, and was President of ClearSpring Technologies, Inc., an event-driven management software company, from 1989 to 1992. Mr. Barker is the co- inventor of Acquisition Trustee, which Intralinks Holdings, Inc. acquired to incorporate in its platform for secure document sharing. The qualifications of Mr. Barker to serve on the Board include his strong data analysis background, significant entrepreneurial achievements, and executive management experience at rapidly growing information technology companies. +Stevenson E. Ward III has served as Director since 2001. Mr. Ward served as Vice President and Chief Financial Officer of Triton Thalassic Technologies, Inc. from 2000 until his retirement in 2014. Triton’s technology controls and inactivates pathogens in the healthcare and industrial industries. From 1998 through 2000, Mr. Ward served as Senior Vice President-Administration of Sanofi-Synthelabo, Inc., a major multinational pharmaceutical company. He served as Executive Vice President (1996-1998), responsible for legal, tax, treasury, employee benefits and other functions, and Chief Financial Officer (1994-1996) of Sanofi, Inc., the North American holding company for Sanofi. He also served as Vice President-Finance and Administration, Pharmaceutical Group, Sterling Winthrop, Inc. (1992-1994). Prior to joining Sterling, he was employed by General Electric Company in management positions in Purchasing, Corporate Audit and Finance. Mr. Ward’s qualifications for service on the Board include his extensive experience in senior executive level positions in finance, corporate audit and administration at two Fortune 100 multinational corporations. He also holds a Masters in Business Administration (MBA) degree. +Code of Conduct +The Company has adopted a Code of Conduct that is applicable to its employees, including the Chief Executive Officer, Chief Financial Officer and Controller. The Code of Conduct is available in the investor relations section on the Company’s website at www.acmeunited.com. +If the Company makes any substantive amendments to the Code of Conduct which apply to its Chief Executive Officer, Chief Financial Officer or Controller, or grants any waiver, including any implicit waiver, from a provision of the Code of Conduct to the Company’s executive officers, the Company will disclose the nature of the amendment or waiver on its website. +Information regarding compliance with Section 16(a) beneficial ownership reporting requirements and certain corporate governance matters is incorporated herein by reference to the sections entitled (i) “Compliance with Section 16(a) of the Securities Exchange Act of 1934”, (ii) “Nominations for Directors”, and (iii) “Audit Committee” contained in the Company’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with its 2020 Annual Meeting of Shareholders. +Item 11. Executive Compensation +Information with respect to executive compensation is incorporated herein by reference to the section entitled “Executive Compensation” contained in the Company’s Proxy Statement to be filed with the SEC in connection with the Company’s 2021 Annual Meeting of Shareholders. +Item 12. Security Ownership of Certain Beneficial Owners and Management +Information regarding security ownership of certain beneficial owners, directors and executive officers is incorporated herein by reference to the information in the section entitled “Security Ownership of Directors and Officers” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its 2021 Annual Meeting of Shareholders. +44 +Item 13. Certain Relationships and Relate d Transactions, and Director Independence +Information regarding certain relationships and related transactions is incorporated herein by reference to the information in the section entitled “Certain Relationships and Related Transactions” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its 2021 Annual Meeting of Shareholders. +Information regarding director independence is incorporated herein by reference to the section entitled “Independence Determinations” contained in the Company’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company’s 2021 Annual Meeting of Shareholders. +Item 14. Principal Accounting Fees and Services +Information regarding principal accountant fees and services is incorporated herein by reference to the section entitled “Fees to Auditors” contained in the Company’s Proxy Statement to be filed with the SEC in connection with its 2021 Annual Meeting of Shareholders . +45 +PART IV +Item 15. Exhibits and Financial Statement Schedules +(a)(1) Financial Statements. +• +Consolidated Balance Sheets +• +Consolidated Statements of Operations +• +Consolidated Statements of Changes in Stockholders’ Equity +• +Consolidated Statements of Cash Flows +• +Notes to Consolidated Financial Statements +• +Report of Independent Registered Public Accounting Firm +(a)(2) Financial Statement Schedules +• +Schedules other than those listed above have been omitted because of the absence of conditions under which they are required or because the required information is presented in the financial statements or notes thereto. +(a)(3) The exhibits listed under Item 15(b) are filed or incorporated by reference herein. +(b) Exhibits. +The exhibits listed below are filed as part of this Annual Report on Form 10-K. Certain of the exhibits, as indicated, have been previously filed and are incorporated herein by reference. +Exhibit No. +Identification of Exhibit +3(i) +Re-Stated Certificate of Incorporation July 1, 2005 (2) +3(ii) +Bylaws (4) +4 +Specimen of Common Stock certificate (18) (p) +4(vi) +Description of Common Stock +10.3 +2002 Acme United Employee Stock Option Plan as amended (12) +10.4 +Severance Pay Plan dated September 28, 2004* (15) +10.5(a) +Salary Continuation Plan dated September 28, 2004, as amended (3)* +10.6(a) +2005 Non-Salaried Director Stock Option Plan, amended (6) +10.6(b) +Amendment to the 2005 Non-Salaried Director Stock Option Plan (12) +10.7 +2017 Non-Salaried Director Stock Option Plan (9) +10.8 +Deferred Compensation Plan dated October 2, 2007* (16) +10.9(a) +2012 Acme United Employee Stock Option Plan (11) +10.9(b) +Amendment to the 2012 Acme United Employee Stock Option Plan* (12) +10.10(a) +Revolving Loan Agreement with HSBC, dated April 5, 2012 (13) +10.10(b) +Amendment No. 1 to Revolving Loan Agreement with HSBC Dated (14) +10.10(c) +Amended and restated secured revolving note (14) +10.10(d) +Amendment No. 2 to Revolving Loan Agreement with HSBC dated October 2013 (15) +10.10(e) +Amendment No. 4 to Revolving Loan Agreement with HSBC dated May 6, 2016 (12) +10.10(f) +Second amended and restated secured revolving note (12) +10.10(g) +Amendment No. 5 to Revolving Loan Agreement with HSBC dated January 2017 (16) +10.10(h) +Amendment No. 6 to Revolving Loan Agreement with HSBC dated March 2018 +10.11 +Change in Control Plan as amended dated February 24, 2011* (17) +21 +Subsidiaries of the Registrant +23.1 +Consent of Marcum LLP, Independent Registered Public Accounting Firm +46 +31.1 +Certification of Walter Johnsen pursuant to Rule 13a-14(a) and 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002 +31.2 +Certification of Paul Driscoll pursuant to Rule 13a-14(a) and 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002 +32.1 +Certification of Walter Johnsen pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +32.2 +Certification of Paul Driscoll pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +* +Indicates a management contract or a compensatory plan or arrangement +(1) +Previously filed as an Exhibit to the Company’s Form 8-K/A filed on August 19, 2014. +(2) +Previously filed in the Company’s Form 8-K filed on July 8, 2005. +(3) +Previously filed in the Company’s Form 8-K filed on February 9, 2005. +(4) +Previously filed in the Company’s Form 8-K filed on March 3, 2006. +(5) +Previously filed in the Company’s Proxy Statement for the 2005 Annual Meeting of Shareholders. +(6) +Previously filed in the Company’s Proxy Statement filed on March 29, 2005. This plan expired in 2015. +(7) +Previously filed in the Company’s Form 8-K filed on December 21, 2010. +(8) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 17, 2005. +(9) +Previously filed as an exhibit to the Company’s Proxy Statement filed on March 22, 2017. +(10) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 12, 2008. +(11) +Previously filed as an exhibit to the Company’s Form 10-Q filed on August 14, 2012. +(12) +Previously filed as an exhibit to the Company’s Form 10-Q filed on May 13, 2016. +(13) +Previously filed as an exhibit to the Company’s Form 10-Q filed on May 14, 2012. +(14) +Previously filed as an exhibit to the Company’s Form 10-Q filed on May 10, 2013. +(15) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 6, 2014. +(16) +Previously filed as an exhibit to the Company’s Form 10-Q filed on August 4, 2017. +(17) +Previously filed as an exhibit to the Company’s Form 10-K filed on March 11, 2011. +(1 8 ) +Previously filed as an exhibit to the Company’s Form 10-K filed in 1971. +Item 16. Form 10-K Summary +Not applicable. +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 31, 2021. +47 +ACME UNITED CORPORATION +(Registrant) +Signatures: +Titles: +/s/ Walter C. Johnsen +Walter C. Johnsen +Chairman and Chief Executive Officer +/s/ Brian S. Olschan +Brian S. Olschan +President, Chief Operating Officer and Director +/s/ Paul G. Driscoll +Paul G. Driscoll +Vice President, Chief Financial Officer, Secretary and Treasurer +/s/ Rex Davidson +Rex Davidson +Director +/s/ Richmond Y. Holden, Jr. +Richmond Y. Holden, Jr. +Director +/s/ Susan H. Murphy +Susan H. Murphy +Director +/s/ Stevenson E. Ward III +Stevenson E. Ward III +Director +/s/ Brian K. Barker +Brian K. Barker +Director +48 \ No newline at end of file diff --git a/raw/filings/0000002098/2020/0001564590-21-017128/filing_metadata.csv b/raw/filings/0000002098/2020/0001564590-21-017128/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..cb0c0bf0b0b1d9a2200ce274e6fa6706279a79b8 --- /dev/null +++ b/raw/filings/0000002098/2020/0001564590-21-017128/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002098,ACU,ACME UNITED CORP,2020,10-K,2021-03-31,2020-12-31,2021-03-31T21:27:13.000Z,0001564590-21-017128,acu-10k_20201231.htm,10-K,10669200,1,1,https://www.sec.gov/Archives/edgar/data/2098/000156459021017128/acu-10k_20201231.htm,https://www.sec.gov/Archives/edgar/data/2098/000156459021017128/ diff --git a/raw/filings/0000002098/2020/0001564590-21-017128/item1.txt b/raw/filings/0000002098/2020/0001564590-21-017128/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..daca1e47979dcb3ff8da981eb38933fa2e3ca22d --- /dev/null +++ b/raw/filings/0000002098/2020/0001564590-21-017128/item1.txt @@ -0,0 +1,82 @@ +Item 1. Business +Overview +Acme United Corporation, a Connecticut corporation (together, with its subsidiaries, the "Company"), is a leading worldwide supplier of innovative first aid and safety solutions and cutting technology to the school, home, office, hardware, sporting goods and industrial markets. Its principal products sold across all segments are first aid kits, and safety related products, scissors, shears, knives, rulers, pencil sharpeners and sharpening tools. The Company sells its products primarily to wholesale, contract and retail stationery distributors, office supply superstores, mass market and e-commerce retailers, industrial distributors, sporting goods stores, hardware chains and wholesale florists. +The Company's operations are in the United States, Canada, Europe (located in Germany) and Asia (located in Hong Kong and China). The operations in the United States, Canada and Europe are primarily involved in product development, marketing, sales, administrative, manufacturing and distribution activities. The operations in Asia consist of sourcing, product development, production planning, quality control and sales activities. Total net sales in 2020 were $164.0 million. The Company was organized as a partnership in l867 and incorporated in l882 under the laws of the State of Connecticut. +The Company sources most of its products from suppliers located outside the United States, primarily in Asia. The Company assembles its first aid kits at its facilities in Vancouver, WA and Rocky Mount, NC. The components for the first aid kits are primarily sourced from U.S. suppliers. In addition, the Company has manufacturing facilities in the U.S. at Smyrna, TN and Santa Ana, CA for Spill Magic absorbent products, Marlborough, MA for DMT sharpening tools, and Brooksville, FL for Med-Nap alcohol and BZK wipes. +Recent accomplishments and initiatives +The Company’s key business accomplishments and initiatives include the following elements: +• +Eleven years of consecutive sales growth averaging 10%; +• +Diversification of Product Lines – D uring the past five years, sales of first aid and safety products have grown to almost 50% of total sales. As a result, our reliance on sales of school and office products has declined, although such sales have remained steady; +• +Growth of eCommerce Sales – In 2020, sales in the eCommerce channel grew substantially and Amazon has become the Company’s second largest customer. The Company has taken a number of actions to support our growth in eCommerce, including the modification of its principal distribution center by upgrading its warehouse layout, installing a mezzanine to handle small packages, and installing new warehouse management software; +• +S uccessful acquisition of two businesses in our first aid and safety space in 2020. +- +The acquisition and successful integration of the business and assets of First Aid Central, a Montreal-based supplier of first aid kits and safety supplies acquired in January 2020; +- +The acquisition of the business and assets of Med-Nap LLC, a Florida-based manufacturer of antiseptic prep pad and towelette solutions in December 2020; +• +Successful Response to Pandemic – Commencing in 2020, the Company has taken decisive actions to respond to the unprecedented uncertainty and disruption caused by the pandemic. As a result, the Company has been able to continue to meet the needs of its customers in 2020 without interruption. These actions included: +- +taking steps to protect our global workforce, including travel restrictions, work-from-home requirements and preventative measures at our sites; +- +shifting its sales force to focus on eCommerce and retailers that it believed would be most able to serve its customers during the pandemic; also enhancing eCommerce content and search; +- +procuring large quantities of first aid products and components to meet the surge in demand for such products resulting from the pandemic; +- +adding additional inventory across its product lines and proactively managing its supply chains to minimize the impact of disruptions and potential disruptions and to ensure supply chain continuity; +- +managing through macroeconomic uncertainty created by the pandemic by preserving the Company’s liquidity, engaging in cash preservation initiatives, and cost control measures; +3 +• +Environmental Footprint - The Company continued in 2020 to take steps to improve its environmental footprint. It increased its efforts to use recycled cardboard, plastic, and steel in its products and has succeeded in reducing the use of cardboard and plastic packaging. In 2020, the Company commenced the installation of new software to reduce the size and usage of boxes for shipping, which not only saves packing material but also improves the efficiency of the delivery system. +Acquisitions +On December 16, 2020, the Company purchased the assets of Med-Nap LLC., located in Brooksville, Florida. Med-Nap is a leading manufacturer of alcohol prep pads, alcohol wipes, benzalkonium chloride wipes (BZK), antiseptic wipes, castile soap, and lens cleaning products. The Company purchased Med-Nap assets for $9.3 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. +On January 7, 2020, the Company purchased the assets of First Aid Central, located in Laval, Quebec, Canada. The First Aid Central line of first aid kits, refills, and safety products to a broad range of industries and end users. Its products meet federal Health Canada and provincial regulatory requirements. The Company purchased First Aid Central assets for $2.1 million in cash using funds borrowed under its revolving credit facility with HSBC Bank, N.A. +Additional information concerning the acquisition of Med-Nap, LLC and First Aid Central assets is set forth in Note 17 – Business Combinations, in the Notes to Consolidated Financial Statements in this report. +Principal Products +The Company markets and sells under two main categories: i) first aid and safety; and ii) cutting, sharpening and measuring. The first aid and safety category includes first aid and safety products (First Aid Only®, PhysiciansCare®, Pac-Kit®, Spill Magic®, First Aid Central® and Med-Nap brands). The cutting, sharpening and measuring category includes school, home and office products (Westcott® brand), and hardware, industrial and sporting goods products (Clauss®, Camillus®, Cuda® and DMT® brands). +FIRST AID AND SAFETY +First Aid and Safety +First Aid Only +The First Aid Only brand offers first aid and safety solutions that meet regulatory requirements for a broad range of industries. The Smart Compliance® first aid system is an effective solution for maintaining OSHA compliance. The Company’s SafetyHub App technology digitizes the replenishment process for a broad range of Safety products and provides data analytics to manage costs. In 2019, we introduced our next generation SmartCompliance Complete ™ which offers a modular system that addresses first aid, bloodborne pathogen, bleed control, eyewash and OTC medication requirements for the most challenging workplace environments. +PhysiciansCare +The PhysiciansCare brand offers a variety of portable eyewash solutions and over-the counter medications, including the active ingredients aspirin, acetaminophen and ibuprofen. +Spill Magic +Spill Magic, an Acme United brand since 2017, is a leader in bodily fluid and spill clean-up solutions with a lightweight, absorbent powder that quickly encapsulates a spill. The Spill Response System provides all the necessary tools to effectively clean up spills, saving time, money and reducing slip & fall accidents in various venues, including grocery, retail, and big box stores; food service & hotel chains; municipal facilities; and industry-specific distributors in the U.S. +First Aid Central +First Aid Central has been a trusted provider and manufacturer of a wide variety of first aid kits and safety supplies since 2007. They assist Canadian businesses to stay compliant with federal & provincial first aid and safety regulations through their wide variety of first aid kits, refills, and safety supplies, including CPR kits, burn kits and automotive & emergency survival Kits. +Med-Nap +Med-Nap manufactures critical FDA regulated components found in first aid kits and used by healthcare facilities, including alcohol prep pads, alcohol wipes, benzalkonium chloride wipes (BZK), various antiseptic wipes, castile soap, and lens cleaning wipes. Med-Nap provides to the Company vertical integration advantages including shorter delivery times, lower total costs, and a secure U.S. source of supply during unprecedented healthcare challenges. The facilities offer a platform for future product expansion. +4 +CUTTING, SHARPENING AND MEASURING +School, Home and Office +Westcott +Westcott, with a history of quality dating back to 1872, provides innovative cutting and measuring products for the school, home and office as well as industrial safety cutting. Principal products under the Westcott brand include scissors, rulers, pencil sharpeners, paper trimmers, safety cutters, lettering products, glue guns and other craft products. Westcott is one of the leading scissor and ruler brands in North America. +Many of the Westcott branded cutting products contain patented titanium bonding and proprietary non-stick coatings, making the blades more than three times harder than stainless steel as well as reducing friction and corrosion. Westcott continues to build on its cutting line with an expanded assortment of the Saber and ceramic safety knives, allowing its customers to remain safer on the job. Also in the cutting line, Westcott has recently introduced the Glide technology scissor with its low friction fulcrum and adjustable tension. Westcott also continued to innovate in the glue gun category-launching a cordless lithium-ion glue gun which heats up in 20 seconds and has a 30-minute run time. +Hardware, Industrial and Sporting Goods +Clauss +Clauss, with its roots dating back to 1877, offers a line of quality cutting tools for professionals in the hardware & industrial, lawn & garden, food processing, sewing and housewares channels. Many of the Clauss products are enhanced with the Company’s patented titanium and proprietary non-stick coatings. +Camillus +Since 1876 Camillus has been supplying innovative and high-quality knives. The Camillus brand has a strong heritage in the hunting, sporting, survival and tactical markets. The Company acquired the brand in 2007 and re-launched it in 2009 with an updated and innovative line of fixed blade, folding knives, line of sight cutting tools and tactical tools. Many of the knives are enhanced with titanium carbonitride coatings to increase the hardness of the blade of up to 10 times that of untreated stainless steel. +Cuda +The Cuda line of fishing tools and knives was launched in 2014. Featuring titanium bonded German steels and alloys, Cuda tools provide world class hardness, corrosion and adhesive resistance. In 2014, Cuda won Best of Show in the “Fish Smart” category at the ICast show in Orlando, Florida. In 2016, Cuda won six GOOD DESIGN awards from the Chicago Athenaeum, Museum of Architecture and Design. In 2017, Cuda launched a line of cut and puncture resistant gloves which feature quadruple layered Kevlar® and a line of telescopic landing nets featuring replaceable nets and a net containment system. In 2018, Cuda launched a Professional Series of knives, tools and fishing gaffs that are directed towards the commercial fishing market. +DMT +DMT products are leaders in diamond sharpening tools for knives, scissors, chisels, skis, skates and many other edges that require sharpening. DMT was founded in 1976 by aerospace engineers. The DMT products use a proprietary process of finely dispersed diamonds bonded to the surfaces of sharpeners and are famous for providing diamond sharpeners with the flattest sharpening surface, greatest concentrated amount of diamonds and the highest quality diamonds per sharpener. In 2017, DMT launched 12 new diamond sharpeners that include a gear-driven sharpener, sonic sharpener and pull through sharpeners that provide a simple sharpening solution for beginners as well as sharpening experts. +Intellectual Property +The Company owns many patents and trademarks that are important to its business. The Company’s success depends in part on its ability to maintain patent protection for its products, to preserve its proprietary technology and to operate without infringing upon the patents or proprietary rights of others. The Company generally files patent applications in the United States and foreign countries where patent protection for its technology is appropriate and available. The Company also considers its trademarks important to the success of its business. The more significant trademarks include Westcott, Clauss, Camillus, PhysiciansCare, First Aid Only, Cuda, DMT, Pac-Kit, Spill Magic and First Aid Central. Patents and trademarks are amortized over their estimated useful lives. The weighted average amortization period remaining for intangible assets at December 31, 2020 was 9 years. +Product Distribution; Major Customers +Independent manufacturer representatives and direct sales are primarily used to sell the Company’s line of consumer products to wholesale, contract and retail stationery distributors, office supply super stores, school supply distributors, industrial distributors, wholesale florists, mass market and ecommerce retailers and hardware chains (including through their websites). The Company also sells a limited selection of its products directly to consumers through its own websites. The Company had two customers in 2020 and one customer in 2019 that individually exceeded 10% of consolidated net sales. Net sales to these two customers were approximately 18% and 13% of consolidated net sales in 2020 and 17% in 2019. +5 +Competition +The Company competes with many companies in each market and geographic area. The Company believes that the principal points of competition in these markets are product innovation, quality, price, merchandising, design and engineering capabilities, product development, timeliness and completeness of delivery, conformity to customer specifications and post-sale support. The major competitors in the cutting category are 3M and Fiskars Corporation. The major competitor in the pencil sharpener category are Bostitch and Elmers. The major competitors in the first aid and safety category are Honeywell and Cintas. +Seasonality +Traditionally, the Company’s sales are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the back-to-school market. +Compliance with Environmental Laws +The Company believes that it is in compliance with applicable environmental laws. The Company anticipates that no material adverse financial impact will result from compliance with current environmental rules and regulations. +Employees and Human Capital Considerations +As of December 31, 2020, the Company employed 552 people, all of whom are full time and none of whom is covered by union contracts. Employee relations are considered good and no foreseeable problems with the work force are evident. +Available Information +You may obtain at no charge, a copy of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports on the Company’s website at http://www.acmeunited.com or by contacting the Investor Relations Department at the Company’s corporate offices by calling (203) 254-6060. Such reports and other information are made available as soon as reasonably practicable after such material is filed with or furnished to the SEC. \ No newline at end of file diff --git a/raw/filings/0000002098/2020/0001564590-21-017128/item13.txt b/raw/filings/0000002098/2020/0001564590-21-017128/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..244a6a067140570ca8972b629e8d143a289f3009 --- /dev/null +++ b/raw/filings/0000002098/2020/0001564590-21-017128/item13.txt @@ -0,0 +1,2 @@ +Item 13. Certain Relationships and Related Transactions, and Director Independence +44 \ No newline at end of file diff --git a/raw/filings/0000002186/2018/0001654954-19-002033/filing.txt b/raw/filings/0000002186/2018/0001654954-19-002033/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..c70198c4e22fdef5f3d70dd82e974ad7e70fb29d --- /dev/null +++ b/raw/filings/0000002186/2018/0001654954-19-002033/filing.txt @@ -0,0 +1,7513 @@ +10-K +1 +bkti_10k.htm +ANNUAL REPORT +Blueprint +UNITED +STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +——————— +FORM 10-K +——————— +☒ +ANNUAL +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +For the fiscal year ended December 31, 2018 +OR +☐ +TRANSITION +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +For the transition period from __________ to +__________ +——————— +BK TECHNOLOGIES, INC. +(Exact +name of registrant as specified in its charter) +——————— +Nevada +001-32644 +59-3486297 +(State +or other jurisdiction of +incorporation +or organization) +(Commission +file +number) +(I.R.S. +Employer +Identification +No.) +7100 Technology Drive +West Melbourne, Florida 32904 +(Address +of principal executive offices) (Zip Code) +Registrant’s telephone number, including area code: (321) +984-1414 +Securities registered pursuant to Section 12(b) of the +Act: +Title of Each Class +Name of Each Exchange on Which +Registered +Common +Stock, par value $.60 +NYSE +American +Securities registered pursuant to Section 12(g) of the +Act: +None +Indicate by check +mark if the registrant is a well-known seasoned issuer, as defined +in Rule 405 of the Securities Act. Yes ☐ +No ☒ +Indicate by check +mark if the registrant is not required to file reports pursuant to +Section 13 or Section 15(d) of the Act. Yes ☐ +No ☒ +Indicate by check +mark whether the registrant: (1) has filed all reports required to +be filed by Section 13 or 15(d) of the Securities Exchange Act +of 1934 during the preceding 12 months (or for such shorter period +that the registrant was required to file such reports), and +(2) has been subject to such filing requirements for the past +90 days. Yes ☒ No ☐ +Indicate by check +mark whether the registrant has submitted electronically every +Interactive Data File required to be submitted pursuant to Rule 405 +of Regulation S-T (§ 232.405 of this chapter) during the +preceding 12 months (or for such shorter period that the registrant +was required to submit such files). Yes ☒ No +☐ +Indicate by check +mark if disclosure of delinquent filers pursuant to Item 405 of +Regulation S-K (§ 229.405 of this chapter) is not +contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information +statements incorporated by reference in Part III of this +Form 10-K or any amendment to this Form 10-K. +☐ +Indicate by check +mark whether the registrant is a large accelerated filer, an +accelerated filer, a non-accelerated filer, a smaller reporting +company, or an emerging growth company. See the definitions of +“large accelerated filer,” “accelerated +filer,” “smaller reporting company,” and +“emerging growth company” in Rule 12b-2 of the +Exchange Act. +Large +accelerated filer ☐ +Accelerated filer +☐ +Non-accelerated +filer ☒ +Smaller +reporting company ☒ +Emerging +growth company ☐ +If an +emerging growth company, indicate by check mark if the registrant +has elected not to use the extended transition period for complying +with any new or revised financial accounting standards provided +pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check +mark whether the registrant is a shell company (as defined in +Rule 12b-2 of the Act). Yes ☐ +No ☒ +The +aggregate market value of the voting and non-voting common equity +held by non-affiliates of the registrant on June 29, 2018, +based on the closing price of such stock on the NYSE American on +such date, was $27,446,444. As of February 19, 2019, 12,754,294 +shares of the registrant’s Common Stock were +outstanding. +Documents Incorporated by Reference: +None. +TABLE OF CONTENTS +Page +PART I +1 +Item +1. +Business +1 +Item +1A. +Risk Factors +8 +Item +1B. +Unresolved Staff Comments +17 +Item +2. +Properties +17 +Item +3. +Legal Proceedings +17 +Item +4. +Mine Safety Disclosures +17 +PART II +18 +Item +5. +Market For Registrant’s Common Equity, Related Stockholder +Matters and Issuer Purchases of Equity Securities +18 +Item +6. +Selected Financial Data +18 +Item +7. +Management’s Discussion and Analysis of Financial Condition +and Results of Operations +19 +Item +7A. +Quantitative and Qualitative Disclosures About Market +Risk +30 +Item +8. +Financial Statements and Supplementary Data +30 +Item +9. +Changes in and Disagreements with Accountants on Accounting and +Financial Disclosure +31 +Item +9A. +Controls and Procedures +31 +Item +9B. +Other Information +31 +PART III +32 +Item +10. +Directors, Executive Officers and Corporate Governance +32 +Item +11. +Executive Compensation +42 +Item +12. +Security Ownership of Certain Beneficial Owners and Management and +Related Stockholder Matters +53 +Item +13. +Certain Relationships and Related Transactions, and Director +Independence +57 +Item +14. +Principal Accountant Fees and Services +58 +PART IV +59 +Item +15. +Exhibits and Financial Statement Schedules +59 +Item +16. +Form 10-K Summary +61 +SIGNATURES +62 +PART I +Item +1. Business +General +BK +Technologies, Inc. (“BK,” the “Company,” +“we” or “us”) provides two-way radio +communications equipment of high quality and +reliability. +In +business for over 70 years, BK (NYSE American: BKTI) designs, +manufactures and markets wireless communications products +consisting of two-way land mobile radios (“LMRs”), +repeaters, base stations and related components and subsystems. +Two-way LMRs can be units that are hand-held (portable) or +installed in vehicles (mobile). Repeaters expand the range of +two-way LMRs, enabling them to operate over a wider area. Base +station components and subsystems are installed at radio +transmitter sites to improve performance by enhancing the signal +and reducing or eliminating signal interference and enabling the +use of one antenna for both transmission and reception. We employ +both analog and digital technologies in our products. +Our +digital technology is compliant with the Project 25 standard +(“P-25”) for digital LMR equipment. The P-25 has been +adopted by representatives from the Association of Public-Safety +Communications Officials-International (“APCO”), the +National Association of State Technology Directors +(“NASTD”), the United States (“U.S.”) +Federal Government and other public safety user organizations. Our +P-25 digital products and our analog products function in the very +high frequency (“VHF”) (136MHz – 174MHz), +ultra-high frequency (“UHF”) (380MHz – 470MHz, +450MHz – 520MHz), and 700-800 MHz bands. Our P-25 KNG and +KNG2 Series mobile and portable digital radios have been validated +under the P-25 Compliance Assessment Program (“CAP”) as +being P-25 compliant and interoperable with the communications +network infrastructure of six of our competitors. Since we do not +provide our own communications network infrastructure, we believe +CAP validation provides confidence for federal, state and local +emergency response agencies that our products are a viable and +attractive alternative for use on the infrastructure of our +competitors. +We +offer products under the brand names BK Technologies, BK Radio and +RELM. Generally, BK Technologies and BK Radio-branded products +serve the government and public safety market, while RELM-branded +products serve the business and industrial market. +BK +Technologies and BK Radio-branded products consist of +high-specification LMR equipment for professional radio users +primarily in government, public safety and military applications. +These products have more extensive features and capabilities than +those offered in the RELM line. Our P-25 digital products are +marketed under the BK Radio brand, which includes the +new-generation KNG and KNG2 product lines. In addition, we +anticipate introducing the first model in our line of multi-band +products to complement our existing KNG products during 2019. +RELM-branded products provide basic yet feature-rich and reliable +two-way communications for commercial and industrial concerns, such +as hotels, construction firms, schools and transportation services. +Typically, these users are not radio professionals and require +easy, fast and affordable communication among a defined group of +users. +We +believe that we provide superior value to a wide array of customers +with demanding requirements, including, for example, emergency +response, public safety, homeland security and military customers +of federal and state government agencies, as well as various +commercial enterprises. Our two-way radio products excel in +applications with harsh and hazardous conditions. They provide +high-specification performance, durability and reliability at a +lower cost relative to comparable offerings. +We were +incorporated under the laws of the State of Nevada on October 24, +1997. We are the resulting corporation from the reincorporation +merger of our predecessor, Adage, Inc., a Pennsylvania corporation, +which reincorporated from Pennsylvania to Nevada effective as of +January 30, 1998. Effective on June 4, 2018, we changed our +corporate name from “RELM Wireless Corporation” to +“BK Technologies, Inc.” Our principal executive offices +are located at 7100 Technology Drive, West Melbourne, Florida 32904 +and our telephone number is (321) 984-1414. +1 +Available Information +Our +Internet website address is www.bktechnologies.com. We make +available on our Internet website, free of charge, our Annual +Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current +Reports on Form 8-K, proxy statements and amendments to these +reports as soon as practicable after we file or furnish such +material with or to the U.S. Securities and Exchange Commission +(the “SEC”). In addition, our Code of Business Conduct +and Ethics, Code of Ethics for the CEO and Senior Financial +Officers, Audit Committee Charter, Compensation Committee Charter, +Nominating and Governance Committee Charter and other corporate +governance policies are available on our website, under +“Investor Relations.” The information contained on our +website is not incorporated by reference in this report. A copy of +any of these materials may be obtained, free of charge, upon +request from our investor relations department. All reports that +the Company files with or furnishes to the SEC also are available +free of charge via the SEC’s website at +http://www.sec.gov. +Significant Events of 2018 +In +September 2018, the Company announced that it was selected as a +supplier under the Subscriber Unit Radio and Accessory Contract +(“SURAC”) issued by the U.S. Army, and received its +first task orders under the contract totaling approximately $0.8 +million. The task orders were for the Company’s UHF portable +radios and related accessories. The SURAC contract is intended to +serve as the U.S. Army’s primary contract vehicle for +procuring P-25 digital communications equipment. The Company was +one of five companies selected by the U.S. Army. The maximum total +value of the contract is $495 million over a five-year period that +commenced on June 18, 2018, and ends on June 18, 2023. The contract +does not specify purchase dates or quantities of equipment from any +particular named supplier, and there is no assurance that the +Company will receive any additional orders. +In July +2018, the Transportation Security Administration +(“TSA”) of the U.S. Department of Homeland Security +(“DHS”) exercised its third one-year option, extending +its contract with the Company for an additional year to September +27, 2019. The option provides for the purchase of up to $2 million +of the Company’s products; however, precise dates for +quantities or deliveries are not specified. The original contract +awarded in September 2015 totaled $26.2 million, with $15.5 million +in firm delivery orders and $10.7 million in potential option +exercises. +During +2018, pursuant to the Company’s capital return program, the +Company declared and paid four quarterly dividends of $0.02 per +share of the Company’s common stock. The Company has paid +eleven consecutive quarterly dividends. +In June +2018, the Company announced that it received orders totaling +approximately $4.5 million for BK Radio-brand KNG-series portable +and mobile radios and related accessories that will be deployed by +a California State public safety agency. The orders were fulfilled +in 2018. +In June +2018, the Company changed its name from “RELM Wireless +Corporation” to “BK Technologies, Inc.” The +Company’s stock began trading on the NYSE American stock +exchange under the new ticker symbol “BKTI” on June 5, +2018. Stockholders approved the name change at the annual meeting +of stockholders held on June 4, 2018. +In +February 2018, the Company announced that it received a purchase +order totaling approximately $2.0 million from Alberta Health +Services for P-25 800MHz portable and mobile radios with +accessories. The order was fulfilled in the first quarter of +2018. +In +February 2018, the Company announced that it received orders +totaling approximately $1.5 million from the U.S. Forest Service. +The orders were for RELM’s KNG-Series Digital P-25 portable +and mobile radios with accessories, and they were fulfilled in the +first quarter 2018. +2 +Industry Overview +LMR +communications consist of hand-held (portable) and vehicle-mounted +(mobile) two-way radios commonly used by the public safety sector +(e.g., police, fire, and emergency responders), military and +commercial business concerns (e.g., corporate disaster recovery, +hotels, airports, farms, transportation service providers, and +construction firms), and government agencies within the U.S. and +abroad. LMR systems are constructed to meet an organization’s +specific communications needs. The cost of a complete system can +vary widely, depending on the size and configuration. Likewise, the +cost of radio sets can range from under $100 for a basic analog +portable, to thousands of dollars for a fully featured P-25 digital +unit. Typically, there are no recurring airtime usage charges. +Accordingly, LMR usage patterns are considerably different from +those for cellular and other wireless communications tools. LMR +usage often consists of direct radio-to-radio communications +outside of the range of a communication network with one to many +members of a group. Also, LMR functions with push-to-talk operation +(i.e., no call set-up or dialing a phone number is required). LMR +communications often consist of multiple short (five second) +transmissions between multiple members of a group. For the public +safety sector, this is known as Mission Critical Voice. The average +useful life of a unit can vary, depending upon the application in +which the unit is deployed and its handling. +LMR +systems are the most widely-used and longest-used form of wireless +dispatch communications in the U.S., having been first placed in +service in 1921. LMR was initially used almost exclusively by law +enforcement, and all radio communications were transmitted in an +analog format. Analog transmissions typically consist of a voice or +other signal modulated directly onto a continuous radio carrier +wave. Over time, advances in technology decreased the cost of LMR +products and increased their popularity and usage by businesses and +other agencies. Responding to the growing usage, additional radio +frequency spectrum was allocated by the Federal Communications +Commission (“FCC”) for LMR use. +More +recently, growth of the LMR industry has slowed, reflecting several +factors: +● +LMR is a mature +industry, having been in existence for over 90 years; +● +some LMR users are +in mature industry segments that have experienced slow growth +rates; +● +funding and budgets +for government and public safety agencies have been constrained; +and +● +limited +availability of radio frequency spectrum, which hinders existing +users in expanding their systems and potential new users from +establishing new systems. +Years +ago, as a result of the limited spectrum availability, the FCC +mandated that new LMR equipment utilize technology that is more +spectrum-efficient. This effectively meant that the industry had to +migrate to digital technology. Responding to the mandate, the APCO, +the NASTD, the U.S. Federal Government and the Telecommunications +Industry Association (“TIA”), in concert with several +LMR manufacturers, including BK, recommended a standard for digital +LMR devices that would meet the FCC spectrum-efficiency +requirements and provide solutions to several problems experienced +primarily by public safety users. The standard is called P-25. The +primary objectives of P-25 are to: (i) allow effective and reliable +communication among users of compliant equipment, regardless of its +manufacturer, known as interoperability, (ii) maximize radio +spectrum efficiency and (iii) promote competition among LMR +providers through an open system architecture. +Although the FCC +does not require public safety agencies or any radio users to +purchase P-25 equipment or otherwise adopt the standard, compliance +with the standard is a primary consideration for government and +public safety purchasers. Users of nationally available 700 MHz +frequencies designed for interoperability are required to use P-25 +equipment. In addition, U.S. Federal Government grant programs that +provide assistance in funding for state and local agencies to +purchase interoperable communications equipment for first +responders strongly encourage compliance with P-25 standards. +Accordingly, although funding for LMR purchases by many government +agencies is limited, we believe that, as users upgrade equipment to +achieve interoperability and comply with FCC narrow-banding +mandates, demand for P-25 equipment will continue to grow. +Additionally, the P-25 standard has also been widely adopted in +other countries. The migration to P-25 equipment is primarily +limited to government and public safety agencies. Radio users in +the business and industrial market utilize alternative digital +technologies (e.g., Digital Mobile Radio) and analog LMR +products. +3 +Presently, the +market is dominated by one supplier, Motorola Solutions, Inc. +However, the open architecture of the P-25 standard is designed to +eliminate the ability of one or more suppliers to lock out +competitors. Formerly, because of proprietary characteristics +incorporated in many LMR systems, a customer was effectively +precluded from purchasing additional LMR products from a supplier +other than the initial supplier of the system. Additionally, the +system infrastructure technology was prohibitive for smaller +suppliers to develop and implement. P-25 provides an environment in +which users will increasingly have a wider selection of LMR +suppliers, including smaller suppliers such as BK. +Description of Products and P-25 CAP Compliance +We +design, manufacture, and market wireless communications equipment +consisting of two-way LMRs, repeaters, base stations and related +components and subsystems. We do not provide complete, integrated, +communications systems and infrastructure. Two-way LMRs can be +units that are hand-held (portable) or installed in vehicles +(mobile). Repeaters expand the range of two-way LMRs, enabling them +to communicate over a wider area. Base station components and +subsystems are installed at radio transmitter sites to improve +performance by enhancing the signal, reducing or eliminating signal +interference and enabling the use of one antenna for both +transmission and reception. +We +employ both analog and digital technologies in our products. Our +digital products are compliant with P-25 specifications. Our P-25 +digital products and our analog products function in the VHF +(136MHz – 174MHz), UHF (380MHz – 470MHz, 450MHz – +520MHz), and 700-800 MHz. +Our +P-25 KNG and KNG2 Series mobile and portable digital radios have +been validated under the P-25 CAP as being P-25 compliant and +interoperable with the communications network infrastructure of six +of our competitors. Since we do not provide our own communications +network infrastructure, we believe CAP validation provides +confidence for federal, state and local emergency response agencies +that our products are a viable and attractive alternative for use +on the infrastructure of our competitors. +The +P-25 CAP is a voluntary program that allows LMR equipment suppliers +to formally demonstrate their products’ compliance with P-25 +requirements. The purpose of the program is to provide federal, +state and local emergency response agencies with evidence that the +communications equipment they are purchasing satisfies P-25 +standards for performance, conformance and interoperability. The +program is a result of legislation passed by the U.S. Congress to +improve communication interoperability for first responders and is +a partnership of the DHS’s Command, Control and +Interoperability Division, the National Institute of Standards and +Technology, radio equipment manufacturers and the emergency +response community. +Description of Markets +Government and Public Safety Market +The +government and public safety market includes military, fire, +rescue, law enforcement, homeland security and emergency responder +personnel. In most instances, BK Radio-branded products serve this +market and are sold either directly to end-users or through two-way +communications dealers. Government and public safety sales +represented approximately 95% of our total sales for 2018 and 97% +for each of 2017 and 2016. +Government and +public safety users currently use products that employ either P-25 +digital or analog technology. However, public safety users in +federal, state and local government agencies and certain other +countries are migrating to solely using digital P-25 products. The +evolution of the standard and compliant digital products is +explained in the “Industry Overview” section at the beginning of this +report. +Business and Industrial Market +This +market includes enterprises of all sizes that require fast and +affordable push-to-talk communication among a discrete group of +users, such as corporate disaster recovery, hotels, construction +firms, schools and transportation service providers. Users in this +market continue to predominantly utilize analog products. We offer +products to this market under the RELM brand name. Our sales in +this market may be direct to end-users or to dealers and +distributors who then resell the products. Our sales to this market +represented approximately 5% of our total sales for 2018 and 3% for +each of 2017 and 2016. +4 +Engineering, Research and Development +Our +engineering and product development activities are conducted by a +team of 25 employees, combined with contract engineering resources. +Their primary development focus has been the design of a new line +of next-generation multiband P-25 digital products to supplement +our flagship KNG and KNG2 products. We anticipate the new multiband +product will be available in 2019 pending approval of the Federal +Communications Commission. The first models in the KNG line were +introduced in 2008 and are included on our primary federal contract +vehicles. Subsequently, we added UHF and 700-800MHz products, as +well as P-25 Phase II TDMA (Time Division Multiple Access) +trunking. The KNG2 Series was introduced in 2016. Our KNG and KNG2 +products also provide encrypted operation, GPS location and network +authentication capabilities. +A +segment of our engineering team is responsible for product +specifications based on customer requirements and participates in +quality assurance activities. They also have primary responsibility +for applied and production engineering. +For +2018, 2017 and 2016, our engineering and development expenses were +approximately $7.8 million, $5.0 million and +$4.1 million, respectively. +Intellectual Property +We +presently have no U.S. patents in force. We have registered federal +trademarks related to the names “BK Technologies” and +“BK Radio” and have applied for registration of +“Radios for Heroes” and “BKR.” We rely on +trade secret laws and employee and third-party nondisclosure +agreements to protect our intellectual property +rights. +Manufacturing and Raw Materials +Our +manufacturing strategy is to utilize the highest quality and most +cost-effective resources available for every aspect of our +manufacturing. Consistent with that strategy, for many years we +have successfully utilized outside contract arrangements for +different segments of our manufacturing operations. These +arrangements, some of which are with offshore concerns, have been +managed and updated to meet our present requirements, and they +continue to be instrumental in controlling our product costs, +allowing us to be competitive and manage our gross +margins. +Contract +manufacturers produce various subassemblies and products on our +behalf. Generally, the contract manufacturers procure raw materials +from BK-approved sources and complete manufacturing activities in +accordance with our specifications. Manufacturing agreements and +purchase orders govern the business relationship with the contract +manufacturers. These agreements and purchase orders have various +terms and conditions and may be renewed or modified upon agreement +by both parties. Their scope may also be expanded to include new +products in the future. +We plan +to continue utilizing contract manufacturing where it furthers our +business objectives. This strategy allows us to focus on our core +technological competencies of product design and development, and +to reduce the substantial capital investment required to +manufacture our products. We also believe that our use of +experienced, high-volume manufacturers will provide greater +manufacturing specialization and expertise, higher levels of +flexibility and responsiveness, and faster delivery of product, all +of which contribute toward product cost control. To ensure that +products manufactured by others meet our quality standards, our +production and engineering team works closely with our ISO 9002 +industry-qualified contract manufacturers in all key aspects of the +production process. We establish product specifications, select the +components and, in some cases, the suppliers. We retain all +document control. We also work with our contract manufacturers to +improve process control and product design and conduct periodic +on-site inspections. +5 +We rely +upon a limited number of both domestic and foreign suppliers for +several key products and components. Approximately 64.7% of our +material, subassembly and product procurements in 2018 were sourced +from three suppliers. We place purchase orders from time to time +with these suppliers and have no guaranteed supply arrangements. In +addition, certain components are obtained from single sources. +During 2018, 2017 and 2016, our operations were not materially +impaired due to delays from single-source suppliers. However, the +absence of a single-source component could potentially delay the +manufacture of finished products. We manage the risk of such delays +by securing secondary sources, where possible, and redesigning +products in response to component shortages or obsolescence. We +strive to maintain strong relationships with all of our suppliers. +We anticipate that the current relationships, or others that are +comparable, will be available to us in the future. +Seasonal Impact +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year budgets and appropriations. We may also +experience fluctuations in our quarterly results, derived, in part, +from sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +results. +Significant Customers +Sales +to the U.S. Government represented approximately 40%, 38% and 58% +of our total sales for the years ended December 31, 2018, 2017 and +2016, respectively. These sales were primarily to various +government agencies, including those within the DHS, the U.S. +Department of Defense (“DOD”), the U.S. Forest Service +(“USFS”) and the U.S. Department of Interior +(“DOI”). +Backlog +Our +backlog of unshipped customer orders was approximately $7.6 million +and $8.3 million as of December 31, 2018 and 2017, +respectively. The decrease was attributed primarily to the timing +and fulfillment of orders. +Competition +We +compete with other domestic and foreign companies primarily in the +North American market, but also internationally. One dominant +competitor, Motorola Solutions, Inc., is estimated to have well in +excess of half the market for LMR products. We compete by +capitalizing on our advantages and strengths, which include price, +product quality and customer responsiveness. +Government Regulation +We are +subject to various international and U.S. federal, state and local +laws affecting our business. Any finding that we have been or +are in noncompliance with such laws could result in, among other +things, governmental penalties. Further, changes in existing +laws or new laws may adversely affect our business and could also +have the effect of limiting capital expenditures by our customers, +which could have a material adverse effect on our business, +financial condition and results of operations. +In +connection with our U.S. Government contracts, we are subject to +the U.S. Federal Government procurement regulations that may +provide the buyer with the right to audit and review our +performance, as well as our compliance with applicable laws and +regulations. In addition, our business is subject to +government regulation based on the products we sell that may be +subject to government requirements, such as obtaining an export +license or end-user certificate from the buyer, in certain +circumstances. If a government audit uncovers improper +or illegal activities, or if we are alleged to have violated any +laws or regulations governing the products we sell under our +government contracts, we may be subject to civil and criminal +penalties and administrative sanctions, including termination of +contracts, forfeiture of profits, suspension of payments, fines and +suspension or debarment from doing business with U.S. Federal +Government agencies. +6 +Our +products are regulated by the FCC in the U.S. and similar agencies +in other countries where we offer our products. Consequently, +we and our customers could be positively or negatively affected by +the rules and regulations adopted from time to time by the FCC or +regulatory agencies in other countries. For example, our +wireless communications products, including two-way LMRs, are +subject to FCC regulations related to radio frequency +spectrum. As a result of limited spectrum availability, the +FCC has mandated that new LMR equipment utilize technology that is +more spectrum-efficient, which effectively meant that the industry +had to migrate to digital technology. These types of mandates +may provide us with new business opportunities or may require us to +modify all or some of our products so that they can continue to be +manufactured and marketed, which may lead to an increase in our +capital expenditures and research and development +expenses. +As a +public company, we are also subject to regulations of the SEC and +the stock exchange on which we are listed (NYSE +American). +Some of +our operations use substances regulated under various federal, +state, local and international laws governing the environment and +worker health and safety, including those governing the discharge +of pollutants into the ground, air and water, the management and +disposal of hazardous substances and wastes and the cleanup of +contaminated sites, as well as relating to the protection of the +environment. Certain of our products are subject to various +federal, state, local and international laws governing chemical +substances in electronic products. During 2018, compliance with +these U.S. federal, state and local and international laws did not +have a material effect on our capital expenditures, earnings or +competitive position. +Employees +As of +December 31, 2018, we had 119 employees, including 112 full-time +employees, most of whom are located at our West Melbourne, Florida +facility; 56 of these employees are engaged in direct manufacturing +or manufacturing support, 26 in engineering, 26 in sales and +marketing and 11 in headquarters, accounting and human resources +activities. Our employees are not represented by any collective +bargaining agreements, nor has there ever been a labor-related work +stoppage. We believe our relations with our employees are +good. +Information Relating to Domestic and Export Sales +The +following table summarizes our sales of LMR products by customer +location: +2018 +2017 +2016 +(in +millions) +United +States +$ 44.8 +$ 34.3 +$ 46.3 +International +4.6 +5.1 +4.4 +Total +$ 49.4 +$ 39.4 +$ 50.7 +Additional +financial information is provided in the Consolidated Financial +Statements included in this report. +7 +Item +1A. Risk Factors +Various portions of this report contain forward-looking statements +that involve risks and uncertainties. Actual results, performance +or achievements could differ materially from those anticipated in +these forward-looking statements as a result of certain risk +factors, including those set forth below and elsewhere in this +report. We undertake no obligation to revise or update any +forward-looking statements contained herein to reflect subsequent +events or circumstances or the occurrence of unanticipated +events. +We depend on the success of our LMR product line +We +currently depend on our LMR products as our sole source of sales. A +decline in the price of and/or demand for LMR products, as a result +of competition, technological change, the introduction of new +products by us or others or a failure to manage product transitions +successfully could have a material adverse effect on our business, +financial condition and results of operations. In addition, our +future success will largely depend on the successful introduction +and sale of new digital LMR products. Even if we successfully +develop these products, the development of which is a complex and +uncertain process requiring innovation and investment, they may not +achieve market acceptance, which could have a material adverse +effect on us. +We are engaged in a highly competitive industry +We face +intense competition from other LMR suppliers, and the failure to +compete effectively could materially and adversely affect our +market share, financial condition and results of operations. The +largest supplier of LMR products in the world, Motorola Solutions, +Inc., currently is estimated to have well in excess of half the +market for LMR products. This supplier is also the world’s +largest supplier of P-25 products. Some of our competitors are +significantly larger and have longer operating histories, greater +name recognition, larger customer bases and significantly greater +financial, technical and marketing resources than we have. Some +also have established reputations for success in developing and +supplying LMR products, including providing complete, integrated, +communications systems and infrastructure. We do not provide +complete, integrated, communications systems and infrastructure. +These advantages may allow them: +● +to be more +attractive to customers who desire a single-source supplier of LMR +products; +● +to respond more +quickly to new or emerging technologies and changes in customer +requirements, which may render our products obsolete or less +marketable; +● +to engage in more +extensive research and development; +● +to undertake more +far-reaching marketing campaigns; +● +to be able to take +advantage of acquisitions and other opportunities; +● +to adopt more +aggressive pricing policies; and +● +to be more +attractive to potential employees and strategic +partners. +Some of +our competitors have established broad networks of sales locations +and multiple distribution channels that are more extensive than +ours. We may not be able to compete successfully and competitive +pressures may materially and adversely affect our business, results +of operations and financial condition. +An +increase in the demand for P-25 products could benefit competitors +that are better financed and positioned to meet such demand. P-25 +products have been brought to the market by an increasing number of +our competitors. Our first P-25 portable radio was brought to +market in 2003, and in recent years we introduced two new lines of +P-25 products, the KNG and KNG2 Series. We are currently developing +a new line of multiband products. Bringing such products to market +and achieving a significant market penetration for them will +continue to require time and expenditures of funds, and we may be +unable to successfully do so. We may be unsuccessful in developing +and marketing, on a timely basis, fully functional product +enhancements or new products that respond to these and other +technological advances, and our new products may not be accepted by +customers. An inability to successfully develop and/or market +products could have a material adverse effect on our business, +results of operations and financial condition. +8 +Our industry is characterized by rapidly changing technology and +our success is dependent on our ability to adapt to such +changes +Our +business could suffer if we are unable to keep pace with rapid +technological changes and product development in our industry. The +market for our LMR products is characterized by ongoing +technological development, evolving industry standards and frequent +product introductions. The LMR industry is experiencing a +transition from analog LMR products to digital LMR products. In +addition, the APCO P-25 standard is being increasingly adopted. If +we are unable to successfully keep up with these changes, our +business, financial condition and results of operations could be +materially adversely affected. +We depend heavily on sales to the U.S. Government +We are +subject to risks associated with our reliance on sales to the U.S. +Government. For the year ended December 31, 2018, approximately 40% +of our sales were to agencies and departments of the U.S. +Government. These sales were primarily to agencies of the DHS, DOD, +USFS and DOI. We may be unable to maintain this government +business. Our ability to maintain our government business will +depend on many factors outside of our control, including +competitive factors, changes in government personnel making +contract decisions, spending limits and political factors. The loss +of sales to the U.S. Government would have a material adverse +effect on our business, financial condition and results of +operations. +In +addition, most U.S. Government customers award business through a +competitive bidding process, which results in greater competition +and increased pricing pressure. The bidding process involves +significant cost and managerial time to prepare bids for contracts +that may not be awarded to us. Even if we are awarded contracts, we +may fail to accurately estimate the resources and costs required to +fulfill a contract, which could negatively impact the profitability +of any contract awarded to us. In addition, following a contract +award, we may experience significant expense or delay, contract +modification or contract rescission as a result of customer delay +or our competitors protesting or challenging contracts awarded to +us in competitive bidding. +Any +delay, especially any prolonged delay, in the U.S. Government +budget process or government shutdown may result in us incurring +substantial labor or other costs without reimbursement under our +customer contracts, decrease the number of purchase orders issued +under our contracts with government agencies, or result in the +suspension of work on contracts in progress or in payment +delays. +Any of +these events could have a material adverse effect on our business, +financial condition and results of operations. +Our business is partially dependent on U.S. Government contracts, +which are highly regulated and subject to terminations and +oversight audits by U.S. Government representatives that could +result in adverse findings and negatively impact our +business +Our +U.S. Government business is subject to specific procurement +regulations with numerous compliance requirements. These +requirements, although customary in U.S. Government contracting, +increase our performance and compliance costs. These costs may +increase in the future, thereby reducing our margins, which could +have an adverse effect on our financial condition. Failure to +comply with these regulations could lead to suspension or debarment +from U.S. Government contracting or subcontracting for a period of +time. Among the causes for debarment are violations of various laws +or policies, including those related to procurement integrity, U.S. +Government security regulations, employment practices, protection +of criminal justice data, protection of the environment, accuracy +of records, proper recording of costs, foreign corruption and the +False Claims Act. +Generally, U.S. +Government contracts are subject to oversight audits by U.S. +Government representatives and could result in adjustments to our +contracts. Any costs found to be improperly allocated to a specific +contract or grant may not be allowed, and such costs already +reimbursed to us may have to be refunded. Future audits and +adjustments, if required, may materially reduce our revenues or +profits upon completion and final negotiation of audits. Negative +audit findings could also result in investigations, termination of +a contract, forfeiture of profits or reimbursements, suspension of +payments, fines and suspension or prohibition from doing business +with the U.S. Government. All contracts with the U.S. Government +are subject to cancellation at the convenience of the U.S. +Government. +In +addition, contacts with government officials and participation in +political activities are areas that are tightly controlled by +federal, state, local and international laws. Failure to comply +with these laws could cost us opportunities to seek certain +government sales opportunities or even result in fines, prosecution +or debarment. +9 +Our business is subject to the economic and political risks of +manufacturing products in foreign countries +We +engage in business with manufacturers located in other countries. +Approximately 66.8% of our material, subassembly and product +procurements in 2018 were sourced internationally. Accordingly, we +are subject to special considerations and risks not typically +associated with companies operating solely in the U.S. These +include the risks associated with the political, economic and legal +environments in such foreign countries, among others. Our business, +operating results and financial condition may be materially and +adversely affected by, among other things, changes in the general +political and social conditions in foreign countries in which we +maintain sourcing relationships, unfavorable changes in U.S. trade +legislation and regulations, the imposition of governmental +economic sanctions on countries in which we do business or other +trade barriers, threats of war, terrorism or governmental +instability, labor disruptions, currency controls, fluctuating +exchange rates with respect to contracts not denominated in U.S. +dollars, and unanticipated or unfavorable changes in government +policies with respect to laws and regulations, anti-inflation +measures and method of taxation. If we were unable to navigate +foreign regulatory environments, or if we were unable to enforce +our contract rights in foreign countries, our business could be +adversely impacted. Any of these events could interrupt our +manufacturing process and cause operational disruptions, increase +prices for manufacturing, reduce our sales or otherwise have an +adverse effect on our operating performance. +The +U.S. Government has indicated its intent to alter its approach to +trade policy, including, in some instances, to revise, renegotiate +or terminate certain multilateral trade agreements. It has also +imposed new tariffs on certain foreign goods and raised the +possibility of imposing additional increases or new tariffs on +other goods. Such actions have, in some cases, led to retaliatory +trade measures by certain foreign governments. Such policies could +make it more difficult or costly for us to do business in or import +our products from those countries. In turn, we may need to raise +prices or make changes to our operations, which could negatively +impact on our revenue or operating results. At this time, it +remains unclear what additional actions, if any, will be taken by +the U.S. Government or foreign governments with respect to tariff +and international trade agreements and policies, and we cannot +predict future trade policy or the terms of any revised trade +agreements or any impact on our business. +We carry substantial quantities of inventory, and inaccurate +estimates of necessary inventory could materially harm our +business, operating results and financial condition +We +carry a significant amount of inventory to service customer +requirements in a timely manner. If we are unable to sell this +inventory over a commercially reasonable time, in the future we may +be required to take inventory markdowns, which would reduce our net +sales and/or gross margins. In addition, it is critical to our +success that we accurately predict trends in customer demand, +including seasonal fluctuations, in the future and do not overstock +unpopular products or fail to sufficiently stock popular products. +Both scenarios could materially harm our business, operating +results and financial condition. +We enter into fixed-price contracts that could subject us to losses +in the event we fail to properly estimate our costs or hedge our +risks associated with currency fluctuations +We +sometimes enter into firm fixed-price contracts. If our initial +cost estimates are incorrect, we can lose money on these contracts. +Because certain of these contracts involve new technologies and +applications, require us to engage subcontractors and/or can last +multiple years, unforeseen events, such as technological +difficulties, fluctuations in the price of raw materials, problems +with our subcontractors or suppliers and other cost overruns, can +result in the contract pricing becoming less favorable or even +unprofitable to us and have an adverse impact on our financial +results. In addition, a significant increase in inflation rates or +currency fluctuations could have an adverse impact on the +profitability of longer-term contracts. +10 +Our investment strategy may not be successful, which could +adversely impact our financial condition +We may +invest part of our cash balances in public companies. For example, +as of December 31, 2018, we held 477,282 shares of the common stock +of 1347 Property Insurance Holdings, Inc. (Nasdaq: PIH) +(“PIH”). These types of investments are more risky than +holding our cash balances as bank deposits or, for example, such +conservative investments as treasury bonds or money market funds. +There can be no assurance that we will be able to maintain or +enhance the value or the performance of the companies in which we +have invested or in which we may invest in the future, or that we +will be able to achieve returns or benefits from these investments. +We may lose all or part of our investment relating to such +companies if their value decreases as a result of their financial +performance or for any other reason. If our interests differ from +those of other investors in companies over which we do not have +control, we may be unable to effect any change at those companies. +We are not required to meet any diversification standards, and our +investments may become concentrated. If our investment strategy is +not successful or we achieve less than expected returns from these +investments, it could have a material adverse effect on us. The +Board of Directors may also change our investment strategy at any +time, and such changes could further increase our exposure, which +could adversely impact us. +Fundamental Global Investors, LLC, with its affiliates, is our +largest stockholder whose interests may differ from the interests +of our other stockholders +The +interests of Fundamental Global Investors, LLC (“Fundamental +Global”) may differ from the interests of our other +stockholders. Fundamental Global and its affiliates, including CWA +Asset Management Group, LLC, 50% of which is owned by Fundamental +Global, together hold approximately 38% of the Company’s +outstanding shares of common stock. Kyle Cerminara, Chief Executive +Officer, Partner and Manager of Fundamental Global and Chairman and +Chief Executive Officer of Ballantyne Strong, Inc. and Lewis +Johnson, President, Partner and Manager of Fundamental Global +Investors, LLC and a director of Ballantyne Strong, Inc., serve as +Chairman and Co-Chairman, respectively, of our Board of Directors. +As a result of its ownership position and Messrs. Cerminara’s +and Johnson’s positions with the Company, Fundamental Global +has the ability to exert significant influence over our policies +and affairs, including the power to impact the election of our +directors, and approval of any action requiring a stockholder vote, +such as amendments to our articles of incorporation, by-laws, +significant stock issuances, reorganizations, mergers and asset +sales. Fundamental Global may have interests that differ from those +of our other stockholders and may vote in a way with which our +other stockholders disagree and which may be adverse to their +interests. Fundamental Global’s significant ownership may +also have the effect of delaying, preventing or deterring a change +of control of the Company, could deprive our stockholders of an +opportunity to receive a premium for their common stock as part of +a sale of the Company and might ultimately affect the market price +of our common stock. +If we are unable to maintain our brand and reputation, our +business, results of operations and prospects could be materially +harmed +Our +business, results of operations and prospects depend, in part, on +maintaining and strengthening our brand and reputation for +providing high-quality products and services. Reputational value is +based in large part on perceptions. Although reputations may take +decades to build, any negative incidents can quickly erode trust +and confidence, particularly if they result in adverse publicity, +governmental investigations or litigation. If problems with our +products cause operational disruption or other difficulties, or +there are delays or other issues with the delivery of our products +or services, our brand and reputation could be diminished. Damage +to our reputation could also arise from actual or perceived legal +violations, product safety issues, cybersecurity breaches, actual +or perceived poor employee relations, actual or perceived poor +service, actual or perceived poor privacy practices, operational or +sustainability issues, actual or perceived ethical issues or other +events within or outside of our control that generate negative +publicity with respect to us. Any event that has the potential to +negatively impact our reputation could lead to lost sales, loss of +new opportunities and retention and recruiting difficulties. If we +fail to promote and maintain our brand and reputation successfully, +our business, results of operations and prospects could be +materially harmed. +11 +We face a number of risks related to challenging economic +conditions +Current +economic conditions in the U.S. and elsewhere remain uncertain. +These challenging economic conditions could materially and +adversely impact our business, liquidity and financial condition in +a number of ways, including: +● +Potential deferment or +reduction of purchases by customers : Significant deficits and limited +appropriations confronting our federal, state and local government +customers may cause them to defer or reduce purchases of our +products. Furthermore, uncertainty about current and future +economic conditions may cause customers to defer purchases of our +products in response to tighter credit and decreased cash +availability. Additionally, any delay, especially any prolonged +delay, in the U.S. Government budget process or government shutdown +may negatively impact the ability of many of our customers to +purchase our products and decrease the number of purchase orders +issued under our contracts with government agencies. +● +Negative impact from +increased financial pressures on third-party dealers, distributors +and suppliers : We +make sales to certain of our customers through third-party dealers +and distributors. We generally do not require collateral from +our customers. If credit pressures +or other financial difficulties result in insolvencies of these +third parties and we are unable to successfully transition the end +customers to purchase our products from other third parties, or +directly from us, it could materially and adversely impact our +operating results and financial condition. Challenging economic +conditions may also impact the financial condition of one or more +of our key suppliers, which could negatively affect our ability to +secure product to meet our customers’ demands. +● +Limited access by us to +credit and capital : +Although we do not anticipate needing additional capital in the +near term, the credit markets may limit our access to credit and +impair our ability to raise capital, if needed, on acceptable terms +or at all. From time to time, we also have cash in financial +institutions in excess of federally insured limits, which funds +might be at risk of loss should such financial institutions face +financial difficulties. +We depend on a limited number of manufacturers and on a limited +number of suppliers of components to produce our products and the +inability to obtain adequate and timely delivery of supplies and +manufactured products could have a material adverse effect on +us +We +contract with manufacturers to produce portions of our products, +and our dependence on a limited number of contract manufacturers +exposes us to certain risks, including shortages of manufacturing +capacity, reduced control over delivery schedules, quality +assurance, production yield and costs. If any of our manufacturers +terminate production or cannot meet our production requirements, we +may have to rely on other contract manufacturing sources or +identify and qualify new contract manufacturers. The lead-time +required to qualify a new manufacturer could range from +approximately two to six months. Despite efforts to do so, we may +not be able to identify or qualify new contract manufacturers in a +timely and cost-effective manner, and these new manufacturers may +not allocate sufficient capacity to us in order to meet our +requirements. Any significant delay in our ability to obtain +adequate quantities of our products from our current or alternative +contract manufacturers could have a material adverse effect on our +business, financial condition and results of +operations. +In +addition, our dependence on limited and sole source suppliers of +components involves several risks, including a potential inability +to obtain an adequate supply of components, price increases, late +deliveries and poor component quality. Approximately 64.7% of our +material, subassembly and product procurements in 2018 were sourced +from three suppliers. We place purchase orders from time to time +with these suppliers and have no guaranteed supply arrangements. +Disruption or termination of the supply of these components could +delay shipments of our products. The lead-time required for orders +of some of our components is as much as six months. In addition, +the lead-time required to qualify new suppliers for our components +is as much as six months. If we are unable to accurately predict +our component needs, or if our component supply is disrupted, we +may miss market opportunities by not being able to meet the demand +for our products. This may damage our relationships with current +and prospective customers and, thus, have a material adverse effect +on our business, financial condition and results of +operations. +12 +We may not be able to manage our growth +Acquisitions and +other business transactions may disrupt or otherwise have a +negative impact on our business and results of operations. We do +not have any acquisitions currently pending, and there can be no +assurance that we will complete any future acquisitions or other +business transactions or that any such transactions which are +completed will prove favorable to our business. We intend to seek +stockholder approval for any such transactions only when so +required by applicable law or regulation. Any acquisitions of +businesses and their respective assets also involve the risks that +the businesses and assets acquired may prove to be less valuable +than we expect and we may assume unknown or unexpected liabilities, +costs and problems. We hope to grow rapidly, and the failure to +manage our growth could materially and adversely affect our +business, operations and financial condition. Our business plan +contemplates, among other things, leveraging our products and +technology for growth in our customer base and sales. This growth, +if it materializes, could significantly challenge our management, +employees, operations and financial capabilities. In the event of +this expansion, we have to continue to implement and improve our +operating systems and to expand, train, and manage our employee +base. If we are unable to manage and integrate our expanding +operations effectively, our business, results of operations and +financial condition could be materially and adversely +affected. +Retention of our executive officers and key personnel is critical +to our business +Our key +executives are critical to our success. The loss of services from +any of our executive officers or other key employees due to any +reason whatsoever could have a material adverse effect on our +business, financial condition and results of +operations. +Our +success is also dependent upon our ability to hire and retain +qualified operations, development and other personnel. Competition +for qualified personnel in our industry is intense, and we may be +unable to hire or retain necessary personnel. The inability to +attract and retain qualified personnel could have a material +adverse effect on our business, financial condition and results of +operations. +We rely on a combination of contract, trademark and trade secret +laws to protect our intellectual property rights, and failure to +effectively utilize or successfully assert these rights could +negatively impact us +Currently, we hold +no U.S. patents. We have several trademarks related to the names +“BK Technologies,” “BK Radio” and have +applied for trademarks related to the names “Radios for +Heroes” and “BKR.” As part of our confidentiality +procedures, we generally enter into nondisclosure agreements with +our employees, distributors and customers and limit access to and +distribution of our proprietary information. We also rely on trade +secret laws to protect our intellectual property rights. There is a +risk that we may be unable to prevent another party from +manufacturing and selling competing products or otherwise violating +our intellectual property rights. Our intellectual property rights, +and any additional rights we may obtain in the future, may be +invalidated, circumvented or challenged in the future. It may also +be particularly difficult to protect our products and intellectual +property under the laws of certain countries in which our products +are or may be manufactured or sold. Our failure to perfect or +successfully assert intellectual property rights could harm our +competitive position and could negatively impact us. +Rising health care costs may have a material adverse effect on +us +The +costs of employee health care insurance have been increasing in +recent years due to rising health care costs, legislative changes +and general economic conditions. We cannot predict what other +health care programs and regulations ultimately will be implemented +at the federal or state level or the effect of any future +legislation or regulation in the U.S. on our business and results +of operations. In addition, we cannot predict when or if Congress +will repeal and/or replace certain health care programs and +regulations at the federal level and the impact such changes would +have on our business. A continued increase in health care costs +could have a material adverse effect on us. +13 +The insurance that we maintain may not fully cover all potential +exposures +We +maintain property, business interruption and casualty insurance, +but such insurance may not cover all risks associated with the +hazards of our business and is subject to limitations, including +deductibles and maximum liabilities covered. We are potentially at +risk if one or more of our insurance carriers fail. Additionally, +severe disruptions in the domestic and global financial markets +could adversely impact the ratings and survival of some insurers. +In the future, we may not be able to obtain coverage at current +levels, and our premiums may increase significantly on coverage +that we maintain. +Our stock price is vulnerable to significant fluctuations, +including due to our fluctuating quarterly operating +results +Our +quarterly operating results may fluctuate significantly from +quarter to quarter and may be below the expectations of the +investment community, resulting in volatility for the market price +for our common stock. Other factors affecting the volatility of our +stock price include: +● +future +announcements concerning us or our competitors; +● +the announcement or +introduction of technological innovations or new products by us or +our competitors; +● +changes in product +pricing policies by us or our competitors; +● +changes in earnings +estimates by us or our competitors or by securities +analysts; +● +additions or +departures of our key personnel; and +● +sales of our common +stock. +In +addition, the stock market is subject to price and volume +fluctuations affecting the market price for the stock of many +companies generally, which fluctuations often are unrelated to +operating performance. +Natural disasters, acts of war or terrorism and other catastrophic +events beyond our control could have a material adverse effect on +our operations and financial condition +The +occurrence of one or more natural disasters, such as fires, +hurricanes, tornados, tsunamis, floods and earthquakes; +geo-political events, such as civil unrest in a country in which +our suppliers or manufacturers are located, or acts of war or +terrorism (wherever located around the world) or military +activities disrupting transportation, communication or utility +systems or otherwise causing damage to our business, employees, +suppliers, manufacturers and customers; or other highly disruptive +events, such as nuclear accidents, pandemics, unusual weather +conditions or cyber attacks, could have a material adverse effect +on our business, operations and financial condition. Such events +could result, among other things, in operational disruptions, +physical damage to or destruction or disruption of one or more of +our properties or properties used by third parties in connection +with the supply of products or services to us, the lack of an +adequate workforce in parts or all of our operations and +communications and transportation disruptions. These factors could +also cause consumer confidence and spending to decrease or result +in increased volatility in the U.S. and global financial markets +and economy. Such occurrences could have a material adverse effect +on us and could also have indirect consequences, such as increases +in the costs of insurance, if they result in significant loss of +property or other insurable damage. +14 +A security breach or other significant disruption of our +information technology systems, or those of our distributors, +manufacturers, suppliers and other partners, caused by cyber attack +or other means, could have a negative impact on our operations, +sales and results of operations +From +time to time, we experience cyber attacks on our information +technology systems and the information systems of our distributors, +manufacturers, suppliers and other partners, whose systems we do +not control. These systems are vulnerable to damage, +unauthorized access or interruption from a variety of sources, +including, but not limited to, continually evolving cyber attacks +(including social engineering and phishing attempts), attempts to +gain unauthorized access to data, cyber intrusion, computer +viruses, security breach, energy blackouts, natural disasters, +terrorism, sabotage, war and telecommunication failures. Cyber +attacks are rapidly evolving and becoming increasingly +sophisticated. Computer hackers and others might compromise our +security measures, or security measures of those parties that we do +business with now or in the future, and obtain the personal +information of our customers, employees and partners or our +business information. A cyber attack or other significant +disruption involving our information technology systems or those of +our distributors, manufacturers, suppliers or other partners, could +result in disruptions in critical systems, corruption or loss of +data, theft of data, funds or intellectual property, and +unauthorized release of proprietary, confidential or sensitive +information of ours or our customers. Such unauthorized access to, +or release of, this information could expose us to data loss, +disrupt our operations, allow others to unfairly compete with us, +subject us to litigation, government enforcement actions, +regulatory penalties and costly response measures, and could +seriously disrupt our operations. Any resulting negative publicity +could also significantly harm our reputation. We may not have +adequate insurance coverage to compensate us for any losses +associated with such events. Any or all of the foregoing could have +a negative impact on our business, financial condition, results of +operations and cash flow. +Because +the techniques used to obtain unauthorized access to, or disable, +degrade or sabotage, information technology systems change +frequently and often are not recognized until launched against a +target, we may be unable to anticipate these techniques, implement +adequate preventative measures or remediate any intrusion on a +timely or effective basis. Moreover, the development and +maintenance of these preventative and detective measures is costly +and requires ongoing monitoring and updating as technologies change +and efforts to overcome security measures become more +sophisticated. We, therefore, remain potentially vulnerable to +additional known or yet unknown threats, as in some instances, we, +our distributors, manufacturers, suppliers and other partners, may +be unaware of an incident or its magnitude and effects. We also +face the risk that we expose our customers or partners to +cybersecurity attacks. In addition, from time to time, we implement +updates to our information technology systems and software, which +can disrupt or shutdown our information technology systems. We may +not be able to successfully integrate and launch these new systems +as planned without disruption to our operations. +Each +of the foregoing factors could have an adverse effect on our +reputation, business, financial condition or results of +operations. +The risk of noncompliance with U.S. and foreign laws and +regulations applicable to us could materially adversely affect +us +Failure +to comply with government regulations applicable to our business +could result in penalties and reputational damage. Our products are +regulated by the FCC and otherwise subject to a wide range of +global laws. As a public company, we are also subject to +regulations of the SEC and the stock exchange on which we are +listed. These laws and regulations are complex, change frequently, +have tended to become more stringent over time and increase our +cost of doing business. Compliance with existing or future laws, +including U.S. tax laws, could subject us to future costs or +liabilities, impact our production capabilities, constrict our +ability to sell, expand or acquire facilities, restrict what +products and services we can offer, and generally impact our +financial performance. Failure to comply with or to respond to +changes in these requirements and regulations could result in +penalties on us, such as fines, restrictions on operations or a +temporary or permanent closure of our facility. These penalties +could have a material adverse effect on our business, operating +results and financial condition. In addition, existing or new +regulatory requirements or interpretations could materially +adversely impact us. +15 +We may not be able to maintain our NYSE American +listing +Our +common stock has been listed on the NYSE American since 2005. If we +are unable to satisfy the continued listing standards of the NYSE +American, which include, among others, minimum stockholders’ +equity, market capitalization, pre-tax income and per share sales +price, our common stock may be delisted. If our common stock is +delisted, we would be forced to have our common stock quoted on the +OTC Markets or some other quotation medium, depending on our +ability to meet the specific requirements of those quotation +systems. In that case, we may lose some or all of our institutional +investors, and selling our common stock on the OTC Markets would be +more difficult because smaller quantities of shares would likely be +bought and sold and transactions could be delayed. These factors +could result in lower prices and larger spreads in the bid and ask +prices for shares of our common stock. If this happens, we will +have greater difficulty accessing the capital markets to raise any +additional necessary capital. +Any infringement claim against us could have a material adverse +effect on our business, results of operations and financial +condition +As the +number of competing products available in the market increases and +the functions of those products further overlap, the potential for +infringement claims may increase. Any such claims, with or without +merit, may result in costly litigation or require us to redesign +the affected product to avoid infringement or require us to obtain +a license for future sales of the affected product. Any of the +foregoing could damage our reputation and have a material adverse +effect upon our business, results of operations and financial +condition. Any litigation resulting from any such claim could +require us to incur substantial costs and divert significant +resources, including the efforts of our management and engineering +personnel. +We have deferred tax assets that we may not be able to utilize +under certain circumstances +If we +incur future operating losses, we may be required to provide some +or all of our deferred tax assets with a valuation allowance, +resulting in additional non-cash income tax expense. The change in +the valuation may have a material impact on future results. If we +do not achieve sufficient federal taxable income in future years to +utilize all or some of our net operating loss carryforwards +(“NOLs”), they will expire. +We may be unable to obtain components and parts that are verified +to be Democratic Republic of Congo (“DRC”) +conflict-free, which could result in reputational +damage +The +Dodd-Frank Wall Street Reform and Consumer Protection Act includes +disclosure requirements regarding the use of tin, tantalum, +tungsten and gold (which are defined as “conflict +minerals”) in our products and whether these materials +originated from the DRC or an adjoining country. The SEC rules +necessitate a complex compliance process and related administrative +expense for a company once it determines a conflict mineral is +necessary to the functionality or production of a product that the +company manufactures or contracts to manufacture. These +requirements could affect the sourcing, availability and cost of +minerals used in the manufacture of certain of our products, and we +may not be able to obtain conflict-free products or supplies in +sufficient quantities or at competitive prices for our operations. +We have incurred, and will continue to incur, costs associated with +complying with these supply chain due diligence procedures. In +addition, because our supply chain is complex, if we discover that +our products include minerals that have been identified as +“not found to be DRC conflict-free” or we are unable to +determine whether such minerals are included in our products, we +may face reputational challenges with our customers, stockholders +and other stakeholders as a result. +16 +Future sales of shares of our common stock may negatively affect +our stock price and impair our ability to raise equity +capital +Approximately +6.2 million (48.7%) of our shares of outstanding common stock +as of December 31, 2018 are owned by certain of our executive +officers and directors and other affiliates, and may be resold +publicly at any time, subject to the volume and other restrictions +under Rule 144 of the Securities Act of 1933, as amended. +Approximately 51.3% of our outstanding shares of common stock as of +December 31, 2018 are freely tradable without +restriction. +Sales +of substantial amounts of shares of our common stock, or even the +potential for such sales, could lower the market price of our +common stock and impair our ability to raise capital through the +sale of equity securities. +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +We do +not own any real estate. We lease approximately 54,000 square feet +of industrial space at 7100 Technology Drive in West Melbourne, +Florida. In November 2018, the lease was amended to provide for +certain leasehold improvements and extend the lease term until June +30, 2027. Rental, maintenance and tax expenses for this facility +were approximately $490,000, $472,000 and $475,000 in 2018, 2017 +and 2016, respectively. We also lease 8,100 square feet of office +space in Lawrence, Kansas, to accommodate a segment of our +engineering team. The lease has an expiration date of December 31, +2019. Rental, maintenance and tax expenses for this facility were +approximately $108,000 in each of 2018, 2017 and 2016. +Item 3. Legal Proceedings +From +time to time we may be involved in various claims and legal actions +arising in the ordinary course of our business. There were no other +pending material claims or legal matters as of December 31, +2018. +Item +4. Mine Safety Disclosures +Not +applicable. +17 +PART II +Item +5. Market For Registrant’s Common Equity, Related +Stockholder Matters and Issuer Purchases of Equity +Securities +(a) +Market Information. +Our +common stock trades on the NYSE American under the symbol +“BKTI.” +(b) +Holders. +On +February 19, 2019, there were 750 holders of record of our common +stock. +(c) +Dividends. +The +Company currently pays quarterly cash dividends. The declaration +and payment of cash dividends, if any, is subject to the discretion +of the Board of Directors. The Board’s final determination as +to whether to declare and pay dividends is based upon its +consideration of our operating results, financial condition and +anticipated capital requirements, as well as such other factors it +may deem relevant. +(d) +Issuer Purchases of Equity Securities. +Period +Total Number of Shares Purchased +Average Price Paid Per Share (1) +Total Number of Shares Purchased as Part of Publicly Announced +Plans or Programs (2) +Maximum Number of Shares that May Yet Be Purchased Under Publicly +Announced Plans or Programs (2) +10/01/18-10/31/18 +31,406 +$ +4.11 +31,406 +475,376 +11/01/18-11/30/18 +28,691 +$ +3.85 +28,691 +446,685 +12/01/18-12/31/18 +511,593 (3) +$ +3.55 (3) +61,193 +385,492 +Total +571,690 (3) +$ +3.84 (3) +121,290 +(1) +Average price paid +per share of common stock repurchased is the executed price, +including commissions paid to brokers. +(2) +The Company has a +repurchase program of up to 1 million shares of the Company’s +common stock that can be purchased, from time to time, pursuant to +a stock repurchase plan in conformity with the provisions of Rule +10b5-1 and Rule 10b-18 promulgated under the Exchange Act. The +repurchase program was initially announced in May 2016 and expanded +in June 2017 and has no termination date. +(3) +On +December 12, 2018, the Company entered into a purchase agreement +with Donald F.U. Goebert, a greater-than-five percent shareholder +of the Company, pursuant to which the Company repurchased 200,000 +shares of the Company’s common stock held by Mr. Goebert, at +a price of $3.70 per share, for an aggregate cash amount of +$740,000. The transaction was approved by the Board of Directors of +the Company. Mr. Goebert previously served as a director of the +Company until his resignation on January 9, 2017. The numbers in +the table also include another 250,400 shares repurchased at $3.70 +per share (not including brokerage commissions) outside of the +Company’s public repurchase program on December 12, +2018. +Item 6. Selected Financial Data +Not +required for smaller reporting companies. +18 +Item 7. Management’s Discussion and Analysis of +Financial Condition and Results of Operations +Executive Summary +During +2018, we realized improvements in many areas of our operations, +primarily derived from the substantial changes that were +implemented since fiscal 2017. These improvements drove sales +growth, increasing gross profit margins and income from operations, +while reducing inventory and generating positive cash flow. They +also enabled us to invest in new product development, which we +believe will provide strategic advantages and fuel our growth in +future periods. We anticipate introducing new generation multiband +P-25 digital products to supplement our flagship KNG and KNG2 +products during 2019. +Total +sales in 2018 increased 25.3% to approximately $49.4 million, +compared with approximately $39.4 million for the prior +year. +Gross +profit margin as a percentage of sales in 2018 was approximately +40.5%, a significant increase from 24.2% for the previous year. +Gross profit margin for 2017 was impacted by a $3.2 million +one-time charge to write-off inventory and approximately $1.8 +million of product-related service charges. +Selling, general +and administrative (“SG&A”) expenses for 2018 +totaled approximately $17.6 million, or 35.5% of sales, compared +with $14.6 million, or 37.0% of sales for 2017. The increase in +SG&A expenses was attributed primarily to new product +development. +The +increases in sales, gross profit margin and SG&A expenses +combined to yield operating income for 2018 of approximately $2.4 +million, compared with an operating loss of $5.0 million for the +prior year. +In +2018, we incurred $2.9 million in other expenses that were +primarily related to investments outside our core business +operations. +For +2018, we recognized a pretax loss of $472,000, compared with a +pretax loss of $4.8 million for the prior year. Net income tax +benefit for 2018 totaled approximately $277,000, compared with $1.2 +million for 2017. Our income tax benefit for both years is largely +non-cash, as a result of deferred items partially derived from +NOLs. +We +recognized a net loss for 2018 totaling approximately $195,000 +($0.01 per basic and diluted share), compared with approximately +$3.6 million ($0.27 per basic and diluted share) for +2017. +As of +December 31, 2018, working capital totaled approximately $21.0 +million, of which $17.0 million was comprised of cash, cash +equivalents and trade receivables. This compares with working +capital totaling approximately $26.7 million at year end 2017, +which included $12.7 million of cash, cash equivalents and trade +receivables. During 2018, we repurchased 873,014 shares of our +common stock, utilizing cash of approximately $3.3 +million. +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year-end budgets and appropriations. We may also +experience fluctuations in our quarterly results, in part, due to +our sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +condition. +In +December 2017, the Tax Cuts and Jobs Act (the “2017 Tax +Act”) was enacted. The 2017 Tax Act represents major tax +reform legislation that, among other provisions, reduces the U.S. +corporate tax rate. See Note 8 to the consolidated financial +statements for further information on the financial statement +impact of the 2017 Tax Act. +19 +Results of Operations +As an +aid to understanding our operating results, the following table +shows items from our consolidated statements of operations +expressed as a percentage of sales: +Percent of +Sales +for Years Ended +December 31, +2018 +2017 +Sales +100.0 % +100.0 % +Cost of +products +(59.5 ) +(75.8 ) +Gross +margin +40.5 +24.2 +Selling, general +and administrative expenses +(35.5 ) +(37.0 ) +Other (expense) +income, net +(6.0 ) +0.7 +Loss before income +taxes +(1.0 ) +(12.1 ) +Income tax +benefit +0.6 +2.9 +Net +loss +(0.4 )% +(9.2 )% +Fiscal Year 2018 Compared With Fiscal Year 2017 +Sales, net +For +2018, net sales increased 25.3% to approximately $49.4 million, +compared with approximately $39.4 million for 2017. +Our +sales growth for the year was broad-based and not reliant upon one +particular contract or customer. We realized sales growth in all of +our primary markets, including federal, state and local public +safety agencies, with a mix of new customers, combined with strong +demand from traditional legacy and Canadian customers. +We +believe our funnel of sales prospects for 2019 is encouraging. +Among other opportunities, it includes the SURAC issued by the U.S. +Army and the third option year of our contract with the TSA. +Additionally, we plan to launch our new multiband product line in +2019, which should increase our potential market. In order to +effectively capitalize on new opportunities and drive sales growth, +we have expanded and upgraded our sales and marketing capabilities. +However, the timing and size of orders from agencies at all levels +can be unpredictable and subject to the influence of budgets and +priorities. Accordingly, we cannot assure that sales will occur +under particular contracts, or that our sales prospects will +otherwise be realized. +Cost of Products and Gross Profit Margin +Gross +profit margin as a percentage of sales for 2018 increased to 40.5% +from 24.2% for the prior year. +Our +cost of products and gross profit margin are primarily derived from +material, labor and overhead costs, product mix, manufacturing +volumes and pricing. The improvement in gross profit margins from +2017 was primarily attributed to increased sales combined with a +more favorable mix of product sales. Furthermore, increased +production volumes enabled us to more effectively utilize and +absorb our base of manufacturing overhead expenses, and we are +realizing benefits associated with manufacturing and quality +improvement programs. +Comparatively, in +2017, the mix of product sales was more heavily weighted toward +lower margin products, and certain products were sold using reduced +promotional pricing. Last year’s gross profit margins were +also adversely impacted by costs associated with the write-off of +inventory and higher product service costs. +We +continue to utilize contract manufacturing relationships for +production efficiencies and to manage material and labor costs. We +anticipate that our current contract manufacturing relationships or +comparable alternatives will be available to us in the future. We +believe gross margin improvements can be realized by leveraging +increased sales volumes, manufacturing efficiencies and quality. We +may encounter product cost and competitive pricing pressures in the +future. However, the extent of their impact on gross margins, if +any, is uncertain. +20 +Selling, General and Administrative Expenses +SG&A expenses +consist of sales, marketing, commissions, engineering, product +development, management information systems, accounting, +headquarters and non-cash, share-based employee compensation +expenses. +For +2018, SG&A expenses totaled approximately $17.6 million, or +35.5% of sales, compared with approximately $14.6 million, or 37.0% +of sales for 2017. +Engineering and +product development expenses for 2018 totaled approximately $7.8 +million (15.7% of total sales), compared with approximately $5.0 +million (12.7% of total sales) for 2017. The increase in +engineering expenses was attributed to costs related to new product +development initiatives. +Marketing and +selling expenses for 2018 totaled approximately $5.4 million (11.0% +of sales), compared with approximately $5.2 million (13.3% of +sales) for 2017. The increase was primarily attributed to sales +commissions and incentive compensation directly related to sales +performance. +General +and administrative expenses for 2018 totaled approximately $4.4 +million (8.9% of total sales), compared with approximately $4.3 +million (11.0% of total sales) for 2017. Compared with the prior +year, SG&A expenses in 2018 increased due to additional +headquarters expenses, some of which pertained to the +Company’s name change. These were partially offset by +one-time costs incurred during 2017 related to changes in senior +leadership. +Operating Income (Loss) +Operating income +for 2018 increased by approximately $7.4 million to approximately +$2.4 million (4.9% of sales), compared with an operating loss of +approximately $5.0 million (12.8% of sales) for 2017. The increase +in operating income was attributed primarily to sales growth and +improved gross profit margins, which were partially offset by +increased product development expenses. +Other Income (Expense) +Interest Income +We +recorded net interest income of approximately $102,000 for 2018, +compared with $46,000 for 2017. Interest income increased primarily +as a result of our higher cash balance. Interest expense may be +incurred from time to time on outstanding borrowings under our +previous revolving credit facility, which matured on December 26, +2018 and was not renewed, and earned interest income on our cash +balances. The interest rate on such revolving credit facility as of +December 26, 2018 was The +Wall Street Journal prime +rate plus 25 basis points (5.75% as of December 26, +2018). +Loss on Investment in Securities +For +2018, we recognized an unrealized loss of approximately $1.8 +million on our investment in 1347 Property Insurance Holdings, Inc. (Nasdaq: PIH). +I n March and May 2018, we indirectly purchased 477,282 shares of common stock of PIH, for +approximately $3.7 million, through an investment in FGI 1347 +Holdings, LP, a consolidated variable interest entity of which we +are the sole limited partner. This investment was initiated in +2018; accordingly, there was no gain or loss during the prior +year. +During +the first quarter of 2018, we sold 1,317,503 shares of Iteris, Inc. +(Nasdaq: ITI), which cost approximately $2.4 million, for +approximately $8.3 million, and recognized a loss of approximately +$849,000. +21 +Legal Settlement +In +2017, we entered into an agreement to settle a dispute with The +Sales Group, Inc. (“TSG”), a former sales +representative (see Note 13 to the consolidated financial +statements). Pursuant to the settlement agreement, we agreed to pay +an amount of $900,000 to TSG on or before December 31, 2017, which +was recorded as an expense in 2017. We also agreed to pay to TSG +commissions, at the rates in effect since February 7, 2013, on all +orders for our products received and accepted from the states of +Arizona, California, Nevada and Hawaii from January 1, 2018 through +December 31, 2018, excluding (i) sales to federal government +agencies, (ii) sales to other end-users, except state and local +government agencies and offices, and (iii) sales of parts or +service, including warranty service. These commissions were +estimated to be $536,000, which was recorded as an expense in 2017. +Actual commissions during 2018 totaled approximately $823,000. +Accordingly, $287,000 of additional commission was recorded as an +expense in 2018. +Other Expense +For +2018, we recognized other expenses totaling approximately $328,000, +compared with approximately $106,000 for 2017. These expenses were +primarily attributed to exchange losses related to sales under a +Canadian dollar-denominated contract. During the first quarter of +2017, we recorded a nonrecurring loss of approximately $104,000 on +the disposal of assets related to a discontinued product +initiative. +Income Tax Benefit +We +recorded a net income tax benefit for 2018 of approximately +$277,000, compared with a net benefit of approximately $1.2 million +for the prior year. +Our +income tax provision is based on the effective tax rate for the +year. For 2018, our effective tax rate declined compared to +2017, primarily due to the implementation of the 2017 Tax Act +enacted in December 2017, which, among other things, reduced the +U.S. federal corporate tax rate from 35% to 21%. +As of +December 31, 2018, our net deferred tax assets totaled +approximately $3.5 million, and were primarily composed of general +business credit carryovers and NOLs. These credits totaled +approximately $1.6 million for federal purposes. In addition, the +deferred tax assets related to the federal NOLs were completely +used in 2018, and total $7.2 million for state purposes, with +expirations starting in 2019 through 2038. +In +order to fully utilize the net deferred tax assets, we will need to +generate sufficient taxable income in future years to utilize our +NOLs prior to their expiration. We analyze all positive and +negative evidence to determine if, based on the weight of available +evidence, we are more likely than not to realize the benefit of the +net deferred tax assets. The recognition of the net deferred tax +assets and related tax benefits is based upon our conclusions +regarding, among other considerations, estimates of future earnings +based on information currently available and current and +anticipated customers, contracts and product introductions, as well +as historical operating results and certain tax planning +strategies. +Based +on our analysis of all available evidence, both positive and +negative, we have concluded that we have the ability to generate +sufficient taxable income in the necessary period to utilize the +entire benefit for the deferred tax asset. Management estimated +that, as of December 31, 2018, a valuation allowance related to our +Florida NOLs was no longer needed due to expected 2018 usage. We +cannot presently estimate what, if any, changes to the valuation of +our deferred tax assets may be deemed appropriate in the future. If +we incur future losses, it may be necessary to record a valuation +allowance related to the deferred tax assets recognized as of +December 31, 2018. +22 +Fiscal Year 2017 Compared With Fiscal Year 2016 +Sales, net +For +2017, net sales totaled approximately $39.4 million, compared with +approximately $50.7 million for 2016. Sales of P-25 digital +products in 2017 totaled approximately $28.7 million (72.7% of +total sales), compared with approximately $33.2 million (65.5% of +total sales) for 2016. +Sales +for 2016 benefited from significant sales to one customer under our +contract with the TSA, which were not fully replicated in 2017, +resulting in the year-over-year decrease. Absent the impact of +sales to the TSA, 2017 sales increased approximately 20.9% from +2016. During 2017, demand from other federal, state and +international public safety agencies strengthened compared with the +prior year, and we were awarded several multi-year contracts and +blanket purchase orders from federal agencies. During the year, we +added sales resources to capitalize on opportunities for potential +sales growth. +Cost of Products and Gross Profit Margin +Cost of +products as a percentage of sales for 2017 was 75.8%, compared +with 66.3% in 2016. Gross profit margin as a percentage of sales +for 2017 was 24.2%, compared with 33.7% for 2016. +Our +cost of products and gross profit margin are derived primarily from +material, labor and overhead costs, product mix, manufacturing +volumes and pricing. For 2017, costs associated with the write-off +of specific inventory and higher product service costs also +adversely impacted costs of products and gross profit +margin. +In +2017, the mix of product sales was more heavily weighted toward +lower margin products, and certain products were sold using +promotional pricing designed to drive sales growth. Following +leadership changes, in the third quarter of 2017, we launched a +comprehensive evaluation of our products, markets and strategies +through the remainder of the year. As a result of this evaluation, +we recognized a charge of $3.2 million to write-off inventory with +limited customer market opportunities, primarily due to concerns +regarding technology and production costs. We also incurred +approximately $1.8 million in incremental product costs associated +with addressing customer requests for modification and +upgrades. +Gross +profit margins for the prior year reflected competitive factors +associated with the TSA sales, which comprised a significant +portion of our sales for 2016. +Selling, General and Administrative Expenses +SG&A expenses +consist of marketing, sales, commissions, engineering, product +development, management information systems, accounting, +headquarters expenses and non-cash, share-based employee +compensation expense. +For +2017, SG&A expenses totaled approximately $14.6 million, or +37.0% of sales, compared with approximately $12.8 million, or +25.3% of sales, for 2016. +Engineering and +product development expenses for 2017 totaled approximately $5.0 +million (12.7% of total sales), compared with approximately $4.1 +million (8.1% of total sales) for the previous year. Expenses +related to new product development projects were the primary +contributor to the increase in engineering expenses. +Marketing and +selling expenses for 2017 totaled approximately $5.2 million (13.3% +of sales), compared with $5.4 million (10.6% of sales) for the +prior year. The decrease was primarily attributed to decreases in +commissions and incentive compensation directly related to sales +performance, which were partially offset by expenses related to new +sales staff. +General +and administrative expenses for 2017 totaled approximately $4.3 +million (11.0% of total sales), compared with approximately $3.3 +million (6.5% of total sales) for 2016. The increase was primarily +related to headquarters professional fees and expenses incurred in +the first quarter associated with changes in senior +management. +23 +Operating (Loss) Income +The +operating loss for 2017 totaled approximately $5.0 million (12.8% +of sales), compared with operating income of approximately $4.3 +million (8.5% of sales) for 2016. The decrease in operating income +was attributed to several factors, which included a) higher costs +of products, derived in large part from charges associated with the +write-off of inventory, b) product costs related to addressing +customer-requested modifications and upgrade, c) engineering +expenses related to new product development, and d) headquarters +professional fees and expenses associated with senior management +changes. +Other Income (Expense) +Interest Income (Expense), net +For +2017, we realized interest income of approximately $46,000 on our +cash balances, compared with approximately $9,000 for the prior +year. +We +incurred no interest expense in 2017 or 2016. Interest expense may +be incurred from time to time on outstanding borrowings under our +revolving credit facility. The interest rate on such revolving +credit facility as of December 31, 2017 was 4.00% per annum. This +rate was variable based on The Wall Street Journal prime rate plus 25 +basis points. Effective as of December 27, 2017, we entered into a +seventh amendment to our Loan and Security Agreement with Silicon +Valley Bank primarily to extend the maturity date by approximately +a year, to December 26, 2018. Our revolving credit facility was not +utilized during 2017 or 2016. +Gain on Sales of Available-for-Sale Securities +During +the year ended December 31, 2017, we sold 460,546 shares of Iteris, +which generated proceeds of approximately $2.6 million and gains of +approximately $1.8 million. There were no comparable gains recorded +for 2016. +Legal Settlement +On +December 19, 2017, we entered into an agreement to settle a dispute +with TSG, a former sales representative (see Note 13 to the +consolidated financial statements). Pursuant to the settlement +agreement, we agreed to pay an amount of $900,000 to TSG on or +before December 31, 2017, which was recorded as an expense in 2017. +We also agreed to pay to TSG commissions, at the rates in effect +since February 7, 2013, on all orders for our products received and +accepted from the states of Arizona, California, Nevada and Hawaii +from January 1, 2018 through December 31, 2018, excluding (i) sales +to federal government agencies, (ii) sales to other end-users, +except state and local government agencies and offices, and (iii) +sales of parts or service, including warranty service. These +commissions were estimated to total approximately $536,000, which +was recorded as an expense in December 2017. +Other Expense +During +2017, we incurred a loss on the disposal of assets related to a +discontinued product initiative. We also recognized an exchange +loss related to sales under a Canadian-dollar-denominated contract. +No comparable expenses were incurred in the prior +year. +Income Tax Benefit (Expense) +We +recorded an income tax benefit for 2017 of approximately $1.2 +million, which is net of tax expense of approximately $665,000 +derived from the impact of revaluing deferred tax assets in +accordance with the 2017 Tax Act. In connection with our initial +analysis of the impact of the 2017 Tax Act, we recorded a discrete +net tax expense of $665,000 in the year ended December 31, 2017 to +account for the effect of the corporate rate reduction. The net tax +expense primarily relates to a reduction in the deferred tax assets +of approximately $1,524,000 and a reduction in the deferred tax +liability related to unrealized gain on available-for-sale +securities of approximately $(859,000). For 2016, we recognized +income tax expense of approximately $1.6 million. Our income tax +benefit and expense are primarily non-cash. +24 +As of +December 31, 2017 and 2016, our net deferred tax assets totaled +approximately $3.3 million and $3.4 million, respectively, and were +primarily composed of NOLs, offset by deferred tax liabilities of +$1.9 million and $1.8 million, respectively, primarily derived from +depreciation and the unrealized gain on available-for-sale +securities. The NOLs, as of December 31, 2017, totaled $6.5 +million for federal and $13.9 million for state purposes, with +expirations starting in 2018 through 2037. +We +evaluated the available evidence and the likelihood of realizing +the benefit of our net deferred tax assets. Based on our +evaluation, we concluded that, based on the weight of available +evidence, it is more likely than not that we will not realize a +portion of the benefit of our state net deferred tax assets +recorded at December 31, 2017. Accordingly, we established a +valuation allowance totaling approximately $64,000 for the portion +of state deferred tax assets that more likely than not will not be +realized. +There +was no significant impact on our operations as a result of +inflation for the fiscal years ended December 31, 2018, 2017 and +2016. +Liquidity and Capital Resources +For the year +ended December 31, 2018, net cash provided by operating activities +totaled approximately $5.3 million, compared with cash used in +operating activities of approximately $2.3 million last year. +Cash provided by operating activities was primarily related to a +decrease in inventories, loss on available-for-sale securities, +deferred revenue, and depreciation and amortization, which was +partially offset by an increase in prepaid expenses and a decrease +in accrued other expenses. +For the +year ended December 31, 2018, we had a net loss of approximately +$195,000, compared with approximately $3.6 million last year. Net +inventories decreased during the year ended December 31, 2018 by +approximately $2.9 million, compared with an increase of $508,000 +last year. The 2018 decrease was primarily attributed to increased +sales and improved supply chain management. The loss on investment +in securities for the year ended December 31, 2018 totaled +approximately $2.7 million, compared with a gain of approximately +$1.8 million last year. For additional information pertaining to +our investment in securities, refer to Notes 1 and 6 to the +consolidated financial statements included in this report. Deferred +revenue for 2018 increased approximately $1.1 million, compared +with approximately $88,000 for the prior year. The increase was +attributed to increased sales of extended warranties. Depreciation +and amortization totaled approximately $921,000 for the year ended +December 31, 2018, compared with approximately $942,000 for the +same period last year. Prepaid expenses and other current assets +increased approximately $1.6 million for the year ended December +31, 2018, compared with a decrease of $637,000 last year. The +increase was attributed primarily to prepayments associated with +the new multiband portable radio product line. Accrued other +expenses and other current liabilities decreased approximately +$867,000 during 2018, which was attributed primarily to the payment +of accrued expenses related to the legal settlement with TSG that +were accrued during the previous year. (See Note 13 to the +consolidated financial statements). +Cash +provided by investing activities for the year ended December 31, +2018 totaled approximately $3.2 million, compared with +approximately $2.0 million last year. Proceeds from the sale of +available-for-sale securities totaled approximately $8.3 million +for the year ended December 31, 2018, compared with approximately +$2.6 million last year. We utilized approximately $3.7 million for +an investment in FGI 1347 Holdings, LP. There was no comparable +investment for the same period last year. For the year ended +December 31, 2018, purchases of property, plant and equipment +totaled approximately $1.4 million, compared with approximately +$628,000 for the same period last year. The increase was primarily +attributed to test and information technology equipment +upgrades. +For the +year ended December 31, 2018, approximately $4.4 million was used +in financing activities, primarily related to our capital return +program, which included quarterly dividends totaling approximately +$1.1 million and stock repurchases totaling approximately $3.3 +million. For the same period last year, approximately $3.0 million +was used to pay dividends and approximately $648,000 was used for +stock repurchases, and we also received approximately $183,000 from +the issuance of common stock upon the exercise of stock +options. +25 +Our +$1.0 million revolving credit facility with Silicon Valley Bank +matured on December 26, 2018, and we elected to not renew it. The +Loan and Security Agreement governing the revolving credit facility +contained customary borrowing terms and conditions, including the +accuracy of representations and warranties, compliance with +financial maintenance and restrictive covenants, and the absence of +events of default. Pursuant to the Loan and Security Agreement, the +Company was permitted to pay cash dividends, the total of which +could not exceed $5.0 million in the aggregate during any +twelve-month period, so long as an event of default did not exist +at the time of such dividend and would not exist after giving +effect to such dividend. The variable rate at which borrowings +under the credit facility were to bear interest was The Wall Street Journal prime rate plus 25 +basis points. +We were +in compliance with all covenants under the Loan and Security +Agreement and there were no borrowings outstanding under the +revolving credit facility as of its maturity date. For +additional information about our revolving credit facility, see +“Note 5—Debt” of the notes to the consolidated +financial statements. +Our +cash and cash equivalents balance at December 31, 2018 was +approximately $11.3 million. We believe these funds, combined +with anticipated cash generated from operations, are sufficient to +meet our working capital requirements for the foreseeable future. +However, although we do not anticipate needing additional capital +in the near term, financial and economic conditions could limit our +access to credit and impair our ability to raise capital, if +needed, on acceptable terms or at all. We also face other risks +that could impact our business, liquidity and financial condition. +For a description of these risks, see “Part I—Item 1A. +Risk Factors” in this report. +Off Balance Sheet Arrangements +We do +not have any off balance sheet arrangements. +Recently Adopted Accounting Pronouncements +In May +2014, the Financial Accounting Standards Board (“FASB”) +issued Accounting Standards Update (“ASU”) ASU 2014-09, +“Revenue from Contracts with Customers,” which provided +for a single, principles-based model for revenue recognition and +replaced the existing revenue recognition guidance, became +effective for annual and interim periods beginning on or after +December 15, 2017, and replaced most existing revenue recognition +guidance under accounting principles generally accepted in the +United States of America (“GAAP”). This ASU required +additional disclosures about the nature, amount, timing and +uncertainty of revenue and cash flows arising from customer +contracts, including significant judgements and estimates and +changes in those estimates. It permitted the use of either a +modified retrospective or cumulative effect transition method. The +Company adopted ASU 2014-09 in the first quarter of 2018 and +applied the modified retrospective approach. Because the +Company’s primary source of revenues is from shipments of +products, the adoption of this new guidance did not have any impact +on its consolidated financial statements and related disclosures. +See Note 1, under “Revenue Recognition,” for additional +information. +In +January 2016, the FASB issued ASU 2016-01 “Financial +Instruments,” which amended the guidance in GAAP on the +classification and measurement of financial instruments. Changes +primarily affected the accounting for equity investments, financial +liabilities under the fair value option, and the presentation and +disclosure requirements for financial instruments. In addition, the +ASU clarified guidance related to the valuation allowance +assessment when recognizing deferred tax assets resulting from +unrealized losses on available-for-sale debt securities. The new +standard became effective for fiscal years and interim periods +beginning after December 15, 2017, and upon adoption, an entity was +required to apply the amendments by means of a cumulative-effect +adjustment to the balance sheet at the beginning of the first +reporting period in which the guidance is effective. The Company +adopted the new guidance in the first quarter of 2018, which had a +material impact on its retained earnings, as the Company +reclassified approximately $4,300 of unrealized gain on investment +securities that was previously classified in other comprehensive +income. +26 +In +August 2018, the FASB issued ASU 2018-15, +“Intangibles—Goodwill and Other—Internal-Use +Software (Subtopic 350-40): Customer’s Accounting for +Implementation Costs Incurred in a Cloud Computing Arrangement That +Is a Service Contract,” to help entities evaluate the +accounting for fees paid by a customer in a cloud computing +arrangement (hosting arrangement) by providing guidance for +determining when the arrangement includes a software license. The +amendments in ASU 2018-15 align the requirements for capitalizing +implementation costs incurred in a hosting arrangement that is a +service contract with the requirements for capitalizing +implementation costs incurred to develop or obtain internal-use +software (and hosting arrangements that include an internal use +software license). The accounting for the service element of a +hosting arrangement that is a service contract is not affected by +the amendments in ASU 2018-15. The amendments in ASU 2018-15 will +become effective for fiscal years and interim periods beginning +after December 15, 2019. Early adoption is permitted, including +adoption in any interim period. The Company adopted the new +guidance in the fourth quarter of 2018, with no material impact on +its consolidated financial statements and related +disclosures. +Recent Accounting Pronouncements +In +February 2016, the FASB issued ASU 2016-02, “Leases,” +which amends leasing guidance by requiring companies to recognize a +right-of-use asset and a lease liability for all operating and +capital (finance) leases with lease terms greater than twelve +months. The lease liability will be equal to the present value of +lease payments. The lease asset will be based on the lease +liability, subject to adjustment, such as for initial direct costs. +For income statement purposes, leases will continue to be +classified as operating or capital (finance), with lease expense in +both cases calculated substantially the same as under the prior +leasing guidance. The updated guidance is effective for interim and +annual periods beginning after December 15, 2018, with early +adoption permitted. The Company +expects this will result in the recognition of right-of-use assets +and lease liabilities not currently recorded on the consolidated +financial statements under existing accounting guidance. Based on +the Company’s evaluation of all of its contractual +arrangements, the Company expects that the adoption of ASU 2016-02 +will have a significant impact on the Company’s consolidated +financial statements. After the adoption, the Company will first +report the operating lease right-of-use assets and lease +liabilities as of March 31, 2019 based on the Company’s lease +portfolio as of that date +In +August 2018, the SEC adopted the final rule under SEC Release No. +33-10532, “Disclosure Update and Simplification,” +amending certain disclosure requirements that were redundant, +duplicative, overlapping, outdated or superseded. In addition, the +amendments expanded the disclosure requirements on the analysis of +stockholders’ equity for interim financial statements. Under +the amendments, an analysis of changes in each caption of +stockholders’ equity presented in the balance sheet must be +provided in a note or separate statement. The analysis should +present a reconciliation of the beginning balance to the ending +balance of each period for which a statement of comprehensive +income is required to be filed. This final rule is effective for +all filings made on or after November 5, 2018. Given the effective +date and the proximity to most filers’ quarterly reports, the +SEC is not objecting to filers deferring the presentation of +interim changes in stockholders’ equity in their Forms 10-Q +until the quarter that begins after the date of adoption, November +5, 2018. The Company intends to present interim changes in +stockholders’ equity beginning with its quarterly report on +Form 10-Q for the first quarter of 2019. +The +Company does not discuss recent pronouncements that are not +anticipated to have an impact on or are unrelated to its financial +condition, results of operations, cash flows or +disclosures. +Critical Accounting Policies and Estimates +Our +revenue recognition process and our more subjective accounting +estimation processes affect our reported revenues and current +assets and are, therefore, critical in assessing our financial and +operating status. The processes for determining the allowance for +collection of trade receivables, allowance for excess or obsolete +inventory, allowance for product warranty, software development and +income taxes involve certain assumptions that, if incorrect, could +create an adverse impact on our operations and financial +position. +27 +Revenue +Effective January +1, 2018, the Company adopted ASU 2014-09, “Revenue from +Contracts with Customers” and the additional related ASUs +(“ASC 606”), which replaces existing revenue guidance +and outlines a single set of comprehensive principles for +recognizing revenue under GAAP. The Company elected the modified +retrospective method upon adoption, with no impact to the opening +retained earnings or revenue reported. These standards provide +guidance on recognizing revenue, including a five-step method to +determine when revenue recognition is appropriate: +Step 1: +Identify the contract with the customer; +Step 2: +Identify the performance obligations in the contract; +Step 3: +Determine the transaction price; +Step 4: +Allocate the transaction price to the performance obligations; +and +Step 5: +Recognize revenue as the Company satisfies a performance +obligation. +ASC 606 +provides that revenue is recognized when control of the promised +goods or services is transferred to customers at an amount that +reflects the consideration to which the entity expects to be +entitled to in exchange for those goods or services. We generally +satisfy performance obligations upon shipment of the product or +service to the customer. This is consistent with the time in which +the customer obtains control of the product or service. For +extended warranties, sales revenue associated with the warranty is +deferred at the time of sale and later recognized on a +straight-line basis over the extended warranty period. Some +contracts include installation services, which are completed in a +short period of time and the revenue is recognized when the +installation is complete. Customary payment terms are granted to +customers, based on credit evaluations. We currently do not have +any contracts where revenue is recognized, but the customer payment +is contingent on a future event. +Allowance +for Doubtful Accounts +The +allowance for doubtful accounts was approximately $50,000 on gross +trade receivables of approximately $5.8 million as of December +31, 2018, as compared with $50,000 on gross trade receivables of +approximately $5.6 million as of December 31, 2017. This allowance +is used to state trade receivables at a net realizable value or the +amount that we estimate will be collected on our gross receivables +as of December 31, 2018 and 2017. Because the amount that we will +actually collect on the receivables outstanding as of December 31, +2018 and 2017 cannot be known with certainty, we rely on prior +experience. Our historical collection losses have typically been +infrequent, with write-offs of trade receivables being less than 1% +of sales during past years. Accordingly, we have maintained a +general allowance of up to approximately 5% of the gross trade +receivables balance in order to allow for future collection losses +that arise from customer accounts that do not indicate the +inability to pay but turn out to have such an inability. Currently, +our general allowance on trade receivables is approximately 1% of +gross receivables. As revenues and total receivables increase, the +allowance balance may also increase. We also maintain a specific +allowance for customer accounts that we know may not be collectible +due to various reasons, such as bankruptcy and other customer +liquidity issues. We analyze our trade receivables portfolio based +on the age of each customer’s invoice. In this way, we can +identify those accounts that are more likely than not to have +collection problems. We may reserve a portion or all of the +customer’s balance. As of December 31, 2018 and 2017, we had +no specific allowance on trade receivables. +Excess and Obsolete Inventory +The +allowance for obsolete and slow-moving inventory was approximately +$629,000 and $789,000 at December 31, 2018 and 2017, +respectively. +The +allowance for slow-moving, excess, or obsolete inventory is used to +state our inventories at the lower of cost and net realizable +value. Because the amount of inventory that we will actually recoup +through sales cannot be known with certainty at any particular +time, we rely on past sales experience, future sales forecasts and +our strategic business plans. Generally, in analyzing our inventory +levels, we classify inventory as having been used or unused during +the past year and establish an allowance based upon several +factors, including, but not limited to, business forecasts, +inventory quantities and historical usage profile. +28 +Supplemental to the +aforementioned analysis, specific inventory items are reviewed +individually by management. Based on the review, considering +business levels, future prospects, new products and technology +changes, management, using its business judgment, may adjust the +valuation of specific inventory items to reflect an accurate +valuation. Management also performs a determination of net +realizable value for all finished goods with a selling price below +cost. For all such items, the inventory is valued at not more than +the selling price less cost, if any, to sell. +Allowance for Product Warranty +We +offer two-year warranties to our customers, depending on the +specific product and terms of the customer purchase agreement. Our +typical warranties require us to repair and replace defective +products during the warranty period at no cost to the customer. At +the time the product revenue is recognized, we record a liability +for estimated costs under our warranties. The costs are estimated +based on historical experience. We periodically assess the adequacy +of our recorded liability for product warranties and adjust the +amount as necessary. +Income Taxes +We +account for income taxes using the asset and liability method. +Deferred tax assets and liabilities are recognized for the future +tax consequences attributable to differences between the financial +statement carrying amounts of existing assets and liabilities and +their respective tax bases. Deferred tax assets and liabilities are +measured using the enacted tax rates expected to apply in the +period in which the deferred tax asset or liability is expected to +be realized. The effect of changes in net deferred tax assets and +liabilities is recognized on our consolidated balance sheets and +consolidated statements of operations in the period in which the +change is recognized. Valuation allowances are provided to the +extent that it is more likely than not that some portion, or all, +of deferred tax assets will not be realized. In determining whether +a tax asset is realizable, we consider, among other things, +estimates of future earnings based on information currently +available, current and anticipated customers, contracts and new +product introductions, as well as recent operating results and +certain tax planning strategies. If we fail to achieve the future +results anticipated in the calculation and valuation of net +deferred tax assets, we may be required to adjust the valuation +allowance related to our deferred tax assets in the +future. +Forward-Looking Statements +We +believe that it is important to communicate our future expectations +to our security holders and to the public. This report, therefore, +contains statements about future events and expectations which are +“forward-looking statements” within the meaning of +Sections 27A of the Securities Act of 1933, as amended, and 21E of +the Exchange Act, including the statements about our plans, +objectives, expectations and prospects under the heading +“Management’s Discussion and Analysis of Financial +Condition and Results of Operations.” You can expect to +identify these statements by forward-looking words such as +“may,” “might,” “could,” +“would,” “should,” “will,” +“anticipate,” “believe,” +“plan,” “estimate,” “project,” +“expect,” “intend,” “seek” and +other similar expressions. Any statement contained in this report +that is not a statement of historical fact may be deemed to be a +forward-looking statement. Forward-looking statements include, but +are not limited to, the following: changes or advances in +technology; the success of our LMR product line; successful +introduction of new products and technologies; competition in the +LMR industry; general economic and business conditions, including +federal, state and local government budget deficits and spending +limitations and any impact from a prolonged shutdown of the U.S. +Government; the availability, terms and deployment of capital; +reliance on contract manufacturers and suppliers; heavy reliance on +sales to agencies of the U.S. Government; allocations by government +agencies among multiple approved suppliers under existing +agreements; our ability to comply with U.S. tax laws and utilize +deferred tax assets; retention of executive officers and key +personnel; our ability to manage our growth; our ability to +identify potential candidates for, and consummate, acquisition or +investment transactions, and risks incumbent to being a +noncontrolling interest stockholder in a corporation; impact of our +capital allocation strategy; government regulation; our business +with manufacturers located in other countries, including changes in +the U.S. Government and foreign governments’ trade and tariff +policies; our inventory and debt levels; protection of our +intellectual property rights; fluctuation in our operating results; +acts of war or terrorism, natural disasters and other catastrophic +events; any infringement claims; data security breaches, cyber +attacks and other factors impacting our technology systems; +availability of adequate insurance coverage; maintenance of our +NYSE American listing; and the effect on our stock price and +ability to raise equity capital of future sales of shares of our +common stock. +29 +Although we believe +that the plans, objectives, expectations and prospects reflected in +or suggested by our forward-looking statements are reasonable, +those statements involve risks, uncertainties and other factors +that may cause our actual results, performance or achievements to +be materially different from any future results, performance or +achievements expressed or implied by these forward-looking +statements, and we can give no assurance that our plans, +objectives, expectations and prospects will be +achieved. +Important factors +that might cause our actual results to differ materially from the +results contemplated by the forward-looking statements are +contained in “Part I—Item 1A. Risk Factors” and +elsewhere in this report and in our subsequent filings with the +SEC. We assume no obligation to publicly update or revise any +forward-looking statements made in this report, whether as a result +of new information, future events, changes in assumptions or +otherwise, after the date of this report. Readers are cautioned not +to place undue reliance on these forward-looking +statements. +Item 7A. Quantitative and Qualitative Disclosures About Market +Risk +Not +required for smaller reporting companies. +Item 8. Financial Statements and Supplementary +Data +See the +Consolidated Financial Statements included in this +report. +30 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING +FIRM +Board of Directors and Stockholders +BK Technologies, Inc. +West Melbourne, Florida +Opinion on the Consolidated Financial Statements +We have +audited the accompanying consolidated balance sheets of BK +Technologies, Inc. (the “Company”) as of +December 31, 2018 and 2017, and the related consolidated +statements of operations, comprehensive loss, changes in +stockholders’ equity, and cash flows for each of the years in +the two-year period ended December 31, 2018, and the related +notes (collectively referred to as the consolidated financial +statements). In our opinion, the consolidated financial statements +present fairly, in all material respects, the financial position of +the Company as of December 31, 2018 and 2017, and the results +of its operations and its cash flows for each of the years in the +two-year period ended December 31, 2018, in conformity with +accounting principles generally accepted in the United States of +America. +Basis for Opinion +These +consolidated financial statements are the responsibility of the +Company’s management. Our responsibility is to express an +opinion on the Company’s consolidated financial statements +based on our audits. We are a public accounting firm registered +with the Public Company Accounting Oversight Board (United States) +(“PCAOB”) and are required to be independent with +respect to the Company in accordance with U.S. federal securities +laws and the applicable rules and regulations of the Securities and +Exchange Commission and the PCAOB. +We +conducted our audits in accordance with the standards of the PCAOB. +Those standards require that we plan and perform the audits to +obtain reasonable assurance about whether the financial statements +are free of material misstatement, whether due to error or fraud. +The Company is not required to have, nor were we engaged to +perform, an audit of its internal control over financial reporting. +As a part of our audits, we are required to obtain an understanding +of internal control over financial reporting, but not for the +purpose of expressing an opinion on the effectiveness of the +Company’s internal control over financial reporting. +Accordingly, we express no such opinion. +Our +audits included performing procedures to assess the risks of +material misstatement of the consolidated financial statements, +whether due to error or fraud, and performing procedures that +respond to those risks. Such procedures included examining, on a +test basis, evidence regarding the amounts and disclosures in the +consolidated financial statements. Our audits also included +evaluating the accounting principles used and significant estimates +made by management, as well as evaluating the overall presentation +of the consolidated financial statements. We believe that our +audits provide a reasonable basis for our opinion. +/s/ Moore Stephens Lovelace, P.A. +We have +served as the Company’s auditor since 2015. +Miami, +Florida +February +27, 2019 +F-1 +BK TECHNOLOGIES, INC. +CONSOLIDATED +BALANCE SHEETS +(in +thousands, except share data) +December +31, +2018 +2017 +ASSETS +Current +assets: +Cash and cash +equivalents +$ 11,268 +$ 7,147 +Available-for-sale +securities +— +9,184 +Trade accounts +receivable, net +5,721 +5,524 +Inventories, +net +11,466 +14,358 +Prepaid expenses +and other current assets +2,401 +772 +Total current +assets +30,856 +36,985 +Property, plant and +equipment, net +2,729 +2,201 +Investment in +securities +1,919 +— +Deferred tax +assets, net +3,495 +3,317 +Other +assets +192 +298 +Total +assets +$ 39,191 +$ 42,801 +LIABILITIES +AND STOCKHOLDERS’ EQUITY +Current +liabilities: +Accounts +payable +$ 5,595 +$ 5,971 +Accrued +compensation and related taxes +2,014 +1,364 +Accrued warranty +expense +1,546 +1,389 +Accrued other +expenses and other current liabilities +292 +1,159 +Dividends payable +256 +273 +Deferred revenue +180 +157 +Total current +liabilities +9,883 +10,313 +Deferred +revenue +1,596 +481 +Total +liabilities +11,479 +10,794 +Commitments and +contingencies +Stockholders’ +equity: +Preferred stock; +$1.00 par value; 1,000,000 authorized shares; none issued or +outstanding +— +— +Common stock; $.60 +par value; 20,000,000 authorized shares; 13,882,937 and 13,844,584 +issued and 12,817,829 and 13,652,490 outstanding shares at December +31, 2018 and 2017, respectively +8,330 +8,307 +Additional paid-in +capital +25,867 +25,642 +Accumulated +deficit +(2,393 ) +(5,450 ) +Accumulated other +comprehensive income +— +4,318 +Treasury stock, at +cost, 1,065,108 and 192,094 shares at December 31, 2018 and 2017, +respectively +(4,092 ) +(810 ) +Total +stockholders’ equity +27,712 +32,007 +Total liabilities +and stockholders’ equity +$ 39,191 +$ 42,801 +See notes to consolidated financial statements. +F-2 +BK TECHNOLOGIES, INC. +CONSOLIDATED +STATEMENTS OF OPERATIONS +(in +thousands, except per share data) +Years Ended +December 31, +2018 +2017 +Sales, +net +$ 49,380 +$ 39,395 +Expenses +Cost of +products +29,403 +29,845 +Selling, general +and administrative +17,552 +14,577 +Total +expenses +46,955 +44,422 +Operating income +(loss) +2,425 +(5,027 ) +Other (expense) +income: +Interest +income +102 +46 +(Loss) gain on +investment in securities +(2,671 ) +1,833 +Legal +settlement +— +(1,436 ) +Loss on disposal of +property, plant and equipment +— +(95 ) +Other +expense +(328 ) +(106 ) +Total other +(expense) income +(2,897 ) +242 +Loss before income +taxes +(472 ) +(4,785 ) +Discrete tax +item-impact of tax reform +— +(665 ) +Income tax +benefit +277 +1,824 +Net +loss +$ (195 ) +$ (3,626 ) +Net loss per +share-basic +$ (0.01 ) +$ (0.27 ) +Net loss per +share-diluted +$ (0.01 ) +$ (0.27 ) +Weighted average +shares outstanding-basic +13,464 +13,625 +Weighted average +shares outstanding-diluted +13,464 +13,625 +CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS +(in thousands) +Years Ended +December 31, +2018 +2017 +Net +loss +$ (195 ) +$ (3,626 ) +Unrealized gain on +available-for-sale securities, net of tax +— +2,257 +Total comprehensive +loss +$ (195 ) +$ (1,369 ) +See notes to consolidated financial statements. +F-3 +BK TECHNOLOGIES, INC. +CONSOLIDATED +STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY +(in +thousands, except share data) +Common Stock +Shares +Common Stock +Amount +Additional Paid-In +Capital +Retained Earnings +(Accumulated +Deficit) +Accumulated Other +Comprehensive Income +Treasury +Stock +Total +Stockholders’ +Equity +Balance at December 31, +2016 +13,754,749 +$ 8,253 +$ 25,382 +$ 240 +$ 2,061 +$ (162 ) +$ 35,774 +Common stock options exercised and +issued +89,835 +54 +129 +— +— +— +183 +Share-based compensation +expense +— +— +55 +— +— +— +55 +Restricted stock unit compensation +expense +— +— +76 +— +— +— +76 +Dividends +declared +— +— +— +(2,064 ) +— +— +(2,064 ) +Net loss +— +— +— +(3,626 ) +— +— +(3,626 ) +Unrealized gain on +available-for-sale securities +— +— +— +— +2,257 +— +2,257 +Repurchase of common +stock +— +— +— +— +— +(648 ) +(648 ) +Balance at December 31, +2017 +13,844,584 +8,307 +25,642 +(5,450 ) +4,318 +(810 ) +32,007 +Restricted stock units +issued +38,353 +23 +(23 ) +— +— +— +— +Share-based compensation +expense +— +— +95 +— +— +— +95 +Restricted stock unit compensation +expense +— +— +153 +— +— +— +153 +Dividends +declared +— +— +— +(1,066 ) +— +— +(1,066 ) +Net loss +— +— +— +(195 ) +— +— +(195 ) +Effect of adoption of ASU +2016-01 +— +— +— +4,318 +(4,318 ) +— +— +Repurchase of common +stock +— +— +— +— +— +(3,282 ) +(3,282 ) +Balance at December 31, +2018 +13,882,937 +$ 8,330 +$ 25,867 +$ (2,393 ) +$ — +$ (4,092 ) +$ 27,712 +See notes to consolidated financial statements. +F-4 +BK TECHNOLOGIES, INC. +CONSOLIDATED +STATEMENTS OF CASH FLOWS +(in +thousands) +Years Ended +December 31, +2018 +2017 +Operating +activities +Net +loss +$ (195 ) +$ (3,626 ) +Adjustments to +reconcile net loss to net cash provided by (used in) operating +activities: +Inventory +allowance +(38 ) +149 +Deferred tax +benefit +(178 ) +(1,163 ) +Depreciation and +amortization +921 +942 +Share-based +compensation expense +95 +55 +Restricted stock +unit compensation expense +153 +76 +Loss (gain) on sale +of available-for-sale securities +2,671 +(1,833 ) +Loss on disposal of +property, plant and equipment +— +95 +Changes in +operating assets and liabilities: +Trade accounts +receivable +(197 ) +(2,076 ) +Inventories +2,930 +(508 ) +Prepaid expenses +and other current assets +(1,629 ) +637 +Other +assets +53 +(20 ) +Accounts +payable +(376 ) +3,998 +Accrued +compensation and related taxes +650 +(829 ) +Accrued warranty +expense +157 +739 +Deferred +revenue +1,138 +88 +Accrued other +expenses and other current liabilities +(867 ) +990 +Net +cash provided by (used in) operating activities +5,288 +(2,286 ) +Investing +activities +Purchases of +property, plant and equipment +(1,396 ) +(628 ) +Investment in +securities +(3,741 ) +— +Proceeds from sale +of available-for-sale securities +8,335 +2,642 +Net +cash provided by investing activities +3,198 +2,014 +Financing +activities +Dividends +paid +(1,083 ) +(3,026 ) +Repurchase of +common stock +(3,282 ) +(648 ) +Proceeds from +issuance of common stock +— +183 +Net +cash used in financing activities +(4,365 ) +(3,491 ) +Net change in cash +and cash equivalents +4,121 +(3,763 ) +Cash and cash +equivalents, beginning of year +7,147 +10,910 +Cash and cash +equivalents, end of year +$ 11,268 +$ 7,147 +Supplemental +disclosure +Cash paid for +income taxes +$ — +$ — +Non-cash +financing activity +Restricted stock +units issued +$ 140 +$ — +Cashless exercise +of stock options and related conversion of net shares to +stockholders’ equity +$ — +$ 27 +See notes to consolidated financial statements. +F-5 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies +Description of Business +The +primary business of BK Technologies, Inc. and its subsidiaries +(collectively, the “Company”) is the designing, +manufacturing and marketing of wireless communications equipment +primarily consisting of two-way land mobile radios and related +products, which are sold in two primary markets: (1) the government +and public safety market, and (2) the business and industrial +market. The Company has only one reportable business +segment. +Principles of Consolidation +The +accounts of the Company have been included in the accompanying +consolidated financial statements. All significant intercompany +balances and transactions have been eliminated in +consolidation. +The +Company consolidates entities in which it has a controlling +financial interest. The Company determines whether it has a +controlling financial interest in an entity by first evaluating +whether the entity is a variable interest entity +(“VIE”) or a voting interest entity. +VIEs +are entities in which (i) the total equity investment at risk is +not sufficient to enable the entity to finance its activities +independently, or (ii) the at-risk equity holders do not have the +normal characteristics of a controlling financial interest. A +controlling financial interest in a VIE is present when an +enterprise has one or more variable interests that have both (i) +the power to direct the activities of the VIE that most +significantly impact the VIE’s economic performance, and (ii) +the obligation to absorb losses of the VIE or the right to receive +benefits from the VIE that could potentially be significant to the +VIE. The enterprise with a controlling financial interest is the +primary beneficiary and consolidates the VIE. +Voting +interest entities lack one or more of the characteristics of a VIE. +The usual condition for a controlling financial interest is +ownership of a majority voting interest for a corporation or a +majority of kick-out or participating rights for a limited +partnership. +When +the Company does not have a controlling financial interest in an +entity but exerts significant influence over the entity’s +operating and financial policies (generally defined as owning a +voting or economic interest of between 20% to 50%), the +Company’s investment is accounted for under the equity method +of accounting. If the Company does not have a controlling financial +interest in, or exert significant influence over, an entity, the +Company accounts for its investment at fair value, if the fair +value option was elected, or at cost. +The +Company has an investment in 1347 Property Insurance Holdings, +Inc., made through FGI 1347 Holdings, LP, a consolidated +VIE. +Inventories +Inventories are +stated at the lower of cost (determined by the average cost method) +or net realizable value. Freight costs are classified as a +component of cost of products in the accompanying consolidated +statements of operations. +The +allowance for slow-moving, excess, or obsolete inventory is used to +state the Company’s inventories at the lower of cost and net +realizable value. Because the amount of inventory that will +actually be recouped through sales cannot be known with certainty +at any particular time, the Company relies on past sales +experience, future sales forecasts, and its strategic business +plans. Generally, in analyzing inventory levels, inventory is +classified as having been used or unused during the past year. The +Company then establishes an allowance based upon several factors, +including, but not limited to, business forecasts, inventory +quantities and historic usage profile. +Supplemental to the +aforementioned analysis, specific inventory items are reviewed +individually by management. Based on the review, considering +business levels, future prospects, new products and technology +changes, management, using its business judgment, may adjust the +valuation of specific inventory items to reflect an accurate +valuation. Management also performs a determination of net +realizable value for all finished goods with a selling price below +cost. For all such items, the inventory is valued at not more than +the selling price less cost, if any, to sell. +F-6 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Property, Plant and Equipment +Property, plant and +equipment is carried at cost. Expenditures for maintenance, repairs +and minor renewals are expensed as incurred. When properties are +retired or otherwise disposed of, the related cost and accumulated +depreciation are removed from the respective accounts and the +resulting gain or loss is reflected in operations for the +period. +Depreciation and +amortization are generally computed on the straight-line method +using lives of 3 to 10 years for machinery and equipment and 5 to 8 +years for leasehold improvements. +Impairment of Long-Lived Assets +Management +regularly reviews long-lived assets and intangible assets for +impairment whenever events or changes in circumstances indicate +that the carrying amount of an asset may not be recoverable. +Recoverability of assets to be held and used is measured by a +comparison of the carrying amount of an asset to future +undiscounted net cash flows expected to be generated by the asset. +If such assets are considered to be impaired, the impairment to be +recognized is measured as the amount by which the carrying amount +of the assets exceeds their fair value, which considers the +discounted future net cash flows. No long-lived assets were +considered impaired at December 31, 2018 and 2017. +Cash Equivalents +The +Company considers all highly liquid investments with an original +maturity of three months or less to be cash +equivalents. +Allowance for Doubtful Accounts +The +Company records an allowance for doubtful accounts based on +specifically identified amounts that the Company believes to be +uncollectible. The Company also records an additional allowance +based on certain percentages of the Company’s aged +receivables , which are determined +based on historical experience and the Company’s assessment +of the general financial conditions affecting the Company’s +customer base. If the Company’s actual collections experience +changes, revisions to the Company’s allowance may be +required. After all attempts to collect a receivable have failed, +the receivable is written off against the allowance. Based on the +information available, management believes the allowance for +doubtful accounts as of December 31, 2018 and 2017 is +adequate. +Revenue Recognition +Effective January +1, 2018, the Company adopted Accounting Standards Update +(“ASU”) 2014-09, “Revenue from Contracts with +Customers” and the additional related ASUs (“ASC +606”), which replaces existing revenue guidance and outlines +a single set of comprehensive principles for recognizing revenue +under accounting principles generally accepted in the United States +of America (“GAAP”). The Company elected the modified +retrospective method upon adoption, with no impact to the opening +retained earnings or revenue reported. These standards provide +guidance on recognizing revenue, including a five-step method to +determine when revenue recognition is appropriate: +Step 1: +Identify the contract with the customer; +Step 2: +Identify the performance obligations in the contract; +Step 3: +Determine the transaction price; +Step 4: +Allocate the transaction price to the performance obligations; +and +Step 5: +Recognize revenue as the Company satisfies a performance +obligation. +F-7 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +ASC 606 +provides that sales revenue is recognized when control of the +promised goods or services is transferred to customers at an amount +that reflects the consideration to which the entity expects to be +entitled to in exchange for those goods or services. The Company +generally satisfies performance obligations upon shipment of the +product or service to the customer. This is consistent with the +time in which the customer obtains control of the product or +service. For extended warranties, sales revenue associated with the +warranty is deferred at the time of sale and later recognized on a +straight-line basis over the extended warranty period. Some +contracts include installation services, which are completed in a +short period of time and the revenue is recognized when the +installation is complete. Customary payment terms are granted to +customers, based on credit evaluations. Currently, the Company does +not have any contracts where revenue is recognized, but the +customer payment is contingent on a future event. +The +Company periodically reviews its revenue recognition procedures to +assure that such procedures are in accordance with GAAP. Surcharges +collected on certain sales to government customers and remitted to +governmental agencies are not included in revenues or in costs and +expenses. +Income Taxes +The +Company accounts for income taxes using the asset and liability +method specified by GAAP. Deferred tax assets and liabilities are +recognized for the future tax consequences attributable to +differences between the financial statement carrying amounts of +existing assets and liabilities and their respective tax bases. +Deferred tax assets and liabilities are measured using the enacted +tax rates expected to apply in the period in which the deferred tax +asset or liability is expected to be realized. The effect of +changes in net deferred tax assets and liabilities is recognized on +the Company’s consolidated balance sheets and consolidated +statements of operations in the period in which the change is +recognized. Valuation allowances are provided to the extent that +impairment of tax assets is more likely than not. In determining +whether a tax asset is realizable, the Company considers, among +other things, estimates of future earnings based on information +currently available, current and anticipated customers, contracts +and new product introductions, as well as recent operating results +during 2018 and 2017 and certain tax planning strategies. If the +Company fails to achieve the future results anticipated in the +calculation and valuation of net deferred tax assets, the Company +may be required to adjust the valuation allowance related to its +deferred tax assets in the future. +On +December 22, 2017, the U.S. government enacted comprehensive tax +legislation commonly referred to as the Tax Cuts and Jobs Act (the +“2017 Tax Act”). The 2017 Tax Act makes broad and +complex changes to the U.S. tax code, including, but not limited +to, (1) reducing the U.S. federal corporate tax rate from 35% to +21%; (2) eliminating the corporate alternative minimum tax +(“AMT”) and changing how existing AMT credits can be +realized; and (3) changing rules related to uses and limitations of +net operating loss carryforwards created in tax years beginning +after December 31, 2017. +In +connection with the Company’s initial analysis of the impact +of the 2017 Tax Act, the Company recorded a discrete net tax +expense of $665 in the year ended December 31, 2017 for the effect +of the corporate rate reduction, which was finalized as of December +31, 2018. The net tax expense primarily relates to a reduction in +the deferred tax assets of $1,524 and a reduction in the deferred +tax liability related to unrealized gain on available-for-sale +securities of $(859). +Concentration of Credit Risk +The +Company performs periodic credit evaluations of its +customers’ financial condition and generally does not require +collateral. At December 31, 2018 and 2017, accounts receivable from +governmental customers were approximately $3,331 and $2,663, +respectively. Generally, receivables are due within 30 days. Credit +losses relating to customers have been consistently within +management’s expectations. +The +Company primarily maintains cash balances at one financial +institution. Accounts are insured by the Federal Deposit Insurance +Corporation (“FDIC”) up to $250. From time to time, the +Company has had cash in financial institutions in excess of +federally insured limits. As of December 31, 2018, the Company had +cash and cash equivalents in excess of FDIC limits of +$11,050. +F-8 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Manufacturing and Raw Materials +The +Company relies upon a limited number of manufacturers to produce +its products and on a limited number of component suppliers. Some +of these manufacturers and suppliers are in other countries. +Approximately 66.8% of the Company’s material, subassembly +and product procurements in 2018 were sourced internationally, of +which approximately 60.0% were sourced from two suppliers. For +2017, approximately 65.7% of the Company’s material, +subassembly and product procurements were sourced internationally, +of which approximately 61.6% were sourced from three suppliers. +Purchase orders denominated in U.S. dollars are placed with these +suppliers from time to time and there are no guaranteed supply +arrangements or commitments. +Use of Estimates +The +preparation of financial statements in conformity with GAAP +requires management to make estimates and assumptions that affect +the reported amounts of assets and liabilities at the date of the +consolidated financial statements and the reported amounts of sales +and expenses during the reporting period. Significant estimates +include accounts receivable allowances, inventory obsolescence +allowance, warranty allowance, and income tax accruals. Actual +results could differ from those estimates. +Fair Value of Financial Instruments +The +Company’s financial instruments consist of cash and cash +equivalents, trade accounts receivable, available-for-sale +securities, investment in securities, accounts payable, accrued +expenses and other liabilities. As of December 31, 2018 and 2017, +the carrying amount of cash and cash equivalents, trade accounts +receivable, accounts payable, accrued expenses and other +liabilities approximated their respective fair value due to the +short-term nature and maturity of these instruments. The Company +uses observable market data or assumptions (Level 1 inputs, as +defined in accounting guidance) that it believes market +participants would use in pricing the available-for-sale securities +and investment in securities. There +were no sales of available-for-sale securities or investment in +securities, as a result of an other-than-temporary impairment of +the available-for-sale securities. There were no transfers +of available-for-sale securities or investments in securities +between Level 1 and Level 2 during the years ended December 31, +2018 and 2017. +Available-For-Sale Securities +Investments +reported on the December 31, 2017 balance sheet consisted of +marketable equity securities of a publicly held company. As of +December 31, 2017, the investment cost was $2,402. On January 1, +2018, the Company adopted ASU 2016-01 “Financial +Instruments,” which amended the guidance in GAAP regarding +the classification and measurement of financial instruments. +Changes to the prior guidance primarily affected the accounting for +equity investments, financial liabilities under the fair value +option and the presentation and disclosure requirements for +financial instruments. In addition, the ASU clarified guidance +related to the valuation allowance assessment when recognizing +deferred tax assets resulting from unrealized losses on +available-for-sale debt securities. Upon its adoption, the Company +applied the amendments by means of a cumulative-effect adjustment +to the balance sheet at the beginning of the first reporting period +in which the guidance was effective. On January 1, 2018, the +Company recognized approximately $4,300 of net unrealized gain in +its accumulated deficit balance. During the first quarter of 2018, +the Company sold 1,317,503 shares of Iteris, Inc. (Nasdaq: ITI), +which cost $2,402, for approximately $8,335 of proceeds and +reported a loss on the sale of approximately $849. +Shipping and Handling Costs +Shipping and +handling costs are classified as a part of cost of products in the +accompanying consolidated statements of operations for the years +ended December 31, 2018 and 2017. Amounts billed to a customer, if +any, for shipping and handling are reported as +revenue. +F-9 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Advertising and Promotion Costs +The +cost for advertising and promotion is expensed as incurred. +Advertising and promotion expenses are classified as part of +selling, general and administrative (“SG&A”) +expenses in the accompanying consolidated statements of operations. +For the years ended December 31, 2018 and 2017, such expenses +totaled $597 and $424, respectively. +Engineering, Research and Development Costs +Included in +SG&A expenses for the years ended December 31, 2018 and 2017 +are engineering, research and development costs of $7,768 and +$5,000, respectively. +Share-Based Compensation +The +Company accounts for share-based arrangements in accordance with +GAAP, which requires a public entity to measure the cost of +employee services received in exchange for an award of equity +instruments based on the grant-date fair value of the award (with +limited exceptions). That cost will be recognized over the period +during which the employee is required to provide service in +exchange for the award requisite service period (usually the +vesting period). No compensation cost is recognized for equity +instruments for which employees do not render the requisite +service. Employee share purchase plans will not result in +recognition of compensation cost if certain conditions are +met. +Restricted Stock Units +On +September 6, 2018, the Company granted to each non-employee +director restricted stock units with a grant fair value of $20 per +award (resulting in total aggregate grant-date fair value of $140), +which will vest in five equal, annual installments beginning with +the first anniversary of the grant date, subject to the +director’s continued service through such date, provided +that, if the director makes himself available and consents to be +nominated by the Company for continued service as a director, but +is not nominated for the Board for election by shareholders, other +than for good reason, as determined by the Board in its discretion, +then the restricted stock units shall vest in full as of the +director’s last date of service as a director of the +Company. +On June +4, 2018, the Company granted to each non-employee director +restricted stock units with a grant fair value of $20 per award +(resulting in total aggregate grant-date fair value of $140), which +will vest on June 4, 2019, subject to continued service through +such vesting date. +On June +15, 2017, the Company granted to each non-employee director +restricted stock units with a grant fair value of $20 per award +(resulting in total aggregate grant-date fair value of $140), which +vested on June 15, 2018. +The +Company recorded non-cash restricted stock unit compensation +expense of $153 and $76 for the years ended December 31, 2018 and +2017, respectively. +Earnings (Loss) Per Share +Earnings (loss) per +share amounts are computed and presented for all periods in +accordance with GAAP. +Other Comprehensive Loss +Other +comprehensive loss consists of net loss and unrealized gain on +available-for-sale securities, net of taxes. +F-10 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Product Warranty +The +Company offers two-year warranties to its customers, depending on +the specific product and terms of the customer purchase agreement. +The Company’s typical warranties require it to repair and +replace defective products during the warranty period at no cost to +the customer. At the time the product revenue is recognized, the +Company records a liability for estimated costs under its +warranties. The costs are estimated based on historical experience. +The Company periodically assesses the adequacy of its recorded +liability for product warranties and adjusts the amount as +necessary. +Reclassifications +Certain +prior year amounts have been reclassified to conform to the current +year presentation. These reclassifications had no impact on +previously reported net loss for the year ended December 31, +2017. +Recently Adopted Accounting Pronouncements +In May 2014, +the Financial Accounting Standards Board (“FASB”) +issued ASU 2014-09 on “Revenue from Contracts with +Customers,” which provided for a single, principles-based +model for revenue recognition and replaced the existing revenue +recognition guidance. In August 2015, the FASB issued ASU 2015-14, +which delayed the effective date of ASU 2014-09 by one year. The +guidance became effective for annual and interim periods beginning +on or after December 15, 2017, and replaced most existing revenue +recognition guidance under GAAP when it became effective. This ASU +required additional disclosures about the nature, amount, timing +and uncertainty of revenue and cash flows arising from customer +contracts, including significant judgments and estimates and +changes in those estimates. It permitted the use of either a +retrospective or cumulative effect transition method. The Company +adopted ASU 2014-09 in the first quarter of 2018 and applied the +modified retrospective approach. Because the Company’s +primary source of revenues is from shipments of products, the +adoption of ASU 2014-09 did not have a material impact on its +consolidated financial statements. See Note 1, under “Revenue +Recognition,” for additional information. +In +January 2016, the FASB issued ASU 2016-01 “Financial +Instruments,” which amended the guidance in GAAP on the +classification and measurement of financial instruments. Changes to +the previous guidance primarily affected the accounting for equity +investments, financial liabilities under the fair value option, and +the presentation and disclosure requirements for financial +instruments. In addition, the ASU clarified guidance related to the +valuation allowance assessment when recognizing deferred tax assets +resulting from unrealized losses on available-for-sale debt +securities. The new standard became effective for fiscal years and +interim periods beginning after December 15, 2017, and upon +adoption, an entity was required to apply the amendments by means +of a cumulative-effect adjustment to the balance sheet at the +beginning of the first reporting period in which the guidance is +effective. On January 1, 2018, the Company adopted the new guidance +and, consequently, the Company recognized approximately $4,300 of +net unrealized gain in its accumulated deficit +balance. +F-11 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +In +August 2018, the FASB issued ASU 2018-15, +“Intangibles—Goodwill and Other—Internal-Use +Software (Subtopic 350-40): Customer’s Accounting for +Implementation Costs Incurred in a Cloud Computing Arrangement That +Is a Service Contract,” to help entities evaluate the +accounting for fees paid by a customer in a cloud computing +arrangement (hosting arrangement) by providing guidance for +determining when the arrangement includes a software license. The +amendments in ASU 2018-15 align the requirements for capitalizing +implementation costs incurred in a hosting arrangement that is a +service contract with the requirements for capitalizing +implementation costs incurred to develop or obtain internal-use +software (and hosting arrangements that include an internal use +software license). The accounting for the service element of a +hosting arrangement that is a service contract is not affected by +the amendments in ASU 2018-15. The amendments in ASU 2018-15 will +become effective for fiscal years and interim periods beginning +after December 15, 2019. Early adoption is permitted, including +adoption in any interim period. The Company adopted the new +guidance in the fourth quarter of 2018, with no material impact on +its consolidated financial statements and related +disclosures. +Recent Accounting Pronouncements +In +February 2016, the FASB issued ASU 2016-02, “Leases,” +which amends leasing guidance by requiring companies to recognize a +right-of-use asset and a lease liability for all operating and +capital (finance) leases with lease terms greater than twelve +months. The lease liability will be equal to the present value of +lease payments. The lease asset will be based on the lease +liability, subject to adjustment, such as for initial direct costs. +For income statement purposes, leases will continue to be +classified as operating or capital (finance), with lease expense in +both cases calculated substantially the same as under the prior +leasing guidance. The updated guidance is effective for interim and +annual periods beginning after December 15, 2018, with early +adoption permitted. The Company +expects this will result in the recognition of right-of-use assets +and lease liabilities not currently recorded on the consolidated +financial statements under existing accounting guidance. Based on +the Company’s evaluation of all of its contractual +arrangements, the Company expects that the adoption of ASU 2016-02 +will have a significant impact on the Company’s consolidated +financial statements. After the adoption, the Company will first +report the operating lease right-of-use assets and lease +liabilities as of March 31, 2019 based on our lease portfolio as of +that date. +In +August 2018, the SEC adopted the final rule under SEC Release No. +33-10532, “Disclosure Update and Simplification,” +amending certain disclosure requirements that were redundant, +duplicative, overlapping, outdated or superseded. In addition, the +amendments expanded the disclosure requirements on the analysis of +stockholders’ equity for interim financial statements. Under +the amendments, an analysis of changes in each caption of +stockholders’ equity presented in the balance sheet must be +provided in a note or separate statement. The analysis should +present a reconciliation of the beginning balance to the ending +balance of each period for which a statement of comprehensive +income is required to be filed. This final rule is effective for +all filings made on or after November 5, 2018. Given the effective +date and the proximity to most filers’ quarterly reports, the +SEC is not objecting to filers deferring the presentation of +interim changes in stockholders’ equity in their Forms 10-Q +until the quarter that begins after the date of adoption, November +5, 2018. The Company intends to present interim changes in +stockholders’ equity beginning with its quarterly report on +Form 10-Q for the first quarter of 2019. +The +Company does not discuss recent pronouncements that are not +anticipated to have an impact on or are unrelated to its financial +condition, results of operations, cash flows or +disclosures. +F-12 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +2. +Inventories, +net +Inventories, which +are presented net of allowance for obsolete and slow-moving +inventory, consisted of the following: +December 31, +2018 +2017 +Finished +goods +$ 2,004 +$ 2,825 +Work in +process +5,750 +7,111 +Raw +materials +3,712 +4,422 +$ 11,466 +$ 14,358 +Changes +in the allowance for obsolete and slow-moving inventory are as +follows: +Years Ended +December 31, +2018 +2017 +Balance, beginning +of year +$ 789 +$ 1,607 +Charged to cost of +sales +(38 ) +149 +Disposal of +inventory +(122 ) +(967 ) +Balance, end of +year +$ 629 +$ 789 +Following +leadership changes, in the third quarter of 2017, the Company +launched a comprehensive evaluation of its products, markets and +strategies through the remainder of the year. As a result of this +evaluation, the Company recognized a direct charge to cost of +products of $3,200 to write-off inventory with limited customer +market opportunities, primarily due to concerns regarding +technology and production costs. +For the +years ended December 31, 2018 and 2017, the Company wrote off +obsolete inventory that had been fully allowed for previously, +which had no material impact to the Company’s consolidated +balance sheets or consolidated statements of +operations. +3. +Allowance +for Doubtful Accounts +Changes +in the allowance for doubtful accounts are composed of the +following: +Years Ended +December 31, +2018 +2017 +Balance, beginning +of year +$ 50 +$ 50 +Provision for +doubtful accounts +— +— +Uncollectible +accounts written off +— +— +Balance, end of +year +$ 50 +$ 50 +F-13 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +4. +Property, +Plant and Equipment, net +Property, plant and +equipment, net include the following: +December 31, +2018 +2017 +Leasehold +improvements +$ 542 +$ 422 +Machinery and +equipment +10,224 +8,970 +Less accumulated +depreciation and amortization +(8,037 ) +(7,191 ) +Property, plant and +equipment, net +$ 2,729 +$ 2,201 +Depreciation and +amortization expense relating to property, plant and equipment for +the years ended December 31, 2018 and 2017 was approximately $868 +and $808, respectively. +5. +Debt +The +Company’s $1,000 credit facility with Silicon Valley Bank +matured on December 26, 2018, and the Company elected to not renew +it. The Loan and Security Agreement governing the revolving credit +facility contained customary borrowing terms and conditions, +including the accuracy of representations and warranties, +compliance with financial maintenance and restrictive covenants and +the absence of events of default. Pursuant to the Loan and Security +Agreement, the Company was permitted to pay cash dividends, the +total of which was not to exceed $5,000 in the aggregate during any +twelve-month period, so long as an event of default did not exist +at the time of such dividend and would not exist after giving +effect to such dividend. The variable rate at which borrowings +under the credit facility were to bear interest was The Wall Street Journal prime rate plus 25 +basis points. +The +financial maintenance covenants, which were required to be +maintained at all times and tested quarterly (or, for the +“adjusted quick ratio” covenant, monthly, if any +obligations are outstanding), included: (1) a ratio of “quick +assets” to the sum of “current liabilities” plus +outstanding borrowings to Silicon Valley Bank to the extent not +included in “current liabilities” minus the current +portion of “deferred revenue” (all as defined in the +Loan and Security Agreement) of at least 1.25:1.00 and (2) maximum +“total leverage” (as defined in the Loan and Security +Agreement) of no greater total consolidated +“indebtedness” than 3 times “adjusted +EBITDA” (all as defined in the Loan and Security Agreement). +The Company’s obligations were collateralized by +substantially all of the Company’s assets, principally +accounts receivable and inventory. +The +Company was in compliance with all covenants under the Loan and +Security Agreement when it matured on December 26, 2018. The +Company had no borrowings outstanding under the credit facility at +the time it matured, and the Company elected not to renew +it. +F-14 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +6. +Investment +in Securities +The +Company has an investment in a limited partnership, FGI 1347 +Holdings, LP, of which the Company is the sole limited partner. FGI +1347 Holdings, LP was established for the purpose of investing in +securities. +As +of December 31, 2018, the Company indirectly held approximately +$217 in cash and 477,282 shares of 1347 Property Insurance +Holdings, Inc. (Nasdaq: PIH) with fair value of $1,919, through an +investment in FGI 1347 Holdings, LP. These shares were purchased in +March and May 2018 for approximately $3,741. As of December 31, +2018, the Company recognized an unrealized loss on the investment +of approximately $1,822. +Affiliates of +Fundamental Global Investors, LLC serve as the general partner and +the investment manager of FGI 1347 Holdings, LP, and the Company is +the sole limited partner. As of December 31, 2018, the Company and +the affiliates of Fundamental Global Investors, LLC, including, +without limitation, Ballantyne Strong, Inc., beneficially owned in +the aggregate 2,714,362 shares of PIH’s common stock, +representing approximately 45.3% of PIH’s outstanding shares. +Fundamental Global with its affiliates is the largest stockholder +of the Company. Mr. Kyle Cerminara, Chairman of the Company’s +Board of Directors, is Chief Executive Officer, Co-Founder and +Partner of Fundamental Global Investors, LLC and serves as Chief +Executive Officer and Chairman of the Board of Directors of +Ballantyne Strong. Mr. Lewis M. Johnson, Co-Chairman of the +Company, is President, Co-Founder and Partner of Fundamental Global +Investors, LLC and serves as a director of Ballantyne Strong. +Messrs. Cerminara and Johnson also serve as Chairman and +Co-Chairman, respectively, of the Board of Directors of +PIH. +7. +Leases +The +Company leases approximately 54,000 square feet (not in thousands) +of industrial space in West Melbourne, Florida, under a +non-cancellable operating lease. The lease has the expiration date +of June 30, 2027. Rental, maintenance and tax expenses for +this facility were approximately $490 and $472 in 2018 and 2017, +respectively. The Company also leases 8,100 square feet (not in +thousands) of office space in Lawrence, Kansas, under a +non-cancellable operating lease, to accommodate a portion of the +Company’s engineering team. The lease has the expiration date +of December 31, 2019. Rental, maintenance and tax expenses for this +facility were approximately $108 in 2018 and 2017. +The +following table summarizes future minimum rental payments under +these leases as of December 31, 2018: +2019 +$ 619 +2020 +543 +2021 +575 +Thereafter +564 +$ 2,301 +F-15 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +8. +Income +Taxes +The +income tax expense (benefit) is summarized as follows: +Years Ended +December 31, +2018 +2017 +Current: +Federal +$ (110 ) +$ (11 ) +State +10 +10 +(100) +(1 ) +Deferred: +Federal +(280 ) +(1,780 ) +State +103 +(43 ) +Impact of rate +change +— +665 +(177 ) +(1,158 ) +$ (277 ) +$ (1,159 ) +A +reconciliation of the statutory U.S. income tax rate to the +effective income tax rate follows: +Years Ended +December 31, +2018 +2017 +Statutory U.S. +income tax rate +(21.00 )% +(34.00 )% +State taxes, net of +federal benefit +1.75 % +(1.37 )% +Non-deductible +items +3.52 % +0.52 % +Change in valuation +allowance +(13.53 )% +(0.25 )% +Change in net +operating loss carryforwards and tax credits +(33.48 )% +(3.27 )% +Other +4.02 % +0.25 % +Effective income +tax rate +(58.72 )% +(38.12 )% +F-16 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +8. +Income +Taxes (Continued) +The +components of the deferred income tax assets (liabilities) are as +follows: +Years Ended +December 31, +2018 +2017 +Deferred tax +assets: +Operating +loss carryforwards +$ 313 +$ 1,874 +R&D +Tax Credit +1,394 +1,478 +AMT Tax +Credit +179 +352 +Section +263A costs +252 +315 +R&D +costs +224 +335 +Amortization +24 +24 +Unrealized +loss +422 +— +Asset +reserves: +Bad +debts +12 +12 +Inventory +allowance +146 +182 +Accrued +expenses: +Non-qualified +stock options +112 +86 +Compensation +140 +165 +Warranty +764 +465 +Deferred tax +assets +3,982 +5,288 +Less state +valuation allowance +— +(64 ) +Total deferred tax +assets +3,982 +5,224 +Deferred tax +liabilities: +Depreciation +(487 ) +(338 ) +Total deferred tax +liabilities +(487 ) +(338 ) +Net deferred tax +assets (before unrealized gain) +3,495 +4,886 +Deferred tax +liability: unrealized gain +— +(1,569 ) +Net deferred tax +assets +$ 3,495 +$ 3,317 +As of +December 31, 2018, the Company had a net deferred tax asset of +approximately $3,982 offset by deferred tax liabilities of $487 +derived from accelerated tax depreciation. This asset is primarily +composed of net operating loss carryforwards (“NOLs”), +research and development costs, deferred revenue and unrealized +loss on investment. The NOLs total approximately $7,200 for state +purposes, with expirations starting in 2019 for state +purposes. +During +2017, the Company generated $4,693, adjusted to final tax return, +of its federal NOLs and, during 2018, the Company generated no +additional NOLs. The deferred tax asset amounts are based upon +management’s conclusions regarding, among other +considerations, the Company’s current and anticipated +customer base, contracts, and product introductions, certain tax +planning strategies, and management’s estimates of future +earnings based on information currently available, as well as +recent operating results during 2018, 2017, and 2016. GAAP requires +that all positive and negative evidence be analyzed to determine +if, based on the weight of available evidence, the Company is more +likely than not to realize the benefit of the deferred tax +asset. +F-17 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +8. +Income +Taxes (Continued) +Management’s +analysis of all available evidence, both positive and negative, +provides support that the Company has the ability to generate +sufficient taxable income in the necessary period to utilize the +entire benefit for the deferred tax asset. Management estimated +that, as of December 31, 2018, a valuation allowance related to the +Florida NOLs was no longer needed due to expected 2018 +usage. +Should +the factors underlying management’s analysis change, future +valuation adjustments to the Company’s net deferred tax asset +may be necessary. If future losses are incurred, it may be +necessary to record a valuation allowance related to the +Company’s net deferred tax asset recorded as of December 31, +2018. It cannot presently be estimated what, if any, changes to the +valuation of the Company’s deferred tax asset may be deemed +appropriate in the future. The 2018 federal and state NOL and tax +credit carryforwards could be subject to limitation if, within any +three-year period prior to the expiration of the applicable +carryforward period, there is a greater than 50% change in +ownership of the Company. +For the +year ended December 31, 2018, the Company is expecting a refund of +a portion of the alternative minimum tax credits of approximately +$110 (net). The alternative minimum tax legislation was repealed by +the 2017 Tax Act. +The +Company performed a comprehensive review of its portfolio of +uncertain tax positions in accordance with recognition standards +established by GAAP. In this regard, an uncertain tax position +represents the Company’s expected treatment of a tax position +taken in a filed tax return or planned to be taken in a future tax +return that has not been reflected in measuring income tax expense +for financial reporting purposes. As a result of this review, on +January 1, 2019, the Company is not aware of any uncertain tax +positions that would require additional liabilities or which such +classification would be required. The amount of unrecognized tax +positions did not change as of December 31, 2018, and the Company +does not believe there will be any material changes in its +unrecognized tax positions over the next twelve +months. +Penalties and +tax-related interest expense, of which there were no material +amounts for the years ended December 31, 2018 and 2017, are +reported as a component of income tax expense +(benefit). +The +Company files federal income tax returns, as well as multiple state +and local jurisdiction tax returns. A number of years may elapse +before an uncertain tax position is audited and finally resolved. +While it is often difficult to predict the final outcome or the +timing of resolution on any particular uncertain tax position, the +Company believes that its allowances for income taxes reflect the +most probable outcome. The Company adjusts these allowances, as +well as the related interest, in light of changing facts and +circumstances. The resolution of a matter would be recognized as an +adjustment to the provision for income taxes and the effective tax +rate in the period of resolution. The calendar years 2015, 2016, +and 2017 are still open to IRS examination under the statute of +limitations. The last IRS examination on the Company’s 2007 +calendar year was closed with no change. +F-18 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +9. +Loss +Per Share +The +following table sets forth the computation of basic and diluted +loss per share: +Years Ended +December 31, +2018 +2017 +Numerator: +Net +loss from continuing operations numerator for basic and diluted +earnings per share +$ (195 ) +$ (3,626 ) +Denominator: +Denominator +for basic loss per share weighted average shares +13,463,826 +13,624,649 +Effect +of dilutive securities: +Stock +options +— +— +Denominator +for diluted loss per share weighted average shares +13,463,826 +13,624,649 +Basic +loss per share +$ (0.01 ) +$ (0.27 ) +Diluted +loss per share +$ (0.01 ) +$ (0.27 ) +Approximately +460,500 stock options and 24,066 restricted stock units for the +year ended December 31, 2018 and 354,500 stock options and 21,201 +restricted stock units for the year ended December 31, 2017, were +excluded from the calculation because they were +anti-dilutive. +10. +Share-Based +Employee Compensation +The +Company has an employee and non-employee director incentive +compensation equity plan. Related to these programs, the Company +recorded $95 and $55 of share-based employee compensation expense +during the years ended December 31, 2018 and 2017, respectively, +which is included as a component of cost of products and SG&A +expenses in the accompanying consolidated statements of operations. +No amount of share-based employee compensation expense was +capitalized as part of capital expenditures or inventory for the +years presented. +The +Company uses the Black-Scholes-Merton option valuation model to +calculate the fair value of a stock option grant. The share-based +employee compensation expense recorded in the years ended December +31, 2018 and 2017 was calculated using the assumptions noted in the +following table. Expected volatilities are based on the historical +volatility of the Company’s common stock over the period of +time, commensurate with the expected life of the stock options. The +dividend yield assumption is based on the Company’s +expectations of dividend payouts at the grant date. In 2018, the +Company paid dividends on January 16, for a dividend declared in +2017, April 16, July 16 and October 15. In 2018, the +Company’s Board of Directors also declared a quarterly +dividend that was paid on January 16, 2019. The Company has +estimated its future stock option exercises. The expected term of +option grants is based upon the observed and expected time to the +date of post vesting exercises and forfeitures of options by the +Company’s employees. The risk-free interest rate is derived +from the average U.S. Treasury rate for the period, which +approximates the rate at the time of the stock option +grant. +FY +2018 +FY +2017 +Expected +Volatility +51.9 % +53.6 % +Expected +Dividends +2.0 % +5.0 % +Expected Term (in +years) +6.5 +3.0-6.5 +Risk-Free +Rate +2.76 % +2.10 % +Estimated +Forfeitures +0.0 % +0.0 % +F-19 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +10. +Share-Based +Employee Compensation (Continued) +A +summary of stock option activity under the Company’s equity +compensation plans as of December 31, 2018, and changes during the +year ended December 31, 2018, are presented below: +Stock +Wgt. +Avg. +Exercise +Price ($) +Wgt. +Avg. +Remaining +Contractual +Wgt +Avg. +Grant +Date +Fair Value +($) +Aggregate +Intrinsic +As of +January 1, 2018 +Options +Per +Share +Life +(Years) +Per +Share +Value +($) +Outstanding +354,500 +4.46 +— +1.79 +— +Vested +113,000 +3.75 +— +2.23 +— +Nonvested +241,500 +4.80 +— +1.58 +— +Period +activity +Issued +130,000 +3.72 +— +1.62 +— +Exercised +— +— +— +— +— +Forfeited +24,000 +5.10 +— +1.37 +— +Expired +— +— +— +— +— +As +of December 31, 2018 +Outstanding +460,500 +4.22 +7.08 +1.76 +43,860 +Vested +156,900 +4.03 +3.87 +2.05 +39,860 +Nonvested +303,600 +4.32 +8.73 +1.61 +4,000 +Outstanding: +Range of +Exercise Prices +($) Per +Share +Stock +Options +Outstanding +Wgt. Avg. +Exercise +Price +($) +Per +Share +Wgt. Avg. +Remaining Contractual +Life +(Years) +1.89 +3.75 +156,000 +3.47 +8.41 +3.83 +5.10 +304,500 +4.60 +6.39 +460,500 +4.22 +7.08 +Exercisable: +Range of +Exercise Prices +($) Per +Share +Stock +Options +Exercisable +Wgt. Avg. +Exercise +Price +($) +Per +Share +1.89 +3.75 +26,000 +2.22 +3.83 +5.10 +130,900 +4.39 +156,900 +4.03 +The +weighted-average grant-date fair value per option granted during +the years ended December 31, 2018 and 2017 was $1.61 and $1.58, +respectively. The aggregate intrinsic value of stock options +exercised during the years ended December 31, 2018 and 2017 was +approximately $0 and $107, respectively. +In +connection with the restricted stock units granted to non-employee +directors, the Company accrues compensation expense based on the +estimated number of shares expected to be issued, utilizing the +most current information available to the Company at the date of +the consolidated financial statements. The Company estimates the +fair value of the restricted stock unit awards based upon the +market price of the underlying common stock on the date of +grant. +As of December 31, +2018, there was approximately $703 of total unrecognized +compensation cost related to non-vested share-based compensation +arrangements, including stock options and restricted stock units. +This compensation cost is expected to be recognized approximately +over four years . +F-20 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +11. +Significant +Customers +Sales +to the U.S. Government represented approximately 40% and 38% of the +Company’s total sales for the years ended December 31, 2018 +and 2017, respectively. These sales were primarily to the various +government agencies, including those within the United States +Department of Defense, the United States Forest Service, the United +States Department of Interior, and the United States Department of +Homeland Security. +12. +Retirement +Plan +The +Company sponsors a participant contributory retirement (401(k)) +plan, which is available to all employees. The Company’s +contribution to the plan is either a percentage of the +participant’s contribution (50% of the participant’s +contribution up to a maximum of 6%) or a discretionary amount. For +the years ended December 31, 2018 and 2017, total contributions +made by the Company were $144 and $136, respectively. +13. +Commitments +and Contingencies +Royalty Commitment +In +2002, the Company entered into a technology license related to its +development of digital products. Under this agreement, the Company +is obligated to pay a royalty for each product sold that utilizes +the technology covered by this agreement. The Company paid $16 and +$136 for the years ended December 31, 2018 and 2017, respectively. +The agreement has an indefinite term, and can be terminated by +either party under certain conditions. +Purchase Commitments +The +Company has purchase commitments for inventory totaling $11,887 as +of December 31, 2018. +Self-Insured Health Benefits +The +Company maintains a self-insured health benefit plan for its +employees. This plan is administered by a third party. As of +December 31, 2018, the plan had a stop-loss provision insuring +losses beyond $80 per employee per year and an aggregate stop-loss +of $1,525. As of December 31, 2018 and 2017, the Company recorded +an accrual for estimated claims in the amount of approximately $165 +and $113, respectively, in accrued other expenses and other current +liabilities on the Company’s consolidated balance +sheets. This amount +represents the Company’s estimate of incurred but not +reported claims as of December 31, 2018 and 2017. +Liability for Product Warranties +Changes +in the Company’s liability for its standard two-year product +warranties during the years ended December 31, 2018 and 2017 are as +follows: +Balance at +Beginning of Year +Warranties +Issued +Warranties +Settled +Balance at End +of Year +2018 +$ 1,389 +$ 1,329 +$ (1,172 ) +$ 1,546 +2017 +$ 650 +$ 1,945 +$ (1,206 ) +$ 1,389 +F-21 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +13. +Commitments +and Contingencies (Continued) +Legal Proceedings +From +time to time the Company may be involved in various claims and +legal actions arising in the ordinary course of its +business. +On +March 28, 2017, The Sales Group, Inc. (“TSG”) filed a +lawsuit in the U.S. District Court for the Central District of +California against the Company. TSG was a sales representative of +the Company that the Company terminated in March 2017. TSG asserted +claims against the Company for alleged breach of oral contract, +violation of the California and Arizona sales representative +statutes, and an accounting of alleged unpaid sales commissions. +TSG’s complaint sought damages in the amount of $6,090 for +alleged unpaid past and future sales commissions. On April 3, 2017, +counsel for TSG sent the Company a letter outlining additional +alleged grounds for recovery against the Company and offering to +settle the litigation in exchange for the continued payment of +sales commissions to TSG for a negotiated period, a buyout of +TSG’s alleged rights for a negotiated sum or reinstatement of +TSG for a period of at least 2.5 years, with commission rates equal +to those in effect at the time of TSG’s termination. The +matter was mediated on November 14, 2017, during which the parties +agreed to a settlement. On December 19, 2017, the Company entered +into a settlement agreement with TSG, pursuant to which TSG agreed +to dismiss with prejudice its lawsuit filed against the Company. +Pursuant to the settlement agreement, the Company agreed to pay an +amount of $900 to TSG on or before December 31, 2017. The Company +also agreed to pay to TSG commissions, at the rates in effect since +February 7, 2013, on all orders for the Company’s products +received and accepted by the Company from the states of Arizona, +California, Nevada and Hawaii from January 1, 2018 through December +31, 2018, other than for (i) sales of the Company’s products +to federal government agencies and offices, (ii) sales of the +Company’s products to other end-users, except state and local +government agencies and offices, and (iii) sales of parts or +service, including warranty service. In addition, if at any time on +or before December 31, 2018, the Company had completed a +change-in-control transaction, then the Company would have paid to +TSG an amount equal to $2,000, less the amount of commissions paid +by the Company with respect to 2018, as described above. The +settlement agreement settled all claims raised by TSG in its +lawsuit against the Company. In December 2017, the Company recorded +an estimated commission amount of approximately $536. For the year +ended December 31, 2018, the Company paid $823 in commissions to +TSG. Accordingly, the Company recorded $287 of additional +commission as an expense in 2018. As of December 31, 2018, the +Company has fulfilled its obligations under the settlement +agreement and the matter is closed. +There +were no other pending material claims or legal matters as of +December 31, 2018. +F-22 +BK TECHNOLOGIES, INC. +YEARS ENDED DECEMBER 31, 2018 AND 2017 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +14. +Capital +Program +In May +2016, the Company implemented a capital return program that +included a stock repurchase program and a quarterly dividend. +Under the program, the Company’s Board of Directors approved +the repurchase of up to 500,000 shares of the Company’s +common stock pursuant to a stock repurchase plan in conformity with +the provisions of Rule 10b5-1 and Rule 10b-18 promulgated under the +Securities Exchange Act of 1934, as amended. In June 2017, the +Board of Directors approved an increase in the Company’s +capital return program, authorizing the repurchase of 500,000 +shares of the Company’s common stock in addition to the +500,000 shares originally authorized, for a total repurchase +authorization of 1 million shares, pursuant to a stock repurchase +plan in conformity with the provisions of Rule 10b5-1 and Rule +10b-18 promulgated under the Securities Exchange Act of 1934, as +amended. The repurchase program has no termination +date. +Pursuant to the +capital return program, during 2017, the Company’s Board of +Directors declared quarterly dividends on the Company’s +common stock of $0.09 per share on March 17, and $0.02 per share on +June 14, September 18 and December 6. The dividends were payable to +stockholders of record as of March 31, 2017, June 30, 2017, October +2, 2017 and January 2, 2018, respectively. These dividends were +paid on April 17, 2017, July 17, 2017, October 16, 2017 and January +16, 2018. +Pursuant to the +capital return program, during 2018, the Company’s Board of +Directors declared quarterly dividends on the Company’s +common stock of $0.02 per share on March 14, June 4, September 6 +and December 7. The dividends were payable to stockholders of +record as of April 2, 2018, July 2, 2018, October 1, 2018 and +January 2, 2019, respectively. These dividends were paid on April +16, 2018, July 16, 2018, October 15, 2018 and January 16, +2019. +F-23 +Item 9. Changes in and Disagreements with Accountants on +Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedures +Evaluation of Disclosure Controls and Procedures +Our +President (who serves as our principal executive officer) and Chief +Financial Officer (who serves as our principal financial and +accounting officer) have evaluated the effectiveness of our +disclosure controls and procedures (as defined in the Exchange Act +Rules 13a-15(e) and 15d-15(e)) as of December 31, 2018. Based on +that evaluation, the President and Chief Financial Officer have +concluded that our disclosure controls and procedures were +effective as of December 31, 2018. +Management’s Report on Internal Control over Financial +Reporting +Our +management is responsible for establishing and maintaining adequate +internal control over our financial reporting, as such term is +defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Our +internal control system was designed to provide reasonable +assurance regarding the reliability of our financial reporting and +the preparation of financial statements for external purposes in +accordance with GAAP. Because of inherent limitations, a system of +internal control over financial reporting may not prevent or detect +misstatements. Also, projections of any evaluation of effectiveness +to future periods are subject to the risk that controls may become +inadequate due to a change in conditions, or that the degree of +compliance with the policies or procedures may +deteriorate. +An +internal control material weakness is a significant deficiency, or +combination of significant deficiencies, that results in more than +a remote likelihood that a material misstatement of the +consolidated financial statements will not be prevented or +detected. +Our +management, including our principal executive officer and principal +financial officer, conducted an evaluation of the effectiveness of +our internal control over financial reporting as of December 31, +2018, and concluded that our internal control over financial +reporting was effective as of December 31, 2018. In making the +assessment of internal control over financial reporting, management +used the criteria established in Internal Control – +Integrated Framework (2013) issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO). +Changes in Internal Control over Financial Reporting +There +were no changes in our internal control over financial reporting +identified in connection with the evaluation required by paragraph +(d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the +fourth fiscal quarter covered by this report that have materially +affected, or are reasonably likely to materially affect, our +internal control over financial reporting. We reviewed our internal +controls to ensure that we adequately evaluated our contracts and +properly assessed the impact of the new accounting standards +related to revenue recognition on our consolidated financial +statements to facilitate their adoption. There were no significant +changes to our internal control over financial reporting due to the +adoption of the new standard. +Item 9B. Other Information +None. +31 +PART III +Item 10. Directors, Executive Officers and Corporate +Governance +BOARD OF DIRECTORS +The +following table sets forth the current directors of the +Company’s Board of Directors, the year each director was +first elected as a director, each director’s age and the +positions currently held by each director with the Company. Each +director is entitled to serve until the 2019 annual meeting of +stockholders of the Company and until a successor is duly elected +and qualified or until his earlier retirement, resignation or +removal. +Name and Year First Elected +Age* +Position +D. Kyle +Cerminara (2015) (1)(2) +41 +Chairman +of the Board +Lewis +M. Johnson (2016) (2) +49 +Co-Chairman +of the Board +Michael +R. Dill (2017) (1)(3) +53 +Director +Charles +T. Lanktree (2017) (1) +69 +Director +E. Gray +Payne (2017) (1)(2)(3) +71 +Director +John W. +Struble (2017) (3) +42 +Director +Ryan +R.K. Turner (2017) (1) +40 +Director +_____________ +* As of February 27, 2019. +(1) +Member of the +compensation committee. +(2) +Member of the +nominating and governance committee. +(3) +Member of the audit +committee. +D. Kyle Cerminara +was appointed to the Board of +Directors in July 2015 and as Chairman in March 2017. Mr. Cerminara +is the Chief Executive Officer and Chairman of the Board for +Ballantyne Strong, Inc., a holding company with diverse business +activities focused on serving the cinema, retail, financial and +government markets. Mr. Cerminara assumed responsibilities as +Chairman of the Board of Ballantyne Strong in May 2015 and as Chief +Executive Officer in November 2015. Since April 2012, Mr. Cerminara +has also served as the Chief Executive Officer, Co-Founder and +Partner of Fundamental Global Investors, LLC, an SEC registered +investment advisor that manages equity and fixed income hedge funds +and is the largest stockholder of the Company. In addition, Mr. +Cerminara is Co-Chief Investment Officer of CWA Asset Management +Group, LLC (d/b/a Capital Wealth Advisors), a wealth advisor and +multi-family office affiliated with Fundamental Global Investors, +LLC, which position he has held since December 2012. Mr. Cerminara +also serves as President and Trustee of StrongVest ETF Trust and +Chief Executive Officer of StrongVest Global Advisors, LLC. +StrongVest Global Advisors, LLC, a wholly-owned subsidiary of +Ballantyne Strong, is an investment advisor, and CWA Asset +Management Group, LLC is a sub-advisor, to CWA Income ETF, an +exchange-traded fund and series of StrongVest ETF Trust. Mr. +Cerminara is a member of the Board of Directors of a number of +publicly-held companies focused in the insurance, technology and +communications sectors, including Ballantyne Strong, Inc. (NYSE +American: BTN) since February 2015, 1347 Property Insurance +Holdings, Inc. (Nasdaq: PIH), a holding company, which, through its +subsidiaries, is engaged in providing property and casualty +insurance, since December 2016, and Itasca Capital, Ltd. (TSXV: +ICL) (formerly Kobex Capital Corp.), a publicly-traded investment +firm, since June 2016. He was appointed Chairman of 1347 Property +Insurance Holdings, Inc. in May 2018 and Chairman of Itasca +Capital, Ltd. in June 2018. He also served on the Board of +Directors of Iteris, Inc. (Nasdaq: ITI), a publicly-traded, applied +informatics company, from August 2016 to November 2017, and +Magnetek, Inc., a publicly-traded manufacturer, in 2015. He also +serves on the Board of Directors of Blueharbor Bank. Prior to these +roles, Mr. Cerminara was a Portfolio Manager at Sigma Capital +Management, an independent financial adviser, from 2011 to 2012, a +Director and Sector Head of the Financials Industry at Highside +Capital Management from 2009 to 2011, and a Portfolio Manager and +Director at CR Intrinsic Investors from 2007 to 2009. Before +joining CR Intrinsic Investors, Mr. Cerminara was a Vice President, +Associate Portfolio Manager and Analyst at T. Rowe Price from 2001 +to 2007 and an Analyst at Legg Mason from 2000 to +2001. +32 +Mr. +Cerminara received an MBA from the Darden School of Business at the +University of Virginia and a B.S. in Finance and Accounting from +the Smith School of Business at the University of Maryland, where +he was a member of Omicron Delta Kappa, an NCAA Academic All +American and Co-Captain of the men’s varsity tennis team. He +also completed a China Executive Residency at the Cheung Kong +Graduate School of Business in Beijing, China. Mr. Cerminara holds +the Chartered Financial Analyst (CFA) designation. Mr. Cerminara +has extensive experience in the financial industry, including +investing, capital allocation, finance and financial analysis of +public companies, and operational experience as the Chief Executive +Officer of a publicly-traded company. He also brings the +perspective of one of the Company’s most significant +stockholders. +Lewis M. Johnson was +elected to the Board of Directors in May 2016 and appointed as +Co-Chairman in June 2018. Since April 2012, Mr. Johnson has served +as the President, Co-Founder and Partner of Fundamental Global +Investors, LLC, an SEC registered investment advisor that manages +equity and fixed income hedge funds and is the largest stockholder +of the Company. In addition, since April 2012, Mr. Johnson has +served as Co-Chief Investment Officer of CWA Asset Management +Group, LLC (d/b/a Capital Wealth Advisors), a wealth advisor and +multi-family office affiliated with Fundamental Global Investors, +LLC. Prior to co-founding Fundamental Global Investors, LLC and +partnering with Capital Wealth Advisors, Mr. Johnson was a private +investor from 2010 to 2012. From 2008 to 2010, Mr. Johnson served +as Portfolio Manager and Managing Director at Louis Dreyfus +Highbridge Energy. Previously, Mr. Johnson was a Senior Vice +President, Portfolio Manager and Analyst at Pequot Capital from +2006 to 2007. Prior to joining Pequot Capital, Mr. Johnson was a +Vice President and Analyst at T. Rowe Price from 2000 to 2006. Mr. +Johnson worked as an Analyst at Capital Research and Management in +1999 and as a Vice President at AYSA from 1992 to 1998. Mr. Johnson +received an MBA from the Wharton School of Business at the +University of Pennsylvania in addition to a M.A. in Political +Science and a B.A. in International Studies from Emory University, +where he graduated Magna Cum Laude and was a member of Phi Beta +Kappa. Mr. Johnson is a member of the Board of Directors of a +number of publicly-held companies, including Ballantyne Strong, +Inc. ( NYSE American: BTN), a holding +company with diverse business activities focused on serving the +cinema, retail, financial and government markets, since May +2016; 1347 Property Insurance Holdings, Inc. (Nasdaq: PIH), a +holding company, which, through its subsidiaries, is engaged in +providing property and casualty insurance, since April 2017; and +Itasca Capital, Ltd. (TSXV: ICL) (formerly Kobex Capital Corp.), a +publicly-traded investment firm, since June 2018. Mr. Johnson was +also appointed Co-Chairman of 1347 Property Insurance Holdings, +Inc. in May 2018. Mr. Johnson brings to the Board the perspective +of one of the Company’s most significant stockholders. He has +extensive experience in the financial industry, including +investing, capital allocation, finance and financial analysis of +public companies. +Michael R. +Dill was appointed to the Board +of Directors in March 2017. Mr. Dill has served as Vice President +and General Manager of GKW Aerospace Engine Systems North America, +a designer and manufacturer of aerospace engine components, since +April 2017. Mr. Dill previously served as President of the +Aerospace, Power Generation and General Industrial divisions at +AFGlobal Corporation, a privately-held, integrated technology and +manufacturing company, from August 2014 to April 2017. Prior to +joining AFGlobal, Mr. Dill held various positions in the Aerospace +and Defense division of CIRCOR International, a publicly-traded +global manufacturer of highly engineered environment products +(NYSE: CIR), including serving as Group Vice President from 2009 to +2014, Vice President of Business Development and Strategy from 2010 +to 2011 and Director of Continuous Improvement from 2009 to 2011. +From 2007 to 2009, he served as a Business Unit Director and +Facility Leader within the aerospace group of Parker Hannifin +Corporation (NYSE: PH), a publicly-traded diversified manufacturer +of motion and control technologies and systems. Before joining +Parker Hannifin Corporation, he held various positions with Shaw +Aero Devices, Inc., a producer of aerospace components and +equipment, from 1996 to 2007, and Milliken and Company, a +manufacturing company, from 1988 to 1996. Mr. Dill received a B.S. +in Management from the Georgia Institute of Technology. +Mr. Dill brings over 20 years of extensive +leadership and operational experience to the Board, including +experience in developing and implementing strategic +plans. +33 +Charles T. Lanktree +was appointed to the Board of +Directors in March 2017. Mr. Lanktree has served as President and +Chief Executive Officer of Eggland’s Best, LLC, a joint +venture between Eggland’s Best, Inc. and Land O’Lakes, +Inc. distributing nationally branded eggs, since 2012. Since 1997, +Mr. Lanktree has served as President and Chief Executive Officer of +Eggland’s Best, Inc., a franchise-driven consumer egg +business, where he previously served as the President and Chief +Operating Officer from 1995 to 1996 and Executive Vice President +and Chief Operating Officer from 1990 to 1994. Mr. Lanktree +currently serves on the Board of Directors of Eggland’s Best, +Inc. and several of its affiliates and on the Board of Directors of +Ballantyne Strong, Inc. (NYSE American: BTN), a holding company +with diverse business activities focused on serving the cinema, +retail, financial and government markets. From 2010 to 2013, he +served on the Board of Directors of Eurofresh Foods, Inc., a +privately-held company, and from 2004 to 2013, he was on the Board +of Directors of Nature’s Harmony Foods, Inc. Prior to joining +Eggland’s Best, Inc., Mr. Lanktree served as the President +and Chief Executive Officer of American Mobile Communications, Inc. +from 1987 to 1990 and as the President and Chief Operating Officer +of Precision Target Marketing, Inc. from 1985 to 1987. From 1976 to +1985, he held various executive-level marketing positions with The +Grand Union Company and BeechNut Foods Corporation. Mr. Lanktree +received an MBA from the University of Notre Dame and a B.S. in +Food Marketing from St. Joseph’s College. He also served in +the U.S. Army and U.S. Army Reserves from 1971 to 1977. +Mr. Lanktree brings extensive +operational and leadership experience, wireless communications +industry experience and public company experience to the Board, +including experience as a Chief Executive +Officer. +E. Gray Payne +was appointed to the Board of +Directors in January 2017. General Payne served as Senior Vice +President of The Columbia Group (“TCG”), from September +2010 to September 2017, where he was responsible for managing the +Marine Corps Programs Division (since September 2010) and the Navy +Programs Division (since October 2013), with combined annual +revenue of approximately $30 million. TCG is a federal consulting +firm working with the Department of Defense, Department of Homeland +Security, NOAA and private clients. TCG consults in the areas of +logistics, acquisitions, program management, information +technology, training, marine architecture and engineering, and +command and control systems. Since December 2011, General Payne has +also provided consulting services to and served on the Advisory +Council of Marstel-Day, LLC, located in Fredericksburg, Virginia, +which consults in the areas of conservation, environmental +compliance, and encroachment. Prior to September 2010, General +Payne was on active duty with the Marine Corps for 10 years, +retiring as a Major General. Prior to March 2001, he worked with a +number of companies in various capacities, including as a +management consultant, Chief Financial Officer, Chief Operating +Officer, and Chief Executive Officer. General Payne currently +serves on the Board of Directors of 1347 Property Insurance +Holdings, Inc. (Nasdaq: PIH), a holding company, which, +through its subsidiaries, is engaged in providing property and +casualty insurance (since May 2018), and currently serves on the following non-profit boards: The +Marine Corps Association & Foundation (since 2004), where he +serves as Chairman of the Board of The Marine Corps Association, +VetCV (since December 2017), and National Wildlife Refuge +Association (since June 2018). He received a B.S. in Economics from +North Carolina State University and a M.S. in Strategic Studies +from U.S. Army War College. General Payne brings extensive +strategic, operational and leadership experience and valuable +insight into the military sector, having over 40 years of military +operational and strategic expertise. +John W. Struble was +appointed to the Board of Directors in March 2017. Mr. Struble has +served as Chief Financial Officer of IntraPac International, a +specialty packaging manufacturing company owned by private equity +investment firm Onex Corporation (TSE: ONEX), since December 2013, +where he is responsible for the finance, information technology and +human resources functions. From May 2012 to December 2013, he +served as Corporate Controller and Treasurer of IntraPac. From May +2010 to May 2012, he served as Corporate Controller (Operations) of +Euramax International, Inc., where he was responsible for the +accounting and finance functions for the North American operations. +Euramax is a public company that produces aluminum, steel, vinyl +and fiberglass products for OEM, distributors, contractors, and +home centers in North America and Europe. Prior to that, he was +Controller of Rock­-Tenn Company, from December 2008 to +February 2010. Mr. Struble is a Certified Public Accountant. He +received an MBA from the University of Georgia and a B.S. in +Business Administration from the State University of New York at +Buffalo. Mr. Struble provides extensive experience in the +accounting/finance field to the Board and qualifies as an +“audit committee financial expert” under the +SEC’s rules. +34 +Ryan R.K. Turner was +appointed to the Board of Directors in March 2017. Mr. Turner has +served as Vice President of Strategic Investments for Ballantyne +Strong, Inc. (NYSE American: BTN), a holding company with diverse +business activities focused on serving the cinema, retail, +financial and government markets, since 2016. Mr. Turner also +serves as President of StrongVest Global Advisors, LLC, a +wholly-owned subsidiary of Ballantyne Strong, since 2016. He +previously served as Director of Business Development for +Ballantyne Strong, Inc. from 2015 to 2016. From 2012 to 2015, Mr. +Turner served as Director of Research and Research Analyst for +Fundamental Global Investors, LLC, an SEC registered investment +advisor that manages equity and fixed income hedge funds and, +together with Ballantyne Strong, is the largest stockholder of the +Company. Prior to joining Fundamental Global Investors, LLC, Mr. +Turner worked as an Associate Analyst at T. Rowe Price from 2006 to +2012, and as an Associate in the Product Services & Development +Department at AST Trust Company from 2002 to 2006. Mr. Turner +received an MBA from the Robert H. Smith School of Business at the +University of Maryland and a B.S. in Business Administration from +the University of Arizona. Mr. Turner holds the Chartered Financial +Analyst (CFA) designation. Mr. Turner brings extensive experience +in investment analysis and capital allocation for a publicly-traded +company to the Board, as well as business development +experience. +There +are no family relationships between any of the Company’s +directors or executive officers. +CORPORATE GOVERNANCE +The +Board of Directors is committed to good business practices, +transparency in financial reporting and the highest level of +corporate governance. The Board of Directors, which is elected by +the stockholders, is the Company’s ultimate decision-making +body, except with respect to those matters reserved to the +Company’s stockholders. The Board selects the senior +management team, which is charged with the conduct of the +Company’s business. Having selected the senior management +team, the Board of Directors acts as an advisor and counselor to +senior management and ultimately monitors its +performance. +Board Leadership and the Board’s Role in Risk +Oversight +The +Company has a separate Chairman and Co-Chairman of the Board and +Principal Executive Officer. The Board of Directors believes this +board leadership structure is best for the Company and its +stockholders at this time. The Chairman of the Board is D. Kyle +Cerminara and the Co-Chairman of the Board is Lewis M. Johnson, +both independent directors, and the Company’s current +Principal Executive Officer is the Company’s President, +Timothy A. Vitou. +The +Board believes it is in the Company’s best interest to have a +separate Chairman and Co-Chairman of the Board and Principal +Executive Officer so that the Principal Executive Officer can +devote his time and energy on the day-to-day management of the +business, while the Company’s Chairman and Co-Chairman, +currently Messrs. Cerminara and Johnson, respectively, can each +focus on providing advice and independent oversight of management. +Because the Company’s Chairman and Co-Chairman are appointed +annually by the Company’s non-management directors, such +directors are able to evaluate the leadership, performance and +independence of the Chairman and Co-Chairman each +year. +The +Board of Directors, through its three standing committees, has an +advisory role in the Company’s risk management process. In +particular, the Board is responsible for monitoring and assessing +strategic and operational risk exposure. The Company’s +management team maintains primary responsibility for the +Company’s risk management, and the Board and its committees +rely on the representations of management, the external audit of +the Company’s financial and operating results, the +Company’s systems of internal controls and the +Company’s historically conservative practices when assessing +the Company’s risks. The audit committee considers and +discusses financial risk exposures and the steps management has +taken to monitor and control these exposures, and also provides +oversight of the performance of the internal audit function. The +nominating and governance committee monitors the effectiveness of +the Company’s corporate governance policies and the selection +of prospective board members and their qualifications. The +compensation committee, in conjunction with the audit committee, +assesses and monitors whether any of the Company’s +compensation policies and programs have the potential to encourage +excessive risk-taking. Each committee must report findings +regarding material risk exposures to the Board as quickly as +possible. The Board believes that its role in risk oversight does +not affect the Board’s leadership structure. +35 +Like +all businesses, the Company also faces threats to its +cybersecurity, as the Company is reliant upon information systems +and the Internet to conduct its business activities. In light of +the pervasive and increasing threat from cyberattacks, the Board +and the audit committee, with input from management, assess the +Company’s cybersecurity threats and the measures implemented +by the Company to mitigate and prevent cyberattacks. The audit +committee consults with management regarding ongoing cybersecurity +initiatives, and requests management to report to the audit +committee or the full Board regularly on their assessment of the +Company’s cybersecurity program and risks. +Director Nomination Process +In +accordance with the nominating and governance committee’s +written charter, the nominating and governance committee has +established policies and procedures for the nomination of director +candidates to the Board of Directors. The committee determines the +required selection criteria and qualifications of director +candidates based upon the Company’s needs at the time +director candidates are considered. Minimum qualifications for +director candidates are set forth in the committee’s +“Policy Regarding Minimum Qualifications of Director +Candidates” and include threshold criteria, such as +integrity, absence of conflicts of interest that would materially +impair a director’s ability to exercise independent judgment +or otherwise discharge the fiduciary duties owed as a director to +the Company and its stockholders, ability to represent fairly and +equally all stockholders, demonstrated achievement in one or more +fields of business, professional, governmental, communal, +scientific or educational endeavors, sound judgment, as a result of +management or policy-making experience, that demonstrates an +ability to function effectively in an oversight role, general +appreciation regarding major issues facing public companies of a +size and operational scope similar to the Company, and adequate +time to serve. As noted in the policy, the committee, as one of its +considerations, considers the extent to which the membership of the +candidate on the Board will promote diversity among the directors, +and seeks to promote through the nominations process an appropriate +diversity on the Board of professional background, experience, +expertise, perspective, age, gender, ethnicity and country of +citizenship. The committee also considers the overall composition +of the Board and its committees, compliance with the NYSE American +listing standards, and the contributions that a candidate can be +expected to make to the collective functioning of the Board based +upon the totality of the candidate’s credentials, experience +and expertise, the composition of the Board at the time, and other +relevant circumstances. +The +Company is of the view that the continuing service of qualified +incumbent directors promotes stability and continuity in the +function of the Board of Directors, contributing to the +Board’s ability to work as a collective body, while giving +the Company the benefit of the familiarity and insight into its +affairs that the Company’s directors have accumulated during +their tenure. +The +nominating and governance committee has adopted procedures +consistent with the practice of re-nominating incumbent directors +who continue to satisfy the committee’s criteria for +membership on the Board, whom the committee believes continue to +make important contributions to the Board and who consent to +continue their service on the Board. These procedures are set forth +in the committee’s “Procedures for Identifying and +Evaluating Director Candidates” policy. When evaluating the +qualifications and performance of the incumbent directors that +desire to continue their service on the Board, the committee will +(i) consider whether the director continues to satisfy the minimum +qualifications for director candidates adopted by the committee, +(ii) review the assessments of the performance of the director +during the preceding term made by the committee, and (iii) +determine whether there exist any special, countervailing +considerations against re-nomination of the director. When there is +no qualified and available incumbent, the committee will also +solicit recommendations for nominees from persons that the +committee believes are likely to be familiar with qualified +candidates. These persons may include members of the Board of +Directors and management of the Company. The committee may also +determine to engage a professional search firm to assist in +identifying candidates. As to each recommended candidate that the +committee believes merits consideration, the committee will +consider, among other things, whether the candidate possesses any +of the specific qualities or skills that under the +committee’s policies must be possessed by one or more members +of the Board, the contribution that the candidate can be expected +to make to the overall functioning of the Board and the extent to +which the membership of the candidate on the Board will promote +diversity among the directors. +36 +The +nominating and governance committee has adopted a policy with +regard to the consideration of director candidates submitted by +stockholders. This policy is set forth in the committee’s +“Policy Regarding Director Candidate Recommendations +Submitted by Stockholders.” The committee will only consider +director candidates submitted by stockholders who satisfy the +minimum qualifications prescribed by the committee, including that +a director must represent the interests of all stockholders and not +serve for the purpose of favoring or advancing the interests of any +particular stockholder group or other constituency. +In +accordance with this policy, the nominating and governance +committee will consider director candidates recommended by +stockholders only where the committee has determined to not +re-nominate an incumbent director. In addition, the committee will +not consider any recommendation by a stockholder or an affiliated +group of stockholders unless such stockholder or group of +stockholders has owned at least five percent (5%) of the +Company’s common stock for at least one year as of the date +the recommendation is made. As previously disclosed, any eligible +stockholder (or affiliated group of stockholders) who desired to +recommend a director candidate for consideration by the nominating +and governance committee for the 2019 annual meeting of +stockholders was required to do so prior to December 21, 2018. +Any such eligible stockholder (or +affiliated group of stockholders) is required to submit complete +information about itself and the recommended director candidate as +specified in the committee’s “Procedures for +Stockholders Submitting Director Candidate +Recommendations” policy and as set forth in the advance +notice provisions in the Company’s amended and restated +bylaws. Such information must include, among other things, (i) the +number of common shares beneficially owned by the recommending +stockholder and the length of time such shares have been held, (ii) +the name, age and experience of the director candidate, (iii) +whether the director candidate owns any of the Company’s +securities, (iv) whether the director candidate has a direct or +indirect material interest in any transaction in which the Company +is a participant, (v) a description of all relationships between +the director candidate and the recommending stockholder, and (vi) a +statement setting forth the director candidate’s +qualifications. Submissions should be addressed to the nominating +and governance committee care of the Corporate Secretary at the +Company’s principal headquarters, 7100 Technology Drive, West +Melbourne, Florida 32904. Submissions must be made by mail, courier +or personal delivery. E-mail submissions will not be +considered. +Copies +of the policies of the nominating and corporate governance +committee are available on the Company’s website at +www.bktechnologies.com/investor-relations. +Stockholder Communications +The +Board of Directors believes that it is important for the +Company’s stockholders and other interested parties to have a +process to send communications to the Board. Accordingly, +stockholders and other interested parties desiring to send a +communication to the Board of Directors or to a specific director +may do so by delivering a letter to the Corporate Secretary of the +Company at 7100 Technology Drive, West Melbourne, Florida 32904. +The mailing envelope must contain a clear notation indicating that +the enclosed letter is a “stockholder-board +communication” or “stockholder-director +communication” (or “interested party-board +communication” or “interested party-director +communication,” as appropriate). All such letters must +identify the author as the stockholder or interested party and +clearly state whether the intended recipients of the letter are all +members of the Board of Directors or certain specified individual +directors. The secretary will open such communications and make +copies, and then circulate them to the appropriate director or +directors and such other individuals in accordance with the +Company’s corporate governance policies. +Hedging and Pledging Policy +The +Company’s insider trading policy prohibits the +Company’s officers, other employees and directors from +hedging or pledging the Company’s shares. +Meetings and Committees of the Board of Directors +The +Board of Directors held six meetings during 2018, and each of the +directors attended at least seventy-five percent (75%) of the total +number of meetings of the Board of Directors held during the period +for which he was a director and the total number of meetings held +by all committees of the Board of Directors on which he served +during the periods that he was a member of that +committee. +The +Board of Directors has a standing audit committee, compensation +committee and nominating and governance committee. +37 +Audit Committee +The +members of the audit committee are John W. Struble, who serves as +chairperson, Michael R. Dill and E. Gray Payne. The audit committee +has a written charter, which is available at the Company’s +website at www.bktechnologies.com/investor-relations. The audit +committee charter requires that the audit committee consist of two +or more members of the Board of Directors, each of whom are +independent, as defined by the corporate governance listing +standards of the NYSE American. +The +Board of Directors has determined that each member of the audit +committee is independent, as defined by Rule 10A-3 of the +Securities Exchange Act of 1934, as amended (the “Exchange +Act”), and the corporate governance listing standards of the +NYSE American. The Board of Directors also has determined that Mr. +Struble is an “audit committee financial expert,” as +defined in Item 407(d)(5) of Regulation S-K. +The +audit committee has oversight responsibility for the quality and +integrity of the Company’s consolidated financial statements +and is directly responsible for the appointment, compensation, +retention and oversight of the Company’s independent +registered public accounting firm. The committee meets privately +with members of the Company’s independent registered public +accounting firm, which has unrestricted access and reports directly +to the committee, and annually reviews their performance and +independence from management in deciding whether to continue to +retain the accounting firm or engage a different accounting firm. +The audit committee also evaluates the lead partner designated by +the independent auditor. As required by the SEC’s rules, the +committee is directly involved in the review and selection of the +audit partners serving on the auditor’s engagement team +during mandated five-year partner rotations. The audit committee +also oversees audit fee negotiations associated with the +Company’s retention of the independent auditor and has the +sole authority to approve such fees. The audit committee met eight +times during 2018. The primary functions of the audit committee are +to oversee: (i) the audit of the Company’s consolidated +financial statements provided to the SEC and the Company’s +stockholders; (ii) the Company’s internal financial and +accounting processes; and (iii) the independent audit process. +Additionally, the audit committee has responsibilities and +authority necessary to comply with Rules 10A-3(b)(2), (3), (4), and +(5) of the Exchange Act, concerning the responsibilities relating +to: (a) registered public accounting firms, (b) complaints relating +to accounting, internal accounting controls or auditing matters, +(c) authority to engage advisors, and (d) funding. These and other +aspects of the audit committee’s authority are more +particularly described in the audit committee charter. +The +audit committee has adopted a formal policy concerning approval of +audit and non-audit services to be provided to the Company by the +Company’s independent registered public accounting firm, +Moore Stephens Lovelace, P.A. The policy requires that all services +to be provided by Moore Stephens Lovelace, P.A., including audit +services and permitted audit-related and non-audit services, must +be pre-approved by the audit committee. The audit committee +approved all audit services provided by Moore Stephens Lovelace, +P.A. to the Company during 2018. Moore Stephens Lovelace, P.A. did +not provide any audit-related or non-audit services to the Company +during 2018. +38 +Compensation Committee +The +members of the compensation committee are E. Gray Payne, who serves +as chairperson (since June 2018), D. Kyle Cerminara, Michael R. +Dill, Charles T. Lanktree and Ryan R.K. Turner. All members of the +compensation committee are independent under the corporate +governance listing standards of the NYSE American and applicable +SEC rules and regulations. The compensation committee has a written +charter, which is available at the Company’s website at +www.bktechnologies.com/investor-relations. The functions performed +by the compensation committee include reviewing and approving all +compensation arrangements for the Company’s executive +officers and administering the Company’s equity incentive +plans and programs. The compensation committee makes all final +compensation decisions for the named executive officers (as +identified in the “Summary Compensation Table for +2017-2018” appearing under “Item 11. Executive +Compensation” below, the “Named Executive +Officers”), including equity grants. The compensation +committee reviews the performance of the Named Executive Officers, +including the principal executive officer. The Company’s +principal executive officer annually reviews the performance of +each of the Named Executive Officers and other officers, and makes +recommendations regarding the Named Executive Officers and other +officers and managers of the Company to the compensation committee +for its consideration and approval. The compensation committee can +exercise its discretion in modifying any of the principal executive +officer’s recommendations. In performing its functions, the +compensation committee may retain and terminate outside counsel, +compensation and benefits consultants or other experts. During +2018, the compensation committee met seven times. +Nominating and Governance Committee +The +members of the nominating and governance committee are Lewis M. +Johnson, who serves as chairperson (since June 2018), D. Kyle +Cerminara and E. Gray Payne. All members of the nominating and +governance committee are independent under the corporate governance +listing standards of the NYSE American. The nominating and +governance committee has a written charter, which is available at +the Company’s website at +www.bktechnologies.com/investor-relations. During 2018, the +nominating and governance committee met three times. +The +functions of the nominating and governance committee include +determining and recommending to the Board of Directors the slate of +director nominees for election to the Board of Directors at each +annual stockholders’ meeting and identifying and recommending +director candidates to fill vacancies occurring between annual +stockholders’ meetings. In addition, the nominating and +governance committee reviews, evaluates and recommends changes to +the Company’s corporate governance policies, including the +Company’s Code of Conduct and Code of Ethics, and monitors +the Company’s compliance with these corporate +policies. +Policy Concerning Director Attendance at Annual Stockholders’ +Meetings +While +the Company encourages all members of the Board of Directors to +attend the Company’s annual stockholders’ meetings, +there is no formal policy as to their attendance at annual +stockholders’ meetings. Messrs. Dill, Johnson, Lanktree and +Payne attended the 2018 annual stockholders’ +meeting. +39 +EXECUTIVE OFFICERS +The +following table presents information with respect to the current +executive officers of the Company. +Name +Age* +Position +Timothy +A. Vitou +62 +President +William +P. Kelly +62 +Executive +Vice President, Chief Financial Officer and Secretary +Henry +R. (Randy) Willis +60 +Chief +Operating Officer +James +R. Holthaus +56 +Chief +Technology Officer +*As +of February 27, 2019 +Timothy A. +Vitou has been the +Company’s President since January 17, 2017. He previously +served as the Company’s Senior Vice President of Sales and +Marketing since May 2008. Prior to that, he served as Vice +President of Sales for Mobility Electronics, Inc., from August 2006 +to May 2007, Senior Director of Global Go-To-Market, for Motorola +Solutions, Inc., from April 2002 to April 2006, and General +Manager, Americas Region, for Motorola Solutions, from April 2000 +to April 2002. +William P. +Kelly has been the Company’s Executive Vice +President and Chief Financial Officer since July 1997, and +Secretary since June 2000. From October 1995 to June 1997, he was +Vice President and Chief Financial Officer of the Company’s +subsidiary, RELM Communications, Inc. From January 1993 to October +1995, he was the Financial Director of Harris Corp. Semiconductor +Sector. +Randy +Willis has been the +Company’s Chief Operating Officer since March 14, 2018. He +previously served as the Company’s Vice President of +Operations since August 2017, overseeing all aspects of +manufacturing and quality. Prior to joining the Company, he held +leadership positions in manufacturing, operations, quality, supply +chain, industrial engineering and program management, including +founding and serving as President of Target Velocity Consulting, +Inc., a “Lean/Six Sigma” firm specializing in +operational improvements, from December 2009 to August 2017 and +Vice President, Continuous Improvement, for CIRCOR International, +Inc. (NYSE: CIR), from August 2007 to December 2009. He also served +in leadership positions for Parker-Hannifin Corporation (NYSE: PH) +from January 2005 to August 2007 and Honeywell International Inc. +(NYSE: HON) from June 1998 to January 2005. Mr. Willis holds +certifications as a Lean Master and Six Sigma Black Belt and B.S. +and M.S. degrees in Industrial Technology from East Carolina +University. +James R. +Holthaus was appointed as the Company’s Chief +Technology Officer effective August 4, 2017. He joined the Company +in 2007 and most recently served as the Vice President – +Project 25 Solutions, responsible for product definition and market +analysis, with a focus on development of our P-25 mobile and +portable radio products. Since 1993, Mr. Holthaus has been active +in the development of land mobile radio products and the P-25 +Digital Radio Standards. He holds an M.S. Degree in Electrical +Engineering from Southern Methodist University. +40 +ADDITIONAL INFORMATION +Section 16(a) Beneficial Ownership Reporting +Compliance +Section +16(a) of the Exchange Act requires that the Company’s +directors and executive officers, and persons who own more than ten +percent (10%) of the Company’s common stock, file with the +SEC initial statements of beneficial ownership of common stock and +statements of changes in beneficial ownership of common +stock. +Based +solely on a review of the copies of such reports and +representations that no other reports were required, the Company +believes that all Section 16 filing requirements applicable to the +Company’s directors, executive officers and ten percent (10%) +beneficial owners were timely complied with during fiscal 2018, +except as follows: as previously disclosed, Mr. Payne’s Form +4 reporting a purchase of shares of the Company’s common +stock, filed on February 12, 2018, was inadvertently filed late, +and Mr. Dill’s Form 4 reporting a grant of restricted stock +units, filed on September 11, 2018, was inadvertently filed +late. +Code of Ethics +The +Board of Directors has adopted the Code of Business Conduct and +Ethics (the “Code of Conduct”) that applies to all of +the Company’s directors, officers and employees, including +its principal executive officer, principal financial officer and +principal accounting officer, and the Code of Ethics for the CEO +and Senior Financial Officers (the “Code of Ethics”) +containing additional specific policies. The Code of Conduct and +the Code of Ethics are posted on the Company’s Internet +website at www.bktechnologies.com/investor-relations and are +available free of charge, upon request to Corporate Secretary, 7100 +Technology Drive, West Melbourne, Florida 32904; telephone number: +(321) 984-1414. +Any +amendment to, or waiver from, a provision of the codes of ethics +applicable to the Company’s directors and executive officers +will be disclosed in a current report on Form 8-K within four +business days following the date of the amendment or waiver, unless +the rules of the NYSE American then permit website posting of such +amendments and waivers, in which case the Company would post such +disclosures on the Company’s Internet website. +41 +Item 11. Executive Compensation +SUMMARY COMPENSATION TABLE FOR 2017-2018 +The +following table provides certain summary information concerning the +compensation of the Company’s Named Executive Officers for +the last two completed fiscal years ended December 31, +2018: +Name and Principal Position +Year +Salary +($) +Bonus ($) (4) +Stock Awards ($) +Option Awards ($) (6) +Non-Equity Incentive Plan Compensation ($) +All Other Compensation ($) +Total ($) +Timothy A. Vitou (1) +2018 +250,000 +125,000 +— +49,110 +— +24,816 (7) +448,926 +President +2017 +247,461 +50,000 +— +54,295 +— +14,878 (7) +366,634 +William P. +Kelly +2018 +200,000 +100,000 +— +32,740 +— +34,266 (8) +367,006 +Executive Vice President, Chief +Financial Officer and Secretary +2017 +201,283 (12) +25,000 +— +54,295 +— +14,705 (8) +295,283 +Randy Willis (2) +2018 +200,000 +100,000 +— +32,740 +— +5,501 (9)(10) +338,241 +Chief Operating +Officer +James R. Holthaus (3) +2018 +202,301 +100,000 +— +32,740 +— +13,252 (11) +348,293 +Chief Technology +Officer +2017 +144,326 +132,556 (5) +— +56,790 +— +11,638 (11) +345,310 +_ ____________ +(1) +Mr. Vitou was +appointed as President of the Company effective January 17, 2017. +Mr. Vitou’s compensation for 2017 includes compensation +received from January 1, 2017 through January 17, 2017 in his role +as Senior Vice President of Sales and Marketing of the +Company. +(2) +Mr. Willis was +appointed as Chief Operating Officer of the Company on March 14, +2018, having previously served as Vice President of Operations +since August 2017. Mr. Willis was not a Named Executive Officer for +fiscal 2017. Mr. Willis’ compensation for 2018 includes +compensation received from January 1, 2018 through March 14, 2018 +in his role as Vice President of Operations. +(3) +Mr. Holthaus was +appointed as Chief Technology Officer of the Company effective +August 4, 2017. Mr. Holthaus’ compensation for 2017 includes +compensation received from January 1, 2017 through August 4, 2017 +in his role as Vice President – Project 25 Solutions for the +Company. +(4) +On January 23, +2019, the compensation committee approved payment of cash bonuses +of $125,000 to Mr. Vitou, $100,000 to Mr. Kelly, $100,000 to Mr. +Willis and $100,000 to Mr. Holthaus based upon their 2018 +performance. On March 14, 2018, the compensation committee approved +payment of cash bonuses of $50,000 to Mr. Vitou, $25,000 to Mr. +Kelly, $25,000 to Mr. Willis and $12,500 to Mr. Holthaus based upon +their 2017 performance. The bonus paid to Mr. Willis is not shown +in the table above as he was not a Named Executive Officer for +fiscal 2017. +42 +(5) +Includes the +$12,500 cash bonus received by Mr. Holthaus on March 14, 2018 (as +described in footnote 4) and the cash bonus received pursuant to a +sales bonus plan related to Mr. Holthaus’ previous position +as Vice President – Project 25 Solutions for the Company. On +August 30, 2017, the compensation committee approved Mr. +Holthaus’ continued participation in the plan through the end +of fiscal 2017. +(6) +The amounts in this +column represent the aggregate grant date fair value of stock +options granted to the Named Executive Officer computed in +accordance with FASB ASC Topic 718. The value ultimately realized +by the Named Executive Officer upon the actual exercise of the +stock options may or may not be equal to the FASB ASC Topic 718 +computed value. For a discussion of valuation assumptions, see Note +10 (Share-Based Employee Compensation) of the consolidated +financial statements included in this Annual Report on Form 10-K +for fiscal 2018. +On March 14, 2018, the committee granted +non-qualified stock options to Messrs. Vitou, Kelly, Willis and +Holthaus to purchase 30,000, 20,000, 20,000 and 20,000 shares, +respectively, of the Company’s common stock, at an exercise +price of $3.75 per share. On August 30, 2017, the committee granted +non-qualified stock options to Messrs. Vitou, Kelly, Willis and +Holthaus to purchase 10,000, 10,000, 25,000 and 25,000 shares, +respectively, of the Company’s common stock, at an exercise +price of $4.20 per share. In addition, on March 17, 2017, the +committee granted non-qualified stock options to Messrs. Vitou, +Kelly and Holthaus to purchase 25,000, 25,000 and 5,000 shares, +respectively, of the Company’s common stock, at an exercise +price of $5.10 per share. The stock options granted to Mr. +Willis in 2017 are not shown in the table above as he was not a +Named Executive Officer for fiscal 2017. Additional information +about the stock option awards can be found below under “— Stock Option +Awards. ” +(7) +The amounts in this +column for Mr. Vitou represent the Company’s matching +contributions for fiscal 2018 and fiscal 2017 of $6,308 and $6,276, +respectively, to Mr. Vitou’s account under the +Company’s 401(k) plan; the Company’s payments for +fiscal 2018 and fiscal 2017 of $8,893 and $8,602, respectively, for +long-term disability, life and health insurance premiums for the +benefit of Mr. Vitou; and the Company’s payment for fiscal +2018 of $9,615 for accrued unused vacation time. +(8) +The amounts in this +column for Mr. Kelly represent the Company’s matching +contributions for fiscal 2018 and fiscal 2017 of $6,142 and $6,142, +respectively, to Mr. Kelly’s account under the +Company’s 401(k) plan; the Company’s payments for +fiscal 2018 and fiscal 2017 of $8,894 and $8,563, respectively, for +long-term disability, life and health insurance premiums for the +benefit of Mr. Kelly; and the Company’s payment for fiscal +2018 of $19,230 for accrued unused vacation time. +(9) +The amount in this +column for Mr. Willis includes the Company’s payment for +fiscal 2018 of $5,501 for long-term disability, life and health +insurance premiums for the benefit of Mr. Willis. +(10) +Does not include a +one-time cash payment of $30,000 paid by the Company to Mr. Willis +after fiscal 2018 to offset potential losses incurred by Mr. Willis +in connection with the sale of his house located in Charlotte, +North Carolina. Mr. Willis relocated from Charlotte, North +Carolina, to Brevard County, Florida, in order to be closer to the +Company’s principal executive offices. The payment was made +pursuant to a retention agreement entered into between the Company +and Mr. Willis. See “—Appointment of Chief Operating +Officer—Retention Agreement” below for more information +about this agreement. In 2017, the Company also paid moving +expenses of $10,972 in connection of Mr. Willis’ relocation, +which amount is not shown in the table above, as Mr. Willis was not +a Named Executive Officer for fiscal 2017. +(11) +The amounts in this +column for Mr. Holthaus represent the Company’s matching +contributions for fiscal 2018 and fiscal 2017 of $4,460 and $3,336, +respectively, to Mr. Holthaus’ account under the +Company’s 401(k) plan and the Company’s payments for +fiscal 2018 and 2017 of $8,792 and $8,302, respectively, for +long-term disability, life and health insurance premiums for the +benefit of Mr. Holthaus. +Except +as disclosed above, Messrs. Vitou, Kelly, Willis and Holthaus did +not receive any other compensation during 2018 or 2017, except for +perquisites and other personal benefits, of which the total +aggregate value for each of them did not exceed +$10,000. +(12) +Includes a payment +of $7,692 for accrued unused vacation time in fiscal +2017. +43 +Appointment of Chief Operating Officer +On +March 14, 2018, the Board of Directors appointed Mr. Willis as +Chief Operating Officer of the Company effective immediately. Mr. +Willis previously served as Vice President of Operations of the +Company since August 2017. As Chief Operating Officer, Mr. Willis +receives an annual base salary of $200,000. In addition, the +compensation committee approved for Mr. Willis a $25,000 cash bonus +for 2017 and granted to Mr. Willis non-qualified stock options to +purchase 20,000 shares of the Company’s common stock at an +exercise price of $3.75 per share under the Company’s 2017 +Incentive Compensation Plan. The options have a ten-year term and +will become exercisable in five equal annual installments, +beginning on the first anniversary of the grant date. Mr. Willis +was not a Named Executive Officer for fiscal 2017. +For +his service as Vice President of Operations from August 2017 to +March 2018, Mr. Willis received payments equal to $80,770 in 2017 +and an additional $46,154 in 2018, and a grant of non-qualified +stock options to purchase 25,000 shares of the Company’s +common stock, at an exercise price of $4.20 per share, on August +30, 2017. The options have a ten-year term and become exercisable +in one-fifth annual installments, beginning on the first +anniversary of the grant date. +Prior +to Mr. Willis joining the Company in August 2017, the Company +engaged Target Velocity Consulting, Inc., of which Mr. Willis is +President, to provide operational consulting services to the +Company in 2017 for total fees of $59,616. +Retention Agreement +On +December 18, 2018, the compensation committee approved a retention +agreement by and between the Company and Mr. Willis in connection +with Mr. Willis’s relocation from Charlotte, North Carolina, +to Brevard County, Florida, in order to be near the Company’s +principal executive offices. The agreement provides for a one-time +cash payment of $30,000 from the Company to Mr. Willis to offset +potential losses incurred by Mr. Willis in connection with the sale +of his house located in Charlotte, North Carolina, which the +Company paid to Mr. Willis in January 2019. Previously, in 2017, +the Company paid $10,972 to Mr. Willis as assistance with his +moving expenses. +Pursuant +to the retention agreement, if Mr. Willis’s employment with +the Company is terminated by Mr. Willis either voluntarily (other +than for “good reason”) or by the Company for +“cause” during (i) the period beginning the date of the +retention agreement and ending on the second anniversary of his +employment date (August 1, 2017), the entire relocation allowance +($30,000) provided under the agreement will be immediately +repayable to the Company, (ii) the period beginning on the day +following the second anniversary of his employment date and ending +on the third anniversary of his employment date, two-thirds of the +relocation allowance ($20,000) will be immediately repayable to the +Company, and (iii) the period beginning on the fourth anniversary +of his employment date, one-third of the relocation allowance +($10,000) will be immediately repayable to the Company. Any such +amounts that are repayable to the Company may also be deducted from +any amounts otherwise payable to Mr. Willis by the Company upon his +termination. For purposes of the retention agreement, +“cause” and “good reason” have the meanings +set forth in the Company’s 2017 Incentive Compensation +Plan. +Compensation Consultant +In +2018, the compensation committee engaged Pay Governance LLC as an +independent compensation consultant to assist the committee with +the review and design of the Company’s executive compensation +program, including providing the committee with pay data regarding +the direct compensation program for the Company’s President, +Chief Operating Officer, Chief Financial Officer and Chief +Technology Officer. In connection with the committee’s +engagement of the consultant, the committee solicited information +from Pay Governance LLC regarding any actual or perceived conflicts +of interest and to evaluate the firm’s independence. Based on +the information received from the consultant, the compensation +committee believes that the work Pay Governance LLC performed in +2018 did not raise a conflict of interest and that they were +independent. +44 +Base Salaries +On +March 14, 2018, the compensation committee approved base salaries +for 2018 of $250,000, $200,000, $200,000 and $200,000 to Messrs. +Vitou, Kelly, Willis and Holthaus, respectively. Mr. Willis was +appointed as Chief Operating Officer of the Company effective March +14, 2018. +On +March 17, 2017, the compensation committee approved base salaries +for 2017 of $250,000 and $200,000 to Messrs. Vitou and Kelly, +respectively. +Effective +August 4, 2017, Mr. Holthaus was appointed as Chief Technology +Officer of the Company. On August 30, 2017, the compensation +committee approved an increase in Mr. Holthaus’s base salary +to a rate of $175,000 per year, effective as of September 1, 2017. +In addition, the committee approved Mr. Holthaus’s continued +participation in a sales bonus plan related to his previous +position as Vice President – Project 25 Solutions of the +Company through the end of fiscal 2017 pursuant to which he +received $120,056. +Bonus Payments +2018 Discretionary Cash Bonuses +On +January 23, 2019, based on management’s recommendations and +the Named Executive Officers’ 2018 performance, the +compensation committee approved the payment of cash bonuses of +$125,000 to Mr. Vitou and $100,000 to each of Messrs. Kelly, Willis +and Holthaus. +2017 Discretionary Cash Bonuses +On +March 14, 2018, based on management’s recommendations and the +Named Executive Officers’ 2017 performance, the compensation +committee approved the payment of cash bonuses of $50,000 to Mr. +Vitou, $25,000 to Mr. Kelly, $25,000 to Mr. Willis and $12,500 to +Mr. Holthaus. +Stock Option Awards +2018 Awards +On +March 14, 2018, the compensation committee granted non-qualified +stock options to Messrs. Vitou, Kelly, Willis and Holthaus to +purchase 30,000, 20,000, 20,000 and 20,000 shares, respectively, of +the Company’s common stock, at an exercise price of $3.75 per +share. The stock options have ten-year terms and become exercisable +in five equal annual installments, beginning on the first +anniversary of the grant date. +2017 Awards +On +March 17, 2017, the compensation committee granted non-qualified +stock options to Messrs. Vitou, Kelly and Holthaus to purchase +25,000, 25,000 and 5,000 shares, respectively, of the +Company’s common stock, at an exercise price of $5.10 per +share. The stock options have ten-year terms and become exercisable +in five equal annual installments, beginning on the first +anniversary of the grant date. +On +August 30, 2017, the compensation committee granted non-qualified +stock options to Messrs. Vitou, Kelly, Willis and Holthaus to +purchase 10,000, 10,000, 25,000 and 25,000 shares, respectively, of +the Company’s common stock, at an exercise price of $4.20 per +share. The stock options have ten-year terms and become exercisable +in five equal annual installments, beginning on the first +anniversary of the grant date. +45 +2017 Incentive Compensation Plan +The +Company’s stockholders approved the 2017 Incentive +Compensation Plan (the “2017 Plan”) at the +Company’s 2017 annual meeting of stockholders held on June +15, 2017. The 2017 Plan replaced the Company’s 2007 Incentive +Compensation Plan, which had been approved by the stockholders in +2007 (the “2007 Plan”). No new awards will be granted +under the 2007 Plan. +The +objective of the 2017 Plan is to provide incentives to attract and +retain key employees, non-employee directors and consultants and +align their interests with those of the Company’s +stockholders. The 2017 Plan is administered by the compensation +committee and has a term of ten years. All non-employee directors +of the Company and employees and consultants of the Company and its +subsidiaries designated by the committee are eligible to +participate in the 2017 Plan and to receive awards, including stock +options (which may be incentive stock options or non-qualified +stock options), stock appreciation rights, restricted shares, +restricted share units, or other share-based awards and cash-based +awards. +OUTSTANDING EQUITY AWARDS AT 2018 FISCAL YEAR-END +The +following table provides information with respect to outstanding +stock option awards for the Company’s shares of common stock +classified as exercisable and unexercisable as of December 31, 2018 +for the Named Executive Officers. +Name +Number of Securities Underlying Unexercised +Options (#) Exercisable (7) +Number of Securities Underlying Unexercised Options (#) +Unexercisable +Option Exercise Price ($) +Option Expiration Date +Timothy +A. Vitou +15,000 (1) +— +4.07 +3/04/20 +5,000 (2) +— +2.23 +3/12/23 +5,000 (3) +20,000 +5.10 +3/17/27 +2,000 (4) +8,000 +4.20 +8/30/27 +— (5) +30,000 +3.75 +3/14/28 +William +P. Kelly +25,000 (1) +— +4.07 +3/04/20 +15,000 (2) +— +2.23 +3/12/23 +4,000 (6) +6,000 +3.83 +2/24/26 +5,000 (3) +20,000 +5.10 +3/17/27 +2,000 (4) +8,000 +4.20 +8/30/27 +— (5) +20,000 +3.75 +3/14/28 +Randy Willis +5,000 (4) +20,000 +4.20 +8/30/27 +— (5) +20,000 +3.75 +3/14/28 +James R. Holthaus +1,000 (3) +4,000 +5.10 +3/17/27 +5,000 (4) +20,000 +4.20 +8/30/27 +— (5) +20,000 +3.75 +3/14/28 +(1) +The options were +granted on March 4, 2010 and are fully vested and +exercisable. +(2) +The options were +granted on March 12, 2013 and are fully vested and +exercisable. +(3) +The options were +granted on March 17, 2017 and vest in five equal annual +installments, beginning on March 17, 2018. +(4) +The options were +granted on August 30, 2017 and vest in five equal annual +installments, beginning on August 30, 2018. +(5) +The options were +granted on March 14, 2018 and vest in five equal annual +installments, beginning on March 14, 2019. +46 +(6) +The options were +granted on February 24, 2016 and vest in five equal annual +installments, beginning on February 24, 2017. +(7) +None of the Named +Executive Officers exercised any options during fiscal +2018. +RETIREMENT BENEFITS FOR 2018 +The +Company does not have a defined benefit plan for the Named +Executive Officers or other employees. The only retirement plan +available to the Named Executive Officers in 2018 was the +Company’s qualified 401(k) retirement plan, which is +available to all employees. +POTENTIAL PAYMENTS UPON TERMINATION IN CONNECTION WITH A CHANGE OF +CONTROL +2016 Change of Control Agreements +Effective +as of February 24, 2016, the Company entered into change of control +agreements (the “2016 Change of Control Agreements”) +with Messrs. Vitou and Kelly, which were approved by the +compensation committee on that same day. The 2016 Change of Control +Agreements replaced and terminated the 2012 Change of Control +Agreements that the Company previously entered into with Messrs. +Vitou and Kelly, which expired on February 29, 2016, and are +substantially similar to the 2012 Change of Control Agreements. The +Company has not entered into any change of control agreements with +Messrs. Willis or Holthaus. +Each +of the 2016 Change of Control Agreements has a term of four years, +unless a “change of control” (as defined in the +agreements) of the Company occurs within such four-year period, in +which case each agreement is automatically extended for twelve +months after the date of such change of control. Pursuant to the +2016 Change of Control Agreements, if the applicable Named +Executive Officer’s employment is terminated within twelve +months following a change in control (i) by the Company for any +reason other than for “cause” (as defined in the +agreements), disability or death or (ii) by such Named Executive +Officer for “good reason” (as defined in the +agreements), the applicable Named Executive Officer will receive +certain payments and benefits. A Named Executive Officer is not +entitled to any payments and benefits if the Named Executive +Officer terminates the Named Executive Officer’s employment +without good reason. +The +payments and benefits to be paid pursuant to the 2016 Change of +Control Agreements are as follows: +● +Mr. +Vitou will receive (i) a cash payment equal to the sum of (x) 50% +of his then-current base salary and (y) the average of his annual +cash bonuses for the two fiscal years preceding the fiscal year in +which termination occurs, (ii) health, life and disability +insurance benefits for himself and, if applicable, his covered +dependents for a period of six months after the date of +termination, and (iii) outplacement services for a period of six +months following the date of termination, provided that the costs +of such services to the Company may not exceed $7,500. +● +Mr. +Kelly will receive (i) a cash payment equal to the sum of (x) 75% +of his then-current base salary and (y) the average of his annual +cash bonuses for the two fiscal years preceding the fiscal year in +which termination occurs, (ii) health, life and disability +insurance benefits for himself and, if applicable, his covered +dependents for a period of nine months after the date of +termination, and (iii) outplacement services for a period of nine +months following the date of termination, provided that the costs +of such services to the Company may not exceed +$11,250. +47 +Under +the 2016 Change of Control Agreements, a change of control will +have occurred if: +● +individuals +who, as of February 24, 2016, constitute the Board of Directors +(the “Incumbent Board”) cease for any reason to +constitute at least a majority of the Board, provided that any +individual becoming a director subsequent to that date whose +election, or nomination for election by the Company’s +stockholders, was approved by a vote of at least a majority of the +directors then comprising the Incumbent Board (other than an +election or nomination of an individual whose initial assumption of +office is in connection with an actual or threatened election +contest relating to the election of the directors of the Company, +as such terms are used in Rule 14a-11 of Regulation 14A promulgated +under the Exchange Act) shall be considered as though such +individual was a member of the Incumbent Board; or +● +the +approval by the stockholders of the Company of a reorganization, +merger, consolidation or other form of corporate transaction or +series of transactions (but not including an underwritten public +offering of the Company’s common stock or other voting +securities (or securities convertible into voting securities of the +Company) for the Company’s own account registered under the +Securities Act of 1933, as amended ), in each case, with respect to +which stockholders of the Company immediately prior to such +reorganization, merger, consolidation or other corporate +transaction do not, immediately thereafter, own more than fifty +percent (50%) of the combined voting power entitled to vote +generally in the election of directors of the reorganized, merged +or consolidated entity’s then outstanding voting securities, +or a liquidation or dissolution of the Company or the sale of all +or substantially all of the assets of the Company (unless such +reorganization, merger, consolidation or other corporate +transaction, liquidation, dissolution or sale is subsequently +abandoned or terminated prior to being consummated); +or +● +the +acquisition by any person, entity or “group,” within +the meaning of Section 13(d)(3) or 14(d)(2) of the Exchange Act, of +more than fifty percent (50%) of either the then outstanding shares +of the Company’s common stock or the combined voting power of +the Company’s then outstanding voting securities entitled to +vote generally in the election of directors (hereinafter referred +to as a “Controlling Interest”) excluding any +acquisitions by (x) the Company or any of its subsidiaries, (y) any +employee benefit plan (or related trust) sponsored or maintained by +the Company or any of its subsidiaries, or (z) any person, entity +or “group” that as of February 24, 2016 owns +beneficially (within the meaning of Rule 13d-3 promulgated under +the Exchange Act) a Controlling Interest. +Each +of the 2016 Change of Control Agreements contains term and +post-termination confidentiality, non-solicitation and +non-competition covenants. The post-termination, non-solicitation +and non-competition covenants survive six months for Mr. Vitou and +nine months for Mr. Kelly, while the post-term confidentiality +covenants survive indefinitely for each of them. +The +Company does not have any employment agreements or severance +agreements with any of its Named Executive Officers. In addition to +the 2016 Change of Control Agreements, the Company’s equity +plans and award agreements entered into with its Named Executive +Officers include change in control provisions. +2017 Incentive Compensation Plan – Change in Control +Provisions +The +Company’s 2017 Incentive Compensation Plan (the “2017 +Plan”) generally provides for “double-trigger” +vesting of equity awards in connection with a change in control of +the Company, as described below. +To +the extent that outstanding awards granted under the 2017 Plan are +assumed in connection with a change in control, then, except as +otherwise provided in the applicable award agreement or in another +written agreement with the participant, all outstanding awards will +continue to vest and become exercisable (as applicable) based on +continued service during the remaining vesting period, with +performance-based awards being converted to service-based awards at +the “target” level. Vesting and exercisability (as +applicable) of awards that are assumed in connection with a change +in control generally would be accelerated in full on a +“double-trigger” basis, if, within two years after the +change in control, the participant’s employment is +involuntarily terminated without cause, or by the participant for +“good reason.” Any stock options or stock appreciation +rights (SARs) that become vested on a “double-trigger” +basis generally would remain exercisable for the full duration of +the term of the applicable award. +48 +To +the extent outstanding awards granted under the 2017 Plan are not +assumed in connection with a change in control, then such awards +generally would become vested in full on a +“single-trigger” basis, effective immediately prior to +the change in control, with performance-based awards becoming +vested at the “target” level. Any stock options or SARs +that become vested on a “single-trigger” basis +generally would remain exercisable for the full duration of the +term of the applicable award. +The +compensation committee has the discretion to determine whether or +not any outstanding awards granted under the 2017 Plan will be +assumed by the resulting entity in connection with a change in +control, and the committee has the authority to make appropriate +adjustments in connection with the assumption of any awards. The +committee also has the right to cancel any outstanding awards in +connection with a change in control, in exchange for a payment in +cash or other property (including shares of the resulting entity) +in an amount equal to the excess of the fair market value of the +shares subject to the award over any exercise price related to the +award, including the right to cancel any “underwater” +stock options and SARs without payment therefor. +For +purposes of the 2017 Plan, subject to exceptions set forth in the +2017 Plan, a “change in control” generally includes (a) +the acquisition of more than 50% of the Company’s common +stock; (b) the incumbent board of directors ceasing to constitute a +majority of the board of directors; (c) a reorganization, merger, +consolidation or similar transaction, or a sale of substantially +all of the Company’s assets; and (d) the complete liquidation +or dissolution of the Company. The full definition of “change +in control” is set forth in the 2017 Plan. +Whether +a participant’s employment has been terminated for +“cause” will be determined by the compensation +committee. Unless otherwise provided in the applicable award +agreement or in an another written agreement with the participant, +“cause,” as a reason for termination of a +participant’s employment generally includes (a) the +participant’s failure to perform, in a reasonable manner, his +or her assigned duties; (b) the participant’s violation or +breach of his or her employment agreement, consulting agreement or +other similar agreement; (c) the participant’s violation or +breach of any non-competition, non-solicitation, non-disclosure +and/or other similar agreement; (d) any act of dishonesty or bad +faith by the participant with respect to the Company or a +subsidiary; (e) the participant’s breach of fiduciary duties +owed to the Company; (f) the use of alcohol, drugs or other similar +substances in a manner that adversely affects the +participant’s work performance; or (g) the +participant’s commission of any act, misdemeanor, or crime +reflecting unfavorably upon the participant or the Company or any +subsidiary. +For +purposes of the 2017 Plan, unless otherwise provided in the +applicable award agreement or in an another written agreement with +the participant, “good reason” generally includes (a) +the assignment to the participant of any duties that are +inconsistent in any material respect with his or her duties or +responsibilities as previously assigned by the Company or a +subsidiary, or any other action by the Company or a subsidiary that +results in a material diminution of the participant’s duties +or responsibilities, other than any action that is remedied by the +Company or a subsidiary promptly after receipt of notice from the +participant; or (b) any material failure by the Company or a +subsidiary to comply with its obligations to the participant as +agreed upon, other than an isolated, insubstantial and inadvertent +failure which is remedied by the Company or subsidiary promptly +after receipt of notice from the participant. +Except +as described above with respect to a change in control, +unexercisable stock options generally become forfeited upon +termination of employment. The stock options that are exercisable +at the time of termination of employment expire (a) twelve months +after the termination of employment by reason of death, or +disability or (b) three months after the termination of employment +for other reasons. With respect to unvested restricted shares and +restricted stock units, unless otherwise provided in the applicable +award agreement, the compensation committee, in its sole +discretion, may provide for the full or partial acceleration of +vesting of the restricted shares or restricted share units, as +applicable, in connection with the termination of the +grantee’s employment for any reason prior to a vesting date, +including, but not limited to, termination of employment as a +result of the grantee’s death or disability. Unless action is +otherwise taken by the compensation committee, any restricted +shares or restricted share units that have not yet vested will be +forfeited automatically in the event of the termination of the +grantee’s employment for any reason prior to a vesting +date. +The +Company’s Named Executive Officers, other employees and +directors are prohibited from hedging or pledging the +Company’s securities. Awards granted under the 2017 Plan also +may be subject to forfeiture or recoupment, as provided pursuant to +any compensation recovery (or “clawback”) policy that +the Company may adopt or maintain from time to time. +49 +2007 Incentive Compensation Plan – Change in Control +Provisions +The +Company’s 2007 Incentive Compensation Plan (the “2007 +Plan”), under which some equity awards remain outstanding, +also contains provisions providing for the vesting of equity awards +in connection with a change in control of the Company, as described +below. +To +the extent that outstanding awards granted under the 2007 Plan are +assumed in connection with a change in control, then, except as +otherwise provided in the applicable award agreement, all +outstanding awards will continue to vest and become exercisable (as +applicable) based on continued service during the remaining vesting +period. +To +the extent outstanding awards granted under the 2007 Plan are not +assumed in connection with a change in control, then such awards +generally would become vested in full on a +“single-trigger” basis in connection with the change in +control. With respect to any outstanding performance-based awards +subject to achievement of performance goals and conditions, the +compensation committee may, in its discretion, deem such +performance goals and conditions as having been met as of the date +of the change in control. Any stock options or SARs that become +vested on a “single-trigger” basis generally would +remain exercisable for the full duration of the term of the +applicable award. +The +compensation committee has the discretion to determine whether or +not any outstanding awards granted under the 2007 Plan will be +assumed by the resulting entity in connection with a change in +control, and the committee has the authority to make appropriate +adjustments in connection with the assumption of any awards. The +committee also has the right to cancel any outstanding awards in +connection with a change in control, in exchange for a payment in +cash or other property (including shares of the resulting entity) +in an amount equal to the excess of the fair market value of the +shares subject to the award over any exercise price related to the +award, including the right to cancel any “underwater” +stock options and SARs without payment therefor. +For +purposes of the 2007 Plan, subject to exceptions set forth in the +2007 Plan, a “change in control” generally includes: +(a) the acquisition of more than 50% of the Company’s common +stock; (b) the incumbent Board of Directors ceasing to constitute a +majority of the Board of Directors; (c) a reorganization, merger, +consolidation or similar transaction, or a sale of substantially +all of the Company’s assets; and (d) the complete liquidation +or dissolution of the Company. The full definition of “change +in control” is set forth in the 2007 Plan. +DIRECTOR COMPENSATION +Director Compensation Program +On +September 6, 2018, the Board, upon the recommendation of the +compensation committee, adopted a new director compensation program +for all non-employee directors, effective as of September 1, 2018. +The program was adopted to remain competitive in attracting and +retaining qualified board members and to better align director +compensation to other public companies of comparable size to the +Company. +Under +the new program, each non-employee director receives an annual +retainer fee of $50,000, payable in quarterly cash installments. +Each non-employee director also receives an annual grant of +restricted stock units with a value of $40,000 pursuant to the 2017 +Incentive Compensation Plan. Each restricted stock unit represents +a contingent right to receive one share of the Company’s +common stock. The restricted stock units vest in five equal annual +installments, beginning with the first anniversary of the grant +date, subject to the recipient’s continued service as a +director of the Company through such date, provided that, if the +director makes himself available and consents to be nominated by +the Company for continued service as a director of the Company, but +is not nominated for the Board of Directors for election by +stockholders, other than for good reason, as determined by the +Board in its discretion, then the restricted stock units will vest +in full as of the director’s last date of service as a +director of the Company. +Following +the adoption of the new director compensation program, which +provides for an annual grant of restricted stock units with a value +of $40,000, on September 6, 2018 the compensation committee granted +5,063 restricted stock units with a value of $20,000 to each of the +non-employee directors. The restricted stock units were granted to +the non-employee directors in light of the grant of 5,479 +restricted stock units with a value of $20,000 granted to each +non-employee director on June 4, 2018 after the 2018 annual +stockholders’ meeting. +50 +In +addition, the new director compensation program provides for an +additional annual cash retainer of $3,000, payable in quarterly +cash installments, for each Board committee served on, or an +additional annual cash retainer of $10,000, payable in quarterly +cash installments, per committee for service as committee chairman. +The Chairman and Co-Chairman of the Board also each receive an +additional annual cash retainer of $75,000, payable in quarterly +cash installments. All non-employee directors are entitled to +reimbursement of reasonable out-of-pocket expenses incurred by them +in connection with their attendance at meetings of the Board and +any committee thereof on which they serve. If a non-employee +director does not serve on the Board or a Board committee, or as +Chairman or Co-Chairman of the Board, or as a Board committee +chairman, for the full year, the Board and any applicable Board +committee, Board Chairman and Board Co-Chairman, as applicable, and +any Board committee chairman retainers are prorated for the portion +of the year served. If a non-employee director joins the Board +after the grant of restricted stock units for that year, the +non-employee director’s grant of restricted stock units will +be prorated for the portion of the year to be served. +The +Company’s 2017 Incentive Compensation Plan provides that the +aggregate grant date fair value of all awards granted to any single +non-employee director during any single calendar year (determined +as of the applicable grant date(s) under applicable financial +accounting rules), taken together with any cash fees paid to the +non-employee director during the same calendar year, may not exceed +$200,000. +Prior +to September 1, 2018, the Company paid to its non-employee +directors an annual retainer fee of $50,000, of which $30,000 was +payable in quarterly cash payments of $7,500, and $20,000 was +payable in the form of an annual grant of restricted stock units +pursuant to the 2017 Incentive Compensation Plan. The restricted +stock units were granted at the Board meeting coinciding with the +Company’s annual stockholders’ meeting and each +restricted stock unit represented a contingent right to receive one +share of the Company’s common stock. The restricted stock +units vest in full 12 months after the grant date, subject to the +recipient’s continued service as a director of the Company +through such date. The previous program also provided for an +additional $3,000 payable in cash each year for each Board +committee served on, or an additional $10,000 payable in cash each +year per committee for service as committee chairman. The Chairman +of the Board also received an additional $10,000 annual retainer +fee payable in cash. All non-employee directors were entitled to +reimbursement of reasonable expenses incurred by them in connection +with their attendance at meetings of the Board and any committee +thereof on which they served or otherwise in furtherance of the +Company’s business. If a non-employee director did not serve +on the Board or a Board committee or as Chairman of the Board or a +Board committee chairman for the full year, the Board and any +applicable Board committee or chairman retainers were prorated for +the portion of the year served. +The +following table shows the compensation paid to the Company’s +non-employee directors for fiscal 2018: +Name +Fees Earned or Paid in Cash ($) +Stock Awards ($) (2) +Option Awards ($) +Total ($) +D. Kyle +Cerminara (3) +90,750 +40,000 +— +130,750 +Michael R. +Dill (3) +46,000 +40,000 +— +86,000 +Lewis M. +Johnson (1)(3)(4) +87,000 +40,000 +— +127,000 +Charles T. +Lanktree (3)(4) +43,000 +40,000 +— +83,000 +General E. Gray +Payne (3) +54,250 +40,000 +— +94,250 +John W. +Struble (3) +50,000 +40,000 +— +90,000 +Ryan R.K. +Turner (3) +43,000 +40,000 +— +83,000 +(1) +Mr. Johnson was +appointed Co-Chairman of the Board on June 4, 2018. +51 +(2) +Stock awards +represent the aggregate grant date fair value of 5,479 restricted +stock units, or RSUs, granted on June 4, 2018 after the 2018 annual +stockholders’ meeting to each non-employee director who was +elected as a director at the meeting and the aggregate grant date +fair value of 5,063 RSUs granted on September 6, 2018 to each of +the non-employee directors. The Company granted the additional RSUs +on September 6, 2018 following the adoption of the Company’s +new director compensation program, effective as of September 1, +2018, which provides for an annual grant of RSUs with a total value +of $40,000 (RSUs with a value of $20,000 were granted to the +non-employee directors on September 6, 2018, in light of grants of +RSUs with a value of $20,000 made to the non-employee directors on +June 4, 2018). +The +RSUs were granted pursuant to the 2017 Incentive Compensation Plan +and represent a portion of the compensation payable to the +Company’s non-employee directors, as described above under +“Director Compensation Program.” Each RSU represents a +contingent right to receive one share of the Company’s common +stock. The 5,479 RSUs granted on June 4, 2018 vest in full 12 +months after the grant date and the 5,063 RSUs granted on September +6, 2018 vest in full in five equal annual installments, beginning +on the first anniversary of the grant date, in each case subject to +the director’s continued service as a director of the Company +through such date, provided that, solely with respect to the RSUs +granted on September 6, 2018, if the director makes himself +available and consents to be nominated by the Company for continued +service as a director of the Company, but is not nominated for the +Board for election by stockholders, other than for good reason, as +determined by the Board in its discretion, then the RSUs shall vest +in full as of the director’s last date of service as a +director of the Company. In addition, the 2017 Incentive +Compensation Plan and the RSU award agreements grant the +compensation committee the discretion to accelerate vesting of the +RSUs upon the occurrence of a “change in control” (as +defined under the plan) or in connection with the termination of +the director’s service for any reason prior to the vesting +date. The amounts shown represent the aggregate grant date fair +value computed in accordance with FASB Accounting Standards +Codification (ASC) Topic 718 “Compensation-Stock +Compensation” (“FASB ASC Topic 718”). For a +discussion of valuation assumptions, see Note 10 (Share-Based +Employee Compensation) of the consolidated financial statements +included in this Annual Report on Form 10-K for fiscal +2018. +(3) +The aggregate +number of option and stock awards outstanding (including exercised +and unexercised stock options and unvested RSUs) as of December 31, +2018 for each non-employee director was as follows: +Name +Option Awards (#) +Stock Awards (#) +D. Kyle Cerminara +10,000 (all exercisable) +10,542 RSUs +Michael +R. Dill +— +10,542 RSUs +Lewis M. Johnson +5,000 (all exercisable) +10,542 RSUs +Charles +T. Lanktree +— +10,542 RSUs +General +E. Gray Payne +5,000 (all exercisable) +10,542 RSUs +John W. +Struble +— +10,542 RSUs +Ryan +R.K. Turner +— +10,542 RSUs +Of the +10,542 RSUs outstanding for each director listed above as of +December 31, 2018, 5,479 RSUs (granted on June 4, 2018) vest in +full on June 4, 2019 and 5,063 RSUs (granted on September 6, 2018) +vest in full in five equal annual installments, beginning on +September 6, 2019, the first anniversary of the grant date, in each +case subject to the director’s continued service as a +director of the Company through such date, provided that, solely +with respect to the RSUs granted on September 6, 2018, if the +director makes himself available and consents to be nominated by +the Company for continued service as a director of the Company, but +is not nominated for the Board of Directors for election by +stockholders, other than for good reason, as determined by the +Board in its discretion, then the restricted stock units will vest +in full as of the director’s last date of service as a +director of the Company. See footnote 2 above for more +information. +(4) +Amount includes +fees ($33,750 for Mr. Johnson and $13,250 for Mr. Lanktree) earned +for Board and committee service in the fourth quarter of fiscal +2018 that were paid in January 2019. +52 +Item +12. Security Ownership of Certain Beneficial Owners and +Management and Related Stockholder Matters +The +table below sets forth information regarding the beneficial +ownership of the Company’s common stock as of February 19, +2019, by the following individuals or groups: +● +each +person who is known by the Company to own beneficially more than 5% +of the Company’s common stock; +● +each +of the Company’s directors; +● +each +of the Company’s named executive officers identified in the +“Summary Compensation Table For 2017-2018” appearing in +this Annual Report on Form 10-K; and +● +all +of the Company’s directors and executive officers as a +group. +Beneficial +ownership is determined in accordance with the rules of the SEC and +generally includes voting or investment power with respect to +securities. Shares of the Company’s common stock that are +subject to stock options that are presently exercisable or +exercisable within 60 days of February 19, 2019 are deemed to be +outstanding and beneficially owned by the person holding the stock +options for the purpose of computing the percentage of ownership of +that person, but are not treated as outstanding for the purpose of +computing the percentage of any other person. +Unless +indicated otherwise below, the address of the Company’s +directors and executive officers is c/o BK Technologies, Inc., 7100 +Technology Drive, West Melbourne, Florida 32904. Except as +indicated below, the persons named in the table have sole +voting and investment power with respect to all shares of common +stock beneficially owned by them. As of February 19, 2019, the +Company had outstanding 12,754,294 shares of common +stock. +Shares of Common Stock +Beneficially Owned +Name and Address of Beneficial Owner +Number of Shares +Percent of Class +Beneficial Owners of More Than 5% of Common Stock: +Fundamental +Global Investors, LLC +4,865,888 (1) +38.2% +D. Kyle +Cerminara, Chairman of the Board +4,881,367 (1)(2)(6)(9) +38.2% +Lewis +M. Johnson, Co-Chairman of the Board +4,876,367 (1)(3)(6)(9) +38.2% +Benchmark +Capital Advisors +1,526,473 (4) +12.0% +Donald +F.U. Goebert +1,264,508 (5) +9.9% +Directors +and Named Executive Officers (not otherwise included +above): +Timothy +A. Vitou, President +70,500 (6)(9) +* +William +P. Kelly, Executive Vice President and Chief Financial +Officer +88,827 (6)(7)(9) +* +Randy +Willis, Chief Operating Officer +9,000 (6)(9) +* +James +R. Holthaus, Chief Technology Officer +11,000 (6)(9) +* +Michael +R. Dill, Director +5,479 (9) +* +Charles +T. Lanktree, Director +13,395 (8)(9) +* +E. Gray +Payne, Director +20,479 (6)(9) +* +John W. +Struble, Director +5,479 (9) +* +Ryan +R.K. Turner, Director +5,831 (9) +* +All +current directors and executive officers as a group (11 +persons) +5,121,836 (9) +39.7% +*Less +than 1% +53 +(1) +The amount shown +and the following information is derived from a Schedule 13D/A +filed by Fundamental Global Investors, LLC ( “ Fundamental Global ” ) and its affiliates on September +14, 2018. Fundamental Global is deemed to beneficially own the +shares disclosed as directly owned by certain of its affiliates. +According to the Schedule 13D/A, CWA Asset Management Group, LLC +( “ CWA ” ) reports ownership of 1,840,514 +shares, or 14.4% of outstanding shares, which are held in its +customer accounts and are included in the number of shares listed +in the table above (including 817,131 shares held by CWA for +accounts owned by Joseph Moglia, an affiliate of Fundamental +Global). CWA has the dispositive power over the shares held in its +customer accounts while CWA’s customers retain the voting +power over their shares. CWA’s business address is 9130 +Galleria Court, Third Floor, Naples, Florida 34109. In addition, D. +Kyle Cerminara and Lewis M. Johnson, the Chairman and Co-Chairman +of the Company, respectively, and affiliates of Fundamental Global, +hold an additional 25,958 shares of common stock, which increases +the total number of shares beneficially owned by Fundamental Global +to 4,891,846, or 38.3% of outstanding shares. Fundamental Global +has shared voting power with respect to 3,025,374 of the shares +listed in the table above and dispositive power with respect to all +4,865,888 shares. Fundamental Global ’ s business address is 4201 Congress +Street, Suite 140, Charlotte, North Carolina 28209. +(2) +Mr. Cerminara is +the Chief Executive Officer, Co-Founder and Partner of Fundamental +Global and Co-Chief Investment Officer of CWA. Due to his positions +with Fundamental Global, Mr. Cerminara is deemed to beneficially +own the 4,865,888 shares disclosed as directly owned by certain +affiliates of Fundamental Global. Mr. Cerminara expressly disclaims +beneficial ownership of these shares. The business addresses for +Mr. Cerminara are c/o Fundamental Global Investors, LLC, 4201 +Congress Street, Suite 140, Charlotte, North Carolina 28209; c/o +Ballantyne Strong, Inc., 11422 Miracle Hills Drive, Suite 300, +Omaha, Nebraska 68154; and 131 Plantation Ridge Drive, Suite 100, +Mooresville, North Carolina 28117. +(3) +Mr. Johnson is the +President, Co-Founder and Partner of Fundamental Global and serves +as Co-Chief Investment Officer of CWA. Accordingly, Mr. Johnson is +deemed to beneficially own the 4,865,888 shares disclosed as +directly held by affiliates of Fundamental Global. Mr. Johnson +expressly disclaims beneficial ownership of these shares. The +business addresses for Mr. Johnson are c/o Fundamental Global +Investors, LLC, 4201 Congress Street, Suite 140, Charlotte, North +Carolina 28209; and c/o CWA Asset Management Group, LLC, 9130 +Galleria Court, Third Floor, Naples, Florida 34109. +(4) +The amount shown +and the following information is derived from a Schedule 13G/A +filed by Benchmark Capital Advisors ( “ Benchmark ” ) on April 27, 2018. According to +the Schedule 13G/A, Benchmark beneficially owns 1,526,473 shares, +and has sole voting and dispositive power with respect 933,924 of +these shares and shared voting and dispositive power with respect +to 592,549 of these shares. Benchmark ’ s business address is 14 Wall +Street, Suite 2087, New York, New York 10005. +(5) +The amount shown is +based on Mr. Goebert’s Form 4 filed on December 30, 2016, +plus 6,225 shares acquired upon option exercises since the filing +of the Form 4, and reflects the repurchase by the Company on +December 12, 2018 of 200,000 shares of common stock held by Mr. +Goebert. Mr. Goebert’s primary address is 3382 Harbor Road +S., Tequesta, Florida 33469. +(6) +Share ownership of +the following persons includes options to purchase common shares +presently exercisable or exercisable within 60 days of February 19, +2019, as follows: for Mr. Cerminara – 10,000 shares; for Mr. Johnson +– 5,000 shares; for Mr. +Vitou – 38,000 shares; for Mr. Kelly – 62,000 shares; for Mr. Willis +– 9,000 shares; for Mr. Holthaus – 11,000 shares; and +for Mr. Payne – 5,000 shares. +(7) +Includes 26,827 +shares held jointly by Mr. Kelly with his wife. +(8) +Includes 7,702 +shares directly owned by the Donna B. Lanktree Family Trust, the +trustee of which is Donna B. Lanktree, the spouse of Mr. +Lanktree. +54 +(9) +Includes 4,865,888 +shares reported as beneficially owned by Fundamental Global, of +which Messrs. Cerminara and Johnson are deemed to have beneficial +ownership by virtue of their respective positions with Fundamental +Global. Includes 26,827 shares held jointly by Mr. Kelly with his +wife. Includes 7,702 shares directly owned by the Donna B. Lanktree +Family Trust, the trustee of which is Donna B. Lanktree, the spouse +of Mr. Lanktree. Includes options to purchase common shares +presently exercisable or exercisable within 60 days of February 19, +2019, as follows: for Mr. Cerminara – 10,000 shares; for Mr. Johnson +– 5,000 shares; for Mr. +Vitou – 38,000 shares; for Mr. Kelly – 62,000 shares; for Mr. Willis +– 9,000 shares; for Mr. Holthaus – 11,000 shares; and +for Mr. Payne – 5,000 shares. +The +following options are not reflected in the table, as they are not +presently exercisable or exercisable within 60 days of February 19, +2019: options to purchase 39,000 common shares held by Mr. +Holthaus; options to purchase 47,000 common shares held by Mr. +Vitou; options to purchase 43,000 common shares held by Mr. Kelly; +and options to purchase 36,000 shares held by Mr. +Willis. +The +table also does not include 5,479 restricted stock units held by +each of Messrs. Cerminara, Dill, Johnson, Lanktree, Payne, Struble +and Turner, which were granted on June 4, 2018 and vest in full 12 +months after the grant date, subject to the recipient’s +continued service as a director of the Company through such date, +and 5,063 restricted stock units held by each of Messrs. Cerminara, +Dill, Johnson, Lanktree, Payne, Struble and Turner, which were +granted on September 6, 2018 and vest in five equal annual +installments, beginning on the first anniversary of the grant date, +subject to the director’s continued service as a director of +the Company through such date. All of the restricted stock units +were granted under the Company’s 2017 Incentive Compensation +Plan. Each restricted stock unit represents a contingent right to +receive one share of common stock of the Company. None of these +restricted stock units have vested as of February 19, 2019 or will +vest within 60 days of such date. +55 +EQUITY COMPENSATION PLAN INFORMATION +The following table provides information as of +December 31, 2018 with respect to the Company’s 2017 +Incentive Compensation Plan, under which the Company’s common +stock is authorized for issuance, and the 2007 Incentive +Compensation Plan. The Company’s stockholders approved the +2017 Incentive Compensation Plan at the 2017 annual +stockholders’ meeting. On December 31, 2018, 519,353 shares +of common stock were available for issuance under the 2017 +Incentive Compensation Plan . +Plan Category +(a) +Number of securities to be issued upon exercise of outstanding +options, warrants and rights (1) +(b) +Weighted- average exercise price of outstanding options, warrants +and rights +(c) +Number of securities remaining available for future issuance under +equity compensation plan (excluding securities reflected in column +(a)) (2) +Equity compensation +plans approved by security holders +460,500 +$ 4.22 +519,353 +Equity compensation +plans not approved by security holders +— +— +— +Total +460,500 +$ 4.22 +519,353 +(1) +Includes +220,000 shares issuable upon the exercise of awards outstanding +under the 2017 Incentive Compensation Plan and 240,500 shares +issuable upon the exercise of awards outstanding under the 2007 +Incentive Compensation Plan. +(2) +Represents +shares available for issuance under the 2017 Incentive Compensation +Plan. +56 +Item 13. Certain Relationships and Related Transactions, +and Director Independence +TRANSACTIONS WITH RELATED PERSONS +Any +transaction with a related person is subject to the Company’s +written policy for transactions with related persons, which is +available on the Company’s website at +www.bktechnologies.com/investor-relations. The nominating and +corporate governance committee is responsible for applying this +policy. As set forth in the policy, the committee reviews the +material facts of the transaction and considers, among other +factors it deems appropriate, whether the transaction is on terms +no less favorable than terms generally available to an unaffiliated +third-party under the same or similar circumstances and the extent +of the related person’s interest in the transaction. The +policy also prohibits the Company’s directors from +participating in any discussion or approval of any interested +transaction for which he is a related person, except that the +director is required to provide all material information concerning +the transaction to the committee. +If +a transaction with a related party will be ongoing, the committee +will establish guidelines for the Company’s management to +follow in its ongoing relationships with the related person, will +review and assess ongoing relationships with the related person to +determine if such relationships are in compliance with the +committee’s guidelines, and based on all the relevant facts +and circumstances, will determine if it is in the best interests of +the Company and its stockholders to continue, modify or terminate +any such interested transaction. +The +policy provides exceptions for certain transactions, including (i) +those involving compensation paid to a director or executive +officer required to be reported in the Company’s proxy +statement, (ii) transactions with another company at which a +related person’s only relationship is as an employee (other +than an executive officer), director or beneficial owner of less +than 10% of that company’s shares, if the aggregate amount +involved does not exceed the greater of $500,000, or two percent +(2%) of that company’s total annual revenues, (iii) certain +charitable contributions, (iv) transactions where all stockholders +of the Company receive proportional benefits, (v) transactions +involving competitive bids, (vi) certain regulated transactions, +and (vii) certain banking-related services. +Repurchase of Common Shares +On +December 12, 2018, the Company entered into a purchase agreement +with Donald F.U. Goebert, a greater-than-five percent stockholder +of the Company, pursuant to which the Company repurchased 200,000 +shares of the Company’s common stock held by Mr. Goebert, at +a price of $3.70 per share, for an aggregate cash amount of +$740,000. The transaction was approved by the Board of Directors of +the Company. Mr. Goebert previously served as a director of the +Company until his resignation on January 9, 2017. +Payments to Consulting Firm +On +March 14, 2018, Randy Willis was appointed as Chief Operating +Officer of the Company, having served as Vice President of +Operations of the Company since August 2017. Prior to Mr. Willis +joining the Company in August 2017, the Company engaged Target +Velocity Consulting, Inc., of which Mr. Willis is President, to +provide operational consulting services to the Company in 2017 for +the total fees of $59,616. See also Part III–Item 11. +Executive Compensation in this report. +Except +as set forth above, during 2018 and 2017, the Company did not have +any transactions with related persons that were reportable under +Item 404 of Regulation S-K, and the Company does not have any +transactions with related persons currently proposed for 2019 that +are reportable under Item 404 of Regulation S-K. +57 +DIRECTOR INDEPENDENCE +In accordance with the NYSE American corporate +governance listing standards, it is the Company’s policy that +the Board of Directors consist of a majority of independent +directors. The Board of Directors reviews the relationships that +each director has with the Company and other parties. Only those +directors who do not have any of the categorical relationships that +preclude them from being independent within the independence +requirements of the NYSE American corporate governance listing +standards and who the Board of Directors affirmatively determines +have no relationships that would interfere with the exercise of +independent judgment in carrying out the responsibilities of a +director are considered to be independent directors. The Board of +Directors has reviewed a number of factors to evaluate the +independence of each of its members. These factors include its +members’ current and historic relationships with the +Company and its subsidiaries; their relationships with management +and other directors; the relationships their current and former +employers have with the Company and its subsidiaries; and the +relationships between the Company and other companies of which the +Company’s Board members are directors or executive officers. +After evaluating these factors, the Board of Directors has +determined that all seven members are +“independent” directors within the independence +requirements of the NYSE American corporate governance listing +standards and all applicable rules and regulations of the SEC. In +addition, all Board committee +members are independent for the purpose of the committees on which +they serve. +Independent +members of the Board of Directors meet in executive session without +management present, and are scheduled to do so at least once per +year. +Item 14. Principal Accountant Fees and Services +The +following table represents the aggregate fees billed by the +Company’s independent registered public accounting firm, +Moore Stephens Lovelace, P.A., for services rendered to the Company +for each of the years ended December 31, 2018 and +2017. +Fees (1)(2)(3)(4) +2018 +2017 +Audit +Fees +$ 135,000 +$ 135,000 +Audited-Related +Fees +— +— +Tax +Fees +— +— +All +Other Fees +— +— +Total +$ 135,000 +$ 135,000 +(1) +For 2018 and 2017, +includes fees paid to Moore Stephens Lovelace, P.A. for +professional services rendered for the audit of the Company’s +annual financial statements for the years ended December 31, 2018 +and 2017 and for reviews of the financial statements included in +the Company’s Quarterly Reports on Form 10-Q for the fiscal +quarters ended March 31, June 30 and September 30 in each of those +years. +(2) +No audit-related +services were performed for the Company by Moore Stephens Lovelace, +P.A. in 2018 or 2017. Audit-related services include assurance and +related services that are related to the performance of the audit +or review of the Company’s financial +statements. +(3) +No tax services +were performed for the Company by Moore Stephens Lovelace, P.A. in +2018 or 2017. Tax services include tax compliance, tax advice and +tax planning. +(4) +No +other services were performed for the Company by Moore Stephens +Lovelace, P.A. in 2018 or 2017. +The +audit committee has adopted a formal policy concerning approval of +audit and non-audit services to be provided by the Company’s +independent registered public accounting firm, Moore Stephens +Lovelace, P.A. The policy requires that all services to be provided +by Moore Stephens Lovelace, P.A., including audit services and +permitted audit-related and non-audit services, must be +pre-approved by the audit committee. The audit committee approved +all audit services provided by Moore Stephens Lovelace, P.A. to the +Company during 2018. Moore Stephens Lovelace, P.A. did not provide +any audit-related or non-audit services to the Company during +2018. +The +audit committee has determined that the provision of the services +by Moore Stephens Lovelace, P.A. reported hereunder had no impact +on its independence. +58 +PART IV +Item 15. Exhibits and Financial Statement +Schedules +(a) +The following +documents are filed as a part of this report: +1. +Consolidated Financial Statements listed below: +Page +Report +of Independent Registered Public Accounting Firm +F-1 +Consolidated +Balance Sheets as of December 31, 2018 and 2017 +F-2 +Consolidated +Statements of Operations - years ended December 31, 2018 and +2017 +F-3 +Consolidated +Statements of Comprehensive Loss - years ended December 31, 2018 +and 2017 +F-3 +Consolidated +Statements of Changes in Stockholders’ Equity - years ended +December 31, 2018 and 2017 +F-4 +Consolidated +Statements of Cash Flows - years ended December 31, 2017 and +2016 +F-5 +Notes +to Consolidated Financial Statements +F-6 +(b) +Exhibits: +Number +Exhibit +3.1 +Articles +of Incorporation (incorporated by reference from Exhibit 3(i) to +the Company’s Annual Report on Form 10-K for the year +ended December 31, 1997) +3.2 +Certificate +of Amendment to Articles of Incorporation (incorporated by +reference from Exhibit 10.3 to the Company’s Quarterly Report +on Form 10-Q for the quarter ended September 30, 2001) +3.3 +Certificate +of Amendment to Articles of Incorporation (2018) (Incorporated by +reference from Exhibit 3.1 to the Company’s Current Report on +Form 8-K filed June 4, 2018) +3.4 +Second +Amended and Restated Bylaws (Incorporated by reference from Exhibit +3.2 to the Company’s Current Report on Form 8-K filed June 4, +2018) +10.1+ +2007 +Incentive Compensation Plan (incorporated by reference from Annex G +to the Company’s Definitive Proxy Statement on Schedule 14A +filed April 5, 2007, relating to the 2007 annual +stockholders’ meeting) +10.2+ +Amendment +to the 2007 Incentive Compensation Plan, effective as of March 17, +2017 (incorporated by reference from Exhibit 10.1 to the +Company’s Current Report on Form 8-K filed March 21, +2017) +10.3+ +Form of +2007 Incentive Compensation Plan Stock Option Agreement +(incorporated by reference from Exhibit 10.15 to the +Company’s Annual Report on Form 10-K for the year ended +December 31, 2012) +10.4 +Loan +and Security Agreement, dated as of October 23, 2008, by and +among Silicon Valley Bank, the Company and RELM Communications, +Inc. (incorporated by reference from Exhibit 10.1 to the +Company’s Current Report on Form 8-K filed October 28, +2008) +10.5 +First +Amendment to Loan and Security Agreement, dated as of +October 20, 2010, by and among Silicon Valley Bank, the +Company and RELM Communications, Inc. (incorporated by reference +from Exhibit 10.1 to the Company’s Current Report on Form 8-K +filed on October 20, 2010) +10.6 +Second +Amendment to Loan and Security Agreement, dated as of June 22, +2011, by and among Silicon Valley Bank, the Company and RELM +Communications, Inc. (incorporated by reference from Exhibit 10.1 +to the Company’s Current Report on Form 8-K filed on June 22, +2011) +10.7 +Third +Amendment to Loan and Security Agreement, dated as of December 18, +2012, by and among Silicon Valley Bank, the Company and RELM +Communications, Inc. (incorporated by reference from Exhibit 10.1 +to the Company’s Current Report on Form 8-K filed on December +19, 2012) +10.8 +Fourth +Amendment to Loan and Security Agreement, dated as of January 28, +2015 and effective as of December 31, 2014, by and among Silicon +Valley Bank, the Company and RELM Communications, Inc. +(incorporated by reference from Exhibit 10.1 to the Company’s +Current Report on Form 8-K filed on January 28, 2015) +10.9 +Fifth +Amendment to Loan and Security Agreement, dated as of December 29, +2015, by and among Silicon Valley Bank, the Company and RELM +Communications, Inc. (incorporated by reference from Exhibit 10.1 +to the Company’s Current Report on Form 8-K filed on December +30, 2015) +59 +10.10 +Sixth +Amendment to Loan and Security Agreement, dated as of January 17, +2017 and effective as of December 28, 2016, by and among Silicon +Valley Bank, the Company and RELM Communications, Inc. +(incorporated by reference from Exhibit 10.1 to the Company’s +Current Report on Form 8-K filed on January 18, 2017) +10.11 +Seventh +Amendment to Loan and Security Agreement, dated as of January 8, +2018 and effective as of December 27, 2017, by and among Silicon +Valley Bank, the Company and RELM Communications, Inc. +(incorporated by reference from Exhibit 10.1 to the Company’s +Current Report on Form 8-K filed January 9, 2018) +10.12+ +Executive +Change of Control Agreement, dated and effective as of February 24, +2016, by and between RELM Wireless Corporation and Timothy A. Vitou +(incorporated by reference from Exhibit 10.1 to the Company’s +Quarterly Report for the quarter ended March 31, 2017) +10.13+ +Executive +Change of Control Agreement, dated and effective as of February 24, +2016, by and between the Company and William P. Kelly (incorporated +by reference from Exhibit 10.2 to the Company’s Current +Report on Form 8-K filed February 25, 2016) +10.14+ +2017 +Incentive Compensation Plan (incorporated by reference from Exhibit +4.5 to the Company’s Registration Statement on Form S-8 filed +June 15, 2017) +10.15+ +Form of +Stock Option Agreement under the 2017 Incentive Compensation Plan +(incorporated by reference from Exhibit 4.6 to the Company’s +Registration Statement on Form S-8 filed June 15, +2017) +10.16+ +Form of +Restricted Share Agreement under the 2017 Incentive Compensation +Plan (incorporated by reference from Exhibit 4.7 to the +Company’s Registration Statement on Form S-8 filed June 15, +2017) +10.17+ +Form of +Restricted Stock Unit Agreement under the 2017 Incentive +Compensation Plan (incorporated by reference from Exhibit 4.8 to +the Company’s Registration Statement on Form S-8 filed June +15, 2017) +10.18+ +Form of +Non-Employee Director Restricted Share Unit Agreement under the +2017 Incentive Compensation Plan (September 2018) (Incorporated by +reference from Exhibit 10.1 to the Company’s Quarterly Report +on Form 10-Q filed November 7, 2018) +10.19 +Purchase +Agreement, dated December 12, 2018, by and between the Company, as +Purchaser, and Donald F.U. Goebert, as Seller (Incorporated by +reference from Exhibit 10.1 to the Company’s Current Report +on Form 8-K filed on December 13, 2018) +10.20 + +Relocation +Agreement, dated December 31, 2018, between the Company and Henry +R. (Randy) Willis* +21 +Subsidiaries +of the Company* +23.1 +Consent +of Moore Stephens Lovelace, P.A. (relating to the Company’s +Registration Statements on Form S-8) (Registration +No. 333-218765 and Registration +No. 333-147354)* +24 +Power +of Attorney (included on signature page) +31.1 +Certification +Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant +to Section 302 of the Sarbanes-Oxley Act of 2002* +31.2 +Certification +Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant +to Section 302 of the Sarbanes-Oxley Act of 2002* +32.1 +Certification +Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002 (furnished +pursuant to Item 601(b)(32) of Regulation S-K)** +32.2 +Certification +Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section +906 of the Sarbanes-Oxley Act of 2002 (furnished pursuant to Item +601(b)(32) of Regulation S-K)** +60 +101.INS +XBRL +Instance Document* +101.SCH +XBRL +Taxonomy Extension Schema Document* +101.CAL +XBRL +Taxonomy Extension Calculation Linkbase Document* +101.LAB +XBRL +Taxonomy Extension Label Linkbase Document* +101.PRE +XBRL +Taxonomy Extension Presentation Linkbase Document* +101.DEF +XBRL +Taxonomy Definition Linkbase Document* +_______________ +* +Included with this filing. +** +Furnished herewith (not filed). ++ Each +management contract or compensatory plan or +arrangement. +(c) +Consolidated +Financial Statement Schedules: +All +schedules have been omitted because they are inapplicable or not +material, or the information called for thereby is included in the +Consolidated Financial Statements and notes thereto. +Item 16. Form 10-K Summary +None. +61 +SIGNATURES +Pursuant to the +requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned, thereunto duly authorized +in the City of West Melbourne, Florida, on the 27th day of +February, 2019. +BK TECHNOLOGIES, INC. +By: +/s/ +Timothy A. Vitou +Timothy +A. Vitou +President +P OWER OF ATTORNEY +Each +person whose signature appears below hereby constitutes and +appoints Timothy A. Vitou and William P. Kelly, and each of them, +his attorneys-in-fact, each with the power of substitution, for him +and in his name, place and stead, in any and all capacities, to +sign this annual report on Form 10-K and any and all amendments to +this report on Form 10-K, and to file the same, with all +exhibits thereto and all documents in connection therewith, with +the Securities and Exchange Commission, granting unto said +attorneys-in-fact and agents, and each of them, full power and +authority to do and perform each and every act and all intents and +purposes as he might or could do in person, hereby ratifying and +confirming all that such attorneys-in-fact and agents or any of +them or his or their substitute or substitutes, may lawfully do or +cause to be done by virtue hereof. +Pursuant to the +requirements of the Securities Exchange Act of 1934, this report +has been signed below by the following persons on behalf of the +Registrant and in the capacities and on the dates +indicated. +SIGNATURE +TITLE +DATE +/s/ D. Kyle +Cerminara +Chairman of the +Board +February 27, +2019 +D. Kyle +Cerminara +/s/ Lewis M. +Johnson +Co-Chairman of the +Board +February 27, +2019 +Lewis M. +Johnson +/s/ +Timothy +A. Vitou +President +(Principal Executive Officer) +February 27, +2019 +Timothy A. +Vitou +/s/ William P. +Kelly +Executive Vice +President and Chief Financial Officer +February 27, +2019 +William P. +Kelly +(Principal +Financial Officer and Principal Accounting +Officer) +/s/ Michael R. +Dill +Director +February 27, +2019 +Michael R. +Dill +/s/ Charles T. +Lanktree +Director +February 27, +2019 +Charles T. +Lanktree +/s/ E. Gray +Payne +Director +February 27, +2019 +E. Gray +Payne +/s/ John W. +Struble +Director +February 27, +2019 +John W. +Struble +/s/ Ryan R.K. +Turner +Director +February 27, +2019 +Ryan R.K. +Turner +62 \ No newline at end of file diff --git a/raw/filings/0000002186/2018/0001654954-19-002033/filing_metadata.csv b/raw/filings/0000002186/2018/0001654954-19-002033/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..83bde04d0d3941222d94a9fd936f93fb53adacc0 --- /dev/null +++ b/raw/filings/0000002186/2018/0001654954-19-002033/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002186,BKTI,BK Technologies Corp,2018,10-K,2019-02-27,2018-12-31,2019-02-27T21:36:34.000Z,0001654954-19-002033,bkti_10k.htm,ANNUAL REPORT,4028346,1,0,https://www.sec.gov/Archives/edgar/data/2186/000165495419002033/bkti_10k.htm,https://www.sec.gov/Archives/edgar/data/2186/000165495419002033/ diff --git a/raw/filings/0000002186/2018/0001654954-19-002033/item1.txt b/raw/filings/0000002186/2018/0001654954-19-002033/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..e1c8f5e22c40cdc85a81472426c5b5a2b36f6c7f --- /dev/null +++ b/raw/filings/0000002186/2018/0001654954-19-002033/item1.txt @@ -0,0 +1,564 @@ +Item +1. Business +General +BK +Technologies, Inc. (“BK,” the “Company,” +“we” or “us”) provides two-way radio +communications equipment of high quality and +reliability. +In +business for over 70 years, BK (NYSE American: BKTI) designs, +manufactures and markets wireless communications products +consisting of two-way land mobile radios (“LMRs”), +repeaters, base stations and related components and subsystems. +Two-way LMRs can be units that are hand-held (portable) or +installed in vehicles (mobile). Repeaters expand the range of +two-way LMRs, enabling them to operate over a wider area. Base +station components and subsystems are installed at radio +transmitter sites to improve performance by enhancing the signal +and reducing or eliminating signal interference and enabling the +use of one antenna for both transmission and reception. We employ +both analog and digital technologies in our products. +Our +digital technology is compliant with the Project 25 standard +(“P-25”) for digital LMR equipment. The P-25 has been +adopted by representatives from the Association of Public-Safety +Communications Officials-International (“APCO”), the +National Association of State Technology Directors +(“NASTD”), the United States (“U.S.”) +Federal Government and other public safety user organizations. Our +P-25 digital products and our analog products function in the very +high frequency (“VHF”) (136MHz – 174MHz), +ultra-high frequency (“UHF”) (380MHz – 470MHz, +450MHz – 520MHz), and 700-800 MHz bands. Our P-25 KNG and +KNG2 Series mobile and portable digital radios have been validated +under the P-25 Compliance Assessment Program (“CAP”) as +being P-25 compliant and interoperable with the communications +network infrastructure of six of our competitors. Since we do not +provide our own communications network infrastructure, we believe +CAP validation provides confidence for federal, state and local +emergency response agencies that our products are a viable and +attractive alternative for use on the infrastructure of our +competitors. +We +offer products under the brand names BK Technologies, BK Radio and +RELM. Generally, BK Technologies and BK Radio-branded products +serve the government and public safety market, while RELM-branded +products serve the business and industrial market. +BK +Technologies and BK Radio-branded products consist of +high-specification LMR equipment for professional radio users +primarily in government, public safety and military applications. +These products have more extensive features and capabilities than +those offered in the RELM line. Our P-25 digital products are +marketed under the BK Radio brand, which includes the +new-generation KNG and KNG2 product lines. In addition, we +anticipate introducing the first model in our line of multi-band +products to complement our existing KNG products during 2019. +RELM-branded products provide basic yet feature-rich and reliable +two-way communications for commercial and industrial concerns, such +as hotels, construction firms, schools and transportation services. +Typically, these users are not radio professionals and require +easy, fast and affordable communication among a defined group of +users. +We +believe that we provide superior value to a wide array of customers +with demanding requirements, including, for example, emergency +response, public safety, homeland security and military customers +of federal and state government agencies, as well as various +commercial enterprises. Our two-way radio products excel in +applications with harsh and hazardous conditions. They provide +high-specification performance, durability and reliability at a +lower cost relative to comparable offerings. +We were +incorporated under the laws of the State of Nevada on October 24, +1997. We are the resulting corporation from the reincorporation +merger of our predecessor, Adage, Inc., a Pennsylvania corporation, +which reincorporated from Pennsylvania to Nevada effective as of +January 30, 1998. Effective on June 4, 2018, we changed our +corporate name from “RELM Wireless Corporation” to +“BK Technologies, Inc.” Our principal executive offices +are located at 7100 Technology Drive, West Melbourne, Florida 32904 +and our telephone number is (321) 984-1414. +1 +Available Information +Our +Internet website address is www.bktechnologies.com. We make +available on our Internet website, free of charge, our Annual +Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current +Reports on Form 8-K, proxy statements and amendments to these +reports as soon as practicable after we file or furnish such +material with or to the U.S. Securities and Exchange Commission +(the “SEC”). In addition, our Code of Business Conduct +and Ethics, Code of Ethics for the CEO and Senior Financial +Officers, Audit Committee Charter, Compensation Committee Charter, +Nominating and Governance Committee Charter and other corporate +governance policies are available on our website, under +“Investor Relations.” The information contained on our +website is not incorporated by reference in this report. A copy of +any of these materials may be obtained, free of charge, upon +request from our investor relations department. All reports that +the Company files with or furnishes to the SEC also are available +free of charge via the SEC’s website at +http://www.sec.gov. +Significant Events of 2018 +In +September 2018, the Company announced that it was selected as a +supplier under the Subscriber Unit Radio and Accessory Contract +(“SURAC”) issued by the U.S. Army, and received its +first task orders under the contract totaling approximately $0.8 +million. The task orders were for the Company’s UHF portable +radios and related accessories. The SURAC contract is intended to +serve as the U.S. Army’s primary contract vehicle for +procuring P-25 digital communications equipment. The Company was +one of five companies selected by the U.S. Army. The maximum total +value of the contract is $495 million over a five-year period that +commenced on June 18, 2018, and ends on June 18, 2023. The contract +does not specify purchase dates or quantities of equipment from any +particular named supplier, and there is no assurance that the +Company will receive any additional orders. +In July +2018, the Transportation Security Administration +(“TSA”) of the U.S. Department of Homeland Security +(“DHS”) exercised its third one-year option, extending +its contract with the Company for an additional year to September +27, 2019. The option provides for the purchase of up to $2 million +of the Company’s products; however, precise dates for +quantities or deliveries are not specified. The original contract +awarded in September 2015 totaled $26.2 million, with $15.5 million +in firm delivery orders and $10.7 million in potential option +exercises. +During +2018, pursuant to the Company’s capital return program, the +Company declared and paid four quarterly dividends of $0.02 per +share of the Company’s common stock. The Company has paid +eleven consecutive quarterly dividends. +In June +2018, the Company announced that it received orders totaling +approximately $4.5 million for BK Radio-brand KNG-series portable +and mobile radios and related accessories that will be deployed by +a California State public safety agency. The orders were fulfilled +in 2018. +In June +2018, the Company changed its name from “RELM Wireless +Corporation” to “BK Technologies, Inc.” The +Company’s stock began trading on the NYSE American stock +exchange under the new ticker symbol “BKTI” on June 5, +2018. Stockholders approved the name change at the annual meeting +of stockholders held on June 4, 2018. +In +February 2018, the Company announced that it received a purchase +order totaling approximately $2.0 million from Alberta Health +Services for P-25 800MHz portable and mobile radios with +accessories. The order was fulfilled in the first quarter of +2018. +In +February 2018, the Company announced that it received orders +totaling approximately $1.5 million from the U.S. Forest Service. +The orders were for RELM’s KNG-Series Digital P-25 portable +and mobile radios with accessories, and they were fulfilled in the +first quarter 2018. +2 +Industry Overview +LMR +communications consist of hand-held (portable) and vehicle-mounted +(mobile) two-way radios commonly used by the public safety sector +(e.g., police, fire, and emergency responders), military and +commercial business concerns (e.g., corporate disaster recovery, +hotels, airports, farms, transportation service providers, and +construction firms), and government agencies within the U.S. and +abroad. LMR systems are constructed to meet an organization’s +specific communications needs. The cost of a complete system can +vary widely, depending on the size and configuration. Likewise, the +cost of radio sets can range from under $100 for a basic analog +portable, to thousands of dollars for a fully featured P-25 digital +unit. Typically, there are no recurring airtime usage charges. +Accordingly, LMR usage patterns are considerably different from +those for cellular and other wireless communications tools. LMR +usage often consists of direct radio-to-radio communications +outside of the range of a communication network with one to many +members of a group. Also, LMR functions with push-to-talk operation +(i.e., no call set-up or dialing a phone number is required). LMR +communications often consist of multiple short (five second) +transmissions between multiple members of a group. For the public +safety sector, this is known as Mission Critical Voice. The average +useful life of a unit can vary, depending upon the application in +which the unit is deployed and its handling. +LMR +systems are the most widely-used and longest-used form of wireless +dispatch communications in the U.S., having been first placed in +service in 1921. LMR was initially used almost exclusively by law +enforcement, and all radio communications were transmitted in an +analog format. Analog transmissions typically consist of a voice or +other signal modulated directly onto a continuous radio carrier +wave. Over time, advances in technology decreased the cost of LMR +products and increased their popularity and usage by businesses and +other agencies. Responding to the growing usage, additional radio +frequency spectrum was allocated by the Federal Communications +Commission (“FCC”) for LMR use. +More +recently, growth of the LMR industry has slowed, reflecting several +factors: +● +LMR is a mature +industry, having been in existence for over 90 years; +● +some LMR users are +in mature industry segments that have experienced slow growth +rates; +● +funding and budgets +for government and public safety agencies have been constrained; +and +● +limited +availability of radio frequency spectrum, which hinders existing +users in expanding their systems and potential new users from +establishing new systems. +Years +ago, as a result of the limited spectrum availability, the FCC +mandated that new LMR equipment utilize technology that is more +spectrum-efficient. This effectively meant that the industry had to +migrate to digital technology. Responding to the mandate, the APCO, +the NASTD, the U.S. Federal Government and the Telecommunications +Industry Association (“TIA”), in concert with several +LMR manufacturers, including BK, recommended a standard for digital +LMR devices that would meet the FCC spectrum-efficiency +requirements and provide solutions to several problems experienced +primarily by public safety users. The standard is called P-25. The +primary objectives of P-25 are to: (i) allow effective and reliable +communication among users of compliant equipment, regardless of its +manufacturer, known as interoperability, (ii) maximize radio +spectrum efficiency and (iii) promote competition among LMR +providers through an open system architecture. +Although the FCC +does not require public safety agencies or any radio users to +purchase P-25 equipment or otherwise adopt the standard, compliance +with the standard is a primary consideration for government and +public safety purchasers. Users of nationally available 700 MHz +frequencies designed for interoperability are required to use P-25 +equipment. In addition, U.S. Federal Government grant programs that +provide assistance in funding for state and local agencies to +purchase interoperable communications equipment for first +responders strongly encourage compliance with P-25 standards. +Accordingly, although funding for LMR purchases by many government +agencies is limited, we believe that, as users upgrade equipment to +achieve interoperability and comply with FCC narrow-banding +mandates, demand for P-25 equipment will continue to grow. +Additionally, the P-25 standard has also been widely adopted in +other countries. The migration to P-25 equipment is primarily +limited to government and public safety agencies. Radio users in +the business and industrial market utilize alternative digital +technologies (e.g., Digital Mobile Radio) and analog LMR +products. +3 +Presently, the +market is dominated by one supplier, Motorola Solutions, Inc. +However, the open architecture of the P-25 standard is designed to +eliminate the ability of one or more suppliers to lock out +competitors. Formerly, because of proprietary characteristics +incorporated in many LMR systems, a customer was effectively +precluded from purchasing additional LMR products from a supplier +other than the initial supplier of the system. Additionally, the +system infrastructure technology was prohibitive for smaller +suppliers to develop and implement. P-25 provides an environment in +which users will increasingly have a wider selection of LMR +suppliers, including smaller suppliers such as BK. +Description of Products and P-25 CAP Compliance +We +design, manufacture, and market wireless communications equipment +consisting of two-way LMRs, repeaters, base stations and related +components and subsystems. We do not provide complete, integrated, +communications systems and infrastructure. Two-way LMRs can be +units that are hand-held (portable) or installed in vehicles +(mobile). Repeaters expand the range of two-way LMRs, enabling them +to communicate over a wider area. Base station components and +subsystems are installed at radio transmitter sites to improve +performance by enhancing the signal, reducing or eliminating signal +interference and enabling the use of one antenna for both +transmission and reception. +We +employ both analog and digital technologies in our products. Our +digital products are compliant with P-25 specifications. Our P-25 +digital products and our analog products function in the VHF +(136MHz – 174MHz), UHF (380MHz – 470MHz, 450MHz – +520MHz), and 700-800 MHz. +Our +P-25 KNG and KNG2 Series mobile and portable digital radios have +been validated under the P-25 CAP as being P-25 compliant and +interoperable with the communications network infrastructure of six +of our competitors. Since we do not provide our own communications +network infrastructure, we believe CAP validation provides +confidence for federal, state and local emergency response agencies +that our products are a viable and attractive alternative for use +on the infrastructure of our competitors. +The +P-25 CAP is a voluntary program that allows LMR equipment suppliers +to formally demonstrate their products’ compliance with P-25 +requirements. The purpose of the program is to provide federal, +state and local emergency response agencies with evidence that the +communications equipment they are purchasing satisfies P-25 +standards for performance, conformance and interoperability. The +program is a result of legislation passed by the U.S. Congress to +improve communication interoperability for first responders and is +a partnership of the DHS’s Command, Control and +Interoperability Division, the National Institute of Standards and +Technology, radio equipment manufacturers and the emergency +response community. +Description of Markets +Government and Public Safety Market +The +government and public safety market includes military, fire, +rescue, law enforcement, homeland security and emergency responder +personnel. In most instances, BK Radio-branded products serve this +market and are sold either directly to end-users or through two-way +communications dealers. Government and public safety sales +represented approximately 95% of our total sales for 2018 and 97% +for each of 2017 and 2016. +Government and +public safety users currently use products that employ either P-25 +digital or analog technology. However, public safety users in +federal, state and local government agencies and certain other +countries are migrating to solely using digital P-25 products. The +evolution of the standard and compliant digital products is +explained in the “Industry Overview” section at the beginning of this +report. +Business and Industrial Market +This +market includes enterprises of all sizes that require fast and +affordable push-to-talk communication among a discrete group of +users, such as corporate disaster recovery, hotels, construction +firms, schools and transportation service providers. Users in this +market continue to predominantly utilize analog products. We offer +products to this market under the RELM brand name. Our sales in +this market may be direct to end-users or to dealers and +distributors who then resell the products. Our sales to this market +represented approximately 5% of our total sales for 2018 and 3% for +each of 2017 and 2016. +4 +Engineering, Research and Development +Our +engineering and product development activities are conducted by a +team of 25 employees, combined with contract engineering resources. +Their primary development focus has been the design of a new line +of next-generation multiband P-25 digital products to supplement +our flagship KNG and KNG2 products. We anticipate the new multiband +product will be available in 2019 pending approval of the Federal +Communications Commission. The first models in the KNG line were +introduced in 2008 and are included on our primary federal contract +vehicles. Subsequently, we added UHF and 700-800MHz products, as +well as P-25 Phase II TDMA (Time Division Multiple Access) +trunking. The KNG2 Series was introduced in 2016. Our KNG and KNG2 +products also provide encrypted operation, GPS location and network +authentication capabilities. +A +segment of our engineering team is responsible for product +specifications based on customer requirements and participates in +quality assurance activities. They also have primary responsibility +for applied and production engineering. +For +2018, 2017 and 2016, our engineering and development expenses were +approximately $7.8 million, $5.0 million and +$4.1 million, respectively. +Intellectual Property +We +presently have no U.S. patents in force. We have registered federal +trademarks related to the names “BK Technologies” and +“BK Radio” and have applied for registration of +“Radios for Heroes” and “BKR.” We rely on +trade secret laws and employee and third-party nondisclosure +agreements to protect our intellectual property +rights. +Manufacturing and Raw Materials +Our +manufacturing strategy is to utilize the highest quality and most +cost-effective resources available for every aspect of our +manufacturing. Consistent with that strategy, for many years we +have successfully utilized outside contract arrangements for +different segments of our manufacturing operations. These +arrangements, some of which are with offshore concerns, have been +managed and updated to meet our present requirements, and they +continue to be instrumental in controlling our product costs, +allowing us to be competitive and manage our gross +margins. +Contract +manufacturers produce various subassemblies and products on our +behalf. Generally, the contract manufacturers procure raw materials +from BK-approved sources and complete manufacturing activities in +accordance with our specifications. Manufacturing agreements and +purchase orders govern the business relationship with the contract +manufacturers. These agreements and purchase orders have various +terms and conditions and may be renewed or modified upon agreement +by both parties. Their scope may also be expanded to include new +products in the future. +We plan +to continue utilizing contract manufacturing where it furthers our +business objectives. This strategy allows us to focus on our core +technological competencies of product design and development, and +to reduce the substantial capital investment required to +manufacture our products. We also believe that our use of +experienced, high-volume manufacturers will provide greater +manufacturing specialization and expertise, higher levels of +flexibility and responsiveness, and faster delivery of product, all +of which contribute toward product cost control. To ensure that +products manufactured by others meet our quality standards, our +production and engineering team works closely with our ISO 9002 +industry-qualified contract manufacturers in all key aspects of the +production process. We establish product specifications, select the +components and, in some cases, the suppliers. We retain all +document control. We also work with our contract manufacturers to +improve process control and product design and conduct periodic +on-site inspections. +5 +We rely +upon a limited number of both domestic and foreign suppliers for +several key products and components. Approximately 64.7% of our +material, subassembly and product procurements in 2018 were sourced +from three suppliers. We place purchase orders from time to time +with these suppliers and have no guaranteed supply arrangements. In +addition, certain components are obtained from single sources. +During 2018, 2017 and 2016, our operations were not materially +impaired due to delays from single-source suppliers. However, the +absence of a single-source component could potentially delay the +manufacture of finished products. We manage the risk of such delays +by securing secondary sources, where possible, and redesigning +products in response to component shortages or obsolescence. We +strive to maintain strong relationships with all of our suppliers. +We anticipate that the current relationships, or others that are +comparable, will be available to us in the future. +Seasonal Impact +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year budgets and appropriations. We may also +experience fluctuations in our quarterly results, derived, in part, +from sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +results. +Significant Customers +Sales +to the U.S. Government represented approximately 40%, 38% and 58% +of our total sales for the years ended December 31, 2018, 2017 and +2016, respectively. These sales were primarily to various +government agencies, including those within the DHS, the U.S. +Department of Defense (“DOD”), the U.S. Forest Service +(“USFS”) and the U.S. Department of Interior +(“DOI”). +Backlog +Our +backlog of unshipped customer orders was approximately $7.6 million +and $8.3 million as of December 31, 2018 and 2017, +respectively. The decrease was attributed primarily to the timing +and fulfillment of orders. +Competition +We +compete with other domestic and foreign companies primarily in the +North American market, but also internationally. One dominant +competitor, Motorola Solutions, Inc., is estimated to have well in +excess of half the market for LMR products. We compete by +capitalizing on our advantages and strengths, which include price, +product quality and customer responsiveness. +Government Regulation +We are +subject to various international and U.S. federal, state and local +laws affecting our business. Any finding that we have been or +are in noncompliance with such laws could result in, among other +things, governmental penalties. Further, changes in existing +laws or new laws may adversely affect our business and could also +have the effect of limiting capital expenditures by our customers, +which could have a material adverse effect on our business, +financial condition and results of operations. +In +connection with our U.S. Government contracts, we are subject to +the U.S. Federal Government procurement regulations that may +provide the buyer with the right to audit and review our +performance, as well as our compliance with applicable laws and +regulations. In addition, our business is subject to +government regulation based on the products we sell that may be +subject to government requirements, such as obtaining an export +license or end-user certificate from the buyer, in certain +circumstances. If a government audit uncovers improper +or illegal activities, or if we are alleged to have violated any +laws or regulations governing the products we sell under our +government contracts, we may be subject to civil and criminal +penalties and administrative sanctions, including termination of +contracts, forfeiture of profits, suspension of payments, fines and +suspension or debarment from doing business with U.S. Federal +Government agencies. +6 +Our +products are regulated by the FCC in the U.S. and similar agencies +in other countries where we offer our products. Consequently, +we and our customers could be positively or negatively affected by +the rules and regulations adopted from time to time by the FCC or +regulatory agencies in other countries. For example, our +wireless communications products, including two-way LMRs, are +subject to FCC regulations related to radio frequency +spectrum. As a result of limited spectrum availability, the +FCC has mandated that new LMR equipment utilize technology that is +more spectrum-efficient, which effectively meant that the industry +had to migrate to digital technology. These types of mandates +may provide us with new business opportunities or may require us to +modify all or some of our products so that they can continue to be +manufactured and marketed, which may lead to an increase in our +capital expenditures and research and development +expenses. +As a +public company, we are also subject to regulations of the SEC and +the stock exchange on which we are listed (NYSE +American). +Some of +our operations use substances regulated under various federal, +state, local and international laws governing the environment and +worker health and safety, including those governing the discharge +of pollutants into the ground, air and water, the management and +disposal of hazardous substances and wastes and the cleanup of +contaminated sites, as well as relating to the protection of the +environment. Certain of our products are subject to various +federal, state, local and international laws governing chemical +substances in electronic products. During 2018, compliance with +these U.S. federal, state and local and international laws did not +have a material effect on our capital expenditures, earnings or +competitive position. +Employees +As of +December 31, 2018, we had 119 employees, including 112 full-time +employees, most of whom are located at our West Melbourne, Florida +facility; 56 of these employees are engaged in direct manufacturing +or manufacturing support, 26 in engineering, 26 in sales and +marketing and 11 in headquarters, accounting and human resources +activities. Our employees are not represented by any collective +bargaining agreements, nor has there ever been a labor-related work +stoppage. We believe our relations with our employees are +good. +Information Relating to Domestic and Export Sales +The +following table summarizes our sales of LMR products by customer +location: +2018 +2017 +2016 +(in +millions) +United +States +$ 44.8 +$ 34.3 +$ 46.3 +International +4.6 +5.1 +4.4 +Total +$ 49.4 +$ 39.4 +$ 50.7 +Additional +financial information is provided in the Consolidated Financial +Statements included in this report. +7 \ No newline at end of file diff --git a/raw/filings/0000002186/2018/0001654954-19-002033/item13.txt b/raw/filings/0000002186/2018/0001654954-19-002033/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e9cd67a7e0fe1a8896c0e229236fc157a544ce82 --- /dev/null +++ b/raw/filings/0000002186/2018/0001654954-19-002033/item13.txt @@ -0,0 +1,5 @@ +Item +13. +Certain Relationships and Related Transactions, and Director +Independence +57 \ No newline at end of file diff --git a/raw/filings/0000002186/2019/0001654954-20-002248/filing.txt b/raw/filings/0000002186/2019/0001654954-20-002248/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..feb914789668615d90e9df964dec62d64d8a5193 --- /dev/null +++ b/raw/filings/0000002186/2019/0001654954-20-002248/filing.txt @@ -0,0 +1,5389 @@ +10-K +1 +bkti_10k.htm +ANNUAL REPORT +Blueprint +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +——————— +FORM 10-K +——————— +☒ ANNUAL +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +For the fiscal year ended December 31, 2019 +OR +☐ TRANSITION +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +For the transition period from __________ to +__________ +Commission file number: 001-32644 +——————— +BK TECHNOLOGIES CORPORATION +(Exact +name of registrant as specified in its charter) +——————— +Nevada +83-4064262 +(State +or other jurisdiction of incorporation or +organization) +(I.R.S. +Employer Identification No.) +7100 Technology Drive +West Melbourne, Florida 32904 +(Address +of principal executive offices) (Zip Code) +Registrant’s telephone number, including area code: (321) +984-1414 +Securities registered pursuant to Section 12(b) of the +Act: +Title +of Each Class +Trading +Symbol(s) +Name of +Each Exchange on Which Registered +Common +Stock, par value $.60 +BKTI +NYSE +American +Securities registered pursuant to Section 12(g) of the +Act: +None +Indicate by check +mark if the registrant is a well-known seasoned issuer, as defined +in Rule 405 of the Securities Act. Yes ☐ +No ☒ +Indicate by check +mark if the registrant is not required to file reports pursuant to +Section 13 or Section 15(d) of the Act. Yes ☐ +No ☒ +Indicate by check +mark whether the registrant: (1) has filed all reports required to +be filed by Section 13 or 15(d) of the Securities Exchange Act +of 1934 during the preceding 12 months (or for such shorter period +that the registrant was required to file such reports), and +(2) has been subject to such filing requirements for the past +90 days. Yes ☒ No ☐ +Indicate by check +mark whether the registrant has submitted electronically every +Interactive Data File required to be submitted pursuant to Rule 405 +of Regulation S-T (§ 232.405 of this chapter) during the +preceding 12 months (or for such shorter period that the registrant +was required to submit such files). Yes ☒ No +☐ +Indicate by check +mark whether the registrant is a large accelerated filer, an +accelerated filer, a non-accelerated filer, a smaller reporting +company, or an emerging growth company. See the definitions of +“large accelerated filer,” “accelerated +filer,” “smaller reporting company,” and +“emerging growth company” in Rule 12b-2 of the +Exchange Act. +Large +accelerated filer ☐ +Accelerated filer +☐ +Non-accelerated +filer ☒ +Smaller +reporting company ☒ +Emerging +growth company ☐ +If an +emerging growth company, indicate by check mark if the registrant +has elected not to use the extended transition period for complying +with any new or revised financial accounting standards provided +pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check +mark whether the registrant is a shell company (as defined in +Rule 12b-2 of the Act). Yes ☐ +No ☒ +The +aggregate market value of the voting and non-voting common equity +held by non-affiliates of the registrant on June 28, 2019, +based on the closing price of such stock on the NYSE American on +such date, was $27,554,176. As of February 20, 2020, 12,548,094 +shares of the registrant’s Common Stock were +outstanding. +Documents Incorporated by Reference: +Portions of the registrant’s +definitive proxy statement for its 2020 annual stockholders’ +meeting are incorporated by reference in Part III of this report. +The registrant’s definitive proxy statement will be filed +with the U.S. Securities and Exchange Commission within 120 days +after December 31, 2019 . +TABLE OF CONTENTS +Page +PART I +1 +Item +1. +Business +1 +Item +1A. +Risk +Factors +9 +Item +1B. +Unresolved Staff +Comments +19 +Item +2. +Properties +19 +Item +3. +Legal +Proceedings +19 +Item +4. +Mine Safety +Disclosures +19 +PART II +20 +Item +5. +Market For +Registrant’s Common Equity, Related Stockholder Matters and +Issuer Purchases of Equity Securities +20 +Item +6. +Selected Financial +Data +20 +Item +7. +Management’s +Discussion and Analysis of Financial Condition and Results of +Operations +21 +Item +7A. +Quantitative and +Qualitative Disclosures About Market Risk +30 +Item +8. +Financial +Statements and Supplementary Data +30 +Item +9. +Changes in and +Disagreements with Accountants on Accounting and Financial +Disclosure +31 +Item +9A. +Controls and +Procedures +31 +Item +9B. +Other +Information +31 +PART III +32 +Item +10. +Directors, +Executive Officers and Corporate Governance +32 +Item +11. +Executive +Compensation +32 +Item +12. +Security Ownership +of Certain Beneficial Owners and Management and Related Stockholder +Matters +32 +Item +13. +Certain +Relationships and Related Transactions, and Director +Independence +32 +Item +14. +Principal +Accounting Fees and Services +32 +PART IV +33 +Item +15. +Exhibits and +Financial Statement Schedules +33 +Item +16. +Form 10-K +Summary +34 +SIGNATURES +35 +PART I +I tem 1. Business +General +BK +Technologies Corporation (NYSE American: BKTI) (together with its +wholly owned subsidiaries, “BK,” the +“Company,” “we” or “us”) is a +holding company that, through BK Technologies, Inc., its operating +subsidiary, provides two-way radio communications equipment of high +quality and reliability. All operating activities described herein +are undertaken by our operating subsidiary. +In +business for over 70 years, BK designs, manufactures and markets +wireless communications products consisting of two-way land mobile +radios (“LMRs”), repeaters, base stations and related +components and subsystems. Two-way LMRs can be units that are +hand-held (portable) or installed in vehicles (mobile). Repeaters +expand the range of two-way LMRs, enabling them to operate over a +wider area. Base station components and subsystems are installed at +radio transmitter sites to improve performance by enhancing the +signal and reducing or eliminating signal interference and enabling +the use of one antenna for both transmission and reception. We +employ both analog and digital technologies in our +products. +Our +digital technology is compliant with the Project 25 standard +(“P-25”) for digital LMR equipment. The P-25 has been +adopted by representatives from the Association of Public-Safety +Communications Officials-International (“APCO”), the +National Association of State Technology Directors +(“NASTD”), the United States (“U.S.”) +Federal Government and other public safety user organizations. Our +P-25 digital products and our analog products function in the very +high frequency (“VHF”) (136MHz – 174MHz), +ultra-high frequency (“UHF”) (380MHz – 470MHz, +450MHz – 520MHz), and 700-800 MHz bands. Our P-25 KNG and +KNG2 Series mobile and portable digital radios have been validated +under the P-25 Compliance Assessment Program (“CAP”) as +being P-25 compliant and interoperable with the communications +network infrastructure of six of our competitors. Since we do not +provide our own communications network infrastructure, we believe +CAP validation provides confidence for federal, state and local +emergency response agencies that our products are a viable and +attractive alternative for use on the infrastructure of our +competitors. +We +offer products under the brand names BK Radio and RELM. Generally, +BK Technologies and BK Radio-branded products serve the government +and public safety market, while RELM-branded products serve the +business and industrial market. +BK +Technologies and BK Radio-branded products consist of +high-specification LMR equipment for professional radio users +primarily in government, public safety and military applications. +These products have more extensive features and capabilities than +those offered in the RELM line. Our P-25 digital products are +marketed under the BK Radio brand, which includes the KNG and KNG2 +product lines. RELM-branded products provide basic yet feature-rich +and reliable two-way communications for commercial and industrial +concerns, such as hotels, construction firms, schools and +transportation services. Typically, these users are not radio +professionals and require easy, fast and affordable communication +among a defined group of users. +We +believe that we provide superior value to a wide array of customers +with demanding requirements, including, for example, emergency +response, public safety, homeland security and military customers +of federal and state government agencies, as well as various +commercial enterprises. Our two-way radio products excel in +applications with harsh and hazardous conditions. They provide +high-specification performance, durability and reliability at a +lower cost relative to comparable offerings. +We were +incorporated under the laws of the State of Nevada on October 24, +1997. We are the resulting corporation from the reincorporation +merger of our predecessor, Adage, Inc., a Pennsylvania corporation, +which reincorporated from Pennsylvania to Nevada effective as of +January 30, 1998. Effective on June 4, 2018, we changed our +corporate name from “RELM Wireless Corporation” to +“BK Technologies, Inc.” +1 +On +March 28, 2019, we implemented a holding company reorganization. +The reorganization created a new holding company, BK Technologies +Corporation, which became the new parent company of BK +Technologies, Inc. BK Technologies Corporation’s only +significant assets are the outstanding equity interests in BK +Technologies, Inc. and any other future subsidiaries of BK +Technologies Corporation. The holding company reorganization was +intended to create a more efficient corporate structure and +increase operational flexibility. For +additional information regarding the reorganization, please see +below under “Significant Events.” +For +the purpose of this report, references to “we” or the +“Company” or our management or business at any period +prior to the holding company reorganization (March 28, 2019) refer +to those of BK Technologies, Inc. as the predecessor company and +its subsidiaries and thereafter to those of BK Technologies +Corporation and its subsidiaries, except as otherwise specified or +to the extent the context otherwise indicates. +Our +principal executive offices are located at 7100 Technology Drive, +West Melbourne, Florida 32904 and our telephone number is (321) +984-1414. +Available Information +Our +Internet website address is www.bktechnologies.com. We make +available on our Internet website, free of charge, our Annual +Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current +Reports on Form 8-K, proxy statements and amendments to these +reports as soon as practicable after we file such material with, or +furnish it to, the U.S. Securities and Exchange Commission (the +“SEC”). In addition, our Code of Business Conduct and +Ethics, Code of Ethics for the CEO and Senior Financial Officers, +Audit Committee Charter, Compensation Committee Charter, Nominating +and Governance Committee Charter and other corporate governance +policies are available on our website, under “Investor +Relations.” The information contained on our website is not +incorporated by reference in this report. A copy of any of these +materials may be obtained, free of charge, upon request from our +investor relations department. All reports that the Company files +with or furnishes to the SEC also are available free of charge via +the SEC’s website at http://www.sec.gov. +Significant Events +On +March 28, 2019, we implemented a holding company reorganization. +The reorganization created a new holding company, BK Technologies +Corporation, which became the new parent company of BK +Technologies, Inc. The holding company reorganization was intended +to create a more efficient corporate structure and increase +operational flexibility. We did not incur any material operational +or financial impacts in connection with the reorganization. The +holding company reorganization was effected through a merger +transaction among BK Technologies, Inc., BK Technologies +Corporation, then a wholly-owned subsidiary of BK Technologies, +Inc., and a former direct, wholly-owned subsidiary of BK +Technologies Corporation that merged with and into BK Technologies, +Inc., with BK Technologies, Inc. surviving as a wholly-owned +subsidiary of BK Technologies Corporation. The merger was a +tax-free transaction for U.S. federal income tax purposes for our +stockholders. No stockholder vote was required to effect the merger +transaction. +As part +of the holding company reorganization, stockholders of BK +Technologies, Inc. became stockholders of BK Technologies +Corporation, on a one-for-one basis, with the same number of shares +and same ownership percentage of common stock that they held +immediately prior to the holding company reorganization. Following +the reorganization, BK Technologies Corporation replaced BK +Technologies, Inc. as the publicly traded entity, and shares of BK +Technologies Corporation were listed on the NYSE American under the +symbol “BKTI,” which is the same symbol as previously +used by BK Technologies, Inc. Our common stock was assigned a new +CUSIP Number: 05587G 104. The holding company has the same +directors and executive officers as its predecessor, BK +Technologies, Inc. +On July +10, 2019, we announced that our operating subsidiary received an +order totaling approximately $3.1 million from the U.S. Forest +Service (“USFS”). The order was for KNG-Series Digital +P-25 portable and mobile radios with accessories. The order was +fulfilled in the third quarter of 2019. +2 +On July +11, 2019, we announced that our operating subsidiary received an +order totaling approximately $1.6 million for KNG-Series radios and +related accessories from a new California State customer. The order +was for KNG-Series Digital P-25 portable and mobile radios with +accessories and was fulfilled in the second quarter of +2019. +In +August 2019, the Transportation Security Administration +(“TSA”) of the U.S. Department of Homeland Security +(“DHS”) notified us of its intent to exercise its +fourth one-year option, extending the contract with us for an +additional year to September 27, 2020. The option provides for the +purchase of up to $2.0 million of our products. Concurrent with the +extension, the TSA placed a firm delivery order for equipment and +services totaling approximately $1.8 million of which approximately +$0.2 million was shipped in September 2019, and the remainder was +fulfilled in the fourth quarter of 2019. The original contract +awarded in September 2015 totaled $26.2 million, with $15.5 million +in firm delivery orders and $10.7 million in annual option +exercises. +On +January 15, 2020, we announced that our operating subsidiary +received an order totaling approximately $2.1 million for +KNG2-Series radios and related accessories from a California State +customer. The order was for KNG2-Series Digital P-25 portable +radios with accessories and was fulfilled in the fourth quarter of +2019. +During +2019, pursuant to our capital return program, we declared and paid +four quarterly dividends of $0.02 per share of our common stock. We +have paid fifteen consecutive quarterly dividends. In addition, we +declared a quarterly dividend of $0.02 per share of our common +stock on March 2, 2020, to be paid on April 13, 2020 to holders of +record as of March 31, 2020. +On +February 5, 2020, we announced that our operating subsidiary +received orders totaling approximately $2.8 million from the USFS. +The orders are for KNG-Series Digital P-25 portable radios, mobile +radios, and base stations, as well as related accessories. The +order is expected to be fulfilled in the first quarter of +2020. +In +December 2019, a strain of the coronavirus surfaced in Wuhan, +China. Subsequently, governmental and commercial efforts commenced +to contain the spread of the virus. As a result, some of our supply +chain partners in China temporarily suspended or modified their +business operations beyond the normal Chinese Lunar New Year +shutdown. In February 2020, operations resumed to varying degrees +at certain of our supply chain partners. These developments have not impacted our +operations to-date. The situation , however, is complex and rapidly-evolving. +The potential future impact on +our operations, if any, is uncertain. +Industry Overview +LMR +communications consist of hand-held (portable) and vehicle-mounted +(mobile) two-way radios commonly used by the public safety sector +(e.g., police, fire, and emergency responders), military and +commercial business concerns (e.g., corporate disaster recovery, +hotels, airports, farms, transportation service providers, and +construction firms), and government agencies within the U.S. and +abroad. LMR systems are constructed to meet an organization’s +specific communications needs. The cost of a complete system can +vary widely, depending on the size and configuration. Likewise, the +cost of radio sets can range from under $100 for a basic analog +portable, to thousands of dollars for a fully featured P-25 digital +unit. Typically, there are no recurring airtime usage charges. +Accordingly, LMR usage patterns are considerably different from +those for cellular and other wireless communications tools. LMR +usage often consists of direct radio-to-radio communications +outside of the range of a communication network with one to many +members of a group. Also, LMR functions with push-to-talk operation +(i.e., no call set-up or dialing a phone number is required). LMR +communications often consist of multiple short (five second) +transmissions between multiple members of a group. For the public +safety sector, this is known as Mission Critical Voice. The average +useful life of a unit can vary, depending upon the application in +which the unit is deployed and its handling. +LMR +systems are the most widely-used and longest-used form of wireless +dispatch communications in the U.S., having been first placed in +service in 1921. LMR was initially used almost exclusively by law +enforcement, and all radio communications were transmitted in an +analog format. Analog transmissions typically consist of a voice or +other signal modulated directly onto a continuous radio carrier +wave. Over time, advances in technology decreased the cost of LMR +products and increased their popularity and usage by businesses and +other agencies. Responding to the growing usage, additional radio +frequency spectrum was allocated by the Federal Communications +Commission (“FCC”) for LMR use. +3 +More +recently, growth of the LMR industry has slowed, reflecting several +factors: +● +LMR is a mature +industry, having been in existence for over 90 years; +● +some LMR users are +in mature industry segments that have experienced slow growth +rates; +● +funding and budgets +for government and public safety agencies have been constrained; +and +● +limited +availability of radio frequency spectrum, which hinders existing +users in expanding their systems and potential new users from +establishing new systems. +Years +ago, as a result of the limited spectrum availability, the FCC +mandated that new LMR equipment utilize technology that is more +spectrum-efficient. This effectively meant that the industry had to +migrate to digital technology. Responding to the mandate, the APCO, +the NASTD, the U.S. Federal Government and the Telecommunications +Industry Association (“TIA”), in concert with several +LMR manufacturers, including BK, recommended a standard for digital +LMR devices that would meet the FCC spectrum-efficiency +requirements and provide solutions to several problems experienced +primarily by public safety users. The standard is called P-25. The +primary objectives of P-25 are to: (i) allow effective and reliable +communication among users of compliant equipment, regardless of its +manufacturer, known as interoperability, (ii) maximize radio +spectrum efficiency and (iii) promote competition among LMR +providers through an open system architecture. +Although the FCC +does not require public safety agencies or any radio users to +purchase P-25 equipment or otherwise adopt the standard, compliance +with the standard is a primary consideration for government and +public safety purchasers. Users of nationally available 700 MHz +frequencies designed for interoperability are required to use P-25 +equipment. In addition, U.S. Federal Government grant programs that +provide assistance in funding for state and local agencies to +purchase interoperable communications equipment for first +responders strongly encourage compliance with the P-25 standard. +Accordingly, although funding for LMR purchases by many government +agencies is limited, we believe that, as users upgrade equipment to +achieve interoperability and comply with FCC narrow-banding +mandates, demand for P-25 equipment will continue to grow. +Additionally, the P-25 standard has also been widely adopted in +other countries. The migration to P-25 equipment is primarily +limited to government and public safety agencies. Radio users in +the business and industrial market utilize alternative digital +technologies (e.g., Digital Mobile Radio) and analog LMR +products. +Presently, the +market is dominated by one supplier, Motorola Solutions, Inc., +which offers a broader range of products than we do, including +multiband radios. However, the open architecture of the P-25 +standard is designed to eliminate the ability of one or more +suppliers to lock out competitors. Formerly, because of proprietary +characteristics incorporated in many LMR systems, a customer was +effectively precluded from purchasing additional LMR products from +a supplier other than the initial supplier of the system. +Additionally, the system infrastructure technology was prohibitive +for smaller suppliers to develop and implement. P-25 provides an +environment in which users will increasingly have a wider selection +of LMR suppliers, including smaller suppliers such as +BK. +Description of Products and P-25 CAP Compliance +We +design, manufacture, and market wireless communications equipment +consisting of two-way LMRs, repeaters, base stations and related +components and subsystems. We do not provide complete, integrated, +communications systems and infrastructure. Two-way LMRs can be +units that are hand-held (portable) or installed in vehicles +(mobile). Repeaters expand the range of two-way LMRs, enabling them +to communicate over a wider area. Base station components and +subsystems are installed at radio transmitter sites to improve +performance by enhancing the signal, reducing or eliminating signal +interference and enabling the use of one antenna for both +transmission and reception. +We +employ both analog and digital technologies in our products. Our +digital products are compliant with P-25 specifications. Our P-25 +digital products and our analog products function in the VHF +(136MHz – 174MHz), UHF (380MHz – 470MHz, 450MHz – +520MHz), and 700-800 MHz bands. +4 +Our +P-25 KNG and KNG2 Series mobile and portable digital radios have +been validated under the P-25 CAP as being P-25 compliant and +interoperable with the communications network infrastructure of six +of our competitors. Since we do not provide our own communications +network infrastructure, we believe CAP validation provides +confidence for federal, state and local emergency response agencies +that our products are a viable and attractive alternative for use +on the infrastructure of our competitors. +The +P-25 CAP is a voluntary program that allows LMR equipment suppliers +to formally demonstrate their products’ compliance with P-25 +requirements. The purpose of the program is to provide federal, +state and local emergency response agencies with evidence that the +communications equipment they are purchasing satisfies the P-25 +standard for performance, conformance and interoperability. The +program is a result of legislation passed by the U.S. Congress to +improve communication interoperability for first responders and is +a partnership of the DHS’s Command, Control and +Interoperability Division, the National Institute of Standards and +Technology, radio equipment manufacturers and the emergency +response community. +Description of Markets +Government and Public Safety Market +The +government and public safety market includes military, fire, +rescue, law enforcement, homeland security and emergency responder +personnel. In most instances, BK Radio-branded products serve this +market and are sold either directly to end-users or through two-way +communications dealers. Government and public safety sales +represented approximately 93% of our total sales for 2019 and 95% +for 2018. +Government and +public safety users currently use products that employ either P-25 +digital or analog technology. However, public safety users in +federal, state and local government agencies and certain other +countries are migrating to primarily using digital P-25 products. +The evolution of the standard and compliant digital products is +explained in the “Industry Overview” section above. +Business and Industrial Market +This +market includes enterprises of all sizes that require fast and +affordable push-to-talk communication among a discrete group of +users, such as corporate disaster recovery, hotels, construction +firms, schools and transportation service providers. Users in this +market continue to predominantly utilize analog products. We offer +products to this market under the RELM brand name. Our sales in +this market may be direct to end-users or to dealers and +distributors who then resell the products. Our sales to this market +represented approximately 7% of our total sales for 2019 and 5% for +2018. +Engineering, Research and Development +Our +engineering and product development activities are conducted by a +team of 18 employees, combined with contract engineering resources. +Their primary development focus has been the design of a new line +of next-generation P-25 digital products, the BKR Series, which we +expect to eventually supplant our flagship KNG and KNG2 products. +We anticipate that the first product in this line will be available +in 2020 pending approval of the FCC. The first models in the KNG +line were introduced in 2008 and are included on our primary +federal contract vehicles. Subsequently, we added UHF and +700-800MHz products, as well as P-25 Phase II TDMA (Time Division +Multiple Access) trunking. The KNG2 Series was introduced in 2016. +Our KNG and KNG2 products also provide encrypted operation, GPS +location and network authentication capabilities. +A +segment of our engineering team is responsible for product +specifications based on customer requirements and participates in +quality assurance activities. They also have primary responsibility +for applied and production engineering. +For +2019 and 2018, our engineering and development expenses were +approximately $9.8 million and $7.8 million, respectively. The +increase was primarily attributed to the development of a new line +of products, including multiband radios, that we anticipate will +supplant the KNG and KNG2 series. +5 +Intellectual Property +We +presently have no U.S. patents in force. We have registered federal +trademarks related to the names “BK Technologies,” +“BK Radio” and “Radios for Heroes” and have +applied for registration of “BKR.” We rely on trade +secret laws and employee and third-party nondisclosure agreements +to protect our intellectual property rights. +Manufacturing and Raw Materials +Our +manufacturing strategy is to utilize the highest quality and most +cost-effective resources available for every aspect of our +manufacturing. Consistent with that strategy, for many years we +have successfully utilized a hybrid of internal manufacturing +capability in concert with outside contract arrangements for +different manufacturing processes. The breadth of our internal +manufacturing capabilities was expanded during 2019. Our outside +contract arrangements, some of which are with offshore concerns, +have been managed and updated to meet our present requirements. +This hybrid approach has been instrumental in controlling our +product costs, allowing us to be competitive and manage our gross +margins. +Contract +manufacturers produce various subassemblies and products on our +behalf. Generally, the contract manufacturers procure raw materials +from BK-approved sources and complete manufacturing activities in +accordance with our specifications. Manufacturing agreements and +purchase orders govern the business relationship with the contract +manufacturers. These agreements and purchase orders have various +terms and conditions and may be renewed or modified upon agreement +by both parties. Their scope may also be expanded to include new +products in the future. +We plan +to continue utilizing both internal and external contract +manufacturing where it furthers our business objectives. This +strategy allows us to effectively manage product costs and +lead-times while focusing other resources on our core technological +competencies of product design and development, and to help reduce +capital investment in manufacturing equipment. We also believe +that, in certain circumstances, the use of experienced, high-volume +manufacturers can provide greater manufacturing specialization and +expertise, higher levels of flexibility and responsiveness, and +faster delivery of product, all of which contribute toward product +cost control. To ensure that products manufactured by others meet +our quality standards, our production and engineering team works +closely with our ISO 9002 industry-qualified contract manufacturers +in all key aspects of the production process. We establish product +specifications, select the components and, in some cases, the +suppliers. We retain all document control. We also work with our +contract manufacturers to improve process control and product +design and conduct periodic on-site inspections. +We rely +upon a limited number of both domestic and foreign suppliers for +several key products and components. Approximately 64.0% of our +material, subassembly and product procurements in 2019 were sourced +from three suppliers. We place purchase orders from time to time +with these suppliers and have no guaranteed supply arrangements. In +addition, certain components are obtained from single sources. +During 2019 and 2018, our operations were not materially impaired +due to delays from single-source suppliers. However, the absence of +a single-source component could potentially delay the manufacture +of finished products. We manage the risk of such delays by securing +secondary sources, where possible, and redesigning products in +response to component shortages or obsolescence. We strive to +maintain strong relationships with all of our suppliers. We +anticipate that the current relationships, or others that are +comparable, will be available to us in the future. +Seasonal Impact +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year budgets and appropriations. We may also +experience fluctuations in our quarterly results, derived, in part, +from sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +results. +6 +Significant Customers +Sales +to the U.S. Government represented approximately 49% and 40% of our +total sales for the years ended December 31, 2019 and 2018, +respectively. These sales were primarily to various government +agencies, including those within the DHS, the U.S. Department of +Defense (“DOD”), the USFS and the U.S. Department of +Interior (“DOI”). +Backlog +Our +backlog of unshipped customer orders was approximately $7.2 million +and $7.6 million as of December 31, 2019 and 2018, +respectively. The decrease was attributed primarily to the timing +and fulfillment of orders. +Competition +We +compete with other domestic and foreign companies primarily in the +North American market, but also internationally. One dominant +competitor, Motorola Solutions, Inc., is estimated to have well in +excess of half the market for LMR products. We compete by +capitalizing on our advantages and strengths, which include price, +product quality and customer responsiveness. +Government Regulation +We are +subject to various international and U.S. federal, state and local +laws affecting our business. Any finding that we have been or +are in noncompliance with such laws could result in, among other +things, governmental penalties. Further, changes in existing +laws or new laws may adversely affect our business and could also +have the effect of limiting capital expenditures by our customers, +which could have a material adverse effect on our business, +financial condition and results of operations. +In +connection with our U.S. Government contracts, we are subject to +the U.S. Federal Government procurement regulations that may +provide the buyer with the right to audit and review our +performance, as well as our compliance with applicable laws and +regulations. In addition, our business is subject to +government regulation based on the products we sell that may be +subject to government requirements, such as obtaining an export +license or end-user certificate from the buyer, in certain +circumstances. If a government audit uncovers improper +or illegal activities, or if we are alleged to have violated any +laws or regulations governing the products we sell under our +government contracts, we may be subject to civil and criminal +penalties and administrative sanctions, including termination of +contracts, forfeiture of profits, suspension of payments, fines and +suspension or debarment from doing business with U.S. Federal +Government agencies. +Our +products are regulated by the FCC in the U.S. and similar agencies +in other countries where we offer our products. Consequently, +we and our customers could be positively or negatively affected by +the rules and regulations adopted from time to time by the FCC or +regulatory agencies in other countries. For example, our +wireless communications products, including two-way LMRs, are +subject to FCC regulations related to radio frequency +spectrum. As a result of limited spectrum availability, the +FCC has mandated that new LMR equipment utilize technology that is +more spectrum-efficient, which effectively meant that the industry +had to migrate to digital technology. These types of mandates +may provide us with new business opportunities or may require us to +modify all or some of our products so that they can continue to be +manufactured and marketed, which may lead to an increase in our +capital expenditures and research and development +expenses. +As a +public company, we are also subject to regulations of the SEC and +the stock exchange on which we are listed (NYSE +American). +Some of +our operations use substances regulated under various federal, +state, local and international laws governing the environment and +worker health and safety, including those governing the discharge +of pollutants into the ground, air and water, the management and +disposal of hazardous substances and wastes and the cleanup of +contaminated sites, as well as relating to the protection of the +environment. Certain of our products are subject to various +federal, state, local and international laws governing chemical +substances in electronic products. During 2019, compliance with +these U.S. federal, state and local and international laws did not +have a material effect on our capital expenditures, earnings or +competitive position. +7 +Employees +As of +December 31, 2019, we had 111 employees, including 109 full-time +employees, most of whom are located at our West Melbourne, Florida +facility; 56 of these employees are engaged in direct manufacturing +or manufacturing support, 18 in engineering, 26 in sales and +marketing and 11 in headquarters, accounting and human resources +activities. Our employees are not represented by any collective +bargaining agreements, nor has there ever been a labor-related work +stoppage. We believe our relations with our employees are +good. +Information Relating to Domestic and Export Sales +The +following table summarizes our sales of LMR products by customer +location: +2019 +2018 +(in +millions) +United +States +$ 39.7 +$ 44.8 +International +0.4 +4.6 +Total +$ 40.1 +$ 49.4 +Additional +financial information is provided in the Consolidated Financial +Statements included in this report. +8 +I tem 1A. Risk Factors +Various portions of this report contain forward-looking statements +that involve risks and uncertainties. Actual results, performance +or achievements could differ materially from those anticipated in +these forward-looking statements as a result of certain risk +factors, including those set forth below and elsewhere in this +report. We undertake no obligation to revise or update any +forward-looking statements contained herein to reflect subsequent +events or circumstances or the occurrence of unanticipated +events. +We depend on the success of our LMR product line +We +currently depend on our LMR products as our sole source of sales. A +decline in the price of and/or demand for LMR products, as a result +of competition, technological change, the introduction of new +products by us or others or a failure to manage product transitions +successfully, could have a material adverse effect on our business, +financial condition and results of operations. In addition, our +future success will largely depend on the successful introduction +and sale of our BKR Series product line, including our initial +multiband product, which has been delayed from initial projections +and which we may be unable to successfully complete in a timely +manner, or at all. Even if we successfully develop and launch the +BKR Series product line, or any other new products, the development +of which is a complex and uncertain process requiring innovation +and investment, such products may not achieve market acceptance, +which could have a material adverse effect on us. +We are engaged in a highly competitive industry +We face +intense competition from other LMR suppliers, and the failure to +compete effectively could materially and adversely affect our +market share, financial condition and results of operations. The +largest supplier of LMR products in the world, Motorola Solutions, +Inc., currently is estimated to have well in excess of half the +market for LMR products. This supplier is also the world’s +largest supplier of P-25 products. Some of our competitors are +significantly larger and have longer operating histories, greater +name recognition, larger customer bases and significantly greater +financial, technical and marketing resources than we have. Some +also have established reputations for success in developing and +supplying LMR products, including providing complete, integrated, +communications systems and infrastructure. We do not provide +complete, integrated, communications systems and infrastructure. +These advantages may allow our competitors: +● +to be more +attractive to customers who desire a single-source supplier of LMR +products; +● +to respond more +quickly to new or emerging technologies and changes in customer +requirements, which may render our products obsolete or less +marketable; +● +to engage in more +extensive research and development; +● +to undertake more +far-reaching marketing campaigns; +● +to be able to take +advantage of acquisitions and other opportunities; +● +to adopt more +aggressive pricing policies; and +● +to be more +attractive to potential employees and strategic +partners. +Some of +our competitors have established broad networks of sales locations +and multiple distribution channels that are more extensive than +ours. We may not be able to compete successfully and competitive +pressures may materially and adversely affect our business, results +of operations and financial condition. +9 +An +increase in the demand for P-25 products could benefit competitors +that are better financed and positioned to meet such demand. P-25 +products have been brought to the market by an increasing number of +our competitors. Our first P-25 portable radio was brought to +market in 2003, and in recent years we introduced two new lines of +P-25 products, the KNG and KNG2 Series. We are currently developing +a new line of P-25 digital products, the BKR Series, which we +anticipate will include multiband products, among other new +products. Bringing such products to market and achieving a +significant market penetration for them will continue to require +time and expenditures of funds, and we may be unable to +successfully do so. We may be unsuccessful in developing and +marketing, on a timely basis, fully functional product enhancements +or new products that respond to these and other technological +advances, and our new products may not be accepted by customers. An +inability to successfully develop and/or market products could have +a material adverse effect on our business, financial condition and +results of operations. +Our industry is characterized by rapidly changing technology and +our success is dependent on our ability to adapt to such +changes +Our +business could suffer if we are unable to keep pace with rapid +technological changes and product development in our industry. The +market for our LMR products is characterized by ongoing +technological development, evolving industry standards and frequent +product introductions. The LMR industry has been transitioning from +analog LMR products to digital LMR products in recent years. In +addition, the APCO P-25 standard is being increasingly adopted. If +we are unable to successfully keep up with these changes, our +business, financial condition and results of operations could be +materially adversely affected. +We depend heavily on sales to the U.S. Government +We are +subject to risks associated with our reliance on sales to the U.S. +Government. For the year ended December 31, 2019, approximately +49.1% of our sales were to agencies and departments of the U.S. +Government. These sales were primarily to agencies of the DHS, DOD, +USFS and DOI. We may be unable to maintain this government +business. Our ability to maintain our government business will +depend on many factors outside of our control, including +competitive factors, changes in government personnel making +contract decisions, spending limits and political factors. The loss +of sales to the U.S. Government would have a material adverse +effect on our business, financial condition and results of +operations. +In +addition, most U.S. Government customers award business through a +competitive bidding process, which results in greater competition +and increased pricing pressure. The bidding process involves +significant cost and managerial time to prepare bids for contracts +that may not be awarded to us. Even if we are awarded contracts, we +may fail to accurately estimate the resources and costs required to +fulfill a contract, which could negatively impact the profitability +of any contract awarded to us. In addition, following a contract +award, we may experience significant expense or delay, contract +modification or contract rescission as a result of customer delay +or our competitors protesting or challenging contracts awarded to +us in competitive bidding. +Any +delay, especially any prolonged delay, in the U.S. Government +budget process or a government shutdown may result in us incurring +substantial labor or other costs without reimbursement under our +customer contracts, decrease the number of purchase orders issued +under our contracts with government agencies, or result in the +suspension of work on contracts in progress or in payment +delays. +Any of +these events could have a material adverse effect on our business, +financial condition and results of operations. +10 +Our business is partially dependent on U.S. Government contracts, +which are highly regulated and subject to terminations and +oversight audits by U.S. Government representatives that could +result in adverse findings and negatively impact our +business +Our +U.S. Government business is subject to specific procurement +regulations with numerous compliance requirements. These +requirements, although customary in U.S. Government contracting, +increase our performance and compliance costs. These costs may +increase in the future, thereby reducing our margins, which could +have an adverse effect on our financial condition. Failure to +comply with these regulations could lead to suspension or debarment +from U.S. Government contracting or subcontracting for a period of +time. Among the causes for debarment are violations of various laws +or policies, including those related to procurement integrity, U.S. +Government security regulations, employment practices, protection +of criminal justice data, protection of the environment, accuracy +of records, proper recording of costs, foreign corruption and the +False Claims Act. +Generally, U.S. +Government contracts are subject to oversight audits by U.S. +Government representatives and could result in adjustments to our +contracts. Any costs found to be improperly allocated to a specific +contract or grant may not be allowed, and such costs already +reimbursed to us may have to be refunded. Future audits and +adjustments, if required, may materially reduce our revenues or +profits upon completion and final negotiation of audits. Negative +audit findings could also result in investigations, termination of +a contract, forfeiture of profits or reimbursements, suspension of +payments, fines and suspension or prohibition from doing business +with the U.S. Government. All contracts with the U.S. Government +are subject to cancellation at the convenience of the U.S. +Government. +In +addition, contacts with government officials and participation in +political activities are areas that are tightly controlled by +federal, state, local and international laws. Failure to comply +with these laws could cost us opportunities to seek certain +government sales opportunities or even result in fines, prosecution +or debarment. +Our business is subject to the economic, political, and other risks +of manufacturing products in foreign countries +We +engage in business with manufacturers located in other countries. +Approximately 67.0% of our material, subassembly and product +procurements in 2019 were sourced internationally. Accordingly, we +are subject to special considerations and risks not typically +associated with companies operating solely in the U.S. These +include the risks associated with the political, economic, legal, +health and other conditions in such foreign countries, among +others. Our business, financial condition and operating results may +be materially and adversely affected by, among other things, +changes in the general political, social, health and economic +conditions in foreign countries in which we maintain sourcing +relationships, unfavorable changes in U.S. trade legislation and +regulations, the imposition of governmental economic sanctions on +countries in which we do business or other trade barriers, threats +of war, terrorism or governmental instability, labor disruptions, +the impact of public health epidemics on employees and the global +economy, such as the coronavirus currently impacting China, which +may cause our manufacturers or suppliers to temporarily suspend +operations in the affected region, potentially negatively impacting +our product launch timing and shipments, currency controls, +fluctuating exchange rates with respect to contracts not +denominated in U.S. dollars, and unanticipated or unfavorable +changes in government policies with respect to laws and +regulations, anti-inflation measures and method of taxation. If we +were unable to navigate foreign regulatory environments, or if we +were unable to enforce our contract rights in foreign countries, +our business could be adversely impacted. Any of these events could +interrupt our manufacturing process and cause operational +disruptions, increase prices for manufacturing, reduce our sales or +otherwise have an adverse effect on our operating +performance. +The +U.S. Government has indicated its intent to alter its approach to +trade policy, including, in some instances, to revise, renegotiate +or terminate certain multilateral trade agreements. It has also +imposed new tariffs on certain foreign goods and raised the +possibility of imposing additional increases or new tariffs on +other goods. Such actions have, in some cases, led to retaliatory +trade measures by certain foreign governments. Such policies could +make it more difficult or costly for us to do business in or import +our products from those countries. In turn, we may need to raise +prices or make changes to our operations, which could negatively +impact our revenue or operating results. At this time, it remains +unclear what additional actions, if any, will be taken by the U.S. +Government or foreign governments with respect to tariff and +international trade agreements and policies, and we cannot predict +future trade policy or the terms of any revised trade agreements or +any impact on our business. +The coronavirus could adversely impact our ability to obtain +necessary materials and ship finished products to customers, which +could negatively impact our results of operations and cash +flow. +Governments and +health organizations have identified an outbreak of an illness +caused by a new coronavirus. The World Health Organization has +declared the outbreak a global public health emergency. It was +first detected in Wuhan City, Hubei Province, China, but has spread +within China and to other countries. Since the outbreak, some of +our China-based supply chain partners were temporarily closed for a +period of time. Most of these facilities have been reopened to +varying degrees. Depending on the progression of the outbreak, our +ability to obtain necessary supplies and ship finished products to +customers may be partly or completely disrupted. If the coronavirus +continues to progress, it could have a material negative impact on +our results of operations and cash flow. +11 +We carry substantial quantities of inventory, and inaccurate +estimates of necessary inventory could materially harm our +business, financial condition and operating results +We +carry a significant amount of inventory to service customer +requirements in a timely manner. If we are unable to sell this +inventory over a commercially reasonable time, in the future we may +be required to take inventory markdowns, which would reduce our net +sales and/or gross margins. In addition, it is critical to our +success that we accurately predict trends in customer demand, +including seasonal fluctuations, in the future and do not overstock +unpopular products or fail to sufficiently stock popular products. +Both scenarios could materially harm our business, financial +condition and operating results. +We enter into fixed-price contracts that could subject us to losses +in the event we fail to properly estimate our costs or hedge our +risks associated with currency fluctuations +We +sometimes enter into firm fixed-price contracts. If our initial +cost estimates are incorrect, we can lose money on these contracts. +Because certain of these contracts involve new technologies and +applications, require us to engage subcontractors and/or can last +multiple years, unforeseen events, such as technological +difficulties, fluctuations in the price of raw materials, problems +with our subcontractors or suppliers and other cost overruns, can +result in the contract pricing becoming less favorable or even +unprofitable to us and have an adverse impact on our financial +results. In addition, a significant increase in inflation rates or +currency fluctuations could have an adverse impact on the +profitability of longer-term contracts. +Our investment strategy may not be successful, which could +adversely impact our financial condition +We may +invest part of our cash balances in public companies. For example, +as of December 31, 2019, we held 477,282 shares of the common stock +of 1347 Property Insurance Holdings, Inc. (Nasdaq: PIH) +(“PIH”). These types of investments are more risky than +holding our cash balances as bank deposits or, for example, such +conservative investments as treasury bonds or money market funds. +There can be no assurance that we will be able to maintain or +enhance the value or the performance of the companies in which we +have invested or in which we may invest in the future, or that we +will be able to achieve returns or benefits from these investments. +We may lose all or part of our investment relating to such +companies if their value decreases as a result of their financial +performance or for any other reason. If our interests differ from +those of other investors in companies over which we do not have +control, we may be unable to effect any change at those companies. +We are not required to meet any diversification standards, and our +investments may become concentrated. If our investment strategy is +not successful or we achieve less than expected returns from these +investments, it could have a material adverse effect on us. The +Board of Directors may also change our investment strategy at any +time, and such changes could further increase our exposure, which +could adversely impact us. +Fundamental Global Investors, LLC, with its affiliates, is our +largest stockholder, and its interests may differ from the +interests of our other stockholders +The +interests of Fundamental Global Investors, LLC (“Fundamental +Global”) may differ from the interests of our other +stockholders. Fundamental Global and its affiliates, including CWA +Asset Management Group, LLC, 50% of which is owned by Fundamental +Global, together hold approximately 39% of the Company’s +outstanding shares of common stock. Kyle Cerminara, Chief Executive +Officer, Partner and Manager of Fundamental Global and Chairman and +Chief Executive Officer of Ballantyne Strong, Inc., and Lewis +Johnson, President, Partner and Manager of Fundamental Global +Investors, LLC and Co-Chairman of Ballantyne Strong, Inc., serve as +Chairman and Co-Chairman, respectively, of our Board of Directors. +As a result of its ownership position and Messrs. Cerminara’s +and Johnson’s positions with the Company, Fundamental Global +has the ability to exert significant influence over our policies +and affairs, including the power to impact the election of our +directors, and approval of any action requiring a stockholder vote, +such as amendments to our articles of incorporation, by-laws, +significant stock issuances, reorganizations, mergers and asset +sales. Fundamental Global may have interests that differ from those +of our other stockholders and may vote in a way with which our +other stockholders disagree and which may be adverse to their +interests. Fundamental Global’s significant ownership may +also have the effect of delaying, preventing or deterring a change +of control of the Company, could deprive our stockholders of an +opportunity to receive a premium for their common stock as part of +a sale of the Company and might ultimately affect the market price +of our common stock. +12 +If we are unable to maintain our brand and reputation, our +business, results of operations and prospects could be materially +harmed +Our +business, results of operations and prospects depend, in part, on +maintaining and strengthening our brand and reputation for +providing high-quality products and services. Reputational value is +based in large part on perceptions. Although reputations may take +decades to build, any negative incidents can quickly erode trust +and confidence, particularly if they result in adverse publicity, +governmental investigations or litigation. If problems with our +products cause operational disruption or other difficulties, or +there are delays or other issues with the delivery of our products +or services, our brand and reputation could be diminished. Damage +to our reputation could also arise from actual or perceived legal +violations or product safety issues, cybersecurity breaches, actual +or perceived poor employee relations, actual or perceived poor +service, actual or perceived poor privacy practices, operational or +sustainability issues, actual or perceived ethical issues or other +events within or outside of our control that generate negative +publicity with respect to us. Any event that has the potential to +negatively impact our reputation could lead to lost sales, loss of +new opportunities and retention and recruiting difficulties. If we +fail to promote and maintain our brand and reputation successfully, +our business, results of operations and prospects could be +materially harmed. +We face a number of risks related to challenging economic +conditions +Current +economic conditions in the U.S. and elsewhere remain uncertain. +These challenging economic conditions could materially and +adversely impact our business, liquidity and financial condition in +a number of ways, including: +● +Potential deferment or +reduction of purchases by customers : Significant deficits and limited +appropriations confronting our federal, state and local government +customers may cause them to defer or reduce purchases of our +products. Furthermore, uncertainty about current and future +economic conditions may cause customers to defer purchases of our +products in response to tighter credit and decreased cash +availability. Additionally, any delay, especially any prolonged +delay, in the U.S. Government budget process or government shutdown +may negatively impact the ability of many of our customers to +purchase our products and decrease the number of purchase orders +issued under our contracts with government agencies. +● +Negative impact from +increased financial pressures on third-party dealers, distributors +and suppliers : We +make sales to certain of our customers through third-party dealers +and distributors. We generally do not require collateral from our +customers. If credit pressures or other financial difficulties +result in insolvencies of these third parties and we are unable to +successfully transition the end customers to purchase our products +from other third parties, or directly from us, it could materially +and adversely impact our business, financial condition and +operating results. Challenging economic conditions may also impact +the financial condition of one or more of our key suppliers, which +could negatively affect our ability to secure product to meet our +customers’ demands. +● +Limited access by us to +credit and capital : +The credit markets may limit our access to credit and impair our +ability to raise capital, if needed, on acceptable terms or at all. +From time to time, we also have cash in financial institutions in +excess of federally insured limits, which funds might be at risk of +loss should such financial institutions face financial +difficulties. +13 +The terms of the credit agreement with JPMorgan Chase Bank, N.A., +contain restrictive covenants that may limit our operating +flexibility +On +January 30, 2020, BK Technologies, Inc., our wholly-owned operating +subsidiary, entered into a $5.0 million Credit Agreement and a +related Line of Credit Note (the “Note” and +collectively with the Credit Agreement, the “Credit +Agreement”) with JPMorgan Chase Bank, N.A. +(“JPMC”), which provides for a revolving line of credit . The Credit +Agreement contains limitations and covenants that may limit BK +Technologies, Inc.’s ability to take certain actions, +including pay dividends to us, enter into liens, indebtedness, loans and guarantees, +acquisitions and mergers, or sales of assets, and engage in stock +repurchases. It also contains one financial covenant requiring BK +Technologies, Inc. to maintain a tangible net worth of at least +$20.0 million at any fiscal quarter end. We are a guarantor +of BK Technologies, Inc.’s obligations under the Credit +Agreement. Events beyond our control, including changes in general +business and economic conditions, may impair BK Technologies, +Inc.’s ability to comply with these covenants, and a breach +of any covenants may result in an event of default. Upon the +occurrence of an event of default, JPMC may declare the entire unpaid balance immediately +due and payable and/or exercise any and all remedial and other +rights under the Credit Agreement. BK Technologies, Inc. may +be unable to repay any accelerated indebtedness, and we may not be +able to repay any indebtedness pursuant to the guarantee or +refinance any accelerated indebtedness on favorable terms, or at +all. In general, the occurrence of any event of default under the +Credit Agreement could have an adverse effect on our financial +condition or results of operations. +We depend on a limited number of manufacturers and on a limited +number of suppliers of components to produce our products, and the +inability to obtain adequate and timely delivery of supplies and +manufactured products could have a material adverse effect on +us +We +contract with manufacturers to produce portions of our products, +and our dependence on a limited number of contract manufacturers +exposes us to certain risks, including shortages of manufacturing +capacity, reduced control over delivery schedules, quality +assurance, production yield and costs. If any of our manufacturers +terminate production or cannot meet our production requirements, we +may have to rely on other contract manufacturing sources or +identify and qualify new contract manufacturers. The lead-time +required to qualify a new manufacturer could range from +approximately two to six months. Despite efforts to do so, we may +not be able to identify or qualify new contract manufacturers in a +timely and cost-effective manner, and these new manufacturers may +not allocate sufficient capacity to us in order to meet our +requirements. Any significant delay in our ability to obtain +adequate quantities of our products from our current or alternative +contract manufacturers could have a material adverse effect on our +business, financial condition and results of +operations. +In +addition, our dependence on limited and sole source suppliers of +components involves several risks, including a potential inability +to obtain an adequate supply of components, price increases, late +deliveries and poor component quality. Approximately 64.0% of our +material, subassembly and product procurements in 2019 were sourced +from three suppliers. We place purchase orders from time to time +with these suppliers and have no guaranteed supply arrangements. +Disruption or termination of the supply of these components could +delay shipments of our products. The lead-time required for orders +of some of our components is as much as six months. In addition, +the lead-time required to qualify new suppliers for our components +is as much as six months. If we are unable to accurately predict +our component needs, or if our component supply is disrupted, we +may miss market opportunities by not being able to meet the demand +for our products. This may damage our relationships with current +and prospective customers and, thus, have a material adverse effect +on our business, financial condition and results of +operations. +14 +We may not be able to manage our growth +Acquisitions and +other business transactions may disrupt or otherwise have a +negative impact on our business, financial condition and results of +operations. We do not have any acquisitions currently pending, and +there can be no assurance that we will complete any future +acquisitions or other business transactions or that any such +transactions which are completed will prove favorable to our +business. We intend to seek stockholder approval for any such +transactions only when so required by applicable law or regulation. +Any acquisitions of businesses and their respective assets also +involve the risks that the businesses and assets acquired may prove +to be less valuable than we expect and we may assume unknown or +unexpected liabilities, costs and problems. We hope to grow +rapidly, and the failure to manage our growth could materially and +adversely affect our business, financial condition and results of +operations. Our business plan contemplates, among other things, +leveraging our products and technology for growth in our customer +base and sales. This growth, if it materializes, could +significantly challenge our management, employees, operations and +financial capabilities. In the event of this expansion, we have to +continue to implement and improve our operating systems and to +expand, train, and manage our employee base. If we are unable to +manage and integrate our expanding operations effectively, our +business, results of operations and financial condition could be +materially and adversely affected. +Retention of our executive officers and key personnel is critical +to our business +Our key +executives are critical to our success. The loss of services from +any of our executive officers or other key employees due to any +reason whatsoever could have a material adverse effect on our +business, financial condition and results of +operations. +Our +success is also dependent upon our ability to hire and retain +qualified operations, development and other personnel. Competition +for qualified personnel in our industry is intense, and we may be +unable to hire or retain necessary personnel. The inability to +attract and retain qualified personnel could have a material +adverse effect on our business, financial condition and results of +operations. +We have +had changes in our senior management team and other personnel over +the past few years and have promoted or hired new employees to fill +certain roles. Our inability to effectively integrate the +newly-hired or promoted senior managers or other employees into our +business process, controls and systems could have a material +adverse effect on us. +We rely on a combination of contract, trademark and trade secret +laws to protect our intellectual property rights, and failure to +effectively utilize or successfully assert these rights could +negatively impact us +Currently, we hold +no U.S. patents. We have several trademarks related to the names +“BK Technologies,” “BK Radio” and +“Radios for Heroes,” and have applied for a trademark +related to the name “BKR.” As part of our +confidentiality procedures, we generally enter into nondisclosure +agreements with our employees, distributors and customers and limit +access to and distribution of our proprietary information. We also +rely on trade secret laws to protect our intellectual property +rights. There is a risk that we may be unable to prevent another +party from manufacturing and selling competing products or +otherwise violating our intellectual property rights. Our +intellectual property rights, and any additional rights we may +obtain in the future, may be invalidated, circumvented or +challenged in the future. It may also be particularly difficult to +protect our products and intellectual property under the laws of +certain countries in which our products are or may be manufactured +or sold. Our failure to perfect or successfully assert intellectual +property rights could harm our competitive position and could +negatively impact us. +Rising health care costs may have a material adverse effect on +us +The +costs of employee health care insurance have been increasing in +recent years due to rising health care costs, legislative changes +and general economic conditions. We cannot predict what other +health care programs and regulations ultimately will be implemented +at the federal or state level or the effect of any future +legislation or regulation in the U.S. on our business, financial +condition and results of operations. In addition, we cannot predict +when or if Congress will repeal and/or replace certain health care +programs and regulations at the federal level and the impact such +changes would have on our business. A continued increase in health +care costs could have a material adverse effect on us. +15 +The insurance that we maintain may not fully cover all potential +exposures +We +maintain property, business interruption and casualty insurance, +but such insurance may not cover all risks associated with the +hazards of our business and is subject to limitations, including +deductibles and maximum liabilities covered. We are potentially at +risk if one or more of our insurance carriers fail. Additionally, +severe disruptions in the domestic and global financial markets +could adversely impact the ratings and survival of some insurers. +In the future, we may not be able to obtain coverage at current +levels, and our premiums may increase significantly on coverage +that we maintain. +Our stock price is vulnerable to significant fluctuations, +including due to our fluctuating quarterly operating +results +Our +quarterly operating results may fluctuate significantly from +quarter to quarter and may be below the expectations of the +investment community, resulting in volatility for the market price +for our common stock. Other factors affecting the volatility of our +stock price include: +● +future +announcements concerning us or our competitors; +● +the announcement or +introduction of technological innovations or new products by us or +our competitors, including announcements regarding the status of +our BKR Series product line; +● +changes in product +pricing policies by us or our competitors; +● +changes in earnings +estimates by us or our competitors or by securities +analysts; +● +additions or +departures of our key personnel; and +● +sales of our common +stock. +In +addition, the stock market is subject to price and volume +fluctuations affecting the market price for the stock of many +companies generally, which fluctuations often are unrelated to +operating performance. +Natural disasters, acts of war or terrorism and other catastrophic +events beyond our control could have a material adverse effect on +our operations and financial condition +The +occurrence of one or more natural disasters, such as fires, +hurricanes, tornados, tsunamis, floods and earthquakes; +geo-political events, such as civil unrest in a country in which +our suppliers or manufacturers are located, or acts of war or +terrorism (wherever located around the world) or military +activities disrupting transportation, communication or utility +systems or otherwise causing damage to our business, employees, +suppliers, manufacturers and customers; or other highly disruptive +events, such as nuclear accidents, pandemics, unusual weather +conditions or cyber attacks, could have a material adverse effect +on our business, financial condition and results of operations. +Such events could result, among other things, in operational +disruptions, physical damage to or destruction or disruption of one +or more of our properties or properties used by third parties in +connection with the supply of products or services to us, the lack +of an adequate workforce in parts or all of our operations and +communications and transportation disruptions. These factors could +also cause consumer confidence and spending to decrease or result +in increased volatility in the U.S. and global financial markets +and economy. Such occurrences could have a material adverse effect +on us and could also have indirect consequences, such as increases +in the costs of insurance, if they result in significant loss of +property or other insurable damage. +16 +A security breach or other significant disruption of our +information technology systems, or those of our distributors, +manufacturers, suppliers and other partners, caused by cyber attack +or other means, could have a negative impact on our operations, +sales and results of operations +From +time to time, we experience cyber attacks on our information +technology systems and the information systems of our distributors, +manufacturers, suppliers and other partners, whose systems we do +not control. These systems are vulnerable to damage, +unauthorized access or interruption from a variety of sources, +including, but not limited to, continually evolving cyber attacks +(including social engineering and phishing attempts), attempts to +gain unauthorized access to data, cyber intrusion, computer +viruses, security breach, misconduct by employees or other insiders +with access to our data, energy blackouts, natural disasters, +terrorism, sabotage, war and telecommunication failures. Cyber +attacks are rapidly evolving and becoming increasingly +sophisticated. Computer hackers and others might compromise our +security measures, or security measures of those parties that we do +business with now or in the future, and obtain the personal +information of our customers, employees and partners or our +business information. A cyber attack or other significant +disruption involving our information technology systems or those of +our distributors, manufacturers, suppliers or other partners, could +result in disruptions in critical systems, corruption or loss of +data, theft of data, funds or intellectual property, and +unauthorized release of our or our customers’ proprietary, +confidential or sensitive information. Such unauthorized access to, +or release of, this information could expose us to data loss, +disrupt our operations, allow others to unfairly compete with us, +subject us to litigation, government enforcement actions, +regulatory penalties and costly response measures, and could +seriously disrupt our operations. Any resulting negative publicity +could also significantly harm our reputation. We may not have +adequate insurance coverage to compensate us for any losses +associated with such events. Any or all of the foregoing could have +a negative impact on our business, financial condition, results of +operations and cash flows. +Because +the techniques used to obtain unauthorized access to, or disable, +degrade or sabotage, information technology systems change +frequently and often are not recognized until launched against a +target, we may be unable to anticipate these techniques, implement +adequate preventative measures or remediate any intrusion on a +timely or effective basis. Moreover, the development and +maintenance of these preventative and detective measures is costly +and requires ongoing monitoring and updating as technologies change +and efforts to overcome security measures become more +sophisticated. We, therefore, remain potentially vulnerable to +additional known or yet unknown threats, as in some instances, we, +our distributors, manufacturers, suppliers and other partners, may +be unaware of an incident or its magnitude and effects. We also +face the risk that we expose our customers or partners to +cybersecurity attacks. In addition, from time to time, we implement +updates to our information technology systems and software, which +can disrupt or shutdown our information technology systems. We may +not be able to successfully integrate and launch these new systems +as planned without disruption to our operations. +Each +of the foregoing factors could have an adverse effect on our +reputation, business, financial condition or results of +operations. +The risk of noncompliance with U.S. and foreign laws and +regulations applicable to us could materially adversely affect +us +Failure +to comply with government regulations applicable to our business +could result in penalties and reputational damage. Our products are +regulated by the FCC and otherwise subject to a wide range of +global laws. As a public company, we are also subject to +regulations of the SEC and the stock exchange on which we are +listed. These laws and regulations are complex, change frequently, +have tended to become more stringent over time and increase our +cost of doing business. Compliance with existing or future laws, +including U.S. tax laws, could subject us to future costs or +liabilities, impact our production capabilities, constrict our +ability to sell, expand or acquire facilities, restrict what +products and services we can offer, and generally impact our +financial performance. Failure to comply with or to respond to +changes in these requirements and regulations could result in +penalties on us, such as fines, restrictions on operations or a +temporary or permanent closure of our facility. These penalties +could have a material adverse effect on our business, operating +results and financial condition. In addition, existing or new +regulatory requirements or interpretations could materially +adversely impact us. +17 +We may not be able to maintain our NYSE American +listing +Our +common stock has been listed on the NYSE American since 2005. If we +are unable to satisfy the continued listing standards of the NYSE +American, which include, among others, minimum stockholders’ +equity, market capitalization, pre-tax income and per share sales +price, our common stock may be delisted. If our common stock is +delisted, we would be forced to have our common stock quoted on the +OTC Markets or some other quotation medium, depending on our +ability to meet the specific requirements of those quotation +systems. In that case, we may lose some or all of our institutional +investors, and selling our common stock on the OTC Markets would be +more difficult because smaller quantities of shares would likely be +bought and sold and transactions could be delayed. These factors +could result in lower prices and larger spreads in the bid and ask +prices for shares of our common stock. If this happens, we will +have greater difficulty accessing the capital markets to raise any +additional necessary capital. +Any infringement claim against us could have a material adverse +effect on our business, financial condition and results of +operations +As the +number of competing products available in the market increases and +the functions of those products further overlap, the potential for +infringement claims may increase. Any such claims, with or without +merit, may result in costly litigation or require us to redesign +the affected product to avoid infringement or require us to obtain +a license for future sales of the affected product. Any of the +foregoing could damage our reputation and have a material adverse +effect upon our business, financial condition and results of +operations. Any litigation resulting from any such claim could +require us to incur substantial costs and divert significant +resources, including the efforts of our management and engineering +personnel. +We have deferred tax assets that we may not be able to utilize +under certain circumstances +If we +incur future operating losses, we may be required to provide some +or all of our deferred tax assets with a valuation allowance, +resulting in additional non-cash income tax expense. The change in +the valuation allowance may have a material impact on future net +income or loss. +We may be unable to obtain components and parts that are verified +to be Democratic Republic of Congo (“DRC”) +conflict-free, which could result in reputational +damage +The +Dodd-Frank Wall Street Reform and Consumer Protection Act includes +disclosure requirements regarding the use of tin, tantalum, +tungsten and gold (which are defined as “conflict +minerals”) in our products and whether these materials +originated from the DRC or an adjoining country. The SEC rules +necessitate a complex compliance process and related administrative +expense for a company once it determines a conflict mineral is +necessary to the functionality or production of a product that the +company manufactures or contracts to manufacture. These +requirements could affect the sourcing, availability and cost of +minerals used in the manufacture of certain of our products, and we +may not be able to obtain conflict-free products or supplies in +sufficient quantities or at competitive prices for our operations. +We have incurred, and will continue to incur, costs associated with +complying with these supply chain due diligence procedures. In +addition, because our supply chain is complex, if we discover that +our products include minerals that have been identified as +“not found to be DRC conflict-free” or we are unable to +determine whether such minerals are included in our products, we +may face reputational challenges with our customers, stockholders +and other stakeholders as a result. +18 +As a holding company, BK Technologies Corporation is dependent on +the operations and funds of its subsidiaries +On +March 28, 2019, we completed a reorganization pursuant to which BK +Technologies Corporation became a holding company with no business +operations of its own. BK Technologies Corporation’s only +significant assets are the outstanding equity interests in BK +Technologies, Inc. and any other future subsidiaries of BK +Technologies Corporation. As a result, we rely on cash flows from +subsidiaries to meet our obligations, including payment of +dividends to our stockholders. Additionally, our subsidiaries may +be restricted in their ability to pay cash dividends or to make +other distributions to BK Technologies Corporation, as the new +holding company; for instance, the Credit Agreement permits BK +Technologies, Inc. to pay dividends to us only if there is no +default, and the payment of the dividends would not result in a +default, under the Credit Agreement. The holding company +reorganization was intended to create a more efficient corporate +structure and increase operational flexibility. The anticipated +benefits of this reorganization may not be obtained if +circumstances prevent us from taking advantage of the opportunities +that we expect it may afford us. As a result, we may incur the +costs of a holding company structure without realizing the +anticipated benefits, which could adversely affect our reputation, +financial condition, and results of operations. +Future sales of shares of our common stock may negatively affect +our stock price and impair our ability to raise equity +capital +Approximately +6.3 million (49.9%) of our shares of outstanding common stock +as of December 31, 2019 were owned by certain of our executive +officers and directors and other affiliates, and may be resold +publicly at any time, subject to the volume and other restrictions +under Rule 144 of the Securities Act of 1933, as amended. +Approximately 50.1% of our outstanding shares of common stock as of +December 31, 2019 are freely tradable without +restriction. +Sales +of substantial amounts of shares of our common stock, or even the +potential for such sales, could lower the market price of our +common stock and impair our ability to raise capital through the +sale of equity securities. +I tem 1B. Unresolved Staff +Comments +None. +I tem 2. Properties +We do +not own any real estate. We lease approximately 54,000 square feet +of industrial space at 7100 Technology Drive in West Melbourne, +Florida. In November 2018, the lease was amended to provide for +certain leasehold improvements and extend the lease term until June +30, 2027. Rental, maintenance and tax expenses for this facility +were approximately $502,000 and $490,000 in 2019 and 2018, +respectively. We also lease 8,100 square feet of office space in +Lawrence, Kansas, to accommodate a segment of our engineering team. +In November 2019, the lease was amended to extend the lease term +until December 31, 2021. Rental, maintenance and tax expenses for +this facility were approximately $108,000 in each of 2019 and +2018. +In +February 2020, we entered into a lease for 6,857 square feet of +office space at Sawgrass Technology Park, 1619 NW 136 th Avenue in Sunrise, +Florida, for a period of 64 months. Annual rental, maintenance and +tax expenses for the facility will be approximately $196,000 for +the first year, increasing by approximately 3% for each subsequent +twelve month period. +I tem 3. Legal Proceedings +From +time to time we may be involved in various claims and legal actions +arising in the ordinary course of our business. There were no +pending material claims or legal matters as of December 31, +2019. +I tem 4. Mine +Safety Disclosures +Not +applicable. +19 +PART II +I tem 5. Market For Registrant’s Common +Equity, Related Stockholder Matters and Issuer Purchases of Equity +Securities +(a) +Market Information. +Our +common stock trades on the NYSE American under the symbol +“BKTI.” +(b) +Holders. +On +February 19, 2020, there were 645 holders of record of our common +stock. +(c) +Dividends. +We +currently pay quarterly cash dividends. The declaration and payment +of cash dividends, if any, is subject to the discretion of the +Board of Directors. The Board’s final determination as to +whether to declare and pay dividends is based upon its +consideration of our operating results, financial condition and +anticipated capital requirements, as well as such other factors it +may deem relevant. +We +receive dividends from our wholly-owned subsidiary, BK +Technologies, Inc., to fund the quarterly cash dividends to our +stockholders. The Credit Agreement permits BK Technologies, Inc. to +pay dividends to us if there is no default, and if the payment of +the dividend would not result in a default, under the Credit +Agreement. +(d) +Issuer Purchases of Equity Securities. +Period +Total Number of Shares Purchased +Average Price Paid Per Share (1) +Total Number of Shares Purchased as Part of Publicly Announced +Plans or Programs (2) +Maximum Number of Shares that May Yet Be Purchased Under Publicly +Announced Plans or Programs (2) +10/01/19-10/31/19 +15,384 +$ 3.44 +15,384 +177,891 +11/01/19-11/30/19 +15,569 +$ 3.18 +15,569 +162,322 +12/01/19-12/31/19 +44,180 +$ 3.09 +44,180 +118,142 +Total +75,133 +$ 3.24 +75,133 +(1) +Average +price paid per share of +common stock repurchased is the executed price, including +commissions paid to brokers. +(2) +The +Company has a repurchase +program of up to 1 million shares of the Company’s common +stock that can be purchased, from time to time, pursuant to a stock +repurchase plan in conformity with the provisions of Rule 10b5-1 +and Rule 10b-18 promulgated under the Exchange Act. The repurchase +program was initially announced in May 2016 and expanded in June +2017 and has no termination date. +I tem 6. Selected Financial Data +Not +required for smaller reporting companies. +20 +I tem 7. Management’s Discussion and Analysis +of Financial Condition and Results of Operations +Executive Summary +BK +Technologies Corporation is a holding company, with a wholly-owned +operating subsidiary, BK Technologies, Inc. We design, manufacture +and market two-way land mobile radios, repeaters, base stations and +related components and subsystems. All operating activities are +undertaken by BK Technologies, Inc. +Generally, our +financial and operating results for 2019 declined from the +preceding year. Sales for 2019 were approximately 18.8% below sales +for 2018, while gross profit margins as a percentage of sales +decreased primarily due to lower sales and manufacturing levels, +which also contributed to higher inventory levels at the end of +2019. Additionally, operating expenses increased, which was largely +attributed to product development and engineering expenses related +to development of an anticipated new line of products, including a +multiband radio. The combination of these factors resulted in an +operating loss for 2019, and the use of approximately $2.5 million +in cash in operating activities. +Total +sales in 2019 decreased 18.8% to approximately $40.1 million, +compared with approximately $49.4 million for the prior year. The +decrease was primarily attributed to decreased sales to state and +international public safety agencies in California and +Canada. +Gross +profit margin as a percentage of sales in 2019 was approximately +39.0%, compared with 40.5% for the previous year. The decrease was +attributed primarily to lower sales and manufacturing +volumes. +Selling, general +and administrative (“SG&A”) expenses for 2019 +totaled approximately $20.0 million, or 50.0% of sales, compared +with $17.6 million, or 35.5% of sales, for 2018. The increase in +SG&A expenses was attributed primarily to new product +development-related expenses. +For +2019, we recognized an operating loss of approximately $4.4 +million, compared with operating income of approximately $2.4 +million for the preceding year. +We +recognized other income totaling approximately $762,000 in 2019, +primarily attributed to an unrealized gain from our investment in +PIH, made through FGI 1347 Holdings, LP, a consolidated variable +interest entity. This compares with $2.9 million of other expense +last year, primarily related to unrealized losses from investments +in PIH and Iteris, Inc. (Nasdaq: ITI), as well as currency exchange +losses. +For +2019, we recognized a pretax loss of approximately $3.6 million, +compared with approximately $472,000 for the prior +year. +We +recognized an income tax benefit for 2019 totaling approximately +$1.0 million, compared with a benefit of approximately $277,000 for +the prior year. The income tax benefit for both years is largely +non-cash as a result of deferred items. +Net +loss for 2019 totaled approximately $2.6 million ($0.21 per basic +and diluted share), compared with approximately $195,000 ($0.01 per +basic and diluted share) for 2018. +As of +December 31, 2019, working capital totaled approximately $14.5 +million, of which $8.6 million was comprised of cash, cash +equivalents and trade receivables. This compares with working +capital totaling approximately $21.0 million at 2018 year end, +which included $17.0 million of cash, cash equivalents and trade +receivables. During 2019, we repurchased 267,350 shares of our +common stock, utilizing cash of approximately $1.0 +million. +In +early 2020, an outbreak of the coronavirus occurred in China and +other countries. These developments have not impacted our +operations to date. The extent of the outbreak and its potential +future impact on our operations, however, is uncertain. A prolonged +outbreak could interrupt our operations and those of our customers +and suppliers. +During +2018, we started development of a new product line, the BKR Series, +including a new multiband product, which we have continued to +develop throughout 2019 and into 2020. Our anticipated introduction +of the new multiband product has been delayed from our initial +expectations and may be delayed beyond our current anticipated +launch date in late 2020 due to various factors, including +potential impacts related to the coronavirus outbreak. We may be +unable to successfully launch our new product line in a timely +manner, or at all. If we do introduce a product in the BKR Series, +we cannot assure that it will gain market acceptance or increase +our addressable markets. +21 +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year-end budgets and appropriations. We may also +experience fluctuations in our quarterly results, in part, due to +our sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +condition. +Results of Operations +As an +aid to understanding our operating results, the following table +shows items from our consolidated statements of operations +expressed as a percentage of sales: +Percent of +Sales +for Years Ended +December 31, +2019 +2018 +Sales +100.0 % +100.0 % +Cost of +products +(61.0 ) +(59.5 ) +Gross +margin +39.0 +40.5 +Selling, general +and administrative expenses +(50.0 ) +(35.5 ) +Other income +(expense), net +1.9 +(6.0 ) +Loss before income +taxes +(9.1 ) +(1.0 ) +Income tax +benefit +2.5 +0.6 +Net +loss +(6.6 )% +(0.4 )% +Fiscal Year 2019 Compared With Fiscal Year 2018 +Sales, net +Sales +for 2019 totaled approximately $40.1 million, compared with +approximately $49.4 last year. +The +decrease in sales was attributed primarily to state and +international public safety agencies in California and Canada, +respectively, that had made substantial purchases during the +previous two years that did not reoccur during 2019, which was +partially offset by sales to new state and local public safety +agencies. Also, while sales for 2019 were adversely impacted by the +federal government shutdown during the year’s first quarter, +legacy federal customers were the largest sales contributors for +the year. +Our funnel of +sales prospects for coming quarters includes potential new customers +in federal, state and local public safety agencies. +Additionally, based on information from customers and our field +sales team, demand from established state and federal agencies may +improve in 2020 from 2019 levels. We also recently +reorganized our sales resources to more effectively focus on target +markets and customers where we believe we can maximize our sales +success. We believe the reorganization and our current sales +funnel better position us to capture new sales opportunities moving +forward. However, the potential future effects of the coronavirus, +while uncertain and without impact to our operations to-date, have +the potential to adversely impact our supply chain, and ultimately +our ability to fulfill customer demand. +The anticipated +launch in 2019 of our BKR Series product line, including multiband +product offerings, was delayed. While the initial product in this +line is anticipated to be available in the first half of 2020, with +additional models coming in late 2020 and early 2021, introduction +could be delayed by various factors, including potential impacts +related to the coronavirus. BKRSeries products, we believe, should +increase our addressable market, in particular, by expanding the +number of federal customers that may purchase our products. +However, the timing and size of orders from agencies at all levels +can be unpredictable and subject to the influence of budgets, +priorities and other factors. Accordingly, we cannot assure that +sales will occur under particular contracts, or that our sales +prospects will otherwise be realized. +22 +Cost of Products and Gross Profit Margin +Gross +profit margin as a percentage of sales for 2019 was approximately +39.0%, compared with 40.5% for the prior year. +Our +cost of products and gross profit margins are primarily derived +from material, labor and overhead costs, product mix, manufacturing +volumes and pricing. For 2019, gross profit margins were adversely +impacted by the first and fourth quarters, during which we +experienced lower manufacturing volumes, resulting in suboptimal +utilization and absorption of manufacturing and support expenses. +Also, the mix of product sales was more heavily weighted toward +lower margin products in 2019 compared with the preceding year. We +believe that our anticipated sales growth and the expected +production and sale of higher margin new products should favorably +impact overall gross profit margins in the future. +We +utilize a combination of internal manufacturing capabilities and +contract manufacturing relationships for production efficiencies +and to manage material and labor costs, and anticipate continuing +to do so in the future. We believe that our current manufacturing +capabilities and contract relationships or comparable alternatives +will continue to be available to us. Although in the future we may +encounter new product cost and competitive pricing pressures, the +extent of their impact on gross margins, if any, is +uncertain. +Selling, General and Administrative Expenses +SG&A expenses +consist of sales, marketing, commissions, engineering, product +development, management information systems, accounting, +headquarters and non-cash, share-based employee compensation +expenses. +SG&A expenses +for 2019 totaled approximately $20.0 million, or 50.0% of sales, +compared with approximately $17.6 million, or 35.5% of sales, for +the previous year. +Engineering and +product development expenses for 2019 totaled approximately $9.8 +million (24.5% of total sales), compared with approximately $7.8 +million (15.7% of total sales) last year. The increase was +attributed primarily to new product development-related expenses. +During 2018, we started initiatives to develop a new line of +portable and mobile radios with enhanced features that are +anticipated to succeed our current KNG line starting in the first +half of 2020. Additionally, expenses related to the development of +our BKR Series product line, including our multiband product, +increased compared with last year. During the fourth quarter of +2019, we replaced our Chief Technology Officer (CTO), appointing a +new CTO with an extensive background and experience in LMR +development. The primary focus of our new CTO was to evaluate, +direct and complete our multiband radio development. The evaluation +identified design changes that we believe should improve the +product’s functionality and performance. As a result of +implementing these changes, the precise date for introducing the +multiband product in the market is uncertain; however, it is +anticipated to be in late 2020. +Marketing and +selling expenses for 2019 totaled approximately $5.2 million (13.0% +of total sales), compared with approximately $5.4 million (11.0% of +total sales) last year. Sales incentive and commission expenses +decreased as a result of lower sales, which were partially offset +by increased expenses associated with additional sales staff and +marketing initiatives. +General +and administrative expenses for 2019 totaled approximately $5.0 +million (12.5% of total sales), compared with approximately $4.4 +million (8.9% of total sales) last year. The increase in general +and administrative expenses for 2019 was primarily attributed to +corporate headquarters, including expenses relating to our holding +company reorganization, and upgrading our information technology +security and capabilities. +For +2019, our operating loss totaled approximately $4.4 million (10.9% +of sales), compared with operating income of approximately $2.4 +million (4.9% of sales) last year. The operating loss for 2019 was +primarily attributed to lower sales, combined with increased +product development expenses. +23 +Other Income (Expense) +Interest Income +We +recorded net interest income of approximately $150,000 for 2019, +compared with approximately $102,000 for the previous year. +Interest income increased primarily as a result of more favorable +interest rates, compared with the prior year period. We may earn +interest income on our cash balances. During 2019, we had no +outstanding borrowing under the Credit Facility (defined below), +and therefore did not incur any interest expense on any outstanding +borrowings under the Credit Facility. The Credit Facility matured +on December 26, 2019 and was not renewed. The interest rate on such +Credit Facility as of December 26, 2019 was The Wall Street Journal prime rate plus 25 +basis points (5.00% as of December 26, 2019). Additionally, on +September 25, 2019, through a wholly-owned subsidiary, we entered +into a Master Loan Agreement with U.S. Bank Equipment Finance, a +division of U.S. Bank National Association, in the amount of +$425,000, to finance various items of equipment. The loan is +collateralized by equipment. The agreement has a term of five years +and bears a fixed interest rate of 5.11%. +(Gain) Loss on Investment in Securities +For +2019, we recognized an unrealized gain of approximately $716,000 on +our investment in PIH , compared to a +loss of approximately $2.7 million last year, which was comprised +of an approximately $1.8 million unrealized loss on the PIH +investment, along with a loss on the sale of securities totaling +approximately $849,000. +During 2018, we sold 1,317,503 shares of +Iteris, Inc. (Nasdaq: ITI), which cost approximately $2.4 million, +for approximately $8.3 million, and recognized a loss of +approximately $849,000. +Other Expense +For +2019, we recognized other expense totaling approximately $104,000, +compared with approximately $328,000 last year. Last year’s +other expenses were primarily attributed to exchange losses related +to sales under a Canadian dollar-denominated contract. +Income Tax Benefit +We +recorded an income tax benefit of approximately $987,000 for 2019, +compared with approximately $277,000 last year. +Our +income tax provision is based on management’s estimate of the +effective tax rate for the full year. The tax provision +(benefit) in any period will be affected by, among other things, +permanent, as well as temporary, differences in the deductibility +of certain items, in addition to changes in tax legislation. As a +result, we may experience significant fluctuations in the effective +book tax rate (that is, tax expense divided by pre-tax book income) +from period to period. +As of +December 31, 2019, our net deferred tax assets totaled +approximately $4.4 million, and were primarily derived from +research and development tax credits, operating loss carryforwards +and accrued expenses. +In +order to fully utilize the net deferred tax assets, we will need to +generate sufficient taxable income in future years. We analyze all +positive and negative evidence to determine if, based on the weight +of available evidence, we are more likely than not to realize the +benefit of the net deferred tax assets. The recognition of the net +deferred tax assets and related tax benefits is based upon our +conclusions regarding, among other considerations, estimates of +future earnings based on information currently available and +current and anticipated customers, contracts and product +introductions, as well as historical operating results and certain +tax planning strategies. +Based +on our analysis of all available evidence, both positive and +negative, we have concluded that we have the ability to generate +sufficient taxable income in the necessary period to utilize the +entire benefit for the deferred tax asset. We cannot presently +estimate what, if any, changes to the valuation of our deferred tax +assets may be deemed appropriate in the future. If we incur future +losses, it may be necessary to record additional valuation +allowance related to the deferred tax assets recognized as of +December 31, 2019. +24 +Liquidity and Capital Resources +For the +year ended December 31, 2019, net cash used in operating activities +totaled approximately $2.5 million, compared with cash provided by +operating activities of approximately $5.3 million for last +year. Cash used in operating activities for 2019 was +primarily related to a net loss, an increase in inventory, a +decrease in accrued compensation, and an unrealized gain on +investment in securities, all of which were partially offset by a +decrease in accounts receivable, an increase in deferred revenue, +and depreciation and amortization. +For the +year ended December 31, 2019, we had a net loss of approximately +$2.6 million, compared with approximately $0.2 million last year. +Net inventories increased during 2019 by approximately $2.2 +million, compared with a decrease of approximately $2.9 million +last year. The increase for 2019 was primarily attributable to +material purchases, combined with a decrease in sales. Accrued +compensation decreased approximately $743,000 for 2019, which was +primarily attributed to the payment of sales and management +incentive compensation. For the same period last year, accrued +compensation increased approximately $650,000. Unrealized gain on +investment in securities for the year ended December 31, 2019 +totaled approximately $716,000, compared with losses of +approximately $2.7 million for the prior year, which comprised of +unrealized loss on investment in securities of approximately $1.8 +million and loss on sale of available-for-sale securities of +approximately $849,000. For additional information pertaining to +our investment in securities, refer to Notes 1 (Summary of +Significant Accounting Policies) and 6 (Investment in Securities) +to the consolidated financial statements for the year ended +December 31, 2019. Accounts receivable for 2019 decreased +approximately $1.8 million, compared with an increase of +approximately $197,000 during the previous year. The decrease in +accounts receivable was attributable to collections and reduced +sales. Deferred revenue for 2019 increased approximately $947,000, +compared with approximately $1.1 million last year. The increases +in deferred revenue were attributed to increased sales of extended +warranties. Depreciation and amortization totaled approximately +$1.2 million for the year ended December 31, 2019, compared with +approximately $921,000 for the same period last year, due primarily +to additional capital equipment purchases. +Cash +used in investing activities for the year ended December 31, 2019 +totaled approximately $2.5 million and was attributed to purchases +of property, plant and equipment. For the same period last year, +cash provided by investing activities totaled approximately $3.2 +million, and was primarily comprised of proceeds from the sale of +available-for-sale securities totaling approximately $8.3 million, +which was partially offset by an investment in FGI 1347 Holdings, +LP of approximately $3.7 million and purchases of property, plant +and equipment totaling approximately $1.4 million. +For the +year ended December 31, 2019, approximately $1.7 million was used +in financing activities, primarily related to our capital return +program, which included quarterly dividends totaling approximately +$1.0 million and stock repurchases totaling approximately $1.0 +million, partially offset by $0.4 million received from U.S. Bank +Equipment Finance for the purchase of manufacturing equipment +items, pursuant to the Master Loan Agreement, described below. For +the same period last year, approximately $1.1 million was used to +pay dividends and approximately $3.3 million was used for stock +repurchases. +On +September 25, 2019, BK Technologies, Inc., our wholly-owned +subsidiary, and U.S. Bank Equipment Finance, a division of U.S. +Bank National Association, as a lender, entered into a Master Loan +Agreement in the amount of $425,000 to finance manufacturing items +of equipment. The loan is collateralized by the equipment purchased +using the proceeds. The Master Loan Agreementis payable in 60 equal +monthly principal and interest payments of approximately $8,046 +beginning on October 25, 2019 and maturing on September 25, 2024 +and bears an interest rate of 5.11%. +On +March 28, 2019, BK Technologies, Inc., our wholly-owned subsidiary, +and RELM Communications, Inc., a wholly-owned subsidiary of BK +Technologies, Inc., entered into an Amended and Restated Loan and +Security Agreement (the “Loan and Security Agreement”) +with Silicon Valley Bank (“SVB”). The Loan and Security +Agreement replaced BK Technologies, Inc.’s prior Loan and +Security Agreement with SVB (the “Prior Agreement”) +under which its collateralized revolving credit facility (the +“Credit Facility”) was maintained. The loan and +security agreement matured on December 26, 2019 and was not +renewed. BK Technologies, Inc. was in +compliance with all covenants under the Loan and Security Agreement +as of the maturity date. As of the maturity date, there were no +borrowings outstanding under the Credit +Facility. +25 +On +January 30, 2020, BK Technologies, Inc., our wholly-owned +subsidiary, entered into the Credit Agreement with JPMC. The Credit +Agreement provides for a revolving line of credit of up to $5.0 +million, with availability under the line of credit subject to a +borrowing base calculated as a percentage of accounts receivable +and inventory. The line of credit will expire on January 31, 2021. +Proceeds of borrowings under the Credit Agreement may be used for +general corporate purposes. The line of credit is collateralized +by a blanket lien on all personal property of BK Technologies, Inc. +pursuant to the terms of the Continuing Security Agreement with +JPMC. We and each subsidiary of BK Technologies, Inc. are +guarantors of obligations under the Credit Agreement, in accordance +with the terms of the Continuing Guaranty. +Borrowings under +the Credit Agreement will bear interest at a rate per annum equal +to one-month LIBOR (or zero if the LIBOR is less than zero) plus a +margin of 1.90%. The line of credit is to be repaid in monthly +payments of interest only, payable in arrears, commencing on +February 1, 2020, with all outstanding principal and interest to be +payable in full at maturity. +The +Credit Agreement contains certain customary restrictive covenants, +including restrictions on liens, indebtedness, loans and +guarantees, acquisitions and mergers, sales of assets, and stock +repurchases by BK Technologies, Inc. The Credit Agreement contains +one financial covenant requiring BK Technologies, Inc. to maintain +a tangible net worth of at least $20.0 million at any fiscal +quarter end. +The +Credit Agreement provides for customary events of default, +including: (1) failure to pay principal, interest or fees under the +Credit Agreement when due and payable; (2) failure to comply with +other covenants and agreements contained in the Credit Agreement +and the other documents executed in connection therewith; (3) the +making of false or inaccurate representations and warranties; (4) +defaults under other agreements with JPMC or under other debt or +other obligations of BK Technologies, Inc.; (5) money judgments and +material adverse changes; (6) a change in control or ceasing to +operate business in the ordinary course; and (7) certain events of +bankruptcy or insolvency. Upon the occurrence of an event of +default, JPMC may declare the entire unpaid balance immediately due +and payable and/or exercise any and all remedial and other rights +under the Credit Agreement. +In +February 2020, we entered into a lease for 6,857 square feet of +office space at Sawgrass Technology Park, 1619 NW 136 th Avenue in Sunrise, +Florida, for a period of 64 months. Annual rental, maintenance and +tax expenses for the facility will be approximately $196,000 for +the first year, increasing by approximately 3% for each subsequent +twelve month period. +Our +cash and cash equivalents balance at December 31, 2019 was +approximately $4.7 million. We believe these funds, combined +with anticipated cash generated from operations and the Credit +Agreement, are sufficient to meet our working capital requirements +for the foreseeable future. However, although we do not anticipate +needing additional capital in the near term, financial and economic +conditions could limit our access to credit and impair our ability +to raise capital, if needed, on acceptable terms or at all. We also +face other risks that could impact our business, liquidity and +financial condition. For a description of these risks, see +“Part I—Item 1A. Risk Factors” in this +report. +Off Balance Sheet Arrangements +We do +not have any off balance sheet arrangements. +Recently Adopted Accounting Pronouncements +In May +2014, the Financial Accounting Standards Board (“FASB”) +issued Accounting Standards Update (“ASU”) ASU 2014-09, +“Revenue from Contracts with Customers,” which provided +for a single, principles-based model for revenue recognition and +replaced the existing revenue recognition guidance, became +effective for annual and interim periods beginning on or after +December 15, 2017, and replaced most existing revenue recognition +guidance under accounting principles generally accepted in the +United States of America (“GAAP”). This ASU required +additional disclosures about the nature, amount, timing and +uncertainty of revenue and cash flows arising from customer +contracts, including significant judgements and estimates and +changes in those estimates. It permitted the use of either a +modified retrospective or cumulative effect transition method. The +Company adopted ASU 2014-09 in the first quarter of 2018 and +applied the modified retrospective approach. Because the +Company’s primary source of revenues is from shipments of +products, the adoption of this new guidance did not have any impact +on its consolidated financial statements and related disclosures. +See Note 1, under “Revenue Recognition,” for additional +information. +26 +In +January 2016, the FASB issued ASU 2016-01 “Financial +Instruments,” which amended the guidance in GAAP on the +classification and measurement of financial instruments. Changes +primarily affected the accounting for equity investments, financial +liabilities under the fair value option, and the presentation and +disclosure requirements for financial instruments. In addition, the +ASU clarified guidance related to the valuation allowance +assessment when recognizing deferred tax assets resulting from +unrealized losses on available-for-sale debt securities. The new +standard became effective for fiscal years and interim periods +beginning after December 15, 2017, and upon adoption, an entity was +required to apply the amendments by means of a cumulative-effect +adjustment to the balance sheet at the beginning of the first +reporting period in which the guidance is effective. The Company +adopted the new guidance in the first quarter of 2018, which had a +material impact on its retained earnings, as the Company +reclassified approximately $4.3 million of unrealized gain on +investment in securities that was previously classified in other +comprehensive income. +In +August 2018, the FASB issued ASU 2018-15, +“Intangibles—Goodwill and Other—Internal-Use +Software (Subtopic 350-40): Customer’s Accounting for +Implementation Costs Incurred in a Cloud Computing Arrangement That +Is a Service Contract,” to help entities evaluate the +accounting for fees paid by a customer in a cloud computing +arrangement (hosting arrangement) by providing guidance for +determining when the arrangement includes a software license. The +amendments in ASU 2018-15 align the requirements for capitalizing +implementation costs incurred in a hosting arrangement that is a +service contract with the requirements for capitalizing +implementation costs incurred to develop or obtain internal-use +software (and hosting arrangements that include an internal use +software license). The accounting for the service element of a +hosting arrangement that is a service contract is not affected by +the amendments in ASU 2018-15. The amendments in ASU 2018-15 will +become effective for fiscal years and interim periods beginning +after December 15, 2019. Early adoption is permitted, including +adoption in any interim period. The Company adopted the new +guidance in the fourth quarter of 2018, with no material impact on +its consolidated financial statements and related +disclosures. +In +February 2016, the FASB issued ASU 2016-02 “Leases,” +which amended leasing guidance by requiring companies to recognize +a right-of-use (“ROU”) asset and a lease liability for +all operating and capital (finance) leases with lease terms greater +than twelve months. The lease liability is equal to the present +value of lease payments. The lease asset is based on the lease +liability, subject to adjustment, such as for initial direct costs. +For income statement purposes, leases continue to be classified as +operating or capital (finance), with lease expense in both cases +calculated substantially the same as under the prior leasing +guidance. The updated guidance became effective for interim and +annual periods beginning after December 15, 2018. The Company +adopted the new guidance on January 1, 2019. Adoption resulted in +the recognition of ROU assets and lease liabilities on the +consolidated financial statements. Based on the Company’s +lease portfolio as of December 31, 2019, which consisted solely of +operating leases, the Company recognized approximately $2.9 million +of ROU assets and $3.0 million of lease liabilities on its +consolidated financial statements as of December 31, 2019. Refer to +Note 7 (Leases) for further details on leases. +Recent Accounting Pronouncements +The +Company does not discuss recent pronouncements that are not +anticipated to have an impact on or are unrelated to its financial +condition, results of operations, cash flows or +disclosures. +Critical Accounting Policies and Estimates +Our +revenue recognition process and our more subjective accounting +estimation processes affect our reported revenues and current +assets and are, therefore, critical in assessing our financial and +operating status. The processes for determining the allowance for +collection of trade receivables, allowance for excess or obsolete +inventory, allowance for product warranty, software development and +income taxes involve certain assumptions that, if incorrect, could +create an adverse impact on our operations and financial +position. +27 +Revenue +Effective January +1, 2018, the Company adopted ASU 2014-09, “Revenue from +Contracts with Customers” and the additional related ASUs +(“ASC 606”), which replaced existing revenue guidance +and outlines a single set of comprehensive principles for +recognizing revenue under GAAP. The Company elected the modified +retrospective method upon adoption, with no impact to the opening +retained earnings or revenue reported. These standards provide +guidance on recognizing revenue, including a five-step method to +determine when revenue recognition is appropriate: +Step 1: +Identify the contract with the customer; +Step 2: +Identify the performance obligations in the contract; +Step 3: +Determine the transaction price; +Step 4: +Allocate the transaction price to the performance obligations; +and +Step 5: +Recognize revenue as the Company satisfies a performance +obligation. +ASC 606 +provides that revenue is recognized when control of the promised +goods or services is transferred to customers at an amount that +reflects the consideration to which the entity expects to be +entitled to in exchange for those goods or services. We generally +satisfy performance obligations upon shipment of the product or +service to the customer. This is consistent with the time in which +the customer obtains control of the product or service. For +extended warranties, sales revenue associated with the warranty is +deferred at the time of sale and later recognized on a +straight-line basis over the extended warranty period. Some +contracts include installation services, which are completed in a +short period of time and the revenue is recognized when the +installation is complete. Customary payment terms are granted to +customers, based on credit evaluations. We currently do not have +any contracts where revenue is recognized, but the customer payment +is contingent on a future event. +Allowance for Doubtful Accounts +The +allowance for doubtful accounts was approximately $50,000 on gross +trade receivables of approximately $4.0 million as of December +31, 2019, as compared with $50,000 on gross trade receivables of +approximately $5.8 million as of December 31, 2018. This allowance +is used to state trade receivables at a net realizable value or the +amount that we estimate will be collected on our gross receivables +as of December 31, 2019 and 2018. Because the amount that we will +actually collect on the receivables outstanding as of December 31, +2019 and 2018 cannot be known with certainty, we rely on prior +experience. Our historical collection losses have typically been +infrequent, with write-offs of trade receivables being less than 1% +of sales during past years. Accordingly, we have maintained a +general allowance of up to approximately 5% of the gross trade +receivables balance in order to allow for future collection losses +that arise from customer accounts that do not indicate the +inability to pay but turn out to have such an inability. Currently, +our general allowance on trade receivables is approximately 1.3% of +gross receivables. As revenues and total receivables increase, the +allowance balance may also increase. We also maintain a specific +allowance for customer accounts that we know may not be collectible +due to various reasons, such as bankruptcy and other customer +liquidity issues. We analyze our trade receivables portfolio based +on the age of each customer’s invoice. In this way, we can +identify those accounts that are more likely than not to have +collection problems. We may reserve a portion or all of the +customer’s balance. As of December 31, 2019 and 2018, we had +no specific allowance on trade receivables. +28 +Excess and Obsolete Inventory +The +allowance for obsolete and slow-moving inventory was approximately +$823,000 and $629,000 at December 31, 2019 and 2018, +respectively. +The +allowance for slow-moving, excess, or obsolete inventory is used to +state our inventories at the lower of cost or net realizable value. +Because the amount of inventory that we will actually recoup +through sales cannot be known with certainty at any particular +time, we rely on past sales experience, future sales forecasts and +our strategic business plans. Generally, in analyzing our inventory +levels, we classify inventory as having been used or unused during +the past year and establish an allowance based upon several +factors, including, but not limited to, business forecasts, +inventory quantities and historical usage profile. Supplemental to +the aforementioned analysis, specific inventory items are reviewed +individually by management. Based on the review, considering +business levels, future prospects, new products and technology +changes, management, using its business judgment, may adjust the +valuation of specific inventory items to reflect an accurate +valuation estimate. Management also performs a determination of net +realizable value for all finished goods with a selling price below +cost. For all such items, the inventory is valued at not more than +the selling price less cost, if any, to sell. +Allowance for Product Warranty +We +offer two-year warranties to our customers, depending on the +specific product and terms of the customer purchase agreement. Our +typical warranties require us to repair and replace defective +products during the warranty period at no cost to the customer. At +the time the product revenue is recognized, we record a liability +for estimated costs under our warranties. The costs are estimated +based on historical experience. We periodically assess the adequacy +of our recorded liability for product warranties and adjust the +amount as necessary. +Income Taxes +We +account for income taxes using the asset and liability method. +Deferred tax assets and liabilities are recognized for the future +tax consequences attributable to differences between the financial +statement carrying amounts of existing assets and liabilities and +their respective tax bases. Deferred tax assets and liabilities are +measured using the enacted tax rates expected to apply in the +period in which the deferred tax asset or liability is expected to +be realized. The effect of changes in net deferred tax assets and +liabilities is recognized on our consolidated balance sheets and +consolidated statements of operations in the period in which the +change is recognized. Valuation allowances are provided to the +extent that it is more likely than not that some portion, or all, +of deferred tax assets will not be realized. In determining whether +a tax asset is realizable, we consider, among other things, +estimates of future earnings based on information currently +available, current and anticipated customers, contracts and new +product introductions, as well as recent operating results and +certain tax planning strategies. If we fail to achieve the future +results anticipated in the calculation and valuation of net +deferred tax assets, we may be required to increase the valuation +allowance related to our deferred tax assets in the +future. +29 +Forward-Looking Statements +We +believe that it is important to communicate our future expectations +to our security holders and to the public. This report, therefore, +contains statements about future events and expectations which are +“forward-looking statements” within the meaning of +Sections 27A of the Securities Act of 1933, as amended, and 21E of +the Exchange Act, including the statements about our plans, +objectives, expectations and prospects under the heading +“Management’s Discussion and Analysis of Financial +Condition and Results of Operations.” You can expect to +identify these statements by forward-looking words such as +“may,” “might,” “could,” +“would,” “should,” “will,” +“anticipate,” “believe,” +“plan,” “estimate,” “project,” +“expect,” “intend,” “seek,” +“are encouraged” and other similar expressions. Any +statement contained in this report that is not a statement of +historical fact may be deemed to be a forward-looking statement. +Forward-looking statements include, but are not limited to, the +following: changes or advances in technology; the success of our +LMR product line; successful introduction of new products and +technologies, including our ability to successfully develop and +sell our anticipated new multiband product and other related +products in the planned new BKR Series product line; competition in +the LMR industry; general economic and business conditions, +including federal, state and local government budget deficits and +spending limitations and any impact from a prolonged shutdown of +the U.S. Government; the availability, terms and deployment of +capital; reliance on contract manufacturers and suppliers; risks +associated with fixed-price contacts; heavy reliance on sales to +agencies of the U.S. Government and our ability to comply with the +requirements of contracts, laws and regulations related to such +sales; allocations by government agencies among multiple approved +suppliers under existing agreements; our ability to comply with +U.S. tax laws and utilize deferred tax assets; our ability to +attract and retain executive officers, skilled workers and key +personnel; our ability to manage our growth; our ability to +identify potential candidates for, and consummate, acquisition, +disposition or investment transactions, and risks incumbent to +being a noncontrolling interest stockholder in a corporation; +impact of our capital allocation strategy; risks related to +maintaining our brand and reputation; impact of government +regulation; rising health care costs; our business with +manufacturers located in other countries, including changes in the +U.S. Government and foreign governments’ trade and tariff +policies; our inventory and debt levels; protection of our +intellectual property rights; fluctuation in our operating results +and stock price; acts of war or terrorism, natural disasters and +other catastrophic events; any infringement claims; data security +breaches, cyber attacks and other factors impacting our technology +systems; availability of adequate insurance coverage; maintenance +of our NYSE American listing; risks related to being a holding +company; and the effect on our stock price and ability to raise +equity capital of future sales of shares of our common +stock. +Although we believe +that the plans, objectives, expectations and prospects reflected in +or suggested by our forward-looking statements are reasonable, +those statements involve risks, uncertainties and other factors +that may cause our actual results, performance or achievements to +be materially different from any future results, performance or +achievements expressed or implied by these forward-looking +statements, and we can give no assurance that our plans, +objectives, expectations and prospects will be +achieved. +Important factors +that might cause our actual results to differ materially from the +results contemplated by the forward-looking statements are +contained in “Part I—Item 1A. Risk Factors” and +elsewhere in this report and in our subsequent filings with the +SEC. We assume no obligation to publicly update or revise any +forward-looking statements made in this report, whether as a result +of new information, future events, changes in assumptions or +otherwise, after the date of this report. Readers are cautioned not +to place undue reliance on these forward-looking +statements. +I tem 7A. Quantitative and +Qualitative Disclosures About Market Risk +Not +required for smaller reporting companies. +I tem 8. Financial Statements and Supplementary +Data +See the +Consolidated Financial Statements included in this +report. +30 +R EPORT OF INDEPENDENT REGISTERED PUBLIC +ACCOUNTING FIRM +Board of Directors and Stockholders +BK Technologies Corporation +West Melbourne, Florida +Opinion on the Consolidated Financial Statements +We have +audited the accompanying consolidated balance sheets of BK +Technologies Corporation (the “Company”) as of December +31, 2019 and 2018, and the related consolidated statements of +operations, changes in stockholders’ equity, and cash flows +for each of the years in the two-year period ended December 31, +2019, and the related notes (collectively referred to as the +consolidated financial statements). In our opinion, the +consolidated financial statements present fairly, in all material +respects, the financial position of the Company as of December 31, +2019 and 2018, and the results of its operations and its cash flows +for each of the years in the two-year period ended December 31, +2019, in conformity with accounting principles generally accepted +in the United States of America. +Basis for Opinion +These +consolidated financial statements are the responsibility of the +Company’s management. Our responsibility is to express an +opinion on the Company’s consolidated financial statements +based on our audits. We are a public accounting firm registered +with the Public Company Accounting Oversight Board (United States) +(“PCAOB”) and are required to be independent with +respect to the Company in accordance with U.S. federal securities +laws and the applicable rules and regulations of the Securities and +Exchange Commission and the PCAOB. +We +conducted our audits in accordance with the standards of the PCAOB. +Those standards require that we plan and perform the audits to +obtain reasonable assurance about whether the financial statements +are free of material misstatement, whether due to error or fraud. +The Company is not required to have, nor were we engaged to +perform, an audit of its internal control over financial reporting. +As a part of our audits, we are required to obtain an understanding +of internal control over financial reporting, but not for the +purpose of expressing an opinion on the effectiveness of the +Company’s internal control over financial reporting. +Accordingly, we express no such opinion. +Our +audits included performing procedures to assess the risks of +material misstatement of the consolidated financial statements, +whether due to error or fraud, and performing procedures that +respond to those risks. Such procedures included examining, on a +test basis, evidence regarding the amounts and disclosures in the +consolidated financial statements. Our audits also included +evaluating the accounting principles used and significant estimates +made by management, as well as evaluating the overall presentation +of the consolidated financial statements. We believe that our +audits provide a reasonable basis for our opinion. +/s/ MSL, P.A. +We have +served as the Company’s auditor since 2015. +Fort +Lauderdale, Florida +March +4, 2020 +F-1 +B K TECHNOLOGIES CORPORATION +CONSOLIDATED +BALANCE SHEETS +(in thousands, except share data) +December +31, +2019 +2018 +ASSETS +Current +assets: +Cash and cash +equivalents +$ 4,676 +$ 11,268 +Trade accounts +receivable, net +3,964 +5,721 +Inventories, +net +13,513 +11,466 +Prepaid expenses +and other current assets +1,733 +2,401 +Total current +assets +23,886 +30,856 +Property, plant and +equipment, net +3,964 +2,729 +Right-of-use (ROU) +asset +2,885 +— +Investment in +securities +2,635 +1,919 +Deferred tax +assets, net +4,373 +3,495 +Other +assets +197 +192 +Total +assets +$ 37,940 +$ 39,191 +LIABILITIES +AND STOCKHOLDERS’ EQUITY +Current +liabilities: +Accounts +payable +$ 5,310 +$ 5,595 +Accrued +compensation and related taxes +1,271 +2,014 +Accrued warranty +expense +1,248 +1,546 +Accrued other +expenses and other current liabilities +479 +292 +Dividends +payable +252 +256 +Short-term lease +liability +369 +— +Note +payable-current portion +78 +— +Deferred +revenue +369 +180 +Total current +liabilities +9,376 +9,883 +Note payable, net +of current portion +328 +— +Long-term lease +liability +2,606 +— +Deferred +revenue +2,354 +1,596 +Total +liabilities +14,664 +11,479 +Commitments and +contingencies +Stockholders’ +equity: +Preferred stock; +$1.00 par value; 1,000,000 authorized shares; none issued or +outstanding +— +— +Common stock; $.60 +par value; 20,000,000 authorized shares; 13,929,381 and 13,882,937 +issued and 12,596,923 and 12,817,829 outstanding shares at December +31, 2019 and 2018, respectively +8,357 +8,330 +Additional paid-in +capital +26,095 +25,867 +Accumulated +deficit +(6,043 ) +(2,393 ) +Treasury stock, at +cost, 1,332,458 and 1,065,108 shares at December 31, 2019 and 2018, +respectively +(5,133 ) +(4,092 ) +Total +stockholders’ equity +23,276 +27,712 +Total liabilities +and stockholders’ equity +$ 37,940 +$ 39,191 +See notes to consolidated financial statements. +F-2 +B K TECHNOLOGIES CORPORATION +CONSOLIDATED +STATEMENTS OF OPERATIONS +(in thousands, except per share data) +Years Ended +December 31, +2019 +2018 +Sales, +net +$ 40,100 +$ 49,380 +Expenses +Cost of +products +24,449 +29,403 +Selling, general +and administrative +20,036 +17,552 +Total +expenses +44,485 +46,955 +Operating (loss) +income +(4,385 ) +2,425 +Other income +(expense): +Interest +income +150 +102 +Gain (loss) on +investment in securities +716 +(2,671 ) +Other +expense +(104 ) +(328 ) +Total other income +(expense) +762 +(2,897 ) +Loss before income +taxes +(3,623 ) +(472 ) +Income tax +benefit +987 +277 +Net +loss +$ (2,636 ) +$ (195 ) +Net loss per +share-basic +$ (0.21 ) +$ (0.01 ) +Net loss per +share-diluted +$ (0.21 ) +$ (0.01 ) +Weighted average +shares outstanding-basic +12,705 +13,464 +Weighted average +shares outstanding-diluted +12,705 +13,464 +See notes to consolidated financial statements. +F-3 +B K TECHNOLOGIES CORPORATION +CONSOLIDATED +STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY +(in thousands, except share and per share data) +Common Stock +Shares +Common Stock +Amount +Additional +Paid-In Capital +Accumulated +Deficit +Other +Comprehensive Income +Treasury +Stock +Total +Balance at December +31, 2017 +13,844,584 +$ 8,307 +$ 25,642 +$ (5,450 ) +$ 4,318 +$ (810 ) +$ 32,007 +Restricted stock +units issued +38,353 +23 +(23 ) +— +— +— +— +Share-based +compensation expense +— +— +95 +— +— +— +95 +Restricted stock +unit compensation expense +— +— +153 +— +— +— +153 +Dividends declared +($0.08 per share) +— +— +— +(1,066 ) +— +— +(1,066 ) +Net +loss +— +— +— +(195 ) +— +— +(195 ) +Effect of adoption +of ASU 2016-01 +— +— +— +4,318 +(4,318 ) +— +— +Repurchase of +common stock +— +— +— +— +— +(3,282 ) +(3,282 ) +Balance at December +31, 2018 +13,882,937 +8,330 +25,867 +(2,393 ) +— +(4,092 ) +27,712 +Stock options +exercised +1,000 +— +2 +— +— +— +2 +Restricted stock +units issued +45,444 +27 +(27 ) +— +— +— +— +Share-based +compensation expense +— +— +148 +— +— +— +148 +Restricted stock +unit compensation expense +— +— +105 +— +— +— +105 +Dividends declared +($0.08 per share) +— +— +— +(1,014 ) +— +— +(1,014 ) +Net +loss +— +— +— +(2,636 ) +— +— +(2,636 ) +Repurchase of +common stock +— +— +— +— +— +(1,041 ) +(1,041 ) +Balance at December +31, 2019 +13,929,381 +$ 8,357 +$ 26,095 +$ (6,043 ) +$ — +$ (5,133 ) +$ 23,276 +See notes to consolidated financial statements. +F-4 +B K TECHNOLOGIES CORPORATION +CONSOLIDATED +STATEMENTS OF CASH FLOWS +(in thousands) +Years Ended +December 31, +2019 +2018 +Operating +activities +Net +loss +$ (2,636 ) +$ (195 ) +Adjustments to +reconcile net loss to net cash (used in) provided by operating +activities: +Inventory +allowance +194 +(38 ) +Deferred tax +benefit +(878 ) +(178 ) +Depreciation and +amortization +1,219 +921 +Share-based +compensation expense +148 +95 +Restricted stock +unit compensation expense +105 +153 +Loss on sale of +available-for-sale securities +— +849 +Unrealized (gain) +loss on investment in securities +(716 ) +1,822 +Changes in +operating assets and liabilities: +Trade accounts +receivable +1,757 +(197 ) +Inventories +(2,241 ) +2,930 +Prepaid expenses +and other current assets +669 +(1,629 ) +Other +assets +(5 ) +53 +Lease +liability +90 +— +Accounts +payable +(285 ) +(376 ) +Accrued +compensation and related taxes +(743 ) +650 +Accrued warranty +expense +(298 ) +157 +Deferred +revenue +947 +1,138 +Accrued other +expenses and other current liabilities +187 +(867 ) +Net +cash (used in) provided by operating activities +(2,486 ) +5,288 +Investing +activities +Purchases of +property, plant and equipment +(2,455 ) +(1,396 ) +Investment in +securities +— +(3,741 ) +Proceeds from sale +of available-for-sale securities +— +8,335 +Net +cash (used in) provided by investing activities +(2,455 ) +3,198 +Financing +activities +Dividends +paid +(1,018 ) +(1,083 ) +Repurchase of +common stock +(1,041 ) +(3,282 ) +Proceeds from +issuance of common stock +2 +— +Proceeds from +debt +425 +— +Repayment of +debt +(19 ) +— +Net +cash used in financing activities +(1,651 ) +(4,365 ) +Net change in cash +and cash equivalents +(6,592 ) +4,121 +Cash and cash +equivalents, beginning of year +11,268 +7,147 +Cash and cash +equivalents, end of year +$ 4,676 +$ 11,268 +Supplemental +disclosure +Cash paid for +income taxes +$ — +$ — +Interest +paid +$ 10 +$ — +Non-cash +financing activity +Restricted stock +units issued +$ 147 +$ 140 +See notes to consolidated financial statements. +F-5 +B K TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of Significant Accounting Policies +Description of Business +BK +Technologies Corporation (collectively with its subsidiaries, the +“Company”) is a holding company. The primary business +of its wholly-owned operating subsidiary, BK Technologies, Inc., is +the designing, manufacturing and marketing of wireless +communications equipment primarily consisting of two-way land +mobile radios and related products, which are sold in two primary +markets: (1) the government and public safety market, and (2) the +business and industrial market. The Company has only one reportable +business segment. +On +March 28, 2019, BK Technologies, Inc., the predecessor of BK +Technologies Corporation, implemented a holding company +reorganization, which resulted in BK Technologies Corporation +becoming the direct parent company of, and the successor issuer to, +BK Technologies, Inc. For the purpose of this report, references to +the “Company” or its management or business at any +period prior to the holding company reorganization (March 28, 2019) +refer to those of BK Technologies, Inc. as the predecessor company +and its subsidiaries and thereafter to those of BK Technologies +Corporation and its subsidiaries, except as otherwise specified or +to the extent the context otherwise indicates. +Principles of Consolidation +The +accounts of the Company have been included in the accompanying +consolidated financial statements. All significant intercompany +balances and transactions have been eliminated in +consolidation. +The +Company consolidates entities in which it has a controlling +financial interest. The Company determines whether it has a +controlling financial interest in an entity by first evaluating +whether the entity is a variable interest entity +(“VIE”) or a voting interest entity. +VIEs +are entities in which (i) the total equity investment at risk is +not sufficient to enable the entity to finance its activities +independently, or (ii) the at-risk equity holders do not have the +normal characteristics of a controlling financial interest. A +controlling financial interest in a VIE is present when an +enterprise has one or more variable interests that have both (i) +the power to direct the activities of the VIE that most +significantly impact the VIE’s economic performance, and (ii) +the obligation to absorb losses of the VIE or the right to receive +benefits from the VIE that could potentially be significant to the +VIE. The enterprise with a controlling financial interest is the +primary beneficiary and consolidates the VIE. +Voting +interest entities lack one or more of the characteristics of a VIE. +The usual condition for a controlling financial interest is +ownership of a majority voting interest for a corporation or a +majority of kick-out or participating rights for a limited +partnership. +When +the Company does not have a controlling financial interest in an +entity but exerts significant influence over the entity’s +operating and financial policies (generally defined as owning a +voting or economic interest of between 20% to 50%), the +Company’s investment is accounted for under the equity method +of accounting. If the Company does not have a controlling financial +interest in, or exert significant influence over, an entity, the +Company accounts for its investment at fair value, if the fair +value option was elected, or at cost. +The +Company has an investment in 1347 Property Insurance Holdings, +Inc., made through FGI 1347 Holdings, LP, a consolidated +VIE. +Inventories +Inventories are +stated at the lower of cost (determined by the average cost method) +or net realizable value. Freight costs are classified as a +component of cost of products in the accompanying consolidated +statements of operations. +F-6 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of Significant Accounting Policies +(Continued) +The +allowance for slow-moving, excess, or obsolete inventory is used to +state the Company’s inventories at the lower of cost or net +realizable value. Because the amount of inventory that will +actually be recouped through sales cannot be known with certainty +at any particular time, the Company relies on past sales +experience, future sales forecasts, and its strategic business +plans. Generally, in analyzing inventory levels, inventory is +classified as having been used or unused during the past year. The +Company then establishes an allowance based upon several factors, +including, but not limited to, business forecasts, inventory +quantities and historic usage profile. +Supplemental to the +aforementioned analysis, specific inventory items are reviewed +individually by management. Based on the review, considering +business levels, future prospects, new products and technology +changes, management, using its business judgment, may adjust the +valuation of specific inventory items to reflect an accurate +valuation estimate. Management also performs a determination of net +realizable value for all finished goods with a selling price below +cost. For all such items, the inventory is valued at not more than +the selling price less cost, if any, to sell. +Property, Plant and Equipment +Property, plant and +equipment is carried at cost less accumulated depreciation. +Expenditures for maintenance, repairs and minor renewals are +expensed as incurred. When assets are retired or otherwise disposed +of, the related cost and accumulated depreciation are removed from +the respective accounts and the resulting gain or loss is reflected +in operations for the period. +Depreciation and +amortization are generally computed on the straight-line method +using lives of 3 to 10 years for machinery and equipment and 5 to 8 +years for leasehold improvements. +Impairment of Long-Lived Assets +Management +regularly reviews long-lived assets and intangible assets for +impairment whenever events or changes in circumstances indicate +that the carrying amount of an asset may not be recoverable. +Recoverability of assets to be held and used is measured by a +comparison of the carrying amount of an asset to future +undiscounted net cash flows expected to be generated by the asset. +If such assets are considered to be impaired, the impairment to be +recognized is measured as the amount by which the carrying amount +of the assets exceeds their fair value, which considers the +discounted future net cash flows. No long-lived assets were +considered impaired at December 31, 2019 and 2018. +Cash Equivalents +The +Company considers all highly liquid investments with an original +maturity of three months or less to be cash +equivalents. +Allowance for Doubtful Accounts +The +Company records an allowance for doubtful accounts based on +specifically identified amounts that the Company believes to be +uncollectible. The Company also records an additional allowance +based on certain percentages of the Company’s aged +receivables , which are determined +based on historical experience and the Company’s assessment +of the general financial conditions affecting the Company’s +customer base. If the Company’s actual collections experience +changes, revisions to the Company’s allowance may be +required. After all attempts to collect a receivable have failed, +the receivable is written off against the allowance. Based on the +information available, management believes the allowance for +doubtful accounts as of December 31, 2019 and 2018 is +adequate. +F-7 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of Significant Accounting Policies +(Continued) +Revenue Recognition +Effective January +1, 2018, the Company adopted Accounting Standards Update +(“ASU”) 2014-09, “Revenue from Contracts with +Customers” and the additional related ASUs (“ASC +606”), which replaced existing revenue guidance and outlines +a single set of comprehensive principles for recognizing revenue +under accounting principles generally accepted in the United States +of America (“GAAP”). The Company elected the modified +retrospective method upon adoption, with no impact to the opening +retained earnings or revenue reported. These standards provide +guidance on recognizing revenue, including a five-step method to +determine when revenue recognition is appropriate: +Step 1: +Identify the contract with the customer; +Step 2: +Identify the performance obligations in the contract; +Step 3: +Determine the transaction price; +Step 4: +Allocate the transaction price to the performance obligations; +and +Step 5: +Recognize revenue as the Company satisfies a performance +obligation. +ASC 606 +provides that sales revenue is recognized when control of the +promised goods or services is transferred to customers at an amount +that reflects the consideration to which the entity expects to be +entitled to in exchange for those goods or services. The Company +generally satisfies performance obligations upon shipment of the +product or service to the customer. This is consistent with the +time in which the customer obtains control of the product or +service. For extended warranties, sales revenue associated with the +warranty is deferred at the time of sale and later recognized on a +straight-line basis over the extended warranty period. Some +contracts include installation services, which are completed in a +short period of time and the revenue is recognized when the +installation is complete. Customary payment terms are granted to +customers, based on credit evaluations. Currently, the Company does +not have any contracts where revenue is recognized, but the +customer payment is contingent on a future event. +The +Company periodically reviews its revenue recognition procedures to +assure that such procedures are in accordance with GAAP. Surcharges +collected on certain sales to government customers and remitted to +governmental agencies are not included in revenues or in costs and +expenses. +Income Taxes +The +Company accounts for income taxes using the asset and liability +method specified by GAAP. Deferred tax assets and liabilities are +recognized for the future tax consequences attributable to +differences between the financial statement carrying amounts of +existing assets and liabilities and their respective tax bases. +Deferred tax assets and liabilities are measured using the enacted +tax rates expected to apply in the period in which the deferred tax +asset or liability is expected to be realized. The effect of +changes in net deferred tax assets and liabilities is recognized on +the Company’s consolidated balance sheets and consolidated +statements of operations in the period in which the change is +recognized. Valuation allowances are provided to the extent that +impairment of tax assets is more likely than not. In determining +whether a tax asset is realizable, the Company considers, among +other things, estimates of future earnings based on information +currently available, current and anticipated customers, contracts +and new product introductions, as well as recent operating results +and certain tax planning strategies. If the Company fails to +achieve the future results anticipated in the calculation and +valuation of net deferred tax assets, the Company may be required +to increase the valuation allowance related to its deferred tax +assets in the future. +F-8 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of Significant Accounting Policies +(Continued) +On +December 22, 2017, the U.S. government enacted comprehensive tax +legislation commonly referred to as the Tax Cuts and Jobs Act (the +“2017 Tax Act”). The 2017 Tax Act makes broad and +complex changes to the U.S. tax code, including, but not limited +to, (1) reducing the U.S. federal corporate tax rate from 35% to +21%; (2) eliminating the corporate alternative minimum tax +(“AMT”) and changing how existing AMT credits can be +realized; and (3) changing rules related to uses and limitations of +net operating loss carryforwards created in tax years beginning +after December 31, 2017. +In +connection with the Company’s initial analysis of the impact +of the 2017 Tax Act, the Company recorded a discrete net tax +expense of $665 in the year ended December 31, 2017 for the effect +of the corporate rate reduction, which was finalized as of December +31, 2018. The net tax expense primarily relates to a reduction in +the deferred tax assets of $1,524 and a reduction in the deferred +tax liability related to unrealized gain on available-for-sale +securities of $(859). +Concentration of Credit Risk +The +Company performs periodic credit evaluations of its +customers’ financial condition and generally does not require +collateral. At December 31, 2019 and 2018, accounts receivable from +governmental customers were approximately $353 and $3,331, +respectively. Generally, receivables are due within 30 days. Credit +losses relating to customers have been consistently within +management’s expectations. +The +Company primarily maintains cash balances at one financial +institution. Accounts are insured by the Federal Deposit Insurance +Corporation (“FDIC”) up to $250. From time to time, the +Company has had cash in financial institutions in excess of +federally insured limits. As of December 31, 2019, the Company had +cash and cash equivalents in excess of FDIC limits of +$5,009. +Manufacturing and Raw Materials +The +Company relies upon a limited number of manufacturers to produce +its products and on a limited number of component suppliers. Some +of these manufacturers and suppliers are in other countries. +Approximately 67.0% of the Company’s material, subassembly +and product procurements in 2019 were sourced internationally, of +which approximately 64.0% were sourced from three suppliers. For +2018, approximately 66.8% of the Company’s material, +subassembly and product procurements were sourced internationally, +of which approximately 60.0%were sourced from two suppliers. +Purchase orders denominated in U.S. dollars are placed with these +suppliers from time to time and there are no guaranteed supply +arrangements or commitments. +Use of Estimates +The +preparation of financial statements in conformity with GAAP +requires management to make estimates and assumptions that affect +the reported amounts of assets and liabilities at the date of the +consolidated financial statements and the reported amounts of sales +and expenses during the reporting period. Significant estimates +include accounts receivable allowances, inventory obsolescence +allowance, warranty allowance, and income tax accruals. Actual +results could differ from those estimates. +Fair Value of Financial Instruments +The +Company’s financial instruments consist of cash and cash +equivalents, trade accounts receivable, investment in securities, +accounts payable, accrued expenses and other liabilities. As of +December 31, 2019 and 2018, the carrying amount of cash and cash +equivalents, trade accounts receivable, accounts payable, accrued +expenses and other liabilities approximated their respective fair +value due to the short-term nature and maturity of these +instruments. The Company uses observable market data or assumptions +(Level 1 inputs, as defined in accounting guidance) that it +believes market participants would use in pricing the investment in +securities. There were no sales of +investment in securities as a result of an other-than-temporary +impairment of the securities. There were no transfers of +investments in securities between Level 1 and Level 2 during the +years ended December 31, 2019 and 2018. +F-9 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of Significant Accounting Policies +(Continued) +Available-For-Sale Securities +Investments +reported on the December 31, 2017 balance sheet consisted of +marketable equity securities of a publicly held company, Iteris, +Inc. (Nasdaq: ITI). As of December 31, 2017, the investment cost +was $2,402. On January 1, 2018, the Company adopted ASU 2016-01 +“Financial Instruments,” which amended the guidance in +GAAP regarding the classification and measurement of financial +instruments. Changes to the prior guidance primarily affected the +accounting for equity investments, financial liabilities under the +fair value option and the presentation and disclosure requirements +for financial instruments. In addition, the ASU clarified guidance +related to the valuation allowance assessment when recognizing +deferred tax assets resulting from unrealized losses on +available-for-sale debt securities. Upon its adoption, the Company +applied the amendments by means of a cumulative-effect adjustment +to the balance sheet at the beginning of the first reporting period +in which the guidance was effective. On January 1, 2018, the +Company recognized approximately $4,300 of net unrealized gain in +its accumulated deficit balance. During the first quarter of 2018, +the Company sold 1,317,503 shares of Iteris, Inc., which cost +$2,402, for approximately $8,335 of proceeds and reported a loss on +the sale of approximately $849. +Shipping and Handling Costs +Shipping and +handling costs are classified as a part of cost of products in the +accompanying consolidated statements of operations for the years +ended December 31, 2019 and 2018. Amounts billed to a customer, if +any, for shipping and handling are reported as +revenue. +Advertising and Promotion Costs +The +cost for advertising and promotion is expensed as incurred. +Advertising and promotion expenses are classified as part of +selling, general and administrative (“SG&A”) +expenses in the accompanying consolidated statements of operations. +For the years ended December 31, 2019 and 2018, such expenses +totaled $555 and $597, respectively. +Engineering, Research and Development Costs +Included in +SG&A expenses for the years ended December 31, 2019 and 2018 +are engineering, research and development costs of $9,803 and +$7,768, respectively. +Share-Based Compensation +The +Company accounts for share-based arrangements in accordance with +GAAP, which requires a public entity to measure the cost of +employee services received in exchange for an award of equity +instruments based on the grant-date fair value of the award (with +limited exceptions). That cost will be recognized over the period +during which the employee is required to provide service in +exchange for the award requisite service period (usually the +vesting period). No compensation cost is recognized for equity +instruments for which employees do not render the requisite +service. +Restricted Stock Units +On +September 6, 2019, the Company granted to each non-employee +director restricted stock units with a grant fair value of $40 per +award (resulting in total aggregate grant-date fair value of $280), +which will vest in five equal, annual installments beginning with +the first anniversary of the grant date, subject to the +director’s continued service through such date, provided +that, if the director makes himself available and consents to be +nominated by the Company for continued service as a director, but +is not nominated for the Board for election by shareholders, other +than for good reason, as determined by the Board in its discretion, +then the restricted stock units shall vest in full as of the +director’s last date of service as a director of the +Company. +F-10 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of +Significant Accounting Policies (Continued) +On +September 6, 2018, the Company granted to each non-employee +director restricted stock units with a grant fair value of $20 per +award (resulting in total aggregate grant-date fair value of $140), +which vest in five equal, annual installments beginning with the +first anniversary of the grant date, subject to the +director’s continued service through such date, provided +that, if the director makes himself available and consents to be +nominated by the Company for continued service as a director, but +is not nominated for the Board for election by shareholders, other +than for good reason, as determined by the Board in its discretion, +then the restricted stock units vest in full as of the +director’s last date of service as a director of the Company. +On September 6, 2019, which was the first anniversary of the grant +date, the first tranche of the September 2018 restricted stock +units vested. +On June +4, 2018, the Company granted to each non-employee director +restricted stock units with a grant fair value of $20 per award +(resulting in total aggregate grant-date fair value of $140), which +vested on June 4, 2019, subject to continued service through such +vesting date. +On June +15, 2017, the Company granted to each non-employee director +restricted stock units with a grant fair value of $20 per award +(resulting in total aggregate grant-date fair value of $140), which +vested on June 15, 2018. +The +Company recorded non-cash restricted stock unit compensation +expense of $105 and $153 for the years ended December 31, 2019 and +2018, respectively. +Earnings (Loss) Per Share +Earnings (loss) per +share amounts are computed and presented for all periods in +accordance with GAAP. +Comprehensive Loss +Comprehensive loss +was equal to net loss for the years ended December 31, 2019 and +2018. +Product Warranty +The +Company offers two-year warranties to its customers, depending on +the specific product and terms of the customer purchase agreement. +The Company’s typical warranties require it to repair and +replace defective products during the warranty period at no cost to +the customer. At the time the product revenue is recognized, the +Company records a liability for estimated costs under its +warranties. The costs are estimated based on historical experience. +The Company periodically assesses the adequacy of its recorded +liability for product warranties and adjusts the amount as +necessary. +Recently Adopted Accounting Pronouncements +In May 2014, +the Financial Accounting Standards Board (“FASB”) +issued ASU 2014-09 on “Revenue from Contracts with +Customers,” which provided for a single, principles-based +model for revenue recognition and replaced the existing revenue +recognition guidance. In August 2015, the FASB issued ASU 2015-14, +which delayed the effective date of ASU 2014-09 by one year. The +guidance became effective for annual and interim periods beginning +on or after December 15, 2017, and replaced most existing revenue +recognition guidance under GAAP when it became effective. This ASU +required additional disclosures about the nature, amount, timing +and uncertainty of revenue and cash flows arising from customer +contracts, including significant judgments and estimates and +changes in those estimates. It permitted the use of either a +retrospective or cumulative effect transition method. The Company +adopted ASU 2014-09 in the first quarter of 2018 and applied the +modified retrospective approach. Because the Company’s +primary source of revenues is from shipments of products, the +adoption of ASU 2014-09 did not have a material impact on its +consolidated financial statements. See Note 1, under “Revenue +Recognition,” for additional information. +F-11 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +1. Summary of Significant Accounting Policies +(Continued) +In +January 2016, the FASB issued ASU 2016-01 “Financial +Instruments,” which amended the guidance in GAAP on the +classification and measurement of financial instruments. Changes to +the previous guidance primarily affected the accounting for equity +investments, financial liabilities under the fair value option, and +the presentation and disclosure requirements for financial +instruments. In addition, the ASU clarified guidance related to the +valuation allowance assessment when recognizing deferred tax assets +resulting from unrealized losses on available-for-sale debt +securities. The new standard became effective for fiscal years and +interim periods beginning after December 15, 2017, and upon +adoption, an entity was required to apply the amendments by means +of a cumulative-effect adjustment to the balance sheet at the +beginning of the first reporting period in which the guidance is +effective. On January 1, 2018, the Company adopted the new guidance +and, consequently, the Company recognized approximately $4,300 of +net unrealized gain in its accumulated deficit +balance. +In +August 2018, the FASB issued ASU 2018-15, +“Intangibles—Goodwill and Other—Internal-Use +Software (Subtopic 350-40): Customer’s Accounting for +Implementation Costs Incurred in a Cloud Computing Arrangement That +Is a Service Contract,” to help entities evaluate the +accounting for fees paid by a customer in a cloud computing +arrangement (hosting arrangement) by providing guidance for +determining when the arrangement includes a software license. The +amendments in ASU 2018-15 align the requirements for capitalizing +implementation costs incurred in a hosting arrangement that is a +service contract with the requirements for capitalizing +implementation costs incurred to develop or obtain internal-use +software (and hosting arrangements that include an internal use +software license). The accounting for the service element of a +hosting arrangement that is a service contract is not affected by +the amendments in ASU 2018-15. The amendments in ASU 2018-15 will +become effective for fiscal years and interim periods beginning +after December 15, 2019. Early adoption is permitted, including +adoption in any interim period. The Company adopted the new +guidance in the fourth quarter of 2018, with no material impact on +its consolidated financial statements and related +disclosures. +In +February 2016, the FASB issued ASU 2016-02 “Leases,” +which amended leasing guidance by requiring companies to recognize +a right-of-use (“ROU”) asset and a lease liability for +all operating and capital (finance) leases with lease terms greater +than twelve months. The lease liability is equal to the present +value of lease payments. The lease asset is based on the lease +liability, subject to adjustment, such as for initial direct costs. +For income statement purposes, leases continue to be classified as +operating or capital (finance), with lease expense in both cases +calculated substantially the same as under the prior leasing +guidance. The updated guidance became effective for interim and +annual periods beginning after December 15, 2018. The Company +adopted the new guidance on January 1, 2019. Adoption resulted in +the recognition of ROU assets and lease liabilities on the +consolidated financial statements. Based on the Company’s +lease portfolio as of December 31, 2019, which consisted solely of +operating leases, the Company recognized approximately $2,885 of +ROU assets and $2,975 of lease liabilities on its consolidated +financial statements as of December 31, 2019. Refer to Note 7 +(Leases) for further details on leases. +Recent Accounting Pronouncements +The +Company does not discuss recent pronouncements that are not +anticipated to have an impact on or are unrelated to its financial +condition, results of operations, cash flows or +disclosures. +F-12 +BK TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +2. Inventories, net +Inventories, which +are presented net of allowance for obsolete and slow-moving +inventory, consisted of the following: +December 31, +2019 +2018 +Finished +goods +$ 3,864 +$ 2,004 +Work in +process +6,122 +5,750 +Raw +materials +3,527 +3,712 +$ 13,513 +$ 11,466 +Changes +in the allowance for obsolete and slow-moving inventory are as +follows: +Years Ended +December 31, +2019 +2018 +Balance, beginning +of year +$ 629 +$ 789 +Charged to cost of +sales +194 +(38 ) +Disposal of +inventory +— +(122 ) +Balance, end of +year +$ 823 +$ 629 +For the +year ended December 31, 2018, the Company wrote off obsolete +inventory that had been fully allowed for previously, which had no +material impact to the Company’s consolidated balance sheets +or consolidated statements of operations. +3. Allowance for Doubtful Accounts +Changes +in the allowance for doubtful accounts are composed of the +following: +Years Ended +December 31, +2019 +2018 +Balance, beginning +of year +$ 50 +$ 50 +Provision for +doubtful accounts +— +— +Uncollectible +accounts written off +— +— +Balance, end of +year +$ 50 +$ 50 +4. Property, Plant and Equipment, net +Property, plant and +equipment, net include the following: +December 31, +2019 +2018 +Leasehold +improvements +$ 732 +$ 542 +Machinery and +equipment +12,430 +10,224 +Less accumulated +depreciation and amortization +(9,198 ) +(8,037 ) +Property, plant and +equipment, net +$ 3,964 +$ 2,729 +Depreciation and +amortization expense relating to property, plant and equipment for +the years ended December 31, 2019 and 2018 was approximately $1,219 +and $868, respectively. +F-13 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +5. Debt +On +January 30, 2020, BK Technologies, Inc., a wholly-owned subsidiary +of the Company, entered into a $5,000 Credit Agreement and a +related Line of Credit Note (the “Note” and +collectively with the Credit Agreement, the “Credit +Agreement”) with JPMorgan Chase Bank, N.A. +(“JPMC”). +The +Credit Agreement provides for a revolving line of credit of up to +$5,000, with availability under the line of credit subject to a +borrowing base calculated as a percentage of accounts receivable +and inventory. The line of credit will expire on January 31, 2021. +Proceeds of borrowings under the Credit Agreement may be used for +general corporate purposes. The line of credit is collateralized +by a blanket lien on all personal property of BK Technologies, Inc. +pursuant to the terms of the Continuing Security Agreement with the +Lender. The Company and each subsidiary of BK Technologies, Inc. +are guarantors of BK Technologies, Inc.’s obligations under +the Credit Agreement, in accordance with the terms of the +Continuing Guaranty. +Borrowings under +the Credit Agreement will bear interest at a rate per annum equal +to one-month LIBOR or zero if the LIBOR is less than zero) plus a +margin of 1.90%. The line of credit is to be repaid in monthly +payments of interest only, payable in arrears, commencing on +February 1, 2020, with all outstanding principal and interest to be +payable in full at maturity. +The +Credit Agreement contains certain customary restrictive covenants, +including restrictions on liens, indebtedness, loans and +guarantees, acquisitions and mergers, sales of assets, and stock +repurchases by BK Technologies, Inc. The Credit Agreement contains +one financial covenant requiring BK Technologies, Inc. to maintain +a tangible net worth of at least $20,000 at any fiscal quarter +end. +The +Credit Agreement provides for customary events of default, +including: (1) failure to pay principal, interest or fees under the +Credit Agreement when due and payable; (2) failure to comply with +other covenants and agreements contained in the Credit Agreement +and the other documents executed in connection therewith; (3) the +making of false or inaccurate representations and warranties; (4) +defaults under other agreements with JPMC or under other debt or +other obligations of BK Technologies, Inc.; (5) money judgments and +material adverse changes; (6) a change in control or ceasing to +operate business in the ordinary course; and (7) certain events of +bankruptcy or insolvency. Upon the occurrence of an event of +default, JPMC may declare the entire unpaid balance immediately due +and payable and/or exercise any and all remedial and other rights +under the Credit Agreement. +On +September 25, 2019, BK Technologies, Inc., a wholly-owned +subsidiary of BK Technologies Corporation, and U.S. Bank Equipment +Finance, a division of U.S. Bank National Association, as a lender, +entered into a Master Loan Agreement in the amount of $425 to +finance various items of equipment. The loan is collateralized by +the equipment purchased using the proceeds. The Master Loan +Agreement is payable in 60 monthly principal and interest payments +of approximately $8 beginning on October 25, 2019 and maturing on +September 25, 2024, and bears a fixed interest rate of +5.11%. +On +March 28, 2019, BK Technologies, Inc., a wholly-owned subsidiary of +the Company, RELM Communications, Inc., a wholly-owned subsidiary +of BK Technologies, Inc., and Silicon Valley Bank, as lender +(“SVB”), entered into an Amended and Restated Loan and +Security Agreement (the “Loan and Security Agreement”). +The Loan and Security Agreement replaced BK Technologies, +Inc.’s prior Loan and Security Agreement with SVB (the +“Prior Agreement”) under which its collateralized +revolving credit facility (the “Credit Facility”) was +maintained. The Loan and Security Agreement matured on December 26, +2019, and the Company elected not to renew it. +Pursuant to the Loan and Security Agreement, the +Credit Facility provided BK Technologies, Inc. with a maximum +borrowing availability of $1,000 and BK Technologies, Inc. was +subject to substantially the same customary borrowing terms and +conditions under the Credit Facility as it was under the Prior +Agreement, including the accuracy of representations and +warranties, compliance with financial maintenance and restrictive +covenants and the absence of events of +default. Pursuant to the Loan and Security Agreement, +payment of cash dividends, in the +aggregate not to exceed $5,000 during any twelve-month period, was +permitted so long as an event of default did not exist at +the time of such dividend and would not exist after giving effect +to such dividend. The variable rate at which borrowings under the +Credit Facility were to bear interest was The Wall Street Journal prime rate plus 25 +basis points. +F-14 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +5. Debt (Continued) +The +financial maintenance covenants, which were required to be +maintained at all times and tested quarterly (or, for the +“Adjusted Quick Ratio” covenant, monthly, if any +obligations were outstanding), included: (1) a ratio of +“Quick Assets” to the sum of “Current +Liabilities” plus outstanding borrowings to SVB to the extent +not included in “Current Liabilities” minus the current +portion of “Deferred Revenue” (all as defined in the +Loan and Security Agreement) of at least 1.25:1.00 and (2) maximum +“Total Leverage” (as defined in the Loan and Security +Agreement) of no greater total consolidated +“Indebtedness” than 3 times “Adjusted +EBITDA” (all as defined in the Loan and Security Agreement). +BK Technologies, Inc.’s obligations were collateralized by +substantially all of its assets, principally accounts receivable +and inventory. +BK +Technologies, Inc. was in compliance with all covenants under the +Loan and Security Agreement when it matured on December 26, 2019. +BK Technologies, Inc. had no borrowings outstanding under the +credit facility at the time it matured. +6. Investment in Securities +The +Company has an investment in a limited partnership, FGI 1347 +Holdings, LP, of which the Company is the sole limited partner. FGI +1347 Holdings, LP was established for the purpose of investing in +securities. +As +of December 31, 2019, the Company indirectly held approximately +$190 in cash and 477,282 shares of 1347 Property Insurance +Holdings, Inc. (Nasdaq: PIH) with fair value of $2,635, through an +investment in FGI 1347 Holdings, LP. These shares were purchased in +March and May 2018 for approximately $3,741. As of December 31, +2019 and 2018, the unrealized loss on the investment was +approximately $1,106 and $1,822, respectively. +During +the years ended December 31, 2019 and 2018, the Company recognized +a gain of approximately $716 and a loss of approximately of $1,822, +respectively, due to changes in the unrealized loss on investment +in securities. +Affiliates of +Fundamental Global Investors, LLC serve as the general partner and +the investment manager of FGI 1347 Holdings, LP, and the Company is +the sole limited partner. As of December 31, 2019, the Company and +the affiliates of Fundamental Global Investors, LLC, including, +without limitation, Ballantyne Strong, Inc., beneficially owned in +the aggregate 2,714,362 shares of PIH’s common stock, +representing approximately 45.1% of PIH’s outstanding shares. +Fundamental Global with its affiliates is the largest stockholder +of the Company. Mr. Kyle Cerminara, Chairman of the Company’s +Board of Directors, is Chief Executive Officer, Co-Founder and +Partner of Fundamental Global Investors, LLC and serves as Chief +Executive Officer and Chairman of the Board of Directors of +Ballantyne Strong. Mr. Lewis M. Johnson, Co-Chairman of the +Company, is President, Co-Founder and Partner of Fundamental Global +Investors, LLC and serves as Co-Chairman of Ballantyne Strong. +Messrs. Cerminara and Johnson also serve as Chairman and +Co-Chairman, respectively, of the Board of Directors of +PIH. +7. Leases +The +Company leases approximately 54,000 square feet (not in thousands) +of industrial space in West Melbourne, Florida, under a +non-cancellable operating lease. The lease has the expiration date +of June 30, 2027. Rental, maintenance and tax expenses for this +facility were approximately $502 and $490 in 2019 and 2018, +respectively. The Company also leases 8,100 square feet (not in +thousands) of office space in Lawrence, Kansas, to accommodate a +portion of the Company's engineering team. In November 2019, this +lease was amended to extend the lease term until December 31, 2021. +Rental, maintenance and tax expenses for this facility were +approximately $108 in 2019 and 2018. +In +February 2020, the Company entered into a lease for 6,857 (not in +thousands) square feet of office space at Sawgrass Technology Park, +1619 NW 136 th Avenue in Sunrise, +Florida, for a period of 64 months. Annual rental, maintenance and +tax expenses for the facility will be approximately $196 for the +first year, increasing by approximately 3% for each subsequent +twelve month period. +The +Company adopted ASU No. 2016-02, “Leases” (Topic 842) +on January 1, 2019 and applied the modified retrospective approach +to adoption whereby the standard is applied only to the current and +future periods. The Company leases manufacturing and office +facilities and equipment under operating leases and determines if +an arrangement is a lease at inception. ROU assets represent the +Company’s right to use an underlying asset for the lease term +and lease liabilities represent its obligation to make lease +payments arising from the lease. Operating lease ROU assets and +liabilities are recognized at the lease commencement date based on +the present value of lease payments over the lease +term. +As +most of its leases do not provide an implicit rate, the Company +uses its incremental borrowing rate based on the information +available at commencement date in determining the present value of +lease payments. The Company’s lease terms may include options +to extend or terminate the lease when it is reasonably certain that +the Company will exercise that option. The Company has lease +agreements with lease and non-lease components, which are accounted +for separately. +F-15 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +7. Leases (Continued) +Lease +costs consist of the following: +December +31, +2019 +Operating lease +cost +$ 573 +Short-term lease +cost +2 +Variable lease +cost +128 +Total lease +cost +$ 703 +Supplemental +cash flow information related to leases was as +follows: +December +31, +2019 +Cash paid for +amounts included in the measurement of lease +liabilities: +Operating +cash flows (fixed payments) +$ 522 +Operating cash +flows (liability reduction) +$ 369 +Other +information related to operating leases was as +follows: +December +31, +2019 +Weighted average +remaining lease term (in years) +6.23 +Weighted average +discount rate +5.50 % +Maturity +of lease liabilities as of December 31, 2019 were as +follows: +December 31, +2019 +2020 +$ 522 +2021 +552 +2022 +439 +2023 +448 +2024 +456 +Thereafter +1,190 +Total +payments +3,607 +Less: +imputed interest +632 +Total +liability +$ 2,975 +F-16 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +8. Income Taxes +The +income tax benefit is summarized as follows: +Years Ended +December 31, +2019 +2018 +Current: +Federal +$ (107 ) +$ (110 ) +State +(3 ) +10 +(110 ) +(100 ) +Deferred: +Federal +(889 ) +(280 ) +State +12 +103 +(877 ) +(177 ) +$ (987 ) +$ (277 ) +A +reconciliation of the statutory U.S. income tax rate to the +effective income tax rate follows: +Years Ended +December 31, +2019 +2018 +Statutory U.S. +income tax rate +(21.00 )% +(21.00 )% +State taxes, net of +federal benefit +(1.21 )% +1.75 % +Permanent +differences +0.61 % +3.52 % +Change in valuation +allowance +0.00 % +(13.53 )% +Change in net +operating loss carryforwards and tax credits +(5.50 )% +(33.48 )% +Other +(0.14 )% +4.02 % +Effective income +tax rate +(27.24 )% +(58.72 )% +F-17 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +8. Income Taxes (Continued) +The +components of the deferred income tax assets (liabilities) are as +follows: +Years Ended +December 31, +2019 +2018 +Deferred tax +assets: +Operating +loss carryforwards +$ 1,347 +$ 313 +R&D +Tax Credit +1,678 +1,394 +AMT Tax +Credit +72 +179 +Section +263A costs +294 +252 +R&D +costs +110 +224 +Amortization +24 +24 +Unrealized +loss +252 +422 +Asset +reserves: +Bad +debts +11 +12 +Inventory +allowance +187 +146 +Accrued +expenses: +Non-qualified +stock options +132 +112 +Compensation +132 +140 +Warranty +904 +764 +Deferred tax +assets +5,143 +3,982 +Less state +valuation allowance +— +— +Total deferred tax +assets +5,143 +3,982 +Deferred tax +liabilities: +Depreciation +(770 ) +(487 ) +Total deferred tax +liabilities +(770 ) +(487 ) +Net deferred tax +assets (before unrealized gain) +4,373 +3,495 +Deferred tax +liability: unrealized gain +— +— +Net deferred tax +assets +$ 4,373 +$ 3,495 +As of +December 31, 2019, the Company had a net deferred tax asset of +approximately $5,143 offset by deferred tax liabilities of $770 +derived from accelerated tax depreciation. This asset is primarily +composed of net operating loss carryforwards (“NOLs”), +research and development tax credits and costs, and deferred +revenue. The NOLs total approximately $4,857 for federal and $7,526 +for state purposes, with expirations starting in 2020 for state +purposes. State NOLs of $1,209 expired in 2019. +During +2018, the Company generated no additional NOLs and during 2019, the +Company generated $4,857 of additional federal NOLs. The deferred +tax asset amounts are based upon management’s conclusions +regarding, among other considerations, the Company’s current +and anticipated customer base, contracts, and product +introductions, certain tax planning strategies, and +management’s estimates of future earnings based on +information currently available, as well as recent operating +results during 2019, 2018, and 2017. GAAP requires that all +positive and negative evidence be analyzed to determine if, based +on the weight of available evidence, the Company is more likely +than not to realize the benefit of the deferred tax +asset. +F-18 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +8. Income Taxes (Continued) +Management’s +analysis of all available evidence, both positive and negative, +provides support that the Company has the ability to generate +sufficient taxable income in the necessary period to utilize the +entire benefit for the deferred tax asset. +Should +the factors underlying management’s analysis change, future +valuation adjustments to the Company’s net deferred tax asset +may be necessary. If future losses are incurred, it may be +necessary to record a valuation allowance related to the +Company’s net deferred tax asset recorded as of December 31, +2019. It cannot presently be estimated what, if any, changes to the +valuation of the Company’s deferred tax asset may be deemed +appropriate in the future. The 2019 federal and state NOLs and tax +credit carryforwards could be subject to limitation if, within any +three-year period prior to the expiration of the applicable +carryforward period, there is a greater than 50% change in +ownership of the Company. +For the +year ended December 31, 2019, the Company is expecting a refund of +a portion of the alternative minimum tax credits of approximately +$72 (net). The alternative minimum tax legislation was repealed by +the 2017 Tax Act. +The +Company performed a comprehensive review of its portfolio of +uncertain tax positions in accordance with recognition standards +established by GAAP. In this regard, an uncertain tax position +represents the Company’s expected treatment of a tax position +taken in a filed tax return or planned to be taken in a future tax +return that has not been reflected in measuring income tax expense +for financial reporting purposes. As a result of this review, on +January 1, 2020, the Company is not aware of any uncertain tax +positions that would require additional liabilities or which such +classification would be required. The amount of unrecognized tax +positions did not change as of December 31, 2019, and the Company +does not believe there will be any material changes in its +unrecognized tax positions over the next twelve +months. +Penalties and +tax-related interest expense, of which there were no material +amounts for the years ended December 31, 2019 and 2018, are +reported as a component of income tax expense +(benefit). +The +Company files federal income tax returns, as well as multiple state +and local jurisdiction tax returns. A number of years may elapse +before an uncertain tax position is audited and finally resolved. +While it is often difficult to predict the final outcome or the +timing of resolution on any particular uncertain tax position, the +Company believes that its allowances for income taxes reflect the +most probable outcome. The Company adjusts these allowances, as +well as the related interest, in light of changing facts and +circumstances. The resolution of a matter would be recognized as an +adjustment to the provision for income taxes and the effective tax +rate in the period of resolution. The calendar years 2016, 2017, +and 2018 are still open to IRS examination under the statute of +limitations. The last IRS examination on the Company’s 2007 +calendar year was closed with no change. +F-19 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +9. Loss Per Share +The +following table sets forth the computation of basic and diluted +loss per share: +Years Ended +December 31, +2019 +2018 +Numerator: +Net +loss from continuing operations numerator for basic and diluted +earnings per share +$ (2,636 ) +$ (195 ) +Denominator: +Denominator +for basic loss per share weighted average shares +12,705,304 +13,463,826 +Effect +of dilutive securities: +Stock +options +— +— +Denominator +for diluted loss per share weighted average shares +12,705,304 +13,463,826 +Basic +loss per share +$ (0.21 ) +$ (0.01 ) +Diluted +loss per share +$ (0.21 ) +$ (0.01 ) +Approximately +569,500 stock options and 0 restricted stock units for the year +ended December 31, 2019 and 460,500 stock options and 24,066 +restricted stock units for the year ended December 31, 2018, were +excluded from the calculation because they were +anti-dilutive. +10. Share-Based Employee Compensation +The +Company has an employee and non-employee director incentive +compensation equity plan. Related to these programs, the Company +recorded $148 and $95 of share-based employee compensation expense +during the years ended December 31, 2019 and 2018, respectively, +which is included as a component of cost of products and SG&A +expenses in the accompanying consolidated statements of operations. +No amount of share-based employee compensation expense was +capitalized as part of capital expenditures or inventory for the +years presented. +The +Company uses the Black-Scholes-Merton option valuation model to +calculate the fair value of a stock option grant. The share-based +employee compensation expense recorded in the years ended December +31, 2019 and 2018 was calculated using the assumptions noted in the +following table. Expected volatilities are based on the historical +volatility of the Company’s common stock over the period of +time, commensurate with the expected life of the stock options. The +dividend yield assumption is based on the Company’s +expectations of dividend payouts at the grant date. In 2019, the +Company paid dividends on January 16, for a dividend declared in +2018, April 15, July 15 and October 15. In December 2019, the +Company’s Board of Directors also declared a quarterly +dividend that was paid on January 17, 2020. The Company has +estimated its future stock option exercises. The expected term of +option grants is based upon the observed and expected time to the +date of post vesting exercises and forfeitures of options by the +Company’s employees. The risk-free interest rate is derived +from the average U.S. Treasury rate for the period, which +approximates the rate at the time of the stock option +grant. +FY +2019 +FY +2018 +Expected +Volatility +49.0 % +51.9 % +Expected +Dividends +2.0 % +2.0 % +Expected Term (in +years) +6.5 +6.5 +Risk-Free +Rate +2.36 % +2.76 % +Estimated +Forfeitures +0.0 % +0.0 % +F-20 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +10. Share-Based Employee Compensation (Continued) +A +summary of stock option activity under the Company’s equity +compensation plans as of December 31, 2019, and changes during the +year ended December 31, 2019, are presented below: +As of +January 1, 2019 +Stock +Options +Wgt. Avg. +Exercise Price ($) Per Share +Wgt. Avg. +Remaining Contractual Life (Years) +Wgt. Avg. Grant +Date Fair Value ($) Per Share +Aggregate +Intrinsic Value ($) +Outstanding +460,500 +4.22 +— +1.76 +— +Vested +156,900 +4.03 +— +2.05 +— +Nonvested +303,600 +4.32 +— +1.61 +— +Period +activity +Issued +150,000 +4.01 +— +1.64 +— +Exercised +1,000 +1.89 +— +0.71 +— +Forfeited +40,000 +4.35 +— +1.49 +— +Expired +— +— +— +— +— +As +of December 31, 2019 +Outstanding +569,500 +4.16 +6.82 +1.75 +24,000 +Vested +214,800 +4.12 +4.20 +1.95 +24,000 +Nonvested +354,700 +4.18 +8.40 +1.63 +— +Outstanding: +Range of +Exercise Prices ($) Per Share +Stock Options +Outstanding +Wgt. +Avg. +Exercise Price +($) Per Share +Wgt. Avg. +Remaining Contractual Life (Years) +2.23 +3.83 +175,000 +3.50 +7.68 +4.07 +5.10 +394,500 +4.45 +6.44 +569,500 +4.16 +6.82 +Exercisable: +Range of +Exercise Prices ($) Per Share +Stock Options +Exercisable +Wgt. +Avg. +Exercise Price +($) Per Share +2.23 +3.83 +53,000 +3.03 +4.07 +5.10 +161,800 +4.48 +214,800 +4.12 +The +weighted-average grant-date fair value per option granted during +the years ended December 31, 2019 and 2018 was $1.64 and $1.61, +respectively. The aggregate intrinsic value of stock options +exercised during the years ended December 31, 2019 and 2018 was +approximately $1 and $0, respectively. +In +connection with the restricted stock units granted to non-employee +directors, the Company accrues compensation expense based on the +estimated number of shares expected to be issued, utilizing the +most current information available to the Company at the date of +the consolidated financial statements. The Company estimates the +fair value of the restricted stock unit awards based upon the +market price of the underlying common stock on the date of grant. +As of December 31, 2019 and 2018, there was approximately $982 and +$703, respectively, of total unrecognized compensation cost related +to non-vested share-based compensation arrangements, including +stock options and restricted stock units. This compensation cost is +expected to be recognized approximately over four +years. +F-21 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +11. Significant Customers +Sales +to the U.S. Government represented approximately 49.1% and 40.0% of +the Company’s total sales for the years ended December 31, +2019 and 2018, respectively. These sales were primarily to the +various government agencies, including those within the United +States Department of Defense, the United States Forest Service, the +United States Department of Interior, and the United States +Department of Homeland Security. +12. Retirement Plan +The +Company sponsors a participant contributory retirement 401(k) plan, +which is available to all employees. The Company’s +contribution to the plan is either a percentage of the +participant’s contribution (50% of the participant’s +contribution up to a maximum of 6%) or a discretionary amount. For +the years ended December 31, 2019 and 2018, total contributions +made by the Company were $164 and $144, respectively. +13. Commitments and Contingencies +Royalty Commitment +In +2002, the Company entered into a technology license related to its +development of digital products. Under this agreement, the Company +is obligated to pay a royalty for each product sold that utilizes +the technology covered by this agreement. The Company paid $133 and +$164 for the years ended December 31, 2019 and 2018, respectively. +The agreement has an indefinite term, and can be terminated by +either party under certain conditions. +Purchase Commitments +The +Company has purchase commitments for inventory totaling $5,324 as +of December 31, 2019. +Self-Insured Health Benefits +The +Company maintains a self-insured health benefit plan for its +employees. This plan is administered by a third party. As of +December 31, 2019, the plan had a stop-loss provision insuring +losses beyond $80 per employee per year and an aggregate stop-loss +of $1,437. As of December 31, 2019 and 2018, the Company recorded +an accrual for estimated claims in the amount of approximately $165 +and $165, respectively, in accrued other expenses and other current +liabilities on the Company’s consolidated balance +sheets. This amount +represents the Company’s estimate of incurred but not +reported claims as of December 31, 2019 and 2018. +Liability for Product Warranties +Changes +in the Company’s liability for its standard two-year product +warranties during the years ended December 31, 2019 and 2018 are as +follows: +Balance at +Beginning of Year +Warranties +Issued +Warranties +Settled +Balance at End +of Year +2019 +$ 1,546 +$ 606 +$ (904 ) +$ 1,248 +2018 +$ 1,389 +$ 1,329 +$ (1,172 ) +$ 1,546 +Legal Proceedings +From +time to time the Company may be involved in various claims and +legal actions arising in the ordinary course of its +business. +There +were no other pending material claims or legal matters as of +December 31, 2019. +F-22 +BK +TECHNOLOGIES CORPORATION +YEARS ENDED DECEMBER 31, 2019 AND 2018 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and +percentages) +14. Capital Program +In May +2016, the Company implemented a capital return program that +included a stock repurchase program and a quarterly dividend. +Under the program, the Company’s Board of Directors approved +the repurchase of up to 500,000 shares of the Company’s +common stock pursuant to a stock repurchase plan in conformity with +the provisions of Rule 10b5-1 and Rule 10b-18 promulgated under the +Securities Exchange Act of 1934, as amended. In June 2017, the +Board of Directors approved an increase in the Company’s +capital return program, authorizing the repurchase of 500,000 +shares of the Company’s common stock in addition to the +500,000 shares originally authorized, for a total repurchase +authorization of 1 million shares, pursuant to a stock repurchase +plan in conformity with the provisions of Rule 10b5-1 and Rule +10b-18 promulgated under the Securities Exchange Act of 1934, as +amended. The repurchase program has no termination +date. +Pursuant to the +capital return program, during 2018, the Company’s Board of +Directors declared quarterly dividends on the Company’s +common stock of $0.02 per share on March 14, June 4, September 6 +and December 7. The dividends were payable to stockholders of +record as of April 2, 2018, July 2, 2018, October 1, 2018 and +January 2, 2019, respectively. These dividends were paid on April +16, 2018, July 16, 2018, October 15, 2018 and January 16, +2019. +Pursuant to the +capital return program, during 2019, the Company’s Board of +Directors declared quarterly dividends on the Company’s +common stock of $0.02 per share on March 5, June 10, September 12 +and December 5. The dividends were payable to stockholders of +record as of April 1, 2019, July 1, 2019, October 1, 2019 and +January 3, 2020, respectively. These dividends were paid on April +15, 2019, July 15, 2019, October 15, 2019 and January 17, +2020. +In +addition, the Company declared a quarterly dividend of $0.02 per +share of common stock on March 2, 2020, to be paid on April 13, +2020 to holders of record as of March 31, 2020. +F-23 +I tem 9. Changes in and Disagreements with +Accountants on Accounting and Financial Disclosure +None. +I tem 9A. Controls and +Procedures +Evaluation of Disclosure Controls and Procedures +Our +President (who serves as our principal executive officer) and Chief +Financial Officer (who serves as our principal financial and +accounting officer) have evaluated the effectiveness of our +disclosure controls and procedures (as defined in the Exchange Act +Rule 13a-15(e)) as of December 31, 2019. Based on that evaluation, +the President and Chief Financial Officer have concluded that our +disclosure controls and procedures were effective as of December +31, 2019. +Management’s Report on Internal Control over Financial +Reporting +Our +management is responsible for establishing and maintaining adequate +internal control over our financial reporting, as such term is +defined in Rule 13a-15(f) of the Exchange Act. Our internal control +system was designed to provide reasonable assurance regarding the +reliability of our financial reporting and the preparation of +financial statements for external purposes in accordance with GAAP. +Because of inherent limitations, a system of internal control over +financial reporting may not prevent or detect misstatements. Also, +projections of any evaluation of effectiveness to future periods +are subject to the risk that controls may become inadequate due to +a change in conditions, or that the degree of compliance with the +policies or procedures may deteriorate. +An +internal control material weakness is a significant deficiency, or +combination of significant deficiencies, that results in more than +a remote likelihood that a material misstatement of the +consolidated financial statements will not be prevented or +detected. +Our +management, including our principal executive officer and principal +financial officer, conducted an evaluation of the effectiveness of +our internal control over financial reporting as of December 31, +2019, and concluded that our internal control over financial +reporting was effective as of December 31, 2019. In making the +assessment of internal control over financial reporting, management +used the criteria established in Internal Control – +Integrated Framework (2013) issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO). +Changes in Internal Control over Financial Reporting +There +were no changes in our internal control over financial reporting +identified in connection with the evaluation required by Exchange +Act Rule 13a-15(d) that occurred during the fourth fiscal quarter +covered by this report that have materially affected, or are +reasonably likely to materially affect, our internal control over +financial reporting. +I tem 9B. Other +Information +None. +31 +PART III +I tem 10. Directors, Executive Officers and +Corporate Governance +Information about +our Directors and Executive Officers will be contained in the +“Proposal 1: Election of Directors” and +“Corporate Governance—Board of Directors +Independence” sections of our definitive proxy statement, to +be filed in connection with our 2020 annual meeting of +stockholders, and is incorporated herein by reference. +The +disclosure of delinquent filers under Section 16(a) of the Exchange +Act, if any, will be contained in the +“Miscellaneous—Delinquent Section 16(a) Reports” +section of our definitive proxy statement, to be filed in +connection with our 2020 annual meeting of stockholders, and is +incorporated herein by reference. +We have +a separately-designated standing audit committee. Information about +our audit committee and the audit committee financial expert will +be contained in the “Corporate Governance—Meetings and +Committees of the Board of Directors” section of our +definitive proxy statement, to be filed in connection with our 2020 +annual meeting of stockholders, and is incorporated herein by +reference. +We have +adopted the Code of Business Conduct and Ethics (the “Code of +Conduct”) that applies to all of our directors, officers and +employees, including our principal executive officer, principal +financial officer and principal accounting officer, and the Code of +Ethics for the CEO and Senior Financial Officers (the “Code +of Ethics”) containing additional specific policies. The Code +of Conduct and the Code of Ethics are posted on our Internet +website, www.bktechnologies.com, under the “Investor +Relations” tab, and are available free of charge, upon +request to Corporate Secretary, 7100 Technology Drive, West +Melbourne, Florida 32904; telephone number: (321) 984-1414. Any +amendment to, or waiver from, the codes applicable to our directors +and executive officers will be disclosed in a current report on +Form 8-K within four business days following the date of the +amendment or waiver unless the rules of the NYSE American then +permit website posting of such amendments and waivers, in which +case we would post such disclosures on our Internet +website. +I tem 11. Executive Compensation +The +information required by this item will be contained in the +“Executive Compensation,” “Summary Compensation +Table for 2018-2019,” “Outstanding Equity Awards at +2019 Fiscal Year-End,” “Retirement Benefits for +2019,” “Potential Payments Upon Termination or in +Connection With a Change of Control,” “Director +Compensation for 2019” and “Corporate +Governance—Meetings and Committees of the Board of +Directors—Compensation Committee” sections of our +definitive proxy statement, to be filed in connection with our 2020 +annual meeting of stockholders, and is incorporated herein by +reference. +I tem 12. Security Ownership of Certain Beneficial +Owners and Management and Related Stockholder Matters +The +information required by this item will be contained in the +“Security Ownership of Certain Beneficial Owners and +Management” and “Equity Compensation Plan +Information” sections of our definitive proxy statement, to +be filed in connection with our 2020 annual meeting of +stockholders, and is incorporated herein by reference. +I tem 13. Certain Relationships and Related +Transactions, and Director Independence +The +information required by this item will be contained in the +“Transactions with Related Persons” and +“Corporate Governance—Board of Directors +Independence” sections of our definitive proxy statement, to +be filed in connection with our 2020 annual meeting of +stockholders, and is incorporated herein by reference. +I tem 14. Principal Accounting +Fees and Services +The +information required by this item will be contained in the +“Fees Paid to Our Independent Registered Public Accounting +Firm” and “Corporate Governance—Meetings and +Committees of the Board of Directors—Audit Committee” +sections of our definitive proxy statement, to be filed in +connection with our 2020 annual meeting of stockholders, and is +incorporated herein by reference. +32 +PART IV +I tem 15. Exhibits and Financial Statement +Schedules +(a) The +following documents are filed as a part of this +report: +1. +Consolidated Financial Statements listed below: +Page +Report of +Independent Registered Public Accounting Firm +F-1 +Consolidated +Balance Sheets as of December 31, 2019 and 2018 +F-2 +Consolidated +Statements of Operations - years ended December 31, 2019 and +2018 +F-3 +Consolidated +Statements of Changes in Stockholders’ Equity - years ended +December 31, 2019 and 2018 +F-4 +Consolidated +Statements of Cash Flows - years ended December 31, 2019 and +2018 +F-5 +Notes to +Consolidated Financial Statements +F-6 +(b) Exhibits: +Number +Exhibit +3.1 +Articles +of Merger, filed with the Nevada Secretary of State on March 28, +2019 (incorporated by reference from Exhibit 3.1 to the +Company’s Current Report on Form 8-K12B filed March 28, +2019) +3.2 +Articles of Incorporation (incorporated by reference from Exhibit +3.2 to the Company’s Current Report on Form 8-K12B filed +March 28, 2019) +3.3 +Bylaws +(incorporated by reference from Exhibit 3.3 to the Company’s +Current Report on Form 8-K12B filed March 28, 2019) +4.1 +Description +of the Company’s Registered Securities* +4.2 +Form of +Common Stock Certificate (incorporated by reference from Exhibit +4.1 to the Company’s Current Report on Form 8-K12B filed +March 28, 2019) +10.1+ +2007 +Incentive Compensation Plan (incorporated by reference from Annex G +to the Company’s Definitive Proxy Statement on Schedule 14A +filed April 5, 2007, relating to the 2007 annual +stockholders’ meeting) +10.2+ +Amendment +to the 2007 Incentive Compensation Plan, effective as of March 17, +2017 (incorporated by reference from Exhibit 10.1 to the +Company’s Current Report on Form 8-K filed March 21, +2017) +10.3+ +Form of +2007 Incentive Compensation Plan Stock Option Agreement +(incorporated by reference from Exhibit 10.15 to the +Company’s Annual Report on Form 10-K for the year ended +December 31, 2012) +10.4+ +2017 +Incentive Compensation Plan (incorporated by reference from Exhibit +4.5 to the Company’s Registration Statement on Form S-8 filed +June 15, 2017) +10.5+ +Omnibus +Amendment to Incentive Compensation Plans, dated as of March 28, +2019, by and between BK Technologies, +Inc. and BK Technologies Corporation (incorporated by +reference from Exhibit 10.1 to the Company’s Current Report +on Form 8-K12B filed March 28, 2019) +10.6+ +Form of +Stock Option Agreement under the 2017 Incentive Compensation Plan +(incorporated by reference from Exhibit 4.6 to the Company’s +Registration Statement on Form S-8 filed June 15, +2017) +10.7+ +Form of +Restricted Share Agreement under the 2017 Incentive Compensation +Plan (incorporated by reference from Exhibit 4.7 to the +Company’s Registration Statement on Form S-8 filed June 15, +2017) +10.8+ +Form of +Restricted Stock Unit Agreement under the 2017 Incentive +Compensation Plan (incorporated by reference from Exhibit 4.8 to +the Company’s Registration Statement on Form S-8 filed June +15, 2017) +10.9+ +Form of +Non-Employee Director Restricted Share Unit Agreement under the +2017 Incentive Compensation Plan (September 2018) (Incorporated by +reference from Exhibit 10.1 to the Company’s Quarterly Report +on Form 10-Q filed November 7, 2018) +10.10+ +Form of +Stock Option Agreement under the BK Technologies Corporation 2017 +Incentive Compensation Plan (incorporated by reference from Exhibit +10.2 to the Company’s Current Report on Form 8-K12B filed +March 28, 2019) +10.11+ +Form of Restricted Share Agreement under the BK Technologies +Corporation 2017 Incentive Compensation Plan (incorporated by +reference from Exhibit 10.3 to the Company’s Current Report +on Form 8-K12B filed March 28, 2019) +10.12+ +Form of +Restricted Stock Unit Agreement under the BK Technologies +Corporation 2017 Incentive Compensation Plan (incorporated by +reference from Exhibit 10.4 to the Company’s Current Report +on Form 8-K12B filed March 28, 2019) +10.13+ +Relocation +Agreement, dated December 31, 2019, between the Company and Henry +R. (Randy) Willis (incorporated by reference from Exhibit 10.20 to +the Company’s Annual Report on Form 10-K for the year ended +December 31, 2018) +10.14+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and Timothy A. Vitou (incorporated by reference from Exhibit +10.1 to the Company’s Current Report on Form 8-K filed March +21, 2019) +10.15+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and William P. Kelly (incorporated by reference from Exhibit +10.2 to the Company’s Current Report on Form 8-K filed March +21, 2019) +10.16+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and Randy Willis (incorporated by reference from Exhibit 10.3 +to the Company’s Current Report on Form 8-K filed March 21, +2019) +10.17+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and James R. Holthaus (incorporated by reference from Exhibit +10.4 to the Company’s Current Report on Form 8-K filed March +21, 2019) +10.18+ +First +Amendment, approved October 30, 2019, to Employment Agreement, +executed March 20, 2019, by and between BK Technologies, Inc. and +James R. Holthaus (incorporated by reference from Exhibit 10.1 to +the Company’s Current Report on Form 8-K filed October 31, +2019) +10.19+ +Employment +Agreement, dated October 31, 2019, by and between BK Technologies, +Inc. and Branko Avanic* +10.20 +Credit +Agreement, executed as of January 30, 2020, by and between JPMorgan +Chase Bank, N.A., as lender, and BK Technologies, Inc., as borrower +(incorporated by reference from Exhibit 10.1 to the Company’s +Current Report on Form 8-K filed January 30, 2020) +10.21 +Line of Credit Note, executed as of January 30, 2020, by BK +Technologies, Inc., as borrower, for the benefit of JPMorgan Chase +Bank, N.A., as lender (incorporated by reference from +Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed January 30, 2020) +10.22 +Continuing +Guaranty, executed as of January 30, 2020, by and among JPMorgan +Chase Bank, N.A., as lender, and BK Technologies Corporation and +RELM Communications, Inc., as guarantors (incorporated by reference +from Exhibit 10.3 to the Company’s Current Report on Form 8-K +filed January 30, 2020) +10.23 +Continuing +Security Agreement, executed as of January 30, 2020, by and between +JPMorgan Chase Bank, N.A., as lender, and BK Technologies, Inc., as +pledgor (incorporated by reference from Exhibit 10.4 to the +Company’s Current Report on Form 8-K filed January 30, +2020) +21 +Subsidiaries +of the Company* +23.1 +Consent +of Moore Stephens Lovelace, P.A. (relating to the Company’s +Registration Statements on Form S-8) (Registration +No. 333-218765 and Registration +No. 333-147354)* +24 +Power +of Attorney (included on signature page) +31.1 +Certification +Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant +to Section 302 of the Sarbanes-Oxley Act of 2002* +31.2 +Certification +Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant +to Section 302 of the Sarbanes-Oxley Act of 2002* +32.1 +Certification +Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002 (furnished +pursuant to Item 601(b)(32) of Regulation S-K)** +32.2 +Certification +Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section +906 of the Sarbanes-Oxley Act of 2002 (furnished pursuant to Item +601(b)(32) of Regulation S-K)** +33 +101.INS +XBRL +Instance Document* +101.SCH +XBRL +Taxonomy Extension Schema Document* +101.CAL +XBRL +Taxonomy Extension Calculation Linkbase Document* +101.LAB +XBRL +Taxonomy Extension Label Linkbase Document* +101.PRE +XBRL +Taxonomy Extension Presentation Linkbase Document* +101.DEF +XBRL +Taxonomy Definition Linkbase Document* +______________________________________ +* +Included with this +filing. +** +Furnished herewith +(not filed). ++ +Each +management contract or compensatory plan or +arrangement. +(c) Consolidated +Financial Statement Schedules: +All +schedules have been omitted because they are inapplicable or not +material, or the information called for thereby is included in the +Consolidated Financial Statements and notes thereto. +I tem 16. Form 10-K Summary +None. +34 +S IGNATURES +Pursuant to the +requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned, thereunto duly +authorized. +BK TECHNOLOGIES CORPORATION +By: +/s/ +Timothy A. Vitou +Timothy +A. Vitou +President +POWER OF ATTORNEY +Each +person whose signature appears below hereby constitutes and +appoints Timothy A. Vitou and William P. Kelly, and each of them, +his attorneys-in-fact, each with the power of substitution, for him +and in his name, place and stead, in any and all capacities, to +sign this annual report on Form 10-K and any and all amendments to +this report on Form 10-K, and to file the same, with all +exhibits thereto and all documents in connection therewith, with +the Securities and Exchange Commission, granting unto said +attorneys-in-fact and agents, and each of them, full power and +authority to do and perform each and every act and all intents and +purposes as he might or could do in person, hereby ratifying and +confirming all that such attorneys-in-fact and agents or any of +them or his or their substitute or substitutes, may lawfully do or +cause to be done by virtue hereof. +Pursuant to the +requirements of the Securities Exchange Act of 1934, this report +has been signed below by the following persons on behalf of the +Registrant and in the capacities and on the dates +indicated. +SIGNATURE +TITLE +DATE +/s/ D. Kyle +Cerminara +Chairman of the +Board +March 4, +2020 +D. Kyle +Cerminara +/s/ Lewis M. +Johnson +Co-Chairman of the +Board +March 4, +2020 +Lewis M. +Johnson +/s/ Timothy A. +Vitou +President +(Principal Executive Officer) +March 4, +2020 +Timothy A. +Vitou +/s/ William P. +Kelly +Executive Vice +President and Chief Financial Officer +March 4, +2020 +William P. +Kelly +(Principal +Financial Officer and Principal Accounting +Officer) +/s/ Michael R. +Dill +Director +March 4, +2020 +Michael R. +Dill +/s/ Charles T. +Lanktree +Director +March 4, +2020 +Charles T. +Lanktree +/s/ E. Gray +Payne +Director +March 4, +2020 +E. Gray +Payne +/s/ John W. +Struble +Director +March 4, +2020 +John W. +Struble +/s/ Ryan R.K. +Turner +Director +March 4, +2020 +Ryan R.K. +Turner +35 \ No newline at end of file diff --git a/raw/filings/0000002186/2019/0001654954-20-002248/filing_metadata.csv b/raw/filings/0000002186/2019/0001654954-20-002248/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..d9048529af2243f94d58bfc2d99fcdd59396a1af --- /dev/null +++ b/raw/filings/0000002186/2019/0001654954-20-002248/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002186,BKTI,BK Technologies Corp,2019,10-K,2020-03-04,2019-12-31,2020-03-04T21:37:04.000Z,0001654954-20-002248,bkti_10k.htm,ANNUAL REPORT,3750267,1,0,https://www.sec.gov/Archives/edgar/data/2186/000165495420002248/bkti_10k.htm,https://www.sec.gov/Archives/edgar/data/2186/000165495420002248/ diff --git a/raw/filings/0000002186/2019/0001654954-20-002248/item1.txt b/raw/filings/0000002186/2019/0001654954-20-002248/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..f2d46f7b9f56b62a08c645d605d62f076dfec259 --- /dev/null +++ b/raw/filings/0000002186/2019/0001654954-20-002248/item1.txt @@ -0,0 +1,4 @@ +Item +1. +Business +1 \ No newline at end of file diff --git a/raw/filings/0000002186/2019/0001654954-20-002248/item13.txt b/raw/filings/0000002186/2019/0001654954-20-002248/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..091dc20362b994f0a100cfff4f79ced5ff26f06c --- /dev/null +++ b/raw/filings/0000002186/2019/0001654954-20-002248/item13.txt @@ -0,0 +1,6 @@ +Item +13. +Certain +Relationships and Related Transactions, and Director +Independence +32 \ No newline at end of file diff --git a/raw/filings/0000002186/2020/0001654954-21-002287/filing.txt b/raw/filings/0000002186/2020/0001654954-21-002287/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..b8aed36c3ec7ef7aab47e548b565368db56e0fcb --- /dev/null +++ b/raw/filings/0000002186/2020/0001654954-21-002287/filing.txt @@ -0,0 +1,5665 @@ +10-K +1 +bkti_10k.htm +ANNUAL REPORT ON FORM 10-K +bkti_10k +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +——————— +FORM 10-K +——————— +☒ +ANNUAL +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +For the fiscal year ended December 31, 2020 +OR +☐ +TRANSITION +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +For the transition period from __________ to +__________ +Commission file number: 001-32644 +——————— +BK TECHNOLOGIES CORPORATION +(Exact +name of registrant as specified in its charter) +——————— +Nevada +83-4064262 +(State +or other jurisdiction ofincorporation or organization) +(I.R.S. +Employer Identification No.) +7100 Technology Drive +West Melbourne, Florida 32904 +(Address +of principal executive offices) (Zip Code) +Registrant’s telephone number, including area code: (321) +984-1414 +Securities registered pursuant to Section 12(b) of the +Act: +Title +of Each Class +Trading +Symbol(s) +Name of +Each Exchange on Which Registered +Common +Stock, par value $.60 +BKTI +NYSE +American +Securities registered pursuant to Section 12(g) of the +Act: +None +Indicate by check +mark if the registrant is a well-known seasoned issuer, as defined +in Rule 405 of the Securities Act. Yes ☐ +No ☒ +Indicate by check +mark if the registrant is not required to file reports pursuant to +Section 13 or Section 15(d) of the Act. Yes ☐ +No ☒ +Indicate by check +mark whether the registrant: (1) has filed all reports required to +be filed by Section 13 or 15(d) of the Securities Exchange Act +of 1934 during the preceding 12 months (or for such shorter period +that the registrant was required to file such reports), and +(2) has been subject to such filing requirements for the past +90 days. Yes ☒ No ☐ +Indicate by check +mark whether the registrant has submitted electronically every +Interactive Data File required to be submitted pursuant to Rule 405 +of Regulation S-T (§ 232.405 of this chapter) during the +preceding 12 months (or for such shorter period that the registrant +was required to submit such files). Yes ☒ No +⬜ +Indicate by check +mark whether the registrant is a large accelerated filer, an +accelerated filer, a non-accelerated filer, a smaller reporting +company, or an emerging growth company. See the definitions of +“large accelerated filer,” “accelerated +filer,” “smaller reporting company,” and +“emerging growth company” in Rule 12b-2 of the +Exchange Act. +Large +accelerated filer ☐ +Accelerated filer +☐ +Non-accelerated +filer ☒ +Smaller +reporting company ☒ +Emerging +growth company ☐ +If an +emerging growth company, indicate by check mark if the registrant +has elected not to use the extended transition period for complying +with any new or revised financial accounting standards provided +pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check +mark whether the registrant has filed a report on and attestation +to its management’s assessment of the effectiveness of its +internal control over financial reporting under Section 404(b) of +the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public +accounting firm that prepared or issued its audit report. +☐ +Indicate by check +mark whether the registrant is a shell company (as defined in +Rule 12b-2 of the Act). Yes ☐ +No ☒ +The +aggregate market value of the voting and non-voting common equity +held by non-affiliates of the registrant on June 30, 2020, +based on the closing price of such stock on the NYSE American on +such date, was $17,141,876. As of February 26, 2021, 12,511,966 +shares of the registrant’s Common Stock were +outstanding. +Documents Incorporated by Reference: +Portions of the registrant’s +definitive proxy statement for its 2021 annual stockholders’ +meeting are incorporated by reference in Part III of this report. +The registrant’s definitive proxy statement will be filed +with the U.S. Securities and Exchange Commission within 120 days +after December 31, 2020 . +TABLE OF CONTENTS +Page +PART I +1 +Item +1. +Business +1 +Item +1A. +Risk +Factors +8 +Item +1B. +Unresolved Staff +Comments +19 +Item +2. +Properties +19 +Item +3. +Legal +Proceedings +19 +Item +4. +Mine Safety +Disclosures +19 +PART II +20 +Item +5. +Market For +Registrant’s Common Equity, Related Stockholder Matters and +Issuer Purchases of Equity Securities +20 +Item +6. +Selected Financial +Data +20 +Item +7. +Management’s +Discussion and Analysis of Financial Condition and Results of +Operations +20 +Item +7A. +Quantitative and +Qualitative Disclosures About Market Risk +30 +Item +8. +Financial +Statements and Supplementary Data +30 +Item +9. +Changes in and +Disagreements with Accountants on Accounting and Financial +Disclosure +31 +Item +9A. +Controls and +Procedures +31 +Item +9B. +Other +Information +31 +PART III +31 +Item +10. +Directors, +Executive Officers and Corporate Governance +31 +Item +11. +Executive +Compensation +32 +Item +12. +Security Ownership +of Certain Beneficial Owners and Management and Related Stockholder +Matters +32 +Item +13. +Certain +Relationships and Related Transactions, and Director +Independence +32 +Item +14. +Principal +Accounting Fees and Services +32 +PART IV +33 +Item +15. +Exhibits and +Financial Statement Schedules +33 +Item +16. +Form 10-K +Summary +35 +SIGNATURES +36 +i +P ART I +I tem 1. Business +General +BK +Technologies Corporation (NYSE American: BKTI) (together with its +wholly owned subsidiaries, “BK,” the +“Company,” “we” or “us”) is a +holding company that, through BK Technologies, Inc., its operating +subsidiary, provides two-way radio communications equipment of high +quality and reliability. All operating activities described herein +are undertaken by our operating subsidiary. +In +business for over 70 years, BK designs, manufactures and markets +American made wireless communications products consisting of +two-way land mobile radios (“LMRs”), repeaters, base +stations and related components and subsystems. Two-way LMRs can be +units that are hand-held (portable) or installed in vehicles +(mobile). Repeaters expand the range of two-way LMRs, enabling them +to operate over a wider area. Base station components and +subsystems are installed at radio transmitter sites to improve +performance by enhancing the signal and reducing or eliminating +signal interference and enabling the use of one antenna for both +transmission and reception. We employ both analog and digital +technologies in our products. +Our +digital technology is compliant with the Project 25 standard +(“P-25”) for digital LMR equipment. The P-25 has been +adopted by representatives from the Association of Public-Safety +Communications Officials-International (“APCO”), the +National Association of State Technology Directors +(“NASTD”), the United States (“U.S.”) +Federal Government and other public safety user organizations. Our +P-25 digital products and our analog products function in the very +high frequency (“VHF”) (136MHz – 174MHz), +ultra-high frequency (“UHF”) (380MHz – 470MHz, +450MHz – 520MHz), and 700-800 MHz bands. Our P-25 KNG and +KNG2 Series mobile and portable digital radios have been validated +under the P-25 Compliance Assessment Program (“CAP”) as +being P-25 compliant and interoperable with the communications +network infrastructure of six of our competitors. Since we do not +provide our own communications network infrastructure, we believe +CAP validation provides confidence for federal, state and local +emergency response agencies that our products are a viable and +attractive alternative for use on the infrastructure of our +competitors. +We +offer products under the brand names BK Radio and RELM. Generally, +BK Technologies and BK Radio-branded products serve the government +and public safety market and comprise the largest segment of our +business, while RELM-branded products serve the commercial and +industrial market. +BK +Technologies, BKR and BK Radio-branded products consist of +high-specification LMR equipment for professional radio users +primarily in government, public safety and military applications. +These products have more extensive features and capabilities than +those offered in the RELM line. Our P-25 digital products are +marketed under the BK Radio brand, which includes the BKR, KNG and +KNG2 product lines. RELM-branded products provide basic yet +feature-rich and reliable two-way communications for commercial and +industrial concerns, such as hotels, construction firms, schools +and transportation services. Typically, these users are not radio +professionals and require easy, fast and affordable communication +among a defined group of users. +We +believe that we provide superior value to a wide array of customers +with demanding requirements, including, for example, emergency +response, public safety, homeland security and military customers +of federal, state and municipal government agencies, as well as +various commercial enterprises. Our two-way radio products excel in +applications with harsh and hazardous conditions. They provide +high-specification performance, durability and reliability at a +lower cost relative to comparable offerings. +We were +incorporated under the laws of the State of Nevada on October 24, +1997. We are the resulting corporation from the reincorporation +merger of our predecessor, Adage, Inc., a Pennsylvania corporation, +which reincorporated from Pennsylvania to Nevada effective as of +January 30, 1998. Effective on June 4, 2018, we changed our +corporate name from “RELM Wireless Corporation” to +“BK Technologies, Inc.” +On +March 28, 2019, we implemented a holding company reorganization. +The reorganization created a new holding company, BK Technologies +Corporation, which became the new parent company of BK +Technologies, Inc. BK Technologies Corporation’s only +significant assets are the outstanding equity interests in BK +Technologies, Inc. and any other future subsidiaries of BK +Technologies Corporation. The holding company reorganization was +intended to create a more efficient corporate structure and +increase operational flexibility. +1 +For +the purpose of this report, references to “we” or the +“Company” or our management or business at any period +prior to the holding company reorganization (March 28, 2019) refer +to those of BK Technologies, Inc. as the predecessor company and +its subsidiaries and thereafter to those of BK Technologies +Corporation and its subsidiaries, except as otherwise specified or +to the extent the context otherwise indicates. +Our +principal executive offices are located at 7100 Technology Drive, +West Melbourne, Florida 32904 and our telephone number is (321) +984-1414. +Available Information +Our +Internet website address is www.bktechnologies.com. We make +available on our Internet website, free of charge, our Annual +Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current +Reports on Form 8-K, proxy statements and amendments to these +reports as soon as practicable after we file such material with, or +furnish it to, the U.S. Securities and Exchange Commission (the +“SEC”). In addition, our Code of Business Conduct and +Ethics, Code of Ethics for the CEO and Senior Financial Officers, +Audit Committee Charter, Compensation Committee Charter, Nominating +and Governance Committee Charter and other corporate governance +policies are available on our website, under “Investor +Relations.” The information contained on our website is not +incorporated by reference in this report. A copy of any of these +materials may be obtained, free of charge, upon request from our +investor relations department. All reports that the Company files +with or furnishes to the SEC also are available free of charge via +the SEC’s website at http://www.sec.gov. +Significant Events +During +2020, pursuant to our capital return program, we declared and paid +four quarterly dividends of $0.02 per share of our common stock. We +have paid nineteen consecutive quarterly +dividends. +In +October 2020, we announced that our operating subsidiary received +an order totaling approximately $1.5 million dollars from a public +safety agency of the U.S. Department of the Interior (DoI). The +order was for BK’s Digital P-25 KNG2-Series portable radios +and KNG Series mobile radios, with related accessories, and was +fulfilled during the fourth quarter of 2020. +In +October 2020, we announced that our operating subsidiary received +an order totaling approximately $1.1 million from an agency of the +state of Tennessee. The order was for BK’s newly introduced +BKR 5000 Digital P-25 portable radio with related accessories and +was fulfilled during the fourth quarter of 2020. +In +August 2020, we announced the market introduction of the BKR 5000 +portable radio; the first model in the new BKR Series of APCO +Project 25 land mobile radio products and solutions, which will +also include multi-band capability. +In +August 2020, we announced the engagement of a national investor +relations firm to launch a comprehensive investor relations +program. +In +August 2020, we announced that our operating subsidiary received an +order totaling approximately $1.1 million from the National +Interagency Fire Center (“NIFC”). The order was for +BK’s KNG2-Series Digital P-25 portable radios with related +accessories. This order was fulfilled during the third quarter of +2020. +In +August 2020, we announced that our operating subsidiary was awarded +a contract for up to $4.2 million dollars from an electric utility +agency of the U.S. Department of Energy (“DoE”). The +contract was for BK’s KNG2 and KNG Digital P-25 portable and +mobile radios with related accessories for deployment at more than +35 sites in the United States. The contract covers a period of one +year, which commenced on June 24, 2020 and will expire on June 23, +2021, providing for purchases of equipment up to $4.2 million. It +did not specify precise delivery dates or quantities. Shortly after +awarding the contract, the DoE issued firm purchase orders for +equipment totaling approximately $3.1 million, which were fulfilled +in the third quarter of 2020. +In May +2020, we announced that our operating subsidiary received orders +totaling approximately $1.4 million from the U.S. Forest Service +(“USFS”). The orders were for KNG-Series Digital P-25 +portable radios, mobile radios and base stations with related +accessories, and were fulfilled during the second quarter of +2020. +2 +In May +2020, we implemented workforce reductions of approximately 18% to +reduce costs and to better position us in an uncertain business +environment due in part to the COVID-19 pandemic. We incurred +approximately $0.2 million in severance costs relating to these +workforce reductions, which were recognized in the second quarter +of 2020 and paid in accordance with our normal payroll practices +through September 2020. +In April 2020, we received approval and funding +pursuant to a promissory note evidencing an unsecured loan in the +amount of approximately $2.2 million (the “Loan”) under +the Paycheck Protection Program (or “PPP”). The PPP was +established under the Coronavirus Aid, Relief, and Economic +Security Act (the “CARES Act”) administered by the U.S. +Small Business Administration (“SBA”). We +intended to use the Loan for qualifying expenses in accordance with +the terms of the CARES Act. At the time of application we believed +that we qualified to receive the funds pursuant to the PPP. +Subsequently, the SBA, in consultation with the Department of +Treasury, issued new guidance that created uncertainty regarding +the qualification requirements for a PPP loan. In April 2020, out +of an abundance of caution, we repaid the loan in +full. +In +February 2020, we announced that our operating subsidiary received +orders totaling approximately $2.8 million from the USFS. The +orders were for KNG-Series Digital P-25 portable radios, mobile +radios, and base stations, as well as related accessories, and were +fulfilled in the first quarter of 2020. +In +March 2020, we announced that our operating subsidiary received an +order totaling approximately $2.1 million from the USFS. The order +was for KNG-Series Digital P-25 mobile radios and related +accessories. The order was fulfilled during the first and second +quarters of 2020. +In +March 2020, Fundamental Global Investors, LLC (“FG”), +on behalf of the funds managed by it, entered into a stock trading +plan in accordance with Rule 10b5-1 of the Securities Exchange Act +of 1934, as amended (the “10b5-1 Plan”), for the +purchase of up to one million shares of our common stock. The +10b5-1 Plan became effective on April 2, 2020 and will terminate on +April 2, 2021 or such earlier date as set forth in the 10b5-1 Plan. +Transactions under the 10b5-1 Plan, if any, will be reported to the +Securities and Exchange Commission in accordance with applicable +securities laws, rules and regulations. D. Kyle Cerminara, the Chief Executive Officer, +Co-Founder and Partner of FG, is a member of the Company’s +Board of Directors. FG, with its affiliates, is our largest +stockholder. +In December 2019, a novel strain of the +coronavirus (“COVID-19”) surfaced in Wuhan, China, +which spread globally and was declared a pandemic by the World +Health Organization in March 2020. The challenges posed by the +COVID-19 pandemic on the global economy increased significantly as +the year 2020 progressed, and we anticipate the effects of COVID-19 +may continue to have an adverse impact on our operations going +forward. In response to COVID-19, national and local governments +around the world have instituted certain measures, including travel +bans, prohibitions on group events and gatherings, shutdowns of +certain businesses, curfews, shelter-in-place orders and +recommendations to practice social distancing. In response to the +COVID-19 pandemic, we have undertaken certain measures in an effort +to mitigate the impact of the COVID-19 pandemic, including +implementing employee safety measures and taking steps to reduce +expenses, including workforce reductions. The ultimate impact of +COVID-19 on our business, results of operations, financial +condition and cash flows is dependent on future developments, +including the duration of the pandemic and the related length of +its impact on the global economy, all of which are uncertain and, +given the evolution of the COVID-19 pandemic and the global +responses to curb its spread, cannot be predicted at this +time. Even after the COVID-19 pandemic has subsided, we may +continue to experience adverse impacts to our business as a result +of the pandemic’s national and, to some extent, global +economic impact, including any recession that has occurred or may +occur in the future. +3 +Industry Overview +LMR +communications consist of hand-held (portable) and vehicle-mounted +(mobile) two-way radios commonly used by the public safety sector +(e.g., police, fire, and emergency responders), military and +commercial business concerns (e.g., corporate disaster recovery, +hotels, airports, farms, transportation service providers, and +construction firms), and government agencies within the U.S. and +abroad. LMR systems are constructed to meet an organization’s +specific communications needs. The cost of a complete system can +vary widely, depending on the size and configuration. Likewise, the +cost of radio sets can range from under $100 for a basic analog +portable, to thousands of dollars for a fully featured P-25 digital +unit. Typically, there are no recurring airtime usage charges. +Accordingly, LMR usage patterns are considerably different from +those for cellular and other wireless communications tools. LMR +usage often consists of direct radio-to-radio communications +outside of the range of a communication network with one-to-many +members of a group. Also, LMR functions with push-to-talk operation +(i.e., no call set-up or dialing a phone number is required). LMR +communications often consist of multiple short (five second) +transmissions between multiple members of a group. For the public +safety sector, this is known as Mission Critical Voice. The average +useful life of a unit can vary, depending upon the application in +which the unit is deployed and its handling. +LMR +systems are the most widely-used and longest-used form of wireless +dispatch communications in the U.S., having been first placed in +service in 1921. LMR was initially used almost exclusively by law +enforcement, and all radio communications were transmitted in an +analog format. Analog transmissions typically consist of a voice or +other signal modulated directly onto a continuous radio carrier +wave. Over time, advances in technology decreased the cost of LMR +products and increased their popularity and usage by businesses and +other agencies. Responding to the growing usage, additional radio +frequency spectrum was allocated by the Federal Communications +Commission (“FCC”) for LMR use. +More +recently, growth of the LMR industry has slowed, reflecting several +factors: +● +LMR is a mature +industry, having been in existence for over 90 years; +● +some LMR users are +in mature industry segments that have experienced slow growth +rates; +● +funding and budgets +for government and public safety agencies have been constrained; +and +● +limited +availability of radio frequency spectrum, which hinders existing +users in expanding their systems and potential new users from +establishing new systems. +Years +ago, as a result of the limited spectrum availability, the FCC +mandated that new LMR equipment utilize technology that is more +spectrum-efficient. This effectively meant that the industry had to +migrate to digital technology. Responding to the mandate, the APCO, +the NASTD, the U.S. Federal Government and the Telecommunications +Industry Association (“TIA”), in concert with several +LMR manufacturers, including BK, recommended a standard for digital +LMR devices that would meet the FCC spectrum-efficiency +requirements and provide solutions to several problems experienced +primarily by public safety users. The standard is called P-25. The +primary objectives of P-25 are to: (i) allow effective and reliable +communication among users of compliant equipment, regardless of its +manufacturer, known as interoperability, (ii) maximize radio +spectrum efficiency and (iii) promote competition among LMR +providers through an open system architecture. +Although the FCC +does not require public safety agencies or any radio users to +purchase P-25 equipment or otherwise adopt the standard, compliance +with the standard is a primary consideration for government and +public safety purchasers. In addition, U.S. Federal Government +grant programs that provide assistance in funding for state and +local agencies to purchase interoperable communications equipment +for first responders strongly encourage compliance with the P-25 +standard. Accordingly, although funding for LMR purchases by many +government agencies is limited, we believe that, as users upgrade +equipment to achieve interoperability and comply with FCC +narrow-banding mandates, demand for P-25 equipment will continue to +grow. Additionally, the P-25 standard has also been widely adopted +in other countries. The migration to P-25 equipment is primarily +limited to government and public safety agencies. Radio users in +the business and industrial market utilize alternative digital +technologies (e.g., Digital Mobile Radio) and analog LMR +products. +4 +Presently, the +market is dominated by one supplier, Motorola Solutions, Inc., +which offers a broader range of products than we do, including +multiband radios. However, the open architecture of the P-25 +standard is designed to eliminate the ability of one or more +suppliers to lock out competitors. Formerly, because of proprietary +characteristics incorporated in many LMR systems, a customer was +effectively precluded from purchasing additional LMR products from +a supplier other than the initial supplier of the system. +Additionally, the system infrastructure technology was prohibitive +for smaller suppliers to develop and implement. P-25 provides an +environment in which users will increasingly have a wider selection +of LMR suppliers, including smaller suppliers such as +BK. +Description of Products and P-25 CAP Compliance +We +design, manufacture, and market wireless communications equipment +consisting of two-way LMRs, repeaters, base stations and related +components and subsystems. We do not provide complete, integrated, +communications systems and infrastructure. Two-way LMRs can be +units that are hand-held (portable) or installed in vehicles +(mobile). Repeaters expand the range of two-way LMRs, enabling them +to communicate over a wider area. Base station components and +subsystems are installed at radio transmitter sites to improve +performance by enhancing the signal, reducing or eliminating signal +interference and enabling the use of one antenna for both +transmission and reception. +We +employ both analog and digital technologies in our products. Our +digital products are compliant with P-25 specifications. Our P-25 +digital products and our analog products function in the VHF +(136MHz – 174MHz), UHF (380MHz – 470MHz, 450MHz – +520MHz), and 700-800 MHz bands. +Our +P-25 KNG, KNG2 and BKR Series mobile and portable digital radios +have been validated under the P-25 CAP as being P-25 compliant and +interoperable with the communications network infrastructure of six +of our competitors. Since we do not provide our own communications +network infrastructure, we believe CAP validation provides +confidence for federal, state and local emergency response agencies +that our products are a viable and attractive alternative for use +on the infrastructure of our competitors. +The +P-25 CAP is a voluntary program that allows LMR equipment suppliers +to formally demonstrate their products’ compliance with P-25 +requirements. The purpose of the program is to provide federal, +state and local emergency response agencies with evidence that the +communications equipment they are purchasing satisfies the P-25 +standard for performance, conformance and interoperability. The +program is a result of legislation passed by the U.S. Congress to +improve communication interoperability for first responders and is +a partnership of the U.S Department of Homeland Security +(“DHS”)’s Command, Control and Interoperability +Division, the National Institute of Standards and Technology, radio +equipment manufacturers and the emergency response +community. +Description of Markets +Government and Public Safety Market +The +government and public safety market includes military, fire, +rescue, law enforcement, homeland security and emergency responder +personnel. In most instances, BK Radio-branded products serve this +market and are sold either directly to end-users or through two-way +communications dealers. Government and public safety sales +represented approximately 92% of our total sales for 2020 and 93% +for 2019. +Government and +public safety users currently use products that employ either P-25 +digital or analog technology. However, public safety users in +federal, state and local government agencies and certain other +countries are migrating to primarily using digital P-25 products. +The evolution of the standard and compliant digital products is +explained in the “Industry Overview” section above. +Business and Industrial Market +This +market includes enterprises of all sizes that require fast and +affordable push-to-talk communication among a discrete group of +users, such as corporate disaster recovery, hotels, construction +firms, schools and transportation service providers. Users in this +market continue to predominantly utilize analog products. We offer +products to this market under the RELM brand name. Our sales in +this market may be direct to end-users or to dealers and +distributors who then resell the products. Our sales to this market +represented approximately 8% of our total sales for 2020 and 7% for +2019. +5 +Engineering, Research and Development +Our +engineering and product development activities are conducted by a +team of 23 employees. Their primary development focus has been the +design of a new line of next-generation P-25 digital products, the +BKR Series, which will include multi-band technology and eventually +supplant our flagship KNG and KNG2 products. The first product in +this line was introduced in August 2020, with additional models +planned for 2021 and beyond. The first models in the KNG line were +introduced in 2008 and are included on our primary federal contract +vehicles. Subsequently, we added UHF and 700-800MHz products, as +well as P-25 Phase II TDMA (Time Division Multiple Access) +trunking. The KNG2 Series was introduced in 2016. Our KNG, KNG2 and +BKR products also provide encrypted operation for secured +communication, GPS location and network authentication +capabilities. +A +segment of our engineering team is responsible for product +specifications based on customer requirements and participates in +quality assurance activities. They also have primary responsibility +for applied and production engineering. +For +2020 and 2019, our engineering and development expenses were +approximately $7.9 million and $9.8 million, respectively. The +decrease was primarily attributed to the elimination or reduction +of outside engineering resources, and the completion of portions of +our new product development initiatives. +Intellectual Property +We +presently have no U.S. patents in force. We have registered federal +trademarks related to the names “BK Technologies,” +“BK Radio” and “Radios for Heroes” and have +applied for registration of “BKR.” We rely on trade +secret laws and employee and third-party nondisclosure agreements +to protect our intellectual property rights. +Manufacturing and Raw Materials +Our +manufacturing strategy is to utilize the highest quality and most +cost-effective resources available for every aspect of our +manufacturing. Consistent with that strategy, we have successfully +utilized a hybrid of U.S.-based internal manufacturing capability +in concert with outside contract arrangements for different +manufacturing processes. The breadth of our internal manufacturing +capabilities has been expanded during 2019 and 2020. Our outside +manufacturing contract arrangements have been managed and updated +to meet our present requirements, including increasing +relationships with American concerns. This hybrid approach has been +instrumental in controlling our product costs, allowing us to be +competitive and manage our gross margins. +Contract +manufacturers produce various subassemblies and products on our +behalf. Generally, the contract manufacturers procure raw materials +from BK-approved sources and complete manufacturing activities in +accordance with our specifications. Manufacturing agreements and +purchase orders govern the business relationship with the contract +manufacturers. These agreements and purchase orders have various +terms and conditions and may be renewed or modified upon agreement +by both parties. Their scope may also be expanded to include new +products in the future. +We plan +to expand our internal manufacturing capabilities and U.S.-based +relationships, combined with other American manufacturers and +suppliers where it furthers our business objectives. This strategy +allows us to effectively manage quality, product costs and +lead-times while focusing other resources on our core technological +competencies of product design and development. We believe that, in +certain circumstances, the use of experienced, high-quality, +high-volume manufacturers can provide greater manufacturing +specialization and expertise, higher levels of flexibility and +responsiveness, and faster delivery of product, all of which +contribute toward product cost control. To ensure that products +manufactured by others meet our quality standards, our production +and engineering team works closely with our contract manufacturers +in all key aspects of the production process. We establish product +specifications, select the components and, in some cases, the +suppliers. We retain all document control. We also work with our +contract manufacturers to improve process control and product +design and conduct periodic on-site inspections. +We rely +upon a limited number of both American and foreign suppliers for +several key products and components. Approximately 65% of our +material, subassembly and product procurements in 2020 were sourced +from six suppliers. We place purchase orders from time to time with +these suppliers and have no guaranteed supply arrangements. In +addition, certain components are obtained from single sources. +During 2020 and 2019, our operations were not materially impaired +due to delays from single-source suppliers. However, the absence of +a single-source component could potentially delay the manufacture +of finished products. We manage the risk of such delays by securing +secondary sources, where possible, and redesigning products in +response to component shortages or obsolescence. We strive to +maintain strong relationships with all of our suppliers. We +anticipate that the current relationships, or others that are +comparable, will be available to us in the future. +6 +Seasonal Impact +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year budgets and appropriations. We may also +experience fluctuations in our quarterly results, derived, in part, +from sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +results. +Significant Customers +Sales +to the U.S. Government represented approximately 51% and 49% of our +total sales for the years ended December 31, 2020 and 2019, +respectively. These sales were primarily to various government +agencies, including those within the DHS, the U.S. Department of +Defense (“DOD”), the USFS and the U.S. Department of +Interior (“DoI”). +Backlog +Our +backlog of unshipped customer orders was approximately $5.9 million +and $7.2 million as of December 31, 2020 and 2019, +respectively. Changes in the backlog are attributed primarily to +the timing and fulfillment of orders. +Competition +We +compete with other domestic and foreign companies primarily in the +North American market, but also internationally. One dominant +competitor, Motorola Solutions, Inc., is estimated to have well in +excess of half the market for LMR products. We compete by +capitalizing on our advantages and strengths, which include price, +product quality and customer responsiveness. +Government Regulation +We are +subject to various international and U.S. federal, state and local +laws affecting our business. Any finding that we have been or +are in noncompliance with such laws could result in, among other +things, governmental penalties. Further, changes in existing +laws or new laws may adversely affect our business and could also +have the effect of limiting capital expenditures by our customers, +which could have a material adverse effect on our business, +financial condition and results of operations. +In +connection with our U.S. Government contracts, we are subject to +the U.S. Federal Government procurement regulations that may +provide the buyer with the right to audit and review our +performance, as well as our compliance with applicable laws and +regulations. In addition, our business is subject to +government regulation based on the products we sell that may be +subject to government requirements, such as obtaining an export +license or end-user certificate from the buyer, in certain +circumstances. If a government audit uncovers improper +or illegal activities, or if we are alleged to have violated any +laws or regulations governing the products we sell under our +government contracts, we may be subject to civil and criminal +penalties and administrative sanctions, including termination of +contracts, forfeiture of profits, suspension of payments, fines and +suspension or debarment from doing business with U.S. Federal +Government agencies. +Our +products are regulated by the FCC in the U.S. and similar agencies +in other countries where we offer our products. Consequently, +we and our customers could be positively or negatively affected by +the rules and regulations adopted from time to time by the FCC or +regulatory agencies in other countries. For example, our +wireless communications products, including two-way LMRs, are +subject to FCC regulations related to radio frequency +spectrum. As a result of limited spectrum availability, the +FCC has mandated that new LMR equipment utilize technology that is +more spectrum-efficient, which effectively meant that the industry +had to migrate to digital technology. These types of mandates +may provide us with new business opportunities or may require us to +modify all or some of our products so that they can continue to be +manufactured and marketed, which may lead to an increase in our +capital expenditures and research and development +expenses. +As a +public company, we are also subject to regulations of the SEC and +the stock exchange on which we are listed (NYSE +American). +7 +Some of +our operations use substances regulated under various federal, +state, local and international laws governing the environment and +worker health and safety, including those governing the discharge +of pollutants into the ground, air and water, the management and +disposal of hazardous substances and wastes and the cleanup of +contaminated sites, as well as relating to the protection of the +environment. Certain of our products are subject to various +federal, state, local and international laws governing chemical +substances in electronic products. During 2020, compliance with +these U.S. federal, state and local and international laws did not +have a material effect on our capital expenditures, earnings or +competitive position. +Human Capital Resources +As of +December 31, 2020, we had 95 employees, most of whom are located at +our West Melbourne, Florida facility; 46 of these employees are +engaged in direct manufacturing or manufacturing support, 23 in +engineering, 16 in sales and marketing, and 10 in headquarters, +accounting and human resources activities. Our employees are not +represented by any collective bargaining agreements, nor has there +ever been a labor-related work stoppage. We believe our relations +with our employees are good. +The +Company complies with all applicable state, local and international +laws governing nondiscrimination in employment in every location in +which the Company operates. All applicants and employees are +treated with the same high level of respect regardless of their +gender, ethnicity, religion, national origin, age, marital status, +political affiliation, sexual orientation, gender identity, +disability or protected veteran status. +Our +mission is to remain deeply rooted in the critical communications +industry for all military, first responders, and public safety +heroes. Our four guiding principles: growth, tenacious commitment +to quality, continuous improvement, and a keen focus on being +customer-centric, continuously drive our efforts to be the best +partner for our customers, investment for our shareholders, +neighbor in our community and to provide an empowering work +environment for our employees. +The Company is +committed to the health, safety and wellness of its +employees. We have +modified our business practices and implemented certain policies at +our offices in accordance with best practices to accommodate, and +at times mandate, social distancing and remote work practices, +including restricting employee travel, modifying employee work +locations, implementing social distancing and enhanced sanitary +measures in our facilities, and cancelling attendance at events and +conferences. In addition, we have invested in employee safety +equipment, additional cleaning supplies and measures, re-designed +production lines and workplaces as necessary and adapted new +processes for interactions with our suppliers and customers to +safely manage our operations. +Information Relating to Domestic and Export Sales +The +following table summarizes our sales of LMR products by customer +location: +2020 +2019 +(in +millions) +United +States +$ 43.1 +$ 39.7 +International +1.0 +0.4 +Total +$ 44.1 +$ 40.1 +Additional +financial information is provided in the Consolidated Financial +Statements included in this report. +I tem 1A. Risk Factors +Various portions of this report contain forward-looking statements +that involve risks and uncertainties. Actual results, performance +or achievements could differ materially from those anticipated in +these forward-looking statements as a result of certain risk +factors, including those set forth below and elsewhere in this +report. We undertake no obligation to revise or update any +forward-looking statements contained herein to reflect subsequent +events or circumstances or the occurrence of unanticipated +events. +8 +We depend on the success of our LMR product line +We +currently depend on our LMR products as our sole source of sales. A +decline in the price of and/or demand for LMR products, as a result +of competition, technological change, the introduction of new +products by us or others or a failure to manage product transitions +successfully, could have a material adverse effect on our business, +financial condition and results of operations. In addition, our +future success will largely depend on the successful introduction +and sale of our BKR Series product line, including our initial +multiband product, which has been delayed from initial projections +and which we may be unable to successfully complete in a timely +manner, or at all. Even if we successfully develop and launch the +BKR Series product line, or any other new products, the development +of which is a complex and uncertain process requiring innovation +and investment, such products may not achieve market acceptance, +which could have a material adverse effect on us. +We are engaged in a highly competitive industry +We face +intense competition from other LMR suppliers, and the failure to +compete effectively could materially and adversely affect our +market share, financial condition and results of operations. The +largest supplier of LMR products in the world, Motorola Solutions, +Inc., currently is estimated to have well in excess of half the +market for LMR products. This supplier is also the world’s +largest supplier of P-25 products. Some of our competitors are +significantly larger and have longer operating histories, greater +name recognition, larger customer bases and significantly greater +financial, technical and marketing resources than we have. Some +also have established reputations for success in developing and +supplying LMR products, including providing complete, integrated, +communications systems and infrastructure. We do not provide +complete, integrated, communications systems and infrastructure. +These advantages may allow our competitors: +● +to be more +attractive to customers who desire a single-source supplier of LMR +products; +● +to respond more +quickly to new or emerging technologies and changes in customer +requirements, which may render our products obsolete or less +marketable; +● +to engage in more +extensive research and development; +● +to undertake more +far-reaching marketing campaigns; +● +to be able to take +advantage of acquisitions and other opportunities; +● +to adopt more +aggressive pricing policies; and +● +to be more +attractive to potential employees and strategic +partners. +Some of +our competitors have established broad networks of sales locations +and multiple distribution channels that are more extensive than +ours. We may not be able to compete successfully and competitive +pressures may materially and adversely affect our business, results +of operations and financial condition. +An +increase in the demand for P-25 products could benefit competitors +that are better financed and positioned to meet such demand. P-25 +products have been brought to the market by an increasing number of +our competitors. Our first P-25 portable radio was brought to +market in 2003, and in recent years we introduced two new lines of +P-25 products, the KNG and KNG2 Series. We are currently developing +a new line of P-25 digital products, the BKR Series, which we +anticipate will include multiband products, among other new +products. Bringing such products to market and achieving a +significant market penetration for them will continue to require +time and expenditures of funds, and we may be unable to +successfully do so. We may be unsuccessful in developing and +marketing, on a timely basis, fully functional product enhancements +or new products that respond to these and other technological +advances, and our new products may not be accepted by customers. An +inability to successfully develop and/or market products could have +a material adverse effect on our business, financial condition and +results of operations. +9 +Our industry is characterized by rapidly changing technology and +our success is dependent on our ability to adapt to such +changes +Our +business could suffer if we are unable to keep pace with rapid +technological changes and product development in our industry. The +market for our LMR products is characterized by ongoing +technological development, evolving industry standards and frequent +product introductions. The LMR industry has largely transitioned +from analog LMR products to digital LMR products in recent years. +In addition, the APCO P-25 standard has been widely adopted. If we +are unable to successfully keep up with these changes, our +business, financial condition and results of operations could be +materially adversely affected. +We depend heavily on sales to the U.S. Government +We are +subject to risks associated with our reliance on sales to the U.S. +Government. For the year ended December 31, 2020, approximately 51% +of our sales were to agencies and departments of the U.S. +Government, including but not limited to, agencies of the DHS, DoA, +DoD and DoI. We may be unable to maintain this government business. +Our ability to maintain our government business will depend on many +factors outside of our control, including competitive factors, +changes in government personnel making contract decisions, spending +limits and political factors. The loss of sales to the U.S. +Government would have a material adverse effect on our business, +financial condition and results of operations. +In +addition, most U.S. Government customers award business through a +competitive bidding process, which results in greater competition +and increased pricing pressure. The bidding process involves +significant cost and managerial time to prepare bids for contracts +that may not be awarded to us. Even if we are awarded contracts, we +may fail to accurately estimate the resources and costs required to +fulfill a contract, which could negatively impact the profitability +of any contract awarded to us. In addition, following a contract +award, we may experience significant expense or delay, contract +modification or contract rescission as a result of customer delay +or our competitors protesting or challenging contracts awarded to +us in competitive bidding. +Any +delay, especially any prolonged delay, in the U.S. Government +budget process or a government shutdown may result in us incurring +substantial labor or other costs without reimbursement under our +customer contracts, decrease the number of purchase orders issued +under our contracts with government agencies, or result in the +suspension of work on contracts in progress or in payment +delays. +Any of +these events could have a material adverse effect on our business, +financial condition and results of operations. +Our business is partially dependent on U.S. Government contracts, +which are highly regulated and subject to terminations and +oversight audits by U.S. Government representatives that could +result in adverse findings and negatively impact our +business +Our +U.S. Government business is subject to specific procurement +regulations with numerous compliance requirements. These +requirements, although customary in U.S. Government contracting, +increase our performance and compliance costs. These costs may +increase in the future, thereby reducing our margins, which could +have an adverse effect on our financial condition. Failure to +comply with these regulations could lead to suspension or debarment +from U.S. Government contracting or subcontracting for a period of +time. Among the causes for debarment are violations of various laws +or policies, including those related to procurement integrity, U.S. +Government security regulations, employment practices, protection +of criminal justice data, protection of the environment, accuracy +of records, proper recording of costs, foreign corruption and the +False Claims Act. +Generally, U.S. +Government contracts are subject to oversight audits by U.S. +Government representatives and could result in adjustments to our +contracts. Any costs found to be improperly allocated to a specific +contract or grant may not be allowed, and such costs already +reimbursed to us may have to be refunded. Future audits and +adjustments, if required, may materially reduce our revenues or +profits upon completion and final negotiation of audits. Negative +audit findings could also result in investigations, termination of +a contract, forfeiture of profits or reimbursements, suspension of +payments, fines and suspension or prohibition from doing business +with the U.S. Government. All contracts with the U.S. Government +are subject to cancellation at the convenience of the U.S. +Government. +10 +In +addition, contacts with government officials and participation in +political activities are areas that are tightly controlled by +federal, state, local and international laws. Failure to comply +with these laws could cost us opportunities to seek certain +government sales opportunities or even result in fines, prosecution +or debarment. +Our business is subject to the economic, political, and other risks +of manufacturing products in foreign countries +We +engage in business with manufacturers located in other countries. +Approximately 53% of our material, subassembly and product +procurements in 2020 were sourced internationally. Accordingly, we +are subject to special considerations and risks not typically +associated with companies operating solely in the U.S. These +include the risks associated with the political, economic, legal, +health and other conditions in such foreign countries, among +others. Our business, financial condition and operating results may +be materially and adversely affected by, among other things, +changes in the general political, social, health and economic +conditions in foreign countries in which we maintain sourcing +relationships, unfavorable changes in U.S. trade legislation and +regulations, the imposition of governmental economic sanctions on +countries in which we do business or other trade barriers, threats +of war, terrorism or governmental instability, labor disruptions, +the impact of public health epidemics on employees and the global +economy, such as the coronavirus currently impacting China, which +may cause our manufacturers or suppliers to temporarily suspend +operations in the affected region, potentially negatively impacting +our product launch timing and shipments, currency controls, +fluctuating exchange rates with respect to contracts not +denominated in U.S. dollars, and unanticipated or unfavorable +changes in government policies with respect to laws and +regulations, anti-inflation measures and method of taxation. If we +were unable to navigate foreign regulatory environments, or if we +were unable to enforce our contract rights in foreign countries, +our business could be adversely impacted. Any of these events could +interrupt our manufacturing process and cause operational +disruptions, increase prices for manufacturing, reduce our sales or +otherwise have an adverse effect on our operating +performance. +The +U.S. Government has indicated its intent to alter its approach to +trade policy, including, in some instances, to revise, renegotiate +or terminate certain multilateral trade agreements. It has also +imposed new tariffs on certain foreign goods and raised the +possibility of imposing additional increases or new tariffs on +other goods. Such actions have, in some cases, led to retaliatory +trade measures by certain foreign governments. Such policies could +make it more difficult or costly for us to do business in or import +our products from those countries. In turn, we may need to raise +prices or make changes to our operations, which could negatively +impact our revenue or operating results. At this time, it remains +unclear what additional actions, if any, will be taken by the U.S. +Government or foreign governments with respect to tariff and +international trade agreements and policies, and we cannot predict +future trade policy or the terms of any revised trade agreements or +any impact on our business. +The COVID-19 pandemic and ensuing governmental responses have +negatively impacted, and could further materially adversely affect, +our business, financial +condition, results of operations and cash flow. +In December 2019, a novel strain of the +coronavirus (COVID-19) surfaced in Wuhan, China, which spread +globally and was declared a pandemic by the World Health +Organization in March 2020. Although we believe the pandemic has +not had a material adverse impact on our business in 2020, it may +have the potential of doing so in the future . The extent of +the potential impact of the COVID-19 pandemic on our business and +financial performance will depend on future developments, which are +uncertain and , given the continuing +evolution of the COVID-19 pandemic and the global responses to curb +its spread, cannot be predicted. In addition, the pandemic +has significantly increased economic uncertainty and caused a +worldwide economic downturn. Even after the COVID-19 pandemic has +subsided, we may continue to experience an adverse impact to our +business as a result of its national and, to some extent, global +economic impact, including any recession that may occur in the +future. +In response to COVID-19, national and local +governments around the world instituted certain measures, including +travel bans, prohibitions on group events and gatherings, shutdowns +of certain businesses, curfews, shelter-in-place orders and +recommendations to practice social distancing. Although many +governmental measures have had specific expiration dates, some of +those measures have already been extended more than once or +re-implemented as cases of COVID-19 increased in certain areas; as +a result, there is considerable uncertainty regarding the duration +of such measures and potential future measures. Measures providing +for business shutdowns generally exclude certain essential +services, and those essential services commonly include critical +infrastructure and the businesses that support that critical +infrastructure, which includes our business. While our +manufacturing operations have remained open, these measures have +impacted and may further impact our workforce and operations, as +well as those of our customers and suppliers. +11 +We have +modified our business practices and implemented certain policies at our offices in +accordance with best practices to accommodate, and at times +mandate, social distancing and remote work practices , +including restricting employee travel, modifying employee work +locations, implementing social distancing and enhanced sanitary +measures in our facilities, and cancelling attendance at events and +conferences. In addition, we have +invested in employee safety equipment, additional cleaning supplies +and measures, re-designed production lines and workplaces as +necessary and adapted new processes for interactions with our +suppliers and customers to safely manage our operations. +Many of our suppliers and service providers have made similar +modifications. If necessary, we may take further actions in the +best interests of our employees, customers, partners and suppliers. +In light of the economic downturn generated by the COVID-19 +pandemic, we have taken steps to reduce expenses throughout the +Company. These reductions have, at various junctures, included limiting travel, discontinuing +participation in trade shows and other business meetings, +instituting strict inventory control and decreasing expenditures. +We restructured our operations to, among other things, +reduce our workforce by approximately 18% during the second quarter +of 2020. We incurred costs as a result of the workforce reduction, +including approximately $221,000 in severance costs, which were +recognized in the second quarter of 2020. There is no certainty +that such measures will be sufficient to mitigate the risks posed +by COVID-19, in which case our employees may become sick, our +ability to perform critical functions could be harmed, and our +business and operations could be negatively impacted. We have had +two employees at our primary West Melbourne, Florida facility test +positive for COVID-19 to-date. The employees were quarantined in +accordance with accepted safety practices and returned to work only +after clearing accepted health protocols. There was no disruption +of our operations as a result of these occurrences. The resumption +of normal business operations after such interruptions may be +delayed or constrained by lingering effects of COVID-19 on our +suppliers, third-party service providers, and/or +customers. +In +addition, we have experienced delays and cost increases, and may +continue to do so, in obtaining and transporting materials. +Since the outbreak, some of our supply +chain partners were temporarily closed for a period of +time. These +facilities have since reopened. Although we have in some +cases experienced delays and increased freight costs, we have, to +date, been able to procure the materials necessary to manufacture +products and fulfill customer orders, which may not continue to be +the case in the event the pandemic worsens or continues for an +extended period of time. Depending on +the continued progression of the pandemic, our ability to obtain +necessary supplies, manufacture our products and ship finished +products to customers may be disrupted. +Further, our +current and potential customers’ businesses could be +disrupted or they could seek to limit spending, including shifting +purchases to lower-priced or other perceived value offerings or +reducing their purchases and inventories due to decreased budgets, +reduced access to credit or various other factors, any of which +could negatively impact the willingness or ability of such +customers to place new, or any, orders with us and ultimately +adversely affect our revenues, as well as negatively impact the +payment of accounts receivable and collections and potentially lead +to write-downs or write-offs. +The +ultimate duration and impact of the COVID-19 pandemic on our +business, results of operations, financial condition and cash flows +is dependent on future developments, +including the duration of the pandemic and the related length of +its impact on the global economy, which remain uncertain and cannot +be predicted at this time. Furthermore, the extent to which +our mitigation efforts are successful, if at all, is not presently +ascertainable. +We carry substantial quantities of inventory, and inaccurate +estimates of necessary inventory could materially harm our +business, financial condition and operating results +We +carry a significant amount of inventory to service customer +requirements in a timely manner. If we are unable to sell this +inventory over a commercially reasonable time, in the future we may +be required to take inventory markdowns, which would reduce our net +sales and/or gross margins. In addition, it is critical to our +success that we accurately predict trends in customer demand, +including seasonal fluctuations, in the future and do not overstock +unpopular products or fail to sufficiently stock popular products. +Both scenarios could materially harm our business, financial +condition and operating results. +12 +We enter into fixed-price contracts that could subject us to losses +in the event we fail to properly estimate our costs or hedge our +risks associated with currency fluctuations +We +sometimes enter into firm fixed-price contracts. If our initial +cost estimates are incorrect, we can lose money on these contracts. +Because certain of these contracts involve new technologies and +applications, require us to engage subcontractors and/or can last +multiple years, unforeseen events, such as technological +difficulties, fluctuations in the price of raw materials, problems +with our subcontractors or suppliers and other cost overruns, can +result in the contract pricing becoming less favorable or even +unprofitable to us and have an adverse impact on our financial +results. In addition, a significant increase in inflation rates or +currency fluctuations could have an adverse impact on the +profitability of longer-term contracts. +Our investment strategy may not be successful, which could +adversely impact our financial condition +We may +invest part of our cash balances in public companies. For example, +as of December 31, 2020, we held 477,282 shares of the common stock +of FG Financial Group, Inc. (formerly 1347 Property Insurance +Holdings, Inc.) (Nasdaq: FGF) (“FGF”). These types of +investments carry more risk than holding our cash balances as bank +deposits or, for example, such conservative investments as treasury +bonds or money market funds. There can be no assurance that we will +be able to maintain or enhance the value or the performance of the +companies in which we have invested or in which we may invest in +the future, or that we will be able to achieve returns or benefits +from these investments. We may lose all or part of our investment +relating to such companies if their value decreases as a result of +their financial performance or for any other reason. If our +interests differ from those of other investors in companies over +which we do not have control, we may be unable to effect any change +at those companies. We are not required to meet any diversification +standards, and our investments may become concentrated. If our +investment strategy is not successful or we achieve less than +expected returns from these investments, it could have a material +adverse effect on us. The Board of Directors may also change our +investment strategy at any time, and such changes could further +increase our exposure, which could adversely impact +us. +FG, with its affiliates, is our largest stockholder, and its +interests may differ from the interests of our other +stockholders +The interests +of FG may differ from the interests of our other +stockholders. FG and its affiliates, owners and managers +together hold approximately 34.3% of the Company’s +outstanding shares of common stock. Kyle Cerminara, Chief Executive +Officer, Partner and Manager of FG and Chairman of Ballantyne +Strong, Inc., is a member of our Board of Directors. As a +result of its ownership position and Mr. Cerminara’s position +with the Company, FG has the ability to exert significant influence +over our policies and affairs, including the power to impact the +election of our directors, and approval of any action requiring a +stockholder vote, such as amendments to our articles of +incorporation, by-laws, significant stock issuances, +reorganizations, mergers and asset sales. FG may have +interests that differ from those of our other stockholders and may +vote in a way with which our other stockholders disagree and which +may be adverse to their interests. FG’s significant +ownership may also have the effect of delaying, preventing or +deterring a change of control of the Company, could deprive our +stockholders of an opportunity to receive a premium for their +common stock as part of a sale of the Company and might ultimately +affect the market price of our common stock. +If we are unable to maintain our brand and reputation, our +business, results of operations and prospects could be materially +harmed +Our +business, results of operations and prospects depend, in part, on +maintaining and strengthening our brand and reputation for +providing high-quality products and services. Reputational value is +based in large part on perceptions. Although reputations may take +decades to build, any negative incidents can quickly erode trust +and confidence, particularly if they result in adverse publicity, +governmental investigations or litigation. If problems with our +products cause operational disruption or other difficulties, or +there are delays or other issues with the delivery of our products +or services, our brand and reputation could be diminished. Damage +to our reputation could also arise from actual or perceived legal +violations or product safety issues, cybersecurity breaches, actual +or perceived poor employee relations, actual or perceived poor +service, actual or perceived poor privacy practices, operational or +sustainability issues, actual or perceived ethical issues or other +events within or outside of our control that generate negative +publicity with respect to us. Any event that has the potential to +negatively impact our reputation could lead to lost sales, loss of +new opportunities and retention and recruiting difficulties. If we +fail to promote and maintain our brand and reputation successfully, +our business, results of operations and prospects could be +materially harmed. +13 +We face a number of risks related to challenging economic +conditions +Current +economic conditions in the U.S. and elsewhere remain uncertain. +These challenging economic conditions could materially and +adversely impact our business, liquidity and financial condition in +a number of ways, including: +● +Potential deferment or +reduction of purchases by customers : Significant deficits and limited +appropriations confronting our federal, state and local government +customers may cause them to defer or reduce purchases of our +products. Furthermore, uncertainty about current and future +economic conditions may cause customers to defer purchases of our +products in response to tighter credit and decreased cash +availability. Additionally, any delay, especially any prolonged +delay, in the U.S. Government budget process or government shutdown +may negatively impact the ability of many of our customers to +purchase our products and decrease the number of purchase orders +issued under our contracts with government agencies. +● +Negative impact from +increased financial pressures on third-party dealers, distributors +and suppliers : We +make sales to certain of our customers through third-party dealers +and distributors. We generally do not require collateral from our +customers. If credit pressures or other financial difficulties +result in insolvencies of these third parties and we are unable to +successfully transition the end customers to purchase our products +from other third parties, or directly from us, it could materially +and adversely impact our business, financial condition and +operating results. Challenging economic conditions may also impact +the financial condition of one or more of our key suppliers, which +could negatively affect our ability to secure product to meet our +customers’ demands. +● +Limited access by us to +credit and capital : +The credit markets may limit our access to credit and impair our +ability to raise capital, if needed, on acceptable terms or at all. +From time to time, we also have cash in financial institutions in +excess of federally insured limits, which funds might be at risk of +loss should such financial institutions face financial +difficulties. +The terms of the credit agreement with JPMorgan Chase Bank, N.A., +contain restrictive covenants that may limit our operating +flexibility +On +January 26, 2021, BK Technologies, Inc., our wholly-owned operating +subsidiary, entered into a Note Modification Agreement (the +“Modification”) to renew its $5.0 million Credit +Agreement and a related Line of Credit Note (the “Note” +and collectively with the Credit Agreement, as modified by the +Modification, the “Credit Agreement”) with JPMorgan +Chase Bank, N.A. (“JPMC”), which provides for a +revolving line of credit through +January 31, 2022 . The Credit Agreement contains limitations +and covenants that may limit BK Technologies, Inc.’s ability +to take certain actions, including pay dividends to us, enter into +liens, indebtedness, loans and +guarantees, acquisitions and mergers, or sales of assets, and +engage in stock repurchases. It also contains one financial +covenant requiring BK Technologies, Inc. to maintain a tangible net +worth of at least $20.0 million at any fiscal quarter end. +We are a guarantor of BK Technologies, Inc.’s obligations +under the Credit Agreement. Events beyond our control, including +changes in general business and economic conditions, may impair BK +Technologies, Inc.’s ability to comply with these covenants, +and a breach of any covenants may result in an event of default. +Upon the occurrence of an event of default, JPMC may declare the entire unpaid balance immediately +due and payable and/or exercise any and all remedial and other +rights under the Credit Agreement. BK Technologies, Inc. may +be unable to repay any accelerated indebtedness, and we may not be +able to repay any indebtedness pursuant to the guarantee or +refinance any accelerated indebtedness on favorable terms, or at +all. In general, the occurrence of any event of default under the +Credit Agreement could have an adverse effect on our financial +condition or results of operations. +We depend on a limited number of manufacturers and on a limited +number of suppliers of components to produce our products, and the +inability to obtain adequate and timely delivery of supplies and +manufactured products could have a material adverse effect on +us +We +contract with manufacturers to produce portions of our products, +and our dependence on a limited number of contract manufacturers +exposes us to certain risks, including shortages of manufacturing +capacity, reduced control over delivery schedules, quality +assurance, production yield and costs. If any of our manufacturers +terminate production or cannot meet our production requirements, we +may have to rely on other contract manufacturing sources or +identify and qualify new contract manufacturers. The lead-time +required to qualify a new manufacturer could range from +approximately two to six months. Despite efforts to do so, we may +not be able to identify or qualify new contract manufacturers in a +timely and cost-effective manner, and these new manufacturers may +not allocate sufficient capacity to us in order to meet our +requirements. Any significant delay in our ability to obtain +adequate quantities of our products from our current or alternative +contract manufacturers could have a material adverse effect on our +business, financial condition and results of +operations. +14 +In +addition, our dependence on limited and sole source suppliers of +components involves several risks, including a potential inability +to obtain an adequate supply of components, price increases, late +deliveries and poor component quality. Approximately 65% of our +material, subassembly and product procurements in 2020 were sourced +from six suppliers. We place purchase orders from time to time with +these suppliers and have no guaranteed supply arrangements. +Disruption or termination of the supply of these components could +delay shipments of our products. The lead-time required for some of +our components is up to as six months. If we are unable to +accurately predict our component needs, or if our component supply +is disrupted, we may miss market opportunities by not being able to +meet the demand for our products. This may damage our relationships +with current and prospective customers and have a material adverse +effect on our business, financial condition and results of +operations. +We may not be able to manage our growth +Acquisitions and +other business transactions may disrupt or otherwise have a +negative impact on our business, financial condition and results of +operations. We do not have any acquisitions currently pending, and +there can be no assurance that we will complete any future +acquisitions or other business transactions or that any such +transactions which are completed will prove favorable to our +business. We intend to seek stockholder approval for any such +transactions only when so required by applicable law or regulation. +Any acquisitions of businesses and their respective assets also +involve the risks that the businesses and assets acquired may prove +to be less valuable than we expect and we may assume unknown or +unexpected liabilities, costs and problems. We hope to grow +rapidly, and the failure to manage our growth could materially and +adversely affect our business, financial condition and results of +operations. Our business plan contemplates, among other things, +leveraging our products and technology for growth in our customer +base and sales. This growth, if it materializes, could +significantly challenge our management, employees, operations and +financial capabilities. In the event of this expansion, we have to +continue to implement and improve our operating systems and to +expand, train, and manage our employee base. If we are unable to +manage and integrate our expanding operations effectively, our +business, results of operations and financial condition could be +materially and adversely affected. +Retention of our executive officers and key personnel is critical +to our business +Our key +executives are critical to our success. The loss of services from +any of our executive officers or other key employees due to any +reason whatsoever could have a material adverse effect on our +business, financial condition and results of +operations. +Our +success is also dependent upon our ability to hire and retain +qualified operations, development and other personnel. Competition +for qualified personnel in our industry is intense, and we may be +unable to hire or retain necessary personnel. The inability to +attract and retain qualified personnel could have a material +adverse effect on our business, financial condition and results of +operations. +We have +had changes in our senior management team and other personnel over +the past few years and have promoted or hired new employees to fill +certain roles. Our inability to effectively integrate the +newly-hired or promoted senior managers or other employees into our +business process, controls and systems could have a material +adverse effect on us. +We rely on a combination of contract, trademark and trade secret +laws to protect our intellectual property rights, and failure to +effectively utilize or successfully assert these rights could +negatively impact us +Currently, we hold +no U.S. patents. We have several trademarks related to the names +“BK Technologies,” “BK Radio”, and +“Radios for Heroes”. We have applied for a trademark +related to the name “BKR.” As part of our +confidentiality procedures, we generally enter into nondisclosure +agreements with our employees, distributors and customers and limit +access to and distribution of our proprietary information. We also +rely on trade secret laws to protect our intellectual property +rights. There is a risk that we may be unable to prevent another +party from manufacturing and selling competing products or +otherwise violating our intellectual property rights. Our +intellectual property rights, and any additional rights we may +obtain in the future, may be invalidated, circumvented or +challenged in the future. It may also be particularly difficult to +protect our products and intellectual property under the laws of +certain countries in which our products are or may be manufactured +or sold. Our failure to perfect or successfully assert intellectual +property rights could harm our competitive position and could +negatively impact us. +15 +Rising health care costs may have a material adverse effect on +us +The +costs of employee health care insurance have been increasing in +recent years due to rising health care costs, legislative changes +and general economic conditions. We cannot predict what other +health care programs and regulations ultimately will be implemented +at the federal or state level or the effect of any future +legislation or regulation in the U.S. on our business, financial +condition and results of operations. In addition, we cannot predict +when or if Congress will repeal and/or replace certain health care +programs and regulations at the federal level and the impact such +changes would have on our business. A continued increase in health +care costs could have a material adverse effect on us. +The insurance that we maintain may not fully cover all potential +exposures +We +maintain property, business interruption and casualty insurance, +but such insurance may not cover all risks associated with the +hazards of our business and is subject to limitations, including +deductibles and maximum liabilities covered. We are potentially at +risk if one or more of our insurance carriers fail. Additionally, +severe disruptions in the domestic and global financial markets +could adversely impact the ratings and survival of some insurers. +In the future, we may not be able to obtain coverage at current +levels, and our premiums may increase significantly on coverage +that we maintain. +Our stock price is vulnerable to significant fluctuations, +including due to our fluctuating quarterly operating +results +Our +quarterly operating results may fluctuate significantly from +quarter to quarter and may be below the expectations of the +investment community, resulting in volatility for the market price +for our common stock. Other factors affecting the volatility of our +stock price include: +● +future +announcements concerning us or our competitors; +● +the announcement or +introduction of technological innovations or new products by us or +our competitors, including announcements regarding the status of +our BKR Series product line; +● +changes in product +pricing policies by us or our competitors; +● +changes in earnings +estimates by us or our competitors or by securities +analysts; +● +additions or +departures of our key personnel; and +● +sales of our common +stock. +In +addition, the stock market is subject to price and volume +fluctuations affecting the market price for the stock of many +companies generally, which fluctuations often are unrelated to +operating performance. +Natural disasters, acts of war or terrorism and other catastrophic +events beyond our control could have a material adverse effect on +our operations and financial condition +The +occurrence of one or more natural disasters, such as fires, +hurricanes, tornados, tsunamis, floods and earthquakes; +geo-political events, such as civil unrest in a country in which +our suppliers or manufacturers are located, or acts of war or +terrorism (wherever located around the world) or military +activities disrupting transportation, communication or utility +systems or otherwise causing damage to our business, employees, +suppliers, manufacturers and customers; or other highly disruptive +events, such as nuclear accidents, pandemics, unusual weather +conditions or cyber attacks, could have a material adverse effect +on our business, financial condition and results of operations. +Such events could result, among other things, in operational +disruptions, physical damage to or destruction or disruption of one +or more of our properties or properties used by third parties in +connection with the supply of products or services to us, the lack +of an adequate workforce in parts or all of our operations and +communications and transportation disruptions. These factors could +also cause consumer confidence and spending to decrease or result +in increased volatility in the U.S. and global financial markets +and economy. Such occurrences could have a material adverse effect +on us and could also have indirect consequences, such as increases +in the costs of insurance, if they result in significant loss of +property or other insurable damage. +16 +A security breach or other significant disruption of our +information technology systems, or those of our distributors, +manufacturers, suppliers and other partners, caused by cyber attack +or other means, could have a negative impact on our operations, +sales and results of operations +From +time to time, we may experience cyber attacks on our information +technology systems and the information systems of our distributors, +manufacturers, suppliers and other partners, whose systems we do +not control. These systems are vulnerable to damage, +unauthorized access or interruption from a variety of sources, +including, but not limited to, continually evolving cyber attacks +(including social engineering and phishing attempts), attempts to +gain unauthorized access to data, cyber intrusion, computer +viruses, security breach, misconduct by employees or other insiders +with access to our data, energy blackouts, natural disasters, +terrorism, sabotage, war and telecommunication failures. Cyber +attacks are rapidly evolving and becoming increasingly +sophisticated. Computer hackers and others might compromise our +security measures, or security measures of those parties that we do +business with now or in the future, and obtain the personal +information of our customers, employees and partners or our +business information. A cyber attack or other significant +disruption involving our information technology systems or those of +our distributors, manufacturers, suppliers or other partners, could +result in disruptions in critical systems, corruption or loss of +data, theft of data, funds or intellectual property, and +unauthorized release of our or our customers’ proprietary, +confidential or sensitive information. Such unauthorized access to, +or release of, this information could expose us to data loss, +disrupt our operations, allow others to unfairly compete with us, +subject us to litigation, government enforcement actions, +regulatory penalties and costly response measures, and could +seriously disrupt our operations. Any resulting negative publicity +could also significantly harm our reputation. We may not have +adequate insurance coverage to compensate us for any losses +associated with such events. Any or all of the foregoing could have +a negative impact on our business, financial condition, results of +operations and cash flows. +Because +the techniques used to obtain unauthorized access to, or disable, +degrade or sabotage, information technology systems change +frequently and often are not recognized until launched against a +target, we may be unable to anticipate these techniques, implement +adequate preventative measures or remediate any intrusion on a +timely or effective basis. Moreover, the development and +maintenance of these preventative and detective measures is costly +and requires ongoing monitoring and updating as technologies change +and efforts to overcome security measures become more +sophisticated. We, therefore, remain potentially vulnerable to +additional known or yet unknown threats, as in some instances, we, +our distributors, manufacturers, suppliers and other partners, may +be unaware of an incident or its magnitude and effects. We also +face the risk that we expose our customers or partners to +cybersecurity attacks. In addition, from time to time, we implement +updates to our information technology systems and software, which +can disrupt or shutdown our information technology systems. We may +not be able to successfully integrate and launch these new systems +as planned without disruption to our operations. +The risk of noncompliance with U.S. and foreign laws and +regulations applicable to us could materially adversely affect +us +Failure +to comply with government regulations applicable to our business +could result in penalties and reputational damage. Our products are +regulated by the FCC and otherwise subject to a wide range of +global laws. As a public company, we are also subject to +regulations of the SEC and the stock exchange on which we are +listed. These laws and regulations are complex, change frequently, +have tended to become more stringent over time and increase our +cost of doing business. Compliance with existing or future laws, +including U.S. tax laws, could subject us to future costs or +liabilities, impact our production capabilities, constrict our +ability to sell, expand or acquire facilities, restrict what +products and services we can offer, and generally impact our +financial performance. Failure to comply with or to respond to +changes in these requirements and regulations could result in +penalties on us, such as fines, restrictions on operations or a +temporary or permanent closure of our facility. These penalties +could have a material adverse effect on our business, operating +results and financial condition. In addition, existing or new +regulatory requirements or interpretations could materially +adversely impact us. +17 +We may not be able to maintain our NYSE American +listing +Our +common stock has been listed on the NYSE American since 2005. If we +are unable to satisfy the continued listing standards of the NYSE +American, which include, among others, minimum stockholders’ +equity, market capitalization, pre-tax income and per share sales +price, our common stock may be delisted. If our common stock is +delisted, we would be forced to have our common stock quoted on the +OTC Markets or some other quotation medium, depending on our +ability to meet the specific requirements of those quotation +systems. In that case, we may lose some or all of our institutional +investors, and selling our common stock on the OTC Markets would be +more difficult because smaller quantities of shares would likely be +bought and sold and transactions could be delayed. These factors +could result in lower prices and larger spreads in the bid and ask +prices for shares of our common stock. If this happens, we will +have greater difficulty accessing the capital markets to raise any +additional necessary capital. +Any infringement claim against us could have a material adverse +effect on our business, financial condition and results of +operations +As the +number of competing products available in the market increases and +the functions of those products further overlap, the potential for +infringement claims may increase. Any such claims, with or without +merit, may result in costly litigation or require us to redesign +the affected product to avoid infringement or require us to obtain +a license for future sales of the affected product. Any of the +foregoing could damage our reputation and have a material adverse +effect upon our business, financial condition and results of +operations. Any litigation resulting from any such claim could +require us to incur substantial costs and divert significant +resources, including the efforts of our management and engineering +personnel. +We have deferred tax assets that we may not be able to utilize +under certain circumstances +If we +incur future operating losses, we may be required to provide some +or all of our deferred tax assets with a valuation allowance, +resulting in additional non-cash income tax expense. The change in +the valuation allowance may have a material impact on future net +income or loss. +We may be unable to obtain components and parts that are verified +to be Democratic Republic of Congo (“DRC”) +conflict-free, which could result in reputational +damage +The +Dodd-Frank Wall Street Reform and Consumer Protection Act includes +disclosure requirements regarding the use of tin, tantalum, +tungsten and gold (which are defined as “conflict +minerals”) in our products and whether these materials +originated from the DRC or an adjoining country. The SEC rules +necessitate a complex compliance process and related administrative +expense for a company once it determines a conflict mineral is +necessary to the functionality or production of a product that the +company manufactures or contracts to manufacture. These +requirements could affect the sourcing, availability and cost of +minerals used in the manufacture of certain of our products, and we +may not be able to obtain conflict-free products or supplies in +sufficient quantities or at competitive prices for our operations. +We have incurred, and will continue to incur, costs associated with +complying with these supply chain due diligence procedures. In +addition, because our supply chain is complex, if we discover that +our products include minerals that have been identified as +“not found to be DRC conflict-free” or we are unable to +determine whether such minerals are included in our products, we +may face reputational challenges with our customers, stockholders +and other stakeholders as a result. +As a holding company, BK Technologies Corporation is dependent on +the operations and funds of its subsidiaries +On +March 28, 2019, we completed a reorganization pursuant to which BK +Technologies Corporation became a holding company with no business +operations of its own. BK Technologies Corporation’s only +significant assets are the outstanding equity interests in BK +Technologies, Inc. and any other future subsidiaries of BK +Technologies Corporation. As a result, we rely on cash flows from +subsidiaries to meet our obligations, including payment of +dividends to our stockholders. Additionally, our subsidiaries may +be restricted in their ability to pay cash dividends or to make +other distributions to BK Technologies Corporation, as the new +holding company; for instance, the Credit Agreement permits BK +Technologies, Inc. to pay dividends to us only if there is no +default, and the payment of the dividends would not result in a +default, under the Credit Agreement. The holding company +reorganization was intended to create a more efficient corporate +structure and increase operational flexibility. The anticipated +benefits of this reorganization may not be obtained if +circumstances prevent us from taking advantage of the opportunities +that we expect it may afford us. As a result, we may incur the +costs of a holding company structure without realizing the +anticipated benefits, which could adversely affect our reputation, +financial condition, and results of operations. +18 +Future sales of shares of our common stock may negatively affect +our stock price and impair our ability to raise equity +capital +Approximately +7.4 million (59.8%) of our shares of outstanding common stock +as of December 31, 2020 were owned by certain of our executive +officers and directors and other affiliates, and may be resold +publicly at any time, subject to the volume and other restrictions +under Rule 144 of the Securities Act of 1933, as amended. +Approximately 40.2% of our outstanding shares of common stock as of +December 31, 2020 are freely tradable without +restriction. +Sales +of substantial amounts of shares of our common stock, or even the +potential for such sales, could lower the market price of our +common stock and impair our ability to raise capital through the +sale of equity securities. +I tem 1B. Unresolved Staff +Comments +None. +I tem 2. Properties +We do +not own any real estate. We lease approximately 54,000 square feet +of industrial space at 7100 Technology Drive in West Melbourne, +Florida. In November 2018, the lease was amended to provide for +certain leasehold improvements and extend the lease term until June +30, 2027. Rental, maintenance and tax expenses for this facility +were approximately $510,000 and $502,000 in 2020 and 2019, +respectively. We also lease 8,100 square feet of office space in +Lawrence, Kansas. In November 2019, the lease was amended to extend +the lease term until December 31, 2021. Rental, maintenance and tax +expenses for this facility were approximately $124,000 and $108,000 +in 2020 and 2019, respectively. +In +February 2020, we entered into a lease for 6,857 square feet of +office space at Sawgrass Technology Park, 1619 NW 136 th Avenue in Sunrise, +Florida, for a period of 64 months. Annual rental, maintenance and +tax expenses for the facility was approximately $169,000 for +2020. +I tem 3. Legal Proceedings +From +time to time we may be involved in various claims and legal actions +arising in the ordinary course of our business. There were no +pending material claims or legal matters as of December 31, +2020. +I tem 4. Mine +Safety Disclosures +Not +applicable. +19 +P ART II +I tem 5. Market For Registrant’s Common +Equity, Related Stockholder Matters and Issuer Purchases of Equity +Securities +(a) +Market Information. +Our +common stock trades on the NYSE American under the symbol +“BKTI.” +(b) +Holders. +On +February 26, 2021, there were 601 holders of record of our common +stock. +(c) +Dividends. +We +currently pay quarterly cash dividends. The declaration and payment +of cash dividends, if any, is subject to the discretion of the +Board of Directors. The Board’s final determination as to +whether to declare and pay dividends is based upon its +consideration of our operating results, financial condition and +anticipated capital requirements, as well as such other factors it +may deem relevant. +We +receive dividends from our wholly-owned subsidiary, BK +Technologies, Inc., to fund the quarterly cash dividends to our +stockholders. The Credit Agreement permits BK Technologies, Inc. to +pay dividends to us if there is no default, and if the payment of +the dividend would not result in a default, under the Credit +Agreement. +(d) +Issuer Purchases of Equity Securities. +Period +Total Number of Shares Purchased +Average Price Paid Per Share (1) +Total Number of Shares Purchased as Part of Publicly Announced +Plans or Programs (2) +Maximum Number of Shares that May Yet Be Purchased Under Publicly +Announced Plans or Programs (2) +01/01/20-01/31/20 +36,155 +$ 2.94 +36,155 +81,787 +02/01/20-02/29/20 +20,963 +$ 2.72 +20,963 +60,824 +03/01/20-03/31/20 +44,695 +$ 1.72 +44,695 +16,129 +04/01/20-04/30/20 +16,129 +$ 1.63 +16,129 +— +Total +117,942 +$ 2.25 +117,942 +(1) +Average price paid +per share of common stock repurchased is the executed price, +including commissions paid to brokers. +(2) +The Company had a +repurchase program of up to one million shares of the +Company’s common stock pursuant to a stock repurchase plan in +conformity with the provisions of Rule 10b5-1 and Rule 10b-18 +promulgated under the Exchange Act. The repurchase program was +initially announced in May 2016, expanded in June 2017 and was +completed in April 2020. +I tem 6. Selected Financial Data +Not +required for smaller reporting companies. +I tem 7. Management’s Discussion and +Analysis of Financial Condition and Results of +Operations +Executive Summary +BK +Technologies Corporation is a holding company, with a wholly-owned +operating subsidiary, BK Technologies, Inc. We design, manufacture +and market American made two-way land mobile radios, repeaters, +base stations and related components and subsystems. All operating +activities are undertaken by BK Technologies, Inc. +Our +overall financial and operating results for 2020 improved markedly +from the preceding year. Sales for 2020 grew over 10% compared with +2019, while gross profit margins as a percentage of sales +increased by 2 percentage +points year-over-year. Selling, general and administrative +and administrative expenses for 2020 declined approximately $3.0 +million, or 15.0%. The combined impact of sales growth, gross +profit margin improvement, and reduced operating expenses yielded +an increase of over $5.4 million in operating income from the prior +year. Additionally, our balance sheet strengthened during the year +with a $4 million (30%) reduction in inventory, which was a +significant contributor to positive cash flow for the year of +approximately $2.2 million. Meanwhile, we launched the first +portable radio, the BKR 5000, in a new line of land mobile radio +products, with additional models planned for 2021. +20 +Total +sales in 2020 grew 10.1% to approximately $44.1 million, compared +with approximately $40.1 million for the prior year. The increase +was primarily attributed to federal and state public safety +agencies, some of which were new customers. We also realized sales +from our new BKR 5000 portable radio, which was introduced during +the third quarter of 2020. +Gross +profit margin as a percentage of sales in 2020 increased to +approximately 41.0%, compared with 39.0% for the previous year. The +improvement was attributed primarily to the improved mix of product +sales and reduced manufacturing costs. +Selling, general +and administrative (“SG&A”) expenses for 2020 +declined approximately $3.0 million (15.0%) to approximately $17.0 +million, or 38.6% of sales, compared with $20.0 million, or 50.0% +of sales, for 2019. The decrease in SG&A expenses was the +result of broad-based cost reduction actions, including a reduction +in our workforce. +For +2020, we recognized operating income of approximately $1.0 million +, which was an improvement of $5.4 million from last year’s +operating loss of $4.4 million. +We +recognized other expenses totaling approximately $797,000 in 2020, +primarily attributed to an unrealized loss from our investment in +FGF, made through FGI 1347 Holdings, LP, a consolidated variable +interest entity. This compares with other income of $762,000 last +year, which was primarily related to an unrealized gain from the +investment in FGF. +For +2020, we recognized pretax income of approximately $251,000, a +significant improvement from last year’s pretax loss of +approximately $3.6 million. +We +recognized a tax expense of approximately $3,000 for 2020, compared +with a benefit of approximately $987,000 for the prior year. The +income tax benefit last year was largely non-cash as a result of +deferred items. +Net +income for 2020 of approximately $248,000 ($0.02 per basic and +diluted share), improved $2.9 million from last year’s net +loss of approximately $2.6 million ($0.21 per basic and diluted +share). +As of +December 31, 2020, working capital totaled approximately $15.1 +million, of which $13.3 million was comprised of cash, cash +equivalents and trade receivables. This compares with working +capital totaling approximately $14.5 million at 2019 year-end, +which included $8.6 million of cash, cash equivalents and trade +receivables. During 2020, we fulfilled the limit of our stock +repurchase program, repurchasing 117,942 shares of our common +stock, utilizing cash of approximately $269,000. +Impact of COVID-19 Pandemic +In +December 2019, a novel strain of the coronavirus (COVID-19) +surfaced, which spread globally and was declared a pandemic by the +World Health Organization in March 2020. The challenges posed by +the COVID-19 pandemic on the global economy increased significantly +in the first several months of 2020. In response to COVID-19, +national and local governments around the world instituted certain +measures, including travel bans, prohibitions on group events and +gatherings, shutdowns of certain businesses, curfews, +shelter-in-place orders and recommendations to practice social +distancing. We are considered an “essential business” +that is supporting first responders and our manufacturing +operations remained open throughout the year. Accordingly, we have +implemented certain policies at our offices in accordance with best +practices to accommodate, and at times mandate, social distancing, +wearing face masks, and remote work practices. Among other things, +we have invested in employee safety equipment, additional cleaning +supplies and measures, adjusted production lines and workplaces as +necessary and adapted new processes for interactions with our +suppliers and customers to safely manage our operations. To-date, +two staff members at our primary facility in West Melbourne, FL +tested positive for COVID-19. These employees were quarantined and +worked remotely in accordance with accepted safety practices until +after passing subsequent testing. +21 +In +planning for the possible disruption of our business, we have taken +steps to reduce expenses throughout the Company. This included +suspending all Company travel for a period of time, as well as our +participation in trade shows and other business meetings, +instituting strict inventory control and decreasing expenditures. +We also implemented workforce reductions during the second quarter +of 2020, decreasing employment and related expenses by +approximately 18% as well as suspended the employer’s 401K +match. During the first nine months, impact to customer orders was +limited as reflected by our sales, which increased compared with +the same period last year. Also, while some of our supply chain +partners were temporarily closed during the early stages of the +pandemic, most of these partners resumed operations and we have +been able to procure the materials necessary to manufacture +products and fulfill customer orders. Depending on the progression +of the pandemic, our ability to obtain necessary supplies and ship +finished products to customers may be partly or completely +disrupted. Continued progression of the pandemic could result in a +decline in customer orders, as our customers could shift purchases +to lower-priced or other perceived value offerings or reduce their +purchases and inventories due to decreased budgets, reduced access +to credit or various other factors, and impair our ability to +manufacture our products, which could have a material adverse +impact on our results of operations and cash flow. While the +current impacts of COVID-19 are reflected in our results of +operations, we cannot at this time separate the direct COVID-19 +impacts from other factors that cause our performance to vary from +year to year. The ultimate duration and impact of the COVID-19 +pandemic on our business, results of operations, financial +condition and cash flows is dependent on future developments, +including the duration and severity of the pandemic, and the +related length of its impact on the global economy, which are +uncertain and, given the daily evolution of the COVID-19 pandemic +and the global responses to curb its spread, cannot be predicted at +this time. Even after the COVID-19 pandemic has subsided, we may +continue to experience an adverse impact to our business as a +result of its national and, to some extent, global economic impact, +including any recession that has occurred or may occur in the +future. Furthermore, the extent to which our mitigation efforts are +successful, if at all, is not presently ascertainable. However, we +anticipate that our results of operations in future periods may +continue to be adversely impacted by the COVID-19 pandemic and its +negative effects on global economic conditions. For additional +risks relating to the COVID-19 pandemic, see Item 1A. Risk Factors +in Part II of this report. +On +March 27, 2020, President Trump signed into law the Coronavirus +Aid, Relief and Economic Security Act (the “CARES +Act”). Among other things, the CARES Act includes provisions +relating to refundable payroll tax credits, deferment of employer +side social security payments, net operating loss carryback +periods, alternative minimum tax credit refunds, modifications to +the net interest deduction limitations and technical corrections to +tax depreciation methods for qualified improvement property. On +April 13, 2020, we received an unsecured Loan (as defined below) in +the amount of $2,196,335 under the Paycheck Protection Program (or +“PPP”) established under the CARES Act, as further +discussed below under “Liquidity and Capital +Resources.” We intended to use the Loan for qualifying +expenses in accordance with the terms of the CARES Act. At the time +of application, we believed we qualified to receive the funds +pursuant to the PPP. +On +April 23, 2020, the SBA, in consultation with the Department of +Treasury, issued new guidance that created uncertainty regarding +the qualification requirements for a PPP loan. In April 2020, out +of an abundance of caution, we repaid the Loan in +full. +On May +4, 2020, the Company implemented workforce reductions of +approximately 18% to reduce costs and to better position the +Company in an uncertain business environment resulting from the +COVID-19 pandemic. The Company incurred approximately $221,000 in +severance costs relating to these workforce reductions, which were +recognized in the second quarter of 2020 and was paid according to +our normal payroll practices through September 2020. +We may +experience fluctuations in our quarterly results, in part, due to +governmental customer spending patterns that are influenced by +government fiscal year-end budgets and appropriations. We may also +experience fluctuations in our quarterly results, in part, due to +our sales to federal and state agencies that participate in +wildland fire-suppression efforts, which may be greater during the +summer season when forest fire activity is heightened. In some +years, these factors may cause an increase in sales for the second +and third quarters, compared with the first and fourth quarters of +the same fiscal year. Such increases in sales may cause quarterly +variances in our cash flow from operations and overall financial +condition. +22 +Results of Operations +As an +aid to understanding our operating results, the following table +shows items from our consolidated statements of operations +expressed as a percentage of sales: +Percent of +Sales +for Years Ended +December 31, +2020 +2019 +Sales +100.0 % +100.0 % +Cost of +products +(59.0 ) +(61.0 ) +Gross +margin +41.0 +39.0 +Selling, general +and administrative expenses +(38.6 ) +(50.0 ) +Other (expense) +income, net +(1.8 ) +1.9 +Income (loss) +before income taxes +0.6 +(9.1 ) +Income tax +expense +(0.0 ) +2.5 +Net Income +(loss) +0.6 %% +(6.6 )% +Fiscal Year 2020 Compared With Fiscal Year 2019 +Sales, net +During +the year, procurement activities of some customers were likely +affected by the COVID-19 pandemic, although the precise impact to +sales cannot be quantified. Despite any such impact, sales for 2020 +grew 10.1% ($4.0 million) to approximately $44.1 million, compared +with approximately $40.1 million last year. +The +increase in sales for the year ended December 31, 2020 was +attributed primarily to federal and state public safety agencies, +which included a combination of new and existing customers. +Furthermore, during the year we launched, and generated sales from, +the first product (BKR 5000) in the BKR Series, a new line of land +mobile radios and solutions. Also, for comparative purposes, the +prior year’s sales were adversely impacted by the federal +government shutdown early in the year. +The BKR +Series is envisioned as a comprehensive line of new products with +additional new models planned for 2021, including products with +multi-band capability. The timing of developing additional BKR +Series products and bringing them to market could be impacted by +various factors, including potential impacts related to the +COVID-19 pandemic. BKR Series products, we believe, should increase +our addressable market by expanding the number of federal and other +public safety customers that may purchase our products. However, +the timing and size of orders from agencies at all levels can be +unpredictable and subject to budgets, priorities and other factors. +Accordingly, we cannot assure that sales will occur under +particular contracts, or that our sales prospects will otherwise be +realized. +In +2020, we reorganized our sales resources to focus more effectively +on target markets and customers where we can realize sales success. +The current funnel of sales prospects includes +potential new +customers in federal, state and local public safety agencies. +We believe the reorganization and our sales funnel better positions +us to capture new sales opportunities moving forward. +While +the potential impacts of the COVID-19 pandemic in coming months and +quarters remain uncertain, such effects have the potential to +adversely impact our customers and our supply chain. Such negative +effects on our customers and suppliers could adversely affect our +future sales, operations and financial results. +Cost of Products and Gross Profit Margin +Gross +profit margins as a percentage of sales for 2020 was approximately +41.0%, compared with 39.0% for the prior year. +Our +cost of products and gross profit margins are primarily derived +from material, labor and overhead costs, product mix, manufacturing +volumes and pricing. The improvement in gross profit margins for +2020 compared with last year was attributed primarily to a more +favorable sales mix of higher margin products. Furthermore, during +the year we reduced manufacturing operations employment by +approximately 21%, as well as other related expenses. These +reductions, combined with increased production volumes, enabled us +to better utilize and absorb our manufacturing support and overhead +expenses, which favorably impacting gross profit +margins. +23 +We +utilize a combination of internal manufacturing capabilities and +contract manufacturing relationships for production efficiencies +and to manage material and labor costs. In the future we anticipate +expanding our utilization of internal manufacturing resources. We +believe that our internal manufacturing capabilities and contract +relationships or comparable alternatives will continue to be +available to us. Although in the future we may encounter new +product cost and competitive pricing pressures, the extent of their +impact on gross margins, if any, is uncertain. +Selling, General and Administrative Expenses +SG&A expenses +consist of sales, marketing, commissions, engineering, product +development, management information systems, accounting, +headquarters and non-cash, share-based employee compensation +expenses. +SG&A expenses +for 2020 decreased 15.0% ($3.0 million) to approximately $17.0 +million, or 38.6% of sales, compared with approximately $20.0 +million, or 50.0% of sales, for the previous year. +Engineering and +product development expenses for 2020 decreased $1.9 million, or +19.8%, to approximately $7.9 million (17.8% of sales), compared +with approximately $9.8 million (24.5% of sales) for the previous +year. Product development expenses related to an anticipated new +line of portable and mobile radios with enhanced features, the BKR +Series, continued to decrease as development activities migrated +away from external resources to our new internal engineering team. +This team is primarily involved with development of the BKR Series, +including our planned multiband product. The precise date for +developing and introducing new products is uncertain and can be +impacted by, among other things, the potential effects of the +COVID-19 pandemic in coming months. +Marketing and +selling expenses for 2020 declined by approximately $1.0 million, +or 19.0%, to approximately $4.2 million (9.5% of sales), compared +with approximately $5.2 million (13.0% of sales) last year. The +decreases are attributed to reductions in sales and go-to-market +employment, as well as other sales and marketing related +expenses. +Other +general and administrative expenses for 2020 totaled approximately +$4.9 million (11.2% of sales), compared with approximately $5.0 +million (12.5% of sales) for the previous year. Decreases in +employment and other headquarters expenses were more than offset by +non-recurring severance costs recognized in the second quarter of +2020 related to our reduction in employment. +Operating Income (Loss) +For +2020, our operating income improved by $5.4 million to +approximately $1.0 million (2.4% of sales), compared with an +operating loss of approximately $4.4 million (10.9% of sales) for +the prior year. The improved operating income for 2020 was +primarily attributed to sales growth and higher gross profit +margins combined with reduced employment and other operating +expenses. +Other Income (Expense) +Interest (Expense) Income +We +recorded net interest expense of approximately $8,000 for the year +ended December 31, 2020, compared with net interest income of +approximately $150,000 last year. Reduced interest income was +primarily the result of lower cash balances and interest +rates. +Gain/Loss on Investment in Securities +For the +year ended December 31, 2020, we recognized an unrealized loss of +$620,000 on our investment in FGF, compared with an unrealized gain +of $716,000 for the previous year. +24 +Other Expense +For +2020, we recognized other expense totaling approximately $169,000, +compared with approximately $104,000 last year. Other expenses were +comprised primarily of foreign exchange transaction losses related +to sales under a Canadian dollar-denominated contract and other +investment management expenses. +Income Tax/Expense Benefit +We +recorded an income tax expense of approximately $3,000 for 2020, +compared with and income tax benefit of approximately $987,000 last +year. +Our +income tax provision is based on management’s estimate of the +effective tax rate for the full year. The tax provision +(benefit) in any period will be affected by, among other things, +permanent, as well as temporary, differences in the deductibility +of certain items, in addition to changes in tax legislation. As a +result, we may experience significant fluctuations in the effective +book tax rate (that is, tax expense divided by pre-tax book income) +from period to period. +As of +December 31, 2020, our net deferred tax assets totaled +approximately $4.3 million, and were primarily derived from +research and development tax credits, operating loss carryforwards +and accrued expenses. +In +order to fully utilize the net deferred tax assets, we will need to +generate sufficient taxable income in future years. We analyze all +positive and negative evidence to determine if, based on the weight +of available evidence, we are more likely than not to realize the +benefit of the net deferred tax assets. The recognition of the net +deferred tax assets and related tax benefits is based upon our +conclusions regarding, among other considerations, estimates of +future earnings based on information currently available and +current and anticipated customers, contracts and product +introductions, as well as historical operating results and certain +tax planning strategies. +Based +on our analysis of all available evidence, both positive and +negative, we have concluded that we do not have the ability to +generate sufficient taxable income in the necessary period to +utilize the entire benefit for the deferred tax asset. Accordingly, +we established a valuation allowance of $98,000. We cannot +presently estimate what, if any, changes to the valuation of our +deferred tax assets may be deemed appropriate in the future. If we +incur future losses, it may be necessary to record additional +valuation allowance related to the deferred tax assets recognized +as of December 31, 2020. +Liquidity and Capital Resources +For the +year ended December 31, 2020, net cash provided by operating +activities totaled approximately $4.4 million, compared with cash +used in operating activities of approximately $2.5 million last +year. Cash provided by operating activities for 2020 was primarily +related to net income and a decrease in inventory, combined with +increases in depreciation and amortization, accrued compensation +and related taxes, and deferred revenue, as well as an unrealized +loss on our investment in FGF. These items were partially offset by +increases in accounts receivable, and a decrease in accrued +warranty expenses. +For the +year ended December 31, 2020, we had a net income of approximately +$248,000, compared with a net loss of approximately $2.6 million +for the prior year. Net inventories decreased during 2020 by +approximately $4.1 million, compared with an increase of +approximately $2.0 million for the prior year. The decrease for the +year was primarily attributed to product sales combined with our +inventory reduction program. Depreciation and amortization totaled +approximately $1.3 million for 2020, compared with approximately +$1.2 million for the prior year, primarily due to capital +expenditures related to manufacturing and engineering equipment. +Accrued compensation and related taxes for 2020 increased +approximately $364,000, compared with a decrease of $743,000 last +year. The increase in 2020 was the result of incentive compensation +related to improved sales and operating results. Deferred revenue +for 2020 increased approximately $585,000, compared with +approximately $947,000 for the prior year, which was attributed +primarily to the sales of extended warranties. Unrealized losses on +securities for 2020 totaled approximately $620,000, compared with +gains of approximately $716,000 for last year. For additional +information pertaining to our investment in securities, refer to +Note 6 (Investment in Securities) to the consolidated financial +statements included in this report. Accounts receivable for 2020 +increased approximately $2.5 million, compared with a decrease of +approximately $1.8 million last year. The increase for the current +year was attributable to the timing of sales later in the year that +had not yet completed their collection cycle. Accrued warranty +expenses for 2020 decreased approximately $457,000, compared with +approximately $298,000 last year. The decrease for the year is +attributed primarily to manufacturing operations and quality +improvements. +25 +Cash +used in investing activities for the year ended December 31, 2020 +totaled approximately $946,000 and was attributed to purchases of +property, plant and equipment. For the same period last year, cash +used in investing activities totaled approximately $2.5 million, +and was also attributed to purchases of property, plant and +equipment. +For the +year ended December 31, 2020, cash of approximately $1.3 million +was used in financing activities. During the year we received +proceeds totaling approximately $2.2 million under the PPP, which +were repaid in full within the same period. We also used cash for +our capital return program, which included quarterly dividends +totaling approximately $1.0 million and stock repurchases totaling +approximately $269,000. Our stock repurchase program terminated in +April 2020 and was not renewed. Last year, approximately $1.0 +million was used to pay dividends and approximately $1.0 million +was used for stock repurchases. Last year we received $425,000 from +U.S. Bank Equipment Finance for the purchase of manufacturing +equipment items, pursuant to the Master Loan Agreement, described +below. +On +April 13, 2020, BK Technologies, Inc., our wholly-owned operating +subsidiary, received approval and funding pursuant to a promissory +note (the “PPP Note”) evidencing an unsecured loan in +the amount of $2,196,335 (the “Loan”) under the PPP. +The PPP was established under the CARES Act and is administered by +the U.S. Small Business Administration (“SBA”). The +Loan was made through JPMorgan Chase Bank, N.A. +(“JPMC”). We intended to use the Loan for qualifying +expenses in accordance with the terms of the CARES Act. At the time +of application, we believed we qualified to receive the funds +pursuant to the PPP. +On +April 23, 2020, the SBA, in consultation with the Department of +Treasury, issued new guidance that created uncertainty regarding +the qualification requirements for a PPP loan. In April 2020, out +of an abundance of caution, we repaid the loan in +full. +On May +4, 2020, the Company implemented workforce reductions of +approximately 18% to reduce costs and to better position the +Company in an uncertain business environment resulting from the +COVID-19 pandemic. The Company incurred approximately $221,000 in +severance costs relating to these workforce reductions, which were +recognized in the second quarter of 2020 and paid under our +customary payroll practices through September 2020. +On +January 30, 2020, BK Technologies, Inc., our wholly-owned +subsidiary, entered into a $5.0 million Credit Agreement and a +related Line of Credit Note (the “Note” and +collectively with the Credit Agreement, as modified by a Note +Modification Agreement, the “Credit Agreement”) with +JPMC. The Credit Agreement provides for a revolving line of credit +of up to $5.0 million, with availability under the line of credit +subject to a borrowing base calculated as a percentage of accounts +receivable and inventory. The line of credit was modified on +January 26, 2021 to, among other things, extend the expiration date +to January 31, 2022. Proceeds of borrowings under the Credit +Agreement may be used for general corporate purposes. The line of +credit is collateralized by a blanket lien on all personal property +of BK Technologies, Inc. pursuant to the terms of the Continuing +Security Agreement with JPMC. We and each subsidiary of BK +Technologies, Inc. are guarantors of BK Technologies, Inc.’s +obligations under the Credit Agreement, in accordance with the +terms of the Continuing Guaranty. +Borrowings under +the Credit Agreement will bear interest at a rate per annum equal +to one-month LIBOR (or zero if the LIBOR is less than zero) plus a +margin of 1.90% (2.054% as of +December 31, 2020) . The line of credit, as modified, is to +be repaid in monthly payments of interest only, payable in arrears, +commencing on February 1, 2020, with all outstanding principal and +interest to be payable in full at maturity, January 31, +2022. +The +Credit Agreement contains certain customary restrictive covenants, +including restrictions on liens, indebtedness, loans and +guarantees, acquisitions and mergers, sales of assets, and stock +repurchases by BK Technologies, Inc. The Credit Agreement contains +one financial covenant requiring BK Technologies, Inc. to maintain +a tangible net worth of at least $20.0 million at any fiscal +quarter end. +The +Credit Agreement provides for customary events of default, +including: (1) failure to pay principal, interest or fees under the +Credit Agreement when due and payable; (2) failure to comply with +other covenants and agreements contained in the Credit Agreement +and the other documents executed in connection therewith; (3) the +making of false or inaccurate representations and warranties; (4) +defaults under other agreements with JPMC or under other debt or +other obligations of BK Technologies, Inc.; (5) money judgments and +material adverse changes; (6) a change in control or ceasing to +operate business in the ordinary course; and (7) certain events of +bankruptcy or insolvency. Upon the occurrence of an event of +default, JPMC may declare the entire unpaid balance immediately due +and payable and/or exercise any and all remedial and other rights +under the Credit Agreement. +26 +BK +Technologies, Inc. was in compliance with all covenants under the +Credit Agreement as of December 31, 2020 and the date of filing +this report. As of December 31, 2020 and the date of filing this +report, there were no borrowings outstanding under the Credit +Agreement and there was approximately $5.0 million of borrowing +available under the Credit Agreement. +Our +cash and cash equivalents balance at December 31, 2020 was +approximately $6.8 million. We believe these funds, combined +with our cost-saving initiatives, anticipated cash generated from +operations and borrowing availability under our Credit Agreement, +are sufficient to meet our working capital requirements for the +foreseeable future. We may, depending on a variety of factors, +including market conditions for capital raises, the trading price +of our common stock and opportunities for uses of any proceeds, +engage in public or private offerings of equity or debt securities +to increase our capital resources. However, financial and economic +conditions, including those resulting from the COVID-19 pandemic, +could limit our access to credit and impair our ability to raise +capital, if needed, on acceptable terms or at all. We also face +other risks that could impact our business, liquidity and financial +condition. For a description of these risks, see “Item 1A. +Risk Factors” set forth in this report. +Off Balance Sheet Arrangements +We do +not have any off-balance-sheet arrangements. +Recently Adopted Accounting Pronouncements +In +February 2016, the FASB issued ASU 2016-02 “Leases,” +which amended leasing guidance by requiring companies to recognize +a right-of-use (“ROU”) asset and a lease liability for +all operating and capital (finance) leases with lease terms greater +than twelve months. The lease liability is equal to the present +value of lease payments. The lease asset is based on the lease +liability, subject to adjustment, such as for initial direct costs. +For income statement purposes, leases continue to be classified as +operating or capital (finance), with lease expense in both cases +calculated substantially the same as under the prior leasing +guidance. The updated guidance became effective for interim and +annual periods beginning after December 15, 2018. The Company +adopted the new guidance on January 1, 2019. Adoption resulted in +the recognition of ROU assets and lease liabilities on the +consolidated financial statements. Based on the Company’s +lease portfolio as of January 1, 2019, which consisted solely of +operating leases, the Company recognized approximately $2.9 million +of ROU assets and $3.0 million of lease liabilities on its +consolidated financial statements.. Refer to Note 7 (Leases) for +further details on leases. +In +August 2018, the FASB issued ASU 2018-15, +“Intangibles—Goodwill and Other—Internal-Use +Software (Subtopic 350-40): Customer’s Accounting for +Implementation Costs Incurred in a Cloud Computing Arrangement That +Is a Service Contract,” to help entities evaluate the +accounting for fees paid by a customer in a cloud computing +arrangement (hosting arrangement) by providing guidance for +determining when the arrangement includes a software license. The +amendments in ASU 2018-15 align the requirements for capitalizing +implementation costs incurred in a hosting arrangement that is a +service contract with the requirements for capitalizing +implementation costs incurred to develop or obtain internal-use +software (and hosting arrangements that include an internal use +software license). The accounting for the service element of a +hosting arrangement that is a service contract is not affected by +the amendments in ASU 2018-15. The amendments in ASU 2018-15 became +effective for fiscal years and interim periods beginning after +December 15, 2019. Early adoption was permitted, including adoption +in any interim period. The Company adopted the new guidance in the +fourth quarter of 2018, with no material impact on its consolidated +financial statements and related disclosures. +In +August 2018, the FASB issued ASU 2018-13, “Disclosure +Framework–Changes to the Disclosure Requirements for Fair +Value Measurement,” which modifies the disclosure +requirements on fair value measurements in Topic 820, Fair Value +Measurement, including the removal of certain disclosure +requirements. The amendments in the ASU are effective for all +entities for fiscal years, and interim periods within those fiscal +years, beginning after December 15, 2019. Early adoption was +permitted upon issuance of the ASU. The Company adopted this +guidance as of January 1, 2020, and the adoption did not have an +impact on its consolidated financial statements. +27 +Recent Accounting Pronouncements +The +Company does not discuss recent pronouncements that are not +anticipated to have an impact on or are unrelated to its financial +condition, results of operations, cash flows or +disclosures. +Critical Accounting Policies and Estimates +Our +revenue recognition process and our more subjective accounting +estimation processes affect our reported revenues and current +assets and are, therefore, critical in assessing our financial and +operating status. The processes for determining the allowance for +collection of trade receivables, allowance for slow-moving, excess +and obsolete inventory, allowance for product warranty, and income +taxes involve certain assumptions that, if incorrect, could create +an adverse impact on our operations and financial +position. +Allowance for Doubtful Accounts +The +allowance for doubtful accounts was approximately $50,000 on gross +trade receivables of approximately $6.5 million as of December +31, 2020, as compared with $50,000 on gross trade receivables of +approximately $4.0 million as of December 31, 2019. This allowance +is used to state trade receivables at a net realizable value or the +amount that we estimate will be collected on our gross receivables +as of December 31, 2020 and 2019. Because the amount that we will +actually collect on the receivables outstanding as of December 31, +2020 and 2019 cannot be known with certainty, we rely on prior +experience. Our historical collection losses have typically been +infrequent, with write-offs of trade receivables being +significantly less than 1% of sales during past years. Accordingly, +we have maintained a general allowance of up to approximately 5% of +the gross trade receivables balance in order to allow for future +collection losses that arise from customer accounts that do not +indicate the inability to pay but turn out to have such an +inability. Currently, our general allowance on trade receivables is +approximately 0.8% of gross receivables. As revenues and total +receivables increase, the allowance balance may also increase. We +also maintain a specific allowance for customer accounts that we +know may not be collectible due to various reasons, such as +bankruptcy and other customer liquidity issues. We analyze our +trade receivables portfolio based on the age of each +customer’s invoice. In this way, we can identify those +accounts that are more likely than not to have collection problems. +We may reserve a portion or all of the customer’s balance. As +of December 31, 2020 and 2019, we had no specific allowance on +trade receivables. +Slow-moving, Excess and Obsolete Inventory +The +allowance for slow-moving, excess and obsolete inventory was +approximately $520,000 and $823,000 at December 31, 2020 and 2019, +respectively. +The +allowance for slow-moving, excess, and obsolete inventory is used +to state our inventories at the lower of cost or net realizable +value. Because the amount of inventory that we will actually recoup +through sales cannot be known with certainty at any particular +time, we rely on past sales experience, future sales forecasts and +our strategic business plans. Generally, in analyzing our inventory +levels, we classify inventory as having been used or unused during +the past year and establish an allowance based upon several +factors, including, but not limited to, business forecasts, +inventory quantities and historical usage profile. Supplemental to +the aforementioned analysis, specific inventory items are reviewed +individually by management. Based on the review, considering +business levels, future prospects, new products and technology +changes, management, using its business judgment, may adjust the +valuation of specific inventory items to reflect an accurate +valuation estimate. Management also performs a determination of net +realizable value for all finished goods with a selling price below +cost. For all such items, the inventory is valued at not more than +the selling price less cost, if any, to sell. +Allowance for Product Warranty +We +offer two-year standard warranties to our customers, depending on +the specific product and terms of the customer purchase agreement. +Our typical warranties require us to repair and replace defective +products during the warranty period at no cost to the customer. At +the time the product revenue is recognized, we record a liability +for estimated costs under our warranties. The costs are estimated +based on historical experience. We periodically assess the adequacy +of our recorded liability for product warranties and adjust the +amount as necessary. +28 +Income Taxes +We +account for income taxes using the asset and liability method. +Deferred tax assets and liabilities are recognized for the future +tax consequences attributable to differences between the financial +statement carrying amounts of existing assets and liabilities and +their respective tax bases. Deferred tax assets and liabilities are +measured using the enacted tax rates expected to apply in the +period in which the deferred tax asset or liability is expected to +be realized. The effect of changes in net deferred tax assets and +liabilities is recognized on our consolidated balance sheets and +consolidated statements of operations in the period in which the +change is recognized. Valuation allowances are provided to the +extent that it is more likely than not that some portion, or all, +of deferred tax assets will not be realized. In determining whether +a tax asset is realizable, we consider, among other things, +estimates of future earnings based on information currently +available, current and anticipated customers, contracts and new +product introductions, as well as recent operating results and +certain tax planning strategies. If we fail to achieve the future +results anticipated in the calculation and valuation of net +deferred tax assets, we may be required to increase the valuation +allowance related to our deferred tax assets in the +future. +Forward-Looking Statements +We +believe that it is important to communicate our future expectations +to our security holders and to the public. This report, therefore, +contains statements about future events and expectations which are +“forward-looking statements” within the meaning of +Sections 27A of the Securities Act of 1933, as amended, and 21E of +the Exchange Act, including the statements about our plans, +objectives, expectations and prospects under the heading +“Management’s Discussion and Analysis of Financial +Condition and Results of Operations.” You can expect to +identify these statements by forward-looking words such as +“may,” “might,” “could,” +“would,” “should,” “will,” +“anticipate,” “believe,” +“plan,” “estimate,” “project,” +“expect,” “intend,” “seek,” +“are encouraged” and other similar expressions. Any +statement contained in this report that is not a statement of +historical fact may be deemed to be a forward-looking statement. +Forward-looking statements include, but are not limited to, the +following: changes or advances in technology; the success of our +LMR product line; successful introduction of new products and +technologies, including our ability to successfully develop and +sell our anticipated new multiband product and other related +products in the planned new BKR Series product line; competition in +the LMR industry; general economic and business conditions, +including federal, state and local government budget deficits and +spending limitations and any impact from a prolonged shutdown of +the U.S. Government; the availability, terms and deployment of +capital; reliance on contract manufacturers and suppliers; risks +associated with fixed-price contacts; heavy reliance on sales to +agencies of the U.S. Government and our ability to comply with the +requirements of contracts, laws and regulations related to such +sales; allocations by government agencies among multiple approved +suppliers under existing agreements; our ability to comply with +U.S. tax laws and utilize deferred tax assets; our ability to +attract and retain executive officers, skilled workers and key +personnel; our ability to manage our growth; our ability to +identify potential candidates for, and consummate, acquisition, +disposition or investment transactions, and risks incumbent to +being a noncontrolling interest stockholder in a corporation; +impact of our capital allocation strategy; risks related to +maintaining our brand and reputation; impact of government +regulation; rising health care costs; our business with +manufacturers located in other countries, including changes in the +U.S. Government and foreign governments’ trade and tariff +policies; our inventory and debt levels; protection of our +intellectual property rights; fluctuation in our operating results +and stock price; acts of war or terrorism, natural disasters and +other catastrophic events; any infringement claims; data security +breaches, cyber attacks and other factors impacting our technology +systems; availability of adequate insurance coverage; maintenance +of our NYSE American listing; risks related to being a holding +company; and the effect on our stock price and ability to raise +equity capital of future sales of shares of our common +stock. +Although we believe +that the plans, objectives, expectations and prospects reflected in +or suggested by our forward-looking statements are reasonable, +those statements involve risks, uncertainties and other factors +that may cause our actual results, performance or achievements to +be materially different from any future results, performance or +achievements expressed or implied by these forward-looking +statements, and we can give no assurance that our plans, +objectives, expectations and prospects will be +achieved. +29 +Important factors +that might cause our actual results to differ materially from the +results contemplated by the forward-looking statements are +contained in “Part I—Item 1A. Risk Factors” and +elsewhere in this report and in our subsequent filings with the +SEC. We assume no obligation to publicly update or revise any +forward-looking statements made in this report, whether as a result +of new information, future events, changes in assumptions or +otherwise, after the date of this report. Readers are cautioned not +to place undue reliance on these forward-looking +statements. +I tem 7A. Quantitative and +Qualitative Disclosures About Market Risk +Not +required for smaller reporting companies. +I tem 8. Financial Statements and Supplementary +Data +See the +Consolidated Financial Statements included in this +report. +30 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING +FIRM +Board of Directors and Stockholders +BK Technologies Corporation +West Melbourne, Florida +Opinion on the Consolidated Financial Statements +We have +audited the accompanying consolidated balance sheets of BK +Technologies Corporation (the “Company”) as of +December 31, 2020 and 2019, and the related consolidated +statements of operations, changes in stockholders’ equity, +and cash flows for each of the years in the two-year period ended +December 31, 2020, and the related notes (collectively +referred to as the consolidated financial statements). In our +opinion, the consolidated financial statements present fairly, in +all material respects, the financial position of the Company as of +December 31, 2020 and 2019, and the results of its operations +and its cash flows for each of the years in the two-year period +ended December 31, 2020, in conformity with accounting +principles generally accepted in the United States of +America. +Basis for Opinion +These +consolidated financial statements are the responsibility of the +Company’s management. Our responsibility is to express +an opinion on the Company’s consolidated financial statements +based on our audits. We are a public accounting firm +registered with the Public Company Accounting Oversight Board +(United States) (“PCAOB”) and are required to be +independent with respect to the Company in accordance with U.S. +federal securities laws and the applicable rules and regulations of +the Securities and Exchange Commission and the PCAOB. +We +conducted our audits in accordance with the standards of the +PCAOB. Those standards require that we plan and perform the +audits to obtain reasonable assurance about whether the financial +statements are free of material misstatement, whether due to error +or fraud. The Company is not required to have, nor were we +engaged to perform, an audit of its internal control over financial +reporting. As a part of our audits, we are required to obtain +an understanding of internal control over financial reporting, but +not for the purpose of expressing an opinion on the effectiveness +of the Company’s internal control over financial +reporting. Accordingly, we express no such +opinion. +Our +audits included performing procedures to assess the risks of +material misstatement of the consolidated financial statements, +whether due to error or fraud, and performing procedures that +respond to those risks. Such procedures included examining, +on a test basis, evidence regarding the amounts and disclosures in +the consolidated financial statements. Our audits also +included evaluating the accounting principles used and significant +estimates made by management, as well as evaluating the overall +presentation of the consolidated financial statements. We +believe that our audits provide a reasonable basis for our +opinion. +Critical Audit Matters +The +critical audit matters communicated below are matters arising from +the current period audit of the financial statements that were +communicated or required to be communicated to the audit committee +and that: (1) relate to accounts or disclosures that are material +to the financial statements and (2) involved our especially +challenging, subjective, or complex judgments. The communication of +critical audit matters does not alter in any way our opinion on the +financial statements, taken as a whole, and we are not, by +communicating the critical audit matters below, providing separate +opinions on the critical audit matters or on the accounts or +disclosures to which they relate. +Allowance +for slow-moving and obsolete inventory +As +disclosed in Note 1 of the Company’s consolidated financial +statements, the Company records an estimated allowance for +slow-moving, excess, and obsolete inventory to state the +Company’s inventories at the lower of cost or net realizable +value. The Company relies on, among other things, past +usage/sales experience, future sales forecasts, and its strategic +business plan to develop the estimate. As a result of +management’s assessment, the Company recorded an allowance +for slow-moving, excess, and obsolete inventory of approximately +$520,000 as of December 31, 2020. +Auditing +management’s estimate of the allowance for slow-moving, +excess, and obsolete inventory involved subjective evaluation and +high degree of auditor judgement due to significant assumptions +involved in estimating future inventory turnover and +sales. +Addressing +the matter involved performing procedures and evaluating audit +evidence in connection with forming our overall opinion on the +consolidated financial statements. We obtained an +understanding and e valuated +the design of internal controls that address the risks of material +misstatement relating to recording inventory at the lower of cost +or net realizable value. We tested the accuracy and +completeness of the underlying data used in calculating the +allowance, including testing of a sample of inventory usage +transactions, and recomputed the allowance calculation. We +also evaluated the Company’s ability to accurately estimate +the assumptions used to develop the estimate by comparing +historical allowance amounts to the history of actual inventory +write-offs. Furthermore, we reviewed management’s +business plan and forecasts of future sales, including expected +changes in technology and product lines. +Assessment of Realizability of deferred tax assets +As +disclosed in Note 8 of the Company’s consolidated financial +statements, the Company records and measures net deferred tax +assets based on estimated realizability. Valuation allowances +are provided to the extent that it is more likely than not that +some portion, or all, of deferred tax assets will not be realized. +The Company recorded approximately $4.3 million in net deferred tax +assets after valuation allowance as of December 31, +2020. +Auditing +management’s assessment of realizability of deferred tax +assets involved subjective estimation and high degree of auditor +judgment in determining whether sufficient future taxable income, +including projected pre-tax income, will be generated to support +the realization of the existing deferred tax assets before +expiration. +Addressing +the matter involved performing procedures and evaluating audit +evidence in connection with forming our overall opinion on the +consolidated financial statements. We obtained an +understanding and evaluated the design of internal controls that +address the risks of material misstatement relating to the +realizability of deferred tax assets, including controls over +management’s projections of pre-tax income, and related +entity-level controls. We also evaluated the assumptions used +by the Company to develop projections of future taxable income, and +tested the completeness and accuracy of the underlying data used in +the projections, including comparing the projections of pre-tax +income with the actual results of prior periods. In addition, +we analyzed the nature of items giving rise to deferred tax assets +and considered related expiration dates, as applicable. +Furthermore, we evaluated management’s analysis of current +economic and industry trends, including the impact of the COVID-19 +pandemic, and compared projections of future pre-tax income to +other forecasted financial information prepared by +management. +/s/ MSL, P.A. +We have +served as the Company’s auditor since 2015. +Orlando, +Florida +March +3, 2021 +F-1 +BK TECHNOLOGIES CORPORATION +CONSOLIDATED +BALANCE SHEETS +(in thousands, except share data) +December +31, +2020 +2019 +ASSETS +Current +assets: +Cash and cash +equivalents +$ 6,826 +$ 4,676 +Trade accounts +receivable, net +6,466 +3,964 +Inventories, +net +9,441 +13,513 +Prepaid expenses +and other current assets +1,878 +1,733 +Total current +assets +24,611 +23,886 +Property, plant and +equipment, net +3,566 +3,964 +Right-of-use (ROU) +asset +2,887 +2,885 +Investment in +securities +2,014 +2,635 +Deferred tax +assets, net +4,300 +4,373 +Other +assets +112 +197 +Total +assets +$ 37,490 +$ 37,940 +LIABILITIES +AND STOCKHOLDERS’ EQUITY +Current +liabilities: +Accounts +payable +$ 5,119 +$ 5,310 +Accrued +compensation and related taxes +1,635 +1,271 +Accrued warranty +expense +791 +1,248 +Accrued other +expenses and other current liabilities +307 +479 +Dividends +payable +250 +252 +Short-term lease +liability +525 +369 +Note +payable-current portion +82 +78 +Deferred +revenue +757 +369 +Total current +liabilities +9,466 +9,376 +Note payable, net +of current portion +247 +328 +Long-term lease +liability +2,702 +2,606 +Deferred +revenue +2,551 +2,354 +Total +liabilities +14,966 +14,664 +Commitments and +contingencies +Stockholders’ +equity: +Preferred stock; +$1.00 par value; 1,000,000 authorized shares; none issued or +outstanding +— +— +Common stock; $.60 +par value; 20,000,000 authorized shares; 13,962,366 and 13,929,381 +issued and 12,511,966 and 12,596,923 outstanding shares at December +31, 2020 and 2019, respectively +8,377 +8,357 +Additional paid-in +capital +26,346 +26,095 +Accumulated +deficit +(6,797 ) +(6,043 ) +Treasury stock, at +cost, 1,450,400 and 1,332,458 shares at December 31, 2020 and 2019, +respectively +(5,402 ) +(5,133 ) +Total +stockholders’ equity +22,524 +23,276 +Total liabilities +and stockholders’ equity +$ 37,490 +$ 37,940 +See notes to consolidated financial statements. +F-2 +BK TECHNOLOGIES CORPORATION +CONSOLIDATED +STATEMENTS OF OPERATIONS +(in thousands, except per share data) +Years Ended +December 31, +2020 +2019 +Sales, +net +$ 44,139 +$ 40,100 +Expenses +Cost of +products +26,055 +24,449 +Selling, general +and administrative +17,036 +20,036 +Total +expenses +43,091 +44,485 +Operating income +(loss) +1,048 +(4,385 ) +Other (expense) +income: +Net interest +(expense) income +(8 ) +150 +(Loss) gain on +investment in securities +(620 ) +716 +Other (expense) +income +(169 ) +(104 ) +Total other +(expense) income +(797 ) +762 +Income (loss) +before income taxes +251 +(3,623 ) +Income tax +(expense) benefit +(3 ) +987 +Net income +(loss) +$ 248 +$ (2,636 ) +Net income (loss) +per share-basic +$ 0.02 +$ (0.21 ) +Net income (loss) +per share-diluted +$ 0.02 +$ (0.21 ) +Weighted average +shares outstanding-basic +12,553 +12,705 +Weighted average +shares outstanding-diluted +12,561 +12,705 +See notes to consolidated financial statements. +F-3 +BK TECHNOLOGIES CORPORATION +CONSOLIDATED +STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY +(in thousands, except share and per share data) +Common Stock +Shares +Common Stock +Amount +Additional +Paid-In Capital +Accumulated +Deficit +Treasury +Stock +Total +Balance at December 31, +2018 +13,882,937 +$ 8,330 +$ 25,867 +$ (2,393 ) +$ (4,092 ) +$ 27,712 +Stock Options exercised and +issued +1,000 +— +2 +— +— +2 +Common stock issued under +restricted stock units +45,444 +27 +(27 ) +— +— +— +Share-based compensation +expense-stock options +— +— +148 +— +— +148 +Shared-based compensation +expense-restricted stock units +— +— +105 +— +— +105 +Dividends declared ($0.08 per +share) +— +— +— +(1,014 ) +— +(1,014 ) +Net loss +— +— +— +(2,636 ) +— +(2,636 ) +Repurchase of common +stock +— +— +— +— +(1,041 ) +(1,041 ) +Balance at December 31, +2019 +13,929,381 +8,357 +26,095 +(6,043 ) +(5,133 ) +23,276 +Common stock issued-restricted +stock units +32,985 +20 +(20 ) +— +— +— +Share-based compensation +expense-stock options +— +— +129 +— +— +129 +Shared-based compensation +expense-restricted stock units +— +— +142 +— +— +142 +Dividends declared ($0.08 per +share) +— +— +— +(1,002 ) +— +(1,002 ) +Net +income +— +— +— +248 +— +248 +Repurchase of common +stock +— +— +— +— +(269 ) +(269 ) +Balance at December 31, +2020 +13,962,366 +$ 8,377 +$ 26,346 +$ (6,797 ) +$ (5,402 ) +$ 22,524 +See notes to consolidated financial statements. +F-4 +BK TECHNOLOGIES CORPORATION +CONSOLIDATED +STATEMENTS OF CASH FLOWS +(in thousands) +Years Ended +December 31, +2020 +2019 +Operating +activities +Net +income (loss) +$ 248 +$ (2,636 ) +Adjustments to +reconcile net income (loss) to net cash provided by (used in) +operating activities: +Inventory +allowance +126 +194 +Deferred tax +benefit +73 +(878 ) +Depreciation and +amortization +1,344 +1,219 +Share-based compensation expense +-stock options +129 +148 +Share-based compensation +expense-restricted stock units +142 +105 +Unrealized loss (gain) on +investment in securities +620 +(716 ) +Changes in +operating assets and liabilities: +Trade accounts +receivable +(2,502 ) +1,757 +Inventories +3,946 +(2,241 ) +Prepaid expenses +and other current assets +(145 ) +669 +Other +assets +84 +(5 ) +Lease +liability +250 +90 +Accounts +payable +(191 ) +(285 ) +Accrued +compensation and related taxes +364 +(743 ) +Accrued warranty +expense +(457 ) +(298 ) +Deferred +revenue +585 +947 +Accrued other +expenses and other current liabilities +(172 ) +187 +Net +cash provided by (used in) operating activities +4,444 +(2,486 ) +Investing +activities +Purchases of +property, plant and equipment +(946 ) +(2,455 ) +Net +cash used in investing activities +(946 ) +(2,455 ) +Financing +activities +Dividends +paid +(1,002 ) +(1,018 ) +Repurchase of +common stock +(269 ) +(1,041 ) +Proceeds from +issuance of common stock +— +2 +Proceeds from +debt +2,196 +425 +Repayment of +debt +(2,273 ) +(19 ) +Net +cash used in financing activities +(1,348 ) +(1,651 ) +Net change in cash +and cash equivalents +2,150 +(6,592 ) +Cash and cash +equivalents, beginning of year +4,676 +11,268 +Cash and cash +equivalents, end of year +$ 6,826 +$ 4,676 +Supplemental +disclosure +Interest +paid +$ 22 +$ 10 +Non-cash +financing activity +Common Stock issued +under restricted stock units +$ 128 +$ 147 +See notes to consolidated financial statements. +F-5 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies +Description of Business +BK +Technologies Corporation (collectively with its subsidiaries, the +“Company”) is a holding company. The primary business +of its wholly-owned operating subsidiary, BK Technologies, Inc., is +the designing, manufacturing and marketing of wireless +communications equipment primarily consisting of two-way land +mobile radios and related products, which are sold in two primary +markets: (1) the government and public safety market, and (2) the +business and industrial market. The Company has only one reportable +business segment. +On +March 28, 2019, BK Technologies, Inc., the predecessor of BK +Technologies Corporation, implemented a holding company +reorganization, which resulted in BK Technologies Corporation +becoming the direct parent company of, and the successor issuer to, +BK Technologies, Inc. For the purpose of this report, references to +the “Company” or its management or business at any +period prior to the holding company reorganization (March 28, 2019) +refer to those of BK Technologies, Inc. as the predecessor company +and its subsidiaries and thereafter to those of BK Technologies +Corporation and its subsidiaries, except as otherwise specified or +to the extent the context otherwise indicates. +Principles of Consolidation +The +accounts of the Company have been included in the accompanying +consolidated financial statements. All significant intercompany +balances and transactions have been eliminated in +consolidation. +The +Company consolidates entities in which it has a controlling +financial interest. The Company determines whether it has a +controlling financial interest in an entity by first evaluating +whether the entity is a variable interest entity +(“VIE”) or a voting interest entity. +VIEs +are entities in which (i) the total equity investment at risk is +not sufficient to enable the entity to finance its activities +independently, or (ii) the at-risk equity holders do not have the +normal characteristics of a controlling financial interest. A +controlling financial interest in a VIE is present when an +enterprise has one or more variable interests that have both (i) +the power to direct the activities of the VIE that most +significantly impact the VIE’s economic performance, and (ii) +the obligation to absorb losses of the VIE or the right to receive +benefits from the VIE that could potentially be significant to the +VIE. The enterprise with a controlling financial interest is the +primary beneficiary and consolidates the VIE. +Voting +interest entities lack one or more of the characteristics of a VIE. +The usual condition for a controlling financial interest is +ownership of a majority voting interest for a corporation or a +majority of kick-out or participating rights for a limited +partnership. +When +the Company does not have a controlling financial interest in an +entity but exerts significant influence over the entity’s +operating and financial policies (generally defined as owning a +voting or economic interest of between 20% to 50%), the +Company’s investment is accounted for under the equity method +of accounting. If the Company does not have a controlling financial +interest in, or exert significant influence over, an entity, the +Company accounts for its investment at fair value, if the fair +value option was elected, or at cost. +The +Company has an investment in FG Financial Group, Inc. (formerly +1347 Property Insurance Holdings, Inc.), made through FGI 1347 +Holdings, LP, a consolidated VIE (see Note +6) . +Inventories +Inventories are +stated at the lower of cost (determined by the average cost method) +or net realizable value. Freight costs are classified as a +component of cost of products in the accompanying consolidated +statements of operations. +F-6 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +The +allowance for slow-moving, excess, and obsolete inventory is used +to state the Company’s inventories at the lower of cost or +net realizable value. Because the amount of inventory that will +actually be recouped through sales cannot be known with certainty +at any particular time, the Company relies on past sales +experience, future sales forecasts, and its strategic business +plans. Generally, in analyzing inventory levels, inventory is +classified as having been used or +unused during the past year. The Company then establishes an +allowance based upon several factors, including, but not limited +to, business forecasts, inventory quantities and historic usage +profile. +Supplemental to the +aforementioned analysis, specific inventory items are reviewed +individually by management. Based on the review, considering +business levels, future prospects, new products and technology +changes, management, using its business judgment, may adjust the +valuation of specific inventory items to reflect an accurate +valuation estimate. Management also performs a determination of net +realizable value for all finished goods with a selling price below +cost. For all such items, the inventory is valued at not more than +the selling price less cost, if any, to sell. +Property, Plant and Equipment +Property, plant and +equipment is carried at cost less accumulated depreciation. +Expenditures for maintenance, repairs and minor renewals are +expensed as incurred. When assets are retired or otherwise disposed +of, the related cost and accumulated depreciation are removed from +the respective accounts and the resulting gain or loss is reflected +in operations for the period. +Depreciation and +amortization are generally computed on the straight-line method +using lives of 3 to 10 years for machinery and equipment and 5 to 8 +years for leasehold improvements. +Impairment of Long-Lived Assets +Management +regularly reviews long-lived assets and intangible assets for +impairment whenever events or changes in circumstances indicate +that the carrying amount of an asset may not be recoverable. +Recoverability of assets to be held and used is measured by a +comparison of the carrying amount of an asset to future +undiscounted net cash flows expected to be generated by the asset. +If such assets are considered to be impaired, the impairment to be +recognized is measured as the amount by which the carrying amount +of the assets exceeds their fair value, which considers the +discounted future net cash flows. No long-lived assets were +considered impaired at December 31, 2020 and 2019. +Cash Equivalents +The +Company considers all highly liquid investments with an original +maturity of three months or less to be cash +equivalents. +Allowance for Doubtful Accounts +The +Company records an allowance for doubtful accounts based on +specifically identified amounts that the Company believes to be +uncollectible. The Company also records an additional allowance +based on certain percentages of the Company’s aged +receivables , which are determined +based on historical experience and the Company’s assessment +of the general financial conditions affecting the Company’s +customer base. If the Company’s actual collections experience +changes, revisions to the Company’s allowance may be +required. After all attempts to collect a receivable have failed, +the receivable is written off against the allowance. Based on the +information available, management believes the allowance for +doubtful accounts as of December 31, 2020 and 2019 is +adequate. +F-7 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Revenue Recognition +The +Company recognizes revenues in accordance with the Financial +Accounting Standards Board (“FASB”) Accounting +Standards Update (“ASU”) 2014-09, “Revenue from +Contracts with Customers” and the additional related ASUs +(“ASC 606”), which replaced previous revenue guidance +and outlines a single set of comprehensive principles for +recognizing revenue under accounting principles generally accepted +in the United States of America (“GAAP”). These +standards provide guidance on recognizing revenue, including a +five-step method to determine when revenue recognition is +appropriate: +Step 1: +Identify the contract with the customer; +Step 2: +Identify the performance obligations in the contract; +Step 3: +Determine the transaction price; +Step 4: +Allocate the transaction price to the performance obligations; +and +Step 5: +Recognize revenue as the Company satisfies a performance +obligation. +ASC 606 +provides that sales revenue is recognized when control of the +promised goods or services is transferred to customers at an amount +that reflects the consideration to which the entity expects to be +entitled to in exchange for those goods or services. The Company +generally satisfies performance obligations upon shipment of the +product or service to the customer. This is consistent with the +time in which the customer obtains control of the product or +service. For extended warranties, sales revenue associated with the +warranty is deferred at the time of sale and later recognized on a +straight-line basis over the extended warranty period. Some +contracts include installation services, which are completed in a +short period of time and the revenue is recognized when the +installation is complete. Customary payment terms are granted to +customers, based on credit evaluations. Currently, the Company does +not have any contracts where revenue is recognized, but the +customer payment is contingent on a future event. +The +Company periodically reviews its revenue recognition procedures to +assure that such procedures are in accordance with GAAP. Surcharges +collected on certain sales to government customers and remitted to +governmental agencies are not included in revenues or in costs and +expenses. +Income Taxes +The +Company accounts for income taxes using the asset and liability +method specified by GAAP. Deferred tax assets and liabilities are +recognized for the future tax consequences attributable to +differences between the financial statement carrying amounts of +existing assets and liabilities and their respective tax bases. +Deferred tax assets and liabilities are measured using the enacted +tax rates expected to apply in the period in which the deferred tax +asset or liability is expected to be realized. The effect of +changes in net deferred tax assets and liabilities is recognized on +the Company’s consolidated balance sheets and consolidated +statements of operations in the period in which the change is +recognized. Valuation allowances are provided to the extent that +impairment of tax assets is more likely than not. In determining +whether a tax asset is realizable, the Company considers, among +other things, estimates of future earnings based on information +currently available, current and anticipated customers, contracts +and new product introductions, as well as recent operating results +and certain tax planning strategies. If the Company fails to +achieve the future results anticipated in the calculation and +valuation of net deferred tax assets, the Company may be required +to increase the valuation allowance related to its deferred tax +assets in the future. +Concentration of Credit Risk +The +Company performs periodic credit evaluations of its +customers’ financial condition and generally does not require +collateral. At December 31, 2020 and 2019, accounts receivable from +governmental customers were approximately $2,102 and $353, +respectively. Generally, receivables are due within 30 days. Credit +losses relating to customers have been consistently within +management’s expectations. +F-8 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +The +Company primarily maintains cash balances at one financial +institution. Accounts are insured by the Federal Deposit Insurance +Corporation (“FDIC”) up to $250. From time to time, the +Company has had cash in financial institutions in excess of +federally insured limits. As of December 31, 2020, the Company had +cash and cash equivalents in excess of FDIC limits of +$6,576. +Manufacturing and Raw Materials +The Company relies +upon a limited number of manufacturers to produce its products and +on a limited number of component suppliers. Some of these +manufacturers and suppliers are in other countries. +Approximately 53.0% of the +Company’s material, subassembly and product procurements in +2020 were sourced internationally, of which approximately 48.0% +were sourced from three suppliers. For 2019, approximately 67.0% of +the Company’s material, subassembly and product procurements +were sourced internationally, of which approximately 64.0% +were sourced from three +suppliers. Purchase orders denominated in U.S. dollars are placed +with these suppliers from time to time and there are no guaranteed +supply arrangements or commitments. +Use of Estimates +The +preparation of financial statements in conformity with GAAP +requires management to make estimates and assumptions that affect +the reported amounts of assets and liabilities at the date of the +consolidated financial statements and the reported amounts of sales +and expenses during the reporting period. Significant estimates +include accounts receivable allowances, inventory obsolescence +allowance, warranty allowance, and income tax accruals. Actual +results could differ from those estimates. +Fair Value of Financial Instruments +The +Company’s financial instruments consist of cash and cash +equivalents, trade accounts receivable, investment in securities, +accounts payable, accrued expenses, notes payable, and other +liabilities. As of December 31, 2020 and 2019, the carrying amount +of cash and cash equivalents, trade accounts receivable, accounts +payable, accrued expenses, notes payable, and other liabilities +approximated their respective fair value due to the short-term +nature and maturity of these instruments. +The +Company uses observable market data assumptions (Level 1 inputs, as +defined in accounting guidance) that it believes market +participants would use in pricing investment in +securities. +Shipping and Handling Costs +Shipping and +handling costs are classified as a part of cost of products in the +accompanying consolidated statements of operations for the years +ended December 31, 2020 and 2019. Amounts billed to a customer, if +any, for shipping and handling are reported as +revenue. +Advertising and Promotion Costs +The +cost for advertising and promotion is expensed as incurred. +Advertising and promotion expenses are classified as part of +selling, general and administrative (“SG&A”) +expenses in the accompanying consolidated statements of operations. +For the years ended December 31, 2020 and 2019, such expenses +totaled $214 and $555, respectively. +Engineering, Research and Development Costs +Included in +SG&A expenses for the years ended December 31, 2020 and 2019 +are engineering, research and development costs of $7,869 and +$9,803, respectively. +Share-Based Compensation +The +Company accounts for share-based arrangements in accordance with +GAAP, which requires a public entity to measure the cost of +employee services received in exchange for an award of equity +instruments based on the grant-date fair value of the award (with +limited exceptions). That cost will be recognized over the period +during which the employee is required to provide service in +exchange for the award requisite service period (usually the +vesting period). No compensation cost is recognized for equity +instruments for which employees do not render the requisite +service. +F-9 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Restricted Stock Units +On +August 24, 2020, the Company granted to each non-employee director +restricted stock units with a grant-date fair value of $40 per +award (resulting in total aggregate grant-date fair value of $240), +which will vest in five equal, annual installments beginning with +the first anniversary of the grant date, subject to the +director’s continued service through such date, provided +that, if the director makes himself available and consents to be +nominated by the Company for continued service as a director, but +is not nominated for the Board for election by stockholders, other +than for good reason, as determined by the Board in its discretion, +then the restricted stock units shall vest in full as of the +director’s last date of service as a director of the +Company. +On +April 24, 2020, upon the resignation of former director Ryan +Turner, the Company, at the direction of the Board of Directors, +accelerated the vesting of Mr. Turner’s unvested restricted +stock units granted September 6, 2019 and issued 10,389 shares of +common stock. +On +September 6, 2019, the Company granted to each non-employee +director restricted stock units with a grant-date fair value of $40 +per award (resulting in total aggregate grant-date fair value of +$280), which will vest in five equal, annual installments beginning +with the first anniversary of the grant date, subject to the +director’s continued service through such date, provided +that, if the director makes himself available and consents to be +nominated by the Company for continued service as a director, but +is not nominated for the Board for election by stockholders, other +than for good reason, as determined by the Board in its discretion, +then the restricted stock units shall vest in full as of the +director’s last date of service as a director of the +Company. +On +September 6, 2018, the Company granted to each non-employee +director restricted stock units with a grant-date fair value of $20 +per award (resulting in total aggregate grant-date fair value of +$140), which vest in five equal, annual installments beginning with +the first anniversary of the grant date, subject to the +director’s continued service through such date, provided +that, if the director makes himself available and consents to be +nominated by the Company for continued service as a director, but +is not nominated for the Board for election by stockholders, other +than for good reason, as determined by the Board in its discretion, +then the restricted stock units vest in full as of the +director’s last date of service as a director of the Company. +On September 6, 2019, which was the first anniversary of the grant +date, the first tranche of the September 2018 restricted stock +units vested. On April 24, 2020, upon the resignation of Mr. +Turner, the Company accelerated the vesting of Mr. Turner’s +unvested restricted stock units granted September 6, 2018 and +issued 4,050 shares of common stock. +On June +4, 2018, the Company granted to each non-employee director +restricted stock units with a grant fair value of $20 per award +(resulting in total aggregate grant-date fair value of $140), which +vested on June 4, 2019. +Earnings (Loss) Per Share +Earnings (loss) per +share amounts are computed and presented for all periods in +accordance with GAAP. +Comprehensive Income (loss) +Comprehensive +income (loss) was equal to net income (loss) for the years ended +December 31, 2020 and 2019. +Product Warranty +The +Company offers two-year standard warranties to its customers, +depending on the specific product and terms of the customer +purchase agreement. The Company’s typical warranties require +it to repair and replace defective products during the warranty +period at no cost to the customer. At the time the product revenue +is recognized, the Company records a liability for estimated costs +under its warranties. The costs are estimated based on historical +experience. The Company periodically assesses the adequacy of its +recorded liability for product warranties and adjusts the amount as +necessary. +F-10 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +1. +Summary +of Significant Accounting Policies (Continued) +Recently Adopted Accounting Pronouncements +In +February 2016, the FASB issued ASU 2016-02 “Leases,” +which amended leasing guidance by requiring companies to recognize +a right-of-use (“ROU”) asset and a lease liability for +all operating and capital (finance) leases with lease terms greater +than twelve months. The lease liability is equal to the present +value of lease payments. The lease asset is based on the lease +liability, subject to adjustment, such as for initial direct costs. +For income statement purposes, leases continue to be classified as +operating or capital (finance), with lease expense in both cases +calculated substantially the same as under the prior leasing +guidance. The updated guidance became effective for interim and +annual periods beginning after December 15, 2018. The Company +adopted the new guidance on January 1, 2019. Adoption resulted in +the recognition of ROU assets and lease liabilities on the +consolidated financial statements. Based on the Company’s +lease portfolio as of January1, 2019, which consisted solely of +operating leases, the Company recognized approximately $2,885 of +ROU assets and $2,975 of lease liabilities on its consolidated +financial statements.. Refer to Note 7 (Leases) for further details +on leases. +In +August 2018, the FASB issued ASU 2018-15, +“Intangibles—Goodwill and Other—Internal-Use +Software (Subtopic 350-40): Customer’s Accounting for +Implementation Costs Incurred in a Cloud Computing Arrangement That +Is a Service Contract,” to help entities evaluate the +accounting for fees paid by a customer in a cloud computing +arrangement (hosting arrangement) by providing guidance for +determining when the arrangement includes a software license. The +amendments in ASU 2018-15 align the requirements for capitalizing +implementation costs incurred in a hosting arrangement that is a +service contract with the requirements for capitalizing +implementation costs incurred to develop or obtain internal-use +software (and hosting arrangements that include an internal use +software license). The accounting for the service element of a +hosting arrangement that is a service contract is not affected by +the amendments in ASU 2018-15. The amendments in ASU 2018-15 became +effective for fiscal years and interim periods beginning after +December 15, 2019. Early adoption was permitted, including adoption +in any interim period. The Company adopted the new guidance in the +fourth quarter of 2018, with no material impact on its consolidated +financial statements and related disclosures. +In +August 2018, the FASB issued ASU 2018-13, “Disclosure +Framework–Changes to the Disclosure Requirements for Fair +Value Measurement,” which modifies the disclosure +requirements on fair value measurements in Topic 820, Fair Value +Measurement, including the removal of certain disclosure +requirements. The amendments in the ASU are effective for all +entities for fiscal years, and interim periods within those fiscal +years, beginning after December 15, 2019. The Company adopted this +guidance as of January 1, 2020, and the adoption did not have an +impact on its consolidated financial statements. +Recent Accounting Pronouncements +The +Company does not discuss recent pronouncements that are not +anticipated to have an impact on or are unrelated to its financial +condition, results of operations, cash flows or +disclosures. +F-11 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +2. +Inventories, +net +Inventories, which +are presented net of allowance for obsolete and slow-moving +inventory, consisted of the following: +December 31, +2020 +2019 +Finished +goods +$ 1,975 +$ 3,864 +Work in +process +3,288 +6,122 +Raw +materials +4,178 +3,527 +$ 9,441 +$ 13,513 +Changes +in the allowance for obsolete and slow-moving inventory are as +follows: +Years Ended +December 31, +2020 +2019 +Balance, beginning +of year +$ 823 +$ 629 +Charged to cost of +sales +126 +194 +Disposal of +inventory +(429 ) +— +Balance, +end of year +$ 520 +$ 823 +For the +year ended December 31, 2020, the Company wrote off obsolete +inventory that had been fully allowed for previously, which had no +material impact to the Company’s consolidated balance sheets +or consolidated statements of operations. +3. +Allowance +for Doubtful Accounts +Changes +in the allowance for doubtful accounts are composed of the +following: +Years Ended +December 31, +2020 +2019 +Balance, beginning +of year +$ 50 +$ 50 +Provision for +doubtful accounts +— +— +Uncollectible +accounts written off +— +— +Balance, end of +year +$ 50 +$ 50 +4. +Property, +Plant and Equipment, net +Property, plant and +equipment, net include the following: +December 31, +2020 +2019 +Leasehold +improvements +$ 727 +$ 732 +Machinery and +equipment +11,971 +12,430 +Gross Property, +Plant, and Equipment +12,698 +13,162 +Less accumulated +depreciation and amortization +(9,132 ) +(9,198 ) +Property, +plant and equipment, net +$ 3,566 +$ 3,964 +Depreciation and +amortization expense relating to property, plant and equipment for +the years ended December 31, 2020 and 2019 was approximately $1,344 +and $1,219, respectively. During the year ended 31, 2020, the +company removed from its records approximately $1,400 of fully +depreciated machinery and equipment. +F-12 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +5. +Debt +On +January 30, 2020, BK Technologies, Inc., a wholly-owned subsidiary +of the Company, entered into a $5,000 Credit Agreement and a +related Line of Credit Note (the “Note” and +collectively with the Credit Agreement, as modified by that certain +Note Modification Agreement dated as of January 26, 2021, the +“Credit Agreement”) with JPMorgan Chase Bank, N.A. +(“JPMC”). +The +Credit Agreement provides for a revolving line of credit of up to +$5,000, with availability under the line of credit subject to a +borrowing base calculated as a percentage of accounts receivable +and inventory. The line of credit, as modified by the Note +Modification Agreement, expires on January 31, 2022. Proceeds of +borrowings under the Credit Agreement may be used for general +corporate purposes. The line of credit is collateralized by a +blanket lien on all personal property of BK Technologies, Inc. +pursuant to the terms of the Continuing Security Agreement with the +Lender. The Company and each subsidiary of BK Technologies, Inc. +are guarantors of BK Technologies, Inc.’s obligations under +the Credit Agreement, in accordance with the terms of the +Continuing Guaranty. +Borrowings under +the Credit Agreement will bear interest at a rate per annum equal +to one-month LIBOR or zero if the LIBOR is less than zero) plus a +margin of 1.90% (2.054% as of December 31, 2020). The line of +credit, as modified, is to be repaid in monthly payments of +interest only, payable in arrears, commencing on February 1, 2020, +with all outstanding principal and interest to be payable in full +at maturity (January 31, 2022). +The +Credit Agreement contains certain customary restrictive covenants, +including restrictions on liens, indebtedness, loans and +guarantees, acquisitions and mergers, sales of assets, and stock +repurchases by BK Technologies, Inc. The Credit Agreement contains +one financial covenant requiring BK Technologies, Inc. to maintain +a tangible net worth of at least $20,000 at any fiscal quarter +end. +The +Credit Agreement provides for customary events of default, +including: (1) failure to pay principal, interest or fees under the +Credit Agreement when due and payable; (2) failure to comply with +other covenants and agreements contained in the Credit Agreement +and the other documents executed in connection therewith; (3) the +making of false or inaccurate representations and warranties; (4) +defaults under other agreements with JPMC or under other debt or +other obligations of BK Technologies, Inc.; (5) money judgments and +material adverse changes; (6) a change in control or ceasing to +operate business in the ordinary course; and (7) certain events of +bankruptcy or insolvency. Upon the occurrence of an event of +default, JPMC may declare the entire unpaid balance immediately due +and payable and/or exercise any and all remedial and other rights +under the Credit Agreement. +BK +Technologies, Inc. was in compliance with all covenants under the +Credit Agreement as of December 31, 2020 and the date of filing +this report. As of December 31, 2020 and the date of filing this +report, there were no borrowings outstanding under the Credit +Agreement. +On +September 25, 2019, BK Technologies, Inc., a wholly-owned +subsidiary of BK Technologies Corporation, and U.S. Bank Equipment +Finance, a division of U.S. Bank National Association, as a lender, +entered into a Master Loan Agreement in the amount of $425 to +finance various items of equipment. The loan is collateralized by +the equipment purchased using the proceeds. The Master Loan +Agreement is payable in 60 monthly principal and interest payments +of approximately $8 beginning on October 25, 2019 and maturing on +September 25, 2024, and bears a fixed interest rate of +5.11%. +On +March 28, 2019, BK Technologies, Inc., a wholly-owned subsidiary of +the Company, RELM Communications, Inc., a wholly-owned subsidiary +of BK Technologies, Inc., and Silicon Valley Bank, as lender +(“SVB”), entered into an Amended and Restated Loan and +Security Agreement (the “Loan and Security Agreement”). +The Loan and Security Agreement replaced BK Technologies, +Inc.’s prior Loan and Security Agreement with SVB (the +“Prior Agreement”) under which its collateralized +revolving credit facility (the “Credit Facility”) was +maintained. The Loan and Security Agreement matured on December 26, +2019, and the Company elected not to renew it. +F-13 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +5. +Debt +(Continued) +Pursuant to the Loan and Security Agreement, the +Credit Facility provided BK Technologies, Inc. with a maximum +borrowing availability of $1,000 and BK Technologies, Inc. was +subject to substantially the same customary borrowing terms and +conditions under the Credit Facility as it was under the Prior +Agreement, including the accuracy of representations and +warranties, compliance with financial maintenance and restrictive +covenants and the absence of events of +default. Pursuant to the Loan and Security Agreement, +payment of cash dividends, in the +aggregate not to exceed $5,000 during any twelve-month period, was +permitted so long as an event of default did not exist at +the time of such dividend and would not exist after giving effect +to such dividend. The variable rate at which borrowings under the +Credit Facility were to bear interest was The Wall Street Journal prime rate plus 25 +basis points. +The +financial maintenance covenants, which were required to be +maintained at all times and tested quarterly (or, for the +“Adjusted Quick Ratio” covenant, monthly, if any +obligations were outstanding), included: (1) a ratio of +“Quick Assets” to the sum of “Current +Liabilities” plus outstanding borrowings to SVB to the extent +not included in “Current Liabilities” minus the current +portion of “Deferred Revenue” (all as defined in the +Loan and Security Agreement) of at least 1.25:1.00 and (2) maximum +“Total Leverage” (as defined in the Loan and Security +Agreement) of no greater total consolidated +“Indebtedness” than 3 times “Adjusted +EBITDA” (all as defined in the Loan and Security Agreement). +BK Technologies, Inc.’s obligations were collateralized by +substantially all of its assets, principally accounts receivable +and inventory. +BK +Technologies, Inc. was in compliance with all covenants under the +Loan and Security Agreement when it matured on December 26, 2019. +BK Technologies, Inc. had no borrowings outstanding under the +credit facility at the time it matured. +6. +Investment +in Securities +The +Company has an investment in a limited partnership, FGI 1347 +Holdings, LP (“1347 +LP”) , of which the Company is the sole limited +partner. FGI 1347 Holdings, LP was established for the purpose of +investing in securities. +As of December 31, 2020, the Company indirectly +held approximately $110 in cash and 477,282 shares of FG +Financial Group, Inc. (formerly 1347 +Property Insurance Holdings, Inc.) (Nasdaq: FGF) with fair value of +$2,014, through an investment in FGI 1347 Holdings, LP. These +shares were purchased in March and May 2018 for approximately +$3,741. +During +the years ended December 31, 2020 and 2019, the Company recognized +a loss of approximately $620 and a gain of approximately $716, +respectively, due to changes in the unrealized loss on investment +in securities. +Affiliates of +Fundamental Global +Investors, LLC (“ FG ”) serve as the general +partner and the investment manager of 1347 LP, and the Company is +the sole limited partner. As the sole limited partner, the Company +is entitled to 100% of net assets held by 1347 LP. The general +partner of 1347 LP is entitled to a management fee from 1347 LP. +There were no fees paid to the general partner or its +affiliates for the years ended December 31, 2020 or 2019. As +of December 31, 2020, the Company and the affiliates of FG, +including, without limitation, Ballantyne Strong, Inc., +beneficially owned in the aggregate 3,109,891 shares of FGF’s +common stock, representing approximately 62.7% of FGF’s +outstanding shares. FG with its affiliates is the largest +stockholder of the Company. Mr. Kyle Cerminara, a member of the +Company’s Board of Directors, is Chief Executive Officer, +Co-Founder and Partner of FG and serves as Chairman of the Board of +Directors of Ballantyne Strong, Inc. Mr. Cerminara also serves as +Chairman of the Board of Directors of FGF. +7. +Leases +The +Company leases approximately 54,000 square feet (not in thousands) +of industrial space in West Melbourne, Florida, under a +non-cancellable operating lease. The lease has the expiration date +of June 30, 2027. Rental, maintenance and tax expenses for +this facility were approximately $510 and $502 in 2020 and 2019, +respectively. The Company also leases 8,100 square feet (not in +thousands) of office space in Lawrence, Kansas, to accommodate a +portion of the Company’s engineering team. In November 2019, +this lease was amended to extend the lease term until December 31, +2021. Rental, maintenance and tax expenses for this facility were +approximately $124 and $108 in 2020 and 2019, +respectively. +F-14 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +7. +Leases +(Continued) +In +February 2020, the Company entered into a lease for 6,857 (not in +thousands) square feet of office space at Sawgrass Technology Park, +1619 NW 136 th Avenue in Sunrise, +Florida, for a period of 64 months. The commencement date for this +lease was July 1, 2020. Rental, maintenance, and tax expenses for +the facility were $169 in 2020. +The +Company adopted ASU No. 2016-02, “Leases” (Topic 842) +on January 1, 2019 and applied the modified retrospective approach +to adoption whereby the standard is applied only to the current and +future periods. The Company leases manufacturing and office +facilities and equipment under operating leases and determines if +an arrangement is a lease at inception. ROU assets represent the +Company’s right to use an underlying asset for the lease term +and lease liabilities represent its obligation to make lease +payments arising from the lease. Operating lease ROU assets and +liabilities are recognized at the lease commencement date based on +the present value of lease payments over the lease +term. +As +most of its leases do not provide an implicit rate, the Company +uses its incremental borrowing rate based on the information +available at commencement date in determining the present value of +lease payments. The Company’s lease terms may include options +to extend or terminate the lease when it is reasonably certain that +the Company will exercise that option. The Company has lease +agreements with lease and non-lease components, which are accounted +for separately. +Lease +costs consist of the following: +December 31, +2020 +2019 +Operating lease +cost +$ 610 +$ 573 +Short-term lease +cost +2 +2 +Variable lease +cost +129 +128 +Total lease +cost +$ 741 +$ 703 +Supplemental +cash flow information related to leases was as +follows: +December +31, +2020 +2019 +Cash paid for +amounts included in the measurement of lease +liabilities: +Operating cash +flows (fixed payments) +$ 521 +$ 522 +Operating cash +flows (liability reduction) +367 +369 +ROU assets obtained +in exchange for lease obligations: +Operating +leases +454 +2,840 +F-15 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +7. +Leases +(Continued) +Other +information related to operating leases was as +follows: +December +31, +2020 +Weighted average +remaining lease term (in years) +5.99 +Weighted average +discount rate +5.50 % +Maturity +of lease liabilities as of December 31, 2020 were as +follows: +Year ending +December 31, +2021 +$ 683 +2022 +579 +2023 +592 +2024 +604 +2025 +615 +Thereafter +722 +Total +payments +3,795 +Less: +imputed interest +568 +Total +liability +$ 3,227 +8. +Income +Taxes +The +income tax expense +( benefit) is summarized as follows: +Years Ended +December 31, +2020 +2019 +Current: +Federal +$ (72 ) +$ (107 ) +State +3 +(3 ) +(69 ) +(110 ) +Deferred: +Federal +(44 ) +(889 ) +State +116 +12 +72 +(877 ) +$ 3 +$ (987 ) +A +reconciliation of the statutory U.S. income tax rate to the +effective income tax rate follows: +Years Ended +December 31, +2020 +2019 +Statutory U.S. +income tax rate +21.00 % +(21.00 )% +State taxes, net of +federal benefit +6.00 % +(1.21 )% +Permanent +differences +3.45 % +0.61 % +Change in valuation +allowance +38.83 % +0.00 % +Change in net +operating loss carryforwards and tax credits +(67.58 )% +(5.50 )% +Other +(0.50 )% +(0.14 )% +Effective income +tax rate +1.20 % +(27.24 )% +F-16 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +8. +Income +Taxes (Continued) +The +components of the deferred income tax assets (liabilities) are as +follows: +Years Ended +December 31, +2020 +2019 +Deferred tax +assets: +Operating +loss carryforwards +$ 1,238 +$ 1,347 +R&D +Tax Credit +1,952 +1,678 +AMT Tax +Credit +— +72 +Section +263A costs +203 +294 +R&D +costs +— +110 +Amortization +21 +24 +Unrealized +loss +391 +252 +Asset +reserves: +Bad +debts +11 +11 +Inventory +allowance +118 +187 +Accrued +expenses: +Non-qualified +stock options +175 +132 +Compensation +64 +132 +Warranty +927 +904 +Deferred tax +assets +5,098 +5,143 +Less valuation +allowance +(98 ) +— +Total deferred tax +assets +5,000 +5,143 +Deferred tax +liabilities: +Depreciation +(700 ) +(770 ) +Total deferred tax +liabilities +(700 ) +(770 ) +Net deferred tax +assets (before unrealized gain) +4,300 +4,373 +Deferred tax +liability: unrealized gain +— +— +Net deferred tax +assets +$ 4,300 +$ 4,373 +As of +December 31, 2020, the Company had a net deferred tax asset of +approximately $5,000 offset by deferred tax liabilities of $700 +derived from accelerated tax depreciation. This asset is primarily +composed of net operating loss carryforwards (“NOLs”), +research and development tax credits, and deferred revenue, net of +a valuation allowance of approximately $98. The NOLs total +approximately $4,829 for federal and $6,332 for state purposes, +with expirations starting in 2021 for state purposes. State NOLs of +$648 expired in 2020. +During +2019, the Company generated $5,006 of federal NOLs and during 2020, +the Company expects to use $176 of available federal NOLs. The +deferred tax asset amounts are based upon management’s +conclusions regarding, among other considerations, the +Company’s current and anticipated customer base, contracts, +and product introductions, certain tax planning strategies, and +management’s estimates of future earnings based on +information currently available, as well as recent operating +results during 2020, 2019, and 2018. GAAP requires that all +positive and negative evidence be analyzed to determine if, based +on the weight of available evidence, the Company is more likely +than not to realize the benefit of the deferred tax +asset. +F-17 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +8. +Income +Taxes (Continued) +Management’s +analysis of all available evidence, both positive and negative, +provides support that the Company does not have the ability to +generate sufficient taxable income in the necessary period to +utilize the entire benefit for the deferred tax asset. Accordingly, +as of +December 31, 2020, a valuation allowance has been +established totaling approximately $98. +Should +the factors underlying management’s analysis change, future +valuation adjustments to the Company’s net deferred tax asset +may be necessary. If future losses are incurred, it may be +necessary to record an additional valuation allowance related to +the Company’s net deferred tax asset recorded as of December +31, 2020. It cannot presently be estimated what, if any, changes to +the valuation of the Company’s deferred tax asset may be +deemed appropriate in the future. The 2020 federal and state NOLs +and tax credit carryforwards could be subject to limitation if, +within any three-year period prior to the expiration of the +applicable carryforward period, there is a greater than 50% change +in ownership of the Company by any stockholder with 5% or greater +ownership. +The +Company performed a comprehensive review of its portfolio of +uncertain tax positions in accordance with recognition standards +established by GAAP. In this regard, an uncertain tax position +represents the Company’s expected treatment of a tax position +taken in a filed tax return or planned to be taken in a future tax +return that has not been reflected in measuring income tax expense +for financial reporting purposes. As a result of this review, on +January 1, 2021, the Company is not aware of any uncertain tax +positions that would require additional liabilities or which such +classification would be required. The amount of unrecognized tax +positions did not change as of December 31, 2020, and the Company +does not believe there will be any material changes in its +unrecognized tax positions over the next twelve +months. +Penalties and +tax-related interest expense, of which there were no material +amounts for the years ended December 31, 2020 and 2019, are +reported as a component of income tax expense +(benefit). +The +Company files federal income tax returns, as well as multiple state +and local jurisdiction tax returns. A number of years may elapse +before an uncertain tax position is audited and finally resolved. +While it is often difficult to predict the final outcome or the +timing of resolution on any particular uncertain tax position, the +Company believes that its allowances for income taxes reflect the +most probable outcome. The Company adjusts these allowances, as +well as the related interest, in light of changing facts and +circumstances. The resolution of a matter would be recognized as an +adjustment to the provision for income taxes and the effective tax +rate in the period of resolution. The calendar years 2017, 2018, +and 2019 are still open to IRS examination under the statute of +limitations. The last IRS examination on the Company’s 2007 +calendar year was closed with no change. +9. +Income +(Loss) Per Share +The +following table sets forth the computation of basic and diluted +loss per share: +Years Ended +December 31, +2020 +2019 +Numerator: +Net +income (loss) from continuing operations numerator for basic and +diluted earnings per share +$ 248 +$ (2,636 ) +Denominator: +Denominator +for basic income (loss) per share weighted average +shares +12,552,889 +12,705,304 +Effect +of dilutive securities: +Stock +options +8,440 +— +Denominator +for diluted income ( loss) per share weighted average +shares +12,561,329 +12,705,304 +Basic +income (loss) per share +$ 0.02 +$ (0.21 ) +Basic income (loss) per share +$ 0.02 +$ (0.21 ) +F-18 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +9. +Loss +Per Share (Continued) +Approximately +464,000 stock options and 139,233 restricted stock units for the +year ended December 31, 2020 and 569,500 stock options and 101,073 +restricted stock units for the year ended December 31, 2019, were +excluded from the calculation because they were +anti-dilutive. +10. +Share-Based +Employee Compensation +The +Company has an employee and non-employee director incentive +compensation equity plan. Related to these programs, the Company +recorded $129 and $148 of share-based employee compensation expense +during the years ended December 31, 2020 and 2019, respectively, +which is included as a component of cost of products and SG&A +expenses in the accompanying consolidated statements of operations. +No amount of share-based employee compensation expense was +capitalized as part of capital expenditures or inventory for the +years presented. +The +Company uses the Black-Scholes-Merton option valuation model to +calculate the fair value of a stock option grant. The share-based +employee compensation expense recorded in the years ended December +31, 2020 and 2019 was calculated using the assumptions noted in the +following table. Expected volatilities are based on the historical +volatility of the Company’s common stock over the period of +time, commensurate with the expected life of the stock options. The +dividend yield assumption is based on the Company’s +expectations of dividend payouts at the grant date. In 2020, the +Company paid dividends on January 17, for a dividend declared in +2019, April 13, July 20 and October 19. In December 2020, the +Company’s Board of Directors also declared a quarterly +dividend that was paid on January 19, 2021. The Company has +estimated its future stock option exercises. The expected term of +option grants is based upon the observed and expected time to the +date of post vesting exercises and forfeitures of options by the +Company’s employees. The risk-free interest rate is derived +from the average U.S. Treasury rate for the period, which +approximates the rate at the time of the stock option +grant. +FY +2020 +FY +2019 +Expected +Volatility +52.1 % +49.0 % +Expected +Dividends +2.0 % +2.0 % +Expected Term (in +years) +6.5 +6.5 +Risk-Free +Rate +0.49 % +2.36 % +Estimated +Forfeitures +0.0 % +0.0 % +F-19 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +10. +Share-Based +Employee Compensation (Continued) +A +summary of stock option activity under the Company’s equity +compensation plans as of December 31, 2020, and changes during the +year ended December 31, 2020, are presented below: +As of +January 1, 2020 +Stock +Options +Wgt. +Avg. +Exercise +Price +($) +Per +Share +Wgt. +Avg. +Remaining +Contractual +Life +(Years) +Wgt +Avg. +Grant +Date +Fair Value +($) +Per +Share +Aggregate +Intrinsic +Value +($) +Outstanding +569,500 +4.16 +6.82 +1.75 +24,000 +Vested +214,800 +4.12 +4.20 +1.95 +24,000 +Nonvested +354,700 +4.18 +8.40 +1.63 +— +Period +activity +Issued +110,000 +3.24 +— +1.27 +— +Exercised +— +— +— +— +— +Forfeited +120,500 +4.17 +— +1.69 +— +Expired +70,000 +4.11 +— +2.79 +— +As +of December 31, 2020 +Outstanding +489,000 +3.96 +7.23 +1.51 +20,000 +Vested +185,800 +4.15 +5.65 +1.55 +20,000 +Nonvested +303,200 +3.84 +8.20 +1.49 +— +Outstanding: +Range of +Exercise Prices +($) Per +Share +Stock +Options +Outstanding +Wgt. +Avg.Exercise +Price +($) +Per +Share +Wgt. Avg. +RemainingContractual +Life +(Years) +2.23 +3.83 +245,000 +3.35 +7.82 +4.07 +5.10 +244,000 +4.56 +6.63 +489,000 +3.96 +7.23 +Exercisable: +Range of +Exercise Prices +($) Per +Share +Stock +Options +Exercisable +Wgt. +Avg.Exercise +Price +($) +Per +Share +2.23 +3.83 +67,000 +3.18 +4.07 +5.10 +118,800 +4.70 +185,800 +4.15 +The +weighted-average grant-date fair value per option granted during +the years ended December 31, 2020 and 2019 was $1.27 and $1.64, +respectively. The aggregate intrinsic value of stock options +exercised during the years ended December 31, 2020 and 2019 was +approximately $0 and $1, respectively. +In +connection with the restricted stock units granted to non-employee +directors, the Company accrues compensation expense based on the +estimated number of shares expected to be issued, utilizing the +most current information available to the Company at the date of +the consolidated financial statements. The Company estimates the +fair value of the restricted stock unit awards based upon the +market price of the underlying common stock on the date of grant. +As of December 31, 2020 and 2019, there was approximately $872 and +$982, respectively, of total unrecognized compensation cost related +to non-vested share-based compensation arrangements, including +stock options and restricted stock units. This compensation cost is +expected to be recognized approximately over four +years. +F-20 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +11. +Significant +Customers +Sales +to the U.S. Government represented approximately 50.5% and 49.1% of +the Company’s total sales for the years ended December 31, +2020 and 2019, respectively. These sales were primarily to the +various government agencies, including those within the United +States Department of Defense, the United States Forest Service, the +United States Department of Interior, and the United States +Department of Homeland Security. +12. +Retirement +Plan +The +Company sponsors a participant contributory retirement 401(k) plan, +which is available to all employees. The Company’s +contribution to the plan is either a percentage of the +participant’s contribution (50% of the participant’s +contribution up to a maximum of 6%) or a discretionary amount. In +the second quarter of 2020, the Company suspended the participant +contributory retirement 401(k) plan to reduce costs and to better +position the Company in an uncertain business environment due in +part to the COVID-19 pandemic. For the years ended December 31, +2020 and 2019, total contributions made by the Company were $60 and +$164, respectively. +13. +Commitments +and Contingencies +Royalty Commitment +In +2002, the Company entered into a technology license related to its +development of digital products. Under this agreement, the Company +is obligated to pay a royalty for each product sold that utilizes +the technology covered by this agreement. The Company paid $120 and +$133 for the years ended December 31, 2020 and 2019, respectively. +The agreement has an indefinite term, and can be terminated by +either party under certain conditions. +Purchase Commitments +The +Company has purchase commitments for inventory totaling $8,317 as +of December 31, 2020. +Self-Insured Health Benefits +The +Company maintains a self-insured health benefit plan for its +employees. This plan is administered by a third party. As of +December 31, 2020, the plan had a stop-loss provision insuring +losses beyond $80 per employee per year and an aggregate stop-loss +of $1,215. As of December 31, 2020 and 2019, the Company recorded +an accrual for estimated claims in the amount of approximately $116 +and $165, respectively, in accrued other expenses and other current +liabilities on the Company’s consolidated balance +sheets. This amount +represents the Company’s estimate of incurred but not +reported claims as of December 31, 2020 and 2019. +Liability for Product Warranties +Changes +in the Company’s liability for its standard two-year product +warranties during the years ended December 31, 2020 and 2019 are as +follows: +Balance at +Beginning of Year +Warranties +Issued +Warranties +Settled +Balance at End +of Year +2020 +$ 1,248 +$ 166 +$ (623 ) +$ 791 +2019 +$ 1,546 +$ 606 +$ (904 ) +$ 1,248 +Legal Proceedings +From +time to time the Company may be involved in various claims and +legal actions arising in the ordinary course of its +business. +There +were no pending material claims or legal matters as of December 31, +2020. +F-21 +BK TECHNOLOGIES CORPORATIONYEARS ENDED DECEMBER 31, 2020 AND +2019 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except share data and percentages) +13. +Commitments +and Contingencies (Continued) +Consulting Services +Agreement +On June +24, 2020, the Company entered into a Financial and Consulting +Services Agreement (the “Itasca Agreement”) with Itasca +Financial LLC (“Itasca”), pursuant to which Itasca +agreed to advise the Company on aspects of its strategic direction. +In exchange for Itasca’s services, the Company agreed to pay +Itasca a retainer fee of $50,000, payable in two installments of +$25,000, and a monthly fee of $20,000. On December 15, 2020, the +parties agreed to terminate the agreement and to waive the +provision for a termination fee. This description of the Agreement +is a summary only and is qualified by reference to full text of +Itasca Agreement, which is filed as exhibit 10.1 to the +Company’s Quarterly Report on Form 10-Q filed with the SEC on +August 5, 2020. Total fees incurred +by the Company in connection with the Agreement during the year +ended December 31, 2020 were $70,000. +Fundamental Global +Investors, LLC, with its affiliates, owners and managers +(collectively, “FG”), is the largest stockholder of the +Company. D. Kyle Cerminara, the Chief Executive Officer, Co-Founder +and Partner of FG, is a member of the Company’s Board of +Directors, and John W. Struble, Chairman of the Board of Directors, +serves as a consultant to Fundamental Global Management, LLC, an +affiliate of FG. FG is the controlling stockholder of FGF (see Note +6), and Larry G. Swets, Jr. serves as Interim Chief Executive +Officer and principal executive officer of FGF and as a member of +FGF’s Board of Directors. In addition, Mr. Swets founded and +serves as the managing member of Itasca, which previously provided +services to the Company, as described above, as well as to other +companies affiliated with FG. +COVID-19 +In December 2019, a novel strain of the +coronavirus (COVID-19) surfaced in Wuhan, China, which spread +globally and was declared a pandemic by the World Health +Organization in March 2020. Although we believe the pandemic has +not had a material adverse impact on our business through the first +three quarters of 2020, it may have the potential of doing so in +the future . The extent of the potential impact of the +COVID-19 pandemic on our business and financial performance will +depend on future developments, which are uncertain and , given the continuing evolution of the COVID-19 +pandemic and the global responses to curb its spread, cannot +be predicted. In addition, the pandemic has significantly increased +economic uncertainty and caused a worldwide economic downturn. Even +after the COVID-19 pandemic has subsided, we may continue to +experience an adverse impact to our business as a result of its +national and, to some extent, global economic impact, including any +recession that may occur in the future. +14. +Capital +Program +In May +2016, the Company implemented a capital return program that +included a stock repurchase program and a quarterly dividend. +Under the program, the Company’s Board of Directors approved +the repurchase of up to 500,000 shares of the Company’s +common stock pursuant to a stock repurchase plan in conformity with +the provisions of Rule 10b5-1 and Rule 10b-18 promulgated under the +Securities Exchange Act of 1934, as amended. In June 2017, the +Board of Directors approved an increase in the Company’s +capital return program, authorizing the repurchase of 500,000 +shares of the Company’s common stock in addition to the +500,000 shares originally authorized, for a total repurchase +authorization of one million shares, pursuant to a stock repurchase +plan in conformity with the provisions of Rule 10b5-1 and Rule +10b-18 promulgated under the Securities Exchange Act of 1934, as +amended. The repurchase program was completed in April +2020. +Pursuant to the +capital return program, during 2019, the Company’s Board of +Directors declared quarterly dividends on the Company’s +common stock of $0.02 per share on March 5, June 10, September 12 +and December 5. The dividends were payable to stockholders of +record as of April 1, 2019, July 1, 2019, October 1, 2019 and +January 3, 2020, respectively. These dividends were paid on April +15, 2019, July 15, 2019, October 15, 2019 and January 17, +2020. +Pursuant to the +capital return program, during 2020, the Company’s Board of +Directors declared quarterly dividends on the Company’s +common stock of $0.02 per share on March 2, June 10, September 14 +and December 9. The dividends were payable to stockholders of +record as of March 31, 2020, July 6, 2020, October 5, 2020 and +January 4, 2021, respectively. These dividends were paid on April +13, 2020, July 20, 2020, October 19, 2020 and January 19, +2021. +F-22 +I tem 9. Changes in and Disagreements with +Accountants on Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedure s +Evaluation of Disclosure Controls and Procedures +Our +President (who serves as our principal executive officer) and Chief +Financial Officer (who serves as our principal financial and +accounting officer) have evaluated the effectiveness of our +disclosure controls and procedures (as defined in the Exchange Act +Rule 13a-15(e)) as of December 31, 2020. Based on that evaluation, +the President and Chief Financial Officer have concluded that our +disclosure controls and procedures were effective as of December +31, 2020. +Management’s Report on Internal Control over Financial +Reporting +Our +management is responsible for establishing and maintaining adequate +internal control over our financial reporting, as such term is +defined in Rule 13a-15(f) of the Exchange Act. Our internal control +system was designed to provide reasonable assurance regarding the +reliability of our financial reporting and the preparation of +financial statements for external purposes in accordance with GAAP. +Because of inherent limitations, a system of internal control over +financial reporting may not prevent or detect misstatements. Also, +projections of any evaluation of effectiveness to future periods +are subject to the risk that controls may become inadequate due to +a change in conditions, or that the degree of compliance with the +policies or procedures may deteriorate. +An +internal control material weakness is a significant deficiency, or +combination of significant deficiencies, that results in more than +a remote likelihood that a material misstatement of the +consolidated financial statements will not be prevented or +detected. +Our +management, including our principal executive officer and principal +financial officer, conducted an evaluation of the effectiveness of +our internal control over financial reporting as of December 31, +2020, and concluded that our internal control over financial +reporting was effective as of December 31, 2020. In making the +assessment of internal control over financial reporting, management +used the criteria established in Internal Control – +Integrated Framework (2013) issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO). +Changes in Internal Control over Financial Reporting +There +were no changes in our internal control over financial reporting +identified in connection with the evaluation required by Exchange +Act Rule 13a-15(d) that occurred during the fourth fiscal quarter +covered by this report that have materially affected, or are +reasonably likely to materially affect, our internal control over +financial reporting. +I tem 9B. Other +Information +On March 2, 2021, Lewis M. Johnson, a member of +the Board of Directors, notified the Company of his intention to +resign from the Company’s Board of Directors, effective +immediately. Mr. Johnson was not a member of any of the standing +committees of the Board of Directors. Mr. Johnson did not advise +the Company of any dispute or disagreement with the Company or the +Company’s Board of Directors on any matter relating to the +operations, policies or practices of the Company. +P ART III +I tem 10. Directors, Executive Officers and +Corporate Governance +Information about +our Directors and Executive Officers will be contained in the +“Proposal 1: Election of Directors” and +“Corporate Governance—Board of Directors +Independence” sections of our definitive proxy statement, to +be filed in connection with our 2021 annual meeting of +stockholders, and is incorporated herein by reference. +31 +The +disclosure of delinquent filers under Section 16(a) of the Exchange +Act, if any, will be contained in the +“Miscellaneous—Delinquent Section 16(a) Reports” +section of our definitive proxy statement, to be filed in +connection with our 2021 annual meeting of stockholders, and is +incorporated herein by reference. +We have +a separately-designated standing audit committee. Information about +our audit committee and the audit committee financial expert will +be contained in the “Corporate Governance—Meetings and +Committees of the Board of Directors” section of our +definitive proxy statement, to be filed in connection with our 2021 +annual meeting of stockholders, and is incorporated herein by +reference. +We have +adopted the Code of Business Conduct and Ethics (the “Code of +Conduct”) that applies to all of our directors, officers and +employees, including our principal executive officer, principal +financial officer and principal accounting officer, and the Code of +Ethics for the CEO and Senior Financial Officers (the “Code +of Ethics”) containing additional specific policies. The Code +of Conduct and the Code of Ethics are posted on our Internet +website, www.bktechnologies.com, under the “Investor +Relations” tab, and are available free of charge, upon +request to Corporate Secretary, 7100 Technology Drive, West +Melbourne, Florida 32904; telephone number: (321) 984-1414. Any +amendment to, or waiver from, the codes applicable to our directors +and executive officers will be disclosed in a current report on +Form 8-K within four business days following the date of the +amendment or waiver unless the rules of the NYSE American then +permit website posting of such amendments and waivers, in which +case we would post such disclosures on our Internet +website. +I tem 11. Executive Compensation +The +information required by this item will be contained in the +“Executive Compensation,” “Summary Compensation +Table for 2019-2020,” “Outstanding Equity Awards at +2020 Fiscal Year-End,” “Retirement Benefits for +2019,” “Potential Payments Upon Termination or in +Connection With a Change of Control,” “Director +Compensation for 2020” and “Corporate +Governance—Meetings and Committees of the Board of +Directors—Compensation Committee” sections of our +definitive proxy statement, to be filed in connection with our 2021 +annual meeting of stockholders, and is incorporated herein by +reference. +I tem 12. Security Ownership of Certain +Beneficial Owners and Management and Related Stockholder +Matters +The +information required by this item will be contained in the +“Security Ownership of Certain Beneficial Owners and +Management” and “Equity Compensation Plan +Information” sections of our definitive proxy statement, to +be filed in connection with our 2021 annual meeting of +stockholders, and is incorporated herein by reference. +I tem 13. Certain Relationships and Related +Transactions, and Director Independence +The +information required by this item will be contained in the +“Transactions with Related Persons” and +“Corporate Governance—Board of Directors +Independence” sections of our definitive proxy statement, to +be filed in connection with our 2021 annual meeting of +stockholders, and is incorporated herein by reference. +I tem 14. Principal +Accounting Fees and Services +The +information required by this item will be contained in the +“Fees Paid to Our Independent Registered Public Accounting +Firm” and “Corporate Governance—Meetings and +Committees of the Board of Directors—Audit Committee” +sections of our definitive proxy statement, to be filed in +connection with our 2021 annual meeting of stockholders, and is +incorporated herein by reference. +32 +P ART IV +I tem 15. Exhibits and Financial +Statement Schedules +(a) +The following +documents are filed as a part of this report: +1. +Consolidated Financial Statements listed below: +Page +Report +of Independent Registered Public Accounting Firm +F-1 +Consolidated +Balance Sheets as of December 31, 2020 and 2019 +F-2 +Consolidated +Statements of Operations - years ended December 31, 2020 and +2019 +F-3 +Consolidated +Statements of Changes in Stockholders’ Equity - years ended +December 31, 2020 and 2019 +F-4 +Consolidated +Statements of Cash Flows - years ended December 31, 2020 and +2019 +F-5 +Notes +to Consolidated Financial Statements +F-6 +(b) +Exhibits: +Number +Exhibit +2.1 +Articles +of Merger, filed with the Nevada Secretary of State on March 28, +2019 (incorporated by reference from Exhibit 3.1 to the +Company’s Current Report on Form 8-K12B filed March 28, +2019) +3.1 +Articles of Incorporation (incorporated by reference from Exhibit +3.2 to the Company’s Current Report on Form 8-K12B filed +March 28, 2019) +3.2 +Bylaws +(incorporated by reference from Exhibit 3.3 to the Company’s +Current Report on Form 8-K12B filed March 28, 2019) +4.1 +Description +of the Company’s Registered Securities* +4.2 +Form of +Common Stock Certificate (incorporated by reference from Exhibit +4.1 to the Company’s Current Report on Form 8-K12B filed +March 28, 2019) +10.1+ +2007 +Incentive Compensation Plan (incorporated by reference from Annex G +to the Company’s Definitive Proxy Statement on Schedule 14A +filed April 5, 2007, relating to the 2007 annual +stockholders’ meeting) +10.2+ +Amendment +to the 2007 Incentive Compensation Plan, effective as of March 17, +2017 (incorporated by reference from Exhibit 10.1 to the +Company’s Current Report on Form 8-K filed March 21, +2017) +10.3+ +Form of +2007 Incentive Compensation Plan Stock Option Agreement +(incorporated by reference from Exhibit 10.15 to the +Company’s Annual Report on Form 10-K for the year ended +December 31, 2012) +10.4+ +2017 +Incentive Compensation Plan (incorporated by reference from Exhibit +4.5 to the Company’s Registration Statement on Form S-8 filed +June 15, 2017) +10.5+ +Omnibus +Amendment to Incentive Compensation Plans, dated as of March 28, +2019, by and between BK Technologies, +Inc. and BK Technologies Corporation (incorporated by +reference from Exhibit 10.1 to the Company’s Current Report +on Form 8-K12B filed March 28, 2019) +10.6+ +Form of +Stock Option Agreement under the 2017 Incentive Compensation Plan +(incorporated by reference from Exhibit 4.6 to the Company’s +Registration Statement on Form S-8 filed June 15, +2017) +10.7+ +Form of +Restricted Share Agreement under the 2017 Incentive Compensation +Plan (incorporated by reference from Exhibit 4.7 to the +Company’s Registration Statement on Form S-8 filed June 15, +2017) +10.8+ +Form of +Restricted Stock Unit Agreement under the 2017 Incentive +Compensation Plan (incorporated by reference from Exhibit 4.8 to +the Company’s Registration Statement on Form S-8 filed June +15, 2017) +10.9+ +Form of +Non-Employee Director Restricted Share Unit Agreement under the +2017 Incentive Compensation Plan (September 2018) (Incorporated by +reference from Exhibit 10.1 to the Company’s Quarterly Report +on Form 10-Q filed November 7, 2018) +10.10+ +Form of +Stock Option Agreement under the BK Technologies Corporation 2017 +Incentive Compensation Plan (incorporated by reference from Exhibit +10.2 to the Company’s Current Report on Form 8-K12B filed +March 28, 2019) +33 +10.11+ +Form of Restricted Share Agreement under the BK Technologies +Corporation 2017 Incentive Compensation Plan (incorporated by +reference from Exhibit 10.3 to the Company’s Current Report +on Form 8-K12B filed March 28, 2019) +10.12+ +Form of +Restricted Stock Unit Agreement under the BK Technologies +Corporation 2017 Incentive Compensation Plan (incorporated by +reference from Exhibit 10.4 to the Company’s Current Report +on Form 8-K12B filed March 28, 2019) +10.13+ +Relocation +Agreement, dated December 31, 2019, between the Company and Henry +R. (Randy) Willis (incorporated by reference from Exhibit 10.20 to +the Company’s Annual Report on Form 10-K for the year ended +December 31, 2018) +10.14+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and Timothy A. Vitou (incorporated by reference from Exhibit +10.1 to the Company’s Current Report on Form 8-K filed March +21, 2019) +10.15+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and William P. Kelly (incorporated by reference from Exhibit +10.2 to the Company’s Current Report on Form 8-K filed March +21, 2019) +10.16+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and Randy Willis (incorporated by reference from Exhibit 10.3 +to the Company’s Current Report on Form 8-K filed March 21, +2019) +10.17+ +Employment +Agreement, executed March 20, 2019, by and between BK Technologies, +Inc. and James R. Holthaus (incorporated by reference from Exhibit +10.4 to the Company’s Current Report on Form 8-K filed March +21, 2019) +10.18+ +First +Amendment, approved October 30, 2019, to Employment Agreement, +executed March 20, 2019, by and between BK Technologies, Inc. and +James R. Holthaus (incorporated by reference from Exhibit 10.1 to +the Company’s Current Report on Form 8-K filed October 31, +2019) +10.19+ +Employment +Agreement, dated October 31, 2019, by and between BK Technologies, +Inc. and Branko Avanic (incorporated by reference from Exhibit +10.19 to the Company’s Annual Report on Form 10-K filed March +4, 2020) +10.20 +Credit +Agreement, executed as of January 30, 2020, by and between JPMorgan +Chase Bank, N.A., as lender, and BK Technologies, Inc., as borrower +(incorporated by reference from Exhibit 10.1 to the Company’s +Current Report on Form 8-K filed January 30, 2020) +10.21 +Line of Credit Note, executed as of January 30, 2020, by BK +Technologies, Inc., as borrower, for the benefit of JPMorgan Chase +Bank, N.A., as lender (incorporated by reference from +Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed January 30, 2020) +10.22 +Continuing +Guaranty, executed as of January 30, 2020, by and among JPMorgan +Chase Bank, N.A., as lender, and BK Technologies Corporation and +RELM Communications, Inc., as guarantors (incorporated by reference +from Exhibit 10.3 to the Company’s Current Report on Form 8-K +filed January 30, 2020) +10.23 +Continuing +Security Agreement, executed as of January 30, 2020, by and between +JPMorgan Chase Bank, N.A., as lender, and BK Technologies, Inc., as +pledgor (incorporated by reference from Exhibit 10.4 to the +Company’s Current Report on Form 8-K filed January 30, +2020) +21 +Subsidiaries +of the Company* +23.1 +Consent +of Moore Stephens Lovelace, P.A. (relating to the Company’s +Registration Statements on Form S-3 (Registration +No. 333-218765 and Registration +No. 333-147354)* +24 +Power +of Attorney (included on signature page) +31.1 +Certification +Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant +to Section 302 of the Sarbanes-Oxley Act of 2002* +31.2 +Certification +Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant +to Section 302 of the Sarbanes-Oxley Act of 2002* +32.1 +Certification +Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002 (furnished +pursuant to Item 601(b)(32) of Regulation S-K)** +32.2 +Certification +Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section +906 of the Sarbanes-Oxley Act of 2002 (furnished pursuant to Item +601(b)(32) of Regulation S-K)** +34 +101.INS +XBRL +Instance Document* +101.SCH +XBRL +Taxonomy Extension Schema Document* +101.CAL +XBRL +Taxonomy Extension Calculation Linkbase Document* +101.LAB +XBRL +Taxonomy Extension Label Linkbase Document* +101.PRE +XBRL +Taxonomy Extension Presentation Linkbase Document* +101.DEF +XBRL +Taxonomy Definition Linkbase Document* +* +Included with this filing. +** +Furnished herewith (not filed). ++ Each +management contract or compensatory plan or +arrangement. +(c) +Consolidated +Financial Statement Schedules: +All +schedules have been omitted because they are inapplicable or not +material, or the information called for thereby is included in the +Consolidated Financial Statements and notes thereto. +I tem 16. Form 10-K Summary +None. +35 +S IGNATURES +Pursuant to the +requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned, thereunto duly +authorized. +BK TECHNOLOGIES CORPORATION +By: +/s/ +Timothy A. Vitou +Timothy +A. Vitou +President +P OWER OF ATTORNEY +Each +person whose signature appears below hereby constitutes and +appoints Timothy A. Vitou and William P. Kelly, and each of them, +his attorneys-in-fact, each with the power of substitution, for him +and in his name, place and stead, in any and all capacities, to +sign this annual report on Form 10-K and any and all amendments to +this report on Form 10-K, and to file the same, with all +exhibits thereto and all documents in connection therewith, with +the Securities and Exchange Commission, granting unto said +attorneys-in-fact and agents, and each of them, full power and +authority to do and perform each and every act and all intents and +purposes as he might or could do in person, hereby ratifying and +confirming all that such attorneys-in-fact and agents or any of +them or his or their substitute or substitutes, may lawfully do or +cause to be done by virtue hereof. +Pursuant to the +requirements of the Securities Exchange Act of 1934, this report +has been signed below by the following persons on behalf of the +Registrant and in the capacities and on the dates +indicated. +SIGNATURE +TITLE +DATE +/s/ +John W. Struble +John W. +Struble +Chairman +of the Board +March +3, 2021 +/s/ +Timothy A. Vitou +Timothy +A. Vitou +President +(Principal Executive Officer) +March +3, 2021 +/s/ +William P. Kelly +William +P. Kelly +Executive +Vice President and Chief Financial Officer (Principal Financial +Officer and Principal Accounting Officer) +March +3, 2021 +/s/ D. +Kyle Cerminara +D. Kyle +Cerminara +Director +March +3, 2021 +/s/ +Michael R. Dill +Michael +R. Dill +Director +March +3, 2021 +/s/ +Charles T. Lanktree +Charles +T. Lanktree +Director +March +3, 2021 +/s/ E. +Gray Payne +E. Gray +Payne +Director +March +3, 2021 +36 \ No newline at end of file diff --git a/raw/filings/0000002186/2020/0001654954-21-002287/filing_metadata.csv b/raw/filings/0000002186/2020/0001654954-21-002287/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..849d850a66465b9f0663192b7e6e66f55273b8ba --- /dev/null +++ b/raw/filings/0000002186/2020/0001654954-21-002287/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002186,BKTI,BK Technologies Corp,2020,10-K,2021-03-03,2020-12-31,2021-03-03T21:35:48.000Z,0001654954-21-002287,bkti_10k.htm,ANNUAL REPORT ON FORM 10-K,3746966,1,0,https://www.sec.gov/Archives/edgar/data/2186/000165495421002287/bkti_10k.htm,https://www.sec.gov/Archives/edgar/data/2186/000165495421002287/ diff --git a/raw/filings/0000002186/2020/0001654954-21-002287/item1.txt b/raw/filings/0000002186/2020/0001654954-21-002287/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..f2d46f7b9f56b62a08c645d605d62f076dfec259 --- /dev/null +++ b/raw/filings/0000002186/2020/0001654954-21-002287/item1.txt @@ -0,0 +1,4 @@ +Item +1. +Business +1 \ No newline at end of file diff --git a/raw/filings/0000002186/2020/0001654954-21-002287/item13.txt b/raw/filings/0000002186/2020/0001654954-21-002287/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..091dc20362b994f0a100cfff4f79ced5ff26f06c --- /dev/null +++ b/raw/filings/0000002186/2020/0001654954-21-002287/item13.txt @@ -0,0 +1,6 @@ +Item +13. +Certain +Relationships and Related Transactions, and Director +Independence +32 \ No newline at end of file diff --git a/raw/filings/0000002488/2018/0000002488-19-000011/filing.txt b/raw/filings/0000002488/2018/0000002488-19-000011/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..6d453ce35cb7fabb07f387c7a79322ee75251da9 --- /dev/null +++ b/raw/filings/0000002488/2018/0000002488-19-000011/filing.txt @@ -0,0 +1,5028 @@ +10-K +1 +amd-12292018x10k.htm +10-K +Document +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +ý +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. +For the fiscal year ended December 29, 2018 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. +For the transition period from to +Commission File Number 001-07882 +ADVANCED MICRO DEVICES, INC. +(Exact name of registrant as specified in its charter) +Delaware +94-1692300 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +2485 Augustine Drive, Santa Clara, California +95054 +(Address of principal executive offices) +(Zip Code) +(408) 749-4000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +(Title of each class) +(Name of each exchange on which registered) +Common Stock $0.01 par value per share +The NASDAQ Global Select Market +Securities registered pursuant to Section 12(g) of the Act: +None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No ¨ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No ý +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files): Yes ý No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one): +Large accelerated filer +ý +Accelerated filer +¨ +Non-accelerated filer +¨ +Smaller reporting company +¨ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes ¨ No ý +As of June 30, 2018 , the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $14.5 billion based on the reported closing sale price of $14.99 per share as reported on The NASDAQ Global Select Market (NASDAQ) on June 29, 2018 , which was the last business day of the registrant’s most recently completed second fiscal quarter. +Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 1,005,298,882 shares of common stock, $0.01 par value per share, as of February 1, 2019. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the registrant’s proxy statement for the 2019 Annual Meeting of Stockholders (2019 Proxy Statement) are incorporated into Part III hereof. The 2019 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the registrant’s fiscal year ended December 29, 2018. +Advanced Micro Devices, Inc. +FORM 10-K +For The Fiscal Year Ended December 29, 2018 +INDEX +PART I +1 +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +14 +ITEM 1B. +Unresolved Staff Comments +29 +ITEM 2. +Properties +29 +ITEM 3. +Legal Proceedings +29 +ITEM 4. +Mine Safety Disclosures +32 +PART II +33 +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +33 +ITEM 6. +Selected Financial Data +35 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +36 +ITEM 7A. +Quantitative and Qualitative Disclosure About Market Risk +46 +ITEM 8. +Financial Statements and Supplementary Data +48 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +92 +ITEM 9A. +Controls and Procedures +92 +ITEM 9B. +Other Information +93 +PART III +94 +ITEM 10. +Directors, Executive Officers and Corporate Governance +94 +ITEM 11. +Executive Compensation +94 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +94 +ITEM 13. +Certain Relationships and Related Transactions and Director Independence +94 +ITEM 14. +Principal Accounting Fees and Services +94 +PART IV +95 +ITEM 15. +Exhibits, Financial Statements Schedules +95 +ITEM 16. +Form 10-K Summary +104 +SIGNATURES . +104 +PART I +ITEM 1. BUSINESS +Cautionary Statement Regarding Forward-Looking Statements +The statements in this report include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations and beliefs and involve numerous risks and uncertainties that could cause actual results to differ materially from expectations. These forward-looking statements speak only as of the date hereof or as of the dates indicated in the statements and should not be relied upon as predictions of future events, as we cannot assure you that the events or circumstances reflected in these statements will be achieved or will occur. You can identify forward-looking statements by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “pro forma,” “estimates,” “anticipates,” or the negative of these words and phrases, other variations of these words and phrases or comparable terminology. The forward-looking statements relate to, among other things: possible impact of future accounting rules on AMD’s consolidated financial statements; demand for AMD’s products; the growth, change and competitive landscape of the markets in which AMD participates; the nature and extent of AMD’s future payments to GLOBALFOUNDRIES Inc. (GF) and the materiality of these payments; the materiality of AMD’s future purchases from GF; AMD’s ability to meet its wafer purchase target; the expected amounts to be received by AMD under the IP licensing agreement and AMD’s expected royalty payments from future product sales of China JVs’ products to be developed on the basis of such licensed IP; sales patterns of AMD’s PC products and semi-custom System-on-Chip (SoC) products for game consoles; the level of international sales as compared to total sales; international sales will continue to be a significant portion of total sales in the foreseeable future; that other unrecognized tax benefits will not materially change in the next 12 months; that AMD’s cash and cash equivalents balances together with the availability under that certain secured revolving line of credit (Secured Revolving Line of Credit) made available to AMD and certain of its subsidiaries under the Amended and Restated Loan Agreement, will be sufficient to fund AMD’s operations including capital expenditures over the next 12 months; AMD’s ability to obtain sufficient external financing on favorable terms, or at all; AMD’s expectation that based on the information presently known to management, the potential liability related to AMD’s current litigation will not have a material adverse effect on its financial condition, cash flows or results of operations; any amounts in addition to what has been already accrued by AMD for future remediation costs under clean-up orders will not be material; we expect to file future patent applications in both the United States and abroad on significant inventions, as we deem appropriate; anticipated increase in costs related to enhancing, implementing and monitoring information security controls, remediating any data security breaches and addressing related litigation, mitigating reputational harm and compliance with external regulations related to our IT assets; we expect to receive $448.5 million upon the exercise of a warrant by West Coast Hitech L.P. (WCH) and issue 75 million shares of our common stock to WCH; revenue allocated to remaining performance obligations that are unsatisfied which will be recognized over the next 12 months; and a small number of customers will continue to account for a substantial part of AMD’s revenue in the future. Material factors that could cause actual results to differ materially from current expectations include, without limitation, the following: Intel Corporation’s dominance of the microprocessor market and its aggressive business practices may limit AMD’s ability to compete effectively; AMD has a wafer supply agreement with GF with obligations to purchase all of its microprocessor and APU product requirements, and a certain portion of its GPU product requirements, manufactured at process nodes larger than 7 nanometer (nm) from GF with limited exceptions. If GF is not able to satisfy AMD’s manufacturing requirements, AMD’s business could be adversely impacted; AMD relies on third parties to manufacture its products, and if they are unable to do so on a timely basis in sufficient quantities and using competitive technologies, AMD’s business could be materially adversely affected; failure to achieve expected manufacturing yields for AMD’s products could negatively impact its financial results; the success of AMD’s business is dependent upon its ability to introduce products on a timely basis with features and performance levels that provide value to its customers while supporting and coinciding with significant industry transitions; if AMD cannot generate sufficient revenue and operating cash flow or obtain external financing, it may face a cash shortfall and be unable to make all of its planned investments in research and development or other strategic investments; the loss of a significant customer may have a material adverse effect on AMD; AMD’s receipt of revenue from its semi-custom SoC products is dependent upon its technology being designed into third-party products and the success of those products; global economic and market uncertainty may adversely impact AMD’s business and operating results; AMD’s products may be subject to security vulnerabilities that could have a material adverse effect on AMD; IT outages, data loss, data breaches and cyber-attacks could compromise AMD’s intellectual property or other sensitive information, be costly to remediate and cause significant damage to its business, reputation and operations; AMD’s operating results are subject to quarterly and seasonal sales patterns; AMD may not be able to generate sufficient cash to service its debt obligations or meet its working capital requirements; AMD has a large amount of indebtedness which could adversely affect its financial position and prevent it from implementing its strategy or fulfilling its contractual obligations; the agreements governing AMD’s notes and the Secured Revolving Line of Credit impose restrictions on AMD that may adversely affect AMD’s ability +1 +to operate its business; the markets in which AMD’s products are sold are highly competitive; AMD’s worldwide operations are subject to political, legal and economic risks and natural disasters, which could have a material adverse effect on it; AMD’s issuance to West Coast Hitech L.P. (WCH) of warrants to purchase 75 million shares of its common stock, if and when exercised, will dilute the ownership interests of AMD’s existing stockholders, and the conversion of the 2.125% Convertible Senior Notes due 2026 (2.125% Notes) may dilute the ownership interest of AMD’s existing stockholders, or may otherwise depress the price of its common stock; uncertainties involving the ordering and shipment of AMD’s products could materially adversely affect it; the demand for AMD’s products depends in part on the market conditions in the industries into which they are sold. Fluctuations in demand for AMD’s products or a market decline in any of these industries could have a material adverse effect on its results of operations; AMD’s ability to design and introduce new products in a timely manner is dependent upon third-party intellectual property; AMD depends on third-party companies for the design, manufacture and supply of motherboards, software and other computer platform components to support its business; if AMD loses Microsoft Corporation’s support for its products or other software vendors do not design and develop software to run on AMD’s products, its ability to sell its products could be materially adversely affected; AMD’s reliance on third-party distributors and add-in-board (AIB) partners subjects it to certain risks; AMD may incur future impairments of goodwill and technology license purchases; AMD’s inability to continue to attract and retain qualified personnel may hinder its business; in the event of a change of control, AMD may not be able to repurchase its outstanding debt as required by the applicable indentures and its Secured Revolving Line of Credit, which would result in a default under the indentures and its Secured Revolving Line of Credit; the semiconductor industry is highly cyclical and has experienced severe downturns that have materially adversely affected, and may continue to materially adversely affect its business in the future; acquisitions, divestitures and/or joint ventures could disrupt its business, harm its financial condition and operating results or dilute, or adversely affect the price of, its common stock; AMD’s business is dependent upon the proper functioning of its internal business processes and information systems and modification or interruption of such systems may disrupt its business, processes and internal controls; if essential equipment, materials or manufacturing processes are not available to manufacture its products, AMD could be materially adversely affected; if AMD’s products are not compatible with some or all industry-standard software and hardware, it could be materially adversely affected; costs related to defective products could have a material adverse effect on AMD; if AMD fails to maintain the efficiency of its supply chain as it responds to changes in customer demand for its products, its business could be materially adversely affected; AMD outsources to third parties certain supply-chain logistics functions, including portions of its product distribution, transportation management and information technology support services; AMD’s stock price is subject to volatility; worldwide political conditions may adversely affect demand for AMD’s products; unfavorable currency exchange rate fluctuations could adversely affect AMD; AMD’s inability to effectively control the sales of its products on the gray market could have a material adverse effect on it; if AMD cannot adequately protect its technology or other intellectual property in the United States and abroad, through patents, copyrights, trade secrets, trademarks and other measures, it may lose a competitive advantage and incur significant expenses; AMD is a party to litigation and may become a party to other claims or litigation that could cause it to incur substantial costs or pay substantial damages or prohibit it from selling its products; AMD’s business is subject to potential tax liabilities; and AMD is subject to environmental laws, conflict minerals-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as a variety of other laws or regulations that could result in additional costs and liabilities. +For a discussion of the factors that could cause actual results to differ materially from the forward-looking statements, see “Part I, Item 1A-Risk Factors” and the “Financial Condition” section set forth in “Part II, Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations,” or MD&A, and such other risks and uncertainties as set forth below in this report or detailed in our other Securities and Exchange Commission (SEC) reports and filings. We assume no obligation to update forward-looking statements. +General +We are a global semiconductor company primarily offering: +• x86 microprocessors, as standalone devices or as incorporated into an accelerated processing unit (APU), chipsets; discrete and integrated graphics processing units (GPUs), and professional GPUs; and +• server and embedded processors and semi-custom System-on-Chip (SoC) products and technology for game consoles. +We also license portions of our intellectual property portfolio. +For financial information about geographic areas and for segment information with respect to revenues and operating results, refer to the information set forth in Note 15 of our consolidated financial statements. +2 +We use a 52 or 53 week fiscal year ending on the last Saturday in December. The years ended December 29, 2018 , December 30, 2017 and December 31, 2016 included 52 weeks, 52 weeks and 53 weeks, respectively. References in this report to 2018 , 2017 and 2016 refer to the fiscal year unless explicitly stated otherwise. +Additional Information +Advanced Micro Devices, Inc. (AMD) was incorporated under the laws of Delaware on May 1, 1969 and became a publicly held company in 1972. Our common stock is currently listed on The NASDAQ Global Select Market (NASDAQ) under the symbol “AMD”. Our mailing address and executive offices are located at 2485 Augustine Drive, Santa Clara, California 95054, and our telephone number is (408) 749-4000. The SEC's website, www.sec.gov, contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. +References in this Annual Report on Form 10-K to “AMD,” “we,” “us,” “management,” “our” or the “Company” mean Advanced Micro Devices, Inc. and our consolidated subsidiaries. +AMD, the AMD Arrow logo, Athlon, EPYC, FirePro, FreeSync, Geode, LiquidVR, Opteron, Radeon, Ryzen, Threadripper, and combinations thereof are trademarks of Advanced Micro Devices, Inc. Microsoft, Windows, Direct X, Xbox 360 and Xbox One are trademarks or registered trademarks of Microsoft Corporation in the United States and other jurisdictions. +PlayStation is a registered trademark of Sony Interactive Entertainment, Inc.. Wii and Wii U are registered trademarks of Nintendo of America, Inc. ARM is a registered trademark of ARM Limited in the EU and other countries. Vulkan and the Vulkan logo are registered trademarks of Khronos Group Inc. +Other names are for informational purposes only and are used to identify companies and products and may be trademarks of their respective owners. +Website Access to Our SEC Filings and Corporate Governance Documents +On the Investor Relations pages of our Website, http://ir.amd.com , we post links to our filings with the SEC, our Principles of Corporate Governance, our Code of Ethics for our executive officers, all other senior finance executives and certain representatives from legal and internal audit, our Worldwide Standards of Business Conduct, which applies to our Board of Directors and all of our employees, and the charters of the Audit and Finance, Compensation and Leadership Resources, Nominating and Corporate Governance and Innovation and Technology committees of our Board of Directors. Our filings with the SEC are posted as soon as reasonably practical after they are electronically filed with, or furnished to, the SEC. You can also obtain copies of these documents by writing to us at: Corporate Secretary, AMD, 7171 Southwest Parkway, M/S B100.T, Austin, Texas 78735, or emailing us at: Corporate.Secretary@amd.com . All of these documents and filings are available free of charge. +If we make substantive amendments to our Code of Ethics or grant any waiver, including any implicit waiver, to our principal executive officer, principal financial officer, principal accounting officer, controller or persons performing similar functions, we intend to disclose the nature of such amendment or waiver on our Website. +The information contained on our Website is not incorporated by reference in, or considered to be a part of, this report. +Our Industry +We are a global semiconductor company. Semiconductors are components used in a variety of electronic products and systems. An integrated circuit (IC) is a semiconductor device that consists of many interconnected transistors on a single chip. Since the invention of the transistor in 1948, improvements in IC process and design technologies have led to the development of smaller, more complex and more reliable ICs at a lower cost-per-function. +The x86 Microprocessor and Chipset Markets +Central Processing Unit (CPU) . A microprocessor is an IC that serves as the CPU of a computer. It generally consists of hundreds of millions or billions of transistors that process data in a serial fashion and control other devices in the system, acting as the “brain” of the computer. The performance of a microprocessor is a critical factor impacting the performance of computing and entertainment platforms, such as desktop PCs, notebooks and workstations. The principal elements used to measure CPU performance are work-per-cycle (or how many instructions are executed per cycle), clock speed (representing the rate at which a CPU’s internal logic operates, measured in units of gigahertz, or billions of cycles per second) and power consumption. Other factors impacting microprocessor performance include the process technology used in its manufacture, the number and type of cores, the ability of the cores to process multi-thread or process multiple +3 +instructions simultaneously, the bit size of its instruction set (e.g., 32-bit vs 16-bit), memory size and data access speed. +Developments in IC design and manufacturing process technologies have resulted in significant advances in microprocessor performance. Since businesses and consumers require greater performance from their computer systems due to the growth of digital data and increasingly sophisticated software applications, multi-core microprocessors offer enhanced overall system performance and efficiency because computing tasks can be spread across two or more processing cores, each of which can execute a task at full speed. Multi-core microprocessors can simultaneously increase performance of a computer system without greatly increasing the total amount of power consumed and the total amount of heat emitted. Businesses and consumers also require computer systems with improved power management technology, which helps them to reduce the power consumption of their computer systems, enables smaller and more portable form factors, and can lower the total cost of ownership. +Graphics Processing Unit (GPU). A GPU is a programmable logic chip that helps render images, animations and video and is increasingly being used to handle general computing tasks. GPUs are located in plug-in cards, as a discrete processor or in a chip on the motherboard, or in the same chip as the CPU as part of an accelerated processing unit (APU) or System-on-Chip (SoC). GPUs on stand-alone cards or discrete GPUs on the motherboard typically access their own memory, while GPUs in the chipset or CPU chip share main memory with the CPU. +GPUs perform parallel operations on data to render images for a video display and are essential to presenting computer generated images on that display, decoding and rendering animations and displaying video. The more sophisticated the GPU, the higher the resolution and the faster and smoother moving objects can be displayed on video display or in a virtual environment (virtual reality (VR) and augmented reality (AR)). +In addition to graphics processing, GPUs are used to perform parallel operations on multiple sets of data and are increasingly used to perform vector processing for non-graphics applications that require repetitive computations such as supercomputing, deep learning, artificial and machine intelligence, blockchain and various other applications (e.g., cryptocurrency mining, autonomous driving). +Accelerated Processing Unit (APU). Consumers increasingly demand computing devices with improved end-user experience, system performance and energy efficiency. Consumers also continue to demand thinner and lighter mobile devices, with better performance and longer battery life. We believe that a computing architecture that optimizes the use of its components can provide these improvements. +An APU is a processing unit that integrates a CPU and a GPU onto one chip (or one piece of silicon), along with, in some cases, other special-purpose components. This integration enhances system performance by “offloading” selected tasks to the best-suited component (i.e., the CPU or the GPU) to optimize component use, increasing the speed of data flow between the CPU and GPU through shared memory and allowing the GPU to function as both a graphics engine and an application accelerator. Having the CPU and GPU on the same chip also typically improves energy efficiency by, for example, eliminating connections between discrete chips. +System-on-Chip (SoC) . An SoC is a type of IC with a CPU, GPU and other components, such as a memory controller and peripheral management, comprising a complete computing system on a single chip. By combining all of these elements as an SoC, system performance and energy efficiency is improved, similar to an APU. +Chipset. A chipset is a generic term referring to a device or a collection of devices that allow the microprocessor to connect to a wider range of peripheral devices in the system (such as storage, optical drives, and Universal Serial Bus (USB) peripherals). Chipsets can perform essential logic functions, and operate in concert with the microprocessor to manage system control and power management functions of all the devices in the system. Chipsets are most often found in larger form factor systems, typically desktop systems or larger notebook platforms, which require the expanded peripheral selection that is enabled by the chipset. Typical notebook platforms and small form factor desktop platforms typically do not utilize a chipset and instead rely on the capabilities of the APU to connect to all the required devices on the platform. +Our x86 Microprocessor and Chipset Products +Our microprocessors are incorporated into computing platforms, which are a collection of technologies that are designed to work together to provide a more complete computing solution and to enable and advance the computing components. We believe that integrated, balanced computing platforms consisting of microprocessors, chipsets (either as discrete devices or integrated into an SoC) and GPUs (either as discrete GPUs or integrated into an APU or SoC) that work together at the system level bring end users improved system stability, increased performance and enhanced power efficiency. In addition, we believe our customers also benefit from an all-AMD platform (consisting of an APU or CPU, a discrete GPU, and an AMD Fusion Controller Hub chip when needed), as we are able to optimize interoperability, provide our customers a single +4 +point of contact for the key platform components and enable them to bring the platforms to market quickly in a variety of PC and server system form factors. +We currently base our microprocessors and chipsets on the x86 instruction set architecture and the AMD Infinity Fabric, which connects an on-chip memory controller and input/output (I/O) channels directly to one or more microprocessor cores. We typically integrate two or more processor cores onto a single die, and each core has its own dedicated cache, which is memory that is located on the semiconductor die, permitting quick access to frequently used data and instructions. Some of our microprocessors have additional levels of cache such as L2, or second-level cache, and L3, or third-level cache, to enable fast data access and high performance. +We focus on continually improving the energy efficiency of our products through our design principles and innovations in power management technology. To that end, we offer CPUs, GPUs, APUs, SoCs and chipsets with multiple low power states that are designed to utilize lower clock speeds and voltages to reduce processor power consumption during active and idle times. The use of intelligent, dynamic power management is designed to create lower energy use by allowing compute applications to be completed quickly and efficiently, enabling a return to the ultra-low power idle state. +Desktop. In February 2018, we introduced two AMD Ryzen™ desktop processors with built-in Radeon™ Vega graphics models. AMD Ryzen 5 2400G and AMD Ryzen 3 2200G processors combine four of the latest “Zen” CPU cores with advanced Radeon “Vega” architecture on a single chip. In April 2018, we announced the global availability of our second generation Ryzen desktop processors which include four models: Ryzen 7 2700X, Ryzen 7 2700, Ryzen 5 2600X, and Ryzen 5 2600 processors that are optimized for gamers, creators, and hardware enthusiasts. These four models use 12nm process technology to offer high gaming performance and multiprocessing performance. In August 2018, we announced the availability of our second generation AMD Ryzen™ Threadripper™ 2990WX processor with 32 cores and 64 threads and the Ryzen Threadripper 2950X with 16 cores and 32 threads. In September 2018, we launched a reimagined family of AMD Athlon™ desktop processors with Radeon™ Vega graphics: AMD Athlon 200GE, Athlon 220GE, and Athlon 240GE. These desktop processors combine our x86 “Zen” core and “Vega” graphics architectures on an SOC design. They are designed to offer responsive and reliable computing for web-browsing and video streaming. In October 2018, we launched two additional second generation AMD Ryzen Threadripper processor models, the Ryzen 2970WX with 24 cores and 48 threads and the Ryzen Threadripper 2920X with 12 cores and 24 threads. The Ryzen Threadripper WX series focuses on computational power for heavy workloads and the Ryzen Threadripper X series provides enthusiasts, gamers and streamers high performance and a smooth gaming experience. +Notebooks and 2-in-1s. We continue to invest in designing and developing high performing and low power APUs for notebook PC platforms for the consumer market. In 2018, we introduced the Ryzen 7 2700U Mobile processor with Radeon RX Vega 10 Graphics, the Ryzen 5 2500U Mobile Processor with Radeon Vega 8 Graphics, the Ryzen 3 2300U Mobile Processor with Radeon Vega 6 Graphics, and the Ryzen 3 2200U Mobile Processor with Radeon Vega 3 Graphics. In addition to the Ryzen™ Mobile family, we also continue to offer AMD A-Series APUs based on previous generation CPU and graphics architectures, primarily targeting the value and mainstream segments. In January 2019, we announced our mobility line-up encompassing all notebook segments: second generation AMD Ryzen 3000 Series Mobile Processors, powering ultrathin and gaming notebooks; AMD Athlon 300 Series Mobile Processors, powering mainstream notebooks with the “Zen” core; and optimized seventh generation A-Series processors, elevating performance for mainstream Chromebooks. +Chipsets. We offer a full suite of chipset products, the X470, the B450 and the A320 chipset, that are combined with AMD Ryzen processors for the AM4 desktop platform. The X470 chipset is designed for enthusiast desktop platforms while the B450 is targeted for the performance segment and the A320 is focused on affordable mainstream platforms. We also have the X300 and A300 chipsets designed for small form factors. We offer the X399 chipset, which pairs with our Ryzen Threadripper product line for High-End Desktops (HEDT) using the all-new socket TR4 platform. We also continue to offer AMD 9-Series chipsets for the Socket AM3/3+ platforms serving desktop PCs, and AMD A-Series Control Hubs for the Socket FM2/2+ platforms. We also offer AMD 785E, 780E, 780M, 690E, SR5690, SP5100, SB600, SB710, SB850 and M690E chipsets and AMD A-Series Controller Hubs for our embedded products. +Commercial. We offer enterprise-class desktop and notebook PC solutions sold as AMD PRO Mobile and AMD PRO desktop processors with Radeon Vega Graphics for the commercial client market. These solutions are designed to provide commercial-grade quality, platform longevity and extended image stability, and also include security and manageability features for enterprise customers. In May 2018, we announced the availability of our commercial-grade Ryzen™ PRO mobile processors with Radeon Vega graphics for high performance and energy efficient notebook platforms, including the Ryzen 7 PRO Mobile 2700U with Radeon Vega 10 Graphics, Ryzen 5 PRO Mobile 2500U with Radeon Vega 8 Graphics, and Ryzen 3 PRO Mobile 2300U with Radeon Vega 6 Graphics. In September 2018, we announced the availability of our commercial-grade Athlon™ PRO 200GE desktop processor, along with three 2 nd generation Ryzen™ PRO desktop processor +5 +models for commercial, enterprise and the public sector: the Ryzen 7 PRO 2700X, Ryzen 7 PRO 2700, and Ryzen™ 5 PRO 2600 processors. +Graphics Market +The semiconductor graphics market addresses the need for improved visual and data processing in various computing devices. Many consumers value a rich visual experience to enable a more compelling and immersive experience, and, for these consumers, the PC has evolved from a traditional data processing and communications device to an entertainment platform. As a result, visual realism and graphical display capabilities are key product differentiation elements among computing devices. This has led to increasing creation and use of processing-intensive multimedia content for computing devices, including playing games, capturing media content, viewing online videos, editing photos and managing digital content. In turn, these trends have contributed to higher consumer demand for performance graphics solutions and to manufacturers designing computing devices with these capabilities. Industries that utilize computer assisted design (CAD), that develop content for media and entertainment markets and that generate professional visualizations and renderings can benefit greatly from graphics solutions optimized for the professional graphics market. +In addition to traditional graphics markets, there is a large and growing market for graphics compute which is primarily made up of high performance compute and machine learning/deep learning. Traditional high performance compute focuses on scientific research, model simulation, and exploration which is mainly driven by university and government research needs for high precision graphics compute workloads. The second market is the rapidly growing area of machine learning and deep learning workloads. Graphics processors are used both in the training of machine learning models as well as the application of models via inference. The expansion of compute workloads on graphics processors is driving market expansion for traditional graphics silicon. +Another area of the market for graphics compute is blockchain technology, which is a decentralized digital ledger used to securely store, transmit and process sensitive and valuable data. Currently, the most well-known use case of blockchain is cryptocurrency; however, the number of applications and the potential impact of blockchain technology goes much further. Blockchain applications are typically performed using specifically designed application-specific integrated circuits (ASICs) or a general purpose CPU or GPU. +Our Graphics Products +Graphics processing is a fundamental component of almost everything we create and can be found in an APU, CPU, SoC or a combination of a discrete GPU with one of the other foregoing products working in tandem. Our customers generally use our graphics solutions to increase the speed of rendering images, to help improve image resolution and color definition, and increasingly to process massive data sets for cloud and datacenter applications. We develop our graphics products for use in various computing devices and entertainment platforms, including desktop PCs, notebook PCs, 2-in-1s, All-in-Ones (AIOs), professional workstations, and the datacenter. With each of our graphics products, we have available drivers and supporting software packages that enable the effective use of these products under a variety of operating systems and applications. +Our APUs deliver visual processing functionality for value and mainstream PCs by integrating a CPU and a GPU on a single chip, while discrete GPUs (which are also known as dGPUs) offer high performance graphics processing across all platforms. AMD Accelerated Parallel Processing or General Purpose GPU (GPGPU) refers to a set of advanced hardware and software technologies that enable discrete AMD GPUs, working in concert with the CPU, to accelerate computational tasks beyond traditional CPU processing by utilizing the vast number of discrete GPU cores while working with the CPU to process information cooperatively. In addition, computing devices with heterogeneous computing features run computationally-intensive tasks more efficiently, which we believe provides a superior application experience to the end user. Moreover, heterogeneous computing allows for the elevation of the GPU to the same level as the CPU for memory access, queuing and execution. +Discrete Desktop and Notebook Graphics . Our discrete GPUs for desktop and notebook PCs support current generation application program interface (APIs) like DirectX® 12 and Vulkan™, support new displays using Radeon™ FreeSync™ and Radeon™ FreeSync HDR™ technologies, and are designed to support VR in PC platforms. In June 2018, we introduced the Radeon™ RX Vega56 Nano Edition bringing Vega graphics to small form factor PCs. In October 2018, we introduced new AMD Radeon Vega Mobile graphics processors for next generation notebooks powered by the AMD “Vega” architecture for cool and quiet operation. In November 2018, we introduced the Radeon RX 590 graphics card built upon 12 nm process technology. The Radeon RX 590 pairs with the advanced AMD Radeon FreeSync gaming display technology to deliver an exceptional gaming experience. In December 2018, we announced AMD Radeon™ Software Adrenalin 2019 Edition, the next generation of our software suite for AMD Radeon GPUs that provides gamers, creators and enthusiasts with new +6 +immersive features for visual experiences. It provides high performance and enables streaming of PC-based games and video to mobile devices as well as to standalone VR headsets. In January 2019, we introduced the AMD Radeon™ VII, a premium graphics card for gamers, creators and enthusiasts. It is built on 7nm process technology and has 16GB of HBM2 memory and 1 TB/s memory bandwidth. +Professional Graphics. Our AMD Radeon™ Pro and AMD FirePro™ family of professional graphics products include 3D and 2D multi-view graphics cards and GPUs designed for integration in mobile and desktop workstations. AMD Radeon Pro graphics cards are designed for demanding use cases such as Design and Manufacturing for CAD and Media and Entertainment for broadcast and animation pipelines. AMD Radeon Pro supports end users utilizing GPU accelerated visualization for construction, architecture and mechanical design through gaming and visualization engines on high resolution displays or with VR and AR. Software drivers for AMD Radeon Pro cards are designed to deliver high stability and performance across a wide variety of software packages including those requiring certifications for end user use. Our AMD Radeon™ Instinct family of GPU products are specifically designed to address growing demand for datacenter applications, including deep learning training and inference, as well as traditional high performance computing (HPC) workloads such as simulation where the compute capabilities of GPUs provide exceptional flexibility and performance. Combined with our open-source software, Radeon Open Ecosystem (ROCm), we can deliver acceleration platforms to address intensive predictive data analytics challenges while minimizing power and space needs in the datacenter. +We also provide the AMD FirePro™ S-Series GPU products for the server market, which target HPC primarily focused on artificial and machine intelligence, deep neutral networks (DNN), geosciences, biosciences, academic and government workloads, and virtual desktop infrastructure (VDI) use cases primarily focused on workstation-class virtualization, remote desktop and content streaming workloads. In August 2018, we announced the AMD Radeon™ Pro WX 8200 graphics card for high-end workstation graphics performance. Also in August 2018, we announced the Radeon™ Pro V340 graphics card, a high-performance dual-GPU Virtual Desktop Infrastructure (VDI) solution purpose-built to power and accelerate datacenter visualization workloads, including CAD, design, Desktop as a Service (DaaS) and rendering. The AMD Radeon Pro V340 graphics card is a dual-GPU solution based on the advanced AMD “Vega” architecture. In November 2018, we announced AMD Radeon Instinct™ MI60 and MI50 accelerators, 7nm datacenter GPUs, designed to deliver the compute performance required for next-generation deep learning, HPC, cloud computing and rendering applications. The AMD Radeon Instinct MI60 and MI50 accelerators feature flexible mixed-precision capabilities, powered by high-performance compute units that expand the types of workloads these accelerators can address, including a range of HPC and deep learning applications. +Enterprise, Embedded and Semi-Custom +The Enterprise, Embedded and Semi-Custom Markets +Server. A server is a computer system that performs services for connected customer businesses as part of a client-server architecture. Many servers are designed to run an application or applications often for extended periods of time with minimal human intervention. Examples of servers include cloud, web, e-mail and print servers. These servers can run a variety of applications, including business intelligence, enterprise resource planning, customer relationship management and advanced scientific or engineering models to solve advanced computational problems in disciplines ranging from financial modeling to weather forecasting to oil and gas exploration. Servers are also used in cloud computing, which is a computing model where data, applications and services are delivered over the internet or an intranet which can be rapidly provisioned and released with minimal effort. Today’s datacenters require new technologies and configuration models to meet the demand driven by the growing amount of data that needs to be stored, accessed and managed. Servers must be efficient, scalable and adaptable to meet the compute characteristics of new and changing workloads. +Embedded . Embedded products address computing needs in PC-adjacent markets, such as industrial control and automation, digital signage, point-of-sale/self-service kiosks, medical imaging and casino gaming machines as well as enterprise-class telecommunications, networking, security, storage systems and thin clients (which are computers that serve as an access device on a network). Typically, AMD embedded products are used in applications that require high to moderate levels of performance, where key features may include mobility, relatively low power, small form factor, and 24x7 operations. High-performance graphics are increasingly important in many embedded systems. Support for Linux ® , Windows ® and other operating systems as well as for increasingly sophisticated applications are also critical for some customers. Other requirements may include meeting rigid specifications for industrial temperatures, shock, vibration and reliability. The embedded market has moved from developing proprietary, custom designs to leveraging industry-standard instruction set architectures and processors as a way to help reduce costs and speed time to market. +Semi-Custom . We have leveraged our core IP, including our graphics and processing technologies developed for the gaming, VR, AR and machine intelligence markets, to develop semi-custom solutions for customers who want differentiation in their products. In this market, semiconductor suppliers work alongside system designers and manufacturers to enhance +7 +the performance and overall user experience for semi-custom customers. AMD has used this type of collaborative development approach with many of today’s leading game console manufacturers and can also address customer needs in many other markets beyond game consoles. AMD leverages our existing IP to create a variety of products tailored to a specific customer’s needs, ranging from complex fully-customized SoCs to more modest adaptations and integrations of existing CPU, APU or GPU products. +Our Enterprise, Embedded and Semi-Custom Products +Server Processors. Our microprocessors for server platforms currently include the AMD EPYC™ Series processors and AMD Opteron™ X and A-Series processors. The AMD EPYC 7000 Series of high performance processors that have up to 32 “Zen” compute cores and are designed to support a full range of integer, floating point, memory bandwidth and I/O benchmarks and workloads. The AMD Opteron X3000 Series APUs are a family of fully integrated CPU, GPU and I/O designed to provide processing and graphics performance for personal and small business needs. +Embedded Processors . Our embedded processors are increasingly driving intelligence into new areas of our lives, like interactive digital signage, casino gaming, and medical imaging devices. These products are designed to support greater connectivity and productivity, and we believe they can be a strong driver for the “internet of things” and “immersive computing” areas in the computing industry. Our products for embedded platforms include AMD Embedded R-Series APU, CPU and SoC, AMD Embedded G-Series SoC platform and AMD Embedded Radeon™ GPUs. In February 2018, we introduced two new product families, the AMD EPYC™ Embedded 3000 processor and AMD Ryzen™ Embedded V1000 processor. The AMD EPYC Embedded 3000 brings the power of “Zen” to a variety of new markets including networking, storage, and edge computing devices. AMD Ryzen Embedded V1000 targets medical imaging, industrial systems, digital gaming and thin clients. +Semi-Custom . Our semi-custom products are tailored, high-performance, customer-specific solutions based on AMD’s CPU, GPU and multi-media technologies. We work closely together with our customers to define solutions to precisely match the requirements of the device or application. Historically we have leveraged our core graphics processing technology into the game console market by licensing our graphic technology in game consoles such as the Microsoft ® Xbox 360™ and Nintendo Wii and Wii U. We developed the semi-custom SoC products that power the current generation Sony PlayStation® 4 and PlayStation ® 4 Pro and Microsoft ® Xbox One™ and Xbox One S™ and Xbox One X™ game consoles. +Marketing and Sales +We sell our products through our direct sales force and through independent distributors and sales representatives in both domestic and international markets. Our sales arrangements generally operate on the basis of product forecasts provided by the particular customer, but do not typically include any commitment or requirement for minimum product purchases. We primarily use purchase orders, sales order acknowledgments and contractual agreements as evidence of our sales arrangements. Our agreements typically contain standard terms and conditions covering matters such as payment terms, warranties and indemnities for issues specific to our products. +We generally warrant that our products sold to our customers will conform to our approved specifications and be free from defects in material and workmanship under normal use and conditions for one year. We may also offer one to three year limited warranties based on product type and negotiated warranty terms with certain customers. +We market and sell our latest products under the AMD trademark. Our desktop PC product brands for microprocessors are AMD Ryzen™, AMD Ryzen™ PRO, Threadripper™, AMD A-Series, AMD FX™ , AMD Athlon™, AMD Athlon™ PRO, and AMD Pro A-Series processors. Our notebook and 2-in-1s for microprocessors are AMD Ryzen™ processors with Radeon™ Vega GPUs, AMD A-Series, AMD Athlon, AMD Ryzen™ PRO and AMD Pro A-Series processors. Our server brands for microprocessors are AMD EPYC™ and AMD Opteron™ processors. We also sell low-power versions of our AMD Opteron, AMD Athlon , as well as AMD Geode™, AMD Ryzen™, AMD EPYC™, AMD R-Series and G-Series processors as embedded processor solutions. Our product brand for the consumer graphics market is AMD Radeon™ graphics, and AMD Embedded Radeon™ graphics is our product brand for the embedded graphics market. Our product brand for professional graphics products are AMD Radeon™ Pro and AMD FirePro™ graphics as well as Radeon Instinct™ accelerators for servers. We also market and sell our chipsets under AMD trademarks. +We market our products through direct marketing and co-marketing programs. In addition, we have cooperative advertising and marketing programs with customers and third parties, including market development programs, pursuant to which we may provide product information, training, marketing materials and funds. Under our co-marketing development programs, eligible customers can use market development funds as reimbursement for advertisements and marketing programs related to our products and third-party systems integrating our products, subject to meeting defined criteria. +8 +Customers +Our microprocessor customers consist primarily of original equipment manufacturers (OEMs), large direct datacenters, original design manufacturers (ODMs), system integrators and independent distributors in both domestic and international markets. ODMs provide design and/or manufacturing services to branded and unbranded private label resellers, OEMs and system builders. Our graphics product customers include the foregoing as well as add-in-board manufacturers (AIBs). Large direct datacenters consist of cloud service providers. +Customers of our chipset products consist primarily of PC OEMs, often through ODMs or other contract manufacturers, who build the OEM motherboards, as well as desktop and server motherboard manufacturers who incorporate chipsets into their channel motherboards. +We work closely with our customers to define product features, performance and timing of new products so that the products we are developing meet our customers’ needs. We also employ application engineers to assist our customers in designing, testing and qualifying system designs that incorporate our products. We believe that our commitment to customer service and design support improves our customers’ time-to-market and fosters relationships that encourage customers to use the next generation of our products. +We also work with our customers to create differentiated products that leverage our CPU, GPU and APU technology. Customers of our semi-custom products pay us non-recurring engineering fees for design and development services and a purchase price for the resulting semi-custom products. +Our major customers, Sony Interactive Entertainment LLC and Microsoft Corporation , each accounted for more than 10% of our consolidated net revenue for the year ended December 29, 2018 . Sales to Sony Interactive Entertainment LLC and Microsoft Corporation consisted of products from our Enterprise, Embedded and Semi-Custom segment. A loss of any of these customers would have a material adverse effect on our business. +Original Equipment Manufacturers +We focus on three types of OEM customers: multi-nationals, selected regional accounts and some local system integrators, who target commercial and consumer end customers of all sizes. Large multi-nationals and regional accounts are the core of our OEM customers. Our OEM customers include numerous foreign and domestic manufacturers of servers and workstations, desktops, notebooks, PC motherboards and game consoles. +Third-Party Distributors +Our authorized channel distributors resell to sub-distributors and mid-sized and smaller OEMs and ODMs. Typically, distributors handle a wide variety of products, and may include those that compete with our products. Distributors typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions and provide return rights with respect to any product that we have removed from our price book that is not more than 12 months older than the manufacturing code date. In addition, some agreements with our distributors may contain standard stock rotation provisions permitting limited levels of product returns. +Add-in-Board (AIB) Manufacturers and System Integrators +We offer component-level graphics and chipset products to AIB manufacturers who in turn build and sell board-level products using our technology to system integrators (SIs), retail buyers and sub distributors. Our agreements with AIBs protect their inventory of our products against price reductions. We also sell directly to our SI customers. SIs typically sell from positions of regional or product-based strength in the market. They usually operate on short design cycles and can respond quickly with new technologies. SIs often use discrete graphics solutions as a means to differentiate their products and add value to their customers. +Competition in the Microprocessor and Chipset Market +Intel Corporation has been the market share leader for microprocessors for many years. Intel’s market share, margins and significant financial resources enable it to market its products aggressively, to target our customers and our channel partners with special incentives and to influence customers who do business with us. These aggressive activities have in the past resulted in lower unit sales and a lower average selling price for many of our products and adversely affected our margins and profitability. +Intel exerts substantial influence over computer manufacturers and their channels of distribution through various brand and other marketing programs. As a result of Intel’s position in the microprocessor market, Intel has been able to control x86 microprocessor and computer system standards and benchmarks and to dictate the type of products the microprocessor +9 +market requires of us. Intel also dominates the computer system platform, which includes core logic chipsets, graphics chips, networking devices (wired and wireless), non-volatile storage and other components necessary to assemble a computer system. OEMs that purchase microprocessors for computer systems are highly dependent on Intel, which can make them less innovative on their own and, to a large extent, can become distributors of Intel technology. Additionally, Intel is able to drive de facto standards and specifications for x86 microprocessors that could cause us and other companies to have delayed access to such standards. +As long as Intel remains in this dominant position, we may be materially adversely affected by Intel’s: +• +business practices, including rebating and allocation strategies and pricing actions which may limit our market share and margins; +• +product mix and introduction schedules; +• +product bundling, marketing and merchandising strategies; +• +exclusivity payments to its current and potential customers, retailers and channel partners that require or result in exclusive product arrangements; +• +de facto control over industry standards, and heavy influence on PC manufacturers and other PC industry participants, including motherboard, memory, chipset and basic input/output system (BIOS) suppliers and software companies as well as the graphics interface for Intel platforms; and +• +marketing and advertising expenditures in support of positioning the Intel brand over the brand of its OEM customers and retailers. +Intel has substantially greater financial resources than we do and accordingly spends substantially greater amounts on marketing and research and development than we do. We expect Intel to maintain its market position and to continue to invest heavily in marketing, research and development, new manufacturing facilities and other technology companies. +Intel could take actions that place our discrete GPUs at a competitive disadvantage, including giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel has announced that it is developing their own high-end discrete GPUs. Intel’s position in the microprocessor market and integrated graphics chipset market, its introduction of competitive new products, its existing relationships with top-tier OEMs and its aggressive marketing and pricing strategies could result in lower unit sales and lower average selling prices for our products, which could have a material adverse effect on us. +Other competitors include a variety of companies providing or developing ARM-based designs at relatively low cost and low power processors for the computing market including tablets and thin-client form factors, as well as dense servers, set-top boxes and gaming consoles. ARM Holdings designs and licenses its ARM cores and architecture to third parties, including us, and offers supporting software and services. Our ability to compete with companies who use ARM-based solutions depends on our ability to timely design and bring to market energy-efficient, high-performing products at an attractive price point. +Competition in the Graphics Markets +In the graphics market, our competitors include suppliers of discrete graphics, embedded graphics processors and integrated graphics processor (IGP) chipsets. Intel manufactures and sells embedded graphics processors and IGP chipsets, and is a dominant competitor with respect to this portion of our business. Higher unit shipments of our APUs and Intel’s integrated graphics may drive computer manufacturers to reduce the number of systems they build paired with discrete graphics components, particularly for notebooks, because they may offer satisfactory graphics performance for most mainstream PC users, at a lower cost. Intel could take actions that place our discrete GPUs and IGP chipsets at a competitive disadvantage such as giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel is developing its own high-end discrete GPUs. +Our principal competitor in the discrete graphics market is Nvidia and they are considered the market share leader. Other competitors include a number of smaller companies, which may have greater flexibility to address specific market needs, but less financial resources to do so, especially as we believe that the growing complexity of graphics processors and the associated research and development costs represent an increasingly higher barrier to entry in this market. +We are the market share leader in semi-custom game console products, where graphics performance is critical, we compete primarily against Nvidia. +Competition in the Server Markets +10 +In the server market, we compete primarily against Intel. +Research and Development +We focus our research and development activities on improving product performance and enhancing product design. Our main area of focus is on delivering the next generation of CPU and GPU IP, and designing that IP into our SoCs for our next generation of products, with, in each case, improved system performance and performance-per-watt characteristics. For example, we are focusing on improving the battery life of our APU products for notebooks and the performance and power efficiency of our discrete GPUs and our microprocessors for servers. We are also focusing on delivering a range of low-power integrated platforms to serve key markets, including commercial clients, mobile computing and gaming. We believe that these platforms will bring customers increased performance and energy efficiency. We also work with industry leaders on process technology, software and other functional intellectual property and with others in the industry and industry consortia to conduct early stage research and development. We conduct product and system research and development activities for our products in the United States with additional design and development engineering teams located in Australia, China, Canada, India, Singapore and Taiwan, who undertake specific activities at the direction of our U.S. headquarters. +Manufacturing Arrangements and Assembly and Test Facilities +Third-Party Wafer Foundry Facilities +GLOBALFOUNDRIES Inc . On March 2, 2009, we entered into a Wafer Supply Agreement (WSA) with GLOBALFOUNDRIES Inc. (GF). The WSA governs the terms by which we purchase products manufactured by GF, a related party to us. Pursuant to the WSA, we are required to purchase all of our microprocessor and APU product requirements, and a certain portion of our GPU products from GF manufactured at process nodes larger than 7 nanometer (nm), with limited exceptions. +Taiwan Semiconductor Manufacturing Company . We also have foundry arrangements with Taiwan Semiconductor Manufacturing Company (TSMC) for the production of wafers for certain products. +Other Third-Party Manufacturers . We outsource board-level graphics product manufacturing to third-party manufacturers. +Assembly, Test, Mark and Packaging Facilities +Wafers for our products are delivered from third-party foundries to our test, assembly and packaging partners located in the Asia-Pacific region who package and test our final semiconductor products. We are party to two assembly, test, mark and pack (ATMP) joint ventures (collectively, the JVs) with Tongfu Fujitsu Microelectronics Co., Ltd. The majority of our ATMP services are provided by the JVs, +Intellectual Property and Licensing +We rely on contracts and intellectual property rights to protect our products and technologies from unauthorized third-party copying and use. Intellectual property rights include copyrights, patents, patent applications, trademarks, trade secrets and mask work rights. As of December 29, 2018 , we had approximately 5,000 patents in the United States and approximately 900 patent applications pending in the United States. In certain cases, we have filed corresponding applications in foreign jurisdictions. Including United States and foreign matters, we have approximately 10,600 patent matters worldwide consisting of approximately 8,000 issued patents and 2,600 patent applications pending. We expect to file future patent applications in both the United States and abroad on significant inventions, as we deem appropriate. We do not believe that any individual patent, or the expiration of any patent, is or would be material to our business. +As is typical in the semiconductor industry, we have numerous cross-licensing and technology exchange agreements with other companies under which we both transfer and receive technology and intellectual property rights. One such agreement is the cross-license agreement that we entered into with Intel on November 11, 2009. Under the cross-license agreement, we granted to Intel and Intel granted to us, non-exclusive, royalty-free licenses to all of each other’s patents that were first filed no later than November 11, 2014 and each party can exploit these patents anywhere in the world for making and selling certain semiconductor- and electronic-related products. Under the cross-license agreement, Intel has rights to make semiconductor products for third parties, but the third-party product designs are not licensed as a result of such manufacture. We have rights to perform assembly and testing for third parties but not rights to make semiconductor products for third parties. The term of the cross-license agreement continues until the expiration of the last to expire of the licensed patents, unless earlier terminated. A party can terminate the cross-license agreement or the rights and licenses of +11 +the other party if the other party materially breaches the cross-license agreement and does not correct the noticed material breach within 60 days. Upon such termination, the terminated party’s license rights terminate but the terminating party’s license rights continue, subject to that party’s continued compliance with the terms of the cross-license agreement. The cross-license agreement will automatically terminate if a party undergoes a change of control (as defined in the cross license agreement), and both parties’ licenses will terminate. Upon the bankruptcy of a party, that party may assume, but may not assign, the cross-license agreement, and in the event that the cross-license agreement cannot be assumed, the cross-license agreement and the licenses granted will terminate. +Backlog +Sales are made primarily pursuant to purchase orders for current delivery or agreements covering purchases over a period of time. Some of these orders or agreements may be revised or canceled without penalty. Generally, in light of current industry practice, we do not believe that such orders or agreements provide meaningful backlog figures or are necessarily indicative of actual sales for any succeeding period. With respect to our semi-custom SoC products, our orders and agreements are more stringent resulting in meaningful backlog for the coming quarter. +Seasonality +Our operating results tend to vary seasonally. Historically, first quarter PC product sales are generally lower than fourth quarter sales and with respect to our semi-custom SoC products for game consoles our sales pattern usually reflects higher sales in the second and third quarters compared to the first and fourth quarters. +Employees +As of December 29, 2018 , we had approximately 10,100 employees. +Environmental Regulations +Our operations and properties have in the past been and continue to be subject to various United States and foreign laws and regulations, including those relating to materials used in our products and manufacturing processes, discharge of pollutants into the environment, the treatment, transport, storage and disposal of solid and hazardous wastes and remediation of contamination. These laws and regulations require our suppliers to obtain permits for operations making our products, including the discharge of air pollutants and wastewater. Although our management systems are designed to oversee our suppliers' compliance, we cannot assure you that our suppliers have been or will be at all times in complete compliance with such laws, regulations and permits. If our suppliers violate or fail to comply with any of them, a range of consequences could result, including fines, suspension of production, alteration of manufacturing processes, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions. We could also be held liable for any and all consequences arising out of exposure to hazardous materials used, stored, released, disposed of by us or located at, under or emanating from our facilities or other environmental or natural resource damage. While we have budgeted for foreseeable associated expenditures, we cannot assure you that future environmental legal requirements will not become more stringent or costly in the future. Therefore, we cannot assure you that our costs of complying with current and future environmental and health and safety laws, and our liabilities arising from past and future releases of, or exposure to, hazardous substances will not have a material adverse effect on us. +Environmental laws are complex, change frequently and have tended to become more stringent over time. For example, the European Union (EU) and China are two among a growing number of jurisdictions that have enacted restrictions on the use of lead and other materials in electronic products. These regulations affect semiconductor devices and packaging. As regulations restricting materials in electronic products continue to increase around the world, there is a risk that the cost, quality and manufacturing yields of products that are subject to these restrictions, may be less favorable compared to products that are not subject to such restrictions, or that the transition to compliant products may not meet customer roadmaps, or produce sudden changes in demand, which may result in excess inventory. A number of jurisdictions including the EU, Australia, California and China are developing or have finalized market entry or public procurement regulations for computers and servers based on ENERGY STAR specifications as well as additional energy consumption limits. There is the potential for certain of our products being excluded from some of these markets which could materially adversely affect us. +Certain environmental laws, including the U.S. Comprehensive, Environmental Response, Compensation and Liability Act of 1980, or the Superfund Act, impose strict or, under certain circumstances, joint and several liability on current and previous owners or operators of real property for the cost of removal or remediation of hazardous substances and impose liability for damages to natural resources. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. These environmental laws also assess liability on +12 +persons who arrange for hazardous substances to be sent to disposal or treatment facilities when such facilities are found to be contaminated. Such persons can be responsible for cleanup costs even if they never owned or operated the contaminated facility. +We are named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, we have discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, we received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. We have entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. We remain responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, we have computed and recorded an estimated environmental liability of approximately $3 million and have not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. Costs could also increase as a result of additional test and remediation obligations imposed by the Environmental Protection Agency or California Regional Water Quality Control Board. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. We believe that the potential liability, if any, in excess of amounts already accrued, will not have a material adverse effect on our financial condition, cash flows or results of operations. +13 +ITEM 1A. RISK FACTORS +The risks and uncertainties described below are not the only ones we face. If any of the following risks actually occurs, our business, financial condition or results of operations could be materially adversely affected. In addition, you should consider the interrelationship and compounding effects of two or more risks occurring simultaneously. +Intel Corporation’s dominance of the microprocessor market and its aggressive business practices may limit our ability to compete effectively. +Intel Corporation has been the market share leader for microprocessors for many years. Intel’s market share, margins and significant financial resources enable it to market its products aggressively, to target our customers and our channel partners with special incentives and to influence customers who do business with us. These aggressive activities have in the past and are likely in the future to result in lower unit sales and a lower average selling price for many of our products and adversely affect our margins and profitability. +Intel exerts substantial influence over computer manufacturers and their channels of distribution through various brand and other marketing programs. As a result of Intel’s position in the microprocessor market, Intel has been able to control x86 microprocessor and computer system standards and benchmarks and to dictate the type of products the microprocessor market requires of us. Intel also dominates the computer system platform, which includes core logic chipsets, graphics chips, networking devices (wired and wireless), non-volatile storage and other components necessary to assemble a computer system. Additionally, Intel is able to drive de facto standards and specifications for x86 microprocessors that could cause us and other companies to have delayed access to such standards. +Intel has substantially greater financial resources than we do and accordingly spends substantially greater amounts on marketing and research and development than we do. We expect Intel to maintain its market position and to continue to invest heavily in marketing, research and development, new manufacturing facilities and other technology companies. To the extent Intel manufactures a significantly larger portion of its microprocessor products using more advanced process technologies, or introduces competitive new products into the market before we do, we may be more vulnerable to Intel’s aggressive marketing and pricing strategies for microprocessor products. +As long as Intel remains in this dominant position, we may be materially adversely affected by Intel’s: +• +business practices, including rebating and allocation strategies and pricing actions, designed to limit our market share and margins; +• product mix and introduction schedules; +• product bundling, marketing and merchandising strategies; +• exclusivity payments to its current and potential customers, retailers and channel partners; +• +de facto control over industry standards, and heavy influence on PC manufacturers and other PC industry participants, including motherboard, memory, chipset and basic input/output system (BIOS) suppliers and software companies as well as the graphics interface for Intel platforms; and +• +marketing and advertising expenditures in support of positioning the Intel brand over the brand of its original equipment manufacturer OEM customers and retailers. +Intel could also take actions that place our discrete GPUs at a competitive disadvantage, including giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel recently announced that it is developing their own high-end discrete GPUs. Intel’s position in the microprocessor market and integrated graphics chipset market, its introduction of competitive new products, its existing relationships with top-tier OEMs, and its aggressive marketing and pricing strategies could result in lower unit sales and a lower average selling price for our products, which could have a material adverse effect on us. +We have a wafer supply agreement with GF with obligations to purchase all of our microprocessor and APU product requirements, and a certain portion of our GPU product requirements manufactured at process nodes larger than 7 nanometer from GF, with limited exceptions. If GF is not able to satisfy our manufacturing requirements, our business could be adversely impacted. +The wafer supply agreement (WSA) governs the terms by which we purchase products manufactured by GF. The WSA is in place until 2024. Pursuant to the WSA, we are required to purchase all of our microprocessor and APU product requirements, and a portion of our GPU product requirements from GF manufactured at process nodes larger than 7 nanometer (nm), with limited exceptions. If GF is unable to achieve anticipated manufacturing yields, manufacture our products on a timely basis at competitive prices or meet our capacity requirements, then we may experience supply shortages for certain products or increased costs and our business could be materially adversely affected. +14 +In January 2019, we entered into the seventh amendment to the WSA with GF (the Seventh Amendment). The Seventh Amendment modifies certain purchase commitments, pricing and other terms of the WSA applicable to wafer purchases at the 12 nm technology node and above by us for the period commencing January 1, 2019 and continuing through March 1, 2024. If we fail to meet the agreed wafer purchase target during a calendar year we will be required to pay to GF a portion of the difference between our actual wafer purchases and the applicable annual purchase target. If our actual wafer requirements are less than the number of wafers required to meet the applicable annual wafer purchase target, we could have excess inventory or higher inventory unit costs, both of which may adversely impact our gross margin and our results of operations. +In addition, GF has relied on Mubadala Technology Investments LLC (Mubadala Tech) for its funding needs. If Mubadala Tech fails to adequately fund GF on a timely basis, or at all, and if GF is not otherwise able to adequately fund its operations, GF’s ability to manufacture products for us could be materially adversely affected. +We rely on third parties to manufacture our products, and if they are unable to do so on a timely basis in sufficient quantities and using competitive technologies, our business could be materially adversely affected. +We rely on third-party wafer foundries to fabricate the silicon wafers for all of our products. We also rely on third-party manufacturers to assemble, test, mark and pack (ATMP) our products. It is important to have reliable relationships with all of these third-party manufacturing suppliers to ensure adequate product supply to respond to customer demand. +We cannot guarantee that these manufacturers or our other third-party manufacturing suppliers will be able to meet our near-term or long-term manufacturing requirements. If we experience supply constraints from our third-party manufacturing suppliers, we may be required to allocate the affected products amongst our customers, which could have a material adverse effect on our relationships with these customers and on our financial condition. In addition, if we are unable to meet customer demand due to fluctuating or late supply from our manufacturing suppliers, it could result in lost sales and have a material adverse effect on our business. +We do not have long-term commitment contracts with some of our third-party manufacturing suppliers. We obtain some of these manufacturing services on a purchase order basis and these manufacturers are not required to provide us with any specified minimum quantity of product beyond the quantities in an existing purchase order. Accordingly, we depend on these suppliers to allocate to us a portion of their manufacturing capacity sufficient to meet our needs, to produce products of acceptable quality and at acceptable manufacturing yields and to deliver those products to us on a timely basis and at acceptable prices. The manufacturers we use also fabricate wafers and ATMP products for other companies, including certain of our competitors. They could choose to prioritize capacity for other customers, increase the prices that they charge us on short notice or reduce or eliminate deliveries to us, which could have a material adverse effect on our business. +Other risks associated with our dependence on third-party manufacturers include limited control over delivery schedules and quality assurance, lack of capacity in periods of excess demand, misappropriation of our intellectual property, dependence on several small undercapitalized subcontractors and limited ability to manage inventory and parts. Moreover, if any of our third-party manufacturers suffer any damage to facilities, lose benefits under material agreements, experience power outages, lack sufficient capacity to manufacture our products, encounter financial difficulties, are unable to secure necessary raw materials from their suppliers or suffer any other disruption or reduction in efficiency, we may encounter supply delays or disruptions. If we are unable to secure sufficient or reliable supplies of products, our ability to meet customer demand may be adversely affected and this could materially affect our business. +If we transition the production of some of our products to new manufacturers, we may experience delayed product introductions, lower yields or poorer performance of our products. If we experience problems with product quality or are unable to secure sufficient capacity from a particular third-party manufacturer, or if we for other reasons cease utilizing one of those suppliers, we may be unable to secure an alternative supply for any specific product in a short time frame. We could experience significant delays in the shipment of our products if we are required to find alternative third-party manufacturers, which could have a material adverse effect on our business. +We are party to two ATMP joint ventures (collectively, the JVs) with Tongfu Fujitsu Microelectronics Co., Ltd. The majority of our ATMP services are provided by the JVs and there is no guarantee that the JVs will be able to fulfill our long-term ATMP requirements. If we are unable to meet customer demand due to fluctuating or late supply from the JVs, it could result in lost sales and have a material adverse effect on our business. +Failure to achieve expected manufacturing yields for our products could negatively impact our financial results. +Semiconductor manufacturing yields are a result of both product design and process technology, which is typically proprietary to the manufacturer, and low yields can result from design failures, process technology failures or a combination of both. Our third-party foundries, including GF, are responsible for the process technologies used to fabricate silicon wafers. If our third-party foundries experience manufacturing inefficiencies or encounter disruptions, errors or difficulties during production, we may fail to achieve acceptable yields or experience product delivery delays. We cannot be certain that our third-party foundries will be able to develop, obtain or successfully implement leading-edge process technologies needed to manufacture future generations of our products profitably or on a timely basis or that our competitors will not develop new technologies, products +15 +or processes earlier. Moreover, during periods when foundries are implementing new process technologies, their manufacturing facilities may not be fully productive. A substantial delay in the technology transitions to smaller process technologies could have a material adverse effect on us, particularly if our competitors transition to more cost effective technologies before us. For example, we are presently focusing our 7nm product portfolio on Taiwan Semiconductor Co., Ltd.’s (TSMC) 7nm process. If TSMC is not able to manufacture our products on 7nm in sufficient quantities to meet customer demand, it could have a material adverse effect on our business. +Any decrease in manufacturing yields could result in an increase in per unit costs, which would adversely impact our gross margin and/or force us to allocate our reduced product supply amongst our customers, which could harm our relationships and reputation with our customers and materially adversely affect our business. +The success of our business is dependent upon our ability to introduce products on a timely basis with features and performance levels that provide value to our customers while supporting and coinciding with significant industry transitions. +Our success depends to a significant extent on the development, qualification, implementation and acceptance of new product designs and improvements that provide value to our customers. Our ability to develop, qualify and distribute, and have manufactured, new products and related technologies to meet evolving industry requirements, at prices acceptable to our customers and on a timely basis are significant factors in determining our competitiveness in our target markets. As consumers have new product feature preferences or have different requirements than those consumers in the PC market, PC sales could be negatively impacted, which could adversely impact our business. Our product roadmap includes our next generation AMD Ryzen, AMD Radeon and AMD EPYC processors using 7 nm process technology. We cannot assure you that our efforts to execute our product roadmap will result in innovative products and technologies that provide value to our customers. If we fail to or are delayed in developing, qualifying or shipping new products or technologies that provide value to our customers and address these new trends or if we fail to predict which new form factors consumers will adopt and adjust our business accordingly, we may lose competitive positioning, which could cause us to lose market share and require us to discount the selling prices of our products. Although we make substantial investments in research and development, we cannot be certain that we will be able to develop, obtain or successfully implement new products and technologies on a timely basis or that they will be well-received by our customers. Moreover, our investments in new products and technologies involve certain risks and uncertainties and could disrupt our ongoing business. New investments may not generate sufficient revenue, may incur unanticipated liabilities and may divert our limited resources and distract management from our current operations. We cannot be certain that our ongoing investments in new products and technologies will be successful, will meet our expectations and will not adversely affect our reputation, financial condition and operating results. +Delays in developing, qualifying or shipping new products can also cause us to miss our customers’ product design windows or, in some cases, breach contractual obligations or cause us to pay penalties. If our customers do not include our products in the initial design of their computer systems or products, they will typically not use our products in their systems or products until at least the next design configuration. The process of being qualified for inclusion in a customer’s system or product can be lengthy and could cause us to further miss a cycle in the demand of end-users, which also could result in a loss of market share and harm our business. We also depend on the success and timing of our customers’ platform launches. If our customers delay their product launches or if our customers do not effectively market their platforms with our products, it could result in a delay in bringing our products to market and cause us to miss a cycle in the demand of end-users, which could materially adversely affect our business. In addition, market demand requires that products incorporate new features and performance standards on an industry-wide basis. Over the life of a specific product, the sale price is typically reduced over time. The introduction of new products and enhancements to existing products is necessary to maintain the overall corporate average selling price. If we are unable to introduce new products with sufficiently high sale prices or to increase unit sales volumes capable of offsetting the reductions in the sale prices of existing products over time, our business could be materially adversely affected. +If we cannot generate sufficient revenue and operating cash flow or obtain external financing, we may face a cash shortfall and be unable to make all of our planned investments in research and development or other strategic investments. +Our ability to fund research and development expenditures depends on generating sufficient revenue and cash flow from operations and the availability of external financing, if necessary. Our research and development expenditures, together with ongoing operating expenses, will be a substantial drain on our cash flow and may decrease our cash balances. If new competitors, technological advances by existing competitors, or other competitive factors require us to invest significantly greater resources than anticipated in our research and development efforts, our operating expenses would increase. If we are required to invest significantly greater resources than anticipated in research and development efforts without an increase in revenue, our operating results could decline. +We regularly assess markets for external financing opportunities, including debt and equity financing. Additional debt or equity financing may not be available when needed or, if available, may not be available on satisfactory terms. The health of the credit markets may adversely impact our ability to obtain financing when needed. Any downgrades from credit rating agencies such as Moody’s or Standard & Poor’s may adversely impact our ability to obtain external financing or the terms of such financing. Credit agency downgrades or concerns regarding our credit worthiness may impact relationships with our suppliers, who may +16 +limit our credit lines. Our inability to obtain needed financing or to generate sufficient cash from operations may require us to abandon projects or curtail planned investments in research and development or other strategic initiatives. If we curtail planned investments in research and development or abandon projects, our products may fail to remain competitive and our business would be materially adversely affected. +The loss of a significant customer may have a material adverse effect on us. +We depend on a small number of customers for a substantial portion of our business and we expect that a small number of customers will continue to account for a significant part of our revenue in the future. If one of our key customers decides to stop buying our products, or if one of these customers materially reduces or reorganizes its operations or its demand for our products, our business would be materially adversely affected. +Our receipt of revenue from our semi-custom SoC products is dependent upon our technology being designed into third-party products and the success of those products. +The revenue that we receive from our semi-custom SoC products is in the form of non-recurring engineering fees charged to third parties for design and development services and revenue received in connection with sales of our semi-custom SoC products to these third parties. As a result, our ability to generate revenue from our semi-custom products depends on our ability to secure customers for our semi-custom design pipeline, our customers’ desire to pursue the project, and our semi-custom SoC products being incorporated into those customer’s products. Any revenue from sales of our semi-custom SoC products is directly related to sales of the third-party’s products and reflective of their success in the market. Moreover, we have no control over the marketing efforts of these third parties, and we cannot make any assurances that sales of their products will be successful in current or future years. Consequently, the semi-custom SoC product revenue expected by us may not be fully realized and our operating results may be adversely affected. +Global economic and market uncertainty may adversely impact our business and operating results. +Uncertain global economic conditions have in the past and may in the future adversely impact our business, including, without limitation, a slowdown in the Chinese economy, one of the largest global markets for desktop and notebook PCs. Uncertainty in the worldwide economic environment may negatively impact consumer confidence and spending causing our customers to postpone purchases. In addition, during challenging economic times, our current or potential future customers may experience cash flow problems and as a result may modify, delay or cancel plans to purchase our products. Additionally, if our customers are not successful in generating sufficient revenue or are unable to secure financing, they may not be able to pay, or may delay payment of, accounts receivable that they owe us. The risk related to our customers’ potentially defaulting on or delaying payments to us is increased because we expect that a small number of customers will continue to account for a substantial part of our revenue. Any inability of our current or potential future customers to pay us for our products may adversely affect our earnings and cash flow. Moreover, our key suppliers may reduce their output or become insolvent, thereby adversely impacting our ability to manufacture our products. In addition, uncertain economic conditions may make it more difficult for us to raise funds through borrowings or private or public sales of debt or equity securities. +Our products may be subject to security vulnerabilities that could have a material adverse effect on us . +The products that we sell are complex and may be subject to security vulnerabilities that could result in, among other things, the loss, corruption, theft or misuse of confidential data or system performance issues. Our efforts to prevent and address security vulnerabilities may decrease performance, be only partially effective or not successful at all. We may also depend on third parties, such as customers, vendors and end users, to deploy our mitigations or create their own, and they may delay, decline or modify the implementation of such mitigations. Our relationships with our customers could be adversely affected as some of our customers may stop purchasing our products, reduce or delay future purchases of our products, or use competing products. Any of these actions by our customers could adversely affect our revenue. We also are subject to claims and litigation related to side-channel exploits, such as Spectre, and may face additional claims or litigation for future vulnerabilities. Actual or perceived security vulnerabilities of our products may subject us to adverse publicity, damage to our brand and reputation, and could materially harm our business or financial results. +IT outages, data loss, data breaches and cyber-attacks could compromise our intellectual property or other sensitive information, be costly to remediate or cause significant damage to our business, reputation and operations. +In the ordinary course of our business, we maintain sensitive data on our information technology (IT) assets, and also may maintain sensitive information on our business partners ’ and third party providers ’ IT assets, including our intellectual property and proprietary or confidential business information relating to our business and that of our customers and business partners. Maintaining the security of this information is critical to our business and reputation. We believe that companies have been increasingly subject to a wide variety of security incidents, cyber-attacks, hacking and phishing attacks, and other attempts to gain unauthorized access. These threats can come from a variety of sources, all ranging in sophistication from an individual hacker or insider threat to a state-sponsored attack. Cyber threats may be generic, or they may be custom-crafted against our information systems. Cyber-attacks have become increasingly more prevalent and much harder to detect, defend against or prevent. +17 +Our network and storage applications, as well as those of our customers, business partners, and third-party providers, may be subject to unauthorized access by hackers or breached due to operator error, malfeasance or other system disruptions. +It is often difficult to anticipate or immediately detect such incidents and the damage caused by such incidents. These data breaches and any unauthorized access, misuse or disclosure of our information or intellectual property could compromise our intellectual property and expose sensitive business information. Cyber-attacks on us or our customers, business partners or third party providers could also cause us to incur significant remediation costs, result in product development delays, disrupt key business operations and divert attention of management and key information technology resources. These incidents could also subject us to liability, expose us to significant expense and cause significant harm to our reputation and business. In addition, we are currently subject to claims and could be subject to additional claims in the future for damages resulting from loss of data from alleged vulnerabilities in the security of our processors. We also maintain confidential and personally identifiable information about our workers. The integrity and protection of our worker and consumer data is critical to our business and our workers and consumers have a high expectation that we will adequately protect their personal information. We anticipate an increase in costs related to: +• +enhancing and implementing information security controls, including costs related to upgrading application, computer, and network security components; +• training workers to maintain and monitor our security controls; +• remediating any data security breach and addressing the related litigation; +• mitigating reputational harm; and +• compliance with external regulations. +We often partner with third-party providers for certain worker services and we may provide certain limited worker information to such third parties based on the scope of the services provided to us. However, if these third parties fail to adopt or adhere to adequate data security practices, or in the event of a breach of their networks, our workers’ data may be improperly accessed, used or disclosed. A breach of data privacy is likely to cause significant disruption of our business operations. Failure to adequately maintain and update our security systems could materially adversely affect our operations and our ability to maintain worker confidence. Failure to prevent unauthorized access to electronic and other confidential information, IT outages, data loss and data breaches could materially adversely affect our financial condition, our competitive position and operating results. +Our operating results are subject to quarterly and seasonal sales patterns. +The profile of our sales may be weighted differently during the year. A large portion of our quarterly sales have historically been made in the last month of the quarter. This uneven sales pattern makes prediction of revenue for each financial period difficult and increases the risk of unanticipated variations in quarterly results and financial condition. In addition, our operating results tend to vary seasonally with the markets in which our products are sold. For example, historically, first quarter PC product sales are generally lower than fourth quarter sales and with respect to our semi-custom SoC products for game consoles our sales pattern usually reflects higher sales in the second and third quarters compared to the first and fourth quarters. Many of the factors that create and affect quarterly and seasonal trends are beyond our control. +We may not be able to generate sufficient cash to service our debt obligations or meet our working capital requirements. +Our ability to make payments on and to refinance our debt will depend on our financial and operating performance, which may fluctuate significantly from quarter to quarter, and is subject to prevailing economic, financial and business conditions along with other factors, many of which are beyond our control. We cannot assure you that we will be able to generate cash flow or that we will be able to borrow funds, including under our secured revolving line of credit for a principal amount up to $500 million (our Secured Revolving Line of Credit), in amounts sufficient to enable us to service our debt or to meet our working capital requirements. If we are not able to generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, we may be required to sell assets or equity, reduce expenditures, refinance all or a portion of our existing debt or obtain additional financing. We cannot assure you that we will be able to refinance our debt, sell assets or equity, borrow funds under our Secured Revolving Line of Credit or borrow more funds on terms acceptable to us, if at all. +We have a large amount of indebtedness which could adversely affect our financial position and prevent us from implementing our strategy or fulfilling our contractual obligations. +Our total debt as of December 29, 2018 was $1.3 billion, net of unamortized debt issuance costs and unamortized debt discount associated with the 2.125% Notes. Our large indebtedness may: +• +make it difficult for us to satisfy our financial obligations, including making scheduled principal and interest payments; +• +limit our ability to borrow additional funds for working capital, capital expenditures, acquisitions and general corporate and other purposes; +18 +• +limit our ability to use our cash flow or obtain additional financing for future working capital, capital expenditures, acquisitions or other general corporate purposes; +• require us to use a substantial portion of our cash flow from operations to make debt service payments; +• place us at a competitive disadvantage compared to our competitors with relatively less debt; and +• increase our vulnerability to the impact of adverse economic and industry conditions. +We enter into sale and factoring arrangements from time to time with respect to certain accounts receivables, which arrangements are non-recourse to us in the event that an account debtor fails to pay for credit-related reasons, and are not included in our indebtedness. We could become obligated to repurchase such accounts receivables or otherwise incur liability to the counterparties under these arrangements under certain circumstances, such as where a commercial dispute arises between us and an account debtor. +The agreements governing our notes and our Secured Revolving Line of Credit impose restrictions on us that may adversely affect our ability to operate our business. +The indentures governing our 6.75% Senior Notes due 2019 (6.75% Notes), 7.50% Senior Notes due 2022 (7.50% Notes) and 7.00% Senior Notes due 2024 (7.00% Notes) contain various covenants which limit our ability to, among other things: +• incur additional indebtedness; +• pay dividends and make other restricted payments; +• make certain investments, including investments in our unrestricted subsidiaries; +• create or permit certain liens; +• +create or permit restrictions on the ability of certain restricted subsidiaries to pay dividends or make other distributions to us; +• use the proceeds from sales of assets; +• enter into certain types of transactions with affiliates; and +• consolidate or merge or sell our assets as an entirety or substantially as an entirety. +In addition, the Amended and Restated Loan Agreement restricts our ability to make cash payments on the notes to the extent that, on the date of such payment, a default or event of default exists under the Amended and Restated Loan Agreement, or we have not had at all times during the 45 consecutive days immediately preceding such payment, or would not have, on a pro forma basis after giving effect to such payment, Excess Cash Availability (as defined in the Amended and Restated Loan Agreement) of at least $50 million. Any of our future debt agreements may contain similar restrictions. If we fail to make any cash payment on a series of notes when required by the applicable indenture, it would constitute an event of default under such indenture, which, in turn, would constitute an event of default under the agreements governing our other indebtedness. +Our Secured Revolving Line of Credit also contains various covenants which limit our ability to, among other things, make certain investments, merge or consolidate with other entities and permit certain subsidiaries from incurring indebtedness. In addition, further restrictions apply when certain payment conditions (the Payment Conditions) are not satisfied with respect to specified transactions, events or payments. The Payment Conditions include that (i) no default or event of default exists and (ii) at all times during the 45 consecutive days immediately prior to such transaction, event or payment and on a pro forma basis after giving effect to such transaction, event or payment and any incurrence or repayment of indebtedness in connection therewith, the Excess Cash Availability (as defined in the Amended and Restated Loan Agreement) available cash is greater than the greater of 15% of the total commitment amount and $75 million. If Payment Conditions are not satisfied under certain circumstances, we will become subject to various additional covenants which limit our ability to, among other things: +• +create liens upon any of the Loan Parties’ property (other than customary permitted liens and liens in respect of up to $1.5 billion of secured credit facilities debt, which amount includes our Secured Revolving Line of Credit); +• declare or make cash distributions; +• create any encumbrance on the ability of a subsidiary to make any upstream payments; +• +make asset dispositions other than certain ordinary course dispositions and certain supply chain finance arrangements; +• +make certain loans, make payments with respect to subordinated debt or certain borrowed money prior to its due date; and +• enter into any non-arm’s-length transaction with an affiliate (except for certain customary exceptions). +The agreements governing our notes and our Secured Revolving Line of Credit contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. For example, +19 +the occurrence of a default with respect to any indebtedness or any failure to repay debt when due in an amount in excess of $50 million would cause a cross default under the indentures (to the extent such default would result in the acceleration of such indebtedness) governing our 6.75% Notes, 7.50% Notes, 7.00% Notes and 2.125% Notes, as well as under our Secured Revolving Line of Credit. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under our Secured Revolving Line of Credit to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable. If the note holders or the trustee under the indentures governing our 6.75% Notes, 7.50% Notes, 7.00% Notes or 2.125% Notes or the lenders under our Secured Revolving Line of Credit accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay those borrowings. +The markets in which our products are sold are highly competitive. +The markets in which our products are sold are very competitive and delivering the latest and best products to market on a timely basis is critical to achieving revenue growth. We believe that the main factors that determine our product competitiveness are timely product introductions, product quality, product features and capabilities (including enabling state-of-the-art visual and virtual reality experiences), energy efficiency (including power consumption and battery life), reliability, processor clock speed, performance, size (or form factor), selling price, cost, adherence to industry standards (and the creation of open industry standards), level of integration, software and hardware compatibility, security and stability, brand recognition and availability. +We expect that competition will continue to be intense due to rapid technological changes, frequent product introductions by our competitors or new competitors of products that may provide better performance/experience or may include additional features that render our products uncompetitive. We may also face aggressive pricing by competitors, especially during challenging economic times. In addition, our competitors have significant marketing and sales resources which could increase the competitive environment in such a declining market, leading to lower prices and margins. Some competitors may have greater access or rights to complementary technologies, including interface, processor and memory technical information. For instance, with our APU products and other competing solutions with integrated graphics, we believe that demand for additional discrete graphics chips and cards may decrease in the future due to improvements in the quality and performance of integrated graphics. If competitors introduce competitive new products into the market before us, demand for our products could be adversely impacted and our business could be adversely affected. In addition, Intel Corporation has announced that it plans to expand its position in integrated graphics for the PC market with high-end discrete graphics solutions for a broad range of computing segments, which may negatively impact our ability to compete in these computing segments. +In addition, we are entering markets with current and new competitors who may be able to adapt more quickly to customer requirements and emerging technologies. We cannot assure you that we will be able to compete successfully against current or new competitors who may have stronger positions in these new markets or superior ability to anticipate customer requirements and emerging industry trends. We may face delays or disruptions in research and development efforts, or we may be required to invest significantly greater resources in research and development than anticipated. +Our worldwide operations are subject to political, legal and economic risks and natural disasters, which could have a material adverse effect on us. +We maintain operations around the world, including in the United States, Canada, Europe, Australia and Asia. We rely on third-party wafer foundries in Europe and Asia. Nearly all product assembly and final testing of our products is performed at manufacturing facilities, operated by third-party manufacturing facilities, in China, Malaysia and Taiwan. We also have international sales operations. International sales, as a percent of net revenue, were 80% in 2018. We expect that international sales will continue to be a significant portion of total sales in the foreseeable future. +The political, legal and economic risks associated with our operations in foreign countries include, without limitation: +• +expropriation; +• changes in a specific country’s or region’s political or economic conditions; +• changes in tax laws, trade protection measures and import or export licensing requirements; +• difficulties in protecting our intellectual property; +• difficulties in managing staffing and exposure to different employment practices and labor laws; +• changes in foreign currency exchange rates; +• restrictions on transfers of funds and other assets of our subsidiaries between jurisdictions; +• changes in freight and interest rates; +• disruption in air transportation between the United States and our overseas facilities; +• loss or modification of exemptions for taxes and tariffs; and +• +compliance with U.S. laws and regulations related to international operations, including export control and economic sanctions laws and regulations and the Foreign Corrupt Practices Act. +20 +In addition, our worldwide operations (or those of our business partners) could be subject to natural disasters such as earthquakes, tsunamis, flooding, typhoons and volcanic eruptions that disrupt manufacturing or other operations. For example, our Santa Clara operations are located near major earthquake fault lines in California. There may be conflict or uncertainty in the countries in which we operate, including public health issues (for example, an outbreak of a contagious disease such as avian influenza, measles or Ebola), safety issues, natural disasters, fire, disruptions of service from utilities, nuclear power plant accidents or general economic or political factors. For example, the United Kingdom’s 2016 referendum, commonly referred to as “Brexit,” has created economic and political uncertainty in the European Union. Also, the European Union ’ s General Data Protection Regulation imposes significant new requirements on how we collect, process and transfer personal data, as well as significant fines for non-compliance. Also the United States administration has called for changes to domestic and foreign policy. The United States administration has announced tariffs on certain products imported into the United States with China as the country of origin, and we are taking steps to mitigate the impact of these tariffs on our business and AMD processor-based products. There is also a possibility of future tariffs imposed by the United States, China or other countries that could have a material adverse effect on our business. Any of the above risks, should they occur, could result in an increase in the cost of components, production delays, general business interruptions, delays from difficulties in obtaining export licenses for certain technology, tariffs and other barriers and restrictions, longer payment cycles, increased taxes, restrictions on the repatriation of funds and the burdens of complying with a variety of foreign laws, any of which could ultimately have a material adverse effect on our business. +Our issuance to West Coast Hitech L.P. (WCH) of warrants to purchase 75 million shares of our common stock, if and when exercised, will dilute the ownership interests of our existing stockholders, and the conversion of the 2.125% Notes may dilute the ownership interest of our existing stockholders, or may otherwise depress the price of our common stock. +Pursuant to the sixth amendment to the WSA (Sixth Amendment), we issued warrants to WCH to purchase 75 million shares of our common stock. Any issuance by us of shares of our common stock to WCH upon exercise of the warrants will dilute the ownership interests of our existing stockholders. Any sales in the public market by WCH of any shares owned by WCH could adversely affect prevailing market prices of our common stock, and the anticipated exercise by WCH of the warrants could depress the price of our common stock. On February 5, 2019, WCH sold approximately 34.9 million shares of our common stock and notified us it would exercise its warrant to purchase 75 million shares of our common stock at a purchase price of $5.98 per share for a total amount of $448.5 million . We expect to receive proceeds of $448.5 million upon the exercise of the warrant and issue the 75 million shares of our common stock to WCH in accordance with the terms of the Warrant Agreement. +Also, the conversion of some or all of the 2.125% Notes may dilute the ownership interests of our existing stockholders. The 2.125% Notes will mature on September 1, 2026, unless earlier redeemed or repurchased by us or converted. For example, during the fourth quarter of 2018, the sale price for conversion was satisfied as of the end of December 31, 2018 and as a result, the 2.125% Notes are eligible for conversion during the first calendar quarter of 2019. Any sales in the public market of our common stock issuable upon such conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the 2.125% Notes may encourage short selling by market participants because the conversion thereof could be used to satisfy short positions, or the anticipated conversion of the 2.125% Notes into cash and/or shares of our common stock could depress the price of our common stock. +Uncertainties involving the ordering and shipment of our products could materially adversely affect us. +We typically sell our products pursuant to individual purchase orders. We generally do not have long-term supply arrangements with our customers or minimum purchase requirements except that orders generally must be for standard pack quantities. Generally, our customers may cancel orders for standard products more than 30 days prior to shipment without incurring significant fees. We base our inventory levels in part on customers’ estimates of demand for their products, which may not accurately predict the quantity or type of our products that our customers will want in the future or ultimately end up purchasing. Our ability to forecast demand is even further complicated when our products are sold indirectly through downstream channel distributors and customers, as our forecasts for demand are then based on estimates provided by multiple parties throughout the downstream channel. +PC and consumer markets are characterized by short product lifecycles, which can lead to rapid obsolescence and price erosion. In addition, our customers may change their inventory practices on short notice for any reason. We may build inventories during periods of anticipated growth, and the cancellation or deferral of product orders or overproduction due to failure of anticipated orders to materialize, could result in excess or obsolete inventory, which could result in write-downs of inventory and an adverse effect on gross margins. +Factors that may result in excess or obsolete inventory, which could result in write-downs of the value of our inventory, a reduction in the average selling price or a reduction in our gross margin include: +• +a sudden or significant decrease in demand for our products; +• a production or design defect in our products; +• a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements; +21 +• +a failure to accurately estimate customer demand for our products, including for our older products as our new products are introduced; or +• our competitors introducing new products or taking aggressive pricing actions. +The demand for our products depends in part on the market conditions in the industries into which they are sold. Fluctuations in demand for our products or a market decline in any of these industries could have a material adverse effect on our results of operations. +Industry-wide fluctuations in the computer marketplace have materially adversely affected us in the past and may materially adversely affect us in the future. A large portion of our Computing and Graphics revenue is focused on the consumer desktop PC and notebook segments, which have in the past experienced a decline driven by, among other factors, the adoption of smaller and other form factors, increased competition and changes in replacement cycles. The success of our semi-custom SoC products is dependent on securing customers for our semi-custom design pipeline and consumer market conditions, including the success of the Sony PlayStation ® 4, Sony PlayStation ® 4 Pro, Microsoft ® Xbox One™ S and Microsoft ® Xbox One™ X game console systems worldwide. In addition, the GPU market has at times seen elevated demand due to the application of GPU products to cryptocurrency mining. For example, our GPU revenue has been affected in part by the volatility of the cryptocurrency mining market. Demand for cryptocurrency has changed and is likely to continue to change quickly. For example, China and South Korea have instituted restrictions on cryptocurrency trading and the valuations of the currencies, and corresponding interest in mining of such currencies, are subject to significant fluctuations. If we are unable to manage the risks related to the volatility of the cryptocurrency mining market, our GPU business could be materially adversely affected. +Our ability to design and introduce new products in a timely manner is dependent upon third-party intellectual property. +In the design and development of new and enhanced products, we rely on third-party intellectual property such as development and testing tools for software and hardware. Furthermore, certain product features may rely on intellectual property acquired from third parties. The design requirements necessary to meet customer demand for more features and greater functionality from semiconductor products may exceed the capabilities of the third-party intellectual property or development or testing tools available to us. If the third-party intellectual property that we use becomes unavailable, is not available with required functionality and performance in the time frame or price point needed for our new products or fails to produce designs that meet customer demands, our business could be materially adversely affected. +We depend on third-party companies for the design, manufacture and supply of motherboards, software and other computer platform components to support our business. +We depend on third-party companies for the design, manufacture and supply of motherboards, graphics cards, software (e.g. BIOS, operating systems, drivers) and other components that our customers utilize to support and/or use our microprocessor, GPU and APU offerings. We also rely on our add-in-board (AIB) partners to support our GPU and APU products. In addition, our microprocessors are not designed to function with motherboards and chipsets designed to work with Intel microprocessors. If the designers, manufacturers, AIBs and suppliers of motherboards, graphics cards, software and other components decrease their support for our product offerings, our business could be materially adversely affected. +If we lose Microsoft Corporation’s support for our products or other software vendors do not design and develop software to run on our products, our ability to sell our products could be materially adversely affected. +Our ability to innovate beyond the x86 instruction set controlled by Intel depends partially on Microsoft designing and developing its operating systems to run on or support our x86-based microprocessor products. With respect to our graphics products, we depend in part on Microsoft to design and develop its operating system to run on or support our graphics products. Similarly, the success of our products in the market, such as our APU products, is dependent on independent software providers designing and developing software to run on our products. If Microsoft does not continue to design and develop its operating systems so that they work with our x86 instruction sets or does not continue to develop and maintain their operating systems to support our graphics products, independent software providers may forego designing their software applications to take advantage of our innovations and customers may not purchase PCs with our products. In addition, some software drivers licensed for use with our products are certified by Microsoft. If Microsoft did not certify a driver, or if we otherwise fail to retain the support of Microsoft or other software vendors, our ability to market our products would be materially adversely affected. +Our reliance on third-party distributors and AIB partners subjects us to certain risks. +We market and sell our products directly and through third-party distributors and AIB partners pursuant to agreements that can generally be terminated for convenience by either party upon prior notice to the other party. These agreements are non-exclusive and permit both our distributors and AIB partners to offer our competitors’ products. We are dependent on our distributors and AIB partners to supplement our direct marketing and sales efforts. If any significant distributor or AIB or a substantial number of our distributors or AIB partners terminated their relationship with us, decided to market our competitors’ products over our products or decided not to market our products at all, our ability to bring our products to market would be impacted and we would be materially adversely affected. In addition, if we are unable to collect accounts receivable from our significant distributors and/ +22 +or AIB partners, it could have a material adverse effect on our business. If we are unable to manage the risks related to the use of our third-party distributors and AIB partners or offer appropriate incentives to focus them on the sale of our products, our business could be materially adversely affected. +Additionally, distributors and AIB partners typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions, as well as provide return rights for any product that we have removed from our price book and that is not more than 12 months older than the manufacturing date. Some agreements with our distributors also contain standard stock rotation provisions permitting limited levels of product returns. Our agreements with AIB partners protect their inventory of our products against price reductions. In the event of a significant decline in the price of our products, the price protection rights we offer would materially adversely affect us because our revenue and corresponding gross margin would decline. +We may incur future impairments of goodwill and technology license purchases. +We perform our annual goodwill impairment analysis as of the first day of the fourth quarter of each year. Subsequent to our annual goodwill impairment analysis, we monitor for any events or changes in circumstances, such as significant adverse changes in business climate or operating results, changes in management’s business strategy, an inability to successfully introduce new products in the marketplace, an inability to successfully achieve internal forecasts or significant declines in our stock price, which may represent an indicator of impairment. The occurrence of any of these events may require us to record future goodwill impairment charges. +We license certain third-party technologies and tools for the design and production of our products. We report the value of those licenses as intangible assets on the balance sheet and we periodically evaluate the carrying value of those licenses based on their future economic benefit to us. Factors such as the life of the assets, changes in competing technologies, and changes to the business strategy may represent an indicator of impairment. The occurrence of any of these events may require us to record future technology license impairment charges. For example, during the fourth quarter of 2018, we recorded an impairment charge in Cost of sales of $45 million on technology licenses related to products that are no longer being used. +Our inability to continue to attract and retain qualified personnel may hinder our business. +Much of our future success depends upon the continued service of numerous qualified engineering, marketing, sales and executive personnel. Competition for highly skilled employees and executives in the technology industry is intense and our competitors have targeted our employees that have desired skills. If we are not able to continue to attract, train and retain qualified personnel necessary for our business, the progress of our product development programs could be hindered, and we could be materially adversely affected. To help attract, retain and motivate qualified personnel, we use share-based incentive awards such as employee stock options and non-vested share units (restricted stock units). If the value of such stock awards does not appreciate as measured by the performance of the price of our common stock, or if our share-based compensation otherwise ceases to be viewed as a valuable benefit, our ability to attract, retain and motivate personnel could be weakened, which could harm our results of operations. Also, if the value of our stock awards increases substantially, this could potentially create great personal wealth for our employees and affect our ability to retain these employees. In addition, any future restructuring plans may adversely impact our ability to attract and retain key employees. +In the event of a change of control, we may not be able to repurchase our outstanding debt as required by the applicable indentures and our Secured Revolving Line of Credit, which would result in a default under the indentures and our Secured Revolving Line of Credit. +Upon a change of control, we will be required to offer to repurchase all of our 6.75% Notes, 7.50% Notes, 7.00% Notes and 2.125% Notes then outstanding at 101% of the principal amount thereof, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date. In addition, a change of control would be an event of default under our Secured Revolving Line of Credit. As of December 29, 2018, $70 million of borrowings were outstanding under the Secured Revolving Line of Credit, $26 million related to letters of credit under the Secured Revolving Line of Credit remained outstanding and $1.5 billion principal amount was outstanding under our notes. Future debt agreements may contain similar provisions. We may not have the financial resources to repurchase our outstanding notes and prepay all of our outstanding obligations under our Secured Revolving Line of Credit. +The semiconductor industry is highly cyclical and has experienced severe downturns that have materially adversely affected, and may continue to materially adversely affect, our business in the future. +The semiconductor industry is highly cyclical and has experienced significant downturns, often in conjunction with constant and rapid technological change, wide fluctuations in supply and demand, continuous new product introductions, price erosion and declines in general economic conditions. We have incurred substantial losses in recent downturns, due to: +• +substantial declines in average selling prices; +• the cyclical nature of supply and demand imbalances in the semiconductor industry; +• a decline in demand for end-user products (such as PCs) that incorporate our products; and +23 +• excess inventory levels. +Industry-wide fluctuations in the computer marketplace have materially adversely affected us in the past and may materially adversely affect us in the future. For example, a large portion of our Computing and Graphics revenue is focused on consumer desktop PC and notebook segments. While overall growth in Computing and Graphics is stabilizing, the areas within Computing and Graphics are changing. Our ability to take advantage of the opportunities within Computing and Graphics is based on foreseeing those changes and making timely investments in the form factors that serve those growing sub-segments. +Global economic uncertainty and weakness have in the past impacted the semiconductor market as consumers and businesses have deferred purchases, which negatively impacted demand for our products. Our financial performance has been, and may in the future be, negatively affected by these downturns. +The growth of our business is also dependent on continued demand for our products from high-growth adjacent emerging global markets. Our ability to be successful in such markets depends in part on our ability to establish adequate local infrastructure, as well as our ability to cultivate and maintain local relationships in these markets. If demand from these markets is below our expectations, sales of our products may decrease, which would have a material adverse effect on us. +Acquisitions, divestitures and/or joint ventures could disrupt our business, harm our financial condition and operating results or dilute, or adversely affect the price of, our common stock. +Our success will depend, in part, on our ability to expand our product offerings and grow our business in response to changing technologies, customer demands and competitive pressures. In some circumstances, we may pursue growth through the acquisition of complementary businesses, solutions or technologies or through divestitures or joint ventures rather than through internal development. The identification of suitable acquisition or joint venture candidates can be difficult, time-consuming and costly, and we may not be able to successfully complete identified acquisitions or joint ventures. Moreover, if such acquisitions or joint ventures require us to seek additional debt or equity financing, we may not be able to obtain such financing on terms favorable to us or at all. Even if we successfully complete an acquisition or a joint venture, we may not be able to assimilate and integrate effectively or efficiently the acquired business, technologies, solutions, assets, personnel or operations, particularly if key personnel of the acquired company decide not to work for us. Acquisitions and joint ventures may also involve the entry into geographic or business markets in which we have little or no prior experience. Consequently, we may not achieve anticipated benefits of the acquisitions or joint ventures which could harm our operating results. In addition, to complete an acquisition, we may issue equity securities, which would dilute our stockholders’ ownership and could adversely affect the price of our common stock, as well as incur debt, assume contingent liabilities or have amortization expenses and write-downs of acquired assets, which could adversely affect our results of operations. Acquisitions and joint ventures may also reduce our cash available for operations and other uses, which could harm our business. Also, any failure on our part to effectively evaluate and execute new business initiatives could adversely affect our business. We may not adequately assess the risk of new business initiatives and subsequent events may arise that alter the risks that were initially considered. +Furthermore, we may not achieve the objectives and expectations with respect to future operations, products and services.The majority of our ATMP services are provided by the JVs and there is no guarantee that the JVs will be able to fulfill our long-term ATMP requirements. If we are unable to meet customer demand due to fluctuating or late supply from the JVs, it could result in lost sales and have a material adverse effect on our business. +In addition, we may not realize the anticipated benefits from any new business initiatives. We have a joint venture with Higon Information Technology Co., Ltd. (formerly, Tianjin Haiguang Advanced Technology Investment Co., Ltd.) (THATIC), comprised of two separate legal entities, China JV1 and China JV2 (collectively, the THATIC JV). We may not realize the expected benefits from this joint venture, including the THATIC JV’s expected future performance, the receipt of any future milestone payments from certain licensed intellectual property, and the receipt of any royalty payments from future sales of products by the THATIC JV. +Our business is dependent upon the proper functioning of our internal business processes and information systems and modification or interruption of such systems may disrupt our business, processes and internal controls. +We rely upon a number of internal business processes and information systems to support key business functions, and the efficient operation of these processes and systems is critical to our business. Our business processes and information systems need to be sufficiently scalable to support the growth of our business and may require modifications or upgrades that expose us to a number of operational risks. As such, our information systems will continually evolve and adapt in order to meet our business needs. These changes may be costly and disruptive to our operations and could impose substantial demands on management time. +These changes may also require changes in our information systems, modification of internal control procedures and significant training of employees and third-party resources. We continuously work on simplifying our information systems and applications through consolidation and standardization efforts. There can be no assurance that our business and operations will not experience any disruption in connection with this transition. Our information technology systems, and those of third-party information technology providers or business partners, may also be vulnerable to damage or disruption caused by circumstances beyond our control including catastrophic events, power anomalies or outages, natural disasters, viruses or malware, cyber- +24 +attacks, data breaches and computer system or network failures, exposing us to significant cost, reputational harm and disruption or damage to our business. +In addition, as our IT environment continues to evolve, we are embracing new ways of communicating and sharing data internally and externally with customers and partners using methods such as mobility and the cloud that can promote business efficiency. However, these practices can also result in a more distributed IT environment, making it more difficult for us to maintain visibility and control over internal and external users, and meet scalability and administrative requirements. If our security controls cannot keep pace with the speed of these changes, or if we are not able to meet regulatory and compliance requirements, our business would be materially adversely affected. +If essential equipment, materials or manufacturing processes are not available to manufacture our products, we could be materially adversely affected. +We may purchase equipment and materials for use by our back-end manufacturing service providers from a number of suppliers and our operations depend upon obtaining deliveries of adequate supplies of equipment and materials on a timely basis. Our third-party suppliers also depend on the same timely delivery of adequate quantities of equipment and materials in the manufacture of our products. In addition, as many of our products increase in technical complexity, we rely on our third-party suppliers to update their processes in order to continue meeting our back-end manufacturing needs. Certain equipment and materials that are used in the manufacture of our products are available only from a limited number of suppliers, or in some cases, a sole supplier. We also depend on a limited number of suppliers to provide the majority of certain types of integrated circuit packages for our microprocessors, including our APU products. Similarly, certain non-proprietary materials or components such as memory, printed circuit boards (PCBs), interposers, substrates and capacitors used in the manufacture of our products are currently available from only a limited number of sources. Because some of the equipment and materials that we and our third-party manufacturing suppliers purchase are complex, it is sometimes difficult to substitute one supplier for another. From time to time, suppliers may extend lead times, limit supply or increase prices due to capacity constraints or other factors. Also, some of these materials and components may be subject to rapid changes in price and availability. Interruption of supply or increased demand in the industry could cause shortages and price increases in various essential materials. Dependence on a sole supplier or a limited number of suppliers exacerbates these risks. If we are unable to procure certain of these materials for our back-end manufacturing operations, or our third-party foundries or manufacturing suppliers are unable to procure materials for manufacturing our products, our business would be materially adversely affected. +If our products are not compatible with some or all industry-standard software and hardware, we could be materially adversely affected. +Our products may not be fully compatible with some or all industry-standard software and hardware. Further, we may be unsuccessful in correcting any such compatibility problems in a timely manner. If our customers are unable to achieve compatibility with software or hardware, we could be materially adversely affected. In addition, the mere announcement of an incompatibility problem relating to our products could have a material adverse effect on our business. +Costs related to defective products could have a material adverse effect on us. +Products as complex as those we offer may contain defects or failures when first introduced or when new versions or enhancements to existing products are released. We cannot assure you that, despite our testing procedures, errors will not be found in new products or releases after commencement of commercial shipments in the future, which could result in loss of or delay in market acceptance of our products, material recall and replacement costs, loss of revenue, writing down the inventory of defective products, the diversion of the attention of our engineering personnel from product development efforts, defending against litigation related to defective products or related liabilities, including property damage, personal injury, damage to our reputation in the industry and loss of data or intangible property, and could adversely affect our relationships with our customers. In addition, we may have difficulty identifying the end customers of the defective products in the field. As a result, we could incur substantial costs to implement modifications to correct defects. Any of these problems could materially adversely affect our business. +We could be subject to potential product liability claims if one of our products causes, or merely appears to have caused, an injury, whether tangible or intangible. Claims may be made by consumers or others selling our products, and we may be subject to claims against us even if an alleged injury is due to the actions of others. A product liability claim, recall or other claim with respect to uninsured liabilities or for amounts in excess of insured liabilities could have a material adverse effect on our business. +If we fail to maintain the efficiency of our supply chain as we respond to changes in customer demand for our products, our business could be materially adversely affected. +Our ability to meet customer demand for our products depends, in part, on our ability to deliver the products our customers want on a timely basis. Accordingly, we rely on our supply chain for the manufacturing, distribution and fulfillment of our products. As we continue to grow our business, expand to high-growth adjacent markets, acquire new customers and strengthen relationships with existing customers, the efficiency of our supply chain will become increasingly important because many of our customers tend to have specific requirements for particular products, and specific time-frames in which they require delivery +25 +of these products. If we are unable to consistently deliver the right products to our customers on a timely basis in the right locations, our customers may reduce the quantities they order from us, which could have a material adverse effect on our business. +We outsource to third parties certain supply-chain logistics functions, including portions of our product distribution, transportation management and information technology support services. +We rely on third-party providers to operate our regional product distribution centers and to manage the transportation of our work-in-process and finished products among our facilities, to our manufacturing suppliers and to our customers. In addition, we rely on third parties to provide certain information technology services to us, including help desk support, desktop application services, business and software support applications, server and storage administration, datacenter operations, database administration and voice, video and remote access. We cannot guarantee that these providers will fulfill their respective responsibilities in a timely manner in accordance with the contract terms, in which case our internal operations and the distribution of our products to our customers could be materially adversely affected. Also, we cannot guarantee that our contracts with these third-party providers will be renewed, in which case we would have to transition these functions in-house or secure new providers, which could have a material adverse effect on our business if the transition is not executed appropriately. +Our stock price is subject to volatility. +Our stock price has experienced price and volume fluctuations and could be subject to wide fluctuations in the future. The trading price of our stock may fluctuate widely due to various factors including, actual or anticipated fluctuations in our financial conditions and operating results, changes in financial estimates by us or financial estimates and ratings by securities analysts, changes in our capital structure, including issuance of additional debt or equity to the public, interest rate changes, news regarding our products or products of our competitors, and broad market and industry fluctuations. Stock price fluctuations could impact the value of our equity compensation, which could affect our ability to recruit and retain employees. In addition, volatility in our stock price could adversely affect our business and financing opportunities. +Worldwide political conditions may adversely affect demand for our products. +Worldwide political conditions may create uncertainties that could adversely affect our business. The United States has been and may continue to be involved in armed conflicts that could have a further impact on our sales and our supply chain. The consequences of armed conflict, political instability or civil or military unrest are unpredictable, and we may not be able to foresee events that could have a material adverse effect on us. Terrorist attacks or other hostile acts may negatively affect our operations, or adversely affect demand for our products, and such attacks or related armed conflicts may impact our physical facilities or those of our suppliers or customers. Furthermore, these attacks or hostile acts may make travel and the transportation of our products more difficult and more expensive, which could materially adversely affect us. Any of these events could cause consumer spending to decrease or result in increased volatility in the United States economy and worldwide financial markets. +Unfavorable currency exchange rate fluctuations could adversely affect us. +We have costs, assets and liabilities that are denominated in foreign currencies. As a consequence, movements in exchange rates could cause our foreign currency denominated expenses to increase as a percentage of revenue, affecting our profitability and cash flows. Whenever we believe appropriate, we hedge a portion of our short-term foreign currency exposure to protect against fluctuations in currency exchange rates. We determine our total foreign currency exposure using projections of long-term expenditures for items such as payroll. We cannot assure you that these activities will be effective in reducing foreign exchange rate exposure. Failure to do so could have an adverse effect on our business, financial condition, results of operations and cash flow. In addition, the majority of our product sales are denominated in U.S. dollars. Fluctuations in the exchange rate between the U.S. dollar and the local currency can cause increases or decreases in the cost of our products in the local currency of such customers. An appreciation of the U.S. dollar relative to the local currency could reduce sales of our products. +Our inability to effectively control the sales of our products on the gray market could have a material adverse effect on us. +We market and sell our products directly to OEMs and through authorized third-party distributors. From time to time, our products are diverted from our authorized distribution channels and are sold on the “gray market.” Gray market products result in shadow inventory that is not visible to us, thus making it difficult to forecast demand accurately. Also, when gray market products enter the market, we and our distribution channels compete with these heavily discounted gray market products, which adversely affects demand for our products and negatively impact our margins. In addition, our inability to control gray market activities could result in customer satisfaction issues because any time products are purchased outside our authorized distribution channels there is a risk that our customers are buying counterfeit or substandard products, including products that may have been altered, mishandled or damaged, or are used products represented as new. +26 +If we cannot adequately protect our technology or other intellectual property in the United States and abroad, through patents, copyrights, trade secrets, trademarks and other measures, we may lose a competitive advantage and incur significant expenses. +We rely on a combination of protections provided by contracts, including confidentiality and nondisclosure agreements, copyrights, patents, trademarks and common law rights, such as trade secrets, to protect our intellectual property. However, we cannot assure you that we will be able to adequately protect our technology or other intellectual property from third-party infringement or from misappropriation in the United States and abroad. Any patent licensed by us or issued to us could be challenged, invalidated or circumvented or rights granted there under may not provide a competitive advantage to us. +Furthermore, patent applications that we file may not result in issuance of a patent or, if a patent is issued, the patent may not be issued in a form that is advantageous to us. Despite our efforts to protect our intellectual property rights, others may independently develop similar products, duplicate our products or design around our patents and other rights. In addition, it is difficult to monitor compliance with, and enforce, our intellectual property on a worldwide basis in a cost-effective manner. In jurisdictions where foreign laws provide less intellectual property protection than afforded in the United States and abroad, our technology or other intellectual property may be compromised, and our business would be materially adversely affected. +We are party to litigation and may become a party to other claims or litigation that could cause us to incur substantial costs or pay substantial damages or prohibit us from selling our products. +From time to time, we are a defendant or plaintiff in various legal actions. For example, as described in Note 19 of our consolidated financial statements, we have been subject to certain claims concerning federal securities laws and corporate governance. Our products are purchased by and/or used by consumers, which could increase our exposure to consumer actions such as product liability claims and consumer class action claims, including those described in Note 19 of our consolidated financial statements. On occasion, we receive claims that individuals were allegedly exposed to substances used in our former semiconductor wafer manufacturing facilities and that this alleged exposure caused harm. Litigation can involve complex factual and legal questions, and its outcome is uncertain. It is possible that if a claim is successfully asserted against us, including the claims described in Note 19 of our consolidated financial statements, it could result in the payment of damages that could be material to our business. +With respect to intellectual property litigation, from time to time, we have been notified of, or third parties may bring or have brought, actions against us and/or against our customers based on allegations that we are infringing the intellectual property rights of others, contributing to or inducing the infringement of the intellectual property rights of others, improperly claiming ownership of intellectual property or otherwise improperly using the intellectual property of others. If any such claims are asserted, we may seek to obtain a license under the third parties’ intellectual property rights. We cannot assure you that we will be able to obtain all of the necessary licenses on satisfactory terms, if at all. These parties may file lawsuits against us or our customers seeking damages (potentially up to and including treble damages) or an injunction against the sale of products that incorporate allegedly infringed intellectual property or against the operation of our business as presently conducted, which could result in our having to stop the sale of some of our products or to increase the costs of selling some of our products or which could damage our reputation. The award of damages, including material royalty payments, or other types of damages, or the entry of an injunction against the manufacture and sale of some or all of our products could have a material adverse effect on us. We could decide, in the alternative, to redesign our products or to resort to litigation to challenge such claims. Such challenges could be extremely expensive and time-consuming regardless of their merit, could cause delays in product release or shipment and/or could have a material adverse effect on us. We cannot assure you that litigation related to our intellectual property rights or the intellectual property rights of others can always be avoided or successfully concluded. +Even if we were to prevail, any litigation could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could have a material adverse effect on us. +Our business is subject to potential tax liabilities. +The Company is subject to income tax, indirect tax or other tax claims by tax agencies in jurisdictions in which it conducts business. Significant judgment is required in determining our worldwide provision for income taxes. Tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. The United States federal government enacted significant tax reform, and certain provisions of the new law may adversely affect us. The Tax Cuts and Jobs Act of 2017 (the Tax Reform Act) has resulted in significant changes to the United States corporate income tax system. These changes include a federal statutory rate reduction from 35% to 21%, the elimination or reduction of certain domestic deductions and credits and limitations on the deductibility of interest expense. The Tax Reform Act also transitions international taxation from a worldwide system to a modified territorial system and includes base erosion prevention measures on non-U.S. earnings, which has the effect of subjecting certain earnings of our foreign subsidiaries to United States taxation. These changes became effective in 2018. +In the ordinary course of our business, there are many transactions and calculations where the ultimate income tax, indirect tax, or other tax determination is uncertain. Although we believe our tax estimates are reasonable, we cannot assure that the final +27 +determination of any tax audits and litigation will not be materially different from that which is reflected in historical tax provisions and accruals. Should additional taxes be assessed as a result of an audit, assessment or litigation, there could be a material adverse effect on our cash, tax provisions and net income in the period or periods for which that determination is made. +We are subject to environmental laws, conflict minerals-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as a variety of other laws or regulations that could result in additional costs and liabilities. +Our operations and properties have in the past been and continue to be subject to various United States and foreign laws and regulations, including those relating to materials used in our products and manufacturing processes, discharge of pollutants into the environment, the treatment, transport, storage and disposal of solid and hazardous wastes and remediation of contamination. These laws and regulations require our suppliers to obtain permits for operations making our products, including the discharge of air pollutants and wastewater. Although our management systems are designed to oversee our suppliers’ compliance, we cannot assure you that our suppliers have been or will be at all times in complete compliance with such laws, regulations and permits. If our suppliers violate or fail to comply with any of them, a range of consequences could result, including fines, suspension of production, alteration of manufacturing processes, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions. Such non-compliance from our manufacturing suppliers could result in disruptions in supply, higher sourcing costs, and/or reputational damage for us. +Environmental laws are complex, change frequently and have tended to become more stringent over time. For example, the European Union (EU) and China are two among a growing number of jurisdictions that have enacted restrictions on the use of lead and other materials in electronic products. These regulations affect semiconductor devices and packaging. As regulations restricting materials in electronic products continue to increase around the world, there is a risk that the cost, quality and manufacturing yields of products that are subject to these restrictions may be less favorable compared to products that are not subject to such restrictions, or that the transition to compliant products may not meet customer roadmaps, or produce sudden changes in demand, which may result in excess inventory. A number of jurisdictions including the EU, Australia, California and China are developing or have finalized market entry or public procurement regulations for computers and servers based on ENERGY STAR specifications as well as additional energy consumption limits. There is the potential for certain of our products being excluded from some of these markets which could materially adversely affect us. +Certain environmental laws, including the United States Comprehensive, Environmental Response, Compensation and Liability Act of 1980, or the Superfund Act, impose strict or, under certain circumstances, joint and several liability on current and previous owners or operators of real property for the cost of removal or remediation of hazardous substances and impose liability for damages to natural resources. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. These environmental laws also assess liability on persons who arrange for hazardous substances to be sent to disposal or treatment facilities when such facilities are found to be contaminated. Such persons can be responsible for cleanup costs even if they never owned or operated the contaminated facility. We have been named as a responsible party at three Superfund sites in Sunnyvale, California. Although we have not yet been, we could be named a potentially responsible party at other Superfund or contaminated sites in the future. In addition, contamination that has not yet been identified could exist at our other facilities. +Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC adopted disclosure and reporting requirements for companies that use “conflict” minerals originating from the Democratic Republic of Congo or adjoining countries. We continue to incur additional costs associated with complying with these requirements, such as costs related to developing internal controls for the due diligence process, determining the source of any conflict minerals used in our products, auditing the process and reporting to our customers and the SEC. In addition to the SEC regulation, the European Union, China and other jurisdictions are developing new policies focused on conflict minerals that may impact and increase the cost of our compliance program. Also, since our supply chain is complex, we may face reputational challenges if we are unable to sufficiently verify the origins of the subject minerals. Moreover, we are likely to encounter challenges to satisfy those customers who require that all of the components of our products are certified as “conflict free.” If we cannot satisfy these customers, they may choose a competitor’s products. +The United States federal government has issued new policies for federal procurement focused on eradicating the practice of forced labor and human trafficking. In addition, the United Kingdom, Australia and the State of California have issued laws that require us to disclose our policy and practices for identifying and eliminating forced labor and human trafficking in our supply chain. Several customers as well as the Responsible Business Alliance have also issued expectations to eliminate these practices that may impact us. While we have a policy and management systems to identify and avoid these practices in our supply chain, we cannot guarantee that our suppliers will always be in conformance to these laws and expectations. We may face enforcement liability and reputational challenges if we are unable to sufficiently meet these expectations. Moreover, we are likely to encounter challenges with customers if we cannot satisfy their forced and trafficked labor polices and they may choose a competitor’s product. +28 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +None. +ITEM 2. +PROPERTIES +As of December 29, 2018, we leased approximately 2.47 million square feet of space for research and development, engineering, administrative and warehouse use, including our headquarters in Santa Clara, California, our principal administrative facilities in Austin, Texas, our main facility with respect to graphics and chipset products located in Markham, Ontario, Canada and a number of smaller regional sales offices located in commercial centers near customers, principally in the United States, Latin America, Europe and Asia. These leases expire at varying dates through 2028, although some of these leases include optional renewals. We occupy 220,000 square feet of space in our headquarters in Santa Clara, California under a 10-year operating lease which commenced in August 2017. We have the option to extend the term of the lease for two additional 5-year periods. The lease for our principal administrative facilities in Austin, Texas expires in March 2025, and provides for one 10-year optional renewal. The leases for our facilities in Markham, Ontario, Canada expire in February 2028, and provide for one 5-year optional renewals. +We currently do not anticipate difficulty in either retaining occupancy of any of our facilities through lease renewals prior to expiration or through month-to-month occupancy, or replacing them with equivalent facilities. +We believe that our existing facilities are suitable and adequate for our present purposes, and that, the productive capacity of such facilities is substantially being utilized or we have plans to utilize such capacity. +ITEM 3. LEGAL PROCEEDINGS +Shareholder Derivative Lawsuits (Wessels, Hamilton and Ha) +On March 20, 2014, a purported shareholder derivative lawsuit captioned Wessels v. Read, et al. , Case No. 1:14 cv-262486 (Wessels) was filed against us (as a nominal defendant only) and certain of our directors and officers in the Santa Clara County Superior Court of the State of California. The complaint purports to assert claims against us and certain individual directors and officers for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by us and the individual directors and officers regarding our 32nm technology and “Llano” product, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for our common stock during the period. On April 27, 2015, a similar purported shareholder derivative lawsuit captioned Christopher Hamilton and David Hamilton v. Barnes, et al. , Case No. 5:15-cv-01890 (Hamilton) was filed against us (as a nominal defendant only) and certain of our directors and officers in the United States District Court for the Northern District of California. +On September 29, 2015, a similar purported shareholder derivative lawsuit captioned Jake Ha v Caldwell, et al., Case No. 3:15-cv-04485 (Ha) was filed against us (as a nominal defendant only) and certain of our directors and officers in the United States District Court for the Northern District of California. The lawsuit also seeks a court order voiding the stockholder vote on our 2015 proxy. The case was transferred to the judge handling the Hamilton Lawsuit and is now Case No. 4:15-cv-04485. The Wessels, Hamilton and Ha shareholder derivative lawsuits were stayed pending resolution of a class action lawsuit captioned Hatamian v. AMD, et al. , C.A. No. 3:14-cv-00226 filed against us in the United States District Court for the Northern District of California (the Hatamian Lawsuit). The Hatamian Lawsuit asserted claims against us and certain of our officers for alleged violations of Section 10(b) of the Exchange Act of 1934, as amended (the Exchange Act), and SEC Rule 10b-5 concerning certain statements regarding our 32nm technology and “Llano” products. On October 9, 2017, the parties signed a definitive settlement agreement resolving the Hatamian Lawsuit and submitted it to the Court for approval. Under the terms of this agreement, the settlement was funded entirely by certain of our insurance carriers and the defendants continued to deny any liability or wrongdoing. On March 2, 2018, the court approved the settlement and entered a final judgment in the Hatamian Lawsuit. +On January 30, 2018, the Wessels and Hamilton plaintiffs amended their complaints. On February 2, 2018, the Ha plaintiff also filed an amended complaint. On February 22, 2018, we filed motions to dismiss the Hamilton and Ha plaintiffs’ amended complaints. On April 2, 2018, we filed a demurrer seeking to dismiss the Wessels amended complaint. On July 23, 2018, the Santa Clara Superior Court sustained our demurrer in the Wessels case, dismissing all claims in that matter with prejudice. The Wessels plaintiff filed a Notice of Appeal on September 27, 2018. On October 4, 2018, the Federal Court issued an order dismissing the Hamilton and Ha amended complaints. The Hamilton plaintiffs filed a Notice of Appeal on October 8, 2018, and the Ha plaintiffs filed a Notice of Appeal on October 15, 2018. +The Wessels, Hamilton, and Ha appeals are currently pending; the plaintiffs have not yet filed their opening briefs in any of the three matters. On November 19, 2018, the Hamilton and Ha plaintiffs filed a motion seeking summary reversal of the order dismissing their claims. We opposed this motion on December 13, 2018, and it remains pending. +29 +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Kim Securities Litigation +On January 16, 2018, a putative class action lawsuit captioned Kim et al. v. AMD, et al. , Case No. 3:18-cv-00321 was filed against us in the United States District Court for the Northern District of California. The complaint purports to assert claims against us and certain individual officers for alleged violations of Sections 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 of the Exchange Act. The plaintiff seeks to represent a proposed class of all persons who purchased or otherwise acquired our common stock during the period February 21, 2017 through January 11, 2018. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by us and the individual officers regarding a security vulnerability (Spectre), which statements and omissions, the plaintiff claims, allegedly caused our common stock price to be artificially inflated during the purported class period. The complaint seeks unspecified compensatory damages, attorneys’ fees and costs. On August 3, 2018, plaintiffs filed an amended complaint with similar allegations and shortening the class period to June 29, 2017 through January 11, 2018. We filed a motion to dismiss plaintiffs’ claims on September 25, 2018, and plaintiffs filed an opposition to our motion to dismiss on November 14, 2018. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Hauck et al. Litigation +Since January 19, 2018, three putative class action complaints have been filed against us in the United States District Court for the Northern District of California: (1) Diana Hauck et al. v. AMD, Inc., Case No. 5:18-cv-0047, filed on January 19, 2018; (2) Brian Speck et al. v. AMD, Inc. , Case No. 5:18-cv-0744, filed on February 4, 2018; and (3) Nathan Barnes and Jonathan Caskey-Medina, et al. v. AMD, Inc. , Case No. 5:18-cv-00883, filed on February 9, 2018. On April 9, 2018, the court consolidated these cases and ordered that Diana Hauck et al. v. AMD, Inc. serve as the lead case. On June 13, 2018, six plaintiffs (from California, Louisiana, Florida, and Massachusetts) filed a consolidated amended complaint alleging that we failed to disclose our processors’ alleged vulnerability to Spectre. Plaintiffs further allege that our processors cannot perform at their advertised processing speeds without exposing consumers to Spectre, and that any “patches” to remedy this security vulnerability will result in degradation of processor performance. The plaintiffs seek damages under several causes of action on behalf of a nationwide class and four state subclasses (California, Florida, Massachusetts, Louisiana) of consumers who purchased our processors and/or devices containing AMD processors. The plaintiffs also seek attorneys’ fees, equitable relief, and restitution. Pursuant to the court’s order directing the parties to litigate only eight of the causes of action in the consolidated amended complaint initially, we filed a motion to dismiss on July 13, 2018. On October 29, 2018, after the plaintiffs voluntarily dismissed one of their claims, the court granted our motion and dismissed six causes of action with leave to amend. The plaintiffs filed their amended consolidated complaint on December 6, 2018. On January 3, 2019, we again moved to dismiss the subset of claims currently at issue. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Quarterhill Inc. Litigation +On July 2, 2018, three entities named Aquila Innovations, Inc. (Aquila), Collabo Innovations, Inc. (Collabo), and Polaris Innovations, Ltd. (Polaris), filed separate patent infringement complaints against us in the United States District Court for the Western District of Texas. Aquila alleges that we infringe two patents (6,239,614 and 6,895,519) relating to power management; Collabo alleges that we infringe one patent (7,930,575) related to power management; and Polaris alleges that we infringe two patents (6,728,144 and 8,117,526) relating to control or use of dynamic random-access memory, or DRAM. Each of the three complaints seeks unspecified monetary damages, interest, fees, expenses, and costs against us; Aquila and Collabo also seek enhanced damages. Aquila, Collabo, and Polaris each appear to be related to a patent assertion entity named Quarterhill Inc. (formerly WiLAN Inc.). On November 16, 2018, AMD filed answers in the Collabo and Aquila cases and filed a motion to dismiss in the Polaris case. On January 25, 2019, we filed amended answers and counterclaims in the Collabo and Aquila cases. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Zeng Shareholder Derivative Lawsuit +On March 8, 2018, a purported shareholder derivative lawsuit captioned Zeng v. Su, et al. , Case No. 18CIV01192 was filed against us (as a nominal defendant only) and certain of our directors and officers in the San Mateo County Superior Court of the State of California. The complaint purports to assert claims against us and certain individual directors and officers for breach of +30 +fiduciary duty, unjust enrichment, abuse of control, gross mismanagement and waste of corporate assets. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by us and the individual directors and officers regarding Spectre, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for our common stock during the period. On April 26, 2018, the lawsuit was transferred to Santa Clara County and assigned a new case number, 18CV327692. On August 14, 2018, the Court stayed this lawsuit pending a decision on the motion to dismiss in Kim et al. v. AMD, et al. , Case No. 3:18-cv-00321 filed against us in the United States District Court for the Northern District of California. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +In re Advanced Micro Devices, Inc. Shareholder Derivative Litigation +Two purported shareholder derivative lawsuits were filed against us (as a nominal defendant only) and certain of our directors and officers in the United States District Court, Northern District of California: (1) Jacqueline Dolby, derivatively on behalf of AMD, Inc. v. Su et al., Case No. 5:18-cv-03575, filed on June 14, 2018; and (2) Gusinsky Trust, derivatively on behalf of AMD, Inc. v. Su et al., Case No. 5:18-cv-03811, filed on June 26, 2018. The complaints purport to assert claims against us and certain individual directors and officers for violation of Section 14(a) of the Exchange Act and SEC Rule 14a-9, breach of fiduciary duty, waste of corporate assets, and unjust enrichment. The complaints seek damages purportedly caused by alleged materially misleading statements and/or material omissions by us and the individual directors and officers regarding Spectre. The plaintiffs allege that these statements and omissions operated to artificially inflate the price paid for our common stock during the period. On July 12, 2018, the court consolidated the Dolby and Gusinsky Trust shareholder derivative lawsuits under the caption In re Advanced Micro Devices, Inc. Shareholder Derivative Litigation. On August 10, 2018, the Court stayed this lawsuit pending a decision on the motion to dismiss in Kim et al. v. AMD, et al. , Case No. 3:18-cv-00321 filed against us in the United States District Court for the Northern District of California. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Dickey Litigation +On October 26, 2015, a putative class action complaint captioned Dickey et al. v. AMD , No. 15-cv-04922 was filed against us in the United States District Court for the Northern District of California. Plaintiffs allege that we misled consumers by using the term “eight cores” in connection with the marketing of certain AMD FX CPUs that are based on our “Bulldozer” core architecture. The plaintiffs allege these products cannot perform eight calculations simultaneously, without restriction. The plaintiffs seek to obtain damages under several causes of action for a nationwide class of consumers who allegedly were deceived into purchasing certain Bulldozer-based CPUs that were marketed as containing eight cores. The plaintiffs also seek attorneys’ fees. On December 21, 2015, we filed a motion to dismiss the complaint, which was granted on April 7, 2016. The plaintiffs then filed an amended complaint with a narrowed putative class definition, which the Court dismissed upon our motion on October 31, 2016. The plaintiffs subsequently filed a second amended complaint, and we filed a motion to dismiss the second amended complaint. On June 14, 2017, the Court issued an order granting in part and denying in part our motion to dismiss, and allowing the plaintiffs to move forward with a portion of their complaint. On March 27, 2018, plaintiffs filed their motion for class certification. On January 17, 2019, the Court granted plaintiffs’ motion for class certification. The class definition does not encompass our Ryzen TM or EPYC TM processors. On January 31, 2019, we filed a petition in the Ninth Circuit Court of Appeals seeking review of certain aspects of the January 17, 2019 class certification order. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Environmental Matters +We are named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, we have discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, we received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. We have entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. We remain responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +31 +To address anticipated future remediation costs under the orders, we have computed and recorded an estimated environmental liability of approximately $3 million and have not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. Costs could also increase as a result of additional test and remediation obligations imposed by the Environmental Protection Agency or California Regional Water Quality Control Board. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. We believe that the potential liability, if any, in excess of amounts already accrued, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Other Matters +We are a defendant or plaintiff in various actions that arose in the normal course of business. With respect to these matters, based on our management’s current knowledge, we believe that the amount or range of reasonably possible loss, if any, will not, either individually or in the aggregate, have a material adverse effect on our business, financial position, results of operations or cash flows. +ITEM 4. MINE SAFETY DISCLOSURES +Not Applicable. +32 +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on The NASDAQ Global Select Market (NASDAQ) under the symbol “AMD”. On February 1, 2019, there were 4,614 registered holders of our common stock, and the closing price of our common stock was $24.51 per share as reported on NASDAQ. +For information about our equity compensation plans, see Part III, Item 11, below. +Performance Graph +Comparison of Five-Year Cumulative Total Returns +Advanced Micro Devices, S&P 500 Index and S&P 500 Semiconductor Index +The following graph shows a five-year comparison of cumulative total return on our common stock, the S&P 500 Index and the S&P 500 Semiconductor Index from December 28, 2013 through December 29, 2018. The past performance of our common stock is no indication of future performance. +Base Period +Years Ending +Company / Index +12/28/2013 +12/27/2014 +12/26/2015 +12/31/2016 +12/30/2017 +12/29/2018 +Advanced Micro Devices, Inc. +100 +70.11 +77.25 +300.00 +271.96 +471.43 +S&P 500 Index +100 +115.76 +116.64 +129.55 +157.84 +150.92 +S&P 500 Semiconductors Index +100 +139.35 +140.00 +175.90 +239.79 +224.48 +33 +Unregistered Sales of Equity Securities +On December 26, 2018, we issued warrants to purchase 127,435 shares of our common stock to a commercial partner pursuant to a strategic arrangement with such partner. The warrants have an exercise price of $20.0423 per share and expire on December 26, 2021. The warrants were issued pursuant to Section 4(a)(2) of the Securities Act of 1933, as amended. +During the fourth quarter of 2018, we settled $35 million in aggregate principal amount of our 7.00% Senior Notes due 2024 (7.00% Notes) with 1,789,751 treasury shares. +34 +ITEM 6. +SELECTED FINANCIAL DATA +2018 (1) +2017 (1)(2) +2016 (1)(2) +2015 (1) +2014 (1) +In millions except per share amounts +Net revenue +$ +6,475 +$ +5,253 +$ +4,319 +$ +3,991 +$ +5,506 +Net income (loss) (3)(4)(5)(6)(7) +337 +(33 +) +(498 +) +(660 +) +(403 +) +Earnings (loss) per share +Basic +$ +0.34 +$ +(0.03 +) +$ +(0.60 +) +$ +(0.84 +) +$ +(0.53 +) +Diluted +$ +0.32 +$ +(0.03 +) +$ +(0.60 +) +$ +(0.84 +) +$ +(0.53 +) +Shares used in per share calculation +Basic +982 +952 +835 +783 +768 +Diluted +1,064 +952 +835 +783 +768 +Long-term debt, net and other long term liabilities (8)(9) +$ +1,306 +$ +1,443 +$ +1,559 +$ +2,093 +$ +2,110 +Total assets (9) +$ +4,556 +$ +3,552 +$ +3,328 +$ +3,084 +$ +3,737 +(1) +2018, 2017, 2015 and 2014 each consisted of 52 weeks, whereas 2016 consisted of 53 weeks. +(2) +2017 and 2016 amounts adjusted to reflect the retrospective application of Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers . Refer to Note 2 Summary of Significant Accounting Policies. +(3) +During the third quarter of 2016, we agreed to pay GF $100 million in installments related to the Sixth Amendment with GF starting in the fourth fiscal quarter of 2016 through the third quarter of 2017. As of December 30, 2017, we paid GF $100 million in aggregate. In addition, in 2016 we recorded a charge of $340 million in Cost of sales, consisting of the $100 million payment under the Sixth Amendment and the $240 million value of the warrant under the Warrant Agreement issued in consideration of the Sixth Amendment. +(4) +In 2015 and 2014, we implemented restructuring plans and incurred net charges of $53 million and $58 million in 2015 and 2014, respectively, which primarily consisted of severance and related employee benefits. +(5) +In 2015, we exited the dense server systems business, formerly SeaMicro resulting in a charge of $76 million in restructuring and other special charges, net. In 2014, we incurred other special charges of $13 million primarily related to the departure of a former CEO. +(6) +In 2014, we recorded a goodwill impairment charge of $233 million related to our Computing and Graphics segment. Also in 2014, we recorded a $58 million lower of cost or market inventory adjustment related to our second generation APU products. In 2015, we recorded an inventory write-down of $65 million, which was primarily the result of lower anticipated demand for older-generation APUs, and a technology node transition charge of $33 million. +(7) +In 2016, we recorded a cumulative pre-tax gain on the sale of our 85% equity interest in ATMP JV of $146 million which was recognized in Other income (expense) on our consolidated statements of operations. +(8) +Total long-term debt and other long term liabilities decreased by $534 million from 2015 to 2016, primarily due to $1,048 million of net debt repayment, partially offset by the issuance of $805 million in principal amount of 2.125% Notes net of unamortized discount of $308 million and unamortized financing cost of $14 million, and $38 million increase in other long-term liabilities mainly due to higher technology licenses payable. +(9) +Amounts retrospectively reflected adoption of FASB ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs beginning in the first quarter of 2016. We reclassified debt issuance costs from long-term assets to long-term debt, net by $25 million and $30 million for 2015 and 2014, respectively, on our consolidated balance sheets. +35 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +The following discussion should be read in conjunction with the consolidated financial statements as of December 29, 2018 and December 30, 2017 and for each of the three years in the period ended December 29, 2018 and related notes, which are included in this Annual Report on Form 10-K as well as with the other sections of this Annual Report on Form 10-K, including “Part I, Item 1: Business,” “Part II, Item 6: Selected Financial Data” and “Part II, Item 8: Financial Statements and Supplementary Data.” +Introduction +We are a global semiconductor company primarily offering: +• +x86 microprocessors, as standalone devices or as incorporated into an accelerated processing unit (APU), chipsets, discrete and integrated graphics processing units (GPUs), and professional GPUs; and +• +server and embedded processors, semi-custom System-on-Chip (SoC) products and technology for game consoles. +We also license portions of our intellectual property (IP) portfolio. +In this management’s discussion and analysis (MD&A), we will describe the results of operations and the financial condition for us and our consolidated subsidiaries, including a discussion of our results of operations for 2018 compared to 2017 and 2017 compared to 2016 , an analysis of changes in our financial condition and a discussion of our contractual obligations and off balance sheet arrangements. +Overview +Our 2018 financial results demonstrate the success of our strong product roadmap execution. Customers continued to adopt our high performance products as new products accounted for over 65% of our annual 2018 revenue. Net revenue for 2018 was $6.5 billion, an increase of 23% compared to 2017 net revenue of $5.3 billion. Gross margin, as a percentage of net revenue for 2018, was 38%, a 4% increase compared to 34% in 2017. Our operating income for 2018 improved to $451 million compared to operating income of $127 million for 2017. Our net income for 2018 improved to $337 million compared to a net loss of $33 million in the prior year. +We significantly expanded our desktop processor offerings in 2018 with the launch of our second-generation AMD Ryzen and high-end AMD Ryzen Threadripper™ WX processors for gamers, creators and hardware enthusiasts. We announced the availability of our first desktop consumer and commercial Ryzen and Ryzen PRO APUs that combine our high-performance “Zen” CPU and Radeon “Vega” graphics cores into a single chip. We also introduced the first entry-level processors based on our “Zen” CPU and “Vega” GPU cores for the consumer and commercial desktop PC market with the AMD Athlon™ and AMD PRO processors. In the notebook market, multiple customers launched premium consumer and commercial PCs featuring our mobile AMD Ryzen APUs, including our first enterprise-class notebooks powered by our new AMD Ryzen PRO APUs. For the high-performance embedded markets, we introduced the AMD EPYC™ Embedded 3000 processor and AMD Ryzen Embedded V1000 processor families that bring new levels of computing and graphics performance to the thin client, digital signage, and infrastructure markets. +Cash, cash equivalents and marketable securities as of December 29, 2018 were $1.16 billion, down from $1.18 billion at the end of 2017. Principal amount of total debt as of December 29, 2018 was $1.53 billion, compared to $1.70 billion as of December 30, 2017. +We intend the discussion of our financial condition and results of operations that follows to provide information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period, the primary factors that resulted in those changes, and how certain accounting principles, policies and estimates affect our financial statements. +Critical Accounting Estimates +Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts in our consolidated financial statements. We evaluate our estimates on an on-going basis, including those related to our revenue, inventories, goodwill impairments and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Although actual results have historically been reasonably consistent with +36 +management’s expectations, the actual results may differ from these estimates or our estimates may be affected by different assumptions or conditions. +Management believes the following critical accounting estimates are the most significant to the presentation of our financial statements and require the most difficult, subjective and complex judgments. +Revenue recognition. In accordance with the adoption of the new revenue standard effective the beginning of the first quarter of 2018, we now recognize revenue upon the shipment of the product to our distributors (sell-in), rather than upon the resale of the product by our distributors to their customers (sell-through). Accordingly, we have established provisions for rights of return and price protection on unsold product held by our distributors. +Revenue Allowances. We record a provision for estimated sales returns and allowances on product sales for estimated future price reductions and other customer incentives in the same period that the related revenues are recorded. We base these estimates on actual historical sales returns, historical allowances, historical price reductions, market activity and other known or anticipated trends and factors. These estimates are subject to management’s judgment and actual provisions could be different from our estimates and current provisions, resulting in future adjustments to our revenue and operating results. +Inventory Valuation. At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence based on projected sales outlook. This evaluation includes analysis of historical sales levels by product and projections of future demand. These projections assist us in determining the carrying value of our inventory. In addition, we write off inventories that we consider obsolete. We adjust the remaining specific inventory balances to approximate the lower of our standard manufacturing cost or net realizable value. Among other factors, management considers forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and realizable value. If in any period we anticipate future demand or market conditions to be less favorable than our previous estimates, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made. This would have a negative impact on our gross margin in that period. If in any period we are able to sell inventories that were not valued or that had been written down in a previous period, related revenues would be recorded without any offsetting charge to cost of sales resulting in a net benefit to our gross margin in that period. +Goodwill. We perform our goodwill impairment analysis as of the first day of the fourth quarter of each year and, if certain events or circumstances indicate that an impairment loss may have been incurred, on a more frequent basis. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. +Qualitative factors include industry and market consideration, overall financial performance, share price trends and market capitalization and Company-specific events. We first analyze qualitative factors. If we conclude it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, we do not proceed to perform a quantitative impairment test. +A quantitative impairment analysis, if necessary, considers the income approach, which requires estimates of the present value of expected future cash flows to determine a reporting unit’s fair value. Significant estimates include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates, and future economic and market conditions. If we conclude it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative goodwill impairment test will be performed by comparing the fair value of each reporting unit to its carrying value. +A goodwill impairment charge is recognized for the amount by which the reporting unit’s fair value is less than its carrying value. Any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +Income Taxes. In determining taxable income for financial statement reporting purposes, we must make certain estimates and judgments. These estimates and judgments are applied in the calculation of certain tax liabilities and in the determination of the recoverability of deferred tax assets which arise from temporary differences between the recognition of assets and liabilities for tax and financial statement reporting purposes. +We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our charge to income tax expense in the form of a valuation allowance for the deferred tax assets that we estimate will not ultimately be recoverable. We consider past performance, future expected taxable income and prudent and feasible tax planning strategies in determining the need for a valuation allowance. +In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax rules and the potential for future adjustment of our uncertain tax positions by the Internal Revenue Service or other taxing authorities. If our estimates of these taxes are greater or less than actual results, an additional tax benefit or charge will result. We recognize the interest and penalties related to unrecognized tax benefits as interest expense and income tax expense, respectively. +37 +In December 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act of 2017 (Tax Reform Act). The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates, implementing a modified territorial tax system and imposing a transition tax on deemed repatriated earnings of foreign subsidiaries. The Tax Reform Act permanently reduces the U.S. corporate income tax rate from a maximum of 35% to a flat 21% rate, effective January 1, 2018. The SEC staff issued Staff Accounting Bulletin No. 118 (SAB 118) to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act. More specifically, SAB 118 allowed companies to record provisional amounts during a measurement period that is similar to the measurement period used when accounting for business combinations. As a result, we have recognized the provisional tax impacts related to deemed repatriated earnings and the revaluation of deferred tax assets and liabilities in our consolidated financial statements for the year ended December 30, 2017. During 2018, we finalized our computation of the impact of the Tax Reform Act. +In January 2018, the FASB released guidance on the accounting for tax on the global intangible low-taxed income (GILTI) provisions of the Tax Reform Act. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The guidance allows companies to make an accounting policy election to either (i) account for GILTI as a component of tax expense in the period in which they are subject to the rules (the period cost method), or (ii) account for GILTI in the Company’s measurement of deferred taxes (the deferred method). After completing the analysis of the GILTI provisions, we elected to account for GILTI using the period cost method. +Results of Operations +We report our financial performance based on the following two reportable segments:the Computing and Graphics segment and the Enterprise, Embedded and Semi-Custom segment. +Additional information on our reportable segments is contained in Note 15: Segment Reporting of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). +Our operating results tend to vary seasonally. Historically, first quarter PC product sales were generally lower than fourth quarter sales and with respect to our semi-custom SoC products for game consoles our sales pattern usually reflects higher sales in the second and third quarters compared to the first and fourth quarters. +The following table provides a summary of net revenue and operating income (loss) by segment for 2018 , 2017 and 2016 . +2018 +2017 +2016 +(In millions) +Net revenue: +Computing and Graphics +$ +4,125 +$ +2,977 +$ +1,988 +Enterprise, Embedded and Semi-Custom +2,350 +2,276 +2,331 +Total net revenue +$ +6,475 +$ +5,253 +$ +4,319 +Operating income (loss): +Computing and Graphics +$ +470 +$ +92 +$ +(243 +) +Enterprise, Embedded and Semi-Custom +163 +132 +287 +All Other +(182 +) +(97 +) +(417 +) +Total operating income (loss) +$ +451 +$ +127 +$ +(373 +) +Computing and Graphics +Computing and Graphics net revenue of $4.1 billion in 2018 increased by 39% , compared to $3.0 billion in 2017 , primarily as a result of a 15% increase in average selling price and a 17% increase in unit shipments. The increase in average selling price and unit shipments was primarily driven by higher demand for our Ryzen™ processors. +Computing and Graphics net revenue of $3.0 billion in 2017 increased by 50%, compared to $2.0 billion in 2016 as a result of a 38% increase in average selling price and a 1% increase in unit shipments. The increase in the average selling price was primarily driven by Ryzen desktop processor and Radeon graphics products sales. The increase in unit shipments was primarily attributable to higher demand for our Radeon graphics products. +Computing and Graphics operating income was $470 million in 2018 compared to operating income of $92 million in 2017 . The improvement in operating income was primarily driven by higher demand for Ryzen and Radeon products as customers continued to adopt our new products, partially offset by a $195 million increase in operating expenses. Operating expenses increased for the reasons set forth under “Expenses” below. +38 +Computing and Graphics operating income was $92 million in 2017 , compared to an operating loss of $243 million in 2016 . The improvement in operating results was primarily due to the increase in net revenue referenced above, partially offset by the related increase in cost of sales and operating expenses. Operating expenses increased for the reasons set forth under “Expenses” below. +Enterprise, Embedded and Semi-Custom +Enterprise, Embedded and Semi-Custom net revenue of $2.4 billion in 2018 increased by 3% compared to net revenue of $2.3 billion 2017 . The increase in net revenue was primarily due to higher sales of our EPYC™ server products, partially offset by lower semi-custom revenue. +Enterprise, Embedded and Semi-Custom net revenue of $2.28 billion in 2017 decreased by 2% compared to net revenue of $2.33 billion in 2016 . IP related revenue and sales of our EPYC datacenter processors, which were launched in June of 2017, were mostly offset by a decrease in non-recurring engineering (NRE) revenue and lower sales of our semi-custom SoC products. +Enterprise, Embedded and Semi-Custom operating income was $163 million in 2018 compared to operating income of $132 million in 2017 . The improvement in operating income was due primarily to richer server and semi-custom product mix, partially offset by a $50 million increase in operating expenses and lower IP-related revenue. In 2017, operating income also included a licensing gain of $52 million. Operating expenses increased for the reasons set forth under “Expenses” below. +Enterprise, Embedded and Semi-Custom operating income was $132 million in 2017 compared to operating income of $287 million in 2016 . The decline in operating results was primarily due to an increase in operating expenses driven primarily by datacenter-related expenses and lower licensing gain recorded in 2017 related to the licensed IP to the THATIC JV compared to 2016. Operating expenses increased for the reasons set forth under “Expenses” below. +All Other +All Other operating loss of $182 million in 2018 included stock-based compensation expense of $137 million and an impairment of technology licenses of $45 million . +All Other operating loss of $97 million in 2017 was related to stock-based compensation expense. +All Other operating loss of $417 million in 2016 included a charge of $340 million, which was comprised of the $100 million payment under the Sixth Amendment and the $240 million value of the warrant under the Warrant Agreement with WCH, and stock-based compensation expense of $86 million, partially offset by restructuring reversals of $10 million. +Comparison of Gross Margin, Expenses, Interest Expense, Other Income (Expense), Net Income Taxes and Equity Loss in Investee +The following is a summary of certain consolidated statement of operations data for 2018 , 2017 and 2016 : +2018 +2017 +2016 +(In millions, except for percentages) +Cost of sales +$ +4,028 +$ +3,466 +$ +3,316 +Gross margin +2,447 +1,787 +1,003 +Gross margin percentage +38 +% +34 +% +23 +% +Research and development +1,434 +1,196 +1,008 +Marketing, general and administrative +562 +516 +466 +Restructuring and other special charges, net +— +— +(10 +) +Licensing gain +— +(52 +) +(88 +) +Interest expense +(121 +) +(126 +) +(156 +) +Other income (expense), net +— +(9 +) +80 +Provision (benefit) for income taxes +(9 +) +18 +39 +Equity loss in investee +$ +(2 +) +$ +(7 +) +$ +(10 +) +Gross Margin +Gross margin as a percentage of net revenue was 38% in 2018 compared to 34% in 2017 . The improvement in gross margin was primarily driven by the ramp of new products with higher gross margin than the corporate average. +39 +Gross margin as a percentage of net revenue was 34% in 2017 compared to 23% in 2016 . Gross margin improved in 2017 primarily due to the absence of the charge of $340 million recorded in 2016, comprised of a $100 million payment under the Sixth Amendment and the value of the warrant of $240 million under the Warrant Agreement, which accounted for eight gross margin percentage points. In addition, the increase in gross margin percentage for 2017 compared to 2016 was due to a favorable shift in product mix to new Radeon GPU and Ryzen desktop processor products in the Computing and Graphics segment. +Expenses +Research and Development Expenses +Research and development expenses of $1.4 billion in 2018 increased by $238 million , or 20% , compared to $1.2 billion in 2017 . The increase was primarily driven by a $168 million increase in product engineering and design related costs attributable to both segments, and higher annual employee incentives driven by improved financial performance. +Research and development expenses of $1.2 billion in 2017 increased by $188 million , or 19% , compared to $1.0 billion in 2016 . The increase was primarily due to a $136 million increase in product engineering and design related costs attributable to both segments, and higher annual employee incentives driven by improved financial performance. +Marketing, General and Administrative Expenses +Marketing, general and administrative expenses of $562 million in 2018 increased by $46 million , or 9% , compared to $516 million in 2017 . The increase was primarily due to a $41 million increase in sales and marketing activities attributable to both segments and higher annual employee incentives driven by our improved financial performance. +Marketing, general and administrative expenses of $516 million in 2017 increased by $50 million , or 11% , compared to $466 million in 2016 . The increase was primarily due to a $29 million increase in sales and marketing activities attributable to both segments and higher annual employee incentives driven by our improved financial performance. +Interest Expense +Interest expense of $121 million in 2018 decreased by $5 million compared to $126 million in 2017 , primarily due to lower debt balances and lower weighted average interest rates . +Interest expense of $126 million in 2017 decreased by $30 million compared to $156 million in 2016 , primarily due to lower weighted average interest rates and lower debt balances. +Other Income (Expense), Net +Other income (expense) , net of zero in 2018 changed by $9 million compared to $9 million Other expense , net in 2017 . The change from 2017 to 2018 was primarily due to $12 million higher interest income in 2018 mainly related to a withholding tax refund from a foreign jurisdiction. +Other expense, net of $9 million in 2017 changed by $89 million compared to $80 million Other income , net in 2016 . The change from 2016 to 2017 was primarily due to the absence in 2017 of the substantial gain on sale of equity interests in ATMP JV that was partially offset by loss on debt redemption in 2016. +Provision (Benefit) For Income Taxes +We recorded an income tax benefit of $9 million in 2018 and an income tax provision of $18 million and $39 million in 2017 and 2016 , respectively. +The income tax benefit in 2018 was primarily due to a $36 million refund of withholding tax from a foreign jurisdiction related to a legal settlement from 2010, offset by $13 million of U.S. income taxes resulting from the Tax Reform Act, $7 million tax provision in foreign locations and $7 million of withholding taxes on cross-border transactions. +The income tax provision in 2017 was primarily due to withholding taxes applicable to IP-related revenue and licensing gains from foreign locations. +The income tax provision in 2016 was primarily due to $41 million of foreign taxes in profitable locations including $27 million attributable to a gain on the sale of 85% of the ownership interest in the subsidiary operating a factory in Suzhou and $9 million of withholding taxes on cross-border transactions where no foreign tax credit is expected to be realizable, offset by $2 million of tax benefits for Canadian tax credits and the monetization of certain U.S. tax credits. +40 +International Sales +International sales as a percentage of net revenue were 80% in 2018 and 74% in 2017 . The increase in international sales as a percentage of net revenue in 2018 compared to 2017 was primarily driven by a higher proportion of revenue from China and Taiwan related to sales of our products within the Computing and Graphics segment. +International sales as a percentage of net revenue were 74% in 2017 and 79% in 2016 . The decrease in international sales as a percentage of net revenue in 2017 compared to 2016 was primarily driven by a higher proportion of revenue from domestic sales of our desktop processors, graphics processors and semi-custom SoC products. +We expect that international sales will continue to be a significant portion of total sales in the foreseeable future. Substantially all of our sales transactions were denominated in U.S. dollars. +FINANCIAL CONDITION +Liquidity and Capital Resources +As of December 29, 2018 , our cash, cash equivalents and marketable securities were $1.16 billion compared to $1.18 billion as of December 30, 2017 . The percentage of cash and cash equivalents held domestically was 88% as of December 29, 2018 , and 95% as of December 30, 2017 . Our operating, investing and financing activities for fiscal 2018 , 2017 and 2016 were as follows: +2018 +2017 +2016 +(In millions) +Net cash provided by (used in): +Operating activities +$ +34 +$ +12 +$ +81 +Investing activities +(170 +) +(54 +) +277 +Financing activities +28 +(33 +) +122 +Net increase (decrease) in cash and cash equivalents, and restricted cash +$ +(108 +) +$ +(75 +) +$ +480 +Our aggregate principal debt obligations were $1.5 billion and $1.7 billion as of December 29, 2018 and December 30, 2017 , respectively. +We believe our cash, cash equivalents and marketable securities balance along with our Secured Revolving Line of Credit will be sufficient to fund operations, including capital expenditures, over the next 12 months. We believe we will be able to access the capital markets should we require additional funds. However, we cannot assure that such funds will be available on favorable terms, or at all. +Operating Activities +Net cash provided by operating activities was $34 million in 2018 compared to net cash provided by operating activities of $12 million in 2017 . The increase in net cash provided in operating activities was primarily due to changes in working capital, largely driven by higher cash collections from increased revenue, partially offset by higher labor costs and timing of accounts payable payments. +Net cash provided by operating activities was $12 million in 2017 compared to net cash provided by operating activities of $81 million in 2016 . The decrease in cash inflows from operating activities was primarily due to higher operating costs including higher wafer purchases and higher labor costs, partially offset by higher cash collection primarily due to higher revenue and lower interest payments resulting from debt reductions. +Investing Activities +Net cash used in investing activities was $170 million in 2018, which primarily consisted of $163 million for purchases of property and equipment, a net cash outflow from purchases and maturities of available-for-sale debt securities partially offset by collection of deferred proceeds on sale of receivables. +Net cash used in investing activities was $54 million in 2017, which consisted primarily of a cash outflow of $113 million for purchases of property and equipment, partially offset by collection of deferred proceeds on sale of receivables. +Net cash provided by investing activities was $277 million in 2016, which primarily consisted of a net cash inflow of $342 million from sale of equity interests in the ATMP JV, partially offset by purchases of property and equipment . +41 +Financing Activities +Net cash provided by financing activities was $28 million in 2018, which consisted of a net cash inflow of $69 million from the issuance of common stock through employee equity incentive plans, partially offset by the repurchase of an aggregate principal amount of $40 million of our outstanding 6.75% Senior Notes due 2019 (6.75% Notes) and 7.00% Senior Notes due 2024 (7.00% Notes) for $41 million in cash. +Net cash used in financing activities was $33 million in 2017, which primarily consisted of the repurchases of an aggregate principal amount of $103 million of our outstanding 6.75% Notes and 7.00% Notes for $110 million in cash and $13 million for tax withholding on the vesting of restricted stock, partially offset by the $70 million net proceeds from our Secured Revolving Line of Credit and the $20 million proceeds from issuance of common stock under stock-based compensation equity plans. +Net cash provided by financing activities was $122 million in 2016, which primarily consisted of the $782 million net proceeds from the issuance of our 2.125% Convertible Senior Notes due 2026 (2.125% Notes), the $667 million net proceeds from selling 115 million shares of our common stock and the $20 million proceeds from issuance of common stock under stock-based compensation equity plans, partially offset by the repurchases of an aggregate principal amount of $1.1 billion of our outstanding 6.75% Notes, 7.75% Senior Notes due 2020 (7.75% Notes), 7.50% Senior Notes due 2022 (7.50% Notes) and 7.00% Notes for $1.1 billion in cash and repayments in aggregate of $230 million of our Secured Revolving Line of Credit. +Contractual Obligations +The following table summarizes our consolidated principal contractual cash obligations, as of December 29, 2018 , and is supplemented by the discussion following the table: +Payment due by period +(In millions) +Total +2019 +2020 +2021 +2022 +2023 +2024 and +thereafter +Term Debt +$ +1,458 +$ +66 +$ +— +$ +— +$ +337 +$ +— +$ +1,055 +Secured Revolving Line of Credit +70 +70 +— +— +— +— +— +Other long-term liabilities (1) +170 +50 +42 +40 +35 +1 +2 +Aggregate interest obligation (2) +349 +63 +61 +61 +60 +35 +69 +Operating leases +322 +54 +48 +43 +40 +35 +102 +Purchase obligations (3) +337 +287 +29 +15 +4 +2 +— +Obligations to GF (4) +2,435 +1,200 +715 +520 +— +— +— +Total contractual obligations (5) +$ +5,141 +$ +1,790 +$ +895 +$ +679 +$ +476 +$ +73 +$ +1,228 +(1) +Amounts largely represent future fixed and non-cancellable cash payments associated with software technology and licenses and IP licenses, including the payments due within the next 12 months. +(2) +Represents estimated aggregate interest obligations for our outstanding debt obligations that are payable in cash, excluding non-cash amortization of debt issuance costs and debt discount. +(3) +We have purchase obligations for goods and services where payments are based, in part, on the volume or type of services we acquire. In those cases, we only included the minimum volume of purchase obligations in the table above. Purchase orders for goods and services that are cancellable upon notice and without significant penalties are not included in the amounts above. +(4) +Subsequent to the year end, on January 28, 2019, we entered into a Seventh Amendment with GF, which among other terms modified our minimum wafer purchase obligations to GF which are reflected in the above table. These minimum purchase obligations are our contractual minimums and do not necessarily reflect our actual expected expenditures, which could be significantly different. We cannot meaningfully quantify or estimate our future purchase obligations to GF beyond 2021 but expect that our future purchases from GF will continue to be material. +(5) +Total amount excludes contractual obligations already recorded on our condensed consolidated balance sheets except for debt obligations and other liabilities related to software and technology licenses and IP licenses. +42 +Senior Notes +6.75% Senior Notes Due 2019 +On February 26, 2014, we issued $600 million of our 6.75% Notes. Our 6.75% Notes are our general unsecured senior obligations. Interest is payable on March 1 and September 1 of each year beginning September 1, 2014 until the maturity date of March 1, 2019. Our 6.75% Notes are governed by the terms of an indenture (the 6.75% Indenture) dated February 26, 2014 between us and Wells Fargo Bank, N.A., as trustee. +At any time before March 1, 2019, we may redeem some or all of our 6.75% Notes at a price equal to 100% of the principal amount, plus accrued and unpaid interest and a “make whole” premium (as set forth in the 6.75% Indenture). +In 2016, we repurchased $404 million in aggregate principal amount of our 6.75% Notes pursuant to a partial tender offer for $442 million. In 2017, we settled $30 million in aggregate principal amount of our 6.75% Notes, of which $26 million was settled in cash and $5 million was settled in treasury stock. During 2018, we settled $101 million in aggregate principal amount of our 6.75% Notes, of which $14 million was settled in cash and $87 million was settled in treasury stock. As of December 29, 2018 , the outstanding aggregate principal amount of our 6.75% Notes was $66 million. +See Note 13 of “Notes to Consolidated Financial Statements” below, for additional information regarding our 6.75% Notes. +7.50% Senior Notes Due 2022 +On August 15, 2012, we issued $500 million of our 7.50% Notes. Our 7.50% Notes are our general unsecured senior obligations. Interest is payable on February 15 and August 15 of each year beginning February 15, 2013 until the maturity date of August 15, 2022. The 7.50% Notes are governed by the terms of an indenture (the 7.50% Indenture) dated August 15, 2012 between us and Wells Fargo Bank, N.A., as trustee. +Prior to August 15, 2022, we may redeem some or all of our 7.50% Notes at a price equal to 100% of the principal amount, plus accrued and unpaid interest and a “make whole” premium (as set forth in the 7.50% Indenture). +In 2014, we repurchased $25 million in aggregate principal amount of our 7.50% Notes. In 2016, we repurchased $125 million in aggregate principal amount of our 7.50% Notes. In 2017, we settled $3 million in aggregate principal amount of our 7.50% Notes in treasury stock. During 2018, we settled $10 million in aggregate principal amount of our 7.50% Notes in treasury stock. As of December 29, 2018 , the outstanding aggregate principal amount of our 7.50% Notes was $337 million. +See Note 13 of “Notes to Consolidated Financial Statements” below, for additional information regarding our 7.50% Notes. +7.00% Senior Notes Due 2024 +On June 16, 2014, we issued $500 million of our 7.00% Notes. The 7.00% Notes are our general unsecured senior obligations. Interest is payable on January 1 and July 1 of each year beginning January 1, 2015 until the maturity date of July 1, 2024. The 7.00% Notes are governed by the terms of an indenture (the 7.00% Indenture) dated June 16, 2014 between us and Wells Fargo Bank, N.A., as trustee. +Prior to July 1, 2019, we may redeem some or all of the 7.00% Notes at a price equal to 100% of the principal amount plus accrued and unpaid interest and a “make whole” premium (as set forth in the 7.00% Indenture). +Starting July 1, 2019, we may redeem our 7.00% Notes for cash at the following specified prices plus accrued and unpaid interest: +Period +Price as +Percentage of +Principal Amount +Beginning on July 1, 2019 through June 30, 2020 +103.500% +Beginning on July 1, 2020 through June 30, 2021 +102.333% +Beginning on July 1, 2021 through June 30, 2022 +101.167% +On July 1, 2022 and thereafter +100.000% +In 2016, we settled $84 million in aggregate principal amount of our 7.00% Notes for $77 million in cash and $8 million with treasury stock. In 2017, we settled $105 million in aggregate principal amount of our 7.00% Notes for $84 million in cash and $26 million in treasury stock. During 2018 , we settled $61 million in aggregate principal amount of our 7.00% Notes for $26 million in cash and $35 million in treasury stock. As of December 29, 2018 , the outstanding aggregate principal amount of the 7.00% Notes was $250 million . +43 +See Note 13 of “Notes to Consolidated Financial Statements” below, for additional information regarding our 7.00% Notes. +During 2018, we recorded $12 million in losses on extinguishment of debt associated with the debt repurchases noted above. +2.125% Convertible Senior Notes Due 2026 +On September 14, 2016, we issued $700 million in aggregate principal amount of our 2.125% Notes. We also granted an option to the underwriters to purchase up to an additional $105 million aggregate principal amount of our 2.125% Notes. On September 28, 2016, this option was exercised in full and we issued an additional $105 million aggregate principal amount of our 2.125% Notes. +Our 2.125% Notes are our general unsecured senior obligations and will mature on September 1, 2026, unless earlier repurchased or converted. Interest is payable in arrears on March 1 and September 1 of each year beginning on March 1, 2017. Our 2.125% Notes are governed by the terms of a base indenture and a supplemental indenture (together the 2.125% Indentures) dated September 14, 2016 between us and Wells Fargo Bank, N.A., as trustee. +Holders may convert their notes at their option at any time prior to the close of business on the business day immediately preceding June 1, 2026 only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2016 (and only during such calendar quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; (2) during the five business day period after any 10 consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or (3) upon the occurrence of specified corporate events. On or after June 1, 2026 and until the close of business on the business day immediately preceding the maturity date, holders may convert their notes at any time, regardless of the foregoing circumstances. Upon conversion, we will pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election. +During the fourth quarter of 2018, the conversion conditions were satisfied and as a result, the 2.125% Notes are eligible for conversion during the first calendar quarter of 2019. We may not redeem the notes prior to the maturity date, and no sinking fund is provided for the notes. +The conversion rate is initially 125.0031 shares of common stock per $1,000 principal amount of notes (equivalent to an initial conversion price of approximately $8.00 per share of common stock). The conversion rate is subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. In addition, following certain corporate events that occur prior to the maturity date, we will increase the conversion rate for a holder who elects to convert its notes in connection with such a corporate event in certain circumstances. +If we undergo a fundamental change prior to the maturity date of the notes, holders may require us to repurchase for cash all or any portion of their notes at a fundamental change repurchase price equal to 100% of the principal amount of the notes to be repurchased plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. +As of December 29, 2018 , the outstanding aggregate principal amount of our 2.125% Notes was $805 million . See Note 13 of “Notes to Consolidated Financial Statements” below for additional information regarding our 2.125% Notes. +Potential Repurchase of Outstanding Notes +We may elect to purchase or otherwise retire all or a portion of our 6.75% Notes, 7.50% Notes, 7.00% Notes and 2.125% Notes with cash, stock or other assets from time to time in open market or privately negotiated transactions, either directly or through intermediaries or by tender offer when we believe the market conditions are favorable to do so. +Secured Revolving Line of Credit +On April 14, 2015, we and our subsidiary, AMD International Sales & Service, Ltd. (together, the Borrowers), ATI Technologies ULC (collectively with the Borrowers, the Loan Parties), a group of lenders and Bank of America N.A., acting as the agent for the lenders, entered into an amended and restated loan and security agreement, as amended (the Agreement). The Agreement provides for a secured revolving line of credit (the Secured Revolving Line of Credit) that allows the Borrowers to borrow, repay and re-borrow amounts from time to time up to $500 million with up to $45 million available for issuance of letters of credit, subject to certain conditions. Borrowings are limited up to a certain amount of eligible accounts receivable, as determined in accordance with the Agreement. The size of the commitment under the Secured Revolving Line of Credit may be increased by up to an aggregate amount of $200 million. The commitments under the Secured Revolving Line of Credit are available through +44 +March 21, 2022. The Borrowers are subject to commitment fees and letter of credit facility fees. The Loan Parties are required to comply with certain covenants under the Agreement. +The Secured Revolving Line of Credit bears interest, at the option of the Borrowers, either at (a) a customary London Interbank Offered Rate (LIBOR) plus an applicable margin (as determined in accordance with the agreement), or (b) (i) the greatest of (x) the bank’s prime rate, (y) the federal funds rate as published by the Federal Reserve Bank of New York plus 0.50%, and (z) LIBOR for a one-month period plus 1.00%, plus (ii) an applicable margin. +As of December 29, 2018 and December 30, 2017 , the Secured Revolving Line of Credit had an outstanding loan balance of $70 million at an interest rate of 6.00% and 4.75%. respectively. As of December 31, 2016 , we had repaid an aggregate of $230 million of the Secured Revolving Line of Credit and we had no borrowings outstanding. As of December 29, 2018 , the Secured Revolving Line of Credit had $26 million related to outstanding letters of credit and up to $175 million available for future borrowings. We report intra-period changes in revolving credit balance on a net basis in our condensed consolidated statement of cash flows as we intend the period of the borrowings to be brief, repaying borrowed amounts within 90 days. As of December 29, 2018 , we were in compliance with all required covenants stated in the Loan Agreement. +The agreements governing our 6.75% Notes, 7.50% Notes, 7.00% Notes, 2.125% Notes and our Secured Revolving Line of Credit contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under the Secured Revolving Line of Credit to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable. +Operating Leases +We lease certain of our facilities and in some jurisdictions we lease the land on which our facilities are built under non-cancellable lease agreements that expire at various dates through 2028. In addition, we lease certain office equipment for terms ranging from one to five years. Total future non-cancellable lease obligations as of December 29, 2018 were $322 million , including $259 million of future lease payments related to leases in Austin, Texas, Santa Clara, California, Markham, Canada, Singapore and Shanghai, China. +During the second quarter of 2018, we entered into a 10-year operating lease to occupy approximately 270,000 square feet of office space in Shanghai, China. Base rent payments commenced in October 2018 and the total estimated base rent payments over the life of the lease are approximately $72 million. As of December 29, 2018, the total estimate of future base rent over the life of the lease is approximately $68 million . In addition to the base rent payments, we are obligated to pay certain customary amounts for our share of operating expenses and tax obligations. We will also incur costs for capital projects for the new office space. +During the third quarter of 2016, we entered into a 10-year operating lease to occupy 220,000 square feet of new office space in Santa Clara. The base rent obligation commenced in August 2017. As of December 29, 2018 , the total estimate of future base rent over the life of the lease is approximately $94 million , included in amounts above. In addition to the base rent payments, we will be obligated to pay certain customary amounts for our share of operating expenses and tax obligation. We will also incur costs for capital projects on the new office space. We have the option to extend the term of the lease for two additional five-year periods. +Off-Balance Sheet Arrangements +As of December 29, 2018 , we had no off-balance sheet arrangements. +45 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK +Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt. We usually invest our cash in investments with short maturities or with frequent interest reset terms. Accordingly, our interest income fluctuates with short-term market conditions. As of December 29, 2018 , our investment portfolio consisted primarily of commercial paper. These investments were highly liquid. Due to the relatively short, weighted-average maturity of our investment portfolio and the current low interest rate environment, our exposure to interest rate risk is minimal. +As of December 29, 2018 , all of our outstanding long term debt had fixed interest rates. Consequently, our exposure to market risk for changes in interest rates on reported interest expense and corresponding cash flows is minimal. +We will continue to monitor our exposure to interest rate risk. +Default Risk. We mitigate default risk in our investment portfolio by investing in only high credit quality securities and by constantly positioning our portfolio to respond to a significant reduction in a credit rating of any investment issuer or guarantor. Our portfolio includes investments in marketable debt securities with active secondary or resale markets to ensure portfolio liquidity. We are averse to principal loss and strive to preserve our invested funds by limiting default risk and market risk. +We actively monitor market conditions and developments specific to the securities and security classes in which we invest. We believe that we take a conservative approach to investing our funds in that we invest only in highly-rated debt securities with relatively short maturities and do not invest in securities which we believe involve a higher degree of risk. As of December 29, 2018 , substantially all of our investments in debt securities were A-rated by at least one of the rating agencies. While we believe we take prudent measures to mitigate investment-related risks, such risks cannot be fully eliminated as there are circumstances outside of our control. +There were no significant sales of available-for-sale securities during 2018 . +The following table presents the cost basis, fair value and related weighted-average interest rates by year of maturity for our investment portfolio and debt obligations as of December 29, 2018 : +2019 +2020 +2021 +2022 +2023 +2024 and thereafter +Total +2018 +Fair Value +(In millions, except for percentages) +Investment Portfolio +Cash equivalents: +Fixed rate amounts +$ +488 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +488 +$ +488 +Weighted-average rate +2.45 +% +— +— +— +— +— +2.45 +% +Variable rate amounts +$ +312 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +312 +$ +312 +Weighted-average rate +2.29 +% +— +— +— +— +— +2.29 +% +Marketable securities +Fixed rate amounts +$ +78 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +78 +$ +78 +Weighted-average rate +2.77 +% +— +— +— +— +— +2.77 +% +Total Investment Portfolio +$ +878 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +878 +$ +878 +Debt Obligations +Fixed rate amounts +$ +66 +$ +— +$ +— +$ +337 +$ +— +$ +1,055 +$ +1,458 +$ +2,494 +Weighted-average effective interest rate +6.75 +% +— +% +— +% +7.50 +% +— +% +3.28 +% +4.41 +% +Variable rate amounts +$ +70 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +70 +$ +70 +Weighted-average effective interest rate +6.00 +% +— +% +— +% +— +% +— +% +— +% +6.00 +% +Total Debt Obligations +$ +136 +$ +— +$ +— +$ +337 +$ +— +$ +1,055 +$ +1,528 +$ +2,564 +Foreign Exchange Risk. As a result of our foreign operations, we incur costs and we carry assets and liabilities that are denominated in foreign currencies, while sales of products are primarily denominated in U.S. dollars. +We maintain a foreign currency hedging strategy which uses derivative financial instruments to mitigate the risks associated with changes in foreign currency exchange rates. This strategy takes into consideration all of our exposures. We do not use derivative financial instruments for trading or speculative purposes. +In applying our strategy, from time to time we use foreign currency forward contracts to hedge certain forecasted expenses denominated in foreign currencies. We designate these contracts as cash flow hedges of forecasted expenses to the extent eligible +46 +under the accounting rules and evaluate hedge effectiveness prospectively and retrospectively. As such, the effective portion of the gain or loss on these contracts is reported as a component of accumulated other comprehensive income (loss) and reclassified to earnings in the same line item as the associated forecasted transaction and in the same period during which the hedged transaction affects earnings. Any ineffective portion is immediately recorded in earnings. +We also use, from time to time, foreign currency forward contracts to economically hedge recognized foreign currency exposures on the balance sheets of various subsidiaries. We do not designate these forward contracts as hedging instruments. Accordingly, the gain or loss associated with these contracts is immediately recorded in earnings. +The following table provides information about our foreign currency forward contracts as of December 29, 2018 and December 30, 2017 . All of our foreign currency forward contracts mature within 12 months. +December 29, 2018 +December 30, 2017 +Notional +Amount +Average +Contract +Rate +Estimated +Fair Value +Gain (Loss) +Notional +Amount +Average +Contract +Rate +Estimated +Fair Value +Gain (Loss) +(In millions except contract rates) +Foreign currency forward contracts: +Canadian Dollar +$ +110 +1.3007 +$ +(5 +) +$ +111 +1.2751 +$ +2 +Malaysian Ringgit +12 +4.1775 +— +— +— +— +Indian Rupee +45 +72.2338 +— +33 +66.1548 +1 +Singapore Dollar +26 +1.3478 +— +23 +1.3553 +— +Taiwan Dollar +21 +29.6490 +— +18 +29.6586 +— +Chinese Renminbi +182 +6.5733 +(3 +) +115 +6.7972 +4 +Total +$ +396 +$ +(8 +) +$ +300 +$ +7 +47 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Advanced Micro Devices, Inc. +Consolidated Statements of Operations (1) +Year Ended +December 29, +2018 +December 30, +2017 +December 31, +2016 +(In millions, except per share amounts) +Net revenue +$ +6,475 +$ +5,253 +$ +4,319 +Cost of sales +4,028 +3,466 +3,316 +Gross margin +2,447 +1,787 +1,003 +Research and development +1,434 +1,196 +1,008 +Marketing, general and administrative +562 +516 +466 +Restructuring and other special charges, net +— +— +(10 +) +Licensing gain +— +(52 +) +(88 +) +Operating income (loss) +451 +127 +(373 +) +Interest expense +(121 +) +(126 +) +(156 +) +Other income (expense), net +— +(9 +) +80 +Income (loss) before income taxes and equity loss +330 +(8 +) +(449 +) +Provision (benefit) for income taxes +(9 +) +18 +39 +Equity loss in investee +(2 +) +(7 +) +(10 +) +Net income (loss) +$ +337 +$ +(33 +) +$ +(498 +) +Earnings (loss) per share +Basic +$ +0.34 +$ +(0.03 +) +$ +(0.60 +) +Diluted +$ +0.32 +$ +(0.03 +) +$ +(0.60 +) +Shares used in per share calculation +Basic +982 +952 +835 +Diluted +1,064 +952 +835 +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2. +See accompanying notes to consolidated financial statements. +48 +Advanced Micro Devices, Inc. +Consolidated Statements of Comprehensive Income (Loss) (1) +Year Ended +December 29, +2018 +December 30, +2017 +December 31, +2016 +(In millions) +Net income (loss) +$ +337 +$ +(33 +) +$ +(498 +) +Other comprehensive income (loss): +Unrealized gains (losses) on available-for-sale securities: +Unrealized gains (losses) arising during period, net of tax effects of $0, $0 and $1 +— +1 +— +Unrealized gains (losses) on cash flow hedges: +Unrealized gains (losses) arising during period, net of tax effects of $0, $0 and $2 +(19 +) +17 +1 +Reclassification adjustment for (gains) losses realized and included in net income (loss), net of tax effect of $0, $1 and $0 +5 +(7 +) +2 +Total change in unrealized gains (losses) on cash flow hedges, net of tax +(14 +) +10 +3 +Total other comprehensive income (loss) +(14 +) +11 +3 +Cumulative-effect adjustment to accumulated deficit related to the adoption of ASU 2016-01, Financial Instruments +2 +— +— +Total comprehensive income (loss) +$ +325 +$ +(22 +) +$ +(495 +) +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2. +See accompanying notes to consolidated financial statements. +49 +Advanced Micro Devices, Inc. +Consolidated Balance Sheets (1) +December 29, +2018 +December 30, +2017 +(In millions, except par value amounts) +ASSETS +Current assets: +Cash and cash equivalents +$ +1,078 +$ +1,185 +Marketable securities +78 +— +Accounts receivable, net +1,235 +454 +Inventories, net +845 +694 +Prepayment and receivables - related parties +52 +33 +Prepaid expenses +57 +77 +Other current assets +195 +191 +Total current assets +3,540 +2,634 +Property and equipment, net +348 +261 +Goodwill +289 +289 +Investment: equity method +58 +58 +Other assets +321 +310 +Total assets +$ +4,556 +$ +3,552 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Short-term debt +$ +136 +$ +70 +Accounts payable +528 +384 +Payables to related parties +533 +412 +Accrued liabilities +763 +555 +Other current liabilities +24 +92 +Total current liabilities +1,984 +1,513 +Long-term debt, net +1,114 +1,325 +Other long-term liabilities +192 +118 +Commitments and contingencies (see Notes 18 and 19) +Stockholders’ equity: +Capital stock: +Common stock, par value $0.01; 2,250 shares authorized, 1,010 shares issued and 1,005 shares outstanding as of December 29, 2018; 1,500 shares authorized, 979 shares issued and 967 shares outstanding as of December 30, 2017 +10 +9 +Additional paid-in capital +8,750 +8,464 +Treasury stock, at cost ( 5 shares as of December 29, 2018 and 12 shares as of December 30, 2017) +(50 +) +(108 +) +Accumulated deficit +(7,436 +) +(7,775 +) +Accumulated other comprehensive income (loss) +(8 +) +6 +Total stockholders’ equity +1,266 +596 +Total liabilities and stockholders’ equity +$ +4,556 +$ +3,552 +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2. +See accompanying notes to consolidated financial statements. +50 +Advanced Micro Devices, Inc. +Consolidated Statements of Stockholders’ Equity (Deficit) (1) +Three Years Ended December 29, 2018 +(In millions) +Number +of +shares +Common Stock +Additional +paid-in +capital +Treasury +stock +Accumulated +deficit +Accumulated +other +comprehensive +income (loss) +Total +stockholders’ +equity (deficit) +December 26, 2015 +792 +$ +8 +$ +7,017 +$ +(123 +) +$ +(7,244 +) +$ +(8 +) +$ +(350 +) +Net loss +— +— +— +— +(498 +) +— +(498 +) +Other comprehensive income +— +— +— +— +— +3 +3 +Common stock issued under employee equity incentive plans, net of tax withholding +27 +— +20 +(4 +) +— +— +16 +Stock-based compensation +— +— +86 +— +— +— +86 +Equity component of the 2.125% Notes, net +— +— +305 +— +— +— +305 +Warrant issued related to sixth amendment to the WSA +— +— +240 +— +— +— +240 +Issuance of common stock, net of issuance costs +115 +1 +666 +— +— +— +667 +Issuance of common stock to partially settle the 7.00% Notes +1 +— +— +8 +— +— +8 +December 31, 2016 +935 +9 +8,334 +(119 +) +(7,742 +) +(5 +) +477 +Net loss +— +— +— +— +(33 +) +— +(33 +) +Other comprehensive income +— +— +— +— +— +11 +11 +Common stock issued under employee equity incentive plans, net of tax withholding +32 +— +20 +(13 +) +— +— +7 +Stock-based compensation +— +— +97 +— +— +— +97 +Issuance of treasury stock to partially settle the 6.75% notes and the 7.00% notes +— +— +13 +24 +— +— +37 +December 30, 2017 +967 +9 +8,464 +(108 +) +(7,775 +) +6 +596 +Net income +— +— +— +— +337 +— +337 +Other comprehensive loss +— +— +— +— +— +(14 +) +(14 +) +Common stock issued under employee equity incentive plans, net of tax withholding +31 +1 +71 +(6 +) +— +— +66 +Stock-based compensation +— +— +137 +— +— +— +137 +Issuance of treasury stock to partially settle the 6.75% notes, 7.5% notes and the 7.00% notes +7 +— +78 +64 +— +— +142 +Cumulative-effect adjustment to accumulated deficit related to the adoption of ASU 2016-01, Financial Instruments +— +— +— +— +2 +— +2 +December 29, 2018 +1,005 +$ +10 +$ +8,750 +$ +(50 +) +$ +(7,436 +) +$ +(8 +) +$ +1,266 +(1) The cumulative-effect adjustment to Accumulated deficit related to the adoption of ASU No. 2014-09, Revenue from Contracts with Customers as of December 26, 2015 was $62 million. Refer to Note 2. +See accompanying notes to consolidated financial statements. +51 +Advanced Micro Devices, Inc. +Consolidated Statements of Cash Flows (1) +Year Ended +December 29, +2018 +December 30, +2017 +December 31, +2016 +(In millions) +Cash flows from operating activities: +Net income (loss) +$ +337 +$ +(33 +) +$ +(498 +) +Adjustments to reconcile net income (loss) to net cash used in operating activities: +Net gain on sale of equity interests in ATMP JV +— +(3 +) +(146 +) +Net loss on disposal of property and equipment +27 +— +1 +Impairment of technology licenses +45 +— +— +Depreciation and amortization +170 +144 +133 +Deferred income taxes +(4 +) +— +11 +Stock-based compensation expense +137 +97 +86 +Amortization of debt discount and issuance costs +38 +36 +21 +Loss on debt redemption +12 +12 +68 +Fair value of warrant issued related to sixth amendment to the WSA +— +— +240 +Other +(1 +) +3 +(7 +) +Changes in operating assets and liabilities: +Accounts receivable +(806 +) +(103 +) +178 +Inventories +(151 +) +(3 +) +(48 +) +Prepayment and receivables - related parties +(19 +) +(1 +) +1 +Prepaid expenses and other assets +(79 +) +(172 +) +(163 +) +Payables to related parties +121 +29 +138 +Accounts payable, accrued liabilities and other +207 +6 +66 +Net cash provided by operating activities +34 +12 +81 +Cash flows from investing activities: +Net proceeds from sale of equity interests in ATMP JV +— +1 +342 +Purchases of available-for-sale debt securities +(123 +) +(222 +) +— +Purchases of property and equipment +(163 +) +(113 +) +(77 +) +Proceeds from maturity of available-for-sale debt securities +45 +222 +— +Collection of deferred proceeds on sale of receivables +71 +60 +10 +Other +— +(2 +) +2 +Net cash provided by (used in) investing activities +(170 +) +(54 +) +277 +Cash flows from financing activities: +Proceeds from issuance of common stock, net of issuance costs +— +— +667 +Proceeds from issuance of convertible senior notes, net of issuance costs +— +— +782 +Proceeds from issuance of common stock through employee equity incentive plans +70 +20 +20 +Proceeds from (repayments of) short-term borrowings, net +— +70 +(230 +) +Repayments of long-term debt +(41 +) +(110 +) +(1,113 +) +Other +(1 +) +(13 +) +(4 +) +Net cash provided by (used in) financing activities +28 +(33 +) +122 +Net increase (decrease) in cash and cash equivalents, and restricted cash +(108 +) +(75 +) +480 +Cash, cash equivalents, and restricted cash at beginning of year +1,191 +1,266 +786 +Cash, cash equivalents, and restricted cash at end of year +$ +1,083 +$ +1,191 +$ +1,266 +52 +Year Ended +December 29, +2018 +December 30, +2017 +December 31, +2016 +(In millions) +Supplemental cash flow information: +Cash paid during the year for: +Interest +$ +79 +$ +88 +$ +149 +Income taxes, net of refund +$ +(8 +) +$ +20 +$ +20 +Non-cash investing and financing activities: +Purchases of property and equipment, accrued but not paid +$ +49 +$ +50 +$ +— +Issuance of treasury stock to partially settle debt +$ +141 +$ +38 +$ +8 +Deferred proceeds on sale of receivables +$ +25 +$ +21 +$ +15 +Non-cash acquisition of property and equipment +$ +28 +$ +12 +$ +— +Reconciliation of cash, cash equivalents, and restricted cash +Cash and cash equivalents +$ +1,078 +$ +1,185 +$ +1,264 +Restricted cash included in Other current assets +$ +5 +$ +3 +$ +2 +Restricted cash included in Other assets +$ +— +$ +3 +$ +— +Total cash, cash equivalents, and restricted cash +$ +1,083 +$ +1,191 +$ +1,266 +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers , ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments and ASU 2016-18, Statement of Cash Flows, Restricted Cash . Refer to Note 2. +See accompanying notes to consolidated financial statements. +53 +Advanced Micro Devices, Inc. +Notes to Consolidated Financial Statements +Fiscal Years Ended December 29, 2018 , December 30, 2017 and December 31, 2016 +NOTE 1: Nature of Operations +Advanced Micro Devices, Inc. is a global semiconductor company. References herein to AMD or the Company mean Advanced Micro Devices, Inc. and its consolidated subsidiaries. The Company primarily offers: +(i) +x86 microprocessors, as standalone devices or as incorporated into an accelerated processing unit (APU), chipsets, discrete and integrated graphics processing units (GPUs), and professional GPUs; and +(ii) +server and embedded processors, semi-custom System-on-Chip (SoC) products and technology for game consoles. +We also license portions of our intellectual property (IP) portfolio. +NOTE 2: Summary of Significant Accounting Policies +Fiscal Year . The Company uses a 52 or 53 week fiscal year ending on the last Saturday in December. Fiscal 2018 , 2017 and 2016 ended December 29, 2018 , December 30, 2017 and December 31, 2016 , respectively. Fiscal 2018, 2017 and 2016 consisted of 52, 52 and 53 weeks, respectively. +Principles of Consolidation. The consolidated financial statements include the Company’s accounts and those of its wholly-owned subsidiaries. Upon consolidation, all significant inter-company accounts and transactions are eliminated. +Use of Estimates. The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of commitments and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results are likely to differ from those estimates, and such differences may be material to the financial statements. Areas where management uses subjective judgment include, but are not limited to, revenue allowances, inventory valuation, valuation and impairment of goodwill and deferred income taxes. +Revenue Recognition. Revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the Company expects to receive in exchange for those goods or services. Sales, value-added, and other taxes collected concurrently with the provision of goods or services are excluded from revenue. Shipping and handling costs associated with product sales are included in cost of sales. +Nature of products and services +The Company's microprocessors, chipsets, GPUs, professional graphics products, server and embedded processors, and SoC products may be sold as standard non-custom products, or custom products manufactured to customers’ specifications. +Non-custom products: The Company transfers control and recognizes revenue when non-custom products are shipped to customers, which includes original equipment manufacturers (OEM) and distributors, in accordance with the shipping terms of the sale. Certain OEMs may be entitled to rights of return and rebates under OEM agreements. The Company also sells to distributors under terms allowing the majority of distributors certain rights of return and price protection on unsold merchandise held by them. The Company estimates the amount of variable consideration under OEM and distributor arrangements and, accordingly, records a provision for product returns, allowances for price protection and rebates based on actual historical experience and any known events. +The Company offers incentive programs to certain customers, including cooperative advertising, marketing promotions, volume based incentives and special pricing arrangements. Where funds provided for such programs can be estimated, the Company recognizes a reduction to revenue at the time the related revenue is recognized; otherwise, the Company recognizes such reduction to revenue at the later of when: i) the related revenue transaction occurs; or ii) the program is offered. For transactions where the Company reimburses a customer for a portion of the customer’s cost to perform specific product advertising or marketing and promotional activities, such amounts are recognized as a reduction to revenue unless they qualify for expense recognition. +Custom products: Custom products which are associated with the Company’s Enterprise, Embedded, and Semi-Custom segment (semi-custom products), under non-cancellable purchases orders and have no alternative use to the Company at contract +54 +inception, are recognized as revenue, based on the value of the inventory and expected margin, over the time of production of the products by the Company. Sales of semi-custom products are not subject to a right of return. +Development and intellectual property licensing agreements: From time to time, the Company may enter into arrangements with customers that combine the provision of development services and a license to the right to use the IP, which is deemed to be a single performance obligation. Accordingly, the Company recognizes revenue for the entire consideration of the arrangement upon transfer of control of the IP license to the customer. +Customers are generally required to pay for products and services within the Company’s standard contractual terms, which are typically net 30 to 60 days. The Company has determined that it does not have significant financing components in its contracts with customers. +Refer to Note 6: Supplemental Balance Sheet Information for further information. +Inventories. Inventories are stated at standard cost adjusted to approximate the lower of actual cost (first-in, first-out method) or net realizable value. The Company adjusts inventory carrying value for estimated obsolescence equal to the difference between the cost of inventory and the estimated net realizable value based upon assumptions about future demand and market conditions. The Company fully reserves for inventories and non-cancellable purchase orders for inventory deemed obsolete. The Company performs periodic reviews of inventory items to identify excess inventories on hand by comparing on-hand balances to anticipated usage using recent historical activity as well as anticipated or forecasted demand. If estimates of customer demand diminish further or market conditions become less favorable than those projected by the Company, additional inventory adjustments may be required . +Goodwill. The Company performs its goodwill impairment analysis as of the first day of the fourth quarter of each year and, if certain events or circumstances indicate that an impairment loss may have been incurred, on a more frequent basis. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. +Qualitative factors include industry and market consideration, overall financial performance, share price trends and market capitalization and Company-specific events. The Company first analyzes qualitative factors. If the Company concludes it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, the Company does not proceed to perform a quantitative impairment test. +A quantitative impairment analysis, if necessary, considers the income approach, which requires estimates of the present value of expected future cash flows to determine a reporting unit’s fair value. Significant estimates include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates, and future economic and market conditions. If the Company concludes it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative goodwill impairment test will be performed by comparing the fair value of each reporting unit to its carrying value. +A goodwill impairment charge is recognized for the amount by which the reporting unit’s fair value is less than its carrying value. Any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +Commitments and Contingencies. From time to time the Company is a defendant or plaintiff in various legal actions that arise in the normal course of business. The Company is also subject to income tax, indirect tax or other tax claims by tax agencies in jurisdictions in which it conducts business. In addition, the Company is a party to environmental matters including local, regional, state and federal government clean-up activities at or near locations where the Company currently or has in the past conducted business. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of reasonably possible losses. A determination of the amount of reserves required for these commitments and contingencies that would be charged to earnings, if any, includes assessing the probability of adverse outcomes and estimating the amount of potential losses. The required reserves, if any, may change due to new developments in each matter or changes in circumstances such as a change in settlement strategy. +Cash Equivalents. Cash equivalents consist of financial instruments that are readily convertible into cash and have original maturities of three months or less at the time of purchase. +Accounts Receivable. Accounts receivable are primarily comprised of trade receivables that are recorded at the invoice amount, net of an allowance for doubtful accounts. Accounts receivable also include unbilled receivables, which primarily represent work completed on semi-custom products under non-cancellable purchase orders that have no alternative use to the Company at contract inception, for which revenue has been recognized but not yet invoiced to customers. The Company maintains an allowance for doubtful accounts based on its assessment of the collectability of amounts owed by customers. The allowance consists of known specific troubled accounts as well as an amount based on overall estimated potential uncollectible accounts receivable based on historical experience. +55 +Investments in Available-for-sale Debt Securities . The Company classifies its investments in debt securities at the date of acquisition as available-for-sale. Available-for-sale debt securities are reported at fair value with the related unrealized gains and losses included, net of tax, in accumulated other comprehensive income (loss), a component of stockholders’ equity. Realized gains and losses and declines in the value of available-for-sale debt securities determined to be other than temporary are included in other income (expense), net. The cost of securities sold is determined based on the specific identification method. +The Company classifies investments in available-for-sale debt securities with maturities of more than three months at the time of purchase as marketable securities on its consolidated balance sheet. Classification of these securities as current is based on the Company’s intent and belief in its ability to sell these securities and use the proceeds from sale in operations within 12 months. +Derivative Financial Instruments. The Company maintains a foreign currency hedging strategy which uses derivative financial instruments to mitigate the risks associated with changes in foreign currency exchange rates. This strategy takes into consideration all of the Company’s consolidated exposures. The Company does not use derivative financial instruments for trading or speculative purposes. +In applying its strategy, the Company uses foreign currency forward contracts to hedge certain forecasted expenses denominated in foreign currencies. The Company designates these contracts as cash flow hedges of forecasted expenses, to the extent eligible under the accounting rules, and evaluates hedge effectiveness prospectively and retrospectively. As such, the effective portion of the gain or loss on these contracts is reported as a component of accumulated other comprehensive income (loss) and is reclassified to earnings in the same line item as the associated forecasted transaction and in the same period during which the hedged transaction affects earnings. Any ineffective portion is immediately recorded in earnings. +The Company also uses, from time to time, foreign currency forward contracts to economically hedge recognized foreign currency exposures on the balance sheets of various subsidiaries. The Company does not designate these forward contracts as hedging instruments. Accordingly, the gain or loss associated with these contracts is immediately recorded in earnings. +Property and Equipment. Property and equipment are stated at cost. Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. Estimated useful lives are as follows: equipment uses two to six years , and leasehold improvements are measured by the shorter of the remaining terms of the leases or the estimated useful economic lives of the improvements. +Product Warranties. The Company generally warrants that its products sold to its customers will conform to its approved specifications and be free from defects in material and workmanship under normal use and conditions for one year. The Company may also offer one to three year limited warranties based on product type and negotiated warranty terms with certain customers. The Company accrues warranty costs to Cost of sales at the time of sale of warranted products. +Foreign Currency Translation/Transactions. The functional currency of all of the Company’s foreign subsidiaries is the U.S. dollar. Assets and liabilities denominated in non-U.S. dollars have been remeasured into U.S. dollars at current exchange rates for monetary assets and liabilities and historical exchange rates for non-monetary assets and liabilities. Non-U.S. dollar denominated transactions have been remeasured at average exchange rates in effect during each period, except for those cost of sales and expense transactions related to non-monetary balance sheet amounts which have been remeasured at historical exchange rates. The gains or losses from foreign currency remeasurement are included in earnings. +Subsidies. The Company received investment grants in connection with the construction and operation of certain facilities in Canada and Asia. Generally, such grants are subject to forfeiture in declining amounts over the life of the agreement if the Company does not maintain certain levels of employment or meet other conditions specified in the relevant grant documents. Accordingly, amounts granted are initially recorded as a receivable until cash proceeds are received. In the period the grant receivable is recorded, a current and long-term liability is also recorded which is subsequently amortized as a reduction to cost of sales. +The Company also received grants relating to certain research and development projects. These research and development funds are generally recorded as a reduction of research and development expenses when all conditions and requirements set forth in the underlying grant agreement are met. +Marketing and Advertising Expenses. Marketing and advertising expenses include cooperative advertising funding obligations under customer incentive programs, which costs are recorded upon agreement with customers and vendor partners. Cooperative advertising expenses are recorded as marketing, general and administrative expense to the extent the cash paid does not exceed the estimated fair value of the advertising benefit received. Any excess of cash paid over the estimated fair value of the advertising benefit received is recorded as a reduction of revenue. Marketing and advertising expenses for 2018 , 2017 and 2016 were approximately $176 million , $156 million and $131 million , respectively. +56 +Stock-Based Compensation . The Company estimates stock-based compensation cost for stock options at the grant date based on the option’s fair-value as calculated by the lattice-binomial option-pricing model. For restricted stock units, including performance-based restricted stock units (PRSUs), fair value is based on the closing price of the Company’s common stock on the grant date. The Company estimates the grant-date fair value of restricted stock units that involve a market condition using the Monte Carlo simulation model. The Company estimates the grant-date fair value of stock to be issued under the ESPP using the Black-Scholes model. Compensation expense is recognized over the vesting period of the applicable award using the straight-line method, except for the compensation expense related to PRSUs, which are recognized ratably for each vesting tranche from the service inception date to the end of the requisite service period. +Forfeiture rates are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. +Income Taxes. The Company computes the provision for income taxes using the liability method and recognizes deferred tax assets and liabilities for temporary differences between financial statement and income tax bases of assets and liabilities, as well as for operating loss and tax credit carryforwards. The Company measures deferred tax assets and liabilities using tax rates applicable to taxable income in effect for the years in which those tax assets are expected to be realized or settled and provides a valuation allowance against deferred tax assets when it cannot conclude that it is more likely than not that some or all deferred tax assets will be realized. In addition, the Company recognizes tax benefits from uncertain tax positions only if it expects that its tax positions are more likely than not that they will be sustained, based on the technical merits of the positions, on examination by the jurisdictional tax authority. The Company recognizes any accrued interest and penalties to unrecognized tax benefits as interest expense and income tax expense, respectively. +Recently Adopted Accounting Standards +Revenue from Contracts with Customers. In May 2014, the Financial Accounting Standards Board (FASB) issued ASU 2014-09, Revenue from Contracts with Customers (ASC 606) , which creates a single source of revenue guidance under U.S. GAAP for all companies in all industries and replaces most existing revenue recognition guidance in U.S. GAAP. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the new standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The FASB has issued several amendments to the new standard, including clarification on accounting for licenses of intellectual property and identifying performance obligations. The Company adopted the new standard in the first quarter of 2018, using the full retrospective method, which required the Company to adjust prior reporting periods presented. The Company implemented internal controls and key system functionality to enable the preparation of financial information on adoption. +The most significant impacts of the adoption of ASC 606 to the Company related to: (1) the acceleration of revenue recognition for sales of semi-custom products subject to a non-cancellable customer purchase order, (2) the acceleration of revenue recognition for sales to distributors, and (3) the timing and financial statement classification of certain development and intellectual property licensing agreements. Revenue from sales of semi-custom products under non-cancellable purchases orders, and that have no alternative use to the Company at contract inception, is recognized, based on the value of the semi-custom products and expected margin, over the time of production of the semi-custom products by the Company, rather than upon shipment. Revenue from sales to the Company's distributors is recognized upon shipment of the product to the distributors (sell-in), net of provision for estimated reserves, instead of the previous revenue recognition which was upon the reported resale of the product by the distributors to their customers (sell-through). For a development and IP licensing agreement executed in 2017, the Company recognized IP-related revenue in the third quarter of 2018 for the entire amount of arrangement consideration upon the completion of all the technology milestones. Previously, the agreement resulted in the reduction to research and development expenses in 2017 for development work as the expenses were incurred and would have resulted in licensing revenue to be recognized in periods beyond 2017 upon completion of the deliverables, based on a fair value allocation of the consideration received. Revenue recognition related to the Company’s other revenue streams remain substantially unchanged. +The adoption of ASC 606 had an impact on the Company’s consolidated statements of operations and consolidated balance sheets, but had no impact on cash provided by or used in operating, financing, or investing activities on the consolidated statements of cash flows. The impact on the Company’s 2017 and 2016 consolidated statement of operations as a result of the adoption of the new standard is as follows: +57 +Year Ended +December 30, +2017 +December 31, +2016 +As reported +Adjustment +As adjusted +As reported +Adjustment +As adjusted +(In millions, except per share amounts) +Net revenue (1) +$ +5,329 +$ +(76 +) +$ +5,253 +$ +4,272 +$ +47 +$ +4,319 +Cost of sales (1) +3,506 +(40 +) +3,466 +3,274 +42 +3,316 +Gross margin +1,823 +(36 +) +1,787 +998 +5 +1,003 +Research and development (2) +1,160 +36 +1,196 +1,008 +— +1,008 +Marketing, general and administrative +511 +5 +516 +460 +6 +466 +Restructuring and other special charges, net +— +— +— +(10 +) +— +(10 +) +Licensing gain +(52 +) +— +(52 +) +(88 +) +— +(88 +) +Operating income (loss) +204 +(77 +) +127 +(372 +) +(1 +) +(373 +) +Interest expense +(126 +) +— +(126 +) +(156 +) +— +(156 +) +Other income (expense), net +(9 +) +— +(9 +) +80 +— +80 +Income (loss) before equity loss and income taxes +69 +(77 +) +(8 +) +(448 +) +(1 +) +(449 +) +Provision for income taxes +19 +(1 +) +18 +39 +— +39 +Equity loss in investee +(7 +) +— +(7 +) +(10 +) +— +(10 +) +Net income (loss) +$ +43 +$ +(76 +) +$ +(33 +) +$ +(497 +) +$ +(1 +) +$ +(498 +) +Earnings (loss) per share +Basic +$ +0.04 +$ +(0.07 +) +$ +(0.03 +) +$ +(0.60 +) +$ +— +$ +(0.60 +) +Diluted +$ +0.04 +$ +(0.07 +) +$ +(0.03 +) +$ +(0.60 +) +$ +— +$ +(0.60 +) +Shares used in per share calculation +Basic +952 +952 +835 +835 +Diluted +1,039 +952 +835 +835 +(1) +2017 and 2016 revenue and cost of sales changes were due to a net drain (decrease in revenue) or net build (increase in revenue) in channel and semi-custom product inventories, respectively. +(2) +2017 Research and development expenses increased due to the absence of credits to research and development expenses recognized for a development and intellectual property licensing agreement under the “As reported” standard, the entire amount of consideration was recognized as revenue in 2018 upon transfer of control of the IP license to the customer under the new standard. +The impact on the Company’s affected 2017 and 2016 consolidated balance sheets line items, as a result of the adoption of the new standard is as follows: +Year Ended +December 30, +2017 +December 31, +2016 +As reported +Adjustment +As adjusted +As reported +Adjustment +As adjusted +(In millions) +Accounts receivable, net (1) +$ +400 +$ +54 +$ +454 +$ +311 +$ +61 +$ +372 +Inventories, net (2) +739 +(45 +) +694 +751 +(60 +) +691 +Other current assets +188 +3 +191 +109 +6 +115 +Accrued liabilities +541 +14 +555 +391 +9 +400 +Other current liabilities (3) +57 +35 +92 +69 +— +69 +Deferred income on shipments to distributors (4) +22 +(22 +) +— +63 +(63 +) +— +Accumulated deficit +(7,760 +) +(15 +) +(7,775 +) +(7,803 +) +61 +(7,742 +) +(1) +2017 and 2016 Accounts receivable, net increased primarily due to the acceleration in timing of semi-custom product revenue. +(2) +2017 and 2016 Inventories, net decreased primarily due to the acceleration in timing of semi-custom product revenue. +58 +(3) +2017 Other current liabilities adjusted primarily due to the absence of credits to research and development expenses recognized for a development and intellectual property licensing agreement under the “As reported” standard, the entire amount of consideration was recognized as revenue in 2018 upon transfer of control of the IP license to the customer under the new standard. The credits are recorded as deferred revenue under the new standard. +(4) +2017 and 2016 deferred income on shipments to distributors is eliminated due to the change in the revenue recognition model for sales to distributors, whereby revenue is recognized upon the shipment of the product to the distributors (sell-in), instead of upon reported resale of the product by the distributors to their customers (sell-through). +The impact on the Company’s 2017 and 2016 net revenue and operating income (loss) by segments as a result of the adoption of the new standard is as follows: +Year Ended +December 30, +2017 +December 31, +2016 +As reported +Adjustment +As adjusted +As reported +Adjustment +As adjusted +(In millions) +Net revenue: +Computing and Graphics (1) +$ +3,029 +$ +(52 +) +$ +2,977 +$ +1,967 +$ +21 +$ +1,988 +Enterprise, Embedded and Semi-Custom (2) +2,300 +(24 +) +2,276 +2,305 +26 +2,331 +Total net revenue +$ +5,329 +$ +(76 +) +$ +5,253 +$ +4,272 +$ +47 +$ +4,319 +Operating income (loss): +Computing and Graphics (3) +$ +147 +$ +(55 +) +$ +92 +$ +(238 +) +$ +(5 +) +$ +(243 +) +Enterprise, Embedded and Semi-Custom (4) +154 +(22 +) +132 +283 +4 +287 +All Other +(97 +) +— +(97 +) +(417 +) +— +(417 +) +Total operating income (loss) +$ +204 +$ +(77 +) +$ +127 +$ +(372 +) +$ +(1 +) +$ +(373 +) +(1) +2017 and 2016 Computing and Graphics revenue changes were due to a net drain (decrease in revenue) or net build (increase in revenue) in channel inventory. +(2) +2017 and 2016 Enterprise, Embedded and Semi-Custom revenue changes were due to a net drain (decrease in revenue) or net build (increase in revenue) in semi-custom product inventory. +(3) +2017 Computing and Graphics operating income decreased primarily due to the lower revenue from sales to distributors. In addition, 2017 is lower due to the absence of credits to research and development expenses recognized for a development and intellectual property licensing agreement under the “As Reported” standard, the entire amount of consideration was recognized as revenue in 2018 upon transfer of control of the IP license to the customer under the new standard. 2016 Computing and Graphics operating loss increased due to slightly higher operating expenses. +(4) +2017 Enterprise, Embedded and Semi-Custom operating income decreased primarily due to lower revenue from sales of semi-custom products. In addition, 2017 is lower due to the absence of credits to research and development expenses recognized for a certain development and intellectual property licensing agreement under the “As reported” standard, the entire amount of consideration was recognized as revenue in 2018 upon transfer of control of the IP license to the customer under the new standard. 2016 Enterprise, Embedded and Semi-Custom operating income increased due to higher revenue from sales of semi-custom products. +Stock Compensation. In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (ASC 718): Scope of Modification Accounting (ASU 2017-09) to provide clarity and reduce both the (1) diversity in practice and (2) cost and complexity when changing the terms or conditions of share-based payment awards. Under ASU 2017-09, modification accounting is required to be applied unless all of the following criteria are the same immediately before and after the change: +1. The award’s fair value (or calculated value or intrinsic value, if those measurement methods are used); +2. The award’s vesting conditions; and +3. The award’s classification as an equity or liability instrument. +ASU 2017-09 is effective for annual and interim periods beginning after December 15, 2017 on a prospective basis, and early adoption is permitted. The Company adopted this guidance in the first quarter of 2018 and the guidance did not have an impact on its consolidated financial statements. +Income Taxes. In October 2016, the FASB issued ASU 2016-16, Income Taxes (ASC 740): Intra-Entity Transfers of Assets Other Than Inventory (ASU 2016-16), which requires entities to recognize the income tax consequences of an intra-entity transfer +59 +of an asset other than inventory when the transfer occurs. This amends current GAAP which prohibits recognition of current and deferred income taxes for all types of intra-entity asset transfers until the asset has been sold to an outside party. ASU 2016-16 is effective for fiscal years beginning after December 15, 2017, including interim periods therein. Upon adoption, the Company must apply a modified retrospective transition approach through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. The Company adopted this guidance in the first quarter of 2018 and the guidance did not have a material impact on its consolidated financial statements. +Statement of Cash Flows. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (ASC 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15), which is intended to reduce the existing diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows, Restricted Cash (ASU 2016-18), which requires the inclusion of restricted cash with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-15 and ASU 2016-18 are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, provided that all of the amendments are adopted in the same period. The amendments will be applied using a retrospective transition method to each period presented. The Company adopted ASU 2016-18 in 2018, which resulted in the additional presentation of restricted cash on the statement of cash flows for each period presented. The Company adopted ASU 2016-15 in 2018, which resulted in the reclassification of certain cash receipts from operating activities to investing activities on the statement of cash flows for each period presented. The adoption of these standards had no material impact on the Company’s consolidated financial statements. +Financial Instruments. In January 2016, the FASB issued ASU 2016-01, Financial Instruments—Overall (ASC 825): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01), which requires that most equity investments be measured at fair value, with subsequent changes in fair value recognized in net income. The ASU also impacts financial liabilities under the fair value option and the presentation and disclosure requirements for financial instruments. In addition, the FASB clarified guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities. Entities have to assess the realizability of such deferred tax assets in combination with the entities’ other deferred tax assets. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017 and for interim periods within those fiscal years. The Company adopted this guidance in the first quarter of 2018 with no material impact on its consolidated financial statements. +Recently Issued Accounting Standards +Intangibles. In August 2018, the FASB issued ASU 2018-15, Intangibles—Goodwill and Other—Internal-Use Software (ASC 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract , which requires hosting arrangements that are service contracts to follow the guidance for internal-use software to determine which implementation costs can be capitalized. ASU 2018-15 is effective either prospectively or retrospectively for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years, with early adoption permitted. The Company is currently evaluating how to apply the new guidance. +Reporting Comprehensive Income . In February 2018, the FASB issued ASU 2018-02, Income Statement — Reporting Comprehensive Income (ASC 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (AOCI), which gives entities the option to reclassify to retained earnings the tax effects resulting from the Tax Reform Act related to items in AOCI that the FASB refers to as having been stranded in AOCI. The new guidance may be applied retrospectively to each period in which the effect of the Tax Reform Act is recognized in the period of adoption. The Company must adopt this guidance for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted for periods for which financial statements have not yet been issued or made available for issuance, including the period the Tax Reform Act was enacted. The guidance, when adopted, will require new disclosures regarding a company’s accounting policy for releasing the tax effects in AOCI and permit the company the option to reclassify to retained earnings the tax effects resulting from the Tax Reform Act that are stranded in AOCI. The Company will adopt this guidance in the first quarter of 2019 and does not expect a material impact on its consolidated financial statements. +Derivatives and Hedging. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (ASC 815): Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12), which amends and simplifies existing guidance in order to allow companies to more accurately present the economic effects of risk management activities in the financial statements. ASU 2017-12 is effective for fiscal years beginning after December 15, 2018, including interim periods therein with early adoption permitted. The Company will adopt this guidance in the first quarter of 2019 and does not expect a material impact on its consolidated financial statements. +Financial Instruments. In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (ASC 326), Measurement of Credit Losses on Financial Instruments (ASU 2016-13). The standard changes the methodology for measuring +60 +credit losses on financial instruments and the timing of when such losses are recorded. ASU 2016-13 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019. Early adoption is permitted for fiscal years, and interim periods within those years, beginning after December 15, 2018. The Company will adopt this guidance in the first quarter of 2020 and is currently evaluating the impact of this new standard on its consolidated financial statements. +Leases. In February 2016, the FASB issued ASU 2016-02, Leases (ASC 842) , to increase transparency and comparability among organizations for lease recognition and disclosure. ASU 2016-02 requires lessees to recognize lease assets and lease liabilities on the balance sheet, while recognizing expenses on the income statements in a manner similar to current guidance. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted. The Company did not early adopt this standard and therefore the standard will be effective for the Company in the first quarter of 2019. ASU 2016-02 requires that leases be recognized and measured as of the earliest period presented, using a modified retrospective approach, with all periods presented being adjusted and presented under the new standard. In July 2018, the FASB issued ASU 2018-11, Leases (ASC 842) : Targeted Improvements, which provides companies an optional adoption method to ASU 2016-02 whereby a company does not have to adjust comparative period financial statements for the new standard. The Company will adopt the new standard using the optional adoption method and thereby not adjust comparative financial statements. +The Company is finalizing its implementation related to policies, processes and internal controls to comply with the guidance. The Company estimates that the right-of-use assets and lease liabilities for the lease portfolio as of December 29, 2018 to be recorded on its consolidated balance sheet, as of December 30, 2018 to be within the range of $225 million to $275 million , primarily relating to real estate. No impact is expected to its consolidated statements of operations or its consolidated statement of cash flows. +Although there are several other new accounting pronouncements issued or proposed by the FASB, which the Company has adopted or will adopt, as applicable, the Company does not believe any of these accounting pronouncements has had or will have a material impact on its consolidated financial position, operating results or statements of cash flows. +NOTE 3: GLOBALFOUNDRIES +Wafer Supply Agreement. The Company and GLOBALFOUNDRIES Inc. (GF) entered into a Wafer Supply Agreement (the WSA) in 2009, under which, among other terms, the Company would purchase wafers from GF. The WSA, which has been amended from time to time, governs the terms by which the Company purchases products manufactured by GF. +Sixth Amendment to Wafer Supply Agreement. On August 30, 2016, the Company entered into a sixth amendment to the WSA (the WSA Sixth Amendment). The WSA Sixth Amendment modified certain terms of the WSA applicable to wafers for the Company’s microprocessor, graphics processor and semi-custom products for a five -year period from January 1, 2016 to December 31, 2020. The Company and GF also agreed to establish a comprehensive framework for technology collaboration for the 7nm technology node. +The WSA Sixth Amendment also provides the Company a limited waiver with rights to contract with another wafer foundry with respect to certain products in the 14nm and 7nm technology nodes and gives the Company greater flexibility in sourcing foundry services across its product portfolio. In consideration for these rights, the Company agreed to pay GF $100 million , to be paid in a series of installments starting in the fourth quarter of 2016 through the third quarter of 2017. The Company paid these installments in compliance with the agreement. Starting in 2017 and continuing through 2020, the Company also agreed to make quarterly payments to GF based on the volume of certain wafers purchased from another wafer foundry. +Further, for each calendar year during the term of the WSA Sixth Amendment, the Company and GF agreed to annual wafer purchase targets that increase from 2016 through 2020. If the Company does not meet the annual wafer purchase target for any calendar year, the Company will be required to pay to GF a portion of the difference between the Company’s actual wafer purchases and the wafer purchase target for that year. The annual targets were established based on the Company’s business and market expectations and took into account the limited waiver it received for certain products. In 2018 , 2017 and 2016 , the Company met its respective annual wafer purchase targets. +The Company and GF also agreed on fixed pricing for wafers purchased during 2016 and established a framework to agree on annual wafer pricing for the years 2017 to 2020. In 2018 and 2017 , the Company and GF had agreed on pricing for wafer purchases. +The Company’s total purchases from GF related to wafer manufacturing, research and development activities and other for 2018 , 2017 and 2016 were $1.6 billion , $1.1 billion and $0.7 billion , respectively. Included in the total purchases for the year ended December 29, 2018 were amounts related to the volume of certain wafers purchased from another wafer foundry, as agreed by the Company and GF under the WSA Sixth Amendment. As of December 29, 2018 and December 30, 2017 , the amount of prepayment and receivables related to GF was $18 million and $27 million , respectively, included in Prepayment and receivables +61 +- related parties on the Company's consolidated balance sheets. As of December 29, 2018 and December 30, 2017 , the amount of payable to GF was $326 million and $241 million , respectively, included in Payables to related parties on the Company's consolidated balance sheets. +Seventh Amendment to Wafer Supply Agreement . On January 28, 2019, the Company entered into a seventh amendment (the Seventh Amendment) to the Wafer Supply Agreement with GF. The Seventh Amendment modifies certain purchase commitments, pricing and other terms of the WSA applicable to wafer purchases at the 12 nm technology node and above by the Company for the period commencing on January 1, 2019 and continuing through March 1, 2024. +The Seventh Amendment also provides the Company with full flexibility to contract with any wafer foundry with respect to all products manufactured using 7nm and smaller technology nodes without any one-time payments or royalties by the Company to GF. +Further, the Company and GF agreed to modify the annual wafer purchase targets previously agreed to in the WSA Sixth Amendment for years 2019 and 2020. The parties also agreed to an annual wafer purchase target for 2021 and agreed to pricing for wafers purchased for years 2019, 2020 and 2021. If the Company does not meet the annual wafer purchase target for any of these years, the Company will be required to pay to GF a portion of the difference between the Company’s actual wafer purchases and the wafer purchase target for that year. The Company expects that its future purchases from GF will be material under the WSA, which is in place until March 1, 2024. +Warrant Agreement. Also on August 30, 2016, in consideration for the limited waiver and rights under the WSA Sixth Amendment, the Company entered into a warrant agreement (the Warrant Agreement) with WCH, a wholly-owned subsidiary of Mubadala. Under the Warrant Agreement, WCH and its permitted assigns are entitled to purchase 75 million shares of the Company’s common stock (the Warrant Shares) at a purchase price of $5.98 per share. The warrant is exercisable in whole or in part until February 29, 2020. Notwithstanding the foregoing, the Warrant Agreement will only be exercisable to the extent that Mubadala does not beneficially own, either directly or through any other entities directly and indirectly owned by Mubadala or its subsidiaries, an aggregate of more than 19.99% of the Company’s outstanding capital stock after any such exercise. +GF continues to be a related party of the Company because Mubadala and Mubadala Tech are affiliated with WCH, a significant stockholder of the Company. GF, WCH and Mubadala Tech are wholly-owned subsidiaries of Mubadala. +On February 5, 2019, WCH notified the Company it would exercise its warrant to purchase 75 million shares of the Company’s common stock at a purchase price of $5.98 per share for a total amount of $448.5 million . The Company expects to receive proceeds of $448.5 million upon the exercise of the warrant and issue the 75 million shares of its common stock to WCH in accordance with the terms of the Warrant Agreement. +62 +NOTE 4: Equity Interest Purchase Agreement - ATMP Joint Venture +In April 2016, the Company and certain of its subsidiaries completed the sale of a majority of the equity interests in Suzhou TF-AMD Semiconductor Co., Ltd. (formerly, AMD Technologies (China) Co., Ltd.), and TF AMD Microelectronics (Penang) Sdn. Bhd. (formerly, Advanced Micro Devices Export Sdn. Bhd.), to affiliates of Tongfu Microelectronics Co., Ltd. (formerly, Nantong Fujitsu Microelectronics Co., Ltd.) (TFME), a Chinese joint stock company, to form two joint ventures (collectively, the ATMP JV). As a result of the sale, TFME’s affiliates own 85% of the equity interests in the ATMP JV while certain of the Company’s subsidiaries own the remaining 15% . The Company has no obligation to fund the ATMP JV. +As a result of the transaction, the Company received approximately $342 million , including purchase price adjustments, in net cash proceeds for selling 85% of the equity interest in each of Suzhou TF-AMD Semiconductor Co., Ltd. and TF AMD Microelectronics (Penang) Sdn. Bhd. These proceeds, net of certain transaction costs, were included in investing activities on the Company’s consolidated statements of cash flows for the year ended December 31, 2016. +The Company recognized a net pre-tax gain on the sale of its 85% equity interest in ATMP JV of $146 million for the year ended December 31, 2016, which was recognized in Other income (expense), net on the Company’s consolidated statements of operations. The net pre-tax gain reflects the excess of the sum of net cash proceeds and fair value of the Company’s retained 15% equity interests in the ATMP JV over the sum of the net book values of the Company’s former subsidiaries and other closing costs directly attributed to the divestiture. The above gain includes $11 million in excess of fair value of the Company’s retained interest over the corresponding net book values. During 2017, the Company recorded a $3 million pre-tax gain for final settlement related to the sale of 85% of the equity interest in ATMP facilities in Other income (expense), net on its consolidated statements of operations. +The Company accounts for its equity interests in the ATMP JV under the equity method of accounting due to its significant influence over the ATMP JV. As of December 29, 2018 and December 30, 2017 , the carrying value of the Company’s investment in the ATMP JV was approximately $58 million and $58 million , respectively. The ATMP JV is a related party of the Company. The ATMP JV provides assembly, test, mark and packaging (ATMP) services to the Company. The Company currently pays the ATMP JV for ATMP services on a cost-plus basis. The Company assists the ATMP JV in its management of certain raw material inventory. The purchases from and resales back to the ATMP JV of the inventory under inventory management is reported within purchases and resales with the ATMP JV and does not impact the Company’s consolidated statement of operations. +The Company’s total purchases from the ATMP JV during 2018 and 2017 amounted to approximately $574 million and $438 million , respectively. As of December 29, 2018 and December 30, 2017 , the amount payable to the ATMP JV was $207 million and $171 million , respectively, included in Payables to related parties on the Company’s consolidated balance sheets. The Company’s resales back to the ATMP JV during 2018 and 2017 amounted to approximately $62 million and $3 million , respectively. As of December 29, 2018 and December 30, 2017 , the Company had receivables from ATMP JV of $16 million and $3 million , respectively, included in Prepayment and receivables - related parties on the Company’s consolidated balance sheets. +During 2018 , 2017 , and 2016 , the Company recorded $2 million , $7 million and $10 million , respectively, in Equity loss in investee on its consolidated statements of operations, which included certain expenses incurred by the Company on behalf of the ATMP JV. +NOTE 5: Equity Joint Venture +In February 2016, the Company and Higon Information Technology Co., Ltd. (formerly, Tianjin Haiguang Advanced Technology Investment Co., Ltd.) (THATIC), a third-party Chinese entity (JV Partner), formed a joint venture comprised of two separate legal entities, China JV1 and China JV2 (collectively, the THATIC JV). The Company’s equity share in China JV1 and China JV2 is a majority and minority interest, respectively, funded by the Company’s contribution of certain of its patents. The JV Partner is responsible for the initial and on-going financing of the THATIC JV’s operations. The Company has no obligations to fund the THATIC JV. +The Company concluded the China JV1 and China JV2 are not operating joint ventures and are variable interest entities due to their reliance on on-going financing by the JV Partner. The Company determined that it is not the primary beneficiary of either China JV1 or China JV2, as the Company does not have unilateral power to direct selling and marketing, manufacturing and product development activities related to the THATIC JV’s products. Accordingly, the Company does not consolidate either of these entities and therefore accounts for its investments in the THATIC JV under the equity method of accounting. The THATIC JV is a related party of the Company. +63 +In February 2016, the Company licensed certain of its intellectual property (Licensed IP) to the THATIC JV for a total of approximately $293 million in license fees payable over several years contingent upon achievement of certain milestones. The Company also expects to receive a royalty based on the sales of the THATIC JV’s products to be developed on the basis of such Licensed IP. The Company also provided certain engineering and technical support to the THATIC JV in connection with the product development. In March 2017, the Company entered into a development and intellectual property agreement (Development and IP) with THATIC JV, and also expects to receive a royalty based on the sales of the THATIC JV’s products to be developed on the basis of such agreement. In addition, from time to time the Company enters into certain agreements with the THATIC JV to provide other services primarily related to research and development. +The Company recognized income related to the Licensed IP over the period commencing upon delivery of the first Licensed IP milestone through the date of the milestone that required the Company’s continuing involvement in the product development process, which was completed at the end of the second quarter of 2017. Royalty payments will be recognized in income once earned. The Company classifies Licensed IP income and royalty income associated with the February 2016 agreement as licensing gain within other operating income. +During 2018 , the Company recognized $86 million of IP-related revenue upon completion of all technology milestones under the Development and IP agreement. During 2017 and 2016, the Company recognized $52 million and $88 million , respectively, as licensing gain associated with the Licensed IP. +The Company’s share in the net losses of the THATIC JV for 2018 was not material and is not recorded in the Company’s consolidated statement of operations since the Company is not obligated to fund the THATIC JV’s losses in excess of the Company’s investment in the THATIC JV, which was zero as of December 29, 2018 . The Company’s receivable from the THATIC JV for these agreements was $18 million and $3 million as of December 29, 2018 and December 30, 2017 , respectively, included in Prepayment and receivables - related parties on its consolidated balance sheets. As of December 29, 2018 and December 30, 2017 , the total assets and liabilities of the THATIC JV were not material . +NOTE 6: Supplemental Balance Sheet Information +Accounts Receivable, net +As of December 29, 2018 and December 30, 2017 , Accounts receivable, net included unbilled accounts receivable of $308 million and $75 million , respectively. Unbilled receivables primarily represent work completed on semi-custom products under non-cancellable purchase orders that have no alternative use to the Company at contract inception, for which revenue has been recognized but not yet invoiced to customers. All unbilled accounts receivables are expected to be billed and collected within 12 months. +Inventories, net +December 29, +2018 +December 30, +2017 +(In millions) +Raw materials +$ +134 +$ +34 +Work in process +354 +446 +Finished goods +357 +214 +Total inventories, net +$ +845 +$ +694 +Property and Equipment, net +December 29, +2018 +December 30, +2017 +(In millions) +Leasehold improvements +$ +179 +$ +187 +Equipment +798 +758 +Construction in progress +78 +56 +Property and equipment, gross +1,055 +1,001 +Accumulated depreciation and amortization +(707 +) +(740 +) +Total property and equipment, net +$ +348 +$ +261 +64 +Depreciation expense for 2018 , 2017 and 2016 was $94 million , $77 million and $71 million , respectively. +Other Assets +December 29, +2018 +December 30, +2017 +(In millions) +Software and technology licenses, net +$ +226 +$ +239 +Other +95 +71 +Total other assets +$ +321 +$ +310 +During the fourth quarter of 2018, the Company recorded an impairment charge in Cost of sales of $45 million on technology licenses that are no longer being used. +Accrued Liabilities +December 29, +2018 +December 30, +2017 +(In millions) +Accrued compensation and benefits +$ +236 +$ +206 +Marketing programs and advertising expenses +275 +145 +Software technology and licenses payable +28 +41 +Other accrued and current liabilities +224 +163 +Total accrued liabilities +$ +763 +$ +555 +Other Current Liabilities +December 29, +2018 +December 30, +2017 +(In millions) +Unearned revenue +$ +11 +$ +85 +Other +13 +7 +Total other current liabilities +$ +24 +$ +92 +Unearned revenue represents consideration received or due from customers in advance of the Company satisfying its performance obligations. The unearned revenue is associated with any combination of development services, IP licensing and product revenue. Changes in unearned revenue were as follows: +December 29, +2018 +December 30, +2017 +(In millions) +Beginning balance +$ +85 +$ +22 +Unearned revenue +132 +104 +Revenue recognized during the period +(186 +) +(41 +) +Other +(20 +) +— +Ending balance +$ +11 +$ +85 +Revenue allocated to remaining performance obligations that are unsatisfied (or partially unsatisfied) as of December 29, 2018 is $95 million , which may include amounts received from customer but not yet earned and amounts that will be invoiced and recognized as revenue in future periods associated with any combination of development services, IP licensing and product revenue. The Company expects to recognize $78 million in the next 12 months, and the remainder thereafter. As permitted under ASC 606, the Company has not disclosed the comparative amounts as of December 30, 2017. +65 +The revenue allocated to remaining performance obligations did not include amounts which have an original expected duration of less than one year. +NOTE 7: Goodwill +Goodwill +The carrying amount of goodwill as of both December 29, 2018 and December 30, 2017 was $289 million , which was fully allocated to the Company's Enterprise, Embedded and Semi-Custom segment. +In the fourth quarters of 2018 and 2017 , the Company conducted its annual impairment tests of goodwill. The Company determined that the estimated fair value exceeded the carrying value of the reporting units, indicating that there was no goodwill impairment with respect to these reporting units. +NOTE 8: Financial Instruments +Cash, Cash Equivalents, and Marketable Securities +Cash and financial instruments measured and recorded at fair value on a recurring basis, which approximates amortized cost, as of December 29, 2018 and December 30, 2017 are summarized below: +Total Fair +Value +Cash and +Cash +Equivalents +Short-Term +Marketable +Securities +(In millions) +December 29, 2018 +Cash +$ +315 +$ +315 +$ +— +Level 1 (1) (2) +Government money market funds +$ +275 +$ +275 +$ +— +Total level 1 +$ +275 +$ +275 +$ +— +Level 2 (1) (3) +Commercial paper +$ +566 +$ +488 +$ +78 +Total level 2 +$ +566 +$ +488 +$ +78 +Total +$ +1,156 +$ +1,078 +$ +78 +Total Fair +Value +Cash and +Cash +Equivalents +Short-Term +Marketable +Securities +(In millions) +December 30, 2017 +Cash +$ +108 +$ +108 +$ +— +Level 1 (1) (2) +Government money market funds +$ +395 +$ +395 +$ +— +Total level 1 +$ +395 +$ +395 +$ +— +Level 2 (1) (3) +Commercial paper +$ +682 +$ +682 +$ +— +Total level 2 +$ +682 +$ +682 +$ +— +Total +$ +1,185 +$ +1,185 +$ +— +(1) +The Company did not have any transfers between Level 1 and Level 2 during 2018 and 2017 . +(2) +The Company’s Level 1 assets are valued using quoted prices for identical instruments in active markets. +(3) +The Company’s Level 2 assets are valued using broker reports that utilize quoted prices for identical instruments in markets that are not active or comparable instruments in active markets. Brokers gather observable inputs for all of the Company’s fixed income securities from a variety of industry data providers and other third-party sources. +66 +In addition to those amounts presented above, as of December 29, 2018 and December 30, 2017 , the Company had approximately $5 million and $2 million , respectively, of investments in money market funds used as collateral for letters of credit deposits which were included in Other current assets and Other assets, respectively, on the Company’s consolidated balance sheets. These money market funds are classified within Level 1 because they are valued using quoted prices for identical instruments in active markets. Their amortized costs are the same as the fair value for all periods presented. The Company is restricted from accessing these deposits. +As of December 29, 2018 and December 30, 2017 , the Company also had approximately $21 million and $18 million , respectively, of investments in mutual funds held in a Rabbi trust established for the Company’s deferred compensation plan which were also included in Other assets on the Company’s consolidated balance sheets. These mutual funds are classified within Level 1 because they are valued using quoted prices for identical instruments in active markets. Their amortized cost approximates the fair value for all periods presented. The Company is restricted from accessing these investments. +Financial Instruments Not Recorded at Fair Value on a Recurring Basis. The Company carries its financial instruments at fair value with the exception of its debt. Financial instruments that are not recorded at fair value are measured at fair value on a quarterly basis for disclosure purposes. The carrying amounts and estimated fair values of financial instruments not recorded at fair value are as follows: +December 29, 2018 +December 30, 2017 +Carrying +Amount +Estimated +Fair Value +Carrying +Amount +Estimated +Fair Value +(In millions) +Short-term debt +$ +136 +$ +136 +$ +70 +$ +70 +Long-term debt, net (1) +$ +1,114 +$ +2,428 +$ +1,324 +$ +2,103 +(1) +Carrying amounts of long-term debt are net of unamortized debt issuance costs of $16 million and $19 million as of December 29, 2018 and December 30, 2017 , respectively, and net of $262 million and $286 million unamortized debt discount associated with the 2.125% Notes as of December 29, 2018 and December 30, 2017 , respectively. +The Company’s short-term and long-term debt, net are classified within Level 2. The fair value of the debt was estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. +The fair value of the Company’s accounts receivable, accounts payable and other short-term obligations approximate their carrying value based on existing payment terms. +Hedging Transactions and Derivative Financial Instruments +Cash Flow Hedges and Foreign Currency Forward Contracts not Designated as Hedges +The following table shows the amount of gain (loss) included in accumulated other comprehensive income (loss), the amount of gain (loss) reclassified from accumulated other comprehensive income (loss) (OCI) and included in earnings related to the foreign currency forward contracts designated as cash flow hedges and the amount of gain (loss) included in other income (expense), net, related to contracts not designated as hedging instruments which was allocated in the consolidated statements of operations: +Consolidated Statements of Operations and +Statements of Comprehensive Income (Loss) Location +2018 +2017 +(In millions) +Foreign Currency Forward Contracts - gains (losses) +Contracts designated as cash flow hedging instruments +Other comprehensive income (loss) +$ +(14 +) +$ +9 +Gains (losses) reclassified from OCI into income +Research and development +(4 +) +7 +Gains (losses) reclassified from OCI into income +Cost of sales; Marketing, general and administrative +(1 +) +1 +Total Gains (losses) reclassified from OCI into income +(5 +) +8 +Contracts not designated as hedging instruments +Gains (losses) recognized in income +Other income (expense), net +$ +(3 +) +$ +(3 +) +67 +The Company’s foreign currency derivative contracts are classified within Level 2 because the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets such as currency spot and forward rates. +The following table shows the fair value amounts included in Other current assets should the foreign currency forward contracts be in a gain position or included in Other current liabilities should these contracts be in a loss position. These amounts were recorded in the Company’s consolidated balance sheets as follows: +December 29, +2018 +December 30, +2017 +(In millions) +Foreign Currency Forward Contracts - gains (losses) +Contracts designated as cash flow hedging instruments +$ +(7 +) +$ +7 +For the foreign currency contracts designated as cash flow hedges, the ineffective portions of the hedging relationship and the amounts excluded from the assessment of hedge effectiveness were immaterial. +As of December 29, 2018 and December 30, 2017 , the notional values of the Company’s outstanding foreign currency forward contracts were $396 million and $300 million , respectively. All the contracts mature within 12 months and, upon maturity, the amounts recorded in accumulated other comprehensive income (loss) are expected to be reclassified into earnings. The Company hedges its exposure to the variability in future cash flows for forecasted transactions over a maximum of 12 months. +NOTE 9: Accumulated Other Comprehensive Income (Loss) +Unrealized holding gains or losses on the Company’s available-for-sale securities and unrealized holding gains and losses on derivative financial instruments qualifying as cash flow hedges are included in other comprehensive income (loss). +The table below summarizes the changes in accumulated other comprehensive income (loss) by component for the years ended December 29, 2018 and December 30, 2017: +Year Ended +December 29, 2018 +December 30, 2017 +Unrealized gains (losses) on available-for-sale securities +Unrealized gains (losses) on cash flow hedges +Total +Unrealized gains (losses) on available-for-sale securities +Unrealized gains (losses) on cash flow hedges +Total +(In millions) +Beginning balance +$ +— +$ +6 +$ +6 +$ +(1 +) +$ +(4 +) +$ +(5 +) +Unrealized gains (losses) arising during the period +— +(19 +) +(19 +) +1 +17 +18 +Reclassification adjustment for gains realized and included in net income (loss) +— +5 +5 +— +(7 +) +(7 +) +Tax effect +— +— +— +— +— +— +Total other comprehensive income (loss) +— +(14 +) +(14 +) +1 +10 +11 +Ending balance +$ +— +$ +(8 +) +$ +(8 +) +$ +— +$ +6 +$ +6 +NOTE 10: Concentrations of Credit and Operation Risk +Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of investments in available-for-sale debt securities, trade receivables and derivative financial instruments used in hedging activities. +The Company places its investments with high credit quality financial institutions and, by policy, limits the amount of credit exposure with any one financial institution. The Company invests in time deposits and certificates of deposit from banks having combined capital, surplus and undistributed profits of not less than $200 million . At the time an investment is made, investments in commercial paper of industrial firms and financial institutions are rated A1, P1 or better. The Company invests in tax-exempt securities including municipal notes and bonds and bonds that are rated A, A2 or better and repurchase agreements, each of which have securities of the type and quality listed above as collateral. +The Company believes that concentrations of credit risk with respect to trade receivables are limited because a large number of geographically diverse customers make up the Company’s customer base, thus diluting the trade credit risk. Accounts receivable from the Company’s top three customers accounted for approximately 16% , 12% and 7% of the total consolidated accounts +68 +receivable balance as of December 29, 2018 and 15% , 13% and 11% of the total consolidated accounts receivable balance as of December 30, 2017 . However, the Company does not believe the receivable balance from these customers represents a significant credit risk based on past collection experience and review of their current credit quality. The Company manages its exposure to customer credit risk through credit limits, credit lines, ongoing monitoring procedures and credit approvals. Furthermore, the Company performs in-depth credit evaluations of all new customers and, at intervals, for existing customers. From this, the Company may require letters of credit, bank or corporate guarantees or advance payments if deemed necessary. +The Company’s existing derivative financial instruments are with large international financial institutions of investment grade credit rating. The Company does not believe that there is significant risk of nonperformance by these counter-parties because the Company monitors their credit rating on an ongoing basis. By using derivative instruments, the Company is subject to credit and market risk. If a counter-party fails to fulfill its performance obligations under a derivative contract, the Company’s credit risk will equal the fair value of the derivative instrument. Generally, when the fair value of a derivative contract is positive, the counter-party owes the Company, thus creating a receivable risk for the Company. Based upon certain factors including a review of the credit default swap rates for the Company’s counter-parties, the Company determined its counter-party credit risk to be immaterial. At December 29, 2018 , the Company’s obligations under the contracts exceeded counter-parties' obligations by $8 million . +The Company is dependent on certain equipment and materials from a limited number of suppliers and relies on a limited number of foreign companies to supply the majority of certain types of integrated circuit packages for back-end manufacturing operations. Similarly, certain non-proprietary materials or components such as memory, PCBs, substrates and capacitors used in the manufacture of the Company’s graphics products are currently available from only a limited number of sources. Interruption of supply or increased demand in the industry could cause shortages and price increases in various essential materials. If the Company or its third-party manufacturing suppliers are unable to procure certain of these materials or its foundries are unable to procure materials for manufacturing its products, its business would be materially adversely affected. +NOTE 11: Income Taxes +The provision (benefit) for income taxes consists of: +2018 +2017 (1) +2016 (1) +(In millions) +Current: +U.S. Federal +$ +12 +$ +(3 +) +$ +(2 +) +U.S. State and Local +— +— +— +Foreign National and Local +(17 +) +37 +21 +Total +(5 +) +34 +19 +Deferred: +U.S. Federal +— +(15 +) +(1 +) +Foreign National and Local +(4 +) +(1 +) +21 +Total +(4 +) +(16 +) +20 +Provision (benefit) for income taxes +$ +(9 +) +$ +18 +$ +39 +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2. +The income tax benefit in 2018 was primarily due to a $36 million refund of withholding tax from a foreign jurisdiction related to a legal settlement from 2010, offset by $13 million of U.S. income taxes resulting from the Tax Reform Act, $7 million tax provision in foreign locations and $7 million of withholding taxes on cross-border transactions. +The income tax provision in 2017 was primarily due to withholding taxes applicable to IP-related revenue and licensing gains from foreign locations. +The income tax provision in 2016 was primarily due to $41 million of foreign taxes in profitable locations including $27 million attributable to a gain on the sale of 85% of the ownership interest in the subsidiary operating a factory in Suzhou and $9 million of withholding taxes on cross-border transactions where no foreign tax credit is expected to be realizable, offset by $2 million of tax benefits for Canadian tax credits and the monetization of certain U.S. tax credits. +Income (loss) before income taxes consists of the following: +69 +2018 +2017 +2016 +(In millions) +U.S. +$ +114 +$ +53 +$ +(609 +) +Foreign +214 +(68 +) +150 +Total pre-tax income (loss) including equity loss in investee +$ +328 +$ +(15 +) +$ +(459 +) +Deferred income taxes reflect the net tax effects of tax carryovers and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the balances for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 29, 2018 and December 30, 2017 are as follows: +December 29, +2018 +December 30, +2017 (1) +(In millions) +Deferred tax assets: +Net operating loss carryovers +$ +1,533 +$ +1,551 +Inventory valuation +25 +20 +Accrued expenses not currently deductible +98 +61 +Acquired intangibles +76 +102 +Tax deductible goodwill +25 +56 +Federal and state tax credit carryovers +527 +546 +Foreign research and development ITC credits +370 +391 +Other +89 +62 +Total deferred tax assets +2,743 +2,789 +Less: valuation allowance +(2,580 +) +(2,621 +) +Total deferred tax assets, net of valuation allowance +163 +168 +Deferred tax liabilities: +Discount of convertible notes +(54 +) +(58 +) +Undistributed foreign earnings +(94 +) +(97 +) +Other +(11 +) +(13 +) +Total deferred tax liabilities +(159 +) +(168 +) +Net deferred tax assets +$ +4 +$ +— +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2. +The breakdown between deferred tax assets and deferred tax liabilities as of December 29, 2018 and December 30, 2017 is as follows: +December 29, +2018 +December 30, +2017 (1) +(In millions) +Deferred tax assets +$ +15 +$ +11 +Deferred tax liabilities +(11 +) +(11 +) +Net deferred tax assets +$ +4 +$ +— +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers. Refer to Note 2. +Deferred tax assets are included in the caption Other assets on the consolidated balance sheets. Deferred tax liabilities are included in the caption Other long-term liabilities on the consolidated balance sheets. +In December 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act of 2017 (Tax Reform Act). The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates, implementing a modified territorial tax system and imposing a transition tax on deemed repatriated earnings of foreign subsidiaries. The Tax Reform Act permanently reduces the U.S. corporate income tax rate from a maximum of 35% to a flat 21% rate, effective January 1, 2018. ASC 740: Income Taxes , requires companies to recognize the effect of the tax law changes +70 +in the period of enactment. However, the SEC staff issued Staff Accounting Bulletin No. 118 (SAB 118) which allowed companies to record provisional amounts during a measurement period that is similar to the measurement period used when accounting for business combinations. As a result, in 2017, the Company provisionally adjusted its deferred tax assets and liabilities based on the reduction of the U.S. federal corporate tax rate from 35% to 21% and assessed the realizability of its deferred tax assets based upon the best available information at that time. In addition, the Company recognized the provisional tax impacts related to deemed repatriated earnings and the revaluation of deferred tax assets and liabilities in its consolidated financial statements for the year ended December 30, 2017. During 2018, the Company finalized its computation of the impact of the Tax Reform Act. +The Tax Reform Act also eliminated the corporate alternative minimum tax (AMT) for tax years commencing on or after January 1, 2018. As a result, AMT credit carryforwards may be utilized to reduce future income tax liabilities. In addition, excess AMT credits are refundable in any taxable year beginning after 2017 and before 2022 in an amount equal to 50% (100% in the case of taxable years beginning in 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. Accordingly, the Company recorded $16 million of AMT credit carry forwards as a tax receivable in 2017. +As of December 29, 2018 , substantially all of the Company’s U.S. and foreign deferred tax assets, net of deferred tax liabilities, continued to be subject to a valuation allowance. The realization of these assets is dependent on substantial future taxable income which at December 29, 2018 , in management’s estimate, is not more likely than not to be achieved. In 2018 , the net valuation allowance decreased by $43 million primarily for decreases related to net operating loss carryovers, federal and state tax credit carryovers, acquired intangibles and goodwill. In 2017 , gross deferred tax assets decreased by $1,018 million primarily for provisional decreases related to the remeasurement of deferred tax assets due to the 21% tax rate under the Tax Reform Act, as well as decreases related to acquired intangibles and goodwill, offset by a decrease in the gross deferred tax liability balance of $112 million primarily for provisional decreases related to the remeasurement of deferred tax liabilities due to the 21% tax rate under the Tax Reform Act, and a decrease in the gross valuation allowance of $905 million . In 2016 , the net valuation allowance decreased by $143 million primarily for increases in deferred tax assets related to foreign capitalized research costs, acquired intangibles and goodwill. +The following is a summary of the Company’s various tax attribute carryforwards as of December 29, 2018 . +Carryforward +Federal +State / +Provincial +Expiration +(In millions) +U.S.-net operating loss carryovers +$ +7,140 +$ +317 +2018 to 2037 +U.S.-credit carryovers +$ +372 +$ +219 +2018 to 2037 +Canada-net operating loss carryovers +$ +17 +$ +17 +2027 to 2028 +Canada-credit carryovers +$ +338 +$ +28 +2023 to 2037 +Other foreign net operating loss carryovers +$ +44 +N/A +various +Utilization of $6 million of the Company’s U.S. federal net operating loss carryforwards are subject to annual limitations as a result of the ATI Technologies ULC (ATI) acquisition. +The table below displays the reconciliation between statutory federal income taxes and the total provision (benefit) for income taxes. +2018 +2017 +2016 +(In millions) +Statutory federal income tax expense (benefit) at 21%, 35% and 35% rate +$ +69 +$ +22 +$ +(160 +) +State taxes, net of federal benefit +1 +1 +1 +Foreign (income) expense at other than U.S. rates +2 +— +(1 +) +U.S. valuation allowance generated (utilized) +(93 +) +15 +201 +Credit monetization +(1 +) +(20 +) +(2 +) +Tax Reform Act taxes +13 +— +— +Provision (benefit) for income taxes +$ +(9 +) +$ +18 +$ +39 +As part of the transition from a world-wide tax system to a territorial (dividend exemption) system, the Tax Reform Act imposes a one-time transition tax on the cumulative undistributed post-1986 earnings and profits of certain foreign subsidiaries. The transition tax applies at a rate of 15.5% for earnings held as liquid assets and 8.0% for earnings held as illiquid assets by the foreign subsidiaries. +71 +Because of the transition to a territorial system under the Tax Reform Act, the taxation of future dividend distributions by foreign subsidiaries is expected to be limited to withholding taxes which may apply based on the jurisdiction of the subsidiary. The Company has made no provision for taxes on approximately $142 million of cumulative undistributed earnings of certain foreign subsidiaries as of December 29, 2018, and on approximately $117 million as of December 30, 2017, based on the Company’s intention to indefinitely reinvest such earnings. However, if such earnings were distributed, the Company would incur additional foreign withholding taxes. +A reconciliation of the Company's gross unrecognized tax benefits is as follows: +2018 +2017 (1) +2016 (1) +(In millions) +Balance at beginning of year +$ +49 +$ +42 +$ +38 +Increases for tax positions taken in prior years +1 +7 +3 +Decreases for tax positions taken in prior years +(1 +) +(2 +) +— +Increases for tax positions taken in the current year +3 +3 +2 +Decreases for settlements with taxing authorities +(2 +) +— +— +Decreases for lapsing of the statute of limitations +(1 +) +(1 +) +(1 +) +Balance at end of year +$ +49 +$ +49 +$ +42 +(1) Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2. +The amount of unrecognized tax benefits that would impact the effective tax rate was $9 million , $9 million and $4 million as of December 29, 2018 , December 30, 2017 and December 31, 2016 , respectively. The Company had no material amounts of accrued interest and accrued penalties related to unrecognized tax benefits as of December 29, 2018 , December 30, 2017 and December 31, 2016 . +The Company does not believe it is reasonably possible that its unrecognized tax benefits will materially change in the next 12 months. However, the resolutions and/or closure of open audits are highly uncertain. The Company and its subsidiaries have several foreign, foreign provincial, and U.S. state audits in process at any one point in time. The Company has provided for uncertain tax positions that require a liability under the adopted method to account for uncertainty in income taxes. +NOTE 12: Earnings (Loss) Per Share +Earnings (Loss) Per Share. Basic earnings (loss) per share is computed based on the weighted-average number of shares outstanding. +Diluted net income (loss) per share is computed based on the weighted-average number of shares outstanding plus potentially dilutive shares outstanding during the period. Potentially dilutive shares are determined by applying the treasury stock method to the assumed exercise of outstanding stock options, the assumed vesting of outstanding RSUs, the assumed issuance of common stock under the employee stock purchase plan (ESPP) and the assumed exercise of the warrant under the warrant agreement (the Warrant Agreement) with West Coast Hitech L.P. (WCH), a wholly-owned subsidiary of Mubadala Investment Company PJSC (Mubadala). Potentially dilutive shares issuable upon conversion of the 2.125% Convertible Senior Notes due 2026 ( 2.125% Notes) are calculated using the if-converted method. +The following table sets forth the components of basic and diluted earnings (loss) per share: +72 +2018 +2017 +2016 +(In millions, except per share amounts) +Numerator—Net income (loss): +Numerator for basic and diluted earnings (loss) per share +$ +337 +$ +(33 +) +$ +(498 +) +Denominator—Weighted average shares: +Denominator for basic earnings (loss) per share +982 +952 +835 +Effect of potentially dilutive shares: +Employee equity incentive plans and warrants +82 +— +— +Denominator for diluted earnings (loss) per share +1,064 +952 +835 +Earnings (loss) per share: +Basic +$ +0.34 +$ +(0.03 +) +$ +(0.60 +) +Diluted +$ +0.32 +$ +(0.03 +) +$ +(0.60 +) +Potential shares from employee equity incentive plans and the conversion of the 2.125% Notes totaling 105 million shares for 2018 and potential shares from employee equity incentive plans, the conversion of the 2.125% Notes and the warrants under the Warrants Agreement totaling 189 million and 231 million shares for 2017 and 2016 , respectively, were not included in the diluted earnings (loss) per share calculation as their inclusion would have been anti-dilutive. +NOTE 13: Debt and Secured Revolving Line of Credit +Debt +The Company’s total debt as of December 29, 2018 and December 30, 2017 consisted of: +December 29, +2018 +December 30, +2017 +(In millions) +6.75% Notes +$ +66 +$ +166 +7.50% Notes +337 +347 +7.00% Notes +250 +311 +2.125% Notes +805 +805 +Secured Revolving Line of Credit +70 +70 +Total debt (principal amount) +1,528 +1,699 +Unamortized debt discount associated with 2.125% Notes +(262 +) +(286 +) +Unamortized debt issuance costs +(16 +) +(19 +) +Other +— +1 +Total debt (net) +1,250 +1,395 +Less: current portion +(136 +) +(70 +) +Total debt, less current portion +$ +1,114 +$ +1,325 +2.125% Convertible Senior Notes Due 2026 +In September 2016, the Company issued $805 million in aggregate principal amount of 2.125% Convertible Senior Notes due 2026 ( 2.125% Notes). The 2.125% Notes are general unsecured senior obligations of the Company. The interest is payable semi-annually in March and September of each year, commencing in March 2017. As of December 29, 2018 , the Company had $805 million principal amount outstanding. +The 2.125% Notes mature on September 1, 2026. However, as outlined in the indenture governing the 2.125% Notes, holders of the 2.125% Notes may convert them at their option during certain time periods and upon the occurrence of one of the following circumstances: +(1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2016 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar +73 +quarter is greater than or equal to 130% of the conversion price on each applicable trading day (equivalent to an initial conversion price of approximately $8.00 per share of common stock); +(2) during the five business day period after any ten consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of the Company's common stock and the conversion rate on each such trading day; or +(3) upon the occurrence of specified corporate events. +On or after June 1, 2026 and until the close of business on the business day immediately preceding the maturity date, holders may convert their notes at any time regardless of the foregoing circumstances. Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company’s common stock or a combination of cash and shares of the Company’s common stock at the Company’s election. +The first event described in (1) above was met during the fourth quarter of 2018 and, as a result, the 2.125% Notes are convertible at the option of the holder from January 1, 2019 and remain convertible until March 31, 2019. +The Company’s current intent is to deliver shares of its common stock upon conversion of the 2.125% Notes. As such, no sinking fund is provided for the 2.125% Notes and the Company continued to classify the carrying value of the liability component of the 2.125% Notes as long-term debt and the equity component of the 2.125% Notes as permanent equity on its condensed consolidated balance sheet as of December 29, 2018 . +The determination of whether or not the 2.125% Notes are convertible is performed on a calendar-quarter basis. +The 2.125% Notes consisted of the following: +December 29, +2018 +December 30, +2017 +(In millions) +Principal amounts: +Principal +$ +805 +$ +805 +Unamortized debt discount (1) +(262 +) +(286 +) +Unamortized debt issuance costs +(11 +) +(12 +) +Net carrying amount +$ +532 +$ +507 +Carrying amount of the equity component, net (2) +$ +305 +$ +305 +(1) +Included in the consolidated balance sheets within Long-term debt, net and amortized over the remaining life of the notes using the effective interest rate method. +(2) +Included in the consolidated balance sheets within additional paid-in capital, net of $9 million in equity issuance costs. +As of December 29, 2018 , the remaining life of the 2.125% Notes was approximately 93 months . +Based on the closing price of the Company’s common stock of $17.82 on December 28, 2018, the last trading day of 2018, the if-converted value of the 2.125% Notes exceeded its principal amount by approximately $988 million . +The effective interest rate of the liability component of the 2.125% Notes is 8% . This interest rate was based on the interest rates of similar liabilities at the time of issuance that did not have associated conversion features. The following table sets forth total interest expense recognized related to the 2.125% Notes for the year ended December 29, 2018 : +December 29, +2018 +December 30, +2017 +(In millions) +Contractual interest expense +$ +17 +$ +17 +Interest cost related to amortization of debt issuance costs +1 +2 +Interest cost related to amortization of the debt discount +$ +24 +$ +22 +74 +6.75% Senior Notes Due 2019 +On February 26, 2014 , the Company issued $600 million of its 6.75% Senior Notes due 2019 ( 6.75% Notes). The 6.75% Notes are general unsecured senior obligations of the Company. Interest is payable on March 1 and September 1 of each year beginning September 1, 2014 until the maturity date of March 1, 2019 . The 6.75% Notes are governed by the terms of an indenture (the 6.75% Indenture) dated February 26, 2014 between the Company and Wells Fargo Bank, N.A., as trustee. +In 2016, the Company repurchased $404 million in aggregate principal amount of its 6.75% Notes pursuant to a partial tender offer for $442 million . In 2017, the Company settled $30 million in aggregate principal amount of its 6.75% Notes, of which $26 million was settled in cash and $5 million was settled in treasury stock. +During 2018 , the Company settled $101 million in aggregate principal amount of its 6.75% Notes for $14 million in cash and $87 million in treasury stock at a weighted-average cost of $9.04 per share. As of December 29, 2018 , the outstanding aggregate principal amount of the 6.75% Notes was $66 million . +At any time before March 1, 2019, the Company may redeem some or all of the 6.75% Notes at a price equal to 100% of the principal amount, plus accrued and unpaid interest and a “make whole” premium (as set forth in the 6.75% Indenture). +Holders have the right to require the Company to repurchase all or a portion of the 6.75% Notes in the event that the Company undergoes a change of control, as defined in the 6.75% Indenture, at a price of 101% of the principal amount plus accrued and unpaid interest. Additionally, an event of default (as defined in the 6.75% Indenture) may result in the acceleration of the maturity of the 6.75% Notes. +The 6.75% Indenture contains certain covenants that limit, among other things, the Company’s ability and the ability of its subsidiaries, to: +• +incur additional indebtedness, except specified permitted debt; +• +pay dividends and make other restricted payments; +• +make certain investments if an event of a default exists, or if specified financial conditions are not satisfied; +• +create or permit certain liens; +• +create or permit restrictions on the ability of its subsidiaries to pay dividends or make other distributions to the Company; +• +use the proceeds from sales of assets; +• +enter into certain types of transactions with affiliates; and +• +consolidate, merge or sell its assets as entirety or substantially as an entirety. +7.50% Senior Notes Due 2022 +On August 15, 2012 , the Company issued $500 million of its 7.50% Senior Notes due 2022 ( 7.50% Notes). The 7.50% Notes are general unsecured senior obligations of the Company. Interest is payable on February 15 and August 15 of each year beginning February 15, 2013 until the maturity date of August 15, 2022 . The 7.50% Notes are governed by the terms of an indenture (the 7.50% Indenture) dated August 15, 2012 between the Company and Wells Fargo Bank, N.A., as trustee. +In 2014, the Company repurchased $25 million in aggregate principal amount of its 7.50% Notes in open market transactions for $24 million . In 2016, the Company repurchased $125 million in aggregate principal amount of its 7.50% Notes pursuant to a partial tender offer for $135 million . In 2017, the Company settled $3 million in aggregate principal amount of its 7.50% Notes in treasury stock. +During 2018, the Company settled $10 million in aggregate principal amount of its 7.50% Notes in treasury stock at a weighted-average cost of $9.01 per share. As of December 29, 2018, the outstanding aggregate principal amount of the 7.50% Notes was $337 million . +Prior to August 15, 2022, the Company may redeem some or all of the 7.50% Notes at a price equal to 100% of the principal amount plus accrued and unpaid interest and a “make whole” premium (as defined in the 7.50% Indenture). Holders have the right to require the Company to repurchase all or a portion of the 7.50% Notes in the event that the Company undergoes a change of control as defined in the 7.50% Indenture, at a repurchase price of 101% of the principal amount plus accrued and unpaid interest. Additionally, an event of default (as defined in the 7.50% Indenture) may result in the acceleration of the maturity of the 7.50% Notes. +75 +The 7.50% Indenture contains certain covenants that limit, among other things, the Company’s ability and the ability of its subsidiaries, to: +• incur additional indebtedness, except specified permitted debt; +• pay dividends and make other restricted payments; +• make certain investments if an event of a default exists, or if specified financial conditions are not satisfied; +• create or permit certain liens; +• +create or permit restrictions on the ability of its subsidiaries to pay dividends or make other distributions to the Company; +• use the proceeds from sales of assets; +• enter into certain types of transactions with affiliates; and +• consolidate, merge or sell its assets as entirety or substantially as an entirety. +7.00% Senior Notes Due 2024 +On June 16, 2014 , the Company issued $500 million of its 7.00% Senior Notes due 2024 ( 7.00% Notes). The 7.00% Notes are general unsecured senior obligations of the Company. Interest is payable on January 1 and July 1 of each year beginning January 1, 2015 until the maturity date of July 1, 2024 . The 7.00% Notes are governed by the terms of an indenture (the 7.00% Indenture) dated June 16, 2014 between the Company and Wells Fargo Bank, N.A., as trustee. +In 2016, the Company settled $84 million in aggregate principal amount of its 7.00% Notes for $77 million in cash and $8 million in treasury stock. In 2017, the Company settled $105 million in aggregate principal amount of its 7.00% Notes for $84 million in cash and $26 million in treasury stock. +During 2018 , the Company settled $61 million in aggregate principal amount of its 7.00% Notes for $26 million in cash and $35 million in treasury stock at a weighted-average cost of $9.42 per share. As of December 29, 2018 , the outstanding aggregate principal amount of the 7.00% Notes was $250 million . +Prior to July 1, 2019, the Company may redeem some or all of the 7.00% Notes at a price equal to 100% of the principal amount plus accrued and unpaid interest and a “make whole” premium (as set forth in the 7.00% Indenture). +Starting July 1, 2019, the Company may redeem the 7.00% Notes for cash at the following specified prices plus accrued and unpaid interest: +Period +Price as +Percentage of +Principal Amount +Beginning on July 1, 2019 through June 30, 2020 +103.500 +% +Beginning on July 1, 2020 through June 30, 2021 +102.333 +% +Beginning on July 1, 2021 through June 30, 2022 +101.167 +% +On July 1, 2022 and thereafter +100.000 +% +Holders have the right to require the Company to repurchase all or a portion of the 7.00% Notes in the event that the Company undergoes a change of control as defined in the 7.00% Indenture at a repurchase price of 101% of the principal amount plus accrued and unpaid interest. Additionally, an event of default (as defined in the 7.00% Indenture) may result in the acceleration of the maturity of the 7.00% Notes. +The 7.00% Indenture contains certain covenants that limit, among other things, the Company’s ability and the ability of its subsidiaries, to: +• +incur additional indebtedness, except specified permitted debt; +• +pay dividends and make other restricted payments; +• +make certain investments if an event of a default exists, or if specified financial conditions are not satisfied; +• +create or permit certain liens; +• +create or permit restrictions on the ability of its subsidiaries to pay dividends or make other distributions to the Company; +• +use the proceeds from sales of assets; +76 +• +enter into certain types of transactions with affiliates; and +• +consolidate, merge or sell its assets as entirety or substantially as an entirety. +The 6.75% Notes, 7.50% Notes, 7.00% Notes and 2.125% Notes rank equally with the Company’s existing and future senior debt and are senior to all of the Company’s future subordinated debt. The 6.75% Notes, 7.50% Notes, 7.00% Notes and 2.125% Notes rank junior to all of the Company’s future senior secured debt to the extent of the collateral securing such debt and are structurally subordinated to all existing and future debt and liabilities of the Company’s subsidiaries. +The Company calculated the cost of reissued shares from treasury stock based on weighted-average cost of the treasury stock. During 2018, the Company recorded $12 million of aggregate losses from the extinguishment of debt noted above in Other Income & Expense, net on its consolidated statements of operations. +Potential Repurchase of Outstanding Notes +The Company may elect to purchase or otherwise retire the 6.75% Notes, 7.50% Notes, 7.00% Notes and 2.125% Notes with cash, stock or other assets from time to time in open market or privately negotiated transactions either directly or through intermediaries or by tender offer when the Company believes the market conditions are favorable to do so. +Secured Revolving Line of Credit +On April 14, 2015, the Company and its subsidiary, AMD International Sales & Service, Ltd. (together, the Borrowers), ATI Technologies ULC (collectively with the Borrowers, the Loan Parties), a group of lenders and Bank of America N.A., acting as the agent for the lenders, entered into an amended and restated loan and security agreement, as amended (the Agreement). The Agreement provides for a secured revolving line of credit (the Secured Revolving Line of Credit) that allows the Borrowers to borrow, repay and re-borrow amounts from time to time up to $500 million with up to $45 million available for issuance of letters of credit, subject to certain conditions. Borrowings are limited up to a certain amount of eligible accounts receivable, as determined in accordance with the Agreement. The size of the commitment under the Secured Revolving Line of Credit may be increased by up to an aggregate amount of $200 million . The commitments under the Secured Revolving Line of Credit are available through March 21, 2022. The Borrowers are subject to commitment fees and letter of credit facility fees. The Loan Parties are required to comply with certain covenants under the Agreement. +The Secured Revolving Line of Credit bears interest, at the option of the Borrowers, either at (a) a customary London Interbank Offered Rate (LIBOR) plus an applicable margin (as determined in accordance with the agreement), or (b) (i) the greatest of (x) the bank’s prime rate, (y) the federal funds rate as published by the Federal Reserve Bank of New York plus 0.50% , and (z) LIBOR for a one-month period plus 1.00% , plus (ii) an applicable margin. +As of December 29, 2018 and December 30, 2017 , the Secured Revolving Line of Credit had an outstanding loan balance of $70 million at an interest rate of 6.00% and 4.75% , respectively. As of December 29, 2018 , the Secured Revolving Line of Credit had $26 million related to outstanding letters of credit and up to $175 million available for future borrowings. The Company reports its intra-period changes in its revolving credit balance on a net basis in its condensed consolidated statement of cash flows as the Company intends the period of the borrowings to be brief, repaying borrowed amounts within 90 days. As of December 29, 2018 , the Company was in compliance with all required covenants stated in the Loan Agreement. +The agreements governing the 6.75% Notes, 7.50% Notes, 7.00% Notes, 2.125% Notes and the Secured Revolving Line of Credit contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under the Secured Revolving Line of Credit to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable. +77 +Future Payments on Total Debt +As of December 29, 2018 , the Company’s future debt payment obligations for the respective fiscal years were as follows: +Term Debt +(Principal only) +(In millions) +2019 +$ +66 +2020 +— +2021 +— +2022 +337 +2023 +— +2024 and thereafter +1,055 +Total +$ +1,458 +NOTE 14: Other Income (Expense), Net +The following table summarizes the components of Other income (expense), net: +2018 +2017 +2016 +(In millions) +Interest income +$ +18 +$ +6 +$ +2 +Gain on sale of 85% ATMP JV +— +3 +146 +Loss on debt redemption +(12 +) +(12 +) +(68 +) +Other +(6 +) +(6 +) +— +Other income (expense), net +$ +— +$ +(9 +) +$ +80 +78 +NOTE 15: Segment Reporting +Management, including the Chief Operating Decision Maker, who is the Company’s Chief Executive Officer, reviews and assesses operating performance using segment net revenue and operating income (loss) before interest, other income (expense), net, income taxes and equity loss of investee. These performance measures include the allocation of expenses to the operating segments based on management’s judgment. The Company has the following two reportable segments: +• +the Computing and Graphics segment, which primarily includes desktop and notebook processors and chipsets, discrete and integrated graphics processing units (GPUs), professional GPUs and licensing portions of its IP portfolio; and +• +the Enterprise, Embedded and Semi-Custom segment, which primarily includes server and embedded processors, semi-custom System-on-Chip (SoC) products, development services, technology for game consoles and licensing portions of its IP portfolio. +In addition to these reportable segments, the Company has an All Other category, which is not a reportable segment. This category primarily includes certain expenses and credits that are not allocated to any of the reportable segments because management does not consider these expenses and credits in evaluating the performance of the reportable segments. Also included in this category are employee stock-based compensation expense, the charge related to the WSA Sixth Amendment and restructuring and other special charges, net. The Company also reported the results of former businesses in the All Other category because the operating results were not material. +The following table provides a summary of net revenue and operating income (loss) by segment for 2018 , 2017 and 2016 . +2018 +2017 +2016 +(In millions) +Net revenue: +Computing and Graphics +$ +4,125 +$ +2,977 +$ +1,988 +Enterprise, Embedded and Semi-Custom +2,350 +2,276 +2,331 +Total net revenue +$ +6,475 +$ +5,253 +$ +4,319 +Operating income (loss): +Computing and Graphics +$ +470 +$ +92 +$ +(243 +) +Enterprise, Embedded and Semi-Custom +163 +132 +287 +All Other +(182 +) +(97 +) +(417 +) +Total operating income (loss) +$ +451 +$ +127 +$ +(373 +) +The following table provides major items included in All Other category: +2018 +2017 +2016 +(In millions) +Operating loss: +Stock-based compensation expense +$ +(137 +) +$ +(97 +) +$ +(86 +) +Restructuring and other special charges, net +— +— +10 +Impairment of technology licenses +(45 +) +— +— +Charge related to the WSA Sixth Amendment +— +— +(340 +) +Other +— +— +(1 +) +Total operating loss +$ +(182 +) +$ +(97 +) +$ +(417 +) +The Company does not discretely allocate assets to its operating segments, nor does management evaluate operating segments using discrete asset information. +79 +The Company’s operations outside the United States include research and development activities and sales, marketing and administrative activities. The Company conducts product and system research and development activities for its products in the United States with additional design and development engineering teams located in China, Canada, India, Singapore, Australia and Taiwan. The Company’s ATMP facilities located in Malaysia and China were sold in the second quarter of 2016 (see Note 4: Equity Interest Agreement - ATMP Joint Venture). The Company’s material sales and marketing offices are located in the United States, Latin America, Europe and Asia. +The following table summarizes sales to external customers by geographic regions based on billing location of the customer: +2018 +2017 +2016 +(In millions) +United States +$ +1,327 +$ +1,360 +$ +922 +Europe +470 +263 +154 +China (including Taiwan) +2,516 +1,712 +1,153 +Singapore +728 +550 +569 +Japan +1,225 +1,215 +1,456 +Other countries +209 +153 +65 +Total sales to external customers +$ +6,475 +$ +5,253 +$ +4,319 +The following table summarizes long-lived assets by geographic areas: +2018 +2017 +(In millions) +United States +$ +232 +$ +200 +Malaysia +3 +5 +China +17 +7 +Singapore +29 +22 +Other countries +67 +27 +Total long-lived assets +$ +348 +$ +261 +The following table summarizes sales to major customers that accounted for at least 10% of the Company’s consolidated net revenue for the respective years: +2018 +2017 +2016 +Customer A +19 +% +23 +% +33 +% +Customer B +11 +% +15 +% +16 +% +Customer C +7 +% +6 +% +10 +% +Sales to customers A and B consisted of products from the Company's Enterprise, Embedded and Semi-Custom segment and sales to customer C consisted primarily of products from the Company's Computing and Graphics segment. +NOTE 16: Common Stock and Stock-Based Incentive Compensation Plans +Common Stock +During the third quarter of 2016, the Company completed its registered underwritten public offering of 115 million shares of the Company’s common stock, par value $0.01 per share, at a public offering price of $6.00 per share pursuant to an underwriting agreement with J.P. Morgan Securities LLC, Barclays Capital Inc. and Credit Suisse Securities (USA) LLC as representatives of the several underwriters named therein. The resulting aggregate net proceeds to the Company from the common stock offering were approximately $667 million , after deducting underwriting discounts and offering expenses totaling approximately $23 million . +Stock-Based Incentive Compensation Plans +The Company’s stock-based incentive programs are intended to attract, retain and motivate highly qualified employees. On April 29, 2004, the Company’s stockholders approved the 2004 Equity Incentive Plan (the 2004 Plan). +80 +Under the 2004 Plan, stock options generally vest and become exercisable over a three -year period from the date of grant and expire within ten years after the grant date. Unvested shares that are reacquired by the Company from forfeited outstanding equity awards become available for grant and may be reissued as new awards. +Under the 2004 Plan, the Company can grant fair market value awards or full value awards. Fair market value awards are awards granted at or above the fair market value of the Company’s common stock on the date of grant. Full value awards are awards granted at less than the fair market value of the Company’s common stock on the date of grant. Awards can consist of (i) stock options granted at the fair market value of the Company’s common stock on the date of grant and (ii) restricted stock units as full value awards. The following is a description of the material terms of the awards that may be granted under the 2004 Plan. +Stock Options. A stock option is the right to purchase shares of the Company’s common stock at a fixed exercise price for a fixed period of time. Under the 2004 Plan, nonstatutory and incentive stock options may be granted. The exercise price of the shares subject to each nonstatutory stock option and incentive stock option cannot be less than 100% of the fair market value of the Company’s common stock on the date of the grant. The exercise price of each option granted under the 2004 Plan must be paid in full at the time of the exercise. +Restricted Stock Units. Restricted stock units (RSUs) are awards that can be granted to any employee, director or consultant and that obligate the Company to issue a specific number of shares of the Company’s common stock in the future if the vesting terms and conditions are satisfied. The purchase price for the shares is $0.00 per share. +Performance-based Restricted Stock Units. Performance-based Restricted Stock Units (PRSUs) can be granted to certain of the Company’s senior executives. The performance metrics can be financial performance, non-financial performance and/or market condition. Each PRSU award reflects a target number of shares (Target Shares) that may be issued to an award recipient before adjusting based on the Company’s financial performance, non-financial performance and/or market conditions. The actual number of shares that a grant recipient receives at the end of the period may range from 0% to 250% of the Target Shares granted, depending upon the degree of achievement of the performance target designated by each individual award. +Employee Stock Purchase Plan. The Company has introduced the Employee Stock Purchase Plan (ESPP) in the fourth quarter of 2017. Under the ESPP, eligible employees who participate in an offering period may have up to 10% of their earnings withheld, up to certain limitations, to purchase shares of common stock at 85% of the lower of the fair market value on the first or the last business day of the six -month offering period. The offering periods commence in November and May each year. +As of December 29, 2018 , the Company had 40 million shares of common stock that were available for future grants and 38 million shares reserved for issuance upon the exercise of outstanding stock options or the vesting of unvested restricted stock units. In addition, the Company had 45 million shares of common stock that were available for issuance under the ESPP. +Valuation and Expense +Stock-based compensation expense related to employee stock options, restricted stock units, including PRSUs and the ESPP, was allocated in the consolidated statements of operations as follows: +2018 +2017 +2016 +(In millions) +Cost of sales +$ +4 +$ +2 +$ +2 +Research and development +91 +57 +49 +Marketing, general, and administrative +42 +38 +35 +Total stock-based compensation expense, net of tax of $0 +$ +137 +$ +97 +$ +86 +During 2018 , 2017 and 2016 , the Company did no t realize any excess tax benefits related to stock-based compensation and therefore the Company did not record any related financing cash flows. +81 +Stock Options. The Company uses the lattice-binomial model in determining the fair value of the stock options. +The weighted-average estimated fair value of employee stock options granted for the years ended December 29, 2018 , December 30, 2017 and December 31, 2016 was $7.62 , $5.46 and $3.10 per share, respectively, using the following assumptions: +2018 +2017 +2016 +Expected volatility +51.51% - 60.46% +57.26 +% +62.33 +% +Risk-free interest rate +2.20% - 2.83% +1.68 +% +1.02 +% +Expected dividends +— +% +— +% +— +% +Expected life (in years) +3.92 - 3.94 +3.92 +3.98 +The Company uses a combination of the historical volatility of its common stock and the implied volatility for publicly traded options on the Company’s common stock as the expected volatility assumption required by the lattice-binomial model. The risk-free interest rate is based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the option grant at the date closest to the option grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the future. The expected term of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice-binomial model. +The following table summarizes stock option activity and related information: +Outstanding Number +of Shares +Weighted- +Average +Exercise +Price +Aggregate Intrinsic Value +Weighted-Average Remaining Contractual Life (in years) +(In millions, except share price) +Balance as of December 30, 2017 +17 +$ +4.32 +$ +104 +3.75 +Granted +1 +$ +18.35 +Canceled +— +$ +8.93 +Exercised +(5 +) +$ +4.65 +Balance as of December 29, 2018 +13 +$ +5.33 +$ +152 +3.49 +Exercisable December 29, 2018 +11 +$ +3.64 +$ +145 +3.15 +The total intrinsic value of stock options exercised for 2018 , 2017 and 2016 was $67 million , $27 million and $10 million , respectively. +As of December 29, 2018 , the Company had $9 million of total unrecognized compensation expense related to stock options that will be recognized over the weighted-average period of 1.89 years . +RSUs. The Company uses the fair value of the Company’s common stock on the date of the grant in determining the fair value of the RSUs. The weighted-average grant date fair values of RSUs granted during 2018 , 2017 and 2016 were $14.81 , $11.63 and $4.72 per share, respectively. +The following table summarizes RSU activity, including PRSU activity, and related information: +Number +of Shares +Weighted- +Average +Fair Value +(In millions except share price) +Unvested shares as of December 30, 2017 +35 +$ +6.60 +Granted +15 +$ +14.81 +Forfeited +(2 +) +$ +8.74 +Vested +(22 +) +$ +4.46 +Unvested shares as of December 29, 2018 +26 +$ +13.14 +The total fair value of RSUs vested during 2018 , 2017 and 2016 was $399 million , $328 million and $151 million , respectively. +As of December 29, 2018 , the Company had $267 million of total unrecognized compensation expense related to RSUs that will be recognized over the weighted-average period of 1.75 years . +82 +PRSUs. The Company uses the Monte Carlo simulation model on the date of grant in determining the fair value of the PRSUs with a market condition. The weighted-average grant date fair values of PRSUs granted during 2018 , 2017 and 2016 were $21.67 , $17.18 and $9.00 , respectively, using the following assumptions: +2018 +2017 +2016 +Stock price at valuation date +$12.02 - $32.72 +$12.83 +$5.14 +Expected volatility +63.77% - 67.97% +64.39 +% +57.83 +% +Risk-free interest rate +2.06% - 2.82% +1.50 +% +0.88 +% +Expected dividends +— +% +— +% +— +% +Expected term (in years) +2.48 - 3.00 +3.00 +3.07 +The following table summarizes PRSU activity and related information: +(Shares in millions) +Unvested shares as of December 30, 2017 +3 +Granted +3 +Forfeited +— +Vested +(4 +) +Unvested shares as of December 29, 2018 +2 +ESPP. The Company uses the Black-Scholes model in determining the fair value of the ESPP. The weighted-average grant date fair value for the ESPP during 2018 and 2017 was within a range from $3.42 to $6.43 and $3.46 per share, respectively, using the following assumptions: +2018 +2017 +Expected volatility +45.88% - 66.66% +56.07 +% +Risk-free interest rate +2.05% - 2.52% +1.36 +% +Expected dividends +— +% +— +% +Expected term (in years) +0.49 - 0.50 +0.49 +During 2018 , 2.2 million and 2.5 million shares of common stock were purchased in each of the two six -month offering periods under the ESPP at a purchase price of $9.57 and $10.31 per share, respectively, resulting in aggregate cash proceeds of $47 million . As of December 29, 2018 , the Company had $9 million of total unrecognized compensation expense related to the ESPP that will be recognized over the weighted-average period of 0.36 years . +NOTE 17: Retirement Benefit Plans +The Company provides retirement benefit plans in the United States and certain foreign countries. The Company has a 401(k) retirement plan that allows participating employees in the United States to contribute as defined by the plan and subject to Internal Revenue Service limitations. The Company matches 75% of employees' contributions up to 6% of their compensation. The Company’s contributions to the 401(k) plan for 2018 , 2017 and 2016 were approximately $21 million , $18 million and $16 million , respectively. +NOTE 18: Commitments and Guarantees +Operating Leases +The Company leases certain of its facilities and in some jurisdictions the Company leases the land on which these facilities are built under non-cancellable lease agreements that expire at various dates through 2028. The Company also leases certain manufacturing and office equipment for terms ranging from one to five years. +83 +As of December 29, 2018 , the Company’s future non-cancellable operating lease commitments were as follows: +Year +Operating +leases +(In millions) +2019 +$ +54 +2020 +48 +2021 +43 +2022 +40 +2023 +35 +2024 and thereafter +102 +Total non-cancellable operating lease commitments +$ +322 +Rent expense for 2018 , 2017 and 2016 was $53 million , $44 million and $39 million , respectively. +During the second quarter of 2018, the Company entered into a 10 -year operating lease to occupy approximately 270,000 square feet of office space in China. Base rent payments commenced in October 2018. As of December 29, 2018 , the total estimated base rent payments over the life of the lease were approximately $68 million . In addition to the base rent payments, the Company is obligated to pay certain customary amounts for its share of operating expenses and tax obligations. The Company will also incur costs for capital projects for the new office space. +The Company leases 220,000 square feet of office space in Santa Clara for 10 years. The base rent obligation commenced in August 2017. As of December 29, 2018 , the total estimate of future base rent payments over the life of the lease was approximately $94 million . In addition to the base rent payments, the Company will be obligated to pay certain customary amounts for its share of operating expenses and tax obligation. The Company has the option to extend the term of the lease for two additional five -year periods. +Certain other operating leases contain provisions for escalating lease payments subject to changes in the consumer price index. +Purchase and Other Contractual Obligations +The Company’s purchase obligations primarily include the Company’s obligations to purchase wafers and substrates from third parties. As of December 29, 2018 , total non-cancellable purchase obligations excluding the Company’s wafer purchase commitments to GF under the WSA were $337 million . +The Company also had other contractual obligations, primarily included in Other long-term liabilities and Accrued liabilities on its consolidated balance sheet, which primarily consisted of $161 million of payments due under certain software and technology licenses and IP licenses that will be paid through 2022. +Future unconditional purchase obligations as of December 29, 2018 were as follows: +Year +Unconditional purchase obligations +(In millions) +2019 +$ +335 +2020 +70 +2021 +54 +2022 +37 +2023 +2 +2024 and thereafter +— +Total unconditional purchase commitments +$ +498 +Obligations to GF +As of December 29, 2018 , the Company's minimum purchase obligations for wafer purchases for the years 2019 through 2021 are approximately $2.4 billion . +Warranties and Indemnities +Changes in the Company’s estimated liability for product warranty during the years ended December 29, 2018 and December 30, 2017 are as follows: +84 +December 29, +2018 +December 30, +2017 +(In millions) +Beginning balance +$ +12 +$ +12 +New warranties issued during the period +27 +25 +Settlements during the period +(28 +) +(21 +) +Changes in liability for pre-existing warranties during the period, including expirations +2 +(4 +) +Ending balance +$ +13 +$ +12 +In addition to product warranties, the Company from time to time in its normal course of business indemnifies other parties with whom it enters into contractual relationships, including customers, lessors and parties to other transactions with the Company, with respect to certain matters. In these limited matters, the Company has agreed to hold certain third parties harmless against specific types of claims or losses such as those arising from a breach of representations or covenants, third-party claims that the Company’s products when used for their intended purpose(s) and under specific conditions infringe the intellectual property rights of a third party, or other specified claims made against the indemnified party. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the unique facts and circumstances that are likely to be involved in each particular claim and indemnification provision. Historically, payments made by the Company under these obligations have not been material. +85 +NOTE 19: Contingencies +Shareholder Derivative Lawsuits (Wessels, Hamilton and Ha) +On March 20, 2014, a purported shareholder derivative lawsuit captioned Wessels v. Read, et al. , Case No. 1:14 cv-262486 (Wessels) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the Santa Clara County Superior Court of the State of California. The complaint purports to assert claims against the Company and certain individual directors and officers for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by the Company and the individual directors and officers regarding its 32nm technology and “Llano” product, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for the Company's common stock during the period. On April 27, 2015, a similar purported shareholder derivative lawsuit captioned Christopher Hamilton and David Hamilton v. Barnes, et al. , Case No. 5:15-cv-01890 (Hamilton) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court for the Northern District of California. +On September 29, 2015, a similar purported shareholder derivative lawsuit captioned Jake Ha v Caldwell, et al., Case No. 3:15-cv-04485 (Ha) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court for the Northern District of California. The lawsuit also seeks a court order voiding the stockholder vote on the Company's 2015 proxy. The case was transferred to the judge handling the Hamilton Lawsuit and is now Case No. 4:15-cv-04485. The Wessels, Hamilton and Ha shareholder derivative lawsuits were stayed pending resolution of a class action lawsuit captioned Hatamian v. AMD, et al. , C.A. No. 3:14-cv-00226 filed against the Company in the United States District Court for the Northern District of California (the Hatamian Lawsuit). The Hatamian Lawsuit asserted claims against the Company and certain of its officers for alleged violations of Section 10(b) of the Exchange Act of 1934, as amended (the Exchange Act), and SEC Rule 10b-5 concerning certain statements regarding its 32nm technology and “Llano” products. On October 9, 2017, the parties signed a definitive settlement agreement resolving the Hatamian Lawsuit and submitted it to the Court for approval. Under the terms of this agreement, the settlement was funded entirely by certain of the Company's insurance carriers and the defendants continued to deny any liability or wrongdoing. On March 2, 2018, the court approved the settlement and entered a final judgment in the Hatamian Lawsuit. +On January 30, 2018, the Wessels and Hamilton plaintiffs amended their complaints. On February 2, 2018, the Ha plaintiff also filed an amended complaint. On February 22, 2018, the Company filed motions to dismiss the Hamilton and Ha plaintiffs’ amended complaints. On April 2, 2018, the Company filed a demurrer seeking to dismiss the Wessels amended complaint. On July 23, 2018, the Santa Clara Superior Court sustained the Company's demurrer in the Wessels case, dismissing all claims in that matter with prejudice. The Wessels plaintiff filed a Notice of Appeal on September 27, 2018. On October 4, 2018, the Federal Court issued an order dismissing the Hamilton and Ha amended complaints. The Hamilton plaintiffs filed a Notice of Appeal on October 8, 2018, and the Ha plaintiffs filed a Notice of Appeal on October 15, 2018. +The Wessels, Hamilton, and Ha appeals are currently pending; the plaintiffs have not yet filed their opening briefs in any of the three matters. On November 19, 2018, the Hamilton and Ha plaintiffs filed a motion seeking summary reversal of the order dismissing their claims. The Company opposed this motion on December 13, 2018, and it remains pending. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Kim Securities Litigation +On January 16, 2018, a putative class action lawsuit captioned Kim et al. v. AMD, et al. , Case No. 3:18-cv-00321 was filed against the Company in the United States District Court for the Northern District of California. The complaint purports to assert claims against the Company and certain individual officers for alleged violations of Sections 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 of the Exchange Act. The plaintiff seeks to represent a proposed class of all persons who purchased or otherwise acquired the Company's common stock during the period February 21, 2017 through January 11, 2018. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by the Company and the individual officers regarding a security vulnerability (Spectre), which statements and omissions, the plaintiff claims, allegedly caused the Company's common stock price to be artificially inflated during the purported class period. The complaint seeks unspecified compensatory damages, attorneys’ fees and costs. On August 3, 2018, plaintiffs filed an amended complaint with similar allegations and shortening the class period to June 29, 2017 through January 11, 2018. The Company filed a motion to dismiss plaintiffs’ claims on September 25, 2018, and plaintiffs filed an opposition to the Company's motion to dismiss on November 14, 2018. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +86 +Hauck et al. Litigation +Since January 19, 2018, three putative class action complaints have been filed against the Company in the United States District Court for the Northern District of California: (1) Diana Hauck et al. v. AMD, Inc., Case No. 5:18-cv-0047, filed on January 19, 2018; (2) Brian Speck et al. v. AMD, Inc. , Case No. 5:18-cv-0744, filed on February 4, 2018; and (3) Nathan Barnes and Jonathan Caskey-Medina, et al. v. AMD, Inc. , Case No. 5:18-cv-00883, filed on February 9, 2018. On April 9, 2018, the court consolidated these cases and ordered that Diana Hauck et al. v. AMD, Inc. serve as the lead case. On June 13, 2018, six plaintiffs (from California, Louisiana, Florida, and Massachusetts) filed a consolidated amended complaint alleging that the Company failed to disclose its processors’ alleged vulnerability to Spectre. Plaintiffs further allege that the Company's processors cannot perform at their advertised processing speeds without exposing consumers to Spectre, and that any “patches” to remedy this security vulnerability will result in degradation of processor performance. The plaintiffs seek damages under several causes of action on behalf of a nationwide class and four state subclasses (California, Florida, Massachusetts, Louisiana) of consumers who purchased the Company's processors and/or devices containing AMD processors. The plaintiffs also seek attorneys’ fees, equitable relief, and restitution. Pursuant to the court’s order directing the parties to litigate only eight of the causes of action in the consolidated amended complaint initially, the Company filed a motion to dismiss on July 13, 2018. On October 29, 2018, after the plaintiffs voluntarily dismissed one of their claims, the court granted the Company's motion and dismissed six causes of action with leave to amend. The plaintiffs filed their amended consolidated complaint on December 6, 2018. On January 3, 2019, the Company again moved to dismiss the subset of claims currently at issue. +Based upon information presently known to management, The Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Quarterhill Inc. Litigation +On July 2, 2018, three entities named Aquila Innovations, Inc. (Aquila), Collabo Innovations, Inc. (Collabo), and Polaris Innovations, Ltd. (Polaris), filed separate patent infringement complaints against the Company in the United States District Court for the Western District of Texas. Aquila alleges that the Company infringes two patents (6,239,614 and 6,895,519) relating to power management; Collabo alleges that the Company infringes one patent (7,930,575) related to power management; and Polaris alleges that the Company infringes two patents (6,728,144 and 8,117,526) relating to control or use of dynamic random-access memory, or DRAM. Each of the three complaints seeks unspecified monetary damages, interest, fees, expenses, and costs against the Company; Aquila and Collabo also seek enhanced damages. Aquila, Collabo, and Polaris each appear to be related to a patent assertion entity named Quarterhill Inc. (formerly WiLAN Inc.). On November 16, 2018, AMD filed answers in the Collabo and Aquila cases and filed a motion to dismiss in the Polaris case. On January 25, 2019, the Company filed amended answers and counterclaims in the Collabo and Aquila cases. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Zeng Shareholder Derivative Lawsuit +On March 8, 2018, a purported shareholder derivative lawsuit captioned Zeng v. Su, et al. , Case No. 18CIV01192 was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the San Mateo County Superior Court of the State of California. The complaint purports to assert claims against the Company and certain individual directors and officers for breach of fiduciary duty, unjust enrichment, abuse of control, gross mismanagement and waste of corporate assets. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by the Company and the individual directors and officers regarding Spectre, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for the Company's common stock during the period. On April 26, 2018, the lawsuit was transferred to Santa Clara County and assigned a new case number, 18CV327692. On August 14, 2018, the Court stayed this lawsuit pending a decision on the motion to dismiss in Kim et al. v. AMD, et al. , Case No. 3:18-cv-00321 filed against the Company in the United States District Court for the Northern District of California. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +In re Advanced Micro Devices, Inc. Shareholder Derivative Litigation +Two purported shareholder derivative lawsuits were filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court, Northern District of California: (1) Jacqueline Dolby, derivatively on behalf of AMD, Inc. v. Su et al., Case No. 5:18-cv-03575, filed on June 14, 2018; and (2) Gusinsky Trust, derivatively on behalf of AMD, Inc. v. Su et al., Case No. 5:18-cv-03811, filed on June 26, 2018. The complaints purport to assert claims against the Company and certain individual directors and officers for violation of Section 14(a) of the Exchange Act and SEC Rule 14a-9, +87 +breach of fiduciary duty, waste of corporate assets, and unjust enrichment. The complaints seek damages purportedly caused by alleged materially misleading statements and/or material omissions by the Company and the individual directors and officers regarding Spectre. The plaintiffs allege that these statements and omissions operated to artificially inflate the price paid for the Company's common stock during the period. On July 12, 2018, the court consolidated the Dolby and Gusinsky Trust shareholder derivative lawsuits under the caption In re Advanced Micro Devices, Inc. Shareholder Derivative Litigation. On August 10, 2018, the Court stayed this lawsuit pending a decision on the motion to dismiss in Kim et al. v. AMD, et al. , Case No. 3:18-cv-00321 filed against the Company in the United States District Court for the Northern District of California. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Dickey Litigation +On October 26, 2015, a putative class action complaint captioned Dickey et al. v. AMD , No. 15-cv-04922 was filed against the Company in the United States District Court for the Northern District of California. Plaintiffs allege that the Company misled consumers by using the term “eight cores” in connection with the marketing of certain AMD FX CPUs that are based on the Company’s “Bulldozer” core architecture. The plaintiffs allege these products cannot perform eight calculations simultaneously, without restriction. The plaintiffs seek to obtain damages under several causes of action for a nationwide class of consumers who allegedly were deceived into purchasing certain Bulldozer-based CPUs that were marketed as containing eight cores. The plaintiffs also seek attorneys’ fees. On December 21, 2015, the Company filed a motion to dismiss the complaint, which was granted on April 7, 2016. The plaintiffs then filed an amended complaint with a narrowed putative class definition, which the Court dismissed upon the Company’s motion on October 31, 2016. The plaintiffs subsequently filed a second amended complaint, and the Company filed a motion to dismiss the second amended complaint. On June 14, 2017, the Court issued an order granting in part and denying in part the Company’s motion to dismiss, and allowing the plaintiffs to move forward with a portion of their complaint. On March 27, 2018, plaintiffs filed their motion for class certification. On January 17, 2019, the Court granted plaintiffs’ motion for class certification. The class definition does not encompass the Company’s Ryzen TM or EPYC TM processors. On January 31, 2019, the Company filed a petition in the Ninth Circuit Court of Appeals, seeking review of certain aspects of the January 17, 2019 class certification order. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Environmental Matters +The Company is named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, the Company has discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, the Company received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. The Company has entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. The Company remains responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, the Company has computed and recorded an estimated environmental liability of approximately $3 million and has not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. The Company believes that any amount in addition to what has already been accrued would not be material. +Other Legal Matters +The Company is a defendant or plaintiff in various actions that arose in the normal course of business. With respect to these matters, based on the management’s current knowledge, the Company believes that the amount or range of reasonably possible loss, if any, will not, either individually or in the aggregate, have a material adverse effect on the Company’s financial position, results of operations, or cash flows. +88 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Advanced Micro Devices, Inc. +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Advanced Micro Devices, Inc. (the Company) as of December 29, 2018 and December 30, 2017, the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 29, 2018, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 29, 2018 and December 30, 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 29, 2018, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 29, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 8, 2019 expressed an unqualified opinion thereon. +Adoption of New Accounting Standard +As discussed in Note 2 to the consolidated financial statements, the Company changed its method for recognizing revenue as a result of the adoption of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), and the amendments effective December 31, 2017 under the full retrospective method. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ Ernst & Young LLP +We have served as the Company’s auditor since 1970. +San Jose, California +February 8, 2019 +89 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Advanced Micro Devices, Inc. +Opinion on Internal Control over Financial Reporting +We have audited Advanced Micro Devices, Inc.’s internal control over financial reporting as of December 29, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Advanced Micro Devices, Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 29, 2018, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 29, 2018 and December 30, 2017 , the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 29, 2018, and the related notes and our report dated February 8, 2019 expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. +Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ Ernst & Young LLP +San Jose, California +February 8, 2019 +90 +Supplementary Financial Information (unaudited) (1) +The Company uses a 52 or 53 week fiscal year ending on the last Saturday in December. All quarters of 2018 and 2017 consisted of 13 weeks. +(In millions, except per share amounts) +2018 +2017 +Dec. 29 +Sep. 29 +June 30 +Mar. 31 +Dec. 30 +Sep. 30 +July 1 +April 1 +Net revenue +$ +1,419 +$ +1,653 +$ +1,756 +$ +1,647 +$ +1,340 +$ +1,584 +$ +1,151 +$ +1,178 +Cost of sales +882 +992 +1,104 +1,050 +888 +1,013 +765 +800 +Gross margin +537 +661 +652 +597 +452 +571 +386 +378 +Research and development +371 +363 +357 +343 +320 +320 +285 +271 +Marketing, general and administrative +138 +148 +142 +134 +134 +132 +127 +123 +Licensing gain +— +— +— +— +— +— +(25 +) +(27 +) +Operating income (loss) +28 +150 +153 +120 +(2 +) +119 +(1 +) +11 +Interest expense +(29 +) +(30 +) +(31 +) +(31 +) +(31 +) +(31 +) +(32 +) +(32 +) +Other income (expense), net +4 +(6 +) +1 +1 +2 +(3 +) +(3 +) +(5 +) +Income (loss) before income taxes +3 +114 +123 +90 +(31 +) +85 +(36 +) +(26 +) +Provision (benefit) for income taxes +(35 +) +12 +6 +8 +(12 +) +22 +3 +5 +Equity loss in investee +— +— +(1 +) +(1 +) +— +(2 +) +(3 +) +(2 +) +Net income (loss) +38 +102 +116 +81 +(19 +) +61 +(42 +) +(33 +) +Earnings (loss) per share +Basic +$ +0.04 +$ +0.10 +$ +0.12 +$ +0.08 +$ +(0.02 +) +$ +0.06 +$ +(0.04 +) +$ +(0.04 +) +Diluted +$ +0.04 +$ +0.09 +$ +0.11 +$ +0.08 +$ +(0.02 +) +$ +0.06 +$ +(0.04 +) +$ +(0.04 +) +Shares used in per share calculation +Basic +1,002 +987 +972 +968 +965 +957 +945 +939 +Diluted +1,079 +1,076 +1,147 +1,039 +965 +1,042 +945 +939 +(1) +Prior year amounts adjusted to reflect the retrospective application of ASU 2014-09, Revenue from Contracts with Customers . Refer to Note 2 Summary of Significant Accounting Policies. +91 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. +CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +We maintain disclosure controls and procedures that are designed with the objective of providing reasonable assurance that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. +As of December 29, 2018 , the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e). This type of evaluation is performed on a quarterly basis so that conclusions of management, including our Chief Executive Officer and Chief Financial Officer, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on Form 10-Q and Form 10-K. The overall goals of these evaluation activities are to monitor our disclosure controls and to modify them as necessary. We intend to maintain the disclosure controls as dynamic systems that we adjust as circumstances merit. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of the end of the period covered by this report. +Management’s Report on Internal Control over Financial Reporting +Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles, and includes those policies and procedures that: +(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. +Management has used the 2013 framework set forth in the report entitled “Internal Control—Integrated Framework” published by the Committee of Sponsoring Organizations of the Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the Company’s internal control over financial reporting was effective as of December 29, 2018 at the reasonable assurance level. Our independent registered public accounting firm, Ernst & Young LLP, has issued an attestation report on the Company’s internal control over financial reporting as of December 29, 2018 , which is included in Part II, Item 8, above. +92 +Changes in Internal Control over Financial Reporting +There has been no change in our internal controls over financial reporting during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. +ITEM 9B. +OTHER INFORMATION +None. +93 +PART III +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information under the captions “Item 1—Election of Directors” (including “Consideration of Stockholder Nominees for Director”), “Corporate Governance,” “Meetings and Committees of the Board of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our proxy statement for our 2019 annual meeting of stockholders (our 2019 Proxy Statement) is incorporated herein by reference. There were no material changes to the procedures by which stockholders may recommend nominees to our board of directors. See also, “Part 1, Item 1-Website Access to Company Reports and Corporate Governance Documents,” above. +ITEM 11. +EXECUTIVE COMPENSATION +The information under the captions “Directors’ Compensation and Benefits” (including “2018 Non-Employee Director Compensation”), “Compensation Discussion and Analysis,” “Compensation Policies and Practices,” “Executive Compensation” (including “2018 Summary Compensation Table,” “2018 Nonqualified Deferred Compensation,” “Outstanding Equity Awards at 2018 Fiscal Year-End,” “Grants of Plan-Based Awards in 2018” and “Option Exercises and Stock Vested in 2018”) and “Severance and Change in Control Arrangements” in our 2019 Proxy Statement is incorporated herein by reference. +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information under the captions “Principal Stockholders,” “Security Ownership of Directors and Executive Officers” and “Equity Compensation Plan Information” in our 2019 Proxy Statement is incorporated herein by reference. +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance—Independence of Directors” and “Certain Relationships and Related Transactions” in our 2019 Proxy Statement is incorporated herein by reference. +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the captions “Item 2—Ratification of Appointment of Independent Registered Public Accounting Firm—Independent Registered Public Accounting Firm’s Fees” in our 2019 Proxy Statement is incorporated herein by reference. +With the exception of the information specifically incorporated by reference in Part III of this Annual Report on Form 10-K from our 2019 Proxy Statement, our 2019 Proxy Statement will not be deemed to be filed as part of this report. Without limiting the foregoing, the information under the captions “Compensation Committee Report” and “Audit Committee Report” in our 2019 Proxy Statement is not incorporated by reference in this Annual Report on Form 10-K. +94 +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES +1. Financial Statements +The financial statements of AMD are set forth in Item 8 of this Annual Report on Form 10-K. +All schedules have been omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedules or because the information required is included in the Consolidated Financial Statements or related notes. +2. Exhibits +The exhibits listed in the accompanying Index to Exhibits are filed as part of, or incorporated by reference into, this Annual Report on Form 10-K. The following is a list of such Exhibits: +Exhibit +Description of Exhibits +3.1 +Amended and Restated Certificate of Incorporation of Advanced Micro Devices, Inc., dated May 2, 2018, filed as Exhibit 3.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 30, 2018, is hereby incorporated by reference. +3.2 +Advanced Micro Devices, Inc. Amended and Restated Bylaws, as amended on July 30, 2009, filed as Exhibit 3.1 to AMD’s Current Report on Form 8-K dated July 30, 2009, are hereby incorporated by reference. +4.1 +AMD hereby agrees to file on request of the SEC a copy of all instruments not otherwise filed with respect to AMD’s long-term debt or any of its subsidiaries for which the total amount of securities authorized under such instruments does not exceed 10 percent of the total assets of AMD and its subsidiaries on a consolidated basis. +4.2 +Indenture governing 6.00% Convertible Senior Notes due 2015, including the Form of 6.00% Senior Note due 2015, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated April 27, 2007, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated April 24, 2007, is hereby incorporated by reference. +4.3 +Indenture governing 7.75% Senior Notes due 2020, including the Form of 7.75% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated August 4, 2010, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated August 4, 2010, is hereby incorporated by reference. +4.4 +Indenture governing 7.50% Senior Notes due 2022, including the Form of 7.50% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated as of August 15, 2012, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated August 15, 2012, is hereby incorporated by reference. +4.5 +Indenture governing the 6.75% Senior Notes due 2019, including the form of the 6.75% Note, between Advanced Micro Devices, Inc. and Wells Fargo, N.A., as Trustee, dated February 26, 2014, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated February 26, 2014 is hereby incorporated by reference. +4.6 +Indenture governing 7.00% Senior Notes due 2024, including the Form of 7.00% Senior Note due 2024, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated June 16, 2014, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated June 16, 2014, is hereby incorporated by reference. +4.7 +First Supplemental Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated June 20, 2014, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated June 23, 2014, is hereby incorporated by reference. +4.8 +Amendment to Indenture governing 6.75% Senior Notes due 2019, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated September 22, 2014, filed as Exhibit 4.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2014, is hereby incorporated by reference. +95 +4.9 +Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated September 14, 2016, filed as Exhibit 4.1 to AMD's Current Report on Form 8-K dated September 14, 2016, is hereby incorporated by reference. +4.10 +First Supplemental Indenture governing 2.125% Convertible Senior Notes due 2026, including Form of 2.125% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A. dated September 14, 2016, filed as Exhibit 4.2 to AMD's Current Report on Form 8-K dated September 14, 2016, is hereby incorporated by reference. +4.11 +First Supplemental Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated September 23, 2016, filed as Exhibit 4.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +*10.1 +1996 Stock Incentive Plan, as amended, filed as Exhibit 10.58 to AMD’s Quarterly Report on Form 10-Q for the period ended June 29, 2003, is hereby incorporated by reference. +*10.2 +1998 Stock Incentive Plan, as amended, filed as Exhibit 10.32 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 29, 2003, is hereby incorporated by reference. +*10.3 +2000 Stock Incentive Plan, as amended, filed as Exhibit 10.12 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 29, 2003, is hereby incorporated by reference +*10.4 +2004 Equity Incentive Plan, as amended and restated, filed as Exhibit 10.1 to AMD’s Registration Statement on Form S-8 filed with the SEC on May 15, 2014, is hereby incorporated by reference +*10.5 +2011 Executive Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended April 2, 2011, is hereby incorporated by reference. +*10.6 +1995 Stock Plan of NexGen, Inc., as amended, filed as Exhibit 10.37 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1996, is hereby incorporated by reference. +*10.7 +ATI Technologies Inc. Share Option Plan, as amended effective January 25, 2005, filed as Exhibit 99.3 to AMD’s Registration Statement on Form S-8 filed with the SEC on October 30, 2006, is hereby incorporated by reference. +*10.8 +SeaMicro, Inc. Amended and Restated 2007 Equity Incentive Plan, filed as Exhibit 10.1 on AMD’s Registration Statement on Form S-8, filed with the SEC on March 23, 2012, is hereby incorporated by reference. +*10.9 +AMD’s U.S. Stock Option Program for Options Granted after April 25, 2000, filed as Exhibit 10.14 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000, is hereby incorporated by reference. +*10.10 +AMD’s Stock Option Program for Employees Outside the U.S. for Options Granted after April 25, 2000, filed as Exhibit 10.24 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000, is hereby incorporated by reference. +*10.11 +AMD’s U.S. Stock Option Program for Options Granted after April 24, 2001, filed as Exhibit 10.23(a) to AMD’s Annual Report on Form 10-K for the fiscal year ended December 30, 2001, is hereby incorporated by reference. +*10.12 +Form of Stock Option Agreement (U.S.) under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 27, 2009, is hereby incorporated by reference. +*10.13 +Form of Stock Option Agreement (Non-U.S.) under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended June 27, 2009, is hereby incorporated by reference. +*10.14 +Form of Stock Option Agreement (U.S. Senior Vice Presidents and Above) under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 26, 2010, is hereby incorporated by reference. +96 +*10.15 +Form of Stock Option Agreement (Non-U.S. Senior Vice Presidents and Above) under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended June 26, 2010, is hereby incorporated by reference. +*10.16 +Form of Restricted Stock Unit Agreement (U.S.) under the 2004 Equity Incentive Plan, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2006, is hereby incorporated by reference. +*10.17 +Form of Restricted Stock Unit Agreement (Non-U.S.) under the 2004 Equity Incentive Plan, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended June 27, 2009, is hereby incorporated by reference. +*10.18 +Form of Restricted Stock Unit Agreement (U.S. Senior Vice Presidents and Above) under the 2004 Equity Plan, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended June 26, 2010, is hereby incorporated by reference. +*10.19 +Form of Restricted Stock Unit Agreement (Non-U.S. Senior Vice Presidents and Above) under the 2004 Equity Plan, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the period ended June 26, 2010, is hereby incorporated by reference. +*10.20 +Outside Director Equity Compensation Policy, amended and restated as of May 8, 2014, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 28, 2014, is hereby incorporated by reference. +*10.21 +AMD Executive Severance Plan and Summary Plan Description for Senior Vice Presidents, effective June 1, 2013, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated June 7, 2013, is hereby incorporated by reference. +*10.22 +Guidelines for Business Aircraft Usage And Commercial Travel By Personal Guests, revised as of May 16, 2013, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 29, 2013, is hereby incorporated by reference. +*10.23 +AMD Deferred Income Account Plan, as amended and restated, effective January 1, 2008, filed as Exhibit 10.18 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007, is hereby incorporated by reference. +*10.24 +Amendment No. 1 to the AMD Deferred Income Account Plan, as amended and restated, effective July 1, 2012, filed as Exhibit 10.16(a) to AMD’s Annual Report on Form 10-K for the period ended December 29, 2012, is hereby incorporated by reference. +*10.25 +Form of Indemnity Agreement, between Advanced Micro Devices, Inc. and its officers and directors, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 6, 2008, is hereby incorporated by reference. +*10.26 +Form of Management Continuity Agreement, as amended and restated, filed as Exhibit 10.13(b) to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007, is hereby incorporated by reference. +*10.27 +Form of Change in Control Agreement, filed as Exhibit 10.11 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 26, 2009, is hereby incorporated by reference. +*10.28 +Amended and Restated Management Continuity Agreement, between Advanced Micro Devices, Inc. and Devinder Kumar, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended September 29, 2012, is hereby incorporated by reference. +*10.29 +Executive Resignation Agreement and General Release, between Advanced Micro Devices, Inc., its subsidiaries, joint ventures or other affiliates and Emilio Ghilardi, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K/A dated April 30, 2012, is hereby incorporated by reference. +*10.30 +Employment Agreement, between Rory P. Read and Advanced Micro Devices, Inc., effective August 25, 2011, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated August 25, 2011, is hereby incorporated by reference. +*10.31 +Relocation Expenses Agreement, between Advanced Micro Devices, Inc. and Rory P. Read, dated September 8, 2011, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2011, is hereby incorporated by reference. +97 +*10.32 +Sign-On Restricted Stock Unit Grant Notice, between Advanced Micro Devices, Inc. and Rory P. Read, dated August 25, 2011, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2011, is hereby incorporated by reference. +*10.33 +Sign-On Performance Restricted Stock Unit Grant Notice, between Advanced Micro Devices, Inc. and Rory P. Read, dated August 25, 2011, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2011, is hereby incorporated by reference. +*10.34 +Special Sign-On Restricted Stock Unit Grant Notice, between Advanced Micro Devices, Inc. and Rory P. Read, dated August 25, 2011, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2011, is hereby incorporated by reference. +*10.35 +Sign-On Stock Option Grant Notice, between Advanced Micro Devices, Inc. and Rory P. Read, dated August 25, 2011, filed as Exhibit 10.5 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2011, is hereby incorporated by reference. +*10.36 +Sign-On Performance Stock Option Grant Notice, between Advanced Micro Devices, Inc. and Rory P. Read, dated August 25, 2011 filed, as Exhibit 10.6 to AMD’s Quarterly Report on Form 10-Q for the period ended October 1, 2011, is hereby incorporated by reference. +*10.37 +Sign-On Bonus Agreement, between Advanced Micro Devices, Inc. and Mark D. Papermaster, dated October 7, 2011, filed as Exhibit 10.62 to AMD’s Annual Report on Form 10-K for the period ended December 31, 2011, is hereby incorporated by reference. +*10.38 +Offer Letter, between Advanced Micro Devices, Inc. and Mark D. Papermaster, dated October 7, 2011, filed as Exhibit 10.63 to AMD’s Annual Report on Form 10-K for the period ended December 31, 2011, is hereby incorporated by reference. +*10.39 +Sign-On Bonus Agreement, between Advanced Micro Devices, Inc. and Dr. Lisa Su, dated December 14, 2011, filed as Exhibit 10.64 to AMD’s Annual Report on Form 10-K for the period ended December 31, 2011, is hereby incorporated by reference. +*10.40 +Offer Letter, between Advanced Micro Devices, Inc. and Dr. Lisa Su, dated December 14, 2011, filed as Exhibit 10.65 to AMD’s Annual Report on Form 10-K for the period ended December 31, 2011, is hereby incorporated by reference. +*10.41 +Summary of Terms for John Byrne, Senior Vice President, Chief Sales Officer, dated August 6, 2012, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended September 29, 2012, is hereby incorporated by reference. +*10.42 +Special Retention Bonus Award to John Byrne, dated October 25, 2011, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended September 29, 2012, is hereby incorporated by reference. +10.43 +Stock Purchase Agreement, between West Coast Hitech L.P. and Advanced Micro Devices, Inc., dated as of November 15, 2007, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated November 15, 2007, is hereby incorporated by reference. +10.44 +Master Transaction Agreement, among Advanced Micro Devices, Inc., Advanced Technology Investment Company LLC and West Coast Hitech L.P., dated October 6, 2008, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 16, 2008, is hereby incorporated by reference. +10.45 +Amendment to Master Transaction Agreement, among Advanced Micro Devices, Inc., Advanced Technology Investment Company LLC and West Coast Hitech L.P., dated December 5, 2008, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated December 5, 2008, is hereby incorporated by reference. +**10.46 +Wafer Supply Agreement, among Advanced Micro Devices, Inc., The Foundry Company and AMD Fab Technologies US, Inc., dated March 2, 2009, filed as Exhibit 10.5 to AMD’s Current Report on Form 8-K dated March 2, 2009, is hereby incorporated by reference. +**10.47 +Wafer Supply Agreement Amendment No. 1, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc., GLOBALFOUNDRIES U.S. Inc. and GLOBALFOUNDRIES Singapore. Pte. Ltd., dated March 29, 2011, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q/A for the period ended April 2, 2011, is hereby incorporated by reference. +98 +**10.48 +Wafer Supply Agreement Amendment No. 2, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc., GLOBALFOUNDRIES U.S. Inc., Advanced Technology Investment Company LLC and ATIC International Investment Company LLC, dated March 4, 2012, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended March 31, 2012, is hereby incorporated by reference. +**10.49 +Wafer Supply Agreement Amendment No. 3, among Advanced Micro Devices, Inc., GlOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated December 6, 2012, filed as Exhibit 10.34(c) to AMD’s Annual Report on Form 10-K for the period ended December 29, 2012, is hereby incorporated by reference. +10.50 +Settlement Agreement, between Advanced Micro Devices, Inc. and Intel Corporation, dated November 11, 2009, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated November 11, 2009, is hereby incorporated by reference. +**10.51 +Patent Cross License Agreement, between Advanced Micro Devices, Inc. and Intel Corporation filed, dated November 11, 2009, as Exhibit 10.2 to AMD’s Current Report on Form 8-K dated November 17, 2009, is hereby incorporated by reference. +10.52 +Loan and Security Agreement, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., the financial institutions party thereto from time to time as lenders and Bank of America, N.A., dated November 12, 2013, filed as Exhibit 1.01 to AMD’s Current Report on Form 8-K dated November 12, 2013, is hereby incorporated by reference. +10.53 +Lease Agreement, between AMD and Delaware Chip LLC, dated December 22, 1998, filed as Exhibit 10.27 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 1998, is hereby incorporated by reference. +10.54 +Agreement of Purchase and Sale, between Advanced Micro Devices, Inc. and 7171 Southwest Parkway Holdings, LP, effective March 11, 2013, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.55 +Sublease Agreement, between Lantana HP, LTD and Advanced Micro Devices, Inc., dated March 26, 2013, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.56 +Master Landlord’s Consent to Sublease, between 7171 Southwest Parkway Holdings, L.P., Lantana HP, Ltd. and Advanced Micro Devices, Inc., dated March 26, 2013, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.57 +Lease Agreement, between 7171 Southwest Parkway Holdings, L.P. and Lantana HP, Ltd., dated March 26, 2013, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +**10.58 +Wafer Supply Agreement Amendment No. 4, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated March 30, 2014, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended March 29, 2014, is hereby incorporated by reference. +*10.59 +Transition, Separation Agreement and Release by and between Rory P. Read and Advanced Micro Devices, Inc. effective October 8, 2014, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K/A dated October 14, 2014, is hereby incorporated by reference. +*10.60 +Employment Agreement by and between Lisa T. Su and Advanced Micro Devices, Inc. effective October 8, 2014, filed as Exhibit 10.2 to AMD’s Current Report on Form 8-K/A dated October 14, 2014, is hereby incorporated by reference. +*10.61 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2014, is hereby incorporated by reference. +*10.62 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2014, is hereby incorporated by reference. +99 +*10.63 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2014, is hereby incorporated by reference. +10.64 +First Amendment to Loan and Security Agreement, dated as of December 11, 2014, by and among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., the financial institutions party thereto as lenders and Bank of America, N.A., filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated December 11, 2014, is hereby incorporated by reference. +*10.65 +Offer Letter, between Advanced Micro Devices, Inc. and Forrest E. Norrod, dated October 20, 2014, filed as Exhibit 10.66 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +*10.66 +Sign-On Bonus Agreement, between Advanced Micro Devices, Inc. and Forrest E. Norrod, dated October 20, 2014, filed as Exhibit 10.67 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +*10.67 +Advanced Micro Devices, Inc. Executive Severance Plan and Summary Plan Description for Senior Vice Presidents effective December 31, 2014, filed as Exhibit 10.68 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +10.68 +Amended and Restated Loan and Security Agreement dated as of April 14, 2015, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated April 14, 2015, is hereby incorporated by reference. +10.69 +First Amendment to Amended and Restated Loan and Security Agreement dated as of June 10, 2015, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2015, is hereby incorporated by reference. +*10.70 +Offer Letter between Advanced Micro Devices, Inc. and Jim R. Anderson, dated April 17, 2015, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2015, is hereby incorporated by reference. +*10.71 +Sign-on Bonus Letter between Advanced Micro Devices, Inc. and Jim R. Anderson, dated May 27, 2015, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2015, is hereby incorporated by reference. +*10.72 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2015, is hereby incorporated by reference. +*10.73 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2015, is hereby incorporated by reference. +*10.74 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2015, is hereby incorporated by reference. +10.75 +Equity Interest Purchase Agreement by and between Advanced Micro Devices, Inc. and Nantong Fujitsu Microelectronics Co., Ltd. dated as of October 15, 2015, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 15, 2015, is hereby incorporated by reference. +**10.76 +Wafer Supply Agreement Amendment No. 5, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated as of April 16, 2015, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended June 27, 2015, is hereby incorporated by reference. +*10.77 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.78 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +100 +*10.78 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.79 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +*10.79 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.80 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +10.80 +Second Amendment to Amended and Restated Loan and Security Agreement, dated as of April 29, 2016, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended June 25, 2016, is hereby incorporated by reference. +10.81 +Third Amendment to Amended and Restated Loan and Security Agreement, dated as of June 21, 2016, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.2 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended June 25, 2016, is hereby incorporated by reference. +10.82 +Warrant to Purchase Shares of Common Stock, dated August 30, 2016, between Advanced Micro Devices, Inc. and West Coast Hitech L.P., filed as Exhibit 10.1 to AMD's Current Report on Form 8-K dated August 31, 2016, is hereby incorporated by reference. +10.83 +First Amended and Restated Registration Rights Agreement, dated as of August 30, 2016, between Advanced Micro Devices, Inc. and West Coast Hitech L.P., filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +10.84 +Fourth Amendment to Amended and Restated Loan and Security Agreement, dated as of September 7, 2016, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.2 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +**10.85 +Wafer Supply Agreement Amendment No. 6, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES, Inc. and GLOBALFOUNDRIES U.S., Inc., dated August 30, 2016, filed as Exhibit 10.3 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +10.86 +Amendment to Master Transaction Agreement dated as of August 30, 2016 among Advanced Micro Devices, Inc., Advanced Technology Investment Company LLC and West Coast Hitech L.P., filed as Exhibit 10.4 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +*10.87 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.88 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.88 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Plan, filed as Exhibit 10.89 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.89 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.90 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +10.90 +Fifth Amendment to Amended and Restated Loan and Security Agreement, dated as of March 21, 2017, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated March 21, 2017, is hereby incorporated by reference. +*10.91 +Outside Director Equity Compensation Policy, amended and restated as of April 26, 2017, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended April 1, 2017, is hereby incorporated by reference. +*10.92 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended April 4, 2017, is hereby incorporated by reference. +101 +*10.93 +2004 Equity Incentive Plan, as amended and restated, filed as Exhibit 10.1 to AMD’s Registration Statement on Form S-8 filed with the SEC on May 8, 2017, is hereby incorporated by reference. +*10.94 +Amended and Restated 2017 Employee Stock Purchase Plan dated August 23, 2018, filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 29, 2018, is hereby incorporated by reference. +10.95 +Sixth Amendment to Amended and Restated Loan and Security Agreement, dated as of September 19, 2017, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2017, is hereby incorporated by reference. +10.96 +Outside Director Equity Compensation Policy, amended and restated as of October 31, 2017, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2017, is hereby incorporated by reference. +10.97 +Seventh Amendment to Amended and Restated Loan and Security Agreement, dated as of November 14, 2017, among Advanced Micro Devices, Inc., AMD International Sales & Service, Ltd., ATI Technologies ULC, and Bank of America, N.A., filed as Exhibit 10.97 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.98 +2017 Employee Stock Purchase Plan, as amended and restated October 12, 2017, filed as Exhibit 10.98 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.99 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.99 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.100 +Form of Restricted Stock Unit Award Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.100 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.101 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan filed as Exhibit 10.101 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.102 +Amendment to Advanced Micro Devices, Inc. Executive Incentive Plan dated as of February 8, 2018, filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2018, is hereby incorporated by reference. +*10.103 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive plan. +*10.104 +Form of Performance-based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan. +*10.105 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan. +21 +List of AMD subsidiaries. +23 +Consent of Independent Registered Public Accounting Firm +24 +Power of Attorney. +31.1 +Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32.1 +Certification of the Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +102 +101.INS +XBRL Instance Document +101.SCH +XBRL Taxonomy Extension Schema Document +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +_____________________ +* Management contracts and compensatory plans or arrangements. +** Portions of this exhibit have been omitted pursuant to a request for confidential treatment, which has been granted. These portions have been filed separately with the SEC. +AMD will furnish a copy of any exhibit on request and payment of AMD’s reasonable expenses of furnishing such exhibit. +103 +ITEM 16. +FORM 10-K SUMMARY +Not applicable. +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +February 8, 2019 +A DVANCED M ICRO D EVICES , I NC . +By: +/s/ Devinder Kumar +Devinder Kumar +Senior Vice President, Chief Financial Officer, and Treasurer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, on behalf of the registrant and in the capacities and on the dates indicated. +104 +Signature +Title +Date +/s/Lisa T. Su +President and Chief Executive Officer +(Principal Executive Officer), Director +February 8, 2019 +Lisa T. Su +/s/Devinder Kumar +Senior Vice President, Chief Financial Officer and Treasurer +(Principal Financial Officer) +February 8, 2019 +Devinder Kumar +/s/Darla Smith +Corporate Vice President, Chief Accounting Officer (Principal Accounting Officer) +February 8, 2019 +Darla Smith +* +Director, Chairman of the Board +February 8, 2019 +John E. Caldwell +* +Director +February 8, 2019 +Nora M. Denzel +* +Director +Mark Durcan +February 8, 2019 +* +Director +February 8, 2019 +Joseph A. Householder +* +Director +February 8, 2019 +Michael J. Inglis +* +Director +February 8, 2019 +John W. Marren +* +Director +February 8, 2019 +Abhi Y. Talwalkar +* +Director +February 8, 2019 +Ahmed Yahia +*By: +/s/Devinder Kumar +Devinder Kumar, Attorney-in-Fact +105 \ No newline at end of file diff --git a/raw/filings/0000002488/2018/0000002488-19-000011/filing_metadata.csv b/raw/filings/0000002488/2018/0000002488-19-000011/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..b228f518b06947a412c70b442a355931220c4cd1 --- /dev/null +++ b/raw/filings/0000002488/2018/0000002488-19-000011/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002488,AMD,ADVANCED MICRO DEVICES INC,2018,10-K,2019-02-08,2018-12-29,2019-02-08T21:44:26.000Z,0000002488-19-000011,amd-12292018x10k.htm,10-K,14934215,1,0,https://www.sec.gov/Archives/edgar/data/2488/000000248819000011/amd-12292018x10k.htm,https://www.sec.gov/Archives/edgar/data/2488/000000248819000011/ diff --git a/raw/filings/0000002488/2018/0000002488-19-000011/item1.txt b/raw/filings/0000002488/2018/0000002488-19-000011/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..4aa7f3328b8f2ca94c1459063ed790a5d55e19ff --- /dev/null +++ b/raw/filings/0000002488/2018/0000002488-19-000011/item1.txt @@ -0,0 +1,6 @@ +ITEM 1. BUSINESS +Cautionary Statement Regarding Forward-Looking Statements +The statements in this report include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations and beliefs and involve numerous risks and uncertainties that could cause actual results to differ materially from expectations. These forward-looking statements speak only as of the date hereof or as of the dates indicated in the statements and should not be relied upon as predictions of future events, as we cannot assure you that the events or circumstances reflected in these statements will be achieved or will occur. You can identify forward-looking statements by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “pro forma,” “estimates,” “anticipates,” or the negative of these words and phrases, other variations of these words and phrases or comparable terminology. The forward-looking statements relate to, among other things: possible impact of future accounting rules on AMD’s consolidated financial statements; demand for AMD’s products; the growth, change and competitive landscape of the markets in which AMD participates; the nature and extent of AMD’s future payments to GLOBALFOUNDRIES Inc. (GF) and the materiality of these payments; the materiality of AMD’s future purchases from GF; AMD’s ability to meet its wafer purchase target; the expected amounts to be received by AMD under the IP licensing agreement and AMD’s expected royalty payments from future product sales of China JVs’ products to be developed on the basis of such licensed IP; sales patterns of AMD’s PC products and semi-custom System-on-Chip (SoC) products for game consoles; the level of international sales as compared to total sales; international sales will continue to be a significant portion of total sales in the foreseeable future; that other unrecognized tax benefits will not materially change in the next 12 months; that AMD’s cash and cash equivalents balances together with the availability under that certain secured revolving line of credit (Secured Revolving Line of Credit) made available to AMD and certain of its subsidiaries under the Amended and Restated Loan Agreement, will be sufficient to fund AMD’s operations including capital expenditures over the next 12 months; AMD’s ability to obtain sufficient external financing on favorable terms, or at all; AMD’s expectation that based on the information presently known to management, the potential liability related to AMD’s current litigation will not have a material adverse effect on its financial condition, cash flows or results of operations; any amounts in addition to what has been already accrued by AMD for future remediation costs under clean-up orders will not be material; we expect to file future patent applications in both the United States and abroad on significant inventions, as we deem appropriate; anticipated increase in costs related to enhancing, implementing and monitoring information security controls, remediating any data security breaches and addressing related litigation, mitigating reputational harm and compliance with external regulations related to our IT assets; we expect to receive $448.5 million upon the exercise of a warrant by West Coast Hitech L.P. (WCH) and issue 75 million shares of our common stock to WCH; revenue allocated to remaining performance obligations that are unsatisfied which will be recognized over the next 12 months; and a small number of customers will continue to account for a substantial part of AMD’s revenue in the future. Material factors that could cause actual results to differ materially from current expectations include, without limitation, the following: Intel Corporation’s dominance of the microprocessor market and its aggressive business practices may limit AMD’s ability to compete effectively; AMD has a wafer supply agreement with GF with obligations to purchase all of its microprocessor and APU product requirements, and a certain portion of its GPU product requirements, manufactured at process nodes larger than 7 nanometer (nm) from GF with limited exceptions. If GF is not able to satisfy AMD’s manufacturing requirements, AMD’s business could be adversely impacted; AMD relies on third parties to manufacture its products, and if they are unable to do so on a timely basis in sufficient quantities and using competitive technologies, AMD’s business could be materially adversely affected; failure to achieve expected manufacturing yields for AMD’s products could negatively impact its financial results; the success of AMD’s business is dependent upon its ability to introduce products on a timely basis with features and performance levels that provide value to its customers while supporting and coinciding with significant industry transitions; if AMD cannot generate sufficient revenue and operating cash flow or obtain external financing, it may face a cash shortfall and be unable to make all of its planned investments in research and development or other strategic investments; the loss of a significant customer may have a material adverse effect on AMD; AMD’s receipt of revenue from its semi-custom SoC products is dependent upon its technology being designed into third-party products and the success of those products; global economic and market uncertainty may adversely impact AMD’s business and operating results; AMD’s products may be subject to security vulnerabilities that could have a material adverse effect on AMD; IT outages, data loss, data breaches and cyber-attacks could compromise AMD’s intellectual property or other sensitive information, be costly to remediate and cause significant damage to its business, reputation and operations; AMD’s operating results are subject to quarterly and seasonal sales patterns; AMD may not be able to generate sufficient cash to service its debt obligations or meet its working capital requirements; AMD has a large amount of indebtedness which could adversely affect its financial position and prevent it from implementing its strategy or fulfilling its contractual obligations; the agreements governing AMD’s notes and the Secured Revolving Line of Credit impose restrictions on AMD that may adversely affect AMD’s ability +1 +to operate its business; the markets in which AMD’s products are sold are highly competitive; AMD’s worldwide operations are subject to political, legal and economic risks and natural disasters, which could have a material adverse effect on it; AMD’s issuance to West Coast Hitech L.P. (WCH) of warrants to purchase 75 million shares of its common stock, if and when exercised, will dilute the ownership interests of AMD’s existing stockholders, and the conversion of the 2.125% Convertible Senior Notes due 2026 (2.125% Notes) may dilute the ownership interest of AMD’s existing stockholders, or may otherwise depress the price of its common stock; uncertainties involving the ordering and shipment of AMD’s products could materially adversely affect it; the demand for AMD’s products depends in part on the market conditions in the industries into which they are sold. Fluctuations in demand for AMD’s products or a market decline in any of these industries could have a material adverse effect on its results of operations; AMD’s ability to design and introduce new products in a timely manner is dependent upon third-party intellectual property; AMD depends on third-party companies for the design, manufacture and supply of motherboards, software and other computer platform components to support its business; if AMD loses Microsoft Corporation’s support for its products or other software vendors do not design and develop software to run on AMD’s products, its ability to sell its products could be materially adversely affected; AMD’s reliance on third-party distributors and add-in-board (AIB) partners subjects it to certain risks; AMD may incur future impairments of goodwill and technology license purchases; AMD’s inability to continue to attract and retain qualified personnel may hinder its business; in the event of a change of control, AMD may not be able to repurchase its outstanding debt as required by the applicable indentures and its Secured Revolving Line of Credit, which would result in a default under the indentures and its Secured Revolving Line of Credit; the semiconductor industry is highly cyclical and has experienced severe downturns that have materially adversely affected, and may continue to materially adversely affect its business in the future; acquisitions, divestitures and/or joint ventures could disrupt its business, harm its financial condition and operating results or dilute, or adversely affect the price of, its common stock; AMD’s business is dependent upon the proper functioning of its internal business processes and information systems and modification or interruption of such systems may disrupt its business, processes and internal controls; if essential equipment, materials or manufacturing processes are not available to manufacture its products, AMD could be materially adversely affected; if AMD’s products are not compatible with some or all industry-standard software and hardware, it could be materially adversely affected; costs related to defective products could have a material adverse effect on AMD; if AMD fails to maintain the efficiency of its supply chain as it responds to changes in customer demand for its products, its business could be materially adversely affected; AMD outsources to third parties certain supply-chain logistics functions, including portions of its product distribution, transportation management and information technology support services; AMD’s stock price is subject to volatility; worldwide political conditions may adversely affect demand for AMD’s products; unfavorable currency exchange rate fluctuations could adversely affect AMD; AMD’s inability to effectively control the sales of its products on the gray market could have a material adverse effect on it; if AMD cannot adequately protect its technology or other intellectual property in the United States and abroad, through patents, copyrights, trade secrets, trademarks and other measures, it may lose a competitive advantage and incur significant expenses; AMD is a party to litigation and may become a party to other claims or litigation that could cause it to incur substantial costs or pay substantial damages or prohibit it from selling its products; AMD’s business is subject to potential tax liabilities; and AMD is subject to environmental laws, conflict minerals-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as a variety of other laws or regulations that could result in additional costs and liabilities. +For a discussion of the factors that could cause actual results to differ materially from the forward-looking statements, see “Part I, \ No newline at end of file diff --git a/raw/filings/0000002488/2018/0000002488-19-000011/item13.txt b/raw/filings/0000002488/2018/0000002488-19-000011/item13.txt new file mode 100644 index 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as specified in its charter) +Delaware +94-1692300 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +2485 Augustine Drive +Santa Clara, +California +95054 +(Address of principal executive offices) +(Zip Code) +( 408 ) 749-4000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +(Title of each class) +(Trading symbol) +(Name of each exchange on which registered) +Common Stock, $0.01 par value per share +AMD +The NASDAQ Global Select Market +Securities registered pursuant to Section 12(g) of the Act: +None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No ¨ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No ý +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files): Yes ý No ¨ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act (check one): +Large accelerated filer +ý +Accelerated filer +¨ +Non-accelerated filer +¨ +Smaller reporting company +☐ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes ☐ No ý +As of June 29, 2019 , the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $ 32.8 billion based on the reported closing sale price of $30.37 per share as reported on The NASDAQ Global Select Market (NASDAQ) on June 28, 2019 , which was the last business day of the registrant’s most recently completed second fiscal quarter. +Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 1,169,661,536 shares of common stock, $0.01 par value per share, as of January 31, 2020. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the registrant’s proxy statement for the 2020 Annual Meeting of Stockholders (2020 Proxy Statement) are incorporated into Part III hereof. The 2020 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the registrant’s fiscal year ended December 28, 2019. +Advanced Micro Devices, Inc. +FORM 10-K +For The Fiscal Year Ended December 28, 2019 +INDEX +PART I +1 +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +13 +ITEM 1B. +Unresolved Staff Comments +27 +ITEM 2. +Properties +27 +ITEM 3. +Legal Proceedings +28 +ITEM 4. +Mine Safety Disclosures +30 +PART II +31 +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +31 +ITEM 6. +Selected Financial Data +33 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +34 +ITEM 7A. +Quantitative and Qualitative Disclosure About Market Risk +41 +ITEM 8. +Financial Statements and Supplementary Data +43 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +81 +ITEM 9A. +Controls and Procedures +81 +ITEM 9B. +Other Information +82 +PART III +83 +ITEM 10. +Directors, Executive Officers and Corporate Governance +83 +ITEM 11. +Executive Compensation +83 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +83 +ITEM 13. +Certain Relationships and Related Transactions and Director Independence +83 +ITEM 14. +Principal Accounting Fees and Services +83 +PART IV +84 +ITEM 15. +Exhibits, Financial Statements Schedules +84 +ITEM 16. +Form 10-K Summary +90 +SIGNATURES . +90 +PART I +ITEM 1. BUSINESS +Cautionary Statement Regarding Forward-Looking Statements +The statements in this report include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations and beliefs and involve numerous risks and uncertainties that could cause actual results to differ materially from expectations. These forward-looking statements speak only as of the date hereof or as of the dates indicated in the statements and should not be relied upon as predictions of future events, as we cannot assure you that the events or circumstances reflected in these statements will be achieved or will occur. You can identify forward-looking statements by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “pro forma,” “estimates,” “anticipates,” or the negative of these words and phrases, other variations of these words and phrases or comparable terminology. The forward-looking statements relate to, among other things: possible impact of future accounting rules on AMD’s consolidated financial statements; demand for AMD’s products; the growth, change and competitive landscape of the markets in which AMD participates; the expected amounts to be received by AMD under the IP licensing agreement and AMD’s expected royalty payments from future product sales of China JVs’ products to be developed on the basis of such licensed IP; sales patterns of AMD’s PC products and semi-custom System-on-Chip (SoC) products for game consoles; international sales will continue to be a significant portion of total sales in the foreseeable future; the balance of the uncertain tax benefits in the next 12 months; that AMD’s cash, cash equivalents and marketable securities balances together with the availability under that certain revolving credit facility (Secured Revolving Facility) made available to AMD and certain of its subsidiaries under the Credit Agreement, will be sufficient to fund AMD’s operations including capital expenditures over the next 12 months; AMD’s ability to obtain sufficient external financing on favorable terms, or at all; AMD’s expectation that based on the information presently known to management, the potential liability related to AMD’s current litigation will not have a material adverse effect on its financial condition, cash flows or results of operations; any amounts in addition to what has been already accrued by AMD for future remediation costs under clean-up orders will not be material; we expect to file future patent applications in both the United States and abroad on significant inventions as we deem appropriate; anticipated ongoing and increased in costs related to enhancing and implementing information security controls; revenue allocated to remaining performance obligations that are unsatisfied which will be recognized over the next 12 months; all unbilled accounts receivables are expected to be billed and collected within 12 months; and a small number of customers will continue to account for a substantial part of AMD’s revenue in the future. For a discussion of the factors that could cause actual results to differ materially from the forward-looking statements, see “Part I, Item 1A-Risk Factors” and the “Financial Condition” section set forth in “Part II, Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations,” or MD&A, and such other risks and uncertainties as set forth below in this report or detailed in our other Securities and Exchange Commission (SEC) reports and filings. We assume no obligation to update forward-looking statements. +General +We are a global semiconductor company primarily offering: +• x86 microprocessors, as standalone devices or as incorporated into an accelerated processing unit (APU), chipsets, discrete and integrated graphics processing units (GPUs), data center and professional GPUs, and development services; and +• server and embedded processors, semi-custom System-on-Chip (SoC) products, development services and technology for game consoles. +We also license portions of our intellectual property (IP) portfolio. +For financial information about geographic areas and for segment information with respect to revenues and operating results, refer to the information set forth in Note 15 of our consolidated financial statements. +We use a 52 or 53 week fiscal year ending on the last Saturday in December. References in this report to 2019 , 2018 and 2017 refer to the fiscal year unless explicitly stated otherwise. +1 +Additional Information +Advanced Micro Devices, Inc. (AMD) was incorporated under the laws of Delaware on May 1, 1969 and became a publicly held company in 1972. Our common stock is currently listed on The NASDAQ Global Select Market (NASDAQ) under the symbol “AMD”. Our mailing address and executive offices are located at 2485 Augustine Drive, Santa Clara, California 95054, and our telephone number is (408) 749-4000. The SEC’s website, www.sec.gov, contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. +References in this Annual Report on Form 10-K to “AMD,” “we,” “us,” “management,” “our” or the “Company” mean Advanced Micro Devices, Inc. and our consolidated subsidiaries. +AMD, the AMD Arrow logo, Athlon, EPYC, FirePro, FreeSync, Geode, Opteron, Radeon, Ryzen, Threadripper, Infinity Fabric, and combinations thereof are trademarks of Advanced Micro Devices, Inc. +Microsoft, Windows, DirectX, Xbox 360 and Xbox One are either registered trademarks or trademarks of Microsoft Corporation in the United States and/or other countries. PCIe is a registered trademark of PCI-SIG Corporation. Chromebook and Stadia are trademarks of Google Inc. Cray is a trademark of Cray Inc. and is registered in the United States and other countries. Linux is the registered trademark of Linus Torvalds in the United States and other countries. PlayStation is a registered trademark or trademark of Sony Interactive Entertainment, Inc.. Arm is a registered trademark of ARM Limited (or its subsidiaries) in the US and/or elsewhere. Vulkan and the Vulkan logo are registered trademarks of Khronos Group Inc. +Other names are for informational purposes only and are used to identify companies and products and may be trademarks of their respective owners. +Website Access to Our SEC Filings and Corporate Governance Documents +On the Investor Relations pages of our Website, http://ir.amd.com , we post links to our filings with the SEC, our Principles of Corporate Governance, our Code of Ethics for our executive officers, all other senior finance executives and certain representatives from legal and internal audit, our Worldwide Standards of Business Conduct, which applies to our Board of Directors and all of our employees, and the charters of the Audit and Finance, Compensation and Leadership Resources, Nominating and Corporate Governance and Innovation and Technology committees of our Board of Directors. Our filings with the SEC are posted as soon as reasonably practical after they are electronically filed with, or furnished to, the SEC. You can also obtain copies of these documents by writing to us at: Corporate Secretary, AMD, 7171 Southwest Parkway, M/S B100.T, Austin, Texas 78735, or emailing us at: Corporate.Secretary@amd.com . All of these documents and filings are available free of charge. +If we make substantive amendments to our Code of Ethics or grant any waiver, including any implicit waiver, to our principal executive officer, principal financial officer, principal accounting officer, controller or persons performing similar functions, we intend to disclose the nature of such amendment or waiver on our Website. +The information contained on our Website is not incorporated by reference in, or considered to be a part of, this report. +Our Industry +We are a global semiconductor company. Semiconductors are components used in a variety of electronic products and systems. An integrated circuit (IC) is a semiconductor device that consists of many interconnected transistors on a single chip. Since the invention of the transistor in 1948, improvements in IC process and design technologies have led to the development of smaller, more complex and more reliable ICs at a lower cost-per-function. +Computing and Graphics +Computing and Graphics Markets +Central Processing Unit (CPU) . A microprocessor is an IC that serves as the CPU of a computer. It generally consists of hundreds of millions or billions of transistors that process data in a serial fashion and control other devices in the system, acting as the “brain” of the computer. The performance of a microprocessor is a critical factor impacting the performance of computing and entertainment platforms, such as desktop PCs, notebooks and workstations. The principal elements used to measure CPU performance are work-per-cycle (or how many instructions are executed per cycle), clock speed (representing the rate at which a CPU’s internal logic operates, measured in units of gigahertz, or billions of cycles per second) and power consumption. Other factors impacting microprocessor performance include the process technology used in its manufacture, the number and type of cores, the ability of the cores to process multi-thread or process multiple +2 +instructions simultaneously, the bit size of its instruction set, memory size and data access speed. +Developments in IC design and manufacturing process technologies have resulted in significant advances in microprocessor performance. Since businesses and consumers require greater performance from their computer systems due to the growth of digital data and increasingly sophisticated software applications, multi-core microprocessors offer enhanced overall system performance and efficiency because computing tasks can be spread across two or more processing cores, each of which can execute a task at full speed. Multi-core microprocessors can simultaneously increase performance of a computer system without greatly increasing the total amount of power consumed and the total amount of heat emitted. Businesses and consumers also require computer systems with improved power management technology, which helps them to reduce the power consumption of their computer systems, enables smaller and more portable form factors, and can lower the total cost of ownership. +Graphics Processing Unit (GPU). A GPU is a programmable logic chip that helps render images, animations and video and is increasingly being used to handle general computing tasks. GPUs are located in plug-in cards, as a discrete processor or in a chip on the motherboard, or in the same chip as the CPU as part of an accelerated processing unit (APU) or System-on-Chip (SoC). GPUs on stand-alone cards or discrete GPUs on the motherboard typically access their own memory, while GPUs in the chipset or CPU chip share main memory with the CPU. +GPUs perform parallel operations on data to render images for a video display and are essential to presenting computer generated images on that display, decoding and rendering animations and displaying video. The more sophisticated the GPU, the higher the resolution and the faster and smoother moving objects can be displayed on video display or in a virtual environment (e.g. virtual reality (VR) and augmented reality (AR)). +In addition to graphics processing, GPUs are used to perform parallel operations on multiple sets of data and are increasingly used to perform vector processing for non-graphics applications that require repetitive computations such as supercomputing, deep learning, artificial and machine intelligence, blockchain and various other applications (e.g., cryptocurrency mining and autonomous driving). +Accelerated Processing Unit (APU). Consumers increasingly demand computing devices with improved end-user experience, system performance and energy efficiency. Consumers also continue to demand thinner and lighter mobile devices, with better performance and longer battery life. We believe that a computing architecture that optimizes the use of its components can provide these improvements. +An APU is a processing unit that integrates a CPU and a GPU onto one chip (or one piece of silicon), along with, in some cases, other special-purpose components. This integration enhances system performance by “offloading” selected tasks to the best-suited component (i.e., the CPU or the GPU) to optimize component use, increasing the speed of data flow between the CPU and GPU through shared memory and allowing the GPU to function as both a graphics engine and an application accelerator. Having the CPU and GPU on the same chip also typically improves energy efficiency by, for example, eliminating connections between discrete chips. +System-on-Chip (SoC) . An SoC is a type of IC with a CPU, GPU and other components, such as a memory controller and peripheral management, comprising a complete computing system on a single chip. By combining all of these elements as an SoC, system performance and energy efficiency is improved, similar to an APU. +Chipset. A chipset is a generic term referring to a device or a collection of devices that allow the microprocessor to connect to a wider range of peripheral devices in the system (such as storage, optical drives, and Universal Serial Bus (USB) peripherals). Chipsets can perform essential logic functions, and operate in concert with the microprocessor to manage system control and power management functions of all the devices in the system. Chipsets are most often found in larger form factor systems, typically desktop systems or larger notebook platforms, which require the expanded peripheral selection that is enabled by the chipset. Typical notebook platforms and small form factor desktop platforms typically do not utilize a chipset and instead rely on the capabilities of the APU to connect to all the required devices on the platform. +Our Computing and Graphics Products +Our microprocessors are incorporated into computing platforms, which are a collection of technologies that are designed to work together to provide a more complete computing solution and to enable and advance the computing components. We believe that integrated, balanced computing platforms consisting of microprocessors, chipsets (either as discrete devices or integrated into an SoC) and GPUs (either as discrete GPUs or integrated into an APU or SoC) that work together at the system level bring end users improved system stability, increased performance and enhanced power efficiency. In addition, we believe our customers also benefit from an all-AMD platform (consisting of an APU or CPU, a discrete GPU, and a chipset when needed), as we are able to optimize interoperability, provide our customers a single point of contact for the +3 +key platform components and enable them to bring the platforms to market quickly in a variety of PC and server system form factors. +We currently base our microprocessors and chipsets on the x86 instruction set architecture and the AMD Infinity Fabric, which connects an on-chip memory controller and input/output (I/O) channels directly to one or more microprocessor cores. We typically integrate two or more processor cores onto a single die, and each core has its own dedicated cache, which is memory that is located on the semiconductor die, permitting quick access to frequently used data and instructions. Some of our microprocessors have additional levels of cache such as L2, or second-level cache, and L3, or third-level cache, to enable fast data access and high performance. +We focus on continually improving the energy efficiency of our products through our design principles and innovations in power management technology. To that end, we offer CPUs, GPUs, APUs, SoCs and chipsets with multiple low power states that are designed to utilize lower clock speeds and voltages to reduce processor power consumption during active and idle times. The use of intelligent, dynamic power management is designed to create lower energy use by allowing compute applications to be completed quickly and efficiently, enabling a return to the ultra-low power idle state. +Desktop. In May 2019, we introduced the 3 rd Gen AMD Ryzen™ desktop processor family based on the new “Zen 2” core architecture with AMD chiplet design approach. Following that introduction, we announced in November 2019 the global availability of the flagship product in our AM4 mainstream platform infrastructure, the AMD Ryzen™ 9 3950X. This product enables a high core count with 16 cores and 32 threads designed for PC buyers. At the value end of the mainstream AM4 platform portfolio, we also announced the new AMD Athlon™ 3000G processor offering better performance and value for end users building budget oriented desktop platforms. In addition to the mainstream product family, we introduced the next generation of the Ryzen™ Threadripper™ product line built on the new TRX40 platform to serve the needs of the high-end desktop segment for creators and enthusiasts. Our November 2019 introduction included the 24-core AMD Ryzen™ Threadripper™ 3960X and the 32-core AMD Ryzen™ Threadripper™ 3970X processors. In January 2020, we announced a processor for creative professionals, the 64-core, 128-thread AMD Ryzen™ Threadripper™ 3990X built to enable extreme performance for 3D, visual effects, and video professionals. +Notebooks and 2-in-1s. We continue to invest in designing and developing high performing and low power APUs for notebook PC platforms for the consumer and commercial markets. In January 2019, we announced our mobility line-up encompassing all notebook segments: second generation AMD Ryzen™ 3000 Series Mobile Processors, powering ultrathin, commercial and gaming notebooks; AMD Athlon™ 300 Series Mobile Processors, powering mainstream notebooks with the “Zen” core; and optimized seventh generation A-Series processors, elevating performance for mainstream Chromebooks™ notebook computers. In January 2020, we announced our x86 8-core ultrathin laptop processors, the AMD Ryzen™ 4000 U-Series, as part of the AMD Ryzen™ 4000 Series Mobile Processor family, built on “Zen 2” core architecture with 7nm process technology and high performance Radeon™ graphics in an SOC design. In addition, as part of the AMD Ryzen 4000 Series Mobile Processor family, we announced the Ryzen™ 4000 H-Series Mobile Processors for gaming and content creation. These processors support AMD SmartShift technology, which allows for automatic power shifting with AMD Radeon discrete mobile GPUs to enable new levels of performance in thin notebooks. We also announced the AMD Athlon™ 3000 Series Mobile Processor family powered by “Zen” architecture for mainstream notebook users. +Commercial. We offer enterprise-class desktop and notebook PC solutions sold as AMD PRO Mobile and AMD PRO desktop processors with Radeon™ Vega Graphics for the commercial client market. These solutions are designed to provide enterprise customers with the performance, security and business features such as commercial-grade quality, platform longevity and extended image stability they require. In April 2019, we announced the 2 nd Gen AMD Ryzen™ PRO mobile processors with Radeon Vega Graphics and the AMD Athlon™ PRO mobile processors with Radeon Vega Graphics. These processors provide power-efficient performance, security features and commercial-grade reliability and manageability. In September 2019, we expanded our commercial desktop lineup with the global availability of our new AMD Ryzen™ PRO 3000 Series desktop processors: AMD Ryzen™ 9 PRO 3900, AMD Ryzen™ 7 PRO 3700, and AMD Ryzen™ 5 PRO 3600. The processors offer up to 12 cores and 24 threads and bring the computing performance of “Zen 2” and high core count to the commercial segment. +Chipsets. We offer a full suite of chipset products, including the new X570 chipset introduced in July 2019 which supports PCIe® 4.0 (fourth generation Peripheral Component Interconnect Express motherboard interface) designed for enthusiast desktop platforms. In addition, we also offer the B450 and the A320 chipset that are combined with AMD Ryzen processors for the AM4 desktop platform for the performance and affordable mainstream platforms segments. We also have the A300 chipsets designed for small form factors. In the High-End Desktop (HEDT) segment, we introduced the new TRX40 chipset to support the 3rd generation Ryzen Threadripper platform which offers high speed I/O and platform bandwidth. For the 1st and 2nd generation Threadripper families, we continue to offer the X399 chipset. We also continue to offer AMD 9-Series chipsets for the Socket AM3/3+ platforms serving desktop PCs, and AMD A-Series Controller Hubs +4 +for the Socket FM2/2+ platforms. We also offer AMD 785E, 780E, 780M, 690E, SR5690, SP5100, SB600, SB710, SB850 and M690E chipsets and AMD A-Series Controller Hubs for our embedded products. +Graphics Market +The semiconductor graphics market addresses the need for improved visual and data processing in various computing devices. Many consumers value a rich visual experience to enable a more compelling and immersive experience, and, for these consumers, the PC has evolved from a traditional data processing and communications device to an entertainment platform. As a result, visual realism and graphical display capabilities are key product differentiation elements among computing devices. This has led to increasing creation and use of processing-intensive multimedia content for computing devices, including playing games, capturing media content, viewing online videos, editing photos and managing digital content. In turn, these trends have contributed to higher consumer demand for performance graphics solutions and to manufacturers designing computing devices with these capabilities. Industries that utilize computer assisted design (CAD), that develop content for media and entertainment markets and that generate professional visualizations and renderings can benefit greatly from graphics solutions optimized for the professional graphics market. +In addition to traditional graphics markets, there is a large and growing market for accelerated computing, powered by graphics processors, which is primarily made up of high-performance computing and machine learning/deep learning. Traditional high performance computing focuses on scientific research, model simulation, and exploration which is mainly driven by a need for computing throughput in universities and government research centers. The second market is the rapidly growing area of machine learning and deep learning workloads. Graphics processors are used both in the training of machine learning models as well as the application of models via inference. The expansion of compute workloads on graphics processors is driving market expansion for traditional graphics silicon. +Another area of the market for graphics compute is blockchain technology, which is a decentralized digital ledger used to securely store, transmit and process sensitive and valuable data. Blockchain applications are typically performed using specifically designed application-specific integrated circuits (ASICs) or a general purpose CPU or GPU. +Our Graphics Products +Graphics processing is a fundamental component of almost everything we create and can be found in an APU, GPU, SoC or a combination of a discrete GPU with one of the other foregoing products working in tandem. Our customers generally use our graphics solutions to enable or increase the speed of rendering images, to help improve image resolution and color definition, and increasingly to process massive data sets for cloud and data center applications. We develop our graphics products for use in various computing devices and entertainment platforms, including desktop PCs, notebook PCs, 2-in-1s, All-in-Ones (AIOs), professional workstations, and the data center. With each of our graphics products, we have available drivers and supporting software packages that enable the effective use of these products under a variety of operating systems and applications. +Our APUs deliver visual processing functionality for value and mainstream PCs by integrating a CPU and a GPU on a single chip, while discrete GPUs (which are also known as dGPUs) offer high performance graphics processing across all platforms. AMD Accelerated Parallel Processing or General Purpose GPU (GPGPU) refers to a set of advanced hardware and software technologies that enable discrete AMD GPUs, working in concert with the CPU, to accelerate computational tasks beyond traditional CPU processing by utilizing the vast number of discrete GPU cores while working with the CPU to process information cooperatively. In addition, computing devices with heterogeneous computing features can run computationally-intensive tasks more efficiently, which we believe provides a superior application experience to the end user. Moreover, heterogeneous computing allows for the elevation of the GPU to the same level as the CPU for memory access, queuing and execution. +Discrete Desktop and Notebook Graphics . Our discrete GPUs for desktop and notebook PCs support current generation application program interface (APIs) like DirectX® 12 and Vulkan®, support new displays using Radeon™ FreeSync™ and Radeon™ FreeSync 2 HDR™ technologies, and are designed to support VR in PC platforms. In January 2019, we introduced the AMD Radeon™ VII, a premium graphics card for gamers, creators and enthusiasts built on 7nm process technology and with 16GB of HBM2 memory (High Bandwidth Memory) and 1 TB/s memory bandwidth. In May 2019, we announced the RDNA gaming architecture which is designed to deliver better performance, power and memory efficiency. In July 2019, we announced the availability of the 7nm AMD Radeon™ RX 5700-series gaming graphics card family (AMD Radeon™ RX 5700 XT and RX 5700) featuring AMD RDNA architecture, high-speed GDDR6 (Graphics Double Data Rate type 6) memory and support for the PCIe 4.0 interface. In October 2019, we announced the AMD Radeon™ RX 5500 series that includes the Radeon RX 5500 graphics card that will be available in desktop PCs from manufacturers and graphics cards from board partners as well as the Radeon™ 5500M GPU for notebook PCs. In December 2019, we announced AMD +5 +Radeon™ RX 5500 XT graphics card that is optimized to deliver high performance. In January 2020, we introduced AMD Radeon™ RX 5600 series graphics products, which includes the AMD Radeon™ RX 5600 XT graphics card and the AMD Radeon RX 5600 graphics card, with AMD RDNA architecture and software feature to provide high-performance and high-fidelity experiences for 1080p gamers. +Professional Graphics. Our AMD Radeon™ Pro family of professional graphics products includes multi-view graphics cards and GPUs designed for integration in mobile and desktop workstations. AMD Radeon Pro graphics cards are designed for demanding use cases such as design and manufacturing for CAD, and media and entertainment for broadcast and animation pipelines. AMD Radeon Pro supports end users utilizing GPU accelerated visualization for construction, architecture and mechanical design through gaming and visualization engines on high resolution displays; Radeon VR™ Creator cards are also capable of supporting this functionality with VR and AR. Software drivers for AMD Radeon Pro cards are designed to deliver high stability and performance across a wide variety of software packages including those requiring professional software vendor certifications. In June 2019, we announced the AMD Radeon™ Pro Vega II GPUs which utilizes 7nm AMD Radeon™ Vega family GPUs, HBM2 and AMD Infinity Fabric Link GPU interconnect technology designed to power demanding professional applications. In November 2019, we announced the AMD Radeon™ Pro W5700, a 7nm professional PC workstation graphics card that enables 3D designers, architects and engineers to visualize, review and interact with their designs in real time to accelerate decision-making processes and product development cycles. +Data Center Graphics . Our AMD Radeon Instinct™ family of GPU products are specifically designed to address growing demand for data center applications, including deep learning training and traditional high performance computing (HPC) workloads such as simulation where the compute capabilities of GPUs provide exceptional flexibility and performance. Combined with our open-source software, Radeon™ Open eCosystem (ROCm), our customers can deliver a differentiated acceleration platforms to address the next-generation of computing challenges while minimizing power and space needs in the data center. +In March 2019, Google announced its new Stadia™ cloud gaming service using high-performance, custom AMD Radeon data center GPUs. In May 2019, the US Department of Energy announced the Frontier exascale A+A (AMD CPUs plus AMD GPUs) system with Oakridge National Labs (ORNL). In August 2019, Microsoft announced its new NVv4-series cloud offering of Azure Virtual Machines based on Radeon Instinct™ MI25 GPUs. And in November 2019, we released ROCm 3.0, marking a major milestone in the path to Exascale class systems and platforms. +Enterprise, Embedded and Semi-Custom +The Enterprise, Embedded and Semi-Custom Markets +Server. A server is a computer system that performs services for connected customers as part of a client-server architecture. Many servers are designed to run an application or applications often for extended periods of time with minimal human intervention. Examples of servers include cloud, web, e-mail, print and on-premise servers. These servers can run a variety of applications, including business intelligence, enterprise resource planning, customer relationship management and advanced scientific or engineering models to solve advanced computational problems in disciplines ranging from financial modeling to weather forecasting to oil and gas exploration. Servers are also used in cloud computing, which is a computing model where data, applications and services are delivered over the internet or an intranet which can be rapidly provisioned and released with minimal effort. Today’s data centers require new technologies and configuration models to meet the demand driven by the growing amount of data that needs to be stored, accessed, analyzed and managed. Servers must be efficient, scalable and adaptable to meet the compute characteristics of new and changing workloads. +Embedded . Embedded products address computing needs in casino gaming machines as well as enterprise-class telecommunications, networking, security, storage systems and thin clients (which are computers that serve as an access device on a network), and in PC-adjacent markets, such as industrial control and automation, digital signage, point-of-sale/self-service kiosks, and medical imaging. Typically, AMD embedded products are used in applications that require high to moderate levels of performance, where key features may include relatively low power, small form factor, and 24x7 operations. High-performance graphics are increasingly important in many embedded systems. Support for Linux ® , Windows ® and other operating systems as well as for increasingly sophisticated applications are also critical for some customers. Other requirements may include meeting rigid specifications for industrial temperatures, shock, vibration and reliability. The embedded market has moved from developing proprietary, custom designs to leveraging industry-standard instruction set architectures and processors as a way to help reduce costs and speed time to market. +Semi-Custom . We have leveraged our core IP, including our graphics and processing technologies developed for the gaming, VR, AR and machine intelligence markets, to develop semi-custom solutions for customers who want differentiation in their products. In this market, semiconductor suppliers work alongside system designers and manufacturers to enhance the performance and overall user experience for semi-custom customers. AMD has used this type of collaborative co- +6 +development approach with many of today’s leading game console manufacturers and can also address customer needs in many other markets beyond game consoles. AMD leverages our existing IP to create a variety of products tailored to a specific customer’s needs, ranging from complex fully-customized SoCs to more modest adaptations and integrations of existing CPU, APU or GPU products. +Our Enterprise, Embedded and Semi-Custom Products +Server Processors. Our microprocessors for server platforms currently include the AMD EPYC™ Series processors and AMD Opteron™ X and A-Series processors. The AMD EPYC™ 7001 Series of high performance processors have up to 32 “Zen” compute cores and are designed to support a full range of integer, floating point, memory bandwidth and I/O benchmarks and workloads. The AMD Opteron™ X3000 Series APUs are a family of fully integrated CPU, GPU and I/O designed to provide processing and graphics performance for personal and small business needs. In August 2019, we introduced the 2 nd Gen AMD EPYC family of processors that feature up to 64 “Zen 2” cores in 7nm process technology for performance and are designed to reduce total cost of ownership (TOC) by up to 50%. In September 2019, we announced a new addition to the 2 nd Gen AMD EPYC family, the AMD EPYC™ 7H12 processor. The 64 core, 2.6Ghz base frequency, 3.3Ghz max boost frequency, 280W TDP processor is built for HPC customers and workloads. +Embedded Processors . Our embedded processors are increasingly driving intelligence into new areas of our lives, like interactive digital signage, casino gaming, and medical imaging devices. These products are designed to support greater connectivity and productivity, and we believe they can be a strong driver for the “internet of things” and “immersive computing” areas in the computing industry. Our products for embedded platforms include AMD Embedded V-Series APUs, CPUs and SoCs, AMD Embedded R-Series APUs, CPUs and SoCs, AMD Embedded G-Series SoC platform and AMD Embedded Radeon GPUs. In April 2019, we announced the AMD Ryzen™ Embedded R1000 Series of processors and the AMD EPYC™ Embedded 3000 Series of processors. The AMD Ryzen™ Embedded R1000 Series provides customers with dual core, quad-threaded performance as well as the ability to run fanless, low power solutions for 4K displays for applications in digital displays, high-performance edge computing, networking, thin clients and more. The AMD EPYC Embedded 3000 Series of processors addresses new markets including, networking, storage and edge computing devices. +Semi-Custom . Our semi-custom products are tailored, co-developed, high-performance, customer-specific solutions based on AMD CPU, GPU and multi-media technologies. We work closely together with our customers to define solutions to precisely match the requirements of the device or application. Historically we have leveraged our core graphics processing technology into the game console market by licensing our graphic technology in game consoles. We developed the semi-custom SoC products that power the current generation Sony PlayStation® 4 and PlayStation ® 4 Pro and Microsoft ® Xbox One™ and Xbox One S™ and Xbox One X™ game consoles. In April 2019, Sony Interactive Entertainment, Inc. released details about its next-generation game console, which will be powered by a custom AMD chip based on the “Zen 2” CPU and next generation GPU architectures. Microsoft announced in June 2019, that AMD will power its next generation game console, codenamed Project Scarlett, with a custom, high performance SoC combining the AMD Ryzen “Zen 2” CPU core 4 and a next generation GPU based on the Radeon RDNA gaming architecture. +Marketing and Sales +We sell our products through our direct sales force and through independent distributors and sales representatives in both domestic and international markets. Our sales arrangements generally operate on the basis of product forecasts provided by the particular customer, but do not typically include any commitment or requirement for minimum product purchases. We primarily use purchase orders, sales order acknowledgments and contractual agreements as evidence of our sales arrangements. Our agreements typically contain standard terms and conditions covering matters such as payment terms, warranties and indemnities for issues specific to our products. +We generally warrant that our products sold to our customers will conform to our approved specifications and be free from defects in material and workmanship under normal use and conditions for one year. We offer up to three-year limited warranties for certain product types, and sometimes provide other warranty periods based on negotiated terms with certain customers. +We market and sell our latest products under the AMD trademark. Our desktop PC product brands for microprocessors are AMD Ryzen™, AMD Ryzen™ PRO, Ryzen™ Threadripper™, AMD A-Series, AMD FX™, AMD Athlon™, AMD Athlon™ PRO, and AMD Pro A-Series processors. Our notebook and 2-in-1s for microprocessors are AMD Ryzen™ processors with Radeon™ Vega Graphics, AMD A-Series, AMD Athlon, AMD Ryzen PRO with Radeon Vega Graphics, AMD Athlon™ PRO with Radeon Vega Graphics and AMD Pro A-Series processors. Our server brands for microprocessors are AMD EPYC™ and AMD Opteron™ processors. We also sell low-power versions of our AMD Opteron, AMD Athlon, as well as AMD Geode™, AMD Ryzen, AMD EPYC, AMD R-Series and G-Series processors as embedded processor solutions. Our product brand for the consumer graphics market is AMD Radeon graphics, and AMD Embedded Radeon +7 +graphics is our product brand for the embedded graphics market. Our product brand for professional graphics products are AMD Radeon Pro AMD FirePro™ graphics; our product brand for data center graphics is Radeon Instinct™ accelerators for servers. We also market and sell our chipsets under AMD trademarks. +We market our products through direct marketing and co-marketing programs. In addition, we have cooperative advertising and marketing programs with customers and third parties, including market development programs, pursuant to which we may provide product information, training, marketing materials and funds. Under our co-marketing development programs, eligible customers can use market development funds as reimbursement for advertisements and marketing programs related to our products and third-party systems integrating our products, subject to meeting defined criteria. +Customers +Our microprocessor customers consist primarily of original equipment manufacturers (OEMs), large direct data centers, original design manufacturers (ODMs), system integrators and independent distributors in both domestic and international markets. ODMs provide design and/or manufacturing services to branded and unbranded private label resellers, OEMs and system builders. Customers of our microprocessor products also include online retailers. Our graphics product customers include the foregoing as well as add-in-board manufacturers (AIBs). Large direct data centers consist of cloud service providers. +Customers of our chipset products consist primarily of PC OEMs, often through ODMs or other contract manufacturers, who build the OEM motherboards, as well as desktop and server motherboard manufacturers who incorporate chipsets into their channel motherboards. +We work closely with our customers to define product features, performance and timing of new products so that the products we are developing meet our customers’ needs. We also employ application engineers to assist our customers in designing, testing and qualifying system designs that incorporate our products. We believe that our commitment to customer service and design support improves our customers’ time-to-market and fosters relationships that encourage customers to use the next generation of our products. +We also work with our customers to create differentiated products that leverage our CPU, GPU and APU technology. Certain customers pay us non-recurring engineering fees for design and development services and a purchase price for the resulting products. +Our major customer, Sony Interactive Entertainment LLC, accounted for more than 10% of our consolidated net revenue for the year ended December 28, 2019 . Sales to Sony Interactive Entertainment LLC consisted of products from our Enterprise, Embedded and Semi-Custom segment. A loss of this customer would have a material adverse effect on our business. +Original Equipment Manufacturers +We focus on three types of OEM partners: multi-nationals, selected regional accounts and some local system integrators, who target commercial and consumer end customers of all sizes. Large multi-nationals and regional accounts are the core of our OEM partners. Our OEM customers include numerous foreign and domestic manufacturers of servers and workstations, desktops, notebooks, PC motherboards and game consoles. +Third-Party Distributors +Our authorized channel distributors resell to sub-distributors and mid-sized and smaller OEMs and ODMs. Typically, distributors handle a wide variety of products, and may include those that compete with our products. Distributors typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions and provide return rights with respect to any product that we have removed from our price book that is not more than 12 months older than the manufacturing code date. In addition, some agreements with our distributors may contain standard stock rotation provisions permitting limited levels of product returns. +Add-in-Board (AIB) Manufacturers and System Integrators +We offer component-level graphics and chipset products to AIB manufacturers who in turn build and sell board-level products using our technology to system integrators (SIs), retail buyers and sub distributors. Our agreements with AIBs protect their inventory of our products against price reductions. We also sell directly to our SI customers. SIs typically sell from positions of regional or product-based strength in the market. They usually operate on short design cycles and can respond quickly with new technologies. SIs often use discrete graphics solutions as a means to differentiate their products and add value to their customers. +8 +Competition in the Microprocessor and Chipset Market +Intel Corporation has been the market share leader for microprocessors for many years. Intel’s market share, margins and significant financial resources enable it to market its products aggressively, to target our customers and our channel partners with special incentives and to influence customers who do business with us. These aggressive activities have in the past resulted in lower unit sales and a lower average selling price for many of our products and adversely affected our margins and profitability. +Intel exerts substantial influence over computer manufacturers and their channels of distribution through various brand and other marketing programs. As a result of Intel’s position in the microprocessor market, Intel has been able to control x86 microprocessor and computer system standards and benchmarks and to dictate the type of products the microprocessor market requires of us. Intel also dominates the computer system platform, which includes core logic chipsets, graphics chips, networking devices (wired and wireless), non-volatile storage and other components necessary to assemble a computer system. OEMs that purchase microprocessors for computer systems are highly dependent on Intel, which can make them less innovative on their own and, to a large extent, can become distributors of Intel technology. Additionally, Intel is able to drive de facto standards and specifications for x86 microprocessors that could cause us and other companies to have delayed access to such standards. +As long as Intel remains in this dominant position, we may be materially adversely affected by Intel’s: business practices, including rebating and allocation strategies and pricing actions which may limit our market share and margins; product mix and introduction schedules; product bundling, marketing and merchandising strategies; exclusivity payments to its current and potential customers, retailers and channel partners that require or result in exclusive product arrangements; de facto control over industry standards, and heavy influence on PC manufacturers and other PC industry participants, including motherboard, memory, chipset and basic input/output system (BIOS) suppliers and software companies as well as the graphics interface for Intel platforms; and marketing and advertising expenditures in support of positioning the Intel brand over the brand of its OEM customers and retailers. +Intel has substantially greater financial resources than we do and accordingly spends substantially greater amounts on marketing and research and development than we do. We expect Intel to continue to invest heavily in marketing, research and development, new manufacturing facilities and other technology companies. +Intel could take actions that place our discrete GPUs at a competitive disadvantage, including giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel has announced that it is developing their own high-end discrete GPUs. Intel’s position in the microprocessor market and integrated graphics chipset market, its introduction of competitive new products, its existing relationships with top-tier OEMs and its aggressive marketing and pricing strategies could result in lower unit sales and lower average selling prices for our products, which could have a material adverse effect on us. +Other competitors include a variety of companies providing or developing ARM-based designs at relatively low cost and low power processors for the computing market including tablets and thin-client form factors, as well as dense servers, set-top boxes and gaming consoles. ARM Holdings designs and licenses its ARM cores and architecture to third parties, including us, and offers supporting software and services. Our ability to compete with companies who use ARM-based solutions depends on our ability to timely design and bring to market energy-efficient, high-performing products at an attractive price point. +Competition in the Graphics Markets +In the graphics market, our competitors include suppliers of discrete graphics, embedded graphics processors and integrated graphics processor (IGP) chipsets. Intel manufactures and sells embedded graphics processors and IGP chipsets, and is a dominant competitor with respect to this portion of our business. Higher unit shipments of our APUs and Intel’s integrated graphics may drive computer manufacturers to reduce the number of systems they build paired with discrete graphics components, particularly for notebooks, because they may offer satisfactory graphics performance for most mainstream PC users, at a lower cost. Intel could take actions that place our discrete GPUs and IGP chipsets at a competitive disadvantage such as giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel is developing its own high-end discrete GPUs for both consumer and commercial applications. +Our principal competitor in the discrete graphics market is Nvidia and they are considered the market share leader. Other competitors include a number of smaller companies, which may have greater flexibility to address specific market needs, but less financial resources to do so, especially as we believe that the growing complexity of graphics processors and the associated research and development costs represent an increasingly higher barrier to entry in this market. +9 +In the data center, our principal competitor is Nvidia as the adoption of their proprietary CUDA software platform established their market share in high performance computing and machine learning. Other competitors include numerous deep learning accelerator companies, consisting mostly of early to late stage start-ups. +We are the market share leader in semi-custom game console products, where graphics performance is critical, and where we compete primarily against Nvidia. +Competition in the Server Markets +In the server market, we compete against Intel with our CPU server products and Nvidia with our GPU server products. +Research and Development +We focus our research and development activities on improving product performance and enhancing product design. Our main area of focus is on delivering the next generation of CPU and GPU IP, and designing that IP into our SoCs for our next generation of products, with, in each case, improved system performance and performance-per-watt characteristics. For example, we are focusing on improving the battery life of our APU products for notebooks and the performance and power efficiency of our discrete GPUs and our microprocessors for servers. We are also focusing on delivering a range of low-power integrated platforms to serve key markets, including commercial clients, mobile computing and gaming. We believe that these platforms will bring customers increased performance and energy efficiency. We also work with industry leaders on process technology, software and other functional intellectual property and with others in the industry and industry consortia to conduct early stage research and development. We conduct product and system research and development activities for our products in the United States with additional design and development engineering teams located in Canada, China, India, Taiwan and Singapore who undertake specific activities at the direction of our U.S. headquarters. +Manufacturing Arrangements and Assembly and Test Facilities +Third-Party Wafer Foundry Facilities +GLOBALFOUNDRIES Inc . We are a party to a Wafer Supply Agreement (WSA) with GLOBALFOUNDRIES Inc. (GF), which governs the terms by which we purchase products manufactured by GF. Pursuant to the WSA, we are required to purchase all of our microprocessor and APU product requirements, and a certain portion of our GPU products, from GF manufactured at process nodes larger than 7 nm, with limited exceptions. GF was a related party to us until May 15, 2019. +Taiwan Semiconductor Manufacturing Company . We also have foundry arrangements with Taiwan Semiconductor Manufacturing Company (TSMC) for the production of wafers for certain products. +Other Third-Party Manufacturers . We outsource board-level graphics product manufacturing to third-party manufacturers. +Assembly, Test, Mark and Packaging Facilities +Wafers for our products are delivered from third-party foundries to our assembly, test, mark and packaging partners located in the Asia-Pacific region who package and test our final semiconductor products. We are party to two assembly, test, mark and pack (ATMP) joint ventures (collectively, the ATMP JVs) with Tongfu Microelectronics Co., Ltd. The majority of our ATMP services are provided by the ATMP JVs. +Intellectual Property and Licensing +We rely on contracts and intellectual property rights to protect our products and technologies from unauthorized third-party copying and use. Intellectual property rights include copyrights, patents, patent applications, trademarks, trade secrets and mask work rights. As of December 28, 2019 , we had approximately 4,000 patents in the United States and approximately 900 patent applications pending in the United States. In certain cases, we have filed corresponding applications in foreign jurisdictions. Including United States and foreign matters, we have approximately 9,900 patent matters worldwide consisting of approximately 7,200 issued patents and 2,800 patent applications pending. We expect to file future patent applications in both the United States and abroad on significant inventions, as we deem appropriate. We do not believe that any individual patent, or the expiration of any patent, is or would be material to our business. +As is typical in the semiconductor industry, we have numerous cross-licensing and technology exchange agreements with other companies under which we both transfer and receive technology and intellectual property rights. One such agreement is the cross-license agreement that we entered into with Intel on November 11, 2009. Under the cross-license +10 +agreement, we granted to Intel and Intel granted to us, non-exclusive, royalty-free licenses to all of each other’s patents that were first filed no later than November 11, 2014 and each party can exploit these patents anywhere in the world for making and selling certain semiconductor- and electronic-related products. Under the cross-license agreement, Intel has rights to make semiconductor products for third parties, but the third-party product designs are not licensed as a result of such manufacture. We have rights to perform assembly and testing for third parties but not rights to make semiconductor products for third parties. The term of the cross-license agreement continues until the expiration of the last to expire of the licensed patents, unless earlier terminated. A party can terminate the cross-license agreement or the rights and licenses of the other party if the other party materially breaches the cross-license agreement and does not correct the noticed material breach within 60 days. Upon such termination, the terminated party’s license rights terminate but the terminating party’s license rights continue, subject to that party’s continued compliance with the terms of the cross-license agreement. The cross-license agreement will automatically terminate if a party undergoes a change of control (as defined in the cross-license agreement), and both parties’ licenses will terminate. Upon the bankruptcy of a party, that party may assume, but may not assign, the cross-license agreement, and in the event that the cross-license agreement cannot be assumed, the cross-license agreement and the licenses granted will terminate. +Backlog +Sales are made primarily pursuant to purchase orders for current delivery or agreements covering purchases over a period of time. Some of these orders or agreements may be revised or canceled without penalty. Generally, in light of current industry practice, we do not believe that such orders or agreements provide meaningful backlog figures or are necessarily indicative of actual sales for any succeeding period. With respect to our semi-custom SoC products, our orders and agreements are more stringent resulting in meaningful backlog for the coming quarter. +Seasonality +Our operating results tend to vary seasonally. Historically, our net revenue has been generally higher in the second half of the year than in the first half of the year, although market conditions and product transitions could impact these trends. +Employees +As of December 28, 2019 , we had approximately 11,400 employees. +Environmental Regulations +Our operations and properties have in the past been and continue to be subject to various United States and foreign laws and regulations, including those relating to materials used in our products and manufacturing processes, discharge of pollutants into the environment, the treatment, transport, storage and disposal of solid and hazardous wastes and remediation of contamination. These laws and regulations require our suppliers to obtain permits for operations making our products, including the discharge of air pollutants and wastewater. Although our management systems are designed to oversee our suppliers’ compliance, we cannot assure you that our suppliers have been or will be at all times in complete compliance with such laws, regulations and permits. If our suppliers violate or fail to comply with any of them, a range of consequences could result, including fines, suspension of production, alteration of manufacturing processes, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions. We could also be held liable for any and all consequences arising out of exposure to hazardous materials used, stored, released, disposed of by us or located at, under or emanating from our facilities or other environmental or natural resource damage. While we have budgeted for foreseeable associated expenditures, we cannot assure you that future environmental legal requirements will not become more stringent or costly in the future. Therefore, we cannot assure you that our costs of complying with current and future environmental and health and safety laws, and our liabilities arising from past and future releases of, or exposure to, hazardous substances will not have a material adverse effect on us. +Environmental laws are complex, change frequently and have tended to become more stringent over time. For example, the European Union (EU) and China are two among a growing number of jurisdictions that have enacted restrictions on the use of lead and other materials in electronic products. These regulations affect semiconductor devices and packaging. As regulations restricting materials in electronic products continue to increase around the world, there is a risk that the cost, quality and manufacturing yields of products that are subject to these restrictions, may be less favorable compared to products that are not subject to such restrictions, or that the transition to compliant products may not meet customer roadmaps, or produce sudden changes in demand, which may result in excess inventory. A number of jurisdictions including the EU, Australia, California and China are developing or have finalized market entry or public procurement regulations for computers and servers based on ENERGY STAR specifications as well as additional energy consumption limits. There is the potential for certain of our products being excluded from some of these markets which could materially adversely affect us. +11 +Certain environmental laws, including the U.S. Comprehensive, Environmental Response, Compensation and Liability Act of 1980, or the Superfund Act, impose strict or, under certain circumstances, joint and several liability on current and previous owners or operators of real property for the cost of removal or remediation of hazardous substances and impose liability for damages to natural resources. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. These environmental laws also assess liability on persons who arrange for hazardous substances to be sent to disposal or treatment facilities when such facilities are found to be contaminated. Such persons can be responsible for cleanup costs even if they never owned or operated the contaminated facility. +We are named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, we have discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, we received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. We have entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. We remain responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, we have computed and recorded an estimated environmental liability of approximately $3 million and have not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. Costs could also increase as a result of additional test and remediation obligations imposed by the Environmental Protection Agency or California Regional Water Quality Control Board. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. We believe that the potential liability, if any, in excess of amounts already accrued, will not have a material adverse effect on our financial condition, cash flows or results of operations. +12 +ITEM 1A. +RISK FACTORS +The risks and uncertainties described below are not the only ones we face. If any of the following risks actually occurs, our business, financial condition or results of operations could be materially adversely affected. In addition, you should consider the interrelationship and compounding effects of two or more risks occurring simultaneously. +Intel Corporation’s dominance of the microprocessor market and its aggressive business practices may limit our ability to compete effectively. +Intel Corporation has been the market share leader for microprocessors for many years. Intel’s market share, margins and significant financial resources enable it to market its products aggressively, to target our customers and our channel partners with special incentives and to influence customers who do business with us. These aggressive activities have in the past resulted in lower unit sales and a lower average selling price for many of our products and adversely affect our margins and profitability. +Intel exerts substantial influence over computer manufacturers and their channels of distribution through various brand and other marketing programs. As a result of Intel’s position in the microprocessor market, Intel has been able to control x86 microprocessor and computer system standards and benchmarks and to dictate the type of products the microprocessor market requires of us. Intel also dominates the computer system platform, which includes core logic chipsets, graphics chips, networking devices (wired and wireless), non-volatile storage and other components necessary to assemble a computer system. Additionally, Intel is able to drive de facto standards and specifications for x86 microprocessors that could cause us and other companies to have delayed access to such standards. +Intel has substantially greater financial resources than we do and accordingly spends substantially greater amounts on marketing and research and development than we do. We expect Intel to continue to invest heavily in marketing, research and development, new manufacturing facilities and other technology companies. To the extent Intel manufactures a significantly larger portion of its microprocessor products using more advanced process technologies, or introduces competitive new products into the market before we do, we may be more vulnerable to Intel’s aggressive marketing and pricing strategies for microprocessor products. +As long as Intel remains in this dominant position, we may be materially adversely affected by Intel’s business practices, including rebating and allocation strategies and pricing actions, designed to limit our market share and margins; product mix and introduction schedules; product bundling, marketing and merchandising strategies; exclusivity payments to its current and potential customers, retailers and channel partners; de facto control over industry standards, and heavy influence on PC manufacturers and other PC industry participants, including motherboard, memory, chipset and basic input/output system (BIOS) suppliers and software companies as well as the graphics interface for Intel platforms; and marketing and advertising expenditures in support of positioning the Intel brand over the brand of its original equipment manufacturer OEM customers and retailers. +Intel could also take actions that place our discrete graphics processing units (GPUs) at a competitive disadvantage, including giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel has announced that it is developing their own high-end discrete GPUs. Intel’s position in the microprocessor market and integrated graphics chipset market, its introduction of competitive new products, its existing relationships with top-tier OEMs, and its aggressive marketing and pricing strategies could result in lower unit sales and lower average selling prices for our products, which could have a material adverse effect on us. +We rely on third parties to manufacture our products, and if they are unable to do so on a timely basis in sufficient quantities and using competitive technologies, our business could be materially adversely affected. +We rely on third-party wafer foundries to fabricate the silicon wafers for all of our products. We also rely on third-party manufacturers to assemble, test, mark and pack (ATMP) our products. It is important to have reliable relationships with all of these third-party manufacturing suppliers to ensure adequate product supply to respond to customer demand. +We cannot guarantee that these manufacturers or our other third-party manufacturing suppliers will be able to meet our near-term or long-term manufacturing requirements. If we experience supply constraints from our third-party manufacturing suppliers, we may be required to allocate the affected products amongst our customers, which could have a material adverse effect on our relationships with these customers and on our financial condition. In addition, if we are unable to meet customer demand due to fluctuating or late supply from our manufacturing suppliers, it could result in lost sales and have a material adverse effect on our business. +We do not have long-term commitment contracts with some of our third-party manufacturing suppliers. We obtain some of these manufacturing services on a purchase order basis and these manufacturers are not required to provide us with any specified minimum quantity of product beyond the quantities in an existing purchase order. Accordingly, we depend on these suppliers to +13 +allocate to us a portion of their manufacturing capacity sufficient to meet our needs, to produce products of acceptable quality and at acceptable manufacturing yields and to deliver those products to us on a timely basis and at acceptable prices. The manufacturers we use also fabricate wafers and ATMP products for other companies, including certain of our competitors. They could choose to prioritize capacity for other customers, increase the prices that they charge us on short notice or reduce or eliminate deliveries to us, which could have a material adverse effect on our business. +Other risks associated with our dependence on third-party manufacturers include limited control over delivery schedules and quality assurance, lack of capacity in periods of excess demand, misappropriation of our intellectual property, dependence on several small undercapitalized subcontractors and limited ability to manage inventory and parts. Moreover, if any of our third-party manufacturers suffer any damage to facilities, lose benefits under material agreements, experience power outages, lack sufficient capacity to manufacture our products, encounter financial difficulties, are unable to secure necessary raw materials from their suppliers or suffer any other disruption or reduction in efficiency, we may encounter supply delays or disruptions. If we are unable to secure sufficient or reliable supplies of products, our ability to meet customer demand may be adversely affected and this could materially affect our business. +If we transition the production of some of our products to new manufacturers, we may experience delayed product introductions, lower yields or poorer performance of our products. If we experience problems with product quality or are unable to secure sufficient capacity from a particular third-party manufacturer, or if we for other reasons cease utilizing one of those suppliers, we may be unable to secure an alternative supply for any specific product in a short time frame. We could experience significant delays in the shipment of our products if we are required to find alternative third-party manufacturers, which could have a material adverse effect on our business. +We are party to two ATMP joint ventures (collectively, the ATMP JVs) with Tongfu Microelectronics Co., Ltd. The majority of our ATMP services are provided by the JVs and there is no guarantee that the JVs will be able to fulfill our long-term ATMP requirements. If we are unable to meet customer demand due to fluctuating or late supply from the ATMP JVs, it could result in lost sales and have a material adverse effect on our business. +Failure to achieve expected manufacturing yields for our products could negatively impact our financial results. +Semiconductor manufacturing yields are a result of both product design and process technology, which is typically proprietary to the manufacturer, and low yields can result from design failures, process technology failures or a combination of both. Our third-party foundries are responsible for the process technologies used to fabricate silicon wafers. If our third-party foundries experience manufacturing inefficiencies or encounter disruptions, errors or difficulties during production, we may fail to achieve acceptable yields or experience product delivery delays. We cannot be certain that our third-party foundries will be able to develop, obtain or successfully implement leading-edge process technologies needed to manufacture future generations of our products profitably or on a timely basis or that our competitors will not develop new technologies, products or processes earlier. Moreover, during periods when foundries are implementing new process technologies, their manufacturing facilities may not be fully productive. A substantial delay in the technology transitions to smaller process technologies could have a material adverse effect on us, particularly if our competitors transition to more cost effective technologies before us. For example, we are presently focusing our 7 nanometer (nm) product portfolio on Taiwan Semiconductor Co., Ltd.’s (TSMC) 7nm process. If TSMC is not able to manufacture our 7nm products in sufficient quantities to meet customer demand, it could have a material adverse effect on our business. +Any decrease in manufacturing yields could result in an increase in per unit costs, which would adversely impact our gross margin and/or force us to allocate our reduced product supply amongst our customers, which could harm our relationships and reputation with our customers and materially adversely affect our business. +The success of our business is dependent upon our ability to introduce products on a timely basis with features and performance levels that provide value to our customers while supporting and coinciding with significant industry transitions. +Our success depends to a significant extent on the development, qualification, implementation and acceptance of new product designs and improvements that provide value to our customers. Our ability to develop, qualify and distribute, and have manufactured, new products and related technologies to meet evolving industry requirements, at prices acceptable to our customers and on a timely basis are significant factors in determining our competitiveness in our target markets. As consumers have new product feature preferences or have different requirements than those consumers in the PC market, PC sales could be negatively impacted, which could adversely impact our business. Our product roadmap includes our next generation AMD Ryzen™, AMD Radeon™ and AMD EPYC™ processors using 7nm+ process technology. We cannot assure you that our efforts to execute our product roadmap will result in innovative products and technologies that provide value to our customers. If we fail to or are delayed in developing, qualifying or shipping new products or technologies that provide value to our customers and address these new trends or if we fail to predict which new form factors consumers will adopt and adjust our business accordingly, we may lose competitive positioning, which could cause us to lose market share and require us to discount the selling prices of our +14 +products. Although we make substantial investments in research and development, we cannot be certain that we will be able to develop, obtain or successfully implement new products and technologies on a timely basis or that they will be well-received by our customers. Moreover, our investments in new products and technologies involve certain risks and uncertainties and could disrupt our ongoing business. New investments may not generate sufficient revenue, may incur unanticipated liabilities and may divert our limited resources and distract management from our current operations. We cannot be certain that our ongoing investments in new products and technologies will be successful, will meet our expectations and will not adversely affect our reputation, financial condition and operating results. +Delays in developing, qualifying or shipping new products can also cause us to miss our customers’ product design windows or, in some cases, breach contractual obligations or cause us to pay penalties. If our customers do not include our products in the initial design of their computer systems or products, they will typically not use our products in their systems or products until at least the next design configuration. The process of being qualified for inclusion in a customer’s system or product can be lengthy and could cause us to further miss a cycle in the demand of end-users, which also could result in a loss of market share and harm our business. We also depend on the success and timing of our customers’ platform launches. If our customers delay their product launches or if our customers do not effectively market their platforms with our products, it could result in a delay in bringing our products to market and cause us to miss a cycle in the demand of end-users, which could materially adversely affect our business. In addition, market demand requires that products incorporate new features and performance standards on an industry-wide basis. Over the life of a specific product, the sale price is typically reduced over time. The introduction of new products and enhancements to existing products is necessary to maintain the overall corporate average selling price. If we are unable to introduce new products with sufficiently high sale prices or to increase unit sales volumes capable of offsetting the reductions in the sale prices of existing products over time, our business could be materially adversely affected. +If we cannot generate sufficient revenue and operating cash flow or obtain external financing, we may face a cash shortfall and be unable to make all of our planned investments in research and development or other strategic investments. +Our ability to fund research and development expenditures depends on generating sufficient revenue and cash flow from operations and the availability of external financing, if necessary. Our research and development expenditures, together with ongoing operating expenses, will be a substantial drain on our cash flow and may decrease our cash balances. If new competitors, technological advances by existing competitors, or other competitive factors require us to invest significantly greater resources than anticipated in our research and development efforts, our operating expenses would increase. If we are required to invest significantly greater resources than anticipated in research and development efforts without an increase in revenue, our operating results could decline. +We regularly assess markets for external financing opportunities, including debt and equity financing. Additional debt or equity financing may not be available when needed or, if available, may not be available on satisfactory terms. The health of the credit markets may adversely impact our ability to obtain financing when needed. Any downgrades from credit rating agencies such as Moody’s or Standard & Poor’s may adversely impact our ability to obtain external financing or the terms of such financing. Credit agency downgrades or concerns regarding our credit worthiness may impact relationships with our suppliers, who may limit our credit lines. Our inability to obtain needed financing or to generate sufficient cash from operations may require us to abandon projects or curtail planned investments in research and development or other strategic initiatives. If we curtail planned investments in research and development or abandon projects, our products may fail to remain competitive and our business would be materially adversely affected. +The loss of a significant customer may have a material adverse effect on us. +We depend on a small number of customers for a substantial portion of our business and we expect that a small number of customers will continue to account for a significant part of our revenue in the future. If one of our key customers decides to stop buying our products, or if one of these customers materially reduces its operations or its demand for our products, our business would be materially adversely affected. +Our receipt of revenue from our semi-custom SoC products is dependent upon our technology being designed into third-party products and the success of those products. +The revenue that we receive from our semi-custom SoC products is in the form of non-recurring engineering fees charged to third parties for design and development services and revenue received in connection with sales of our semi-custom SoC products to these third parties. As a result, our ability to generate revenue from our semi-custom products depends on our ability to secure customers for our semi-custom design pipeline, our customers’ desire to pursue the project, and our semi-custom SoC products being incorporated into those customer’s products. Any revenue from sales of our semi-custom SoC products is directly related to sales of the third-party’s products and reflective of their success in the market. Moreover, we have no control over the marketing efforts of these third parties, and we cannot make any assurances that sales of their products will be successful in current or future years. Consequently, the semi-custom SoC product revenue expected by us may not be fully realized and our +15 +operating results may be adversely affected. +Global economic and market uncertainty may adversely impact our business and operating results. +Uncertain global economic conditions have in the past and may in the future adversely impact our business, including, without limitation, a slowdown in the Chinese economy, one of the largest global markets for desktop and notebook PCs. Uncertainty in the worldwide economic environment may negatively impact consumer confidence and spending causing our customers to postpone purchases. In addition, during challenging economic times, our current or potential future customers may experience cash flow problems and as a result may modify, delay or cancel plans to purchase our products. Additionally, if our customers are not successful in generating sufficient revenue or are unable to secure financing, they may not be able to pay, or may delay payment of, accounts receivable that they owe us. The risk related to our customers’ potentially defaulting on or delaying payments to us is increased because we expect that a small number of customers will continue to account for a substantial part of our revenue. Any inability of our current or potential future customers to pay us for our products may adversely affect our earnings and cash flow. Moreover, our key suppliers may reduce their output or become insolvent, thereby adversely impacting our ability to manufacture our products. In addition, uncertain economic conditions may make it more difficult for us to raise funds through borrowings or private or public sales of debt or equity securities. +Our worldwide operations are subject to political, legal and economic risks and natural disasters, which could have a material adverse effect on us. +We maintain operations around the world, including in the United States, Canada, Europe, Australia and Asia. We rely on third-party wafer foundries in the United States, Europe and Asia. Nearly all product assembly and final testing of our products is performed at manufacturing facilities, operated by third-party manufacturing facilities, in China, Malaysia and Taiwan. We also have international sales operations. International sales, as a percent of net revenue, were 74% for the year ended December 28, 2019. We expect that international sales will continue to be a significant portion of total sales in the foreseeable future. +The political, legal and economic risks associated with our operations in foreign countries include, without limitation: expropriation; changes in a specific country’s or region’s political or economic conditions; changes in tax laws, trade protection measures and import or export licensing requirements; difficulties in protecting our intellectual property; difficulties in managing staffing and exposure to different employment practices and labor laws; changes in foreign currency exchange rates; restrictions on transfers of funds and other assets of our subsidiaries between jurisdictions; changes in freight and interest rates; disruption in air transportation between the United States and our overseas facilities; loss or modification of exemptions for taxes and tariffs; and compliance with U.S. laws and regulations related to international operations, including export control and economic sanctions laws and regulations and the Foreign Corrupt Practices Act. +In addition, our worldwide operations (or those of our business partners) could be subject to natural disasters such as earthquakes, tsunamis, flooding, typhoons and volcanic eruptions that disrupt manufacturing or other operations. For example, our Santa Clara operations are located near major earthquake fault lines in California. There may be conflict or uncertainty in the countries in which we operate, including public health issues (for example, an outbreak of a contagious disease such as 2019-Novel Coronavirus (2019-nCoV), avian influenza, measles or Ebola), safety issues, natural disasters, fire, disruptions of service from utilities, nuclear power plant accidents or general economic or political factors. For example, the United Kingdom’s 2016 referendum, commonly referred to as “Brexit,” has created economic and political uncertainty in the European Union. Also, the European Union’s General Data Protection Regulation imposes significant new requirements on how we collect, process and transfer personal data, as well as significant fines for non-compliance. Any of the above risks, should they occur, could result in an increase in the cost of components, production delays, general business interruptions, delays from difficulties in obtaining export licenses for certain technology, tariffs and other barriers and restrictions, longer payment cycles, increased taxes, restrictions on the repatriation of funds and the burdens of complying with a variety of foreign laws, any of which could ultimately have a material adverse effect on our business. +Government actions and regulations such as export administration regulations, tariffs, and trade protection measures, may limit our ability to export our products to certain customers. +We have a joint venture with Higon Information Technology Co., Ltd. (THATIC), comprised of two separate legal entities, China JV1 and China JV2 (collectively, the THATIC JV). In June 2019, the United States Commerce Department’s Bureau of Industry and Security (BIS) added certain Chinese entities to the Entity List, including THATIC and the THATIC JV. In October 2019, the BIS added additional Chinese entities to the Entity List. Also, the United States administration has called for changes to domestic and foreign policy. Specifically, United States-China trade relations remain uncertain. The United States administration has announced tariffs on certain products imported into the United States with China as the country of origin, and China has imposed tariffs in response to the actions of the United States. We are taking steps to mitigate the impact of these tariffs on our business and AMD processor-based products. There is also a possibility of future tariffs, trade protection measures, import or export regulations or other restrictions imposed on our products or on our customers by the United States, China or other +16 +countries that could have a material adverse effect on our business. A significant trade disruption or the establishment or increase of any tariffs, trade protection measures or restrictions could result in lost sales adversely impacting our reputation and business. +Our products may be subject to security vulnerabilities that could have a material adverse effect on us. +The products that we sell are complex and may be subject to security vulnerabilities that could result in, among other things, the loss, corruption, theft or misuse of confidential data or system performance issues. Our efforts to prevent and address security vulnerabilities may decrease performance, be only partially effective or not successful at all. We may also depend on third parties, such as customers, vendors and end users, to deploy our mitigations or create their own, and they may delay, decline or modify the implementation of such mitigations. Our relationships with our customers could be adversely affected as some of our customers may stop purchasing our products, reduce or delay future purchases of our products, or use competing products. Any of these actions by our customers could adversely affect our revenue. We also are subject to claims and litigation related to Spectre side-channel exploits and may face additional claims or litigation for future vulnerabilities. Actual or perceived security vulnerabilities of our products may subject us to adverse publicity, damage to our brand and reputation, and could materially harm our business or financial results. +IT outages, data loss, data breaches and cyber-attacks could compromise our intellectual property or other sensitive information, be costly to remediate or cause significant damage to our business, reputation and operations. +In the ordinary course of our business, we maintain sensitive data on our information technology (IT) assets, and also may maintain sensitive information on our business partners’ and third-party providers’ IT assets, including our intellectual property and proprietary or confidential business information relating to our business and that of our customers and business partners. Maintaining the security of this information is important to our business and reputation. We believe that companies have been increasingly subject to a wide variety of security incidents, cyber-attacks, hacking and phishing attacks, business and system disruption attacks, and other attempts to gain unauthorized access. These threats can come from a variety of sources, all ranging in sophistication from an individual hacker or insider threat to a state-sponsored attack. Cyber threats may be generic, or they may be custom-crafted against our information systems. Cyber-attacks have become increasingly more prevalent and much harder to detect, defend against or prevent. Our network and storage applications, as well as those of our customers, business partners, and third-party providers, may be subject to unauthorized access by hackers or breached due to operator error, malfeasance or other system disruptions. +It is often difficult to anticipate or immediately detect such incidents and the damage caused by such incidents. These data breaches and any unauthorized access, misuse or disclosure of our information or intellectual property could compromise our intellectual property and expose sensitive business information. Cyber-attacks on us or our customers, business partners or third party providers could also cause us to incur significant remediation costs, result in product development delays, disrupt key business operations and divert attention of management and key information technology resources. These incidents could also subject us to liability, expose us to significant expense and cause significant harm to our reputation and business. +We also maintain confidential and personally identifiable information about our workers. The confidentiality and integrity of our worker and consumer data is important to our business and our workers and consumers have a high expectation that we adequately protect their personal information. +We anticipate ongoing and increasing costs related to: enhancing and implementing information security controls, including costs related to upgrading application, computer, and network security components; training workers to maintain and monitor our security controls; remediating any data security breach and addressing the related litigation; mitigating reputational harm; and compliance with external regulations, such as the European Union’s General Data Protection Regulation and the California Consumer Privacy Act. +We often partner with third-party providers for certain worker services and we may provide certain limited worker information to such third parties based on the scope of the services provided to us. However, if these third parties fail to adopt or adhere to adequate data security practices, or in the event of a breach of their networks, our workers’ data may be improperly accessed, used or disclosed. +A breach of data privacy may cause significant disruption of our business operations. Failure to adequately maintain and update our security systems could materially adversely affect our operations and our ability to maintain worker confidence. Failure to prevent unauthorized access to electronic and other confidential information, IT outages, data loss and data breaches could materially adversely affect our financial condition, our competitive position and operating results. +17 +We have a wafer supply agreement with GLOBALFOUNDRIES Inc. (GF) with obligations to purchase all of our microprocessor and accelerated processing unit (APU) product requirements and a certain portion of our graphics processing unit (GPU) product requirements manufactured at process nodes larger than 7 nanometer from GF, with limited exceptions. If GF is not able to satisfy our manufacturing requirements, our business could be adversely impacted. +The wafer supply agreement (WSA) governs the terms by which we purchase products manufactured by GF and is in place until 2024. Pursuant to the WSA, we are required to purchase all of our microprocessor and APU product requirements and a certain portion of our GPU product requirements from GF manufactured at process nodes larger than 7 nanometer (nm), with limited exceptions. If GF is unable to achieve anticipated manufacturing yields, manufacture our products on a timely basis at competitive prices or meet our capacity requirements, then we may experience supply shortages for certain products or increased costs and our business could be materially adversely affected. +Under the terms of the WSA, we have agreed to minimum annual wafer purchase targets through 2021. If we fail to meet the agreed wafer purchase target during a calendar year, we will be required to pay to GF a portion of the difference between our actual wafer purchases and the applicable annual purchase target. If our actual wafer requirements are less than the number of wafers required to meet the applicable annual wafer purchase target, we could have excess inventory or higher inventory unit costs, both of which may adversely impact our gross margin and our results of operations. +In addition, GF has relied on Mubadala Technology Investments LLC (Mubadala Tech) for its funding needs. If Mubadala Tech fails to adequately fund GF on a timely basis, or at all, and if GF is not otherwise able to adequately fund its operations, GF’s ability to manufacture products for us could be materially adversely affected. +Uncertainties involving the ordering and shipment of our products could materially adversely affect us. +We typically sell our products pursuant to individual purchase orders. We generally do not have long-term supply arrangements with our customers or minimum purchase requirements except that orders generally must be for standard pack quantities. Generally, our customers may cancel orders for standard products more than 30 days prior to shipment without incurring significant fees. We base our inventory levels in part on customers’ estimates of demand for their products, which may not accurately predict the quantity or type of our products that our customers will want in the future or ultimately end up purchasing. Our ability to forecast demand is even further complicated when our products are sold indirectly through downstream channel distributors and customers, as our forecasts for demand are then based on estimates provided by multiple parties throughout the downstream channel. +PC and consumer markets are characterized by short product lifecycles, which can lead to rapid obsolescence and price erosion. In addition, our customers may change their inventory practices on short notice for any reason. We may build inventories during periods of anticipated growth, and the cancellation or deferral of product orders or overproduction due to failure of anticipated orders to materialize could result in excess or obsolete inventory, which could result in write-downs of inventory and an adverse effect on gross margins. +Factors that may result in excess or obsolete inventory, which could result in write-downs of the value of our inventory, a reduction in the average selling price or a reduction in our gross margin include: a sudden or significant decrease in demand for our products; a production or design defect in our products; a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements; a failure to accurately estimate customer demand for our products, including for our older products as our new products are introduced; or our competitors introducing new products or taking aggressive pricing actions. +Our operating results are subject to quarterly and seasonal sales patterns. +The profile of our sales may be weighted differently during the year. A large portion of our quarterly sales have historically been made in the last month of the quarter. This uneven sales pattern makes prediction of revenue for each financial period difficult and increases the risk of unanticipated variations in quarterly results and financial condition. In addition, our operating results tend to vary seasonally with the markets in which our products are sold. For example, historically, our net revenue has been generally higher in the second half of the year than in the first half of the year, although market conditions and product transitions could impact these trends. Many of the factors that create and affect quarterly and seasonal trends are beyond our control. +The agreements governing our notes and our Secured Revolving Facility impose restrictions on us that may adversely affect our ability to operate our business. +The indenture governing our 7.50% Senior Notes due 2022 (7.50% Notes) contains various covenants which limit our ability to, among other things: incur additional indebtedness; pay dividends and make other restricted payments; make certain investments, including investments in our unrestricted subsidiaries; create or permit certain liens; create or permit restrictions on the ability of certain restricted subsidiaries to pay dividends or make other distributions to us; use the proceeds from sales of assets; enter +18 +into certain types of transactions with affiliates; and consolidate or merge or sell our assets as an entirety or substantially as an entirety. +In addition, the Secured Revolving Facility’s credit agreement (Credit Agreement) restricts our ability to make cash payments on the notes to the extent that (i) on the date of such payment, an event of default exists under the Credit Agreement or would result therefrom or (ii) if we would have, on a pro forma basis after giving effect to such payment, a consolidated total leverage ratio that exceeds 3.50x. Any of our future debt agreements may contain similar restrictions. If under certain circumstances we fail to make a cash payment on a series of notes when required by the applicable indenture, it would constitute an event of default under such indenture, which, in turn, could constitute an event of default under the agreements governing our other indebtedness. +Our Secured Revolving Facility also contains various covenants which limit our ability to, among other things, incur additional indebtedness and liens, make certain investments, merge or consolidate with other entities, make certain dispositions, create any encumbrance on the ability of a subsidiary to make any upstream payments, make payments with respect to subordinated debt or certain borrowed money prior to its due date and enter into any non-arm’s-length transaction with an affiliate (in each case, except for certain customary exceptions). +The agreements governing our notes and our Secured Revolving Facility contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other indebtedness. For example, the occurrence of a default with respect to any indebtedness or any failure to repay indebtedness when due in an amount in excess of (i) $50 million would cause a cross default under the indentures (to the extent such default would result in the acceleration of such indebtedness) governing our 7.50% Notes and 2.125% Convertible Senior Notes due 2026 (2.125% Notes), and (ii) $100 million would cause a cross default under the Secured Revolving Facility. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under our Secured Revolving Facility to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable. If the note holders or the trustee under the indentures governing our 7.50% Notes or 2.125% Notes or the lenders under our Secured Revolving Facility accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay those borrowings. +The markets in which our products are sold are highly competitive. +The markets in which our products are sold are very competitive and delivering the latest and best products to market on a timely basis is critical to achieving revenue growth. We believe that the main factors that determine our product competitiveness are timely product introductions, product quality, product features and capabilities (including enabling state-of-the-art visual and virtual reality experiences), energy efficiency (including power consumption and battery life), reliability, processor clock speed, performance, size (or form factor), selling price, cost, adherence to industry standards (and the creation of open industry standards), level of integration, software and hardware compatibility, security and stability, brand recognition and availability. +We expect that competition will continue to be intense due to rapid technological changes, frequent product introductions by our competitors or new competitors of products that may provide better performance/experience or may include additional features that render our products comparatively less competitive. We may also face aggressive pricing by competitors, especially during challenging economic times. In addition, our competitors have significant marketing and sales resources which could increase the competitive environment in such a declining market, leading to lower prices and margins. Some competitors may have greater access or rights to complementary technologies, including interface, processor and memory technical information. For instance, with our APU products and other competing solutions with integrated graphics, we believe that demand for additional discrete graphics chips and cards may decrease in the future due to improvements in the quality and performance of integrated graphics. If competitors introduce competitive new products into the market before us, demand for our products could be adversely impacted and our business could be adversely affected. In addition, Intel has announced that it plans to expand its position in integrated graphics for the PC market with high-end discrete graphics solutions for a broad range of computing segments, which may negatively impact our ability to compete in these computing segments. +In addition, we are entering markets with current and new competitors who may be able to adapt more quickly to customer requirements and emerging technologies. We cannot assure you that we will be able to compete successfully against current or new competitors who may have stronger positions in these new markets or superior ability to anticipate customer requirements and emerging industry trends. We may face delays or disruptions in research and development efforts, or we may be required to invest significantly greater resources in research and development than anticipated. Also, the semiconductor industry has seen several mergers and acquisitions over the last number of years. Further consolidation could adversely impact our business due to there being fewer suppliers, customers and partners in the industry. +19 +The conversion of the 2.125% Notes may dilute the ownership interest of our existing stockholders, or may otherwise depress the price of our common stock. +The conversion of some or all of the 2.125% Notes may dilute the ownership interests of our existing stockholders. The 2.125% Notes will mature on September 1, 2026, unless earlier redeemed or repurchased by us or converted. During the fourth quarter of 2019, the sale price for conversion was satisfied as of the end of December 31, 2019 and as a result, the 2.125% Notes are eligible for conversion during the first calendar quarter of 2020. Any sales in the public market of our common stock issuable upon such conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the 2.125% Notes may encourage short selling by market participants because the conversion thereof could be used to satisfy short positions, or the anticipated conversion of the 2.125% Notes into cash and/or shares of our common stock could depress the price of our common stock. +The demand for our products depends in part on the market conditions in the industries into which they are sold. Fluctuations in demand for our products or a market decline in any of these industries could have a material adverse effect on our results of operations. +Industry-wide fluctuations in the computer marketplace have materially adversely affected us in the past and may materially adversely affect us in the future. A large portion of our Computing and Graphics revenue is focused on the consumer desktop PC and notebook segments, which have in the past experienced a decline driven by, among other factors, the adoption of smaller and other form factors, increased competition and changes in replacement cycles. The success of our semi-custom SoC products is dependent on securing customers for our semi-custom design pipeline and consumer market conditions, including the success of the Sony PlayStation®4, Sony PlayStation®4 Pro, Microsoft® Xbox One™ S and Microsoft® Xbox One™ X game console systems worldwide. In addition, the GPU market has at times seen elevated demand due to the application of GPU products to cryptocurrency mining. For example, our GPU revenue has been affected in part by the volatility of the cryptocurrency mining market. Demand for cryptocurrency has changed and is likely to continue to change quickly. For example, China and South Korea have instituted restrictions on cryptocurrency trading and the valuations of the currencies, and corresponding interest in mining of such currencies are subject to significant fluctuations. If we are unable to manage the risks related to the volatility of the cryptocurrency mining market, our GPU business could be materially adversely affected. +Our ability to design and introduce new products in a timely manner is dependent upon third-party intellectual property. +In the design and development of new and enhanced products, we rely on third-party intellectual property such as development and testing tools for software and hardware. Furthermore, certain product features may rely on intellectual property acquired from third parties. The design requirements necessary to meet customer demand for more features and greater functionality from semiconductor products may exceed the capabilities of the third-party intellectual property or development or testing tools available to us. If the third-party intellectual property that we use becomes unavailable, is not available with required functionality or performance in the time frame or price point needed for our new products or fails to produce designs that meet customer demands, our business could be materially adversely affected. +We depend on third-party companies for the design, manufacture and supply of motherboards, software, memory and other computer platform components to support our business. +We depend on third-party companies for the design, manufacture and supply of motherboards, graphics cards, software (e.g. BIOS, operating systems, drivers), memory and other components that our customers utilize to support and/or use our microprocessor, GPU and APU offerings. We also rely on our add-in-board (AIB) partners to support our GPU and APU products. In addition, our microprocessors are not designed to function with motherboards and chipsets designed to work with Intel microprocessors. If the designers, manufacturers, AIBs and suppliers of motherboards, graphics cards, software, memory and other components cease or reduce their design, manufacture or production of current or future products that are based on or support our products, our business could be materially adversely affected. +If we lose Microsoft Corporation’s support for our products or other software vendors do not design and develop software to run on our products, our ability to sell our products could be materially adversely affected. +Our ability to innovate beyond the x86 instruction set controlled by Intel depends partially on Microsoft designing and developing its operating systems to run on or support our x86-based microprocessor products. With respect to our graphics products, we depend in part on Microsoft to design and develop its operating system to run on or support our graphics products. Similarly, the success of our products in the market, such as our APU products, is dependent on independent software providers designing and developing software to run on our products. If Microsoft does not continue to design and develop its operating systems so that they work with our x86 instruction sets or does not continue to develop and maintain their operating systems to support our graphics products, independent software providers may forego designing their software applications to take advantage of our innovations and customers may not purchase PCs with our products. In addition, some software drivers licensed for use +20 +with our products are certified by Microsoft. If Microsoft did not certify a driver, or if we otherwise fail to retain the support of Microsoft or other software vendors, our ability to market our products would be materially adversely affected. +Our reliance on third-party distributors and AIB partners subjects us to certain risks. +We market and sell our products directly and through third-party distributors and AIB partners pursuant to agreements that can generally be terminated for convenience by either party upon prior notice to the other party. These agreements are non-exclusive and permit both our distributors and AIB partners to offer our competitors’ products. We are dependent on our distributors and AIB partners to supplement our direct marketing and sales efforts. If any significant distributor or AIB partner or a substantial number of our distributors or AIB partners terminated their relationship with us, decided to market our competitors’ products over our products or decided not to market our products at all, our ability to bring our products to market would be impacted and we would be materially adversely affected. In addition, if we are unable to collect accounts receivable from our significant distributors and/or AIB partners, it could have a material adverse effect on our business. If we are unable to manage the risks related to the use of our third-party distributors and AIB partners or offer appropriate incentives to focus them on the sale of our products, our business could be materially adversely affected. +Additionally, distributors and AIB partners typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions, as well as provide return rights for any product that we have removed from our price book and that is not more than 12 months older than the manufacturing date. Some agreements with our distributors also contain standard stock rotation provisions permitting limited levels of product returns. Our agreements with AIB partners protect their inventory of our products against price reductions. In the event of a significant decline in the price of our products, the price protection rights we offer would materially adversely affect us because our revenue and corresponding gross margin would decline. +We may incur future impairments of goodwill and technology license purchases. +We perform our annual goodwill impairment analysis as of the first day of the fourth quarter of each year. Subsequent to our annual goodwill impairment analysis, we monitor for any events or changes in circumstances, such as significant adverse changes in business climate or operating results, changes in management’s business strategy, an inability to successfully introduce new products in the marketplace, an inability to successfully achieve internal forecasts or significant declines in our stock price, which may represent an indicator of impairment. The occurrence of any of these events may require us to record future goodwill impairment charges. +We license certain third-party technologies and tools for the design and production of our products. We report the value of those licenses as intangible assets on the balance sheet and we periodically evaluate the carrying value of those licenses based on their future economic benefit to us. Factors such as the life of the assets, changes in competing technologies, and changes to the business strategy may represent an indicator of impairment. The occurrence of any of these events may require us to record future technology license impairment charges. For example, during the fourth quarter of 2018, we recorded an impairment charge in Cost of sales of $45 million on technology licenses related to products that were no longer being used. +Our inability to continue to attract and retain qualified personnel may hinder our business. +Much of our future success depends upon the continued service our executives of numerous qualified engineering, marketing, sales and executive employees. Competition for highly skilled executives and employees in the technology industry is intense and our competitors have targeted individuals in our organization that have desired skills and experience. If we are not able to continue to attract, train and retain our leadership team and our qualified employees necessary for our business, the progress of our product development programs could be hindered, and we could be materially adversely affected. To help attract, retain and motivate our executives and qualified employees, we use share-based incentive awards such as employee stock options and non-vested share units (restricted stock units). If the value of such stock awards does not appreciate as measured by the performance of the price of our common stock, or if our share-based compensation otherwise ceases to be viewed as a valuable benefit, our ability to attract, retain and motivate our executives and employees could be weakened, which could harm our results of operations. Also, if the value of our stock awards increases substantially, this could potentially create great personal wealth for our executives and employees and affect our ability to retain our personnel. In addition, any future restructuring plans may adversely impact our ability to attract and retain key employees. +Our indebtedness could adversely affect our financial position and prevent us from implementing our strategy or fulfilling our contractual obligations. +Our total debt principal amount as of December 28, 2019 was $0.6 billion. Our indebtedness may make it difficult for us to satisfy our financial obligations, including making scheduled principal and interest payments; limit our ability to borrow additional funds for working capital, capital expenditures, acquisitions and general corporate and other purposes; limit our ability to use +21 +our cash flow or obtain additional financing for future working capital, capital expenditures, acquisitions or other general corporate purposes; require us to use a substantial portion of our cash flow from operations to make debt service payments; place us at a competitive disadvantage compared to our competitors with relatively less debt; and increase our vulnerability to the impact of adverse economic and industry conditions. +We enter into sale and factoring arrangements from time to time with respect to certain accounts receivables, which arrangements are non-recourse to us in the event that an account debtor fails to pay for credit-related reasons, and are not included in our indebtedness. We could become obligated to repurchase such accounts receivables or otherwise incur liability to the counterparties under these arrangements under certain circumstances, such as where a commercial dispute arises between us and an account debtor. +We may not be able to generate sufficient cash to service our debt obligations or meet our working capital requirements. +Our ability to make payments on and to refinance our debt will depend on our financial and operating performance, which may fluctuate significantly from quarter to quarter, and is subject to prevailing economic, financial and business conditions along with other factors, many of which are beyond our control. We cannot assure you that we will be able to generate cash flow or that we will be able to borrow funds, including under our secured revolving credit facility for a principal amount up to $500 million (our Secured Revolving Facility), in amounts sufficient to enable us to service our debt or to meet our working capital requirements. If we are not able to generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, we may be required to sell assets or equity, reduce expenditures, refinance all or a portion of our existing debt or obtain additional financing. We cannot assure you that we will be able to refinance our debt, sell assets or equity, borrow funds under our Secured Revolving Facility or borrow more funds on terms acceptable to us, if at all. +In the event of a change of control, we may not be able to repurchase our outstanding debt as required by the applicable indentures and our Secured Revolving Facility, which would result in a default under the indentures and our Secured Revolving Facility. +Upon a change of control, we will be required to offer to repurchase all of our 7.50% Notes and 2.125% Notes then outstanding at 101% of the principal amount thereof, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date. In addition, a change of control would be an event of default under our Secured Revolving Facility. As of December 28, 2019, $0.6 billion principal amount was outstanding under our notes. Future debt agreements may contain similar provisions. We may not have the financial resources to repurchase our outstanding notes and prepay all of our outstanding obligations under our Secured Revolving Facility. +The semiconductor industry is highly cyclical and has experienced severe downturns that have materially adversely affected, and may continue to materially adversely affect, our business in the future. +The semiconductor industry is highly cyclical and has experienced significant downturns, often in conjunction with constant and rapid technological change, wide fluctuations in supply and demand, continuous new product introductions, price erosion and declines in general economic conditions. We have incurred substantial losses in recent downturns, due to: substantial declines in average selling prices; the cyclical nature of supply and demand imbalances in the semiconductor industry; a decline in demand for end-user products (such as PCs) that incorporate our products; and excess inventory levels. +Industry-wide fluctuations in the computer marketplace have materially adversely affected us in the past and may materially adversely affect us in the future. Global economic uncertainty and weakness have in the past impacted the semiconductor market as consumers and businesses have deferred purchases, which negatively impacted demand for our products. Our financial performance has been, and may in the future be, negatively affected by these downturns. +The growth of our business is also dependent on continued demand for our products from high-growth adjacent emerging global markets. Our ability to be successful in such markets depends in part on our ability to establish adequate local infrastructure, as well as our ability to cultivate and maintain local relationships in these markets. If demand from these markets is below our expectations, sales of our products may decrease, which would have a material adverse effect on us. +Acquisitions, joint ventures and/or investments could disrupt our business and/or dilute or adversely affect the price of our common stock. +Our success will depend, in part, on our ability to expand our product offerings and grow our business in response to changing technologies, customer demands and competitive pressures. In some circumstances, we may pursue growth through the acquisition of complementary businesses, solutions or technologies or through joint ventures or investments rather than through internal development. The identification of suitable acquisition or joint venture candidates can be difficult, time-consuming and costly, and we may not be able to successfully complete identified acquisitions or joint ventures. Moreover, if such acquisitions or joint +22 +ventures require us to seek additional debt or equity financing, we may not be able to obtain such financing on terms favorable to us or at all. Even if we successfully complete an acquisition or a joint venture, we may not be able to assimilate and integrate effectively or efficiently the acquired business, technologies, solutions, assets, personnel or operations, particularly if key personnel of the acquired company decide not to work for us. Acquisitions and joint ventures may also involve the entry into geographic or business markets in which we have little or no prior experience. Consequently, we may not achieve anticipated benefits of the acquisitions or joint ventures which could harm our operating results. In addition, to complete an acquisition, we may issue equity securities, which would dilute our stockholders’ ownership and could adversely affect the price of our common stock, as well as incur debt, assume contingent liabilities or have amortization expenses and write-downs of acquired assets, which could adversely affect our results of operations. Acquisitions and joint ventures may also reduce our cash available for operations and other uses, which could harm our business. Also, any failure on our part to effectively evaluate and execute new business initiatives could adversely affect our business. We may not adequately assess the risk of new business initiatives and subsequent events may arise that alter the risks that were initially considered. +Furthermore, we may not achieve the objectives and expectations with respect to future operations, products and services. The majority of our ATMP services are provided by the JVs, and there is no guarantee that the JVs will be able to fulfill our long-term ATMP requirements. If we are unable to meet customer demand due to fluctuating or late supply from the JVs, it could result in lost sales and have a material adverse effect on our business. +In addition, we may not realize the anticipated benefits from any new business initiatives such as the THATIC JV. We may not realize the expected benefits from the THATIC JV’s expected future performance, the receipt of any future milestone payments and royalties from certain licensed intellectual property. In June 2019, the United States Commerce Department’s Bureau of Industry and Security added certain Chinese entities to the Entity List, including THATIC and the THATIC JV. We are complying with U.S. law pertaining to the Entity List designation. +Our business is dependent upon the proper functioning of our internal business processes and information systems and modification or interruption of such systems may disrupt our business, processes and internal controls. +We rely upon a number of internal business processes and information systems to support key business functions, and the efficient operation of these processes and systems is critical to our business. Our business processes and information systems need to be sufficiently scalable to support the growth of our business and may require modifications or upgrades that expose us to a number of operational risks. As such, our information systems will continually evolve and adapt in order to meet our business needs. These changes may be costly and disruptive to our operations and could impose substantial demands on management time. +These changes may also require changes in our information systems, modification of internal control procedures and significant training of employees and third-party resources. We continuously work on simplifying our information systems and applications through consolidation and standardization efforts. There can be no assurance that our business and operations will not experience any disruption in connection with this transition. Our information technology systems, and those of third-party information technology providers or business partners, may also be vulnerable to damage or disruption caused by circumstances beyond our control including catastrophic events, power anomalies or outages, natural disasters, viruses or malware, cyber-attacks, data breaches and computer system or network failures, exposing us to significant cost, reputational harm and disruption or damage to our business. +In addition, as our IT environment continues to evolve, we are embracing new ways of communicating and sharing data internally and externally with customers and partners using methods such as mobility and the cloud that can promote business efficiency. However, these practices can also result in a more distributed IT environment, making it more difficult for us to maintain visibility and control over internal and external users, and meet scalability and administrative requirements. If our security controls cannot keep pace with the speed of these changes, or if we are not able to meet regulatory and compliance requirements, our business would be materially adversely affected. +If essential equipment, materials or manufacturing processes are not available to manufacture our products, we could be materially adversely affected. +We may purchase equipment and materials for use by our back-end manufacturing service providers from a number of suppliers and our operations depend upon obtaining deliveries of adequate supplies of equipment and materials on a timely basis. Our third-party suppliers also depend on the same timely delivery of adequate quantities of equipment and materials in the manufacture of our products. In addition, as many of our products increase in technical complexity, we rely on our third-party suppliers to update their processes in order to continue meeting our back-end manufacturing needs. Certain equipment and materials that are used in the manufacture of our products are available only from a limited number of suppliers, or in some cases, a sole supplier. We also depend on a limited number of suppliers to provide the majority of certain types of integrated circuit packages for our microprocessors, including our APU products. Similarly, certain non-proprietary materials or components such as memory, printed circuit boards (PCBs), interposers, substrates and capacitors used in the manufacture of our products are +23 +currently available from only a limited number of sources. Because some of the equipment and materials that we and our third-party manufacturing suppliers purchase are complex, it is sometimes difficult to substitute one supplier for another. From time to time, suppliers may extend lead times, limit supply or increase prices due to capacity constraints or other factors. Also, some of these materials and components may be subject to rapid changes in price and availability. Interruption of supply or increased demand in the industry could cause shortages and price increases in various essential materials. Dependence on a sole supplier or a limited number of suppliers exacerbates these risks. If we are unable to procure certain of these materials for our back-end manufacturing operations, or our third-party foundries or manufacturing suppliers are unable to procure materials for manufacturing our products, our business would be materially adversely affected. +If our products are not compatible with some or all industry-standard software and hardware, we could be materially adversely affected. +Our products may not be fully compatible with some or all industry-standard software and hardware. Further, we may be unsuccessful in correcting any such compatibility problems in a timely manner. If our customers are unable to achieve compatibility with software or hardware, we could be materially adversely affected. In addition, the mere announcement of an incompatibility problem relating to our products could have a material adverse effect on our business. +Costs related to defective products could have a material adverse effect on us. +Products as complex as those we offer may contain defects or failures when first introduced or when new versions or enhancements to existing products are released. We cannot assure you that, despite our testing procedures, errors will not be found in new products or releases after commencement of commercial shipments in the future, which could result in loss of or delay in market acceptance of our products, material recall and replacement costs, loss of revenue, writing down the inventory of defective products, the diversion of the attention of our engineering personnel from product development efforts, defending against litigation related to defective products or related liabilities, including property damage, personal injury, damage to our reputation in the industry and loss of data or intangible property, and could adversely affect our relationships with our customers. In addition, we may have difficulty identifying the end customers of the defective products in the field. As a result, we could incur substantial costs to implement modifications to correct defects. Any of these problems could materially adversely affect our business. +We could be subject to potential product liability claims if one of our products causes, or merely appears to have caused, an injury, whether tangible or intangible. Claims may be made by consumers or others selling our products, and we may be subject to claims against us even if an alleged injury is due to the actions of others. A product liability claim, recall or other claim with respect to uninsured liabilities or for amounts in excess of insured liabilities could have a material adverse effect on our business. +If we fail to maintain the efficiency of our supply chain as we respond to changes in customer demand for our products, our business could be materially adversely affected. +Our ability to meet customer demand for our products depends, in part, on our ability to deliver the products our customers want on a timely basis. Accordingly, we rely on our supply chain for the manufacturing, distribution and fulfillment of our products. As we continue to grow our business, expand to high-growth adjacent markets, acquire new customers and strengthen relationships with existing customers, the efficiency of our supply chain will become increasingly important because many of our customers tend to have specific requirements for particular products, and specific time-frames in which they require delivery of these products. If we are unable to consistently deliver the right products to our customers on a timely basis in the right locations, our customers may reduce the quantities they order from us, which could have a material adverse effect on our business. +We outsource to third parties certain supply-chain logistics functions, including portions of our product distribution, transportation management and information technology support services. +We rely on third-party providers to operate our regional product distribution centers and to manage the transportation of our work-in-process and finished products among our facilities, to our manufacturing suppliers and to our customers. In addition, we rely on third parties to provide certain information technology services to us, including help desk support, desktop application services, business and software support applications, server and storage administration, data center operations, database administration and voice, video and remote access. We cannot guarantee that these providers will fulfill their respective responsibilities in a timely manner in accordance with the contract terms, in which case our internal operations and the distribution of our products to our customers could be materially adversely affected. Also, we cannot guarantee that our contracts with these third-party providers will be renewed, in which case we would have to transition these functions in-house or secure new providers, which could have a material adverse effect on our business if the transition is not executed appropriately. +24 +Our stock price is subject to volatility. +Our stock price has experienced price and volume fluctuations and could be subject to wide fluctuations in the future. The trading price of our stock may fluctuate widely due to various factors including actual or anticipated fluctuations in our financial conditions and operating results, changes in financial estimates by us or financial estimates and ratings by securities analysts, changes in our capital structure, including issuance of additional debt or equity to the public, interest rate changes, news regarding our products or products of our competitors, and broad market and industry fluctuations. Stock price fluctuations could impact the value of our equity compensation, which could affect our ability to recruit and retain employees. In addition, volatility in our stock price could adversely affect our business and financing opportunities. +Worldwide political conditions may adversely affect demand for our products. +Worldwide political conditions may create uncertainties that could adversely affect our business. The United States has been and may continue to be involved in armed conflicts that could have a further impact on our sales and our supply chain. The consequences of armed conflict, political instability or civil or military unrest are unpredictable, and we may not be able to foresee events that could have a material adverse effect on us. Terrorist attacks or other hostile acts may negatively affect our operations, or adversely affect demand for our products, and such attacks or related armed conflicts may impact our physical facilities or those of our suppliers or customers. Furthermore, these attacks or hostile acts may make travel and the transportation of our products more difficult and more expensive, which could materially adversely affect us. Any of these events could cause consumer spending to decrease or result in increased volatility in the United States economy and worldwide financial markets. +Unfavorable currency exchange rate fluctuations could adversely affect us. +We have costs, assets and liabilities that are denominated in foreign currencies. As a consequence, movements in exchange rates could cause our foreign currency denominated expenses to increase as a percentage of revenue, affecting our profitability and cash flows. Whenever we believe appropriate, we hedge a portion of our short-term foreign currency exposure to protect against fluctuations in currency exchange rates. We determine our total foreign currency exposure using projections of long-term expenditures for items such as payroll. We cannot assure you that these activities will be effective in reducing foreign exchange rate exposure. Failure to do so could have an adverse effect on our business, financial condition, results of operations and cash flow. In addition, the majority of our product sales are denominated in U.S. dollars. Fluctuations in the exchange rate between the U.S. dollar and the local currency can cause increases or decreases in the cost of our products in the local currency of such customers. An appreciation of the U.S. dollar relative to the local currency could reduce sales of our products. +Our inability to effectively control the sales of our products on the gray market could have a material adverse effect on us. +We market and sell our products directly to OEMs and through authorized third-party distributors. From time to time, our products are diverted from our authorized distribution channels and are sold on the “gray market.” Gray market products result in shadow inventory that is not visible to us, thus making it difficult to forecast demand accurately. Also, when gray market products enter the market, we and our distribution channels compete with these heavily discounted gray market products, which adversely affects demand for our products and negatively impacts our margins. In addition, our inability to control gray market activities could result in customer satisfaction issues because any time products are purchased outside our authorized distribution channels there is a risk that our customers are buying counterfeit or substandard products, including products that may have been altered, mishandled or damaged, or are used products represented as new. +If we cannot adequately protect our technology or other intellectual property in the United States and abroad, through patents, copyrights, trade secrets, trademarks and other measures, we may lose a competitive advantage and incur significant expenses. +We rely on a combination of protections provided by contracts, including confidentiality and nondisclosure agreements, copyrights, patents, trademarks and common law rights, such as trade secrets, to protect our intellectual property. However, we cannot assure you that we will be able to adequately protect our technology or other intellectual property from third-party infringement or from misappropriation in the United States and abroad. Any patent licensed by us or issued to us could be challenged, invalidated or circumvented or rights granted there under may not provide a competitive advantage to us. +Furthermore, patent applications that we file may not result in issuance of a patent or, if a patent is issued, the patent may not be issued in a form that is advantageous to us. Despite our efforts to protect our intellectual property rights, others may independently develop similar products, duplicate our products or design around our patents and other rights. In addition, it is difficult to monitor compliance with, and enforce, our intellectual property on a worldwide basis in a cost-effective manner. In jurisdictions where foreign laws provide less intellectual property protection than afforded in the United States and abroad, our technology or other intellectual property may be compromised, and our business would be materially adversely affected. +25 +We are party to litigation and may become a party to other claims or litigation that could cause us to incur substantial costs or pay substantial damages or prohibit us from selling our products. +From time to time, we are a defendant or plaintiff in various legal actions. For example, as described in Note 18 of our consolidated financial statements, we have been subject to certain claims concerning federal securities laws and corporate governance. Our products are purchased by and/or used by consumers, which could increase our exposure to consumer actions such as product liability claims and consumer class action claims, including those described in Note 18 of our consolidated financial statements. On occasion, we receive claims that individuals were allegedly exposed to substances used in our former semiconductor wafer manufacturing facilities and that this alleged exposure caused harm. Litigation can involve complex factual and legal questions, and its outcome is uncertain. It is possible that if a claim is successfully asserted against us, including the claims described in Note 18 of our consolidated financial statements, it could result in the payment of damages that could be material to our business. +With respect to intellectual property litigation, from time to time, we have been notified of, or third parties may bring or have brought, actions against us and/or against our customers based on allegations that we are infringing the intellectual property rights of others, contributing to or inducing the infringement of the intellectual property rights of others, improperly claiming ownership of intellectual property or otherwise improperly using the intellectual property of others. If any such claims are asserted, we may seek to obtain a license under the third parties’ intellectual property rights. We cannot assure you that we will be able to obtain all of the necessary licenses on satisfactory terms, if at all. These parties may file lawsuits against us or our customers seeking damages (potentially up to and including treble damages) or an injunction against the sale of products that incorporate allegedly infringed intellectual property or against the operation of our business as presently conducted, which could result in our having to stop the sale of some of our products or to increase the costs of selling some of our products or which could damage our reputation. The award of damages, including material royalty payments, or other types of damages, or the entry of an injunction against the manufacture and sale of some or all of our products could have a material adverse effect on us. We could decide, in the alternative, to redesign our products or to resort to litigation to challenge such claims. Such challenges could be extremely expensive and time-consuming regardless of their merit, could cause delays in product release or shipment and/or could have a material adverse effect on us. We cannot assure you that litigation related to our intellectual property rights or the intellectual property rights of others can always be avoided or successfully concluded. +Even if we were to prevail, any litigation could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could have a material adverse effect on us. +Our business is subject to potential tax liabilities. +We are subject to income tax, indirect tax or other tax claims by tax agencies in jurisdictions in which we conduct business. Significant judgment is required in determining our worldwide provision for income taxes. Tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. The Tax Cuts and Jobs Act of 2017 (the Tax Reform Act) contains many significant changes to the U.S. federal income tax laws, which the consequences of could have a material impact on the value of our deferred tax assets and could increase our future U.S. income tax expense. As additional regulatory guidance is issued by the applicable taxing authorities and as new accounting treatment is clarified, we may report additional adjustments in the period if new information becomes available. We have a significant amount of deferred tax assets and a portion of the deferred tax assets related to net operating losses or tax credits could be subject to limitations under Internal Revenue Code Section 382 or 383, separate return loss year rules, or dual consolidated loss rules. The limitations could reduce the ability of the Company to be able to utilize the net operating losses or tax credits before the expiration of the tax attributes. Tax law changes or the limitations could be material and could materially affect our tax obligations and effective tax rate. +In the ordinary course of our business, there are many transactions and calculations where the ultimate income tax, indirect tax, or other tax determination is uncertain. Although we believe our tax estimates are reasonable, we cannot assure that the final determination of any tax audits and litigation will not be materially different from that which is reflected in historical tax provisions and accruals. Should additional taxes be assessed as a result of an audit, assessment or litigation, there could be a material adverse effect on our cash, tax provisions and net income in the period or periods for which that determination is made. +We are subject to environmental laws, conflict minerals-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as a variety of other laws or regulations that could result in additional costs and liabilities. +Our operations and properties have in the past been and continue to be subject to various United States and foreign laws and regulations, including those relating to materials used in our products and manufacturing processes, discharge of pollutants into the environment, the treatment, transport, storage and disposal of solid and hazardous wastes and remediation of contamination. These laws and regulations require our suppliers to obtain permits for operations making our products, including the discharge of air pollutants and wastewater. Although our management systems are designed to oversee our suppliers’ compliance, we cannot assure you that our suppliers have been or will be at all times in complete compliance with such laws, regulations and permits. +26 +If our suppliers violate or fail to comply with any of them, a range of consequences could result, including fines, suspension of production, alteration of manufacturing processes, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions. Such non-compliance from our manufacturing suppliers could result in disruptions in supply, higher sourcing costs, and/or reputational damage for us. +Environmental laws are complex, change frequently and have tended to become more stringent over time. For example, the European Union (EU) and China are two among a growing number of jurisdictions that have enacted restrictions on the use of lead and other materials in electronic products. These regulations affect semiconductor devices and packaging. As regulations restricting materials in electronic products continue to increase around the world, there is a risk that the cost, quality and manufacturing yields of products that are subject to these restrictions may be less favorable compared to products that are not subject to such restrictions, or that the transition to compliant products may not meet customer roadmaps, or produce sudden changes in demand, which may result in excess inventory. A number of jurisdictions including the EU, Australia, California and China are developing or have finalized market entry or public procurement regulations for computers and servers based on ENERGY STAR specifications as well as additional energy consumption limits. There is the potential for certain of our products being excluded from some of these markets which could materially adversely affect us. +Certain environmental laws, including the United States Comprehensive, Environmental Response, Compensation and Liability Act of 1980, or the Superfund Act, impose strict or, under certain circumstances, joint and several liability on current and previous owners or operators of real property for the cost of removal or remediation of hazardous substances and impose liability for damages to natural resources. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. These environmental laws also assess liability on persons who arrange for hazardous substances to be sent to disposal or treatment facilities when such facilities are found to be contaminated. Such persons can be responsible for cleanup costs even if they never owned or operated the contaminated facility. We have been named as a responsible party at three Superfund sites in Sunnyvale, California. Although we have not yet been, we could be named a potentially responsible party at other Superfund or contaminated sites in the future. In addition, contamination that has not yet been identified could exist at our other facilities. +Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC adopted disclosure and reporting requirements for companies that use “conflict” minerals originating from the Democratic Republic of Congo or adjoining countries. We continue to incur additional costs associated with complying with these requirements, such as costs related to developing internal controls for the due diligence process, determining the source of any conflict minerals used in our products, auditing the process and reporting to our customers and the SEC. In addition to the SEC regulation, the European Union, China and other jurisdictions are developing new policies focused on conflict minerals that may impact and increase the cost of our compliance program. Also, since our supply chain is complex, we may face reputational challenges if we are unable to sufficiently verify the origins of the subject minerals. Moreover, we are likely to encounter challenges to satisfy those customers who require that all of the components of our products are certified as “conflict free.” If we cannot satisfy these customers, they may choose a competitor’s products. +The United States federal government has issued new policies for federal procurement focused on eradicating the practice of forced labor and human trafficking. Germany’s federal procurement office, in collaboration with the Bitkom trade association, issued new supply chain labor requirements. In addition, the United Kingdom, Australia and the State of California have issued laws that require us to disclose our policy and practices for identifying and eliminating forced labor and human trafficking in our supply chain. Several customers as well as the Responsible Business Alliance have also issued expectations to eliminate these practices that may impact us. While we have a policy and management systems to identify and avoid these practices in our supply chain, we cannot guarantee that our suppliers will always be in conformance to these laws and expectations. We may face enforcement liability and reputational challenges if we are unable to sufficiently meet these expectations. Moreover, we are likely to encounter challenges with customers if we cannot satisfy their forced and trafficked labor polices and they may choose a competitor’s product. +ITEM 1B. +UNRESOLVED STAFF COMMENTS +None. +ITEM 2. +PROPERTIES +As of December 28, 2019 , we leased approximately 2.35 million square feet of space for research and development, engineering, administrative and warehouse use, including our headquarters in Santa Clara, California, our principal administrative facilities in Austin, Texas, our design center in Shanghai, China, our main facility with respect to graphics and chipset products located in Markham, Ontario, Canada and a number of smaller regional sales offices located in commercial centers near customers, +27 +principally in the United States, Europe, Asia and Latin America. These leases expire at varying dates through 2028, although some of these leases include optional renewals. We occupy 220,000 square feet of space in our headquarters in Santa Clara, California under a 10-year operating lease which commenced in August 2017 and expires in July 2027. We have the option to extend the term of the lease for two additional 5-year periods. The lease for our principal administrative facilities in Austin, Texas expires in March 2025, and provides for one 10-year optional renewal. The leases for our facilities in Markham, Ontario, Canada expire in February 2028, and provide for one 5-year optional renewals. We occupy approximately 265,000 square feet of space in our design center in Shanghai, China under a 10-year operating lease, which expires in March 2028. +We currently do not anticipate difficulty in either retaining occupancy of any of our facilities through lease renewals prior to expiration or through month-to-month occupancy or replacing them with equivalent facilities. +We believe that our existing facilities are suitable and adequate for our present purposes and that the productive capacity of such facilities is substantially being utilized or we have plans to utilize such capacity. +ITEM 3. LEGAL PROCEEDINGS +Shareholder Derivative Lawsuits (Wessels, Hamilton and Ha) +On March 20, 2014, a purported shareholder derivative lawsuit captioned Wessels v. Read, et al. , Case No. 1:14 cv-262486 (Wessels) was filed against us (as a nominal defendant only) and certain of our directors and officers in the Santa Clara County Superior Court of the State of California. The complaint purports to assert claims against us and certain individual directors and officers for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by us and the individual directors and officers regarding our 32nm technology and “Llano” product, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for our common stock during the period. On April 27, 2015, a similar purported shareholder derivative lawsuit captioned Christopher Hamilton and David Hamilton v. Barnes, et al. , Case No. 5:15-cv-01890 (Hamilton) was filed against us (as a nominal defendant only) and certain of our directors and officers in the United States District Court for the Northern District of California. +On September 29, 2015, a similar purported shareholder derivative lawsuit captioned Jake Ha v Caldwell, et al., Case No. 3:15-cv-04485 (Ha) was filed against us (as a nominal defendant only) and certain of our directors and officers in the United States District Court for the Northern District of California. The lawsuit also seeks a court order voiding the stockholder vote on our 2015 proxy. The case was transferred to the judge handling the Hamilton Lawsuit and is now Case No. 4:15-cv-04485. The Wessels, Hamilton and Ha shareholder derivative lawsuits were stayed pending resolution of a class action lawsuit captioned Hatamian v. AMD, et al. , C.A. No. 3:14-cv-00226 filed against us in the United States District Court for the Northern District of California (the Hatamian Lawsuit). The Hatamian Lawsuit asserted claims against us and certain of our officers for alleged violations of Section 10(b) of the Exchange Act of 1934, as amended (the Exchange Act), and SEC Rule 10b-5 concerning certain statements regarding our 32nm technology and “Llano” products. On October 9, 2017, the parties signed a definitive settlement agreement resolving the Hatamian Lawsuit and submitted it to the Court for approval. Under the terms of this agreement, the settlement was funded entirely by certain of our insurance carriers and the defendants continued to deny any liability or wrongdoing. On March 2, 2018, the court approved the settlement and entered a final judgment in the Hatamian Lawsuit. +On January 30, 2018, the Wessels and Hamilton plaintiffs amended their complaints. On February 2, 2018, the Ha plaintiff also filed an amended complaint. On February 22, 2018, we filed motions to dismiss the Hamilton and Ha plaintiffs’ amended complaints. On April 2, 2018, we filed a demurrer seeking to dismiss the Wessels amended complaint. On July 23, 2018, the Santa Clara Superior Court sustained our demurrer in the Wessels case, dismissing all claims in that matter with prejudice. The Wessels plaintiff filed a Notice of Appeal on September 27, 2018. On October 4, 2018, the Federal Court issued an order dismissing the Hamilton and Ha amended complaints. The Hamilton plaintiffs filed a Notice of Appeal on October 8, 2018, and the Ha plaintiffs filed a Notice of Appeal on October 15, 2018. On November 19, 2018, the Hamilton and Ha plaintiffs filed a motion seeking summary reversal of the order dismissing their claims. We opposed this motion on December 13, 2018, and the Court denied it on February 25, 2019. The Wessels, Hamilton, and Ha appeals are currently pending. Briefing has completed in each appeal. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Hauck et al. Litigation +Since January 19, 2018, three putative class action complaints have been filed against us in the United States District Court for the Northern District of California: (1) Diana Hauck et al. v. AMD, Inc., Case No. 5:18-cv-0047, filed on January 19, 2018; (2) Brian Speck et al. v. AMD, Inc. , Case No. 5:18-cv-0744, filed on February 4, 2018; and (3) Nathan Barnes and Jonathan Caskey-Medina, et al. v. AMD, Inc. , Case No. 5:18-cv-00883, filed on February 9, 2018. On April 9, 2018, the court consolidated +28 +these cases and ordered that Diana Hauck et al. v. AMD, Inc. serve as the lead case. On June 13, 2018, six plaintiffs (from California, Louisiana, Florida, and Massachusetts) filed a consolidated amended complaint alleging that we failed to disclose our processors’ alleged vulnerability to Spectre. Plaintiffs further allege that our processors cannot perform at their advertised processing speeds without exposing consumers to Spectre, and that any “patches” to remedy this security vulnerability will result in degradation of processor performance. The plaintiffs seek damages under several causes of action on behalf of a nationwide class and four state subclasses (California, Florida, Massachusetts, Louisiana) of consumers who purchased our processors and/or devices containing AMD processors. The plaintiffs also seek attorneys’ fees, equitable relief, and restitution. Pursuant to the court’s order directing the parties to litigate only eight of the causes of action in the consolidated amended complaint initially, we filed a motion to dismiss on July 13, 2018. On October 29, 2018, after the plaintiffs voluntarily dismissed one of their claims, the court granted our motion and dismissed six causes of action with leave to amend. The plaintiffs filed their amended consolidated complaint on December 6, 2018. On January 3, 2019, we again moved to dismiss the subset of claims currently at issue. On April 4, 2019, the court granted our motion and dismissed all claims currently at issue with prejudice. On May 6, 2019, the court granted the parties’ stipulation and request under Fed. R. Civ. P. 54(b) to enter a partial final judgment and certify for appeal the court’s April 4, 2019 dismissal order, and on that same date, the plaintiffs voluntarily dismissed without prejudice their remaining claims pursuant to an agreement whereby, subject to certain terms and conditions, we agreed to toll the statute of limitations and/or statute of repose. On May 30, 2019, the plaintiffs filed a Notice of Appeal with the U.S. Court of Appeals for the Ninth Circuit. Briefing has completed for the appeal. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Quarterhill Inc. Litigation +On July 2, 2018, three entities named Aquila Innovations, Inc. (Aquila), Collabo Innovations, Inc. (Collabo), and Polaris Innovations, Ltd. (Polaris), filed separate patent infringement complaints against us in the United States District Court for the Western District of Texas. Aquila alleges that we infringe two patents (6,239,614 and 6,895,519) relating to power management; Collabo alleges that we infringe one patent (7,930,575) related to power management; and Polaris alleges that we infringe two patents (6,728,144 and 8,117,526) relating to control or use of dynamic random-access memory, or DRAM. Each of the three complaints seeks unspecified monetary damages, interest, fees, expenses, and costs against us; Aquila and Collabo also seek enhanced damages. Aquila, Collabo, and Polaris each appear to be related to a patent assertion entity named Quarterhill Inc. (formerly WiLAN Inc.). On November 16, 2018, AMD filed answers in the Collabo and Aquila cases and filed a motion to dismiss in the Polaris case. On January 25, 2019, we filed amended answers and counterclaims in the Collabo and Aquila cases. On July 22, 2019, our motion to dismiss in the Polaris case was denied. On August 23, 2019, the Court held a claim construction hearing in each case. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Dickey Litigation +On October 26, 2015, a putative class action complaint captioned Dickey et al. v. AMD , No. 15-cv-04922 was filed against us in the United States District Court for the Northern District of California. Plaintiffs allege that we misled consumers by using the term “eight cores” in connection with the marketing of certain AMD FX CPUs that are based on our “Bulldozer” core architecture. The plaintiffs allege these products cannot perform eight calculations simultaneously, without restriction. The plaintiffs seek to obtain damages under several causes of action for a nationwide class of consumers who allegedly were deceived into purchasing certain Bulldozer-based CPUs that were marketed as containing eight cores. The plaintiffs also seek attorneys’ fees. On December 21, 2015, we filed a motion to dismiss the complaint, which was granted on April 7, 2016. The plaintiffs then filed an amended complaint with a narrowed putative class definition, which the Court dismissed upon our motion on October 31, 2016. The plaintiffs subsequently filed a second amended complaint, and we filed a motion to dismiss the second amended complaint. On June 14, 2017, the Court issued an order granting in part and denying in part our motion to dismiss, and allowing the plaintiffs to move forward with a portion of their complaint. On March 27, 2018, plaintiffs filed their motion for class certification. On January 17, 2019, the Court granted plaintiffs’ motion for class certification. The class definition does not encompass our Ryzen or EPYC processors. On January 31, 2019, we filed a petition in the Ninth Circuit Court of Appeals seeking review of certain aspects of the January 17, 2019 class certification order. On May 9, 2019, the parties attended mediation and reached a tentative settlement. On June 3, 2019, the Ninth Circuit Court of Appeals denied our petition seeking appellate review of the January 17, 2019, class certification order. On August 9, 2019, the parties executed a formal settlement agreement. On August 23, 2019, plaintiffs filed their motion for preliminary approval of the settlement agreement. On October 4, 2019, the Court granted the motion for preliminary approval of the settlement agreement. +29 +Based upon information presently known to management, we believe that the settlement will not have a material adverse effect on our financial condition, cash flows or results of operations. +Monterey Research Litigation +On November 15, 2019, Monterey Research, LLC filed a patent infringement complaint against us in the United States District Court for the District of Delaware. Monterey Research alleges that we infringe six U.S. patents: 6,534,805 (related to SRAM cell design); 6,629,226 (related to read interface protocols); 6,651,134 (related to memory devices); 6,765,407 (related to programmable digital circuits); 6,961,807 (related to integrated circuits and associated memory systems); and 8,373,455 (related to output buffer circuits). Monterey Research seeks unspecified monetary damages, enhanced damages, interest, fees, expenses, costs, and injunctive relief against us. On January 22, 2020, we filed a motion to dismiss part of Monterey Research’s complaint. +Based upon information presently known to management, we believe that the potential liability, if any, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Environmental Matters +We are named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, we have discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, we received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. We have entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. We remain responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, we have computed and recorded an estimated environmental liability of approximately $3 million and have not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. Costs could also increase as a result of additional test and remediation obligations imposed by the Environmental Protection Agency or California Regional Water Quality Control Board. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. We believe that the potential liability, if any, in excess of amounts already accrued, will not have a material adverse effect on our financial condition, cash flows or results of operations. +Other Matters +We are a defendant or plaintiff in various actions that arose in the normal course of business. With respect to these matters, based on our management’s current knowledge, we believe that the amount or range of reasonably possible loss, if any, will not, either individually or in the aggregate, have a material adverse effect on our business, financial position, results of operations or cash flows. +ITEM 4. MINE SAFETY DISCLOSURES +Not Applicable. +30 +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on The NASDAQ Global Select Market (NASDAQ) under the symbol “AMD”. On January 31, 2020, there were 4,364 registered holders of our common stock, and the closing price of our common stock was $47.00 per share as reported on NASDAQ. +For information about our equity compensation plans, see Part III, Item 11, below. +Performance Graph +Comparison of Five-Year Cumulative Total Returns +Advanced Micro Devices, S&P 500 Index and S&P 500 Semiconductor Index +The following graph shows a five-year comparison of cumulative total return on our common stock, the S&P 500 Index and the S&P 500 Semiconductor Index from December 27, 2014 through December 28, 2019. The past performance of our common stock is no indication of future performance. +Base Period +Years Ending +Company / Index +12/27/2014 +12/26/2015 +12/31/2016 +12/30/2017 +12/29/2018 +12/28/2019 +Advanced Micro Devices, Inc. +100 +110.19 +427.92 +387.92 +672.45 +1,742.64 +S&P 500 Index +100 +100.77 +111.92 +136.35 +129.26 +171.64 +S&P 500 Semiconductors Index +100 +100.47 +126.23 +172.07 +160.39 +237.49 +31 +Unregistered Sales of Equity Securities +We issued warrants dated December 30, 2019 to purchase 40,162 shares of our common stock to a commercial partner pursuant to a strategic arrangement with such partner. The warrants have an exercise price of $25.4994 per share and expire on December 30, 2022. The warrants were issued pursuant to Section 4(a)(2) of the Securities Act of 1933, as amended. +32 +ITEM 6. SELECTED FINANCIAL DATA +2019 (1) +2018 (1) +2017 (1)(2) +2016 (1)(2) +2015 (1) +In millions except per share amounts +Net revenue +$ +6,731 +$ +6,475 +$ +5,253 +$ +4,319 +$ +3,991 +Net income (loss) (3)(4) +$ +341 +$ +337 +$ +(33 +) +$ +(498 +) +$ +(660 +) +Earnings (loss) per share +Basic +$ +0.31 +$ +0.34 +$ +(0.03 +) +$ +(0.60 +) +$ +(0.84 +) +Diluted +$ +0.30 +$ +0.32 +$ +(0.03 +) +$ +(0.60 +) +$ +(0.84 +) +Shares used in per share calculation +Basic +1,091 +982 +952 +835 +783 +Diluted +1,120 +1,064 +952 +835 +783 +Long-term debt, net and other long-term liabilities (5) +$ +643 +$ +1,306 +$ +1,443 +$ +1,559 +$ +2,093 +Total assets +$ +6,028 +$ +4,556 +$ +3,552 +$ +3,328 +$ +3,084 +(1) +2019, 2018, 2017, and 2015 each consisted of 52 weeks, whereas 2016 consisted of 53 weeks. +(2) +2017 and 2016 amounts adjusted to reflect the retrospective application of Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers . +(3) +In 2016, we recorded a charge of $340 million in Cost of sales, consisting of the $240 million value of the warrant under a warrant agreement and the $100 million payment, which were both associated with the sixth amendment to the WSA. In addition, we recorded a cumulative pre-tax gain of $146 million on the sale of our 85% equity interest in the ATMP JV. +(4) +In 2015, we implemented restructuring plans and incurred net charges of $53 million, which primarily consisted of severance and related employee benefits. In addition, we exited the dense server systems business, formerly Sea Micro, Inc., resulting in a charge of $76 million in restructuring and other special charges, net. Also, we recorded an inventory write-down of $65 million, which was primarily the result of lower anticipated demand for older-generation APUs, and a technology node transition charge of $33 million. +(5) +In 2019, we reduced our long-term debt, net and other long term liabilities by $663 million, primarily due to $628 million of net debt conversion and repayment. In 2016, we reduced our long-term debt, net and other long term liabilities by $534 million, primarily due to $1,048 million of net debt repayment, partially offset by the issuance of $805 million in principal amount of 2.125% Notes net of unamortized discount of $308 million and unamortized issuance cost of $14 million. +33 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +The following discussion should be read in conjunction with the consolidated financial statements as of December 28, 2019 and December 29, 2018 and for each of the three years in the period ended December 28, 2019 and related notes, which are included in this Annual Report on Form 10-K as well as with the other sections of this Annual Report on Form 10-K, including “Part I, Item 1: Business,” “Part II, Item 6: Selected Financial Data” and “Part II, Item 8: Financial Statements and Supplementary Data.” +Introduction +In this section, we will describe the general financial condition and the results of operations of Advanced Micro Devices, Inc. and its wholly-owned subsidiaries (collectively, “us,” “our” or “AMD”), including a discussion of our results of operations for 2019 compared to 2018 , an analysis of changes in our financial condition and a discussion of our contractual obligations and off-balance sheet arrangements. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 29, 2018 . +Overview +2019 marked a milestone in our multi-year journey with the launch of our 7 nanometer (nm) product portfolio. We executed our product roadmap and introduced a number of high-performance products in 2019. For the PC market, we introduced the 3rd Gen AMD Ryzen™ desktop processor family based on the new Zen 2 core architecture with AMD chiplet design approach. In addition to our mainstream PC product family, we introduced the next generation of the Ryzen™ Threadripper™ product line designed for the high-end desktop segment for creators and enthusiasts. We announced our second-generation AMD Ryzen™ 3000 Series notebook processors, powering ultrathin, commercial and gaming notebooks. +A number of high-performance graphics products were also launched in 2019. We introduced the AMD Radeon™ VII, a premium graphics card for gamers, creators and enthusiasts. We also announced the availability of the AMD Radeon™ RX 5700-series gaming graphics card family, the AMD Radeon™ RX 5500 series that will be available in desktop PCs from major PC manufacturers as well as the Radeon™ 5500M GPU for notebook PCs. Our AMD Radeon™ Pro Vega II GPU is designed to power demanding professional applications. We also announced the AMD Radeon™ Pro W5700, a 7nm professional PC workstation graphics card that enables 3D professionals to visualize and interact with their designs in real time. +For the server market, we introduced the 2nd Gen AMD EPYC™ family of processors that feature up to 64 “Zen 2” cores in 7nm process technology for performance and are designed to reduce total cost of ownership (TOC) by up to 50%. +Net revenue for 2019 was $6.7 billion , an increase of 4% compared to 2018 net revenue of $6.5 billion . Gross margin, as a percentage of net revenue for 2019, was 43% , compared to 38% in 2018. Our operating income for 2019 improved to $631 million compared to operating income of $451 million for 2018. Our net income for 2019 improved to $341 million compared to $337 million in the prior year. +Cash, cash equivalents and marketable securities as of December 28, 2019 were $ 1.5 billion , up from $1.2 billion at the end of 2018. We made significant progress towards improving our balance sheet in 2019 as we reduced our debt. Principal amount of total debt as of December 28, 2019 was $563 million , compared to $ 1.5 billion as of December 29, 2018. +We intend the discussion of our financial condition and results of operations that follows to provide information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period, the primary factors that resulted in those changes, and how certain accounting principles, policies and estimates affect our financial statements. +34 +Critical Accounting Estimates +Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts in our consolidated financial statements. We evaluate our estimates on an on-going basis, including those related to our revenue, inventories, goodwill impairments and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Although actual results have historically been reasonably consistent with management’s expectations, the actual results may differ from these estimates or our estimates may be affected by different assumptions or conditions. +Management believes the following critical accounting estimates are the most significant to the presentation of our financial statements and require the most difficult, subjective and complex judgments. +Revenue recognition. We recognize revenue upon the shipment of the product to our distributors (sell-in), rather than upon the resale of the product by our distributors to their customers (sell-through). Accordingly, we have established provisions for rights of return and price protection on unsold product held by our distributors. +Revenue Allowances. We record a provision for estimated sales returns and allowances on product sales for estimated future price reductions and other customer incentives in the same period that the related revenues are recorded. We base these estimates on actual historical sales returns, historical allowances, historical price reductions, market activity and other known or anticipated trends and factors. These estimates are subject to management’s judgment and actual provisions could be different from our estimates and current provisions, resulting in future adjustments to our revenue and operating results. +Inventory Valuation. At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence based on projected sales outlook. This evaluation includes analysis of historical sales levels by product and projections of future demand. These projections assist us in determining the carrying value of our inventory. In addition, we write off inventories that we consider obsolete. We adjust the remaining specific inventory balances to approximate the lower of our actual cost or estimated net realizable value. Among other factors, management considers recent historical activity as well as anticipated or forecasted demand, estimates of future selling prices, competitiveness of product offerings, market and industry conditions, customer requirements and product life cycles when determining excess, obsolescence and net realizable value in relation to the inventory on hand. If in any period we anticipate future demand or market conditions to be less favorable than our previous estimates, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made. This would have a negative impact on our gross margin in that period. If in any period we are able to sell inventories that were not valued or that had been written down in a previous period, related revenues would be recorded without any offsetting charge to cost of sales resulting in a net benefit to our gross margin in that period. +Goodwill. We perform our goodwill impairment analysis as of the first day of the fourth quarter of each year and, if certain events or circumstances indicate that an impairment loss may have been incurred, on a more frequent basis. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. +Qualitative factors include industry and market consideration, overall financial performance, share price trends and market capitalization and Company-specific events. We first analyze qualitative factors. If we conclude it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, we do not proceed to perform a quantitative impairment test. +If we conclude it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative goodwill impairment test will be performed by comparing the fair value of each reporting unit to its carrying value. A quantitative impairment analysis, if necessary, considers the income approach, which requires estimates of the present value of expected future cash flows to determine a reporting unit’s fair value. Significant estimates include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates, and future economic and market conditions. +A goodwill impairment charge is recognized for the amount by which the reporting unit’s fair value is less than its carrying value. Any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +Income Taxes . In determining taxable income for financial statement reporting purposes, we must make certain estimates and judgments. These estimates and judgments are applied in the calculation of certain tax liabilities and in the determination of the recoverability of deferred tax assets which arise from temporary differences between the recognition of assets and liabilities for tax and financial statement reporting purposes. +35 +We must assess the likelihood that we will be able to recover our deferred tax assets. Unless recovery is considered more-likely-than-not (a probability level of more than 50%), we will record a charge to income tax expense in the form of a valuation allowance for the deferred tax assets that we estimate will not ultimately be recoverable or maintain the valuation allowance recorded in prior periods. In determining the need to establish or maintain a valuation allowance, we consider multiple factors including past performance, the reversal of deferred tax liabilities, tax planning strategies, and future expected taxable income. When considering all available evidence, if it is determined we can more-likely-than-not realize our deferred tax assets, we will reverse the existing valuation allowance, which would result in a credit to income tax expense and the establishment of an asset in the period of reversal. +In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax rules and the potential for future adjustment of our uncertain tax positions by the Internal Revenue Service or other taxing authorities. If our estimates of these taxes are greater or less than actual results, an additional tax benefit or charge will result. We recognize the interest and penalties related to unrecognized tax benefits as interest expense and income tax expense, respectively. +Results of Operations +We report our financial performance based on the following two reportable segments: the Computing and Graphics segment and the Enterprise, Embedded and Semi-Custom segment. +Additional information on our reportable segments is contained in Note 15: Segment Reporting of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). +Our operating results tend to vary seasonally. Historically, our net revenue has been generally higher in the second half of the year than in the first half of the year, although market conditions and product transitions could impact these trends. +The following table provides a summary of net revenue and operating income (loss) by segment for 2019 , 2018 and 2017 . +2019 +2018 +2017 +(In millions) +Net revenue: +Computing and Graphics +$ +4,709 +$ +4,125 +$ +2,977 +Enterprise, Embedded and Semi-Custom +2,022 +2,350 +2,276 +Total net revenue +$ +6,731 +$ +6,475 +$ +5,253 +Operating income (loss): +Computing and Graphics +$ +577 +$ +470 +$ +92 +Enterprise, Embedded and Semi-Custom +263 +163 +132 +All Other +(209 +) +(182 +) +(97 +) +Total operating income +$ +631 +$ +451 +$ +127 +Computing and Graphics +Computing and Graphics net revenue of $4.7 billion in 2019 increased by 14% , compared to $4.1 billion in 2018 , primarily as a result of a 22% increase in average selling price and a 4% increase in unit shipments. The increase in average selling price was primarily driven by a richer mix of client processors due to strong demand of our Ryzen processors. The increase in unit shipments was primarily due to higher demand for our Ryzen processors, partially offset by lower demand for our Radeon graphics products. +Computing and Graphics operating income was $577 million in 2019 compared to operating income of $470 million in 2018 . The increase in operating income was primarily driven by higher sales, partially offset by a $194 million increase in operating expenses. Operating expenses increased for the reasons outlined under “Expenses” below. +Enterprise, Embedded and Semi-Custom +Enterprise, Embedded and Semi-Custom net revenue of $2.0 billion in 2019 decreased by 14% compared to net revenue of $2.4 billion in 2018 , primarily as a result of lower semi-custom product revenue, partially offset by higher sales of our EPYC server processors. +Enterprise, Embedded and Semi-Custom operating income was $263 million in 2019 compared to operating income of $163 million in 2018 . The increase in operating income was due primarily to higher sales of our EPYC server processor and a licensing +36 +gain of $60 million recognized in the first quarter of 2019, partially offset by lower semi-custom product revenue and a $37 million increase in operating expenses. Operating expenses increased for the reasons outlined under “Expenses” below. +All Other +All Other operating loss of $209 million in 2019 included $197 million of stock-based compensation expense and a $12 million contingent loss accrual on a legal matter. +All Other operating loss of $182 million in 2018 included $137 million of stock-based compensation expense and an impairment of technology licenses of $45 million . +Comparison of Gross Margin, Expenses, Licensing Gain, Interest Expense, Other Expense and Income Taxes +The following is a summary of certain consolidated statement of operations data for 2019 , 2018 and 2017 : +2019 +2018 +2017 +(In millions, except for percentages) +Cost of sales +$ +3,863 +$ +4,028 +$ +3,466 +Gross profit +2,868 +2,447 +1,787 +Gross margin percentage +43 +% +38 +% +34 +% +Research and development +1,547 +1,434 +1,196 +Marketing, general and administrative +750 +562 +516 +Licensing gain +(60 +) +— +(52 +) +Interest expense +(94 +) +(121 +) +(126 +) +Other expense, net +(165 +) +— +(9 +) +Provision for (benefit from) income taxes +31 +(9 +) +18 +Gross Margin +Gross margin as a percentage of net revenue was 43% in 2019 compared to 38% in 2018 . The improvement in gross margin was primarily driven by higher sales of Ryzen and EPYC processors, which have a higher gross margin than the corporate average. +Expenses +Research and Development Expenses +Research and development expenses of $1.5 billion in 2019 increased by $113 million , or 8% , compared to $1.4 billion in 2018 . The increase was primarily due to an increase in product development costs in both the Computing and Graphics and Enterprise, Embedded and Semi-Custom segments as well as an increase in stock-based compensation expense. +Marketing, General and Administrative Expenses +Marketing, general and administrative expenses of $750 million in 2019 increased by $188 million , or 33% , compared to $562 million in 2018 . The increase was primarily due to an increase in go-to-market activities in both the Computing and Graphics and Enterprise, Embedded and Semi-Custom segments, as well as an increase in stock-based compensation expense. +Licensing Gain +During 2019 , we recognized $60 million as licensing gain associated with the licensed IP to THATIC JV. See Note 4 of “Notes to Consolidated Financial Statements” for additional information. +Interest Expense +Interest expense of $94 million in 2019 decreased by $27 million compared to $121 million in 2018 , primarily due to lower debt balances. +Other Expense, Net +Other expense , net increased in 2019 by $165 million from net of zero in 2018 . The change from 2018 to 2019 was primarily due to $176 million of loss on redemption, repurchases and conversions of debt in 2019. +37 +Provision For (Benefit From) Income Taxes +We recorded an income tax provision of $31 million in 2019 and income tax benefit of $9 million in 2018. +The income tax provision in 2019 was primarily due to $22 million of withholding taxes related to cross-border transactions and $22 million of foreign income taxes in profitable locations partially offset by a $13 million benefit for a reduction of U.S. income taxes accrued in the prior year. +The income tax benefit in 2018 was primarily due to a $36 million refund of withholding tax from a foreign jurisdiction related to a legal settlement from 2010, offset by $13 million of U.S. income taxes resulting from the Tax Reform Act, $7 million tax provision in foreign locations and $7 million of withholding taxes on cross-border transactions. +As we continue to make progress in our business resulting in improved financial results, our future reassessment could possibly result in a determination that a valuation allowance is no longer required. The impact of the determination would result in the release of the valuation allowance and significant financial impact in a future reporting period with a material non-cash income tax benefit and the recording of additional deferred tax assets on our consolidated balance sheet. +International Sales +International sales as a percentage of net revenue were 74% in 2019 and 80% in 2018 . We expect that international sales will continue to be a significant portion of total sales in the foreseeable future. Substantially all of our sales transactions are denominated in U.S. dollars. +FINANCIAL CONDITION +Liquidity and Capital Resources +As of December 28, 2019 , our cash, cash equivalents and marketable securities were $1.5 billion compared to $1.2 billion as of December 29, 2018 . The percentage of cash and cash equivalents held domestically was 90% as of December 28, 2019 , and 88% as of December 29, 2018 . Our operating, investing and financing activities for fiscal 2019 , 2018 and 2017 were as follows: +2019 +2018 +2017 +(In millions) +Net cash provided by (used in): +Operating activities +$ +493 +$ +34 +$ +12 +Investing activities +(149 +) +(170 +) +(54 +) +Financing activities +43 +28 +(33 +) +Net increase (decrease) in cash and cash equivalents, and restricted cash +$ +387 +$ +(108 +) +$ +(75 +) +Our aggregate principal debt obligations were $0.6 billion and $1.5 billion as of December 28, 2019 and December 29, 2018 , respectively. +We believe our cash, cash equivalents and marketable securities balance along with our Secured Revolving Facility entered into in June 2019 (refer to Note 7 of “Notes to Consolidated Financial Statements for additional information) will be sufficient to fund operations, including capital expenditures, over the next 12 months. We believe we will be able to access the capital markets should we require additional funds. However, we cannot assure that such funds will be available on favorable terms, or at all. +Operating Activities +Net cash provided by operating activities was $493 million in 2019 compared to net cash provided by operating activities of $34 million in 2018 . The increase in net cash provided by operating activities was primarily due to changes in working capital, largely driven by higher cash collections, partially offset by timing of accounts payable payments and higher wafer purchases and payroll. +Investing Activities +Net cash used in investing activities was $149 million in 2019, which primarily consisted of $217 million for purchases of property and equipment, partially offset by a net cash inflow from purchases and maturities of available-for-sale debt securities of $41 million. +38 +Net cash used in investing activities was $170 million in 2018, which primarily consisted of $163 million for purchases of property and equipment and a net cash outflow from purchases and maturities of available-for-sale debt securities of $78 million. +Financing Activities +Net cash provided by financing activities was $43 million in 2019, which primarily consisted of a cash inflow of $449 million from the warrant exercised by West Coast Hitech L.P. (WCH) and $74 million from the issuance of common stock under our stock-based compensation equity plans, partially offset by $473 million of cash used for debt reduction activities during the year. +Net cash provided by financing activities was $28 million in 2018, which consisted of a net cash inflow of $70 million from the issuance of common stock through employee equity incentive plans, partially offset by $41 million of cash used for debt reduction activities in 2018. +Contractual Obligations +The following table summarizes our consolidated principal contractual cash obligations, as of December 28, 2019 , and is supplemented by the discussion following the table: +Payment due by period +(In millions) +Total +2020 +2021 +2022 +2023 +2024 +2025 and +thereafter +Term debt +$ +563 +$ +— +$ +— +$ +312 +$ +— +$ +— +$ +251 +Aggregate interest obligation (1) +102 +30 +30 +21 +6 +6 +9 +Other long-term liabilities (2) +155 +54 +50 +48 +1 +— +2 +Operating leases +287 +54 +48 +44 +37 +33 +71 +Purchase obligations (3) +2,290 +1,677 +592 +10 +4 +2 +5 +Total contractual obligations (4) +$ +3,397 +$ +1,815 +$ +720 +$ +435 +$ +48 +$ +41 +$ +338 +(1) +Represents interest obligations, payable in cash, for our outstanding debt. +(2) +Amounts primarily represent future fixed and non-cancellable cash payments associated with software technology and licenses and IP licenses, including the payments due within the next 12 months. +(3) +Represents purchase obligations for goods and services where payments are based, in part, on the volume or type of services we acquire. In those cases, we only included the minimum volume of purchase obligations in the table above. Purchase orders for goods and services that are cancellable upon notice and without significant penalties are not included in the amounts above. +(4) +Total amount excludes contractual obligations already recorded on our consolidated balance sheets except for debt obligations and other liabilities related to software and technology licenses and IP licenses. +The expected timing of payments of the obligations in the preceding table is estimated based on current information. Timing of payments and actual amounts paid may be different, depending on the timing of receipt of goods or services, or changes to agreed-upon amounts for some obligations. +Term Debt +7.50% Senior Notes Due 2022 +On August 15, 2012, we issued $500 million of the 7.50% Senior Notes due 2022 (7.50% Notes). The 7.50% Notes are our general unsecured senior obligations. Interest is payable on February 15 and August 15 of each year beginning February 15, 2013 until the maturity date of August 15, 2022. The 7.50% Notes are governed by the terms of an indenture (the 7.50% Indenture) dated August 15, 2012 between us and Wells Fargo Bank, N.A., as trustee. +In 2014, we repurchased $25 million in aggregate principal amount of the 7.50% Notes in open market transactions for $24 million . In 2016, we repurchased $125 million in aggregate principal amount of the 7.50% Notes pursuant to a partial tender offer for $135 million . In 2017, we settled $3 million in aggregate principal amount of the 7.50% Notes in treasury stock. In 2018 , we settled $10 million in aggregate principal amount of the 7.50% Notes in treasury stock at a weighted-average cost of $9.01 per share. During 2019 , we repurchased $25 million in aggregate principal amount of the 7.50% Notes in cash. As of December 28, 2019 , the outstanding aggregate principal amount of the 7.50% Notes was $312 million . +39 +2.125% Convertible Senior Notes Due 2026 +In September 2016, we issued $805 million in aggregate principal amount of 2.125% Convertible Senior Notes due 2026 ( 2.125% Notes). The 2.125% Notes are our general unsecured senior obligations. The interest is payable semi-annually in March and September of each year, commencing in March 2017. +The 2.125% Notes mature on September 1, 2026. However, as outlined in the indenture governing the 2.125% Notes, holders of the 2.125% Notes may convert them at their option during certain time periods and upon the occurrence of one of the following circumstances: +(1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2016 (and only during such calendar quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day (equivalent to an initial conversion price of approximately $8.00 per share of common stock); +(2) during the five business day period after any ten consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or +(3) upon the occurrence of specified corporate events. +On or after June 1, 2026 and until the close of business on the business day immediately preceding the maturity date, holders may convert their notes at any time regardless of the foregoing circumstances. Upon conversion, we will pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock at our election. +The event described in (1) above was met during the fourth calendar quarter of 2019 and, as a result, the 2.125% Notes are convertible at the option of the holder from January 1, 2020 and remain convertible until March 31, 2020. +During 2019, we converted $554 million principal amount of the 2.125% Notes through the issuance of approximately 69 million shares of our common stock at the conversion price of $8.00 per share and an aggregate cash payment of $56 million. As of December 28, 2019 , we had $251 million principal of 2.125% Notes outstanding. +See Note 7 of “Notes to Consolidated Financial Statements” below for additional information regarding our 7.50% Notes and 2.125% Notes. +Operating Leases +We lease certain of our facilities under non-cancellable lease agreements that expire at various dates through 2028. In addition, we lease certain office equipment for terms ranging from one to five years. Total future non-cancellable lease obligations as of December 28, 2019 were $287 million , including future lease payments related to leases in Santa Clara, California; Austin, Texas; Markham, Canada and Shanghai, China. +Off-Balance Sheet Arrangements +As of December 28, 2019 , we had no off-balance sheet arrangements. +40 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK +Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt. We usually invest our cash in investments with short maturities or with frequent interest reset terms. Accordingly, our interest income fluctuates with short-term market conditions. As of December 28, 2019 , our investment portfolio consisted primarily of commercial paper. These investments were highly liquid. Due to the relatively short, weighted-average maturity of our investment portfolio and the current low interest rate environment, our exposure to interest rate risk is minimal. +As of December 28, 2019 , all of our outstanding long-term debt had fixed interest rates. Consequently, our exposure to market risk for changes in interest rates on reported interest expense and corresponding cash flows is minimal. +We will continue to monitor our exposure to interest rate risk. +Default Risk. We mitigate default risk in our investment portfolio by investing in only high credit quality securities and by constantly positioning our portfolio to respond to a significant reduction in a credit rating of any investment issuer or guarantor. Our portfolio includes investments in marketable debt securities with active secondary or resale markets to ensure portfolio liquidity. We are averse to principal loss and strive to preserve our invested funds by limiting default risk and market risk. +We actively monitor market conditions and developments specific to the securities and security classes in which we invest. We believe that we take a conservative approach to investing our funds in that we invest only in highly-rated debt securities with relatively short maturities and do not invest in securities which we believe involve a higher degree of risk. As of December 28, 2019 , substantially all of our investments in debt securities were A-rated by at least one of the rating agencies. While we believe we take prudent measures to mitigate investment-related risks, such risks cannot be fully eliminated as there are circumstances outside of our control. +The following table presents certain information for our investment portfolio and debt obligations as of December 28, 2019 : +2020 +2021 +2022 +2023 +2024 +2025 and thereafter +Total (1) +2019 +Fair Value (2) +(In millions, except for percentages) +Investment Portfolio +Cash equivalents: +Variable rate amounts +$ +1,425 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +1,425 +$ +1,425 +Weighted-average rate +1.83 +% +— +% +— +% +— +% +— +% +— +% +1.83 +% +Marketable securities +Fixed rate amounts +$ +37 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +37 +$ +37 +Weighted-average rate +2.13 +% +— +% +— +% +— +% +— +% +— +% +2.13 +% +Total Investment Portfolio +$ +1,462 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +1,462 +$ +1,462 +Debt Obligations +Fixed rate amounts +$ +— +$ +— +$ +312 +$ +— +$ +— +$ +251 +$ +563 +$ +1,823 +Weighted-average +effective interest rate +— +% +— +% +7.50 +% +— +% +— +% +2.125 +% +5.10 +% +Total Debt Obligations +$ +— +$ +— +$ +312 +$ +— +$ +— +$ +251 +$ +563 +$ +1,823 +(1) +The dollar amounts represent the cost basis of our investment portfolio and the remaining principal of our debt obligations. +(2) +Our 2.125% Notes, included in debt obligations above, were convertible at the option of the holder as of December 28, 2019. The estimated fair value of the 2.125% Notes takes into account the value of our stock price of $46.18 as of December 28, 2019 and the initial conversion price of approximately $8.00 per share of common stock. +Foreign Exchange Risk. As a result of our foreign operations, we incur costs and we carry assets and liabilities that are denominated in foreign currencies, while sales of products are primarily denominated in U.S. dollars. +We maintain a foreign currency hedging strategy which uses derivative financial instruments to mitigate the risks associated with changes in foreign currency exchange rates. This strategy takes into consideration all of our exposures. We do not use derivative financial instruments for trading or speculative purposes. +In applying our strategy, from time to time we use foreign currency forward contracts to hedge certain forecasted expenses denominated in foreign currencies. We designate these contracts as cash flow hedges of forecasted expenses to the extent eligible under the accounting rules and evaluate hedge effectiveness prospectively and retrospectively. To the extent such hedges are effective, the gain or loss on these contracts is recorded as a component of accumulated other comprehensive income (loss) and +41 +reclassified to earnings in the same line item as the associated forecasted transaction and in the same period during which the hedged transaction affects earnings. +We also use, from time to time, foreign currency forward contracts to economically hedge recognized foreign currency exposures on the balance sheets of various subsidiaries. We do not designate these forward contracts as hedging instruments. Accordingly, the gain or loss associated with these contracts is immediately recorded in earnings. +The following table provides information about our foreign currency forward contracts as of December 28, 2019 and December 29, 2018 . All of our foreign currency forward contracts mature within 12 months. +December 28, 2019 +December 29, 2018 +Notional +Amount +Average +Contract +Rate +Estimated +Fair Value +Gain (Loss) +Notional +Amount +Average +Contract +Rate +Estimated +Fair Value +Gain (Loss) +(In millions except contract rates) +Foreign currency forward contracts: +Chinese Renminbi +$ +277 +6.9890 +$ +(1 +) +$ +182 +6.5733 +$ +(3 +) +Canadian Dollar +249 +1.3183 +2 +110 +1.3007 +(5 +) +Indian Rupee +76 +72.9476 +— +45 +72.2338 +— +Singapore Dollar +50 +1.3597 +— +26 +1.3478 +— +Euro +48 +0.8927 +1 +— +— +— +Taiwan Dollar +38 +30.1873 +— +21 +29.6490 +— +Pound Sterling +1 +0.7614 +— +— +— +— +Malaysian Ringgit +— +4.0889 +— +12 +4.1775 +— +Total +$ +739 +$ +2 +$ +396 +$ +(8 +) +42 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Advanced Micro Devices, Inc. +Consolidated Statements of Operations +Year Ended +December 28, +2019 +December 29, +2018 +December 30, +2017 +(In millions, except per share amounts) +Net revenue +$ +6,731 +$ +6,475 +$ +5,253 +Cost of sales +3,863 +4,028 +3,466 +Gross profit +2,868 +2,447 +1,787 +Research and development +1,547 +1,434 +1,196 +Marketing, general and administrative +750 +562 +516 +Licensing gain +( 60 +) +— +( 52 +) +Operating income +631 +451 +127 +Interest expense +( 94 +) +( 121 +) +( 126 +) +Other expense, net +( 165 +) +— +( 9 +) +Income (loss) before income taxes and equity loss +372 +330 +( 8 +) +Provision for (benefit from) income taxes +31 +( 9 +) +18 +Equity loss in investee +— +( 2 +) +( 7 +) +Net income (loss) +$ +341 +$ +337 +$ +( 33 +) +Earnings (loss) per share +Basic +$ +0.31 +$ +0.34 +$ +( 0.03 +) +Diluted +$ +0.30 +$ +0.32 +$ +( 0.03 +) +Shares used in per share calculation +Basic +1,091 +982 +952 +Diluted +1,120 +1,064 +952 +See accompanying notes to consolidated financial statements. +43 +Advanced Micro Devices, Inc. +Consolidated Statements of Comprehensive Income (Loss) +Year Ended +December 28, +2019 +December 29, +2018 +December 30, +2017 +(In millions) +Net income (loss) +$ +341 +$ +337 +$ +( 33 +) +Other comprehensive income (loss), net of tax of zero: +Unrealized gains (losses) on available-for-sale securities: +Unrealized gains arising during period +— +— +1 +Unrealized gains (losses) on cash flow hedges: +Unrealized gains (losses) arising during period +2 +( 19 +) +17 +Reclassification adjustment for (gains) losses realized and included in net income (loss) +6 +5 +( 7 +) +Total change in unrealized gains (losses) on cash flow hedges +8 +( 14 +) +10 +Cumulative-effect adjustment to accumulated deficit related to the adoption of ASU 2016-01, Financial Instruments +— +2 +— +Total comprehensive income (loss) +$ +349 +$ +325 +$ +( 22 +) +See accompanying notes to consolidated financial statements. +44 +Advanced Micro Devices, Inc. +Consolidated Balance Sheets +December 28, +2019 +December 29, +2018 +(In millions, except par value amounts) +ASSETS +Current assets: +Cash and cash equivalents +$ +1,466 +$ +1,078 +Marketable securities +37 +78 +Accounts receivable, net +1,859 +1,235 +Inventories, net +982 +845 +Prepayment and receivables—related parties +20 +34 +Prepaid expenses and other current assets +233 +270 +Total current assets +4,597 +3,540 +Property and equipment, net +500 +348 +Operating lease right-of-use assets +205 +— +Goodwill +289 +289 +Investment: equity method +58 +58 +Other assets +379 +321 +Total assets +$ +6,028 +$ +4,556 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Short-term debt, net +$ +— +$ +136 +Accounts payable +988 +834 +Payables to related parties +213 +207 +Accrued liabilities +1,084 +783 +Other current liabilities +74 +24 +Total current liabilities +2,359 +1,984 +Long-term debt, net +486 +1,114 +Long-term operating lease liabilities +199 +— +Other long-term liabilities +157 +192 +Commitments and contingencies (see Notes 17 and 18) +Stockholders’ equity: +Capital stock: +Common stock, par value $0.01; 2,250 shares authorized, 1,175 shares issued and 1,170 shares outstanding as of December 28, 2019; 2,250 shares authorized, 1,010 shares issued and 1,005 shares outstanding as of December 29, 2018 +12 +10 +Additional paid-in capital +9,963 +8,750 +Treasury stock, at cost (5 shares as of December 28, 2019 and December 29, 2018) +( 53 +) +( 50 +) +Accumulated deficit +( 7,095 +) +( 7,436 +) +Accumulated other comprehensive income (loss) +— +( 8 +) +Total stockholders’ equity +2,827 +1,266 +Total liabilities and stockholders’ equity +$ +6,028 +$ +4,556 +See accompanying notes to consolidated financial statements. +45 +Advanced Micro Devices, Inc. +Consolidated Statements of Stockholders’ Equity +Year Ended +December 28, +2019 +December 29, +2018 +December 30, +2017 +(In millions) +Capital stock +Common stock +Balance, beginning of period +$ +10 +$ +9 +$ +9 +Common stock issued under employee equity +incentive plans, net of tax withholding +— +1 +— +Issuance of common stock upon warrant exercise +1 +— +— +Issuance of common stock to partially settle convertible debt +1 +— +— +Balance, end of period +$ +12 +$ +10 +$ +9 +Additional paid-in capital +Balance, beginning of period +$ +8,750 +$ +8,464 +$ +8,334 +Common stock issued under employee equity +incentive plans, net of tax withholding +74 +71 +20 +Stock-based compensation +197 +137 +97 +Issuance of common stock upon warrant exercise +448 +— +— +Issuance of common stock to partially settle convertible debt, net +485 +— +— +Issuance of treasury stock to partially settle debt +4 +78 +13 +Issuance of warrants +5 +— +— +Balance, end of period +$ +9,963 +$ +8,750 +$ +8,464 +Treasury stock +Balance, beginning of period +$ +( 50 +) +$ +( 108 +) +$ +( 119 +) +Purchase of treasury stock for tax withholding +under employee equity incentive plans +( 6 +) +( 6 +) +( 13 +) +Issuance of treasury stock to partially settle debt +3 +64 +24 +Balance, end of period +$ +( 53 +) +$ +( 50 +) +$ +( 108 +) +Accumulated deficit +Balance, beginning of period +$ +( 7,436 +) +$ +( 7,775 +) +$ +( 7,742 +) +Net income (loss) +341 +337 +( 33 +) +Cumulative effect adjustment to accumulated +deficit related to the adoption of ASU +2016-01, Financial Instruments +— +2 +— +Balance, end of period +$ +( 7,095 +) +$ +( 7,436 +) +$ +( 7,775 +) +Accumulated other comprehensive income (loss) +Balance, beginning of period +$ +( 8 +) +$ +6 +$ +( 5 +) +Other comprehensive income (loss) +8 +( 14 +) +11 +Balance, end of period +$ +— +$ +( 8 +) +$ +6 +Total stockholders' equity +$ +2,827 +$ +1,266 +$ +596 +See accompanying notes to consolidated financial statements. +46 +Advanced Micro Devices, Inc. +Consolidated Statements of Cash Flows +Year Ended +December 28, +2019 +December 29, +2018 +December 30, +2017 +(In millions) +Cash flows from operating activities: +Net income (loss) +$ +341 +$ +337 +$ +( 33 +) +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Depreciation and amortization +222 +170 +144 +Stock-based compensation +197 +137 +97 +Amortization of debt discount and issuance costs +30 +38 +36 +Amortization of operating lease right-of-use assets +36 +— +— +Loss on debt redemption, repurchase and conversion +176 +12 +12 +Loss on sale/disposal of property and equipment +42 +27 +— +Impairment of technology licenses +— +45 +— +Deferred income taxes +( 4 +) +( 4 +) +— +Other +( 5 +) +( 1 +) +— +Changes in operating assets and liabilities: +Accounts receivable +( 623 +) +( 806 +) +( 103 +) +Inventories +( 137 +) +( 151 +) +( 3 +) +Prepayment and receivables—related parties +14 +( 28 +) +( 6 +) +Prepaid expenses and other assets +( 176 +) +( 70 +) +( 167 +) +Payables to related parties +7 +35 +43 +Accounts payable, accrued liabilities and other +373 +293 +( 8 +) +Net cash provided by operating activities +493 +34 +12 +Cash flows from investing activities: +Purchases of available-for-sale debt securities +( 284 +) +( 123 +) +( 222 +) +Purchases of property and equipment +( 217 +) +( 163 +) +( 113 +) +Proceeds from maturity of available-for-sale debt securities +325 +45 +222 +Collection of deferred proceeds on sale of receivables +25 +71 +60 +Other +2 +— +( 1 +) +Net cash used in investing activities +( 149 +) +( 170 +) +( 54 +) +Cash flows from financing activities: +Proceeds from issuance of common stock through employee equity incentive plans +74 +70 +20 +Proceeds from (repayments of) short-term debt +( 70 +) +— +70 +Proceeds from warrant exercised by related party +449 +— +— +Payments to extinguish long-term debt +( 403 +) +( 41 +) +( 110 +) +Other +( 7 +) +( 1 +) +( 13 +) +Net cash provided by (used in) financing activities +43 +28 +( 33 +) +Net increase (decrease) in cash and cash equivalents, and restricted cash +387 +( 108 +) +( 75 +) +Cash, cash equivalents, and restricted cash at beginning of year +1,083 +1,191 +1,266 +Cash, cash equivalents, and restricted cash at end of year +$ +1,470 +$ +1,083 +$ +1,191 +47 +Year Ended +December 28, +2019 +December 29, +2018 +December 30, +2017 +(In millions) +Supplemental cash flow information: +Cash paid during the year for: +Interest +$ +67 +$ +79 +$ +88 +Income taxes, net of refund +$ +( 4 +) +$ +( 8 +) +$ +20 +Non-cash investing and financing activities: +Purchases of property and equipment, accrued but not paid +$ +65 +$ +49 +$ +50 +Issuance of common stock to partially settle convertible debt +$ +377 +$ +— +$ +— +Issuance of treasury stock to partially settle debt +$ +7 +$ +141 +$ +38 +Deferred proceeds on sale of receivables +$ +— +$ +25 +$ +21 +Transfer of assets for the acquisition of property and equipment +$ +115 +$ +28 +$ +12 +Other +$ +9 +$ +— +$ +— +Reconciliation of cash, cash equivalents, and restricted cash +Cash and cash equivalents +$ +1,466 +$ +1,078 +$ +1,185 +Restricted cash included in Other current assets +$ +4 +$ +5 +$ +3 +Restricted cash included in Other assets +$ +— +$ +— +$ +3 +Total cash, cash equivalents, and restricted cash +$ +1,470 +$ +1,083 +$ +1,191 +See accompanying notes to consolidated financial statements. +48 +Advanced Micro Devices, Inc. +Notes to Consolidated Financial Statements +NOTE 1: The Company +Advanced Micro Devices, Inc. is a global semiconductor company. References herein to AMD or the Company mean Advanced Micro Devices, Inc. and its consolidated subsidiaries. +NOTE 2: Summary of Significant Accounting Policies +Fiscal Year . The Company uses a 52 or 53 week fiscal year ending on the last Saturday in December. Fiscal 2019 , 2018 and 2017 ended December 28, 2019 , December 29, 2018 and December 30, 2017 , respectively. Fiscal 2019, 2018 and 2017 each consisted of 52 weeks. +Principles of Consolidation. The consolidated financial statements include the Company’s accounts and those of its wholly-owned subsidiaries. Upon consolidation, all inter-company accounts and transactions have been eliminated. +Reclassification. Certain prior period amounts have been reclassified to conform to current period presentation. +Use of Estimates. The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of commitments and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results are likely to differ from those estimates, and such differences may be material to the financial statements. Areas where management uses subjective judgment include, but are not limited to, revenue allowances, inventory valuation, valuation and impairment of goodwill and deferred income taxes. +Basis of Presentation . Effective in the first quarter of 2018, the Company adopted Accounting Standard Update (ASU) 2014-09, Revenue from Contracts with Customers (ASC 606), using the full retrospective method, which required the Company to adjust prior reporting periods presented. The 2017 amounts presented in the consolidated financial statements and notes to the consolidated financial statements were previously adjusted in the Company’s 2018 Form 10-K to reflect the retrospective application. +Revenue Recognition. Revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the Company expects to receive in exchange for those goods or services. Sales, value-added, and other taxes collected concurrently with the provision of goods or services are excluded from revenue. Shipping and handling costs associated with product sales are included in cost of sales. +Nature of products and services +The Company’s microprocessors (CPUs), chipsets, graphics processing unites (GPUs), data center and professional graphics products, accelerated processing units (APUs), server and embedded processors, and System-on-Chip (SoC) products may be sold as standard non-custom products, or custom products manufactured to customers’ specifications. The Company also provides development services and licenses portions of its intellectual property (IP) portfolio. +Non-custom products: The Company transfers control and recognizes revenue when non-custom products are shipped to customers, which includes original equipment manufacturers (OEM) and distributors, in accordance with the shipping terms of the sale. Certain OEMs may be entitled to rights of return and rebates under OEM agreements. The Company also sells to distributors under terms allowing the majority of distributors certain rights of return and price protection on unsold merchandise held by them. The Company estimates the amount of variable consideration under OEM and distributor arrangements and, accordingly, records a provision for product returns, allowances for price protection and rebates based on actual historical experience and any known events. +The Company offers incentive programs to certain customers, including cooperative advertising, marketing promotions, volume-based incentives and special pricing arrangements. Where funds provided for such programs can be estimated, the Company recognizes a reduction to revenue at the time the related revenue is recognized; otherwise, the Company recognizes such reduction to revenue at the later of when: i) the related revenue transaction occurs; or ii) the program is offered. For transactions where the Company reimburses a customer for a portion of the customer’s cost to perform specific product advertising or marketing and promotional activities, such amounts are recognized as a reduction to revenue unless they qualify for expense recognition. +Custom products: Custom products which are associated with the Company’s Enterprise, Embedded, and Semi-Custom segment (semi-custom products), sold under non-cancellable purchases orders and which have no alternative use to the Company +49 +at contract inception, are recognized as revenue, based on the value of the inventory and expected margin, over the time of production of the products by the Company. Sales of semi-custom products are not subject to a right of return. +Development and intellectual property licensing agreements: From time to time, the Company may enter into arrangements with customers that combine the provision of development services and a license to the right to use the IP. These arrangements are deemed to be single or multiple performance obligations based upon the nature of the arrangements. Revenue is recognized upon the transfer of control, over time or at a point-in time, depending on the nature of the arrangements. +Customers are generally required to pay for products and services within the Company’s standard contractual terms, which are typically net 30 to 60 days. The Company has determined that it does not have significant financing components in its contracts with customers. +Inventories. Inventories are stated at standard cost adjusted to approximate the lower of actual cost (first-in, first-out method) or estimated net realizable value. The Company adjusts inventory carrying value for estimated excess and obsolescence equal to the difference between the cost of inventory and the estimated net realizable value based upon assumptions about anticipated or forecasted demand, estimates of future selling prices, competitiveness of product offerings, market and industry conditions, customer requirements and product life cycles. The Company fully reserves for inventories and non-cancellable purchase orders for inventory deemed obsolete. The Company performs periodic reviews of inventory items to identify excess inventories on hand by comparing on-hand balances to anticipated usage using recent historical activity as well as anticipated or forecasted demand. If estimates of customer demand diminish further or market conditions become less favorable than those projected by the Company, additional inventory adjustments may be required . +Goodwill. The Company performs its goodwill impairment analysis as of the first day of the fourth quarter of each year and, if certain events or circumstances indicate that an impairment loss may have been incurred, on a more frequent basis. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. +Qualitative factors include industry and market consideration, overall financial performance, share price trends and market capitalization and Company-specific events. The Company first analyzes qualitative factors. If the Company concludes it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, the Company does not proceed to perform a quantitative impairment test. +If the Company concludes it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative goodwill impairment test will be performed by comparing the fair value of each reporting unit to its carrying value. A quantitative impairment analysis, if necessary, considers the income approach, which requires estimates of the present value of expected future cash flows to determine a reporting unit’s fair value. Significant estimates include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates, and future economic and market conditions. +A goodwill impairment charge is recognized for the amount by which the reporting unit’s fair value is less than its carrying value. Any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +Commitments and Contingencies. From time to time the Company is a defendant or plaintiff in various legal actions that arise in the normal course of business. The Company is also subject to income tax, indirect tax or other tax claims by tax agencies in jurisdictions in which it conducts business. In addition, the Company is a party to environmental matters including local, regional, state and federal government clean-up activities at or near locations where the Company currently or has in the past conducted business. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of reasonably possible losses. A determination of the amount of reserves required for these commitments and contingencies that would be charged to earnings, if any, includes assessing the probability of adverse outcomes and estimating the amount of potential losses. The required reserves, if any, may change due to new developments in each matter or changes in circumstances such as a change in settlement strategy. +Cash Equivalents. Cash equivalents consist of financial instruments that are readily convertible into cash and have original maturities of three months or less at the time of purchase. +Accounts Receivable. Accounts receivable are primarily comprised of trade receivables presented net of rebates, price protection and an allowance for doubtful accounts. Accounts receivable also include unbilled receivables, which primarily represent work completed on semi-custom products under non-cancellable purchase orders that have no alternative use to the Company at contract inception, for which revenue has been recognized but not yet invoiced to customers. The Company maintains an allowance for doubtful accounts based on its assessment of the collectability of amounts owed by customers. The allowance consists of known specific troubled accounts as well as an amount based on overall estimated potential uncollectible accounts receivable based on historical experience. +50 +Investments in Available-for-sale Debt Securities . The Company classifies its investments in debt securities at the date of acquisition as available-for-sale. Available-for-sale debt securities are reported at fair value with the related unrealized gains and losses included, net of tax, in accumulated other comprehensive income (loss), a component of stockholders’ equity. Realized gains and losses and declines in the value of available-for-sale debt securities determined to be other than temporary are included in other expense, net. The cost of securities sold is determined based on the specific identification method. +The Company classifies investments in available-for-sale debt securities with maturities of more than three months at the time of purchase as marketable securities on its consolidated balance sheets. Classification of these securities as current is based on the Company’s intent and belief in its ability to sell these securities and use the proceeds from sale in operations within 12 months. +Derivative Financial Instruments. The Company maintains a foreign currency hedging strategy which uses derivative financial instruments to mitigate the risks associated with changes in foreign currency exchange rates. This strategy takes into consideration some of the Company’s consolidated exposures. The Company does not use derivative financial instruments for trading or speculative purposes. +In applying its strategy, the Company uses foreign currency forward contracts to hedge certain forecasted revenue and expenses denominated in foreign currencies. The Company designates these contracts as cash flow hedges of forecasted revenue and expenses, to the extent eligible under the accounting rules, and evaluates hedge effectiveness prospectively and retrospectively. To the extent such hedges are effective, the Company records the gain or loss on these contracts as a component of accumulated other comprehensive income (loss) and it reclassifies such gains or losses to earnings in the same period during which the hedged transaction affects earnings. Such amounts are included in the same line item in earnings as the associated forecasted transaction. +The Company also uses, from time to time, foreign currency forward contracts to economically hedge recognized foreign currency exposures on the balance sheets of various subsidiaries. The Company does not designate these forward contracts as hedging instruments. Accordingly, the gain or loss associated with these contracts is immediately recorded in Other expense, net. +Property and Equipment. Property and equipment are stated at cost. Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. Estimated useful lives are as follows: equipment uses two to six years , and leasehold improvements are measured by the shorter of the remaining terms of the leases or the estimated useful economic lives of the improvements. +Leases. The Company determines if an arrangement is a lease, or contains a lease, at the inception of the arrangement. When the Company determines the arrangement is a lease, or contains a lease, at lease inception, it then determines whether the lease is an operating lease or a finance lease. Operating and finance leases result in the Company recording a right-of-use (ROU) asset and lease liability on its balance sheet. ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent its obligation to make lease payments arising from the lease. Operating and finance lease ROU assets and liabilities are initially recognized based on the present value of lease payments over the lease term. In determining the present value of lease payments, the Company uses the implicit interest rate if readily determinable or when the implicit interest rate is not readily determinable, the Company uses its incremental borrowing rate. The incremental borrowing rate is not a commonly quoted rate and is derived through a combination of inputs including the Company’s credit rating and the impact of full collateralization. The incremental borrowing rate is based on the Company’s collateralized borrowing capabilities over a similar term of the lease payments. The Company utilizes the consolidated group incremental borrowing rate for all leases as the Company has centralized treasury operations. The operating lease ROU asset also includes any lease payments made and excludes any lease incentives. Specific lease terms may include options to extend or terminate the lease when the Company believes it is reasonably certain that it will exercise that option. Lease expense for operating lease payments is recognized on a straight-line basis over the lease term. As allowed by the guidance, the Company has elected not to recognize ROU assets and lease liabilities that arise from short-term (12 months or less) leases for any class of underlying asset. Operating leases are included in operating lease ROU assets, other current liabilities, and long-term operating lease liabilities on the Company’s consolidated balance sheet. The Company’s finance leases are immaterial. +Product Warranties. The Company generally warrants that its products sold to its customers will conform to its approved specifications and be free from defects in material and workmanship under normal use and conditions for one year . The Company may also offer one to three -year limited warranties based on product type and negotiated warranty terms with certain customers. The Company accrues warranty costs to Cost of sales at the time of sale of warranted products. +Foreign Currency Translation/Transactions. The functional currency of all of the Company’s foreign subsidiaries is the U.S. dollar. Assets and liabilities denominated in non-U.S. dollars have been remeasured into U.S. dollars at current exchange rates for monetary assets and liabilities and historical exchange rates for non-monetary assets and liabilities. Non-U.S. dollar denominated transactions have been remeasured at average exchange rates in effect during each period, except for those cost of sales and expense +51 +transactions related to non-monetary balance sheet amounts which have been remeasured at historical exchange rates. The gains or losses from foreign currency remeasurement are included in earnings. +Marketing and Advertising Expenses. Advertising costs are expensed as incurred. In addition, the Company’s marketing and advertising expenses include certain cooperative advertising funding obligations under customer incentive programs, which costs are recorded upon agreement with customers and vendor partners. Cooperative advertising expenses are recorded as marketing, general and administrative expense to the extent the cash paid does not exceed the estimated fair value of the advertising benefit received. Any excess of cash paid over the estimated fair value of the advertising benefit received is recorded as a reduction of revenue. Total marketing and advertising expenses for 2019 , 2018 and 2017 were approximately $ 217 million , $ 176 million and $ 156 million , respectively. +Stock-Based Compensation . The Company estimates stock-based compensation cost for stock options at the grant date based on the option’s fair value as calculated by the lattice-binomial option-pricing model. For time-based restricted stock units, fair value is based on the closing price of the Company’s common stock on the grant date. The Company estimates the grant-date fair value of restricted stock units that involve a market condition using the Monte Carlo simulation model. The Company estimates the grant-date fair value of stock to be issued under the ESPP using the Black-Scholes model. Compensation expense is recognized over the vesting period of the applicable award using the straight-line method, except for the compensation expense related to PRSUs, which are recognized ratably for each vesting tranche from the service inception date to the end of the requisite service period. Forfeiture rates are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. +Income Taxes. The Company computes the provision for income taxes using the liability method and recognizes deferred tax assets and liabilities for temporary differences between financial statement and income tax bases of assets and liabilities, as well as for operating loss and tax credit carryforwards. The Company measures deferred tax assets and liabilities using tax rates applicable to taxable income in effect for the years in which those tax assets are expected to be realized or settled and provides a valuation allowance against deferred tax assets when it cannot conclude that it is more likely than not that some or all deferred tax assets will be realized. In addition, the Company recognizes tax benefits from uncertain tax positions only if it expects that its tax positions are more likely than not that they will be sustained, based on the technical merits of the positions, on examination by the jurisdictional tax authority. The Company recognizes any accrued interest and penalties to unrecognized tax benefits as interest expense and income tax expense, respectively. +Recently Adopted Accounting Standards +Leases. In February 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-02, Leases (Topic 842) , to increase transparency and comparability among organizations for lease recognition and disclosure. This standard requires lessees to recognize lease assets and lease liabilities on the balance sheet, while recognizing expenses on the income statements in a manner similar to legacy guidance. The Company adopted this standard in the first quarter of 2019, using the optional modified retrospective approach, which did not require an adjustment to comparative period financial statements, and recorded $ 228 million of right-of-use assets and $ 261 million of lease liabilities primarily related to office buildings on its consolidated balance sheet as of December 30, 2018. The Company’s accounting for capital leases, now referred to as finance leases, remains unchanged. The adoption of the new standard had no impact on the Company’s consolidated statement of operations or on net cash provided by or used in operating, financing, or investing activities on its consolidated statement of cash flows. +Upon adoption of ASU 2016-02, the Company elected a transition practical expedient under the new accounting standard allowing it not to separate lease and non-lease components and instead to account for each separate lease component and non-lease component as a single lease component. The Company implemented internal controls and key system functionality to enable the preparation of financial information on adoption. +Recently Issued Accounting Standards +Financial Instruments. In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments . This standard changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, using a modified retrospective adoption method. The Company will adopt this standard in the first quarter of 2020 and the adoption will not have a material impact on its consolidated financial statements. +52 +Income Taxes. In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes . This standard simplifies the accounting for income taxes by eliminating certain exceptions to the guidance in Topic 740 related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill and allocating consolidated income taxes to separate financial statements of entities not subject to income tax. ASU 2019-12 is effective for fiscal years beginning after December 15, 2020, with early adoption permitted. Upon adoption, the Company must apply certain aspects of this standard retrospectively for all periods presented while other aspects are applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. The Company is currently evaluating the impact of this new standard on its consolidated financial statements. +Although there are several other new accounting pronouncements issued by the FASB, the Company does not believe any of these accounting pronouncements had or will have a material impact on its consolidated financial statements. +NOTE 3: Supplemental Balance Sheet Information +Accounts Receivable, net +As of December 28, 2019 and December 29, 2018 , Accounts receivable, net included unbilled accounts receivable of $ 197 million and $ 308 million , respectively. Unbilled receivables primarily represent work completed on semi-custom products under non-cancellable purchase orders that have no alternative use to the Company at contract inception, for which revenue has been recognized but not yet invoiced to customers. All unbilled accounts receivables are expected to be billed and collected within 12 months. +Inventories, net +December 28, +2019 +December 29, +2018 +(In millions) +Raw materials +$ +94 +$ +134 +Work in process +691 +354 +Finished goods +197 +357 +Total inventories, net +$ +982 +$ +845 +Property and Equipment, net +December 28, +2019 +December 29, +2018 +(In millions) +Leasehold improvements +$ +203 +$ +179 +Equipment +951 +798 +Construction in progress +114 +78 +Property and equipment, gross +1,268 +1,055 +Accumulated depreciation and amortization +( 768 +) +( 707 +) +Total property and equipment, net +$ +500 +$ +348 +Depreciation expense for 2019 , 2018 and 2017 was $ 142 million , $ 94 million and $ 77 million , respectively. +Other Assets +December 28, +2019 +December 29, +2018 +(In millions) +Software and technology licenses, net +$ +210 +$ +226 +Other +169 +95 +Total other assets +$ +379 +$ +321 +53 +During 2018, the Company recorded an impairment charge in Cost of sales of $ 45 million on technology licenses that are no longer being used. +Accrued Liabilities +December 28, +2019 +December 29, +2018 +(In millions) +Accrued compensation and benefits +$ +285 +$ +236 +Marketing programs and advertising expenses +454 +275 +Other accrued and current liabilities +345 +272 +Total accrued liabilities +$ +1,084 +$ +783 +Other Current Liabilities +December 28, +2019 +December 29, +2018 +(In millions) +Unearned revenue +$ +2 +$ +11 +Operating lease liabilities +43 +— +Other +29 +13 +Total other current liabilities +$ +74 +$ +24 +Unearned revenue represents consideration received or due from customers in advance of the Company satisfying its performance obligations. The unearned revenue is associated with any combination of development services, IP licensing and product revenue. Changes in unearned revenue were as follows: +December 28, +2019 +December 29, +2018 +(In millions) +Beginning balance +$ +11 +$ +85 +Unearned revenue +43 +132 +Revenue recognized during the period +( 52 +) +( 186 +) +Other +— +( 20 +) +Ending balance +$ +2 +$ +11 +Revenue allocated to remaining performance obligations that are unsatisfied (or partially unsatisfied) as of December 28, 2019 is $ 456 million , which may include amounts received from customer but not yet earned and amounts that will be invoiced and recognized as revenue in future periods associated with any combination of development services, IP licensing and product revenue. The Company expects to recognize $ 188 million in the next 12 months . +The revenue allocated to remaining performance obligations did not include amounts which have an original expected duration of less than one year. +NOTE 4: Equity Joint Ventures +ATMP Joint Venture s +The Company holds a 15 % equity interest in two joint ventures (collectively, the ATMP JV) with Tongfu Microelectronics Co., Ltd, a Chinese joint stock company, and as such, the ATMP JV is a related party of the Company. The Company has no obligation to fund the ATMP JV. The Company accounts for its equity interests in the ATMP JV under the equity method of accounting due to its significant influence over the ATMP JV. +The ATMP JV provides assembly, test, mark and packaging (ATMP) services to the Company. The Company assists the ATMP JV in its management of certain raw material inventory. The purchases from and resales to the ATMP JV of inventory under +54 +inventory management is reported within purchases and resales with the ATMP JV and does not impact the Company’s consolidated statement of operations. +The Company’s total purchases from the ATMP JV during 2019 and 2018 amounted to $ 660 million and $ 574 million , respectively. As of December 28, 2019 and December 29, 2018 , the amount payable to the ATMP JV was $ 213 million and $ 207 million , respectively, included in Payables to related parties on the Company’s consolidated balance sheets. The Company’s resales back to the ATMP JV during 2019 and 2018 amounted to $ 56 million and $ 62 million , respectively. As of December 28, 2019 and December 29, 2018 , the Company had receivables from ATMP JV of $ 7 million and $ 16 million , respectively, included in Prepayment and receivables—related parties on the Company’s consolidated balance sheets. +During 2019, the Company did no t record any gain or loss in Equity loss in investee on its consolidated statements of operations. During 2018 and 2017 , the Company recorded $ 2 million and $ 7 million , respectively, in Equity loss in investee , which included certain expenses incurred by the Company on behalf of the ATMP JV. As of December 28, 2019 and December 29, 2018 , the carrying value of the Company’s investment in the ATMP JV was approximately $ 58 million . +THATIC Joint Ventures +In February 2016, the Company and Higon Information Technology Co., Ltd. (THATIC), a third-party Chinese entity (JV Partner), formed a joint venture comprised of two separate legal entities, China JV1 and China JV2 (collectively, the THATIC JV). The Company’s equity share in China JV1 and China JV2 is a majority and minority interest, respectively, funded by the Company’s contribution of certain of its patents. The JV Partner is responsible for the initial and on-going financing of the THATIC JV’s operations. The Company has no obligations to fund the THATIC JV. The Company does not consolidate either of these entities and accounts for its investments in the THATIC JV under the equity method of accounting. The THATIC JV is a related party of the Company. +The Company’s share in the net losses of the THATIC JV for 2019 is not recorded in the Company’s consolidated statements of operations since the Company is not obligated to fund the THATIC JV’s losses in excess of the Company’s investment in the THATIC JV, which was zero as of December 28, 2019 . +In February 2016, the Company licensed certain of its intellectual property (Licensed IP) to the THATIC JV for a total of $ 293 million in license fees payable over several years upon achievement of certain milestones. The Company also expects to receive a royalty based on the sales of the THATIC JV’s products to be developed on the basis of such Licensed IP. The Company classifies Licensed IP income and royalty income, associated with the February 2016 agreement, as licensing gain within operating income. +In March 2017, the Company entered into a development and intellectual property agreement (Development and IP) with the THATIC JV, and also expects to receive a royalty based on the sales of the THATIC JV’s products to be developed on the basis of such agreement. The Company classifies Development and IP income and royalty income, associated with the March 2017 agreement, as revenue once earned. +In addition, from time to time, the Company enters into certain agreements with the THATIC JV to provide other services primarily related to research and development. +During 2019 and 2017 , the Company recognized $ 60 million and $ 52 million as licensing gain associated with the Licensed IP. During 2018 , the Company recognized $ 86 million of IP-related revenue upon completion of all technology milestones under the Development and IP agreement. +The Company’s receivable from the THATIC JV for the above agreements was $ 13 million and $ 18 million as of December 28, 2019 and December 29, 2018 , respectively, included in Prepayment and receivables—related parties on its consolidated balance sheets. +In June 2019, the U.S. Commerce Department’s Bureau of Industry and Security added certain Chinese entities to the Entity List, including THATIC and the THATIC JV. The Company is complying with U.S. law pertaining to the Entity List designation. +NOTE 5: GLOBALFOUNDRIES +In March 2009, the Company and GLOBALFOUNDRIES Inc. (GF) entered into a Wafer Supply Agreement (WSA) under which the Company would purchase wafers from GF. The WSA, which has been amended from time to time, governs the terms +55 +by which the Company purchases products manufactured by GF through March 1, 2024. Pursuant to the WSA and its amendments, the Company is required to purchase all of its microprocessor and APU product requirements and a certain portion of its GPU product requirements from GF manufactured at process nodes larger than 7 nanometer (nm), with limited exceptions. Under the terms of the WSA, the Company has minimum annual wafer purchase targets through 2021. If the Company fails to meet the agreed wafer purchase target during a calendar year, it will be required to pay to GF a portion of the difference between the actual wafer purchases and the applicable annual purchase target. The Company also agreed to continue to make quarterly payments to GF based on the volume of certain wafers purchased from another wafer foundry. +On August 30, 2016, in consideration for the limited waiver and rights under the WSA Sixth Amendment, the Company entered into a warrant agreement (the Warrant Agreement) with West Coast Hitech L.P. (WCH), a wholly-owned subsidiary of Mubadala Development Company PJSC (Mubadala). Under the Warrant Agreement, WCH and its permitted assigns were entitled to purchase 75 million shares of the Company’s common stock at a purchase price of $ 5.98 per share. On February 13, 2019, WCH exercised its warrant to purchase 75 million shares of the Company’s common stock at a purchase price of $ 5.98 per share for a total amount of $ 449 million . +Through May 15, 2019, GF was a related party of the Company because Mubadala and Mubadala Technology Investments LLC (Mubadala Tech, a party to the WSA) were affiliated with WCH, and a director of the Company’s Board of Directors (the Board) was associated with Mubadala. GF, WCH and Mubadala Tech are wholly-owned subsidiaries of Mubadala. Effective May 15, 2019, the director of the Board associated with Mubadala retired from the Board, and as a result, GF was no longer considered a related party of the Company. All prior period related party classifications on the financial statements for GF have been reclassified to conform to the current period presentation. +The Company’s total purchases from GF related to wafer manufacturing, research and development activities and other for 2019 (through May 15, 2019), 2018 and 2017 were $ 0.5 billion , $ 1.6 billion and $ 1.1 billion , respectively. Included in the total purchases were amounts related to the volume of certain wafers purchased from another wafer foundry, as agreed by the Company and GF. As of December 29, 2018, the amount of prepayment and receivables related to GF was $ 18 million and the amount of payable to GF was $ 326 million . +NOTE 6: Goodwill +The carrying amount of goodwill as of both December 28, 2019 and December 29, 2018 was $ 289 million , which was fully allocated to reporting units within the Company’s Enterprise, Embedded and Semi-Custom segment. +In the fourth quarters of 2019 and 2018 , the Company conducted its annual impairment tests of goodwill and concluded that there was no goodwill impairment with respect to its reporting units. +NOTE 7: Debt, Secured Revolving Facility and Secured Revolving Line of Credit +Debt +The Company’s total debt as of December 28, 2019 and December 29, 2018 consisted of: +December 28, +2019 +December 29, +2018 +(In millions) +6.75% Notes +$ +— +$ +66 +7.50% Notes +312 +337 +7.00% Notes +— +250 +2.125% Notes +251 +805 +Secured Revolving Line of Credit +— +70 +Total debt (principal amount) +$ +563 +$ +1,528 +Unamortized debt discount associated with 2.125% Notes +( 73 +) +( 262 +) +Unamortized debt issuance costs +( 4 +) +( 16 +) +Total debt (net) +$ +486 +1,250 +Less: current portion +— +( 136 +) +Total debt, less current portion +$ +486 +$ +1,114 +56 +2.125 % Convertible Senior Notes Due 2026 +In September 2016, the Company issued $ 805 million in aggregate principal amount of 2.125 % Convertible Senior Notes due 2026 ( 2.125 % Notes). The 2.125 % Notes are general unsecured senior obligations of the Company. The interest is payable semi-annually in March and September of each year, commencing in March 2017. +The 2.125 % Notes mature on September 1, 2026. However, as outlined in the indenture governing the 2.125 % Notes, holders of the 2.125 % Notes may convert them at their option during certain time periods and upon the occurrence of one of the following circumstances: +(1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2016 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130 % of the conversion price on each applicable trading day (equivalent to an initial conversion price of approximately $ 8.00 per share of common stock); +(2) during the five business day period after any ten consecutive trading day period (the “measurement period”) in which the trading price per $ 1,000 principal amount of notes for each trading day of the measurement period was less than 98 % of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such trading day; or +(3) upon the occurrence of specified corporate events. +On or after June 1, 2026 and until the close of business on the business day immediately preceding the maturity date, holders may convert their notes at any time regardless of the foregoing circumstances. Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company’s common stock or a combination of cash and shares of the Company’s common stock at the Company’s election. +The event described in (1) above was met during the fourth calendar quarter of 2019 and, as a result, the 2.125 % Notes are convertible at the option of the holder from January 1, 2020 and remain convertible until March 31, 2020. +During 2019, the Company converted $ 554 million principal amount of its 2.125 % Notes through the issuance of approximately 69 million shares of the Company’s common stock at the conversion price of $ 8.00 per share and an aggregate cash payment of $ 56 million . As of December 28, 2019 , the Company had $ 251 million principal of its 2.125 % Notes outstanding. +The Company’s current intent is to deliver shares of its common stock upon conversion of the 2.125 % Notes. As such, no sinking fund is provided for the 2.125 % Notes and the Company continued to classify the carrying value of the liability component of the 2.125 % Notes as long-term debt and the equity component of the 2.125 % Notes as permanent equity on its consolidated balance sheet as of December 28, 2019 . +The determination of whether or not the 2.125 % Notes are convertible is performed on a calendar-quarter basis. +The 2.125 % Notes consisted of the following: +December 28, +2019 +December 29, +2018 +(In millions) +Principal +$ +251 +$ +805 +Unamortized debt discount (1) +( 73 +) +( 262 +) +Unamortized debt issuance costs +( 3 +) +( 11 +) +Net carrying amount +$ +175 +$ +532 +Carrying amount of the equity component, net (2) +$ +95 +$ +305 +(1) +Included in the consolidated balance sheets within Long-term debt, net and amortized over the remaining life of the notes using the effective interest rate method. +(2) +Included in the consolidated balance sheets within additional paid-in capital, net of $ 3 million in equity issuance costs. +As of December 28, 2019 , the remaining life of the 2.125 % Notes was approximately 81 months. +Based on the closing price of the Company’s common stock of $ 46.18 on December 27, 2019, the last trading day of 2019, the if-converted value of the 2.125 % Notes exceeded its principal amount by approximately $ 1.2 billion . +57 +The effective interest rate of the liability component of the 2.125 % Notes is 8 % . This interest rate was based on the interest rates of similar liabilities at the time of issuance that did not have associated conversion features. The following table sets forth total interest expense recognized related to the 2.125 % Notes for the year ended December 28, 2019 : +December 28, +2019 +December 29, +2018 +(In millions) +Contractual interest expense +$ +15 +$ +17 +Interest cost related to amortization of debt issuance costs +$ +1 +$ +1 +Interest cost related to amortization of the debt discount +$ +22 +$ +24 +6.75 % Senior Notes Due 2019 +On February 26, 2014 , the Company issued $ 600 million of its 6.75 % Senior Notes due 2019 ( 6.75 % Notes). The 6.75 % Notes were general unsecured senior obligations of the Company. Interest was payable on March 1 and September 1 of each year beginning September 1, 2014 until the maturity date of March 1, 2019 . The 6.75 % Notes were governed by the terms of an indenture (the 6.75 % Indenture) dated February 26, 2014 between the Company and Wells Fargo Bank, N.A., as trustee. +In 2016, the Company repurchased $ 404 million in aggregate principal amount of its 6.75 % Notes pursuant to a partial tender offer for $ 442 million . In 2017, the Company settled $ 30 million in aggregate principal amount of its 6.75 % Notes, of which $ 26 million was settled in cash and $ 5 million was settled in treasury stock. During 2018 , the Company settled $ 101 million in aggregate principal amount of its 6.75 % Notes for $ 14 million in cash and $ 87 million in treasury stock at a weighted-average cost of $ 9.04 per share. +During 2019 , the Company redeemed the remaining $ 66 million in aggregate principal amount of its 6.75 % Notes with a combination of cash and treasury stock. +7.50 % Senior Notes Due 2022 +On August 15, 2012 , the Company issued $ 500 million of its 7.50 % Senior Notes due 2022 ( 7.50 % Notes). The 7.50 % Notes are general unsecured senior obligations of the Company. Interest is payable on February 15 and August 15 of each year beginning February 15, 2013 until the maturity date of August 15, 2022 . The 7.50 % Notes are governed by the terms of an indenture (the 7.50 % Indenture) dated August 15, 2012 between the Company and Wells Fargo Bank, N.A., as trustee. +In 2014, the Company repurchased $ 25 million in aggregate principal amount of its 7.50 % Notes in open market transactions for $ 24 million . In 2016, the Company repurchased $ 125 million in aggregate principal amount of its 7.50 % Notes pursuant to a partial tender offer for $ 135 million . In 2017, the Company settled $ 3 million in aggregate principal amount of its 7.50 % Notes in treasury stock. In 2018 , the Company settled $ 10 million in aggregate principal amount of its 7.50 % Notes in treasury stock at a weighted-average cost of $ 9.01 per share. During 2019 , the Company repurchased $ 25 million in aggregate principal amount of its 7.50 % Notes in cash. As of December 28, 2019 , the outstanding aggregate principal amount of the 7.50 % Notes was $ 312 million . +Prior to August 15, 2022, the Company may redeem some or all of the 7.50 % Notes at a price equal to 100 % of the principal amount plus accrued and unpaid interest and a “make whole” premium (as defined in the 7.50 % Indenture). Holders have the right to require the Company to repurchase all or a portion of the 7.50 % Notes in the event that the Company undergoes a change of control as defined in the 7.50 % Indenture, at a repurchase price of 101 % of the principal amount plus accrued and unpaid interest. Additionally, an event of default (as defined in the 7.50 % Indenture) may result in the acceleration of the maturity of the 7.50 % Notes. +7.00 % Senior Notes Due 2024 +On June 16, 2014 , the Company issued $ 500 million of its 7.00 % Senior Notes due 2024 ( 7.00 % Notes). The 7.00 % Notes are general unsecured senior obligations of the Company. Interest is payable on January 1 and July 1 of each year beginning January 1, 2015 until the maturity date of July 1, 2024 . The 7.00 % Notes are governed by the terms of an indenture (the 7.00 % Indenture) dated June 16, 2014 between the Company and Wells Fargo Bank, N.A., as trustee. +In 2016, the Company settled $ 84 million in aggregate principal amount of its 7.00 % Notes for $ 77 million in cash and $ 8 million in treasury stock. In 2017, the Company settled $ 105 million in aggregate principal amount of its 7.00 % Notes for $ 84 million in cash and $ 26 million in treasury stock. In 2018 , the Company settled $ 61 million in aggregate principal amount of its 7.00 % Notes for $ 26 million in cash and $ 35 million in treasury stock at a weighted-average cost of $ 9.42 per share. During 2019 , +58 +the Company repurchased the remaining $ 250 million in aggregate principal amount of its 7.00 % Notes with a combination of cash and treasury stock. +Debt Covenants and Seniority +The 7.50 % Notes require the Company to comply with certain financial covenants and a number of restrictive covenants. The 7.50 % Notes and 2.125 % Notes rank equally with the Company’s existing and future senior debt and are senior to all of the Company’s future subordinated debt. The 7.50 % Notes and 2.125 % Notes rank junior to all of the Company’s future senior secured debt to the extent of the collateral securing such debt and are structurally subordinated to all existing and future debt and liabilities of the Company’s subsidiaries. +Loss from Debt Redemption, Repurchase and Conversion +In aggregate, during 2019, the Company recorded $ 176 million of aggregate losses from the redemption, repurchase and conversion of debt noted above in Other expense, net on its consolidated statement of operations. +Potential Repurchase of Outstanding Notes +The Company may elect to purchase or otherwise retire the 7.50 % Notes and 2.125 % Notes with cash, stock or other assets from time to time in open market or privately negotiated transactions either directly or through intermediaries or by tender offer when the Company believes the market conditions are favorable to do so. +Secured Revolving Facility +On June 7, 2019 , the Company entered into a secured revolving credit facility for up to $ 500 million (the Secured Revolving Facility) pursuant to a credit agreement by and among the Company, as borrower, the lenders party thereto and Wells Fargo Bank, National Association, as administrative agent (the Credit Agreement). The Secured Revolving Facility consists of a $ 500 million , five-year secured revolving loan facility, including a $ 50 million swingline subfacility and a $ 75 million sublimit for letters of credit. The Company’s obligations under the Credit Agreement are secured by a lien on substantially all of the Company’s property, other than intellectual property. +The Credit Agreement also provides the ability to increase the Secured Revolving Facility or incur incremental term loans or other incremental equivalent debt by an amount not to exceed certain amounts as set forth in the Credit Agreement. The Company’s available borrowings under the Secured Revolving Facility are also subject to reduction by an amount equal to the net cash proceeds of (i) any debt issuances not permitted by the Secured Revolving Facility and (ii) any non-ordinary course asset sales, in excess of $ 250 million , if such net cash proceeds are not reinvested by the Company within twelve months of receipt. +Borrowings under the Secured Revolving Facility bear interest at a variable rate based upon, at the Company’s option, either the LIBOR rate or the base rate (in each case, as customarily defined) plus an applicable margin. The applicable margin for LIBOR rate loans ranges, based on an applicable total leverage ratio, from 1.00 % to 1.75 % per annum, and the applicable margin for base rate loans ranges from 0.00 % to 0.75 % per annum. The Company is required to pay fees on the undrawn portion available under the Secured Revolving Facility and in respect of outstanding letters of credit. In the event the LIBOR rate is not available, the agreement allows the Company to use the base rate. +The Credit Agreement contains customary affirmative and negative covenants, as well as a total leverage covenant requiring the Company to maintain a maximum ratio of consolidated funded debt to consolidated EBITDA of 4.00 :1.00 and an interest coverage covenant requiring the Company to maintain a minimum ratio of consolidated EBITDA to consolidated cash interest expense of 3.00 :1.00. The Credit Agreement also contains customary events of default, which if they occur, could result in the termination of commitments under the Secured Revolving Facility, the declaration that all outstanding loans are immediately due and payable in whole or in part and the requirement to maintain cash collateral deposits in respect of outstanding letters of credit. +As of December 28, 2019 , there were no borrowings outstanding under the Credit Agreement, and the Company was in compliance with all required covenants under the Credit Agreement as of December 28, 2019 . As of December 28, 2019 , the Company had $ 14 million of letters of credit outstanding under the Credit Agreement. +Secured Revolving Line of Credit +On June 7, 2019, in connection with entering into the Credit Agreement as described above, the Company repaid its outstanding loan balance of $ 70 million under the secured revolving line of credit (Secured Revolving Line of Credit) and terminated the Amended and Restated Loan and Security Agreement dated as of April 14, 2015, as amended, among the Company, a group of +59 +lenders, and Bank of America, N.A., acting as agent for the lenders. +Future Payments on Total Debt +As of December 28, 2019 , the Company’s future debt payment obligations for the respective fiscal years were as follows: +Term Debt +(Principal only) +(In millions) +2020 +$ +— +2021 +— +2022 +312 +2023 +— +2024 +— +2025 and thereafter +251 +Total +$ +563 +NOTE 8: Financial Instruments +Cash, Cash Equivalents, and Marketable Securities +Cash and financial instruments measured and recorded at fair value on a recurring basis, which approximates amortized cost, as of December 28, 2019 and December 29, 2018 are summarized below: +Total Fair +Value +Cash and +Cash +Equivalents +Marketable +Securities +(In millions) +December 28, 2019 +Cash +$ +1,465 +$ +1,465 +$ +— +Level 1 (1) +Government money market funds +$ +1 +$ +1 +$ +— +Total level 1 +$ +1 +$ +1 +$ +— +Level 2 (2) +Commercial paper +$ +37 +$ +— +$ +37 +Total level 2 +$ +37 +$ +— +$ +37 +Total +$ +1,503 +$ +1,466 +$ +37 +60 +Total Fair +Value +Cash and +Cash +Equivalents +Marketable +Securities +(In millions) +December 29, 2018 +Cash +$ +315 +$ +315 +$ +— +Level 1 (1) +Government money market funds +$ +275 +$ +275 +$ +— +Total level 1 +$ +275 +$ +275 +$ +— +Level 2 (2) +Commercial paper +$ +566 +$ +488 +$ +78 +Total level 2 +$ +566 +$ +488 +$ +78 +Total +$ +1,156 +$ +1,078 +$ +78 +(1) +Level 1 fair value estimates are based on quoted prices for identical instruments in active markets. +(2) +Level 2 fair value estimates are based on quoted prices for identical or comparable instruments in markets that are not active or comparable instruments in active markets. +In addition to those amounts presented above, as of December 28, 2019 and December 29, 2018 , the Company had approximately $ 4 million and $ 5 million , respectively, of investments in money market funds, used as collateral for letters of credit deposits, which were included in Other current assets on the Company’s consolidated balance sheets. As of December 28, 2019 and December 29, 2018 , the Company also had approximately $ 30 million and $ 21 million , respectively, of investments in mutual funds held in a Rabbi trust established for the Company’s deferred compensation plan, which were included in Other assets on the Company’s consolidated balance sheets. These government money market funds and mutual funds are classified within Level 1 because they are valued using quoted prices for identical instruments in active markets. Their amortized cost approximates the fair value for all periods presented. The Company is restricted from accessing these investments. +Financial Instruments Not Recorded at Fair Value on a Recurring Basis. The Company carries its certain financial instruments at fair value with the exception of its debt. Financial instruments that are not recorded at fair value are measured at fair value on a quarterly basis for disclosure purposes. The carrying amounts and estimated fair values of financial instruments not recorded at fair value are as follows: +December 28, 2019 +December 29, 2018 +Carrying +Amount +Estimated +Fair Value +Carrying +Amount +Estimated +Fair Value +(In millions) +Short-term debt +$ +— +$ +— +$ +136 +$ +136 +Long-term debt, net (1) +$ +486 +$ +1,823 +$ +1,114 +$ +2,428 +(1) +Carrying amounts of long-term debt are net of unamortized debt issuance costs of $ 4 million and $ 16 million as of December 28, 2019 and December 29, 2018 , respectively, and net of $ 73 million and $ 262 million unamortized debt discount associated with the 2.125 % Notes as of December 28, 2019 and December 29, 2018 , respectively. The carrying amounts above do not include the equity component related to the conversion feature of the 2.125 % Notes of $ 95 million and $ 305 million as of December 28, 2019 and December 29, 2018 , respectively. +The estimated fair value of the Company’s short-term and long-term debt are based on Level 2 inputs. The Company’s 2.125 % Notes, included in Long-term debt, net, above, were convertible at the option of the holder as of December 28, 2019 . The estimated fair value of the 2.125 % Notes takes into account the value of the Company’s stock price of $ 46.18 as of December 28, 2019 and the initial conversion price of approximately $ 8.00 per share of common stock. +The fair value of the Company’s accounts receivable, accounts payable and other short-term obligations approximate their carrying value based on existing payment terms. +61 +Hedging Transactions and Derivative Financial Instruments +Cash Flow Hedges and Foreign Currency Forward Contracts not Designated as Hedges +The following table shows the amount of losses included in accumulated other comprehensive income (loss) (AOCI), the amount of losses reclassified from accumulated other comprehensive income (loss) and included in earnings related to the foreign currency forward contracts designated as cash flow hedges and the amount of losses included in other expense, net, related to contracts not designated as hedging instruments which was allocated in the consolidated statements of operations: +Year Ended +December 28, 2019 +December 29, 2018 +Cost of sales +Research and development +Marketing, general and administrative +Other expense, net +Research and development +Marketing, general and administrative +Other expense, net +(In millions) +Contracts designated as cash flow hedging instruments +Losses reclassified from AOCI into earnings +$ +( 1 +) +$ +( 4 +) +$ +( 1 +) +$ +— +$ +( 4 +) +$ +( 1 +) +$ +— +Contracts not designated as hedging instruments +Losses recognized in earnings +— +— +— +( 1 +) +— +— +( 3 +) +Total losses +$ +( 1 +) +$ +( 4 +) +$ +( 1 +) +$ +( 1 +) +$ +( 4 +) +$ +( 1 +) +$ +( 3 +) +The Company’s foreign currency derivative contracts are classified within Level 2 because the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets such as currency spot and forward rates. +The following table shows the fair value amounts of the Company’s foreign currency derivative contracts depending on whether the foreign currency forward contracts were a gain or loss position. These amounts were recorded in the Company’s consolidated balance sheets in either Other current assets or Other current liabilities. +December 28, +2019 +December 29, +2018 +(In millions) +Foreign Currency Forward Contracts - gains (losses) +Contracts designated as cash flow hedging instruments - gains +$ +2 +$ +1 +Contracts designated as cash flow hedging instruments - losses +$ +( 2 +) +$ +( 8 +) +For the foreign currency contracts designated as cash flow hedges, the ineffective portions of the hedging relationship and the amounts excluded from the assessment of hedge effectiveness were immaterial. +As of December 28, 2019 and December 29, 2018 , the notional values of the Company’s outstanding foreign currency forward contracts were $ 739 million and $ 396 million , respectively. All the contracts mature within 12 months and, upon maturity, the amounts recorded in Accumulated other comprehensive income (loss) are expected to be reclassified into earnings. The Company hedges its exposure to the variability in future cash flows for forecasted transactions over a maximum of 12 months. +NOTE 9: Accumulated Other Comprehensive Income (Loss) +Unrealized holding gains or losses on the Company’s available-for-sale debt securities and unrealized holding gains and losses on derivative financial instruments qualifying as cash flow hedges are included in other comprehensive income (loss). +62 +The table below summarizes the changes in accumulated other comprehensive income (loss) for the years ended December 28, 2019 and December 29, 2018 : +Year Ended +December 28, 2019 +December 29, 2018 +Unrealized gains (losses) on cash flow hedges +Unrealized gains (losses) on cash flow hedges +Beginning balance +$ +( 8 +) +$ +6 +Unrealized gain (losses) arising during the period, net of tax of zero +2 +( 19 +) +Reclassification adjustment for gains realized and included in net income, net of tax of zero +6 +5 +Total other comprehensive income (loss) +8 +( 14 +) +Ending balance +$ +— +$ +( 8 +) +NOTE 10: Concentrations of Credit and Operation Risk +Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of investments in available-for-sale debt securities, trade receivables and derivative financial instruments used in hedging activities. +The Company places its investments with high credit quality financial institutions and, by policy, limits the amount of credit exposure with any one financial institution. At the time an investment is made, investments in commercial paper of industrial firms and financial institutions are rated A1, P1 or better. The Company invests in tax-exempt securities including municipal notes and bonds and bonds that are rated A, A2 or better and repurchase agreements, each of which have securities of the type and quality listed above as collateral. +The Company believes that concentrations of credit risk with respect to trade receivables are limited because a large number of geographically diverse customers make up the Company’s customer base, thus diluting the trade credit risk. The Company’s top three customers with the highest accounts receivable balances each accounted for approximately 15 % , 9 % and 8 % , respectively, of the total consolidated accounts receivable balance as of December 28, 2019 and 16 % , 12 % and 7 % , respectively, of the total consolidated accounts receivable balance as of December 29, 2018 . However, the Company does not believe the receivable balance from these customers represents a significant credit risk based on past collection experience and review of their current credit quality. The Company manages its exposure to customer credit risk through credit limits, credit lines, ongoing monitoring procedures and credit approvals. Furthermore, the Company performs in-depth credit evaluations of all new customers and, at intervals, for existing customers. From this, the Company may require letters of credit, bank or corporate guarantees or advance payments if deemed necessary. +The Company’s existing derivative financial instruments are with large international financial institutions of investment grade credit rating. The Company does not believe that there is significant risk of nonperformance by these counterparties because the Company monitors their credit rating on an ongoing basis. By using derivative instruments, the Company is subject to credit and market risk. If a counter-party fails to fulfill its performance obligations under a derivative contract, the Company’s credit risk will equal the fair value of the derivative instrument. Generally, when the fair value of a derivative contract is positive, the counter-party owes the Company, thus creating a receivable risk for the Company. Based upon certain factors including a review of the credit default swap rates for the Company’s counter-parties, the Company determined its counter-party credit risk to be immaterial. At December 28, 2019 , the Company’s obligations under the contracts did not exceed counter-parties’ obligations. +The Company is dependent on certain equipment and materials from a limited number of suppliers and relies on a limited number of foreign companies to supply the majority of certain types of integrated circuit packages for back-end manufacturing operations. Similarly, certain non-proprietary materials or components such as memory, PCBs, substrates and capacitors used in the manufacture of the Company’s graphics products are currently available from only a limited number of sources. Interruption of supply or increased demand in the industry could cause shortages and price increases in various essential materials. If the Company or its third-party manufacturing suppliers are unable to procure certain of these materials or its foundries are unable to procure materials for manufacturing its products, its business would be materially adversely affected. +63 +NOTE 11: Earnings (Loss) Per Share +Basic earnings (loss) per share is computed based on the weighted-average number of shares outstanding. +Diluted earnings (loss) per share is computed based on the weighted-average number of shares outstanding plus potentially dilutive shares outstanding during the period. Potentially dilutive shares are determined by applying the treasury stock method to the assumed exercise of outstanding stock options, the assumed vesting of outstanding RSUs, the assumed issuance of common stock under the employee stock purchase plan (ESPP) and the assumed exercise of the warrants. Potentially dilutive shares issuable upon conversion of the 2.125 % Convertible Senior Notes due 2026 ( 2.125 % Notes) are calculated using the if-converted method. +The following table sets forth the components of basic and diluted earnings (loss) per share: +2019 +2018 +2017 +(In millions, except per share amounts) +Numerator-Net income (loss): +Numerator for basic and diluted earnings per share +341 +337 +( 33 +) +Denominator-Weighted average shares: +Denominator for basic earnings per share +1,091 +982 +952 +Effect of potentially dilutive shares: +Employee equity incentive plans and warrants +29 +82 +— +Denominator for diluted earnings per share +1,120 +1,064 +952 +Earnings (loss) per share: +Basic +$ +0.31 +$ +0.34 +$ +( 0.03 +) +Diluted +$ +0.30 +$ +0.32 +$ +( 0.03 +) +Potential shares from employee equity incentive plans and the conversion of the 2.125 % Notes totaling 93 million and 105 million shares for 2019 and 2018 , respectively, and potential shares from employee equity incentive plans, the conversion of the 2.125 % Notes and the warrants under the Warrant Agreement totaling 189 million shares for 2017 , were not included in the diluted earnings (loss) per share calculation as their inclusion would have been anti-dilutive. +NOTE 12: Common Stock and Stock-Based Incentive Compensation Plans +Shares Outstanding +Shares of common stock outstanding were as follows: +Year Ended +December 28, +2019 +December 29, +2018 +December 30, +2017 +(In millions) +Number of shares +Balance, beginning of period +1,005 +967 +935 +Common stock issued under employee equity +incentive plans, net of tax withholding +20 +31 +32 +Issuance of common stock upon warrant exercise +75 +— +— +Issuance of common stock to partially settle convertible debt +69 +— +— +Issuance of treasury stock to partially settle debt +1 +7 +— +Balance, end of period +1,170 +1,005 +967 +The Company’s stock-based incentive programs are intended to attract, retain and motivate highly qualified employees. On April 29, 2004, the Company’s stockholders approved the 2004 Equity Incentive Plan (the 2004 Plan). The Company introduced the Employee Stock Purchase Plan (ESPP) in the fourth quarter of 2017. +Under the 2004 Plan, stock options generally vest and become exercisable over a three -year period from the date of grant and expire within ten years after the grant date. Unvested shares that are reacquired by the Company from forfeited outstanding equity awards become available for grant and may be reissued as new awards. +64 +Under the 2004 Plan, the Company can grant (i) stock options, and (ii) RSUs, including time-based RSUs and Performance-based Restricted Stock Units (PRSUs). +Stock Options. A stock option is the right to purchase shares of the Company’s common stock at a fixed exercise price for a fixed period of time. Under the 2004 Plan, nonstatutory and incentive stock options may be granted. The exercise price of the shares subject to each nonstatutory stock option and incentive stock option cannot be less than 100 % of the fair market value of the Company’s common stock on the date of the grant. The exercise price of each option granted under the 2004 Plan must be paid in full at the time of the exercise. +Time-based RSUs. Time-based RSUs are awards that can be granted to any employee, director or consultant and that obligate the Company to issue a specific number of shares of the Company’s common stock in the future if the vesting terms and conditions are satisfied. The purchase price for the shares is $ 0.00 per share. +Performance-based Restricted Stock Units. Performance-based Restricted Stock Units (PRSUs) can be granted to certain of the Company’s senior executives. The performance metrics can be financial performance, non-financial performance and/or market conditions. Each PRSU award reflects a target number of shares (Target Shares) that may be issued to an award recipient before adjusting based on the Company’s financial performance, non-financial performance and/or market conditions. The actual number of shares that a grant recipient receives at the end of the period may range from 0 % to 250 % of the Target Shares granted, depending upon the degree of achievement of the performance target designated by each individual award. +Employee Stock Purchase Plan. Under the ESPP, eligible employees who participate in an offering period may have up to 10 % of their earnings withheld, up to certain limitations, to purchase shares of common stock at 85 % of the lower of the fair market value on the first or the last business day of the six -month offering period. The offering periods commence in May and November each year. +As of December 28, 2019 , the Company had 61 million shares of common stock that were available for future grants and 30 million shares reserved for issuance upon the exercise of outstanding stock options or the vesting of unvested restricted stock units. In addition, the Company had 42 million shares of common stock that were available for issuance under the ESPP. +Valuation and Expense +Stock-based compensation expense was allocated in the consolidated statements of operations as follows: +2019 +2018 +2017 +(In millions) +Cost of sales +$ +6 +$ +4 +$ +2 +Research and development +129 +91 +57 +Marketing, general, and administrative +62 +42 +38 +Total stock-based compensation expense, net of tax of $0 +$ +197 +$ +137 +$ +97 +During 2019 , 2018 and 2017 , the Company did no t realize any excess tax benefits related to stock-based compensation and therefore the Company did not record any related financing cash flows. +Stock Options. The weighted-average estimated fair value of employee stock options granted for the years ended December 28, 2019 , December 29, 2018 and December 30, 2017 was $ 13.31 , $ 7.62 and $ 5.46 per share, respectively, using the following assumptions: +2019 +2018 +2017 +Expected volatility +52.60% - 56.51% +51.51% - 60.46% +57.26 +% +Risk-free interest rate +1.53% - 2.51% +2.20% - 2.83% +1.68 +% +Expected dividends +— +% +— +% +— +% +Expected life (in years) +3.94 - 3.95 +3.92 - 3.94 +3.92 +The Company uses a combination of the historical volatility of its common stock and the implied volatility for publicly traded options on the Company’s common stock as the expected volatility assumption required by the lattice-binomial model. The risk-free interest rate is based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the option grant at the date closest to the option grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the near future. The expected term of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice-binomial model. +65 +The following table summarizes stock option activity and related information: +Outstanding Number +of Shares +Weighted- +Average +Exercise +Price +Aggregate Intrinsic Value +Weighted-Average Remaining Contractual Life +(in years) +(In millions, except share price) +Balance as of December 29, 2018 +13 +$ +5.33 +Granted +1 +$ +32.86 +Canceled +( 1 +) +$ +17.52 +Exercised +( 3 +) +$ +3.74 +Balance as of December 28, 2019 +10 +$ +7.56 +$ +226 +3.20 +Exercisable December 28, 2019 +9 +$ +4.56 +$ +215 +2.72 +The total intrinsic value of stock options exercised for 2019 , 2018 and 2017 was $ 84 million , $ 67 million and $ 27 million , respectively. +As of December 28, 2019 , the Company had $ 12 million of total unrecognized compensation expense related to stock options, which will be recognized over the weighted-average period of 1.87 years . +Time-based RSUs. The weighted-average grant date fair values of time-based RSUs granted during 2019 , 2018 and 2017 were $ 32.52 , $ 17.66 and $ 12.65 per share, respectively. +The following table summarizes time-based RSU activity and related information: +Number +of Shares +Weighted- +Average +Fair Value +Aggregate Intrinsic Value +Weighted-Average Remaining Contractual Life +(in years) +(In millions except share price) +Unvested shares as of December 29, 2018 +24 +$ +12.86 +Granted +8 +$ +32.52 +Forfeited +( 2 +) +$ +16.49 +Vested +( 12 +) +$ +10.39 +Unvested shares as of December 28, 2019 +18 +$ +22.93 +$ +503 +1.19 +The total fair value of time-based RSUs vested during 2019 , 2018 and 2017 was $ 395 million , $ 315 million and $ 294 million , respectively. +As of December 28, 2019 , the Company had $ 322 million of total unrecognized compensation expense related to time-based RSUs, which will be recognized over the weighted-average period of 1.80 years . +PRSUs. The weighted-average grant date fair values of PRSUs granted during 2019 , 2018 and 2017 were $ 50.00 , $ 21.67 and $ 17.18 , respectively, using the following assumptions: +2019 +2018 +2017 +Expected volatility +60.54% - 62.52% +63.77% - 67.97% +64.39 +% +Risk-free interest rate +1.56% - 2.49% +2.06% - 2.82% +1.50 +% +Expected dividends +— +% +— +% +— +% +Expected term (in years) +2.48 - 5.00 +2.48 - 3.00 +3.00 +The Company uses the historical volatility of its common stock and risk-free interest rate based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the PRSUs grant at the date closest to the grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the near future. The expected term of PRSUs represents the weighted-average period the PRSUs are expected to remain outstanding. +66 +The following table summarizes PRSU activity and related information: +Number +of Shares +Weighted- +Average +Fair Value +Aggregate Intrinsic Value +Weighted-Average Remaining Contractual Life +(in years) +(In millions except share price) +Unvested shares as of December 29, 2018 +2 +$ +14.58 +Granted +2 +$ +50.00 +Forfeited +— +$ +22.39 +Vested +( 1 +) +$ +3.60 +Unvested shares as of December 28, 2019 +3 +$ +36.13 +$ +90 +2.56 +The total fair value of PRSUs vested during 2019 , 2018 and 2017 was $ 65 million , $ 84 million and $ 34 million , respectively. +As of December 28, 2019 , the Company had $ 85 million of total unrecognized compensation expense related to PRSUs, which will be recognized over the weighted-average period of 2.56 years . +ESPP. The weighted-average grant date fair value for the ESPP during 2019 , 2018 and 2017 was $ 9.96 , $ 4.71 and $ 3.46 per share, respectively, using the following assumptions: +2019 +2018 +2017 +Expected volatility +48.95% - 67.02% +45.88% - 66.66% +56.07 +% +Risk-free interest rate +1.58% - 2.46% +2.05% - 2.52% +1.36 +% +Expected dividends +— +% +— +% +— +% +Expected term (in years) +0.50 +0.50 +0.49 +The Company uses the historical volatility of its common stock and the risk-free interest rate based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the ESPP grant at the date closest to the ESPP grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the near future. The expected term of the ESPP represents the weighted-average period the ESPP is expected to remain outstanding. +During 2019 , 1.8 million and 1.4 million shares of common stock were purchased in each of the two six -month offering periods under the ESPP at a purchase price of $ 16.18 and $ 23.77 per share, respectively, resulting in aggregate cash proceeds of $ 62 million . As of December 28, 2019 , the Company had $ 9 million of total unrecognized compensation expense related to the ESPP, which will be recognized over the weighted-average period of 0.37 years . +NOTE 13: Retirement Benefit Plans +The Company provides retirement benefit plans in the United States and certain foreign countries. The Company has a 401(k) retirement plan that allows participating employees in the United States to contribute as defined by the plan and subject to Internal Revenue Service limitations. The Company matches 75 % of employees’ contributions up to 6 % of their compensation. The Company’s contributions to the 401(k) plan for 2019 , 2018 and 2017 were approximately $ 25 million , $ 21 million and $ 18 million , respectively. +NOTE 14: Income Taxes +Income (loss) before income taxes consists of the following: +2019 +2018 +2017 +(In millions) +U.S. +$ +334 +$ +114 +$ +53 +Non-U.S. +38 +214 +( 68 +) +Total pre-tax income (loss) including equity loss in investee +$ +372 +$ +328 +$ +( 15 +) +67 +The provision for (benefit from) income taxes consists of: +2019 +2018 +2017 +(In millions) +Current: +U.S. Federal +$ +( 13 +) +$ +12 +$ +( 3 +) +U.S. State and Local +1 +— +— +Non-U.S. +50 +( 17 +) +37 +Total +38 +( 5 +) +34 +Deferred: +U.S. Federal +— +— +( 15 +) +Non-U.S. +( 7 +) +( 4 +) +( 1 +) +Total +( 7 +) +( 4 +) +( 16 +) +Provision for (benefit from) income taxes +$ +31 +$ +( 9 +) +$ +18 +The table below displays the reconciliation between statutory federal income taxes and the total provision for (benefit from) income taxes. +2019 +2018 +2017 +(In millions) +Statutory federal income tax expense (benefit) +at 21%, 21% and 35% rate +$ +78 +$ +69 +$ +22 +State taxes +1 +1 +1 +Foreign withholding taxes (refund) +22 +( 29 +) +27 +Foreign rate detriment +2 +2 +— +Valuation allowance change +( 59 +) +( 64 +) +( 12 +) +Credit monetization +— +( 1 +) +( 20 +) +Tax Reform Act +( 13 +) +13 +— +Provision for (benefit from) income taxes +$ +31 +$ +( 9 +) +$ +18 +The income tax provision in 2019 was primarily due to $ 22 million of tax provision of withholding tax related to cross-border transactions, $ 22 million tax provision in foreign locations offset by a $ 13 million benefit for a reduction of U.S. income taxes accrued in the prior year. +The income tax provision in 2018 was primarily due to a $ 36 million refund of withholding tax from a foreign jurisdiction related to a legal settlement from 2010, offset by $ 13 million of U.S. income taxes resulting from the Tax Reform Act, $ 7 million tax provision in foreign locations and $ 7 million of withholding taxes on cross-border transactions. +The income tax provision in 2017 was primarily due to $ 38 million of foreign taxes in profitable locations including $ 27 million of withholding taxes on cross-border transactions, offset by $ 1 million of tax benefits for Canadian tax credits and $ 19 million primarily attributable to the reversal of the valuation allowance on Alternate Minimum Tax (AMT) credit carryovers due to the Tax Reform Act. +68 +Deferred income taxes reflect the net tax effects of tax carryovers and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the balances for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 28, 2019 and December 29, 2018 are as follows: +December 28, +2019 +December 29, +2018 +(In millions) +Deferred tax assets: +Net operating loss carryovers +$ +1,455 +$ +1,533 +Accruals and reserves not currently deductible +245 +123 +Acquired intangibles and goodwill +45 +101 +Federal and state tax credit carryovers +617 +527 +Foreign research and development ITC credits +429 +370 +Other +159 +104 +Total deferred tax assets +2,950 +2,758 +Less: valuation allowance +( 2,743 +) +( 2,580 +) +Total deferred tax assets, net of valuation allowance +207 +178 +Deferred tax liabilities: +Discount of convertible notes +( 22 +) +( 54 +) +Undistributed foreign earnings +( 110 +) +( 105 +) +Other +( 64 +) +( 15 +) +Total deferred tax liabilities +( 196 +) +( 174 +) +Net deferred tax assets +$ +11 +$ +4 +The breakdown between deferred tax assets and deferred tax liabilities as of December 28, 2019 and December 29, 2018 is as follows: +December 28, +2019 +December 29, +2018 +(In millions) +Deferred tax assets +$ +22 +$ +15 +Deferred tax liabilities +( 11 +) +( 11 +) +Net deferred tax assets +$ +11 +$ +4 +Deferred tax assets are included in Other assets on the consolidated balance sheets. Deferred tax liabilities are included in Other long-term liabilities on the consolidated balance sheets. +As of December 28, 2019 , substantially all of the Company’s U.S. and foreign deferred tax assets, net of deferred tax liabilities, continued to be subject to a valuation allowance. The Company evaluates the need for and the amount of a valuation allowance for deferred tax assets based on available evidence whether it is more-likely-than-not (a probability level of more than 50%) that these assets will be realized. In completing this assessment management must consider both objective and subjective factors in its assessment. These factors include, but are not limited to a history of losses in prior years, unique competitiveness of the semiconductor industry, future reversal of existing temporary differences, tax planning strategies, and future taxable income exclusive of reversing temporary differences and loss carryforwards. After evaluating all available evidence, the Company determined that the valuation allowances for the United States and Canada should both be maintained. +The Company’s United States federal and state net operating losses carryforwards as of December 28, 2019, were $ 6.7 billion and $ 0.5 billion , respectively. The United States federal net operating losses will expire between 2026 through 2037, and the state net operating losses will expire at various dates through 2037. The federal credit of $ 399 million will expire at various dates between 2020 and 2039. The state credits of $ 239 million will expire at various dates between 2020 through 2039 except for California R&D credit, which does not expire. The Company also has $ 365 million of credit carryforward in Canada that will expire between 2023 and 2028. +The Tax Reform Act modified the income tax liability in the United States for companies with subsidiaries outside of the United States. As a result of the Tax Reform Act the impact of future distributions of undistributed earnings that are indefinitely +69 +reinvested are anticipated to be withholding taxes from local jurisdictions. The amount of cumulative undistributed earnings that are permanently reinvested that could be subject to withholding taxes are $ 142 million as of December 28, 2019. +A reconciliation of the Company's gross unrecognized tax benefits is as follows: +2019 +2018 +2017 +(In millions) +Balance at beginning of year +$ +49 +$ +49 +$ +42 +Increases for tax positions taken in prior years +5 +1 +7 +Decreases for tax positions taken in prior years +— +( 1 +) +( 2 +) +Increases for tax positions taken in the current year +15 +3 +3 +Decreases for settlements with taxing authorities +( 3 +) +( 2 +) +— +Decreases for lapsing of the statute of limitations +( 1 +) +( 1 +) +( 1 +) +Balance at end of year +$ +65 +$ +49 +$ +49 +The amount of unrecognized tax benefits that would impact the effective tax rate was $ 17 million , $ 9 million and $ 9 million as of December 28, 2019 , December 29, 2018 and December 30, 2017 , respectively. The Company had no material amounts of accrued interest and accrued penalties related to unrecognized tax benefits as of December 28, 2019 , December 29, 2018 and December 30, 2017 . +It is possible the Company may have tax audits close in the next 12 months that could materially change the balance of the uncertain tax benefits; however, the timing of tax audit closures and settlements are highly uncertain. The Company and its subsidiaries have several foreign and U.S. state audits in process at any one point in time. The Company has provided for uncertain tax positions that require a liability under the adopted method to account for uncertainty in income taxes. +The Company is subject to taxation in the United States and foreign jurisdictions. Earnings from non-U.S. activities are subject to local country income tax. The material jurisdiction in which the Company is subject to potential examination by the taxing authority is the United States, which is open for years from 2006 onwards due to the net operating losses. +NOTE 15: Segment Reporting +Management, including the Chief Operating Decision Maker, who is the Company’s Chief Executive Officer, reviews and assesses operating performance using segment net revenue and operating income (loss). These performance measures include the allocation of expenses to the operating segments based on management’s judgment. The Company has the following two reportable segments: +• +the Computing and Graphics segment, which primarily includes desktop and notebook processors and chipsets, discrete and integrated graphics processing units (GPUs), data center and professional GPUs and development services. The Company also licenses portions of its IP portfolio. +• +the Enterprise, Embedded and Semi-Custom segment, which primarily includes server and embedded processors, semi-custom System-on-Chip (SoC) products, development services and technology for game consoles. The Company also licenses portions of its IP portfolio. +In addition to these reportable segments, the Company has an All Other category, which is not a reportable segment. This category primarily includes certain expenses and credits that are not allocated to any of the reportable segments because management does not consider these expenses and credits in evaluating the performance of the reportable segments. This category primarily includes employee stock-based compensation expense. +70 +The following table provides a summary of net revenue and operating income (loss) by segment for 2019 , 2018 and 2017 . +2019 +2018 +2017 +(In millions) +Net revenue: +Computing and Graphics +$ +4,709 +$ +4,125 +$ +2,977 +Enterprise, Embedded and Semi-Custom +2,022 +2,350 +2,276 +Total net revenue +$ +6,731 +$ +6,475 +$ +5,253 +Operating income (loss): +Computing and Graphics +$ +577 +$ +470 +$ +92 +Enterprise, Embedded and Semi-Custom +263 +163 +132 +All Other +( 209 +) +( 182 +) +( 97 +) +Total operating income +$ +631 +$ +451 +$ +127 +The following table provides major items included in All Other category: +2019 +2018 +2017 +(In millions) +Operating loss: +Stock-based compensation expense +$ +( 197 +) +$ +( 137 +) +$ +( 97 +) +Impairment of technology licenses +— +( 45 +) +— +Loss contingency on legal matter +( 12 +) +— +— +Total operating loss +$ +( 209 +) +$ +( 182 +) +$ +( 97 +) +The Company does not discretely allocate assets to its operating segments, nor does management evaluate operating segments using discrete asset information. +The Company’s operations outside the United States include research and development activities and sales, marketing and administrative activities. The Company conducts product and system research and development activities for its products in the United States with additional design and development engineering teams located in Canada, China, India, Taiwan and Singapore. The Company’s material sales and marketing offices are located in the United States, Latin America, Europe and Asia. +The following table summarizes sales to external customers by geographic regions based on billing location of the customer: +2019 +2018 +2017 +(In millions) +United States +$ +1,764 +$ +1,327 +$ +1,360 +China (including Hong Kong) +1,736 +1,319 +974 +Japan +840 +1,225 +1,215 +Europe +762 +470 +263 +Taiwan +719 +1,197 +738 +Singapore +597 +728 +550 +Other countries +313 +209 +153 +Total sales to external customers +$ +6,731 +$ +6,475 +$ +5,253 +71 +The following table summarizes Property and equipment, net by geographic areas: +2019 +2018 +(In millions) +United States +$ +300 +$ +232 +Canada +99 +51 +China +36 +17 +Singapore +33 +29 +Other countries +32 +19 +Total property and equipment, net +$ +500 +$ +348 +The following table summarizes sales to major customers that accounted for at least 10% of the Company’s consolidated net revenue for the respective years: +2019 +2018 +2017 +Customer A +12 +% +19 +% +23 +% +Customer B +* +11 +% +15 +% +* +Less than 10% +Sales to customers A and B consisted of products from the Company’s Enterprise, Embedded and Semi-Custom segment. +NOTE 16: Other Expense, Net +The following table summarizes the components of Other expense, net: +2019 +2018 +2017 +(In millions) +Interest income +$ +15 +$ +18 +$ +6 +Gain on sale of 85% ATMP JV +— +— +3 +Loss on debt redemption, repurchase and conversion +( 176 +) +( 12 +) +( 12 +) +Other +( 4 +) +( 6 +) +( 6 +) +Other expense, net +$ +( 165 +) +$ +— +$ +( 9 +) +NOTE 17: Commitments and Guarantees +Operating Leases +The Company has entered into operating and finance leases for its corporate offices, data centers, research and development facilities and certain equipment. The leases expire at various dates through 2028, some of which include options to extend the lease for up to 5 years . +For 2019 , 2018 and 2017 , the Company recorded $ 56 million , $ 53 million and $ 44 million , respectively, of operating lease expense, including short-term lease expense. For the year ended December 28, 2019 , the Company recorded $ 25 million of variable lease expense, which primarily included operating expenses and property taxes associated with the usage of facilities under the operating leases. For the year ended December 28, 2019 , cash paid for operating leases included in operating cash flows was $ 47 million . The Company’s finance leases and short-term leases are immaterial. +Supplemental information related to leases is as follows: +December 28, +2019 +Weighted-average remaining lease term – operating leases +6.26 years +Weighted-average discount rate – operating leases +5.55 +% +72 +Future minimum lease payments under non-cancellable operating lease liabilities as of December 28, 2019 are as follows: +Year +(In millions) +2020 +$ +54 +2021 +48 +2022 +44 +2023 +37 +2024 +33 +2025 and thereafter +71 +Total minimum lease payments +287 +Less: interest +( 45 +) +Present value of net minimum lease payments +242 +Less: current portion +( 43 +) +Total long-term operating lease liabilities +$ +199 +Certain other operating leases contain provisions for escalating lease payments subject to changes in the consumer price index. +Purchase and Other Contractual Obligations +The Company’s purchase obligations primarily include the Company’s obligations to purchase wafers and substrates from third parties. The Company also had other contractual obligations, primarily included in Other long-term liabilities and Accrued liabilities on its consolidated balance sheet, which primarily consisted of $ 146 million of payments due under certain software and technology licenses and IP licenses that will be paid through 2022. +Total future unconditional purchase obligations as of December 28, 2019 were as follows: +Year +(In millions) +2020 +$ +1,731 +2021 +642 +2022 +58 +2023 +5 +2024 +2 +2025 and thereafter +7 +Total unconditional purchase commitments +$ +2,445 +Warranties and Indemnities +Changes in the Company’s estimated liability for product warranty during the years ended December 28, 2019 and December 29, 2018 are as follows: +December 28, +2019 +December 29, +2018 +(In millions) +Beginning balance +$ +13 +$ +12 +New warranties issued during the period +31 +27 +Settlements during the period +( 29 +) +( 28 +) +Changes in liability for pre-existing warranties during the period, including expirations +— +2 +Ending balance +$ +15 +$ +13 +In addition to product warranties, the Company from time to time in its normal course of business indemnifies other parties with whom it enters into contractual relationships, including customers, lessors and parties to other transactions with the Company, with respect to certain matters. In these limited matters, the Company has agreed to hold certain third parties harmless against specific types of claims or losses such as those arising from a breach of representations or covenants, third-party claims that the Company’s products when used for their intended purpose(s) and under specific conditions infringe the intellectual property rights +73 +of a third party, or other specified claims made against the indemnified party. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the unique facts and circumstances that are likely to be involved in each particular claim and indemnification provision. Historically, payments made by the Company under these obligations have not been material. +NOTE 18: Contingencies +Shareholder Derivative Lawsuits (Wessels, Hamilton and Ha) +On March 20, 2014, a purported shareholder derivative lawsuit captioned Wessels v. Read, et al. , Case No. 1:14 cv-262486 (Wessels) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the Santa Clara County Superior Court of the State of California. The complaint purports to assert claims against the Company and certain individual directors and officers for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by the Company and the individual directors and officers regarding its 32nm technology and “Llano” product, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for the Company’s common stock during the period. On April 27, 2015, a similar purported shareholder derivative lawsuit captioned Christopher Hamilton and David Hamilton v. Barnes, et al. , Case No. 5:15-cv-01890 (Hamilton) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court for the Northern District of California. +On September 29, 2015, a similar purported shareholder derivative lawsuit captioned Jake Ha v Caldwell, et al., Case No. 3:15-cv-04485 (Ha) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court for the Northern District of California. The lawsuit also seeks a court order voiding the stockholder vote on the Company’s 2015 proxy. The case was transferred to the judge handling the Hamilton Lawsuit and is now Case No. 4:15-cv-04485. The Wessels, Hamilton and Ha shareholder derivative lawsuits were stayed pending resolution of a class action lawsuit captioned Hatamian v. AMD, et al. , C.A. No. 3:14-cv-00226 filed against the Company in the United States District Court for the Northern District of California (the Hatamian Lawsuit). The Hatamian Lawsuit asserted claims against the Company and certain of its officers for alleged violations of Section 10(b) of the Exchange Act of 1934, as amended (the Exchange Act), and SEC Rule 10b-5 concerning certain statements regarding its 32nm technology and “Llano” products. On October 9, 2017, the parties signed a definitive settlement agreement resolving the Hatamian Lawsuit and submitted it to the Court for approval. Under the terms of this agreement, the settlement was funded entirely by certain of the Company’s insurance carriers and the defendants continued to deny any liability or wrongdoing. On March 2, 2018, the court approved the settlement and entered a final judgment in the Hatamian Lawsuit. +On January 30, 2018, the Wessels and Hamilton plaintiffs amended their complaints. On February 2, 2018, the Ha plaintiff also filed an amended complaint. On February 22, 2018, the Company filed motions to dismiss the Hamilton and Ha plaintiffs’ amended complaints. On April 2, 2018, the Company filed a demurrer seeking to dismiss the Wessels amended complaint. On July 23, 2018, the Santa Clara Superior Court sustained the Company’s demurrer in the Wessels case, dismissing all claims in that matter with prejudice. The Wessels plaintiff filed a Notice of Appeal on September 27, 2018. On October 4, 2018, the Federal Court issued an order dismissing the Hamilton and Ha amended complaints. The Hamilton plaintiffs filed a Notice of Appeal on October 8, 2018, and the Ha plaintiffs filed a Notice of Appeal on October 15, 2018. On November 19, 2018, the Hamilton and Ha plaintiffs filed a motion seeking summary reversal of the order dismissing their claims. The Company opposed this motion on December 13, 2018, and the Court denied it on February 25, 2019. The Wessels, Hamilton, and Ha appeals are currently pending. Briefing has completed in each appeal. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Hauck et al. Litigation +Since January 19, 2018, three putative class action complaints have been filed against the Company in the United States District Court for the Northern District of California: (1) Diana Hauck et al. v. AMD, Inc., Case No. 5:18-cv-0047, filed on January 19, 2018; (2) Brian Speck et al. v. AMD, Inc. , Case No. 5:18-cv-0744, filed on February 4, 2018; and (3) Nathan Barnes and Jonathan Caskey-Medina, et al. v. AMD, Inc. , Case No. 5:18-cv-00883, filed on February 9, 2018. On April 9, 2018, the court consolidated these cases and ordered that Diana Hauck et al. v. AMD, Inc. serve as the lead case. On June 13, 2018, six plaintiffs (from California, Louisiana, Florida, and Massachusetts) filed a consolidated amended complaint alleging that the Company failed to disclose its processors’ alleged vulnerability to Spectre. Plaintiffs further allege that the Company’s processors cannot perform at their advertised processing speeds without exposing consumers to Spectre, and that any “patches” to remedy this security vulnerability will result in degradation of processor performance. The plaintiffs seek damages under several causes of action on behalf of a nationwide class and four state subclasses (California, Florida, Massachusetts, Louisiana) of consumers who purchased +74 +the Company’s processors and/or devices containing AMD processors. The plaintiffs also seek attorneys’ fees, equitable relief, and restitution. Pursuant to the court’s order directing the parties to litigate only eight of the causes of action in the consolidated amended complaint initially, the Company filed a motion to dismiss on July 13, 2018. On October 29, 2018, after the plaintiffs voluntarily dismissed one of their claims, the court granted the Company’s motion and dismissed six causes of action with leave to amend. The plaintiffs filed their amended consolidated complaint on December 6, 2018. On January 3, 2019, the Company again moved to dismiss the subset of claims currently at issue. On April 4, 2019, the court granted the Company’s motion and dismissed all claims currently at issue with prejudice. On May 6, 2019, the court granted the parties’ stipulation and request under Fed. R. Civ. P. 54(b) to enter a partial final judgment and certify for appeal the court’s April 4, 2019 dismissal order, and on that same date, the plaintiffs voluntarily dismissed without prejudice their remaining claims pursuant to an agreement whereby, subject to certain terms and conditions, the Company agreed to toll the statute of limitations and/or statute of repose. On May 30, 2019, the plaintiffs filed a Notice of Appeal with the U.S. Court of Appeals for the Ninth Circuit. Briefing has completed for the appeal. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Quarterhill Inc. Litigation +On July 2, 2018, three entities named Aquila Innovations, Inc. (Aquila), Collabo Innovations, Inc. (Collabo), and Polaris Innovations, Ltd. (Polaris), filed separate patent infringement complaints against the Company in the United States District Court for the Western District of Texas. Aquila alleges that the Company infringes two patents (6,239,614 and 6,895,519) relating to power management; Collabo alleges that the Company infringes one patent (7,930,575) related to power management; and Polaris alleges that the Company infringes two patents (6,728,144 and 8,117,526) relating to control or use of dynamic random-access memory, or DRAM. Each of the three complaints seeks unspecified monetary damages, interest, fees, expenses, and costs against the Company; Aquila and Collabo also seek enhanced damages. Aquila, Collabo, and Polaris each appear to be related to a patent assertion entity named Quarterhill Inc. (formerly WiLAN Inc.). On November 16, 2018, AMD filed answers in the Collabo and Aquila cases and filed a motion to dismiss in the Polaris case. On January 25, 2019, the Company filed amended answers and counterclaims in the Collabo and Aquila cases. On July 22, 2019, the Company’s motion to dismiss in the Polaris case was denied. On August 23, 2019, the Court held a claim construction hearing in each case. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Dickey Litigation +On October 26, 2015, a putative class action complaint captioned Dickey et al. v. AMD , No. 15-cv-04922 was filed against the Company in the United States District Court for the Northern District of California. Plaintiffs allege that the Company misled consumers by using the term “eight cores” in connection with the marketing of certain AMD FX CPUs that are based on the Company’s “Bulldozer” core architecture. The plaintiffs allege these products cannot perform eight calculations simultaneously, without restriction. The plaintiffs seek to obtain damages under several causes of action for a nationwide class of consumers who allegedly were deceived into purchasing certain Bulldozer-based CPUs that were marketed as containing eight cores. The plaintiffs also seek attorneys’ fees. On December 21, 2015, the Company filed a motion to dismiss the complaint, which was granted on April 7, 2016. The plaintiffs then filed an amended complaint with a narrowed putative class definition, which the Court dismissed upon the Company’s motion on October 31, 2016. The plaintiffs subsequently filed a second amended complaint, and the Company filed a motion to dismiss the second amended complaint. On June 14, 2017, the Court issued an order granting in part and denying in part the Company’s motion to dismiss, and allowing the plaintiffs to move forward with a portion of their complaint. On March 27, 2018, plaintiffs filed their motion for class certification. On January 17, 2019, the Court granted plaintiffs’ motion for class certification. The class definition does not encompass the Company’s Ryzen or EPYC processors. On January 31, 2019, the Company filed a petition in the Ninth Circuit Court of Appeals, seeking review of certain aspects of the January 17, 2019 class certification order. On May 9, 2019, the parties attended mediation and reached a tentative settlement. On June 3, 2019, the Ninth Circuit Court of Appeals denied the Company’s petition seeking appellate review of the January 17, 2019 class certification order. On August 9, 2019, the parties executed a formal settlement agreement. On August 23, 2019, plaintiffs filed their motion for preliminary approval of the settlement agreement. On October 4, 2019, the Court granted the motion for preliminary approval of the settlement agreement. +Based upon information presently known to management, the Company believes that the settlement will not have a material adverse effect on its financial condition, cash flows or results of operations. +Monterey Research Litigation +On November 15, 2019, Monterey Research, LLC filed a patent infringement complaint against the Company in the United States District Court for the District of Delaware. Monterey Research alleges that the Company infringes six U.S. patents: 6,534,805 +75 +(related to SRAM cell design); 6,629,226 (related to read interface protocols); 6,651,134 (related to memory devices); 6,765,407 (related to programmable digital circuits); 6,961,807 (related to integrated circuits and associated memory systems); and 8,373,455 (related to output buffer circuits). Monterey Research seeks unspecified monetary damages, enhanced damages, interest, fees, expenses, costs, and injunctive relief against the Company. On January 22, 2020, the Company filed a motion to dismiss part of Monterey Research’s complaint. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Environmental Matters +The Company is named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, the Company has discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, the Company received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. The Company has entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. The Company remains responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, the Company has computed and recorded an estimated environmental liability of approximately $ 3 million and has not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. The Company believes that any amount in addition to what has already been accrued would not be material. +Other Legal Matters +The Company is a defendant or plaintiff in various actions that arose in the normal course of business. With respect to these matters, based on the management’s current knowledge, the Company believes that the amount or range of reasonably possible loss, if any, will not, either individually or in the aggregate, have a material adverse effect on the Company’s financial position, results of operations, or cash flows. +76 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Advanced Micro Devices, Inc. +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Advanced Micro Devices, Inc. (the Company) as of December 28, 2019 and December 29, 2018, the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the three years in the period ended December 28, 2019, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 28, 2019 and December 29, 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 28, 2019, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 28, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 4, 2020 expressed an unqualified opinion thereon. +Adoption of New Accounting Standard +As discussed in Note 2 to the consolidated financial statements, the Company changed its method for accounting for leases as a result of the adoption of Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), and the amendments effective December 30, 2018 under the optional modified retrospective approach. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. +77 +Inventory Valuation +Description of the Matter +At December 28, 2019, the Company’s net inventory balance was $982 million. As discussed in Note 2 of the consolidated financial statements, the Company adjusts the inventory carrying value to the lower of actual cost or the estimated net realizable value after completing ongoing reviews of on-hand inventory quantities in excess of forecasted demand, by considering recent historical activity as well as anticipated or forecasted demand. +Auditing management’s inventory carrying value adjustments involved significant judgment because the estimates are based on a number of factors that are affected by market, industry, and competitive conditions outside the Company's control. In particular, in estimating inventory carrying value adjustments, management developed assumptions such as forecasts of future sales quantities and the selling prices, which are sensitive to the competitiveness of product offerings, customer requirements, and product life cycles. These significant assumptions are forward-looking and could be affected by future economic and market conditions. +How We Addressed the Matter in Our Audit +We obtained an understanding, evaluated the design and tested the operating effectiveness of internal controls over the Company's inventory carrying value adjustment determination process, including the basis for developing above described assumptions and management’s judgments. +Our audit procedures included, among others, testing the reasonableness of management’s key assumptions and judgments and testing the accuracy and completeness of the underlying data used to determine the amount of inventory carrying value adjustments. For instance, we compared the quantities and carrying value of on-hand inventories to related unit sales, both historical and forecasted, assessed the reasonableness of management’s estimates of future sales prices by analyzing historical sales and evaluating any factors that may impact sales prices, and evaluated the appropriateness and adequacy of management’s adjustments to such sales forecasts by analyzing potential technological changes in line with product life cycles and/or identified alternative customer uses. We also assessed the accuracy of forecasts underlying management's estimates by comparing management’s historical forecasts to actual results, evaluated industry and market factors and performed sensitivity analyses over the significant assumptions used by management to evaluate necessary changes in the inventory carrying value adjustments. +/s/ Ernst & Young LLP +We have served as the Company’s auditor since 1970. +San Jose, California +February 4, 2020 +78 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Advanced Micro Devices, Inc. +Opinion on Internal Control over Financial Reporting +We have audited Advanced Micro Devices, Inc.’s internal control over financial reporting as of December 28, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Advanced Micro Devices, Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 28, 2019, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 28, 2019 and December 29, 2018 , the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the three years in the period ended December 28, 2019, and the related notes and our report dated February 4, 2020 expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. +Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ Ernst & Young LLP +San Jose, California +February 4, 2020 +79 +Supplementary Financial Information (unaudited) +The Company uses a 52 or 53 week fiscal year ending on the last Saturday in December. All quarters of 2019 and 2018 consisted of 13 weeks. +(In millions, except per share amounts) +2019 +2018 +Dec. 28 +Sep. 28 +June 29 +Mar. 30 +Dec. 29 +Sep. 29 +June 30 +Mar. 31 +Net revenue +$ +2,127 +$ +1,801 +$ +1,531 +$ +1,272 +$ +1,419 +$ +1,653 +$ +1,756 +$ +1,647 +Cost of sales +1,178 +1,024 +910 +751 +882 +992 +1,104 +1,050 +Gross margin +949 +777 +621 +521 +537 +661 +652 +597 +Research and development +395 +406 +373 +373 +371 +363 +357 +343 +Marketing, general and administrative +206 +185 +189 +170 +138 +148 +142 +134 +Licensing gain +— +— +— +( 60 +) +— +— +— +— +Operating income +348 +186 +59 +38 +28 +150 +153 +120 +Interest expense +( 18 +) +( 24 +) +( 25 +) +( 27 +) +( 29 +) +( 30 +) +( 31 +) +( 31 +) +Other income (expense), net +( 125 +) +( 36 +) +3 +( 7 +) +4 +( 6 +) +1 +1 +Income before income taxes +205 +126 +37 +4 +3 +114 +123 +90 +Provision for (benefit from) income taxes +35 +7 +2 +( 13 +) +( 35 +) +12 +6 +8 +Equity loss in investee +— +1 +— +( 1 +) +— +— +( 1 +) +( 1 +) +Net income +$ +170 +$ +120 +$ +35 +$ +16 +$ +38 +$ +102 +$ +116 +$ +81 +Earnings per share +Basic +$ +0.15 +$ +0.11 +$ +0.03 +$ +0.01 +$ +0.04 +$ +0.10 +$ +0.12 +$ +0.08 +Diluted +$ +0.15 +$ +0.11 +$ +0.03 +$ +0.01 +$ +0.04 +$ +0.09 +$ +0.11 +$ +0.08 +Shares used in per share calculation +Basic +1,140 +1,097 +1,084 +1,044 +1,002 +987 +972 +968 +Diluted +1,188 +1,117 +1,109 +1,094 +1,079 +1,076 +1,147 +1,039 +80 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. +CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +We maintain disclosure controls and procedures that are designed with the objective of providing reasonable assurance that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. +As of December 28, 2019 , the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e). This type of evaluation is performed on a quarterly basis so that conclusions of management, including our Chief Executive Officer and Chief Financial Officer, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on Form 10-Q and Form 10-K. The overall goals of these evaluation activities are to monitor our disclosure controls and to modify them as necessary. We intend to maintain the disclosure controls as dynamic systems that we adjust as circumstances merit. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of the end of the period covered by this report. +Management’s Report on Internal Control over Financial Reporting +Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles, and includes those policies and procedures that: +(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. +Management has used the 2013 framework set forth in the report entitled “Internal Control—Integrated Framework” published by the Committee of Sponsoring Organizations of the Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the Company’s internal control over financial reporting was effective as of December 28, 2019 at the reasonable assurance level. Our independent registered public accounting firm, Ernst & Young LLP, has issued an attestation report on the Company’s internal control over financial reporting as of December 28, 2019 , which is included in Part II, Item 8, above. +81 +Changes in Internal Control over Financial Reporting +There has been no change in our internal controls over financial reporting during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. +ITEM 9B. +OTHER INFORMATION +None. +82 +PART III +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information under the captions “Item 1—Election of Directors” (including “Consideration of Stockholder Nominees for Director”), “Corporate Governance,” “Meetings and Committees of the Board of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our proxy statement for our 2020 annual meeting of stockholders (our 2020 Proxy Statement) is incorporated herein by reference. There were no material changes to the procedures by which stockholders may recommend nominees to our board of directors. See also, “Part 1, Item 1-Website Access to Company Reports and Corporate Governance Documents,” above. +ITEM 11. +EXECUTIVE COMPENSATION +The information under the captions “Directors’ Compensation and Benefits” (including “2019 Non-Employee Director Compensation”), “Compensation Discussion and Analysis,” “Compensation Policies and Practices,” “Executive Compensation” (including “2019 Summary Compensation Table,” “2019 Nonqualified Deferred Compensation,” “Outstanding Equity Awards at 2019 Fiscal Year-End,” “Grants of Plan-Based Awards in 2019” and “Option Exercises and Stock Vested in 2019”) and “Severance and Change in Control Arrangements” in our 2020 Proxy Statement is incorporated herein by reference. +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information under the captions “Principal Stockholders,” “Security Ownership of Directors and Executive Officers” and “Equity Compensation Plan Information” in our 2020 Proxy Statement is incorporated herein by reference. +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance—Independence of Directors” and “Certain Relationships and Related Transactions” in our 2020 Proxy Statement is incorporated herein by reference. +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the captions “Item 2—Ratification of Appointment of Independent Registered Public Accounting Firm—Independent Registered Public Accounting Firm’s Fees” in our 2020 Proxy Statement is incorporated herein by reference. +With the exception of the information specifically incorporated by reference in Part III of this Annual Report on Form 10-K from our 2020 Proxy Statement, our 2020 Proxy Statement will not be deemed to be filed as part of this report. Without limiting the foregoing, the information under the captions “Compensation Committee Report” and “Audit Committee Report” in our 2020 Proxy Statement is not incorporated by reference in this Annual Report on Form 10-K. +83 +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES +1. Financial Statements +The financial statements of AMD are set forth in Item 8 of this Annual Report on Form 10-K. +All schedules have been omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedules or because the information required is included in the Consolidated Financial Statements or related notes. +2. Exhibits +The exhibits listed in the accompanying Index to Exhibits are filed as part of, or incorporated by reference into, this Annual Report on Form 10-K. The following is a list of such Exhibits: +Exhibit +Description of Exhibits +3.1 +Amended and Restated Certificate of Incorporation of Advanced Micro Devices, Inc., dated May 2, 2018, filed as Exhibit 3.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 30, 2018, is hereby incorporated by reference. +3.2 +Advanced Micro Devices, Inc. Amended and Restated Bylaws, as amended on July 30, 2009, filed as Exhibit 3.1 to AMD’s Current Report on Form 8-K dated July 30, 2009, are hereby incorporated by reference. +4.1 +Description of Advanced Micro Devices, Inc. Common Stock +4.2 +Indenture governing 7.50% Senior Notes due 2022, including the Form of 7.50% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated as of August 15, 2012, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated August 15, 2012, is hereby incorporated by reference. +4.3 +Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated September 14, 2016, filed as Exhibit 4.1 to AMD's Current Report on Form 8-K dated September 14, 2016, is hereby incorporated by reference. +4.4 +First Supplemental Indenture governing 2.125% Convertible Senior Notes due 2026, including Form of 2.125% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A. dated September 14, 2016, filed as Exhibit 4.2 to AMD's Current Report on Form 8-K dated September 14, 2016, is hereby incorporated by reference. +4.5 +First Supplemental Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated September 23, 2016, filed as Exhibit 4.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +*10.1 +2011 Executive Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended April 2, 2011, is hereby incorporated by reference. +*10.2 +SeaMicro, Inc. Amended and Restated 2007 Equity Incentive Plan, filed as Exhibit 10.1 on AMD’s Registration Statement on Form S-8, filed with the SEC on March 23, 2012, is hereby incorporated by reference. +*10.3 +AMD Executive Severance Plan and Summary Plan Description for Senior Vice Presidents, effective June 1, 2013, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated June 7, 2013, is hereby incorporated by reference. +*10.4 +Guidelines for Business Aircraft Usage And Commercial Travel By Personal Guests, revised as of May 16, 2013, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 29, 2013, is hereby incorporated by reference. +84 +*10.5 +AMD Deferred Income Account Plan, as amended and restated, effective January 1, 2008, filed as Exhibit 10.18 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007, is hereby incorporated by reference. +*10.6 +Amendment No. 1 to the AMD Deferred Income Account Plan, as amended and restated, effective July 1, 2012, filed as Exhibit 10.16(a) to AMD’s Annual Report on Form 10-K for the period ended December 29, 2012, is hereby incorporated by reference. +*10.7 +Form of Indemnity Agreement, between Advanced Micro Devices, Inc. and its officers and directors, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 6, 2008, is hereby incorporated by reference. +*10.8 +Form of Management Continuity Agreement, as amended and restated, filed as Exhibit 10.13(b) to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007, is hereby incorporated by reference. +*10.9 +Form of Change in Control Agreement, filed as Exhibit 10.11 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 26, 2009, is hereby incorporated by reference. +*10.10 +Amended and Restated Management Continuity Agreement, between Advanced Micro Devices, Inc. and Devinder Kumar, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended September 29, 2012, is hereby incorporated by reference. +*10.11 +Offer Letter, between Advanced Micro Devices, Inc. and Mark D. Papermaster, dated October 7, 2011, filed as Exhibit 10.63 to AMD’s Annual Report on Form 10-K for the period ended December 31, 2011, is hereby incorporated by reference. +**10.12 +Wafer Supply Agreement, among Advanced Micro Devices, Inc., The Foundry Company and AMD Fab Technologies US, Inc., dated March 2, 2009, filed as Exhibit 10.5 to AMD’s Current Report on Form 8-K dated March 2, 2009, is hereby incorporated by reference. +**10.13 +Wafer Supply Agreement Amendment No. 1, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc., GLOBALFOUNDRIES U.S. Inc. and GLOBALFOUNDRIES Singapore. Pte. Ltd., dated March 29, 2011, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q/A for the period ended April 2, 2011, is hereby incorporated by reference. +**10.14 +Wafer Supply Agreement Amendment No. 2, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc., GLOBALFOUNDRIES U.S. Inc., Advanced Technology Investment Company LLC and ATIC International Investment Company LLC, dated March 4, 2012, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the period ended March 31, 2012, is hereby incorporated by reference. +**10.15 +Wafer Supply Agreement Amendment No. 3, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated December 6, 2012, filed as Exhibit 10.34(c) to AMD’s Annual Report on Form 10-K for the period ended December 29, 2012, is hereby incorporated by reference. +10.16 +Settlement Agreement, between Advanced Micro Devices, Inc. and Intel Corporation, dated November 11, 2009, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated November 11, 2009, is hereby incorporated by reference. +**10.17 +Patent Cross License Agreement, between Advanced Micro Devices, Inc. and Intel Corporation filed, dated November 11, 2009, as Exhibit 10.2 to AMD’s Current Report on Form 8-K dated November 17, 2009, is hereby incorporated by reference. +10.18 +Sublease Agreement, between Lantana HP, LTD and Advanced Micro Devices, Inc., dated March 26, 2013, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.19 +Master Landlord’s Consent to Sublease, between 7171 Southwest Parkway Holdings, L.P., Lantana HP, Ltd. and Advanced Micro Devices, Inc., dated March 26, 2013, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.20 +Lease Agreement, between 7171 Southwest Parkway Holdings, L.P. and Lantana HP, Ltd., dated March 26, 2013, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +85 +**10.21 +Wafer Supply Agreement Amendment No. 4, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated March 30, 2014, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended March 29, 2014, is hereby incorporated by reference. +*10.22 +Employment Agreement by and between Lisa T. Su and Advanced Micro Devices, Inc. effective October 8, 2014, filed as Exhibit 10.2 to AMD’s Current Report on Form 8-K/A dated October 14, 2014, is hereby incorporated by reference. +*10.23 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2014, is hereby incorporated by reference. +*10.24 +Offer Letter, between Advanced Micro Devices, Inc. and Forrest E. Norrod, dated October 20, 2014, filed as Exhibit 10.66 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +*10.25 +Advanced Micro Devices, Inc. Executive Severance Plan and Summary Plan Description for Senior Vice Presidents effective December 31, 2014, filed as Exhibit 10.68 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +*10.26 +Offer Letter between Advanced Micro Devices, Inc. and Jim R. Anderson, dated April 17, 2015, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2015, is hereby incorporated by reference. +*10.27 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2015, is hereby incorporated by reference. +10.28 +Equity Interest Purchase Agreement by and between Advanced Micro Devices, Inc. and Nantong Fujitsu Microelectronics Co., Ltd. dated as of October 15, 2015, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 15, 2015, is hereby incorporated by reference. +**10.29 +Wafer Supply Agreement Amendment No. 5, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated as of April 16, 2015, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended June 27, 2015, is hereby incorporated by reference. +*10.30 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.78 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +*10.31 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.79 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +*10.32 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.80 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +**10.33 +Wafer Supply Agreement Amendment No. 6, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES, Inc. and GLOBALFOUNDRIES U.S., Inc., dated August 30, 2016, filed as Exhibit 10.3 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +*10.34 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.88 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.35 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Plan, filed as Exhibit 10.89 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.36 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.90 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +86 +*10.37 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended April 4, 2017, is hereby incorporated by reference. +*10.38 +2004 Equity Incentive Plan, as amended and restated, filed as Exhibit 10.1 to AMD’s Registration Statement on Form S-8 filed with the SEC on May 8, 2017, is hereby incorporated by reference. +*10.39 +Amended and Restated 2017 Employee Stock Purchase Plan dated August 23, 2018, filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 29, 2018, is hereby incorporated by reference. +*10.40 +Outside Director Equity Compensation Policy, amended and restated as of October 31, 2017, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2017, is hereby incorporated by reference. +*10.41 +2017 Employee Stock Purchase Plan, as amended and restated October 12, 2017, filed as Exhibit 10.98 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.42 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.99 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.43 +Form of Restricted Stock Unit Award Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.100 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.44 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan filed as Exhibit 10.101 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.45 +Amendment to Advanced Micro Devices, Inc. Executive Incentive Plan dated as of February 8, 2018, filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2018, is hereby incorporated by reference. +*10.46 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive plan, filed as Exhibit 10.103 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2018, is hereby incorporated by reference. +*10.47 +Form of Performance-based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.104 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2018, is hereby incorporated by reference. +*10.48 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.105 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2018, is hereby incorporated by reference. +**10.49 +Wafer Supply Agreement Amendment No. 7, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated January 28, 2019, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 30, 2019, is hereby incorporated by reference. +*10.50 +Offer Letter, between Advanced Micro Devices, Inc. and Sandeep Chennakeshu, dated January 14, 2019, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 30, 2019, is hereby incorporated by reference. +*10.51 +Sign-On Bonus Agreement, between Advanced Micro Devices, Inc. and Sandeep Chennakeshu, dated January 19, 2019, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 30, 2019, is hereby incorporated by reference. +10.52 +Credit Agreement dated as of June 7, 2019 by and among Advanced Micro Devices, Inc., as borrower, the lenders as referred to therein, as lenders, and Wells Fargo Bank, National Association, as administrative agent, swingline agent and an issuing lender, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated June 10, 2019, is hereby incorporated by reference. +*10.53 +Offer Letter between Advanced Micro Devices, Inc. and Rick Bergman dated August 1, 2019, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +87 +*10.54 +Sign-On Bonus Letter between Advanced Micro Devices, Inc. and Rick Bergman dated August 1, 2019, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.55 +Value Creation Performance-Based Restricted Stock Unit Grant Notice between Advanced Micro Devices, Inc. and Lisa T. Su, dated August 9, 2019, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.56 +Value Creation Performance-Based Restricted Stock Unit Grant Notice between Advanced Micro Devices, Inc. and Mark Papermaster, dated August 9, 2019, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.57 +Advanced Micro Devices, Inc. Outside Director Equity Compensation Policy, as amended and restated, dated August 21, 2019, filed as Exhibit 10.5 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.58 +Amendment to Advanced Micro Devices, Inc. Executive Incentive Plan dated as of August 21, 2019, filed as Exhibit 10.6 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.59 +2004 Equity Incentive Plan, as amended and restated, dated August 21, 2019, filed as Exhibit 10.7 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +21 +List of AMD subsidiaries. +23 +Consent of Independent Registered Public Accounting Firm +24 +Power of Attorney. +31.1 +Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32.1 +Certification of the Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101.INS +XBRL Instance Document -the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document +101.SCH +XBRL Taxonomy Extension Schema Document +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +104 +Cover Page Interactive Data File -the Cover Page Interactive Data File does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document +_____________________ +* Management contracts and compensatory plans or arrangements. +** Portions of this exhibit have been omitted pursuant to a request for confidential treatment, which has been granted. These portions have been filed separately with the SEC. +88 +AMD will furnish a copy of any exhibit on request and payment of AMD’s reasonable expenses of furnishing such exhibit. +89 +ITEM 16. +FORM 10-K SUMMARY +Not applicable. +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +February 4, 2020 +A DVANCED M ICRO D EVICES , I NC . +By: +/s/ Devinder Kumar +Devinder Kumar +Senior Vice President, Chief Financial Officer, and Treasurer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, on behalf of the registrant and in the capacities and on the dates indicated. +90 +Signature +Title +Date +/s/Lisa T. Su +President and Chief Executive Officer +(Principal Executive Officer), Director +February 4, 2020 +Lisa T. Su +/s/Devinder Kumar +Senior Vice President, Chief Financial Officer and Treasurer +(Principal Financial Officer) +February 4, 2020 +Devinder Kumar +/s/Darla Smith +Corporate Vice President, Chief Accounting Officer (Principal Accounting Officer) +February 4, 2020 +Darla Smith +* +Director, Chairman of the Board +February 4, 2020 +John E. Caldwell +* +Director +February 4, 2020 +Nora M. Denzel +* +Director +Dermot Mark Durcan +February 4, 2020 +* +Director +February 4, 2020 +Michael P. Gregoire +* +Director +February 4, 2020 +Joseph A. Householder +* +Director +February 4, 2020 +John W. Marren +* +Director +February 4, 2020 +Abhi Y. Talwalkar +*By: +/s/Devinder Kumar +Devinder Kumar, Attorney-in-Fact +91 \ No newline at end of file diff --git a/raw/filings/0000002488/2019/0000002488-20-000008/filing_metadata.csv b/raw/filings/0000002488/2019/0000002488-20-000008/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..dc89cd39be488580e0148e4ad4e12dde4bedc20f --- /dev/null +++ b/raw/filings/0000002488/2019/0000002488-20-000008/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002488,AMD,ADVANCED MICRO DEVICES INC,2019,10-K,2020-02-04,2019-12-28,2020-02-04T22:21:47.000Z,0000002488-20-000008,amdform10-kfy2019.htm,10-K,13258755,1,1,https://www.sec.gov/Archives/edgar/data/2488/000000248820000008/amdform10-kfy2019.htm,https://www.sec.gov/Archives/edgar/data/2488/000000248820000008/ diff --git a/raw/filings/0000002488/2019/0000002488-20-000008/item1.txt b/raw/filings/0000002488/2019/0000002488-20-000008/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..7805a8f6f3fc3e36e6203aab69d0f9067513681f --- /dev/null +++ b/raw/filings/0000002488/2019/0000002488-20-000008/item1.txt @@ -0,0 +1,3 @@ +ITEM 1. BUSINESS +Cautionary Statement Regarding Forward-Looking Statements +The statements in this report include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations and beliefs and involve numerous risks and uncertainties that could cause actual results to differ materially from expectations. These forward-looking statements speak only as of the date hereof or as of the dates indicated in the statements and should not be relied upon as predictions of future events, as we cannot assure you that the events or circumstances reflected in these statements will be achieved or will occur. You can identify forward-looking statements by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “pro forma,” “estimates,” “anticipates,” or the negative of these words and phrases, other variations of these words and phrases or comparable terminology. The forward-looking statements relate to, among other things: possible impact of future accounting rules on AMD’s consolidated financial statements; demand for AMD’s products; the growth, change and competitive landscape of the markets in which AMD participates; the expected amounts to be received by AMD under the IP licensing agreement and AMD’s expected royalty payments from future product sales of China JVs’ products to be developed on the basis of such licensed IP; sales patterns of AMD’s PC products and semi-custom System-on-Chip (SoC) products for game consoles; international sales will continue to be a significant portion of total sales in the foreseeable future; the balance of the uncertain tax benefits in the next 12 months; that AMD’s cash, cash equivalents and marketable securities balances together with the availability under that certain revolving credit facility (Secured Revolving Facility) made available to AMD and certain of its subsidiaries under the Credit Agreement, will be sufficient to fund AMD’s operations including capital expenditures over the next 12 months; AMD’s ability to obtain sufficient external financing on favorable terms, or at all; AMD’s expectation that based on the information presently known to management, the potential liability related to AMD’s current litigation will not have a material adverse effect on its financial condition, cash flows or results of operations; any amounts in addition to what has been already accrued by AMD for future remediation costs under clean-up orders will not be material; we expect to file future patent applications in both the United States and abroad on significant inventions as we deem appropriate; anticipated ongoing and increased in costs related to enhancing and implementing information security controls; revenue allocated to remaining performance obligations that are unsatisfied which will be recognized over the next 12 months; all unbilled accounts receivables are expected to be billed and collected within 12 months; and a small number of customers will continue to account for a substantial part of AMD’s revenue in the future. For a discussion of the factors that could cause actual results to differ materially from the forward-looking statements, see “Part I, \ No newline at end of file diff --git a/raw/filings/0000002488/2019/0000002488-20-000008/item13.txt b/raw/filings/0000002488/2019/0000002488-20-000008/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..a11a7ec670b59c6e0137b5e9044ef3051ef9033f --- /dev/null +++ b/raw/filings/0000002488/2019/0000002488-20-000008/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. +Certain Relationships and Related Transactions and Director Independence +83 \ No newline at end of file diff --git a/raw/filings/0000002488/2020/0001628280-21-001185/filing.txt b/raw/filings/0000002488/2020/0001628280-21-001185/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..6742a4df10ab3952c2d110d0396c9a0cf5a594ae --- /dev/null +++ b/raw/filings/0000002488/2020/0001628280-21-001185/filing.txt @@ -0,0 +1,1933 @@ +amd-20201226 +false 2020 FY 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OF 1934. +For the transition period from to +Commission File Number 001-07882 +ADVANCED MICRO DEVICES, INC. +(Exact name of registrant as specified in its charter) +Delaware 94-1692300 +(State or other jurisdiction of +incorporation or organization) (I.R.S. Employer +Identification No.) +2485 Augustine Drive +Santa Clara , California 95054 +(Address of principal executive offices) +( 408 ) 749-4000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +(Title of each class) (Trading symbol) (Name of each exchange on which registered) +Common Stock, $0.01 par value per share AMD The NASDAQ Global Select Market +Securities registered pursuant to Section 12(g) of the Act: +None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☑ No ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ☐ No ☑ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files): Yes ☑ No ☐ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ☑ Accelerated filer ☐ +Non-accelerated filer ☐ Smaller reporting company ☐ +Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C.7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☑ +Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes ☐ No ☑ +As of June 27, 2020, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $ 58.5 billion based on the reported closing sale price of $50.10 per share as reported on The NASDAQ Global Select Market (NASDAQ) on June 26, 2020, which was the last business day of the registrant’s most recently completed second fiscal quarter. +Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 1,211,280,009 shares of common stock, $0.01 par value per share, as of January 22, 2021. +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the registrant’s proxy statement for the 2021 Annual Meeting of Stockholders (2021 Proxy Statement) are incorporated into Part III hereof. The 2021 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the registrant’s fiscal year ended December 26, 2020. +INDEX +PART I +1 +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +14 +ITEM 1B. +Unresolved Staff Comments +34 +ITEM 2. +Properties +34 +ITEM 3. +Legal Proceedings +35 +ITEM 4. +Mine Safety Disclosures +35 +PART II +36 +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +36 +ITEM 6. +Selected Financial Data +38 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +39 +ITEM 7A. +Quantitative and Qualitative Disclosure About Market Risk +48 +ITEM 8. +Financial Statements and Supplementary Data +49 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +87 +ITEM 9A. +Controls and Procedures +87 +ITEM 9B. +Other Information +88 +PART III +89 +ITEM 10. +Directors, Executive Officers and Corporate Governance +89 +ITEM 11. +Executive Compensation +89 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +89 +ITEM 13. +Certain Relationships and Related Transactions and Director Independence +89 +ITEM 14. +Principal Accounting Fees and Services +89 +PART IV +90 +ITEM 15. +Exhibits, Financial Statements Schedules +90 +ITEM 16. +Form 10-K Summary +96 +SIGNATURES . +96 +PART I +ITEM 1. BUSINESS +Cautionary Statement Regarding Forward-Looking Statements +The statements in this report include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations and beliefs and involve numerous risks and uncertainties that could cause actual results to differ materially from expectations. These forward-looking statements speak only as of the date hereof or as of the dates indicated in the statements and should not be relied upon as predictions of future events, as we cannot assure you that the events or circumstances reflected in these statements will be achieved or will occur. You can identify forward-looking statements by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “pro forma,” “estimates,” “anticipates,” or the negative of these words and phrases, other variations of these words and phrases or comparable terminology. The forward-looking statements relate to, among other things: possible impact of future accounting rules on AMD’s consolidated financial statements; demand for AMD’s products; the growth, change and competitive landscape of the markets in which AMD participates; the expected amounts to be received by AMD under the IP licensing agreement and AMD’s expected royalty payments from future product sales of the two joint ventures AMD holds equity in with Higon Information Technology Co., Ltd. (THATIC JVs) products to be developed on the basis of such licensed IP; sales patterns of AMD’s products; international sales will continue to be a significant portion of total sales in the foreseeable future; that AMD’s cash, cash equivalents and short-term investment balances together with the availability under that certain revolving credit facility (the Revolving Credit Facility) made available to AMD and certain of its subsidiaries under the Credit Agreement, will be sufficient to fund AMD’s operations including capital expenditures over the next 12 months; AMD’s ability to obtain sufficient external financing on favorable terms, or at all; AMD’s expectation that based on the information presently known to management, the potential liability related to AMD’s current litigation will not have a material adverse effect on its financial condition, cash flows or results of operations; any amounts in addition to what has been already accrued by AMD for future remediation costs under clean-up orders will not have a material effect on our financial condition, cash flows or results of operations; we expect to file future patent applications in both the United States and abroad on significant inventions as we deem appropriate; anticipated ongoing and increased costs related to enhancing and implementing information security controls; revenue allocated to remaining performance obligations that are unsatisfied which will be recognized over the next 12 months; all unbilled accounts receivables are expected to be billed and collected within 12 months; a small number of customers will continue to account for a substantial part of AMD’s revenue in the future; and the acquisition of Xilinx, Inc. is currently expected to close by the end of calendar year 2021. For a discussion of the factors that could cause actual results to differ materially from the forward-looking statements, see “Part I, Item 1A-Risk Factors” and the “Financial Condition” section set forth in “Part II, Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations,” or MD&A, and such other risks and uncertainties as set forth below in this report or detailed in our other Securities and Exchange Commission (SEC) reports and filings. We assume no obligation to update forward-looking statements. +General +We are a global semiconductor company primarily offering: +• x86 microprocessors, as standalone devices or as incorporated into an accelerated processing unit (APU), chipsets, discrete and integrated graphics processing units (GPUs), data center and professional GPUs, and development services; and +• server and embedded processors, semi-custom System-on-Chip (SoC) products, development services and technology for game consoles. +From time to time, we may also sell or license portions of our intellectual property (IP) portfolio. +For financial information about geographic areas and for segment information with respect to revenues and operating results, refer to the information set forth in Note 14 of our consolidated financial statements. +We use a 52 or 53 week fiscal year ending on the last Saturday in December. References in this report to 2020, 2019 and 2018 refer to the fiscal year unless explicitly stated otherwise. +1 +Pending Acquisition +On October 26, 2020, we entered into an Agreement and Plan of Merger (the Merger Agreement) with Thrones Merger Sub, Inc., our wholly owned subsidiary (Merger Sub), and Xilinx, Inc. (Xilinx), whereby Merger Sub will merge with and into Xilinx (the Merger), with Xilinx surviving such Merger as a wholly owned subsidiary of ours. Under the Merger Agreement, at the effective time of the Merger (the Effective Time), each share of common stock of Xilinx (Xilinx Common Stock) issued and outstanding immediately prior to the Effective Time (other than treasury shares and any shares of Xilinx Common Stock held directly by us or Merger Sub) will be converted into the right to receive 1.7234 fully paid and non-assessable shares of our common stock and, if applicable, cash in lieu of fractional shares, subject to any applicable withholding. As of the signing of the Merger Agreement, the transaction was valued at $35 billion . The actual valuation of the transaction could differ significantly from the estimated amount due to movements in the price of our Common Stock, the number of shares of Xilinx common stock outstanding on the closing date of the Merger and other factors . The closing of the Merger is subject to customary conditions, including regulatory approval and approval by our stockholders and Xilinx stockholders. The transaction is currently expected to close by the end of calendar year 2021. +Additional Information +Advanced Micro Devices, Inc. (AMD) was incorporated under the laws of Delaware on May 1, 1969 and became a publicly held company in 1972. Our common stock is currently listed on The NASDAQ Global Select Market (NASDAQ) under the symbol “AMD”. Our mailing address and executive offices are located at 2485 Augustine Drive, Santa Clara, California 95054, and our telephone number is (408) 749-4000. The SEC website, www.sec.gov, contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. +References in this Annual Report on Form 10-K to “AMD,” “we,” “us,” “management,” “our” or the “Company” mean Advanced Micro Devices, Inc. and our consolidated subsidiaries. +AMD, the AMD Arrow logo, Athlon, AMD CDNA, AMD Instinct, AMD RDNA, EPYC, FirePro, FreeSync, Geode, Opteron, Radeon, Radeon Instinct, RDNA, Ryzen, Threadripper, Infinity Fabric, and combinations thereof are trademarks of Advanced Micro Devices, Inc. +Microsoft, Windows, DirectX and Xbox One are either registered trademarks or trademarks of Microsoft Corporation in the United States and/or other countries. PCIe is a registered trademark of PCI-SIG Corporation. Chromebook and Stadia are trademarks of Google Inc. Linux is the registered trademark of Linus Torvalds in the United States and other countries. PlayStation is a registered trademark or trademark of Sony Interactive Entertainment, Inc. Arm is a registered trademark of ARM Limited (or its subsidiaries) in the US and/or elsewhere. Vulkan and the Vulkan logo are registered trademarks of Khronos Group Inc. +Other names are for informational purposes only and are used to identify companies and products and may be trademarks of their respective owners. +Website Access to Our SEC Filings and Corporate Governance Documents +On the Investor Relations pages of our Website, http://ir.amd.com , we post links to our filings with the SEC, our Principles of Corporate Governance, our Code of Ethics for our executive officers, all other senior finance executives and certain representatives from legal and internal audit, our Worldwide Standards of Business Conduct, which applies to our Board of Directors and all of our employees, and the charters of the Audit and Finance, Compensation and Leadership Resources, Nominating and Corporate Governance and Innovation and Technology committees of our Board of Directors. Our filings with the SEC are posted as soon as reasonably practical after they are electronically filed with, or furnished to, the SEC. You can also obtain copies of these documents by writing to us at: Corporate Secretary, AMD, 7171 Southwest Parkway, M/S B100.T, Austin, Texas 78735, or emailing us at: Corporate.Secretary@amd.com . All of these documents and filings are available free of charge. +If we make substantive amendments to our Code of Ethics or grant any waiver, including any implicit waiver, to our principal executive officer, principal financial officer, principal accounting officer, controller or persons performing similar functions, we intend to disclose the nature of such amendment or waiver on our Website. +The information contained on our Website is not incorporated by reference in, or considered to be a part of, this report. +2 +Our Industry +We are a global semiconductor company. Semiconductors are components used in a variety of electronic products and systems. An integrated circuit (IC) is a semiconductor device that consists of many interconnected transistors on a single chip. Since the invention of the transistor in 1948, improvements in IC process and design technologies have led to the development of smaller, more complex and more reliable ICs at a lower cost-per-function. +Computing and Graphics +Computing and Graphics Markets +The Computing and Graphics market addresses the need for computational and visual data processing in computing devices that include personal computers, laptops / notebooks, and workstations. We service this market with our CPU, GPU, APU, system-on-chip and chipset product offerings. +Central Processing Unit (CPU) . A microprocessor is an IC that serves as the CPU of a computer. It generally consists of hundreds of millions or billions of transistors that process data in a serial fashion and control other devices in the system, acting as the “brain” of the computer. The performance of a microprocessor is a critical factor impacting the performance of computing and entertainment platforms, such as desktop PCs, notebooks and workstations. The principal elements used to measure CPU performance are work-per-cycle (or how many instructions are executed per cycle), clock speed (representing the rate at which a CPU’s internal logic operates, measured in units of gigahertz, or billions of cycles per second) and power consumption. Other factors impacting microprocessor performance include the process technology used in its manufacture, the number and type of cores, the ability of the cores to process multi-thread or process multiple instructions simultaneously, the bit size of its instruction set, memory size and data access speed. +Developments in IC design and manufacturing process technologies have resulted in significant advances in microprocessor performance. Since businesses and consumers require greater performance from their computer systems due to the growth of digital data and increasingly sophisticated software applications, multi-core microprocessors offer enhanced overall system performance and efficiency because computing tasks can be spread across two or more processing cores, each of which can execute a task at full speed. Multi-core microprocessors can simultaneously increase performance of a computer system without greatly increasing the total amount of power consumed and the total amount of heat emitted. Businesses and consumers also require computer systems with improved power management technology, which helps them to reduce the power consumption of their computer systems, enables smaller and more portable form factors, and can lower the total cost of ownership. +Graphics Processing Unit (GPU). A GPU is a programmable logic chip that helps render images, animations and video and is increasingly being used to handle general computing tasks. GPUs are located in plug-in cards, as a discrete processor or in a chip on the motherboard, or in the same chip as the CPU as part of an accelerated processing unit (APU) or System-on-Chip (SoC). GPUs on stand-alone cards or discrete GPUs on the motherboard typically access their own memory, while GPUs in the chipset or CPU chip share main memory with the CPU. +GPUs perform parallel operations on data to render images for a video display and are essential to presenting computer generated images on that display, decoding and rendering animations and displaying video. The more sophisticated the GPU, the higher the resolution and the faster and smoother moving objects can be displayed on a video display or in a virtual environment (e.g. virtual reality (VR) and augmented reality (AR)). +In addition to graphics processing, GPUs are used to perform parallel operations on multiple sets of data and are increasingly used to perform vector processing for non-graphics applications that require repetitive computations such as high-performance computing (HPC), deep learning, artificial and machine intelligence, blockchain and various other applications (e.g., cryptocurrency mining and autonomous driving). +Accelerated Processing Unit (APU). Consumers increasingly demand computing devices with improved end-user experience, system performance and energy efficiency. Consumers also continue to demand thinner and lighter mobile devices, with better performance and longer battery life. We believe that a computing architecture that optimizes the use of its components can provide these improvements. +An APU is a processing unit that integrates a CPU and a GPU onto one chip (or one piece of silicon), along with, in some cases, other special-purpose components. This integration enhances system performance by “offloading” selected tasks to the best-suited component (i.e. the CPU or the GPU) to optimize component use, increasing the +3 +speed of data flow between the CPU and GPU through shared memory and allowing the GPU to function as both a graphics engine and an application accelerator. Having the CPU and GPU on the same chip also typically improves energy efficiency by, for example, eliminating connections between discrete chips. +System-on-Chip (SoC) . An SoC is a type of IC with a CPU, GPU and other components, such as a memory controller and peripheral management, comprising a complete computing system on a single chip. By combining all of these elements as an SoC, system performance and energy efficiency are improved, similar to an APU. +Chipset. A chipset is a generic term referring to a device or a collection of devices that allow the microprocessor to connect to a wider range of peripheral devices in the system (such as storage, optical drives, and Universal Serial Bus (USB) peripherals). Chipsets can perform essential logic functions and operate in concert with the microprocessor to manage system control and power management functions of all the devices in the system. Chipsets are most often found in larger form factor systems, typically desktop systems or larger notebook platforms, which require the expanded peripheral selection that is enabled by the chipset. Typical notebook platforms and small form factor desktop platforms usually do not utilize a chipset and instead rely on the capabilities of the APU to connect to all the required devices on the platform. +Our Computing and Graphics Products +Our microprocessors are incorporated into computing platforms, which are a collection of technologies that are designed to work together to provide a more complete computing solution. We believe that integrated, balanced computing platforms consisting of microprocessors, chipsets (either as discrete devices or integrated into an SoC) and GPUs (either as discrete GPUs or integrated into an APU or SoC) that work together at the system level bring end users improved system stability, increased performance and enhanced power efficiency. In addition, we believe our customers also benefit from an all-AMD platform (consisting of an APU or CPU, a discrete GPU, and a chipset when needed), as we are able to optimize interoperability, provide our customers a single point of contact for the key platform components and enable them to bring the platforms to market quickly in a variety of PC and server system form factors. +We currently base our microprocessors and chipsets on the x86 instruction set architecture and the AMD Infinity Fabric™, which connects an on-chip memory controller and input/output (I/O) channels directly to one or more microprocessor cores. We typically integrate two or more processor cores onto a single die, and each core has its own dedicated cache, which is memory that is located on the semiconductor die, permitting quick access to frequently used data and instructions. Some of our microprocessors have additional levels of cache such as L2, or second-level cache, and L3, or third-level cache, to enable fast data access and high-performance. +We focus on continually improving the energy efficiency of our products through our design principles and innovations in power management technology. To that end, we offer CPUs, GPUs, APUs, SoCs and chipsets with multiple low power states that are designed to utilize lower clock speeds and voltages to reduce processor power consumption during active and idle times. The use of intelligent, dynamic power management is designed to create lower energy use by allowing compute applications to be completed quickly and efficiently, enabling a return to the ultra-low power idle state. +Desktop. Our microprocessors for desktop platforms currently include the AMD Ryzen™ series processors and AMD Athlon™ processors. In April 2020, we expanded our 3rd Gen AMD Ryzen desktop processor family by adding AMD Ryzen 3 3100 and AMD Ryzen 3 3300X processors with “Zen 2” core architecture to business users, gamers and creators. In June 2020, we announced further additions to the 3rd Gen AMD Ryzen desktop processor family, by introducing the AMD Ryzen 9 3900XT, AMD Ryzen 7 3800XT and AMD Ryzen 5 3600XT desktop processors designed for the enthusiast market. In July 2020, we introduced for the consumer market, the AMD Ryzen 4000 series desktop processors and the AMD Athlon 3000 series desktop processors with built-in Radeon™ graphics. The AMD Ryzen 4000 G-Series desktop processors offer power efficiency for consumers, gamers, streamers and creators and include multi-layered security features. The AMD Athlon 3000 G-Series desktop processors provide responsive performance and features for entry-level PCs using “Zen” core architecture. In October 2020, we introduced the AMD Ryzen 5000 Series desktop processor family powered by “Zen 3” core architecture. The AMD Ryzen 5000 Series processors have up to 16 cores and deliver across the board leadership performance for gamers and content creators. +Notebooks and 2-in-1s. We continue to invest in designing and developing high performing and low power APUs for notebook PC platforms and we offer AMD Ryzen and AMD Athlon mobile processors for the consumer and commercial markets. In January 2020, we introduced the AMD Ryzen 4000 Series Mobile Processors for ultrathin and gaming laptops designed to deliver performance and power efficiency. In September 2020, we introduced the +4 +first mobile AMD Ryzen and AMD Athlon processors for Chromebooks. The AMD Ryzen and Athlon 3000 C-Series mobile processors are designed to enable thinner and lighter Chromebook designs with long battery life and enhanced connectivity. +Commercial. We offer enterprise-class desktop and notebook PC solutions sold as AMD PRO Mobile and AMD PRO desktop processors with Radeon graphics for the commercial market. These solutions are designed to provide enterprise customers with the performance, security capabilities and business features such as enhanced security and manageability, platform longevity and extended image stability. In May 2020, we announced the global availability of the AMD Ryzen PRO 4000 series mobile family for commercial notebooks built with enterprise-grade AMD PRO technologies, which deliver a set of security and manageability features for Enterprise IT deployments. In July 2020, we introduced the AMD Ryzen PRO 4000 series and AMD Athlon PRO 3000 series desktop processors with built-in Radeon graphics for the commercial market. Also in July, we announced the new AMD Ryzen Threadripper™ PRO Processor family with up to 64 cores and built with enterprise grade AMD PRO technologies. Designed for professional workstations from OEMs and system integrators, AMD Ryzen Threadripper PRO processors offer full spectrum compute capabilities for multi-threaded workloads and high frequency single core performance for lightly threaded workloads. +Chipsets. We offer a full suite of chipset products, including the X570 chipset which supports PCIe® 4.0 (fourth generation Peripheral Component Interconnect Express motherboard interface) designed for enthusiast desktop platforms. We also introduced the B550 chipset in April 2020 and the A520 chipset in July 2020 for socket AM4 for 3rd Gen AMD Ryzen desktop processors and 5000 processors. In addition, we continue to offer the B450 and A320 chipsets that are combined with AMD Ryzen processors for the AM4 desktop platform for the performance and affordable mainstream platforms segments. In the High-End Desktop (HEDT) and Workstation segments, we offer the TRX40 and the WRX80 chipsets, respectively, to support the 3rd generation Ryzen Threadripper and Threadripper Pro platforms offering high speed I/O and platform bandwidth. +Graphics Market +The semiconductor graphics market addresses the need for improved visual and data processing in various computing devices. Many consumers use PCs as entertainment platforms, in addition to traditional productivity and communications uses, and therefore value a richer, more visually compelling and immersive experience. As a result, visual realism and graphical display capabilities are key product differentiation elements among computing devices. This has led to the increased creation and use of processing-intensive multimedia content for playing games, capturing media, viewing online videos, editing photos and managing digital content on computing devices. In turn, these trends have contributed to higher consumer demand for performance graphics solutions and to manufacturers designing computing devices with these capabilities. Industries that utilize computer assisted design (CAD), that develop content for media and entertainment markets and that generate professional visualizations and renderings can benefit greatly from graphics solutions optimized for the professional graphics market. +In addition to traditional graphics markets, there is a large and growing demand for accelerated computing, powered by graphics processors in markets such as high performance computing (HPC), artificial intelligence, and Cloud Visualization (Virtual Desktop Infrastructure & Cloud Gaming). Traditional HPC focused on scientific research, model simulation, and exploration is driving an increased need for computing throughput at universities and government research centers. Artificial intelligence is a rapidly growing area of machine learning and deep learning workloads. Graphics processors are used primarily in the training of machine learning models. The cloud visualization market is fueled by the trend to in work from home and thus the increased need for remote accessibility, and the shift from traditional desktop and notebook workloads to the cloud. The expansion of compute workloads on graphics processors is driving market expansion for traditional graphics silicon. +Another area of the market for graphics compute is blockchain technology, which is a decentralized digital ledger used to securely store, transmit and process sensitive and valuable data. Blockchain applications are typically performed using specially designed application-specific integrated circuits (ASICs) or a general purpose CPU or GPU. +Our Graphics Products +Graphics processing is a fundamental component of almost everything we create and can be found in an APU, GPU, SoC or a combination of a discrete GPU with one of the other foregoing products working in tandem. Our customers generally use our graphics solutions to enable or increase the speed of rendering images, to help improve image resolution and color definition, and increasingly to process massive data sets for cloud and data +5 +center applications. We develop our graphics products for use in various computing devices and entertainment platforms, including desktop PCs, notebook PCs, 2-in-1s, All-in-Ones (AIOs), professional workstations, and the data center. With each of our graphics products, we have available drivers and supporting software packages that enable the effective use of these products under a variety of operating systems and applications. We have developed RDNA™ 2, a high performing and power efficient graphics architecture, which is the foundation for next-generation PC gaming graphics, the PlayStation 5 and Xbox Series S and X consoles. Additionally, the RDNA 2 architecture supports advanced graphics features such as ray tracing, Infinity Cache and variable rate shading. Our hardware and software components are used to implement ray tracing technology to simulate the paths of light rays moving through a movie or game scene, resulting in photorealistic 3D images. +Our APUs deliver visual processing functionality for value and mainstream PCs by integrating a CPU and a GPU on a single chip, while discrete GPUs (which are also known as dGPUs) offer high-performance graphics processing across all platforms. AMD Accelerated Parallel Processing or General Purpose GPU (GPGPU) refers to a set of advanced hardware and software technologies that enable discrete AMD GPUs, working in concert with the CPU, to accelerate computational tasks beyond traditional CPU processing by utilizing the vast number of discrete GPU cores while working with the CPU to process information cooperatively. In addition, computing devices with heterogeneous computing features can run computationally-intensive tasks more efficiently, which we believe provides a superior application experience to the end user. Moreover, heterogeneous computing allows for the elevation of the GPU to the same level as the CPU for memory access, queuing, and execution. +Discrete Desktop and Notebook Graphics . Our discrete GPUs for desktop and notebook PCs support current generation application program interfaces (APIs) like DirectX® 12 Ultimate and Vulkan®, support new displays using AMD FreeSync™, AMD FreeSync Premium, and AMD FreeSync Premium Pro technologies, and are designed to support VR in PC platforms. In August 2020, we announced the availability of the new AMD Radeon Pro 5000 series GPUs for the updated 27-inch iMac bringing a wide variety of graphically intensive applications and workloads to consumer and professional users. In October 2020, we unveiled the AMD Radeon RX™ 6000 series graphics cards for enthusiast-class PC gaming experiences. The AMD Radeon RX 6000 series includes the AMD Radeon RX 6800 and Radeon RX 6800 XT graphics cards as well as the Radeon RX 6900 XT built upon the AMD RDNA 2 gaming architecture that spans from game consoles to PCs. The AMD RDNA 2 GPUs feature enhancements in the compute unit, advancements in the visual pipeline, and the introduction of a new high-speed cache called AMD Infinity Cache. These architecture enhancements enable ultra-high performance and ultra-high fidelity in the latest games. Complimenting the introduction of the new AMD RX 6000 Series graphics cards, AMD introduced AMD Smart Access Memory, which when combined with an AMD Ryzen 5000 series processor, offers an incremental performance boost in many games. +Professional Graphics. Our AMD Radeon Pro family of professional graphics products includes multi-view graphics cards and GPUs designed for integration in mobile and desktop workstations. AMD Radeon Pro graphics cards are designed for demanding use cases such as design and manufacturing for CAD, and media and entertainment for broadcast and animation pipelines. AMD Radeon Pro supports end users utilizing GPU accelerated visualization for construction, architecture and mechanical design through gaming and visualization engines on high resolution displays; Radeon VR Creator cards are also capable of supporting this functionality with VR and AR. Software drivers for AMD Radeon Pro cards are designed to deliver high stability and performance across a wide variety of software packages including those requiring professional software vendor certifications. In February 2020, we announced the AMD Radeon Pro W5500 workstation graphics card for Design & Manufacturing and Architecture, Engineering & Construction (AEC) professionals. We also announced the AMD Radeon Pro W5500M GPU designed and optimized to power next-generation, high-performance professional mobile workstations. In May 2020, we announced the AMD Radeon Pro VII workstation graphics card for broadcast and engineering professionals. In June 2020, we announced the AMD Radeon Pro 5600M mobile GPU built with 7 nanometer (nm) process technology and advanced AMD RDNA architecture for pro applications, including video editing, color grading, application development, game creation and more. +Data Center Graphics . We offer two families of products to accelerate workloads in the data center. Our visual cloud data center GPUs include a range of solutions tailored towards workloads requiring remote visualization, such as Desktop-as-a-Service, Workstation-as-a-Service and Cloud Gaming. These GPUs are designed to cover the full range of graphical application acceleration, from light desktop tasks, to workstation tasks, multi-GPU high end rendering, and cloud gaming activities. Our software solutions carry certification for a number of professional software vendor applications as well as being optimized for modern gaming titles. In December 2020 Amazon Web Services announced and made available their new “G4ad” instance, designed for graphics intensive applications such as virtual workstations, game streaming and graphics rendering. G4ad utilizes both AMD EPYC processors and the AMD Radeon Pro V520 GPU. The AMD Radeon Pro V520 is the first AMD RDNA based, 7 nm GPU +6 +released for cloud environments. +Our AMD Radeon Instinct™ and AMD Instinct family of GPU products are specifically designed to address growing demand for compute-oriented data center applications, including deep learning training and traditional HPC workloads such as simulation where the compute capabilities of GPUs provide exceptional flexibility and performance. Combined with our ROCm™ open software platform, our customers can deliver differentiated acceleration platforms to address the next-generation of computing challenges while minimizing power and space needs in the data center. In November 2020, we announced the AMD Instinct MI100 accelerator built on the new AMD CDNA™ architecture. The MI100 GPU is built to accelerate workloads in the scientific computing and AI markets. +Enterprise, Embedded and Semi-Custom +The Enterprise, Embedded and Semi-Custom Markets +The Enterprise, Embedded and Semi-Custom Markets address the need for computational and visual data processing in the Server, Embedded computing device, and custom designed computing device markets. We service these markets with our CPU, GPU, APU, and customized designed system-on-chips products. +Server. A server is a computer system that performs services for connected customers as part of a client-server architecture. Many servers are designed to run an application or applications often for extended periods of time with minimal human intervention. Examples of servers include cloud, web, e-mail, print and on-premise servers. These servers can run a variety of applications, including business intelligence, enterprise resource planning, customer relationship management and advanced scientific or engineering models to solve advanced computational problems in disciplines ranging from financial modeling to weather forecasting to oil and gas exploration. Servers are also used in cloud computing, which is a computing model where data, applications and services are delivered over the internet or an intranet which can be rapidly provisioned and released with minimal effort. Today’s data centers require new technologies and configuration models to meet the demand driven by the growing amount of data that needs to be stored, accessed, analyzed and managed. Servers must be efficient, scalable and adaptable to meet the compute characteristics of new and changing workloads. +Embedded . Embedded products address computing needs in enterprise-class telecommunications, networking, security, storage systems and thin clients (which are computers that serve as an access device on a network). Typically, AMD embedded products are used in applications that require high to moderate levels of performance, where key features may include relatively low power, small form factor, and 24x7 operations. High-performance graphics are important in some embedded systems. Support for Linux ® , Windows ® and other operating systems as well as for increasingly sophisticated applications are also critical for some customers. Other requirements may include meeting rigid specifications for industrial temperatures, shock, vibration and reliability. The embedded market has moved from developing proprietary, custom designs to leveraging industry-standard instruction set architectures and processors as a way to help reduce costs and speed time to market. +Semi-Custom . We leverage our core IP, including our graphics and processing technologies to develop semi-custom solutions for the PC and gaming markets. In this market, semiconductor suppliers work alongside system designers and manufacturers to enhance the performance and overall user experience for semi-custom customers. We have used this type of collaborative co-development approach with many of today’s leading game console manufacturers and can also address customer needs in many other markets beyond game consoles. We leverage our existing IP to create a variety of products tailored to a specific customer’s needs, ranging from complex fully-customized SoCs to more modest adaptations and integrations of existing CPU, APU or GPU products. +Our Enterprise, Embedded and Semi-Custom Products +Server Processors. Our microprocessors for server platforms currently include the AMD EPYC™ Series processors and AMD Opteron™ X and A-Series processors. The AMD Opteron™ X3000 Series APUs are a family of fully integrated CPU, GPU and I/O designed to provide processing and graphics performance for personal and small business needs. The AMD EPYC 7001 Series of high-performance processors have up to 32 “Zen” compute cores with 2nd Gen AMD EPYC 7002 Series containing up to 64 “Zen 2” compute cores. Both are designed to support a full range of integer, floating point, memory bandwidth and I/O benchmarks and workloads. In April 2020, we announced the extension of the 2nd Gen AMD EPYC processor family with three new processors: AMD EPYC 7F32 (8 cores), AMD EPYC 7F52 (16 cores) and AMD EPYC 7F72 (24 cores). These new processors leverage up to 500 MHz of additional base frequency and large amounts of cache. AMD EPYC processors are powering cloud +7 +instances from leading cloud providers. +Embedded Processors . Our embedded processors are designed to support greater connectivity and security, and we believe they can be a strong driver for the high-performance bandwidth and storage requirements of enterprise and cloud infrastructure and “immersive computing” areas in the computing industry. Our products for embedded platforms include AMD Embedded EPYC CPUs, AMD Embedded V-Series APUs, CPUs and SoCs, AMD Embedded R-Series APUs, CPUs and SoCs, AMD Embedded G-Series SoC platform and AMD Embedded Radeon GPUs. In February 2020, we announced the expansion of the embedded family with two new AMD Ryzen Embedded R1000 low-power processors that provide customers with a thermal design power (TDP) range of 6 up to 10 watts. The AMD Ryzen Embedded R1000 family now includes the Ryzen Embedded R1102G and R1305G processors, designed for efficient power envelopes and giving customers the ability to create fanless systems. In November 2020, we launched the AMD Ryzen Embedded V2000 Series processor built with 7 nm process technology, up to eight “Zen 2” cores and seven AMD Radeon graphics CPU compute units, providing power efficiency and enterprise-class security features for embedded customers. +Semi-Custom . Our semi-custom products are tailored, co-developed, high-performance, customer-specific solutions based on AMD CPU, GPU and multi-media technologies. We work closely with our customers to define solutions to precisely match the requirements of the device or application. We developed the semi-custom SoC products that power both the Sony PlayStation® 4 and Sony PlayStation ® 5 as well as the Microsoft ® Xbox One X, Microsoft ® Xbox One S, Microsoft ® Xbox Series X™ and Xbox Series S™ game consoles. Microsoft and Sony launched their new consoles in November 2020. +Sales and Marketing +We sell our products through our direct sales force and through independent distributors and sales representatives in both domestic and international markets. Our sales arrangements generally operate on the basis of product forecasts provided by the particular customer, but do not typically include any commitment or requirement for minimum product purchases. We primarily use purchase orders, sales order acknowledgments and contractual agreements as evidence of our sales arrangements. Our agreements typically contain standard terms and conditions covering matters such as payment terms, warranties and indemnities for issues specific to our products. +We generally warrant that our products sold to our customers will conform to our approved specifications and be free from defects in material and workmanship under normal use and conditions for one year. We offer up to three-year limited warranties for certain product types, and sometimes provide other warranty periods based on negotiated terms with certain customers. +We market and sell our latest products under the AMD trademark. Our desktop PC microprocessor product brands are AMD Ryzen™, AMD Ryzen™ PRO, Ryzen™ Threadripper™, AMD A-Series, AMD FX™, AMD Athlon™, AMD Athlon™ PRO, and AMD Pro A-Series. Our notebook and 2-in-1s for microprocessors are AMD Ryzen™ processors with Radeon™ Vega Graphics, AMD A-Series, AMD Athlon, AMD Ryzen PRO with Radeon Vega Graphics, AMD Athlon™ PRO with Radeon Vega Graphics and AMD Pro A-Series processors. Our server brands for microprocessors are AMD EPYC™ and AMD Opteron™ processors. We also sell low-power versions of our AMD Opteron, AMD Athlon, as well as AMD Geode™, AMD Ryzen, AMD EPYC, AMD R-Series and G-Series processors as embedded processor solutions. Our product brand for the consumer graphics market is AMD Radeon graphics, and AMD Embedded Radeon graphics is our product brand for the embedded graphics market. Our product brand for professional graphics products are AMD Radeon Pro and AMD FirePro™ graphics. Our product brand for data center graphics is Radeon Instinct™ and AMD Instinct accelerators for servers. We also market and sell our chipsets under AMD trademarks. +We market our products through direct marketing and co-marketing programs. In addition, we have cooperative advertising and marketing programs with customers and third parties, including market development programs, pursuant to which we may provide product information, training, marketing materials and funds. Under our co-marketing development programs, eligible customers can use market development funds as reimbursement for advertisements and marketing programs related to our products and third-party systems integrating our products, subject to meeting defined criteria. +Customers +Our microprocessor customers consist primarily of original equipment manufacturers (OEMs), large public cloud service providers, original design manufacturers (ODMs), system integrators and independent distributors in both +8 +domestic and international markets. ODMs provide design and/or manufacturing services to branded and unbranded private label resellers, OEMs and system builders. Customers of our microprocessor products also include online retailers. Our graphics product customers include the foregoing as well as add-in-board manufacturers (AIBs). +Customers of our chipset products consist primarily of PC OEMs, often through ODMs or other contract manufacturers, who build the OEM motherboards, as well as desktop and server motherboard manufacturers who incorporate chipsets into their channel motherboards. +We work closely with our customers to define product features, performance and timing of new products so that the products we are developing meet our customers’ needs. We also employ application engineers to assist our customers in designing, testing and qualifying system designs that incorporate our products. We believe that our commitment to customer service and design support improves our customers’ time-to-market and fosters relationships that encourage customers to use the next generation of our products. +We also work with our customers to create differentiated products that leverage our CPU, GPU and APU technology. Certain customers pay us non-recurring engineering fees for design and development services and a purchase price for the resulting products. +No single customer accounted for more than 10% of our consolidated net revenue for the year ended December 26, 2020. +Original Equipment Manufacturers +We focus on three types of OEM partners: multi-nationals, selected regional accounts and some local system integrators, who target commercial and consumer end customers of all sizes. Large multi-nationals and regional accounts are the core of our OEM partners’ business; however, a growing focus for us is the Value Added Reseller (VAR) channel which resells OEM systems to the mid-market and the small and medium business (SMB) segments. Our OEM customers include numerous foreign and domestic manufacturers of servers and workstations, desktops, notebooks, PC motherboards and game consoles. +Third-Party Distributors +Our authorized channel distributors resell to sub-distributors and mid-sized and smaller OEMs and ODMs. Typically, distributors handle a wide variety of products, and may include those that compete with our products. Distributors typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions and provide return rights with respect to any product that we have removed from our price book that is less than 12 months older than the manufacturing code date. In addition, some agreements with our distributors may contain standard stock rotation provisions permitting limited levels of product returns. +Add-in-Board (AIB) Manufacturers and System Integrators +We offer component-level graphics and chipset products to AIB manufacturers who in turn build and sell board-level products using our technology to system integrators (SIs), retail buyers and sub distributors. Our agreements with AIBs protect their inventory of our products against price reductions. We also sell directly to our SI customers. SIs typically sell from positions of regional or product-based strength in the market. They usually operate on short design cycles and can respond quickly with new technologies. SIs often use discrete graphics solutions as a means to differentiate their products and add value to their customers. +Competition in the Microprocessor and Chipset Market +Intel Corporation has been the market share leader for microprocessors for many years. Intel’s market share, margins and significant financial resources enable it to market its products aggressively, to target our customers and our channel partners with special incentives and to influence customers who do business with us. Intel exerts substantial influence over computer manufacturers and their channels of distribution through various brand and other marketing programs. Additionally, Intel is able to drive de facto standards and specifications for x86 microprocessors that could cause us and other companies to have delayed access to such standards. We expect Intel to continue to invest heavily in marketing, research and development, new manufacturing facilities and other technology companies. +A variety of companies provide or have developed ARM-based microprocessors and platforms. ARM-based designs +9 +are being used in the PC and server markets, which could lead to further growth and development of the ARM ecosystem. In 2020, Nvidia announced that it had entered into an agreement to acquire ARM Holdings. Nvidia is our principal competitor in the discrete graphics market. Our ability to compete with companies who use ARM-based solutions depends on our ability to timely design and bring to market energy-efficient, high-performing products at an attractive price point. +Competition in the Graphics Markets +In the graphics market, our competitors include suppliers of discrete graphics, embedded graphics processors and integrated graphics processor (IGP) chipsets. Intel manufactures and sells embedded graphics processors and IGP chipsets and is a dominant competitor with respect to this portion of our business. Higher unit shipments of our APUs and Intel’s integrated graphics may drive computer manufacturers to reduce the number of systems they build paired with discrete graphics components, particularly for notebooks, because they may offer satisfactory graphics performance for most mainstream PC users at a lower cost. Intel could take actions that place our discrete GPUs and IGP chipsets at a competitive disadvantage such as providing preferential access to its proprietary graphics interface or other useful information to our competitors in the graphics market or restricting access to external companies, while developing its own high-end discrete GPUs for both consumer and commercial applications. +Our principal competitor in the discrete graphics market is Nvidia and they are considered the market share leader. We believe that the growing complexity of graphics processors and the associated research and development costs represent a high and growing barrier to entry in this market. +Also, Intel has announced that it is developing their own high-end discrete GPUs. +Competition in the Enterprise, Embedded and Semi-Custom Markets +In the server market, we compete against Intel with our CPU server products and Nvidia with our GPU server products. +In the data center, our principal competitor is Nvidia as the adoption of its proprietary CUDA software platform established its market share in HPC and machine learning. Another competitor is Intel as it builds products for acceleration in the data center, such as Intel Xe or Habana AI processors. Other competitors include numerous deep learning accelerator companies, consisting mostly of early to late stage start-ups. Large cloud service providers have also shown interest in building their own products to accelerate AI. +We are the market share leader in semi-custom game console products, where graphics performance is critical, and where we compete primarily against Nvidia. +Research and Development +We focus our research and development activities on improving product performance and enhancing product design. Our main area of focus is on delivering the next generation of CPU and GPU IP, and designing that IP into our SoCs for our next generation of products, with, in each case, improved system performance and performance-per-watt characteristics. For example, we are focusing on improving the battery life of our APU products for notebooks and the performance and power efficiency of our discrete GPUs and our microprocessors for servers. Another important area of focus is on HPC. HPC has traditionally been synonymous with scientific computing and supercomputers, but we are seeing a blurring of boundaries between HPC and machine learning along with high-performance CPU and GPU deployments going into workstations and cloud computing data centers as well as supercomputers. We are also focusing on delivering a range of low-power integrated platforms to serve key markets, including commercial clients, mobile computing and gaming. We believe these platforms will bring customers increased performance and energy efficiency. We also work on advanced memory technologies. As SoC technology advances, the memory can sometimes limit CPU performance and we work on improving memory technology to improve performance. Another area of focus is machine intelligence which is the platform for the growing field of machine learning. Our CPUs, GPUs, accelerators, and APUs offer the computation capability and the flexibility required for various deployments of machine learning . We also work with industry leaders on process technology, software and other functional intellectual property and with others in the industry and industry consortia to conduct early stage research and development. We conduct product and system research and development activities for our products in the United States with additional design and development engineering teams located in Canada, China, India, Taiwan and Singapore who undertake specific activities at the direction of our U.S. headquarters. +10 +Manufacturing Arrangements and Assembly and Test Facilities +Third-Party Wafer Foundry Facilities +We have foundry arrangements with Taiwan Semiconductor Manufacturing Company Limited (TSMC) for the production of wafers for certain products, including the production of all our 7 nm products. +We are also a party to a Wafer Supply Agreement (WSA) with GLOBALFOUNDRIES Inc. (GF), pursuant to which we are required to purchase all of our microprocessor and APU product requirements, and a certain portion of our GPU products, from GF manufactured at process nodes larger than 7 nm, with limited exceptions. +Other Third-Party Manufacturers +We outsource board-level graphics product manufacturing to third-party manufacturers. +Assembly, Test, Mark and Packaging Facilities +Wafers for our products are delivered from third-party foundries to our assembly, test, mark and packaging partners located in the Asia-Pacific region who package and test our final semiconductor products. We are party to two assembly, test, mark and pack (ATMP) joint ventures (collectively, the ATMP JVs) with Tongfu Microelectronics Co., Ltd. The majority of our ATMP services are provided by the ATMP JVs. +Intellectual Property and Licensing +We rely on contracts and intellectual property rights to protect our products and technologies from unauthorized third-party copying and use. Intellectual property rights include copyrights, patents, patent applications, trademarks, trade secrets and mask work rights. As of December 26, 2020, we had approximately 4,200 patents in the United States and approximately 1,000 patent applications pending in the United States. In certain cases, we have filed corresponding applications in foreign jurisdictions. Including United States and foreign matters, we have approximately 10,600 patent matters worldwide consisting of approximately 7,500 issued patents and 3,000 patent applications pending. We expect to file future patent applications in both the United States and abroad on significant inventions, as we deem appropriate. We do not believe that any individual patent, or the expiration of any patent, is or would be material to our business. +As is typical in the semiconductor industry, we have numerous cross-licensing and technology exchange agreements with other companies under which we both transfer and receive technology and intellectual property rights. One such agreement is the cross-license agreement that we entered into with Intel on November 11, 2009. Under the cross-license agreement, we granted to Intel and Intel granted to us, non-exclusive, royalty-free licenses to all of each other’s patents that were first filed no later than November 11, 2014 and each party can exploit these patents anywhere in the world for making and selling certain semiconductor- and electronic-related products. Under the cross-license agreement, Intel has rights to make semiconductor products for third parties, but the third-party product designs are not licensed as a result of such manufacture. We have rights to perform assembly and testing for third parties but not rights to make semiconductor products for third parties. The term of the cross-license agreement continues until the expiration of the last to expire of the licensed patents, unless earlier terminated. A party can terminate the cross-license agreement or the rights and licenses of the other party if the other party materially breaches the cross-license agreement and does not correct the noticed material breach within 60 days. Upon such termination, the terminated party’s license rights terminate but the terminating party’s license rights continue, subject to that party’s continued compliance with the terms of the cross-license agreement. The cross-license agreement will automatically terminate if a party undergoes a change of control (as defined in the cross-license agreement), and both parties’ licenses will terminate. Upon the bankruptcy of a party, that party may assume, but may not assign, the cross-license agreement, and in the event that the cross-license agreement cannot be assumed, the cross-license agreement and the licenses granted will terminate. +Backlog +Sales are made primarily pursuant to purchase orders for current delivery or agreements covering purchases over a period of time. Although such orders or agreements may provide visibility into future quarters, they may not necessarily be indicative of actual sales for any succeeding period as some of these orders or agreements may be revised or canceled without penalty. With respect to our semi-custom SoC products, our orders and agreements are more stringent resulting in meaningful backlog for the coming quarter. +11 +Seasonality +Our operating results tend to vary seasonally. Historically, our net revenue has been generally higher in the second half of the year than in the first half of the year, although market conditions and product transitions could impact these trends. +Human Capital +As of December 26, 2020, we had approximately 12,600 employees in our global workforce. We believe we are at our best when our culture of innovation, creative minds and people from all kinds of backgrounds work together in an engaging and open environment. Areas of focus for us include the following: +Mission, Culture, and Engagement +Our History - Founded in 1969 as a Silicon Valley start-up, the AMD journey began with dozens of employees focused on leading-edge semiconductor products. From those modest beginnings, we have grown into a global company achieving many important industry firsts along the way. Today, we develop high-performance computing and visualization products to solve some of the world’s toughest and most interesting challenges. +Our Vision - High performance computing is transforming our lives. +Our Mission - Build great products that accelerate next-generation computing experiences. +Our employees are driven by this vision and mission. Innovation occurs when creative minds and diverse perspectives from all over the world work together. This is the foundation of our unique culture and the reason why AMD employees are among the most engaged in our industry. +We conduct a confidential annual survey of our global workforce to measure our culture, engagement, and manager quality. The results are reviewed by the AMD Board of Directors and acted upon by our senior leadership team and individual managers at every level. Results from our 2020 survey reported continued improvement across all categories, and scores were among the very best for global companies in the technology industry. Our employees described our culture as innovative, open, and respectful, and rated the quality of our managers among the top 10% of our technology industry peers. +Belonging and Inclusion +Our diverse and inclusive workforce encourages employees to share their opinions and different perspectives. We believe that building a diverse talent pipeline, encouraging a culture of respect and belonging, and increasing inclusion of unique and underrepresented voices makes AMD stronger. AMD’s Employee Resource Groups encourage employee engagement and play an important role in our culture. +We are focused on hiring and developing under-represented minorities and women leaders. We are proud to be led by a highly regarded CEO who has won many esteemed awards for her business and technical prowess. In 2020, Lisa Su received the chip industry’s highest honor as the 2020 recipient of the Robert N. Noyce Award. Dr. Su also ranked #2 on Fortune’s Businessperson of the Year list for her strategic vision and successful company turn around. +Total Rewards +We invest in our workforce by offering competitive salaries, incentives, and benefits that are determined based on employee’s preferences. Our incentives are meritocracy-based and we have a strong pay for performance culture that we believe drives superior results. We benchmark our total rewards annually to ensure our compensation and benefit programs remain competitive with our peers. +Development +We offer our employees opportunities to advance their careers at AMD. We are focused on leadership progression and encourage our employees take advantage of new opportunities. Our manager and leadership development programs are highly rated and we provide specialized development programs for our employees. +Environmental Regulations +Our operations and properties have in the past been and continue to be subject to various United States and foreign laws and regulations, including those relating to materials used in our products and manufacturing processes, +12 +discharge of pollutants into the environment, the treatment, transport, storage and disposal of solid and hazardous wastes and remediation of contamination. These laws and regulations require our suppliers to obtain permits for operations making our products, including the discharge of air pollutants and wastewater. Although our management systems are designed to oversee our suppliers’ compliance, we cannot assure you that our suppliers have been or will be at all times in complete compliance with such laws, regulations and permits. If our suppliers violate or fail to comply with any of them, a range of consequences could result, including fines, suspension of production, alteration of manufacturing processes, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions. We could also be held liable for any and all consequences arising out of exposure to hazardous materials used, stored, released, disposed of by us or located at, under or emanating from our facilities or other environmental or natural resource damage. While we have budgeted for foreseeable associated expenditures, we cannot assure you that future environmental legal requirements will not become more stringent or costly in the future. Therefore, we cannot assure you that our costs of complying with current and future environmental and health and safety laws, and our liabilities arising from past and future releases of, or exposure to, hazardous substances will not have a material adverse effect on us. +Environmental laws are complex, change frequently and have tended to become more stringent over time. For example, the European Union (EU) and China are two among a growing number of jurisdictions that have enacted restrictions on the use of lead and other materials in electronic products. These regulations affect semiconductor devices and packaging. As regulations restricting materials in electronic products continue to increase around the world, there is a risk that the cost, quality and manufacturing yields of products that are subject to these restrictions, may be less favorable compared to products that are not subject to such restrictions, or that the transition to compliant products may not meet customer roadmaps, or produce sudden changes in demand, which may result in excess inventory. A number of jurisdictions including the EU, Australia, California and China are developing or have finalized market entry or public procurement regulations for computers and servers based on ENERGY STAR specifications as well as additional energy consumption limits. There is the potential for certain of our products being excluded from some of these markets which could materially adversely affect us. +Certain environmental laws, including the U.S. Comprehensive, Environmental Response, Compensation and Liability Act of 1980, or the Superfund Act, impose strict or, under certain circumstances, joint and several liability on current and previous owners or operators of real property for the cost of removal or remediation of hazardous substances and impose liability for damages to natural resources. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. These environmental laws also assess liability on persons who arrange for hazardous substances to be sent to disposal or treatment facilities when such facilities are found to be contaminated. Such persons can be responsible for cleanup costs even if they never owned or operated the contaminated facility. +We are named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, we have discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, we received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. We have entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. We remain responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, we have computed and recorded an estimated environmental liability of approximately $4 million and have not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. Costs could also increase as a result of additional test and remediation obligations imposed by the Environmental Protection Agency or California Regional Water Quality Control Board. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. We believe that the potential liability, if any, in excess of amounts already accrued, will not have a material adverse effect on our financial condition, cash flows or results of operations. +13 +ITEM 1A. RISK FACTORS +The risks and uncertainties described below are not the only ones we face. If any of the following risks actually occurs, our business, financial condition or results of operations could be materially adversely affected. In addition, you should consider the interrelationship and compounding effects of two or more risks occurring simultaneously. +Risk Factors Summary +The following is a summary of the principal risks that could adversely affect our business, operations and financial results. +Economic and Strategic Risks +• Intel Corporation’s dominance of the microprocessor market and its aggressive business practices may limit our ability to compete effectively on a level playing field. +• Global economic and market uncertainty may adversely impact our business and operating results. +• The loss of a significant customer may have a material adverse effect on us. +• The ongoing novel coronavirus (COVID-19) pandemic could materially adversely affect our business, financial condition and results of operations. +• The markets in which our products are sold are highly competitive. +• Our operating results are subject to quarterly and seasonal sales patterns. +• The demand for our products depends in part on the market conditions in the industries into which they are sold. Fluctuations in demand for our products or a market decline in any of these industries could have a material adverse effect on our results of operations. +• The semiconductor industry is highly cyclical and has experienced severe downturns that have materially adversely affected, and may continue to materially adversely affect, our business in the future. +• If we cannot adequately protect our technology or other intellectual property in the United States and abroad, through patents, copyrights, trade secrets, trademarks and other measures, we may lose a competitive advantage and incur significant expenses. +• Unfavorable currency exchange rate fluctuations could adversely affect us. +Operational and Technology Risks +• We rely on third parties to manufacture our products, and if they are unable to do so on a timely basis in sufficient quantities and using competitive technologies, our business could be materially adversely affected. +• Failure to achieve expected manufacturing yields for our products could negatively impact our financial results. +• If essential equipment, materials, substrates or manufacturing processes are not available to manufacture our products, we could be materially adversely affected. +• The success of our business is dependent upon our ability to introduce products on a timely basis with features and performance levels that provide value to our customers while supporting and coinciding with significant industry transitions. +• Our receipt of revenue from our semi-custom SoC products is dependent upon our semi-custom SoC products being incorporated into customer’s products and the success of those products. +• Our products may be subject to security vulnerabilities that could have a material adverse effect on us. +• IT outages, data loss, data breaches and cyber-attacks could compromise our intellectual property or other sensitive information, be costly to remediate or cause significant damage to our business, reputation and operations. +• Uncertainties involving the ordering and shipment of our products could materially adversely affect us. +• Our ability to design and introduce new products in a timely manner is dependent upon third-party intellectual property. +• We depend on third-party companies for the design, manufacture and supply of motherboards, software, memory and other computer platform components to support our business. +• If we lose Microsoft Corporation’s support for our products or other software vendors do not design and develop software to run on our products, our ability to sell our products could be materially adversely affected. +• Our reliance on third-party distributors and AIB partners subjects us to certain risks. +• Our business is dependent upon the proper functioning of our internal business processes and information systems and modification or interruption of such systems may disrupt our business, processes and internal controls. +14 +• If our products are not compatible with some or all industry-standard software and hardware, we could be materially adversely affected. +• Costs related to defective products could have a material adverse effect on us. +• If we fail to maintain the efficiency of our supply chain as we respond to changes in customer demand for our products, our business could be materially adversely affected. +• We outsource to third parties certain supply-chain logistics functions, including portions of our product distribution, transportation management and information technology support services. +• Our inability to effectively control the sales of our products on the gray market could have a material adverse effect on us. +Legal and Regulatory Risks +• Government actions and regulations such as export administration regulations, tariffs, and trade protection measures, may limit our ability to export our products to certain customers. +• If we cannot realize our deferred tax assets, our results of operations would be adversely affected +• Our business is subject to potential tax liabilities. +• We are party to litigation and may become a party to other claims or litigation that could cause us to incur substantial costs or pay substantial damages or prohibit us from selling our products. +• We are subject to environmental laws, conflict minerals-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as a variety of other laws or regulations that could result in additional costs and liabilities. +Xilinx Merger and Acquisition Risks +• Acquisitions, joint ventures and/or investments, including our recently announced acquisition of Xilinx, and the failure to integrate acquired businesses, could disrupt our business and/or dilute or adversely affect the price of our common stock. +• Our ability to complete the Merger is subject to closing conditions, including approval by our and Xilinx’s stockholders and the receipt of consents and approvals from governmental authorities, which may impose conditions that could adversely affect us or cause the Merger not to be completed. +• Whether or not it is completed, the announcement and pendency of the Merger could cause disruptions in our business, which could have an adverse effect on our business and financial results. +• Any impairment of the combined company’s tangible, definite-lived intangible or indefinite-lived intangible assets, including goodwill, may adversely impact the combined company’s financial position and results of operations. +Liquidity and Capital Resources Risks +• The agreements governing our notes and our Revolving Credit Facility impose restrictions on us that may adversely affect our ability to operate our business. +• Our indebtedness could adversely affect our financial position and prevent us from implementing our strategy or fulfilling our contractual obligations. +• We may not be able to generate sufficient cash to service our debt obligations or meet our working capital requirements. +• In the event of a change of control, we may not be able to repurchase our outstanding debt as required by the applicable indentures and our Revolving Credit Facility, which would result in a default under the indentures and our Revolving Credit Facility. +• If we cannot generate sufficient revenue and operating cash flow or obtain external financing, we may face a cash shortfall and be unable to make all of our planned investments in research and development or other strategic investments. +General Risks +• Our worldwide operations are subject to political, legal and economic risks and natural disasters, which could have a material adverse effect on us. +• We may incur future impairments of goodwill and technology license purchases. +• Our inability to continue to attract and retain qualified personnel may hinder our business. +• Our stock price is subject to volatility. +• Worldwide political conditions may adversely affect demand for our products. +For a more complete discussion of the material risks facing our business, see below. +15 +Economic and Strategic Risks +Intel Corporation’s dominance of the microprocessor market and its aggressive business practices may limit our ability to compete effectively on a level playing field. +Intel Corporation has been the market share leader for microprocessors for many years. Intel’s market share, margins and significant financial resources enable it to market its products aggressively, to target our customers and our channel partners with special incentives and to influence customers who do business with us. These aggressive activities have in the past resulted in lower unit sales and a lower average selling price for many of our products and adversely affect our margins and profitability. +Intel exerts substantial influence over computer manufacturers and their channels of distribution through various brand and other marketing programs. As a result of Intel’s position in the microprocessor market, Intel has been able to control x86 microprocessor and computer system standards and benchmarks and to dictate the type of products the microprocessor market requires of us. Intel also dominates the computer system platform, which includes core logic chipsets, graphics chips, networking devices (wired and wireless), non-volatile storage and other components necessary to assemble a computer system. Additionally, Intel is able to drive de facto standards and specifications for x86 microprocessors that could cause us and other companies to have delayed access to such standards. +As long as Intel remains in this dominant position, we may be materially adversely affected by Intel’s business practices, including rebating and allocation strategies and pricing actions, designed to limit our market share and margins; product mix and introduction schedules; product bundling, marketing and merchandising strategies; exclusivity payments to its current and potential customers, retailers and channel partners; de facto control over industry standards, and heavy influence on PC manufacturers and other PC industry participants, including motherboard, memory, chipset and basic input/output system (BIOS) suppliers and software companies as well as the graphics interface for Intel platforms; and marketing and advertising expenditures in support of positioning the Intel brand over the brand of its original equipment manufacturer (OEM) customers and retailers. +Intel has substantially greater financial resources than we do and accordingly spends substantially greater amounts on marketing and research and development than we do. We expect Intel to continue to invest heavily in marketing, research and development, new manufacturing facilities and other technology companies. To the extent Intel manufactures a significantly larger portion of its microprocessor products using more advanced process technologies, or introduces competitive new products into the market before we do, we may be more vulnerable to Intel’s aggressive marketing and pricing strategies for microprocessor products. +Intel could also take actions that place our discrete graphics processing units (GPUs) at a competitive disadvantage, including giving one or more of our competitors in the graphics market, such as Nvidia Corporation, preferential access to its proprietary graphics interface or other useful information. Also, Intel has announced that it is developing their own high-end discrete GPUs. Intel’s position in the microprocessor market and integrated graphics chipset market, its introduction of competitive new products, its existing relationships with top-tier OEMs, and its aggressive marketing and pricing strategies could result in lower unit sales and lower average selling prices for our products, which could have a material adverse effect on us. +Global economic and market uncertainty may adversely impact our business and operating results. +Uncertain global economic conditions have in the past and may in the future adversely impact our business, including, without limitation, a slowdown in the Chinese economy, one of the largest global markets for desktop and notebook PCs. Uncertainty in the worldwide economic environment may negatively impact consumer confidence and spending causing our customers to postpone purchases. In addition, during challenging economic times, our current or potential future customers may experience cash flow problems and as a result may modify, delay or cancel plans to purchase our products. Additionally, if our customers are not successful in generating sufficient revenue or are unable to secure financing, they may not be able to pay, or may delay payment of, accounts receivable that they owe us. The risk related to our customers’ potentially defaulting on or delaying payments to us is increased because we expect that a small number of customers will continue to account for a substantial part of our revenue. Any inability of our current or potential future customers to pay us for our products may adversely affect our earnings and cash flow. Moreover, our key suppliers may reduce their output or become insolvent, thereby adversely impacting our ability to manufacture our products. In addition, uncertain economic conditions may +16 +make it more difficult for us to raise funds through borrowings or private or public sales of debt or equity securities. +The loss of a significant customer may have a material adverse effect on us. +We depend on a small number of customers for a substantial portion of our business and we expect that a small number of customers will continue to account for a significant part of our revenue in the future. If one of our key customers decides to stop buying our products, or if one of these customers materially reduces its operations or its demand for our products, our business would be materially adversely affected. +The ongoing novel coronavirus (COVID-19) pandemic could materially adversely affect our business, financial condition and results of operations. +The COVID-19 pandemic has caused government authorities to implement numerous public health measures, including quarantines, business closures, travel bans, and restrictions related to social gathering and mobility, to contain the virus. We have experienced and expect to continue to experience disruptions to our business as these measures have, and will continue to have, an effect on our business operations and practices. +While many of our offices around the world remain open, either because the pandemic has been contained in that location or to enable critical on-site business functions in compliance with government guidelines, most of our employees continue to work from home until further notice. It is uncertain as to when the measures put in place to attempt to contain the spread of COVID-19 will be lifted or whether there will be additional measures put into place. If COVID-19 continues to spread or if there are further waves of the virus, we may need to further limit operations or modify our business practices in a manner that may impact our business. If our employees are not able to perform their job duties due to self-isolation, quarantine, travel restrictions or illness, or are unable to perform them as efficiently at home for an extended period of time, we may not be able to meet our product schedules, roadmaps and customer commitments and we may experience an overall lower productivity of our workforce. We continue to monitor our operations and public health measures implemented by governmental authorities in response to COVID-19. Although some public health measures have eased and a small portion of our employees are at work in certain offices, our efforts to reopen our offices safely may not be successful and could expose our employees to health risks. Even when COVID-19 measures regarding mobility are lifted or modified, our employees’ ability to return to work may delay the return of our full workforce and the resumption of normal business operations. +We have experienced some disruptions to parts of our supply chain as the result of COVID-19. We continue to monitor demand signals as we adjust our supply chain requirements based on changing customer needs and demands. If the supply of our products to customers is delayed, reduced or canceled due to disruptions encountered by our third-party manufacturing, suppliers or vendors as a result of facility closures, border and port closures, and mobility limitations put on their workforces, it could have a material adverse effect on our business. +COVID-19 has in the short-term and may in the long-term adversely impact the global economy, potentially leading to an economic downturn. This could negatively impact consumer confidence and spending causing our customers to postpone or cancel purchases, or delay paying or default on payment of outstanding amounts due to us, which may have a material adverse effect on our business. For example, we experienced some softness in PC-related sales in China, one of the largest global markets for desktop and notebook PCs, during the first quarter of 2020. Also, we experienced some delays in payments from customers due to COVID-19 during the first half of 2020. +COVID-19 has also led to a disruption and volatility in the global capital and financial markets. While we believe our cash, cash equivalents and short-term investments along with our Revolving Credit Facility will be sufficient to fund operations, including capital expenditures, over the next 12 months, to the extent we may require additional funding to finance our operations and capital expenditures and such funding may not be available to us as a result of contracting capital and financial markets resulting from COVID-19, it may have an adverse effect on our business. +The extent to which COVID-19 impacts our business and financial results will depend on future developments, which are unpredictable and highly uncertain, including the continued spread, duration and severity of the outbreak, the breadth and duration of business disruptions related to COVID-19, the availability and distribution of effective vaccines, and public health measures and actions taken throughout the world to contain COVID-19. The prolonged effect of COVID-19 could materially adversely impact our business, financial condition and results of operations. +The markets in which our products are sold are highly competitive. +The markets in which our products are sold are very competitive and delivering the latest and best products to market on a timely basis is critical to achieving revenue growth. We believe that the main factors that determine our +17 +product competitiveness are timely product introductions, product quality, product features and capabilities (including enabling state-of-the-art visual and virtual reality experiences), energy efficiency (including power consumption and battery life), reliability, processor clock speed, performance, size (or form factor), selling price, cost, adherence to industry standards (and the creation of open industry standards), level of integration, software and hardware compatibility, security and stability, brand recognition and availability. +We expect that competition will continue to be intense due to rapid technological changes, frequent product introductions by our competitors or new competitors of products that may provide better performance/experience or that may include additional features that render our products comparatively less competitive. We may also face aggressive pricing by competitors, especially during challenging economic times. In addition, our competitors have significant marketing and sales resources which could increase the competitive environment in a declining market, leading to lower prices and margins. Some competitors may have greater access or rights to complementary technologies, including interface, processor and memory technical information. For instance, with our APU products and other competing solutions with integrated graphics, we believe that demand for additional discrete graphics chips and cards may decrease in the future due to improvements in the quality and performance of integrated graphics. If competitors introduce competitive new products into the market before us, demand for our products could be adversely impacted and our business could be adversely affected. In addition, Intel is seeking to expand its position in integrated graphics for the PC market with high-end discrete graphics solutions for a broad range of computing segments, which may negatively impact our ability to compete in these computing segments. +In addition, we are entering markets with current and new competitors who may be able to adapt more quickly to customer requirements and emerging technologies. We cannot assure you that we will be able to compete successfully against current or new competitors who may have stronger positions in these new markets or superior ability to anticipate customer requirements and emerging industry trends. Furthermore, we may face competition from some of our customers who internally develop the same products as us. We may face delays or disruptions in research and development efforts, or we may be required to invest significantly greater resources in research and development than anticipated. Also, the semiconductor industry has seen several mergers and acquisitions over the last number of years. Further consolidation could adversely impact our business due to there being fewer suppliers, customers and partners in the industry. +Our operating results are subject to quarterly and seasonal sales patterns. +The profile of our sales may be weighted differently during the year. A large portion of our quarterly sales have historically been made in the last month of the quarter. This uneven sales pattern makes prediction of revenue for each financial period difficult and increases the risk of unanticipated variations in quarterly results and financial condition. In addition, our operating results tend to vary seasonally with the markets in which our products are sold. For example, historically, our net revenue has been generally higher in the second half of the year than in the first half of the year, although market conditions and product transitions could impact these trends. Many of the factors that create and affect quarterly and seasonal trends are beyond our control. +The demand for our products depends in part on the market conditions in the industries into which they are sold. Fluctuations in demand for our products or a market decline in any of these industries could have a material adverse effect on our results of operations. +Industry-wide fluctuations in the computer marketplace have materially adversely affected us in the past and may materially adversely affect us in the future. A large portion of our Computing and Graphics revenue is focused on the consumer desktop PC and notebook segments, which have in the past experienced a decline driven by, among other factors, the adoption of smaller and other form factors, increased competition and changes in replacement cycles. The success of our semi-custom SoC products is dependent on securing customers for our semi-custom design pipeline and consumer market conditions, including the success of the Sony PlayStation®4, Sony PlayStation®4 Pro, Microsoft® Xbox One™ S and Microsoft® Xbox One™ X game console systems and next generation consoles for Sony and Microsoft, worldwide. In addition, the GPU market has at times seen elevated demand due to the application of GPU products to cryptocurrency mining. For example, our GPU revenue has been affected in part by the volatility of the cryptocurrency mining market. Demand for cryptocurrency has changed and is likely to continue to change quickly. For example, China and South Korea have instituted restrictions on cryptocurrency trading and the valuations of the currencies, and corresponding interest in mining of such currencies are subject to significant fluctuations. Alternatively, countries may create, or in the case of China are creating, their own cryptocurrencies or equivalents that could also impact interest in mining. If we are unable to manage the risks related to the volatility of the cryptocurrency mining market, our GPU business could be materially adversely affected. +18 +The semiconductor industry is highly cyclical and has experienced severe downturns that have materially adversely affected, and may continue to materially adversely affect, our business in the future. +The semiconductor industry is highly cyclical and has experienced significant downturns, often in conjunction with constant and rapid technological change, wide fluctuations in supply and demand, continuous new product introductions, price erosion and declines in general economic conditions. We have incurred substantial losses in recent downturns, due to substantial declines in average selling prices; the cyclical nature of supply and demand imbalances in the semiconductor industry; a decline in demand for end-user products (such as PCs) that incorporate our products; and excess inventory levels. +Industry-wide fluctuations in the computer marketplace have materially adversely affected us in the past and may materially adversely affect us in the future. Global economic uncertainty and weakness have in the past impacted the semiconductor market as consumers and businesses have deferred purchases, which negatively impacted demand for our products. Our financial performance has been, and may in the future be, negatively affected by these downturns. +The growth of our business is also dependent on continued demand for our products from high-growth adjacent emerging global markets. Our ability to be successful in such markets depends in part on our ability to establish adequate local infrastructure, as well as our ability to cultivate and maintain local relationships in these markets. If demand from these markets is below our expectations, sales of our products may decrease, which would have a material adverse effect on us. +If we cannot adequately protect our technology or other intellectual property in the United States and abroad, through patents, copyrights, trade secrets, trademarks and other measures, we may lose a competitive advantage and incur significant expenses. +We rely on a combination of protections provided by contracts, including confidentiality and nondisclosure agreements, copyrights, patents, trademarks and common law rights, such as trade secrets, to protect our intellectual property. However, we cannot assure you that we will be able to adequately protect our technology or other intellectual property from third-party infringement or from misappropriation in the United States and abroad. Any patent licensed by us or issued to us could be challenged, invalidated or circumvented or rights granted there under may not provide a competitive advantage to us. Also, due to measures to slow down the outbreak of COVID-19, various patent offices and courts have been adversely impacted and there is a potential for delay or disruptions that might affect certain of our patent rights. +Furthermore, patent applications that we file may not result in issuance of a patent or, if a patent is issued, the patent may not be issued in a form that is advantageous to us. Despite our efforts to protect our intellectual property rights, others may independently develop similar products, duplicate our products or design around our patents and other rights. In addition, it is difficult to monitor compliance with, and enforce, our intellectual property on a worldwide basis in a cost-effective manner. In jurisdictions where foreign laws provide less intellectual property protection than afforded in the United States and abroad, our technology or other intellectual property may be compromised, and our business would be materially adversely affected. +Unfavorable currency exchange rate fluctuations could adversely affect us. +We have costs, assets and liabilities that are denominated in foreign currencies. As a consequence, movements in exchange rates could cause our foreign currency denominated expenses to increase as a percentage of revenue, affecting our profitability and cash flows. Whenever we believe appropriate, we hedge a portion of our short-term foreign currency exposure to protect against fluctuations in currency exchange rates. We determine our total foreign currency exposure using projections of long-term expenditures for items such as payroll. We cannot assure you that these activities will be effective in reducing foreign exchange rate exposure. Failure to do so could have an adverse effect on our business, financial condition, results of operations and cash flow. In addition, the majority of our product sales are denominated in U.S. dollars. Fluctuations in the exchange rate between the U.S. dollar and the local currency can cause increases or decreases in the cost of our products in the local currency of such customers. An appreciation of the U.S. dollar relative to the local currency could reduce sales of our products. +19 +Operational and Technology Risks +We rely on third parties to manufacture our products, and if they are unable to do so on a timely basis in sufficient quantities and using competitive technologies, our business could be materially adversely affected. +We rely on third-party wafer foundries to fabricate the silicon wafers for all of our products. For the production of wafers for certain products, including the production of all our 7 nanometer (nm) products, we use Taiwan Semiconductor Manufacturing Company Limited (TSMC). We purchase wafers for all our CPU and APU products, and wafers for a certain portion of our GPU products manufactured at process nodes larger than 7 nm, with limited exceptions, from GLOBALFOUNDRIES, Inc. (GF). We also rely on third-party manufacturers to assemble, test, mark and pack (ATMP) our products. It is important to have reliable relationships with all of these third-party manufacturing suppliers to ensure adequate product supply to respond to customer demand. +We cannot guarantee that these manufacturers or our other third-party manufacturing suppliers will be able to meet our near-term or long-term manufacturing requirements. If we experience supply constraints from our third-party manufacturing suppliers, we may be required to allocate the affected products amongst our customers, which could have a material adverse effect on our relationships with these customers and on our financial condition. In addition, if we are unable to meet customer demand due to fluctuating or late supply from our manufacturing suppliers, it could result in lost sales and have a material adverse effect on our business. For example, if TSMC is not able to manufacture wafers for our 7 nm products in sufficient quantities to meet customer demand, it could have a material adverse effect on our business. +We do not have long-term commitment contracts with some of our third-party manufacturing suppliers. We obtain some of these manufacturing services on a purchase order basis and these manufacturers are not required to provide us with any specified minimum quantity of product beyond the quantities in an existing purchase order. Accordingly, we depend on these suppliers to allocate to us a portion of their manufacturing capacity sufficient to meet our needs, to produce products of acceptable quality and at acceptable manufacturing yields and to deliver those products to us on a timely basis and at acceptable prices. The manufacturers we use also fabricate wafers and ATMP products for other companies, including certain of our competitors. They could choose to prioritize capacity for other customers, increase the prices that they charge us on short notice or reduce or eliminate deliveries to us, which could have a material adverse effect on our business. +Other risks associated with our dependence on third-party manufacturers include limited control over delivery schedules and quality assurance, lack of capacity in periods of excess demand, misappropriation of our intellectual property, dependence on several subcontractors, and limited ability to manage inventory and parts. Moreover, if any of our third-party manufacturers suffer any damage to facilities, lose benefits under material agreements, experience power outages, lack sufficient capacity to manufacture our products, encounter financial difficulties, are unable to secure necessary raw materials from their suppliers, suffer any other disruption or reduction in efficiency, or experience uncertain social economic or political circumstances or conditions, we may encounter supply delays or disruptions. If we are unable to secure sufficient or reliable supplies of products, our ability to meet customer demand may be adversely affected and this could materially affect our business. +If we transition the production of some of our products to new manufacturers, we may experience delayed product introductions, lower yields or poorer performance of our products. If we experience problems with product quality or are unable to secure sufficient capacity from a particular third-party manufacturer, or if we for other reasons cease utilizing one of those suppliers, we may be unable to secure an alternative supply for any specific product in a short time frame. We could experience significant delays in the shipment of our products if we are required to find alternative third-party manufacturers, which could have a material adverse effect on our business. +We are a party to a wafer supply agreement (WSA) with GF that governs the terms by which we purchase products manufactured by GF and is in place until 2024. Pursuant to the WSA, we are required to purchase wafers for all of our CPU and APU product requirements and wafers for a certain portion of our GPU product requirements from GF manufactured at process nodes larger than 7 nm, with limited exceptions. We have agreed to minimum annual wafer purchase targets through 2021. If we fail to meet the agreed wafer purchase target during a calendar year, we will be required to pay to GF a portion of the difference between our actual wafer purchases and the applicable annual purchase target. If our actual wafer requirements are less than the number of wafers required to meet the applicable annual wafer purchase target, we could have excess inventory or higher inventory unit costs, both of which may adversely impact our gross margin and our results of operations. We could experience significant delays +20 +in the shipment of our products if we are required to find alternative third-party manufacturers, which could have a material adverse effect on our business. +We are party to two ATMP joint ventures (collectively, the ATMP JVs) with Tongfu Microelectronics Co., Ltd. The majority of our ATMP services are provided by the ATMP JVs and there is no guarantee that the ATMP JVs will be able to fulfill our long-term ATMP requirements. If we are unable to meet customer demand due to fluctuating or late supply from the ATMP JVs, it could result in lost sales and have a material adverse effect on our business. +Failure to achieve expected manufacturing yields for our products could negatively impact our financial results. +Semiconductor manufacturing yields are a result of both product design and process technology, which is typically proprietary to the manufacturer, and low yields can result from design failures, process technology failures or a combination of both. Our third-party foundries are responsible for the process technologies used to fabricate silicon wafers. If our third-party foundries experience manufacturing inefficiencies or encounter disruptions, errors or difficulties during production, we may fail to achieve acceptable yields or experience product delivery delays. We cannot be certain that our third-party foundries will be able to develop, obtain or successfully implement leading-edge process technologies needed to manufacture future generations of our products profitably or on a timely basis or that our competitors will not develop new technologies, products or processes earlier. Moreover, during periods when foundries are implementing new process technologies, their manufacturing facilities may not be fully productive. A substantial delay in the technology transitions to smaller process technologies could have a material adverse effect on us, particularly if our competitors transition to more cost effective technologies before us. For example, we are presently focusing our 7 nm product portfolio on TSMC’s 7 nm process. If TSMC is not able to manufacture wafers for our 7 nm products in sufficient quantities to meet customer demand, it could have a material adverse effect on our business. +Any decrease in manufacturing yields could result in an increase in per unit costs, which would adversely impact our gross margin and/or force us to allocate our reduced product supply amongst our customers, which could harm our relationships and reputation with our customers and materially adversely affect our business. +If essential equipment, materials, substrates or manufacturing processes are not available to manufacture our products, we could be materially adversely affected. +We may purchase equipment, materials and substrates for use by our back-end manufacturing service providers from a number of suppliers and our operations depend upon obtaining deliveries of adequate supplies of equipment and materials on a timely basis. Our third-party suppliers also depend on the same timely delivery of adequate quantities of equipment and materials in the manufacture of our products. In addition, as many of our products increase in technical complexity, we rely on our third-party suppliers to update their processes in order to continue meeting our back-end manufacturing needs. Certain equipment and materials that are used in the manufacture of our products are available only from a limited number of suppliers, or in some cases, a sole supplier. We also depend on a limited number of suppliers to provide the majority of certain types of integrated circuit packages for our microprocessors, including our APU products. Similarly, certain non-proprietary materials or components such as memory, printed circuit boards (PCBs), interposers, substrates and capacitors used in the manufacture of our products are currently available from only a limited number of sources. If we are unable to procure a stable supply of substrates on an ongoing basis and at reasonable costs to meet our production requirements, we could experience a shortage in substrate supply or an increase in production costs, which could have a material adverse effect on our business. Because some of the equipment and materials that we and our third-party manufacturing suppliers purchase are complex, it is sometimes difficult to substitute one supplier for another. From time to time, suppliers may extend lead times, limit supply or increase prices due to capacity constraints or other factors. Also, some of these materials and components may be subject to rapid changes in price and availability. Interruption of supply or increased demand in the industry could cause shortages and price increases in various essential materials. Dependence on a sole supplier or a limited number of suppliers exacerbates these risks. If we are unable to procure certain of these materials for our back-end manufacturing operations, or our third-party foundries or manufacturing suppliers are unable to procure materials for manufacturing our products, our business would be materially adversely affected. +The success of our business is dependent upon our ability to introduce products on a timely basis with features and performance levels that provide value to our customers while supporting and coinciding with significant industry transitions. +Our success depends to a significant extent on the development, qualification, implementation and acceptance of +21 +new product designs and improvements that provide value to our customers. Our ability to develop, qualify and distribute, and have manufactured, new products and related technologies to meet evolving industry requirements, at prices acceptable to our customers and on a timely basis are significant factors in determining our competitiveness in our target markets. As consumers have new product feature preferences or have different requirements than those consumers in the PC market, PC sales could be negatively impacted, which could adversely impact our business. Our product roadmap includes our next generation AMD Ryzen™, AMD Radeon™ and AMD EPYC™ processors using 7 nm process technology. We cannot assure you that our efforts to execute our product roadmap will result in innovative products and technologies that provide value to our customers. If we fail to or are delayed in developing, qualifying or shipping new products or technologies that provide value to our customers and address these new trends or if we fail to predict which new form factors consumers will adopt and adjust our business accordingly, we may lose competitive positioning, which could cause us to lose market share and require us to discount the selling prices of our products. Although we make substantial investments in research and development, we cannot be certain that we will be able to develop, obtain or successfully implement new products and technologies on a timely basis or that they will be well-received by our customers. Moreover, our investments in new products and technologies involve certain risks and uncertainties and could disrupt our ongoing business. New investments may not generate sufficient revenue, may incur unanticipated liabilities and may divert our limited resources and distract management from our current operations. We cannot be certain that our ongoing investments in new products and technologies will be successful, will meet our expectations and will not adversely affect our reputation, financial condition and operating results. +Delays in developing, qualifying or shipping new products can also cause us to miss our customers’ product design windows or, in some cases, breach contractual obligations or cause us to pay penalties. If our customers do not include our products in the initial design of their computer systems or products, they will typically not use our products in their systems or products until at least the next design configuration. The process of being qualified for inclusion in a customer’s system or product can be lengthy and could cause us to further miss a cycle in the demand of end-users, which also could result in a loss of market share and harm our business. We also depend on the success and timing of our customers’ platform launches. If our customers delay their product launches or if our customers do not effectively market their platforms with our products, it could result in a delay in bringing our products to market and cause us to miss a cycle in the demand of end-users, which could materially adversely affect our business. In addition, market demand requires that products incorporate new features and performance standards on an industry-wide basis. Over the life of a specific product, the sale price is typically reduced over time. The introduction of new products and enhancements to existing products is necessary to maintain the overall corporate average selling price. If we are unable to introduce new products with sufficiently high sale prices or to increase unit sales volumes capable of offsetting the reductions in the sale prices of existing products over time, our business could be materially adversely affected. +Our receipt of revenue from our semi-custom SoC products is dependent upon our semi-custom SoC products being incorporated into customer’s products and the success of those products. +The revenue that we receive from our semi-custom SoC products is in the form of non-recurring engineering fees charged to third parties for design and development services and revenue received in connection with sales of our semi-custom SoC products to these third parties. As a result, our ability to generate revenue from our semi-custom products depends on our ability to secure customers for our semi-custom design pipeline, our customers’ desire to pursue the project and our semi-custom SoC products being incorporated into those customer’s products. Any revenue from sales of our semi-custom SoC products is directly related to sales of the third-party’s products and reflective of their success in the market. Moreover, we have no control over the marketing efforts of these third parties, and we cannot make any assurances that sales of their products will be successful in current or future years. Consequently, the semi-custom SoC product revenue expected by us may not be fully realized and our operating results may be adversely affected. +Our products may be subject to security vulnerabilities that could have a material adverse effect on us. +The products that we sell are complex and may be subject to security vulnerabilities that could result in, among other things, the loss, corruption, theft or misuse of confidential data or system performance issues. Our efforts to prevent and address security vulnerabilities may decrease performance, be only partially effective or not successful at all. We may also depend on third parties, such as customers, vendors and end users, to deploy our mitigations or create their own, and they may delay, decline or modify the implementation of such mitigations. Our relationships with our customers could be adversely affected as some of our customers may stop purchasing our products, reduce or delay future purchases of our products, or use competing products. Any of these actions by our customers could adversely affect our revenue. We also are subject to claims and litigation related to Spectre side- +22 +channel exploits and may face additional claims or litigation for future vulnerabilities. Actual or perceived security vulnerabilities of our products may subject us to adverse publicity, damage to our brand and reputation, and could materially harm our business or financial results. +IT outages, data loss, data breaches and cyber-attacks could compromise our intellectual property or other sensitive information, be costly to remediate or cause significant damage to our business, reputation and operations. +In the ordinary course of our business, we maintain sensitive data on our information technology (IT) assets, and also may maintain sensitive information on our business partners’ and third-party providers’ IT assets, including our intellectual property and proprietary or confidential business information relating to our business and that of our customers and business partners. Maintaining the security of this information is important to our business and reputation. We believe that companies like AMD have been increasingly subject to a wide variety of security incidents, cyber-attacks, hacking and phishing attacks, business and system disruption attacks, and other attempts to gain unauthorized access. These threats can come from a variety of sources, all ranging in sophistication from an individual hacker or insider threat to a state-sponsored attack. Cyber threats may be generic, or they may be custom-crafted against our information systems. Cyber-attacks have become increasingly more prevalent and much harder to detect, defend against or prevent. Our network and storage applications, as well as those of our customers, business partners, and third-party providers, may be subject to unauthorized access by hackers or breached due to operator error, malfeasance or other system disruptions. +It is often difficult to anticipate or immediately detect such incidents and the damage caused by such incidents. These data breaches and any unauthorized access, misuse or disclosure of our information or intellectual property could compromise our intellectual property and expose sensitive business information. Cyber-attacks on us or our customers, business partners or third-party providers could also cause us to incur significant remediation costs, result in product development delays, disrupt key business operations and divert attention of management and key information technology resources. These incidents could also subject us to liability, expose us to significant expense and cause significant harm to our reputation and business. +We also maintain confidential and personally identifiable information about our workers and consumers. The confidentiality and integrity of our worker and consumer data is important to our business and our workers and consumers have a high expectation that we adequately protect their personal information. +We anticipate ongoing and increasing costs related to: enhancing and implementing information security controls, including costs related to upgrading application, computer, and network security components; training workers to maintain and monitor our security controls; remediating any data security breach and addressing the related litigation; mitigating reputational harm; and compliance with external regulations, such as the European Union’s General Data Protection Regulation and the California Consumer Privacy Act. +We often partner with third-party providers for certain worker services and we may provide certain limited worker information to such third parties based on the scope of the services provided to us. However, if these third parties fail to adopt or adhere to adequate data security practices, or in the event of a breach of their networks, our workers’ data may be improperly accessed, used or disclosed. +A breach of data privacy may cause significant disruption of our business operations. Failure to adequately maintain and update our security systems could materially adversely affect our operations and our ability to maintain worker confidence. Failure to prevent unauthorized access to electronic and other confidential information, IT outages, data loss and data breaches could materially adversely affect our financial condition, our competitive position and operating results. +Uncertainties involving the ordering and shipment of our products could materially adversely affect us. +We typically sell our products pursuant to individual purchase orders. We generally do not have long-term supply arrangements with our customers or minimum purchase requirements except that orders generally must be for standard pack quantities. Generally, our customers may cancel orders for standard products more than 30 days prior to shipment without incurring significant fees. We base our inventory levels in part on customers’ estimates of demand for their products, which may not accurately predict the quantity or type of our products that our customers will want in the future or ultimately end up purchasing. Our ability to forecast demand is even further complicated when our products are sold indirectly through downstream channel distributors and customers, as our forecasts for demand are then based on estimates provided by multiple parties throughout the downstream channel. +23 +Many of our markets are characterized by short product lifecycles, which can lead to rapid obsolescence and price erosion. In addition, our customers may change their inventory practices on short notice for any reason. We may build inventories during periods of anticipated growth, and the cancellation or deferral of product orders or overproduction due to failure of anticipated orders to materialize could result in excess or obsolete inventory, which could result in write-downs of inventory and an adverse effect on gross margins. +Factors that may result in excess or obsolete inventory, which could result in write-downs of the value of our inventory, a reduction in the average selling price or a reduction in our gross margin include: a sudden or significant decrease in demand for our products; a production or design defect in our products; a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements; a failure to accurately estimate customer demand for our products, including for our older products as our new products are introduced; or our competitors introducing new products or taking aggressive pricing actions. +Our ability to design and introduce new products in a timely manner is dependent upon third-party intellectual property. +In the design and development of new and enhanced products, we rely on third-party intellectual property such as development and testing tools for software and hardware. Furthermore, certain product features may rely on intellectual property acquired from third parties. The design requirements necessary to meet customer demand for more features and greater functionality from semiconductor products may exceed the capabilities of the third-party intellectual property or development or testing tools available to us. If the third-party intellectual property that we use becomes unavailable, is not available with required functionality or performance in the time frame, manufacturing technology, or price point needed for our new products or fails to produce designs that meet customer demands, our business could be materially adversely affected. +We depend on third-party companies for the design, manufacture and supply of motherboards, software, memory and other computer platform components to support our business. +We depend on third-party companies for the design, manufacture and supply of motherboards, graphics cards, software (e.g., BIOS, operating systems, drivers), memory and other components that our customers utilize to support and/or use our microprocessor, GPU and APU offerings. We also rely on our add-in-board (AIB) partners to support our GPU and APU products. In addition, our microprocessors are not designed to function with motherboards and chipsets designed to work with Intel microprocessors. If the designers, manufacturers, AIBs and suppliers of motherboards, graphics cards, software, memory and other components cease or reduce their design, manufacture or production of current or future products that are based on or support our products, our business could be materially adversely affected. +If we lose Microsoft Corporation’s support for our products or other software vendors do not design and develop software to run on our products, our ability to sell our products could be materially adversely affected. +Our ability to innovate beyond the x86 instruction set controlled by Intel depends partially on Microsoft designing and developing its operating systems to run on or support our x86-based microprocessor products. With respect to our graphics products, we depend in part on Microsoft to design and develop its operating system to run on or support our graphics products. Similarly, the success of our products in the market, such as our APU products, is dependent on independent software providers designing and developing software to run on our products. If Microsoft does not continue to design and develop its operating systems so that they work with our x86 instruction sets or does not continue to develop and maintain their operating systems to support our graphics products, independent software providers may forego designing their software applications to take advantage of our innovations and customers may not purchase PCs with our products. In addition, some software drivers licensed for use with our products are certified by Microsoft. If Microsoft did not certify a driver, or if we otherwise fail to retain the support of Microsoft or other software vendors, our ability to market our products would be materially adversely affected. +Our reliance on third-party distributors and AIB partners subjects us to certain risks. +We market and sell our products directly and through third-party distributors and AIB partners pursuant to agreements that can generally be terminated for convenience by either party upon prior notice to the other party. These agreements are non-exclusive and permit both our distributors and AIB partners to offer our competitors’ products. We are dependent on our distributors and AIB partners to supplement our direct marketing and sales efforts. If any significant distributor or AIB partner or a substantial number of our distributors or AIB partners +24 +terminated their relationship with us, decided to market our competitors’ products over our products or decided not to market our products at all, our ability to bring our products to market would be impacted and we would be materially adversely affected. In addition, if we are unable to collect accounts receivable from our significant distributors and/or AIB partners, it could have a material adverse effect on our business. If we are unable to manage the risks related to the use of our third-party distributors and AIB partners or offer appropriate incentives to focus them on the sale of our products, our business could be materially adversely affected. +Additionally, distributors and AIB partners typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions, as well as provide return rights for any product that we have removed from our price book and that is not more than 12 months older than the manufacturing date. Some agreements with our distributors also contain standard stock rotation provisions permitting limited levels of product returns. Our agreements with AIB partners protect their inventory of our products against price reductions. In the event of a significant decline in the price of our products, the price protection rights we offer would materially adversely affect us because our revenue and corresponding gross margin would decline. +Our business is dependent upon the proper functioning of our internal business processes and information systems and modification or interruption of such systems may disrupt our business, processes and internal controls. +We rely upon a number of internal business processes and information systems to support key business functions, and the efficient operation of these processes and systems is critical to our business. Our business processes and information systems need to be sufficiently scalable to support the growth of our business and may require modifications or upgrades that expose us to a number of operational risks. As such, our information systems will continually evolve and adapt in order to meet our business needs. These changes may be costly and disruptive to our operations and could impose substantial demands on management time. +These changes may also require changes in our information systems, modification of internal control procedures and significant training of employees and third-party resources. We continuously work on simplifying our information systems and applications through consolidation and standardization efforts. There can be no assurance that our business and operations will not experience any disruption in connection with this transition. Our information technology systems, and those of third-party information technology providers or business partners, may also be vulnerable to damage or disruption caused by circumstances beyond our control including catastrophic events, power anomalies or outages, natural disasters, viruses or malware, cyber-attacks, data breaches and computer system or network failures, exposing us to significant cost, reputational harm and disruption or damage to our business. +In addition, as our IT environment continues to evolve, we are embracing new ways of communicating and sharing data internally and externally with customers and partners using methods such as mobility and the cloud that can promote business efficiency. However, these practices can also result in a more distributed IT environment, making it more difficult for us to maintain visibility and control over internal and external users, and meet scalability and administrative requirements. If our security controls cannot keep pace with the speed of these changes, or if we are not able to meet regulatory and compliance requirements, our business would be materially adversely affected. +If our products are not compatible with some or all industry-standard software and hardware, we could be materially adversely affected. +Our products may not be fully compatible with some or all industry-standard software and hardware. Further, we may be unsuccessful in correcting any such compatibility problems in a timely manner. If our customers are unable to achieve compatibility with software or hardware, we could be materially adversely affected. In addition, the mere announcement of an incompatibility problem relating to our products could have a material adverse effect on our business. +Costs related to defective products could have a material adverse effect on us. +Products as complex as those we offer may contain defects or failures when first introduced or when new versions or enhancements to existing products are released. We cannot assure you that, despite our testing procedures, errors will not be found in new products or releases after commencement of commercial shipments in the future, which could result in loss of or delay in market acceptance of our products, material recall and replacement costs, loss of revenue, writing down the inventory of defective products, the diversion of the attention of our engineering personnel from product development efforts, defending against litigation related to defective products or related liabilities, including property damage, personal injury, damage to our reputation in the industry and loss of data or +25 +intangible property, and could adversely affect our relationships with our customers. In addition, we may have difficulty identifying the end customers of the defective products in the field. As a result, we could incur substantial costs to implement modifications to correct defects. Any of these problems could materially adversely affect our business. +We could be subject to potential product liability claims if one of our products causes, or merely appears to have caused, an injury, whether tangible or intangible. Claims may be made by consumers or others selling our products, and we may be subject to claims against us even if an alleged injury is due to the actions of others. A product liability claim, recall or other claim with respect to uninsured liabilities or for amounts in excess of insured liabilities could have a material adverse effect on our business. +If we fail to maintain the efficiency of our supply chain as we respond to changes in customer demand for our products, our business could be materially adversely affected. +Our ability to meet customer demand for our products depends, in part, on our ability to deliver the products our customers want on a timely basis. Accordingly, we rely on our supply chain for the manufacturing, distribution and fulfillment of our products. As we continue to grow our business, expand to high-growth adjacent markets, acquire new customers and strengthen relationships with existing customers, the efficiency of our supply chain will become increasingly important because many of our customers tend to have specific requirements for particular products, and specific time-frames in which they require delivery of these products. If we are unable to consistently deliver the right products to our customers on a timely basis in the right locations, our customers may reduce the quantities they order from us, which could have a material adverse effect on our business. +We outsource to third parties certain supply-chain logistics functions, including portions of our product distribution, transportation management and information technology support services. +We rely on third-party providers to operate our regional product distribution centers and to manage the transportation of our work-in-process and finished products among our facilities, to our manufacturing suppliers and to our customers. In addition, we rely on third parties to provide certain information technology services to us, including help desk support, desktop application services, business and software support applications, server and storage administration, data center operations, database administration and voice, video and remote access. We cannot guarantee that these providers will fulfill their respective responsibilities in a timely manner in accordance with the contract terms, in which case our internal operations and the distribution of our products to our customers could be materially adversely affected. Also, we cannot guarantee that our contracts with these third-party providers will be renewed, in which case we would have to transition these functions in-house or secure new providers, which could have a material adverse effect on our business if the transition is not executed appropriately. +Our inability to effectively control the sales of our products on the gray market could have a material adverse effect on us. +We market and sell our products directly to OEMs and through authorized third-party distributors. From time to time, our products are diverted from our authorized distribution channels and are sold on the “gray market.” Gray market products result in shadow inventory that is not visible to us, thus making it difficult to forecast demand accurately. Also, when gray market products enter the market, we and our distribution channels compete with these heavily discounted gray market products, which adversely affects demand for our products and negatively impacts our margins. In addition, our inability to control gray market activities could result in customer satisfaction issues because any time products are purchased outside our authorized distribution channels there is a risk that our customers are buying counterfeit or substandard products, including products that may have been altered, mishandled or damaged, or are used products represented as new. +26 +Legal and Regulatory Risks +Government actions and regulations such as export administration regulations, tariffs, and trade protection measures, may limit our ability to export our products to certain customers. +We have equity interests in two joint ventures (collectively, the THATIC JV) with Higon Information Technology Co., Ltd. (THATIC), a third-party Chinese entity. In June 2019, the Bureau of Industry and Security (BIS) of the United States Department of Commerce added certain Chinese entities to the Entity List, including THATIC and the THATIC JV. In October 2019, the BIS added additional Chinese entities to the Entity List. Also, the United States administration has called for changes to domestic and foreign policy. Specifically, United States-China trade relations remain uncertain. The United States administration has announced tariffs on certain products imported into the United States with China as the country of origin, and China has imposed tariffs in response to the actions of the United States. We are taking steps to mitigate the impact of these tariffs on our business and AMD processor-based products. There is also a possibility of future tariffs, trade protection measures, import or export regulations or other restrictions imposed on our products or on our customers by the United States, China or other countries that could have a material adverse effect on our business. A significant trade disruption or the establishment or increase of any tariffs, trade protection measures or restrictions could result in lost sales adversely impacting our reputation and business. +If we cannot realize our deferred tax assets, our results of operations could be adversely affected. +In the fourth quarter of 2020, we reduced the valuation allowance against a significant portion of our deferred tax assets resulting in $1.4 billion of deferred tax assets on our balance sheet. Our deferred tax assets include net operating losses and tax credit carryforwards that can be used to offset taxable income and reduce income taxes payable in future periods. Each quarter, we consider both positive and negative evidence to determine whether all or a portion of the deferred tax assets are more likely than not to be realized. If we determine that some or all of our deferred tax assets are not realizable, it could result in a material expense in the period in which this determination is made which may have a material adverse effect on our financial condition and results of operations. +In addition, a significant amount of our deferred tax assets and a portion of the deferred tax assets related to net operating losses or tax credits which remain under a valuation allowance could be subject to limitations under Internal Revenue Code Section 382 or 383, separate return loss year rules, or dual consolidated loss rules. The limitations could reduce our ability to utilize the net operating losses or tax credits before the expiration of the tax attributes. +Our business is subject to potential tax liabilities. +We are subject to income tax, indirect tax or other tax claims by tax agencies in jurisdictions in which we conduct business. Significant judgment is required in determining our worldwide provision for income taxes. Tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. Any changes to tax laws could have a material adverse effect on our tax obligations and effective tax rate. +In the ordinary course of our business, there are many transactions and calculations where the ultimate income tax, indirect tax, or other tax determination is uncertain. Although we believe our tax estimates are reasonable, we cannot assure that the final determination of any tax audits and litigation will not be materially different from that which is reflected in historical tax provisions and accruals. Should additional taxes be assessed as a result of an audit, assessment or litigation, there could be a material adverse effect on our cash, tax provisions and net income in the period or periods for which that determination is made. +We are party to litigation and may become a party to other claims or litigation that could cause us to incur substantial costs or pay substantial damages or prohibit us from selling our products. +From time to time, we are a defendant or plaintiff in various legal actions. For example, as described in Note 17 of our consolidated financial statements, we have been subject to certain claims concerning federal securities laws and corporate governance. Our products are purchased by and/or used by consumers, which could increase our exposure to consumer actions such as product liability claims and consumer class action claims, including those described in Note 17 of our consolidated financial statements. On occasion, we receive claims that individuals were allegedly exposed to substances used in our former semiconductor wafer manufacturing facilities and that this alleged exposure caused harm. Litigation can involve complex factual and legal questions, and its outcome is uncertain. It is possible that if a claim is successfully asserted against us, including the claims described in Note 17 of our consolidated financial statements, it could result in the payment of damages that could be material to our business. +27 +With respect to intellectual property litigation, from time to time, we have been notified of, or third parties may bring or have brought, actions against us and/or against our customers based on allegations that we are infringing the intellectual property rights of others, contributing to or inducing the infringement of the intellectual property rights of others, improperly claiming ownership of intellectual property or otherwise improperly using the intellectual property of others. If any such claims are asserted, we may seek to obtain a license under the third parties’ intellectual property rights. We cannot assure you that we will be able to obtain all of the necessary licenses on satisfactory terms, if at all. These parties may file lawsuits against us or our customers seeking damages (potentially up to and including treble damages) or an injunction against the sale of products that incorporate allegedly infringed intellectual property or against the operation of our business as presently conducted, which could result in our having to stop the sale of some of our products or to increase the costs of selling some of our products or which could damage our reputation. The award of damages, including material royalty payments, or other types of damages, or the entry of an injunction against the manufacture and sale of some or all of our products could have a material adverse effect on us. We could decide, in the alternative, to redesign our products or to resort to litigation to challenge such claims. Such challenges could be extremely expensive and time-consuming regardless of their merit, could cause delays in product release or shipment and/or could have a material adverse effect on us. We cannot assure you that litigation related to our intellectual property rights or the intellectual property rights of others can always be avoided or successfully concluded. +Even if we were to prevail, any litigation could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could have a material adverse effect on us. +We are subject to environmental laws, conflict minerals-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as a variety of other laws or regulations that could result in additional costs and liabilities. +Our operations and properties have in the past been and continue to be subject to various United States and foreign laws and regulations, including those relating to materials used in our products and manufacturing processes, discharge of pollutants into the environment, the treatment, transport, storage and disposal of solid and hazardous wastes and remediation of contamination. These laws and regulations require our suppliers to obtain permits for operations making our products, including the discharge of air pollutants and wastewater. Although our management systems are designed to oversee our suppliers’ compliance, we cannot assure you that our suppliers have been or will be at all times in complete compliance with such laws, regulations and permits. If our suppliers violate or fail to comply with any of them, a range of consequences could result, including fines, suspension of production, alteration of manufacturing processes, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions. Such non-compliance from our manufacturing suppliers could result in disruptions in supply, higher sourcing costs, and/or reputational damage for us. +Environmental laws are complex, change frequently and have tended to become more stringent over time. For example, the European Union (EU) and China are two among a growing number of jurisdictions that have enacted restrictions on the use of lead and other materials in electronic products. These regulations affect semiconductor devices and packaging. As regulations restricting materials in electronic products continue to increase around the world, there is a risk that the cost, quality and manufacturing yields of products that are subject to these restrictions may be less favorable compared to products that are not subject to such restrictions, or that the transition to compliant products may not meet customer roadmaps, or produce sudden changes in demand, which may result in excess inventory. A number of jurisdictions including the EU, Australia, California and China are developing or have finalized market entry or public procurement regulations for computers and servers based on ENERGY STAR specifications as well as additional energy consumption limits. There is the potential for certain of our products being excluded from some of these markets which could materially adversely affect us. +Certain environmental laws, including the United States Comprehensive, Environmental Response, Compensation and Liability Act of 1980, or the Superfund Act, impose strict or, under certain circumstances, joint and several liability on current and previous owners or operators of real property for the cost of removal or remediation of hazardous substances and impose liability for damages to natural resources. These laws often impose liability even if the owner or operator did not know of, or was not responsible for, the release of such hazardous substances. These environmental laws also assess liability on persons who arrange for hazardous substances to be sent to disposal or treatment facilities when such facilities are found to be contaminated. Such persons can be responsible for cleanup costs even if they never owned or operated the contaminated facility. We have been named as a responsible party at three Superfund sites in Sunnyvale, California. Although we have not yet been, we could be named a potentially responsible party at other Superfund or contaminated sites in the future. In addition, contamination that has not yet been identified could exist at our other facilities. +28 +Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC adopted disclosure and reporting requirements for companies that use “conflict” minerals originating from the Democratic Republic of Congo or adjoining countries. We continue to incur additional costs associated with complying with these requirements, such as costs related to developing internal controls for the due diligence process, determining the source of any conflict minerals used in our products, auditing the process and reporting to our customers and the SEC. In addition to the SEC regulation, the European Union, China and other jurisdictions are developing new policies focused on conflict minerals that may impact and increase the cost of our compliance program. Also, since our supply chain is complex, we may face reputational challenges if we are unable to sufficiently verify the origins of the subject minerals. Moreover, we are likely to encounter challenges to satisfy those customers who require that all of the components of our products be certified as “conflict free.” If we cannot satisfy these customers, they may choose a competitor’s products. +The United States federal government has issued new policies for federal procurement focused on eradicating the practice of forced labor and human trafficking. Germany’s federal procurement office, in collaboration with the Bitkom trade association, issued new supply chain labor requirements. In addition, the United Kingdom, Australia and the State of California have issued laws that require us to disclose our policy and practices for identifying and eliminating forced labor and human trafficking in our supply chain. Several customers as well as the Responsible Business Alliance have also issued expectations to eliminate these practices that may impact us. While we have a policy and management systems to identify and avoid these practices in our supply chain, we cannot guarantee that our suppliers will always be in conformance to these laws and expectations. We may face enforcement liability and reputational challenges if we are unable to sufficiently meet these expectations. Moreover, we are likely to encounter challenges with customers if we cannot satisfy their forced and trafficked labor polices and they may choose a competitor’s product. +Xilinx Merger and Acquisition Risks +Acquisitions, joint ventures and/or investments, including our recently announced acquisition of Xilinx, and the failure to integrate acquired businesses, could disrupt our business and/or dilute or adversely affect the price of our common stock. +Our success will depend, in part, on our ability to expand our product offerings and grow our business in response to changing technologies, customer demands and competitive pressures. In some circumstances, we may pursue growth through the acquisition of complementary businesses, solutions or technologies or through joint ventures or investments rather than through internal development. The identification of suitable acquisition or joint venture candidates can be difficult, time-consuming and costly, and we may not be able to successfully complete identified acquisitions or joint ventures. +For example, on October 26, 2020, we, along with a direct wholly-owned subsidiary of ours, entered into an Agreement and Plan of Merger (the Merger Agreement) with Xilinx, Inc. (Xilinx), whereby we agreed to acquire Xilinx (the Merger). We entered into the Merger Agreement with the belief that the Merger will result in certain benefits, including certain operational synergies and cost efficiencies, and drive product innovations. Achieving these anticipated benefits will depend on successfully combining our and Xilinx’s businesses together. It is not certain that Xilinx’s business can be successfully integrated with our business in a timely manner or at all, or that any of the anticipated benefits will be realized for a variety of reasons, including, but not limited to: failure to obtain applicable regulatory or stockholder approvals in a timely manner or otherwise; failure to satisfy other closing conditions to the Merger; our inability to integrate or benefit from Xilinx’s acquired technologies or services in a profitable manner; diversion of capital and other resources, including management’s attention from our existing business; unanticipated costs or liabilities associated with the Merger; failure to leverage the increased scale of the combined businesses quickly and effectively; coordinating and integrating in countries in which we have not previously operated; the potential impact of the Merger on our relationships with employees, vendors, suppliers and customers; the impairment of relationships with, or the loss of, Xilinx’s employees, vendors, suppliers and customers; adverse changes in general economic conditions in regions in which we and Xilinx operate; potential litigation associated with the Merger; difficulties in the assimilation of employees and culture; difficulties in managing the expanded operations of a larger and more complex company; challenges in attracting and retaining key personnel; and difficulties with harmonizing our and Xilinx’s financial reporting systems. Many of these factors will be outside of our control and any one of them could result in increased costs, decreases in expected revenues and diversion of management’s time and attention, which could materially impact the combined company. In addition, even if the operations of the businesses are integrated successfully, the full benefits of the Merger may not be realized within the anticipated time frame or at all. All of these factors could decrease or delay the expected accretive effect of the Merger and negatively impact the combined company. If we cannot successfully integrate our +29 +and Xilinx’s businesses and operations, or if there are delays in combining the businesses, it could negatively impact our ability to develop or sell new products and impair our ability to grow our business, which in turn could adversely affect our financial condition and operating results. +Acquisitions and joint ventures may also involve the entry into geographic or business markets in which we have little or no prior experience. Consequently, we may not achieve anticipated benefits of acquisitions or joint ventures, which could harm our operating results. In addition, to complete an acquisition (and as contemplated in the Merger), we may issue equity securities, which would dilute our stockholders’ ownership and could adversely affect the price of our common stock, and/or incur debt, assume contingent liabilities or have amortization expenses and write-downs of acquired assets, which could adversely affect our results of operations. Moreover, if such acquisitions or joint ventures require us to seek additional debt or equity financing, we may not be able to obtain such financing on terms favorable to us or at all. Even if we successfully complete an acquisition or joint venture, we may not be able to assimilate and integrate effectively or efficiently the acquired business, technologies, solutions, assets, personnel or operations, particularly if key personnel of the acquired company decide not to work for us. +Acquisitions and joint ventures may also reduce our cash available for operations and other uses, which could harm our business. Also, any failure on our part to effectively evaluate and execute new business initiatives could adversely affect our business. We may not adequately assess the risks of new business initiatives and subsequent events may arise that alter the risks that were initially considered. Furthermore, we may not achieve the objectives and expectations with respect to future operations, products and services. The majority of our ATMP services are provided by the ATMP JVs, and there is no guarantee that the JVs will be able to fulfill our long-term ATMP requirements. If we are unable to meet customer demand due to fluctuating or late supply from the ATMP JVs, it could result in lost sales and have a material adverse effect on our business. +In addition, we may not realize the anticipated benefits from our business initiatives. For example, we may not realize the expected benefits from the THATIC JV’s expected future performance, including the receipt of any future milestone payments and any royalties from certain licensed intellectual property. In June 2019, the BIS added certain Chinese entities to the Entity List, including THATIC and the THATIC JV. We are complying with U.S. law pertaining to the Entity List designation. +Our ability to complete the Merger is subject to closing conditions, including approval by our and Xilinx’s stockholders and the receipt of consents and approvals from governmental authorities, which may impose conditions that could adversely affect us or cause the Merger not to be completed. +The Merger is subject to a number of closing conditions as specified in the Merger Agreement. These include, among others, approvals by our and Xilinx’s stockholders, the receipt of approvals under certain competition laws and the absence of governmental restraints or prohibitions preventing the consummation of the Merger. No assurance can be given that the required consents and approvals will be obtained or that the closing conditions will be satisfied in a timely manner or at all. Any delay in completing the Merger could cause the combined company not to realize, or to be delayed in realizing, some or all of the benefits that we expect to achieve. In addition, we can provide no assurance that these conditions will not result in the abandonment or delay of the Merger. The occurrence of any of these events could have a material adverse effect on our results of operations and the trading price of our common stock. Additionally, under the Merger Agreement, Xilinx will be required to pay a termination fee to us equal to $1 billion if the Merger Agreement is terminated in certain circumstances, including if the Merger Agreement is terminated because Xilinx’s board of directors has changed its recommendation. We will be required to pay a termination fee to Xilinx equal to $1.5 billion if the Merger Agreement is terminated in certain circumstances, including if the Merger Agreement is terminated because our board of directors has changed its recommendation. We will be required to pay a termination fee equal to $1 billion if the Merger Agreement is terminated in certain circumstances related to the failure to obtain required regulatory approvals by October 26, 2021 (subject to automatic extension first to January 26, 2022 and then to April 26, 2022, in each case, to the extent the regulatory closing conditions remain outstanding). +Whether or not it is completed, the announcement and pendency of the Merger could cause disruptions in our business, which could have an adverse effect on our business and financial results . +Whether or not it is completed, the announcement and pendency of the Merger could cause disruptions in our business: our and Xilinx’s current and prospective employees may experience uncertainty about their future roles with the combined company, which might adversely affect the ability to retain key employees; uncertainty regarding the completion of the Merger may cause customers, suppliers, distributors, vendors, strategic partners or others to delay or defer entering into contracts, make other decisions or seek to change or cancel existing business +30 +relationships; and the attention of management may be directed toward the completion of the Merger. If the Merger is not completed, we will have incurred significant costs, including the potential payment of termination fees and the diversion of management resources, for which we will have received little or no benefit. +Any impairment of the combined company’s tangible, definite-lived intangible or indefinite-lived intangible +assets, including goodwill, may adversely impact the combined company’s financial position and results of operations. +The Merger will be accounted for using the acquisition method of accounting under the provisions of ASC 805, Business Combinations, with AMD representing the accounting acquirer under this guidance. We will record assets acquired, including identifiable intangible assets, and liabilities assumed from Xilinx at their respective fair values at the date of completion of the Merger. Any excess of the purchase price over the net fair value of such assets and liabilities will be recorded as goodwill. In connection with the Merger, the combined company is expected to record significant goodwill and other intangible assets on its consolidated balance sheet. +Indefinite-lived intangible assets, including goodwill, will be tested for impairment at least annually, and all tangible and intangible assets including goodwill will be tested for impairment when certain indicators are present. If, in the future, the combined company determines that tangible or intangible assets, including goodwill, are impaired, the combined company would record an impairment charge at that time. Impairment testing of goodwill and intangible assets requires significant use of judgment and assumptions, particularly as it relates to the determination of fair value. A decrease in the long-term economic outlook and future cash flows of the combined company’s business could significantly impact asset values and potentially result in the impairment of intangible assets, including goodwill, which may have a material adverse impact on the combined company’s financial position and results of operations. +Liquidity and Capital Resources Risks +The agreements governing our notes and our Revolving Credit Facility impose restrictions on us that may adversely affect our ability to operate our business. +The indenture governing our 7.50% Senior Notes due 2022 (7.50% Notes) contains various covenants which limit our ability to, among other things: incur additional indebtedness; pay dividends and make other restricted payments; make certain investments, including investments in our unrestricted subsidiaries; create or permit certain liens; create or permit restrictions on the ability of certain restricted subsidiaries to pay dividends or make other distributions to us; use the proceeds from sales of assets; enter into certain types of transactions with affiliates; and consolidate or merge or sell our assets as an entirety or substantially as an entirety. +In addition, the Revolving Credit Facility’s credit agreement (Credit Agreement) restricts our ability to make cash payments on the notes to the extent that (i) on the date of such payment, an event of default exists under the Credit Agreement or would result therefrom or (ii) if we would have, on a pro forma basis after giving effect to such payment, a consolidated total leverage ratio that exceeds 3.50x. Any of our future debt agreements may contain similar restrictions. If under certain circumstances we fail to make a cash payment on a series of notes when required by the applicable indenture, it would constitute an event of default under such indenture, which, in turn, could constitute an event of default under the agreements governing our other indebtedness. +Our Revolving Credit Facility also contains various covenants which limit our ability to, among other things, incur additional indebtedness and liens, make certain investments, merge or consolidate with other entities, make certain dispositions, create any encumbrance on the ability of a subsidiary to make any upstream payments, make payments with respect to subordinated debt or certain borrowed money prior to its due date and enter into any non-arm’s-length transaction with an affiliate (in each case, except for certain customary exceptions). +The agreements governing our notes and our Revolving Credit Facility contain cross-default provisions whereby a default under certain agreements with respect to other indebtedness would result in cross defaults under the indentures or the Revolving Credit Facility. For example, the occurrence of a default with respect to any indebtedness or any failure to repay indebtedness when due in an amount in excess of (i) $50 million would cause a cross default under the indentures (to the extent such default would result in the acceleration of such indebtedness) governing our 7.50% Notes and 2.125% Convertible Senior Notes due 2026 (2.125% Notes), and (ii) $100 million would cause a cross default under the Revolving Credit Facility. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under our Revolving Credit Facility to declare all amounts outstanding under the indentures or the Revolving Credit Facility to be immediately due and payable. If the note holders or the trustee under the indentures governing our 7.50% Notes or 2.125% Notes or the +31 +lenders under our Revolving Credit Facility accelerate the repayment of borrowings, we cannot assure you that we will have sufficient assets to repay those borrowings. +The conversion of the 2.125% Notes may dilute the ownership interest of our existing stockholders, or may otherwise depress the price of our common stock. +The conversion of some or all of the 2.125% Notes may dilute the ownership interests of our existing stockholders. The 2.125% Notes will mature on September 1, 2026, unless earlier redeemed or repurchased by us or converted. During the fourth calendar quarter of 2020, the sale price of our common stock for conversion was satisfied as of December 31, 2020 and as a result, the 2.125% Notes are eligible for conversion during the first calendar quarter of 2021. Any sales in the public market of our common stock issuable upon such conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the 2.125% Notes may encourage short selling by market participants because the conversion thereof could be used to satisfy short positions, or the anticipated conversion of the 2.125% Notes into cash and/or shares of our common stock could depress the price of our common stock. +Our indebtedness could adversely affect our financial position and prevent us from implementing our strategy or fulfilling our contractual obligations. +Our total debt principal amount outstanding as of December 26, 2020 was $ 338 million. Our indebtedness may make it difficult for us to satisfy our financial obligations, including making scheduled principal and interest payments; limit our ability to borrow additional funds for working capital, capital expenditures, acquisitions and general corporate and other purposes; limit our ability to use our cash flow or obtain additional financing for future working capital, capital expenditures, acquisitions or other general corporate purposes; require us to use a substantial portion of our cash flow from operations to make debt service payments; place us at a competitive disadvantage compared to our competitors with relatively less debt; and increase our vulnerability to the impact of adverse economic and industry conditions. +We may not be able to generate sufficient cash to service our debt obligations or meet our working capital requirements. +Our ability to make payments on and to refinance our debt will depend on our financial and operating performance, which may fluctuate significantly from quarter to quarter, and is subject to prevailing economic, financial and business conditions along with other factors, many of which are beyond our control. We cannot assure you that we will be able to generate cash flow or that we will be able to borrow funds, including under our revolving credit facility for a principal amount up to $500 million (our Revolving Credit Facility), in amounts sufficient to enable us to service our debt or to meet our working capital requirements. If we are not able to generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, we may be required to sell assets or equity, reduce expenditures, refinance all or a portion of our existing debt or obtain additional financing. We cannot assure you that we will be able to refinance our debt, sell assets or equity, borrow funds under our Revolving Credit Facility or borrow more funds on terms acceptable to us, if at all. +In the event of a change of control, we may not be able to repurchase our outstanding debt as required by the applicable indentures and our Revolving Credit Facility, which would result in a default under the indentures and our Revolving Credit Facility. +Upon a change of control, we will be required to offer to repurchase all of our 7.50% Notes and 2.125% Notes then outstanding at 101% of the principal amount thereof, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date. In addition, a change of control would be an event of default under our Revolving Credit Facility. As of December 26, 2020, $ 338 million principal amount was outstanding, consisting of our Notes. Future debt agreements may contain similar provisions. We may not have the financial resources to repurchase our outstanding notes and prepay all of our outstanding obligations under our Revolving Credit Facility. +If we cannot generate sufficient revenue and operating cash flow or obtain external financing, we may face a cash shortfall and be unable to make all of our planned investments in research and development or other strategic investments. +Our ability to fund research and development expenditures depends on generating sufficient revenue and cash flow from operations and the availability of external financing, if necessary. Our research and development expenditures, together with ongoing operating expenses, will be a substantial drain on our cash flow and may decrease our cash balances. If new competitors, technological advances by existing competitors, or other competitive factors require +32 +us to invest significantly greater resources than anticipated in our research and development efforts, our operating expenses would increase. If we are required to invest significantly greater resources than anticipated in research and development efforts without an increase in revenue, our operating results could decline. +We regularly assess markets for external financing opportunities, including debt and equity financing. Additional debt or equity financing may not be available when needed or, if available, may not be available on satisfactory terms. The health of the credit markets may adversely impact our ability to obtain financing when needed. Any downgrades from credit rating agencies such as Moody’s or Standard & Poor’s may adversely impact our ability to obtain external financing or the terms of such financing. Credit agency downgrades or concerns regarding our credit worthiness may impact relationships with our suppliers, who may limit our credit lines. Our inability to obtain needed financing or to generate sufficient cash from operations may require us to abandon projects or curtail planned investments in research and development or other strategic initiatives. If we curtail planned investments in research and development or abandon projects, our products may fail to remain competitive and our business would be materially adversely affected. +General Risks +Our worldwide operations are subject to political, legal and economic risks and natural disasters, which could have a material adverse effect on us. +We maintain operations around the world, including in the United States, Canada, Europe, Australia and Asia. We rely on third-party wafer foundries in the United States, Europe and Asia. Nearly all product assembly and final testing of our products is performed at manufacturing facilities, operated by third-party manufacturing facilities, in China, Malaysia and Taiwan. We also have international sales operations. International sales, as a percent of net revenue, were 77% for the year ended December 26, 2020. We expect that international sales will continue to be a significant portion of total sales in the foreseeable future. +The political, legal and economic risks associated with our operations in foreign countries include, without limitation: expropriation; changes in a specific country’s or region’s political or economic conditions; changes in tax laws, trade protection measures and import or export licensing requirements; difficulties in protecting our intellectual property; difficulties in managing staffing and exposure to different employment practices and labor laws; changes in foreign currency exchange rates; restrictions on transfers of funds and other assets of our subsidiaries between jurisdictions; changes in freight and interest rates; disruption in air transportation between the United States and our overseas facilities; loss or modification of exemptions for taxes and tariffs; and compliance with U.S. laws and regulations related to international operations, including export control and economic sanctions laws and regulations and the Foreign Corrupt Practices Act. +In addition, our worldwide operations (or those of our business partners) could be subject to natural disasters such as earthquakes, tsunamis, flooding, typhoons, fires and volcanic eruptions that disrupt manufacturing or other operations. For example, our Santa Clara operations are located near major earthquake fault lines in California. There may be conflict or uncertainty in the countries in which we operate, including public health issues (for example, an outbreak of a contagious disease such as COVID-19, avian influenza, measles or Ebola), safety issues, natural disasters, fire, disruptions of service from utilities, nuclear power plant accidents or general economic or political factors. For example, governments worldwide have implemented, and continue to implement, measures to slow down the outbreak of COVID-19. We have experienced, and will continue to experience, disruptions to our business as these measures have, and will continue to have, an effect on our business operations and practices. Also, the European Union’s General Data Protection Regulation imposes significant new requirements on how we collect, process and transfer personal data, as well as significant fines for non-compliance. Any of the above risks, should they occur, could result in an increase in the cost of components, production delays, general business interruptions, delays from difficulties in obtaining export licenses for certain technology, tariffs and other barriers and restrictions, longer payment cycles, increased taxes, restrictions on the repatriation of funds and the burdens of complying with a variety of foreign laws, any of which could ultimately have a material adverse effect on our business. +We may incur future impairments of goodwill and technology license purchases. +We perform our annual goodwill impairment analysis as of the first day of the fourth quarter of each year. Subsequent to our annual goodwill impairment analysis, we monitor for any events or changes in circumstances, such as significant adverse changes in business climate or operating results, changes in management’s business strategy, an inability to successfully introduce new products in the marketplace, an inability to successfully achieve +33 +internal forecasts or significant declines in our stock price, which may represent an indicator of impairment. The occurrence of any of these events may require us to record future goodwill impairment charges. +We license certain third-party technologies and tools for the design and production of our products. We report the value of those licenses as other non-current assets on the balance sheet and we periodically evaluate the carrying value of those licenses based on their future economic benefit to us. Factors such as the life of the assets, changes in competing technologies, and changes to the business strategy may represent an indicator of impairment. The occurrence of any of these events may require us to record future technology license impairment charges. +Our inability to continue to attract and retain qualified personnel may hinder our business. +Much of our future success depends upon the continued service of numerous qualified engineering, marketing, sales and executive employees. Competition for highly skilled executives and employees in the technology industry is intense and our competitors have targeted individuals in our organization that have desired skills and experience. If we are not able to continue to attract, train and retain our leadership team and our qualified employees necessary for our business, the progress of our product development programs could be hindered, and we could be materially adversely affected. To help attract, retain and motivate our executives and qualified employees, we use share-based incentive awards such as employee stock options and non-vested share units (restricted stock units). If the value of such stock awards does not appreciate as measured by the performance of the price of our common stock, or if our share-based compensation otherwise ceases to be viewed as a valuable benefit, our ability to attract, retain and motivate our executives and employees could be weakened, which could harm our results of operations. Also, if the value of our stock awards increases substantially, this could potentially create great personal wealth for our executives and employees and affect our ability to retain our personnel. In addition, any future restructuring plans may adversely impact our ability to attract and retain key employees. +Our stock price is subject to volatility. +Our stock price has experienced price and volume fluctuations and could be subject to wide fluctuations in the future. The trading price of our stock may fluctuate widely due to various factors including actual or anticipated fluctuations in our financial conditions and operating results, changes in financial estimates by us or financial estimates and ratings by securities analysts, changes in our capital structure, including issuance of additional debt or equity to the public, interest rate changes, news regarding our products or products of our competitors, and broad market and industry fluctuations. Stock price fluctuations could impact the value of our equity compensation, which could affect our ability to recruit and retain employees. In addition, volatility in our stock price could adversely affect our business and financing opportunities. +Worldwide political conditions may adversely affect demand for our products. +Worldwide political conditions may create uncertainties that could adversely affect our business. The United States has been and may continue to be involved in armed conflicts that could have a further impact on our sales and our supply chain. The consequences of armed conflict, political instability or civil or military unrest are unpredictable, and we may not be able to foresee events that could have a material adverse effect on us. Terrorist attacks or other hostile acts may negatively affect our operations, or adversely affect demand for our products, and such attacks or related armed conflicts may impact our physical facilities or those of our suppliers or customers. Furthermore, these attacks or hostile acts may make travel and the transportation of our products more difficult and more expensive, which could materially adversely affect us. Any of these events could cause consumer spending to decrease or result in increased volatility in the United States economy and worldwide financial markets. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +As of December 26, 2020, we leased approximately 2.46 million square feet of space for research and development, engineering, administrative and warehouse use, including our headquarters in Santa Clara, California, our principal administrative facilities in Austin, Texas, our design center in Shanghai, China, our main facility with respect to graphics and chipset products located in Markham, Ontario, Canada, two design centers in Bangalore and Hyderabad, India, and a number of smaller regional sales offices located in commercial centers near customers, principally in the United States, Europe, Asia and Latin America. These leases expire at varying dates through 2028, although some of these leases include optional renewals. We occupy approximately 251,000 square +34 +feet of space in our headquarters in Santa Clara, California under an operating lease which expires in July 2027. We have the option to extend the term of the lease for two additional five-year periods. The lease for our principal administrative facilities in Austin, Texas for approximately 511,000 square feet expires in March 2025, and provides for one ten-year optional renewal. The leases for our facilities in Markham, Ontario, Canada for approximately 365,000 square feet expire in February 2028, and provide for one five-year optional renewals. We occupy approximately 265,000 square feet of space in our design center in Shanghai, China under a ten-year operating lease, which expires in March 2028. We also occupy approximately 287,000 square feet, in aggregate, under two leases in India. The lease for our design center in Bangalore, India expires in September 2026, with an undefined term renewal option. The lease for our design center in Hyderabad, India expires in November 2022, with a five-year renewal option . +We currently do not anticipate difficulty in either retaining occupancy of any of our facilities through lease renewals prior to expiration or through month-to-month occupancy or replacing them with equivalent facilities. +We believe that our existing facilities are suitable and adequate for our present purposes and that the productive capacity of such facilities is substantially being utilized or we have plans to utilize such capacity. +ITEM 3. LEGAL PROCEEDINGS +For a discussion of our legal proceedings, refer to Note 17 – Contingencies of the Notes to Consolidated Financial Statements (Part II, Item 8 of this Form 10-K). +ITEM 4. MINE SAFETY DISCLOSURES +Not Applicable. +35 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND +ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on The NASDAQ Global Select Market (NASDAQ) under the symbol “AMD”. On January 22, 2021, there were 4,155 registered holders of our common stock, and the closing price of our common stock was $92.79 per share as reported on NASDAQ. +For information about our equity compensation plans, see Part III, Item 11, below. +Performance Graph +Comparison of Five-Year Cumulative Total Returns +Advanced Micro Devices, S&P 500 Index and S&P 500 Semiconductor Index +The following graph shows a five-year comparison of cumulative total return on our common stock, the S&P 500 Index and the S&P 500 Semiconductor Index from December 26, 2015 through December 26, 2020. The past performance of our common stock is no indication of future performance. +Base Period Years Ending +Company / Index 12/26/2015 12/31/2016 12/30/2017 12/29/2018 12/28/2019 12/26/2020 +Advanced Micro Devices, Inc. 100 388 352 610 1,582 3,144 +S&P 500 Index 100 111 135 128 171 199 +S&P 500 Semiconductors Index 100 126 171 160 236 331 +36 +Unregistered Sales of Equity Securities +We issued warrants dated December 28, 2020 to purchase 42,439 shares of our common stock to a commercial partner pursuant to a strategic arrangement with such partner. The warrants have an exercise price of $25.4994 per share and expire on December 28, 2023. The warrants were issued pursuant to Section 4(a)(2) of the Securities Act of 1933, as amended. +37 +ITEM 6. SELECTED FINANCIAL DATA +2020 (1) +2019 (1) +2018 (1) +2017 (1)(2) +2016 (1)(2) +In millions except per share amounts +Net revenue $ 9,763 $ 6,731 $ 6,475 $ 5,253 $ 4,319 +Net income (loss) (3) +$ 2,490 $ 341 $ 337 $ (33) $ (498) +Earnings (loss) per share +Basic $ 2.10 $ 0.31 $ 0.34 $ (0.03) $ (0.60) +Diluted $ 2.06 $ 0.30 $ 0.32 $ (0.03) $ (0.60) +Shares used in per share calculation +Basic 1,184 1,091 982 952 835 +Diluted 1,207 1,120 1,064 952 835 +Long-term debt, net and other long-term liabilities (4) +$ 507 $ 643 $ 1,306 $ 1,443 $ 1,559 +Total assets $ 8,962 $ 6,028 $ 4,556 $ 3,552 $ 3,328 +(1) 2020, 2019, 2018, and 2017 each consisted of 52 weeks, whereas 2016 consisted of 53 weeks. +(2) +2017 and 2016 amounts adjusted to reflect the retrospective application of Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers . +(3) In 2020, we recognized a $1.3 billion income tax benefit upon the release of a portion of the valuation allowance on deferred tax assets, which resulted in an equivalent increase to our deferred tax assets and thus an increase to total assets. In 2016, we recorded a charge of $340 million in Cost of sales, consisting of the $240 million value of the warrant under a warrant agreement and the $100 million payment, which were both associated with the sixth amendment to the wafer sourcing agreement (WSA) with Global Foundries. In addition, we recorded a cumulative pre-tax gain of $146 million on the sale of our 85% equity interest in the ATMP JV. +(4) In 2019, we reduced our long-term debt, net and other long-term liabilities by $663 million, primarily due to $628 million of net debt conversion and repayment. In 2016, we reduced our long-term debt, net and other long term liabilities by $534 million, primarily due to $1,048 million of net debt repayment, partially offset by the issuance of $805 million in principal amount of 2.125% Notes net of unamortized discount of $308 million and unamortized issuance cost of $14 million. +38 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF +OPERATIONS +The following discussion should be read in conjunction with the consolidated financial statements as of December 26, 2020 and December 28, 2019 and for each of the three years in the period ended December 26, 2020 and related notes, which are included in this Annual Report on Form 10-K as well as with the other sections of this Annual Report on Form 10-K, including “Part I, Item 1: Business,” “Part II, Item 6: Selected Financial Data” and “Part II, Item 8: Financial Statements and Supplementary Data.” +Introduction +In this section, we will describe the general financial condition and the results of operations of Advanced Micro Devices, Inc. and its wholly-owned subsidiaries (collectively, “us,” “our” or “AMD”), including a discussion of our results of operations for 2020 compared to 2019, an analysis of changes in our financial condition and a discussion of our contractual obligations and off-balance sheet arrangements. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 28, 2019. +Overview +During 2020, we continued to build on our technical, operational and financial foundation to drive our long-term growth strategy. We delivered strong financial results and further extended our industry-leading product portfolio despite the backdrop of the COVID-19 pandemic. Net revenue for 2020 was $9.8 billion, an increase of 45% compared to 2019 net revenue of $6.7 billion. Gross margin, as a percentage of net revenue for 2020, was 45%, compared to 43% in 2019. Our operating income for 2020 improved to $1.4 billion compared to operating income of $631 million for 2019. Our net income for 2020 improved to $2.5 billion compared to $341 million in the prior year. We recognized a $1.3 billion income tax benefit upon the release of a portion of the valuation allowance on deferred tax assets. We made significant progress towards improving our balance sheet in 2020. Cash, cash equivalents and short-term investments as of December 26, 2020 were $2.3 billion, compared to $1.5 billion at the end of 2019. The aggregate principal amount of total debt as of December 26, 2020 was $338 million, compared to $563 million as of December 28, 2019. +During 2020, we consistently executed our product roadmap and launched multiple products in leading-edge manufacturing technologies. We introduced a number of 7 nanometer (nm) products during the year, including new additions to our 3rd Gen AMD Ryzen™ desktop processor family, the AMD Ryzen 3 3100 and AMD Ryzen 3 3300X for the mainstream market, and the AMD Ryzen 9 3900XT, AMD Ryzen 7 3800XT and AMD Ryzen 5 3600XT processors for the enthusiast market. In July 2020, we introduced the AMD Ryzen Threadripper™ PRO Processor family designed for professional workstations from OEMs to system integrators and AMD Ryzen 4000 Series desktop processors with Radeon™ graphics for consumers, gamers, streamers and creators. We also introduced AMD Athlon™ 3000 Series desktop processors using the same Zen core architecture and built-in Radeon graphics as the AMD Ryzen desktop processor family. Also, the AMD Ryzen PRO 4000 series and AMD Athlon PRO 3000 series desktop processors were introduced for the commercial market. In October 2020, we introduced the AMD Ryzen 5000 Series desktop processor family powered by “Zen 3” core architecture. We also expanded our notebook products in 2020. In May 2020, we announced the global availability of the AMD Ryzen™ PRO 4000 Series Mobile family for commercial notebooks built with enterprise-grade AMD PRO technologies, which deliver a set of security and manageability features for Enterprise IT deployments. Also, we announced the AMD Ryzen 3000 C-Series mobile processors and the AMD Athlon 3000 C-Series mobile processors for Chromebook platforms designed for multi-tasking and content creation in distance learning and remote working. With respect to our graphics products, we expanded our professional offerings with the AMD Radeon™ Pro VII workstation graphics card designed for broadcast and engineering professionals. In August 2020, we announced the availability of the new AMD Radeon Pro 5000 series GPUs for the updated 27-inch iMac bringing a wide variety of graphically intensive applications and workloads to consumer and professional users. We also introduced the AMD Radeon RX 6000 Series graphics cards built on AMD RDNA™ 2 gaming architecture and designed for enthusiast-class PC gaming. In November 2020, we introduced our data center graphics processor, the AMD Instinct™ MI100 GPU accelerator, the first accelerator to use new AMD CDNA architecture dedicated to HPC workloads. +We expanded our EPYC server family during the year. In April 2020, we announced the extension of the 2nd Gen AMD EPYC processor family with three new processors: AMD EPYC 7F32 (8 cores), AMD EPYC 7F52 (16 cores) and AMD EPYC 7F72 (24 cores). These new processors leverage up to 500 MHz of additional base frequency and large amounts of cache. In October 2020, we announced the AMD EPYC™ processor based Azure Dav4, Eav4, +39 +Easv4 and Lsv2 VMs for use to improve real-time analysis on large volumes of data streaming from applications, websites and more. We also expanded our embedded processor family with two new AMD Ryzen Embedded R1000 low-power processors that provide customers with a thermal design power (TDP) range of 6 up to 10 watts. In November 2020, we launched the AMD Ryzen Embedded V2000 series processor built on 7 nm process technology, “Zen 2” cores and high-performance AMD Radeon graphics. +While the current COVID-19 pandemic continues to impact our business operations and practices, and we expect that it may continue to impact our business, we experienced limited financial disruption during 2020. Although many of our offices remained open to enable critical on-site business functions in accordance with local government guidelines, most of our employees worked from home during 2020. During the second half of 2020, the majority of our employees in China returned to work and we maintained normal business operations subject to local government health measures. We continue to monitor and take measures to protect the health and safety of our employees, and support those employees who work from home so that they can be productive. We monitor demand signals as we adjust our supply chain requirements based on changing customer needs and demands. We also assess our product schedules and roadmaps to make any adjustments that may be necessary to support remote working requirements and address the geographic and market demand shifts caused by COVID-19. +As part of our strategy to establish AMD as the industry’s high performance computing leader, we announced in October 2020 that we entered into a definitive agreement to acquire Xilinx, Inc. in an all-stock transaction. The transaction is currently expected to close by the end of calendar year 2021. +We intend the discussion of our financial condition and results of operations that follows to provide information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period, the primary factors that resulted in those changes, and how certain accounting principles, policies and estimates affect our financial statements. +Critical Accounting Estimates +Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts in our consolidated financial statements. We evaluate our estimates on an on-going basis, including those related to our revenue, inventories, goodwill and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Although actual results have historically been reasonably consistent with management’s expectations, the actual results may differ from these estimates or our estimates may be affected by different assumptions or conditions. +Management believes the following critical accounting estimates are the most significant to the presentation of our financial statements and require the most difficult, subjective and complex judgments. +Revenue Allowances. Revenue contracts with our customers include variable amounts which we evaluate under ASC 606-10-32-8 through 14 in order to determine the net amount of consideration to which we are entitled and which we recognize as revenue. We determine the net amount of consideration to which we are entitled by estimating the most likely amount of consideration we expect to receive from the customer after adjustments to the contract price for rights of return and rebates to our OEM customers and rights of return, rebates and price protection on unsold merchandise to our distributor customers. +We base our determination of necessary adjustments to the contract price by reference to actual historical activity and experience, including actual historical returns, rebates and credits issued to OEM and distributor customers adjusted, as applicable, to include adjustments, if any, for known events or current economic conditions, or both. +Our estimates of necessary adjustments for distributor price incentives and price protection on unsold products held by distributors are based on actual historical incentives provided to distributor customers and known future price movements based on our internal and external market data analysis. +Our estimates of necessary adjustments for OEM price incentives utilize, in addition to known pricing agreements, actual historical rebate attainment rates and estimates of future OEM rebate program attainment based on internal and external market data analysis. +40 +We offer incentive programs through cooperative advertising and marketing promotions. Where funds provided for such programs can be estimated, we recognize a reduction to revenue at the time the related revenue is recognized; otherwise, we recognize such reduction to revenue at the later of when: i) the related revenue transaction occurs; or ii) the program is offered. For transactions where we reimburse a customer for a portion of the customer’s cost to perform specific product advertising or marketing and promotional activities, such amounts are recognized as a reduction to revenue unless they qualify for expense recognition. +We also provide limited product return rights to certain OEMs and to most distribution customers. These return rights are generally limited to a contractual percentage of the customer’s prior quarter shipments, although, from time to time we may approve additional product returns beyond the contractual arrangements based on the applicable facts and circumstances. In order to estimate adjustments to revenue to account for these returns, including product restocking rights provided to distributor and OEM customers, we utilize relevant, trended actual historical product return rate information gathered, adjusted for actual known information or events, as applicable. +Overall, our estimates of adjustments to contract price due to variable consideration under our contracts with OEM and distributor customers, based on our assumptions and include adjustments, if any, for known events, have been materially consistent with actual results; however, these estimates are subject to management’s judgment and actual provisions could be different from our estimates and current provisions, resulting in future adjustments to our revenue and operating results. +Inventory Valuation. We value inventory at standard cost, adjusted to approximate the lower of actual cost or estimated net realizable value using assumptions about future demand and market conditions. Material assumptions we use to estimate necessary inventory carrying value adjustments can be unique to each product and are based on specific facts and circumstances. In determining excess or obsolescence reserves for products, we consider assumptions such as changes in business and economic conditions, other-than-temporary decreases in demand for our products, and changes in technology or customer requirements. In determining the lower of cost or net realizable value reserves, we consider assumptions such as recent historical sales activity and selling prices, as well as estimates of future selling prices. If in any period we anticipate a change in assumptions such as future demand or market conditions to be less favorable than our previous estimates, additional inventory write-downs may be required and would be reflected in cost of sales, resulting in a negative impact to our gross margin in that period. If in any period we are able to sell inventories that had been written down to a level below the ultimate realized selling price in a previous period, related revenue would be recorded with a lower or no offsetting charge to cost of sales resulting in a net benefit to our gross margin in that period. Overall, our estimates of inventory carrying value adjustments have been materially consistent with actual results. +Goodwill. We perform our goodwill impairment analysis as of the first day of the fourth quarter of each year and, if certain events or circumstances indicate that an impairment loss may have been incurred, on a more frequent basis. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. +We first analyze qualitative factors to determine if it is more likely than not that the fair value of a reporting unit exceeds its carrying amount. Qualitative factors include industry and market considerations, overall financial performance, share price trends and market capitalization and Company-specific events. If we conclude it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, we do not proceed to perform a quantitative impairment test. +If we conclude it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative goodwill impairment test will be performed by comparing the fair value of each reporting unit to its carrying value. A quantitative impairment analysis, if necessary, considers the income approach, which requires estimates of the present value of expected future cash flows to determine a reporting unit’s fair value. Significant estimates include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates, and future economic and market conditions. +A goodwill impairment charge is recognized for the amount by which a reporting unit’s fair value is less than its carrying value, not to exceed the total amount of goodwill allocated to that reporting unit. +Income Taxes . In determining taxable income for financial statement reporting purposes, we must make certain estimates and judgments. These estimates and judgments are applied in the calculation of certain tax liabilities and in the determination of the recoverability of deferred tax assets which arise from temporary differences between the recognition of assets and liabilities for tax and financial statement reporting purposes. +41 +We regularly assess the likelihood that we will be able to recover our deferred tax assets. Unless recovery is considered more-likely-than-not (a probability level of more than 50%), we will record a charge to income tax expense in the form of a valuation allowance for the deferred tax assets that we estimate will not ultimately be recoverable or maintain the valuation allowance recorded in prior periods. When considering all available evidence, if we determine it is more-likely-than-not we will realize our deferred tax assets, we will reverse some or all of the existing valuation allowance, which would result in a credit to income tax expense and the establishment of an asset in the period of reversal. +In determining the need to establish or maintain a valuation allowance, we consider the four sources of jurisdictional taxable income: (i) carryback of net operating losses to prior years; (ii) future reversals of existing taxable temporary differences; (iii) viable and prudent tax planning strategies; and (iv) future taxable income exclusive of reversing temporary differences and carryforwards. +Through the end of 2020, we demonstrated consistent, continued and increasing profitability over the preceding three-year period. Our ability to sustain and grow our profitability is supported by the continued positive momentum of our consumer and commercial products, including our newly released desktop, mobile and graphics processors, greater market acceptance for our server products, the successful adoption of our new game console processor products, and our leadership in the continued development of HPC products. In assessing the realizability of the deferred tax assets, we considered the highly dynamic and competitive landscape of our industry, the continued performance and market acceptance of our new products, and the impact of such market acceptance on our estimates of future profitability. As a result, in the fourth quarter of 2020, we concluded that our history of profitable operating results, including the current period results, along with increasingly favorable forecasts of continued future profitability, provided sufficient positive evidence supporting the realizability of a certain amount of our U.S. deferred tax assets, accordingly, the release of the related valuation allowance previously recorded against these deferred tax assets, resulting in a tax benefit of $1.3 billion in the fourth quarter of 2020. +We continue to maintain a valuation allowance of approximately $1.6 billion for certain federal, state, and foreign tax attributes. The federal valuation allowance maintained is due to current limitations, including limitations under Internal Revenue Code Section 382 or 383, separate return loss year rules, or dual consolidated loss rules. The state and foreign valuation allowance maintained is due to lack of sufficient sources of income. +In addition, the calculation of our tax liabilities involves addressing uncertainties in the application of complex, multi-jurisdictional tax rules and the potential for future adjustment of our uncertain tax positions by the Internal Revenue Service or other taxing authorities. If our estimates of these taxes are greater or less than actual results, an additional tax benefit or charge could result. +Results of Operations +We report our financial performance based on the following two reportable segments: the Computing and Graphics segment and the Enterprise, Embedded and Semi-Custom segment. +Additional information on our reportable segments is contained in Note 14 – Segment Reporting of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). +Our operating results tend to vary seasonally. Historically, our net revenue has been generally higher in the second half of the year than in the first half of the year, although market conditions and product transitions could impact these trends. +42 +The following table provides a summary of net revenue and operating income (loss) by segment for 2020, 2019 and 2018. +2020 2019 2018 +(In millions) +Net revenue: +Computing and Graphics $ 6,432 $ 4,709 $ 4,125 +Enterprise, Embedded and Semi-Custom 3,331 2,022 2,350 +Total net revenue $ 9,763 $ 6,731 $ 6,475 +Operating income (loss): +Computing and Graphics $ 1,266 $ 577 $ 470 +Enterprise, Embedded and Semi-Custom 391 263 163 +All Other (288) (209) (182) +Total operating income $ 1,369 $ 631 $ 451 +Computing and Graphics +Computing and Graphics net revenue of $6.4 billion in 2020 increased by 37%, compared to $4.7 billion in 2019, primarily as a result of a 37% increase in unit shipments and a 2% increase in average selling price. The increase in unit shipments was primarily due to higher demand for our Ryzen processors. The increase in average selling price was primarily driven by a richer mix of client processors from higher sales of our Ryzen processors, which have a higher average selling price, partially offset by lower average selling price for our Radeon products due to product cycle timing. +Computing and Graphics operating income was $1.3 billion in 2020 compared to $577 million in 2019. The increase in operating income was primarily driven by the margin contribution from higher sales which more than offset higher operating expenses. Operating expenses increased for the reasons outlined under “Expenses” below. +Enterprise, Embedded and Semi-Custom +Enterprise, Embedded and Semi-Custom net revenue of $3.3 billion in 2020 increased by 65% compared to net revenue of $2.0 billion in 2019, primarily driven by higher sales of our EPYC server processors and higher semi-custom revenue. +Enterprise, Embedded and Semi-Custom operating income was $391 million in 2020 compared to $263 million in 2019. The increase in operating income was primarily due to the margin contribution from the increase in revenue which more than offset higher operating expenses in 2020 and a $60 million licensing gain recorded in 2019. Operating expenses increased for the reasons outlined under “Expenses” below. +All Other +All Other operating loss of $288 million in 2020 included stock-based compensation expense of $274 million and acquisition-related costs of $14 million. +All Other operating loss of $209 million in 2019 included $197 million of stock-based compensation expense and a $12 million contingent loss accrual on a legal matter. +43 +Comparison of Gross Margin, Expenses, Licensing Gain, Interest Expense, Other Expense and Income Taxes +The following is a summary of certain consolidated statement of operations data for 2020, 2019 and 2018: +2020 2019 2018 +(In millions, except for percentages) +Net revenue $ 9,763 $ 6,731 $ 6,475 +Cost of sales 5,416 3,863 4,028 +Gross profit 4,347 2,868 2,447 +Gross margin 45 % 43 % 38 % +Research and development 1,983 1,547 1,434 +Marketing, general and administrative 995 750 562 +Licensing gain — (60) — +Interest expense (47) (94) (121) +Other expense, net (47) (165) — +Income tax provision (benefit) (1,210) 31 (9) +Gross Margin +Gross margin as a percentage of net revenue was 45% in 2020 compared to 43% in 2019. The increase in gross margin was primarily driven by sales of Ryzen and EPYC processors in 2020, which have a higher gross margin than the corporate average, partially offset by sales of semi-custom products and Radeon products, which have a lower gross margin than the corporate average. +Expenses +Research and Development Expenses +Research and development expenses of $2.0 billion in 2020 increased by $436 million, or 28%, compared to $1.5 billion in 2019. The increase was primarily driven by an increase in product development costs in both the Computing and Graphics and Enterprise and Embedded and Semi-Custom segments, due to an increase in headcount and higher annual employee incentives driven by improved financial performance. +Marketing, General and Administrative Expenses +Marketing, general and administrative expenses of $995 million in 2020 increased by $245 million, or 33%, compared to $750 million in 2019. The increase was primarily due to an increase in go-to-market activities in both the Computing and Graphics and Enterprise, Embedded and Semi-Custom segments, and an increase in headcount and higher annual employee incentives driven by improved financial performance. +Licensing Gain +During 2019, we recognized $60 million as licensing gain associated with the licensed IP to THATIC JV. See Note 4 of “Notes to Consolidated Financial Statements” for additional information. +Interest Expense +Interest expense of $47 million in 2020 decreased by $47 million compared to $94 million in 2019, primarily due to lower debt balances. +Other Expense, Net +Other expense, net decreased in 2020 by $118 million from net of $165 million in 2019. Other expense, net for both periods primarily comprised of losses on redemptions, repurchases and conversions of our outstanding debt and convertible debt instruments. +44 +Income Taxes Provision (Benefit) +Through the end of 2020, we demonstrated consistent, continued and increasing profitability over the preceding three-year period. Our ability to sustain and grow such profitability is supported by the continued positive momentum of our consumer and commercial products including our newly released desktop, mobile and graphics processors, greater market acceptance for our server products, the successful adoption of our new game console processor products, and our continued leadership in the development of HPC products. In assessing the realizability of the deferred tax assets, we considered the highly dynamic and competitive landscape of our industry, the continued performance and market acceptance of our new products, and the impact of such market acceptance on forecasts of future profitability. As a result, in the fourth quarter of 2020, we concluded that our history of profitable operating results, including the current period results, along with increasingly favorable forecasts of continued future profitability, provided sufficient positive evidence supporting the realizability of a certain amount of our U.S. deferred tax assets and, accordingly, the release of the related valuation allowance previously recorded against these deferred tax assets, resulting in a tax benefit of $1.3 billion in the fourth quarter of 2020. +We continue to maintain a valuation allowance of approximately $1.6 billion for certain federal, state, and foreign tax attributes. The federal valuation allowance maintained is due to current limitations, including limitations under Internal Revenue Code Section 382 or 383, separate return loss year rules, or dual consolidated loss rules. The state and foreign valuation allowance maintained is due to lack of sufficient sources of income. +We recorded an income tax benefit of $1.2 billion in 2020 and an income tax provision of $31 million in 2019. The income tax benefit in 2020 was primarily due to $1.3 billion of tax benefit from the valuation allowance release in the U.S. This benefit was partially offset by approximately $10 million of withholding tax expense related to cross-border transactions, $13 million of state and foreign taxes, and a $75 million increase in valuation allowance against certain state and foreign tax credits, which are reflected as part of the state taxes and foreign rate benefit in the reconciliation table in the tax footnote. +The income tax provision in 2019 was primarily due to $22 million of withholding taxes related to cross-border transactions and $22 million of foreign income taxes in profitable locations, partially offset by a $13 million benefit for a reduction of U.S. income taxes accrued in the prior year. +International Sales +International sales as a percentage of net revenue were 77% in 2020 and 74% in 2019. We expect that international sales will continue to be a significant portion of total sales in the foreseeable future. Substantially all of our sales transactions are denominated in U.S. dollars. +FINANCIAL CONDITION +Liquidity and Capital Resources +As of December 26, 2020, our cash, cash equivalents and short-term investments were $2.3 billion compared to $1.5 billion as of December 28, 2019. The percentage of cash and cash equivalents held domestically was 94% as of December 26, 2020, and 90% as of December 28, 2019. +Our operating, investing and financing cash flow activities for fiscal 2020, 2019 and 2018 were as follows: +2020 2019 2018 +(In millions) +Net cash provided by (used in): +Operating activities $ 1,071 $ 493 $ 34 +Investing activities (952) (149) (170) +Financing activities 6 43 28 +Net increase (decrease) in cash and cash equivalents, and restricted cash $ 125 $ 387 $ (108) +Our aggregate principal debt obligations were $338 million and $563 million as of December 26, 2020 and December 28, 2019, respectively. +45 +We believe our cash, cash equivalents and short-term investments balance along with our Revolving Credit Facility entered into in June 2019 (refer to Note 6 of “Notes to Consolidated Financial Statements for additional information) will be sufficient to fund operations, including capital expenditures, over the next 12 months. We believe we will be able to access the capital markets should we require additional funds. However, we cannot assure that such funds will be available on favorable terms, or at all. +Operating Activities +Our working capital cash inflows and outflows from operations are primarily cash collections from our customers, payments for inventory purchases and payments for employee-related expenditures. +Net cash provided by operating activities was $1.1 billion in 2020, primarily due to our net income of $2.5 billion, adjusted for non-cash adjustments of $488 million and net cash outflows of $931 million from changes in our operating assets and liabilities. The primary drivers of the changes in operating assets and liabilities included a $219 million increase in accounts receivable driven primarily by $1.1 billion higher revenue in the fourth quarter of 2020 compared to the fourth quarter of 2019, partially offset by higher collections due to better revenue linearity in the fourth quarter of 2020 compared to the fourth quarter of 2019, a $417 million increase in inventories driven by an increase in product build in support of customer demand, a $231 million increase in prepaid expenses and other assets due primarily to an increase in vendor credits, a $513 million decrease in accounts payable primarily due to timing of payments to our suppliers, offset by a $574 million increase in accrued liabilities and other driven by higher marketing accruals and higher accrued annual employee incentives due to improved financial performance. +Net cash provided by operating activities was $493 million in 2019, primarily due to our net income of $341 million, adjusted for non-cash and non-operating charges of $694 million and net cash outflows of $542 million from changes in our operating assets and liabilities. The primary drivers of the changes in operating assets and liabilities included a $623 million increase in account receivable driven primarily by $708 million higher revenue during the fourth quarter of 2019 compared to the fourth quarter of 2018, a $137 million increase in inventories driven by an increase in wafer purchases during the fourth quarter of 2019 compared to the fourth quarter of 2018, and a $176 million increase in prepaid expenses and other assets due primarily to an increase in vendor credits and other non-current assets, partially offset by a $153 million increase in accounts payable due to an increase in inventory purchases and a $220 million increase in accrued liabilities and other driven by higher marketing accruals. +Investing Activities +Net cash used in investing activities was $952 million in 2020, which primarily consisted of $850 million for purchases of short-term investments and $294 million for purchases of property and equipment, partially offset by $192 million for maturities of short-term investments. +Net cash used in investing activities was $149 million in 2019, which primarily consisted of $217 million for purchases of property and equipment, partially offset by a net cash inflow from purchases and maturities of available-for-sale debt securities of $41 million. +Financing Activities +Net cash provided by financing activities was $6 million in 2020, which primarily consisted of proceeds from the issuance of common stock under our employee equity plans of $85 million, partially offset by $78 million of common stock repurchased to cover employee withholding taxes on vesting of employee equity grants. We borrowed $200 million of short-term debt during the second quarter of 2020 and paid off the balance during the third quarter of 2020. +Net cash provided by financing activities was $43 million in 2019, which primarily consisted of a cash inflow of $449 million from the warrant exercised by West Coast Hitech L.P. (WCH) and $74 million from the issuance of common stock under our stock-based compensation equity plans, partially offset by $473 million of cash used for debt reduction activities during the year. +46 +Contractual Obligations +The following table summarizes our consolidated principal contractual cash obligations, as of December 26, 2020, and is supplemented by the discussion following the table: +Payment due by period +(In millions) Total 2021 2022 2023 2024 2025 2026 and +thereafter +Term debt (1) +$ 338 $ — $ 312 $ — $ — $ — $ 26 +Aggregate interest obligation (2) +54 25 25 1 1 1 1 +Other long-term liabilities (3) +159 55 64 19 10 8 3 +Operating leases (4) +284 52 55 48 41 34 54 +Purchase obligations (5) +3,032 2,971 7 15 15 15 9 +Total contractual obligations (6) +$ 3,867 $ 3,103 $ 463 $ 83 $ 67 $ 58 $ 93 +(1) +See Note 6 – Debt and Revolving Credit Facility of the Notes to Consolidated Financial Statements for additional information. +(2) Represents interest obligations, payable in cash, for our outstanding debt. +(3) Amounts primarily represent future fixed and non-cancellable cash payments associated with software technology and licenses and IP licenses, including the payments due within the next 12 months. +(4) +See Note 16 – Commitments and Guarantees of the Notes to Consolidated Financial Statements for additional information. +(5) Represents purchase obligations for goods and services where payments are based, in part, on the volume or type of services we acquire. In those cases, we only included the minimum volume of purchase obligations in the table above. Purchase orders for goods and services that are cancellable upon notice and without significant penalties are not included in the amounts above. +(6) Total amount excludes contractual obligations already recorded on our consolidated balance sheets except for debt obligations and other liabilities related to software and technology licenses and IP licenses. +The expected timing of payments of the obligations in the preceding table is estimated based on current information. Timing of payments and actual amounts paid may be different, depending on the timing of receipt of goods or services, or changes to agreed-upon amounts for some obligations. +Our total gross unrecognized tax benefits were $119 million as of December 26, 2020. We have foreign and U.S. state tax audits in process at any one point in time. At this time, we are unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligations table. +Off-Balance Sheet Arrangements +As of December 26, 2020, we had no off-balance sheet arrangements. +47 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK +Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt. We usually invest our cash in investments with short maturities or with frequent interest reset terms. Accordingly, our interest income fluctuates with short-term market conditions. As of December 26, 2020, our investment portfolio consisted of time deposits and commercial paper. Due to the relatively short, weighted-average maturity of our investment portfolio and the current low interest rate environment, our exposure to interest rate risk is minimal. +As of December 26, 2020, all of our outstanding long-term debt had fixed interest rates. Consequently, our exposure to market risk for changes in interest rates on reported interest expense and corresponding cash flows is minimal. +We will continue to monitor our exposure to interest rate risk. +Default Risk. We mitigate default risk in our investment portfolio by investing in only high credit quality securities and by constantly positioning our portfolio to respond to a significant reduction in a credit rating of any investment issuer or guarantor. Our portfolio includes investments in marketable debt securities with active secondary or resale markets to ensure portfolio liquidity. We are averse to principal loss and strive to preserve our invested funds by limiting default risk and market risk. +We actively monitor market conditions and developments specific to the securities and security classes in which we invest. We believe that we take a conservative approach to investing our funds in that we invest only in highly-rated debt securities with relatively short maturities and do not invest in securities which we believe involve a higher degree of risk. As of December 26, 2020, substantially all of our investments in debt securities were A-rated by at least one of the rating agencies. While we believe we take prudent measures to mitigate investment-related risks, such risks cannot be fully eliminated as there are circumstances outside of our control. +Foreign Exchange Risk. As a result of our foreign operations, we incur costs and we carry assets and liabilities that are denominated in foreign currencies, while sales of products are primarily denominated in U.S. dollars. +We maintain a foreign currency hedging strategy which uses derivative financial instruments to mitigate the risks associated with changes in foreign currency exchange rates. This strategy takes into consideration all of our exposures. We do not use derivative financial instruments for trading or speculative purposes. +The following table provides information about our foreign currency forward contracts as of December 26, 2020 and December 28, 2019. All of our foreign currency forward contracts mature within 12 months. +December 26, 2020 December 28, 2019 +Notional +Amount Average +Contract +Rate Estimated +Fair Value +Gain (Loss) Notional +Amount Average +Contract +Rate Estimated +Fair Value +Gain (Loss) +(In millions except contract rates) +Foreign currency forward contracts: +Chinese Renminbi $ 261 6.8160 $ 8 $ 277 6.9890 $ (1) +Canadian Dollar 247 1.3165 6 249 1.3183 2 +Indian Rupee 97 76.0259 1 76 72.9476 — +Singapore Dollar 50 1.3574 1 50 1.3597 — +Euro 35 0.8578 1 48 0.8927 1 +Taiwan Dollar 58 28.0978 — 38 30.1873 — +Pound Sterling 3 0.7375 — 1 0.7614 — +Malaysian Ringgit 3 4.0456 — — 4.0889 — +Japanese Yen 1 103.5000 — — — — +Total $ 755 $ 17 $ 739 $ 2 +48 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Advanced Micro Devices, Inc. +Consolidated Statements of Operations +Year Ended +December 26, +2020 December 28, +2019 December 29, +2018 +(In millions, except per share amounts) +Net revenue $ 9,763 $ 6,731 $ 6,475 +Cost of sales 5,416 3,863 4,028 +Gross profit 4,347 2,868 2,447 +Research and development 1,983 1,547 1,434 +Marketing, general and administrative 995 750 562 +Licensing gain — ( 60 ) — +Operating income 1,369 631 451 +Interest expense ( 47 ) ( 94 ) ( 121 ) +Other expense, net ( 47 ) ( 165 ) — +Income before income taxes and equity income (loss) 1,275 372 330 +Income tax provision (benefit) ( 1,210 ) 31 ( 9 ) +Equity income (loss) in investee 5 — ( 2 ) +Net income $ 2,490 $ 341 $ 337 +Earnings per share +Basic $ 2.10 $ 0.31 $ 0.34 +Diluted $ 2.06 $ 0.30 $ 0.32 +Shares used in per share calculation +Basic 1,184 1,091 982 +Diluted 1,207 1,120 1,064 +See accompanying notes to consolidated financial statements. +49 +Advanced Micro Devices, Inc. +Consolidated Statements of Comprehensive Income +Year Ended +December 26, +2020 December 28, +2019 December 29, +2018 +(In millions) +Net income $ 2,490 $ 341 $ 337 +Other comprehensive income (loss) +Net change in unrealized gains (losses) on cash flow hedges 17 8 ( 14 ) +Cumulative-effect adjustment to accumulated deficit related to the adoption of ASU 2016-01, Financial Instruments — — 2 +Total comprehensive income $ 2,507 $ 349 $ 325 +See accompanying notes to consolidated financial statements. +50 +Advanced Micro Devices, Inc. +Consolidated Balance Sheets +December 26, +2020 December 28, +2019 +(In millions, except par value amounts) +ASSETS +Current assets: +Cash and cash equivalents $ 1,595 $ 1,466 +Short-term investments 695 37 +Accounts receivable, net 2,066 1,859 +Inventories 1,399 982 +Receivables from related parties 10 20 +Prepaid expenses and other current assets 378 233 +Total current assets 6,143 4,597 +Property and equipment, net 641 500 +Operating lease right-of-use assets 208 205 +Goodwill 289 289 +Investment: equity method 63 58 +Deferred tax assets 1,245 22 +Other non-current assets 373 357 +Total assets $ 8,962 $ 6,028 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable $ 468 $ 988 +Payables to related parties 78 213 +Accrued liabilities 1,796 1,084 +Other current liabilities 75 74 +Total current liabilities 2,417 2,359 +Long-term debt, net 330 486 +Long-term operating lease liabilities 201 199 +Other long-term liabilities 177 157 +Commitments and Contingencies (see Notes 16 and 17) +Stockholders’ equity: +Capital stock: +Common stock, par value $ 0.01 ; shares authorized: 2,250 ; shares issued: 1,217 and 1,175 ; shares outstanding: 1,211 and 1,170 +12 12 +Additional paid-in capital 10,544 9,963 +Treasury stock, at cost (shares held: 6 and 5 ) +( 131 ) ( 53 ) +Accumulated deficit ( 4,605 ) ( 7,095 ) +Accumulated other comprehensive income 17 — +Total stockholders’ equity 5,837 2,827 +Total liabilities and stockholders’ equity $ 8,962 $ 6,028 +See accompanying notes to consolidated financial statements. +51 +Advanced Micro Devices, Inc. +Consolidated Statements of Stockholders’ Equity +Year Ended +December 26, +2020 December 28, +2019 December 29, +2018 +(In millions) +Capital stock +Common stock +Balance, beginning of period $ 12 $ 10 $ 9 +Common stock issued under employee equity plans — — 1 +Issuance of common stock upon warrant exercise — 1 — +Issuance of common stock to settle convertible debt — 1 — +Balance, end of period $ 12 $ 12 $ 10 +Additional paid-in capital +Balance, beginning of period $ 9,963 $ 8,750 $ 8,464 +Common stock issued under employee equity plans 85 74 71 +Stock-based compensation 274 197 137 +Issuance of common stock upon warrant exercise — 448 — +Issuance of common stock to settle convertible debt 217 485 — +Issuance of treasury stock to partially settle debt — 4 78 +Issuance of warrants 5 5 — +Balance, end of period $ 10,544 $ 9,963 $ 8,750 +Treasury stock +Balance, beginning of period $ ( 53 ) $ ( 50 ) $ ( 108 ) +Common stock repurchases for tax withholding on employee equity plans ( 78 ) ( 6 ) ( 6 ) +Issuance of treasury stock to partially settle debt — 3 64 +Balance, end of period $ ( 131 ) $ ( 53 ) $ ( 50 ) +Accumulated deficit +Balance, beginning of period $ ( 7,095 ) $ ( 7,436 ) $ ( 7,775 ) +Net income 2,490 341 337 +Cumulative effect adjustment to accumulated deficit related to the adoption of ASU 2016-01, Financial Instruments — — 2 +Balance, end of period $ ( 4,605 ) $ ( 7,095 ) $ ( 7,436 ) +Accumulated other comprehensive income (loss) +Balance, beginning of period $ — $ ( 8 ) $ 6 +Other comprehensive income (loss) 17 8 ( 14 ) +Balance, end of period $ 17 $ — $ ( 8 ) +Total stockholders' equity $ 5,837 $ 2,827 $ 1,266 +See accompanying notes to consolidated financial statements. +52 +Advanced Micro Devices, Inc. +Consolidated Statements of Cash Flows +Year Ended +December 26, +2020 December 28, +2019 December 29, +2018 +(In millions) +Cash flows from operating activities: +Net income $ 2,490 $ 341 $ 337 +Adjustments to reconcile net income to net cash provided by operating activities: +Depreciation and amortization 312 222 170 +Stock-based compensation 274 197 137 +Amortization of debt discount and issuance costs 14 30 38 +Amortization of operating lease right-of-use assets 42 36 — +Loss on debt redemption, repurchase and conversion 54 176 12 +Loss on sale/disposal of property and equipment 33 42 27 +Impairment of technology licenses — — 45 +Deferred income taxes ( 1,223 ) ( 7 ) ( 4 ) +Other 6 ( 2 ) ( 1 ) +Changes in operating assets and liabilities: +Accounts receivable, net ( 219 ) ( 623 ) ( 806 ) +Inventories ( 417 ) ( 137 ) ( 151 ) +Receivables from related parties 10 14 ( 28 ) +Prepaid expenses and other assets ( 231 ) ( 176 ) ( 70 ) +Payables to related parties ( 135 ) 7 35 +Accounts payable ( 513 ) 153 212 +Accrued liabilities and other 574 220 81 +Net cash provided by operating activities 1,071 493 34 +Cash flows from investing activities: +Purchases of property and equipment ( 294 ) ( 217 ) ( 163 ) +Purchases of short-term investments ( 850 ) ( 284 ) ( 123 ) +Proceeds from maturity of short-term investments 192 325 45 +Collection of deferred proceeds on sale of receivables — 25 71 +Other — 2 — +Net cash used in investing activities ( 952 ) ( 149 ) ( 170 ) +Cash flows from financing activities: +Proceeds from short-term borrowings 200 — — +Repayments and extinguishment of debt ( 200 ) ( 473 ) ( 41 ) +Proceeds from warrant exercise — 449 — +Proceeds from sales of common stock through employee equity plans 85 74 70 +Common stock repurchases for tax withholding on employee equity plans +( 78 ) ( 6 ) ( 6 ) +Other ( 1 ) ( 1 ) 5 +Net cash provided by financing activities 6 43 28 +Net increase (decrease) in cash and cash equivalents, and restricted cash 125 387 ( 108 ) +Cash, cash equivalents and restricted cash at beginning of year 1,470 1,083 1,191 +Cash, cash equivalents and restricted cash at end of year $ 1,595 $ 1,470 $ 1,083 +53 +Year Ended +December 26, +2020 December 28, +2019 December 29, +2018 +(In millions) +Supplemental cash flow information: +Cash paid during the year for: +Interest $ 31 $ 67 $ 79 +Income taxes, net of refund $ 8 $ ( 4 ) $ ( 8 ) +Non-cash investing and financing activities: +Purchases of property and equipment, accrued but not paid $ 31 $ 65 $ 49 +Issuance of common stock to settle convertible debt $ 217 $ 377 $ — +Transfer of assets for the acquisition of property and equipment $ 111 $ 115 $ 28 +Issuance of treasury stock to partially settle debt $ — $ 7 $ 141 +Deferred proceeds on sale of receivables $ — $ — $ 25 +Non-cash activities for leases: +Operating lease right-of-use assets acquired by assuming related liabilities $ 45 $ 22 $ — +Reconciliation of cash, cash equivalents and restricted cash +Cash and cash equivalents $ 1,595 $ 1,466 $ 1,078 +Restricted cash included in Prepaid expense and other current assets $ — $ 4 $ 5 +Total cash, cash equivalents and restricted cash $ 1,595 $ 1,470 $ 1,083 +See accompanying notes to consolidated financial statements. +54 +Advanced Micro Devices, Inc. +Notes to Consolidated Financial Statements +NOTE 1 – The Company +Advanced Micro Devices, Inc. is a global semiconductor company. References herein to AMD or the Company mean Advanced Micro Devices, Inc. and its consolidated subsidiaries. AMD’s products include x86 microprocessors (CPUs), accelerated processing units which integrate microprocessors and graphics (APUs), discrete graphics processing units (GPUs), semi-custom System-on-Chip (SOC) products and chipsets for the PC, gaming, datacenter and embedded markets. In addition, AMD provides development services and sells or licenses portions of its intellectual property portfolio. +NOTE 2 – Summary of Significant Accounting Policies +Fiscal Year . The Company uses a 52- or 53-week fiscal year ending on the last Saturday in December. Fiscal 2020, 2019 and 2018 ended December 26, 2020, December 28, 2019 and December 29, 2018, respectively. Fiscal 2020, 2019 and 2018 each consisted of 52 weeks. +Principles of Consolidation. The consolidated financial statements include the Company’s accounts and those of its wholly-owned subsidiaries. Upon consolidation, all inter-company accounts and transactions have been eliminated. +Reclassification. Certain prior period amounts have been reclassified to conform to current period presentation. +Use of Estimates. The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of commitments and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results are likely to differ from those estimates, and such differences may be material to the financial statements. Areas where management uses subjective judgment include, but are not limited to, revenue allowances, inventory valuation, valuation and assessing potential impairment, if any, of goodwill and deferred income taxes. +Revenue Recognition +Revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the Company expects to receive in exchange for those goods or services. Sales, value-added, and other taxes collected concurrently with the provision of goods or services are excluded from revenue. Shipping and handling costs associated with product sales are included in cost of sales. Substantially all the Company’s revenue is derived from product sales, representing a single performance obligation. +Non-custom products +The Company transfers control and recognizes revenue when non-custom products are shipped to customers, which includes original equipment manufacturers (OEM) and distributors, in accordance with the shipping terms of the sale. Non-custom product arrangements generally comprise a single performance obligation. Certain OEMs may be entitled to rights of return and rebates under OEM agreements. The Company also sells to distributors under terms allowing the majority of distributors certain rights of return and price protection on unsold merchandise held by them. The Company estimates the amount of variable consideration under OEM and distributor arrangements and, accordingly, records a provision for product returns, allowances for price protection and rebates based on actual historical experience and any known events. +The Company offers incentive programs to certain customers, including cooperative advertising, marketing promotions, volume-based incentives and special pricing arrangements. Where funds provided for such programs can be estimated, the Company recognizes a reduction to revenue at the time the related revenue is recognized; otherwise, the Company recognizes such reduction to revenue at the later of when: i) the related revenue transaction occurs; or ii) the program is offered. For transactions where the Company reimburses a customer for a portion of the customer’s cost to perform specific product advertising or marketing and promotional activities, such amounts are recognized as a reduction to revenue unless they qualify for expense recognition. +Constraints of variable consideration have not been material. +55 +Custom products +Custom products which are associated with the Company’s Enterprise, Embedded, and Semi-Custom segment (semi-custom products), sold under non-cancellable purchases orders, for which the Company has an enforceable right to payment, and which have no alternative use to the Company at contract inception, are recognized as revenue, over the time of production of the products by the Company. The Company utilizes a cost-based input method, calculated as cost incurred plus estimated margin, to determine the amount of revenue to recognize for in-process, but incomplete, customer orders at a reporting date. The Company believes that a cost-based input method is the most appropriate manner to measure how the Company satisfies its performance obligations to customers because the effort and costs incurred best depict the Company’s satisfaction of its performance obligation. +Sales of semi-custom products are not subject to a right of return. Custom products arrangements involve a single performance obligation. There are no variable consideration estimates associated with custom products. +Development and intellectual property licensing agreements +From time to time, the Company may enter into arrangements with customers that combine the provision of development services and a license to the right to use the Company’s IP. These arrangements are deemed to be single or multiple performance obligations based upon the nature of the arrangements. Revenue is recognized upon the transfer of control, over time or at a point in time, depending on the nature of the arrangements. The Company evaluates whether the licensing component is distinct. A licensing component is distinct if it is both (i) capable of being distinct and (ii) distinct in the context of the arrangement. If the license is not distinct it is combined with the development services as a single performance obligation and recognized over time. If the license is distinct, revenue is recognized at a point in time when the customer has the ability to benefit from the license. +From time to time, the Company may enter into arrangements with customers that solely involve the sale or licensing of its patents or IP. Generally, there are no performance obligations beyond transferring the designated license to the Company’s patents or IP. Accordingly, revenue is recognized at a point in time when the customer has the ability to benefit from the license. +There are no variable consideration estimates associated with either combined development and intellectual property arrangements or for standalone arrangements involving either the sale or licensing of IP. +Total revenue recognized over time associated with custom products and development services accounted for approximately 18 %, 19 % and 29 % of the Company’s revenue in 2020, 2019 and 2018, respectively. +Customers are generally required to pay for products and services within the Company’s standard contractual terms, which are typically net 30 to 60 days. The Company has determined that it does not have significant financing components in its contracts with customers. +Inventories +The Company values inventory at standard cost, adjusted to approximate the lower of actual cost or estimated net realizable value using assumptions about future demand and market conditions. In determining excess or obsolescence reserves for its products, the Company considers assumptions such as changes in business and economic conditions, other-than-temporary decreases in demand for its products, and changes in technology or customer requirements. In determining the lower of cost or net realizable value reserves, the Company considers assumptions such as recent historical sales activity and selling prices, as well as estimates of future selling prices. The Company fully reserves for inventories and non-cancellable purchase orders for inventory deemed obsolete. The Company performs periodic reviews of inventory items to identify excess inventories on hand by comparing on-hand balances and non-cancellable purchase orders to anticipated usage using recent historical activity as well as anticipated or forecasted demand. If estimates of customer demand diminish further or market conditions become less favorable than those projected by the Company, additional inventory carrying value adjustments may be required . +Goodwill +The Company performs its goodwill impairment analysis as of the first day of the fourth quarter of each year and, if certain events or circumstances indicate that an impairment loss may have been incurred, on a more frequent basis. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. +56 +The Company first analyzes qualitative factors to determine if it is more likely than not that the fair value of a reporting unit exceeds its carrying amount. Qualitative factors include industry and market considerations, overall financial performance, share price trends and market capitalization and Company-specific events. If the Company concludes it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, the Company does not proceed to perform a quantitative impairment test. +If the Company concludes it is more likely than not that the fair value of a reporting unit is less than its carrying value, a quantitative goodwill impairment test will be performed by comparing the fair value of each reporting unit to its carrying value. A quantitative impairment analysis, if necessary, considers the income approach, which requires estimates of the present value of expected future cash flows to determine a reporting unit’s fair value. Significant estimates include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates, and future economic and market conditions. +A goodwill impairment charge is recognized for the amount by which a reporting unit’s fair value is less than its carrying value, not to exceed the total amount of goodwill allocated to that reporting unit. +Contingencies +From time to time the Company is a defendant or plaintiff in various legal actions that arise in the normal course of business. The Company is also subject to income tax, indirect tax or other tax claims by tax agencies in jurisdictions in which it conducts business. In addition, the Company is a party to environmental matters including local, regional, state and federal government clean-up activities at or near locations where the Company currently or has in the past conducted business. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of reasonably possible losses. A determination of the amount of reserves required for these commitments and contingencies that would be charged to earnings, if any, includes assessing the probability of adverse outcomes and estimating the amount of potential losses. The required reserves, if any, may change due to new developments in each matter or changes in circumstances such as a change in settlement strategy. +Cash Equivalents and Short-term Investments +Cash equivalents consist of financial instruments that are readily convertible into cash and have original maturities of three months or less at the time of purchase. Other investments in time deposits due within 12 months and marketable securities are included in short-term investments. Classification of marketable securities as current is based on the Company’s intent and belief in its ability to sell these securities and use the proceeds from sale in operations within 12 months. +Investments in Available-for-sale Debt Securities +The Company classifies its investments in debt securities at the date of acquisition as available-for-sale. Available-for-sale debt securities are reported at fair value with the related unrealized gains and losses included, net of tax, in accumulated other comprehensive income (loss), a component of stockholders’ equity. If an available-for-sale debt security’s fair value is less than its amortized cost basis, then the Company evaluates whether the decline is the result of a credit loss, in which case an impairment is recorded through an allowance for credit losses. Unrealized gains and losses not attributable to credit losses are included, net of tax, in accumulated other comprehensive income (loss), a component of stockholders’ equity. The cost of securities sold is determined based on the specific identification method. +Accounts Receivable +Accounts receivable are primarily comprised of trade receivables presented net of rebates, price protection and an allowance for doubtful accounts. Accounts receivable also include unbilled receivables, which primarily represent work completed on development services recognized as revenue but not yet invoiced to customers and semi-custom products under non-cancellable purchase orders that have no alternative use to the Company at contract inception, for which revenue has been recognized but not yet invoiced to customers. All unbilled accounts receivables are expected to be billed and collected within twelve months. +The Company manages its exposure to customer credit risk through credit limits, credit lines, ongoing monitoring procedures and credit approvals. Furthermore, the Company performs in-depth credit evaluations of all new customers and, at intervals, for existing customers. From this, the Company may require letters of credit, bank or corporate guarantees or advance payments if deemed necessary. The Company maintains an allowance for doubtful accounts, consisting of known specific troubled accounts as well as an amount based on overall estimated +57 +potential uncollectible accounts receivable based on historical experience and review of their current credit quality. The Company does not believe the receivable balance from its customers represents a significant credit risk. +Property and Equipment +Property and equipment are stated at cost. Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. Estimated useful lives are as follows: equipment uses two to six years , and leasehold improvements are measured by the shorter of the remaining terms of the leases or the estimated useful economic lives of the improvements. +Leases +The Company determines if an arrangement is a lease, or contains a lease, at the inception of the arrangement. When the Company determines the arrangement is a lease, or contains a lease, at lease inception, it then determines whether the lease is an operating lease or a finance lease. Operating and finance leases result in the Company recording a right-of-use (ROU) asset and lease liability on its balance sheet. ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent its obligation to make lease payments arising from the lease. Operating and finance lease ROU assets and liabilities are initially recognized based on the present value of lease payments over the lease term. In determining the present value of lease payments, the Company uses the implicit interest rate if readily determinable or when the implicit interest rate is not readily determinable, the Company uses its incremental borrowing rate. The incremental borrowing rate is not a commonly quoted rate and is derived through a combination of inputs including the Company’s credit rating and the impact of full collateralization. The incremental borrowing rate is based on the Company’s collateralized borrowing capabilities over a similar term of the lease payments. The Company utilizes the consolidated group incremental borrowing rate for all leases as the Company has centralized treasury operations. The operating lease ROU asset also includes any lease payments made and excludes any lease incentives. Specific lease terms may include options to extend or terminate the lease when the Company believes it is reasonably certain that it will exercise that option. Lease expense for operating lease payments is recognized on a straight-line basis over the lease term. As allowed by the guidance, the Company has elected not to recognize ROU assets and lease liabilities that arise from short-term (12 months or less) leases for any class of underlying asset. Operating leases are included in operating lease ROU assets, other current liabilities, and long-term operating lease liabilities on the Company’s consolidated balance sheets. The Company’s finance leases are immaterial. +Foreign Currency Translation/Transactions +The functional currency of all of the Company’s foreign subsidiaries is the U.S. dollar. Assets and liabilities denominated in non-U.S. dollars have been remeasured into U.S. dollars at current exchange rates for monetary assets and liabilities and historical exchange rates for non-monetary assets and liabilities. Non-U.S. dollar denominated transactions have been remeasured at average exchange rates in effect during each period, except for those cost of sales and expense transactions related to non-monetary balance sheet amounts which have been remeasured at historical exchange rates. The gains or losses from foreign currency remeasurement are included in earnings. +Marketing and Advertising Expenses +Advertising costs are expensed as incurred. In addition, the Company’s marketing and advertising expenses include certain cooperative advertising funding obligations under customer incentive programs, which costs are recorded upon agreement with customers and vendor partners. Cooperative advertising expenses are recorded as marketing, general and administrative expense to the extent the cash paid does not exceed the estimated fair value of the advertising benefit received. Any excess of cash paid over the estimated fair value of the advertising benefit received is recorded as a reduction of revenue. Total marketing and advertising expenses for 2020, 2019 and 2018 were approximately $ 314 million, $ 217 million and $ 176 million, respectively. +Stock-Based Compensation +The Company estimates stock-based compensation cost for stock options at the grant date based on the option’s fair value as calculated by the Black-Scholes model. For time-based restricted stock units (RSUs), fair value is based on the closing price of the Company’s common stock on the grant date. The Company estimates the grant-date fair value of RSUs that involve a market condition using the Monte Carlo simulation model. The Company estimates the grant-date fair value of stock to be issued under the Employee Stock Purchase plan (ESPP) using the Black-Scholes model. Compensation expense is recognized over the vesting period of the applicable award using +58 +the straight-line method, except for the compensation expense related to RSUs with performance or market conditions (PRSUs), which are recognized ratably for each vesting tranche from the service inception date to the end of the requisite service period. Forfeiture rates are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. +Income Taxes +The Company computes the provision for income taxes using the liability method and recognizes deferred tax assets and liabilities for temporary differences between financial statement and income tax bases of assets and liabilities, as well as for operating loss and tax credit carryforwards. The Company measures deferred tax assets and liabilities using tax rates applicable to taxable income in effect for the years in which those tax assets are expected to be realized or settled and provides a valuation allowance against deferred tax assets when it cannot conclude that it is more likely than not that some or all deferred tax assets will be realized. The assessment requires significant judgment and is performed in each of the applicable taxing jurisdictions. In addition, the Company recognizes tax benefits from uncertain tax positions only if it expects that its tax positions are more likely than not that they will be sustained, based on the technical merits of the positions, on examination by the jurisdictional tax authority. The Company recognizes any accrued interest and penalties to unrecognized tax benefits as interest expense and income tax expense, respectively. +Recently Adopted Accounting Standards +In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments — Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments . This standard changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. The Company adopted this standard in the first quarter of 2020 using the modified retrospective adoption method. This standard did not have an impact on the consolidated financial statements upon adoption. +Recently Issued Accounting Standards +In August 2020, the FASB issued ASU 2020-06, Debt — Debt with Conversion and Other Options (Subtopic 470-20) and Contracts in Entity’s Own Equity (Subtopic 815-40), Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity. This standard simplifies the accounting for convertible instruments and its application of the derivatives scope exception for contracts in its own equity by eliminating some of the models that require separating embedded conversion features from convertible instruments. The guidance also addresses how convertible instruments are accounted for in the diluted earnings per share calculation and enhances disclosures about the terms of convertible instruments and contracts in an entity’s own equity. The standard is effective for fiscal years beginning after December 15, 2021, with early adoption permitted, and can be adopted through either a modified retrospective method with a cumulative effect adjustment to opening retained earnings or a full retrospective method. The Company is currently evaluating the impact of this new standard on its consolidated financial statements. +Although there are several other new accounting pronouncements issued by the FASB, the Company does not believe any of these accounting pronouncements had or will have a material impact on its consolidated financial statements. +NOTE 3 – Supplemental Financial Statement Information +Short-term Investments +As of December 26, 2020, the Company had $ 400 million of time deposits and $ 295 million of commercial paper. As of December 28, 2019, the Company had $ 37 million of commercial paper. +Accounts Receivable, net +As of December 26, 2020 and December 28, 2019, Accounts receivable, net included unbilled accounts receivable of $ 123 million and $ 197 million, respectively. +59 +Inventories +December 26, +2020 December 28, +2019 +(In millions) +Raw materials $ 93 $ 94 +Work in process 1,139 691 +Finished goods 167 197 +Total inventories $ 1,399 $ 982 +Property and Equipment, net +December 26, +2020 December 28, +2019 +(In millions) +Leasehold improvements $ 208 $ 203 +Equipment 1,209 951 +Construction in progress 136 114 +Property and equipment, gross 1,553 1,268 +Accumulated depreciation ( 912 ) ( 768 ) +Total property and equipment, net $ 641 $ 500 +Depreciation expense for 2020, 2019 and 2018 was $ 217 million, $ 142 million and $ 94 million, respectively. +Other Non-current Assets +December 26, +2020 December 28, +2019 +(In millions) +Software and technology licenses, net $ 229 $ 210 +Other 144 147 +Total other non-current assets $ 373 $ 357 +Accrued Liabilities +December 26, +2020 December 28, +2019 +(In millions) +Accrued compensation and benefits $ 513 $ 285 +Accrued marketing programs and advertising expenses 839 454 +Other accrued and current liabilities 444 345 +Total accrued liabilities $ 1,796 $ 1,084 +Unearned Revenue +Unearned revenue represents consideration received or due from customers in advance of the Company satisfying its performance obligations. The unearned revenue is associated with any combination of development services, IP licensing and product revenue. Changes in unearned revenue were as follows: +December 26, +2020 December 28, +2019 +(In millions) +Beginning balance $ 2 $ 11 +Unearned revenue 22 43 +Revenue recognized during the period ( 9 ) ( 52 ) +Ending balance $ 15 $ 2 +60 +Revenue allocated to remaining performance obligations that are unsatisfied (or partially unsatisfied) as of December 26, 2020 was $ 337 million, which may include amounts received from customers but not yet earned and amounts that will be invoiced and recognized as revenue in future periods associated with any combination of development services, IP licensing and product revenue. The Company expects to recognize $ 174 million of revenue allocated to remaining performance obligations in the next 12 months. +The revenue allocated to remaining performance obligations did not include amounts which have an original expected duration of one year or less. +NOTE 4 – Related Parties—Equity Joint Ventures +ATMP Joint Venture s +The Company holds a 15 % equity interest in two joint ventures (collectively, the ATMP JV) with affiliates of Tongfu Microelectronics Co., Ltd, a Chinese joint stock company. The Company has no obligation to fund the ATMP JV. The Company accounts for its equity interests in the ATMP JV under the equity method of accounting due to its significant influence over the ATMP JV. +The ATMP JV provides assembly, test, mark and packaging (ATMP) services to the Company. The Company assists the ATMP JV in its management of certain raw material inventory. The purchases from and resales to the ATMP JV of inventory under the Company’s inventory management program are reported within purchases and resales with the ATMP JV and do not impact the Company’s consolidated statement of operations. +The Company’s purchases from the ATMP JV during 2020 and 2019 amounted to $ 831 million and $ 660 million, respectively. As of December 26, 2020 and December 28, 2019, the amounts payable to the ATMP JV were $ 78 million and $ 213 million, respectively, and are included in Payables to related parties on the Company’s consolidated balance sheets. The Company’s resales to the ATMP JV during 2020 and 2019 amounted to $ 28 million and $ 56 million, respectively. As of December 26, 2020 and December 28, 2019, the Company had receivables from ATMP JV of $ 10 million and $ 7 million, respectively, included in Receivables from related parties on the Company’s consolidated balance sheets. +During 2020, the Company recorded a gain of $ 5 million in Equity income (loss) in investee on its consolidated statements of operations. During 2019, the Company did no t record any gain or loss in Equity income (loss) in investee. During 2018, the Company recorded a $ 2 million loss in Equity income (loss) in investee, which included certain expenses incurred by the Company on behalf of the ATMP JV. As of December 26, 2020 and December 28, 2019, the carrying value of the Company’s investment in the ATMP JV were approximately $ 63 million and $ 58 million, respectively. +THATIC Joint Ventures +The Company holds equity interests in two joint ventures (collectively, the THATIC JV) with Higon Information Technology Co., Ltd. (THATIC), a third-party Chinese entity. The Company holds a majority interest in one of the joint ventures and a minority interest in the other. The Company is not a primary beneficiary of the THATIC JV and, as such, the Company does not consolidate either of these entities and accounts for its equity interests in the THATIC JV under the equity method of accounting. +The Company’s share in the net losses of the THATIC JV is not recorded in the Company’s consolidated statements of operations since the Company is not obligated to fund the THATIC JV’s losses in excess of the Company’s investment in the THATIC JV, which was zero as of both December 26, 2020 and December 28, 2019. +In February 2016, the Company licensed certain of its intellectual property (Licensed IP) to the THATIC JV for a total of $ 293 million in license fees payable over several years upon achievement of certain milestones. The Company also expects to receive a royalty based on the sales of the THATIC JV’s products to be developed on the basis of such Licensed IP. The Company classifies Licensed IP income and royalty income, associated with the February 2016 agreement, as licensing gain within operating income. +In March 2017, the Company entered into a development and intellectual property agreement (Development and IP) with the THATIC JV, and also expects to receive a royalty based on the sales of the THATIC JV’s products to be developed on the basis of such agreement. The Company classifies Development and IP income and royalty income, associated with the March 2017 agreement, as revenue once earned. +61 +The Company recognized $ 60 million as licensing gain associated with the Licensed IP during 2019. During 2018, the Company recognized $ 86 million of IP-related revenue upon completion of all technology milestones under the Development and IP agreement. +As of December 26, 2020, the Company had no receivables from the THATIC JV. The Company’s receivable from the THATIC JV was $ 13 million as of December 28, 2019, included in Receivables from related parties on its consolidated balance sheets. +In June 2019, the Bureau of Industry and Security of the United States Department of Commerce added certain Chinese entities to the Entity List, including THATIC and the THATIC JV. The Company is complying with U.S. law pertaining to the Entity List designation. +NOTE 5 – Goodwill +The carrying amount of goodwill as of both December 26, 2020 and December 28, 2019 was $ 289 million, which was all allocated to reporting units within the Company’s Enterprise, Embedded and Semi-Custom segment. +In the fourth quarters of 2020 and 2019, the Company conducted its annual impairment tests of goodwill and concluded that there was no goodwill impairment with respect to its reporting units. +NOTE 6 – Debt and Revolving Credit Facility +Debt +The Company’s total debt as of December 26, 2020 and December 28, 2019 consisted of: +December 26, +2020 December 28, +2019 +(In millions) +7.50 % Senior Notes Due 2022 ( 7.50 % Notes) +$ 312 $ 312 +2.125 % Convertible Senior Notes Due 2026 ( 2.125 % Notes) +26 251 +Total debt (principal amount) 338 563 +Unamortized debt discount for 2.125 % Notes +( 7 ) ( 73 ) +Unamortized debt issuance costs for 2.125 % Notes +— ( 3 ) +Unamortized debt issuance costs for 7.50 % Notes +( 1 ) ( 1 ) +Total long-term debt (net) $ 330 $ 486 +2.125 % Convertible Senior Notes Due 2026 +In September 2016, the Company issued $ 805 million in aggregate principal amount of 2.125 % Convertible Senior Notes due 2026 ( 2.125 % Notes). The 2.125 % Notes are general unsecured senior obligations of the Company. The interest is payable semi-annually in March and September of each year, commencing in March 2017. As of December 26, 2020, the outstanding aggregate principal amount of the 2.125 % Notes was $ 26 million. +The 2.125 % Notes mature on September 1, 2026. However, as outlined in the indenture governing the 2.125 % Notes, holders of the 2.125 % Notes may convert them at their option during certain time periods and upon the occurrence of one of the following circumstances: +(1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2016 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130 % of the conversion price on each applicable trading day (equivalent to an initial conversion price of approximately $ 8.00 per share of common stock); +(2) during the five business day period after any ten consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each trading day of the measurement period was less than 98 % of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such trading day; or +(3) upon the occurrence of specified corporate events. +62 +On or after June 1, 2026 and until the close of business on the business day immediately preceding the maturity date, holders may convert their notes at any time regardless of the foregoing circumstances. Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company’s common stock or a combination of cash and shares of the Company’s common stock at the Company’s election. +The event described in (1) above was met during the fourth calendar quarter of 2020 and, as a result, the 2.125 % Notes are convertible at the option of the holder from January 1, 2021 and remain convertible until March 31, 2021. +During 2020, holders of the 2.125 % Notes converted $ 225 million principal amount of these notes, for which the Company issued approximately 28 million shares of the Company’s common stock at the conversion price of $ 8.00 per share. The Company recorded a loss of $ 54 million from these conversions in Other expense, net on its consolidated statements of operations. +The Company’s current intent is to deliver shares of its common stock upon conversion of the 2.125 % Notes. As such, no sinking fund is provided for the 2.125 % Notes and the Company continued to classify the carrying value of the liability component of the 2.125 % Notes as long-term debt and the equity component of the 2.125 % Notes as permanent equity on its consolidated balance sheet as of December 26, 2020. +The determination of whether or not the 2.125 % Notes are convertible is performed on a calendar-quarter basis. +Based on the closing price of the Company’s common stock of $ 91.81 on December 24, 2020, the last trading day of 2020, the if-converted value of the 2.125 % Notes exceeded its principal amount by approximately $ 272 million. +The effective interest rate of the liability component of the 2.125 % Notes is 8 %. This interest rate was based on the interest rates of similar liabilities at the time of issuance that did not have associated conversion features. The following table sets forth total interest expense recognized related to the 2.125 % Notes for the year ended December 26, 2020: +December 26, +2020 December 28, +2019 +(In millions) +Contractual interest expense $ 4 $ 15 +Interest cost related to amortization of debt issuance costs $ — $ 1 +Interest cost related to amortization of the debt discount $ 6 $ 22 +The carrying amount of the equity component of the 2.125 % Notes was $ 10 million and $ 95 million as of December 26, 2020 and December 28, 2019, respectively. +7.50 % Senior Notes Due 2022 +On August 15, 2012, the Company issued $ 500 million of its 7.50 % Senior Notes due 2022 ( 7.50 % Notes). The 7.50 % Notes are general unsecured senior obligations of the Company. Interest is payable on February 15 and August 15 of each year beginning February 15, 2013 until the maturity date of August 15, 2022. The 7.50 % Notes are governed by the terms of an indenture (the 7.50 % Indenture) dated August 15, 2012 between the Company and Wells Fargo Bank, N.A., as trustee. As of December 26, 2020, the outstanding aggregate principal amount of the 7.50 % Notes was $ 312 million. +Prior to August 15, 2022, the Company may redeem some or all of the 7.50 % Notes at a price equal to 100 % of the principal amount plus accrued and unpaid interest and a “make whole” premium (as defined in the 7.50 % Indenture). Holders have the right to require the Company to repurchase all or a portion of the 7.50 % Notes in the event that the Company undergoes a change of control as defined in the 7.50 % Indenture, at a repurchase price of 101 % of the principal amount plus accrued and unpaid interest. Additionally, an event of default (as defined in the 7.50 % Indenture) may result in the acceleration of the maturity of the 7.50 % Notes. +Debt Covenants and Seniority +The 7.50 % Notes require the Company to comply with certain financial covenants and a number of restrictive covenants. The 7.50 % Notes and 2.125 % Notes rank equally with the Company’s existing and future senior debt and are senior to all of the Company’s future subordinated debt. The 7.50 % Notes and 2.125 % Notes rank junior to all of the Company’s future senior secured debt to the extent of the collateral securing such debt and are structurally subordinated to all existing and future debt and liabilities of the Company’s subsidiaries. +63 +Potential Repurchase of Outstanding Notes +The Company may elect to purchase or otherwise retire the 7.50 % Notes and 2.125 % Notes with cash, stock or other assets from time to time in open market or privately negotiated transactions either directly or through intermediaries or by tender offer when the Company believes the market conditions are favorable to do so. +Revolving Credit Facility +On June 7, 2019, the Company entered into a secured revolving credit facility for up to $ 500 million (the Revolving Credit Facility) pursuant to a credit agreement by and among the Company, as borrower, the lenders party thereto and Wells Fargo Bank, National Association, as administrative agent (the Credit Agreement). The Revolving Credit Facility consists of a $ 500 million, five-year secured revolving loan facility, including a $ 50 million swingline subfacility and a $ 75 million sublimit for letters of credit. +Prior to the third quarter ended September 26, 2020, obligations under the Credit Agreement were secured by a lien on substantially all the Company’s property, other than intellectual property. During the third quarter ended September 26, 2020, as a result of upgrades of the Company’s debt ratings, the security requirements under the Credit Agreement were terminated and the liens on the Company’s collateral were released. +The Credit Agreement also provides the ability to increase the Revolving Credit Facility or incur incremental term loans or other incremental equivalent. The Company’s available borrowings under the Revolving Credit Facility are also subject to reduction. +Borrowings under the Revolving Credit Facility bear interest at either the LIBOR rate or the base rate at the Company’s option (in each case, as customarily defined) plus an applicable margin. +The Credit Agreement contains customary affirmative and negative covenants, as well as a total leverage covenant. The Credit Agreement also contains customary events of default. +On April 6, 2020, the Company borrowed $ 200 million under the Credit Agreement via the LIBOR rate loan option at an annual interest rate of 2.37 %. The Company repaid the $ 200 million borrowing plus interest on July 6, 2020. As of December 26, 2020, the Company had $ 13 million of letters of credit outstanding under the Credit Agreement and the Company was in compliance with all required covenants under the Credit Agreement. +Future Payments on Total Debt +As of December 26, 2020, the Company’s future debt payment obligations were as follows: +Term Debt +(Principal only) +(In millions) +2022 $ 312 +2026 26 +Total $ 338 +NOTE 7 – Financial Instruments +Fair Value Measurements +Financial Instruments Recorded at Fair Value on a Recurring Basis +As of December 26, 2020 and December 28, 2019, the Company had $ 295 million and $ 37 million of commercial paper, respectively, included in Short-term investments on the Company’s consolidated balance sheets. The commercial paper is classified within Level 2 as its fair value estimates were based on quoted prices for comparable instruments . +64 +In addition, as of December 26, 2020 and December 28, 2019, the Company also had approximately $ 46 million and $ 30 million, respectively, of investments in mutual funds held in a Rabbi trust established for the Company’s deferred compensation plan, which were included in Other non-current assets on the Company’s consolidated balance sheets. As of December 28, 2019, the Company also had approximately $ 4 million of investments in money market funds, used as collateral for letters of credit deposits, which were included in Other current assets on the Company’s consolidated balance sheets. These money market funds and mutual funds are classified within Level 1 because they are valued using quoted prices for identical instruments in active markets. Their amortized cost approximates the fair value for all periods presented. The Company is restricted from accessing these investments. +Financial Instruments Not Recorded at Fair Value +The Company carries its financial instruments at fair value with the exception of its long-term debt. The carrying amounts and estimated fair values of the Company’s long-term debt are as follows: +December 26, 2020 December 28, 2019 +Carrying +Amount Estimated +Fair Value Carrying +Amount Estimated +Fair Value +(In millions) +Long-term debt, net $ 330 $ 642 $ 486 $ 1,823 +The estimated fair value of the Company’s long-term debt are based on Level 2 inputs as the fair value is based on quoted prices for the Company’s debt and comparable instruments in inactive markets. The Company’s 2.125 % Notes, included in Long-term debt, net, above, were convertible at the option of the holder as of December 26, 2020. The estimated fair value of the 2.125 % Notes as of December 26, 2020 takes into account the value of the Company’s stock price of $ 91.81 as of December 24, 2020, the last trading date for the year ended December 26, 2020 and the initial conversion price of approximately $ 8.00 per share of common stock. +The fair value of the Company’s time deposits, accounts receivable, accounts payable and other short-term obligations approximate their carrying value based on existing terms. +Hedging Transactions and Derivative Financial Instruments +Cash Flow Hedges Designated as Accounting Hedges and Foreign Currency Forward Contracts not Designated as Accounting Hedges +The Company enters into foreign currency forward contracts to hedge its exposure to foreign currency exchange rate risk related to future forecasted transactions denominated in currencies other than the U.S. Dollar. These contracts generally mature within 12 months and are designated as accounting hedges. As of December 26, 2020 and December 28, 2019, the notional values of the Company’s outstanding foreign currency forward contracts designated as cash flow hedges were $ 501 million and $ 467 million, respectively. The fair value of these contracts was not material as of December 26, 2020 and December 28, 2019. +The Company also enters into foreign currency forward contracts to reduce the short-term effects of foreign currency fluctuations on certain receivables or payables denominated in currencies other than the U.S. Dollar. These forward contracts generally mature within 3 months and are not designated as accounting hedges. As of December 26, 2020 and December 28, 2019, the notional values of outstanding contracts were $ 254 million and $ 272 million, respectively. The fair value of these contracts was not material as of December 26, 2020 and December 28, 2019. +NOTE 8 – Accumulated Other Comprehensive Income (Loss) +Unrealized holding gains or losses on the Company’s available-for-sale debt securities and unrealized holding gains and losses on derivative financial instruments qualifying as cash flow hedges are included in other comprehensive income (loss). +65 +The table below summarizes the changes in accumulated other comprehensive income (loss): +2020 2019 2018 +Gains (losses) on cash flow hedges: (In millions) +Beginning balance $ — $ ( 8 ) $ 6 +Net unrealized gains (losses) arising during +the period 18 2 ( 19 ) +Net losses (gains) reclassified into income during the period ( 1 ) 6 5 +Total other comprehensive income (loss) 17 8 ( 14 ) +Ending balance $ 17 $ — $ ( 8 ) +NOTE 9 – Concentrations of Credit Risk +Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of investments in time deposits, available-for-sale debt securities and trade receivables. +The Company places its investments with high credit quality financial institutions. At the time an investment is made, investments in commercial paper of industrial firms and financial institutions are rated A1, P1 or better. The Company invests in tax-exempt securities including municipal notes and bonds and bonds that are rated A, A2 or better and repurchase agreements, each of which have securities of the type and quality listed above as collateral. +The Company believes that concentrations of credit risk with respect to trade receivables are limited because a large number of geographically diverse customers make up the Company’s customer base, thus diluting the trade credit risk. The Company’s top three customers with the highest accounts receivable balances each accounted for approximately 18 %, 17 % and 6 %, respectively, of the total consolidated accounts receivable balance as of December 26, 2020 and 15 %, 9 % and 8 %, respectively, of the total consolidated accounts receivable balance as of December 28, 2019. However, the Company does not believe the receivable balance from these customers represents a significant credit risk based on past collection experience and review of their current credit quality. +NOTE 10 – Earnings Per Share +Basic earnings per share is computed based on the weighted-average number of shares outstanding. +Diluted earnings per share is computed based on the weighted-average number of shares outstanding plus potentially dilutive shares outstanding during the period. Potentially dilutive shares are determined by applying the treasury stock method to the Company’s stock options, RSUs (including PRSUs), common stock to be issued under the ESPP and warrants. Potentially dilutive shares issuable upon conversion of the 2.125 % Convertible Senior Notes due 2026 ( 2.125 % Notes) are calculated using the if-converted method. +66 +The following table sets forth the components of basic and diluted earnings per share: +2020 2019 2018 +(In millions, except per share amounts) +Numerator +Net income for basic earnings per share $ 2,490 $ 341 $ 337 +Effect of potentially dilutive shares: +Interest expense related to the 2.125% Notes 1 — — +Net income for diluted earnings per share $ 2,491 $ 341 $ 337 +Denominator +Basic weighted average shares 1,184 1,091 982 +Effect of potentially dilutive shares: +Employee equity plans and warrants 20 29 82 +2.125% Notes 3 — — +Diluted weighted average shares 1,207 1,120 1,064 +Earnings per share: +Basic $ 2.10 $ 0.31 $ 0.34 +Diluted $ 2.06 $ 0.30 $ 0.32 +Potential shares from employee equity plans and the impact from the conversion of the 2.125 % Notes up to the conversion date, totaling 22 million for 2020, were not included in the earnings per share calculation because their inclusion would have been anti-dilutive. +Potential shares from employee equity plans, the impact from the conversion of the 2.125 % Notes up to the conversion date and the assumed conversion of the remaining outstanding 2.125 % Notes, totaling 93 million and 105 million shares for 2019 and 2018, respectively, were not included in the earnings per share calculation because their inclusion would have been anti-dilutive. +NOTE 11 – Common Stock and Stock-Based Compensation +Common Stock +Shares of common stock outstanding were as follows: +Year Ended +December 26, +2020 December 28, +2019 December 29, +2018 +(In millions) +Balance, beginning of period 1,170 1,005 967 +Common stock issued under employee equity plans 14 20 31 +Common stock repurchases for tax withholding on equity awards ( 1 ) — — +Issuance of common stock upon warrant exercise — 75 — +Issuance of common stock to settle convertible debt 28 69 — +Issuance of treasury stock to partially settle debt — 1 7 +Balance, end of period 1,211 1,170 1,005 +Stock-Based Compensation +The Company’s employee equity programs are intended to attract, retain and motivate highly qualified employees. On April 29, 2004, the Company’s stockholders approved the 2004 Equity Incentive Plan, as amended and restated (the 2004 Plan). In the fourth quarter of 2017, the Company introduced the 2017 Employee Stock Purchase Plan, as amended and restated (the 2017 Plan). +67 +Under the 2004 Plan, stock options generally vest and become exercisable over a three-year period from the date of grant and expire within seven years after the grant date. Unvested shares that are reacquired by the Company from forfeited outstanding equity awards become available for grant and may be reissued as new awards. +Under the 2004 Plan, the Company can grant (i) stock options, and (ii) RSUs, including time-based RSUs and PRSUs. +Stock Options. Under the 2004 Plan, nonstatutory and incentive stock options may be granted. The exercise price of the shares subject to each nonstatutory stock option and incentive stock option cannot be less than 100 % of the fair market value of the Company’s common stock on the date of the grant. The exercise price of each option granted under the 2004 Plan must be paid in full at the time of the exercise. +Time-based RSUs. Time-based RSUs are awards that can be granted to any employee, director or consultant and that obligate the Company to issue a specific number of shares of the Company’s common stock in the future if the vesting terms and conditions are satisfied. The purchase price for the shares is $ 0.00 per share. +PRSUs. PRSUs can be granted to certain of the Company’s senior executives. The performance metrics can be financial performance, non-financial performance and/or market conditions. Each PRSU award reflects a target number of shares (Target Shares) that may be issued to an award recipient before adjusting based on the Company’s financial performance, non-financial performance and/or market conditions. The actual number of shares that a grant recipient receives at the end of the period may range from 0 % to 250 % of the Target Shares granted, depending upon the degree of achievement of the performance target designated by each individual award. +ESPP. Under the 2017 Plan, eligible employees who participate in an offering period may have up to 10 % of their eligible earnings withheld, up to certain limitations, to purchase shares of common stock at 85 % of the lower of the fair market value on the first or the last business day of the six-month offering period. The offering periods commence in May and November each year. +As of December 26, 2020, the Company had 57 million shares of common stock that were available for future grants and 22 million shares reserved for issuance upon the exercise of outstanding stock options or the vesting of unvested RSUs, including PRSUs, under the 2004 Plan. In addition, the Company had 40 million shares of common stock that were available for issuance under the 2017 plan. +Valuation and Expense +Stock-based compensation expense was allocated in the consolidated statements of operations as follows: +2020 2019 2018 +(In millions) +Cost of sales $ 6 $ 6 $ 4 +Research and development 173 129 91 +Marketing, general, and administrative 95 62 42 +Total stock-based compensation expense before income taxes 274 197 137 +Income tax benefit ( 42 ) — — +Total stock-based compensation expense, net of income taxes $ 232 $ 197 $ 137 +Stock Options. The weighted-average estimated fair value of employee stock options granted for the years ended December 26, 2020, December 28, 2019 and December 29, 2018 was $ 38.49 , $ 13.31 and $ 7.62 per share, respectively, using the following assumptions: +2020 2019 2018 +Expected volatility 57.87 % +52.60 % - 56.51 % +51.51 % - 60.46 % +Risk-free interest rate 0.18 % +1.53 % - 2.51 % +2.20 % - 2.83 % +Expected dividends — % — % — % +Expected life (in years) 4.3 +3.94 - 3.95 +3.92 - 3.94 +The Company uses a combination of the historical volatility of its common stock and the implied volatility for publicly traded options on the Company’s common stock as the expected volatility assumption. The risk-free interest rate is +68 +based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the option grant at the date closest to the option grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the near future. The expected term of employee stock options represents the weighted-average period the stock options are expected to remain outstanding. +The following table summarizes stock option activity and related information: +Outstanding Number +of Shares Weighted- +Average +Exercise +Price Aggregate Intrinsic Value Weighted-Average Remaining Contractual Life +(in years) +(In millions, except share price) +Balance as of December 28, 2019 10 $ 7.56 +Granted — $ 84.85 +Exercised ( 3 ) $ 3.62 +Balance as of December 26, 2020 7 $ 12.91 $ 589 2.92 +Exercisable December 26, 2020 6 $ 7.01 $ 538 2.43 +The total intrinsic value of stock options exercised for 2020, 2019 and 2018 was $ 180 million, $ 84 million and $ 67 million, respectively. +As of December 26, 2020, the Company had $ 19 million of total unrecognized compensation expense related to stock options, which will be recognized over the weighted-average period of 1.66 years. +Time-based RSUs. The weighted-average grant date fair values of time-based RSUs granted during 2020, 2019 and 2018 were $ 78.59 , $ 32.52 and $ 17.66 per share, respectively. +The following table summarizes time-based RSU activity and related information: +Number +of Shares Weighted- +Average +Fair Value Aggregate Intrinsic Value Weighted-Average Remaining Contractual Life +(in years) +(In millions except share price) +Unvested shares as of December 28, 2019 18 $ 22.93 +Granted 4 $ 78.59 +Forfeited ( 1 ) $ 30.82 +Vested ( 9 ) $ 20.67 +Unvested shares as of December 26, 2020 12 $ 43.98 $ 1,078 1.13 +The total fair value of time-based RSUs vested during 2020, 2019 and 2018 was $ 642 million, $ 395 million and $ 315 million, respectively. +As of December 26, 2020, the Company had $ 462 million of total unrecognized compensation expense related to time-based RSUs, which will be recognized over the weighted-average period of 1.69 years. +PRSUs. The weighted-average grant date fair values of PRSUs granted during 2020, 2019 and 2018 were $ 122.95 , $ 50.00 and $ 21.67 , respectively, using the following assumptions: +2020 2019 2018 +Expected volatility +55.74 % - 60.10 % +60.54 % - 62.52 % +63.77 % - 67.97 % +Risk-free interest rate +0.14 % - 1.41 % +1.56 % - 2.49 % +2.06 % - 2.82 % +Expected dividends — % — % — % +Expected term (in years) +2.48 - 3.00 +2.48 - 5.00 +2.48 - 3.00 +The Company uses the historical volatility of its common stock and risk-free interest rate based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the PRSUs grant at the date closest to the grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the near future. The expected term of PRSUs represents the requisite service periods of these PRSUs. +69 +The following table summarizes PRSU activity and related information: +Number +of Shares Weighted- +Average +Fair Value Aggregate Intrinsic Value Weighted-Average Remaining Contractual Life +(in years) +(In millions except share price) +Unvested shares as of December 28, 2019 3 $ 36.13 +Granted 1 $ 122.95 +Forfeited — $ 45.25 +Vested ( 1 ) $ 16.45 +Unvested shares as of December 26, 2020 3 $ 55.63 $ 248 2.25 +The total fair value of PRSUs vested during 2020, 2019 and 2018 was $ 76 million, $ 65 million and $ 84 million, respectively. +As of December 26, 2020, the Company had $ 102 million of total unrecognized compensation expense related to PRSUs, which will be recognized over the weighted-average period of 1.73 years. +ESPP. The weighted-average grant date fair value for the ESPP during 2020, 2019 and 2018 was $ 20.97 , $ 9.96 and $ 4.71 per share, respectively, using the following assumptions: +2020 2019 2018 +Expected volatility +55.16 % - 66.53 % +48.95 % - 67.02 % +45.88 % - 66.66 % +Risk-free interest rate +0.11 % - 0.15 % +1.58 % - 2.46 % +2.05 % - 2.52 % +Expected dividends — % — % — % +Expected term (in years) 0.50 0.50 0.50 +The Company uses the historical volatility of its common stock and the risk-free interest rate based on the rate for a U.S. Treasury zero-coupon yield curve with a term that approximates the expected life of the ESPP grant at the date closest to the ESPP grant date. The expected dividend yield is zero as the Company does not expect to pay dividends in the near future. The expected term of the ESPP represents the six-month offering period. +During 2020, 2 million shares of common stock were purchased under the ESPP at a purchase price of $ 37.81 resulting in aggregate cash proceeds of $ 75 million. As of December 26, 2020, the Company had $ 12 million of total unrecognized compensation expense related to the ESPP, which will be recognized over the weighted-average period of 0.37 years. +NOTE 12 – Retirement Benefit Plans +The Company provides retirement benefit plans in the United States and certain foreign countries. The Company has a 401(k) retirement plan that allows participating employees in the United States to contribute as defined by the plan and subject to Internal Revenue Service limitations. The Company matches 75 % of employees’ contributions up to 6 % of their eligible compensation. The Company’s contributions to the 401(k) plan for 2020, 2019 and 2018 were approximately $ 29 million , $ 25 million and $ 21 million, respectively. +NOTE 13 – Income Taxes +Income before income taxes consists of the following: +2020 2019 2018 +(In millions) +U.S. $ 1,213 $ 334 $ 114 +Non-U.S. 67 38 214 +Total pre-tax income including equity income (loss) in investee $ 1,280 $ 372 $ 328 +70 +The income tax provision (benefit) consists of: +2020 2019 2018 +(In millions) +Current: +U.S. Federal $ — $ ( 13 ) $ 12 +U.S. State and Local 5 1 — +Non-U.S. 8 50 ( 17 ) +Total 13 38 ( 5 ) +Deferred: +U.S. Federal ( 1,193 ) — — +U.S. State and Local ( 28 ) — — +Non-U.S. ( 2 ) ( 7 ) ( 4 ) +Total ( 1,223 ) ( 7 ) ( 4 ) +Income tax provision (benefit) $ ( 1,210 ) $ 31 $ ( 9 ) +The table below displays the reconciliation between statutory federal income taxes and the total income tax provision (benefit). +2020 2019 2018 +(In millions) +Statutory federal income tax expense at 21% $ 269 $ 78 $ 69 +State taxes ( 6 ) 1 1 +Foreign withholding taxes (refund) 10 22 ( 29 ) +Foreign rate detriment / (benefit) ( 3 ) 2 2 +Valuation allowance change ( 1,301 ) ( 59 ) ( 64 ) +Research credits ( 57 ) — ( 1 ) +Excess tax benefits relating to share-based compensation ( 116 ) — — +Tax Reform Act — ( 13 ) 13 +Other ( 6 ) — — +Income tax provision (benefit) $ ( 1,210 ) $ 31 $ ( 9 ) +The income tax benefit in 2020 was primarily due to $ 1.3 billion of tax benefit from the valuation allowance release in the U.S. This benefit was partially offset by approximately $ 10 million of withholding tax expense related to cross-border transactions, $ 13 million of state and foreign taxes and $ 75 million increase in valuation allowance against certain state and foreign tax credits, which are reflected as part of the state taxes and foreign rate benefit in the reconciliation table above. +The income tax provision in 2019 was primarily due to $ 22 million of withholding tax related to cross-border transactions and $ 22 million of tax in foreign locations, partially offset by a $ 13 million benefit for a reduction of U.S. income taxes accrued in the prior year. +The income tax provision in 2018 was primarily due to a $ 36 million refund of withholding tax from a foreign jurisdiction related to a legal settlement from 2010, partially offset by $ 13 million of U.S. income taxes resulting from the Tax Reform Act, a $ 7 million tax provision in foreign locations and $ 7 million of withholding taxes on cross-border transactions. +71 +Deferred income taxes reflect the net tax effects of tax carryovers and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the balances for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 26, 2020 and December 28, 2019 were as follows: +December 26, +2020 December 28, +2019 +(In millions) +Deferred tax assets: +Net operating loss carryovers $ 1,029 $ 1,357 +Accruals and reserves not currently deductible 514 257 +Acquired intangibles and goodwill — 50 +Federal and state tax credit carryovers 569 584 +Foreign research and development ITC credits 489 429 +Capitalized costs 174 232 +Lease liability 72 57 +Other 149 105 +Total deferred tax assets 2,996 3,071 +Less: valuation allowance ( 1,576 ) ( 2,867 ) +Total deferred tax assets, net of valuation allowance 1,420 204 +Deferred tax liabilities: +Right-of-use assets ( 62 ) ( 49 ) +Discount of convertible notes ( 2 ) ( 16 ) +Undistributed foreign earnings ( 114 ) ( 111 ) +Other ( 8 ) ( 17 ) +Total deferred tax liabilities ( 186 ) ( 193 ) +Net deferred tax assets $ 1,234 $ 11 +The movement in the deferred tax valuation allowance was as follows: +2020 2019 2018 +(In millions) +Balance at beginning of year $ 2,867 $ 2,443 $ 2,621 +Charges (reductions) to income tax expense/other accounts* ( 1,301 ) ( 61 ) ( 59 ) +Net (deductions) recoveries + +10 485 ( 119 ) +Balance at end of year $ 1,576 $ 2,867 $ 2,443 +* +Amounts recorded against other accounts are not material ++ The 2019 and 2020 net recoveries were primarily related to net originating deferred tax assets and newly generated tax credits +Deferred tax liabilities are included in Other long-term liabilities on the consolidated balance sheets. The breakdown between deferred tax assets and deferred tax liabilities as of December 26, 2020 and December 28, 2019 is as follows: +December 26, +2020 December 28, +2019 +(In millions) +Deferred tax assets $ 1,245 $ 22 +Deferred tax liabilities ( 11 ) ( 11 ) +Net deferred tax assets $ 1,234 $ 11 +72 +Through the end of 2020, the Company demonstrated consistent and continued profitability over the preceding three-year period. The Company’s ability to sustain and grow its such profitability is supported by the continued positive momentum of its consumer and commercial products including its newly released desktop, mobile and graphics processors, greater market acceptance for its server products, the successful adoption of its new game console processor products, and its continued leadership in the development of HPC products. In assessing the realizability of the deferred tax assets, the Company considered the highly dynamic and competitive landscape of its industry, the continued performance and market acceptance of its new products, and the impact of such market acceptance on forecasts of future profitability. As a result, in the fourth quarter of 2020, the Company concluded that its history of profitable operating results, including the current period results, along with increasingly favorable forecasts of continued future profitability, provided sufficient positive evidence supporting the realizability of a certain amount of its U.S. deferred tax assets and, accordingly, the release of the related valuation allowance previously recorded against these deferred tax assets, resulting in a tax benefit of $ 1.3 billion in the fourth quarter of 2020. +The Company continues to maintain a valuation allowance of approximately $ 1.6 billion for certain federal, state, and foreign tax attributes. The federal valuation allowance maintained is due to current limitations, including limitations under Internal Revenue Code Section 382 or 383, separate return loss year rules, or dual consolidated loss rules. The state and foreign valuation allowance maintained is due to lack of sufficient sources of income. +The Company’s United States federal and state net operating losses carryforwards as of December 26, 2020, were $ 5.2 billion and $ 343 million, respectively. The United States federal net operating losses will expire between 2029 and 2037, and the state net operating losses will expire at various dates through 2039. The federal tax credits of $ 385 million will expire at various dates between 2021 and 2040. The state tax credits of $ 252 million will expire at various dates between 2021 through 2035 except for California R&D credit, which does not expire. The Company also has $ 494 million of credit carryforward in Canada that will expire between 2026 and 2040. +Under current U.S. tax law the impact of future distributions of undistributed earnings that are indefinitely reinvested are anticipated to be withholding taxes from local jurisdictions and non-conforming U.S. state jurisdictions. The amount of cumulative undistributed earnings that are permanently reinvested that could be subject to withholding taxes are $ 304 million as of December 26, 2020. +A reconciliation of the Company's gross unrecognized tax benefits was as follows: +2020 2019 2018 +(In millions) +Balance at beginning of year $ 65 $ 49 $ 49 +Increases for tax positions taken in prior years 41 5 1 +Decreases for tax positions taken in prior years ( 15 ) — ( 1 ) +Increases for tax positions taken in the current year 30 15 3 +Decreases for settlements with taxing authorities ( 1 ) ( 3 ) ( 2 ) +Decreases for lapsing of the statute of limitations ( 1 ) ( 1 ) ( 1 ) +Balance at end of year $ 119 $ 65 $ 49 +The amount of unrecognized tax benefits that would impact the effective tax rate was $ 77 million, $ 17 million and $ 9 million as of December 26, 2020, December 28, 2019 and December 29, 2018, respectively. The Company had no material amounts of accrued interest and accrued penalties related to unrecognized tax benefits as of December 26, 2020, December 28, 2019 and December 29, 2018. +It is possible the Company may have tax audits close in the next 12 months that could materially change the balance of the uncertain tax benefits; however, the timing of tax audit closures and settlements are highly uncertain. The Company and its subsidiaries have several foreign and U.S. state audits in process at any one point in time. The Company has provided for uncertain tax positions that require a liability under the adopted method to account for uncertainty in income taxes. +The Company is subject to taxation in the United States and foreign jurisdictions. Earnings from non-U.S. activities are subject to local country income tax. The material jurisdiction in which the Company is subject to potential examination by the taxing authority is the United States, which is open for years from 2007 onwards due to the net operating losses. +73 +NOTE 14 – Segment Reporting +Management, including the Chief Operating Decision Maker, who is the Company’s Chief Executive Officer, reviews and assesses operating performance using segment net revenue and operating income (loss). These performance measures include the allocation of expenses to the operating segments based on management’s judgment. The Company has the following two reportable segments: +• the Computing and Graphics segment, which primarily includes desktop and notebook processors and chipsets, discrete and integrated graphics processing units (GPUs), data center and professional GPUs and development services. From time to time, the Company may also sell or license portions of its IP portfolio. +• the Enterprise, Embedded and Semi-Custom segment, which primarily includes server and embedded processors, semi-custom System-on-Chip (SoC) products, development services and technology for game consoles. From time to time, the Company may also sell or license portions of its IP portfolio. +In addition to these reportable segments, the Company has an All Other category, which is not a reportable segment. This category primarily includes certain expenses and credits that are not allocated to any of the reportable segments because management does not consider these expenses and credits in evaluating the performance of the reportable segments. This category primarily includes employee stock-based compensation expense. +The following table provides a summary of net revenue and operating income (loss) by segment for 2020, 2019 and 2018. +2020 2019 2018 +(In millions) +Net revenue: +Computing and Graphics $ 6,432 $ 4,709 $ 4,125 +Enterprise, Embedded and Semi-Custom 3,331 2,022 2,350 +Total net revenue $ 9,763 $ 6,731 $ 6,475 +Operating income (loss): +Computing and Graphics $ 1,266 $ 577 $ 470 +Enterprise, Embedded and Semi-Custom 391 263 163 +All Other ( 288 ) ( 209 ) ( 182 ) +Total operating income $ 1,369 $ 631 $ 451 +The following table provides items included in All Other category: +2020 2019 2018 +(In millions) +Operating loss: +Stock-based compensation expense $ ( 274 ) $ ( 197 ) $ ( 137 ) +Acquisition-related costs ( 14 ) — — +Impairment of technology licenses — — ( 45 ) +Loss contingency on legal matter — ( 12 ) — +Total operating loss $ ( 288 ) $ ( 209 ) $ ( 182 ) +The Company does not discretely allocate assets to its operating segments, nor does management evaluate operating segments using discrete asset information. +74 +The following table summarizes sales to external customers by geographic regions based on billing location of the customer: +2020 2019 2018 +(In millions) +United States $ 2,294 $ 1,764 $ 1,327 +China (including Hong Kong) 2,329 1,736 1,319 +Japan 1,033 840 1,225 +Europe 1,108 762 470 +Taiwan 1,187 719 1,197 +Singapore 1,096 597 728 +Other countries 716 313 209 +Total sales to external customers $ 9,763 $ 6,731 $ 6,475 +The following table summarizes sales to major customers that accounted for at least 10% of the Company’s consolidated net revenue for the respective years: +2020 2019 2018 +Customer A * 12 % 19 % +Customer B * * 11 % +* +Less than 10% +Sales to customers A and B consisted of products from the Company’s Enterprise, Embedded and Semi-Custom segment. +The following table summarizes Property and equipment, net by geographic areas: +December 26, +2020 December 28, +2019 +(In millions) +United States $ 421 $ 300 +Canada 126 99 +China 34 36 +Singapore 32 33 +Other countries 28 32 +Total property and equipment, net $ 641 $ 500 +NOTE 15 – Other Expense, Net +The following table summarizes the components of Other expense, net: +2020 2019 2018 +(In millions) +Interest income $ 8 $ 15 $ 18 +Loss on debt redemption, repurchase and conversion ( 54 ) ( 176 ) ( 12 ) +Other ( 1 ) ( 4 ) ( 6 ) +Other expense, net $ ( 47 ) $ ( 165 ) $ — +NOTE 16 – Commitments and Guarantees +Operating Leases +The Company has entered into operating and finance leases for its corporate offices, data centers, research and development facilities and certain equipment. The leases expire at various dates through 2028, some of which include options to extend the lease for up to five years. +75 +For 2020, 2019 and 2018, the Company recorded $ 59 million, $ 56 million and $ 53 million, respectively, of operating lease expense, including short-term lease expense. For 2020 and 2019, the Company recorded $ 27 million and $ 25 million, respectively, of variable lease expense, which primarily included operating expenses and property taxes associated with the usage of facilities under the operating leases. For 2020 and 2019, cash paid for operating leases included in operating cash flows was $ 55 million and $ 47 million, respectively. The Company’s finance leases and short-term leases are immaterial. +Supplemental information related to leases is as follows: +December 26, +2020 +Weighted-average remaining lease term – operating leases 5.56 years +Weighted-average discount rate – operating leases 5.29 % +Future minimum lease payments under non-cancellable operating lease liabilities as of December 26, 2020 are as follows: +Year (In millions) +2021 $ 52 +2022 55 +2023 48 +2024 41 +2025 34 +2026 and thereafter 54 +Total minimum lease payments 284 +Less: interest ( 42 ) +Present value of net minimum lease payments 242 +Less: current portion ( 41 ) +Total long-term operating lease liabilities $ 201 +Certain other operating leases contain provisions for escalating lease payments subject to changes in the consumer price index. +Purchase and Other Contractual Obligations +The Company’s purchase obligations primarily include the Company’s obligations to purchase wafers and substrates from third parties. The Company also had other contractual obligations, primarily included in Other long-term liabilities and Accrued liabilities on its consolidated balance sheets, which primarily consisted of $ 149 million of payments due under certain software and technology licenses and IP licenses that will be paid through 2025. +Total future unconditional purchase obligations as of December 26, 2020 were as follows: +Year (In millions) +2021 $ 3,026 +2022 71 +2023 34 +2024 25 +2025 23 +2026 and thereafter 12 +Total unconditional purchase commitments $ 3,191 +76 +Warranties and Indemnities +The Company generally warrants that its products sold to its customers will conform to its approved specifications and be free from defects in material and workmanship under normal use and conditions for one year . The Company may also offer one to three-year limited warranties based on product type and negotiated warranty terms with certain customers. The Company accrues warranty costs to Cost of sales at the time of sale of warranted products. +Changes in the Company’s estimated liability for product warranty during the years ended December 26, 2020 and December 28, 2019 are as follows: +December 26, +2020 December 28, +2019 +(In millions) +Beginning balance $ 15 $ 13 +Provisions during the period 82 31 +Settlements during the period ( 60 ) ( 29 ) +Ending balance $ 37 $ 15 +In addition to product warranties, the Company from time to time in its normal course of business indemnifies other parties with whom it enters into contractual relationships, including customers, lessors and parties to other transactions with the Company, with respect to certain matters. In these limited matters, the Company has agreed to hold certain third parties harmless against specific types of claims or losses such as those arising from a breach of representations or covenants, third-party claims that the Company’s products when used for their intended purpose(s) and under specific conditions infringe the intellectual property rights of a third party, or other specified claims made against the indemnified party. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the unique facts and circumstances that are likely to be involved in each particular claim and indemnification provision. Historically, payments made by the Company under these obligations have not been material. In addition, the impact from changes in estimates for pre-existing warranties has been immaterial. +NOTE 17 – Contingencies +Shareholder Derivative Lawsuits (Wessels, Hamilton and Ha) +On March 20, 2014, a purported shareholder derivative lawsuit captioned Wessels v. Read, et al. , Case No. 1:14 cv-262486 (Wessels) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the Santa Clara County Superior Court of the State of California. The complaint purports to assert claims against the Company and certain individual directors and officers for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks damages allegedly caused by alleged materially misleading statements and/or material omissions by the Company and the individual directors and officers regarding its 32nm technology and “Llano” product, which statements and omissions, the plaintiffs claim, allegedly operated to artificially inflate the price paid for the Company’s common stock during the period. On April 27, 2015, a similar purported shareholder derivative lawsuit captioned Christopher Hamilton and David Hamilton v. Barnes, et al. , Case No. 5:15-cv-01890 (Hamilton) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court for the Northern District of California. +On September 29, 2015, a similar purported shareholder derivative lawsuit captioned Jake Ha v Caldwell, et al., Case No. 3:15-cv-04485 (Ha) was filed against the Company (as a nominal defendant only) and certain of its directors and officers in the United States District Court for the Northern District of California. The lawsuit also seeks a court order voiding the stockholder vote on the Company’s 2015 proxy. The case was transferred to the judge handling the Hamilton Lawsuit and is now Case No. 4:15-cv-04485. The Wessels, Hamilton and Ha shareholder derivative lawsuits were stayed pending resolution of a class action lawsuit captioned Hatamian v. AMD, et al. , C.A. No. 3:14-cv-00226 filed against the Company in the United States District Court for the Northern District of California (the Hatamian Lawsuit). The Hatamian Lawsuit asserted claims against the Company and certain of its officers for alleged violations of Section 10(b) of the Exchange Act of 1934, as amended (the Exchange Act), and SEC Rule 10b-5 concerning certain statements regarding its 32nm technology and “Llano” products. On October 9, 2017, the parties signed a definitive settlement agreement resolving the Hatamian Lawsuit and submitted it to the Court for approval. Under the terms of this agreement, the settlement was funded entirely by certain of the +77 +Company’s insurance carriers and the defendants continued to deny any liability or wrongdoing. On March 2, 2018, the court approved the settlement and entered a final judgment in the Hatamian Lawsuit. +On January 30, 2018, the Wessels and Hamilton plaintiffs amended their complaints. On February 2, 2018, the Ha plaintiff also filed an amended complaint. On February 22, 2018, the Company filed motions to dismiss the Hamilton and Ha plaintiffs’ amended complaints. On April 2, 2018, the Company filed a demurrer seeking to dismiss the Wessels amended complaint. On July 23, 2018, the Santa Clara Superior Court sustained the Company’s demurrer in the Wessels case, dismissing all claims in that matter with prejudice. The Wessels plaintiff filed a Notice of Appeal on September 27, 2018. On October 4, 2018, the Federal Court issued an order dismissing the Hamilton and Ha amended complaints. The Hamilton plaintiffs filed a Notice of Appeal on October 8, 2018, and the Ha plaintiffs filed a Notice of Appeal on October 15, 2018. On November 19, 2018, the Hamilton and Ha plaintiffs filed a motion seeking summary reversal of the order dismissing their claims. The Company opposed this motion on December 13, 2018, and the Court denied it on February 25, 2019. On March 16, 2020, the Ninth Circuit affirmed the district court’s dismissal of the Ha complaint and the time to seek further appeals has since expired. On the same day, the Ninth Circuit also reversed and remanded the district court’s dismissal of the Hamilton complaint for further consideration of defendants’ motion to dismiss. Following supplemental briefing, that motion to dismiss remains pending. On August 27, 2020, the California Court of Appeal affirmed the district court’s dismissal of the Wessels complaint and the time to seek further appeals has since expired. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Hauck et al. Litigation +Since January 19, 2018, three putative class action complaints have been filed against the Company in the United States District Court for the Northern District of California: (1) Diana Hauck et al. v. AMD, Inc., Case No. 5:18-cv-0047, filed on January 19, 2018; (2) Brian Speck et al. v. AMD, Inc. , Case No. 5:18-cv-0744, filed on February 4, 2018; and (3) Nathan Barnes and Jonathan Caskey-Medina, et al. v. AMD, Inc. , Case No. 5:18-cv-00883, filed on February 9, 2018. On April 9, 2018, the court consolidated these cases and ordered that Diana Hauck et al. v. AMD, Inc. serve as the lead case. On June 13, 2018, six plaintiffs (from California, Louisiana, Florida, and Massachusetts) filed a consolidated amended complaint alleging that the Company failed to disclose its processors’ alleged vulnerability to Spectre. Plaintiffs further allege that the Company’s processors cannot perform at their advertised processing speeds without exposing consumers to Spectre, and that any “patches” to remedy this security vulnerability will result in degradation of processor performance. The plaintiffs seek damages under several causes of action on behalf of a nationwide class and four state subclasses (California, Florida, Massachusetts, Louisiana) of consumers who purchased the Company’s processors and/or devices containing AMD processors. The plaintiffs also seek attorneys’ fees, equitable relief, and restitution. Pursuant to the court’s order directing the parties to litigate only eight of the causes of action in the consolidated amended complaint initially, the Company filed a motion to dismiss on July 13, 2018. On October 29, 2018, after the plaintiffs voluntarily dismissed one of their claims, the court granted the Company’s motion and dismissed six causes of action with leave to amend. The plaintiffs filed their amended consolidated complaint on December 6, 2018. On January 3, 2019, the Company again moved to dismiss the subset of claims currently at issue. On April 4, 2019, the court granted the Company’s motion and dismissed all claims currently at issue with prejudice. On May 6, 2019, the court granted the parties’ stipulation and request under Fed. R. Civ. P. 54(b) to enter a partial final judgment and certify for appeal the court’s April 4, 2019 dismissal order, and on that same date, the plaintiffs voluntarily dismissed without prejudice their remaining claims pursuant to an agreement whereby, subject to certain terms and conditions, the Company agreed to toll the statute of limitations and/or statute of repose. On May 30, 2019, the plaintiffs filed a Notice of Appeal with the U.S. Court of Appeals for the Ninth Circuit. Briefing has completed for the appeal. On May 15, 2020, the Ninth Circuit affirmed the district court’s ruling dismissing the subset of claims currently at issue against the Company. On August 14, 2020, the district court dismissed the remaining claims with prejudice. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Quarterhill Inc. Litigation +On July 2, 2018, three entities named Aquila Innovations, Inc. (Aquila), Collabo Innovations, Inc. (Collabo), and Polaris Innovations, Ltd. (Polaris), filed separate patent infringement complaints against the Company in the United States District Court for the Western District of Texas. Aquila alleges that the Company infringes two patents (6,239,614 and 6,895,519) relating to power management; Collabo alleges that the Company infringes one patent (7,930,575) related to power management; and Polaris alleges that the Company infringes two patents (6,728,144 +78 +and 8,117,526) relating to control or use of dynamic random-access memory, or DRAM. Each of the three complaints seeks unspecified monetary damages, interest, fees, expenses, and costs against the Company; Aquila and Collabo also seek enhanced damages. Aquila, Collabo, and Polaris each appear to be related to a patent assertion entity named Quarterhill Inc. (formerly WiLAN Inc.). On November 16, 2018, AMD filed answers in the Collabo and Aquila cases and filed a motion to dismiss in the Polaris case. On January 25, 2019, the Company filed amended answers and counterclaims in the Collabo and Aquila cases. On July 22, 2019, the Company’s motion to dismiss in the Polaris case was denied. On August 23, 2019, the Court held a claim construction hearing in each case. On May 14, 2020, at the request of Polaris, the Court dismissed all claims related to one of the two patents in suite in the Polaris case. On June 10, 2020, the Court granted AMD’s motions to stay the Polaris and Aquila cases pending the completion of inter partes review of each of the patents-in-suit in those cases by the Patent Trial and Appeals Board. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Monterey Research Litigation +On November 15, 2019, Monterey Research, LLC filed a patent infringement complaint against the Company in the United States District Court for the District of Delaware. Monterey Research alleges that the Company infringes six U.S. patents: 6,534,805 (related to SRAM cell design); 6,629,226 (related to read interface protocols); 6,651,134 (related to memory devices); 6,765,407 (related to programmable digital circuits); 6,961,807 (related to integrated circuits and associated memory systems); and 8,373,455 (related to output buffer circuits). Monterey Research seeks unspecified monetary damages, enhanced damages, interest, fees, expenses, costs, and injunctive relief against the Company. On January 22, 2020, the Company filed a motion to dismiss part of Monterey Research’s complaint. On February 5, 2020, Monterey Research filed an amended complaint. On February 19, 2020, the Company filed a renewed motion to dismiss part of Monterey Research’s complaint. On October 13, 2020, the Court granted-in-part and denied-in-part the Company’s renewed motion to dismiss. On October 27, 2020, the Company filed its answer to Monterey’s complaint and also filed counterclaims based on Monterey’s breach of the parties’ pre-suit non-disclosure agreement. On December 1, 2020, Monterey filed a motion to dismiss the Company’s counterclaims. On January 5, 2021, the Court granted the Company’s motion to stay the litigation pending inter partes review of the patents-in-suit by the Patent Trial and Appeals Board. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +City of Pontiac Police and Fire Retirement System Litigation +On September 29, 2020, the City of Pontiac Police and Fire Retirement System, an AMD shareholder, filed a shareholder derivative complaint (the “Complaint”) against AMD and the members of its Board of Directors (collectively, “Defendants”) in the United States District Court for the Northern District of California. See City of Pontiac Police and Fire Retirement System v. Caldwell, et al., No. 5:20-cv-6794 (N.D. Cal.). The Complaint alleges that Defendants breached their fiduciary duties, violated Section 14(a) of the Exchange Act of 1934, and were unjustly enriched by misrepresenting the Company’s commitment to diversity, particularly with respect to the composition of the membership of AMD’s Board of Directors and senior leadership team. On December 18, 2020, Defendants filed a motion to dismiss the Complaint. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Xilinx Acquisition Litigation +On October 26, 2020, the Company, its wholly owned subsidiary, Thrones Merger Sub, Inc., and Xilinx, Inc. (“Xilinx”) entered a definitive agreement (the “Merger Agreement”) in which the Company will acquire Xilinx by merging Thrones Merger Sub, Inc. with and into Xilinx, with Xilinx continuing as the surviving corporation and becoming a wholly owned subsidiary of the Company (the “Proposed Transaction”). See Note 18 of Notes to Consolidated Financial Statements for additional information. On December 3, 2020, the Company and Xilinx filed a Registration Statement on Form S-4 (together with the joint proxy statement and prospectus contained therein, the “Registration Statement”) describing the Proposed Transaction and other related matters. On December 11, 2020, a Xilinx shareholder filed a putative class action in the New York State Supreme Court, New York County, regarding the Proposed Transaction. Nunez v. Xilinx , Case No. 656971/2020 (N.Y. Sup. Ct.). The lawsuit alleges that the Board of Directors of Xilinx breached their fiduciary duties to Xilinx shareholders in connection with the Proposed Transaction +79 +by allegedly failing to obtain fair, adequate and maximum consideration for Xilinx shareholders in connection with the Proposed Transaction and by not disclosing certain material information about the Proposed Transaction in the Registration Statement. The lawsuit asserts a single claim against the Company, alleging that it aided and abetted the Xilinx directors’ breach of their fiduciary duties. The lawsuit seeks to enjoin or rescind any transaction with Xilinx as well as certain other equitable relief, unspecified damages and attorneys’ fees and costs. +On December 15, 2020, a Xilinx shareholder filed a lawsuit in the United States District Court for the Southern District of New York, regarding the Proposed Transaction. Shumacher v. Xilinx , Case No. 1:20-cv-10595 (S.D.N.Y.). The lawsuit alleges that Xilinx and its Board of Directors disseminated a false and misleading Registration Statement that omitted material information regarding the Proposed Transaction, thereby violating Section 14(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The lawsuit also asserts a single claim against the Company, alleging that it acted as a controlling person of Xilinx within the meaning of Section 20(a) of the Exchange Act by virtue of its supervisory control over the composition of the Registration Statement. The lawsuit seeks to enjoin or rescind any transaction with Xilinx as well as certain other equitable relief, unspecified damages and attorneys’ fees and costs. +On December 23, 2020, a shareholder of the Company filed a lawsuit in the United States District Court of the Southern District of New York regarding the Proposed Transaction. Vazirani v. Advanced Micro Devices , Case No. 1:20-cv-10894 (S.D.N.Y). The lawsuit alleges that the Company and its Board of Directors disseminated a false and misleading Registration Statement that omitted material information regarding the Proposed Transaction, thereby violating Sections 14(a) and 20(a) of the Exchange Act. The lawsuit seeks to enjoin or rescind any transaction with Xilinx as well as certain other equitable relief, unspecified damages and attorneys’ fees and costs. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations. +Future Link Systems Litigation +On December 21, 2020, Future Link Systems, LLC filed a patent infringement complaint against the Company in the United States District Court for the Western District of Texas. Future Link Systems alleges that the Company infringes three U.S. patents: 7,983,888 (related to simulated PCI express circuitry); 6,363,466 (related to out of order data transactions); and 6,622,108 (related to interconnect testing). Future Link Systems seeks unspecified monetary damages, enhanced damages, interest, fees, expenses, costs, and injunctive relief against the Company. +Based upon information presently known to management, the Company believes that the potential liability, if any, will not have a material adverse effect on its financial condition, cash flows or results of operations . +Environmental Matters +The Company is named as a responsible party on Superfund clean-up orders for three sites in Sunnyvale, California that are on the National Priorities List. Since 1981, the Company has discovered hazardous material releases to the groundwater from former underground tanks and proceeded to investigate and conduct remediation at these three sites. The chemicals released into the groundwater were commonly used in the semiconductor industry in the United States in the wafer fabrication process prior to 1979. +In 1991, the Company received Final Site Clean-up Requirements Orders from the California Regional Water Quality Control Board relating to the three sites. The Company has entered into settlement agreements with other responsible parties on two of the orders. During the term of such agreements, other parties have agreed to assume most of the foreseeable costs as well as the primary role in conducting remediation activities under the orders. The Company remains responsible for additional costs beyond the scope of the agreements as well as all remaining costs in the event that the other parties do not fulfill their obligations under the settlement agreements. +To address anticipated future remediation costs under the orders, the Company has computed and recorded an estimated environmental liability of approximately $ 4 million and has not recorded any potential insurance recoveries in determining the estimated costs of the cleanup. The progress of future remediation efforts cannot be predicted with certainty and these costs may change. The Company believes that any amount in addition to what has already been accrued would not be material. +Other Legal Matters +The Company is a defendant or plaintiff in various actions that arose in the normal course of business. With respect to these matters, based on the management’s current knowledge, the Company believes that the amount or range +80 +of reasonably possible loss, if any, will not, either individually or in the aggregate, have a material adverse effect on the Company’s financial position, results of operations, or cash flows. +NOTE 18 – Pending Acquisition +On October 26, 2020 , the Company entered into an Agreement and Plan of Merger (the Merger Agreement),with Thrones Merger Sub, Inc., a wholly owned subsidiary of the Company (Merger Sub), and Xilinx, Inc.(Xilinx), whereby Merger Sub will merge with and into Xilinx (the Merger), with Xilinx surviving such Merger as a wholly owned subsidiary of the Company. Under the Merger Agreement, at the effective time of the Merger (the Effective Time), each share of common stock of Xilinx (Xilinx Common Stock) issued and outstanding immediately prior to the Effective Time (other than treasury shares and any shares of Xilinx Common Stock held directly by the Company or Merger Sub) will be converted into the right to receive 1.7234 fully paid and non-assessable shares of common stock of the Company and, if applicable, cash in lieu of fractional shares, subject to any applicable withholding. As of the signing of the Merger Agreement, the transaction was valued at $ 35 billion. The actual valuation of the transaction could differ significantly from the estimated amount due to movements in the price of the Company’s common stock, the number of shares of Xilinx common stock outstanding on the closing date of the Merger and other factors . +Under the Merger Agreement, the Company will be required to pay a termination fee to Xilinx equal to $ 1.5 billion if the Merger Agreement is terminated in certain circumstances, including if the Merger Agreement is terminated because the Company’s board of directors has changed its recommendation. The Company will be required to pay a termination fee equal to $ 1 billion if the Merger Agreement is terminated in certain circumstances related to the failure to obtain required regulatory approvals prior to October 26, 2021 (subject to automatic extension first to January 26, 2022 and then to April 26, 2022, in each case, to the extent the regulatory closing conditions remain outstanding). +The closing of the Merger is subject to customary conditions, including regulatory approval and approval by the stockholders of both the Company and Xilinx. The Merger is currently expected to close by the end of calendar year 2021. +81 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Advanced Micro Devices, Inc. +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Advanced Micro Devices, Inc. (the Company) as of December 26, 2020 and December 28, 2019, the related consolidated statements of operations, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 26, 2020, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 26, 2020 and December 28, 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 26, 2020, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 26, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated January 29, 2021 expressed an unqualified opinion thereon. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +82 +Inventory Valuation +Description of the Matter At December 26, 2020, the Company’s net inventory balance was $1,399 million. As discussed in Note 2 of the consolidated financial statements, the Company adjusts the inventory carrying value to the lower of actual cost or the estimated net realizable value after completing ongoing reviews of on-hand inventory quantities in excess of forecasted demand, by considering recent historical activity as well as anticipated or forecasted demand. +Auditing management’s inventory carrying value adjustments involved significant judgment because the estimates are based on a number of factors that are affected by market, industry, and competitive conditions outside the Company's control. In particular, in estimating inventory carrying value adjustments, management developed assumptions such as forecasts of future sales quantities and the selling prices, which are sensitive to the competitiveness of product offerings, customer requirements, and product life cycles. These significant assumptions are forward-looking and could be affected by future economic and market conditions. +How We Addressed the Matter in Our Audit We obtained an understanding, evaluated the design and tested the operating effectiveness of internal controls over the Company's inventory carrying value adjustment determination process, including the basis for developing above described assumptions and management’s judgments. +Our audit procedures included, among others, testing the reasonableness of management’s key assumptions and judgments and testing the accuracy and completeness of the underlying data used to determine the amount of inventory carrying value adjustments. For instance, we compared the quantities and carrying value of on-hand inventories to related unit sales, both historical and forecasted, assessed the reasonableness of management’s estimates of future sales prices by analyzing historical sales and evaluating any factors that may impact sales prices, and evaluated the appropriateness and adequacy of management’s adjustments to such sales forecasts by analyzing potential technological changes in line with product life cycles and/or identified alternative customer uses. We also assessed the accuracy of forecasts underlying management's estimates by comparing management’s historical forecasts to actual results, evaluated industry and market factors and performed sensitivity analyses over the significant assumptions used by management to evaluate necessary changes in the inventory carrying value adjustments. +Deferred Tax Asset Valuation Allowance +Description of the Matter +As discussed in Note 13 to the consolidated financial statements, at December 26, 2020, the Company carried deferred tax assets of $1,420 million, net of a $1,576 million valuation allowance. Deferred tax assets are reduced by a valuation allowance if, based on the weight of all available evidence, in management’s judgment it is more likely than not that some portion, or all, of the deferred tax assets will not be realized. Once established, the valuation allowance is released when, based on the weight of all available evidence, management concludes that related deferred tax assets are more likely than not to be realized. In 2020, management concluded sufficient positive evidence exists to release a portion of the valuation allowance related to U.S. deferred tax assets, resulting in an income tax benefit of $1,301 million in 2020. +Auditing management's analysis of the realizability of the deferred tax assets was complex and highly judgmental because the assessment process involves significant judgment and subjective evaluation of assumptions that may be affected by future operations of the Company, market or economic conditions. +83 +How We Addressed the Matter in Our Audit +We obtained an understanding, evaluated the design and tested the operating effectiveness of controls that address the risks of material misstatement relating to the realizability of deferred tax assets, including controls over management’s evaluation of the nature of its tax attributes and projections of the future reversal of existing taxable temporary differences and future taxable income. +We evaluated the Company's assessment of the realizability of its U.S. deferred tax assets and the resultant release of valuation allowance. Our audit procedures included, among others, evaluation of the nature of the Company’s tax attributes, application of the technical tax guidance related to attributes subject to additional limitation, projections of the future reversal of existing taxable temporary differences and assumptions used by the Company to assess reliability of its projected future taxable income. We compared the projections of future taxable income with the actual results of prior periods and assessed management's consideration of current industry and economic trends. We also compared the projections of future taxable income with other forecasted financial information prepared by the Company. Further, we tested the completeness and accuracy of the underlying data used in the Company’s projections. We involved our tax professionals with specialized skills and knowledge to evaluate the Company’s assessment of the scheduling of the reversal of existing temporary taxable differences and carryforward amounts and the carryforward lives of its deferred tax assets, and whether the estimated future sources of taxable income were of the appropriate character to utilize the deferred tax assets in the relevant time period. +/s/ Ernst & Young LLP +We have served as the Company’s auditor since 1970. +San Jose, California +January 29, 2021 +84 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Advanced Micro Devices, Inc. +Opinion on Internal Control over Financial Reporting +We have audited Advanced Micro Devices, Inc.’s internal control over financial reporting as of December 26, 2020, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Advanced Micro Devices, Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 26, 2020, based on the COSO criteria. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 26, 2020 and December 28, 2019, the related consolidated statements of operations, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 26, 2020, and the related notes and our report dated January 29, 2021 expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. +Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ Ernst & Young LLP +San Jose, California +January 29, 2021 +85 +Supplementary Financial Information (unaudited) +The Company uses a 52- or 53-week fiscal year ending on the last Saturday in December. All quarters of 2020 and 2019 consisted of 13 weeks. +(In millions, except per share amounts) +2020 2019 +Dec 26 Sep 26 June 27 Mar 28 Dec 28 Sep 28 June 29 Mar 30 +Net revenue $ 3,244 $ 2,801 $ 1,932 $ 1,786 $ 2,127 $ 1,801 $ 1,531 $ 1,272 +Cost of sales 1,793 1,571 1,084 968 1,178 1,024 910 751 +Gross profit 1,451 1,230 848 818 949 777 621 521 +Research and development 573 508 460 442 395 406 373 373 +Marketing, general and administrative 308 273 215 199 206 185 189 170 +Licensing gain — — — — — — — ( 60 ) +Operating income 570 449 173 177 348 186 59 38 +Interest expense ( 9 ) ( 11 ) ( 14 ) ( 13 ) ( 18 ) ( 24 ) ( 25 ) ( 27 ) +Other income (expense), net ( 15 ) ( 37 ) 1 4 ( 125 ) ( 36 ) 3 ( 7 ) +Income before income taxes 546 401 160 168 205 126 37 4 +Income tax provision (benefit) (1) +( 1,232 ) 12 4 6 35 7 2 ( 13 ) +Equity income (loss) in investee 3 1 1 — — 1 — ( 1 ) +Net income $ 1,781 $ 390 $ 157 $ 162 $ 170 $ 120 $ 35 $ 16 +Earnings per share +Basic $ 1.48 $ 0.33 $ 0.13 $ 0.14 $ 0.15 $ 0.11 $ 0.03 $ 0.01 +Diluted $ 1.45 $ 0.32 $ 0.13 $ 0.14 $ 0.15 $ 0.11 $ 0.03 $ 0.01 +Shares used in per share calculation +Basic 1,205 1,184 1,174 1,170 1,140 1,097 1,084 1,044 +Diluted 1,226 1,215 1,227 1,224 1,188 1,117 1,109 1,094 +(1) During the fourth quarter of 2020, the Company recognized a $ 1.3 billion income tax benefit upon the release of a portion of the valuation allowance on U.S. deferred tax assets. +86 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL +DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +We maintain disclosure controls and procedures that are designed with the objective of providing reasonable assurance that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. +As of December 26, 2020, the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e). This type of evaluation is performed on a quarterly basis so that conclusions of management, including our Chief Executive Officer and Chief Financial Officer, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on Form 10-Q and Form 10-K. The overall goals of these evaluation activities are to monitor our disclosure controls and to modify them as necessary. We intend to maintain the disclosure controls as dynamic systems that we adjust as circumstances merit. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of the end of the period covered by this report. +Management’s Report on Internal Control over Financial Reporting +Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles, and includes those policies and procedures that: +(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. +Management has used the 2013 framework set forth in the report entitled “Internal Control—Integrated Framework” published by the Committee of Sponsoring Organizations of the Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the +87 +Company’s internal control over financial reporting was effective as of December 26, 2020 at the reasonable assurance level. Our independent registered public accounting firm, Ernst & Young LLP, has issued an attestation report on the Company’s internal control over financial reporting as of December 26, 2020, which is included in Part II, Item 8, above. +Changes in Internal Control over Financial Reporting +There has been no change in our internal controls over financial reporting during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. +ITEM 9B. OTHER INFORMATION +None. +88 +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information under the captions “Item 1—Election of Directors” (including “Consideration of Stockholder Nominees for Director”), “Corporate Governance,” “Meetings and Committees of the Board of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our proxy statement for our 2021 annual meeting of stockholders (our 2021 Proxy Statement) is incorporated herein by reference. There were no material changes to the procedures by which stockholders may recommend nominees to our board of directors. See also, “Part 1, Item 1-Website Access to Company Reports and Corporate Governance Documents,” above. +ITEM 11. EXECUTIVE COMPENSATION +The information under the captions “Directors’ Compensation and Benefits” (including “2020 Non-Employee Director Compensation”), “Compensation Discussion and Analysis,” “Compensation Policies and Practices,” “Executive Compensation” (including “2020 Summary Compensation Table,” “2020 Nonqualified Deferred Compensation,” “Outstanding Equity Awards at 2020 Fiscal Year-End,” “Grants of Plan-Based Awards in 2020” and “Option Exercises and Stock Vested in 2020) and “Severance and Change in Control Arrangements” in our 2021 Proxy Statement is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND +RELATED STOCKHOLDER MATTERS +The information under the captions “Principal Stockholders,” “Security Ownership of Directors and Executive Officers” and “Equity Compensation Plan Information” in our 2021 Proxy Statement is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance—Independence of Directors” and “Certain Relationships and Related Transactions” in our 2021 Proxy Statement is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the captions “Item 2—Ratification of Appointment of Independent Registered Public Accounting Firm—Independent Registered Public Accounting Firm’s Fees” in our 2021 Proxy Statement is incorporated herein by reference. +With the exception of the information specifically incorporated by reference in Part III of this Annual Report on Form 10-K from our 2021 Proxy Statement, our 2021 Proxy Statement will not be deemed to be filed as part of this report. Without limiting the foregoing, the information under the captions “Compensation Committee Report” and “Audit Committee Report” in our 2021 Proxy Statement is not incorporated by reference in this Annual Report on Form 10-K. +89 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +1. Financial Statements +The financial statements of AMD are set forth in Item 8 of this Annual Report on Form 10-K. +All schedules have been omitted because the information is not required, is not applicable, or is included in the Notes to the Consolidated Financial Statements. +2. Exhibits +The exhibits listed in the accompanying Index to Exhibits are filed as part of, or incorporated by reference into, this Annual Report on Form 10-K. The following is a list of such Exhibits: +Exhibit Description of Exhibits +2.1 +Agreement and Plan of Merger by and among Advanced Micro Devices, Inc., Thrones Merger Sub, Inc., and Xilinx, Inc. dated October 26, 2020, filed as exhibit 2.1 to AMD’s Current Report on Form 8-K dated October 26, 2020, is hereby incorporated by reference. +3.1 +Amended and Restated Certificate of Incorporation of Advanced Micro Devices, Inc., dated May 2, 2018, filed as Exhibit 3.1 to AMD’s Quarterly Report on Form 10-Q for the period ended June 30, 2018, is hereby incorporated by reference. +3.2 +Advanced Micro Devices, Inc. Amended and Restated Bylaws, as amended on January 2 9 , 2021. +4.1 +Description of Advanced Micro Devices, Inc. Common Stock , filed as Exhibit 4.1 to AMD ’ s Annual Report on Form 10-K for the period ended December 28, 2019, is hereby incorporated by reference. +4.2 +Indenture governing 7.50% Senior Notes due 2022, including the Form of 7.50% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A., dated as of August 15, 2012, filed as Exhibit 4.1 to AMD’s Current Report on Form 8-K dated August 15, 2012, is hereby incorporated by reference. +4.3 +Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated September 14, 2016, filed as Exhibit 4.1 to AMD's Current Report on Form 8-K dated September 14, 2016, is hereby incorporated by reference. +4.4 +First Supplemental Indenture governing 2.125% Convertible Senior Notes due 2026, including Form of 2.125% Note, between Advanced Micro Devices, Inc. and Wells Fargo Bank, N.A. dated September 14, 2016, filed as Exhibit 4.2 to AMD's Current Report on Form 8-K dated September 14, 2016, is hereby incorporated by reference. +4.5 +First Supplemental Indenture by and among Advanced Micro Devices, Inc. and Wells Fargo Bank N.A., dated September 23, 2016, filed as Exhibit 4.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 24, 2016, is hereby incorporated by reference. +*10.1 +2011 Executive Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended April 2, 2011, is hereby incorporated by reference. +*10.2 +SeaMicro, Inc. Amended and Restated 2007 Equity Incentive Plan, filed as Exhibit 10.1 on AMD’s Registration Statement on Form S-8, filed with the SEC on March 23, 2012, is hereby incorporated by reference. +*10.3 +AMD Executive Severance Plan and Summary Plan Description for Senior Vice Presidents, effective June 1, 2013, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated June 7, 2013, is hereby incorporated by reference. +*10.4 +AMD Deferred Income Account Plan, as amended and restated, effective January 1, 2008, filed as Exhibit 10.18 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007, is hereby incorporated by reference. +90 +*10.5 +Amendment No. 1 to the AMD Deferred Income Account Plan, as amended and restated, effective July 1, 2012, filed as Exhibit 10.16(a) to AMD’s Annual Report on Form 10-K for the period ended December 29, 2012, is hereby incorporated by reference. +*10.6 +Form of Indemnity Agreement, between Advanced Micro Devices, Inc. and its officers and directors, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 6, 2008, is hereby incorporated by reference. +*10.7 +Form of Management Continuity Agreement, as amended and restated, filed as Exhibit 10.13(b) to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2007, is hereby incorporated by reference. +*10.8 +Form of Change in Control Agreement, filed as Exhibit 10.11 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 26, 2009, is hereby incorporated by reference. +*10.9 +Amended and Restated Management Continuity Agreement, between Advanced Micro Devices, Inc. and Devinder Kumar, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended September 29, 2012, is hereby incorporated by reference. +*10.10 +Offer Letter, between Advanced Micro Devices, Inc. and Mark D. Papermaster, dated October 7, 2011, filed as Exhibit 10.63 to AMD’s Annual Report on Form 10-K for the period ended December 31, 2011, is hereby incorporated by reference. +10.11 +Settlement Agreement, between Advanced Micro Devices, Inc. and Intel Corporation, dated November 11, 2009, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated November 11, 2009, is hereby incorporated by reference. +**10.12 +Patent Cross License Agreement, between Advanced Micro Devices, Inc. and Intel Corporation filed, dated November 11, 2009, as Exhibit 10.2 to AMD’s Current Report on Form 8-K dated November 17, 2009, is hereby incorporated by reference. +10.13 +Sublease Agreement, between Lantana HP, LTD and Advanced Micro Devices, Inc., dated March 26, 2013, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.14 +Master Landlord’s Consent to Sublease, between 7171 Southwest Parkway Holdings, L.P., Lantana HP, Ltd. and Advanced Micro Devices, Inc., dated March 26, 2013, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +10.15 +Lease Agreement, between 7171 Southwest Parkway Holdings, L.P. and Lantana HP, Ltd., dated March 26, 2013, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the period ended March 30, 2013, is hereby incorporated by reference. +*10.16 +Employment Agreement by and between Lisa T. Su and Advanced Micro Devices, Inc. effective October 8, 2014, filed as Exhibit 10.2 to AMD’s Current Report on Form 8-K/A dated October 14, 2014, is hereby incorporated by reference. +*10.17 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 27, 2014, is hereby incorporated by reference. +*10.18 +Offer Letter, between Advanced Micro Devices, Inc. and Forrest E. Norrod, dated October 20, 2014, filed as Exhibit 10.66 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +*10.19 +Advanced Micro Devices, Inc. Executive Severance Plan and Summary Plan Description for Senior Vice Presidents effective December 31, 2014, filed as Exhibit 10.68 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 27, 2014, is hereby incorporated by reference. +*10.20 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2015, is hereby incorporated by reference. +91 +10.21 +Equity Interest Purchase Agreement by and between Advanced Micro Devices, Inc. and Nantong Fujitsu Microelectronics Co., Ltd. dated as of October 15, 2015, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated October 15, 2015, is hereby incorporated by reference. +*10.22 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.78 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +*10.23 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.79 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +*10.24 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.80 to AMD's Annual Report on Form 10-K for the fiscal year ended December 26, 2015, is hereby incorporated by reference. +*10.25 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.88 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.26 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Plan, filed as Exhibit 10.89 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.27 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.90 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, is hereby incorporated by reference. +*10.28 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended April 4, 2017, is hereby incorporated by reference. +*10.29 +2004 Equity Incentive Plan, as amended and restated, filed as Exhibit 10.1 to AMD’s Registration Statement on Form S-8 filed with the SEC on May 8, 2017, is hereby incorporated by reference. +*10.30 +Amended and Restated 2017 Employee Stock Purchase Plan dated August 23, 2018, filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended September 29, 2018, is hereby incorporated by reference. +*10.31 +2017 Employee Stock Purchase Plan, as amended and restated October 12, 2017, filed as Exhibit 10.98 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.32 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.99 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.33 +Form of Restricted Stock Unit Award Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.100 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.34 +Form of Performance-Based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan filed as Exhibit 10.101 to AMD's Annual Report on Form 10-K for the fiscal year ended December 30, 2017, is hereby incorporated by reference. +*10.35 +Amendment to Advanced Micro Devices, Inc. Executive Incentive Plan dated as of February 8, 2018, filed as Exhibit 10.1 to AMD's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2018, is hereby incorporated by reference. +*10.36 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive plan, filed as Exhibit 10.103 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2018, is hereby incorporated by reference. +*10.37 +Form of Performance-based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.104 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2018, is hereby incorporated by reference. +92 +*10.38 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.105 to AMD’s Annual Report on Form 10-K for the fiscal year ended December 29, 2018, is hereby incorporated by reference. +10.39 +Credit Agreement dated as of June 7, 2019 by and among Advanced Micro Devices, Inc., as borrower, the lenders as referred to therein, as lenders, and Wells Fargo Bank, National Association, as administrative agent, swingline agent and an issuing lender, filed as Exhibit 10.1 to AMD’s Current Report on Form 8-K dated June 10, 2019, is hereby incorporated by reference. +*10.40 +Offer Letter between Advanced Micro Devices, Inc. and Rick Bergman dated August 1, 2019, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.41 +Sign-On Bonus Letter between Advanced Micro Devices, Inc. and Rick Bergman dated August 1, 2019, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.42 +Value Creation Performance-Based Restricted Stock Unit Grant Notice between Advanced Micro Devices, Inc. and Lisa T. Su, dated August 9, 2019, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.43 +Value Creation Performance-Based Restricted Stock Unit Grant Notice between Advanced Micro Devices, Inc. and Mark Papermaster, dated August 9, 2019, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.44 +Amendment to Advanced Micro Devices, Inc. Executive Incentive Plan dated as of August 21, 2019, filed as Exhibit 10.6 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.45 +2004 Equity Incentive Plan, as amended and restated, dated August 21, 2019, filed as Exhibit 10.7 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 28, 2019, is hereby incorporated by reference. +*10.46 +Outside Director Equity Compensation Policy, as amended and restated, dated as of February 12, 2020, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 28, 2020, is hereby incorporated by reference. +*10.47 +Form of Performance-based Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2020, is hereby incorporated by reference. +*10.48 +Form of Stock Option Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive plan, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2020, is hereby incorporated by reference. +*10.49 +Form of Restricted Stock Unit Agreement for Senior Vice Presidents and Above under the 2004 Equity Incentive Plan, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 27, 2020, is hereby incorporated by reference. +***10.50 +Wafer Supply Agreement, among Advanced Micro Devices, Inc., The Foundry Company and AMD Fab Technologies US, Inc., dated March 2, 2009, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2020, is hereby incorporated by reference . +***10.51 +Wafer Supply Agreement Amendment No. 1, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc., GLOBALFOUNDRIES U.S. Inc. and GLOBALFOUNDRIES Singapore. Pte. Ltd., dated March 29, 2011, filed as Exhibit 10.2 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26, 2020, is hereby incorporated by reference. +93 +***10.52 +Wafer Supply Agreement Amendment No. 2, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc., GLOBALFOUNDRIES U.S. Inc., Advanced Technology Investment Company LLC and ATIC International Investment Company LLC, dated March 4, 2012, filed as Exhibit 10.3 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26October 28, 2020, is hereby incorporated by reference. +***10.53 +Wafer Supply Agreement Amendment No. 3, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated December 6, 2012, filed as Exhibit 10.4 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26October 28, 2020, is hereby incorporated by reference . +***10.54 +Wafer Supply Agreement Amendment No. 4, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated March 30, 2014, filed as Exhibit 10.5 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26October 28, 2020, is hereby incorporated by reference. +***10.55 +Wafer Supply Agreement Amendment No. 5, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated as of April 16, 2015, filed as Exhibit 10.6 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26October 28, 2020, is hereby incorporated by reference. +***10.56 +Wafer Supply Agreement Amendment No. 6, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES, Inc. and GLOBALFOUNDRIES U.S., Inc., dated August 30, 2016, filed as Exhibit 10.7 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended September 26October 28, 2020, is hereby incorporated by reference. +**10.57 +Wafer Supply Agreement Amendment No. 7, among Advanced Micro Devices, Inc., GLOBALFOUNDRIES Inc. and GLOBALFOUNDRIES U.S. Inc., dated January 28, 2019, filed as Exhibit 10.1 to AMD’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 30, 2019, is hereby incorporated by reference. +10.58 +Company-Provided Business Aircraft Usage and Commercial Travel by Personal Guests Policy revised as of January 25, 2021. +21 +List of AMD subsidiaries. +23 +Consent of Independent Registered Public Accounting Firm . +24 +Power of Attorney. +31.1 +Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32.1 +Certification of the Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101.INS XBRL Instance Document -the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document +101.SCH XBRL Taxonomy Extension Schema Document +101.CAL XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF XBRL Taxonomy Extension Definition Linkbase Document +101.LAB XBRL Taxonomy Extension Label Linkbase Document +94 +101.PRE XBRL Taxonomy Extension Presentation Linkbase Document +104 Cover Page Interactive Data File -the Cover Page Interactive Data File does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document +_____________________ +* Management contracts and compensatory plans or arrangements. +** Portions of this exhibit have been omitted pursuant to a request for confidential treatment, which has been granted. These portions have been filed separately with the SEC. +*** Portions of this exhibit have been omitted because they are both (i) not material and (ii) would be competitively harmful if publicly disclosed. +AMD will furnish a copy of any exhibit on request and payment of AMD’s reasonable expenses of furnishing such exhibit. +95 +ITEM 16. FORM 10-K SUMMARY +Not applicable. +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +January 29, 2021 +A DVANCED M ICRO D EVICES , I NC . +By: +/s/ Devinder Kumar +Devinder Kumar +Executive Vice President, Chief Financial Officer, and Treasurer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, on behalf of the registrant and in the capacities and on the dates indicated. +96 +Signature Title Date +/s/Lisa T. Su President and Chief Executive Officer +(Principal Executive Officer), Director January 29, 2021 +Lisa T. Su +/s/Devinder Kumar Executive Vice President, Chief Financial Officer and Treasurer +(Principal Financial Officer) January 29, 2021 +Devinder Kumar +/s/Darla Smith Corporate Vice President, Chief Accounting Officer (Principal Accounting Officer) January 29, 2021 +Darla Smith +* Director, Chairman of the Board January 29, 2021 +John E. Caldwell +* Director January 29, 2021 +Nora M. Denzel +* Director +Dermot Mark Durcan January 29, 2021 +* Director January 29, 2021 +Michael P. Gregoire +* Director January 29, 2021 +Joseph A. Householder +* Director January 29, 2021 +John W. Marren +* Director January 29, 2021 +Abhi Y. Talwalkar +*By: /s/Devinder Kumar +Devinder Kumar, Attorney-in-Fact +97 \ No newline at end of file diff --git a/raw/filings/0000002488/2020/0001628280-21-001185/filing_metadata.csv b/raw/filings/0000002488/2020/0001628280-21-001185/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..71d9512e25ec7302c8868d1c803fdc37c69f6b92 --- /dev/null +++ b/raw/filings/0000002488/2020/0001628280-21-001185/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002488,AMD,ADVANCED MICRO DEVICES INC,2020,10-K,2021-01-29,2020-12-26,2021-01-29T22:24:00.000Z,0001628280-21-001185,amd-20201226.htm,10-K,11900446,1,1,https://www.sec.gov/Archives/edgar/data/2488/000162828021001185/amd-20201226.htm,https://www.sec.gov/Archives/edgar/data/2488/000162828021001185/ diff --git a/raw/filings/0000002488/2020/0001628280-21-001185/item1.txt b/raw/filings/0000002488/2020/0001628280-21-001185/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..2632789f7d2b3d6b6a99b2e5feab969516318883 --- /dev/null +++ b/raw/filings/0000002488/2020/0001628280-21-001185/item1.txt @@ -0,0 +1,3 @@ +ITEM 1. BUSINESS +Cautionary Statement Regarding Forward-Looking Statements +The statements in this report include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations and beliefs and involve numerous risks and uncertainties that could cause actual results to differ materially from expectations. These forward-looking statements speak only as of the date hereof or as of the dates indicated in the statements and should not be relied upon as predictions of future events, as we cannot assure you that the events or circumstances reflected in these statements will be achieved or will occur. You can identify forward-looking statements by the use of forward-looking terminology including “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “pro forma,” “estimates,” “anticipates,” or the negative of these words and phrases, other variations of these words and phrases or comparable terminology. The forward-looking statements relate to, among other things: possible impact of future accounting rules on AMD’s consolidated financial statements; demand for AMD’s products; the growth, change and competitive landscape of the markets in which AMD participates; the expected amounts to be received by AMD under the IP licensing agreement and AMD’s expected royalty payments from future product sales of the two joint ventures AMD holds equity in with Higon Information Technology Co., Ltd. (THATIC JVs) products to be developed on the basis of such licensed IP; sales patterns of AMD’s products; international sales will continue to be a significant portion of total sales in the foreseeable future; that AMD’s cash, cash equivalents and short-term investment balances together with the availability under that certain revolving credit facility (the Revolving Credit Facility) made available to AMD and certain of its subsidiaries under the Credit Agreement, will be sufficient to fund AMD’s operations including capital expenditures over the next 12 months; AMD’s ability to obtain sufficient external financing on favorable terms, or at all; AMD’s expectation that based on the information presently known to management, the potential liability related to AMD’s current litigation will not have a material adverse effect on its financial condition, cash flows or results of operations; any amounts in addition to what has been already accrued by AMD for future remediation costs under clean-up orders will not have a material effect on our financial condition, cash flows or results of operations; we expect to file future patent applications in both the United States and abroad on significant inventions as we deem appropriate; anticipated ongoing and increased costs related to enhancing and implementing information security controls; revenue allocated to remaining performance obligations that are unsatisfied which will be recognized over the next 12 months; all unbilled accounts receivables are expected to be billed and collected within 12 months; a small number of customers will continue to account for a substantial part of AMD’s revenue in the future; and the acquisition of Xilinx, Inc. is currently expected to close by the end of calendar year 2021. For a discussion of the factors that could cause actual results to differ materially from the forward-looking statements, see “Part I, \ No newline at end of file diff --git a/raw/filings/0000002488/2020/0001628280-21-001185/item13.txt b/raw/filings/0000002488/2020/0001628280-21-001185/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..0fdbe2f2d43f0ba26770e5e264f57ae8f5366a22 --- /dev/null +++ b/raw/filings/0000002488/2020/0001628280-21-001185/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. +Certain Relationships and Related Transactions and Director Independence +89 \ No newline at end of file diff --git a/raw/filings/0000002969/2018/0000002969-18-000044/filing.txt b/raw/filings/0000002969/2018/0000002969-18-000044/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..4cfe7815680177a38b67ef1f45707f8da769e32f --- /dev/null +++ b/raw/filings/0000002969/2018/0000002969-18-000044/filing.txt @@ -0,0 +1,12212 @@ +Document +50600000 P8Y 0.5 P10Y 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PRODUCTS AND CHEMICALS, INC. +7201 Hamilton Boulevard +State of incorporation: Delaware +Allentown, Pennsylvania, 18195-1501 +I.R.S. identification number: 23-1274455 +Tel. (610) 481-4911 +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class: +Registered on: +Common Stock, par value $1.00 per share +New York Stock Exchange +2.0% Euro Notes due 2020 +New York Stock Exchange +0.375% Euro Notes due 2021 +New York Stock Exchange +1.0% Euro Notes due 2025 +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +YES +x +NO +¨ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +YES +¨ +NO +x +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +YES +x +NO +¨ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +YES +x +NO +¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. +¨ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. +Large accelerated filer x +Accelerated filer ¨ +Non-accelerated filer ¨ +Smaller reporting company ¨ +Emerging growth company ¨ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. +¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +YES +¨ +NO +x +The aggregate market value of the voting stock held by non-affiliates of the registrant on 31 March 2018 was approximately $ 34.8 billion . For purposes of the foregoing calculations, all directors and/or executive officers have been deemed to be affiliates, but the registrant disclaims that any such director and/or executive officer is an affiliate. +The number of shares of common stock outstanding as of 31 October 2018 was 219,533,532 . +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the registrant’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 are incorporated by reference into Part III. +Table of Contents +AIR PRODUCTS AND CHEMICALS, INC. +ANNUAL REPORT ON FORM 10-K +For the fiscal year ended 30 September 2018 +TABLE OF CONTENTS +ITEM 1. +BUSINESS +4 +ITEM 1A. +RISK FACTORS +8 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +14 +ITEM 2. +PROPERTIES +14 +ITEM 3. +LEGAL PROCEEDINGS +15 +ITEM 4. +MINE SAFETY DISCLOSURES +16 +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES +16 +ITEM 6. +SELECTED FINANCIAL DATA +18 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +20 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +55 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +57 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +122 +ITEM 9A. +CONTROLS AND PROCEDURES +122 +ITEM 9B. +OTHER INFORMATION +123 +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +123 +ITEM 11. +EXECUTIVE COMPENSATION +123 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +124 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +125 +ITEM 14. +PRINCIPAL ACCOUNTANT FEES AND SERVICES +125 +ITEM 15. +EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +125 +ITEM 16. +FORM 10-K SUMMARY +125 +INDEX TO EXHIBITS +126 +SIGNATURES +130 +2 +Table of Contents +FORWARD-LOOKING STATEMENTS +This Annual Report on Form 10-K contains “forward-looking statements” within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and can generally be identified by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “goal,” “intend,” “may,” “outlook,” “plan,” “positioned,” “possible,” “potential,” “project,” “should,” “target,” “will,” “would,” and similar expressions or variations thereof, or the negative thereof, but these terms are not the exclusive means of identifying such statements. Forward-looking statements are based on management’s expectations and assumptions as of the date of this report and are not guarantees of future performance. You are cautioned not to place undue reliance on our forward-looking statements. +Forward-looking statements may relate to a number of matters, including expectations regarding revenue, margins, expenses, earnings, tax provisions, cash flows, pension obligations, share repurchases or other statements regarding economic conditions or our business outlook; statements regarding plans, projects, strategies and objectives for our future operations, including our ability to win new projects and execute the projects in our backlog; and statements regarding our expectations with respect to pending legal claims or disputes. While forward-looking statements are made in good faith and based on assumptions, expectations and projections that management believes are reasonable based on currently available information, actual performance and financial results may differ materially from projections and estimates expressed in the forward-looking statements because of many factors, including, without limitation: +• +changes in global or regional economic conditions, supply and demand dynamics in the market segments we serve, or in the financial markets; +• +risks associated with having extensive international operations, including political risks, risks associated with unanticipated government actions and risks of investing in developing markets; +• +project delays, contract terminations, customer cancellations, or postponement of projects and sales; +• +future financial and operating performance of major customers and joint venture partners; +• +our ability to develop, implement, and operate new technologies, or to execute the projects in our backlog; +• +tariffs, economic sanctions and regulatory activities in jurisdictions in which we and our affiliates and joint ventures operate; +• +the impact of environmental, tax or other legislation, as well as regulations affecting our business and related compliance requirements, including regulations related to global climate change; +• +changes in tax rates and other changes in tax law; +• +the timing, impact, and other uncertainties relating to acquisitions and divestitures, including our ability to integrate acquisitions and separate divested businesses, respectively; +• +risks relating to cybersecurity incidents, including risks from the interruption, failure or compromise of our information systems; +• +catastrophic events, such as natural disasters, acts of war, or terrorism; +• +the impact of price fluctuations in natural gas and disruptions in markets and the economy due to oil price volatility; +• +costs and outcomes of legal or regulatory proceedings and investigations; +• +asset impairments due to economic conditions or specific events; +• +significant fluctuations in interest rates and foreign currency exchange rates from those currently anticipated; +• +damage to facilities, pipelines or delivery systems, including those we own or operate for third parties; +• +availability and cost of raw materials; and +• +the success of productivity and operational improvement programs. +3 +Table of Contents +In addition to the foregoing factors, forward-looking statements contained herein are qualified with respect to the risks disclosed elsewhere in this document, including in Item 1A, Risk Factors, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 7A, Quantitative and Qualitative Disclosures About Market Risk. Any of these factors, as well as those not currently anticipated by management, could cause our results of operations, financial condition or liquidity to differ materially from what is expressed or implied by any forward-looking statement. Except as required by law, we disclaim any obligation or undertaking to update or revise any forward-looking statements contained herein to reflect any change in assumptions, beliefs, or expectations or any change in events, conditions, or circumstances upon which any such forward-looking statements are based. +PART I +ITEM 1. BUSINESS +Air Products and Chemicals, Inc., a Delaware corporation originally founded in 1940, serves customers globally with a unique portfolio of products, services, and solutions that include atmospheric gases, process and specialty gases, equipment, and services. The Company is the world’s largest supplier of hydrogen and has built leading positions in growth markets such as helium and natural gas liquefaction. As used in this report, unless the context indicates otherwise, the terms “we,” “our,” “us,” the “Company,” or “registrant” include controlled subsidiaries, affiliates, and predecessors of Air Products and its controlled subsidiaries and affiliates. +During its fiscal year ended 30 September 2018 (“fiscal year 2018 ”), the Company reported its continuing operations in five reporting segments under which it managed its operations, assessed performance, and reported earnings: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. +Except as otherwise noted, the description of the Company's business below reflects the Company's continuing operations. Refer to Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 25 , Business Segment and Geographic Information , and Note 3 , Discontinued Operations , to the consolidated financial statements for additional details on our reportable business segments and our discontinued operations. +Industrial Gases Business +The Company’s Industrial Gases business produces atmospheric gases (oxygen, nitrogen, argon, and rare gases); process gases (hydrogen, helium, carbon dioxide, carbon monoxide, syngas, and specialty gases); and equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. Atmospheric gases are produced through various air separation processes of which cryogenic is the most prevalent. Process gases are produced by methods other than air separation. For example, hydrogen, carbon monoxide and syngas are produced by steam methane reforming of natural gas and by the gasification of liquid and solid hydrocarbons. Hydrogen is also produced by purifying byproduct sources obtained from the chemical and petrochemical industries; and helium is produced as a byproduct of gases extracted from underground reservoirs, primarily natural gas, but also carbon dioxide purified before resale. +The Company’s Industrial Gases business is organized and operated regionally. The regional Industrial Gases segments (Americas, EMEA, and Asia) supply gases and related equipment in the relevant region to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels. The chemicals industry uses hydrogen, oxygen, nitrogen, carbon monoxide, and syngas as feedstocks in the production of many basic chemicals. The energy production industry uses nitrogen injection for enhanced recovery of oil and natural gas and oxygen for gasification. Oxygen is used in combustion and industrial heating applications, including in the gasification, steel, certain nonferrous metals, glass, and cement industries. Nitrogen applications are used in food processing for freezing and preserving flavor and nitrogen for inerting is used in various fields, including the metals, chemical, and semiconductor industries. Helium is used in laboratories and healthcare for cooling and in other industries for pressurizing, purging, and lifting. Argon is used in the metals and other industries for its unique inerting, thermal conductivity, and other properties. Industrial gases are also used in welding and providing healthcare and are utilized in various manufacturing processes to make them more efficient and to optimize performance. +4 +Table of Contents +We distribute gases to our customers through a variety of supply modes: +Liquid Bulk— Product is delivered in bulk (in liquid or gaseous form) by tanker or tube trailer and stored, usually in its liquid state, in equipment designed and installed typically by the Company at the customer’s site for vaporizing into a gaseous state as needed. Liquid bulk sales are usually governed by three- to five-year contracts. +Packaged Gases— Small quantities of product are delivered in either cylinders or dewars. The Company operates packaged gas businesses in Europe, Asia, and Latin America. In the United States, the Company’s packaged gas business sells products (principally helium) only for the electronics and magnetic resonance imaging industries. +On-Site Gases— Large quantities of hydrogen, nitrogen, oxygen, carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide) are provided to customers, principally the energy production and refining, chemical, gasification, and metals industries worldwide, that require large volumes of gases and have relatively constant demand. Gases are produced at large facilities located adjacent to customers’ facilities or by pipeline systems from centrally located production facilities and are generally governed by 15- to 20- year contracts. The Company also delivers small quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically either via a 10- to 15- year sale of gas contract or through the sale of the equipment to the customer. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide and syngas. We mitigate electricity, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. During fiscal year 2018 , no significant difficulties were encountered in obtaining adequate supplies of power and natural gas. +The Company obtains helium from a number of sources globally, including crude helium for purification from the U.S. Bureau of Land Management's helium reserve. +The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method. The largest of these joint ventures operate in Mexico, Italy, South Africa, India, Saudi Arabia, and Thailand. +Each of the regional Industrial Gases segments competes against two global industrial gas companies: Air Liquide S.A. and Linde plc (the successor to Praxair, Inc. and Linde AG, pursuant to a combination that became effective on 31 October 2018), as well as regional competitors. Competition in Industrial Gases is based primarily on price, reliability of supply, and the development of industrial gas applications. In locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to larger customers, we derive a competitive advantage. +Overall regional industrial gases sales constituted approximately 94% of consolidated sales in fiscal year 2018 , 90% in fiscal year 2017 , and 90% in fiscal year 2016 . Sales of tonnage hydrogen and related products constituted approximately 25% of consolidated sales in fiscal year 2018 , 24% in fiscal year 2017 , and 21% in fiscal year 2016 . Sales of atmospheric gases constituted approximately 46% of consolidated sales in fiscal year 2018 , 45% in fiscal year 2017 , and 46% in fiscal year 2016 . +Industrial Gases Equipment +The Company designs and manufactures equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction ("LNG"), and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global segment includes activity related to cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Corporate and other segment includes three global equipment businesses: our LNG equipment business, our Gardner Cryogenics business fabricating helium and hydrogen transport and storage containers, and our Rotoflow business which manufactures turboexpanders and other precision rotating equipment. Steel, aluminum, and capital equipment subcomponents (compressors, etc.) are the principal raw materials in the manufacturing of equipment. Adequate raw materials for individual projects are acquired under firm purchase agreements. Equipment is produced at the Company’s manufacturing sites with certain components being procured from subcontractors and vendors. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Sale of equipment constituted approximately 6% of consolidated sales in fiscal year 2018 , 10% in fiscal year 2017 , and 10% in fiscal year 2016 . +5 +Table of Contents +The backlog of equipment orders was approximately $.2 billion on 30 September 2018 (as compared to a total backlog of approximately $.5 billion on 30 September 2017 ). The Company estimates that approximately 50% of the total sales backlog as of 30 September 2018 will be recognized as revenue during fiscal year 2019 , dependent on execution schedules of the relevant projects. +International Operations +The Company, through subsidiaries, affiliates, and less-than-controlling interests, conducts business in 50 countries outside the United States. Its international businesses are subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls; import and export controls; and other economic, political, and regulatory policies of local governments described in Item 1A, Risk Factors, below. +The Company has majority or wholly owned foreign subsidiaries that operate in Canada; 16 European countries (including the United Kingdom, the Netherlands, and Spain); eight Asian countries (including China, South Korea, and Taiwan); seven Latin American countries (including Chile and Brazil); four countries in the Middle East, and two African countries. The Company also owns less-than-controlling interests in entities operating in Europe, Asia, Africa, the Middle East, and Latin America (including Italy, Germany, China, India, Saudi Arabia, Thailand, Oman, South Africa, and Mexico). +Financial information about the Company’s foreign operations and investments is included in Note 8 , Summarized Financial Information of Equity Affiliates ; Note 22 , Income Taxes ; and Note 25 , Business Segment and Geographic Information , to the consolidated financial statements included under Item 8, below. Information about foreign currency translation is included under “Foreign Currency” in Note 1 , Major Accounting Policies , and information on the Company’s exposure to currency fluctuations is included in Note 13 , Financial Instruments , to the consolidated financial statements, included under Item 8, below, and in “Foreign Currency Exchange Rate Risk,” included under Item 7A, below. Export sales from operations in the United States to third-party customers amounted to $33.1 million, $64.2 million, and $134.9 million in fiscal years 2018 , 2017 , and 2016 , respectively. +Technology Development +The Company pursues a market-oriented approach to technology development through research and development, engineering, and commercial development processes. It conducts research and development principally in its laboratories located in the United States (Trexlertown, Pennsylvania), Canada (Vancouver), the United Kingdom (Basingstoke and Carrington), Spain (Barcelona), China (Shanghai), and Saudi Arabia (Dhahran). The Company also funds and cooperates in research and development programs conducted by a number of major universities and undertakes research work funded by others, principally the United States government. +The Company’s research groups are aligned with and support the research efforts of various businesses throughout the Company. Development of technology for use within the Industrial Gases business focuses primarily on new and improved processes and equipment for the production and delivery of industrial gases and new or improved applications for industrial gas products. +During fiscal year 2018 , the Company owned approximately 535 United States patents, approximately 2,888 foreign patents, and was a licensee under certain patents owned by others. While the patents and licenses are considered important, the Company does not consider its business as a whole to be materially dependent upon any particular patent, patent license, or group of patents or licenses. +Environmental Controls +The Company is subject to various environmental laws and regulations in the countries in which it has operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, the Company is involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA: the federal Superfund law); Resource Conservation and Recovery Act (RCRA); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. The Company’s accounting policy for environmental expenditures is discussed in Note 1 , Major Accounting Policies , and environmental loss contingencies are discussed in Note 17 , Commitments and Contingencies , to the consolidated financial statements, included under Item 8, below. +The amounts charged to income from continuing operations related to environmental matters totaled $12.8 million in fiscal year 2018 , $11.4 million in fiscal year 2017 , and $12.2 million in fiscal year 2016 . These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet internal Company standards. Refer to Note 17 , Commitments and Contingencies , to the consolidated financial statements for additional information. +6 +Table of Contents +The Company estimates that we spent approximately $3 million in fiscal year 2018 , $7 million in fiscal year 2017 , and $3 million in fiscal year 2016 on capital projects reflected in continuing operations to control pollution. Capital expenditures to control pollution are estimated to be approximately $4 million in both fiscal years 2019 and 2020 . +Employees +On 30 September 2018 , the Company (including majority-owned subsidiaries) had approximately 16,300 employees, of whom approximately 16,000 were full-time employees and of whom approximately 11,800 were located outside the United States. The Company has collective bargaining agreements with unions at various locations that expire on various dates over the next four years. The Company considers relations with its employees to be satisfactory. +Available Information +All periodic and current reports, registration statements, and other filings that the Company is required to file with the Securities and Exchange Commission ("SEC"), including the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through the Company’s website at www.airproducts.com. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC. All such reports filed during the period covered by this report were available on the Company’s website on the same day as filing. In addition, our filings with the SEC are available free of charge on the SEC's website, www.sec.gov. +Seasonality +The Company’s businesses are not subject to seasonal fluctuations to any material extent. +Inventories +The Company maintains limited inventory where required to facilitate the supply of products to customers on a reasonable delivery schedule. Inventory consists primarily of crude helium, industrial gas, and specialty gas inventories supplied to customers through liquid bulk and packaged gases supply modes. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues . We do have concentrations of customers in specific industries, primarily refining, chemicals, and electronics. Within each of these industries, the Company has several large-volume customers with long-term contracts. A negative trend affecting one of these industries, or the loss of one of these major customers, although not material to our consolidated revenue, could have an adverse impact on our financial results. +Governmental Contracts +Our business is not subject to a government entity’s renegotiation of profits or termination of contracts that would be material to our business as a whole. +7 +Table of Contents +Executive Officers of the Company +The Company’s executive officers and their respective positions and ages on 20 November 2018 follow. Information with respect to offices held is stated in fiscal years. +Name +Age +Office +M. Scott Crocco +54 +Executive Vice President and Chief Financial Officer (became Executive Vice President and Chief Financial Officer in 2016; Senior Vice President and Chief Financial Officer in 2013; and Vice President and Corporate Controller in 2008). +Seifi Ghasemi +74 +Chairman, President, and Chief Executive Officer (became Chairman, President and Chief Executive Officer in 2014 and previously served as Chairman and Chief Executive Officer of Rockwood Holdings, Inc. beginning in 2001). Mr. Ghasemi is a member and Chairman of the Board of Directors and the Chairman of the Executive Committee of the Board of Directors. +Sean D. Major +54 +Executive Vice President, General Counsel and Secretary (Secretary since December 2017 and Executive Vice President and General Counsel since May 2017). Previously, Mr. Major served as Executive Vice President, General Counsel and Secretary for Joy Global Inc. since 2007. From 1998 until joining Joy Global Inc. in 2007, Mr. Major was employed by Johnson Controls, Inc., serving in roles of increasing legal responsibility, including Assistant General Counsel and Assistant Secretary. +Dr. Samir Serhan +57 +Executive Vice President (since December 2016). Previously, Dr. Serhan served as President, Global HyCO, since 2014 for Praxair Inc. From 2000-2014, he worked in leadership positions in the U.S. and Germany for The Linde Group, including Managing Director of Linde Engineering from 2008-2014. +ITEM 1A. RISK FACTORS +Our operations are affected by various risks, many of which are beyond our control. In evaluating investment in the Company and the forward-looking information contained in this Annual Report on Form 10-K or presented elsewhere by management from time to time, you should consider the following risk factors. Any of the following risks could have a material adverse effect on our business, operating results, financial condition, and the actual outcome of matters as to which forward-looking statements are made and could adversely affect the value of an investment in our common stock as well. While we believe we have identified and discussed below the key risk factors affecting our business, there may be additional risks and uncertainties that adversely affect our business, performance, or financial condition in the future that are not presently known, are not currently believed to be significant, or are not identified below because they are common to all businesses. +Changes in global and regional economic conditions, the markets we serve, or the financial markets may adversely affect our results of operations and cash flows. +Unfavorable conditions in the global economy or regional economies, the markets we serve or financial markets may decrease the demand for our goods and services and adversely impact our revenues, operating results, and cash flows. +Demand for our products and services depends in part on the general economic conditions affecting the countries and markets in which we do business. Weak economic conditions in certain geographies and changing supply and demand balances in the markets we serve have negatively impacted demand for our products and services in the past and may do so in the future. Reduced demand for our products and services would have a negative impact on our revenues and earnings. In addition, reduced demand could depress sales, reduce our margins, constrain our operating flexibility or reduce efficient utilization of our manufacturing capacity, or result in charges which are unusual or nonrecurring. Excess capacity in our manufacturing facilities or those of our competitors could decrease our ability to maintain pricing and generate profits. +Our operating results in one or more segments may also be affected by uncertain or deteriorating economic conditions for particular customer markets within a segment. A decline in the industries served by our customers or adverse events or circumstances affecting individual customers can impair the ability of such customers to satisfy their obligations to the Company, resulting in uncollected receivables, unanticipated contract terminations, project delays, or inability to recover plant investments, any of which may negatively impact our financial results. +8 +Table of Contents +Weak overall demand or specific customer conditions may also cause customer shutdowns or default, or other inabilities to operate facilities profitably, and may force sale or abandonment of facilities and equipment or prevent projects from coming on-stream. These or other events associated with weak economic conditions or specific end market, product, or customer events may require us to record an impairment on tangible assets, such as facilities and equipment, or intangible assets, such as intellectual property or goodwill, which would have a negative impact on our financial results. +Our extensive international operations can be adversely impacted by operational, economic, political, security, legal, and currency translation risks that could decrease profitability. +In fiscal year 2018, over 60% of our sales were derived from customers outside the United States and many of our operations, suppliers, and employees are located outside the United States. Our operations in foreign jurisdictions may be subject to risks including exchange control regulations, import and trade restrictions, trade policy and other potentially detrimental domestic and foreign governmental practices or policies affecting U.S. companies doing business abroad. Changing economic and political conditions within foreign jurisdictions, strained relations between countries, or the imposition of tariffs or international sanctions can cause fluctuations in demand, price volatility, supply disruptions, or loss of property. The occurrence of any of these risks could have a material adverse impact on our financial condition, results of operation, and cash flows. +Our growth strategies depend in part on our ability to further penetrate markets outside the United States, particularly in higher-growth markets, and involve larger and more complex projects, including world-scale gasification projects, in regions where there is the potential for significant economic and political disruptions, including Russia, the Middle East and China. We are actively investing significant capital and other resources, in some cases through joint ventures, in developing or high growth markets, which present special risks. Our operations in these markets may be subject to greater risks than those faced by our operations in mature economies, including political and economic instability, project delay or abandonment due to unanticipated government actions, inadequate investment in infrastructure, undeveloped property rights and legal systems, unfamiliar regulatory environments, relationships with local partners, language and cultural differences and talent risks. Our contracts in these locations may be subject to cancellation without full compensation for loss. Successful operation of particular facilities or execution of projects may be disrupted by civil unrest, acts of sabotage or terrorism, and other local security concerns. Such concerns may require us to incur greater costs for security or require us to shut down operations for a period of time. +Because the majority of our revenue is generated from sales outside the United States, we are exposed to fluctuations in foreign currency exchange rates. Our business is primarily exposed to translational currency risk as the results of our foreign operations are translated into U.S. dollars at current exchange rates throughout the fiscal period. Our policy is to minimize cash flow volatility from changes in currency exchange rates. We choose not to hedge the translation of our foreign subsidiaries’ earnings into dollars. Accordingly, reported sales, net earnings, cash flows, and fair values have been, and in the future will be, affected by changes in foreign exchange rates. For a more detailed discussion of currency exposure, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk, below. +Operational and project execution risks may adversely affect our operations or financial results. +Some of our projects, including some of our largest growth projects, involve challenging engineering, procurement and construction phases that may occur in more risky locations and over extended time periods, sometimes up to several years. We may encounter difficulties in engineering, delays in designs or materials provided by the customer or a third party, equipment and materials delivery delays, schedule changes, customer scope changes, delays related to obtaining regulatory permits and rights-of-way, inability to find adequate sources of labor in the locations where we are building new plants, weather-related delays, delays by customers' contractors in completing their portion of a project, technical or transportation difficulties, and other factors, some of which are beyond our control, but which may impact our ability to complete a project within the original delivery schedule. In some cases, delays and additional costs may be substantial, and we may be required to cancel a project and/or compensate the customer for the delay. We may not be able to recover any of these costs. These factors could also negatively impact our reputation or relationships with our customers, which could adversely affect our ability to secure new contracts in the future, and these risks are more significant as we take on larger and more complex projects, including gasification projects, as part of our growth strategy. +9 +Table of Contents +The operation of our facilities, pipelines, and delivery systems inherently entails hazards that require continuous oversight and control, such as pipeline leaks and ruptures, fire, explosions, toxic releases, mechanical failures, or vehicle accidents. If operational risks materialize, they could result in loss of life, damage to the environment, or loss of production, all of which could negatively impact our ongoing operations, reputation, financial results, and cash flows. In addition, our operating results are dependent on the continued operation of our production facilities and our ability to meet customer requirements, which depend, in part, on our ability to properly maintain and replace aging assets. +We are subject to extensive government regulation in the jurisdictions in which we do business. Regulations addressing, among other things, environmental compliance, import/export restrictions, anti-bribery and corruption, and taxes, can negatively impact our financial condition, results of operation, and cash flows. +We are subject to government regulation in the United States and in the foreign jurisdictions where we conduct business. The application of laws and regulations to our business is sometimes unclear. Compliance with laws and regulations may involve significant costs or require changes in business practices that could result in reduced profitability. If there is a determination that we have failed to comply with applicable laws or regulations, we may be subject to penalties or sanctions that could adversely impact our reputation and financial results. Compliance with changes in laws or regulations can result in increased operating costs and require additional capital expenditures. Export controls or other regulatory restrictions could prevent us from shipping our products to and from some markets or increase the cost of doing so. Changes in tax laws and regulations and international tax treaties could affect the financial results of our businesses. Increasingly aggressive enforcement of anti-bribery and anti-corruption requirements, including the U.S. Foreign Corrupt Practices Act, the United Kingdom Bribery Act and the China Anti-Unfair Competition Law, could subject us to criminal or civil sanctions if a violation is deemed to have occurred. In addition, we are subject to laws and sanctions imposed by the U.S. and other jurisdictions where we do business that may prohibit us, or certain of our affiliates, from doing business in certain countries, or restricting the kind of business that we may conduct. Such restrictions may provide a competitive advantage to competitors who are not subject to comparable restrictions or prevent us from taking advantage of growth opportunities. +Further, we cannot guarantee that our internal controls and compliance systems will always protect us from acts committed by employees, agents, business partners, or businesses that we acquire that would violate U.S. and/or non-U.S. laws, including the laws governing payments to government officials, bribery, fraud, kickbacks and false claims, pricing, sales and marketing practices, conflicts of interest, competition, export and import compliance, money laundering, and data privacy. Any such improper actions or allegations of such acts could damage our reputation and subject us to civil or criminal investigations in the United States and in other jurisdictions and related shareholder lawsuits, could lead to substantial civil and criminal, monetary and non-monetary penalties, and could cause us to incur significant legal and investigatory fees. In addition, the government may seek to hold us liable as a successor for violations committed by companies in which we invest or that we acquire. +We may be unable to successfully identify, execute or effectively integrate acquisitions, or effectively disentangle divested businesses. +Our ability to grow revenue, earnings, and cash flow at anticipated rates depends in part on our ability to identify, successfully acquire and integrate businesses and assets at appropriate prices, and realize expected growth, synergies, and operating efficiencies. We may not be able to complete transactions on favorable terms, on a timely basis or at all. In addition, our results of operations and cash flows may be adversely impacted by the failure of acquired businesses or assets to meet expected returns, the failure to integrate acquired businesses, the inability to dispose of non-core assets and businesses on satisfactory terms and conditions, and the discovery of unanticipated liabilities or other problems in acquired businesses or assets for which we lack adequate contractual protections or insurance. In addition, we may incur asset impairment charges related to acquisitions that do not meet expectations. +We continually assess the strategic fit of our existing businesses and may divest businesses that are deemed not to fit with our strategic plan or are not achieving the desired return on investment. These transactions pose risks and challenges that could negatively impact our business and financial statements. For example, when we decide to sell or otherwise dispose of a business or assets, we may be unable to do so on satisfactory terms within our anticipated time frame or at all. In addition, divestitures or other dispositions may dilute our earnings per share, have other adverse financial and accounting impacts, distract management, and give rise to disputes with buyers. In addition, we have agreed, and may in the future agree, to indemnify buyers against known and unknown contingent liabilities. Our financial results could be impacted adversely by claims under these indemnities. +10 +Table of Contents +The security of our information technology systems could be compromised, which could adversely affect our ability to operate. +We depend on information technology to enable us to operate efficiently and interface with customers as well as to maintain financial accuracy and efficiency. Our information technology capabilities are delivered through a combination of internal and external services and service providers. If we do not allocate and effectively manage the resources necessary to build and sustain the proper technology infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to our confidential business information due to a security breach. In addition, our information technology systems may be damaged, disrupted or shut down due to attacks by computer hackers, computer viruses, employee error or malfeasance, power outages, hardware failures, telecommunication or utility failures, catastrophes or other unforeseen events, and in any such circumstances our system redundancy and other disaster recovery planning may be ineffective or inadequate. Security breaches of our systems (or the systems of our customers, suppliers or other business partners) could result in the misappropriation, destruction or unauthorized disclosure of confidential information or personal data belonging to us or to our employees, partners, customers or suppliers, and may subject us to legal liability. +As with most large systems, our information technology systems have in the past been, and in the future likely will be subject to computer viruses, malicious codes, unauthorized access and other cyber-attacks, and we expect the sophistication and frequency of such attacks to continue to increase. To date, we are not aware of any significant impact on our operations or financial results from such attempts; however, unauthorized access could disrupt our business operations, result in the loss of assets, and have a material adverse effect on our business, financial condition, or results of operations. Any of the attacks, breaches or other disruptions or damage described above could: interrupt our operations at one or more sites; delay production and shipments; result in the theft of our and our customers’ intellectual property and trade secrets; damage customer and business partner relationships and our reputation; result in defective products or services, legal claims and proceedings, liability and penalties under privacy laws, or increased costs for security and remediation; or raise concerns regarding our accounting for transactions. Each of these consequences could adversely affect our business, reputation and our financial statements. +Our business involves the use, storage, and transmission of information about our employees, vendors, and customers. The protection of such information, as well as our proprietary information, is critical to us. The regulatory environment surrounding information security and privacy is increasingly demanding, with the frequent imposition of new and constantly changing requirements. We have established policies and procedures to help protect the security and privacy of this information. We also, from time to time, export sensitive customer data and technical information to recipients outside the United States. Breaches of our security measures or the accidental loss, inadvertent disclosure, or unapproved dissemination of proprietary information or sensitive or confidential data about us or our customers, including the potential loss or disclosure of such information or data as a result of fraud, trickery, or other forms of deception, could expose us, our customers, or the individuals affected to a risk of loss or misuse of this information, which could ultimately result in litigation and potential legal and financial liability. These events could also damage our reputation or otherwise harm our business. +Interruption in ordinary sources of raw material or energy supply or an inability to recover increases in energy and raw material costs from customers could result in lost sales or reduced profitability. +Hydrocarbons, including natural gas, are the primary feedstock for the production of hydrogen, carbon monoxide, and syngas. Energy, including electricity, natural gas, and diesel fuel for delivery trucks is the largest cost component of our business. Because our industrial gas facilities use substantial amounts of electricity, energy price fluctuations could materially impact our revenues and earnings. A disruption in the supply of energy, components, or raw materials, whether due to market conditions, legislative or regulatory actions, natural events, or other disruption, could prevent us from meeting our contractual commitments and harm our business and financial results. +Our supply of crude helium for purification and resale is largely dependent upon natural gas production by crude helium suppliers. Lower natural gas production resulting from natural gas pricing dynamics, supplier operating or transportation issues or other interruptions in sales from crude helium suppliers, can reduce our supplies of crude helium available for processing and resale to customers. +We typically contract to pass-through cost increases in energy and raw materials to customers, but cost variability can still have a negative impact on our results. We may be unable to raise prices as quickly as costs rise, or competitive pressures may prevent full recovery of such costs. Increases in energy or raw material costs that cannot be passed on to customers for competitive or other reasons may negatively impact our revenues and earnings. Even where costs are passed through, price increases can cause lower sales volume. +11 +Table of Contents +Catastrophic events could disrupt our operations or the operations of our suppliers or customers, having a negative impact on our business, financial results, and cash flows. +Our operations could be impacted by catastrophic events outside our control, including severe weather conditions such as hurricanes, floods, earthquakes, storms, epidemics, or acts of war and terrorism. Any such event could cause a serious business disruption that could affect our ability to produce and distribute products and possibly expose us to third-party liability claims. Additionally, such events could impact our suppliers or customers, which could cause energy and raw materials to be unavailable to us, or our customers to be unable to purchase or accept our products and services. Any such occurrence could have a negative impact on our operations and financial results. +New technologies create performance risks that could impact our financial results or reputation. +We are continually developing and implementing new technologies and product offerings. Existing technologies are being implemented in products and designs or at scales beyond our experience base. These technological expansions can create nontraditional performance risks to our operations. Failure of the technologies to work as predicted, or unintended consequences of new designs or uses, could lead to cost overruns, project delays, financial penalties, or damage to our reputation. Large scale gasification projects may contain processes or technologies that we have not operated at the same scale or in the same combination, and although such projects generally include technologies and processes that have been demonstrated previously by others, such technologies or processes may be new to us and may introduce new risks to our operations. +Legislative, regulatory and societal responses to global climate change create financial risk. +We are the world’s leading supplier of hydrogen, the primary use of which is the production of ultra-low sulfur transportation fuels that have significantly reduced transportation emissions and helped improve human health. To make the high volumes of hydrogen needed by our customers, we use steam methane reforming, which releases carbon dioxide. Some of our operations are within jurisdictions that have or are developing regulatory regimes governing emissions of greenhouse gases ("GHG"), including carbon dioxide. These include existing coverage under the European Union Emission Trading system, the California cap and trade schemes, Alberta’s Carbon Competitiveness Incentive Regulation, China’s Emission Trading Scheme, South Korea’s Emission Trading Scheme, nation-wide expansion of the China Emission Trading Scheme, revisions to the Alberta regulation, and Environment Canada's developing Output Based Pricing System. In addition, the U.S. Environmental Protection Agency ("EPA") requires mandatory reporting of GHG emissions and is regulating GHG emissions for new construction and major modifications to existing facilities. Some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern may result in more international, U.S. federal, and/or regional requirements to reduce or mitigate the effects of GHG. Although uncertain, these developments could increase our costs related to consumption of electric power and hydrogen production. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +Our financial results may be affected by various legal and regulatory proceedings, including those involving antitrust, tax, environmental, or other matters. +We are subject to litigation and regulatory investigations and proceedings in the normal course of business and could become subject to additional claims in the future, some of which could be material. While we seek to limit our liability in our commercial contractual arrangements, there are no guarantees that each contract will contain suitable limitations of liability or that limitations of liability will be enforceable. Also, the outcome of existing legal proceedings may differ from our expectations because the outcomes of litigation, including regulatory matters, are often difficult to predict reliably. Various factors or developments can lead us to change current estimates of liabilities and related insurance receivables, where applicable, or make such estimates for matters previously not susceptible to reasonable estimates, such as a significant judicial ruling or judgment, a significant settlement, significant regulatory developments, or changes in applicable law. A future adverse ruling, settlement, or unfavorable development could result in charges that could have a material adverse effect on our financial condition, results of operations, and cash flows in any particular period. +12 +Table of Contents +Costs and expenses resulting from compliance with environmental regulations may negatively impact our operations and financial results. +We are subject to extensive federal, state, local, and foreign environmental and safety laws and regulations concerning, among other things, emissions in the air; discharges to land and water; and the generation, handling, treatment, and disposal of hazardous waste and other materials. We take our environmental responsibilities very seriously, but there is a risk of environmental impact inherent in our manufacturing operations and in the transportation of our products. Future developments and more stringent environmental regulations may require us to make additional unforeseen environmental expenditures. In addition, laws and regulations may require significant expenditures for environmental protection equipment, compliance, and remediation. These additional costs may adversely affect financial results. For a more detailed description of these matters, see Item 1 - Business Environmental Controls, above. +Implementation of the United Kingdom’s (“UK”) exit from European Union (“EU”) membership could adversely affect our European Operations. +The UK’s exit from EU membership may adversely affect customer demand, our relationships with customers and suppliers and our European business. Although it is unknown what the terms of the United Kingdom’s future relationship with the EU will be, it is possible that there will be greater restrictions on imports and exports between the United Kingdom and EU members and increased regulatory complexities. Any of these factors could adversely affect customer demand, our relationships with customers and suppliers, and our European business. +Inability to compete effectively in a segment could adversely impact sales and financial performance. +We face strong competition from large global competitors and many smaller regional ones in many of our business segments. Introduction by competitors of new technologies, competing products, or additional capacity could weaken demand for or impact pricing of our products, negatively impacting financial results. In addition, competitors’ pricing policies could affect our profitability or market share. +A change of tax law in key jurisdictions could result in a material increase in our tax expense. +The multinational nature of our business subjects us to taxation in the United States and numerous foreign jurisdictions. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The company’s future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation. +Changes to income tax laws and regulations in any of the jurisdictions in which we operate, or in the interpretation of such laws, could significantly increase our effective tax rate and adversely impact our financial condition, results of operations or cash flows. In December 2017, the U.S. enacted the Tax Cuts and Jobs Act ("the Tax Act"), which significantly revised the U.S. federal corporate income tax law by, among other things, lowering the corporate income tax rate, implementing a territorial tax system, and imposing a one-time tax on unremitted cumulative non-U.S. earnings of foreign subsidiaries. As a result of the Tax Act, we recorded a discrete net tax expense of $180.6 for fiscal 2018, including a reduction in the deemed repatriation tax related to the taxation of deemed foreign dividends that may be eliminated by future legislation. Various levels of government are increasingly focused on tax reform and other legislative action to increase tax revenue. Further changes in tax laws in the U.S. or foreign jurisdictions where we operate could have a material adverse effect on our business, results of operations, or financial condition. +13 +Table of Contents +We could incur significant liability if the distribution of Versum common stock to our stockholders is determined to be a taxable transaction. +We have received an opinion from outside tax counsel to the effect that the spin-off of Versum qualifies as a transaction that is described in Sections 355(a) and 368(a)(1)(D) of the Internal Revenue Code. The opinion relies on certain facts, assumptions, representations and undertakings from Versum and us regarding the past and future conduct of the companies’ respective businesses and other matters. If any of these facts, assumptions, representations or undertakings are incorrect or not satisfied, our shareholders and we may not be able to rely on the opinion of tax counsel and could be subject to significant tax liabilities. Notwithstanding the opinion of tax counsel we have received, the IRS could determine on audit that the spin-off is taxable if it determines that any of these facts, assumptions, representations or undertakings are not correct or have been violated or if it disagrees with the conclusions in the opinion. If the spin-off is determined to be taxable for U.S. federal income tax purposes, our shareholders that are subject to U.S. federal income tax and we could incur significant U.S. federal income tax liabilities. +ITEM 1B. UNRESOLVED STAFF COMMENTS +We have not received any written comments from the Commission staff that remain unresolved. +ITEM 2. PROPERTIES +Air Products and Chemicals, Inc. owns its principal administrative offices, which are the Company’s headquarters located in Trexlertown, Pennsylvania, Hersham, England, and Santiago, Chile. The Company leases the principal administrative office in Shanghai, China. The Company leases administrative offices in the United States, Spain, Malaysia, and China for its Global Business Support organization. +The following is a description of the properties used by our five business segments. We believe that our facilities are suitable and adequate for our current and anticipated future levels of operation. +Industrial Gases – Americas +This business segment currently operates from over 400 production and distribution facilities in North and South America (approximately one-fourth of which are located on owned property), and 10% of which are integrated sites that serve dedicated customers as well as merchant customers. The Company has sufficient property rights and permits for the ongoing operation of our pipeline systems in the Gulf Coast, California, and Arizona in the United States and Alberta and Ontario, Canada. Management and sales support is based in our Trexlertown and Santiago offices referred to above, and at 12 leased properties located throughout North and South America. +Hydrogen fueling stations built by the Company support commercial markets in California and Japan as well as demonstration projects in Europe and other parts of Asia. +Industrial Gases – EMEA +This business segment currently operates from over 180 production and distribution facilities in Europe, the Middle East, and Africa (approximately one-third of which are on owned property). The Company has sufficient property rights and permits for the ongoing operation of our pipeline systems in the Netherlands, the United Kingdom, Belgium, France, and Germany. Management and sales support for this business segment is based in Hersham, England, referred to above, Barcelona, Spain and at 16 leased regional office sites and at least 15 leased local office sites, located throughout the region. +Industrial Gases – Asia +Industrial Gases – Asia currently operates from over 170 production and distribution facilities within Asia (approximately one-fourth of which are on owned property or long duration term grants). The Company has sufficient property rights and permits for the ongoing operation of our pipeline systems in China, South Korea, Taiwan, Malaysia, Singapore, and Indonesia. Management and sales support for this business segment is based in Shanghai, China and Kuala Lumpur, Malaysia, and in 18 leased office locations throughout the region. +14 +Table of Contents +Industrial Gases – Global +Management, sales, and engineering support for this business segment is based in our principal administrative offices noted above, and an office in India. +Equipment is manufactured in Missouri, Pennsylvania, and China. +Research and development ("R&D") activities for this business segment are conducted at owned locations in the U.S., the United Kingdom, and Spain, and 4 leased locations in Canada, Europe, and Asia. +Helium is processed at multiple sites in the U.S. and then distributed to/from transfill sites globally. +Corporate and other +Corporate administrative functions are based in the Company’s administrative offices referred to above. +The LNG business operates a manufacturing facility in Florida in the United States with management, engineering, and sales support based in the Trexlertown offices referred to above and a nearby leased office. +The Gardner Cryogenic business operates at facilities in Pennsylvania and Kansas in the United States and in France. +The Rotoflow business operates manufacturing and service facilities in Texas and Pennsylvania in the United States with management, engineering, and sales support based in the Trexlertown offices referred to above and a nearby leased office. +ITEM 3. LEGAL PROCEEDINGS +In the normal course of business, the Company and its subsidiaries are involved in various legal proceedings, including contract, product liability, intellectual property, insurance, and regulatory matters. Although litigation with respect to these matters is routine and incidental to the conduct of our business, such litigation could result in large monetary awards, especially if compensatory and/or punitive damages are awarded. However, we believe that litigation currently pending to which we are a party will be resolved without any material adverse effect on our financial position, earnings, or cash flows. +From time to time, we are also involved in proceedings, investigations, and audits involving governmental authorities in connection with environmental, health, safety, competition, and tax matters. +The Company is a party to proceedings under CERCLA, the RCRA, and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Presently there are 32 sites on which a final settlement has not been reached where the Company, along with others, has been designated a potentially responsible party by the Environmental Protection Agency or is otherwise engaged in investigation or remediation, including cleanup activity at certain of its current and former manufacturing sites. We do not expect that any sums we may have to pay in connection with these environmental matters would have a material adverse impact on our consolidated financial position. Additional information on the Company’s environmental exposure is included under Item 1. Business, Environmental Controls. +In September 2010, the Brazilian Administrative Council for Economic Defense ("CADE") issued a decision against our Brazilian subsidiary, Air Products Brasil Ltda., and several other Brazilian industrial gas companies for alleged anticompetitive activities. CADE imposed a civil fine of R$179.2 million (approximately $44 million at 30 September 2018 ) on Air Products Brasil Ltda. This fine was based on a recommendation by a unit of the Brazilian Ministry of Justice, whose investigation began in 2003, alleging violation of competition laws with respect to the sale of industrial and medical gases. The fines are based on a percentage of the Company’s total revenue in Brazil in 2003. +We have denied the allegations made by the authorities and filed an appeal in October 2010 to the Brazilian courts. On 6 May 2014, our appeal was granted and the fine against Air Products Brasil Ltda. was dismissed. CADE has appealed that ruling and the matter remains pending. The Company, with advice of its outside legal counsel, has assessed the status of this matter and has concluded that, although an adverse final judgment after exhausting all appeals is possible, such a judgment is not probable. As a result, no provision has been made in the consolidated financial statements. +Other than this matter, we do not currently believe there are any legal proceedings, individually or in the aggregate, that are reasonably possible to have a material impact on our financial condition, results of operations, or cash flows. However, a future charge for regulatory fines or damage awards could have a significant impact on our net income in the period in which it is recorded. +15 +Table of Contents +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, +AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock (ticker symbol APD) is listed on the New York Stock Exchange. Our transfer agent and registrar is Broadridge Corporate Issuer Solutions, Inc., P.O. Box 1342, Brentwood, New York 11717, telephone (844) 318-0129 (U.S.) or (720) 358-3595 (all other locations); website, http://shareholder.broadridge.com/airproducts; and e-mail address, shareholder@broadridge.com. As of 31 October 2018 , there were 5,391 record holders of our common stock. +Cash dividends on the Company’s common stock are paid quarterly. It is our expectation that we will continue to pay cash dividends in the future at comparable or increased levels. The Board of Directors determines whether to declare dividends and the timing and amount based on financial condition and other factors it deems relevant. Dividend information for each quarter of fiscal years 2018 and 2017 is summarized below: +2018 +2017 +First quarter +$.95 +$.86 +Second quarter +1.10 +.95 +Third quarter +1.10 +.95 +Fourth quarter +1.10 +.95 +Total +$4.25 +$3.71 +Purchases of Equity Securities by the Issuer +On 15 September 2011, the Board of Directors authorized the repurchase of up to $1.0 billion of our outstanding common stock. This program does not have a stated expiration date. We repurchase shares pursuant to Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended, through repurchase agreements established with one or more brokers. There were no purchases of stock during fiscal year 2018 . At 30 September 2018 , $485.3 million in share repurchase authorization remained. Additional purchases will be completed at the Company’s discretion while maintaining sufficient funds for investing in its businesses and growth opportunities. +16 +Table of Contents +Performance Graph +The performance graph below compares the five-year cumulative returns of the Company’s common stock with those of the Standard & Poor’s 500 Index (S&P 500 Index) and the Standard & Poor’s 500 Materials Index (S&P 500 Materials Index). The figures assume an initial investment of $100 and the reinvestment of all dividends. +COMPARISON OF FIVE YEAR CUMULATIVE SHAREHOLDER RETURN +Air Products, S&P 500 Index, and S&P 500 Materials Index +Comparative Growth of a $100 Investment +(Assumes Reinvestment of All Dividends) +Sept 2013 +Sept 2014 +Sept 2015 +Sept 2016 +Sept 2017 +Sept 2018 +Air Products +100 +128 +122 +149 +168 +191 +S&P 500 Index +100 +120 +116 +137 +161 +191 +S&P 500 Materials Index +100 +122 +96 +120 +146 +152 +17 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +Unless otherwise indicated, information presented is on a continuing operations basis. +(Millions of dollars, except for share and per share data) +2018 (A) +2017 (A) +2016 (A) +2015 (A) +2014 (A) +Operating Results +Sales +$8,930 +$8,188 +$7,504 +$7,824 +$8,384 +Cost of sales (B) +6,190 +5,752 +5,177 +5,584 +6,178 +Selling and administrative (B) +761 +714 +684 +765 +876 +Research and development +65 +58 +72 +76 +78 +Cost reduction and asset actions +— +151 +35 +180 +11 +Operating income (B) +1,966 +1,440 +1,535 +1,276 +976 +Equity affiliates’ income (C) +175 +80 +147 +152 +149 +Income from continuing operations attributable to Air Products +1,456 +1,134 +1,100 +933 +697 +Net income attributable to Air Products (D) +1,498 +3,000 +631 +1,278 +992 +Basic earnings per common share attributable to Air Products: +Income from continuing operations +6.64 +5.20 +5.08 +4.34 +3.28 +Net income (D) +6.83 +13.76 +2.92 +5.95 +4.66 +Diluted earnings per common share attributable to Air Products: +Income from continuing operations +6.59 +5.16 +5.04 +4.29 +3.24 +Net income (D) +6.78 +13.65 +2.89 +5.88 +4.61 +Year-End Financial Position +Plant and equipment, at cost +$21,490 +$19,548 +$18,660 +$17,999 +$18,180 +Total assets (D) +19,178 +18,467 +18,029 +17,317 +17,648 +Working capital (D) +2,744 +3,388 +1,034 +(851 +) +199 +Total debt (E) +3,813 +3,963 +5,211 +5,856 +6,081 +Air Products shareholders’ equity (D) +10,858 +10,086 +7,080 +7,249 +7,366 +Total equity (D) +11,176 +10,186 +7,213 +7,381 +7,521 +Financial Ratios +Return on average Air Products shareholders’ equity (F) +13.9 +% +13.2 +% +15.4 +% +12.7 +% +9.5 +% +Operating margin (B) +22.0 +% +17.6 +% +20.5 +% +16.3 +% +11.6 +% +Selling and administrative as a percentage of sales (B) +8.5 +% +8.7 +% +9.1 +% +9.8 +% +10.4 +% +Total debt to total capitalization (E)(G) +25.4 +% +28.0 +% +41.9 +% +44.2 +% +43.8 +% +Other Data +Income from continuing operations including noncontrolling interests +$1,491 +$1,155 +$1,122 +$966 +$691 +Adjusted EBITDA (B)(H) +3,116 +2,799 +2,622 +2,422 +2,322 +Adjusted EBITDA margin (B) +34.9 +% +34.2 +% +34.9 +% +31.0 +% +27.7 +% +Depreciation and amortization +971 +866 +855 +859 +876 +Capital expenditures on a GAAP basis (I) +1,914 +1,056 +908 +1,201 +1,297 +Capital expenditures on a non-GAAP basis (I) +1,934 +1,066 +935 +1,575 +1,498 +Cash provided by operating activities +2,555 +2,534 +2,259 +2,047 +1,862 +Cash used for investing activities +(1,649 +) +(1,418 +) +(865 +) +(1,147 +) +(1,257 +) +Cash used for financing activities +(1,360 +) +(2,041 +) +(860 +) +(960 +) +(524 +) +Dividends declared per common share +4.25 +3.71 +3.39 +3.20 +3.02 +Weighted Average Common Shares – Basic (in millions) +219 +218 +216 +215 +213 +Weighted Average Common Shares – Diluted (in millions) +221 +220 +218 +217 +215 +Book value per common share at year-end +$49.46 +$46.19 +$32.57 +$33.66 +$34.49 +Shareholders at year-end +5,500 +5,700 +6,000 +6,400 +6,600 +Employees at year-end (J) +16,300 +15,300 +18,600 +19,700 +21,200 +18 +Table of Contents +(A) +Unless otherwise stated, selected financial data is presented in accordance with U.S. generally accepted accounting principles (GAAP). The Company has presented certain financial measures on a non-GAAP (“adjusted”) basis to exclude items which management does not believe to be indicative of ongoing business trends. Refer to pages 33-39 for reconciliations of the GAAP to non-GAAP measures for fiscal years 2018 , 2017 , and 2016 . Descriptions of the excluded items appear on pages 25-28 . For fiscal year 2015 , these items include: (i) a charge to operating income of $8 ($.03 per share) related to business separation costs, (ii) a charge to operating income of $180 ($133 after-tax, or $.61 per share) related to business restructuring and cost reduction actions, (iii) a gain of $18 ($11 after tax, or $.05 per share) reflected in operating income related to the gain on previously held equity interest in a liquefied atmospheric industrial gases production joint venture, (iv) a gain of $34 ($28 after tax, or $.13 per share) reflected in operating income resulting from the sale of two parcels of land, and (v) a charge to other non-operating income (expense), net related to pension settlement losses of $19 ($12 after-tax, or $.06 per share). For fiscal year 2014 , these items include: (i) a charge to operating income of $11 ($7 after-tax, or $.03 per share) related to business restructuring and cost reduction actions, (ii) a charge to operating income of $310 ($275 attributable to Air Products, after-tax, or $1.27 per share) related to the impairment of goodwill and intangible assets, and (iii) a charge to other non-operating income (expense), net related to pension settlement losses of $5 ($3 after-tax, or $.02 per share). +(B) +Reflects adoption of guidance on presentation of net periodic pension and postretirement benefit cost on a retrospective basis during the first quarter of fiscal year 2018. Refer to Note 2 , New Accounting Guidance , to the consolidated financial statements for additional information. +(C) +Fiscal year 2017 includes the third quarter impact of an other-than-temporary noncash impairment charge of $79.5 ($.36 per share) on our investment in Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (AHG), a 25%‑owned equity affiliate in our Industrial Gases – EMEA segment. +(D) +Information presented on a total company basis, which includes both continuing and discontinued operations. +(E) +Total debt includes long-term debt, including debt to related parties, current portion of long-term debt, and short-term borrowings as of the end of the year for continuing operations. +(F) +Calculated using income from continuing operations attributable to Air Products and five-quarter average Air Products shareholders’ equity. +(G) +Total capitalization includes total debt for continuing operations plus total equity plus redeemable noncontrolling interest as of the end of the year. Redeemable noncontrolling interest was $287 as of 30 September 2014. There was no redeemable noncontrolling interest for the other periods presented. +(H) +A reconciliation of income from continuing operations on a GAAP basis to adjusted EBITDA is presented on pages 36-39 . +(I) +Capital expenditures presented on a GAAP basis include additions to plant and equipment, acquisitions, less cash acquired, and investment in and advances to unconsolidated affiliates. The Company utilizes a non-GAAP measure in the computation of capital expenditures and includes spending associated with facilities accounted for as capital leases and purchases of noncontrolling interests. Refer to page 41 for a reconciliation of the GAAP to non-GAAP measures for fiscal years 2018 , 2017 , and 2016 . In fiscal year 2015 , the GAAP measure was adjusted by $96 and $278 for spending associated with facilities accounted for as capital leases and purchases of noncontrolling interests, respectively. In fiscal year 2014 , the GAAP measure was adjusted by $200 for spending associated with facilities accounted for as capital leases. +(J) +Includes full- and part-time employees from continuing and discontinued operations. +19 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS +OF OPERATIONS +Business Overview +20 +2018 in Summary +21 +2019 Outlook +23 +Results of Operations +23 +Reconciliation of Non-GAAP Financial Measures +33 +Liquidity and Capital Resources +40 +Contractual Obligations +43 +Pension Benefits +45 +Environmental Matters +46 +Off-Balance Sheet Arrangements +47 +Related Party Transactions +48 +Inflation +48 +Critical Accounting Policies and Estimates +48 +New Accounting Guidance +55 +This Management’s Discussion and Analysis contains “forward-looking statements” within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, including statements about business outlook. These forward-looking statements are based on management’s expectations and assumptions as of the date of this report and are not guarantees of future performance. Actual performance and financial results may differ materially from projections and estimates expressed in the forward-looking statements because of many factors not anticipated by management, including, without limitation, those described in our Forward-Looking Statements and Part I, Item 1A. Risk Factors, of this Annual Report on Form 10-K. +The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes contained in this report. Unless otherwise indicated, financial information is presented on a continuing operations basis. All comparisons in the discussion are to the corresponding prior year, unless otherwise stated. All amounts presented are in accordance with U.S. generally accepted accounting principles (GAAP), except as noted. All amounts are presented in millions of dollars, except for per share data, unless otherwise indicated. +Captions such as income from continuing operations attributable to Air Products, net income attributable to Air Products, and diluted earnings per share attributable to Air Products are simply referred to as “income from continuing operations,” “net income,” and “diluted earnings per share (EPS)” throughout this Management’s Discussion and Analysis, unless otherwise stated. +The discussion of results that follows includes comparisons to certain non-GAAP ("adjusted") financial measures. The presentation of non-GAAP measures is intended to provide investors, potential investors, securities analysts, and others with useful supplemental information to evaluate the performance of the business because such measures, when viewed together with our financial results computed in accordance with GAAP, provide a more complete understanding of the factors and trends affecting our historical financial performance and projected future results. The reconciliations of reported GAAP results to non-GAAP measures are presented on pages 33-39 . Descriptions of the excluded items appear on pages 25-28 . +BUSINESS OVERVIEW +Air Products and Chemicals, Inc. is a world-leading Industrial Gases company in operation for over 75 years. The Company’s core industrial gases business provides atmospheric, process, and specialty gases and related equipment to many industries including refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Air Products is also the world’s leading supplier of liquefied natural gas (LNG) process technology and equipment. With operations in 50 countries, in fiscal year 2018 we had sales of $8.9 billion , assets of $19.2 billion , and a worldwide workforce of approximately 16,300 full- and part-time employees. +As of 30 September 2018 , our operations were organized into five reportable business segments: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. The financial statements and analysis that follow discuss our results based on these operations. Refer to Note 25 , Business Segment and Geographic Information, to the consolidated financial statements for additional details on our reportable business segments. +20 +Table of Contents +2018 IN SUMMARY +In fiscal year 2018 , we delivered strong safety and financial results. Sales of $8.9 billion increased nine percent over the prior year primarily driven by higher volumes from base business growth and new, large industrial gas project onstreams. The higher regional volumes were partially offset by lower sale of equipment activity on our Jazan project as we near project completion. In addition, we began to execute our gasification strategy with the completion and onstream of the Lu'An acquisition and our announcements of the Jazan gasifier/power project in Jazan, Saudi Arabia, the Yankuang coal-to-syngas production facility in Yulin City, Shaanxi Province, China, and the Jiutai coal-to-syngas project in Hohhot, China. +We delivered operating margin of 22.0% and adjusted EBITDA margin of 34.9% . Diluted EPS of $6.59 increased 28% from the prior year. On a non-GAAP basis, adjusted diluted EPS of $7.45 increased 18% . +Highlights for 2018 +• +Sales of $8,930.2 increased 9% , or $742.6 , from underlying sales growth of 7% and favorable currency impacts of 2% . The underlying sales growth was primarily driven by higher volumes across all regional Industrial Gases segments, partially offset by lower sale of equipment activity in the Industrial Gases – Global segment. +• +Operating income of $1,965.6 increased 37% , or $525.6 , and operating margin of 22.0% increased 440 bp. On a non‑GAAP basis, adjusted operating income of $1,941.5 increased 9% , or $167.7 , and adjusted operating margin of 21.7% was flat . +• +Income from continuing operations of $1,455.6 increased 28% , or $321.2 , and diluted EPS of $6.59 increased 28% , or $1.43 . On a non-GAAP basis, adjusted income from continuing operations of $1,644.7 increased 19% , or $258.8 , and adjusted diluted EPS of $7.45 increased 18% , or $1.14 . A summary table of changes in diluted earnings per share is presented on the following page. +• +Adjusted EBITDA of $3,115.5 increased 11% , or $316.3 . Adjusted EBITDA margin of 34.9% increased 70 bp. +• +We completed the formation of a syngas supply joint venture with Lu'An, including the acquisition of Lu'An's gasification and syngas purification assets. +• +We increased our quarterly dividend by 16% from $.95 to $1.10 per share, or $4.40 per share annually, the largest increase in Company history. This represents the 36th consecutive year that we have increased our dividend payment. +21 +Table of Contents +Changes in Diluted Earnings per Share Attributable to Air Products +Increase +2018 +2017 +(Decrease) +Diluted Earnings per Share +Net income +$6.78 +$13.65 +($6.87 +) +Income from discontinued operations +.19 +8.49 +(8.30 +) +Income from Continuing Operations – GAAP +$6.59 +$5.16 +$1.43 +Operating Income Impact (after-tax) +Underlying business +Volume +$.71 +Price/raw materials +.16 +Costs +(.45 +) +Currency +.16 +Change in inventory valuation method +.08 +Business separation costs +.12 +Cost reduction and asset actions +.49 +Goodwill and intangible asset impairment charge +.70 +Gain on land sale +(.03 +) +Total Operating Income Impact (after-tax) +$1.94 +Other Impact (after-tax) +Equity affiliates' income +.15 +Equity method investment impairment charge +.36 +Interest expense +(.03 +) +Other non-operating income (expense), net +(.04 +) +Income tax +.44 +Tax reform repatriation +(2.16 +) +Tax reform benefit related to deemed foreign dividends +.25 +Tax reform rate change and other +.96 +Tax restructuring +.16 +Tax benefit associated with business separation +(.02 +) +Tax election benefit +(.50 +) +Noncontrolling interests +(.05 +) +Weighted average diluted shares +(.03 +) +Total Other Impact (after-tax) +($.51 +) +Total Change in Diluted Earnings per Share from Continuing Operations – GAAP Measure +$1.43 +22 +Table of Contents +Increase +2018 +2017 +(Decrease) +Income from Continuing Operations – GAAP Basis +$6.59 +$5.16 +$1.43 +Change in inventory valuation method +(.08 +) +— +($.08 +) +Business separation costs +— +.12 +(.12 +) +Tax benefit associated with business separation +— +(.02 +) +.02 +Cost reduction and asset actions +— +.49 +(.49 +) +Goodwill and intangible asset impairment charge +— +.70 +(.70 +) +Gain on land sale +— +(.03 +) +.03 +Equity method investment impairment charge +— +.36 +(.36 +) +Pension settlement loss +.15 +.03 +.12 +Tax reform repatriation +2.16 +— +2.16 +Tax reform benefit related to deemed foreign dividends +(.25 +) +— +(.25 +) +Tax reform rate change and other +(.96 +) +— +(.96 +) +Tax restructuring +(.16 +) +— +(.16 +) +Tax election benefit +— +(.50 +) +.50 +Income from Continuing Operations – Non-GAAP Measure +$7.45 +$6.31 +$1.14 +2019 OUTLOOK +In fiscal year 2019, we intend to grow our earnings by continuing to improve our base businesses and by bringing new, large projects onstream. We expect the full year impact of the Lu'An project to be a large contributor to our earnings growth. Backed by our strong financial position, we will strive to continue to win and invest in key growth projects, including large gasification projects that are consistent with our onsite business model. In addition, we expect lower sale of equipment activity from our Jazan project as it nears completion. +The above guidance should be read in conjunction with the section entitled “Forward-Looking Statements” of this Annual Report on Form 10-K. +RESULTS OF OPERATIONS +Discussion of Consolidated Results +2018 +2017 +2016 +Sales +$8,930.2 +$8,187.6 +$7,503.7 +Operating income +1,965.6 +1,440.0 +1,535.1 +Operating margin +22.0 +% +17.6 +% +20.5 +% +Equity affiliates’ income +174.8 +80.1 +147.0 +Income from continuing operations +1,455.6 +1,134.4 +1,099.5 +Non-GAAP Measures +Adjusted EBITDA +$3,115.5 +$2,799.2 +$2,621.8 +Adjusted EBITDA margin +34.9 +% +34.2 +% +34.9 +% +Adjusted operating income +1,941.5 +1,773.8 +1,620.2 +Adjusted operating margin +21.7 +% +21.7 +% +21.6 +% +Adjusted equity affiliates' income +203.3 +159.6 +147.0 +23 +Table of Contents +% Change from Prior Year +Sales +2018 +2017 +Underlying business +Volume +6 +% +6 +% +Price +1 +% +1 +% +Energy and raw material cost pass-through +— +% +3 +% +Currency +2 +% +(1 +)% +Total Consolidated Sales Change +9 +% +9 +% +2018 vs. 2017 +Sales of $8,930.2 increased 9% , or $742.6 . Underlying sales increased 7% from higher volumes of 6% and higher pricing of 1% . Volumes were higher across all regional Industrial Gases segments driven by new project onstreams, primarily in the Industrial Gases – Asia and Industrial Gases – EMEA segments, underlying base business growth, and an equipment sale resulting from the termination of a contract in the Industrial Gases – Asia segment. The regional volume increase was partially offset by lower sale of equipment activity in the Industrial Gases – Global segment. The pricing improvement was primarily attributable to the China and Europe merchant businesses. Energy and natural gas cost pass-through to customers was flat versus the prior year. Favorable currency impacts, primarily from the Euro, the British Pound Sterling, and the Chinese Renminbi, increased sales by 2% . +2017 vs. 2016 +Sales of $8,187.6 increased 9.0% , or $683.9 . Underlying sales increased 7% from higher volumes of 6% and higher pricing of 1%. Higher volumes, primarily due to new project onstreams, underlying base business growth across the Industrial Gases regions, and continued progress on the Jazan project within our Industrial Gases – Global segment, were partially offset by lower LNG project activity in the Corporate and other segment. The pricing improvement was primarily attributable to the Industrial Gases – Asia segment. Higher energy and natural gas cost pass-through to customers increased sales by 3%, and unfavorable currency effects reduced sales by 1%. +Operating Income and Margin +2018 vs. 2017 +Operating income of $1,965.6 increased 37% , or $525.6 , due to higher volumes of $204, a prior year goodwill and intangible asset impairment charge of $162, prior year cost reduction and asset actions of $151 , favorable currency impacts of $47, favorable pricing, net of energy, fuel, and raw material costs, of $47, prior year business separation costs of $33 , and a favorable impact from the change in inventory valuation method of $24 , partially offset by unfavorable net operating costs of $130 and a prior year gain on land sale of $12 . The increase in net operating costs was primarily driven by higher planned maintenance costs, lower cost reimbursement, including costs for transitions services, and higher costs to support growth opportunities. Operating margin of 22.0% increased 440 bp, primarily due to the goodwill and intangible asset impairment charge, cost reduction and asset actions, and business separation costs in the prior year. +On a non-GAAP basis, adjusted operating income of $1,941.5 increased 9% , or $167.7 , primarily due to higher volumes, favorable currency impacts, and favorable pricing, net of energy, fuel, and raw material costs, partially offset by unfavorable net operating costs. Adjusted operating margin of 21.7% was flat as higher volumes and favorable pricing, net of power costs, were mostly offset by higher costs. +2017 vs. 2016 +Operating income of $1,440.0 decreased 6% , or $95.1 , as a goodwill and intangible asset impairment charge of $162 , higher cost reduction and asset actions of $117 , and unfavorable currency impacts of $9 were partially offset by favorable volumes of $83, favorable net operating costs of $73, lower business separation costs of $18 , a gain on sale of land of $12 , and favorable pricing, net of energy, fuel, and raw material costs of $7. Operating margin of 17.6% decreased 290 bp, primarily due to the goodwill and intangible asset impairment charge and higher cost reduction and asset actions. +On a non-GAAP basis, adjusted operating income of $1,773.8 increased 9% , or $153.6 , primarily due to higher volumes and favorable cost performance. Adjusted operating margin of 21.7% increased 10 bp as lower costs were partially offset by higher energy and natural gas pass-through to customers. +24 +Table of Contents +Adjusted EBITDA +We define Adjusted EBITDA as income from continuing operations (including noncontrolling interests) excluding certain disclosed items, which the Company does not believe to be indicative of underlying business trends, before interest expense, other non-operating income (expense), net, income tax provision, and depreciation and amortization expense. Adjusted EBITDA provides a useful metric for management to assess operating performance. +2018 vs. 2017 +Adjusted EBITDA of $3,115.5 increased 11% , or $316.3 , primarily due to higher volumes, favorable currency, positive pricing, and income from regional industrial gases equity affiliates, partially offset by higher costs. Adjusted EBITDA margin of 34.9% increased 70 bp , primarily due to higher volumes and income from regional industrial gases equity affiliates, partially offset by higher costs. +2017 vs. 2016 +Adjusted EBITDA of $2,799.2 increased 7% , or $177.4 , primarily due to higher volumes and favorable cost performance. Adjusted EBITDA margin of 34.2% decreased 70 bp, primarily due to a 90 bp impact from higher energy pass-through to customers. +Equity Affiliates’ Income +2018 vs. 2017 +Income from equity affiliates of $174.8 increased $94.7 . The fiscal year 2017 income included a noncash impairment charge of $79.5 ($.36 per share) on our investment in Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (AHG), a 25%-owned equity affiliate in our Industrial Gases – EMEA segment. This charge has been excluded from segment results. Refer to Note 8 , Summarized Financial Information of Equity Affiliates , to the consolidated financial statements for additional information. Fiscal year 2018 included an expense of $28.5 resulting from the U.S. Tax Cuts and Jobs Act. Refer to Note 22 , Income Taxes, to the consolidated financial statements for additional information. On a non-GAAP basis, adjusted equity affiliates' income of $203.3 increased 27% , or $43.7 , primarily driven by Industrial Gases – Americas and Industrial Gases – EMEA affiliates. +2017 vs. 2016 +Income from equity affiliates of $80.1 decreased $66.9 , primarily due to a noncash impairment charge of $79.5 ($.36 per share) on our investment in AHG in fiscal year 2017. On a non-GAAP basis, adjusted equity affiliates' income of $159.6 increased 9%, or $12.6. +Cost of Sales and Gross Margin +2018 vs. 2017 +Cost of sales of $6,189.5 increased 8% , or $438.0 , primarily due to higher costs attributable to sales volumes of $225, unfavorable currency impacts of $133, and higher other costs, including maintenance costs, of $97, partially offset by the benefit from the change in inventory valuation method from a last-in, first-out (LIFO) basis to a first-in, first-out (FIFO) basis of $24 in fiscal year 2018. For additional information on the change in inventory valuation method, refer to Note 1 , Major Accounting Policies , and Note 7 , Inventories , to the consolidated financial statements. +Gross margin of 30.7% increased 90 bp , primarily due to higher volumes, favorable pricing, net of raw materials, and the benefit from the change in inventory valuation adjustment, partially offset by higher other costs. +2017 vs. 2016 +Cost of sales of $5,751.5 increased 11% , or $574.2 , due to higher costs attributable to sales volumes of $418, higher energy and natural gas cost pass-through to customers of $218, and higher other costs of $21, partially offset by favorable currency impacts of $83. +Gross margin of 29.8% decreased 120 bp , primarily due to higher energy and natural gas cost pass-through to customers and unfavorable volume mix. +25 +Table of Contents +Selling and Administrative Expense +2018 vs. 2017 +Selling and administrative expense of $760.8 increased 7% , or $47.3 , primarily driven by unfavorable currency impacts and higher costs to support growth opportunities, partially offset by cost reductions associated with the completion of transition services agreements with Versum and Evonik. Selling and administrative expense as a percent of sales decreased to 8.5% in fiscal year 2018 from 8.7% in fiscal year 2017 . +2017 vs. 2016 +Selling and administrative expense of $713.5 increased 4% , or $29.7 , primarily due to costs in support of transition services agreements with Versum and Evonik, for which the reimbursement is reflected in "Other income (expense), net." Selling and administrative expense as a percent of sales decreased to 8.7% in fiscal year 2017 from 9.1% in fiscal year 2016 . +Research and Development +2018 vs. 2017 +Research and development expense of $64.5 increased 12% , or $6.9 . Research and development expense as a percent of sales in fiscal years 2018 and 2017 was .7% . +2017 vs. 2016 +Research and development expense of $57.6 decreased 20% , or $14.2 . Research and development expense as a percent of sales decreased to .7% in fiscal year 2017 from 1.0% in fiscal year 2016 . +Business Separation Costs +In fiscal year 2017, we completed the separation of the divisions comprising the former Materials Technologies segment through the spin-off of the Electronics Materials Division (EMD) as Versum Materials, Inc. (Versum) and the sale of the Performance Materials Division (PMD) to Evonik Industries AG (Evonik). For additional information on the dispositions, refer to Note 3 , Discontinued Operations , to the consolidated financial statements. +In connection with the dispositions, we incurred net separation costs of $30.2 ( $26.5 after-tax, or $.12 per share) in fiscal year 2017. The net costs include legal and advisory fees of $32.5 , which are reflected on the consolidated income statements as “Business separation costs,” and a pension settlement benefit of $2.3 presented within "Other non-operating income (expense), net." Our fiscal year 2017 income tax provision includes net tax benefits of $5.5 ( $.02 per share), primarily related to changes in tax positions on business separation activities. +In fiscal year 2016, we incurred business separation costs of $50.6 ( $46.7 after-tax, or $.21 per share) for legal and advisory fees. Our fiscal year 2016 income tax provision includes additional tax expense related to the separation of $51.8 ( $.24 per share), of which $45.7 resulted from a dividend to repatriate $443.8 from a subsidiary in South Korea to the U.S. in anticipation of the separation of EMD from the industrial gases business in South Korea. +Cost Reduction and Asset Actions +In fiscal year 2017, we recognized a net expense of $ 151.4 ($109.3 attributable to Air Products, after-tax, or $.49 per share) for cost reduction and asset actions. The year-to-date net expense included a charge of $154.8 for actions taken during fiscal year 2017, partially offset by the favorable settlement of the remaining $3.4 accrued balance associated with business restructuring actions taken in 2015. The charge included asset actions of $88.5 and severance actions of $66.3. +In fiscal year 2016, we recognized an expense of $34.5 ($24.7 after-tax, or $.11 per share) for severance and other benefits. +The charges we record for cost reduction and asset actions have been excluded from segment operating income. Refer to Note 5 , Cost Reduction and Asset Actions , to the consolidated financial statements for additional details on these actions. +26 +Table of Contents +Goodwill and Intangible Asset Impairment Charge +During the third quarter of fiscal year 2017, we determined that the goodwill and indefinite-lived intangible assets (primarily acquired trade names) associated with our Latin America reporting unit of our Industrial Gases – Americas segment were impaired. We recorded a noncash impairment charge of $162.1 ($154.1 attributable to Air Products, after-tax, or $.70 per share), which was driven by lower economic growth and profitability in the region. This impairment charge has been excluded from segment results. Refer to Note 10 , Goodwill , and Note 11 , Intangible Assets , to the consolidated financial statements for additional information. +Other Income (Expense), Net +Items recorded to "Other income (expense), net" arise from transactions and events not directly related to our principal income earning activities. The detail of "Other income (expense), net" is presented in Note 23 , Supplemental Information , to the consolidated financial statements. +2018 vs. 2017 +Other income (expense), net of $50.2 decreased $70.8 , primarily due to lower income from the transition services agreements with Versum and Evonik, lower income from the sale of assets and investments, lower favorable contract settlements, and an unfavorable foreign exchange impact. +2017 vs. 2016 +Other income (expense), net of $121.0 increased $71.6 , primarily due to income from transition services agreements with Versum and Evonik, income from the sale of assets and investments, including a gain of $12.2 ($7.6 after-tax, or $.03 per share) resulting from the sale of a parcel of land, and a favorable foreign exchange impact. +Interest Expense +2018 +2017 +2016 +Interest incurred +$150.0 +$139.6 +$147.9 +Less: Capitalized interest +19.5 +19.0 +32.7 +Interest Expense +$130.5 +$120.6 +$115.2 +2018 vs. 2017 +Interest incurred increased $10.4 as project financing associated with the Lu'An joint venture and a higher average interest rate on the debt portfolio were partially offset by the impact from a lower average debt balance. The change in capitalized interest was driven by an increase in the carrying value of projects under construction. +2017 vs. 2016 +Interest incurred decreased $8.3 as the impact from a lower average debt balance of $26 was partially offset by the impact from a higher average interest rate on the debt portfolio of $19. The change in capitalized interest was driven by a decrease in the carrying value of projects under construction, primarily as a result of our decision to exit from the EfW business. +Other Non-Operating Income (Expense), Net +2018 vs. 2017 +Other non-operating income (expense), net of $5.1 decreased $11.5 . During the fourth quarter of fiscal year 2018, we recognized a pension settlement loss of $43.7 ( $33.2 after-tax, or $.15 per share) that primarily resulted from the transfer of certain pension payment obligations to an insurer for our U.S. salaried and hourly plans through the purchase of an irrevocable, nonparticipating group annuity contract with plan assets. For additional information, refer to Note 16 , Retirement Benefits , to the consolidated financial statements. This loss was partially offset by higher interest income on cash and cash items and short-term investments and lower other non-service pension expense. The prior year pension expense included a settlement loss of $10.5 ($6.6 after-tax, or $.03 per share) associated with the U.S. Supplementary Pension Plan and a settlement benefit of $2.3 related to the disposition of EMD and PMD. +27 +Table of Contents +2017 vs. 2016 +Other non-operating income of $16.6 increased $22.0 from an expense of $5.4 in fiscal year 2016, primarily due to interest income on cash and time deposits, which are comprised primarily of proceeds from the sale of PMD. Fiscal year 2016 included a pension settlement loss of $5.1 ( $3.3 after-tax, or $.02 per share) to accelerate recognition of a portion of actuarial losses deferred in accumulated other comprehensive loss, primarily associated with the U.S. Supplementary Pension Plan. In fiscal year 2016, interest income was included in "Other income (expense), net" and was not material. +Loss on Extinguishment of Debt +On 30 September 2016, in anticipation of the spin-off of EMD, Versum issued $425.0 of notes to Air Products, who then exchanged these notes with certain financial institutions for $418.3 of Air Products’ outstanding commercial paper. This noncash exchange, which was excluded from the consolidated statements of cash flows, resulted in a loss of $6.9 ($4.3 after-tax, or $.02 per share). This loss was deductible for tax purposes. +Effective Tax Rate +The effective tax rate equals the income tax provision divided by income from continuing operations before taxes. Refer to Note 22 , Income Taxes , to the consolidated financial statements for details on factors affecting the effective tax rate. +2018 vs. 2017 +The effective tax rate was 26.0% and 18.4% in fiscal years 2018 and 2017 , respectively. The current year rate was higher primarily due to the enactment of the U.S. Tax Cuts and Jobs Act ("the Tax Act") in the first quarter of fiscal year 2018, which significantly changed existing U.S. tax laws, including a reduction in the federal corporate income tax rate from 35% to 21% that became effective 1 January 2018, a deemed repatriation tax on unremitted foreign earnings, as well as other changes. As a result of the Tax Act, our income tax provision for fiscal year 2018 reflects a discrete net income tax expense of $180.6 . This included a deemed repatriation tax on accumulated unremitted foreign earnings and adjustments to the future cost of repatriation from foreign investments of $448.6 , partially offset by a benefit of $56.2 related to the U.S. taxation of deemed foreign dividends under the Tax Act. This benefit may be eliminated by future legislation. Fiscal year 2018 tax expense also includes a benefit of $211.8 , primarily from the re-measurement of our net U.S. deferred tax liabilities at the lower corporate tax rate. In fiscal year 2018, we also recorded a tax benefit of $35.7 from the restructuring of foreign subsidiaries. +The income tax provision in fiscal year 2017 included a net income tax benefit of $111.4 resulting from a tax election related to a non-U.S. subsidiary. The effective tax rate in the prior year was also impacted by a goodwill impairment charge of $145.3 in our Latin America reporting unit and an impairment of $79.5 of an equity method investment for which no tax benefits were available. +On a non-GAAP basis, the adjusted effective tax rate decreased from 23.2% in fiscal year 2017 to 18.6% in fiscal year 2018 . We estimate that the lower U.S. federal statutory rate and other impacts of the Tax Act reduced our fiscal year 2018 adjusted effective tax rate by approximately 3.5%. The current year rate was also lower due to a benefit of $9.1 related to a final foreign tax audit settlement. +We are reporting the impacts of the Tax Act provisionally based upon reasonable estimates as of 30 September 2018 . The impacts are not yet finalized as they are dependent on factors and analysis not yet known or fully completed, including but not limited to, further book to U.S. tax adjustments for the earnings of foreign entities, the issuance of additional guidance, as well as our ongoing analysis of the Tax Act. +As a fiscal year-end taxpayer, certain provisions of the Tax Act became effective in our fiscal year 2018, while other provisions do not become effective until fiscal year 2019. The corporate tax rate reduction is effective as of 1 January 2018 and, accordingly, reduces our 2018 fiscal year U.S. federal statutory rate to a blended rate of approximately 24.5%. +28 +Table of Contents +2017 vs. 2016 +The effective tax rate was 18.4% and 27.8% in fiscal years 2017 and 2016 , respectively. The 2017 rate included an impact of approximately 700 bp from a net income tax benefit resulting from a tax election related to a non-U.S. subsidiary and an impact of approximately 100 bp from excess tax benefits on share-based compensation resulting from the adoption of new accounting guidance in the first quarter of fiscal year 2017. These impacts were partially offset by an increase of approximately 200 bp due to both a goodwill impairment charge in our Latin America reporting unit and an impairment of an equity method investment for which no tax benefits were available. The 2016 rate included a 330 bp impact from tax costs associated with business separation, primarily resulting from a dividend declared in 2016 to repatriate cash from a foreign subsidiary as discussed above under Business Separation Costs. The remaining change was primarily due to the impact of business separation costs for which a tax benefit was estimated to not be available. On a non-GAAP basis, the adjusted effective tax rate decreased from 24.2% in fiscal year 2016 to 23.2% in fiscal year 2017 , primarily due to excess tax benefits on share-based compensation. +Discontinued Operations +In fiscal year 2018, income from discontinued operations, net of tax, of $42.2 includes an income tax benefit of $25.6 resulting from the resolution of uncertain tax positions taken in conjunction with the disposition of our former European Homecare business in fiscal year 2012. In addition, we recorded an after-tax benefit of $17.6 resulting from the resolution of certain post-closing adjustments associated with the sale of PMD. Refer to Note 22 , Income Taxes, to the consolidated financial statements for additional information. These benefits were partially offset by an after-tax loss of $1.0 related to EfW project exit activities, which were completed during the first quarter of fiscal year 2018. +In fiscal year 2017, income from discontinued operations, net of tax, of $1,866.0 includes a gain of $2,870 ( $1,828 after-tax, or $8.32 per share) for the sale of PMD to Evonik. The sale closed on 3 January 2017 for $3.8 billion in cash. In addition, we recorded a loss on the disposal of EfW of $59.3 ( $47.1 after-tax) during the first quarter of 2017, primarily for land lease obligations and to update our estimate of the net realizable value of the plant assets. +In fiscal year 2016, the loss from discontinued operations, net of tax, of $460.5 includes a loss of $945.7 ( $846.6 after-tax) from the write down of EfW plant assets to their estimated net realizable value and a liability recorded for plant disposition and other costs. This loss was partially offset by the results of PMD and EMD. +Refer to Note 3 , Discontinued Operations , to the consolidated financial statements for additional information. +Segment Analysis +Industrial Gases – Americas +2018 +2017 +2016 +Sales +$3,758.8 +$3,637.0 +$3,344.1 +Operating income +927.9 +946.1 +891.3 +Operating margin +24.7 +% +26.0 +% +26.7 +% +Equity affiliates’ income +82.0 +58.1 +52.7 +Adjusted EBITDA +1,495.2 +1,468.6 +1,387.6 +Adjusted EBITDA margin +39.8 +% +40.4 +% +41.5 +% +% Change from Prior Year +Sales +2018 +2017 +Underlying business +Volume +4 +% +2 +% +Price +— +% +— +% +Energy and raw material cost pass-through +(1 +)% +6 +% +Currency +— +% +1 +% +Total Industrial Gases – Americas Sales Change +3 +% +9 +% +29 +Table of Contents +2018 vs. 2017 +Sales of $3,758.8 increased 3% , or $121.8 . Underlying sales were up 4% from higher volumes, primarily in our onsite and merchant businesses, as pricing was flat. The onsite increase was primarily driven by higher hydrogen volumes in North America. Lower energy and natural gas cost pass-through to customers decreased sales by 1% . Currency was flat versus the prior year. +Operating income of $927.9 decreased 2% , or $18.2 , primarily due to higher costs of $84 and lower pricing, net of power and fuel costs, of $13, partially offset by higher volumes of $76 and favorable currency impacts of $3. The higher costs included higher maintenance and supply chain costs. Operating margin of 24.7% decreased 130 bp from the prior year, primarily due to higher costs, partially offset by favorable volumes. +Equity affiliates’ income of $82.0 increased 41% , or $23.9 , primarily due to volume growth. +2017 vs. 2016 +Underlying sales were up 2% from stronger hydrogen volumes and a new hydrogen plant in Canada. Higher energy and natural gas cost pass-through to customers increased sales by 6%. Favorable currency effects, primarily from the Chilean Peso, increased sales by 1%. +Operating income of $946.1 increased 6% , or $54.8 , primarily due to lower operating costs of $35 and higher volumes of $18. Operating costs were lower due to benefits from productivity improvements. Operating margin decreased 70 bp from the prior year primarily due to higher energy and natural gas pass-through to customers, partially offset by favorable cost performance. +Equity affiliates’ income of $58.1 increased $5.4, primarily due to lower maintenance expense and a new plant onstream. +Industrial Gases – EMEA +2018 +2017 +2016 +Sales +$2,193.3 +$1,780.4 +$1,704.4 +Operating income +445.8 +395.5 +387.0 +Operating margin +20.3 +% +22.2 +% +22.7 +% +Equity affiliates’ income +61.1 +47.1 +36.5 +Adjusted EBITDA +705.5 +619.7 +609.2 +Adjusted EBITDA margin +32.2 +% +34.8 +% +35.7 +% +% Change from Prior Year +Sales +2018 +2017 +Underlying business +Volume +12 +% +6 +% +Price +1 +% +— +% +Energy and raw material cost pass-through +3 +% +1 +% +Currency +7 +% +(3 +)% +Total Industrial Gases – EMEA Sales Change +23 +% +4 +% +2018 vs. 2017 +Sales of $2,193.3 increased 23% , or $412.9 . Underlying sales were up 13% from higher volumes of 12% and higher pricing of 1% . The volume increase was primarily driven by a hydrogen plant in India and higher merchant volumes. Higher energy and natural gas cost pass-through to customers increased sales by 3% . Favorable currency impacts, primarily from the Euro and British Pound Sterling, increased sales by 7% . +Operating income of $445.8 increased 13% , or $50.3 , due to higher volumes of $38, favorable currency impacts of $26, and higher pricing, net of power and fuel costs, of $4, partially offset by unfavorable costs $18. Operating margin of 20.3% decreased 190 bp from the prior year, primarily due to unfavorable costs and lower margins on the hydrogen volumes in India. +Equity affiliates’ income of $61.1 increased 30% , or $14.0 , primarily due to volume growth, lower costs, and favorable currency. +30 +Table of Contents +2017 vs. 2016 +Underlying sales were up 6% from higher volumes as pricing was flat. Volumes increased primarily due to a new plant onstream in India. Higher energy and natural gas cost pass-through to customers increased sales by 1%. Unfavorable currency effects, primarily from the British Pound Sterling, reduced sales by 3%. +Operating income of $395.5 increased 2% , or $8.5 , primarily due to lower operating costs of $27 and higher volumes, including a new plant onstream, of $15, partially offset by lower price net of power costs of $18 and unfavorable currency impacts of $15. Operating costs were lower primarily due to benefits from operational improvements. Operating margin decreased 50 bp from the prior year, as lower price net of power costs, higher energy and natural gas pass-through to customers, and unfavorable currency impacts were partially offset by favorable cost performance. +Equity affiliates’ income of $47.1 increased $10.6, primarily due to higher volumes. +Industrial Gases – Asia +2018 +2017 +2016 +Sales +$2,458.0 +$1,964.7 +$1,720.4 +Operating income +689.9 +532.6 +452.8 +Operating margin +28.1 +% +27.1 +% +26.3 +% +Equity affiliates’ income +58.3 +53.5 +57.8 +Adjusted EBITDA +1,014.0 +789.3 +708.5 +Adjusted EBITDA margin +41.3 +% +40.2 +% +41.2 +% +% Change from Prior Year +Sales +2018 +2017 +Underlying business +Volume +17 +% +14 +% +Price +4 +% +1 +% +Energy and raw material cost pass-through +— +% +— +% +Currency +4 +% +(1 +)% +Total Industrial Gases – Asia Sales Change +25 +% +14 +% +2018 vs. 2017 +Sales of $2,458.0 increased 25% , or $493.3 . Underlying sales were up 21% from higher volumes of 17% and higher pricing of 4% . The volume increase was primarily driven by new plant onstreams, including the Lu'An project, an equipment sale resulting from the termination of a contract in the first quarter of fiscal year 2018, and higher merchant volumes, partially offset by the impact of short-term sale of equipment activity in fiscal year 2017. Pricing improved across Asia driven primarily by the China merchant market. Energy and natural gas cost pass-through to customers was flat versus the prior year. Favorable currency impacts, primarily from the Chinese Renminbi, South Korean Won, and Taiwan Dollar, increased sales by 4% . +Operating income of $689.9 increased 30% , or $157.3 , due to higher volumes of $107, favorable price, net of power costs, of $53, and favorable currency impacts of $21, partially offset by higher operating costs of $24. Operating margin of 28.1% increased 100 bp as favorable price, net of power costs, and higher volumes were partially offset by unfavorable cost performance. +Equity affiliates’ income of $58.3 increased 9% , or $4.8 , primarily due to higher volumes. +2017 vs. 2016 +Underlying sales were up 15% from higher volumes of 14% and higher pricing of 1%. Volumes increased primarily due to new plant onstreams, sale of equipment activity, and base business growth driven by higher merchant volumes across Asia. Pricing was up 1% primarily due to increases in China wholesale, spot, and underlying prices during the second half of the year across all merchant liquid product lines. Unfavorable currency effects reduced sales by 1%, primarily from the Chinese Renminbi, partially offset by strengthening of the South Korean Won and Taiwan Dollar. +31 +Table of Contents +Operating income of $532.6 increased 18% , or $79.8 , due to higher volumes of $68 and higher price net of power costs of $24, partially offset by higher operating costs of $8 and an unfavorable currency impact of $4. Operating margin increased 80 bp, primarily due to higher price net of power costs and favorable volumes partially offset by unfavorable cost performance. +Equity affiliates’ income of $53.5 decreased $4.3, primarily due to favorable contract and insurance settlements in fiscal year 2016. +Industrial Gases – Global +The Industrial Gases – Global segment includes sales of cryogenic and gas processing equipment for air separation and centralized global costs associated with management of all the Industrial Gases segments. +2018 +2017 +2016 +Sales +$436.1 +$722.9 +$498.8 +Operating income (loss) +53.9 +71.1 +(21.5 +) +Adjusted EBITDA +63.9 +80.9 +(13.6 +) +2018 vs. 2017 +Sales of $436.1 decreased 40% , or $286.8 . The decrease in sales was primarily driven by lower sale of equipment activity on the multiple air separation units that will serve Saudi Aramco’s Jazan oil refinery and power plant in Saudi Arabia. We expect to complete this project in 2019. +Operating income of $53.9 decreased 24% , or $17.2 , primarily due to the lower sale of equipment activity. +2017 vs. 2016 +Sales of $722.9 increased $224.1, or 45%. The increase in sales was primarily driven by higher sales activity for our Jazan sale of equipment project. +Operating income of $71.1 increased $92.6 from an operating loss in fiscal year 2016, primarily from income on the Jazan project and productivity improvements. +Corporate and other +The Corporate and other segment includes our LNG and helium storage and distribution sale of equipment businesses and corporate support functions that benefit all segments. The results of the Corporate and other segment also include income and expense that is not directly associated with the other segments, such as foreign exchange gains and losses and stranded costs related to the former Materials Technologies segment, which is presented within discontinued operations. Stranded costs primarily relate to costs in support of transition services agreements with Versum and Evonik, the majority of which were reimbursed to Air Products. All transition services were completed during fiscal year 2018. +2018 +2017 +2016 +Sales +$84.0 +$82.6 +$236.0 +Operating loss +(176.0 +) +(171.5 +) +(89.4 +) +Adjusted EBITDA +(163.1 +) +(159.3 +) +(69.9 +) +2018 vs. 2017 +Sales of $84.0 increased 2% , or $1.4 . Operating loss of $176.0 increased 3% , or $4.5 . +2017 vs. 2016 +Sales of $82.6 decreased $153.4, primarily due to lower LNG activity. Operating loss of $171.5 increased $82.1 due to lower LNG activity, partially offset by productivity improvements and income from transition service agreements with Versum and Evonik. +32 +Table of Contents +RECONCILIATION OF NON-GAAP FINANCIAL MEASURES +(Millions of dollars unless otherwise indicated, except for per share data) +The Company has presented certain financial measures on a non-GAAP (“adjusted”) basis and has provided a reconciliation to the most directly comparable financial measure calculated in accordance with GAAP. These financial measures are not meant to be considered in isolation or as a substitute for the most directly comparable financial measure calculated in accordance with GAAP. The Company believes these non-GAAP measures provide investors, potential investors, securities analysts, and others with useful information to evaluate the performance of the business because such measures, when viewed together with our financial results computed in accordance with GAAP, provide a more complete understanding of the factors and trends affecting our historical financial performance and projected future results. +In many cases, our non-GAAP measures are determined by adjusting the most directly comparable GAAP financial measure to exclude certain disclosed items (“non-GAAP adjustments”) that we believe are not representative of the underlying business performance. For example, in fiscal years 2017 and 2016, we restructured the Company to focus on its core Industrial Gases business. This resulted in significant cost reduction and asset actions that we believe were important for investors to understand separately from the performance of the underlying business. Additionally, in fiscal year 2018, we recorded discrete impacts associated with the Tax Act . The reader should be aware that we may incur similar expenses in the future. +The tax impact on our pre-tax non-GAAP adjustments reflects the expected current and deferred income tax expense impact of the transactions and is impacted primarily by the statutory tax rate of the various relevant jurisdictions and the taxability of the adjustments in those jurisdictions. Investors should also consider the limitations associated with these non-GAAP measures, including the potential lack of comparability of these measures from one company to another. +During the first quarter of fiscal year 2018, we adopted accounting guidance on the presentation of net periodic pension and postretirement benefit cost. Certain prior year information has been reclassified to conform to the fiscal year 2018 presentation. Refer to Note 2 , New Accounting Guidance , to the consolidated financial statements for additional information. +33 +Table of Contents +Presented below are reconciliations of the reported GAAP results to the non-GAAP measures: +CONSOLIDATED RESULTS +Continuing Operations +Operating +Income +Operating +Margin (A) +Equity Affiliates' Income +Income Tax Provision +Net +Income +Diluted +EPS +2018 GAAP +$1,965.6 +22.0 +% +$174.8 +$524.3 +$1,455.6 +$6.59 +2017 GAAP +1,440.0 +17.6 +% +80.1 +260.9 +1,134.4 +5.16 +Change GAAP +$525.6 +440 +bp +$94.7 +$263.4 +$321.2 +$1.43 +% Change GAAP +37 +% +118 +% +101 +% +28 +% +28 +% +2018 GAAP +$1,965.6 +22.0 +% +$174.8 +$524.3 +$1,455.6 +$6.59 +Change in inventory valuation method +(24.1 +) +(.3 +)% +— +(6.6 +) +(17.5 +) +(.08 +) +Pension settlement loss (B) +— +— +% +— +10.5 +33.2 +.15 +Tax reform repatriation +— +— +% +28.5 +(448.6 +) +477.1 +2.16 +Tax reform benefit related to deemed foreign dividends +— +— +% +— +56.2 +(56.2 +) +(.25 +) +Tax reform rate change and other +— +— +% +— +211.8 +(211.8 +) +(.96 +) +Tax restructuring +— +— +% +— +35.7 +(35.7 +) +(.16 +) +2018 Non-GAAP Measure +$1,941.5 +21.7 +% +$203.3 +$383.3 +$1,644.7 +$7.45 +2017 GAAP +$1,440.0 +17.6 +% +$80.1 +$260.9 +$1,134.4 +$5.16 +Business separation costs +32.5 +.4 +% +— +3.7 +26.5 +.12 +Tax benefit associated with business separation +— +— +% +— +5.5 +(5.5 +) +(.02 +) +Cost reduction and asset actions (C) +151.4 +1.8 +% +— +41.6 +109.3 +.49 +Goodwill and intangible asset impairment charge (D) +162.1 +2.0 +% +— +4.6 +154.1 +.70 +Gain on land sale +(12.2 +) +(.1 +)% +— +(4.6 +) +(7.6 +) +(.03 +) +Equity method investment impairment charge +— +— +% +79.5 +— +79.5 +.36 +Pension settlement loss (B) +— +— +% +— +3.9 +6.6 +.03 +Tax election benefit +— +— +% +— +111.4 +(111.4 +) +(.50 +) +2017 Non-GAAP Measure +$1,773.8 +21.7 +% +$159.6 +$427.0 +$1,385.9 +$6.31 +Change Non-GAAP Measure +$167.7 +— +$43.7 +($43.7 +) +$258.8 +$1.14 +% Change Non-GAAP Measure +9 +% +27 +% +(10 +)% +19 +% +18 +% +34 +Table of Contents +Continuing Operations +Operating +Income +Operating +Margin (A) +Equity Affiliates' Income +Income Tax Provision +Net +Income +Diluted +EPS +2017 GAAP +$1,440.0 +17.6 +% +$80.1 +$260.9 +$1,134.4 +$5.16 +2016 GAAP +1,535.1 +20.5 +% +147.0 +432.6 +1,099.5 +5.04 +Change GAAP +($95.1 +) +(290 +)bp +($66.9 +) +($171.7 +) +$34.9 +$.12 +% Change GAAP +(6 +)% +(46 +)% +(40 +)% +3 +% +2 +% +2017 GAAP +$1,440.0 +17.6 +% +$80.1 +$260.9 +$1,134.4 +$5.16 +Business separation costs +32.5 +.4 +% +— +3.7 +26.5 +.12 +Tax benefit associated with business separation +— +— +% +— +5.5 +(5.5 +) +(.02 +) +Cost reduction and asset actions (C) +151.4 +1.8 +% +— +41.6 +109.3 +.49 +Goodwill and intangible asset impairment charge (D) +162.1 +2.0 +% +— +4.6 +154.1 +.70 +Gain on land sale +(12.2 +) +(.1 +)% +— +(4.6 +) +(7.6 +) +(.03 +) +Equity method investment impairment charge +— +— +% +79.5 +— +79.5 +.36 +Pension settlement loss (B) +— +— +% +— +3.9 +6.6 +.03 +Tax election benefit +— +— +% +— +111.4 +(111.4 +) +(.50 +) +2017 Non-GAAP Measure +$1,773.8 +21.7 +% +$159.6 +$427.0 +$1,385.9 +$6.31 +2016 GAAP +$1,535.1 +20.5 +% +$147.0 +$432.6 +$1,099.5 +$5.04 +Business separation costs +50.6 +.7 +% +— +3.9 +46.7 +.21 +Tax costs associated with business separation +— +— +% +— +(51.8 +) +51.8 +.24 +Cost reduction and asset actions +34.5 +.4 +% +— +9.8 +24.7 +.11 +Pension settlement loss (B) +— +— +% +— +1.8 +3.3 +.02 +Loss on extinguishment of debt (E) +— +— +% +— +2.6 +4.3 +.02 +2016 Non-GAAP Measure +$1,620.2 +21.6 +% +$147.0 +$398.9 +$1,230.3 +$5.64 +Change Non-GAAP Measure +$153.6 +10 +bp +$12.6 +$28.1 +$155.6 +$.67 +% Change Non-GAAP Measure +9 +% +9 +% +7 +% +13 +% +12 +% +(A) +Operating margin is calculated by dividing operating income by sales. +(B) +Reflected on the consolidated income statements in "Other non-operating income (expense), net." Fiscal year 2018 includes a before-tax impact of $43.7 primarily resulting from the transfer of certain pension payment obligations to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract during the fourth quarter. +(C) +Noncontrolling interests impact of $.5 in fiscal year 2017. +(D) +Noncontrolling interests impact of $3.4 in fiscal year 2017. +(E) +Income from continuing operations before taxes impact of $6.9 in fiscal year 2016. +35 +Table of Contents +ADJUSTED EBITDA +We define Adjusted EBITDA as income from continuing operations (including noncontrolling interests) excluding certain disclosed items, which the Company does not believe to be indicative of underlying business trends, before interest expense, other non-operating income (expense), net, income tax provision, and depreciation and amortization expense. Adjusted EBITDA provides a useful metric for management to assess operating performance. +Below is a reconciliation of income from continuing operations on a GAAP basis to adjusted EBITDA: +2018 +2017 +2016 +2015 +2014 +Income From Continuing Operations (A) +$1,490.7 +$1,155.2 +$1,122.0 +$965.9 +$691.0 +Less: Change in inventory valuation method +24.1 +— +— +— +— +Add: Interest expense +130.5 +120.6 +115.2 +102.8 +124.0 +Less: Other non-operating income (expense), net +5.1 +16.6 +(5.4 +) +(42.3 +) +(51.7 +) +Add: Income tax provision +524.3 +260.9 +432.6 +300.2 +258.1 +Add: Depreciation and amortization +970.7 +865.8 +854.6 +858.5 +875.6 +Add: Business separation costs +— +32.5 +50.6 +7.5 +— +Add: Cost reduction and asset actions +— +151.4 +34.5 +180.1 +11.1 +Add: Goodwill and intangible asset impairment charge +— +162.1 +— +— +310.1 +Less: Gain on previously held equity interest +— +— +— +17.9 +— +Less: Gain on land sales +— +12.2 +— +33.6 +— +Add: Equity method investment impairment charge +— +79.5 +— +— +— +Add: Loss on extinguishment of debt +— +— +6.9 +16.6 +— +Add: Tax reform repatriation - equity method investment +28.5 +— +— +— +— +Adjusted EBITDA +$3,115.5 +$2,799.2 +$2,621.8 +$2,422.4 +$2,321.6 +Adjusted EBITDA margin +34.9 +% +34.2 +% +34.9 +% +31.0 +% +27.7 +% +Change GAAP +Income from continuing operations change +$335.5 +$33.2 +$156.1 +$274.9 +Income from continuing operations % change +29 +% +3 +% +16 +% +40 +% +Change Non-GAAP +Adjusted EBITDA change +$316.3 +$177.4 +$199.4 +$100.8 +Adjusted EBITDA % change +11 +% +7 +% +8 +% +4 +% +Adjusted EBITDA margin change +70 +bp +(70 +) bp +390 +bp +330 +bp +(A) +Includes net income attributable to noncontrolling interests. +36 +Table of Contents +Below is a summary of segment operating income: +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Segment +Total +GAAP Measure +Twelve Months Ended 30 September 2018 +Operating income (loss) +$927.9 +$445.8 +$689.9 +$53.9 +($176.0 +) +$1,941.5 +Operating margin +24.7 +% +20.3 +% +28.1 +% +21.7 +% +Twelve Months Ended 30 September 2017 +Operating income (loss) +$946.1 +$395.5 +$532.6 +$71.1 +($171.5 +) +$1,773.8 +Operating margin +26.0 +% +22.2 +% +27.1 +% +21.7 +% +Twelve Months Ended 30 September 2016 +Operating income (loss) +$891.3 +$387.0 +$452.8 +($21.5 +) +($89.4 +) +$1,620.2 +Operating margin +26.7 +% +22.7 +% +26.3 +% +21.6 +% +2018 vs. 2017 +Operating income (loss) change +($18.2 +) +$50.3 +$157.3 +($17.2 +) +($4.5 +) +$167.7 +Operating income (loss) % change +(2 +)% +13 +% +30 +% +(24 +)% +(3 +)% +9 +% +Operating margin change +(130 +) bp +(190 +) bp +100 +bp +— +2017 vs. 2016 +Operating income (loss) change +$54.8 +$8.5 +$79.8 +$92.6 +($82.1 +) +$153.6 +Operating income (loss) % change +6 +% +2 +% +18 +% +431 +% +(92 +)% +9 +% +Operating margin change +(70 +) bp +(50 +) bp +80 +bp +10 +bp +37 +Table of Contents +Below is a reconciliation of segment operating income to adjusted EBITDA: +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Segment +Total +Non-GAAP Measure +Twelve Months Ended 30 September 2018 +Operating income (loss) +$927.9 +$445.8 +$689.9 +$53.9 +($176.0 +) +$1,941.5 +Add: Depreciation and amortization +485.3 +198.6 +265.8 +8.1 +12.9 +970.7 +Add: Equity affiliates' income +82.0 +61.1 +58.3 +1.9 +— +203.3 +Adjusted EBITDA +$1,495.2 +$705.5 +$1,014.0 +$63.9 +($163.1 +) +$3,115.5 +Adjusted EBITDA margin (A) +39.8 +% +32.2 +% +41.3 +% +34.9 +% +Twelve Months Ended 30 September 2017 +Operating income (loss) +$946.1 +$395.5 +$532.6 +$71.1 +($171.5 +) +$1,773.8 +Add: Depreciation and amortization +464.4 +177.1 +203.2 +8.9 +12.2 +865.8 +Add: Equity affiliates' income +58.1 +47.1 +53.5 +.9 +— +159.6 +Adjusted EBITDA +$1,468.6 +$619.7 +$789.3 +$80.9 +($159.3 +) +$2,799.2 +Adjusted EBITDA margin (A) +40.4 +% +34.8 +% +40.2 +% +34.2 +% +Twelve Months Ended 30 September 2016 +Operating income (loss) +$891.3 +$387.0 +$452.8 +($21.5 +) +($89.4 +) +$1,620.2 +Add: Depreciation and amortization +443.6 +185.7 +197.9 +7.9 +19.5 +854.6 +Add: Equity affiliates' income +52.7 +36.5 +57.8 +— +— +147.0 +Adjusted EBITDA +$1,387.6 +$609.2 +$708.5 +($13.6 +) +($69.9 +) +$2,621.8 +Adjusted EBITDA margin (A) +41.5 +% +35.7 +% +41.2 +% +34.9 +% +2018 vs. 2017 +Adjusted EBITDA change +$26.6 +$85.8 +$224.7 +($17.0 +) +($3.8 +) +$316.3 +Adjusted EBITDA % change +2 +% +14 +% +28 +% +(21 +)% +(2 +)% +11 +% +Adjusted EBITDA margin change +(60 +) bp +(260 +) bp +110 +bp +70 +bp +2017 vs. 2016 +Adjusted EBITDA change +$81.0 +$10.5 +$80.8 +$94.5 +($89.4 +) +$177.4 +Adjusted EBITDA % change +6 +% +2 +% +11 +% +695 +% +(128 +)% +7 +% +Adjusted EBITDA margin change +(110 +) bp +(90 +) bp +(100 +) bp +(70 +) bp +(A) +Adjusted EBITDA margin is calculated by dividing Adjusted EBITDA by sales. +Below is a reconciliation of segment total operating income to consolidated operating income: +Operating Income +2018 +2017 +2016 +Segment total +$1,941.5 +$1,773.8 +$1,620.2 +Change in inventory valuation method +24.1 +— +— +Business separation costs +— +(32.5 +) +(50.6 +) +Cost reduction and asset actions +— +(151.4 +) +(34.5 +) +Goodwill and intangible asset impairment charge +— +(162.1 +) +— +Gain on land sale +— +12.2 +— +Consolidated Total +$1,965.6 +$1,440.0 +$1,535.1 +38 +Table of Contents +Below is a reconciliation of segment total equity affiliates' income to consolidated equity affiliates' income : +Equity Affiliates' Income +2018 +2017 +2016 +Segment total +$203.3 +$159.6 +$147.0 +Equity method investment impairment charge +— +(79.5 +) +— +Tax reform repatriation - equity method investment +(28.5 +) +— +— +Consolidated Total +$174.8 +$80.1 +$147.0 +INCOME TAXES +The tax impact of our pre-tax non-GAAP adjustments reflects the expected current and deferred income tax expense impact of the transactions and is impacted primarily by the statutory tax rate of the various relevant jurisdictions and the taxability of the adjustments in those jurisdictions. For additional discussion on the fiscal year 2018 non-GAAP tax adjustments, including the impact of the U.S. Tax Cuts and Jobs Act , refer to Note 22 , Income Taxes , to the consolidated financial statements. +Effective Tax Rate +2018 +2017 +2016 +Income Tax Provision—GAAP +$524.3 +$260.9 +$432.6 +Income From Continuing Operations Before Taxes—GAAP +$2,015.0 +$1,416.1 +$1,554.6 +Effective Tax Rate—GAAP +26.0 +% +18.4 +% +27.8 +% +Income Tax Provision—GAAP +$524.3 +$260.9 +$432.6 +Change in inventory valuation method +(6.6 +) +— +— +Business separation costs +— +3.7 +3.9 +Tax benefit (costs) associated with business separation +— +5.5 +(51.8 +) +Cost reduction and asset actions +— +41.6 +9.8 +Goodwill and intangible asset impairment charge +— +4.6 +— +Gain on land sale +— +(4.6 +) +— +Pension settlement loss +10.5 +3.9 +1.8 +Loss on extinguishment of debt +— +— +2.6 +Tax reform repatriation +(448.6 +) +— +— +Tax reform benefit related to deemed foreign dividends +56.2 +— +— +Tax reform rate change and other +211.8 +— +— +Tax restructuring +35.7 +— +— +Tax election benefit +— +111.4 +— +Income Tax Provision—Non-GAAP Measure +$383.3 +$427.0 +$398.9 +Income from Continuing Operations before Taxes—GAAP +$2,015.0 +$1,416.1 +$1,554.6 +Change in inventory valuation method +(24.1 +) +— +— +Business separation costs +— +30.2 +50.6 +Cost reduction and asset actions +— +151.4 +34.5 +Goodwill and intangible asset impairment charge +— +162.1 +— +Gain on land sale +— +(12.2 +) +— +Equity method investment impairment charge +— +79.5 +— +Pension settlement loss +43.7 +10.5 +5.1 +Loss on extinguishment of debt +— +— +6.9 +Tax reform repatriation - equity method investment +28.5 +— +— +Income From Continuing Operations Before Taxes—Non-GAAP Measure +$2,063.1 +$1,837.6 +$1,651.7 +Effective Tax Rate—Non-GAAP Measure +18.6 +% +23.2 +% +24.2 +% +39 +Table of Contents +LIQUIDITY AND CAPITAL RESOURCES +We maintained a strong financial position throughout 2018 and as of 30 September 2018 our consolidated balance sheet included cash and cash items of $2,791.3 . We continue to have consistent access to commercial paper markets, and cash flows from operating and financing activities are expected to meet liquidity needs for the foreseeable future. +As of 30 September 2018 , we had $995.1 of foreign cash and cash items compared to a total amount of cash and cash items of $2,791.3 . As a result of the Tax Act, we currently do not expect that a significant portion of the earnings of our foreign subsidiaries and affiliates will be subject to U.S. income tax upon subsequent repatriation to the United States. Depending on the country in which the subsidiaries and affiliates reside, the repatriation of these earnings may be subject to foreign withholding and other taxes. However, since we have significant current investment plans outside the U.S., it is our intent to permanently reinvest the majority of our foreign cash and cash items that would be subject to additional taxes outside the U.S. Refer to Note 22 , Income Taxes, for additional information. +Our cash flows from operating, investing, and financing activities from continuing operations, as reflected in the consolidated statements of cash flows, are summarized in the following table: +Cash provided by (used for) +2018 +2017 +2016 +Operating activities +$2,554.7 +$2,534.1 +$2,258.8 +Investing activities +(1,649.1 +) +(1,417.7 +) +(864.8 +) +Financing activities +(1,359.8 +) +(2,040.9 +) +(860.2 +) +Operating Activities +For the year ended 2018 , cash provided by operating activities was $2,554.7 . Income from continuing operations of $1,455.6 was adjusted for items including depreciation and amortization, deferred income taxes, impacts from the Tax Act, undistributed earnings of unconsolidated affiliates, share-based compensation, and noncurrent capital lease receivables. Other adjustments of $131.6 include a $54.9 net impact from the remeasurement of intercompany transactions. The related hedging instruments that eliminate the earnings impact are included as a working capital adjustment in other receivables or payables and accrued liabilities. In addition, other adjustments were impacted by cash received from the early termination of a cross currency swap of $54.4, as well as the excess of pension expense over pension contributions of $23.5. The working capital accounts were a use of cash of $265.4, primarily driven by payables and accrued liabilities, inventories, and trade receivables, partially offset by other receivables. The use of cash in payables and accrued liabilities of $277.7 includes a decrease in customer advances of $145.7 primarily related to sale of equipment activity and $67.1 for maturities of forward exchange contracts that hedged foreign currency exposures. The use of cash in inventories primarily resulted from the purchase of helium molecules. In addition, inventories reflect the noncash impact of our change in accounting for U.S. inventories from LIFO to FIFO. The source of cash from other receivables of $ 123.6 was primarily due to the maturities of forward exchange contracts that hedged foreign currency exposures +For the year ended 2017, cash provided by operating activities was $2,534.1. Income from continuing operations of $1,134.4 included a goodwill and intangible asset impairment charge of $162.1, an equity method investment impairment charge of $79.5, and a write-down of long-lived assets associated with restructuring of $69.2. Refer to Note 5, Cost Reduction and Asset Actions; Note 8, Summarized Financial Information of Equity Affiliates; Note 10, Goodwill; and Note 11, Intangible Assets, of the consolidated financial statements for additional information on these charges. Other adjustments of $165.4 included changes in uncertain tax positions and the fair value of foreign exchange contracts that hedge intercompany loans as well as pension contributions and expense. The working capital accounts were a source of cash of $48.0 that were primarily driven by payables and accrued liabilities and other receivables, partially offset by other working capital and trade receivables. The increase in payables and accrued liabilities of $163.8 was primarily due to timing differences related to payables and accrued liabilities and an increase in customer advances of $52.8 primarily related to sale of equipment activity. The source of cash from other receivables of $124.7 was primarily due to the maturities of forward exchange contracts that hedged foreign currency exposures. Other working capital was a use of cash of $154.0, primarily driven by payments for income taxes. Trade receivables was a use of cash of $73.6 which is primarily due to timing differences. +40 +Table of Contents +For the year ended 2016, cash provided by operating activities was $2,258.8. Income from continuing operations of $1,099.5 included a loss on extinguishment of debt of $6.9. Other adjustments of $156.7 were primarily driven by the remeasurement of intercompany transactions as the related hedging instruments that eliminate the earnings impact are included in other receivables and payables and accrued liabilities. The working capital accounts were a source of cash of $21.2 that were primarily driven by payables and accrued liabilities and inventory partially offset by trade receivables and other working capital. The increase in payables and accrued liabilities of $60.1 was primarily related to an increase in customer advances which includes payment from our joint venture in Jazan, Saudi Arabia and was partially offset by the changes in the fair value of foreign exchange contracts that hedge intercompany loans. The use of cash from other working capital of $47.8 was primarily driven by advances associated with the purchase of helium partially offset by an increase in accrued income taxes, including the impacts of higher income. +Investing Activities +For the year ended 30 September 2018 , cash used for investing activities was $1,649.1 . Capital expenditures for plant and equipment was $1,568.4 . Cash paid for acquisitions, net of cash acquired was $345.4. Refer to Note 6 , +Acquisitions, to the consolidated financial statements for further details. Purchases of investments of $530.3 include short-term instruments with original maturities greater than three months and less than one year. Proceeds from investments of $748.2 resulted from maturities of short-term instruments with original maturities greater than three months and less than one year. +For the year ended 30 September 2017, cash used for investing activities was $1,417.7. Capital expenditures for plant and equipment was $1,039.7. Purchases of investments of $2,692.6 exceeded our proceeds from investments of $2,290.7. +For the year ended 30 September 2016, cash used for investing activities was $864.8, driven by capital expenditures for plant and equipment of $907.7. Proceeds from the sale of assets and investments of $44.6 was primarily driven by the receipt of $30.0 for our rights to a corporate aircraft that was under construction. +Capital Expenditures +Capital expenditures are detailed in the following table: +2018 +2017 +2016 +Additions to plant and equipment +$1,568.4 +$1,039.7 +$907.7 +Acquisitions, less cash acquired +345.4 +8.2 +— +Investments in and advances to unconsolidated affiliates +— +8.1 +— +Capital Expenditures on a GAAP Basis +$1,913.8 +$1,056.0 +$907.7 +Capital lease expenditures (A) +20.2 +9.9 +27.2 +Capital Expenditures on a Non-GAAP Basis +$1,934.0 +$1,065.9 +$934.9 +(A) +We utilize a non-GAAP measure in the computation of capital expenditures and include spending associated with facilities accounted for as capital leases. Certain contracts associated with facilities that are built to provide product to a specific customer are required to be accounted for as leases, and such spending is reflected as a use of cash in the consolidated statements of cash flows within "Cash Provided by Operating Activities" if the arrangement qualifies as a capital lease. The presentation of this non-GAAP measure is intended to enhance the usefulness of information by providing a measure that our management uses internally to evaluate and manage our expenditures. +Capital expenditures on a GAAP basis in fiscal year 2018 totaled $1,913.8 , compared to $1,056.0 in fiscal year 2017 . The increase of $857.8 was primarily due to major project spending and higher business combination activity, including the purchase of gasification and syngas clean up assets from Lu'An. Refer to Note 6, Acquisitions, to the consolidated financial statements for additional information. Additions to plant and equipment also included support capital of a routine, ongoing nature, including expenditures for distribution equipment and facility improvements. +Capital expenditures on a non-GAAP basis in fiscal year 2018 totaled $1,934.0 compared to $1,065.9 in fiscal year 2017 . The increase of $868.1 was primarily due to higher major project spending and higher business combination activity. +41 +Table of Contents +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20-year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. Air Products owns 25% of the joint venture. During 2016, we recorded a noncash transaction of $26.9 to our investment in net assets of and advances to equity affiliates to increase our obligation to invest in the joint venture to $94.4. This noncash transaction was excluded from the consolidated statements of cash flows. We expect to invest approximately $100 in this joint venture. +Sales backlog represents our estimate of revenue to be recognized in the future on our share of Air Products’ sale of equipment orders and related process technologies that are under firm contracts. The sales backlog for the Company at 30 September 2018 was $204 compared to $481 at 30 September 2017 . +2019 Outlook +Capital expenditures for new plant and equipment in fiscal year 2019 are expected to be approximately $2,300 to $2,500 . A majority of the total capital expenditures are expected to be for new plants that are currently under construction or expected to start construction. It is anticipated that capital expenditures will be funded principally with our current cash balance and cash generated from continuing operations. In addition, we intend to continue to evaluate acquisitions of small and medium size industrial gas companies or assets from other industrial gas companies; the purchase of existing industrial gas facilities from our customers to create long-term contracts where we own and operate the plant and sell industrial gases to the customer based on a fixed fee; and investment in very large industrial gas projects driven by demand for more energy, cleaner energy, and emerging market growth. +Financing Activities +For the year ended 2018 , cash used for financing activities was $1,359.8 . This consisted primarily of dividend payments to shareholders of $897.8 and payments on long-term debt of $418.7. Payments on long-term debt primarily related to the repayment of a 1.2% U.S. Senior Note of $400.0 that matured on 16 October 2017. +For the year ended 2017, cash used for financing activities was $2,040.9. This consisted primarily of repayments of commercial paper and short-term borrowings of $798.6, dividend payments to shareholders of $787.9 and payments on long-term debt of $483.9. Payments on long-term debt primarily consisted of the repayment of a 4.625% Eurobond of €300 million ($317.2) that matured on 15 March 2017 and $138.0 for the repayment of industrial revenue bonds. +For the year ended 2016, cash used for financing activities was $860.2. Our borrowings (short- and long-term proceeds, net of repayments) were a net use of cash of $237.7 and included the repayment of the 2.0% Senior Note of $350.0 million on 2 August 2016, and a $144.2 use of cash for net commercial paper and other short-term debt borrowings which were partially offset by debt proceeds from the issuance of a .375% Eurobond of €350 million ($386.9) on 1 June 2016. Versum distributed in-kind notes with an aggregate principal amount of $425.0 to Air Products. However, since Air Products exchanged these notes with certain financial institutions for $418.3 of Air Products’ outstanding commercial paper, this noncash debt for debt exchange was excluded from the consolidated statements of cash flows. Refer to Note 4, Materials Technologies Separation, to the consolidated financial statements for additional details. We also used cash to pay dividends of $721.2 and received proceeds from stock option exercises of $141.3. +Discontinued Operations +For the year ended 2018, cash flows of discontinued operations were not material. +For the year ended 2017, cash flows of discontinued operations primarily included impacts associated with the spin-off of EMD as Versum on 1 October 2016 and the sale of PMD to Evonik on 3 January 2017. Cash used for operating activities of $966.2 was primarily driven by taxes paid on the gain on the sale of PMD. Cash provided by investing activities of $3,750.6 primarily resulted from the proceeds on the sale of PMD. Cash provided by financing activities resulted from a $69.5 receipt of cash from Versum related to finalization of the spin-off. +For the year ended 2016, discontinued operations primarily includes the Energy-from-Waste business, which the Company decided to exit in the second quarter of 2016, and the Materials Technologies business which contained two divisions, EMD and PMD. Cash provided by discontinued operations was $753.6 primarily driven by income from operations of discontinued operations, which excludes the noncash impairment charge, of $386.1 and long-term debt proceeds from Versum's Term Loan B of $575.0, partially offset by capital expenditures for plant and equipment of $245.1. Refer to Note 3, Discontinued Operations, to the consolidated financial statements for additional information. +42 +Table of Contents +Financing and Capital Structure +Capital needs in fiscal year 2018 were satisfied primarily with cash from operations. At the end of 2018 , total debt outstanding was $3,812.6 compared to $3,962.8 at the end of 2017 , and cash and cash items were $2,791.3 compared to $3,273.6 at the end of 2017 . Total debt as of 30 September 2018 includes related party debt of 2.6 billion RMB ( $384 ) associated with the Lu'An joint venture. +On 31 March 2017 , we entered into a five -year $2,500.0 revolving credit agreement maturing 31 March 2022 with a syndicate of banks (the “2017 Credit Agreement”), under which senior unsecured debt is available to both the Company and certain of its subsidiaries. On 28 September 2018, we amended the 2017 Credit Agreement to reduce the maximum borrowing capacity to $2,300.0 . No other terms were impacted by the amendment. +The 2017 Credit Agreement provides a source of liquidity for the Company and supports its commercial paper program. The Company’s only financial covenant under the 2017 Credit Agreement is a maximum ratio of total debt to total capitalization (total debt plus total equity) no greater than 70% . Total debt at 30 September 2018 and 2017 expressed as a percentage of total capitalization was 25.4% and 28.0% , respectively. No borrowings were outstanding under the 2017 Credit Agreement as of 30 September 2018 . +Commitments totaling $7.0 are maintained by our foreign subsidiaries, all of which was borrowed and outstanding at 30 September 2018 . +As of 30 September 2018 , we are in compliance with all of the financial and other covenants under our debt agreements. +On 15 September 2011, the Board of Directors authorized the repurchase of up to $1,000 of our outstanding common stock. We did not purchase any of our outstanding shares during fiscal years 2018 , 2017 or 2016 . At 30 September 2018, $485.3 in share repurchase authorization remains. +2019 Outlook +Cash flows from operations and financing activities are expected to meet liquidity needs for the foreseeable future and our working capital balance was $2,743.9 at 30 September 2018 . We expect that we will continue to be in compliance with all of our financial covenants. +Dividends +Dividends are declared by the Board of Directors and are usually paid during the sixth week after the close of the fiscal quarter. During 2018 , the Board of Directors increased the quarterly dividend from $.95 per share to $1.10 per share, or $4.40 per share annually. +CONTRACTUAL OBLIGATIONS +We are obligated to make future payments under various contracts, such as debt agreements, lease agreements, unconditional purchase obligations, and other long-term obligations. The following table summarizes our obligations on a continuing operations basis as of 30 September 2018 : +Total +2019 +2020 +2021 +2022 +2023 +Thereafter +Debt maturities +$3,774 +$407 +$381 +$474 +$448 +$449 +$1,615 +Contractual interest on debt +589 +101 +81 +71 +57 +46 +233 +Capital leases +23 +2 +2 +3 +1 +1 +14 +Operating leases +334 +66 +50 +41 +31 +23 +123 +Pension obligations +310 +53 +40 +41 +41 +41 +94 +Unconditional purchase obligations +7,660 +851 +362 +342 +318 +326 +5,461 +Deemed repatriation tax related to the Tax Act +184 +— +14 +16 +16 +16 +122 +Obligation for future contribution to an equity affiliate +100 +— +100 +— +— +— +— +Total Contractual Obligations +$12,974 +$1,480 +$1,030 +$988 +$912 +$902 +$7,662 +43 +Table of Contents +Debt Obligations +Our debt obligations include the maturity payments of the principal amount of long-term debt, including the current portion and amounts owed to related parties, and the related contractual interest obligations. Refer to Note 15 , Debt , to the consolidated financial statements for additional information on our debt obligations. +Contractual interest is the interest we are contracted to pay on our debt obligations without taking into account the interest impact of interest rate swaps related to any of this debt, which at current interest rates would slightly decrease contractual interest. We had approximately $640 of long-term debt subject to variable interest rates at 30 September 2018 , excluding fixed-rate debt that has been swapped to variable-rate debt. The rate assumed for the variable interest component of the contractual interest obligation was the rate in effect at 30 September 2018 . Variable interest rates are primarily determined by U.S. short-term tax-exempt interest rates and by interbank offer rates. +Leases +Refer to Note 12 , Leases , to the consolidated financial statements for additional information on capital and operating leases. +Pension Obligations +The amounts in the table above represent the current estimated cash payments to be made by us that, in total, equal the recognized pension liabilities for our U.S. and international pension plans. For additional information, refer to Note 16 , Retirement Benefits , to the consolidated financial statements. These payments are based upon the current valuation assumptions and regulatory environment. +The total accrued liability for pension benefits may be impacted by interest rates, plan demographics, actual return on plan assets, continuation or modification of benefits, and other factors. Such factors can significantly impact the amount of the liability and related contributions. +Unconditional Purchase Obligations +Approximately $6,800 of our unconditional purchase obligations relate to helium purchases. The majority of these obligations occur after fiscal year 2023. Helium purchases include crude feedstock supply to multiple helium refining plants in North America as well as refined helium purchases from sources around the world. As a rare byproduct of natural gas production in the energy sector, these helium sourcing agreements are medium- to long-term and contain take-if-tendered provisions. The refined helium is distributed globally and sold as a merchant gas, primarily under medium-term requirements contracts. While contract terms in the energy sector are longer than those in merchant, helium is a rare gas used in applications with few or no substitutions because of its unique physical and chemical properties. +Approximately $210 of our long-term unconditional purchase obligations relate to feedstock supply for numerous HyCO (hydrogen, carbon monoxide, and syngas) facilities. The price of feedstock supply is principally related to the price of natural gas. However, long-term take-or-pay sales contracts to HyCO customers are generally matched to the term of the feedstock supply obligations and provide recovery of price increases in the feedstock supply. Due to the matching of most long-term feedstock supply obligations to customer sales contracts, we do not believe these purchase obligations would have a material effect on our financial condition or results of operations. +The unconditional purchase obligations also include other product supply and purchase commitments and electric power and natural gas supply purchase obligations, which are primarily pass-through contracts with our customers. +Purchase commitments to spend approximately $455 for additional plant and equipment are included in the unconditional purchase obligations in 2019 . +We also purchase materials, energy, capital equipment, supplies, and services as part of the ordinary course of business under arrangements that are not unconditional purchase obligations. The majority of such purchases are for raw materials and energy, which are obtained under requirements-type contracts at market prices. +44 +Table of Contents +Income Tax Liabilities +Tax liabilities related to unrecognized tax benefits as of 30 September 2018 were $233.6 . These tax liabilities were excluded from the Contractual Obligations table as it is impractical to determine a cash impact by year given that payments will vary according to changes in tax laws, tax rates, and our operating results. In addition, there are uncertainties in timing of the effective settlement of our uncertain tax positions with respective taxing authorities. However, the Contractual Obligations table above includes our accrued liability of approximately $184 for deemed repatriation tax that is payable over eight years related to the Tax Act. Refer to Note 22 , Income Taxes , to the consolidated financial statements for additional information. +Obligation for Future Contribution to an Equity Affiliate +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20-year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. Air Products owns 25% of the joint venture and guarantees the repayment of its share of an equity bridge loan. In total, we expect to invest approximately $100 in this joint venture. As of 30 September 2018 , we recorded a noncurrent liability of $94.4 for our obligation to make future equity contributions in 2020 based on our proportionate share of the advances received by the joint venture under the loan. +Expected Investment in Joint Venture +On 12 August 2018, Air Products entered an agreement to form a gasification/power joint venture ("JV") with Saudi Aramco and ACWA in Jazan, Saudi Arabia. Air Products will own at least 55% of the JV, with Saudi Aramco and ACWA Power owning the balance. The JV will purchase the gasification assets, power block, and the associated utilities from Saudi Aramco for approximately $8 billion. Our expected investment has been excluded from the contractual obligations table above pending closing, which is currently expected in fiscal year 2020. +The JV will own and operate the facility under a 25-year contract for a fixed monthly fee. Saudi Aramco will supply feedstock to the JV, and the JV will produce power, hydrogen and other utilities for Saudi Aramco. +PENSION BENEFITS +The Company and certain of its subsidiaries sponsor defined benefit pension plans and defined contribution plans that cover a substantial portion of its worldwide employees. The principal defined benefit pension plans are the U.S. salaried pension plan and the U.K. pension plan. These plans were closed to new participants in 2005, after which defined contribution plans were offered to new employees. The shift to defined contribution plans is expected to continue to reduce volatility of both plan expense and contributions. +The fair market value of plan assets for our defined benefit pension plans as of the 30 September 2018 measurement date decreased to $4,273.1 from $4,409.2 at the end of fiscal year 2017 . The projected benefit obligation for these plans was $4,583.3 and $5,107.2 at the end of fiscal years 2018 and 2017 , respectively. The net unfunded liability decreased $387.8 from $698.0 to $310.2 , primarily due to higher discount rates and favorable asset experience. Refer to Note 16 , Retirement Benefits , to the consolidated financial statements for comprehensive and detailed disclosures on our postretirement benefits. +Pension Expense +2018 +2017 +2016 +Pension expense – Continuing operations +$91.8 +$72.0 +$55.8 +Settlements, termination benefits, and curtailments (included above) +48.9 +15.0 +6.0 +Weighted average discount rate – Service cost +3.2 +% +2.9 +% +4.1 +% +Weighted average discount rate – Interest cost +2.9 +% +2.5 +% +3.4 +% +Weighted average expected rate of return on plan assets +6.9 +% +7.4 +% +7.5 +% +Weighted average expected rate of compensation increase +3.5 +% +3.5 +% +3.5 +% +45 +Table of Contents +2018 vs. 2017 +Pension expense, excluding settlements, termination benefits, and curtailments ("special items"), decreased from the prior year primarily due to recognition of favorable asset experience, partially offset by lower expected returns on assets. In fiscal year 2018, special items of $48.9 included a pension settlement loss of $43.7 primarily resulting from the transfer of certain U.S. pension payment obligations to an insurer during the fourth quarter, $4.8 of pension settlement losses related to lump sum payouts from the U.S. Supplemental Pension Plan, and $.4 of termination benefits, all of which are reflected in "Other non-operating income (expense), net" on the consolidated income statements. +2017 vs. 2016 +Pension expense, excluding special items, increased from fiscal year 2016 primarily due to a decrease in the discount rate offset by favorable asset experience. Special items of $15.0 included pension settlement losses of $10.5 related to the U.S. Supplementary Pension Plan, as well as curtailment and termination benefits of $4.5. +2019 Outlook +In fiscal year 2019 , pension expense, excluding special items, is expected to be approximately $20 to $30. This results from lower loss amortization primarily due to favorable asset experience and the impact of higher discount rates, partially offset by lower expected returns on assets. Pension settlement losses of $10 to $15 are expected, depending on the timing of retirements. In fiscal year 2019, we expect pension expense to include approximately $75 for amortization of actuarial losses. In fiscal year 2018 , pension expense included amortization of actuarial losses of $128. Net actuarial gains of $232 were recognized in accumulated other comprehensive income in fiscal year 2018 . Actuarial gains/losses are amortized into pension expense over prospective periods to the extent they are not offset by future gains or losses. Future changes in the discount rate and actual returns on plan assets different from expected returns would impact the actuarial gains/losses and resulting amortization in years beyond fiscal year 2019 . +Subsequent Event – GMP Equalization +On 26 October 2018, the United Kingdom High Court issued a ruling in a case relating to equalization of pension plan participants’ benefits for the gender effects of Guaranteed Minimum Pensions ("GMP equalization"). The ruling relates to the Lloyds Banking Group pension plans but impacts other U.K. defined benefit pension plans. We are still assessing the impact of this ruling. If we determine that the ruling impacts our U.K. pension plan, the approach to achieve GMP equalization may retroactively increase our benefit obligation for some participants in the plan and may impact funding requirements. +Pension Funding +Pension funding includes both contributions to funded plans and benefit payments for unfunded plans, which are primarily non-qualified plans. With respect to funded plans, our funding policy is that contributions, combined with appreciation and earnings, will be sufficient to pay benefits without creating unnecessary surpluses. +In addition, we make contributions to satisfy all legal funding requirements while managing our capacity to benefit from tax deductions attributable to plan contributions. With the assistance of third party actuaries, we analyze the liabilities and demographics of each plan, which help guide the level of contributions. During 2018 and 2017 , our cash contributions to funded plans and benefit payments for unfunded plans were $68.3 and $64.1, respectively. +For fiscal year 2019 , cash contributions to defined benefit plans are estimated to be $45 to $65. The estimate is based on expected contributions to certain international plans and anticipated benefit payments for unfunded plans, which are dependent upon the timing of retirements. Actual future contributions will depend on future funding legislation, discount rates, investment performance, plan design, and various other factors. Refer to the Contractual Obligations discussion on pages 43-44 for a projection of future contributions. +ENVIRONMENTAL MATTERS +We are subject to various environmental laws and regulations in the countries in which we have operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, we are involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA: the federal Superfund law); Resource Conservation and Recovery Act (RCRA); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Our accounting policy for environmental expenditures is discussed in Note 1 , Major Accounting Policies , to the consolidated financial statements, and environmental loss contingencies are discussed in Note 17 , Commitments and Contingencies , to the consolidated financial statements. +46 +Table of Contents +The amounts charged to income from continuing operations related to environmental matters totaled $12.8 , $11.4 , and $12.2 in fiscal years 2018 , 2017 , and 2016 , respectively. These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet internal Company standards. Refer to Note 17 , Commitments and Contingencies , to the consolidated financial statements for additional information. +Although precise amounts are difficult to determine, we estimate that we spent $3 , $7 , and $3 in fiscal years 2018 , 2017 , and 2016 , respectively, on capital projects to control pollution. Capital expenditures to control pollution are estimated to be approximately $4 in both fiscal years 2019 and 2020 . +We accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The potential exposure for such costs is estimated to range from $76 to a reasonably possible upper exposure of $90 as of 30 September 2018 . The consolidated balance sheets at 30 September 2018 and 2017 included an accrual of $76.8 and $83.6 , respectively, primarily as part of other noncurrent liabilities. The accrual for the environmental obligations includes amounts for the Pace, Florida; Piedmont, South Carolina; and Pasadena, Texas, locations which were a part of previously divested chemicals businesses. Refer to Note 17 , Commitments and Contingencies , to the consolidated financial statements for further details on these facilities. +Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Subject to the imprecision in estimating future environmental costs, we do not expect that any sum we may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed above would have a material adverse impact on our financial position or results of operations in any one year. +Some of our operations are within jurisdictions that have or are developing regulatory regimes governing emissions of greenhouse gases ("GHG"), including carbon dioxide. These include existing coverage under the European Union Emission Trading system, the California cap and trade schemes, Alberta’s Carbon Competitiveness Incentive Regulation, China’s Emission Trading Scheme, South Korea’s Emission Trading Scheme, nation-wide expansion of the China Emission Trading Scheme, revisions to the Alberta regulation, and Environment Canada's developing Output Based Pricing System. In addition, the U.S. Environmental Protection Agency ("EPA") requires mandatory reporting of GHG emissions and is regulating GHG emissions for new construction and major modifications to existing facilities. Some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern may result in more international, U.S. federal, and/or regional requirements to reduce or mitigate the effects of GHG. Although uncertain, these developments could increase our costs related to consumption of electric power and hydrogen production. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +Regulation of GHG may also produce new opportunities for us. We continue to develop technologies to help our facilities and our customers lower energy consumption, improve efficiency, and lower emissions. We also have developed a portfolio of technologies that capture carbon dioxide from steam methane reforming, enable cleaner transportation fuels, and facilitate alternate fuel source development. In addition, the potential demand for clean coal could increase demand for oxygen, one of our main products, and our proprietary technology for delivering low-cost oxygen. +OFF-BALANCE SHEET ARRANGEMENTS +We have entered into certain guarantee agreements as discussed in Note 17 , Commitments and Contingencies , to the consolidated financial statements. In addition, we are not a primary beneficiary in any material variable interest entity. Our off-balance sheet arrangements are not reasonably likely to have a material impact on financial condition, changes in financial condition, results of operations, or liquidity. +47 +Table of Contents +RELATED PARTY TRANSACTIONS +We have related party sales to some of our equity affiliates and joint venture partners. Sales to related parties totaled approximately $340 , $580 , and $320 during fiscal years 2018 , 2017 , and 2016 , respectively, and primarily related to Jazan sale of equipment activity. Agreements with related parties include terms that are consistent with those that we believe would have been negotiated at an arm’s length with an independent party. +In addition, we completed the formation of Air Products Lu An (Changzhi) Co., Ltd., a 60%-owned JV with Lu'An Clean Energy Company ("Lu'An"), and the JV acquired gasification and syngas clean-up assets from Lu'An during the third quarter of 2018. In connection with the acquisition, Lu'An made a loan of 2.6 billion RMB to the JV, and we established a liability of 2.3 billion RMB for cash payments expected to be made to or on behalf of Lu'An in fiscal year 2019. As of 30 September 2018, long-term debt payable to Lu'An of 2.6 billion RMB ( $384 ) is presented on the consolidated balance sheets as " Long-term debt – related party ," and our expected remaining cash payments of approximately 2.2 billion RMB ( $330 ) are presented within "Payables and accrued liabilities." +INFLATION +We operate in many countries that experience volatility in inflation and foreign exchange rates. The ability to pass on inflationary cost increases is an uncertainty due to general economic conditions and competitive situations. It is estimated that the cost of replacing our plant and equipment today is greater than its historical cost. Accordingly, depreciation expense would be greater if the expense were stated on a current cost basis. +CRITICAL ACCOUNTING POLICIES AND ESTIMATES +Note 1 , Major Accounting Policies , to the consolidated financial statements describes our major accounting policies. Judgments and estimates of uncertainties are required in applying our accounting policies in many areas. However, application of the critical accounting policies discussed below requires management’s significant judgments, often as the result of the need to make estimates of matters that are inherently uncertain. If actual results were to differ materially from the estimates made, the reported results could be materially affected. Our management has reviewed these critical accounting policies and estimates and related disclosures with our audit committee. +Depreciable Lives of Plant and Equipment +Net plant and equipment at 30 September 2018 totaled $9,923.7 , and depreciation expense totaled $940.7 during fiscal year 2018 . Plant and equipment is recorded at cost and depreciated using the straight-line method, which deducts equal amounts of the cost of each asset from earnings every year over its estimated economic useful life. +Economic useful life is the duration of time an asset is expected to be productively employed by us, which may be less than its physical life. Assumptions on the following factors, among others, affect the determination of estimated economic useful life: wear and tear, obsolescence, technical standards, contract life, market demand, competitive position, raw material availability, and geographic location. +The estimated economic useful life of an asset is monitored to determine its appropriateness, especially in light of changed business circumstances. For example, changes in technology, changes in the estimated future demand for products, or excessive wear and tear may result in a shorter estimated useful life than originally anticipated. In these cases, we would depreciate the remaining net book value over the new estimated remaining life, thereby increasing depreciation expense per year on a prospective basis. Likewise, if the estimated useful life is increased, the adjustment to the useful life decreases depreciation expense per year on a prospective basis. +The regional Industrial Gases segments have numerous long-term customer supply contracts for which we construct an on-site plant adjacent to or near the customer’s facility. These contracts typically have initial contract terms of 10 to 20 years. Depreciable lives of the production assets related to long-term contracts are matched to the contract lives. Extensions to the contract term of supply frequently occur prior to the expiration of the initial term. As contract terms are extended, the depreciable life of the remaining net book value of the production assets is adjusted to match the new contract term, as long as it does not exceed the remaining physical life of the asset. +Our regional Industrial Gases segments also have contracts for liquid or gaseous bulk supply and, for smaller customers, packaged gases. The depreciable lives of production facilities associated with these contracts are +generally 15 years. These depreciable lives have been determined based on historical experience combined with judgment on future assumptions such as technological advances, potential obsolescence, competitors’ actions, etc. +48 +Table of Contents +In addition, we may purchase assets through transactions accounted for as either an asset acquisition or a business combination. Depreciable lives are assigned to acquired assets based on our historical experience with similar assets. Management monitors its assumptions and may potentially need to adjust depreciable life as circumstances change. +A change in the weighted average remaining depreciable life by one year for assets associated with our regional Industrial Gases segments would impact annual depreciation expense as summarized below: +Decrease Life +By 1 Year +Increase Life +By 1 Year +Industrial Gases – Regional +$45 +($39 +) +Impairment of Assets +Plant and Equipment +Plant and equipment meeting the held for sale criteria are reported at the lower of carrying amount or fair value less cost to sell. Plant and equipment held for use is grouped for impairment testing at the lowest level for which there is identifiable cash flows. Impairment testing of the asset group occurs whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Such circumstances would include a significant decrease in the market value of a long-lived asset grouping, a significant adverse change in the manner in which the asset grouping is being used or in its physical condition, an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the long-lived asset, a history of operating or cash flow losses associated with the use of the asset grouping, or changes in the expected useful life of the long-lived assets. +If such circumstances are determined to exist, an estimate of undiscounted future cash flows produced by that asset group is compared to the carrying value to determine whether impairment exists. If an asset group is determined to be impaired, the loss is measured based on the difference between the asset group’s fair value and its carrying value. An estimate of the asset group’s fair value is based on the discounted value of its estimated cash flows. +The assumptions underlying the undiscounted future cash flow projections require significant management judgment. Factors that management must estimate include industry and market conditions, sales volume and prices, costs to produce, inflation, etc. The assumptions underlying the cash flow projections represent management’s best estimates at the time of the impairment review. Changes in key assumptions or actual conditions that differ from estimates could result in an impairment charge. We use reasonable and supportable assumptions when performing impairment reviews and cannot predict the occurrence of future events and circumstances that could result in impairment charges. +In fiscal year 2018, there was no need to test for impairment on any of our asset groupings as no events or changes in circumstances indicated that the carrying amount of the asset groupings may not be recoverable. +In fiscal year 2017, we performed interim impairment testing of our Latin America reporting unit (LASA) long-lived assets and indefinite-lived intangible assets, including goodwill, as of 30 June 2017. See the 2017 Impairment Testing discussions under the Goodwill and Intangible Assets sections below . We also tested the recoverability of LASA's long-lived assets, including finite-lived intangible assets subject to amortization, and concluded that they were recoverable from expected future undiscounted cash flows. +In fiscal year 2016, the Board of Directors approved the Company’s exit of its EfW business. We assessed the recoverability of capital costs for the two projects associated with this business and recorded an impairment charge of $913.5 to reduce the carrying values of plant assets to their estimated net realizable value. We estimated the net realizable value of the projects assuming an orderly liquidation of assets capable of being marketed on a secondary equipment market based on market quotes and our experience with selling similar equipment. An asset’s orderly liquidation value is the amount that could be realized from a liquidation sale, given a reasonable period of time to find a buyer, selling the asset in the existing condition where it is located, and assuming the highest and best use of the asset by market participants. The loss was measured as the difference between the orderly liquidation value of the assets and the net book value of the assets. The loss was recorded in the results of discontinued operations. +49 +Table of Contents +During the first quarter of fiscal year 2017, we recorded an additional loss of $6.3 to update our estimate of the net realizable value of the plant assets. The loss was recorded in the results of discontinued operations. In fiscal year 2017, we also recorded a charge of $45.7 to write-down the air separation unit in the Industrials Gases – EMEA segment that was constructed mainly to provide oxygen to one of the EfW plants to its net realizable value of $1.4 . The charge was recorded in the results of continuing operations. The remaining assets associated with EfW were liquidated during fiscal year 2018 with no value remaining as of 30 September 2018. +Refer to Note 3 , Discontinued Operations , and Note 5 , Cost Reduction and Asset Actions , to the consolidated financial statements for additional information. +Goodwill +The acquisition method of accounting for business combinations requires us to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the net tangible and identifiable intangible assets. Goodwill represents the excess of the aggregate purchase price (plus the fair value of any noncontrolling interest and previously held equity interest in the acquiree) over the fair value of identifiable net assets of an acquired entity. Goodwill was $788.9 as of 30 September 2018 . Disclosures related to goodwill are included in Note 10 , Goodwill , to the consolidated financial statements. +We review goodwill for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that the carrying value of goodwill might not be recoverable. The tests are done at the reporting unit level, which is defined as being equal to or one level below the operating segment for which discrete financial information is available and whose operating results are reviewed by segment managers regularly. We have five business segments that are comprised of ten reporting units within seven operating segments. Refer to Note 25 , Business Segment and Geographic Information , for additional information. Reporting units are primarily based on products and subregions within each reportable segment. The majority of our goodwill is assigned to reporting units within our regional Industrial Gases segments. +As part of the goodwill impairment testing, we have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If we choose not to complete a qualitative assessment for a given reporting unit, or if the initial assessment indicates that it is more likely than not that the carrying value of a reporting unit exceeds its estimated fair value, a quantitative test is required. We choose to bypass the qualitative assessment and conduct quantitative testing to determine if the carrying value of the reporting unit exceeds its fair value. An impairment loss will be recognized for the amount by which the carrying value of the reporting unit exceeds its fair value, not to exceed the total amount of goodwill allocated to that reporting unit. +To determine the fair value of a reporting unit, we initially use an income approach valuation model, representing the present value of estimated future cash flows. Our valuation model uses a discrete growth period and an estimated exit trading multiple. The income approach is an appropriate valuation method due to our capital-intensive nature, the long-term contractual nature of our business, and the relatively consistent cash flows generated by our reporting units. The principal assumptions utilized in our income approach valuation model include revenue growth rates, operating profit and/or EBITDA margins, discount rate, and exit multiple. Projected revenue growth rates and operating profit and/or EBITDA assumptions are consistent with those utilized in our operating plan and/or revised forecasts and long-term financial planning process. The discount rate assumption is calculated based on an estimated market-participant risk-adjusted weighted-average cost of capital, which includes factors such as the risk-free rate of return, cost of debt, and expected equity premiums. The exit multiple is determined from comparable industry transactions and where appropriate, reflects expected long-term growth rates. +If our initial review under the income approach indicates there may be impairment, we incorporate results under the market approach to further evaluate the existence of impairment. When the market approach is utilized, fair value is estimated based on market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies and/or regional manufacturing companies engaged in the same or similar lines of business as the reporting unit, adjusted to reflect differences in size and growth prospects. When both the income and market approach are utilized, we review relevant facts and circumstances and make a qualitative assessment to determine the proper weighting. Management judgment is required in the determination of each assumption utilized in the valuation model, and actual results could differ from the estimates. +50 +Table of Contents +2018 Impairment Testing +During the fourth quarter of fiscal year 2018 , we conducted our annual goodwill impairment test. We determined that the fair value of all our reporting units substantially exceeded their carrying value except LASA, for which the fair value exceeded the carrying value by 8%. +The excess of fair value over carrying value for our reporting units other than LASA ranged from approximately 110% to approximately 280%. Management judgment is required in the determination of each assumption utilized in the valuation model, and actual results could differ from the estimates. In order to evaluate the sensitivity of the fair value calculation on the goodwill impairment test, we applied a hypothetical 10% decrease to the fair value of these reporting units. In this scenario, the fair value of our reporting units other than LASA continued to exceed their carrying value by a range of approximately 90% to 240%. +As of 30 September 2018, the carrying value of LASA goodwill was $65.6, or less than 1% of consolidated total assets. Further events that could have a negative impact on the level of excess fair value over carrying value of the reporting unit include but are not limited to a decline in market share, pricing pressures, and further economic weakening in the markets we serve. Revenue growth and EBITDA margin assumptions are two primary drivers of the fair value of LASA. We determined that, with other assumptions held constant, a decrease in revenue rates of approximately 230 basis points or a decrease in EBITDA margin of approximately 210 basis points would result in an impairment of the remaining goodwill balance. The carrying value of LASA's other material assets at 30 September 2018 included: Plant and equipment, net of $341.1; customer relationships of $152.1; and trade names and trademarks of $48.4. The trade names and trademarks are classified as indefinite-lived intangible assets. +Future events that could have a negative impact on the level of excess fair value over carrying value of the reporting units include, but are not limited to: long-term economic weakness, decline in market share, pricing pressures, inability to successfully implement cost improvement measures, increases to our cost of capital, and changes to the structure of our business as a result of future reorganizations or divestitures of assets or businesses. Negative changes in one or more of these factors, among others, could result in impairment charges. +2017 Impairment Testing +For the first nine months of fiscal year 2017, volumes declined in our LASA reporting unit, and overall revenue growth did not meet expectations. Due to weak economic conditions in Latin America and expectations for continued volume weakness in the Latin American countries and markets in which we operate, we lowered our long-term growth projections for LASA by more than 200 basis points, which also unfavorably impacted our EBITDA margin. Management considered the revised projections for LASA to be indicators of potential impairment and, accordingly, performed interim impairment testing of our long-lived assets and indefinite-lived intangible assets, including goodwill, as of 30 June 2017 utilizing the revised projections. LASA represented approximately 6% of the Company’s total revenue in 2017 with business units in Chile, Colombia, and other Latin America countries. +We estimated the fair value of LASA as of 30 June 2017 based on two valuation approaches, the income approach and the market approach, as described above. We reviewed relevant facts and circumstances in determining the weighting of the approaches. Under the income approach, we estimated the fair value of LASA based on management's estimates of revenue growth rates and EBITDA margins, taking into consideration business and market conditions for the Latin American countries and markets in which we operate. These estimates were consistent with our revised forecast and long-term financial planning processes, which included a reduction in sales growth by more than 200 basis points from that previously identified. We calculated the discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry-specific rates of return on debt and equity capital for a target industry capital structure, adjusted for risks associated with business size and geography. Under the market approach, we estimated fair value based on market multiples of revenue and earnings derived from publicly-traded industrial gases companies and regional manufacturing companies, adjusted to reflect differences in size and growth prospects. +Based on the results of the valuations, we determined that the goodwill associated with LASA was impaired and recorded a noncash impairment charge of $145.3, the amount by which the carrying value of the reporting unit exceeded its fair value, during the third quarter of 2017. This impairment is reflected on our consolidated income statements within “Goodwill and intangible asset impairment charge.” This charge was not deductible for tax purposes and is excluded from segment operating income. +51 +Table of Contents +Intangible Assets +Intangible assets, net with determinable lives at 30 September 2018 totaled $387.3 and consisted primarily of customer relationships, purchased patents and technology, and land use rights. These intangible assets are tested for impairment as part of the long-lived asset grouping impairment tests. Impairment testing of the asset group occurs whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. See the impairment discussion above under Plant and Equipment for a description of how impairment losses are determined. +Indefinite-lived intangible assets at 30 September 2018 totaled $51.2 and consisted of trade names and trademarks. Indefinite-lived intangibles are subject to impairment testing at least annually or more frequently if events or changes in circumstances indicate that potential impairment exists. The impairment test for indefinite-lived intangible assets involves calculating the fair value of the indefinite-lived intangible assets and comparing the fair value to their carrying value. If the fair value is less than the carrying value, the difference is recorded as an impairment loss. To determine fair value, we utilize the royalty savings method, a form of the income approach. This method values an intangible asset by estimating the royalties avoided through ownership of the asset. +Disclosures related to intangible assets other than goodwill are included in Note 11 , Intangible Assets , to the consolidated financial statements. +2018 Impairment Testing +In the fourth quarter of 2018, we conducted our annual impairment test of indefinite-lived intangibles which resulted in no impairment. +2017 Impairment Testing +During the third quarter of fiscal year 2017, we conducted an interim impairment test of the indefinite-lived intangible assets associated with LASA. We determined that the carrying value of trade names and trademarks was in excess of fair value, and as a result, we recorded a noncash impairment charge of $16.8 to reduce these indefinite-lived intangible assets to their fair value. This impairment charge has been excluded from segment operating income and is reflected on our consolidated income statements within “Goodwill and intangible asset impairment charge." +Equity Investments +Investments in and advances to equity affiliates totaled $1,277.2 at 30 September 2018 . The majority of our investments are non-publicly traded ventures with other companies in the industrial gas business. Summarized financial information of equity affiliates is included in Note 8 , Summarized Financial Information of Equity Affiliates , to the consolidated financial statements. Equity investments are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment may not be recoverable. +An impairment loss is recognized in the event that an other-than-temporary decline in fair value of an investment occurs. Management’s estimate of fair value of an investment is based on the income approach and/or market approach. We utilize estimated discounted future cash flows expected to be generated by the investee under the income approach. For the market approach, we utilize market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies. Changes in key assumptions about the financial condition of an investee or actual conditions that differ from estimates could result in an impairment charge. +During the third quarter of fiscal year 2017, Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (AHG), a 25% ‑owned equity affiliate in our Industrial Gases – EMEA segment, completed a review of its business plan and outlook. As a result of the revised business plan, we determined there was an other-than-temporary impairment of our investment in AHG and recorded a noncash impairment charge of $79.5 to reduce the carrying value of our investment. The impairment charge is reflected on our consolidated income statements within “Equity affiliates' income.” This charge was not deductible for tax purposes and has been excluded from segment results. +The decline in value resulted from expectations for lower future cash flows to be generated by AHG, primarily due to challenging economic conditions in Saudi Arabia, including the impacts of lower prices in the oil and gas industry, increased competition, and capital project growth opportunities not materializing as anticipated. +52 +Table of Contents +The AHG investment was valued based on the results of the income and market valuation approaches. The income approach utilized a discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry required rates of return on debt and equity capital for a target industry capital structure adjusted for risks associated with size and geography. Other significant estimates and assumptions that drove our updated valuation of AHG included revenue growth rates and profit margins that were lower than those upon acquisition and our assessment of AHG's business improvement plan effectiveness. Under the market approach, we estimated fair value based on market multiples of revenue and earnings derived from publicly-traded industrial gases companies engaged in similar lines of business, adjusted to reflect differences in size and growth prospects. +Revenue Recognition – Percentage-of-Completion Method +Revenue from equipment sale contracts is recorded primarily using the percentage-of-completion method. Under this method, revenue from the sale of major equipment, such as LNG heat exchangers and large air separation units, is primarily recognized based on costs incurred to date compared with total estimated costs to be incurred. We estimate the profit on a contract as the difference between the total estimated revenue and expected costs to complete the contract and recognize the profit over the life of the contract. +Accounting for contracts using the percentage-of-completion method requires management judgment relative to assessing risks and their impact on the estimate of revenues and costs. Our estimates are impacted by factors such as the potential for incentives or penalties on performance, schedule and technical issues, labor productivity, the complexity of work performed, the cost and availability of materials, and performance of subcontractors. When adjustments in estimated total contract revenues or estimated total costs are required, any changes in the estimated profit from prior estimates are recognized in the current period for the inception-to-date effect of such change. When estimates of total costs to be incurred on a contract exceed estimates of total revenues to be earned, a provision for the entire estimated loss on the contract is recorded in the period in which the loss is determined. +In addition to the typical risks associated with underlying performance of project procurement and construction activities, our Jazan large air separation unit sale of equipment project within our Industrial Gases – Global segment requires monitoring of risks associated with schedule, geography, and other aspects of the contract and their effects on our estimates of total revenues and total costs to complete the contract. +Changes in estimates on projects accounted for under the percentage-of-completion method, including the Jazan project, favorably impacted operating income by approximately $38 , $27 , and $20 in fiscal years 2018 , 2017 , and 2016 , respectively. Our changes in estimates would not have significantly impacted amounts recorded in prior years. +We assess the performance of our sale of equipment projects as they progress. Our earnings could be positively or negatively impacted by changes to our forecast of revenues and costs on these projects. +Income Taxes +We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities measured using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. At 30 September 2018 , accrued income taxes, including the amount recorded in noncurrent, was $244.0 and net deferred tax liabilities was $653.7 . Tax liabilities related to uncertain tax positions as of 30 September 2018 were $233.6 , excluding interest and penalties. Income tax expense for the year ended 30 September 2018 was $524.3 and includes a discrete net income tax expense of $180.6 related to the Tax Act. The net expense was recorded based on provisional estimates pursuant to the SEC Staff Accounting Bulletin No. 118. Subsequent adjustments, if any, will be accounted for in the period such adjustments are identified. Disclosures related to income taxes are included in Note 22 , Income Taxes , to the consolidated financial statements. +Management judgment is required concerning the ultimate outcome of tax contingencies and the realization of deferred tax assets. +Actual income taxes paid may vary from estimates, depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. We believe that our recorded tax liabilities adequately provide for these assessments. +53 +Table of Contents +Deferred tax assets are recorded for operating losses and tax credit carryforwards. However, when we do not expect sufficient sources of future taxable income to realize the benefit of the operating losses or tax credit carryforwards, these deferred tax assets are reduced by a valuation allowance. A valuation allowance is recognized if, based on the weight of available evidence, it is considered more likely than not that some portion or all of the deferred tax asset will not be realized. The factors used to assess the likelihood of realization include forecasted future taxable income and available tax planning strategies that could be implemented to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits. The effect of a change in the valuation allowance is reported in the income tax expense. +A 1% point increase/decrease in our effective tax rate would decrease/increase net income by approximately $20 . +Pension and Other Postretirement Benefits +The amounts recognized in the consolidated financial statements for pension and other postretirement benefits are determined on an actuarial basis utilizing numerous assumptions. The discussion that follows provides information on the significant assumptions and expense associated with the defined benefit plans. +Actuarial models are used in calculating the expense and liability related to the various defined benefit plans. These models have an underlying assumption that the employees render service over their service lives on a relatively consistent basis; therefore, the expense of benefits earned should follow a similar pattern. +Several assumptions and statistical variables are used in the models to calculate the expense and liability related to the plans. We determine assumptions about the discount rate, the expected rate of return on plan assets, and the rate of compensation increase. Note 16 , Retirement Benefits , to the consolidated financial statements includes disclosure of these rates on a weighted-average basis for both the U.S. and international plans. The actuarial models also use assumptions about demographic factors such as retirement age, mortality, and turnover rates. Mortality rates are based on the most recent U.S. and international mortality tables. We believe the actuarial assumptions are reasonable. However, actual results could vary materially from these actuarial assumptions due to economic events and different rates of retirement, mortality, and turnover. +One of the assumptions used in the actuarial models is the discount rate used to measure benefit obligations. This rate reflects the prevailing market rate for high-quality, fixed-income debt instruments with maturities corresponding to the expected timing of benefit payments as of the annual measurement date for each of the various plans. The Company measures the service cost and interest cost components of pension expense by applying spot rates along the yield curve to the relevant projected cash flows. The rates along the yield curve are used to discount the future cash flows of benefit obligations back to the measurement date. These rates change from year to year based on market conditions that affect corporate bond yields. A higher discount rate decreases the present value of the benefit obligations and results in lower pension expense. A 50 bp increase/decrease in the discount rate decreases/increases pension expense by approximately $32 per year. +The expected rate of return on plan assets represents an estimate of the average rate of return to be earned by plan assets over the period that the benefits included in the benefit obligation are to be paid. The expected return on plan assets assumption is based on a weighted average of estimated long-term returns of major asset classes and the historical performance of plan assets. In determining estimated asset class returns, we take into account historical and future expected long-term returns and the value of active management, as well as the interest rate environment. Asset allocation is determined based on long-term return, volatility and correlation characteristics of the asset classes, the profiles of the plans’ liabilities, and acceptable levels of risk. Lower returns on the plan assets result in higher pension expense. A 50 bp increase/decrease in the estimated rate of return on plan assets decreases/increases pension expense by approximately $21 per year. +We use a market-related valuation method for recognizing certain investment gains or losses for our significant pension plans. Investment gains or losses are the difference between the expected return and actual return on plan assets. The expected return on plan assets is determined based on a market-related value of plan assets. For equities, this is a calculated value that recognizes investment gains and losses in fair value related to equities over a five-year period from the year in which they occur and reduces year-to-year volatility. The market-related value for fixed income investments equals the actual fair value. Expense in future periods will be impacted as gains or losses are recognized in the market-related value of assets. +The expected rate of compensation increase is another key assumption. We determine this rate based on review of the underlying long-term salary increase trend characteristic of labor markets and historical experience, as well as comparison to peer companies. A 50 bp increase/decrease in the expected rate of compensation increases/decreases pension expense by approximately $11 per year. +54 +Table of Contents +Loss Contingencies +In the normal course of business, we encounter contingencies, or situations involving varying degrees of uncertainty as to the outcome and effect on the Company. We accrue a liability for loss contingencies when it is considered probable that a liability has been incurred and the amount of loss can be reasonably estimated. When only a range of possible loss can be established, the most probable amount in the range is accrued. If no amount within +this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. +Contingencies include those associated with litigation and environmental matters, for which our accounting policy is discussed in Note 1 , Major Accounting Policies , to the consolidated financial statements, and details are provided in Note 17 , Commitments and Contingencies , to the consolidated financial statements. Significant judgment is required to determine both the probability and whether the amount of loss associated with a contingency can be reasonably estimated. These determinations are made based on the best available information at the time. As additional information becomes available, we reassess probability and estimates of loss contingencies. Revisions to the estimates associated with loss contingencies could have a significant impact on our results of operations in the period in which an accrual for loss contingencies is recorded or adjusted. For example, due to the inherent uncertainties related to environmental exposures, a significant increase to environmental liabilities could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or our proportionate share is increased. Similarly, a future charge for regulatory fines or damage awards associated with litigation could have a significant impact on our net income in the period in which it is recorded. +NEW ACCOUNTING GUIDANCE +See Note 2 , New Accounting Guidance , to the consolidated financial statements for information concerning the implementation and impact of new accounting guidance. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Our earnings, cash flows, and financial position are exposed to market risks relating to fluctuations in interest rates and foreign currency exchange rates. It is our policy to minimize our cash flow exposure to adverse changes in currency exchange rates and to manage the financial risks inherent in funding with debt capital. +We address these financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. We have established counterparty credit guidelines and generally enter into +transactions with financial institutions of investment grade or better, thereby minimizing the risk of credit loss. All instruments are entered into for other than trading purposes. For details on the types and use of these derivative instruments and the major accounting policies, see Note 1 , Major Accounting Policies , and Note 13 , Financial Instruments , to the consolidated financial statements, for additional information. Additionally, we mitigate adverse energy price impacts through our cost pass-through contracts with customers and price increases. +Our derivative and other financial instruments consist of long-term debt (including current and related party portions), interest rate swaps, cross currency interest rate swaps, and foreign exchange-forward contracts. The net market value of these financial instruments combined is referred to below as the net financial instrument position and is disclosed in Note 14, Fair Value Measurements, to the consolidated financial statements. At 30 September 2018 and 2017 , the net financial instrument position was a liability of $3,736.2 and $3,832.3, respectively. +The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market rates and prices. Market values are the present value of projected future cash flows based on the market rates and prices chosen. The market values for interest rate risk and foreign currency risk are calculated by us using a third-party software model that utilizes standard pricing models to determine the present value of the instruments based on market conditions (interest rates, spot and forward exchange rates, and implied volatilities) as of the valuation date. +55 +Table of Contents +Interest Rate Risk +Our debt portfolio as of 30 September 2018, including the effect of currency and interest rate swap agreements, was composed of 66% fixed-rate debt and 34% variable-rate debt. Our debt portfolio as of 30 September 2017, including the effect of currency and interest rate swap agreements, was composed of 65% fixed-rate debt and 35% variable-rate debt. +The sensitivity analysis related to the interest rate risk on the fixed portion of our debt portfolio assumes an instantaneous 100 bp move in interest rates from the level at 30 September 2018 , with all other variables held constant. A 100 bp increase in market interest rates would result in a decrease of $96 and $112 in the net liability position of financial instruments at 30 September 2018 and 2017 , respectively. A 100 bp decrease in market interest rates would result in an increase of $101 and $119 in the net liability position of financial instruments at 30 September 2018 and 2017 , respectively. +Based on the variable-rate debt included in our debt portfolio, including the interest rate swap agreements, a 100 bp increase in interest rates would result in an additional $13 and $14 of interest incurred per year at the end of 30 September 2018 and 2017, respectively. A 100 bp decline in interest rates would lower interest incurred by $13 and $14 per year at 30 September 2018 and 2017, respectively. +Foreign Currency Exchange Rate Risk +The sensitivity analysis related to foreign currency exchange rates assumes an instantaneous 10% change in the foreign currency exchange rates from their levels at 30 September 2018 and 2017 , with all other variables held constant. A 10% strengthening or weakening of the functional currency of an entity versus all other currencies would result in a decrease or increase, respectively, of $329 and $312 in the net liability position of financial instruments at 30 September 2018 and 2017 , respectively. +The primary currency pairs for which we have exchange rate exposure are the Euro and U.S. Dollar and Chinese Renminbi and U.S. Dollar. Foreign currency debt, cross currency interest rate swaps, and foreign exchange-forward contracts are used in countries where we do business, thereby reducing our net asset exposure. Foreign exchange-forward contracts and cross currency interest rate swaps are also used to hedge our firm and highly anticipated foreign currency cash flows. Thus, there is either an asset/liability or cash flow exposure related to all of the financial instruments in the above sensitivity analysis for which the impact of a movement in exchange rates would be in the opposite direction and materially equal to the impact on the instruments in the analysis. +The majority of the Company’s sales are derived from outside of the United States and denominated in foreign currencies. Financial results therefore will be affected by changes in foreign currency rates. The Chinese Renminbi and the Euro represent the largest exposures in terms of our foreign earnings. We estimate that a 10% reduction in either the Chinese Renminbi or the Euro versus the U.S. Dollar would lower our annual operating income by approximately $30 and $25, respectively. +56 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Air Products’ management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting, which is defined in the following sentences, is a process designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that: +(i) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(ii) +provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(iii) +provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of inherent limitations, internal control over financial reporting can only provide reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions, the effectiveness of our internal control over financial reporting may vary over time. Our processes contain self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified. +Management has evaluated the effectiveness of its internal control over financial reporting based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management concluded that, as of 30 September 2018 , the Company’s internal control over financial reporting was effective. +KPMG LLP, an independent registered public accounting firm, has issued its opinion on the Company’s internal control over financial reporting as of 30 September 2018 as stated in its report which appears herein. +/s/ Seifi Ghasemi +/s/ M. Scott Crocco +Seifi Ghasemi +M. Scott Crocco +Chairman, President, and +Executive Vice President and +Chief Executive Officer +Chief Financial Officer +20 November 2018 +20 November 2018 +57 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Shareholders and Board of Directors of Air Products and Chemicals, Inc.: +Opinions on the Consolidated Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Air Products and Chemicals, Inc. and Subsidiaries (the Company) as of 30 September 2018 and 2017, the related consolidated income statements, consolidated comprehensive income statements, consolidated statements of cash flows and consolidated statements of equity for each of the years in the three-year period ended 30 September 2018, and the related notes and the financial statement schedule referred to in Item 15(a)(2) in this Form 10-K (collectively, the consolidated financial statements). We also have audited the Company’s internal control over financial reporting as of 30 September 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of 30 September 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended 30 September 2018, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of 30 September 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Report on Internal Control over Financial Reporting”. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +We have served as the Company’s auditor since 2002. +Philadelphia, Pennsylvania +20 November 2018 +58 +Table of Contents +The Consolidated Financial Statements +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED INCOME STATEMENTS +Year ended 30 September (Millions of dollars, except for share and per share data) +2018 +2017 +2016 +Sales +$ 8,930.2 +$ 8,187.6 +$ 7,503.7 +Cost of sales +6,189.5 +5,751.5 +5,177.3 +Selling and administrative +760.8 +713.5 +683.8 +Research and development +64.5 +57.6 +71.8 +Business separation costs +— +32.5 +50.6 +Cost reduction and asset actions +— +151.4 +34.5 +Goodwill and intangible asset impairment charge +— +162.1 +— +Other income (expense), net +50.2 +121.0 +49.4 +Operating Income +1,965.6 +1,440.0 +1,535.1 +Equity affiliates' income +174.8 +80.1 +147.0 +Interest expense +130.5 +120.6 +115.2 +Other non-operating income (expense), net +5.1 +16.6 +( 5.4 +) +Loss on extinguishment of debt +— +— +6.9 +Income From Continuing Operations Before Taxes +2,015.0 +1,416.1 +1,554.6 +Income tax provision +524.3 +260.9 +432.6 +Income From Continuing Operations +1,490.7 +1,155.2 +1,122.0 +Income (Loss) From Discontinued Operations, net of tax +42.2 +1,866.0 +( 460.5 +) +Net Income +1,532.9 +3,021.2 +661.5 +Net Income Attributable to Noncontrolling Interests of Continuing Operations +35.1 +20.8 +22.5 +Net Income Attributable to Noncontrolling Interests of Discontinued Operations +— +— +7.9 +Net Income Attributable to Air Products +$ 1,497.8 +$ 3,000.4 +$ 631.1 +Net Income Attributable to Air Products +Income from continuing operations +$ 1,455.6 +$ 1,134.4 +$ 1,099.5 +Income (Loss) from discontinued operations +42.2 +1,866.0 +( 468.4 +) +Net Income Attributable to Air Products +$ 1,497.8 +$ 3,000.4 +$ 631.1 +Basic Earnings Per Common Share Attributable to Air Products +Income from continuing operations +$ 6.64 +$ 5.20 +$ 5.08 +Income (Loss) from discontinued operations +.19 +8.56 +( 2.16 +) +Net Income Attributable to Air Products +$ 6.83 +$ 13.76 +$ 2.92 +Diluted Earnings Per Common Share Attributable to Air Products +Income from continuing operations +$ 6.59 +$ 5.16 +$ 5.04 +Income (Loss) from discontinued operations +.19 +8.49 +( 2.15 +) +Net Income Attributable to Air Products +$ 6.78 +$ 13.65 +$ 2.89 +Weighted Average Common Shares — Basic (in millions) +219.3 +218.0 +216.4 +Weighted Average Common Shares — Diluted (in millions) +220.8 +219.8 +218.3 +The accompanying notes are an integral part of these statements. +59 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED COMPREHENSIVE INCOME STATEMENTS +Year ended 30 September (Millions of dollars) +2018 +2017 +2016 +Net Income +$ 1,532.9 +$ 3,021.2 +$ 661.5 +Other Comprehensive Income (Loss), net of tax: +Translation adjustments, net of tax of $1.1, ($19.3), and ($19.8) +( 244.6 +) +101.9 +9.9 +Net gain (loss) on derivatives, net of tax of $9.7, ($11.0), and $9.1 +45.9 +( 12.6 +) +13.7 +Pension and postretirement benefits, net of tax of $55.2, $109.0, and ($157.4) +179.4 +251.6 +( 335.1 +) +Reclassification adjustments: +Currency translation adjustment +3.1 +57.3 +2.7 +Derivatives, net of tax of ($9.2), $11.7, and ($9.4) +( 30.4 +) +24.2 +( 36.0 +) +Pension and postretirement benefits, net of tax of $44.9, $50.7, and $43.0 +133.1 +110.7 +87.2 +Total Other Comprehensive Income (Loss) +86.5 +533.1 +( 257.6 +) +Comprehensive Income +1,619.4 +3,554.3 +403.9 +Net Income Attributable to Noncontrolling Interests +35.1 +20.8 +30.4 +Other Comprehensive Income (Loss) Attributable to Noncontrolling Interests +( 19.0 +) +3.7 +4.8 +Comprehensive Income Attributable to Air Products +$ 1,603.3 +$ 3,529.8 +$ 368.7 +The accompanying notes are an integral part of these statements. +60 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED BALANCE SHEETS +30 September (Millions of dollars, except for share and per share data) +2018 +2017 +Assets +Current Assets +Cash and cash items +$ 2,791.3 +$ 3,273.6 +Short-term investments +184.7 +404.0 +Trade receivables, net +1,207.2 +1,174.0 +Inventories +396.1 +335.4 +Contracts in progress, less progress billings +77.5 +84.8 +Prepaid expenses +129.6 +191.4 +Other receivables and current assets +295.8 +403.3 +Current assets of discontinued operations +— +10.2 +Total Current Assets +5,082.2 +5,876.7 +Investment in net assets of and advances to equity affiliates +1,277.2 +1,286.9 +Plant and equipment, net +9,923.7 +8,440.2 +Goodwill, net +788.9 +721.5 +Intangible assets, net +438.5 +368.3 +Noncurrent capital lease receivables +1,013.3 +1,131.8 +Other noncurrent assets +654.5 +641.8 +Total Noncurrent Assets +14,096.1 +12,590.5 +Total Assets +$ 19,178.3 +$ 18,467.2 +Liabilities and Equity +Current Liabilities +Payables and accrued liabilities +$ 1,817.8 +$ 1,814.3 +Accrued income taxes +59.6 +98.6 +Short-term borrowings +54.3 +144.0 +Current portion of long-term debt +406.6 +416.4 +Current liabilities of discontinued operations +— +15.7 +Total Current Liabilities +2,338.3 +2,489.0 +Long-term debt +2,967.4 +3,402.4 +Long-term debt – related party +384.3 +— +Other noncurrent liabilities +1,536.9 +1,611.9 +Deferred income taxes +775.1 +778.4 +Total Noncurrent Liabilities +5,663.7 +5,792.7 +Total Liabilities +8,002.0 +8,281.7 +Commitments and Contingencies – See Note 17 +Air Products Shareholders’ Equity +Common stock (par value $1 per share; issued 2018 and 2017 - 249,455,584 shares) +249.4 +249.4 +Capital in excess of par value +1,029.3 +1,001.1 +Retained earnings +13,409.9 +12,846.6 +Accumulated other comprehensive loss +( 1,741.9 +) +( 1,847.4 +) +Treasury stock, at cost (2018 - 29,940,339 shares; 2017 - 31,109,510 shares) +( 2,089.2 +) +( 2,163.5 +) +Total Air Products Shareholders' Equity +10,857.5 +10,086.2 +Noncontrolling Interests +318.8 +99.3 +Total Equity +11,176.3 +10,185.5 +Total Liabilities and Equity +$ 19,178.3 +$ 18,467.2 +The accompanying notes are an integral part of these statements. +61 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED STATEMENTS OF CASH FLOWS +Year ended 30 September (Millions of dollars) +2018 +2017 +2016 +Operating Activities +Net income +$ 1,532.9 +$ 3,021.2 +$ 661.5 +Less: Net income attributable to noncontrolling interests of continuing operations +35.1 +20.8 +22.5 +Less: Net income attributable to noncontrolling interests of discontinued operations +— +— +7.9 +Net income attributable to Air Products +1,497.8 +3,000.4 +631.1 +(Income) Loss from discontinued operations +( 42.2 +) +( 1,866.0 +) +468.4 +Income from continuing operations attributable to Air Products +1,455.6 +1,134.4 +1,099.5 +Adjustments to reconcile income to cash provided by operating activities: +Depreciation and amortization +970.7 +865.8 +854.6 +Deferred income taxes +( 55.4 +) +( 38.0 +) +61.8 +Loss on extinguishment of debt +— +— +6.9 +Tax reform repatriation +240.6 +— +— +Undistributed earnings of unconsolidated affiliates +( 52.3 +) +( 60.1 +) +( 51.1 +) +Gain on sale of assets and investments +( 6.9 +) +( 24.3 +) +( 7.3 +) +Share-based compensation +38.8 +39.9 +31.0 +Noncurrent capital lease receivables +97.4 +92.2 +85.5 +Goodwill and intangible asset impairment charge +— +162.1 +— +Equity method investment impairment charge +— +79.5 +— +Write-down of long-lived assets associated with cost reduction actions +— +69.2 +— +Other adjustments +131.6 +165.4 +156.7 +Working capital changes that provided (used) cash, excluding effects of acquisitions and divestitures: +Trade receivables +( 42.8 +) +( 73.6 +) +( 44.8 +) +Inventories +( 64.2 +) +6.4 +32.2 +Contracts in progress, less progress billings +4.7 +( 19.3 +) +28.2 +Other receivables +123.6 +124.7 +( 6.7 +) +Payables and accrued liabilities +( 277.7 +) +163.8 +60.1 +Other working capital +( 9.0 +) +( 154.0 +) +( 47.8 +) +Cash Provided by Operating Activities +2,554.7 +2,534.1 +2,258.8 +Investing Activities +Additions to plant and equipment +( 1,568.4 +) +( 1,039.7 +) +( 907.7 +) +Acquisitions, less cash acquired +( 345.4 +) +( 8.2 +) +— +Investment in and advances to unconsolidated affiliates +— +( 8.1 +) +— +Proceeds from sale of assets and investments +48.8 +42.5 +44.6 +Purchases of investments +( 530.3 +) +( 2,692.6 +) +— +Proceeds from investments +748.2 +2,290.7 +— +Other investing activities +( 2.0 +) +( 2.3 +) +( 1.7 +) +Cash Used for Investing Activities +( 1,649.1 +) +( 1,417.7 +) +( 864.8 +) +Financing Activities +Long-term debt proceeds +.5 +2.4 +386.9 +Payments on long-term debt +( 418.7 +) +( 483.9 +) +( 480.4 +) +Net decrease in commercial paper and short-term borrowings +( 78.5 +) +( 798.6 +) +( 144.2 +) +Dividends paid to shareholders +( 897.8 +) +( 787.9 +) +( 721.2 +) +Proceeds from stock option exercises +76.2 +68.4 +141.3 +Other financing activities +( 41.5 +) +( 41.3 +) +( 42.6 +) +Cash Used for Financing Activities +( 1,359.8 +) +( 2,040.9 +) +( 860.2 +) +Discontinued Operations +Cash (used for) provided by operating activities +( 12.8 +) +( 966.2 +) +401.9 +Cash (used for) provided by investing activities +18.6 +3,750.6 +( 204.2 +) +Cash provided by financing activities +— +69.5 +555.9 +Cash Provided by Discontinued Operations +5.8 +2,853.9 +753.6 +Effect of Exchange Rate Changes on Cash +( 33.9 +) +13.4 +7.5 +(Decrease) Increase in cash and cash items +( 482.3 +) +1,942.8 +1,294.9 +Cash and Cash items – Beginning of Year +3,273.6 +1,330.8 +206.4 +Cash and Cash Items – End of Period +$ 2,791.3 +$ 3,273.6 +$ 1,501.3 +Less: Cash and Cash Items – Discontinued Operations +$ — +$ — +$ 208.1 +Cash and Cash Items – Continuing Operations +$ 2,791.3 +$ 3,273.6 +$ 1,293.2 +The accompanying notes are an integral part of these statements. +62 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED STATEMENTS OF EQUITY +Year ended 30 September +(Millions of dollars) +Common +Stock +Capital +in Excess +of Par +Value +Retained +Earnings +Accumulated +Other +Comprehensive +Income (Loss) +Treasury +Stock +Air Products +Shareholders’ +Equity +Non- +controlling +Interests +Total +Equity +Balance 30 September 2015 +$ 249.4 +$ 904.7 +$ 10,580.4 +($ 2,125.9 +) +($ 2,359.6 +) +$ 7,249.0 +$ 132.1 +$ 7,381.1 +Net income +— +— +631.1 +— +— +631.1 +30.4 +661.5 +Other comprehensive income (loss) +— +— +— +( 262.4 +) +— +( 262.4 +) +4.8 +( 257.6 +) +Dividends on common stock (per share $3.39) +— +— +( 733.7 +) +— +— +( 733.7 +) +— +( 733.7 +) +Dividends to noncontrolling interests +— +— +— +— +— +— +( 33.6 +) +( 33.6 +) +Share-based compensation +— +37.6 +— +— +— +37.6 +— +37.6 +Issuance of treasury shares for stock option and award plans +— +( 5.5 +) +— +— +132.6 +127.1 +— +127.1 +Tax benefit of stock option and award plans +— +33.2 +— +— +— +33.2 +— +33.2 +Other equity transactions +— +— +( 2.3 +) +— +— +( 2.3 +) +.1 +( 2.2 +) +Balance 30 September 2016 +$ 249.4 +$ 970.0 +$ 10,475.5 +($ 2,388.3 +) +($ 2,227.0 +) +$ 7,079.6 +$ 133.8 +$ 7,213.4 +Net income +— +— +3,000.4 +— +— +3,000.4 +20.8 +3,021.2 +Other comprehensive income +— +— +— +529.4 +— +529.4 +3.7 +533.1 +Dividends on common stock (per share $3.71) +— +— +( 808.5 +) +— +— +( 808.5 +) +— +( 808.5 +) +Dividends to noncontrolling interests +— +— +— +— +— +— +( 28.0 +) +( 28.0 +) +Share-based compensation +— +40.7 +— +— +— +40.7 +— +40.7 +Issuance of treasury shares for stock option and award plans +— +( 9.6 +) +— +— +63.5 +53.9 +— +53.9 +Spin-off of Versum +— +— +175.0 +11.5 +— +186.5 +( 33.9 +) +152.6 +Cumulative change in accounting principle +— +— +8.8 +— +— +8.8 +— +8.8 +Other equity transactions +— +— +( 4.6 +) +— +— +( 4.6 +) +2.9 +( 1.7 +) +Balance 30 September 2017 +$ 249.4 +$ 1,001.1 +$ 12,846.6 +($ 1,847.4 +) +($ 2,163.5 +) +$ 10,086.2 +$ 99.3 +$ 10,185.5 +Net income +— +— +1,497.8 +— +— +1,497.8 +35.1 +1,532.9 +Other comprehensive income (loss) +— +— +— +105.5 +— +105.5 +( 19.0 +) +86.5 +Dividends on common stock (per share $4.25) +— +— +( 931.8 +) +— +— +( 931.8 +) +— +( 931.8 +) +Dividends to noncontrolling interests +— +— +— +— +— +( 29.9 +) +( 29.9 +) +Share-based compensation +— +38.1 +— +— +— +38.1 +— +38.1 +Issuance of treasury shares for stock option and award plans +— +( 11.3 +) +— +— +74.3 +63.0 +— +63.0 +Lu'An joint venture +— +— +— +— +— +— +227.4 +227.4 +Other equity transactions +— +1.4 +( 2.7 +) +— +— +( 1.3 +) +5.9 +4.6 +Balance 30 September 2018 +$ 249.4 +$ 1,029.3 +$ 13,409.9 +($ 1,741.9 +) +($ 2,089.2 +) +$ 10,857.5 +$ 318.8 +$ 11,176.3 +The accompanying notes are an integral part of these statements. +63 +Table of Contents +NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS +(Millions of dollars, except for share and per share data) +1 +. +Major Accounting Policies +65 +2 +. +New Accounting Guidance +71 +3 +. +Discontinued Operations +74 +4 +. +Materials Technologies Separation +77 +5 +. +Cost Reduction and Asset Actions +77 +6 +. +Acquisitions +78 +7 +. +Inventories +79 +8 +. +Summarized Financial Information of Equity Affiliates +79 +9 +. +Plant and Equipment, net +81 +10 +. +Goodwill +81 +11 +. +Intangible Assets +82 +12 +. +Leases +83 +13 +. +Financial Instruments +85 +14 +. +Fair Value Measurements +89 +15 +. +Debt +91 +16 +. +Retirement Benefits +93 +17 +. +Commitments and Contingencies +101 +18 +. +Capital Stock +104 +19 +. +Share-Based Compensation +105 +20 +. +Accumulated Other Comprehensive Loss +108 +21 +. +Earnings per Share +109 +22 +. +Income Taxes +110 +23 +. +Supplemental Information +115 +24 +. +Summary by Quarter (Unaudited) +117 +25 +. +Business Segment and Geographic Information +119 +64 +Table of Contents +1 . MAJOR ACCOUNTING POLICIES +Basis of Presentation and Consolidation Principles +The accompanying consolidated financial statements of Air Products and Chemicals, Inc. were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Air Products and Chemicals, Inc. and those of its controlled subsidiaries (“we,” “our,” “us,” the “Company,” “Air Products,” or “registrant”), which are generally majority owned. Intercompany transactions and balances are eliminated in consolidation. +We consolidate all entities that we control. The general condition for control is ownership of a majority of the voting interests of an entity. Control may also exist in arrangements where we are the primary beneficiary of a variable interest entity (VIE). An entity that has both the power to direct the activities that most significantly impact the economic performance of a VIE and the obligation to absorb losses or receive benefits significant to the VIE is considered the primary beneficiary of that entity. We have determined that we are not a primary beneficiary in any material VIE. +The results of operations and cash flows for our discontinued operations have been segregated from the results of continuing operations and segment results for all periods presented. The assets and liabilities of the discontinued operations are segregated in the consolidated balance sheets. The comprehensive income related to discontinued operations has not been segregated and is included in the consolidated comprehensive income statement for all periods presented. Refer to Note 3 , Discontinued Operations , for detail of the businesses presented in discontinued operations. +The notes to the consolidated financial statements, unless otherwise indicated, are on a continuing operations basis. The term "total company" includes both continuing and discontinued operations. +Reclassifications +The consolidated financial statements and accompanying notes reflect accounting guidance that was adopted during fiscal year 2018 . Refer to Note 2 , New Accounting Guidance , for additional information. Certain prior year information has been reclassified to conform to the fiscal year 2018 presentation. +Estimates and Assumptions +The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. +Revenue Recognition +Revenue from product sales is recognized as risk and title to the product transfer to the customer (which generally occurs at the time shipment is made), the sales price is fixed or determinable, and collectability is reasonably assured. Sales returns and allowances are not a business practice in the industry. +Revenue from equipment sale contracts is recorded primarily using the percentage-of-completion method. Under this method, revenue from the sale of major equipment, such as liquefied natural gas (LNG) heat exchangers and large air separation units, is primarily recognized based on costs incurred to date compared with total estimated costs to be incurred. When adjustments in estimated total contract revenues or estimated total costs are required, any changes in the estimated profit from prior estimates are recognized in the current period for the inception-to-date effect of such change. Changes in estimates on projects accounted for under the percentage-of-completion method favorably impacted operating income by approximately $ 38 , $ 27 , and $ 20 in fiscal years 2018 , 2017 , and 2016 , respectively. Our changes in estimates would not have significantly impacted amounts recorded in prior years. +Certain contracts associated with facilities that are built to provide product to a specific customer are required to be accounted for as leases. In cases where operating lease treatment is appropriate, there is no difference in revenue recognition over the life of the contract as compared to accounting for the contract as product sales. In cases where capital lease treatment is appropriate, the timing of revenue and expense recognition is impacted. Revenue and expense are recognized up front for the sale of equipment component of the contract as compared to revenue recognition over the life of the arrangement under contracts not qualifying as capital leases. Additionally, a portion of the revenue representing interest income from the financing component of the lease receivable is reflected as sales over the life of the contract. Allowances for credit losses associated with capital lease receivables are recorded using the specific identification method. As of 30 September 2018 and 2017 , the credit quality of capital lease receivables did not require a material allowance for credit losses. +65 +Table of Contents +If an arrangement involves multiple deliverables, the delivered items are considered separate units of accounting if the items have value on a stand-alone basis. Revenues are allocated to each deliverable based upon relative selling prices derived from company specific evidence. +Amounts billed for shipping and handling fees are classified as sales in the consolidated income statements. +Amounts billed for sales and use taxes, value-added taxes, and certain excise and other specific transactional taxes imposed on revenue-producing transactions are presented on a net basis and excluded from sales in the consolidated income statements. We record a liability until remitted to the respective taxing authority. +Cost of Sales +Cost of sales predominantly represents the cost of tangible products sold. These costs include labor, raw materials, plant engineering, power, depreciation, production supplies and materials packaging costs, and maintenance costs. Costs incurred for shipping and handling are also included in cost of sales. +Depreciation +Depreciation is recorded using the straight-line method, which deducts equal amounts of the cost of each asset from earnings every year over its expected economic useful life. The principal lives for major classes of plant and equipment are summarized in Note 9 , Plant and Equipment, net . +Selling and Administrative +The principal components of selling and administrative expenses are compensation, advertising, and promotional costs. Selling and administrative expenses also include costs for functional support previously provided to the former Electronic Materials and Performance Materials Divisions and in support of transition services agreements with Versum and with Evonik, for which the reimbursement is reflected in "Other income (expense), net" on our consolidated income statements. +Postemployment Benefits +We provide termination benefits to employees as part of ongoing benefit arrangements and record a liability for termination benefits when probable and estimable. These criteria are met when management, with the appropriate level of authority, approves and commits to its plan of action for termination; the plan identifies the employees to be terminated and their related benefits; and the plan is to be completed within one year. We do not provide material one-time benefit arrangements. +Fair Value Measurements +We are required to measure certain assets and liabilities at fair value, either upon initial measurement or for subsequent accounting or reporting. For example, fair value is used in the initial measurement of assets and liabilities acquired in a business combination; on a recurring basis in the measurement of derivative financial instruments; and on a nonrecurring basis when long-lived assets are written down to fair value when held for sale or determined to be impaired. Refer to Note 14 , Fair Value Measurements , and Note 16 , Retirement Benefits, for information on the methods and assumptions used in our fair value measurements. +Financial Instruments +We address certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. The types of derivative financial instruments permitted for such risk management programs are specified in policies set by management. Refer to Note 13 , Financial Instruments , for further detail on the types and use of derivative instruments into which we enter. +Major financial institutions are counterparties to all of these derivative contracts. We have established counterparty credit guidelines and generally enter into transactions with financial institutions of investment grade or better. Management believes the risk of incurring losses related to credit risk is remote, and any losses would be immaterial to the consolidated financial results, financial condition, or liquidity. +We recognize derivatives on the balance sheet at fair value. On the date the derivative instrument is entered into, we generally designate the derivative as either (1) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge), (2) a hedge of a net investment in a foreign operation (net investment hedge), or (3) a hedge of the fair value of a recognized asset or liability (fair value hedge). +66 +Table of Contents +The following details the accounting treatment of our cash flow, fair value, net investment, and non-designated hedges: +• +Changes in the fair value of a derivative that is designated as and meets the cash flow hedge criteria are recorded in accumulated other comprehensive loss (AOCL) to the extent effective and then recognized in earnings when the hedged items affect earnings. +• +Changes in the fair value of a derivative that is designated as and meets all the required criteria for a fair value hedge, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. +• +Changes in the fair value of a derivative and foreign currency debt that are designated as and meet all the required criteria for a hedge of a net investment are recorded as translation adjustments in AOCL. +• +Changes in the fair value of a derivative that is not designated as a hedge are recorded immediately in earnings. +We formally document the relationships between hedging instruments and hedged items, as well as our risk management objective and strategy for undertaking various hedge transactions. This process includes relating derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also formally assess, at the inception of the hedge and on an ongoing basis, whether derivatives are highly effective in offsetting changes in fair values or cash flows of the hedged item. If it is determined that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we will discontinue hedge accounting with respect to that derivative prospectively. +Foreign Currency +Since we do business in many foreign countries, fluctuations in currency exchange rates affect our financial position and results of operations. +In most of our foreign operations, the local currency is considered the functional currency. Foreign subsidiaries translate their assets and liabilities into U.S. dollars at current exchange rates in effect at the end of the fiscal period. The gains or losses that result from this process are shown as translation adjustments in AOCL in the equity section of the balance sheet. +The revenue and expense accounts of foreign subsidiaries are translated into U.S. dollars at the average exchange rates that prevail during the period. Therefore, the U.S. dollar value of these items on the consolidated income statements fluctuates from period to period, depending on the value of the dollar against foreign currencies. Some transactions are made in currencies different from an entity’s functional currency. Gains and losses from these foreign currency transactions are generally reflected in "Other income (expense), net" on our consolidated income statements as they occur. +Environmental Expenditures +Accruals for environmental loss contingencies are recorded when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. Remediation costs are capitalized if the costs improve the Company’s property as compared with the condition of the property when originally constructed or acquired, or if the costs prevent environmental contamination from future operations. We expense environmental costs related to existing conditions resulting from past or current operations and from which no current or future benefit is discernible. The amounts charged to income from continuing operations related to environmental matters totaled $ 12.8 , $ 11.4 , and $ 12.2 in fiscal years 2018 , 2017 , and 2016 , respectively. +The measurement of environmental liabilities is based on an evaluation of currently available information with respect to each individual site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. An environmental liability related to cleanup of a contaminated site might include, for example, a provision for one or more of the following types of costs: site investigation and testing costs, remediation costs, post-remediation monitoring costs, natural resource damages, and outside legal fees. These liabilities include costs related to other potentially responsible parties to the extent that we have reason to believe such parties will not fully pay their proportionate share. They do not consider any claims for recoveries from insurance or other parties and are not discounted. +67 +Table of Contents +As assessments and remediation progress at individual sites, the amount of projected cost is reviewed, and the liability is adjusted to reflect additional technical and legal information that becomes available. Management has an established process in place to identify and monitor the Company’s environmental exposures. An environmental accrual analysis is prepared and maintained that lists all environmental loss contingencies, even where an accrual has not been established. This analysis assists in monitoring the Company’s overall environmental exposure and serves as a tool to facilitate ongoing communication among the Company’s technical experts, environmental managers, environmental lawyers, and financial management to ensure that required accruals are recorded and potential exposures disclosed. +Given inherent uncertainties in evaluating environmental exposures, actual costs to be incurred at identified sites in future periods may vary from the estimates. Refer to Note 17 , Commitments and Contingencies , for additional information on the Company’s environmental loss contingencies. +The accruals for environmental liabilities are reflected in the consolidated balance sheets, primarily as part of other noncurrent liabilities. +Litigation +In the normal course of business, we are involved in legal proceedings. We accrue a liability for such matters when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. When only a range of possible loss can be established, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. The accrual for a litigation loss contingency includes estimates of potential damages and other directly related costs expected to be incurred. Refer to Note 17 , Commitments and Contingencies , for additional information on our current legal proceedings. +Share-Based Compensation +We have various share-based compensation programs, which include deferred stock units, stock options, and restricted stock. We expense the grant-date fair value of these awards over the vesting period during which employees perform related services. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. Refer to Note 19 , Share-Based Compensation , for additional information regarding these awards and the models and assumptions used to determine the grant-date fair value of our awards. +Income Taxes +We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. A principal temporary difference results from the excess of tax depreciation over book depreciation because accelerated methods of depreciation and shorter useful lives are used for income tax purposes. The cumulative impact of a change in tax rates or regulations is included in income tax expense in the period that includes the enactment date. We recognize deferred tax assets net of existing valuation allowances to the extent we believe that these assets are more likely than not to be realized considering all available evidence. +A tax benefit for an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination based on its technical merits. This position is measured as the largest amount of tax benefit that is greater than 50% likely of being realized. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense. For additional information regarding our income taxes, refer to Note 22 , Income Taxes . +Other Non-Operating Income (Expense), net +Beginning in the second quarter of fiscal year 2017, other non-operating income (expense), net includes interest income associated with our cash and cash items and short-term investments. Interest income in previous periods was included in "Other income (expense), net." In addition, other non-operating income (expense), net includes non-service cost components of net periodic pension and postretirement benefit cost. Our non-service costs primarily include interest cost, expected return on plan assets, amortization of actuarial gains and losses, and settlements. +Cash and Cash Items +Cash and cash items include cash, time deposits, treasury securities, and certificates of deposit acquired with an original maturity of three months or less. +68 +Table of Contents +Short-term Investments +Short-term investments include time deposits and certificates of deposit with original maturities greater than three months and less than one year. +Trade Receivables, net +Trade receivables comprise amounts owed to us through our operating activities and are presented net of allowances for doubtful accounts. The allowances for doubtful accounts represent estimated uncollectible receivables associated with potential customer defaults on contractual obligations. A provision for customer defaults is made on a general formula basis when it is determined that the risk of some default is probable and estimable but cannot yet be associated with specific customers. The assessment of the likelihood of customer defaults is based on various factors, including the length of time the receivables are past due, historical experience, and existing economic conditions. The allowance also includes amounts for certain customers where a risk of default has been specifically identified, considering factors such as the financial condition of the customer and customer disputes over contractual terms and conditions. Allowances for doubtful accounts were $ 91.3 and $ 93.5 as of 30 September 2018 and 2017 , respectively. Provisions to the allowance for doubtful accounts charged against income were $ 24.0 , $ 45.8 , and $ 21.8 in fiscal years 2018 , 2017 , and 2016 , respectively. +Inventories +We carry inventory on our consolidated balance sheets that is comprised of finished goods, work-in-process, raw materials and supplies. Inventories are stated at the lower of cost or net realizable value. We write down our inventories for estimated obsolescence or unmarketable inventory based upon assumptions about future demand and market conditions. +Effective 1 July 2018, we changed our accounting method for U.S. industrial gases inventories from a last-in, first-out basis (LIFO) to a first-in, first-out basis (FIFO). Previously, the LIFO method was used to determine the cost of industrial gases inventories in the United States. We believe this change in accounting method is preferable as it is consistent with how we manage our business, results in a uniform method to value our inventory across all regions of our business, improves comparability with our peers, and is expected to better reflect the current value of inventory on the consolidated balance sheets. We applied this accounting change as a cumulative effect adjustment to cost of sales in the fourth quarter of fiscal year 2018 and did not restate prior period financial statements because the impact was not material. Refer to Note 7 , Inventories , for additional information. +Equity Investments +The equity method of accounting is used when we exercise significant influence but do not have operating control, generally assumed to be 20% – 50% ownership. Under the equity method, original investments are recorded at cost and adjusted by our share of undistributed earnings or losses of these companies. Equity investments are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment may not be recoverable. +Plant and Equipment, Net +Plant and equipment, net is stated at cost less accumulated depreciation. Construction costs, labor, and applicable overhead related to installations are capitalized. Expenditures for additions and improvements that extend the lives or increase the capacity of plant assets are capitalized. The costs of maintenance and repairs of plant and equipment are charged to expense as incurred. +Fully depreciated assets are retained in the gross plant and equipment and accumulated depreciation accounts until they are removed from service. In the case of disposals, assets, and related depreciation are removed from the accounts, and the net amounts, less proceeds from disposal, are included in income. Refer to Note 9 , Plant and Equipment, net , for further detail. +Computer Software +We capitalize costs incurred to purchase or develop software for internal use. Capitalized costs include purchased computer software packages, payments to vendors/consultants for development and implementation or modification to a purchased package to meet our requirements, payroll and related costs for employees directly involved in development, and interest incurred while software is being developed. Capitalized computer software costs are reflected in "Plant and equipment, net" on the consolidated balance sheets and are depreciated over the estimated useful life of the software, generally a period of three to five years. +69 +Table of Contents +Capitalized Interest +As we build new plant and equipment, we include in the cost of these assets a portion of the interest payments we make during the year. The amount of capitalized interest was $ 19.5 , $ 19.0 , and $ 32.7 in fiscal years 2018 , 2017 , and 2016 , respectively. +Impairment of Long-Lived Assets +Long-lived assets are grouped for impairment testing at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other assets and liabilities and are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. We assess recoverability by comparing the carrying amount of the asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If an asset group is considered impaired, the impairment loss to be recognized is measured as the amount by which the asset group’s carrying amount exceeds its fair value. Long-lived assets meeting the held for sale criteria are reported at the lower of carrying amount or fair value less cost to sell. +Asset Retirement Obligations +The fair value of a liability for an asset retirement obligation is recognized in the period in which it is incurred. The fair value of the liability is measured using discounted estimated cash flows and is adjusted to its present value in subsequent periods as accretion expense is recorded. The corresponding asset retirement costs are capitalized as part of the carrying amount of the related long-lived asset and depreciated over the asset’s useful life. Our asset retirement obligations are primarily associated with on-site long-term supply contracts under which we have built a facility on land owned by the customer and are obligated to remove the facility at the end of the contract term. Our asset retirement obligations totaled $ 190.4 and $ 144.7 at 30 September 2018 and 2017 , respectively. +Goodwill +Business combinations are accounted for using the acquisition method. The purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. Any excess purchase price (plus the fair value of any noncontrolling interest and previously held equity interest in the acquiree) over the fair market value of the net assets acquired, including identified intangibles, is recorded as goodwill. Preliminary purchase price allocations are made at the date of acquisition and finalized when information about facts and circumstances that existed as of the acquisition date needed to finalize underlying estimates is obtained or when we determine that such information is not obtainable, within a maximum allocation period of one year. +Goodwill is subject to impairment testing at least annually. In addition, goodwill is tested more frequently if a change in circumstances or the occurrence of events indicates that potential impairment exists. Refer to Note 10 , Goodwill , for further detail. +Intangible Assets +Intangible assets with determinable lives primarily consist of customer relationships, purchased patents and technology, and land use rights. The cost of intangible assets with determinable lives is amortized on a straight-line basis over the estimated period of economic benefit. No residual value is estimated for these intangible assets. Indefinite-lived intangible assets consist of trade names and trademarks. Indefinite-lived intangibles are subject to impairment testing at least annually. In addition, intangible assets are tested more frequently if a change in circumstances or the occurrence of events indicates that potential impairment exists. +Customer relationships are generally amortized over periods of five to twenty-five years. Purchased patents and technology and other are generally amortized over periods of five to fifteen years. Land use rights, which are included in other intangibles, are generally amortized over a period of fifty years. Amortizable lives are adjusted whenever there is a change in the estimated period of economic benefit. Refer to Note 11 , Intangible Assets , for further detail. +Retirement Benefits +The cost of pension benefits is recognized over the employees’ service period. We use actuarial methods and assumptions in the valuation of defined benefit obligations and the determination of expense. Differences between actual and expected results or changes in the value of obligations and plan assets are not recognized in earnings as they occur but, rather, systematically and gradually over subsequent periods. Refer to Note 16 , Retirement Benefits , for disclosures related to our pension and other postretirement benefits. +70 +Table of Contents +2 . NEW ACCOUNTING GUIDANCE +Accounting Guidance Implemented in Fiscal Year 2018 +Disclosure Simplification +In August 2018, the SEC issued a final rule on disclosure update and simplification, amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. This rule was effective on 5 November 2018. We adopted the amended guidance, which reduced or eliminated certain annual disclosure requirements outside the consolidated financial statements, including the elimination of the ratio of earnings to fixed charges previously filed under Exhibit 12. However, the amendments expanded interim disclosure requirements that will be adopted in our Form 10-Q for our first fiscal quarter ended 31 December 2018, including those related to the analysis of shareholders' equity. +Income Taxes +In March 2018, the Financial Accounting Standards Board (FASB) issued an update for Staff Accounting Bulletin (SAB) No. 118 issued by the SEC in December 2017 related to the U.S. Tax Cuts and Jobs Act (“the Tax Act"). We adopted the SEC guidance under SAB No. 118 in the first quarter of fiscal year 2018. We continue to report the impacts of the Tax Act as provisional based on reasonable estimates as of 30 September 2018. We are continuing to gather additional information and expect to complete our accounting by the first quarter of fiscal year 2019, within the prescribed one-year measurement period. For additional details, see Note 22, Income Taxes. +Presentation of Net Periodic Pension and Postretirement Benefit Cost +In March 2017, the FASB issued guidance for improving the presentation of net periodic pension cost and net periodic postretirement benefit cost. The amendments require the service cost component of net periodic benefit cost to be presented in the same operating income line items as other compensation costs arising from services rendered by employees during the period. The non-service costs (e.g., interest cost, expected return on plan assets, amortization of actuarial gains/losses, settlements) should be presented in the consolidated income statements outside of operating income. The amendments also allow only the service cost component to be eligible for capitalization when applicable. We early adopted this guidance during the first quarter of fiscal year 2018. The amendments have been applied retrospectively for the income statement presentation requirements and prospectively for the limit on costs eligible for capitalization. We applied the practical expedient to use the amounts disclosed in our retirement benefits note for the prior comparative periods as the estimation basis for applying the retrospective presentation requirements. +Prior to adoption of the guidance, we classified all net periodic benefit costs within operating costs, primarily within "Cost of sales" and "Selling and administrative" on the consolidated income statements. The line item classification changes required by the new guidance did not impact our pre-tax earnings or net income; however, "Operating income" and "Other non-operating income (expense), net" changed by immaterial offsetting amounts. +Derivative Contract Novations +In March 2016, the FASB issued guidance to clarify that a change in the counterparty to a derivative instrument that has been designated as a hedging instrument does not, in and of itself, require re-designation of that hedging relationship provided that all other hedge accounting criteria continue to be met. We adopted this guidance in the first quarter of fiscal year 2018. This guidance did not have an impact on our consolidated financial statements upon adoption. +New Accounting Guidance to be Implemented +Revenue Recognition +In May 2014, the FASB issued guidance based on the principle that revenue is recognized in an amount expected to be collected and to which the entity expects to be entitled in exchange for the transfer of goods or services. We will adopt this guidance in fiscal year 2019 under the modified retrospective approach. Upon adoption, we will no longer present "Contracts in progress, less progress billings" on our consolidated balance sheets and will have expanded disclosure requirements. Otherwise, we do not expect adoption of this guidance to have a material impact on our consolidated financial statements. +71 +Table of Contents +The expected balance sheet impacts of no longer presenting "Contracts in progress, less progress billings" are summarized below: +30 September 2018 +New Revenue Standard Adjustments +1 October 2018 +Assets +Current Assets +Cash and cash items +$ 2,791.3 +$ — +$ 2,791.3 +Short-term investments +184.7 +— +184.7 +Trade receivables, net +1,207.2 +— +1,207.2 +Inventories +396.1 +— +396.1 +Contracts in progress, less progress billings +77.5 +( 77.5 +) +— +Prepaid expenses +129.6 +— +129.6 +Other receivables and current assets +295.8 +103.7 +399.5 +Total Current Assets +5,082.2 +26.2 +5,108.4 +Total Noncurrent Assets +14,096.1 +— +14,096.1 +Total Assets +$ 19,178.3 +$ 26.2 +$ 19,204.5 +Liabilities and Equity +Current Liabilities +Payables and accrued liabilities +$ 1,817.8 +$ 26.2 +$ 1,844.0 +Accrued income taxes +59.6 +— +59.6 +Short-term borrowings +54.3 +— +54.3 +Current portion of long-term debt +406.6 +— +406.6 +Total Current Liabilities +2,338.3 +26.2 +2,364.5 +Total Noncurrent Liabilities +5,663.7 +— +5,663.7 +Total Liabilities +8,002.0 +26.2 +8,028.2 +Total Equity +11,176.3 +— +11,176.3 +Total Liabilities and Equity +$ 19,178.3 +$ 26.2 +$ 19,204.5 +Our expanded disclosure requirements will include the disaggregation of revenue and disclosure of the fixed transaction price allocated to remaining performance obligations. We intend to disaggregate our revenue by supply mode. Our fixed transaction price allocated to remaining performance obligations will primarily relate to our onsite gases business. +Leases +In February 2016, the FASB issued guidance that requires lessees to recognize a right-of-use asset and lease liability on the balance sheet for all leases, including operating leases, with a term in excess of 12 months. The guidance also expands the quantitative and qualitative disclosure requirements. The guidance is effective in fiscal year 2020, with early adoption permitted. The guidance must be applied using a modified retrospective approach with the option to apply either at the adoption date or at the earliest comparative period presented in the consolidated financial statements. +The Company is the lessee under various agreements for real estate, distribution equipment, aircraft, and vehicles that are currently accounted for as operating leases. The new guidance will require the Company to record all leases, including operating leases, on the balance sheet with a right-of-use asset and corresponding liability for future payment obligations. +We will adopt this guidance in fiscal year 2020 and are currently evaluating the impact it will have on our consolidated financial statements, including the assessment of our current lease population under the revised definition of what qualifies as a leased asset. In addition, we are implementing a new application to administer the accounting and disclosure requirements under the new guidance. +72 +Table of Contents +Credit Losses on Financial Instruments +In June 2016, the FASB issued guidance on the measurement of credit losses, which requires measurement and recognition of expected credit losses for financial assets, including trade receivables and capital lease receivables, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The method to determine a loss is different from the existing guidance, which requires a credit loss to be recognized when it is probable. The guidance is effective beginning in fiscal year 2021, with early adoption permitted beginning in fiscal year 2020. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +Cash Flow Statement Classification +In August 2016, the FASB issued guidance to reduce diversity in practice on how certain cash receipts and cash payments are classified in the statement of cash flows. The guidance is effective beginning in fiscal year 2019, with early adoption permitted, and should be applied retrospectively. We plan to adopt this guidance in fiscal year 2019 and do not expect adoption to have a significant impact on our consolidated financial statements. +Intra-Entity Asset Transfers +In October 2016, the FASB issued guidance on accounting for the income tax effects of intra-entity transfers of assets other than inventory. Current guidance prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. Under the new guidance, the income tax consequences of an intra-entity asset transfer are recognized when the transfer occurs. The guidance is effective beginning in fiscal year 2019, with early adoption permitted as of the beginning of an annual reporting period. The guidance must be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the date of adoption. We will adopt the guidance in fiscal year 2019 and do not expect adoption of this guidance to have a significant impact on our consolidated financial statements. +Derecognition of Nonfinancial Assets +In February 2017, the FASB issued an update to clarify the scope of guidance on gains and losses from the derecognition of nonfinancial assets and to add guidance for partial sales of nonfinancial assets. We will adopt this guidance in fiscal year 2019 under the modified retrospective approach. We do not expect this update to have a significant impact on our consolidated financial statements. +Hedging Activities +In August 2017, the FASB issued guidance on hedging activities to expand the related presentation and disclosure requirements, change how companies assess effectiveness, and eliminate the separate measurement and reporting of hedge ineffectiveness. The guidance also enables more financial and nonfinancial hedging strategies to become eligible for hedge accounting. The guidance is effective in fiscal year 2020, with early adoption permitted. For cash flow and net investment hedges existing at the date of adoption, an entity should apply a cumulative-effect adjustment to eliminate the separate measurement of ineffectiveness within equity as of the beginning of the fiscal year the guidance is adopted. The amended presentation and disclosure guidance is applied prospectively. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income +In February 2018, the FASB issued guidance allowing a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Act. The guidance is effective in fiscal year 2020, with early adoption permitted, including adoption in any interim period. If elected, the reclassification can be applied in either the period of adoption or retrospectively to the period of the Tax Act's enactment (i.e., our first quarter of fiscal year 2018). We are currently evaluating the adoption alternatives and the impact this guidance will have on our consolidated financial statements. +Fair Value Measurement Disclosures +In August 2018, the FASB issued guidance which modifies the disclosure requirements for fair value measurements. The guidance is effective in fiscal year 2021, with early adoption permitted. Certain amendments must be applied prospectively and other amendments retrospectively. We are currently evaluating the impact this guidance will have on the disclosures in the notes to our consolidated financial statements. +73 +Table of Contents +Retirement Benefit Disclosures +In August 2018, the FASB issued guidance which modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. The guidance is effective in fiscal year 2021, with early adoption permitted, and must be applied on a retrospective basis. We are currently evaluating the impact this guidance will have on the disclosures in the notes to our consolidated financial statements. +Cloud Computing Implementation Costs +In August 2018, the FASB issued guidance which aligns the capitalization requirements for implementation costs incurred in a hosting arrangement that is a service contract with the existing capitalization requirements for implementation costs incurred to develop or obtain internal-use software. The guidance is effective in fiscal year 2021, with early adoption permitted, and may be applied either prospectively or retrospectively. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +Related Party Guidance for Variable Interest Entities +In October 2018, the FASB issued an update which amends the guidance for determining whether a decision-making fee is a variable interest. The amendments require consideration of indirect interests held through related parties under common control on a proportional basis rather than as the equivalent of a direct interest in its entirety as currently required. The guidance is effective in fiscal year 2021, with early adoption permitted. The amendments must be applied retrospectively with a cumulative-effect adjustment to retained earnings at the beginning of the earliest period presented. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +3 . DISCONTINUED OPERATIONS +In fiscal year 2018, income from discontinued operations, net of tax, of $ 42.2 includes an income tax benefit of $ 25.6 resulting from the resolution of uncertain tax positions taken in conjunction with the disposition of our former European Homecare business in fiscal year 2012. In addition, we recorded an after-tax benefit of $ 17.6 resulting from the resolution of certain post-closing adjustments associated with the sale of our former Performance Materials Division (PMD). Refer to Note 22 , Income Taxes, for additional information. These benefits were partially offset by an after-tax loss of $ 1.0 related to Energy-from-Waste (EfW) project exit activities, which were completed during the first quarter of fiscal year 2018. +There were no assets or liabilities presented in discontinued operations on the consolidated balance sheets as of 30 September 2018. As of 30 September 2017, current assets of discontinued operations of $ 10.2 related to EfW and current liabilities of discontinued operations of $ 15.7 primarily related to reserves associated with the disposition of PMD. +74 +Table of Contents +The following table details income from discontinued operations, net of tax, on the consolidated income statements for fiscal year 2017: +Total +Performance +Energy-from- +Discontinued +Year Ended 30 September 2017 +Materials +Waste (A) +Operations +Sales +$ 254.8 +$ — +$ 254.8 +Cost of sales +182.3 +13.8 +196.1 +Selling and administrative +22.5 +.7 +23.2 +Research and development +5.1 +— +5.1 +Other income (expense), net +.3 +( 2.0 +) +( 1.7 +) +Operating Income (Loss) +45.2 +( 16.5 +) +28.7 +Equity affiliates’ income +.3 +— +.3 +Income (Loss) Before Taxes +45.5 +( 16.5 +) +29.0 +Income tax benefit (B) +( 50.8 +) +( 5.7 +) +( 56.5 +) +Income (Loss) From Operations of Discontinued Operations, net of tax +96.3 +( 10.8 +) +85.5 +Gain (Loss) on disposal of business, net of tax (C) +1,827.6 +( 47.1 +) +1,780.5 +Income (Loss) From Discontinued Operations, net of tax +$ 1,923.9 +($ 57.9 +) +$ 1,866.0 +(A) +The loss from operations of discontinued operations for EfW primarily relates to costs incurred for ongoing project exit activities, administrative costs, and land lease obligation s. +(B) +As a result of the expected gain on the sale of PMD, we released valuation allowances related to capital loss and net operating loss carryforwards primarily during the first quarter of 2017 that favorably impacted our income tax provision within discontinued operations by approximately $ 69 . +(C) +After-tax gain on sale of $ 1,827.6 includes expense for income tax reserves for uncertain tax positions of $ 28.0 gross ( $ 21.0 net) in various jurisdictions. +In fiscal year 2017, income from discontinued operations, net of tax, of $ 1,866.0 includes a gain of $ 2,870 ( $ 1,828 after-tax, or $ 8.32 per share) for the sale of PMD to Evonik Industries AG (Evonik). The sale closed on 3 January 2017 for $ 3.8 billion in cash. In addition, we recorded a loss on the disposal of EfW of $ 59.3 ( $ 47.1 after-tax) during the first quarter of 2017, primarily for land lease obligations and to update our estimate of the net realizable value of the plant assets. The loss on disposal was recorded as a component of discontinued operations while the liability associated with land lease obligations was and continues to be recorded in continuing operations. As of 30 September 2018, liabilities associated with EfW recorded in continuing operations were approximately $ 63 and primarily related to the land lease obligations. +On 1 October 2016 (the distribution date), Air Products completed the spin-off of its Electronic Materials Division (EMD) as Versum Materials, Inc. (Versum), a separate and independent public company. The spin-off was completed by way of a distribution to Air Products’ stockholders of all of the then issued and outstanding shares of common stock of Versum on the basis of one share of Versum common stock for every two shares of Air Products’ common stock held as of the close of business on 21 September 2016 (the record date for the distribution). Fractional shares of Versum common stock were not distributed to Air Products' common stockholders. Air Products’ stockholders received cash in lieu of fractional shares. Subsequent to the distribution, Versum became an independent public company, and its common stock is listed under the symbol “VSM” on the New York Stock Exchange. The spin-off of Versum was treated as a noncash transaction in the consolidated statements of cash flows in fiscal year 2017. Seifi Ghasemi, Director, Chairman, President, and Chief Executive Officer of Air Products, continues to serve as non-executive chairman of the Versum Board of Directors. +75 +Table of Contents +The following table details the loss from discontinued operations, net of tax, on the consolidated income statements for fiscal year 2016: +Total +Electronic +Performance +Energy-from- +Discontinued +Year Ended 30 September 2016 +Materials +Materials +Waste (A) +Operations +Sales +$ 961.6 +$ 1,059.1 +$ — +$ 2,020.7 +Cost of sales +521.6 +704.5 +24.6 +1,250.7 +Selling and administrative +87.7 +76.6 +2.8 +167.1 +Research and development +40.8 +19.6 +.9 +61.3 +Other income (expense), net +2.2 +4.2 +( 12.7 +) +( 6.3 +) +Operating Income (Loss) +313.7 +262.6 +( 41.0 +) +535.3 +Equity affiliates’ income +.2 +1.4 +— +1.6 +Interest expense +.3 +— +— +.3 +Income (Loss) Before Taxes (B) +313.6 +264.0 +( 41.0 +) +536.6 +Income tax provision (benefit) +73.4 +80.5 +( 3.4 +) +150.5 +Income (Loss) From Operations of Discontinued Operations, net of tax +240.2 +183.5 +( 37.6 +) +386.1 +Loss on disposal of business, net of tax +— +— +( 846.6 +) +( 846.6 +) +Income (Loss) From Discontinued Operations, net of tax +240.2 +183.5 +( 884.2 +) +( 460.5 +) +Net Income Attributable to Noncontrolling Interests of Discontinued Operations +7.9 +— +— +7.9 +Net Income (Loss) From Discontinued Operations +$ 232.3 +$ 183.5 +($ 884.2 +) +($ 468.4 +) +(A) +The loss from operations of discontinued operations for EfW primarily relates to project suspension costs, land lease obligations, and administrative costs. +(B) +In fiscal year 2016 , income before taxes from operations of discontinued operations attributable to Air Products was $ 527.1 . +In fiscal year 2016, the Company's Board of Directors approved the exit of the EfW business, and efforts to start up the two EfW projects located in Tees Valley, United Kingdom, were discontinued. The loss from discontinued operations, net of tax, of $ 460.5 includes a loss of $ 945.7 ( $ 846.6 after-tax) from the write down of the EfW plant assets to their estimated net realizable value and a liability recorded for plant disposition and other costs. Income tax benefits related only to one of the projects as the other did not qualify for a local tax deduction. We estimated the net realizable value of the projects assuming an orderly liquidation of assets capable of being marketed on a secondary equipment market based on market quotes and our experience with selling similar equipment. An asset’s orderly liquidation value is the amount that could be realized from a liquidation sale, given a reasonable period of time to find a buyer, selling the asset in the existing condition where it is located, and assuming the highest and best use of the asset by market participants. A valuation allowance of $ 58.0 and unrecognized tax benefits of $ 7.9 were recorded relating to deferred tax assets on capital assets generated from the loss. +Fiscal year 2016 also includes the results of PMD and EMD prior to their dispositions. +76 +Table of Contents +4 . MATERIALS TECHNOLOGIES SEPARATION +In fiscal year 2017, we completed the separation of the divisions comprising the former Materials Technologies segment through the spin-off of EMD as Versum and the sale of PMD to Evonik. For additional information on the dispositions, refer to Note 3 , Discontinued Operations . +Business Separation Costs +In connection with the dispositions of EMD and PMD, we incurred net separation costs of $ 30.2 in fiscal year 2017. The net costs include legal and advisory fees of $ 32.5 , which are reflected on the consolidated income statements as “Business separation costs,” and a pension settlement benefit of $ 2.3 presented within "Other non-operating income (expense), net." Our fiscal year 2017 income tax provision includes net tax benefits of $ 5.5 , primarily related to changes in tax positions on business separation activities. +In fiscal year 2016, we incurred business separation costs of $ 50.6 for legal and advisory fees. Our fiscal year 2016 income tax provision includes additional tax expense related to the separation of $ 51.8 , of which $ 45.7 resulted from a dividend that was declared in June 2016 to repatriate $ 443.8 from a subsidiary in South Korea to the U.S. in anticipation of the separation of EMD from the industrial gases business in South Korea. +Transition Services Agreements +We entered into transition services agreements by which we provided certain transition services to Versum for EMD and to Evonik for PMD subsequent to their respective separation dates. The reimbursement for costs in support of the agreements has been reflected on the consolidated income statements within “Other income (expense), net.” All transition services were completed during fiscal year 2018. +Loss on Extinguishment of Debt +On 30 September 2016, in anticipation of the spin-off, Versum entered into certain financing transactions to allow for a cash distribution of $ 550.0 and a distribution in-kind of senior unsecured notes (the "Notes") issued by Versum with an aggregate principal amount of $ 425.0 to Air Products. Air Products then exchanged these Notes with certain financial institutions for $ 418.3 of Air Products’ outstanding commercial paper. This noncash exchange, which was excluded from the consolidated statements of cash flows, resulted in a loss of $ 6.9 that has been reflected on the consolidated income statements as “Loss on extinguishment of debt.” This loss was deductible for tax purposes. +5 . COST REDUCTION AND ASSET ACTIONS +In fiscal year 2017, we recognized a net expense of $ 151.4 . The year-to-date net expense included a charge of $ 154.8 for actions taken during fiscal year 2017, partially offset by the favorable settlement of the remaining $ 3.4 accrued balance associated with business restructuring actions taken in 2015. The charge included asset actions of $ 88.5 and severance actions of $ 66.3 . The asset actions included charges resulting from the write-down of an air separation unit in the Industrial Gases – EMEA segment that was constructed mainly to provide oxygen to one of the Energy-from-Waste plants, the planned sale of a non-industrial gas hardgoods business in the Industrial Gases – Americas segment, and the closure of a facility in the Corporate and other segment that manufactured LNG heat exchangers. The severance actions related to the elimination or planned elimination of approximately 625 positions, primarily in the Corporate and other segment and in the Industrial Gases – EMEA segment. The actions in the Corporate and other segment were driven by the reorganization of our engineering, manufacturing, and technology functions. +The 2017 charge related to the segments as follows: $ 39.3 in Industrial Gases – Americas, $ 77.9 in Industrial Gases – EMEA, $ .9 in Industrial Gases – Asia, $ 2.5 in Industrial Gases – Global, and $ 34.2 in Corporate and other. +In fiscal year 2016, we recognized an expense of $ 34.5 for severance and other benefits related to cost reduction actions which resulted in the elimination of approximately 610 positions. The expenses related primarily to the Industrial Gases – Americas segment and the Industrial Gases – EMEA segment. +The charges we record for cost reduction and asset actions have been excluded from segment operating income. +77 +Table of Contents +The following table summarizes the carrying amount of the accrual for cost reduction actions at 30 September 2018 : +Severance and +Other Benefits +Asset +Actions/Other +Total +2016 Charge +$ 34.5 +$ — +$ 34.5 +Cash expenditures +( 21.6 +) +— +( 21.6 +) +Amount reflected in pension liability +( .9 +) +— +( .9 +) +Currency translation adjustment +.3 +— +.3 +30 September 2016 +$ 12.3 +$ — +$ 12.3 +2017 Charge +66.3 +88.5 +154.8 +Noncash expenses +— +( 84.2 +) +( 84.2 +) +Cash expenditures +( 35.7 +) +( 1.2 +) +( 36.9 +) +Amount reflected in pension liability +( 2.0 +) +— +( 2.0 +) +Amount reflected in other noncurrent liabilities +— +( 2.2 +) +( 2.2 +) +Currency translation adjustment +( .3 +) +— +( .3 +) +30 September 2017 +$ 40.6 +$ .9 +$ 41.5 +Cash expenditures +( 30.3 +) +( .9 +) +( 31.2 +) +Amount reflected in pension liability +( .4 +) +— +( .4 +) +30 September 2018 +$ 9.9 +$ — +$ 9.9 +6 . ACQUISITIONS +Asset Acquisition +On 9 September 2017, Air Products signed an agreement to form a joint venture, Air Products Lu An (Changzhi) Co., Ltd. (“the JV”) with Lu’An Clean Energy Company ("Lu’An"). On 26 April 2018 ("the acquisition date"), we completed the formation of the JV, of which Air Products owns 60 % and Lu’An owns 40 % . The JV receives coal, steam and power from Lu’An and supplies syngas to Lu’An under a long-term onsite contract. The JV is consolidated within the results of the Industrial Gases – Asia segment. +Air Products contributed four large air separation units to the JV with a carrying value of approximately $ 300 , and the JV acquired gasification and syngas clean-up assets from Lu’An for 7.9 billion RMB (approximately $ 1.2 billion ). As a result, the carrying value of the plant and equipment of the JV was approximately $ 1.5 billion at the acquisition date. +We accounted for the acquisition of the gasification and syngas clean-up assets as an asset acquisition. In connection with closing the acquisition, we paid net cash of approximately 1.5 billion RMB ( $ 235 ) and issued equity of 1.4 billion RMB ( $ 227 ) to Lu'An for their noncontrolling interest in the JV. +In addition, Lu'An made a loan of 2.6 billion RMB to the JV with regularly scheduled principal and interest payments at a fixed interest rate of 5.5 % , and we established a liability of 2.3 billion RMB for cash payments expected to be made to or on behalf of Lu'An in fiscal year 2019. +As of 30 September 2018, long-term debt payable to Lu'An of 2.6 billion RMB ( $ 384 ) is presented on the consolidated balance sheets as " Long-term debt – related party ," and our expected remaining cash payments of approximately 2.2 billion RMB ( $ 330 ) are presented within "Payables and accrued liabilities." +The issuance of equity to Lu'An for their noncontrolling interest, the long-term debt, and the liability for the remaining cash payments were noncash transactions; therefore, they have been excluded from the consolidated statement of cash flows for the fiscal year ended 30 September 2018. +78 +Table of Contents +Business Combinations +In fiscal year 2018, we completed eight acquisitions that were accounted for as business combinations. These acquisitions had an aggregate purchase price, net of cash acquired, of $ 355.4 . The largest of the acquisitions was completed during the first quarter of fiscal year 2018 and consisted primarily of three air separation units serving onsite and merchant customers in China. This acquisition is expected to strengthen our position in the region. The results of this business are consolidated within our Industrial Gases – Asia segment. +Our fiscal year 2018 business combinations resulted in the recognition of $ 178.4 of plant and equipment, $ 78.0 of goodwill, $ 17.7 of which is deductible for tax purposes, and $ 105.8 of intangible assets, primarily customer relationships, having a weighted-average useful life of twelve years . The goodwill recognized on the transactions is attributable to expected growth and cost synergies and was primarily recorded in the Industrial Gases – Asia and the Industrial Gases – EMEA segments. +Our 2018 business combinations did not materially impact our consolidated income statements for the periods presented. +7 . INVENTORIES +The components of inventories are as follows: +30 September +2018 +2017 +Finished goods +$ 125.4 +$ 120.0 +Work in process +21.2 +15.7 +Raw materials, supplies and other +249.5 +223.0 +Total FIFO Cost +396.1 +358.7 +Less: Excess of FIFO cost over LIFO cost +— +( 23.3 +) +Inventories +$ 396.1 +$ 335.4 +As discussed in Note 1 , Major Accounting Policies , we changed our accounting method for U.S. inventories from a LIFO basis to a FIFO basis effective 1 July 2018. As of 30 September 2017, inventories valued using the LIFO method comprised approximately 49 % of consolidated inventories before LIFO adjustment. Liquidation of LIFO inventory layers prior to our change in accounting policy in fiscal year 2018 and in fiscal years 2017 and 2016 did not materially affect the results of operations. +We did not restate prior period financial statements for the change in U.S. inventories as the impact was not material. Instead, the Company applied the accounting change as a cumulative effect adjustment to cost of sales in the fourth quarter of fiscal year 2018. This change increased inventories by $ 24.1 at 1 July 2018 and increased pre-tax income from continuing operations by $ 24.1 for the quarter and fiscal year ended 30 September 2018. +8 . SUMMARIZED FINANCIAL INFORMATION OF EQUITY AFFILIATES +The summarized financial information below is on a combined 100% basis and has been compiled based on financial statements of the companies accounted for by the equity method. The amounts presented include the accounts of the following equity affiliates: +Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (25%); +INOX Air Products Limited (50%); +Air Products South Africa (Proprietary) Limited (50%); +Jazan Gas Projects Company (25%); +Bangkok Cogeneration Company Limited (49%); +Kulim Industrial Gases Sdn. Bhd. (50%); +Bangkok Industrial Gases Co., Ltd. (49%); +Sapio Produzione Idrogeno Ossigeno S.r.l. (49%); +Chengdu Air & Gas Products Ltd. (50%); +Tecnologia en Nitrogeno S. de R.L. de C.V. (50%); +Helios S.p.A. (49%); +Tyczka Industrie-Gases GmbH (50%); +High-Tech Gases (Beijing) Co., Ltd. (50%); +WuXi Hi-Tech Gas Co., Ltd. (50%); +INFRA Group (40%); +and principally, other industrial gas producers. +79 +Table of Contents +30 September +2018 +2017 +Current assets +$ 1,556.9 +$ 1,333.2 +Noncurrent assets +4,340.8 +4,026.9 +Current liabilities +635.7 +666.8 +Noncurrent liabilities +2,652.5 +2,194.3 +Year Ended 30 September +2018 +2017 +2016 +Net sales +$ 2,663.1 +$ 2,343.3 +$ 2,271.6 +Sales less cost of sales +1,050.6 +878.6 +871.5 +Operating income +635.3 +509.5 +482.1 +Net income +388.0 +343.5 +334.1 +Dividends received from equity affiliates were $ 122.5 , $ 99.5 , and $ 95.9 in fiscal years 2018 , 2017 , and 2016 , respectively. +The investment in net assets of and advances to equity affiliates as of 30 September 2018 and 2017 included investment in foreign affiliates of $ 1,276.0 and $ 1,285.1 , respectively. +As of 30 September 2018 and 2017 , the amount of investment in companies accounted for by the equity method included equity method goodwill of $ 42.4 and $ 45.8 , respectively. +U.S. Tax Cuts and Jobs Act +For the year ended 30 September 2018, equity affiliates' income includes an expense of $ 28.5 for our proportionate share of the impact of the U.S. Tax Cuts and Jobs Act primarily recorded during the first quarter of fiscal year 2018. This expense is included in the fiscal year 2018 net income on a 100% basis in the table above. Refer to Note 22 , Income Taxes , for additional information. +Equity Affiliate Impairment Charge +During the third quarter of fiscal year 2017, we recorded an other-than-temporary impairment charge of $ 79.5 on our investment in Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (AHG), a 25 % -owned equity affiliate in our Industrial Gases – EMEA segment. The impairment charge is reflected on our consolidated income statements within “Equity affiliates' income." This charge was not deductible for tax purposes and has been excluded from segment results. +The decline in value resulted from expectations for lower future cash flows to be generated by AHG, primarily due to challenging economic conditions in Saudi Arabia, including the impacts of lower prices in the oil and gas industry, increased competition, and capital project growth opportunities not materializing as anticipated. +The AHG investment was valued based on the results of the income and market valuation approaches. The income approach utilized a discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry required rates of return on debt and equity capital for a target industry capital structure adjusted for risks associated with size and geography. Other significant estimates and assumptions that drove our updated valuation of AHG included revenue growth rates and profit margins that were lower than those upon acquisition and our assessment of AHG's business improvement plan effectiveness. Under the market approach, we estimated fair value based on market multiples of revenue and earnings derived from publicly-traded industrial gases companies engaged in similar lines of business, adjusted to reflect differences in size and growth prospects. +Jazan +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20 -year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. Air Products owns 25 % of the joint venture and guarantees the repayment of its share of an equity bridge loan. ACWA also guarantees their share of the loan. We determined that the joint venture is a variable interest entity, for which we are not the primary beneficiary. +80 +Table of Contents +As of 30 September 2018 and 2017 , other noncurrent liabilities included $ 94.4 for our obligation to make future equity contributions in 2020 based on our proportionate share of the advances received by the joint venture under the loan. During fiscal year 2016, we recorded a noncash transaction that resulted in an increase of $ 26.9 to our investment in net assets of and advances to equity affiliates. This noncash transaction has been excluded from the consolidated statement of cash flows. In total, we expect to invest approximately $ 100 in this joint venture. There has been no change to our investment during fiscal years 2018 and 2017. +9 . PLANT AND EQUIPMENT, NET +The major classes of plant and equipment are as follows: +30 September +Useful Life +in years +2018 +2017 +Land +$ 269.4 +$ 231.0 +Buildings +30 +988.6 +977.8 +Production facilities (A) +10 +to +20 +15,082.8 +13,577.1 +Distribution and other machinery and equipment (B) +5 +to +25 +4,400.9 +3,944.0 +Construction in progress +748.5 +817.9 +Plant and equipment, at cost +21,490.2 +19,547.8 +Less: Accumulated depreciation +11,566.5 +11,107.6 +Plant and equipment, net +$ 9,923.7 +$ 8,440.2 +(A) +Depreciable lives of production facilities related to long-term customer supply contracts are matched to the contract lives. +(B) +The depreciable lives for various types of distribution equipment are 10 to 25 years for cylinders, depending on the nature and properties of the product; 20 years for tanks; 7.5 years for customer stations; and 5 to 15 years for tractors and trailers. +The increase in our production facilities during fiscal year 2018 primarily relates to the Lu'An asset acquisition completed in April 2018. Refer to Note 6 , Acquisitions , for additional information. +Depreciation expense was $ 940.7 , $ 843.2 , and $ 832.3 in fiscal years 2018 , 2017 , and 2016 , respectively. +10 . GOODWILL +Changes to the carrying amount of consolidated goodwill by segment are as follows: +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate and other +Total +Goodwill, net at 30 September 2016 +$ 309.1 +$ 380.6 +$ 135.2 +$ 20.2 +$ — +$ 845.1 +Impairment loss +( 145.3 +) +— +— +— +— +( 145.3 +) +Acquisitions +— +3.5 +— +— +— +3.5 +Currency translation +( .1 +) +18.3 +— +— +— +18.2 +Goodwill, net at 30 September 2017 +$ 163.7 +$ 402.4 +$ 135.2 +$ 20.2 +$ — +$ 721.5 +Acquisitions +— +29.5 +38.1 +— +10.4 +78.0 +Currency translation +( 1.6 +) +( 7.5 +) +( 1.4 +) +( .1 +) +— +( 10.6 +) +Goodwill, net at 30 September 2018 +$ 162.1 +$ 424.4 +$ 171.9 +$ 20.1 +$ 10.4 +$ 788.9 +30 September +2018 +2017 +2016 +Goodwill, gross +$ 1,194.7 +$ 1,138.7 +$ 1,103.7 +Accumulated impairment losses (A) +( 405.8 +) +( 417.2 +) +( 258.6 +) +Goodwill, net +$ 788.9 +$ 721.5 +$ 845.1 +(A) +Accumulated impairment losses include the impacts of currency translation. These losses are attributable to our Latin America reporting unit (LASA) within the Industrial Gases – Americas segment. +81 +Table of Contents +We review goodwill for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that the carrying value of goodwill might not be recoverable. The impairment test for goodwill involves calculating the fair value of each reporting unit and comparing that value to the carrying value. If the fair value of the reporting unit is less than its carrying value, the difference is recorded as a goodwill impairment charge, not to exceed the total amount of goodwill allocated to that reporting unit. During the fourth quarter of fiscal year 2018 , we conducted our annual goodwill impairment test and determined that the fair value of all our reporting units exceeded their carrying value. +During the third quarter of fiscal year 2017, we conducted an interim impairment test of the goodwill associated with our Latin America Reporting unit (LASA) within the Industrial Gases – Americas segment. This was driven by Management's decision to lower long-term growth projections in response to declining volumes and weak economic conditions in Latin America during fiscal year 2017. We determined that the fair value of LASA was less than its carrying value and recorded a noncash impairment charge of $ 145.3 , which is reflected on our consolidated income statements within “Goodwill and intangible asset impairment charge.” This charge was not deductible for tax purposes and has been excluded from segment operating income. +LASA includes assets and goodwill associated with operations in Chile and other Latin American countries. We estimated the fair value of LASA based on two valuation approaches, the income approach and the market approach. We reviewed relevant facts and circumstances in determining the weighting of the approaches. +Under the income approach, we estimated the fair value of LASA based on the present value of estimated future cash flows. Cash flow projections were based on management’s estimates of revenue growth rates and EBITDA margins, taking into consideration business and market conditions for the Latin American countries and markets in which we operate. We calculated the discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry‑specific rates of return on debt and equity capital for a target industry capital structure, adjusted for risks associated with business size and geography. +Under the market approach, we estimated fair value based on market multiples of revenue and earnings derived from publicly-traded industrial gases companies and regional manufacturing companies, adjusted to reflect differences in size and growth prospects. +Management judgment is required in the determination of each assumption utilized in the valuation model, and actual results could differ from our estimates. +11 . INTANGIBLE ASSETS +The table below provides details of acquired intangible assets: +30 September 2018 +30 September 2017 +Gross +Accumulated +Amortization/ +Impairment +Net +Gross +Accumulated +Amortization/ +Impairment +Net +Customer relationships +$ 491.9 +($ 165.5 +) +$ 326.4 +$ 424.1 +($ 142.3 +) +$ 281.8 +Patents and technology +34.0 +( 11.9 +) +22.1 +13.4 +( 10.6 +) +2.8 +Other +72.6 +( 33.8 +) +38.8 +73.4 +( 36.6 +) +36.8 +Total finite-lived intangibles +598.5 +( 211.2 +) +387.3 +510.9 +( 189.5 +) +321.4 +Trade names and trademarks, indefinite-lived +64.8 +( 13.6 +) +51.2 +67.8 +( 20.9 +) +46.9 +Total Intangible Assets +$ 663.3 +($ 224.8 +) +$ 438.5 +$ 578.7 +($ 210.4 +) +$ 368.3 +The increase in net intangible assets during fiscal year 2018 is primarily attributable to intangible assets acquired through business combinations, partially offset by amortization. For additional information on intangible assets acquired, refer to Note 6, Acquisitions. +Amortization expense for intangible assets was $ 30.0 , $ 22.6 , and $ 22.3 in fiscal years 2018 , 2017 , and 2016 , respectively. Refer to Note 1 , Major Accounting Policies , for amortization periods associated with our intangible assets. +82 +Table of Contents +Projected annual amortization expense for intangible assets as of 30 September 2018 is as follows: +2019 +$ 32.7 +2020 +32.4 +2021 +30.5 +2022 +27.8 +2023 +27.3 +Thereafter +236.6 +Total +$ 387.3 +Indefinite-lived intangible assets are subject to impairment testing at least annually or more frequently if events or changes in circumstances indicate that potential impairment exists. The impairment test for indefinite-lived intangible assets involves calculating the fair value of the indefinite-lived intangible assets and comparing the fair value to their carrying value. If the fair value is less than the carrying value, the difference is recorded as an impairment loss. During the fourth quarter of fiscal year 2018 , we conducted our annual impairment test of indefinite-lived intangible assets and determined that the fair value of all our intangible assets exceeded their carrying value. +During the third quarter of fiscal year 2017, we conducted an interim impairment test of the indefinite-lived intangible assets associated with LASA within the Industrial Gases – Americas segment and recorded a noncash impairment charge of $ 16.8 to write down the carrying value of the trade names and trademarks to their fair value. The impairment charge has been excluded from segment operating income and is reflected on our consolidated income statements within “Goodwill and intangible asset impairment charge." As discussed in Note 10, Goodwill, the reduction in value resulted from lowered long-term growth projections. We estimated the fair value of the indefinite-lived intangibles associated with LASA utilizing the royalty savings method, a form of the income approach. +In addition, we tested the recoverability of LASA long-lived assets, including finite-lived intangible assets subject to amortization, in fiscal year 2017 and concluded that they were recoverable from expected future undiscounted cash flows. +12 . LEASES +Lessee Accounting +Capital leases, primarily for the right to use machinery and equipment, are included with owned plant and equipment within "Plant and Equipment, net" on the consolidated balance sheets in the amount of $ 21.6 and $ 22.3 at 30 September 2018 and 2017 , respectively. Related amounts of accumulated depreciation are $ 6.1 and $ 5.3 , respectively. +Operating leases principally relate to real estate and also include aircraft, distribution equipment, and vehicles. Certain leases include escalation clauses, renewal, and/or purchase options. Rent expense is recognized on a straight-line basis over the minimum lease term. Rent expense under operating leases, including month-to-month agreements, was $ 82.7 , $ 65.8 , and $ 67.6 in fiscal years 2018 , 2017 , and 2016 , respectively. +At 30 September 2018 , minimum payments due under leases associated with continuing operations are as follows: +Capital +Leases +Operating +Leases +2019 +$ 1.7 +$ 65.9 +2020 +1.4 +50.4 +2021 +2.9 +41.4 +2022 +1.3 +30.4 +2023 +1.2 +23.3 +Thereafter +14.3 +123.0 +Total +$ 22.8 +$ 334.4 +The present value of the above future capital lease payments totaled $ 10.5 . Refer to Note 15 , Debt . +83 +Table of Contents +Included in the operating lease payments disclosed above are future minimum payments due under leases related to the Energy-from-Waste discontinued operations (i.e., Tees Valley, United Kingdom) of approximately $ 2 in each of the next five years and $ 40 thereafter, for a total lease commitment of approximately $ 50 . As discussed in Note 3, Discontinued Operations, during the first quarter of 2017, we recorded an accrual for these lease obligations to other noncurrent liabilities in continuing operations. +Lessor Accounting +As discussed under Revenue Recognition in Note 1 , Major Accounting Policies , certain contracts associated with facilities that are built to provide product to a specific customer are required to be accounted for as leases. +Operating Leases +Assets subject to operating lease treatment in which we are the lessor are recorded within "Plant and equipment, net" on the consolidated balance sheets. As of 30 September 2018, plant and equipment, at cost, was $ 2.4 billion, and accumulated depreciation was $ .4 billion. Assets subject to operating leases include those of the Lu’An joint venture, which is discussed in Note 6, Acquisitions. +At 30 September 2018, minimum lease payments expected to be collected are as follows: +2019 +$ 261.5 +2020 +259.1 +2021 +255.8 +2022 +251.5 +2023 +244.9 +Thereafter +2,904.8 +Total +$ 4,177.6 +Capital Leases +Lease receivables, net, are primarily included within "Noncurrent capital lease receivables" on our consolidated balance sheets, with the remaining balance in "Other receivables and current assets." +The components of lease receivables were as follows: +30 September +2018 +2017 +Gross minimum lease payments receivable +$ 1,673.7 +$ 1,897.0 +Unearned interest income +( 568.3 +) +( 671.9 +) +Lease Receivables, net +$ 1,105.4 +$ 1,225.1 +Lease payments collected in fiscal years 2018 , 2017 , and 2016 were $ 182.7 , $ 183.6 , and $ 186.0 , respectively. These payments reduced the lease receivable balance by $ 97.4 , $ 92.2 , and $ 85.5 in fiscal years 2018 , 2017 , and 2016 , respectively. +At 30 September 2018 , minimum lease payments expected to be collected are as follows: +2019 +$ 172.5 +2020 +167.8 +2021 +161.9 +2022 +150.6 +2023 +144.3 +Thereafter +876.6 +Total +$ 1,673.7 +84 +Table of Contents +13 . FINANCIAL INSTRUMENTS +Currency Price Risk Management +Our earnings, cash flows, and financial position are exposed to foreign currency risk from foreign currency-denominated transactions and net investments in foreign operations. It is our policy to minimize our cash flow volatility from changes in currency exchange rates. This is accomplished by identifying and evaluating the risk that our cash flows will change in value due to changes in exchange rates and by executing the appropriate strategies necessary to manage such exposures. Our objective is to maintain economically balanced currency risk management strategies that provide adequate downside protection. +Forward Exchange Contracts +We enter into forward exchange contracts to reduce the cash flow exposure to foreign currency fluctuations associated with highly anticipated cash flows and certain firm commitments, such as the purchase of plant and equipment. We also enter into forward exchange contracts to hedge the cash flow exposure on intercompany loans. This portfolio of forward exchange contracts consists primarily of Euros and U.S. Dollars. The maximum remaining term of any forward exchange contract currently outstanding and designated as a cash flow hedge at 30 September 2018 is 1.9 years . +Forward exchange contracts are also used to hedge the value of investments in certain foreign subsidiaries and affiliates by creating a liability in a currency in which we have a net equity position. The primary currency pair in this portfolio of forward exchange contracts is Euros and U.S. Dollars. +In addition to the forward exchange contracts that are designated as hedges, we utilize forward exchange contracts that are not designated as hedges. These contracts are used to economically hedge foreign currency-denominated monetary assets and liabilities, primarily working capital. The primary objective of these forward exchange contracts is to protect the value of foreign currency-denominated monetary assets and liabilities from the effects of volatility in foreign exchange rates that might occur prior to their receipt or settlement. This portfolio of forward exchange contracts consists of many different foreign currency pairs, with a profile that changes from time to time depending on business activity and sourcing decisions. +The table below summarizes our outstanding currency price risk management instruments: +30 September 2018 +30 September 2017 +US$ +Notional +Years +Average +Maturity +US$ +Notional +Years +Average +Maturity +Forward Exchange Contracts +Cash flow hedges +$ 2,489.1 +0.4 +$ 3,150.2 +0.4 +Net investment hedges +457.5 +1.7 +675.5 +3.0 +Not designated +1,736.1 +0.8 +273.8 +0.1 +Total Forward Exchange Contracts +$ 4,682.7 +0.7 +$ 4,099.5 +0.8 +The notional value of forward exchange contracts not designated in the table above increased as a result of repayment of intercompany loans prior to their original maturity dates. The outstanding forward exchange contracts no longer qualified as cash flow hedges due to the early repayment of the loans. In addition, as a result of changes in our currency exposures, we de-designated a portion of forward exchange contracts previously designated as net investment hedges. To eliminate any future earnings impact from these items, we entered into equal and offsetting forward exchange contracts. +In addition to the above, we use foreign currency-denominated debt to hedge the foreign currency exposures of our net investment in certain foreign subsidiaries. The designated foreign currency-denominated debt and related accrued interest included € 908.8 million ( $ 1,054.6 ) at 30 September 2018 and € 912.2 million ( $ 1,077.7 ) at 30 September 2017 . The designated foreign currency-denominated debt is located on the balance sheets in the long-term debt line item. +85 +Table of Contents +Debt Portfolio Management +It is our policy to identify on a continuing basis the need for debt capital and evaluate the financial risks inherent in funding the Company with debt capital. Reflecting the result of this ongoing review, the debt portfolio and hedging program are managed with the objectives and intent to (1) reduce funding risk with respect to borrowings made by us to preserve our access to debt capital and provide debt capital as required for funding and liquidity purposes, and (2) manage the aggregate interest rate risk and the debt portfolio in accordance with certain debt management parameters. +Interest Rate Management Contracts +We enter into interest rate swaps to change the fixed/variable interest rate mix of our debt portfolio in order to maintain the percentage of fixed- and variable-rate debt within the parameters set by management. In accordance with these parameters, the agreements are used to manage interest rate risks and costs inherent in our debt portfolio. Our interest rate management portfolio generally consists of fixed-to-floating interest rate swaps (which are designated as fair value hedges), pre-issuance interest rate swaps and treasury locks (which hedge the interest rate risk associated with anticipated fixed-rate debt issuances and are designated as cash flow hedges), and floating-to-fixed interest rate swaps (which are designated as cash flow hedges). At 30 September 2018 , the outstanding interest rate swaps were denominated in U.S. Dollars. The notional amount of the interest rate swap agreements is equal to or less than the designated debt being hedged. When interest rate swaps are used to hedge variable-rate debt, the indices of the swaps and the debt to which they are designated are the same. It is our policy not to enter into any interest rate management contracts which lever a move in interest rates on a greater than one-to-one basis. +Cross Currency Interest Rate Swap Contracts +We enter into cross currency interest rate swap contracts when our risk management function deems necessary. These contracts may entail both the exchange of fixed- and floating-rate interest payments periodically over the life of the agreement and the exchange of one currency for another currency at inception and at a specified future date. The contracts are used to hedge either certain net investments in foreign operations or nonfunctional currency cash flows related to intercompany loans. The current cross currency interest rate swap portfolio consists of fixed-to-fixed swaps primarily between U.S. Dollars and Chinese Renminbi, U.S. Dollars and Chilean Pesos, and U.S. Dollars and Indian Rupee. +The following table summarizes our outstanding interest rate management contracts and cross currency interest rate swaps: +30 September 2018 +30 September 2017 +US$ +Notional +Average Pay % +Average +Receive +% +Years +Average +Maturity +US$ +Notional +Average Pay % +Average +Receive +% +Years +Average +Maturity +Interest rate swaps (fair value hedge) +$ 600.0 +LIBOR +2.60 +% +1.6 +$ 600.0 +LIBOR +2.28 +% +1.3 +Cross currency interest rate swaps (net investment hedge) +$ 201.7 +4.42 +% +2.97 +% +3.1 +$ 539.7 +3.27 +% +2.59 +% +1.9 +Cross currency interest rate swaps (cash flow hedge) +$ 1,052.7 +4.99 +% +2.89 +% +2.3 +$ 1,095.7 +4.96 +% +2.78 +% +2.4 +Cross currency interest rate swaps (not designated) +$ 80.2 +4.88 +% +3.43 +% +3.9 +$ 41.6 +3.28 +% +2.32 +% +1.7 +86 +Table of Contents +The table below summarizes the fair value and balance sheet location of our outstanding derivatives: +Balance Sheet +30 September +Balance Sheet +30 September +Location +2018 +2017 +Location +2018 +2017 +Derivatives Designated as Hedging Instruments: +Forward exchange contracts +Other receivables +$ 24.9 +$ 81.7 +Accrued liabilities +$ 37.0 +$ 82.0 +Interest rate management contracts +Other receivables +24.3 +11.1 +Accrued liabilities +2.3 +10.7 +Forward exchange contracts +Other noncurrent assets +19.8 +27.1 +Other noncurrent +liabilities +4.6 +13.8 +Interest rate management contracts +Other noncurrent assets +48.7 +102.6 +Other noncurrent +liabilities +11.6 +22.2 +Total Derivatives Designated as Hedging Instruments +$ 117.7 +$ 222.5 +$ 55.5 +$ 128.7 +Derivatives Not Designated as Hedging Instruments: +Forward exchange contracts +Other receivables +7.9 +1.1 +Accrued liabilities +$ 14.9 +$ 2.2 +Interest rate management contracts +Other receivables +4.0 +— +Accrued liabilities +— +1.0 +Forward exchange contracts +Other noncurrent assets +16.2 +— +Other noncurrent liabilities +23.7 +— +Interest rate management contracts +Other noncurrent assets +.3 +4.2 +Other noncurrent +liabilities +— +— +Total Derivatives Not Designated as Hedging Instruments +$ 28.4 +$ 5.3 +$ 38.6 +$ 3.2 +Total Derivatives +$ 146.1 +$ 227.8 +$ 94.1 +$ 131.9 +Refer to Note 14 , Fair Value Measurements , which defines fair value, describes the method for measuring fair value, and provides additional disclosures regarding fair value measurements. +87 +Table of Contents +The table below summarizes the gain or loss related to our cash flow hedges, fair value hedges, net investment hedges, and derivatives not designated as hedging instruments: +Year Ended 30 September +Forward +Exchange Contracts +Foreign +Currency +Debt +Other (A) +Total +2018 +2017 +2018 +2017 +2018 +2017 +2018 +2017 +Cash Flow Hedges, net of tax: +Net gain (loss) recognized in OCI (effective portion) +$ 2.4 +$ .3 +$— +$— +$ 43.5 +($ 12.9 +) +$ 45.9 +($ 12.6 +) +Net (gain) loss reclassified from OCI to sales/cost of sales (effective portion) +7.1 +18.3 +— +— +— +— +7.1 +18.3 +Net (gain) loss reclassified from OCI to other income (expense), net (effective portion) +( 7.8 +) +( 3.8 +) +— +— +( 33.8 +) +10.5 +( 41.6 +) +6.7 +Net (gain) loss reclassified from OCI to interest expense (effective portion) +1.2 +( 2.1 +) +— +— +3.9 +2.9 +5.1 +.8 +Net (gain) loss reclassified from OCI to other income (expense), net (ineffective portion) +( .5 +) +( 1.6 +) +— +— +( .5 +) +— +( 1.0 +) +( 1.6 +) +Fair Value Hedges: +Net gain (loss) recognized in interest expense (B) +$ — +$ — +$— +$— +($ 10.1 +) +($ 14.7 +) +($ 10.1 +) +($ 14.7 +) +Net Investment Hedges, net of tax: +Net gain (loss) recognized in OCI +($ .6 +) +($ 11.1 +) +$ 10.2 +($ 32.8 +) +$ 11.0 +($ 15.6 +) +$ 20.6 +($ 59.5 +) +Derivatives Not Designated as Hedging Instruments: +Net gain (loss) recognized in other income (expense), net (C) +($ 4.0 +) +$ 4.1 +$— +$— +($ .8 +) +($ 2.4 +) +($ 4.8 +) +$ 1.7 +(A) +Other includes the impact on other comprehensive income (OCI) and earnings primarily related to interest rate and cross currency interest rate swaps. +(B) +The impact of fair value hedges noted above was largely offset by recognized gains and losses resulting from the impact of changes in related interest rates on outstanding debt. +(C) +The impact of the non-designated hedges noted above was largely offset by recognized gains and losses resulting from the impact of changes in exchange rates on assets and liabilities denominated in nonfunctional currencies. +The amount of cash flow hedges’ unrealized gains and losses at 30 September 2018 that are expected to be reclassified to earnings in the next twelve months is not material. +The cash flows related to all derivative contracts are reported in the operating activities section of the consolidated statements of cash flows. +Credit Risk-Related Contingent Features +Certain derivative instruments are executed under agreements that require us to maintain a minimum credit rating with both Standard & Poor’s and Moody’s. If our credit rating falls below this threshold, the counterparty to the derivative instruments has the right to request full collateralization on the derivatives’ net liability position. The net liability position of derivatives with credit risk-related contingent features was $ 33.4 as of 30 September 2018 and $ 34.6 as of 30 September 2017 . Because our current credit rating is above the various pre-established thresholds, no collateral has been posted on these liability positions. +88 +Table of Contents +Counterparty Credit Risk Management +We execute financial derivative transactions with counterparties that are highly rated financial institutions, all of which are investment grade at this time. Some of our underlying derivative agreements give us the right to require the institution to post collateral if its credit rating falls below the pre-established thresholds with Standard & Poor’s or Moody’s. The collateral that the counterparties would be required to post was $ 97.6 as of 30 September 2018 and $ 138.5 as of 30 September 2017 . No financial institution is required to post collateral at this time, as all have credit ratings at or above the threshold. +14 . FAIR VALUE MEASUREMENTS +Fair value is defined as an exit price, i.e., the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. +The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows: +Level 1— +Quoted prices (unadjusted) in active markets for identical assets or liabilities. +Level 2— +Inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the asset or liability. +Level 3— +Inputs that are unobservable for the asset or liability based on our own assumptions (about the assumptions market participants would use in pricing the asset or liability). +The methods and assumptions used to measure the fair value of financial instruments are as follows: +Short-term Investments +Short-term investments include time deposits with original maturities greater than three months and less than one year. The estimated fair value of the short-term investments, which approximates carrying value as of 30 September 2018 and 2017 , was determined using level 2 inputs within the fair value hierarchy. Level 2 measurements were based on current interest rates for similar investments with comparable credit risk and time to maturity. +Derivatives +The fair value of our interest rate management contracts and forward exchange contracts are quantified using the income approach and are based on estimates using standard pricing models. These models take into account the value of future cash flows as of the balance sheet date, discounted to a present value using discount factors that match both the time to maturity and currency of the underlying instruments. The computation of the fair values of these instruments is generally performed by the Company. These standard pricing models utilize inputs which are derived from or corroborated by observable market data such as interest rate yield curves as well as currency spot and forward rates. Therefore, the fair value of our derivatives is classified as a level 2 measurement. On an ongoing basis, we randomly test a subset of our valuations against valuations received from the transaction’s counterparty to validate the accuracy of our standard pricing models. Counterparties to these derivative contracts are highly rated financial institutions. +Refer to Note 13 , Financial Instruments , for a description of derivative instruments, including details on the balance sheet line classifications. +Long-term Debt, Including Related Party +The fair value of our debt is based on estimates using standard pricing models that take into account the value of future cash flows as of the balance sheet date, discounted to a present value using discount factors that match +both the time to maturity and currency of the underlying instruments. These standard valuation models utilize observable market data such as interest rate yield curves and currency spot rates. Therefore, the fair value of our debt is classified as a level 2 measurement. We generally perform the computation of the fair value of these instruments. +89 +Table of Contents +The carrying values and fair values of financial instruments were as follows: +30 September 2018 +30 September 2017 +Carrying Value +Fair Value +Carrying Value +Fair Value +Assets +Derivatives +Forward exchange contracts +$ 68.8 +$ 68.8 +$ 109.9 +$ 109.9 +Interest rate management contracts +77.3 +77.3 +117.9 +117.9 +Liabilities +Derivatives +Forward exchange contracts +$ 80.2 +$ 80.2 +$ 98.0 +$ 98.0 +Interest rate management contracts +13.9 +13.9 +33.9 +33.9 +Long-term debt, including current portion +3,758.3 +3,788.2 +3,818.8 +3,928.2 +The carrying amounts reported on the consolidated balance sheets for cash and cash items, short-term investments, trade receivables, payables and accrued liabilities, accrued income taxes, and short-term borrowings approximate fair value due to the short-term nature of these instruments. Accordingly, these items have been excluded from the above table. +The following table summarizes assets and liabilities measured at fair value on a recurring basis in the consolidated balance sheets: +30 September 2018 +30 September 2017 +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +Assets at Fair Value +Derivatives +Forward exchange contracts +$ 68.8 +$ — +$ 68.8 +$ — +$ 109.9 +$ — +$ 109.9 +$ — +Interest rate management contracts +77.3 +— +77.3 +— +117.9 +— +117.9 +— +Total Assets at Fair Value +$ 146.1 +$ — +$ 146.1 +$ — +$ 227.8 +$ — +$ 227.8 +$ — +Liabilities at Fair Value +Derivatives +Forward exchange contracts +$ 80.2 +$ — +$ 80.2 +$ — +$ 98.0 +$ — +$ 98.0 +$ — +Interest rate management contracts +13.9 +— +13.9 +— +33.9 +— +33.9 +— +Total Liabilities at Fair Value +$ 94.1 +$ — +$ 94.1 +$ — +$ 131.9 +$ — +$ 131.9 +$ — +The following is a tabular presentation of nonrecurring fair value measurements along with the level within the fair value hierarchy in which the fair value measurement in its entirety falls: +30 June 2017 +2017 Loss +Total +Level 1 +Level 2 +Level 3 +Investment in Equity Affiliate (A) +$ 68.5 +$ — +$ — +$ 68.5 +$ 79.5 +(A) +In fiscal year 2017, we assessed the recoverability of the carrying value of our equity investment in AHG. We estimated the fair value of our investment using weighting of the results of the income and market approaches. An impairment loss was recognized for the difference between the carrying amount and the fair value of the investment as of 30 June 2017. There have been no events during fiscal year 2018 requiring reassessment of our investment. For additional information, see Note 8 , Summarized Financial Information of Equity Affiliates . +90 +Table of Contents +During the third quarter ended 30 June 2017, we recognized a goodwill impairment charge of $ 145.3 and an intangible asset impairment charge of $ 16.8 associated with our LASA reporting unit. Refer to Note 10 , Goodwill , and Note 11 , Intangible Assets , for more information related to these charges and the associated fair value measurement methods and significant inputs/assumptions, which were classified as Level 3 since unobservable inputs were utilized in the fair value measurements. +15 . DEBT +The tables below summarize our outstanding debt at 30 September 2018 and 2017 : +Total Debt +30 September +2018 +2017 +Short-term borrowings +$ 54.3 +$ 144.0 +Current portion of long-term debt +406.6 +416.4 +Long-term debt +2,967.4 +3,402.4 +Long-term debt – related party (A) +384.3 +— +Total Debt +$ 3,812.6 +$ 3,962.8 +(A) +Refer to Note 6 , Acquisitions , for additional information regarding related party debt. +Short-term Borrowings +Short-term borrowings consisted of bank obligations of $ 54.3 and $ 144.0 at 30 September 2018 and 2017 , respectively. The weighted average interest rate of short-term borrowings outstanding at 30 September 2018 and 2017 was 5.0 % and 4.6 % , respectively. +91 +Table of Contents +Long-term Debt +30 September +Fiscal Year +Maturities +2018 +2017 +Payable in U.S. Dollars +Debentures +8.75 % +2021 +$ 18.4 +$ 18.4 +Medium-term Notes (weighted average rate) +Series E 7.6 % +2026 +17.2 +17.2 +Senior Notes +Note 1.2 % +2018 +— +400.0 +Note 4.375 % +2019 +400.0 +400.0 +Note 3.0 % +2022 +400.0 +400.0 +Note 2.75 % +2023 +400.0 +400.0 +Note 3.35 % +2024 +400.0 +400.0 +Other (weighted average rate) +Variable-rate industrial revenue bonds 1.51 % +2035 to 2050 +631.9 +631.9 +Other .25 % +2019 to 2022 +.9 +10.9 +Payable in Other Currencies +Eurobonds 2.0 % +2020 +348.1 +354.4 +Eurobonds .375 % +2021 +406.2 +413.5 +Eurobonds 1.0 % +2025 +348.1 +354.4 +Other 4.3 % +2019 to 2023 +8.0 +25.8 +Related Party (A) +Chinese Renminbi 5.5 % +2020 to 2026 +384.3 +— +Capital Lease Obligations +United States 5.0 % +2018 +— +.2 +Foreign 10.4 % +2019 to 2036 +10.5 +10.6 +Total Principal Amount +3,773.6 +3,837.3 +Less: Unamortized discount and debt issuance costs +( 15.3 +) +( 18.5 +) +Total Long-term Debt +3,758.3 +3,818.8 +Less: Current portion of long-term debt +( 406.6 +) +( 416.4 +) +Less: Long-term debt – related party +( 384.3 +) +— +Long-term Debt +$ 2,967.4 +$ 3,402.4 +(A) +Refer to Note 6 , Acquisitions , for additional information regarding related party debt. +Maturities of long-term debt, including related party, in each of the next five years and beyond are as follows: +2019 +$ 406.6 +2020 +380.9 +2021 +473.9 +2022 +448.3 +2023 +448.8 +Thereafter +1,615.1 +Total +$ 3,773.6 +Various debt agreements to which we are a party include financial covenants and other restrictions, including restrictions pertaining to the ability to create property liens and enter into certain sale and leaseback transactions. As of 30 September 2018 , we are in compliance with all the financial and other covenants under our debt agreements. +Additional commitments totaling $ 7.0 are maintained by our foreign subsidiaries, all of which were borrowed and outstanding at 30 September 2018 . +92 +Table of Contents +Cash paid for interest, net of amounts capitalized, was $ 123.1 , $ 125.9 , and $ 120.6 in fiscal years 2018 , 2017 , and 2016 , respectively. +2017 Credit Agreement +On 31 March 2017 , we entered into a five -year $ 2,500.0 revolving credit agreement maturing 31 March 2022 with a syndicate of banks (the “ 2017 Credit Agreement”), under which senior unsecured debt is available to both the Company and certain of its subsidiaries. On 28 September 2018, we amended the 2017 Credit Agreement to reduce the maximum borrowing capacity to $ 2,300.0 . No other terms were impacted by the amendment. +The 2017 Credit Agreement provides a source of liquidity for the Company and supports its commercial paper program. The Company’s only financial covenant under the 2017 Credit Agreement is a maximum ratio of total debt to total capitalization (total debt plus total equity) no greater than 70 % . No borrowings were outstanding under the 2017 Credit Agreement as of 30 September 2018 . +Loss on Extinguishment of Debt +In September 2016, we exchanged notes issued to us by Versum in anticipation of the spin-off. The exchange resulted in a loss of $ 6.9 . Refer to Note 4 , Materials Technologies Separation , for additional information. +16 . RETIREMENT BENEFITS +The Company and certain of its subsidiaries sponsor defined benefit pension plans and defined contribution plans that cover a substantial portion of its worldwide employees. The principal defined benefit pension plans are the U.S. salaried pension plan and the U.K. pension plan. These plans were closed to new participants in 2005, after which defined contribution plans were offered to new employees. The principal defined contribution plan is the Retirement Savings Plan, in which a substantial portion of the U.S. employees participate. A similar plan is offered to U.K. employees. We also provide other postretirement benefits consisting primarily of healthcare benefits to U.S. retirees who meet age and service requirements. +Defined Benefit Pension Plans +Pension benefits earned are generally based on years of service and compensation during active employment. The cost of our defined benefit pension plans in fiscal years 2018 , 2017 , and 2016 included the following components: +2018 +2017 +2016 +U.S. +International +U.S. +International +U.S. +International +Service cost +$ 25.5 +$ 25.5 +$ 29.0 +$ 25.9 +$ 36.5 +$ 24.3 +Interest cost +107.2 +37.3 +107.5 +32.2 +110.7 +44.3 +Expected return on plan assets +( 201.6 +) +( 81.7 +) +( 207.7 +) +( 75.2 +) +( 202.0 +) +( 78.3 +) +Amortization +Net actuarial loss +87.4 +40.2 +88.7 +54.7 +85.3 +35.6 +Prior service cost (credit) +1.6 +— +2.3 +( .1 +) +2.8 +( .2 +) +Settlements +45.0 +3.5 +10.5 +1.7 +5.1 +1.3 +Curtailments +— +— +4.3 +( 1.3 +) +— +( 1.1 +) +Special termination benefits +.4 +— +2.8 +.4 +2.0 +— +Other +— +1.5 +— +1.1 +( .3 +) +2.1 +Net Periodic Benefit Cost – Total +$ 65.5 +$ 26.3 +$ 37.4 +$ 39.4 +$ 40.1 +$ 28.0 +Less: Discontinued Operations +— +— +( .7 +) +( 4.1 +) +( 7.9 +) +( 4.4 +) +Net Periodic Benefit Cost – Continuing Operations +$ 65.5 +$ 26.3 +$ 36.7 +$ 35.3 +$ 32.2 +$ 23.6 +93 +Table of Contents +As discussed in Note 2, New Accounting Guidance, we early adopted guidance on the presentation of net periodic pension and postretirement benefit cost during the first quarter of fiscal year 2018. The amendments require the service cost component of net periodic benefit cost to be presented within the same line items as other compensation costs arising from services rendered by employees during the period. Accordingly, our service costs are primarily included within "Cost of sales" and "Selling and administrative expense" on our consolidated income statements. The non-service related costs, including pension settlement losses, are presented outside operating income within "Other non-operating income (expense), net." The amount of service costs capitalized in fiscal year 2018 and the amount of net periodic benefit costs capitalized in fiscal years 2017 and 2016 were not material. +During the fourth quarter of fiscal year 2018, we recognized a pension settlement loss of $ 43.7 primarily resulting from the transfer of certain pension payment obligations for our U.S. salaried and hourly plans to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract with plan assets on 17 September 2018. The transaction does not change the amount of the monthly pension benefits received by affected retirees. +Certain of our pension plans provide for a lump sum benefit payment option at the time of retirement, or for corporate officers, six months after their retirement date. A participant’s vested benefit is considered settled upon cash payment of the lump sum. We recognize pension settlement losses when cash payments exceed the sum of the service and interest cost components of net periodic benefit cost of the plan for the fiscal year. We recognized pension settlement losses of $ 10.5 and $ 5.1 in fiscal years 2017 and 2016 , respectively, to accelerate recognition of a portion of actuarial losses deferred in accumulated other comprehensive loss, primarily associated with the U.S. Supplementary Pension Plan. +We calculate net periodic benefit cost for a given fiscal year based on assumptions developed at the end of the previous fiscal year. The following table sets forth the weighted average assumptions used in the calculation of net periodic benefit cost: +2018 +2017 +2016 +U.S. +International +U.S. +International +U.S. +International +Discount rate – Service cost +3.9 +% +2.6 +% +3.6 +% +2.1 +% +4.5 +% +3.4 +% +Discount rate – Interest cost +3.3 +% +2.2 +% +3.0 +% +1.8 +% +3.6 +% +2.9 +% +Expected return on plan assets +7.5 +% +5.8 +% +8.0 +% +6.1 +% +8.0 +% +6.3 +% +Rate of compensation increase +3.5 +% +3.6 +% +3.5 +% +3.5 +% +3.5 +% +3.5 +% +The projected benefit obligation (PBO) is the actuarial present value of benefits attributable to employee service rendered to date, including the effects of estimated future salary increases. The following table sets forth the weighted average assumptions used in the calculation of the PBO: +2018 +2017 +U.S. +International +U.S. +International +Discount rate +4.3 +% +2.5 +% +3.8 +% +2.4 +% +Rate of compensation increase +3.5 +% +3.5 +% +3.5 +% +3.6 +% +94 +Table of Contents +The following tables reflect the change in the PBO and the change in the fair value of plan assets based on the plan year measurement date, as well as the amounts recognized in the consolidated balance sheets: +2018 +2017 +U.S. +International +U.S. +International +Change in Projected Benefit Obligation +Obligation at beginning of year +$ 3,357.7 +$ 1,749.5 +$ 3,477.7 +$ 1,849.6 +Service cost +25.5 +25.5 +29.0 +25.9 +Interest cost +107.2 +37.3 +107.5 +32.2 +Amendments +.1 +.7 +1.9 +— +Actuarial gain +( 217.8 +) +( 33.9 +) +( 68.0 +) +( 132.4 +) +Divestitures +— +— +— +( 34.1 +) +Curtailments +— +— +( 17.3 +) +( 4.2 +) +Settlements +( 193.0 +) +( 24.6 +) +7.0 +— +Special termination benefits +.4 +— +2.8 +— +Participant contributions +— +1.4 +— +1.4 +Benefits paid +( 157.3 +) +( 51.3 +) +( 182.9 +) +( 46.5 +) +Currency translation/other +— +( 44.1 +) +— +57.6 +Obligation at End of Year +$ 2,922.8 +$ 1,660.5 +$ 3,357.7 +$ 1,749.5 +2018 +2017 +U.S. +International +U.S. +International +Change in Plan Assets +Fair value at beginning of year +$ 2,869.2 +$ 1,540.0 +$ 2,705.3 +$ 1,411.1 +Actual return on plan assets +150.2 +115.5 +319.6 +87.9 +Company contributions +14.6 +53.7 +27.2 +42.2 +Participant contributions +— +1.4 +— +1.4 +Divestitures +— +— +— +( 3.0 +) +Benefits paid +( 157.3 +) +( 51.3 +) +( 182.9 +) +( 46.5 +) +Settlements +( 191.8 +) +( 24.6 +) +— +( 5.3 +) +Currency translation/other +— +( 46.5 +) +— +52.2 +Fair Value at End of Year +$ 2,684.9 +$ 1,588.2 +$ 2,869.2 +$ 1,540.0 +Funded Status at End of Year +($ 237.9 +) +($ 72.3 +) +($ 488.5 +) +($ 209.5 +) +Amounts Recognized +Noncurrent assets +$ 28.2 +$ 103.5 +$ 5.3 +$ 13.1 +Accrued liabilities +23.5 +1.2 +12.6 +— +Noncurrent liabilities +242.6 +174.6 +481.2 +222.6 +Net Liability Recognized +$ 237.9 +$ 72.3 +$ 488.5 +$ 209.5 +Settlements in the table above primarily reflect the impact of the transfer of certain pension obligations and plan assets of our U.S. salaried and hourly plans to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract in the fourth quarter of fiscal year 2018. +95 +Table of Contents +The changes in plan assets and benefit obligation that have been recognized in other comprehensive income on a pretax basis during fiscal years 2018 and 2017 consist of the following: +2018 +2017 +U.S. +International +U.S. +International +Net actuarial gain arising during the period +($ 167.7 +) +($ 64.6 +) +($ 189.8 +) +($ 162.0 +) +Amortization of net actuarial loss +( 132.4 +) +( 43.7 +) +( 103.3 +) +( 55.7 +) +Prior service cost arising during the period +.1 +.7 +1.9 +— +Amortization of prior service cost +( 1.6 +) +— +( 2.3 +) +.1 +Total +($ 301.6 +) +($ 107.6 +) +($ 293.5 +) +($ 217.6 +) +The net actuarial gain represents the actual changes in the estimated obligation and plan assets that have not yet been recognized in the consolidated income statements and are included in accumulated other comprehensive loss. Actuarial gains arising during fiscal year 2018 are primarily attributable to higher discount rates and higher than expected return on plan assets. Accumulated actuarial gains and losses that exceed a corridor are amortized over the average remaining service period of U.S. participants, which was approximately eight years as of 30 September 2018 . For U.K. participants, accumulated actuarial gains and losses that exceed a corridor are amortized over the average remaining life expectancy, which was approximately 26 years as of 30 September 2018. +The components recognized in accumulated other comprehensive loss on a pretax basis at 30 September consisted of the following: +2018 +2017 +U.S. +International +U.S. +International +Net actuarial loss +$ 680.4 +$ 443.6 +$ 980.5 +$ 551.9 +Prior service cost (credit) +6.6 +( 1.1 +) +8.1 +( 1.8 +) +Net transition liability +— +.4 +— +.4 +Total +$ 687.0 +$ 442.9 +$ 988.6 +$ 550.5 +The amount of accumulated other comprehensive loss at 30 September 2018 that is expected to be recognized as a component of net periodic pension cost during fiscal year 2019 , excluding discontinued operations and amounts that may be recognized through settlement losses, is as follows: +U.S. +International +Net actuarial loss +$ 65.1 +$ 11.2 +Prior service cost (credit) +1.0 +( .2 +) +The accumulated benefit obligation (ABO) is the actuarial present value of benefits attributed to employee service rendered to a particular date, based on current salaries. The ABO for all defined benefit pension plans was $ 4,376.4 and $ 4,842.8 as of 30 September 2018 and 2017 , respectively. +96 +Table of Contents +The following table provides information on pension plans where the benefit liability exceeds the value of plan assets: +30 September 2018 +30 September 2017 +U.S. +International +U.S. +International +Pension Plans with PBO in Excess of Plan Assets: +PBO +$ 2,733.6 +$ 452.6 +$ 3,116.7 +$ 465.7 +Fair value of plan assets +2,467.5 +276.8 +2,623.0 +243.1 +Pension Plans with ABO in Excess of Plan Assets: +ABO +$ 2,608.6 +$ 357.9 +$ 2,951.0 +$ 365.6 +Fair value of plan assets +2,467.5 +228.2 +2,623.0 +197.1 +The tables above include several pension arrangements that are not funded because of jurisdictional practice. The ABO and PBO related to these plans as of 30 September 2018 were $ 92.8 and $ 100.9 , respectively. +Pension Plan Assets +Our pension plan investment strategy is to invest in diversified portfolios to earn a long-term return consistent with acceptable risk in order to pay retirement benefits and meet regulatory funding requirements while minimizing company cash contributions over time. De-risking strategies are also employed for closed plans as funding improves, generally resulting in higher allocations to long duration bonds. The plans invest primarily in passive and actively managed equity and debt securities. Equity investments are diversified geographically and by investment style and market capitalization. Fixed income investments include sovereign, corporate and asset-backed securities generally denominated in the currency of the plan. +Asset allocation targets are established based on the long-term return, volatility and correlation characteristics of the asset classes, the profiles of the plans’ liabilities, and acceptable levels of risk. Actual allocations vary from target due to market changes and are reviewed regularly. Assets are routinely rebalanced through contributions, benefit payments, and otherwise as deemed appropriate. The actual and target allocations at the measurement date are as follows: +2018 Target Allocation +2018 Actual Allocation +2017 Actual Allocation +U.S. +International +U.S. +International +U.S. +International +Asset Category +Equity securities +38 +- +48 % +40 +- +49 % +41 +% +46 +% +58 +% +53 +% +Debt securities +44 +- +54 % +50 +- +60 % +50 +% +53 +% +34 +% +46 +% +Real estate/other +— +- +10 % +— +- +— % +8 +% +— +% +7 +% +1 +% +Cash +—% +—% +1 +% +1 +% +1 +% +— +% +Total +100 +% +100 +% +100 +% +100 +% +In fiscal year 2018, the 7.5 % expected return for U.S. plan assets was based on a weighted average of estimated long-term returns of major asset classes and the historical performance of plan assets. The estimated long-term return for equity, debt securities, and real estate is 8.0 % , 5.4 % , and 6.9 % , respectively. In determining asset class returns, we take into account historical long-term returns and the value of active management, as well as other economic and market factors. +In fiscal year 2018, the 5.8 % expected rate of return for international plan assets was based on a weighted average return for plans outside the U.S., which vary significantly in size, asset structure and expected returns. The expected asset return for the U.K. plan, which represents over 80 % of the assets of our International plans, is 6.2 % and was derived from expected equity and debt security returns of 7.4 % and 2.7 % , respectively. +97 +Table of Contents +The following table summarizes pension plan assets measured at fair value by asset class (see Note 14 , Fair Value Measurements , for definition of the levels): +30 September 2018 +30 September 2017 +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +U.S. Qualified Pension Plans +Cash and cash equivalents +$ 13.8 +$ 13.8 +$ — +$ — +$ 13.6 +$ 13.6 +$ — +$ — +Equity securities +397.9 +397.9 +— +— +598.6 +598.6 +— +— +Equity mutual funds +173.8 +173.8 +— +— +276.5 +276.5 +— +— +Equity pooled funds +545.2 +— +545.2 +— +787.0 +— +787.0 +— +Fixed income: +Bonds (government +and corporate) +1,344.6 +— +1,344.6 +— +985.7 +— +985.7 +— +Total U.S. Qualified Pension Plans at Fair Value +$ 2,475.3 +$ 585.5 +$ 1,889.8 +$ — +$ 2,661.4 +$ 888.7 +$ 1,772.7 +$ — +Real estate pooled funds (A) +$ 209.6 +$ 207.8 +Total U.S. Qualified Pension Plans +$ 2,684.9 +$ 2,869.2 +International Pension Plans +Cash and cash equivalents +$ 15.8 +$ 15.8 +$ — +$ — +$ 7.3 +$ 7.3 +$ — +$ — +Equity pooled funds +727.9 +— +727.9 +— +821.4 +— +821.4 +— +Fixed income pooled funds +615.2 +— +615.2 +— +651.3 +— +651.3 +— +Other pooled funds +11.6 +— +11.6 +— +18.6 +— +10.8 +7.8 +Insurance contracts +217.7 +— +— +217.7 +41.4 +— +— +41.4 +Total International Pension Plans +$ 1,588.2 +$ 15.8 +$ 1,354.7 +$ 217.7 +$ 1,540.0 +$ 7.3 +$ 1,483.5 +$ 49.2 +(A) +Real estate pooled funds consist of funds that invest in properties. Interests in these funds are valued using the net asset value ("NAV") per share practical expedient and are not classified in the fair value hierarchy. During fiscal year 2018, we identified that these investments were improperly included in the fair value hierarchy table of our 2017 Form 10-K. Accordingly, we have updated the prior period to conform with the appropriate current year presentation. +The following table summarizes changes in fair value of the pension plan assets classified as Level 3, by asset class: +Other +Pooled Funds +Insurance +Contracts +Total +30 September 2016 +$ 7.3 +$ 45.8 +$ 53.1 +Actual return on plan assets: +Assets held at end of year +1.2 +( 1.0 +) +.2 +Assets sold during the period +.3 +— +.3 +Purchases, sales, and settlements, net +( 1.0 +) +( 3.4 +) +( 4.4 +) +30 September 2017 +$ 7.8 +$ 41.4 +$ 49.2 +Actual return on plan assets: +Assets held at end of year +— +.9 +.9 +Assets sold during the period +.5 +— +.5 +Purchases, sales, and settlements, net +( 8.3 +) +175.4 +167.1 +30 September 2018 +$ — +$ 217.7 +$ 217.7 +98 +Table of Contents +The descriptions and fair value methodologies for the U.S. and International pension plan assets are as follows: +Cash and Cash Equivalents +The carrying amounts of cash and cash equivalents approximate fair value due to the short-term maturity. +Equity Securities +Equity securities are valued at the closing market price reported on a U.S. or international exchange where the security is actively traded and are therefore classified as Level 1 assets. +Equity Mutual and Pooled Funds +Shares of mutual funds are valued at the net asset value (NAV) of the fund and are classified as Level 1 assets. Units of pooled funds are valued at the per unit NAV determined by the fund manager based on the value of the underlying traded holdings and are classified as Level 2 assets. +Corporate and Government Bonds +Corporate and government bonds are classified as Level 2 assets, as they are either valued at quoted market prices from observable pricing sources at the reporting date or valued based upon comparable securities with similar yields and credit ratings. +Other Pooled Funds +Other pooled funds classified as Level 2 assets are valued at the NAV of the shares held at year end, which is based on the fair value of the underlying investments. Securities and interests classified as Level 3 are carried at the estimated fair value. The estimated fair value is based on the fair value of the underlying investment values, which includes estimated bids from brokers or other third-party vendor sources that utilize expected cash flow streams and other uncorroborated data including counterparty credit quality, default risk, discount rates, and the overall capital market liquidity. +Insurance Contracts +Insurance contracts are classified as Level 3 assets, as they are carried at contract value, which approximates the estimated fair value. The estimated fair value is based on the fair value of the underlying investment of the insurance company and discount rates that require inputs with limited observability. +Contributions and Projected Benefit Payments +Pension contributions to funded plans and benefit payments for unfunded plans for fiscal year 2018 were $ 68.3 . Contributions for funded plans resulted primarily from contractual and regulatory requirements. Benefit payments to unfunded plans were due primarily to the timing of retirements. We anticipate contributing $ 45 to $ 65 to the defined benefit pension plans in fiscal year 2019 . These contributions are anticipated to be driven primarily by contractual and regulatory requirements for funded plans and benefit payments for unfunded plans, which are dependent upon timing of retirements. +Projected benefit payments, which reflect expected future service, are as follows: +U.S. +International +2019 +$ 165.5 +$ 52.8 +2020 +152.4 +53.9 +2021 +157.0 +55.6 +2022 +163.7 +56.0 +2023 +167.9 +60.6 +2024-2028 +900.2 +336.8 +These estimated benefit payments are based on assumptions about future events. Actual benefit payments may vary significantly from these estimates. +99 +Table of Contents +Subsequent Event – GMP Equalization +On 26 October 2018, the United Kingdom High Court issued a ruling in a case relating to equalization of pension plan participants’ benefits for the gender effects of Guaranteed Minimum Pensions ("GMP equalization"). The ruling relates to the Lloyds Banking Group pension plans but impacts other U.K. defined benefit pension plans. We are still assessing the impact of this ruling. If we determine that the ruling impacts our U.K. pension plan, the approach to achieve GMP equalization may retroactively increase our benefit obligation for some participants in the plan and may impact funding requirements. +Defined Contribution Plans +We maintain a nonleveraged employee stock ownership plan (ESOP) which forms part of the Air Products and Chemicals, Inc. Retirement Savings Plan (RSP). The ESOP was established in May of 2002. The balance of the RSP is a qualified defined contribution plan including a 401(k) elective deferral component. A substantial portion of U.S. employees are eligible and participate. +We treat dividends paid on ESOP shares as ordinary dividends. Under existing tax law, we may deduct dividends which are paid with respect to shares held by the plan. Shares of the Company’s common stock in the ESOP totaled 2,378,336 as of 30 September 2018 . +Our contributions to the RSP include a Company core contribution for certain eligible employees who do not receive their primary retirement benefit from the defined benefit pension plans, with the core contribution based on a percentage of pay that is dependent on years of service. For the RSP, we also make matching contributions on overall employee contributions as a percentage of the employee contribution and include an enhanced contribution for certain eligible employees that do not participate in the defined benefit pension plans. Worldwide contributions, excluding discontinued operations, expensed to income in fiscal years 2018 , 2017 , and 2016 were $ 34.2 , $ 33.7 , and $ 34.6 , respectively. +Other Postretirement Benefits +We provide other postretirement benefits consisting primarily of healthcare benefits to certain U.S. retirees who meet age and service requirements. The healthcare benefit is a continued medical benefit until the retiree reaches age 65. Healthcare benefits are contributory, with contributions adjusted periodically. The retiree medical costs are capped at a specified dollar amount, with the retiree contributing the remainder. The cost of these benefits were not material in fiscal years 2018 , 2017 , and 2016 . Accumulated postretirement benefit obligations as of the end of fiscal years 2018 and 2017 were $ 56.4 and $ 67.0 , respectively, of which $ 9.4 and $ 10.0 were current obligations, respectively. +The changes in other postretirement benefit plan obligations that have been recognized in other comprehensive income on a pretax basis during fiscal years 2018 and 2017 were gains of $ 3.1 and $ 10.7 that arose during the periods, respectively, and $ .3 and $ .2 of net actuarial loss amortization, respectively. The net actuarial loss recognized in accumulated other comprehensive loss on a pretax basis was $ 4.4 at 30 September 2018 and $ 7.8 at 30 September 2017 . +Expected per capita claims costs are currently assumed to be greater than the annual cap; therefore, the assumed healthcare cost trend rate, ultimate trend rate, and the year the ultimate trend rate is reached have no impact on plan obligations. +100 +Table of Contents +17 . COMMITMENTS AND CONTINGENCIES +LITIGATION +We are involved in various legal proceedings, including commercial, competition, environmental, health, safety, product liability, and insurance matters. In September 2010, the Brazilian Administrative Council for Economic Defense ("CADE") issued a decision against our Brazilian subsidiary, Air Products Brasil Ltda., and several other Brazilian industrial gas companies for alleged anticompetitive activities. CADE imposed a civil fine of R$ 179.2 million (approximately $ 44 at 30 September 2018 ) on Air Products Brasil Ltda. This fine was based on a recommendation by a unit of the Brazilian Ministry of Justice, whose investigation began in 2003, alleging violation of competition laws with respect to the sale of industrial and medical gases. The fines are based on a percentage of our total revenue in Brazil in 2003. +We have denied the allegations made by the authorities and filed an appeal in October 2010 with the Brazilian courts. On 6 May 2014, our appeal was granted and the fine against Air Products Brasil Ltda. was dismissed. CADE has appealed that ruling and the matter remains pending. We, with advice of our outside legal counsel, have assessed the status of this matter and have concluded that, although an adverse final judgment after exhausting all appeals is possible, such a judgment is not probable. As a result, no provision has been made in the consolidated financial statements. We estimate the maximum possible loss to be the full amount of the fine of R$ 179.2 million (approximately $ 44 at 30 September 2018 ) plus interest accrued thereon until final disposition of the proceedings. +Other than this matter, we do not currently believe there are any legal proceedings, individually or in the aggregate, that are reasonably possible to have a material impact on our financial condition, results of operations, or cash flows. +ENVIRONMENTAL +In the normal course of business, we are involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA: the federal Superfund law); Resource Conservation and Recovery Act (RCRA); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Presently, there are 32 sites on which a final settlement has not been reached where we, along with others, have been designated a potentially responsible party by the Environmental Protection Agency or are otherwise engaged in investigation or remediation, including cleanup activity at certain of our current and former manufacturing sites. We continually monitor these sites for which we have environmental exposure. +Accruals for environmental loss contingencies are recorded when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The consolidated balance sheets at 30 September 2018 and 2017 included an accrual of $ 76.8 and $ 83.6 , respectively, primarily as part of other noncurrent liabilities. The environmental liabilities will be paid over a period of up to 30 years . We estimate the exposure for environmental loss contingencies to range from $ 76 to a reasonably possible upper exposure of $ 90 as of 30 September 2018 . +Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Using reasonably possible alternative assumptions of the exposure level could result in an increase to the environmental accrual. Due to the inherent uncertainties related to environmental exposures, a significant increase to the reasonably possible upper exposure level could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or a significant increase in our proportionate share occurs. We do not expect that any sum we may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed above would have a material adverse impact on our financial position or results of operations in any one year. +Pace +At 30 September 2018 , $ 26.0 of the environmental accrual was related to the Pace facility. +In 2006, we sold our Amines business, which included operations at Pace, Florida, and recognized a liability for retained environmental obligations associated with remediation activities at Pace. We are required by the Florida Department of Environmental Protection (FDEP) and the United States Environmental Protection Agency (USEPA) to continue our remediation efforts. We estimated that it would take a substantial period of time to complete the groundwater remediation, and the costs through completion were estimated to range from $ 42 to $ 52 . As no amount within the range was a better estimate than another, we recognized a before-tax expense of $ 42 in fiscal 2006 as a component of income from discontinued operations and recorded an environmental accrual of $ 42 in continuing operations on the consolidated balance sheets. There has been no change to the estimated exposure range related to the Pace facility. +101 +Table of Contents +We have implemented many of the remedial corrective measures at the Pace facility required under 1995 Consent Orders issued by the FDEP and the USEPA. Contaminated soils have been bioremediated, and the treated soils have been secured in a lined on-site disposal cell. Several groundwater recovery systems have been installed to contain and remove contamination from groundwater. We completed an extensive assessment of the site to determine how well existing measures are working, what additional corrective measures may be needed, and whether newer remediation technologies that were not available in the 1990s might be suitable to more quickly and effectively remove groundwater contaminants. Based on assessment results, we completed a focused feasibility study that has identified alternative approaches that may more effectively remove contaminants. We continue to review alternative remedial approaches with the FDEP and have started additional field work to support the design of an improved groundwater recovery network with the objective of targeting areas of higher contaminant concentration and avoiding areas of high groundwater iron which has proven to be a significant operability issue for the project. In the first quarter of 2015, we entered into a new Consent Order with the FDEP requiring us to continue our remediation efforts at the Pace facility. The costs we are incurring under the new Consent Order are consistent with our previous estimates. +Piedmont +At 30 September 2018 , $ 15.7 of the environmental accrual was related to the Piedmont site. +On 30 June 2008, we sold our Elkton, Maryland, and Piedmont, South Carolina, production facilities and the related North American atmospheric emulsions and global pressure sensitive adhesives businesses. In connection with the sale, we recognized a liability for retained environmental obligations associated with remediation activities at the Piedmont site. This site is under active remediation for contamination caused by an insolvent prior owner. +We are required by the South Carolina Department of Health and Environmental Control (SCDHEC) to address both contaminated soil and groundwater. Numerous areas of soil contamination have been addressed, and contaminated groundwater is being recovered and treated. The SCDHEC issued its final approval to the site-wide feasibility study on 13 June 2017 and the Record of Decision for the site on 27 June 2018. Field work has started to support the remedial design, and in the fourth quarter of fiscal year 2018, we signed a Consent Agreement Amendment memorializing our obligations to complete the cleanup of the site. We estimate that source area remediation and groundwater recovery and treatment will continue through 2029. Thereafter, we expect this site to go into a state of monitored natural attenuation through 2047. +We recognized a before-tax expense of $ 24 in 2008 as a component of income from discontinued operations and recorded an environmental liability of $ 24 in continuing operations on the consolidated balance sheets. There have been no significant changes to the estimated exposure. +Pasadena +At 30 September 2018 , $ 11.7 of the environmental accrual was related to the Pasadena site. +During the fourth quarter of 2012, management committed to permanently shutting down our polyurethane intermediates (PUI) production facility in Pasadena, Texas. In shutting down and dismantling the facility, we have undertaken certain obligations related to soil and groundwater contaminants. We have been pumping and treating groundwater to control off-site contaminant migration in compliance with regulatory requirements and under the approval of the Texas Commission on Environmental Quality (TCEQ). We estimate that the pump and treat system will continue to operate until 2042 . +We plan to perform additional work to address other environmental obligations at the site. This additional work includes remediating, as required, impacted soils, investigating groundwater west of the former PUI facility, performing post closure care for two closed RCRA surface impoundment units, and establishing engineering controls. In 2012, we estimated the total exposure at this site to be $ 13 . There have been no significant changes to the estimated exposure. +102 +Table of Contents +ASSET RETIREMENT OBLIGATIONS +Our asset retirement obligations are primarily associated with on-site long-term supply contracts under which we have built a facility on land owned by the customer and are obligated to remove the facility at the end of the contract term. The retirement of assets includes the contractually required removal of a long-lived asset from service and encompasses the sale, removal, abandonment, recycling, or disposal of the assets as required at the end of the contract terms. These obligations are primarily reflected in "Other noncurrent liabilities" on the consolidated balance sheets. The timing and/or method of settlement of these obligations are conditional on a future event that may or may not be within our control. +Changes to the carrying amount of our asset retirement obligations are as follows: +Balance at 30 September 2016 +$ 119.9 +Additional accruals +22.7 +Liabilities settled +( 4.1 +) +Accretion expense +5.8 +Currency translation adjustment +.4 +Balance at 30 September 2017 +$ 144.7 +Additional accruals +43.8 +Liabilities settled +( 2.6 +) +Accretion expense +7.2 +Currency translation adjustment +( 2.7 +) +Balance at 30 September 2018 +$ 190.4 +The increase in the liability during fiscal year 2018 primarily relates to new obligations associated with the Lu'An asset acquisition completed in April 2018. +GUARANTEES AND WARRANTIES +In April 2015, we entered into joint venture arrangements in Saudi Arabia. An equity bridge loan has been provided to the joint venture until 2020 to fund equity commitments. We guaranteed the repayment of our 25 % share of this loan, and our venture partner guaranteed repayment of its share. Our maximum exposure under the guarantee is approximately $ 100 . As of 30 September 2018 and 2017 , we recorded a noncurrent liability of $ 94.4 for our obligation to make future equity contributions based on our proportionate share of the advances received by the joint venture under the loan. +Air Products has also entered into a long-term sale of equipment contract with the joint venture to engineer, procure, and construct the industrial gas facilities that will supply gases to Saudi Aramco. We provided bank guarantees to the joint venture to support our performance under the contract. As of 30 September 2018 , our maximum potential payments were $ 249 . Exposures under the guarantees decline over time and will be completely extinguished after completion of the project. +We are party to an equity support agreement and operations guarantee related to an air separation facility constructed in Trinidad for a venture in which we own 50 % . At 30 September 2018 , maximum potential payments under joint and several guarantees were $ 27.0 . Exposures under the guarantees decline over time and will be completely extinguished by 2024 . +During the first quarter of 2014, we sold the remaining portion of our Homecare business and entered into an operations guarantee related to obligations under certain homecare contracts assigned in connection with the transaction. Our maximum potential payment under the guarantee is £ 20 million (approximately $ 25 at 30 September 2018 ), and our exposure will be extinguished by 2020 . +To date, no equity contributions or payments have been made since the inception of these guarantees. The fair value of the above guarantees is not material. +We, in the normal course of business operations, have issued product warranties related to equipment sales. Also, contracts often contain standard terms and conditions which typically include a warranty and indemnification to the buyer that the goods and services purchased do not infringe on third-party intellectual property rights. The provision for estimated future costs relating to warranties is not material to the consolidated financial statements. +We do not expect that any sum we may have to pay in connection with guarantees and warranties will have a material adverse effect on our consolidated financial condition, liquidity, or results of operations. +103 +Table of Contents +UNCONDITIONAL PURCHASE OBLIGATIONS +We are obligated to make future payments under unconditional purchase obligations as summarized below: +2019 +$ 851 +2020 +362 +2021 +342 +2022 +318 +2023 +326 +Thereafter +5,461 +Total +$ 7,660 +Approximately $ 6,800 of our unconditional purchase obligations relate to helium purchases. The majority of these obligations occur after fiscal year 2023. Helium purchases include crude feedstock supply to multiple helium refining plants in North America as well as refined helium purchases from sources around the world. As a rare byproduct of natural gas production in the energy sector, these helium sourcing agreements are medium- to long-term and contain take-if-tendered provisions. The refined helium is distributed globally and sold as a merchant gas, primarily under medium-term requirements contracts. While contract terms in the energy sector are longer than those in merchant, helium is a rare gas used in applications with few or no substitutions because of its unique physical and chemical properties. +Approximately $ 210 of our long-term unconditional purchase obligations relate to feedstock supply for numerous HyCO (hydrogen, carbon monoxide, and syngas) facilities. The price of feedstock supply is principally related to the price of natural gas. However, long-term take-or-pay sales contracts to HyCO customers are generally matched to the term of the feedstock supply obligations and provide recovery of price increases in the feedstock supply. Due to the matching of most long-term feedstock supply obligations to customer sales contracts, we do not believe these purchase obligations would have a material effect on our financial condition or results of operations. +The unconditional purchase obligations also include other product supply and purchase commitments and electric power and natural gas supply purchase obligations, which are primarily pass-through contracts with our customers. +Purchase commitments to spend approximately $ 455 for additional plant and equipment are included in the unconditional purchase obligations in 2019 . +18 . CAPITAL STOCK +Common Stock +Authorized common stock consists of 300 million shares with a par value of $ 1 per share. As of 30 September 2018 , 249 million shares were issued, with 220 million outstanding. +On 15 September 2011, the Board of Directors authorized the repurchase of up to $ 1.0 billion of our outstanding common stock. We repurchase shares pursuant to Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended, through repurchase agreements established with several brokers. We did not purchase any of our outstanding shares during fiscal year 2018 . At 30 September 2018 , $ 485.3 in share repurchase authorization remains. +The following table reflects the changes in common shares: +Year ended 30 September +2018 +2017 +2016 +Number of Common Shares Outstanding +Balance, beginning of year +218,346,074 +217,350,825 +215,359,113 +Issuance of treasury shares for stock option and award plans +1,169,171 +995,249 +1,991,712 +Balance, end of year +219,515,245 +218,346,074 +217,350,825 +Preferred Stock +Authorized preferred stock consists of 25 million shares with a par value of $ 1 per share, of which 2.5 million were designated as Series A Junior Participating Preferred Stock. There were no shares issued or outstanding as of 30 September 2018 and 2017 . +104 +Table of Contents +19 . SHARE-BASED COMPENSATION +We have various share-based compensation programs, which include deferred stock units, stock options, and restricted stock. Under all programs, the terms of the awards are fixed at the grant date. We issue shares from treasury stock upon the payout of deferred stock units, the exercise of stock options, and the issuance of restricted stock awards. Share information presented is on a total company basis. As of 30 September 2018 , there were 4,869,212 shares available for future grant under our Long-Term Incentive Plan (LTIP), which is shareholder approved. +Share-based compensation cost recognized in the consolidated income statements is summarized below: +2018 +2017 +2016 +Before-Tax Share-Based Compensation Cost – Total +$ 38.8 +$ 40.7 +$ 37.6 +Before-Tax Share-Based Compensation Cost – Discontinued Operations +— +.8 +6.6 +Before-Tax Share-Based Compensation Cost – Continuing Operations +$ 38.8 +$ 39.9 +$ 31.0 +Income tax benefit – Continuing Operations +( 9.1 +) +( 14.0 +) +( 10.8 +) +After-Tax Share-Based Compensation Cost – Continuing Operations +$ 29.7 +$ 25.9 +$ 20.2 +Before-tax share-based compensation cost is primarily included in selling and administrative expense on our consolidated income statements. The amount of share-based compensation cost capitalized in fiscal years 2018 , 2017 , and 2016 was not material. +On a total company basis, before-tax share-based compensation cost by type of program was as follows: +2018 +2017 +2016 +Deferred stock units +$ 38.3 +$ 34.5 +$ 29.9 +Stock options +.2 +1.4 +4.2 +Restricted stock +.3 +4.8 +3.5 +Before-Tax Share-Based Compensation Cost – Total +$ 38.8 +$ 40.7 +$ 37.6 +Deferred Stock Units +We have granted deferred stock units to executives, selected employees, and outside directors. These deferred stock units entitle the recipient to one share of common stock upon vesting, which is conditioned, for employee recipients, on continued employment during the deferral period and may be conditioned on achieving certain performance targets. We grant deferred stock unit awards with a two - to five -year deferral period that is subject to payout upon death, disability, or retirement. Deferred stock units issued to outside directors are paid after service on the Board of Directors ends at the time elected by the director (not to exceed 10 years after service ends). We generally expense the grant-date fair value of these awards on a straight-line basis over the vesting period; however, expense recognition is accelerated for retirement eligible individuals who meet the requirements for vesting upon retirement. We have elected to account for forfeitures as they occur, rather than to estimate them. Forfeitures have not been significant historically. +Market-based deferred stock units vest as long as the employee continues to be employed by the Company and upon the achievement of the performance target. The performance target, which is approved by the Compensation Committee, is the Company’s total shareholder return (share price appreciation and dividends paid) in relation to a defined peer group over a three ‑year performance period beginning 1 October of the fiscal year of grant. We granted 105,268 , 117,692 , and 130,167 market-based deferred stock units in fiscal years 2018 , 2017 , and 2016 , respectively. +105 +Table of Contents +The fair value of market-based deferred stock units was estimated using a Monte Carlo simulation model as these equity awards are tied to a market condition. The model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the grant and calculates the fair value of the awards. We generally expense the grant-date fair value of these awards on a straight-line basis over the vesting period. The estimated grant-date fair value of market-based deferred stock units was $ 202.50 , $ 156.87 , and $ 135.49 per unit in fiscal years 2018 , 2017 , and 2016, respectively. The calculation of the fair value used the following assumptions: +2018 +2017 +2016 +Expected volatility +18.7 +% +20.6 +% +20.5 +% +Risk-free interest rate +1.9 +% +1.4 +% +1.2 +% +Expected dividend yield +2.6 +% +2.5 +% +2.2 +% +In addition, during fiscal year 2018 , we granted 143,379 time-based deferred stock units at a weighted average grant-date fair value of $ 162.11 . In fiscal years 2017 and 2016, we granted 165,121 and 164,711 time-based deferred stock units at a weighted average grant-date fair value of and $ 143.75 and $ 128.03 , respectively. +Deferred Stock Units +Shares (000) +Weighted Average +Grant-Date Fair Value +Outstanding at 30 September 2017 +975 +$ 127.29 +Granted +249 +179.21 +Paid out +( 237 +) +134.99 +Forfeited/adjustments +( 47 +) +153.57 +Outstanding at 30 September 2018 +940 +$ 137.78 +Cash payments made for deferred stock units were $ 2.2 , $ 2.1 , and $ 2.9 in fiscal years 2018 , 2017 , and 2016 , respectively. As of 30 September 2018 , there was $ 40.5 of unrecognized compensation cost related to deferred stock units. The cost is expected to be recognized over a weighted average period of 1.6 years . The total fair value of deferred stock units paid out during fiscal years 2018 , 2017 , and 2016 , including shares vested in prior periods, was $ 38.5 , $ 36.6 , and $ 41.6 , respectively. +Stock Options +We have granted awards of options to purchase common stock to executives and selected employees. The exercise price of stock options equals the market price of our stock on the date of the grant. Options generally vest incrementally over three years , and remain exercisable for ten years from the date of grant. In fiscal years 2018 , 2017 , and 2016 , no stock options were awarded. +A summary of stock option activity is presented below: +Stock Options +Shares (000) +Weighted Average +Exercise Price +Outstanding at 30 September 2017 +3,202 +$ 84.85 +Exercised +( 1,015 +) +75.15 +Forfeited +( 1 +) +124.76 +Outstanding and Exercisable at 30 September 2018 +2,186 +$ 89.33 +Stock Options +Weighted Average Remaining Contractual Term (in years) +Aggregate Intrinsic Value +Outstanding and Exercisable at 30 September 2018 +3.9 +$ 170 +The aggregate intrinsic value represents the amount by which our closing stock price of $ 167.05 as of 30 September 2018 exceeds the exercise price multiplied by the number of in-the-money options outstanding or exercisable. +On a total company basis, the intrinsic value of stock options exercised during fiscal years 2018 , 2017 , and 2016 was $ 90.4 , $ 57.3 , and $ 115.3 , respectively. +106 +Table of Contents +Compensation cost is generally recognized over the stated vesting period consistent with the terms of the arrangement (i.e., either on a straight-line or graded-vesting basis). Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. As of 30 September 2018 , there was no unrecognized compensation cost as all stock option awards were fully vested. +Cash received from option exercises during fiscal year 2018 was $ 76.2 . The total tax benefit realized from stock option exercises in fiscal year 2018 was $ 25.8 , of which $ 19.0 was the excess tax benefit. +Restricted Stock +The grant-date fair value of restricted stock is estimated on the date of grant based on the closing price of the stock, and compensation cost is generally amortized to expense on a straight-line basis over the vesting period during which employees perform related services. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. We have elected to account for forfeitures as they occur, rather than to estimate them. Forfeitures have not been significant historically. +We have issued shares of restricted stock to certain officers. Participants are entitled to cash dividends and to vote their respective shares. Restrictions on shares lift in one to four years or upon the earlier of retirement, death, or disability. The shares are nontransferable while subject to forfeiture. +A summary of restricted stock activity is presented below: +Restricted Stock +Shares (000) +Weighted Average +Grant-Date Fair Value +Outstanding at 30 September 2017 +56 +$ 135.74 +Vested +( 14 +) +121.90 +Outstanding at 30 September 2018 +42 +$ 140.28 +As of 30 September 2018 , there was $ .1 of unrecognized compensation cost related to restricted stock awards. The cost is expected to be recognized over a weighted average period of 0.5 years . The total fair value of restricted stock vested during fiscal years 2018 , 2017 , and 2016 was $ 2.2 , $ 4.1 , and $ 4.3 , respectively. +As discussed in Note 3 , Discontinued Operations , Air Products completed the spin-off of Versum on 1 October 2016. In connection with the spin-off, the Company adjusted the number of deferred stock units and stock options pursuant to existing anti-dilution provisions in the LTIP to preserve the intrinsic value of the awards immediately before and after the separation. The outstanding awards will continue to vest over the original vesting period defined at the grant date. Outstanding awards at the time of spin-off were primarily converted into awards of the holders' employer following the separation. +Stock awards held upon separation were adjusted based upon the conversion ratio of Air Products' New York Stock Exchange (“NYSE”) volume weighted-average closing stock price on 30 September 2016 ( $ 150.35 ) to the NYSE volume weighted-average opening stock price on 3 October 2016 ( $ 140.38 ), or 1.071 . The adjustment to the awards did not result in incremental fair value, and no incremental compensation expense was recorded related to the conversion of these awards. +107 +Table of Contents +20 . ACCUMULATED OTHER COMPREHENSIVE LOSS +The table below summarizes changes in AOCL, net of tax, attributable to Air Products: +Derivatives +qualifying +as hedges +Foreign +currency +translation +adjustments +Pension and +postretirement +benefits +Total +Balance at 30 September 2015 +($ 42.9 +) +($ 956.5 +) +($ 1,126.5 +) +($ 2,125.9 +) +Other comprehensive income (loss) before reclassifications +13.7 +9.9 +( 335.1 +) +( 311.5 +) +Amounts reclassified from AOCL +( 36.0 +) +2.7 +87.2 +53.9 +Net current period other comprehensive income (loss) +($ 22.3 +) +$ 12.6 +($ 247.9 +) +($ 257.6 +) +Amount attributable to noncontrolling interest +( .2 +) +5.4 +( .4 +) +4.8 +Balance at 30 September 2016 +($ 65.0 +) +($ 949.3 +) +($ 1,374.0 +) +($ 2,388.3 +) +Other comprehensive income (loss) before reclassifications +( 12.6 +) +101.9 +251.6 +340.9 +Amounts reclassified from AOCL +24.2 +57.3 +110.7 +192.2 +Net current period other comprehensive income +$ 11.6 +$ 159.2 +$ 362.3 +$ 533.1 +Spin-off of Versum +.2 +6.0 +5.3 +11.5 +Amount attributable to noncontrolling interest +( .1 +) +3.0 +.8 +3.7 +Balance at 30 September 2017 +($ 53.1 +) +($ 787.1 +) +($ 1,007.2 +) +($ 1,847.4 +) +Other comprehensive income (loss) before reclassifications +45.9 +( 244.6 +) +179.4 +( 19.3 +) +Amounts reclassified from AOCL +( 30.4 +) +3.1 +133.1 +105.8 +Net current period other comprehensive income (loss) +$ 15.5 +($ 241.5 +) +$ 312.5 +$ 86.5 +Amount attributable to noncontrolling interest +— +( 18.8 +) +( .2 +) +( 19.0 +) +Balance at 30 September 2018 +($ 37.6 +) +($ 1,009.8 +) +($ 694.5 +) +($ 1,741.9 +) +108 +Table of Contents +The table below summarizes the reclassifications out of accumulated other comprehensive loss and the affected line item on the consolidated income statements: +2018 +2017 +2016 +(Gain) Loss on Cash Flow Hedges, net of tax +Sales/Cost of sales +$ 7.1 +$ 18.3 +$ .2 +Other income (expense), net +( 42.6 +) +5.1 +( 46.2 +) +Interest expense +5.1 +.8 +10.0 +Total (Gain) Loss on Cash Flow Hedges, net of tax +($ 30.4 +) +$ 24.2 +($ 36.0 +) +Currency Translation Adjustment +Cost of sales (A) +$ 3.1 +$ — +$ — +Cost reduction and assets actions (B) +— +8.2 +— +Loss from discontinued operations, net of tax (C) +— +49.1 +2.7 +Total Currency Translation Adjustment +$ 3.1 +$ 57.3 +$ 2.7 +Pension and Postretirement Benefits, net of tax (D) +$ 133.1 +$ 110.7 +$ 87.2 +(A) +The fiscal year 2018 impact relates to an equipment sale resulting from the termination of a contract in the Industrial Gases – Asia segment during the first quarter. +(B) +The fiscal year 2017 impact relates to the planned sale of a non-industrial gas hardgoods business in the Industrial Gases – Americas segment recorded in the third quarter. +(C) +The fiscal year 2017 impact relates to the sale of PMD during the second quarter. The fiscal year 2016 impact primarily relates to the sale of an equity affiliate in the first quarter. +(D) +The components of net periodic benefit cost reclassified out of AOCL include items such as prior service cost amortization, actuarial loss amortization, and settlements and are included in “Other non-operating income (expense), net” on the consolidated income statements. Refer to Note 16 , Retirement Benefits , for additional information. +21 . EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted earnings per share (EPS): +30 September +2018 +2017 +2016 +Numerator +Income from continuing operations +$ 1,455.6 +$ 1,134.4 +$ 1,099.5 +Income (Loss) from discontinued operations +42.2 +1,866.0 +( 468.4 +) +Net Income Attributable to Air Products +$ 1,497.8 +$ 3,000.4 +$ 631.1 +Denominator (in millions) +Weighted average common shares — Basic +219.3 +218.0 +216.4 +Effect of dilutive securities +Employee stock option and other award plans +1.5 +1.8 +1.9 +Weighted average common shares — Diluted +220.8 +219.8 +218.3 +Basic EPS Attributable to Air Products +Income from continuing operations +$ 6.64 +$ 5.20 +$ 5.08 +Income (Loss) from discontinued operations +.19 +8.56 +( 2.16 +) +Net Income Attributable to Air Products +$ 6.83 +$ 13.76 +$ 2.92 +Diluted EPS Attributable to Air Products +Income from continuing operations +$ 6.59 +$ 5.16 +$ 5.04 +Income (Loss) from discontinued operations +.19 +8.49 +( 2.15 +) +Net Income Attributable to Air Products +$ 6.78 +$ 13.65 +$ 2.89 +109 +Table of Contents +Diluted EPS attributable to Air Products reflects the potential dilution that could occur if stock options or other share-based awards were exercised or converted into common stock. The dilutive effect is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used by the Company to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. Outstanding share-based awards of .1 million and .2 million shares were antidilutive and therefore excluded from the computation of diluted EPS for 2018 and 2016, respectively. There were no antidilutive outstanding share-based awards in fiscal year 2017. +22 . INCOME TAXES +The following table summarizes the income of U.S. and foreign operations before taxes: +2018 +2017 +2016 +Income from Continuing Operations before Taxes +United States +$ 688.5 +$ 669.8 +$ 631.7 +Foreign +1,151.7 +666.2 +775.9 +Income from equity affiliates +174.8 +80.1 +147.0 +Total +$ 2,015.0 +$ 1,416.1 +$ 1,554.6 +On 22 December 2017, the United States enacted the U.S. Tax Cuts and Jobs Act (“Tax Act” or "Tax reform") which significantly changed existing U.S. tax laws, including a reduction in the federal corporate income tax rate from 35 % to 21 % , a deemed repatriation tax on unremitted foreign earnings, as well as other changes. Our consolidated income statements for the twelve months ended 30 September 2018 reflect a discrete net tax expense of $ 180.6 and a $ 28.5 reduction in equity affiliate income for the impacts of the Tax Act. The $ 180.6 includes a $ 392.4 cost comprised of $ 322.1 for the deemed repatriation tax and $ 70.3 primarily for additional foreign taxes on the repatriation of foreign earnings. This cost is partially offset by a $ 211.8 benefit primarily from the re-measurement of our net U.S. deferred tax liabilities at the lower corporate tax rate. +The deemed repatriation tax includes a $ 56.2 non-recurring benefit related to the U.S. taxation of deemed foreign dividends in fiscal year 2018, the year of enactment of the Tax Act. This benefit may be eliminated by future legislation. +After applying tax credits, the balance of the deemed repatriation tax obligation is $ 203.2 , which we intend to pay in installments over eight years. We have recorded $ 184.4 of this obligation on our consolidated balance sheets in noncurrent liabilities. +In December 2017, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118, which addresses how a company recognizes provisional estimates when a company does not have the necessary information available, prepared or analyzed in reasonable detail to complete its accounting for the effect of the changes in the Tax Act. We are reporting the $ 392.4 cost of deemed repatriation tax and foreign repatriation taxes and the $ 211.8 re-measurement of our net U.S. deferred tax liabilities provisionally based upon reasonable estimates as of 30 September 2018 . The impacts are not yet finalized as they are dependent on factors and analysis not yet known or fully completed, including but not limited to, changes in our estimates of book to U.S. tax adjustments for the earnings and foreign taxes of foreign and domestic entities, as well as our ongoing analysis of the Tax Act. Estimates used in the provisional amounts include earnings, cash positions, foreign taxes and withholding taxes attributable to foreign subsidiaries as well as the anticipated reversal pattern of gross deferred balances. We are continuing to gather additional information and expect to complete our accounting by the first quarter of fiscal year 2019, within the prescribed one-year measurement period. +Due to the Company’s fiscal year, certain amounts cannot be finalized until the completion and filing of the Company’s U.S. federal 2018 tax return, which is due in the fourth quarter of fiscal year 2019, and any changes to the tax positions reflected in those returns could result in an adjustment to the impact of the Tax Act. In addition to final calculations of the earnings and taxes of foreign entities that would impact the deemed repatriation tax, estimates that are timing-related may result in adjustments due to the reduction of the U.S. tax rate. Foreign audit settlements, as well as future regulatory guidance, could also significantly impact the deemed repatriation tax. +110 +Table of Contents +We have historically asserted our intention to indefinitely reinvest foreign earnings in certain foreign subsidiaries. We have reevaluated our historic assertion as a result of enactment of the Tax Act and adjusted our position relative to the indefinitely reinvested earnings of various foreign subsidiaries. The impact of these changes is included in the $ 70.3 for additional foreign taxes on the repatriation of foreign earnings. +The Tax Act also enacted new provisions related to the taxation of foreign operations, known as Global Intangible Low Tax Income or (“GILTI”). We have elected as an accounting policy to account for GILTI as a period cost when incurred. This and various other provisions of the Tax Act do not become effective until fiscal year 2019 and did not impact our tax provision in fiscal year 2018. We have also elected as an accounting policy to record within income tax expense transaction gains and losses on foreign currency denominated withholding tax liabilities. +As a fiscal year-end taxpayer, certain provisions of the Tax Act become effective in our fiscal year 2018 while other provisions do not become effective until fiscal year 2019. The corporate tax rate reduction is effective as of 1 January 2018 and, accordingly, reduces our 2018 fiscal year U.S. federal statutory rate to a blended rate of approximately 24.5 % . The 21 % federal tax rate will apply to our fiscal year ended 30 September 2019 and each year thereafter. +The following table shows the components of the provision for income taxes: +2018 +2017 +2016 +Current Tax Provision +Federal +$ 305.1 +$ 62.8 +$ 171.0 +State +17.7 +7.0 +21.2 +Foreign +256.9 +229.1 +178.6 +579.7 +298.9 +370.8 +Deferred Tax Provision +Federal +( 121.7 +) +1.4 +45.0 +State +12.5 +6.0 +2.8 +Foreign +53.8 +( 45.4 +) +14.0 +( 55.4 +) +( 38.0 +) +61.8 +Income Tax Provision +$ 524.3 +$ 260.9 +$ 432.6 +Total company income tax payments, net of refunds, were $ 372.0 , $ 1,348.8 , and $ 440.8 in fiscal years 2018 , 2017 , and 2016 , respectively. Tax payments were higher in 2017 due to taxes related to the $ 2,870 gain on the sale of PMD. +The effective tax rate equals the income tax provision divided by income from continuing operations before taxes. A reconciliation of the differences between the United States federal statutory tax rate and the effective tax rate is as follows: +(Percent of income before taxes) +2018 +2017 +2016 +U.S. federal statutory tax rate +24.5 +% +35.0 +% +35.0 +% +State taxes, net of federal benefit +1.0 +1.0 +1.2 +Income from equity affiliates +( 2.1 +) +( 2.0 +) +( 3.3 +) +Foreign tax differentials +( 1.0 +) +( 7.9 +) +( 6.6 +) +Tax on foreign repatriated earnings +( .4 +) +( 2.2 +) +( 3.1 +) +Domestic production activities +( .4 +) +( .8 +) +( .8 +) +Share-based compensation +( 1.0 +) +( 1.2 +) +— +Tax reform repatriation +19.5 +— +— +Tax reform rate change and other +( 11.1 +) +— +— +Tax restructuring benefit +( 1.8 +) +— +— +Non-deductible goodwill impairment charge +— +3.6 +— +Non-U.S. subsidiary tax election +— +( 7.7 +) +— +Business separation costs +— +.2 +4.2 +Other +( 1.2 +) +.4 +1.2 +Effective Tax Rate +26.0 +% +18.4 +% +27.8 +% +111 +Table of Contents +Foreign tax differentials represent the differences between foreign earnings subject to foreign tax rates lower than the U.S. federal statutory tax rate. Some of our foreign earnings are subject to local country tax rates that are below the U.S. federal statutory rate and include tax holidays and incentives. As a result of the reduction in the federal corporate income tax rates under the Tax Act our effective non-U.S. tax rate is now closer to our blended current year U.S. statutory rate of 24.5 % . +Tax on foreign repatriated earnings includes benefits and costs related to U.S. and additional foreign taxation on the current and future repatriation of foreign earnings and a U.S. benefit for related foreign tax credits. As a result of the Tax Act, the impact on our effective rate from repatriations and credits has been significantly reduced. Due to the effective date of provisions under the Tax Act, certain benefits reported in fiscal year 2018 will not recur in fiscal year 2019. +The Tax Act repeals the domestic production activities deduction, effective for our fiscal 2019 tax year, and lowers the benefit taken in fiscal year 2018. +In fiscal year 2018, we recognized a tax benefit of $ 35.7 , net of reserves for uncertain tax positions, and a corresponding decrease in net deferred tax liabilities resulting from the restructuring of several foreign subsidiaries. +During the first quarter of fiscal year 2017, we adopted new accounting guidance that requires excess tax benefits and deficiencies from share-based compensation to be recognized in the consolidated income statements rather than in additional paid-in capital on the consolidated balance sheets. As a result of applying this change prospectively, we recognized $ 21.5 and $ 17.6 of excess tax benefits in our provision for income taxes during fiscal year 2018 and 2017, respectively. +Primarily due to the impact of the Tax Act and the restructuring benefit, our effective tax rate was 26 % for the twelve months ended 30 September 2018 . +In 2017 , the effective tax rate was impacted by a tax election made with respect to a Chilean holding company resulting in an income tax benefit of $ 111.4 on tax losses related to investments in Chile. The effective tax rate was also impacted by a goodwill impairment charge of $ 145.3 for which no tax benefits were available. See Note 10 , Goodwill , for additional information regarding the impairment charge. +In 2016 , the effective tax rate was impacted by tax costs of $ 51.8 incurred in anticipation of the tax-free spin-off of Versum, primarily for a dividend declared during the third quarter of 2016 to repatriate $ 443.8 from a subsidiary in South Korea to the U.S. Previously, most of these foreign earnings were considered to be indefinitely reinvested. In addition, a tax benefit was not available on a significant portion of the business separation costs. See Note 4 , Materials Technologies Separation , for additional information. +The significant components of deferred tax assets and liabilities are as follows: +30 September +2018 +2017 +Gross Deferred Tax Assets +Retirement benefits and compensation accruals +$ 153.1 +$ 370.1 +Tax loss carryforwards +143.5 +64.5 +Tax credits and other tax carryforwards +17.1 +76.1 +Reserves and accruals +42.5 +88.2 +Currency losses +3.8 +20.7 +Other +45.4 +37.2 +Valuation allowance +( 105.0 +) +( 107.7 +) +Deferred Tax Assets +300.4 +549.1 +Gross Deferred Tax Liabilities +Plant and equipment +811.8 +1,035.6 +Unremitted earnings of foreign entities +36.1 +20.9 +Partnership and other investments +16.3 +5.4 +Intangible assets +84.3 +81.9 +Other +5.6 +9.2 +Deferred Tax Liabilities +954.1 +1,153.0 +Net Deferred Income Tax Liability +$ 653.7 +$ 603.9 +112 +Table of Contents +Deferred tax assets and liabilities are included within the consolidated financial statements as follows: +2018 +2017 +Deferred Tax Assets +Other noncurrent assets +$ 121.4 +$ 174.5 +Deferred Tax Liabilities +Deferred income taxes +775.1 +778.4 +Net Deferred Income Tax Liability +$ 653.7 +$ 603.9 +The various components of deferred tax assets and liabilities, including plant and equipment, retirement benefits and compensation accruals, and reserves and accruals were reduced by the re-measurement of our U.S. deferred tax accounts to the lower U.S. corporate tax rate. Tax loss carryforwards increased primarily due to the sale of plant and equipment related to our EfW business. The sale converted these assets into capital losses which are subject to a full valuation allowance. In addition, deferred tax liabilities related to plant and equipment also includes an increase due to the impact of the immediate expensing provision allowed for under the Tax Act. The balance of unremitted earnings of foreign entities and partnership and other investments were increased by additional foreign withholding tax liability recorded as a result of the Tax Act, net of tax payments. Retirement benefits and compensation accruals are also impacted significantly by the changes in plan assets and benefit obligations that have been recognized in other comprehensive income. See Note 16, Retirement Benefits, for additional information. +As of 30 September 2018, the Company had the following deferred tax assets for certain tax credits: +Jurisdiction +Gross Tax Asset +Expiration Period +U.S. State +$ 1.9 +2019 - 2034 +Foreign +21.6 +2019 - 2030; Indefinite +At 30 September 2018 , the Company had the following loss carryforwards: +Jurisdiction +Gross Loss Carryforward +Expiration Period +U.S. State Net Operating Loss +$ 324.9 +2019 - 2034 +Foreign Net Operating Loss +340.6 +2019 - 2028; Indefinite +Foreign Capital Loss +281.9 +Indefinite +In fiscal year 2018 we utilized the balance of our federal tax credit carryforward against the deemed repatriation tax. Of the $ 340.6 of foreign net operating loss carryforwards, $ 121.8 have indefinite carryforward periods. Of the $ 21.6 foreign tax credits, $ 16.4 have indefinite carryforward periods. +The valuation allowance as of 30 September 2018 of $ 105.0 , primarily related to the tax benefit of foreign loss carryforwards of $ 56.0 as well as foreign capital losses of $ 47.9 that were generated from the loss recorded on the exit from the Energy-from-Waste business in 2016. If events warrant the reversal of the valuation allowance, it would result in a reduction of tax expense. We believe it is more likely than not that future earnings and reversal of deferred tax liabilities will be sufficient to utilize our deferred tax assets, net of existing valuation allowance, at 30 September 2018 . +As a result of the Tax Act we recorded $ 322.1 of federal income tax from the deemed repatriation tax on approximately $ 5.8 billion of previously undistributed earnings from our foreign subsidiaries and corporate joint ventures. These earnings are now eligible to be repatriated to the U.S. with reduced U.S. tax impacts. However, such earnings may be subject to foreign withholding and other taxes. We record foreign and U.S. income taxes on the undistributed earnings of our foreign subsidiaries and corporate joint ventures unless those earnings are indefinitely reinvested. The cumulative undistributed earnings that are considered to be indefinitely reinvested in foreign subsidiaries and corporate joint ventures are included in retained earnings on the consolidated balance sheets and amounted to $ 3.2 billion as of 30 September 2018 . An estimated $ 420.4 in additional foreign withholding and other income taxes would be due if these earnings were remitted as dividends. +113 +Table of Contents +A reconciliation of the beginning and ending amount of the unrecognized tax benefits is as follows: +Unrecognized Tax Benefits +2018 +2017 +2016 +Balance at beginning of year +$ 146.4 +$ 90.2 +$ 83.8 +Additions for tax positions of the current year +26.4 +47.5 +12.5 +Additions for tax positions of prior years +119.2 +16.1 +2.9 +Reductions for tax positions of prior years +( 41.3 +) +( 4.0 +) +— +Settlements +( 14.2 +) +( 2.0 +) +( 5.6 +) +Statute of limitations expiration +( 2.6 +) +( 3.2 +) +( 2.9 +) +Foreign currency translation +( .3 +) +1.8 +( .5 +) +Balance at End of Year +$ 233.6 +$ 146.4 +$ 90.2 +At 30 September 2018 and 2017 , we had $ 233.6 and $ 146.4 of unrecognized tax benefits, excluding interest and penalties, of which $ 88.6 and $ 73.8 , respectively, would impact the effective tax rate from continuing operations if recognized. +Interest and penalties related to unrecognized tax benefits are recorded as a component of income tax expense and totaled ($ 2.4 ) , $ 3.7 , and $ 1.8 in fiscal years 2018 , 2017 , and 2016 , respectively. Our accrued balance for interest and penalties was $ 8.4 and $ 12.1 as of 30 September 2018 and 2017 , respectively. +The additions for tax positions of prior years of $ 119.2 relates primarily to uncertain state tax filing positions taken related to the sale of PMD. Additions for tax positions of the current year of $ 26.4 included uncertain tax positions related to the restructuring of foreign subsidiaries and reserves for ongoing transfer pricing uncertainties. +On 17 April 2018, we received a final audit settlement agreement that resolved uncertainties related to unrecognized tax benefits of $ 43.1 , including interest. This settlement primarily related to tax positions taken in conjunction with the disposition of our Homecare business in 2012. As a result, we recorded an income tax benefit of $ 25.6 , including interest, in income from discontinued operations during 2018. The settlement also resulted in an income tax benefit of approximately $ 9.1 , including interest, in continuing operations for the release of tax reserves on other matters. The reduction in prior year positions and settlement payments also reflect the settlement of U.S. federal tax audits for 2012 through 2014 reported in the first quarter of the year. +We are currently under examination in a number of tax jurisdictions, some of which may be resolved in the next twelve months. As a result, it is reasonably possible that a change in the unrecognized tax benefits may occur during the next twelve months. However, quantification of an estimated range cannot be made at this time. +We generally remain subject to examination in the following major tax jurisdictions for the years indicated below: +Major Tax Jurisdiction +Open Tax Years +North America +United States – Federal +2015 +- +2018 +United States – All States +2011 +- +2018 +Canada +2014 +- +2018 +Europe +France +2015 +- +2018 +Germany +2013 +- +2018 +Netherlands +2012 +- +2018 +Spain +2015 +- +2018 +United Kingdom +2014 +- +2018 +Asia +China +2013 +- +2018 +South Korea +2010 +- +2018 +Taiwan +2013 +- +2018 +Latin America +Chile +2015 +- +2018 +114 +Table of Contents +23 . SUPPLEMENTAL INFORMATION +Other Receivables and Current Assets +30 September +2018 +2017 +Derivative instruments +$ 61.1 +$ 93.9 +Other receivables +139.0 +188.0 +Current capital lease receivables +92.1 +93.3 +Other +3.6 +28.1 +Other receivables and current assets +$ 295.8 +$ 403.3 +Other Noncurrent Assets +30 September +2018 +2017 +Derivative instruments +$ 85.0 +$ 133.9 +Noncurrent customer receivable +92.4 +62.6 +Prepaid tax +13.2 +5.1 +Deferred tax assets +121.4 +174.5 +Pension benefits +131.7 +18.4 +Deposits +— +34.8 +Other +210.8 +212.5 +Other noncurrent assets +$ 654.5 +$ 641.8 +Payables and Accrued Liabilities +30 September +2018 +2017 +Trade creditors +$ 594.6 +$ 659.5 +Payables associated with Lu'An +330.0 +— +Customer advances +156.6 +438.9 +Accrued payroll and employee benefits +201.4 +187.1 +Pension and postretirement benefits +34.1 +22.6 +Dividends payable +241.5 +207.5 +Outstanding payments in excess of certain cash balances +9.1 +4.5 +Accrued interest expense +49.5 +42.2 +Derivative instruments +54.2 +95.9 +Severance and other costs associated with cost reduction actions +9.9 +41.5 +Other +136.9 +114.6 +Payables and accrued liabilities +$ 1,817.8 +$ 1,814.3 +115 +Table of Contents +Other Noncurrent Liabilities +30 September +2018 +2017 +Pension benefits +$ 417.2 +$ 703.8 +Postretirement benefits +47.0 +57.0 +Other employee benefits +94.4 +99.3 +Noncurrent customer liability +92.4 +62.6 +Long-term accrued income taxes related to U.S. tax reform +184.4 +— +Contingencies related to uncertain tax positions +113.2 +130.6 +Advance payments +58.2 +39.0 +Environmental liabilities +64.6 +72.3 +Derivative instruments +39.9 +36.0 +Asset retirement obligations +189.5 +144.0 +Obligation for future contribution to an equity affiliate +94.4 +94.4 +Obligations associated with EfW +63.3 +65.3 +Other +78.4 +107.6 +Other noncurrent liabilities +$ 1,536.9 +$ 1,611.9 +Other Income (Expense), Net +30 September +2018 +2017 +2016 +Technology and royalty income (A) +$ 22.8 +$ 20.8 +$ 19.0 +Interest income (B) +— +1.5 +6.1 +Foreign exchange +( 3.9 +) +4.3 +( 7.2 +) +Sale of assets and investments (C) +6.9 +24.3 +8.8 +Contract settlements +2.9 +14.3 +12.6 +Transition service agreements reimbursement (D) +12.7 +38.4 +— +Other +8.8 +17.4 +10.1 +Other income (expense), net +$ 50.2 +$ 121.0 +$ 49.4 +(A) +Primarily includes related party activity with our equity affiliates. +(B) +Beginning in the second quarter of fiscal year 2017, interest income associated with our cash and cash items and short-term investments is reflected on the consolidated income statements in "Other non-operating income (expense), net." +(C) +Includes a gain of $ 12.2 resulting from the sale of a parcel of land during the fourth quarter of fiscal year 2017. +(D) +Reflects reimbursement for costs in support of transition services agreements with Versum for EMD and with Evonik for PMD. Refer to Note 4 , Materials Technologies Separation , for additional information. +Other Non-Operating Income (Expense), Net +30 September +2018 +2017 +2016 +Interest income (A) +$ 46.3 +$ 29.8 +$ — +Pension settlement loss (B) +( 48.5 +) +( 10.5 +) +( 5.1 +) +Other non-service pension benefit (costs) +7.7 +( 1.9 +) +( .3 +) +Other +( .4 +) +( .8 +) +— +Other non-operating income (expense), net +$ 5.1 +$ 16.6 +($ 5.4 +) +(A) +Prior to the second quarter of fiscal year 2017, interest income associated with our cash and cash items and short-term investments was reflected on the consolidated income statements in "Other income (expense), net." +(B) +Fiscal year 2018 includes a loss of $ 43.7 that primarily resulted from the transfer of certain pension payment obligations to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract during the fourth quarter. +116 +Table of Contents +Related Party Sales +We have related party sales to some of our equity affiliates and joint venture partners. Sales to related parties totaled approximately $ 340 , $ 580 , and $ 320 during fiscal years 2018 , 2017 , and 2016 , respectively, and primarily related to Jazan sale of equipment activity. Agreements with related parties include terms that are consistent with those that we believe would have been negotiated at an arm’s length with an independent party. +24 . SUMMARY BY QUARTER (UNAUDITED) +These tables summarize the unaudited results of operations for each quarter of fiscal years 2018 and 2017 : +2018 +Q1 +Q2 +Q3 +Q4 +Total +Sales +$ 2,216.6 +$ 2,155.7 +$ 2,259.0 +$ 2,298.9 +$ 8,930.2 +Gross profit +644.8 +649.2 +713.6 +733.1 +2,740.7 +Operating income +460.7 +455.4 +515.8 +533.7 +1,965.6 +Equity affiliates income +13.8 +(A) +43.7 +58.1 +59.2 +(A) +174.8 +(A) +Income tax provision +291.8 +(A) +56.2 +(B) +107.1 +69.2 +(A)(B) +524.3 +(A)(B) +Net income +161.7 +423.6 +487.9 +459.7 +1,532.9 +Net income attributable to Air Products +Income from continuing operations +155.6 +416.4 +430.7 +452.9 +1,455.6 +Income (Loss) from discontinued operations +( 1.0 +) +— +43.2 +(C) +— +42.2 +(C) +Net income attributable to Air Products +154.6 +416.4 +473.9 +452.9 +1,497.8 +Basic Earnings Per Common Share Attributable to Air Products +Income from continuing operations +.71 +1.90 +1.96 +2.06 +6.64 +Income from discontinued operations +— +— +.20 +— +.19 +Net income attributable to Air Products +.71 +1.90 +2.16 +2.06 +6.83 +Diluted Earnings Per Common Share Attributable to Air Products +Income from continuing operations +.70 +1.89 +1.95 +2.05 +6.59 +Income from discontinued operations +— +— +.20 +— +.19 +Net income attributable to Air Products +.70 +1.89 +2.15 +2.05 +6.78 +Weighted Average Common Shares — Diluted (in millions) +220.4 +220.8 +220.9 +220.9 +220.8 +Dividends declared per common share +.95 +1.10 +1.10 +1.10 +4.25 +Market price per common share – High +164.78 +175.17 +170.29 +171.66 +Market price per common share – Low +150.55 +152.71 +154.67 +153.02 +117 +Table of Contents +2017 +Q1 +Q2 +Q3 +Q4 +Total +Sales +$ 1,882.5 +$ 1,980.1 +$ 2,121.9 +$ 2,203.1 +$ 8,187.6 +Gross profit +565.8 +576.3 +635.9 +658.1 +2,436.1 +Business separation costs (D) +32.5 +— +— +— +32.5 +Cost reduction and assets actions (E) +50.0 +10.3 +42.7 +48.4 +151.4 +Goodwill and intangible asset impairment charge (F) +— +— +162.1 +— +162.1 +Gain on land sale +— +— +— +12.2 +12.2 +Operating income +328.3 +395.6 +258.7 +457.4 +1,440.0 +Equity affiliates income (loss) +38.0 +34.2 +( 36.9 +) +(G) +44.8 +80.1 +(G) +Income tax provision (benefit) +78.4 +94.5 +89.3 +( 1.3 +) +(H) +260.9 +(H) +Net income +306.4 +2,135.7 +(I) +104.1 +475.0 +3,021.2 +(I) +Net income attributable to Air Products +Income from continuing operations +251.6 +304.4 +104.2 +474.2 +1,134.4 +Income (Loss) from discontinued operations +48.2 +1,825.6 +(I) +( 2.3 +) +( 5.5 +) +1,866.0 +(I) +Net income attributable to Air Products +299.8 +2,130.0 +101.9 +468.7 +3,000.4 +Basic Earnings Per Common Share Attributable to Air Products +Income from continuing operations +1.16 +1.40 +.48 +2.17 +5.20 +Income (Loss) from discontinued operations +.22 +8.38 +( .01 +) +( .02 +) +8.56 +Net income attributable to Air Products +1.38 +9.78 +.47 +2.15 +13.76 +Diluted Earnings Per Common Share Attributable to Air Products +Income from continuing operations +1.15 +1.39 +.47 +2.15 +5.16 +Income (Loss) from discontinued operations +.22 +8.31 +( .01 +) +( .02 +) +8.49 +Net income attributable to Air Products +1.37 +9.70 +.46 +2.13 +13.65 +Weighted Average Common Shares — Diluted (in millions) +219.7 +219.7 +219.8 +220.1 +219.8 +Dividends declared per common share +.86 +.95 +.95 +.95 +3.71 +Market price per common share – High +150.45 +149.46 +147.66 +152.26 +Market price per common share – Low +129.00 +133.63 +134.09 +141.88 +(A) +Includes the impacts of the Tax Act. For additional information, refer to Note 22 , Income Taxes . +(B) +Includes the impacts of the restructuring of several foreign subsidiaries. For additional information, refer to Note 22 , Income Taxes . +(C) +Primarily includes benefits resulting from the resolution of uncertain tax positions related to the disposition of our former European Homecare business and post-closing adjustments associated with the sale of PMD. For additional information, refer to Note 3 , Discontinued Operations . +(D) +For additional information, refer to Note 4 , Materials Technologies Separation . +(E) +For additional information, refer to Note 5 , Cost Reduction and Asset Actions . +(F) +For additional information, refer to Note 10 , Goodwill , and Note 11 , Intangible Assets . +(G) +Includes the impact of an other-than-temporary impairment of an investment in an equity affiliate. For additional information, refer to Note 8 , Summarized Financial Information of Equity Affiliates . +(H) +Includes the impact of a tax election benefit related to a non-U.S. subsidiary. For additional information, see Note 22 , Income Taxes . +(I) +Includes the after-tax gain on the sale of PMD. For additional information, see Note 3 , Discontinued Operations . +118 +Table of Contents +25 . BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION +Our reporting segments reflect the manner in which our chief operating decision maker reviews results and allocates resources. Except in the Industrial Gases – EMEA and Corporate and other segments, each reporting segment meets the definition of an operating segment and does not include the aggregation of multiple operating segments. Our Industrial Gases – EMEA and Corporate and other segment each include the aggregation of two operating segments that meet the aggregation criteria under GAAP. +Our reporting segments are: +• +Industrial Gases – Americas +• +Industrial Gases – EMEA (Europe, Middle East, and Africa) +• +Industrial Gases – Asia +• +Industrial Gases – Global +• +Corporate and other +Industrial Gases – Regional +The regional Industrial Gases segments (Americas, EMEA, and Asia) include the results of our regional industrial gas businesses, which produce and sell atmospheric gases such as oxygen, nitrogen, argon, and rare gases (primarily recovered by the cryogenic distillation of air), process gases such as hydrogen, helium, carbon dioxide, carbon monoxide, syngas (a mixture of hydrogen and carbon monoxide), and specialty gases, and equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +We supply gases to customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. We distribute gases to our customers through a variety of supply modes including liquid or gaseous bulk supply delivered by tanker or tube trailer and, for smaller customers, packaged gases delivered in cylinders and dewars or small on-sites (cryogenic or non-cryogenic generators). For large-volume customers, we construct an on-site plant adjacent to or near the customer’s facility or deliver product from one of our pipelines. We are the world’s largest provider of hydrogen, which is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels. +Electricity is the largest cost component in the production of atmospheric gases, and natural gas is the principal raw material for hydrogen, carbon monoxide, and syngas production. We mitigate energy and natural gas price fluctuations contractually through pricing formulas, surcharges, cost pass-through, and tolling arrangements. The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method. The largest of these joint ventures operate in Mexico, Italy, South Africa, India, Saudi Arabia, and Thailand. +Each of the regional Industrial Gases segments competes against global industrial gas companies as well as regional competitors. Competition is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to larger customers. +Industrial Gases – Global +The Industrial Gases – Global segment includes cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Industrial Gases – Global segment also includes centralized global costs associated with management of all the Industrial Gases segments. These costs include Industrial Gases global administrative costs, product development costs, and research and development costs. We compete with a large number of firms for all the offerings included in the Industrial Gases – Global segment. Competition in the equipment businesses is based primarily on technological performance, service, technical know-how, price, and performance guarantees. +Corporate and other +The Corporate and other segment includes our LNG equipment and helium storage and distribution sale of equipment businesses and corporate support functions that benefit all segments. Competition for the sale of equipment businesses is based primarily on technological performance, service, technical know-how, price, and performance guarantees. +119 +Table of Contents +Corporate and other also includes income and expense that is not directly associated with the other segments, including foreign exchange gains and losses and stranded costs. Stranded costs result from functional support previously provided to the two divisions comprising the former Materials Technologies segment. The majority of these costs are reimbursed to Air Products pursuant to short-term transition services agreements under which Air Products provides transition services to Versum for EMD and to Evonik for PMD. The reimbursement for costs in support of the transition services has been reflected on the consolidated income statements within “Other income (expense), net.” All transition services were completed during fiscal year 2018. Refer to Note 4 , Materials Technologies Separation , for additional information. +In addition to assets of the global businesses included in this segment, other assets include cash, deferred tax assets, and financial instruments. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues. +Accounting Policies +The accounting policies of the segments are the same as those described in Note 1 , Major Accounting Policies . We evaluate the performance of segments based upon reported segment operating income. +Business Segment +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Segment +Total +2018 +Sales +$ 3,758.8 +$ 2,193.3 +$ 2,458.0 +$ 436.1 +$ 84.0 +$ 8,930.2 +Operating income (loss) +927.9 +445.8 +689.9 +53.9 +( 176.0 +) +1,941.5 +Depreciation and amortization +485.3 +198.6 +265.8 +8.1 +12.9 +970.7 +Equity affiliates' income +82.0 +61.1 +58.3 +1.9 +— +203.3 +Expenditures for long-lived assets +546.5 +163.1 +791.9 +17.3 +49.6 +1,568.4 +Investments in net assets of and advances to equity affiliates +312.1 +503.3 +445.6 +16.2 +— +1,277.2 +Total assets +5,904.0 +3,280.4 +5,899.5 +240.1 +3,854.3 +19,178.3 +2017 +Sales +$ 3,637.0 +$ 1,780.4 +$ 1,964.7 +$ 722.9 +$ 82.6 +$ 8,187.6 +Operating income (loss) +946.1 +395.5 +532.6 +71.1 +( 171.5 +) +1,773.8 +Depreciation and amortization +464.4 +177.1 +203.2 +8.9 +12.2 +865.8 +Equity affiliates' income +58.1 +47.1 +53.5 +.9 +— +159.6 +Expenditures for long-lived assets +427.2 +143.2 +337.8 +25.6 +105.9 +1,039.7 +Investments in net assets of and advances to equity affiliates +287.5 +508.6 +471.8 +19.0 +— +1,286.9 +Total assets +5,840.8 +3,276.1 +4,412.1 +279.6 +4,648.4 +18,457.0 +2016 +Sales +$ 3,344.1 +$ 1,704.4 +$ 1,720.4 +$ 498.8 +$ 236.0 +$ 7,503.7 +Operating income (loss) +891.3 +387.0 +452.8 +( 21.5 +) +( 89.4 +) +1,620.2 +Depreciation and amortization +443.6 +185.7 +197.9 +7.9 +19.5 +854.6 +Equity affiliates' income +52.7 +36.5 +57.8 +— +— +147.0 +Expenditures for long-lived assets +406.6 +159.5 +313.3 +6.0 +22.3 +907.7 +Investments in net assets of and advances to equity affiliates +250.6 +580.5 +442.5 +10.0 +— +1,283.6 +Total assets +5,896.7 +3,178.6 +4,232.7 +367.6 +2,384.5 +16,060.1 +120 +Table of Contents +Below is a reconciliation of segment total operating income to consolidated operating income: +Operating Income +2018 +2017 +2016 +Segment total +$ 1,941.5 +$ 1,773.8 +$ 1,620.2 +Change in inventory valuation method +24.1 +— +— +Business separation costs +— +( 32.5 +) +( 50.6 +) +Cost reduction and asset actions +— +( 151.4 +) +( 34.5 +) +Goodwill and intangible asset impairment charge +— +( 162.1 +) +— +Gain on land sale +— +12.2 +— +Consolidated Total +$ 1,965.6 +$ 1,440.0 +$ 1,535.1 +Below is a reconciliation of segment total equity affiliates' income to consolidated equity affiliates' income : +Equity Affiliates' Income +2018 +2017 +2016 +Segment total +$ 203.3 +$ 159.6 +$ 147.0 +Equity method investment impairment charge +— +( 79.5 +) +— +Tax reform repatriation - equity method investment +( 28.5 +) +— +— +Consolidated Total +$ 174.8 +$ 80.1 +$ 147.0 +Below is a reconciliation of segment total assets to consolidated total assets: +Total Assets +2018 +2017 +2016 +Segment total +$ 19,178.3 +$ 18,457.0 +$ 16,060.1 +Discontinued operations +— +10.2 +1,968.5 +Consolidated Total +$ 19,178.3 +$ 18,467.2 +$ 18,028.6 +The sales information noted above relates to external customers only. All intersegment sales are eliminated in consolidation. The Industrial Gases – Global segment had intersegment sales of $ 254.3 , $ 239.0 , and $ 232.4 in fiscal years 2018 , 2017 , and 2016 , respectively. These sales are generally transacted at market pricing. +We generally do not have intersegment sales from our regional industrial gases businesses. Equipment manufactured for our regional industrial gases segments are generally transferred at cost and are not reflected as an intersegment sale. +121 +Table of Contents +Geographic Information +Sales to External Customers +2018 +2017 +2016 +United States +$ 3,149.6 +$ 2,886.8 +$ 2,911.7 +Europe, including Middle East +2,292.5 +2,478.5 +2,186.5 +Asia, excluding China and India +904.0 +849.6 +721.4 +China +1,585.7 +1,143.4 +1,020.4 +Other (A) +998.4 +829.3 +663.7 +Total +$ 8,930.2 +$ 8,187.6 +$ 7,503.7 +Long-Lived Assets (B) +2018 +2017 +2016 +United States +$ 3,512.7 +$ 3,407.4 +$ 3,411.4 +Europe, including Middle East +1,283.3 +1,279.0 +1,292.5 +Asia, excluding China and India +899.8 +778.5 +707.0 +China +3,066.6 +1,737.9 +1,675.8 +Other (A) +1,161.3 +1,237.4 +1,173.0 +Total +$ 9,923.7 +$ 8,440.2 +$ 8,259.7 +(A) +Includes Canada, Latin America, and India. +(B) +Long-lived assets include plant and equipment, net. +Geographic information is based on country of origin. Included in United States revenues are export sales to third‑party customers of $ 33.1 in fiscal year 2018 , $ 64.2 in fiscal year 2017 , and $ 134.9 in fiscal year 2016 . +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not applicable. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +We maintain a comprehensive set of disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act). Under the supervision of the Chief Executive Officer and Chief Financial Officer, the Company’s management conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of 30 September 2018 . Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of 30 September 2018 , the disclosure controls and procedures were effective. +Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Management has evaluated the effectiveness of its internal control over financial reporting as of 30 September 2018 based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, management concluded that, as of 30 September 2018 , the Company’s internal control over financial reporting was effective. Management’s Report on Internal Control over Financial Reporting is provided under Part II, Item 8, of this Form 10-K. +There was no change in the Company’s internal control over financial reporting during the fourth quarter of fiscal year 2018 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +KPMG LLP, the Company’s independent registered public accounting firm, has audited the Company’s internal control over financial reporting as of 30 September 2018 . The Report of the Independent Registered Public Accounting Firm is provided under Part II, Item 8, of this Form 10-K. +122 +Table of Contents +ITEM 9B. OTHER INFORMATION +On 19 November 2018, the Management Development and Compensation Committee (the “Committee”) of the Board of Directors granted Dr. Samir Serhan, Executive Vice President, a deferred stock unit retention award of $1.5 million. This award will consist of restricted stock units (“RSUs”) with a 3 December 2018 grant date. The RSUs will vest in three equal installments beginning on 3 December 2019. The Committee took this action in recognition of Dr. Serhan’s expanded scope of responsibilities in the Company’s operations, and in particular the leadership role he will play in winning and executing our largest projects and building out and integrating our global gasification technologies. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information required by this item relating to the Company’s directors and nominees is incorporated herein by reference to the section captioned “The Board of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . The information required by this item relating to the Company’s executive officers is set forth in Item 1 of Part I of this report. +The information required by this item relating to the Company’s Audit and Finance Committee and its Audit and Finance Committee Financial Expert is incorporated herein by reference to the sections captioned “Standing Committees Of The Board” and “Audit and Finance Committee” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +The information required by this item relating to the Company’s procedures regarding the consideration of candidates recommended by shareholders and a procedure for submission of such candidates is incorporated herein by reference to the section captioned “Selection of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +The information required by the item relating to Section 16(a) Beneficial Ownership Reporting Compliance is incorporated herein by reference to the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +The Company has adopted a Code of Conduct that applies to all employees, including the Chief Executive Officer, the Chief Financial Officer, and the Principal Accounting Officer. The Code of Conduct can be found at our website at www.airproducts.com/codeofconduct. +ITEM 11. EXECUTIVE COMPENSATION +The information required by this item is incorporated herein by reference to the sections captioned “Compensation of Executive Officers” and “Compensation of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +123 +Table of Contents +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Securities Authorized for Issuance Under Equity Compensation Plans. +Equity Compensation Plan Information +The following table provides information as of 30 September 2018 about Company stock that may be issued upon the exercise of options, warrants, and rights granted to employees or members of the Board under the Company’s existing equity compensation plans, including plans approved by shareholders and plans that have not been approved by shareholders in reliance on the NYSE’s former treasury stock exception or other applicable exception to the Exchange’s listing requirements. +Plan Category +Number of securities to be issued upon exercise of outstanding options, warrants, and rights +Weighted-average exercise price of outstanding options, warrants, and rights +Number of Securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) +Equity compensation plans approved by security holders +3,181,790 +(1) +$89.33 +4,869,212 +(2) +Equity compensation plans not approved by security holders +63,060 +(3) +$— +— +Total +3,244,850 +$89.33 +4,869,212 +(1) +Represents Long-Term Incentive Plan outstanding stock options and deferred stock units that have been granted. Deferred stock units entitle the recipient to one share of Company common stock upon vesting, which is conditioned on continued employment during a deferral period and may also be conditioned on earn-out against certain performance targets. The amount presented assumes the maximum potential payout. +(2) +Represents authorized shares that were available for future grants as of 30 September 2018. These shares may be used for options, deferred stock units, restricted stock, and other stock-based awards to officers, directors, and key employees. Full value awards such as restricted stock are limited to 20% of cumulative awards after 1 October 2001. +(3) +This number represents deferred stock units issued under the Deferred Compensation Plan, which are purchased for the fair value of the underlying shares of stock with eligible deferred compensation. +The Deferred Compensation Plan was not approved by shareholders. It does not require shareholder approval because participants forego compensation equal to the full market value of any share units credited under the plans. +Deferred Compensation Plan —The Company’s Deferred Compensation Plan is an unfunded employee retirement benefit plan available to certain of the Company’s U.S.-based management and other highly compensated employees (and those of its subsidiaries) who receive awards under the Company’s Annual Incentive Plan, which is the annual cash bonus plan for executives and key salaried employees of the Company and its subsidiaries. Because participants forego current compensation to “purchase” deferred stock units for full value under the Plan, it is not required to be approved by shareholders under the NYSE listing standards. Under the Plan, participants may defer a portion of base salary (elective deferrals) which cannot be contributed to the Company’s Retirement Savings Plan, a 401(k) and profit-sharing plan offered to all salaried employees (RSP), because of tax limitations and earn matching contributions from the Company that they would have received if their elective deferrals had been contributed to the RSP (matching credits). In addition, participants in the Plan may defer all or a portion of their bonus awards under the Annual Incentive Plan (bonus deferrals) under the Deferred Compensation Plan. Finally, certain participants under the Plan who participate in the profit-sharing component of the RSP rather than the Company’s salaried pension plans receive contribution credits under the Plan which are a percentage ranging from 4%-6%, based on their years of service, of their salary in excess of tax limitations and their bonus awards under the Annual Incentive Plan (contribution credits). The dollar amount of elective deferrals, matching credits, bonus deferrals, and contribution credits is initially credited to an unfunded account, which earns interest credits. Participants are periodically permitted while employed by the Company to irrevocably convert all or a portion of their interest-bearing account to deferred stock units in a Company stock account. Upon conversion, the Company stock account is credited with deferred stock units based on the fair value of a share of Company stock on the date of crediting. Dividend equivalents corresponding to the number of units are credited quarterly to the interest-bearing account. Deferred stock units generally are paid after termination of employment in shares of Company stock. +124 +Table of Contents +The Deferred Compensation Plan was formerly known as the Supplementary Savings Plan. The name was changed in 2006 when the deferred bonus program, previously administered under the Annual Incentive Plan, was merged into this Plan. +Certain information required by this item regarding the beneficial ownership of the Company’s common stock is incorporated herein by reference to the sections captioned “Persons Owning More than 5% of Air Products Stock as of September 30, 2018 ” and “Air Products Stock Beneficially Owned by Officers and Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information required by this item is incorporated herein by reference to the sections captioned “Director Independence” and “Transactions with Related Persons” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES +The information required by this item is incorporated herein by reference to the section captioned “Independent Registered Public Accountant” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 24 January 2019 . +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +(a) +The following documents are filed as a part of this report: +(1) +The Company’s 2018 consolidated financial statements and the Report of the Independent Registered Public Accounting Firm are included in Part II, Item 8. +Report of Independent Registered Public Accounting Firm dated 20 November 2018 +58 +Consolidated Income Statements for the three fiscal years ended 30 September 2018 +59 +Consolidated Comprehensive Income Statements for the three fiscal years ended 30 September 2018 +60 +Consolidated Balance Sheets as of 30 September 2018 and 2017 +61 +Consolidated Statements of Cash Flows for the three fiscal years ended 30 September 2018 +62 +Consolidated Statements of Equity for the three fiscal years ended 30 September 2018 +63 +(2) +Financial Statement Schedules—the following additional information should be read in conjunction with the consolidated financial statements in the Company’s 2018 consolidated financial statements. +Schedule II Valuation and Qualifying Accounts for the three fiscal years ended 30 September 2018 +132 +All other schedules are omitted because the required matter or conditions are not present or because the information required by the Schedules is submitted as part of the consolidated financial statements and notes thereto. +(3) +Exhibits—The exhibits filed as a part of this Annual Report on Form 10-K are listed in the Index to Exhibits located on page 126 of this Report. +ITEM 16. FORM 10-K SUMMARY +None +125 +Table of Contents +INDEX TO EXHIBITS +Exhibit No. +Description +(2) +Plan of acquisition, reorganization, arrangement, liquidation or succession. +(3) +Articles of Incorporation and By-Laws. +3.1 +Amended and Restated By-Laws of the Company. (Filed as Exhibit 3.1 to the Company’s Form 8-K Report dated 21 November 2014.)* +3.2 +Restated Certificate of Incorporation of the Company. (Filed as Exhibit 3.2 to the Company’s Form 10-K Report for the fiscal year ended 30 September 1987.)* +3.3 +Amendment to the Restated Certificate of Incorporation of the Company dated 25 January 1996. (Filed as Exhibit 3.3 to the Company’s Form 10-K Report for the fiscal year ended 30 September 1996.) * +3.4 +Amendment to the Restated Certificate of Incorporation of the Company dated 28 January 2014. (Filed as Exhibit 10.2 to the Company’s Form 10-Q Report for the quarter ended 30 June 2014.) * +(4) +Instruments defining the rights of security holders, including indentures. Upon request of the Securities and Exchange Commission, the Company hereby undertakes to furnish copies of the instruments with respect to its long-term debt. +4.1 +Indenture, dated as of January 18, 1985, between the Company and The Chase Manhattan Bank (National Association), as Trustee. (Filed as Exhibit 4(a) to the Company’s Registration Statement No. 33-36974.)* +4.2 +Indenture, dated as of January 10, 1995, between the Company and The Bank of New York Trust Company, N.A. (formerly Wachovia Bank, National Association and initially First Fidelity Bank Company, National Association), as Trustee. (Filed as Exhibit 4(a) to the Company’s Registration Statement No. 33-57357.) * +(10) +Material Contracts +10.1 +1990 Deferred Stock Plan of the Company, as amended and restated effective 1 October 1989. (Filed as Exhibit 10.1 to the Company’s Form 10-K Report for the fiscal year ended 30 September 1989.)*† +10.2 +Annual Incentive Plan as Amended and Restated effective 1 October 2008. (Filed as Exhibit 10.7 to the Company’s Form 10-Q Report for the quarter ended 31 March 2009.) *† +10.3 +Stock Incentive Program of the Company effective 1 October 1996. (Filed as Exhibit 10.21 to the Company’s Form 10-K Report for the fiscal year ended 30 September 2002.) *† +10.4 +Amended and Restated Deferred Compensation Program for Directors, effective 25 January 2017. (Filed as Exhibit 10.4 to the Company's Form 10-K Report for the fiscal year ended 30 September 2017.) *† +10.5 +Amended and Restated Long-Term Incentive Plan of the Company effective 1 October 2014. (Filed as Exhibit 10.1 to the Company’s Form 8-K filed on 23 September 2014.) † +10.5(a) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY 2009 Awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2008.) *† +10.5(b) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2010 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2009.) *† +126 +Table of Contents +Exhibit No. +Description +10.5(c) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2011 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2010.) *† +10.5(d) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2012 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2011.) *† +10.5(e) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2013 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2012.) *† +10.5(f) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2014 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2013.) *† +10.5(g) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2015 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2014.) *† +10.5(h) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2016 awards. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 December 2015.) *† +10.5(i) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2017 awards. (Filed as Exhibit 10.1 and 10.2 to the Company’s Form 10-Q Report for the quarter ended 31 December 2016.) *† +10.5(j) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2018 awards. (Filed as Exhibit 10.1 and 10.2 to the Company's Form 10-Q Report for the quarter ended 31 December 2017.) *† +10.6 +Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 November 2017 with provisions effective 1 January 2018. (Filed as Exhibit 10.4 to the Company's Form 10-Q Report for the quarter ended 31 December 2017.) *† +10.6(a) +Amendment No. 1 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 November 2017 with provisions effective 1 January 2018. † +10.7 +Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective August 1, 2014. (Filed as Exhibit 10.10 to the Company’s Form 10-K Report for the fiscal year ended 30 September 2014.) *† +10.7(a) +Amendment No. 1 dated as of 30 September 2015 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2014. (Filed as Exhibit 10.10(a) to the Company’s Form 10-K Report for the fiscal year ended 30 September 2015.) † +10.7(b) +Amendment No. 2 dated as of 30 September 2016 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2014. (Filed as Exhibit 10.7(b) to the Company's Form 10-K Report for fiscal year ended 30 September 2016.) † +10.7(c) +Amendment No. 3 dated as of 26 July 2017 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2017.(Filed as Exhibit 10.7(c) to the Company's Form 10-K Report for the fiscal year ended 30 September 2017.) *† +127 +Table of Contents +Exhibit No. +Description +10.8 +Deferred Compensation Plan as Amended and Restated effective 1 January 2018. (Filed as Exhibit 10.5 to the Company's Form 10-Q Report for the quarter ended 31 December 2017.) *† +10.9 +Revolving Credit Facility dated as of 31 March 2017 for $2,500,000,000. (Filed as Exhibit 10.1 to the Company’s Form 10-Q Report for the quarter ended 31 March 2017.) * +10.9(a) +Amendment and Appointment of Successor Administrative Agent dated 28 September 2018 to the Revolving Credit Agreement dated 31 March 2017 +10.10 +Air Products and Chemicals, Inc. Executive Separation Program as amended effective as of 20 July 2018. † +10.11 +Form of Change in Control Severance Agreement for an Executive Officer. (filed as Exhibit 10.2 of the Company's Form 8-K Report dated 23 September 2014.) *† +10.12 +Compensation Program for Non-Employee Directors effective 1 July 2017. (Filed as Exhibit 10.2 to the Company's Form 10-Q Report for the quarter ended 30 June 2017.) *† +10.13 +Air Products and Chemicals, Inc. Corporate Executive Committee Retention Agreements effective as of 10 January 2014. (Filed as Exhibit 10.1 to the Company’s Form 8-K Report dated 15 January 2014.) *† +10.14 +Amended and Restated Employment Agreement dated 14 November 2017, between the Company and Seifollah Ghasemi. (Filed as Exhibit 10.1 to the Company's Form 8-K Report filed 14 November 2017.) *† +10.16 +Senior Management Severance and Summary Plan Description effective as of 1 October 2017. (Filed as Exhibit 10.16 to the Company's Form 10-K Report for the fiscal year ended 30 September 2017) *† +16.1 +Letter from KPMG LLP (Filed as Exhibit 16.1 to the Company’s Form 8-K Report dated 26 July 2018). * +14 +Code of Conduct revised on 17 May 2012. (Filed as Exhibit 14 to the Company’s Form 8-K Report filed on 23 May 2012.) * +21 +Subsidiaries of the registrant. +(23) +Consents of Experts and Counsel. +23.1 +Consent of Independent Registered Public Accounting Firm. +24 +Power of Attorney. +(31) +Rule 13a-14(a)/15d-14(a) Certifications. +31.1 +Certification by the Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification by the Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +(32) +Section 1350 Certifications. +32.1 +Certification by the Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. †† +128 +Table of Contents +Exhibit No. +Description +99.1 +Description of Common Stock (Filed as Exhibit 99.1 to the Company’s Form 10-K Report for the fiscal year ended 30 September 2014.) * +101.INS +XBRL Instance Document. The XBRL Instance Document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH +XBRL Taxonomy Extension Schema +101.CAL +XBRL Taxonomy Extension Calculation Linkbase +101.LAB +XBRL Taxonomy Extension Label Linkbase +101.PRE +XBRL Taxonomy Extension Presentation Linkbase +101.DEF +XBRL Taxonomy Extension Definition Linkbase +* +Previously filed as indicated and incorporated herein by reference. Exhibits incorporated by reference are located in SEC File No. 001-04534 unless otherwise indicated. +† +Indicated management contract or compensatory arrangement. +†† +The certification attached as Exhibit 32.1 that accompanies this Annual Report on Form 10-K, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Air Products and Chemicals, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Form 10-K, irrespective of any general incorporation language contained in such filing. +129 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. +AIR PRODUCTS AND CHEMICALS, INC. +(Registrant) +By: +/s/ M. Scott Crocco +M. Scott Crocco +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +Date: +20 November 2018 +Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature and Title +Date +/s/ Seifi Ghasemi +20 November 2018 +(Seifi Ghasemi) +Director, Chairman, President, and +Chief Executive Officer +(Principal Executive Officer) +/s/ Russell A. Flugel +20 November 2018 +(Russell A. Flugel) +Vice President and Corporate Controller +(Principal Accounting Officer) +* +20 November 2018 +(Susan K. Carter) +Director +* +20 November 2018 +(Charles I. Cogut) +Director +* +20 November 2018 +(Chad C. Deaton) +Director +* +20 November 2018 +(David H. Y. Ho) +Director +* +20 November 2018 +(Margaret G. McGlynn) +Director +130 +Table of Contents +Signature and Title +Date +* +20 November 2018 +(Edward L. Monser) +Director +* +20 November 2018 +(Matthew H. Paull) +Director +* +Sean D. Major, Executive Vice President, General Counsel and Secretary, by signing his name hereto, does sign this document on behalf of the above noted individuals, pursuant to a power of attorney duly executed by such individuals, which is filed with the Securities and Exchange Commission herewith. +/s/ Sean D. Major +Sean D. Major +Executive Vice President, General Counsel and Secretary +Date: +20 November 2018 +131 +Table of Contents +AIR PRODUCTS AND CHEMICALS, INC. AND SUBSIDIARIES +SCHEDULE II–VALUATION AND QUALIFYING ACCOUNTS +For the Years Ended 30 September 2018 , 2017 , and 2016 +Balance at +Beginning +of Period +Additions +Charged to +Expense +Additions +Charged to +Other Accounts +Other +Changes (A) +Balance +at End of +Period +Year Ended 30 September 2018 +Allowance for doubtful accounts +$ 94 +$ 17 +$ 7 +($ 27 +) +$ 91 +Allowance for deferred tax assets +108 +3 +4 +( 10 +) +105 +Year Ended 30 September 2017 +Allowance for doubtful accounts +$ 55 +$ 7 +$ 39 +($ 7 +) +$ 94 +Allowance for deferred tax assets (B) +165 +6 +7 +( 70 +) +108 +Year Ended 30 September 2016 +Allowance for doubtful accounts +$ 48 +$ 9 +$ 13 +($ 15 +) +$ 55 +Allowance for deferred tax assets (C) +112 +1 +52 +— +165 +(A) +Other changes related to allowance for doubtful accounts primarily includes write-offs of uncollectible trade receivables, net of recoveries. Other Changes also includes the impact of foreign currency translation adjustments. +(B) +The decrease in the valuation allowance was primarily due to the utilization of federal and state loss carryforwards as a result of recognizing the gain on the sale of our PMD business. This benefit was recorded in discontinued operations. See Note 3, Discontinued Operations, for additional information. +(C) +The increase in the valuation allowance was primarily due to the loss recorded on the exit from the Energy-from-Waste business. These costs were recorded in discontinued operations. See Note 3 , Discontinued Operations , for additional information. +132 \ No newline at end of file diff --git a/raw/filings/0000002969/2018/0000002969-18-000044/filing_metadata.csv b/raw/filings/0000002969/2018/0000002969-18-000044/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..b3979700b457b4cdd721b33ab2249f0b7206527b --- /dev/null +++ b/raw/filings/0000002969/2018/0000002969-18-000044/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002969,APD,"Air Products & Chemicals, Inc.",2018,10-K,2018-11-20,2018-09-30,2018-11-20T19:47:42.000Z,0000002969-18-000044,apd-10xkx30sep2018.htm,FORM 10-K,28913798,1,1,https://www.sec.gov/Archives/edgar/data/2969/000000296918000044/apd-10xkx30sep2018.htm,https://www.sec.gov/Archives/edgar/data/2969/000000296918000044/ diff --git a/raw/filings/0000002969/2018/0000002969-18-000044/item1.txt b/raw/filings/0000002969/2018/0000002969-18-000044/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..bc149730987141c44154d7177bc37057fb43091e --- /dev/null +++ b/raw/filings/0000002969/2018/0000002969-18-000044/item1.txt @@ -0,0 +1,68 @@ +ITEM 1. BUSINESS +Air Products and Chemicals, Inc., a Delaware corporation originally founded in 1940, serves customers globally with a unique portfolio of products, services, and solutions that include atmospheric gases, process and specialty gases, equipment, and services. The Company is the world’s largest supplier of hydrogen and has built leading positions in growth markets such as helium and natural gas liquefaction. As used in this report, unless the context indicates otherwise, the terms “we,” “our,” “us,” the “Company,” or “registrant” include controlled subsidiaries, affiliates, and predecessors of Air Products and its controlled subsidiaries and affiliates. +During its fiscal year ended 30 September 2018 (“fiscal year 2018 ”), the Company reported its continuing operations in five reporting segments under which it managed its operations, assessed performance, and reported earnings: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. +Except as otherwise noted, the description of the Company's business below reflects the Company's continuing operations. Refer to Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 25 , Business Segment and Geographic Information , and Note 3 , Discontinued Operations , to the consolidated financial statements for additional details on our reportable business segments and our discontinued operations. +Industrial Gases Business +The Company’s Industrial Gases business produces atmospheric gases (oxygen, nitrogen, argon, and rare gases); process gases (hydrogen, helium, carbon dioxide, carbon monoxide, syngas, and specialty gases); and equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. Atmospheric gases are produced through various air separation processes of which cryogenic is the most prevalent. Process gases are produced by methods other than air separation. For example, hydrogen, carbon monoxide and syngas are produced by steam methane reforming of natural gas and by the gasification of liquid and solid hydrocarbons. Hydrogen is also produced by purifying byproduct sources obtained from the chemical and petrochemical industries; and helium is produced as a byproduct of gases extracted from underground reservoirs, primarily natural gas, but also carbon dioxide purified before resale. +The Company’s Industrial Gases business is organized and operated regionally. The regional Industrial Gases segments (Americas, EMEA, and Asia) supply gases and related equipment in the relevant region to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels. The chemicals industry uses hydrogen, oxygen, nitrogen, carbon monoxide, and syngas as feedstocks in the production of many basic chemicals. The energy production industry uses nitrogen injection for enhanced recovery of oil and natural gas and oxygen for gasification. Oxygen is used in combustion and industrial heating applications, including in the gasification, steel, certain nonferrous metals, glass, and cement industries. Nitrogen applications are used in food processing for freezing and preserving flavor and nitrogen for inerting is used in various fields, including the metals, chemical, and semiconductor industries. Helium is used in laboratories and healthcare for cooling and in other industries for pressurizing, purging, and lifting. Argon is used in the metals and other industries for its unique inerting, thermal conductivity, and other properties. Industrial gases are also used in welding and providing healthcare and are utilized in various manufacturing processes to make them more efficient and to optimize performance. +4 +Table of Contents +We distribute gases to our customers through a variety of supply modes: +Liquid Bulk— Product is delivered in bulk (in liquid or gaseous form) by tanker or tube trailer and stored, usually in its liquid state, in equipment designed and installed typically by the Company at the customer’s site for vaporizing into a gaseous state as needed. Liquid bulk sales are usually governed by three- to five-year contracts. +Packaged Gases— Small quantities of product are delivered in either cylinders or dewars. The Company operates packaged gas businesses in Europe, Asia, and Latin America. In the United States, the Company’s packaged gas business sells products (principally helium) only for the electronics and magnetic resonance imaging industries. +On-Site Gases— Large quantities of hydrogen, nitrogen, oxygen, carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide) are provided to customers, principally the energy production and refining, chemical, gasification, and metals industries worldwide, that require large volumes of gases and have relatively constant demand. Gases are produced at large facilities located adjacent to customers’ facilities or by pipeline systems from centrally located production facilities and are generally governed by 15- to 20- year contracts. The Company also delivers small quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically either via a 10- to 15- year sale of gas contract or through the sale of the equipment to the customer. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide and syngas. We mitigate electricity, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. During fiscal year 2018 , no significant difficulties were encountered in obtaining adequate supplies of power and natural gas. +The Company obtains helium from a number of sources globally, including crude helium for purification from the U.S. Bureau of Land Management's helium reserve. +The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method. The largest of these joint ventures operate in Mexico, Italy, South Africa, India, Saudi Arabia, and Thailand. +Each of the regional Industrial Gases segments competes against two global industrial gas companies: Air Liquide S.A. and Linde plc (the successor to Praxair, Inc. and Linde AG, pursuant to a combination that became effective on 31 October 2018), as well as regional competitors. Competition in Industrial Gases is based primarily on price, reliability of supply, and the development of industrial gas applications. In locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to larger customers, we derive a competitive advantage. +Overall regional industrial gases sales constituted approximately 94% of consolidated sales in fiscal year 2018 , 90% in fiscal year 2017 , and 90% in fiscal year 2016 . Sales of tonnage hydrogen and related products constituted approximately 25% of consolidated sales in fiscal year 2018 , 24% in fiscal year 2017 , and 21% in fiscal year 2016 . Sales of atmospheric gases constituted approximately 46% of consolidated sales in fiscal year 2018 , 45% in fiscal year 2017 , and 46% in fiscal year 2016 . +Industrial Gases Equipment +The Company designs and manufactures equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction ("LNG"), and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global segment includes activity related to cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Corporate and other segment includes three global equipment businesses: our LNG equipment business, our Gardner Cryogenics business fabricating helium and hydrogen transport and storage containers, and our Rotoflow business which manufactures turboexpanders and other precision rotating equipment. Steel, aluminum, and capital equipment subcomponents (compressors, etc.) are the principal raw materials in the manufacturing of equipment. Adequate raw materials for individual projects are acquired under firm purchase agreements. Equipment is produced at the Company’s manufacturing sites with certain components being procured from subcontractors and vendors. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Sale of equipment constituted approximately 6% of consolidated sales in fiscal year 2018 , 10% in fiscal year 2017 , and 10% in fiscal year 2016 . +5 +Table of Contents +The backlog of equipment orders was approximately $.2 billion on 30 September 2018 (as compared to a total backlog of approximately $.5 billion on 30 September 2017 ). The Company estimates that approximately 50% of the total sales backlog as of 30 September 2018 will be recognized as revenue during fiscal year 2019 , dependent on execution schedules of the relevant projects. +International Operations +The Company, through subsidiaries, affiliates, and less-than-controlling interests, conducts business in 50 countries outside the United States. Its international businesses are subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls; import and export controls; and other economic, political, and regulatory policies of local governments described in Item 1A, Risk Factors, below. +The Company has majority or wholly owned foreign subsidiaries that operate in Canada; 16 European countries (including the United Kingdom, the Netherlands, and Spain); eight Asian countries (including China, South Korea, and Taiwan); seven Latin American countries (including Chile and Brazil); four countries in the Middle East, and two African countries. The Company also owns less-than-controlling interests in entities operating in Europe, Asia, Africa, the Middle East, and Latin America (including Italy, Germany, China, India, Saudi Arabia, Thailand, Oman, South Africa, and Mexico). +Financial information about the Company’s foreign operations and investments is included in Note 8 , Summarized Financial Information of Equity Affiliates ; Note 22 , Income Taxes ; and Note 25 , Business Segment and Geographic Information , to the consolidated financial statements included under Item 8, below. Information about foreign currency translation is included under “Foreign Currency” in Note 1 , Major Accounting Policies , and information on the Company’s exposure to currency fluctuations is included in Note 13 , Financial Instruments , to the consolidated financial statements, included under Item 8, below, and in “Foreign Currency Exchange Rate Risk,” included under Item 7A, below. Export sales from operations in the United States to third-party customers amounted to $33.1 million, $64.2 million, and $134.9 million in fiscal years 2018 , 2017 , and 2016 , respectively. +Technology Development +The Company pursues a market-oriented approach to technology development through research and development, engineering, and commercial development processes. It conducts research and development principally in its laboratories located in the United States (Trexlertown, Pennsylvania), Canada (Vancouver), the United Kingdom (Basingstoke and Carrington), Spain (Barcelona), China (Shanghai), and Saudi Arabia (Dhahran). The Company also funds and cooperates in research and development programs conducted by a number of major universities and undertakes research work funded by others, principally the United States government. +The Company’s research groups are aligned with and support the research efforts of various businesses throughout the Company. Development of technology for use within the Industrial Gases business focuses primarily on new and improved processes and equipment for the production and delivery of industrial gases and new or improved applications for industrial gas products. +During fiscal year 2018 , the Company owned approximately 535 United States patents, approximately 2,888 foreign patents, and was a licensee under certain patents owned by others. While the patents and licenses are considered important, the Company does not consider its business as a whole to be materially dependent upon any particular patent, patent license, or group of patents or licenses. +Environmental Controls +The Company is subject to various environmental laws and regulations in the countries in which it has operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, the Company is involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA: the federal Superfund law); Resource Conservation and Recovery Act (RCRA); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. The Company’s accounting policy for environmental expenditures is discussed in Note 1 , Major Accounting Policies , and environmental loss contingencies are discussed in Note 17 , Commitments and Contingencies , to the consolidated financial statements, included under Item 8, below. +The amounts charged to income from continuing operations related to environmental matters totaled $12.8 million in fiscal year 2018 , $11.4 million in fiscal year 2017 , and $12.2 million in fiscal year 2016 . These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet internal Company standards. Refer to Note 17 , Commitments and Contingencies , to the consolidated financial statements for additional information. +6 +Table of Contents +The Company estimates that we spent approximately $3 million in fiscal year 2018 , $7 million in fiscal year 2017 , and $3 million in fiscal year 2016 on capital projects reflected in continuing operations to control pollution. Capital expenditures to control pollution are estimated to be approximately $4 million in both fiscal years 2019 and 2020 . +Employees +On 30 September 2018 , the Company (including majority-owned subsidiaries) had approximately 16,300 employees, of whom approximately 16,000 were full-time employees and of whom approximately 11,800 were located outside the United States. The Company has collective bargaining agreements with unions at various locations that expire on various dates over the next four years. The Company considers relations with its employees to be satisfactory. +Available Information +All periodic and current reports, registration statements, and other filings that the Company is required to file with the Securities and Exchange Commission ("SEC"), including the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through the Company’s website at www.airproducts.com. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC. All such reports filed during the period covered by this report were available on the Company’s website on the same day as filing. In addition, our filings with the SEC are available free of charge on the SEC's website, www.sec.gov. +Seasonality +The Company’s businesses are not subject to seasonal fluctuations to any material extent. +Inventories +The Company maintains limited inventory where required to facilitate the supply of products to customers on a reasonable delivery schedule. Inventory consists primarily of crude helium, industrial gas, and specialty gas inventories supplied to customers through liquid bulk and packaged gases supply modes. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues . We do have concentrations of customers in specific industries, primarily refining, chemicals, and electronics. Within each of these industries, the Company has several large-volume customers with long-term contracts. A negative trend affecting one of these industries, or the loss of one of these major customers, although not material to our consolidated revenue, could have an adverse impact on our financial results. +Governmental Contracts +Our business is not subject to a government entity’s renegotiation of profits or termination of contracts that would be material to our business as a whole. +7 +Table of Contents +Executive Officers of the Company +The Company’s executive officers and their respective positions and ages on 20 November 2018 follow. Information with respect to offices held is stated in fiscal years. +Name +Age +Office +M. Scott Crocco +54 +Executive Vice President and Chief Financial Officer (became Executive Vice President and Chief Financial Officer in 2016; Senior Vice President and Chief Financial Officer in 2013; and Vice President and Corporate Controller in 2008). +Seifi Ghasemi +74 +Chairman, President, and Chief Executive Officer (became Chairman, President and Chief Executive Officer in 2014 and previously served as Chairman and Chief Executive Officer of Rockwood Holdings, Inc. beginning in 2001). Mr. Ghasemi is a member and Chairman of the Board of Directors and the Chairman of the Executive Committee of the Board of Directors. +Sean D. Major +54 +Executive Vice President, General Counsel and Secretary (Secretary since December 2017 and Executive Vice President and General Counsel since May 2017). Previously, Mr. Major served as Executive Vice President, General Counsel and Secretary for Joy Global Inc. since 2007. From 1998 until joining Joy Global Inc. in 2007, Mr. Major was employed by Johnson Controls, Inc., serving in roles of increasing legal responsibility, including Assistant General Counsel and Assistant Secretary. +Dr. Samir Serhan +57 +Executive Vice President (since December 2016). Previously, Dr. Serhan served as President, Global HyCO, since 2014 for Praxair Inc. From 2000-2014, he worked in leadership positions in the U.S. and Germany for The Linde Group, including Managing Director of Linde Engineering from 2008-2014. \ No newline at end of file diff --git a/raw/filings/0000002969/2018/0000002969-18-000044/item13.txt b/raw/filings/0000002969/2018/0000002969-18-000044/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..251ebb1f1d5783fb24d48c0c4c7d55e9d80db7f8 --- /dev/null +++ b/raw/filings/0000002969/2018/0000002969-18-000044/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +125 \ No newline at end of file diff --git a/raw/filings/0000002969/2019/0000002969-19-000051/filing.txt b/raw/filings/0000002969/2019/0000002969-19-000051/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..e1a1a4e8e8f9e7e5daf00f722b5e52e6583f2f21 --- /dev/null +++ b/raw/filings/0000002969/2019/0000002969-19-000051/filing.txt @@ -0,0 +1,11395 @@ 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SECURITIES EXCHANGE ACT OF 1934 For the transition period from to +Commission file number 001-04534 +AIR PRODUCTS AND CHEMICALS, INC. +Delaware +23-1274455 +(State or Other Jurisdiction of Incorporation or Organization) +(I.R.S. Employer Identification No.) +7201 Hamilton Boulevard +Allentown , Pennsylvania 18195-1501 +(Address of Principal Executive Offices and Zip Code) +610 - 481-4911 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class: +Trading Symbol(s) +Registered on: +Common Stock, par value $1.00 per share +APD +New York Stock Exchange +2.000% Euro Notes due 2020 +APD20 +New York Stock Exchange +0.375% Euro Notes due 2021 +APD21B +New York Stock Exchange +1.000% Euro Notes due 2025 +APD25 +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes +☒ +No +☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +Yes +☐ +No +☒ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes +☒ +No +☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes +☒ +No +☐ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. +Large accelerated filer +☒ +Accelerated filer +☐ +Non-accelerated filer +☐ +Smaller reporting company +☐ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. +☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +Yes +☐ +No +☒ +The aggregate market value of the voting stock held by non-affiliates of the registrant on 29 March 2019 was approximately $ 42.0 billion . For purposes of the foregoing calculations, all directors and/or executive officers have been deemed to be affiliates, but the registrant disclaims that any such director and/or executive officer is an affiliate. +The number of shares of common stock outstanding as of 31 October 2019 was 220,433,925 . +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the registrant’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 are incorporated by reference into Part III. +Table of Contents +AIR PRODUCTS AND CHEMICALS, INC. +ANNUAL REPORT ON FORM 10-K +For the fiscal year ended 30 September 2019 +TABLE OF CONTENTS +ITEM 1. +BUSINESS +4 +ITEM 1A. +RISK FACTORS +8 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +14 +ITEM 2. +PROPERTIES +14 +ITEM 3. +LEGAL PROCEEDINGS +15 +ITEM 4. +MINE SAFETY DISCLOSURES +16 +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES +17 +ITEM 6. +SELECTED FINANCIAL DATA +19 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +20 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +47 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +49 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +116 +ITEM 9A. +CONTROLS AND PROCEDURES +117 +ITEM 9B. +OTHER INFORMATION +117 +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +118 +ITEM 11. +EXECUTIVE COMPENSATION +118 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +119 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +120 +ITEM 14. +PRINCIPAL ACCOUNTANT FEES AND SERVICES +120 +ITEM 15. +EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +121 +ITEM 16. +FORM 10-K SUMMARY +121 +INDEX TO EXHIBITS +122 +SIGNATURES +126 +2 +Table of Contents +FORWARD-LOOKING STATEMENTS +This Annual Report on Form 10-K contains “forward-looking statements” within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and can generally be identified by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “goal,” “intend,” “may,” “outlook,” “plan,” “positioned,” “possible,” “potential,” “project,” “should,” “target,” “will,” “would,” and similar expressions or variations thereof, or the negative thereof, but these terms are not the exclusive means of identifying such statements. Forward-looking statements are based on management’s expectations and assumptions as of the date of this report and are not guarantees of future performance. You are cautioned not to place undue reliance on our forward-looking statements. +Forward-looking statements may relate to a number of matters, including expectations regarding revenue, margins, expenses, earnings, tax provisions, cash flows, pension obligations, share repurchases or other statements regarding economic conditions or our business outlook; statements regarding plans, projects, strategies and objectives for our future operations, including our ability to win new projects and execute the projects in our backlog; and statements regarding our expectations with respect to pending legal claims or disputes. While forward-looking statements are made in good faith and based on assumptions, expectations and projections that management believes are reasonable based on currently available information, actual performance and financial results may differ materially from projections and estimates expressed in the forward-looking statements because of many factors, including, without limitation: +• +changes in global or regional economic conditions, supply and demand dynamics in the market segments we serve, or in the financial markets; +• +risks associated with having extensive international operations, including political risks, risks associated with unanticipated government actions and risks of investing in developing markets; +• +project delays, contract terminations, customer cancellations, or postponement of projects and sales; +• +our ability to develop and operate large scale and technically complex projects, including gasification projects; +• +the future financial and operating performance of major customers and joint venture partners; +• +our ability to develop, implement, and operate new technologies, or to execute the projects in our backlog; +• +tariffs, economic sanctions and regulatory activities in jurisdictions in which we and our affiliates and joint ventures operate; +• +the impact of environmental, tax or other legislation, as well as regulations affecting our business and related compliance requirements, including legislation or regulations related to global climate change; +• +changes in tax rates and other changes in tax law; +• +the timing, impact, and other uncertainties relating to acquisitions and divestitures, including our ability to integrate acquisitions and separate divested businesses, respectively; +• +risks relating to cybersecurity incidents, including risks from the interruption, failure or compromise of our information systems; +• +catastrophic events, such as natural disasters, acts of war, or terrorism; +• +the impact of price fluctuations in oil and natural gas and disruptions in markets and the economy due to oil and natural gas price volatility; +• +costs and outcomes of legal or regulatory proceedings and investigations; +• +asset impairments due to economic conditions or specific events; +• +significant fluctuations in interest rates and foreign currency exchange rates from those currently anticipated; +• +damage to facilities, pipelines or delivery systems, including those we own or operate for third parties; +• +availability and cost of raw materials; and +• +the success of productivity and operational improvement programs. +3 +Table of Contents +In addition to the foregoing factors, forward-looking statements contained herein are qualified with respect to the risks disclosed elsewhere in this document, including in Item 1A, Risk Factors , Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , and Item 7A, Quantitative and Qualitative Disclosures About Market Risk . Any of these factors, as well as those not currently anticipated by management, could cause our results of operations, financial condition or liquidity to differ materially from what is expressed or implied by any forward-looking statement. Except as required by law, we disclaim any obligation or undertaking to update or revise any forward-looking statements contained herein to reflect any change in assumptions, beliefs, or expectations or any change in events, conditions, or circumstances upon which any such forward-looking statements are based. +PART I +ITEM 1. BUSINESS +Air Products and Chemicals, Inc., a Delaware corporation originally founded in 1940, serves customers globally with a unique portfolio of products, services, and solutions that include atmospheric gases, process and specialty gases, equipment, and services. The Company is the world’s largest supplier of hydrogen and has built leading positions in growth markets such as helium and liquefied natural gas ("LNG") process technology and equipment. The Company also develops, engineers, builds, owns and operates some of the world’s largest industrial gas projects, including gasification projects that sustainably convert abundant natural resources into syngas for the production of high-value power, fuels and chemicals. +As used in this report, unless the context indicates otherwise, the terms “we,” “our,” “us,” the “Company,” or “registrant” include controlled subsidiaries, affiliates, and predecessors of Air Products and its controlled subsidiaries and affiliates. +During its fiscal year ended 30 September 2019 (“fiscal year 2019 ”), the Company reported its continuing operations in five reporting segments under which it managed its operations, assessed performance, and reported earnings: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. +Except as otherwise noted, the description of the Company's business below reflects the Company's continuing operations. Refer to Note 4 , Discontinued Operations , to the consolidated financial statements for additional details on our discontinued operations. +Industrial Gases Business +The Company’s Industrial Gases business produces atmospheric gases, such as oxygen, nitrogen, and argon, process gases, such as hydrogen, helium, carbon dioxide, carbon monoxide, and syngas, and specialty gases. Atmospheric gases are produced through various air separation processes of which cryogenic is the most prevalent. Process gases are produced by methods other than air separation. For example, hydrogen, carbon monoxide and syngas are produced by steam methane reforming of natural gas and by the gasification of liquid and solid hydrocarbons. Hydrogen is produced by purifying byproduct sources obtained from the chemical and petrochemical industries; and helium is produced as a byproduct of gases extracted from underground reservoirs, primarily natural gas, but also carbon dioxide purified before resale. The Industrial Gases business also develops, builds and operates equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +The Company’s Industrial Gases business is organized and operated regionally. The regional Industrial Gases segments (Americas, EMEA, and Asia) supply gases and related equipment in the relevant region to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels. The chemicals industry uses hydrogen, oxygen, nitrogen, carbon monoxide, and syngas as feedstocks in the production of many basic chemicals. The energy production industry uses nitrogen injection for enhanced recovery of oil and natural gas and oxygen for gasification. Oxygen is used in combustion and industrial heating applications, including in the gasification, steel, certain nonferrous metals, glass, and cement industries. Nitrogen applications are used in food processing for freezing and preserving flavor and nitrogen for inerting is used in various fields, including the metals, chemical, and semiconductor industries. Helium is used in laboratories and healthcare for cooling and in other industries for pressurizing, purging, and lifting. Argon is used in the metals and other industries for its unique inerting, thermal conductivity, and other properties. Industrial gases are also used in welding and providing healthcare and are utilized in various manufacturing processes to make them more efficient and to optimize performance. +4 +Table of Contents +We distribute gases to our sale of gas customers through different supply modes depending on various factors including the customer's volume requirements and location. Our supply modes are as follows: +Liquid Bulk— Product is delivered in bulk (in liquid or gaseous form) by tanker or tube trailer and stored, usually in its liquid state, in equipment designed and installed typically by the Company at the customer’s site for vaporizing into a gaseous state as needed. Liquid bulk sales are usually governed by three- to five-year contracts. +Packaged Gases— Small quantities of product are delivered in either cylinders or dewars. The Company operates packaged gas businesses in Europe, Asia, and Latin America. In the United States, the Company’s packaged gas business sells products (principally helium) only for the electronics and magnetic resonance imaging industries. +On-Site Gases— Large quantities of hydrogen, nitrogen, oxygen, carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide) are provided to customers, principally in the energy production and refining, chemical, gasification, and metals industries worldwide, that require large volumes of gases and have relatively constant demand. Gases are produced at large facilities located adjacent to customers’ facilities or by pipeline systems from centrally located production facilities and are generally governed by 15- to 20- year contracts. The Company also delivers small quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically either via a 10- to 15- year sale of gas contract or through the sale of the equipment to the customer. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide and syngas. We mitigate electricity, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. During fiscal year 2019 , no significant difficulties were encountered in obtaining adequate supplies of power and natural gas. +The Company obtains helium from a number of sources globally, including crude helium for purification from the U.S. Bureau of Land Management's helium reserve. +The regional Industrial Gases segments also include our interests in the results of several joint ventures accounted for by the equity method, which are reported in our financial statements as income from equity affiliates. The largest of these joint ventures operate in Mexico, Italy, South Africa, India, Saudi Arabia, and Thailand. +Each of the regional Industrial Gases segments competes against two global industrial gas companies: Air Liquide S.A. and Linde plc (the successor to Praxair, Inc. and Linde AG, pursuant to a combination that became effective on 31 October 2018), as well as regional competitors. Competition in Industrial Gases is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to our larger customers. +Overall regional industrial gases sales constituted approximately 96% , 94% , and 90% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively. Sales of atmospheric gases constituted approximately 46% , 46% , 45% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively, while sales of tonnage hydrogen, syngas, and related products constituted approximately 26% , 25% , and 24% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively. +5 +Table of Contents +Industrial Gases Equipment +The Company designs and manufactures equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction ("LNG"), and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global segment includes activity related to cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Corporate and other segment includes three global equipment businesses: our LNG equipment business, our Gardner Cryogenics business fabricating helium and hydrogen transport and storage containers, and our Rotoflow business, which manufactures turboexpanders and other precision rotating equipment. Steel, aluminum, and capital equipment subcomponents (compressors, etc.) are the principal raw materials in the manufacturing of equipment. Raw materials for individual projects typically are acquired under firm purchase agreements. Equipment is produced at the Company’s manufacturing sites with certain components being procured from subcontractors and vendors. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Sale of equipment constituted approximately 4% , 6% , and 10% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively. +The backlog of equipment orders was approximately $.9 billion on 30 September 2019 (as compared to a total backlog of approximately $.2 billion on 30 September 2018 ). The Company estimates that approximately 50% of the total equipment sales backlog as of 30 September 2019 will be recognized as revenue during fiscal year 2020 , dependent on execution schedules of the relevant projects. +International Operations +The Company, through subsidiaries, affiliates, and joint ventures accounted for using the equity method, conducts business in 51 countries outside the United States. Its international businesses are subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls, tariffs, trade sanctions, and import and export controls, and other economic, political, and regulatory policies of local governments described in Item 1A, Risk Factors , below. +The Company has majority or wholly owned foreign subsidiaries that operate in Canada; 17 European countries (including the Netherlands, Spain, and the United Kingdom); nine Asian countries (including China, South Korea, and Taiwan); seven Latin American countries (including Brazil and Chile); five countries in the Middle East (including Saudi Arabia), and three African countries. The Company also owns less-than-controlling interests in entities operating in Europe, Asia, Latin America, the Middle East, and Africa (including China, Germany, India, Italy, Mexico, Oman, Saudi Arabia, South Africa, and Thailand). +Financial information about the Company’s foreign operations and investments is included in Note 9 , Summarized Financial Information of Equity Affiliates ; Note 23 , Income Taxes ; and Note 26 , Business Segment and Geographic Information , to the consolidated financial statements included under Item 8, below. Information about foreign currency translation is included under “Foreign Currency” in Note 1 , Major Accounting Policies , and information on the Company’s exposure to currency fluctuations is included in Note 14 , Financial Instruments , to the consolidated financial statements, included under Item 8, below, and in “Foreign Currency Exchange Rate Risk,” included under Item 7A, below. Export sales from operations in the United States to third-party customers amounted to $41.3 million, $33.1 million, and $64.2 million in fiscal years 2019 , 2018 , and 2017 , respectively. +Technology Development +The Company pursues a market-oriented approach to technology development through research and development, engineering, and commercial development processes. It conducts research and development principally in its laboratories located in the United States (Trexlertown, Pennsylvania), Canada (Vancouver), the United Kingdom (Basingstoke and Carrington), Spain (Barcelona), China (Shanghai), and Saudi Arabia (Dhahran). The Company also funds and cooperates in research and development programs conducted by a number of major universities and undertakes research work funded by others, principally the United States government. +The Company’s research groups are aligned with and support the research efforts of various businesses throughout the Company. Development of technology for use within the Industrial Gases business focuses primarily on new and improved processes and equipment for the production and delivery of industrial gases and new or improved applications for industrial gas products. +6 +Table of Contents +During fiscal year 2019 , the Company owned approximately 857 United States patents, approximately 3,733 foreign patents, and was a licensee under certain patents owned by others. The increase in the number of patents compared to fiscal year 2018 is primarily attributable to the acquisition of General Electric Company’s gasification business, completed in August 2019, inclusive of its related patent estate. While the patents and licenses are considered important, the Company does not consider its business as a whole to be materially dependent upon any particular patent, patent license, or group of patents or licenses. +Environmental Controls +The Company is subject to various environmental laws and regulations in the countries in which it has operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, the Company is involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA," the federal Superfund law); Resource Conservation and Recovery Act ("RCRA"); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. The Company’s accounting policy for environmental expenditures is discussed in Note 1 , Major Accounting Policies , and environmental loss contingencies are discussed in Note 18 , Commitments and Contingencies , to the consolidated financial statements, included under Item 8, below. +The amounts charged to income from continuing operations related to environmental matters totaled $14.2 million , $12.8 million , and $11.4 million in fiscal years 2019 , 2018 , and 2017 , respectively. These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet internal Company standards. Refer to Note 18 , Commitments and Contingencies , to the consolidated financial statements for additional information. +The Company estimates that we spent approximately $5 million, $3 million, and $7 million in fiscal years 2019 , 2018 , and 2017 , respectively, on capital projects reflected in continuing operations to control pollution. Capital expenditures to control pollution are estimated to be approximately $5 million in both fiscal years 2020 and 2021 . +Employees +On 30 September 2019 , the Company (including majority-owned subsidiaries) had approximately 17,700 employees, of whom approximately 17,440 were full-time employees and of whom approximately 12,950 were located outside the United States. The Company has collective bargaining agreements with unions at various locations that expire on various dates over the next four years. The Company considers relations with its employees to be satisfactory. +Seasonality +The Company’s businesses are not subject to seasonal fluctuations to any material extent. +Inventories +The Company maintains limited inventory where required to facilitate the supply of products to customers on a reasonable delivery schedule. Inventory consists primarily of crude helium, industrial gas, and specialty gas inventories supplied to customers through liquid bulk and packaged gases supply modes. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues . We do have concentrations of customers in specific industries, primarily refining, chemicals, and electronics. Within each of these industries, we have several large-volume customers with long-term contracts. A negative trend affecting one of these industries, or the loss of one of these major customers, although not material to our consolidated revenue, could have an adverse impact on our financial results. +Governmental Contracts +Our business is not subject to a government entity’s renegotiation of profits or termination of contracts that would be material to our business as a whole. +Available Information +All periodic and current reports, registration statements, proxy statements, and other filings that the Company is required to file with the Securities and Exchange Commission ("SEC"), including the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through the Company’s website at www.airproducts.com. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC. All such reports filed during the period +7 +Table of Contents +covered by this report were available on the Company’s website on the same day as filing. In addition, our filings with the SEC are available free of charge on the SEC's website, www.sec.gov. +Executive Officers of the Company +The Company’s executive officers and their respective positions and ages on 26 November 2019 follow. Information with respect to offices held is stated in fiscal years. +Name +Age +Office +M. Scott Crocco +55 +Executive Vice President and Chief Financial Officer (became Executive Vice President and Chief Financial Officer in 2016; Senior Vice President and Chief Financial Officer in 2013; and Vice President and Corporate Controller in 2008). +Seifi Ghasemi +75 +Chairman, President, and Chief Executive Officer (became Chairman, President and Chief Executive Officer in 2014 and previously served as Chairman and Chief Executive Officer of Rockwood Holdings, Inc. from 2001 to 2014). Mr. Ghasemi is a member and Chairman of the Board of Directors and the Chairman of the Executive Committee of the Board of Directors. +Sean D. Major +55 +Executive Vice President, General Counsel and Secretary (Secretary since December 2017 and Executive Vice President and General Counsel since May 2017). Previously, Mr. Major served as Executive Vice President, General Counsel and Secretary for Joy Global Inc. from 2007 to 2017. +Dr. Samir J. Serhan +58 +Executive Vice President (since December 2016). Previously, Dr. Serhan served as President, Global HyCO, since 2014 for Praxair Inc. From 2000-2014, he worked in leadership positions in the U.S. and Germany for The Linde Group, including Managing Director of Linde Engineering from 2008-2014. +ITEM 1A. RISK FACTORS +Our operations are affected by various risks, many of which are beyond our control. In evaluating investment in the Company and the forward-looking information contained in this Annual Report on Form 10-K or presented elsewhere by management from time to time, you should consider the following risk factors. Any of the following risks could have a material adverse effect on our business, operating results, financial condition, and the actual outcome of matters as to which forward-looking statements are made and could adversely affect the value of an investment in our common stock as well. While we believe we have identified and discussed below the key risk factors affecting our business, there may be additional risks and uncertainties that adversely affect our business, performance, or financial condition in the future that are not presently known, are not currently believed to be significant, or are not identified below because they are common to all businesses. +Changes in global and regional economic conditions, the markets we serve, or the financial markets may adversely affect our results of operations and cash flows. +Unfavorable conditions in the global economy or regional economies, the markets we serve or financial markets may decrease the demand for our goods and services and adversely impact our revenues, operating results, and cash flows. +Demand for our products and services depends in part on the general economic conditions affecting the countries and markets in which we do business. Weak economic conditions in certain geographies and changing supply and demand balances in the markets we serve have negatively impacted demand for our products and services in the past and may do so in the future. Reduced demand for our products and services would have a negative impact on our revenues and earnings. In addition, reduced demand could depress sales, reduce our margins, constrain our operating flexibility or reduce efficient utilization of our manufacturing capacity, or result in charges which are unusual or nonrecurring. Excess capacity in our manufacturing facilities or those of our competitors could decrease our ability to maintain pricing and generate profits. +Our operating results in one or more segments may also be affected by uncertain or deteriorating economic conditions for particular customer markets within a segment. A decline in the industries served by our customers or adverse events or circumstances affecting individual customers can impair the ability of such customers to satisfy their obligations to the Company, resulting in uncollected receivables, unanticipated contract terminations, project delays, or inability to recover plant investments, any of which may negatively impact our financial results. +Weak overall demand or specific customer conditions may also cause customer shutdowns or default, or other inabilities to operate facilities profitably, and may force sale or abandonment of facilities and equipment or prevent projects from coming on-stream. These or other events associated with weak economic conditions or specific end +8 +Table of Contents +market, product, or customer events may require us to record an impairment on tangible assets, such as facilities and equipment, or intangible assets, such as intellectual property or goodwill, which would have a negative impact on our financial results. +Our extensive international operations can be adversely impacted by operational, economic, political, security, legal, and currency translation risks that could decrease profitability. +In fiscal year 2019 , over 60% of our sales were derived from customers outside the United States and many of our operations, suppliers, and employees are located outside the United States. Our operations in foreign jurisdictions may be subject to risks including exchange control regulations, import and trade restrictions, trade policy and other potentially detrimental domestic and foreign governmental practices or policies affecting U.S. companies doing business abroad. Changing economic and political conditions within foreign jurisdictions, strained relations between countries, or the imposition of tariffs or international sanctions can cause fluctuations in demand, price volatility, supply disruptions, or loss of property. The occurrence of any of these risks could have a material adverse impact on our financial condition, results of operation, and cash flows. +Our growth strategies depend in part on our ability to further penetrate markets outside the United States, particularly in higher-growth markets such as China, India, Russia and the Middle East, and involve significantly larger and more complex projects, including gasification projects, some in regions where there is the potential for significant economic and political disruptions. We are actively investing large amounts of capital and other resources, in some cases through joint ventures, in developing markets with high growth potential. Our operations in these markets may be subject to greater risks than those faced by our operations in mature economies, including political and economic instability, project delay or abandonment due to unanticipated government actions, inadequate investment in infrastructure, undeveloped property rights and legal systems, unfamiliar regulatory environments, relationships with local partners, language and cultural differences and increased difficulty recruiting, training and retaining qualified employees. Our contracts in these locations may be subject to cancellation without full compensation for loss. Successful operation of particular facilities or execution of projects may be disrupted by civil unrest, acts of sabotage or terrorism, and other local security concerns. Such concerns may require us to incur greater costs for security or require us to shut down operations for a period of time. +Because the majority of our revenue is generated from sales outside the United States, we are exposed to fluctuations in foreign currency exchange rates. Our business is primarily exposed to translational currency risk as the results of our foreign operations are translated into U.S. dollars at current exchange rates throughout the fiscal period. Our policy is to minimize cash flow volatility from changes in currency exchange rates. We choose not to hedge the translation of our foreign subsidiaries’ earnings into dollars. Accordingly, reported sales, net earnings, cash flows, and fair values have been, and in the future will be, affected by changes in foreign exchange rates. For a more detailed discussion of currency exposure, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk , below. +Operational and project execution risks may adversely affect our operations or financial results. +Gasification and other large projects involve challenging engineering, procurement and construction phases that may occur in more risky locations and over extended time periods, sometimes up to several years. These projects are large scale and technically complex and, as a result, face greater development and operational risks. We may encounter difficulties in engineering, delays in designs or materials provided by the customer or a third party, equipment and materials delivery delays, schedule changes, customer scope changes, delays related to obtaining regulatory permits and rights-of-way, inability to find adequate sources of labor in the locations where we are building new plants, weather-related delays, delays by customers' contractors in completing their portion of a project, technical or transportation difficulties, cost overruns and other factors, many of which are beyond our control, that may impact our ability to complete a project within the original delivery schedule. In some cases, delays and additional costs may be substantial, and we may be required to cancel a project and/or compensate the customer for the delay. We may not be able to recover any of these costs. In addition, in some cases we seek limited recourse financing for certain large projects and face market risk associated with the availability and terms of such financing. These financing arrangements may require that we comply with certain performance requirements which, if not met, could result in default and restructuring costs or other losses. All of these factors could also negatively impact our reputation or relationships with our customers, which could adversely affect our ability to secure new contracts in the future. +9 +Table of Contents +The operation of our facilities, pipelines, and delivery systems inherently entails hazards that require continuous oversight and control, such as pipeline leaks and ruptures, fire, explosions, toxic releases, mechanical failures, or vehicle accidents. If operational risks materialize, they could result in loss of life, damage to the environment, or loss of production, all of which could negatively impact our ongoing operations, reputation, financial results, and cash flows. In addition, our operating results are dependent on the continued operation of our production facilities and our ability to meet customer requirements, which depend, in part, on our ability to properly maintain and replace aging assets. +We are subject to extensive government regulation in the jurisdictions in which we do business. Regulations addressing, among other things, import/export restrictions, anti-bribery and corruption, and taxes, can negatively impact our financial condition, results of operation, and cash flows. +We are subject to government regulation in the United States and in the foreign jurisdictions where we conduct business. The application of laws and regulations to our business is sometimes unclear. Compliance with laws and regulations may involve significant costs or require changes in business practices that could result in reduced profitability. If there is a determination that we have failed to comply with applicable laws or regulations, we may be subject to penalties or sanctions that could adversely impact our reputation and financial results. Compliance with changes in laws or regulations can result in increased operating costs and require additional capital expenditures. Export controls or other regulatory restrictions could prevent us from shipping our products to and from some markets or increase the cost of doing so. Changes in tax laws and regulations and international tax treaties could affect the financial results of our businesses. Increasingly aggressive enforcement of anti-bribery and anti-corruption requirements, including the U.S. Foreign Corrupt Practices Act, the United Kingdom Bribery Act and the China Anti-Unfair Competition Law, could subject us to criminal or civil sanctions if a violation is deemed to have occurred. In addition, we are subject to laws and sanctions imposed by the U.S. and other jurisdictions where we do business that may prohibit us, or certain of our affiliates, from doing business in certain countries, or restricting the kind of business that we may conduct. Such restrictions may provide a competitive advantage to competitors who are not subject to comparable restrictions or prevent us from taking advantage of growth opportunities. +Further, we cannot guarantee that our internal controls and compliance systems will always protect us from acts committed by employees, agents, business partners, or businesses that we acquire that would violate U.S. and/or non-U.S. laws, including the laws governing payments to government officials, bribery, fraud, kickbacks and false claims, pricing, sales and marketing practices, conflicts of interest, competition, export and import compliance, money laundering, and data privacy. Any such improper actions or allegations of such acts could damage our reputation and subject us to civil or criminal investigations in the United States and in other jurisdictions and related shareholder lawsuits, could lead to substantial civil and criminal, monetary and non-monetary penalties, and could cause us to incur significant legal and investigatory fees. In addition, the government may seek to hold us liable as a successor for violations committed by companies in which we invest or that we acquire. +We may be unable to successfully identify, execute or effectively integrate acquisitions, or effectively disentangle divested businesses. +Our ability to grow revenue, earnings, and cash flow at anticipated rates depends in part on our ability to identify, successfully acquire and integrate businesses and assets at appropriate prices, and realize expected growth, synergies, and operating efficiencies. We may not be able to complete transactions on favorable terms, on a timely basis or at all. In addition, our results of operations and cash flows may be adversely impacted by the failure of acquired businesses or assets to meet expected returns, the failure to integrate acquired businesses, the inability to dispose of non-core assets and businesses on satisfactory terms and conditions, and the discovery of unanticipated liabilities or other problems in acquired businesses or assets for which we lack adequate contractual protections or insurance. In addition, we may incur asset impairment charges related to acquisitions that do not meet expectations. +We continually assess the strategic fit of our existing businesses and may divest businesses that are deemed not to fit with our strategic plan or are not achieving the desired return on investment. These transactions pose risks and challenges that could negatively impact our business and financial statements. For example, when we decide to sell or otherwise dispose of a business or assets, we may be unable to do so on satisfactory terms within our anticipated time frame or at all. In addition, divestitures or other dispositions may dilute our earnings per share, have other adverse financial and accounting impacts, distract management, and give rise to disputes with buyers. In addition, we have agreed, and may in the future agree, to indemnify buyers against known and unknown contingent liabilities. Our financial results could be impacted adversely by claims under these indemnities. +10 +Table of Contents +The security of our information technology systems could be compromised, which could adversely affect our ability to operate. +We depend on information technology to enable us to operate efficiently and interface with customers as well as to maintain financial accuracy and efficiency. Our information technology capabilities are delivered through a combination of internal and external services and service providers. If we do not allocate and effectively manage the resources necessary to build and sustain the proper technology infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to our confidential business information due to a security breach. In addition, our information technology systems may be damaged, disrupted or shut down due to attacks by computer hackers, computer viruses, employee error or malfeasance, power outages, hardware failures, telecommunication or utility failures, catastrophes or other unforeseen events, and in any such circumstances our system redundancy and other disaster recovery planning may be ineffective or inadequate. Security breaches of our systems (or the systems of our customers, suppliers or other business partners) could result in the misappropriation, destruction or unauthorized disclosure of confidential information or personal data belonging to us or to our employees, partners, customers or suppliers, and may subject us to legal liability. +As with most large systems, our information technology systems have in the past been, and in the future likely will be subject to computer viruses, malicious codes, unauthorized access and other cyber-attacks, and we expect the sophistication and frequency of such attacks to continue to increase. To date, we are not aware of any significant impact on our operations or financial results from such attempts; however, unauthorized access could disrupt our business operations, result in the loss of assets, and have a material adverse effect on our business, financial condition, or results of operations. Any of the attacks, breaches or other disruptions or damage described above could: interrupt our operations at one or more sites; delay production and shipments; result in the theft of our and our customers’ intellectual property and trade secrets; damage customer and business partner relationships and our reputation; result in defective products or services, legal claims and proceedings, liability and penalties under privacy laws, or increased costs for security and remediation; or raise concerns regarding our accounting for transactions. Each of these consequences could adversely affect our business, reputation and our financial statements. +Our business involves the use, storage, and transmission of information about our employees, vendors, and customers. The protection of such information, as well as our proprietary information, is critical to us. The regulatory environment surrounding information security and privacy is increasingly demanding, with the frequent imposition of new and constantly changing requirements. We have established policies and procedures to help protect the security and privacy of this information. We also, from time to time, export sensitive customer data and technical information to recipients outside the United States. Breaches of our security measures or the accidental loss, inadvertent disclosure, or unapproved dissemination of proprietary information or sensitive or confidential data about us or our customers, including the potential loss or disclosure of such information or data as a result of fraud, trickery, or other forms of deception, could expose us, our customers, or the individuals affected to a risk of loss or misuse of this information, which could ultimately result in litigation and potential legal and financial liability. These events could also damage our reputation or otherwise harm our business. +Interruption in ordinary sources of raw material or energy supply or an inability to recover increases in energy and raw material costs from customers could result in lost sales or reduced profitability. +Hydrocarbons, including natural gas, are the primary feedstock for the production of hydrogen, carbon monoxide, and syngas. Energy, including electricity, natural gas, and diesel fuel for delivery trucks is the largest cost component of our business. Because our industrial gas facilities use substantial amounts of electricity, energy price fluctuations could materially impact our revenues and earnings. A disruption in the supply of energy, components, or raw materials, whether due to market conditions, legislative or regulatory actions, natural events, or other disruption, could prevent us from meeting our contractual commitments and harm our business and financial results. +Our supply of crude helium for purification and resale is largely dependent upon natural gas production by crude helium suppliers. Lower natural gas production resulting from natural gas pricing dynamics, supplier operating or transportation issues or other interruptions in sales from crude helium suppliers, can reduce our supplies of crude helium available for processing and resale to customers. +We typically contract to pass-through cost increases in energy and raw materials to customers, but cost variability can still have a negative impact on our results. We may be unable to raise prices as quickly as costs rise, or competitive pressures may prevent full recovery of such costs. Increases in energy or raw material costs that cannot be passed on to customers for competitive or other reasons may negatively impact our revenues and earnings. Even where costs are passed through, price increases can cause lower sales volume. +11 +Table of Contents +Catastrophic events could disrupt our operations or the operations of our suppliers or customers, having a negative impact on our business, financial results, and cash flows. +Our operations could be impacted by catastrophic events outside our control, including severe weather conditions such as hurricanes, floods, earthquakes, storms, epidemics, or acts of war and terrorism. Any such event could cause a serious business disruption that could affect our ability to produce and distribute products and possibly expose us to third-party liability claims. Additionally, such events could impact our suppliers or customers, which could cause energy and raw materials to be unavailable to us, or our customers to be unable to purchase or accept our products and services. Any such occurrence could have a negative impact on our operations and financial results. +New technologies create performance risks that could impact our financial results or reputation. +We are continually developing and implementing new technologies and product offerings. Existing technologies are being implemented in products and designs or at scales beyond our experience base. These technological expansions can create nontraditional performance risks to our operations. Failure of the technologies to work as predicted, or unintended consequences of new designs or uses, could lead to cost overruns, project delays, financial penalties, or damage to our reputation. In addition, large scale gasification projects may contain processes or technologies that we have not operated at the same scale or in the same combination, and although such projects generally include technologies and processes that have been demonstrated previously by others, such technologies or processes may be new to us and may introduce new risks to our operations. Performance difficulties on these larger projects may have a material adverse effect on our operations and financial results. In addition, performance challenges may adversely affect our reputation and our ability to obtain future contracts for gasification projects. +Legislative, regulatory and societal responses to global climate change create financial risk. +We are the world’s leading supplier of hydrogen, the primary use of which is the production of ultra-low sulfur transportation fuels that have significantly reduced transportation emissions and helped improve human health. To make the high volumes of hydrogen needed by our customers, we use steam methane reforming, which releases carbon dioxide. In addition, although gasification enables the conversion of lower value feedstocks into cleaner energy and value-added products, our gasification projects will increase our carbon footprint because the gasification process produces carbon dioxide. Some of our operations are within jurisdictions that have or are developing regulatory regimes governing emissions of greenhouse gases ("GHGs"), including carbon dioxide. These include existing coverage under the European Union Emission Trading system, the California cap and trade scheme, China’s Emission Trading Scheme and its nation-wide expansion, and South Korea’s Emission Trading Scheme. In Canada, Alberta and Ontario are both in the development/approval process for new GHG regulations. Alberta’s Carbon Competitiveness Incentive Regulation will end December 31, 2019 and will be replaced by the proposed Technology Innovation and Emission Reduction ("TIER") System or Environment & Climate Change Canada's Output Based Pricing System ("OBPS"). In lieu of adherence to the OBPS, Ontario seeks approval from Environment & Climate Change Canada to implement their proposed GHG Emissions Performance Standards program. In addition, the U.S. Environmental Protection Agency ("EPA") requires mandatory reporting of GHG emissions and is regulating GHG emissions for new construction and major modifications to existing facilities. Some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern may result in more international, U.S. federal, and/or regional requirements to reduce or mitigate the effects of GHG. Although uncertain, these developments could increase our costs related to consumption of electric power, hydrogen production and application of our gasification technology. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +12 +Table of Contents +Our financial results may be affected by various legal and regulatory proceedings, including those involving antitrust, tax, environmental, or other matters. +We are subject to litigation and regulatory investigations and proceedings in the normal course of business and could become subject to additional claims in the future, some of which could be material. While we seek to limit our liability in our commercial contractual arrangements, there are no guarantees that each contract will contain suitable limitations of liability or that limitations of liability will be enforceable. Also, the outcome of existing legal proceedings may differ from our expectations because the outcomes of litigation, including regulatory matters, are often difficult to predict reliably. Various factors or developments can lead us to change current estimates of liabilities and related insurance receivables, where applicable, or make such estimates for matters previously not susceptible to reasonable estimates, such as a significant judicial ruling or judgment, a significant settlement, significant regulatory developments, or changes in applicable law. A future adverse ruling, settlement, or unfavorable development could result in charges that could have a material adverse effect on our financial condition, results of operations, and cash flows in any particular period. +Costs and expenses resulting from compliance with environmental regulations may negatively impact our operations and financial results. +We are subject to extensive federal, state, local, and foreign environmental and safety laws and regulations concerning, among other things, emissions in the air; discharges to land and water; and the generation, handling, treatment, and disposal of hazardous waste and other materials. We take our environmental responsibilities very seriously, but there is a risk of environmental impact inherent in our manufacturing operations and in the transportation of our products. Future developments and more stringent environmental regulations may require us to make additional unforeseen environmental expenditures. In addition, laws and regulations may require significant expenditures for environmental protection equipment, compliance, and remediation. These additional costs may adversely affect financial results. For a more detailed description of these matters, see Item 1, Business–Environmental Controls , above. +Implementation of the United Kingdom’s (“UK”) exit from European Union (“EU”) membership could adversely affect our European Operations. +The UK’s exit from EU membership may adversely affect customer demand, our relationships with customers and suppliers and our European business. Although it is unknown what the terms of the United Kingdom’s future relationship with the EU will be, it is possible that there will be greater restrictions on imports and exports between the United Kingdom and EU members and increased regulatory complexities. Any of these factors could adversely affect customer demand, our relationships with customers and suppliers, and our European business. +Inability to compete effectively in a segment could adversely impact sales and financial performance. +We face strong competition from large global competitors and many smaller regional ones in many of our business segments. Introduction by competitors of new technologies, competing products, or additional capacity could weaken demand for or impact pricing of our products, negatively impacting financial results. In addition, competitors’ pricing policies could affect our profitability or market share. +A change of tax law in key jurisdictions could result in a material increase in our tax expense. +The multinational nature of our business subjects us to taxation in the United States and numerous foreign jurisdictions. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The company’s future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation. +Changes to income tax laws and regulations in any of the jurisdictions in which we operate, or in the interpretation of such laws, could significantly increase our effective tax rate and adversely impact our financial condition, results of operations or cash flows. In December 2017, the U.S. enacted the Tax Cuts and Jobs Act (the "Tax Act"), which significantly revised the U.S. federal corporate income tax law by, among other things, lowering the corporate income tax rate, implementing a territorial tax system, and imposing a one-time tax on unremitted cumulative non-U.S. earnings of foreign subsidiaries. Various levels of government are increasingly focused on tax reform and other legislative action to increase tax revenue. Further changes in tax laws in the U.S. or foreign jurisdictions where we operate could have a material adverse effect on our business, results of operations, or financial condition. +13 +Table of Contents +We could incur significant liability if the distribution of Versum common stock to our stockholders is determined to be a taxable transaction. +We have received an opinion from outside tax counsel to the effect that the spin-off of Versum qualifies as a transaction that is described in Sections 355(a) and 368(a)(1)(D) of the Internal Revenue Code. The opinion relies on certain facts, assumptions, representations and undertakings from Versum and us regarding the past and future conduct of the companies’ respective businesses and other matters. If any of these facts, assumptions, representations or undertakings are incorrect or not satisfied, our shareholders and we may not be able to rely on the opinion of tax counsel and could be subject to significant tax liabilities. Notwithstanding the opinion of tax counsel we have received, the IRS could determine on audit that the spin-off is taxable if it determines that any of these facts, assumptions, representations or undertakings are not correct or have been violated or if it disagrees with the conclusions in the opinion. If the spin-off is determined to be taxable for U.S. federal income tax purposes, our shareholders that are subject to U.S. federal income tax and we could incur significant U.S. federal income tax liabilities. +ITEM 1B. UNRESOLVED STAFF COMMENTS +We have not received any written comments from the Commission staff that remain unresolved. +ITEM 2. PROPERTIES +Air Products and Chemicals, Inc. owns its principal administrative offices, which are the Company’s headquarters located in Trexlertown, Pennsylvania, Hersham, England, and Santiago, Chile. The Company leases the principal administrative office in Shanghai, China. The Company leases administrative offices in the United States, Spain, Malaysia, and China for its Global Business Support organization. +The following is a description of the properties used by our five business segments. We believe that our facilities are suitable and adequate for our current and anticipated future levels of operation. +Industrial Gases – Americas +This business segment currently operates from over 400 production and distribution facilities in North and South America (approximately one-fourth of which are located on owned property), and 10% of which are integrated sites that serve dedicated customers as well as merchant customers. The Company has sufficient property rights and permits for the ongoing operation of our pipeline systems in the Gulf Coast, California, and Arizona in the United States and Alberta and Ontario, Canada. Management and sales support is based in our Trexlertown and Santiago offices referred to above, and at 12 leased properties located throughout North and South America. +Hydrogen fueling stations built by the Company support commercial markets in California and Japan as well as demonstration projects in Europe and other parts of Asia. +Industrial Gases – EMEA +This business segment currently operates from over 180 production and distribution facilities in Europe, the Middle East, and Africa (approximately one-third of which are on owned property). The Company has sufficient property rights and permits for the ongoing operation of our pipeline systems in the Netherlands, the United Kingdom, Belgium, France, and Germany. Management and sales support for this business segment is based in Hersham, England, referred to above, Barcelona, Spain and at 16 leased regional office sites and at least 15 leased local office sites, located throughout the region. +Industrial Gases – Asia +Industrial Gases – Asia currently operates from over 170 production and distribution facilities within Asia (approximately one-fourth of which are on owned property or long-duration term grants). The Company has sufficient property rights and permits for the ongoing operation of our pipeline systems in China, South Korea, Taiwan, Malaysia, Singapore, and Indonesia. Management and sales support for this business segment is based in Shanghai, China and Kuala Lumpur, Malaysia, and in 18 leased office locations throughout the region. +14 +Table of Contents +Industrial Gases – Global +Management, sales, and engineering support for this business segment is based in our principal administrative offices noted above, and an office in India. +Equipment is manufactured in Missouri, Pennsylvania, and China. +Research and development ("R&D") activities for this business segment are conducted at owned locations in the U.S., the United Kingdom, and Spain, and 4 leased locations in Canada, Europe, and Asia. +Helium is processed at multiple sites in the U.S. and then distributed to/from transfill sites globally. +Corporate and other +Corporate administrative functions are based in the Company’s administrative offices referred to above. +The LNG business operates a manufacturing facility in Florida in the United States with management, engineering, and sales support based in the Trexlertown offices referred to above and a nearby leased office. +The Gardner Cryogenic business operates at facilities in Pennsylvania and Kansas in the United States and in France. +The Rotoflow business operates manufacturing and service facilities in Texas and Pennsylvania in the United States with management, engineering, and sales support based in the Trexlertown offices referred to above and a nearby leased office. +ITEM 3. LEGAL PROCEEDINGS +In the normal course of business, the Company and its subsidiaries are involved in various legal proceedings, including commercial, competition, environmental, intellectual property, regulatory, product liability, and insurance matters . Although litigation with respect to these matters is routine and incidental to the conduct of our business, such litigation could result in large monetary awards, especially if compensatory and/or punitive damages are awarded. However, we believe that litigation currently pending to which we are a party will be resolved without any material adverse effect on our financial position, earnings, or cash flows. +From time to time, we are also involved in proceedings, investigations, and audits involving governmental authorities in connection with environmental, health, safety, competition, and tax matters. +The Company is a party to proceedings under CERCLA, RCRA, and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Presently there are 31 sites on which a final settlement has not been reached where the Company, along with others, has been designated a potentially responsible party by the Environmental Protection Agency or is otherwise engaged in investigation or remediation, including cleanup activity at certain of its current and former manufacturing sites. We do not expect that any sums we may have to pay in connection with these environmental matters would have a material adverse impact on our consolidated financial position. Additional information on the Company’s environmental exposure is included under Item 1, Business–Environmental Controls . +In September 2010, the Brazilian Administrative Council for Economic Defense ("CADE") issued a decision against our Brazilian subsidiary, Air Products Brasil Ltda., and several other Brazilian industrial gas companies for alleged anticompetitive activities. CADE imposed a civil fine of R$179.2 million (approximately $43 million at 30 September 2019 ) on Air Products Brasil Ltda. This fine was based on a recommendation by a unit of the Brazilian Ministry of Justice, whose investigation began in 2003, alleging violation of competition laws with respect to the sale of industrial and medical gases. The fines are based on a percentage of the Company’s total revenue in Brazil in 2003. +We have denied the allegations made by the authorities and filed an appeal in October 2010 to the Brazilian courts. On 6 May 2014, our appeal was granted and the fine against Air Products Brasil Ltda. was dismissed. CADE has appealed that ruling and the matter remains pending. The Company, with advice of its outside legal counsel, has assessed the status of this matter and has concluded that, although an adverse final judgment after exhausting all appeals is possible, such a judgment is not probable. As a result, no provision has been made in the consolidated financial statements. +In November 2019, the Company finalized a Consent Order with the City of Santa Clara, CA (“City”) to address certain alleged administrative violations at its Santa Clara facility. The Consent Order requires the Company to pay the City approximately $.6 million to settle the allegations, which includes an enforcement penalty and funding for various supplemental environmental and training projects. +15 +Table of Contents +Other than the CADE matter discussed above, we do not currently believe there are any legal proceedings, individually or in the aggregate, that are reasonably possible to have a material impact on our financial condition, results of operations, or cash flows. However, a future charge for regulatory fines or damage awards could have a significant impact on our net income in the period in which it is recorded. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +16 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, +AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on the New York Stock Exchange under the symbol "APD." As of 31 October 2019 , there were 5,166 record holders of our common stock. +Cash dividends on the Company’s common stock are paid quarterly. It is our expectation that we will continue to pay cash dividends in the future at comparable or increased levels. The Board of Directors determines whether to declare dividends and the timing and amount based on financial condition and other factors it deems relevant. Dividend information for each quarter of fiscal years 2019 and 2018 is summarized below: +2019 +2018 +First quarter +$1.10 +$.95 +Second quarter +1.16 +1.10 +Third quarter +1.16 +1.10 +Fourth quarter +1.16 +1.10 +Total +$4.58 +$4.25 +Purchases of Equity Securities by the Issuer +On 15 September 2011, the Board of Directors authorized the repurchase of up to $1.0 billion of our outstanding common stock. This program does not have a stated expiration date. We repurchase shares pursuant to Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended, through repurchase agreements established with one or more brokers. There were no purchases of stock during fiscal year 2019 . At 30 September 2019 , $485.3 million in share repurchase authorization remained. Additional purchases will be completed at the Company’s discretion while maintaining sufficient funds for investing in its businesses and growth opportunities. +17 +Table of Contents +Performance Graph +The performance graph below compares the five-year cumulative returns of the Company’s common stock with those of the Standard & Poor’s 500 Index (S&P 500 Index) and the Standard & Poor’s 500 Materials Index (S&P 500 Materials Index). The figures assume an initial investment of $100 and the reinvestment of all dividends. +COMPARISON OF FIVE YEAR CUMULATIVE SHAREHOLDER RETURN +Air Products, S&P 500 Index, and S&P 500 Materials Index +Comparative Growth of a $100 Investment +(Assumes Reinvestment of All Dividends) +Sept 2014 +Sept 2015 +Sept 2016 +Sept 2017 +Sept 2018 +Sept 2019 +Air Products +100 +100 +120 +134 +153 +208 +S&P 500 Index +100 +99 +115 +136 +160 +167 +S&P 500 Materials Index +100 +82 +100 +122 +126 +130 +18 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +(Millions of dollars, except for share and per share data) +2019 +2018 +2017 +2016 +2015 +Sales +$8,919 +$8,930 +$8,188 +$7,504 +$7,824 +Operating income +2,144 +1,966 +1,440 +1,535 +1,276 +Operating margin +24.0 +% +22.0 +% +17.6 +% +20.5 +% +16.3 +% +Equity affiliates’ income (A) +215 +175 +80 +147 +152 +Net income (B)(C) +1,809 +1,533 +3,021 +662 +1,318 +Net income margin (C) +20.3 +% +17.2 +% +36.9 +% +8.8 +% +16.8 +% +Income from continuing operations +1,809 +1,491 +1,155 +1,122 +966 +Basic earnings per common share from continuing operations +7.99 +6.64 +5.20 +5.08 +4.34 +Diluted earnings per common share from continuing operations +7.94 +6.59 +5.16 +5.04 +4.29 +Adjusted diluted earnings per common share from continuing operations (C) +$8.21 +$7.45 +$6.31 +$5.64 +$4.88 +Adjusted EBITDA (C) +3,468 +3,116 +2,799 +2,622 +2,422 +Adjusted EBITDA margin (C) +38.9 +% +34.9 +% +34.2 +% +34.9 +% +31.0 +% +Dividends declared per common share +4.58 +4.25 +3.71 +3.39 +3.20 +Total assets (D) +18,943 +19,178 +18,467 +18,029 +17,317 +Total debt (E) +3,326 +3,813 +3,963 +5,211 +5,856 +(A) +Fiscal year 2017 included the impact of an other-than-temporary noncash impairment charge of $80 on a 25%‑owned equity affiliate in Saudi Arabia. +(B) +Fiscal year 2017 included net income from discontinued operations of $1,866 primarily resulting from the sale of the Performance Materials Division to Evonik Industries AG. Fiscal year 2016 included a net loss from discontinued operations of $465, which included an after-tax loss on the disposal of the Energy-from-Waste business of $847, partially offset by income from operations of the former Electronic Materials and Performance Materials divisions. +(C) +A reconciliation of adjusted diluted earnings per common share from continuing operations to diluted earnings per common share from continuing operations on a GAAP basis is presented on page 30 . A reconciliation of adjusted EBITDA and adjusted EBITDA margin to net income and net income margin on a GAAP basis, respectively, is presented on page 31 . +(D) +Total assets includes assets from continuing and discontinued operations. +(E) +Total debt includes long-term debt and current portion of long-term debt, including debt to related parties, and short-term borrowings as of the end of the year for continuing operations. Long-term obligations decreased in fiscal year 2017 primarily due to debt repayments subsequent to the spin-off of the former Electronic Materials division as Versum Materials, Inc. +19 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS +OF OPERATIONS +Business Overview +21 +2019 in Summary +21 +2020 Outlook +23 +Results of Operations +23 +Reconciliations of Non-GAAP Financial Measures +29 +Liquidity and Capital Resources +34 +Contractual Obligations +37 +Pension Benefits +38 +Environmental Matters +40 +Off-Balance Sheet Arrangements +41 +Related Party Transactions +41 +Inflation +41 +Critical Accounting Policies and Estimates +41 +New Accounting Guidance +46 +This Management’s Discussion and Analysis contains “forward-looking statements” within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, including statements about business outlook. These forward-looking statements are based on management’s expectations and assumptions as of the date of this report and are not guarantees of future performance. Actual performance and financial results may differ materially from projections and estimates expressed in the forward-looking statements because of many factors not anticipated by management, including, without limitation, those described in Forward-Looking Statements and Item 1A, Risk Factors , of this Annual Report on Form 10-K. +The discussion that follows includes a comparison of our results of operations and liquidity and capital resources for fiscal years 2019 and 2018. For the discussion of changes from fiscal year 2017 to fiscal year 2018 and other financial information related to fiscal year 2017, refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , of our fiscal year 2018 Form 10-K. This document was filed with the United States Securities and Exchange Commission on 20 November 2018. +The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes contained in this report. Financial information is presented in millions of dollars, except for per share data. Except for net income, financial information is presented on a continuing operations basis. +The financial measures included in the discussion that follows are presented in accordance with U.S. generally accepted accounting principles ("GAAP"), except as noted. We present certain financial measures on a non-GAAP ("adjusted") basis because we believe such measures, when viewed together with financial results computed in accordance with GAAP, provide a more complete understanding of the factors and trends affecting the Company's historical financial performance and projected future results. For each non-GAAP financial measure, including adjusted diluted earnings per share ("EPS"), adjusted EBITDA, adjusted EBITDA margin, and adjusted effective tax rate, we present a reconciliation to the most directly comparable financial measure calculated in accordance with GAAP. These reconciliations and explanations regarding the use of these measures are presented on pages 29-33 . +20 +Table of Contents +BUSINESS OVERVIEW +Air Products and Chemicals, Inc. is a world-leading industrial gases company in operation for nearly 80 years. Focused on serving energy, environment and emerging markets, the Company provides essential industrial gases, related equipment and applications expertise to customers in dozens of industries, including refining, chemical, metals, electronics, manufacturing, and food and beverage. Air Products is also the global leader in the supply of liquefied natural gas ("LNG") process technology and equipment. The Company also develops, engineers, builds, owns and operates some of the world's largest industrial gas projects, including gasification projects that sustainably convert abundant natural resources into syngas for the production of high-value power, fuels and chemicals. With operations in 51 countries outside the United States, in fiscal year 2019 we had sales of $8.9 billion , assets of $18.9 billion , and a worldwide workforce of approximately 17,700 full- and part-time employees. +As of 30 September 2019 , our operations were organized into five reportable business segments: +• +Industrial Gases – Americas; +• +Industrial Gases – EMEA (Europe, Middle East, and Africa); +• +Industrial Gases – Asia; +• +Industrial Gases – Global; and +• +Corporate and other +This Management’s Discussion and Analysis discusses our results based on these operations. Refer to Note 26 , Business Segment and Geographic Information , to the consolidated financial statements for additional details on our reportable business segments. +2019 IN SUMMARY +In fiscal year 2019, we remained focused on improving our existing business while deploying capital into larger, more complex industrial gas projects. We continued to execute our gasification strategy, with the Lu'An project in China reaching its first full year of operation and the progression of other projects such as the Jiutai coal-to-syngas project and the Debang syngas project. We also received a number of important recognitions for our strong focus on sustainability and our commitment to advancing diversity and inclusion. The results below are compared to fiscal year 2018. +• +Sales of $8,918.9 were flat as favorable pricing of 3% and higher volumes of 2% were offset by negative currency impacts of 3% and the negative impact of a contract modification to a tolling arrangement in India of 2% . +• +Operating income of $2,144.4 increased 9% , or $178.8 , and operating margin of 24.0% increased 200 bp. +• +Net income of $1,809.4 increased 18% , or $276.5 , and net income margin of 20.3% increased 310 bp . +• +Adjusted EBITDA of $3,468.0 increased 11% , or $352.5 , and adjusted EBITDA margin of 38.9% increased 400 bp. +• +Diluted EPS of $7.94 increased 20% , or $1.35 per share. Adjusted diluted EPS of $8.21 increased 10% , or $.76 per share. A summary table of changes in diluted EPS is presented on the following page. +• +We increased our quarterly dividend by 5% from $1.10 to $1.16 per share, or $4.64 per share annually. This is the 37th consecutive year that we have increased our dividend payment, reflecting continued confidence in our financial strength, significant cash flows, and growth outlook. +21 +Table of Contents +Changes in Diluted EPS Attributable to Air Products +Increase +2019 +2018 +(Decrease) +Diluted EPS +$7.94 +$6.59 +$1.35 +Operating Income Impact (after-tax) +Underlying business +Volume +$.40 +Price, net of variable costs +.81 +Other costs +(.17 +) +Currency +(.20 +) +Facility closure +(.10 +) +Change in inventory valuation method +(.08 +) +Cost reduction actions +(.08 +) +Gain on exchange of equity affiliate investments +.13 +Total Operating Income Impact (after-tax) +$.71 +Other Impact (after-tax) +Equity affiliates' income +.04 +Interest expense +(.02 +) +Other non-operating income (expense), net +.21 +Change in effective tax rate, excluding discrete items below +(.09 +) +Tax reform repatriation +2.22 +Tax reform adjustment related to deemed foreign dividends +(.51 +) +Tax reform rate change and other +(.96 +) +Tax restructuring +(.16 +) +Noncontrolling interests +(.06 +) +Weighted average diluted shares +(.03 +) +Total Other Impact (after-tax) +$.64 +Total Change in Diluted EPS +$1.35 +Increase +2019 +2018 +(Decrease) +Diluted EPS +$7.94 +$6.59 +$1.35 +Facility closure +.10 +— +.10 +Change in inventory valuation method +— +(.08 +) +.08 +Cost reduction actions +.08 +— +.08 +Gain on exchange of equity affiliate investments +(.13 +) +— +(.13 +) +Pension settlement loss +.02 +.15 +(.13 +) +Tax reform repatriation +(.06 +) +2.16 +(2.22 +) +Tax reform adjustment related to deemed foreign dividends +.26 +(.25 +) +.51 +Tax reform rate change and other +— +(.96 +) +.96 +Tax restructuring +— +(.16 +) +.16 +Adjusted Diluted EPS +$8.21 +$7.45 +$.76 +22 +Table of Contents +2020 OUTLOOK +In fiscal year 2020 , we intend to grow our earnings by continuing to improve our base businesses and execute against our capital deployment strategy. Backed by our current financial position, we will strive to continue to win and invest in key growth projects, including large gasification projects that are consistent with our onsite business model. We expect earnings to grow from an investment in a new equity affiliate that will acquire the gasification, power, and industrial gas assets at Jazan Economic City, Saudi Arabia ("the Jazan gas and power project"). +The above guidance should be read in conjunction with the Forward-Looking Statements of this Annual Report on Form 10-K. +RESULTS OF OPERATIONS +Discussion of Consolidated Results +2019 +2018 +$ Change +Change +GAAP Measures +Sales +$8,918.9 +$8,930.2 +($11.3 +) +— +% +Operating income +2,144.4 +1,965.6 +178.8 +9 +% +Operating margin +24.0 +% +22.0 +% +— +200 bp +Equity affiliates’ income +$215.4 +$174.8 +$40.6 +23 +% +Net income +1,809.4 +1,532.9 +276.5 +18 +% +Net income margin +20.3 +% +17.2 +% +— +310 +bp +Non-GAAP Measures +Adjusted EBITDA +$3,468.0 +$3,115.5 +$352.5 +11 +% +Adjusted EBITDA margin +38.9 +% +34.9 +% +— +400 bp +Sales +Sales % Change from Prior Year +Volume +2 +% +Price +3 +% +Energy and raw material cost pass-through +— +% +Currency +(3 +)% +Other (A) +(2 +)% +Total Consolidated Sales Change +— +% +(A) +Includes the impact from the modification of a hydrogen supply contract to a tolling arrangement in India in December 2018 ("the India contract modification"). +Sales of $8,918.9 were flat as favorable pricing of 3% and higher volumes of 2% were offset by negative currency impacts of 3% and the impact of the India contract modification of 2% . The pricing improvement was primarily attributable to our merchant business across the regional segments. Volumes were higher from new projects, mainly the Lu'An project in Asia, and positive base business growth. These drivers were partially offset by lower Jazan sale of equipment activity, which negatively impacted volumes by 2%, and a prior year equipment sale resulting from a contract termination in Asia. Unfavorable currency impacts were driven by the Chinese Renminbi, Euro, and British Pound Sterling. Energy and natural gas cost pass-through to customers was flat versus the prior year. +23 +Table of Contents +Cost of Sales and Gross Margin +Cost of sales, including the facility closure discussed below, was $6,004.5 . Total cost of sales decreased 3% , or $185.0 , as a favorable impact from the India contract modification of $193 and positive currency impacts of $189 were partially offset by higher other costs of $67, higher costs attributable to sales volumes of $44, higher energy and natural gas cost pass-through to customers of $33, the facility closure of $29, and a benefit of $24 for the change in inventory valuation method for our United States industrial gas inventories in the prior year. Gross margin of 32.7% increased 200 bp, primarily due to positive pricing, favorable volume mix, and the India contract modification, partially offset by unfavorable net operating costs. +Facility Closure +In December 2018, one of our customers was subject to a government enforced shutdown due to environmental reasons. As a result, we recognized a charge of $29.0 ( $22.1 after-tax, or $.10 per share) during the first quarter of fiscal year 2019 primarily related to the write-off of onsite assets. This charge is reflected as “Facility closure” on our consolidated income statements. We do not expect to recognize additional charges related to this shutdown. +Selling and Administrative Expense +Selling and administrative expense of $750.0 decreased 1% , or $10.8 . Selling and administrative expense as a percent of sales decreased from 8.5% to 8.4% . +Research and Development +Research and development expense of $72.9 increased 13% , or $8.4 . Research and development expense as a percent of sales increased to .8% from .7% . +Cost Reduction and Asset Actions +In fiscal year 2019, we recognized an expense of $25.5 ( $18.8 after-tax, or $.08 per share) for severance and other benefits associated with position eliminations that are expected to drive cost synergies, primarily within the Industrial Gases – EMEA and the Industrial Gases – Americas segments. This expense has been reflected as " Cost reduction and asset actions " on our consolidated income statements. +Gain on Exchange of Equity Affiliate Investments +In fiscal year 2019, we recognized a net gain of $29.1 ( $.13 per share) resulting from the exchange of two 50% -owned industrial gas joint ventures in China. Refer to Note 7 , Acquisitions , to the consolidated financial statements for additional information. The net gain has been reflected as " Gain on exchange of equity affiliate investments " on our consolidated income statements. There were no tax impacts on the exchange. +Other Income (Expense), Net +Other income (expense), net of $49.3 decreased 2% , or $.9 , primarily due to lower income from transition services agreements, mostly offset by income from the sale of assets and investments and a favorable foreign exchange impact. +Operating Income and Margin +Operating income of $2,144.4 increased 9% , or $178.8 , as positive pricing, net of power and fuel costs, of $220, favorable volumes of $110, and a gain on the exchange of two 50%-owned equity affiliates of $29 were partially offset by unfavorable currency impacts of $55, higher net operating costs of $46, a charge for a facility closure of $29, a charge for cost reduction actions of $26, and the impact of the change in inventory valuation method of $24 in the prior year. Operating margin of 24.0% increased 200 bp, primarily due to positive pricing and favorable volume mix, partially offset by unfavorable net operating costs. +Equity Affiliates’ Income +Income from equity affiliates of $215.4 increased 23% , or $40.6 , primarily due to an expense of $28.5 in the prior year resulting from the U.S. Tax Cuts and Jobs Act, favorable volumes, and new plant contributions. For additional information on the U.S. Tax Cuts and Jobs Act, refer to Note 23 , Income Taxes , to the consolidated financial statements. +24 +Table of Contents +Interest Expense +2019 +2018 +Interest incurred +$150.5 +$150.0 +Less: Capitalized interest +13.5 +19.5 +Interest Expense +$137.0 +$130.5 +Interest incurred increased $.5 as interest expense associated with financing the Lu'An joint venture was mostly offset by favorable impacts from currency, a lower average interest rate on the debt portfolio, and a lower average debt balance. Capitalized interest decreased 31% , or $6.0 , due to a decrease in the carrying value of projects under construction, primarily driven by the Lu'An project in Asia. +Other Non-Operating Income (Expense), Net +Other non-operating income (expense), net of $66.7 increased $61.6 , primarily due to lower pension settlement losses, higher non-service pension income, and higher interest income on cash and cash items. The prior year included pension settlement losses of $43.7 ($33.2 after-tax, or $.15 per share) primarily in connection with the transfer of certain pension assets and payment obligations to an insurer for our U.S. salaried and hourly plans. In fiscal year 2019, we recognized a pension settlement loss of $5.0 ($3.8 after-tax, or $.02 per share) associated with the U.S. Supplementary Pension Plan during the second quarter. +Net Income and Net Income Margin +Net income of $1,809.4 increased 18% , or $276.5 , primarily due to impacts from the U.S. Tax Cuts and Jobs Act , positive pricing, and favorable volumes. Net income margin of 20.3% increased 310 bp . +Adjusted EBITDA and Adjusted EBITDA Margin +Adjusted EBITDA of $3,468.0 increased 11% , or $352.5 , primarily due to positive pricing and higher volumes, partially offset by unfavorable currency. Adjusted EBITDA margin of 38.9% increased 400 bp , primarily due to higher volumes, positive pricing, and the India contract modification. The India contract modification contributed 80 bp. +Effective Tax Rate +The effective tax rate equals the income tax provision divided by income from continuing operations before taxes. The effective tax rate was 21.0% and 26.0% in fiscal years 2019 and 2018 , respectively. +The current year rate was lower primarily due to impacts related to the enactment of the U.S. Tax Cuts and Jobs Act (the “Tax Act") in 2018, which significantly changed existing U.S. tax laws, including a reduction in the federal corporate income tax rate from 35% to 21%, a deemed repatriation tax on unremitted foreign earnings, as well as other changes. As a result of the Tax Act, our income tax provision reflects discrete net income tax costs of $43.8 and $180.6 in fiscal years 2019 and 2018, respectively. The current year included a cost of $56.2 ($.26 per share) for the reversal of a benefit recorded in 2018 related to the U.S. taxation of deemed foreign dividends. We recorded this reversal based on regulations issued in 2019. The 2019 reversal was partially offset by a favorable adjustment of $12.4 ( $.06 per share) that was recorded as we completed our estimates of the impacts of the Tax Act. This adjustment is primarily related to foreign tax items, including the deemed repatriation tax for foreign tax redeterminations. In addition, the current year rate included a net gain on the exchange of two equity affiliates of $29.1 , which was not a taxable transaction. The higher 2018 expense resulting from the Tax Act was partially offset by a $35.7 tax benefit from the restructuring of foreign subsidiaries, a $9.1 benefit from a foreign audit settlement agreement, and higher excess tax benefits on share-based compensation. +The adjusted effective tax rate was 19.4% and 18.6% in fiscal years 2019 and 2018 , respectively. The lower prior year rate was primarily due to the $9.1 benefit from a foreign audit settlement agreement and higher excess tax benefits on share-based compensation. +25 +Table of Contents +Refer to Note 23 , Income Taxes , to the consolidated financial statements for additional information. +Discontinued Operations +In fiscal year 2018, income from discontinued operations, net of tax, of $42.2 included an income tax benefit of $25.6 resulting from the resolution of uncertain tax positions taken in conjunction with the disposition of our former European Homecare business in fiscal year 2012. In addition, we recorded an after-tax benefit of $17.6 resulting from the resolution of certain post-closing adjustments associated with the sale of our former Performance Materials Division. These benefits were partially offset by an after-tax loss of $1.0 related to Energy-from-Waste. +Segment Analysis +Industrial Gases – Americas +2019 +2018 +$ Change +Change +Sales +$3,873.5 +$3,758.8 +$114.7 +3 +% +Operating income +997.7 +927.9 +69.8 +8 +% +Operating margin +25.8 +% +24.7 +% +— +110 bp +Equity affiliates’ income +$84.8 +$82.0 +$2.8 +3 +% +Adjusted EBITDA +1,587.7 +1,495.2 +92.5 +6 +% +Adjusted EBITDA margin +41.0 +% +39.8 +% +— +120 bp +Sales % Change from Prior Year +Volume +1 +% +Price +3 +% +Energy and natural gas cost pass-through +— +% +Currency +(1 +)% +Total Industrial Gases – Americas Sales Change +3 +% +Sales of $3,873.5 increased 3% , or $114.7 , as positive pricing of 3% and higher volumes of 1% were partially offset by a negative impact from currency of 1% . The pricing improvement was primarily driven by our merchant business. Energy and natural gas cost pass-through to customers was flat versus the prior year. +Operating income of $997.7 increased 8% , or $69.8 , as higher pricing, net of power and fuel costs, of $85 and favorable volumes of $34 were partially offset by higher costs of $44 and unfavorable currency impacts of $5. The higher costs were primarily driven by distribution costs. Operating margin of 25.8% increased 110 bp as positive pricing and higher volumes were partially offset by unfavorable costs. +Equity affiliates’ income of $84.8 increased 3% , or $2.8 , primarily due to positive pricing and lower costs, partially offset by unfavorable impacts from currency. +26 +Table of Contents +Industrial Gases – EMEA +2019 +2018 +$ Change +Change +Sales +$2,002.5 +$2,193.3 +($190.8 +) +(9 +)% +Operating income +472.4 +445.8 +26.6 +6 +% +Operating margin +23.6 +% +20.3 +% +— +330 bp +Equity affiliates’ income +$69.0 +$61.1 +$7.9 +13 +% +Adjusted EBITDA +730.9 +705.5 +25.4 +4 +% +Adjusted EBITDA margin +36.5 +% +32.2 +% +— +430 bp +Sales % Change from Prior Year +Volume +2 +% +Price +3 +% +Energy and natural gas cost pass-through +— +% +Currency +(5 +)% +Other (A) +(9 +)% +Total Industrial Gases – EMEA Sales Change +(9 +)% +(A) +Includes the impact from the modification of a hydrogen supply contract to a tolling arrangement in India in December 2018 ("the India contract modification"). +Sales of $2,002.5 decreased 9% , or $190.8 , as the negative impact from the India contract modification of 9% and unfavorable currency impacts of 5% were partially offset by positive pricing of 3% and higher volumes of 2% . The negative currency impact was mainly driven by the Euro and British Pound Sterling. The pricing improvement was mostly attributable to our merchant business. The volume increase was primarily driven by acquisition activity as our base business remained stable. Energy and natural gas cost pass-through to customers was flat versus the prior year. +Operating income of $472.4 increased 6% , or $26.6 , primarily due to higher pricing, net of power and fuel costs, of $60, partially offset by unfavorable currency impacts of $25 and higher costs of $10. Operating margin of 23.6% increased 330 bp as favorable pricing and the impact of the India tolling arrangement were partially offset by higher costs. +Equity affiliates’ income of $69.0 increased 13% , or $7.9 , primarily due to the Jazan Gas Projects Company joint venture. +Industrial Gases – Asia +2019 +2018 +$ Change +Change +Sales +$2,663.6 +$2,458.0 +$205.6 +8 +% +Operating income +864.2 +689.9 +174.3 +25 +% +Operating margin +32.4 +% +28.1 +% +— +430 bp +Equity affiliates’ income +$58.4 +$58.3 +$.1 +— +% +Adjusted EBITDA +1,284.1 +1,014.0 +270.1 +27 +% +Adjusted EBITDA margin +48.2 +% +41.3 +% +— +690 bp +Sales % Change from Prior Year +Volume +9 +% +Price +3 +% +Energy and natural gas cost pass-through +— +% +Currency +(4 +)% +Total Industrial Gases – Asia Sales Change +8 +% +27 +Table of Contents +Sales of $2,663.6 increased 8% , or $205.6 , as higher volumes of 9% and positive pricing of 3% were partially offset by unfavorable currency impacts of 4% . The volume increase was primarily driven by new plants onstream, mainly the Lu'An gasification project, and base business growth, partially offset by the impact of a prior year equipment sale resulting from a contract termination. Pricing improved across Asia, primarily driven by our merchant business. The unfavorable currency impact was primarily attributable to the Chinese Renminbi. Energy and natural gas cost pass-through to customers was flat versus the prior year. +Operating income of $864.2 increased 25% , or $174.3 , due to higher volumes of $117, favorable pricing, net of power and fuel costs, of $73, and lower net operating costs of $14, partially offset by unfavorable currency impacts of $30. Operating margin of 32.4% increased 430 bp , primarily due to higher volumes and positive pricing. +Equity affiliates’ income of $58.4 was flat versus the prior year. +Industrial Gases – Global +The Industrial Gases – Global segment includes sales of cryogenic and gas processing equipment for air separation and centralized global costs associated with management of all the Industrial Gases segments. +2019 +2018 +$ Change +Change +Sales +$261.0 +$436.1 +($175.1 +) +(40 +)% +Operating income (loss) +(11.7 +) +53.9 +(65.6 +) +(122 +)% +Adjusted EBITDA +.1 +63.9 +(63.8 +) +(100 +)% +Sales of $261.0 decreased 40% , or $175.1 . The decrease in sales was primarily driven by lower sale of equipment activity as we near completion on the multiple air separation units that will serve Saudi Aramco’s Jazan oil refinery and power plant in Saudi Arabia. We expect to complete this project by the end of the first quarter of fiscal year 2020. +Operating loss of $11.7 decreased $65.6 from operating income of $53.9 in the prior year, primarily due to the lower sale of equipment activity. +Corporate and other +The Corporate and other segment includes our LNG, turbo machinery equipment, and helium storage and distribution sale of equipment businesses and corporate support functions that benefit all segments. The results of the Corporate and other segment also include income and expense that is not directly associated with the other segments, such as foreign exchange gains and losses. +2019 +2018 +$ Change +Change +Sales +$118.3 +$84.0 +$34.3 +41 +% +Operating loss +(152.8 +) +(176.0 +) +23.2 +13 +% +Adjusted EBITDA +(134.8 +) +(163.1 +) +28.3 +17 +% +Sales of $118.3 increased 41% , or $34.3 , primarily due to higher turbo machinery activity. Operating loss of $152.8 decreased 13% , or $23.2 , primarily due to income generated from turbo machinery and lower corporate costs. +28 +Table of Contents +RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES +Millions of dollars unless otherwise indicated, except for per share data +The Company presents certain financial measures on a non-GAAP (“adjusted”) basis. On a consolidated basis, these measures include adjusted diluted earnings per share ("EPS"), adjusted EBITDA, adjusted EBITDA margin, and adjusted effective tax rate. On a segment basis, these measures include adjusted EBITDA and adjusted EBITDA margin. In addition to these measures, which are presented above, we also include certain supplemental non-GAAP financial measures that are presented below to help the reader understand the impact that our non-GAAP adjustments have on the calculation of our adjusted diluted EPS. For each non-GAAP financial measure, we present below a reconciliation to the most directly comparable financial measure calculated in accordance with U.S. Generally Accepted Accounting Principles ("GAAP"). +The Company's non-GAAP measures are not meant to be considered in isolation or as a substitute for the most directly comparable measure calculated in accordance with GAAP. The Company believes these non-GAAP measures provide investors, potential investors, securities analysts, and others with useful information to evaluate the performance of the business because such measures, when viewed together with financial results computed in accordance with GAAP, provide a more complete understanding of the factors and trends affecting the Company's historical financial performance and projected future results. +In many cases, non-GAAP measures are determined by adjusting the most directly comparable GAAP measure to exclude certain disclosed items, or “non-GAAP adjustments,” that the Company believes are not representative of underlying business performance. For example, the Company previously excluded certain expenses associated with cost reduction actions, impairment charges, and gains on disclosed transactions. The reader should be aware that the Company may recognize similar losses or gains in the future. Readers should also consider the limitations associated with these non-GAAP measures, including the potential lack of comparability of these measures from one company to another. +The tax impact on our pre-tax non-GAAP adjustments reflects the expected current and deferred income tax impact of the transactions. These tax impacts are primarily driven by the statutory tax rate of the various relevant jurisdictions and the taxability of the adjustments in those jurisdictions. +29 +Table of Contents +Consolidated Results +The tables below provide a reconciliation to the most directly comparable GAAP measure for each of the major components used to calculate adjusted diluted EPS, which the Company views as a key performance metric. We believe it is important for the reader to understand the per share impact of our non-GAAP adjustments as management does not consider these impacts when evaluating underlying business performance. The measures presented are based on continuing operations. +Operating +Income +Equity Affiliates' Income +Income Tax Provision +Net Income Attributable to Air Products +Diluted +EPS +2019 GAAP +$2,144.4 +$215.4 +$480.1 +$1,760.0 +$7.94 +2018 GAAP +1,965.6 +174.8 +524.3 +1,455.6 +6.59 +Change GAAP +$304.4 +$1.35 +% Change GAAP +21 +% +20 +% +2019 GAAP +$2,144.4 +$215.4 +$480.1 +$1,760.0 +$7.94 +Facility closure +29.0 +— +6.9 +22.1 +.10 +Cost reduction actions +25.5 +— +6.7 +18.8 +.08 +Gain on exchange of equity affiliate investments +(29.1 +) +— +— +(29.1 +) +(.13 +) +Pension settlement loss (A) +— +— +1.2 +3.8 +.02 +Tax reform repatriation +— +— +12.4 +(12.4 +) +(.06 +) +Tax reform adjustment related to deemed foreign dividends +— +— +(56.2 +) +56.2 +.26 +2019 Non-GAAP Measures ("Adjusted") +$2,169.8 +$215.4 +$451.1 +$1,819.4 +$8.21 +2018 GAAP +$1,965.6 +$174.8 +$524.3 +$1,455.6 +$6.59 +Change in inventory valuation method +(24.1 +) +— +(6.6 +) +(17.5 +) +(.08 +) +Pension settlement loss (A) +— +— +10.5 +33.2 +.15 +Tax reform repatriation +— +28.5 +(448.6 +) +477.1 +2.16 +Tax reform adjustment related to deemed foreign dividends +— +— +56.2 +(56.2 +) +(.25 +) +Tax reform rate change and other +— +— +211.8 +(211.8 +) +(.96 +) +Tax restructuring +— +— +35.7 +(35.7 +) +(.16 +) +2018 Non-GAAP Measures ("Adjusted") +$1,941.5 +$203.3 +$383.3 +$1,644.7 +$7.45 +Change Non-GAAP Measures ("Adjusted") +$174.7 +$.76 +% Change Non-GAAP Measures ("Adjusted") +11 +% +10 +% +(A) +The before-tax impact of $5.0 and $43.7 for fiscal years 2019 and 2018, respectively, is reflected on the consolidated income statements within "Other non-operating income (expense), net." +The table below provides a reconciliation of adjusted diluted EPS to GAAP diluted EPS for fiscal years 2017, 2016, and 2015: +2017 +2016 +2015 +Diluted EPS +$5.16 +$5.04 +$4.29 +Business separation costs +.12 +.21 +.03 +Tax (benefit) costs associated with business separation +(.02 +) +.24 +— +Business restructuring, cost reduction, and asset actions +.49 +.11 +.61 +Goodwill and intangible asset impairment charge +.70 +— +— +Gain on previously held equity interest +— +— +(.05 +) +Gain on land sales +(.03 +) +— +(.13 +) +Equity method investment impairment charge +.36 +— +— +Pension settlement loss +.03 +.02 +.06 +Loss on extinguishment of debt +— +.02 +.07 +Tax election benefit +(.50 +) +— +— +Adjusted Diluted EPS +$6.31 +$5.64 +$4.88 +30 +Table of Contents +Adjusted EBITDA +We define Adjusted EBITDA as net income less income (loss) from discontinued operations, net of tax, and excluding certain non‑GAAP adjustments, which the Company does not believe to be indicative of underlying business trends, before interest expense, other non‑operating income (expense), net, income tax provision, and depreciation and amortization expense. Adjusted EBITDA and adjusted EBITDA margin provide useful metrics for management to assess operating performance. Margin is calculated for each period by dividing each line item by consolidated sales for the respective period. +Below is a presentation of consolidated sales and a reconciliation of net income on a GAAP basis to adjusted EBITDA and net income margin on a GAAP basis to adjusted EBITDA margin: +2019 +2018 +2017 +2016 +2015 +Sales +$8,918.9 +$8,930.2 +$8,187.6 +$7,503.7 +$7,824.3 +2019 +2018 +2017 +2016 +2015 +$ +Margin +$ +Margin +$ +Margin +$ +Margin +$ +Margin +Net income and net income margin +$1,809.4 +20.3 +% +$1,532.9 +17.2 +% +$3,021.2 +36.9 +% +$661.5 +8.8 +% +$1,317.6 +16.8 +% +Less: Income (Loss) from discontinued operations, net of tax +— +— +% +42.2 +.5 +% +1,866.0 +22.8 +% +(460.5 +) +(6.1 +)% +351.7 +4.5 +% +Add: Interest expense +137.0 +1.5 +% +130.5 +1.5 +% +120.6 +1.5 +% +115.2 +1.5 +% +102.8 +1.3 +% +Less: Other non-operating income (expense), net +66.7 +.7 +% +5.1 +.1 +% +16.6 +.2 +% +(5.4 +) +(.1 +)% +(42.3 +) +(.5 +)% +Add: Income tax provision +480.1 +5.4 +% +524.3 +5.9 +% +260.9 +3.2 +% +432.6 +5.8 +% +300.2 +3.8 +% +Add: Depreciation and amortization +1,082.8 +12.1 +% +970.7 +10.9 +% +865.8 +10.6 +% +854.6 +11.4 +% +858.5 +11.0 +% +Less: Change in inventory valuation method +— +— +% +24.1 +.3 +% +— +— +% +— +— +% +— +— +% +Add: Facility closure +29.0 +.3 +% +— +— +% +— +— +% +— +— +% +— +— +% +Add: Business separation costs +— +— +% +— +— +% +32.5 +.4 +% +50.6 +.7 +% +7.5 +.1 +% +Add: Business restructuring, cost reduction, and asset actions +25.5 +.3 +% +— +— +% +151.4 +1.8 +% +34.5 +.4 +% +180.1 +2.4 +% +Add: Goodwill and intangible asset impairment charge +— +— +% +— +— +% +162.1 +2.0 +% +— +— +% +— +— +% +Less: Gain on previously held equity interest +— +— +% +— +— +% +— +— +% +— +— +% +17.9 +.2 +% +Less: Gain on exchange of equity affiliate investments +29.1 +.3 +% +— +— +% +— +— +% +— +— +% +— +— +% +Less: Gain on land sales +— +— +% +— +— +% +12.2 +.2 +% +— +— +% +33.6 +.4 +% +Add: Equity method investment impairment charge +— +— +% +— +— +% +79.5 +1.0 +% +— +— +% +— +— +% +Add: Loss on extinguishment of debt +— +— +% +— +— +% +— +— +% +6.9 +.1 +% +16.6 +.2 +% +Add: Tax reform repatriation - equity method investment +— +— +% +28.5 +.3 +% +— +— +% +— +— +% +— +— +% +Adjusted EBITDA and adjusted EBITDA margin +$3,468.0 +38.9 +% +$3,115.5 +34.9 +% +$2,799.2 +34.2 +% +$2,621.8 +34.9 +% +$2,422.4 +31.0 +% +2019 +2018 +2017 +2016 +Change GAAP +Net income $ change +$276.5 +($1,488.3 +) +$2,359.7 +($656.1 +) +Net income % change +18 +% +(49 +)% +357 +% +(50 +)% +Net income margin change +310 +bp +(1,970 +) bp +2,810 +bp +(800 +) bp +Change Non-GAAP +Adjusted EBITDA $ change +$352.5 +$316.3 +$177.4 +$199.4 +Adjusted EBITDA % change +11 +% +11 +% +7 +% +8 +% +Adjusted EBITDA margin change +400 +bp +70 +bp +(70 +) bp +390 +bp +31 +Table of Contents +Below is reconciliation of operating income and operating margin by segment to adjusted EBITDA and adjusted EBITDA margin by segment: +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Total +GAAP Measure +Twelve Months Ended 30 September 2019 +Operating income (loss) +$997.7 +$472.4 +$864.2 +($11.7 +) +($152.8 +) +$2,169.8 +(A) +Operating margin +25.8 +% +23.6 +% +32.4 +% +Twelve Months Ended 30 September 2018 +Operating income (loss) +$927.9 +$445.8 +$689.9 +$53.9 +($176.0 +) +$1,941.5 +(A) +Operating margin +24.7 +% +20.3 +% +28.1 +% +2019 vs. 2018 +Operating income (loss) change +$69.8 +$26.6 +$174.3 +($65.6 +) +$23.2 +Operating income (loss) % change +8 +% +6 +% +25 +% +(122 +)% +13 +% +Operating margin change +110 +bp +330 +bp +430 +bp +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Total +Non-GAAP Measure +Twelve Months Ended 30 September 2019 +Operating income (loss) +$997.7 +$472.4 +$864.2 +($11.7 +) +($152.8 +) +$2,169.8 +(A) +Add: Depreciation and amortization +505.2 +189.5 +361.5 +8.6 +18.0 +1,082.8 +Add: Equity affiliates' income +84.8 +69.0 +58.4 +3.2 +— +215.4 +(B) +Adjusted EBITDA +$1,587.7 +$730.9 +$1,284.1 +$.1 +($134.8 +) +$3,468.0 +Adjusted EBITDA margin +41.0 +% +36.5 +% +48.2 +% +Twelve Months Ended 30 September 2018 +Operating income (loss) +$927.9 +$445.8 +$689.9 +$53.9 +($176.0 +) +$1,941.5 +(A) +Add: Depreciation and amortization +485.3 +198.6 +265.8 +8.1 +12.9 +970.7 +Add: Equity affiliates' income +82.0 +61.1 +58.3 +1.9 +— +203.3 +(B) +Adjusted EBITDA +$1,495.2 +$705.5 +$1,014.0 +$63.9 +($163.1 +) +$3,115.5 +Adjusted EBITDA margin +39.8 +% +32.2 +% +41.3 +% +2019 vs. 2018 +Adjusted EBITDA change +$92.5 +$25.4 +$270.1 +($63.8 +) +$28.3 +Adjusted EBITDA % change +6 +% +4 +% +27 +% +(100 +)% +17 +% +Adjusted EBITDA margin change +120 +bp +430 +bp +690 +bp +(A) +The table below reconciles operating income as reflected on our consolidated income statements to total operating income in the table above: +Operating Income +2019 +2018 +Consolidated operating income +$2,144.4 +$1,965.6 +Change in inventory valuation method +— +(24.1 +) +Facility closure +29.0 +— +Cost reduction and asset actions +25.5 +— +Gain on exchange of equity affiliate investments +(29.1 +) +— +Total +$2,169.8 +$1,941.5 +32 +Table of Contents +(B) +The table below reconciles equity affiliates' income as reflected on our consolidated income statements to total equity affiliates' income in the table above: +Equity Affiliates' Income +2019 +2018 +Consolidated equity affiliates' income +$215.4 +$174.8 +Tax reform repatriation - equity method investment +— +28.5 +Total +$215.4 +$203.3 +Income Taxes +The tax impact of our pre-tax non-GAAP adjustments reflects the expected current and deferred income tax expense associated with each adjustment and is primarily dependent upon the statutory tax rate of the various relevant jurisdictions and the taxability of the adjustments in those jurisdictions. For additional discussion on the impact of the U.S. Tax Cuts and Jobs Act , refer to Note 23 , Income Taxes , to the consolidated financial statements. +Effective Tax Rate +2019 +2018 +Income Tax Provision +$480.1 +$524.3 +Income From Continuing Operations Before Taxes +$2,289.5 +$2,015.0 +Effective Tax Rate +21.0 +% +26.0 +% +Income Tax Provision +$480.1 +$524.3 +Change in inventory valuation method +— +(6.6 +) +Facility closure +6.9 +— +Cost reduction actions +6.7 +— +Pension settlement loss +1.2 +10.5 +Tax reform repatriation +12.4 +(448.6 +) +Tax reform adjustment related to deemed foreign dividends +(56.2 +) +56.2 +Tax reform rate change and other +— +211.8 +Tax restructuring +— +35.7 +Adjusted Income Tax Provision +$451.1 +$383.3 +Income from Continuing Operations Before Taxes +$2,289.5 +$2,015.0 +Change in inventory valuation method +— +(24.1 +) +Facility closure +29.0 +— +Cost reduction actions +25.5 +— +Gain on exchange of equity affiliate investments +(29.1 +) +— +Pension settlement loss +5.0 +43.7 +Tax reform repatriation - equity method investment +— +28.5 +Adjusted Income From Continuing Operations Before Taxes +$2,319.9 +$2,063.1 +Adjusted Effective Tax Rate +19.4 +% +18.6 +% +33 +Table of Contents +LIQUIDITY AND CAPITAL RESOURCES +We maintained a strong financial position throughout fiscal year 2019 . As of 30 September 2019 , our consolidated balance sheet included cash and cash items of $2,248.7 . We continue to have consistent access to commercial paper markets, and cash flows from operating and financing activities are expected to meet liquidity needs for the foreseeable future. +As of 30 September 2019 , we had $971.5 of foreign cash and cash items compared to a total amount of cash and cash items of $2,248.7 . As a result of the Tax Act, we do not expect that a significant portion of our foreign subsidiaries' and affiliates' earnings will be subject to U.S. income tax upon subsequent repatriation to the United States. The repatriation of these earnings may be subject to foreign withholding and other taxes depending on the country in which the subsidiaries and affiliates reside. However, because we have significant current investment plans outside the U.S., it is our intent to permanently reinvest the majority of our foreign cash and cash items that would be subject to additional taxes outside the U.S. Refer to Note 23 , Income Taxes , for additional information. +The table below summarizes our cash flows from operating activities, investing activities, and financing activities from continuing operations as reflected on the consolidated statements of cash flows: +Cash Provided by (Used for) +2019 +2018 +Operating activities +$2,969.9 +$2,547.2 +Investing activities +(2,113.4 +) +(1,641.6 +) +Financing activities +(1,370.5 +) +(1,359.8 +) +Operating Activities +For the fiscal year ended 30 September 2019 , cash provided by operating activities was $2,969.9 . Income from continuing operations of $1,760.0 was adjusted for items including depreciation and amortization, deferred income taxes, impacts from the Tax Act, a charge for the facility closure of one of our customers, undistributed earnings of unconsolidated affiliates, gain on sale of assets and investments, share-based compensation, noncurrent capital lease receivables, and certain other adjustments. The caption "Gain on sale of assets and investments" includes a gain of $14.1 recognized on the disposition of our interest in High-Tech Gases (Beijing) Co., Ltd., a previously held equity investment in our Industrial Gases – Asia segment. Refer to Note 7 , Acquisitions , to the consolidated financial statements for additional information. The working capital accounts were a use of cash of $25.3, primarily driven by $ 69.0 from trade receivables and $41.8 from payables and accrued liabilities, partially offset by $ 79.8 from other receivables. The use of cash within "Payables and accrued liabilities" was primarily driven by a $48.9 decrease in accrued utilities and a $30.3 decrease in accrued interest, partially offset by a $51.6 increase in customer advances primarily related to sale of equipment activity. The decrease in accrued utilities was primarily driven by a contract modification to a tolling arrangement in India and lower utility costs in the Industrial Gases – Americas segment. The source of cash from other receivables of $ 79.8 was primarily due to the maturities of forward exchange contracts that hedged foreign currency exposures and the collection of value added taxes. +For the fiscal year ended 30 September 2018, cash provided by operating activities was $2,547.2, including income from continuing operations of $1,455.6 . Other adjustments of $131.6 include a $54.9 net impact from the remeasurement of intercompany transactions. The related hedging instruments that eliminate the earnings impact are included as a working capital adjustment in other receivables or payables and accrued liabilities. In addition, other adjustments were impacted by cash received from the early termination of a cross currency swap of $54.4, as well as the excess of pension expense over pension contributions of $23.5. The working capital accounts were a use of cash of $265.4, primarily driven by payables and accrued liabilities, inventories, and trade receivables, partially offset by other receivables. The use of cash in payables and accrued liabilities of $277.7 includes a decrease in customer advances of $145.7 primarily related to sale of equipment activity and $67.1 for maturities of forward exchange contracts that hedged foreign currency exposures. The use of cash in inventories primarily resulted from the purchase of helium molecules. In addition, inventories reflect the noncash impact of our change in accounting for U.S. inventories from LIFO to FIFO. The source of cash from other receivables of $128.3 was primarily due to the maturities of forward exchange contracts that hedged foreign currency exposures. +34 +Table of Contents +Investing Activities +For the fiscal year ended 30 September 2019 , cash used for investing activities was $2,113.4 . Payments for additions to plant and equipment totaled $1,989.7 . Cash paid for acquisitions, net of cash acquired, was $ 123.2 . Refer to Note 7 , Acquisitions , to the consolidated financial statements for further details. Proceeds from investments of $ 190.5 resulting from maturities of short-term instruments with original maturities greater than three months and less than one year exceeded purchase of $172.1 . +For the fiscal year ended 30 September 2018, cash used for investing activities was $1,641.6. Payments for additions to plant and equipment totaled $1,568.4. Cash paid for acquisitions, net of cash acquired, was $ 345.4 . Refer to Note 7 , Acquisitions , to the consolidated financial statements for further details. Proceeds from investments of $748.2 exceeded our purchases of investments of $530.3. +Capital Expenditures +Capital expenditures is a non-GAAP measure that we define as cash flows for additions to plant and equipment, acquisitions (less cash acquired), and investment in and advances to unconsolidated affiliates. A reconciliation of cash used for investing activities to our reported capital expenditures is provided below: +2019 +2018 +Cash used for investing activities +$2,113.4 +$1,641.6 +Proceeds from sale of assets and investments +11.1 +48.8 +Purchases of investments +(172.1 +) +(530.3 +) +Proceeds from investments +190.5 +748.2 +Other investing activities +(14.3 +) +5.5 +Capital Expenditures +$2,128.6 +$1,913.8 +The components of our capital expenditures are detailed in the table below: +2019 +2018 +Additions to plant and equipment +$1,989.7 +$1,568.4 +Acquisitions, less cash acquired +123.2 +345.4 +Investments in and advances to unconsolidated affiliates +15.7 +— +Capital Expenditures +$2,128.6 +$1,913.8 +Capital expenditures in fiscal year 2019 totaled $2,128.6 compared to $1,913.8 in fiscal year 2018 . The increase of $214.8 was primarily due to major project spending, including payment for gasification and syngas clean up assets from Lu'An. Additions to plant and equipment also included support capital of a routine, ongoing nature, including expenditures for distribution equipment and facility improvements. +2020 Outlook for Investing Activities +Capital expenditures in fiscal year 2020 are expected to be approximately $4 billion to $4.5 billion, which primarily includes our initial expected equity affiliate investment in the Jazan gas and power project as well as new plants that are currently under construction or expected to start construction. It is not possible, without unreasonable efforts, to reconcile our forecasted capital expenditures to future cash used for investing activities because we are unable to identify the timing or occurrence of our future investment activity, which is driven by our assessment of competing opportunities at the time we enter into transactions. These decisions, either individually or in the aggregate, could have a significant effect on our cash used for investing activities. +We anticipate capital expenditures to be funded principally with our current cash balance and cash generated from continuing operations. In addition, we intend to continue to evaluate (1) acquisitions of small- and medium-sized industrial gas companies or assets from other industrial gas companies; (2) purchases of existing industrial gas facilities from our customers to create long-term contracts under which we own and operate the plant and sell industrial gases to the customer based on a fixed fee; and (3) investment in large industrial gas projects driven by demand for more energy, cleaner energy, and emerging market growth. +35 +Table of Contents +Financing Activities +For the fiscal year ended 2019 , cash used for financing activities was $1,370.5 . This use of cash was largely attributable to dividend payments to shareholders of $994.0 and payments on long-term debt of $428.6. Payments on long-term debt primarily related to the repayment of a 4.375% U.S. Senior Note of $400.0 that matured on 21 August 2019. +For the fiscal year ended 2018, cash used for financing activities was $1,359.8. This use of cash was largely attributable to dividend payments to shareholders of $897.8 and payments on long-term debt of $418.7. Payments on long-term debt primarily related to the repayment of a 1.2% U.S. Senior Note of $400.0 that matured on 16 October 2017. +Financing and Capital Structure +Capital needs in fiscal year 2019 were satisfied primarily with cash from operations. At the end of 2019 , total debt outstanding was $3,326.0 compared to $3,812.6 at the end of 2018 , and cash and cash items were $2,248.7 compared to $2,791.3 at the end of 2018 . Total debt as of 30 September 2019 includes related party debt $357.9 associated with the Lu'An joint venture. +On 31 March 2017 , we entered into a five -year $2,500.0 revolving credit agreement maturing 31 March 2022 with a syndicate of banks (the “2017 Credit Agreement”), under which senior unsecured debt is available to both the Company and certain of its subsidiaries. On 28 September 2018, we amended the 2017 Credit Agreement to reduce the maximum borrowing capacity to $2,300.0 . No other terms were impacted by the amendment. +The 2017 Credit Agreement provides a source of liquidity for the Company and supports its commercial paper program. The Company’s only financial covenant under the 2017 Credit Agreement is a maximum ratio of total debt to total capitalization (total debt plus total equity) no greater than 70% . Total debt at 30 September 2019 and 2018 expressed as a percentage of total capitalization was 22.6% and 25.4% , respectively. No borrowings were outstanding under the 2017 Credit Agreement as of 30 September 2019 . +As of 30 September 2019, we classified our 2.000% Eurobond of €300 million ($327.0) maturing in August 2020 as long-term debt because we have the ability to refinance the debt under the 2017 Credit Agreement. Our current intent is to refinance this debt via the U.S. or European public or private placement markets. +Commitments totaling $2.3 are maintained by our foreign subsidiaries, all of which was borrowed and outstanding at 30 September 2019 . +As of 30 September 2019 , we are in compliance with all of the financial and other covenants under our debt agreements. +On 15 September 2011, the Board of Directors authorized the repurchase of up to $1,000 of our outstanding common stock. We did not purchase any of our outstanding shares during fiscal years 2019 or 2018 . As of 30 September 2019 , $485.3 in share repurchase authorization remains. +Dividends +Dividends are declared by the Board of Directors and are usually paid during the sixth week after the close of the fiscal quarter. During 2019 , the Board of Directors increased the quarterly dividend from $1.10 per share to $1.16 per share, or $4.64 per share annually. +On 26 November 2019, the Board of Directors declared the first quarter 2020 dividend of $1.16 per share. The dividend is payable on 10 February 2020 to shareholders of record at the close of business on 2 January 2020. +36 +Table of Contents +CONTRACTUAL OBLIGATIONS +We are obligated to make future payments under various contracts, such as debt agreements, lease agreements, unconditional purchase obligations, and other long-term obligations. The following table summarizes our obligations on a continuing operations basis as of 30 September 2019 : +Total +2020 +2021 +2022 +2023 +2024 +Thereafter +Debt maturities +$3,275 +$367 +$440 +$439 +$454 +$454 +$1,121 +Contractual interest on debt +466 +78 +69 +55 +44 +35 +185 +Capital leases +21 +2 +3 +1 +1 +1 +13 +Operating leases +418 +75 +63 +44 +36 +29 +171 +Pension obligations +641 +35 +51 +52 +52 +52 +399 +Unconditional purchase obligations +8,310 +1,358 +407 +369 +349 +350 +5,477 +Deemed repatriation tax related to the Tax Act +215 +— +21 +21 +21 +37 +115 +Obligation for future contribution to an equity affiliate +100 +100 +— +— +— +— +— +Total Contractual Obligations +$13,446 +$2,015 +$1,054 +$981 +$957 +$958 +$7,481 +Debt Obligations +Our debt obligations include the maturity payments of the principal amount of long-term debt, including the current portion and amounts owed to related parties, and the related contractual interest obligations. Refer to Note 16 , Debt , to the consolidated financial statements for additional information on our debt obligations. +Contractual interest is the interest we are contracted to pay on our debt obligations without taking into account the interest impact of interest rate swaps related to any of this debt, which at current interest rates would slightly decrease contractual interest. We had approximately $635 of long-term debt subject to variable interest rates at 30 September 2019 , excluding fixed-rate debt that has been swapped to variable-rate debt. The rate assumed for the variable interest component of the contractual interest obligation was the rate in effect at 30 September 2019 . Variable interest rates are primarily determined by U.S. short-term tax-exempt interest rates and by interbank offer rates. +Leases +Refer to Note 13 , Leases , to the consolidated financial statements for additional information on capital and operating leases. +Pension Obligations +The amounts in the table above represent the current estimated cash payments to be made by us that, in total, equal the recognized pension liabilities for our U.S. and international pension plans. For additional information, refer to Note 17 , Retirement Benefits , to the consolidated financial statements. These payments are based upon the current valuation assumptions and regulatory environment. +The total accrued liability for pension benefits may be impacted by interest rates, plan demographics, actual return on plan assets, continuation or modification of benefits, and other factors. Such factors can significantly impact the amount of the liability and related contributions. +Unconditional Purchase Obligations +Approximately $7,100 of our unconditional purchase obligations relate to helium purchases. The majority of these obligations occur after fiscal year 2024. Helium purchases include crude feedstock supply to helium refining plants in North America as well as refined helium purchases from sources around the world. As a rare byproduct of natural gas production in the energy sector, these helium sourcing agreements are medium- to long-term and contain take-if-tendered provisions. The refined helium is distributed globally and sold as a merchant gas, primarily under medium-term requirements contracts. While contract terms in our helium sourcing contracts are generally longer than our customer sales contracts, helium is a rare gas used in applications with few or no substitutions because of its unique physical and chemical properties. +37 +Table of Contents +Approximately $160 of our long-term unconditional purchase obligations relate to feedstock supply for numerous HyCO (hydrogen, carbon monoxide, and syngas) facilities. The price of feedstock supply is principally related to the price of natural gas. However, long-term take-or-pay sales contracts to HyCO customers are generally matched to the term of the feedstock supply obligations and provide recovery of price increases in the feedstock supply. Due to the matching of most long-term feedstock supply obligations to customer sales contracts, we do not believe these purchase obligations would have a material effect on our financial condition or results of operations. +The unconditional purchase obligations also include other product supply and purchase commitments and electric power and natural gas supply purchase obligations, which are primarily pass-through contracts with our customers. +We estimate our maximum obligation for future purchases of plant and equipment to be approximately $890 based on open purchase orders as of 30 September 2019. This includes spending for the Jiutai coal-to-syngas project. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to reschedule, cancel, or otherwise modify based on our business needs. We have disclosed this obligation in fiscal year 2020; however, timing of actual satisfaction of the obligation may vary. +We also purchase materials, energy, capital equipment, supplies, and services as part of the ordinary course of business under arrangements that are not unconditional purchase obligations. The majority of such purchases are for raw materials and energy, which are obtained under requirements-type contracts at market prices. +Income Tax Liabilities +Tax liabilities related to unrecognized tax benefits as of 30 September 2019 were $231.7 . These tax liabilities were excluded from the table above as it is impractical to determine a cash impact by year given that payments will vary according to changes in tax laws, tax rates, and our operating results. In addition, there are uncertainties in timing of the effective settlement of our uncertain tax positions with respective taxing authorities. However, the table above includes our accrued liability of approximately $215 for deemed repatriation tax that is payable through 2026 related to the Tax Act. Refer to Note 23 , Income Taxes , to the consolidated financial statements for additional information. +Obligation for Future Contribution to an Equity Affiliate +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20-year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. We guarantee the repayment of our 25% share of an equity bridge loan to fund equity commitments to the joint venture. In total, we expect to invest approximately $100 in this joint venture. As of 30 September 2019, payables and accrued liabilities included $94.4 for our obligation to make future equity contributions in 2020 based on our proportionate share of the advances received by the joint venture under the loan. +Expected Equity Affiliate Investment in Jazan Gas and Power Project +On 12 August 2018, Air Products entered an agreement to form a gasification/power joint venture ("JV") with Saudi Aramco and ACWA in Jazan, Saudi Arabia. Air Products expects to own 51% of the JV, with Saudi Aramco and ACWA Power owning the balance. The JV will purchase the gasification assets, power block, and the associated utilities from Saudi Aramco for approximately $11.5 billion. Our expected equity affiliate investment has been excluded from the contractual obligations table above pending financial closing, which is currently expected in fiscal year 2020. +PENSION BENEFITS +The Company and certain of its subsidiaries sponsor defined benefit pension plans and defined contribution plans that cover a substantial portion of its worldwide employees. The principal defined benefit pension plans are the U.S. salaried pension plan and the U.K. pension plan. These plans were closed to new participants in 2005, after which defined contribution plans were offered to new employees. The shift to defined contribution plans is expected to continue to reduce volatility of both plan expense and contributions. +The fair market value of plan assets for our defined benefit pension plans as of the 30 September 2019 measurement date increased to $4,504.8 from $4,273.1 at the end of fiscal year 2018 . The projected benefit obligation for these plans was $5,145.6 and $4,583.3 at the end of fiscal years 2019 and 2018 , respectively. The net unfunded liability increased $330.6 from $310.2 to $640.8 , primarily due to lower discount rates partially offset by favorable asset experience. Refer to Note 17 , Retirement Benefits , to the consolidated financial statements for additional disclosures on our postretirement benefits. +38 +Table of Contents +Pension Expense +2019 +2018 +Pension expense, including special items noted below +$27.6 +$91.8 +Settlements, termination benefits, and curtailments ("special items") +7.2 +48.9 +Weighted average discount rate – Service cost +3.4 +% +3.2 +% +Weighted average discount rate – Interest cost +3.4 +% +2.9 +% +Weighted average expected rate of return on plan assets +6.4 +% +6.9 +% +Weighted average expected rate of compensation increase +3.5 +% +3.5 +% +Pension expense decreased from the prior year due to lower pension settlements, lower loss amortization, primarily from favorable asset experience and the impact of higher discount rates, partially offset by lower expected returns on assets. Special items (settlements, termination benefits, and curtailments) decreased from the prior year primarily due to lower pension settlement losses. In fiscal year 2019, special items of $7.2 included pension settlement losses of $6.4 , of which $5.0 was recorded during the second quarter and related to the U.S. Supplementary Pension Plan, and $.8 of termination benefits. These amounts are reflected within "Other non-operating income (expense), net" on the consolidated income statements. In fiscal year 2018, special items of $48.9 included a pension settlement loss of $43.7 primarily in connection with the transfer of certain pension assets and payment obligations for our U.S. salaried and hourly plans to an insurer during the fourth quarter, $4.8 of pension settlement losses related to lump sum payouts from the U.S. Supplementary Pension Plan, and $.4 of termination benefits. +U.K. Lloyds Equalization Ruling +On 26 October 2018, the United Kingdom High Court issued a ruling related to the equalization of pension plan participants’ benefits for the gender effects of Guaranteed Minimum Pensions. As a result of this ruling, we estimated the impact of retroactively increasing benefits in our U.K. plan in accordance with the High Court ruling. We treated the additional benefits as a prior service cost, which resulted in an increase to our projected benefit obligation and accumulated other comprehensive loss of $4.7 during the first quarter of fiscal year 2019. We are amortizing this cost over the average remaining life expectancy of the U.K. participants. +2020 Outlook +In fiscal year 2020 , we expect pension expense to be approximately $5 to $20 , which includes expected pension settlement losses of $5 to $10 , depending on the timing of retirements. The expected range reflects lower expected interest cost and higher total assets, partially offset by higher expected loss amortization primarily due to the impact of lower discount rates. In fiscal year 2020, we expect pension expense to include approximately $105 for amortization of actuarial losses. +In fiscal year 2019 , pension expense included amortization of actuarial losses of $76.2 . Net actuarial losses of $424.4 were recognized in accumulated other comprehensive income in fiscal year 2019 . Actuarial (gains) losses are amortized into pension expense over prospective periods to the extent they are not offset by future gains or losses. Future changes in the discount rate and actual returns on plan assets different from expected returns would impact the actuarial (gains) losses and resulting amortization in years beyond fiscal year 2020 . +Pension Funding +Pension funding includes both contributions to funded plans and benefit payments for unfunded plans, which are primarily non-qualified plans. With respect to funded plans, our funding policy is that contributions, combined with appreciation and earnings, will be sufficient to pay benefits without creating unnecessary surpluses. +In addition, we make contributions to satisfy all legal funding requirements while managing our capacity to benefit from tax deductions attributable to plan contributions. With the assistance of third-party actuaries, we analyze the liabilities and demographics of each plan, which help guide the level of contributions. During 2019 and 2018 , our cash contributions to funded plans and benefit payments for unfunded plans were $40.2 and $68.3 , respectively. +For fiscal year 2020 , cash contributions to defined benefit plans are estimated to be $30 to $40 . The estimate is based on expected contributions to certain international plans and anticipated benefit payments for unfunded plans, which are dependent upon the timing of retirements. Actual future contributions will depend on future funding legislation, discount rates, investment performance, plan design, and various other factors. Refer to the Contractual Obligations discussion on page 37 for a projection of future contributions. +39 +Table of Contents +ENVIRONMENTAL MATTERS +We are subject to various environmental laws and regulations in the countries in which we have operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, we are involved in legal proceedings under the CERCLA, RCRA, and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Our accounting policy for environmental expenditures is discussed in Note 1 , Major Accounting Policies , to the consolidated financial statements, and environmental loss contingencies are discussed in Note 18 , Commitments and Contingencies , to the consolidated financial statements. +The amounts charged to income from continuing operations related to environmental matters totaled $14.2 and $12.8 in fiscal years 2019 and 2018 , respectively. These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet internal Company standards. Refer to Note 18 , Commitments and Contingencies , to the consolidated financial statements for additional information. +Although precise amounts are difficult to determine, we estimate that we spent $5 and $3 , in fiscal years 2019 and 2018 , respectively, on capital projects to control pollution. Capital expenditures to control pollution are estimated to be approximately $5 in both fiscal years 2020 and 2021 . +We accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The potential exposure for such costs is estimated to range from $68 to a reasonably possible upper exposure of $82 as of 30 September 2019 . The consolidated balance sheets at 30 September 2019 and 2018 included an accrual of $68.9 and $76.8 , respectively, primarily as part of other noncurrent liabilities. The accrual for the environmental obligations includes amounts for the Pace, Florida; Piedmont, South Carolina; and Pasadena, Texas, locations which were a part of previously divested chemicals businesses. Refer to Note 18 , Commitments and Contingencies , to the consolidated financial statements for further details on these facilities. +Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Subject to the imprecision in estimating future environmental costs, we do not expect that any sum we may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed above would have a material adverse impact on our financial position or results of operations in any one year. +Some of our operations are within jurisdictions that have or are developing regulatory regimes governing emissions of greenhouse gases ("GHGs"), including carbon dioxide. These include existing coverage under the European Union Emission Trading system, the California cap and trade scheme, China’s Emission Trading Scheme and its nation-wide expansion, and South Korea’s Emission Trading Scheme. In Canada, Alberta and Ontario are both in the development/approval process for new GHG regulations. Alberta’s Carbon Competitiveness Incentive Regulation will end December 31, 2019 and will be replaced by the proposed Technology Innovation and Emission Reduction ("TIER") System or Environment & Climate Change Canada's Output Based Pricing System ("OBPS"). In lieu of adherence to the OBPS, Ontario seeks approval from Environment & Climate Change Canada to implement their proposed GHG Emissions Performance Standards program. In addition, the U.S. Environmental Protection Agency ("EPA") requires mandatory reporting of GHG emissions and is regulating GHG emissions for new construction and major modifications to existing facilities. Some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern may result in more international, U.S. federal, and/or regional requirements to reduce or mitigate the effects of GHG. Although uncertain, these developments could increase our costs related to consumption of electric power, hydrogen production and application of our gasification technology. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +Regulation of GHG may also produce new opportunities for us. We continue to develop technologies to help our facilities and our customers lower energy consumption, improve efficiency, and lower emissions. We also have developed a portfolio of technologies that capture carbon dioxide from steam methane reforming, enable cleaner transportation fuels, and facilitate alternate fuel source development. In addition, the potential demand for clean coal could increase demand for oxygen, one of our main products, and our proprietary technology for delivering low-cost oxygen. +40 +Table of Contents +OFF-BALANCE SHEET ARRANGEMENTS +We have entered into certain guarantee agreements as discussed in Note 18 , Commitments and Contingencies , to the consolidated financial statements. In addition, we are not a primary beneficiary in any material variable interest entity. Our off-balance sheet arrangements are not reasonably likely to have a material impact on financial condition, changes in financial condition, results of operations, or liquidity. +RELATED PARTY TRANSACTIONS +We have related party sales to some of our equity affiliates and joint venture partners as well as other income primarily from fees charged for use of Air Products' patents and technology. Sales to and other income from related parties totaled approximately $410 and $360 in fiscal years 2019 and 2018 , respectively. Sales agreements with related parties include terms that are consistent with those that we believe would have been negotiated at an arm’s length with an independent party. +In addition, we completed the formation of Air Products Lu An (Changzhi) Co., Ltd., a 60%-owned JV with Lu'An Clean Energy Company ("Lu'An"), and the JV acquired gasification and syngas clean-up assets from Lu'An during the third quarter of fiscal year 2018. Refer to Note 7 , Acquisitions , to the consolidated financial statements for additional information on outstanding liabilities associated with the acquisition. +INFLATION +We operate in many countries that experience volatility in inflation and foreign exchange rates. The ability to pass on inflationary cost increases is an uncertainty due to general economic conditions and competitive situations. It is estimated that the cost of replacing our plant and equipment today is greater than its historical cost. Accordingly, depreciation expense would be greater if the expense were stated on a current cost basis. +CRITICAL ACCOUNTING POLICIES AND ESTIMATES +Note 1 , Major Accounting Policies , to the consolidated financial statements describes our major accounting policies. Judgments and estimates of uncertainties are required in applying our accounting policies in many areas. However, application of the critical accounting policies discussed below requires management’s significant judgments, often as the result of the need to make estimates of matters that are inherently uncertain. If actual results were to differ materially from the estimates made, the reported results could be materially affected. Our management has reviewed these critical accounting policies and estimates and related disclosures with our audit committee. +Depreciable Lives of Plant and Equipment +Net plant and equipment at 30 September 2019 totaled $10,337.6 , and depreciation expense totaled $1,049.7 during fiscal year 2019 . Plant and equipment is recorded at cost and depreciated using the straight-line method, which deducts equal amounts of the cost of each asset from earnings every year over its estimated economic useful life. +Economic useful life is the duration of time an asset is expected to be productively employed by us, which may be less than its physical life. Assumptions on the following factors, among others, affect the determination of estimated economic useful life: wear and tear, obsolescence, technical standards, contract life, market demand, competitive position, raw material availability, and geographic location. +The estimated economic useful life of an asset is monitored to determine its appropriateness, especially in light of changed business circumstances. For example, changes in technology, changes in the estimated future demand for products, or excessive wear and tear may result in a shorter estimated useful life than originally anticipated. In these cases, we would depreciate the remaining net book value over the new estimated remaining life, thereby increasing depreciation expense per year on a prospective basis. Likewise, if the estimated useful life is increased, the adjustment to the useful life decreases depreciation expense per year on a prospective basis. +The regional Industrial Gases segments have numerous long-term customer supply contracts for which we construct an on-site plant adjacent to or near the customer’s facility. These contracts typically have initial contract terms of 10 to 20 years . Depreciable lives of the production assets related to long-term contracts are matched to the contract lives. Extensions to the contract term of supply frequently occur prior to the expiration of the initial term. As contract terms are extended, the depreciable life of the remaining net book value of the production assets is adjusted to match the new contract term, as long as it does not exceed the remaining physical life of the asset. +41 +Table of Contents +Our regional Industrial Gases segments also have contracts for liquid or gaseous bulk supply and, for smaller customers, packaged gases. The depreciable lives of production facilities associated with these contracts are +generally 15 years. These depreciable lives have been determined based on historical experience combined with judgment on future assumptions such as technological advances, potential obsolescence, competitors’ actions, etc. +In addition, we may purchase assets through transactions accounted for as either an asset acquisition or a business combination. Depreciable lives are assigned to acquired assets based on our historical experience with similar assets. Management monitors its assumptions and may potentially need to adjust depreciable life as circumstances change. +Impairment of Assets – Plant and Equipment +Plant and equipment meeting the held for sale criteria are reported at the lower of carrying amount or fair value less cost to sell. Plant and equipment to be disposed of other than by sale may be reviewed for impairment upon the occurrence of certain triggering events, such as unexpected contract terminations or unexpected foreign government-imposed restrictions or expropriations. Plant and equipment held for use is grouped for impairment testing at the lowest level for which there is identifiable cash flows. Impairment testing of the asset group occurs whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Such circumstances would include a significant decrease in the market value of a long-lived asset grouping, a significant adverse change in the manner in which the asset grouping is being used or in its physical condition, an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the long-lived asset, a history of operating or cash flow losses associated with the use of the asset grouping, or changes in the expected useful life of the long-lived assets. +If such circumstances are determined to exist, an estimate of undiscounted future cash flows produced by that asset group is compared to the carrying value to determine whether impairment exists. If an asset group is determined to be impaired, the loss is measured based on the difference between the asset group’s fair value and its carrying value. An estimate of the asset group’s fair value is based on the discounted value of its estimated cash flows. +The assumptions underlying the undiscounted future cash flow projections require significant management judgment. Factors that management must estimate include industry and market conditions, sales volume and prices, costs to produce, inflation, etc. The assumptions underlying the cash flow projections represent management’s best estimates at the time of the impairment review. Changes in key assumptions or actual conditions that differ from estimates could result in an impairment charge. We use reasonable and supportable assumptions when performing impairment reviews and cannot predict the occurrence of future events and circumstances that could result in impairment charges. +In fiscal year 2019, there was no need to test for impairment on any of our asset groupings as no events or changes in circumstances indicated that the carrying amount of the asset groupings may not be recoverable. However, one of our customers was subject to a government enforced shutdown due to environmental reasons. As a result, we recognized a charge of $29.0 during the first quarter of fiscal year 2019 primarily related to the write-off of related onsite assets. Refer to Note 24, Supplemental Information , to the consolidated financial statements for additional information. +Impairment of Assets – Goodwill +The acquisition method of accounting for business combinations requires us to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the net tangible and identifiable intangible assets. Goodwill represents the excess of the aggregate purchase price (plus the fair value of any noncontrolling interest and previously held equity interest in the acquiree) over the fair value of identifiable net assets of an acquired entity. Goodwill was $797.1 as of 30 September 2019 . Disclosures related to goodwill are included in Note 11 , Goodwill , to the consolidated financial statements. +We review goodwill for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that the carrying value of goodwill might not be recoverable. The tests are done at the reporting unit level, which is defined as being equal to or one level below the operating segment for which discrete financial information is available and whose operating results are reviewed by segment managers regularly. We have five business segments that are comprised of ten reporting units within seven operating segments. Refer to Note 26 , Business Segment and Geographic Information , for additional information. Reporting units are primarily based on products and subregions within each reportable segment. The majority of our goodwill is assigned to reporting units within our regional Industrial Gases segments. +42 +Table of Contents +As part of the goodwill impairment testing, we have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If we choose not to complete a qualitative assessment for a given reporting unit, or if the initial assessment indicates that it is more likely than not that the carrying value of a reporting unit exceeds its estimated fair value, a quantitative test is required. We choose to bypass the qualitative assessment and conduct quantitative testing to determine if the carrying value of the reporting unit exceeds its fair value. An impairment loss will be recognized for the amount by which the carrying value of the reporting unit exceeds its fair value, not to exceed the total amount of goodwill allocated to that reporting unit. +To determine the fair value of a reporting unit, we initially use an income approach valuation model, representing the present value of estimated future cash flows. Our valuation model uses a discrete growth period and an estimated exit trading multiple. The income approach is an appropriate valuation method due to our capital-intensive nature, the long-term contractual nature of our business, and the relatively consistent cash flows generated by our reporting units. The principal assumptions utilized in our income approach valuation model include revenue growth rates, operating profit and/or adjusted EBITDA margins, discount rate, and exit multiple. Projected revenue growth rates and operating profit and/or adjusted EBITDA assumptions are consistent with those utilized in our operating plan and/or revised forecasts and long-term financial planning process. The discount rate assumption is calculated based on an estimated market-participant risk-adjusted weighted-average cost of capital, which includes factors such as the risk-free rate of return, cost of debt, and expected equity premiums. The exit multiple is determined from comparable industry transactions and where appropriate, reflects expected long-term growth rates. +If our initial review under the income approach indicates there may be impairment, we incorporate results under the market approach to further evaluate the existence of impairment. When the market approach is utilized, fair value is estimated based on market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies and/or regional manufacturing companies engaged in the same or similar lines of business as the reporting unit, adjusted to reflect differences in size and growth prospects. When both the income and market approach are utilized, we review relevant facts and circumstances and make a qualitative assessment to determine the proper weighting. Management judgment is required in the determination of each assumption utilized in the valuation model, and actual results could differ from the estimates. +During the fourth quarter of fiscal year 2019 , we conducted our annual goodwill impairment test. We determined that the fair value of all our reporting units substantially exceeded their carrying value except LASA, which is further discussed below. Substantially all of the remaining goodwill balance related to reporting units in which the fair value exceeded the carrying value by at least 100%. +The fair value of LASA exceeded its carrying value by 11%. Revenue growth and adjusted EBITDA margin assumptions are two primary drivers of the fair value. We determined that, with other assumptions held constant, a decrease in revenue growth rates of approximately 310 basis points or a decrease in adjusted EBITDA margin of approximately 300 basis points would result in the fair value of the reporting unit being equal to its carrying value. As of 30 September 2019, the carrying value of LASA goodwill was $59.8, or less than 1% of consolidated total assets. The carrying value of LASA's other material assets at 30 September 2019 included: Plant and equipment, net of $339.2; customer relationships of $129.0; and trade names and trademarks of $41.3. The trade names and trademarks are classified as indefinite-lived intangible assets. +Future events that could have a negative impact on the level of excess fair value over carrying value of the reporting units include, but are not limited to: long-term economic weakness, decline in market share, pricing pressures, inability to successfully implement cost improvement measures, increases to our cost of capital, and changes to the structure of our business as a result of future reorganizations or divestitures of assets or businesses. Negative changes in one or more of these factors, among others, could result in impairment charges. +Impairment of Assets – Intangible Assets +Intangible assets, net with determinable lives at 30 September 2019 totaled $375.4 and consisted primarily of customer relationships, purchased patents and technology, and land use rights. These intangible assets are tested for impairment as part of the long-lived asset grouping impairment tests. Impairment testing of the asset group occurs whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. See the impairment discussion above under Plant and Equipment for a description of how impairment losses are determined. +43 +Table of Contents +Indefinite-lived intangible assets at 30 September 2019 totaled $44.1 and consisted of trade names and trademarks. Indefinite-lived intangibles are subject to impairment testing at least annually or more frequently if events or changes in circumstances indicate that potential impairment exists. The impairment test for indefinite-lived intangible assets involves calculating the fair value of the indefinite-lived intangible assets and comparing the fair value to their carrying value. If the fair value is less than the carrying value, the difference is recorded as an impairment loss. To determine fair value, we utilize the royalty savings method, a form of the income approach. This method values an intangible asset by estimating the royalties avoided through ownership of the asset. +Disclosures related to intangible assets other than goodwill are included in Note 12 , Intangible Assets , to the consolidated financial statements. +In the fourth quarter of 2019, we conducted our annual impairment test of indefinite-lived intangibles which resulted in no impairment. +Impairment of Assets – Equity Method Investments +Investments in and advances to equity affiliates totaled $1,276.2 at 30 September 2019 . The majority of our investments are non-publicly traded ventures with other companies in the industrial gas business. Summarized financial information of equity affiliates is included in Note 9 , Summarized Financial Information of Equity Affiliates , to the consolidated financial statements. Equity investments are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment may not be recoverable. +An impairment loss is recognized in the event that an other-than-temporary decline in fair value of an investment occurs. Management’s estimate of fair value of an investment is based on the income approach and/or market approach. We utilize estimated discounted future cash flows expected to be generated by the investee under the income approach. For the market approach, we utilize market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies. Changes in key assumptions about the financial condition of an investee or actual conditions that differ from estimates could result in an impairment charge. +In fiscal year 2019, there was no need to test for impairment on any of our equity affiliate investments as no events or changes in circumstances indicated that the carrying amount of the investments may not be recoverable. +Revenue Recognition – Cost Incurred Input Method +Revenue from equipment sale contracts is generally recognized over time as we have an enforceable right to payment for performance completed to date and our performance under the contract terms does not create an asset with alternative use. We use a cost incurred input method to recognize revenue by which costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. +Accounting for contracts using the cost incurred input method requires management judgment relative to assessing risks and their impact on the estimate of revenues and costs. Our estimates are impacted by factors such as the potential for incentives or penalties on performance, schedule and technical issues, labor productivity, the complexity of work performed, the cost and availability of materials, and performance of subcontractors. When adjustments in estimated total contract revenues or estimated total costs are required, any changes in the estimated profit from prior estimates are recognized in the current period for the inception-to-date effect of such change. When estimates of total costs to be incurred on a contract exceed estimates of total revenues to be earned, a provision for the entire estimated loss on the contract is recorded in the period in which the loss is determined. +In addition to the typical risks associated with underlying performance of project procurement and construction activities, our Jazan large air separation unit sale of equipment project within our Industrial Gases – Global segment requires monitoring of risks associated with schedule, geography, and other aspects of the contract and their effects on our estimates of total revenues and total costs to complete the contract. +Changes in estimates on projects accounted for under the cost incurred input method, including the Jazan project, favorably impacted operating income by approximately $37 and $38 in fiscal years 2019 and 2018 , respectively. Our changes in estimates would not have significantly impacted amounts recorded in prior years. +We assess the performance of our sale of equipment projects as they progress. Our earnings could be positively or negatively impacted by changes to our forecast of revenues and costs on these projects. +44 +Table of Contents +Revenue Recognition – On-site Customer Contracts +For customers who require large volumes of gases on a long-term basis, we produce and supply gases under long-term contracts from large facilities that we build, own and operate on or near the customer’s facilities. Certain of these on-site contracts contain complex terms and provisions such as tolling arrangements, minimum payment requirements, variable components and pricing provisions that require significant judgment to determine the amount and timing of revenue recognition. +Income Taxes +We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities measured using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. At 30 September 2019 , accrued income taxes, including the amount recorded in noncurrent, was $302.0 and net deferred tax liabilities was $678.6 . Tax liabilities related to uncertain tax positions as of 30 September 2019 were $231.7 , excluding interest and penalties. Income tax expense for the year ended 30 September 2019 was $480.1 and includes a discrete net income tax expense of $43.8 related to the Tax Act. Disclosures related to income taxes are included in Note 23 , Income Taxes , to the consolidated financial statements. +Management judgment is required concerning the ultimate outcome of tax contingencies and the realization of deferred tax assets. +Actual income taxes paid may vary from estimates, depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. We believe that our recorded tax liabilities adequately provide for these assessments. +Deferred tax assets are recorded for operating losses and tax credit carryforwards. However, when we do not expect sufficient sources of future taxable income to realize the benefit of the operating losses or tax credit carryforwards, these deferred tax assets are reduced by a valuation allowance. A valuation allowance is recognized if, based on the weight of available evidence, it is considered more likely than not that some portion or all of the deferred tax asset will not be realized. The factors used to assess the likelihood of realization include forecasted future taxable income and available tax planning strategies that could be implemented to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits. The effect of a change in the valuation allowance is reported in the income tax expense. +A 1% increase/decrease in our effective tax rate would decrease/increase net income by approximately $23 . +Pension and Other Postretirement Benefits +The amounts recognized in the consolidated financial statements for pension and other postretirement benefits are determined on an actuarial basis utilizing numerous assumptions. The discussion that follows provides information on the significant assumptions and expense associated with the defined benefit plans. +Actuarial models are used in calculating the expense and liability related to the various defined benefit plans. These models have an underlying assumption that the employees render service over their service lives on a relatively consistent basis; therefore, the expense of benefits earned should follow a similar pattern. +Several assumptions and statistical variables are used in the models to calculate the expense and liability related to the plans. We determine assumptions about the discount rate, the expected rate of return on plan assets, and the rate of compensation increase. Note 17 , Retirement Benefits , to the consolidated financial statements includes disclosure of these rates on a weighted-average basis for both the U.S. and international plans. The actuarial models also use assumptions about demographic factors such as retirement age, mortality, and turnover rates. Mortality rates are based on the most recent U.S. and international mortality tables. We believe the actuarial assumptions are reasonable. However, actual results could vary materially from these actuarial assumptions due to economic events and different rates of retirement, mortality, and turnover. +45 +Table of Contents +One of the assumptions used in the actuarial models is the discount rate used to measure benefit obligations. This rate reflects the prevailing market rate for high-quality, fixed-income debt instruments with maturities corresponding to the expected timing of benefit payments as of the annual measurement date for each of the various plans. The Company measures the service cost and interest cost components of pension expense by applying spot rates along the yield curve to the relevant projected cash flows. The rates along the yield curve are used to discount the future cash flows of benefit obligations back to the measurement date. These rates change from year to year based on market conditions that affect corporate bond yields. A higher discount rate decreases the present value of the benefit obligations and results in lower pension expense. A 50 bp increase/decrease in the discount rate decreases/increases pension expense by approximately $18 per year. +The expected rate of return on plan assets represents an estimate of the long-term average rate of return to be earned by plan assets reflecting current asset allocations. In determining estimated asset class returns, we take into account historical and future expected long-term returns and the value of active management, as well as the interest rate environment. Asset allocation is determined based on long-term return, volatility and correlation characteristics of the asset classes, the profiles of the plans’ liabilities, and acceptable levels of risk. Lower returns on the plan assets result in higher pension expense. A 50 bp increase/decrease in the estimated rate of return on plan assets decreases/increases pension expense by approximately $20 per year. +We use a market-related valuation method for recognizing certain investment gains or losses for our significant pension plans. Investment gains or losses are the difference between the expected return and actual return on plan assets. The expected return on plan assets is determined based on a market-related value of plan assets. For equities, this is a calculated value that recognizes investment gains and losses in fair value related to equities over a five-year period from the year in which they occur and reduces year-to-year volatility. The market-related value for non-equity investments equals the actual fair value. Expense in future periods will be impacted as gains or losses are recognized in the market-related value of assets. +The expected rate of compensation increase is another key assumption. We determine this rate based on review of the underlying long-term salary increase trend characteristic of labor markets and historical experience, as well as comparison to peer companies. A 50 bp increase/decrease in the expected rate of compensation increases/decreases pension expense by approximately $8 per year. +Loss Contingencies +In the normal course of business, we encounter contingencies, or situations involving varying degrees of uncertainty as to the outcome and effect on the Company. We accrue a liability for loss contingencies when it is considered probable that a liability has been incurred and the amount of loss can be reasonably estimated. When only a range of possible loss can be established, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. +Contingencies include those associated with litigation and environmental matters, for which our accounting policy is discussed in Note 1 , Major Accounting Policies , to the consolidated financial statements, and details are provided in Note 18 , Commitments and Contingencies , to the consolidated financial statements. Significant judgment is required to determine both the probability and whether the amount of loss associated with a contingency can be reasonably estimated. These determinations are made based on the best available information at the time. As additional information becomes available, we reassess probability and estimates of loss contingencies. Revisions to the estimates associated with loss contingencies could have a significant impact on our results of operations in the period in which an accrual for loss contingencies is recorded or adjusted. For example, due to the inherent uncertainties related to environmental exposures, a significant increase to environmental liabilities could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or our proportionate share is increased. Similarly, a future charge for regulatory fines or damage awards associated with litigation could have a significant impact on our net income in the period in which it is recorded. +NEW ACCOUNTING GUIDANCE +See Note 2 , New Accounting Guidance , to the consolidated financial statements for information concerning the implementation and impact of new accounting guidance. +46 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Our earnings, cash flows, and financial position are exposed to market risks relating to fluctuations in interest rates and foreign currency exchange rates. It is our policy to minimize our cash flow exposure to adverse changes in currency exchange rates and to manage the financial risks inherent in funding with debt capital. +We address these financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. We have established counterparty credit guidelines and generally enter into +transactions with financial institutions of investment grade or better, thereby minimizing the risk of credit loss. All instruments are entered into for other than trading purposes. For details on the types and use of these derivative instruments and the major accounting policies, see Note 1 , Major Accounting Policies , and Note 14 , Financial Instruments , to the consolidated financial statements, for additional information. Additionally, we mitigate adverse energy price impacts through our cost pass-through contracts with customers and price increases. +Our derivative and other financial instruments consist of long-term debt (including current and related party portions), interest rate swaps, cross currency interest rate swaps, and foreign exchange-forward contracts. The net market value of these financial instruments combined is referred to below as the net financial instrument position and is disclosed in Note 15 , Fair Value Measurements , to the consolidated financial statements. At 30 September 2019 and 2018 , the net financial instrument position was a liability of $3,239.1 and $3,736.2, respectively. The decrease in the net financial instrument position was primarily due to the repayment of long-term debt. +The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market rates and prices. Market values are the present value of projected future cash flows based on the market rates and prices chosen. The market values for interest rate risk and foreign currency risk are calculated by us using a third-party software model that utilizes standard pricing models to determine the present value of the instruments based on market conditions (interest rates, spot and forward exchange rates, and implied volatilities) as of the valuation date. +Interest Rate Risk +Our debt portfolio as of 30 September 2019, including the effect of currency and interest rate swap agreements, was composed of 74% fixed-rate debt and 26% variable-rate debt. Our debt portfolio as of 30 September 2018, including the effect of currency and interest rate swap agreements, was composed of 66% fixed-rate debt and 34% variable-rate debt. The decrease in variable-rate debt was the result of the repayment and maturity of the 4.375% Senior Note and related fixed-to-variable interest rate swaps. +The sensitivity analysis related to the interest rate risk on the fixed portion of our debt portfolio assumes an instantaneous 100 bp parallel move in interest rates from the level at 30 September 2019 , with all other variables held constant. A 100 bp increase in market interest rates would result in a decrease of $75 and $96 in the net liability position of financial instruments at 30 September 2019 and 2018 , respectively. A 100 bp decrease in market interest rates would result in an increase of $80 and $101 in the net liability position of financial instruments at 30 September 2019 and 2018 , respectively. +Based on the variable-rate debt included in our debt portfolio, including the interest rate swap agreements, a 100 bp increase in interest rates would result in an additional $8 and $13 of interest incurred per year at the end of 30 September 2019 and 2018, respectively. A 100 bp decline in interest rates would lower interest incurred by $8 and $13 per year at 30 September 2019 and 2018, respectively. +Foreign Currency Exchange Rate Risk +The sensitivity analysis related to foreign currency exchange rates assumes an instantaneous 10% change in the foreign currency exchange rates from their levels at 30 September 2019 and 2018 , with all other variables held constant. A 10% strengthening or weakening of the functional currency of an entity versus all other currencies would result in a decrease or increase, respectively, of $326 and $329 in the net liability position of financial instruments at 30 September 2019 and 2018 , respectively. +The primary currency pairs for which we have exchange rate exposure are the Euro and U.S. Dollar and Chinese Renminbi and U.S. Dollar. Foreign currency debt, cross currency interest rate swaps, and foreign exchange-forward contracts are used in countries where we do business, thereby reducing our net asset exposure. Foreign exchange-forward contracts and cross currency interest rate swaps are also used to hedge our firm and highly anticipated foreign currency cash flows. Thus, there is either an asset/liability or cash flow exposure related to all of the financial instruments in the above sensitivity analysis for which the impact of a movement in exchange rates would be in the opposite direction and materially equal to the impact on the instruments in the analysis. +47 +Table of Contents +The majority of the Company’s sales are derived from outside of the United States and denominated in foreign currencies. Financial results therefore will be affected by changes in foreign currency rates. The Chinese Renminbi and the Euro represent the largest exposures in terms of our foreign earnings. We estimate that a 10% reduction in either the Chinese Renminbi or the Euro versus the U.S. Dollar would lower our annual operating income by approximately $40 and $25, respectively. +48 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Management's Report on Internal Control Over Financial Reporting +50 +Report of Deloitte & Touche LLP, Independent Registered Public Accounting Firm +51 +Report of KPMG LLP, Independent Registered Public Accounting Firm +53 +Consolidated Income Statements – Years Ended 30 September 2019, 2018, and 2017 +54 +Consolidated Comprehensive Income Statements – Years Ended 30 September 2019, 2018, and 2017 +55 +Consolidated Balance Sheets – 30 September 2019 and 2018 +56 +Consolidated Statements of Cash Flows – Years Ended 30 September 2019, 2018, and 2017 +57 +Consolidated Statements of Equity – Years Ended 30 September 2019, 2018, and 2017 +58 +Notes to Consolidated Financial Statements +59 +49 +Table of Contents +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Air Products’ management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting, which is defined in the following sentences, is a process designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that: +(i) +pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(ii) +provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(iii) +provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of inherent limitations, internal control over financial reporting can only provide reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions, the effectiveness of our internal control over financial reporting may vary over time. Our processes contain self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified. +Management has evaluated the effectiveness of its internal control over financial reporting based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management concluded that, as of 30 September 2019 , the Company’s internal control over financial reporting was effective. +Deloitte & Touche LLP, an independent registered public accounting firm, has issued its opinion on the Company’s internal control over financial reporting as of 30 September 2019 as stated in its report which appears herein. +/s/ Seifi Ghasemi +/s/ M. Scott Crocco +Seifi Ghasemi +M. Scott Crocco +Chairman, President, and +Executive Vice President and +Chief Executive Officer +Chief Financial Officer +26 November 2019 +26 November 2019 +50 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Shareholders and Board of Directors of Air Products and Chemicals, Inc.: +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheet of Air Products and Chemicals, Inc. and subsidiaries (the "Company") as of September 30, 2019, the related consolidated income statement, comprehensive income statement, statement of equity, and statement of cash flows, for the year then ended, and the related notes and the schedule listed in Item 15(a)(2) as of and for the year ended September 30, 2019 (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of September 30, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 30, 2019, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO. +Basis for Opinions +The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audit of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +51 +Table of Contents +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Revenue - On-site Industrial Gas Customer Contracts - Refer to Notes 1 and 3 to the financial statements +Critical Audit Matter Description +On-site industrial gas customer contracts involve large capital investments to construct facilities and serve customers who require large volumes of gases and have relatively constant demand. The Company builds, owns and operates facilities on or near the customer’s facilities to produce and supply the customer with gases under a long-term arrangement. Typically, these contracts have 15 to 20-year terms and contain fixed monthly charges and/or minimum purchase requirements. Revenue associated with these contracts is generally recognized over time during the period in which the Company delivers or makes available the agreed upon quantity of gases. In addition, certain on-site industrial gas contracts contain complex terms and provisions such as tolling arrangements, minimum payment requirements, variable components, and pricing provisions that are specific to a customer arrangement, which may require greater judgment in determining when contractual requirements have been met impacting the timing and amount of revenue to be recorded. +We identified revenue recognition for certain on-site industrial gas customer contracts with complex terms and provisions as a critical audit matter because of the judgments necessary for management to assess complex contract terms and provisions in order to determine the amount and timing of revenue recognition. This required a high degree of auditor judgment when performing procedures to audit management’s determination of the amount and timing of revenue recognition and evaluating the results of those procedures. +How the Critical Audit Matter Was Addressed in the Audit +Our audit procedures related to revenue recognition for certain on-site industrial gas customer contracts with complex terms and provisions included the following procedures, among others: +• +We tested the effectiveness of the Company’s controls related to the amount and timing of revenue recognition, including controls over identifying and assessing complex contract terms and provisions in certain on-site industrial gas customer contracts. +• +We evaluated the terms included within customer contracts to assess the accounting for provisions such as tolling arrangements, minimum payment requirements, pricing provisions, and variable components that require management to apply judgment in determining revenue recognition associated with the contract. +• +We tested the probability of collection of variable components, including penalties, which impacts the amount of revenue to which the Company is entitled. +• +We considered subsequent events, write-offs of customer receivables, collectability, and other factors that would impact the amount and timing of revenue recognition. +/s/ Deloitte & Touche LLP +Philadelphia, Pennsylvania +November 26, 2019 +We have served as the Company's auditor since 2018. +52 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Shareholders and Board of Directors of Air Products and Chemicals, Inc.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheet of Air Products and Chemicals, Inc. and Subsidiaries (the Company) as of 30 September 2018, the related consolidated income statements, consolidated comprehensive income statements, consolidated statements of cash flows and consolidated statements of equity for each of the years in the two‑year period ended 30 September 2018, and the related notes and financial statement schedule referred to in Item 15(a)(2) in the Form 10-K (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of 30 September 2018, and the results of its operations and its cash flows for each of the years in the two‑year period ended 30 September 2018, in conformity with U.S. generally accepted accounting principles. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ KPMG LLP +We served as the Company’s auditor from 2002 to 2018. +Philadelphia, Pennsylvania +November 20, 2018 +53 +Table of Contents +The Consolidated Financial Statements +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED INCOME STATEMENTS +Millions of dollars, except for share and per share data +Year Ended 30 September +2019 +2018 +2017 +Sales +$ 8,918.9 +$ 8,930.2 +$ 8,187.6 +Cost of sales +5,975.5 +6,189.5 +5,751.5 +Facility closure +29.0 +— +— +Selling and administrative +750.0 +760.8 +713.5 +Research and development +72.9 +64.5 +57.6 +Business separation costs +— +— +32.5 +Cost reduction and asset actions +25.5 +— +151.4 +Goodwill and intangible asset impairment charge +— +— +162.1 +Gain on exchange of equity affiliate investments +29.1 +— +— +Other income (expense), net +49.3 +50.2 +121.0 +Operating Income +2,144.4 +1,965.6 +1,440.0 +Equity affiliates' income +215.4 +174.8 +80.1 +Interest expense +137.0 +130.5 +120.6 +Other non-operating income (expense), net +66.7 +5.1 +16.6 +Income From Continuing Operations Before Taxes +2,289.5 +2,015.0 +1,416.1 +Income tax provision +480.1 +524.3 +260.9 +Income From Continuing Operations +1,809.4 +1,490.7 +1,155.2 +Income from discontinued operations, net of tax +— +42.2 +1,866.0 +Net Income +1,809.4 +1,532.9 +3,021.2 +Net income attributable to noncontrolling interests of continuing operations +49.4 +35.1 +20.8 +Net Income Attributable to Air Products +$ 1,760.0 +$ 1,497.8 +$ 3,000.4 +Net Income Attributable to Air Products +Net income from continuing operations +$ 1,760.0 +$ 1,455.6 +$ 1,134.4 +Net income from discontinued operations +— +42.2 +1,866.0 +Net Income Attributable to Air Products +$ 1,760.0 +$ 1,497.8 +$ 3,000.4 +Basic Earnings Per Common Share Attributable to Air Products +Basic earnings per share from continuing operations +$ 7.99 +$ 6.64 +$ 5.20 +Basic earnings per share from discontinued operations +— +.19 +8.56 +Basic Earnings Per Common Share Attributable to Air Products +$ 7.99 +$ 6.83 +$ 13.76 +Diluted Earnings Per Common Share Attributable to Air Products +Diluted earnings per share from continuing operations +$ 7.94 +$ 6.59 +$ 5.16 +Diluted earnings per share from discontinued operations +— +.19 +8.49 +Diluted Earnings Per Common Share Attributable to Air Products +$ 7.94 +$ 6.78 +$ 13.65 +Weighted Average Common Shares — Basic (in millions) +220.3 +219.3 +218.0 +Weighted Average Common Shares — Diluted (in millions) +221.6 +220.8 +219.8 +The accompanying notes are an integral part of these statements. +54 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED COMPREHENSIVE INCOME STATEMENTS +Millions of dollars +Year ended 30 September +2019 +2018 +2017 +Net Income +$ 1,809.4 +$ 1,532.9 +$ 3,021.2 +Other Comprehensive Income (Loss), net of tax: +Translation adjustments, net of tax of $25.1, $1.1, and ($19.3) +( 356.2 +) +( 244.6 +) +101.9 +Net gain (loss) on derivatives, net of tax of ($1.5), $9.7, and ($11.0) +( 44.1 +) +45.9 +( 12.6 +) +Pension and postretirement benefits, net of tax of ($97.9), $55.2, and $109.0 +( 326.2 +) +179.4 +251.6 +Reclassification adjustments: +Currency translation adjustment +( 2.6 +) +3.1 +57.3 +Derivatives, net of tax of $4.5, ($9.2), and $11.7 +12.3 +( 30.4 +) +24.2 +Pension and postretirement benefits, net of tax of $20.5, $44.9, and $50.7 +63.2 +133.1 +110.7 +Total Other Comprehensive Income (Loss) +( 653.6 +) +86.5 +533.1 +Comprehensive Income +1,155.8 +1,619.4 +3,554.3 +Net Income Attributable to Noncontrolling Interests +49.4 +35.1 +20.8 +Other Comprehensive Income (Loss) Attributable to Noncontrolling Interests +( 19.9 +) +( 19.0 +) +3.7 +Comprehensive Income Attributable to Air Products +$ 1,126.3 +$ 1,603.3 +$ 3,529.8 +The accompanying notes are an integral part of these statements. +55 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED BALANCE SHEETS +Millions of dollars, except for share and per share data +30 September +2019 +2018 +Assets +Current Assets +Cash and cash items +$ 2,248.7 +$ 2,791.3 +Short-term investments +166.0 +184.7 +Trade receivables, net +1,260.2 +1,207.2 +Inventories +388.3 +396.1 +Prepaid expenses +77.4 +129.6 +Other receivables and current assets +477.7 +373.3 +Total Current Assets +4,618.3 +5,082.2 +Investment in net assets of and advances to equity affiliates +1,276.2 +1,277.2 +Plant and equipment, net +10,337.6 +9,923.7 +Goodwill, net +797.1 +788.9 +Intangible assets, net +419.5 +438.5 +Noncurrent capital lease receivables +890.0 +1,013.3 +Other noncurrent assets +604.1 +654.5 +Total Noncurrent Assets +14,324.5 +14,096.1 +Total Assets +$ 18,942.8 +$ 19,178.3 +Liabilities and Equity +Current Liabilities +Payables and accrued liabilities +$ 1,635.7 +$ 1,817.8 +Accrued income taxes +86.6 +59.6 +Short-term borrowings +58.2 +54.3 +Current portion of long-term debt +40.4 +406.6 +Total Current Liabilities +1,820.9 +2,338.3 +Long-term debt +2,907.3 +2,967.4 +Long-term debt – related party +320.1 +384.3 +Other noncurrent liabilities +1,712.4 +1,536.9 +Deferred income taxes +793.8 +775.1 +Total Noncurrent Liabilities +5,733.6 +5,663.7 +Total Liabilities +7,554.5 +8,002.0 +Commitments and Contingencies - See Note 18 +Air Products Shareholders’ Equity +Common stock (par value $1 per share; issued 2019 and 2018 - 249,455,584 shares) +249.4 +249.4 +Capital in excess of par value +1,070.9 +1,029.3 +Retained earnings +14,138.4 +13,409.9 +Accumulated other comprehensive loss +( 2,375.6 +) +( 1,741.9 +) +Treasury stock, at cost (2019 - 29,040,322 shares; 2018 - 29,940,339 shares) +( 2,029.5 +) +( 2,089.2 +) +Total Air Products Shareholders' Equity +11,053.6 +10,857.5 +Noncontrolling Interests +334.7 +318.8 +Total Equity +11,388.3 +11,176.3 +Total Liabilities and Equity +$ 18,942.8 +$ 19,178.3 +The accompanying notes are an integral part of these statements. +56 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED STATEMENTS OF CASH FLOWS +Millions of dollars +Year ended 30 September +2019 +2018 +2017 +Operating Activities +Net income +$ 1,809.4 +$ 1,532.9 +$ 3,021.2 +Less: Net income attributable to noncontrolling interests of continuing operations +49.4 +35.1 +20.8 +Net income attributable to Air Products +1,760.0 +1,497.8 +3,000.4 +Income from discontinued operations +— +( 42.2 +) +( 1,866.0 +) +Income from continuing operations attributable to Air Products +1,760.0 +1,455.6 +1,134.4 +Adjustments to reconcile income to cash provided by operating activities: +Depreciation and amortization +1,082.8 +970.7 +865.8 +Deferred income taxes +57.6 +( 55.4 +) +( 38.0 +) +Tax reform repatriation +49.4 +240.6 +— +Facility closure +29.0 +— +— +Undistributed earnings of unconsolidated affiliates +( 75.8 +) +( 59.8 +) +( 65.8 +) +Gain on sale of assets and investments +( 24.2 +) +( 6.9 +) +( 24.3 +) +Share-based compensation +41.2 +38.8 +39.9 +Noncurrent capital lease receivables +94.6 +97.4 +92.2 +Goodwill and intangible asset impairment charge +— +— +162.1 +Equity method investment impairment charge +— +— +79.5 +Write-down of long-lived assets associated with cost reduction actions +— +— +69.2 +Other adjustments +( 19.4 +) +131.6 +165.4 +Working capital changes that provided (used) cash, excluding effects of acquisitions: +Trade receivables +( 69.0 +) +( 42.8 +) +( 73.6 +) +Inventories +( 3.0 +) +( 64.2 +) +6.4 +Other receivables +79.8 +128.3 +105.4 +Payables and accrued liabilities +( 41.8 +) +( 277.7 +) +163.8 +Other working capital +8.7 +( 9.0 +) +( 154.0 +) +Cash Provided by Operating Activities +2,969.9 +2,547.2 +2,528.4 +Investing Activities +Additions to plant and equipment +( 1,989.7 +) +( 1,568.4 +) +( 1,039.7 +) +Acquisitions, less cash acquired +( 123.2 +) +( 345.4 +) +( 8.2 +) +Investment in and advances to unconsolidated affiliates +( 15.7 +) +— +( 8.1 +) +Proceeds from sale of assets and investments +11.1 +48.8 +42.5 +Purchases of investments +( 172.1 +) +( 530.3 +) +( 2,692.6 +) +Proceeds from investments +190.5 +748.2 +2,290.7 +Other investing activities +( 14.3 +) +5.5 +3.4 +Cash Used for Investing Activities +( 2,113.4 +) +( 1,641.6 +) +( 1,412.0 +) +Financing Activities +Long-term debt proceeds +— +.5 +2.4 +Payments on long-term debt +( 428.6 +) +( 418.7 +) +( 483.9 +) +Net increase (decrease) in commercial paper and short-term borrowings +3.9 +( 78.5 +) +( 798.6 +) +Dividends paid to shareholders +( 994.0 +) +( 897.8 +) +( 787.9 +) +Proceeds from stock option exercises +68.1 +76.2 +68.4 +Other financing activities +( 19.9 +) +( 41.5 +) +( 41.3 +) +Cash Used for Financing Activities +( 1,370.5 +) +( 1,359.8 +) +( 2,040.9 +) +Discontinued Operations +Cash used for operating activities +— +( 12.8 +) +( 966.2 +) +Cash provided by investing activities +— +18.6 +3,750.6 +Cash provided by financing activities +— +— +69.5 +Cash Provided by Discontinued Operations +— +5.8 +2,853.9 +Effect of Exchange Rate Changes on Cash +( 28.6 +) +( 33.9 +) +13.4 +Increase (Decrease) in cash and cash items +( 542.6 +) +( 482.3 +) +1,942.8 +Cash and Cash items – Beginning of Year +2,791.3 +3,273.6 +1,330.8 +Cash and Cash Items – End of Period +$ 2,248.7 +$ 2,791.3 +$ 3,273.6 +The accompanying notes are an integral part of these statements. +57 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED STATEMENTS OF EQUITY +Millions of dollars +Year ended 30 September +Common +Stock +Capital +in Excess +of Par +Value +Retained +Earnings +Accumulated +Other +Comprehensive +Income (Loss) +Treasury +Stock +Air Products +Shareholders’ +Equity +Non- +controlling +Interests +Total +Equity +Balance 30 September 2016 +$ 249.4 +$ 970.0 +$ 10,475.5 +($ 2,388.3 +) +($ 2,227.0 +) +$ 7,079.6 +$ 133.8 +$ 7,213.4 +Net income +— +— +3,000.4 +— +— +3,000.4 +20.8 +3,021.2 +Other comprehensive income (loss) +— +— +— +529.4 +— +529.4 +3.7 +533.1 +Dividends on common stock (per share $3.71) +— +— +( 808.5 +) +— +— +( 808.5 +) +— +( 808.5 +) +Dividends to noncontrolling interests +— +— +— +— +— +— +( 28.0 +) +( 28.0 +) +Share-based compensation +— +40.7 +— +— +— +40.7 +— +40.7 +Issuance of treasury shares for stock option and award plans +— +( 9.6 +) +— +— +63.5 +53.9 +— +53.9 +Spin-off of Versum +— +— +175.0 +11.5 +— +186.5 +( 33.9 +) +152.6 +Cumulative change in accounting principle +— +— +8.8 +— +— +8.8 +— +8.8 +Other equity transactions +— +— +( 4.6 +) +— +— +( 4.6 +) +2.9 +( 1.7 +) +Balance 30 September 2017 +$ 249.4 +$ 1,001.1 +$ 12,846.6 +($ 1,847.4 +) +($ 2,163.5 +) +$ 10,086.2 +$ 99.3 +$ 10,185.5 +Net income +— +— +1,497.8 +— +— +1,497.8 +35.1 +1,532.9 +Other comprehensive income +— +— +— +105.5 +— +105.5 +( 19.0 +) +86.5 +Dividends on common stock (per share $4.25) +— +— +( 931.8 +) +— +— +( 931.8 +) +— +( 931.8 +) +Dividends to noncontrolling interests +— +— +— +— +— +— +( 29.9 +) +( 29.9 +) +Share-based compensation +— +38.1 +— +— +— +38.1 +— +38.1 +Issuance of treasury shares for stock option and award plans +— +( 11.3 +) +— +— +74.3 +63.0 +— +63.0 +Lu'An joint venture +— +— +— +— +— +— +227.4 +227.4 +Other equity transactions +— +1.4 +( 2.7 +) +— +— +( 1.3 +) +5.9 +4.6 +Balance 30 September 2018 +$ 249.4 +$ 1,029.3 +$ 13,409.9 +($ 1,741.9 +) +($ 2,089.2 +) +$ 10,857.5 +$ 318.8 +$ 11,176.3 +Net income +— +— +1,760.0 +— +— +1,760.0 +49.4 +1,809.4 +Other comprehensive income (loss) +— +— +— +( 633.7 +) +— +( 633.7 +) +( 19.9 +) +( 653.6 +) +Dividends on common stock (per share $4.58) +— +— +( 1,008.3 +) +— +— +( 1,008.3 +) +— +( 1,008.3 +) +Dividends to noncontrolling interests +— +— +— +— +— +( 12.2 +) +( 12.2 +) +Share-based compensation +— +40.7 +— +— +— +40.7 +— +40.7 +Issuance of treasury shares for stock option and award plans +— +2.2 +— +— +59.7 +61.9 +— +61.9 +Cumulative change in accounting principle +— +— +( 17.1 +) +— +( 17.1 +) +— +( 17.1 +) +Other equity transactions +— +( 1.3 +) +( 6.1 +) +— +— +( 7.4 +) +( 1.4 +) +( 8.8 +) +Balance 30 September 2019 +$ 249.4 +$ 1,070.9 +$ 14,138.4 +($ 2,375.6 +) +($ 2,029.5 +) +$ 11,053.6 +$ 334.7 +$ 11,388.3 +The accompanying notes are an integral part of these statements. +58 +Table of Contents +NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS +Millions of dollars, except for share and per share data +1 +. +Major Accounting Policies +60 +2 +. +New Accounting Guidance +66 +3 +. +Revenue Recognition +68 +4 +. +Discontinued Operations +71 +5 +. +Materials Technologies Separation +72 +6 +. +Cost Reduction and Asset Actions +72 +7 +. +Acquisitions +73 +8 +. +Inventories +74 +9 +. +Summarized Financial Information of Equity Affiliates +75 +10 +. +Plant and Equipment, net +76 +11 +. +Goodwill +77 +12 +. +Intangible Assets +78 +13 +. +Leases +79 +14 +. +Financial Instruments +80 +15 +. +Fair Value Measurements +84 +16 +. +Debt +86 +17 +. +Retirement Benefits +88 +18 +. +Commitments and Contingencies +96 +19 +. +Capital Stock +99 +20 +. +Share-Based Compensation +100 +21 +. +Accumulated Other Comprehensive Loss +103 +22 +. +Earnings per Share +105 +23 +. +Income Taxes +105 +24 +. +Supplemental Information +110 +25 +. +Summary by Quarter (Unaudited) +112 +26 +. +Business Segment and Geographic Information +114 +59 +Table of Contents +1 . MAJOR ACCOUNTING POLICIES +Basis of Presentation and Consolidation Principles +The accompanying consolidated financial statements of Air Products and Chemicals, Inc. were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Air Products and Chemicals, Inc. and those of its controlled subsidiaries (“we,” “our,” “us,” the “Company,” “Air Products,” or “registrant”), which are generally majority owned. Intercompany transactions and balances are eliminated in consolidation. +We consolidate all entities that we control. The general condition for control is ownership of a majority of the voting interests of an entity. Control may also exist in arrangements where we are the primary beneficiary of a variable interest entity (VIE). An entity that has both the power to direct the activities that most significantly impact the economic performance of a VIE and the obligation to absorb losses or receive benefits significant to the VIE is considered the primary beneficiary of that entity. We have determined that we are not a primary beneficiary of any material VIE. +The results of operations and cash flows for our discontinued operations have been segregated from the results of continuing operations and segment results. There were no assets and liabilities presented as discontinued operations on the consolidated balance sheets. The comprehensive income related to discontinued operations has not been segregated and is included in the consolidated comprehensive income statement for fiscal years 2018 and 2017. Refer to Note 4 , Discontinued Operations , for detail of the businesses presented in discontinued operations. +The notes to the consolidated financial statements, unless otherwise indicated, are on a continuing operations basis. The term "total company" includes both continuing and discontinued operations. +Reclassifications +The consolidated financial statements and accompanying notes reflect accounting guidance that was adopted during fiscal year 2019 . Refer to Note 2 , New Accounting Guidance , for additional information. Certain prior year information has been reclassified to conform to the fiscal year 2019 presentation. +Estimates and Assumptions +The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. +Revenue Recognition +The Company recognizes revenue when or as performance obligations are satisfied, which occurs when control is transferred to the customer. +We determine the transaction price of our contracts based on the amount of consideration to which we expect to be entitled to receive in exchange for the goods or services provided. Our contracts within the scope of revenue guidance do not contain payment terms that include a significant financing component. +Sales returns and allowances are not a business practice in the industry. +Our sale of gas contracts are either accounted for over time during the period in which we deliver or make available the agreed upon quantity of goods or at a point in time when the customer receives and obtains control of the product, which generally occurs upon delivery. We generally recognize revenue from our sale of gas contracts based on the right to invoice practical expedient. +Our sale of equipment contracts are generally comprised of a single performance obligation as the individual promised goods or services contained within the contracts are integrated with or dependent upon other goods or services in the contract for a single output to the customer. Revenue from our sale of equipment contracts is generally recognized over time as we have an enforceable right to payment for performance completed to date and our performance under the contract terms does not create an asset with alternative use. We recognize these contracts using a cost incurred input method by which costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. +60 +Table of Contents +Amounts billed for shipping and handling fees are classified as sales in the consolidated income statements. Shipping and handling activities for our sale of equipment contracts may be performed after the customer obtains control of the promised goods. In these cases, we have elected to apply the practical expedient to account for shipping and handling as activities to fulfill the promise to transfer the goods. For our sale of gas contracts, control generally transfers to the customer upon delivery. +Amounts billed for sales and use taxes, value-added taxes, and certain excise and other specific transactional taxes imposed on revenue-producing transactions are presented on a net basis and excluded from sales in the consolidated income statements. +For additional information, refer to Note 3 , Revenue Recognition . +Cost of Sales +Cost of sales predominantly represents the cost of tangible products sold. These costs include labor, raw materials, plant engineering, power, depreciation, production supplies and materials packaging costs, and maintenance costs. Costs incurred for shipping and handling are also included in cost of sales. +Depreciation +Depreciation is recorded using the straight-line method, which deducts equal amounts of the cost of each asset from earnings every year over its expected economic useful life. The principal lives for major classes of plant and equipment are summarized in Note 10 , Plant and Equipment, net . +Selling and Administrative +The principal components of selling and administrative expenses are compensation, advertising, and promotional costs. +Postemployment Benefits +We provide termination benefits to employees as part of ongoing benefit arrangements and record a liability for termination benefits when probable and estimable. These criteria are met when management, with the appropriate level of authority, approves and commits to its plan of action for termination; the plan identifies the employees to be terminated and their related benefits; and the plan is to be completed within one year. We do not provide material one-time benefit arrangements. +Fair Value Measurements +We are required to measure certain assets and liabilities at fair value, either upon initial measurement or for subsequent accounting or reporting. For example, fair value is used in the initial measurement of assets and liabilities acquired in a business combination; on a recurring basis in the measurement of derivative financial instruments; and on a nonrecurring basis when long-lived assets are written down to fair value when held for sale or determined to be impaired. Refer to Note 15 , Fair Value Measurements , and Note 17 , Retirement Benefits , for information on the methods and assumptions used in our fair value measurements. +Financial Instruments +We address certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. The types of derivative financial instruments permitted for such risk management programs are specified in policies set by management. Refer to Note 14 , Financial Instruments , for further detail on the types and use of derivative instruments into which we enter. +Major financial institutions are counterparties to all of these derivative contracts. We have established counterparty credit guidelines and generally enter into transactions with financial institutions of investment grade or better. Management believes the risk of incurring losses related to credit risk is remote, and any losses would be immaterial to the consolidated financial results, financial condition, or liquidity. +We recognize derivatives on the balance sheet at fair value. On the date the derivative instrument is entered into, we generally designate the derivative as either (1) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge), (2) a hedge of a net investment in a foreign operation (net investment hedge), or (3) a hedge of the fair value of a recognized asset or liability (fair value hedge). +61 +Table of Contents +The following details the accounting treatment of our cash flow, fair value, net investment, and non-designated hedges: +• +Changes in the fair value of a derivative that is designated as and meets the cash flow hedge criteria are recorded in accumulated other comprehensive loss (AOCL) to the extent effective and then recognized in earnings when the hedged items affect earnings. +• +Changes in the fair value of a derivative that is designated as and meets all the required criteria for a fair value hedge, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. +• +Changes in the fair value of a derivative and foreign currency debt that are designated as and meet all the required criteria for a hedge of a net investment are recorded as translation adjustments in AOCL. +• +Changes in the fair value of a derivative that is not designated as a hedge are recorded immediately in earnings. +We formally document the relationships between hedging instruments and hedged items, as well as our risk management objective and strategy for undertaking various hedge transactions. This process includes relating derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also formally assess, at the inception of the hedge and on an ongoing basis, whether derivatives are highly effective in offsetting changes in fair values or cash flows of the hedged item. If it is determined that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we will discontinue hedge accounting with respect to that derivative prospectively. +Foreign Currency +Since we do business in many foreign countries, fluctuations in currency exchange rates affect our financial position and results of operations. +In most of our foreign operations, the local currency is considered the functional currency. Foreign subsidiaries translate their assets and liabilities into U.S. dollars at current exchange rates in effect at the end of the fiscal period. The gains or losses that result from this process are shown as translation adjustments in AOCL in the equity section of the balance sheet. +The revenue and expense accounts of foreign subsidiaries are translated into U.S. dollars at the average exchange rates that prevail during the period. Therefore, the U.S. dollar value of these items on the consolidated income statements fluctuates from period to period, depending on the value of the U.S. dollar against foreign currencies. Some transactions are made in currencies different from an entity’s functional currency. Gains and losses from these foreign currency transactions are generally reflected in "Other income (expense), net" on our consolidated income statements as they occur. +Environmental Expenditures +Accruals for environmental loss contingencies are recorded when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. Remediation costs are capitalized if the costs improve the Company’s property as compared with the condition of the property when originally constructed or acquired, or if the costs prevent environmental contamination from future operations. We expense environmental costs related to existing conditions resulting from past or current operations and from which no current or future benefit is discernible. The amounts charged to income from continuing operations related to environmental matters totaled $ 14.2 , $ 12.8 , and $ 11.4 in fiscal years 2019 , 2018 , and 2017 , respectively. +The measurement of environmental liabilities is based on an evaluation of currently available information with respect to each individual site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. An environmental liability related to cleanup of a contaminated site might include, for example, a provision for one or more of the following types of costs: site investigation and testing costs, remediation costs, post-remediation monitoring costs, natural resource damages, and outside legal fees. These liabilities include costs related to other potentially responsible parties to the extent that we have reason to believe such parties will not fully pay their proportionate share. They do not consider any claims for recoveries from insurance or other parties and are not discounted. +62 +Table of Contents +As assessments and remediation progress at individual sites, the amount of projected cost is reviewed, and the liability is adjusted to reflect additional technical and legal information that becomes available. Management has an established process in place to identify and monitor the Company’s environmental exposures. An environmental accrual analysis is prepared and maintained that lists all environmental loss contingencies, even where an accrual has not been established. This analysis assists in monitoring the Company’s overall environmental exposure and serves as a tool to facilitate ongoing communication among the Company’s technical experts, environmental managers, environmental lawyers, and financial management to ensure that required accruals are recorded and potential exposures disclosed. +Given inherent uncertainties in evaluating environmental exposures, actual costs to be incurred at identified sites in future periods may vary from the estimates. Refer to Note 18 , Commitments and Contingencies , for additional information on the Company’s environmental loss contingencies. +The accruals for environmental liabilities are reflected in the consolidated balance sheets, primarily as part of other noncurrent liabilities. +Litigation +In the normal course of business, we are involved in legal proceedings. We accrue a liability for such matters when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. When only a range of possible loss can be established, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. The accrual for a litigation loss contingency includes estimates of potential damages and other directly related costs expected to be incurred. Refer to Note 18 , Commitments and Contingencies , for additional information on our current legal proceedings. +Share-Based Compensation +We have various share-based compensation programs, which include deferred stock units, stock options, and restricted stock. We expense the grant-date fair value of these awards over the vesting period during which employees perform related services. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. Refer to Note 20 , Share-Based Compensation , for additional information regarding these awards and the models and assumptions used to determine the grant-date fair value of our awards. +Income Taxes +We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. A principal temporary difference results from the excess of tax depreciation over book depreciation because accelerated methods of depreciation and shorter useful lives are used for income tax purposes. The cumulative impact of a change in tax rates or regulations is included in income tax expense in the period that includes the enactment date. We recognize deferred tax assets net of existing valuation allowances to the extent we believe that these assets are more likely than not to be realized considering all available evidence. +A tax benefit for an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination based on its technical merits. This position is measured as the largest amount of tax benefit that is greater than 50% likely of being realized. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense. For additional information regarding our income taxes, refer to Note 23 , Income Taxes . +Other Non-Operating Income (Expense), net +Other non-operating income (expense), net primarily includes interest income associated with our cash and cash items and short-term investments and non-service cost components of net periodic pension and postretirement benefit cost. Our non-service costs primarily include interest cost, expected return on plan assets, amortization of actuarial gains and losses, and settlements. +Cash and Cash Items +Cash and cash items include cash, time deposits, treasury securities, and certificates of deposit acquired with an original maturity of three months or less. +63 +Table of Contents +Short-term Investments +Short-term investments include time deposits and certificates of deposit with original maturities greater than three months and less than one year. +Trade Receivables, net +Trade receivables comprise amounts owed to us through our operating activities and are presented net of allowances for doubtful accounts. The allowances for doubtful accounts represent estimated uncollectible receivables associated with potential customer defaults on contractual obligations. A provision for customer defaults is made on a general formula basis when it is determined that the risk of some default is probable and estimable but cannot yet be associated with specific customers. The assessment of the likelihood of customer defaults is based on various factors, including the length of time the receivables are past due, historical experience, and existing economic conditions. The allowance also includes amounts for certain customers where a risk of default has been specifically identified, considering factors such as the financial condition of the customer and customer disputes over contractual terms and conditions. Allowances for doubtful accounts were $ 88.2 and $ 91.3 as of 30 September 2019 and 2018 , respectively. Provisions to the allowance for doubtful accounts charged against income were $ 48.8 , $ 24.0 , and $ 45.8 in fiscal years 2019 , 2018 , and 2017 , respectively. +Inventories +We carry inventory that is comprised of finished goods, work-in-process, raw materials and supplies. Refer to Note 8 , Inventories , for further detail. +Inventories on our consolidated balance sheets are stated at the lower of cost or net realizable value. We write down our inventories for estimated obsolescence or unmarketable inventory based upon assumptions about future demand and market conditions. +Effective 1 July 2018, we determine the cost of all our inventories on a first-in, first-out basis ("FIFO"). Prior to 1 July 2018, we determined the cost of our industrial gas inventories in the United States on a last-in, first-out basis ("LIFO"). We applied this accounting change as a cumulative effect adjustment to cost of sales in the fourth quarter of fiscal year 2018 and did not restate prior period financial statements because the impact was not material. This change decreased our cost of sales by $ 24.1 for the quarter and fiscal year ended 30 September 2018. +Equity Investments +The equity method of accounting is used when we exercise significant influence but do not have operating control, generally assumed to be 20% – 50% ownership. Under the equity method, original investments are recorded at cost and adjusted by our share of undistributed earnings or losses of these companies. Equity investments are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment may not be recoverable. +Plant and Equipment, net +Plant and equipment, net is stated at cost less accumulated depreciation. Construction costs, labor, and applicable overhead related to installations are capitalized. Expenditures for additions and improvements that extend the lives or increase the capacity of plant assets are capitalized. The costs of maintenance and repairs of plant and equipment are charged to expense as incurred. +Fully depreciated assets are retained in the gross plant and equipment and accumulated depreciation accounts until they are removed from service. In the case of disposals, assets and related depreciation are removed from the accounts, and the net amounts, less proceeds from disposal, are included in income. Refer to Note 10 , Plant and Equipment, net , for further detail. +Computer Software +We capitalize costs incurred to purchase or develop software for internal use. Capitalized costs include purchased computer software packages, payments to vendors/consultants for development and implementation or modification to a purchased package to meet our requirements, payroll and related costs for employees directly involved in development, and interest incurred while software is being developed. Capitalized computer software costs are reflected in "Plant and equipment, net" on the consolidated balance sheets and are depreciated over the estimated useful life of the software, generally a period of three to five years . +64 +Table of Contents +Capitalized Interest +As we build new plant and equipment, we include in the cost of these assets a portion of the interest payments we make during the year. The amount of capitalized interest was $ 13.5 , $ 19.5 , and $ 19.0 in fiscal years 2019 , 2018 , and 2017 , respectively. +Impairment of Long-Lived Assets +Long-lived assets are grouped for impairment testing at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other assets and liabilities and are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. We assess recoverability by comparing the carrying amount of the asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If an asset group is considered impaired, the impairment loss to be recognized is measured as the amount by which the asset group’s carrying amount exceeds its fair value. Long-lived assets meeting the held for sale criteria are reported at the lower of carrying amount or fair value less cost to sell. +Asset Retirement Obligations +The fair value of a liability for an asset retirement obligation is recognized in the period in which it is incurred. The fair value of the liability is measured using discounted estimated cash flows and is adjusted to its present value in subsequent periods as accretion expense is recorded. The corresponding asset retirement costs are capitalized as part of the carrying amount of the related long-lived asset and depreciated over the asset’s useful life. Our asset retirement obligations are primarily associated with on-site long-term supply contracts under which we have built a facility on land owned by the customer and are obligated to remove the facility at the end of the contract term. Our asset retirement obligations totaled $ 208.2 and $ 190.4 at 30 September 2019 and 2018 , respectively. +Goodwill +Business combinations are accounted for using the acquisition method. The purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. Any excess purchase price (plus the fair value of any noncontrolling interest and previously held equity interest in the acquiree) over the fair market value of the net assets acquired, including identified intangibles, is recorded as goodwill. Preliminary purchase price allocations are made at the date of acquisition and finalized when information about facts and circumstances that existed as of the acquisition date needed to finalize underlying estimates is obtained or when we determine that such information is not obtainable, within a maximum allocation period of one year. +Goodwill is subject to impairment testing at least annually. In addition, goodwill is tested more frequently if a change in circumstances or the occurrence of events indicates that potential impairment exists. Refer to Note 11 , Goodwill , for further detail. +Intangible Assets +Intangible assets with determinable lives primarily consist of customer relationships, purchased patents and technology, and land use rights. The cost of intangible assets with determinable lives is amortized on a straight-line basis over the estimated period of economic benefit. No residual value is estimated for these intangible assets. Indefinite-lived intangible assets consist of trade names and trademarks. Indefinite-lived intangibles are subject to impairment testing at least annually. In addition, intangible assets are tested more frequently if a change in circumstances or the occurrence of events indicates that potential impairment exists. +Customer relationships are generally amortized over periods of five to twenty-five years . Purchased patents and technology and other finite-lived intangibles are generally amortized over periods of five to fifteen years . Other intangibles includes land use rights, which are generally amortized over a period of fifty years . Amortizable lives are adjusted whenever there is a change in the estimated period of economic benefit. Refer to Note 12 , Intangible Assets , for further detail. +Retirement Benefits +The cost of pension benefits is generally recognized over the employees’ service period. We use actuarial methods and assumptions in the valuation of defined benefit obligations and the determination of expense. Differences between actual and expected results or changes in the value of obligations and plan assets are not recognized in earnings as they occur but, rather, systematically and gradually over subsequent periods. Refer to Note 17 , Retirement Benefits , for disclosures related to our pension and other postretirement benefits. +65 +Table of Contents +2 . NEW ACCOUNTING GUIDANCE +Accounting Guidance Implemented in Fiscal Year 2019 +Revenue Recognition +In May 2014, the Financial Accounting Standards Board (FASB) issued the new revenue standard, which is based on the principle that revenue is recognized in an amount expected to be collected and to which the entity expects to be entitled in exchange for the transfer of goods or services. We adopted this guidance under the modified retrospective approach as of 1 October 2018. Upon adoption, we no longer present "Contracts in progress, less progress billings" on our consolidated balance sheets and have expanded disclosure requirements. Otherwise, adoption of this guidance did not impact our consolidated financial statements, and no adjustment was necessary to opening retained earnings. Accordingly, sales presented during fiscal year 2019 would not change if presented under accounting standards in effect prior to 1 October 2018. Refer to Note 3 , Revenue Recognition , for additional information. +Cash Flow Statement Classification +In August 2016, the FASB issued guidance to reduce diversity in practice related to the classification of certain cash receipts and cash payments in the statement of cash flows. We adopted this guidance retrospectively in the first quarter of fiscal year 2019 and elected to use the cumulative earnings approach to determine the classification of distributions received from equity affiliates. As a result, we reclassified net activity from operating activities to investing activities of $ 7.5 and $ 5.7 for the fiscal years ended 30 September 2018 and 2017, respectively. +Intra-Entity Asset Transfers +In October 2016, the FASB issued guidance on accounting for the income tax effects of intra-entity transfers of assets other than inventory. Previous guidance prohibited the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset had been sold to an outside party. Under the new guidance, the income tax consequences of an intra-entity asset transfer are recognized when the transfer occurs. We adopted this guidance in the first quarter of fiscal year 2019 on a modified retrospective basis through a cumulative-effect adjustment of $ 17.1 that decreased retained earnings as of 1 October 2018. +Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income +In February 2018, the FASB issued guidance allowing for a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the U.S. Tax Cuts and Jobs Act. We adopted this guidance in the fourth quarter and elected to not reclassify the income tax effects stranded in accumulated other comprehensive income to retained earnings. As a result, there was no impact on the Company’s consolidated financial statements. Our policy for releasing the income tax effects from accumulated other comprehensive income utilizes either the specific identification approach or the portfolio approach based on the nature of the underlying item and when it is reclassified to earnings. +New Accounting Guidance to be Implemented +Leases +In February 2016, the FASB issued guidance that requires lessees to recognize a right-of-use asset and lease liability on the balance sheet for all leases, including operating leases, with a term in excess of 12 months. The guidance also expands the quantitative and qualitative disclosure requirements. +The Company is the lessee under various agreements for real estate, distribution equipment, aircraft, and vehicles that are currently accounted for as operating leases. +We will adopt this guidance in fiscal year 2020 using a modified retrospective approach with the election to apply the guidance as of the adoption date instead of the earliest comparative period presented in the consolidated financial statements. +66 +Table of Contents +Upon adoption, we will elect the following practical expedients provided by this guidance: +• +The package of practical expedients, which allows us to carry forward the historical lease population and classification, among other things; +• +The land easements practical expedient, which allows us to carry forward our current accounting treatment for land easements on existing agreements; +• +The hindsight practical expedient, which is used to determine the reasonably certain lease term for existing leases as of the date of adoption; +• +The single component practical expedient, which allows us to account for lease and non-lease components associated with that lease as a single component, if certain criteria are met; and +• +The short-term leases practical expedient, which allows us to not record the related lease liabilities and right-of-use assets for operating leases in which we are the lessee with a term of 12 months or less. +We expect adoption of the standard will result in recognition of lease liabilities and right-of-use assets on our consolidated balance sheets of approximately $ 380 and $ 340 , respectively. The standard will not materially affect our results of operations or liquidity. +Credit Losses on Financial Instruments +In June 2016, the FASB issued guidance on the measurement of credit losses, which requires measurement and recognition of expected credit losses for financial assets, including trade receivables and capital lease receivables, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The method to determine a loss is different from the existing guidance, which requires a credit loss to be recognized when it is probable. The guidance is effective beginning in fiscal year 2021, with early adoption permitted beginning in fiscal year 2020. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +Hedging Activities +In August 2017, the FASB issued guidance on hedging activities to expand the related presentation and disclosure requirements, change how companies assess effectiveness, and eliminate the separate measurement and reporting of hedge ineffectiveness. The guidance also enables more hedging strategies to become eligible for hedge accounting. +We will adopt the new guidance on 1 October 2019 on a prospective basis. The primary impact of adoption will be the presentation in the consolidated income statement of excluded components of our cash flow hedges of intercompany loans. Excluded components are certain portions of the change in fair value of derivative instruments that are excluded from the assessment of hedge effectiveness. Historically, the impacts from changes in value of these components were recorded in "Interest expense." Beginning in fiscal year 2020, we will present these excluded components in "Other non-operating income (expense), net" consistent with the remeasurement of the intercompany loans. In fiscal years 2019 and 2018, the excluded components recognized within "Interest expense” totaled approximately $ 35 and $ 40 , respectively. +In accordance with the transition provisions of the guidance, the separate measurement of ineffectiveness for our cash flow hedging instruments existing as of the date of adoption should be eliminated through a cumulative-effect adjustment within equity. +Fair Value Measurement Disclosures +In August 2018, the FASB issued guidance which modifies the disclosure requirements for fair value measurements. The guidance is effective in fiscal year 2021, with early adoption permitted. Certain amendments must be applied prospectively and other amendments retrospectively. We are currently evaluating the impact this guidance will have on the disclosures in the notes to our consolidated financial statements. +Retirement Benefit Disclosures +In August 2018, the FASB issued guidance which modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. The guidance is effective in fiscal year 2021, with early adoption permitted, and must be applied on a retrospective basis. We are currently evaluating the impact this guidance will have on the disclosures in the notes to our consolidated financial statements. +67 +Table of Contents +Cloud Computing Implementation Costs +In August 2018, the FASB issued guidance which aligns the capitalization requirements for implementation costs incurred in a hosting arrangement that is a service contract with the existing capitalization requirements for implementation costs incurred to develop or obtain internal-use software. The guidance is effective in fiscal year 2021, with early adoption permitted, and may be applied either prospectively or retrospectively. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +Related Party Guidance for Variable Interest Entities +In October 2018, the FASB issued an update which amends the guidance for determining whether a decision-making fee is a variable interest. The amendments require consideration of indirect interests held through related parties under common control on a proportional basis rather than as the equivalent of a direct interest in its entirety as currently required. The guidance is effective in fiscal year 2021, with early adoption permitted. The amendments must be applied retrospectively with a cumulative-effect adjustment to retained earnings at the beginning of the earliest period presented. We are currently evaluating the impact this guidance will have on our consolidated financial statements. +3 . REVENUE RECOGNITION +Nature of Goods and Services +The principal activities from which the Company generates its sales from its contracts with customers, separated between our regional industrial gases businesses and industrial gases equipment businesses, are described below with their respective revenue recognition policies. For an overall summary of these policies and discussion on payment terms and presentation, refer to Note 1 , Major Accounting Policies . +Industrial Gases – Regional +Our regional industrial gases businesses produce and sell atmospheric gases such as oxygen, nitrogen, and argon (primarily recovered by the cryogenic distillation of air) and process gases such as hydrogen, helium, carbon dioxide, carbon monoxide, syngas, and specialty gases. We distribute gases to our sale of gas customers through different supply modes depending on various factors including the customer's volume requirements and location. Our supply modes are as follows: +On-site Gases—Supply mode associated with customers who require large volumes of gases and have relatively constant demand. Gases are produced and supplied by large facilities we construct on or near the customers’ facilities or by pipeline systems from centrally located production facilities. These sale of gas contracts generally have 15- to 20- year terms. The Company also delivers smaller quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically via a 10- to 15- year sale of gas contract. The contracts within this supply mode generally contain fixed monthly charges and/or minimum purchase requirements with price escalation provisions that are generally based on external indices. Revenue associated with this supply mode is generally recognized over time during the period in which we deliver or make available the agreed upon quantity of goods. +Merchant Gases—Supply mode associated with liquid bulk and packaged gases customers. Liquid bulk customers receive delivery of product in liquid or gaseous form by tanker or tube trailer. The product is stored, usually in its liquid state, in equipment typically designed and installed by the Company at the customer’s site for vaporizing into a gaseous state as needed. Packaged gases customers receive small quantities of product delivered in either cylinders or dewars. Both liquid bulk and packaged gases sales do not contain minimum purchase requirements as they are governed by contracts and/or purchase orders based on the customer's requirements. These contracts contain stated terms that are generally 5 years or less. Performance obligations associated with this supply mode are satisfied at a point in time when the customer receives and obtains control of the product, which generally occurs upon delivery. +The timing of revenue recognition for our regional industrial gases businesses is generally consistent with our right to invoice the customer. Variable components of consideration that may not be resolved within the month, such as the ability to earn an annual bonus or incur a penalty, are more relevant to on-site contracts and are considered constrained as they can be impacted by a single significant event such as a plant outage, which could occur at the end of a contract period. We consider contract modifications on an individual basis to determine appropriate accounting treatment. However, contract modifications are generally accounted for prospectively as they relate to distinct goods or services associated with future periods of performance. +68 +Table of Contents +We mitigate energy and natural gas price risk contractually through pricing formulas, surcharges, and cost pass-through arrangements. +Industrial Gases – Equipment +The Company designs and manufactures equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction (LNG), and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global and the Corporate and other segments serve our sale of equipment customers. +Our sale of equipment contracts are generally comprised of a single performance obligation as the individual promised goods or services contained within the contracts are integrated with or dependent upon other goods or services in the contract for a single output to the customer. +Revenue from our sale of equipment contracts is generally recognized over time as we have an enforceable right to payment for performance completed to date and our performance under the contract terms does not create an asset with alternative use. Otherwise, sale of equipment contracts are satisfied at the point in time the customer obtains control of the equipment, which is generally determined based on the shipping terms of the contract. For contracts recognized over time, we primarily recognize revenue using a cost incurred input method by which costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. +Since our contracts are generally comprised of a single performance obligation, contract modifications are typically accounted for as part of the existing contract and are recognized as a cumulative adjustment for the inception-to-date effect of such change. In addition, changes in estimates on projects accounted for under the cost incurred input method are recognized as a cumulative adjustment for the inception-to-date effect of such change. Changes in estimates favorably impacted operating income by approximately $ 37 , $ 38 , and $ 27 in fiscal years 2019 , 2018 , and 2017 , respectively. Our changes in estimates would not have significantly impacted amounts recorded in prior years. +Disaggregation of Revenue +The table below presents our consolidated sales disaggregated by each of the supply modes described above for each of our reporting segments for the year ended 30 September 2019 . We believe this presentation best depicts the nature, timing, type of customer, and contract terms for our sales. +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Total +% +2019 +On-site +$ 2,230.6 +$ 728.4 +$ 1,622.6 +$ — +$ — +$ 4,581.6 +52 +% +Merchant +1,642.9 +1,274.1 +1,041.0 +— +— +3,958.0 +44 +% +Sale of Equipment +— +— +— +261.0 +118.3 +379.3 +4 +% +Total +$ 3,873.5 +$ 2,002.5 +$ 2,663.6 +$ 261.0 +$ 118.3 +$ 8,918.9 +100 +% +Approximately 5 % of total consolidated sales for the year ended 30 September 2019 was associated with lease revenue relating to our on-site supply mode and therefore not within the scope of the new revenue standard. +Remaining Performance Obligations +As of 30 September 2019 , the transaction price allocated to remaining performance obligations is estimated to be approximately $ 14 billion . This amount includes fixed-charge contract provisions associated with our on-site and sale of equipment supply modes. We estimate that approximately half of this revenue will be recognized over approximately the next five years and the balance thereafter. +Expected revenue associated with new on-site plants that are not yet onstream is excluded from this amount. In addition, this amount excludes consideration associated with contracts determined to be leases, those with an expected duration of less than one year, and variable consideration for which we recognize revenue at the amount to which we have the right to invoice, including pass-through costs related to energy and natural gas. +In the future, actual amounts will differ due to events outside of our control, including but not limited to inflationary price escalations, currency exchange rates, and terminated or renewed contracts. +69 +Table of Contents +Contract Balances +Upon adoption of the new revenue standard, we no longer present "Contracts in progress, less progress billings" on our consolidated balance sheets. The balance as of 30 September 2018 has been reclassified to " Other receivables and current assets ." +Our sale of equipment contracts generally contain a single performance obligation which, as discussed below, results in presentation of either a contract asset or contract liability. +The table below details balances arising from contracts with customers as of our most recent balance sheet date and our date of adoption: +30 September 2019 +1 October 2018 +Assets +Contract assets – current +$ 64.3 +$ 53.0 +Contract fulfillment costs – current +64.5 +50.7 +Liabilities +Contract liabilities – current +247.4 +174.5 +Contract liabilities – noncurrent +49.2 +53.5 +Contract assets and liabilities result from differences in timing of revenue recognition and customer invoicing. These balances are reported on the consolidated balance sheets on a contract-by-contract basis at the end of each reporting period. +Contract assets primarily relate to our sale of equipment contracts for which revenue is recognized over time. These balances represent unbilled revenue, which occurs when revenue recognized under the measure of progress exceeds the amount invoiced to our customers. Our ability to invoice the customer for contract asset balances is not only based on the passage of time, but also the achievement of certain contractual milestones. Our contract assets are included within "Other receivables and current assets" on the consolidated balance sheets. +Contract fulfillment costs primarily include deferred costs related to sale of equipment projects that cannot be inventoried and for which we expect to recognize revenue upon transfer of control at project completion or costs related to fulfilling a specific anticipated contract. Contract fulfillment costs are generally classified as current and are included within "Other receivables and current assets" on the consolidated balance sheets. +Costs to obtain a contract, or contract acquisition costs, are capitalized only after we have established a contract with the customer. We elected to apply the practical expedient to expense these costs as they are incurred if the amortization period of the asset that would have otherwise been recognized is one year or less. Our contract acquisition costs capitalized as of 30 September 2019 were not material. +Contract liabilities include advance payments or right to consideration prior to performance under the contract. Contract liabilities are recognized as revenue when or as we perform under the contract. The increase in our contract liabilities – current balance primarily relates to new sale of equipment projects as balances associated with our sale of gas contracts are generally related to fixed charges and are relatively consistent period over period. During the year ended 30 September 2019 , we recognized approximately $ 110 in revenue associated with sale of equipment contracts that was included within our contract liabilities as of 30 September 2018. The current and noncurrent portions of our contract liabilities are included within "Payables and accrued liabilities" and "Other noncurrent liabilities" on our consolidated balance sheets, respectively. Advanced payments from our customers do not represent a significant financing component as these payments are intended for purposes other than financing, such as to meet working capital demands or to protect us from our customer failing to meet its obligations under the terms of the contract. +Changes in contract asset and liability balances during the year ended 30 September 2019 were not materially impacted by any other factors. +70 +Table of Contents +4 . DISCONTINUED OPERATIONS +In fiscal year 2018, income from discontinued operations, net of tax, was $ 42.2 . This included an income tax benefit of $ 25.6 resulting from the resolution of uncertain tax positions taken in conjunction with the disposition of our former European Homecare business in fiscal year 2012 and an after-tax benefit of $ 17.6 resulting from the resolution of certain post-closing adjustments associated with the sale of our former Performance Materials Division ("PMD") in fiscal year 2017. These benefits were partially offset by an after-tax loss of $ 1.0 related to Energy-from-Waste ("EfW"). +There were no assets or liabilities presented in discontinued operations on the consolidated balance sheets as of 30 September 2019 or 2018. +The following table details income from discontinued operations, net of tax, on the consolidated income statements for fiscal year 2017: +Total +Performance +Energy-from- +Discontinued +Year Ended 30 September 2017 +Materials +Waste (A) +Operations +Sales +$ 254.8 +$ — +$ 254.8 +Cost of sales +182.3 +13.8 +196.1 +Selling and administrative +22.5 +.7 +23.2 +Research and development +5.1 +— +5.1 +Other income (expense), net +.3 +( 2.0 +) +( 1.7 +) +Operating Income (Loss) +45.2 +( 16.5 +) +28.7 +Equity affiliates’ income +.3 +— +.3 +Income (Loss) Before Taxes +45.5 +( 16.5 +) +29.0 +Income tax benefit (B) +( 50.8 +) +( 5.7 +) +( 56.5 +) +Income (Loss) From Operations of Discontinued Operations, net of tax +96.3 +( 10.8 +) +85.5 +Gain (Loss) on disposal of business, net of tax (C) +1,827.6 +( 47.1 +) +1,780.5 +Income (Loss) From Discontinued Operations, net of tax +$ 1,923.9 +($ 57.9 +) +$ 1,866.0 +(A) +The loss from operations of discontinued operations for EfW primarily related to costs incurred for ongoing project exit activities, administrative costs, and land lease obligations. +(B) +As a result of the expected gain on the sale of PMD, we released valuation allowances related to capital loss and net operating loss carryforwards primarily during the first quarter of 2017 that favorably impacted our income tax provision within discontinued operations by approximately $ 69 . +(C) +After-tax gain on sale of $ 1,827.6 included expense for income tax reserves for uncertain tax positions of $ 28.0 gross ( $ 21.0 net) in various jurisdictions. +In fiscal year 2017, income from discontinued operations, net of tax, of $ 1,866.0 included a gain of $ 2,870 ( $ 1,828 after-tax, or $ 8.32 per share) for the sale of PMD. Refer to Note 5 , Materials Technologies Separation , for additional information. In addition, we recorded a loss on the disposal of EfW of $ 59.3 ( $ 47.1 after-tax) during the first quarter of 2017, primarily for land lease obligations and to update our estimate of the net realizable value of the plant assets. The loss on disposal was recorded as a component of discontinued operations while the liability associated with land lease obligations was and continues to be recorded in continuing operations. As of 30 September 2019, liabilities associated with EfW recorded in continuing operations were approximately $ 58 and primarily related to the land lease obligations. +71 +Table of Contents +5 . MATERIALS TECHNOLOGIES SEPARATION +As further discussed below, we completed the separation of the divisions comprising the former Materials Technologies segment through the spin-off of EMD as Versum Materials, Inc. and the sale of PMD to Evonik Industries AG ("Evonik") in fiscal year 2017. In connection with the dispositions, we incurred net separation costs of $ 30.2 . The net costs included legal and advisory fees of $ 32.5 , which are reflected on the consolidated income statements as “Business separation costs,” and a pension settlement benefit of $ 2.3 presented within "Other non-operating income (expense), net." Our fiscal year 2017 income tax provision included net tax benefits of $ 5.5 , primarily related to changes in tax positions on business separation activities. +Spin-off of EMD +On 1 October 2016 (the distribution date), Air Products completed the spin-off of its Electronic Materials Division (EMD) as Versum Materials, Inc. ("Versum"), a separate and independent public company. The spin-off was completed by way of a distribution to Air Products’ stockholders of all of the then issued and outstanding shares of common stock of Versum on the basis of one share of Versum common stock for every two shares of Air Products’ common stock held as of the close of business on 21 September 2016 (the record date for the distribution). Fractional shares of Versum common stock were not distributed to Air Products' common stockholders. Air Products’ stockholders received cash in lieu of fractional shares. The spin-off of Versum was treated as a noncash transaction in the consolidated statement of cash flows in fiscal year 2017. +Sale of PMD +On 3 January 2017, we completed the sale of PMD to Evonik for $ 3.8 billion . We recognized a gain on the sale of $ 2,870 ( $ 1,828 after-tax, or $ 8.32 per share), which is reflected within "Income from discontinued operations, net of tax" for the year ended 30 September 2017. +6 . COST REDUCTION AND ASSET ACTIONS +The charges we record for cost reduction and asset actions are not recorded in segment results. Liabilities associated with these actions are reflected on our consolidated balance sheets within "Payables and accrued liabilities." +Fiscal Year 2019 Cost Reduction Actions +In fiscal year 2019, we recognized an expense of $ 25.5 for severance and other benefits associated with the elimination or planned elimination of approximately 300 positions. These actions are expected to drive cost synergies primarily within the Industrial Gases – EMEA and the Industrial Gases – Americas segments. +The following table summarizes the carrying amount of the accrual as of 30 September 2019 . +2019 Charge +$ 25.5 +Cash expenditures +( 6.9 +) +Amount reflected in pension liability +( .3 +) +Currency translation adjustment +( .5 +) +30 September 2019 +$ 17.8 +Fiscal Year 2017 Cost Reduction and Asset Actions +In fiscal year 2017, we recognized a net expense of $ 151.4 for cost reduction and asset actions. The net expense included a charge of $ 154.8 for actions taken in 2017 ("the 2017 charge"), partially offset by the favorable settlement of the remaining $ 3.4 accrued balance associated with business restructuring actions taken in 2015. +The 2017 charge included $ 88.5 for asset actions related to the write-down of an air separation unit in the Industrial Gases – EMEA segment that was constructed mainly to provide oxygen to a former EfW plant; the planned sale of a non-industrial gas hardgoods business in the Industrial Gases – Americas segment; and the closure of an LNG heat exchanger manufacturing facility in the Corporate and other segment. The 2017 charge also included $ 66.3 for severance and other benefits associated with the elimination of approximately 625 positions, primarily in the Corporate and other and Industrial Gases – EMEA segments. The actions in the Corporate and other segment were driven by the reorganization of our engineering, manufacturing, and technology functions. The 2017 charge related to the segments as follows: $ 39.3 in Industrial Gases – Americas; $ 77.9 in Industrial Gases – EMEA; $ .9 in Industrial Gases – Asia; $ 2.5 in Industrial Gases – Global; and $ 34.2 in Corporate and other. +72 +Table of Contents +7 . ACQUISITIONS +Fiscal Year 2019 Business Combinations +As further discussed below, we completed three business combinations in fiscal year 2019. +Exchange of Equity Affiliate Investments +As of 30 September 2018, we held 50 % ownership interests in High-Tech Gases (Beijing) Co., Ltd. ("High-Tech Gases") and WuXi Hi-Tech Gas Co., Ltd. ("WuXi"), both of which were joint ventures with another industrial gas company in China. We accounted for these arrangements as equity method investments in our Industrial Gases – Asia segment through 30 April 2019. +On 1 May 2019, we acquired our partner's 50 % interest in WuXi in exchange for our 50 % interest in High-Tech Gases. The purpose of the exchange was to simplify the current structure of the two entities and to allow each party to serve its customers more efficiently in their respective geographies. Subsequent to the acquisition date, we own 100 % of WuXi and no longer have an equity interest in High-Tech Gases. +The exchange resulted in a net gain of $ 29.1 , of which $ 15.0 resulted from the revaluation of our previously held equity interest in WuXi to its acquisition date fair value and $ 14.1 resulted from the disposition of our interest in High-Tech Gases. The net gain has been reflected as " Gain on exchange of equity affiliate investments " on our consolidated income statements in fiscal year 2019 and was not recorded in segment results. There were no tax impacts on the exchange. +We revalued our previously held 50 % equity interest in WuXi based on an estimated acquisition date fair value of $ 27.0 . We calculated this fair value using a discounted cash flow analysis under the income approach, which required estimates and assumptions regarding projected revenue growth, customer attrition rates, profit margin, and discount rate. +The acquisition of the remaining interest in WuXi was accounted for as a business combination. The results of this business have been consolidated within our Industrial Gases – Asia segment as of the acquisition date. Upon acquisition, we recognized plant and equipment of $ 28.0 , intangible assets of $ 27.4 , and goodwill of $ 3.9 . The intangible assets were primarily customer relationships, having a weighted-average useful life of approximately 10 years . The goodwill recognized on the transaction, none of which is deductible for tax purposes, was recorded in the Industrial Gases – Asia segment and is attributable to expected growth synergies. The acquisition did not materially impact our consolidated income statements for the periods presented. +Other Fiscal Year 2019 Business Combinations +The remaining business combinations completed in fiscal year 2019 had total consideration, net of cash acquired, of $ 126.6 . The largest of these business combinations was the acquisition of ACP Europe SA ("ACP"), the largest independent carbon dioxide business in Continental Europe, which closed on 1 March 2019. We expect this acquisition to enable us to better serve existing merchant customers and pursue new industrial gas growth opportunities across additional European geographies. The results of this business are consolidated within our Industrial Gases – EMEA segment and did not materially impact our consolidated income statements for the periods presented. +Our other 2019 business combinations resulted in the recognition of plant and equipment of $ 75.1 and goodwill of $ 44.7 , partially offset by net liabilities acquired. The goodwill recognized on the transactions, $ 1.7 of which is deductible for tax purposes, was primarily recorded in the Industrial Gases – EMEA segment and is attributable to expected growth and cost synergies. +The acquired assets and liabilities resulting from our 2019 business combinations were recorded at their estimated fair values, which were calculated based on a preliminary purchase price allocation prepared by management. We may record adjustments to these assets and liabilities during the preliminary purchase price allocation period, which could be up to one year from the acquisition date. +73 +Table of Contents +Fiscal Year 2018 Asset Acquisition +On 26 April 2018 ("the acquisition date"), we completed the formation of Air Products Lu An (Changzhi) Co., Ltd. (“the JV”), a 60 % -owned joint venture with Lu’An Clean Energy Company ("Lu’An"). The JV receives coal, steam and power from Lu’An and supplies syngas to Lu’An under a long-term onsite contract. The results of the JV are consolidated within the Industrial Gases – Asia segment. +Air Products contributed four large air separation units to the JV with a carrying value of approximately $ 300 , and the JV acquired gasification and syngas clean-up assets from Lu’An for 7.9 billion RMB (approximately $ 1.2 billion ). As a result, the carrying value of the plant and equipment of the JV was approximately $ 1.5 billion at the acquisition date. +We accounted for the acquisition of the gasification and syngas clean-up assets as an asset acquisition. In connection with closing the acquisition, we paid net cash of approximately 1.5 billion RMB ( $ 235 ) and issued equity of 1.4 billion RMB ( $ 227 ) to Lu'An for their noncontrolling interest in the JV. In addition, Lu'An made a loan of 2.6 billion RMB to the JV with regularly scheduled principal and interest payments at a fixed interest rate of 5.5 % , and we established a liability of 2.3 billion RMB for remaining cash payments. The issuance of equity to Lu'An for their noncontrolling interest, the long-term debt, and the liability for the remaining cash payments were noncash transactions that have been excluded from the consolidated statement of cash flows for the fiscal year ended 30 September 2018. +The following table summarizes the liabilities resulting from this acquisition as reflected on our consolidated balance sheets: +30 September +2019 +2018 +Payables and accrued liabilities +$ 8.9 +$ 330.0 +Current portion of long-term debt +37.8 +— +Long-term debt – related party +320.1 +384.3 +Fiscal Year 2018 Business Combinations +In fiscal year 2018, we completed eight acquisitions that were accounted for as business combinations. These acquisitions had total consideration, net of cash acquired, of $ 355.4 . The largest of the acquisitions was completed during the first quarter of fiscal year 2018 and primarily consisted of three air separation units serving onsite and merchant customers in China, which strengthened our position in the region. The results of this business are consolidated within our Industrial Gases – Asia segment. +8 . INVENTORIES +The components of inventories are as follows: +30 September +2019 +2018 +Finished goods +$ 128.8 +$ 125.4 +Work in process +27.5 +21.2 +Raw materials, supplies and other +232.0 +249.5 +Inventories +$ 388.3 +$ 396.1 +74 +Table of Contents +9 . SUMMARIZED FINANCIAL INFORMATION OF EQUITY AFFILIATES +The summarized financial information below is on a combined 100% basis and has been compiled based on financial statements of the companies accounted for by the equity method. The amounts presented include the accounts of the following equity affiliates: +Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (25%); +INOX Air Products Private Limited (50%); +Air Products South Africa (Proprietary) Limited (50%); +Jazan Gas Projects Company (26%); +Bangkok Cogeneration Company Limited (49%); +Kulim Industrial Gases Sdn. Bhd. (50%); +Bangkok Industrial Gases Co., Ltd. (49%); +Sapio Produzione Idrogeno Ossigeno S.r.l. (49%); +Chengdu Air & Gas Products Ltd. (50%); +Tecnologia en Nitrogeno S. de R.L. de C.V. (50%); +Helios S.p.A. (49%); +Tyczka Industrie-Gases GmbH (50%); +INFRA Group (40%); +and principally, other industrial gas producers. +30 September +2019 +2018 +Current assets +$ 1,660.6 +$ 1,556.9 +Noncurrent assets +4,400.4 +4,340.8 +Current liabilities +725.1 +635.7 +Noncurrent liabilities +2,853.6 +2,652.5 +Year Ended 30 September +2019 +2018 +2017 +Net sales +$ 2,885.6 +$ 2,663.1 +$ 2,343.3 +Sales less cost of sales +1,193.4 +1,050.6 +878.6 +Operating income +763.4 +635.3 +509.5 +Net income +492.4 +388.0 +343.5 +Dividends received from equity affiliates were $ 144.3 , $ 122.5 , and $ 99.5 in fiscal years 2019 , 2018 , and 2017 , respectively. +The investment in net assets of and advances to equity affiliates as of 30 September 2019 and 2018 included investment in foreign affiliates of $ 1,275.4 and $ 1,276.0 , respectively. +As of 30 September 2019 and 2018 , the amount of investment in companies accounted for by the equity method included equity method goodwill of $ 42.8 and $ 42.4 , respectively. +Exchange of Equity Affiliate Investments +As of 30 September 2018, we held 50 % ownership interests in High-Tech Gases (Beijing) Co., Ltd. ("High-Tech Gases") and WuXi Hi-Tech Gas Co., Ltd. ("WuXi"), both of which were joint ventures with another industrial gas company in China. We accounted for these arrangements as equity method investments in our Industrial Gases – Asia segment through 30 April 2019. +On 1 May 2019, we acquired our partner's 50 % interest in WuXi in exchange for our 50 % interest in High-Tech Gases. Subsequent to the acquisition date, we own 100 % of WuXi and no longer have an equity interest in High-Tech Gases. The results and financial position of this business have been consolidated within our Industrial Gases – Asia segment as of the acquisition date. +Refer to Note 7 , Acquisitions , to the consolidated financial statements for additional information. +U.S. Tax Cuts and Jobs Act +For the year ended 30 September 2018, equity affiliates' income includes an expense of $ 28.5 for our proportionate share of the impact of the U.S. Tax Cuts and Jobs Act primarily recorded during the first quarter of fiscal year 2018. This expense is included in the fiscal year 2018 net income on a 100% basis in the table above. Refer to Note 23 , Income Taxes , for additional information. +75 +Table of Contents +Equity Affiliate Impairment Charge +During the third quarter of fiscal year 2017, we recorded an other-than-temporary impairment charge of $ 79.5 on our investment in Abdullah Hashim Industrial Gases & Equipment Co., Ltd. (AHG), a 25 % -owned equity affiliate in our Industrial Gases – EMEA segment. The impairment charge is reflected on our consolidated income statements within “Equity affiliates' income." This charge was not deductible for tax purposes and has been excluded from segment results. +The decline in value resulted from expectations for lower future cash flows to be generated by AHG, primarily due to challenging economic conditions in Saudi Arabia, including the impacts of lower prices in the oil and gas industry, increased competition, and capital project growth opportunities not materializing as anticipated. +The AHG investment was valued based on the results of the income and market valuation approaches. The income approach utilized a discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry required rates of return on debt and equity capital for a target industry capital structure adjusted for risks associated with size and geography. Other significant estimates and assumptions that drove our updated valuation of AHG included revenue growth rates and profit margins that were lower than those upon acquisition and our assessment of AHG's business improvement plan effectiveness. Under the market approach, we estimated fair value based on market multiples of revenue and earnings derived from publicly-traded industrial gases companies engaged in similar lines of business, adjusted to reflect differences in size and growth prospects. +Jazan +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20 -year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. Air Products owns 26 % of the joint venture and guarantees the repayment of its share of an equity bridge loan. ACWA also guarantees their share of the loan. We determined that the joint venture is a variable interest entity, for which we are not the primary beneficiary. +As of 30 September 2018, other noncurrent liabilities included $ 94.4 for our obligation to make future equity contributions in 2020 based on our proportionate share of the advances received by the joint venture under the loan. During 2019, this balance was reclassified from other noncurrent liabilities to payables and accrued liabilities on our consolidated balance sheets as the obligation is required to be funded within the next twelve months. This noncash transaction has been excluded from the consolidated statement of cash flows for the year ended 30 September 2019. +10 . PLANT AND EQUIPMENT, NET +The major classes of plant and equipment are as follows: +30 September +Useful Life +in years +2019 +2018 +Land +$ 281.5 +$ 269.4 +Buildings +30 +946.8 +988.6 +Production facilities (A) +10 +to +20 +15,602.1 +15,082.8 +Distribution and other machinery and equipment (B) +5 +to +25 +4,491.9 +4,400.9 +Construction in progress +1,011.4 +748.5 +Plant and equipment, at cost +22,333.7 +21,490.2 +Less: Accumulated depreciation +11,996.1 +11,566.5 +Plant and equipment, net +$ 10,337.6 +$ 9,923.7 +(A) +Depreciable lives of production facilities related to long-term customer supply contracts are matched to the contract lives. +(B) +The depreciable lives for various types of distribution equipment are: 10 to 25 years for cylinders, depending on the nature and properties of the product; 20 years for tanks; 7.5 years for customer stations; and 5 to 15 years for tractors and trailers. +Depreciation expense was $ 1,049.7 , $ 940.7 , and $ 843.2 in fiscal years 2019 , 2018 , and 2017 , respectively. +76 +Table of Contents +11 . GOODWILL +Changes to the carrying amount of consolidated goodwill by segment are as follows: +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate and other +Total +Goodwill, net at 30 September 2017 +$ 163.7 +$ 402.4 +$ 135.2 +$ 20.2 +$ — +$ 721.5 +Acquisitions +— +29.5 +38.1 +— +10.4 +78.0 +Currency translation and other +( 1.6 +) +( 7.5 +) +( 1.4 +) +( .1 +) +— +( 10.6 +) +Goodwill, net at 30 September 2018 +$ 162.1 +$ 424.4 +$ 171.9 +$ 20.1 +$ 10.4 +$ 788.9 +Acquisitions +— +38.5 +10.1 +— +— +48.6 +Currency translation and other +( 5.8 +) +( 30.6 +) +( 3.5 +) +( .5 +) +— +( 40.4 +) +Goodwill, net at 30 September 2019 +$ 156.3 +$ 432.3 +$ 178.5 +$ 19.6 +$ 10.4 +$ 797.1 +30 September +2019 +2018 +2017 +Goodwill, gross +$ 1,162.2 +$ 1,194.7 +$ 1,138.7 +Accumulated impairment losses (A) +( 365.1 +) +( 405.8 +) +( 417.2 +) +Goodwill, net +$ 797.1 +$ 788.9 +$ 721.5 +(A) +Accumulated impairment losses include the impacts of currency translation. These losses are attributable to our Latin America reporting unit (LASA) within the Industrial Gases – Americas segment. +We review goodwill for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that the carrying value of goodwill might not be recoverable. The impairment test for goodwill involves calculating the fair value of each reporting unit and comparing that value to the carrying value. If the fair value of the reporting unit is less than its carrying value, the difference is recorded as a goodwill impairment charge, not to exceed the total amount of goodwill allocated to that reporting unit. During the fourth quarter of fiscal year 2019 , we conducted our annual goodwill impairment test and determined that the fair value of all our reporting units exceeded their carrying value. +During the third quarter of fiscal year 2017, we conducted an interim impairment test of the goodwill associated with our Latin America Reporting unit (LASA) within the Industrial Gases – Americas segment. This was driven by Management's decision to lower long-term growth projections in response to declining volumes and weak economic conditions in Latin America during fiscal year 2017. We determined that the fair value of LASA was less than its carrying value and recorded a noncash impairment charge of $ 145.3 , which is reflected on our consolidated income statements within “Goodwill and intangible asset impairment charge.” This charge was not deductible for tax purposes and has been excluded from segment operating income. +LASA includes assets and goodwill associated with operations in Chile and other Latin American countries. We estimated the fair value of LASA based on two valuation approaches, the income approach and the market approach. We reviewed relevant facts and circumstances in determining the weighting of the approaches. +Under the income approach, we estimated the fair value of LASA based on the present value of estimated future cash flows. Cash flow projections were based on management’s estimates of revenue growth rates and EBITDA margins, taking into consideration business and market conditions for the Latin American countries and markets in which we operate. We calculated the discount rate based on a market-participant, risk-adjusted weighted average cost of capital, which considers industry‑specific rates of return on debt and equity capital for a target industry capital structure, adjusted for risks associated with business size and geography. +Under the market approach, we estimated fair value based on market multiples of revenue and earnings derived from publicly-traded industrial gases companies and regional manufacturing companies, adjusted to reflect differences in size and growth prospects. +Management judgment is required in the determination of each assumption utilized in the valuation model, and actual results could differ from our estimates. +77 +Table of Contents +12 . INTANGIBLE ASSETS +The table below summarizes the major classes of our intangible assets: +30 September 2019 +30 September 2018 +Gross +Accumulated +Amortization/ +Impairment +Net +Gross +Accumulated +Amortization/ +Impairment +Net +Customer relationships +$ 487.9 +($ 179.8 +) +$ 308.1 +$ 491.9 +($ 165.5 +) +$ 326.4 +Patents and technology +39.0 +( 13.3 +) +25.7 +34.0 +( 11.9 +) +22.1 +Other +75.0 +( 33.4 +) +41.6 +72.6 +( 33.8 +) +38.8 +Total finite-lived intangibles +601.9 +( 226.5 +) +375.4 +598.5 +( 211.2 +) +387.3 +Trade names and trademarks, indefinite-lived +56.2 +( 12.1 +) +44.1 +64.8 +( 13.6 +) +51.2 +Total Intangible Assets +$ 658.1 +($ 238.6 +) +$ 419.5 +$ 663.3 +($ 224.8 +) +$ 438.5 +The decrease in net intangible assets in fiscal year 2019 was primarily attributable to amortization and the impact of currency translation, partially offset by intangible assets acquired through an exchange of equity affiliate investments. For additional information on the exchange, refer to Note 7 , Acquisitions . +Amortization expense for intangible assets was $ 33.1 , $ 30.0 , and $ 22.6 in fiscal years 2019 , 2018 , and 2017 , respectively. Refer to Note 1 , Major Accounting Policies , for the amortization periods for each major class of intangible assets. The table below details p rojected annual amortization expense for intangible assets as of 30 September 2019 : +2020 +$ 35.3 +2021 +33.5 +2022 +30.8 +2023 +29.6 +2024 +28.6 +Thereafter +217.6 +Total +$ 375.4 +Indefinite-lived intangible assets are subject to impairment testing at least annually or more frequently if events or changes in circumstances indicate that potential impairment exists. The impairment test for indefinite-lived intangible assets involves calculating the fair value of the indefinite-lived intangible assets and comparing the fair value to their carrying value. If the fair value is less than the carrying value, the difference is recorded as an impairment loss. During the fourth quarter of fiscal year 2019 , we conducted our annual impairment test of indefinite-lived intangible assets and determined that the fair value of all our intangible assets exceeded their carrying value. +During the third quarter of fiscal year 2017, we conducted an interim impairment test of the indefinite-lived intangible assets associated with LASA and recorded a noncash impairment charge of $ 16.8 to write down the carrying value of the trade names and trademarks to their fair value. The impairment charge has been excluded from the Industrial Gases – Americas segment's operating income and is reflected on our consolidated income statements within “Goodwill and intangible asset impairment charge." As discussed in Note 11 , Goodwill , the reduction in value resulted from lowered long-term growth projections. We estimated the fair value of the indefinite-lived intangibles associated with LASA utilizing the royalty savings method, a form of the income approach. +In addition, we tested the recoverability of LASA long-lived assets, including finite-lived intangible assets subject to amortization, in fiscal year 2017 and concluded that they were recoverable from expected future undiscounted cash flows. +78 +Table of Contents +13 . LEASES +Lessee Accounting +Capital leases, primarily for the right to use machinery and equipment, are included with owned plant and equipment within "Plant and Equipment, net" on the consolidated balance sheets in the amount of $ 23.1 and $ 21.6 at 30 September 2019 and 2018 , respectively. Related amounts of accumulated depreciation are $ 7.2 and $ 6.1 , respectively. +Operating leases principally relate to real estate and also include aircraft, distribution equipment, and vehicles. Certain leases include escalation clauses, renewal, and/or purchase options. Rent expense is recognized on a straight-line basis over the minimum lease term. Rent expense under operating leases, including month-to-month agreements, was $ 87.0 , $ 82.7 , and $ 65.8 in fiscal years 2019 , 2018 , and 2017 , respectively. +At 30 September 2019 , minimum payments due under leases are as follows: +Capital +Leases +Operating +Leases +2020 +$ 1.7 +$ 75.1 +2021 +2.5 +62.6 +2022 +1.3 +44.4 +2023 +1.1 +35.9 +2024 +1.1 +28.6 +Thereafter +12.8 +171.4 +Total +$ 20.5 +$ 418.0 +The present value of the above future capital lease payments totaled $ 10.1 . Refer to Note 16 , Debt . +Lessor Accounting +Certain contracts associated with facilities that are built to provide product to a specific customer have been accounted for as leases. In cases where operating lease treatment is appropriate, there is no difference in revenue recognition over the life of the contract as compared to accounting for the contract under a sale of gas agreement. In cases where capital lease treatment is appropriate, the timing of revenue and expense recognition is impacted. Revenue and expense are recognized up front for the sale of equipment component of the contract as compared to revenue recognition over the life of the arrangement under contracts not qualifying as capital leases. Additionally, a portion of the revenue representing interest income from the financing component of the lease receivable is reflected as sales over the life of the contract. As discussed in Note 2 , New Accounting Guidance , upon adoption of the new lease guidance we will elect the package of practical expedients permitted under the transition guidance to carry forward these lease determinations as of 30 September 2019. +Operating Leases +Assets subject to operating lease treatment in which we are the lessor are recorded within "Plant and equipment, net" on the consolidated balance sheets. As of 30 September 2019 , plant and equipment, at cost, was $ 2.9 billion , and accumulated depreciation was $ .5 billion . Assets subject to operating leases include those of the Lu’An joint venture, which is discussed in Note 7 , Acquisitions . +At 30 September 2019 , minimum lease payments expected to be collected are as follows: +2020 +$ 321.7 +2021 +287.3 +2022 +283.1 +2023 +278.4 +2024 +275.5 +Thereafter +3,042.5 +Total +$ 4,488.5 +79 +Table of Contents +Capital Leases +Lease receivables, net, are primarily included within "Noncurrent capital lease receivables" on our consolidated balance sheets, with the remaining balance in "Other receivables and current assets." Allowances for credit losses associated with capital lease receivables are recorded using the specific identification method. As of 30 September 2019 and 2018 , the credit quality of capital lease receivables did not require a material allowance for credit losses. +The components of lease receivables were as follows: +30 September +2019 +2018 +Gross minimum lease payments receivable +$ 1,453.2 +$ 1,673.7 +Unearned interest income +( 472.3 +) +( 568.3 +) +Lease Receivables, net +$ 980.9 +$ 1,105.4 +Lease payments collected in fiscal years 2019 , 2018 , and 2017 were $ 171.6 , $ 182.7 , and $ 183.6 , respectively. These payments reduced the lease receivable balance by $ 94.6 , $ 97.4 , and $ 92.2 in fiscal years 2019 , 2018 , and 2017 , respectively. +At 30 September 2019 , minimum lease payments expected to be collected are as follows: +2020 +$ 162.5 +2021 +156.9 +2022 +145.7 +2023 +139.4 +2024 +133.2 +Thereafter +715.5 +Total +$ 1,453.2 +14 . FINANCIAL INSTRUMENTS +Currency Price Risk Management +Our earnings, cash flows, and financial position are exposed to foreign currency risk from foreign currency-denominated transactions and net investments in foreign operations. It is our policy to seek to minimize our cash flow volatility from changes in currency exchange rates. This is accomplished by identifying and evaluating the risk that our cash flows will change in value due to changes in exchange rates and by executing strategies necessary to manage such exposures. Our objective is to maintain economically balanced currency risk management strategies that provide adequate downside protection. +Forward Exchange Contracts +We enter into forward exchange contracts to reduce the cash flow exposure to foreign currency fluctuations associated with highly anticipated cash flows and certain firm commitments, such as the purchase of plant and equipment. We also enter into forward exchange contracts to hedge the cash flow exposure on intercompany loans. This portfolio of forward exchange contracts consists primarily of Euros and U.S. Dollars. The maximum remaining term of any forward exchange contract currently outstanding and designated as a cash flow hedge at 30 September 2019 is 2.2 years . +Forward exchange contracts are also used to hedge the value of investments in certain foreign subsidiaries and affiliates by creating a liability in a currency in which we have a net equity position. The primary currency pair in this portfolio of forward exchange contracts is Euros and U.S. Dollars. +We also utilize forward exchange contracts that are not designated as hedges. These contracts are used to economically hedge foreign currency-denominated monetary assets and liabilities, primarily working capital. The primary objective of these forward exchange contracts is to protect the value of foreign currency-denominated monetary assets and liabilities from the effects of volatility in foreign exchange rates that might occur prior to their receipt or settlement. This portfolio of forward exchange contracts consists of many different foreign currency pairs, with a profile that changes from time to time depending on business activity and sourcing decisions. +80 +Table of Contents +The table below summarizes our outstanding currency price risk management instruments: +30 September 2019 +30 September 2018 +US$ +Notional +Years +Average +Maturity +US$ +Notional +Years +Average +Maturity +Forward Exchange Contracts +Cash flow hedges +$ 2,418.2 +0.5 +$ 2,489.1 +0.4 +Net investment hedges +830.8 +0.9 +457.5 +1.7 +Not designated +1,053.5 +0.6 +1,736.1 +0.8 +Total Forward Exchange Contracts +$ 4,302.5 +0.6 +$ 4,682.7 +0.7 +The notional value of forward exchange contracts not designated decreased from the prior year as a result of maturities. +We also use foreign currency-denominated debt to hedge the foreign currency exposures of our net investment in certain foreign subsidiaries. The designated foreign currency-denominated debt and related accrued interest was € 951.3 million ( $ 1,036.9 ) at 30 September 2019 and € 908.8 million ( $ 1,054.6 ) at 30 September 2018 . The designated foreign currency-denominated debt is presented within "Long-term debt" on the consolidated balance sheets. +Debt Portfolio Management +It is our policy to identify on a continuing basis the need for debt capital and evaluate the financial risks inherent in funding the Company with debt capital. Reflecting the result of this ongoing review, our debt portfolio and hedging program are managed with the intent to (1) reduce funding risk with respect to borrowings made by us to preserve our access to debt capital and provide debt capital as required for funding and liquidity purposes, and (2) manage the aggregate interest rate risk and the debt portfolio in accordance with certain debt management parameters. +Interest Rate Management Contracts +We enter into interest rate swaps to change the fixed/variable interest rate mix of our debt portfolio in order to maintain the percentage of fixed- and variable-rate debt within the parameters set by management. In accordance with these parameters, the agreements are used to manage interest rate risks and costs inherent in our debt portfolio. Our interest rate management portfolio generally consists of fixed-to-floating interest rate swaps (which are designated as fair value hedges), pre-issuance interest rate swaps and treasury locks (which hedge the interest rate risk associated with anticipated fixed-rate debt issuances and are designated as cash flow hedges), and floating-to-fixed interest rate swaps (which are designated as cash flow hedges). As of 30 September 2019 , the outstanding interest rate swaps were denominated in U.S. Dollars. The notional amount of the interest rate swap agreements is equal to or less than the designated debt being hedged. When interest rate swaps are used to hedge variable-rate debt, the indices of the swaps and the debt to which they are designated are the same. It is our policy not to enter into any interest rate management contracts which lever a move in interest rates on a greater than one-to-one basis. +Cross Currency Interest Rate Swap Contracts +We enter into cross currency interest rate swap contracts when our risk management function deems necessary. These contracts may entail both the exchange of fixed- and floating-rate interest payments periodically over the life of the agreement and the exchange of one currency for another currency at inception and at a specified future date. The contracts are used to hedge either certain net investments in foreign operations or non-functional currency cash flows related to intercompany loans. The current cross currency interest rate swap portfolio consists of fixed-to-fixed swaps primarily between U.S. Dollars and Chinese Renminbi, U.S. Dollars and Indian Rupee, and U.S. Dollars and Chilean Pesos. +81 +Table of Contents +The following table summarizes our outstanding interest rate management contracts and cross currency interest rate swaps: +30 September 2019 +30 September 2018 +US$ +Notional +Average Pay % +Average +Receive +% +Years +Average +Maturity +US$ +Notional +Average Pay % +Average +Receive +% +Years +Average +Maturity +Interest rate swaps (fair value hedge) +$ 200.0 +LIBOR +2.76 +% +2.1 +$ 600.0 +LIBOR +2.60 +% +1.6 +Cross currency interest rate swaps (net investment hedge) +$ 216.8 +4.80 +% +3.31 +% +3.5 +$ 201.7 +4.42 +% +2.97 +% +3.1 +Cross currency interest rate swaps (cash flow hedge) +$ 1,129.3 +4.92 +% +3.04 +% +2.3 +$ 1,052.7 +4.99 +% +2.89 +% +2.3 +Cross currency interest rate swaps (not designated) +$ 6.1 +2.55 +% +3.72 +% +4.5 +$ 80.2 +4.88 +% +3.43 +% +3.9 +The table below summarizes the fair value and balance sheet location of our outstanding derivatives: +Balance Sheet +30 September +Balance Sheet +30 September +Location +2019 +2018 +Location +2019 +2018 +Derivatives Designated as Hedging Instruments: +Forward exchange contracts +Other receivables +$ 79.0 +$ 24.9 +Accrued liabilities +$ 53.8 +$ 37.0 +Interest rate management contracts +Other receivables +24.8 +24.3 +Accrued liabilities +1.1 +2.3 +Forward exchange contracts +Other noncurrent assets +11.9 +19.8 +Other noncurrent +liabilities +.7 +4.6 +Interest rate management contracts +Other noncurrent assets +60.9 +48.7 +Other noncurrent +liabilities +.7 +11.6 +Total Derivatives Designated as Hedging Instruments +$ 176.6 +$ 117.7 +$ 56.3 +$ 55.5 +Derivatives Not Designated as Hedging Instruments: +Forward exchange contracts +Other receivables +38.7 +7.9 +Accrued liabilities +$ 36.3 +$ 14.9 +Interest rate management contracts +Other receivables +— +4.0 +Accrued liabilities +— +— +Forward exchange contracts +Other noncurrent assets +8.4 +16.2 +Other noncurrent liabilities +19.8 +23.7 +Interest rate management contracts +Other noncurrent assets +.5 +.3 +Other noncurrent +liabilities +— +— +Total Derivatives Not Designated as Hedging Instruments +$ 47.6 +$ 28.4 +$ 56.1 +$ 38.6 +Total Derivatives +$ 224.2 +$ 146.1 +$ 112.4 +$ 94.1 +Refer to Note 15 , Fair Value Measurements , which defines fair value, describes the method for measuring fair value, and provides additional disclosures regarding fair value measurements. +82 +Table of Contents +The table below summarizes the gain or loss related to our cash flow hedges, fair value hedges, net investment hedges, and derivatives not designated as hedging instruments: +Year Ended 30 September +Forward +Exchange Contracts +Foreign +Currency +Debt +Other (A) +Total +2019 +2018 +2019 +2018 +2019 +2018 +2019 +2018 +Cash Flow Hedges, net of tax: +Net gain (loss) recognized in OCI (effective portion) +($ 35.7 +) +$ 2.4 +$— +$— +($ 8.4 +) +$ 43.5 +($ 44.1 +) +$ 45.9 +Net (gain) loss reclassified from OCI to sales/cost of sales (effective portion) +.6 +7.1 +— +— +— +— +.6 +7.1 +Net (gain) loss reclassified from OCI to other income (expense), net (effective portion) +21.8 +( 7.8 +) +— +— +( 24.7 +) +( 33.8 +) +( 2.9 +) +( 41.6 +) +Net (gain) loss reclassified from OCI to interest expense (effective portion) +12.1 +1.2 +— +— +2.6 +3.9 +14.7 +5.1 +Net (gain) loss reclassified from OCI to other income (expense), net (ineffective portion) +— +( .5 +) +— +— +( .1 +) +( .5 +) +( .1 +) +( 1.0 +) +Fair Value Hedges: +Net gain (loss) recognized in interest expense (B) +$ — +$ — +$— +$— +$ 4.3 +($ 10.1 +) +$ 4.3 +($ 10.1 +) +Net Investment Hedges, net of tax: +Net gain (loss) recognized in OCI +$ 39.1 +($ .6 +) +$ 49.6 +$ 10.2 +$ 9.8 +$ 11.0 +$ 98.5 +$ 20.6 +Derivatives Not Designated as Hedging Instruments: +Net gain (loss) recognized in other income (expense), net (C) +($ 1.3 +) +($ 4.0 +) +$— +$— +$ 2.0 +($ .8 +) +$ .7 +($ 4.8 +) +(A) +Includes the impact on other comprehensive income (OCI) and earnings primarily related to interest rate and cross currency interest rate swaps. +(B) +The impact of fair value hedges was largely offset by recognized gains and losses resulting from the impact of changes in related interest rates on outstanding debt. +(C) +The impact of the non-designated hedges was largely offset by recognized gains and losses resulting from the impact of changes in exchange rates on assets and liabilities denominated in non-functional currencies. +The amount of cash unrealized gains and losses related to cash flow hedges as of 30 September 2019 that are expected to be reclassified to earnings in the next twelve months is not material. +The cash flows related to all derivative contracts are reported in the operating activities section of the consolidated statements of cash flows. +Credit Risk-Related Contingent Features +Certain derivative instruments are executed under agreements that require us to maintain a minimum credit rating with both Standard & Poor’s and Moody’s. If our credit rating falls below this threshold, the counterparty to the derivative instruments has the right to request full collateralization on the derivatives’ net liability position. The net liability position of derivatives with credit risk-related contingent features was $ 30.1 as of 30 September 2019 and $ 33.4 as of 30 September 2018 , respectively. Because our current credit rating is above the various pre-established thresholds, no collateral has been posted on these liability positions. +83 +Table of Contents +Counterparty Credit Risk Management +We execute financial derivative transactions with counterparties that are highly rated financial institutions, all of which are investment grade at this time. Some of our underlying derivative agreements give us the right to require the institution to post collateral if its credit rating falls below the pre-established thresholds with Standard & Poor’s or Moody’s. The collateral that the counterparties would be required to post was $ 157.1 as of 30 September 2019 and $ 97.6 as of 30 September 2018 , respectively. No financial institution is required to post collateral at this time, as all have credit ratings at or above threshold. +15 . FAIR VALUE MEASUREMENTS +Fair value is defined as an exit price, or the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. +The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows: +Level 1— +Quoted prices (unadjusted) in active markets for identical assets or liabilities. +Level 2— +Inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the asset or liability. +Level 3— +Inputs that are unobservable for the asset or liability based on our own assumptions (about the assumptions market participants would use in pricing the asset or liability). +The methods and assumptions used to measure the fair value of financial instruments are as follows: +Short-term Investments +Short-term investments primarily include time deposits with original maturities greater than three months and less than one year. We estimated the fair value of our short-term investments, which approximates carrying value as of the balance sheet date, using Level 2 inputs within the fair value hierarchy. Level 2 measurements were based on current interest rates for similar investments with comparable credit risk and time to maturity. +Derivatives +The fair value of our interest rate management contracts and forward exchange contracts are quantified using the income approach and are based on estimates using standard pricing models. These models consider the value of future cash flows as of the balance sheet date, discounted to a present value using discount factors that match both the time to maturity and currency of the underlying instruments. The computation of the fair values of these instruments is generally performed by the Company. These standard pricing models utilize inputs that are derived from or corroborated by observable market data such as interest rate yield curves as well as currency spot and forward rates; therefore, the fair value of our derivatives is classified as a Level 2 measurement. On an ongoing basis, we randomly test a subset of our valuations against valuations received from the transaction’s counterparty to validate the accuracy of our standard pricing models. Counterparties to these derivative contracts are highly rated financial institutions. +Refer to Note 14 , Financial Instruments , for a description of derivative instruments, including details related to the balance sheet line classifications. +Long-term Debt, Including Related Party +The fair value of our debt is based on estimates using standard pricing models that consider the value of future cash flows as of the balance sheet date, discounted to a present value using discount factors that match both the time to maturity and currency of the underlying instruments. These standard valuation models utilize observable market data such as interest rate yield curves and currency spot rates; therefore, the fair value of our debt is classified as a Level 2 measurement. We generally perform the computation of the fair value of these instruments. +84 +Table of Contents +The carrying values and fair values of financial instruments were as follows: +30 September 2019 +30 September 2018 +Carrying Value +Fair Value +Carrying Value +Fair Value +Assets +Derivatives +Forward exchange contracts +$ 138.0 +$ 138.0 +$ 68.8 +$ 68.8 +Interest rate management contracts +86.2 +86.2 +77.3 +77.3 +Liabilities +Derivatives +Forward exchange contracts +$ 110.6 +$ 110.6 +$ 80.2 +$ 80.2 +Interest rate management contracts +1.8 +1.8 +13.9 +13.9 +Long-term debt, including current portion and related party +3,267.8 +3,350.9 +3,758.3 +3,788.2 +The carrying amounts reported on the consolidated balance sheets for cash and cash items, short-term investments, trade receivables, payables and accrued liabilities, accrued income taxes, and short-term borrowings approximate fair value due to the short-term nature of these instruments. Accordingly, these items have been excluded from the above table. +The following table summarizes assets and liabilities on the consolidated balance sheets that are measured at fair value on a recurring basis: +30 September 2019 +30 September 2018 +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +Assets at Fair Value +Derivatives +Forward exchange contracts +$ 138.0 +$ — +$ 138.0 +$ — +$ 68.8 +$ — +$ 68.8 +$ — +Interest rate management contracts +86.2 +— +86.2 +— +77.3 +— +77.3 +— +Total Assets at Fair Value +$ 224.2 +$ — +$ 224.2 +$ — +$ 146.1 +$ — +$ 146.1 +$ — +Liabilities at Fair Value +Derivatives +Forward exchange contracts +$ 110.6 +$ — +$ 110.6 +$ — +$ 80.2 +$ — +$ 80.2 +$ — +Interest rate management contracts +1.8 +— +1.8 +— +13.9 +— +13.9 +— +Total Liabilities at Fair Value +$ 112.4 +$ — +$ 112.4 +$ — +$ 94.1 +$ — +$ 94.1 +$ — +The following is a tabular presentation of nonrecurring fair value measurements along with the level within the fair value hierarchy in which the fair value measurement in its entirety falls: +30 June 2017 +2017 Loss +Total +Level 1 +Level 2 +Level 3 +Investment in Equity Affiliate (A) +$ 68.5 +$ — +$ — +$ 68.5 +$ 79.5 +(A) +In fiscal year 2017, we assessed the recoverability of the carrying value of our equity investment in AHG. We estimated the fair value of our investment using weighting of the results of the income and market approaches. An impairment loss was recognized for the difference between the carrying amount and the fair value of the investment as of 30 June 2017. There have been no events during fiscal years 2018 or 2019 requiring reassessment of our investment. For additional information, see Note 9 , Summarized Financial Information of Equity Affiliates . +85 +Table of Contents +During the third quarter ended 30 June 2017, we recognized a goodwill impairment charge of $ 145.3 and an intangible asset impairment charge of $ 16.8 associated with our LASA reporting unit. Refer to Note 11 , Goodwill , and Note 12 , Intangible Assets , for more information related to these charges and the associated fair value measurement methods and significant inputs/assumptions, which were classified as Level 3 since unobservable inputs were utilized in the fair value measurements. +16 . DEBT +The tables below summarize our outstanding debt at 30 September 2019 and 2018 : +Total Debt +30 September +2019 +2018 +Short-term borrowings +$ 58.2 +$ 54.3 +Current portion of long-term debt (A)(B) +40.4 +406.6 +Long-term debt +2,907.3 +2,967.4 +Long-term debt – related party (B) +320.1 +384.3 +Total Debt +$ 3,326.0 +$ 3,812.6 +(A) +Fiscal year 2019 includes the current portion of long-term debt owed to a related party of $ 37.8 . +(B) +Refer to Note 7 , Acquisitions , for additional information regarding related party debt. +Short-term Borrowings +Short-term borrowings consisted of bank obligations of $ 58.2 and $ 54.3 at 30 September 2019 and 2018 , respectively. The weighted average interest rate of short-term borrowings outstanding at 30 September 2019 and 2018 was 3.7 % and 5.0 % , respectively. +86 +Table of Contents +Long-term Debt +30 September +Fiscal Year +Maturities +2019 +2018 +Payable in U.S. Dollars +Debentures +8.75 % +2021 +$ 18.4 +$ 18.4 +Medium-term Notes (weighted average rate) +Series E 7.6 % +2026 +17.2 +17.2 +Senior Notes +Note 4.375 % +2019 +— +400.0 +Note 3.0 % +2022 +400.0 +400.0 +Note 2.75 % +2023 +400.0 +400.0 +Note 3.35 % +2024 +400.0 +400.0 +Other (weighted average rate) +Variable-rate industrial revenue bonds 1.44 % +2035 to 2050 +631.9 +631.9 +Other .25% (A) +— +.9 +Payable in Other Currencies +Eurobonds 2.0 % +2020 +327.0 +348.1 +Eurobonds .375 % +2021 +381.5 +406.2 +Eurobonds 1.0 % +2025 +327.0 +348.1 +Other 2.9 % +2020 to 2023 +3.8 +8.0 +Related Party (B) +Chinese Renminbi 5.5 % +2020 to 2026 +357.9 +384.3 +Capital Lease Obligations +Foreign 10.3 % +2020 to 2036 +10.1 +10.5 +Total Principal Amount +3,274.8 +3,773.6 +Less: Unamortized discount and debt issuance costs +( 12.2 +) +( 15.3 +) +Less: Fair value hedge accounting adjustments (A) +5.2 +— +Total Long-term Debt +3,267.8 +3,758.3 +Less: Current portion of long-term debt +( 40.4 +) +( 406.6 +) +Less: Long-term debt – related party +( 320.1 +) +( 384.3 +) +Long-term Debt +$ 2,907.3 +$ 2,967.4 +(A) +The Company has entered into LIBOR-based interest rate swap arrangements with various counterparty financial institutions on certain of our outstanding fixed-rate senior notes, which have maturity dates between 2019 and 2022. These interest rate swaps have been designated as fair value hedges of the notes. Refer to Note 14 , Financial Instruments , for additional information. The fiscal year 2018 fair value hedge accounting adjustment is reflected as "Other" senior notes in the table above. +(B) +Refer to Note 7 , Acquisitions , for additional information regarding related party debt. +Maturities of long-term debt, including related party, in each of the next five years and beyond are as follows: +2020 +$ 367.4 +2021 +440.2 +2022 +439.3 +2023 +453.7 +2024 +453.4 +Thereafter +1,120.8 +Total +$ 3,274.8 +87 +Table of Contents +Various debt agreements to which we are a party include financial covenants and other restrictions, including restrictions pertaining to the ability to create property liens and enter into certain sale and leaseback transactions. As of 30 September 2019 , we are in compliance with all the financial and other covenants under our debt agreements. +As of 30 September 2019 , we classified our 2.0 % Eurobond of € 300.0 million ( $ 327.0 ) maturing in August 2020 as long-term debt because we have the ability to refinance the debt under the 2017 Credit Agreement. Our current intent is to refinance this debt via the U.S. or European public or private placement markets. +Additional commitments totaling $ 2.3 are maintained by our foreign subsidiaries, all of which were borrowed and outstanding at 30 September 2019 . +Cash paid for interest, net of amounts capitalized, was $ 155.9 , $ 123.1 , and $ 125.9 in fiscal years 2019 , 2018 , and 2017 , respectively. +2017 Credit Agreement +On 31 March 2017 , we entered into a five -year $ 2,500 revolving credit agreement maturing 31 March 2022 with a syndicate of banks (the “ 2017 Credit Agreement”), under which senior unsecured debt is available to both the Company and certain of its subsidiaries. On 28 September 2018, we amended the 2017 Credit Agreement to reduce the maximum borrowing capacity to $ 2,300 . No other terms were impacted by the amendment. +The 2017 Credit Agreement provides a source of liquidity for the Company and supports our commercial paper program. The Company’s only financial covenant under the 2017 Credit Agreement is a maximum ratio of total debt to total capitalization (total debt plus total equity) no greater than 70 % . No borrowings were outstanding under the 2017 Credit Agreement as of 30 September 2019 . +17 . RETIREMENT BENEFITS +The Company and certain of its subsidiaries sponsor defined benefit pension plans and defined contribution plans that cover a substantial portion of its worldwide employees. The principal defined benefit pension plans are the U.S. salaried pension plan and the U.K. pension plan. These plans were closed to new participants in 2005, after which defined contribution plans were offered to new employees. The principal defined contribution plan is the Retirement Savings Plan, in which a substantial portion of the U.S. employees participate. A similar plan is offered to U.K. employees. We also provide other postretirement benefits consisting primarily of healthcare benefits to U.S. retirees who meet age and service requirements. +88 +Table of Contents +Defined Benefit Pension Plans +Pension benefits earned are generally based on years of service and compensation during active employment. The cost of our defined benefit pension plans in fiscal years 2019 , 2018 , and 2017 included the following components: +2019 +2018 +2017 +U.S. +International +U.S. +International +U.S. +International +Service cost +$ 21.4 +$ 19.3 +$ 25.5 +$ 25.5 +$ 29.0 +$ 25.9 +Interest cost +113.4 +35.8 +107.2 +37.3 +107.5 +32.2 +Expected return on plan assets +( 172.5 +) +( 75.1 +) +( 201.6 +) +( 81.7 +) +( 207.7 +) +( 75.2 +) +Amortization +Net actuarial loss +65.3 +10.9 +87.4 +40.2 +88.7 +54.7 +Prior service cost (credit) +1.1 +— +1.6 +— +2.3 +( .1 +) +Settlements +6.2 +.2 +45.0 +3.5 +10.5 +1.7 +Curtailments +— +— +— +— +4.3 +( 1.3 +) +Special termination benefits +.7 +.1 +.4 +— +2.8 +.4 +Other +— +.8 +— +1.5 +— +1.1 +Net Periodic Benefit Cost/(Benefit) – Total +$ 35.6 +($ 8.0 +) +$ 65.5 +$ 26.3 +$ 37.4 +$ 39.4 +Less: Discontinued Operations +— +— +— +— +( .7 +) +( 4.1 +) +Net Periodic Benefit Cost/(Benefit) – Continuing Operations +$ 35.6 +($ 8.0 +) +$ 65.5 +$ 26.3 +$ 36.7 +$ 35.3 +Our service costs are primarily included within "Cost of sales" and "Selling and administrative" on our consolidated income statements. The amount of service costs capitalized in fiscal years 2019 and 2018 and the amount of net periodic benefit costs capitalized in fiscal year 2017 were not material. The non-service related costs, including pension settlement losses, are presented outside operating income within "Other non-operating income (expense), net." +During the fourth quarter of fiscal year 2018, we recognized a pension settlement loss of $ 43.7 primarily in connection with the transfer of certain pension assets and payment obligations for our U.S. salaried and hourly plans to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract. The transaction does not change the amount of the monthly pension benefits received by affected retirees. +Certain of our pension plans provide for a lump sum benefit payment option at the time of retirement, or for corporate officers, six months after their retirement date. A participant’s vested benefit is considered settled upon cash payment of the lump sum. We recognize pension settlement losses when cash payments exceed the sum of the service and interest cost components of net periodic benefit cost of the plan for the fiscal year. We recognized pension settlement losses of $ 6.2 , $ 5.2 and $ 10.5 in fiscal years 2019, 2018 and 2017 , respectively, to accelerate recognition of a portion of actuarial losses deferred in accumulated other comprehensive loss, primarily associated with the U.S. supplementary pension plan. +89 +Table of Contents +We calculate net periodic benefit cost for a given fiscal year based on assumptions developed at the end of the previous fiscal year. The following table sets forth the weighted average assumptions used in the calculation of net periodic benefit cost: +2019 +2018 +2017 +U.S. +International +U.S. +International +U.S. +International +Discount rate – Service cost +4.3 +% +2.5 +% +3.9 +% +2.6 +% +3.6 +% +2.1 +% +Discount rate – Interest cost +4.0 +% +2.2 +% +3.3 +% +2.2 +% +3.0 +% +1.8 +% +Expected return on plan assets +7.0 +% +5.3 +% +7.5 +% +5.8 +% +8.0 +% +6.1 +% +Rate of compensation increase +3.5 +% +3.5 +% +3.5 +% +3.6 +% +3.5 +% +3.5 +% +The projected benefit obligation (PBO) is the actuarial present value of benefits attributable to employee service rendered to date, including the effects of estimated future salary increases. The following table sets forth the weighted average assumptions used in the calculation of the PBO: +2019 +2018 +U.S. +International +U.S. +International +Discount rate +3.2 +% +1.5 +% +4.3 +% +2.5 +% +Rate of compensation increase +3.5 +% +3.3 +% +3.5 +% +3.5 +% +The following tables reflect the change in the PBO and the change in the fair value of plan assets based on the plan year measurement date, as well as the amounts recognized in the consolidated balance sheets: +2019 +2018 +U.S. +International +U.S. +International +Change in Projected Benefit Obligation +Obligation at beginning of year +$ 2,922.8 +$ 1,660.5 +$ 3,357.7 +$ 1,749.5 +Service cost +21.4 +19.3 +25.5 +25.5 +Interest cost +113.4 +35.8 +107.2 +37.3 +Amendments +1.1 +4.7 +.1 +.7 +Actuarial loss (gain) +380.3 +300.2 +( 217.8 +) +( 33.9 +) +Settlements +( 12.2 +) +( 1.6 +) +( 193.0 +) +( 24.6 +) +Special termination benefits +.7 +.1 +.4 +— +Participant contributions +— +1.3 +— +1.4 +Benefits paid +( 146.2 +) +( 47.7 +) +( 157.3 +) +( 51.3 +) +Currency translation and other +.3 +( 108.6 +) +— +( 44.1 +) +Obligation at End of Year +$ 3,281.6 +$ 1,864.0 +$ 2,922.8 +$ 1,660.5 +2019 +2018 +U.S. +International +U.S. +International +Change in Plan Assets +Fair value at beginning of year +$ 2,684.9 +$ 1,588.2 +$ 2,869.2 +$ 1,540.0 +Actual return on plan assets +289.9 +208.0 +150.2 +115.5 +Company contributions +16.0 +24.2 +14.6 +53.7 +Participant contributions +— +1.3 +— +1.4 +Benefits paid +( 146.2 +) +( 47.7 +) +( 157.3 +) +( 51.3 +) +Settlements +( 12.2 +) +( 1.6 +) +( 191.8 +) +( 24.6 +) +Currency translation and other +— +( 100.0 +) +— +( 46.5 +) +Fair Value at End of Year +$ 2,832.4 +$ 1,672.4 +$ 2,684.9 +$ 1,588.2 +Funded Status at End of Year +($ 449.2 +) +($ 191.6 +) +($ 237.9 +) +($ 72.3 +) +90 +Table of Contents +2019 +2018 +U.S. +International +U.S. +International +Amounts Recognized +Noncurrent assets +$ 17.3 +$ 11.4 +$ 28.2 +$ 103.5 +Accrued liabilities +18.3 +— +23.5 +1.2 +Noncurrent liabilities +448.2 +203.0 +242.6 +174.6 +Net Liability Recognized +$ 449.2 +$ 191.6 +$ 237.9 +$ 72.3 +Fiscal year 2018 settlements in the table above primarily reflect the impact of the transfer of certain pension obligations and plan assets of our U.S. salaried and hourly plans to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract in the fourth quarter of fiscal year 2018. +The changes in plan assets and benefit obligation that have been recognized in other comprehensive income on a pretax basis during fiscal years 2019 and 2018 consist of the following: +2019 +2018 +U.S. +International +U.S. +International +Net actuarial loss (gain) arising during the period +$ 262.9 +$ 161.5 +($ 167.7 +) +($ 64.6 +) +Amortization of net actuarial loss +( 71.5 +) +( 11.1 +) +( 132.4 +) +( 43.7 +) +Prior service cost arising during the period +1.1 +4.7 +.1 +.7 +Amortization of prior service cost +( 1.1 +) +— +( 1.6 +) +— +Total +$ 191.4 +$ 155.1 +($ 301.6 +) +($ 107.6 +) +The net actuarial gain represents the actual changes in the estimated obligation and plan assets that have not yet been recognized in the consolidated income statements and are included in accumulated other comprehensive loss. Actuarial losses arising during fiscal year 2019 are primarily attributable to lower discount rates and partially offset by higher than expected return on plan assets. Accumulated actuarial gains and losses that exceed a corridor are amortized over the average remaining service period of U.S. participants, which was approximately 7 years as of 30 September 2019 . For U.K. participants, accumulated actuarial gains and losses that exceed a corridor are amortized over the average remaining life expectancy, which was approximately 25 years as of 30 September 2019. +The components recognized in accumulated other comprehensive loss on a pretax basis at 30 September consisted of the following: +2019 +2018 +U.S. +International +U.S. +International +Net actuarial loss +$ 871.8 +$ 594.0 +$ 680.4 +$ 443.6 +Prior service cost (credit) +6.6 +3.6 +6.6 +( 1.1 +) +Net transition liability +— +.4 +— +.4 +Total +$ 878.4 +$ 598.0 +$ 687.0 +$ 442.9 +The amount of accumulated other comprehensive loss at 30 September 2019 that is expected to be recognized as a component of net periodic pension cost during fiscal year 2020 , excluding amounts that may be recognized through settlement losses, is as follows: +U.S. +International +Net actuarial loss +$ 84.2 +$ 19.2 +Prior service cost (credit) +1.4 +— +The accumulated benefit obligation (ABO) is the actuarial present value of benefits attributed to employee service rendered to a particular date, based on current salaries. The ABO for all defined benefit pension plans was $ 4,931.6 and $ 4,376.4 as of 30 September 2019 and 2018 , respectively. +91 +Table of Contents +The following table provides information on pension plans where the benefit liability exceeds the value of plan assets: +30 September 2019 +30 September 2018 +U.S. +International +U.S. +International +Pension Plans with PBO in Excess of Plan Assets: +PBO +$ 3,069.2 +$ 521.1 +$ 2,733.6 +$ 452.6 +Fair value of plan assets +2,602.8 +318.0 +2,467.5 +276.8 +Pension Plans with ABO in Excess of Plan Assets: +ABO +$ 2,941.2 +$ 413.3 +$ 2,608.6 +$ 357.9 +Fair value of plan assets +2,602.8 +266.5 +2,467.5 +228.2 +The tables above include several pension arrangements that are not funded because of jurisdictional practice. The ABO and PBO related to these plans as of 30 September 2019 were $ 92.6 and $ 99.2 , respectively. +Pension Plan Assets +Our pension plan investment strategy is to invest in diversified portfolios to earn a long-term return consistent with acceptable risk in order to pay retirement benefits and meet regulatory funding requirements while minimizing company cash contributions over time. De-risking strategies are also employed for closed plans as funding improves, generally resulting in higher allocations to long duration bonds. The plans invest primarily in passive and actively managed equity and debt securities. Equity investments are diversified geographically and by investment style and market capitalization. Fixed income investments include sovereign, corporate and asset-backed securities generally denominated in the currency of the plan. +Asset allocation targets are established based on the long-term return, volatility and correlation characteristics of the asset classes, the profiles of the plans’ liabilities, and acceptable levels of risk. As of 30 September 2019, actual allocations vary from target due to market movements, primarily lower interest rates in the fourth quarter. Subsequent to 30 September 2019, rebalancing actions have been taken so that the U.S. salaried and hourly plan portfolio is within asset allocation target ranges. Assets are routinely rebalanced through contributions, benefit payments, and otherwise as deemed appropriate. The actual and target allocations at the measurement date are as follows: +2019 Target Allocation +2019 Actual Allocation +2018 Actual Allocation +U.S. +International +U.S. +International +U.S. +International +Asset Category +Equity securities +43 +- +58 % +39 +- +49 % +38 +% +42 +% +41 +% +46 +% +Debt securities +34 +- +49 % +51 +- +61 % +56 +% +57 +% +50 +% +53 +% +Real estate and other +— +- +10 % +—% +6 +% +— +% +8 +% +— +% +Cash +—% +—% +— +% +1 +% +1 +% +1 +% +Total +100 +% +100 +% +100 +% +100 +% +In fiscal year 2019, the 7.0 % expected return for U.S. plan assets was based on a weighted average of estimated long-term returns of major asset classes and the historical performance of plan assets. The estimated long-term return for equity, debt securities, and real estate is 7.8 % , 4.7 % , and 6.5 % , respectively. In determining asset class returns, we take into account historical long-term returns and the value of active management, as well as other economic and market factors. +In fiscal year 2019, the 5.3 % expected rate of return for international plan assets was based on a weighted average return for plans outside the U.S., which vary significantly in size, asset structure and expected returns. The expected asset return for the U.K. plan, which represents over 80 % of the assets of our International plans, is 5.8 % and was derived from expected equity and debt security returns of 7.4 % and 2.7 % , respectively. +92 +Table of Contents +The following table summarizes pension plan assets measured at fair value by asset class (see Note 15 , Fair Value Measurements , for definition of the levels): +30 September 2019 +30 September 2018 +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +U.S. Qualified Pension Plans +Cash and cash equivalents +$ 13.7 +$ 13.7 +$ — +$ — +$ 13.8 +$ 13.8 +$ — +$ — +Equity securities +401.1 +401.1 +— +— +397.9 +397.9 +— +— +Equity mutual funds +152.9 +152.9 +— +— +173.8 +173.8 +— +— +Equity pooled funds +524.8 +— +524.8 +— +545.2 +— +545.2 +— +Fixed income: +Bonds (government +and corporate) +1,572.1 +— +1,572.1 +— +1,344.6 +— +1,344.6 +— +Total U.S. Qualified Pension Plans at Fair Value +$ 2,664.6 +$ 567.7 +$ 2,096.9 +$ — +$ 2,475.3 +$ 585.5 +$ 1,889.8 +$ — +Real estate pooled funds (A) +$ 167.8 +$ 209.6 +Total U.S. Qualified Pension Plans +$ 2,832.4 +$ 2,684.9 +International Pension Plans +Cash and cash equivalents +$ 13.4 +$ 13.4 +$ — +$ — +$ 15.8 +$ 15.8 +$ — +$ — +Equity pooled funds +711.3 +— +711.3 +— +727.9 +— +727.9 +— +Fixed income pooled funds +679.9 +— +679.9 +— +615.2 +— +615.2 +— +Other pooled funds +13.7 +— +13.7 +— +11.6 +— +11.6 +— +Insurance contracts +254.1 +— +— +254.1 +217.7 +— +— +217.7 +Total International Pension Plans +$ 1,672.4 +$ 13.4 +$ 1,404.9 +$ 254.1 +$ 1,588.2 +$ 15.8 +$ 1,354.7 +$ 217.7 +(A) +Real estate pooled funds consist of funds that invest in properties. These funds generally allow for quarterly redemption with 30 days' notice. Timing for redemption could be delayed based on the priority of our request and the availability of funds. Interests in these funds are valued using the net asset value (NAV) per share practical expedient and are not classified in the fair value hierarchy. +The following table summarizes changes in fair value of the pension plan assets classified as Level 3, by asset class: +Other +Pooled Funds +Insurance +Contracts +Total +30 September 2017 +$ 7.8 +$ 41.4 +$ 49.2 +Actual return on plan assets: +Assets held at end of year +— +.9 +.9 +Assets sold during the period +.5 +— +.5 +Purchases, sales, and settlements, net +( 8.3 +) +175.4 +167.1 +30 September 2018 +$ — +$ 217.7 +$ 217.7 +Actual return on plan assets: +Assets held at end of year +— +38.1 +38.1 +Purchases, sales, and settlements, net +— +( 1.7 +) +( 1.7 +) +30 September 2019 +$ — +$ 254.1 +$ 254.1 +93 +Table of Contents +The descriptions and fair value methodologies for the U.S. and International pension plan assets are as follows: +Cash and Cash Equivalents +The carrying amounts of cash and cash equivalents approximate fair value due to the short-term maturity. +Equity Securities +Equity securities are valued at the closing market price reported on a U.S. or international exchange where the security is actively traded and are therefore classified as Level 1 assets. +Equity Mutual and Pooled Funds +Shares of mutual funds are valued at the NAV of the fund and are classified as Level 1 assets. Units of pooled funds are valued at the per unit NAV determined by the fund manager based on the value of the underlying traded holdings and are classified as Level 2 assets. +Corporate and Government Bonds +Corporate and government bonds are classified as Level 2 assets, as they are either valued at quoted market prices from observable pricing sources at the reporting date or valued based upon comparable securities with similar yields and credit ratings. +Other Pooled Funds +Other pooled funds classified as Level 2 assets are valued at the NAV of the shares held at year end, which is based on the fair value of the underlying investments. Securities and interests classified as Level 3 assets are carried at the estimated fair value. The estimated fair value is based on the fair value of the underlying investment values, which includes estimated bids from brokers or other third-party vendor sources that utilize expected cash flow streams and other uncorroborated data including counterparty credit quality, default risk, discount rates, and the overall capital market liquidity. +Insurance Contracts +Insurance contracts are classified as Level 3 assets, as they are carried at contract value, which approximates the estimated fair value. The estimated fair value is based on the fair value of the underlying investment of the insurance company and discount rates that require inputs with limited observability. +Contributions and Projected Benefit Payments +Pension contributions to funded plans and benefit payments for unfunded plans for fiscal year 2019 were $ 40.2 . Contributions for funded plans resulted primarily from contractual and regulatory requirements. Benefit payments to unfunded plans were due primarily to the timing of retirements. We anticipate contributing $ 30 to $ 40 to the defined benefit pension plans in fiscal year 2020 . These contributions are anticipated to be driven primarily by contractual and regulatory requirements for funded plans and benefit payments for unfunded plans, which are dependent upon timing of retirements. +Projected benefit payments, which reflect expected future service, are as follows: +U.S. +International +2020 +$ 166.8 +$ 47.9 +2021 +160.0 +49.1 +2022 +166.0 +50.1 +2023 +170.1 +54.3 +2024 +174.1 +58.0 +2025-2029 +919.9 +308.3 +These estimated benefit payments are based on assumptions about future events. Actual benefit payments may vary significantly from these estimates. +94 +Table of Contents +U.K. Lloyds Equalization Ruling +On 26 October 2018, the United Kingdom High Court issued a ruling related to the equalization of pension plan participants’ benefits for the gender effects of Guaranteed Minimum Pensions. As a result of this ruling, we estimated the impact of retroactively increasing benefits in our U.K. plan in accordance with the High Court ruling. We treated the additional benefits as a prior service cost, which resulted in an increase to our projected benefit obligation and accumulated other comprehensive loss of $ 4.7 during the first quarter of fiscal year 2019. We are amortizing this cost over the average remaining life expectancy of the U.K. participants. +Defined Contribution Plans +We maintain a nonleveraged employee stock ownership plan (ESOP) which forms part of the Air Products and Chemicals, Inc. Retirement Savings Plan (RSP). The ESOP was established in May of 2002. The balance of the RSP is a qualified defined contribution plan including a 401(k) elective deferral component. A substantial portion of U.S. employees are eligible and participate. +We treat dividends paid on ESOP shares as ordinary dividends. Under existing tax law, we may deduct dividends which are paid with respect to shares held by the plan. Shares of the Company’s common stock in the ESOP totaled 2,197,262 as of 30 September 2019 . +Our contributions to the RSP include a Company core contribution for certain eligible employees who do not receive their primary retirement benefit from the defined benefit pension plans, with the core contribution based on a percentage of pay that is dependent on years of service. For the RSP, we also make matching contributions on overall employee contributions as a percentage of the employee contribution and include an enhanced contribution for certain eligible employees that do not participate in the defined benefit pension plans. Worldwide contributions, excluding discontinued operations, expensed to income in fiscal years 2019 , 2018 , and 2017 were $ 40.6 , $ 34.2 , and $ 33.7 , respectively. +Other Postretirement Benefits +We provide other postretirement benefits consisting primarily of healthcare benefits to certain U.S. retirees who meet age and service requirements. The healthcare benefit is a continued medical benefit until the retiree reaches age 65. Healthcare benefits are contributory, with contributions adjusted periodically. The retiree medical costs are capped at a specified dollar amount, with the retiree contributing the remainder. The cost of these benefits were not material in fiscal years 2019 , 2018 , and 2017 . Accumulated postretirement benefit obligations as of the end of fiscal years 2019 and 2018 were $ 43.7 and $ 56.4 , respectively, of which $ 7.7 and $ 9.4 were current obligations, respectively. +We recognize changes in other postretirement benefit plan obligations in other comprehensive income on a pretax basis. In fiscal years 2019 and 2018 , we recognized gains that arose during the period of $ 6.1 and $ 3.1 , respectively. In fiscal year 2018, we recognized net actuarial loss amortization of $ .3 . There was no net actuarial loss amortization in fiscal year 2019 as the corridor for the plan was not exceeded. +The net actuarial gain/loss recognized in accumulated other comprehensive loss on a pretax basis was a net gain of $ 1.7 and a net loss of $ 4.4 as of 30 September 2019 and 2018 , respectively. +Expected per capita claims costs are currently assumed to be greater than the annual cap; therefore, the assumed healthcare cost trend rate, ultimate trend rate, and the year the ultimate trend rate is reached have no impact on plan obligations. +95 +Table of Contents +18 . COMMITMENTS AND CONTINGENCIES +LITIGATION +We are involved in various legal proceedings, including commercial, competition, environmental, intellectual property, regulatory, product liability, and insurance matters . In September 2010, the Brazilian Administrative Council for Economic Defense (CADE) issued a decision against our Brazilian subsidiary, Air Products Brasil Ltda., and several other Brazilian industrial gas companies for alleged anticompetitive activities. CADE imposed a civil fine of R$ 179.2 million (approximately $ 43 at 30 September 2019 ) on Air Products Brasil Ltda. This fine was based on a recommendation by a unit of the Brazilian Ministry of Justice, whose investigation began in 2003, alleging violation of competition laws with respect to the sale of industrial and medical gases. The fines are based on a percentage of our total revenue in Brazil in 2003. +We have denied the allegations made by the authorities and filed an appeal in October 2010 with the Brazilian courts. On 6 May 2014, our appeal was granted and the fine against Air Products Brasil Ltda. was dismissed. CADE has appealed that ruling and the matter remains pending. We, with advice of our outside legal counsel, have assessed the status of this matter and have concluded that, although an adverse final judgment after exhausting all appeals is possible, such a judgment is not probable. As a result, no provision has been made in the consolidated financial statements. We estimate the maximum possible loss to be the full amount of the fine of R$ 179.2 million (approximately $ 43 at 30 September 2019 ) plus interest accrued thereon until final disposition of the proceedings. +Other than this matter, we do not currently believe there are any legal proceedings, individually or in the aggregate, that are reasonably possible to have a material impact on our financial condition, results of operations, or cash flows. +ENVIRONMENTAL +In the normal course of business, we are involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA," the federal Superfund law), Resource Conservation and Recovery Act ("RCRA"), and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Presently, there are 31 sites on which a final settlement has not been reached where we, along with others, have been designated a potentially responsible party by the Environmental Protection Agency or are otherwise engaged in investigation or remediation, including cleanup activity at certain of our current and former manufacturing sites. We continually monitor these sites for which we have environmental exposure. +Accruals for environmental loss contingencies are recorded when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The consolidated balance sheets at 30 September 2019 and 2018 included an accrual of $ 68.9 and $ 76.8 , respectively, primarily as part of other noncurrent liabilities. The environmental liabilities will be paid over a period of up to 30 years . We estimate the exposure for environmental loss contingencies to range from $ 68 to a reasonably possible upper exposure of $ 82 as of 30 September 2019 . +Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Using reasonably possible alternative assumptions of the exposure level could result in an increase to the environmental accrual. Due to the inherent uncertainties related to environmental exposures, a significant increase to the reasonably possible upper exposure level could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or a significant increase in our proportionate share occurs. We do not expect that any sum we may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed above would have a material adverse impact on our financial position or results of operations in any one year. +Pace +At 30 September 2019 , $ 24.3 of the environmental accrual was related to the Pace facility. +In 2006, we sold our Amines business, which included operations at Pace, Florida, and recognized a liability for retained environmental obligations associated with remediation activities at Pace. We are required by the Florida Department of Environmental Protection (FDEP) and the United States Environmental Protection Agency (USEPA) to continue our remediation efforts. We estimated that it would take a substantial period of time to complete the groundwater remediation, and the costs through completion were estimated to range from $ 42 to $ 52 . As no amount within the range was a better estimate than another, we recognized a before-tax expense of $ 42 in fiscal 2006 as a component of income from discontinued operations and recorded an environmental accrual of $ 42 in continuing operations on the consolidated balance sheets. There has been no change to the estimated exposure range related to the Pace facility. +96 +Table of Contents +We have implemented many of the remedial corrective measures at the Pace facility required under 1995 Consent Orders issued by the FDEP and the USEPA. Contaminated soils have been bioremediated, and the treated soils have been secured in a lined on-site disposal cell. Several groundwater recovery systems have been installed to contain and remove contamination from groundwater. We completed an extensive assessment of the site to determine how well existing measures are working, what additional corrective measures may be needed, and whether newer remediation technologies that were not available in the 1990s might be suitable to more quickly and effectively remove groundwater contaminants. Based on assessment results, we completed a focused feasibility study that has identified alternative approaches that may more effectively remove contaminants. We continue to review alternative remedial approaches with the FDEP and have started additional field work to support the design of an improved groundwater recovery network with the objective of targeting areas of higher contaminant concentration and avoiding areas of high groundwater iron which has proven to be a significant operability issue for the project. In the first quarter of 2015, we entered into a new Consent Order with the FDEP requiring us to continue our remediation efforts at the Pace facility. The costs we are incurring under the new Consent Order are consistent with our previous estimates. +Piedmont +At 30 September 2019 , $ 14.7 of the environmental accrual was related to the Piedmont site. +On 30 June 2008, we sold our Elkton, Maryland, and Piedmont, South Carolina, production facilities and the related North American atmospheric emulsions and global pressure sensitive adhesives businesses. In connection with the sale, we recognized a liability for retained environmental obligations associated with remediation activities at the Piedmont site. This site is under active remediation for contamination caused by an insolvent prior owner. +We are required by the South Carolina Department of Health and Environmental Control (SCDHEC) to address both contaminated soil and groundwater. Numerous areas of soil contamination have been addressed, and contaminated groundwater is being recovered and treated. The SCDHEC issued its final approval to the site-wide feasibility study on 13 June 2017 and the Record of Decision for the site on 27 June 2018. Field work has started to support the remedial design, and in the fourth quarter of fiscal year 2018, we signed a Consent Agreement Amendment memorializing our obligations to complete the cleanup of the site. We estimate that source area remediation and groundwater recovery and treatment will continue through 2029. Thereafter, we expect this site to go into a state of monitored natural attenuation through 2047. +We recognized a before-tax expense of $ 24 in 2008 as a component of income from discontinued operations and recorded an environmental liability of $ 24 in continuing operations on the consolidated balance sheets. There have been no significant changes to the estimated exposure. +Pasadena +At 30 September 2019 , $ 11.8 of the environmental accrual was related to the Pasadena site. +During the fourth quarter of 2012, management committed to permanently shutting down our polyurethane intermediates (PUI) production facility in Pasadena, Texas. In shutting down and dismantling the facility, we have undertaken certain obligations related to soil and groundwater contaminants. We have been pumping and treating groundwater to control off-site contaminant migration in compliance with regulatory requirements and under the approval of the Texas Commission on Environmental Quality (TCEQ). We estimate that the pump and treat system will continue to operate until 2042 . +We plan to perform additional work to address other environmental obligations at the site. This additional work includes remediating, as required, impacted soils, investigating groundwater west of the former PUI facility, performing post closure care for two closed RCRA surface impoundment units, and establishing engineering controls. In 2012, we estimated the total exposure at this site to be $ 13 . There have been no significant changes to the estimated exposure. +97 +Table of Contents +ASSET RETIREMENT OBLIGATIONS +Our asset retirement obligations are primarily associated with long-term on-site supply contracts under which we have built a facility on land owned by the customer and are obligated to remove the facility at the end of the contract term. The retirement of assets includes the contractually required removal of a long-lived asset from service and encompasses the sale, removal, abandonment, recycling, or disposal of the assets as required at the end of the contract term. These obligations are primarily reflected within "Other noncurrent liabilities" on the consolidated balance sheets. The timing and/or method of settlement of these obligations are conditional on a future event that may or may not be within our control. +Changes to the carrying amount of our asset retirement obligations were as follows: +Balance at 30 September 2017 +$ 144.7 +Additional accruals +43.8 +Liabilities settled +( 2.6 +) +Accretion expense +7.2 +Currency translation adjustment +( 2.7 +) +Balance at 30 September 2018 +$ 190.4 +Additional accruals +14.7 +Liabilities settled +( 2.1 +) +Accretion expense +8.7 +Currency translation adjustment +( 3.5 +) +Balance at 30 September 2019 +$ 208.2 +The increase in the liability during fiscal year 2018 primarily related to new obligations associated with the Lu'An asset acquisition completed in April 2018. +GUARANTEES AND WARRANTIES +We guaranteed the repayment of our 25 % share of an equity bridge loan that has been provided to fund equity commitments to a joint venture arrangement with ACWA Holding in Saudi Arabia. ACWA also guarantees their share of the loan. Our maximum exposure under the guarantee, which expires in 2020, is approximately $ 100 . As of 30 September 2018, other noncurrent liabilities included $ 94.4 for our obligation to make future equity contributions in 2020 based on our proportionate share of the advances received by the joint venture under the loan. During 2019, this balance was reclassified from other noncurrent liabilities to payables and accrued liabilities on our consolidated balance sheets as the obligation is required to be funded within the next twelve months. +Air Products has also entered into a long-term sale of equipment contract with the joint venture to engineer, procure, and construct the industrial gas facilities that will supply gases to Saudi Aramco. We provided bank guarantees to the joint venture to support our performance under the contract. As of 30 September 2019 , our maximum potential payments were $ 247 . Exposures under the guarantees decline over time and will be completely extinguished after completion of the project. +We are party to an equity support agreement and operations guarantee related to an air separation facility constructed in Trinidad for a venture in which we own 50 % . At 30 September 2019 , maximum potential payments under joint and several guarantees were $ 26.0 . Exposures under the guarantees decline over time and will be completely extinguished by 2024 . +To date, no equity contributions or payments have been made since the inception of these guarantees. The fair value of the above guarantees is not material. +We, in the normal course of business operations, have issued product warranties related to equipment sales. Also, contracts often contain standard terms and conditions which typically include a warranty and indemnification to the buyer that the goods and services purchased do not infringe on third-party intellectual property rights. The provision for estimated future costs relating to warranties is not material to the consolidated financial statements. +We do not expect that any sum we may have to pay in connection with guarantees and warranties will have a material adverse effect on our consolidated financial condition, liquidity, or results of operations. +98 +Table of Contents +UNCONDITIONAL PURCHASE OBLIGATIONS +We are obligated to make future payments under unconditional purchase obligations as summarized below: +2020 +$ 1,358 +2021 +407 +2022 +369 +2023 +349 +2024 +350 +Thereafter +5,477 +Total +$ 8,310 +Approximately $ 7,100 of our unconditional purchase obligations relate to helium purchases. The majority of these obligations occur after fiscal year 2024. Helium purchases include crude feedstock supply to helium refining plants in North America as well as refined helium purchases from sources around the world. As a rare byproduct of natural gas production in the energy sector, these helium sourcing agreements are medium- to long-term and contain take-if-tendered provisions. The refined helium is distributed globally and sold as a merchant gas, primarily under medium-term requirements contracts. While contract terms in our helium sourcing contracts are generally longer than our customer sales contracts, helium is a rare gas used in applications with few or no substitutions because of its unique physical and chemical properties. +Approximately $ 160 of our long-term unconditional purchase obligations relate to feedstock supply for numerous HyCO (hydrogen, carbon monoxide, and syngas) facilities. The price of feedstock supply is principally related to the price of natural gas. However, long-term take-or-pay sales contracts to HyCO customers are generally matched to the term of the feedstock supply obligations and provide recovery of price increases in the feedstock supply. Due to the matching of most long-term feedstock supply obligations to customer sales contracts, we do not believe these purchase obligations would have a material effect on our financial condition or results of operations. +The unconditional purchase obligations also include other product supply and purchase commitments and electric power and natural gas supply purchase obligations, which are primarily pass-through contracts with our customers. +We estimate our maximum obligation for future purchases of plant and equipment to be approximately $ 890 based on open purchase orders as of 30 September 2019. This includes spending for the Jiutai coal-to-syngas project. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to reschedule, cancel, or otherwise modify based on our business needs. We have disclosed this obligation in fiscal year 2020; however, timing of actual satisfaction of the obligation may vary. +19 . CAPITAL STOCK +Common Stock +Authorized common stock consists of 300 million shares with a par value of $ 1 per share. As of 30 September 2019 , 249 million shares were issued, with 220 million outstanding. +On 15 September 2011, the Board of Directors authorized the repurchase of up to $ 1.0 billion of our outstanding common stock. We repurchase shares pursuant to Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended, through repurchase agreements established with several brokers. We did not purchase any of our outstanding shares during fiscal year 2019 . At 30 September 2019 , $ 485.3 in share repurchase authorization remains. +The following table reflects the changes in common shares: +Year ended 30 September +2019 +2018 +2017 +Number of Common Shares Outstanding +Balance, beginning of year +219,515,245 +218,346,074 +217,350,825 +Issuance of treasury shares for stock option and award plans +900,017 +1,169,171 +995,249 +Balance, end of year +220,415,262 +219,515,245 +218,346,074 +99 +Table of Contents +Preferred Stock +Authorized preferred stock consists of 25 million shares with a par value of $ 1 per share, of which 2.5 million were designated as Series A Junior Participating Preferred Stock. There were no shares issued or outstanding as of 30 September 2019 and 2018 . +20 . SHARE-BASED COMPENSATION +We have various share-based compensation programs, which include deferred stock units, stock options, and restricted stock. Under all programs, the terms of the awards are fixed at the grant date. We issue shares from treasury stock upon the payout of deferred stock units, the exercise of stock options, and the issuance of restricted stock awards. Share information presented is on a total company basis. As of 30 September 2019 , there were 4,581,960 shares available for future grant under our Long-Term Incentive Plan (LTIP), which is shareholder approved. +Share-based compensation cost recognized in the consolidated income statements is summarized below: +2019 +2018 +2017 +Before-Tax Share-Based Compensation Cost – Total +$ 41.2 +$ 38.8 +$ 40.7 +Before-Tax Share-Based Compensation Cost – Discontinued Operations +— +— +.8 +Before-Tax Share-Based Compensation Cost – Continuing Operations +$ 41.2 +$ 38.8 +$ 39.9 +Income tax benefit – Continuing Operations +( 9.7 +) +( 9.1 +) +( 14.0 +) +After-Tax Share-Based Compensation Cost – Continuing Operations +$ 31.5 +$ 29.7 +$ 25.9 +Before-tax share-based compensation cost is primarily included in selling and administrative expense on our consolidated income statements. The amount of share-based compensation cost capitalized in fiscal years 2019 , 2018 , and 2017 was not material. +On a total company basis, before-tax share-based compensation cost by type of program was as follows: +2019 +2018 +2017 +Deferred stock units +$ 41.1 +$ 38.3 +$ 34.5 +Stock options +— +.2 +1.4 +Restricted stock +.1 +.3 +4.8 +Before-Tax Share-Based Compensation Cost – Total +$ 41.2 +$ 38.8 +$ 40.7 +Deferred Stock Units +We have granted deferred stock units to executives, selected employees, and outside directors. These deferred stock units entitle the recipient to one share of common stock upon vesting, which is conditioned, for employee recipients, on continued employment during the deferral period and may be conditioned on achieving certain performance targets. We grant deferred stock unit awards with a two - to five -year deferral period that is subject to payout upon death, disability, or retirement. Deferred stock units issued to outside directors are paid after service on the Board of Directors ends at the time elected by the director (not to exceed ten years after service ends). We generally expense the grant-date fair value of these awards on a straight-line basis over the vesting period; however, expense recognition is accelerated for retirement eligible individuals who meet the requirements for vesting upon retirement. We have elected to account for forfeitures as they occur, rather than to estimate them. Forfeitures have not been significant historically. +Market-based deferred stock units vest as long as the employee continues to be employed by the Company and upon the achievement of the performance target. The performance target, which is approved by the Compensation Committee, is the Company’s total shareholder return (share price appreciation and dividends paid) in relation to a defined peer group over a three ‑year performance period beginning 1 October of the fiscal year of grant. We granted 114,929 , 105,268 , and 117,692 market-based deferred stock units in fiscal years 2019 , 2018 , and 2017 , respectively. +100 +Table of Contents +The fair value of market-based deferred stock units was estimated using a Monte Carlo simulation model as these equity awards are tied to a market condition. The model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the grant and calculates the fair value of the awards. We generally expense the grant-date fair value of these awards on a straight-line basis over the vesting period. The estimated grant-date fair value of market-based deferred stock units was $ 229.61 , $ 202.50 , and $ 156.87 per unit in fiscal years 2019 , 2018 , and 2017 , respectively. The calculation of the fair value used the following assumptions: +2019 +2018 +2017 +Expected volatility +17.5 +% +18.7 +% +20.6 +% +Risk-free interest rate +2.8 +% +1.9 +% +1.4 +% +Expected dividend yield +2.6 +% +2.6 +% +2.5 +% +In addition, during fiscal year 2019 , we granted 169,666 time-based deferred stock units at a weighted average grant-date fair value of $ 168.68 . In fiscal years 2018 and 2017 , we granted 143,379 and 165,121 time-based deferred stock units at a weighted average grant-date fair value of and $ 162.11 and $ 143.75 , respectively. +Deferred Stock Units +Shares (000) +Weighted Average +Grant-Date Fair Value +Outstanding at 30 September 2018 +940 +$ 137.78 +Granted +285 +193.29 +Paid out +( 113 +) +119.59 +Forfeited/adjustments +( 136 +) +136.11 +Outstanding at 30 September 2019 +976 +$ 156.31 +Cash payments made for deferred stock units were $ 1.9 , $ 2.2 , and $ 2.1 in fiscal years 2019 , 2018 , and 2017 , respectively. As of 30 September 2019 , there was $ 49.2 of unrecognized compensation cost related to deferred stock units. The cost is expected to be recognized over a weighted average period of 1.6 years. The total fair value of deferred stock units paid out during fiscal years 2019 , 2018 , and 2017 , including shares vested in prior periods, was $ 19.2 , $ 38.5 , and $ 36.6 , respectively. +Stock Options +We have granted awards of options to purchase common stock to executives and selected employees. The exercise price of stock options equals the market price of our stock on the date of the grant. Options generally vest incrementally over three years and remain exercisable for ten years from the date of grant. The Company has not issued stock option awards since fiscal year 2015. +A summary of stock option activity is presented below: +Stock Options +Shares (000) +Weighted Average +Exercise Price +Outstanding at 30 September 2018 +2,186 +$ 89.33 +Exercised +( 842 +) +82.27 +Forfeited +— +— +Outstanding and Exercisable at 30 September 2019 +1,344 +$ 93.75 +Stock Options +Weighted Average Remaining Contractual Term (in years) +Aggregate Intrinsic Value +Outstanding and Exercisable at 30 September 2019 +3.4 +$ 172 +The aggregate intrinsic value represents the amount by which our closing stock price of $ 221.86 as of 30 September 2019 exceeds the exercise price multiplied by the number of in-the-money options outstanding or exercisable. +On a total company basis, the intrinsic value of stock options exercised during fiscal years 2019 , 2018 , and 2017 was $ 87.2 , $ 90.4 , and $ 57.3 , respectively. +101 +Table of Contents +Compensation cost is generally recognized over the stated vesting period consistent with the terms of the arrangement (i.e., either on a straight-line or graded-vesting basis). Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. As of 30 September 2019 , there was no unrecognized compensation cost as all stock option awards were fully vested. +Cash received from option exercises during fiscal year 2019 was $ 68.1 . The total tax benefit realized from stock option exercises in fiscal year 2019 was $ 20.4 , of which $ 16.4 was the excess tax benefit. +Restricted Stock +The grant-date fair value of restricted stock is estimated on the date of grant based on the closing price of the stock, and compensation cost is generally amortized to expense on a straight-line basis over the vesting period during which employees perform related services. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. We have elected to account for forfeitures as they occur, rather than to estimate them. Forfeitures have not been significant historically. +We have issued shares of restricted stock to certain officers. Participants are entitled to cash dividends and to vote their respective shares. Restrictions on shares lift in one to four years or upon the earlier of retirement, death, or disability. The shares are nontransferable while subject to forfeiture. +A summary of restricted stock activity is presented below: +Restricted Stock +Shares (000) +Weighted Average +Grant-Date Fair Value +Outstanding at 30 September 2018 +42 +$ 140.28 +Vested +( 16 +) +144.09 +Outstanding at 30 September 2019 +26 +$ 138.00 +As of 30 September 2019 , there was no unrecognized compensation cost as all restricted stock awards were fully vested. The total fair value of restricted stock vested during fiscal years 2019 , 2018 , and 2017 was $ 2.6 , $ 2.2 , and $ 4.1 , respectively. +Versum Spin-off +As discussed in Note 4 , Discontinued Operations , Air Products completed the spin-off of Versum on 1 October 2016. In connection with the spin-off, the Company adjusted the number of deferred stock units and stock options pursuant to existing anti-dilution provisions in the LTIP to preserve the intrinsic value of the awards immediately before and after the separation. The outstanding awards continue to vest over the original vesting period defined at the grant date. Outstanding awards at the time of spin-off were primarily converted into awards of the holders' employer following the separation. +Stock awards held upon separation were adjusted based upon the conversion ratio of Air Products' New York Stock Exchange (“NYSE”) volume weighted-average closing stock price on 30 September 2016 ( $ 150.35 ) to the NYSE volume weighted-average opening stock price on 3 October 2016 ( $ 140.38 ), or 1.071 . The adjustment to the awards did not result in incremental fair value, and no incremental compensation expense was recorded related to the conversion of these awards. +102 +Table of Contents +21 . ACCUMULATED OTHER COMPREHENSIVE LOSS +The table below summarizes changes in AOCL, net of tax, attributable to Air Products: +Derivatives +qualifying +as hedges +Foreign +currency +translation +adjustments +Pension and +postretirement +benefits +Total +Balance at 30 September 2016 +($ 65.0 +) +($ 949.3 +) +($ 1,374.0 +) +($ 2,388.3 +) +Other comprehensive income (loss) before reclassifications +( 12.6 +) +101.9 +251.6 +340.9 +Amounts reclassified from AOCL +24.2 +57.3 +110.7 +192.2 +Net current period other comprehensive income +$ 11.6 +$ 159.2 +$ 362.3 +$ 533.1 +Spin-off of Versum +.2 +6.0 +5.3 +11.5 +Amount attributable to noncontrolling interest +( .1 +) +3.0 +.8 +3.7 +Balance at 30 September 2017 +($ 53.1 +) +($ 787.1 +) +($ 1,007.2 +) +($ 1,847.4 +) +Other comprehensive income (loss) before reclassifications +45.9 +( 244.6 +) +179.4 +( 19.3 +) +Amounts reclassified from AOCL +( 30.4 +) +3.1 +133.1 +105.8 +Net current period other comprehensive income (loss) +$ 15.5 +($ 241.5 +) +$ 312.5 +$ 86.5 +Amount attributable to noncontrolling interest +— +( 18.8 +) +( .2 +) +( 19.0 +) +Balance at 30 September 2018 +($ 37.6 +) +($ 1,009.8 +) +($ 694.5 +) +($ 1,741.9 +) +Other comprehensive loss before reclassifications +( 44.1 +) +( 356.2 +) +( 326.2 +) +( 726.5 +) +Amounts reclassified from AOCL +12.3 +( 2.6 +) +63.2 +72.9 +Net current period other comprehensive loss +($ 31.8 +) +($ 358.8 +) +($ 263.0 +) +($ 653.6 +) +Amount attributable to noncontrolling interest +( 8.0 +) +( 11.7 +) +( .2 +) +( 19.9 +) +Balance at 30 September 2019 +($ 61.4 +) +($ 1,356.9 +) +($ 957.3 +) +($ 2,375.6 +) +103 +Table of Contents +The table below summarizes the reclassifications out of AOCL and the affected line item on the consolidated income statements: +2019 +2018 +2017 +(Gain) Loss on Cash Flow Hedges, net of tax +Sales/Cost of sales +$ .6 +$ 7.1 +$ 18.3 +Other income (expense), net +( 3.0 +) +( 42.6 +) +5.1 +Interest expense +14.7 +5.1 +.8 +Total (Gain) Loss on Cash Flow Hedges, net of tax +$ 12.3 +($ 30.4 +) +$ 24.2 +Currency Translation Adjustment +Cost of sales (A) +$ — +$ 3.1 +$ — +Cost reduction and asset actions (B) +— +— +8.2 +Gain on exchange of equity affiliate investments (C) +( 2.6 +) +— +— +Loss from discontinued operations, net of tax (D) +— +— +49.1 +Total Currency Translation Adjustment +($ 2.6 +) +$ 3.1 +$ 57.3 +Pension and Postretirement Benefits, net of tax (E) +$ 63.2 +$ 133.1 +$ 110.7 +(A) +The fiscal year 2018 impact relates to an equipment sale resulting from the termination of a contract in the Industrial Gases – Asia segment during the first quarter. +(B) +The fiscal year 2017 impact relates to the planned sale of a non-industrial gas hardgoods business in the Industrial Gases – Americas segment recorded in the third quarter. +(C) +The fiscal year 2019 impact relates to a net gain on the exchange of two equity affiliates with a joint venture partner. Refer to Note 7 , Acquisitions , for additional information. +(D) +The fiscal year 2017 impact relates to the sale of PMD during the second quarter. +(E) +The components of net periodic benefit cost reclassified out of AOCL include items such as prior service cost amortization, actuarial loss amortization, and settlements and are included in “Other non-operating income (expense), net” on the consolidated income statements. Refer to Note 17 , Retirement Benefits , for additional information. +104 +Table of Contents +22 . EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted earnings per share (EPS): +30 September +2019 +2018 +2017 +Numerator +Net income from continuing operations +$ 1,760.0 +$ 1,455.6 +$ 1,134.4 +Net income from discontinued operations +— +42.2 +1,866.0 +Net Income Attributable to Air Products +$ 1,760.0 +$ 1,497.8 +$ 3,000.4 +Denominator (in millions) +Weighted average common shares — Basic +220.3 +219.3 +218.0 +Effect of dilutive securities +Employee stock option and other award plans +1.3 +1.5 +1.8 +Weighted average common shares — Diluted +221.6 +220.8 +219.8 +Basic EPS Attributable to Air Products +Basic earnings per share from continuing operations +$ 7.99 +$ 6.64 +$ 5.20 +Basic earnings per share from discontinued operations +— +.19 +8.56 +Basic Earnings Per Common Share Attributable to Air Products +$ 7.99 +$ 6.83 +$ 13.76 +Diluted EPS Attributable to Air Products +Diluted earnings per share from continuing operations +$ 7.94 +$ 6.59 +$ 5.16 +Diluted earnings per share from discontinued operations +— +.19 +8.49 +Diluted Earnings Per Common Share Attributable to Air Products +$ 7.94 +$ 6.78 +$ 13.65 +Diluted EPS attributable to Air Products reflects the potential dilution that could occur if stock options or other share-based awards were exercised or converted into common stock. The dilutive effect is computed using the treasury stock method, which assumes all share-based awards are exercised and the hypothetical proceeds from exercise are used by the Company to purchase common stock at the average market price during the period. The incremental shares (difference between shares assumed to be issued versus purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. There were no antidilutive outstanding share-based awards in fiscal year 2019 and 2017, respectively. Outstanding share-based awards of .1 million shares were antidilutive and therefore excluded from the computation of diluted EPS for fiscal year 2018. +23 . INCOME TAXES +The following table summarizes the income of U.S. and foreign operations before taxes: +2019 +2018 +2017 +Income from Continuing Operations Before Taxes +United States +$ 723.3 +$ 688.5 +$ 669.8 +Foreign +1,350.8 +1,151.7 +666.2 +Income from equity affiliates +215.4 +174.8 +80.1 +Total +$ 2,289.5 +$ 2,015.0 +$ 1,416.1 +On 22 December 2017, the United States enacted the U.S. Tax Cuts and Jobs Act (the “Tax Act” or "Tax reform"), which significantly changed existing U.S. tax laws, including a reduction in the federal corporate income tax rate from 35 % to 21 % , a deemed repatriation tax on unremitted foreign earnings, as well as other changes. Our consolidated income statements reflect a discrete net income tax expense of $ 43.8 and $ 180.6 in fiscal years 2019 and 2018, respectively, related to impacts of the Tax Act. +In fiscal year 2019, our income tax expense reflects the reversal of a non-recurring $ 56.2 benefit recorded in fiscal year 2018 related to the U.S. taxation of deemed foreign dividends. This was partially offset by a benefit of $ 12.4 to reduce the total expected costs of the deemed repatriation tax. The non-recurring benefit recorded in fiscal year 2018 was eliminated by regulations issued in fiscal year 2019. +105 +Table of Contents +In fiscal year 2018, our consolidated income statements reflect a discrete net income tax expense of $ 180.6 and a $ 28.5 reduction to equity affiliates' income for the impacts of the Tax Act. The income tax expense of $ 180.6 included a cost of $ 392.4 , which included $ 322.1 for the deemed repatriation tax and $ 70.3 primarily for additional foreign taxes on the repatriation of foreign earnings. This cost was partially offset by a $ 211.8 benefit primarily from the re-measurement of our net U.S. deferred tax liabilities at the lower corporate tax rate. The deemed repatriation tax of $ 322.1 included the $ 56.2 non-recurring benefit related to the U.S. taxation of deemed foreign dividends that was eliminated in 2019. We have historically asserted our intention to indefinitely reinvest foreign earnings in certain foreign subsidiaries. We reevaluated our historic assertions as a result of enactment of the Tax Act and adjusted our position relative to the indefinitely reinvested earnings of various foreign subsidiaries. The impact of these changes is included in the $ 70.3 for additional foreign taxes on the repatriation of foreign earnings recorded in fiscal year 2018. +After applying tax credits, the balance of the deemed repatriation tax obligation is $ 256.8 , which we are paying in installments over seven remaining years. As of 30 September 2019, we recorded $ 215.4 of this obligation on our consolidated balance sheets in noncurrent liabilities. +While our accounting for the provisions of the Tax Act is not provisional, further adjustments to the deemed repatriation tax could result from future U.S. or foreign tax examinations of the years impacted by the calculation or from the issuance of additional federal or state guidance. +As a fiscal year-end taxpayer, certain provisions of the Tax Act became effective in our fiscal year 2018 while other provisions did not become effective until fiscal year 2019. The corporate tax rate reduction was effective as of 1 January 2018 and, accordingly, reduced our 2018 fiscal year U.S. federal statutory rate to a blended rate of approximately 24.5 % . The 21 % federal tax rate now applies to our fiscal year ended 30 September 2019 and each year thereafter. +The following table details the components of the provision for income taxes: +2019 +2018 +2017 +Current Tax Provision +Federal +$ 163.7 +$ 305.1 +$ 62.8 +State +23.3 +17.7 +7.0 +Foreign +235.5 +256.9 +229.1 +Total Current Tax Provision +422.5 +579.7 +298.9 +Deferred Tax Provision +Federal +9.7 +( 121.7 +) +1.4 +State +2.4 +12.5 +6.0 +Foreign +45.5 +53.8 +( 45.4 +) +Total Deferred Tax Provision +57.6 +( 55.4 +) +( 38.0 +) +Total Income Tax Provision +$ 480.1 +$ 524.3 +$ 260.9 +Total company income tax payments, net of refunds, were $ 324.3 , $ 372.0 , and $ 1,348.8 in fiscal years 2019 , 2018 , and 2017 , respectively. Tax payments were higher in fiscal year 2017 due to taxes related to the $ 2,870 gain on the sale of PMD. Refer to Note 4 , Discontinued Operations , for additional information. +106 +Table of Contents +The effective tax rate equals the income tax provision divided by income from continuing operations before taxes. A reconciliation of the differences between the United States federal statutory tax rate and the effective tax rate is as follows: +(Percent of income before taxes) +2019 +2018 +2017 +U.S. federal statutory tax rate +21.0 +% +24.5 +% +35.0 +% +State taxes, net of federal benefit +1.0 +1.0 +1.0 +Income from equity affiliates +( 2.0 +) +( 2.1 +) +( 2.0 +) +Foreign tax differentials +1.0 +( 1.0 +) +( 7.9 +) +Tax on foreign repatriated earnings +.1 +( .4 +) +( 2.2 +) +Domestic production activities +— +( .4 +) +( .8 +) +Share-based compensation +( .6 +) +( 1.0 +) +( 1.2 +) +Tax reform repatriation +1.9 +19.5 +— +Tax reform rate change and other +— +( 11.1 +) +— +Tax restructuring benefit +— +( 1.8 +) +— +Non-deductible goodwill impairment charge +— +— +3.6 +Non-U.S. subsidiary tax election +— +— +( 7.7 +) +Business separation costs +— +— +.2 +Other +( 1.4 +) +( 1.2 +) +.4 +Effective Tax Rate +21.0 +% +26.0 +% +18.4 +% +Foreign tax differentials represent the differences between foreign earnings subject to foreign tax rates that are different than the U.S. federal statutory rate and include tax holidays and incentives. As a result of the reduction in the federal corporate income tax rates under the Tax Act, our effective non-U.S. tax rate is now higher than our fiscal year 2019 U.S. statutory rate of 21.0 % . As a result of the lower statutory rate in fiscal year 2019 versus fiscal year 2018, the net impact of foreign tax rates reflects the cost of foreign rates higher than the U.S. federal statutory rate. +Tax on foreign repatriated earnings includes benefits and costs related to U.S. and additional foreign taxation on the current and future repatriation of foreign earnings and a U.S. benefit for related foreign tax credits. In addition, the Tax Act also enacted new provisions related to the taxation of foreign operations, known as Global Intangible Low Tax Income (“GILTI”). We have elected as an accounting policy to account for GILTI as a period cost when incurred. This and various other provisions of the Tax Act did not become effective until fiscal year 2019 and did not impact our tax provision in fiscal year 2018. +The Tax Act repealed the domestic production activities deduction, effective for our fiscal 2019 tax year, and lowered the benefit taken in fiscal year 2018. +Share-based compensation reflects the impact from recognition of $ 14.6 , $ 21.5 , and $ 17.6 of excess tax benefits in our provision for income taxes during fiscal years 2019, 2018, and 2017, respectively. +In fiscal year 2018, we recognized a tax benefit of $ 35.7 , net of reserves for uncertain tax positions, and a corresponding decrease to net deferred tax liabilities resulting from the restructuring of several foreign subsidiaries. +In fiscal year 2017, the effective tax rate was impacted by a tax election made with respect to a Chilean holding company resulting in an income tax benefit of $ 111.4 on tax losses related to investments in Chile. The effective tax rate was also impacted by a goodwill impairment charge of $ 145.3 for which no tax benefits were available. Refer to Note 11 , Goodwill , for additional information regarding the impairment charge. +107 +Table of Contents +The significant components of deferred tax assets and liabilities are as follows: +30 September +2019 +2018 +Gross Deferred Tax Assets +Retirement benefits and compensation accruals +$ 227.1 +$ 153.1 +Tax loss carryforwards +140.6 +143.5 +Tax credits and other tax carryforwards +31.1 +17.1 +Reserves and accruals +69.6 +42.5 +Currency losses +— +3.8 +Other +57.7 +45.4 +Valuation allowance +( 92.1 +) +( 105.0 +) +Deferred Tax Assets +434.0 +300.4 +Gross Deferred Tax Liabilities +Plant and equipment +954.6 +811.8 +Currency gains +23.9 +— +Unremitted earnings of foreign entities +31.0 +36.1 +Partnership and other investments +14.8 +16.3 +Intangible assets +80.0 +84.3 +Other +8.3 +5.6 +Deferred Tax Liabilities +1,112.6 +954.1 +Net Deferred Income Tax Liability +$ 678.6 +$ 653.7 +Deferred tax assets and liabilities are included within the consolidated balance sheets as follows: +2019 +2018 +Deferred Tax Assets +Other noncurrent assets +$ 115.2 +$ 121.4 +Deferred Tax Liabilities +Deferred income taxes +793.8 +775.1 +Net Deferred Income Tax Liability +$ 678.6 +$ 653.7 +Retirement benefits and compensation accruals are impacted significantly by the changes in plan assets and benefit obligations that have been recognized in other comprehensive income. Refer to Note 17 , Retirement Benefits , for additional information. Deferred tax liabilities related to plant and equipment increased due to the impact of an increase in accelerated tax depreciation deductions in excess of book depreciation in multiple jurisdictions. The deferred tax component for currency transactions moved into an overall deferred tax liability position due primarily to currency movements on hedging transactions as several foreign based currencies weakened against the U.S. dollar in fiscal year 2019. Reserves and accruals were impacted by an increase in tax deferred deductions related to the timing of recognizing accruals for local tax and accounting purposes. +As of 30 September 2019, the Company had the following deferred tax assets for certain tax credits: +Jurisdiction +Gross Tax Asset +Expiration Period +U.S. State +$ 1.7 +2020 - 2034 +U.S. Federal +13.3 +2024 - 2029 +Foreign +20.8 +2020 - 2025; Indefinite +108 +Table of Contents +The generation of $ 13.3 in excess U.S. foreign tax credits in fiscal year 2019 increased the balance of the tax credits and other tax carryforwards component. Of the $ 20.8 foreign tax credits, $ 5.8 have indefinite carryforward periods. +As of 30 September 2019 , the Company had the following loss carryforwards: +Jurisdiction +Gross Loss Carryforward +Expiration Period +U.S. State Net Operating Loss +$ 296.3 +2020 - 2034 +U.S. Federal Capital Loss +1.8 +2023 +Foreign Net Operating Loss +352.6 +2020 - 2029; Indefinite +Foreign Capital Loss +262.5 +Indefinite +Of the $ 352.6 of foreign net operating loss carryforwards, $ 148.9 have indefinite carryforward periods. +The valuation allowance as of 30 September 2019 of $ 92.1 primarily related to $ 42.8 of foreign credits and loss carryforwards as well as $ 44.6 related to foreign capital losses that were generated from the loss recorded on the exit from the EfW business in 2016. If events warrant the reversal of the valuation allowance, it would result in a reduction of tax expense. We believe it is more likely than not that future earnings and reversal of deferred tax liabilities will be sufficient to utilize our deferred tax assets, net of existing valuation allowance, as of 30 September 2019 . +As a result of the Tax Act, we recorded $ 373.2 of federal income tax from the deemed repatriation tax on approximately $ 5.8 billion of previously undistributed earnings from our foreign subsidiaries and corporate joint ventures. These earnings are now eligible to be repatriated to the U.S. with reduced U.S. tax impacts. However, such earnings may be subject to foreign withholding and other taxes. We record foreign and U.S. income taxes on the undistributed earnings of our foreign subsidiaries and corporate joint ventures unless those earnings are indefinitely reinvested. The cumulative undistributed earnings that are considered to be indefinitely reinvested in foreign subsidiaries and corporate joint ventures are included in retained earnings on the consolidated balance sheets and amounted to $ 4.2 billion as of 30 September 2019 . An estimated $ 359.6 in additional foreign withholding and other income taxes would be due if these earnings were remitted as dividends. +A reconciliation of the beginning and ending amount of the unrecognized tax benefits is as follows: +Unrecognized Tax Benefits +2019 +2018 +2017 +Balance at beginning of year +$ 233.6 +$ 146.4 +$ 90.2 +Additions for tax positions of the current year +7.8 +26.4 +47.5 +Additions for tax positions of prior years +14.2 +119.2 +16.1 +Reductions for tax positions of prior years +( 14.7 +) +( 41.3 +) +( 4.0 +) +Settlements +( 1.5 +) +( 14.2 +) +( 2.0 +) +Statute of limitations expiration +( 3.9 +) +( 2.6 +) +( 3.2 +) +Foreign currency translation +( 3.8 +) +( .3 +) +1.8 +Balance at End of Year +$ 231.7 +$ 233.6 +$ 146.4 +As of 30 September 2019 and 2018 , we had $ 231.7 and $ 233.6 of unrecognized tax benefits, excluding interest and penalties, respectively, of which $ 75.0 and $ 88.6 , respectively, would impact the effective tax rate from continuing operations if recognized. +Interest and penalties related to unrecognized tax benefits are recorded as a component of income tax expense and totaled $ 12.0 , ($ 2.4 ) , and $ 3.7 in fiscal years 2019 , 2018 , and 2017 , respectively. Our accrued balance for interest and penalties was $ 19.5 and $ 8.4 as of 30 September 2019 and 2018 , respectively. +In fiscal year 2018, $ 119.2 in additions for tax positions of prior years related primarily to uncertain state tax filing positions taken related to the sale of PMD. Additions for tax positions of the current year in fiscal year 2018 of $ 26.4 included uncertain tax positions related to the restructuring of foreign subsidiaries and reserves for ongoing transfer pricing uncertainties. +109 +Table of Contents +In fiscal year 2018, we received a final audit settlement agreement that resolved uncertainties related to unrecognized tax benefits of $ 43.1 , including interest. This settlement primarily related to tax positions taken in conjunction with the disposition of our Homecare business in 2012. As a result, we recorded an income tax benefit of $ 25.6 , including interest, in income from discontinued operations during 2018. The settlement also resulted in an income tax benefit of approximately $ 9.1 , including interest, in continuing operations for the release of tax reserves on other matters. The reduction in prior year positions and settlement payments also reflect the settlement of U.S. federal tax audits for 2012 through 2014 reported in the first quarter of the year. +We are currently under examination in a number of tax jurisdictions, some of which may be resolved in the next twelve months. As a result, it is reasonably possible that a change in the unrecognized tax benefits may occur during the next twelve months. However, quantification of an estimated range cannot be made as of the date of this report. +We generally remain subject to examination in the following major tax jurisdictions for the years indicated below: +Major Tax Jurisdiction +Open Tax Years +North America +United States – Federal +2016 +- +2019 +United States – State +2010 +- +2019 +Canada +2015 +- +2019 +Europe +France +2016 +- +2019 +Germany +2013 +- +2019 +Netherlands +2018 +- +2019 +Spain +2015 +- +2019 +United Kingdom +2015 +- +2019 +Asia +China +2014 +- +2019 +South Korea +2010 +- +2019 +Taiwan +2014 +- +2019 +Latin America +Chile +2016 +- +2019 +24 . SUPPLEMENTAL INFORMATION +Other Receivables and Current Assets +30 September +2019 +2018 +Contract assets +$ 64.3 +$ — +Contract fulfillment costs +64.5 +— +Derivative instruments +142.5 +61.1 +Current capital lease receivables +90.9 +92.1 +Contracts in progress, less progress billings +— +77.5 +Other +115.5 +142.6 +Other receivables and current assets +$ 477.7 +$ 373.3 +Other Noncurrent Assets +30 September +2019 +2018 +Derivative instruments +$ 81.7 +$ 85.0 +Noncurrent customer receivable +118.0 +92.4 +Prepaid tax +17.0 +13.2 +Deferred tax assets +115.2 +121.4 +Pension benefits +28.7 +131.7 +Other +243.5 +210.8 +Other noncurrent assets +$ 604.1 +$ 654.5 +110 +Table of Contents +Payables and Accrued Liabilities +30 September +2019 +2018 +Trade creditors +$ 519.3 +$ 594.6 +Payables associated with Lu'An +8.9 +330.0 +Contract liabilities +247.4 +156.6 +Accrued payroll and employee benefits +186.1 +201.4 +Pension and postretirement benefits +26.0 +34.1 +Dividends payable +255.7 +241.5 +Derivative instruments +91.2 +54.2 +Obligation for future contribution to an equity affiliate +94.4 +— +Other +206.7 +205.4 +Payables and accrued liabilities +$ 1,635.7 +$ 1,817.8 +Other Noncurrent Liabilities +30 September +2019 +2018 +Pension benefits +$ 651.2 +$ 417.2 +Postretirement benefits +36.0 +47.0 +Noncurrent customer liability +118.0 +92.4 +Long-term accrued income taxes related to U.S. tax reform +215.4 +184.4 +Contingencies related to uncertain tax positions +123.3 +113.2 +Contract liabilities +49.2 +58.2 +Environmental liabilities +59.1 +64.6 +Derivative instruments +21.2 +39.9 +Asset retirement obligations +201.9 +189.5 +Obligation for future contribution to an equity affiliate +— +94.4 +Obligations associated with EfW +57.8 +63.3 +Other +179.3 +172.8 +Other noncurrent liabilities +$ 1,712.4 +$ 1,536.9 +Facility Closure +In December 2018, one of our customers was subject to a government enforced shutdown due to environmental reasons. As a result, we recognized a charge of $ 29.0 during the first quarter of fiscal year 2019 primarily related to the write-off of onsite assets. This charge is reflected as “Facility closure” on our consolidated income statements for the fiscal year ended 30 September 2019 and has not been recorded in segment results. Annual sales and operating income associated with this customer prior to the facility closure were not material to the Industrial Gases – Asia segment. We do not expect to recognize additional charges related to this shutdown. +Sales to and Other Income From Related Parties +We have related party sales to some of our equity affiliates and joint venture partners as well as other income primarily from fees charged for use of Air Products' patents and technology. Sales to and other income from related parties totaled approximately $ 410 , $ 360 , and $ 600 in fiscal years 2019 , 2018 , and 2017 , respectively. Sales agreements with related parties include terms that are consistent with those that we believe would have been negotiated at an arm’s length with an independent party. +111 +Table of Contents +25 . SUMMARY BY QUARTER (UNAUDITED) +The table below provides unaudited selected financial data and weighted average share information for each quarter of fiscal year 2019 : +2019 +Q1 +Q2 +Q3 +Q4 +Total +Sales +$ 2,224.0 +$ 2,187.7 +$ 2,224.0 +$ 2,283.2 +$ 8,918.9 +Gross profit +651.0 +(A) +713.0 +758.0 +792.4 +2,914.4 +(A) +Cost reduction actions (See Note 6) +— +— +25.5 +— +25.5 +Gain on exchange of equity affiliate investments (See Note 7) +— +— +29.1 +— +29.1 +Operating income +455.0 +516.5 +569.7 +603.2 +2,144.4 +Equity affiliates' income +52.9 +46.2 +56.4 +59.9 +215.4 +Pension settlement loss (See Note 17) +— +5.0 +— +— +5.0 +Income tax provision +132.1 +(B) +107.5 +109.3 +(B) +131.2 +480.1 +(B) +Income from continuing operations +357.0 +433.5 +500.2 +518.7 +1,809.4 +Income from discontinued operations, net of tax +— +— +— +— +— +Net income +357.0 +433.5 +500.2 +518.7 +1,809.4 +Net Income Attributable to Air Products +Net income from continuing operations +$ 347.5 +$ 421.3 +$ 488.0 +$ 503.2 +$ 1,760.0 +Net income from discontinued operations +— +— +— +— +— +Net Income Attributable to Air Products +$ 347.5 +$ 421.3 +$ 488.0 +$ 503.2 +$ 1,760.0 +Basic Earnings Per Common Share Attributable to Air Products +Basic earnings per share from continuing operations +$ 1.58 +$ 1.91 +$ 2.21 +$ 2.28 +$ 7.99 +Basic earnings per share from discontinued operations +— +— +— +— +— +Basic Earnings Per Common Share Attributable to Air Products +$ 1.58 +$ 1.91 +$ 2.21 +$ 2.28 +$ 7.99 +Diluted Earnings Per Common Share Attributable to Air Products +Diluted earnings per share from continuing operations +$ 1.57 +$ 1.90 +$ 2.20 +$ 2.27 +$ 7.94 +Diluted earnings per share from discontinued operations +— +— +— +— +— +Diluted Earnings Per Common Share Attributable to Air Products +$ 1.57 +$ 1.90 +$ 2.20 +$ 2.27 +$ 7.94 +Weighted Average Common Shares (in millions) +Basic +219.9 +220.2 +220.6 +220.7 +220.3 +Diluted +221.0 +221.4 +221.9 +222.1 +221.6 +Dividend Information +Dividends declared per common share +$ 1.10 +$ 1.16 +$ 1.16 +$ 1.16 +$ 4.58 +112 +Table of Contents +The table below provides unaudited selected financial data and weighted average share information for each quarter of fiscal year 2018 : +2018 +Q1 +Q2 +Q3 +Q4 +Total +Sales +$ 2,216.6 +$ 2,155.7 +$ 2,259.0 +$ 2,298.9 +$ 8,930.2 +Gross profit +644.8 +649.2 +713.6 +733.1 +(C) +2,740.7 +(C) +Operating income +460.7 +455.4 +515.8 +533.7 +1,965.6 +Equity affiliates' income +13.8 +43.7 +58.1 +59.2 +174.8 +Pension settlement loss (See Note 17) +— +— +— +43.7 +43.7 +Income tax provision +291.8 +(B) +56.2 +(D) +107.1 +69.2 +(B)(D) +524.3 +(B)(D) +Income from continuing operations +162.7 +423.6 +444.7 +459.7 +1,490.7 +Income from discontinued operations, net of tax (See Note 4) +( 1.0 +) +— +43.2 +— +42.2 +Net income +161.7 +423.6 +487.9 +459.7 +1,532.9 +Net Income Attributable to Air Products +Net income from continuing operations +$ 155.6 +$ 416.4 +$ 430.7 +$ 452.9 +$ 1,455.6 +Net income from discontinued operations +( 1.0 +) +— +43.2 +— +42.2 +Net Income Attributable to Air Products +$ 154.6 +$ 416.4 +$ 473.9 +$ 452.9 +$ 1,497.8 +Basic Earnings Per Common Share Attributable to Air Products +Basic earnings per share from continuing operations +$ .71 +$ 1.90 +$ 1.96 +$ 2.06 +$ 6.64 +Basic earnings per share from discontinued operations +— +— +.20 +— +.19 +Basic Earnings Per Common Share Attributable to Air Products +$ .71 +$ 1.90 +$ 2.16 +$ 2.06 +$ 6.83 +Diluted Earnings Per Common Share Attributable to Air Products +Diluted earnings per share from continuing operations +$ .70 +$ 1.89 +$ 1.95 +$ 2.05 +$ 6.59 +Diluted earnings per share from discontinued operations +— +— +.20 +— +.19 +Diluted Earnings Per Common Share Attributable to Air Products +$ .70 +$ 1.89 +$ 2.15 +$ 2.05 +$ 6.78 +Weighted Average Common Shares (in millions) +Basic +218.9 +219.4 +219.5 +219.6 +219.3 +Diluted +220.4 +220.8 +220.9 +220.9 +220.8 +Dividend Information +Dividends declared per common share +$ .95 +$ 1.10 +$ 1.10 +$ 1.10 +$ 4.25 +(A) +Includes the impact of a facility closure charge of $ 29.0 resulting from the government enforced shutdown of a customer. Refer to Note 24, Supplemental Information , for additional information. +(B) +Our income tax provision for fiscal years 2019 and 2018 reflects impacts from the U.S. Tax Cuts and Jobs Act (the "Tax Act"). Refer to Note 23 , Income Taxes , for additional information. Fiscal year 2019 includes a discrete net income tax expense of $ 43.8 , primarily recorded in the first quarter to finalize our estimates of the impacts of the Tax Act. Fiscal year 2018 includes a discrete net income tax expense of $ 180.6 , primarily recorded in the first quarter for our initial estimates of the impacts of the Tax Act. +(C) +Includes the impact of a benefit of $ 24.1 for the change in inventory valuation method for our United States industrial gas inventories. Refer to Note 1, Major Accounting Policies , for additional information. +(D) +Includes an income tax benefit of $ 35.7 , net of reserves for uncertain tax positions, resulting from the restructuring of several foreign subsidiaries, primarily during the second quarter. +113 +Table of Contents +26 . BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION +Our reporting segments reflect the manner in which our chief operating decision maker reviews results and allocates resources. Except in the Industrial Gases – EMEA and Corporate and other segments, each reporting segment meets the definition of an operating segment and does not include the aggregation of multiple operating segments. Our Industrial Gases – EMEA and Corporate and other segment each include the aggregation of two operating segments that meet the aggregation criteria under GAAP. +Our reporting segments are: +• +Industrial Gases – Americas; +• +Industrial Gases – EMEA (Europe, Middle East, and Africa); +• +Industrial Gases – Asia; +• +Industrial Gases – Global; and +• +Corporate and other +Industrial Gases – Regional +The regional Industrial Gases segments (Americas, EMEA, and Asia) include the results of our regional industrial gas businesses, which produce and sell atmospheric gases such as oxygen, nitrogen, argon, and rare gases (primarily recovered by the cryogenic distillation of air), process gases such as hydrogen, helium, carbon dioxide, carbon monoxide, syngas (a mixture of hydrogen and carbon monoxide), and specialty gases, and equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +We supply gases to customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. We distribute gases to our customers through a variety of supply modes including liquid or gaseous bulk supply delivered by tanker or tube trailer and, for smaller customers, packaged gases delivered in cylinders and dewars or small on-sites (cryogenic or non-cryogenic generators). For large-volume customers, we construct an on-site plant adjacent to or near the customer’s facility or deliver product from one of our pipelines. +Electricity is the largest cost component in the production of atmospheric gases, and natural gas is the principal raw material for hydrogen, carbon monoxide, and syngas production. We mitigate energy and natural gas price fluctuations contractually through pricing formulas, surcharges, cost pass-through, and tolling arrangements. The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method. The largest of these joint ventures operate in Mexico, Italy, South Africa, India, Saudi Arabia, and Thailand. +Each of the regional Industrial Gases segments competes against global industrial gas companies as well as regional competitors. Competition is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to larger customers. +Industrial Gases – Global +The Industrial Gases – Global segment includes cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Industrial Gases – Global segment also includes centralized global costs associated with management of all the Industrial Gases segments. These costs include Industrial Gases global administrative costs, product development costs, and research and development costs. We compete with a large number of firms for all the offerings included in the Industrial Gases – Global segment. Competition in the equipment businesses is based primarily on technological performance, service, technical know-how, price, and performance guarantees. +Corporate and other +The Corporate and other segment includes our LNG equipment and helium storage and distribution sale of equipment businesses and corporate support functions that benefit all segments. Competition for the sale of equipment businesses is based primarily on technological performance, service, technical know-how, price, and performance guarantees. +Corporate and other also includes income and expense that is not directly associated with the other segments, including foreign exchange gains and losses. +114 +Table of Contents +In addition to assets of the global businesses included in this segment, other assets include cash, deferred tax assets, and financial instruments. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues. +Accounting Policies +The accounting policies of the segments are the same as those described in Note 1 , Major Accounting Policies . We evaluate the performance of segments based upon reported segment operating income. +Business Segment +Industrial +Gases– +Americas +Industrial +Gases– +EMEA +Industrial +Gases– +Asia +Industrial +Gases– +Global +Corporate +and other +Total +2019 +Sales +$ 3,873.5 +$ 2,002.5 +$ 2,663.6 +$ 261.0 +$ 118.3 +$ 8,918.9 +(A) +Operating income (loss) +997.7 +472.4 +864.2 +( 11.7 +) +( 152.8 +) +2,169.8 +(B) +Depreciation and amortization +505.2 +189.5 +361.5 +8.6 +18.0 +1,082.8 +Equity affiliates' income +84.8 +69.0 +58.4 +3.2 +— +215.4 +(B) +Expenditures for long-lived assets +545.8 +216.3 +1,105.5 +33.8 +88.3 +1,989.7 +Investments in net assets of and advances to equity affiliates +301.6 +493.4 +445.5 +35.7 +— +1,276.2 +Total assets +5,832.2 +3,250.8 +6,240.6 +325.7 +3,293.5 +18,942.8 +2018 +Sales +$ 3,758.8 +$ 2,193.3 +$ 2,458.0 +$ 436.1 +$ 84.0 +$ 8,930.2 +(A) +Operating income (loss) +927.9 +445.8 +689.9 +53.9 +( 176.0 +) +1,941.5 +(B) +Depreciation and amortization +485.3 +198.6 +265.8 +8.1 +12.9 +970.7 +Equity affiliates' income +82.0 +61.1 +58.3 +1.9 +— +203.3 +(B) +Expenditures for long-lived assets +546.5 +163.1 +791.9 +17.3 +49.6 +1,568.4 +Investments in net assets of and advances to equity affiliates +312.1 +503.3 +445.6 +16.2 +— +1,277.2 +Total assets +5,904.0 +3,280.4 +5,899.5 +240.1 +3,854.3 +19,178.3 +2017 +Sales +$ 3,637.0 +$ 1,780.4 +$ 1,964.7 +$ 722.9 +$ 82.6 +$ 8,187.6 +(A) +Operating income (loss) +946.1 +395.5 +532.6 +71.1 +( 171.5 +) +1,773.8 +(B) +Depreciation and amortization +464.4 +177.1 +203.2 +8.9 +12.2 +865.8 +Equity affiliates' income +58.1 +47.1 +53.5 +.9 +— +159.6 +(B) +Expenditures for long-lived assets +427.2 +143.2 +337.8 +25.6 +105.9 +1,039.7 +(A) +The sales information noted above relates to external customers only. All intersegment sales are eliminated in consolidation. Intersegment sales are generally transacted at market pricing. We generally do not have intersegment sales from our regional industrial gases businesses. Equipment manufactured for our regional industrial gases segments are generally transferred at cost and are not reflected as an intersegment sale. +(B) +Refer to the Reconciliations to Consolidated Results section below. +115 +Table of Contents +Reconciliations to Consolidated Results +The table below reconciles total operating income in the table above to consolidated operating income as reflected on our consolidated income statements: +Operating Income +2019 +2018 +2017 +Total +$ 2,169.8 +$ 1,941.5 +$ 1,773.8 +Change in inventory valuation method +— +24.1 +— +Facility closure +( 29.0 +) +— +— +Business separation costs +— +— +( 32.5 +) +Cost reduction and asset actions +( 25.5 +) +— +( 151.4 +) +Goodwill and intangible asset impairment charge +— +— +( 162.1 +) +Gain on exchange of equity affiliate investments +29.1 +— +— +Gain on land sale +— +— +12.2 +Consolidated Operating Income +$ 2,144.4 +$ 1,965.6 +$ 1,440.0 +The table below reconciles total equity affiliates' income in the table above to consolidated equity affiliates' income as reflected on our consolidated income statements: +Equity Affiliates' Income +2019 +2018 +2017 +Total +$ 215.4 +$ 203.3 +$ 159.6 +Equity method investment impairment charge +— +— +( 79.5 +) +Tax reform repatriation - equity method investment +— +( 28.5 +) +— +Consolidated Equity Affiliates' Income +$ 215.4 +$ 174.8 +$ 80.1 +Geographic Information +Sales to External Customers +2019 +2018 +2017 +United States +$ 3,351.8 +$ 3,149.6 +$ 2,886.8 +Europe, including Middle East +2,090.3 +2,292.5 +2,478.5 +Asia, excluding China and India +953.1 +904.0 +849.6 +China +1,730.2 +1,585.7 +1,143.4 +Other (A) +793.5 +998.4 +829.3 +Total +$ 8,918.9 +$ 8,930.2 +$ 8,187.6 +Long-Lived Assets (B) +2019 +2018 +2017 +United States +$ 3,721.3 +$ 3,512.7 +$ 3,407.4 +Europe, including Middle East +1,278.9 +1,283.3 +1,279.0 +Asia, excluding China and India +933.8 +899.8 +778.5 +China +3,302.6 +3,066.6 +1,737.9 +Other (A) +1,101.0 +1,161.3 +1,237.4 +Total +$ 10,337.6 +$ 9,923.7 +$ 8,440.2 +(A) +Includes Canada, Latin America, and India. +(B) +Long-lived assets include plant and equipment, net. +Geographic information is based on country of origin. Included in United States revenues are export sales to third‑party customers of $ 41.3 , $ 33.1 , and $ 64.2 in fiscal years 2019 , 2018 , and 2017 , respectively. +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not applicable. +116 +Table of Contents +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +We maintain a comprehensive set of disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act). Under the supervision of the Chief Executive Officer and Chief Financial Officer, the Company’s management conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of 30 September 2019 . Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of 30 September 2019 , the disclosure controls and procedures were effective. +Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Management has evaluated the effectiveness of its internal control over financial reporting as of 30 September 2019 based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, management concluded that, as of 30 September 2019 , the Company’s internal control over financial reporting was effective. Management’s Report on Internal Control over Financial Reporting is provided under Part II, Item 8, of this Form 10-K. +There was no change in the Company’s internal control over financial reporting during the fourth quarter of fiscal year 2019 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +Deloitte & Touche LLP, the Company’s independent registered public accounting firm, has audited the Company’s internal control over financial reporting as of 30 September 2019 . The Report of the Independent Registered Public Accounting Firm is provided under Part II, Item 8, of this Form 10-K. +ITEM 9B. OTHER INFORMATION +None. +117 +Table of Contents +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +The information required by this item relating to the Company’s directors and nominees is incorporated herein by reference to the section captioned “The Board of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . The information required by this item relating to the Company’s executive officers is set forth in Item 1 of Part I of this report. +The information required by this item relating to the Company’s Audit and Finance Committee and its Audit and Finance Committee Financial Expert is incorporated herein by reference to the sections captioned “Standing Committees Of The Board” and “Audit and Finance Committee” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +The information required by this item relating to the Company’s procedures regarding the consideration of candidates recommended by shareholders and a procedure for submission of such candidates is incorporated herein by reference to the section captioned “Selection of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +The information required by the item relating to Section 16(a) Beneficial Ownership Reporting Compliance is incorporated herein by reference to the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +The Company has adopted a Code of Conduct that applies to all employees, including the Chief Executive Officer, the Chief Financial Officer, and the Principal Accounting Officer. The Code of Conduct can be found at our website at www.airproducts.com/codeofconduct. +ITEM 11. EXECUTIVE COMPENSATION +The information required by this item is incorporated herein by reference to the sections captioned “Compensation of Executive Officers” and “Compensation of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +118 +Table of Contents +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Securities Authorized for Issuance Under Equity Compensation Plans. +Equity Compensation Plan Information +The following table provides information as of 30 September 2019 about Company stock that may be issued upon the exercise of options, warrants, and rights granted to employees or members of the Board under the Company’s existing equity compensation plans, including plans approved by shareholders and plans that have not been approved by shareholders in reliance on the NYSE’s former treasury stock exception or other applicable exception to the Exchange’s listing requirements. +Plan Category +Number of securities to be issued upon exercise of outstanding options, warrants, and rights +Weighted-average exercise price of outstanding options, warrants, and rights +Number of Securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) +Equity compensation plans approved by security holders +2,567,962 +(1) +$93.75 +4,581,960 +(2) +Equity compensation plans not approved by security holders +54,304 +(3) +— +— +Total +2,622,266 +$93.75 +4,581,960 +(1) +Represents Long-Term Incentive Plan outstanding stock options and deferred stock units that have been granted. Deferred stock units entitle the recipient to one share of Company common stock upon vesting, which is conditioned on continued employment during a deferral period and may also be conditioned on earn-out against certain performance targets. The amount presented assumes the maximum potential payout. +(2) +Represents authorized shares that were available for future grants as of 30 September 2019. These shares may be used for options, deferred stock units, restricted stock, and other stock-based awards to officers, directors, and key employees. Full value awards such as restricted stock are limited to 20% of cumulative awards after 1 October 2001. +(3) +This number represents deferred stock units issued under the Deferred Compensation Plan, which are purchased for the fair value of the underlying shares of stock with eligible deferred compensation. +The Deferred Compensation Plan was not approved by shareholders. It does not require shareholder approval because participants forego compensation equal to the full market value of any share units credited under the plans. +Deferred Compensation Plan —The Company’s Deferred Compensation Plan is an unfunded employee retirement benefit plan available to certain of the Company’s U.S.-based management and other highly compensated employees (and those of its subsidiaries) who receive awards under the Company’s Annual Incentive Plan, which is the annual cash bonus plan for executives and key salaried employees of the Company and its subsidiaries. Because participants forego current compensation to “purchase” deferred stock units for full value under the Plan, it is not required to be approved by shareholders under the NYSE listing standards. Under the Plan, participants may defer a portion of base salary (elective deferrals) which cannot be contributed to the Company’s Retirement Savings Plan, a 401(k) and profit-sharing plan offered to all salaried employees (RSP), because of tax limitations and earn matching contributions from the Company that they would have received if their elective deferrals had been contributed to the RSP (matching credits). In addition, participants in the Plan may defer all or a portion of their bonus awards under the Annual Incentive Plan (bonus deferrals) under the Deferred Compensation Plan. Finally, certain participants under the Plan who participate in the profit-sharing component of the RSP rather than the Company’s salaried pension plans receive contribution credits under the Plan which are a percentage ranging from 4%-6%, based on their years of service, of their salary in excess of tax limitations and their bonus awards under the Annual Incentive Plan (contribution credits). The dollar amount of elective deferrals, matching credits, bonus deferrals, and contribution credits is initially credited to an unfunded account, which earns interest credits. Participants are periodically permitted while employed by the Company to irrevocably convert all or a portion of their interest-bearing account to deferred stock units in a Company stock account. Upon conversion, the Company stock account is credited with deferred stock units based on the fair value of a share of Company stock on the date of crediting. Dividend equivalents corresponding to the number of units are credited quarterly to the interest-bearing account. Deferred stock units generally are paid after termination of employment in shares of Company stock. +119 +Table of Contents +The Deferred Compensation Plan was formerly known as the Supplementary Savings Plan. The name was changed in 2006 when the deferred bonus program, previously administered under the Annual Incentive Plan, was merged into this Plan. +Certain information required by this item regarding the beneficial ownership of the Company’s common stock is incorporated herein by reference to the sections captioned “Persons Owning More than 5% of Air Products Stock as of September 30, 2019 ” and “Air Products Stock Beneficially Owned by Officers and Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information required by this item is incorporated herein by reference to the sections captioned “Director Independence” and “Transactions with Related Persons” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES +The information required by this item is incorporated herein by reference to the section captioned “Independent Registered Public Accountant” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 23 January 2020 . +120 +Table of Contents +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +(a) The documents below are filed as a part of this report: +(1) +Financial Statements. The following is a list of the Consolidated Financial Statements of Air Products and Chemicals, Inc. and its subsidiaries included in Item 8 of Part II of this report: +Report of Deloitte & Touche LLP, Independent Registered Public Accounting Firm +51 +Report of KPMG LLP, Independent Registered Public Accounting Firm +53 +Consolidated Income Statements – Years Ended 30 September 2019, 2018, and 2017 +54 +Consolidated Comprehensive Income Statements – Years Ended 30 September 2019, 2018, and 2017 +55 +Consolidated Balance Sheets – 30 September 2019 and 2018 +56 +Consolidated Statements of Cash Flows – Years Ended 30 September 2019, 2018, and 2017 +57 +Consolidated Statements of Equity – Years Ended 30 September 2019, 2018, and 2017 +58 +(2) +Financial Statement Schedules. The financial statement schedule below is filed as a part of this report as required by Form 10-K. All other schedules are omitted because the required matter or conditions are not present or because the information required by the Schedules is submitted as part of the consolidated financial statements and notes thereto. +Schedule II Valuation and Qualifying Accounts for the three fiscal years ended 30 September 2019 +128 +(3) +Exhibits. The exhibits filed as a part of this report as required by Item 601 of Regulation S-K are listed in the Index to Exhibits located on page 122 of this report. +ITEM 16. FORM 10-K SUMMARY +None. +121 +Table of Contents +INDEX TO EXHIBITS +Exhibit No. +Description +(2) +Plan of acquisition, reorganization, arrangement, liquidation or succession. +(3) +Articles of Incorporation and By-Laws. +3.1 +Restated Certificate of Incorporation of the Company. (Filed as Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 1987.)* +3.2 +Amendment to the Restated Certificate of Incorporation of the Company dated 25 January 1996. (Filed as Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 1996.) * +3.3 +Amendment to the Restated Certificate of Incorporation of the Company dated 28 January 2014. (Filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended 30 June 2014.) * +3.4 +Amended and Restated Bylaws of the Company. (Filed as Exhibit 3.1 to the Company’s Form 8-K Report dated 21 November 2014.)* +(4) +Instruments defining the rights of security holders, including indentures. Upon request of the Securities and Exchange Commission, the Company hereby undertakes to furnish copies of the instruments with respect to its long-term debt. +4.1 +Indenture, dated as of January 18, 1985, between the Company and The Chase Manhattan Bank (National Association), as Trustee. (Filed as Exhibit 4(a) to the Company’s Registration Statement File No. 33-36974.)* +4.2 +Indenture, dated as of January 10, 1995, between the Company and The Bank of New York Trust Company, N.A. (formerly Wachovia Bank, National Association and initially First Fidelity Bank Company, National Association), as Trustee. (Filed as Exhibit 4(a) to the Company’s Registration Statement on Form S-3 filed January 19, 1995, File No. 33-57357.) * +4.3 +Description of 2.000% Euro Notes due 2020 (incorporated by reference to the description included in the Company’s prospectus filed under Rule 424(b)(5) under the Securities Act of 1933 on August 5, 2013, appearing under the headings “Description of Notes” in the prospectus supplement dated July 31, 2013 and “Description of Securities” in the base prospectus dated November 22, 2011, which form a part of the Company’s Registration Statement on Form S-3 (File No. 333-178120)). * +4.4 +Description of 0.375% Euro Notes due 2021(incorporated by reference to the description included in the Company’s prospectus filed under Rule 424(b)(5) under the Securities Act of 1933 on May 25, 2016, appearing under the headings “Description of Notes” in the prospectus supplement dated May 24, 2016 and “Description of Securities” in the base prospectus dated November 24, 2014, which form a part of the Company’s Registration Statement on Form S-3 (File No. 333-200537)). * +4.5 +Description of 1.000% Euro Notes due 2025 (incorporated by reference to the description included in the Company’s prospectus filed under Rule 424(b)(5) under the Securities Act of 1933 on February 4, 2015, appearing under the headings “Description of Notes” in the prospectus supplement dated February 3, 2015 and “Description of Securities” in the base prospectus dated November 24, 2014, which form a part of the Company’s Registration Statement on Form S-3 (File No. 333-200537)). * +(10) +Material Contracts +10.1 +1990 Deferred Stock Plan of the Company, as amended and restated effective 1 October 1989. (Filed as Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 1989.)*† +122 +Table of Contents +Exhibit No. +Description +10.2 +Annual Incentive Plan as Amended and Restated effective 1 October 2008. (Filed as Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended 31 March 2009.) *† +10.3 +Stock Incentive Program of the Company effective 1 October 1996. (Filed as Exhibit 10.21 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 2002.) *† +10.4 +Amended and Restated Deferred Compensation Program for Directors, effective 25 January 2017. (Filed as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2017.) *† +10.5 +Amended and Restated Long-Term Incentive Plan of the Company effective 1 October 2014. (Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on 23 September 2014.) *† +10.5(a) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2018 awards. (Filed as Exhibit 10.1 and 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2017.) *† +10.5(b) +Form of Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2019 awards. (Filed as Exhibit 10.1 and 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.5(c) +Restricted Stock Unit Retention Award Agreement dated 3 December 2018 under the Long-Term Incentive Plan of the Company. (Filed as Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.6 +Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 November 2017 with provisions effective 1 January 2018. (Filed as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2017.) *† +10.6(a) +Amendment No. 1 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 November 2017 with provisions effective 1 January 2018. (Filed as Exhibit 10.6(a) to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2018). *† +10.6(b) +Amendment No. 2 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 January 2019. (Filed as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.6(c) +Amendment No. 3 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 January 2019. (Filed as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.6(d) +Amendment No. 4 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 August 2019. † +10.6(e) +Amendment No. 5 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 August 2019. † +10.7 +Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective August 1, 2014. (Filed as Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 2014.) *† +10.7(a) +Amendment No. 1 dated as of 30 September 2015 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2014. (Filed as Exhibit 10.10(a) to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 2015.) *† +123 +Table of Contents +Exhibit No. +Description +10.7(b) +Amendment No. 2 dated as of 30 September 2016 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2014. (Filed as Exhibit 10.7(b) to the Company's Annual Report on Form 10-K for fiscal year ended 30 September 2016.) *† +10.7(c) +Amendment No. 3 dated as of 26 July 2017 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2017.(Filed as Exhibit 10.7(c) to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2017.) *† +10.8 +Deferred Compensation Plan as Amended and Restated effective 1 January 2018. (Filed as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2017.) *† +10.9 +Revolving Credit Facility dated as of 31 March 2017 for $2,500,000,000. (Filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended 31 March 2017.) * +10.9(a) +Amendment and Appointment of Successor Administrative Agent dated 28 September 2018 to the Revolving Credit Agreement dated 31 March 2017. (Filed as Exhibit 10.9(a) to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2018.) * +10.10 +Air Products and Chemicals, Inc. Executive Separation Program as amended effective as of 20 July 2018. (Filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2018.) *† +10.11 +Form of Change in Control Severance Agreement for an Executive Officer. (filed as Exhibit 10.2 of the Company's Current Report on Form 8-K dated 23 September 2014.) *† +10.12 +Compensation Program for Non-Employee Directors effective 1 July 2017. (Filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 30 June 2017.) *† +10.13 +Air Products and Chemicals, Inc. Corporate Executive Committee Retention Agreements effective as of 10 January 2014. (Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K dated 15 January 2014.) *† +10.14 +Amended and Restated Employment Agreement dated 14 November 2017, between the Company and Seifollah Ghasemi. (Filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed 14 November 2017.) *† +10.16 +Senior Management Severance and Summary Plan Description effective as of 1 October 2017. (Filed as Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2017.) *† +16 +Letter re change in certifying accountant +16.1 +Letter from KPMG LLP (Filed as Exhibit 16.1 to the Company’s Current Report on Form 8-K dated 26 July 2018). * +21 +Subsidiaries of the registrant. +(23) +Consents of Experts and Counsel. +23.1 +Consent of Deloitte & Touche LLP, Independent Registered Public Accounting Firm. +23.2 +Consent of KPMG LLP, Independent Registered Public Accounting Firm. +24 +Power of Attorney. +124 +Table of Contents +Exhibit No. +Description +(31) +Rule 13a-14(a)/15d-14(a) Certifications. +31.1 +Certification by the Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification by the Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +(32) +Section 1350 Certifications. +32.1 +Certification by the Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. †† +(99) +Additional Financial Exhibits +99.1 +Description of Common Stock (Filed as Exhibit 99.1 to the Company’s Form 10-K Report for the fiscal year ended 30 September 2014.) * +(101) +Interactive Data Files +101.INS +Inline XBRL Instance Document. The XBRL Instance Document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH +Inline XBRL Taxonomy Extension Schema Document. +101.CAL +Inline XBRL Taxonomy Extension Calculation Linkbase Document. +101.LAB +Inline XBRL Taxonomy Extension Label Linkbase Document. +101.PRE +Inline XBRL Taxonomy Extension Presentation Linkbase Document. +101.DEF +Inline XBRL Taxonomy Extension Definition Linkbase Document. +104 +Cover Page Interactive Data File, formatted in Inline XBRL (included in Exhibit 101). +* +Previously filed as indicated and incorporated herein by reference. Exhibits incorporated by reference are located in SEC File No. 001-04534 unless otherwise indicated. +† +Indicated management contract or compensatory arrangement. +†† +The certification attached as Exhibit 32.1 that accompanies this Annual Report on Form 10-K, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Air Products and Chemicals, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Form 10-K, irrespective of any general incorporation language contained in such filing. +125 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. +AIR PRODUCTS AND CHEMICALS, INC. +(Registrant) +By: +/s/ M. Scott Crocco +M. Scott Crocco +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +Date: +26 November 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature and Title +Date +/s/ Seifi Ghasemi +26 November 2019 +(Seifi Ghasemi) +Director, Chairman, President, and +Chief Executive Officer +(Principal Executive Officer) +/s/ Russell A. Flugel +26 November 2019 +(Russell A. Flugel) +Senior Vice President, Corporate Controller, and Principal Accounting Officer +* +26 November 2019 +(Susan K. Carter) +Director +* +26 November 2019 +(Charles I. Cogut) +Director +* +26 November 2019 +(Chad C. Deaton) +Director +* +26 November 2019 +(David H. Y. Ho) +Director +* +26 November 2019 +(Margaret G. McGlynn) +Director +126 +Table of Contents +Signature and Title +Date +* +26 November 2019 +(Edward L. Monser) +Director +* +26 November 2019 +(Matthew H. Paull) +Director +* +Sean D. Major, Executive Vice President, General Counsel and Secretary, by signing his name hereto, does sign this document on behalf of the above noted individuals, pursuant to a power of attorney duly executed by such individuals, which is filed with the Securities and Exchange Commission herewith. +/s/ Sean D. Major +Sean D. Major +Executive Vice President, General Counsel and Secretary +Date: +26 November 2019 +127 +Table of Contents +AIR PRODUCTS AND CHEMICALS, INC. AND SUBSIDIARIES +SCHEDULE II–VALUATION AND QUALIFYING ACCOUNTS +For the Years Ended 30 September 2019 , 2018 , and 2017 +Balance at +Beginning +of Period +Additions +Charged to +Expense +Additions +Charged to +Other Accounts +Other +Changes (A) +Balance +at End of +Period +Year Ended 30 September 2019 +Allowance for doubtful accounts +$ 91 +$ 12 +$ 37 +($ 52 +) +$ 88 +Allowance for deferred tax assets +105 +5 +2 +( 20 +) +92 +Year Ended 30 September 2018 +Allowance for doubtful accounts +$ 94 +$ 17 +$ 7 +($ 27 +) +$ 91 +Allowance for deferred tax assets +108 +3 +4 +( 10 +) +105 +Year Ended 30 September 2017 +Allowance for doubtful accounts +$ 55 +$ 7 +$ 39 +($ 7 +) +$ 94 +Allowance for deferred tax assets (B) +165 +6 +7 +( 70 +) +108 +(A) +Other changes related to allowance for doubtful accounts primarily includes write-offs of uncollectible trade receivables, net of recoveries. Other Changes also includes the impact of foreign currency translation adjustments. +(B) +The decrease in the valuation allowance was primarily due to the utilization of federal and state loss carryforwards as a result of recognizing the gain on the sale of our PMD business. This benefit was recorded in discontinued operations. See Note 4 , Discontinued Operations , for additional information. +128 \ No newline at end of file diff --git a/raw/filings/0000002969/2019/0000002969-19-000051/filing_metadata.csv b/raw/filings/0000002969/2019/0000002969-19-000051/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..2bdbe009344ab20d6b414f8bb62aedfca1c3ff9a --- /dev/null +++ b/raw/filings/0000002969/2019/0000002969-19-000051/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002969,APD,"Air Products & Chemicals, Inc.",2019,10-K,2019-11-26,2019-09-30,2019-11-26T18:55:27.000Z,0000002969-19-000051,apd-10xkx30sep19.htm,FORM 10-K,28140469,1,1,https://www.sec.gov/Archives/edgar/data/2969/000000296919000051/apd-10xkx30sep19.htm,https://www.sec.gov/Archives/edgar/data/2969/000000296919000051/ diff --git a/raw/filings/0000002969/2019/0000002969-19-000051/item1.txt b/raw/filings/0000002969/2019/0000002969-19-000051/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..86e753c948714b1651fa02fe2e58f5a1418b71ba --- /dev/null +++ b/raw/filings/0000002969/2019/0000002969-19-000051/item1.txt @@ -0,0 +1,70 @@ +ITEM 1. BUSINESS +Air Products and Chemicals, Inc., a Delaware corporation originally founded in 1940, serves customers globally with a unique portfolio of products, services, and solutions that include atmospheric gases, process and specialty gases, equipment, and services. The Company is the world’s largest supplier of hydrogen and has built leading positions in growth markets such as helium and liquefied natural gas ("LNG") process technology and equipment. The Company also develops, engineers, builds, owns and operates some of the world’s largest industrial gas projects, including gasification projects that sustainably convert abundant natural resources into syngas for the production of high-value power, fuels and chemicals. +As used in this report, unless the context indicates otherwise, the terms “we,” “our,” “us,” the “Company,” or “registrant” include controlled subsidiaries, affiliates, and predecessors of Air Products and its controlled subsidiaries and affiliates. +During its fiscal year ended 30 September 2019 (“fiscal year 2019 ”), the Company reported its continuing operations in five reporting segments under which it managed its operations, assessed performance, and reported earnings: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. +Except as otherwise noted, the description of the Company's business below reflects the Company's continuing operations. Refer to Note 4 , Discontinued Operations , to the consolidated financial statements for additional details on our discontinued operations. +Industrial Gases Business +The Company’s Industrial Gases business produces atmospheric gases, such as oxygen, nitrogen, and argon, process gases, such as hydrogen, helium, carbon dioxide, carbon monoxide, and syngas, and specialty gases. Atmospheric gases are produced through various air separation processes of which cryogenic is the most prevalent. Process gases are produced by methods other than air separation. For example, hydrogen, carbon monoxide and syngas are produced by steam methane reforming of natural gas and by the gasification of liquid and solid hydrocarbons. Hydrogen is produced by purifying byproduct sources obtained from the chemical and petrochemical industries; and helium is produced as a byproduct of gases extracted from underground reservoirs, primarily natural gas, but also carbon dioxide purified before resale. The Industrial Gases business also develops, builds and operates equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +The Company’s Industrial Gases business is organized and operated regionally. The regional Industrial Gases segments (Americas, EMEA, and Asia) supply gases and related equipment in the relevant region to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels. The chemicals industry uses hydrogen, oxygen, nitrogen, carbon monoxide, and syngas as feedstocks in the production of many basic chemicals. The energy production industry uses nitrogen injection for enhanced recovery of oil and natural gas and oxygen for gasification. Oxygen is used in combustion and industrial heating applications, including in the gasification, steel, certain nonferrous metals, glass, and cement industries. Nitrogen applications are used in food processing for freezing and preserving flavor and nitrogen for inerting is used in various fields, including the metals, chemical, and semiconductor industries. Helium is used in laboratories and healthcare for cooling and in other industries for pressurizing, purging, and lifting. Argon is used in the metals and other industries for its unique inerting, thermal conductivity, and other properties. Industrial gases are also used in welding and providing healthcare and are utilized in various manufacturing processes to make them more efficient and to optimize performance. +4 +Table of Contents +We distribute gases to our sale of gas customers through different supply modes depending on various factors including the customer's volume requirements and location. Our supply modes are as follows: +Liquid Bulk— Product is delivered in bulk (in liquid or gaseous form) by tanker or tube trailer and stored, usually in its liquid state, in equipment designed and installed typically by the Company at the customer’s site for vaporizing into a gaseous state as needed. Liquid bulk sales are usually governed by three- to five-year contracts. +Packaged Gases— Small quantities of product are delivered in either cylinders or dewars. The Company operates packaged gas businesses in Europe, Asia, and Latin America. In the United States, the Company’s packaged gas business sells products (principally helium) only for the electronics and magnetic resonance imaging industries. +On-Site Gases— Large quantities of hydrogen, nitrogen, oxygen, carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide) are provided to customers, principally in the energy production and refining, chemical, gasification, and metals industries worldwide, that require large volumes of gases and have relatively constant demand. Gases are produced at large facilities located adjacent to customers’ facilities or by pipeline systems from centrally located production facilities and are generally governed by 15- to 20- year contracts. The Company also delivers small quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically either via a 10- to 15- year sale of gas contract or through the sale of the equipment to the customer. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide and syngas. We mitigate electricity, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. During fiscal year 2019 , no significant difficulties were encountered in obtaining adequate supplies of power and natural gas. +The Company obtains helium from a number of sources globally, including crude helium for purification from the U.S. Bureau of Land Management's helium reserve. +The regional Industrial Gases segments also include our interests in the results of several joint ventures accounted for by the equity method, which are reported in our financial statements as income from equity affiliates. The largest of these joint ventures operate in Mexico, Italy, South Africa, India, Saudi Arabia, and Thailand. +Each of the regional Industrial Gases segments competes against two global industrial gas companies: Air Liquide S.A. and Linde plc (the successor to Praxair, Inc. and Linde AG, pursuant to a combination that became effective on 31 October 2018), as well as regional competitors. Competition in Industrial Gases is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to our larger customers. +Overall regional industrial gases sales constituted approximately 96% , 94% , and 90% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively. Sales of atmospheric gases constituted approximately 46% , 46% , 45% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively, while sales of tonnage hydrogen, syngas, and related products constituted approximately 26% , 25% , and 24% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively. +5 +Table of Contents +Industrial Gases Equipment +The Company designs and manufactures equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction ("LNG"), and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global segment includes activity related to cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Corporate and other segment includes three global equipment businesses: our LNG equipment business, our Gardner Cryogenics business fabricating helium and hydrogen transport and storage containers, and our Rotoflow business, which manufactures turboexpanders and other precision rotating equipment. Steel, aluminum, and capital equipment subcomponents (compressors, etc.) are the principal raw materials in the manufacturing of equipment. Raw materials for individual projects typically are acquired under firm purchase agreements. Equipment is produced at the Company’s manufacturing sites with certain components being procured from subcontractors and vendors. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Sale of equipment constituted approximately 4% , 6% , and 10% of consolidated sales in fiscal years 2019 , 2018 , and 2017 , respectively. +The backlog of equipment orders was approximately $.9 billion on 30 September 2019 (as compared to a total backlog of approximately $.2 billion on 30 September 2018 ). The Company estimates that approximately 50% of the total equipment sales backlog as of 30 September 2019 will be recognized as revenue during fiscal year 2020 , dependent on execution schedules of the relevant projects. +International Operations +The Company, through subsidiaries, affiliates, and joint ventures accounted for using the equity method, conducts business in 51 countries outside the United States. Its international businesses are subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls, tariffs, trade sanctions, and import and export controls, and other economic, political, and regulatory policies of local governments described in Item 1A, Risk Factors , below. +The Company has majority or wholly owned foreign subsidiaries that operate in Canada; 17 European countries (including the Netherlands, Spain, and the United Kingdom); nine Asian countries (including China, South Korea, and Taiwan); seven Latin American countries (including Brazil and Chile); five countries in the Middle East (including Saudi Arabia), and three African countries. The Company also owns less-than-controlling interests in entities operating in Europe, Asia, Latin America, the Middle East, and Africa (including China, Germany, India, Italy, Mexico, Oman, Saudi Arabia, South Africa, and Thailand). +Financial information about the Company’s foreign operations and investments is included in Note 9 , Summarized Financial Information of Equity Affiliates ; Note 23 , Income Taxes ; and Note 26 , Business Segment and Geographic Information , to the consolidated financial statements included under Item 8, below. Information about foreign currency translation is included under “Foreign Currency” in Note 1 , Major Accounting Policies , and information on the Company’s exposure to currency fluctuations is included in Note 14 , Financial Instruments , to the consolidated financial statements, included under Item 8, below, and in “Foreign Currency Exchange Rate Risk,” included under Item 7A, below. Export sales from operations in the United States to third-party customers amounted to $41.3 million, $33.1 million, and $64.2 million in fiscal years 2019 , 2018 , and 2017 , respectively. +Technology Development +The Company pursues a market-oriented approach to technology development through research and development, engineering, and commercial development processes. It conducts research and development principally in its laboratories located in the United States (Trexlertown, Pennsylvania), Canada (Vancouver), the United Kingdom (Basingstoke and Carrington), Spain (Barcelona), China (Shanghai), and Saudi Arabia (Dhahran). The Company also funds and cooperates in research and development programs conducted by a number of major universities and undertakes research work funded by others, principally the United States government. +The Company’s research groups are aligned with and support the research efforts of various businesses throughout the Company. Development of technology for use within the Industrial Gases business focuses primarily on new and improved processes and equipment for the production and delivery of industrial gases and new or improved applications for industrial gas products. +6 +Table of Contents +During fiscal year 2019 , the Company owned approximately 857 United States patents, approximately 3,733 foreign patents, and was a licensee under certain patents owned by others. The increase in the number of patents compared to fiscal year 2018 is primarily attributable to the acquisition of General Electric Company’s gasification business, completed in August 2019, inclusive of its related patent estate. While the patents and licenses are considered important, the Company does not consider its business as a whole to be materially dependent upon any particular patent, patent license, or group of patents or licenses. +Environmental Controls +The Company is subject to various environmental laws and regulations in the countries in which it has operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, the Company is involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA," the federal Superfund law); Resource Conservation and Recovery Act ("RCRA"); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. The Company’s accounting policy for environmental expenditures is discussed in Note 1 , Major Accounting Policies , and environmental loss contingencies are discussed in Note 18 , Commitments and Contingencies , to the consolidated financial statements, included under Item 8, below. +The amounts charged to income from continuing operations related to environmental matters totaled $14.2 million , $12.8 million , and $11.4 million in fiscal years 2019 , 2018 , and 2017 , respectively. These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet internal Company standards. Refer to Note 18 , Commitments and Contingencies , to the consolidated financial statements for additional information. +The Company estimates that we spent approximately $5 million, $3 million, and $7 million in fiscal years 2019 , 2018 , and 2017 , respectively, on capital projects reflected in continuing operations to control pollution. Capital expenditures to control pollution are estimated to be approximately $5 million in both fiscal years 2020 and 2021 . +Employees +On 30 September 2019 , the Company (including majority-owned subsidiaries) had approximately 17,700 employees, of whom approximately 17,440 were full-time employees and of whom approximately 12,950 were located outside the United States. The Company has collective bargaining agreements with unions at various locations that expire on various dates over the next four years. The Company considers relations with its employees to be satisfactory. +Seasonality +The Company’s businesses are not subject to seasonal fluctuations to any material extent. +Inventories +The Company maintains limited inventory where required to facilitate the supply of products to customers on a reasonable delivery schedule. Inventory consists primarily of crude helium, industrial gas, and specialty gas inventories supplied to customers through liquid bulk and packaged gases supply modes. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues . We do have concentrations of customers in specific industries, primarily refining, chemicals, and electronics. Within each of these industries, we have several large-volume customers with long-term contracts. A negative trend affecting one of these industries, or the loss of one of these major customers, although not material to our consolidated revenue, could have an adverse impact on our financial results. +Governmental Contracts +Our business is not subject to a government entity’s renegotiation of profits or termination of contracts that would be material to our business as a whole. +Available Information +All periodic and current reports, registration statements, proxy statements, and other filings that the Company is required to file with the Securities and Exchange Commission ("SEC"), including the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through the Company’s website at www.airproducts.com. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC. All such reports filed during the period +7 +Table of Contents +covered by this report were available on the Company’s website on the same day as filing. In addition, our filings with the SEC are available free of charge on the SEC's website, www.sec.gov. +Executive Officers of the Company +The Company’s executive officers and their respective positions and ages on 26 November 2019 follow. Information with respect to offices held is stated in fiscal years. +Name +Age +Office +M. Scott Crocco +55 +Executive Vice President and Chief Financial Officer (became Executive Vice President and Chief Financial Officer in 2016; Senior Vice President and Chief Financial Officer in 2013; and Vice President and Corporate Controller in 2008). +Seifi Ghasemi +75 +Chairman, President, and Chief Executive Officer (became Chairman, President and Chief Executive Officer in 2014 and previously served as Chairman and Chief Executive Officer of Rockwood Holdings, Inc. from 2001 to 2014). Mr. Ghasemi is a member and Chairman of the Board of Directors and the Chairman of the Executive Committee of the Board of Directors. +Sean D. Major +55 +Executive Vice President, General Counsel and Secretary (Secretary since December 2017 and Executive Vice President and General Counsel since May 2017). Previously, Mr. Major served as Executive Vice President, General Counsel and Secretary for Joy Global Inc. from 2007 to 2017. +Dr. Samir J. Serhan +58 +Executive Vice President (since December 2016). Previously, Dr. Serhan served as President, Global HyCO, since 2014 for Praxair Inc. From 2000-2014, he worked in leadership positions in the U.S. and Germany for The Linde Group, including Managing Director of Linde Engineering from 2008-2014. \ No newline at end of file diff --git a/raw/filings/0000002969/2019/0000002969-19-000051/item13.txt b/raw/filings/0000002969/2019/0000002969-19-000051/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..0c0c9562678de1ec5cf335089c293a2fac03d5ec --- /dev/null +++ b/raw/filings/0000002969/2019/0000002969-19-000051/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +120 \ No newline at end of file diff --git a/raw/filings/0000002969/2020/0000002969-20-000049/filing.txt b/raw/filings/0000002969/2020/0000002969-20-000049/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..5f7fa74b6396161ffb024dca995cb5569372d933 --- /dev/null +++ b/raw/filings/0000002969/2020/0000002969-20-000049/filing.txt @@ -0,0 +1,3147 @@ 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2018-09-30 0000002969 country:CN 2020-09-30 0000002969 country:CN 2019-09-30 0000002969 country:CN 2018-09-30 0000002969 apd:OtherForeignOperationsMember 2020-09-30 0000002969 apd:OtherForeignOperationsMember 2019-09-30 0000002969 apd:OtherForeignOperationsMember 2018-09-30 +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended 30 September 2020 +or +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from _______________________ to ______________________ +Commission file number 001-04534 +AIR PRODUCTS AND CHEMICALS, INC. +(Exact name of registrant as specified in its charter) +Delaware 23-1274455 +(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) +7201 Hamilton Boulevard +Allentown , Pennsylvania 18195-1501 +(Address of principal executive offices) (Zip Code) +610 - 481-4911 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol(s) Name of each exchange on which registered +Common Stock, par value $1.00 per share APD New York Stock Exchange +0.375% Euro Notes due 2021 APD21B New York Stock Exchange +1.000% Euro Notes due 2025 APD25 New York Stock Exchange +0.500% Euro Notes due 2028 APD28 New York Stock Exchange +0.800% Euro Notes due 2032 APD32 New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act +Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of +the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C.7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ +The aggregate market value of the voting stock held by non-affiliates of the registrant on 31 March 2020 was approximately $ 44.0 billion. For purposes of the foregoing calculations, all directors and/or executive officers have been deemed to be affiliates, but the registrant disclaims that any such director and/or executive officer is an affiliate. +The number of shares of common stock outstanding as of 31 October 2020 was 221,026,592 . +DOCUMENTS INCORPORATED BY REFERENCE +Portions of the registrant’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021 are incorporated by reference into Part III. +Table of Contents +AIR PRODUCTS AND CHEMICALS, INC. +ANNUAL REPORT ON FORM 10-K +For the fiscal year ended 30 September 2020 +TABLE OF CONTENTS +ITEM 1. +BUSINESS +4 +ITEM 1A. +RISK FACTORS +9 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +16 +ITEM 2. +PROPERTIES +16 +ITEM 3. +LEGAL PROCEEDINGS +17 +ITEM 4. +MINE SAFETY DISCLOSURES +17 +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES +18 +ITEM 6. +SELECTED FINANCIAL DATA +20 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +21 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +48 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +50 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +118 +ITEM 9A. +CONTROLS AND PROCEDURES +119 +ITEM 9B. +OTHER INFORMATION +119 +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +119 +ITEM 11. +EXECUTIVE COMPENSATION +120 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +120 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +120 +ITEM 14. +PRINCIPAL ACCOUNTANT FEES AND SERVICES +120 +ITEM 15. +EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +120 +ITEM 16. +FORM 10-K SUMMARY +120 +INDEX TO EXHIBITS +121 +SIGNATURES +125 +2 +Table of Contents +FORWARD-LOOKING STATEMENTS +This Annual Report on Form 10-K contains “forward-looking statements” within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and can generally be identified by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” "future," “goal,” “intend,” “may,” “outlook,” “plan,” “positioned,” “possible,” “potential,” “project,” “should,” “target,” “will,” “would,” and similar expressions or variations thereof, or the negative thereof, but these terms are not the exclusive means of identifying such statements. Forward-looking statements are based on management’s expectations and assumptions as of the date of this report and are not guarantees of future performance. You are cautioned not to place undue reliance on our forward-looking statements. +Forward-looking statements may relate to a number of matters, including expectations regarding revenue, margins, expenses, earnings, tax provisions, cash flows, pension obligations, share repurchases or other statements regarding economic conditions or our business outlook; statements regarding plans, projects, strategies and objectives for our future operations, including our ability to win new projects and execute the projects in our backlog; and statements regarding our expectations with respect to pending legal claims or disputes. While forward-looking statements are made in good faith and based on assumptions, expectations and projections that management believes are reasonable based on currently available information, actual performance and financial results may differ materially from projections and estimates expressed in the forward-looking statements because of many factors, including, without limitation: +• the duration and impacts of the novel coronavirus (“COVID-19”) global pandemic and efforts to contain its transmission, including the effect of these factors on our business, our customers, economic conditions and markets generally; +• changes in global or regional economic conditions, supply and demand dynamics in the market segments we serve, or in the financial markets that may affect the availability and terms on which we may obtain financing; +• risks associated with having extensive international operations, including political risks, risks associated with unanticipated government actions and risks of investing in developing markets; +• project delays, contract terminations, customer cancellations, or postponement of projects and sales; +• our ability to develop and operate large scale and technically complex projects, including gasification projects; +• the future financial and operating performance of major customers and joint venture partners; +• our ability to develop, implement, and operate new technologies; +• our ability to execute the projects in our backlog; +• tariffs, economic sanctions and regulatory activities in jurisdictions in which we and our affiliates and joint ventures operate; +• the impact of environmental, tax or other legislation, as well as regulations affecting our business and related compliance requirements, including legislation or regulations related to global climate change; +• changes in tax rates and other changes in tax law; +• the timing, impact, and other uncertainties relating to acquisitions and divestitures, including our ability to integrate acquisitions and separate divested businesses, respectively; +• risks relating to cybersecurity incidents, including risks from the interruption, failure or compromise of our information systems; +• catastrophic events, such as natural disasters, public health crises, acts of war, or terrorism; +• the impact on our business and customers of price fluctuations in oil and natural gas and disruptions in markets and the economy due to oil and natural gas price volatility; +• costs and outcomes of legal or regulatory proceedings and investigations; +• asset impairments due to economic conditions or specific events; +3 +Table of Contents +FORWARD-LOOKING STATEMENTS (CONTINUED) +• significant fluctuations in interest rates and foreign currency exchange rates from those currently anticipated; +• damage to facilities, pipelines or delivery systems, including those we own or operate for third parties; +• availability and cost of raw materials; and +• the success of productivity and operational improvement programs. +In addition to the foregoing factors, forward-looking statements contained herein are qualified with respect to the risks disclosed elsewhere in this document, including in Item 1A, Risk Factors , Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , and Item 7A, Quantitative and Qualitative Disclosures About Market Risk . Any of these factors, as well as those not currently anticipated by management, could cause our results of operations, financial condition or liquidity to differ materially from what is expressed or implied by any forward-looking statement. Except as required by law, we disclaim any obligation or undertaking to update or revise any forward-looking statements contained herein to reflect any change in assumptions, beliefs, or expectations or any change in events, conditions, or circumstances upon which any such forward-looking statements are based. +PART I +Item 1. Business. +Air Products and Chemicals, Inc., a Delaware corporation originally founded in 1940, serves customers globally with a unique portfolio of products, services, and solutions that include atmospheric gases, process and specialty gases, equipment, and services. We are the world’s largest supplier of hydrogen and have built leading positions in growth markets such as helium and liquefied natural gas ("LNG") process technology and equipment. We also develop, engineer, build, own and operate some of the world’s largest industrial gas projects, including gasification projects that sustainably convert abundant natural resources into syngas for the production of high-value power, fuels and chemicals, carbon capture projects, and world-scale carbon-free hydrogen projects supporting global transportation and the energy transition. +As used in this report, unless the context indicates otherwise, the terms “we,” “our,” “us,” the “Company,” "Air Products," or “registrant” include controlled subsidiaries, affiliates, and predecessors of Air Products and our controlled subsidiaries and affiliates. +During the fiscal year ended 30 September 2020 (“fiscal year 2020”), we reported our continuing operations in five reporting segments under which we managed our operations, assessed performance, and reported earnings: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. +Except as otherwise noted, the description of our business below reflects our continuing operations. Refer to Note 6, Discontinued Operations , to the consolidated financial statements for activity associated with discontinued operations. +Industrial Gases Business +Our Industrial Gases business produces atmospheric gases, such as oxygen, nitrogen, and argon, process gases, such as hydrogen, helium, carbon dioxide (CO 2 ), carbon monoxide, and syngas, and specialty gases. Atmospheric gases are produced through various air separation processes of which cryogenic is the most prevalent. Process gases are produced by methods other than air separation. For example, hydrogen, carbon monoxide and syngas are produced by steam methane reforming of natural gas and by the gasification of liquid and solid hydrocarbons. Hydrogen is produced by purifying byproduct sources obtained from the chemical and petrochemical industries; and helium is produced as a byproduct of gases extracted from underground reservoirs, primarily natural gas, but also CO 2 purified before resale. The Industrial Gases business also develops, builds and operates equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +4 +Table of Contents +Our Industrial Gases business is organized and operated regionally. The regional Industrial Gases segments (Americas, EMEA, and Asia) supply gases and related equipment in the relevant region to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels as well as in the developing mobility markets. The chemicals industry uses hydrogen, oxygen, nitrogen, carbon monoxide, and syngas as feedstocks in the production of many basic chemicals. The energy production industry uses nitrogen injection for enhanced recovery of oil and natural gas and oxygen for gasification. Oxygen is used in combustion and industrial heating applications, including in the gasification, steel, certain nonferrous metals, glass, and cement industries. Nitrogen applications are used in food processing for freezing and preserving flavor and nitrogen for inerting is used in various fields, including the metals, chemical, and semiconductor industries. Helium is used in laboratories and healthcare for cooling and in other industries for pressurizing, purging, and lifting. Argon is used in the metals and other industries for its unique inerting, thermal conductivity, and other properties. Industrial gases are also used in welding and providing healthcare and are utilized in various manufacturing processes to make them more efficient and to optimize performance. +Industrial gases are generally produced at or near the point of use given the complexity and inefficiency with storing molecules at low temperatures. Helium, however, is generally sourced globally, at long distances from point of sale. As a result, we maintain an inventory of helium stored in our fleet of ISO containers as well as the U.S. Bureau of Land Management underground storage facility in Amarillo, Texas. +We distribute gases to our sale of gas customers through different supply modes depending on various factors including the customer's volume requirements and location. Our supply modes are as follows: +• Liquid Bulk — Product is delivered in bulk (in liquid or gaseous form) by tanker or tube trailer and stored, usually in its liquid state, in equipment that we typically design and install at the customer’s site for vaporizing into a gaseous state as needed. Liquid bulk sales are usually governed by three- to five-year contracts. +• Packaged Gases — Small quantities of product are delivered in either cylinders or dewars. We operate packaged gas businesses in Europe, Asia, and Latin America. In the United States, our packaged gas business sells products (principally helium) only for the electronics and magnetic resonance imaging industries. +• On-Site Gases — Large quantities of hydrogen, nitrogen, oxygen, carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide) are provided to customers, principally in the energy production and refining, chemical, gasification, and metals industries worldwide, that require large volumes of gases and have relatively constant demand. Gases are produced at large facilities located adjacent to customers’ facilities or by pipeline systems from centrally located production facilities and are generally governed by 15- to 20- year contracts. We also deliver small quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically either via a 10- to 15- year sale of gas contract or through the sale of the equipment to the customer. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide and syngas. We mitigate electricity, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. During fiscal year 2020, no significant difficulties were encountered in obtaining adequate supplies of power and natural gas. +We obtain helium from a number of sources globally, including crude helium for purification from the U.S. Bureau of Land Management's helium reserve. +The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method, which are reported in our financial statements as income from equity affiliates. The largest of these joint ventures operate in China, India, Italy, Mexico, Saudi Arabia, South Africa, and Thailand. +5 +Table of Contents +Each of the regional Industrial Gases segments competes against three global industrial gas companies: Air Liquide S.A., Messer and Linde plc (the successor to Praxair, Inc. and Linde AG, pursuant to a combination that became effective on 31 October 2018), as well as regional competitors. Competition in Industrial Gases is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to our larger customers. +Overall regional industrial gases sales constituted approximately 94%, 96%, and 94% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively. Sales of atmospheric gases constituted approximately 47%, 46%, and 46% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively, while sales of tonnage hydrogen, syngas, and related products constituted approximately 22%, 26%, and 25% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively. +Industrial Gases Equipment +We design and manufacture equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction, and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global segment includes activity related to the sale of cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Corporate and other segment includes three global equipment businesses: our LNG equipment business, our Gardner Cryogenics business fabricating helium and hydrogen transport and storage containers, and our Rotoflow business, which manufactures turboexpanders and other precision rotating equipment. Steel, aluminum, and capital equipment subcomponents (compressors, etc.) are the principal raw materials in the manufacturing of equipment. Raw materials for individual projects typically are acquired under firm purchase agreements. Equipment is produced at our manufacturing sites with certain components being procured from subcontractors and vendors. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Sale of equipment constituted approximately 6%, 4%, and 6% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively. +The backlog of equipment orders was approximately $1.6 billion on 30 September 2020 (as compared to a total backlog of approximately $0.9 billion on 30 September 2019). We estimate that approximately 50% of the total equipment sales backlog as of 30 September 2020 will be recognized as revenue during fiscal year 2021, dependent on execution schedules of the relevant projects. +International Operations +Through our subsidiaries, affiliates, and joint ventures accounted for using the equity method, we conduct business in 53 countries outside the United States. Our international businesses are subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls, tariffs, trade sanctions, and import and export controls, and other economic, political, and regulatory policies of local governments described in Item 1A, Risk Factors, below. +We have majority or wholly owned foreign subsidiaries that operate in Canada; 18 European countries (including the Netherlands, Spain, and the United Kingdom); 11 Asian countries (including China, South Korea, and Taiwan); seven Latin American countries (including Brazil and Chile); six countries in the Middle East (including Saudi Arabia), and three African countries. We also own less-than-controlling interests in entities operating in Europe, Asia, Latin America, the Middle East, and Africa (including China, Germany, India, Italy, Mexico, Oman, Saudi Arabia, South Africa, and Thailand). +Financial information about our foreign operations and investments is included in Note 8, Summarized Financial Information of Equity Affiliates ; Note 22, Income Taxes ; and Note 25, Business Segment and Geographic Information , to the consolidated financial statements included under Item 8, below. Information about foreign currency translation is included under “Foreign Currency” in Note 1, Major Accounting Policies , and information on our exposure to currency fluctuations is included in Note 13, Financial Instruments , to the consolidated financial statements, included under Item 8, below, and in “Foreign Currency Exchange Rate Risk,” included under Item 7A, below. +6 +Table of Contents +Technology Development +We pursue a market-oriented approach to technology development through research and development, engineering, and commercial development processes. It conducts research and development principally in its laboratories located in the United States (Trexlertown, Pennsylvania), the United Kingdom (Basingstoke and Carrington), Spain (Barcelona), China (Shanghai), and Saudi Arabia (Dhahran). We also fund and cooperate in research and development programs conducted by a number of major universities and undertake research work funded by others, including the United States government. +Development of technology for use within the Industrial Gases business focuses primarily on new and improved processes and equipment for the production and delivery of industrial gases and new or improved applications for industrial gas products. +During fiscal year 2020, we owned approximately 850 United States patents, approximately 3,600 foreign patents, and were a licensee under certain patents owned by others. While the patents and licenses are considered important, we do not consider our business as a whole to be materially dependent upon any particular patent, patent license, or group of patents or licenses. +Environmental Regulation +We are subject to various environmental laws and regulations in the countries in which we have operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, we are involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA," the federal Superfund law); Resource Conservation and Recovery Act ("RCRA"); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Our accounting policy for environmental expenditures is discussed in Note 1, Major Accounting Policies , and environmental loss contingencies are discussed in Note 17, Commitments and Contingencies , to the consolidated financial statements, included under Item 8, below. +Some of our operations are within jurisdictions that have or are developing regulatory regimes governing emissions of greenhouse gases (“GHG”), including CO 2 . These include existing coverage under the European Union Emission Trading System, the California cap and trade scheme, China’s Emission Trading Scheme and its nation-wide expansion, and South Korea’s Emission Trading Scheme. In the Netherlands, a CO 2 emissions tax will come into force on 1 January 2021. In Canada, Alberta’s Technology Innovation and Emission Reduction (“TIER”) System went into effect 1 January 2020. In Ontario, Environment & Climate Change Canada’s ("ECCC”) Output Based Pricing System (“OBPS”) is currently in effect, however, on 20 September 2020, ECCC granted approval of Ontario’s GHG Emissions Performance Standards program, which will be used in lieu of adherence to the OBPS, with the effective date to be determined. In addition, the U.S. Environmental Protection Agency (“EPA”) requires mandatory reporting of GHG emissions and is regulating GHG emissions for new construction and major modifications to existing facilities. Some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern may result in more international, U.S. federal, and/or regional requirements to reduce or mitigate the effects of GHG emissions. Although uncertain, these developments could increase our costs related to consumption of electric power, hydrogen production and application of our gasification technology. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +Regulation of GHG may also produce new opportunities for us. We continue to develop technologies to help our facilities and our customers lower energy consumption, improve efficiency and lower emissions. We see significant opportunities for gasification, carbon capture technologies and hydrogen for mobility and energy transition. +We estimate that we spent approximately $4 million, $5 million, and $3 million in fiscal years 2020, 2019, and 2018, respectively, on capital projects reflected in continuing operations to control pollution. Capital expenditures to control pollution are estimated to be approximately $6 million in both fiscal years 2021 and 2022. +For additional information regarding environmental matters, refer to Item 7, “ Management’s Discussion and Analysis of Financial Condition and Results of Operations – Environmental Matters ” and Note 17, Commitments and Contingencies , to the consolidated financial statements. +7 +Table of Contents +Employees +We believe our employees are our most valuable asset and are critical to our success as an organization. Our goal is to be the safest, most diverse and most profitable industrial gas company in the world, providing excellent service to our customers. Integral to our success is the continued development of our 4S culture (Safety, Speed, Simplicity and Self-Confidence) and creating a work environment where all employees feel that they belong and matter. Our talent related initiatives, including employee recruitment and development, diversity and inclusion and compensation and benefit programs, are focused on building and retaining the world-class and talented staff that is needed to meet our goals. +On 30 September 2020 we had approximately 19,275 employees, of whom approximately 19,000 were full-time and of whom approximately 14,150 were located outside the United States. We have collective bargaining agreements with unions at certain locations that expire on various dates over the next four years. We consider relations with our employees to be good. +We value the contributions of our employees, particularly in the face of the challenges posed by the COVID-19 pandemic. Many of our employees are on the front line during the pandemic, keeping our plants running and delivering to our customers the products they need. When possible, employees have been working from home to help maintain their health and safety as well as business continuity. We have not laid off any of our employees or reduced their salaries due to COVID-19. +In October 2020, we announced goals to further increase the percentage of women and U.S. minorities in professional and managerial roles. By 2025, we aim to achieve at least 28 percent female representation in the professional and managerial population globally, and at least 20 percent minority representation in that same population in the United States. These measures are increases from 25 and 17 percent representation (2020 baseline), respectively. We established these new targets following analysis of our global employee representation metrics and future talent needs, as well as assessing industry benchmarks and peer companies. +Seasonality +Our businesses are not subject to seasonal fluctuations to any material extent. +Inventories +We maintain limited inventory where required to facilitate the supply of products to customers on a reasonable delivery schedule. Inventory consists primarily of crude helium, industrial gas, and specialty gas inventories supplied to customers through liquid bulk and packaged gases supply modes. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues. We do have concentrations of customers in specific industries, primarily refining, chemicals, and electronics. Within each of these industries, we have several large-volume customers with long-term contracts. A negative trend affecting one of these industries, or the loss of one of these major customers, although not material to our consolidated revenue, could have an adverse impact on our financial results. +Governmental Contracts +Our business is not subject to a government entity’s renegotiation of profits or termination of contracts that would be material to our business as a whole. +Available Information +All periodic and current reports, registration statements, proxy statements, and other filings that we are required to file with the Securities and Exchange Commission ("SEC"), including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through our website at www.airproducts.com. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC. All such reports filed during the period covered by this report were available on our website on the same day as filing. In addition, our filings with the SEC are available free of charge on the SEC's website, www.sec.gov. +8 +Table of Contents +Our Executive Officers +Our executive officers and their respective positions and ages on 19 November 2020 follow. Information with respect to offices held is stated in fiscal years. +Name Age Office +M. Scott Crocco 56 Executive Vice President and Chief Financial Officer (became Executive Vice President and Chief Financial Officer in 2016; Senior Vice President and Chief Financial Officer in 2013; and Vice President and Corporate Controller in 2008). +Seifi Ghasemi 76 Chairman, President, and Chief Executive Officer (became Chairman, President and Chief Executive Officer in 2014 and previously served as Chairman and Chief Executive Officer of Rockwood Holdings, Inc. from 2001 to 2014). Mr. Ghasemi is a member and Chairman of the Board of Directors and the Chairman of the Executive Committee of the Board of Directors. +Sean D. Major 56 Executive Vice President, General Counsel and Secretary (Executive Vice President and General Counsel since May 2017 and Secretary since December 2017). Previously, Mr. Major served as Executive Vice President, General Counsel and Secretary for Joy Global Inc. from 2007 to 2017. +Dr. Samir J. Serhan 59 Executive Vice President and Chief Operating Officer (Executive Vice President since December 2016 and Chief Operating Officer since May 2020). Dr. Serhan served as President, Global HyCO, from 2014 to 2016 for Praxair Inc. From 2000-2014, he worked in leadership positions in the U.S. and Germany for The Linde Group, including as Managing Director of Linde Engineering from 2008-2014. +Item 1A. Risk Factors. +Our operations are affected by various risks, many of which are beyond our control. In evaluating investment in the Company and the forward-looking information contained in this Annual Report on Form 10-K or presented elsewhere by management from time to time, you should carefully consider the risk factors discussed below. Any of these risks could have a material adverse effect on our business, operating results, financial condition, and the actual outcome of matters as to which forward-looking statements are made and could adversely affect the value of an investment in our securities. In addition to the following risks, there may be additional risks and uncertainties that adversely affect our business, performance, or financial condition in the future that are not presently known, are not currently believed to be significant, or are not identified below because they are common to all businesses. +Risks Related to Economic Conditions +The COVID-19 global pandemic may materially and adversely impact our business, financial condition and results of operations. +The COVID-19 global pandemic and efforts to reduce its spread have led to a significant decline of economic activity and significant disruption and volatility in global markets. These factors have led to reduced demand for industrial gas products, particularly in our merchant business. We expect demand to continue to be impacted as well as the timing of certain planned maintenance activities. In addition, COVID-19 may result in reduced sales in our other businesses, lower returns for certain of our projects, and the potential delay or cancellation of certain projects in our pipeline. In addition, we are monitoring the health of our employees and many of our employees, including those based at our headquarters, are working remotely in accordance with health safety guidance and applicable governmental orders. Action by health or other governmental authorities requiring the closure of our facilities or recommending other physical distancing measures could negatively impact our business and those of our service providers and customers. Although we have business continuity and other safeguards in place, we cannot be certain that they will be fully effective for extended periods of time. As the pandemic and responses to it continue to evolve we may experience further adverse impacts on our operations and our ability to access capital on favorable terms, or at all, may be impaired. In addition, we may face unpredictable increases in demand for certain of our products when restrictions on business and travel end. If demand for our products exceeds our capacity, it could adversely affect our financial results and customer relationships. Although the duration and ultimate impact of these factors is unknown at this time, the decline in economic conditions due to COVID-19, or another disease-causing similar impacts, may adversely affect our business, financial condition and results of operations and such impact may be material. +Further, to the extent COVID-19 adversely affects our business, financial condition, and results of operations and global economic conditions more generally, it may also have the effect of heightening many of the other risks described herein. +9 +Table of Contents +Changes in global and regional economic conditions, the markets we serve, or the financial markets may adversely affect our results of operations and cash flows. +Unfavorable conditions in the global economy or regional economies, the markets we serve or financial markets may decrease the demand for our goods and services and adversely impact our revenues, operating results, and cash flows. +Demand for our products and services depends in part on the general economic conditions affecting the countries and markets in which we do business. Weak economic conditions in certain geographies and changing supply and demand balances in the markets we serve have negatively impacted demand for our products and services in the past, including most recently due to COVID-19, and may do so in the future. Reduced demand for our products and services would have a negative impact on our revenues and earnings. In addition, reduced demand could depress sales, reduce our margins, constrain our operating flexibility or reduce efficient utilization of our manufacturing capacity, or result in charges which are unusual or nonrecurring. Excess capacity in our manufacturing facilities or those of our competitors could decrease our ability to maintain pricing and generate profits. +In addition, our operating results in one or more segments may be affected by uncertain or deteriorating economic conditions for particular customer markets within a segment. A decline in the industries served by our customers or adverse events or circumstances affecting individual customers can reduce demand for our products and services, and impair the ability of such customers to satisfy their obligations to us, resulting in uncollected receivables, unanticipated contract terminations, project delays or the inability to recover plant investments, any of which may negatively impact our financial results. +Weak overall demand or specific customer conditions may also cause customer shutdowns or defaults or other inabilities to operate facilities profitably and may force sale or abandonment of facilities and equipment or prevent projects from coming on-stream when expected. These or other events associated with weak economic conditions or specific market, product, or customer events may require us to record an impairment on tangible assets, such as facilities and equipment, or intangible assets, such as intellectual property or goodwill, which would have a negative impact on our financial results. +Our extensive international operations can be adversely impacted by operational, economic, political, security, legal, and currency translation risks that could decrease profitability. +In fiscal year 2020, over 60% of our sales were derived from customers outside the United States and many of our operations, suppliers, and employees are located outside the United States. Our operations in foreign jurisdictions may be subject to risks including exchange control regulations, import and trade restrictions, trade policy and other potentially detrimental domestic and foreign governmental practices or policies affecting U.S. companies doing business abroad. Changing economic and political conditions within foreign jurisdictions, strained relations between countries, or the imposition of tariffs or international sanctions can cause fluctuations in demand, price volatility, supply disruptions, or loss of property. The occurrence of any of these risks could have a material adverse impact on our financial condition, results of operation, and cash flows. +Our growth strategies depend in part on our ability to further penetrate markets outside the United States, particularly in markets such as China, India, Indonesia, and the Middle East, and involve significantly larger and more complex projects, including gasification projects, some in regions where there is the potential for significant economic and political disruptions. We are actively investing large amounts of capital and other resources, in some cases through joint ventures, in developing markets, which we believe to have high growth potential. Our operations in these markets may be subject to greater risks than those faced by our operations in mature economies, including political and economic instability, project delay or abandonment due to unanticipated government actions, inadequate investment in infrastructure, undeveloped property rights and legal systems, unfamiliar regulatory environments, relationships with local partners, language and cultural differences and increased difficulty recruiting, training and retaining qualified employees. In addition, our properties and contracts in these locations may be subject to seizure and cancellation, respectively, without full compensation for loss. Successful operation of particular facilities or execution of projects may be disrupted by civil unrest, acts of war, sabotage or terrorism, and other local security concerns. Such concerns may require us to incur greater costs for security or require us to shut down operations for a period of time. +10 +Table of Contents +Furthermore, because the majority of our revenue is generated from sales outside the United States, we are exposed to fluctuations in foreign currency exchange rates. Our business is primarily exposed to translational currency risk as the results of our foreign operations are translated into U.S. dollars at current exchange rates throughout the fiscal period. Our policy is to minimize cash flow volatility from changes in currency exchange rates. We choose not to hedge the translation of our foreign subsidiaries’ earnings into dollars. Accordingly, reported sales, net earnings, cash flows, and fair values have been, and in the future will be, affected by changes in foreign exchange rates. For a more detailed discussion of currency exposure, see Item 7A, Quantitative and Qualitative Disclosures About Market Risk , below. +Risks Related to Our Business +Operational and project execution risks, particularly with respect to our largest projects, may adversely affect our operations or financial results. +A significant and growing portion of our business involves gasification and other large-scale projects that involve challenging engineering, procurement and construction phases that may last up to several years. These projects are technically complex, often reliant on significant interaction with government authorities and face significant financing, development, operational and reputational risks. We may encounter difficulties in engineering, delays in designs or materials provided by the customer or a third party, equipment and materials delivery delays, schedule changes, customer scope changes, delays related to obtaining regulatory permits and rights-of-way, inability to find adequate sources of labor in the locations where we are building new plants, weather-related delays, delays by customers' contractors in completing their portion of a project, technical or transportation difficulties, cost overruns, supply difficulties, geopolitical risks and other factors, many of which are beyond our control, that may impact our ability to complete a project within the original delivery schedule. In some cases, delays and additional costs may be substantial, and we may be required to cancel a project and/or compensate the customer for the delay. We may not be able to recover any of these costs. In addition, in some cases we seek financing for large projects and face market risk associated with the availability and terms of such financing. These financing arrangements may require that we comply with certain performance requirements which, if not met, could result in default and restructuring costs or other losses. All of these factors could also negatively impact our reputation or relationships with our customers, suppliers and other third parties, any of which could adversely affect our ability to secure new projects in the future. +The operation of our facilities, pipelines, and delivery systems inherently entails hazards that require continuous oversight and control, such as pipeline leaks and ruptures, fire, explosions, toxic releases, mechanical failures, or vehicle accidents. If operational risks materialize, they could result in loss of life, damage to the environment, or loss of production, all of which could negatively impact our ongoing operations, reputation, financial results, and cash flows. In addition, our operating results are dependent on the continued operation of our production facilities and our ability to meet customer requirements, which depend, in part, on our ability to properly maintain and replace aging assets. +We are subject to extensive government regulation in the jurisdictions in which we do business. Regulations addressing, among other things, import/export restrictions, anti-bribery and corruption, and taxes, can negatively impact our financial condition, results of operation, and cash flows. +We are subject to government regulation in the United States and in the foreign jurisdictions where we conduct business. The application of laws and regulations to our business is sometimes unclear. Compliance with laws and regulations may involve significant costs or require changes in business practices that could result in reduced profitability. If there is a determination that we have failed to comply with applicable laws or regulations, we may be subject to penalties or sanctions that could adversely impact our reputation and financial results. Compliance with changes in laws or regulations can result in increased operating costs and require additional, unplanned capital expenditures. Export controls or other regulatory restrictions could prevent us from shipping our products to and from some markets or increase the cost of doing so. Changes in tax laws and regulations and international tax treaties could affect the financial results of our businesses. Increasingly aggressive enforcement of anti-bribery and anti-corruption requirements, including the U.S. Foreign Corrupt Practices Act, the United Kingdom Bribery Act and the China Anti-Unfair Competition Law, could subject us to criminal or civil sanctions if a violation is deemed to have occurred. In addition, we are subject to laws and sanctions imposed by the U.S. and other jurisdictions where we do business that may prohibit us, or certain of our affiliates, from doing business in certain countries, or restricting the kind of business that we may conduct. Such restrictions may provide a competitive advantage to competitors who are not subject to comparable restrictions or prevent us from taking advantage of growth opportunities. +11 +Table of Contents +Further, we cannot guarantee that our internal controls and compliance systems will always protect us from acts committed by employees, agents, business partners or that businesses that we acquire would not violate U.S. and/or non-U.S. laws, including the laws governing payments to government officials, bribery, fraud, kickbacks and false claims, pricing, sales and marketing practices, conflicts of interest, competition, export and import compliance, money laundering, and data privacy. Any such improper actions or allegations of such acts could damage our reputation and subject us to civil or criminal investigations in the U.S. and in other jurisdictions and related shareholder lawsuits, could lead to substantial civil and criminal, monetary and non-monetary penalties, and could cause us to incur significant legal and investigatory fees. In addition, the government may seek to hold us liable as a successor for violations committed by companies in which we invest or that we acquire. +We may be unable to successfully identify, execute or effectively integrate acquisitions, or effectively disentangle divested businesses . +Our ability to grow revenue, earnings, and cash flow at anticipated rates depends in part on our ability to identify, successfully acquire and integrate businesses and assets at appropriate prices, and realize expected growth, synergies, and operating efficiencies. We may not be able to complete transactions on favorable terms, on a timely basis or at all. In addition, our results of operations and cash flows may be adversely impacted by the failure of acquired businesses or assets to meet expected returns, the failure to integrate acquired businesses, the inability to dispose of non-core assets and businesses on satisfactory terms and conditions, and the discovery of unanticipated liabilities or other problems in acquired businesses or assets for which we lack adequate contractual protections or insurance. In addition, we may incur asset impairment charges related to acquisitions that do not meet expectations. +We continually assess the strategic fit of our existing businesses and may divest businesses that are deemed not to fit with our strategic plan or are not achieving the desired return on investment. These transactions pose risks and challenges that could negatively impact our business and financial statements. For example, when we decide to sell or otherwise dispose of a business or assets, we may be unable to do so on satisfactory terms within our anticipated time frame or at all. In addition, divestitures or other dispositions may dilute our earnings per share, have other adverse financial and accounting impacts, distract management, and give rise to disputes with buyers. In addition, we have agreed, and may in the future agree, to indemnify buyers against known and unknown contingent liabilities. Our financial results could be impacted adversely by claims under these indemnification provisions. +The security of our information technology systems could be compromised, which could adversely affect our ability to operate. +We depend on information technology to enable us to operate efficiently and interface with customers as well as to maintain our internal controls environment and financial reporting accuracy and efficiency. Our information technology capabilities are delivered through a combination of internal and external services and service providers. If we do not allocate and effectively manage the resources necessary to build and sustain the proper technology infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to our confidential business information due to a security breach. In addition, our information technology systems may be damaged, disrupted or shut down due to attacks by computer hackers, computer viruses, employee error or malfeasance, power outages, hardware failures, telecommunication or utility failures, catastrophes or other unforeseen events, and in any such circumstances our system redundancy and other disaster recovery planning may be ineffective or inadequate. Security breaches of our systems (or the systems of our customers, suppliers or other business partners) could result in the misappropriation, destruction or unauthorized disclosure of confidential information or personal data belonging to us or to our employees, partners, customers or suppliers, and may subject us to legal liability. +As with most large systems, our information technology systems have in the past been, and in the future likely will be subject to computer viruses, malicious codes, unauthorized access and other cyber-attacks, and we expect the sophistication and frequency of such attacks to continue to increase. To date, we are not aware of any significant impact on our operations or financial results from such attempts; however, unauthorized access could disrupt our business operations, result in the loss of assets, and have a material adverse effect on our business, financial condition, or results of operations. Any of the attacks, breaches or other disruptions or damage described above could: interrupt our operations at one or more sites; delay production and shipments; result in the theft of our and our customers’ intellectual property and trade secrets; damage customer and business partner relationships and our reputation; result in defective products or services, legal claims and proceedings, liability and penalties under privacy laws, or increased costs for security and remediation; or raise concerns regarding our internal controls environment and internal controls over financial reporting. Each of these consequences could adversely affect our business, reputation and our financial statements. +12 +Table of Contents +Our business involves the use, storage, and transmission of information about our employees, vendors, and customers. The protection of such information, as well as our proprietary information, is critical to us. The regulatory environment surrounding information security and privacy is increasingly demanding, with the frequent imposition of new and constantly changing requirements. We have established policies and procedures to help protect the security and privacy of this information. We also, from time to time, export sensitive customer data and technical information to recipients outside the United States. Breaches of our security measures or the accidental loss, inadvertent disclosure, or unapproved dissemination of proprietary information or sensitive or confidential data about us or our customers, including the potential loss or disclosure of such information or data as a result of fraud, trickery, or other forms of deception, could expose us, our customers, or the individuals affected to a risk of loss or misuse of this information, which could ultimately result in litigation and potential legal and financial liability. These events could also damage our reputation or otherwise harm our business. +Interruption in ordinary sources of raw material or energy supply or an inability to recover increases in energy and raw material costs from customers could result in lost sales or reduced profitability. +Hydrocarbons, including natural gas, are the primary feedstock for the production of hydrogen, carbon monoxide, and syngas. Energy, including electricity, natural gas, and diesel fuel for delivery trucks, is the largest cost component of our business. Because our industrial gas facilities use substantial amounts of electricity, energy price fluctuations could materially impact our revenues and earnings. A disruption in the supply of energy, components, or raw materials, whether due to market conditions, legislative or regulatory actions, natural events, or other disruption, could prevent us from meeting our contractual commitments and harm our business and financial results. +Our supply of crude helium for purification and resale is largely dependent upon natural gas production by crude helium suppliers. Lower natural gas production resulting from natural gas pricing dynamics, supplier operating or transportation issues or other interruptions in sales from crude helium suppliers, can reduce our supplies of crude helium available for processing and resale to customers. +We typically contract to pass-through cost increases in energy and raw materials to customers, but cost variability can still have a negative impact on our results. We may be unable to raise prices as quickly as costs rise, or competitive pressures may prevent full recovery of such costs. Increases in energy or raw material costs that cannot be passed on to customers for competitive or other reasons may negatively impact our revenues and earnings. Even where costs are passed through, price increases can cause lower sales volume. +New technologies create performance risks that could impact our financial results or reputation. +We are continually developing and implementing new technologies and product offerings. Existing technologies are being implemented in products and designs or at scales beyond our experience base. These technological expansions can create nontraditional performance risks to our operations. Failure of the technologies to work as predicted, or unintended consequences of new designs or uses, could lead to cost overruns, project delays, financial penalties, or damage to our reputation. In addition, large scale gasification projects may contain processes or technologies that we have not operated at the same scale or in the same combination, and although such projects generally include technologies and processes that have been demonstrated previously by others, such technologies or processes may be new to us and may introduce new risks to our operations. Additionally, there is also a risk that our new technologies may become obsolete and replaced by other market alternatives. Performance difficulties on these larger projects may have a material adverse effect on our operations and financial results. In addition, performance challenges may adversely affect our reputation and our ability to obtain future contracts for gasification projects. +Protecting our intellectual property is critical to our technological development and we may suffer competitive harm from infringement on such rights. +As we develop new technologies, it is critical that we protect our intellectual property assets against third-party infringement. We own a number of patents and other forms of intellectual property related to our products and services. As we develop new technologies there is a risk that our patent applications may not be granted, or we may not receive sufficient protection of our proprietary interests. We may also expend considerable resources in defending our patents against third-party infringement. It is critical that we protect our proprietary interests to prevent competitive harm. +13 +Table of Contents +Legal and Regulatory Risks +Legislative, regulatory and societal responses to global climate change create financial risk. +We are the world’s leading supplier of hydrogen, the primary use of which is the production of ultra-low sulfur transportation fuels that have significantly reduced transportation emissions and helped improve human health. To make the high volumes of hydrogen needed by our customers, we use steam methane reforming, which releases carbon dioxide. In addition, although gasification enables the conversion of lower value feedstocks into cleaner energy and value-added products, our gasification projects will increase our carbon footprint because the gasification process produces carbon dioxide. Some of our operations are within jurisdictions that have or are developing regulatory regimes governing GHG emissions, including CO 2 , which may lead to direct and indirect costs on our operations. Furthermore, some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern and governmental action may result in more international, U.S. federal and/or regional requirements to reduce or mitigate the effects of GHG emissions. Although uncertain, these developments could increase our costs related to consumption of electric power, hydrogen production and application of our gasification technology. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation or governmental action that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +Our financial results may be affected by various legal and regulatory proceedings, including antitrust, tax, environmental, or other matters. +We are subject to litigation and regulatory investigations and proceedings in the normal course of business and could become subject to additional claims in the future, some of which could be material. While we seek to limit our liability in our commercial contractual arrangements, there are no guarantees that each contract will contain suitable limitations of liability or that limitations of liability will be enforceable. Also, the outcome of existing legal proceedings may differ from our expectations because the outcomes of litigation, including regulatory matters, are often difficult to predict reliably. Various factors or developments can lead us to change current estimates of liabilities and related insurance receivables, where applicable, or make such estimates for matters previously not susceptible to reasonable estimates, such as a significant judicial ruling or judgment, a significant settlement, significant regulatory developments, or changes in applicable law. A future adverse ruling, settlement, or unfavorable development could result in charges that could have a material adverse effect on our financial condition, results of operations, and cash flows in any particular period. +Costs and expenses resulting from compliance with environmental regulations may negatively impact our operations and financial results. +We are subject to extensive federal, state, local, and foreign environmental and safety laws and regulations concerning, among other things, emissions in the air; discharges to land and water; and the generation, handling, treatment, and disposal of hazardous waste and other materials. We take our environmental responsibilities very seriously, but there is a risk of adverse environmental impact inherent in our manufacturing operations and in the transportation of our products. Future developments and more stringent environmental regulations may require us to make additional unforeseen environmental expenditures. In addition, laws and regulations may require significant expenditures for environmental protection equipment, compliance, and remediation. These additional costs may adversely affect our financial results. For a more detailed description of these matters, see Item 1, Business–Environmental Regulation , above. +14 +Table of Contents +A change of tax law in key jurisdictions could result in a material increase in our tax expense. +The multinational nature of our business subjects us to taxation in the United States and numerous foreign jurisdictions. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. Our future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation. +Changes to income tax laws and regulations in any of the jurisdictions in which we operate, or in the interpretation of such laws, could significantly increase our effective tax rate and adversely impact our financial condition, results of operations or cash flows. In December 2017, the U.S. enacted the Tax Cuts and Jobs Act (the "Tax Act"), which significantly revised the U.S. federal corporate income tax law by, among other things, lowering the corporate income tax rate, implementing a territorial tax system, and imposing a one-time tax on accumulated, unremitted non-U.S. earnings of foreign subsidiaries. Various levels of government are increasingly focused on tax reform and other legislative action to increase tax revenue. Further changes in tax laws in the U.S. or foreign jurisdictions where we operate could have a material adverse effect on our business, results of operations, or financial condition. +We could incur significant liability if the distribution of Versum common stock to our stockholders is determined to be a taxable transaction. +We have received an opinion from outside tax counsel to the effect that the spin-off of Versum qualifies as a transaction that is described in Sections 355(a) and 368(a)(1)(D) of the Internal Revenue Code. The opinion relies on certain facts, assumptions, representations and undertakings from Versum and us regarding the past and future conduct of the companies’ respective businesses and other matters. If any of these facts, assumptions, representations or undertakings are incorrect or not satisfied, our shareholders and we may not be able to rely on the opinion of tax counsel and could be subject to significant tax liabilities. Notwithstanding the opinion of tax counsel we have received, the IRS could determine on audit that the spin-off is taxable if it determines that any of these facts, assumptions, representations or undertakings are not correct or have been violated or if it disagrees with the conclusions in the opinion. If the spin-off is determined to be taxable for U.S. federal income tax purposes, our shareholders that are subject to U.S. federal income tax and we could incur significant U.S. federal income tax liabilities. +General Risk Factors +Catastrophic events could disrupt our operations or the operations of our suppliers or customers, having a negative impact on our business, financial results, and cash flows. +Our operations could be impacted by catastrophic events outside our control, including severe weather conditions such as hurricanes, floods, earthquakes, storms, epidemics, pandemics, acts of war and terrorism. Any such event could cause a serious business disruption that could affect our ability to produce and distribute products and possibly expose us to third-party liability claims. Additionally, such events could impact our suppliers, customers and partners, which could cause energy and raw materials to be unavailable to us, or our customers to be unable to purchase or accept our products and services. Any such occurrence could have a negative impact on our operations and financial results. +The United Kingdom’s (“UK”) exit from European Union (“EU”) membership could adversely affect our European Operations. +The UK’s exit from EU membership may adversely affect customer demand, our relationships with customers and suppliers and our European business. Although it is unknown what the terms of the United Kingdom’s future relationship with the EU will be, it is possible that there will be greater restrictions on imports and exports between the United Kingdom and EU members and increased regulatory complexities. Any of these factors could adversely affect customer demand, our relationships with customers and suppliers, and our European business overall. +Inability to compete effectively in a segment could adversely impact sales and financial performance. +We face strong competition from large global competitors and many smaller regional competitors in many of our business segments. Introduction by competitors of new technologies, competing products, or additional capacity could weaken demand for, or impact pricing of our products, negatively impacting financial results. In addition, competitors’ pricing policies could affect our profitability or market share. +15 +Table of Contents +Item 1B. Unresolved Staff Comments. +We have not received any written comments from the Commission staff that remain unresolved. +Item 2. Properties. +Air Products and Chemicals, Inc. owns its principal administrative offices, which are the Company’s headquarters located in Trexlertown, Pennsylvania; Hersham, England; Medellin, Colombia; and Santiago, Chile. We lease the principal administrative offices in Shanghai, China; Pune, India; Vadodara, India; and Dhahran, Saudi Arabia. We lease administrative offices in the United States, Canada, Spain, Malaysia, and China for our Global Business Support organization. In addition, we are currently constructing new administrative offices and a co-located research and development facility in Trexlertown, Pennsylvania in preparation for re-location of our principal offices to the nearby site. +Descriptions of the properties used by our five business segments are provided below. We believe that our facilities are suitable and adequate for our current and anticipated future levels of operation. +Industrial Gases – Americas +This business segment currently operates from over 425 production and distribution facilities in North and South America. Approximately 25% of these facilities are located on owned property and 10% are integrated sites that serve dedicated customers as well as merchant customers. We have sufficient property rights and permits for the ongoing operation of our pipeline systems in the Gulf Coast, California, and Arizona in the United States and Alberta and Ontario, Canada. Management and sales support is based in our Trexlertown, Medellin, and Santiago offices referred to above, and at 12 leased properties located throughout North and South America. +We built hydrogen fueling stations that support commercial markets in California and Japan as well as demonstration projects in Europe and other parts of Asia. +Industrial Gases – EMEA +This business segment currently operates from over 200 production and distribution facilities in Europe, the Middle East, India, and Africa, approximately one-third of which are on owned property. We have sufficient property rights and permits for the ongoing operation of our pipeline systems in the Netherlands, the United Kingdom, Belgium, France, and Germany. Management and sales support for this business segment is based in Hersham, England, referred to above; Barcelona, Spain; and at 16 leased regional office sites and 15 leased local office sites, located throughout the region. +Industrial Gases – Asia +This business segment currently operates from over 211 production and distribution facilities within Asia, approximately 25% of which are on owned property or long-duration term grants. We have sufficient property rights and permits for the ongoing operation of our pipeline systems in China, South Korea, Taiwan, Malaysia, Singapore, and Indonesia. Management and sales support for this business segment is based in Shanghai, China, and Kuala Lumpur, Malaysia, and in 30 leased office locations throughout the region. +Industrial Gases – Global +Management, sales, and engineering support for this business segment is based in our principal administrative offices noted above. +Equipment is manufactured in Missouri in the United States and Shanghai, China. +Research and development activities for this business segment are conducted at owned locations in the United States, the United Kingdom, and Spain, and three leased locations in Europe and Asia. +Helium is processed at multiple sites in the United States and then distributed to and from transfill sites globally. +16 +Table of Contents +Corporate and other +Corporate administrative functions are based in our administrative offices referred to above. +The LNG business operates a manufacturing facility in Florida in the United States with management, engineering, and sales support based in the Trexlertown offices referred to above. +The Gardner Cryogenic business operates at facilities in Pennsylvania and Kansas in the United States. +The Rotoflow business operates manufacturing and service facilities in Texas and Pennsylvania in the United States with management, engineering, and sales support based in the Trexlertown offices referred to above and a nearby leased office. +Item 3. Legal Proceedings. +In the normal course of business, we and our subsidiaries are involved in various legal proceedings, including commercial, competition, environmental, intellectual property, regulatory, product liability, and insurance matters. Although litigation with respect to these matters is routine and incidental to the conduct of our business, such litigation could result in large monetary awards, especially if compensatory and/or punitive damages are awarded. However, we believe that litigation currently pending to which we are a party will be resolved without any material adverse effect on our financial position, earnings, or cash flows. +From time to time, we are also involved in proceedings, investigations, and audits involving governmental authorities in connection with environmental, health, safety, competition, and tax matters. +We are a party to proceedings under CERCLA, RCRA, and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Presently there are 31 sites on which a final settlement has not been reached where we, along with others, have been designated a potentially responsible party by the Environmental Protection Agency or is otherwise engaged in investigation or remediation, including cleanup activity at certain of its current and former manufacturing sites. We do not expect that any sums we may have to pay in connection with these environmental matters would have a material adverse impact on our consolidated financial position. Additional information on our environmental exposure is included under Item 1, Business–Environmental Regulation, and Note 17, Commitments and Contingencies , to the consolidated financial statements. +In September 2010, the Brazilian Administrative Council for Economic Defense ("CADE") issued a decision against our Brazilian subsidiary, Air Products Brasil Ltda., and several other Brazilian industrial gas companies for alleged anticompetitive activities. CADE imposed a civil fine of R$179.2 million (approximately $32 million at 30 September 2020) on Air Products Brasil Ltda. This fine was based on a recommendation by a unit of the Brazilian Ministry of Justice, whose investigation began in 2003, alleging violation of competition laws with respect to the sale of industrial and medical gases. The fines are based on a percentage of our total revenue in Brazil in 2003. +We have denied the allegations made by the authorities and filed an appeal in October 2010 to the Brazilian courts. On 6 May 2014, our appeal was granted and the fine against Air Products Brasil Ltda. was dismissed. CADE has appealed that ruling and the matter remains pending. We, with advice of our outside legal counsel, have assessed the status of this matter and have concluded that, although an adverse final judgment after exhausting all appeals is possible, such a judgment is not probable. As a result, no provision has been made in the consolidated financial statements. +Other than the CADE matter discussed above, we do not currently believe there are any legal proceedings, individually or in the aggregate, that are reasonably possible to have a material impact on our financial condition, results of operations, or cash flows. However, a future charge for regulatory fines or damage awards could have a significant impact on our net income in the period in which it is recorded. +Additional information on our legal proceedings can be found in Note 17, Commitments and Contingencies , to the consolidated financial statements. +Item 4. Mine Safety Disclosures. +Not applicable. +17 +Table of Contents +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Our common stock is listed on the New York Stock Exchange under the symbol "APD." As of 31 October 2020, there were 4,957 record holders of our common stock. +Cash dividends on our common stock are paid quarterly. It is our expectation that we will continue to pay cash dividends in the future at comparable or increased levels. The Board of Directors determines whether to declare dividends and the timing and amount based on financial condition and other factors it deems relevant. Dividend information for each quarter of fiscal years 2020 and 2019 is summarized below: +2020 2019 +Fourth quarter $1.34 $1.16 +Third quarter $1.34 $1.16 +Second quarter $1.34 $1.16 +First quarter $1.16 $1.10 +Total $5.18 $4.58 +Purchases of Equity Securities by the Issuer +On 15 September 2011, the Board of Directors authorized the repurchase of up to $1.0 billion of our outstanding common stock. This program does not have a stated expiration date. We repurchase shares pursuant to Rules 10b5-1 and 10b-18 under the Exchange Act through repurchase agreements established with one or more brokers. There were no purchases of stock during fiscal year 2020. At 30 September 2020, $485.3 million in share repurchase authorization remained. Additional purchases will be completed at our discretion while maintaining sufficient funds for investing in businesses and growth opportunities. +18 +Table of Contents +Performance Graph +The performance graph below compares the five-year cumulative returns of our common stock with those of the Standard & Poor’s 500 Index ("S&P 500 Index") and the Standard & Poor’s 500 Materials Index ("S&P 500 Materials Index"). The figures assume an initial investment of $100 and the reinvestment of all dividends. +Sept 2015 Sept 2016 Sept 2017 Sept 2018 Sept 2019 Sept 2020 +Air Products & Chemicals, Inc. 100 120 134 153 208 285 +S&P 500 Index 100 115 137 161 168 194 +S&P 500 Materials Index 100 122 148 154 158 178 +19 +Table of Contents +Item 6. Selected Financial Data. +(Millions of dollars, except for share and per share data) 2020 2019 2018 2017 2016 +Sales $8,856 $8,919 $8,930 $8,188 $7,504 +Operating income 2,238 2,144 1,966 1,440 1,535 +Operating margin 25.3 % 24.0 % 22.0 % 17.6 % 20.5 % +Equity affiliates’ income (A) +265 215 175 80 147 +Net income (B) +1,931 1,809 1,533 3,021 662 +Net income margin 21.8 % 20.3 % 17.2 % 36.9 % 8.8 % +Income from continuing operations 1,945 1,809 1,491 1,155 1,122 +Basic earnings per common share from continuing operations 8.59 7.99 6.64 5.20 5.08 +Diluted earnings per common share from continuing operations 8.55 7.94 6.59 5.16 5.04 +Adjusted diluted earnings per common share from continuing operations (C) +$8.38 $8.21 $7.45 $6.31 $5.64 +Adjusted EBITDA (C) +3,620 3,468 3,116 2,799 2,622 +Adjusted EBITDA margin (C) +40.9 % 38.9 % 34.9 % 34.2 % 34.9 % +Dividends declared per common share 5.18 4.58 4.25 3.71 3.39 +Total assets (D) +25,169 18,943 19,178 18,467 18,029 +Total debt (E) +7,908 3,326 3,813 3,963 5,211 +(A) Fiscal year 2020 included a benefit of $34 related to legislation passed by the Indian government in the second quarter. Fiscal year 2018 included an expense of $29 related to the U.S. Tax Cuts and Jobs Act. Fiscal year 2017 included the impact of an other-than-temporary noncash impairment charge of $80 on a 25%‑owned equity affiliate in Saudi Arabia. +(B) Fiscal year 2017 included net income from discontinued operations of $1,866 primarily resulting from the sale of the Performance Materials Division to Evonik Industries AG. Fiscal year 2016 included a net loss from discontinued operations of $465, which included an after-tax loss of $847 related to the exit of Energy-from-Waste, partially offset by income from operations of the former Electronic Materials and Performance Materials divisions. +(C) A reconciliation of adjusted diluted earnings per common share from continuing operations to diluted earnings per common share from continuing operations on a GAAP basis is presented on page 32. A reconciliation of adjusted EBITDA and adjusted EBITDA margin to net income and net income margin on a GAAP basis, respectively, is presented on page 33. +(D) Total assets as of 30 September 2020 was impacted by proceeds from the issuance of U.S. Dollar- and Euro-denominated fixed-rate notes in the third quarter of fiscal year 2020. Total assets as of 30 September 2017 and 2016 included those associated with continuing and discontinued operations. +(E) Total debt includes long-term debt and current portion of long-term debt, including debt owed to related parties, and short-term borrowings as of the end of the fiscal year for continuing operations. Long-term obligations increased in fiscal year 2020 due to the issuance of U.S. Dollar- and Euro-denominated fixed-rate notes in the third quarter. Long-term obligations decreased in fiscal year 2017 primarily due to debt repayments subsequent to the spin-off of the former Electronic Materials Division as Versum Materials, Inc. +20 +Table of Contents +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Business Overview +22 +2020 in Summary +22 +2021 Outlook +24 +Results of Operations +24 +Reconciliations of Non-GAAP Financial Measures +31 +Liquidity and Capital Resources +35 +Contractual Obligations +38 +Pension Benefits +40 +Environmental Matters +41 +Off-Balance Sheet Arrangements +41 +Related Party Transactions +41 +Inflation +41 +Critical Accounting Policies and Estimates +42 +New Accounting Guidance +48 +This Management’s Discussion and Analysis contains “forward-looking statements” within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, including statements about business outlook. These forward-looking statements are based on management’s expectations and assumptions as of the date of this Annual Report and are not guarantees of future performance. Actual performance and financial results may differ materially from projections and estimates expressed in the forward-looking statements because of many factors not anticipated by management, including, without limitation, those described in Forward-Looking Statements and Item 1A, Risk Factors , of this Annual Report on Form 10-K. +The discussion that follows includes a comparison of our results of operations and liquidity and capital resources for fiscal years 2020 and 2019. For the discussion of changes from fiscal year 2018 to fiscal year 2019 and other financial information related to fiscal year 2018, refer to Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , of our Form 10-K for the fiscal year ended 30 September 2019. This document was filed with the SEC on 26 November 2019. +The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes contained in this Annual Report. Unless otherwise stated, financial information is presented in millions of dollars, except for per share data. Except for net income, which includes the results of discontinued operations, financial information is presented on a continuing operations basis. +The financial measures included in the discussion that follows are presented in accordance with U.S. generally accepted accounting principles ("GAAP"), except as noted. We present certain financial measures on an "adjusted," or "non-GAAP," basis because we believe such measures, when viewed together with financial results computed in accordance with GAAP, provide a more complete understanding of the factors and trends affecting our historical financial performance. For each non-GAAP financial measure, including adjusted diluted earnings per share ("EPS"), adjusted EBITDA, adjusted EBITDA margin, and adjusted effective tax rate, we present a reconciliation to the most directly comparable financial measure calculated in accordance with GAAP. These reconciliations and explanations regarding the use of these measures are presented beginning on page 31. +In March 2020, the World Health Organization declared the novel strain of coronavirus, COVID-19, a global pandemic and recommended containment and mitigation measures worldwide. In response to COVID-19, we implemented certain health and safety policies to help keep our employees, contractors, customers, and communities safe while continuing to run our facilities, which generally have been considered "essential" by local governments and public health authorities. In compliance with government protocols, our non-essential employees were instructed to work from home until government mandated restrictions allow for a return to the workplace. Those working and visiting our sites are required to follow appropriate procedures, including completion of trainings and performance of self- and on-site screenings, as well as adhere to our personal protective equipment, social distancing, and personal hygiene protocols. +21 +Table of Contents +BUSINESS OVERVIEW +Air Products and Chemicals, Inc. is a world-leading industrial gases company that has been in operation for 80 years. Focused on serving energy, environment and emerging markets, we provide essential industrial gases, related equipment and applications expertise to customers in dozens of industries, including refining, chemical, metals, electronics, manufacturing, and food and beverage. Air Products is also the global leader in the supply of liquefied natural gas ("LNG") process technology and equipment. We develop, engineer, build, own and operate some of the world's largest industrial gas projects, including gasification projects that sustainably convert abundant natural resources into syngas for the production of high-value power, fuels and chemicals. +With operations in 50 countries, in fiscal year 2020 we had sales of $8.9 billion and assets of $25.2 billion. Approximately 19,275 passionate, talented and committed full- and part-time employees from diverse backgrounds are driven by Air Products’ higher purpose to create innovative solutions that benefit the environment, enhance sustainability and address the challenges facing customers, communities, and the world. +As of 30 September 2020, our operations were organized into five reportable business segments: +• Industrial Gases – Americas; +• Industrial Gases – EMEA (Europe, Middle East, and Africa); +• Industrial Gases – Asia; +• Industrial Gases – Global; and +• Corporate and other +This Management’s Discussion and Analysis discusses our results based on these operations. Refer to Note 25, Business Segment and Geographic Information , to the consolidated financial statements for additional details on our reportable business segments. +2020 IN SUMMARY +In fiscal year 2020, our number one priority was the safety and well-being of our people. Since the beginning of the COVID-19 pandemic, we have kept our global plants running, supplied critical products, and supported our local communities during this time of need. We continued to win significant new growth projects around the world and serve our customers, delivering stable results despite the significant health crisis facing the world. We also remained focused on sustainability and our commitment to advancing diversity and inclusion. We set new goals that are aligned with Air Products' business strategy and higher purpose to create innovative solutions that benefit the environment, enhance sustainability, and address the challenges facing customers, communities, and the world. +Fiscal year 2020 results and highlights are summarized below: +• Sales of $8,856.3 decreased 1%, or $62.6, as 3% higher pricing and 2% favorable volumes were more than offset by 4% lower energy and natural gas cost pass-through to customers, 1% unfavorable currency, and the 1% impact of a contract modification to a tolling arrangement in India. We estimate that COVID-19 negatively impacted our overall sales by approximately 4%, primarily driven by lower volumes in our merchant business in the regional industrial gas segments. +• Operating income of $2,237.6 increased 4%, or $93.2, and operating margin of 25.3% increased 130 bp. +• Net income of $1,931.1 increased 7%, or $121.7, and net income margin of 21.8% increased 150 bp. +• Adjusted EBITDA of $3,619.8 increased 4%, or $151.8, and adjusted EBITDA margin of 40.9% increased 200 bp. +• Diluted EPS of $8.55 increased 8%, or $0.61, and adjusted diluted EPS of $8.38 increased 2%, or $0.17. We estimate that COVID-19 negatively impacted our fiscal year 2020 EPS by approximately $0.60-$0.65 per share. A summary table of changes in diluted EPS is presented below. +22 +Table of Contents +Fiscal year 2020 results and highlights (continued): +• We increased our quarterly dividend by over 15% from $1.16 to $1.34 per share, representing the largest dividend increase in our 80-year history. This is the 38 th consecutive year that we have increased our quarterly dividend payment. +• We successfully executed a debt offering of approximately $5 billion during the third quarter, supporting significant opportunities to invest in high-return industrial gas projects and the repayment of upcoming debt maturities. The issuance included both U.S. Dollar- and Euro-denominated fixed-rate notes. +Changes in Diluted EPS Attributable to Air Products +The per share impacts presented in the table below were calculated independently and may not sum to the total change in diluted EPS due to rounding. +Increase +Year Ended 30 September 2020 2019 (Decrease) +Diluted EPS +Total Diluted EPS $8.49 $7.94 $0.55 +Less: Diluted EPS from loss from discontinued operations (0.06) — (0.06) +Diluted EPS From Continuing Operations +$8.55 $7.94 $0.61 +Operating Impacts +Underlying business +Volume ($0.19) +Price, net of variable costs 0.77 +Other costs (0.38) +Currency (0.07) +Facility closure 0.10 +Company headquarters relocation income (expense) 0.12 +Cost reduction actions 0.08 +Gain on exchange of equity affiliate investments (0.13) +Total Operating Impacts $0.30 +Other Impacts +Equity affiliates' income $0.06 +Interest expense 0.10 +Other non-operating income (expense), net (0.13) +Change in effective tax rate, excluding discrete items below 0.04 +India Finance Act 2020 0.06 +Tax reform repatriation (0.06) +Tax reform adjustment related to deemed foreign dividends 0.26 +Noncontrolling interests 0.02 +Weighted average diluted shares (0.03) +Total Other Impacts $0.32 +Total Change in Diluted EPS From Continuing Operations (A) +$0.61 +(A) Includes an estimated negative impact of $0.60-$0.65 from COVID-19. This estimate includes impacts on our sales, costs, and equity affiliates' income. +23 +Table of Contents +Increase +Year Ended 30 September 2020 2019 (Decrease) +Diluted EPS From Continuing Operations $8.55 $7.94 $0.61 +Facility closure — 0.10 (0.10) +Cost reduction actions — 0.08 (0.08) +Gain on exchange of equity affiliate investments — (0.13) 0.13 +Company headquarters relocation (income) expense (0.12) — (0.12) +India Finance Act 2020 (0.06) — (0.06) +Pension settlement loss — 0.02 (0.02) +Tax reform repatriation — (0.06) 0.06 +Tax reform adjustment related to deemed foreign dividends — 0.26 (0.26) +Adjusted Diluted EPS From Continuing Operations $8.38 $8.21 $0.17 +2021 OUTLOOK +As COVID-19 continues, we remain focused on the safety and well-being of our people. We are committed to safely maintaining plant operations and ensuring business continuity, including providing financial security for employees, reliably supplying critical products and services to our customers, and winning new opportunities for world-scale projects. +We expect lower volumes from COVID-19 to continue into fiscal year 2021 with recovery in demand depending on the duration of COVID-19 and measures implemented by governments, public health authorities and businesses to mitigate its spread. Given the dynamic nature of these circumstances, the future impact on our ongoing business, results of operations, and overall financial performance cannot be reasonably estimated. +Despite the uncertainty of the duration of COVID-19, we will continue to focus on pricing discipline in our merchant business and expect our onsite business model, which represents approximately half of our business, to continue generating stable cash flow. This will allow us to execute our strategic focus on our industrial gas business and the creation of long-term shareholder value, including the ongoing growth of our dividend, continued execution of projects in our backlog, and new investments in high-return industrial gas projects. +A long-term onsite customer in Asia delayed restarting their plant following a planned major maintenance turnaround completed in September 2020. While we expect the plant to restart in fiscal year 2021, we are negotiating with the customer regarding contract terms that could impact sales in our Industrial Gases – Asia segment. +The above guidance should be read in conjunction with the Forward-Looking Statements of this Annual Report on Form 10-K. +RESULTS OF OPERATIONS +Discussion of Consolidated Results +2020 2019 $ Change Change +GAAP Measures +Sales $8,856.3 $8,918.9 ($62.6) (1) % +Operating income 2,237.6 2,144.4 93.2 4 % +Operating margin 25.3 % 24.0 % 130 bp +Equity affiliates’ income $264.8 $215.4 49.4 23 % +Net income 1,931.1 1,809.4 121.7 7 % +Net income margin 21.8 % 20.3 % 150 bp +Non-GAAP Measures +Adjusted EBITDA $3,619.8 $3,468.0 151.8 4 % +Adjusted EBITDA margin 40.9 % 38.9 % 200 bp +24 +Table of Contents +Sales +Sales % Change from Prior Year +Volume 2 % +Price 3 % +Energy and natural gas cost pass-through (4) % +Currency (1) % +Other (A) +(1) % +Total Consolidated Sales Change (1) % +(A) Includes the impact from the modification of a hydrogen supply contract to a tolling arrangement in India in December 2018 (the "India contract modification"). +Sales of $8,856.3 decreased 1%, or $62.6, as higher pricing of 3% and favorable volumes of 2% were more than offset by lower energy and natural gas cost pass-through to customers of 4%, unfavorable currency of 1%, and the impact from the India contract modification of 1%. The pricing improvement was attributable to our merchant business across the regional segments. The volume growth exceeded the negative impacts from COVID-19 and was primarily driven by acquisitions, new plants, and higher sale of equipment project activity. We estimate that COVID-19 negatively impacted overall sales by approximately 4%, primarily driven by lower volumes in our merchant business across the regional segments as our onsite business remained stable. Unfavorable currency impacts were driven by the Chilean Peso, Chinese Renminbi, Euro, and South Korean Won. +Cost of Sales and Gross Margin +Cost of sales of $5,858.1 decreased 2%, or $146.4, from total cost of sales of $6,004.5 in the prior year, which included the facility closure further discussed below. The decrease from the prior year was driven by lower energy and natural gas cost pass-through to customers of $314, positive currency impacts of $73, the favorable impact from the India contract modification of $41, and the prior year facility closure of $29, partially offset by higher costs attributable to sales volumes of $250 and higher other costs, including planned maintenance, of $61. Gross margin of 33.9% increased 120 bp from 32.7% in the prior year, primarily due to positive pricing, lower energy and natural gas cost pass-through to customers, and the prior year facility closure, partially offset by unfavorable volume mix and net operating costs. +Facility Closure +In fiscal year 2019, one of our customers was subject to a government enforced shutdown due to environmental reasons. As a result, we recognized a charge of $29.0 ($22.1 after-tax, or $0.10 per share) primarily related to the write-off of onsite assets. This charge was reflected as “Facility closure” on our consolidated income statements for the fiscal year ended 30 September 2019 and was not recorded in segment results. +Selling and Administrative +Selling and administrative expense of $775.9 increased 3%, or $25.9, due to higher business development costs to support our growth strategy and higher incentive compensation, partially offset by currency impacts and lower travel expenses. Selling and administrative expense, as a percentage of sales, increased from 8.4% to 8.8%. +Research and Development +Research and development expense of $83.9 increased 15%, or $11.0, primarily due to higher product development costs. Research and development expense as a percentage of sales increased from 0.8% to 0.9%. +Company Headquarters Relocation Income (Expense) +During the second quarter of fiscal year 2020, we sold property at our current corporate headquarters located in Trexlertown, Pennsylvania, for net proceeds of $44.1. The sale was completed in anticipation of relocating our U.S. headquarters and resulted in a gain of $33.8 ($25.6 after-tax, or $0.12 per share). This gain is reflected on our consolidated income statements as "Company headquarters relocation income (expense)" for the fiscal year ended 30 September 2020 and was not recorded in segment results. +25 +Table of Contents +Cost Reduction Actions +In fiscal year 2019, we recognized an expense of $25.5 ($18.8 after-tax, or $0.08 per share) for severance and other benefits associated with position eliminations, primarily within the Industrial Gases – EMEA and the Industrial Gases – Americas segments. This expense was reflected as "Cost reduction actions" on our consolidated income statements for the fiscal year ended 30 September 2019 and was not recorded in segment results. Refer to Note 5, Cost Reduction Actions , to the consolidated financial statements for additional information. +Gain on Exchange of Equity Affiliate Investments +In fiscal year 2019, we recognized a net gain of $29.1 ($0.13 per share) resulting from the exchange of two 50%-owned industrial gas joint ventures in China. The net gain was reflected as "Gain on exchange of equity affiliate investments" on our consolidated income statements for the fiscal year ended 30 September 2019 and was not recorded in segment results. Refer to Note 3, Acquisitions , to the consolidated financial statements for additional information. +Other Income (Expense), Net +Other income (expense), net of $65.4 increased 33%, or $16.1, primarily due to the adjustment of a benefit plan liability resulting from a change in plan terms. +Operating Income and Margin +Operating income of $2,237.6 increased 4%, or $93.2, due to positive pricing, net of power and fuel costs, of $212, income associated with the company headquarters relocation of $34, and prior year charges for a facility closure of $29 and cost reduction actions of $26, partially offset by higher net operating costs of $104, including planned maintenance, unfavorable volume mix of $55, a gain on the exchange of equity affiliates of $29 in the prior year, and unfavorable currency of $20. +Operating margin of 25.3% increased 130 bp, primarily due to positive pricing, lower energy and natural gas cost pass-through to customers, the impact of income associated with the company headquarters relocation, and prior year charges for a facility closure and cost reduction actions, partially offset by unfavorable volume mix, higher operating costs, and a gain on the exchange of two equity affiliates in the prior year. +Equity Affiliates’ Income +Equity affiliates' income of $264.8 increased 23%, or $49.4, primarily due to a current year benefit of $33.8 for the release of our share of accumulated dividend distribution taxes related to an Indian affiliate as a result of the enactment of a tax law in India. Refer to Note 22, Income Taxes , to the consolidated financial statements for additional information. The current year also includes higher income from affiliates in India, Italy, and Saudi Arabia, partially offset by negative impacts from COVID-19. +Interest Expense +2020 2019 +Interest incurred $125.2 $150.5 +Less: Capitalized interest 15.9 13.5 +Interest expense $109.3 $137.0 +Interest incurred decreased 17%, or $25.3. The prior year included an expense of $33.3 related to foreign currency forward points and currency swap basis differences ("excluded components") of our cash flow hedges of intercompany loans. As discussed in Note 2, New Accounting Guidance , to the consolidated financial statements, we adopted new accounting guidance on hedging activities that changed the presentation of these items from "Interest expense, net" to “Other non-operating income (expense), net” in fiscal year 2020. In addition to this presentation change, interest incurred decreased due to lower expenses related to the Lu'An joint venture financing and a lower average interest rate on the debt portfolio, partially offset by a higher debt balance due to the issuance of debt during the third quarter of fiscal year 2020. Refer to Note 15, Debt , to the consolidated financial statements for additional information. We expect interest expense to be higher in future periods due to this issuance. Capitalized interest increased 18%, or $2.4, due to an increase in the carrying value of projects under construction. +26 +Table of Contents +Other Non-Operating Income (Expense), Net +Other non-operating income of $30.7 decreased 54%, or $36.0, primarily due to an expense of $33.5 for the excluded components of cash flow hedges of intercompany loans. These components were historically recorded in "Interest expense" prior to the adoption of the guidance discussed above. The current year also included lower interest income on cash and cash items. These factors were partially offset by higher non-service pension income due to lower interest cost and higher expected asset returns, primarily for our U.S. pension plans. The prior year includes a settlement loss of $5.0 ($3.8 after-tax, or $0.02 per share) associated with the U.S. Supplementary Pension Plan. +Discontinued Operations +During the second quarter of fiscal year 2020, we recorded a pre-tax loss from discontinued operations of $19.0 ($14.3 after-tax, or $0.06 per share) to increase our liability for retained environmental obligations associated with the sale of our former Amines business in September 2006. Refer to the Pace discussion within Note 17, Commitments and Contingencies , to the consolidated financial statements for additional information. +Net Income and Net Income Margin +Net income of $1,931.1 increased 7%, or $121.7, primarily due to higher pricing and income from the sale of property at our current corporate headquarters. In addition, the prior year was negatively impacted by a facility closure, cost reduction actions, and the U.S. Tax Cuts and Jobs Act. These factors were partially offset by higher costs, including the after-tax loss from discontinued operations, unfavorable volume mix, and a gain on the exchange of two equity affiliates in the prior year. Net income margin of 21.8% increased 150 bp, primarily due to the factors noted above as well as lower energy and natural gas cost pass-through to customers. +Adjusted EBITDA and Adjusted EBITDA Margin +Adjusted EBITDA of $3,619.8 increased 4%, or $151.8, primarily due to higher pricing, partially offset by higher operating costs. Adjusted EBITDA margin of 40.9% increased 200 bp, primarily due to the higher pricing and lower energy and natural gas cost pass-through to customers, partially offset by unfavorable volume mix and higher operating costs. +Effective Tax Rate +The effective tax rate equals the income tax provision divided by income from continuing operations before taxes. The effective tax rate was 19.7% and 21.0% for the fiscal years ended 30 September 2020 and 2019, respectively. +The 2019 tax rate reflected a discrete net income tax expense of $43.8 related to impacts from the U.S. Tax Cuts and Jobs Act (the “Tax Act”). The net expense included the reversal of a non-recurring $56.2 ($0.26 per share) benefit recorded in 2018 related to the U.S. taxation of deemed foreign dividends. This was partially offset by a benefit of $12.4 ($0.06 per share) to finalize our estimates of the impacts of the Tax Act and reduce the total expected costs of the deemed repatriation tax. In addition, the net expense from the Tax Act was partially offset by benefits from changes in valuation allowance recorded at various entities in 2019. +The lower current year rate reflects favorable impacts from higher benefits on the revaluation of deferred tax accounts due to enacted changes in foreign tax law, changes in the tax profile of U.S. entities in various state jurisdictions, and higher excess tax benefits on share-based compensation. These items were partially offset by the enactment of the India Finance Act 2020 (the "India Finance Act"), which increased income tax expense by $20.3. The enactment also increased equity affiliates' income by $33.8 for changes in the future tax costs of repatriated earnings. The overall impact to net income resulting from the India Finance Act was a benefit of $13.5 ($0.06 per share). +The adjusted effective tax rate was 19.1% and 19.4% for the fiscal years ended 30 September 2020 and 2019, respectively. The lower current year rate reflects favorable impacts from higher benefits on the revaluation of deferred tax accounts due to enacted changes in foreign tax law, changes in the tax profile of U.S. entities in various state jurisdictions, and higher excess tax benefits on share-based compensation. These items were partially offset by benefits from changes in valuation allowances recorded at various entities in 2019. +Refer to Note 22, Income Taxes , to the consolidated financial statements for additional information. +27 +Table of Contents +Segment Analysis +Industrial Gases – Americas +Year Ended 30 September 2020 2019 $ Change Change +Sales $3,630.7 $3,873.5 ($242.8) (6) % +Operating income 1,012.4 997.7 14.7 1 % +Operating margin 27.9 % 25.8 % 210 bp +Equity affiliates’ income $84.3 $84.8 ($0.5) (1) % +Adjusted EBITDA 1,656.2 1,587.7 68.5 4 % +Adjusted EBITDA margin 45.6 % 41.0 % 460 bp +Sales % Change from Prior Year +Volume (1) % +Price 3 % +Energy and natural gas cost pass-through (6) % +Currency (2) % +Total Industrial Gases – Americas Sales Change (6) % +Sales of $3,630.7 decreased 6%, or $242.8, as lower energy and natural gas cost pass-through to customers of 6%, a negative impact from currency of 2%, and lower volumes of 1% were partially offset by positive pricing of 3%. The pricing improvement was driven by our merchant business. Lower volumes, particularly in our merchant business, were primarily driven by COVID-19, which began impacting this segment at the end of March 2020 and continued through the end of the fiscal year. The negative impact of COVID-19 was partially offset by positive contributions from the commencement of a long-term hydrogen supply agreement with PBF Energy Inc. from assets we acquired in April. The unfavorable currency impact was driven by the Chilean Peso. +Operating income of $1,012.4 increased 1%, or $14.7, due to higher pricing, net of power and fuel costs, of $95, partially offset by higher net operating costs of $40, lower volumes of $33, and unfavorable currency impacts of $7. Operating margin of 27.9% increased 210 bp, primarily due to positive pricing and lower energy and natural gas cost pass-through to customers, partially offset by lower volumes and unfavorable net operating costs. +Equity affiliates’ income of $84.3 decreased 1%, or $0.5. +28 +Table of Contents +Industrial Gases – EMEA +2020 2019 $ Change Change +Sales $1,926.3 $2,002.5 ($76.2) (4) % +Operating income 473.3 472.4 0.9 — % +Operating margin 24.6 % 23.6 % 100 bp +Equity affiliates’ income $74.8 $69.0 $5.8 8 % +Adjusted EBITDA 744.0 730.9 13.1 2 % +Adjusted EBITDA margin 38.6 % 36.5 % 210 bp +Sales % Change from Prior Year +Volume — % +Price 3 % +Energy and natural gas cost pass-through (4) % +Currency (1) % +Other (A) +(2) % +Total Industrial Gases – EMEA Sales Change (4) % +(A) Includes the impact from the modification of a hydrogen supply contract to a tolling arrangement in India in December 2018 (the "India contract modification"). +Sales of $1,926.3 decreased 4%, or $76.2, as lower energy and natural gas cost pass-through to customers of 4%, the negative impact from the India contract modification of 2%, and unfavorable currency impacts of 1% were only partially offset by positive pricing of 3%. The pricing improvement was attributable to our merchant business. Volumes were flat versus the prior year as improvements from acquisitions and demand for hydrogen in our Rotterdam pipeline system were offset by lower volumes from COVID-19, particularly in our merchant business. COVID-19 began impacting this segment at the end of March 2020 and continued through the end of the fiscal year. The negative currency impact was mainly driven by the Euro. +Operating income of $473.3 was flat as higher pricing, net of power and fuel costs, of $71 was offset by higher costs of $41, unfavorable volume mix of $27, and unfavorable currency impacts of $3. Operating margin of 24.6% increased 100 bp, primarily due to favorable pricing, lower energy and natural gas cost pass-through to customers, and the India contract modification, partially offset by higher costs and unfavorable volume mix. +Equity affiliates’ income of $74.8 increased 8%, or $5.8, primarily due to Jazan Gas Projects Company, which began to contribute in the second half of fiscal year 2019, and higher income from an affiliate in Italy. +29 +Table of Contents +Industrial Gases – Asia +2020 2019 $ Change Change +Sales $2,716.5 $2,663.6 $52.9 2 % +Operating income 870.3 864.2 6.1 1 % +Operating margin 32.0 % 32.4 % (40) bp +Equity affiliates’ income $61.0 $58.4 $2.6 4 % +Adjusted EBITDA 1,330.7 1,284.1 46.6 4 % +Adjusted EBITDA margin 49.0 % 48.2 % 80 bp +Sales % Change from Prior Year +Volume 1 % +Price 2 % +Energy and natural gas cost pass-through — % +Currency (1) % +Total Industrial Gases – Asia Sales Change 2 % +Sales of $2,716.5 increased 2%, or $52.9, as positive pricing of 2% and higher volumes of 1% were partially offset by unfavorable currency impacts of 1%. Volume improvements from new plants were partially offset by negative impacts from planned maintenance outages, completion of a short-term supply contract, and COVID-19, which began impacting this segment in the second quarter and continued through the end of the fiscal year. The negative impact from COVID-19 was primarily on our merchant volumes. Pricing improved across Asia, driven by our merchant business. The unfavorable currency impact was primarily attributable to the Chinese Renminbi and the South Korean Won. Energy and natural gas cost pass-through to customers was flat versus the prior year. +Operating income of $870.3 increased 1%, or $6.1, due to positive pricing, net of power and fuel costs, of $46 and favorable net operating costs of $4, partially offset by unfavorable volume mix of $33 and currency impacts of $11. Operating margin of 32.0% decreased 40 bp, as unfavorable volume mix more than offset positive pricing. +Equity affiliates’ income of $61.0 increased 4%, or $2.6. +Industrial Gases – Global +The Industrial Gases – Global segment includes sales of cryogenic and gas processing equipment for air separation and centralized global costs associated with management of all the Industrial Gases segments. +2020 2019 $ Change Change +Sales $364.9 $261.0 $103.9 40 % +Operating loss (40.0) (11.7) (28.3) (242) % +Adjusted EBITDA (19.5) 0.1 (19.6) N/M* +* Not meaningful +Sales of $364.9 increased 40%, or $103.9, primarily due to higher sale of equipment activity. Operating loss of $40.0 increased 242%, or $28.3, as higher project and product development costs were only partially offset by higher sale of equipment and other project activity. +30 +Table of Contents +Corporate and other +The Corporate and other segment includes our LNG, turbo machinery equipment and services, and distribution sale of equipment businesses as well as our corporate support functions that benefit all segments. The results of the Corporate and other segment also include income and expense that is not directly associated with the other segments, such as foreign exchange gains and losses. +2020 2019 $ Change Change +Sales $217.9 $118.3 $99.6 84 % +Operating loss (112.2) (152.8) 40.6 27 % +Adjusted EBITDA (91.6) (134.8) 43.2 32 % +Sales of $217.9 increased 84%, or $99.6, primarily due to higher LNG sale of equipment activity. Operating loss of $112.2 decreased 27%, or $40.6, primarily due to the higher LNG sale of equipment activity, partially offset by higher business development costs to support our growth strategy. +RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES +(Millions of dollars unless otherwise indicated, except for per share data) +We present certain financial measures, other than in accordance with U.S. generally accepted accounting principles ("GAAP"), on an "adjusted" or "non-GAAP" basis. On a consolidated basis, these measures include adjusted diluted earnings per share ("EPS"), adjusted EBITDA, adjusted EBITDA margin, and adjusted effective tax rate. On a segment basis, these measures include adjusted EBITDA and adjusted EBITDA margin. In addition to these measures, we also include certain supplemental non-GAAP financial measures that are presented below to help the reader understand the impact that our non-GAAP adjustments have on the calculation of our adjusted diluted EPS. For each non-GAAP financial measure, we present below a reconciliation to the most directly comparable financial measure calculated in accordance with GAAP. +Our non-GAAP financial measures are not meant to be considered in isolation or as a substitute for the most directly comparable measure calculated in accordance with GAAP. We believe these non-GAAP financial measures provide investors, potential investors, securities analysts, and others with useful information to evaluate the performance of our business because such measures, when viewed together with financial results computed in accordance with GAAP, provide a more complete understanding of the factors and trends affecting our historical financial performance and projected future results. +In many cases, non-GAAP financial measures are determined by adjusting the most directly comparable GAAP measure to exclude certain disclosed items, or “non-GAAP adjustments,” that we believe are not representative of underlying business performance. For example, we previously excluded certain expenses associated with cost reduction actions, impairment charges, and gains on disclosed transactions. The reader should be aware that we may recognize similar losses or gains in the future. Readers should also consider the limitations associated with these non-GAAP financial measures, including the potential lack of comparability of these measures from one company to another. +The tax impact on our pre-tax non-GAAP adjustments reflects the expected current and deferred income tax impact of our non-GAAP adjustments. These tax impacts are primarily driven by the statutory tax rate of the various relevant jurisdictions and the taxability of the adjustments in those jurisdictions. +31 +Table of Contents +ADJUSTED DILUTED EPS +The table below provides a reconciliation to the most directly comparable GAAP measure for each of the major components used to calculate adjusted diluted EPS from continuing operations, which we view as a key performance metric. We believe it is important for the reader to understand the per share impact of our non-GAAP adjustments as management does not consider these impacts when evaluating underlying business performance. The per share impact for each non-GAAP adjustment was calculated independently and may not sum to total adjusted diluted EPS due to rounding. +Year Ended 30 September Operating Income Equity Affiliates' Income Income Tax Provision Net Income Attributable to Air Products Diluted EPS +2020 GAAP $2,237.6 $264.8 $478.4 $1,901.0 $8.55 +2019 GAAP 2,144.4 215.4 480.1 1,760.0 7.94 +Change GAAP $141.0 $0.61 +% Change GAAP 8 % 8 % +2020 GAAP $2,237.6 $264.8 $478.4 $1,901.0 $8.55 +Company headquarters relocation (income) expense (33.8) — (8.2) (25.6) (0.12) +India Finance Act 2020 — (33.8) (20.3) (13.5) (0.06) +2020 Non-GAAP Measure ("Adjusted") +$2,203.8 $231.0 $449.9 $1,861.9 $8.38 +2019 GAAP $2,144.4 $215.4 $480.1 $1,760.0 $7.94 +Facility closure 29.0 — 6.9 22.1 0.10 +Cost reduction actions 25.5 — 6.7 18.8 0.08 +Gain on exchange of equity affiliate investments (29.1) — — (29.1) (0.13) +Pension settlement loss (A) +— — 1.2 3.8 0.02 +Tax reform repatriation — — 12.4 (12.4) (0.06) +Tax reform adjustment related to deemed foreign dividends — — (56.2) 56.2 0.26 +2019 Non-GAAP Measure ("Adjusted") +$2,169.8 $215.4 $451.1 $1,819.4 $8.21 +Change Non-GAAP Measure ("Adjusted") $42.5 $0.17 +% Change Non-GAAP Measure ("Adjusted") 2 % 2 % +(A) Before-tax impact of $5.0 is reflected on the consolidated income statements within “Other non-operating income (expense), net.” +The table below provides a reconciliation of adjusted diluted EPS to GAAP diluted EPS for each fiscal year noted: +Year Ended 30 September 2020 2019 2018 2017 2016 +Diluted EPS $8.55 $7.94 $6.59 $5.16 $5.04 +Change in inventory valuation method — — (0.08) — — +Facility closure — 0.10 — — — +Business separation costs — — — 0.12 0.21 +Tax (benefit) costs associated with business separation — — — (0.02) 0.24 +Cost reduction and asset actions — 0.08 — 0.49 0.11 +Goodwill and intangible asset impairment charge — — — 0.70 — +Gain on exchange of equity affiliate investments — (0.13) — — — +Company headquarters relocation (income) expense (0.12) — — — — +Gain on land sale — — — (0.03) — +India Finance Act 2020 (0.06) — — — — +Equity method investment impairment charge — — — 0.36 — +Pension settlement loss — 0.02 0.15 0.03 0.02 +Loss on extinguishment of debt — — — — 0.02 +Tax reform repatriation — (0.06) 2.16 — — +Tax reform adjustment related to deemed foreign dividends — 0.26 (0.25) — — +Tax reform rate change and other — — (0.96) — — +Tax restructuring — — (0.16) — — +Tax election benefit — — — (0.50) — +Adjusted Diluted EPS $8.38 $8.21 $7.45 $6.31 $5.64 +32 +Table of Contents +ADJUSTED EBITDA AND ADJUSTED EBITDA MARGIN +We define adjusted EBITDA as net income less income (loss) from discontinued operations, net of tax, and excluding non-GAAP adjustments, which we do not believe to be indicative of underlying business trends, before interest expense, other non-operating income (expense), net, income tax provision, and depreciation and amortization expense. Adjusted EBITDA and adjusted EBITDA margin provide useful metrics for management to assess operating performance. Margins are calculated independently for each period by dividing each line item by consolidated sales for the respective period and may not sum to total margin due to rounding. +Below is a presentation of consolidated sales and a reconciliation of net income on a GAAP basis to adjusted EBITDA and net income margin on a GAAP basis to adjusted EBITDA margin: +Year Ended 30 September 2020 2019 2018 2017 2016 +Sales $8,856.3 $8,918.9 $8,930.2 $8,187.6 $7,503.7 +$ Margin $ Margin $ Margin $ Margin $ Margin +Net income and net income margin $1,931.1 21.8 % $1,809.4 20.3 % $1,532.9 17.2 % $3,021.2 36.9 % $661.5 8.8 % +Less: (Loss) Income from discontinued operations, net of tax (14.3) (0.2) % — — % 42.2 0.5 % 1,866.0 22.8 % (460.5) (6.1) % +Add: Interest expense 109.3 1.2 % 137.0 1.5 % 130.5 1.5 % 120.6 1.5 % 115.2 1.5 % +Less: Other non-operating income (expense), net 30.7 0.3 % 66.7 0.7 % 5.1 0.1 % 16.6 0.2 % (5.4) (0.1) % +Add: Income tax provision 478.4 5.4 % 480.1 5.4 % 524.3 5.9 % 260.9 3.2 % 432.6 5.8 % +Add: Depreciation and amortization 1,185.0 13.4 % 1,082.8 12.1 % 970.7 10.9 % 865.8 10.6 % 854.6 11.4 % +Less: Change in inventory valuation method — — % — — % 24.1 0.3 % — — % — — % +Add: Facility closure — — % 29.0 0.3 % — — % — — % — — % +Add: Business separation costs — — % — — % — — % 32.5 0.4 % 50.6 0.7 % +Add: Cost reduction and asset actions — — % 25.5 0.3 % — — % 151.4 1.8 % 34.5 0.4 % +Add: Goodwill and intangible asset impairment charge — — % — — % — — % 162.1 2.0 % — — % +Less: Gain on exchange of equity affiliate investments — — % 29.1 0.3 % — — % — — % — — % +Less: Company headquarters relocation income (expense) 33.8 0.4 % — — % — — % — — % — — % +Less: Gain on land sale — — % — — % — — % 12.2 0.2 % — — % +Less: India Finance Act 2020 33.8 0.4 % — — % — — % — — % — — % +Add: Equity method investment impairment charge — — % — — % — — % 79.5 1.0 % — — % +Add: Loss on extinguishment of debt — — % — — % — — % — — % 6.9 0.1 % +Add: Tax reform repatriation - equity method investment — — % — — % 28.5 0.3 % — — % — — % +Adjusted EBITDA and adjusted EBITDA margin $3,619.8 40.9 % $3,468.0 38.9 % $3,115.5 34.9 % $2,799.2 34.2 % $2,621.8 34.9 % +Year Ended 30 September 2020 vs. 2019 2019 vs. 2018 2018 vs. 2017 2017 vs. 2016 +Change GAAP +Net income $ change $121.7 $276.5 ($1,488.3) $2,359.7 +Net income % change 7% 18% (49)% 357% +Net income margin change 150 bp 310 bp (1,970) bp 2,810 bp +Change Non-GAAP +Adjusted EBITDA $ change $151.8 $352.5 $316.3 $177.4 +Adjusted EBITDA % change 4% 11% 11% 7% +Adjusted EBITDA margin change 200 bp 400 bp 70 bp (70) bp +33 +Table of Contents +Below is reconciliation of operating income and operating margin by segment to adjusted EBITDA and adjusted EBITDA margin by segment: +Year Ended 30 September Industrial +Gases– +Americas Industrial +Gases– +EMEA Industrial +Gases– +Asia Industrial +Gases– +Global Corporate +and other Total +2020 GAAP Measures +Operating income (loss) $1,012.4 $473.3 $870.3 ($40.0) ($112.2) $2,203.8 +(A) +Operating margin 27.9 % 24.6 % 32.0 % +2019 GAAP Measures +Operating income (loss) $997.7 $472.4 $864.2 ($11.7) ($152.8) $2,169.8 +(A) +Operating margin 25.8 % 23.6 % 32.4 % +2020 vs. 2019 +Operating income/loss change $14.7 $0.9 $6.1 ($28.3) $40.6 +Operating income/loss % change 1 % — % 1 % (242) % 27 % +Operating margin change 210 bp 100 bp (40) bp +2020 Non-GAAP Measures +Operating income (loss) $1,012.4 $473.3 $870.3 ($40.0) ($112.2) $2,203.8 +(A) +Add: Depreciation and amortization 559.5 195.9 399.4 9.6 20.6 1,185.0 +Add: Equity affiliates' income 84.3 74.8 61.0 10.9 — 231.0 +(B) +Adjusted EBITDA $1,656.2 $744.0 $1,330.7 ($19.5) ($91.6) $3,619.8 +Adjusted EBITDA margin 45.6 % 38.6 % 49.0 % +2019 Non-GAAP Measures +Operating income (loss) $997.7 $472.4 $864.2 ($11.7) ($152.8) $2,169.8 +(A) +Add: Depreciation and amortization 505.2 189.5 361.5 8.6 18.0 1,082.8 +Add: Equity affiliates' income 84.8 69.0 58.4 3.2 — 215.4 +(B) +Adjusted EBITDA $1,587.7 $730.9 $1,284.1 $0.1 ($134.8) $3,468.0 +Adjusted EBITDA margin 41.0 % 36.5 % 48.2 % +2020 vs. 2019 +Adjusted EBITDA change $68.5 $13.1 $46.6 ($19.6) $43.2 +Adjusted EBITDA % change 4 % 2 % 4 % N/M* 32 % +Adjusted EBITDA margin change 460 bp 210 bp 80 bp +* Not meaningful +(A) The table below reconciles consolidated operating income as reflected on our consolidated income statements to total operating income disclosed in the table above for the years ended 30 September: +Operating Income 2020 2019 +Consolidated operating income $2,237.6 $2,144.4 +Facility closure — 29.0 +Cost reduction actions — 25.5 +Gain on exchange of equity affiliate investments — (29.1) +Company headquarters relocation (income) expense (33.8) — +Total $2,203.8 $2,169.8 +(B) The table below reconciles consolidated equity affiliates' income as reflected on our consolidated income statements to total equity affiliates' income disclosed in the table above for the years ended 30 September: +Equity Affiliates' Income 2020 2019 +Consolidated equity affiliates' income $264.8 $215.4 +India Finance Act 2020 (33.8) — +Total $231.0 $215.4 +34 +Table of Contents +ADJUSTED EFFECTIVE TAX RATE +The tax impact of our pre-tax non-GAAP adjustments reflects the expected current and deferred income tax expense associated with each adjustment and is primarily dependent upon the statutory tax rate of the various relevant jurisdictions and the taxability of the adjustments in those jurisdictions. +Effective Tax Rate +Year Ended 30 September 2020 2019 +Income Tax Provision $478.4 $480.1 +Income From Continuing Operations Before Taxes $2,423.8 $2,289.5 +Effective Tax Rate 19.7 % 21.0 % +Income Tax Provision $478.4 $480.1 +Facility closure — 6.9 +Cost reduction actions — 6.7 +Company headquarters relocation (8.2) — +India Finance Act 2020 (20.3) — +Pension settlement loss — 1.2 +Tax reform repatriation — 12.4 +Tax reform adjustment related to deemed foreign dividends — (56.2) +Adjusted Income Tax Provision $449.9 $451.1 +Income From Continuing Operations Before Taxes $2,423.8 $2,289.5 +Facility closure — 29.0 +Cost reduction actions — 25.5 +Gain on exchange of equity affiliate investments — (29.1) +Company headquarters relocation (income) expense (33.8) — +India Finance Act 2020 - equity affiliate income impact (33.8) — +Pension settlement loss — 5.0 +Adjusted Income From Continuing Operations Before Taxes $2,356.2 $2,319.9 +Adjusted Effective Tax Rate 19.1 % 19.4 % +LIQUIDITY AND CAPITAL RESOURCES +Our cash balance and cash flows from operations are our primary sources of liquidity and are generally sufficient to meet our liquidity needs. In addition, we have the flexibility to access capital through a variety of financing activities, including accessing the capital markets, drawing upon our credit facility, or alternatively, accessing the commercial paper markets. During the third quarter of fiscal year 2020, we issued U.S. Dollar- and Euro-denominated fixed-rate notes with aggregate principal amounts of $3.8 billion and €1.0 billion ($1.2 billion as of 30 September 2020), respectively. We intend to use the majority of the proceeds to fund growth projects and repay debt maturities through 2021, including a €350.0 million Eurobond due in June 2021. At this time, we have not utilized, nor do we expect to access, our credit facility for additional liquidity. In addition, we have considered the impacts of COVID-19 on our liquidity and capital resources and do not expect it to impact our ability to meet future liquidity needs. +As of 30 September 2020, we had $1,376.6 of foreign cash and cash items compared to total cash and cash items of $5,253.0. Since the enactment of the Tax Act, we do not expect that a significant portion of the earnings of our foreign subsidiaries and affiliates will be subject to U.S. income tax upon repatriation to the U.S. Depending on the country in which the subsidiaries and affiliates reside, the repatriation of these earnings may be subject to foreign withholding and other taxes. However, since we have significant current investment plans outside the U.S., it is our intent to permanently reinvest the majority of our foreign cash and cash items that would be subject to additional taxes outside the U.S. +35 +Table of Contents +The table below summarizes our cash flows from operating, investing, and financing activities as reflected on the consolidated statements of cash flows for the years ended 30 September: +Cash Provided by (Used for) 2020 2019 +Operating activities $3,264.7 $2,969.9 +Investing activities (3,560.0) (2,113.4) +Financing activities 3,284.7 (1,370.5) +Operating Activities +For the fiscal year ended 30 September 2020, cash provided by operating activities was $3,264.7. Income from continuing operations of $1,901.0 was adjusted for items including depreciation and amortization, deferred income taxes, undistributed earnings of unconsolidated affiliates, gain on sale of assets and investments, share-based compensation, noncurrent capital lease receivables, and certain other adjustments. We recorded a net benefit of $13.5 on our consolidated income statements related to a recently enacted tax law in India during the second quarter. This net benefit, which is further discussed in Note 22, Income Taxes , to the consolidated financial statements, increased "Undistributed earnings of unconsolidated affiliates" by $33.8 and increased "Deferred income taxes" by $20.3. The "Gain on sale of assets and investments" of $45.8 includes a gain of $33.8 related to the sale of property at our current corporate headquarters. Refer to Note 23, Supplemental Information , to the consolidated financial statements for additional information. The working capital accounts were a use of cash of $40.1, primarily driven by other working capital uses of $130.6, partially offset by a source of $84.4 from other receivables. The use of cash within "Other working capital" was primarily due to timing of tax payments and a tax benefit as a result of the assets acquired in April 2020 from PBF Energy Inc. The source of cash within "Other receivables" was primarily driven by maturities of forward exchange contracts. +For the fiscal year ended 30 September 2019, cash provided by operating activities was $2,969.9, including income from continuing operations of $1,760.0. The gain on sale of assets and investments included a gain of $14.1 recognized on the disposition of our interest in High-Tech Gases (Beijing) Co., Ltd., a previously held equity investment in our Industrial Gases - Asia segment. Refer to Note 3, Acquisitions , to the consolidated financial statements for additional information. The working capital accounts were a use of cash of $25.3, primarily driven by $69.0 from trade receivables and $41.8 from payables and accrued liabilities, partially offset by $79.8 from other receivables. The use of cash within "Payables and accrued liabilities" was primarily driven by a $48.9 decrease in accrued utilities and a $30.3 decrease in accrued interest, partially offset by a $51.6 increase in customer advances primarily related to sale of equipment activity. The decrease in accrued utilities was primarily driven by a contract modification to a tolling arrangement in India and lower utility costs in the Industrial Gases – Americas segment. The source of cash from other receivables of $79.8 was primarily due to the maturities of forward exchange contracts that hedged foreign currency exposures and the collection of value added taxes. +Investing Activities +For the fiscal year ended 30 September 2020, cash used for investing activities was $3,560.0. Payments for additions to plant and equipment, including long-term deposits, were $2,509.0. This includes the acquisition of five operating hydrogen production plants from PBF Energy Inc. in Delaware and California for approximately $580 during the third quarter. Additionally, acquisitions, less cash acquired, includes $183.3 for three businesses we acquired on 1 July 2020, the largest of which was a business in Israel that primarily offers merchant gas products. Refer to Note 3, Acquisitions , to the consolidated financial statements for additional information. Purchases of investments of $2,865.5 relate to time deposits and treasury securities with terms greater than three months and less than one year and exceeded proceeds from investments of $1,938.0. Proceeds from sale of assets and investments of $80.3 includes net proceeds of $44.1 related to the sale of property at our current corporate headquarters in the second quarter. +For the fiscal year ended 30 September 2019, cash used for investing activities was $2,113.4. Payments for additions to plant and equipment totaled $1,989.7. Cash paid for acquisitions, net of cash acquired, was $123.2. Refer to Note 3, Acquisitions , to the consolidated financial statements for further details. Proceeds from investments of $190.5 resulting from maturities of short-term instruments with original maturities greater than three months and less than one year exceeded purchases of $172.1. +36 +Table of Contents +Capital Expenditures +Capital expenditures is a non-GAAP measure that we define as cash flows for additions to plant and equipment, acquisitions (less cash acquired), and investment in and advances to unconsolidated affiliates. A reconciliation of cash used for investing activities to our reported capital expenditures is provided below: +2020 2019 +Cash used for investing activities $3,560.0 $2,113.4 +Proceeds from sale of assets and investments 80.3 11.1 +Purchases of investments (2,865.5) (172.1) +Proceeds from investments 1,938.0 190.5 +Other investing activities 3.9 (14.3) +Capital Expenditures $2,716.7 $2,128.6 +The components of our capital expenditures are detailed in the table below: +2020 2019 +Additions to plant and equipment $2,509.0 $1,989.7 +Acquisitions, less cash acquired 183.3 123.2 +Investments in and advances to unconsolidated affiliates 24.4 15.7 +Capital Expenditures $2,716.7 $2,128.6 +Capital expenditures in fiscal year 2020 totaled $2,716.7 compared to $2,128.6 in fiscal year 2019. The increase of $588.1 was primarily due to the acquisition of the hydrogen production plants from PBF Energy Inc., as noted above. Additions to plant and equipment also included support capital of a routine, ongoing nature, including expenditures for distribution equipment and facility improvements. +2021 Outlook for Investing Activities +Due to the significant uncertainty that remains regarding the duration of COVID-19, the pace of recovery, and its negative impact on the global economy, we are not providing capital expenditure guidance for fiscal year 2021. We are monitoring our projects to determine whether capital spending and project onstream timing may be delayed for those currently under construction. +We anticipate capital expenditures to be funded principally with our current cash balance and cash generated from continuing operations. In addition, we intend to continue to evaluate (1) acquisitions of small- and medium-sized industrial gas companies or assets from other industrial gas companies; (2) purchases of existing industrial gas facilities from our customers to create long-term contracts under which we own and operate the plant and sell industrial gases to the customer based on a fixed fee; and (3) investment in large industrial gas projects driven by demand for more energy, cleaner energy, and emerging market growth. +Financing Activities +In fiscal year 2020, cash provided by financing activities was $3,284.7 as we successfully accessed the debt markets in April 2020 to support opportunities for growth projects and repay upcoming debt maturities. Long-term debt proceeds of $4,895.8, as further discussed below under "Financing and Capital Structure," were partially offset by dividend payments to shareholders of $1,103.6 and payments on long-term debt of $406.6 primarily related to the repayment of a 2.0% Eurobond of €300.0 million ($353.9) that matured on 7 August 2020. Other financing activities were a use of cash of $80.1 and included financing charges associated with the third quarter debt issuance. +For the fiscal year ended 2019, cash used for financing activities was $1,370.5. This use of cash was largely attributable to dividend payments to shareholders of $994.0 and payments on long-term debt of $428.6. Payments on long-term debt primarily related to the repayment of a 4.375% U.S. Senior Note of $400.0 that matured on 21 August 2019. +37 +Table of Contents +Financing and Capital Structure +Capital needs in fiscal year 2020 were satisfied primarily with cash from operations. Total debt increased from $3,326.0 at 30 September 2019 to $7,907.8 at 30 September 2020 due to the issuance of U.S. Dollar- and Euro-denominated fixed-rate notes in the third quarter, partially offset by the repayment of a 2.0% Eurobond. For additional information, refer to Note 15, Debt , to the consolidated financial statements. Similarly, cash and cash items and short-term investments increased from $2,248.7 and $166.0, respectively, at the end of 2019 to $5,253.0 and $1,104.9, respectively, at the end of 2020, primarily due to the issuance of the notes. The current year total debt balance includes $338.5 of related party debt associated with the Lu'An joint venture. +We have a $2,300.0 five-year revolving credit agreement with a syndicate of banks (the "Credit Agreement”) maturing 31 March 2022. Under the Credit Agreement, senior unsecured debt is available to us and certain of our subsidiaries. The Credit Agreement provides us a source of liquidity and supports our commercial paper program. Our only financial covenant under the Credit Agreement is a maximum ratio of total debt to total capitalization, or total debt plus total equity, no greater than 70%. Total debt as of 30 September 2020 and 30 September 2019, expressed as a percentage of total capitalization was 38.9% and 22.6%, respectively. No borrowings were outstanding under the Credit Agreement as of 30 September 2020. +There were no commitments maintained by our foreign subsidiaries at 30 September 2020. +As of 30 September 2020, we are in compliance with all of the financial and other covenants under our debt agreements. +On 15 September 2011, the Board of Directors authorized the repurchase of up to $1,000 of our outstanding common stock. We did not purchase any of our outstanding shares during fiscal years 2020 or 2019. As of 30 September 2020, $485.3 in share repurchase authorization remains. +Dividends +Dividends are declared by the Board of Directors and are usually paid during the sixth week after the close of the fiscal quarter. In 2020, the Board of Directors increased our quarterly dividend by over 15% from $1.16 to $1.34 per share, representing the largest dividend increase in our 80-year history. This is the 38 th consecutive year that we have increased our quarterly dividend payment. +On 19 November 2020, the Board of Directors declared the first quarter 2021 dividend of $1.34 per share. The dividend is payable on 8 February 2021 to shareholders of record as of 4 January 2021. +CONTRACTUAL OBLIGATIONS +We are obligated to make future payments under various contracts, such as debt agreements, lease agreements, unconditional purchase obligations, and other long-term obligations. The following table summarizes our obligations on a continuing operations basis as of 30 September 2020: +Total 2021 2022 2023 2024 2025 Thereafter +Debt maturities $7,950 $470 $442 $456 $456 $416 $5,710 +Contractual interest on debt 1,772 155 141 129 121 102 1,124 +Operating leases 475 79 56 47 37 30 226 +Pension obligations 598 51 45 42 42 28 390 +Unconditional purchase obligations 9,556 1,460 460 450 455 454 6,277 +Deemed repatriation tax related to the Tax Act 211 21 21 21 39 50 59 +Obligation for future contribution to an equity affiliate 100 100 — — — — — +Total Contractual Obligations $20,662 $2,336 $1,165 $1,145 $1,150 $1,080 $13,786 +38 +Table of Contents +Debt Obligations +Our debt obligations include the maturity payments of the principal amount of long-term debt, including the current portion and amounts owed to related parties, and the related contractual interest obligations. Refer to Note 15, Debt , to the consolidated financial statements for additional information on our debt obligations. +Contractual interest is the interest we are contracted to pay on our debt obligations without taking into account the interest impact of interest rate swaps related to any of this debt, which at current interest rates would slightly decrease contractual interest. We had approximately $632 of long-term debt subject to variable interest rates at 30 September 2020, excluding fixed-rate debt that has been swapped to variable-rate debt. The rate assumed for the variable interest component of the contractual interest obligation was the rate in effect at 30 September 2020. Variable interest rates are primarily determined by U.S. short-term tax-exempt interest rates and by interbank offer rates. +Leases +We are the lessee under various agreements for real estate, vehicles, aircraft, and other equipment. Refer to Note 12, Leases , to the consolidated financial statements for additional information. +Pension Obligations +The amounts in the table above represent the current estimated cash payments to be made by us that, in total, equal the recognized pension liabilities for our U.S. and international pension plans. For additional information, refer to Note 16, Retirement Benefits , to the consolidated financial statements. These payments are based upon the current valuation assumptions and regulatory environment. +The total accrued liability for pension benefits may be impacted by interest rates, plan demographics, actual return on plan assets, continuation or modification of benefits, and other factors. Such factors can significantly impact the amount of the liability and related contributions. +Unconditional Purchase Obligations +We are obligated to make future payments under unconditional purchase obligations, which primarily relate to helium and rare gases as well as commitments for purchases of plant and equipment. For additional information, refer to Note 17, Commitments and Contingencies , to the consolidated financial statements. +Income Tax Liabilities +Tax liabilities related to unrecognized tax benefits as of 30 September 2020 were $237.0. These tax liabilities are not included in the table above as it is impractical to determine a cash impact by year given that payments will vary according to changes in tax laws, tax rates, and our operating results. In addition, there are uncertainties in timing of the effective settlement of our uncertain tax positions with respective taxing authorities. However, the table above includes our accrued liability of approximately $211 for deemed repatriation tax that is payable through 2026 related to the Tax Act. Refer to Note 22, Income Taxes , to the consolidated financial statements for additional information. +Obligation for Future Contribution to an Equity Affiliate +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20-year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. We guaranteed the repayment of our 25% share of an equity bridge loan that has been provided to fund equity commitments to the joint venture. In total, we expect to invest approximately $100 in this joint venture. As of 30 September 2020, our consolidated balance sheets included $94.4 reflected within "Payables and accrued liabilities" for our obligation to make future equity contributions in 2021 based on our proportionate share of the advances received by the joint venture under the loan. +Future Investment in Jazan Gas and Power Project +On 12 August 2018, Air Products entered an agreement to form a gasification/power joint venture ("JV") with Saudi Aramco and ACWA in Jazan, Saudi Arabia. Air Products expects to own 51% of the JV, with Saudi Aramco and ACWA Power owning the balance. In July 2020, we commenced the process to secure project financing with our partners for the JV, which will purchase the gasification assets, power block, and the associated utilities from Saudi Aramco for approximately $12 billion. Our future investment is not considered a contractual obligation until definitive agreements have been signed; therefore, it is not included in the contractual obligations table above. +39 +Table of Contents +PENSION BENEFITS +We and certain of our subsidiaries sponsor defined benefit pension plans and defined contribution plans that cover a substantial portion of its worldwide employees. The principal defined benefit pension plans are the U.S. salaried pension plan and the U.K. pension plan. These plans were closed to new participants in 2005, after which defined contribution plans were offered to new employees. The shift to defined contribution plans is expected to continue to reduce volatility of both plan expense and contributions. +The fair market value of plan assets for our defined benefit pension plans as of the 30 September 2020 measurement date increased to $4,775.1 from $4,504.8 at the end of fiscal year 2019. The projected benefit obligation for these plans was $5,373.5 and $5,145.6 at the end of fiscal years 2020 and 2019, respectively. The net unfunded liability decreased $42.4 from $640.8 to $598.4, primarily due to favorable asset experience. Refer to Note 16, Retirement Benefits , to the consolidated financial statements for additional disclosures on our postretirement benefits. +Pension Expense +2020 2019 +Pension expense, including special items noted below $7.0 $27.6 +Settlements, termination benefits, and curtailments ("special items") 5.2 7.2 +Weighted average discount rate – Service cost 2.4 % 3.4 % +Weighted average discount rate – Interest cost 2.3 % 3.4 % +Weighted average expected rate of return on plan assets 6.3 % 6.4 % +Weighted average expected rate of compensation increase 3.4 % 3.5 % +Pension expense decreased from the prior year due to lower interest cost and higher total assets, partially offset by higher actuarial loss amortization due to the impact of lower discount rates. Special items (settlements, termination benefits, and curtailments) decreased from the prior year primarily due to lower pension settlement losses. In fiscal year 2020, special items of $5.2 included pension settlement losses of $5.0 related to lump sum payouts from the U.S. Supplementary Pension Plan. These amounts are reflected within "Other non-operating income (expense), net" on the consolidated income statements. In fiscal year 2019, special items of $7.2 included pension settlement losses of $6.4 related to lump sum payouts from the U.S. Supplementary Pension Plan and $0.8 of termination benefits. +U.K. Lloyds Equalization Ruling +On 26 October 2018, the United Kingdom High Court issued a ruling related to the equalization of pension plan participants’ benefits for the gender effects of Guaranteed Minimum Pensions. As a result of this ruling, we estimated the impact of retroactively increasing benefits in our U.K. plan in accordance with the High Court ruling. We treated the additional benefits as a prior service cost, which resulted in an increase to our projected benefit obligation and accumulated other comprehensive loss of $4.7 during the first quarter of fiscal year 2019. We are amortizing this cost over the average remaining life expectancy of the U.K. participants. +2021 Outlook +In fiscal year 2021, we expect pension income of approximately $25 to $35, which includes expected pension settlement losses of $0 to $5, depending on the timing of retirements. The expected income range reflects lower expected interest cost and higher total assets. In fiscal year 2021, we expect our net pension income to include approximately $100 for amortization of actuarial losses. +In fiscal year 2020, pension expense included amortization of actuarial losses of $103.2. Net actuarial losses of $83.5 were recognized in accumulated other comprehensive income in fiscal year 2020. Actuarial (gains) losses are amortized into pension expense over prospective periods to the extent they are not offset by future gains or losses. Future changes in the discount rate and actual returns on plan assets different from expected returns would impact the actuarial (gains) losses and resulting amortization in years beyond fiscal year 2021. +Pension Funding +Pension funding includes both contributions to funded plans and benefit payments for unfunded plans, which are primarily non-qualified plans. With respect to funded plans, our funding policy is that contributions, combined with appreciation and earnings, will be sufficient to pay benefits without creating unnecessary surpluses. +40 +Table of Contents +In addition, we make contributions to satisfy all legal funding requirements while managing our capacity to benefit from tax deductions attributable to plan contributions. With the assistance of third-party actuaries, we analyze the liabilities and demographics of each plan, which help guide the level of contributions. During 2020 and 2019, our cash contributions to funded plans and benefit payments for unfunded plans were $37.5 and $40.2, respectively. +For fiscal year 2021, cash contributions to defined benefit plans are estimated to be $45 to $55. The estimate is based on expected contributions to certain international plans and anticipated benefit payments for unfunded plans, which are dependent upon the timing of retirements. Actual future contributions will depend on future funding legislation, discount rates, investment performance, plan design, and various other factors. We do not expect COVID-19 to impact our contribution forecast for fiscal year 2021. Refer to the Contractual Obligations discussion on page 38 for a projection of future contributions. +ENVIRONMENTAL MATTERS +As discussed above in Item 1, “ Business–Environmental Regulation ”, we are subject to various environmental laws and regulations in the countries in which we have operations, which results in higher capital expenditures and costs. The amounts charged to income from continuing operations related to environmental matters totaled $18.3 and $14.2 in fiscal years 2020 and 2019, respectively. These amounts represent an estimate of expenses for compliance with environmental laws and activities undertaken to meet our internal standards. We estimate that we spent approximately $4 and $5, in fiscal years 2020 and 2019, respectively, on capital projects reflected in continuing operations to control pollution. We expect that our capital expenditures to control pollution will be approximately $6 in both fiscal years 2021 and 2022. +Our accounting policy for environmental expenditures is discussed in Note 1, Major Accounting Policies , to the consolidated financial statements, and environmental loss contingencies are discussed in Note 17, Commitments and Contingencies , to the consolidated financial statements. +OFF-BALANCE SHEET ARRANGEMENTS +We have entered into certain guarantee agreements as discussed in Note 17, Commitments and Contingencies , to the consolidated financial statements. In addition, we are not a primary beneficiary in any material variable interest entity. Our off-balance sheet arrangements are not reasonably likely to have a material impact on financial condition, changes in financial condition, results of operations, or liquidity. +RELATED PARTY TRANSACTIONS +See Note 23, Supplemental Information , to the consolidated financial statements for information concerning activity with our related parties. +INFLATION +We operate in many countries that experience volatility in inflation and foreign exchange rates. The ability to pass on inflationary cost increases is an uncertainty due to general economic conditions and competitive situations. It is estimated that the cost of replacing our plant and equipment today is greater than its historical cost. Accordingly, depreciation expense would be greater if the expense were stated on a current cost basis. +41 +Table of Contents +CRITICAL ACCOUNTING POLICIES AND ESTIMATES +Note 1, Major Accounting Policies , to the consolidated financial statements describes our major accounting policies. Judgments and estimates of uncertainties are required in applying our accounting policies in many areas. However, application of the critical accounting policies discussed below requires management’s significant judgments, often as the result of the need to make estimates of matters that are inherently uncertain. If actual results were to differ materially from the estimates made, the reported results could be materially affected. Our management has reviewed these critical accounting policies and estimates and related disclosures with our audit committee. +Depreciable Lives of Plant and Equipment +Net plant and equipment at 30 September 2020 totaled $11,964.7, and depreciation expense totaled $1,150.5 during fiscal year 2020. Plant and equipment is recorded at cost and depreciated using the straight-line method, which deducts equal amounts of the cost of each asset from earnings every year over its estimated economic useful life. +Economic useful life is the duration of time an asset is expected to be productively employed by us, which may be less than its physical life. Assumptions on the following factors, among others, affect the determination of estimated economic useful life: wear and tear, obsolescence, technical standards, contract life, market demand, competitive position, raw material availability, and geographic location. +The estimated economic useful life of an asset is monitored to determine its appropriateness, especially when business circumstances change. For example, changes in technology, changes in the estimated future demand for products, excessive wear and tear, or unanticipated government actions may result in a shorter estimated useful life than originally anticipated. In these cases, we would depreciate the remaining net book value over the new estimated remaining life, thereby increasing depreciation expense per year on a prospective basis. Likewise, if the estimated useful life is increased, the adjustment to the useful life decreases depreciation expense per year on a prospective basis. +The regional Industrial Gases segments have numerous long-term customer supply contracts for which we construct an on-site plant adjacent to or near the customer’s facility. These contracts typically have initial contract terms of 10 to 20 years. Depreciable lives of the production assets related to long-term supply contracts are matched to the contract lives. Extensions to the contract term of supply frequently occur prior to the expiration of the initial term. As contract terms are extended, the depreciable life of the associated production assets is adjusted to match the new contract term, as long as it does not exceed the remaining physical life of the asset. +Our regional Industrial Gases segments also have contracts for liquid or gaseous bulk supply and, for smaller customers, packaged gases. The depreciable lives of production facilities associated with these contracts are generally 15 years. These depreciable lives have been determined based on historical experience combined with judgment on future assumptions such as technological advances, potential obsolescence, competitors’ actions, etc. +In addition, we may purchase assets through transactions accounted for as either an asset acquisition or a business combination. Depreciable lives are assigned to acquired assets based on the age and condition of the assets, the remaining duration of long-term supply contracts served by the assets, and our historical experience with similar assets. Management monitors its assumptions and may potentially need to adjust depreciable life as circumstances change. +42 +Table of Contents +Impairment of Assets +While our results of operations have been negatively affected by COVID-19 as of and for the fiscal year ended 30 September 2020, there have been no triggering events that would require impairment testing for any of our asset groups, reporting units that contain goodwill, indefinite-lived intangible assets, or equity method investments. As further discussed below, we completed our annual impairment tests and concluded there were no indications of impairment. We will continue to evaluate the nature and extent of COVID-19 impacts on our business and any impact they may have on management's estimates, particularly those for our Latin America business. The duration and severity of the COVID-19 outbreak and its long-term impact on our business is uncertain. +Impairment of Assets – Plant and Equipment +Plant and equipment meeting the held for sale criteria are reported at the lower of carrying amount or fair value less cost to sell. Plant and equipment to be disposed of other than by sale may be reviewed for impairment upon the occurrence of certain triggering events, such as unexpected contract terminations or unexpected foreign government-imposed restrictions or expropriations. Plant and equipment held for use is grouped for impairment testing at the lowest level for which there is identifiable cash flows. Impairment testing of the asset group occurs whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Such circumstances would include a significant decrease in the market value of a long-lived asset grouping, a significant adverse change in the manner in which the asset grouping is being used or in its physical condition, an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the long-lived asset, a history of operating or cash flow losses associated with the use of the asset grouping, or changes in the expected useful life of the long-lived assets. +If such circumstances are determined to exist, an estimate of undiscounted future cash flows produced by that asset group is compared to the carrying value to determine whether impairment exists. If an asset group is determined to be impaired, the loss is measured based on the difference between the asset group’s fair value and its carrying value. An estimate of the asset group’s fair value is based on the discounted value of its estimated cash flows. +The assumptions underlying the undiscounted future cash flow projections require significant management judgment. Factors that management must estimate include industry and market conditions, sales volume and prices, costs to produce, inflation, etc. The assumptions underlying the cash flow projections represent management’s best estimates at the time of the impairment review and could include probability weighting of cash flow projections associated with multiple potential future scenarios. Changes in key assumptions or actual conditions that differ from estimates could result in an impairment charge. We use reasonable and supportable assumptions when performing impairment reviews and cannot predict the occurrence of future events and circumstances that could result in impairment charges. +In fiscal year 2020, there was no need to test for impairment on any of our asset groupings as no events or changes in circumstances indicated that the carrying amount of the asset groupings may not be recoverable. +Impairment of Assets – Goodwill +The acquisition method of accounting for business combinations requires us to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the net tangible and identifiable intangible assets. Goodwill represents the excess of the aggregate purchase price (plus the fair value of any noncontrolling interest and previously held equity interest in the acquiree) over the fair value of identifiable net assets of an acquired entity. Goodwill was $891.5 as of 30 September 2020. Disclosures related to goodwill are included in Note 10, Goodwill , to the consolidated financial statements. +We review goodwill for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that the carrying value of goodwill might not be recoverable. The tests are done at the reporting unit level, which is defined as being equal to or one level below the operating segment for which discrete financial information is available and whose operating results are reviewed by segment managers regularly. We have five reportable business segments, seven operating segments and ten reporting units, seven of which include a goodwill balance. Refer to Note 25, Business Segment and Geographic Information , for additional information. Reporting units are primarily based on products and subregions within each reportable segment. The majority of our goodwill is assigned to reporting units within our regional Industrial Gases segments. +43 +Table of Contents +As part of the goodwill impairment testing, we have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. However, we choose to bypass the qualitative assessment and conduct quantitative testing to determine if the carrying value of the reporting unit exceeds its fair value. An impairment loss will be recognized for the amount by which the carrying value of the reporting unit exceeds its fair value, not to exceed the total amount of goodwill allocated to that reporting unit. +To determine the fair value of a reporting unit, we initially use an income approach valuation model, representing the present value of estimated future cash flows. Our valuation model uses a discrete growth period and an estimated exit trading multiple. The income approach is an appropriate valuation method due to our capital-intensive nature, the long-term contractual nature of our business, and the relatively consistent cash flows generated by our reporting units. The principal assumptions utilized in our income approach valuation model include revenue growth rates, operating profit and/or adjusted EBITDA margins, discount rate, and exit multiple. Projected revenue growth rates and operating profit and/or adjusted EBITDA assumptions are consistent with those utilized in our operating plan and/or revised forecasts and long-term financial planning process. The discount rate assumption is calculated based on an estimated market-participant risk-adjusted weighted-average cost of capital, which includes factors such as the risk-free rate of return, cost of debt, and expected equity premiums. The exit multiple is determined from comparable industry transactions and where appropriate, reflects expected long-term growth rates. +If our initial review under the income approach indicates there may be impairment, we incorporate results under the market approach to further evaluate the existence of impairment. When the market approach is utilized, fair value is estimated based on market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies and/or regional manufacturing companies engaged in the same or similar lines of business as the reporting unit, adjusted to reflect differences in size and growth prospects. When both the income and market approach are utilized, we review relevant facts and circumstances and make a qualitative assessment to determine the proper weighting. Management judgment is required in the determination of each assumption utilized in the valuation model, and actual results could differ from the estimates. +During the fourth quarter of fiscal year 2020, we conducted our annual goodwill impairment test. We determined that the fair value of all our reporting units substantially exceeded their carrying value except for our Latin America reporting unit (LASA), which is further discussed below. Substantially all of the remaining goodwill balance related to reporting units in which the fair value exceeded the carrying value by at least 100%. +The fair value of LASA exceeded its carrying value by 10%. Revenue growth and adjusted EBITDA margin assumptions are two primary drivers of the fair value. We determined that, with other assumptions held constant, a decrease in revenue growth rates of approximately 320 basis points or a decrease in adjusted EBITDA margin of approximately 290 basis points would result in the fair value of the reporting unit being equal to its carrying value. As of 30 September 2020, the carrying value of LASA goodwill was $56.1, or less than 1% of consolidated total assets. The carrying value of LASA's other material assets at 30 September 2020 included: Plant and equipment, net of $309.2; customer relationships of $112.1; and trade names and trademarks of $38.2. The trade names and trademarks are classified as indefinite-lived intangible assets. +Future events that could have a negative impact on the level of excess fair value over carrying value of the reporting units include, but are not limited to: long-term economic weakness, decline in market share, pricing pressures, inability to successfully implement cost improvement measures, increases to our cost of capital, changes in the strategy of the reporting unit, and changes to the structure of our business as a result of future reorganizations or divestitures of assets or businesses. Negative changes in one or more of these factors, among others, could result in impairment charges. +44 +Table of Contents +Impairment of Assets – Intangible Assets +Intangible assets, net with determinable lives at 30 September 2020 totaled $394.8 and consisted primarily of customer relationships, purchased patents and technology, and land use rights. These intangible assets are tested for impairment as part of the long-lived asset grouping impairment tests. Impairment testing of the asset group occurs whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. See the impairment discussion above under " Impairment of Assets – Plant and Equipment " for a description of how impairment losses are determined. +Indefinite-lived intangible assets at 30 September 2020 totaled $41.0 and consisted of trade names and trademarks. Indefinite-lived intangibles are subject to impairment testing at least annually or more frequently if events or changes in circumstances indicate that potential impairment exists. The impairment test for indefinite-lived intangible assets involves calculating the fair value of the indefinite-lived intangible assets and comparing the fair value to their carrying value. If the fair value is less than the carrying value, the difference is recorded as an impairment loss. To determine fair value, we utilize the royalty savings method, a form of the income approach. This method values an intangible asset by estimating the royalties avoided through ownership of the asset. +Disclosures related to intangible assets other than goodwill are included in Note 11, Intangible Assets , to the consolidated financial statements. +In the fourth quarter of 2020, we conducted our annual impairment test of indefinite-lived intangibles which resulted in no impairment. +Impairment of Assets – Equity Method Investments +Investments in and advances to equity affiliates totaled $1,432.2 at 30 September 2020. The majority of our investments are non-publicly traded ventures with other companies in the industrial gas business. Summarized financial information of equity affiliates is included in Note 8, Summarized Financial Information of Equity Affiliates , to the consolidated financial statements. Equity investments are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment may not be recoverable. +An impairment loss is recognized in the event that an other-than-temporary decline in fair value below the carrying value of an investment occurs. Management’s estimate of fair value of an investment is based on the income approach and/or market approach. We utilize estimated discounted future cash flows expected to be generated by the investee under the income approach. For the market approach, we utilize market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies. Changes in key assumptions about the financial condition of an investee or actual conditions that differ from estimates could result in an impairment charge. +In fiscal year 2020, there was no need to test any of our equity affiliate investments for impairment, as no events or changes in circumstances indicated that the carrying amount of the investments may not be recoverable. +Revenue Recognition – Cost Incurred Input Method +Revenue from equipment sale contracts is generally recognized over time as we have an enforceable right to payment for performance completed to date and our performance under the contract terms does not create an asset with alternative use. We use a cost incurred input method to recognize revenue by which costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. +Accounting for contracts using the cost incurred input method requires management judgment relative to assessing risks and their impact on the estimate of revenues and costs. Our estimates are impacted by factors such as the potential for incentives or penalties on performance, schedule and technical issues, labor productivity, the complexity of work performed, the cost and availability of materials, and performance of subcontractors. When adjustments in estimated total contract revenues or estimated total costs are required, any changes in the estimated profit from prior estimates are recognized in the current period for the inception-to-date effect of such change. When estimates of total costs to be incurred on a contract exceed estimates of total revenues to be earned, a provision for the entire estimated loss on the contract is recorded in the period in which the loss is determined. +45 +Table of Contents +In addition to the typical risks associated with underlying performance of project procurement and construction activities, our sale of equipment projects within our Industrial Gases – Global segment require monitoring of risks associated with schedule, geography, and other aspects of the contract and their effects on our estimates of total revenues and total costs to complete the contract. +Changes in estimates on projects accounted for under the cost incurred input method, including the Jazan project, favorably impacted operating income by approximately $7 and $37 in fiscal years 2020 and 2019, respectively. Our changes in estimates would not have significantly impacted amounts recorded in prior years. +We assess the performance of our sale of equipment projects as they progress. Our earnings could be positively or negatively impacted by changes to our forecast of revenues and costs on these projects. +Revenue Recognition – On-site Customer Contracts +For customers who require large volumes of gases on a long-term basis, we produce and supply gases under long-term contracts from large facilities that we build, own and operate on or near the customer’s facilities. Certain of these on-site contracts contain complex terms and provisions such as tolling arrangements, minimum payment requirements, variable components and pricing provisions that require significant judgment to determine the amount and timing of revenue recognition. +Income Taxes +We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities measured using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As of 30 September 2020, accrued income taxes, including the amount recorded as noncurrent, was $296.7, and net deferred tax liabilities were $847.5. Tax liabilities related to uncertain tax positions as of 30 September 2020 were $237.0, excluding interest and penalties. Income tax expense for the fiscal year ended 30 September 2020 was $478.4. Disclosures related to income taxes are included in Note 22, Income Taxes , to the consolidated financial statements. +Management judgment is required concerning the ultimate outcome of tax contingencies and the realization of deferred tax assets. +Actual income taxes paid may vary from estimates, depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. We believe that our recorded tax liabilities adequately provide for these assessments. +Deferred tax assets are recorded for operating losses and tax credit carryforwards. However, when we do not expect sufficient sources of future taxable income to realize the benefit of the operating losses or tax credit carryforwards, these deferred tax assets are reduced by a valuation allowance. A valuation allowance is recognized if, based on the weight of available evidence, it is considered more likely than not that some portion or all of the deferred tax asset will not be realized. The factors used to assess the likelihood of realization include forecasted future taxable income and available tax planning strategies that could be implemented to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits. The effect of a change in the valuation allowance is reported in the income tax expense. +A 1% increase or decrease in our effective tax rate may result in a decrease or increase to net income, respectively, of approximately $24. +46 +Table of Contents +Pension and Other Postretirement Benefits +The amounts recognized in the consolidated financial statements for pension and other postretirement benefits are determined on an actuarial basis utilizing numerous assumptions. The discussion that follows provides information on the significant assumptions and expense associated with the defined benefit plans. +Actuarial models are used in calculating the expense and liability related to the various defined benefit plans. These models have an underlying assumption that the employees render service over their service lives on a relatively consistent basis; therefore, the expense of benefits earned should follow a similar pattern. +Several assumptions and statistical variables are used in the models to calculate the expense and liability related to the plans. We determine assumptions about the discount rate, the expected rate of return on plan assets, and the rate of compensation increase. Note 16, Retirement Benefits , to the consolidated financial statements includes disclosure of these rates on a weighted-average basis for both the U.S. and international plans. The actuarial models also use assumptions about demographic factors such as retirement age, mortality, and turnover rates. Mortality rates are based on the most recent U.S. and international mortality tables. We believe the actuarial assumptions are reasonable. However, actual results could vary materially from these actuarial assumptions due to economic events and differences in rates of retirement, mortality, and turnover. +One of the assumptions used in the actuarial models is the discount rate used to measure benefit obligations. This rate reflects the prevailing market rate for high-quality, fixed-income debt instruments with maturities corresponding to the expected timing of benefit payments as of the annual measurement date for each of the various plans. We measure the service cost and interest cost components of pension expense by applying spot rates along the yield curve to the relevant projected cash flows. The rates along the yield curve are used to discount the future cash flows of benefit obligations back to the measurement date. These rates change from year to year based on market conditions that affect corporate bond yields. A higher discount rate decreases the present value of the benefit obligations and results in lower pension expense. A 50 bp increase or decrease in the discount rate may result in a decrease or increase to pension expense, respectively, of approximately $26 per year. +The expected rate of return on plan assets represents an estimate of the long-term average rate of return to be earned by plan assets reflecting current asset allocations. In determining estimated asset class returns, we take into account historical and future expected long-term returns and the value of active management, as well as the interest rate environment. Asset allocation is determined based on long-term return, volatility and correlation characteristics of the asset classes, the profiles of the plans’ liabilities, and acceptable levels of risk. Lower returns on the plan assets result in higher pension expense. A 50 bp increase or decrease in the estimated rate of return on plan assets may result in a decrease or increase to pension expense, respectively, of approximately $22 per year. +We use a market-related valuation method for recognizing certain investment gains or losses for our significant pension plans. Investment gains or losses are the difference between the expected return and actual return on plan assets. The expected return on plan assets is determined based on a market-related value of plan assets. For equities, this is a calculated value that recognizes investment gains and losses in fair value related to equities over a five-year period from the year in which they occur and reduces year-to-year volatility. The market-related value for non-equity investments equals the actual fair value. Expense in future periods will be impacted as gains or losses are recognized in the market-related value of assets. +The expected rate of compensation increase is another key assumption. We determine this rate based on review of the underlying long-term salary increase trend characteristic of labor markets and historical experience, as well as comparison to peer companies. A 50 bp increase or decrease in the expected rate of compensation may result in an increase or decrease to pension expense, respectively, of approximately $12 per year. +Loss Contingencies +In the normal course of business, we encounter contingencies, or situations involving varying degrees of uncertainty as to the outcome and effect on our company. We accrue a liability for loss contingencies when it is considered probable that a liability has been incurred and the amount of loss can be reasonably estimated. When only a range of possible loss can be established, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. +47 +Table of Contents +Contingencies include those associated with litigation and environmental matters, for which our accounting policy is discussed in Note 1, Major Accounting Policies , to the consolidated financial statements, and details are provided in Note 17, Commitments and Contingencies , to the consolidated financial statements. Significant judgment is required to determine both the probability and whether the amount of loss associated with a contingency can be reasonably estimated. These determinations are made based on the best available information at the time. As additional information becomes available, we reassess probability and estimates of loss contingencies. Revisions to the estimates associated with loss contingencies could have a significant impact on our results of operations in the period in which an accrual for loss contingencies is recorded or adjusted. For example, due to the inherent uncertainties related to environmental exposures, a significant increase to environmental liabilities could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or our proportionate share of the liability increases. Similarly, a future charge for regulatory fines or damage awards associated with litigation could have a significant impact on our net income in the period in which it is recorded. +NEW ACCOUNTING GUIDANCE +See Note 2, New Accounting Guidance , and Note 12, Leases , to the consolidated financial statements for information concerning the implementation and impact of new accounting guidance. +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +Our earnings, cash flows, and financial position are exposed to market risks arising from fluctuations in interest rates and foreign currency exchange rates. It is our policy to minimize our cash flow exposure to adverse changes in currency exchange rates and to manage the financial risks inherent in funding with debt capital. +We address these financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. We have established counterparty credit guidelines and generally enter into transactions with financial institutions of investment grade or better, thereby minimizing the risk of credit loss. All instruments are entered into for other than trading purposes. For details on the types and use of these derivative instruments and related major accounting policies, refer to Note 1, Major Accounting Policies , and Note 13, Financial Instruments , to the consolidated financial statements. Additionally, we mitigate adverse energy price impacts through our cost pass-through contracts with customers and price increases. +Our derivative and other financial instruments consist of long-term debt, including the current portion and amounts owed to related parties; interest rate swaps; cross currency interest rate swaps; and foreign exchange-forward contracts. The net market value of these financial instruments combined is referred to below as the "net financial instrument position" and is disclosed in Note 14, Fair Value Measurements , to the consolidated financial statements. Our net financial instrument position increased from a liability of $3,239.1 at 30 September 2019 to a liability of $8,220.7 at 30 September 2020 due to the issuance of the $3.8 billion U.S. Dollar-denominated notes and €1.0 billion Eurobonds in the third quarter of fiscal year 2020. See Note 15, Debt , for additional information. +The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market rates and prices. Market values are the present values of projected future cash flows based on the market rates and prices chosen. The market values for interest rate risk and foreign currency risk are calculated by us using a third-party software model that utilizes standard pricing models to determine the present value of the instruments based on market conditions as of the valuation date, such as interest rates, spot and forward exchange rates, and implied volatilities. +Interest Rate Risk +Our debt portfolio as of 30 September 2020, including the effect of currency and interest rate swap agreements, was composed of 89% fixed-rate debt and 11% variable-rate debt. Our debt portfolio as of 30 September 2019, including the effect of currency and interest rate swap agreements, was composed of 74% fixed-rate debt and 26% variable-rate debt. The increase in fixed rate debt is the result of the U.S. Dollar- and Euro-denominated notes issued during the third quarter of fiscal year 2020. +The sensitivity analysis related to the interest rate risk on the fixed portion of our debt portfolio assumes an instantaneous 100 bp parallel move in interest rates from the level at 30 September 2020, with all other variables held constant. A 100 bp increase in market interest rates would result in a decrease of $711 and $75 in the net liability position of financial instruments at 30 September 2020 and 2019, respectively. A 100 bp decrease in market interest rates would result in an increase of $846 and $80 in the net liability position of financial instruments at 30 +48 +Table of Contents +September 2020 and 2019, respectively. The longer maturities and increased principal associated with the U.S. Dollar- and Euro-denominated notes issued during the third quarter of fiscal year 2020 created a higher sensitivity to market interest rates. +Based on the variable-rate debt included in our debt portfolio, including the interest rate swap agreements, a 100 bp increase in interest rates would result in an additional $8 of interest incurred per year at 30 September 2020 and 2019. A 100 bp decline in interest rates would lower interest incurred by $8 per year at 30 September 2020 and 2019. +Foreign Currency Exchange Rate Risk +The sensitivity analysis related to foreign currency exchange rates assumes an instantaneous 10% change in the foreign currency exchange rates from their levels at 30 September 2020 and 2019, with all other variables held constant. A 10% strengthening or weakening of the functional currency of an entity versus all other currencies would result in a decrease or increase, respectively, of $360 and $326 in the net liability position of financial instruments at 30 September 2020 and 2019, respectively. +The primary currency pairs for which we have exchange rate exposure are the Euro and U.S. Dollar and Chinese Renminbi and U.S. Dollar. Foreign currency debt, cross currency interest rate swaps, and foreign exchange-forward contracts are used in countries where we do business, thereby reducing our net asset exposure. Foreign exchange-forward contracts and cross currency interest rate swaps are also used to hedge our firm and highly anticipated foreign currency cash flows. Thus, there is either an asset or liability or cash flow exposure related to all of the financial instruments in the above sensitivity analysis for which the impact of a movement in exchange rates would be in the opposite direction and materially equal to the impact on the instruments in the analysis. +The majority of our sales are denominated in foreign currencies as they are derived outside the United States. Therefore, financial results will be affected by changes in foreign currency rates. The Chinese Renminbi and the Euro represent the largest exposures in terms of our foreign earnings. We estimate that a 10% reduction in either the Chinese Renminbi or the Euro versus the U.S. Dollar would lower our annual operating income by approximately $40 and $25, respectively. +COVID-19 Risks and Uncertainties +Refer to Item 1A. Risk Factors within this Annual Report on Form 10-K for additional discussion of current and potential risks of COVID-19 on our business and financial performance. +49 +Table of Contents +Item 8. Financial Statements and Supplementary Data. +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +Management's Report on Internal Control Over Financial Reporting +51 +Report of Deloitte & Touche LLP, Independent Registered Public Accounting Firm +52 +Report of KPMG LLP, Independent Registered Public Accounting Firm +55 +Consolidated Income Statements – Years Ended 30 September 2020, 2019, and 2018 +56 +Consolidated Comprehensive Income Statements – Years Ended 30 September 2020, 2019, and 2018 +57 +Consolidated Balance Sheets – 30 September 2020 and 2019 +58 +Consolidated Statements of Cash Flows – Years Ended 30 September 2020, 2019, and 2018 +59 +Consolidated Statements of Equity – Years Ended 30 September 2020, 2019, and 2018 +60 +Notes to Consolidated Financial Statements +61 +50 +Table of Contents +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Air Products’ management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting, which is defined in the following sentences, is a process designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that: +(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(ii) provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of inherent limitations, internal control over financial reporting can only provide reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions, the effectiveness of our internal control over financial reporting may vary over time. Our processes contain self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified. +Management has evaluated the effectiveness of its internal control over financial reporting based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management concluded that, as of 30 September 2020, the Company’s internal control over financial reporting was effective. +Deloitte & Touche LLP, an independent registered public accounting firm, has issued its opinion on the Company’s internal control over financial reporting as of 30 September 2020 as stated in its report which appears herein. +/s/ Seifi Ghasemi /s/ M. Scott Crocco +Seifi Ghasemi M. Scott Crocco +Chairman, President, and Executive Vice President and +Chief Executive Officer Chief Financial Officer +19 November 2020 19 November 2020 +51 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the shareholders and the Board of Directors of Air Products and Chemicals, Inc. +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of Air Products and Chemicals, Inc. and subsidiaries (the "Company") as of September 30, 2020 and 2019, the related consolidated income statements, comprehensive income statements, statements of equity, and statements of cash flows, for each of the two years in the period ended September 30, 2020, and the related notes (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of September 30, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 30, 2020 and 2019, and the results of its operations and its cash flows for each of the two years in the period ended September 30, 2020, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by COSO. +Basis for Opinions +The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +52 +Table of Contents +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Revenue – On-site Industrial Gas Customer Contracts – Refer to Notes 1 and 4 to the financial statements +Critical Audit Matter Description +On-site industrial gas customer contracts involve large capital investments to construct facilities and serve customers who require large volumes of gases and have relatively constant demand. The Company builds, owns and operates facilities on or near the customer’s facilities to produce and supply the customer with gases under a long-term arrangement. Typically, these contracts have 15 to 20-year terms and contain fixed monthly charges and/or minimum purchase requirements. Revenue associated with these contracts is generally recognized over time during the period in which the Company delivers or makes available the agreed upon quantity of gases. In addition, certain on-site industrial gas contracts contain complex terms and provisions such as tolling arrangements, minimum payment requirements, pricing provisions, and variable components that are specific to a customer arrangement, including certain contracts with related parties. These arrangements may require greater judgment in determining when contractual requirements have been met, impacting the timing and amount of revenue to be recorded. +We identified revenue recognition for certain on-site industrial gas customer contracts with complex terms and provisions as a critical audit matter because of the judgments necessary for management to evaluate these contract terms, including amendments, when determining the amount of revenue to be recognized. This required a high degree of auditor judgment when performing procedures to audit management’s identification and assessment of contract terms when determining the amount and timing of revenue recognition and evaluating the results of those procedures. +How the Critical Audit Matter Was Addressed in the Audit +Our audit procedures related to revenue recognition for certain on-site industrial gas customer contracts with complex terms and provisions included the following procedures, among others: +• We tested the effectiveness of the Company’s controls related to the amount and timing of revenue recognition, including controls over the evaluation of complex terms and provisions in certain on-site industrial gas customer contracts. +• We evaluated the terms included within original customer contracts and related amendments to assess the accounting for provisions such as minimum payment requirements, pricing provisions, settlement terms, and variable components that require management to apply judgment in determining revenue recognition associated with the contract. +53 +Table of Contents +• We tested the probability of collection of variable components, including penalties, which impacts the amount and timing of revenue which the Company expects to collect. +• We inquired of personnel who oversee operations, customer relations, and revenue recognition as to the presence of contract amendments, and interpretation of contract terms. +• We considered the nature of transactions with related parties and any potential impact on revenue recognition. +• We evaluated customer transactions and agreed the amount of revenue recognized to underlying contracts, customer invoices, and cash receipts. +• We considered customer payment history, subsequent events, write-offs of customer receivables, collectability, modification of contract terms, and other factors that could impact the amount and timing of revenue recognition. +/s/ Deloitte & Touche LLP +Philadelphia, Pennsylvania +November 19, 2020 +We have served as the Company's auditor since 2018. +54 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Shareholders and Board of Directors of Air Products and Chemicals, Inc.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated statements of income, comprehensive income, cash flows and equity of Air Products and Chemicals, Inc. and Subsidiaries (the Company) for the year ended 30 September 2018, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the results of operations of the Company and its cash flows for the year ended 30 September 2018, in conformity with U.S. generally accepted accounting principles. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audit included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audit provides a reasonable basis for our opinion. +/s/ KPMG LLP +We served as the Company’s auditor from 2002 to 2018. +Philadelphia, Pennsylvania +November 20, 2018 +55 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED INCOME STATEMENTS +Year Ended 30 September ( Millions of dollars, except for share and per share data) +2020 2019 2018 +Sales $ 8,856.3 $ 8,918.9 $ 8,930.2 +Cost of sales 5,858.1 5,975.5 6,189.5 +Facility closure — 29.0 — +Selling and administrative 775.9 750.0 760.8 +Research and development 83.9 72.9 64.5 +Cost reduction actions — 25.5 — +Gain on exchange of equity affiliate investments — 29.1 — +Company headquarters relocation income (expense) 33.8 — — +Other income (expense), net 65.4 49.3 50.2 +Operating Income 2,237.6 2,144.4 1,965.6 +Equity affiliates' income 264.8 215.4 174.8 +Interest expense 109.3 137.0 130.5 +Other non-operating income (expense), net 30.7 66.7 5.1 +Income From Continuing Operations Before Taxes 2,423.8 2,289.5 2,015.0 +Income tax provision 478.4 480.1 524.3 +Income From Continuing Operations 1,945.4 1,809.4 1,490.7 +(Loss) Income from discontinued operations, net of tax ( 14.3 ) — 42.2 +Net Income 1,931.1 1,809.4 1,532.9 +Net income attributable to noncontrolling interests of continuing operations 44.4 49.4 35.1 +Net Income Attributable to Air Products $ 1,886.7 $ 1,760.0 $ 1,497.8 +Net Income Attributable to Air Products +Net income from continuing operations $ 1,901.0 $ 1,760.0 $ 1,455.6 +Net (loss) income from discontinued operations ( 14.3 ) — 42.2 +Net Income Attributable to Air Products $ 1,886.7 $ 1,760.0 $ 1,497.8 +Per Share Data* +Basic EPS from continuing operations $ 8.59 $ 7.99 $ 6.64 +Basic EPS from discontinued operations ( 0.06 ) — 0.19 +Basic EPS Attributable to Air Products $ 8.53 $ 7.99 $ 6.83 +Diluted EPS from continuing operations $ 8.55 $ 7.94 $ 6.59 +Diluted EPS from discontinued operations ( 0.06 ) — 0.19 +Diluted EPS Attributable to Air Products $ 8.49 $ 7.94 $ 6.78 +Weighted Average Common Shares (in millions) +Basic +221.2 220.3 219.3 +Diluted +222.3 221.6 220.8 +* Earnings per share ("EPS") is calculated independently for each component and may not sum to total EPS due to rounding. +The accompanying notes are an integral part of these statements. +56 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED COMPREHENSIVE INCOME STATEMENTS +Year ended 30 September (Millions of dollars) +2020 2019 2018 +Net Income $ 1,931.1 $ 1,809.4 $ 1,532.9 +Other Comprehensive Income (Loss), net of tax: +Translation adjustments, net of tax of ($ 29.4 ), $ 25.1 , and $ 1.1 +233.4 ( 356.2 ) ( 244.6 ) +Net gain (loss) on derivatives, net of tax of $ 23.7 , ($ 1.5 ), and $ 9.7 +43.5 ( 44.1 ) 45.9 +Pension and postretirement benefits, net of tax of ($ 15.6 ), ($ 97.9 ), and $ 55.2 +( 68.2 ) ( 326.2 ) 179.4 +Reclassification adjustments: +Currency translation adjustment +— ( 2.6 ) 3.1 +Derivatives, net of tax of ($ 17.7 ), $ 4.5 , and ($ 9.2 ) +( 57.7 ) 12.3 ( 30.4 ) +Pension and postretirement benefits, net of tax of $ 27.1 , $ 20.5 , and $ 44.9 +82.5 63.2 133.1 +Total Other Comprehensive Income (Loss) 233.5 ( 653.6 ) 86.5 +Comprehensive Income 2,164.6 1,155.8 1,619.4 +Net Income Attributable to Noncontrolling Interests 44.4 49.4 35.1 +Other Comprehensive Loss Attributable to Noncontrolling Interests ( 2.0 ) ( 19.9 ) ( 19.0 ) +Comprehensive Income Attributable to Air Products $ 2,122.2 $ 1,126.3 $ 1,603.3 +The accompanying notes are an integral part of these statements. +57 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED BALANCE SHEETS +30 September ( Millions of dollars, except for share and per share data) +2020 2019 +Assets +Current Assets +Cash and cash items $ 5,253.0 $ 2,248.7 +Short-term investments 1,104.9 166.0 +Trade receivables, net 1,274.8 1,260.2 +Inventories 404.8 388.3 +Prepaid expenses 164.5 77.4 +Other receivables and current assets 482.9 477.7 +Total Current Assets 8,684.9 4,618.3 +Investment in net assets of and advances to equity affiliates 1,432.2 1,276.2 +Plant and equipment, net 11,964.7 10,337.6 +Goodwill, net 891.5 797.1 +Intangible assets, net 435.8 419.5 +Noncurrent lease receivables 816.3 890.0 +Other noncurrent assets 943.1 604.1 +Total Noncurrent Assets 16,483.6 14,324.5 +Total Assets $ 25,168.5 $ 18,942.8 +Liabilities and Equity +Current Liabilities +Payables and accrued liabilities $ 1,833.2 $ 1,635.7 +Accrued income taxes 105.8 86.6 +Short-term borrowings 7.7 58.2 +Current portion of long-term debt 470.0 40.4 +Total Current Liabilities 2,416.7 1,820.9 +Long-term debt 7,132.9 2,907.3 +Long-term debt – related party 297.2 320.1 +Other noncurrent liabilities 1,916.0 1,712.4 +Deferred income taxes 962.6 793.8 +Total Noncurrent Liabilities 10,308.7 5,733.6 +Total Liabilities 12,725.4 7,554.5 +Commitments and Contingencies - See Note 17 +Air Products Shareholders’ Equity +Common stock (par value $ 1 per share; issued 2020 and 2019 - 249,455,584 shares) +249.4 249.4 +Capital in excess of par value 1,094.8 1,070.9 +Retained earnings 14,875.7 14,138.4 +Accumulated other comprehensive loss ( 2,140.1 ) ( 2,375.6 ) +Treasury stock, at cost (2020 - 28,438,125 shares; 2019 - 29,040,322 shares) +( 2,000.0 ) ( 2,029.5 ) +Total Air Products Shareholders' Equity 12,079.8 11,053.6 +Noncontrolling Interests 363.3 334.7 +Total Equity 12,443.1 11,388.3 +Total Liabilities and Equity $ 25,168.5 $ 18,942.8 +The accompanying notes are an integral part of these statements. +58 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED STATEMENTS OF CASH FLOWS +Year ended 30 September ( Millions of dollars) +2020 2019 2018 +Operating Activities +Net income $ 1,931.1 $ 1,809.4 $ 1,532.9 +Less: Net income attributable to noncontrolling interests of continuing operations 44.4 49.4 35.1 +Net income attributable to Air Products 1,886.7 1,760.0 1,497.8 +Loss (Income) from discontinued operations 14.3 — ( 42.2 ) +Income from continuing operations attributable to Air Products 1,901.0 1,760.0 1,455.6 +Adjustments to reconcile income to cash provided by operating activities: +Depreciation and amortization 1,185.0 1,082.8 970.7 +Deferred income taxes 165.0 57.6 ( 55.4 ) +Tax reform repatriation — 49.4 240.6 +Facility closure — 29.0 — +Undistributed (earnings) losses of unconsolidated affiliates ( 161.9 ) ( 75.8 ) ( 59.8 ) +Gain on sale of assets and investments ( 45.8 ) ( 24.2 ) ( 6.9 ) +Share-based compensation 53.5 41.2 38.8 +Noncurrent lease receivables 91.6 94.6 97.4 +Other adjustments 116.4 ( 19.4 ) 131.6 +Working capital changes that provided (used) cash, excluding effects of acquisitions: +Trade receivables 43.2 ( 69.0 ) ( 42.8 ) +Inventories ( 5.2 ) ( 3.0 ) ( 64.2 ) +Other receivables 84.4 79.8 128.3 +Payables and accrued liabilities ( 31.9 ) ( 41.8 ) ( 277.7 ) +Other working capital ( 130.6 ) 8.7 ( 9.0 ) +Cash Provided by Operating Activities 3,264.7 2,969.9 2,547.2 +Investing Activities +Additions to plant and equipment, including long-term deposits ( 2,509.0 ) ( 1,989.7 ) ( 1,568.4 ) +Acquisitions, less cash acquired ( 183.3 ) ( 123.2 ) ( 345.4 ) +Investment in and advances to unconsolidated affiliates ( 24.4 ) ( 15.7 ) — +Proceeds from sale of assets and investments 80.3 11.1 48.8 +Purchases of investments ( 2,865.5 ) ( 172.1 ) ( 530.3 ) +Proceeds from investments 1,938.0 190.5 748.2 +Other investing activities 3.9 ( 14.3 ) 5.5 +Cash Used for Investing Activities ( 3,560.0 ) ( 2,113.4 ) ( 1,641.6 ) +Financing Activities +Long-term debt proceeds 4,895.8 — 0.5 +Payments on long-term debt ( 406.6 ) ( 428.6 ) ( 418.7 ) +Net increase (decrease) in commercial paper and short-term borrowings ( 54.9 ) 3.9 ( 78.5 ) +Dividends paid to shareholders ( 1,103.6 ) ( 994.0 ) ( 897.8 ) +Proceeds from stock option exercises 34.1 68.1 76.2 +Other financing activities ( 80.1 ) ( 19.9 ) ( 41.5 ) +Cash Provided by (Used for) Financing Activities 3,284.7 ( 1,370.5 ) ( 1,359.8 ) +Discontinued Operations +Cash used for operating activities — — ( 12.8 ) +Cash provided by investing activities — — 18.6 +Cash provided by financing activities — — — +Cash Provided by Discontinued Operations — — 5.8 +Effect of Exchange Rate Changes on Cash 14.9 ( 28.6 ) ( 33.9 ) +Increase (Decrease) in cash and cash items 3,004.3 ( 542.6 ) ( 482.3 ) +Cash and Cash items – Beginning of Year 2,248.7 2,791.3 3,273.6 +Cash and Cash Items – End of Period $ 5,253.0 $ 2,248.7 $ 2,791.3 +The accompanying notes are an integral part of these statements. +59 +Table of Contents +Air Products and Chemicals, Inc. and Subsidiaries +CONSOLIDATED STATEMENTS OF EQUITY +Year ended 30 September +(Millions of dollars, +except for per share data) +Common +Stock Capital +in Excess +of Par +Value Retained +Earnings Accumulated +Other +Comprehensive +Income (Loss) Treasury +Stock Air Products +Shareholders’ +Equity Non- +controlling +Interests Total +Equity +Balance 30 September 2017 $ 249.4 $ 1,001.1 $ 12,846.6 ($ 1,847.4 ) ($ 2,163.5 ) $ 10,086.2 $ 99.3 $ 10,185.5 +Net income — — 1,497.8 — — 1,497.8 35.1 1,532.9 +Other comprehensive income (loss) — — — 105.5 — 105.5 ( 19.0 ) 86.5 +Dividends on common stock (per share $ 4.25 ) +— — ( 931.8 ) — — ( 931.8 ) — ( 931.8 ) +Dividends to noncontrolling interests — — — — — — ( 29.9 ) ( 29.9 ) +Share-based compensation — 38.1 — — — 38.1 — 38.1 +Issuance of treasury shares for stock option and award plans — ( 11.3 ) — — 74.3 63.0 — 63.0 +Lu'An joint venture — — — — — — 227.4 227.4 +Other equity transactions — 1.4 ( 2.7 ) — — ( 1.3 ) 5.9 4.6 +Balance 30 September 2018 $ 249.4 $ 1,029.3 $ 13,409.9 ($ 1,741.9 ) ($ 2,089.2 ) $ 10,857.5 $ 318.8 $ 11,176.3 +Net income — — 1,760.0 — — 1,760.0 49.4 1,809.4 +Other comprehensive income (loss) — — — ( 633.7 ) — ( 633.7 ) ( 19.9 ) ( 653.6 ) +Dividends on common stock (per share $ 4.58 ) +— — ( 1,008.3 ) — — ( 1,008.3 ) — ( 1,008.3 ) +Dividends to noncontrolling interests — — — — — — ( 12.2 ) ( 12.2 ) +Share-based compensation — 40.7 — — — 40.7 — 40.7 +Issuance of treasury shares for stock option and award plans — 2.2 — — 59.7 61.9 — 61.9 +Cumulative change in accounting principle — — ( 17.1 ) — — ( 17.1 ) — ( 17.1 ) +Other equity transactions — ( 1.3 ) ( 6.1 ) — — ( 7.4 ) ( 1.4 ) ( 8.8 ) +Balance 30 September 2019 $ 249.4 $ 1,070.9 $ 14,138.4 ($ 2,375.6 ) ($ 2,029.5 ) $ 11,053.6 $ 334.7 $ 11,388.3 +Net income — — 1,886.7 — — 1,886.7 44.4 1,931.1 +Other comprehensive income (loss) — — — 235.5 — 235.5 ( 2.0 ) 233.5 +Dividends on common stock (per share $ 5.18 ) +— — ( 1,144.1 ) — — ( 1,144.1 ) — ( 1,144.1 ) +Dividends to noncontrolling interests — — — — — — ( 31.8 ) ( 31.8 ) +Share-based compensation — 44.2 — — — 44.2 — 44.2 +Issuance of treasury shares for stock option and award plans — ( 14.1 ) — — 29.5 15.4 — 15.4 +Investments by noncontrolling interests — — — — — — 17.1 17.1 +Other equity transactions — ( 6.2 ) ( 5.3 ) — — ( 11.5 ) 0.9 ( 10.6 ) +Balance 30 September 2020 $ 249.4 $ 1,094.8 $ 14,875.7 ($ 2,140.1 ) ($ 2,000.0 ) $ 12,079.8 $ 363.3 $ 12,443.1 +The accompanying notes are an integral part of these statements. +60 +Table of Contents +AIR PRODUCTS AND CHEMICALS, INC. and Subsidiaries +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +(Millions of dollars unless otherwise indicated, except for share and per share data) +1. +Major Accounting Policies +62 +2. +New Accounting Guidance +70 +3. +Acquisitions +71 +4. +Revenue Recognition +73 +5. +Cost Reduction Actions +76 +6. +Discontinued Operations +76 +7. +Inventories +76 +8. +Summarized Financial Information of Equity Affiliates +77 +9. +Plant and Equipment, net +78 +10. +Goodwill +78 +11. +Intangible Assets +79 +12. +Leases +80 +13. +Financial Instruments +82 +14. +Fair Value Measurements +87 +15. +Debt +89 +16. +Retirement Benefits +91 +17. +Commitments and Contingencies +97 +18. +Capital Stock +101 +19. +Share-Based Compensation +102 +20. +Accumulated Other Comprehensive Loss +105 +21. +Earnings Per Share +106 +22. +Income Taxes +106 +23. +Supplemental Information +112 +24. +Summary by Quarter (Unaudited) +114 +25. +Business Segment and Geographic Information +116 +61 +Table of Contents +1. MAJOR ACCOUNTING POLICIES +Basis of Presentation and Consolidation Principles +The accompanying consolidated financial statements of Air Products and Chemicals, Inc. were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Air Products and Chemicals, Inc. and those of its controlled subsidiaries (“we,” “our,” “us,” the “Company,” “Air Products,” or “registrant”), which are generally majority owned. Intercompany transactions and balances are eliminated in consolidation. +We consolidate all entities that we control. The general condition for control is ownership of a majority of the voting interests of an entity. Control may also exist in arrangements where we are the primary beneficiary of a variable interest entity ("VIE"). An entity that has both the power to direct the activities that most significantly impact the economic performance of a VIE and the obligation to absorb losses or receive benefits significant to the VIE is considered the primary beneficiary of that entity. We have determined that we are not a primary beneficiary of any material VIE. +The results of operations and cash flows for our discontinued operations have been segregated from the results of continuing operations and segment results. The comprehensive income related to discontinued operations has not been segregated and is included in the consolidated comprehensive income statements. There were no assets and liabilities presented as discontinued operations on the consolidated balance sheets. Refer to Note 6, Discontinued Operations , for additional information. +The notes to the consolidated financial statements, unless otherwise indicated, are on a continuing operations basis. The term "total company" includes both continuing and discontinued operations. +Certain prior year information has been reclassified to conform to the fiscal year 2020 presentation. +Estimates and Assumptions +The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. +COVID-19 Risks and Uncertainties +In March 2020, the World Health Organization declared the novel strain of coronavirus, COVID-19, a global pandemic and recommended containment and mitigation measures worldwide. COVID-19 had a negative impact on our operating results in fiscal year 2020, primarily in the regional industrial gas segments. We continue to monitor its impact on our operations; however, we are unable to predict the future impact that COVID-19 will have on our future financial position and operating results due to numerous uncertainties, including the duration and severity of the outbreak. +Revenue Recognition +We recognize revenue when or as performance obligations are satisfied, which occurs when control is transferred to the customer. +We determine the transaction price of our contracts based on the amount of consideration to which we expect to be entitled to receive in exchange for the goods or services provided. Our contracts within the scope of revenue guidance do not contain payment terms that include a significant financing component. +Sales returns and allowances are not a business practice in the industry. +Our sale of gas contracts are either accounted for over time during the period in which we deliver or make available the agreed upon quantity of goods or at a point in time when the customer receives and obtains control of the product, which generally occurs upon delivery. We generally recognize revenue from our sale of gas contracts based on the right to invoice practical expedient. +62 +Table of Contents +Our sale of equipment contracts are generally comprised of a single performance obligation as the individual promised goods or services contained within the contracts are integrated with or dependent upon other goods or services in the contract for a single output to the customer. Revenue from our sale of equipment contracts is generally recognized over time as we have an enforceable right to payment for performance completed to date and our performance under the contract terms does not create an asset with alternative use. We recognize these contracts using a cost incurred input method by which costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. +Amounts billed for shipping and handling fees are classified as sales in the consolidated income statements. Shipping and handling activities for our sale of equipment contracts may be performed after the customer obtains control of the promised goods. In these cases, we have elected to apply the practical expedient to account for shipping and handling as activities to fulfill the promise to transfer the goods. For our sale of gas contracts, control generally transfers to the customer upon delivery. +Amounts billed for sales and use taxes, value-added taxes, and certain excise and other specific transactional taxes imposed on revenue-producing transactions are presented on a net basis and excluded from sales in the consolidated income statements. +For additional information, refer to Note 4, Revenue Recognition . +Cost of Sales +Cost of sales predominantly represents the cost of tangible products sold. These costs include labor, raw materials, plant engineering, power, depreciation, production supplies and materials packaging costs, and maintenance costs. Costs incurred for shipping and handling are also included in cost of sales. +Depreciation +Depreciation is recorded using the straight-line method, which deducts equal amounts of the cost of each asset from earnings every year over its expected economic useful life. The principal lives for major classes of plant and equipment are summarized in Note 9, Plant and Equipment, net . +Selling and Administrative +The principal components of selling and administrative expenses are compensation, advertising, and promotional costs. +Postemployment Benefits +We provide termination benefits to employees as part of ongoing benefit arrangements and record a liability for termination benefits when probable and estimable. These criteria are met when management, with the appropriate level of authority, approves and commits to its plan of action for termination; the plan identifies the employees to be terminated and their related benefits; and the plan is to be completed within one year. We do not provide material one-time benefit arrangements. +Fair Value Measurements +We are required to measure certain assets and liabilities at fair value, either upon initial measurement or for subsequent accounting or reporting. For example, fair value is used in the initial measurement of assets and liabilities acquired in a business combination; on a recurring basis in the measurement of derivative financial instruments; and on a nonrecurring basis when long-lived assets are written down to fair value when held for sale or determined to be impaired. Refer to Note 14, Fair Value Measurements , and Note 16, Retirement Benefits , for information on the methods and assumptions used in our fair value measurements. +63 +Table of Contents +Financial Instruments +We address certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments. The types of derivative financial instruments permitted for such risk management programs are specified in policies set by management. Refer to Note 13, Financial Instruments , for further detail on the types and use of derivative instruments into which we enter. +Major financial institutions are counterparties to all of these derivative contracts. We have established counterparty credit guidelines and generally enter into transactions with financial institutions of investment grade or better. Management believes the risk of incurring losses related to credit risk is remote, and any losses would be immaterial to the consolidated financial results, financial condition, or liquidity. +We recognize derivatives on the balance sheet at fair value. On the date the derivative instrument is entered into, we generally designate the derivative as either (1) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge), (2) a hedge of a net investment in a foreign operation (net investment hedge), or (3) a hedge of the fair value of a recognized asset or liability (fair value hedge). +The following details the accounting treatment of our cash flow, fair value, net investment, and non-designated hedges: +• Changes in the fair value of a derivative that is designated as and meets the cash flow hedge criteria are recorded in accumulated other comprehensive loss ("AOCL") to the extent effective and then recognized in earnings when the hedged items affect earnings. +• Changes in the fair value of a derivative that is designated as and meets all the required criteria for a fair value hedge, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. +• Changes in the fair value of a derivative and foreign currency debt that are designated as and meet all the required criteria for a hedge of a net investment are recorded as translation adjustments in AOCL. +• Changes in the fair value of a derivative that is not designated as a hedge are recorded immediately in earnings. +We formally document the relationships between hedging instruments and hedged items, as well as our risk management objective and strategy for undertaking various hedge transactions. This process includes relating derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also formally assess, at the inception of the hedge and on an ongoing basis, whether derivatives are highly effective in offsetting changes in fair values or cash flows of the hedged item. If it is determined that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we will discontinue hedge accounting with respect to that derivative prospectively. +Foreign Currency +Since we do business in many foreign countries, fluctuations in currency exchange rates affect our financial position and results of operations. +In most of our foreign operations, the local currency is considered the functional currency. Foreign subsidiaries translate their assets and liabilities into U.S. dollars at current exchange rates in effect as of the balance sheet date. The gains or losses that result from this process are shown as translation adjustments in AOCL in the equity section of the balance sheet. +The revenue and expense accounts of foreign subsidiaries are translated into U.S. dollars at the average exchange rates that prevail during the period. Therefore, the U.S. dollar value of these items on the consolidated income statements fluctuates from period to period, depending on the value of the U.S. dollar against foreign currencies. Some transactions are made in currencies different from an entity’s functional currency. Gains and losses from these foreign currency transactions are generally reflected in "Other income (expense), net" on our consolidated income statements as they occur. Net foreign exchange losses reflected in "Other income (expense), net" were not material for the periods presented. Refer to the Other Non-Operating Income (Expense), Net section below for discussion on other foreign currency presentation. +64 +Table of Contents +Environmental Expenditures +Accruals for environmental loss contingencies are recorded when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. Remediation costs are capitalized if the costs improve our property as compared with the condition of the property when originally constructed or acquired, or if the costs prevent environmental contamination from future operations. We expense environmental costs related to existing conditions resulting from past or current operations and from which no current or future benefit is discernible. The amounts charged to income from continuing operations related to environmental matters totaled $ 18.3 , $ 14.2 , and $ 12.8 in fiscal years 2020, 2019, and 2018, respectively. In addition, we recorded a pre-tax expense of $ 19.0 in results from discontinued operations to increase our environmental accrual for the Pace facility in the second quarter of fiscal year 2020. Refer to the Pace discussion within Note 17, Commitments and Contingencies , for additional information. +The measurement of environmental liabilities is based on an evaluation of currently available information with respect to each individual site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. An environmental liability related to cleanup of a contaminated site might include, for example, a provision for one or more of the following types of costs: site investigation and testing costs, remediation costs, post-remediation monitoring costs, natural resource damages, and outside legal fees. These liabilities include costs related to other potentially responsible parties to the extent that we have reason to believe such parties will not fully pay their proportionate share. They do not consider any claims for recoveries from insurance or other parties and are not discounted. +As assessments and remediation progress at individual sites, the amount of projected cost is reviewed and the liability is adjusted to reflect additional technical and legal information that becomes available. Management has an established process in place to identify and monitor our environmental exposures. An environmental accrual analysis is prepared and maintained that lists all environmental loss contingencies, even where an accrual has not been established. This analysis assists in monitoring our overall environmental exposure and serves as a tool to facilitate ongoing communication among our technical experts, environmental managers, environmental lawyers, and financial management to ensure that required accruals are recorded and potential exposures disclosed. +Given inherent uncertainties in evaluating environmental exposures, actual costs to be incurred at identified sites in future periods may vary from the estimates. Refer to Note 17, Commitments and Contingencies , for additional information on our environmental loss contingencies. +The accruals for environmental liabilities are reflected in the consolidated balance sheets, primarily as part of other noncurrent liabilities. +Litigation +In the normal course of business, we are involved in legal proceedings. We accrue a liability for such matters when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. When only a range of possible loss can be established, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. The accrual for a litigation loss contingency includes estimates of potential damages and other directly related costs expected to be incurred. Refer to Note 17, Commitments and Contingencies , for additional information on our current legal proceedings. +Share-Based Compensation +We have various share-based compensation programs, which include deferred stock units, stock options, and restricted stock. We expense the grant-date fair value of these awards over the vesting period during which employees perform related services. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. Refer to Note 19, Share-Based Compensation , for additional information regarding these awards and the models and assumptions used to determine the grant-date fair value of our awards. +65 +Table of Contents +Income Taxes +We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. A principal temporary difference results from the excess of tax depreciation over book depreciation because accelerated methods of depreciation and shorter useful lives are used for income tax purposes. The cumulative impact of a change in tax rates or regulations is included in income tax expense in the period that includes the enactment date. We recognize deferred tax assets net of existing valuation allowances to the extent we believe that these assets are more likely than not to be realized considering all available evidence. +A tax benefit for an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination based on its technical merits. This position is measured as the largest amount of tax benefit that is greater than 50% likely of being realized. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense. For additional information regarding our income taxes, refer to Note 22, Income Taxes . +Other Non-Operating Income (Expense), net +Other non-operating income (expense), net includes interest income associated with our cash and cash items and short-term investments, certain impacts from hedging activities, and non-service cost components of net periodic pension and postretirement benefit cost. Our non-service costs primarily include interest cost, expected return on plan assets, amortization of actuarial gains and losses, and settlements. +In fiscal year 2020, we adopted new accounting guidance on hedging activities that changed the income statement presentation of excluded components (foreign currency forward points and currency swap basis differences) of our cash flow hedges of intercompany loans. This activity is amortized on a straight-line basis within “Other non-operating income (expense), net." In addition, gains and losses from the foreign currency remeasurement of balances associated with intercompany and third-party financing transactions, related income tax assets and liabilities, and the impact of related hedges are also reflected within “Other non-operating income (expense), net.” Refer to Note 2, New Accounting Guidance , for additional information. +Cash and Cash Items +Cash and cash items include cash, time deposits, and treasury securities acquired with an original maturity of three months or less. +Short-term Investments +Short-term investments include time deposits and treasury securities with original maturities greater than three months and less than one year. +66 +Table of Contents +Trade Receivables, net +Trade receivables comprise amounts owed to us through our operating activities and are presented net of allowances for doubtful accounts. The allowances for doubtful accounts represent estimated uncollectible receivables associated with potential customer defaults on contractual obligations. A provision for customer defaults is made on a general formula basis when it is determined that the risk of some default is probable and estimable but cannot yet be associated with specific customers. The assessment of the likelihood of customer defaults is based on various factors, including the length of time the receivables are past due, historical experience, and existing economic conditions. The allowance also includes amounts for certain customers where a risk of default has been specifically identified, considering factors such as the financial condition of the customer and their inability to pay. The allowance excludes amounts associated with customer disputes over contractual terms and conditions. Changes to the carrying amount of the allowance for doubtful accounts are summarized below: +Balance at 30 September 2017 $ 22.6 +Provision for credit losses 11.2 +Write-offs charged against the allowance ( 7.2 ) +Currency translation and other ( 0.2 ) +Balance at 30 September 2018 $ 26.4 +Provision for credit losses 7.7 +Write-offs charged against the allowance ( 6.8 ) +Currency translation and other ( 2.5 ) +Balance at 30 September 2019 $ 24.8 +Provision for credit losses 7.7 +Write-offs charged against the allowance ( 8.3 ) +Currency translation and other ( 0.3 ) +Balance at 30 September 2020 $ 23.9 +Inventories +We carry inventory that is comprised of finished goods, work-in-process, raw materials and supplies. Refer to Note 7, Inventories , for further detail. +Inventories on our consolidated balance sheets are stated at the lower of cost or net realizable value. We write down our inventories for estimated obsolescence or unmarketable inventory based upon assumptions about future demand and market conditions. +Effective 1 July 2018, we determine the cost of all our inventories on a first-in, first-out basis ("FIFO"). Prior to 1 July 2018, we determined the cost of our industrial gas inventories in the United States on a last-in, first-out basis ("LIFO"). We applied this accounting change as a cumulative effect adjustment to cost of sales in the fourth quarter of fiscal year 2018. This change decreased our cost of sales by $ 24.1 for the quarter and fiscal year ended 30 September 2018. +Equity Investments +The equity method of accounting is used when we exercise significant influence but do not have operating control, generally assumed to be 20% – 50% ownership. Under the equity method, original investments are recorded at cost and adjusted by our share of undistributed earnings or losses of these companies. We use the cumulative earnings approach for determining cash flow presentation of cash distributions received from equity method investees. Equity investments are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment may not be recoverable. +67 +Table of Contents +Plant and Equipment, net +Plant and equipment, net is stated at cost less accumulated depreciation. Construction costs, labor, and applicable overhead related to installations are capitalized. Expenditures for additions and improvements that extend the lives or increase the capacity of plant assets are capitalized. The costs of maintenance and repairs of plant and equipment are charged to expense as incurred. +Fully depreciated assets are retained in the gross plant and equipment and accumulated depreciation accounts until they are removed from service. In the case of disposals, assets and related depreciation are removed from the accounts, and the net amounts, less proceeds from disposal, are included in income. Refer to Note 9, Plant and Equipment, net , for further detail. +Computer Software +We capitalize costs incurred to purchase or develop software for internal use. Capitalized costs include purchased computer software packages, payments to vendors/consultants for development and implementation or modification to a purchased package to meet our requirements, payroll and related costs for employees directly involved in development, and interest incurred while software is being developed. Capitalized computer software costs are reflected in "Plant and equipment, net" on the consolidated balance sheets and are depreciated over the estimated useful life of the software, generally a period of three to five years . +Capitalized Interest +As we build new plant and equipment, we include in the cost of these assets a portion of the interest payments we make during the year. The amount of capitalized interest was $ 15.9 , $ 13.5 , and $ 19.5 in fiscal years 2020, 2019, and 2018, respectively. +Leases +As lessee, we recognize a right-of-use ("ROU") asset and lease liability on the balance sheet for all leases with a term in excess of 12 months. We determine if an arrangement contains a lease at inception. The arrangement contains a lease when there is an identifiable asset, we obtain substantially all of the economic benefits from that asset, and we direct how and for what purpose the asset is used during the term of the arrangement. If the initial term of an arrangement is 12 months or less, we have made an accounting election to not assess if these arrangements contain a lease for inclusion on our balance sheet. +ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the commencement date based on the present value of lease payments over the lease term. Since our leases generally do not provide an implicit discount rate, we use our incremental borrowing rates based on the information available at the commencement date in determining the present value of lease payments. To determine the incremental borrowing rate, we consider our unsecured borrowings and published market rates, and then adjust those rates to assume full collateralization and to factor in the individual lease term, geography, and payment structure. +Our lease term includes periods covered by options to extend or terminate the lease when it is reasonably certain that we will exercise an option to extend or not exercise an option to terminate. Lease payments consider our practical expedient to combine amounts for lease and related non-lease components for all classes of underlying assets in which we are lessee. Fixed payments and payments associated with escalation clauses based on an index are included in the ROU asset and lease liability at commencement. Variable lease payments are excluded from the ROU assets and lease liabilities and are recognized in the period in which the obligation for those payments is incurred. Our variable lease payments primarily include the impact from escalation clauses that are not fixed or based on an index. Prepaid lease payments are included in the recognition of ROU assets. Our lease agreements do not contain any material lease incentives, residual value guarantees or restrictions or covenants. +Impairment of Long-Lived Assets +Long-lived assets are grouped for impairment testing at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other assets and liabilities and are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. We assess recoverability by comparing the carrying amount of the asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If an asset group is considered impaired, the impairment loss to be recognized is measured as the amount by which the asset group’s carrying amount exceeds its fair value. Long-lived assets meeting the held for sale criteria are reported at the lower of carrying amount or fair value less cost to sell. +68 +Table of Contents +Asset Retirement Obligations +The fair value of a liability for an asset retirement obligation is recognized in the period in which it is incurred. The fair value of the liability is measured using discounted estimated cash flows and is adjusted to its present value in subsequent periods as accretion expense is recorded. The corresponding asset retirement costs are capitalized as part of the carrying amount of the related long-lived asset and depreciated over the asset’s useful life. Our asset retirement obligations are primarily associated with on-site long-term supply contracts under which we have built a facility on land owned by the customer and are obligated to remove the facility at the end of the contract term. Our asset retirement obligations totaled $ 241.4 and $ 208.2 at 30 September 2020 and 2019, respectively. +Goodwill +Business combinations are accounted for using the acquisition method. The purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. Any excess purchase price (plus the fair value of any noncontrolling interest and previously held equity interest in the acquiree) over the fair market value of the net assets acquired, including identified intangibles, is recorded as goodwill. Preliminary purchase price allocations are made at the date of acquisition and finalized when information about facts and circumstances that existed as of the acquisition date needed to finalize underlying estimates is obtained or when we determine that such information is not obtainable, within a maximum measurement period of one year. +Goodwill is subject to impairment testing at least annually. In addition, goodwill is tested more frequently if a change in circumstances or the occurrence of events indicates that potential impairment exists. Refer to Note 10, Goodwill , for further detail. +Intangible Assets +Intangible assets with determinable lives primarily consist of customer relationships, purchased patents and technology, and land use rights. The cost of intangible assets with determinable lives is amortized on a straight-line basis over the estimated period of economic benefit. No residual value is estimated for these intangible assets. Indefinite-lived intangible assets consist of trade names and trademarks. Indefinite-lived intangibles are subject to impairment testing at least annually. In addition, intangible assets are tested more frequently if a change in circumstances or the occurrence of events indicates that potential impairment exists. +Customer relationships are generally amortized over periods of five to twenty-five years . Purchased patents and technology and other finite-lived intangibles are generally amortized over periods of five to fifteen years . Other intangibles includes land use rights, which are generally amortized over a period of fifty years . Amortizable lives are adjusted whenever there is a change in the estimated period of economic benefit. Refer to Note 11, Intangible Assets , for further detail. +Retirement Benefits +The cost of pension benefits is generally recognized over the employees’ service period. We use actuarial methods and assumptions in the valuation of defined benefit obligations and the determination of expense. Differences between actual and expected results or changes in the value of obligations and plan assets are not recognized in earnings as they occur but, rather, are recognized systematically over subsequent periods. Refer to Note 16, Retirement Benefits , for disclosures related to our pension and other postretirement benefits. +69 +Table of Contents +2. NEW ACCOUNTING GUIDANCE +Accounting Guidance Implemented in Fiscal Year 2020 +Leases +In February 2016, the FASB issued lease guidance (the "new lease guidance") that requires lessees to recognize a right-of-use asset and lease liability on the balance sheet for all leases, including operating leases, with a term in excess of 12 months. The guidance also expands the quantitative and qualitative disclosure requirements. +We are the lessee under various agreements for real estate, vehicles, aircraft, and other equipment that are accounted for as operating leases. +We adopted this guidance in fiscal year 2020 using a modified retrospective approach with the election to apply the guidance as of 1 October 2019, "the adoption date," instead of the earliest comparative period presented in the consolidated financial statements. +We elected the following practical expedients provided by this guidance: +• The package of practical expedients, which allows us to carry forward the lease population and classification existing as of the adoption date, among other things; +• The land easements practical expedient, which allows us to carry forward our accounting treatment for land easements on agreements existing before the adoption date; +• The hindsight practical expedient, which is used to determine the reasonably certain lease term for existing leases as of the adoption date; +• The component combination practical expedient, which allows us to account for lease and non-lease components associated with that lease as a single component, if certain criteria are met; and +• The short-term leases practical expedient, which allows us to not record the related lease liabilities and right-of-use assets for operating leases in which we are the lessee with a term of 12 months or less. +Adoption of the standard resulted in recognition of lease liabilities and right-of-use assets on our consolidated balance sheets as of the adoption date of $ 375.3 and $ 332.3 , respectively. The standard did not materially affect our retained earnings, results of operations or liquidity. Refer to Note 12, Leases , for additional information. +Hedging Activities +In August 2017, the FASB issued guidance on hedging activities to expand the related presentation and disclosure requirements, change how companies assess effectiveness, and eliminate the separate measurement and reporting of hedge ineffectiveness. The guidance also enables more hedging strategies to become eligible for hedge accounting. +We adopted the new guidance on 1 October 2019 on a modified retrospective basis. The primary impact of adoption was the presentation in the consolidated income statement of foreign currency forward points and currency swap basis differences ("excluded components"), since these are excluded from the assessment of hedge effectiveness for our hedges of intercompany loans. Historically, the impacts from changes in value of these components were recorded in "Interest expense." In fiscal year 2020, excluded components of $ 33.5 were recognized in "Other non-operating income (expense), net" consistent with the remeasurement of the intercompany loans. Interest expense of $ 33.3 and $ 42.6 in fiscal years 2019 and 2018, respectively, has not been restated to conform to the 2020 presentation. +In accordance with the transition provisions of the guidance, the separate measurement of ineffectiveness for our cash flow hedging instruments existing as of the date of adoption should be eliminated through a cumulative-effect adjustment within equity. Ineffectiveness recognized for our cash flow hedging instruments existing as of the date of adoption was not material to the consolidated financial statements. +70 +Table of Contents +Retirement Benefit Disclosures +In August 2018, the FASB issued guidance which modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. The guidance is effective in fiscal year 2021, with early adoption permitted, and must be applied on a retrospective basis. We adopted this guidance in the fourth quarter of fiscal year 2020 and updated the disclosures contained in Note 16, Retirement Benefits , accordingly. Other than the modification of certain disclosures, this guidance had no effect on our consolidated financial statements. +New Accounting Guidance to be Implemented +Credit Losses on Financial Instruments +In June 2016, the FASB issued guidance on the measurement of credit losses, which requires measurement and recognition of expected credit losses for financial assets, including trade receivables and capital lease receivables, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The method to determine a loss is different from the existing guidance, which requires a credit loss to be recognized when it is probable. We will adopt this guidance at the beginning of fiscal year 2021 under the modified retrospective approach with an adjustment to retained earnings as of the effective date. This guidance will not have a material impact on our consolidated financial statements upon adoption. +Cloud Computing Implementation Costs +In August 2018, the FASB issued guidance which aligns the capitalization requirements for implementation costs incurred in a hosting arrangement that is a service contract with the existing capitalization requirements for implementation costs incurred to develop or obtain internal-use software. We will adopt this guidance at the beginning of fiscal year 2021. This guidance will not have a material impact on our consolidated financial statements upon adoption. +Simplifying the Accounting for Income Taxes +In December 2019, the FASB issued an update to simplify the accounting for income taxes and improve consistent application by clarifying or amending existing guidance. We will adopt this guidance at the beginning of fiscal year 2021. This guidance will not have a material impact on our consolidated financial statements upon adoption. +Reference Rate Reform +In March 2020, the FASB issued an update to provide practical expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. This update is primarily applicable to our contracts and hedging relationships that reference LIBOR. The amendments may be applied to impacted contracts and hedges prospectively through 31 December 2022. To date, we have had no impacts on our hedging relationships related to reference rate reform. We will continue to evaluate the impact this guidance could have on our consolidated financial statements. +3. ACQUISITIONS +Fiscal Year 2020 +Asset Acquisition +On 17 April 2020, we acquired five operating hydrogen production plants from PBF Energy Inc. ("PBF") and commenced contractual long-term supply of hydrogen from those plants to PBF's refineries. We accounted for the transaction as an asset acquisition and recorded the aggregate purchase price of approximately $ 580 to plant and equipment on our consolidated balance sheets. +Business Combinations +We completed three acquisitions on 1 July 2020 that were accounted for as business combinations. These acquisitions had an aggregate purchase price, net of cash acquired, of $ 185.4 . The largest of these acquisitions was the purchase of Oxygen & Argon Works Ltd., the leading manufacturer and marketer of industrial gases in Israel, primarily offering merchant gas products. We expect this acquisition to create growth opportunities in the region and allow us to leverage synergies and operating efficiencies. The results of this business are consolidated within our Industrial Gases – EMEA segment and did not materially impact our consolidated income statement. +71 +Table of Contents +Our fiscal year 2020 business combinations resulted in the recognition of plant and equipment of $ 71.2 , goodwill of $ 71.1 , and intangible assets of $ 50.7 , partially offset by net liabilities acquired. The goodwill recognized on the transactions, $ 8.1 of which is deductible for tax purposes, is attributable to expected growth and cost synergies. The intangible assets recognized primarily resulted from acquired customer relationships, having a weighted-average useful life of 19 years. +The acquired assets and liabilities resulting from our 2020 business combinations were recorded at their estimated fair values, which were calculated based primarily on a preliminary purchase price allocation prepared by independent valuation specialists. We may record adjustments to these assets and liabilities during the preliminary purchase price allocation period, which could be up to one year from the acquisition date. +Fiscal Year 2019 +As further discussed below, we completed three business combinations in fiscal year 2019. +Exchange of Equity Affiliate Investments +We previously held 50 % ownership interests in High-Tech Gases (Beijing) Co., Ltd. ("High-Tech Gases") and WuXi Hi-Tech Gas Co., Ltd. ("WuXi"), both of which were joint ventures with another industrial gas company in China. We accounted for these arrangements as equity method investments in our Industrial Gases – Asia segment through 30 April 2019. +On 1 May 2019, we acquired our partner's 50 % interest in WuXi in exchange for our 50 % interest in High-Tech Gases. The exchange resulted in a net gain of $ 29.1 , of which $ 15.0 resulted from the revaluation of our previously held equity interest in WuXi to its acquisition date fair value and $ 14.1 resulted from the disposition of our interest in High-Tech Gases. The net gain was reflected as "Gain on exchange of equity affiliate investments" on our consolidated income statements in fiscal year 2019 and was excluded from the results of the Industrial Gases – Asia segment. +We revalued our previously held 50 % equity interest in WuXi based on an estimated acquisition date fair value of $ 27.0 . We calculated this fair value using a discounted cash flow analysis under the income approach, which required estimates and assumptions regarding projected revenue growth, customer attrition rates, profit margin, and discount rate. +The acquisition of the remaining interest in WuXi was accounted for as a business combination. The results of this business are consolidated within our Industrial Gases – Asia segment. +Other Fiscal Year 2019 Business Combinations +The remaining business combinations completed in fiscal year 2019 had total consideration, net of cash acquired, of $ 126.6 . The largest of these business combinations was the acquisition of ACP Europe SA ("ACP"), the largest independent carbon dioxide business in Continental Europe, which closed in the second quarter. The results of this business are consolidated within our Industrial Gases – EMEA segment. +Fiscal Year 2018 +Asset Acquisition +On 26 April 2018 ("the acquisition date"), we completed the formation of Air Products Lu An (Changzhi) Co., Ltd. (the “JV”), a 60 %-owned joint venture with Lu’An Clean Energy Company ("Lu’An"). The results of the JV are consolidated within the Industrial Gases – Asia segment. +Air Products contributed four large air separation units to the JV, and the JV acquired gasification and syngas clean-up assets from Lu’An. We accounted for the acquisition of the gasification and syngas clean-up assets as an asset acquisition. In connection with closing the acquisition, we paid net cash of approximately 1.5 billion RMB ($ 235 ) and issued equity of 1.4 billion RMB ($ 227 ) to Lu'An for their noncontrolling interest in the JV. In addition, Lu'An made a loan of 2.6 billion RMB to the JV, and we established a liability for remaining cash payments. The issuance of equity to Lu'An for their noncontrolling interest, the long-term debt, and the liability for the remaining cash payments were noncash transactions that were excluded from the consolidated statement of cash flows for the fiscal year ended 30 September 2018. Refer to Note 15, Debt , for additional information on our related party debt. +72 +Table of Contents +Business Combinations +We completed eight acquisitions that were accounted for as business combinations in fiscal year 2018. These acquisitions had total consideration, net of cash acquired, of $ 355.4 . The largest of the acquisitions was completed during the first quarter of fiscal year 2018 and primarily consisted of three air separation units serving onsite and merchant customers in China. The results of this business are consolidated within our Industrial Gases – Asia segment. +4. REVENUE RECOGNITION +Nature of Goods and Services +The principal activities from which we generate sales from our contracts with customers, separated between our regional industrial gases businesses and industrial gases equipment businesses, are described below with their respective revenue recognition policies. For an overall summary of these policies and discussion on payment terms and presentation, refer to Note 1, Major Accounting Policies . +Industrial Gases – Regional +Our regional industrial gases businesses produce and sell atmospheric gases such as oxygen, nitrogen, and argon (primarily recovered by the cryogenic distillation of air) and process gases such as hydrogen, helium, carbon dioxide, carbon monoxide, syngas, and specialty gases. We distribute gases to our sale of gas customers through different supply modes depending on various factors including the customer's volume requirements and location. Our supply modes are as follows: +• On-site Gases —Supply mode associated with customers who require large volumes of gases and have relatively constant demand. Gases are produced and supplied by large facilities we construct on or near the customers’ facilities or by pipeline systems from centrally located production facilities. These sale of gas contracts generally have 15- to 20- year terms. We also deliver smaller quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically via 10- to 15- year sale of gas contracts. The contracts within this supply mode generally contain fixed monthly charges and/or minimum purchase requirements with price escalation provisions that are generally based on external indices. Revenue associated with this supply mode is generally recognized over time during the period in which we deliver or make available the agreed upon quantity of goods. +• Merchant Gases —Supply mode associated with liquid bulk and packaged gases customers. Liquid bulk customers receive delivery of product in liquid or gaseous form by tanker or tube trailer. The product is stored, usually in its liquid state, in equipment we typically design and install at the customer’s site for vaporizing into a gaseous state as needed. Packaged gases customers receive small quantities of product delivered in either cylinders or dewars. Both liquid bulk and packaged gases sales do not contain minimum purchase requirements as they are governed by contracts and/or purchase orders based on the customer's requirements. These contracts contain stated terms that are generally 5 years or less. Performance obligations associated with this supply mode are satisfied at a point in time when the customer receives and obtains control of the product, which generally occurs upon delivery. +The timing of revenue recognition for our regional industrial gases businesses is generally consistent with our right to invoice the customer. Variable components of consideration that may not be resolved within the month, such as the ability to earn an annual bonus or incur a penalty, are more relevant to on-site contracts and are considered constrained as they can be impacted by a single significant event such as a plant outage, which could occur at the end of a contract period. We consider contract modifications on an individual basis to determine appropriate accounting treatment. However, contract modifications are generally accounted for prospectively as they relate to distinct goods or services associated with future periods of performance. +We mitigate energy and natural gas price risk contractually through pricing formulas, surcharges, and cost pass-through arrangements. +73 +Table of Contents +Industrial Gases – Equipment +We design and manufacture equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction, and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global and the Corporate and other segments serve our sale of equipment customers. +Our sale of equipment contracts are generally comprised of a single performance obligation as the individual promised goods or services contained within the contracts are integrated with or dependent upon other goods or services in the contract for a single output to the customer. +Revenue from our sale of equipment contracts is generally recognized over time as we have an enforceable right to payment for performance completed to date and our performance under the contract terms does not create an asset with alternative use. Otherwise, sale of equipment contracts are satisfied at the point in time the customer obtains control of the equipment, which is generally determined based on the shipping terms of the contract. For contracts recognized over time, we primarily recognize revenue using a cost incurred input method by which costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. +Since our contracts are generally comprised of a single performance obligation, contract modifications are typically accounted for as part of the existing contract and are recognized as a cumulative adjustment for the inception-to-date effect of such change. In addition, changes in estimates on projects accounted for under the cost incurred input method are recognized as a cumulative adjustment for the inception-to-date effect of such change. Changes in estimates favorably impacted operating income by approximately $ 7 , $ 37 , and $ 38 in fiscal years 2020, 2019, and 2018, respectively. Our changes in estimates would not have significantly impacted amounts recorded in prior years. +Disaggregation of Revenue +The table below presents our consolidated sales for fiscal years 2020 and 2019 disaggregated by supply mode for each of our reporting segments. We believe this presentation best depicts the nature, timing, type of customer, and contract terms for our sales. +Industrial +Gases– +Americas Industrial +Gases– +EMEA Industrial +Gases– +Asia Industrial +Gases– +Global Corporate +and other Total % +2020 +On-site $ 2,040.2 $ 629.3 $ 1,652.8 $ — $ — $ 4,322.3 49 % +Merchant 1,590.5 1,297.0 1,063.7 — — 3,951.2 45 % +Sale of Equipment — — — 364.9 217.9 582.8 6 % +Total $ 3,630.7 $ 1,926.3 $ 2,716.5 $ 364.9 $ 217.9 $ 8,856.3 100 % +2019 +On-site $ 2,230.6 $ 728.4 $ 1,622.6 $ — $ — $ 4,581.6 52 % +Merchant 1,642.9 1,274.1 1,041.0 — — 3,958.0 44 % +Sale of Equipment — — — 261.0 118.3 379.3 4 % +Total $ 3,873.5 $ 2,002.5 $ 2,663.6 $ 261.0 $ 118.3 $ 8,918.9 100 % +Remaining Performance Obligations +As of 30 September 2020, the transaction price allocated to remaining performance obligations is estimated to be approximately $ 22 billion. This amount includes fixed-charge contract provisions associated with our on-site and sale of equipment supply modes. We estimate that approximately half of this revenue will be recognized over approximately the next five years and the balance thereafter. +Expected revenue associated with new on-site plants that are not yet onstream is excluded from this amount. In addition, this amount excludes consideration associated with contracts having an expected duration of less than one year, and variable consideration for which we recognize revenue at the amount to which we have the right to invoice, including pass-through costs related to energy and natural gas. +74 +Table of Contents +In the future, actual amounts will differ due to events outside of our control, including but not limited to inflationary price escalations, currency exchange rates, and terminated or renewed contracts. +Contract Balances +The table below details balances arising from contracts with customers: +30 September Balance Sheet Location 2020 2019 +Assets +Contract assets – current Other receivables and current assets $ 55.9 $ 64.3 +Contract fulfillment costs – current Other receivables and current assets 109.9 64.5 +Liabilities +Contract liabilities – current Payables and accrued liabilities 313.8 247.4 +Contract liabilities – noncurrent Other noncurrent liabilities 57.9 49.2 +Contract assets and liabilities result from differences in timing of revenue recognition and customer invoicing. These balances are reported on the consolidated balance sheets on a contract-by-contract basis at the end of each reporting period. +Contract assets primarily relate to our sale of equipment contracts for which revenue is recognized over time. These balances represent unbilled revenue, which occurs when revenue recognized under the measure of progress exceeds the amount invoiced to our customers. Our ability to invoice the customer for contract asset balances is not only based on the passage of time, but also the achievement of certain contractual milestones. +Contract fulfillment costs primarily include deferred costs related to sale of equipment projects that cannot be inventoried and for which we expect to recognize revenue upon transfer of control at project completion or costs related to fulfilling a specific anticipated contract. +Costs to obtain a contract, or contract acquisition costs, are capitalized only after we have established a contract with the customer. We elected to apply the practical expedient to expense these costs as they are incurred if the amortization period of the asset that would have otherwise been recognized is one year or less. Our contract acquisition costs capitalized as of 30 September 2020 and 2019 were not material. +Contract liabilities include advance payments or right to consideration prior to performance under the contract. Contract liabilities are recognized as revenue when or as we perform under the contract. The increase in our contract liabilities – current balance primarily relates to new sale of equipment projects as balances associated with our sale of gas contracts are generally related to fixed charges and are relatively consistent period over period. During the fiscal year ended 30 September 2020, we recognized approximately $ 145 in revenue associated with sale of equipment contracts that was included within our contract liabilities as of 30 September 2019. Advanced payments from our customers do not represent a significant financing component as these payments are intended for purposes other than financing, such as to meet working capital demands or to protect us from our customer failing to meet its obligations under the terms of the contract. +Changes in contract asset and liability balances during the fiscal year ended 30 September 2020 were not materially impacted by any other factors. +75 +Table of Contents +5. COST REDUCTION ACTIONS +In fiscal year 2019, we recognized an expense of $ 25.5 for severance and other benefits associated with the elimination or planned elimination of approximately 300 positions. These actions were taken to drive cost synergies primarily within the Industrial Gases – EMEA and the Industrial Gases – Americas segments. The charge was not recorded in segment results. +Liabilities associated with these actions are reflected on our consolidated balance sheets within "Payables and accrued liabilities." The table below summarizes the carrying amount of the accrual as of 30 September 2020: +2019 Charge $ 25.5 +Cash expenditures ( 6.9 ) +Amount reflected in pension liability ( 0.3 ) +Currency translation adjustment ( 0.5 ) +30 September 2019 $ 17.8 +Cash expenditures ( 13.5 ) +Currency translation adjustment 0.4 +30 September 2020 $ 4.7 +6. DISCONTINUED OPERATIONS +In fiscal year 2020, loss from discontinued operations, net of tax, was $ 14.3 . This resulted from a pre-tax loss of $ 19.0 recorded in the second quarter to increase our existing liability for retained environmental obligations associated with the sale of our former Amines business in September 2006. Refer to the Pace discussion within Note 17, Commitments and Contingencies , for additional information. The loss did not have an impact on our cash flows for the fiscal year ended 30 September 2020. +In fiscal year 2018, income from discontinued operations, net of tax, was $ 42.2 . This included an income tax benefit of $ 25.6 resulting from the resolution of uncertain tax positions taken in conjunction with the disposition of our former European Homecare business in fiscal year 2012 and an after-tax benefit of $ 17.6 resulting from the resolution of certain post-closing adjustments associated with the sale of our former Performance Materials Division in fiscal year 2017. These benefits were partially offset by an after-tax loss of $ 1.0 associated with Energy-from-Waste project exit activities. +7. INVENTORIES +The components of inventories are as follows: +30 September 2020 2019 +Finished goods $ 134.5 $ 128.8 +Work in process 21.3 27.5 +Raw materials, supplies and other 249.0 232.0 +Inventories $ 404.8 $ 388.3 +76 +Table of Contents +8. SUMMARIZED FINANCIAL INFORMATION OF EQUITY AFFILIATES +The summarized financial information below is on a combined 100% basis and has been compiled based on financial statements of the companies accounted for by the equity method. The amounts presented include the accounts of the following equity affiliates: +Abdullah Hashim Industrial Gases & Equipment Co., Ltd. ( 25 %); +INOX Air Products Private Limited ( 50 %); +Air Products South Africa (Proprietary) Limited ( 50 %); +Jazan Gas Projects Company ( 26 %); +Bangkok Cogeneration Company Limited ( 49 %); +Kulim Industrial Gases Sdn. Bhd. ( 50 %); +Bangkok Industrial Gases Co., Ltd. ( 49 %); +Sapio Produzione Idrogeno Ossigeno S.r.l. ( 49 %); +Chengdu Air & Gas Products Ltd. ( 50 %); +Tecnologia en Nitrogeno S. de R.L. de C.V. ( 50 %); +Helios S.p.A. ( 49 %); +Tyczka Industrie-Gases GmbH ( 50 %); +INFRA Group ( 40 %); +and principally, other industrial gas producers. +30 September 2020 2019 +Current assets $ 1,943.5 $ 1,660.6 +Noncurrent assets 4,529.2 4,400.4 +Current liabilities 765.3 725.1 +Noncurrent liabilities 2,958.8 2,853.6 +Year Ended 30 September 2020 2019 2018 +Net sales $ 2,809.1 $ 2,885.6 $ 2,663.1 +Sales less cost of sales 1,212.5 1,193.4 1,050.6 +Operating income 748.6 763.4 635.3 +Net income 567.8 492.4 388.0 +Dividends received from equity affiliates were $ 107.0 , $ 144.3 , and $ 122.5 in fiscal years 2020, 2019, and 2018, respectively. +The investment in net assets of and advances to equity affiliates as of 30 September 2020 and 2019 included investment in foreign affiliates of $ 1,431.3 and $ 1,275.4 , respectively. +As of 30 September 2020 and 2019, the amount of investment in companies accounted for by the equity method included equity method goodwill of $ 50.0 and $ 42.8 , respectively. +India Finance Act 2020 +For the fiscal year ended 30 September 2020, equity affiliates' income includes a benefit of $ 33.8 due to tax legislation passed by the Indian government (the "India Finance Act"). This benefit relates to INOX Air Products Private Limited for the release of our share of accumulated dividend distribution taxes and is included in the fiscal year 2020 net income on a 100% basis in the table above. Refer to Note 22, Income Taxes , for additional information. +U.S. Tax Cuts and Jobs Act +For the fiscal year ended 30 September 2018, equity affiliates' income includes an expense of $ 28.5 for our proportionate share of the impact of the U.S. Tax Cuts and Jobs Act primarily recorded during the first quarter of fiscal year 2018. This expense is included in the fiscal year 2018 net income on a 100% basis in the table above. Refer to Note 22, Income Taxes , for additional information. +77 +Table of Contents +Jazan Gas Project Company +On 19 April 2015, a joint venture between Air Products and ACWA Holding entered into a 20 -year oxygen and nitrogen supply agreement to supply Saudi Aramco’s oil refinery and power plant being built in Jazan, Saudi Arabia. Air Products owns 26 % of the joint venture and guarantees the repayment of its share of an equity bridge loan. ACWA also guarantees their share of the loan. We determined that the joint venture is a variable interest entity, for which we are not the primary beneficiary. As of 30 September 2020, our consolidated balance sheets included $ 94.4 reflected within "Payables and accrued liabilities" for our obligation to make future equity contributions in 2021 based on our proportionate share of the advances received by the joint venture under the loan. +9. PLANT AND EQUIPMENT, NET +The major classes of plant and equipment are as follows: +30 September Useful Life +in years 2020 2019 +Land $ 296.8 $ 281.5 +Buildings 30 997.8 946.8 +Production facilities (A) +10 to 20 17,289.7 15,602.1 +Distribution and other machinery and equipment (B) +5 to 25 4,807.7 4,491.9 +Construction in progress 1,784.2 1,011.4 +Plant and equipment, at cost 25,176.2 22,333.7 +Less: Accumulated depreciation 13,211.5 11,996.1 +Plant and equipment, net $ 11,964.7 $ 10,337.6 +(A) Depreciable lives of production facilities related to long-term customer supply contracts are matched to the contract lives. +(B) The depreciable lives for various types of distribution equipment are: 10 to 25 years for cylinders, depending on the nature and properties of the product; 20 years for tanks; 7.5 years for customer stations; and 5 to 15 years for tractors and trailers. +Depreciation expense was $ 1,150.5 , $ 1,049.7 , and $ 940.7 in fiscal years 2020, 2019, and 2018, respectively. +10. GOODWILL +Changes to the carrying amount of consolidated goodwill by segment are as follows: +Industrial +Gases– +Americas Industrial +Gases– +EMEA Industrial +Gases– +Asia Industrial +Gases– +Global Corporate and other Total +Goodwill, net at 30 September 2018 $ 162.1 $ 424.4 $ 171.9 $ 20.1 $ 10.4 $ 788.9 +Acquisitions — 38.5 10.1 — — 48.6 +Currency translation and other ( 5.8 ) ( 30.6 ) ( 3.5 ) ( 0.5 ) — ( 40.4 ) +Goodwill, net at 30 September 2019 $ 156.3 $ 432.3 $ 178.5 $ 19.6 $ 10.4 $ 797.1 +Acquisitions — 66.6 — — 4.5 71.1 +Currency translation and other ( 3.7 ) 25.2 1.9 ( 0.1 ) — 23.3 +Goodwill, net at 30 September 2020 $ 152.6 $ 524.1 $ 180.4 $ 19.5 $ 14.9 $ 891.5 +30 September 2020 2019 2018 +Goodwill, gross $ 1,230.2 $ 1,162.2 $ 1,194.7 +Accumulated impairment losses (A) +( 338.7 ) ( 365.1 ) ( 405.8 ) +Goodwill, net $ 891.5 $ 797.1 $ 788.9 +(A) Accumulated impairment losses include the impacts of currency translation. These losses are attributable to our Latin America reporting unit ("LASA") within the Industrial Gases – Americas segment. +78 +Table of Contents +We review goodwill for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that the carrying value of goodwill might not be recoverable. The impairment test for goodwill involves calculating the fair value of each reporting unit and comparing that value to the carrying value. If the fair value of the reporting unit is less than its carrying value, the difference is recorded as a goodwill impairment charge, not to exceed the total amount of goodwill allocated to that reporting unit. During the fourth quarter of fiscal year 2020, we conducted our annual goodwill impairment test and determined that the fair value of all our reporting units exceeded their carrying value. +11. INTANGIBLE ASSETS +The table below summarizes the major classes of our intangible assets: +2020 2019 +30 September Gross Accumulated +Amortization/ +Impairment Net Gross Accumulated +Amortization/ +Impairment Net +Customer relationships $ 538.0 ($ 209.9 ) $ 328.1 $ 487.9 ($ 179.8 ) $ 308.1 +Patents and technology 39.1 ( 16.3 ) 22.8 39.0 ( 13.3 ) 25.7 +Other 77.6 ( 33.7 ) 43.9 75.0 ( 33.4 ) 41.6 +Total finite-lived intangible assets 654.7 ( 259.9 ) 394.8 601.9 ( 226.5 ) 375.4 +Trade names and trademarks (indefinite-lived) 52.2 ( 11.2 ) 41.0 56.2 ( 12.1 ) 44.1 +Total Intangible Assets $ 706.9 ($ 271.1 ) $ 435.8 $ 658.1 ($ 238.6 ) $ 419.5 +The increase in net intangible assets in fiscal year 2020 was primarily attributable to intangible assets acquired through business combinations, partially offset by amortization. +Amortization expense for intangible assets was $ 34.5 , $ 33.1 , and $ 30.0 in fiscal years 2020, 2019, and 2018, respectively. Refer to Note 1, Major Accounting Policies , for the amortization periods for each major class of intangible assets. The table below details projected annual amortization expense for intangible assets as of 30 September 2020: +2021 $ 36.6 +2022 34.1 +2023 33.0 +2024 31.8 +2025 30.7 +Thereafter 228.6 +Total $ 394.8 +Indefinite-lived intangible assets are subject to impairment testing at least annually or more frequently if events or changes in circumstances indicate that potential impairment exists. The impairment test for indefinite-lived intangible assets involves calculating the fair value of the indefinite-lived intangible assets and comparing the fair value to their carrying value. If the fair value is less than the carrying value, the difference is recorded as an impairment loss. During the fourth quarter of fiscal year 2020, we conducted our annual impairment test of indefinite-lived intangible assets and determined that the fair value of all our intangible assets exceeded their carrying value. +79 +Table of Contents +12. LEASES +As discussed in Note 2, New Accounting Guidance , we adopted the new lease guidance in fiscal year 2020 using a modified retrospective approach with the election to apply the guidance as of 1 October 2019. For adoption, we elected the package of practical expedients permitted under the transition guidance to carry forward the historical lease populations as well as their classifications existing as of the adoption date (i.e. contracts having a lease commencement date prior to 1 October 2019). Refer to Note 1, Major Accounting Policies , and Note 2, New Accounting Guidance , for additional information on our adoption and related policies under the new lease standard. +Lessee Accounting +We are the lessee under various agreements for real estate, vehicles, aircraft, and other equipment that are accounted for as operating leases. Our finance leases principally relate to the right to use machinery and equipment and are not material. +The operating lease expense for fiscal year 2020 was $ 80.1 . This amount excludes short-term and variable lease expenses, which were not material. +Amounts associated with operating leases and their presentation on our consolidated balance sheets as of our most recent balance sheet date and our adoption date are as follows: +30 September 2020 1 October 2019 +Operating lease ROU asset +Other noncurrent assets $ 376.8 $ 332.3 +Operating lease liabilities +Payables and accrued liabilities 70.7 68.6 +Other noncurrent liabilities 335.8 306.7 +Total Operating Lease Liabilities $ 406.5 $ 375.3 +The difference between the ROU assets and lease liabilities recorded upon adoption primarily relate to the land lease associated with our former Energy-from-Waste business in which an ROU asset was not recognized. +30 September 2020 +Weighted-average remaining lease term (in years) (A) +15.7 +Weighted-average discount rate (B) +2.1 % +(A) Calculated on the basis of the remaining lease term and the lease liability balance for each lease as of the reporting date. +(B) Calculated on the basis of the discount rate used to calculate the lease liability for each lease and the remaining balance of the lease payments for each lease as of the reporting date. +At 30 September 2020, the maturity analysis of lease liabilities, showing the undiscounted cash flows, were as follows: +Operating +Leases +2021 $ 78.5 +2022 55.7 +2023 46.5 +2024 37.5 +2025 30.5 +Thereafter 226.0 +Total Undiscounted Lease Payments 474.7 +Imputed interest ( 68.2 ) +Present Value of Lease Liability Recognized on the Balance Sheet $ 406.5 +80 +Table of Contents +As previously disclosed in our 2019 Form 10-K, at 30 September 2019, prior to our adoption of the new lease guidance, our rent expense under operating leases, including month-to-month agreements was $ 87.0 and $ 82.7 in fiscal years 2019 and 2018, respectively. In addition, minimum payments due under leases were as follows: +Operating +Leases +2020 $ 75.1 +2021 62.6 +2022 44.4 +2023 35.9 +2024 28.6 +Thereafter 171.4 +Total Undiscounted Lease Payments $ 418.0 +The impacts associated with our operating leases on the consolidated statements of cash flows are reflected within "Other adjustments" within operating activities. This includes the non-cash operating lease expense of $ 80.1 as well as a use of cash of $ 90.0 for payments on amounts included in the measurement of the lease liability for fiscal year 2020. +In addition to the ROU assets established upon adoption, we recorded $ 110 of non-cash additions during fiscal year 2020. +We have additional operating leases that have not yet commenced as of 30 September 2020 having lease payments totaling approximately $ 60 . +Lessor Accounting +Historically, certain contracts associated with facilities that are built to provide product to a specific customer were accounted for as leases. As noted above, we elected the package of practical expedients permitted under the transition guidance to carry forward these lease determinations as of 30 September 2019. As we generally control the operations and maintenance of the assets that provide the supply of gas to our customers, there have been no new arrangements that qualified as a lease in fiscal year 2020. +In cases where operating lease treatment is appropriate, there is no difference in revenue recognition over the life of the contract as compared to accounting for the contract under a sale of gas agreement. Under the new lease standard, these contracts qualify for a practical expedient available to lessors to combine the lease and non-lease components and account for the combined component in accordance with the accounting treatment for the predominant component. We elected to apply this practical expedient and have accounted for the combined component as product sales under the revenue standard as we control the operations and maintenance of the assets that provide the supply of gas to our customers. +In cases where sales-type lease treatment is appropriate, revenue and expense are recognized up front for the sale of equipment component of the contract as compared to revenue recognition over the life of the arrangement under contracts not qualifying as sales-type leases. Additionally, a portion of the revenue representing interest income from the financing component of the lease receivable is reflected as sales over the life of the contract. During fiscal year 2020, we recognized interest income of $ 71.2 on our lease receivables. +Our contracts generally do not have the option to extend or terminate the lease or provide the customer the right to purchase the asset at the end of the contract term. Instead, renewal of such contracts requires negotiation of mutually agreed terms by both parties. Unless the customer terminates within the required notice period, the contract will go into evergreen. Given the long-term duration of our contracts, there is no assumed residual value for the assets at the end of the lease term. +Lease receivables, net, primarily relate to sales-type leases and are mostly included within "Noncurrent lease receivables" on our consolidated balance sheets, with the remaining balance in "Other receivables and current assets." As of 30 September 2020 and 2019, the credit quality of lease receivables did not require a material allowance for credit losses. +81 +Table of Contents +Lease payments collected in fiscal years 2020, 2019, and 2018 were $ 162.8 , $ 171.6 , and $ 182.7 , respectively. These payments reduced the lease receivable balance by $ 91.6 , $ 94.6 , and $ 97.4 in fiscal years 2020, 2019, and 2018, respectively. +At 30 September 2020, minimum lease payments expected to be collected, which reconciles to lease receivables, net, were as follows: +2021 $ 153.9 +2022 147.0 +2023 142.5 +2024 136.2 +2025 130.7 +Thereafter 608.5 +Total 1,318.8 +Unearned interest income ( 415.8 ) +Lease Receivables, net $ 903.0 +As previously disclosed in our 2019 Form 10-K, at 30 September 2019, prior to our adoption of the new lease guidance, minimum lease payments expected to be collected were as follows: +2020 $ 162.5 +2021 156.9 +2022 145.7 +2023 139.4 +2024 133.2 +Thereafter 715.5 +Total 1,453.2 +Unearned interest income ( 472.3 ) +Lease Receivables, net $ 980.9 +Other than lease payments received during fiscal year 2020 and the impact of currency, there have been no significant changes to our minimum lease payments expected to be collected since those disclosed as of 30 September 2019 in our 2019 Form 10-K. +13. FINANCIAL INSTRUMENTS +Currency Price Risk Management +Our earnings, cash flows, and financial position are exposed to foreign currency risk from foreign currency-denominated transactions and net investments in foreign operations. It is our policy to seek to minimize our cash flow volatility from changes in currency exchange rates. This is accomplished by identifying and evaluating the risk that our cash flows will change in value due to changes in exchange rates and by executing strategies necessary to manage such exposures. Our objective is to maintain economically balanced currency risk management strategies that provide adequate downside protection. +Forward Exchange Contracts +We enter into forward exchange contracts to reduce the cash flow exposure to foreign currency fluctuations associated with highly anticipated cash flows and certain firm commitments, such as the purchase of plant and equipment. We also enter into forward exchange contracts to hedge the cash flow exposure on intercompany loans and third-party debt. This portfolio of forward exchange contracts consists primarily of Euros and U.S. Dollars. The maximum remaining term of any forward exchange contract currently outstanding and designated as a cash flow hedge at 30 September 2020 is 2.8 years. +Forward exchange contracts are also used to hedge the value of investments in certain foreign subsidiaries and affiliates by creating a liability in a currency in which we have a net equity position. The primary currency pair in this portfolio of forward exchange contracts is Euros and U.S. Dollars. +82 +Table of Contents +We also utilize forward exchange contracts that are not designated as hedges. These contracts are used to economically hedge foreign currency-denominated monetary assets and liabilities, primarily working capital. The primary objective of these forward exchange contracts is to protect the value of foreign currency-denominated monetary assets and liabilities from the effects of volatility in foreign exchange rates that might occur prior to their receipt or settlement. This portfolio of forward exchange contracts consists of many different foreign currency pairs, with a profile that changes from time to time depending on business activity and sourcing decisions. +The table below summarizes our outstanding currency price risk management instruments: +2020 2019 +30 September US$ +Notional Years +Average +Maturity US$ +Notional Years +Average +Maturity +Forward Exchange Contracts +Cash flow hedges $ 2,842.1 0.5 $ 2,418.2 0.5 +Net investment hedges 636.6 3.8 830.8 0.9 +Not designated 1,685.2 0.3 1,053.5 0.6 +Total Forward Exchange Contracts $ 5,163.9 0.8 $ 4,302.5 0.6 +The increase in the notional value of cash flow hedges from 30 September 2019 to 30 September 2020 is primarily due to the addition of a forward exchange contract that hedges the repayment of our Eurobond maturing in fiscal year 2021. The increase in the notional value of our forward exchange contracts that are not designated is primarily due to the origination of forward exchange contracts that offset other forward exchange contracts previously designated as net investment hedges or cash flow hedges that were de-designated during fiscal year 2020. +We also use foreign currency-denominated debt to hedge the foreign currency exposures of our net investment in certain foreign subsidiaries. The designated foreign currency-denominated debt and related accrued interest was € 1,288.7 million ($ 1,510.8 ) at 30 September 2020 and € 951.3 million ($ 1,036.9 ) at 30 September 2019. The designated foreign currency-denominated debt is presented within "Long-term debt" on the consolidated balance sheets. +Debt Portfolio Management +It is our policy to identify, on a continuing basis, the need for debt capital and to evaluate the financial risks inherent in funding the Company with debt capital. Reflecting the result of this ongoing review, our debt portfolio and hedging program are managed with the intent to (1) reduce funding risk with respect to borrowings made by us to preserve our access to debt capital and provide debt capital as required for funding and liquidity purposes, and (2) manage the aggregate interest rate risk and the debt portfolio in accordance with certain debt management parameters. +Interest Rate Management Contracts +We enter into interest rate swaps to change the fixed/variable interest rate mix of our debt portfolio in order to maintain the percentage of fixed- and variable-rate debt within the parameters set by management. In accordance with these parameters, the agreements are used to manage interest rate risks and costs inherent in our debt portfolio. Our interest rate management portfolio generally consists of fixed-to-floating interest rate swaps (which are designated as fair value hedges), pre-issuance interest rate swaps and treasury locks (which hedge the interest rate risk associated with anticipated fixed-rate debt issuances and are designated as cash flow hedges), and floating-to-fixed interest rate swaps (which are designated as cash flow hedges). As of 30 September 2020, the outstanding interest rate swaps were denominated in U.S. Dollars. The notional amount of the interest rate swap agreements is equal to or less than the designated debt being hedged. When interest rate swaps are used to hedge variable-rate debt, the indices of the swaps and the debt to which they are designated are the same. It is our policy not to enter into any interest rate management contracts which lever a move in interest rates on a greater than one-to-one basis. +Cross Currency Interest Rate Swap Contracts +We enter into cross currency interest rate swap contracts when our risk management function deems necessary. These contracts may entail both the exchange of fixed- and floating-rate interest payments periodically over the life of the agreement and the exchange of one currency for another currency at inception and at a specified future date. The contracts are used to hedge either certain net investments in foreign operations or non-functional currency cash flows related to intercompany loans. The current cross currency interest rate swap portfolio consists of fixed-to-fixed +83 +Table of Contents +swaps primarily between U.S. Dollars and Chinese Renminbi, U.S. Dollars and Indian Rupee, and U.S. Dollars and Chilean Pesos. +The following table summarizes our outstanding interest rate management contracts and cross currency interest rate swaps: +2020 2019 +30 September US$ +Notional Average Pay % Average +Receive +% Years +Average +Maturity US$ +Notional Average Pay % Average +Receive +% Years +Average +Maturity +Interest rate swaps (fair value hedge) $ 200.0 LIBOR 2.76 % 1.1 $ 200.0 LIBOR 2.76 % 2.1 +Cross currency interest rate swaps (net investment hedge) $ 201.6 4.27 % 3.12 % 3.2 $ 216.8 4.80 % 3.31 % 3.5 +Cross currency interest rate swaps (cash flow hedge) $ 1,057.9 4.83 % 2.98 % 2.5 $ 1,129.3 4.92 % 3.04 % 2.3 +Cross currency interest rate swaps (not designated) $ 12.8 5.39 % 3.54 % 3.2 $ 6.1 2.55 % 3.72 % 4.5 +The table below provides the amounts recorded on the consolidated balance sheet related to cumulative basis adjustments for fair value hedges: +Carrying amounts of hedged item Cumulative hedging adjustment, included in carrying amount +30 September 2020 2019 2020 2019 +Long-term debt $ 405.4 $ 404.7 $ 5.7 $ 5.2 +The table below summarizes the fair value and balance sheet location of our outstanding derivatives: +30 September Balance Sheet Location 2020 2019 Balance Sheet Location 2020 2019 +Derivatives Designated as Hedging Instruments: +Forward exchange contracts Other receivables and current assets $ 51.1 $ 79.0 Payables and accrued liabilities $ 22.5 $ 53.8 +Interest rate management contracts Other receivables and current assets 14.7 24.8 Payables and accrued liabilities 0.4 1.1 +Forward exchange contracts Other noncurrent assets 0.8 11.9 Other noncurrent +liabilities 33.0 0.7 +Interest rate management contracts Other noncurrent assets 44.3 60.9 Other noncurrent +liabilities 1.7 0.7 +Total Derivatives Designated as Hedging Instruments $ 110.9 $ 176.6 $ 57.6 $ 56.3 +Derivatives Not Designated as Hedging Instruments: +Forward exchange contracts Other receivables and current assets $ 31.7 $ 38.7 Payables and accrued liabilities $ 28.0 $ 36.3 +Forward exchange contracts Other noncurrent assets — 8.4 Other noncurrent liabilities — 19.8 +Interest rate management contracts Other noncurrent assets 0.7 0.5 Other noncurrent +liabilities — — +Total Derivatives Not Designated as Hedging Instruments $ 32.4 $ 47.6 $ 28.0 $ 56.1 +Total Derivatives $ 143.3 $ 224.2 $ 85.6 $ 112.4 +Refer to Note 14, Fair Value Measurements , which defines fair value, describes the method for measuring fair value, and provides additional disclosures regarding fair value measurements. +84 +Table of Contents +The tables below summarize gains (losses) recognized in other comprehensive income during the period related to our net investment and cash flow hedging relationships: +2020 2019 +Net Investment Hedging Relationships +Forward exchange contracts ($ 15.9 ) $ 51.5 +Foreign currency debt ( 100.2 ) 65.3 +Cross currency interest rate swaps 1.9 12.6 +Total Amount Recognized in OCI ( 114.2 ) 129.4 +Tax effects 28.2 ( 30.9 ) +Net Amount Recognized in OCI ($ 86.0 ) $ 98.5 +2020 2019 +Derivatives in Cash Flow Hedging Relationships +Forward exchange contracts $ 116.6 ($ 30.3 ) +Forward exchange contracts, excluded components ( 15.2 ) ( 16.1 ) +Other (A) +( 34.2 ) 0.8 +Total Amount Recognized in OCI 67.2 ( 45.6 ) +Tax effects ( 23.7 ) 1.5 +Net Amount Recognized in OCI $ 43.5 ($ 44.1 ) +(A) Other primarily includes interest rate and cross currency interest rate swaps for which excluded components are recognized in “Payables and accrued liabilities” and “Other receivables and current assets” as a component of accrued interest payable and accrued interest receivable, respectively. These excluded components are recorded in “Other Non-operating income (expense), net” over the life of the cross currency interest rate swap. Other also includes the recognition of our share of gains and losses, net of tax, related to interest rate swaps held by our equity affiliates. +85 +Table of Contents +The table below summarizes the location and amounts recognized in income related to our cash flow and fair value hedging relationships by contract type: +Sales Cost of Sales Other Income (Expense), Net Interest Expense Other Non-Operating Income (Expense), Net +2020 2019 2020 2019 2020 2019 2020 2019 2020 2019 +Total Amounts Presented in the Consolidated Income Statement in which the Effects of Cash Flow and Fair Value Hedges are Recorded $ 8,856.3 $ 8,918.9 $ 5,858.1 $ 5,975.5 $ 65.4 $ 49.3 $ 109.3 $ 137.0 $ 30.7 $ 66.7 +(Gain) Loss Effects of Cash Flow Hedging: +Forward Exchange Contracts: +Amount reclassified from OCI into income (A) +($ 0.2 ) $ 0.5 ($ 1.0 ) $ 0.3 $ — $ 28.5 $ — $ 16.0 ($ 117.9 ) $ — +Amount excluded from effectiveness testing recognized in earnings based on amortization approach (A) +— — — — — — — — 17.0 — +Other: +Amount reclassified from OCI into income (B) +— — — — — ( 32.4 ) 4.2 3.9 22.5 — +Total (Gain) Loss Reclassified from OCI to Income ( 0.2 ) 0.5 ( 1.0 ) 0.3 — ( 3.9 ) 4.2 19.9 ( 78.4 ) — +Tax effects — ( 0.1 ) 0.2 ( 0.1 ) — 0.9 ( 1.4 ) ( 5.2 ) 18.9 — +Net (Gain) Loss Reclassified from OCI to Income ($ 0.2 ) $ 0.4 ($ 0.8 ) $ 0.2 $ — ($ 3.0 ) $ 2.8 $ 14.7 ($ 59.5 ) $ — +(Gain) Loss Effects of Fair Value Hedging: +Other: +Hedged items $ — $ — $ — $ — $ — $ — $ 0.5 $ 4.3 $ — $ — +Derivatives designated as hedging instruments — — — — — — ( 0.5 ) ( 4.3 ) — — +Total (Gain) Loss Recognized in Income $ — $ — $ — $ — $ — $ — $ — $ — $ — $ — +(A) Net amount excluded from effectiveness testing recognized in interest expense for fiscal year 2019, see Note 2, New Accounting Guidance , for additional details. +(B) Other primarily includes interest rate and cross currency interest rate swaps for which excluded components are recognized in “Payables and accrued liabilities” and “Other receivables and current assets” as a component of accrued interest payable and accrued interest receivable, respectively. These excluded components are recorded in “Other Non-operating income (expense), net” over the life of the cross currency interest rate swap. +The table below summarizes the location and amounts recognized in income related to our derivatives not designated as hedging instruments by contract type: +Other Income (Expense), Net Other Non-Operating Income (Expense), Net +2020 2019 2020 2019 +The Effects of Derivatives Not Designated as Hedging Instruments: +Forward Exchange Contracts ($ 1.5 ) $ 1.3 $ 1.1 $ — +Other — ( 2.0 ) 0.7 — +Total (Gain) Loss Recognized in Income ($ 1.5 ) ($ 0.7 ) $ 1.8 $ — +The amount of unrealized gains and losses related to cash flow hedges as of 30 September 2020 that are expected to be reclassified to earnings in the next twelve months is not material. +The cash flows related to all derivative contracts are reported in the operating activities section of the consolidated statements of cash flows. +86 +Table of Contents +Credit Risk-Related Contingent Features +Certain derivative instruments are executed under agreements that require us to maintain a minimum credit rating with both Standard & Poor’s and Moody’s. If our credit rating falls below this threshold, the counterparty to the derivative instruments has the right to request full collateralization on the derivatives’ net liability position. The net liability position of derivatives with credit risk-related contingent features was $ 30.0 and $ 30.1 as of 30 September 2020 and 2019, respectively. Because our current credit rating is above the various pre-established thresholds, no collateral has been posted on these liability positions. +Counterparty Credit Risk Management +We execute financial derivative transactions with counterparties that are highly rated financial institutions, all of which are investment grade at this time. Some of our underlying derivative agreements give us the right to require the institution to post collateral if its credit rating falls below the pre-established thresholds with Standard & Poor’s or Moody’s. The collateral that the counterparties would be required to post was $ 76.5 and $ 157.1 as of 30 September 2020 and 2019, respectively. No financial institution is required to post collateral at this time, as all have credit ratings at or above threshold. +14. FAIR VALUE MEASUREMENTS +Fair value is defined as an exit price, or the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. +The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows: +• Level 1 —Quoted prices (unadjusted) in active markets for identical assets or liabilities. +• Level 2 —Inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the asset or liability. +• Level 3 —Inputs that are unobservable for the asset or liability based on our own assumptions about the assumptions market-participants would use in pricing the asset or liability. +The methods and assumptions used to measure the fair value of financial instruments are as follows: +Short-term Investments +Short-term investments primarily include time deposits with original maturities greater than three months and less than one year. We estimated the fair value of our short-term investments, which approximates carrying value as of the balance sheet date, using Level 2 inputs within the fair value hierarchy. Level 2 measurements were based on current interest rates for similar investments with comparable credit risk and time to maturity. +Derivatives +The fair value of our interest rate management contracts and forward exchange contracts are quantified using the income approach and are based on estimates using standard pricing models. These models consider the value of future cash flows as of the balance sheet date, discounted to a present value using discount factors that match both the time to maturity and currency of the underlying instruments. These standard pricing models utilize inputs that are derived from or corroborated by observable market data such as interest rate yield curves as well as currency spot and forward rates; therefore, the fair value of our derivatives is classified as a Level 2 measurement. On an ongoing basis, we randomly test a subset of our valuations against valuations received from the transaction’s counterparty to validate the accuracy of our standard pricing models. Counterparties to these derivative contracts are highly rated financial institutions. +Refer to Note 13, Financial Instruments , for a description of derivative instruments, including details related to the balance sheet line classifications. +87 +Table of Contents +Long-term Debt, Including Related Party +The fair value of our debt is based on estimates using standard pricing models that consider the value of future cash flows as of the balance sheet date, discounted to a present value using discount factors that match both the time to maturity and currency of the underlying instruments. These standard valuation models utilize observable market data such as interest rate yield curves and currency spot rates; therefore, the fair value of our debt is classified as a Level 2 measurement. We generally perform the computation of the fair value of these instruments. +The carrying values and fair values of financial instruments were as follows: +2020 2019 +30 September Carrying Value Fair Value Carrying Value Fair Value +Assets +Derivatives +Forward exchange contracts $ 83.6 $ 83.6 $ 138.0 $ 138.0 +Interest rate management contracts 59.7 59.7 86.2 86.2 +Liabilities +Derivatives +Forward exchange contracts $ 83.5 $ 83.5 $ 110.6 $ 110.6 +Interest rate management contracts 2.1 2.1 1.8 1.8 +Long-term debt, including current portion and related party 7,900.1 8,278.4 3,267.8 3,350.9 +The carrying amounts reported on the consolidated balance sheets for cash and cash items, short-term investments, trade receivables, payables and accrued liabilities, accrued income taxes, and short-term borrowings approximate fair value due to the short-term nature of these instruments. Accordingly, these items have been excluded from the above table. +The following table summarizes assets and liabilities on the consolidated balance sheets that are measured at fair value on a recurring basis: +2020 2019 +30 September Total Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 +Assets at Fair Value +Derivatives +Forward exchange contracts $ 83.6 $ — $ 83.6 $ — $ 138.0 $ — $ 138.0 $ — +Interest rate management contracts 59.7 — 59.7 — 86.2 — 86.2 — +Total Assets at Fair Value $ 143.3 $ — $ 143.3 $ — $ 224.2 $ — $ 224.2 $ — +Liabilities at Fair Value +Derivatives +Forward exchange contracts $ 83.5 $ — $ 83.5 $ — $ 110.6 $ — $ 110.6 $ — +Interest rate management contracts 2.1 — 2.1 — 1.8 — 1.8 — +Total Liabilities at Fair Value $ 85.6 $ — $ 85.6 $ — $ 112.4 $ — $ 112.4 $ — +88 +Table of Contents +15. DEBT +In fiscal year 2020, Air Products issued U.S. Dollar- and Euro-denominated fixed-rate notes in multiple tranches with aggregate principal amounts of $ 3.8 billion and € 1.0 billion ($ 1.2 billion as of 30 September 2020), respectively. The U.S. Dollar-denominated notes were issued on 30 April 2020, and the Euro-denominated notes were issued on 5 May 2020. The proceeds from these notes were reduced by deferred financing charges and discounts of approximately $ 45 , which are being amortized over the life of the underlying bonds. We intend to use the majority of the proceeds to fund growth projects and repay debt maturities through 2021. In August 2020, we repaid a 2.0 % Eurobond of € 300.0 million that had been previously reflected as long-term debt due to our intent to refinance as of 30 September 2019. +Total Debt +The table below summarizes our total outstanding debt as reflected on our consolidated balance sheets as of 30 September 2020 and 2019: +30 September 2020 2019 +Short-term borrowings (A) +$ 7.7 $ 58.2 +Current portion of long-term debt (B)(C) +470.0 40.4 +Long-term debt 7,132.9 2,907.3 +Long-term debt – related party (B) +297.2 320.1 +Total Debt $ 7,907.8 $ 3,326.0 +(A) Includes bank obligations with weighted average interest rates of 1.6 % and 3.7 % as of 30 September 2020 and 2019, respectively. +(B) Our related party debt resulted from the 2018 acquisition of gasification and syngas clean-up assets from our joint venture partner, Lu'An, who partially funded the acquisition with a loan to the joint venture. +(C) Includes current portions of long-term debt owed to Lu'An of $ 41.3 and $ 37.8 as of 30 September 2020 and 2019, respectively. +Long-term Debt +The coupon interest rates, maturities, and carrying amounts of our long-term debt as of 30 September 2020 and 2019 are summarized in the table below: +30 September Fiscal Year +Maturities 2020 2019 +Payable in U.S. Dollars +Debentures +8.75 % 2021 $ 18.4 $ 18.4 +Medium-term Notes (weighted average rate) +Series E 7.6 % 2026 17.2 17.2 +Senior Notes +Note 3.0 % 2022 400.0 400.0 +Note 2.75 % 2023 400.0 400.0 +Note 3.35 % 2024 400.0 400.0 +Note 1.50 % 2026 550.0 — +Note 1.85 % 2027 650.0 — +Note 2.05 % 2030 900.0 — +Note 2.70 % 2040 750.0 — +Note 2.80 % 2050 950.0 — +Other (weighted average rate) +Variable-rate industrial revenue bonds 0.1 % 2035 to 2050 631.9 631.9 +89 +Table of Contents +30 September Fiscal Year +Maturities 2020 2019 +Payable in Other Currencies +Eurobonds 2.0 % 2020 — 327.0 +Eurobonds 0.375 % 2021 410.3 381.5 +Eurobonds 1.0 % 2025 351.7 327.0 +Eurobonds 0.50 % 2028 586.2 — +Eurobonds 0.80 % 2032 586.2 — +Other 2023 0.6 3.8 +Related Party +Chinese Renminbi 5.5 % 2021 to 2027 338.5 357.9 +Capital Lease Obligations (weighted average rate) +Foreign 10.9 % 2021 to 2036 9.2 10.1 +Total Principal Amount 7,950.2 3,274.8 +Less: Unamortized discount and debt issuance costs ( 55.8 ) ( 12.2 ) +Less: Fair value hedge accounting adjustments (A) +5.7 5.2 +Total Long-term Debt 7,900.1 3,267.8 +Less: Current portion of long-term debt ( 470.0 ) ( 40.4 ) +Less: Long-term debt – related party ( 297.2 ) ( 320.1 ) +Long-term Debt $ 7,132.9 $ 2,907.3 +(A) We have entered into LIBOR-based interest rate swap arrangements with various counterparty financial institutions on the 3.0 % Senior Note maturing in fiscal year 2022. These interest rate swaps have been designated as fair value hedges of the Note. Refer to Note 13, Financial Instruments , for additional information. +Maturities of long-term debt, including principal amounts owed to related parties, in each of the next five years and thereafter are as follows: +2021 $ 470.4 +2022 441.7 +2023 456.3 +2024 456.4 +2025 415.8 +Thereafter 5,709.6 +Total $ 7,950.2 +Various debt agreements to which we are a party include financial covenants and other restrictions, including restrictions pertaining to the ability to create property liens and enter into certain sale and leaseback transactions. As of 30 September 2020, we are in compliance with all the financial and other covenants under our debt agreements. +There were no additional commitments maintained by our foreign subsidiaries as of 30 September 2020. +Cash paid for interest, net of amounts capitalized, was $ 67.2 , $ 155.9 , and $ 123.1 in fiscal years 2020, 2019, and 2018, respectively. +Credit Agreement +We have a $ 2,300 five-year revolving credit agreement maturing 31 March 2022 with a syndicate of banks (the “Credit Agreement”). Under the Credit Agreement, senior unsecured debt is available to us and certain of our subsidiaries. The Credit Agreement provides us a source of liquidity and supports our commercial paper program. Our only financial covenant under the Credit Agreement is a maximum ratio of total debt to total capitalization, or total debt plus total equity, no greater than 70 %. No borrowings were outstanding under the Credit Agreement as of 30 September 2020. +90 +Table of Contents +16. RETIREMENT BENEFITS +We and certain of our subsidiaries sponsor defined benefit pension plans and defined contribution plans that cover a substantial portion of our worldwide employees. The principal defined benefit pension plans are the U.S. salaried pension plan and the U.K. pension plan. These plans were closed to new participants in 2005, after which defined contribution plans were offered to new employees. The principal defined contribution plan is the Retirement Savings Plan, in which a substantial portion of the U.S. employees participate. A similar plan is offered to U.K. employees. We also provide other postretirement benefits consisting primarily of healthcare benefits to U.S. retirees who meet age and service requirements. +Defined Benefit Pension Plans +Pension benefits earned are generally based on years of service and compensation during active employment. The components of net periodic benefit cost for our defined benefit pension plans for fiscal years 2020, 2019, and 2018 were as follows: +2020 2019 2018 +Year Ended 30 September U.S. International U.S. International U.S. International +Service cost $ 23.4 $ 23.3 $ 21.4 $ 19.3 $ 25.5 $ 25.5 +Interest cost 91.2 24.8 113.4 35.8 107.2 37.3 +Expected return on plan assets ( 188.7 ) ( 77.4 ) ( 172.5 ) ( 75.1 ) ( 201.6 ) ( 81.7 ) +Prior service cost amortization 1.2 — 1.1 — 1.6 — +Actuarial loss amortization 83.7 19.5 65.3 10.9 87.4 40.2 +Settlements 5.0 0.2 6.2 0.2 45.0 3.5 +Special termination benefits — — 0.7 0.1 0.4 — +Other — 0.8 — 0.8 — 1.5 +Net Periodic (Benefit) Cost $ 15.8 ($ 8.8 ) $ 35.6 ($ 8.0 ) $ 65.5 $ 26.3 +Our service costs are primarily included within "Cost of sales" and "Selling and administrative" on our consolidated income statements. The amount of service costs capitalized in fiscal years 2020, 2019 and 2018 were not material. The non-service related costs, including pension settlement losses, are presented outside operating income within "Other non-operating income (expense), net." +During the fourth quarter of fiscal year 2018, we recognized a pension settlement loss of $ 43.7 primarily in connection with the transfer of certain pension assets and payment obligations for our U.S. salaried and hourly plans to an insurer through the purchase of an irrevocable, nonparticipating group annuity contract. The transaction does not change the amount of the monthly pension benefits received by affected retirees. +Certain of our pension plans provide for a lump sum benefit payment option at the time of retirement, or for corporate officers, six months after their retirement date. A participant’s vested benefit is considered settled upon cash payment of the lump sum. We recognize pension settlement losses when cash payments exceed the sum of the service and interest cost components of net periodic benefit cost of the plan for the fiscal year. We recognized pension settlement losses of $ 5.0 , $ 6.2 and $ 5.2 in fiscal years 2020, 2019 and 2018, respectively, to accelerate recognition of a portion of actuarial losses deferred in accumulated other comprehensive loss, primarily associated with the U.S. supplementary pension plan. +91 +Table of Contents +We calculate net periodic benefit cost for a given fiscal year based on assumptions developed at the end of the previous fiscal year. The following table sets forth the weighted average assumptions used in the calculation of net periodic benefit cost: +2020 2019 2018 +U.S. International U.S. International U.S. International +Discount rate – Service cost 3.3 % 1.5 % 4.3 % 2.5 % 3.9 % 2.6 % +Discount rate – Interest cost 2.9 % 1.3 % 4.0 % 2.2 % 3.3 % 2.2 % +Expected return on plan assets 7.0 % 5.0 % 7.0 % 5.3 % 7.5 % 5.8 % +Rate of compensation increase 3.5 % 3.3 % 3.5 % 3.5 % 3.5 % 3.6 % +The projected benefit obligation ("PBO") is the actuarial present value of benefits attributable to employee service rendered to date, including the effects of estimated future salary increases. The following table sets forth the weighted average assumptions used in the calculation of the PBO: +2020 2019 +U.S. International U.S. International +Discount rate 2.7 % 1.5 % 3.2 % 1.5 % +Rate of compensation increase 3.5 % 3.3 % 3.5 % 3.3 % +The following tables reflect the change in the PBO and the change in the fair value of plan assets based on the plan year measurement date, as well as the amounts recognized in the consolidated balance sheets: +2020 2019 +U.S. International U.S. International +Change in Projected Benefit Obligation +Obligation at beginning of year $ 3,281.6 $ 1,864.0 $ 2,922.8 $ 1,660.5 +Service cost 23.4 23.3 21.4 19.3 +Interest cost 91.2 24.8 113.4 35.8 +Amendments 1.6 — 1.1 4.7 +Actuarial loss (gain) 190.5 ( 11.6 ) 380.3 300.2 +Settlements ( 11.7 ) ( 0.9 ) ( 12.2 ) ( 1.6 ) +Special termination benefits — — 0.7 0.1 +Participant contributions — 1.2 — 1.3 +Benefits paid ( 152.5 ) ( 49.8 ) ( 146.2 ) ( 47.7 ) +Currency translation and other ( 0.3 ) 98.7 0.3 ( 108.6 ) +Obligation at End of Year $ 3,423.8 $ 1,949.7 $ 3,281.6 $ 1,864.0 +2020 2019 +U.S. International U.S. International +Change in Plan Assets +Fair value at beginning of year $ 2,832.4 $ 1,672.4 $ 2,684.9 $ 1,588.2 +Actual return on plan assets 364.6 ( 3.1 ) 289.9 208.0 +Company contributions 15.5 22.0 16.0 24.2 +Participant contributions — 1.2 — 1.3 +Benefits paid ( 152.5 ) ( 49.8 ) ( 146.2 ) ( 47.7 ) +Settlements ( 11.7 ) ( 0.9 ) ( 12.2 ) ( 1.6 ) +Currency translation and other — 85.0 — ( 100.0 ) +Fair Value at End of Year $ 3,048.3 $ 1,726.8 $ 2,832.4 $ 1,672.4 +Funded Status at End of Year ($ 375.5 ) ($ 222.9 ) ($ 449.2 ) ($ 191.6 ) +92 +Table of Contents +2020 2019 +U.S. International U.S. International +Amounts Recognized +Noncurrent assets $ 26.5 $ — $ 17.3 $ 11.4 +Accrued liabilities 10.5 0.2 18.3 — +Noncurrent liabilities 391.5 222.7 448.2 203.0 +Net Liability Recognized $ 375.5 $ 222.9 $ 449.2 $ 191.6 +The changes in plan assets and benefit obligation that have been recognized in other comprehensive income on a pretax basis during fiscal years 2020 and 2019 consist of the following: +2020 2019 +U.S. International U.S. International +Net actuarial loss arising during the period $ 14.6 $ 68.9 $ 262.9 $ 161.5 +Amortization of net actuarial loss ( 88.7 ) ( 19.7 ) ( 71.5 ) ( 11.1 ) +Prior service cost arising during the period 1.6 — 1.1 4.7 +Amortization of prior service cost ( 1.2 ) — ( 1.1 ) — +Total ($ 73.7 ) $ 49.2 $ 191.4 $ 155.1 +The net actuarial loss represents the actual changes in the estimated obligation and plan assets that have not yet been recognized in the consolidated income statements and are included in accumulated other comprehensive loss. Actuarial losses arising during fiscal year 2020 are primarily attributable to lower discount rates, partially offset by higher than expected return on plan assets. Accumulated actuarial gains and losses that exceed a corridor are amortized over the average remaining service period of U.S. participants, which was approximately seven years as of 30 September 2020. For U.K. participants, accumulated actuarial gains and losses that exceed a corridor are amortized over the average remaining life expectancy, which was approximately twenty-five years as of 30 September 2020. +The components recognized in accumulated other comprehensive loss on a pretax basis at 30 September consisted of the following: +2020 2019 +U.S. International U.S. International +Net actuarial loss $ 797.7 $ 643.2 $ 871.8 $ 594.0 +Prior service cost (credit) 7.0 3.6 6.6 3.6 +Net transition liability — 0.4 — 0.4 +Total $ 804.7 $ 647.2 $ 878.4 $ 598.0 +The accumulated benefit obligation ("ABO") is the actuarial present value of benefits attributed to employee service rendered to a particular date, based on current salaries. The ABO for all defined benefit pension plans was $ 5,166.5 and $ 4,931.6 as of 30 September 2020 and 2019, respectively. +93 +Table of Contents +The following table provides information on pension plans where the benefit liability exceeds the value of plan assets: +2020 2019 +30 September U.S. International U.S. International +Pension Plans with PBO in Excess of Plan Assets: +PBO $ 3,202.2 $ 1,949.7 $ 3,069.2 $ 521.1 +Fair value of plan assets 2,800.3 1,726.7 2,602.8 318.0 +PBO in excess of plan assets $ 401.9 $ 223.0 $ 466.4 $ 203.1 +Pension Plans with ABO in Excess of Plan Assets: +ABO $ 3,081.4 $ 475.8 $ 2,941.2 $ 413.3 +Fair value of plan assets 2,800.3 324.4 2,602.8 266.5 +ABO in excess of plan assets $ 281.1 $ 151.4 $ 338.4 $ 146.8 +The tables above include several pension arrangements that are not funded because of jurisdictional practice. The ABO and PBO related to these plans as of 30 September 2020 were $ 86.6 and $ 91.7 , respectively. As of 30 September 2019, the U.K. pension plan had plan assets in excess of both PBO and ABO and was therefore not included in the table above. As of 30 September 2020, the PBO of this plan exceeded the fair value of plan assets, resulting in an increase to the International balances. +Pension Plan Assets +Our pension plan investment strategy is to invest in diversified portfolios to earn a long-term return consistent with acceptable risk in order to pay retirement benefits and meet regulatory funding requirements while minimizing company cash contributions over time. De-risking strategies are also employed for closed plans as funding improves, generally resulting in higher allocations to long duration bonds. The plans invest primarily in passive and actively managed equity and debt securities. Equity investments are diversified geographically and by investment style and market capitalization. Fixed income investments include sovereign, corporate and asset-backed securities generally denominated in the currency of the plan. +Asset allocation targets are established based on the long-term return, volatility and correlation characteristics of the asset classes, the profiles of the plans’ liabilities, and acceptable levels of risk. Assets are routinely rebalanced through contributions, benefit payments, and otherwise as deemed appropriate. The actual and target allocations at the measurement date are as follows: +2020 Target Allocation 2020 Actual Allocation 2019 Actual Allocation +U.S. International U.S. International U.S. International +Asset Category +Equity securities +42 - 57 % +40 - 49 % +51 % 43 % 38 % 42 % +Debt securities +35 - 50 % +51 - 60 % +43 % 56 % 56 % 57 % +Real estate and other +— - 10 % +— % 5 % — % 6 % — % +Cash — % — % 1 % 1 % — % 1 % +Total 100 % 100 % 100 % 100 % +In fiscal year 2020, the 7.0 % expected return for U.S. plan assets was based on a weighted average of estimated long-term returns of major asset classes and the historical performance of plan assets. The estimated long-term return for equity, debt securities, and real estate is 7.6 %, 5.1 %, and 6.5 %, respectively. In determining asset class returns, we take into account historical long-term returns and the value of active management, as well as other economic and market factors. +In fiscal year 2020, the 5.0 % expected rate of return for international plan assets was based on a weighted average return for plans outside the U.S., which vary significantly in size, asset structure and expected returns. The expected asset return for the U.K. plan, which represents over 80 % of the assets of our International plans, is 5.7 % and was derived from expected equity and debt security returns of 7.3 % and 1.8 %, respectively. +94 +Table of Contents +The following table summarizes pension plan assets measured at fair value by asset class (see Note 14, Fair Value Measurements , for definition of the levels): +2020 2019 +30 September Total Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 +U.S. Qualified Pension Plans +Cash and cash equivalents $ 16.9 $ 16.9 $ — $ — $ 13.7 $ 13.7 $ — $ — +Equity securities 573.9 573.9 — — 401.1 401.1 — — +Equity mutual funds 213.1 213.1 — — 152.9 152.9 — — +Equity pooled funds 762.0 — 762.0 — 524.8 — 524.8 — +Fixed income: +Bonds (government +and corporate) +1,312.7 — 1,312.7 — 1,572.1 — 1,572.1 — +Total U.S. Qualified Pension Plans at Fair Value $ 2,878.6 $ 803.9 $ 2,074.7 $ — $ 2,664.6 $ 567.7 $ 2,096.9 $ — +Real estate pooled funds (A) +169.7 167.8 +Total U.S. Qualified Pension Plans $ 3,048.3 $ 2,832.4 +International Pension Plans +Cash and cash equivalents $ 13.9 $ 13.9 $ — $ — $ 13.4 $ 13.4 $ — $ — +Equity pooled funds 746.8 — 746.8 — 711.3 — 711.3 — +Fixed income pooled funds 694.1 — 694.1 — 679.9 — 679.9 — +Other pooled funds 15.5 — 15.5 — 13.7 — 13.7 — +Insurance contracts 256.5 — — 256.5 254.1 — — 254.1 +Total International Pension Plans $ 1,726.8 $ 13.9 $ 1,456.4 $ 256.5 $ 1,672.4 $ 13.4 $ 1,404.9 $ 254.1 +(A) Real estate pooled funds consist of funds that invest in properties. These funds generally allow for quarterly redemption with 30 days' notice. Timing for redemption could be delayed based on the priority of our request and the availability of funds. Interests in these funds are valued using the net asset value ("NAV") per share practical expedient and are not classified in the fair value hierarchy. +The following table summarizes changes in fair value of the pension plan assets classified as Level 3, which comprised of investments in insurance contracts: +Balance at 30 September 2018 $ 217.7 +Actual return on plan assets: +Assets held at end of year 38.1 +Purchases, sales, and settlements, net ( 1.7 ) +Balance at 30 September 2019 $ 254.1 +Actual return on plan assets: +Assets held at end of year 2.4 +Balance at 30 September 2020 $ 256.5 +95 +Table of Contents +The descriptions and fair value methodologies for the U.S. and International pension plan assets are as follows: +Cash and Cash Equivalents +The carrying amounts of cash and cash equivalents approximate fair value due to the short-term maturity. +Equity Securities +Equity securities are valued at the closing market price reported on a U.S. or international exchange where the security is actively traded and are therefore classified as Level 1 assets. +Equity Mutual and Pooled Funds +Shares of mutual funds are valued at the NAV of the fund and are classified as Level 1 assets. Units of pooled funds are valued at the per unit NAV determined by the fund manager based on the value of the underlying traded holdings and are classified as Level 2 assets. +Corporate and Government Bonds +Corporate and government bonds are classified as Level 2 assets, as they are either valued at quoted market prices from observable pricing sources at the reporting date or valued based upon comparable securities with similar yields and credit ratings. +Other Pooled Funds +Other pooled funds classified as Level 2 assets are valued at the NAV of the shares held at year end, which is based on the fair value of the underlying investments. +Insurance Contracts +Insurance contracts are classified as Level 3 assets, as they are carried at contract value, which approximates the estimated fair value. The estimated fair value is based on the fair value of the underlying investment of the insurance company and discount rates that require inputs with limited observability. +Contributions and Projected Benefit Payments +Pension contributions to funded plans and benefit payments for unfunded plans for fiscal year 2020 were $ 37.5 . Contributions for funded plans resulted primarily from contractual and regulatory requirements. Benefit payments to unfunded plans were due primarily to the timing of retirements. We anticipate contributing $ 45 to $ 55 to the defined benefit pension plans in fiscal year 2021. These contributions are anticipated to be driven primarily by contractual and regulatory requirements for funded plans and benefit payments for unfunded plans, which are dependent upon timing of retirements. +Projected benefit payments, which reflect expected future service, are as follows: +U.S. International +2021 $ 163.7 $ 52.0 +2022 165.2 52.8 +2023 169.8 56.9 +2024 174.0 60.2 +2025 177.9 59.9 +2026-2030 932.6 334.4 +These estimated benefit payments are based on assumptions about future events. Actual benefit payments may vary significantly from these estimates. +U.K. Lloyds Equalization Ruling +On 26 October 2018, the United Kingdom High Court issued a ruling related to the equalization of pension plan participants’ benefits for the gender effects of Guaranteed Minimum Pensions. As a result of this ruling, we estimated the impact of retroactively increasing benefits in our U.K. plan in accordance with the High Court ruling. We treated the additional benefits as a prior service cost, which resulted in an increase to our projected benefit obligation and accumulated other comprehensive loss of $ 4.7 during the first quarter of fiscal year 2019. We are amortizing this cost over the average remaining life expectancy of the U.K. participants. +96 +Table of Contents +Defined Contribution Plans +We maintain a non-leveraged employee stock ownership plan ("ESOP") which forms part of the Air Products and Chemicals, Inc. Retirement Savings Plan ("RSP"). The ESOP was established in May of 2002. The balance of the RSP is a qualified defined contribution plan including a 401(k) elective deferral component. A substantial portion of U.S. employees are eligible and participate. +We treat dividends paid on ESOP shares as ordinary dividends. Under existing tax law, we may deduct dividends which are paid with respect to shares held by the plan. Shares of our common stock in the ESOP totaled 2,001,152 as of 30 September 2020. +Our contributions to the RSP include a Company core contribution for certain eligible employees who do not receive their primary retirement benefit from the defined benefit pension plans, with the core contribution based on a percentage of pay that is dependent on years of service. For the RSP, we also make matching contributions on overall employee contributions as a percentage of the employee contribution and include an enhanced contribution for certain eligible employees that do not participate in the defined benefit pension plans. Worldwide contributions expensed to income in fiscal years 2020, 2019, and 2018 were $ 45.6 , $ 40.6 , and $ 34.2 , respectively. +Other Postretirement Benefits +We provide other postretirement benefits consisting primarily of healthcare benefits to certain U.S. retirees who meet age and service requirements. The healthcare benefit is a continued medical benefit until the retiree reaches age 65. Healthcare benefits are contributory, with contributions adjusted periodically. The retiree medical costs are capped at a specified dollar amount, with the retiree contributing the remainder. The cost of these benefits were not material in fiscal years 2020, 2019, and 2018. Accumulated postretirement benefit obligations as of the end of fiscal years 2020 and 2019 were $ 38.6 and $ 43.7 , respectively, of which $ 7.2 and $ 7.7 were current obligations, respectively. +We recognize changes in other postretirement benefit plan obligations in other comprehensive income on a pretax basis. In fiscal years 2020 and 2019, we recognized gains that arose during the period of $ 1.3 and $ 6.1 , respectively. There was no net actuarial loss amortization in fiscal years 2020 and 2019 as the corridor for the plan was not exceeded. +The net actuarial gain/loss recognized in accumulated other comprehensive loss on a pretax basis was a net gain of $ 3.0 and $ 1.7 as of 30 September 2020 and 2019, respectively. +17. COMMITMENTS AND CONTINGENCIES +Litigation +We are involved in various legal proceedings, including commercial, competition, environmental, intellectual property, regulatory, product liability, and insurance matters. In September 2010, the Brazilian Administrative Council for Economic Defense ("CADE") issued a decision against our Brazilian subsidiary, Air Products Brasil Ltda., and several other Brazilian industrial gas companies for alleged anticompetitive activities. CADE imposed a civil fine of R$ 179.2 million (approximately $ 32 at 30 September 2020) on Air Products Brasil Ltda. This fine was based on a recommendation by a unit of the Brazilian Ministry of Justice, whose investigation began in 2003, alleging violation of competition laws with respect to the sale of industrial and medical gases. The fines are based on a percentage of our total revenue in Brazil in 2003. +We have denied the allegations made by the authorities and filed an appeal in October 2010 with the Brazilian courts. On 6 May 2014, our appeal was granted and the fine against Air Products Brasil Ltda. was dismissed. CADE has appealed that ruling and the matter remains pending. We, with advice of our outside legal counsel, have assessed the status of this matter and have concluded that, although an adverse final judgment after exhausting all appeals is possible, such a judgment is not probable. As a result, no provision has been made in the consolidated financial statements. We estimate the maximum possible loss to be the full amount of the fine of R$ 179.2 million (approximately $ 32 at 30 September 2020) plus interest accrued thereon until final disposition of the proceedings. +We do not currently believe there are any legal proceedings, individually or in the aggregate, that are reasonably possible to have a material impact on our financial condition, results of operations, or cash flows. +97 +Table of Contents +Environmental +In the normal course of business, we are involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA," the federal Superfund law), Resource Conservation and Recovery Act ("RCRA"), and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Presently, there are 31 sites on which a final settlement has not been reached where we, along with others, have been designated a potentially responsible party by the Environmental Protection Agency or are otherwise engaged in investigation or remediation, including cleanup activity at certain of our current and former manufacturing sites. We continually monitor these sites for which we have environmental exposure. +Accruals for environmental loss contingencies are recorded when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The consolidated balance sheets at 30 September 2020 and 2019 included an accrual of $ 84.7 and $ 68.9 , respectively, primarily as part of other noncurrent liabilities. The environmental liabilities will be paid over a period of up to 30 years . We estimate the exposure for environmental loss contingencies to range from $ 84 to a reasonably possible upper exposure of $ 98 as of 30 September 2020. +Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Using reasonably possible alternative assumptions of the exposure level could result in an increase to the environmental accrual. Due to the inherent uncertainties related to environmental exposures, a significant increase to the reasonably possible upper exposure level could occur if a new site is designated, the scope of remediation is increased, a different remediation alternative is identified, or a significant increase in our proportionate share occurs. We do not expect that any sum we may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed above would have a material adverse impact on our financial position or results of operations in any one year. +Pace +At 30 September 2020, $ 42.2 of the environmental accrual was related to the Pace facility. +In 2006, we sold our Amines business, which included operations at Pace, Florida, and recognized a liability for retained environmental obligations associated with remediation activities at Pace. We are required by the Florida Department of Environmental Protection ("FDEP") and the United States Environmental Protection Agency ("USEPA") to continue our remediation efforts. We recognized a before-tax expense of $ 42 in fiscal year 2006 in results from discontinued operations and recorded an environmental accrual of $ 42 in continuing operations on the consolidated balance sheets. +During the second quarter of fiscal year 2020, we completed an updated cost review of the environmental remediation status at the Pace facility. The review was completed in conjunction with requirements to maintain financial assurance per the Consent Order issued by the FDEP and the USEPA discussed below. Based on our review, we expect ongoing activities to continue for 30 years. Additionally, we will require near-term spending to install new groundwater recovery wells and piping, in addition to future capital to consider the extended time horizon for remediation at the site. As a result of these changes, we increased our environmental accrual for this site by $ 19 in continuing operations on the consolidated balance sheets and recognized a pre-tax expense of $ 19 in results from discontinued operations in the second quarter of fiscal year 2020. +We have implemented many of the remedial corrective measures at the Pace facility required under 1995 Consent Orders issued by the FDEP and the USEPA. Contaminated soils have been bioremediated, and the treated soils have been secured in a lined on-site corrective action management unit. Several groundwater recovery systems have been installed to contain and remove contamination from groundwater. We completed an extensive assessment of the site to determine the efficacy of existing measures, what additional corrective measures may be needed, and whether newer remediation technologies that were not available in the 1990s might be suitable to more quickly and effectively remediate groundwater. Based on assessment results, we completed a focused feasibility study that has identified alternative approaches that may more effectively remove contaminants. We continue to review alternative remedial approaches with the FDEP and have started additional field work to support the design of an improved groundwater recovery network with the objective of targeting areas of higher contaminant concentration and avoiding areas of high groundwater iron which has proven to be a significant operability issue for the project. In the first quarter of 2015, we entered into a new Consent Order with the FDEP requiring us to continue our remediation efforts at the Pace facility, along with the completion of a cost review every 5 years. In the second quarter of fiscal year 2020, we completed an updated cost review which resulted in a change in assumptions regarding future operating costs as discussed above. The costs we are incurring based on the fiscal year 2020 review are higher than our previous estimates. +98 +Table of Contents +Piedmont +At 30 September 2020, $ 13.3 of the environmental accrual was related to the Piedmont site. +On 30 June 2008, we sold our Elkton, Maryland, and Piedmont, South Carolina, production facilities and the related North American atmospheric emulsions and global pressure sensitive adhesives businesses. In connection with the sale, we recognized a liability for retained environmental obligations associated with remediation activities at the Piedmont site. This site is under active remediation for contamination caused by an insolvent prior owner. +We are required by the South Carolina Department of Health and Environmental Control ("SCDHEC") to address both contaminated soil and groundwater. Numerous areas of soil contamination have been addressed, and contaminated groundwater is being recovered and treated. The SCDHEC issued its final approval to the site-wide feasibility study on 13 June 2017 and the Record of Decision for the site on 27 June 2018. Field work has started to support the remedial design, and in the fourth quarter of fiscal year 2018, we signed a Consent Agreement Amendment memorializing our obligations to complete the cleanup of the site. We estimate that source area remediation and groundwater recovery and treatment will continue through 2029. Thereafter, we expect this site to go into a state of monitored natural attenuation through 2047. +We recognized a before-tax expense of $ 24 in 2008 as a component of income from discontinued operations and recorded an environmental liability of $ 24 in continuing operations on the consolidated balance sheets. There have been no significant changes to the estimated exposure. +Pasadena +At 30 September 2020, $ 11.5 of the environmental accrual was related to the Pasadena site. +During the fourth quarter of 2012, management committed to permanently shutting down our polyurethane intermediates ("PUI") production facility in Pasadena, Texas. In shutting down and dismantling the facility, we have undertaken certain obligations related to soil and groundwater contaminants. We have been pumping and treating groundwater to control off-site contaminant migration in compliance with regulatory requirements and under the approval of the Texas Commission on Environmental Quality ("TCEQ"). We estimate that the pump and treat system will continue to operate until 2042. +We plan to perform additional work to address other environmental obligations at the site. This additional work includes remediating, as required, impacted soils, investigating groundwater west of the former PUI facility, performing post closure care for two closed RCRA surface impoundment units, and establishing engineering controls. In 2012, we estimated the total exposure at this site to be $ 13 . There have been no significant changes to the estimated exposure. +99 +Table of Contents +Asset Retirement Obligations +Our asset retirement obligations are primarily associated with long-term on-site supply contracts under which we have built a facility on land owned by the customer and are obligated to remove the facility at the end of the contract term. The retirement of assets includes the contractually required removal of a long-lived asset from service and encompasses the sale, removal, abandonment, recycling, or disposal of the assets as required at the end of the contract term. These obligations are primarily reflected within "Other noncurrent liabilities" on the consolidated balance sheets. The timing and/or method of settlement of these obligations are conditional on a future event that may or may not be within our control. +Changes to the carrying amount of our asset retirement obligations were as follows: +Balance at 30 September 2018 $ 190.4 +Additional accruals 14.7 +Liabilities settled ( 2.1 ) +Accretion expense 8.7 +Currency translation adjustment ( 3.5 ) +Balance at 30 September 2019 $ 208.2 +Additional accruals 22.0 +Liabilities settled ( 2.8 ) +Accretion expense 9.5 +Currency translation adjustment 4.5 +Balance at 30 September 2020 $ 241.4 +Guarantees and Warranties +We guaranteed the repayment of our 25 % share of an equity bridge loan that has been provided to fund equity commitments to a joint venture arrangement with ACWA Holding in Saudi Arabia. ACWA also guarantees their share of the loan. Our maximum exposure under the guarantee, which expires in 2021, is approximately $ 100 . As of 30 September 2020, our consolidated balance sheets included $ 94.4 reflected within "Payables and accrued liabilities" for our obligation to make future equity contributions in 2021 based on our proportionate share of the advances received by the joint venture under the loan. +Air Products has also entered into a long-term sale of equipment contract with the joint venture to engineer, procure, and construct the industrial gas facilities that will supply gases to Saudi Aramco. We provided bank guarantees to the joint venture to support our performance under the contract. As of 30 September 2020, our maximum potential payments were $ 247 . Exposures under the guarantees will be extinguished after completion of the project. +We are party to an equity support agreement and operations guarantee related to an air separation facility constructed in Trinidad for a venture in which we own 50 %. At 30 September 2020, maximum potential payments under joint and several guarantees were $ 25.0 . Exposures under the guarantees decline over time and will be completely extinguished by 2024. +To date, no equity contributions or payments have been made since the inception of these guarantees. The fair value of the above guarantees is not material. +We, in the normal course of business operations, have issued product warranties related to equipment sales. Also, contracts often contain standard terms and conditions which typically include a warranty and indemnification to the buyer that the goods and services purchased do not infringe on third-party intellectual property rights. The provision for estimated future costs relating to warranties is not material to the consolidated financial statements. +We do not expect that any sum we may have to pay in connection with guarantees and warranties will have a material adverse effect on our consolidated financial condition, liquidity, or results of operations. +100 +Table of Contents +Unconditional Purchase Obligations +We are obligated to make future payments under unconditional purchase obligations as summarized below: +2021 $ 1,460 +2022 460 +2023 450 +2024 455 +2025 454 +Thereafter 6,277 +Total $ 9,556 +Approximately $ 7.9 billion of our unconditional purchase obligations relate to helium and rare gases. The majority of these obligations occur after fiscal year 2025. Helium purchases include crude feedstock supply to helium refining plants in North America as well as refined helium purchases from sources around the world. As a rare byproduct of natural gas production in the energy sector, these helium sourcing agreements are medium- to long-term and contain take-if-tendered provisions. The refined helium is distributed globally and sold as a merchant gas, primarily under medium-term requirements contracts. While contract terms in our helium sourcing contracts are generally longer than our customer sales contracts, helium is a rare gas used in applications with few or no substitutions because of its unique physical and chemical properties. +We estimate our maximum obligation for future purchases of plant and equipment to be approximately $ 1.0 billion based on open purchase orders as of 30 September 2020. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to reschedule, cancel, or otherwise modify based on our business needs. We have disclosed this obligation in fiscal year 2021; however, timing of actual satisfaction of the obligation may vary. +Our unconditional purchase obligations also include commitments for power and natural gas supply as well as feedstock supply or numerous HyCO (hydrogen, carbon monoxide, and syngas) facilities. Our long-term sales contracts to customers are generally matched to the term of these obligations and provide recovery of price increases. As a result, we do not believe these purchase obligations would have a material effect on our financial condition or results of operations. +18. CAPITAL STOCK +Common Stock +Authorized common stock consists of 300 million shares with a par value of $ 1 per share. As of 30 September 2020, 249 million shares were issued, with 221 million outstanding. +On 15 September 2011, the Board of Directors authorized the repurchase of up to $ 1.0 billion of our outstanding common stock. We repurchase shares pursuant to Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended, through repurchase agreements established with several brokers. We did no t purchase any of our outstanding shares during fiscal year 2020. At 30 September 2020, $ 485.3 in share repurchase authorization remains. +A summary of the changes in common shares in fiscal year 2020 is presented below: +Year Ended 30 September 2020 2019 2018 +Number of common shares outstanding, beginning of year 220,415,262 219,515,245 218,346,074 +Issuance of treasury shares for stock option and award plans 602,197 900,017 1,169,171 +Number of common shares outstanding, end of year 221,017,459 220,415,262 219,515,245 +Preferred Stock +Authorized preferred stock consisted of 25 million shares with a par value of $ 1 per share, of which 2.5 million were designated as Series A Junior Participating Preferred Stock. There were no preferred shares issued or outstanding as of 30 September 2020 and 2019. +101 +Table of Contents +19. SHARE-BASED COMPENSATION +We have various share-based compensation programs, which include deferred stock units, stock options, and restricted stock. During the fiscal year ended 30 September 2020, we granted market-based and time-based deferred stock units. Under all programs, the terms of the awards are fixed at the grant date. We issue shares from treasury stock upon the payout of deferred stock units, the exercise of stock options, and the issuance of restricted stock awards. As of 30 September 2020, there were 4,341,614 shares available for future grant under our Long-Term Incentive Plan ("LTIP"), which is shareholder approved. +Share-based compensation cost recognized in the consolidated income statements is summarized below: +2020 2019 2018 +Before-tax share-based compensation cost $ 55.8 $ 41.2 $ 38.8 +Income tax benefit ( 13.0 ) ( 9.7 ) ( 9.1 ) +After-tax share-based compensation cost $ 42.8 $ 31.5 $ 29.7 +Before-tax share-based compensation cost is primarily included in "Selling and administrative expense" on our consolidated income statements. The amount of share-based compensation cost capitalized in fiscal years 2020, 2019, and 2018 was not material. +Before-tax share-based compensation cost by type of program was as follows: +2020 2019 2018 +Deferred stock units $ 55.8 $ 41.1 $ 38.3 +Stock options — — 0.2 +Restricted stock — 0.1 0.3 +Before-tax share-based compensation cost $ 55.8 $ 41.2 $ 38.8 +Deferred Stock Units +We have granted deferred stock units to executives, selected employees, and outside directors. These deferred stock units entitle the recipient to one share of common stock upon vesting, which is conditioned, for employee recipients, on continued employment during the deferral period and may be conditioned on achieving certain performance targets. We grant deferred stock unit awards with a two - to five-year deferral period that is subject to payout upon death, disability, or retirement. Deferred stock units issued to outside directors are paid after service on the Board of Directors ends at the time elected by the director (not to exceed 10 years after service ends). We generally expense the grant-date fair value of these awards on a straight-line basis over the vesting period; however, expense recognition is accelerated for retirement eligible individuals who meet the requirements for vesting upon retirement. We have elected to account for forfeitures as they occur, rather than to estimate them. Forfeitures have not been significant historically. +Market-based deferred stock units vest as long as the employee continues to be employed by the Company and upon the achievement of the performance target. The performance target, which is approved by the Compensation Committee, is our share price appreciation and dividends paid, or "total shareholder return," in relation to a defined peer group over a three-year performance period beginning 1 October of the fiscal year of grant. We granted 80,215 , 114,929 , and 105,268 market-based deferred stock units in fiscal years 2020, 2019, and 2018, respectively. +102 +Table of Contents +The fair value of market-based deferred stock units was estimated using a Monte Carlo simulation model as these equity awards are tied to a market condition. The model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the grant and calculates the fair value of the awards. We generally expense the grant-date fair value of these awards on a straight-line basis over the vesting period. The estimated grant-date fair value of market-based deferred stock units was $ 275.19 , $ 229.61 , and $ 202.50 per unit in fiscal years 2020, 2019, and 2018, respectively. The calculation of the fair value of these market-based deferred stock units used the following assumptions: +2020 2019 2018 +Expected volatility 17.8 % 17.5 % 18.7 % +Risk-free interest rate 1.6 % 2.8 % 1.9 % +Expected dividend yield 2.4 % 2.6 % 2.6 % +In addition, we granted 123,448 time-based deferred stock units at a weighted average grant-date fair value of $ 230.92 . In fiscal years 2019 and 2018, we granted 169,666 and 143,379 time-based deferred stock units at a weighted average grant-date fair value of and $ 168.68 and $ 162.11 , respectively. +A summary of deferred stock unit activity in fiscal year 2020 is presented below: +Shares (000) Weighted Average +Grant-Date Fair Value +Deferred stock units outstanding at 30 September 2019 976 $ 156.31 +Granted 203 252.53 +Paid out ( 300 ) 141.08 +Forfeited/adjustments 47 131.35 +Deferred stock units outstanding at 30 September 2020 926 $ 181.14 +Cash payments made for deferred stock units totaled $ 4.8 , $ 1.9 , and $ 2.2 in fiscal years 2020, 2019, and 2018, respectively. As of 30 September 2020, there was $ 52.7 of unrecognized compensation cost related to deferred stock units. This cost is expected to be recognized over a weighted average period of 2.0 years. The total fair value of deferred stock units paid out during fiscal years 2020, 2019, and 2018, including shares vested in prior periods, was $ 65.4 , $ 19.2 , and $ 38.5 , respectively. +Stock Options +We have granted awards of options to purchase common stock to executives and selected employees. The exercise price of stock options equals the market price of our stock on the date of the grant. Options generally vest incrementally over three years and remain exercisable for ten years from the date of grant. We have not issued stock option awards since fiscal year 2015. As of 30 September 2020, there was no unrecognized compensation cost as all stock option awards were fully vested. +A summary of stock option activity in fiscal year 2020 is presented below: +Shares (000) Weighted Average +Exercise Price +Stock options outstanding and exercisable at 30 September 2019 1,344 $ 93.75 +Exercised ( 403 ) 86.28 +Forfeited — — +Stock options outstanding and exercisable at 30 September 2020 941 $ 96.95 +The weighted average remaining contractual term of stock options outstanding and exercisable at 30 September 2020 was 2.7 years. The aggregate intrinsic value of these stock options was $ 189 , which represents the amount by which our closing stock price of $ 297.86 as of 30 September 2020 exceeds the exercise price multiplied by the number of in-the-money options outstanding or exercisable. The intrinsic value of stock options exercised during fiscal years 2020, 2019, and 2018 was $ 65.7 , $ 87.2 , and $ 90.4 , respectively. +103 +Table of Contents +Compensation cost is generally recognized over the stated vesting period consistent with the terms of the arrangement, which is either on a straight-line or graded-vesting basis. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. +Cash received from option exercises during fiscal year 2020 was $ 34.1 . The total tax benefit realized from stock option exercises in fiscal year 2020 was $ 15.4 , of which $ 14.2 was the excess tax benefit. +Restricted Stock +The grant-date fair value of restricted stock is estimated on the date of grant based on the closing price of the stock, and compensation cost is generally amortized to expense on a straight-line basis over the vesting period during which employees perform related services. Expense recognition is accelerated for retirement-eligible individuals who would meet the requirements for vesting of awards upon their retirement. We have elected to account for forfeitures as they occur rather than to estimate them. Historically, forfeitures have not been significant. +We have issued shares of restricted stock to certain officers. Participants are entitled to cash dividends and to vote their respective shares. Restrictions on shares lift in one to four years or upon the earlier of retirement, death, or disability. The shares are nontransferable while subject to forfeiture. +A summary of restricted stock activity in fiscal year 2020 is presented below: +Shares (000) Weighted Average +Grant-Date Fair Value +Restricted stock outstanding at 30 September 2019 26 $ 138.00 +Vested ( 26 ) 138.00 +Restricted stock outstanding at 30 September 2020 — $ — +As of 30 September 2020, there was no unrecognized compensation cost as all restricted stock awards were fully vested. The total fair value of restricted stock vested during fiscal years 2020, 2019, and 2018 was $ 6.1 , $ 2.6 , and $ 2.2 , respectively. +104 +Table of Contents +20. ACCUMULATED OTHER COMPREHENSIVE LOSS +The table below summarizes changes in accumulated other comprehensive loss ("AOCL"), net of tax, attributable to Air Products: +Derivatives +qualifying +as hedges Foreign +currency +translation +adjustments Pension and +postretirement +benefits Total +Balance at 30 September 2017 ($ 53.1 ) ($ 787.1 ) ($ 1,007.2 ) ($ 1,847.4 ) +Other comprehensive income (loss) before reclassifications 45.9 ( 244.6 ) 179.4 ( 19.3 ) +Amounts reclassified from AOCL ( 30.4 ) 3.1 133.1 105.8 +Net current period other comprehensive income (loss) $ 15.5 ($ 241.5 ) $ 312.5 $ 86.5 +Amount attributable to noncontrolling interests — ( 18.8 ) ( 0.2 ) ( 19.0 ) +Balance at 30 September 2018 ($ 37.6 ) ($ 1,009.8 ) ($ 694.5 ) ($ 1,741.9 ) +Other comprehensive loss before reclassifications ( 44.1 ) ( 356.2 ) ( 326.2 ) ( 726.5 ) +Amounts reclassified from AOCL 12.3 ( 2.6 ) 63.2 72.9 +Net current period other comprehensive loss ($ 31.8 ) ($ 358.8 ) ($ 263.0 ) ($ 653.6 ) +Amount attributable to noncontrolling interest ( 8.0 ) ( 11.7 ) ( 0.2 ) ( 19.9 ) +Balance at 30 September 2019 ($ 61.4 ) ($ 1,356.9 ) ($ 957.3 ) ($ 2,375.6 ) +Other comprehensive income (loss) before reclassifications 43.5 233.4 ( 68.2 ) 208.7 +Amounts reclassified from AOCL ( 57.7 ) — 82.5 24.8 +Net current period other comprehensive income (loss) ($ 14.2 ) $ 233.4 $ 14.3 $ 233.5 +Amount attributable to noncontrolling interest ( 21.1 ) 19.3 ( 0.2 ) ( 2.0 ) +Balance at 30 September 2020 ($ 54.5 ) ($ 1,142.8 ) ($ 942.8 ) ($ 2,140.1 ) +The table below summarizes the reclassifications out of AOCL and the affected line item on the consolidated income statements: +Year Ended 30 September +2020 2019 2018 +(Gain) Loss on Cash Flow Hedges, net of tax +Sales/Cost of sales ($ 1.0 ) $ 0.6 $ 7.1 +Other income (expense), net — ( 3.0 ) ( 42.6 ) +Interest expense 2.8 14.7 5.1 +Other non-operating income (expense), net (A) +( 59.5 ) — — +Total (Gain) Loss on Cash Flow Hedges, net of tax ($ 57.7 ) $ 12.3 ($ 30.4 ) +Currency Translation Adjustment (B) +$ — ($ 2.6 ) $ 3.1 +Pension and Postretirement Benefits, net of tax (C) +$ 82.5 $ 63.2 $ 133.1 +(A) The fiscal year 2020 impact includes amortization of the excluded component and the effective portion of the related hedges. +(B) The fiscal year 2019 impact relates to a net gain on the exchange of two equity affiliates with a joint venture partner. Refer to Note 3, Acquisitions , for additional information. The fiscal year 2018 impact relates to an equipment sale resulting from the termination of a contract in the Industrial Gases – Asia segment during the first quarter. +(C) The components of net periodic benefit cost reclassified out of AOCL include items such as prior service cost amortization, actuarial loss amortization, and settlements and are included in “Other non-operating income (expense), net” on the consolidated income statements. Refer to Note 16, Retirement Benefits , for additional information. +105 +Table of Contents +21. EARNINGS PER SHARE +The table below details the computation of basic and diluted earnings per share ("EPS"): +Year Ended 30 September 2020 2019 2018 +Numerator +Net income from continuing operations $ 1,901.0 $ 1,760.0 $ 1,455.6 +Net (loss) income from discontinued operations ( 14.3 ) — 42.2 +Net Income Attributable to Air Products $ 1,886.7 $ 1,760.0 $ 1,497.8 +Denominator (in millions) +Weighted average common shares — Basic 221.2 220.3 219.3 +Effect of dilutive securities +Employee stock option and other award plans 1.1 1.3 1.5 +Weighted average common shares — Diluted 222.3 221.6 220.8 +Per Share Data* +Basic EPS from continuing operations $ 8.59 $ 7.99 $ 6.64 +Basic EPS from discontinued operations ( 0.06 ) — 0.19 +Basic EPS Attributable to Air Products $ 8.53 $ 7.99 $ 6.83 +Diluted EPS from continuing operations $ 8.55 $ 7.94 $ 6.59 +Diluted EPS from discontinued operations ( 0.06 ) — 0.19 +Diluted EPS Attributable to Air Products $ 8.49 $ 7.94 $ 6.78 +*EPS is calculated independently for each component and may not sum to total EPS due to rounding. +Diluted EPS attributable to Air Products reflects the potential dilution that could occur if stock options or other share-based awards were exercised or converted into common stock. The dilutive effect is computed using the treasury stock method, which assumes all share-based awards are exercised, and the hypothetical proceeds from exercise are used by the Company to purchase common stock at the average market price during the period. To the extent they would have been dilutive, the incremental shares, or the difference between shares assumed to be issued versus purchased, are included in the denominator of the diluted EPS calculation. There were no antidilutive outstanding share-based awards in fiscal years 2020 and 2019. Outstanding share-based awards of 0.1 million shares were antidilutive and therefore excluded from the computation of diluted EPS for fiscal year 2018. +22. INCOME TAXES +The following table summarizes the income of U.S. and foreign operations before taxes: +2020 2019 2018 +United States income $ 943.7 $ 723.3 $ 688.5 +Foreign income 1,215.3 1,350.8 1,151.7 +Equity affiliates' income 264.8 215.4 174.8 +Income from Continuing Operations Before Taxes $ 2,423.8 $ 2,289.5 $ 2,015.0 +On 22 December 2017, the United States enacted the U.S. Tax Cuts and Jobs Act (the “Tax Act” or "Tax Reform"), which significantly changed existing U.S. tax laws, including a reduction in the federal corporate income tax rate from 35 % to 21 %, a deemed repatriation tax on unremitted foreign earnings, as well as other changes. Our consolidated income statements reflect a discrete net income tax expense of $ 43.8 and $ 180.6 in fiscal years 2019 and 2018, respectively, related to impacts of the Tax Act. +106 +Table of Contents +In fiscal year 2019, our income tax expense reflects the reversal of a non-recurring $ 56.2 benefit recorded in fiscal year 2018 related to the U.S. taxation of deemed foreign dividends. This was partially offset by a benefit of $ 12.4 to reduce the total expected costs of the deemed repatriation tax. The non-recurring benefit recorded in fiscal year 2018 was eliminated by regulations issued in fiscal year 2019. +In fiscal year 2018, our consolidated income statements reflect a discrete net income tax expense of $ 180.6 and a $ 28.5 reduction to equity affiliates' income for the impacts of the Tax Act. The income tax expense of $ 180.6 included a cost of $ 392.4 , which included $ 322.1 for the deemed repatriation tax and $ 70.3 primarily for additional foreign taxes on the repatriation of foreign earnings. This cost was partially offset by a $ 211.8 benefit primarily from the re-measurement of our net U.S. deferred tax liabilities at the lower corporate tax rate. The deemed repatriation tax of $ 322.1 included the $ 56.2 non-recurring benefit related to the U.S. taxation of deemed foreign dividends that was eliminated in 2019. We have historically asserted our intention to indefinitely reinvest foreign earnings in certain foreign subsidiaries. We reevaluated our historic assertions as a result of enactment of the Tax Act and adjusted our position relative to the indefinitely reinvested earnings of various foreign subsidiaries. The impact of these changes is included in the $ 70.3 for additional foreign taxes on the repatriation of foreign earnings recorded in fiscal year 2018. +As of 30 September 2020, the remaining balance of the deemed repatriation tax obligation is $ 211.4 , $ 190.9 of which is presented on our consolidated balance sheets in noncurrent liabilities. We are paying the obligation in installments over six remaining years. +While our accounting for the provisions of the Tax Act is not provisional, further adjustments to the deemed repatriation tax could result from future U.S. or foreign tax examinations of the years impacted by the calculation or from the issuance of additional federal or state guidance. +As a fiscal year-end taxpayer, certain provisions of the Tax Act became effective in our fiscal year 2018 while other provisions did not become effective until fiscal year 2019. The corporate tax rate reduction was effective as of 1 January 2018 and, accordingly, reduced our 2018 fiscal year U.S. federal statutory rate to a blended rate of approximately 24.5 %. The 21.0 % federal tax rate applied to our fiscal year ended 30 September 2019 and each year thereafter. +The following table details the components of the provision for income taxes: +2020 2019 2018 +Current Tax Provision +Federal $ 26.9 $ 163.7 $ 305.1 +State 23.8 23.3 17.7 +Foreign 262.7 235.5 256.9 +Total Current Tax Provision 313.4 422.5 579.7 +Deferred Tax Provision +Federal 108.8 9.7 ( 121.7 ) +State ( 3.6 ) 2.4 12.5 +Foreign 59.8 45.5 53.8 +Total Deferred Tax Provision 165.0 57.6 ( 55.4 ) +Total Income Tax Provision $ 478.4 $ 480.1 $ 524.3 +Total company income tax payments, net of refunds, were $ 379.9 , $ 324.3 , and $ 372.0 in fiscal years 2020, 2019, and 2018, respectively. +107 +Table of Contents +The effective tax rate equals the income tax provision divided by income from continuing operations before taxes. A reconciliation of the differences between the United States federal statutory tax rate and the effective tax rate is as follows: +(Percent of income before taxes) 2020 2019 2018 +U.S. federal statutory tax rate 21.0 % 21.0 % 24.5 % +State taxes, net of federal benefit 0.6 1.0 1.0 +Income from equity affiliates ( 2.3 ) ( 2.0 ) ( 2.1 ) +Foreign tax differentials 0.1 1.0 ( 1.0 ) +Tax on foreign repatriated earnings 0.9 0.1 ( 0.4 ) +Share-based compensation ( 0.8 ) ( 0.6 ) ( 1.0 ) +Tax reform repatriation — 1.9 19.5 +Tax reform rate change and other — — ( 11.1 ) +Tax restructuring benefit — — ( 1.8 ) +Domestic production activities — — ( 0.4 ) +Other 0.2 ( 1.4 ) ( 1.2 ) +Effective Tax Rate 19.7 % 21.0 % 26.0 % +Foreign tax differentials represent the differences between foreign earnings subject to foreign tax rates that are different than the U.S. federal statutory rate and include tax holidays and incentives. As a result of the Tax Act, our effective non-U.S. tax rates in fiscal years 2020 and 2019 are higher than our statutory rate of 21.0 % in those years. Our income tax holidays relate to operations in jurisdictions that provide reduced income tax rates for certain qualifying activities and are conditional upon us meeting certain operating thresholds. The impact of these tax holidays decreased income tax expense by $ 26.9 ($ 0.12 per share) in fiscal year 2020, primarily related to a preferential tax rate in China that is effective until 31 December 2030. This includes the impact of remeasurement of the deferred tax assets and liabilities due to an extension of the holiday period in China. The impact of tax holidays in fiscal years 2019 and 2018 were not material. +Tax on foreign repatriated earnings includes benefits and costs related to U.S. and additional foreign taxation on the current and future repatriation of foreign earnings and a U.S. benefit for related foreign tax credits. The enactment of the India Finance Act 2020, increased income tax expense by $ 20.3 and increased equity affiliate income by $ 33.8 for changes in the future tax costs of repatriated earnings. In addition, the Tax Act included new provisions related to the taxation of foreign operations, known as Global Intangible Low Tax Income (“GILTI”). We have elected as an accounting policy to account for GILTI as a period cost when incurred. This and various other provisions of the Tax Act did not become effective until fiscal year 2019 and did not impact our tax provision in fiscal year 2018. +The Tax Act repealed the domestic production activities deduction, effective for our fiscal 2019 tax year. +Share-based compensation reflects the impact from recognition of $ 20.0 , $ 14.6 , and $ 21.5 of excess tax benefits in our provision for income taxes during fiscal years 2020, 2019, and 2018, respectively. +In fiscal year 2018, we recognized a tax benefit of $ 35.7 , net of reserves for uncertain tax positions, and a corresponding decrease to net deferred tax liabilities resulting from the restructuring of several foreign subsidiaries. +108 +Table of Contents +The significant components of deferred tax assets and liabilities are as follows: +30 September 2020 2019 +Gross Deferred Tax Assets +Retirement benefits and compensation accruals $ 209.0 $ 227.1 +Tax loss carryforwards 112.6 140.6 +Tax credits and other tax carryforwards 40.3 31.1 +Reserves and accruals 67.0 69.6 +Currency losses 30.4 — +Other 64.6 57.7 +Valuation allowance ( 95.0 ) ( 92.1 ) +Deferred Tax Assets 428.9 434.0 +Gross Deferred Tax Liabilities +Plant and equipment 1,110.9 954.6 +Currency gains — 23.9 +Unremitted earnings of foreign entities 58.7 31.0 +Partnership and other investments 19.3 14.8 +Intangible assets 83.6 80.0 +Other 3.9 8.3 +Deferred Tax Liabilities 1,276.4 1,112.6 +Net Deferred Income Tax Liability $ 847.5 $ 678.6 +Deferred tax assets and liabilities are included within the consolidated balance sheets as follows: +2020 2019 +Deferred Tax Assets +Other noncurrent assets $ 115.1 $ 115.2 +Deferred Tax Liabilities +Deferred income taxes 962.6 793.8 +Net Deferred Income Tax Liability $ 847.5 $ 678.6 +Deferred tax liabilities related to plant and equipment increased due to the impact of accelerated tax depreciation deductions in excess of book depreciation primarily in the United States. The deferred tax component for currency transactions moved into an overall deferred tax asset position due primarily to currency movements on hedging transactions as several foreign based currencies strengthened against the U.S. dollar in fiscal year 2020. We also realized a deferred tax liability related to the unrealized foreign exchange gain for a euro denominated financial instrument. Unremitted earnings of foreign entities increased primarily as a result of the enactment of the India Finance Act 2020 which increased the future tax costs of repatriated earnings. +As of 30 September 2020, we had the following deferred tax assets for certain tax credits: +Jurisdiction Gross Tax Asset Expiration Period +U.S. State $ 2.0 2021 - 2034 +U.S. Federal 14.1 2027 - 2030 +Foreign 28.6 2021 - 2025; Indefinite +Of the $ 28.6 foreign tax credits, $ 13.3 have indefinite carryforward periods. +109 +Table of Contents +As of 30 September 2020, we had the following loss carryforwards: +Jurisdiction Gross Loss Carryforward Expiration Period +U.S. State Net Operating Loss $ 323.2 2021 - 2040 +U.S. Federal Capital Loss 24.4 2025 +Foreign Net Operating Loss 236.6 2021 - 2030; Indefinite +Foreign Capital Loss 274.8 Indefinite +In fiscal year 2020, the U.S. Federal capital losses increased by $ 22.6 primarily due to the recognition of a capital loss for the liquidation of a foreign subsidiary. Of the $ 236.6 of foreign net operating loss carryforwards, $ 83.1 have indefinite carryforward periods. Foreign net operating losses decreased by $ 116.0 in fiscal year 2020 primarily due to utilization in China and a tax election in India that reduced tax loss carryforwards and decreased plant and equipment net deferred tax liabilities. +The valuation allowance was $ 95.0 and $ 92.1 as of 30 September 2020 and 2019, respectively. As of 30 September 2020, the balance primarily related to $ 40.3 of foreign credits and loss carryforwards as well as $ 52.2 related to foreign capital losses that were generated from the loss recorded on the exit from the Energy-from-Waste project in 2016. If events warrant the reversal of the valuation allowance, it would result in a reduction of tax expense. We believe it is more likely than not that future earnings and reversal of deferred tax liabilities will be sufficient to utilize our deferred tax assets, net of existing valuation allowance, as of 30 September 2020. +As a result of the Tax Act, we recorded $ 373.2 of federal income tax from the deemed repatriation tax on approximately $ 5.8 billion of previously undistributed earnings from our foreign subsidiaries and corporate joint ventures. These earnings are now eligible to be repatriated to the U.S. with reduced U.S. tax impacts. However, such earnings may be subject to foreign withholding and other taxes. We record foreign and U.S. income taxes on the undistributed earnings of our foreign subsidiaries and corporate joint ventures unless those earnings are indefinitely reinvested. The cumulative undistributed earnings that are considered to be indefinitely reinvested in foreign subsidiaries and corporate joint ventures are included in retained earnings on the consolidated balance sheets and amounted to $ 4.7 billion as of 30 September 2020. An estimated $ 454.4 in additional foreign withholding and other income taxes would be due if these earnings were remitted as dividends. +A reconciliation of the beginning and ending amount of the unrecognized tax benefits is as follows: +2020 2019 2018 +Unrecognized tax benefits balance at beginning of year $ 231.7 $ 233.6 $ 146.4 +Additions for tax positions of the current year 7.6 7.8 26.4 +Additions for tax positions of prior years 17.7 14.2 119.2 +Reductions for tax positions of prior years ( 4.1 ) ( 14.7 ) ( 41.3 ) +Settlements ( 1.2 ) ( 1.5 ) ( 14.2 ) +Statute of limitations expiration ( 14.0 ) ( 3.9 ) ( 2.6 ) +Foreign currency translation ( 0.7 ) ( 3.8 ) ( 0.3 ) +Unrecognized tax benefits balance at end of year $ 237.0 $ 231.7 $ 233.6 +As of 30 September 2020 and 2019, we had $ 237.0 and $ 231.7 of unrecognized tax benefits, excluding interest and penalties, respectively. Of these benefits, $ 86.1 and $ 75.0 as of 30 September 2020 and 2019, respectively, would impact the effective tax rate from continuing operations if recognized. +Interest and penalties related to unrecognized tax benefits are recorded as a component of income tax expense and totaled $ 6.1 , $ 12.0 , and ($ 2.4 ) in fiscal years 2020, 2019, and 2018, respectively. Our accrued balance for interest and penalties was $ 25.2 and $ 19.5 as of 30 September 2020 and 2019, respectively. +110 +Table of Contents +In fiscal year 2018, $ 119.2 in additions for tax positions of prior years related primarily to uncertain state tax filing positions taken related to the sale of our former Performance Materials Division in fiscal year 2017. Additions for tax positions of the current year in fiscal year 2018 of $ 26.4 included uncertain tax positions related to the restructuring of foreign subsidiaries and reserves for ongoing transfer pricing uncertainties. +In fiscal year 2018, we received a final audit settlement agreement that resolved uncertainties related to unrecognized tax benefits of $ 43.1 , including interest. This settlement primarily related to tax positions taken in conjunction with the disposition of our Homecare business in 2012. As a result, we recorded an income tax benefit of $ 25.6 , including interest, in income from discontinued operations during 2018. The settlement also resulted in an income tax benefit of approximately $ 9.1 , including interest, in continuing operations for the release of tax reserves on other matters. +We are currently under examination in a number of tax jurisdictions, some of which may be resolved in the next twelve months. As a result, it is reasonably possible that a change in the unrecognized tax benefits may occur during the next twelve months. However, quantification of an estimated range cannot be made as of the date of this report. +We generally remain subject to examination in the following major tax jurisdictions for the years indicated below: +Major Tax Jurisdiction Open Tax Years +North America +United States – Federal +2017 - 2020 +United States – State +2012 - 2020 +Canada +2015 - 2020 +Europe +France +2017 - 2020 +Germany +2017 - 2020 +Netherlands +2016 - 2020 +Spain +2015 - 2020 +United Kingdom +2016 - 2020 +Asia +China +2015 - 2020 +South Korea +2010 - 2020 +Taiwan +2015 - 2020 +Latin America +Chile +2017 - 2020 +111 +Table of Contents +23. SUPPLEMENTAL INFORMATION +Other Receivables and Current Assets +30 September 2020 2019 +Contract assets $ 55.9 $ 64.3 +Contract fulfillment costs 109.9 64.5 +Derivative instruments 97.5 142.5 +Current lease receivables 86.7 90.9 +Other 132.9 115.5 +Other receivables and current assets $ 482.9 $ 477.7 +Other Noncurrent Assets +30 September 2020 2019 +Operating lease right-of-use assets $ 376.8 $— +Deferred tax assets 115.1 115.2 +Derivative instruments 45.8 81.7 +Noncurrent customer receivable — 118.0 +Prepaid tax 19.3 17.0 +Pension benefits 26.5 28.7 +Long-term deposits on plant and equipment 100.0 — +Other 259.6 243.5 +Other noncurrent assets $ 943.1 $ 604.1 +Payables and Accrued Liabilities +30 September 2020 2019 +Trade creditors $ 546.2 $ 528.2 +Contract liabilities 313.8 247.4 +Dividends payable 296.2 255.7 +Accrued payroll and employee benefits 196.8 186.1 +Obligation for future contribution to an equity affiliate 94.4 94.4 +Current lease obligations 70.7 — +Derivative instruments 50.9 91.2 +Pension and postretirement benefits 17.9 26.0 +Other 246.3 206.7 +Payables and accrued liabilities $ 1,833.2 $ 1,635.7 +112 +Table of Contents +Other Noncurrent Liabilities +30 September 2020 2019 +Pension benefits $ 614.2 $ 651.2 +Postretirement benefits 31.4 36.0 +Operating lease liabilities (A) +335.8 — +Asset retirement obligations 236.2 201.9 +Long-term accrued income taxes related to U.S. tax reform 190.9 215.4 +Contingencies related to uncertain tax positions 138.6 123.3 +Environmental liabilities 73.6 59.1 +Contract liabilities 57.9 49.2 +Derivative instruments 34.7 21.2 +Noncurrent customer liability — 118.0 +Obligations associated with Energy-from-Waste (A) +— 57.8 +Other 202.7 179.3 +Other noncurrent liabilities $ 1,916.0 $ 1,712.4 +(A) In connection with our adoption of the new lease guidance, the presentation of our lease liability associated with our former Energy-from-Waste project has been recorded in aggregate with our other operating lease liabilities effective 1 October 2019. +Company Headquarters Relocation Income (Expense) +During the second quarter of fiscal year 2020, we sold property at our current corporate headquarters located in Trexlertown, Pennsylvania, for net proceeds of $ 44.1 . The sale was completed in anticipation of relocating our U.S. headquarters and resulted in a gain of $ 33.8 . This gain is reflected on our consolidated income statements as "Company headquarters relocation income (expense)" for the fiscal year ended 30 September 2020 and has been excluded from the results of the Corporate and other segment. +Facility Closure +In December 2018, one of our customers was subject to a government enforced shutdown due to environmental reasons. As a result, we recognized a charge of $ 29.0 during the first quarter of fiscal year 2019 primarily related to the write-off of onsite assets. This charge was reflected as “Facility closure” on our consolidated income statements for the fiscal year ended 30 September 2019 and was not recorded in segment results. +Related Party Transactions +We have related party sales to some of our equity affiliates and joint venture partners as well as other income primarily from fees charged for use of Air Products' patents and technology. Sales to and other income from related parties totaled approximately $ 335 , $ 410 , and $ 360 for the fiscal years ended 30 September 2020, 2019, and 2018, respectively. Sales agreements with related parties include terms that are consistent with those that we believe would have been negotiated at an arm’s length with an independent party. As of 30 September 2020 and 2019, our consolidated balance sheets include related party trade receivables of approximately $ 95 and $ 130 , respectively. +113 +Table of Contents +24. SUMMARY BY QUARTER (UNAUDITED) +The tables below provide unaudited selected financial data and weighted average share information for each quarter of fiscal years 2020 and 2019: +2020 Q1 Q2 Q3 Q4 Total +Sales $ 2,254.7 $ 2,216.3 $ 2,065.2 $ 2,320.1 $ 8,856.3 +Gross profit 768.1 +756.2 720.3 753.6 2,998.2 +Company headquarters relocation income (expense) (See Note 23) +— 33.8 — — 33.8 +Operating income 561.0 577.2 539.2 560.2 2,237.6 +Equity affiliates' income 58.2 88.2 +(A) +51.2 67.2 264.8 +(A) +Income tax provision 120.7 148.5 +(A) +109.3 99.9 478.4 +(A) +Income from continuing operations 488.9 504.7 457.1 494.7 1,945.4 +Loss from discontinued operations, net of tax (See Note 6) +— ( 14.3 ) — — ( 14.3 ) +Net income 488.9 490.4 457.1 494.7 1,931.1 +Net Income Attributable to Air Products +Net income from continuing operations $ 475.6 $ 492.1 $ 446.5 $ 486.8 $ 1,901.0 +Net loss from discontinued operations — ( 14.3 ) — — ( 14.3 ) +Net Income Attributable to Air Products $ 475.6 $ 477.8 $ 446.5 $ 486.8 $ 1,886.7 +Per Share Data* +Basic EPS from continuing operations $ 2.15 $ 2.22 $ 2.02 $ 2.20 $ 8.59 +Basic EPS from discontinued operations — ( 0.06 ) — — ( 0.06 ) +Basic EPS Attributable to Air Products $ 2.15 $ 2.16 $ 2.02 $ 2.20 $ 8.53 +Diluted EPS from continuing operations $ 2.14 $ 2.21 $ 2.01 $ 2.19 $ 8.55 +Diluted EPS from discontinued operations — ( 0.06 ) — — ( 0.06 ) +Diluted EPS Attributable to Air Products $ 2.14 $ 2.15 $ 2.01 $ 2.19 $ 8.49 +Weighted Average Common Shares (in millions) +Basic 220.9 221.2 221.2 221.3 221.2 +Diluted 222.2 222.3 222.4 222.6 222.3 +Dividend Information +Dividends declared per common share $ 1.16 $ 1.34 $ 1.34 $ 1.34 $ 5.18 +* EPS is calculated independently for each component and may not sum to total EPS due to rounding. +(A) Includes the impact of the enactment of India Finance Act 2020, which increased equity affiliates' income by $ 33.8 and our income tax provision by $ 20.3 . Refer to Note 22, Income Taxes , for additional information. +114 +Table of Contents +2019 Q1 Q2 Q3 Q4 Total +Sales $ 2,224.0 $ 2,187.7 $ 2,224.0 $ 2,283.2 $ 8,918.9 +Gross profit 651.0 +(A) +713.0 758.0 792.4 2,914.4 +(A) +Cost reduction actions (See Note 5) +— — 25.5 — 25.5 +Gain on exchange of equity affiliate investments (See Note 3) +— — 29.1 — 29.1 +Operating income 455.0 516.5 569.7 603.2 2,144.4 +Equity affiliates' income 52.9 46.2 56.4 59.9 215.4 +Pension settlement loss (See Note 16) +— 5.0 — — 5.0 +Income tax provision 132.1 +(B) +107.5 109.3 +(B) +131.2 480.1 +(B) +Income from continuing operations 357.0 433.5 500.2 518.7 1,809.4 +Income from discontinued operations, net of tax — — — — — +Net income 357.0 433.5 500.2 518.7 1,809.4 +Net Income Attributable to Air Products +Net income from continuing operations $ 347.5 $ 421.3 $ 488.0 $ 503.2 $ 1,760.0 +Net income from discontinued operations — — — — — +Net Income Attributable to Air Products $ 347.5 $ 421.3 $ 488.0 $ 503.2 $ 1,760.0 +Per Share Data* +Basic EPS from continuing operations $ 1.58 $ 1.91 $ 2.21 $ 2.28 $ 7.99 +Basic EPS from discontinued operations — — — — — +Basic EPS Attributable to Air Products $ 1.58 $ 1.91 $ 2.21 $ 2.28 $ 7.99 +Diluted EPS from continuing operations $ 1.57 $ 1.90 $ 2.20 $ 2.27 $ 7.94 +Diluted EPS from discontinued operations — — — — — +Diluted EPS Attributable to Air Products $ 1.57 $ 1.90 $ 2.20 $ 2.27 $ 7.94 +Weighted Average Common Shares (in millions) +Basic 219.9 220.2 220.6 220.7 220.3 +Diluted 221.0 221.4 221.9 222.1 221.6 +Dividend Information +Dividends declared per common share $ 1.10 $ 1.16 $ 1.16 $ 1.16 $ 4.58 +* EPS is calculated independently for each component and may not sum to total EPS due to rounding. +(A) Includes the impact of a facility closure charge of $ 29.0 resulting from the government enforced shutdown of a customer in December 2018. Refer to Note 23, Supplemental Information , for additional information. +(B) Includes a discrete net income tax expense of $ 43.8 , primarily recorded in the first quarter of fiscal year 2019 to finalize our estimates of the impacts of the U.S. Tax Cuts and Jobs Act. Refer to Note 22, Income Taxes , for additional information. +115 +Table of Contents +25. BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION +Our reporting segments reflect the manner in which our chief operating decision maker reviews results and allocates resources. Except in the Industrial Gases – EMEA and Corporate and other segments, each reporting segment meets the definition of an operating segment and does not include the aggregation of multiple operating segments. Our Industrial Gases – EMEA and Corporate and other segment each include the aggregation of two operating segments that meet the aggregation criteria under GAAP. +Our reporting segments are: +• Industrial Gases – Americas; +• Industrial Gases – EMEA (Europe, Middle East, and Africa); +• Industrial Gases – Asia; +• Industrial Gases – Global; and +• Corporate and other +Industrial Gases – Regional +The regional Industrial Gases segments (Americas, EMEA, and Asia) include the results of our regional industrial gas businesses, which produce and sell atmospheric gases, such as oxygen, nitrogen, and argon; process gases, such as hydrogen, helium, carbon dioxide (CO 2 ), carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide); and specialty gases. The industrial gases business also develops, builds, and operates equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +We supply gases to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. We distribute gases to our customers through a variety of supply modes including liquid or gaseous bulk supply delivered by tanker or tube trailer and, for smaller customers, packaged gases delivered in cylinders and dewars or small on-sites (cryogenic or non-cryogenic generators). For large-volume customers, we construct an on-site plant adjacent to or near the customer’s facility or deliver product from one of our pipelines. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide, and syngas. We mitigate energy, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. +The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method. The largest of these joint ventures operate in China, India, Italy, Mexico, Saudi Arabia, South Africa, and Thailand. +Each of the regional Industrial Gases segments competes against global industrial gas companies as well as regional competitors. Competition is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to larger customers. +Industrial Gases – Global +The Industrial Gases – Global segment includes activity related to the sale of cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Industrial Gases – Global segment also includes centralized global costs associated with management of all the Industrial Gases segments. These costs include Industrial Gases global administrative costs, product development costs, and research and development costs. We compete with a large number of firms for all the offerings included in the Industrial Gases – Global segment. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. +116 +Table of Contents +Corporate and other +The Corporate and other segment includes our liquefied natural gas, turbo machinery equipment and services, and distribution sale of equipment businesses as well as our corporate support functions that benefit all segments. Competition for the sale of equipment businesses is based primarily on technological performance, service, technical know-how, price, and performance guarantees. +The results of the Corporate and other segment also include income and expense that is not directly associated with the other segments, such as foreign exchange gains and losses. +In addition to assets of the global businesses included in this segment, other assets include cash, deferred tax assets, and financial instruments. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues. +Accounting Policies +The accounting policies of the segments are the same as those described in Note 1, Major Accounting Policies . We evaluate the performance of segments based upon reported segment operating income. +Business Segment Information +Industrial +Gases– +Americas Industrial +Gases– +EMEA Industrial +Gases– +Asia Industrial +Gases– +Global Corporate +and other Total +2020 +Sales $ 3,630.7 $ 1,926.3 $ 2,716.5 $ 364.9 $ 217.9 $ 8,856.3 +(A) +Operating income (loss) 1,012.4 473.3 870.3 ( 40.0 ) ( 112.2 ) 2,203.8 +(B) +Depreciation and amortization 559.5 195.9 399.4 9.6 20.6 1,185.0 +Equity affiliates' income 84.3 74.8 61.0 10.9 — 231.0 +(B) +Expenditures for long-lived assets 1,264.7 327.6 690.3 35.3 191.1 2,509.0 +Investments in net assets of and advances to equity affiliates 310.9 535.2 539.7 46.4 — 1,432.2 +Total assets 6,610.1 3,917.0 6,842.9 397.8 7,400.7 25,168.5 +2019 +Sales $ 3,873.5 $ 2,002.5 $ 2,663.6 $ 261.0 $ 118.3 $ 8,918.9 +(A) +Operating income (loss) 997.7 472.4 864.2 ( 11.7 ) ( 152.8 ) 2,169.8 +(B) +Depreciation and amortization 505.2 189.5 361.5 8.6 18.0 1,082.8 +Equity affiliates' income 84.8 69.0 58.4 3.2 — 215.4 +(B) +Expenditures for long-lived assets 545.8 216.3 1,105.5 33.8 88.3 1,989.7 +Investments in net assets of and advances to equity affiliates 301.6 493.4 445.5 35.7 — 1,276.2 +Total assets 5,832.2 3,250.8 6,240.6 325.7 3,293.5 18,942.8 +2018 +Sales $ 3,758.8 $ 2,193.3 $ 2,458.0 $ 436.1 $ 84.0 $ 8,930.2 +(A) +Operating income (loss) 927.9 445.8 689.9 53.9 ( 176.0 ) 1,941.5 +(B) +Depreciation and amortization 485.3 198.6 265.8 8.1 12.9 970.7 +Equity affiliates' income 82.0 61.1 58.3 1.9 — 203.3 +(B) +Expenditures for long-lived assets 546.5 163.1 791.9 17.3 49.6 1,568.4 +(A) The sales information noted above relates to external customers only. All intersegment sales are eliminated in consolidation. Intersegment sales are generally transacted at market pricing. We generally do not have intersegment sales from our regional industrial gases businesses. Equipment manufactured for our regional industrial gases segments are generally transferred at cost and are not reflected as an intersegment sale. +(B) Refer to the Reconciliations to Consolidated Results section below. +117 +Table of Contents +Reconciliations to Consolidated Results +Operating Income +The table below reconciles total operating income disclosed in the table above to consolidated operating income as reflected on our consolidated income statements: +Year Ended 30 September 2020 2019 2018 +Total $ 2,203.8 $ 2,169.8 $ 1,941.5 +Change in inventory valuation method — — 24.1 +Facility closure — ( 29.0 ) — +Cost reduction actions — ( 25.5 ) — +Gain on exchange of equity affiliate investments — 29.1 — +Company headquarters relocation income (expense) 33.8 — — +Consolidated Operating Income $ 2,237.6 $ 2,144.4 $ 1,965.6 +Equity Affiliates' Income +The table below reconciles total equity affiliates' income disclosed in the table above to consolidated equity affiliates' income as reflected on our consolidated income statements: +Year Ended 30 September 2020 2019 2018 +Total $ 231.0 $ 215.4 $ 203.3 +India Finance Act 2020 33.8 — — +Tax reform repatriation - equity method investment — — ( 28.5 ) +Consolidated Equity Affiliates' Income $ 264.8 $ 215.4 $ 174.8 +Geographic Information +Sales to External Customers +Year Ended 30 September 2020 2019 2018 +United States $ 3,359.6 $ 3,351.8 $ 3,149.6 +China 1,719.7 1,730.2 1,585.7 +Other foreign operations 3,777.0 3,836.9 4,194.9 +Total $ 8,856.3 $ 8,918.9 $ 8,930.2 +Long-Lived Assets (A) +30 September 2020 2019 2018 +United States $ 4,633.9 $ 3,721.3 $ 3,512.7 +China 3,719.4 3,302.6 3,066.6 +Other foreign operations 3,611.4 3,313.7 3,344.4 +Total $ 11,964.7 $ 10,337.6 $ 9,923.7 +(A) Long-lived assets represents plant and equipment, net. +Geographic information is based on country of origin. +Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. +Not applicable. +118 +Table of Contents +Item 9A. Controls and Procedures. +Disclosure Controls and Procedures +We maintain a comprehensive set of disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15(e) under the Exchange Act). Under the supervision of the Chief Executive Officer and Chief Financial Officer, our management conducted an evaluation of the effectiveness of our disclosure controls and procedures as of 30 September 2020. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of 30 September 2020, the disclosure controls and procedures were effective. +Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Management has evaluated the effectiveness of its internal control over financial reporting as of 30 September 2020 based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on that evaluation, management concluded that, as of 30 September 2020, our internal control over financial reporting was effective. Management’s Report on Internal Control over Financial Reporting is provided under Part II, Item 8, of this Form 10-K. +There was no change in our internal control over financial reporting during the fourth quarter of fiscal year 2020 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Deloitte & Touche LLP, our independent registered public accounting firm, has audited our internal control over financial reporting as of 30 September 2020. The Report of the Independent Registered Public Accounting Firm is provided under Part II, Item 8, of this Form 10-K. +Item 9B. Other Information. +On 19 November 2020, Margaret G. McGlynn informed the Company of her retirement from the Company’s Board of Directors, effective 23 November 2020. Ms. McGlynn indicated that her decision to retire was not a result of any disagreement with the Company. +PART III +Item 10. Directors, Executive Officers and Corporate Governance. +The information required by this item relating to our directors and nominees is incorporated herein by reference to the section captioned “The Board of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. The information required by this item relating to our executive officers is set forth in Item 1 of Part I of this report. +The information required by this item relating to our Audit and Finance Committee and our Audit and Finance Committee Financial Expert is incorporated herein by reference to the sections captioned “Board Structure–Standing Committees of the Board” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +The information required by this item relating to our procedures regarding the consideration of candidates recommended by shareholders and a procedure for submission of such candidates is incorporated herein by reference to the section captioned “The Board of Directors–Selection of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +The information required by the item relating to Section 16(a) Beneficial Ownership Reporting Compliance is incorporated herein by reference to the section captioned “Section 16(a) Beneficial Ownership Reporting” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +We have adopted a Code of Conduct that applies to all employees, including the Chief Executive Officer, the Chief Financial Officer, and the Principal Accounting Officer. The Code of Conduct can be found at our website at www.airproducts.com/company/governance/code-of-conduct. +119 +Table of Contents +Item 11. Executive Compensation. +The information required by this item is incorporated herein by reference to the sections captioned “Executive Compensation” and “Compensation of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by this item is incorporated herein by reference to the sections captioned "Information About Stock Ownership" and “Equity Compensation Plan Information” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +Item 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this item is incorporated herein by reference to the sections captioned “The Board of Directors–Director Independence” and “Board Practices, Processes and Policies–Transactions with Related Persons” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +Item 14. Principal Accountant Fees and Services. +The information required by this item is incorporated herein by reference to the section captioned “Fees of Independent Registered Public Accounting Firm” in the Proxy Statement for the Annual Meeting of Shareholders to be held on 28 January 2021. +PART IV +Item 15. Exhibits and Financial Statement Schedules. +(a) The documents below are filed as a part of this report: +(1) +Financial Statements. The following is a list of the Consolidated Financial Statements of Air Products and Chemicals, Inc. and its subsidiaries included in Item 8 of Part II of this report: +Report of Deloitte & Touche LLP, Independent Registered Public Accounting Firm +52 +Report of KPMG LLP, Independent Registered Public Accounting Firm +55 +Consolidated Income Statements – Years Ended 30 September 2020, 2019, and 2018 +56 +Consolidated Comprehensive Income Statements – Years Ended 30 September 2020, 2019, and 2018 +57 +Consolidated Balance Sheets – 30 September 2020 and 2019 +58 +Consolidated Statements of Cash Flows – Years Ended 30 September 2020, 2019, and 2018 +59 +Consolidated Statements of Equity – Years Ended 30 September 2020, 2019, and 2018 +60 +(2) +Financial Statement Schedules. Financial statement schedules are omitted as they are either not required or the information is otherwise included in the consolidated financial statements or notes thereto. +(3) +Exhibits. The exhibits filed as a part of this report as required by Item 601 of Regulation S-K are listed in the Index to Exhibits located on page 121 of this report. +Item 16. Form 10-K Summary. +None. +120 +Table of Contents +INDEX TO EXHIBITS +Exhibit No. Description +(3) Articles of Incorporation and Bylaws. +3.1 Restated Certificate of Incorporation of the Company. (Filed as Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 1987.)* +3.2 +Amendment to the Restated Certificate of Incorporation of the Company dated 25 January 1996. (Filed as Exhibit 3.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 1996.) * +3.3 +Amendment to the Restated Certificate of Incorporation of the Company dated 28 January 2014. (Filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended 30 June 2014.) * +3.4 +Amended and Restated Bylaws of the Company. (Filed as Exhibit 3.1 to the Company’s Current Report on Form 8-K dated 26 November 2019.)* +(4) Instruments defining the rights of security holders, including indentures. Upon request of the Securities and Exchange Commission, the Company hereby undertakes to furnish copies of the instruments with respect to its long-term debt. +4.1 +Indenture, dated as of January 10, 1995, between the Company and The Bank of New York Trust, N.A. (formerly Wachovia Bank, National Association and initially First Fidelity Bank Company, National Association), as Trustee. (Filed as Exhibit 4(a) to the Company’s Registration Statement on Form S-3 filed January 19, 1995, File No. 033-57357.) * +4.2 +Indenture, dated as of April 30, 2020, between the Company and The Bank of New York Trust Company, N.A., as Trustee (Filed as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed April 30, 2020). * +4.3 +Description of Securities +(10) Material Contracts +10.1 1990 Deferred Stock Plan of the Company, as amended and restated effective 1 October 1989. (Filed as Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 1989.)*† +10.2 +Annual Incentive Plan as Amended and Restated effective 1 October 2008. (Filed as Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended 31 March 2009.) *† +10.3 +Stock Incentive Program of the Company effective 1 October 1996. (Filed as Exhibit 10.21 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 2002.) *† +10.4 +Deferred Compensation Program for Directors, effective 7 October 2019. (Filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for quarter ended 31 December 2019.) *† +10.5 +Amended and Restated Long-Term Incentive Plan of the Company effective 1 October 2014. (Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on 23 September 2014.) *† +10.5(a) +Form of Performance Share Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2019 awards. (Filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.5(b) +Form of Performance Share Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2019 awards. (Filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.5(c) +Restricted Stock Unit Retention Award Agreement dated 3 December 2018 under the Long-Term Incentive Plan of the Company. (Filed as Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.5(d) +Form of Restricted Stock Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2020 awards. (Filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 March 2020.) *† +10.5(e) +Form of Performance Share Award Agreement under the Long-Term Incentive Plan of the Company, used for FY2020 awards. (Filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 March 2020.) *† +121 +Table of Contents +INDEX TO EXHIBITS +Exhibit No. Description +10.6 +Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 November 2017 with provisions effective 1 January 2018. (Filed as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2017.) *† +10.6(a) +Amendment No. 1 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 November 2017 with provisions effective 1 January 2018. (Filed as Exhibit 10.6(a) to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2018). *† +10.6(b) +Amendment No. 2 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 January 2019. (Filed as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.6(c) +Amendment No. 3 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 January 2019. (Filed as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2018.) *† +10.6(d) +Amendment No. 4 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 August 2019. (Filed as Exhibit 10.6D to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2019.) .*† +10.6(e) +Amendment No. 5 to the Air Products and Chemicals, Inc. Retirement Savings Plan as amended and restated effective 1 August 2019. (Filed as Exhibit 10.6E to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2019.) *† +10.7 +Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective August 1, 2014. (Filed as Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 2014.) *† +10.7(a) +Amendment No. 1 dated as of 30 September 2015 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2014. (Filed as Exhibit 10.10(a) to the Company’s Annual Report on Form 10-K for the fiscal year ended 30 September 2015.) *† +10.7(b) +Amendment No. 2 dated as of 30 September 2016 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2014. (Filed as Exhibit 10.7(b) to the Company's Annual Report on Form 10-K for fiscal year ended 30 September 2016.) *† +10.7(c) +Amendment No. 3 dated as of 26 July 2017 to the Supplementary Pension Plan of Air Products and Chemicals, Inc. as Amended and Restated effective 1 August 2017.(Filed as Exhibit 10.7(c) to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2017.) *† +10.8 +Deferred Compensation Plan as Amended and Restated effective 1 January 2018. (Filed as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2017.) *† +10.9 +Revolving Credit Facility dated as of 31 March 2017 for $2,500,000,000. (Filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended 31 March 2017.) * +10.9(a) +Amendment and Appointment of Successor Administrative Agent dated 28 September 2018 to the Revolving Credit Agreement dated 31 March 2017. (Filed as Exhibit 10.9(a) to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2018.) * +10.10 +Air Products and Chemicals, Inc. Executive Separation Program as amended effective as of 20 July 2018. (Filed as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2018.) *† +10.11 +Form of Change in Control Severance Agreement for an Executive Officer. (filed as Exhibit 10.2 of the Company's Current Report on Form 8-K dated 23 September 2014.) *† +10.12 +Compensation Program for Non-Employee Directors effective 1 July 2017. (Filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 30 June 2017.) *† +122 +Table of Contents +INDEX TO EXHIBITS +Exhibit No. Description +10.13 +Air Products and Chemicals, Inc. Corporate Executive Committee Retention Agreements effective as of 10 January 2014. (Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K dated 15 January 2014.) *† +10.14 +Amended and Restated Employment Agreement dated 14 November 2017, between the Company and Seifollah Ghasemi. (Filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed 14 November 2017.) *† +10.15 +Amendment to Employment Agreement, dated May 21, 2020, between Air Products and Chemicals, Inc. and Seifollah Ghasemi. (Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed May 21, 2020.) *† +10.16 +Senior Management Severance and Summary Plan Description effective as of 1 October 2017. (Filed as Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended 30 September 2017.) *† +10.17 +Compensation Programs for Nonemployee Directors effective 26 November 2019. (Filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended 31 December 2019.) *† +(16) Letter re change in certifying accountant +16.1 +Letter from KPMG LLP (Filed as Exhibit 16.1 to the Company’s Current Report on Form 8-K dated 26 July 2018). * +21 +Subsidiaries of the registrant. +(23) Consents of Experts and Counsel. +23.1 +Consent of Deloitte & Touche LLP, Independent Registered Public Accounting Firm. +23.2 +Consent of KPMG LLP, Independent Registered Public Accounting Firm. +24 +Power of Attorney. +(31) Rule 13a-14(a)/15d-14(a) Certifications. +31.1 +Certification by the Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2 +Certification by the Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +(32) Section 1350 Certifications. +32.1 +Certification by the Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. †† +(101) Interactive Data Files +101.INS Inline XBRL Instance Document. The XBRL Instance Document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH Inline XBRL Taxonomy Extension Schema Document. +101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase Document. +101.LAB Inline XBRL Taxonomy Extension Label Linkbase Document. +101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase Document. +101.DEF Inline XBRL Taxonomy Extension Definition Linkbase Document. +104 Cover Page Interactive Data File, formatted in Inline XBRL (included in Exhibit 101). +123 +Table of Contents +* Previously filed as indicated and incorporated herein by reference. Exhibits incorporated by reference are located in SEC File No. 001-04534 unless otherwise indicated. +† Indicated management contract or compensatory arrangement. +†† The certification attached as Exhibit 32.1 that accompanies this Annual Report on Form 10-K, is not deemed filed with the SEC and is not to be incorporated by reference into any filing of Air Products and Chemicals, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Form 10-K, irrespective of any general incorporation language contained in such filing. +124 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. +AIR PRODUCTS AND CHEMICALS, INC. +(Registrant) +By: /s/ M. Scott Crocco +M. Scott Crocco +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +Date: 19 November 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature and Title Date +/s/ Seifi Ghasemi 19 November 2020 +(Seifi Ghasemi) +Director, Chairman, President, and +Chief Executive Officer +(Principal Executive Officer) +/s/ Russell A. Flugel 19 November 2020 +(Russell A. Flugel) +Senior Vice President, Corporate Controller, and Principal Accounting Officer +* 19 November 2020 +(Susan K. Carter) +Director +* 19 November 2020 +(Charles I. Cogut) +Director +* 19 November 2020 +(Lisa A. Davis) +Director +* 19 November 2020 +(Chad C. Deaton) +Director +125 +Table of Contents +Signature and Title Date +* 19 November 2020 +(David H. Y. Ho) +Director +* 19 November 2020 +(Margaret G. McGlynn) +Director +* 19 November 2020 +(Edward L. Monser) +Director +* 19 November 2020 +(Matthew H. Paull) +Director +* Sean D. Major, Executive Vice President, General Counsel and Secretary, by signing his name hereto, does sign this document on behalf of the above noted individuals, pursuant to a power of attorney duly executed by such individuals, which is filed with the Securities and Exchange Commission herewith. +/s/ Sean D. Major +Sean D. Major +Executive Vice President, General Counsel and Secretary +Date: 19 November 2020 +126 \ No newline at end of file diff --git a/raw/filings/0000002969/2020/0000002969-20-000049/filing_metadata.csv b/raw/filings/0000002969/2020/0000002969-20-000049/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..de03d969b61838ca4fcce7bd027a83e67c8dc18a --- /dev/null +++ b/raw/filings/0000002969/2020/0000002969-20-000049/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000002969,APD,"Air Products & Chemicals, Inc.",2020,10-K,2020-11-19,2020-09-30,2020-11-19T20:29:11.000Z,0000002969-20-000049,apd-20200930.htm,FORM 10-K,25160934,1,1,https://www.sec.gov/Archives/edgar/data/2969/000000296920000049/apd-20200930.htm,https://www.sec.gov/Archives/edgar/data/2969/000000296920000049/ diff --git a/raw/filings/0000002969/2020/0000002969-20-000049/item1.txt b/raw/filings/0000002969/2020/0000002969-20-000049/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..dbb5840b7b5008a624a641820723915119415696 --- /dev/null +++ b/raw/filings/0000002969/2020/0000002969-20-000049/item1.txt @@ -0,0 +1,68 @@ +Item 1. Business. +Air Products and Chemicals, Inc., a Delaware corporation originally founded in 1940, serves customers globally with a unique portfolio of products, services, and solutions that include atmospheric gases, process and specialty gases, equipment, and services. We are the world’s largest supplier of hydrogen and have built leading positions in growth markets such as helium and liquefied natural gas ("LNG") process technology and equipment. We also develop, engineer, build, own and operate some of the world’s largest industrial gas projects, including gasification projects that sustainably convert abundant natural resources into syngas for the production of high-value power, fuels and chemicals, carbon capture projects, and world-scale carbon-free hydrogen projects supporting global transportation and the energy transition. +As used in this report, unless the context indicates otherwise, the terms “we,” “our,” “us,” the “Company,” "Air Products," or “registrant” include controlled subsidiaries, affiliates, and predecessors of Air Products and our controlled subsidiaries and affiliates. +During the fiscal year ended 30 September 2020 (“fiscal year 2020”), we reported our continuing operations in five reporting segments under which we managed our operations, assessed performance, and reported earnings: Industrial Gases – Americas; Industrial Gases – EMEA (Europe, Middle East, and Africa); Industrial Gases – Asia; Industrial Gases – Global; and Corporate and other. +Except as otherwise noted, the description of our business below reflects our continuing operations. Refer to Note 6, Discontinued Operations , to the consolidated financial statements for activity associated with discontinued operations. +Industrial Gases Business +Our Industrial Gases business produces atmospheric gases, such as oxygen, nitrogen, and argon, process gases, such as hydrogen, helium, carbon dioxide (CO 2 ), carbon monoxide, and syngas, and specialty gases. Atmospheric gases are produced through various air separation processes of which cryogenic is the most prevalent. Process gases are produced by methods other than air separation. For example, hydrogen, carbon monoxide and syngas are produced by steam methane reforming of natural gas and by the gasification of liquid and solid hydrocarbons. Hydrogen is produced by purifying byproduct sources obtained from the chemical and petrochemical industries; and helium is produced as a byproduct of gases extracted from underground reservoirs, primarily natural gas, but also CO 2 purified before resale. The Industrial Gases business also develops, builds and operates equipment for the production or processing of gases, such as air separation units and non-cryogenic generators. +4 +Table of Contents +Our Industrial Gases business is organized and operated regionally. The regional Industrial Gases segments (Americas, EMEA, and Asia) supply gases and related equipment in the relevant region to diversified customers in many industries, including those in refining, chemical, gasification, metals, electronics, manufacturing, and food and beverage. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels as well as in the developing mobility markets. The chemicals industry uses hydrogen, oxygen, nitrogen, carbon monoxide, and syngas as feedstocks in the production of many basic chemicals. The energy production industry uses nitrogen injection for enhanced recovery of oil and natural gas and oxygen for gasification. Oxygen is used in combustion and industrial heating applications, including in the gasification, steel, certain nonferrous metals, glass, and cement industries. Nitrogen applications are used in food processing for freezing and preserving flavor and nitrogen for inerting is used in various fields, including the metals, chemical, and semiconductor industries. Helium is used in laboratories and healthcare for cooling and in other industries for pressurizing, purging, and lifting. Argon is used in the metals and other industries for its unique inerting, thermal conductivity, and other properties. Industrial gases are also used in welding and providing healthcare and are utilized in various manufacturing processes to make them more efficient and to optimize performance. +Industrial gases are generally produced at or near the point of use given the complexity and inefficiency with storing molecules at low temperatures. Helium, however, is generally sourced globally, at long distances from point of sale. As a result, we maintain an inventory of helium stored in our fleet of ISO containers as well as the U.S. Bureau of Land Management underground storage facility in Amarillo, Texas. +We distribute gases to our sale of gas customers through different supply modes depending on various factors including the customer's volume requirements and location. Our supply modes are as follows: +• Liquid Bulk — Product is delivered in bulk (in liquid or gaseous form) by tanker or tube trailer and stored, usually in its liquid state, in equipment that we typically design and install at the customer’s site for vaporizing into a gaseous state as needed. Liquid bulk sales are usually governed by three- to five-year contracts. +• Packaged Gases — Small quantities of product are delivered in either cylinders or dewars. We operate packaged gas businesses in Europe, Asia, and Latin America. In the United States, our packaged gas business sells products (principally helium) only for the electronics and magnetic resonance imaging industries. +• On-Site Gases — Large quantities of hydrogen, nitrogen, oxygen, carbon monoxide, and syngas (a mixture of hydrogen and carbon monoxide) are provided to customers, principally in the energy production and refining, chemical, gasification, and metals industries worldwide, that require large volumes of gases and have relatively constant demand. Gases are produced at large facilities located adjacent to customers’ facilities or by pipeline systems from centrally located production facilities and are generally governed by 15- to 20- year contracts. We also deliver small quantities of product through small on-site plants (cryogenic or non-cryogenic generators), typically either via a 10- to 15- year sale of gas contract or through the sale of the equipment to the customer. +Electricity is the largest cost component in the production of atmospheric gases. Steam methane reformers utilize natural gas as the primary raw material and gasifiers use liquid and solid hydrocarbons as the principal raw material for the production of hydrogen, carbon monoxide and syngas. We mitigate electricity, natural gas, and hydrocarbon price fluctuations contractually through pricing formulas, surcharges, and cost pass-through and tolling arrangements. During fiscal year 2020, no significant difficulties were encountered in obtaining adequate supplies of power and natural gas. +We obtain helium from a number of sources globally, including crude helium for purification from the U.S. Bureau of Land Management's helium reserve. +The regional Industrial Gases segments also include our share of the results of several joint ventures accounted for by the equity method, which are reported in our financial statements as income from equity affiliates. The largest of these joint ventures operate in China, India, Italy, Mexico, Saudi Arabia, South Africa, and Thailand. +5 +Table of Contents +Each of the regional Industrial Gases segments competes against three global industrial gas companies: Air Liquide S.A., Messer and Linde plc (the successor to Praxair, Inc. and Linde AG, pursuant to a combination that became effective on 31 October 2018), as well as regional competitors. Competition in Industrial Gases is based primarily on price, reliability of supply, and the development of industrial gas applications. We derive a competitive advantage in locations where we have pipeline networks, which enable us to provide reliable and economic supply of products to our larger customers. +Overall regional industrial gases sales constituted approximately 94%, 96%, and 94% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively. Sales of atmospheric gases constituted approximately 47%, 46%, and 46% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively, while sales of tonnage hydrogen, syngas, and related products constituted approximately 22%, 26%, and 25% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively. +Industrial Gases Equipment +We design and manufacture equipment for air separation, hydrocarbon recovery and purification, natural gas liquefaction, and liquid helium and liquid hydrogen transport and storage. The Industrial Gases – Global segment includes activity related to the sale of cryogenic and gas processing equipment for air separation. The equipment is sold worldwide to customers in a variety of industries, including chemical and petrochemical manufacturing, oil and gas recovery and processing, and steel and primary metals processing. The Corporate and other segment includes three global equipment businesses: our LNG equipment business, our Gardner Cryogenics business fabricating helium and hydrogen transport and storage containers, and our Rotoflow business, which manufactures turboexpanders and other precision rotating equipment. Steel, aluminum, and capital equipment subcomponents (compressors, etc.) are the principal raw materials in the manufacturing of equipment. Raw materials for individual projects typically are acquired under firm purchase agreements. Equipment is produced at our manufacturing sites with certain components being procured from subcontractors and vendors. Competition in the equipment business is based primarily on technological performance, service, technical know-how, price, and performance guarantees. Sale of equipment constituted approximately 6%, 4%, and 6% of consolidated sales in fiscal years 2020, 2019, and 2018, respectively. +The backlog of equipment orders was approximately $1.6 billion on 30 September 2020 (as compared to a total backlog of approximately $0.9 billion on 30 September 2019). We estimate that approximately 50% of the total equipment sales backlog as of 30 September 2020 will be recognized as revenue during fiscal year 2021, dependent on execution schedules of the relevant projects. +International Operations +Through our subsidiaries, affiliates, and joint ventures accounted for using the equity method, we conduct business in 53 countries outside the United States. Our international businesses are subject to risks customarily encountered in foreign operations, including fluctuations in foreign currency exchange rates and controls, tariffs, trade sanctions, and import and export controls, and other economic, political, and regulatory policies of local governments described in Item 1A, Risk Factors, below. +We have majority or wholly owned foreign subsidiaries that operate in Canada; 18 European countries (including the Netherlands, Spain, and the United Kingdom); 11 Asian countries (including China, South Korea, and Taiwan); seven Latin American countries (including Brazil and Chile); six countries in the Middle East (including Saudi Arabia), and three African countries. We also own less-than-controlling interests in entities operating in Europe, Asia, Latin America, the Middle East, and Africa (including China, Germany, India, Italy, Mexico, Oman, Saudi Arabia, South Africa, and Thailand). +Financial information about our foreign operations and investments is included in Note 8, Summarized Financial Information of Equity Affiliates ; Note 22, Income Taxes ; and Note 25, Business Segment and Geographic Information , to the consolidated financial statements included under Item 8, below. Information about foreign currency translation is included under “Foreign Currency” in Note 1, Major Accounting Policies , and information on our exposure to currency fluctuations is included in Note 13, Financial Instruments , to the consolidated financial statements, included under Item 8, below, and in “Foreign Currency Exchange Rate Risk,” included under Item 7A, below. +6 +Table of Contents +Technology Development +We pursue a market-oriented approach to technology development through research and development, engineering, and commercial development processes. It conducts research and development principally in its laboratories located in the United States (Trexlertown, Pennsylvania), the United Kingdom (Basingstoke and Carrington), Spain (Barcelona), China (Shanghai), and Saudi Arabia (Dhahran). We also fund and cooperate in research and development programs conducted by a number of major universities and undertake research work funded by others, including the United States government. +Development of technology for use within the Industrial Gases business focuses primarily on new and improved processes and equipment for the production and delivery of industrial gases and new or improved applications for industrial gas products. +During fiscal year 2020, we owned approximately 850 United States patents, approximately 3,600 foreign patents, and were a licensee under certain patents owned by others. While the patents and licenses are considered important, we do not consider our business as a whole to be materially dependent upon any particular patent, patent license, or group of patents or licenses. +Environmental Regulation +We are subject to various environmental laws and regulations in the countries in which we have operations. Compliance with these laws and regulations results in higher capital expenditures and costs. In the normal course of business, we are involved in legal proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA," the federal Superfund law); Resource Conservation and Recovery Act ("RCRA"); and similar state and foreign environmental laws relating to the designation of certain sites for investigation or remediation. Our accounting policy for environmental expenditures is discussed in Note 1, Major Accounting Policies , and environmental loss contingencies are discussed in Note 17, Commitments and Contingencies , to the consolidated financial statements, included under Item 8, below. +Some of our operations are within jurisdictions that have or are developing regulatory regimes governing emissions of greenhouse gases (“GHG”), including CO 2 . These include existing coverage under the European Union Emission Trading System, the California cap and trade scheme, China’s Emission Trading Scheme and its nation-wide expansion, and South Korea’s Emission Trading Scheme. In the Netherlands, a CO 2 emissions tax will come into force on 1 January 2021. In Canada, Alberta’s Technology Innovation and Emission Reduction (“TIER”) System went into effect 1 January 2020. In Ontario, Environment & Climate Change Canada’s ("ECCC”) Output Based Pricing System (“OBPS”) is currently in effect, however, on 20 September 2020, ECCC granted approval of Ontario’s GHG Emissions Performance Standards program, which will be used in lieu of adherence to the OBPS, with the effective date to be determined. In addition, the U.S. Environmental Protection Agency (“EPA”) requires mandatory reporting of GHG emissions and is regulating GHG emissions for new construction and major modifications to existing facilities. Some jurisdictions have various mechanisms to target the power sector to achieve emission reductions, which often result in higher power costs. +Increased public concern may result in more international, U.S. federal, and/or regional requirements to reduce or mitigate the effects of GHG emissions. Although uncertain, these developments could increase our costs related to consumption of electric power, hydrogen production and application of our gasification technology. We believe we will be able to mitigate some of the increased costs through contractual terms, but the lack of definitive legislation or regulatory requirements prevents an accurate estimate of the long-term impact these measures will have on our operations. Any legislation that limits or taxes GHG emissions could negatively impact our growth, increase our operating costs, or reduce demand for certain of our products. +Regulation of GHG may also produce new opportunities for us. We continue to develop technologies to help our facilities and our customers lower energy consumption, improve efficiency and lower emissions. We see significant opportunities for gasification, carbon capture technologies and hydrogen for mobility and energy transition. +We estimate that we spent approximately $4 million, $5 million, and $3 million in fiscal years 2020, 2019, and 2018, respectively, on capital projects reflected in continuing operations to control pollution. Capital expenditures to control pollution are estimated to be approximately $6 million in both fiscal years 2021 and 2022. +For additional information regarding environmental matters, refer to Item 7, “ Management’s Discussion and Analysis of Financial Condition and Results of Operations – Environmental Matters ” and Note 17, Commitments and Contingencies , to the consolidated financial statements. +7 +Table of Contents +Employees +We believe our employees are our most valuable asset and are critical to our success as an organization. Our goal is to be the safest, most diverse and most profitable industrial gas company in the world, providing excellent service to our customers. Integral to our success is the continued development of our 4S culture (Safety, Speed, Simplicity and Self-Confidence) and creating a work environment where all employees feel that they belong and matter. Our talent related initiatives, including employee recruitment and development, diversity and inclusion and compensation and benefit programs, are focused on building and retaining the world-class and talented staff that is needed to meet our goals. +On 30 September 2020 we had approximately 19,275 employees, of whom approximately 19,000 were full-time and of whom approximately 14,150 were located outside the United States. We have collective bargaining agreements with unions at certain locations that expire on various dates over the next four years. We consider relations with our employees to be good. +We value the contributions of our employees, particularly in the face of the challenges posed by the COVID-19 pandemic. Many of our employees are on the front line during the pandemic, keeping our plants running and delivering to our customers the products they need. When possible, employees have been working from home to help maintain their health and safety as well as business continuity. We have not laid off any of our employees or reduced their salaries due to COVID-19. +In October 2020, we announced goals to further increase the percentage of women and U.S. minorities in professional and managerial roles. By 2025, we aim to achieve at least 28 percent female representation in the professional and managerial population globally, and at least 20 percent minority representation in that same population in the United States. These measures are increases from 25 and 17 percent representation (2020 baseline), respectively. We established these new targets following analysis of our global employee representation metrics and future talent needs, as well as assessing industry benchmarks and peer companies. +Seasonality +Our businesses are not subject to seasonal fluctuations to any material extent. +Inventories +We maintain limited inventory where required to facilitate the supply of products to customers on a reasonable delivery schedule. Inventory consists primarily of crude helium, industrial gas, and specialty gas inventories supplied to customers through liquid bulk and packaged gases supply modes. +Customers +We do not have a homogeneous customer base or end market, and no single customer accounts for more than 10% of our consolidated revenues. We do have concentrations of customers in specific industries, primarily refining, chemicals, and electronics. Within each of these industries, we have several large-volume customers with long-term contracts. A negative trend affecting one of these industries, or the loss of one of these major customers, although not material to our consolidated revenue, could have an adverse impact on our financial results. +Governmental Contracts +Our business is not subject to a government entity’s renegotiation of profits or termination of contracts that would be material to our business as a whole. +Available Information +All periodic and current reports, registration statements, proxy statements, and other filings that we are required to file with the Securities and Exchange Commission ("SEC"), including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), are available free of charge through our website at www.airproducts.com. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC. All such reports filed during the period covered by this report were available on our website on the same day as filing. In addition, our filings with the SEC are available free of charge on the SEC's website, www.sec.gov. +8 +Table of Contents +Our Executive Officers +Our executive officers and their respective positions and ages on 19 November 2020 follow. Information with respect to offices held is stated in fiscal years. +Name Age Office +M. Scott Crocco 56 Executive Vice President and Chief Financial Officer (became Executive Vice President and Chief Financial Officer in 2016; Senior Vice President and Chief Financial Officer in 2013; and Vice President and Corporate Controller in 2008). +Seifi Ghasemi 76 Chairman, President, and Chief Executive Officer (became Chairman, President and Chief Executive Officer in 2014 and previously served as Chairman and Chief Executive Officer of Rockwood Holdings, Inc. from 2001 to 2014). Mr. Ghasemi is a member and Chairman of the Board of Directors and the Chairman of the Executive Committee of the Board of Directors. +Sean D. Major 56 Executive Vice President, General Counsel and Secretary (Executive Vice President and General Counsel since May 2017 and Secretary since December 2017). Previously, Mr. Major served as Executive Vice President, General Counsel and Secretary for Joy Global Inc. from 2007 to 2017. +Dr. Samir J. Serhan 59 Executive Vice President and Chief Operating Officer (Executive Vice President since December 2016 and Chief Operating Officer since May 2020). Dr. Serhan served as President, Global HyCO, from 2014 to 2016 for Praxair Inc. From 2000-2014, he worked in leadership positions in the U.S. and Germany for The Linde Group, including as Managing Director of Linde Engineering from 2008-2014. \ No newline at end of file diff --git a/raw/filings/0000002969/2020/0000002969-20-000049/item13.txt b/raw/filings/0000002969/2020/0000002969-20-000049/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..0c0c9562678de1ec5cf335089c293a2fac03d5ec --- /dev/null +++ b/raw/filings/0000002969/2020/0000002969-20-000049/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +120 \ No newline at end of file diff --git a/raw/filings/0000003197/2018/0001564590-19-006619/filing.txt b/raw/filings/0000003197/2018/0001564590-19-006619/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..7362793f4a8769d7a44a805a8528879208a53907 --- /dev/null +++ b/raw/filings/0000003197/2018/0001564590-19-006619/filing.txt @@ -0,0 +1,5038 @@ +10-K +1 +cece-10k_20181231.htm +10-K +cece-10k_20181231.htm +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark one) +☒ +Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the fiscal year ended December 31, 2018 +or +☐ +Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the transition period from to +Commission File No. 0-7099 +CECO ENVIRONMENTAL CORP. +Delaware +13-2566064 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +14651 North Dallas Parkway +Suite 500 +Dallas, Texas +75254 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: (214) 357-6181 +Securities registered under Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock, $0.01 par value per share +The NASDAQ Stock Market LLC +Securities registered under Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer +☐ +Accelerated Filer +☒ +Non-Accelerated Filer +☐ +Smaller reporting company +☒ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant was $162.7 million based upon the closing market price and shares of common stock outstanding as of June 29, 2018, the last business day of our most recently completed second fiscal quarter. For the purpose of the foregoing calculation only, all directors and executive officers of the registrant and owners of more than 10% of the registrant’s common stock are assumed to be affiliates of the registrant. This determination of affiliate status is not necessarily conclusive for any other purpose. +As of February 28, 2019, the registrant had 34,979,895 shares of common stock, par value $0.01 per share, outstanding. +Documents Incorporated by Reference +Portions of the definitive Proxy Statement for the 2019 Annual Meeting of Stockholders, which is to be filed with the Securities and Exchange Commission within 120 days of the fiscal year ended December 31, 2018, are incorporated by reference into Part III of this Annual Report to the extent described herein. +C ECO Environmental Corp . and Subsidiaries +ANNUAL REPORT ON FORM 10-K +For the year ended December 31, 2018 +TABLE OF CONTENTS +Item +Description +Page +PART I. +Item 1. +Business +2 +Item 1A. +Risk Factors +9 +Item 1B. +Unresolved Staff Comments +19 +Item 2. +Properties +20 +Item 3. +Legal Proceedings +20 +Item 4. +Mine Safety Disclosures +21 +PART II. +Item 5. +Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +22 +Item 6. +Selected Financial Data +23 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +24 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +40 +Item 8. +Financial Statements and Supplementary Data +41 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +41 +Item 9A. +Controls and Procedures +41 +Item 9B. +Other Information +44 +PART III. +Item 10. +Directors, Executive Officers and Corporate Governance +45 +Item 11. +Executive Compensation +45 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +45 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +45 +Item 14. +Principal Accounting Fees and Services +45 +PART IV. +Item 15. +Exhibits and Financial Statement Schedules +45 +Item 16. +Form 10-K Summary +47 +SIGNATURES +48 +CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS +This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”) which are intended to be covered by the safe harbor for "forward-looking statements" provided by the Private Securities Litigation Reform Act of 1995. Any statements contained in this Annual Report on Form 10-K, other than statements of historical fact, including statements about management’s beliefs and expectations, are forward-looking statements and should be evaluated as such. These statements are made on the basis of management’s views and assumptions regarding future events and business performance. We use words such as “believe,” “expect,” “anticipate,” “intends,” “estimate,” “forecast,” “project,” “will,” “plan,” “should” and similar expressions to identify forward-looking statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from any future results, performance or achievements expressed or implied by such statements. Potential risks and uncertainties, among others, that could cause actual results to differ materially are discussed under “Part I – Item 1A. Risk Factors” of this Annual Report on Form 10-K and include, but are not limited to: our ability to successfully realize the expected benefits of our restructuring program; our ability to successfully integrate acquired businesses and realize the synergies from acquisitions, as well as a number of factors related to our business, including economic and financial market conditions generally and economic conditions in our service areas; dependence on fixed price contracts and the risks associated therewith, including actual costs exceeding estimates and method of accounting for revenue; fluctuations in operating results from period to period due to cyclicality or seasonality of the business; the effect of growth on our infrastructure, resources, and existing sales; the ability to expand operations in both new and existing markets; the potential for contract delay or cancellation; liabilities arising from faulty services or products that could result in significant professional or product liability, warranty, or other claims; changes in or developments with respect to any litigation or investigation; failure to meet timely completion or performance standards that could result in higher cost and reduced profits or, in some cases, losses on projects; the potential for fluctuations in prices for manufactured components and raw materials, including as a result of tariffs and surcharges; the substantial amount of debt incurred in connection with our acquisitions and our ability to repay or refinance it or incur additional debt in the future; the impact of federal, state or local government regulations; economic and political conditions generally; our ability to successfully complete the divestitures of non-core assets and the effect of competition in the industries served by our Energy Solutions segment, Industrial Solutions segment and Fluid Handling Solutions segment. Many of these risks are beyond management’s ability to control or predict. Should one or more of these risks or uncertainties materialize, or should the assumptions prove incorrect, actual results may vary in material aspects from those currently anticipated. Investors are cautioned not to place undue reliance on such forward-looking statements as they speak only to our views as of the date the statement is made. Furthermore, forward-looking statements speak only as of the date they are made. Except as required under the federal securities laws or the rules and regulations of the Securities and Exchange Commission (the “SEC”), we undertake no obligation to update or review any forward-looking statements, whether as a result of new information, future events or otherwise. +1 +PART I +Item 1. +Business +General +CECO Environmental Corp. (“CECO” or the “Company”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customer’s mission critical applications. The secular growth industries CECO serves include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +To achieve our mission of being a world-class global leader in industrial air quality and fluid handling, we strive to maximize the availability, reliability and efficiency of our customers’ operating assets. Additionally, we continue to focus on increasing our recurring revenue stream from aftermarket parts and services, as well as continuously improving the efficiencies and capabilities of our technologies. +CECO has over $5 billion of installed equipment base with end users, which we target to expand and grow a higher recurring revenue of aftermarket products and services. We also focus on operational excellence strategies as a central theme to improving our earnings and cash flows. +We believe we succeed because of the relationships we have developed, the long history of performance and reliability of our systems and products, our ability to deliver products in compliance with our customers’ needs and our advanced technical engineering capabilities on complex projects. We work closely with our customers to design, custom-engineer and fabricate our systems and products to meet their specific needs. +Our customers include some of the largest natural gas processors, transmission and distribution companies, refineries, power generators, boiler manufacturers, compressor manufacturers, metals and minerals, industrial manufacturing, engineering and construction companies in the world. +We believe our value differentiators include, but are not limited to, reliable product performance, timely delivery, customer satisfaction, and advanced engineering. We believe these are critical in maintaining our competitive position and have adopted a spirit of continuous improvement to ensure we maintain our market leadership position. +CECO was incorporated in the State of New York in 1966 and reincorporated in the State of Delaware in January 2002. The Company has been publicly traded since January 1, 1978 and its common stock trades on the NASDAQ Stock Market under the symbol “CECE.” +Industry Overview +We serve a multi-billion dollar global market that is highly fragmented and serves various end markets including power generation, natural gas power plants, petrochemical processing, general industrial, refining, oil & gas and wastewater treatment. +We believe demand for our products and services will continue to be driven by the following factors: +• +Global Economic Conditions. The Company’s businesses are impacted by economic conditions around the globe. Higher economic growth and other factors that would increase industrial gross domestic product and capital expenditures are projected to impact the markets the Company serves and could affect the Company’s businesses by increasing demand for the Company’s products and services. +• +Worldwide Industrialization . Global trade has increased significantly over the last decade and is driven by growth in emerging markets, including China and India, as well as other developing nations in Asia and the Europe, Middle East, and Africa (“EMEA”) region. As a result of globalization, manufacturing that was historically performed domestically continues to migrate to lower cost countries. This movement of the manufacture of goods throughout the world increases demand for industrial ventilation products as new construction continues. We expect that more rigorous environmental +2 +regulations will be introduced to create a cleaner working environment and reduce environmental emissions as these economies evolve. +• +Natural Gas Infrastructure . The natural gas industry consists of the exploration, production, processing, transportation, storage and distribution of natural gas. The International Energy Association (“IEA”) projects a pronounced shift in Organization for Economic Cooperation and Development (“OECD”) countries away from oil and coal towards natural gas and renewables. Natural gas continues to be the fuel of choice for the electrical power and industrial sectors in many of the world’s regions, in part because of its lower carbon intensity compared with coal and oil, which makes it an attractive fuel source in countries where governments are implementing policies to reduce greenhouse gas emissions. +Natural gas delivery is a complex process that refines raw natural gas for industrial, commercial or residential uses. Initially, raw natural gas is extracted from the earth and cleansed of contaminants such as dirt and water at the well site. The natural gas is then transported through a gathering facility to a processing facility, where it is processed to meet quality standards set by pipeline and distribution companies, such as specified levels of solids, liquids and other gases. After processing, the natural gas is transmitted for storage or through an extensive network of pipelines to consumers. +• +Power Generation. Power generation encompasses a broad range of activities related to the production of electricity. The primary types of fuel used to generate electricity are coal, natural gas and nuclear. In the United States, concerns about potential environmental regulations enhance the attractiveness of natural gas-fired power plants compared with coal-fired power plants, which generally have higher pollutant emission rates than natural gas-powered plants. Natural gas-fired power plants have lower initial capital needs and are more flexible in terms of operating times than coal plants. +• +Refining, Oil Production and Petrochemical Processing . Refining, oil production and petrochemical processing involves the producing, refining and processing of fuels and chemicals for use in a variety of applications, such as gasoline, fertilizers and plastics. In response to increasing international demand for petrochemicals and refined products, companies are producing more products from new sources, constructing new refineries and petrochemical processing facilities as well as expanding existing facilities. In many cases, these new and expanded facilities must comply with stricter environmental regulations, which influence both choice of fuel and demand for systems to control exhaust emissions. These facilities use a broad range of our products and systems, including our selective catalytic reduction (“SCR”) pollution reduction systems, oily water treatment systems and separation and filtration products and our fluid catalytic cracking cyclone technology. +• +Stringent Regulatory Environment . The adoption of increasingly stringent environmental regulations globally requires businesses to pay strict attention to environmental protection. Businesses and industries of all types from refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing must comply with these various international, federal, state and local government regulations or potentially face substantial fines or be forced to suspend production or alter their production processes. These increasingly stringent environmental regulations are a principal factor that drives our business. +These factors, individually or collectively, tend to cause increases in industrial capital spending that are not directly impacted by general economic conditions, expansion, or capacity increases. In contrast, favorable conditions in the economy generally lead to plant expansions and the construction of new industrial sites. However, in a weak economy, customers tend to lengthen the time from their initial inquiry to the purchase order or defer purchases. +Mission and Strategy +Our mission is to help companies grow their business with safe, clean and more efficient solutions that help protect people and our shared environment. +We seek to fulfill this mission through established global leadership in air quality and fluid handling solutions focused on serving the energy, industrial, and other niche markets around the world. We will continue to leverage our innovative technology and application expertise to customers around the world. We work to improve air quality, optimize the energy value chain, and provide custom engineered solutions for applications including oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing along with a wide range of other applications. +Our strategy to become the global leader in air quality and fluid handling solutions is to drive an operating environment of performance excellence across the Company with a near term focus on targeted value creation enablers, and growth-oriented business segment performance. +3 +Four Value Creation Enablers Driving Growth : +All four of these are inter-connected and critical to achieving our objectives. +• +Outside-In Leadership is all about an increased attention on our customers and the trends affecting the world around us as we make decisions that enable our organization to be responsive and with an orientation for growth. +• +Innovation is about us finding better ways to help our customers get their jobs done – whether that is a new product and technology or the way we serve and work with them. +• +Simplification involves aligning and streamlining our operational practices and metrics to match our customers’ key performance indicators (“KPIs”) for success and removing complexity from our systems and structure. +• +Active Portfolio Management dictates a regular evaluation of our business units for market attractiveness and profitability together with scanning the market for attractive potential additions that strengthen the long-term outlook of the Company. +Three Business Segments: +The Company executes and reports in three reportable segments focused on attractive end markets. Each segment is aligned to generate profitable growth for the Company across a targeted industry with a compelling technology and solution set to benefit customers. Additionally, we seek to protect and deepen our end user relationships by expanding our aftermarket services with long-term service contracts that deliver a full life-cycle of customer support. +• +Energy Solutions segment: Serves the energy market, where we are a key part of helping meet the global demand for clean energy with products and services that support our customers with efficient solutions and technologies to keep the world clean and safe. Our offerings improve air quality with market leading, highly engineered, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Serves the industrial pollution control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings improve air quality with a compelling solution set of air pollution control technologies that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Competitive Strengths +Leading market position as a complete solution provider . We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. The multi-billion dollar global market is highly fragmented with numerous small and regional contracting firms separately supplying engineering services, fabrication, installation, testing and monitoring, products and spare parts. We offer our customers a complete end-to-end solution, including engineering and project management services, procurement and fabrication, construction and installation, aftermarket support, and sale of consumables, which allows our customers to avoid dealing with multiple vendors when managing projects. +Long-standing experience and customer relationships in growing industry . We have serviced the needs of our target markets for over 50 years. Our extensive experience and expertise in providing diversified solutions enhances our overall customer relationships, and provides us with a competitive advantage in our markets relative to other companies in the industry. We believe this is evidenced by strong relationships with many of our world-class customers. We believe no single competitor has the resources to offer a similar portfolio of product and service capabilities. We offer the depth of a large organization, while our lean organizational structure keeps us close to our customers and markets, allowing us to offer rapid and complete solutions in each unique situation. +Global diversification and broad customer base. The global diversity of our operations and customer base provides us with multiple growth opportunities. As of December 31, 2018, we had a diversified customer base of approximately 4,200 active customers +4 +across a range of industries. Our customers represent some of the largest refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing companies. We believe that the diversity of our customers and end markets mitig ates our risk of a potential fluctuation or downturn in demand from any individual industry or particular customer. We believe we have the resources and capabilities to meet the needs of our customers as they upgrade and expand domestically as well as into new international markets. Once systems have been installed and a relationship has been established with the customer, we are often awarded repetitive service and maintenance business as the customers’ processes change and modifications or additions to th eir systems become necessary. +Experienced management and engineering team. Our senior management team has substantial experience in industrial air quality and fluid handling solutions. The business experience of our management team enables us to pursue our strategy. Our senior management team is supported by a strong operating management team, which possesses extensive operational and managerial experience. Our workforce includes approximately 200 engineers, designers, and project managers whose significant specialized industry experience and technical expertise enables them to have a deep understanding of the solutions that will best suit the needs of our customers. The experience and stability of our management, operating and engineering teams have been crucial to our growth, developing and maintaining customer relationships, and increasing our market share. +Expand customer base and penetrate end markets through global market coverage . We constantly look for opportunities to gain new customers and penetrate geographic locations and end markets with existing products and services or acquire new product or service opportunities. We intend to continue to expand our sales force, customer base, and end markets, and have continued to pursue potential attractive growth opportunities both domestically and globally, including international projects in Asia, South America, and EMEA. +Develop innovative solutions . We intend to continue to leverage our engineering and manufacturing expertise and strong customer relationships to develop new customized products to address the identified needs of our customers or a particular end market. We thoroughly analyze new product opportunities by considering projected demand for the product or service, price point, and expected operating costs, and only pursue those opportunities that we believe will contribute to earnings growth in the near-term. In addition, we continually improve our traditional technologies and adapt them to new industries and processes. +Maintain strong customer focus . We enjoy a diversified customer base of approximately 4,200 active customers across a broad base of industries, including power, municipalities, chemical, industrial manufacturing, refining, petrochemical, metals, minerals and mining, hospitals and universities. We believe that there are multiple opportunities for us to expand our penetration of existing markets and customers. +Disciplined acquisition program with successful integration . We believe that we have demonstrated an ability to successfully acquire and integrate companies with complementary product or service offerings. We will continue to seek and execute additional strategic acquisitions and focus on expanding our product service and breadth, as well as entering into new adjacent markets. We believe that the breadth and diversity of our products and services and our ability to deliver full solutions to various end markets provides us with multiple sources of stable growth and a competitive advantage relative to other players in the industry. +Products and Services +We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that control emissions from such facilities, as well as fluid handling and filtration systems. We provide a wide spectrum of products and services including dampers and diverters, selective catalytic reduction and selective non-catalytic reduction systems, cyclonic technology, thermal oxidizers, filtration systems, scrubbers, fluid handling equipment and plant engineering services and engineered design build fabrication. +Project Design and Research and Development +We seek to achieve our Outside-In Leadership by understanding our customers’ needs and delivering better outcomes for them by focusing new product development efforts that help protect our shared environment while working to improve a variety of operational outcomes including, but not limited to, facility uptime, production quality, and process performance. We produce specialized products that are often tailored to the specifications of a customer or application. +5 +We continually collaborate with our customers on their projects to develop the proper solution and ensure customer satisfaction. The project development cycle may follow many different paths depending on the specifics of the job and end market. The cycle can take from one to more than twelve months from concept and design to production but may vary significantly depending on developments that occur during the process, including among others, t he emergence of new environmental demands, changes in design specifications and ability to obtain necessary approvals. +Sales, Marketing and Support +Our global selling strategy is to provide a solutions-based approach by being a single source provider of technology products and services. The strategy involves expanding our scope of products and services through selective acquisitions and the formation and integration of new business units. We believe this strategy provides a discernible competitive advantage. We execute this strategy by utilizing our portfolio of in-house technologies and those of third-party equipment suppliers. Many of these have been long-standing relationships, which have evolved from pure supplier roles to value-added business partnerships. This enables us to leverage existing business with selective alliances of suppliers and application specific engineering expertise. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support, and single source. Our value proposition to customers is to provide competitively priced, customized solutions. Our industry-specific knowledge, accompanied by our product and service offerings, provides valuable synergies for design innovation. +We sell and market our products and services with our own direct sales force, including employees in the United States, the Netherlands, United Kingdom, Canada, United Arab Emirates, India, Mexico, China, and Singapore, in conjunction with outside sales representatives in North America, South America, EMEA, Asia, and India. We expect to continue expanding our sales and support capabilities and our network of outside sales representatives in key regions domestically and internationally. +We market our offerings to our customers through a variety of channels including, but not limited to, digital, web, social media, email campaigns, individual customer visits, product announcements, brochures, magazine articles, advertisements and cover or article features in trade journals and other publications. We also participate in public relations and promotional events, including industry tradeshows and technical conferences. +Our customer service organization or sales force provides our customers with technical assistance, use and maintenance information as well as other key information regarding their purchase. We also actively provide our customers with access to key information regarding changes and pending changes in environmental regulations as well as new product or service developments. We believe that maintaining a close relationship with our customers and providing them with the support they request improves their level of satisfaction and enables us to foresee their potential future product needs or service demands. Moreover, this approach can lead to sales of annual service and support contracts as well as consumables. Our website also provides our customers with online tools and technical resources. +Quality Assurance +In engineered systems, quality is defined as system performance. We review with our customers, before the contract is signed, the technical specification and the efficiency of the equipment that will be customized to meet their specific needs. We then review these same parameters internally to assure that warranties will be met. Standard project management and production management tools are used to help ensure that all work is done to specification and that project schedules are met. Equipment is tested at the site to ensure it is functioning properly. +Customers +We are not dependent upon any single customer, and no customer comprised 10% or more of our consolidated revenues for 2018, 2017 or 2016. We do not believe the loss of any one of our customers would have a material adverse effect on us. +Suppliers and Subcontractors +We purchase our raw materials and supplies from a variety of global sources. When possible, we directly secure angle iron and sheet plate products from steel mills, whereas other materials are purchased from a variety of steel service centers. Steel prices have traditionally been volatile, but we typically mitigate the risk of higher prices by including a “surcharge” on our standard products. On contract work, we mitigate the risk of higher prices by including the current price in our estimate and generally include price inflation clauses for protection. +We believe we have a good relationship with our suppliers and do not anticipate any difficulty in continuing to purchase such items on terms acceptable to us. We have not experienced difficulty in procuring a sufficient supply of materials in the past. To the extent that our current suppliers are unable or unwilling to continue to supply us with materials, we believe that we would be able to obtain such materials from other suppliers on acceptable terms. +6 +Typically, on turnkey projects, we subcontract manufacturing, electrical work, concrete work, controls, conveyors and insulation. We use subcontractors with whom we have good working relationships and review each project at the beginning and on an ongoing basis to help ensure that all work is being done according to our specifications. Subcontractors are generally paid when we are paid by our customers according to the terms of our contract with the customer. The Company’s asset-light business model focuses on effective management of subcontractors, which allows the Company to achieve targeted working capital levels through reduction in certain assets and reduced capital expenditures. +Backlog +Backlog is a representation of the amount of revenue expected from complete performance of firm fixed-price contracts that have not been completed for products and services we expect to substantially deliver within the next 12 to 18 months. Our customers may have the right to cancel a given order, although historically cancellations have been rare. Backlog increased to $182.1 million as of December 31, 2018 from $168.9 million as of December 31, 2017. Substantially all 2017 backlog was completed in 2018. Most of the 2018 backlog is expected to be completed in 2019. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Competition +The markets we serve are highly fragmented with numerous small and regional participants. We believe no single company competes with us across the full range of our systems and products. Competition in the markets we serve is based on a number of considerations, including price, timeliness of delivery, technology, applications experience, know-how, reputation, product warranties and service. Demand for our product can vary period over period depending on conditions in the markets we serve. We believe our reputation, technical engineering capabilities and service differentiate us from many of our competitors, including those competitors who often offer products at a lower price. +Due to the size and shipping weight of many of our projects, localized manufacturing/fabrication capabilities are very important to our customers. As a result, competition varies widely by region and industry. The market for our engineered products is reasonably competitive and is characterized by technological change, continuously changing environmental regulations, and evolving customer requirements. We believe that the additional competitive factors in our markets include: +• +performance track record in difficult plant applications; +• +comprehensive portfolio of products with leading technology; +• +solid brand recognition; +• +ability to design standard and custom products that meet customers’ needs; +• +ability to provide reliable solutions in a timely manner; +• +quality customer service and support; and +• +financial and operational stability, including reputation. +We believe we compete favorably with respect to these factors. +Government Regulations +We believe our operations are in material compliance with applicable environmental laws and regulations. We believe that changes in environmental laws and regulations create opportunity given the nature of our business. +We are subject to the requirements of the Occupational Safety and Health Administration (“OSHA”) and comparable state statutes. We believe we are in material compliance with OSHA and state requirements, including general industry standards, record keeping requirements and monitoring of occupational exposures. In general, we expect to increase our expenditures to comply with stricter industry and regulatory safety standards when needed. Although such expenditures cannot be accurately estimated at this time, we do not believe that they will have a material adverse effect on our financial position, results of operations or cash flows. +Intellectual Property +We rely on a combination of patent, trademark, copyright and trade secret laws, employee and third-party nondisclosure/confidentiality agreements and license agreements to protect our intellectual property. We sell most of our products under a number of registered trade names, brand names and registered trademarks, which we believe are widely recognized in the industry. While we hold patents within a number of our businesses, we do not view our patents to be material to our business. +7 +Employees +We had approximately 800 full-time employees as of December 31, 2018. The facilities in Greensboro, North Carolina, Louisville, Kentucky, Columbia, Tennessee, and Telford, Pennsylvania are unionized except for selling, engineering, design, administrative and operating management personnel. None of our other employees are subject to any collective bargaining agreements. We consider our relationship with our employees to be satisfactory. In total, as of December 31, 2018, approximately 140 employees were represented by independent labor unions under various union contracts that expire at various intervals. +Executive Officers of CECO +The following are the executive officers of the Company as of February 28, 2019. The terms of all officers expire at the next annual meeting of the board of shareholders and upon the election of the successors of such officers. +Name +Age +Position +Dennis Sadlowski +58 +Chief Executive Officer and Director +Matthew Eckl +38 +Chief Financial Officer +Paul Gohr +37 +Chief Accounting Officer +Dennis Sadlowski has served as our Chief Executive Officer since January 2017 and as a director since May 2016. Mr. Sadlowski served as Interim Chief Executive Officer and President from January 2017 until his appointment as Chief Executive Officer in June 2017. Previously, he was the Chief Operating Officer of LSG Sky Chefs North America, a provider of food and food-related services for transportation providers, from April 2013 until March 2015. As Chief Operating Officer, Mr. Sadlowski oversaw operations across over 40 locations in North America and managed over 8,000 employees. Previously, Mr. Sadlowski served as the Chief Executive Officer of International Battery, an early stage green tech company focused on large format lithium ion batteries for the grid storage markets, from September 2011 until April 2012. Mr. Sadlowski worked at Siemens from July 2000 to March 2010, serving as the President & Chief Executive Officer of Siemens Energy & Automation, Inc. from July 2007 until October 2009, an operating subsidiary of the global manufacturer Siemens AG, where he had executive accountability for the company’s global strategic direction, operating performance and marketplace success. His responsibilities at Siemens Energy & Automation included overseeing six operating divisions along with a combined sales organization, a number of wholly-owned subsidiaries and over 12,000 employees. Mr. Sadlowski has also previously worked at General Electric and Thomas & Betts. Mr. Sadlowski was a former member of the board of directors and audit committee of Trojan Battery, a privately-held global leader in deep cycle lead-acid batteries. Mr. Sadlowski earned a Bachelor’s degree in Chemical and Nuclear Engineering from the University of California at Berkeley, and his Master’s Degree in Business Administration from Seattle University. +Matthew Eckl has served as our Chief Financial Officer since January 2017. Prior to joining the Company, Mr. Eckl served as Vice President, Finance – Energy Group at Gardner Denver, Inc. from 2012 until January 2017. In this role, he oversaw a $1 billion revenue business group that designs, manufactures, markets and services pumps, fluid transfer equipment and engineered systems for oil & gas and petrochemical industries. Prior to joining Gardner Denver, Mr. Eckl served in various roles of increasing responsibility within General Electric Company, a global digital industrial company, from 2002 until 2012, where he worked with various business groups to integrate new acquisitions and streamline financial reporting processes. Mr. Eckl earned a Bachelor’s degree in Management Information Systems from Pennsylvania State University. +Paul Gohr has served as the Chief Accounting Officer since May 2017. Mr. Gohr previously served as our Vice President of Financial Reporting since joining the Company in September 2014. From 2004 to 2014, Mr. Gohr served in various roles of increasing responsibility within Grant Thornton LLP, a global public accounting firm, most recently as a Senior Manager of Audit Services. While at Grant Thornton LLP, Mr. Gohr served a broad base of both public and private companies with international operations, many of which were acquisitive in nature. Mr. Gohr is a Certified Public Accountant. Mr. Gohr earned a Bachelor’s degree in Business, Accountancy and a Masters of Accountancy degree from Miami University. +Available Information +We use the Investor Relations section of our website, www.cecoenviro.com , as a channel for routine distribution of important information, including news releases, investor presentations and financial information. We post filings as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC, including our annual, quarterly, and current reports on Forms 10-K, 10-Q, and 8-K; proxy statements; and any amendments to those reports or statements. All such postings and filings are available on our website free of charge. The SEC also maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The content on any website referred to in this Annual Report on Form 10-K is not incorporated by reference into this Annual Report on Form 10-K unless expressly noted. +8 +Item 1A. +Risk Factors +An investment in our securities involves a high degree of risk. You should carefully consider the risk factors described below, together with the other information included in this Annual Report on Form 10-K, before you decide to invest in our securities. The risks described below are the material risks of which we are currently aware; however, they may not be the only risks that we may face. Additional risks and uncertainties not currently known to us or that we currently view as immaterial may also impair our business. If any of these risks develop into actual events, it could materially and adversely affect our business, financial condition, results of operations and cash flows, and the trading price of your shares could decline and you may lose all or part of your investment. +Risks Related to Our Business and Industry +Our business may be adversely affected by global economic conditions. +A national or global economic downturn or credit crisis may have a significant negative impact on our financial condition, future results of operations and cash flows. Specific risk factors related to these overall economic and credit conditions include the following: customers or potential customers may reduce or delay their procurement or new product development; key suppliers may become insolvent resulting in delays for our material purchases; vendors and other third parties may fail to perform their contractual obligations; customers may be unable to obtain credit to finance purchases of our products and services; and certain customers may become insolvent. These risk factors could reduce our product sales, increase our operating costs, impact our ability to collect customer receivables, lengthen our cash conversion cycle and increase our need for cash, which would ultimately decrease our profitability and negatively impact our financial condition. They could also limit our ability to expand through acquisitions due to the tightening of the credit markets. +Our dependence upon fixed-price contracts could adversely affect our operating results. +The majority of our projects are currently performed on a fixed-price basis. Under a fixed-price contract, we agree on the price that we will receive for the entire project, based upon a defined scope, which includes specific assumptions and project criteria. If our estimates of the costs to complete the project are below the actual costs that we incur, our margins will decrease, or we may incur a loss. The revenue, cost and gross profit realized on a fixed-price contract will often vary from the estimated amounts because of unforeseen conditions or changes in job conditions and variations in labor and equipment productivity over the term of the contract. If we are unsuccessful in mitigating these risks, we may realize gross profits that are different from those originally estimated and incur reduced profitability or losses on projects. Depending on the size of a project, these variations from estimated contract performance could have a significant effect on our operating results. In general, turnkey contracts to be performed on a fixed-price basis involve an increased risk of significant variations. This is a result of the long-term nature of these contracts and the inherent difficulties in estimating costs and of the interrelationship of the integrated services to be provided under these contracts whereby unanticipated costs or delays in performing part of the contract can have compounding effects by increasing costs of performing other parts of the contract. +Accounting for contract revenue may result in material adjustments that would adversely affect our financial condition and results of operations. +We derive a significant portion of our revenues from fixed price contracts. We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +Contract revenue and total direct cost estimates are reviewed and revised periodically as the work progresses and as change orders are approved, and adjustments are reflected in contract revenue in the period when these estimates are revised. These estimates are based on management’s reasonable assumptions and our historical experience, and are only estimates. Variation of actual results from these assumptions, which are outside the control of management and can differ from our historical experience, could be material. To the extent that these adjustments result in an increase, a reduction or the elimination of previously reported contract revenue, we would recognize a credit or a charge against current earnings, which could be material. +9 +Our inability to deliver our backlog on time could affect our future sales and profitability, and our relationships with our customers. +Our backlog was $182.1 million at December 31, 2018 and $168.9 million at December 31, 2017. Our ability to meet customer delivery schedules for our backlog is dependent on a number of factors including, but not limited to, access to the raw materials required for production, an adequately trained and capable workforce, project engineering expertise for certain large projects, sufficient internal manufacturing plant capacity, available subcontractors and appropriate planning and scheduling of manufacturing resources. Our failure to deliver in accordance with customer expectations may result in damage to existing customer relationships and result in the loss of future business. Failure to deliver backlog in accordance with expectations could negatively impact our financial performance and cause adverse changes in the market price of our common stock. +Volatility of oil and natural gas prices can adversely affect demand for our products and services +Volatility in oil and natural gas prices can impact our customers’ activity levels and spending for our products and services. Current energy prices are important contributors to cash flow for our customers and their ability to fund capital expenditures. Expectations about future prices and price volatility are important for determining future spending levels. Lower oil and natural gas prices generally lead to decreased spending by our customers. While higher oil and natural gas prices generally lead to increased spending by our customers, sustained high energy prices can be an impediment to economic growth, and can therefore negatively impact spending by our customers. Our customers also take into account the volatility of energy prices and other risk factors by requiring higher returns for individual projects if there is a higher perceived risk. Any of these factors could affect the demand for oil and natural gas and could have a material effect on our results of operations. +Our financial performance may vary significantly from period to period. +Our annual revenues and earnings have varied in the past and are likely to vary in the future. Our contracts generally stipulate customer specific delivery terms and may have contract cycles of a year or more, which subjects these contracts to many factors beyond our control. In addition, contracts that are significantly larger in size than our typical contracts tend to intensify their impact on our annual operating results. Furthermore, as a significant portion of our operating costs are fixed, an unanticipated decrease in our revenues, a delay or cancellation of orders in backlog, or a decrease in the demand for our products, may have a significant impact on our annual operating results. Therefore, our annual operating results may be subject to significant variations and our operating performance in one period may not be indicative of our future performance. +Customers may cancel or delay projects. As a result, our backlog may not be indicative of our future revenue. +Customers may cancel or delay projects for reasons beyond our control. Our orders normally contain cancellation provisions that permit us to recover our costs, and, for most contracts, a portion of our anticipated profit in the event a customer cancels an order. If a customer elects to cancel an order, we may not realize the full amount of revenues included in our backlog. If projects are delayed, the timing of our revenues could be affected and projects may remain in our backlog for extended periods of time. Revenue recognition occurs over long periods of time and is subject to unanticipated delays. If we receive relatively large orders in any given quarter, fluctuations in the levels of our quarterly backlog can result because the backlog in that quarter may reach levels that may not be sustained in subsequent quarters. As a result, our backlog may not be indicative of our future revenues. With rare exceptions, we are not issued contracts until a customer is ready to start work on a project. Thus, it is our experience that the only relationship between the length of a project and the possibility that a project may be cancelled is simply the fact that there is more time involved. In a year-long project as opposed to a three-month project, more time is available for the customer to experience a softening in its business, which may cause the customer to cancel a project. +We face significant competition in the markets we serve. +All of the industries in which we compete are highly competitive and highly fragmented. We compete against a number of local, regional and national contractors and manufacturers in each of our product or service lines, many of which have been in existence longer than us and some of which have substantially greater financial resources than we do. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support and single source. Any failure by us to compete effectively in the markets we serve could have a material adverse effect on our financial condition, results of operations and cash flows. +10 +We may incur material costs as a result of existing or future product liability cl aims, or other claims and litigation that could adversely affect our financial condition, results of operations and cash flows; and our insurance coverage may not cover all claims or may be insufficient to cover the claims. +Despite our quality assurance measures, we may be exposed to product liability claims, other claims and litigation in the event that the use of our products results, or is alleged to result, in bodily injury and/or property damage or our products actually or allegedly fail to perform as expected. Such claims may also be accompanied by fraud and deceptive trade practices claims. While we maintain insurance coverage with respect to certain product liability and other claims, we may not be able to obtain such insurance on acceptable terms in the future, if at all, and any such insurance may not provide adequate coverage against product liability and other claims. Furthermore, our insurance may not cover damages from breach of contract by us or based on alleged fraud or deceptive trade practices. Any future damages that are not covered by insurance or are in excess of policy limits could have a material adverse effect on our financial condition, results of operations and cash flows. In addition, product liability and other claims can be expensive to defend and can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. +An unsuccessful defense of a product liability or other claim could have an adverse effect on our financial condition, results of operations and cash flows. Even if we are successful in defending against a claim relating to our products, claims of this nature could cause our customers to lose confidence in our products and us. +Liability to customers under warranties may adversely affect our reputation, our ability to obtain future business and our results of operations. +We provide certain warranties as to the proper operation and conformance to specifications of the products we manufacture or produce. Failure of our products to operate properly or to meet specifications may increase our costs by requiring additional engineering resources and services, replacement of parts and equipment or monetary reimbursement to customers. We have in the past received warranty claims, are currently subject to warranty claims, and we expect to continue to receive claims in the future. To the extent that we incur substantial warranty claims in any period, our reputation, our ability to obtain future business and our results of operations could be adversely affected. +If we do not develop new products in a timely manner in response to industry demands, our business and revenues will be adversely affected. +Our industry is characterized by ongoing technological developments and changing customer requirements. As a result, our success and continued growth depend, in part, on our ability in a timely manner to develop or acquire rights to, and successfully introduce into the marketplace, enhancements of existing products and new products that incorporate technological advances, meet customer requirements and respond to products developed by our competition. We cannot assure you that we will be successful in developing or acquiring such rights to products on a timely basis or that such products will adequately address the changing needs of the marketplace. +Our business can be significantly affected by changes in technology and regulatory standards. +The markets that the Company serves are characterized by changing technology, competitively imposed process standards and regulatory requirements, each of which influences the demand for our products and services. Changes in legislative, regulatory or industrial requirements may render certain of our products and processes obsolete. Acceptance of new products and services may also be affected by the adoption of new government regulations requiring stricter standards. Our ability to anticipate changes in technology and regulatory standards and to respond with new and enhanced products on a timely basis will be a significant factor in our ability to grow and to remain competitive. We cannot guarantee that we will be able to achieve the technological advances that may be necessary for us to remain competitive or that certain of our products or services will not become obsolete. +Changes in current environmental legislation could have an adverse impact on the sale of our environmental control systems and products and on our financial condition, results of operations and cash flows. +Our business is primarily driven by capital spending, clean air rules, plant upgrades by our customers to comply with laws and regulations governing the discharge of pollutants into the environment or otherwise relating to the protection of the environment or human health. These laws include, but are not limited to, United States federal statues such as Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, the Clean Water Act, the Clean Air Act, the Clean Air Interstate Rule, and the regulations implementing these statutes, as well as similar laws and regulations at state and local levels and in other countries. These United States laws and regulations may change and other countries may not adopt similar laws and regulations. Our business may be adversely impacted to the extent that environmental regulations are repealed, amended, implementation dates are delayed, or to the extent that regulatory authorities reduce enforcement. +11 +Our operations outside o f the United States are subject to political, investment and local business risks. +For the year ended December 31, 2018, approximately 33% of our total revenue was derived from products or services ultimately delivered or provided to end users outside the United States. As part of our operating strategy, we intend to expand our international operations through internal growth and selected acquisitions. Operations outside of the United States, particularly in emerging markets, are subject to a variety of risks that are different from or are in addition to the risks we face within the United States. Among others, these risks include: +• +local, economic, political and social conditions, including potential hyperinflationary conditions and political instability in certain countries; +• +imposition of limitations on the remittance of dividends and payments by foreign subsidiaries; +• +adverse currency exchange rate fluctuations, including significant devaluations of currencies; +• +tax-related risks, including the imposition of taxes and the lack of beneficial treaties, that result in higher effective tax rate for us; +• +difficulties in enforcing agreements and collecting receivables through certain foreign local systems; +• +domestic and foreign customs, tariffs and quotas or other trade barriers; +• +increased costs for transportation and shipping; +• +difficulties in protecting intellectual property; +• +risk of nationalization of private enterprises by foreign governments; +• +managing and obtaining support and distribution channels for overseas operations; +• +hiring and retaining qualified management personnel for our overseas operations; +• +legal and regulatory requirements, including import, export, defense regulations and foreign exchange controls; +• +imposition or increase of restrictions on investment; +• +disadvantages of competing against companies from countries that are not subject to United States laws and regulations, including the Foreign Corrupt Practices Act (“FCPA”); +• +required compliance with a variety of local laws and regulations, which may differ materially from those to which we are subject in the United States; and +• +increasingly complex laws and regulations concerning privacy and data security, including the European Union’s General Data Protection Regulations. +In addition, we could be adversely affected by violations of the FCPA and similar worldwide anti-bribery laws as well as export controls and economic sanction laws. The FCPA and similar anti-bribery laws in other jurisdictions generally prohibit companies and their intermediaries from making improper payments to non-United States officials for the purposes of obtaining or retaining business. Our policies mandate compliance with these laws. We operate in many parts of the world that have experienced governmental corruption to some degree and, in certain circumstances, strict compliance with anti-bribery laws may conflict with local customs and practices. We cannot assure you that our internal controls and procedures will always protect us from reckless or criminal acts committed by our employees or agents. If we are found to be liable for FCPA, export control or sanction violations, we could suffer from criminal or civil penalties or other sanctions, including loss of export privileges or authorization needed to conduct aspects of our international business, which could have a material adverse effect on our business. +The occurrence of one or more of the foregoing factors could have a material adverse effect on our international operations or upon our financial condition, results of operations and cash flows. +12 +Increasing costs for manufactured components, raw materials, transportation, health care and energy prices may adversely affect our profitability. +We use a broad range of manufactured components and raw materials in our products, including raw steel, steel-related components, filtration media, and equipment such as fans and motors. Materials and subcontracting costs comprise the largest components of our total costs. Further increases in the price of these items could further materially increase our operating costs and materially adversely affect our profit margins. In particular, the price of steel has increased due to import duties and tariffs. Similarly, transportation, steel and health care costs have risen steadily over the past few years and represent an increasing burden for us. Although we try to contain these costs whenever possible, and although we try to pass along increased costs in the form of price increases to our customers, we may be unsuccessful in doing so, and even when successful, the timing of such price increases may lag significantly behind our incurrence of higher costs. +Our gross margins are affected by shifts in our product mix. +Certain of our products have higher gross profit margins than others. Consequently, changes in the product mix of our sales from quarter-to-quarter or from year-to-year can have a significant impact on our reported gross profit margins. Certain of our products also have a much higher internally manufactured cost component. Therefore, changes from quarter-to-quarter or from year-to-year can have a significant impact on our reported gross margins. In addition, contracts with a higher percentage of subcontracted work or equipment purchases may result in lower gross profit margins. +Our manufacturing operations are dependent on third-party suppliers. +Although we are not dependent on any one supplier, we are dependent on the ability of our third-party suppliers to supply our raw materials, as well as certain specific component parts. The third-party suppliers upon which we depend may default on their obligations to us due to bankruptcy, insolvency, lack of liquidity, adverse economic conditions, operational failure, fraud, loss of key personnel, or other reasons. We cannot assure you that our third-party suppliers will dedicate sufficient resources to meet our scheduled delivery requirements or that our suppliers will have sufficient resources to satisfy our requirements during any period of sustained demand. Failure of suppliers to supply, or delays in supplying, our raw materials or certain components, or allocations in the supply of certain high demand raw components could materially adversely affect our operations and ability to meet our own delivery schedules on a timely and competitive basis. Additionally, our third-party suppliers may provide us with raw materials or component parts that fail to meet our expectations or the expectations of our customers, which could subject us to product liability claims, other claims and litigation. +Our use of subcontractors could potentially harm our profitability and business reputation. +Occasionally we act as a prime contractor in some of the engineered projects we undertake. In our capacity as lead provider and when acting as a prime contractor, we perform a portion of the work on our projects with our own resources and typically subcontract activities such as manufacturing, electrical work, concrete work, insulation, conveyors and controls. In our industry, the lead contractor is normally responsible for the performance of the entire contract, including subcontract work. Thus, when acting as a prime contractor, we are subject to risk associated with the failure of one or more subcontractors to perform as anticipated. +We employ subcontractors at various locations around the world to meet our customers’ needs in a timely manner, meet local content requirements and reduce costs. Subcontractors generally perform the majority of our manufacturing for international customers. We also utilize subcontractors in North America. The use of subcontractors decreases our control over the performance of these functions and could result in project delays, escalated costs and substandard quality. These risks could adversely affect our profitability and business reputation. In addition, many of our competitors, who have greater financial resources and greater bargaining power than we have, use the same subcontractors that we use and could potentially influence our ability to hire these subcontractors. If we were to lose relationships with key subcontractors, our business could be adversely impacted. +A significant portion of our accounts receivable are related to larger contracts, which increases our exposure to credit risk. +Significant portions of our sales are to customers who place large orders for custom products and whose activities are related to the power and oil & gas industries. As a result, our exposure to credit risk is affected to some degree by conditions within these industries and governmental and or political conditions. We frequently attempt to reduce our exposure to credit risk by requiring progress payments and letters of credit as well as closely monitoring the credit worthiness of our customers. However, the continuing economic climate and other unanticipated events that affect our customers could have a materially adverse impact on our operating results. +13 +Changes in billing terms can increase our exposure to working capital and credit risk. +Our products are generally sold under contracts that allow us to bill upon the completion of certain agreed upon milestones or upon actual shipment of the product, and certain contracts include a retention provision. We attempt to negotiate progress-billing milestones on all large contracts to help us manage the working capital and credit risk associated with these large contracts. Consequently, shifts in the billing terms of the contracts in our backlog from period to period can increase our requirement for working capital and can increase our exposure to credit risk. +Currency fluctuations may reduce profits on our foreign sales or increase our costs, either of which could adversely affect our financial results. +Given that approximately 33% of our 2018 revenues are outside the United States, we are subject to the impact of fluctuations in foreign currency exchange rates. Transaction losses resulting from currency fluctuations may adversely affect our results of operations. Foreign currency fluctuations may also make our systems and products more expensive for our customers, which could have a negative impact on our sales. In addition, we purchase some foreign-made products directly from and through our subcontractors. Due to the multiple currencies involved in our business, foreign currency positions partially offset and are netted against one another to reduce exposure. We cannot be assured that fluctuations in foreign currency exchange rates will not make these products more expensive to purchase. Increases in our direct or indirect cost of purchasing these products could negatively impact our financial results if we are not able to pass those increased costs on to our customers. +If our goodwill or indefinite lived intangibles become impaired, we may be required to recognize charges that would adversely impact our results of operations. +As of December 31, 2018, goodwill and indefinite lived intangibles were $170.4 million, or 43.4%, of our total assets. Goodwill and indefinite lived intangible assets are not amortized, but instead are subject to annual impairment evaluations (or more frequently if circumstances require). Major factors that influence our evaluations are estimates for future revenue and expenses associated with the specific intangible asset or the reporting unit in which the goodwill resides. This is the most sensitive of our estimates related to our evaluations. Other factors considered in our evaluations include assumptions as to the business climate, industry and economic conditions. These assumptions are subjective and different estimates could have a significant impact on the results of our analyses. While management, based on current forecasts and outlooks, believes that the assumptions and estimates are reasonable, we can make no assurances that future actual operating results will be realized as planned and that there will not be material impairment charges as a result. In particular, an economic downturn could have a material adverse impact on our customers thereby forcing them to reduce or curtail doing business with us and such a result may materially affect the amount of cash flow generated by our future operations. Any write-down of goodwill or intangible assets resulting from future periodic evaluations could adversely materially impact our results of operations. +We may incur costs as a result of certain restructuring activities, which may negatively impact our financial results, and we may not achieve some or all of the expected benefits of our restructuring plans. +We are continuously seeking the most cost-effective means and structure to serve our customers, protect our shareholders and respond to changes in our markets. From time to time, we may engage in restructuring activities in an effort to improve cost competitiveness and profitability. We may not achieve the desired or anticipated benefits from these restructuring activities. As a result, restructuring costs may vary significantly from year to year depending on the scope of such activities. Such restructuring costs and expenses could adversely impact our financial results. +Changes in laws or regulations or the manner of their interpretation or enforcement could adversely impact our financial performance and restrict our ability to operate our business or execute our strategies. +New laws or regulations, or changes in existing laws or regulations, or the manner of their interpretation or enforcement, could increase our cost of doing business and restrict our ability to operate our business or execute our strategies. In particular, there may be significant changes in U.S. laws and regulations and existing international trade agreements by the current U.S. presidential administration that could affect a wide variety of industries and businesses, including those businesses we own and operate. If the current U.S. presidential administration materially modifies U.S. laws and regulations and international trade agreements, our business, financial condition, and results of operations could be adversely affected. +14 +We are p arty to asbestos-containing product litigation that could adversely affect our financial condition, results of operations and cash flows. +Our subsidiary, Met-Pro, beginning in 2002, began to be named in asbestos-related lawsuits filed against a large number of industrial companies including, in particular, those in the pump and fluid handling industries. In management’s opinion, the complaints typically have been vague, general and speculative, alleging that Met-Pro, along with the numerous other defendants, sold unidentified asbestos-containing products and engaged in other related actions that caused injuries (including death) and loss to the plaintiffs. Counsel has advised that more recent cases typically allege more serious claims of mesothelioma. The Company’s insurers have hired attorneys who, together with the Company, are vigorously defending these cases. Many cases have been dismissed after the plaintiff fails to produce evidence of exposure to Met-Pro’s products. In those cases where evidence has been produced, the Company’s experience has been that the exposure levels are low and the Company’s position has been that its products were not a cause of death, injury or loss. The Company has been dismissed from or settled a large number of these cases. Cumulative settlement payments of all legal fees other than corporate counsel expenses from 2002 through December 31, 2018 for cases involving asbestos-related claims were $2.9 million, of which $2.7 million has been paid by the Company’s insurers. The average cost per settled claim, excluding legal fees, was approximately $36,000. +Based upon the most recent information available to the Company regarding such claims, there were a total of 208 cases pending against the Company as of December 31, 2018 (with Illinois, New York, Pennsylvania and West Virginia having the largest number of cases), as compared with 218 cases that were pending as of December 31, 2017. During 2018, 96 new cases were filed against the Company, and the Company was dismissed from 63 cases and settled 43 cases. Most of the pending cases have not advanced beyond the early stages of discovery, although a number of cases are on schedules leading to, or are scheduled for trial. The Company believes that its insurance coverage is adequate for the cases currently pending against the Company and for the foreseeable future, assuming a continuation of the current volume, nature of cases and settlement amounts. However, the Company has no control over the number and nature of cases that are filed against it, nor as to the financial health of its insurers or their position as to coverage. The Company also presently believes that none of the pending cases will have a material adverse impact upon the Company’s results of operations, liquidity or financial condition. +We have $76.1 million of indebtedness as of December 31, 2018, and incurrence of additional indebtedness could adversely affect our ability to operate our business, remain in compliance with debt covenants, make payments on our debt and limit our growth. +Our outstanding indebtedness could have important consequences for investors, including the following: +• +it may be more difficult for us to satisfy our obligations with respect to the agreement governing our senior secured credit facilities (“Credit Facility”), and any failure to comply with the obligations of any of the agreements governing any additional indebtedness, including financial and other restrictive covenants, could result in an event of default under such agreements; +• +the covenants contained in our debt agreements, including our Credit Agreement, limit our ability to borrow money in the future for acquisitions, capital expenditures or to meet our operating expenses or other general corporate obligations; +• +the amount of our interest expense may increase because a substantial portion of our borrowings are at variable rates of interest, which, if interest rates increase, could result in higher interest expense; +• +we may need to use a portion of our cash flows to pay interest on our debt, which will reduce the amount of money we have for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other business activities; +• +we may have a higher level of debt than some of our competitors, which could put us at a competitive disadvantage; +• +we may be more vulnerable to economic downturns and adverse developments in our industry or the economy in general; and +• +our debt level could limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate. +Our ability to meet our expenses and debt obligations will depend on our future performance, which will be affected by financial, business, economic, regulatory and other factors. We will not be able to control many of these factors. We cannot be certain that our earnings will be sufficient to allow us to pay the principal and interest on our existing or future debt and meet our other obligations. If we do not have enough money to service our existing or future debt, we may be required to refinance all or part of our existing or future debt, sell assets, borrow more money or raise equity. We may not be able to refinance our existing or future debt, sell assets, borrow more money or raise equity on terms acceptable to us, if at all. +15 +We might be unable to protect our intellectual property rights and our products could infringe the intellectual property rights of others, which could expose us to costly disputes. +Although we believe that our products do not infringe patents or violate the proprietary rights of others, it is possible that our existing patent rights may not be valid or that infringement of existing or future patents or proprietary rights may occur. In the event our products infringe patents or proprietary rights of others, we may be required to modify the design of our products or obtain a license for certain technology. We cannot guarantee that we will be able to do so in a timely manner, upon acceptable terms and conditions, or at all. Failure to do any of the foregoing could have a material adverse effect upon our business. Moreover, if our products infringe patents or proprietary rights of others, we could, under certain circumstances, become liable for damages, which also could have a material adverse effect on our business. +Risks related to our pension plan may adversely impact our results of operations and cash flow. +Significant changes in actual investment return on pension assets, discount rates, and other factors may adversely affect our results of operations and pension plan contributions in future periods. GAAP requires that we calculate the income or expense of our plan using actuarial valuations. These valuations reflect assumptions about financial markets and interest rates. We establish the discount rate used to determine the present value of the projected and accumulated benefit obligation at the end of each year based upon the available market rates for high quality, fixed-income investments. An increase in the discount rate would increase future pension expense and, conversely, a decrease in the discount rate would decrease future pension expense. Funding requirements for our pension plan may become more significant. The ultimate amounts to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory changes related to pension funding obligations. For a discussion regarding the significant assumptions used to estimate pension expense, including discount rate and the expected long-term rate of return on plan assets, and how our financial statements can be affected by pension plan accounting policies, see “Critical Accounting Policies” included in this Annual Report on Form 10-K in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +We may be subject to substantial withdrawal liability assessments in the future related to multiemployer pension plans to which certain of our subsidiaries make contributions pursuant to collective bargaining agreements. +Under applicable federal law, any employer contributing to a multiemployer pension plan that completely ceases participating in the plan while the plan is underfunded is subject to payment of such employer’s assessed share of the aggregate unfunded vested benefits of the plan. In certain circumstances, an employer can be assessed a withdrawal liability for a partial withdrawal from a multiemployer pension plan. If any of these adverse events were to occur in the future, it could result in a substantial withdrawal liability assessment that could have a material adverse effect on our business, financial condition, results of operations or cash flows. +We rely on several key employees whose absence or loss could disrupt our operations or be adverse to our business. +We are highly dependent on the experience of our management in the continuing development of our operations. The loss of the services of certain of these individuals would have a material adverse effect on our business. Although we have employment and non-competition agreements with certain of our key employees, as a practical matter, those agreements will not assure the retention of our employees, and we may not be able to enforce all of the provisions in any employment or non-competition agreement. Our future success will depend in part on our ability to attract and retain qualified personnel to manage our development and future growth. We cannot guarantee that we will be successful in attracting and retaining such personnel. Our failure to recruit additional key personnel could have a material adverse effect on our financial condition, results of operations and cash flows. +Work stoppages or similar difficulties could significantly disrupt our operations. +As of December 31, 2018, approximately 140 of our approximately 800 employees are represented by international or independent labor unions under various union contracts that expire from May 31, 2019 to May 31, 2022. It is possible that our workforce will become more unionized in the future. Although we consider our employee relations to generally be good, our existing labor agreements may not prevent a strike or work stoppage at one or more of our facilities in the future and we may be affected by other labor disputes. A work stoppage at one or more of our facilities may have a material adverse effect on our business. Unionization activities could also increase our costs, which could have an adverse effect on our profitability. +Additionally, a work stoppage at one of our suppliers could adversely affect our operations if an alternative source of supply were not readily available. Work stoppages by employees of our customers also could result in reduced demand for our products. +16 +Failure to maintain adequate internal controls coul d adversely affect our business. +Under Section 404 of Sarbanes-Oxley, we are required to include in each of our Annual Reports on Form 10-K, a report containing our management’s assessment of the effectiveness of our internal control over financial reporting and an attestation report of our independent auditor. These laws, rules and regulations continue to evolve and could become increasingly stringent in the future. We have undertaken actions to enhance our ability to comply with the requirements of Sarbanes-Oxley, including, but not limited to, the engagement of consultants, the documentation of existing controls and the implementation of new controls or modification of existing controls as deemed appropriate. +We continue to devote substantial time and resources to the documentation and testing of our controls, and to plan for and the implementation of remedial efforts in those instances where remediation is indicated. If we fail to maintain the adequacy of our internal controls, including remediating any material weaknesses or deficiencies in our internal controls, as such standards are modified, supplemented or amended in the future, we could be subject to regulatory actions, civil or criminal penalties or shareholder litigation. In addition, failure to maintain adequate internal controls could result in financial statements that do not accurately reflect our financial condition, results of operations and cash flows. We believe that the out-of-pocket costs, the diversion of management’s attention from running our day-to-day operations and operational changes caused by the need to comply with the requirements of Section 404 will continue to be significant. +There are inherent limitations in all internal control systems over financial reporting, and misstatements due to error or fraud may occur and not be detected. +While we continue to take action to ensure compliance with the internal control, disclosure control and other requirements of Sarbanes-Oxley and the rules and regulations promulgated thereunder by the SEC, there are inherent limitations in our ability to control all circumstances. Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and disclosure controls can prevent all errors and all frauds. A control system, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be evaluated in relation to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Further, controls can be circumvented by individual acts of some persons, by collusion of two or more persons, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, a control may be inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. +If we are not able to maintain the adequacy of our internal control over financial reporting, including any failure to implement required new or improved controls, or if we experience difficulties in their implementation, our business, financial condition and operating results could be harmed. We can give no assurances that any additional material weaknesses will not arise in the future due to our failure to implement and maintain adequate internal control over financial reporting. +We have made and may make future acquisitions or divestitures, which involve numerous risks that could impact our financial condition, results of operations and cash flows. +Our operating strategy has involved expanding or contracting our scope of products and services through selective acquisitions or divestitures and the formation or elimination of new business units that are then integrated or separated into or out of our family of turnkey system providers. We have acquired other businesses, product or service lines, assets or technologies that are complementary to our business. We may be unable to find or consummate future acquisitions at acceptable prices and terms. We continually evaluate potential acquisition opportunities in the ordinary course of business. +Although we conduct what we believe to be a prudent level of investigation regarding the operating and financial condition of the businesses, product or service lines, assets or technologies we purchase, an unavoidable level of risk remains regarding their actual operating and financial condition. Until we actually assume operating control of these businesses, product or service lines, assets or technologies, we may not be able to ascertain their actual value or understand potential liabilities. This is particularly true with respect to acquisitions outside the United States. +In addition, acquisitions of businesses may require additional debt or equity financing, resulting in additional leverage or dilution of ownership. Our Credit Facility contains certain covenants that limit, or which may have the effect of limiting, among other things, acquisitions, capital expenditures, the sale of assets and the incurrence of additional indebtedness. +17 +While aligning our portfolio of products and companies with our 4- 3-3 operating strategy we have and may continue to divest of certain of our businesses. We may not be able to successfully manage these divestitures and our financial results could by adversely impacted by the diluted impacts from the loss of earnings and cash flows a ssociated with the divested businesses . +Our ability to obtain financing for future growth opportunities may be limited. +Our ability to execute our growth strategies may be limited by our ability to secure and retain additional financing on terms reasonably acceptable to us or at all. Certain of our competitors are larger companies that may have greater access to capital, and therefore, may have a competitive advantage over us should our access to capital be limited. +Our dependence on information systems and the failure of such systems, could significantly disrupt our business and negatively affect our financial condition, results of operations and cash flows. +We are highly dependent on information systems that are increasingly operated by third-parties and as a result we have a limited ability to ensure their continued operation. We rely on information technology systems, networks and infrastructure in managing our day-to-day operations. In the event of systems failure or interruption, we will have limited ability to affect the timing and success of systems restoration. Any failure or interruption of our systems could cause delays or other problems in the delivery of our services, which could have a material adverse effect on our operating results. +Increased information technology cyber security threats and more sophisticated and targeted computer crime could pose a risk to our systems, networks, and products. +Increased global information technology cyber security threats and more sophisticated and targeted computer crime pose a risk to the security of our systems and networks and the confidentiality, availability and integrity of our data and communications. While we attempt to mitigate these risks by employing a number of measures, including employee training, comprehensive monitoring of our networks and systems, and maintenance of backup and protective systems, our systems, networks and products remain potentially vulnerable to advanced persistent threats. Depending on their nature and scope, such threats could potentially lead to the compromising of confidential information and communications, improper use of our systems and networks, manipulation and destruction of data, defective products, production downtimes and operational disruptions, which in turn could adversely affect our reputation, competitiveness and results of operations. +In addition, we could be subject to legal claims or proceedings, liability under laws that protect the privacy of personal information and regulatory penalties if confidential information relating to our employees or other parties is misappropriated from our systems and networks. +Risks Related to Our Common Stock +The market price of our common stock may be volatile or may decline regardless of our operating performance and investors may not be able to resell shares they purchase at their purchase price. +The stock market has experienced and may in the future experience volatility that has often been unrelated to the operating performance of particular companies. The market price of our common stock has experienced, and may continue to experience, substantial volatility. During 2018, the sales price of our common stock on the NASDAQ ranged from $4.08 to $8.91 per share. We expect our common stock to continue to be subject to fluctuations. Broad market and industry factors may adversely affect the market price of our common stock, regardless of our actual operating performance. Factors that could cause fluctuation in the common stock price may include, among other things: +• +actual or anticipated variations in operating results; +• +adverse general economic conditions, including, but not limited to, withdrawals of investments in the stock markets generally or a tightening of credit available to potential acquirers of businesses, that result in lower average prices being paid for public company shares and lower valuations being placed on businesses; +• +other domestic and international macroeconomic factors unrelated to our performance; +• +our failure to meet the expectations of the investment community; +• +industry trends and the business success of our customers; +• +loss of key customers; +• +announcements of technological advances by us or our competitors; +18 +• +current events affecting the political and economic environment in the United States; +• +conditions or trends in our industry, including demand for our products and services, technological advances and governmental regulations; +• +litigation or other proceedings involving or affecting us; and +• +additions or departures of our key personnel. +The realization of any of these risks and other factors beyond our control could cause the market price of our common stock to decline significantly. +We are not currently paying dividends and cannot make assurances that we will pay dividends on our common stock and our indebtedness could limit our ability to pay dividends. +The timing, declaration, amount and payment of future dividends to our shareholders fall within the discretion of our Board of Directors and will depend on many factors, including our financial condition, results of operations and capital requirements, as well as applicable law, regulatory constraints, industry practice and other business considerations that our Board of Directors considers relevant. There can be no assurance that we will pay a dividend in the future. +The number of shares of our common stock eligible for future sale could adversely affect the market price of our stock. +We have reserved 1.9 million shares of our common stock for issuance under our 2017 Equity Incentive Plan (the “2017 Plan”), which may include option grants, stock grants, performance unit grants and restricted stock grants. We had outstanding options to purchase approximately 441,000 shares of our common stock and 150,000 outstanding restricted stock units under our 2007 Equity Incentive Plan (the “2007 Plan”), and outstanding options to purchase approximately 67,000 shares of our common stock and 1,101,000 outstanding restricted stock units under our 2017 Plan as of December 31, 2018. The shares under both plans are registered for resale on currently effective registration statements. +We may issue additional restricted securities or register additional shares of common stock under the Securities Act in the future. The issuance of a significant number of shares of common stock upon the exercise of stock options or warrants, vesting of restricted stock units, or the availability for sale, or resale, of a substantial number of the shares of common stock under registration statements, under Rule 144 or otherwise, could adversely affect the market price of our common stock. +One or more issuances of shares of our common stock under our stock incentive plan or securities in connection with financing transactions or the conversion of warrants will dilute current shareholders. +Pursuant to our stock incentive plan, we may grant stock awards to our employees, directors and consultants. Dilution will occur upon exercise of any outstanding stock awards convertible into or exchangeable or exercisable for common stock. Moreover, if we raise additional funds by issuing additional common stock, or securities, further dilution to our existing shareholders will result. In addition, we have historically issued warrants to purchase common shares in conjunction with business acquisitions, debt issuances and employment contracts, which may cause dilution when exercised. +Our ability to issue preferred stock could adversely affect the rights of holders of our common stock. +Our certificate of incorporation authorizes us to issue up to 10,000 shares of preferred stock in one or more series on terms that may be determined at the time of issuance by our board of directors. Accordingly, we may issue shares of any series of preferred stock that would rank senior to our common stock as to voting or dividend rights or rights upon our liquidation, dissolution or winding up. +Certain provisions in our charter documents have anti-takeover effects. +Certain provisions of our certificate of incorporation and bylaws may have the effect of delaying, deferring or preventing a change in control of us. Such provisions, including those limiting who may call special shareholders’ meetings, together with the possible issuance of our preferred stock without shareholder approval, may make it more difficult for other persons, without the approval of our board of directors, to make a tender offer or otherwise acquire substantial amounts of our common stock or to launch other takeover attempts that a shareholder might consider to be in such shareholder’s best interest. +Item 1B. +Unresolved Staff Comments +Not Applicable. +19 +Item 2. +P roperties +The following facilities were owned or leased by the Company as of December 31, 2018. +Owned and Leased Locations +Type +Square Footage +Leased or Owned +Energy Solutions segment: +Moorpark, California +Sales +4,300 +Leased +Cincinnati, Ohio +Manufacturing +96,400 +Leased +Nunspeet, the Netherlands +Manufacturing +44,600 +Leased +Nunspeet, the Netherlands +Sales +6,545 +Leased +Montreal, Canada +Sales +3,514 +Leased +Orchard Park, New York +Sales +17,900 +Leased +Denton, Texas +Manufacturing +80,000 +Leased +Monroe, Connecticut +Sales +8,825 +Leased +Pune, India +Sales +678 +Leased +Islandia, New York +Sales +8,178 +Leased +Dubai, United Arab Emirates +Sales +2,463 +Leased +Singapore +Sales +4,643 +Leased +Essex, United Kingdom +Sales +120 +Leased +Zhenjiang, People’s Republic of China +Manufacturing +64,500 +Leased +Wichita Falls, Texas +Held for Sale +128,000 +Owned +Industrial Solutions segment: +Anaheim, California +Sales/Warehouse +7,000 +Leased +Wood Dale, Illinois +Sales/Warehouse +16,000 +Leased +Lennon, Michigan +Sales/Warehouse +8,000 +Leased +Louisville, Kentucky +Manufacturing +35,000 +Owned +Louisville, Kentucky +Sales +5,450 +Leased +Lebanon, Pennsylvania +Sales +4,221 +Leased +Pittsburgh, Pennsylvania +Sales +4,000 +Leased +Columbia, Tennessee +Manufacturing +34,800 +Leased +Shanghai, People's Republic of China +Sales +270 +Leased +Cambridgeshire, United Kingdom +Sales +1,600 +Leased +Shanghai, People’s Republic of China +Sales +5,608 +Leased +Greensboro, North Carolina +Manufacturing +30,000 +Leased +Fluid Handling Solutions segment: +Telford, Pennsylvania +Manufacturing +93,500 +Leased +Indianapolis, Indiana +Manufacturing +66,000 +Leased +Heerenveen, the Netherlands +Manufacturing +34,000 +Owned +Guangzhou, People’s Republic of China +Manufacturing +17,168 +Leased +Corporate offices: +Cincinnati, Ohio +Administrative +7,000 +Leased +Toronto, Canada +Administrative +4,000 +Leased +Dallas, Texas (a) +Administrative +18,267 +Leased +(a) Location is also used by the Company’s Energy Solutions and Industrial Solutions segments as a management office. +It is anticipated that most leases coming due in the near future will be renewed at expiration. The property we own is subject to collateral mortgages to secure the amounts owed under the Credit Agreement. Our current capacity, with limited capital additions, is expected to be sufficient to meet production requirements for the near future. We believe our production facilities are suitable and can meet our future production needs. +Item 3. +Legal Proceedings +See Note 13 “Commitments and Contingencies – Legal Proceedings” to the Consolidated Financial Statements contained in Part II, Item 8 of this Annual Report on Form 10-K for information regarding legal proceedings in which we are involved. +20 +Item 4. +Mine Saf ety Disclosures +Not applicable. +21 +PART II +Item 5. +Mark et for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Market Information +Our common stock is traded on the NASDAQ under the symbol “CECE.” +Performance Graph +The following graph sets forth the cumulative total return to CECO’s shareholders during the five years ended December 31, 2018, as well as the following indices: Russell 2000 Index, Standard and Poor’s (“S&P”) 600 Small Cap Industrial Machinery Index, and S&P 500 Index. Assumes $100 was invested on December 31, 2013, including the reinvestment of dividends, in each category. +Dividends +Our dividend policy and the payment of cash dividends under that policy are subject to the Board of Director’s continuing determination that the dividend policy and the declaration of dividends are in the best interest of our shareholders. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the stockholders to suspend dividend payments. Future dividends and the dividend policy may be changed at the Board of Director’s discretion at any time. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Agreement. +Holders +The approximate number of registered shareholders of record of our common stock as of February 28, 2019 was 314, although there are a larger number of beneficial owners. +Purchases of Equity Securities by the Issuer and Affiliated Purchasers +We did not repurchase any shares of our common stock during 2018. +Recent Sales of Unregistered Securities +Not applicable. +22 +Item 6. Selected Financial Data +The following table sets forth selected summary financial data. We have derived this data from our consolidated financial statements for the five years ended December 31, 2018 which were audited by BDO USA, LLP, independent registered public accounting firm. The selected financial data should be read in conjunction with our Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included herein. +(In thousands, except share and per share data) +Year Ended December 31, +2018 +2017 +2016 +2015 +2014 +Net sales +$ +337,339 +$ +345,051 +$ +417,011 +$ +367,422 +$ +263,217 +Gross profit +111,537 +113,194 +134,859 +109,171 +84,823 +Amortization and earnout expenses +9,683 +7,132 +20,231 +25,613 +10,151 +Intangible asset and goodwill impairment +— +7,168 +57,923 +3,340 +— +Loss on divestitures, net of selling costs +4,390 +— +— +— +— +Restructuring expenses +— +1,895 +— +— +— +Income (loss) from operations +10,002 +8,024 +(25,562 +) +4,949 +21,663 +Net (loss) income +(7,121 +) +(3,029 +) +(38,254 +) +(5,734 +) +13,077 +Net (loss) income attributable to CECO Environmental Corp. +(7,121 +) +(3,029 +) +(38,218 +) +(5,602 +) +13,077 +Basic (loss) earnings per common share +$ +(0.21 +) +$ +(0.09 +) +$ +(1.12 +) +$ +(0.19 +) +$ +0.51 +Diluted (loss) earnings per common share +$ +(0.21 +) +$ +(0.09 +) +$ +(1.12 +) +$ +(0.19 +) +$ +0.50 +Weighted average shares outstanding – basic +34,714,395 +34,445,256 +33,979,549 +28,791,662 +25,750,972 +Weighted average shares outstanding – diluted +34,714,395 +34,445,256 +33,979,549 +28,791,662 +26,196,901 +Dividends declared per common share +$ +— +$ +0.225 +$ +0.264 +$ +0.264 +$ +0.230 +Dividends paid +$ +— +$ +7,792 +$ +8,995 +$ +7,977 +$ +5,937 +Total assets +$ +392,582 +$ +438,549 +$ +498,634 +$ +598,819 +$ +412,107 +Short-term debt +— +11,296 +8,827 +19,494 +8,887 +Long-term debt +74,456 +103,537 +114,366 +157,834 +102,969 +Short-term capital lease and sale-leaseback financing liability +698 +703 +764 +— +— +Long-term capital lease and sale-leaseback financing liability +12,018 +11,880 +12,533 +— +— +Shareholders’ equity +$ +178,560 +$ +186,569 +$ +190,082 +$ +245,021 +$ +181,224 +Results of operations from acquired businesses are included from the date of acquisition forward. The fair value of assets and liabilities, inclusive of changes resulting from operating the businesses, are included in the first period ended after the date of each acquisition, and all periods thereafter. Acquisitions consist of the following: (i) HEE Environmental Engineering (“HEE”) in August 2014, (ii) SAT Technology, Inc. (“SAT”) in September 2014, (iii) Emtrol LLC (“Emtrol”) in November 2014, (iv) Jiangyin Zhongli Industrial Technology Co. Ltd. (“Zhongli”) in December 2014, and (v) Peerless Mfg. Co. (“PMFG”) in September 2015. +Results of operations from businesses that are divested are excluded from the date of the disposition. Dispositions consist of the following: (i) Keystone Filter in February 2018, (ii) Strobic Air Corporation in March 2018, and (iii) Zhongli in November 2018. +23 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +Management’s discussion and analysis (“MD&A”) should be read in conjunction with the consolidated financial statements and accompanying notes included in Item 8 of this Annual Report on Form 10-K, which include additional information about our accounting policies, practices and the transactions underlying our financial results. The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and the accompanying notes including various claims and contingencies related to lawsuits, taxes, environmental and other matters arising during the normal course of business. We apply our best judgment, our knowledge of existing facts and circumstances and actions that we may undertake in the future in determining the estimates that affect our consolidated financial statements. We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change. As future events and their effects cannot be determined with precision, actual results may differ from these estimates. +Overview +Business Overview +CECO Environmental is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. CECO serves both established and emerging industries in regions around the world working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in multiple applications that include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +Industry Trends and Corporate Strategy +We are a global corporation with worldwide operations. As a global business, our operations are affected by worldwide, regional and industry-specific economic factors, wherever we operate or do business. Our geographic and industry diversity, and the breadth of our product and services portfolios, have helped mitigate the impact of any one industry or the economy of any single country on our consolidated operating results. +We believe growth for our products and services is driven by the increasing demand for energy consumption and a shift towards cleaner sources such as natural gas, nuclear, and renewable sources. These trends should stimulate investment in new power generation facilities, pipeline expansion and related infrastructure, and in upgrading of existing facilities. +With a shift to cleaner, more environmentally responsible power generation, power providers and industrial power consumers are building new facilities that use cleaner fuels. In developed markets, natural gas is increasingly becoming one of the energy sources of choice. We supply product offerings throughout the entire natural gas infrastructure value chain and believe expansion will drive growth within our Energy Solutions segment for our pressure products and SCR systems for natural-gas-fired power plants. Increased global natural gas production as a percent of total energy consumption, miles of new pipeline being added globally, and an increase in liquification capacity all stand to drive the need for our products. +We also believe there is a trend in both developed and emerging markets to control and reduce emissions of harsher fuel sources for which our air pollution control equipment is required. In emerging markets including China, India, and South East Asia our business is positioned to benefit from tightening of air pollution standards. In developed markets, growth of industrialization will drive greater output of emissions requiring our equipment as well. In both markets, we expect capital expenditures for our equipment to increase and the need for our aftermarket services to grow as companies seek to meet new standards. +We continue to focus on increasing revenues and profitability globally while continuing to strengthen and expand our presence domestically. Our operating strategy has historically involved horizontally expanding our scope of technology, products, and services through selective acquisitions and the formation of new business units that are then vertically integrated into our growing group of turnkey system providers. Our continuing focus will be on global growth, market coverage, and expansion of our Asia operations. Operational excellence, margin expansion, after-market recurring revenue growth, and safety leadership are also critical to our growth strategy. +24 +Operations Overview +We operate using an “outside-in” approach to our business model. We are structured to win in target markets with a core focus on understanding customer needs. This means there is a high application mix across multiple industries who have diverse needs for products and solutions. Our business model requires scalable efficiencies enabling us to serve our customers with a variety of products that we typically classify into three categories: make-to-order, configure-to-order, and engineer-to-order. We use an asset light model to accomplish this by focusing on application and technical expertise throughout our operations. This has provided us with critical efficiencies over other models. +The Company’s segments are led by presidents with distinct industry expertise coupled with strong leadership skills resulting in a customer-first mindset across the business. They manage their teams who are responsible for successfully running the segment operations. The segment presidents work closely with our Chief Executive Officer on global growth strategies, operational excellence, and employee development. +Within our segments we have monthly operating reviews to ensure we are both winning in the markets and winning as a business. These reviews include, but are not limited to, deal reviews, project reviews, and manufacturing reviews. Each of these reviews takes a customer-first approach where we adopt the metrics that matter most to our customer and to our shareholders. In these reviews we focus on metrics such as quality, customer satisfaction, on-time-delivery, lead-times, price, position, project margins, backlog, and above all, safety. +The headquarters focuses on enabling the core back-office key functions for scale and efficiency, that is, accounting, payroll, human resources/benefits, information technology, safety support, internal control over financial reporting, and administration. We have excellent organizational focus from headquarters throughout our divisional businesses with clarity and minimal duplicative work streams. +Our three reportable segments are: +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for Clean Energy with products and services that support our customers with efficient solutions and technologies to keep the world clean and safe. Our offerings improve air quality and solves fluid handling needs with market leading, highly engineered, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Industrial Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings improve air quality with a compelling solution set of air pollution control technologies that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Our contracts are obtained either through competitive bidding or as a result of negotiations with our customers. Contract terms offered by us are generally dependent on the complexity and risk of the project as well as the resources that will be required to complete the project. Our focus is on increasing our operating margins as well as our gross margin percentage, which translates into stronger operating results. +Our cost of sales is principally driven by a number of factors, including material prices and labor cost and availability. Changes in these factors may have a material impact on our overall gross profit margins. +25 +We break down costs of sales into five categories. They are: +• +Subcontracts—Electrical work, concrete work, subcomponents and other subcontracts necessary to produce our products; +• +Labor—Our direct labor both in the shop and in the field; +• +Material—Raw material that we buy to build our products; +• +Equipment—Fans, motors, control panels and other equipment necessary for turnkey systems; and +• +Factory overhead—Costs of facilities and supervision wages necessary to produce our products. +In general, subcontracts provide us the most flexibility in margin followed by labor, material, and equipment. Across our various product lines, the relative relationships of these factors change and cause variations in gross margin percentage. Material costs have also increased faster than labor costs, which also reduces gross margin percentage. As material cost inflation occurs, the Company seeks to pass this cost onto our customers as price increases. +Selling and administrative expense principally includes sales and engineering payroll and related fringes, advertising and marketing expenditures as well as all corporate and administrative functions and other costs that support our operations. The majority of these expenses are fixed. With our asset light model, we expect our operations to leverage our fixed cost structure as revenue grows. +Note Regarding Use of Non-GAAP Financial Measures +The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) . These GAAP financial statements include certain charges the Company believes are not indicative of its ongoing operational performance. +As a result, the Company provides financial information in this MD&A that was not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. The Company provides this supplemental non-GAAP financial information, which the Company’s management utilizes to evaluate its ongoing financial performance, and which the Company believes provides greater transparency to investors as supplemental information to its GAAP results. +The Company has provided the non-GAAP financial measures of non-GAAP gross profit and non-GAAP gross profit margin, non-GAAP operating income, non-GAAP operating margin, and non-GAAP net income attributable to CECO Environmental Corp. as a result of the adjustment for items that the Company believes are not indicative of its ongoing operations. These items include charges associated with the Company’s acquisitions, divestitures and the items described below in “Consolidated Results.” The Company believes that evaluation of its financial performance compared with prior and future periods can be enhanced by a presentation of results that exclude the impact of these items. The Company has incurred additional charges related to its restructuring program that was implemented in the fourth quarter of 2017. While the Company cannot predict the exact timing or amounts of such charges, it does expect to treat these charges as special items in its future presentation of non-GAAP results. +26 +Results of Operations +Consolidated Results +Our consolidated statements of operations for the years ended December 31, 2018, 2017 and 2016 are as follows: +Year ended December 31, +(dollars in millions) +2018 +2017 +2016 +Net sales +$ +337.3 +$ +345.1 +$ +417.0 +Cost of goods sold +225.8 +231.9 +282.1 +Gross profit +$ +111.5 +$ +113.2 +$ +134.9 +Percent of sales +33.1 +% +32.8 +% +32.4 +% +Selling and administrative expenses +$ +87.4 +$ +89.0 +$ +81.9 +Percent of sales +25.9 +% +25.8 +% +19.6 +% +Acquisition and integration expenses +$ +— +$ +— +$ +0.5 +Amortization and earnout expenses +$ +9.7 +$ +7.1 +$ +20.2 +Loss on divestitures, net of selling costs +$ +4.4 +$ +— +$ +— +Intangible asset and goodwill impairment +$ +— +$ +7.2 +$ +57.9 +Restructuring expenses +$ +— +$ +1.9 +$ +— +Operating income (loss) +$ +10.0 +$ +8.0 +$ +(25.6 +) +Percent of sales +3.0 +% +2.3 +% +(6.1 +)% +Non-GAAP Measures +To compare operating performance between the years ended December 31, 2018, 2017 and 2016, the Company has adjusted GAAP operating income (loss) to exclude (1) amortization and contingent acquisition expenses, including amortization of acquisition related intangibles, retention, severance, and earnout expenses, (2) acquisition and integration related expenses, including legal, accounting, and banking expenses, (3) executive transition expenses, including severance for its former Chief Executive Officer, fees incurred in the search for a new Chief Executive Officer, and expenses associated with hiring a new Chief Financial Officer, (4) gain on insurance settlement, (5) facility exit expenses associated with the closure of certain leased facilities, (6) legacy design repair expenses related to costs to rectify issues on products that are no longer in production, (7) restructuring expenses primarily relating to severance, facility exit, legal and property, plant and equipment impairment, (8) intangible asset and goodwill impairment, (9) inventory valuation and plant, property and equipment valuation adjustments related to acquisitions and (10) loss on divestitures. See “Note Regarding Use of Non-GAAP Financial Measures” above. The following tables present the reconciliation of GAAP gross profit and GAAP gross profit margin to non-GAAP gross profit and non-GAAP gross profit margin, GAAP operating (loss) income and GAAP operating margin to non-GAAP operating income and non-GAAP operating margin, and GAAP net (loss) income attributable to CECO Environmental Corp. to non-GAAP net income attributable to CECO Environmental Corp.: +Year Ended December 31, +(dollars in millions) +2018 +2017 +2016 +Gross profit as reported in accordance with GAAP +$ +111.5 +$ +113.2 +$ +134.9 +Gross profit margin in accordance with GAAP +33.1 +% +32.8 +% +32.4 +% +Legacy design repairs +— +2.0 +— +Inventory valuation adjustment +— +— +0.1 +Plant, property and equipment valuation adjustment +— +0.6 +0.6 +Non-GAAP gross profit +$ +111.5 +$ +115.8 +$ +135.6 +Non-GAAP gross profit margin +33.1 +% +33.6 +% +32.5 +% +27 +Year Ended December 31, +(dollars in millions) +2018 +2017 +2016 +Operating income (loss) as reported in accordance with GAAP +$ +10.0 +$ +8.0 +$ +(25.6 +) +Operating margin in accordance with GAAP +3.0 +% +2.3 +% +(6.1 +)% +Legacy design repairs +— +2.0 +— +Inventory valuation adjustment +— +— +0.1 +Plant, property and equipment valuation adjustment +— +0.6 +0.6 +Gain on insurance settlement +— +— +(1.0 +) +Acquisition and integration expenses +— +— +0.5 +Amortization and earnout expenses +9.7 +7.1 +20.2 +Loss on divestitures, net of selling costs +4.4 +— +— +Intangible asset and goodwill impairment +— +7.2 +57.9 +Restructuring expenses +— +1.9 +— +Executive transition expenses +— +1.3 +— +Facility exit expenses +— +0.2 +— +Non-GAAP operating income +$ +24.1 +$ +28.3 +$ +52.7 +Non-GAAP operating margin +7.1 +% +8.2 +% +12.6 +% +Year Ended December 31, +(dollars in millions) +2018 +2017 +2016 +Net loss attributable to CECO Environmental Corp. as reported in accordance with GAAP +$ +(7.1 +) +$ +(3.0 +) +$ +(38.2 +) +Legacy design repairs +— +2.0 +— +Inventory valuation adjustment +— +— +0.1 +Plant, property and equipment valuation adjustment +— +0.6 +0.6 +Gain on insurance settlement +— +— +(1.0 +) +Acquisition and integration expenses +— +— +0.5 +Amortization and earnout expenses +9.7 +7.1 +20.2 +Loss on divestitures, net of selling costs +4.4 +— +— +Intangible asset and goodwill impairment +— +7.2 +57.9 +Restructuring expenses +— +1.9 +— +Executive transition expenses +— +1.3 +— +Facility exit expenses +— +0.2 +— +Foreign currency remeasurement +0.8 +(2.1 +) +0.8 +Tax benefit of expenses +2.4 +(5.7 +) +(7.4 +) +Non-GAAP net income attributable to CECO Environmental Corp. +$ +10.2 +$ +9.5 +$ +33.5 +Non-GAAP net income as a percentage of sales +3.0 +% +2.8 +% +8.0 +% +In 2018, we divested three non-core businesses; Keystone filter brand (“Keystone”) and Strobic Air Corporation (“Strobic”) in the first quarter and Jiangyin Zhongli Industrial Technology Co. Ltd. (“Zhongli”) in the fourth quarter (collectively, “the Divestitures”). The exclusion of the operating results subsequent to their disposition impacts the comparability of our consolidated and segment operating results. +Comparison of the years ended December 31, 2018 and 2017 +Consolidated sales in 2018 were $337.3 million compared with $345.1 million in 2017, a decrease of $7.8 million. The decrease is primarily attributable to the Divestitures, which contributed $34.6 million of sales in 2017 and only $9.3 million of sales in 2018. Strong year-over-year sales in our Energy Solutions segment, with an increase of $22.2 million, partially offset the impact of the Divestitures. Excluding the impact of the Divestitures, sales increased $30.5 million, or 17.4%. +28 +Gross profit decreased by $1.7 million, or 1.5% , to $111.5 million in 2018 compared with $113.2 million in 2017 . Gross profit as a percentage of sales increased to 33.1% in 2018 compared with 32.8% in 201 7 . The decrease in gross profit was primarily attributable to the Divestitures . N on-GAAP gross profit was $111.5 million , or 33.1% as a percentage of sales for 2018 , a decrease of $4.3 million compared with non-GAAP gross profit of $115.8 million , or 33.6% as a percentage of sales in 2017 . T he gross profit margin in 2017 was impacted by incurring $3.0 million in warranty expense and $2.0 million in legacy design repairs in 2017 . The higher warranty expense in 2017 is primarily attributabl e to a legacy product design issue . The 2017 legacy design repairs are primarily attributable to specific issues on certain pre-acquisition projects. +Selling and administrative expenses were $87.4 million in 2018 compared with $89.0 million in 2017. Selling and administrative expenses as a percentage of sales were 25.9% in 2018 compared with 25.8% in 2017. The decrease in expenses is primarily due to lower year-over-year sales. The benefit of our 2017 restructuring was offset by investments in selling and customer service. +Amortization and earnout expense was $9.7 million in 2018 and $7.1 million in 2017, which was comprised of $9.6 million and $11.6 million of amortization expense in 2018 and 2017, respectively, and $0.1 million of earnout loss and $4.5 million of earnout income in 2018 and 2017, respectively. The change in the earnout year-over-year is primarily due to earnout adjustments related to Zhongli resulting in income of $0.3 million in 2018 and income of $6.6 million in 2017. Amortization expense decreased in 2018 due to the impact of the Divestitures. +In 2018, the Company divested Keystone, Strobic and Zhongli, resulting in a net loss on divestitures of $4.4 million. The loss was comprised of a $6.9 million gain for Keystone, $4.3 million gain for Strobic and $15.6 million loss for Zhongli. +There were no goodwill or tradename impairment charges in 2018. In 2017, the Company recorded a non-cash impairment charge of $7.2 million. The charge included $4.5 million to fully impair the carrying value of the goodwill of the Zhongli reporting unit. An additional charge of $2.7 million was recorded to reduce the carrying value of four tradenames within the Energy segment to their fair value. +The Company implemented a restructuring program during the second half of 2017 and incurred restructuring expenses of $1.9 million. There were no restructuring charges in 2018. +Operating income for 2018 was $10.0 million, an increase of $2.0 million from $8.0 million in 2017. Operating income as a percentage of sales for 2018 was 3.0% compared with 2.3% for 2017. The increase in operating income was attributable to the factors described above. +Non-GAAP operating income was $24.1 million in 2018, a decrease of $4.2 million from $28.3 million in 2017. Non-GAAP operating income as a percentage of sales for 2018 was 7.1% compared with 8.2% for 2017. +Other (expense) income for 2018 was $0.4 million of expense compared with $0.1 million of income in 2017, and was comprised primarily of foreign currency transaction gains and losses. +Interest expense increased to $7.1 million in 2018 from $6.7 million in 2017. The increase is due to higher interest rates in 2018 compared to 2017, which was partially offset by lower average debt balances in 2018. +Income tax expense was $9.6 million and $4.4 million in 2018 and 2017, respectively. The effective tax rate for 2018 was 385.2% compared with 315.0% in 2017. +Income tax expense and the effective tax rate for 2018 were significantly impacted by permanent differences between the tax reporting and financial statement reporting of the net loss on the Divestitures. The net effect of those permanent differences was $7.0 million of tax expense in 2018. The Company completed its accounting for the tax effects of the Tax Cuts and Jobs Act (“Tax Act”) in 2018 and recorded a $1.7 million favorable adjustment to the amount of tax liability provisionally recorded in 2017 for the one-time deemed repatriation of foreign earnings. +Income tax expense and the effective tax rate for 2017 were significantly impacted by certain aspects of the Tax Act. As a result of the Tax Act, the effective tax rate was adversely impacted in 2017 by a $6.4 million charge related to the deemed, one-time repatriation of foreign earnings, which was partially offset by a favorable $4.8 million benefit related to the revaluation of net deferred tax assets and liabilities from the reduction in the U.S. corporate income tax rate from 35% to 21%. Other significant impacts to the 2017 effective tax rate included the adverse effect of $1.8 million of nondeductible intangible asset and goodwill impairment charges, as well as a $1.8 million benefit from nondeductible earnout expenses. +29 +Comparison of the years ended December 31, 201 7 and 201 6 +Consolidated sales in 2017 were $345.1 million compared with $417.0 million in 2016, a decrease of $71.9 million. The decrease is primarily attributable to a decline within the Company’s Energy Solutions segment and in the Company’s Industrial Solutions segment. These declines were partially offset by increased sales in the Company’s Fluid Handling Solutions segment. +Gross profit decreased by $21.7 million, or 16.1%, to $113.2 million in 2017 compared with $134.9 million in 2016. Gross profit as a percentage of sales increased to 32.8% in 2017 compared with 32.4% in 2016. The decrease in gross profit was primarily attributable to a sales volume decline period over period. On an as adjusted basis, non-GAAP gross profit was $115.8 million, or 33.6% as a percentage of sales for 2017, a decrease of $19.8 million compared with non-GAAP gross profit of $135.6 million, or 32.5% as a percentage of sales in 2016. The higher gross profit margin in 2017 was primarily due to favorable project mix and was partially offset by the Company incurring $3.0 million in warranty expense and $2.0 million in legacy design repairs in 2017, compared with warranty expense of $0.5 million during in 2016. The increase in warranty expense is primarily attributable to a legacy product design issue. The increase in legacy design repairs is primarily attributable to specific issues on certain pre-acquisition projects. +Selling and administrative expenses were $89.0 million in 2017 compared with $81.9 million in 2016. Selling and administrative expenses as a percentage of sales were 25.8% in 2017 compared with 19.6% in 2016. The increase is primarily attributable to executive transition expenses related to the Company’s transition and search for a new Chief Executive Officer and expenses associated with the hiring of a new Chief Financial Officer of $1.3 million in 2017, an increase of $3.0 million of allowance for bad debt expense during 2017 compared with 2016 and additional investments in selling and finance personnel in 2017. Other factors leading to the increase are related to the Company recording gains of $1.6 million during 2016, which consisted of $1.0 million related to a life insurance settlement and $0.6 million related to a warranty settlement received from an external service provider of the Company. +Amortization and earnout expense was $7.1 million in 2017 and $20.2 million in 2016 which was comprised of $11.6 million and $14.0 million of amortization expense in 2017 and 2016, respectively, and $4.5 million of earnout income and $6.2 million of earnout loss in 2017 and 2016, respectively. The adjustment recorded to the fair value of the earnout from the Zhongli acquisition was $6.6 million of income in 2017 and $6.5 million of expense in 2016. The fair value adjustment to the earnout in 2017 was the result of Zhongli performing below operational expectations set for 2017, while in 2016, it performed above initial acquisition date operational expectations. Amortization expense decreased year-over-year due to fully amortized intangible assets. +In 2017, the Company recorded a non-cash impairment charge of $7.2 million. The charge included $4.5 million to fully impair the carrying value of the goodwill of the Zhongli reporting unit. An additional charge of $2.7 million was recorded to reduce the carrying value of four tradenames within the Energy segment to their fair value. +In 2016, the Company recorded a non-cash impairment charge of $57.9 million. A charge of $53.8 million was recorded to reduce the carrying value of the goodwill of three reporting units. An additional charge of $4.2 million was recorded to reduce the carrying value of four tradenames to their fair value. +The Company implemented a restructuring program during the fourth quarter of 2017 and incurred restructuring expenses of $1.9 million. +Operating income for 2017 was $8.0 million, an increase of $33.6 million from a loss of $25.6 million in 2016. Operating income as a percentage of sales for 2017 was 2.3% compared with a negative (6.1)% for 2016. The increase in operating income was attributable to the factors described above. +Non-GAAP operating income was $28.3 million for 2017, a decrease of $24.4 million from $52.7 million in 2016. Non-GAAP operating income as a percentage of sales for 2017 was 8.2% compared with 12.6% for 2016. +Other income, which is primarily foreign currency transaction gains and losses, was $0.1 million of income in 2017 compared with $0.3 million of income in 2016. +Interest expense decreased to $6.7 million in 2017 from $7.7 million in 2016. The decrease is attributable to debt repayments made throughout 2016 and 2017 that decreased the amount of outstanding debt throughout 2017. +Income tax expense was $4.4 million and $5.3 million in 2017 and 2016, respectively. The effective tax rate for 2017 was 315.0% compared with (16.0) % in 2016. +30 +Income tax expense and the effective tax rate for 2017 were significantly impacted by the Tax Act. As a result of the Tax Act, the effective tax rate was adversely i mpacted by a $6.4 million charge related to the deemed, one-time repatriation of foreign earnings, but it was favorably impacted by a $4.8 million benefit related to the revaluation of net deferred tax assets and liabilities as a result of the reduction in the U.S. corporate income tax rate from 35% to 21%. Other significant impacts to the 2017 effective tax rate include the adverse effect of $1.8 million nondeductible of intangible asset and goodwill impairment charges, as well as a benefit of nondeductible $1.8 million related to an adjustment to estimated earnout expenses. The amounts reported related to changes brought about by the Tax Act were provisio nal amounts, subject to change within the measurement period ending December 22, 201 8 . +The 2016 effective tax rate was adversely impacted by $2.6 million of nondeductible earnout expenses and $17.9 million of nondeductible intangible asset and goodwill impairment charges, which more than offset the benefits of $1.7 million from foreign rate differences, $0.6 million of the domestic production activities deduction, $1.0 million related to United States and Foreign tax incentives and deferred tax asset movement, and $0.6 million of changes in uncertain tax position reserves. +Business Segments +The Company’s operations are organized and reviewed by management along its product lines or end market that the segment serves and are presented in three reportable segments. The results of the segments are reviewed through the “Income (loss) from operations” line on the Consolidated Statements of Operations. The amounts presented in the Net Sales table below and in the following comments regarding our net sales at the reportable business segment level exclude both intra-segment and inter-segment net sales. The Income (loss) from Operations table and corresponding comments regarding operating income (loss) at the reportable segment level include both intra-segment and inter-segment operating income. +During the first quarter of 2018, the Company finalized an overall assessment and recalibration of its strategy. As a part of the changes to its strategy, management determined that a realignment of the Company’s segments was necessary to better reflect the technologies and solutions we provide, and the end markets we serve. As a result of this realignment, the reportable segments of the Company have been renamed and we reclassified the operating results of certain business units within the Energy Solutions and Industrial Solutions segments to have their reportable segment more closely align with our strategy. All prior years have been reclassified to conform to the current year presentation. +2018 +2017 +2016 +Net Sales (less intra-, inter-segment sales) +(Table only in thousands) +Energy Solutions segment +$ +211,185 +$ +188,955 +$ +254,806 +Industrial Solutions segment +75,414 +87,838 +101,909 +Fluid Handling Solutions segment +50,740 +69,159 +61,788 +Corporate and Other (1) +— +(901 +) +(1,492 +) +Net sales +$ +337,339 +$ +345,051 +$ +417,011 +(1) +Includes adjustment for revenue on intercompany jobs. +2018 +2017 +2016 +Income (loss) from Operations +(Table only in thousands) +Energy Solutions segment +$ +28,398 +$ +14,565 +$ +30,582 +Industrial Solutions segment +5,635 +8,123 +8,481 +Fluid Handling Solutions segment +8,402 +14,736 +(36,209 +) +Corporate and Other (2) +(32,433 +) +(26,649 +) +(26,817 +) +Eliminations +— +(2,751 +) +(1,599 +) +Income (loss) from operations +$ +10,002 +$ +8,024 +$ +(25,562 +) +(2) +Includes loss on divestitures, net of selling costs, corporate compensation, professional services, information technology, acquisition and integration expenses, and other general and administrative corporate expenses. This figure excludes earnout expenses / income, which are recorded in the segment in which the expense / income occurs. See Note 7 to the consolidated financial statements for further information. +31 +Comparison of the years ended December 31, 2018 and 2017 +Energy Solutions segment +Our Energy Solutions segment net sales increased $22.2 million to $211.2 million in 2018 compared with $189.0 million in 2017, an increase of 11.7%. Sales of nox semi-catalytic reduction systems were up $24.6 million, FCC cyclone sales to the refinery market were up $6.7 million and sales of oily water separation equipment were up $9.1 million. These increases were partially offset by $11.6 million of lower sales of exhaust stacks and acoustical silencers and the impact of the divestiture of Zhongli. Zhongli had sales of $4.5 million in 2018 and $12.8 million in 2017. +Operating income increased $13.8 million to $28.4 million for 2018 compared with $14.6 million in 2017, an increase of 95.0% . The increase in operating income in 2018 was due to an increase in revenues, which resulted in an increase in gross profit of $5.5 million. Operating income in 2017 included a $7.2 million non-cash goodwill and tradename intangible assets impairment charge. O perating income in 2018 and 2017 was impacted by adjustments to the fair value of the earnout from the Zhongli acquisition, which resulted in $0.3 million of income in 2018 and $6.6 million of income in 2017. The 2017 year also included $2.3 million in warranty expense and $2.0 million in legacy design repair, while 2018 only had $0.6 million of warranty expense. +Industrial Solutions segment +Our Industrial Solutions segment net sales decreased $12.4 million to $75.4 million in 2018 compared with $87.8 million in 2017, a decrease of 14.1%. The decrease is primarily due to decreased sales volume for the segment’s wet scrubbers, bioreactor solutions and installation, and fabrication of ventilation duct work and related equipment. +Operating income decreased $2.5 million to $5.6 million for 2018 compared with $8.1 million in 2017, a decrease of 30.9%. The decrease in operating income was primarily due to the decrease in sales. +Fluid Handling Solutions segment +Our Fluid Handling Solutions segment net sales decreased $18.5 million to $50.7 million in 2018 compared with $69.2 million in 2017, a decrease of 26.7%. The decrease is primarily due to the divestitures of Keystone and Strobic, which had aggregate sales of $21.8 million in 2017 and $4.8 million in 2018, an impact of $17.0 million. +Operating income decreased $6.3 million to $8.4 million for 2018 compared with an operating income of $14.7 million for 2017, a decrease of 42.9%. The decrease in operating income is attributable to lower sales as well as a $3.0 million year-over-year decrease from the divestitures of Keystone and Strobic. +Comparison of the years ended December 31, 2017 and 2016 +Energy Solutions segment +Our Energy Solutions segment net sales decreased $65.8 million to $189.0 million in 2017 compared with $254.8 million in 2016, a decrease of 25.8%. The decrease is due primarily to decreased sales volume for the Company’s natural gas turbine exhaust systems related products and services and solid fuel power generation because of a weakening of this market in Europe and China and a weakening in the gas turbine powered market due to over-capacity. In addition, there were decreased sales for refinery related products and services attributable to the cyclical deferral of maintenance and capital expenditures by our customers in refinery related end markets. +Operating income from the Energy Solutions segment decreased $16.0 million to $14.6 million in 2017 compared with $30.6 million in 2016, a decrease of 52.4%. The decrease in operating income in 2017 was from a decrease in gross profit from the decrease in sales. The decrease in operating income was also attributable to a non-cash impairment charge of $7.2 million in 2017 to reduce the carrying value of goodwill at one reporting unit and tradename intangible assets at four reporting units to their fair value. The decrease in operating income was partially offset by adjustments recorded to the fair value of the earnout from the Zhongli acquisition, which resulted in $6.6 million of income in 2017 and $6.5 million of expense in 2016. +Industrial Solutions segment +Our Industrial Solutions segment net sales decreased $14.1 million to $87.8 million in 2017 compared with $101.9 million in 2016, a decrease of 13.8%. The decrease is primarily due to decreased sales volume for the Company’s installation and fabrication of +32 +ventilation of duct work and related equipment and thermal oxidizers which was partially offset by increase d s ales of bio reactor scrubber sales. +Operating income from the Industrial Solutions segment decreased $0.4 million to $8.1 million in 2017 compared with $8.5 million in 2016, a decrease of 4.7%. The decrease in operating income was primarily due to a $6.1 million decrease in gross profit from the lower sales. Additionally, operating income in 2016 was higher due to $2.3 million of income recorded in 2016 as a result of adjustments to the fair value of earnouts, which was partially offset by a non-cash impairment charge of $6.8 million recorded in 2016 to reduce the carrying value of the goodwill at two reporting units to their fair value. +Fluid Handling Solutions segment +Our Fluid Handling Solutions segment net sales increased $7.4 million to $69.2 million in 2017 compared with $61.8 million in 2016, an increase of 12.0%. The increase is due to increased international demand for the segments products and strengthening of the North America industrial market in 2017. +Operating income increased $50.9 million to $14.7 million for 2017 compared with an operating loss of $(36.2) million for 2016, an increase of 140.6%. The increase was primarily due to a non-cash impairment charge of $46.9 million in 2016, which was recorded to reduce the carrying value of the goodwill at a reporting unit to its fair value and an additional non-cash intangible asset impairment charge of $1.8 million in 2016 related to a tradename intangible asset. In addition, the increase in operating income was due to an increase in revenue, which resulted in an increase in gross profit of $2.7 million. +Backlog +Backlog is a representation of the amount of revenue expected from complete performance of firm fixed-price contracts that have not been completed for products and services we expect to substantially deliver within the next twelve-month to eighteen-month period. Our backlog only includes firm orders, but our customers may have the right to cancel a given order. Backlog increased to $182.1 million as of December 31, 2018 from $168.9 million as of December 31, 2017. We removed $18.3 million of backlog in 2018 as a result of the Divestitures. Excluding the impact of Divestitures, backlog increased by $31.5 million year-over-year. Backlog is adjusted on a quarterly basis for adjustments in foreign currency exchange rates. There have been no other orders removed from backlog that were previously disclosed as backlog as of December 31, 2017. Backlog is not defined by GAAP and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Liquidity and Capital Resources +Our principal sources of liquidity are cash flow from operations and available borrowings under our Credit Facility (defined below). Our principal uses of cash are operating costs, payment of principal and interest on our outstanding debt, working capital and other corporate requirements. +When we undertake large jobs, our working capital objective is to make these projects self-funding. We work to achieve this by obtaining initial down payments, progress billing contracts, when possible, utilizing extended payment terms from material suppliers, and paying sub-contractors after payment from our customers, which is an industry practice. Our investment in net working capital is funded by cash flow from operations and by our revolving line of credit. +At December 31, 2018, the Company had working capital of $57.0 million, compared with $66.1 million at December 31, 2017. The ratio of current assets to current liabilities was 1.55 to 1 at December 31, 2018 as compared with a ratio of 1.61 to 1 at December 31, 2017. +At December 31, 2018 and 2017, cash and cash equivalents totaled $43.7 million and $29.9 million, respectively. As of December 31, 2018 and 2017, $23.3 million and $19.7 million, respectively, of our cash and cash equivalents were held by non-U.S. subsidiaries, as well as being denominated in foreign currencies. +33 +Debt consisted of the following at December 31, 2018 and 2017 : +December 31, +(Table only in thousands) +2018 +2017 +Outstanding borrowings under Credit Facility. +Term loan due in September 2020. +– Term loan +$ +76,147 +$ +113,903 +– U.S. Dollar revolving loans +— +1,000 +– Unamortized debt discount +(1,691 +) +(2,834 +) +Total outstanding borrowings under Credit Facility +74,456 +112,069 +Outstanding borrowings (U.S. dollar equivalent) under +Aarding Facility +— +2,764 +Total outstanding borrowings +74,456 +114,833 +Less: current portion +— +11,296 +Total debt, less current portion +$ +74,456 +$ +103,537 +In 2018, the Company made prepayments of $36.2 million on the term loan. Due to the prepayments made in 2018, there are no additional payments due on the term loan until the final payment of $76.1 million in September 2020. +The Company entered into a credit agreement (the “Credit Agreement”) with various lenders and letter of credit issuers providing for various senior secured credit facilities (collectively, the “Credit Facility”). The Credit Agreement contains customary affirmative and negative covenants, including the requirement to maintain compliance with a consolidated leverage ratio of less than 3.75 and a consolidated fixed charge coverage ratio of more than 1.25. Per the Credit Agreement, the maximum consolidated leverage ratio of 3.75 will remain constant at this ratio through March 31, 2019, when it will decrease to 3.50 through September 30, 2019. The consolidated leverage ratio will then decrease to 3.25 where it will remain until the end of the Credit Agreement. As of December 31, 2018 and 2017, the Company was in compliance with all related financial and other restrictive covenants under the Credit Facility. +A subsidiary of the Company located in the Netherlands has a Euro denominated facilities agreement (“Aarding Facility”). In March 2018, the Company settled the outstanding amount of $2.8 million of the overdraft facility. The Company plans to exit this facility and consolidate it with the existing Credit Facility in 2019. +See Note 9 to the consolidated financial statements for further information on the Company’s debt facilities. +Total unused credit availability under our Credit Facility and other non-U.S. credit facilities and agreements, exclusive of any potential asset base limitations, is as follows: +December 31, +2018 +2017 +(dollars in millions) +Credit Facility, U.S. Dollar revolving loans +$ +60.5 +$ +60.5 +Draw down +— +(1.0 +) +Letters of credit open +(29.3 +) +(24.4 +) +Credit Facility, Multi-currency revolving facilities +19.5 +19.5 +Netherlands facilities (€0.0 million at December 31, 2018 +and €13.0 million at December 31, 2017 in U.S. Dollar equivalent) +— +15.6 +Draw down +— +(2.8 +) +Letters of credit open +— +(3.9 +) +China Facility +— +4.6 +Draw down +— +— +Total unused credit availability +$ +50.7 +$ +68.1 +Amount available based on borrowing limitations +$ +50.7 +$ +18.7 +34 +Overview of Cash Flows and Liquidity +For the year ended December 31, +(dollars in thousands) +2018 +2017 +2016 +Total operating cash flow provided by operating activities +$ +21,952 +$ +6,570 +$ +69,599 +Net cash provided by (used in) investing activities +38,258 +(660 +) +(1,406 +) +Net cash used in financing activities +(44,900 +) +(24,138 +) +(57,988 +) +Effect of exchange rate changes on cash, cash equivalents and restricted cash +(1,531 +) +881 +(1,712 +) +Net increase (decrease) in cash, cash equivalents and restricted cash +$ +13,779 +$ +(17,347 +) +$ +8,493 +Operating Activities +In 2018, $22.0 million of cash was provided by operating activities compared with $6.6 million provided in 2017 , an increase of $15.4 million . Net earnings, adjusted for non-cash items (depreciation and amortization, unrealized foreign currency (gain) loss, impairment of intangible assets and goodwill, loss on divestitures and share based compensation) decreased $5.3 million year-over-year. Cash flow from operating activities in 2018 had a favorable year-over-year net impact of working capital balances as reflected in the Consolidated Statement of Cash Flows. In addition, Zhongli earnout payments, classified as operating activities, were $2.9 million in 2018 and $7.8 million in 2017. +In 2017, $6.6 million of cash was provided by operating activities as compared with $69.6 million provided in 2016, a decrease of $63.0 million. Net earnings, adjusted for non-cash items (depreciation and amortization, unrealized foreign currency (gain) loss, impairment of intangible assets and goodwill, loss on divestiture and share based compensation) decreased $21.7 million year-over-year. Cash flow from operating activities in 2017 had a negative year-over-year impact of working capital balances as reflected in the Consolidated Statement of Cash Flows. In addition, Zhongli earnout payments, classified as operating activities, were $7.8 million in 2017 with no corresponding payments in 2016. +Investing Activities +In 2018, $38.3 million of cash was provided by investing activities as compared with a use of cash of $0.7 million in 2017. The primary driver of the year-over-year changes was $35.1 million of proceeds from divestitures and $6.3 million of proceeds from the disposal of assets held for sale. A significant portion of the proceeds from divestitures was used to pay down the Credit Facility. +In 2017, $0.7 million of cash was used in investing activities as compared with $1.4 million in 2016. The change was due to a $1.0 million payoff on life insurance policy loans in 2016. +Financing Activities +Financing activities in 2018 used cash of $44.9 million, which consisted primarily of $37.8 million of payments on our Term Loan and $3.7 million net payments on our revolving credit lines. +Financing activities in 2017 used cash of $24.1 million, which consisted primarily of repayments of $11.2 million on our term loan, earnout payments of $7.4 million, and dividends paid to our shareholders of $7.8 million, less cash received from net borrowings on revolving credit lines of $2.3 million and proceeds from stock option exercises and employee stock purchases of $1.4 million. +Financing activities in 2016 used cash of $58.0 million, which consisted primarily of $55.2 million of net repayments on our Term Loan and revolving lines of credit, earnout payments of $9.3 million, and dividends paid to our shareholders of $9.0 million, less cash received from sale-leaseback transactions of $14.2 million and proceeds from stock option exercises and employee stock purchases of $1.7 million. +We believe that cash flows from operating activities, together with our existing cash and borrowings available under our Credit Facility, will be sufficient for at least the next twelve months to fund our current anticipated uses of cash. After that, our ability to fund these expected uses of cash and to comply with the financial covenants under our debt agreements will depend on the results of future operations, performance and cash flow. Our ability to fund these expected uses from the results of future operations will be subject to prevailing economic conditions and to financial, business, regulatory, legislative and other factors, many of which are beyond our control. +35 +Employee Benefit Obligation +Based on current assumptions, estimated contributions to our pension plan of $0.5 million are required in 2019. The amount and timing of required contributions to the pension trust depends on future investment performance of the pension funds and interest rate movements, among other things and, accordingly, we cannot reasonably estimate actual required payments. Currently, our pension plan is under-funded. As a result, absent major increases in long-term interest rates, above average returns on pension assets and/or changes in legislated funding requirements, we will be required to make contributions to our pension trust of varying amounts in future years. +Off-Balance Sheet Arrangements +None. +Contractual Obligations +The following table summarizes the Company’s contractual obligations as of December 31, 2018 (in thousands): +Payments Due by Period +Total +Less than 1 +year +1-3 years +3-5 years +More than +5 years +Long-term debt +$ +76,147 +$ +— +$ +76,147 +$ +— +$ +— +Note payable +1,700 +1,700 +— +— +— +Interest expense (estimated) +10,534 +6,019 +4,515 +— +— +Unconditional purchase obligations (1) +88,201 +88,201 +— +— +— +Pension obligations (2) +6,075 +491 +3,197 +2,387 +— +Operating lease obligations +10,139 +2,745 +3,334 +1,782 +2,278 +Capital lease & sale leaseback financing obligations +16,580 +1,252 +2,580 +2,683 +10,065 +Totals +$ +209,376 +$ +100,408 +$ +89,773 +$ +6,852 +$ +12,343 +( 1 ) +Primarily consists of purchase obligations for various costs associated with uncompleted sales contracts. +(2 ) +Future expected obligations under the Company’s pension plan is included in the contractual cash obligations table above, up to, but not more than five years. The Company’s pension plan policy allows it to fund an amount, which could be in excess of the pension cost expensed, subject to the limitations imposed by current tax regulations. +Critical Accounting Policies and Estimates +Our consolidated financial statements are prepared in conformity with GAAP. The preparation of these financial statements requires the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. We believe that, of our significant accounting policies, the following accounting policies involve a higher degree of judgments, estimates, and complexity. +Use of Estimates +Preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses and related contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to revenues, bad debts, share based compensation, income taxes, goodwill and intangible asset valuation, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. +Revenue Recognition +A substantial portion of our revenue is derived from fixed-price contracts. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. +We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance +36 +obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +The judgments and estimates involved include management’s ability to accurately estimate the contracts’ progress to completion at each financial reporting period. In addition, certain contracts are highly dependent on the work of contractors and other subcontractors participating in a project, over which we have no or limited control, and their performance on such project could have an adverse effect on the profitability of our contracts. Delays resulting from these contractors and subcontractors, changes in the scope of the project, weather, and labor availability also can have an effect on a contract’s profitability. Changes to job performance, job conditions, and estimated profitability may result in revisions to contract revenue and costs and are recognized in the period in which the revisions are made +Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. No provision for estimated losses on uncompleted contracts was needed at December 31, 2018, 2017 and 2016. +Credit and Collections +The Company maintains allowances for doubtful accounts receivable for probable estimated losses resulting from either customer disputes or the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in their inability to make the required payments, the Company may be required to record additional allowances or charges against income. The Company determines its allowance for doubtful accounts by considering all known collectability problems of customers’ accounts and reviewing the aging of the outstanding receivables. The resulting allowance for doubtful accounts receivable is an estimate based upon the Company’s knowledge of its business and customer base, and historical trends. The amount ultimately not collected may differ from the reserve established. +Inventories +The Company’s inventories are valued at the lower of cost or net realizable value using the first-in, first-out inventory costing method. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the Company’s forecast of future demand and market conditions. Significant unanticipated changes to the Company’s forecasts could require a change in the provision for excess or obsolete inventory. +Assets Held for Sale +The Company classifies properties as held for sale when certain criteria are met. At such time, the properties, including significant assets that are expected to be transferred as part of a sale transaction, are presented separately on the consolidated balance sheet at the lower of carrying value or estimated fair value less costs to sell and depreciation is no longer recognized. As of December 31, 2018, the Company had one building and one tract of land classified as held for sale. +Property, plant and equipment +Property, plant and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Depreciation and amortization are provided using the straight-line method in amounts sufficient to amortize the cost of the assets over their estimated useful lives (buildings and improvements—generally five to 40 years; machinery and equipment—generally two to 15 years). +Intangible assets +Indefinite life intangible assets are comprised of tradenames, while finite life intangible assets are comprised of technology, customer lists, noncompetition agreements, and tradenames. Finite life intangible assets are amortized on a straight line or accelerated basis over their estimated useful lives of seven to 10 years for technology, five to 20 years for customer lists, five years for noncompetition agreements, and 10 years for tradenames. +Long-lived assets +Property, plant and equipment and finite life intangible assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. If events or changes in circumstances occur that indicate possible impairment, our impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely +37 +independent of other groups of our assets and liabilities. This analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. We conduct annual reviews for idle and underutilized equipment, and review business plans for possible impairment. Impairment occurs when the carry ing value of the assets exceeds the future undiscounted cash flows expected to be earned by the use of the asset or asset group. When impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset or asset group and an impairment charge is recorded for the difference between the carrying value and the estimated fair value. +Additionally, we also evaluate the remaining useful life each reporting period to determine whether events and circumstances warrant a revision to the remaining period of depreciation or amortization. If the estimate of a long-lived asset’s remaining useful life is changed, the remaining carrying amount of the asset is amortized prospectively over that revised remaining useful life. +The Company completes an annual (or more often if circumstances require) impairment assessment of its indefinite life intangible assets. As a part of its annual assessment, typically, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of an asset is less than its carrying amount. If there is a qualitative determination that the fair value of a particular asset is more likely than not greater than its carrying value, we do not need to proceed to the quantitative estimated fair value test for that asset. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined by the relief from royalty method. If the estimated fair value of an asset is less than its carrying value, an impairment charge is recorded for the amount by which the carrying value of the asset exceeds its estimated fair value. For the 2018 and 2017 annual assessments, given the lower than expected results for certain reporting units, we determined that a quantitative assessment of fair value for all indefinite life intangible assets using the relief from royalty method was appropriate. For additional information on impairment testing results, see Note 7 to the consolidated financial statements. +Goodwill +The Company completes an annual (or more often if circumstances require) goodwill impairment assessment on October 1 on a reporting unit level, at or below the operating segment level. As a part of its annual assessment, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If there is a qualitative determination that the fair value of a particular reporting unit is more likely than not greater than its carrying value, the Company does not need to quantitatively test for goodwill impairment for that reporting unit. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is calculated using a weighting of the income method and the market method. If the estimated fair value of a reporting unit is less than its carrying value, an impairment charge is recorded. +The Company bases its measurement of the fair value of a reporting unit using a 50/50 weighting of the income method and the market method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital. Projected revenue, projected operational profit and terminal growth rates are significant assumptions because they are three primary drivers of the projected cash flows in the discounted future cash flow approach. Cost of capital is a significant assumption as it is the discount rate used to calculate the current fair value of those projected cash flows. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. Based on the analysis, the resultant estimated fair value of all of the reporting units exceeded their carrying value as of December 31, 2018. +In 2018, because of changes in management and the resulting changes to the Company’s reporting and operating structure, the number of reporting units for goodwill testing was aggregated to three reporting units from 11 prior to the change. Prior to the adoption of the new reporting structure we tested our goodwill impairment under the old reporting unit structure. Based on this analysis, the estimated fair value of all of our reporting units exceeded their carrying value as of October 1, 2018. The estimated fair value of each of the reporting units under the new structure exceed their respective carrying value by over 30%. For additional information on goodwill impairment testing results, see Note 7 to the consolidated financial statements. +Income Taxes +Income taxes are determined using the asset and liability method of accounting for income taxes in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 740, “Income Taxes”. Income tax expense includes federal, state and foreign income taxes. +38 +Deferred income taxes are provided using the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operatin g loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases and are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Tax credits and other incentives reduce income tax expense in the year the credits are claimed. +Management must assess the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal, state and foreign tax authorities who regularly audit the Company in the normal course of business. In making these assessments, management must often analyze complex tax laws of multiple jurisdictions, including many foreign jurisdictions. The accounting guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. +Management must access the realizability of the Company’s deferred tax assets. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this assessment. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The Company has made an accounting policy election to record the U.S. income tax effect of future global intangible low-taxed income (“GILTI”) inclusions in the period in which they arise, rather than establishing deferred taxes with respect to the expected future tax liabilities associated with future GILTI inclusion. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested. A liability has been recorded for the deferred taxes on such undistributed foreign earnings. The amount is attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +Pension Benefit Plan Assumptions +We sponsor a pension plan for certain employees. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense and liability related to the plan. These factors include key assumptions, such as a discount rate and expected return on plan assets. In addition, our actuarial consultants use subjective factors such as withdrawal and mortality rates to estimate the liability. The actuarial assumptions we use may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of participants. These differences may result in a significant impact to the amount of pension expense we have recorded or may record in the future. An analysis for the expense associated with our pension plan is difficult due to the variety of assumptions utilized. For example, one of the significant assumptions used to determin e projected benefit obligation is the discount rate. At December 31, 2018, a 25 basis point change in the discount rate would change the projected benefit obligation by approximately $0.9 million and the annual pension expense by approximately $3,000. Additionally, a 25 basis point change in the expected return on plan assets would change the pension expense by approximately $58,000. +39 +Share-Based Compensation +We measure the cost of employee services received in exchange for an award of equity instruments and recognize this cost over the period during which an employee is required to provide the services, based on the fair value of the award at the date of the grant as determined by current publicly traded market price on the grant date for restricted stock units. +Certain of our awards of restricted share units include performance conditions for achieving designated levels of operating performance. We must estimate the probability of achieving the performance condition at each reporting period. +Product Warranties +The Company’s warranty reserve is to cover the products sold. The warranty accrual is based on historical claims information. The warranty reserve is reviewed and adjusted as necessary at each reporting period. +Other significant accounting policies +Other significant accounting policies, not involving the same level of uncertainties as those discussed above, are nevertheless important to an understanding of our financial statements. See Note 1 to the consolidated financial statements, Summary of Significant Accounting Policies, which discusses accounting policies that must be selected by us when there are acceptable alternatives. +New Accounting Pronouncements +For information regarding recent accounting pronouncements, see Note 2 to the consolidated financial statements included in this annual report on Form 10-K. +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +We are exposed to certain market risks, primarily changes in interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. For the Company, these exposures are primarily related to changes in interest rates. We do not currently hold any derivatives or other financial instruments purely for trading or speculative purposes. However, we do have an interest rate swap in place as of December 31, 2018 to hedge against a portion of our interest rate exposure related to debt indexed to LIBOR market rates. See Note 9 to the consolidated financial statements for further information on this interest rate swap. +The carrying value of the Company’s total long-term debt and current maturities of long-term debt at December 31, 2018 was $74.5 million. Market risk was estimated as the potential decrease (increase) in future earnings and cash flows resulting from a hypothetical 10% increase (decrease) in the Company’s estimated weighted average borrowing rate at December 31, 2018. Most of the interest on the Company’s debt is indexed to either the LIBOR or EURIBOR market rates. The estimated annual impact of a hypothetical 10% change in the estimated weighted average borrowing rate, excluding the portion of debt which has an interest rate fixed by the interest rate swap described above, at December 31, 2018 is $0.2 million. +The Company has wholly-owned subsidiaries including in the Netherlands, Canada, the People’s Republic of China, Mexico, United Kingdom, Singapore, and Chile. In the past, we have not hedged our foreign currency exposure, and fluctuations in exchange rates have not materially affected our operating results. Future changes in exchange rates may positively or negatively impact our revenues, operating expenses and earnings. Since most of our foreign sales are denominated in the local currency, we do not anticipate that exposure to foreign currency rate fluctuations will be material in 2019. +40 +Item 8. +Financial Stateme nts and Supplementary Data +The consolidated financial statements of CECO Environmental Corp. and subsidiaries for the years ended December 31, 2018, 2017 and 2016 and other data are included in this report following the signature page of this report and incorporated into this Item 8 by reference: +Report of Independent Registered Public Accounting Firm +F-1 +Consolidated Balance Sheets +F-2 +Consolidated Statements of Operations +F-3 +Consolidated Statements of Comprehensive Income (Loss) +F-4 +Consolidated Statements of Shareholders’ Equity +F-5 +Consolidated Statements of Cash Flows +F-7 +Notes to Consolidated Financial Statements for the Years Ended December 31, 2018, 2017 and 2016 +F-9 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. +Controls and Procedures +Disclosure Controls and Procedures +Disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) are controls and other procedures that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and made known to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +In connection with the preparation of this Annual Report on Form 10-K, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2018. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2018. +The management of the Company does not expect that its disclosure controls and procedures will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instance of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur due to simple errors or mistakes. The design of any system of controls is based in part upon certain assumptions regarding the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. +Management’s Report on Internal Control over Financial Reporting +The management of the Company is responsible for the preparation and accuracy of the financial statements and other information included in this report. Under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2018, based on the criteria set forth in Internal Control – Integrated Framework (2013) (the “Framework”) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management concluded that, as of December 31, 2018, its internal control over financial reporting was effective based on the Framework. +There are inherent limitations on the effectiveness of any system of internal controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective internal controls and procedures can only provide reasonable assurance of achieving their control objectives. +41 +Item 9A includes the audit report of BDO USA, LLP on the Company’s internal control over financial reporting as of December 31, 201 8 . +Changes in Internal Control Over Financial Reporting +There were no changes in our internal control over financial reporting during the quarter ended December 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. During 2018, we implemented internal controls to ensure we have adequately evaluated our lease contracts and properly assessed the impact of the new accounting standard related to lease recognition on our financial statements to facilitate the adoption on January 1, 2019. We do not expect significant changes to our internal control over financial reporting due to the adoption of the new standard. +42 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +CECO Environmental Corp. and Subsidiaries +Cincinnati, Ohio +Opinion on Internal Control over Financial Reporting +We have audited CECO Environmental Corp. and Subsidiaries’ (the “Company’s”) internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the COSO criteria . +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and our report dated March 7, 2019, expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ BDO USA, LLP +Cincinnati, Ohio +March 7, 2019 +43 +Item 9B. +Othe r Information +None. +44 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +The information called for by this Item 10 of Part III of Form 10-K is incorporated by reference to the information set forth in our definitive proxy statement relating to our 2019 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A under the Exchange Act within 120 days from December 31, 2018 (the “Proxy Statement”). Reference is also made to the information appearing in Item 1 of Part I of this Annual Report on Form 10-K under the caption “Business— Executive Officers of CECO.” +Item 11. +Executive Compensation +The information called for by this Item 11 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Item 12. +Security Ownership of C ertain Beneficial Owners and Management and Related Stockholder Matters +The information called for by this Item 12 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Securities Authorized for Issuance Under Equity Compensation Plans +EQUITY COMPENSATION PLAN INFORMATION +December 31, 2018 +(a) +(b) +(c) +Plan Category +Number of securities +to be issued upon +exercise of outstanding +options and rights +Weighted-average +exercise price of +outstanding options and rights, compensation plans +Number of securities +remaining available for +future issuance under +equity compensation +plans (excluding +securities reflected in +column (a)) +Equity compensation plans approved by security +holders +2007 Equity Incentive Plan 1 +590,989 +$ +7.92 +— +2017 Equity and Incentive Plan 2 +1,245,595 +$ +0.49 +1,266,491 +Employee Stock Purchase Plan 3 +13,699 +$ +5.33 +1,324,784 +Equity compensation plans not approved by security holders +— +$ +— +— +TOTAL +1,850,283 +2,591,275 +1 +The 2007 Plan was replaced with the 2017 Equity and Incentive Plan and no further grants will be made under the 2007 Plan. The 2007 Plan remains in effect solely for the continued administration of the awards currently outstanding under the 2007 Plan. +2 +The 2017 Equity and Incentive Plan was approved by our shareholders on May 16, 2017. We have reserved 1.9 million shares of our common stock for issuance under our 2017 Equity Incentive Plan. In 2018, 960,000 restricted stock units were awarded to plan participants under the 2017 Equity and Incentive Plan. +3 +The Employee Stock Purchase Plan was approved by our shareholders on May 21, 2009. +Item 1 3. +Certain Relationships and Related Transactions, and Director Independence +The information called for by this Item 13 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Item 14. +Principal Accounting Fees and Services +The information called for by this Item 14 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +PART IV +Item 15. +Exhibits and Financial Statement Schedules +1. Financial statements are set forth in this report following the signature page of this report. +45 +2. Financial statement schedules are omitted because they are not applicable or because the required information is shown in the financial statements or in the notes thereto. +3. Exhibit Index. The exhibits listed below, as part of Form 10-K, are numbered in conformity with the numbering used in Item 601 of Regulation S-K and relate to SEC File No. 0-07099, unless otherwise indicated. +Exhibit +Number +2 +2.1 +Stock Purchase Agreement, dated March 30, 2018, by and among CECO Environmental Corp., Met-Pro Corporation, LLC, Strobic Air Corporation and Cincinnati Fan & Ventilation Company., Inc (Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on April 5, 2018). +3(i) +Certificate of Incorporation (Incorporated by reference to Exhibit 3(i) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001) +3(ii) +Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 13, 2017) +**10.1 * +Summary term sheet governing arrangement of consulting services provided by Icarus Investment Corp. +**10.2 +Second Amended and Restated CECO Environmental Corp. 2007 Equity Incentive Plan (Incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +**10.3 +Form of Restricted Stock Award Agreement (Incorporated by reference to Exhibit 10.41 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008) +**10.4 +Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010) +**10.5 +Form of Non-Statutory Stock Option Agreement (Incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010) +**10.6 +CECO Environmental Corp. Employee Stock Purchase Plan (Incorporated by reference to Exhibit A to the Company’s definitive proxy statement on Schedule 14A filed with the SEC on April 13, 2009) +**10.7 * +Summary term sheet governing arrangement of consulting services provided by JMP Fam Holdings Inc. to the Company +10.8 +Amended and Restated Credit Agreement, dated as of September 3, 2015, among the Company and certain of its subsidiaries, the Lenders party thereto, and Bank of America, N.A. (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +10.9 +Securities Pledge Agreement, dated August 27, 2013, by and among the Company, the Subsidiaries named therein and Bank of America, N.A., as Administrative Agent (Incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +**10.10 +Director and Officer Indemnification Agreement, dated as of May 12, 2016, by and between the Company and the Directors and Officers of the Company (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on May 16, 2016) +**10.11 +Executive Employment Agreement, effective as of January 9, 2017, by and between the Company and Matthew Eckl (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2017) +**10.12 +Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.13 +Form of Nonqualified Stock Option Agreement (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.14 +Form of Restricted Stock Units Agreement for Directors (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +46 +Exhibit +Number +**10.15 +Form of Restricted Stock Units Agreement for Employees (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.16 +Executive Employment Agreement, dated as of June 10, 2017, between the Company and Dennis Sadlowski (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on June 12, 2017) +**10.17 +CECO Environmental Corp. 2017 Equity and Incentive Compensation Plan (Incorporated by reference to Exhibit 4.3 to the Registrant’s Registration Statement on Form S-8 filed on May 16, 2017 (Registration No. 333-218030)) +10.18 +Amendment No. 1 to Amended and Restated Credit Agreement (Incorporated by reference to Exhibit 10.26 to the Company’s Report on Form 10-K filed with the SEC on March 9, 2018) +10.19 +Amendment No. 2 to Amended and Restated Credit Agreement (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +10.20 +Amendment No. 3 to Amended and Restated Credit Agreement (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 8, 2017) +10.21 +Amendment No. 4 to Amended and Restated Credit Agreement (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 7, 2018) +*21 +Subsidiaries of the Company +*23.1 +Consent of BDO USA, LLP +*31.1 +Rule 13(a)/15d-14(a) Certification by Chief Executive Officer +*31.2 +Rule 13(a)/15d-14(a) Certification by Chief Financial Officer +*32.1 +Certification of Chief Executive Officer (18 U.S. Section 1350) +*32.2 +Certification of Chief Financial Officer (18 U.S. Section 1350) +*101.INS +XBRL Instance Document +*101.SCH +XBRL Taxonomy Extension Schema Document +*101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +*101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +*101.LAB +XBRL Taxonomy Extension Label Linkbase Document +*101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* +Filed or furnished herewith +** +Management contracts or compensation plans or arrangement +Item 16. +Form 10-K Summary +Not applicable. +47 +SIGNAT URES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +CECO ENVIRONMENTAL CORP. +By: +/S/ M ATTHEW E CKL +Matthew Eckl +Chief Financial Officer +March 7, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: +Principal Executive Officer: +/S/ D ENNIS S ADLOWSKI +March 7, 2019 +Dennis Sadlowski +Chief Executive Officer and Director +Principal Financial Officer: +/S/ M ATTHEW E CKL +March 7, 2019 +Matthew Eckl +Chief Financial Officer +Principal Accounting Officer: +/S/ P AUL G OHR +March 7, 2019 +Paul Gohr +Chief Accounting Officer +Directors: +/S/ J ASON D EZWIREK +March 7, 2019 +Jason DeZwirek +Chairman of the Board and Director +/S/ E RIC M. G OLDBERG +March 7, 2019 +Eric M. Goldberg +Director +/S/ D AVID B . L INER +March 7, 2019 +David B. Liner +Director +/S/ C LAUDIO A. M ANNARINO +March 7, 2019 +Claudio A. Mannarino +Director +/S/ M UNISH N ANDA +March 7, 2019 +Munish Nanda +Director +/S/ J ONATHAN P OLLACK +March 7, 2019 +Jonathan Pollack +Director +/S/ V ALERIE G ENTILE S ACHS +March 7, 2019 +Valerie Gentile Sachs +Director +48 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED FINANCIAL STATEMENTS +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +CECO Environmental Corp. and Subsidiaries +Cincinnati, Ohio +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of CECO Environmental Corp. and Subsidiaries (the “Company”) as of December 31, 2018 and 2017, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2018, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2018 and 2017, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2018 , in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated March 7, 2019 expressed an unqualified opinion thereon. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ BDO USA, LLP +We have served as the Company's auditor since 2008. +Cincinnati, Ohio +March 7, 2019 +F-1 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +December 31, +($ in thousands, except share data) +2018 +2017 +ASSETS +Current assets: +Cash and cash equivalents +$ +43,676 +$ +29,902 +Restricted cash +762 +591 +Accounts receivable, net +53,225 +67,990 +Costs and estimated earnings in excess of billings on uncompleted contracts +29,694 +33,947 +Inventories, net +20,817 +20,969 +Prepaid expenses and other current assets +10,117 +10,760 +Prepaid income taxes +1,388 +1,930 +Assets held for sale +1,186 +7,853 +Total current assets +160,865 +173,942 +Property, plant and equipment, net +22,200 +23,400 +Goodwill +152,156 +166,951 +Intangible assets – finite life, net +35,959 +49,956 +Intangible assets – indefinite life +18,258 +19,691 +Deferred charges and other assets +3,144 +4,609 +Total assets +$ +392,582 +$ +438,549 +LIABILITIES AND SHAREHOLDERS’ EQUITY +Current liabilities: +Current portion of debt +$ +— +$ +11,296 +Accounts payable and accrued expenses +80,229 +70,786 +Billings in excess of costs and estimated earnings on uncompleted contracts +20,144 +20,469 +Note payable +1,700 +5,300 +Income taxes payable +1,813 +— +Total current liabilities +103,886 +107,851 +Other liabilities +26,925 +30,382 +Debt, less current portion +74,456 +103,537 +Deferred income tax liability, net +8,755 +10,210 +Total liabilities +214,022 +251,980 +Commitments and contingencies +Shareholders’ equity: +Preferred stock, $.01 par value; 10,000 shares authorized, none issued +— +— +Common stock, $.01 par value; 100,000,000 shares authorized, 34,953,825 and +34,707,924 shares issued and outstanding at December 31, 2018 +and 2017, respectively +349 +347 +Capital in excess of par value +251,409 +248,170 +Accumulated loss +(59,427 +) +(52,673 +) +Accumulated other comprehensive loss +(13,415 +) +(8,919 +) +178,916 +186,925 +Less treasury stock, at cost, 137,920 shares at December 31, 2018 and 2017 +(356 +) +(356 +) +Total shareholders’ equity +178,560 +186,569 +Total liabilities and shareholders’ equity +$ +392,582 +$ +438,549 +The notes to consolidated financial statements are an integral part of the above statements. +F-2 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +Year Ended December 31, +($ in thousands, except share and per share data) +2018 +2017 +2016 +Net sales +$ +337,339 +$ +345,051 +$ +417,011 +Cost of sales +225,802 +231,857 +282,152 +Gross profit +111,537 +113,194 +134,859 +Selling and administrative expenses +87,462 +88,975 +81,743 +Acquisition and integration expenses +— +— +524 +Amortization and earnout expenses +9,683 +7,132 +20,231 +Intangible asset and goodwill impairment +— +7,168 +57,923 +Loss on divestitures, net of selling costs +4,390 +— +— +Restructuring expenses +— +1,895 +— +Income (loss) from operations +10,002 +8,024 +(25,562 +) +Other (expense) income, net +(365 +) +106 +310 +Interest expense +(7,140 +) +(6,721 +) +(7,712 +) +Income (loss) before income taxes +2,497 +1,409 +(32,964 +) +Income tax expense +9,618 +4,438 +5,290 +Net loss +(7,121 +) +(3,029 +) +(38,254 +) +Net loss attributable to noncontrolling interest +— +— +(36 +) +Net loss attributable to CECO Environmental Corp. +$ +(7,121 +) +$ +(3,029 +) +$ +(38,218 +) +Loss per share: +Basic +$ +(0.21 +) +$ +(0.09 +) +$ +(1.12 +) +Diluted +$ +(0.21 +) +$ +(0.09 +) +$ +(1.12 +) +Weighted average number of common shares outstanding: +Basic +34,714,395 +34,445,256 +33,979,549 +Diluted +34,714,395 +34,445,256 +33,979,549 +The notes to consolidated financial statements are an integral part of the above statements. +F-3 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +Year Ended December 31, +2018 +2017 +2016 +Net loss +$ +(7,121 +) +$ +(3,029 +) +$ +(38,254 +) +Other comprehensive (loss) income, net of tax: +Translation (loss) income +(3,858 +) +4,021 +(3,864 +) +Interest rate swap +76 +180 +312 +Minimum pension liability adjustment +(22 +) +(78 +) +87 +Comprehensive (loss) income +(10,925 +) +1,094 +(41,719 +) +Net loss attributable to noncontrolling interest +— +— +(36 +) +Comprehensive (loss) income attributable to CECO Environmental Corp. +$ +(10,925 +) +$ +1,094 +$ +(41,683 +) +The notes to consolidated financial statements are an integral part of the above statements. +F-4 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +(in thousands) +Accumulated +Total +Capital in +Accumulated +Other +CECO +Total +Common Stock +excess of +Earnings +Comprehensive +Treasury Stock +Shareholders' +Noncontrolling +Shareholders’ +Shares +Amount +par value +(Loss) +Loss +Shares +Amount +Equity +Interest +Equity +Balance January 1, 2016 +34,056 +$ +340 +$ +243,274 +$ +5,472 +$ +(9,577 +) +(138 +) +$ +(356 +) +$ +239,153 +$ +5,868 +$ +245,021 +Net loss for the year ended December 31, 2016 +(38,218 +) +(38,218 +) +(36 +) +(38,254 +) +Common stock dividends +(8,995 +) +(8,995 +) +(8,995 +) +Exercise of stock options and dividend reinvestment issuances +215 +2 +1,513 +1,515 +1,515 +Excess tax benefit from stock options exercised +137 +137 +137 +Restricted stock units issued +17 +— +(9 +) +(9 +) +(9 +) +Share based compensation earned +27 +1 +2,457 +2,458 +2,458 +Issuance of shares for cashless warrant exercise (See Note 10) +90 +1 +(1 +) +— +— +Stock repurchase and retirement +(105 +) +(1 +) +(1,237 +) +(1,238 +) +(1,238 +) +Noncontrolling interest acquisition (See Note 16) +(1,256 +) +(1,256 +) +(5,832 +) +(7,088 +) +Adjustment for minimum pension liability, net of tax of $53 +87 +87 +87 +Adjustment for interest rate swap net of tax of $181 +312 +312 +312 +Translation loss +(3,864 +) +(3,864 +) +(3,864 +) +Balance December 31, 2016 +34,300 +343 +244,878 +(41,741 +) +(13,042 +) +(138 +) +(356 +) +190,082 +— +190,082 +Net loss for the year ended December 31, 2017 +(3,029 +) +(3,029 +) +(3,029 +) +Cumulative effect adjustment adopting ASU 2016-09 (See Note 1) +177 +(111 +) +66 +66 +Common stock dividends +(7,792 +) +(7,792 +) +(7,792 +) +Exercise of stock options and dividend reinvestment issuances +291 +3 +1,292 +1,295 +1,295 +Restricted stock units issued +92 +1 +(136 +) +(135 +) +(135 +) +Share based compensation earned +25 +— +1,959 +1,959 +1,959 +Adjustment for minimum pension liability, net of tax of $48 +(78 +) +(78 +) +(78 +) +Adjustment for interest rate swap net of tax of $103 +180 +180 +180 +Translation income +4,021 +4,021 +4,021 +Balance December 31, 2017 +34,708 +347 +248,170 +(52,673 +) +(8,919 +) +(138 +) +(356 +) +186,569 +— +186,569 +Net loss for the year ended December 31, 2018 +(7,121 +) +(7,121 +) +(7,121 +) +Cumulative effect adjustment of adopting ASU 2018-02 (See Note 1) +1,037 +(1,067 +) +(30 +) +(30 +) +Cumulative effect adjustment of adopting ASU 2014-09 (See Note 1) +(622 +) +(622 +) +(622 +) +Cumulative translation adjustment for divestiture +375 +375 +375 +Exercise of stock options and dividend reinvestment issuances +16 +— +89 +89 +89 +Restricted stock units issued +192 +2 +(207 +) +(48 +) +(253 +) +(253 +) +Share based compensation earned +38 +— +3,357 +3,357 +3,357 +Adjustment for minimum pension liability, net of tax of $17 +(22 +) +(22 +) +(22 +) +Adjustment for interest rate swap, net of tax of $111 +76 +76 +76 +Translation loss +(3,858 +) +(3,858 +) +(3,858 +) +Balance December 31, 2018 +34,954 +$ +349 +$ +251,409 +$ +(59,427 +) +$ +(13,415 +) +(138 +) +$ +(356 +) +$ +178,560 +$ +178,560 +The notes to consolidated financial statements are an integral part of the above statements. +F-5 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +ACCUMULATED OTHER COMPREHENSIVE LOSS +(in thousands) +($ in thousands) +Translation +loss +Interest rate swap adjustment +Minimum pension +liability +adjustment +Accumulated other +comprehensive loss +January 1, 2016 +$ +(4,407 +) +$ +— +$ +(5,170 +) +$ +(9,577 +) +2016 activity +(3,864 +) +312 +87 +(3,465 +) +Balance December 31, 2016 +(8,271 +) +312 +(5,083 +) +(13,042 +) +2017 activity +4,021 +180 +(78 +) +4,123 +Balance December 31, 2017 +(4,250 +) +492 +(5,161 +) +(8,919 +) +Cumulative effect adjustment adopting ASU 2018-02 (See Note 1) +— +(5 +) +(1,062 +) +(1,067 +) +Cumulative translation adjustment for divestiture +375 +— +— +375 +2018 activity +(3,858 +) +76 +(22 +) +(3,804 +) +Balance December 31, 2018 +$ +(7,733 +) +$ +563 +$ +(6,245 +) +$ +(13,415 +) +The notes to consolidated financial statements are an integral part of the above statements. +F-6 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +Year Ended December 31, +($ in thousands) +2018 +2017 +2016 +Cash flows from operating activities: +Net loss +$ +(7,121 +) +$ +(3,029 +) +$ +(38,254 +) +Adjustments to reconcile net loss to net cash provided by +operating activities: +Depreciation and amortization +13,272 +16,088 +18,903 +Unrealized foreign currency loss (gain) +836 +(2,103 +) +777 +Net (gain) loss on interest rate swaps +(276 +) +(327 +) +95 +Impairment of property and equipment +300 +695 +— +Impairment of intangible assets and goodwill +— +7,168 +57,923 +Fair value adjustments to earnout liabilities +(330 +) +(6,610 +) +4,218 +Earnout payments +(2,862 +) +(7,797 +) +— +Loss on sale of property and equipment +(217 +) +130 +217 +Loss on divestitures +4,390 +— +— +Amortization of debt discount +1,143 +1,033 +1,054 +Share based compensation expense +3,187 +1,768 +2,280 +Bad debt expense +1,357 +3,895 +848 +Inventory reserve expense +519 +240 +1,167 +Excess tax benefit from stock options exercised +— +— +(137 +) +Deferred income tax benefit +(42 +) +(3,123 +) +(3,750 +) +Changes in operating assets and liabilities, net of acquisitions and divestitures: +Accounts receivable +(6,084 +) +14,107 +13,294 +Cost and estimated earnings of billings on uncompleted contracts +(4,557 +) +6,232 +2,537 +Inventories +(1,704 +) +887 +9,449 +Prepaid expenses and other current assets +773 +3,530 +(2,218 +) +Deferred charges and other assets +(416 +) +1,585 +(73 +) +Accounts payable and accrued expenses +21,321 +(15,847 +) +(6,593 +) +Billings in excess of costs and estimated earnings on uncompleted contracts +70 +(15,186 +) +7,440 +Income taxes payable +1,839 +(1,827 +) +143 +Other liabilities +(3,446 +) +5,061 +279 +Net cash provided by operating activities +21,952 +6,570 +69,599 +Cash flows from investing activities: +Acquisitions of property and equipment +(3,090 +) +(1,028 +) +(1,076 +) +Net cash proceeds from divestitures +35,052 +— +— +Payoff of loans on life insurance policies +— +— +(987 +) +Net proceeds from sale of assets +6,296 +368 +657 +Net cash provided by (used in) investing activities +38,258 +(660 +) +(1,406 +) +Cash flows from financing activities: +Net (repayments) borrowings on revolving credit lines +(3,723 +) +2,269 +(13,407 +) +Repayments of long-term debt +(41,356 +) +(11,168 +) +(41,768 +) +Deferred financing fees paid +— +(692 +) +— +Earnout payments +— +(7,396 +) +(9,270 +) +Proceeds from sale-leaseback transactions +800 +— +14,244 +Payments on capital leases and sale-leaseback financing liability +(675 +) +(711 +) +(426 +) +Proceeds from employee stock purchase plan, exercise of stock options, +and dividend reinvestment plan +54 +1,352 +1,685 +Cash paid for repurchase of common shares +— +— +(188 +) +Excess tax benefit from stock options exercised +— +— +137 +Dividends paid to common shareholders +— +(7,792 +) +(8,995 +) +Net cash used in financing activities +(44,900 +) +(24,138 +) +(57,988 +) +Effect of exchange rate changes on cash and cash equivalents +(1,531 +) +881 +(1,712 +) +Net increase (decrease) in cash, cash equivalents and restricted cash +13,779 +(17,347 +) +8,493 +Cash, cash equivalents and restricted cash at beginning of year +30,659 +48,006 +39,513 +Cash, cash equivalents and restricted cash at end of year +$ +44,438 +$ +30,659 +$ +48,006 +The notes to consolidated financial statements are an integral part of the above statements. +F-7 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION +Year Ended December 31, +($ in thousands) +2018 +2017 +2016 +Non-cash transactions +Property, plant and equipment acquired under capital leases +$ +— +$ +— +$ +4,385 +Noncontrolling interest acquired through an issuance of a note payable (See Note 16) +$ +— +$ +— +$ +5,300 +Earnout settled through an exchange of accounts receivable +$ +— +$ +— +$ +3,272 +Accrual of share repurchase +$ +— +$ +— +$ +1,050 +Cash paid during the year for: +Interest +$ +5,559 +$ +5,686 +$ +6,923 +Income taxes +$ +10,205 +$ +3,048 +$ +6,415 +The notes to consolidated financial statements are an integral part of the above statements. +F-8 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +For the Years Ended December 31, 2018, 2017 and 2016 +1. +Nature of Business and Summary of Significant Accounting Policies +Nature of business — CECO Environmental Corp. and its consolidated subsidiaries (“CECO,” the “Company,” “we,” “us,” or “our”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. CECO serves both established and emerging industries in regions around the world working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in multiple applications that include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +Principles of consolidation —Our consolidated financial statements include the Company and its controlled subsidiaries. All intercompany balances and transactions have been eliminated. +Unless indicated, all balances within tables are in thousands except per share amounts. +Use of estimates —The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +Cash equivalents —We consider all highly liquid investments with original maturities of three months or less to be cash equivalents. At December 31, 2018 and 2017, Restricted Cash is cash in support of letters of credit issued by various foreign subsidiaries of the Company. The Company occasionally enters into letters of credit with durations in excess of one year. +The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the Consolidated Statements of Cash Flows. +December 31, +2018 +2017 +Cash and cash equivalents +$ +43,676 +$ +29,902 +Restricted cash +762 +591 +Restricted cash included within deferred charges and other assets +— +166 +Total cash, cash equivalents and restricted cash +$ +44,438 +$ +30,659 +Accounts Receivable —Receivables are generally uncollateralized customer obligations due under normal terms requiring payment generally within 30 days from the invoice date unless otherwise determined by specific contract terms, generally due to retainage provisions. The Company’s estimate of the allowance for doubtful accounts for trade receivables is primarily determined based upon the length of time that the receivables are past due. In addition, management estimates are used to determine probable losses based upon an analysis of prior collection experience, specific account risks and economic conditions. Accounts are deemed uncollectible based on past account experience and the current financial condition of the account. +Inventories —The Company’s inventory is valued at the lower of cost or net realizable value, using the first-in, first-out inventory costing method. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded based on the Company’s forecast of future demand and market conditions. Significant unanticipated changes to the Company’s forecasts could require a change in the provision for excess or obsolete inventory. +Assets Held for Sale —The Company classifies properties as held for sale when certain criteria are met. At such time, the properties, including significant assets that are expected to be transferred as part of a sale transaction, are presented separately on the consolidated balance sheet at the lower of carrying value or estimated fair value less costs to sell and depreciation is no longer recognized. Assets classified as held for sale included buildings, tracts of land and equipment. +Property, plant and equipment —Property, plant and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Depreciation and amortization are provided using the straight-line method in +F-9 +amounts sufficient to amortize the cost of the assets over their estimated useful lives (buildings and improvements—generally five to 40 years; machinery and equipment—generally two to 15 years). Upon sale or disposal of property, plant and equipment, the applicable amounts of asset cost and accum ulated depreciation are removed from the accounts, and the net amount, less any proceeds from sale, is recorded in income. +Intangible assets — Indefinite life intangible assets are comprised of tradenames, while finite life intangible assets are comprised of technology, customer lists, noncompetition agreements and tradenames. Finite life intangible assets are amortized on a straight line or accelerated basis over their estimated useful lives of seven to 10 years for technology, five to 20 years for customer lists, five years for noncompetition agreements and 10 years for tradenames. +Long-lived assets —Property, plant and equipment and finite life intangible assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. If events or changes in circumstances occur that indicate possible impairment, our impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely independent of other groups of our assets and liabilities. This analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. We conduct annual reviews for idle and underutilized equipment, and review business plans for possible impairment. Impairment occurs when the carrying value of the assets exceeds the future undiscounted cash flows expected to be earned by the use of the asset or asset group. When impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset or asset group and an impairment charge is recorded for the difference between the carrying value and the estimated fair value. +Additionally, the Company evaluates the remaining useful life each reporting period to determine whether events and circumstances warrant a revision to the remaining period of depreciation or amortization. If the estimate of a long-lived asset’s remaining useful life is changed, the remaining carrying amount of the asset is amortized prospectively over that revised remaining useful life. +The Company completes an annual (or more often if circumstances require) impairment assessment of its indefinite life intangible assets. As a part of its annual assessment, typically, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of an asset is less than its carrying amount. If there is a qualitative determination that the fair value of a particular asset is more likely than not greater than its carrying value, we do not need to proceed to the quantitative estimated fair value test for that asset. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined by the relief from royalty method. If the estimated fair value of an asset is less than its carrying value, an impairment charge is recorded for the amount by which the carrying value of the asset exceeds its estimated fair value. +Goodwill —The Company completes an annual (or more often if circumstances require) impairment assessment on October 1 of its goodwill on a reporting unit level, at or below the operating segment level. As a part of its annual assessment, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If there is a qualitative determination that the fair value of a particular reporting unit is more likely than not greater than its carrying value, the Company does not need to quantitatively test for goodwill impairment for that reporting unit. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined using a weighting of the income method and the market method . If the estimated fair value of a reporting unit is less than its carrying value, an impairment charge is recorded. +Deferred charges —Deferred charges include deferred financing costs, which are amortized to interest expense over the life of the related loan. The Company incurred and capitalized $0.7 million of deferred financing fees in 2017 related to long-term debt modifications. Amortization expense was $1.1 million, $1.0 million and $1.1 million for 2018, 2017 and 2016, respectively. As of December 31, 2018 and 2017, remaining capitalized deferred financing costs of $1.7 million and $2.8 million, respectively, are included as a discount to debt in the accompanying Consolidated Balance Sheets. +Revenue recognition +Energy Solutions and Industrial Solutions Segments — Within the Energy Solutions and Industrial Solutions segments, a significant portion of our revenue is derived from fixed-price contracts. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. +For each contract, we assess the goods and services promised to a customer and identify a performance obligation for each distinct promised good or service. The typical life of our contracts is generally less than 12 months and each contract generally +F-10 +contains only one performance obligation, to provide goods or services to the customer. We determine the transaction price for each contract based on the consideration we expect to receive for the products or services being provided under the contract. +We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +For contracts where the duration is short, total contract revenue is insignificant, or control does not continuously transfer to the customer, revenues are recognized at the point in time control passes to the customer, which occurs generally upon shipment of product. +Progress payments are generally made over the duration of the contract. Shipping and handling activities after control of the products has transferred to the customer are considered fulfillment activities. Sales taxes are recorded on a net basis. +Fluid Handling Solutions Segments — Within the Fluid Handling Solutions segment, a significant portion of our revenue is primarily derived from sales of inventory product and is recognized at the point in time control passes to the customer, which occurs generally upon shipment of the product. +Payments vary by customer but are typically due within 30 days. Shipping and handling activities after control of the products has transferred to the customer are considered fulfillment activities. Sales taxes are recorded on a net basis. +Contract Assets and Contract Liabilities — Contract assets consist of costs and earnings in excess of billings, costs incurred for contracts recognized at a point in time, and retainage. Costs and earnings in excess of billings represent the estimated value of unbilled work for contracts with performance obligations recognized over time and are separately classified as current assets in the Consolidated Balance Sheets. Costs incurred for contracts recognized at a point in time are classified within inventories as work-in-process. Retainage represents a portion of the contract billings that have been billed, but for which the contract allows the customer to retain a portion of the billed amount until final settlement. Retainage is not considered to be a significant financing component because the intent is to protect the customer. Retainage is classified within accounts receivable and deferred charges and other depending on when it is due. Almost all of the Company’s contract assets are classified as current assets in the Consolidated Balance Sheets. +Billings in excess of costs and estimated earnings on uncompleted contracts are current liabilities, which relate to fixed-price contracts recognized over time, and represents payments in advance of performing the related contract work. Billings in excess of costs and estimated earnings on uncompleted contracts is not considered to be a significant financing component because it is generally used to meet working capital demands that can be higher in the early stages of a contract. Contract liabilities, classified in accounts payable and accrued expenses in the Consolidated Balance Sheets, include advance payments received from customers for which revenue has not been recognized for contracts where revenue is recognized at a point in time. Contract liabilities are reduced when the associated revenue from the contract is recognized, which is generally within one year. +The revenue streams within the Company are consistent with those disclosed for our reportable segments. For descriptions of our product offerings and segments, see Note 18— Business Segment Information. +Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes to job performance, job conditions, and estimated profitability may result in revisions to contract revenue and costs and are recognized in the period in which the revisions are made. There was no provision for estimated losses on uncompleted contracts at December 31, 2018 and 2017. +Cost of sales —Cost of sales amounts include materials, direct labor and associated benefits, inbound freight charges, purchasing and receiving, inspection, warehousing, and depreciation. +Claims —Change orders arise when the scope of the original project is modified for any of a variety of reasons. The Company will negotiate the extent of the modifications, its expected costs and recovery with the customer. Costs related to change orders are added to the expected total cost of the project. In cases where contract revenues are assured beyond a reasonable doubt to be increased in excess of the expected costs of the change order, incremental profit also is recognized on the contract. Such assurance is generally only achieved when the customer approves in writing the scope and pricing of the change order. Change orders that are in dispute are effectively handled as claims. +F-11 +Claims are amounts in excess of the agreed contract price that the Company seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price. Costs attributable to claims are treated as contract costs as incurred. +The Company recognizes certain significant claims for recovery of incurred costs when it is probable that the claim will result in additional contract revenue and when the amount of the claim can be reliably estimated. When the customer or other parties agree in writing to the amount of the claim to be recovered by the Company, the amount of the claim becomes contractual and is accounted for as an increase in the contract’s total estimated revenue and estimated cost. As actual costs are incurred and revenues are recognized over time, a corresponding percentage of the revised total estimated profit will therefore be recognized. +Should it become probable that the claim will not result in additional contract revenue, the Company removes the related contract revenues from its previous estimate of total revenues, which effectively reduces the estimated profit margin on the job and negatively impacts profit for the period. +Pre-contract costs —Pre-contract costs are not significant and are primarily internal costs. As most of the Company’s contracts are one year of less, the Company expenses all pre-contract costs as incurred regardless of whether or not the bids are successful. A majority of our business is obtained through a bidding process and this activity is on-going with multiple bids in process at any one time. These costs consist primarily of engineering, sales and project manager wages, fringes and general corporate overhead and it is deemed impractical to track activities related to any one specific contract. +Selling and administrative expenses —Selling and administrative expenses on the Consolidated Statements of Operations include sales and administrative wages and associated benefits, selling and office expenses, professional fees, bad debt expense and depreciation. Selling and administrative expenses are charged to expense as incurred. +Acquisition and integration expenses —Acquisition and integration expenses on the Consolidated Statements of Operations are related to acquisition activities, which include retention, legal, accounting, banking, and other expenses. +Amortization and earnout expenses —Amortization and earnout expenses on the Consolidated Statements of Operations include amortization of intangible assets, and changes to earnout and contingent compensation amounts related to acquisitions as more fully presented and described in Note 8. +Restructuring expenses —Restructuring expense on the Consolidated Statements of Operations include expenses related to a restructuring program implemented during the fourth quarter of 2017 to reduce operating costs in the future. Within restructuring expenses are charges related to severance, facility exit, legal and property, plant and equipment impairment. The Company’s policy is to recognize restructuring expenses in accordance with the accounting rules related to exit or disposal activities. +Product Warranties —The Company’s warranty reserve is to cover the products sold. The warranty accrual is based on historical claims information. The warranty reserve is reviewed and adjusted as necessary on a quarterly basis and is presented within Note 8. +Research and Development —Although not technically defined as research and development, a significant amount of time, effort and expense is devoted to (a) custom engineering which qualifies products for specific customer applications, (b) developing proprietary process technology and (c) partnering with customers to develop new products. +Income Taxes —Income taxes are determined using the asset and liability method of accounting for income taxes in accordance with Financial Accounting Standards Board (“FASB”), ASC Topic 740, “Income Taxes”. Income tax expense includes federal, state and foreign income taxes. +Deferred income taxes are provided using the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases and are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Tax credits and other incentives reduce income tax expense in the year the credits are claimed. +Management must assess the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal, state and foreign tax authorities who regularly audit the Company in the normal course of business. In making these assessments, management must often analyze complex tax laws of multiple jurisdictions, including many foreign jurisdictions. The accounting guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and +F-12 +measurement of a tax position taken or expected to be taken in a tax return. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. +The company has made an accounting policy election to record the U.S. income tax effect of future global intangible low-taxed income (“GILTI”) inclusions in the period in which they arise, rather than establishing deferred taxes with respect to the expected future tax liabilities associated with future GILTI inclusion. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested. A liability has been recorded for the deferred taxes on such undistributed foreign earnings. The amount is attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +Earnings per share —The following table reconciles the numerators and denominators used to calculate basic and diluted earnings per share for 2018, 2017 and 2016. +For the Year Ended December 31 +2018 +2017 +2016 +(Table only in thousands) +Numerator (for basic and diluted earnings per share) +Net loss +$ +(7,121 +) +$ +(3,029 +) +$ +(38,218 +) +Denominator +Basic weighted-average shares outstanding +34,714 +34,445 +33,980 +Common stock equivalents arising from stock options and restricted stock awards +— +— +— +Diluted weighted-average shares outstanding +34,714 +34,445 +33,980 +Options and unvested restricted stock units are included in the computation of diluted earnings per share using the treasury stock method. For 2018, 2017 and 2016, outstanding options and unvested restricted stock units of 0.8 million, 0.7 million and 1.6 million, respectively, were excluded from the computation of diluted earnings per share due to their having an anti-dilutive effect. +Once a restricted stock award vests, it is included in the computation of weighted average shares outstanding for purposes of basic and diluted earnings per share. +Foreign Currency Translation —The functional currencies of the Company’s foreign subsidiaries are their local currencies and their books and records are maintained in the local currency. The assets and liabilities of these foreign subsidiaries are translated into United States Dollars (“USD”) based on the end-of period exchange rates and the resultant translation adjustments are reported in Accumulated Other Comprehensive Loss in Shareholders’ equity on the Consolidated Balance Sheets. +Income and expenses are translated into USD at average exchange rates in effect during the period. +Transactions denominated in other than the local currency are remeasured into the local currency and the resulting exchange gains or losses are included in “Other income (expense), net” line of the Consolidated Statements of Operations. Transaction gains were $0.7 million, $0.1 million and $0.7 million in 2018, 2017 and 2016, respectively. +New Financial Accounting Pronouncements +Accounting Standards Adopted in 2018 +In March 2018, the FASB issued Accounting Standards Update (“ASU”) 2018-05, “Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118.” The standard relates to the accounting and disclosures around the issuance of the SEC’s Staff Accounting Bulletin No. 118, “Income Tax Accounting Implications of the Tax Cuts and Jobs Act” (“SAB 118”), which the Company has adopted. See Note 14 – Income Taxes for the disclosures related to this amended guidance. +In February 2018, the FASB issued ASU No. 2018-02, “Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.” The standard allows for reclassification of stranded tax effects on items resulting from the Tax Cuts and Jobs Act (the “Tax Act”) from accumulated other comprehensive income to retained earnings. Tax effects unrelated to the Tax Act are released from accumulated other comprehensive income based on the nature of the underlying item. The Company adopted this ASU in the first quarter of 2018, under the prospective method resulting in accumulated loss in the Consolidated Balance Sheets decreasing by approximately $1.1 million, with a corresponding increase in accumulated other comprehensive loss in the Consolidated Balance Sheets due to the reduction in the federal income tax rate from 35% to 21%. See Note 14 — Income Taxes for additional information about the Tax Act. +F-13 +In May 2017, the FASB issued ASU 2017-09, “Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting.” ASU 2017-09 clarifies when changes t o the terms or conditions of a share-based award must be accounted for as a modification. We adopted ASU 2017-09 on January 1, 2018, under the prospective method. The adoption had no impact on our consolidated financial statements as there were no events requiring management to evaluate for a potential modification to a share-based payment award. +In March 2017, the FASB issued ASU 2017-07, “Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” Under existing GAAP, an entity is required to present all components of net periodic pension cost and net periodic postretirement benefit cost aggregated as a net amount in the income statement, and this net amount may be capitalized as part of an asset where appropriate. ASU 2017-07 requires that the service cost component is reported in the same line item or items as other compensation costs arising from services rendered by the employees during the period, and requires the other components of net periodic pension cost and net periodic postretirement benefit cost to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. We adopted ASU 2017-07 on January 1, 2018, under the retrospective method for the presentation of the service cost component and the other components of net periodic pension cost and net periodic postretirement benefit cost in the income statement and prospectively, on and after the effective date, for the capitalization of the service cost component of net periodic pension cost and net periodic postretirement benefit in assets. The adoption resulted in reclassification of the other components of net periodic pension cost outside of operating income the impact of which was not material. See Note 11 – Pension and Employee Benefit Plans for additional disclosures related to the adoption of the standard. +In January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” ASU 2017-01 clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. We adopted ASU 2017-01 on January 1, 2018, under the prospective method. The adoption of the standard’s definition of a business was followed for the Company’s 2018 divestitures. The divestitures would have been considered a business both before and after the adoption of the standard and, therefore, the provisions of ASU 2017-01 did not have a material effect on the Company’s consolidated financial statements. +In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash.” ASU 2016-18 requires the change during the period in the total of cash, cash equivalents, and restricted cash to be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. We adopted ASU 2016-18 on January 1, 2018, under the retrospective method. The prior year statement of cash flows has been reclassified to conform with the standard. The impact of the adoption was not material to the Company. The adoption resulted in the Company classifying restricted cash in Cash, Cash Equivalents and Restricted Cash in the Consolidated Statements of Cash Flows for each period presented. +In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 provides guidance on how certain cash receipts and cash payments are presented and classified in the statement of cash flows. We adopted ASU 2016-15 on January 1, 2018, under the retrospective method. The adoption resulted in the reclassification of $1.0 million payoff of loans on life insurance policies in the 2016 Statement of Cash Flows from financing activities to investing activities. +In May 2014, the FASB issued ASU 2014-09, “Revenue From Contracts With Customers.” ASU 2014-09 supersedes nearly all existing revenue recognition principles under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration an entity expects to be entitled to for those goods or services using a defined five-step process. In 2016, the FASB issued accounting standards updates to address implementation issues and to clarify the guidance for identifying performance obligations, licenses and determining if a company is the principal or agent in a revenue arrangement. +We adopted ASU 2014-09 on January 1, 2018, under the modified retrospective method where the cumulative effect is recognized through retained earnings as of the date of adoption. Under the new standard, certain contract arrangements that were historically recognized over time under our previous policies will now be recognized at a point in time upon completion of the contracts. Based on the Company’s evaluation of existing contracts that were not substantially complete as of January 1, 2018, the $0.6 million cumulative effect adjustment to the opening balance of retained earnings is reflected in the Consolidated Statement of Shareholders’ Equity. See Note 1—Nature of Business and Summary of Significant Accounting Policies for details on our accounting policies under the new standard. +F-14 +Accounting Standards Yet to be Adopted +In August 2018, the FASB issued ASU 2018-14, “Compensation—Retirement Benefits—Defined Benefit Plans—General (Subtopic 715-20): Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans,” that makes minor changes to the disclosure requirements for employers that sponsor defined benefit pension and/or other postretirement benefit plans. The new guidance eliminates requirements for certain disclosures that are no longer considered cost beneficial and requires new ones that the FASB considers pertinent. ASU 2018-14 is effective for us January 1, 2021. We are evaluating the impact of the adoption of ASU 2018-14 on our consolidated financial statements. +In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” ASU 2017-12 expands an entity’s ability to apply hedge accounting for nonfinancial and financial risk components and allows for a simplified approach for fair value hedging of interest rate risk. ASU 2017-12 eliminates the need to separately measure and report hedge ineffectiveness and generally requires the entire change in fair value of a hedging instrument to be presented in the same income statement line as the hedged item. Additionally, ASU 2017-12 simplifies the hedge documentation and effectiveness assessment under the previous guidance. We will adopt the standard on January 1, 2019. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. +In February 2016, the FASB issued ASU 2016-02, “Leases,” which, together with its related clarifying ASUs, provides revised guidance for lease accounting and related disclosure requirements and establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition. This guidance is effective for us on January 1, 2019. We will adopt the standard using the modified retrospective method which will be applied to leases that exist or are entered into on or after January 1, 2019. The Company will elect to utilize the package of practical expedients that allows entities to 1) not reassess whether any expired or existing contracts are or contain leases, 2) retain the existing classification of lease contracts as of the date of adoption, and 3) not reassess initial direct costs for any existing leases. The Company is in the final stages of evaluating its existing lease portfolio and is continuing to assess and quantify the amount of ROU assets and lease liabilities that will be included on its balance sheet as of January 1, 2019. The Company is finalizing its implementation of a new lease accounting and administration software solution to manage and account for leases under the new guidance and is updating certain of its business processes and internal controls to meet the reporting and disclosure requirements of the new standard. We believe that the new standard will have a material impact on our consolidated balance sheet due to the recognition of ROU assets and liabilities for our operating leases, but it is not expected to have a material impact on our statement of operations or liquidity. The ASU will also require disclosures to allow financial statement users to better understand the amount, timing and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements. Our leasing activity is primarily related to buildings as well as various sale-leaseback transactions. +2. +Financial Instruments +Our financial instruments consist primarily of cash and cash equivalents, receivables and certain other assets, foreign debt, and accounts payable, which approximate fair value at December 31, 2018 and 2017, due to their short-term nature or variable, market-driven interest rates. +The fair value of the debt issued under the Credit Agreement was $76.1 million and $114.9 million at December 31, 2018 and 2017, respectively. The fair value of the note payable was $1.7 million and $5.3 million at December 31, 2018 and 2017, respectively. The fair value was determined considering market conditions, our credit worthiness and the current terms of our debt. +In accordance with the terms of the Credit Agreement, the Company entered into an interest rate swap on December 30, 2015 to hedge against interest rate exposure related to a portion of the outstanding debt indexed to LIBOR market rates. See Note 9 for further information regarding the interest rate swap. +At December 31, 2018 and 2017, the Company had cash and cash equivalents of $43.7 million and $29.9 million, respectively, of which $23.3 million and $19.7 million, respectively, was held outside of the United States, principally in the Netherlands, United Kingdom, China, and Canada. +Concentrations of credit risk: +Financial instruments that potentially subject us to credit risk consist principally of cash and cash equivalents, and accounts receivable. We maintain cash and cash equivalents with various major financial institutions. We perform periodic evaluations of the financial institutions in which our cash is invested. Concentrations of credit risk with respect to trade and contract receivables are +F-15 +lim ited due to the large number of customers and various geographic areas. Additionally, we perform ongoing credit evaluations of our customers’ financial condition. +3. Accounts Receivable +Accounts receivable consisted of the following: +December 31, +(Table only in thousands) +2018 +2017 +Trade receivables +$ +7,296 +$ +11,603 +Contract receivables +48,826 +60,543 +Allowance for doubtful accounts +(2,897 +) +(4,156 +) +Total accounts receivable +$ +53,225 +$ +67,990 +Balances billed, but not paid by customers under retainage provisions in contracts that are recorded in deferred charges and other assets within the Consolidated Balance Sheets, amounted to approximately $0.9 million and $2.5 million at December 31, 2018 and 2017, respectively. Retainage receivables on contracts in progress are generally collected within a year or two subsequent to contract completion. +Provision for doubtful accounts was $1.4 million, $3.9 million and $0.8 million during 2018, 2017 and 2016, respectively, while accounts charged to the allowance were $0.8 million, $1.5 million and $0.3 million during 2018, 2017 and 2016, respectively. +In 2018, the divestitures impacted contract receivables by $22.2 million as well as $1.2 million on the allowance for doubtful accounts. +4. +Costs and Estimated Earnings on Uncompleted Contracts +Our contracts have various lengths to completion ranging from a few days to several months. We anticipate that a majority of our current contracts will be completed within the next 12 months and any unrecognized billings will be recorded as revenue in that same period. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. The assets and liabilities recognized in association with these contracts are as follows: +December 31, +(Table only in thousands) +2018 +2017 +Costs incurred on uncompleted contracts +$ +174,168 +$ +169,665 +Estimated earnings +67,427 +61,556 +Total costs and estimated earnings on uncompleted contracts, gross +241,595 +231,221 +Less billings to date +(232,045 +) +(217,743 +) +Total costs and estimated earnings on uncompleted contracts, net +$ +9,550 +$ +13,478 +Included in the accompanying consolidated balance sheets +under the following captions: +Costs and estimated earnings in excess of billings on +uncompleted contracts +$ +29,694 +$ +33,947 +Billings in excess of costs and estimated earnings on +uncompleted contracts +(20,144 +) +(20,469 +) +Total costs and estimated earnings on uncompleted contracts, net +$ +9,550 +$ +13,478 +F-16 +5. +Inventories +Inventories consisted of the following: +December 31, +(Table only in thousands) +2018 +2017 +Raw materials +$ +15,819 +$ +18,444 +Work in process +6,098 +3,182 +Finished goods +807 +940 +Obsolescence allowance +(1,907 +) +(1,597 +) +Total inventories +$ +20,817 +$ +20,969 +Amounts credited to the allowance for obsolete inventory and charged to cost of sales amounted to $0.5 million, $0.2 million and $1.2 million during 2018, 2017 and 2016, respectively. Items charged to the allowance for inventory write-offs were $0.3 million, $0.6 million and $0.2 million, during 2018, 2017 and 2016, respectively. +6. +Property, Plant and Equipment +December 31, +(Table only in thousands) +2018 +2017 +Land +$ +1,623 +$ +1,627 +Building and improvements +18,185 +18,063 +Machinery and equipment +25,257 +25,068 +Property, plant and equipment, gross +45,065 +44,758 +Less accumulated depreciation +(22,865 +) +(21,358 +) +Property, plant and equipment, net +$ +22,200 +$ +23,400 +Depreciation expense was $3.5 million, $4.5 million and $5.0 million for 2018, 2017 and 2016, respectively. +7. +Goodwill and Intangible Assets +(Table only in thousands) +Energy Solutions +segment +Industrial Solutions +s egment +Fluid Handling segment +Totals +Balance of goodwill at December 31, 2016 +$ +101,610 +$ +22,419 +$ +46,124 +$ +170,153 +Impairment charge +(4,443 +) +— +— +(4,443 +) +Foreign currency translation +1,241 +— +— +1,241 +Balance of goodwill at December 31, 2017 +98,408 +22,419 +46,124 +166,951 +Divestitures +— +— +(14,317 +) +(14,317 +) +Foreign currency translation +(478 +) +— +— +(478 +) +Balance of goodwill at December 31, 2018 +$ +97,930 +$ +22,419 +$ +31,807 +$ +152,156 +As of December 31, 2018 and 2017, the Company has an aggregate amount of goodwill acquired of $212.8 million and $242.3 million, respectively, and an aggregate amount of impairment losses of $60.7 million and $75.3 million, respectively. +The Company’s indefinite lived intangible assets as of December 31, 2018 and 2017 consisted of the following: +Tradenames +(Table only in thousands) +2018 +2017 +Balance beginning of year +$ +19,691 +$ +22,042 +Impairment charge +— +(2,725 +) +Divestitures +(1,340 +) +— +Foreign currency adjustments +(93 +) +374 +Balance end of year +$ +18,258 +$ +19,691 +F-17 +The Company completes an annual (or more often if circumstances require) impairment assessment of its goodwill and indefinite life intangible assets on October 1 at the reporting unit level . +The Company bases its measurement of the fair value of a reporting unit using a 50/50 weighting of the income method and the market method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital. Projected revenue and operational profit, and terminal growth rates were determined to be significant assumptions because they are three primary drivers of the projected cash flows in the discounted future cash flow approach. Cost of capital was also determined to be a significant assumption as it is the discount rate used to calculate the current fair value of those projected cash flows. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. +In 2018, because of changes in management and the subsequent changes to the Company’s reporting and operating structure, the number of our reporting units was aggregated to three reporting units from 11 prior to the change. Prior to the adoption of the new reporting structure we tested our goodwill impairment under the old reporting unit structure. Based on this analysis, the estimated fair value of all of our reporting units exceeded their carrying value as of October 1, 2018. +There was no goodwill impairment in 2018. There was goodwill impairment of $4.4 million and $53.8 in 2017 and 2016, respectively. +The Company also performed an impairment analysis for all reporting units with indefinite life intangible assets as of October 1, 2018. The Company based its measurement of the fair value of the indefinite life intangible assets utilizing the relief from royalty method. The significant assumptions used under the relief from royalty method are projected revenue, royalty rates, terminal growth rates, and the cost of capital. Projected revenue, royalty rates and terminal growth rates were determined to be significant assumptions because they are three primary drivers of the projected royalty cash flows in the relief from royalty method. Cost of capital was also determined to be a significant assumption as it is the discount rate used to calculate the current fair value of those projected royalty cash flows. Changes in any of the significant assumptions used can materially affect the expected cash flows, and such impacts can result in material non-cash impairment charges. Under this approach, the estimated fair value of the indefinite life intangible assets exceeded their carrying value for all reporting units as of the testing date. +During the annual impairment test of indefinite life intangible assets in 2017 and 2016, the carrying values of four reporting units’ indefinite life intangible assets exceeded their fair values. The Company recorded a $2.7 million and $4.2 million impairment charge in 2017 and 2016, respectively. +As described above, the fair value measurement methods used in the Company’s goodwill and indefinite life intangible assets impairment analyses utilizes a number of significant unobservable inputs or Level 3 assumptions. These assumptions include, among others, projections of our future operating results, the implied fair value of these assets using an income approach by preparing a discounted cash flow analysis and other subjective assumptions. +The Company’s finite lived intangible assets as of December 31, 2018 and 2017 consisted of the following: +2018 +2017 +(Table only in thousands) +Intangible assets – finite life +Cost +Accum. +Amort. +Cost +Accum. +Amort. +Technology +$ +14,457 +$ +9,414 +$ +15,867 +$ +8,609 +Customer lists +68,943 +37,873 +77,497 +35,024 +Noncompetition agreements +910 +762 +1,118 +698 +Tradename +1,390 +579 +1,390 +440 +Foreign currency adjustments +(1,520 +) +(407 +) +(1,214 +) +(69 +) +Total finite life intangible assets +$ +84,180 +$ +48,221 +$ +94,658 +$ +44,702 +Amortization expense of finite life intangible assets was $9.6 million, $11.5 million and $13.9 million for 2018, 2017 and 2016, respectively. Amortization over the next five years for finite life intangibles is $8.1 million in 2019, $6.5 million in 2020, $5.3 million in 2021, $4.5 million in 2022, and $3.6 million in 2023. +F-18 +8. +Accounts Payable and Accrued Expenses +Accounts payable and accrued expense consisted of the following: +December 31, +(Table only in thousands) +2018 +2017 +Trade accounts payable, including amounts due to subcontractors +$ +51,984 +$ +45,409 +Compensation and related benefits +7,578 +5,246 +Current portion of earnout liability +— +2,989 +Accrued warranty +3,384 +4,464 +Contract liability +6,541 +1,676 +Other +10,742 +11,002 +Total accounts payable and accrued expenses +$ +80,229 +$ +70,786 +The activity in the Company’s earnout liability was as follows for the years ended December 31, 2018 and 2017: +(Table only in thousands) +2018 +2017 +Earnout accrued at beginning of year +$ +4,475 +$ +24,213 +Fair value adjustment +(330 +) +(6,610 +) +Compensation expense adjustment +222 +1,240 +Foreign currency translation adjustment +(65 +) +825 +Payments +(2,862 +) +(15,193 +) +Other reclassifications +(1,440 +) +— +Earnout accrued at end of year +— +4,475 +Less: current portion of earnout +— +(2,989 +) +Balance of long-term portion of earnout recorded in other liabilities +$ +— +$ +1,486 +The earnout liability is only associated with the Energy Solutions segment +9. +Senior debt +Debt consisted of the following at December 31, 2018 and 2017: +December 31, +(Table only in thousands) +2018 +2017 +Outstanding borrowings under Credit Facility (defined below). +Term loan balance due upon maturity in September 2020. +– Term loan +$ +76,147 +$ +113,903 +– U.S. Dollar revolving loans +— +1,000 +– Unamortized debt discount +(1,691 +) +(2,834 +) +Total outstanding borrowings under Credit Facility +74,456 +112,069 +Outstanding borrowings (U.S. dollar equivalent) under +Foreign Debt +— +2,764 +Total outstanding borrowings +74,456 +114,833 +Less: current portion +— +11,296 +Total debt, less current portion +$ +74,456 +$ +103,537 +In 2018, the Company made prepayments of $36.2 million on the term loan. Due to the prepayments made in 2018, there are no additional payments due on the term loan until the final payment of $76.1 million in September 2020. +Credit Facility +The Company has entered into a credit agreement (the “Credit Agreement”) with various lenders (the “Lenders”) and letter of credit issuers (each, an “L/C Issuer”), and Bank of America, N.A., as Administrative Agent (the “Agent”), swing line lender and an L/C Issuer, providing for various senior secured credit facilities (collectively, the “Credit Facility”). +F-19 +Pursuant to the amended and restated Credit Agreement, the Lenders currently provided a term loan in an aggregate principal amount of $170.0 million and a U.S. dollar revolving credit commitment in the aggregate principal amount of $60.5 million. The agreement includes a $19.5 million senior secured multi-currency revolving credit facility for U.S. dollar and specific foreign currency loans. +Under the terms of the Credit Facility, the Company is required to maintain certain financial and other covenants including the maintenance of a Consolidated Leverage Ratio as defined in the Credit Agreement. The Company must maintain a Consolidated Leverage Ratio of 3.75 through March 31, 2019, decreasing to 3.50 through September 30, 2019. The ratio will then decrease to 3.25 until the termination of the Credit Facility. +As of December 31, 2018 and 2017, $29.3 million and $24.4 million of letters of credit were outstanding, respectively. Total unused credit availability under the Credit Facility was $50.7 million and $54.6 million at December 31, 2018 and 2017, respectively. Revolving loans may be borrowed, repaid and reborrowed until September 3, 2020, at which time all amounts borrowed pursuant to the Credit Facility must be repaid. +At the Company’s option, revolving loans and the term loans accrue interest at a per annum rate based on either the highest of (a) the federal funds rate plus 0.5%, (b) the Agent’s prime lending rate, (c) one-month LIBOR plus 1.00%, plus a margin ranging from 1.0% to 2.0% depending on the Company’s Consolidated Leverage Ratio (“Base Rate”), or (d) a Eurocurrency Rate (as defined in the Credit Agreement) plus 1.0% to 2.0% depending on the Company’s Consolidated Leverage Ratio. Interest on swing line loans is the Base Rate. +Interest on Base Rate loans is payable quarterly in arrears on the last day of each calendar quarter and at maturity. Interest on Eurocurrency Rate loans is payable on the last date of each applicable Interest Period (as defined in the agreement), but in no event less than once every three months and at maturity. The weighted average interest rate on outstanding borrowings was 5.27% and 4.08% at December 31, 2018 and 2017, respectively. +The Company has granted a security interest in substantially all of its assets to secure its obligations pursuant to the Credit Agreement. The Company’s obligations under the Credit Agreement are guaranteed by the Company’s U.S. subsidiaries and such guaranty obligations are secured by a security interest on substantially all the assets of such subsidiaries, including certain real property. The Company’s obligations under the Credit Agreement may also be guaranteed by the Company’s material foreign subsidiaries to the extent no adverse tax consequences would result to the Company. +As of December 31, 2018 and 2017, the Company was in compliance with all related financial and other restrictive covenants under the Credit Facility. +In accordance with the Credit Facility terms, the Company entered into an interest rate swap on December 30, 2015 to hedge against interest rate exposure related to approximately one-third of the outstanding debt as of the date of the agreement indexed to LIBOR market rates. The fair value of the interest rate swap was an asset of $0.5 million and $0.3 million at December 31, 2018, and 2017, respectively, which is recorded in “Deferred charges and other assets” on the Consolidated Balance Sheets. The Company did not designate the interest rate swap as an effective hedge until the first quarter of 2016. The change in the fair value of the hedge prior to being designated as an effective hedge during the year ended December 31, 2016 of $0.5 million, was recorded in earnings in “Other income (expense), net” in the Consolidated Statements of Operations. From the date of designation, all changes to the fair value of the interest rate swap are recorded in other comprehensive income (loss) as long as the hedge is deemed effective. +Foreign Debt +The Company has a number of facilities and bilateral agreements in various countries currently supported by letters of credit issued by the Credit Facility or cash. As of December 31, 2018, the borrowers of these facilities and agreements were in compliance with all related financial and other restrictive covenants. +A subsidiary of the Company located in the Netherlands has a Euro-denominated facilities agreement which as of December 31, 2018 had no outstanding borrowings. The Company settled the outstanding amount of the overdraft facility in 2018. The Company plans to exit this facility and consolidate it with the Credit Facility. +F-20 +10. +Shareholders’ Equity +Dividends +Our dividend policy and the payment of cash dividends under that policy are subject to the Board of Director’s continuing determination that the dividend policy and the declaration of dividends are in the best interest of the Company’s shareholders. Future dividends and the dividend policy may be changed at the Company’s discretion at any time. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Facility. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the shareholders to suspend dividend payments. +During 2017 and 2016, our Board declared the following quarterly cash dividends on our common stock: +Dividend +Per Share +Record Date +Payment Date +$0.075 +August 7, 2017 +September 29, 2017 +$0.075 +May 10, 2017 +June 30, 2017 +$0.075 +March 6, 2017 +March 31, 2017 +$0.066 +December 16, 2016 +December 30, 2016 +$0.066 +September 16, 2016 +September 30, 2016 +$0.066 +June 18, 2016 +June 30, 2016 +$0.066 +March 18, 2016 +March 31, 2016 +Effective August 13, 2012, the Company implemented a Dividend Reinvestment Plan (the “Plan”), under which the Company may issue up to 750,000 shares of common stock. The Plan provides a way for interested shareholders to increase their holdings in our common stock. Participation in the Plan is strictly voluntary and is open only to existing shareholders. The Plan has had limited participation. +Share-Based Compensation +The Company’s 2017 Equity and Incentive Compensation Plan (the “2017 Plan”) was approved by the Company’s stockholders on May 16, 2017 which replaced the 2007 Equity Incentive Plan (the “2007 Plan”). No further grants will be made under the 2007 Plan, but outstanding awards under the 2007 Plan will continue to be unaffected in accordance with their terms. The 2017 Plan permits the granting of stock options with an exercise price equal to or greater than the fair market value of the Company’s common stock at the date of the grant, and other stock-based awards, including appreciation rights, restricted stock, restricted stock units, performance shares and dividend equivalents. A total of 1.9 million shares of common stock were authorized for issuance. As of December 31, 2018, 1.3 million shares remain available for future issuance. Stock options granted to employees generally vest equally over a period of four years from the date of the grant. Stock awards granted to employees generally vest over a period of three to four years from the date of the grant. +On June 10, 2017, the Company granted 700,000 performance units to our Chief Executive Officer with a fair value of $175,000 and are being expensed over the vesting period of three years. The maximum shares of common stock that the participant could receive upon vesting is 77,778 shares. The performance units are earned based upon the Company’s stock price during 30 consecutive trading days within a specified date range of approximately two years. The performance units are settled in the Company’s common stock subsequent to this specified date range. The estimated grant date fair value and compensation expense of each performance share was determined on the date of grant by using the Monte Carlo valuation model. +Share-based compensation expense for stock options and restricted stock awards under these plans was $3.1 million, $1.7 million and $2.2 million for 2018, 2017 and 2016, respectively. The tax benefit related to share based compensation expense was $0.5 million, zero and $0.2 million in 2018, 2017 and 2016, respectively. +Employee Stock Purchase Plan +The 2009 Employee Stock Purchase Plan (“ESPP”) was approved by shareholders on May 21, 2009. The ESPP is administered by the Compensation Committee. The ESPP allows employees to purchase shares of common stock at a 15% discount from market price and pay for the shares through payroll deductions. Eligible employees can enter the plan at specific “offering dates” that occur in six-month intervals. +F-21 +The aggregate maximum number of shares of the Company’s common stock that may be granted under the ESPP is 1,500,000 shares over the ten-year term of the ESPP, subject to adjustment in the event there is a reorganization, merger, consolidation, recapitalization, reclassification, stock split-up, or similar transaction with respe ct to the common stock. As of December 31, 201 8 , 1.3 million shares remain available for future issuance. +The Company recognized employee stock purchase plan expense of $90,000, $83,000 and $71,000 in 2018, 2017 and 2016, respectively. +Stock Options +The estimated weighted-average fair value of stock options granted during 2017 and 2016, was $2.68 and $2.07 per option, respectively, using the Black-Scholes option-pricing model based on the following assumptions: +Expected Volatility : The Company utilizes a volatility factor based on the Company’s historical stock prices for a period of time equal to the expected term of the stock option utilizing weekly price observations. For 2017 and 2016, the Company utilized weighted-average volatility factors of 39%. +Expected Term : Due to limited historical exercise data, the Company utilizes the simplified method of determining the expected term based on the vesting schedules and terms of the stock options. For 2017 and 2016, the Company utilized weighted-average expected term factors of 6.3 years and 6.5 years, respectively. +Risk-Free Interest Rate : The risk-free interest rate factor utilized is based upon the implied yields currently available on U.S. Treasury zero-coupon issues over the expected term of the stock options. For 2017 and 2016, the Company utilized a weighted-average risk-free interest rate factor of 2.2% and 2.1%, respectively. +Expected Dividends : The Company utilized a weighted average expected dividend rate of 3.3% and 3.6% to value options granted during 2017 and 2016, respectively. +Information related to all stock options under the 2017 Plan and 2007 Plan for 2018, 2017 and 2016 is shown in the tables below: +(Shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2017 +655 +$ +10.53 +6.0 years +Forfeitures +(132 +) +11.53 +Exercised +(16 +) +5.55 +Outstanding at December 31, 2018 +507 +10.43 +5.2 years +$ +186 +Exercisable at December 31, 2018 +402 +10.52 +4.6 years +$ +186 +(Shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2016 +1,519 +$ +10.25 +6.1 years +Granted +128 +9.24 +Forfeitures +(700 +) +12.44 +Exercised +(292 +) +3.92 +Outstanding at December 31, 2017 +655 +10.53 +6.0 years +$ +78 +Exercisable at December 31, 2017 +463 +10.49 +5.2 years +$ +78 +F-22 +(Shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2015 +1,877 +$ +10.30 +6.8 years +Granted +105 +7.36 +Forfeitures +(268 +) +11.91 +Exercised +(195 +) +6.90 +Outstanding at December 31, 2016 +1,519 +10.25 +6.1 years +$ +5,816 +Exercisable at December 31, 2016 +959 +9.23 +5.3 years +$ +4,608 +Restricted Stock Awards +Information related to restricted stock awards under the 2017 Plan and 2007 Plan for 2018, 2017 and 2016 is shown in the table below. The fair value of restricted stock awards is based on the price of the stock in the open market on the date of the grant. The fair value of the restricted stock awards is recorded as compensation expense on a straight-line basis over the vesting periods of the awards and we account for forfeitures when they occur. +(Shares in thousands) +Shares +Weighted +Average +Grant Date +Fair Value +Nonvested at December 31, 2015 +321 +$ +9.55 +Granted +267 +9.76 +Vested +(17 +) +10.24 +Forfeited +(62 +) +9.64 +Nonvested at December 31, 2016 +509 +9.64 +Granted +405 +9.88 +Vested +(92 +) +9.78 +Forfeited +(268 +) +9.70 +Nonvested at December 31, 2017 +554 +9.75 +Granted +963 +5.21 +Vested +(217 +) +9.50 +Forfeited +(49 +) +9.80 +Nonvested at December 31, 2018 +1,251 +6.30 +The Company received $0.1 million, $1.1 million and $1.3 million of cash from employees exercising options in 2018, 2017 and 2016, respectively. The intrinsic value of options exercised during 2018, 2017 and 2016 was $24,000, $2.6 million and $1.0 million, respectively. Unrecognized compensation expense related to nonvested shares of stock options, restricted stock and performance units was $6.3 million at December 31, 2018 and will be recognized over a weighted average vesting period of 2.3 years. +Warrants to Purchase Common Stock +On December 28, 2006, the Company issued warrants to purchase 250,000 shares to Icarus Investment Corp. (“Icarus”), a related party, at an exercise price of $9.07 and an expiration date of December 26, 2016. On December 7, 2016, the Company and Icarus entered into an amendment to the warrant agreement pursuant to which the warrants were amended to provide for the cashless exercise of the warrants. In 2016, all of the outstanding warrants were exercised and the Company issued 89,640 shares of common stock through a cashless exercise at an effective price of $9.07 per share. There are no additional warrants outstanding. +Stock Purchase +During 2016, the Company repurchased 30,000 shares of common stock from a former owner of a subsidiary acquired by the Company in 2014 for a total cost of $0.2 million. In December 2016, the Company entered into an agreement to repurchase 75,000 shares of common stock from a current segment president, who was a former owner of a subsidiary acquired by the Company in 2013, for a total cost of $1.1 million, which was paid in January 2017. The shares were immediately retired subsequent to their repurchase. +F-23 +11. +Pension and Employee Benefit Plans +We sponsor a non-contributory defined benefit pension plan for certain union employees. The accrual of future benefits for all participants who are non-union employees was frozen effective December 31, 2008. The plan is funded in accordance with the funding requirements of the Employee Retirement Income Security Act of 1974. +The following tables set forth the plan changes in benefit obligations, plan assets and funded status on the measurement dates, December 31, 2018, 2017 and 2016, and amounts recognized in our Consolidated Balance Sheets within other long-term liabilities. +(Table only in thousands) +2018 +2017 +2016 +Change in projected benefit obligation: +Projected benefit obligation at beginning of year +$ +36,327 +$ +35,012 +$ +36,140 +Service cost +— +415 +447 +Interest cost +1,190 +1,314 +1,426 +Actuarial (gain) / loss +(2,629 +) +1,787 +301 +Administrative expenses +— +(402 +) +(606 +) +Benefits paid +(1,890 +) +(1,799 +) +(2,696 +) +Projected benefit obligation at end of year +32,998 +36,327 +35,012 +Change in plan assets: +Fair value of plan assets at beginning of year +26,836 +24,063 +25,296 +Actual (loss) return on plan assets +(1,388 +) +3,152 +2,040 +Employer contribution +639 +1,822 +29 +Administrative expenses +— +(402 +) +(606 +) +Benefits paid +(1,890 +) +(1,799 +) +(2,696 +) +Fair value of plan assets at end of year +24,197 +26,836 +24,063 +Unfunded status +$ +(8,801 +) +$ +(9,491 +) +$ +(10,949 +) +Defined benefit liability included in other liabilities +$ +(8,801 +) +$ +(9,491 +) +$ +(10,949 +) +Deferred tax benefit associated with accumulated other comprehensive loss +2,116 +3,153 +3,107 +Accumulated other comprehensive loss, net of tax +6,224 +5,154 +5,074 +Other comprehensive (loss) income: +Net loss (gain) +$ +271 +$ +358 +$ +90 +Amortization of net actuarial gain +(238 +) +(227 +) +(212 +) +Total recognized in other comprehensive (loss) income +$ +33 +$ +131 +$ +(122 +) +Amount recognized in accumulated other +comprehensive (loss) income - Prior service cost +$ +8,340 +$ +8,307 +$ +8,181 +Weighted-average assumptions used to determine +benefit obligations for the year ended December 31: +Discount rate +4.05 +% +3.35 +% +3.85 +% +Benefits under the plan is not based on wages and, therefore, future wage adjustments have no effect on the projected benefit obligation. +During 2018, 2017 and 2016, the Company updated the mortality tables (RP-2017 Total Mortality Table, RP-2016 Total Mortality Table, and RP-2015 Total Mortality Table for each respective year) in the underlying assumptions used to determine the benefit obligation. +F-24 +The details of net periodic benefit cost for pension benefits included in the accompanying Consolidated Statements of Operations for t he years ended December 31, 2018, 2017 and 2016 are as follows: +(Table only in thousands) +2018 +2017 +2016 +Service cost +$ +— +$ +415 +$ +447 +Interest cost +1,190 +1,314 +1,426 +Expected return on plan assets +(1,511 +) +(1,723 +) +(1,829 +) +Net amortization and deferral +238 +227 +212 +Net periodic benefit cost (income) +$ +(83 +) +$ +233 +$ +256 +Weighted-average assumptions used to determine net +periodic benefit costs for the years ended December 31: +Discount rate +3.35 +% +3.85 +% +4.00 +% +Expected return on assets +5.75 +% +7.25 +% +7.50 +% +The basis of the long-term rate of return assumption reflects the current asset mix for the pension plan of approximately 30% to 40% debt securities and 60% to 70% equity securities with assumed average annual returns of approximately 4% to 6% for debt securities and 8% to 12% for equity securities. The investment portfolio for the pension plan will be adjusted periodically to maintain the current ratios of debt securities and equity securities. Additional consideration is given to the historical returns for the pension plan as well as future long range projections of investment returns for each asset category. The long-term rate of return also considers administrative expenses of the plan. +The net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive loss into net periodic benefit cost during 2019 are $0.2 million and zero, respectively. +Pension plan assets are invested in trusts comprised primarily of investments in various debt and equity funds. A fiduciary committee establishes the target asset mix and monitors asset performance. The expected rate of return on assets includes the determination of a real rate of return for equity and fixed income investment applied to the portfolio based on their relative weighting, increased by an underlying inflation rate. Our defined benefit pension plan asset allocation by asset category is as follows: +Target +Allocation +Percentage of +Plan Assets +2018 +2018 +2017 +Asset Category: +Cash and cash equivalents +0 +% +3 +% +4 +% +Equity securities +70 +% +70 +% +70 +% +Debt securities +30 +% +27 +% +26 +% +Total +100 +% +100 +% +100 +% +Estimated pension plan cash obligations are $2.1 million, $2.1 million, $2.1 million, $2.1 million, and $2.1 million for 2019 through 2023, respectively, and a total of $10.5 million for the years 2024 through 2028. +Fair Value Measurements of Pension Plan Assets +Following is a description of the valuation methodologies used for pension assets measured at fair value: +• +Cash and cash equivalents: Cash and cash equivalents consist primarily of cash on deposit in money market funds. Cash and cash equivalents are stated at cost, which approximates fair value. +• +Equity securities: Equity securities consist of various managed funds that invest primarily in common stocks. These securities are valued at the net asset value of shares held by the plans at year end. The net asset value is calculated based on the underlying shares and investments held by the funds. +• +Debt securities: Debt securities consist of U.S. government and agency securities, corporate bonds and notes, and managed funds that invest in fixed income securities. U.S governmental and agency securities are valued at closing prices reported in the active market in which the individual securities are traded. Corporate bonds and notes are valued using market inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications. Inputs may be prioritized differently at certain times based on market conditions. Managed funds are valued at the net asset value of shares held by the plans at year end. The net asset value is calculated based on the underlying investments held by the fund. +F-25 +The preceding methods described may produce a fair value calculation that m ay not be indicative of net realizable value or reflective of future fair values. Furthermore, although the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumpti ons to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. +The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels. +The levels assigned to the defined benefit plan assets as of December 31, 2018, are summarized in the tables below: +(Table only in thousands) +Level 1 +Level 2 +Level 3 +Total +Pension assets, at fair value: +Cash and cash equivalents +$ +685 +$ +— +$ +— +$ +685 +Equity securities +16,994 +— +— +16,994 +Debt securities +6,518 +— +— +6,518 +Total assets +$ +24,197 +$ +— +$ +— +$ +24,197 +The levels assigned to the defined benefit plan assets as of December 31, 2017, are summarized in the tables below: +(Table only in thousands) +Level 1 +Level 2 +Level 3 +Total +Pension assets, at fair value: +Cash and cash equivalents +$ +1,147 +$ +— +$ +— +$ +1,147 +Equity securities +18,722 +— +— +18,722 +Debt securities +6,967 +— +— +6,967 +Total assets +$ +26,836 +$ +— +$ +— +$ +26,836 +The Company contributes to a number of multiemployer defined benefit pension plans under the terms of collective-bargaining agreements that cover its union-represented employees. The risks of participating in these multiemployer plans are different from single-employer plans in the following aspects: +• +Assets contributed to the multiemployer plan by one employer may be used to provide benefits to employees of other participating employers. +• +If a participating employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. +• +If the Company chooses to stop participating in some of its multiemployer plans, CECO may be required to pay those plans an amount based on the underfunded status of the plan, referred to as a withdrawal liability. +F-26 +The Company participation in these plans for the year ended December 31, 201 8 , is outlined in the table below. The “EIN/Pension Plan Numb er” column provides the Employer Identification Number and the three-digit plan number, if applicable. Unless otherwise noted, the most recent Pension Protection Act zone status available in 201 8 is for the plan ’s year-end at December 31, 2017 . The zone status is based on information that the Company received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65% funded, plans in the yellow zone are less than 80% fun ded, and plans in the green zone are at least 80% funded. The “FIP/RP Status Pending/Implemented” column indicates plans for which a financial improvement plan (FIP) or a rehabilitation plan (RP) is either pending or has been implemented. The last column l ists the expiration date(s) of the collective-bargaining agreement(s) to which the plans are subject. +Pension Fund +EIN/Pension +Plan Number +Pension +Protection +Act Zone +Status +FIP/RP Status Pending/ +Implemented +Surcharge +Imposed +Expiration +of Collective +Bargaining +Agreement +Sheet Metal Workers’ National Pension Fund +52-6112463/001 +Yellow +FIP: Yes - Implemented RP: Yes - Implemented +No +various +Sheet Metal Workers Local 224 Pension Plan +31-6171353/001 +Yellow +FIP: Yes - Implemented +No +May 31, 2022 +Sheet Metal Workers Local No. 20, Indianapolis Area Pension fund +51-0168516/001 +Green +Is not subject +No +May 31, 2020 +Sheet Metal Workers Local No. 177 Pension Fund +62-6093256/001 +Green +Is not subject +No +May 1, 2019 +Kirk and Blum was listed in the Sheet Metal Workers Local No. 177 Pension Fund’s Form 5500 as providing more than five percent of total contributions for the year ended December 31, 2017. The Company was not listed in any of the other plans’ Forms 5500 as providing more than five percent of the total contributions for the plans and plan years. At the date the financial statements were issued, Forms 5500 were not available for the plan years ended December 31, 2018. +We have no current intention of withdrawing from any plan and, therefore, no liability has been provided in the accompanying consolidated financial statements. +Amounts charged to pension expense under the above plans including the multi-employer plans totaled $1.4 million, $2.0 million and $2.1 million in 2018, 2017 and 2016, respectively. +We have a profit sharing and 401(k) savings retirement plan for employees of certain of our subsidiaries. The plan covers substantially all employees who have 30 days of service, and who have attained 18 years of age. The plan allows us to make discretionary contributions and provides for employee salary deferrals of up to 100%. We made aggregate matching contributions and discretionary contributions of $1.7 million, $1.6 million, and $1.5 million during 2018, 2017 and 2016, respectively. +F-27 +12. +Leases +Sale-leaseback Transactions +Financing Transaction +In 2016, the Company entered into an agreement to sell one of its manufacturing facilities for gross proceeds of $5.0 million, less costs associated with the transaction of $0.3 million, or net proceeds of $4.7 million. As a part of the transaction, the Company entered into a lease for the property from the purchaser for an initial period of 13 years. In June 2017, the agreement was amended extending the term through June 2031. This sale-leaseback has been accounted for as a financing transaction with a current effective interest rate of 4.53%. Payments made by the Company are allocated between interest expense and a reduction to the sale-leaseback financing liability. +As of December 31, 2018, future payments on the sale-leaseback financing liability are as follows (in thousands): +Years +2019 +$ +414 +2020 +422 +2021 +431 +2022 +439 +2023 +448 +Thereafter +3,658 +Total payments +5,812 +Less amount representing interest +(1,431 +) +Total liability +4,381 +Less current portion, included in accounts payable and accrued expenses +(220 +) +Long-term portion included, in other liabilities +$ +4,161 +As of December 31, 2018 and 2017, the net carrying value of the facility assets that are included in property, plant, and equipment on our Consolidated Balance Sheets amounted to $10.2 million and $11.0 million, respectively, which are depreciated over the remaining term of the lease. +Capital Leases +In 2016, the Company entered into agreements to sell two of its manufacturing facilities for gross proceeds of $9.3 million, less costs associated with the transaction of $0.5 million, or net proceeds of $8.8 million. As a part of the transactions, the Company entered into 13-year leases for the properties from the purchasers. In June 2018, the leases were amended extending the expiration date through August 2030. +The Company recorded a $4.4 million deferred gain on the sale of these facilities which is recorded in the Consolidated Balance Sheets as a reduction to property, plant, and equipment. The deferred gain is recognized over the remainder of the lease term. As a result of these transactions, the Company recorded a capital lease obligation of $8.7 million. The current weighted-average effective interest rates of the capital leases are 4.26% to 4.67%. +F-28 +The future minimum payments for the aforementioned capital leases as of December 31, 2018 , are as follows (in thousands): +Fiscal Years +2019 +$ +838 +2020 +855 +2021 +872 +2022 +889 +2023 +907 +Thereafter +6,407 +Total payments +10,768 +Less amount representing interest +(2,433 +) +Present value of future minimum lease payments +8,335 +Less current portion, included in accounts payable and accrued expenses +(478 +) +Long-term portion, included in other liabilities +$ +7,857 +Capital lease assets included in the Consolidated Balance Sheets as part of property, plant, and equipment as of December 31, 2018 and 2017, are as follows (in thousands): +2018 +2017 +Depreciable Life (Years) +Building and improvements, net of deferred gain +$ +4,385 +$ +4,385 +13 +Less: Accumulated depreciation +(850 +) +(534 +) +Total +$ +3,535 +$ +3,851 +Rent +We lease certain facilities on a year-to-year basis. We also have future annual minimum rental commitments under noncancelable operating leases as follows: +(Table only in thousands) +December 31, +2019 +$ +2,745 +2020 +1,880 +2021 +1,454 +2022 +931 +2023 +851 +2024 and thereafter +2,278 +$ +10,139 +Total rent expense under all operating leases for 2018, 2017 and 2016 was $3.7 million, $4.2 million and $4.5 million, respectively. +13. +Commitments and Contingencies +Legal Proceedings +Asbestos cases +Our subsidiary, Met-Pro, beginning in 2002 began to be named in asbestos-related lawsuits filed against a large number of industrial companies including, in particular, those in the pump and fluid handling industries. In management’s opinion, the complaints typically have been vague, general and speculative, alleging that Met-Pro, along with the numerous other defendants, sold unidentified asbestos-containing products and engaged in other related actions which caused injuries (including death) and loss to the plaintiffs. Counsel has advised that more recent cases typically allege more serious claims of mesothelioma. The Company’s insurers have hired attorneys who, together with the Company, are vigorously defending these cases. Many cases have been dismissed after the plaintiff fails to produce evidence of exposure to Met-Pro’s products. In those cases, where evidence has been produced, the Company’s experience has been that the exposure levels are low and the Company’s position has been that its products were not a +F-29 +cause of death, injury or loss. The Company has been dismissed from or settled a large number of these cases. Cum ulative settlement payments from 2002 through December 31, 201 8 for cases involving asbestos-related claims were $ 2 . 9 million which together with all legal fees other than corporate counsel expenses; $ 2 . 7 million have been paid by the Company’s insurers. T he average cost per settled claim, excluding legal fees, was approximately $ 36 ,000. +Based upon the most recent information available to the Company regarding such claims, there were a total of 208 cases pending against the Company as of December 31, 2018 (with Illinois, New York, Pennsylvania and West Virginia having the largest number of cases), as compared with 218 cases that were pending as of December 31, 2017. During 2018, 96 new cases were filed against the Company, and the Company was dismissed from 63 cases and settled 43 cases. Most of the pending cases have not advanced beyond the early stages of discovery, although a number of cases are on schedules leading to or are scheduled for trial. The Company believes that its insurance coverage is adequate for the cases currently pending against the Company and for the foreseeable future, assuming a continuation of the current volume, nature of cases and settlement amounts. However, the Company has no control over the number and nature of cases that are filed against it, nor as to the financial health of its insurers or their position as to coverage. The Company also presently believes that none of the pending cases will have a material adverse impact upon the Company’s results of operations, liquidity or financial condition. +Other +The Company is also a party to routine contract and employment-related litigation matters and routine audits of state and local tax returns arising in the ordinary course of its business. +The final outcome and impact of open matters, and related claims and investigations that may be brought in the future, are subject to many variables, and cannot be predicted. In accordance with ASC 450, “Contingencies,” and related guidance, we record reserves for estimated losses relating to claims and lawsuits when available information indicates that a loss is probable and the amount of the loss, or range of loss, can be reasonably estimated. The Company expenses legal costs as they are incurred. +We are not aware of pending claims or assessments, other than as described above, which may have a material adverse impact on our liquidity, financial position, results of operations, or cash flows. +14. +Income Taxes +On December 22, 2017, the Tax Act was signed into law making significant changes to the U.S. tax code. In conjunction with guidance set forth under SAB 118, the Company recorded provisional amounts at December 31, 2017 for, most significantly, the remeasurement of deferred tax assets and liabilities to reflect the new U.S. statutory rate of 21 percent, and to account for the one-time “transition” tax on unrepatriated foreign earnings. During the year ended December 31, 2018, the Company updated its SAB 118 provisional estimates and completed its accounting for the provisions made as of December 31, 2017, which resulted in a $1.7 million adjustment for deemed distributions on foreign earnings. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested, as management intends to repatriate foreign-held cash as needed to meet domestic cash needs for operating, investing, and financing activities. A liability of $0.6 million has been recorded for the deferred taxes on such undistributed foreign earnings. The deferred taxes are attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +Income (loss) before income taxes was generated in the United States and globally as follows: +(Table only in thousands) +2018 +2017 +2016 +Domestic +$ +6,230 +$ +3,891 +$ +(39,623 +) +Foreign +(3,733 +) +(2,482 +) +6,659 +$ +2,497 +$ +1,409 +$ +(32,964 +) +F-30 +Income tax provision consisted of the following for the years ended December 31: +(Table only in thousands) +2018 +2017 +2016 +Current: +Federal +$ +5,166 +$ +6,234 +$ +4,957 +State +1,660 +388 +892 +Foreign +2,834 +939 +3,191 +9,660 +7,561 +9,040 +Deferred: +Federal +1,144 +(2,479 +) +(2,794 +) +State +56 +114 +(409 +) +Foreign +(1,242 +) +(758 +) +(547 +) +(42 +) +(3,123 +) +(3,750 +) +$ +9,618 +$ +4,438 +$ +5,290 +The income tax provision differs from the statutory rate due to the following: +(Table only in thousands) +2018 +2017 +2016 +Tax expense (benefit) at statutory rate +$ +524 +$ +494 +$ +(11,525 +) +Increase (decrease) in tax resulting from: +State income tax, net of federal benefit +1,337 +367 +174 +Domestic production activities deduction +— +(235 +) +(561 +) +Intangible asset and goodwill impairment +— +1,789 +17,859 +Change in uncertain tax position reserves +73 +465 +(624 +) +Permanent differences related to divestitures +7,048 +— +— +Permanent differences +693 +1,026 +(31 +) +Impact of rate differences and adjustments +57 +(20 +) +(1,655 +) +United States and foreign tax incentives +(1,443 +) +(240 +) +(1,035 +) +Earnout (income) expense +(69 +) +(1,779 +) +2,573 +Change in valuation allowance +1,521 +1,044 +222 +Revaluation of deferred tax assets and liabilities +— +(4,819 +) +— +Net deemed distribution on repatriation of foreign earnings +(1,713 +) +6,426 +— +Foreign withholding taxes on repatriation of foreign earnings +666 +— +— +Other +924 +(80 +) +(107 +) +$ +9,618 +$ +4,438 +$ +5,290 +F-31 +Deferred income taxes reflect the future tax consequences of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and tax credit carry forwards. The net deferred tax liabilities consisted of the following at December 31: +December 31 +(Table only in thousands) +2018 +2017 +Gross deferred tax assets: +Accrued expenses and other +$ +417 +$ +286 +Reserves on assets +1,276 +2,000 +Share-based compensation awards +459 +436 +Minimum pension +2,153 +2,318 +Net operating loss carry-forwards +3,478 +3,471 +Tax credit carry-forwards +2,352 +1,634 +Valuation allowances +(5,474 +) +(3,873 +) +4,661 +6,272 +Gross deferred tax liabilities: +Depreciation +(646 +) +(448 +) +Goodwill and intangibles +(10,907 +) +(13,588 +) +Prepaid expenses and inventory +(798 +) +(585 +) +Withholding tax on unremitted foreign earnings +(551 +) +— +Revenue recognition +(514 +) +(1,861 +) +(13,416 +) +(16,482 +) +Net deferred tax liabilities +$ +(8,755 +) +$ +(10,210 +) +As of December 31, 2018, the Company has utilized substantially all of its federal net operating loss carry forwards. State and local net operating loss carry forwards total $29.4 million, which expire from 2019 to 2038. The Company has recorded a valuation allowance on certain of these net operating loss carry forwards to reflect expected realization. A $1.1 million foreign tax credit carryforward was generated in 2017 and a full valuation allowance has been recorded against it. The Company also has net operating loss carry forwards in foreign jurisdictions totaling $11.5 million. A full valuation allowance has been established against substantially all of these losses in foreign jurisdictions. As of December 31, 2018 and 2017, the Company has recorded a valuation reserve in the amount of $5.5 million and $3.9 million, respectively. The changes in the valuation allowance resulted in additional income tax expense of $1.5 million, $1.0 million, and $0.2 million in 2018, 2017, and 2016, respectively. +In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this assessment. Based on this assessment, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2018. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The Company accounts for uncertain tax positions pursuant to FASB ASC Topic 740. The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. The Company estimates that it may settle one or more foreign and domestic audits in the next twelve months that may result in a decrease in the amount of accrual for uncertain tax positions of up to $0.5 million. A reconciliation of the beginning and ending amount of uncertain tax position reserves included in other liabilities on the Consolidated Balance Sheets is as follows: +(Table only in thousands) +2018 +2017 +Balance as of January 1, +$ +866 +$ +401 +Additions for tax positions taken in prior years +73 +465 +Statute expirations +— +— +Reductions of tax positions taken in prior years +— +— +Balance as of December 31, +$ +939 +$ +866 +F-32 +The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. The reserve for uncertain tax positions includes $0.3 million, $0.3 million and $0.2 million of interest and penalties as of December 31, 2018, 2017 and 2016, respectively. The favorable settlement of all uncertain tax positions would impact the Company’s effective income tax rate. Tax years going back to 2014 remain open for examination by Federal authorities, and back to 2013 remain open for all significant state and foreign authorities. +15. +Related Party Transactions +During 2018, 2017 and 2016 we paid fees of $0.2 million, $0.3 million and $0.4 million, respectively, for consulting services to Icarus, through which Jason DeZwirek, our Chairman of our Board, provides services. During 2018, 2017 and 2016, we paid fees of $0.1 million in each year for consulting services to JMP Fam Holdings Inc., through which Jonathan Pollack, a member of the Board of Directors, provides services. All services described above are based on verbal agreements with the Company. The Board of Directors approves the above services on an annual basis. +During the year ended December 31, 2016, the Company issued 89,640 shares of common stock to Icarus in connection with a cashless exercise of a warrant. In 2016, the Company entered into an agreement to repurchase 75,000 shares of common stock from a current employee. See Note 10 for further detail related to these transactions. +During 2018, 2017, and 2016, we incurred rent expense of $0.6 million, $0.6 million, and $1.1 million, respectively, to lease facilities owned by the subsidiaries’ former owners at Adwest, Zhongli and Emtrol. Effective January 1, 2017, Adwest moved facilities and ended their lease with the former owner of the subsidiary, resulting in zero rent expense paid to the former owner. +During 2018, 2017, and 2016, we purchased $0.3 million, $0.8 million and $0.8 million in inventory from companies owned by the former owner of the Zhongli subsidiary. During 2018, 2017, and 2016, we sold $0.1 million, $0.1 million and zero of inventory to the same companies. The Company employed the former owner in a managerial role at this subsidiary through December 31, 2017. +16. Acquisition of Noncontrolling Interest +In connection with the 2015 Peerless Mfg. Co. acquisition, the Company acquired a 60% equity investment in Peerless Propulsys that entitled the Company to 80% of Peerless Propulsys’s earnings. On July 11, 2016, the Company entered into an agreement with the noncontrolling owner of Peerless Propulsys and issued a promissory note in the amount of $5.3 million due on July 11, 2019 in exchange for 100% ownership in the equity and earnings of Peerless Propulsys. The minority interest had a carrying value of $4.1 million on the transaction date, compared to the purchase price of $5.3 million. Since the Company already had control over the equity investment, the $1.2 million excess paid over the carrying value was recorded as a reduction to additional paid in capital. The interest rate on the note is 1.50%, which approximates the market rate given the short-term duration of the note. As of December 31, 2018, the outstanding balance of the note was $1.7 million and was paid off in January 2019. The note is classified as a current liability in the Consolidated Balance Sheets as of December 31, 2018. +1 7 . +Divestitures +Strobic Air Corporation +On March 30, 2018, the Company completed the sale of Strobic Air Corporation (“Strobic”) as part of its strategic decision to exit brands that do not align with the CECO portfolio to increase focus on better serving the energy and industrial solutions and fluid handling markets. The sales price was $28.5 million, subject to post-closing purchase price adjustments. The disposition resulted in a gain of $6.9 million, comprised of $27.9 million of net proceeds received as consideration after post-closing purchase price adjustments less net assets disposed of $18.8 million and transaction costs of $2.2 million. The net assets disposed of are primarily comprised of $13.0 million of goodwill, $2.3 million of definite-lived intangible assets and $1.2 million of indefinite-lived intangible assets allocated to the Strobic business. In 2017, Strobic reported $17.7 million in net sales and $1.6 million in income from operations. Strobic results through the date of disposition are included within income before income taxes in the Consolidated Statement of Operations and are reported within the Fluid Handling Solutions segment. The sale of Strobic did not constitute a significant strategic shift that will have a material impact on the Company’s ongoing operations and financial results. +F-33 +Keystone Filter +On February 28, 2018, the Company completed the sale of the Keystone Filter brand (“Keystone”) as part of its strategic decision to exit brands that do not align with the CECO portfolio to increase focus on better serving energy and industrial solutions and fluid handling markets. The sales price was $7.5 million, subject to post-closing purchase price adjustments. The disposition resulted in a gain of $4.3 million, comprised of $7.2 million of net proceeds after post-closing purchase price adjustments less net assets disposed of $2.7 million and transaction costs of $0.2 million. Keystone results are reported within the Fluid Handling Solutions segment through the date of disposition. +Zhongli +On November 27, 2018, the Company completed the sale of Jiangyin Zhongli Industrial Technology Co. Ltd (“Zhongli”), a business in our Energy Solutions segment operating in China for a price of $3.6 million. In the third quarter of 2018, we classified the assets and liabilities of Zhongli as held-for-sale. In connection with classifying this business as held-for-sale, GAAP required us to assess impairment by comparing the estimated selling price, less cost to sell to our carrying value in Zhongli. Based on this analysis, we recorded a $15.1 million estimated loss. The disposal of this business does not constitute a significant strategic shift that will have a material impact on the Company’s ongoing operations and financial results. Zhongli results are reported within the Energy Solutions segment through the date of disposition. +1 8 . +Business Segment Information +The Company’s operations are organized and reviewed by management along its product lines or end market that the segment serves and are presented in three reportable segments. The results of the segments are reviewed through to the “Income (loss) from operations” line on the Consolidated Statements of Operations. The accounting policies of the segments are the same as those in the consolidated financial statements. Except for the information reported on a segment basis, the Company does not accumulate net sales information by product or service and therefore, the Company does not disclose net sales by product or service because to do so would be impractical. +During the first quarter of 2018, the Company finalized an overall assessment and recalibration of its strategy. As a part of the changes to its strategy, management determined that a realignment of the Company’s segments was necessary to better reflect the technologies and solutions we provide, and the end markets we serve. As a result of this realignment, the reportable segments of the Company have been renamed and we reclassified the operating results of certain business units within the Energy Solutions and Industrial Solutions segments to have their reportable segment more closely align with our strategy. We have reclassified all prior year amounts to reflect the new segment structure. +The Company’s reportable segments are organized as groups of similar products and services, as described as follows: +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for Clean Energy with products and services that support our customers with efficient solutions and technologies to keep the world clean and safe. Our offerings improve air quality and solves fluid handling needs with market leading, highly engineered, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Industrial Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings improve air quality with a compelling solution set of air pollution control technologies that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +F-34 +2018 +2017 +2016 +Net Sales (less intra-, inter-segment sales) +(Table only in thousands) +Energy Solutions segment +$ +211,185 +$ +188,955 +$ +254,806 +Industrial Solutions segment +75,414 +87,838 +101,909 +Fluid Handling Solutions segment +50,740 +69,159 +61,788 +Corporate and Other (1) +— +(901 +) +(1,492 +) +Net sales +$ +337,339 +$ +345,051 +$ +417,011 +(1) +Includes adjustment for revenue on intercompany jobs. +2018 +2017 +2016 +Income (loss) from Operations +(Table only in thousands) +Energy Solutions segment +$ +28,398 +$ +14,565 +$ +30,582 +Industrial Solutions segment +5,635 +8,123 +8,481 +Fluid Handling Solutions segment +8,402 +14,736 +(36,209 +) +Corporate and Other (2) +(32,433 +) +(26,649 +) +(26,817 +) +Eliminations +— +(2,751 +) +(1,599 +) +Income (loss) from operations +$ +10,002 +$ +8,024 +$ +(25,562 +) +(2) Includes corporate compensation, professional services, information technology, acquisition and integration expenses, and other general , administrative corporate expenses and loss on divestitures +2018 +2017 +2016 +Property and Equipment Additions +(Table only in thousands) +Energy Solutions segment +$ +205 +$ +444 +$ +672 +Industrial Solutions segment +756 +160 +301 +Fluid Handling Solutions segment (3) +1,226 +382 +4,481 +Corporate and Other +903 +42 +7 +Property and equipment additions +$ +3,090 +$ +1,028 +$ +5,461 +(3) +Includes non-cash additions of $4,385 for property, plant, and equipment acquired under capital leases for 2016. See Note 12 for further detail. +2018 +2017 +2016 +Depreciation and Amortization +(Table only in thousands) +Energy Solutions segment +$ +8,112 +$ +9,675 +$ +11,557 +Industrial Solutions segment +1,067 +1,488 +1,814 +Fluid Handling Solutions segment +3,517 +4,754 +5,406 +Corporate and Other +576 +171 +126 +Depreciation and amortization +$ +13,272 +$ +16,088 +$ +18,903 +December 31, +2018 +2017 +Identifiable Assets +(Table only in thousands) +Energy Solutions segment +$ +245,842 +$ +258,218 +Industrial Solutions segment +54,179 +66,723 +Fluid Handling Solutions segment +73,910 +100,917 +Corporate and Other (4) +18,651 +12,691 +Identifiable assets +$ +392,582 +$ +438,549 +(4) +Corporate assets primarily consist of cash and income tax related assets. +F-35 +December 31, +2018 +2017 +Goodwill +(Table only in thousands) +Energy Solutions segment +$ +97,930 +$ +98,408 +Industrial Solutions segment +22,419 +22,419 +Fluid Handling Solutions segment +31,807 +46,124 +Goodwill +$ +152,156 +$ +166,951 +Intra-segment and Inter-segment Revenues +The Company has divisions that sell to each other within segments (intra-segment sales) and between segments (inter-segment sales) as indicated in the following tables: +Year Ended December 31, 2018 +Less Inter-Segment Sales +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Corp +and +Other +Net Sales to +Outside +Customers +Net Sales +(Table only in thousands) +Energy Solutions segment +$ +220,334 +$ +(7,912 +) +$ +(1,232 +) +$ +— +$ +(5 +) +$ +— +$ +211,185 +Industrial Solutions segment +79,139 +(3,084 +) +— +(600 +) +(41 +) +— +75,414 +Fluid Handling Solutions segment +52,846 +(1,483 +) +(616 +) +(7 +) +— +— +50,740 +Corporate and Other +— +— +— +— +— +— +— +Net Sales +$ +352,319 +$ +(12,479 +) +$ +(1,848 +) +$ +(607 +) +$ +(46 +) +$ +— +$ +337,339 +Year Ended December 31, 2017 +Less Inter-Segment Sales +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Corp +and +Other +Net Sales to +Outside +Customers +Net Sales +(Table only in thousands) +Energy Solutions segment +$ +197,897 +$ +(8,833 +) +$ +(109 +) +$ +— +$ +— +$ +— +$ +188,955 +Industrial Solutions segment +91,915 +(3,235 +) +— +(787 +) +(55 +) +— +87,838 +Fluid Handling Solutions segment +73,652 +(3,169 +) +(492 +) +(832 +) +— +— +69,159 +Corporate and Other (5) +— +— +— +— +— +(901 +) +(901 +) +Net Sales +$ +363,464 +$ +(15,237 +) +$ +(601 +) +$ +(1,619 +) +$ +(55 +) +$ +(901 +) +$ +345,051 +Year Ended December 31, 2016 +Less Inter-Segment Sales +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Corp +and +Other +Net Sales to +Outside +Customers +Net Sales +(Table only in thousands) +Energy Solutions segment +$ +258,710 +$ +(3,506 +) +$ +(398 +) +$ +— +$ +— +$ +— +$ +254,806 +Industrial Solutions segment +109,524 +(4,256 +) +— +(3,153 +) +(206 +) +— +101,909 +Fluid Handling Solutions segment +64,332 +(1,714 +) +(317 +) +(513 +) +— +— +61,788 +Corporate and Other (5) +— +— +— +— +— +(1,492 +) +(1,492 +) +Net Sales +$ +432,566 +$ +(9,476 +) +$ +(715 +) +$ +(3,666 +) +$ +(206 +) +$ +(1,492 +) +$ +417,011 +(5) +Includes adjustment for revenue on intercompany jobs. +No single customer represented greater than 10% of consolidated net sales or accounts receivable for 2018, 2017, or 2016. +For 2018, 2017, and 2016, sales to customers outside the United States, including export sales, accounted for approximately 33%, 32%, and 37%, respectively, of consolidated net sales. The largest portion of export sales in 2018 was destined for Asia (11.5%), +F-36 +Europe ( 11.0 % ) , and Middle East and Africa (6.2%) . Of consolidated long - lived assets, $ 19 . 1 million and $ 29 . 7 million were located outside of the United States as of December 31, 2018 and 2017, respectively. The largest portion of long-lived assets loca ted outside the United States at December 31, 2018 were in Europe ($1 4 . 5 million). +19 . +Quarterly Data (Unaudited) +Earnings per share amounts are computed independently each quarter. Accordingly, the sum of each quarter’s per share amount may not equal the total per share amount for the respective year. +Quarter +(Table only in thousands, except per share data) +First +Second +Third +Fourth +Year ended December 31, 2018 +Net sales +$ +74,139 +$ +81,089 +$ +88,256 +$ +93,854 +Gross profit +25,561 +27,525 +28,674 +29,777 +Net income (loss) attributable to CECO Environmental Corp. +5,763 +(901 +) +(12,915 +) +931 +Basic earnings (loss) per share +$ +0.17 +$ +(0.03 +) +$ +(0.37 +) +$ +0.03 +Diluted earnings (loss) per share +$ +0.17 +$ +(0.03 +) +$ +(0.37 +) +$ +0.03 +Year ended December 31, 2017 +Net sales +$ +92,651 +$ +93,870 +$ +84,987 +$ +73,543 +Gross profit +31,929 +28,486 +27,133 +25,646 +Net income (loss) attributable to CECO Environmental Corp. +38 +5,486 +3,036 +(11,589 +) +Basic earnings (loss) per share +$ +0.00 +$ +0.16 +$ +0.09 +$ +(0.34 +) +Diluted earnings (loss) per share +$ +0.00 +$ +0.16 +$ +0.09 +$ +(0.34 +) +F-37 \ No newline at end of file diff --git a/raw/filings/0000003197/2018/0001564590-19-006619/filing_metadata.csv b/raw/filings/0000003197/2018/0001564590-19-006619/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..6554c52fbdd491c7f9f20ef733f28960b3cabf1d --- /dev/null +++ b/raw/filings/0000003197/2018/0001564590-19-006619/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003197,CECO,CECO ENVIRONMENTAL CORP,2018,10-K,2019-03-07,2018-12-31,2019-03-07T12:05:01.000Z,0001564590-19-006619,cece-10k_20181231.htm,10-K,18602049,1,0,https://www.sec.gov/Archives/edgar/data/3197/000156459019006619/cece-10k_20181231.htm,https://www.sec.gov/Archives/edgar/data/3197/000156459019006619/ diff --git a/raw/filings/0000003197/2018/0001564590-19-006619/item1.txt b/raw/filings/0000003197/2018/0001564590-19-006619/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..c4b38b403e558d912982a4eca0b13d6bbc5ee82f --- /dev/null +++ b/raw/filings/0000003197/2018/0001564590-19-006619/item1.txt @@ -0,0 +1,132 @@ +Item 1. +Business +General +CECO Environmental Corp. (“CECO” or the “Company”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customer’s mission critical applications. The secular growth industries CECO serves include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +To achieve our mission of being a world-class global leader in industrial air quality and fluid handling, we strive to maximize the availability, reliability and efficiency of our customers’ operating assets. Additionally, we continue to focus on increasing our recurring revenue stream from aftermarket parts and services, as well as continuously improving the efficiencies and capabilities of our technologies. +CECO has over $5 billion of installed equipment base with end users, which we target to expand and grow a higher recurring revenue of aftermarket products and services. We also focus on operational excellence strategies as a central theme to improving our earnings and cash flows. +We believe we succeed because of the relationships we have developed, the long history of performance and reliability of our systems and products, our ability to deliver products in compliance with our customers’ needs and our advanced technical engineering capabilities on complex projects. We work closely with our customers to design, custom-engineer and fabricate our systems and products to meet their specific needs. +Our customers include some of the largest natural gas processors, transmission and distribution companies, refineries, power generators, boiler manufacturers, compressor manufacturers, metals and minerals, industrial manufacturing, engineering and construction companies in the world. +We believe our value differentiators include, but are not limited to, reliable product performance, timely delivery, customer satisfaction, and advanced engineering. We believe these are critical in maintaining our competitive position and have adopted a spirit of continuous improvement to ensure we maintain our market leadership position. +CECO was incorporated in the State of New York in 1966 and reincorporated in the State of Delaware in January 2002. The Company has been publicly traded since January 1, 1978 and its common stock trades on the NASDAQ Stock Market under the symbol “CECE.” +Industry Overview +We serve a multi-billion dollar global market that is highly fragmented and serves various end markets including power generation, natural gas power plants, petrochemical processing, general industrial, refining, oil & gas and wastewater treatment. +We believe demand for our products and services will continue to be driven by the following factors: +• +Global Economic Conditions. The Company’s businesses are impacted by economic conditions around the globe. Higher economic growth and other factors that would increase industrial gross domestic product and capital expenditures are projected to impact the markets the Company serves and could affect the Company’s businesses by increasing demand for the Company’s products and services. +• +Worldwide Industrialization . Global trade has increased significantly over the last decade and is driven by growth in emerging markets, including China and India, as well as other developing nations in Asia and the Europe, Middle East, and Africa (“EMEA”) region. As a result of globalization, manufacturing that was historically performed domestically continues to migrate to lower cost countries. This movement of the manufacture of goods throughout the world increases demand for industrial ventilation products as new construction continues. We expect that more rigorous environmental +2 +regulations will be introduced to create a cleaner working environment and reduce environmental emissions as these economies evolve. +• +Natural Gas Infrastructure . The natural gas industry consists of the exploration, production, processing, transportation, storage and distribution of natural gas. The International Energy Association (“IEA”) projects a pronounced shift in Organization for Economic Cooperation and Development (“OECD”) countries away from oil and coal towards natural gas and renewables. Natural gas continues to be the fuel of choice for the electrical power and industrial sectors in many of the world’s regions, in part because of its lower carbon intensity compared with coal and oil, which makes it an attractive fuel source in countries where governments are implementing policies to reduce greenhouse gas emissions. +Natural gas delivery is a complex process that refines raw natural gas for industrial, commercial or residential uses. Initially, raw natural gas is extracted from the earth and cleansed of contaminants such as dirt and water at the well site. The natural gas is then transported through a gathering facility to a processing facility, where it is processed to meet quality standards set by pipeline and distribution companies, such as specified levels of solids, liquids and other gases. After processing, the natural gas is transmitted for storage or through an extensive network of pipelines to consumers. +• +Power Generation. Power generation encompasses a broad range of activities related to the production of electricity. The primary types of fuel used to generate electricity are coal, natural gas and nuclear. In the United States, concerns about potential environmental regulations enhance the attractiveness of natural gas-fired power plants compared with coal-fired power plants, which generally have higher pollutant emission rates than natural gas-powered plants. Natural gas-fired power plants have lower initial capital needs and are more flexible in terms of operating times than coal plants. +• +Refining, Oil Production and Petrochemical Processing . Refining, oil production and petrochemical processing involves the producing, refining and processing of fuels and chemicals for use in a variety of applications, such as gasoline, fertilizers and plastics. In response to increasing international demand for petrochemicals and refined products, companies are producing more products from new sources, constructing new refineries and petrochemical processing facilities as well as expanding existing facilities. In many cases, these new and expanded facilities must comply with stricter environmental regulations, which influence both choice of fuel and demand for systems to control exhaust emissions. These facilities use a broad range of our products and systems, including our selective catalytic reduction (“SCR”) pollution reduction systems, oily water treatment systems and separation and filtration products and our fluid catalytic cracking cyclone technology. +• +Stringent Regulatory Environment . The adoption of increasingly stringent environmental regulations globally requires businesses to pay strict attention to environmental protection. Businesses and industries of all types from refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing must comply with these various international, federal, state and local government regulations or potentially face substantial fines or be forced to suspend production or alter their production processes. These increasingly stringent environmental regulations are a principal factor that drives our business. +These factors, individually or collectively, tend to cause increases in industrial capital spending that are not directly impacted by general economic conditions, expansion, or capacity increases. In contrast, favorable conditions in the economy generally lead to plant expansions and the construction of new industrial sites. However, in a weak economy, customers tend to lengthen the time from their initial inquiry to the purchase order or defer purchases. +Mission and Strategy +Our mission is to help companies grow their business with safe, clean and more efficient solutions that help protect people and our shared environment. +We seek to fulfill this mission through established global leadership in air quality and fluid handling solutions focused on serving the energy, industrial, and other niche markets around the world. We will continue to leverage our innovative technology and application expertise to customers around the world. We work to improve air quality, optimize the energy value chain, and provide custom engineered solutions for applications including oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing along with a wide range of other applications. +Our strategy to become the global leader in air quality and fluid handling solutions is to drive an operating environment of performance excellence across the Company with a near term focus on targeted value creation enablers, and growth-oriented business segment performance. +3 +Four Value Creation Enablers Driving Growth : +All four of these are inter-connected and critical to achieving our objectives. +• +Outside-In Leadership is all about an increased attention on our customers and the trends affecting the world around us as we make decisions that enable our organization to be responsive and with an orientation for growth. +• +Innovation is about us finding better ways to help our customers get their jobs done – whether that is a new product and technology or the way we serve and work with them. +• +Simplification involves aligning and streamlining our operational practices and metrics to match our customers’ key performance indicators (“KPIs”) for success and removing complexity from our systems and structure. +• +Active Portfolio Management dictates a regular evaluation of our business units for market attractiveness and profitability together with scanning the market for attractive potential additions that strengthen the long-term outlook of the Company. +Three Business Segments: +The Company executes and reports in three reportable segments focused on attractive end markets. Each segment is aligned to generate profitable growth for the Company across a targeted industry with a compelling technology and solution set to benefit customers. Additionally, we seek to protect and deepen our end user relationships by expanding our aftermarket services with long-term service contracts that deliver a full life-cycle of customer support. +• +Energy Solutions segment: Serves the energy market, where we are a key part of helping meet the global demand for clean energy with products and services that support our customers with efficient solutions and technologies to keep the world clean and safe. Our offerings improve air quality with market leading, highly engineered, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Serves the industrial pollution control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings improve air quality with a compelling solution set of air pollution control technologies that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Competitive Strengths +Leading market position as a complete solution provider . We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. The multi-billion dollar global market is highly fragmented with numerous small and regional contracting firms separately supplying engineering services, fabrication, installation, testing and monitoring, products and spare parts. We offer our customers a complete end-to-end solution, including engineering and project management services, procurement and fabrication, construction and installation, aftermarket support, and sale of consumables, which allows our customers to avoid dealing with multiple vendors when managing projects. +Long-standing experience and customer relationships in growing industry . We have serviced the needs of our target markets for over 50 years. Our extensive experience and expertise in providing diversified solutions enhances our overall customer relationships, and provides us with a competitive advantage in our markets relative to other companies in the industry. We believe this is evidenced by strong relationships with many of our world-class customers. We believe no single competitor has the resources to offer a similar portfolio of product and service capabilities. We offer the depth of a large organization, while our lean organizational structure keeps us close to our customers and markets, allowing us to offer rapid and complete solutions in each unique situation. +Global diversification and broad customer base. The global diversity of our operations and customer base provides us with multiple growth opportunities. As of December 31, 2018, we had a diversified customer base of approximately 4,200 active customers +4 +across a range of industries. Our customers represent some of the largest refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing companies. We believe that the diversity of our customers and end markets mitig ates our risk of a potential fluctuation or downturn in demand from any individual industry or particular customer. We believe we have the resources and capabilities to meet the needs of our customers as they upgrade and expand domestically as well as into new international markets. Once systems have been installed and a relationship has been established with the customer, we are often awarded repetitive service and maintenance business as the customers’ processes change and modifications or additions to th eir systems become necessary. +Experienced management and engineering team. Our senior management team has substantial experience in industrial air quality and fluid handling solutions. The business experience of our management team enables us to pursue our strategy. Our senior management team is supported by a strong operating management team, which possesses extensive operational and managerial experience. Our workforce includes approximately 200 engineers, designers, and project managers whose significant specialized industry experience and technical expertise enables them to have a deep understanding of the solutions that will best suit the needs of our customers. The experience and stability of our management, operating and engineering teams have been crucial to our growth, developing and maintaining customer relationships, and increasing our market share. +Expand customer base and penetrate end markets through global market coverage . We constantly look for opportunities to gain new customers and penetrate geographic locations and end markets with existing products and services or acquire new product or service opportunities. We intend to continue to expand our sales force, customer base, and end markets, and have continued to pursue potential attractive growth opportunities both domestically and globally, including international projects in Asia, South America, and EMEA. +Develop innovative solutions . We intend to continue to leverage our engineering and manufacturing expertise and strong customer relationships to develop new customized products to address the identified needs of our customers or a particular end market. We thoroughly analyze new product opportunities by considering projected demand for the product or service, price point, and expected operating costs, and only pursue those opportunities that we believe will contribute to earnings growth in the near-term. In addition, we continually improve our traditional technologies and adapt them to new industries and processes. +Maintain strong customer focus . We enjoy a diversified customer base of approximately 4,200 active customers across a broad base of industries, including power, municipalities, chemical, industrial manufacturing, refining, petrochemical, metals, minerals and mining, hospitals and universities. We believe that there are multiple opportunities for us to expand our penetration of existing markets and customers. +Disciplined acquisition program with successful integration . We believe that we have demonstrated an ability to successfully acquire and integrate companies with complementary product or service offerings. We will continue to seek and execute additional strategic acquisitions and focus on expanding our product service and breadth, as well as entering into new adjacent markets. We believe that the breadth and diversity of our products and services and our ability to deliver full solutions to various end markets provides us with multiple sources of stable growth and a competitive advantage relative to other players in the industry. +Products and Services +We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that control emissions from such facilities, as well as fluid handling and filtration systems. We provide a wide spectrum of products and services including dampers and diverters, selective catalytic reduction and selective non-catalytic reduction systems, cyclonic technology, thermal oxidizers, filtration systems, scrubbers, fluid handling equipment and plant engineering services and engineered design build fabrication. +Project Design and Research and Development +We seek to achieve our Outside-In Leadership by understanding our customers’ needs and delivering better outcomes for them by focusing new product development efforts that help protect our shared environment while working to improve a variety of operational outcomes including, but not limited to, facility uptime, production quality, and process performance. We produce specialized products that are often tailored to the specifications of a customer or application. +5 +We continually collaborate with our customers on their projects to develop the proper solution and ensure customer satisfaction. The project development cycle may follow many different paths depending on the specifics of the job and end market. The cycle can take from one to more than twelve months from concept and design to production but may vary significantly depending on developments that occur during the process, including among others, t he emergence of new environmental demands, changes in design specifications and ability to obtain necessary approvals. +Sales, Marketing and Support +Our global selling strategy is to provide a solutions-based approach by being a single source provider of technology products and services. The strategy involves expanding our scope of products and services through selective acquisitions and the formation and integration of new business units. We believe this strategy provides a discernible competitive advantage. We execute this strategy by utilizing our portfolio of in-house technologies and those of third-party equipment suppliers. Many of these have been long-standing relationships, which have evolved from pure supplier roles to value-added business partnerships. This enables us to leverage existing business with selective alliances of suppliers and application specific engineering expertise. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support, and single source. Our value proposition to customers is to provide competitively priced, customized solutions. Our industry-specific knowledge, accompanied by our product and service offerings, provides valuable synergies for design innovation. +We sell and market our products and services with our own direct sales force, including employees in the United States, the Netherlands, United Kingdom, Canada, United Arab Emirates, India, Mexico, China, and Singapore, in conjunction with outside sales representatives in North America, South America, EMEA, Asia, and India. We expect to continue expanding our sales and support capabilities and our network of outside sales representatives in key regions domestically and internationally. +We market our offerings to our customers through a variety of channels including, but not limited to, digital, web, social media, email campaigns, individual customer visits, product announcements, brochures, magazine articles, advertisements and cover or article features in trade journals and other publications. We also participate in public relations and promotional events, including industry tradeshows and technical conferences. +Our customer service organization or sales force provides our customers with technical assistance, use and maintenance information as well as other key information regarding their purchase. We also actively provide our customers with access to key information regarding changes and pending changes in environmental regulations as well as new product or service developments. We believe that maintaining a close relationship with our customers and providing them with the support they request improves their level of satisfaction and enables us to foresee their potential future product needs or service demands. Moreover, this approach can lead to sales of annual service and support contracts as well as consumables. Our website also provides our customers with online tools and technical resources. +Quality Assurance +In engineered systems, quality is defined as system performance. We review with our customers, before the contract is signed, the technical specification and the efficiency of the equipment that will be customized to meet their specific needs. We then review these same parameters internally to assure that warranties will be met. Standard project management and production management tools are used to help ensure that all work is done to specification and that project schedules are met. Equipment is tested at the site to ensure it is functioning properly. +Customers +We are not dependent upon any single customer, and no customer comprised 10% or more of our consolidated revenues for 2018, 2017 or 2016. We do not believe the loss of any one of our customers would have a material adverse effect on us. +Suppliers and Subcontractors +We purchase our raw materials and supplies from a variety of global sources. When possible, we directly secure angle iron and sheet plate products from steel mills, whereas other materials are purchased from a variety of steel service centers. Steel prices have traditionally been volatile, but we typically mitigate the risk of higher prices by including a “surcharge” on our standard products. On contract work, we mitigate the risk of higher prices by including the current price in our estimate and generally include price inflation clauses for protection. +We believe we have a good relationship with our suppliers and do not anticipate any difficulty in continuing to purchase such items on terms acceptable to us. We have not experienced difficulty in procuring a sufficient supply of materials in the past. To the extent that our current suppliers are unable or unwilling to continue to supply us with materials, we believe that we would be able to obtain such materials from other suppliers on acceptable terms. +6 +Typically, on turnkey projects, we subcontract manufacturing, electrical work, concrete work, controls, conveyors and insulation. We use subcontractors with whom we have good working relationships and review each project at the beginning and on an ongoing basis to help ensure that all work is being done according to our specifications. Subcontractors are generally paid when we are paid by our customers according to the terms of our contract with the customer. The Company’s asset-light business model focuses on effective management of subcontractors, which allows the Company to achieve targeted working capital levels through reduction in certain assets and reduced capital expenditures. +Backlog +Backlog is a representation of the amount of revenue expected from complete performance of firm fixed-price contracts that have not been completed for products and services we expect to substantially deliver within the next 12 to 18 months. Our customers may have the right to cancel a given order, although historically cancellations have been rare. Backlog increased to $182.1 million as of December 31, 2018 from $168.9 million as of December 31, 2017. Substantially all 2017 backlog was completed in 2018. Most of the 2018 backlog is expected to be completed in 2019. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Competition +The markets we serve are highly fragmented with numerous small and regional participants. We believe no single company competes with us across the full range of our systems and products. Competition in the markets we serve is based on a number of considerations, including price, timeliness of delivery, technology, applications experience, know-how, reputation, product warranties and service. Demand for our product can vary period over period depending on conditions in the markets we serve. We believe our reputation, technical engineering capabilities and service differentiate us from many of our competitors, including those competitors who often offer products at a lower price. +Due to the size and shipping weight of many of our projects, localized manufacturing/fabrication capabilities are very important to our customers. As a result, competition varies widely by region and industry. The market for our engineered products is reasonably competitive and is characterized by technological change, continuously changing environmental regulations, and evolving customer requirements. We believe that the additional competitive factors in our markets include: +• +performance track record in difficult plant applications; +• +comprehensive portfolio of products with leading technology; +• +solid brand recognition; +• +ability to design standard and custom products that meet customers’ needs; +• +ability to provide reliable solutions in a timely manner; +• +quality customer service and support; and +• +financial and operational stability, including reputation. +We believe we compete favorably with respect to these factors. +Government Regulations +We believe our operations are in material compliance with applicable environmental laws and regulations. We believe that changes in environmental laws and regulations create opportunity given the nature of our business. +We are subject to the requirements of the Occupational Safety and Health Administration (“OSHA”) and comparable state statutes. We believe we are in material compliance with OSHA and state requirements, including general industry standards, record keeping requirements and monitoring of occupational exposures. In general, we expect to increase our expenditures to comply with stricter industry and regulatory safety standards when needed. Although such expenditures cannot be accurately estimated at this time, we do not believe that they will have a material adverse effect on our financial position, results of operations or cash flows. +Intellectual Property +We rely on a combination of patent, trademark, copyright and trade secret laws, employee and third-party nondisclosure/confidentiality agreements and license agreements to protect our intellectual property. We sell most of our products under a number of registered trade names, brand names and registered trademarks, which we believe are widely recognized in the industry. While we hold patents within a number of our businesses, we do not view our patents to be material to our business. +7 +Employees +We had approximately 800 full-time employees as of December 31, 2018. The facilities in Greensboro, North Carolina, Louisville, Kentucky, Columbia, Tennessee, and Telford, Pennsylvania are unionized except for selling, engineering, design, administrative and operating management personnel. None of our other employees are subject to any collective bargaining agreements. We consider our relationship with our employees to be satisfactory. In total, as of December 31, 2018, approximately 140 employees were represented by independent labor unions under various union contracts that expire at various intervals. +Executive Officers of CECO +The following are the executive officers of the Company as of February 28, 2019. The terms of all officers expire at the next annual meeting of the board of shareholders and upon the election of the successors of such officers. +Name +Age +Position +Dennis Sadlowski +58 +Chief Executive Officer and Director +Matthew Eckl +38 +Chief Financial Officer +Paul Gohr +37 +Chief Accounting Officer +Dennis Sadlowski has served as our Chief Executive Officer since January 2017 and as a director since May 2016. Mr. Sadlowski served as Interim Chief Executive Officer and President from January 2017 until his appointment as Chief Executive Officer in June 2017. Previously, he was the Chief Operating Officer of LSG Sky Chefs North America, a provider of food and food-related services for transportation providers, from April 2013 until March 2015. As Chief Operating Officer, Mr. Sadlowski oversaw operations across over 40 locations in North America and managed over 8,000 employees. Previously, Mr. Sadlowski served as the Chief Executive Officer of International Battery, an early stage green tech company focused on large format lithium ion batteries for the grid storage markets, from September 2011 until April 2012. Mr. Sadlowski worked at Siemens from July 2000 to March 2010, serving as the President & Chief Executive Officer of Siemens Energy & Automation, Inc. from July 2007 until October 2009, an operating subsidiary of the global manufacturer Siemens AG, where he had executive accountability for the company’s global strategic direction, operating performance and marketplace success. His responsibilities at Siemens Energy & Automation included overseeing six operating divisions along with a combined sales organization, a number of wholly-owned subsidiaries and over 12,000 employees. Mr. Sadlowski has also previously worked at General Electric and Thomas & Betts. Mr. Sadlowski was a former member of the board of directors and audit committee of Trojan Battery, a privately-held global leader in deep cycle lead-acid batteries. Mr. Sadlowski earned a Bachelor’s degree in Chemical and Nuclear Engineering from the University of California at Berkeley, and his Master’s Degree in Business Administration from Seattle University. +Matthew Eckl has served as our Chief Financial Officer since January 2017. Prior to joining the Company, Mr. Eckl served as Vice President, Finance – Energy Group at Gardner Denver, Inc. from 2012 until January 2017. In this role, he oversaw a $1 billion revenue business group that designs, manufactures, markets and services pumps, fluid transfer equipment and engineered systems for oil & gas and petrochemical industries. Prior to joining Gardner Denver, Mr. Eckl served in various roles of increasing responsibility within General Electric Company, a global digital industrial company, from 2002 until 2012, where he worked with various business groups to integrate new acquisitions and streamline financial reporting processes. Mr. Eckl earned a Bachelor’s degree in Management Information Systems from Pennsylvania State University. +Paul Gohr has served as the Chief Accounting Officer since May 2017. Mr. Gohr previously served as our Vice President of Financial Reporting since joining the Company in September 2014. From 2004 to 2014, Mr. Gohr served in various roles of increasing responsibility within Grant Thornton LLP, a global public accounting firm, most recently as a Senior Manager of Audit Services. While at Grant Thornton LLP, Mr. Gohr served a broad base of both public and private companies with international operations, many of which were acquisitive in nature. Mr. Gohr is a Certified Public Accountant. Mr. Gohr earned a Bachelor’s degree in Business, Accountancy and a Masters of Accountancy degree from Miami University. +Available Information +We use the Investor Relations section of our website, www.cecoenviro.com , as a channel for routine distribution of important information, including news releases, investor presentations and financial information. We post filings as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC, including our annual, quarterly, and current reports on Forms 10-K, 10-Q, and 8-K; proxy statements; and any amendments to those reports or statements. All such postings and filings are available on our website free of charge. The SEC also maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The content on any website referred to in this Annual Report on Form 10-K is not incorporated by reference into this Annual Report on Form 10-K unless expressly noted. +8 \ No newline at end of file diff --git a/raw/filings/0000003197/2018/0001564590-19-006619/item13.txt b/raw/filings/0000003197/2018/0001564590-19-006619/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..4e38bab70c954723701fb1b3a9fbb046120d3b3e --- /dev/null +++ b/raw/filings/0000003197/2018/0001564590-19-006619/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +45 \ No newline at end of file diff --git a/raw/filings/0000003197/2019/0001564590-20-008551/filing.txt b/raw/filings/0000003197/2019/0001564590-20-008551/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..e679281a1878a5a8edc3211d6d4b7861d4fc3280 --- /dev/null +++ b/raw/filings/0000003197/2019/0001564590-20-008551/filing.txt @@ -0,0 +1,4535 @@ +10-K +1 +cece-10k_20191231.htm +10-K +cece-10k_20191231.htm +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark one) +☒ +Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the fiscal year ended December 31, 2019 +or +☐ +Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the transition period from to +Commission File No. 0-7099 +CECO ENVIRONMENTAL CORP. +Delaware +13-2566064 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +14651 North Dallas Parkway +Suite 500 +Dallas, Texas +75254 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: (214) 357-6181 +Securities registered under Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +Common Stock, par value $0.01 per share +CECE +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer +☐ +Accelerated Filer +☒ +Non-Accelerated Filer +☐ +Smaller reporting company +☒ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant was $248.9 million based upon the closing market price and shares of common stock outstanding as of June 28, 2019, the last business day of our most recently completed second fiscal quarter. For the purpose of the foregoing calculation only, all directors and executive officers of the registrant and owners of more than 10% of the registrant’s common stock are assumed to be affiliates of the registrant. This determination of affiliate status is not necessarily conclusive for any other purpose. +As of February 28, 2020, the registrant had 35,284,847 shares of common stock, par value $0.01 per share, outstanding. +Documents Incorporated by Reference +Portions of the definitive Proxy Statement for the 2020 Annual Meeting of Stockholders, which is to be filed with the Securities and Exchange Commission within 120 days of the fiscal year ended December 31, 2019, are incorporated by reference into Part III of this Annual Report to the extent described herein. +C ECO Environmental Corp . and Subsidiaries +ANNUAL REPORT ON FORM 10-K +For the year ended December 31, 2019 +TABLE OF CONTENTS +Item +Description +Page +PART I. +Item 1. +Business +2 +Item 1A. +Risk Factors +9 +Item 1B. +Unresolved Staff Comments +19 +Item 2. +Properties +19 +Item 3. +Legal Proceedings +19 +Item 4. +Mine Safety Disclosures +20 +PART II. +Item 5. +Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +21 +Item 6. +Selected Financial Data +22 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +23 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +36 +Item 8. +Financial Statements and Supplementary Data +38 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +38 +Item 9A. +Controls and Procedures +38 +Item 9B. +Other Information +41 +PART III. +Item 10. +Directors, Executive Officers and Corporate Governance +42 +Item 11. +Executive Compensation +42 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +42 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +42 +Item 14. +Principal Accounting Fees and Services +42 +PART IV. +Item 15. +Exhibits and Financial Statement Schedules +42 +Item 16. +Form 10-K Summary +44 +SIGNATURES +45 +CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS +This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”) which are intended to be covered by the safe harbor for "forward-looking statements" provided by the Private Securities Litigation Reform Act of 1995. Any statements contained in this Annual Report on Form 10-K, other than statements of historical fact, including statements about management’s beliefs and expectations, are forward-looking statements and should be evaluated as such. These statements are made on the basis of management’s views and assumptions regarding future events and business performance. We use words such as “believe,” “expect,” “anticipate,” “intends,” “estimate,” “forecast,” “project,” “will,” “plan,” “should” and similar expressions to identify forward-looking statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from any future results, performance or achievements expressed or implied by such statements. Potential risks and uncertainties, among others, that could cause actual results to differ materially are discussed under “Part I – Item 1A. Risk Factors” of this Annual Report on Form 10-K and include, but are not limited to: our ability to successfully realize the expected benefits of our restructuring program; our ability to successfully integrate acquired businesses and realize the synergies from acquisitions, as well as a number of factors related to our business, including economic and financial market conditions generally and economic conditions in our service areas; dependence on fixed price contracts and the risks associated therewith, including actual costs exceeding estimates and method of accounting for revenue; fluctuations in operating results from period to period due to cyclicality or seasonality of the business; the effect of growth on our infrastructure, resources, and existing sales; the ability to expand operations in both new and existing markets; the potential for contract delay or cancellation; liabilities arising from faulty services or products that could result in significant professional or product liability, warranty, or other claims; changes in or developments with respect to any litigation or investigation; failure to meet timely completion or performance standards that could result in higher cost and reduced profits or, in some cases, losses on projects; the potential for fluctuations in prices for manufactured components and raw materials, including as a result of tariffs and surcharges; the substantial amount of debt incurred in connection with our acquisitions and our ability to repay or refinance it or incur additional debt in the future; the impact of federal, state or local government regulations; economic and political conditions generally; our ability to successfully complete the divestitures of non-core assets and the effect of competition in the industries served by our Energy Solutions segment, Industrial Solutions segment and Fluid Handling Solutions segment. Many of these risks are beyond management’s ability to control or predict. Should one or more of these risks or uncertainties materialize, or should the assumptions prove incorrect, actual results may vary in material aspects from those currently anticipated. Investors are cautioned not to place undue reliance on such forward-looking statements as they speak only to our views as of the date the statement is made. Furthermore, forward-looking statements speak only as of the date they are made. Except as required under the federal securities laws or the rules and regulations of the Securities and Exchange Commission (the “SEC”), we undertake no obligation to update or review any forward-looking statements, whether as a result of new information, future events or otherwise. +1 +PART I +Item 1. +Business +General +CECO Environmental Corp. (“CECO” or the “Company”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customer’s mission critical applications. The secular growth industries CECO serves include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +CECO has over $6 billion of installed equipment base with end users, which we target to expand and grow a higher recurring revenue of aftermarket products and services. We also focus on operational excellence strategies as a central theme to improving our earnings and cash flows. +Our customers include some of the largest natural gas processors, transmission and distribution companies, refineries, power generators, boiler manufacturers, compressor manufacturers, metals and minerals, industrial manufacturing, engineering and construction companies in the world. +We believe our value differentiators include, but are not limited to, reliable product performance, timely delivery, customer satisfaction, and advanced engineering. We believe these are critical in maintaining our competitive position and have adopted a spirit of continuous improvement to ensure we maintain our market leadership position. The Company has been publicly traded since January 1, 1978. +Industry Overview +We serve a $5 billion dollar global market that is highly fragmented and serves various end markets including power generation, natural gas power plants, petrochemical processing, general industrial, refining, oil & gas and wastewater treatment. +We believe demand for our products and services will continue to be driven by the following factors: +• +Global Economic Conditions. The Company’s businesses are impacted by economic conditions around the globe. Higher economic growth and other factors that would increase industrial gross domestic product and capital expenditures are projected to impact the markets the Company serves and could affect the Company’s businesses by increasing demand for the Company’s products and services. +• +Worldwide Industrialization . Global trade has increased significantly over the last decade and is driven by growth in emerging markets, including China and India, as well as other developing nations in Asia and the Europe, Middle East, and Africa (“EMEA”) region. As a result of globalization, manufacturing that was historically performed domestically continues to migrate to lower cost countries. This movement of the manufacture of goods throughout the world increases demand for industrial ventilation products as new construction continues. We expect that more rigorous environmental regulations will be introduced to create a cleaner working environment and reduce environmental emissions as these economies evolve. +• +Natural Gas Infrastructure . The natural gas industry consists of the exploration, production, processing, transportation, storage and distribution of natural gas. The International Energy Association (“IEA”) projects a pronounced shift in Organization for Economic Cooperation and Development (“OECD”) countries away from oil and coal towards natural gas and renewables. Natural gas continues to be the fuel of choice for the electrical power and industrial sectors in many of the world’s regions, in part because of its lower carbon intensity compared with coal and oil, which makes it an attractive fuel source in countries where governments are implementing policies to reduce greenhouse gas emissions. +• +P ower Generation. Power generation encompasses a broad range of activities related to the production of electricity. The primary types of fuel used to generate electricity are coal, natural gas and nuclear. In the United States, concerns about potential environmental regulations enhance the attractiveness of natural gas-fired power plants compared with coal-fired power plants, which generally have higher pollutant emission rates than natural gas-powered plants. Natural gas-fired power plants have lower initial capital needs and are more flexible in terms of operating times than coal plants. +2 +• +Refining, Oil Production and Petrochemical Processing . Refining, oil production and petrochemical processing involves the producing, refining and processing of fuels and chemicals for use in a variety of applications, such as gasoline, fertilizers and plastics. In response to increasing international demand for petrochemicals and refined products, companies are producing more products from new sources, constructing new ref ineries and petrochemical processing facilities as well as expanding existing facilities. In many cases, these new and expanded facilities must comply with stricter environmental regulations, which influence both choice of fuel and demand for systems to co ntrol exhaust emissions. +• +Stringent Regulatory Environment . The adoption of increasingly stringent environmental regulations globally requires businesses to pay strict attention to environmental protection. Businesses and industries of all types from refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing must comply with these various international, federal, state and local government regulations or potentially face substantial fines or be forced to suspend production or alter their production processes. These increasingly stringent environmental regulations are a principal factor that drives our business. +These factors, individually or collectively, tend to cause increases in industrial capital spending that are not directly impacted by general economic conditions, expansion, or capacity increases. In contrast, favorable conditions in the economy generally lead to plant expansions and the construction of new industrial sites. However, in a weak economy, customers tend to lengthen the time from their initial inquiry to the purchase order or defer purchases. +Mission and Strategy +Our mission is to help companies grow their business with safe, clean and more efficient solutions that help protect people and our shared environment. +We seek to fulfill this mission through established global leadership in air quality and fluid handling solutions focused on serving the energy, industrial, and other niche markets around the world. We will continue to leverage our innovative technology and application expertise to customers around the world. We work to improve air quality, optimize the energy value chain, and provide custom engineered solutions for applications including oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing along with a wide range of other applications. +Our strategy to become the global leader in air quality and fluid handling solutions is to drive an operating environment of performance excellence across the Company with a near term focus on targeted value creation enablers, and growth-oriented business segment performance. +Four Value Creation Enablers Driving Growth: +All four of these are inter-connected and critical to achieving our objectives. +• +Outside-In Leadership is all about an increased attention on our customers and the trends affecting the world around us as we make decisions that enable our organization to be responsive and with an orientation for growth. +• +Innovation is about us finding better ways to help our customers get their jobs done – whether that is a new product and technology or the way we serve and work with them. +• +Simplification involves aligning and streamlining our operational practices and metrics to match our customers’ key performance indicators (“KPIs”) for success and removing complexity from our systems and structure. +• +Active Portfolio Management dictates a regular evaluation of our business units for market attractiveness and profitability together with scanning the market for attractive potential additions that strengthen the long-term outlook of the Company. +3 +Three Business Segments: +The Company executes and reports in three reportable segments focused on attractive end markets. Each segment is aligned to generate profitable growth for the Company across a targeted industry with a compelling technology and solution set to benefit customers. Additionally, we seek to protect and deepen our end user relationships by expanding our aftermarket services with long-term service contracts that deliver a full life-cycle of customer support. +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for Clean Energy through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Competitive Strengths +Leading market position as a complete solution provider . We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. The multi-billion dollar global market is highly fragmented with numerous small and regional contracting firms separately supplying engineering services, fabrication, installation, testing and monitoring, products and spare parts. We offer our customers a complete end-to-end solution, including engineering and project management services, procurement and fabrication, construction and installation, aftermarket support, and sale of consumables, which allows our customers to avoid dealing with multiple vendors when managing projects. +Long-standing experience and customer relationships in growing industry . We have serviced the needs of our target markets for over 50 years. Our extensive experience and expertise in providing diversified solutions enhances our overall customer relationships, and provides us with a competitive advantage in our markets relative to other companies in the industry. We believe this is evidenced by strong relationships with many of our world-class customers. We believe no single competitor has the resources to offer a similar portfolio of product and service capabilities. We offer the depth of a large organization, while our lean organizational structure keeps us close to our customers and markets, allowing us to offer rapid and complete solutions in each unique situation. +Global diversification and broad customer base. The global diversity of our operations and customer base provides us with multiple growth opportunities. As of December 31, 2019, we had a diversified customer base of approximately 4,800 active customers across a range of industries. We believe that the diversity of our customers and end markets mitigates our risk of a potential fluctuation or downturn in demand from any individual industry or particular customer. We believe we have the resources and capabilities to meet the needs of our customers as they upgrade and expand domestically as well as into new international markets. Once systems have been installed and a relationship has been established with the customer, we are often awarded repetitive service and maintenance business as the customers’ processes change and modifications or additions to their systems become necessary. +Experienced management and engineering team. Our senior management team has substantial experience in industrial air quality and fluid handling solutions. The business experience of our management team enables us to pursue our strategy. Our workforce includes approximately 200 engineers, designers, and project managers whose significant specialized industry experience and technical expertise enables them to have a deep understanding of the solutions that will best suit the needs of our customers. The experience and stability of our management, operating and engineering teams have been crucial to our growth, developing and maintaining customer relationships, and increasing our market share. +Expand customer base and penetrate end markets through global market coverage . We constantly look for opportunities to gain new customers and penetrate geographic locations and end markets with existing products and services or acquire new product or +4 +service o pportunities. We intend to continue to expand our sales force, customer base, and end markets, and have continued to pursue potential attractive growth opportunities both domestically and globally. In the last three years we have expanded our international presence with sales & engineering hubs in Shanghai, Singapore, Pune India, and Dubai. +Develop innovative solutions . We leverage our engineering and manufacturing expertise and strong customer relationships to develop new customized products to address the identified needs of our customers or a particular end market. We thoroughly analyze new product opportunities by considering projected demand for the product or service, price point, and expected operating costs, and only pursue those opportunities that we believe will contribute to earnings growth in the near-term. In addition, we continually improve our traditional technologies and adapt them to new industries and processes. +Disciplined acquisition program with successful integration . We believe that we have demonstrated an ability to successfully acquire and integrate companies with complementary product or service offerings. We will continue to seek and execute additional strategic acquisitions and focus on expanding our product service and breadth, as well as entering into new adjacent markets. We believe that the breadth and diversity of our products and services and our ability to deliver full solutions to various end markets provides us with multiple sources of stable growth and a competitive advantage relative to other players in the industry. +Products and Services +We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that control emissions from such facilities, as well as fluid handling and filtration systems. We provide a wide spectrum of products and services including dampers and diverters, selective catalytic reduction and selective non-catalytic reduction systems, cyclonic technology, thermal oxidizers, filtration systems, scrubbers, fluid handling equipment and plant engineering services and engineered design build fabrication. +Project Design and Research and Development +We seek to achieve our Outside-In Leadership by understanding our customers’ needs and delivering better outcomes for them by focusing new product development efforts that help protect our shared environment while working to improve a variety of operational outcomes including, but not limited to, facility uptime, production quality, and process performance. We produce specialized products that are often tailored to the specifications of a customer or application. +We continually collaborate with our customers on their projects to develop the proper solution and ensure customer satisfaction. The project development cycle may follow many different paths depending on the specifics of the job and end market. The cycle can take from one to more than twelve months from concept and design to production but may vary significantly depending on developments that occur during the process, including among others, the emergence of new environmental demands, changes in design specifications and ability to obtain necessary approvals. +Sales, Marketing and Support +Our global selling strategy is to provide a solutions-based approach by being a single source provider of technology products and services. The strategy involves expanding our scope of products and services through selective acquisitions and the formation and integration of new business units. We believe this strategy provides a discernible competitive advantage. We execute this strategy by utilizing our portfolio of in-house technologies and those of third-party equipment suppliers. Many of these have been long-standing relationships, which have evolved from pure supplier roles to value-added business partnerships. This enables us to leverage existing business with selective alliances of suppliers and application specific engineering expertise. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support, and single source. Our value proposition to customers is to provide competitively priced, customized solutions. Our industry-specific knowledge, accompanied by our product and service offerings, provides valuable synergies for design innovation. +We sell and market our products and services with our own direct sales force, including employees in the United States, the Netherlands, United Kingdom, Canada, United Arab Emirates, India, Mexico, China, and Singapore, in conjunction with outside sales representatives in North America, South America, EMEA, Asia, and India. We expect to continue expanding our sales and support capabilities and our network of outside sales representatives in key regions domestically and internationally. +We market our offerings to our customers through a variety of channels including, but not limited to, digital, web, social media, email campaigns, individual customer visits, product announcements, brochures, magazine articles, advertisements and cover or +5 +article features in trade journals and other publications. We also participate in public relations an d promotional events, including industry tradeshows and technical conferences. +Our customer service organization or sales force provides our customers with technical assistance, use and maintenance information as well as other key information regarding their purchase. We also actively provide our customers with access to key information regarding changes and pending changes in environmental regulations as well as new product or service developments. We believe that maintaining a close relationship with our customers and providing them with the support they request improves their level of satisfaction and enables us to foresee their potential future product needs or service demands. Moreover, this approach can lead to sales of annual service and support contracts as well as consumables. Our website also provides our customers with online tools and technical resources. +Quality Assurance +In engineered systems, quality is defined as system performance. We review with our customers, before the contract is signed, the technical specification and the efficiency of the equipment that will be customized to meet their specific needs. We then review these same parameters internally to assure that warranties will be met. Standard project management and production management tools are used to help ensure that all work is done to specification and that project schedules are met. Equipment is tested at the site to ensure it is functioning properly. +Customers +We are not dependent upon any single customer, and no customer comprised 10% or more of our consolidated revenues for 2019. +Suppliers and Subcontractors +We purchase our raw materials and supplies from a variety of global sources. When possible, we directly secure angle iron and sheet plate products from steel mills, whereas other materials are purchased from a variety of steel service centers. Steel prices have traditionally been volatile, but we typically mitigate the risk of higher prices by including a “surcharge” on our standard products. On contract work, we mitigate the risk of higher prices by including the current price in our estimate and generally include price inflation clauses for protection. +We believe we have a good relationship with our suppliers and do not anticipate any difficulty in continuing to purchase such items on terms acceptable to us. We have not experienced difficulty in procuring a sufficient supply of materials in the past. To the extent that our current suppliers are unable or unwilling to continue to supply us with materials, we believe that we would be able to obtain such materials from other suppliers on acceptable terms. +Typically, on turnkey projects, we subcontract manufacturing, electrical work, concrete work, controls, conveyors and insulation. We use subcontractors with whom we have good working relationships and review each project at the beginning and on an ongoing basis to help ensure that all work is being done according to our specifications. Subcontractors are generally paid when we are paid by our customers according to the terms of our contract with the customer. The Company’s asset-light business model focuses on effective management of subcontractors, which allows the Company to achieve targeted working capital levels through reduction in certain assets and reduced capital expenditures. +Backlog +Backlog (i.e., unfulfilled or remaining performance obligations) represents the sales we expect to recognize for our products and services for which control has not yet transferred to the customer. Backlog increased to $216.6 million as of December 31, 2019 from $182.1 million as of December 31, 2018 . Our customers may have the right to cancel a given order. Historically cancellations have not been common, however, during the year 2019, the Company removed $6.7 million of orders that were previously disclosed as backlog in prior periods, due to cancellations by customers. Backlog is adjusted on a quarterly basis for adjustments in foreign currency exchange rates. Substantially all backlog is expected to be delivered within 12 to 18 months. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Competition +The markets we serve are highly fragmented with numerous small and regional participants. We believe no single company competes with us across the full range of our systems and products. Competition in the markets we serve is based on a number of +6 +considerations, including timeliness of delivery, technology, applications experience, know-how, reputation, product warranties , service an d price . Demand for our product can vary period over period depending on conditions in the markets we serve. We believe our reputation, technical engineering capabilities and service differentiate us from many of our competitors, including those competit ors who often offer products at a lower price. +Due to the size and shipping weight of many of our projects, localized manufacturing/fabrication capabilities are very important to our customers. As a result, competition varies widely by region and industry. The market for our engineered products is reasonably competitive and is characterized by technological change, continuously changing environmental regulations, and evolving customer requirements. We believe that the additional competitive factors in our markets include: +• +performance track record in difficult plant applications; +• +comprehensive portfolio of products with leading technology; +• +solid brand recognition; +• +ability to design standard and custom products that meet customers’ needs; +• +ability to provide reliable solutions in a timely manner; +• +quality customer service and support; and +• +financial and operational stability, including reputation. +We believe we compete favorably with respect to these factors. +Government Regulations +We believe our operations are in compliance with applicable environmental laws and regulations. We believe that changes in environmental laws and regulations create opportunity given the nature of our business. +Intellectual Property +We rely on a combination of patent, trademark, copyright and trade secret laws, employee and third-party nondisclosure/confidentiality agreements and license agreements to protect our intellectual property. We sell most of our products under a number of registered trade names, brand names and registered trademarks, which we believe are widely recognized in the industry. While we hold patents within a number of our businesses, we do not view our patents to be material to our business. +Employees +We had approximately 830 full-time employees as of December 31, 2019. The facilities in Greensboro, North Carolina, Louisville, Kentucky, Columbia, Tennessee, and Telford, Pennsylvania are unionized except for selling, engineering, design, administrative and operating management personnel. None of our other employees are subject to any collective bargaining agreements. We consider our relationship with our employees to be satisfactory. In total, as of December 31, 2019, approximately 200 employees were represented by independent labor unions under various union contracts that expire at various intervals. +Executive Officers of CECO +The following are the executive officers of the Company as of February 28, 2020. The terms of all officers expire at the next annual meeting of stockholders and upon the election of the successors of such officers. +Dennis Sadlowski (59) served as our Interim Chief Executive Officer and President from January 2017 until his permanent appointment as Chief Executive Officer in June 2017 and as a director since May 2016. Previously, he was the Chief Operating Officer of LSG Sky Chefs North America, a provider of food and food-related services for transportation providers, from April 2013 until March 2015. As Chief Operating Officer, Mr. Sadlowski oversaw operations across over 40 locations in North America and managed over 8,000 employees. Previously, Mr. Sadlowski served as the Chief Executive Officer of International Battery, an early stage green tech company focused on large format lithium ion batteries for the grid storage markets, from September 2011 until April 2012. Mr. Sadlowski worked at Siemens from July 2000 to March 2010, serving as the President & Chief Executive Officer of Siemens Energy & Automation, Inc. from July 2007 until October 2009, an operating subsidiary of the global manufacturer Siemens AG, where he had executive accountability for the company’s global strategic direction, operating performance and marketplace success. His responsibilities at Siemens Energy & Automation included overseeing six operating +7 +divisions along with a combined sales organization, a number of wholly-owned subsidiaries and over 12,000 employees. Mr. Sadlowski has also previously worked at General Electric and Thomas & Betts. Mr. Sadlowski was a former member of the B oard of D irectors and audit committee of Trojan Battery, a privately-held global leader in deep cycle lead-acid batteries. Mr. Sadlowski earned a bachelor’s degree in Chemical and Nuclear Engi neering from the University of California at Berkeley, and his master’s degree in Business Administration from Seattle University. +Matthew Eckl (39) has served as our Chief Financial Officer since January 2017. Prior to joining the Company, Mr. Eckl served as Vice President, Finance – Energy Group at Gardner Denver, Inc. from 2012 until January 2017. In this role, he oversaw a $1 billion revenue business group that designs, manufactures, markets and services pumps, fluid transfer equipment and engineered systems for oil & gas and petrochemical industries. Prior to joining Gardner Denver, Mr. Eckl served in various roles of increasing responsibility within General Electric Company, a global digital industrial company, from 2002 until 2012, where he worked with various business groups to integrate new acquisitions and streamline financial reporting processes. Mr. Eckl earned a Bachelor’s degree in Management Information Systems from Pennsylvania State University. +Paul Gohr (38) has served as the Chief Accounting Officer since May 2017. Mr. Gohr previously served as our Vice President of Financial Reporting since joining the Company in September 2014. From 2004 to 2014, Mr. Gohr served in various roles of increasing responsibility within Grant Thornton LLP, a global public accounting firm, most recently as a Senior Manager of Audit Services. While at Grant Thornton LLP, Mr. Gohr served a broad base of both public and private companies with international operations, many of which were acquisitive in nature. Mr. Gohr is a Certified Public Accountant. Mr. Gohr earned a Bachelor’s degree in Business, Accountancy and a Masters of Accountancy degree from Miami University. +Available Information +We use the Investor Relations section of our website, www.cecoenviro.com , as a channel for routine distribution of important information, including news releases, investor presentations and financial information. We post filings as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC, including our annual, quarterly, and current reports on Forms 10-K, 10-Q, and 8-K; proxy statements; and any amendments to those reports or statements. All such postings and filings are available on our website free of charge. The SEC also maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The content on any website referred to in this Annual Report on Form 10-K is not incorporated by reference into this Annual Report on Form 10-K unless expressly noted. +8 +Item 1A. +Risk Factors +An investment in our securities involves a high degree of risk. You should carefully consider the risk factors described below, together with the other information included in this Annual Report on Form 10-K, before you decide to invest in our securities. The risks described below are the material risks of which we are currently aware; however, they may not be the only risks that we may face. Additional risks and uncertainties not currently known to us or that we currently view as immaterial may also impair our business. If any of these risks develop into actual events, it could materially and adversely affect our business, financial condition, results of operations and cash flows, and the trading price of your shares could decline and you may lose all or part of your investment. +Risks Related to Our Business and Industry +Our business may be adversely affected by global economic conditions. +A national or global economic downturn or credit crisis may have a significant negative impact on our financial condition, future results of operations and cash flows. Specific risk factors related to these overall economic and credit conditions include the following: customers or potential customers may reduce or delay their procurement or new product development; key suppliers may become insolvent resulting in delays for our material purchases; vendors and other third parties may fail to perform their contractual obligations; customers may be unable to obtain credit to finance purchases of our products and services; and certain customers may become insolvent. These risk factors could reduce our product sales, increase our operating costs, impact our ability to collect customer receivables, lengthen our cash conversion cycle and increase our need for cash, which would ultimately decrease our profitability and negatively impact our financial condition. They could also limit our ability to expand through acquisitions due to the tightening of the credit markets. +Our dependence upon fixed-price contracts could adversely affect our operating results. +The majority of our projects are currently performed on a fixed-price basis, while a limited number of projects are currently performed on a time and materials basis. Under a fixed-price contract, we agree on the price that we will receive for the entire project, based upon a defined scope, which includes specific assumptions and project criteria. If our estimates of the costs to complete the project are below the actual costs that we incur, our margins will decrease, or we may incur a loss. The revenue, cost and gross profit realized on a fixed-price contract will often vary from the estimated amounts because of unforeseen conditions or changes in job conditions and variations in labor and equipment productivity over the term of the contract. While our fixed-price contracts are typically not individually material to our operating results, if we are unsuccessful in mitigating these risks, we may realize gross profits that are different from those originally estimated and incur reduced profitability or losses on projects. Depending on the size of a project, these variations from estimated contract performance could have a significant effect on our operating results. In general, turnkey contracts to be performed on a fixed-price basis involve an increased risk of significant variations. Generally, our contracts and projects vary in length, depending on the size and complexity of the project, project owner demands and other factors. The foregoing risks are exacerbated for projects with longer-term durations and the inherent difficulties in estimating costs and of the interrelationship of the integrated services to be provided under these contracts whereby unanticipated costs or delays in performing part of the contract can have compounding effects by increasing costs of performing other parts of the contract. +Accounting for contract revenue may result in material adjustments that would adversely affect our financial condition and results of operations. +We derive a significant portion of our revenues from fixed price contracts. We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +Contract revenue and total direct cost estimates are reviewed and revised periodically as the work progresses and as change orders are approved, and adjustments are reflected in contract revenue in the period when these estimates are revised. These estimates are based on management’s reasonable assumptions and our historical experience, and are only estimates. Variation of actual results from these assumptions, which are outside the control of management and can differ from our historical experience, could be material. To the extent that these adjustments result in an increase, a reduction or the elimination of previously reported contract revenue, we would recognize a credit or a charge against current earnings, which could be material. +9 +Our inability to deliver our backlog on time could affect our future sales and profitability, and our relationships with our customers. +Our backlog was $216.6 million at December 31, 2019 and $182.1 million at December 31, 2018. Our ability to meet customer delivery schedules for our backlog is dependent on a number of factors including, but not limited to, access to the raw materials required for production, an adequately trained and capable workforce, project engineering expertise for certain large projects, sufficient internal manufacturing plant capacity, available subcontractors and appropriate planning and scheduling of manufacturing resources. Our failure to deliver in accordance with customer expectations may result in damage to existing customer relationships and result in the loss of future business. Failure to deliver backlog in accordance with expectations could negatively impact our financial performance and cause adverse changes in the market price of our common stock. +Volatility of oil and natural gas prices can adversely affect demand for our products and services. +Volatility in oil and natural gas prices can impact our customers’ activity levels and spending for our products and services. Current energy prices are important contributors to cash flow for our customers and their ability to fund capital expenditures. Expectations about future prices and price volatility are important for determining future spending levels. Lower oil and natural gas prices generally lead to decreased spending by our customers. While higher oil and natural gas prices generally lead to increased spending by our customers, sustained high energy prices can be an impediment to economic growth, and can therefore negatively impact spending by our customers. Our customers also take into account the volatility of energy prices and other risk factors by requiring higher returns for individual projects if there is a higher perceived risk. Any of these factors could affect the demand for oil and natural gas and could have a material effect on our results of operations. +Our financial performance may vary significantly from period to period. +Our annual revenues and earnings have varied in the past and are likely to vary in the future. Our contracts generally stipulate customer specific delivery terms and may have contract cycles of a year or more, which subjects these contracts to many factors beyond our control. In addition, contracts that are significantly larger in size than our typical contracts tend to intensify their impact on our annual operating results. Furthermore, as a significant portion of our operating costs are fixed, an unanticipated decrease in our revenues, a delay or cancellation of orders in backlog, or a decrease in the demand for our products, may have a significant impact on our annual operating results. Therefore, our annual operating results may be subject to significant variations and our operating performance in one period may not be indicative of our future performance. +Customers may cancel or delay projects. As a result, our backlog may not be indicative of our future revenue. +Customers may cancel or delay projects for reasons beyond our control. Our orders normally contain cancellation provisions that permit us to recover our costs, and, for most contracts, a portion of our anticipated profit in the event a customer cancels an order. If a customer elects to cancel an order, we may not realize the full amount of revenues included in our backlog. If projects are delayed, the timing of our revenues could be affected and projects may remain in our backlog for extended periods of time. Revenue recognition occurs over long periods of time and is subject to unanticipated delays. If we receive relatively large orders in any given quarter, fluctuations in the levels of our quarterly backlog can result because the backlog in that quarter may reach levels that may not be sustained in subsequent quarters. As a result, our backlog may not be indicative of our future revenues. With rare exceptions, we are not issued contracts until a customer is ready to start work on a project. Thus, it is our experience that the only relationship between the length of a project and the possibility that a project may be cancelled is simply the fact that there is more time involved. In a year-long project as opposed to a three-month project, more time is available for the customer to experience a softening in its business, which may cause the customer to cancel a project. +We face significant competition in the markets we serve. +All of the industries in which we compete are highly competitive and highly fragmented. We compete in primarily mature markets against a number of local, regional and national contractors and manufacturers in each of our product or service lines, many of which have been in existence longer than us and some of which have substantially greater financial resources than we do. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support and single source. We must also be responsive to any technological developments and related changing customer requirements. Any failure by us to compete effectively in the markets we serve could have a material adverse effect on our financial condition, results of operations and cash flows. +10 +We may incur material costs as a result of existing or future product liability claims, or other claims and litigation that could adversely affect our financial condition, results of operations and cash flows; and our insurance coverage may not cover all claims or may be insufficient to cover the claims. +Despite our quality assurance measures, we may be exposed to product liability claims, other claims and litigation in the event that the use of our products results, or is alleged to result, in bodily injury and/or property damage or our products actually or allegedly fail to perform as expected. Such claims may also be accompanied by fraud and deceptive trade practices claims. While we maintain insurance coverage with respect to certain product liability and other claims, we may not be able to obtain such insurance on acceptable terms in the future, if at all, and any such insurance may not provide adequate coverage against product liability and other claims. Furthermore, our insurance may not cover damages from breach of contract by us or based on alleged fraud or deceptive trade practices. Any future damages that are not covered by insurance or are in excess of policy limits could have a material adverse effect on our financial condition, results of operations and cash flows. In addition, product liability and other claims can be expensive to defend and can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. +An unsuccessful defense of a product liability or other claim could have an adverse effect on our financial condition, results of operations and cash flows. Even if we are successful in defending against a claim relating to our products, claims of this nature could cause our customers to lose confidence in our products and us. +Liability to customers under warranties may adversely affect our reputation, our ability to obtain future business and our results of operations. +We provide certain warranties as to the proper operation and conformance to specifications of the products we manufacture or produce. Failure of our products to operate properly or to meet specifications may increase our costs by requiring additional engineering resources and services, replacement of parts and equipment or monetary reimbursement to customers. We have in the past received warranty claims, are currently subject to warranty claims, and we expect to continue to receive claims in the future. To the extent that we incur substantial warranty claims in any period, our reputation, our ability to obtain future business and our results of operations could be adversely affected. +Our business can be significantly affected by changes in regulatory standards. +The markets that the Company serves are characterized by competitively imposed process standards and regulatory requirements, each of which influences the demand for our products and services. Changes in legislative, regulatory or industrial requirements may render certain of our products and processes obsolete. Conversely, these changes may present new business opportunities for us. Acceptance of new products and services may also be affected by the adoption of new government regulations requiring stricter standards. Our ability to anticipate changes in regulatory standards and to respond with new and enhanced products on a timely basis will be a significant factor in our ability to grow and to remain competitive. We cannot guarantee that we will be able to achieve the technological advances that may be necessary for us to remain competitive or that certain of our products or services will not become obsolete. +Changes in current environmental legislation and enforcement could have an adverse impact on the sale of our environmental control systems and products and on our financial condition, results of operations and cash flows. +Our business is primarily driven by capital spending, clean air rules, plant upgrades by our customers to comply with laws and regulations governing the discharge of pollutants into the environment or otherwise relating to the protection of the environment or human health. These laws include, but are not limited to, United States federal statues such as Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, the Clean Water Act, the Clean Air Act, the Clean Air Interstate Rule, and the regulations implementing these statutes, as well as similar laws and regulations at state and local levels and in other countries. These United States laws and regulations may change and other countries may not adopt similar laws and regulations. Our business may be adversely impacted to the extent that environmental regulations are repealed, amended, implementation dates are delayed, or to the extent that regulatory authorities reduce enforcement. +Our operations outside of the United States are subject to political, investment and local business risks. +For the year ended December 31, 2019, approximately 30% of our total revenue was derived from products or services ultimately delivered or provided to end users outside the United States. As part of our operating strategy, we intend to expand our international operations through internal growth and selected acquisitions. Operations outside of the United States, particularly in emerging markets, are subject to a variety of risks that are different from or are in addition to the risks we face within the United States. Among others, these risks include: (i) local, economic, political and social conditions, including potential hyperinflationary conditions and political instability in certain countries; (ii) tax-related risks, including the imposition of taxes and the lack of beneficial +11 +treaties, that result in higher effective tax rate for us; (iii) imposition of limitations on the remittance of dividends and payments by foreign subsidiaries; (iv) difficulties in enforcing agreements and collecting receivables through certain foreign local systems; (v) domestic and foreign customs, tariffs and quotas or other trade barriers; (vi) risk of nationalization of priv ate enterprises by foreign governments; (vii) managing and obtaining support and distribution channels for overseas operations; (viii) hiring and retaining qualified management personnel for our overseas operations; and (ix) the results of the United Kingd om’s referendum on European Union membership, advising for the exit from the European Union. +We are also exposed to risks relating to U.S. policy with respect to companies doing business in foreign jurisdictions. Changes in laws or policies governing the terms of foreign trade, in particular increased trade restrictions, tariffs or taxes on import from countries where we procure or manufacture products, such as China, could have a material adverse effect on our business and results of operations. For instance, the U.S. and Chinese governments have imposed a series of significant incremental retaliatory tariffs to certain imported goods. Given the uncertainty regarding the duration of the imposed tariffs, as well as the potential for additional tariffs by the U.S., China or other countries, as well as other changes in tax policy, trade regulations or trade agreements, and the Company’s ability to implement strategies to mitigate the impact of changes in tax policy, tariffs or other trade regulations, our exposure to the risks described above could have a material adverse effect on our business and results of operations. +In addition, compliance with foreign and domestic legal and regulatory requirements, including import, export, defense regulations and foreign exchange controls and anti-corruption laws, such as the Foreign Corrupt Practices Act, the United Kingdom’s Bribery Act, the European Union’s General Data Protection Regulations and similar laws of other jurisdictions, could adversely impact our ability to compete against companies in such jurisdictions. Moreover, the violation of such laws or regulations, by us or our representatives, could result in severe penalties including monetary fines, criminal proceedings and suspension of export privileges. We operate in many parts of the world that have experienced governmental corruption to some degree and, in certain circumstances, strict compliance with anti-bribery laws may conflict with local customs and practices. We cannot assure you that our internal controls and procedures will always protect us from reckless or criminal acts committed by our employees or agents. If we are found to be liable for such violations, we could suffer from criminal or civil penalties or other sanctions, including loss of export privileges or authorization needed to conduct aspects of our international business, which could have a material adverse effect on our business. +The occurrence of one or more of the foregoing factors could have a material adverse effect on our international operations or upon our financial condition, results of operations and cash flows. +Increasing costs for manufactured components, raw materials, transportation, health care and energy prices may adversely affect our profitability. +We use a broad range of manufactured components and raw materials in our products, including raw steel, steel-related components, filtration media, and equipment such as fans and motors. Materials and subcontracting costs comprise the largest components of our total costs. Further increases in the price of these items could further materially increase our operating costs and materially adversely affect our profit margins. Similarly, transportation, steel and health care costs have risen steadily over the past few years and represent an increasing burden for us. Although we try to contain these costs whenever possible, and although we try to pass along increased costs in the form of price increases to our customers, we may be unsuccessful in doing so, and even when successful, the timing of such price increases may lag significantly behind our incurrence of higher costs. +Our gross margins are affected by shifts in our product mix. +Certain of our products have higher gross profit margins than others. Consequently, changes in the product mix of our sales from quarter-to-quarter or from year-to-year can have a significant impact on our reported gross profit margins. Certain of our products also have a much higher internally manufactured cost component. Therefore, changes from quarter-to-quarter or from year-to-year can have a significant impact on our reported gross margins. In addition, contracts with a higher percentage of subcontracted work or equipment purchases may result in lower gross profit margins. +Our manufacturing operations are dependent on third-party suppliers. +Although we are not dependent on any one supplier, we are dependent on the ability of our third-party suppliers to supply our raw materials, as well as certain specific component parts. The third-party suppliers upon which we depend may default on their obligations to us due to bankruptcy, insolvency, lack of liquidity, adverse economic conditions, operational failure, fraud, loss of key personnel, or other reasons. We cannot assure you that our third-party suppliers will dedicate sufficient resources to meet our scheduled delivery requirements or that our suppliers will have sufficient resources to satisfy our requirements during any period of sustained demand. Failure of suppliers to supply, or delays in supplying, our raw materials or certain components, or allocations in the supply of certain high demand raw components, for any reason, including, without limitation, disruptions in our suppliers’ due to cybersecurity incidents, terrorist activity, public health crises (such as coronavirus), fires or other natural disasters could materially adversely affect our operations and ability to meet our own delivery schedules on a timely and competitive basis. Additionally, our +12 +third-party suppliers may provide us with raw mate rials or component parts that fail to meet our expectations or the expectations of our customers, which could subject us to product liability claims, other claims and litigation. +Our use of subcontractors could potentially harm our profitability and business reputation. +Occasionally we act as a prime contractor in some of the engineered projects we undertake. In our capacity as lead provider and when acting as a prime contractor, we perform a portion of the work on our projects with our own resources and typically subcontract activities such as manufacturing, electrical work, concrete work, insulation, conveyors and controls. In our industry, the lead contractor is normally responsible for the performance of the entire contract, including subcontract work. Thus, when acting as a prime contractor, we are subject to risk associated with the failure of one or more subcontractors to perform as anticipated. +We employ subcontractors at various locations around the world to meet our customers’ needs in a timely manner, meet local content requirements and reduce costs. Subcontractors generally perform the majority of our manufacturing for international customers. We also utilize subcontractors in North America. The use of subcontractors decreases our control over the performance of these functions and could result in project delays, escalated costs and substandard quality. These risks could adversely affect our profitability and business reputation. In addition, many of our competitors, who have greater financial resources and greater bargaining power than we have, use the same subcontractors that we use and could potentially influence our ability to hire these subcontractors. If we were to lose relationships with key subcontractors, our business could be adversely impacted. +A significant portion of our accounts receivable are related to larger contracts, which increases our exposure to credit risk. +Significant portions of our sales are to customers who place large orders for custom products and whose activities are related to the power and oil & gas industries. As a result, our exposure to credit risk is affected to some degree by conditions within these industries and governmental and or political conditions. We frequently attempt to reduce our exposure to credit risk by requiring progress or milestone payments and letters of credit as well as closely monitoring the credit worthiness of our customers. However, the continuing economic climate and other unanticipated events that affect our customers could have a materially adverse impact on our operating results. +Changes in billing terms can increase our exposure to working capital and credit risk. +Our products are generally sold under contracts that allow us to bill upon the completion of certain agreed upon milestones or upon actual shipment of the product, and certain contracts include a retention provision. We attempt to negotiate progress-billing milestones on all large contracts to help us manage the working capital and credit risk associated with these large contracts. Consequently, shifts in the billing terms of the contracts in our backlog from period to period can increase our requirement for working capital and can increase our exposure to credit risk. +Currency fluctuations may reduce profits on our foreign sales or increase our costs, either of which could adversely affect our financial results. +Given that approximately 30% of our 2019 revenues are outside the United States, we are subject to the impact of fluctuations in foreign currency exchange rates. Although our financial results are reported in U.S. dollars, a portion of our sales and operating costs are realized in foreign currencies. Our sales and profitability are impacted by the movement of the U.S. dollar against foreign currencies in the countries in which we generate sales and conduct operations. Long-term fluctuations in relative currency values could have an adverse effect on our operations and financial conditions. +If our goodwill or indefinite lived intangibles become impaired, we may be required to recognize charges that would adversely impact our results of operations. +As of December 31, 2019, goodwill and indefinite lived intangibles were $166.3 million, or 40.8%, of our total assets. Goodwill and indefinite lived intangible assets are not amortized, but instead are subject to annual impairment evaluations (or more frequently if circumstances require). Major factors that influence our evaluations are estimates for future revenue and expenses associated with the specific intangible asset or the reporting unit in which the goodwill resides. This is the most sensitive of our estimates related to our evaluations. Other factors considered in our evaluations include assumptions as to the business climate, industry and economic conditions. These assumptions are subjective and different estimates could have a significant impact on the results of our analyses. While management, based on current forecasts and outlooks, believes that the assumptions and estimates are reasonable, we can make no assurances that future actual operating results will be realized as planned and that there will not be material impairment charges as a result. In particular, an economic downturn could have a material adverse impact on our customers thereby forcing them to reduce or curtail doing business with us and such a result may materially affect the amount of cash flow generated by our future operations. Any +13 +write-down of goodwill or intangible ass ets resulting from future periodic evaluations could adversely materially impact our results of operations. +We may incur costs as a result of certain restructuring activities, which may negatively impact our financial results, and we may not achieve some or all of the expected benefits of our restructuring plans. +We are continuously seeking the most cost-effective means and structure to serve our customers, protect our shareholders and respond to changes in our markets. From time to time, we may engage in restructuring activities in an effort to improve cost competitiveness and profitability. We may not achieve the desired or anticipated benefits from these restructuring activities. As a result, restructuring costs may vary significantly from year to year depending on the scope of such activities. Such restructuring costs and expenses could adversely impact our financial results. +Changes in laws or regulations or the manner of their interpretation or enforcement could adversely impact our financial performance and restrict our ability to operate our business or execute our strategies. +New laws or regulations, or changes in existing laws or regulations, or the manner of their interpretation or enforcement, could increase our cost of doing business and restrict our ability to operate our business or execute our strategies. In particular, there may be significant changes in U.S. laws and regulations and existing international trade agreements by the current U.S. presidential administration that could affect a wide variety of industries and businesses, including those businesses we own and operate. If the current or future U.S. presidential administrations materially modifies U.S. laws and regulations and international trade agreements, our business, financial condition, and results of operations could be adversely affected. +We are party to asbestos-containing product litigation that could adversely affect our financial condition, results of operations and cash flows. +Our subsidiary, Met-Pro, along with numerous other third parties, has been named as a defendant in asbestos-related lawsuits filed against a large number of industrial companies including, in particular, those in the pump and fluid handling industries. In management’s opinion, the complaints typically have been vague, general and speculative, alleging that Met-Pro, along with the numerous other defendants, sold unidentified asbestos-containing products and engaged in other related actions that caused injuries (including death) and loss to the plaintiffs. The Company’s insurers have hired attorneys who, together with the Company, are vigorously defending these cases. The Company believes that its insurance coverage is adequate for the cases currently pending against the Company and for the foreseeable future, assuming a continuation of the current volume, nature of cases and settlement amounts. However, the Company has no control over the number and nature of cases that are filed against it, nor as to the financial health of its insurers or their position as to coverage. The Company also presently believes that none of the pending cases will have a material adverse impact upon the Company’s results of operations, liquidity or financial condition. +See Note 13 to the Consolidated Financial Statements contained in Part II, Item 8 of this Annual Report on Form 10-K for information regarding the asbestos-related litigation in which we are involved. +We have $67.3 million of indebtedness as of December 31, 2019, and incurrence of additional indebtedness could adversely affect our ability to operate our business, remain in compliance with debt covenants, make payments on our debt and limit our growth. +Our outstanding indebtedness could have important consequences for investors, including the following: +• +it may be more difficult for us to satisfy our obligations with respect to the agreement governing our Credit Facility (as defined herein), and any failure to comply with the obligations of any of the agreements governing any additional indebtedness, including financial and other restrictive covenants, could result in an event of default under such agreements; +• +the covenants contained in our debt agreements, including our Credit Facility, limit our ability to borrow money in the future for acquisitions, capital expenditures or to meet our operating expenses or other general corporate obligations; +• +the amount of our interest expense may increase because a substantial portion of our borrowings are at variable rates of interest, which, if interest rates increase, could result in higher interest expense; +• +we may need to use a portion of our cash flows to pay interest on our debt, which will reduce the amount of money we have for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other business activities; +• +we may have a higher level of debt than some of our competitors, which could put us at a competitive disadvantage; +14 +• +we may be more vulnerable to economic downturns and adverse developments in our industry or the economy in general; and +• +our debt level could limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate. +Our ability to meet our expenses and debt obligations will depend on our future performance, which will be affected by financial, business, economic, regulatory and other factors. We will not be able to control many of these factors. We cannot be certain that our earnings will be sufficient to allow us to pay the principal and interest on our existing or future debt and meet our other obligations. If we do not have enough money to service our existing or future debt, we may be required to refinance all or part of our existing or future debt, sell assets, borrow more money or raise equity. We may not be able to refinance our existing or future debt, sell assets, borrow more money or raise equity on terms acceptable to us, if at all. +We might be unable to protect our intellectual property rights and our products could infringe the intellectual property rights of others, which could expose us to costly disputes. +Although we believe that our products do not infringe patents or violate the proprietary rights of others, it is possible that our existing patent rights may not be valid or that infringement of existing or future patents or proprietary rights may occur. In the event our products infringe patents or proprietary rights of others, we may be required to modify the design of our products or obtain a license for certain technology. We cannot guarantee that we will be able to do so in a timely manner, upon acceptable terms and conditions, or at all. Failure to do any of the foregoing could have a material adverse effect upon our business. Moreover, if our products infringe patents or proprietary rights of others, we could, under certain circumstances, become liable for damages, which also could have a material adverse effect on our business. +Risks related to our pension plan may adversely impact our results of operations and cash flow. +Significant changes in actual investment return on pension assets, discount rates, and other factors may adversely affect our results of operations and pension plan contributions in future periods. GAAP requires that we calculate the income or expense of our plan using actuarial valuations. These valuations reflect assumptions about financial markets and interest rates. We establish the discount rate used to determine the present value of the projected and accumulated benefit obligation at the end of each year based upon the available market rates for high quality, fixed-income investments. An increase in the discount rate would increase future pension expense and, conversely, a decrease in the discount rate would decrease future pension expense. Funding requirements for our pension plan may become more significant. The ultimate amounts to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory changes related to pension funding obligations. For a discussion regarding the significant assumptions used to estimate pension expense, including discount rate and the expected long-term rate of return on plan assets, and how our financial statements can be affected by pension plan accounting policies, see “Critical Accounting Policies” included in this Annual Report on Form 10-K in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +We may be subject to substantial withdrawal liability assessments in the future related to multiemployer pension plans to which certain of our subsidiaries make contributions pursuant to collective bargaining agreements. +Under applicable federal law, any employer contributing to a multiemployer pension plan that completely ceases participating in the plan while the plan is underfunded is subject to payment of such employer’s assessed share of the aggregate unfunded vested benefits of the plan. In certain circumstances, an employer can be assessed a withdrawal liability for a partial withdrawal from a multiemployer pension plan. If any of these adverse events were to occur in the future, it could result in a substantial withdrawal liability assessment that could have a material adverse effect on our business, financial condition, results of operations or cash flows. +We rely on several key employees whose absence or loss could disrupt our operations or be adverse to our business. +We are highly dependent on the experience of our management in the continuing development of our operations. The loss of the services of certain of these individuals would have a material adverse effect on our business. Although we have employment and non-competition agreements with certain of our key employees, as a practical matter, those agreements will not assure the retention of our employees, and we may not be able to enforce all of the provisions in any employment or non-competition agreement. Our future success will depend in part on our ability to attract and retain qualified personnel to manage our development and future growth. We cannot guarantee that we will be successful in attracting and retaining such personnel. Our failure to recruit additional key personnel could have a material adverse effect on our financial condition, results of operations and cash flows. +15 +Work stoppages or similar difficulties could significantly disrupt our operations. +As of December 31, 2019, approximately 200 of our approximately 860 employees are represented by international or independent labor unions under various union contracts that expire from May 31, 2020 to April 30, 2023. It is possible that our workforce will become more unionized in the future. Although we consider our employee relations to generally be good, our existing labor agreements may not prevent a strike or work stoppage at one or more of our facilities in the future and we may be affected by other labor disputes. A work stoppage at one or more of our facilities may have a material adverse effect on our business. Unionization activities could also increase our costs, which could have an adverse effect on our profitability. +Additionally, a work stoppage at one of our suppliers could adversely affect our operations if an alternative source of supply were not readily available. Work stoppages by employees of our customers also could result in reduced demand for our products. +Failure to maintain adequate internal controls could adversely affect our business. +Under Section 404 of Sarbanes-Oxley, we are required to include in each of our Annual Reports on Form 10-K, a report containing our management’s assessment of the effectiveness of our internal control over financial reporting and an attestation report of our independent auditor. These laws, rules and regulations continue to evolve and could become increasingly stringent in the future. We have undertaken actions to enhance our ability to comply with the requirements of Sarbanes-Oxley, including, but not limited to, the engagement of consultants, the documentation of existing controls and the implementation of new controls or modification of existing controls as deemed appropriate. +We continue to devote substantial time and resources to the documentation and testing of our controls, and to plan for and the implementation of remedial efforts in those instances where remediation is indicated. If we fail to maintain the adequacy of our internal controls, including remediating any material weaknesses or deficiencies in our internal controls, as such standards are modified, supplemented or amended in the future, we could be subject to regulatory actions, civil or criminal penalties or shareholder litigation. In addition, failure to maintain adequate internal controls could result in financial statements that do not accurately reflect our financial condition, results of operations and cash flows. We believe that the out-of-pocket costs, the diversion of management’s attention from running our day-to-day operations and operational changes caused by the need to comply with the requirements of Section 404 will continue to be significant. +There are inherent limitations in all internal control systems over financial reporting, and misstatements due to error or fraud may occur and not be detected. +While we continue to take action to ensure compliance with the internal control, disclosure control and other requirements of Sarbanes-Oxley and the rules and regulations promulgated thereunder by the SEC, there are inherent limitations in our ability to control all circumstances. Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and disclosure controls can prevent all errors and all frauds. A control system, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be evaluated in relation to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Further, controls can be circumvented by individual acts of some persons, by collusion of two or more persons, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, a control may be inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. +If we are not able to maintain the adequacy of our internal control over financial reporting, including any failure to implement required new or improved controls, or if we experience difficulties in their implementation, our business, financial condition and operating results could be harmed. We can give no assurances that any additional material weaknesses will not arise in the future due to our failure to implement and maintain adequate internal control over financial reporting. +16 +We have made and may make future acquis itions or divestitures , which involve numerous risks that could impact our financial condition, results of operations and cash flows. +Our operating strategy has involved expanding or contracting our scope of products and services through selective acquisitions or divestitures and the formation or elimination of new business units that are then integrated or separated into or out of our family of turnkey system providers. We have acquired other businesses, product or service lines, assets or technologies that are complementary to our business. We may be unable to find or consummate future acquisitions at acceptable prices and terms. We continually evaluate potential acquisition opportunities in the ordinary course of business. +Although we conduct what we believe to be a prudent level of investigation regarding the operating and financial condition of the businesses, product or service lines, assets or technologies we purchase, an unavoidable level of risk remains regarding their actual operating and financial condition. Until we actually assume operating control of these businesses, product or service lines, assets or technologies, we may not be able to ascertain their actual value or understand potential liabilities. This is particularly true with respect to acquisitions outside the United States. +In addition, acquisitions of businesses may require additional debt or equity financing, resulting in additional leverage or dilution of ownership. Our Credit Facility contains certain covenants that limit, or which may have the effect of limiting, among other things, acquisitions, capital expenditures, the sale of assets and the incurrence of additional indebtedness. +Our ability to obtain financing for future growth opportunities may be limited. +Our ability to execute our growth strategies may be limited by our ability to secure and retain additional financing on terms reasonably acceptable to us or at all. Certain of our competitors are larger companies that may have greater access to capital, and therefore, may have a competitive advantage over us should our access to capital be limited. +Our dependence on information systems and the failure of such systems, could significantly disrupt our business and negatively affect our financial condition, results of operations and cash flows. +We are highly dependent on information systems that are increasingly operated by third-parties and as a result we have a limited ability to ensure their continued operation. We rely on information technology systems, networks and infrastructure in managing our day-to-day operations. In the event of systems failure or interruption, we will have limited ability to affect the timing and success of systems restoration. Any failure or interruption of our systems could cause delays or other problems in the delivery of our services, which could have a material adverse effect on our operating results. +Increased information technology cyber security threats and more sophisticated and targeted computer crime could pose a risk to our systems, networks, and products. +Increased global information technology cyber security threats and more sophisticated and targeted computer crime pose a risk to the security of our systems and networks and the confidentiality, availability and integrity of our data and communications. While we attempt to mitigate these risks by employing a number of measures, including employee training, comprehensive monitoring of our networks and systems, and maintenance of backup and protective systems, our systems, networks and products remain potentially vulnerable to advanced persistent threats. Depending on their nature and scope, such threats could potentially lead to the compromising of confidential information and communications, improper use of our systems and networks, manipulation and destruction of data, defective products, production downtimes and operational disruptions, which in turn could adversely affect our reputation, competitiveness and results of operations. We have cybersecurity insurance related to a breach event covering expenses for notification, credit monitoring, investigation, crisis management, public relations and legal advice. However, damage and claims arising from such incidents may not be covered or exceed the amount of any insurance available, or may result in increased cybersecurity and other insurance premiums. +In addition, we could be subject to legal claims or proceedings, liability under laws that protect the privacy of personal information and regulatory penalties if confidential information relating to our employees or other parties is misappropriated from our systems and networks. +Risks Related to Our Common Stock +The market price of our common stock may be volatile or may decline regardless of our operating performance and investors may not be able to resell shares they purchase at their purchase price. +The stock market has experienced and may in the future experience volatility that has often been unrelated to the operating performance of particular companies. The market price of our common stock has experienced, and may continue to experience, +17 +substantial volatility. During 201 9 , the sales price of ou r common stock on the NASDAQ ranged from $ 6 . 71 to $ 9 . 60 per share. We expect our common stock to continue to be subject to fluctuations. Broad market and industry factors may adversely affect the market price of our common stock, regardless of our actual operating performance. Factors that could cause fluctuat ion in the common stock price may include, among other things: +• +actual or anticipated variations in operating results; +• +adverse general economic conditions, including, but not limited to, withdrawals of investments in the stock markets generally or a tightening of credit available to potential acquirers of businesses, that result in lower average prices being paid for public company shares and lower valuations being placed on businesses; +• +other domestic and international macroeconomic factors unrelated to our performance; +• +our failure to meet the expectations of the investment community; +• +industry trends and the business success of our customers; +• +loss of key customers; +• +announcements of technological advances by us or our competitors; +• +current events affecting the political and economic environment in the United States; +• +conditions or trends in our industry, including demand for our products and services, technological advances and governmental regulations; +• +litigation or other proceedings involving or affecting us; and +• +additions or departures of our key personnel. +The realization of any of these risks and other factors beyond our control could cause the market price of our common stock to decline significantly. +We are not currently paying dividends and cannot make assurances that we will pay dividends on our common stock and our indebtedness could limit our ability to pay dividends. +The timing, declaration, amount and payment of future dividends to our shareholders fall within the discretion of our Board of Directors and will depend on many factors, including our financial condition, results of operations and capital requirements, as well as applicable legal, regulatory constraints, industry practice and other business considerations that our Board of Directors considers relevant. There can be no assurance that we will pay a dividend in the future. +The number of shares of our common stock eligible for future sale could adversely affect the market price of our stock. +We have reserved 1.9 million shares of our common stock for issuance under our 2017 Equity Incentive Plan (the “2017 Plan”), which may include option grants, stock grants, performance unit grants and restricted stock grants. We had outstanding options to purchase approximately 356,000 shares of our common stock and 65,000 outstanding restricted stock units under our 2007 Equity Incentive Plan (the “2007 Plan”), and outstanding options to purchase approximately 54,000 shares of our common stock and 1,257,000 outstanding restricted stock units under our 2017 Plan as of December 31, 2019. The shares under both plans are registered for resale on currently effective registration statements. +We may issue additional restricted securities or register additional shares of common stock under the Securities Act in the future. The issuance of a significant number of shares of common stock upon the exercise of stock options or warrants, vesting of restricted stock units, or the availability for sale, or resale, of a substantial number of the shares of common stock under registration statements, under Rule 144 or otherwise, could adversely affect the market price of our common stock. +18 +One or more issuances of shares of our common stock under our stock incentive plan or securities in connection with financing transactions or the conversion of warrants will dilute current shareholders. +Pursuant to our stock incentive plan, we may grant stock awards to our employees, directors and consultants. Dilution will occur upon exercise of any outstanding stock awards convertible into or exchangeable or exercisable for common stock. Moreover, if we raise additional funds by issuing additional common stock, or securities, further dilution to our existing shareholders will result. In addition, we have historically issued warrants to purchase common shares in conjunction with business acquisitions, debt issuances and employment contracts, which may cause dilution when exercised. +Our ability to issue preferred stock could adversely affect the rights of holders of our common stock. +Our certificate of incorporation authorizes us to issue up to 10,000 shares of preferred stock in one or more series on terms that may be determined at the time of issuance by our Board of Directors. Accordingly, we may issue shares of any series of preferred stock that would rank senior to our common stock as to voting or dividend rights or rights upon our liquidation, dissolution or winding up. +Certain provisions in our charter documents have anti-takeover effects. +Certain provisions of our certificate of incorporation and bylaws may have the effect of delaying, deferring or preventing a change in control of us. Such provisions, including those limiting who may call special shareholders’ meetings, together with the possible issuance of our preferred stock without shareholder approval, may make it more difficult for other persons, without the approval of our Board of Directors, to make a tender offer or otherwise acquire substantial amounts of our common stock or to launch other takeover attempts that a shareholder might consider to be in such shareholder’s best interest. +Item 1B. +Unresolved Staff Comments +Not Applicable. +Item 2. +Properties +The Company has 30 principal operating facilities across 12 states and seven foreign countries. The Company’s executive offices are located in Dallas, Texas. We maintain our facilities in good operating condition, and we believe they are suitable and adequate for the purposes for which they are intended to conduct business. Our current capacity, with limited capital additions, is expected to be sufficient to meet production requirements for the near future. It is anticipated that most leases coming due in the near future will be renewed at expiration. The property we own is subject to collateral mortgages to secure the amounts owed under the Credit Facility. Information on the number, ownership and location of principal operating facilities by segment was as follows as of December 31, 2019. +Location of Facilities +Segment +Owned +Leased +States +Countries +Energy Solutions segment +— +15 +California, Connecticut, New York, Ohio, Texas +United States, The Netherlands, Canada, India, United Arab Emirates, Singapore, United Kingdom, People's Republic of China +Industrial Solutions segment +— +9 +California, Illinois, Kentucky, Michigan, North Carolina, Pennsylvania, Tennessee +United States, United Kingdom, People's Republic of China +Fluid Handling Solutions segment +1 +2 +Indiana, Pennsylvania +United States, The Netherlands +Corporate +— +3 +Ohio, Texas +United States, Canada +1 +29 +Item 3. +Legal Proceedings +See Note 13 to the Consolidated Financial Statements contained in Part II, Item 8 of this Annual Report on Form 10-K for information regarding legal proceedings in which we are involved. +19 +Item 4. +Mine Saf ety Disclosures +Not applicable. +20 +PART II +Item 5. +Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Market Information +Our common stock is traded on the NASDAQ under the symbol “CECE.” +Performance Graph +The following graph sets forth the cumulative total return to CECO’s shareholders during the five years ended December 31, 2019, as well as the following indices: Russell 2000 Index, Standard and Poor’s (“S&P”) 600 Small Cap Industrial Machinery Index, and S&P 500 Index. Assumes $100 was invested on December 31, 2014, including the reinvestment of dividends, in each category. +Dividends +Our dividend policy and the payment of cash dividends under that policy are subject to the Board of Director’s continuing determination that the dividend policy and the declaration of dividends are in the best interest of our shareholders. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the stockholders to suspend dividend payments. Future dividends and the dividend policy may be changed at the Board of Director’s discretion at any time. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Facility. +Holders +The approximate number of registered shareholders of record of our common stock as of February 28, 2020 was 305, although there are a larger number of beneficial owners. +Purchases of Equity Securities by the Issuer and Affiliated Purchasers +We did not repurchase any shares of our common stock during 2019. +Recent Sales of Unregistered Securities +Not applicable. +21 +Item 6. Selected Financial Data +The following table sets forth selected summary financial data. We have derived this data from our consolidated financial statements for the five years ended December 31, 2019 which were audited by BDO USA, LLP, independent registered public accounting firm. The selected financial data should be read in conjunction with our Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included herein and previously filed for 2016 and 2015. +Year Ended December 31, +(In thousands, except share and per share data) +2019 +2018 +2017 +2016 +2015 +Net sales +$ +341,869 +$ +337,339 +$ +345,051 +$ +417,011 +$ +367,422 +Gross profit +114,099 +111,537 +113,194 +134,859 +109,171 +Amortization and earnout expenses +8,499 +9,683 +7,132 +20,231 +25,613 +Restructuring expenses, net +1,097 +— +1,895 +— +— +Acquisition and integration expenses +465 +— +— +— +— +Loss on divestitures, net of selling costs +70 +4,390 +— +— +— +Intangible asset and goodwill impairment +— +— +7,168 +57,923 +3,340 +Income (loss) from operations +17,990 +10,002 +8,024 +(25,562 +) +4,949 +Net income (loss) +17,707 +(7,121 +) +(3,029 +) +(38,218 +) +(5,602 +) +Basic earnings (loss) per common share +$ +0.51 +$ +(0.21 +) +$ +(0.09 +) +$ +(1.12 +) +$ +(0.19 +) +Diluted earnings (loss) per common share +$ +0.50 +$ +(0.21 +) +$ +(0.09 +) +$ +(1.12 +) +$ +(0.19 +) +Weighted average shares outstanding – basic +34,987,878 +34,714,395 +34,445,256 +33,979,549 +28,791,662 +Weighted average shares outstanding – diluted +35,484,273 +34,714,395 +34,445,256 +33,979,549 +28,791,662 +Dividends declared per common share +$ +— +$ +— +$ +0.225 +$ +0.264 +$ +0.264 +Dividends paid +$ +— +$ +— +$ +7,792 +$ +8,995 +$ +7,977 +Total assets +$ +408,637 +$ +392,582 +$ +438,549 +$ +498,634 +$ +598,819 +Short-term debt +2,500 +— +11,296 +8,827 +19,494 +Long-term obligations +81,457 +86,474 +115,417 +126,899 +157,834 +Shareholders’ equity +$ +193,017 +$ +178,560 +$ +186,569 +$ +190,082 +$ +245,021 +Results of operations from acquired businesses are included from the date of acquisition forward. The fair value of assets and liabilities, inclusive of changes resulting from operating the businesses, are included in the first period ended after the date of each acquisition, and all periods thereafter. Acquisitions consist of Peerless Mfg. Co. (“PMFG”) in September 2015. +Results of operations from businesses that are divested are excluded from the date of the disposition. Dispositions consist of the following: (i) Keystone Filter in February 2018, (ii) Strobic Air Corporation in March 2018, and (iii) Jiangyin Zhongli Industrial Technology Co. Ltd. (“Zhongli”) in November 2018. +22 +Item 7. Management’s Discussion and Analysis of Financial Condition and Result s of Operations +Management’s discussion and analysis (“MD&A”) should be read in conjunction with the consolidated financial statements and accompanying notes included in Item 8 of this Annual Report on Form 10-K, which include additional information about our accounting policies, practices and the transactions underlying our financial results. The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and the accompanying notes including various claims and contingencies related to lawsuits, taxes, environmental and other matters arising during the normal course of business. We apply our best judgment, our knowledge of existing facts and circumstances and actions that we may undertake in the future in determining the estimates that affect our consolidated financial statements. We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change. As future events and their effects cannot be determined with precision, actual results may differ from these estimates. +Overview +Business Overview +CECO is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customer’s mission critical applications. The industries CECO serves include oil & gas, power generation, water and wastewater, battery production, poly silicon fabrication, and chemical and petrochemical processing, along with a wide range of other industries. +Industry Trends and Corporate Strategy +We are a global corporation with worldwide operations. As a global business, our operations are affected by worldwide, regional and industry-specific economic factors, wherever we operate or do business. Our geographic and industry diversity, and the breadth of our product and services portfolios, have helped mitigate the impact of any one industry or the economy of any single country on our consolidated operating results. +We believe growth for our products and services is driven by the increasing demand for energy consumption and a shift towards cleaner sources such as natural gas, nuclear, and renewable sources. These trends should stimulate investment in new power generation facilities, pipeline expansion and related infrastructure, and in upgrading of existing facilities. +With a shift to cleaner, more environmentally responsible power generation, power providers and industrial power consumers are building new facilities that use cleaner fuels. In developed markets, natural gas is increasingly becoming one of the energy sources of choice. We supply product offerings throughout the entire natural gas infrastructure value chain and believe expansion will drive growth within our Energy Solutions segment for our pressure products and SCR systems for natural-gas-fired power plants. Increased global natural gas production as a percent of total energy consumption, miles of new pipeline being added globally, and an increase in liquification capacity all stand to drive the need for our products. +We also believe there is a trend in both developed and emerging markets to control and reduce emissions of harsher fuel sources for which our air pollution control equipment is required. In emerging markets including China, India, and South East Asia our business is positioned to benefit from tightening of air pollution standards. In developed markets, growth of industrialization will drive greater output of emissions requiring our equipment as well. In both markets, we expect capital expenditures for our equipment to increase and the need for our aftermarket services to grow as companies seek to meet new standards. +We continue to focus on increasing revenues and profitability globally while continuing to strengthen and expand our presence domestically. Our operating strategy has historically involved horizontally expanding our scope of technology, products, and services through selective acquisitions and the formation of new business units that are then vertically integrated into our growing group of turnkey system providers. Our continuing focus will be on global growth, market coverage, and expansion of our Asia operations. Operational excellence, margin expansion, after-market recurring revenue growth, and safety leadership are also critical to our growth strategy. +23 +Operations Overview +We operate using an “outside-in” approach to our business model. We are structured to win in target markets with a core focus on understanding customer needs. Our business model requires scalable efficiencies enabling us to serve our customers with a variety of products that we typically classify into three categories: make-to-order, configure-to-order, and engineer-to-order. We use an asset light model to accomplish this by focusing on application and technical expertise throughout our operations. +The Company’s segments are led by presidents with distinct industry expertise coupled with strong leadership skills resulting in a customer-first mindset across the business. They manage their teams who are responsible for successfully running the segment operations. The segment presidents work closely with our Chief Executive Officer on global growth strategies, operational excellence, and employee development. +Within our segments we have monthly operating reviews to ensure we are both winning in the markets and winning as a business. These reviews include, but are not limited to, deal reviews, project reviews, and manufacturing reviews. Each of these reviews takes a customer-first approach where we adopt the metrics that matter most to our customer and to our shareholders. In these reviews we focus on metrics such as quality, customer satisfaction, on-time-delivery, lead-times, price, position, project margins, backlog, and above all, safety. +The headquarters focuses on enabling the core back-office key functions for scale and efficiency, that is, accounting, payroll, human resources/benefits, information technology, safety support, internal control over financial reporting, and administration. We have excellent organizational focus from headquarters throughout our divisional businesses with clarity and minimal duplicative work streams. +Our three reportable segments are: +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for Clean Energy through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Our contracts are obtained either through competitive bidding or as a result of negotiations with our customers. Contract terms offered by us are generally dependent on the complexity and risk of the project as well as the resources that will be required to complete the project. Our focus is on increasing our operating margins as well as our gross margin percentage, which translates into stronger operating results. +Our cost of sales is principally driven by a number of factors, including material and subcontract prices and labor cost and availability. Changes in these factors may have a material impact on our overall gross profit margins. +24 +We break down costs of sales into five categories. They are: +• +Subcontracts—Electrical work, concrete work, subcomponents and other subcontracts necessary to produce our products; +• +Labor—Our direct labor both in the shop and in the field; +• +Material—Raw material that we buy to build our products; +• +Equipment—Fans, motors, control panels and other equipment necessary for turnkey systems; and +• +Factory overhead—Costs of facilities and supervision wages necessary to produce our products. +In general, subcontracts provide us the most flexibility in margin followed by labor, material, and equipment. Across our various product lines, the relative relationships of these factors change and cause variations in gross margin percentage. Material costs have also increased faster than labor costs, which also reduces gross margin percentage. As material cost inflation occurs, the Company seeks to pass this cost onto our customers as price increases. +Selling and administrative expense principally includes sales and engineering payroll and related fringes, advertising and marketing expenditures as well as all corporate and administrative functions and other costs that support our operations. The majority of these expenses are fixed. With our asset light model, we expect our operations to leverage our fixed cost structure as revenue grows. +Note Regarding Use of Non-GAAP Financial Measures +The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) . These GAAP financial statements include certain charges the Company believes are not indicative of its ongoing operational performance. +As a result, the Company provides financial information in this MD&A that was not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. The Company provides this supplemental non-GAAP financial information, which the Company’s management utilizes to evaluate its ongoing financial performance, and which the Company believes provides greater transparency to investors as supplemental information to its GAAP results. +The Company has provided the non-GAAP financial measures non-GAAP operating income, non-GAAP operating margin, and non-GAAP net income attributable to CECO Environmental Corp. as a result of the adjustment for items that the Company believes are not indicative of its ongoing operations. These items include charges associated with the Company’s acquisitions, divestitures and the items described below in “Consolidated Results.” The Company believes that evaluation of its financial performance compared with prior and future periods can be enhanced by a presentation of results that exclude the impact of these items. The Company has incurred substantial expense and income associated with acquisitions and divestitures. While the Company cannot predict the exact timing or amounts of such charges, it does expect to treat these charges as special items in its future presentation of non-GAAP results. +25 +Results of Operations +Consolidated Results +Our consolidated statements of operations for the years ended December 31, 2019, 2018 and 2017 are as follows: +Year ended December 31, +(dollars in millions) +2019 +2018 +2017 +Net sales +$ +341.9 +$ +337.3 +$ +345.1 +Cost of goods sold +227.8 +225.8 +231.9 +Gross profit +$ +114.1 +$ +111.5 +$ +113.2 +Percent of sales +33.4 +% +33.1 +% +32.8 +% +Selling and administrative expenses +$ +85.9 +$ +87.4 +$ +89.0 +Percent of sales +25.1 +% +25.9 +% +25.8 +% +Amortization and earnout expenses +$ +8.5 +$ +9.7 +$ +7.1 +Loss on divestitures, net of selling costs +$ +0.1 +$ +4.4 +$ +— +Acquisition and integration expenses +$ +0.5 +$ +— +$ +— +Intangible asset and goodwill impairment +$ +— +$ +— +$ +7.2 +Restructuring expenses, net +$ +1.1 +$ +— +$ +1.9 +Operating income +$ +18.0 +$ +10.0 +$ +8.0 +Percent of sales +5.3 +% +3.0 +% +2.3 +% +Non-GAAP Measures +To compare operating performance between the years ended December 31, 2019, 2018 and 2017, the Company has adjusted GAAP operating income to exclude (1) executive transition expenses, including severance for its former Chief Executive Officer, fees incurred in the search for a new Chief Executive Officer, and expenses associated with hiring a new Chief Financial Officer, (2) facility exit expenses associated with the closure of certain leased facilities, (3) legacy design repair expenses related to costs to rectify issues on products that are no longer in production, (4) restructuring expenses primarily relating to severance, facility exit, legal and property, plant and equipment impairment, (5) intangible asset and goodwill impairment, (6) plant, property and equipment valuation adjustments related to acquisitions, (7) loss on divestitures and (8) acquisition and integration related expenses, including legal and accounting. See “Note Regarding Use of Non-GAAP Financial Measures” above. The following tables present the reconciliation of GAAP operating income and GAAP operating margin to non-GAAP operating income and non-GAAP operating margin, and GAAP net income (loss) to non-GAAP net income. +Year Ended December 31, +(dollars in millions) +2019 +2018 +2017 +Operating income as reported in accordance with GAAP +$ +18.0 +$ +10.0 +$ +8.0 +Operating margin in accordance with GAAP +5.3 +% +3.0 +% +2.3 +% +Legacy design repairs +— +— +2.0 +Plant, property and equipment valuation adjustment +— +— +0.6 +Amortization and earnout expenses +8.5 +9.7 +7.1 +Loss on divestitures, net of selling costs +0.1 +4.4 +— +Intangible asset and goodwill impairment +— +— +7.2 +Acquisition and integration expenses +0.5 +— +— +Restructuring expenses, net +1.1 +— +1.9 +Executive transition expenses +— +— +1.3 +Facility exit expenses +— +— +0.2 +Non-GAAP operating income +$ +28.2 +$ +24.1 +$ +28.3 +Non-GAAP operating margin +8.2 +% +7.1 +% +8.2 +% +26 +Year Ended December 31, +(dollars in millions) +2019 +2018 +2017 +Net income (loss) as reported in accordance with GAAP +$ +17.7 +$ +(7.1 +) +$ +(3.0 +) +Legacy design repairs +— +— +2.0 +Plant, property and equipment valuation adjustment +— +— +0.6 +Amortization and earnout expenses +8.5 +9.7 +7.1 +Loss on divestitures, net of selling costs +0.1 +4.4 +— +Intangible asset and goodwill impairment +— +— +7.2 +Acquisition and integration expenses +0.5 +— +— +Restructuring expenses, net +1.1 +— +1.9 +Deferred financing fee adjustment +0.4 +— +— +Executive transition expenses +— +— +1.3 +Facility exit expenses +— +— +0.2 +Foreign currency remeasurement +(0.5 +) +0.8 +(2.1 +) +Tax (benefit) expense of adjustments +(2.5 +) +2.4 +(5.7 +) +Zhongli tax benefit +(4.4 +) +— +— +Non-GAAP net income +$ +20.9 +$ +10.2 +$ +9.5 +Non-GAAP net income as a percentage of sales +6.1 +% +3.0 +% +2.8 +% +In 2018, we divested three non-core businesses; Keystone filter brand (“Keystone”) and Strobic Air Corporation (“Strobic”) in the first quarter and Zhongli in the fourth quarter (collectively, “the Divestitures”). The exclusion of the operating results subsequent to their disposition impacts the comparability of our consolidated and segment operating results. +Comparison of the years ended December 31, 2019 and 2018 +Consolidated net sales in 2019 were $341.9 million compared with $337.3 million in 2018, an increase of $4.6 million. The increase is primarily attributable to increased sales volume for the Company’s industrial air pollution products and midstream oil & gas products, partially offset by the impact of the Divestitures. Excluding the impact of the Divestitures, sales grew organically by $13.9 million. +Gross profit increased by $2.6 million, or 2.3%, to $114.1 million in 2019 compared with $111.5 million in 2018. Gross profit as a percentage of sales increased to 33.4% in 2019 compared with 33.1% in 2018. The increase in gross profit was primarily attributable to sales volume increases year over year. +Selling and administrative expenses were $85.9 million in 2019 compared with $87.4 million in 2018. The decrease in administration expenses is primarily attributable to the impact of the Divestitures. Selling and administrative expenses as a percentage of sales were 25.1% in 2019 compared with 25.9% in 2018. The decrease in selling and administrative expenses as a percentage of sales is primarily attributable to the increase in net sales. +Amortization and earnout expense was $8.5 million in 2019 and $9.7 million in 2018. The decrease in expense is attributable to $1.2 million decrease in definite lived intangible asset amortization. There was no earnout expenses in 2019 or 2018, and we currently have no earnout obligations. +In 2018, the Company divested Keystone, Strobic and Zhongli, resulting in a net loss on divestitures of $4.4 million. The loss was comprised of a $15.6 million loss for Zhongli, offset by a $6.9 million gain for Keystone and $4.3 million gain for Strobic. Refer to Note 16 of the Consolidated Financial Statement for discussion of the Divestitures. +In 2019, the Company implemented restructuring measures in China to simplify operating efficiencies and reduce manufacturing footprint, accordingly we incurred expenses of $1.1 million. There were no restructuring charges in 2018. +Operating income for 2019 was $18.0 million, an increase of $8.0 million from $10.0 million in 2018. Operating income as a percentage of sales for 2019 was 5.3% compared with 3.0% for 2018. The increase in operating income is primarily attributable to higher sales, which led to an increase in gross profit, and decreases in administration expenses. +Non-GAAP operating income was $28.2 million in 2019, an increase of $4.1 million from $24.1 million in 2018.. Non-GAAP operating income as a percentage of sales for 2019 was 8.2% compared with 7.1% for 2018. The increase in Non-GAAP operating income was attributable to the factors described above. +27 +Other income (expense) for 2019 was $0.8 million of income compare d with $ ( 0.4 ) million of expense in 2018 , and was comprised primarily of foreign currency transaction gains and losses. +Interest expense decreased to $5.4 million in 2019 from $7.1 million in 2018. The decrease is due to lower interest rates and lower average debt balances in 2019 compared to 2018. +Income tax (benefit) expense was $(4.4) million and $9.6 million in 2019 and 2018, respectively. The effective tax rate for 2019 was (32.7)% compared with 385.2% in 2018. +Income tax benefit and th e effective tax rate for 2019 were significantly impacted by a $4.4 million tax benefit on finalization of a tax position related to the 2018 divestiture of Zhongli. In addition, the Company also recorded $3.5 million tax benefit related to U.S. and foreign tax incentives. +Income tax expense and the effective tax rate for 2018 were significantly impacted by permanent differences between the tax reporting and financial statement reporting of the net loss on the Divestitures. The net effect of those permanent differences was $7.0 million of tax expense in 2018. The Company completed its accounting for the tax effects of the Tax Cuts and Jobs Act (“Tax Act”) in 2018 and recorded a $1.7 million favorable adjustment to the amount of tax liability provisionally recorded in 2017 for the one-time deemed repatriation of foreign earnings. +Comparison of the years ended December 31, 2018 and 2017 +See the Management Discussion and Analysis section of our Annual Report on Form 10-K for the year ended December 31, 2018 for a discussion of our results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017. +Business Segments +The Company’s operations are organized and reviewed by management along its product lines or end markets that the segment serves and are presented in three reportable segments. The results of the segments are reviewed through the “Income from operations” line on the Consolidated Statements of Operations. The amounts presented in the Net Sales table below and in the following comments regarding our net sales at the reportable business segment level exclude both intra-segment and inter-segment net sales. The Income (loss) from Operations table and corresponding comments regarding operating income (loss) at the reportable segment level include both intra-segment and inter-segment operating income. +During the first quarter of 2019, as a result of further evaluating the Company’s operating structure, management determined that a minor realignment of the Company’s segments would help maximize growth and improve customer experience. As a result of this minor realignment, the operating results of the reportable segments Industrial Solutions and Fluid Handling Solutions have been reclassified to have their results align. All prior years have been reclassified to conform to the current year presentation. +The exclusion of the Divestitures’ operating results subsequent to their disposition impacts the comparability of our segment operating results. +2019 +2018 +2017 +Net Sales (less intra-, inter-segment sales) +(table only in thousands) +Energy Solutions segment +$ +210,319 +$ +211,185 +$ +188,955 +Industrial Solutions segment +91,347 +80,699 +93,960 +Fluid Handling Solutions segment +40,203 +45,455 +63,037 +Corporate and Other (1) +— +— +(901 +) +Net sales +$ +341,869 +$ +337,339 +$ +345,051 +(1) +Includes adjustment for revenue on intercompany jobs. +28 +2019 +2018 +2017 +Income (loss) from Operations +(table only in thousands) +Energy Solutions segment +$ +33,886 +$ +28,797 +$ +14,565 +Industrial Solutions segment +5,679 +6,308 +8,800 +Fluid Handling Solutions segment +5,558 +7,730 +14,059 +Corporate and Other (2) +(27,133 +) +(32,833 +) +(26,649 +) +Eliminations +— +— +(2,751 +) +Income from operations +$ +17,990 +$ +10,002 +$ +8,024 +(2) +Includes loss on divestitures, net of selling costs, corporate compensation, professional services, information technology, and other general and administrative corporate expenses. This figure excludes earnout expenses / income, which are recorded in the segment in which the expense / income occurs. +Comparison of the years ended December 31, 2019 and 2018 +Energy Solutions segment +Our Energy Solutions segment net sales decreased $0.9 million to $210.3 million in 2019 compared with $211.2 million in 2018, a decrease of 0.4%. Excluding the impact of the 2018 divested division Zhongli, net sales increased $3.6 million or 1.7% in 2019. The increase in organic sales is due primarily to increased sales volume for the Company’s refinery related products and separation equipment serving the midstream oil & gas markets offset by sales volume decreases in SCR (DeNOx) solutions serving power generation markets. +Operating income increased $5.1 million to $33.9 million for 2019 compared with $28.8 million in 2018, an increase of 17.7%. The increase in operating income in 2019 is primarily attributable to an increase in gross profit due to product mix, an operating loss in 2018 of $1.6 million related to Zhongli divestiture, and a decrease in amortization expense of $0.9 million, offset by a $0.5 million increase in restructuring expense. +Industrial Solutions segment +Our Industrial Solutions segment net sales increased $10.6 million to $91.3 million in 2019 compared with $80.7 million in 2018, an increase of 13.1%. The increase is primarily attributable to volume increases for the Company’s clean air pollution control technologies and aftermarket air filtration parts. +Operating income decreased $0.6 million to $5.7 million for 2019 compared with $6.3 million in 2018, a decrease of 9.5%. The decrease is attributable to $1.5 million increase in selling expenses related to the investment in sales & marketing personnel and customer focused product innovation and $0.5 million in acquisition and integration expenses which did not occur in 2018, offset by a $1.4 million increase in gross profit due to favorable product sales volume. +Fluid Handling Solutions segment +Our Fluid Handling Solutions segment net sales decreased $5.3 million to $40.2 million in 2019 compared with $45.5 million in 2018, a decrease of 11.6%. The decrease is primarily due to the divestitures of Keystone and Strobic, which had aggregate sales of $4.8 million in 2018, and sales volume decreases in the Company’s filtration and pump solutions. +Operating income decreased $2.1 million to $5.6 million for 2019 compared with an operating income of $7.7 million for 2018, a decrease of 27.3%. The decrease is primarily attributable the decrease in sales and operating income of $1.2 million from the divestitures of Keystone and Strobic. Excluding the divested businesses, segment income decreased $0.9 million due to volume and plant investments. +29 +Comparison of the years ended December 31, 201 8 and 201 7 +See the Management Discussion and Analysis section of our Annual Report on Form 10-K for the year ended December 31, 2018 for a discussion of our results of operations for our business segments and cash flows for the year ended December 31, 2018 compared to the year ended December 31, 2017. +Backlog +Backlog (i.e., unfulfilled or remaining performance obligations) represents the sales we expect to recognize for our products and services for which control has not yet transferred to the customer. Backlog increased to $216.6 million as of December 31, 2019 from $182.1 million as of December 31, 2018. Our customers may have the right to cancel a given order. Historically cancellations have not been common, however, during the year 2019, the Company removed $6.7 million of orders that were previously disclosed as backlog in prior periods, due to cancellations by customers. Backlog is adjusted on a quarterly basis for adjustments in foreign currency exchange rates. Substantially all backlog is expected to be delivered within 12 to 18 months. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Liquidity and Capital Resources +Our principal sources of liquidity are cash flow from operations and available borrowings under our Credit Facility (as defined below). Our principal uses of cash are operating costs, payment of principal and interest on our outstanding debt, working capital and other corporate requirements. Depending on market conditions, our liquidity requirements, contractual restrictions and other factors, we may also repurchase some of our outstanding shares of common stock. +When we undertake large jobs, our working capital objective is to make these projects self-funding. We work to achieve this by obtaining initial down payments, progress billing contracts, when possible, utilizing extended payment terms from material suppliers, and paying sub-contractors after payment from our customers, which is an industry practice. Our investment in net working capital is funded by cash flow from operations and by our revolving line of credit. +At December 31, 2019, the Company had working capital of $64.3 million, compared with $57.0 million at December 31, 2018. The ratio of current assets to current liabilities was 1.56 to 1.00 at December 31, 2019 as compared with a ratio of 1.55 to 1.00 at December 31, 2018. +At December 31, 2019 and 2018, cash and cash equivalents totaled $35.6 million and $43.7 million, respectively. As of December 31, 2019 and 2018, $27.0 million and $23.3 million, respectively, of our cash and cash equivalents were held by non-U.S. subsidiaries, as well as being denominated in foreign currencies. +Debt consisted of the following: +December 31, +(table only in thousands) +2019 +2018 +Outstanding borrowings under Credit Facility +Term loan payable in quarterly principal installments of $0.6 million +through June 2021, $0.9 million through June 2023, and $1.3 million +thereafter with balance due upon maturity in June 2024. +– Term loan +$ +48,750 +$ +76,147 +– U.S. Dollar revolving loans +18,500 +— +– Unamortized debt discount +(1,749 +) +(1,691 +) +Total outstanding borrowings under Credit Facility +65,501 +74,456 +Less: current portion +(2,500 +) +— +Total debt, less current portion +$ +63,001 +$ +74,456 +In 2019, the Company made repayments of $3.0 million on the term loan and net repayments on the revolving credit lines of $7.6 million. +On June 11, 2019, the Company entered into a Second Amended and Restated Credit Agreement (the “Credit Facility”). The Credit Facility amended and restated the Company’s prior credit agreement. Pursuant to the Credit Facility, the lenders provided a term loan in the aggregate principal amount of $50.0 million and the lenders increased their senior secured revolving credit commitments to the aggregate principal amount of $140.0 million. This revolving credit commitment allows the Company the ability +30 +to borrow loans denominated in different currencies. Additionally, the Credit Facility extended the maturity date to June 11, 2024, reduced interest rates, and redefined certain financial covenan ts. +Under the terms of the Credit Facility, the Company is required to maintain certain financial covenants, including the maintenance of a Consolidated Net Leverage Ratio (as defined in the Credit Facility). Through September 30, 2020, the maximum Consolidated Net Leverage Ratio is 3.75, after which time it will decrease to 3.50 through September 30, 2021. The Consolidated Net Leverage Ratio will then decrease to 3.25 until the end of the term of the Credit Facility. +As of December 31, 2019 and 2018, the Company was in compliance with all related financial and other restrictive covenants under the Credit Facility. +Foreign Debt +In addition, the Company has a number of bank guarantee facilities and bilateral lines of credit in various foreign countries currently supported by cash, letters of credit or pledged assets and collateral under the Credit Facility. The Credit Facility allows letters of credit and bank guarantee issuances of up to $50.0 million from the bilateral lines of credit secured by pledged assets and collateral under the Credit Facility. +See Note 9 to the Consolidated Financial Statements for further information on the Company’s foreign debt. +Total unused credit availability under our Credit Facility and other non-U.S. credit facilities and agreements, exclusive of any potential asset base limitations, is as follows: +December 31, +2019 +2018 +(dollars in millions) +Credit Facility, revolving loans +$ +140.0 +$ +80.0 +Draw down +(18.5 +) +— +Letters of credit open +(11.0 +) +(29.3 +) +Total unused credit availability +$ +110.5 +$ +50.7 +Amount available based on borrowing limitations +$ +82.3 +$ +50.7 +Overview of Cash Flows and Liquidity +For the year ended December 31, +(dollars in thousands) +2019 +2018 +2017 +Total operating cash flow provided by operating activities +$ +10,227 +$ +21,952 +$ +6,570 +Net cash (used in) provided by investing activities +(5,146 +) +38,258 +(660 +) +Net cash used in financing activities +(12,116 +) +(44,900 +) +(24,138 +) +Effect of exchange rate changes on cash, cash equivalents and restricted cash +(445 +) +(1,531 +) +881 +Net (decrease) increase in cash, cash equivalents and restricted cash +$ +(7,480 +) +$ +13,779 +$ +(17,347 +) +Operating Activities +In 2019, $10.2 million of cash was provided by operating activities compared with $22.0 million provided in 2018, a decrease of $11.8 million . Net earnings, adjusted for non-cash items (depreciation and amortization, unrealized foreign currency (gain) loss, loss on divestitures and share based compensation) increased $16.0 million year-over-year. Cash flow from operating activities in 2019 had a negative year-over-year net impact due to greater working capital primarily from increases in accounts receivable and costs in excess of billings and decreases in other liabilities as reflected in the Consolidated Statement of Cash Flows. +In 2018, $22.0 million of cash was provided by operating activities compared with $6.6 million provided in 2017, an increase of $15.4 million. Net earnings, adjusted for non-cash items (depreciation and amortization, unrealized foreign currency (gain) loss, impairment of intangible assets and goodwill, loss on divestitures and share based compensation) decreased $5.3 million year-over-year. Cash flow from operating activities in 2018 had a favorable year-over-year net impact of working capital balances as reflected in the Consolidated Statement of Cash Flows. In addition, Zhongli earnout payments, classified as operating activities, were $2.9 million in 2018 and $7.8 million in 2017. +31 +Investing Activities +In 2019, $5.1 million of cash was used in investing activities, which consisted of $5.7 million of acquisition of property and equipment offset by $0.5 million of proceeds from disposals of assets held for sale. +In 2018, $38.3 million of cash was provided by investing activities, which primarily consisted of $35.1 million of proceeds from divestitures, $6.3 million of proceeds from the disposal of assets held for sale, offset by $3.1 million of acquisition of property and equipment. Of the proceeds from the Divestitures, $29.2 million was used to pay down the Credit Facility. +Financing Activities +Financing activities in 2019 used cash of $12.1 million, which consisted primarily of $3.0 million of payments on our term loan, $7.6 million net payments on our revolving credit lines, and $1.1 million payment of financing fees related to the refinancing of our Credit Facility. +Financing activities in 2018 used cash of $44.9 million, which consisted primarily of $41.4 million of payments on our term loan and $3.7 million net payments on our revolving credit lines. +We believe that cash flows from operating activities, together with our existing cash and borrowings available under our Credit Facility, will be sufficient for at least the next twelve months to fund our current anticipated uses of cash. After that, our ability to fund these expected uses of cash and to comply with the financial covenants under our debt agreements will depend on the results of future operations, performance and cash flow. Our ability to fund these expected uses from the results of future operations will be subject to prevailing economic conditions and to financial, business, regulatory, legislative and other factors, many of which are beyond our control. +Employee Benefit Obligation +Based on current assumptions, estimated contributions to our pension plan of $1.5 million are required in 2020. The amount and timing of required contributions to the pension trust depends on future investment performance of the pension funds and interest rate movements, among other things and, accordingly, we cannot reasonably estimate actual required payments. Currently, our pension plan is under-funded. As a result, absent major increases in long-term interest rates, above average returns on pension assets and/or changes in legislated funding requirements, we will be required to make contributions to our pension trust of varying amounts in future years. +Off-Balance Sheet Arrangements +None. +32 +Contractual Obligations +The following table summarizes the Company’s contractual obligations as of December 31, 2019: +Payments Due by Period +(dollars in thousands) +Total +Less than 1 +year +1-3 years +3-5 years +More than +5 years +Term Loan Debt +$ +48,750 +$ +2,500 +$ +6,800 +$ +39,450 +$ +— +Revolving Credit Loan +18,500 +— +— +18,500 +— +Interest expense (estimated) +10,548 +2,490 +4,635 +3,423 +— +Unconditional purchase obligations (1) +75,183 +75,183 +— +— +— +Pension obligations (2) +4,339 +1,538 +1,703 +1,098 +— +Operating lease obligations +16,552 +3,161 +4,859 +3,722 +4,810 +Capital lease obligations +9,932 +855 +1,761 +1,832 +5,484 +Totals +$ +183,804 +$ +85,727 +$ +19,758 +$ +68,025 +$ +10,294 +( 1 ) +Primarily consists of purchase obligations for costs associated with uncompleted sales contracts. +(2 ) +Future expected obligations under the Company’s pension plan is included in the contractual cash obligations table above, up to, but not more than five years. The Company’s pension plan policy allows it to fund an amount, which could be in excess of the pension cost expensed, subject to the limitations imposed by current tax regulations. +Critical Accounting Policies and Estimates +Our consolidated financial statements are prepared in conformity with GAAP. The preparation of these financial statements requires the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. We believe that, of our significant accounting policies, the following accounting policies involve a higher degree of judgments, estimates, and complexity. +Use of Estimates +Preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses and related contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to revenues, bad debts, warranties, share based compensation, income taxes, goodwill and intangible asset valuation, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. +Revenue Recognition +A substantial portion of our revenue is derived from fixed-price contracts. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. +We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +The judgments and estimates involved include management’s ability to accurately estimate the contracts’ progress to completion at each financial reporting period. In addition, certain contracts are highly dependent on the work of contractors and other subcontractors participating in a project, over which we have no or limited control, and their performance on such project could have an adverse effect on the profitability of our contracts. Delays resulting from these contractors and subcontractors, changes in the scope of the project, weather, and labor availability also can have an effect on a contract’s profitability. Changes to job performance, job conditions, and estimated profitability may result in revisions to contract revenue and costs and are recognized in the period in which the revisions are made. +33 +Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. No provision for estim ated losses on uncompleted contracts was needed at December 31, 201 9 , 201 8 and 201 7 . +Credit and Collections +The Company maintains allowances for doubtful accounts receivable for probable estimated losses resulting from either customer disputes or the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in their inability to make the required payments, the Company may be required to record additional allowances or charges against income. The Company determines its allowance for doubtful accounts by considering all known collectability problems of customers’ accounts and reviewing the aging of the outstanding receivables. The resulting allowance for doubtful accounts receivable is an estimate based upon the Company’s knowledge of its business and customer base, and historical trends. The amount ultimately not collected may differ from the reserve established. +Inventories +The Company’s inventories are valued at the lower of cost or net realizable value using the first-in, first-out inventory costing method. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the Company’s forecast of future demand and market conditions. Significant unanticipated changes to the Company’s forecasts could require a change in the provision for excess or obsolete inventory. +Assets Held for Sale +The Company classifies properties as held for sale when certain criteria are met. At such time, the properties, including significant assets that are expected to be transferred as part of a sale transaction, are presented separately on the consolidated balance sheet at the lower of carrying value or estimated fair value less costs to sell and depreciation is no longer recognized. As of December 31, 2019, the Company had one tract of land classified as held for sale. +Property, plant and equipment +Property, plant and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Depreciation and amortization are provided using the straight-line method in amounts sufficient to amortize the cost of the assets over their estimated useful lives (buildings and improvements—generally five to 40 years; machinery and equipment—generally two to 15 years). +Intangible assets +Indefinite life intangible assets are comprised of tradenames, while finite life intangible assets are comprised of technology, customer lists, noncompetition agreements, and tradenames. Finite life intangible assets are amortized on a straight line or accelerated basis over their estimated useful lives of seven to 10 years for technology, five to 20 years for customer lists, five years for noncompetition agreements, and 10 years for tradenames. +Long-lived assets +Property, plant and equipment and finite life intangible assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. If events or changes in circumstances occur that indicate possible impairment, our impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely independent of other groups of our assets and liabilities. This analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. We conduct annual reviews for idle and underutilized equipment, and review business plans for possible impairment. Impairment occurs when the carrying value of the assets exceeds the future undiscounted cash flows expected to be earned by the use of the asset or asset group. When impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset or asset group and an impairment charge is recorded for the difference between the carrying value and the estimated fair value. +Additionally, we also evaluate the remaining useful life each reporting period to determine whether events and circumstances warrant a revision to the remaining period of depreciation or amortization. If the estimate of a long-lived asset’s remaining useful life is changed, the remaining carrying amount of the asset is amortized prospectively over that revised remaining useful life. +34 +The Company completes an annual (or more often if circumstances require) impairment assessment of its indefinite life intangible assets. As a part of its annual assessment, typically, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of an asset is less than its carrying amount. If there is a qualitative determination that the fair value of a particular asset is more likely than not greater than its carrying value, we do not need to proceed to the quantitative estimated fair value test for that asset. If this qualitative assessment i ndicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined by the relief from royalty method. If the estimated fair value of an asset is less than its carrying value, an impairment charge is recorded for the amount by which the carrying value of the asset exceeds its estimated fair value. For additional information on impairment testing results, see Note 7 to the C onsolidated F inancial S tatements. +Goodwill +The Company completes an annual (or more often if circumstances require) goodwill impairment assessment on October 1 on a reporting unit level, at or below the operating segment level. As a part of its annual assessment, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If there is a qualitative determination that the fair value of a particular reporting unit is more likely than not greater than its carrying value, the Company does not need to quantitatively test for goodwill impairment for that reporting unit. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is calculated using a weighting of the income method and the market method. If the estimated fair value of a reporting unit is less than its carrying value, an impairment charge is recorded. +The Company bases its measurement of the fair value of a reporting unit using a 50/50 weighting of the income method and the market method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital. Projected revenue, projected operational profit and terminal growth rates are significant assumptions because they are three primary drivers of the projected cash flows in the discounted future cash flow approach. Cost of capital is a significant assumption as it is the discount rate used to calculate the current fair value of those projected cash flows. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. Based on the analysis, the resultant estimated fair value of all of the reporting units exceeded their carrying value as of December 31, 2019. For additional information on goodwill impairment testing results, see Note 7 to the Consolidated Financial Statements. +Income Taxes +Income taxes are determined using the asset and liability method of accounting for income taxes in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 740, “Income Taxes”. Income tax expense includes federal, state and foreign income taxes. +Deferred income taxes are provided using the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases and are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Tax credits and other incentives reduce income tax expense in the year the credits are claimed. +Management must assess the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal, state and foreign tax authorities who regularly audit the Company in the normal course of business. In making these assessments, management must often analyze complex tax laws of multiple jurisdictions, including many foreign jurisdictions. The accounting guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. +Management must access the realizability of the Company’s deferred tax assets. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this +35 +assessment. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The Company has made an accounting policy election to record the U.S. income tax effect of future global intangible low-taxed income (“GILTI”) inclusions in the period in which they arise, rather than establishing deferred taxes with respect to the expected future tax liabilities associated with future GILTI inclusion. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested. A liability has been recorded for the deferred taxes on such undistributed foreign earnings. The amount is attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +Pension Benefit Plan Assumptions +We sponsor a pension plan for certain employees. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense and liability related to the plan. These factors include key assumptions, such as a discount rate and expected return on plan assets. In addition, our actuarial consultants use subjective factors such as withdrawal and mortality rates to estimate the liability. The actuarial assumptions we use may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of participants. These differences may result in a significant impact to the amount of pension expense we have recorded or may record in the future. An analysis for the expense associated with our pension plan is difficult due to the variety of assumptions utilized. For example, one of the significant assumptions used to determine projected benefit obligation i s the discount rate. At December 31, 2019, a 25 basis point change in the discount rate would change the projected benefit obligation by approximately $1.0 million and the annual pension expense by approximately $10,000. Additionally, a 25 basis point change in the expected return on plan assets would change the pension expense by approximately $67,000. +Share-Based Compensation +We measure the cost of employee services received in exchange for an award of equity instruments and recognize this cost over the period during which an employee is required to provide the services, based on the fair value of the award at the date of the grant as determined by current publicly traded market price on the grant date for restricted stock units. +Certain of our awards of restricted share units include performance conditions for achieving designated levels of operating performance. We must estimate the probability of achieving the performance condition at each reporting period. +Product Warranties +The Company’s warranty reserve is to cover the products sold. The warranty accrual is based on historical claims information. The warranty reserve is reviewed and adjusted as necessary at each reporting period. +Other significant accounting policies +Other significant accounting policies, not involving the same level of uncertainties as those discussed above, are nevertheless important to an understanding of our financial statements. See Note 1 to the Consolidated Financial Statements, Summary of Significant Accounting Policies, which discusses accounting policies that must be selected by us when there are acceptable alternatives. +New Accounting Pronouncements +For information regarding recent accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this annual report on Form 10-K. +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +We are exposed to certain market risks, primarily changes in interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. For the Company, these exposures are primarily related to changes in interest rates. We do not currently hold any derivatives or other financial instruments purely for trading or speculative purposes. +36 +The carrying value of the Company’s total long-term debt and current maturities of lon g-term debt at December 31, 201 9 was $ 65 . 5 million. Market risk was estimated as the potential decrease (increase) in future earnings and cash flows resulting from a hypothetical 10% increase (decrease) in the Company’s estimated weighted average borrowing rate at December 31, 201 9 . Most of the interest on the Company’s debt is indexed to either the LIBOR or EURIBOR market rates. The estimated annual impact of a hypothetical 10% change in the estimated weighted average borrowing rate at December 31, 201 9 is $ 0.2 million. +The Company has wholly-owned subsidiaries in several countries, including in the Netherlands, Canada, the People’s Republic of China, Mexico, United Kingdom, Singapore, Shanghai, Pune India, Dubai and Chile. In the past, we have not hedged our foreign currency exposure, and fluctuations in exchange rates have not materially affected our operating results. Future changes in exchange rates may positively or negatively impact our revenues, operating expenses and earnings. Since most of our foreign sales are denominated in the local currency, we do not anticipate that exposure to foreign currency rate fluctuations will be material in 2020. +37 +Item 8. +Financial Stateme nts and Supplementary Data +The Consolidated Financial Statements of CECO Environmental Corp. and subsidiaries for the years ended December 31, 2019, 2018 and 2017 and other data are included in this report following the signature page of this report and incorporated into this Item 8 by reference: +Report of Independent Registered Public Accounting Firm +F-1 +Consolidated Balance Sheets +F-2 +Consolidated Statements of Operations +F-3 +Consolidated Statements of Comprehensive Income (Loss) +F-4 +Consolidated Statements of Shareholders’ Equity +F-5 +Accumulated Other Comprehensive Loss +F-6 +Consolidated Statements of Cash Flows +F-7 +Notes to Consolidated Financial Statements for the Years Ended December 31, 2019, 2018 and 2017 +F-8 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. +Controls and Procedures +Disclosure Controls and Procedures +Disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) are controls and other procedures that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and made known to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +In connection with the preparation of this Annual Report on Form 10-K, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2019. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2019. +The management of the Company does not expect that its disclosure controls and procedures will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur due to simple errors or mistakes. The design of any system of controls is based in part upon certain assumptions regarding the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. +Management’s Report on Internal Control over Financial Reporting +The management of the Company is responsible for the preparation and accuracy of the financial statements and other information included in this report. Under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2019, based on the criteria set forth in Internal Control – Integrated Framework (2013) (the “Framework”) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management concluded that, as of December 31, 2019, its internal control over financial reporting was effective based on the Framework. +There are inherent limitations on the effectiveness of any system of internal controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective internal controls and procedures can only provide reasonable assurance of achieving their control objectives. +38 +Item 9A includes the audit report of BDO USA, LLP on the Company ’s internal control over financial reporting as of December 31, 201 9 . +Changes in Internal Control Over Financial Reporting +There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the fiscal quarter ended December 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +39 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +CECO Environmental Corp. and Subsidiaries +Cincinnati, Ohio +Opinion on Internal Control over Financial Reporting +We have audited CECO Environmental Corp. and Subsidiaries’ (the “Company’s”) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria . +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and our report dated March 4, 2020, expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ BDO USA, LLP +Cincinnati, Ohio +March 4, 2020 +40 +Item 9B. +Othe r Information +None. +41 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +The information called for by this Item 10 of Part III of Form 10-K is incorporated by reference to the information set forth in our definitive proxy statement relating to our 2020 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A under the Exchange Act within 120 days from December 31, 2019 (the “Proxy Statement”). Reference is also made to the information appearing in Item 1 of Part I of this Annual Report on Form 10-K under the caption “Business— Executive Officers of CECO.” +Item 11. +Executive Compensation +The information called for by this Item 11 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +The information called for by this Item 12 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Securities Authorized for Issuance Under Equity Compensation Plans +EQUITY COMPENSATION PLAN INFORMATION +December 31, 2019 +(a) +(b) +(c) +Plan Category +Number of securities +to be issued upon +exercise of outstanding +options and rights +Weighted-average +exercise price of +outstanding options and rights, compensation plans +Number of securities +remaining available for +future issuance under +equity compensation +plans (excluding +securities reflected in +column (a)) +Equity compensation plans approved by security +holders +2007 Equity Incentive Plan 1 +420,755 +$ 9.98 +— +2017 Equity and Incentive Plan 2 +1,399,806 +$ 0.46 +917,823 +Employee Stock Purchase Plan 3 +— +$ — +1,303,366 +Equity compensation plans not approved by security holders +— +$ — +— +TOTAL +1,820,561 +2,221,189 +1 +The 2007 Plan was replaced with the 2017 Equity and Incentive Plan and no further grants will be made under the 2007 Plan. The 2007 Plan remains in effect solely for the continued administration of the awards currently outstanding under the 2007 Plan. +2 +The 2017 Equity and Incentive Plan was approved by our shareholders on May 16, 2017. We have reserved 1.9 million shares of our common stock for issuance under our 2017 Equity Incentive Plan. In 2019, 464,000 restricted stock units were awarded to plan participants under the 2017 Equity and Incentive Plan. +3 +The Employee Stock Purchase Plan was approved by our shareholders on May 21, 2009 and which expired in accordance with the terms thereof on May 31, 2019. +Item 13. +Certain Relationships and Related Transactions, and Director Independence +The information called for by this Item 13 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Item 14. +Principal Accounting Fees and Services +The information called for by this Item 14 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +PART IV +Item 15. +Exhibits and Financial Statement Schedules +1. Financial statements are set forth in this report following the signature page of this report. +42 +2. Financial statement schedules are omitted because they are not applicable or because the required information is shown in the financial s tatements or in the notes thereto. +3. Exhibit Index. The exhibits listed below, as part of Form 10-K, are numbered in conformity with the numbering used in Item 601 of Regulation S-K and relate to SEC File No. 0-07099, unless otherwise indicated. +Exhibit +Number +3(i) +Certificate of Incorporation (Incorporated by reference to Exhibit 3(i) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001) +3(ii) +Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 13, 2017) +*4.1 +Description of Securities +**10.1 +Summary term sheet governing arrangement of consulting services provided by Icarus Investment Corp. (Incorporated by reference to Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018) +**10.2 +Second Amended and Restated CECO Environmental Corp. 2007 Equity Incentive Plan (Incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +**10.3 +Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010) +**10.4 +Form of Non-Statutory Stock Option Agreement (Incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010) +**10.5 +Summary term sheet governing arrangement of consulting services provided by JMP Fam Holdings Inc. to the Company (Incorporated by reference to Exhibit 10.7 to the Company’s Annual Report on From 10-K for the fiscal year ended December 31, 2018) +10.6 +Securities Pledge Agreement, dated August 27, 2013, by and among the Company, the Subsidiaries named therein and Bank of America, N.A., as Administrative Agent (Incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +**10.7 +Director and Officer Indemnification Agreement, dated as of May 12, 2016, by and between the Company and the Directors and Officers of the Company (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on May 16, 2016) +**10.8 +Executive Employment Agreement, effective as of January 9, 2017, by and between the Company and Matthew Eckl (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2017) +**10.9 +Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.10 +Form of Nonqualified Stock Option Agreement (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.11 +Form of Restricted Stock Units Agreement for Directors (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.12 +Form of Restricted Stock Units Agreement for Employees (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.13 +Executive Employment Agreement, dated as of June 10, 2017, between the Company and Dennis Sadlowski (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on June 12, 2017) +**10.14 +CECO Environmental Corp. 2017 Equity and Incentive Compensation Plan (Incorporated by reference to Exhibit 4.3 to the Registrant’s Registration Statement on Form S-8 filed on May 16, 2017 (Registration No. 333-218030)) +43 +Exhibit +Number +10. 1 5 +Amendment No. 1 to Amended and Restated Credit Agreement (Incorporated by reference to Exhibit 10.26 to the Company’s Report on Form 10-K filed with the SEC on March 9, 2018) +10.16 +Second Amended and Restated Credit Agreement, dated as of June 11, 2019, among CECO Environmental Corp. and certain of its subsidiaries, the Lenders party thereto, and Bank of America, N.A. (Incorporated by reference to Exhibit 10.1 to the Company’s Current report on Form 8-K filed with the SEC on June 12, 2019) +*21 +Subsidiaries of the Company +*23.1 +Consent of BDO USA, LLP +*31.1 +Rule 13(a)/15d-14(a) Certification by Chief Executive Officer +*31.2 +Rule 13(a)/15d-14(a) Certification by Chief Financial Officer +*32.1 +Certification of Chief Executive Officer (18 U.S. Section 1350) +*32.2 +Certification of Chief Financial Officer (18 U.S. Section 1350) +*101.INS +XBRL Instance Document +*101.SCH +XBRL Taxonomy Extension Schema Document +*101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +*101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +*101.LAB +XBRL Taxonomy Extension Label Linkbase Document +*101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* Filed or furnished herewith +** +Management contracts or compensation plans or arrangement +Item 16. +Form 10-K Summary +Not applicable. +44 +SIGNAT URES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +CECO ENVIRONMENTAL CORP. +By: +/S/ M ATTHEW E CKL +Matthew Eckl +Chief Financial Officer +March 4, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: +Principal Executive Officer: +/S/ D ENNIS S ADLOWSKI +March 4, 2020 +Dennis Sadlowski +Chief Executive Officer and Director +Principal Financial Officer: +/S/ M ATTHEW E CKL +March 4, 2020 +Matthew Eckl +Chief Financial Officer +Principal Accounting Officer: +/S/ P AUL G OHR +March 4, 2020 +Paul Gohr +Chief Accounting Officer +Directors: +/S/ J ASON D EZWIREK +March 4, 2020 +Jason DeZwirek +Chairman of the Board and Director +/S/ E RIC M. G OLDBERG +March 4, 2020 +Eric M. Goldberg +Director +/S/ D AVID B . L INER +March 4, 2020 +David B. Liner +Director +/S/ C LAUDIO A. M ANNARINO +March 4, 2020 +Claudio A. Mannarino +Director +/S/ M UNISH N ANDA +March 4, 2020 +Munish Nanda +Director +/S/ J ONATHAN P OLLACK +March 4, 2020 +Jonathan Pollack +Director +/S/ V ALERIE G ENTILE S ACHS +March 4, 2020 +Valerie Gentile Sachs +Director +45 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED FINANCIAL STATEMENTS +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +CECO Environmental Corp. and Subsidiaries +Cincinnati, Ohio +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of CECO Environmental Corp. and Subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2019 , in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated March 4, 2020 expressed an unqualified opinion thereon. +Change in Accounting Principle +As discussed in Notes 1 and 12 to the consolidated financial statements, the Company has changed its method of accounting for leases in 2019 due to the adoption of Accounting Standards Codification Topic 842, Leases . +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ BDO USA, LLP +We have served as the Company's auditor since 2008. +Cincinnati, Ohio +March 4, 2020 +F-1 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +December 31, +(dollars in thousands, except share data) +2019 +2018 +ASSETS +Current assets: +Cash and cash equivalents +$ +35,602 +$ +43,676 +Restricted cash +1,356 +762 +Accounts receivable, net +68,434 +53,225 +Costs and estimated earnings in excess of billings on uncompleted contracts +34,805 +29,694 +Inventories, net +20,578 +20,817 +Prepaid expenses and other current assets +9,899 +10,117 +Prepaid and refundable income taxes +8,231 +1,388 +Assets held for sale +593 +1,186 +Total current assets +179,498 +160,865 +Property, plant and equipment, net +15,274 +22,200 +Right-of-use assets from operating leases (Note 12) +13,607 +— +Goodwill +152,020 +152,156 +Intangible assets – finite life, net +31,283 +35,959 +Intangible assets – indefinite life +14,291 +18,258 +Deferred charges and other assets +2,664 +3,144 +Total assets +$ +408,637 +$ +392,582 +LIABILITIES AND SHAREHOLDERS’ EQUITY +Current liabilities: +Current portion of debt +$ +2,500 +$ +— +Accounts payable and accrued expenses +78,319 +80,229 +Billings in excess of costs and estimated earnings on uncompleted contracts +34,369 +20,144 +Note payable +— +1,700 +Income taxes payable +— +1,813 +Total current liabilities +115,188 +103,886 +Other liabilities +20,372 +26,925 +Debt, less current portion +63,001 +74,456 +Deferred income tax liability, net +5,943 +8,755 +Operating lease liabilities (Note 12) +11,116 +— +Total liabilities +215,620 +214,022 +Commitments and contingencies +Shareholders’ equity: +Preferred stock, $.01 par value; 10,000 shares authorized, none issued +— +— +Common stock, $.01 par value; 100,000,000 shares authorized, 35,275,465 and +34,953,825 shares issued and outstanding at December 31, 2019 +and 2018, respectively +353 +349 +Capital in excess of par value +253,869 +251,409 +Accumulated loss +(46,344 +) +(59,427 +) +Accumulated other comprehensive loss +(14,505 +) +(13,415 +) +193,373 +178,916 +Less treasury stock, at cost, 137,920 shares at December 31, 2019 and 2018 +(356 +) +(356 +) +Total shareholders’ equity +193,017 +178,560 +Total liabilities and shareholders’ equity +$ +408,637 +$ +392,582 +The notes to consolidated financial statements are an integral part of the above statements. +F-2 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +Year Ended December 31, +(dollars in thousands, except share and per share data) +2019 +2018 +2017 +Net sales +$ +341,869 +$ +337,339 +$ +345,051 +Cost of sales +227,770 +225,802 +231,857 +Gross profit +114,099 +111,537 +113,194 +Selling and administrative expenses +85,978 +87,462 +88,975 +Amortization and earnout expenses +8,499 +9,683 +7,132 +Restructuring expenses, net +1,097 +— +1,895 +Acquisition and integration expenses +465 +— +— +Loss on divestitures, net of selling costs +70 +4,390 +— +Intangible asset and goodwill impairment +— +— +7,168 +Income from operations +17,990 +10,002 +8,024 +Other income (expense), net +751 +(365 +) +106 +Interest expense +(5,397 +) +(7,140 +) +(6,721 +) +Income before income taxes +13,344 +2,497 +1,409 +Income tax (benefit) expense +(4,363 +) +9,618 +4,438 +Net income (loss) +$ +17,707 +$ +(7,121 +) +$ +(3,029 +) +Income (loss) per share: +Basic +$ +0.51 +$ +(0.21 +) +$ +(0.09 +) +Diluted +$ +0.50 +$ +(0.21 +) +$ +(0.09 +) +Weighted average number of common shares outstanding: +Basic +34,987,878 +34,714,395 +34,445,256 +Diluted +35,484,273 +34,714,395 +34,445,256 +The notes to consolidated financial statements are an integral part of the above statements. +F-3 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +Year Ended December 31, +(dollars in thousands) +2019 +2018 +2017 +Net income (loss) +$ +17,707 +$ +(7,121 +) +$ +(3,029 +) +Other comprehensive income (loss), net of tax: +Translation (loss) income +(343 +) +(3,858 +) +4,021 +Interest rate swap +(574 +) +76 +180 +Minimum pension liability adjustment +(184 +) +(22 +) +(78 +) +Comprehensive income (loss) +$ +16,606 +$ +(10,925 +) +$ +1,094 +The notes to consolidated financial statements are an integral part of the above statements. +F-4 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +Accumulated +Capital in +Other +Total +Common Stock +excess of +Accumulated +Comprehensive +Treasury Stock +Shareholders' +(in thousands) +Shares +Amount +par value +Loss +Loss +Shares +Amount +Equity +Balance January 1, 2017 +34,300 +$ +343 +$ +244,878 +$ +(41,741 +) +$ +(13,042 +) +(138 +) +$ +(356 +) +$ +190,082 +Net loss for the year ended December 31, 2017 +(3,029 +) +(3,029 +) +Cumulative effect adjustment adopting ASU 2016-09 +177 +(111 +) +66 +Common stock dividends +(7,792 +) +(7,792 +) +Exercise of stock options and dividend reinvestment issuances +291 +3 +1,292 +1,295 +Restricted stock units issued +92 +1 +(136 +) +(135 +) +Share based compensation earned +25 +— +1,959 +1,959 +Adjustment for minimum pension liability, net of tax of $48 +(78 +) +(78 +) +Adjustment for interest rate swap net of tax of $103 +180 +180 +Translation income +4,021 +4,021 +Balance December 31, 2017 +34,708 +347 +248,170 +(52,673 +) +(8,919 +) +(138 +) +(356 +) +186,569 +Net loss for the year ended December 31, 2018 +(7,121 +) +(7,121 +) +Cumulative effect adjustment of adopting ASU 2018-02 +1,037 +(1,067 +) +(30 +) +Cumulative effect adjustment of adopting ASU 2014-09 +(622 +) +(622 +) +Cumulative translation adjustment for divestiture +375 +375 +Exercise of stock options and dividend reinvestment issuances +16 +— +89 +89 +Restricted stock units issued +192 +2 +(207 +) +(48 +) +(253 +) +Share based compensation earned +38 +— +3,357 +3,357 +Adjustment for minimum pension liability, net of tax of $17 +(22 +) +(22 +) +Adjustment for interest rate swap, net of tax of $111 +76 +76 +Translation loss +(3,858 +) +(3,858 +) +Balance December 31, 2018 +34,954 +349 +251,409 +(59,427 +) +(13,415 +) +(138 +) +(356 +) +178,560 +Net income for the year ended December 31, 2019 +17,707 +17,707 +Cumulative effect adjustment of adopting ASU 2017-12 (See Note 1) +(11 +) +11 +— +Cumulative effect adjustment of adopting ASU 2016-02 (See Note 1) +(4,590 +) +(4,590 +) +Exercise of stock options and dividend reinvestment issuances +31 +— +— +— +Restricted stock units issued +255 +3 +(427 +) +(23 +) +(447 +) +Share based compensation earned +35 +1 +2,887 +2,888 +Adjustment for minimum pension liability, net of tax of $66 +(184 +) +(184 +) +Adjustment for interest rate swap, net of tax of $236 +(574 +) +(574 +) +Translation loss +(343 +) +(343 +) +Balance December 31, 2019 +35,275 +$ +353 +$ +253,869 +$ +(46,344 +) +$ +(14,505 +) +(138 +) +$ +(356 +) +$ +193,017 +The notes to consolidated financial statements are an integral part of the above statements. +F-5 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +ACCUMULATED OTHER COMPREHENSIVE LOSS +(dollars in thousands) +Translation +loss +Interest rate swap adjustment +Minimum pension +liability +adjustment +Accumulated other +comprehensive loss +January 1, 2017 +$ +(8,271 +) +$ +312 +$ +(5,083 +) +$ +(13,042 +) +2017 activity +4,021 +180 +(78 +) +4,123 +Balance December 31, 2017 +(4,250 +) +492 +(5,161 +) +(8,919 +) +Cumulative effect adjustment adopting ASU 2018-02 +— +(5 +) +(1,062 +) +(1,067 +) +Cumulative translation adjustment for divestiture +375 +— +— +375 +2018 activity +(3,858 +) +76 +(22 +) +(3,804 +) +Balance December 31, 2018 +(7,733 +) +563 +(6,245 +) +(13,415 +) +Cumulative effect adjustment adopting ASU 2017-12 (See Note 1) +— +11 +— +11 +2019 activity +(343 +) +(574 +) +(184 +) +(1,101 +) +Balance December 31, 2019 +$ +(8,076 +) +$ +— +$ +(6,429 +) +$ +(14,505 +) +The notes to consolidated financial statements are an integral part of the above statements. +F-6 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +Year Ended December 31, +(dollars in thousands) +2019 +2018 +2017 +Cash flows from operating activities: +Net income (loss) +$ +17,707 +$ +(7,121 +) +$ +(3,029 +) +Adjustments to reconcile net income (loss) to net cash provided by +operating activities: +Depreciation and amortization +10,609 +13,272 +16,088 +Unrealized foreign currency (gain) loss +(526 +) +836 +(2,103 +) +Net gain on interest rate swaps +(248 +) +(276 +) +(327 +) +Impairment of property and equipment +— +300 +695 +Impairment of intangible assets and goodwill +— +— +7,168 +Fair value adjustments to earnout liabilities +— +(330 +) +(6,610 +) +Earnout payments +— +(2,862 +) +(7,797 +) +Loss on sale of property and equipment +78 +(217 +) +130 +Loss on divestitures +70 +4,390 +— +Amortization of debt discount +1,060 +1,143 +1,033 +Share based compensation expense +2,668 +3,187 +1,768 +Bad debt expense +295 +1,357 +3,895 +Inventory reserve expense +316 +519 +240 +Deferred income tax benefit +(940 +) +(42 +) +(3,123 +) +Changes in operating assets and liabilities, net of divestitures: +— +Accounts receivable +(15,616 +) +(6,084 +) +14,107 +Cost and estimated earnings of billings on uncompleted contracts +(5,029 +) +(4,557 +) +6,232 +Inventories +(207 +) +(1,704 +) +887 +Prepaid expenses and other current assets +(7,097 +) +773 +3,530 +Deferred charges and other assets +758 +(416 +) +1,585 +Accounts payable and accrued expenses +(4,028 +) +21,321 +(15,847 +) +Billings in excess of costs and estimated earnings on uncompleted contracts +14,274 +70 +(15,186 +) +Income taxes payable +(1,671 +) +1,839 +(1,827 +) +Other liabilities +(2,246 +) +(3,446 +) +5,061 +Net cash provided by operating activities +10,227 +21,952 +6,570 +Cash flows from investing activities: +Acquisitions of property and equipment +(5,655 +) +(3,090 +) +(1,028 +) +Net cash proceeds from divestitures +— +35,052 +— +Net proceeds from sale of assets +509 +6,296 +368 +Net cash (used in) provided by investing activities +(5,146 +) +38,258 +(660 +) +Cash flows from financing activities: +Net (repayments) borrowings on revolving credit lines +(7,647 +) +(3,723 +) +2,269 +Repayments of long-term debt +(2,950 +) +(41,356 +) +(11,168 +) +Deferred financing fees paid +(1,117 +) +— +(692 +) +Earnout payments +— +— +(7,396 +) +Proceeds from sale-leaseback transactions +— +800 +— +Payments on capital leases and sale-leaseback financing liability +(478 +) +(675 +) +(711 +) +Proceeds from employee stock purchase plan, exercise of stock options, +and dividend reinvestment plan +76 +54 +1,352 +Dividends paid to common shareholders +— +— +(7,792 +) +Net cash used in financing activities +(12,116 +) +(44,900 +) +(24,138 +) +Effect of exchange rate changes on cash and cash equivalents +(445 +) +(1,531 +) +881 +Net (decrease) increase in cash, cash equivalents and restricted cash +(7,480 +) +13,779 +(17,347 +) +Cash, cash equivalents and restricted cash at beginning of year +44,438 +30,659 +48,006 +Cash, cash equivalents and restricted cash at end of year +$ +36,958 +$ +44,438 +$ +30,659 +Cash paid during the period for: +Interest +$ +3,549 +$ +5,559 +$ +5,686 +Income taxes +$ +5,908 +$ +10,205 +$ +3,048 +The notes to consolidated financial statements are an integral part of the above statements. +F-7 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +For the Years Ended December 31, 2019, 2018 and 2017 +1. +Nature of Business and Summary of Significant Accounting Policies +Nature of business — CECO Environmental Corp. and its consolidated subsidiaries (“CECO,” the “Company,” “we,” “us,” or “our”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. CECO serves both established and emerging industries in regions around the world working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in multiple applications that include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +Principles of consolidation —Our consolidated financial statements include the Company and its controlled subsidiaries. All intercompany balances and transactions have been eliminated. +Unless indicated, all balances within tables are in thousands except per share amounts. +Use of estimates —The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +Cash equivalents —We consider all highly liquid investments with original maturities of three months or less to be cash equivalents. At December 31, 2019 and 2018, Restricted Cash is cash in support of letters of credit issued by various foreign subsidiaries of the Company. The Company occasionally enters into letters of credit with durations in excess of one year. +The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the Consolidated Statements of Cash Flows. +December 31, +2019 +2018 +Cash and cash equivalents +$ +35,602 +$ +43,676 +Restricted cash +1,356 +$ +762 +Total cash, cash equivalents and restricted cash +$ +36,958 +$ +44,438 +Accounts Receivable —Receivables are generally uncollateralized customer obligations due under normal terms requiring payment generally within 30 days from the invoice date unless otherwise determined by specific contract terms, generally due to retainage provisions. The Company’s estimate of the allowance for doubtful accounts for trade receivables is primarily determined based upon the length of time that the receivables are past due. In addition, management estimates are used to determine probable losses based upon an analysis of prior collection experience, specific account risks and economic conditions. Accounts are deemed uncollectible based on past account experience and the current financial condition of the account. +Inventories —The Company’s inventory is valued at the lower of cost or net realizable value, using the first-in, first-out inventory costing method. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded based on the Company’s forecast of future demand and market conditions. Significant unanticipated changes to the Company’s forecasts could require a change in the provision for excess or obsolete inventory. +Assets Held for Sale —The Company classifies properties as held for sale when certain criteria are met. At such time, the properties, including significant assets that are expected to be transferred as part of a sale transaction, are presented separately on the Consolidated Balance Sheets at the lower of carrying value or estimated fair value less costs to sell and depreciation is no longer recognized. Assets classified as held for sale include one building and one tract of land. +Property, plant and equipment —Property, plant and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Depreciation and amortization are provided using the straight-line method in amounts sufficient to amortize the cost of the assets over their estimated useful lives (buildings and improvements—generally five to 40 years; machinery and equipment—generally two to 15 years). Upon sale or disposal of property, plant and equipment, the +F-8 +applicable amounts of asset cost and accumulat ed depreciation are removed from the accounts, and the net amount, less any proceeds from sale, is recorded in income. +Intangible assets — Indefinite life intangible assets are comprised of tradenames, while finite life intangible assets are comprised of technology, customer lists, noncompetition agreements and tradenames. Finite life intangible assets are amortized on a straight line or accelerated basis over their estimated useful lives of seven to 10 years for technology, five to 20 years for customer lists, five years for noncompetition agreements and 10 years for tradenames. +Long-lived assets —Property, plant and equipment and finite life intangible assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. If events or changes in circumstances occur that indicate possible impairment, our impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely independent of other groups of our assets and liabilities. This analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. We conduct annual reviews for idle and underutilized equipment, and review business plans for possible impairment. Impairment occurs when the carrying value of the assets exceeds the future undiscounted cash flows expected to be earned by the use of the asset or asset group. When impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset or asset group and an impairment charge is recorded for the difference between the carrying value and the estimated fair value. +Additionally, the Company evaluates the remaining useful life each reporting period to determine whether events and circumstances warrant a revision to the remaining period of depreciation or amortization. If the estimate of a long-lived asset’s remaining useful life is changed, the remaining carrying amount of the asset is amortized prospectively over that revised remaining useful life. +The Company completes an annual (or more often if circumstances require) impairment assessment of its indefinite life intangible assets. As a part of its annual assessment, typically, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of an asset is less than its carrying amount. If there is a qualitative determination that the fair value of a particular asset is more likely than not greater than its carrying value, we do not need to proceed to the quantitative estimated fair value test for that asset. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined by the relief from royalty method. If the estimated fair value of an asset is less than its carrying value, an impairment charge is recorded for the amount by which the carrying value of the asset exceeds its estimated fair value. +Goodwill —The Company completes an annual (or more often if circumstances require) impairment assessment on October 1 of its goodwill on a reporting unit level, at or below the operating segment level. As a part of its annual assessment, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If there is a qualitative determination that the fair value of a particular reporting unit is more likely than not greater than its carrying value, the Company does not need to quantitatively test for goodwill impairment for that reporting unit. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined using a weighting of the income method and the market method . If the estimated fair value of a reporting unit is less than its carrying value, an impairment charge is recorded. +Deferred charges —Deferred charges include deferred financing costs, which are amortized to interest expense over the life of the related loan. On June 11, 2019, the Company entered into a Second Amended and Restated Credit Agreement (the “Credit Facility”). The Credit Facility amends the Company’s existing amended and restated agreement. In connection with the Credit Facility, the Company incurred $1.1 million in customary closing fees in 2019 that were capitalized and classified as a debt discount. Additionally, during 2019, $0.4 million of existing debt discount related to the 2017 long-term debt modification was expensed, and classified as interest expense, as a result of the Credit Facility (see Note 9 for further details on the modification). Amortization expense was $1.1 million, $1.1 million and $1.0 million for 2019, 2018 and 2017, respectively. As of December 31, 2019, and 2018, remaining capitalized deferred financing costs of $1.7 million are included as a discount to debt in the accompanying Consolidated Balance Sheets. +Revenue recognition +Energy Solutions and Industrial Solutions Segments — Within the Energy Solutions and Industrial Solutions segments, a significant portion of our revenue is derived from fixed-price contracts. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. +F-9 +For each contract, we assess the goods and services promised to a customer and identify a performance obligation for each distinct promised good or service. The typical life of o ur contracts is generally less than 12 months and each contract generally contains only one performance obligation, to provide goods or services to the customer. We determine the transaction price for each contract based on the consideration we expect to r eceive for the products or services being provided under the contract. +We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +For contracts where the duration is short, total contract revenue is insignificant, or control does not continuously transfer to the customer, revenues are recognized at the point in time control passes to the customer, which occurs generally upon shipment of product. +Progress payments are generally made over the duration of the contract. Shipping and handling activities after control of the products has transferred to the customer are considered fulfillment activities. Sales taxes are recorded on a net basis. +Fluid Handling Solutions Segments — Within the Fluid Handling Solutions segment, a significant portion of our revenue is primarily derived from sales of inventory product and is recognized at the point in time control passes to the customer, which occurs generally upon shipment of the product. +Payments vary by customer but are typically due within 30 days. Shipping and handling activities after control of the products has transferred to the customer are considered fulfillment activities. Sales taxes are recorded on a net basis. +Contract Assets and Contract Liabilities — Contract assets consist of costs and earnings in excess of billings, costs incurred for contracts recognized at a point in time, and retainage. Costs and earnings in excess of billings represent the estimated value of unbilled work for contracts with performance obligations recognized over time and are separately classified as current assets in the Consolidated Balance Sheets. Costs incurred for contracts recognized at a point in time are classified within inventories as work-in-process. Retainage represents a portion of the contract billings that have been billed, but for which the contract allows the customer to retain a portion of the billed amount until final settlement. Retainage is not considered to be a significant financing component because the intent is to protect the customer. Retainage is classified within accounts receivable and deferred charges and other assets depending on when it is due. Almost all of the Company’s contract assets are classified as current assets in the Consolidated Balance Sheets. +Billings in excess of costs and estimated earnings on uncompleted contracts are current liabilities, which relate to fixed-price contracts recognized over time, and represents payments in advance of performing the related contract work. Billings in excess of costs and estimated earnings on uncompleted contracts is not considered to be a significant financing component because it is generally used to meet working capital demands that can be higher in the early stages of a contract. Contract liabilities, classified in accounts payable and accrued expenses in the Consolidated Balance Sheets, include advance payments received from customers for which revenue has not been recognized for contracts where revenue is recognized at a point in time. Contract liabilities are reduced when the associated revenue from the contract is recognized, which is generally within one year. +The revenue streams within the Company are consistent with those disclosed for our reportable segments. See Note 17 to the Consolidated Financial Statements for additional information on product offerings and segments. +Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes to job performance, job conditions, and estimated profitability may result in revisions to contract revenue and costs and are recognized in the period in which the revisions are made. There was no provision for estimated losses on uncompleted contracts at December 31, 2019 and 2018. +Cost of sales —Cost of sales amounts include materials, subcontract costs, direct labor and associated benefits, inbound freight charges, purchasing and receiving, inspection, warehousing, and depreciation. +Claims —Change orders arise when the scope of the original project is modified for any of a variety of reasons. The Company will negotiate the extent of the modifications, its expected costs and recovery with the customer. Costs related to change orders are added to the expected total cost of the project. In cases where contract revenues are assured beyond a reasonable doubt to be increased +F-10 +in excess of the expected costs of the change order, incremental profit also is recognized on the contract. Such assurance is generally only achieved when the custo mer approves in writing the scope and pricing of the change order. Change orders that are in dispute are effectively handled as claims. +Claims are amounts in excess of the agreed contract price that the Company seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price. Costs attributable to claims are treated as contract costs as incurred. +The Company recognizes certain significant claims for recovery of incurred costs when it is probable that the claim will result in additional contract revenue and when the amount of the claim can be reliably estimated. When the customer or other parties agree in writing to the amount of the claim to be recovered by the Company, the amount of the claim becomes contractual and is accounted for as an increase in the contract’s total estimated revenue and estimated cost. As actual costs are incurred and revenues are recognized over time, a corresponding percentage of the revised total estimated profit will therefore be recognized. +Should it become probable that the claim will not result in additional contract revenue, the Company removes the related contract revenues from its previous estimate of total revenues, which effectively reduces the estimated profit margin on the job and negatively impacts profit for the period. +Pre-contract costs —Pre-contract costs are not significant and are primarily internal costs. As most of the Company’s contracts are one year or less, the Company expenses all pre-contract costs as incurred regardless of whether or not the bids are successful. A majority of our business is obtained through a bidding process and this activity is on-going with multiple bids in process at any one time. These costs consist primarily of engineering, sales and project manager wages, fringes and general corporate overhead and it is deemed impractical to track activities related to any one specific contract. +Selling and administrative expenses —Selling and administrative expenses on the Consolidated Statements of Operations include sales and administrative wages and associated benefits, selling and office expenses, professional fees, bad debt expense and depreciation. Selling and administrative expenses are charged to expense as incurred. +Acquisition and integration expenses —Acquisition and integration expenses on the Consolidated Statements of Operations are related to acquisition activities, which include, legal, accounting, and other expenses. +Amortization and earnout expenses —Amortization and earnout expenses on the Consolidated Statements of Operations include amortization of intangible assets, and changes to earnout and contingent compensation amounts related to acquisitions. +Restructuring expenses —Restructuring expenses on the Consolidated Statements of Operations include expenses related to an ongoing restructuring program to reduce operating costs in the future. Within restructuring expenses are charges related to severance, facility exit, legal and property, plant and equipment impairment. The Company’s policy is to recognize restructuring expenses in accordance with the accounting rules related to exit or disposal activities. +Product Warranties —The Company’s warranty reserve is to cover the products sold. The warranty accrual is based on historical claims information. The warranty reserve is reviewed and adjusted as necessary on a quarterly basis and is presented within Note 8. +Research and Development —Although not technically defined as research and development, a significant amount of time, effort and expense is devoted to (a) custom engineering which qualifies products for specific customer applications, (b) developing proprietary process technology and (c) partnering with customers to develop new products. +Income Taxes —Income taxes are determined using the asset and liability method of accounting for income taxes in accordance with Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (“ASC”) Topic 740, “Income Taxes”. Income tax expense includes federal, state and foreign income taxes. +Deferred income taxes are provided using the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases and are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Tax credits and other incentives reduce income tax expense in the year the credits are claimed. +Management must assess the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal, state and foreign tax authorities who regularly audit the Company in the normal course of business. In making these +F-11 +assess ments, management must often analyze complex tax laws of multiple jurisdictions, including many foreign jurisdictions. The accounting guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurem ent of a tax position taken or expected to be taken in a tax return. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. +The company has made an accounting policy election to record the U.S. income tax effect of future global intangible low-taxed income (“GILTI”) inclusions in the period in which they arise, rather than establishing deferred taxes with respect to the expected future tax liabilities associated with future GILTI inclusion. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested. A liability has been recorded for the deferred taxes on such undistributed foreign earnings. The amount is attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +Earnings per share —The following table reconciles the numerators and denominators used to calculate basic and diluted earnings per share for 2019, 2018 and 2017. +For the Year Ended December 31 +2019 +2018 +2017 +(table only in thousands) +Numerator (for basic and diluted earnings per share) +Net income (loss) +$ +17,707 +$ +(7,121 +) +$ +(3,029 +) +Denominator +Basic weighted-average shares outstanding +34,988 +34,714 +34,445 +Common stock equivalents arising from stock options and restricted stock awards +496 +— +— +Diluted weighted-average shares outstanding +35,484 +34,714 +34,445 +Options and unvested restricted stock units are included in the computation of diluted earnings per share using the treasury stock method. For 2019, 2018 and 2017, outstanding options and unvested restricted stock units of 0.4 million, 0.8 million and 0.7 million, respectively, were excluded from the computation of diluted earnings per share due to their having an anti-dilutive effect. +Once a restricted stock award vests, it is included in the computation of weighted average shares outstanding for purposes of basic and diluted earnings per share. +Foreign Currency Translation —The functional currencies of the Company’s foreign subsidiaries are their local currencies and their books and records are maintained in the local currency. The assets and liabilities of these foreign subsidiaries are translated into United States Dollars (“USD”) based on the end-of period exchange rates and the resultant translation adjustments are reported in Accumulated Other Comprehensive Loss in Shareholders’ equity on the Consolidated Balance Sheets. +Income and expenses are translated into USD at average exchange rates in effect during the period. +Transactions denominated in other than the local currency are remeasured into the local currency and the resulting exchange gains or losses are included in “Other income (expense), net” line of the Consolidated Statements of Operations. Transaction gains were $0.4 million, $0.7 million and $0.1 million in 2019, 2018 and 2017, respectively. +Recently adopted accounting pronouncements +On January 1, 2019, we adopted the new lease accounting guidance, ASC 842. The guidance establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Under the guidance, leases are classified as either finance or operating, with classification affecting the pattern of expense recognition. We adopted the guidance using the modified retrospective method which was applied to leases that existed or were entered into on or after January 1, 2019. The Company elected to utilize the package of practical expedients that allows us to 1) not reassess whether any expired or existing contracts are or contain leases, 2) retain the existing classification of lease contracts as of the date of adoption, and 3) not reassess initial direct costs for any existing leases. We also elected to not separate lease and non-lease components, for all leases. The adoption of this standard had a material impact on our consolidated balance sheet due to the recognition of ROU assets and liabilities for our operating leases totaling $13.3 million, as well as an adjustment to beginning equity of $4.6 million, net of tax, related to a prior sale-leaseback transaction. The adoption of the standard did not have a material impact on our statement of operations or liquidity. See Note 12 to the Consolidated Financial Statements for additional details on the Company’s leases. +F-12 +In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” This g uidance expands an entity’s ability to apply hedge accounting for nonfinancial and financial risk components and allows for a simplified approach for fair value hedging of interest rate risk. Additionally, this ASU eliminates the need to separately measure and report hedge ineffectiveness and generally requires the entire change in fair value of a hedging instrument to be presented in the same income statement line as the hedged item. The Company adopted this ASU on January 1, 2019 and applied the modified retrospective approach through a cumulative-effect adjustment from accumulated other comprehensive income to retained earnings as of the effective date. The impact of the adoption of this ASU was not material. +Recently issued accounting pronouncements not yet adopted +In August 2018, the FASB issued ASU 2018-14, “Compensation—Retirement Benefits—Defined Benefit Plans—General (Subtopic 715-20): Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans,” that makes minor changes to the disclosure requirements for employers that sponsor defined benefit pension and/or other postretirement benefit plans. The new guidance eliminates requirements for certain disclosures that are no longer considered cost beneficial and requires new ones that the FASB considers pertinent. ASU 2018-14 is effective for us January 1, 2021. We are evaluating the impact of the adoption of ASU 2018-14 on our consolidated financial statements. +2. +Financial Instruments +Our financial instruments consist primarily of cash and cash equivalents, receivables and certain other assets, foreign debt, and accounts payable, which approximate fair value at December 31, 2019 and 2018, due to their short-term nature or variable, market-driven interest rates. +The fair value of the debt issued under our Credit Agreement was $67.3 million and $76.1 million at December 31, 2019 and 2018, respectively. The fair value of the note payable was $1.7 million at December 31, 2018. The fair value was determined considering market conditions, our credit worthiness and the current terms of our debt. +At December 31, 2019 and 2018, the Company had cash and cash equivalents of $35.6 million and $43.7 million, respectively, of which $27.4 million and $23.3 million, respectively, was held outside of the United States, principally in the Netherlands, United Kingdom, China, and Canada. +Concentrations of credit risk: +Financial instruments that potentially subject us to credit risk consist principally of cash and cash equivalents, and accounts receivable. We maintain cash and cash equivalents with various major financial institutions. We perform periodic evaluations of the financial institutions in which our cash is invested. Concentrations of credit risk with respect to trade and contract receivables are limited due to the large number of customers and various geographic areas. Additionally, we perform ongoing credit evaluations of our customers’ financial condition. +3. Accounts Receivable +Accounts receivable consisted of the following: +December 31, +(table only in thousands) +2019 +2018 +Contract receivables +$ +58,881 +$ +48,826 +Trade receivables +12,135 +7,296 +Allowance for doubtful accounts +(2,582 +) +(2,897 +) +Total accounts receivable +$ +68,434 +$ +53,225 +Balances billed, but not paid by customers under retainage provisions in contracts that are recorded in deferred charges and other assets within the Consolidated Balance Sheets, amounted to approximately $0.9 million at December 31, 2019 and 2018. Retainage receivables on contracts in progress are generally collected within a year or two subsequent to contract completion. +Provision for doubtful accounts was $0.3 million, $1.4 million and $3.9 million during 2019, 2018 and 2017, respectively, while accounts charged to the allowance were $0.6 million, $0.8 million and $1.5 million during 2019, 2018 and 2017, respectively. +F-13 +4. +Costs and Estimated Earnings on Uncompleted Contracts +Our contracts have various lengths to completion ranging from a few days to several months. We anticipate that a majority of our current contracts will be completed within the next 12 months and any unrecognized billings will be recorded as revenue in that same period. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. The assets and liabilities recognized in association with these contracts are as follows: +December 31, +(table only in thousands) +2019 +2018 +Costs incurred on uncompleted contracts +$ +184,321 +$ +174,168 +Estimated earnings +77,326 +67,427 +Total costs and estimated earnings on uncompleted contracts, gross +261,647 +241,595 +Less billings to date +(261,211 +) +(232,045 +) +Total costs and estimated earnings on uncompleted contracts, net +$ +436 +$ +9,550 +Included in the accompanying consolidated balance sheets +under the following captions: +Costs and estimated earnings in excess of billings on +uncompleted contracts +$ +34,805 +$ +29,694 +Billings in excess of costs and estimated earnings on +uncompleted contracts +(34,369 +) +(20,144 +) +Total costs and estimated earnings on uncompleted contracts, net +$ +436 +$ +9,550 +5. +Inventories +Inventories consisted of the following: +December 31, +(table only in thousands) +2019 +2018 +Raw materials +$ +15,218 +$ +15,819 +Work in process +7,328 +6,098 +Finished goods +654 +807 +Obsolescence allowance +(2,622 +) +(1,907 +) +Total inventories +$ +20,578 +$ +20,817 +Amounts credited to the allowance for obsolete inventory and charged to cost of sales amounted to $0.3 million, $0.5 million and $0.2 million during 2019, 2018 and 2017, respectively. Items charged to the allowance for inventory write-offs were $0.1 million, $0.3 million and $0.6 million, during 2019, 2018 and 2017, respectively. +6. +Property, Plant and Equipment +December 31, +(table only in thousands) +2019 +2018 +Land +$ +147 +$ +1,623 +Building and improvements +7,400 +18,185 +Machinery and equipment +26,993 +25,257 +Property, plant and equipment, gross +34,540 +45,065 +Less accumulated depreciation +(19,266 +) +(22,865 +) +Property, plant and equipment, net +$ +15,274 +$ +22,200 +Depreciation expense was $2.1 million, $3.5 million and $4.5 million for 2019, 2018 and 2017, respectively. +F-14 +7. +Goodwill and Intangible Assets +(table only in thousands) +Energy Solutions +segment +Industrial Solutions +s egment +Fluid Handling segment +Totals +Balance of goodwill at December 31, 2017 +$ +97,621 +$ +23,436 +$ +45,894 +$ +166,951 +Divestitures +— +— +(14,317 +) +(14,317 +) +Foreign currency translation +(478 +) +— +— +(478 +) +Balance of goodwill at December 31, 2018 +97,143 +23,436 +31,577 +152,156 +Foreign currency translation +(136 +) +— +— +(136 +) +Balance of goodwill at December 31, 2019 +$ +97,007 +$ +23,436 +$ +31,577 +$ +152,020 +As of December 31, 2019 and 2018, the Company has an aggregate amount of goodwill acquired of $212.8 million and an aggregate amount of impairment losses of $60.7 million. +The Company’s indefinite lived intangible assets as of December 31, 2019 and 2018 consisted of the following: +Tradenames +(table only in thousands) +2019 +2018 +Balance beginning of year +$ +18,258 +$ +19,691 +Transfer to finite life classification +(3,904 +) +— +Divestitures +— +(1,340 +) +Foreign currency adjustments +(63 +) +(93 +) +Balance end of year +$ +14,291 +$ +18,258 +During 2019, the Company reassessed the useful lives of certain tradenames and determined that $3.9 million of their tradenames would have useful lives of 10 years now versus indefinite. +The Company completes an annual (or more often if circumstances require) impairment assessment of its goodwill and indefinite life intangible assets on October 1 at the reporting unit level. +The Company bases its measurement of the fair value of a reporting unit using a 50/50 weighting of the income method and the market method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital. Projected revenue and operational profit, and terminal growth rates were determined to be significant assumptions because they are three primary drivers of the projected cash flows in the discounted future cash flow approach. Cost of capital was also determined to be a significant assumption as it is the discount rate used to calculate the current fair value of those projected cash flows. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. Based on this analysis, the estimated fair value of all of our reporting units exceeded their carrying value as of October 1, 2019. There was no goodwill impairment in 2019 and 2018. There was goodwill impairment of $4.4 million in 2017. +The Company also performed an impairment analysis for all reporting units with indefinite life intangible assets as of October 1, 2019. The Company based its measurement of the fair value of the indefinite life intangible assets utilizing the relief from royalty method. The significant assumptions used under the relief from royalty method are projected revenue, royalty rates, terminal growth rates, and the cost of capital. Projected revenue, royalty rates and terminal growth rates were determined to be significant assumptions because they are three primary drivers of the projected royalty cash flows in the relief from royalty method. Cost of capital was also determined to be a significant assumption as it is the discount rate used to calculate the current fair value of those projected royalty cash flows. Changes in any of the significant assumptions used can materially affect the expected cash flows, and such impacts can result in material non-cash impairment charges. Under this approach, the estimated fair value of the indefinite life intangible assets exceeded their carrying value for all reporting units as of the testing date. +There was no impairment charge in 2019 and 2018. During the annual impairment test of indefinite life intangible assets in 2017, the carrying values of four reporting units’ indefinite life intangible assets exceeded their fair values. The Company recorded a $2.7 million impairment charge in 2017. +F-15 +As described above, the fair value measurement methods used in the Company’s goodwill and indefinite life intan gible assets impairment analyses utilizes a number of significant unobservable inputs or Level 3 assumptions. These assumptions include, among others, projections of our future operating results, the implied fair value of these assets using an income appro ach by preparing a discounted cash flow analysis and other subjective assumptions. +The Company’s finite lived intangible assets consisted of the following: +December 31, +2019 +2018 +(table only in thousands) +Intangible assets – finite life +Cost +Accum. +Amort. +Cost +Accum. +Amort. +Technology +$ +14,457 +$ +10,686 +$ +14,457 +$ +9,414 +Customer lists +68,943 +44,484 +68,943 +37,873 +Noncompetition agreements +910 +910 +910 +762 +Tradenames +5,294 +1,154 +1,390 +579 +Foreign currency adjustments +(1,869 +) +(782 +) +(1,520 +) +(407 +) +Total finite life intangible assets +$ +87,735 +$ +56,452 +$ +84,180 +$ +48,221 +Amortization expense of finite life intangible assets was $8.5 million, $9.6 million and $11.5 million for 2019, 2018 and 2017, respectively. Amortization over the next five years for finite life intangibles is $6.8 million in 2020, $5.7 million in 2021, $4.8 million in 2022, $4.0 million in 2023, and $3.4 million in 2024. +8. +Accounts Payable and Accrued Expenses +Accounts payable and accrued expense consisted of the following: +December 31, +(table only in thousands) +2019 +2018 +Trade accounts payable, including amounts due to subcontractors +$ +48,762 +$ +51,984 +Compensation and related benefits +5,712 +7,578 +Accrued warranty +4,664 +3,384 +Contract liability +5,666 +6,541 +Short-term operating lease liability +2,610 +— +Other +10,905 +10,742 +Total accounts payable and accrued expenses +$ +78,319 +$ +80,229 +9. +Senior debt +Debt consisted of the following: +December 31, +(table only in thousands) +2019 +2018 +Outstanding borrowings under Credit Facility +Term loan payable in quarterly principal installments of $0.6 million +through June 2021, $0.9 million through June 2023, and $1.3 million +thereafter with balance due upon maturity in June 2024. +– Term loan +$ +48,750 +$ +76,147 +– Revolving Credit Loan +18,500 +— +– Unamortized debt discount +(1,749 +) +(1,691 +) +Total outstanding borrowings under Credit Facility +65,501 +74,456 +Less: current portion +(2,500 +) +— +Total debt, less current portion +$ +63,001 +$ +74,456 +In 2019, the Company made repayments of $3.0 million on the term loan and net repayments on the revolving credit lines of $7.6 million. Scheduled principal payments under our Credit Facility are $2.5 million in 2020, $3.1 million in 2021, $3.7 million in 2022, $4.5 million in 2023, and $53.5 million in 2024. +F-16 +Credit Facilit y +On June 11, 2019, the Company entered into a Second Amended and Restated Credit Agreement (the “Credit Facility”). The Credit Facility amended and restated the Company’s prior credit agreement. Pursuant to the Credit Facility, the lenders provided a term loan in the aggregate principal amount of $50.0 million and the lenders increased their senior secured revolving credit commitments to the aggregate principal amount of $140.0 million. This revolving credit commitment allows the Company the ability to borrow loans denominated in different currencies. Additionally, the Credit Facility extended the maturity date to June 11, 2024, reduced interest rates, and redefined certain financial covenants. +As of December 31, 2019 and 2018, $11.0 million and $29.3 million of letters of credit were outstanding, respectively. Total unused credit availability under the Company’s senior secured term loan and senior secured revolver loan with sub-facilities for letters of credit, swing-line loans and senior secured multi-currency loans was $82.3 million and $50.7 million at December 31, 2019 and 2018, respectively. Revolving loans may be borrowed, repaid and reborrowed until June 11, 2024, at which time all outstanding balances of the Credit Facility must be repaid. +At the Company’s option, revolving loans and the term loans accrue interest at a per annum rate based on either the highest of (a) the federal funds rate plus 0.5%, (b) the Agent’s prime lending rate, (c) one-month LIBOR plus 1.00%, plus a margin ranging from 1.0% to 2.0% depending on the Company’s Consolidated Leverage Ratio (“Base Rate”), or (d) a Eurocurrency Rate (as defined in the Credit Agreement) plus 1.0% to 2.0% depending on the Company’s Consolidated Leverage Ratio. Interest on swing line loans is the Base Rate. +Interest on Base Rate loans is payable quarterly in arrears on the last day of each calendar quarter and at maturity. Interest on Eurocurrency Rate loans is payable on the last date of each applicable Interest Period (as defined in the agreement), but in no event less than once every three months and at maturity. The weighted average stated interest rate on outstanding borrowings was 3.80% and 5.27% at December 31, 2019 and 2018, respectively. +In connection with the Credit Facility, the Company terminated its existing interest rate swap agreement. The fair value of the interest rate swap was zero and an asset of $0.5 million as of December 31, 2019 and 2018, respectively, and is classified within the “Deferred charges and other assets” on the Consolidated Balance Sheets. The Company designated the interest rate swap as an effective hedge until the date of termination; therefore, the changes to the fair value of the interest rate swap were recorded in other comprehensive income, until the date of termination. Upon termination of the swap agreement, $0.2 million previously recognized in other comprehensive income was recognized into income during the year ended December 31, 2019 and is classified within “Other income (expense), net” on the Consolidated Statements of Operations. +Under the terms of the Credit Facility, the Company is required to maintain certain financial covenants, including the maintenance of a Consolidated Net Leverage Ratio (as defined in the Credit Facility). Through September 30, 2020, the maximum Consolidated Net Leverage Ratio is 3.75, after which time it will decrease to 3.50 through September 30, 2021. The Consolidated Net Leverage Ratio will then decrease to 3.25 until the end of the term of the Credit Facility. +The Company has granted a security interest in substantially all of its assets to secure its obligations pursuant to the Credit Facility. The Company’s obligations under the Credit Agreement are guaranteed by the Company’s U.S. subsidiaries and such guaranty obligations are secured by a security interest on substantially all the assets of such subsidiaries, including certain real property. The Company’s obligations under the Credit Agreement may also be guaranteed by the Company’s material foreign subsidiaries to the extent no adverse tax consequences would result to the Company. +In connection with the Credit Facility, the Company paid $1.1 million in customary closing fees during 2019 that were deferred and classified as a debt discount. Additionally, during 2019, $0.4 million of the existing debt discount was expensed, and classified as interest expense, as a result of the debt modification. +As of December 31, 2019 and 2018, the Company was in compliance with all related financial and other restrictive covenants under the Credit Facility. +Foreign Debt +The Company has a number of bank guarantee facilities and bilateral lines of credit in various foreign countries currently supported by cash, letters of credit or pledged assets and collateral under the Credit Facility. The Credit Facility allows letters of credit and bank guarantee issuances of up to $50.0 million from the bilateral lines of credit secured by pledged assets and collateral under the Credit Facility. As of December 31, 2019, $16.6 million in bank guarantees were outstanding. In addition, a subsidiary of the Company located in the Netherlands has a Euro-denominated bank guarantee agreement secured by local assets under which $3.4 +F-17 +million in bank guarantees were outstanding as of December 31, 20 19. As of December 31, 2019, the borrowers of these facilities and agreements were in compliance with all related financial and other restrictive covenants . +10. +Shareholders’ Equity +Dividends +Our dividend policy and the payment of cash dividends under that policy are subject to the Board of Director’s continuing determination that the dividend policy and the declaration of dividends are in the best interest of the Company’s shareholders. Future dividends and the dividend policy may be changed at the Company’s discretion at any time. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Facility. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the shareholders to suspend dividend payments. +During 2017, our Board declared the following quarterly cash dividends on our common stock: +Dividend Per Share +Record Date +Payment Date +$0.075 +August 7, 2017 +September 29, 2017 +$0.075 +May 10, 2017 +June 30, 2017 +$0.075 +March 6, 2017 +March 31, 2017 +Effective August 13, 2012, the Company implemented a Dividend Reinvestment Plan (the “Plan”), under which the Company may issue up to 750,000 shares of common stock. The Plan provides a way for interested shareholders to increase their holdings in our common stock. Participation in the Plan is strictly voluntary and is open only to existing shareholders. The Plan has had limited participation. +Share-Based Compensation +The Company’s 2017 Equity and Incentive Compensation Plan (the “2017 Plan”) was approved by the Company’s stockholders on May 16, 2017 which replaced the 2007 Equity Incentive Plan (the “2007 Plan”). No further grants will be made under the 2007 Plan, but outstanding awards under the 2007 Plan will continue to be unaffected in accordance with their terms. The 2017 Plan permits the granting of stock options with an exercise price equal to or greater than the fair market value of the Company’s common stock at the date of the grant, and other stock-based awards, including appreciation rights, restricted stock, restricted stock units, performance shares and dividend equivalents. A total of 1.9 million shares of common stock were authorized for issuance. As of December 31, 2019, 0.9 million shares remain available for future issuance. Stock options granted to employees generally vest equally over a period of four years from the date of the grant. Stock awards granted to employees generally vest over a period of three to four years from the date of the grant. +On June 10, 2017, the Company granted 700,000 performance units to our Chief Executive Officer with a fair value of $175,000 and are being expensed over the vesting period of three years. The maximum shares of common stock that the participant could receive upon vesting is 77,778 shares. The performance units are earned based upon the Company’s stock price during 30 consecutive trading days within a specified date range of approximately two years. The performance units are settled in the Company’s common stock subsequent to this specified date range. The estimated grant date fair value and compensation expense of each performance share was determined on the date of grant by using the Monte Carlo valuation model. +Share-based compensation expense for stock options and restricted stock awards under these plans was $2.7 million, $3.1 million and $1.7 million for 2019, 2018 and 2017, respectively. The tax benefit related to share based compensation expense was $0.4 million, $0.5 million and zero in 2019, 2018 and 2017, respectively. +Employee Stock Purchase Plan +The 2009 Employee Stock Purchase Plan (“ESPP”) was approved by shareholders on May 21, 2009. The ESPP is administered by the Compensation Committee. The ESPP allows employees to purchase shares of common stock at a 15% discount from market price and pay for the shares through payroll deductions. Eligible employees can enter the plan at specific “offering dates” that occur in six-month intervals. +The aggregate maximum number of shares of the Company’s common stock that may be granted under the ESPP is 1,500,000 shares over the ten-year term of the ESPP, subject to adjustment in the event there is a reorganization, merger, consolidation, +F-18 +recapitalization, reclassification, stock split-up, or similar transaction with respect to the common stock. As of December 31, 201 9 , 1.3 million shares remain available for future issuance. +The Company recognized employee stock purchase plan expense of $60,000, $90,000 and $83,000 in 2019, 2018 and 2017, respectively. +Stock Options +The estimated weighted-average fair value of stock options granted during 2017, was $2.68 per option, using the Black-Scholes option-pricing model based on the following assumptions: +Expected Volatility : The Company utilizes a volatility factor based on the Company’s historical stock prices for a period of time equal to the expected term of the stock option utilizing weekly price observations. For 2017, the Company utilized weighted-average volatility factors of 39%. +Expected Term : Due to limited historical exercise data, the Company utilizes the simplified method of determining the expected term based on the vesting schedules and terms of the stock options. For 2017, the Company utilized weighted-average expected term factors of 6.3 years. +Risk-Free Interest Rate : The risk-free interest rate factor utilized is based upon the implied yields currently available on U.S. Treasury zero-coupon issues over the expected term of the stock options. For 2017, the Company utilized a weighted-average risk-free interest rate factor of 2.2%. +Expected Dividends : The Company utilized a weighted average expected dividend rate of 3.3% to value options granted during 2017. +Information related to all stock options under the 2017 Plan and 2007 Plan for 2019, 2018 and 2017 is shown in the tables below: +(shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2018 +507 +$ +10.43 +5.2 years +Forfeitures +(31 +) +6.84 +Exercised +(66 +) +4.10 +Outstanding at December 31, 2019 +410 +11.45 +4.7 years +$ +32 +Exercisable at December 31, 2019 +355 +12.08 +4.6 years +$ +29 +(shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2017 +655 +$ +10.53 +6.0 years +Forfeitures +(132 +) +11.53 +Exercised +(16 +) +5.55 +Outstanding at December 31, 2018 +507 +10.43 +5.2 years +$ +186 +Exercisable at December 31, 2018 +402 +10.52 +4.6 years +$ +186 +F-19 +(shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2016 +1,519 +$ +10.25 +6.1 years +Granted +128 +9.24 +Forfeitures +(700 +) +12.44 +Exercised +(292 +) +3.92 +Outstanding at December 31, 2017 +655 +10.53 +6.0 years +$ +78 +Exercisable at December 31, 2017 +463 +10.49 +5.2 years +$ +78 +Restricted Stock Awards +Information related to restricted stock awards under the 2017 Plan and 2007 Plan for 2019, 2018 and 2017 is shown in the table below. The fair value of restricted stock awards is based on the price of the stock in the open market on the date of the grant. The fair value of the restricted stock awards is recorded as compensation expense on a straight-line basis over the vesting periods of the awards and we account for forfeitures when they occur. +(shares in thousands) +Shares +Weighted +Average +Grant Date +Fair Value +Nonvested at December 31, 2016 +509 +$ +9.64 +Granted +405 +9.88 +Vested +(92 +) +9.78 +Forfeited +(268 +) +9.70 +Nonvested at December 31, 2017 +554 +9.75 +Granted +963 +5.21 +Vested +(217 +) +9.50 +Forfeited +(49 +) +9.80 +Nonvested at December 31, 2018 +1,251 +6.30 +Granted +464 +7.50 +Vested +(310 +) +7.24 +Forfeited +(84 +) +6.36 +Nonvested at December 31, 2019 +1,321 +6.80 +The Company received $7,000, $0.1 million and $1.1 million of cash from employees exercising options in 2019, 2018 and 2017, respectively. The intrinsic value of options exercised during 2019, 2018 and 2017 was $0.3 million, $24,000 and $2.6 million, respectively. Unrecognized compensation expense related to nonvested shares of stock options, restricted stock and performance units was $6.4 million at December 31, 2019 and will be recognized over a weighted average vesting period of 2.1 years. +11. +Pension and Employee Benefit Plans +We sponsor a non-contributory defined benefit pension plan for certain union employees. The accrual of future benefits for all participants who are non-union employees was frozen effective December 31, 2008. The plan is funded in accordance with the funding requirements of the Employee Retirement Income Security Act of 1974. +The following tables set forth the plan changes in benefit obligations, plan assets and funded status on the measurement dates, December 31, 2019, 2018 and 2017, and amounts recognized in our Consolidated Balance Sheets within other long-term liabilities. +F-20 +(table only in thousands) +2019 +2018 +2017 +Change in projected benefit obligation: +Projected benefit obligation at beginning of year +$ +32,998 +$ +36,327 +$ +35,012 +Service cost +— +— +415 +Interest cost +1,303 +1,190 +1,314 +Actuarial loss (gain) +3,704 +(2,629 +) +1,787 +Administrative expenses +— +— +(402 +) +Benefits paid +(2,020 +) +(1,890 +) +(1,799 +) +Projected benefit obligation at end of year +35,985 +32,998 +36,327 +Change in plan assets: +Fair value of plan assets at beginning of year +24,197 +26,836 +24,063 +Actual return (loss) on plan assets +4,431 +(1,388 +) +3,152 +Employer contribution +491 +639 +1,822 +Administrative expenses +— +— +(402 +) +Benefits paid +(2,020 +) +(1,890 +) +(1,799 +) +Fair value of plan assets at end of year +27,099 +24,197 +26,836 +Unfunded status +$ +(8,886 +) +$ +(8,801 +) +$ +(9,491 +) +Defined benefit liability included in other liabilities +$ +(8,886 +) +$ +(8,801 +) +$ +(9,491 +) +Deferred tax benefit associated with accumulated other comprehensive loss +2,183 +2,116 +3,153 +Accumulated other comprehensive loss, net of tax +6,420 +6,224 +5,154 +Other comprehensive income (loss): +Net loss +$ +527 +$ +271 +$ +358 +Amortization of net actuarial gain +(263 +) +(238 +) +(227 +) +Total recognized in other comprehensive income (loss) +$ +264 +$ +33 +$ +131 +Amount recognized in accumulated other +comprehensive income (loss) - Prior service cost +$ +8,603 +$ +8,340 +$ +8,307 +Weighted-average assumptions used to determine +benefit obligations for the year ended December 31: +Discount rate +2.95 +% +4.05 +% +3.35 +% +Benefits under the plan is not based on wages and, therefore, future wage adjustments have no effect on the projected benefit obligation. +During 2019, 2018 and 2017, the Company updated the mortality tables (RP-2018 Total Mortality Table, RP-2017 Total Mortality Table, and RP-2016 Total Mortality Table for each respective year) in the underlying assumptions used to determine the benefit obligation. +The details of net periodic benefit cost for pension benefits included in the accompanying Consolidated Statements of Operations for the years ended December 31, 2019, 2018 and 2017 are as follows: +(table only in thousands) +2019 +2018 +2017 +Service cost +$ +— +$ +— +$ +415 +Interest cost +1,303 +1,190 +1,314 +Expected return on plan assets +(1,254 +) +(1,511 +) +(1,723 +) +Net amortization and deferral +263 +238 +227 +Net periodic benefit cost (income) +$ +312 +$ +(83 +) +$ +233 +Weighted-average assumptions used to determine net +periodic benefit costs for the years ended December 31: +Discount rate +4.05 +% +3.35 +% +3.85 +% +Expected return on assets +5.35 +% +5.75 +% +7.25 +% +The basis of the long-term rate of return assumption reflects the current asset mix for the pension plan of approximately 30% to 40% debt securities and 60% to 70% equity securities with assumed average annual returns of approximately 4% to 6% for debt securities and 8% to 12% for equity securities. The investment portfolio for the pension plan will be adjusted periodically to maintain the current ratios of debt securities and equity securities. Additional consideration is given to the historical returns for the pension plan +F-21 +as well as future long range projections of investment returns for each asset category. The long-term rate of return also considers administra tive expenses of the plan. +The net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive loss into net periodic benefit cost during 2020 are $0.3 million and zero, respectively. +Pension plan assets are invested in trusts comprised primarily of investments in various debt and equity funds. A fiduciary committee establishes the target asset mix and monitors asset performance. The expected rate of return on assets includes the determination of a real rate of return for equity and fixed income investment applied to the portfolio based on their relative weighting, increased by an underlying inflation rate. Our defined benefit pension plan asset allocation by asset category is as follows: +Target +Allocation +Percentage of +Plan Assets +2019 +2019 +2018 +Asset Category: +Cash and cash equivalents +0 +% +2 +% +3 +% +Equity securities +70 +% +73 +% +70 +% +Debt securities +30 +% +25 +% +27 +% +Total +100 +% +100 +% +100 +% +Estimated pension plan cash obligations are $2.2 million, $2.2 million, $2.2 million, $2.2 million, and $2.2 million for 2020 through 2024, respectively, and a total of $10.4 million for the years 2025 through 2029. +Fair Value Measurements of Pension Plan Assets +Following is a description of the valuation methodologies used for pension assets measured at fair value: +• +Cash and cash equivalents: Cash and cash equivalents consist primarily of cash on deposit in money market funds. Cash and cash equivalents are stated at cost, which approximates fair value. +• +Equity securities: Equity securities consist of various managed funds that invest primarily in common stocks. These securities are valued at the net asset value of shares held by the plan at year end. The net asset value is calculated based on the underlying shares and investments held by the funds. +• +Debt securities: Debt securities consist of U.S. government and agency securities, corporate bonds and notes, and managed funds that invest in fixed income securities. U.S governmental and agency securities are valued at closing prices reported in the active market in which the individual securities are traded. Corporate bonds and notes are valued using market inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications. Inputs may be prioritized differently at certain times based on market conditions. Managed funds are valued at the net asset value of shares held by the plan at year end. The net asset value is calculated based on the underlying investments held by the fund. +The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. +The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels. +The levels assigned to the defined benefit plan assets as of December 31, 2019, are summarized in the tables below: +(table only in thousands) +Level 1 +Level 2 +Level 3 +Total +Pension assets, at fair value: +Cash and cash equivalents +$ +578 +$ +— +$ +— +$ +578 +Equity securities +19,702 +— +— +19,702 +Debt securities +6,819 +— +— +6,819 +Total assets +$ +27,099 +$ +— +$ +— +$ +27,099 +F-22 +The levels assigned to the defined benefit plan assets as of December 31, 2018, are summarized in the tables below: +(table only in thousands) +Level 1 +Level 2 +Level 3 +Total +Pension assets, at fair value: +Cash and cash equivalents +$ +685 +$ +— +$ +— +$ +685 +Equity securities +16,994 +— +— +16,994 +Debt securities +6,518 +— +— +6,518 +Total assets +$ +24,197 +$ +— +$ +— +$ +24,197 +The Company contributes to a number of multiemployer defined benefit pension plans under the terms of collective-bargaining agreements that cover its union-represented employees. The risks of participating in these multiemployer plans are different from single-employer plans in the following aspects: +• +Assets contributed to the multiemployer plan by one employer may be used to provide benefits to employees of other participating employers. +• +If a participating employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. +• +If the Company chooses to stop participating in some of its multiemployer plans, CECO may be required to pay those plans an amount based on the underfunded status of the plan, referred to as a withdrawal liability. +The Company’s participation in these plans for the year ended December 31, 2019, is outlined in the table below. The “EIN/Pension Plan Number” column provides the Employer Identification Number and the three-digit plan number, if applicable. Unless otherwise noted, the most recent Pension Protection Act zone status available in 2019 is for the plan’s year-end at December 31, 2018. The zone status is based on information that the Company received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65% funded, plans in the yellow zone are less than 80% funded, and plans in the green zone are at least 80% funded. The “FIP/RP Status Pending/Implemented” column indicates plans for which a financial improvement plan (FIP) or a rehabilitation plan (RP) is either pending or has been implemented. The last column lists the expiration date(s) of the collective-bargaining agreement(s) to which the plans are subject. +Pension Fund +EIN/Pension +Plan Number +Pension +Protection +Act Zone +Status +FIP/RP Status Pending/ +Implemented +Surcharge +Imposed +Expiration +of Collective +Bargaining +Agreement +Sheet Metal Workers’ National Pension Fund +52-6112463/001 +Yellow +FIP: Yes - Implemented +RP: Yes - Implemented +No +various +Sheet Metal Workers Local 224 Pension Plan +31-6171353/001 +Yellow +FIP: Yes - Implemented +No +May 31, 2022 +Sheet Metal Workers Local No. 20, Indianapolis Area Pension fund +51-0168516/001 +Green +Is not subject +No +May 31, 2020 +Sheet Metal Workers Local No. 177 Pension Fund +62-6093256/001 +Green +Is not subject +No +April 30, 2023 +Kirk and Blum was listed in the Sheet Metal Workers Local No. 177 Pension Fund’s Form 5500 as providing more than five percent of total contributions for the year ended December 31, 2018. The Company was not listed in any of the other plans’ Forms 5500 as providing more than five percent of the total contributions for the plans and plan years. At the date the financial statements were issued, Forms 5500 were not available for the plan years ended December 31, 2019. +We have no current intention of withdrawing from any plan and, therefore, no liability has been provided in the accompanying consolidated financial statements. +Amounts charged to pension expense under the above plans including the multi-employer plans totaled $1.7 million, $1.4 million and $2.0 million in 2019, 2018 and 2017, respectively. +F-23 +We have a 401(k) savings retirement plan for employees of certain of our subsidiaries. The plan covers substantially all employees who have 30 days of service, and who ha ve attained 18 years of age. The plan allows us to make discretionary contributions and provides for employee salary deferrals of up to 100%. We made aggregate matching contributions and discretionary contributions of $ 1 . 7 million, $1. 7 million, and $1. 6 million during 201 9 , 201 8 and 201 7 , respectively. +12. +Leases +Our leasing activity is primarily related to buildings used for manufacturing, warehousing, sales, and administrative activities. We determine if an arrangement is a lease at inception. Many of our lease agreements contain renewal options; however, we do not recognize ROU assets or lease liabilities for renewal periods unless it is determined that we are reasonably certain of renewing the lease at inception or when a triggering event occurs. Some of our lease agreements contain rent escalation clauses, free-rent periods, or other lease concessions. We recognize our minimum rental expense on a straight-line basis based on the fixed components of a lease arrangement. Variable lease costs represent amounts that are not fixed in nature and are not tied to an index or rate, and are recognized as incurred. Our variable lease costs are not material. +In determining our ROU assets and lease liabilities, we apply a discount rate to the minimum lease payments within each lease agreement. ASU 2016-02 requires us to use the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. When we cannot readily determine the discount rate implicit in the lease agreement, we utilize our fully collateralized incremental borrowing rate. To estimate our specific incremental borrowing rates we consider, among other factors, interest rates on our existing credit facilities, risk-free rates, the types of assets being leased, and the term of the leases. +The components of lease expense were as follows: +(table only in thousands) +December 31, 2019 +Operating lease cost (a) +$ +3,612 +Finance lease cost: +Amortization of right-of-use assets +309 +Interest on lease liability +360 +Total finance lease cost +669 +Total lease cost +$ +4,281 +(a) includes variable lease costs which are immaterial +Supplemental cash flow information related to leases was as follows: +(table only in thousands) +December 31, 2019 +Cash paid for amounts included in the measurement of lease liabilities +Operating cash flows from operating leases +$ +3,453 +Operating cash flows from finance leases +$ +360 +Financing cash flows from finance leases +$ +478 +Right of use assets obtained in exchange for lease obligations +Operating leases +$ +3,547 +Supplemental balance sheet information related to leases was as follows: +F-24 +(table only in thousands) +December 31, 2019 +Operating leases +Right-of-use assets from operating leases +$ +13,607 +Accounts payable and accrued expenses +$ +2,610 +Operating lease liabilities +11,116 +Total operating lease liabilities +$ +13,726 +Finance leases +Property, plant and equipment, net +$ +3,255 +Accounts payable and accrued expenses +$ +516 +Other liabilities +7,340 +Total finance lease liabilities +$ +7,856 +Weighted-average remaining lease term +Operating leases +9 years +Finance leases +12 years +Weighted-average discount rate +Operating leases +5.3% +Finance leases +4.5% +As of December 31, 2019, maturities of lease liabilities were as follows: +(table only in thousands) +Operating Leases +Finance Leases +2020 +3,161 +855 +2021 +2,756 +872 +2022 +2,103 +889 +2023 +1,944 +907 +2024 +1,778 +925 +Thereafter +4,810 +5,484 +Total minimum lease payments +$ +16,552 +$ +9,932 +Less imputed interest +(2,826 +) +(2,076 +) +Lease liability +$ +13,726 +$ +7,856 +Disclosures related to periods prior to the adoption of the New Lease Standard +As previously disclosed in our Annual Report on Form 10-K, for the year ended December 31, 2018 and under previous lease accounting standards, future minimum lease payments for operating leases having initial or remaining noncancelable lease terms in excess of one year would have been as follows: +(table only in thousands) +December 31, 2018 +2019 +$ +2,745 +2020 +1,880 +2021 +1,454 +2022 +931 +2023 +851 +Thereafter +2,278 +Total +$ +10,139 +F-25 +13. +Commitments and Contingencies +Legal Proceedings +Asbestos cases +Our subsidiary, Met-Pro, beginning in 2002 began to be named in asbestos-related lawsuits filed against a large number of industrial companies including, in particular, those in the pump and fluid handling industries. In management’s opinion, the complaints typically have been vague, general and speculative, alleging that Met-Pro, along with the numerous other defendants, sold unidentified asbestos-containing products and engaged in other related actions which caused injuries (including death) and loss to the plaintiffs. Counsel has advised that more recent cases typically allege more serious claims of mesothelioma. The Company’s insurers have hired attorneys who, together with the Company, are vigorously defending these cases. Many cases have been dismissed after the plaintiff fails to produce evidence of exposure to Met-Pro’s products. In those cases, where evidence has been produced, the Company’s experience has been that the exposure levels are low and the Company’s position has been that its products were not a cause of death, injury or loss. The Company has been dismissed from or settled a large number of these cases. Cumulative settlement payments from 2002 through December 31, 2019 for cases involving asbestos-related claims were $3.0 million which together with all legal fees other than corporate counsel expenses; $2.8 million have been paid by the Company’s insurers. The average cost per settled claim, excluding legal fees, was approximately $34,000. +Based upon the most recent information available to the Company regarding such claims, there were a total of 209 cases pending against the Company as of December 31, 2019 (with Illinois, New York, Pennsylvania and West Virginia having the largest number of cases), as compared with 208 cases that were pending as of December 31, 2018. During 2019, 68 new cases were filed against the Company, and the Company was dismissed from 59 cases and settled 8 cases. Most of the pending cases have not advanced beyond the early stages of discovery, although a number of cases are on schedules leading to or are scheduled for trial. The Company believes that its insurance coverage is adequate for the cases currently pending against the Company and for the foreseeable future, assuming a continuation of the current volume, nature of cases and settlement amounts. However, the Company has no control over the number and nature of cases that are filed against it, nor as to the financial health of its insurers or their position as to coverage. The Company also presently believes that none of the pending cases will have a material adverse impact upon the Company’s results of operations, liquidity or financial condition. +Other +The Company is also a party to routine contract and employment-related litigation matters and routine audits of state and local tax returns arising in the ordinary course of its business. +The final outcome and impact of open matters, and related claims and investigations that may be brought in the future, are subject to many variables, and cannot be predicted. In accordance with ASC 450, “Contingencies,” and related guidance, we record reserves for estimated losses relating to claims and lawsuits when available information indicates that a loss is probable and the amount of the loss, or range of loss, can be reasonably estimated. The Company expenses legal costs as they are incurred. +We are not aware of pending claims or assessments, other than as described above, which may have a material adverse impact on our liquidity, financial position, results of operations, or cash flows. +14. +Income Taxes +Income (loss) before income taxes was generated in the United States and globally as follows: +(table only in thousands) +2019 +2018 +2017 +Domestic +$ +11,565 +$ +6,230 +$ +3,891 +Foreign +1,779 +(3,733 +) +(2,482 +) +$ +13,344 +$ +2,497 +$ +1,409 +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested, as management intends to repatriate foreign-held cash as needed to meet domestic cash needs for operating, investing, and financing activities. A liability of $0.7 million has been recorded for the deferred taxes on such undistributed foreign earnings. The deferred taxes are attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +F-26 +Income tax (benefit) expense consisted of the following for the years ended December 31: +(table only in thousands) +2019 +2018 +2017 +Current: +Federal +$ +(4,526 +) +$ +5,166 +$ +6,234 +State +(616 +) +1,660 +388 +Foreign +1,719 +2,834 +939 +(3,423 +) +9,660 +7,561 +Deferred: +Federal +(604 +) +1,144 +(2,479 +) +State +(220 +) +56 +114 +Foreign +(116 +) +(1,242 +) +(758 +) +(940 +) +(42 +) +(3,123 +) +$ +(4,363 +) +$ +9,618 +$ +4,438 +The income tax (benefit) expense differs from the statutory rate due to the following: +(table only in thousands) +2019 +2018 +2017 +Tax expense at statutory rate +$ +2,802 +$ +524 +$ +494 +Increase (decrease) in tax resulting from: +State income tax, net of federal benefit +(707 +) +1,337 +367 +Change in uncertain tax position reserves +(236 +) +73 +465 +Permanent differences related to divestitures +(4,201 +) +7,048 +— +Other Permanent differences +(842 +) +693 +1,026 +Impact of rate differences and adjustments +884 +57 +(20 +) +United States tax credits and incentives +(2,124 +) +(354 +) +(240 +) +Foreign tax credits and incentives +(1,386 +) +(1,088 +) +— +Change in valuation allowance +198 +1,521 +1,044 +Revaluation of deferred tax assets and liabilities +— +— +(4,819 +) +Net deemed distribution on repatriation of foreign earnings +— +(1,713 +) +6,426 +Foreign withholding taxes on repatriation of foreign earnings +646 +666 +— +Earnout income +— +(69 +) +(1,779 +) +Domestic production activities deduction +— +— +(235 +) +Intangible asset and goodwill impairment +— +— +1,789 +Net effect GILTI and FDII +399 +(172 +) +— +Other +204 +1,095 +(80 +) +$ +(4,363 +) +$ +9,618 +$ +4,438 +F-27 +Deferred income taxes reflect the future tax consequences of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and tax credit carry forwards. The net deferred tax liabilities consisted of the following at December 31: +December 31 +(table only in thousands) +2019 +2018 +Gross deferred tax assets: +Accrued expenses +$ +1,167 +$ +417 +Reserves on assets +1,566 +1,276 +Share-based compensation awards +410 +459 +Minimum pension +1,946 +2,153 +Net operating loss carry-forwards +3,141 +3,478 +Tax credit carry-forwards +2,940 +2,352 +Other +360 +— +Depreciation +140 +— +Valuation allowances +(5,810 +) +(5,474 +) +5,860 +4,661 +Gross deferred tax liabilities: +Depreciation +— +(646 +) +Goodwill and intangibles +(9,855 +) +(10,907 +) +Prepaid expenses and inventory +(554 +) +(798 +) +Withholding tax on unremitted foreign earnings +(646 +) +(551 +) +Revenue recognition +(748 +) +(514 +) +(11,803 +) +(13,416 +) +Net deferred tax liabilities +$ +(5,943 +) +$ +(8,755 +) +As of December 31, 2019, the Company has utilized substantially all of its federal net operating loss carry forwards. State and local net operating loss carry forwards total $35.9 million, which expire from 2020 to 2039. The Company has recorded a valuation allowance on certain of these net operating loss carry forwards to reflect expected realization. The Company also has net operating loss carry forwards in foreign jurisdictions totaling $10.4 million. A full valuation allowance has been established against substantially all of these losses in foreign jurisdictions. As of December 31, 2019 and 2018, the Company has recorded a valuation reserve in the amount of $5.8 million and $5.5 million, respectively. The changes in the valuation allowance resulted in additional income tax expense of $0.2 million, $1.5 million, and $1.0 million in 2019, 2018, and 2017, respectively. +In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this assessment. Based on this assessment, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2019. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The Company accounts for uncertain tax positions pursuant to FASB ASC Topic 740. The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. A reconciliation of the beginning and ending amount of uncertain tax position reserves included in other liabilities on the Consolidated Balance Sheets is as follows: +(table only in thousands) +2019 +2018 +Balance as of January 1, +$ +939 +$ +866 +Additions for tax positions taken in prior years +4 +73 +Statute expirations +— +— +Reductions of tax positions taken in prior years +(240 +) +— +Reductions for settlements on tax positions of prior years +(449 +) +— +Balance as of December 31, +$ +254 +$ +939 +F-28 +The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. The reserve for uncertain tax positions includes $0.1 million, $0.3 million and $0.3 million of interest and penalties as of December 31, 2019, 2018 and 2017, respectively. The favorable settlement of all uncertain tax positions would impact the Company’s effective income tax rate. Tax years going back to 2014 remain open for all significant state and foreign authorities. +15. +Related Party Transactions +During 2019, 2018 and 2017 we paid fees of $0.2 million, $0.2 million and $0.3 million, respectively, for consulting services to Icarus, through which Jason DeZwirek, our Chairman of our Board, provides services. During 2019, 2018 and 2017, we paid fees of $0.1 million in each year for consulting services to JMP Fam Holdings Inc., through which Jonathan Pollack, a member of the Board of Directors, provides services. All services described above are based on verbal agreements with the Company. The Board of Directors approves the above services on an annual basis. +1 6 . +Divestitures +Strobic Air Corporation +On March 30, 2018, the Company completed the sale of Strobic Air Corporation (“Strobic”) as part of its strategic decision to exit brands that do not align with the CECO portfolio to increase focus on better serving the energy and industrial solutions and fluid handling markets. The sales price was $28.5 million, subject to post-closing purchase price adjustments. The disposition resulted in a gain of $6.9 million, comprised of $27.9 million of net proceeds received as consideration after post-closing purchase price adjustments less net assets disposed of $18.8 million and transaction costs of $2.2 million. The net assets disposed of are primarily comprised of $13.0 million of goodwill, $2.3 million of definite-lived intangible assets and $1.2 million of indefinite-lived intangible assets allocated to the Strobic business. In 2017, Strobic reported $17.7 million in net sales and $1.6 million in income from operations. Strobic results through the date of disposition are included within income before income taxes in the Consolidated Statement of Operations and are reported within the Fluid Handling Solutions segment. The sale of Strobic did not constitute a significant strategic shift that will have a material impact on the Company’s ongoing operations and financial results. +Keystone Filter +On February 28, 2018, the Company completed the sale of the Keystone Filter brand (“Keystone”) as part of its strategic decision to exit brands that do not align with the CECO portfolio to increase focus on better serving energy and industrial solutions and fluid handling markets. The sales price was $7.5 million, subject to post-closing purchase price adjustments. The disposition resulted in a gain of $4.3 million, comprised of $7.2 million of net proceeds after post-closing purchase price adjustments less net assets disposed of $2.7 million and transaction costs of $0.2 million. Keystone results are reported within the Fluid Handling Solutions segment through the date of disposition. +F-29 +Zhongli +On November 27, 2018, the Company completed the sale of Jiangyin Zhongli Industrial Technology Co. Ltd (“Zhongli”), a business in our Energy Solutions segment operating in China, for a price of $3.6 million. In the third quarter of 2018, we classified the assets and liabilities of Zhongli as held-for-sale. In connection with classifying this business as held-for-sale, GAAP required us to assess impairment by comparing the estimated selling price, less cost to sell to our carrying value in Zhongli. Based on this analysis, we recorded a $15.1 million loss. In 2019, the Company finalized a tax position related to the future carryback of the capital loss recognized in connection with the divestiture, resulting in a $4.4 million income tax benefit. The disposal of this business does not constitute a significant strategic shift that will have a material impact on the Company’s ongoing operations and financial results. Zhongli results are reported within the Energy Solutions segment through the date of disposition. +1 7 . +Business Segment Information +The Company’s operations are organized and reviewed by management along its product lines or end markets that the segment serves and are presented in three reportable segments. The results of the segments are reviewed through to the “Income from operations” line on the Consolidated Statements of Operations. The accounting policies of the segments are the same as those in the consolidated financial statements. Except for the information reported on a segment basis, the Company does not accumulate net sales information by product or service and therefore, the Company does not disclose net sales by product or service because to do so would be impractical. +During the first quarter of 2019, as a result of further evaluating the Company’s operating structure, management determined that a minor realignment of the Company’s segments would help maximize growth and improve customer experience. As a result of this minor realignment, the operating results of the reportable segments Fluid Handling Solutions and Industrial Solutions have been reclassified to have their results align for the years ended December 31, 2019, 2018 and 2017. +The Company’s reportable segments are organized as groups of similar products and services, as described as follows: +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for Clean Energy through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +2019 +2018 +2017 +Net Sales (less intra-, inter-segment sales) +(table only in thousands) +Energy Solutions segment +$ +210,319 +$ +211,185 +$ +188,955 +Industrial Solutions segment +91,347 +80,699 +$ +93,960 +Fluid Handling Solutions segment +40,203 +45,455 +$ +63,037 +Corporate and Other (1) +— +— +(901 +) +Net sales +$ +341,869 +$ +337,339 +$ +345,051 +(1) +Includes adjustment for revenue on intercompany jobs. +F-30 +2019 +2018 +2017 +Income (loss) from Operations +(t able only in thousands) +Energy Solutions segment +$ +33,886 +$ +28,797 +$ +14,565 +Industrial Solutions segment +5,679 +6,308 +8,800 +Fluid Handling Solutions segment +5,558 +7,730 +14,059 +Corporate and Other (2) +(27,133 +) +(32,833 +) +(26,649 +) +Eliminations +— +— +(2,751 +) +Income from operations +$ +17,990 +$ +10,002 +$ +8,024 +(2) Includes corporate compensation, professional services, information technology, acquisition and integration expenses, and other general , administrative corporate expenses and loss on divestitures +2019 +2018 +2017 +Property and Equipment Additions +(t able only in thousands) +Energy Solutions segment +$ +434 +$ +205 +$ +444 +Industrial Solutions segment +402 +756 +160 +Fluid Handling Solutions segment +3,239 +1,226 +382 +Corporate and Other +1,580 +903 +42 +Property and equipment additions +$ +5,655 +$ +3,090 +$ +1,028 +2019 +2018 +2017 +Depreciation and Amortization +(t able only in thousands) +Energy Solutions segment +$ +6,084 +$ +8,112 +$ +9,675 +Industrial Solutions segment +1,320 +1,067 +1,488 +Fluid Handling Solutions segment +2,795 +3,517 +4,754 +Corporate and Other +410 +576 +171 +Depreciation and amortization +$ +10,609 +$ +13,272 +$ +16,088 +December 31, +2019 +2018 +Identifiable Assets +(table only in thousands) +Energy Solutions segment +$ +254,752 +$ +245,842 +Industrial Solutions segment +64,725 +54,179 +Fluid Handling Solutions segment +71,572 +73,910 +Corporate and Other (3) +17,588 +18,651 +Identifiable assets +$ +408,637 +$ +392,582 +( 3 ) +Corporate assets primarily consist of cash and income tax related assets. +December 31, +2019 +2018 +Goodwill +(t able only in thousands) +Energy Solutions segment +$ +97,007 +$ +97,143 +Industrial Solutions segment +23,436 +23,436 +Fluid Handling Solutions segment +31,577 +31,577 +Goodwill +$ +152,020 +$ +152,156 +F-31 +Intra-segment and Inter-segment Revenues +The Company has divisions that sell to each other within segments (intra-segment sales) and between segments (inter-segment sales) as indicated in the following tables: +Year Ended December 31, 2019 +Less Inter-Segment Sales +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Corp +and +Other +Net Sales to +Outside +Customers +Net Sales +(t able only in thousands) +Energy Solutions segment +$ +217,359 +$ +(6,650 +) +$ +(390 +) +$ +— +$ +— +$ +— +$ +210,319 +Industrial Solutions segment +101,369 +(8,278 +) +— +(1,677 +) +(67 +) +— +91,347 +Fluid Handling Solutions segment +41,717 +(1,300 +) +(214 +) +— +— +— +40,203 +Corporate and Other +— +— +— +— +— +— +— +Net Sales +$ +360,445 +$ +(16,228 +) +$ +(604 +) +$ +(1,677 +) +$ +(67 +) +$ +— +$ +341,869 +Year Ended December 31, 2018 +Less Inter-Segment Sales +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Corp +and +Other +Net Sales to +Outside +Customers +Net Sales +(t able only in thousands) +Energy Solutions segment +$ +220,334 +$ +(7,912 +) +$ +(1,232 +) +$ +— +$ +(5 +) +$ +— +$ +211,185 +Industrial Solutions segment +84,424 +(3,084 +) +— +(600 +) +(41 +) +— +80,699 +Fluid Handling Solutions segment +47,561 +(1,483 +) +(616 +) +(7 +) +— +— +45,455 +Corporate and Other +— +— +— +— +— +— +— +Net Sales +$ +352,319 +$ +(12,479 +) +$ +(1,848 +) +$ +(607 +) +$ +(46 +) +$ +— +$ +337,339 +Year Ended December 31, 2017 +Less Inter-Segment Sales +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Corp +and +Other +Net Sales to +Outside +Customers +Net Sales +(t able only in thousands) +Energy Solutions segment +$ +197,897 +$ +(8,833 +) +$ +(109 +) +$ +— +$ +— +$ +— +$ +188,955 +Industrial Solutions segment +98,037 +(3,235 +) +— +(787 +) +(55 +) +— +93,960 +Fluid Handling Solutions segment +67,530 +(3,169 +) +(492 +) +(832 +) +— +— +63,037 +Corporate and Other (4) +— +— +— +— +— +(901 +) +(901 +) +Net Sales +$ +363,464 +$ +(15,237 +) +$ +(601 +) +$ +(1,619 +) +$ +(55 +) +$ +(901 +) +$ +345,051 +(4) Includes adjustment for revenue on intercompany jobs. +No single customer represented greater than 10% of consolidated net sales or accounts receivable for 2019, 2018, or 2017. +For 2019, 2018, and 2017, sales to customers outside the United States, including export sales, accounted for approximately 30%, 33%, and 32%, respectively, of consolidated net sales. The largest portion of export sales in 2019 was destined for Europe (11.5%), and Asia (11.0%). Of consolidated long-lived assets, $16.9 million and $19.1 million were located outside of the United States as of December 31, 2019 and 2018, respectively. The largest portion of long-lived assets located outside the United States at December 31, 2019 were in Europe ($13.3 million). +F-32 +1 8 . +Quarterly Data (Unaudited) +Earnings per share amounts are computed independently each quarter. Accordingly, the sum of each quarter’s per share amount may not equal the total per share amount for the respective year. +Quarter +(table only in thousands, except per share data) +First +Second +Third +Fourth +Year ended December 31, 2019 +Net sales +$ +86,011 +$ +81,179 +$ +85,266 +$ +89,413 +Gross profit +28,432 +26,846 +28,777 +30,044 +Net income +1,864 +5,515 +1,931 +8,397 +Basic earnings per share +$ +0.05 +$ +0.16 +$ +0.06 +$ +0.24 +Diluted earnings per share +$ +0.05 +$ +0.15 +$ +0.05 +$ +0.24 +Year ended December 31, 2018 +Net sales +$ +74,139 +$ +81,089 +$ +88,256 +$ +93,854 +Gross profit +25,561 +27,525 +28,674 +29,777 +Net income (loss) +5,763 +(901 +) +(12,915 +) +931 +Basic earnings (loss) per share +$ +0.17 +$ +(0.03 +) +$ +(0.37 +) +$ +0.03 +Diluted earnings (loss) per share +$ +0.17 +$ +(0.03 +) +$ +(0.37 +) +$ +0.03 +F-33 \ No newline at end of file diff --git a/raw/filings/0000003197/2019/0001564590-20-008551/filing_metadata.csv b/raw/filings/0000003197/2019/0001564590-20-008551/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..7fcc414ca920cc89147ffd83250c983999498e3c --- /dev/null +++ b/raw/filings/0000003197/2019/0001564590-20-008551/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003197,CECO,CECO ENVIRONMENTAL CORP,2019,10-K,2020-03-04,2019-12-31,2020-03-04T14:32:40.000Z,0001564590-20-008551,cece-10k_20191231.htm,10-K,17941845,1,0,https://www.sec.gov/Archives/edgar/data/3197/000156459020008551/cece-10k_20191231.htm,https://www.sec.gov/Archives/edgar/data/3197/000156459020008551/ diff --git a/raw/filings/0000003197/2019/0001564590-20-008551/item1.txt b/raw/filings/0000003197/2019/0001564590-20-008551/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..3a455ae69e6d0898d358d0868ce90d899f82924e --- /dev/null +++ b/raw/filings/0000003197/2019/0001564590-20-008551/item1.txt @@ -0,0 +1,116 @@ +Item 1. +Business +General +CECO Environmental Corp. (“CECO” or the “Company”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customer’s mission critical applications. The secular growth industries CECO serves include oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing, along with a wide range of other industries. +CECO has over $6 billion of installed equipment base with end users, which we target to expand and grow a higher recurring revenue of aftermarket products and services. We also focus on operational excellence strategies as a central theme to improving our earnings and cash flows. +Our customers include some of the largest natural gas processors, transmission and distribution companies, refineries, power generators, boiler manufacturers, compressor manufacturers, metals and minerals, industrial manufacturing, engineering and construction companies in the world. +We believe our value differentiators include, but are not limited to, reliable product performance, timely delivery, customer satisfaction, and advanced engineering. We believe these are critical in maintaining our competitive position and have adopted a spirit of continuous improvement to ensure we maintain our market leadership position. The Company has been publicly traded since January 1, 1978. +Industry Overview +We serve a $5 billion dollar global market that is highly fragmented and serves various end markets including power generation, natural gas power plants, petrochemical processing, general industrial, refining, oil & gas and wastewater treatment. +We believe demand for our products and services will continue to be driven by the following factors: +• +Global Economic Conditions. The Company’s businesses are impacted by economic conditions around the globe. Higher economic growth and other factors that would increase industrial gross domestic product and capital expenditures are projected to impact the markets the Company serves and could affect the Company’s businesses by increasing demand for the Company’s products and services. +• +Worldwide Industrialization . Global trade has increased significantly over the last decade and is driven by growth in emerging markets, including China and India, as well as other developing nations in Asia and the Europe, Middle East, and Africa (“EMEA”) region. As a result of globalization, manufacturing that was historically performed domestically continues to migrate to lower cost countries. This movement of the manufacture of goods throughout the world increases demand for industrial ventilation products as new construction continues. We expect that more rigorous environmental regulations will be introduced to create a cleaner working environment and reduce environmental emissions as these economies evolve. +• +Natural Gas Infrastructure . The natural gas industry consists of the exploration, production, processing, transportation, storage and distribution of natural gas. The International Energy Association (“IEA”) projects a pronounced shift in Organization for Economic Cooperation and Development (“OECD”) countries away from oil and coal towards natural gas and renewables. Natural gas continues to be the fuel of choice for the electrical power and industrial sectors in many of the world’s regions, in part because of its lower carbon intensity compared with coal and oil, which makes it an attractive fuel source in countries where governments are implementing policies to reduce greenhouse gas emissions. +• +P ower Generation. Power generation encompasses a broad range of activities related to the production of electricity. The primary types of fuel used to generate electricity are coal, natural gas and nuclear. In the United States, concerns about potential environmental regulations enhance the attractiveness of natural gas-fired power plants compared with coal-fired power plants, which generally have higher pollutant emission rates than natural gas-powered plants. Natural gas-fired power plants have lower initial capital needs and are more flexible in terms of operating times than coal plants. +2 +• +Refining, Oil Production and Petrochemical Processing . Refining, oil production and petrochemical processing involves the producing, refining and processing of fuels and chemicals for use in a variety of applications, such as gasoline, fertilizers and plastics. In response to increasing international demand for petrochemicals and refined products, companies are producing more products from new sources, constructing new ref ineries and petrochemical processing facilities as well as expanding existing facilities. In many cases, these new and expanded facilities must comply with stricter environmental regulations, which influence both choice of fuel and demand for systems to co ntrol exhaust emissions. +• +Stringent Regulatory Environment . The adoption of increasingly stringent environmental regulations globally requires businesses to pay strict attention to environmental protection. Businesses and industries of all types from refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing must comply with these various international, federal, state and local government regulations or potentially face substantial fines or be forced to suspend production or alter their production processes. These increasingly stringent environmental regulations are a principal factor that drives our business. +These factors, individually or collectively, tend to cause increases in industrial capital spending that are not directly impacted by general economic conditions, expansion, or capacity increases. In contrast, favorable conditions in the economy generally lead to plant expansions and the construction of new industrial sites. However, in a weak economy, customers tend to lengthen the time from their initial inquiry to the purchase order or defer purchases. +Mission and Strategy +Our mission is to help companies grow their business with safe, clean and more efficient solutions that help protect people and our shared environment. +We seek to fulfill this mission through established global leadership in air quality and fluid handling solutions focused on serving the energy, industrial, and other niche markets around the world. We will continue to leverage our innovative technology and application expertise to customers around the world. We work to improve air quality, optimize the energy value chain, and provide custom engineered solutions for applications including oil and gas, power generation, water and wastewater, battery production, poly silicon fabrication, chemical and petrochemical processing along with a wide range of other applications. +Our strategy to become the global leader in air quality and fluid handling solutions is to drive an operating environment of performance excellence across the Company with a near term focus on targeted value creation enablers, and growth-oriented business segment performance. +Four Value Creation Enablers Driving Growth: +All four of these are inter-connected and critical to achieving our objectives. +• +Outside-In Leadership is all about an increased attention on our customers and the trends affecting the world around us as we make decisions that enable our organization to be responsive and with an orientation for growth. +• +Innovation is about us finding better ways to help our customers get their jobs done – whether that is a new product and technology or the way we serve and work with them. +• +Simplification involves aligning and streamlining our operational practices and metrics to match our customers’ key performance indicators (“KPIs”) for success and removing complexity from our systems and structure. +• +Active Portfolio Management dictates a regular evaluation of our business units for market attractiveness and profitability together with scanning the market for attractive potential additions that strengthen the long-term outlook of the Company. +3 +Three Business Segments: +The Company executes and reports in three reportable segments focused on attractive end markets. Each segment is aligned to generate profitable growth for the Company across a targeted industry with a compelling technology and solution set to benefit customers. Additionally, we seek to protect and deepen our end user relationships by expanding our aftermarket services with long-term service contracts that deliver a full life-cycle of customer support. +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for Clean Energy through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Competitive Strengths +Leading market position as a complete solution provider . We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. The multi-billion dollar global market is highly fragmented with numerous small and regional contracting firms separately supplying engineering services, fabrication, installation, testing and monitoring, products and spare parts. We offer our customers a complete end-to-end solution, including engineering and project management services, procurement and fabrication, construction and installation, aftermarket support, and sale of consumables, which allows our customers to avoid dealing with multiple vendors when managing projects. +Long-standing experience and customer relationships in growing industry . We have serviced the needs of our target markets for over 50 years. Our extensive experience and expertise in providing diversified solutions enhances our overall customer relationships, and provides us with a competitive advantage in our markets relative to other companies in the industry. We believe this is evidenced by strong relationships with many of our world-class customers. We believe no single competitor has the resources to offer a similar portfolio of product and service capabilities. We offer the depth of a large organization, while our lean organizational structure keeps us close to our customers and markets, allowing us to offer rapid and complete solutions in each unique situation. +Global diversification and broad customer base. The global diversity of our operations and customer base provides us with multiple growth opportunities. As of December 31, 2019, we had a diversified customer base of approximately 4,800 active customers across a range of industries. We believe that the diversity of our customers and end markets mitigates our risk of a potential fluctuation or downturn in demand from any individual industry or particular customer. We believe we have the resources and capabilities to meet the needs of our customers as they upgrade and expand domestically as well as into new international markets. Once systems have been installed and a relationship has been established with the customer, we are often awarded repetitive service and maintenance business as the customers’ processes change and modifications or additions to their systems become necessary. +Experienced management and engineering team. Our senior management team has substantial experience in industrial air quality and fluid handling solutions. The business experience of our management team enables us to pursue our strategy. Our workforce includes approximately 200 engineers, designers, and project managers whose significant specialized industry experience and technical expertise enables them to have a deep understanding of the solutions that will best suit the needs of our customers. The experience and stability of our management, operating and engineering teams have been crucial to our growth, developing and maintaining customer relationships, and increasing our market share. +Expand customer base and penetrate end markets through global market coverage . We constantly look for opportunities to gain new customers and penetrate geographic locations and end markets with existing products and services or acquire new product or +4 +service o pportunities. We intend to continue to expand our sales force, customer base, and end markets, and have continued to pursue potential attractive growth opportunities both domestically and globally. In the last three years we have expanded our international presence with sales & engineering hubs in Shanghai, Singapore, Pune India, and Dubai. +Develop innovative solutions . We leverage our engineering and manufacturing expertise and strong customer relationships to develop new customized products to address the identified needs of our customers or a particular end market. We thoroughly analyze new product opportunities by considering projected demand for the product or service, price point, and expected operating costs, and only pursue those opportunities that we believe will contribute to earnings growth in the near-term. In addition, we continually improve our traditional technologies and adapt them to new industries and processes. +Disciplined acquisition program with successful integration . We believe that we have demonstrated an ability to successfully acquire and integrate companies with complementary product or service offerings. We will continue to seek and execute additional strategic acquisitions and focus on expanding our product service and breadth, as well as entering into new adjacent markets. We believe that the breadth and diversity of our products and services and our ability to deliver full solutions to various end markets provides us with multiple sources of stable growth and a competitive advantage relative to other players in the industry. +Products and Services +We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that control emissions from such facilities, as well as fluid handling and filtration systems. We provide a wide spectrum of products and services including dampers and diverters, selective catalytic reduction and selective non-catalytic reduction systems, cyclonic technology, thermal oxidizers, filtration systems, scrubbers, fluid handling equipment and plant engineering services and engineered design build fabrication. +Project Design and Research and Development +We seek to achieve our Outside-In Leadership by understanding our customers’ needs and delivering better outcomes for them by focusing new product development efforts that help protect our shared environment while working to improve a variety of operational outcomes including, but not limited to, facility uptime, production quality, and process performance. We produce specialized products that are often tailored to the specifications of a customer or application. +We continually collaborate with our customers on their projects to develop the proper solution and ensure customer satisfaction. The project development cycle may follow many different paths depending on the specifics of the job and end market. The cycle can take from one to more than twelve months from concept and design to production but may vary significantly depending on developments that occur during the process, including among others, the emergence of new environmental demands, changes in design specifications and ability to obtain necessary approvals. +Sales, Marketing and Support +Our global selling strategy is to provide a solutions-based approach by being a single source provider of technology products and services. The strategy involves expanding our scope of products and services through selective acquisitions and the formation and integration of new business units. We believe this strategy provides a discernible competitive advantage. We execute this strategy by utilizing our portfolio of in-house technologies and those of third-party equipment suppliers. Many of these have been long-standing relationships, which have evolved from pure supplier roles to value-added business partnerships. This enables us to leverage existing business with selective alliances of suppliers and application specific engineering expertise. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support, and single source. Our value proposition to customers is to provide competitively priced, customized solutions. Our industry-specific knowledge, accompanied by our product and service offerings, provides valuable synergies for design innovation. +We sell and market our products and services with our own direct sales force, including employees in the United States, the Netherlands, United Kingdom, Canada, United Arab Emirates, India, Mexico, China, and Singapore, in conjunction with outside sales representatives in North America, South America, EMEA, Asia, and India. We expect to continue expanding our sales and support capabilities and our network of outside sales representatives in key regions domestically and internationally. +We market our offerings to our customers through a variety of channels including, but not limited to, digital, web, social media, email campaigns, individual customer visits, product announcements, brochures, magazine articles, advertisements and cover or +5 +article features in trade journals and other publications. We also participate in public relations an d promotional events, including industry tradeshows and technical conferences. +Our customer service organization or sales force provides our customers with technical assistance, use and maintenance information as well as other key information regarding their purchase. We also actively provide our customers with access to key information regarding changes and pending changes in environmental regulations as well as new product or service developments. We believe that maintaining a close relationship with our customers and providing them with the support they request improves their level of satisfaction and enables us to foresee their potential future product needs or service demands. Moreover, this approach can lead to sales of annual service and support contracts as well as consumables. Our website also provides our customers with online tools and technical resources. +Quality Assurance +In engineered systems, quality is defined as system performance. We review with our customers, before the contract is signed, the technical specification and the efficiency of the equipment that will be customized to meet their specific needs. We then review these same parameters internally to assure that warranties will be met. Standard project management and production management tools are used to help ensure that all work is done to specification and that project schedules are met. Equipment is tested at the site to ensure it is functioning properly. +Customers +We are not dependent upon any single customer, and no customer comprised 10% or more of our consolidated revenues for 2019. +Suppliers and Subcontractors +We purchase our raw materials and supplies from a variety of global sources. When possible, we directly secure angle iron and sheet plate products from steel mills, whereas other materials are purchased from a variety of steel service centers. Steel prices have traditionally been volatile, but we typically mitigate the risk of higher prices by including a “surcharge” on our standard products. On contract work, we mitigate the risk of higher prices by including the current price in our estimate and generally include price inflation clauses for protection. +We believe we have a good relationship with our suppliers and do not anticipate any difficulty in continuing to purchase such items on terms acceptable to us. We have not experienced difficulty in procuring a sufficient supply of materials in the past. To the extent that our current suppliers are unable or unwilling to continue to supply us with materials, we believe that we would be able to obtain such materials from other suppliers on acceptable terms. +Typically, on turnkey projects, we subcontract manufacturing, electrical work, concrete work, controls, conveyors and insulation. We use subcontractors with whom we have good working relationships and review each project at the beginning and on an ongoing basis to help ensure that all work is being done according to our specifications. Subcontractors are generally paid when we are paid by our customers according to the terms of our contract with the customer. The Company’s asset-light business model focuses on effective management of subcontractors, which allows the Company to achieve targeted working capital levels through reduction in certain assets and reduced capital expenditures. +Backlog +Backlog (i.e., unfulfilled or remaining performance obligations) represents the sales we expect to recognize for our products and services for which control has not yet transferred to the customer. Backlog increased to $216.6 million as of December 31, 2019 from $182.1 million as of December 31, 2018 . Our customers may have the right to cancel a given order. Historically cancellations have not been common, however, during the year 2019, the Company removed $6.7 million of orders that were previously disclosed as backlog in prior periods, due to cancellations by customers. Backlog is adjusted on a quarterly basis for adjustments in foreign currency exchange rates. Substantially all backlog is expected to be delivered within 12 to 18 months. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Competition +The markets we serve are highly fragmented with numerous small and regional participants. We believe no single company competes with us across the full range of our systems and products. Competition in the markets we serve is based on a number of +6 +considerations, including timeliness of delivery, technology, applications experience, know-how, reputation, product warranties , service an d price . Demand for our product can vary period over period depending on conditions in the markets we serve. We believe our reputation, technical engineering capabilities and service differentiate us from many of our competitors, including those competit ors who often offer products at a lower price. +Due to the size and shipping weight of many of our projects, localized manufacturing/fabrication capabilities are very important to our customers. As a result, competition varies widely by region and industry. The market for our engineered products is reasonably competitive and is characterized by technological change, continuously changing environmental regulations, and evolving customer requirements. We believe that the additional competitive factors in our markets include: +• +performance track record in difficult plant applications; +• +comprehensive portfolio of products with leading technology; +• +solid brand recognition; +• +ability to design standard and custom products that meet customers’ needs; +• +ability to provide reliable solutions in a timely manner; +• +quality customer service and support; and +• +financial and operational stability, including reputation. +We believe we compete favorably with respect to these factors. +Government Regulations +We believe our operations are in compliance with applicable environmental laws and regulations. We believe that changes in environmental laws and regulations create opportunity given the nature of our business. +Intellectual Property +We rely on a combination of patent, trademark, copyright and trade secret laws, employee and third-party nondisclosure/confidentiality agreements and license agreements to protect our intellectual property. We sell most of our products under a number of registered trade names, brand names and registered trademarks, which we believe are widely recognized in the industry. While we hold patents within a number of our businesses, we do not view our patents to be material to our business. +Employees +We had approximately 830 full-time employees as of December 31, 2019. The facilities in Greensboro, North Carolina, Louisville, Kentucky, Columbia, Tennessee, and Telford, Pennsylvania are unionized except for selling, engineering, design, administrative and operating management personnel. None of our other employees are subject to any collective bargaining agreements. We consider our relationship with our employees to be satisfactory. In total, as of December 31, 2019, approximately 200 employees were represented by independent labor unions under various union contracts that expire at various intervals. +Executive Officers of CECO +The following are the executive officers of the Company as of February 28, 2020. The terms of all officers expire at the next annual meeting of stockholders and upon the election of the successors of such officers. +Dennis Sadlowski (59) served as our Interim Chief Executive Officer and President from January 2017 until his permanent appointment as Chief Executive Officer in June 2017 and as a director since May 2016. Previously, he was the Chief Operating Officer of LSG Sky Chefs North America, a provider of food and food-related services for transportation providers, from April 2013 until March 2015. As Chief Operating Officer, Mr. Sadlowski oversaw operations across over 40 locations in North America and managed over 8,000 employees. Previously, Mr. Sadlowski served as the Chief Executive Officer of International Battery, an early stage green tech company focused on large format lithium ion batteries for the grid storage markets, from September 2011 until April 2012. Mr. Sadlowski worked at Siemens from July 2000 to March 2010, serving as the President & Chief Executive Officer of Siemens Energy & Automation, Inc. from July 2007 until October 2009, an operating subsidiary of the global manufacturer Siemens AG, where he had executive accountability for the company’s global strategic direction, operating performance and marketplace success. His responsibilities at Siemens Energy & Automation included overseeing six operating +7 +divisions along with a combined sales organization, a number of wholly-owned subsidiaries and over 12,000 employees. Mr. Sadlowski has also previously worked at General Electric and Thomas & Betts. Mr. Sadlowski was a former member of the B oard of D irectors and audit committee of Trojan Battery, a privately-held global leader in deep cycle lead-acid batteries. Mr. Sadlowski earned a bachelor’s degree in Chemical and Nuclear Engi neering from the University of California at Berkeley, and his master’s degree in Business Administration from Seattle University. +Matthew Eckl (39) has served as our Chief Financial Officer since January 2017. Prior to joining the Company, Mr. Eckl served as Vice President, Finance – Energy Group at Gardner Denver, Inc. from 2012 until January 2017. In this role, he oversaw a $1 billion revenue business group that designs, manufactures, markets and services pumps, fluid transfer equipment and engineered systems for oil & gas and petrochemical industries. Prior to joining Gardner Denver, Mr. Eckl served in various roles of increasing responsibility within General Electric Company, a global digital industrial company, from 2002 until 2012, where he worked with various business groups to integrate new acquisitions and streamline financial reporting processes. Mr. Eckl earned a Bachelor’s degree in Management Information Systems from Pennsylvania State University. +Paul Gohr (38) has served as the Chief Accounting Officer since May 2017. Mr. Gohr previously served as our Vice President of Financial Reporting since joining the Company in September 2014. From 2004 to 2014, Mr. Gohr served in various roles of increasing responsibility within Grant Thornton LLP, a global public accounting firm, most recently as a Senior Manager of Audit Services. While at Grant Thornton LLP, Mr. Gohr served a broad base of both public and private companies with international operations, many of which were acquisitive in nature. Mr. Gohr is a Certified Public Accountant. Mr. Gohr earned a Bachelor’s degree in Business, Accountancy and a Masters of Accountancy degree from Miami University. +Available Information +We use the Investor Relations section of our website, www.cecoenviro.com , as a channel for routine distribution of important information, including news releases, investor presentations and financial information. We post filings as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC, including our annual, quarterly, and current reports on Forms 10-K, 10-Q, and 8-K; proxy statements; and any amendments to those reports or statements. All such postings and filings are available on our website free of charge. The SEC also maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The content on any website referred to in this Annual Report on Form 10-K is not incorporated by reference into this Annual Report on Form 10-K unless expressly noted. +8 \ No newline at end of file diff --git a/raw/filings/0000003197/2019/0001564590-20-008551/item13.txt b/raw/filings/0000003197/2019/0001564590-20-008551/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..3fcf0bfb98e1da4f283fb5e658707b99c4f89eae --- /dev/null +++ b/raw/filings/0000003197/2019/0001564590-20-008551/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +42 \ No newline at end of file diff --git a/raw/filings/0000003197/2020/0001564590-21-010416/filing.txt b/raw/filings/0000003197/2020/0001564590-21-010416/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..5277a3181c4cec8a2a1cb897d253b5b792c7f18f --- /dev/null +++ b/raw/filings/0000003197/2020/0001564590-21-010416/filing.txt @@ -0,0 +1,5515 @@ 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+0000003197 +us-gaap:NonUsMember +2020-12-31 +0000003197 +us-gaap:NonUsMember +2019-12-31 +0000003197 +srt:EuropeMember +2020-12-31 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark one) +☒ +Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the fiscal year ended December 31, 2020 +or +☐ +Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the transition period from to +Commission File No. 0-7099 +CECO ENVIRONMENTAL CORP. +Delaware +13-2566064 +(State or other jurisdiction of +incorporation or organization) +(I.R.S. Employer +Identification No.) +14651 North Dallas Parkway +Suite 500 +Dallas , Texas +75254 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: ( 214 ) 357-6181 +Securities registered under Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +Common Stock, par value $0.01 per share +CECE +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer +☐ +Accelerated Filer +☒ +Non-Accelerated Filer +☐ +Smaller reporting company +☒ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report ☒ +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +The aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant was $ 166.2 million based upon the closing market price and shares of common stock outstanding as of June 30, 2020, the last business day of our most recently completed second fiscal quarter. For the purpose of the foregoing calculation only, all directors and executive officers of the registrant and owners of more than 10% of the registrant’s common stock are assumed to be affiliates of the registrant. This determination of affiliate status is not necessarily conclusive for any other purpose. +As of February 25, 2021, the registrant had 35,350,727 shares of common stock, par value $0.01 per share, outstanding. +Documents Incorporated by Reference +Portions of the definitive Proxy Statement for the 2021 Annual Meeting of Stockholders, which is to be filed with the Securities and Exchange Commission within 120 days of the fiscal year ended December 31, 2020, are incorporated by reference into Part III of this Annual Report to the extent described herein. +CECO Environmental Corp. and Subsidiaries +ANNUAL REPORT ON FORM 10-K +For the year ended December 31, 2020 +TABLE OF CONTENTS +Item +Description +Page +PART I. +Item 1. +Business +2 +Item 1A. +Risk Factors +11 +Item 1B. +Unresolved Staff Comments +22 +Item 2. +Properties +22 +Item 3. +Legal Proceedings +22 +Item 4. +Mine Safety Disclosures +22 +PART II. +Item 5. +Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +23 +Item 6. +Selected Financial Data +24 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +25 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +39 +Item 8. +Financial Statements and Supplementary Data +40 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +40 +Item 9A. +Controls and Procedures +40 +Item 9B. +Other Information +43 +PART III. +Item 10. +Directors, Executive Officers and Corporate Governance +44 +Item 11. +Executive Compensation +44 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +44 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +44 +Item 14. +Principal Accounting Fees and Services +44 +PART IV. +Item 15. +Exhibits and Financial Statement Schedules +45 +Item 16. +Form 10-K Summary +47 +SIGNATURES +48 +CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS +This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”) which are intended to be covered by the safe harbor for "forward-looking statements" provided by the Private Securities Litigation Reform Act of 1995. Any statements contained in this Annual Report on Form 10-K, other than statements of historical fact, including statements about management’s beliefs and expectations, are forward-looking statements and should be evaluated as such. These statements are made on the basis of management’s views and assumptions regarding future events and business performance. We use words such as “believe,” “expect,” “anticipate,” “intends,” “estimate,” “forecast,” “project,” “will,” “plan,” “should” and similar expressions to identify forward-looking statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from any future results, performance or achievements expressed or implied by such statements. Potential risks and uncertainties, among others, that could cause actual results to differ materially are discussed under “Part I – Item 1A. Risk Factors” of this Annual Report on Form 10-K and include, but are not limited to: +• +the sensitivity of our business to economic and financial market conditions generally and economic conditions in CECO’s service areas; +• +dependence on fixed price contracts and the risks associated therewith, including actual costs exceeding estimates and method of accounting for revenue; +• +the effect of growth on CECO’s infrastructure, resources, and existing sales; +• +the ability to expand operations in both new and existing markets; +• +the potential for contract delay or cancellation; liabilities arising from faulty services or products that could result in significant professional or product liability, warranty, or other claims; changes in or developments with respect to any litigation or investigation; +• +failure to meet timely completion or performance standards that could result in higher cost and reduced profits or, in some cases, losses on projects; +• +the potential for fluctuations in prices for manufactured components and raw materials, including as a result of tariffs and surcharges; +• +the substantial amount of debt incurred in connection with our strategic transactions and our ability to repay or refinance it or incur additional debt in the future; the impact of federal, state or local government regulations; +• +economic and political conditions generally; our ability to successfully realize the expected benefits of our restructuring program; +• +our ability to successfully integrate acquired businesses and realize the synergies from strategic transactions; unpredictability and severity of catastrophic events, including cyber security threats, acts of terrorism or outbreak of war or hostilities or public health crises, such as uncertainties regarding the extent and duration of impacts of matters associated with the novel coronavirus (“COVID-19”), as well as management’s response to any of the aforementioned factors. +Many of these risks are beyond management’s ability to control or predict. Should one or more of these risks or uncertainties materialize, or should the assumptions prove incorrect, actual results may vary in material aspects from those currently anticipated. Investors are cautioned not to place undue reliance on such forward-looking statements as they speak only to our views as of the date the statement is made. Furthermore, forward-looking statements speak only as of the date they are made. Except as required under the federal securities laws or the rules and regulations of the Securities and Exchange Commission (the “SEC”), we undertake no obligation to update or review any forward-looking statements, whether as a result of new information, future events or otherwise. +1 +PART I +Item 1. +Business +General +CECO Environmental Corp. (“CECO,” “we,” “us,” or the “Company”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that controls emissions from such facilities, as well as fluid handling and filtration systems. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customers’ mission critical applications. The industries CECO serves include power generation, petrochemical processing, general industrial, refining, oil & gas, electric vehicle production, poly silicon fabrication, battery recycling, and wastewater treatment, along with a wide range of other industries. +CECO has over $6 billion of installed equipment with end users, which we target to expand and grow a higher recurring revenue of aftermarket products and services. +Our customers include some of the largest natural gas processors, transmission and distribution companies, refineries, power generators, industrial manufacturing, engineering and construction companies, semiconductor manufacturers, compressor manufacturers, metals and minerals, and electric vehicle producers in the world. +We believe our value differentiators include, but are not limited to, our product quality, reliability, on-time delivery and safety, supported by advanced engineering and operational excellence. We believe these are critical in maintaining our competitive position and have adopted a spirit of continuous improvement to ensure we maintain our market leadership position. +Industry Overview +We serve a growing $5 billion dollar global market that is highly fragmented and serves various end markets including power generation, natural gas power plants, petrochemical processing, general industrial, refining, oil & gas and wastewater treatment. +We believe demand for our products and services will continue to be driven by the following factors: +• +Global Focus on Environment. Increased demand for efficient solutions and reduced emissions for clean air remains at the forefront of sustainable production. As our customers and end markets navigate this changing landscape, we are making production cleaner, more efficient and flexible, and workplaces safer, using the same high manufacturing standards our customers expect. Increasingly, society, along with government regulation, call for corporations to commit to the preservation and protection of the environment. We believe that through our air quality and emissions control initiatives, companies want to work with us to protect people and our planet from the harmful effects of industrial processes. +• +Global Economic Conditions. The Company’s businesses are impacted by economic conditions around the globe. Higher economic growth and other factors that would increase industrial gross domestic product and capital expenditures are projected to impact the markets the Company serves and could affect the Company’s businesses by increasing demand for the Company’s products and services. +• +Worldwide Industrialization . Global trade has increased significantly over the last decade and is driven by growth in emerging markets, including China and India, as well as other developing nations in Asia and the Europe, Middle East, and Africa (“EMEA”) region. As a result of globalization, manufacturing that was historically performed domestically continues to migrate to lower cost countries. This movement of the manufacture of goods throughout the world increases demand for industrial ventilation products as new construction continues. We expect that more rigorous environmental regulations will be introduced to create a cleaner working environment and reduce environmental emissions as these economies evolve. +• +Natural Gas Infrastructure . The natural gas industry consists of the exploration, production, processing, transportation, storage and distribution of natural gas. The International Energy Association (“IEA”) projects a pronounced shift in Organization for Economic Cooperation and Development (“OECD”) countries away from oil and coal towards natural gas and renewables. Natural gas continues to be the fuel of choice for the electrical power and industrial sectors in many +2 +of the world’s regions, in part because of its lower carbon intensity compared with coal and oil, which makes it an attractive fuel source in countries where governments are implementing policies to reduce greenhouse gas emissions . +• +Power Generation. Power generation encompasses a broad range of activities related to the production of electricity. The primary types of fossil fuels used to generate electricity are coal, natural gas and nuclear. In the United States, concerns about potential environmental regulations enhance the attractiveness of natural gas-fired power plants compared with coal-fired power plants, which generally have higher pollutant emission rates than natural gas-powered plants. Natural gas-fired power plants have lower initial capital needs and are more flexible in terms of operating times than coal plants. +• +Refining, Oil Production and Petrochemical Processing . Refining, oil production and petrochemical processing involves the producing, refining and processing of fuels and chemicals for use in a variety of applications, such as gasoline, fertilizers and plastics. In response to increasing international demand for petrochemicals and refined products, companies are producing more products from new sources, constructing new refineries and petrochemical processing facilities as well as expanding existing facilities. In many cases, these new and expanded facilities must comply with stricter environmental regulations, which influence both choice of fuel and demand for systems to control exhaust emissions. +• +Stringent Regulatory Environment . The adoption of increasingly stringent environmental regulations globally requires businesses to pay strict attention to environmental protection. Businesses and industries of all types from refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing must comply with these various international, federal, state and local government regulations or potentially face substantial fines or be forced to suspend production or alter their production processes. These increasingly stringent environmental regulations are a principal factor that drives our business. +These factors, individually or collectively, tend to cause increases in industrial capital spending that are not directly impacted by general economic conditions, expansion, or capacity increases. In contrast, favorable conditions in the economy generally lead to plant expansions and the construction of new industrial sites. However, in a weak economy, customers tend to lengthen the time from their initial inquiry to the purchase order or defer purchases. +Mission and Strategy +Our mission is to help companies grow their business with safe, clean and more efficient solutions that help protect people and our shared environment. +We seek to fulfill this mission through established global leadership in air quality and fluid handling solutions focused on serving the energy, industrial, and other niche markets around the world. We will continue to leverage our innovative technology and application expertise to customers around the world. We work to improve air quality, optimize the energy value chain, and provide custom engineered solutions for applications including power generation, petrochemical processing, general industrial, refining, oil & gas, electric vehicle production, poly silicon fabrication, battery recycling, and wastewater treatment along with a wide range of other applications. +Our strategy to become the global leader in air quality and fluid handling solutions is to drive an operating environment of performance excellence across the Company with a near term focus on targeted value creation enablers, and growth-oriented business segment performance. +We constantly look for opportunities to gain new customers and penetrate geographic locations and end markets with existing products and services or acquire new product or service opportunities. We intend to continue to expand our customer base and end markets and have continued to pursue potential attractive growth opportunities both domestically and internationally. In the past few years, we have expanded our international presence with new sales & engineering hubs in the United Kingdom, Shanghai, Singapore, Pune India, and Dubai. +Four Value Creation Enablers Driving Growth +All four of these are inter-connected and critical to achieving our objectives. +• +Outside-In Leadership is all about an increased attention on our customers and the trends affecting the world around us as we make decisions that enable CECO to be responsive and prepared for growth. +• +Innovation is about us finding better ways to help our customers get their jobs done – whether that is a new product and technology or the way we serve and work with them. +3 +• +Simplification involves aligning and streamlining our operational practices and metrics to match our customers’ key performance indicators (“KPIs”) for success and removing complexity from our systems and structure. +• +Active Portfolio Management dictates a regular evaluation of our business units for market attractiveness and profitability together with scanning the market for attractive potential additions that strengthen the long-term outlook of the Company. +Three Business Segments: +The Company operates and reports in three reportable segments focused on attractive end markets. Each segment is aligned to generate profitable growth for the Company across a targeted industry with a compelling technology and solution set to benefit customers. +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for clean energy and lower emissions through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings in clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers in the semiconductor manufacturing, electric vehicle production, battery recycling, and wood manufacturing industries to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Competitive Strengths +Leading market position as a complete solution provider . We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. The multi-billion dollar global market is highly fragmented with numerous small and regional contracting firms separately supplying engineering services, fabrication, installation, testing and monitoring, products and spare parts. We offer our customers a complete end-to-end solution, including engineering and project management services, procurement and fabrication, construction and installation, aftermarket support, and sale of consumables, which allows our customers to avoid dealing with multiple vendors when managing projects. +Long-standing experience and customer relationships in growing industry . We have serviced the needs of our target markets for over 50 years. Our extensive experience and expertise in providing diversified solutions enhances our overall customer relationships, and provides us with a competitive advantage in our markets relative to other companies in the industry. We believe this is evidenced by strong relationships with many of our world-class customers. We believe no single competitor has the resources to offer a similar portfolio of product and service capabilities. We offer the depth of a large organization, while our lean organizational structure keeps us close to our customers and markets, allowing us to offer rapid and complete solutions in each unique situation. +Global diversification and broad customer base. The global diversity of our operations and customer base provides us with multiple growth opportunities. As of December 31, 2020, we had a diversified customer base of approximately 5,000 active customers across a range of industries. We believe that the diversity of our customers and end markets mitigates our risk of a potential fluctuation or downturn in demand from any individual industry or particular customer. We believe we have the resources and capabilities to meet the needs of our customers as they upgrade and expand domestically as well as into new international markets. Once systems have been installed and a relationship has been established with the customer, we are often awarded repetitive service and maintenance business as the customers’ processes change and modifications or additions to their systems become necessary. +Experienced management and engineering team. Our senior management team has substantial experience in industrial air quality and fluid handling solutions. The business experience of our management team enables us to pursue our strategy. Our workforce includes +4 +approximately 4 00 engineers, designers, solution experts, and project managers whose significant specialized industry experience and technical expertise enables them to have a deep understanding of the solutions that will best suit the needs of our customers. The experience and stability of our management, operating and engineering teams have been crucial to our growth, developing and maintaining customer relationships, and increasing our market share. +Develop innovative solutions . We leverage our engineering and manufacturing expertise and strong customer relationships to develop new customized products to address the identified needs of our customers or a particular end market. We thoroughly analyze new product opportunities by considering projected demand for the product or service, price point, and expected operating costs, and only pursue those opportunities that we believe will contribute to earnings growth in the near-term. In addition, we continually improve our traditional technologies and adapt them to new industries and processes. +Disciplined acquisition program with successful integration . We believe that we have demonstrated an ability to successfully acquire and integrate companies with complementary product or service offerings. We will continue to seek and execute additional strategic acquisitions and focus on expanding our product service and breadth, as well as entering into new adjacent markets. We believe that the breadth and diversity of our products and services and our ability to deliver full solutions to various end markets provides us with multiple sources of stable growth and a competitive advantage relative to other players in the industry. +Products and Services +We provide a wide spectrum of products and services including dampers and diverters, selective catalytic reduction and selective non-catalytic reduction systems, cyclonic technology, thermal oxidizers, filtration systems, scrubbers, fluid handling equipment and plant engineering services and engineered design build fabrication. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support and single source. +Project Design and Research and Development +We seek to achieve our Outside-In Leadership by understanding our customers’ needs and delivering better outcomes for them by focusing new product development efforts that help protect our shared environment while working to improve a variety of operational outcomes including, but not limited to, facility uptime, production quality, employee safety, equipment protection and process performance. We produce specialized products that are often tailored to the specifications of a customer or application. +We continually collaborate with our customers on their projects to develop the proper solution and ensure customer satisfaction. The project development cycle may follow many different paths depending on the specifics of the job and end market. The cycle can take from one to more than twelve months from concept and design to production but may vary significantly depending on developments that occur during the process, including among others, the emergence of new environmental demands, changes in design specifications and ability to obtain necessary approvals. +Sales, Marketing and Support +Our global selling strategy is to provide a solutions-based approach by being a single source provider of technology products and services. The strategy involves expanding our scope of products and services through selective acquisitions and the formation and integration of new business units. We believe this strategy provides a discernible competitive advantage. We execute this strategy by utilizing our portfolio of in-house technologies and those of third-party equipment suppliers. Many of these have been long-standing relationships, which have evolved from pure supplier roles to value-added business partnerships. This enables us to leverage existing business with selective alliances of suppliers and application specific engineering expertise. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support, and single source. Our value proposition to customers is to provide competitively priced, customized solutions. Our industry-specific knowledge, accompanied by our product and service offerings, provides valuable synergies for design innovation. +We sell and market our products and services with our own direct sales force, including employees in the United States, the Netherlands, United Kingdom, Canada, United Arab Emirates, India, Mexico, China, and Singapore, in conjunction with outside sales representatives in North America, South America, Europe, Middle East, Asia, and India. We expect to continue expanding our sales and support capabilities and our network of outside sales representatives in key regions domestically and internationally. +We market our offerings to our customers through a variety of channels including, but not limited to, digital, web, social media, email campaigns, individual customer visits, product announcements, brochures, magazine articles, advertisements and cover or article features in trade journals and other publications. We also participate in public relations and promotional events, including industry tradeshows and technical conferences. +5 +Our customer service organization or sales force provides our customers with technical assistance, use and maintenance information as well as other key information regarding their purchase. We also actively provide our customers with access to key information regarding changes and pending changes in environmental regulations as well as new product or service developments. We believe that maintaining a close relationship with our customers and providing them with the support they request improves their level of satisfaction and enables us to foresee their potential future product needs or service demands. Moreover, this approach can lead to sales of annual service and support contracts as well as consumables. Our website also provides our customers with online tools and technical resources. +Quality Assurance +In engineered systems, quality is defined as system performance. We review with our customers, before the contract is signed, the technical specification and the efficiency of the equipment that will be customized to meet their specific needs. We then review these same parameters internally to assure that warranties will be met. Standard project management and production management tools are used to help ensure that all work is done to specification and that project schedules are met. Equipment is tested at the site to ensure it is functioning properly. +Customers +We are not dependent upon any single customer, and no customer comprised 10% or more of our consolidated revenues for 2020. +Suppliers and Subcontractors +We purchase our raw materials and supplies from a variety of global sources. When possible, we directly secure angle iron and sheet plate products from steel mills, whereas other materials are purchased from a variety of steel service centers. Steel prices have traditionally been volatile, but we typically mitigate the risk of higher prices by including a “surcharge” on our standard products. On contract work, we mitigate the risk of higher prices by including the current price in our estimate and generally include price inflation clauses for protection. +We believe we have a good relationship with our suppliers and do not anticipate any difficulty in continuing to purchase such items on terms acceptable to us. We have not experienced difficulty in procuring a sufficient supply of materials in the past. To the extent that our current suppliers are unable or unwilling to continue to supply us with materials, we believe that we would be able to obtain such materials from other suppliers on acceptable terms. +Typically, on turnkey projects, we subcontract manufacturing, electrical work, concrete work, controls, conveyors and insulation. We use subcontractors with whom we have good working relationships and review each project at the beginning and on an ongoing basis to help ensure that all work is being done according to our specifications. Subcontractors are generally paid when we are paid by our customers according to the terms of our contract with the customer. The Company’s asset-light business model focuses on effective management of subcontractors, which allows the Company to achieve targeted working capital levels through reduction in certain assets and reduced capital expenditures. +Backlog +Backlog (i.e., unfulfilled or remaining performance obligations) represents the sales we expect to recognize for our products and services for which control has not yet transferred to the customer. Backlog was $183.1 million as of December 31, 2020 as compared to $216.6 million as of December 31, 2019, $9.8 million of backlog in total was acquired from the Environmental Integrated Solutions (“EIS”) acquisition and the Mader Holding L.P. (“Mader”) joint venture. In addition, the Company removed $9.2 million of orders in 2020 that were previously disclosed as backlog in prior periods, due to cancellations by industrial customers with exposure to aerospace end markets. Backlog is adjusted on a quarterly basis for adjustments in foreign currency exchange rates. Substantially all backlog is expected to be delivered within 12 to 18 months. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Competition +The markets we serve are highly fragmented with numerous small and regional participants. We believe no single company competes with us across the full range of our systems and products. Competition in the markets we serve is based on a number of considerations, including timeliness of delivery, technology, applications experience, know-how, reputation, product warranties, service and price. Demand for our product can vary period over period depending on conditions in the markets we serve. We believe our product quality, +6 +reliability, on-time delivery and safety supported by advanced engineering and operational excellence differentiate us from many of our competitors, including those competitors who often offer products at a lower price. +Due to the size and shipping weight of many of our projects, localized manufacturing/fabrication capabilities are very important to our customers. As a result, competition varies widely by region and industry. The market for our engineered products is reasonably competitive and is characterized by technological change, continuously changing environmental regulations, and evolving customer requirements. We believe that the additional competitive factors in our markets include: +• +performance track record; +• +comprehensive portfolio of products with leading technology; +• +brand recognition; +• +high design standard; +• +quality and reliable solutions; +• +on-time delivery; +• +quality customer service and support; and +• +financial and operational stability, including reputation. +We believe we compete favorably with respect to these factors. +Government Regulations +We believe our operations are in compliance with applicable environmental laws and regulations. We believe that changes in environmental laws and regulations create opportunity given the nature of our business. +Our business is subject to numerous laws and regulations. We expect that the change in administration at the federal level will result in an increase in federal regulations applicable to our business. While there are not currently regulations proposed or pending that we believe will result in material capital, operating or other costs to the business at this time, such regulations could be proposed and/or passed into law in 2021 or beyond. Other regulations currently in place could be withdrawn and replaced with more stringent requirements in 2021 or beyond. New laws and regulations and the costs of compliance with such new laws and regulations can only be broadly appraised until their implementation becomes more defined through regulatory guidance and enforcement. +Intellectual Property +We rely on a combination of patent, trademark, copyright and trade secret laws, employee and third-party nondisclosure/confidentiality agreements and license agreements to protect our intellectual property. We sell most of our products under a number of registered trade names, brand names and registered trademarks, which we believe are widely recognized in the industry. While we hold patents within a number of our businesses, we do not view our patents to be material to our business. +Commitment to Values and Ethics +At CECO, we act in accordance with our Code of Business Conduct and Ethics (“Code of Conduct”), which sets forth expectations and guidance for employees to make appropriate decisions. Our Code of Conduct covers topics such as anti-corruption, discrimination, harassment, data privacy, appropriate use of company assets, protecting confidential information, and reporting Code of Conduct violations. The Code of Conduct reflects our commitment to operating in a fair, honest, responsible and ethical manner and also provides direction for reporting complaints in the event of alleged violations of our policies ,including through an anonymous helpline. Our executive officers and managers maintain an “open door” policy, and any form of retaliation is strictly prohibited. +Human Capital Management +CECO recognizes that in order to drive innovation and operational excellence, we must identify, attract, retain and motivate world-class talent. As of December 31, 2020, CECO has approximately 730 employees, across seven countries. One-hundred and fifty of our US employees are unionized in our Pennsylvania, Tennessee and North Carolina facilities. +7 +Talent, Leadership and People Development +To support personal and professional development, we have strategically committed resources to leadership and management development programs, product knowledge, job skills, and compliance training. In 2020, CECO implemented an online learning platform so our employees could continue to enhance their skill sets and knowledge while working remotely due to COVID-19. Our learning platform offers over 16,000 courses and certifications ranging from job function to leadership and resource training. As of December 31, 2020, 72% of CECO’s global workforce registered and engaged with this learning platform. We believe this investment in our team members results in a more knowledgeable and competent workforce while strengthening the commitment between employees and our company. +We provide a variety of resources to help our employees grow in their current roles and build new skills to thrive in the workplace of the future. Strategic talent reviews are conducted annually across all business areas. The Board is updated on the Company’s people strategy on an annual basis, which is refined based on business drivers, market factors and key initiatives designed to drive the corporate strategy and business results, and meets to review our succession planning strategy and leadership pipeline for key roles, taking into account the company’s long-term strategy. +Health and Safety +At CECO, the health and safety of our employees is one of our highest priorities. We believe that all injuries, occupational illnesses and incidents are preventable, and we are committed to operating with a zero-incident culture. Through our environmental, health and safety program we implement policies and training programs, as well as perform self-audits to ensure our colleagues leave the workplace safely every day. To better understand employee safety at the site level, we have implemented safety committees and developed safety scorecards to share best practices between sites. We currently share scorecard information monthly to foster visibility, accountability and commitment across our workplace, communicating and celebrating successful results across the enterprise. In addition to lagging indicators, such as injury performance, the scorecards highlight leading indicators such as safety observations and near-misses, as well as other proactive actions taken at each site to ensure worker safety. For the year ended December 31, 2020, CECO’s domestic Total Recordable Incident Rate (“TRIR”) was 1.9% as compared to our benchmark industry average TRIR of 4.5%. +Our safety focus is also evident in our response to the COVID-19 pandemic around the globe. We implemented all government, federal and state policies, in addition to the following policies and procedures: +• +added work from home flexibility for office job roles; +• +deployed Microsoft Teams world-wide to enable collaboration while ensuring team safety; +• +implemented an Emergency Paid Pandemic Leave policy to encourage those who are sick to stay home; +• +increased cleaning protocols across all locations; +• +initiated regular communication regarding impacts of the COVID-19 pandemic, including health and safety protocols and procedures; +• +implemented a self-certification health assessment for all employees, partners and vendors at our manufacturing facilities (where allowed by local law); +• +established new physical distancing procedures for employees who need to be onsite; +• +provided additional personal protective equipment and cleaning supplies; +• +implemented safety protocols to address actual and suspected COVID-19 cases and potential exposure; +• +prohibited all non-essential domestic and international travel for all employees; +• +required masks to be worn in all locations where allowed by local law; +• +required on site visitors complete a health and travel declaration; and +• +for on site visitors traveling by plane, required a negative Polymerase Chain Reaction test before entering the facility. +CECO manufactures products and performs services deemed essential to critical infrastructure, including manufacturing, and energy, and, as a result, our facilities have continued operating during the COVID-19 pandemic. Importantly, during 2020, our experience and +8 +continuing focus on workplace safety have enabled us to preserve business continuity without sacrificing our commitment to keeping our colleagues and workplace visitors safe during the COVID-19 pandemic. +Diversity, Equity, and an Inclusive Culture +At CECO we believe a diverse and inclusive workforce is critical to inspiring innovative thinking, creative problem-solving, performance, and results, so we cultivate an environment where team members feel valued, engaged, and inspired to give their best. The unique characteristics that shape each individual help inform our decisions as a company, and this mindset allows CECO to realize new opportunities and add value to our customers, partners, and stockholders. +As part of our efforts to expand CECO’s diverse workforce, we are: +• +initiating recruitment efforts to attract and build a more diverse workforce, including expanding career opportunity postings on career websites to diverse job boards, as well as, search engines that aggregate and display job openings by employers, including those dedicated to diverse candidates; +• +implementing training to raise awareness of unconscious bias and further promote personal and professional development; and +• +launching pulse surveys to foster ongoing feedback around our culture, workplace inclusiveness and communications . +CECO’s commitment to expanding our diverse workforce and enhancing our inclusive culture is driven by our recognition that a workplace that is reflective of our global customer base establishes a firm foundation to drive creativity and innovation, which lead to problem solving, development, performance, and business success. +Appointment of Chief Executive Officer +On July 6, 2020, Mr. Todd Gleason started serving as Chief Executive Officer and as a member of the Board of Directors of the Company, succeeding Dennis Sadlowski. See “Executive Officers of CECO” below for Mr. Gleason’s biography. +Executive Officers of CECO +The following are the executive officers of the Company as of February 28, 2021. The terms of all officers expire at the next annual meeting of stockholders and upon the election of the successors of such officers. +Todd Gleason (49) most recently served, from April 2015 to July 2020, as President and Chief Executive Officer of Scientific Analytics Inc., a predictive analytic technologies and services company. Prior to that position, Mr. Gleason served from June 2007 to March 2015 in a number of senior officer and executive positions for Pentair plc, a water treatment company. During his tenure with Pentair, Mr. Gleason served as Senior Vice President and Corporate Officer from January 2013 to March 2015, President, Integration and Standardization from January 2010 to January 2013, and Vice President, Global Growth and Investor Relations from June 2007 to January 2010. Before joining Pentair, Mr. Gleason served as Vice President, Strategy and Investor Relations for American Standard Companies Inc. (later renamed to Trane Inc. prior to its acquisition by Ingersoll-Rand Company Limited), a global, diversified manufacturing company, and in a number of different roles (including as Chief Financial Officer, Honeywell Process Solutions) at Honeywell International Inc., a diversified technology and manufacturing company . Mr. Gleason’s qualifications to sit on the Board include his financial and business background, as well as his extensive executive and leadership experience. +Matthew Eckl (40) has served as our Chief Financial Officer since January 2017. Prior to joining the Company, Mr. Eckl served as Vice President, Finance – Energy Group at Gardner Denver, Inc. from 2012 until January 2017. In this role, he oversaw a $1 billion revenue business group that designs, manufactures, markets and services pumps, fluid transfer equipment and engineered systems for oil & gas and petrochemical industries. Prior to joining Gardner Denver, Mr. Eckl served in various roles of increasing responsibility within General Electric Company, a global digital industrial company, from 2002 until 2012, where he worked with various business groups to integrate new acquisitions and streamline financial reporting processes. Mr. Eckl earned a Bachelor’s degree in Management Information Systems from Pennsylvania State University. +Paul Gohr (39) has served as the Chief Accounting Officer since May 2017. Mr. Gohr previously served as our Vice President of Financial Reporting since joining the Company in September 2014. From 2004 to 2014, Mr. Gohr served in various roles of increasing responsibility within Grant Thornton LLP, a global public accounting firm, most recently as a Senior Manager of Audit Services. While at Grant Thornton LLP, Mr. Gohr served a broad base of both public and private companies with international operations, many of which were acquisitive in nature. Mr. Gohr is a Certified Public Accountant. Mr. Gohr earned a Bachelor’s degree in Business, Accountancy and a Masters of Accountancy degree from Miami University. +9 +Available Information +We use the Investor Relations section of our website, www.cecoenviro.com , as a channel for routine distribution of important information, including news releases, investor presentations and financial information. We post filings as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC, including our annual, quarterly, and current reports on Forms 10-K, 10-Q, and 8-K; proxy statements; and any amendments to those reports or statements. All such postings and filings are available on our website free of charge. The SEC also maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The content on any website referred to in this Annual Report on Form 10-K is not incorporated by reference into this Annual Report on Form 10-K unless expressly noted. +10 +Item 1A. +Risk Factors +An investment in our securities involves a high degree of risk. You should carefully consider the risk factors described below, together with the other information included in this Annual Report on Form 10-K, before you decide to invest in our securities. The risks described below are the material risks of which we are currently aware; however, they may not be the only risks that we may face. Additional risks and uncertainties not currently known to us or that we currently view as immaterial may also impair our business. Although the risks are organized by headings, and each risk is discussed separately, many are interrelated. If any of these risks develop into actual events, it could materially and adversely affect our business, financial condition, results of operations and cash flows, and the trading price of your shares could decline and you may lose all or part of your investment. +COVID-19 Risks +We face risks related to health epidemics and other outbreaks, including the COVID-19 pandemic, which may adversely affect our business, results of operations and financial condition. +We face risks related to health epidemics and other outbreaks, including the COVID-19 pandemic. The continued spread of COVID-19 has reached geographic areas in which we have operations, suppliers, customers and employees. We expect the continued spread of COVID-19 to continue to have a significant impact on our business, and may affect the demand for our products and disrupt our supply chain and the manufacturing and distribution of our products. It is unknown how long these disruptions could continue and such events may affect our business, results of operations and financial condition. +The continuing spread of COVID-19 has caused volatility, severe market dislocations and liquidity constraints in many markets. Several countries, including the United States, have taken steps to restrict travel, temporarily close businesses and issue quarantine orders, and it remains unclear how long such measures will remain in place or whether efforts to contain the spread of COVID-19 will continue to intensify. The foregoing could lead to a significant economic downturn or recession, increased market volatility, a greater number of market closures, higher default rates and adverse effects on the values and liquidity of securities or other assets. Such impacts may adversely affect the Company and your investment in the Company. +The ultimate effect that COVID-19 may have on our operating and financial results is not presently known to us or may present unanticipated risks that cannot be determined at this time. +Risks Related to Our Business and Industry +Our business may be adversely affected by global economic conditions. +A national or global economic downturn or credit crisis may have a significant negative impact on our financial condition, future results of operations and cash flows. Specific risk factors related to these overall economic and credit conditions include the following: +• +the impact that the COVID-19 pandemic may have on global capital markets; +• +customers or potential customers may reduce or delay their procurement or new product development; +• +key suppliers may become insolvent resulting in delays for our material purchases; +• +vendors and other third parties may fail to perform their contractual obligations; +• +customers may be unable to obtain credit to finance purchases of our products and services; +• +and certain customers may become insolvent. +These risk factors could reduce our product sales, increase our operating costs, impact our ability to collect customer receivables, lengthen our cash conversion cycle and increase our need for cash, which would ultimately decrease our profitability and negatively impact our financial condition. They could also limit our ability to expand through acquisitions due to the tightening of the credit markets. +Our dependence upon fixed-price contracts could adversely affect our operating results. +The majority of our projects are currently performed on a fixed-price basis, while a limited number of projects are currently performed on a time and materials basis. Under a fixed-price contract, we agree on the price that we will receive for the entire project, based upon a defined scope, which includes specific assumptions and project criteria. If our estimates of the costs to complete the project are below the actual costs that we incur, our margins will decrease, or we may incur a loss. The revenue, cost and gross profit realized on +11 +a fixed-price contract will often vary from the estimated amounts because of unforeseen conditions or changes in job conditions and variations in labor and equipment productivity over the term of the contract , including those related to the COVID-19 pandemic . While our fixed-price contracts are typically not individually material to our operating results, if we are unsuccessful in mitigating these risks, we may realize gross profits that are different from those originally estimated and incur reduced profitability or losses on projects. Depending on the size of a project, these variations from estimated contract performance could have a significant effect on our operating results. In general, turnkey contracts to be performed on a fixed-price basis involve an increased risk of significant variations. Generally, our contracts and projects vary in length, depending on the size and complexity of the project, project owner demands and other factors. The foregoing risks are exacerbated for projects with longer-term durations and the inherent difficulties in estimating costs and of the interrelationship of the integrated services to be provided under these contracts whereby unanticipated costs or delays in performing part of the contract , including those related to the COVID-19 pandemic, can have compounding effects by increasing costs of performing other parts of the contract. +Accounting for contract revenue may result in material adjustments that would adversely affect our financial condition and results of operations. +We derive a significant portion of our revenues from fixed price contracts. We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +Contract revenue and total direct cost estimates are reviewed and revised periodically as the work progresses and as change orders are approved, and adjustments are reflected in contract revenue in the period when these estimates are revised. These estimates are based on management’s reasonable assumptions and our historical experience, and are only estimates. Variation of actual results from these assumptions, which are outside the control of management and can differ from our historical experience, including for reasons related to the COVID-19 pandemic, could be material. To the extent that these adjustments result in an increase, a reduction or the elimination of previously reported contract revenue, we would recognize a credit or a charge against current earnings, which could be material. +Our inability to deliver our backlog on time could affect our future sales and profitability, and our relationships with our customers. +Our backlog was $183.0 million at December 31, 2020 and $216.6 million at December 31, 2019. Our ability to meet customer delivery schedules for our backlog is dependent on a number of factors including, but not limited to, access to the raw materials required for production, an adequately trained and capable workforce, project engineering expertise for certain large projects, sufficient internal manufacturing plant capacity, available subcontractors and appropriate planning and scheduling of manufacturing resources. Our failure to deliver in accordance with customer expectations may result in damage to existing customer relationships and result in the loss of future business. Failure to deliver backlog in accordance with expectations could negatively impact our financial performance and cause adverse changes in the market price of our common stock. +Volatility of oil and natural gas prices can adversely affect demand for our products and services. +Volatility in oil and natural gas prices can impact our customers’ activity levels and spending for our products and services. Current energy prices are important contributors to cash flow for our customers and their ability to fund capital expenditures. The COVID-19 pandemic has significantly disrupted demand for and expectations about future prices and price volatility, which are important for determining our customers future spending levels. Lower oil and natural gas prices generally lead to decreased spending by our customers. While higher oil and natural gas prices generally lead to increased spending by our customers, sustained high energy prices can be an impediment to economic growth, and can therefore negatively impact spending by our customers. Our customers also take into account the volatility of energy prices and other risk factors by requiring higher returns for individual projects if there is a higher perceived risk. Any of these factors could affect the demand for oil and natural gas and could have a material effect on our results of operations. +Our financial performance may vary significantly from period to period. +Our annual revenues and earnings have varied in the past and are likely to vary in the future. Our contracts generally stipulate customer specific delivery terms and may have contract cycles of a year or more, which subjects these contracts to many factors beyond our control. In addition, contracts that are significantly larger in size than our typical contracts tend to intensify their impact on our annual operating results. Furthermore, as a significant portion of our operating costs are fixed, an unanticipated decrease in our revenues, a delay or cancellation of orders in backlog, or a decrease in the demand for our products, may have a significant impact on +12 +our annual operating results. Therefore, our annual operating results may be subject to significant variations and our operating performance in one period may not be indicative of our future performance. +Customers may cancel or delay projects. As a result, our backlog may not be indicative of our future revenue. +Customers may cancel or delay projects for reasons beyond our control, including for reasons related to the COVID-19 pandemic. Our orders normally contain cancellation provisions that permit us to recover our costs, and, for most contracts, a portion of our anticipated profit in the event a customer cancels an order. If a customer elects to cancel an order, we may not realize the full amount of revenues included in our backlog. If projects are delayed, the timing of our revenues could be affected and projects may remain in our backlog for extended periods of time. Revenue recognition occurs over long periods of time and is subject to unanticipated delays. If we receive relatively large orders in any given quarter, fluctuations in the levels of our quarterly backlog can result because the backlog in that quarter may reach levels that may not be sustained in subsequent quarters. As a result, our backlog may not be indicative of our future revenues. With rare exceptions, we are not issued contracts until a customer is ready to start work on a project. Thus, it is our experience that the only relationship between the length of a project and the possibility that a project may be cancelled is simply the fact that there is more time involved. In a year-long project as opposed to a three-month project, more time is available for the customer to experience a softening in its business, which may cause the customer to cancel a project. +We face significant competition in the markets we serve. +All of the industries in which we compete are highly competitive and highly fragmented. We compete in primarily mature markets against a number of local, regional and national contractors and manufacturers in each of our product or service lines, many of which have been in existence longer than us and some of which have substantially greater financial resources than we do. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support and single source. We must also be responsive to any technological developments and related changing customer requirements. Any failure by us to compete effectively in the markets we serve could have a material adverse effect on our financial condition, results of operations and cash flows. +We may incur material costs as a result of existing or future product liability claims, or other claims and litigation that could adversely affect our financial condition, results of operations and cash flows; and our insurance coverage may not cover all claims or may be insufficient to cover the claims. +Despite our quality assurance measures, we may be exposed to product liability claims, other claims and litigation in the event that the use of our products results, or is alleged to result, in bodily injury and/or property damage or our products actually or allegedly fail to perform as expected. Such claims may also be accompanied by fraud and deceptive trade practices claims. While we maintain insurance coverage with respect to certain product liability and other claims, we may not be able to obtain such insurance on acceptable terms in the future, if at all, and any such insurance may not provide adequate coverage against product liability and other claims. Furthermore, our insurance may not cover damages from breach of contract by us or based on alleged fraud or deceptive trade practices. Any future damages that are not covered by insurance or are in excess of policy limits could have a material adverse effect on our financial condition, results of operations and cash flows. In addition, product liability and other claims can be expensive to defend and can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. +An unsuccessful defense of a product liability or other claim could have an adverse effect on our financial condition, results of operations and cash flows. Even if we are successful in defending against a claim relating to our products, claims of this nature could cause our customers to lose confidence in our products and us. +Liability to customers under warranties may adversely affect our reputation, our ability to obtain future business and our results of operations. +We provide certain warranties as to the proper operation and conformance to specifications of the products we manufacture or produce. Failure of our products to operate properly or to meet specifications may increase our costs by requiring additional engineering resources and services, replacement of parts and equipment or monetary reimbursement to customers. We have in the past received warranty claims, are currently subject to warranty claims, and we expect to continue to receive claims in the future. To the extent that we incur substantial warranty claims in any period, our reputation, our ability to obtain future business and our results of operations could be adversely affected. +13 +Increasing costs for manufactured components, raw materials, transportation, health care and energy prices may adversely affect our profitability. +We use a broad range of manufactured components and raw materials in our products, including raw steel, steel-related components, filtration media, and equipment such as fans and motors. Materials and subcontracting costs comprise the largest components of our total costs. Further increases in the price of these items could further materially increase our operating costs and materially adversely affect our profit margins. Similarly, transportation, steel and health care costs have risen steadily over the past few years and represent an increasing burden for us. Although we try to contain these costs whenever possible, and although we try to pass along increased costs in the form of price increases to our customers, we may be unsuccessful in doing so, and even when successful, the timing of such price increases may lag significantly behind our incurrence of higher costs. +Risks Related to our Business Model and Capital Structure +Our gross margins are affected by shifts in our product mix. +Certain of our products have higher gross profit margins than others. Consequently, changes in the product mix of our sales from quarter-to-quarter or from year-to-year can have a significant impact on our reported gross profit margins. Certain of our products also have a much higher internally manufactured cost component. Therefore, changes from quarter-to-quarter or from year-to-year can have a significant impact on our reported gross margins. In addition, contracts with a higher percentage of subcontracted work or equipment purchases may result in lower gross profit margins. +Our manufacturing operations are dependent on third-party suppliers. +Although we are not dependent on any one supplier, we are dependent on the ability of our third-party suppliers to supply our raw materials, as well as certain specific component parts. The third-party suppliers upon which we depend may default on their obligations to us due to bankruptcy, insolvency, lack of liquidity, adverse economic conditions, operational failure, fraud, loss of key personnel, or other reasons. For example, as a result of the outbreak of COVID-19 and government mandated shutdowns, we have noticed our suppliers are experiencing delays in the production or an inability to perform work. We cannot assure you that our third-party suppliers will dedicate sufficient resources to meet our scheduled delivery requirements or that our suppliers will have sufficient resources to satisfy our requirements during any period of sustained demand, and the global nature of the COVID-19 pandemic could result in there being fewer alternative suppliers. Failure of suppliers to supply, or delays in supplying, our raw materials or certain components, or allocations in the supply of certain high demand raw components, for any reason, including, without limitation, disruptions in our suppliers’ due to cybersecurity incidents, terrorist activity, public health crises (such as COVID-19), fires or other natural disasters could materially adversely affect our operations and ability to meet our own delivery schedules on a timely and competitive basis. Additionally, our third-party suppliers may provide us with raw materials or component parts that fail to meet our expectations or the expectations of our customers, which could subject us to product liability claims, other claims and litigation. +Our use of subcontractors could potentially harm our profitability and business reputation. +Occasionally we act as a prime contractor in some of the engineered projects we undertake. In our capacity as lead provider and when acting as a prime contractor, we perform a portion of the work on our projects with our own resources and typically subcontract activities such as manufacturing, electrical work, concrete work, insulation, conveyors and controls. In our industry, the lead contractor is normally responsible for the performance of the entire contract, including subcontract work. Thus, when acting as a prime contractor, we are subject to risk associated with the failure of one or more subcontractors to perform as anticipated. +Moreover, the outbreak and preventative or protective actions that governments, corporations, individuals or we may take to contain COVID-19 have resulted in, and may continue to result in, a period of reduced operations and business disruption for our subcontractors. The outbreak of COVID-19 and related actions also have prevented, and may continue to prevent, our subcontractors from meeting their obligations to us, which could also contribute to performance delays on our customer obligations and increase our costs. Any costs associated with the COVID-19 pandemic may not be fully recoverable or adequately covered by insurance. +We employ subcontractors at various locations around the world to meet our customers’ needs in a timely manner, meet local content requirements and reduce costs. Subcontractors generally perform the majority of our manufacturing for international customers. We also utilize subcontractors in North America. The use of subcontractors decreases our control over the performance of these functions and could result in project delays, escalated costs and substandard quality. These risks could adversely affect our profitability and business reputation. In addition, many of our competitors, who have greater financial resources and greater bargaining power than we have, use the same subcontractors that we use and could potentially influence our ability to hire these subcontractors. If we were to lose relationships with key subcontractors, our business could be adversely impacted. +14 +The COVID-19 pandemic has adversely affected the progress of construction projects across the globe and will likely continue to cause delays and disruptions. If projects are delayed or cancelled it could have a material adverse effect upon our business and financial condition . +A significant portion of our accounts receivable are related to larger contracts, which increases our exposure to credit risk. +Significant portions of our sales are to customers who place large orders for custom products and whose activities are related to the power and oil & gas industries. As a result, our exposure to credit risk is affected to some degree by conditions within these industries and governmental and or political conditions. We frequently attempt to reduce our exposure to credit risk by requiring progress or milestone payments and letters of credit as well as closely monitoring the credit worthiness of our customers. However, the continuing economic climate and other unanticipated events that affect our customers could have a materially adverse impact on our operating results. Further, we believe that the outbreak and worsening of the COVID-19 pandemic will continue to adversely impact our sales. +Changes in billing terms can increase our exposure to working capital and credit risk. +Our products are generally sold under contracts that allow us to bill upon the completion of certain agreed upon milestones or upon actual shipment of the product, and certain contracts include a retention provision. We attempt to negotiate progress-billing milestones on all large contracts to help us manage the working capital and credit risk associated with these large contracts. Consequently, shifts in the billing terms of the contracts in our backlog from period to period can increase our requirement for working capital and can increase our exposure to credit risk. +Currency fluctuations may reduce profits on our foreign sales or increase our costs, either of which could adversely affect our financial results. +Given that approximately 35% of our 2020 revenues are outside the United States, we are subject to the impact of fluctuations in foreign currency exchange rates. Although our financial results are reported in U.S. dollars, a portion of our sales and operating costs are realized in foreign currencies. Our sales and profitability are impacted by the movement of the U.S. dollar against foreign currencies in the countries in which we generate sales and conduct operations. Long-term fluctuations in relative currency values could have an adverse effect on our operations and financial conditions. +If our goodwill or indefinite lived intangibles become impaired, we may be required to recognize charges that would adversely impact our results of operations. +As of December 31, 2020, goodwill and indefinite lived intangibles were $174.8 million, or 41.7%, of our total assets. Goodwill and indefinite lived intangible assets are not amortized, but instead are subject to annual impairment evaluations (or more frequently if circumstances require). Major factors that influence our evaluations are estimates for future revenue and expenses associated with the specific intangible asset or the reporting unit in which the goodwill resides. This is the most sensitive of our estimates related to our evaluations. Other factors considered in our evaluations include assumptions as to the business climate, industry and economic conditions. These assumptions are subjective and different estimates could have a significant impact on the results of our analyses. While management, based on current forecasts and outlooks, believes that the assumptions and estimates are reasonable, we can make no assurances that future actual operating results will be realized as planned and that there will not be material impairment charges as a result. In particular, an economic downturn could have a material adverse impact on our customers thereby forcing them to reduce or curtail doing business with us and such a result may materially affect the amount of cash flow generated by our future operations. Any write-down of goodwill or intangible assets resulting from future periodic evaluations could adversely materially impact our results of operations. +We may incur costs as a result of certain restructuring activities, which may negatively impact our financial results, and we may not achieve some or all of the expected benefits of our restructuring plans. +We are continuously seeking the most cost-effective means and structure to serve our customers, protect our stockholders and respond to changes in our markets. From time to time, we may engage in restructuring activities in an effort to improve cost competitiveness and profitability. We may not achieve the desired or anticipated benefits from these restructuring activities. As a result, restructuring costs may vary significantly from year to year depending on the scope of such activities. Such restructuring costs and expenses could adversely impact our financial results. +15 +We are party to asbestos-containing product litigation that could adversely affect our financial condition, results of operations and cash flows. +Our subsidiary, Met-Pro, along with numerous other third parties, has been named as a defendant in asbestos-related lawsuits filed against a large number of industrial companies including, in particular, those in the pump and fluid handling industries. In management’s opinion, the complaints typically have been vague, general and speculative, alleging that Met-Pro, along with the numerous other defendants, sold unidentified asbestos-containing products and engaged in other related actions that caused injuries (including death) and loss to the plaintiffs. The Company’s insurers have hired attorneys who, together with the Company, are vigorously defending these cases. The Company believes that its insurance coverage is adequate for the cases currently pending against the Company and for the foreseeable future, assuming a continuation of the current volume, nature of cases and settlement amounts. However, the Company has no control over the number and nature of cases that are filed against it, nor as to the financial health of its insurers or their position as to coverage. The Company also presently believes that none of the pending cases will have a material adverse impact upon the Company’s results of operations, liquidity or financial condition. +See Note 13 to the Consolidated Financial Statements contained in Part II, Item 8 of this Annual Report on Form 10-K for information regarding the asbestos-related litigation in which we are involved. +We have $74.0 million of indebtedness as of December 31, 2020, and incurrence of additional indebtedness could adversely affect our ability to operate our business, remain in compliance with debt covenants, make payments on our debt and limit our growth. +Our outstanding indebtedness could have important consequences for investors, including the following: +• +it may be more difficult for us to satisfy our obligations with respect to the agreement governing our Credit Facility (as defined herein), and any failure to comply with the obligations of any of the agreements governing any additional indebtedness, including financial and other restrictive covenants, could result in an event of default under such agreements; +• +the covenants contained in our debt agreements, including our Credit Facility, limit our ability to borrow money in the future for acquisitions, capital expenditures or to meet our operating expenses or other general corporate obligations; +• +the amount of our interest expense may increase because a substantial portion of our borrowings are at variable rates of interest, which, if interest rates increase, could result in higher interest expense; +• +we may need to use a portion of our cash flows to pay interest on our debt, which will reduce the amount of money we have for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other business activities; +• +we may have a higher level of debt than some of our competitors, which could put us at a competitive disadvantage; +• +we may be more vulnerable to economic downturns and adverse developments in our industry or the economy in general; and +• +our debt level could limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate. +Our ability to meet our expenses and debt obligations will depend on our future performance, which will be affected by financial, business, economic, regulatory and other factors. We will not be able to control many of these factors. We cannot be certain that our earnings will be sufficient to allow us to pay the principal and interest on our existing or future debt and meet our other obligations. Moreover, we currently expect that the COVID-19 pandemic will continue to negatively impact our cash flow and liquidity. If we do not have enough money to service our existing or future debt, we may be required to refinance all or part of our existing or future debt, sell assets, borrow more money or raise equity. We may not be able to refinance our existing or future debt, sell assets, borrow more money or raise equity on terms acceptable to us, if at all, particularly in light of COVID-19’s impact on capital markets. +We might be unable to protect our intellectual property rights and our products could infringe the intellectual property rights of others, which could expose us to costly disputes. +Although we believe that our products do not infringe patents or violate the proprietary rights of others, it is possible that our existing patent rights may not be valid or that infringement of existing or future patents or proprietary rights may occur. In the event our products infringe patents or proprietary rights of others, we may be required to modify the design of our products or obtain a license for certain technology. We cannot guarantee that we will be able to do so in a timely manner, upon acceptable terms and conditions, or at all. Failure to do any of the foregoing could have a material adverse effect upon our business. Moreover, if our products infringe patents or proprietary rights of others, we could, under certain circumstances, become liable for damages, which also could have a material adverse effect on our business. +16 +Risks related to our pension plan may adversely impact our results of operations and cash flow. +Significant changes in actual investment return on pension assets, discount rates, and other factors may adversely affect our results of operations and pension plan contributions in future periods. GAAP requires that we calculate the income or expense of our plan using actuarial valuations. These valuations reflect assumptions about financial markets and interest rates. We establish the discount rate used to determine the present value of the projected and accumulated benefit obligation at the end of each year based upon the available market rates for high quality, fixed-income investments. An increase in the discount rate would increase future pension expense and, conversely, a decrease in the discount rate would decrease future pension expense. Funding requirements for our pension plan may become more significant. The ultimate amounts to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory changes related to pension funding obligations. For a discussion regarding the significant assumptions used to estimate pension expense, including discount rate and the expected long-term rate of return on plan assets, and how our financial statements can be affected by pension plan accounting policies, see “Critical Accounting Policies” included in this Annual Report on Form 10-K in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +We may be subject to substantial withdrawal liability assessments in the future related to multiemployer pension plans to which certain of our subsidiaries make contributions pursuant to collective bargaining agreements. +Under applicable federal law, any employer contributing to a multiemployer pension plan that completely ceases participating in the plan while the plan is underfunded is subject to payment of such employer’s assessed share of the aggregate unfunded vested benefits of the plan. In certain circumstances, an employer can be assessed a withdrawal liability for a partial withdrawal from a multiemployer pension plan. If any of these adverse events were to occur in the future, it could result in a substantial withdrawal liability assessment that could have a material adverse effect on our business, financial condition, results of operations or cash flows. +We have made and may make future acquisitions or divestitures, which involve numerous risks that could impact our financial condition, results of operations and cash flows. +Our operating strategy has involved expanding or contracting our scope of products and services through selective acquisitions or divestitures and the formation or elimination of new business units that are then integrated or separated into or out of our family of turnkey system providers. We have acquired other businesses, product or service lines, assets or technologies that are complementary to our business. We may be unable to find or consummate future acquisitions at acceptable prices and terms. We continually evaluate potential acquisition opportunities in the ordinary course of business. +Although we conduct what we believe to be a prudent level of investigation regarding the operating and financial condition of the businesses, product or service lines, assets or technologies we purchase, an unavoidable level of risk remains regarding their actual operating and financial condition. Until we actually assume operating control of these businesses, product or service lines, assets or technologies, we may not be able to ascertain their actual value or understand potential liabilities. This is particularly true with respect to acquisitions outside the United States. +In addition, acquisitions of businesses may require additional debt or equity financing, resulting in additional leverage or dilution of ownership. Our Credit Facility contains certain covenants that limit, or which may have the effect of limiting, among other things, acquisitions, capital expenditures, the sale of assets and the incurrence of additional indebtedness. +Our ability to obtain financing for future growth opportunities may be limited. +Our ability to execute our growth strategies may be limited by our ability to secure and retain additional financing on terms reasonably acceptable to us or at all. Certain of our competitors are larger companies that may have greater access to capital, and therefore, may have a competitive advantage over us should our access to capital be limited. +17 +Risks Related to Human Capital Management +We may not be able to attract and retain qualified employees. +Our future success depends upon the continued service of our executive officers and other key management and technical personnel, and on our ability to continue to identify, attract, retain and motivate them. Implementing our business strategy requires specialized engineering and other talent, as our revenues are highly dependent on technological and product innovations. The market for employees in our industry is extremely competitive, and competitors for talent, particularly engineering talent, increasingly attempt to hire, and to varying degrees have been successful in hiring, our employees, including by establishing local offices near our headquarters. If we are unable to attract and retain qualified employees, our business may be harmed. +Work stoppages or similar difficulties could significantly disrupt our operations. +As of December 31, 2020, approximately 150 of our approximately 730 employees are represented by international or independent labor unions under various union contracts that expire from June 30, 2021 to May 31, 2023. It is possible that our workforce will become more unionized in the future. Although we consider our employee relations to generally be good, our existing labor agreements may not prevent a strike or work stoppage at one or more of our facilities in the future and we may be affected by other labor disputes. A work stoppage at one or more of our facilities may have a material adverse effect on our business. Unionization activities could also increase our costs, which could have an adverse effect on our profitability. +Additionally, a work stoppage at one of our suppliers could adversely affect our operations if an alternative source of supply were not readily available. Work stoppages by employees of our customers also could result in reduced demand for our products. +Information Technology and Cyber Security Risks +Our dependence on information systems and the failure of such systems, could significantly disrupt our business and negatively affect our financial condition, results of operations and cash flows. +We are highly dependent on information systems that are increasingly operated by third-parties and as a result we have a limited ability to ensure their continued operation. We rely on information technology systems, networks and infrastructure in managing our day-to-day operations. In the event of systems failure or interruption, including those related to the COVID-19 pandemic, we will have limited ability to affect the timing and success of systems restoration. Any failure or interruption of our systems could cause delays or other problems in the delivery of our services, which could have a material adverse effect on our operating results. +Increased information technology cyber security threats and more sophisticated and targeted computer crime could pose a risk to our systems, networks, and products. +Increased global information technology cyber security threats and more sophisticated and targeted computer crime pose a risk to the security of our systems and networks and the confidentiality, availability and integrity of our data and communications. While we attempt to mitigate these risks by employing a number of measures, including employee training, comprehensive monitoring of our networks and systems, and maintenance of backup and protective systems, our systems, networks and products remain potentially vulnerable to advanced persistent threats. Depending on their nature and scope, such threats could potentially lead to the compromising of confidential information and communications, improper use of our systems and networks, manipulation and destruction of data, defective products, production downtimes and operational disruptions, which in turn could adversely affect our reputation, competitiveness and results of operations. We have cybersecurity insurance related to a breach event covering expenses for notification, credit monitoring, investigation, crisis management, public relations and legal advice. However, damage and claims arising from such incidents may not be covered or exceed the amount of any insurance available, or may result in increased cybersecurity and other insurance premiums. In response to the COVID-19 pandemic and an increased reliance on our information technology systems, we have taken proactive measures to strengthen our information technology systems, including completing a National Institute of Standards and Technology (“NIST”) assessment, upgrading of security patches across all servers, development of best-in-class hack protection service, implemented recurring company wide security training and enablement of advanced security for our major information systems. +In addition, we could be subject to legal claims or proceedings, liability under laws that protect the privacy of personal information and regulatory penalties if confidential information relating to our employees or other parties is misappropriated from our systems and networks. +18 +Regulatory Compliance and International Operations Risks +Our business can be significantly affected by changes in regulatory standards. +The markets that the Company serves are characterized by competitively imposed process standards and regulatory requirements, each of which influences the demand for our products and services. Changes in legislative, regulatory or industrial requirements may render certain of our products and processes obsolete. Conversely, these changes may present new business opportunities for us. Acceptance of new products and services may also be affected by the adoption of new government regulations requiring stricter standards. Our ability to anticipate changes in regulatory standards and to respond with new and enhanced products on a timely basis will be a significant factor in our ability to grow and to remain competitive. We cannot guarantee that we will be able to achieve the technological advances that may be necessary for us to remain competitive or that certain of our products or services will not become obsolete. +Changes in current environmental legislation and enforcement could have an adverse impact on the sale of our environmental control systems and products and on our financial condition, results of operations and cash flows. +Our business is primarily driven by capital spending, clean air rules, plant upgrades by our customers to comply with laws and regulations governing the discharge of pollutants into the environment or otherwise relating to the protection of the environment or human health. These laws include, but are not limited to, United States federal statues such as Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, the Clean Water Act, the Clean Air Act, the Clean Air Interstate Rule, and the regulations implementing these statutes, as well as similar laws and regulations at state and local levels and in other countries. These United States laws and regulations may change and other countries may not adopt similar laws and regulations. Our business may be adversely impacted to the extent that environmental regulations are repealed, amended, implementation dates are delayed, or to the extent that regulatory authorities reduce enforcement. +Our operations outside of the United States are subject to political, investment and local business risks. +For the year ended December 31, 2020, approximately 35% of our total revenue was derived from products or services ultimately delivered or provided to end users outside the United States. As part of our operating strategy, we intend to expand our international operations through internal growth and selected acquisitions. Operations outside of the United States, particularly in emerging markets, are subject to a variety of risks that are different from or are in addition to the risks we face within the United States. Among others, these risks include: (i) local, economic, political and social conditions, including potential hyperinflationary conditions and political instability in certain countries; (ii) tax-related risks, including the imposition of taxes and the lack of beneficial treaties, that result in higher effective tax rate for us; (iii) imposition of limitations on the remittance of dividends and payments by foreign subsidiaries; (iv) difficulties in enforcing agreements and collecting receivables through certain foreign local systems; (v) domestic and foreign customs, tariffs and quotas or other trade barriers; (vi) risk of nationalization of private enterprises by foreign governments; (vii) managing and obtaining support and distribution channels for overseas operations; (viii) hiring and retaining qualified management personnel for our overseas operations; (ix) the results of the United Kingdom’s referendum on European Union membership, advising for the exit from the European Union; and (x) the effects of COVID-19 and the extent to which the outbreak may disrupt global capital markets, supply chains, and/or our foreign operations. +We are also exposed to risks relating to U.S. policy with respect to companies doing business in foreign jurisdictions. Changes in laws or policies governing the terms of foreign trade, in particular increased trade restrictions, tariffs or taxes on import from countries where we procure or manufacture products, such as China, could have a material adverse effect on our business and results of operations. For instance, the U.S. and Chinese governments have imposed a series of significant incremental retaliatory tariffs to certain imported goods. Given the uncertainty regarding the duration of the imposed tariffs, as well as the potential for additional tariffs by the U.S., China or other countries, as well as other changes in tax policy, trade regulations or trade agreements, and the Company’s ability to implement strategies to mitigate the impact of changes in tax policy, tariffs or other trade regulations, our exposure to the risks described above could have a material adverse effect on our business and results of operations. +In addition, compliance with foreign and domestic legal and regulatory requirements, including import, export, defense regulations and foreign exchange controls and anti-corruption laws, such as the Foreign Corrupt Practices Act, the United Kingdom’s Bribery Act, the European Union’s General Data Protection Regulations and similar laws of other jurisdictions, could adversely impact our ability to compete against companies in such jurisdictions. Moreover, the violation of such laws or regulations, by us or our representatives, could result in severe penalties including monetary fines, criminal proceedings and suspension of export privileges. We operate in many parts of the world that have experienced governmental corruption to some degree and, in certain circumstances, strict compliance with anti-bribery laws may conflict with local customs and practices. We cannot assure you that our internal controls and procedures will always protect us from reckless or criminal acts committed by our employees or agents. If we are found to be liable +19 +for such violations, we could suffer from criminal or civil penalties or other sanctions, including loss of export privileges or authorization needed to conduct aspects of our international business, which could have a material adverse effect on our business. +The occurrence of one or more of the foregoing factors could have a material adverse effect on our international operations or upon our financial condition, results of operations and cash flows. +Changes in laws or regulations or the manner of their interpretation or enforcement could adversely impact our financial performance and restrict our ability to operate our business or execute our strategies. +New laws or regulations, or changes in existing laws or regulations, or the manner of their interpretation or enforcement, could increase our cost of doing business and restrict our ability to operate our business or execute our strategies. In particular, there may be significant changes in U.S. laws and regulations and existing international trade agreements by the current U.S. presidential administration that could affect a wide variety of industries and businesses, including those businesses we own and operate. If the current or future U.S. presidential administrations materially modifies U.S. laws and regulations and international trade agreements, our business, financial condition, and results of operations could be adversely affected. +Risks Related to Our Common Stock +The market price of our common stock may be volatile or may decline regardless of our operating performance and investors may not be able to resell shares they purchase at their purchase price. +The stock market has experienced and may in the future experience volatility that has often been unrelated to the operating performance of particular companies. The market price of our common stock has experienced, and may continue to experience, substantial volatility. During 2020, the sales price of our common stock on the NASDAQ ranged from $3.53 to $9.00 per share. We expect our common stock to continue to be subject to fluctuations. Broad market and industry factors may adversely affect the market price of our common stock, regardless of our actual operating performance. Factors that could cause fluctuation in the common stock price may include, among other things: +• +actual or anticipated variations in operating results; +• +adverse general economic conditions, including, but not limited to, withdrawals of investments in the stock markets generally or a tightening of credit available to potential acquirers of businesses, that result in lower average prices being paid for public company shares and lower valuations being placed on businesses; +• +other domestic and international macroeconomic factors unrelated to our performance; +• +health epidemics and other outbreaks, including the COVID-19 pandemic; +• +our failure to meet the expectations of the investment community; +• +industry trends and the business success of our customers; +• +loss of key customers; +• +announcements of technological advances by us or our competitors; +• +current events affecting the political and economic environment in the United States; +• +conditions or trends in our industry, including demand for our products and services, technological advances and governmental regulations; +• +litigation or other proceedings involving or affecting us; and +• +additions or departures of our key personnel. +The realization of any of these risks and other factors beyond our control could cause the market price of our common stock to decline significantly. +We are not currently paying dividends and cannot make assurances that we will pay dividends on our common stock and our indebtedness could limit our ability to pay dividends. +The timing, declaration, amount and payment of future dividends to our stockholders fall within the discretion of our Board of Directors and will depend on many factors, including our financial condition, results of operations and capital requirements, as well as +20 +applicable legal, regulatory constraints, industry practice and other business considerations that our Board of Directors considers relevant. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the stockholders to suspend dividend payments. Future dividends and the dividend policy may be changed at the Board of Director’s discretion at any time. There can be no assurance that we will pay a dividend in the future. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Facility. +Our ability to issue preferred stock could adversely affect the rights of holders of our common stock. +Our certificate of incorporation authorizes us to issue up to 10,000 shares of preferred stock in one or more series on terms that may be determined at the time of issuance by our Board of Directors. Accordingly, we may issue shares of any series of preferred stock that would rank senior to our common stock as to voting or dividend rights or rights upon our liquidation, dissolution or winding up. +Certain provisions in our charter documents have anti-takeover effects. +Certain provisions of our certificate of incorporation and bylaws may have the effect of delaying, deferring or preventing a change in control of us. Such provisions, including those limiting who may call special stockholders’ meetings, together with the possible issuance of our preferred stock without stockholder approval, may make it more difficult for other persons, without the approval of our Board of Directors, to make a tender offer or otherwise acquire substantial amounts of our common stock or to launch other takeover attempts that a stockholder might consider to be in such stockholder’s best interest. +General Risk Factors +Failure to maintain adequate internal controls could adversely affect our business. +Under Section 404 of Sarbanes-Oxley, we are required to include in each of our Annual Reports on Form 10-K, a report containing our management’s assessment of the effectiveness of our internal control over financial reporting and an attestation report of our independent auditor. These laws, rules and regulations continue to evolve and could become increasingly stringent in the future. We have undertaken actions to enhance our ability to comply with the requirements of Sarbanes-Oxley, including, but not limited to, the engagement of consultants, the documentation of existing controls and the implementation of new controls or modification of existing controls as deemed appropriate. +We continue to devote substantial time and resources to the documentation and testing of our controls, and to plan for and the implementation of remedial efforts in those instances where remediation is indicated. If we fail to maintain the adequacy of our internal controls, including remediating any material weaknesses or deficiencies in our internal controls, as such standards are modified, supplemented or amended in the future, we could be subject to regulatory actions, civil or criminal penalties or stockholder litigation. In addition, failure to maintain adequate internal controls could result in financial statements that do not accurately reflect our financial condition, results of operations and cash flows. We believe that the out-of-pocket costs, the diversion of management’s attention from running our day-to-day operations and operational changes caused by the need to comply with the requirements of Section 404 will continue to be significant. +There are inherent limitations in all internal control systems over financial reporting, and misstatements due to error or fraud may occur and not be detected. +While we continue to take action to ensure compliance with the internal control, disclosure control and other requirements of Sarbanes-Oxley and the rules and regulations promulgated thereunder by the SEC, there are inherent limitations in our ability to control all circumstances. Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our internal controls and disclosure controls can prevent all errors and all frauds. A control system, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be evaluated in relation to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Further, controls can be circumvented by individual acts of some persons, by collusion of two or more persons, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, a control may be inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. +21 +If we are not able to maintain the adequacy of our internal control over financial reporting, including any failure to implement required new or improved controls, or if we experience difficulties in their implementation, our business, financial condition and operating results could be harmed. We can give no assurances that any additional material weaknesses will not arise in the future due to our failure to implement and maintain adequate internal control over financial reporting. +Item 1B. +Unresolved Staff Comments +Not Applicable. +Item 2. +Properties +The Company has 25 principal operating facilities across 11 states and seven foreign countries. The Company’s executive offices are located in Dallas, Texas. We maintain our facilities in good operating condition, and we believe they are suitable and adequate for the purposes for which they are intended to conduct business. Our current capacity, with limited capital additions, is expected to be sufficient to meet production requirements for the near future. It is anticipated that most leases coming due in the near future will be renewed at expiration. The property we own is subject to collateral mortgages to secure the amounts owed under the Credit Facility. Information on the number and location of principal operating facilities by segment was as follows as of December 31, 2020. +Location of Facilities +Segment +Owned +Leased +States +Countries +Energy Solutions segment +— +12 +California, Connecticut, New York, Ohio, Texas +United States, The Netherlands, Canada, India United Arab Emirates, Singapore, United Kingdom, People's Republic of China +Industrial Solutions segment +— +8 +California, Illinois, Michigan, North Carolina, Pennsylvania, Tennessee +United States, United Kingdom, People's Republic of China +Fluid Handling Solutions segment +1 +2 +Indiana, Pennsylvania +United States, The Netherlands +Corporate +— +2 +Ohio, Texas +United States +1 +24 +Item 3. +Legal Proceedings +See Note 12 to the Consolidated Financial Statements contained in Part II, Item 8 of this Annual Report on Form 10-K for information regarding legal proceedings in which we are involved. +Item 4. +Mine Safety Disclosures +Not applicable. +22 +PART II +Item 5. +Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Market Information +Our common stock is traded on the NASDAQ under the symbol “CECE.” +Performance Graph +The following graph sets forth the cumulative total return to CECO’s stockholders during the five years ended December 31, 2020, as well as the following indices: Russell 2000 Index, Standard and Poor’s (“S&P”) 600 Small Cap Industrial Machinery Index, and S&P 500 Index. Assumes $100 was invested on December 31, 2015, including the reinvestment of dividends, in each category. +Dividends +Our dividend policy and the payment of cash dividends under that policy are subject to the Board of Director’s continuing determination that the dividend policy and the declaration of dividends are in the best interest of our stockholders. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the stockholders to suspend dividend payments. Future dividends and the dividend policy may be changed at the Board of Director’s discretion at any time. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Facility. +Holders +The approximate number of registered stockholders of record of our common stock as of February 25, 2021 was 295, although there are a larger number of beneficial owners. +23 +Purchases of Equity Securities by the Issuer and Affiliated Purchasers +We did not repurchase any shares of our common stock during 2020. +Recent Sales of Unregistered Securities +Not applicable. +Item 6. Selected Financial Data +Reserved. +24 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +Management’s discussion and analysis (“MD&A”) should be read in conjunction with the consolidated financial statements and accompanying notes included in Item 8 of this Annual Report on Form 10-K, which include additional information about our accounting policies, practices and the transactions underlying our financial results. The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and the accompanying notes including various claims and contingencies related to lawsuits, taxes, environmental and other matters arising during the normal course of business. We apply our best judgment, our knowledge of existing facts and circumstances and actions that we may undertake in the future in determining the estimates that affect our consolidated financial statements. We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change. As future events and their effects cannot be determined with precision, actual results may differ from these estimates. +Overview +Business Overview +CECO is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that controls emissions from such facilities, as well as fluid handling and filtration systems. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customers’ mission critical applications. The industries CECO serves include power generation, petrochemical processing, general industrial, refining, oil & gas, electric vehicle production, poly silicon fabrication, battery recycling, and wastewater treatment, along with a wide range of other industries. +COVID-19 +On January 30, 2020, the WHO announced a global health emergency because of a new strain of coronavirus (“COVID-19”) originating in Wuhan, China and the risks to the international community as the virus spreads globally beyond its point of origin. On March 11, 2020, the WHO characterized COVID-19 as a pandemic. As of March 3, 2021, the virus continues to spread and has had a significant impact on worldwide economic activity and on macroeconomic conditions and the end markets of our business. Vaccine administration is underway, however new variants of COVID-19 continue to emerge. There is uncertainty regarding the efficacy of vaccines and current tests and treatments with regard to the new variants. Several countries, including the United States, have taken steps to restrict travel, temporarily close businesses and issue quarantine orders, and it remains unclear how long such measures will remain in place or whether efforts to contain the spread of COVID-19 will continue to intensify. +Within the United States, certain portions of our business have been designated an essential business, and we continue to operate our business in compliance with applicable state and local laws. This allows us to continue to serve our customers, however, the COVID-19 pandemic has also disrupted our global operations. Some of our facilities and our suppliers have experienced temporary disruptions as a result of the COVID-19 pandemic, and we cannot predict whether our facilities will experience more significant disruptions in the future or the impact on our suppliers. +CECO has undertaken necessary measures in compliance with government directives to remain open across its business and continues to work closely with its global supply chain to proactively support customers during this critical time. As a key supplier to critical infrastructure projects, CECO has worked to maintain ongoing essential operations while observing recommended CDC guidelines to minimize the risk of spreading the COVID-19 virus including implementing, where possible, work-from-home procedures and additional sanitization efforts where facilities remain open to provide necessary services. Additionally, in 2020, CECO took several proactive cost reduction measures in response to the economic pressures brought on by the COVID-19 pandemic, including: headcount reductions, lower discretionary spend, senior management team’s temporary salary reduction, elimination or reduction of certain corporate-level costs, travel restrictions across all segments, and the Company implemented a number of furloughs which included, a rolling 2-week furlough of United States-based employees during the 6-week period beginning the week of April 6, 2020. +25 +The senior management team meets regularly to review and assess the status of the Company's operations and the health and safety of its employees. The senior management team continues to monitor and manage the Company’s ability to operate effectively and, to date, the Company has not experienced any significant disruptions within its supply chain as a result of the COVID-19 pandemic. Notwithstanding the Company's continued efforts, COVID-19 has had and may have further negative impacts on its operations, customers and supply chain despite the preventative and precautionary measures being taken. COVID-19 began to impact the Company during the first quarter of 2020 and the impact of the COVID-19 pandemic is fluid and continues to evolve, and therefore, we cannot currently predict the extent to which our business, results of operations, financial condition or liquidity will ultimately be impacted. +Industry Trends and Corporate Strategy +We are a global corporation with worldwide operations. As a global business, our operations are affected by worldwide, regional and industry-specific economic factors, wherever we operate or do business. Our geographic and industry diversity, and the breadth of our product and services portfolios, have helped mitigate the impact of any one industry or the economy of any single country on our consolidated operating results. +We believe growth for our products and services is driven by the increasing demand for energy consumption and a shift towards cleaner sources such as natural gas, nuclear, and renewable sources. These trends should stimulate investment in new power generation facilities, pipeline expansion and related infrastructure, and in upgrading of existing facilities. +With a shift to cleaner, more environmentally responsible power generation, power providers and industrial power consumers are building new facilities that use cleaner fuels. In developed markets, natural gas is increasingly becoming one of the energy sources of choice. We supply product offerings throughout the entire natural gas infrastructure value chain and believe expansion will drive growth within our Energy Solutions segment for our pressure products and SCR systems for natural-gas-fired power plants. Increased global natural gas production as a percent of total energy consumption, miles of new pipeline being added globally, and an increase in liquification capacity all stand to drive the need for our products. +We also believe there is a trend in both developed and emerging markets to control and reduce emissions of harsher fuel sources for which our air pollution control equipment is required. In emerging markets including China, India, and South East Asia our business is positioned to benefit from tightening of air pollution standards. In developed markets, growth of industrialization will drive greater output of emissions requiring our equipment as well. In both markets, we expect capital expenditures for our equipment to increase and the need for our aftermarket services to grow as companies seek to meet new standards. +We continue to focus on increasing revenues and profitability globally while continuing to strengthen and expand our presence domestically. Our operating strategy has historically involved horizontally expanding our scope of technology, products, and services through selective acquisitions and the formation of new business units that are then vertically integrated into our growing group of turnkey system providers. Our continuing focus will be on global growth, market coverage, and expansion of our Asia operations. Operational excellence, margin expansion, after-market recurring revenue growth, and safety leadership are also critical to our growth strategy. +Operations Overview +We operate using an “outside-in” customer approach to our business model. We are structured to win in target markets with a core focus on understanding customer needs. Our business model requires scalable efficiencies enabling us to serve our customers with a variety of products that we typically classify into three categories: make-to-order, configure-to-order, and engineer-to-order. We use an asset light model to accomplish this by focusing on application and technical expertise throughout our operations. +The Company’s segments are led by presidents with distinct industry expertise coupled with strong leadership skills resulting in a customer-first mindset across the business. They manage their teams who are responsible for successfully running the segment operations. The segment presidents work closely with our Chief Executive Officer on global growth strategies, operational excellence, and employee development. +Within our segments we have monthly operating reviews to ensure we are both winning in the markets and winning as a business. These reviews include, but are not limited to, deal reviews, project reviews, and manufacturing reviews. Each of these reviews takes a customer-first approach where we adopt the metrics that matter most to our customer and to our stockholders. In these reviews we focus on metrics such as quality, customer satisfaction, on-time-delivery, lead-times, price, position, project margins, backlog, and above all, safety. +26 +The headquarters focuses on enabling the core back-office key functions for scale and efficiency, that is, accounting, payroll, human resources/benefits, legal , information technology, marketing, safety support, internal control over financial reporting, and administration. We have excellent organizational focus from headquarters throughout our divisional businesses with clarity and minimal duplicative work streams. +Our three reportable segments are: +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for clean energy and lower emissions through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings in clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers in the semiconductor manufacturing, electric vehicle production, battery recycling, and wood manufacturing industries to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Our contracts are obtained either through competitive bidding or as a result of negotiations with our customers. Contract terms offered by us are generally dependent on the complexity and risk of the project as well as the resources that will be required to complete the project. Our focus is on increasing our operating margins as well as our gross margin percentage, which translates into stronger operating results. +Our cost of sales is principally driven by a number of factors, including material and subcontract prices and labor cost and availability. Changes in these factors may have a material impact on our overall gross profit margins. +We break down costs of sales into five categories. They are: +• +Subcontracts—Electrical work, concrete work, subcomponents and other subcontracts necessary to produce our products; +• +Labor—Our direct labor both in the shop and in the field; +• +Material—Raw material that we buy to build our products; +• +Equipment—Fans, motors, control panels and other equipment necessary for turnkey systems; and +• +Factory overhead—Costs of facilities and supervision wages necessary to produce our products. +In general, subcontracts provide us the most flexibility in margin followed by labor, material, and equipment. Across our various product lines, the relative relationships of these factors change and cause variations in gross margin percentage. Material costs have also increased faster than labor costs, which also reduces gross margin percentage. As material cost inflation occurs, the Company seeks to pass this cost onto our customers as price increases. +Selling and administrative expense principally includes sales and engineering payroll and related fringes, advertising and marketing expenditures as well as all corporate and administrative functions and other costs that support our operations. The majority of these expenses are fixed. With our asset light model, we expect our operations to leverage our fixed cost structure as revenue grows. +27 +Note Regarding Use of Non-GAAP Financial Measures +The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) . These GAAP financial statements include certain charges the Company believes are not indicative of its ongoing operational performance. +As a result, the Company provides financial information in this MD&A that was not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. The Company provides this supplemental non-GAAP financial information, which the Company’s management utilizes to evaluate its ongoing financial performance, and which the Company believes provides greater transparency to investors as supplemental information to its GAAP results. +The Company has provided the non-GAAP financial measures including non-GAAP operating income, non-GAAP operating margin, and non-GAAP net income as a result of the adjustment for items that the Company believes are not indicative of its ongoing operations. These items include charges associated with the Company’s acquisitions, divestitures and the items described below in “Consolidated Results.” The Company believes that evaluation of its financial performance compared with prior and future periods can be enhanced by a presentation of results that exclude the impact of these items. The Company has incurred substantial expense and income associated with acquisitions and divestitures. While the Company cannot predict the exact timing or amounts of such charges, it does expect to treat these charges as special items in its future presentation of non-GAAP results. +Results of Operations +Consolidated Results +Our consolidated statements of operations for the years ended December 31, 2020, 2019 and 2018 are as follows: +Year ended December 31, +(dollars in millions) +2020 +2019 +2018 +Net sales +$ +316.0 +$ +341.9 +$ +337.3 +Cost of goods sold +210.9 +227.8 +225.8 +Gross profit +$ +105.1 +$ +114.1 +$ +111.5 +Percent of sales +33.3 +% +33.4 +% +33.1 +% +Selling and administrative expenses +$ +76.9 +$ +85.9 +$ +87.4 +Percent of sales +24.3 +% +25.1 +% +25.9 +% +Amortization and earnout expenses +8.8 +8.5 +9.7 +Restructuring expenses +2.3 +1.1 +— +Acquisition and integration expenses +1.4 +0.5 +— +Executive transition expenses +1.5 +— +— +Loss on divestitures, net of selling costs +— +0.1 +4.4 +Intangible asset impairment +0.9 +— +— +Operating income +$ +13.3 +$ +18.0 +$ +10.0 +Percent of sales +4.2 +% +5.3 +% +3.0 +% +28 +Non-GAAP Measures +To compare operating performance between the years ended December 31, 2020, 2019 and 2018, the Company has adjusted GAAP operating income to exclude (1) amortization of intangible assets, earnout and retention expenses, (2) restructuring expenses primarily relating to severance, facility exits, and associated legal expenses, (3) acquisition and integration expenses, which include legal, accounting, and other expenses, (4) executive transition expenses, including severance for its former Chief Executive Officer, fees and expenses incurred in the search, for and hiring, of a new Chief Executive Officer, (5) loss on divestitures, net of selling costs necessary to complete the divestiture such as legal, accounting and compliance and (6) intangible asset impairment . See “Note Regarding Use of Non-GAAP Financial Measures” above. The following tables present the reconciliation of GAAP operating income and GAAP operating margin to non-GAAP operating income and non-GAAP operating margin, and GAAP net income (loss) to non-GAAP net income. +Year Ended December 31, +(dollars in millions) +2020 +2019 +2018 +Operating income as reported in accordance with GAAP +$ +13.3 +$ +18.0 +$ +10.0 +Operating margin in accordance with GAAP +4.2 +% +5.3 +% +3.0 +% +Amortization and earnout expenses +8.8 +8.5 +9.7 +Restructuring expenses +2.3 +1.1 +— +Acquisition and integration expenses +1.4 +0.5 +— +Executive transition expenses +1.5 +— +— +Loss on divestitures, net of selling costs +— +0.1 +4.4 +Intangible asset impairment +0.9 +— +— +Non-GAAP operating income +$ +28.2 +$ +28.2 +$ +24.1 +Non-GAAP operating margin +8.9 +% +8.2 +% +7.1 +% +Year Ended December 31, +(dollars in millions) +2020 +2019 +2018 +Net income (loss) as reported in accordance with GAAP +$ +8.2 +$ +17.7 +$ +(7.1 +) +Amortization and earnout expenses +8.8 +8.5 +9.7 +Restructuring expenses +2.3 +1.1 +— +Acquisition and integration expenses +1.4 +0.5 +— +Executive transition expenses +1.5 +— +— +Loss on divestitures, net of selling costs +— +0.1 +4.4 +Intangible asset impairment +0.9 +— +— +Deferred financing fee adjustment +— +0.4 +— +Foreign currency remeasurement +0.3 +(0.5 +) +0.8 +Tax (benefit) expense of adjustments +(3.9 +) +(2.5 +) +2.4 +Zhongli tax benefit +— +(4.4 +) +— +Non-GAAP net income +$ +19.5 +$ +20.9 +$ +10.2 +Non-GAAP net income as a percentage of sales +6.2 +% +6.1 +% +3.0 +% +29 +In June 2020 the Company acquired Environmental Integrated Solutions (“EIS”), EIS engineers products that clean air through a variety of technologies including volatile organic compounds (“VOC”) abatement, odor control, regenerative thermal oxidizers, and other air pollution control solutions, which complements our Industrial Solutions Segment businesses. In July 2020, the Company entered into joint venture agreement (the “JV agreement”) with Mader Holding L.P. (“Mader”) in which CECO contributed the net assets of its Effox-Flextor damper business and Mader contributed the net assets of their damper business. During 2020, EIS and the joint venture accounted for $15.8 million in revenue. In 2018, we divested three non-core businesses; the Keystone Filter brand (“Keystone”) and Strobic Air Corporation (“Strobic”) in the first quarter and Zhongli in the fourth quarter (collectively, “the Divestitures”). The exclusion of the operating results subsequent to their disposition impacts the comparability of our consolidated and segment operating results. +Comparison of the years ended December 31, 2020 and 2019 +Consolidated net sales in 2020 were $316.0 million compared with $341.9 million in 2019, a decrease of $25.9 million. The decrease is primarily attributable to decreases of $24.5 million in our Industrial Solutions air pollution control technologies, $18.2 million in custom-designed FCC cyclone systems serving the refinery markets, and $4.4 million in volume decreases in the Company’s filtration and pump solutions sales. These decreases in net sales are offset by increases of $10.1 million in the Company’s custom acoustical technologies that serve the natural gas power generation markets, $8.1 million in volatile organic compounds (“VOC”) abatement solutions from the EIS acquisition and $3.3 million in volume increases in our emissions management and water filtration solutions technologies. +Gross profit decreased by $9.0 million, or 7.9%, to $105.1 million in 2020 compared with $114.1 million in 2019. The decrease in gross profit is primarily due to the decrease in sales as noted above, partially offset by favorable changes to product mix from previous period and cost reduction actions including employee furlough. Gross profit as a percentage of sales was 33.3% and 33.4% in 2020 and 2019, respectively. +Orders booked were $279.6 million in 2020 compared with $383.7 million in 2019. The decrease is primarily attributable to decreases in refinery, oil & gas, and pollution controls end markets due to the COVID-19 pandemic impacting our customers starting in March 2020. +Selling and administrative expenses were $76.9 million in 2020 compared with $85.9 million in 2019. The decrease in administration expenses is primarily attributable to proactive cost reduction measures noted above taken in response to the COVID-19 pandemic including: headcount reductions, lower discretionary spend, the senior management team’s temporary salary reduction, elimination of certain corporate-level costs, a 2-week furlough of United States-based employees, and travel restrictions across all segments. Selling and administrative expenses as a percentage of sales were 24.3% in 2020 compared with 25.1% in 2019. The decrease in selling and administrative expenses as a percentage of sales is primarily attributable to the items described above. +Amortization and earnout expense was $8.8 million in 2020 and $8.5 million in 2019. The increase in expense is primarily attributable to $1.4 million in earnout expenses related to the EIS acquisition. The fair value adjustments to the earnout that were recorded in 2020 were the result of EIS performing above the acquisition operational expectations. The increase was partially offset by $1.1 million decrease in definite lived intangible asset amortization. +Acquisitions and integration expenses related to the acquisition of EIS and the Mader joint venture were $1.4 million in 2020, which include legal, accounting and banking expenses, compared to $0.5 million in 2019 related to various merger and acquisition diligence activities. +In 2020, the Company incurred $1.5 million in executive transition expense related to severance for the Company’s former Chief Executive Officer, as well as fees and expenses incurred in the search for, and hiring of, a new Chief Executive Officer. +In 2020, after conducting the annual impairment testing for goodwill and indefinite lived intangible assets, the Company recorded an impairment charge of $0.9 million. The charge of $0.9 million was recorded to impair the carrying value of a tradename intangible asset in the Company’s Fluid Handling Solutions Segment. The impairment was recorded due to declining revenue related to the tradename exacerbated by the COVID-19 pandemic. +Operating income for 2020 was $13.3 million, a decrease of $4.7 million from $18.0 million in 2019. Operating income as a percentage of sales for 2020 was 4.2% compared with 5.3% for 2019. The decrease in operating income is primarily attributable to $1.5 million in executive transition expenses which did not occur in 2019, $1.2 million increase in restructuring expenses, $0.9 million increase in acquisition and integration expenses in connection to the EIS acquisition and the Mader joint venture, intangible asset impairment of $0.9 million, $0.3 million increase in amortization and earnout expenses, and a decrease in net sales as noted above, +30 +partially offset by the decrease in selling and administration expenses due to the cost reduction measures taken in response to the COVID-19 pand e mic. +Non-GAAP operating income was $28.2 million in 2020 and 2019. Non-GAAP operating income as a percentage of sales for 2020 was 8.9% compared with 8.2% for 2019. Non-GAAP operating income was equal year over year due to cost reductions described above offset by the decline in sales. +Other income for 2020 was $2.0 million, an increase of $1.2 million from $0.8 million in 2019. The increase in other income was primarily attributable to a net periodic gain on pension assets of $0.3 million in 2020 compared to a net periodic expense of $0.3 million on pension assets in 2019 and $0.4 million increase year over year in foreign currency transaction gains. +Interest expense decreased to $3.5 million in 2020 from $5.4 million in 2019. The decrease is due to lower interest rates and lower average debt balances in 2020 compared to 2019. During the year 2020, the Company had net borrowings of $9.5 million on its revolving credit facility, which consisted of $10.3 million used to fund the EIS acquisition on June 4, 2020 and $2.6 million used to pay term debt assumed in connection with the Mader joint venture, and $3.4 million in net repayments on the revolving credit facility. +Income tax expense (benefit) was $3.7 million and $(4.4) million in 2020 and 2019, respectively. The effective tax rate for 2020 was 30.1% compared with (32.7)% in 2019. +Income tax expense and the effective tax rate for 2020 were affected by certain permanent differences, including state income taxes, non-deductible incentive stock-based compensation, the Global Intangible Low-Taxed Income (“GILTI”) inclusion and Foreign-Derived Intangible Income (“FDII”) deduction, tax credits, and differences in tax rates among the jurisdictions in which we operate. +Income tax benefit and the effective tax rate for 2019 were significantly impacted by a $4.4 million tax benefit on finalization of a tax position related to the 2018 divestiture of Zhongli. In addition, the Company recorded $3.5 million tax benefit related to U.S. and foreign tax incentives. +Comparison of the years ended December 31, 2019 and 2018 +See the Management Discussion and Analysis section of our Annual Report on Form 10-K for the year ended December 31, 2019 for a discussion of our results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018. +Business Segments +The Company’s operations in are organized and reviewed by management along its product lines or end markets that the segment serves and are presented in three reportable segments. The results of the segments are reviewed through the “Income from operations” line on the Consolidated Statements of Operations. The amounts presented in the Net Sales table below and in the following comments regarding our net sales at the reportable business segment level exclude both intra-segment and inter-segment net sales. The Income from Operations table and corresponding comments regarding operating income (loss) at the reportable segment level include both intra-segment and inter-segment operating income. The exclusion of the Divestitures’ operating results subsequent to their disposition impacts the comparability of our segment operating results. +2020 +2019 +2018 +Net Sales (less intra-, inter-segment sales) +(table only in thousands) +Energy Solutions segment +$ +205,494 +$ +210,319 +$ +211,185 +Industrial Solutions segment +74,697 +91,347 +80,699 +Fluid Handling Solutions segment +35,820 +40,203 +45,455 +Net sales +$ +316,011 +$ +341,869 +$ +337,339 +31 +2020 +2019 +2018 +Income from Operations +(table only in thousands) +Energy Solutions segment +$ +34,170 +$ +33,886 +$ +28,797 +Industrial Solutions segment +2,183 +5,679 +6,308 +Fluid Handling Solutions segment +5,037 +5,558 +7,730 +Corporate and Other (1) +(28,044 +) +(27,133 +) +(32,833 +) +Income from operations +$ +13,346 +$ +17,990 +$ +10,002 +(1) +Includes corporate compensation, professional services, information technology, other general and administrative corporate expenses and loss on divestitures, net of selling costs. This figure excludes earnout expenses / income, which are recorded in the segment in which the expense / income occurs. +Comparison of the years ended December 31, 2020 and 2019 +Energy Solutions segment +Our Energy Solutions segment net sales decreased $4.8 million to $205.5 million in 2020 compared with $210.3 million in 2019, a decrease of 2.3%. The decrease is primarily attributable to decreases of $18.2 million in custom-designed FCC cyclone systems serving the refinery markets offset by increases of $10.1 million in the Company’s custom acoustical technologies that serve the natural gas power generation markets and $3.3 million in volume increases in our emissions management and water filtration solutions technologies. +Operating income increased $0.3 million to $34.2 million for 2020 compared with $33.9 million in 2019, an increase of 0.8%. The increase in operating income in 2020 is primarily attributable to the decrease of $2.6 million in selling and administrative expenses related to the cost reductions as described above and the decrease in amortization expenses of $1.1 million partially offset by a decrease in gross profit of $3.1 million due to lower net sales and unfavorable product mix and an increase of $0.3 in restructuring expense. +Industrial Solutions segment +Our Industrial Solutions segment net sales decreased $16.6 million to $74.7 million in 2020 compared with $91.3 million in 2019, a decrease of 18.2%. The decrease is primarily attributable to decreases of $24.5 million in our air pollution control technologies partially offset by $8.1 million increase in VOC abatement solutions from the EIS acquisition. +Operating income decreased $3.5 million to $2.2 million for 2020 compared with $5.7 million in 2019. The decrease is primarily attributable to a $4.6 million decrease in gross profit due to lower net sales, an increase of $0.5 million in restructuring expenses, and items related to the EIS acquisition including an increase of $1.4 million in earnout expense and $0.4 million in amortization expense. These decreases were partially offset by $3.2 million decrease in selling and administration related to cost reductions described above. +Fluid Handling Solutions segment +Our Fluid Handling Solutions segment net sales decreased $4.4 million to $35.8 million in 2020 compared with $40.2 million in 2019, a decrease of 10.9%. The decrease is primarily attributable to volume decreases in the Company’s filtration and pump solutions product line driven by lower demand from oil & gas and automotive end market customers. +Operating income decreased $0.6 million to $5.0 million for 2020 compared with $5.6 million for 2019, a decrease of 10.7%. The decrease is primarily attributable to $1.6 million decrease in gross profit due to lower net sales and a $0.9 million intangible asset impairment expense partially offset by $1.8 million decrease in selling and administration related to cost reductions described above. +Corporate and Other segment +Operating expense for the Corporate and Other segment increased $0.9 million to $28.0 million for 2020 compared with $27.1 million for 2019. The increase is primarily attributable to a $1.5 million increase in executive transition expenses, $0.9 million increase in acquisition and integration expenses, partially offset by $1.5 million decrease in selling and administration expenses related to cost reductions described above. +32 +Comparison of the years ended December 31, 201 9 and 201 8 +See the Management Discussion and Analysis section of our Annual Report on Form 10-K for the year ended December 31, 2019 for a discussion of our results of operations for our business segments and cash flows for the year ended December 31, 2019 compared to the year ended December 31, 2018. +Liquidity and Capital Resources +Our principal sources of liquidity are cash flow from operations and available borrowings under our Credit Facility (as defined below). Our principal uses of cash are operating costs, payment of principal and interest on our outstanding debt, working capital and other corporate requirements. Depending on market conditions, our liquidity requirements, contractual restrictions and other factors, we may also repurchase some of our outstanding shares of common stock. +When we undertake large jobs, our working capital objective is to make these projects self-funding. We work to achieve this by obtaining initial down payments, progress billing contracts, when possible, utilizing extended payment terms from material suppliers, and paying sub-contractors after payment from our customers, which is an industry practice. Our investment in net working capital is funded by cash flow from operations and by our revolving line of credit. +At December 31, 2020, the Company had working capital of $74.1 million, compared with $64.3 million at December 31, 2019. The ratio of current assets to current liabilities was 1.68 to 1.00 at December 31, 2020 as compared with a ratio of 1.56 to 1.00 at December 31, 2019. +At December 31, 2020 and 2019, cash and cash equivalents totaled $36.0 million and $35.6 million, respectively. As of December 31, 2020 and 2019, $28.0 million and $27.4 million, respectively, of our cash and cash equivalents were held by non-U.S. subsidiaries, as well as being denominated in foreign currencies. +Debt consisted of the following: +December 31, +(table only in thousands) +2020 +2019 +Outstanding borrowings under Credit Facility +Term loan payable in quarterly principal installments of $0.6 million +through June 2021, $0.9 million through June 2023, and $1.3 million +thereafter with balance due upon maturity in June 2024. +– Term loan +$ +46,250 +$ +48,750 +– Revolving Credit Loan +27,700 +18,500 +– Unamortized debt discount +(1,334 +) +(1,749 +) +Total outstanding borrowings under Credit Facility +72,616 +65,501 +Less: current portion +(3,125 +) +(2,500 +) +Total debt, less current portion +$ +69,491 +$ +63,001 +In 2020, the Company made repayments of $2.5 million on the term loan and net borrowings on the revolving credit lines of $9.5 million, consisting of $10.3 million used to fund the EIS acquisition on June 4, 2020 and $2.6 million used to pay term debt assumed in connection with the Mader joint venture, offset by $3.4 million in net repayments on the revolving credit facility. +Under the terms of the Credit Facility, the Company is required to maintain certain financial covenants, including the maintenance of a Consolidated Net Leverage Ratio (as defined in the Credit Facility). Through September 30, 2021, the maximum Consolidated Net Leverage Ratio is 3.50, after which time it will decrease to 3.25 until the end of the term of the Credit Facility. +As of December 31, 2020 and 2019, the Company was in compliance with all related financial and other restrictive covenants under the Credit Facility. +Foreign Debt +In addition, the Company has a number of bank guarantee facilities and bilateral lines of credit in various foreign countries currently supported by cash, letters of credit or pledged assets and collateral under the Credit Facility. The Credit Facility allows letters of credit and bank guarantee issuances of up to $50.0 million from the bilateral lines of credit secured by pledged assets and collateral under the Credit Facility. +33 +See Note 8 to the C onsolidated F inancial S tatements for further information on the Company’s foreign debt. +Total unused credit availability under our Credit Facility and other non-U.S. credit facilities and agreements, exclusive of any potential asset base limitations, is as follows: +December 31, +2020 +2019 +(dollars in millions) +Credit Facility, revolving loans +$ +140.0 +$ +140.0 +Draw down +(27.7 +) +(18.5 +) +Letters of credit open +(7.6 +) +(11.0 +) +Total unused credit availability +$ +104.7 +$ +110.5 +Amount available based on borrowing limitations +$ +60.8 +$ +82.3 +Overview of Cash Flows and Liquidity +For the year ended December 31, +(dollars in thousands) +2020 +2019 +2018 +Total operating cash flow provided by operating activities +$ +4,421 +$ +10,227 +$ +21,952 +Net cash (used in) provided by investing activities +(9,235 +) +(5,146 +) +38,258 +Net cash provided by (used in) financing activities +3,724 +(12,116 +) +(44,900 +) +Effect of exchange rate changes on cash and cash equivalents +1,943 +(445 +) +(1,531 +) +Net increase (decrease) in cash, cash equivalents and restricted cash +$ +853 +$ +(7,480 +) +$ +13,779 +Operating Activities +In 2020, $4.4 million of cash was provided by operating activities compared with $10.2 million in 2019, a decrease of $5.8 million. Net earnings, adjusted for non-cash items decreased $5.7 million year-over-year. Additionally, working capital change year over year increased by $0.1 million which negatively affected cash flow from operations. +In 2019, $10.2 million of cash was provided by operating activities compared with $22.0 million provided in 2018, a decrease of $11.8 million. Net earnings, adjusted for non-cash items increased $16.0 million year-over-year. Working capital change year over year from operating activities in 2019 had a negative year-over-year net impact primarily from increases in accounts receivable and costs in excess of billings and decreases in other liabilities as reflected in the Consolidated Statement of Cash Flows. +Investing Activities +In 2020, $9.2 million of cash was used in investing activities, which consisted of $5.9 million for acquisitions, $3.9 million of acquisition of property and equipment, offset by $0.6 million of proceeds from the disposal of assets held for sale. +In 2019, $5.1 million of cash was used in investing activities, which consisted of $5.7 million of acquisition of property and equipment offset by $0.5 million of proceeds from disposals of assets held for sale. +Financing Activities +Financing activities in 2020 provided cash of $3.7 million, which consisted primarily of $9.2 million in net borrowings from our revolving credit lines of which $10.3 million was used to fund the EIS acquisition on June 4, 2020. This was offset by $2.5 million of payments on our term loan, $2.6 million used to pay term debt assumed in connection with the Mader joint venture on July 31, 2020, and $0.5 million in payments on capital leases. +Financing activities in 2019 used cash of $12.1 million, which consisted primarily of $3.0 million of payments on our term loan, $7.6 million net payments on our revolving credit lines, and $1.1 million payment of financing fees related to the refinancing of our Credit Facility. +We believe that cash flows from operating activities, together with our existing cash and borrowings available under our Credit Facility, will be sufficient for at least the next twelve months to fund our current anticipated uses of cash. After that, our ability to fund these expected uses of cash and to comply with the financial covenants under our debt agreements will depend on the results of future operations, performance and cash flow. Our ability to fund these expected uses from the results of future operations will be subject to +34 +prevailing economic conditions and to financial, business, regulatory, legislative and other factors, many of which are beyond our control. +Employee Benefit Obligation +Based on current assumptions, estimated contributions to our pension plan required in 2021 is zero. The amount and timing of required contributions to the pension trust depends on future investment performance of the pension funds and interest rate movements, among other things and, accordingly, we cannot reasonably estimate actual required payments. Currently, our pension plan is under-funded. As a result, absent major increases in long-term interest rates, above average returns on pension assets and/or changes in legislated funding requirements, we will be required to make contributions to our pension trust of varying amounts in future years. +Off-Balance Sheet Arrangements +None. +Contractual Obligations +The following table summarizes the Company’s contractual obligations as of December 31, 2020: +Payments Due by Period +(dollars in thousands) +Total +Less than 1 +year +1-3 years +3-5 years +More than +5 years +Term Loan Debt +$ +46,250 +$ +3,125 +$ +8,200 +$ +34,925 +$ +— +Revolving Credit Loan +27,700 +— +— +27,700 +— +Interest expense (estimated) +7,087 +2,129 +4,017 +941 +— +Purchase obligations (1) +65,005 +65,005 +— +— +— +Pension obligations (2) +995 +— +400 +595 +— +Operating lease obligations +13,831 +2,872 +4,257 +3,481 +3,221 +Capital lease obligations +9,077 +872 +1,796 +1,868 +4,541 +Contingent liabilities related to acquisitions (3) +2,202 +2,202 +— +— +— +Totals +$ +172,147 +$ +76,205 +$ +18,670 +$ +69,510 +$ +7,762 +( 1 ) +Primarily consists of purchase obligations for costs associated with uncompleted sales contracts. +(2 ) +Future expected obligations under the Company’s pension plan is included in the contractual cash obligations table above, up to, but not more than five years. The Company’s pension plan policy allows it to fund an amount, which could be in excess of the pension cost expensed, subject to the limitations imposed by current tax regulations. +(3) +Includes expected earnout liability and retention payment. +Critical Accounting Policies and Estimates +Our consolidated financial statements are prepared in conformity with GAAP. The preparation of these financial statements requires the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. We believe that, of our significant accounting policies, the following accounting policies involve a higher degree of judgments, estimates, and complexity. +Use of Estimates +Preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses and related contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to revenues, bad debts, warranties, share based compensation, income taxes, goodwill and intangible asset valuation, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. +35 +Revenue Recognition +A substantial portion of our revenue is derived from fixed-price contracts. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. +We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +The judgments and estimates involved include management’s ability to accurately estimate the contracts’ progress to completion at each financial reporting period. In addition, certain contracts are highly dependent on the work of contractors and other subcontractors participating in a project, over which we have no or limited control, and their performance on such project could have an adverse effect on the profitability of our contracts. Delays resulting from these contractors and subcontractors, changes in the scope of the project, weather, and labor availability also can have an effect on a contract’s profitability. Changes to job performance, job conditions, and estimated profitability may result in revisions to contract revenue and costs and are recognized in the period in which the revisions are made. +Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. No provision for estimated losses on uncompleted contracts was needed at December 31, 2020, 2019 and 2018. +Credit and Collections +The Company maintains allowances for doubtful accounts receivable for probable estimated losses resulting from either customer disputes or the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in their inability to make the required payments, the Company may be required to record additional allowances or charges against income. The Company determines its allowance for doubtful accounts by considering all known collectability problems of customers’ accounts and reviewing the aging of the outstanding receivables. The resulting allowance for doubtful accounts receivable is an estimate based upon the Company’s knowledge of its business and customer base, and historical trends. The amount ultimately not collected may differ from the reserve established. +Inventories +The Company’s inventories are valued at the lower of cost or net realizable value using the first-in, first-out inventory costing method. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the Company’s forecast of future demand and market conditions. Significant unanticipated changes to the Company’s forecasts could require a change in the provision for excess or obsolete inventory. +Property, plant and equipment +Property, plant and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Depreciation and amortization are provided using the straight-line method in amounts sufficient to amortize the cost of the assets over their estimated useful lives (buildings and improvements—generally five to 40 years; machinery and equipment—generally two to 15 years). +Intangible assets +Indefinite life intangible assets are comprised of tradenames, while finite life intangible assets are comprised of technology, customer lists, and tradenames. Finite life intangible assets are amortized on a straight line or accelerated basis over their estimated useful lives of seven to 10 years for technology, five to 20 years for customer lists, and 10 years for tradenames. +36 +Long-lived assets +Property, plant and equipment and finite life intangible assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. If events or changes in circumstances occur that indicate possible impairment, our impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely independent of other groups of our assets and liabilities. This analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. We conduct annual reviews for idle and underutilized equipment, and review business plans for possible impairment. Impairment occurs when the carrying value of the assets exceeds the future undiscounted cash flows expected to be earned by the use of the asset or asset group. When impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset or asset group and an impairment charge is recorded for the difference between the carrying value and the estimated fair value. +Additionally, we also evaluate the remaining useful life each reporting period to determine whether events and circumstances warrant a revision to the remaining period of depreciation or amortization. If the estimate of a long-lived asset’s remaining useful life is changed, the remaining carrying amount of the asset is amortized prospectively over that revised remaining useful life. +The Company completes an annual (or more often if circumstances require) impairment assessment of its indefinite life intangible assets. As a part of its annual assessment, typically, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of an asset is less than its carrying amount. If there is a qualitative determination that the fair value of a particular asset is more likely than not greater than its carrying value, we do not need to proceed to the quantitative estimated fair value test for that asset. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined by the relief from royalty method. If the estimated fair value of an asset is less than its carrying value, an impairment charge is recorded for the amount by which the carrying value of the asset exceeds its estimated fair value. +During 2020 and 2019, our annual impairment test indicated that one and zero, respectively, of our indefinite-lived tradenames was impaired. Accordingly, we recognized impairment charges in our financial results of $0.9 million and zero for the years ended December 31, 2020 and 2019, respectively. For additional information on impairment testing results, see Note 6 to the Consolidated Financial Statements. +Goodwill +The Company completes an annual (or more often if circumstances require) goodwill impairment assessment on October 1 on a reporting unit level, at or below the operating segment level. As a part of its annual assessment, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If there is a qualitative determination that the fair value of a particular reporting unit is more likely than not greater than its carrying value, the Company does not need to quantitatively test for goodwill impairment for that reporting unit. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is calculated using a weighting of the income method and the market method. If the estimated fair value of a reporting unit is less than its carrying value, an impairment charge is recorded. +The Company bases its measurement of the fair value of a reporting unit using a 50/50 weighting of the income method and the market method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital. Projected revenue, projected operational profit and terminal growth rates are significant assumptions because they are three primary drivers of the projected cash flows in the discounted future cash flow approach. Cost of capital is a significant assumption as it is the discount rate used to calculate the current fair value of those projected cash flows. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. Based on the analysis, the resultant estimated fair value of all of the reporting units exceeded their carrying value as of December 31, 2020. For additional information on goodwill impairment testing results, see Note 7 to the Consolidated Financial Statements. +Income Taxes +Income taxes are determined using the asset and liability method of accounting for income taxes in accordance with Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (“ASC”) Topic 740, “Income Taxes”. Income tax expense includes federal, state and foreign income taxes. +37 +Deferred income taxes are provided using the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases and are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Tax credits and other incentives reduce income tax expense in the year the credits are claimed. +Management must assess the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal, state and foreign tax authorities who regularly audit the Company in the normal course of business. In making these assessments, management must often analyze complex tax laws of multiple jurisdictions, including many foreign jurisdictions. The accounting guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. +Management must assess the realizability of the Company’s deferred tax assets. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this assessment. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The company has made an accounting policy election to record the U.S. income tax effect of future global intangible low-taxed income (“GILTI”) inclusions in the period in which they arise, rather than establishing deferred taxes with respect to the expected future tax liabilities associated with future GILTI inclusion. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested. A liability has been recorded for the deferred taxes on such undistributed foreign earnings. The amount is attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +Pension Benefit Plan Assumptions +We sponsor a pension plan for certain employees. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense and liability related to the plan. These factors include key assumptions, such as a discount rate and expected return on plan assets. In addition, our actuarial consultants use subjective factors such as withdrawal and mortality rates to estimate the liability. The actuarial assumptions we use may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of participants. These differences may result in a significant impact to the amount of pension expense we have recorded or may record in the future. An analysis for the expense associated with our pension plan is difficult due to the variety of assumptions utilized. For example, one of the significant assumptions used to determine projected benefit obligation is the discount rate. At December 31, 2020, a 25 basis point change in the discount rate would change the projected benefit obligation by approximately $1.1 million and the annual pension expense by approximately $16,000. Additionally, a 25 basis point change in the expected return on plan assets would change the pension expense by approximately $69,000. +Share-Based Compensation +We measure the cost of employee services received in exchange for an award of equity instruments and recognize this cost over the period during which an employee is required to provide the services, based on the fair value of the award at the date of the grant as determined by the Black-Scholes valuation method for stock options, or current publicly traded market price on the grant date for restricted stock units. +Certain of our awards of restricted share units include performance conditions for achieving designated levels of operating performance. We must estimate the probability of achieving the performance condition at each reporting period. +Product Warranties +The Company’s warranty reserve is to cover the products sold. The warranty accrual is based on historical claims information. The warranty reserve is reviewed and adjusted as necessary at each reporting period. +38 +Other significant accounting policies +Other significant accounting policies, not involving the same level of uncertainties as those discussed above, are nevertheless important to an understanding of our financial statements. See Note 1 to the Consolidated Financial Statements, Summary of Significant Accounting Policies, which discusses accounting policies that must be selected by us when there are acceptable alternatives. +New Accounting Pronouncements +For information regarding recent accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this annual report on Form 10-K. +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +We are exposed to certain market risks, primarily changes in interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. For the Company, these exposures are primarily related to changes in interest rates. We do not currently hold any derivatives or other financial instruments purely for trading or speculative purposes. +The carrying value of the Company’s total long-term debt and current maturities of long-term debt at December 31, 2020 was $74.0 million. Market risk was estimated as the potential decrease (increase) in future earnings and cash flows resulting from a hypothetical 10% increase (decrease) in the Company’s estimated weighted average borrowing rate at December 31, 2020. Most of the interest on the Company’s debt is indexed to either the LIBOR or EURIBOR market rates. The estimated annual impact of a hypothetical 10% change in the estimated weighted average borrowing rate at December 31, 2020 is $0.2 million. +The Company has wholly-owned subsidiaries in several countries, including in the Netherlands, Canada, the People’s Republic of China, Mexico, United Kingdom, Singapore, Shanghai, Pune India, Dubai and Chile. In the past, we have not hedged our foreign currency exposure, and fluctuations in exchange rates have not materially affected our operating results. Future changes in exchange rates may positively or negatively impact our revenues, operating expenses and earnings. Since most of our foreign sales are denominated in the local currency, we do not anticipate that exposure to foreign currency rate fluctuations will be material in 2021. +39 +Item 8 . +Financial Statements and Supplementary Data +The Consolidated Financial Statements of CECO Environmental Corp. and subsidiaries for the years ended December 31, 2020, 2019 and 2018 and other data are included in this report following the signature page of this report and incorporated into this Item 8 by reference: +Report of Independent Registered Public Accounting Firm +F-1 +Consolidated Balance Sheets +F-3 +Consolidated Statements of Operations +F-4 +Consolidated Statements of Comprehensive Income (Loss) +F-5 +Consolidated Statements of Shareholders’ Equity +F-6 +Accumulated Other Comprehensive Loss +F-7 +Consolidated Statements of Cash Flows +F-8 +Notes to Consolidated Financial Statements for the Years Ended December 31, 2020, 2019 and 2018 +F-9 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. +Controls and Procedures +Disclosure Controls and Procedures +Disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) are controls and other procedures that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and made known to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +In connection with the preparation of this Annual Report on Form 10-K, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2020. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2020. +The management of the Company does not expect that its disclosure controls and procedures will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur due to simple errors or mistakes. The design of any system of controls is based in part upon certain assumptions regarding the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. +Management’s Report on Internal Control over Financial Reporting +The management of the Company is responsible for the preparation and accuracy of the financial statements and other information included in this report. Under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2020, based on the criteria set forth in Internal Control – Integrated Framework (2013) (the “Framework”) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management concluded that, as of December 31, 2020, its internal control over financial reporting was effective based on the Framework. +There are inherent limitations on the effectiveness of any system of internal controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective internal controls and procedures can only provide reasonable assurance of achieving their control objectives. +40 +Item 9A includes the audit report of BDO USA, LLP on the Company’s internal control over financial reporting as of December 31, 20 20 . +Changes in Internal Control Over Financial Reporting +There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the fiscal quarter ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +41 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +CECO Environmental Corp. and Subsidiaries +Cincinnati, Ohio +Opinion on Internal Control over Financial Reporting +We have audited CECO Environmental Corp. and Subsidiaries’ (the “Company’s”) internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria . +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2020 and 2019, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and our report dated March 3, 2021, expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ BDO USA, LLP +Cincinnati, Ohio +March 3, 2021 +42 +Item 9B. +Other Information +None. +43 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +The information called for by this Item 10 of Part III of Form 10-K is incorporated by reference to the information set forth in our definitive proxy statement relating to our 2021 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A under the Exchange Act within 120 days from December 31, 2020 (the “Proxy Statement”). Reference is also made to the information appearing in Item 1 of Part I of this Annual Report on Form 10-K under the caption “Business— Executive Officers of CECO.” +Item 11. +Executive Compensation +The information called for by this Item 11 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +The information called for by this Item 12 of Part III of Form 10-K will be incorporated by reference to the Proxy Statement. +Securities Authorized for Issuance Under Equity Compensation Plans +EQUITY COMPENSATION PLAN INFORMATION +December 31, 2020 +(a) +(b) +(c) +Plan Category +Number of securities +to be issued upon +exercise of outstanding +options and rights +Weighted-average +exercise price of +outstanding options and rights, compensation plans +Number of securities +remaining available for +future issuance under +equity compensation +plans (excluding +securities reflected in +column (a)) +Equity compensation plans approved by security +holders +2007 Equity Incentive Plan 1 +330,346 +$ +11.15 +— +2017 Equity and Incentive Plan 2 +962,708 +$ +0.25 +1,151,092 +2020 Employee Stock Purchase Plan 3 +— +$ +— +1,300,000 +Equity compensation plans not approved by security holders 4 +1,309,446 +$ +10.26 +— +TOTAL +2,602,500 +2,451,092 +1 +The 2007 Plan was replaced with the 2017 Equity and Incentive Plan and no further grants will be made under the 2007 Plan. The 2007 Plan remains in effect solely for the continued administration of the awards currently outstanding under the 2007 Plan. +2 +The 2017 Equity and Incentive Plan was approved by our stockholders on May 16, 2017. We have reserved 1.9 million shares of our common stock for issuance under our 2017 Equity Incentive Plan. In 2020, 553,000 restricted stock units were awarded to plan participants under the 2017 Equity and Incentive Plan. +3 +The Employee Stock Purchase Plan was approved by our stockholders on June 11, 2020. +4 +On July 6, 2020, in connection with Mr. Gleason’s appointment as the Company’s Chief Executive Officer, the Company granted Mr. Gleason 0.1 million restricted stock units (the “RSU Inducement Agreement”), 0.3 million in nonqualified stock options, (the “Standard Option Inducement Agreement”) granted at market value, and approximately 0.9 million in premium-priced nonqualified stock options, (the “Premium Option Inducement Agreement”) exercise price equal to two times market value. Mr. Gleason’s restricted stock units and option grants were approved by the Board of Directors of the Company. See Note 9 to the Consolidated Financial Statements for additional information on Mr. Gleason’s inducement grants. +Item 13. +Certain Relationships and Related Transactions, and Director Independence +The information called for by this Item 13 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +Item 14. +Principal Accounting Fees and Services +The information called for by this Item 14 of Part III of Form 10-K is incorporated by reference to the Proxy Statement. +44 +PART IV +Item 15. +Exhibits and Financial Statement Schedules +1. Financial statements are set forth in this report following the signature page of this report. +2. Financial statement schedules are omitted because they are not applicable or because the required information is shown in the financial statements or in the notes thereto. +3. Exhibit Index. The exhibits listed below, as part of Form 10-K, are numbered in conformity with the numbering used in Item 601 of Regulation S-K and relate to SEC File No. 0-07099, unless otherwise indicated. +Exhibit +Number +3(i) +Certificate of Incorporation (Incorporated by reference to Exhibit 3(i) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001) +3(ii) +Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 13, 2017) +4.1 +Description of Securities (Incorporated by reference to Exhibit 4.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019) +**10.1 +Summary term sheet governing arrangement of consulting services provided by Icarus Investment Corp. (Incorporated by reference to Exhibit 10.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018) +**10.2 +Second Amended and Restated CECO Environmental Corp. 2007 Equity Incentive Plan (Incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +**10.3 +Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010) +**10.4 +Form of Non-Statutory Stock Option Agreement (Incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010) +**10.5 +Summary term sheet governing arrangement of consulting services provided by JMP Fam Holdings Inc. to the Company (Incorporated by reference to Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018) +10.6 +Securities Pledge Agreement, dated August 27, 2013, by and among the Company, the Subsidiaries named therein and Bank of America, N.A., as Administrative Agent (Incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed with the SEC on September 3, 2015) +**10.7 +Form of Director and Officer Indemnification Agreement (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on May 16, 2016) +**10.8 +Executive Employment Agreement, effective as of January 9, 2017, by and between the Company and Matthew Eckl (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 10, 2017) +**10.9 +Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.10 +Form of Nonqualified Stock Option Agreement (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.11 +Form of Restricted Stock Units Agreement for Directors (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +45 +Exhibit +Number +**10.12 +Form of Restricted Stock Units Agreement for Employees (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 9, 2017) +**10.13 +CECO Environmental Corp. 2017 Equity and Incentive Compensation Plan (Incorporated by reference to Exhibit 4.3 to the Registrant’s Registration Statement on Form S-8 filed on May 16, 2017 (Registration No. 333-218030)) +10.14 +Second Amended and Restated Credit Agreement, dated as of June 11, 2019, among CECO Environmental Corp. and certain of its subsidiaries, the Lenders party thereto, and Bank of America, N.A. (Incorporated by reference to Exhibit 10.1 to the Company’s Current report on Form 8-K filed with the SEC on June 12, 2019) +**10.15 +CECO Environmental Corp. 2020 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company’s current report on Form 8-K filed with the SEC on June 16, 2020) +**10.16 +Separation and Consulting Agreement, dated as of July 5, 2020, by and between CECO Environmental Corp. and Dennis Sadlowski (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q files with the SEC on November 11, 2020) +**10.17 +Employment Agreement, effective as of July 6, 2020, by and between CECO Environmental Corp. and Todd Gleason (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q files with the SEC on November 11, 2020) +**10.18 +Nonqualified Stock Option Inducement Award Agreement, by and between CECO Environmental Corp. and Todd Gleason, dated as of July 6, 2020 (incorporated by reference to Exhibit 4.3 to the Registrant’s Registration Statement on Form S-8 (Commission File No. 333-239707) filed on July 6, 2020) +**10.19 +Nonqualified Premium Stock Option Inducement Award Agreement, by and between CECO Environmental Corp. and Todd Gleason, dated as of July 6, 2020 (incorporated by reference to Exhibit 4.4 to the Registrant’s Registration Statement on Form S-8 (Commission File No. 333-239707) filed on July 6, 2020) +**10.20 +Restricted Stock Units Inducement Award Agreement, by and between CECO Environmental Corp. and Todd Gleason, dated as of July 6, 2020 (incorporated by reference to Exhibit 4.5 to the Registrant’s Registration Statement on Form S-8 (Commission File No. 333-239707) filed on July 6, 2020) +*21 +Subsidiaries of the Company +*23.1 +Consent of BDO USA, LLP +*31.1 +Rule 13(a)/15d-14(a) Certification by Chief Executive Officer +*31.2 +Rule 13(a)/15d-14(a) Certification by Chief Financial Officer +*32.1 +Certification of Chief Executive Officer (18 U.S. Section 1350) +*32.2 +Certification of Chief Financial Officer (18 U.S. Section 1350) +46 +*101.INS +Inline XBRL Instance Document +*101.SCH +Inline XBRL Taxonomy Extension Schema Document +*101.CAL +Inline XBRL Taxonomy Extension Calculation Linkbase Document +*101.DEF +Inline XBRL Taxonomy Extension Definition Linkbase Document +*101.LAB +Inline XBRL Taxonomy Extension Label Linkbase Document +*101.PRE +Inline XBRL Taxonomy Extension Presentation Linkbase Document +*104 +Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). +* Filed or furnished herewith +** Management contracts or compensation plans or arrangement +Item 16 . +Form 10-K Summary +Not applicable. +47 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +CECO ENVIRONMENTAL CORP. +By: +/S/ M ATTHEW E CKL +Matthew Eckl +Chief Financial Officer +March 3, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: +Principal Executive Officer: +/S/ T ODD G LEASON +March 3, 2021 +Todd Gleason +Chief Executive Officer and Director +Principal Financial Officer: +/S/ M ATTHEW E CKL +March 3, 2021 +Matthew Eckl +Chief Financial Officer +Principal Accounting Officer: +/S/ P AUL G OHR +March 3, 2021 +Paul Gohr +Chief Accounting Officer +Directors: +/S/ J ASON D EZWIREK +March 3, 2021 +Jason DeZwirek +Chairman of the Board and Director +/S/ E RIC M. G OLDBERG +March 3, 2021 +Eric M. Goldberg +Director +/S/ D AVID B . L INER +March 3, 2021 +David B. Liner +Director +/S/ C LAUDIO A. M ANNARINO +March 3, 2021 +Claudio A. Mannarino +Director +/S/ M UNISH N ANDA +March 3, 2021 +Munish Nanda +Director +/S/ J ONATHAN P OLLACK +March 3, 2021 +Jonathan Pollack +Director +/S/ V ALERIE G ENTILE S ACHS +March 3, 2021 +Valerie Gentile Sachs +Director +48 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED FINANCIAL STATEMENTS +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +CECO Environmental Corp. and Subsidiaries +Cincinnati, Ohio +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of CECO Environmental Corp. and Subsidiaries (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2020 and 2019, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2020 , in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated March 3, 2021 expressed an unqualified opinion thereon. +Change in Accounting Principle +As discussed in Note 11 to the consolidated financial statements, the Company changed its method of accounting for leases in 2019 due to the adoption of Accounting Standards Codification Topic 842, Leases . +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing separate opinions on the critical audit matter or on the accounts or disclosures to which it relates. +F-1 +Over Time Revenue Recognition Using the Cost-to-Cost Input Approach +As described in Note 1 to the Company’s consolidated financial statements, the Company derives a substantial portion of its revenues from fixed-price contracts within the Energy Solutions and Industrial Solutions segments. The revenue for such contracts is recognized over a period of time based on the ratio of contract costs incurred to date compared to total estimated costs. Under this method, the Company must continually assess the total estimated costs and progress toward completion for each contract. Changes in these estimates can have a material impact on the amount of revenue and gross profit recognized each period. +We identified over time revenue recognition as a critical audit matter. The determination of estimated cost and progress to completion requires management to make significant estimates and assumptions, which includes an analysis of total estimated labor, material and subcontract costs, historical experience, current performance to date and the conditions to complete each contract. This analysis requires significant management judgment, which affects the amount of revenue recognized by the Company. Auditing these complex judgments and assumptions involves especially challenging auditor judgment due to the nature and extent of audit evidence available and effort required to address these matters . +The primary procedures we performed to address this critical audit matter included: +• +Testing the design and operating effectiveness of internal controls relating to the determination of estimated costs to complete a project including the monthly review of open over time projects and review of estimated cost calculations to complete open projects. These controls include the review of the reasonableness of the assumptions used and the appropriateness of methodologies used to determine costs to complete. +• +Testing the completeness, existence, and accuracy of estimated project cost calculations for a sample of contracts by validating the underlying project data and assumptions used as inputs through the inspection of relevant source documents including project plans or budgets and activity reports, invoices of costs incurred to date, results of recent similar historical projects, other third-party subcontractor support, inquiry of project managers, and confirmations of estimates to complete with customers. +• +Performing a retrospective review on a sample basis of project costs on a project by project basis and investigating variances outside of predetermined thresholds through the inspection of relevant source documents. +/s/ BDO USA, LLP +We have served as the Company's auditor since 2008. +Cincinnati, Ohio +March 3, 2021 +F-2 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +December 31, +(dollars in thousands, except share data) +2020 +2019 +ASSETS +Current assets: +Cash and cash equivalents +$ +35,992 +$ +35,602 +Restricted cash +1,819 +1,356 +Accounts receivable, net +63,046 +68,434 +Costs and estimated earnings in excess of billings on uncompleted contracts +45,498 +34,805 +Inventories, net +17,343 +20,578 +Prepaid expenses and other current assets +11,530 +9,899 +Prepaid income taxes +7,790 +8,231 +Assets held for sale +467 +593 +Total current assets +183,485 +179,498 +Property, plant and equipment, net +16,228 +15,274 +Right-of-use assets from operating leases +11,376 +13,607 +Goodwill +161,820 +152,020 +Intangible assets – finite life, net +29,637 +31,283 +Intangible assets – indefinite life +12,937 +14,291 +Deferred charges and other assets +3,831 +2,664 +Total assets +$ +419,314 +$ +408,637 +LIABILITIES AND SHAREHOLDERS’ EQUITY +Current liabilities: +Current portion of debt +$ +3,125 +$ +2,500 +Accounts payable and accrued expenses +84,997 +78,319 +Billings in excess of costs and estimated earnings on uncompleted contracts +20,691 +34,369 +Income taxes payable +543 +— +Total current liabilities +109,356 +115,188 +Other liabilities +20,576 +20,372 +Debt, less current portion +69,491 +63,001 +Deferred income tax liability, net +6,970 +5,943 +Operating lease liabilities +9,310 +11,116 +Total liabilities +215,703 +215,620 +Commitments and contingencies +Shareholders’ equity: +Preferred stock, $ .01 par value; 10,000 shares authorized, none issued +— +— +Common stock, $ .01 par value; 100,000,000 shares authorized, +35,504,757 and 35,275,465 shares issued and outstanding at +December 31, 2020 and 2019, respectively +355 +353 +Capital in excess of par value +255,296 +253,869 +Accumulated loss +( 38,141 +) +( 46,344 +) +Accumulated other comprehensive loss +( 14,496 +) +( 14,505 +) +203,014 +193,373 +Less treasury stock, at cost, 137,920 shares at December 31, 2020 and 2019 +( 356 +) +( 356 +) +Total CECO shareholders’ equity +202,658 +193,017 +Noncontrolling interest +953 +— +Total shareholders' equity +203,611 +193,017 +Total liabilities and shareholders’ equity +$ +419,314 +$ +408,637 +The notes to consolidated financial statements are an integral part of the above statements. +F-3 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +Year Ended December 31, +(dollars in thousands, except share and per share data) +2020 +2019 +2018 +Net sales +$ +316,011 +$ +341,869 +$ +337,339 +Cost of sales +210,883 +227,770 +225,802 +Gross profit +105,128 +114,099 +111,537 +Selling and administrative expenses +76,926 +85,978 +87,462 +Amortization and earnout expenses +8,799 +8,499 +9,683 +Restructuring expenses +2,331 +1,097 +— +Acquisition and integration expenses +1,354 +465 +— +Executive transition expenses +1,522 +— +— +Loss on divestitures, net of selling costs +— +70 +4,390 +Intangible asset impairment +850 +— +— +Income from operations +13,346 +17,990 +10,002 +Other income (expense), net +2,033 +751 +( 365 +) +Interest expense +( 3,535 +) +( 5,397 +) +( 7,140 +) +Income before income taxes +11,844 +13,344 +2,497 +Income tax expense (benefit) +3,672 +( 4,363 +) +9,618 +Net income (loss) +8,172 +17,707 +( 7,121 +) +Noncontrolling interest +39 +— +— +Net income (loss) attributable to CECO Environmental Corp. +$ +8,211 +$ +17,707 +$ +( 7,121 +) +Income (loss) per share: +Basic +$ +0.23 +$ +0.51 +$ +( 0.21 +) +Diluted +$ +0.23 +$ +0.50 +$ +( 0.21 +) +Weighted average number of common shares outstanding: +Basic +35,289,616 +34,987,878 +34,714,395 +Diluted +35,520,670 +35,484,273 +34,714,395 +The notes to consolidated financial statements are an integral part of the above statements. +F-4 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +Year Ended December 31, +(dollars in thousands) +2020 +2019 +2018 +Net income (loss) +$ +8,172 +$ +17,707 +$ +( 7,121 +) +Other comprehensive income (loss), net of tax: +Translation income (loss) +2,256 +( 343 +) +( 3,858 +) +Interest rate swap +— +( 574 +) +76 +Minimum pension liability adjustment +( 2,247 +) +( 184 +) +( 22 +) +Comprehensive income (loss) +$ +8,181 +$ +16,606 +$ +( 10,925 +) +The notes to consolidated financial statements are an integral part of the above statements. +F-5 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +Accumulated +Capital in +Other +Total +Common Stock +excess of +Accumulated +Comprehensive +Treasury Stock +Noncontrolling +Shareholders' +(in thousands) +Shares +Amount +par value +Loss +Loss +Shares +Amount +Interest +Equity +Balance January 1, 2018 +34,708 +$ +347 +$ +248,170 +$ +( 52,673 +) +$ +( 8,919 +) +( 138 +) +$ +( 356 +) +$ +— +$ +186,569 +Net loss for the year ended December 31, 2018 +( 7,121 +) +( 7,121 +) +Cumulative effect adjustment of adopting ASU 2018-02 +1,037 +( 1,067 +) +( 30 +) +Cumulative effect adjustment of adopting ASU 2014-09 +( 622 +) +( 622 +) +Cumulative translation adjustment for divestiture +375 +375 +Exercise of stock options and dividend reinvestment issuances +16 +— +89 +89 +Restricted stock units issued +192 +2 +( 207 +) +( 48 +) +( 253 +) +Share based compensation earned +38 +— +3,357 +3,357 +Adjustment for minimum pension liability, net of tax of $ 17 +( 22 +) +( 22 +) +Adjustment for interest rate swap, net of tax of $ 111 +76 +76 +Translation loss +( 3,858 +) +( 3,858 +) +Balance December 31, 2018 +34,954 +$ +349 +$ +251,409 +$ +( 59,427 +) +$ +( 13,415 +) +( 138 +) +$ +( 356 +) +$ +— +178,560 +Net income for the year ended December 31, 2019 +17,707 +17,707 +Cumulative effect adjustment of adopting ASU 2017-12 +( 11 +) +11 +— +Cumulative effect adjustment of adopting ASU 2016-02 +( 4,590 +) +( 4,590 +) +Exercise of stock options and dividend reinvestment issuances +31 +— +— +— +Restricted stock units issued +255 +3 +( 427 +) +( 23 +) +( 447 +) +Share based compensation earned +35 +1 +2,887 +2,888 +Adjustment for minimum pension liability, net of tax of $ 66 +( 184 +) +( 184 +) +Adjustment for interest rate swap, net of tax of $ 236 +( 574 +) +( 574 +) +Translation loss +( 343 +) +( 343 +) +Balance December 31, 2019 +35,275 +$ +353 +$ +253,869 +$ +( 46,344 +) +$ +( 14,505 +) +( 138 +) +$ +( 356 +) +$ +— +$ +193,017 +Net income (loss) for the year ended December 31, 2020 +8,211 +( 39 +) +8,172 +Restricted stock units issued +230 +2 +( 331 +) +( 8 +) +( 337 +) +Share based compensation earned +— +— +1,758 +1,758 +Adjustment for minimum pension liability, net of tax of $ 802 +( 2,247 +) +( 2,247 +) +Translation gain +2,256 +2,256 +Noncontrolling interest acquired (see Note 15) +992 +992 +Balance December 31, 2020 +35,505 +$ +355 +$ +255,296 +$ +( 38,141 +) +$ +( 14,496 +) +( 138 +) +$ +( 356 +) +$ +953 +$ +203,611 +The notes to consolidated financial statements are an integral part of the above statements. +F-6 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +ACCUMULATED OTHER COMPREHENSIVE LOSS +(dollars in thousands) +Translation +loss +Interest rate swap adjustment +Minimum pension +liability +adjustment +Accumulated other +comprehensive loss +January 1, 2018 +$ +( 4,250 +) +$ +492 +$ +( 5,161 +) +$ +( 8,919 +) +Cumulative effect adjustment adopting ASU 2018-02 +— +( 5 +) +( 1,062 +) +( 1,067 +) +Cumulative translation adjustment for divestiture +375 +— +— +375 +2018 activity +( 3,858 +) +76 +( 22 +) +( 3,804 +) +Balance December 31, 2018 +( 7,733 +) +563 +( 6,245 +) +( 13,415 +) +Cumulative effect adjustment adopting ASU 2017-12 +— +11 +— +11 +2019 activity +( 343 +) +( 574 +) +( 184 +) +( 1,101 +) +Balance December 31, 2019 +( 8,076 +) +— +( 6,429 +) +( 14,505 +) +2020 activity +2,256 +— +( 2,247 +) +9 +Balance December 31, 2020 +$ +( 5,820 +) +$ +— +$ +( 8,676 +) +$ +( 14,496 +) +The notes to consolidated financial statements are an integral part of the above statements. +F-7 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +Year Ended December 31, +(dollars in thousands) +2020 +2019 +2018 +Cash flows from operating activities: +Net income (loss) +$ +8,172 +$ +17,707 +$ +( 7,121 +) +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Depreciation and amortization +9,921 +10,609 +13,272 +Unrealized foreign currency loss (gain) +346 +( 526 +) +836 +Net gain on interest rate swaps +— +( 248 +) +( 276 +) +Impairment of property and equipment +— +— +300 +Impairment of intangible assets +850 +— +— +Fair value adjustments to earnout liabilities +1,193 +— +( 330 +) +Earnout payments +— +— +( 2,862 +) +Loss (gain) on sale of property and equipment +63 +78 +( 217 +) +Loss on divestitures +— +70 +4,390 +Amortization of debt discount +415 +1,060 +1,143 +Share based compensation expense +1,758 +2,668 +3,187 +Bad debt expense +928 +295 +1,357 +Inventory reserve expense +494 +316 +519 +Deferred income tax expense (benefit) +1,038 +( 940 +) +( 42 +) +Changes in operating assets and liabilities, net of acquisitions and divestitures: +Accounts receivable +8,367 +( 15,616 +) +( 6,084 +) +Cost and estimated earnings of billings on uncompleted contracts +( 9,561 +) +( 5,029 +) +( 4,557 +) +Inventories +4,366 +( 207 +) +( 1,704 +) +Prepaid expenses and other current assets +( 962 +) +( 7,097 +) +773 +Deferred charges and other assets +( 4,095 +) +758 +( 416 +) +Accounts payable and accrued expenses +336 +( 4,028 +) +21,321 +Billings in excess of costs and estimated earnings on uncompleted contracts +( 17,635 +) +14,274 +70 +Income taxes payable +460 +( 1,671 +) +1,839 +Other liabilities +( 2,033 +) +( 2,246 +) +( 3,446 +) +Net cash provided by operating activities +4,421 +10,227 +21,952 +Cash flows from investing activities: +Acquisitions of property and equipment +( 3,945 +) +( 5,655 +) +( 3,090 +) +Net cash proceeds from divestitures +— +— +35,052 +Net proceeds from sale of assets +605 +509 +6,296 +Cash paid for acquisitions +( 5,895 +) +— +— +Net cash (used in) provided by investing activities +( 9,235 +) +( 5,146 +) +38,258 +Cash flows from financing activities: +Borrowings on revolving credit lines +96,000 +45,300 +10,500 +Repayments on revolving credit lines. +( 86,800 +) +( 52,947 +) +( 14,223 +) +Repayments of long-term debt +( 5,009 +) +( 2,950 +) +( 41,356 +) +Deferred financing fees paid +— +( 1,117 +) +— +Proceeds from sale-leaseback transactions +— +— +800 +Payments on capital leases and sale-leaseback financing liability +( 467 +) +( 478 +) +( 675 +) +Proceeds from employee stock purchase plan, exercise of stock options, +and dividend reinvestment plan +— +76 +54 +Net cash provided by (used in) financing activities +3,724 +( 12,116 +) +( 44,900 +) +Effect of exchange rate changes on cash and cash equivalents +1,943 +( 445 +) +( 1,531 +) +Net increase (decrease) in cash, cash equivalents and restricted cash +853 +( 7,480 +) +13,779 +Cash, cash equivalents and restricted cash at beginning of year +36,958 +44,438 +30,659 +Cash, cash equivalents and restricted cash at end of year +$ +37,811 +$ +36,958 +$ +44,438 +Cash paid during the period for: +Interest +$ +3,172 +$ +3,549 +$ +5,559 +Income taxes +$ +2,156 +$ +5,908 +$ +10,205 +The notes to consolidated financial statements are an integral part of the above statements. +F-8 +CECO ENVIRONMENTAL CORP. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +For the Years Ended December 31, 2020, 2019 and 2018 +1. +Nature of Business and Summary of Significant Accounting Policies +Nature of business — CECO Environmental Corp. and its consolidated subsidiaries (“CECO,” the “Company,” “we,” “us,” or “our”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. CECO serves both established and emerging industries in regions around the world working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in multiple applications that include power generation, petrochemical processing, general industrial, refining, oil & gas, electric vehicle production, poly silicon fabrication, battery recycling, and wastewater treatment, along with a wide range of other industries. +COVID-19 +On January 30, 2020, the WHO announced a global health emergency because of a new strain of coronavirus (“COVID-19”) originating in Wuhan, China and the risks to the international community as the virus spreads globally beyond its point of origin. On March 11, 2020, the WHO characterized COVID-19 as a pandemic. As of March 3, 2021, the virus continues to spread and has had a significant impact on worldwide economic activity and on macroeconomic conditions and the end markets of our business. Vaccine administration is underway, however new variants of COVID-19 continue to emerge. There is uncertainty regarding the efficacy of vaccines and current tests and treatments with regard to the new variants. The Company has instituted some and may take additional temporary precautionary measures to comply with government directives and guidelines and minimize business disruption. +On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. The CARES act did not have a material impact on the Company. +The outbreak and a continued spread of COVID-19 has resulted in a substantial curtailment of business activities worldwide and has caused weakened economic conditions, both in the United States and abroad. COVID-19 has had, and may continue to have, a negative impact on the Company's ongoing operations and the end markets in which it serves. However, the full impact of the COVID-19 pandemic continues to evolve as of the date of this filing, and as such, it is uncertain as to the full magnitude that the pandemic will have on the Company’s financial condition, liquidity, and future results of operations. Management is actively monitoring the impact of the pandemic on its financial condition, liquidity, operations, suppliers, industry, and workforce. +Principles of consolidation —Our consolidated financial statements include the Company and its controlled subsidiaries. All intercompany balances and transactions have been eliminated. +In 2020, the Company entered into a joint venture agreement (the “JV agreement”) with Mader Holding L.P. (“Mader”). Under the terms of the JV agreement, CECO holds 70 % of the equity in the joint venture. The noncontrolling interest in Mader is reported as a separate component on the Consolidated Balance Sheets. See Note 15 to the Consolidated Financial Statements for additional information on the joint venture. +Unless indicated, all balances within tables are in thousands except per share amounts. +Use of estimates —The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +Cash equivalents —We consider all highly liquid investments with original maturities of three months or less to be cash equivalents. At December 31, 2020 and 2019, Restricted Cash is cash in support of letters of credit issued by various foreign subsidiaries of the Company. The Company occasionally enters into letters of credit with durations in excess of one year. +F-9 +The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the Consolidated Statements of Cash Flows. +December 31, +2020 +2019 +Cash and cash equivalents +$ +35,992 +$ +35,602 +Restricted cash +1,819 +$ +1,356 +Total cash, cash equivalents and restricted cash +$ +37,811 +$ +36,958 +Accounts Receivable —Receivables are generally uncollateralized customer obligations due under normal terms requiring payment generally within 30 days from the invoice date unless otherwise determined by specific contract terms, generally due to retainage provisions. The Company’s estimate of the allowance for doubtful accounts for trade receivables is primarily determined based upon the length of time that the receivables are past due. In addition, management estimates are used to determine probable losses based upon an analysis of prior collection experience, specific account risks and economic conditions. Accounts are deemed uncollectible based on past account experience and the current financial condition of the account. +Inventories —The Company’s inventory is valued at the lower of cost or net realizable value, using the first-in, first-out inventory costing method. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded based on the Company’s forecast of future demand and market conditions. Significant unanticipated changes to the Company’s forecasts could require a change in the provision for excess or obsolete inventory. +Assets Held for Sale —The Company classifies properties as held for sale when certain criteria are met. At such time, the properties, including significant assets that are expected to be transferred as part of a sale transaction, are presented separately on the Consolidated Balance Sheets at the lower of carrying value or estimated fair value less costs to sell and depreciation is no longer recognized. Assets classified as held for sale at December 31, 2020 include one building. +Property, plant and equipment —Property, plant and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Depreciation and amortization are provided using the straight-line method in amounts sufficient to amortize the cost of the assets over their estimated useful lives (buildings and improvements—generally five to 40 years ; machinery and equipment—generally two to 15 years ). Upon sale or disposal of property, plant and equipment, the applicable amounts of asset cost and accumulated depreciation are removed from the accounts, and the net amount, less any proceeds from sale, is recorded in income. +Intangible assets — Indefinite life intangible assets are comprised of tradenames, while finite life intangible assets are comprised of technology, customer lists, and tradenames. Finite life intangible assets are amortized on a straight line or accelerated basis over their estimated useful lives of seven to 10 years for technology, five to 20 years for customer lists, and 10 years for tradenames. +Long-lived assets —Property, plant and equipment and finite life intangible assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. If events or changes in circumstances occur that indicate possible impairment, our impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely independent of other groups of our assets and liabilities. This analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. We conduct annual reviews for idle and underutilized equipment, and review business plans for possible impairment. Impairment occurs when the carrying value of the assets exceeds the future undiscounted cash flows expected to be earned by the use of the asset or asset group. When impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset or asset group and an impairment charge is recorded for the difference between the carrying value and the estimated fair value. +Additionally, the Company evaluates the remaining useful life each reporting period to determine whether events and circumstances warrant a revision to the remaining period of depreciation or amortization. If the estimate of a long-lived asset’s remaining useful life is changed, the remaining carrying amount of the asset is amortized prospectively over that revised remaining useful life. +The Company completes an annual (or more often if circumstances require) impairment assessment on October 1 of its indefinite life intangible assets. As a part of its annual assessment, typically, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of an asset is less than its carrying amount. If there is a qualitative determination that the fair value of a particular asset is more likely than not greater than its carrying value, we do not need to proceed to the quantitative estimated fair value test for that asset. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is +F-10 +determined by the relief from royalty method. If the estimated fair value of an asset is less than its carrying value, an impairment charge is recorded for the amount by which the carrying value of the asset exceeds its estimated fair value. +During 2020, our annual impairment test indicated that one of our indefinite-lived tradenames was impaired. Accordingly, we recognized impairment charges in our financial results of $ 0.9 million for the year ended December 31, 2020. There was no impairment recorded during the years ended December 31, 2019 and 2018. For additional information on impairment testing results, see Note 6 to the Consolidated Financial Statements. +Goodwill —The Company completes an annual (or more often if circumstances require) impairment assessment on October 1 of its goodwill on a reporting unit level, at or below the operating segment level. As a part of its annual assessment, the Company first qualitatively assesses whether current events or changes in circumstances lead to a determination that it is more likely than not (defined as a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If there is a qualitative determination that the fair value of a particular reporting unit is more likely than not greater than its carrying value, the Company does not need to quantitatively test for goodwill impairment for that reporting unit. If this qualitative assessment indicates a more likely than not potential that the asset may be impaired, the estimated fair value is determined using a weighting of the income method and the market method. If the estimated fair value of a reporting unit is less than its carrying value, an impairment charge is recorded. +Deferred charges —Deferred charges include deferred financing costs, which are amortized to interest expense over the life of the related loan. In fiscal 2019, the Company entered into a Second Amended and Restated Credit Agreement (the “Credit Facility”). The Credit Facility amended the Company’s existing amended and restated agreement. In connection with the Credit Facility, the Company incurred $ 1.1 million in customary closing fees in 2019 that were capitalized and classified as a debt discount. Additionally, in fiscal 2019, $ 0.4 million of existing debt discount related to the 2017 long-term debt modification was expensed, and classified as interest expense, as a result of the Credit Facility (see Note 8 for further details on the Credit Facility). Amortization expense was $ 0.4 million, $ 1.1 million and $ 1.1 million for 2020, 2019 and 2018, respectively. As of December 31, 2020, and 2019, remaining capitalized deferred financing costs of $ 1.3 million and $ 1.7 million, respectively, are included as a discount to debt in the accompanying Consolidated Balance Sheets. +Revenue recognition +Energy Solutions and Industrial Solutions Segments — Within the Energy Solutions and Industrial Solutions segments, a significant portion of our revenue is derived from fixed-price contracts. We account for a contract after it has been approved by all parties to the arrangement, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. +For each contract, we assess the goods and services promised to a customer and identify a performance obligation for each distinct promised good or service. The typical life of our contracts is generally less than 12 months and each contract generally contains only one performance obligation, to provide goods or services to the customer. We determine the transaction price for each contract based on the consideration we expect to receive for the products or services being provided under the contract. +We recognize revenue as performance obligations are satisfied and the customer obtains control of the products and services. A significant amount of our revenue within the Energy Solutions and Industrial Solutions segments is recognized over a period of time as we perform under the contract because control of the work in process transfers continuously to the customer. For performance obligations to deliver products with continuous transfer of control to the customer, revenue is recognized based on the extent of progress towards completion of the performance obligation. Progress is measured based on the ratio of costs incurred to date to the total estimated costs to complete the performance obligation. For these contracts, the cost-to-cost measure best depicts the continuous transfer of goods or services to the customer. +For contracts where the duration is short, total contract revenue is insignificant, or control does not continuously transfer to the customer, revenues are recognized at the point in time control passes to the customer, which occurs generally upon shipment of product. +Progress payments are generally made over the duration of the contract. Shipping and handling activities after control of the products has transferred to the customer are considered fulfillment activities. Sales taxes are recorded on a net basis. +Fluid Handling Solutions Segments — Within the Fluid Handling Solutions segment, a significant portion of our revenue is primarily derived from sales of inventory product and is recognized at the point in time control passes to the customer, which occurs generally upon shipment of the product. +F-11 +Payments vary by customer but are typically due within 30 days. Shipping and handling activities after control of the products has transferred to the customer are considered fulfillment activities. Sales taxes are recorded on a net basis. +Contract Assets and Contract Liabilities — Contract assets consist of costs and earnings in excess of billings, costs incurred for contracts recognized at a point in time, and retainage. Costs and earnings in excess of billings represent the estimated value of unbilled work for contracts with performance obligations recognized over time and are separately classified as current assets in the Consolidated Balance Sheets. Costs incurred for contracts recognized at a point in time are classified within inventories as work-in-process. Retainage represents a portion of the contract billings that have been billed, but for which the contract allows the customer to retain a portion of the billed amount until final settlement. Retainage is not considered to be a significant financing component because the intent is to protect the customer. Retainage is classified within accounts receivable and deferred charges and other assets depending on when it is due. Almost all of the Company’s contract assets are classified as current assets in the Consolidated Balance Sheets. +Billings in excess of costs and estimated earnings on uncompleted contracts are current liabilities, which relate to fixed-price contracts recognized over time, and represents payments in advance of performing the related contract work. Billings in excess of costs and estimated earnings on uncompleted contracts is not considered to be a significant financing component because it is generally used to meet working capital demands that can be higher in the early stages of a contract. Contract liabilities, classified in accounts payable and accrued expenses in the Consolidated Balance Sheets, include advance payments received from customers for which revenue has not been recognized for contracts where revenue is recognized at a point in time. Contract liabilities are reduced when the associated revenue from the contract is recognized, which is generally within one year. +The revenue streams within the Company are consistent with those disclosed for our reportable segments. See Note 17 to the Consolidated Financial Statements for additional information on product offerings and segments. +Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes to job performance, job conditions, and estimated profitability may result in revisions to contract revenue and costs and are recognized in the period in which the revisions are made. There was no provision for estimated losses on uncompleted contracts at December 31, 2020 and 2019. +Cost of sales —Cost of sales amounts include materials, subcontract costs, direct labor and associated benefits, inbound freight charges, purchasing and receiving, inspection, warehousing, and depreciation. +Claims —Change orders arise when the scope of the original project is modified for any of a variety of reasons. The Company will negotiate the extent of the modifications, its expected costs and recovery with the customer. Costs related to change orders are added to the expected total cost of the project. In cases where contract revenues are assured beyond a reasonable doubt to be increased in excess of the expected costs of the change order, incremental profit also is recognized on the contract. Such assurance is generally only achieved when the customer approves in writing the scope and pricing of the change order. Change orders that are in dispute are effectively handled as claims. +Claims are amounts in excess of the agreed contract price that the Company seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price. Costs attributable to claims are treated as contract costs as incurred. +The Company recognizes certain significant claims for recovery of incurred costs when it is probable that the claim will result in additional contract revenue and when the amount of the claim can be reliably estimated. When the customer or other parties agree in writing to the amount of the claim to be recovered by the Company, the amount of the claim becomes contractual and is accounted for as an increase in the contract’s total estimated revenue and estimated cost. As actual costs are incurred and revenues are recognized over time, a corresponding percentage of the revised total estimated profit will therefore be recognized. +Should it become probable that the claim will not result in additional contract revenue, the Company removes the related contract revenues from its previous estimate of total revenues, which effectively reduces the estimated profit margin on the job and negatively impacts profit for the period. +Pre-contract costs —Pre-contract costs are not significant and are primarily internal costs. As most of the Company’s contracts are one year or less, the Company expenses all pre-contract costs as incurred regardless of whether or not the bids are successful. A majority of our business is obtained through a bidding process and this activity is on-going with multiple bids in process at any one time. These costs consist primarily of engineering, sales and project manager wages, fringes and general corporate overhead and it is deemed impractical to track activities related to any one specific contract. +F-12 +Selling and administrative expenses —Selling and administrative expenses on the Consolidated Statements of Operations include sales and administrative wages and associated benefits, selling and office expenses, professional fees, bad debt expense and depreciation. Selling and administrative expenses are charged to expense as incurred. +Acquisition and integration expenses —Acquisition and integration expenses on the Consolidated Statements of Operations are related to acquisition activities, which include, legal, accounting, and other expenses. +Amortization and earnout expenses —Amortization and earnout expenses on the Consolidated Statements of Operations include amortization of intangible assets, and changes to earnout and contingent compensation amounts related to acquisitions. +Restructuring expenses —Restructuring expenses on the Consolidated Statements of Operations include expenses related to an ongoing restructuring program to reduce operating costs in the future. Within restructuring expenses are charges related to severance, facility exit, legal and property, plant and equipment impairment. The Company’s policy is to recognize restructuring expenses in accordance with the accounting rules related to exit or disposal activities. +Executive transition expenses —Executive transition expenses on the Consolidated Statements of Operations include expenses related to the severance for the Company’s former Chief Executive Officer, as well as fees and expenses incurred in the search for, and hiring of, a new Chief Executive Officer. +Product Warranties —The Company’s warranty reserve is to cover the products sold. The warranty accrual is based on historical claims information. The warranty reserve is reviewed and adjusted as necessary on a quarterly basis and is presented within Note 7. +Research and Development —Although not technically defined as research and development, a significant amount of time, effort and expense is devoted to (a) custom engineering which qualifies products for specific customer applications, (b) developing proprietary process technology and (c) partnering with customers to develop new products. +Income taxes - Income taxes are determined using the asset and liability method of accounting for income taxes in accordance with Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (“ASC”) Topic 740, “Income Taxes”. Income tax expense includes federal, state and foreign income taxes. +Deferred income taxes are provided using the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases and are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Tax credits and other incentives reduce income tax expense in the year the credits are claimed. +Management must assess the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal, state and foreign tax authorities who regularly audit the Company in the normal course of business. In making these assessments, management must often analyze complex tax laws of multiple jurisdictions, including many foreign jurisdictions. The accounting guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. +Management must assess the realizability of the Company’s deferred tax assets. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this assessment. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The company has made an accounting policy election to record the U.S. income tax effect of future global intangible low-taxed income (“GILTI”) inclusions in the period in which they arise, rather than establishing deferred taxes with respect to the expected future tax liabilities associated with future GILTI inclusion. +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested. A liability has been recorded for the deferred taxes on such undistributed foreign earnings. The amount is attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +F-13 +Earnings per share —The following table reconciles the numerators and denominators used to calculate basic and diluted earnings per share for 2020, 2019 and 2018. +For the Year Ended December 31 +2020 +2019 +2018 +(table only in thousands) +Numerator (for basic and diluted earnings per share) +Net income (loss) +$ +8,211 +$ +17,707 +$ +( 7,121 +) +Denominator +Basic weighted-average shares outstanding +35,290 +34,988 +34,714 +Common stock equivalents arising from stock options and restricted stock awards +231 +496 +— +Diluted weighted-average shares outstanding +35,521 +35,484 +34,714 +Options and unvested restricted stock units are included in the computation of diluted earnings per share using the treasury stock method. For 2020, 2019 and 2018, outstanding options and unvested restricted stock units of 1.0 million, 0.4 million and 0.8 million, respectively, were excluded from the computation of diluted earnings per share due to their having an anti-dilutive effect. +Once a restricted stock award vests, it is included in the computation of weighted average shares outstanding for purposes of basic and diluted earnings per share. +Foreign Currency Translation —The functional currencies of the Company’s foreign subsidiaries are their local currencies and their books and records are maintained in the local currency. The assets and liabilities of these foreign subsidiaries are translated into United States Dollars (“USD”) based on the end-of period exchange rates and the resultant translation adjustments are reported in Accumulated Other Comprehensive Loss in Shareholders’ equity on the Consolidated Balance Sheets. +Income and expenses are translated into USD at average exchange rates in effect during the period. +Transactions denominated in other than the local currency are remeasured into the local currency and the resulting exchange gains or losses are included in “Other income (expense), net” line of the Consolidated Statements of Operations. Transaction gains were $ 1.3 million, $ 0.9 million and $ 0.7 million in 2020, 2019 and 2018, respectively. +Reclassifications —Certain prior year amounts have been reclassified in order to conform to the current year presentation. +Recently adopted accounting pronouncements +In August 2018, the FASB issued ASU 2018-14, “Compensation—Retirement Benefits—Defined Benefit Plans—General (Subtopic 715-20): Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans,” that makes minor changes to the disclosure requirements for employers that sponsor defined benefit pension and/or other postretirement benefit plans. The new guidance eliminates requirements for certain disclosures that are no longer considered cost beneficial and requires new ones that the FASB considers pertinent. ASU 2018-14 is effective for us December 15, 2020. The adoption of the standard did not have a material impact on our statement of operations or liquidity. See Note 10 to the Consolidated Financial Statements for additional details on the Company’s pension plans. +Recently issued accounting pronouncements not yet adopted +In December 2019, the FASB issued ASU No. 2019-12, "Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes" ("ASU 2019-12"), which is intended to simplify various aspects related to accounting for income taxes. ASU 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. ASU 2019-12 is effective for the Company beginning January 1, 2021. We do not expect ASU 2019-12 to have a material impact on our financial statements . +F-14 +2. +Financial Instruments +Our financial instruments consist primarily of cash and cash equivalents, receivables and certain other assets, foreign debt, and accounts payable, which approximate fair value at December 31, 2020 and 2019, due to their short-term nature or variable, market-driven interest rates. +The fair value of the debt issued under our Credit Agreement was $ 74.0 million and $ 67.3 million at December 31, 2020 and 2019, respectively. The fair value was determined considering market conditions, our credit worthiness and the current terms of our debt, which is considered Level 2 on the fair value hierarchy. +At December 31, 2020 and 2019, the Company had cash and cash equivalents of $ 36.0 million and $ 35.6 million, respectively, of which $ 28.0 million and $ 27.4 million, respectively, was held outside of the United States, principally in the Netherlands, United Kingdom, China, and Canada. +Concentrations of credit risk: +Financial instruments that potentially subject us to credit risk consist principally of cash and cash equivalents, and accounts receivable. We maintain cash and cash equivalents with various major financial institutions. We perform periodic evaluations of the financial institutions in which our cash is invested. Concentrations of credit risk with respect to trade and contract receivables are limited due to the large number of customers and various geographic areas. Additionally, we perform ongoing credit evaluations of our customers’ financial condition. +3. Accounts Receivable +Accounts receivable consisted of the following: +December 31, +(table only in thousands) +2020 +2019 +Contract receivables +$ +57,435 +$ +58,881 +Trade receivables +8,721 +12,135 +Allowance for doubtful accounts +( 3,110 +) +( 2,582 +) +Total accounts receivable +$ +63,046 +$ +68,434 +Balances billed, but not paid by customers under retainage provisions in contracts that are recorded in deferred charges and other assets within the Consolidated Balance Sheets, amounted to approximately $ 1.5 million and $ 0.9 million at December 31, 2020 and 2019, respectively. Retainage receivables on contracts in progress are generally collected within a year or two subsequent to contract completion. +Provision for doubtful accounts was $ 0.9 million, $ 0.3 million and $ 1.4 million during 2020, 2019 and 2018, respectively, while accounts charged to the allowance were $ 0.4 million, $ 0.6 million and $ 0.8 million during 2020, 2019 and 2018, respectively. +4. Inventories +Inventories consisted of the following: +December 31, +(table only in thousands) +2020 +2019 +Raw materials +$ +14,262 +$ +15,218 +Work in process +5,594 +7,328 +Finished goods +496 +654 +Obsolescence allowance +( 3,009 +) +( 2,622 +) +Total inventories +$ +17,343 +$ +20,578 +Amounts credited to the allowance for obsolete inventory and charged to cost of sales amounted to $ 0.5 million, $ 0.3 million and $ 0.5 million during 2020, 2019 and 2018, respectively. Items charged to the allowance for inventory write-offs were $ 0.1 million, $ 0.1 million and $ 0.3 million, during 2020, 2019 and 2018, respectively. +F-15 +5 . +Property, Plant and Equipment +December 31, +(table only in thousands) +2020 +2019 +Land +$ +— +$ +147 +Building and improvements +7,594 +7,400 +Machinery and equipment +26,939 +26,993 +Property, plant and equipment, gross +34,533 +34,540 +Less accumulated depreciation +( 18,305 +) +( 19,266 +) +Property, plant and equipment, net +$ +16,228 +$ +15,274 +Depreciation expense was $ 2.5 million, $ 2.1 million and $ 3.5 million for 2020, 2019 and 2018, respectively. +6 . +Goodwill and Intangible Assets +(table only in thousands) +Energy Solutions +segment +Industrial Solutions +s egment +Fluid Handling Solutions segment +Totals +Balance of goodwill at December 31, 2018 +$ +97,143 +$ +23,436 +$ +31,577 +$ +152,156 +Foreign currency translation +( 136 +) +— +— +( 136 +) +Balance of goodwill at December 31, 2019 +97,007 +23,436 +31,577 +152,020 +Acquisitions +2,085 +7,022 +— +9,107 +Foreign currency translation +693 +— +— +693 +Balance of goodwill at December 31, 2020 +$ +99,785 +$ +30,458 +$ +31,577 +$ +161,820 +As of December 31, 2020 and 2019, the Company has an aggregate amount of goodwill acquired of $ 222.5 million and $ 212.8 million, respectively, and an aggregate amount of impairment losses of $ 60.7 million which was recognized in 2017. +The Company’s indefinite lived intangible assets as of December 31, 2020 and 2019 consisted of the following: +Tradenames +(table only in thousands) +2020 +2019 +Balance beginning of year +$ +14,291 +$ +18,258 +Transfer to finite life classification +( 700 +) +( 3,904 +) +Impairment charge +( 850 +) +— +Foreign currency adjustments +196 +( 63 +) +Balance end of year +$ +12,937 +$ +14,291 +During 2020 and 2019, the Company reassessed the useful lives of certain tradenames and determined that $ 0.7 million and $ 3.9 million, respectively, of tradenames would have useful lives of 10 years versus indefinite. +The Company completes an annual (or more often if circumstances require) impairment assessment of its goodwill and indefinite life intangible assets on October 1 at the reporting unit level. +The Company bases its measurement of the fair value of a reporting unit using a 50/50 weighting of the income method and the market method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital. Projected revenue and operational profit, and terminal growth rates were determined to be significant assumptions because they are three primary drivers of the projected cash flows in the discounted future cash flow approach. Cost of capital was also determined to be a significant assumption as it is the discount rate used to calculate the current fair value of those projected cash flows. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. Based on this analysis, the estimated fair value of all of our reporting units exceeded their carrying value as of October 1, 2020. There was no goodwill impairment in 2020, 2019 and 2018. +F-16 +In the 2020 impairment analysis for the Fluid Handling Solutions reporting unit, which had a goodwill balance of $ 31.6 million at the analysis date, the fair value only exceeded the carrying value by 7 %. Management’s projections used to estimate the undiscounted cash flows included modest increase to sales volumes and operational improvements designed to reduce costs. Changes in any of the significant assumptions used, including if the Company does not successfully achieve its 2021 operating plan, can materially affect the expected cash flows, and such impacts can result in a potentially material non-cash impairment charge. Therefore, the key assumptions most susceptible to change are projected revenue and projected operational profit. We determined that with other assumptions held constant under our weighted income and market method for measuring fair value, a decrease in the projected average revenue growth rates of approximately 90 basis points or a decrease in the projected average EBITDA rates of approximately 105 basis points would result in fair value of the reporting unit being equal to its carrying value. +The Company also performed an impairment analysis for all indefinite life intangible assets, which consists of tradenames, as of October 1, 2020. The Company based its measurement of the fair value of the indefinite life intangible assets utilizing the relief from royalty method. The significant assumptions used under the relief from royalty method are projected revenue, royalty rates, terminal growth rates, and the cost of capital. Projected revenue, royalty rates and terminal growth rates were determined to be significant assumptions because they are three primary drivers of the projected royalty cash flows in the relief from royalty method. Cost of capital was also determined to be a significant assumption as it is the discount rate used to calculate the current fair value of those projected royalty cash flows. Changes in any of the significant assumptions used can materially affect the expected cash flows, and such impacts can result in material non-cash impairment charges. Under this approach, the estimated fair value of the indefinite life intangible assets exceeded their carrying value for all but one tradename within our Fluid Handling Solutions segment as of the testing date. Accordingly, we recognized impairment charges in our financial results of $ 0.9 million for the year ended December 31, 2020. There was no impairment charge in 2019 and 2018. +As described above, the fair value measurement methods used in the Company’s goodwill and indefinite life intangible assets impairment analyses utilizes a number of significant unobservable inputs or Level 3 assumptions. These assumptions include, among others, projections of our future operating results, the implied fair value of these assets using an income approach by preparing a discounted cash flow analysis and other subjective assumptions. +The Company’s finite lived intangible assets consisted of the following: +December 31, +2020 +2019 +(table only in thousands) +Intangible assets – finite life +Cost +Accum. +Amort. +Cost +Accum. +Amort. +Technology +$ +14,457 +$ +13,008 +$ +14,457 +$ +10,686 +Customer lists +73,199 +48,959 +68,943 +44,484 +Tradenames +6,578 +1,758 +5,294 +1,154 +Foreign currency adjustments +( 2,826 +) +( 1,954 +) +( 1,869 +) +( 782 +) +Total finite life intangible assets +$ +91,408 +$ +61,771 +$ +86,825 +$ +55,542 +Amortization expense of finite life intangible assets was $7.4 million, $8.5 million and $9.6 million for 2020, 2019 and 2018, respectively. Amortization over the next five years for finite life intangibles is $6.4 million in 2021, $5.5 million in 2022, $4.6 million in 2023, $3.9 million in 2024, and $2.9 million in 2025. +7 . +Accounts Payable and Accrued Expenses +Accounts payable and accrued expense consisted of the following: +December 31, +(table only in thousands) +2020 +2019 +Trade accounts payable, including amounts due to subcontractors +$ +55,899 +$ +48,762 +Compensation and related benefits +5,079 +5,712 +Accrued warranty +4,090 +4,664 +Contract liability +3,974 +5,666 +Short-term operating lease liability +2,274 +2,610 +Other +13,681 +10,905 +Total accounts payable and accrued expenses +$ +84,997 +$ +78,319 +F-17 +The activity in the Company’s current portion of earnout liability which is recorded in Accounts payable and accrued expenses on our Consolidated Balance Sheets, consisted of the following : +December 31, +(table only in thousands) +2020 +2019 +Earnout accrued at beginning of year +$ +— +$ +— +Fair value of earnout at acquisition date (see Note 15) +553 +— +Fair value adjustment +1,190 +— +Payments +— +— +Earnout accrued at end of year +$ +1,743 +$ +— +8 . +Senior debt +Debt consisted of the following: +December 31, +(table only in thousands) +2020 +2019 +Outstanding borrowings under Credit Facility +Term loan payable in quarterly principal installments of $ 0.6 million +through June 2021, $ 0.9 million through June 2023, and $ 1.3 million +thereafter with balance due upon maturity in June 2024 . +– Term loan +$ +46,250 +$ +48,750 +– Revolving Credit Loan +27,700 +18,500 +– Unamortized debt discount +( 1,334 +) +( 1,749 +) +Total outstanding borrowings under Credit Facility +72,616 +65,501 +Less: current portion +( 3,125 +) +( 2,500 +) +Total debt, less current portion +$ +69,491 +$ +63,001 +In 2020, the Company made repayments of $ 2.5 million on the term loan and had net borrowings on the revolving credit lines of $ 9.2 million. Scheduled principal payments under our Credit Facility are $ 3.1 million in 2021, $ 3.7 million in 2022, $ 4.4 million in 2023, and $ 62.8 million in 2024. +Credit Facility +As of December 31, 2020 and 2019, $ 7.6 million and $ 11.0 million of letters of credit were outstanding, respectively. Total unused credit availability under the Company’s senior secured term loan and senior secured revolver loan with sub-facilities for letters of credit, swing-line loans and senior secured multi-currency loans was $ 60.8 million and $ 82.3 million at December 31, 2020 and 2019, respectively. Revolving loans may be borrowed, repaid and reborrowed until June 11, 2024, at which time all outstanding balances of the Credit Facility must be repaid. +At the Company’s option, revolving loans and the term loans accrue interest at a per annum rate based on either the highest of (a) the federal funds rate plus 0.5 %, (b) the Agent’s prime lending rate, (c) one-month LIBOR plus 1.00 %, plus a margin ranging from 1.0 % to 2.0 % depending on the Company’s Consolidated Leverage Ratio (“Base Rate”), or (d) a Eurocurrency Rate (as defined in the Credit Agreement) plus 1.0 % to 2.0 % depending on the Company’s Consolidated Leverage Ratio. Interest on swing line loans is the Base Rate. +Interest on Base Rate loans is payable quarterly in arrears on the last day of each calendar quarter and at maturity. Interest on Eurocurrency Rate loans is payable on the last date of each applicable Interest Period (as defined in the agreement), but in no event less than once every three months and at maturity. The weighted average stated interest rate on outstanding borrowings was 2.25 % and 3.80 % at December 31, 2020 and 2019, respectively. +Under the terms of the Credit Facility, the Company is required to maintain certain financial covenants, including the maintenance of a Consolidated Net Leverage Ratio (as defined in the Credit Facility). Through September 30, 2021, the maximum Consolidated Net Leverage Ratio is 3.50 , after which time it will decrease to 3.25 until the end of the term of the Credit Facility. +The Company has granted a security interest in substantially all of its assets to secure its obligations pursuant to the Credit Facility. The Company’s obligations under the Credit Agreement are guaranteed by the Company’s U.S. subsidiaries and such guaranty obligations are secured by a security interest on substantially all the assets of such subsidiaries, including certain real property. The +F-18 +Company’s obligations under the Credit Agreement may also be guaranteed by the Company’s material foreign subsidiaries to the extent no adverse tax consequences would result to the Company. +As of December 31, 2020 and 2019, the Company was in compliance with all related financial and other restrictive covenants under the Credit Facility. +Foreign Debt +The Company has a number of bank guarantee facilities and bilateral lines of credit in various foreign countries currently supported by cash, letters of credit or pledged assets and collateral under the Credit Facility. The Credit Facility allows letters of credit and bank guarantee issuances of up to $ 50.0 million from the bilateral lines of credit secured by pledged assets and collateral under the Credit Facility. As of December 31, 2020, $ 17.2 million in bank guarantees were outstanding. In addition, a subsidiary of the Company located in the Netherlands has a Euro-denominated bank guarantee agreement secured by local assets under which $ 3.4 million in bank guarantees were outstanding as of December 31, 2020. As of December 31, 2020, the borrowers of these facilities and agreements were in compliance with all related financial and other restrictive covenants. +9 . +Shareholders’ Equity +Share-Based Compensation +The Company’s 2017 Equity and Incentive Compensation Plan (the “2017 Plan”) was approved by the Company’s stockholders on May 16, 2017 which replaced the 2007 Equity Incentive Plan (the “2007 Plan”). No further grants will be made under the 2007 Plan, but outstanding awards under the 2007 Plan will continue to be unaffected in accordance with their terms. The 2017 Plan permits the granting of stock options with an exercise price equal to or greater than the fair market value of the Company’s common stock at the date of the grant, and other stock-based awards, including appreciation rights, restricted stock, restricted stock units, performance shares and dividend equivalents. A total of 1.9 million shares of common stock were authorized for issuance. As of December 31, 2020, 1.1 million shares remain available for future issuance. Stock options granted to employees generally vest equally over a period of four years from the date of the grant. Stock awards granted to employees generally vest over a period of three to four years from the date of the grant. +On July 6, 2020, in connection with the appointment of our Chief Executive Officer, the Company granted our Chief Executive Officer approximately 94,000 restricted stock units with a fair value of $ 0.6 million, which are being expensed over the vesting period of four years . The Company also granted our Chief Executive Officer approximately 1.2 million stock options with a fair value of $ 2.4 million that are being expensed over the vesting period of four years . These grants of restricted stock units and stock options (“2020 Inducement Awards”) were approved by the Board of Directors of the Company and are not included in 2017 Plan. +Share-based compensation expense for stock options and restricted stock awards under these plans was $ 1.8 million, $ 2.7 million and $ 3.1 million for 2020, 2019 and 2018, respectively. The tax benefit related to share based compensation expense was $ 0.3 million, $ 0.4 million and $ 0.5 million in 2020, 2019 and 2018, respectively. +Employee Stock Purchase Plan +The 2020 Employee Stock Purchase Plan (“ESPP”) was approved by shareholders on June 11, 2020. The ESPP is administered by the Compensation Committee. The ESPP allows employees to purchase shares of common stock at a 15 % discount from market price and pay for the shares through payroll deductions. Eligible employees can enter the plan at specific “offering dates” that occur in six-month intervals. +The aggregate maximum number of shares of the Company’s common stock that may be granted under the ESPP is 1.3 million shares over the ten-year term of the ESPP, subject to adjustment in the event there is a reorganization, merger, consolidation, recapitalization, reclassification, stock split-up, or similar transaction with respect to the common stock. As of December 31, 2020, 1.3 million shares remain available for future issuance. +The Company recognized employee stock purchase plan expense of $ 20,000 , $ 60,000 and $ 90,000 in 2020, 2019 and 2018, respectively. +F-19 +Stock Options +The estimated weighted-average fair value of stock options granted during 2020, was $ 1.98 per option, using the Black-Scholes option-pricing model based on the following assumptions: +Expected Volatility : The Company utilizes a volatility factor based on the Company’s historical stock prices for a period of time equal to the expected term of the stock option utilizing weekly price observations. For 2020, the Company utilized weighted-average volatility factors of 52.5 %. +Expected Term : Due to limited historical exercise data, the Company utilizes the simplified method of determining the expected term based on the vesting schedules and terms of the stock options. For 2020, the Company utilized weighted-average expected term factors of 5.0 years. +Risk-Free Interest Rate : The risk-free interest rate factor utilized is based upon the implied yields currently available on U.S. Treasury zero-coupon issues over the expected term of the stock options. For 2020, the Company utilized a weighted-average risk-free interest rate factor of 0.3 %. +The fair value of stock options is recorded as compensation expense on a straight-line basis over the vesting periods of the options and we account for forfeitures when they occur. +Information related to all stock options under the 2017 Plan, 2007 Plan, and the 2020 Inducement Awards for 2020, 2019 and 2018 is shown in the tables below: +(shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2019 +410 +$ +11.45 +4.7 years +Forfeitures +( 71 +) +10.86 +Granted +1,215 +11.06 +Outstanding at December 31, 2020 +1,554 +11.17 +5.8 years +$ +195 +Exercisable at December 31, 2020 +330 +11.66 +3.0 years +$ +6 +(Shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2018 +507 +$ +10.43 +5.2 years +Forfeitures +( 31 +) +6.84 +Exercised +( 66 +) +4.10 +Outstanding at December 31, 2019 +410 +11.45 +4.7 years +$ +32 +Exercisable at December 31, 2019 +355 +12.08 +4.6 years +$ +29 +(Shares in thousands) +Shares +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +Aggregate +Intrinsic +Value +($000) +Outstanding at December 31, 2017 +655 +$ +10.53 +6.0 years +Forfeitures +( 132 +) +11.53 +Exercised +( 16 +) +5.55 +Outstanding at December 31, 2018 +507 +10.43 +5.2 years +$ +186 +Exercisable at December 31, 2018 +402 +10.52 +4.6 years +$ +186 +F-20 +Restricted Stock Awards +Information related to restricted stock awards under the 2017 Plan, 2007 Plan, and the 2020 Inducement Awards for 2020, 2019 and 2018 is shown in the table below. The fair value of restricted stock awards is based on the price of the stock in the open market on the date of the grant. The fair value of the restricted stock awards is recorded as compensation expense on a straight-line basis over the vesting periods of the awards and we account for forfeitures when they occur. +(Shares in thousands) +Shares +Weighted +Average +Grant Date +Fair Value +Nonvested at December 31, 2017 +554 +$ +9.75 +Granted +963 +5.21 +Vested +( 217 +) +9.50 +Forfeited +( 49 +) +9.80 +Nonvested at December 31, 2018 +1,251 +6.30 +Granted +464 +7.50 +Vested +( 310 +) +7.24 +Forfeited +( 84 +) +6.36 +Nonvested at December 31, 2019 +1,321 +6.80 +Granted +648 +5.64 +Vested +( 284 +) +7.60 +Forfeited +( 638 +) +5.91 +Nonvested at December 31, 2020 +1,047 +6.00 +The Company received zero , $ 7,000 and $ 0.1 million of cash from employees exercising options in 2020, 2019 and 2018, respectively. The intrinsic value of options exercised during 2020, 2019 and 2018 was zero , $ 0.3 million and $ 24,000 , respectively. +Unrecognized compensation expense related to nonvested shares of stock options, restricted stock and performance units was $ 6.0 million at December 31, 2020 and will be recognized over a weighted average vesting period of 2.7 years. +Dividends +Our dividend policy and the payment of cash dividends under that policy are subject to the Board of Director’s continuing determination that the dividend policy and the declaration of dividends are in the best interest of the Company’s stockholders. Future dividends and the dividend policy may be changed at the Company’s discretion at any time. Payment of dividends is also subject to the continuing compliance with our financial covenants under our Credit Facility. On November 6, 2017, the Board of Directors reviewed the Company’s dividend policy and determined that it would be in the best interest of the stockholders to suspend dividend payments. +1 0 . +Pension and Employee Benefit Plans +We sponsor a non-contributory defined benefit pension plan for certain union employees. The accrual of future benefits for all participants who are non-union employees was frozen effective December 31, 2008. The plan is funded in accordance with the funding requirements of the Employee Retirement Income Security Act of 1974. +F-21 +The following tables set forth the plan changes in benefit obligations, plan assets and funded status on the measurement dates: +December 31, +(table only in thousands) +2020 +2019 +2018 +Change in projected benefit obligation: +Projected benefit obligation at beginning of year +$ +35,985 +$ +32,998 +$ +36,327 +Interest cost +1,034 +1,303 +1,190 +Actuarial loss (gain) +3,323 +3,704 +( 2,629 +) +Benefits paid +( 2,070 +) +( 2,020 +) +( 1,890 +) +Projected benefit obligation at end of year +38,272 +35,985 +32,998 +Change in plan assets: +Fair value of plan assets at beginning of year +27,099 +24,197 +26,836 +Actual return (loss) on plan assets +1,629 +4,431 +( 1,388 +) +Employer contribution +1,887 +491 +639 +Benefits paid +( 2,070 +) +( 2,020 +) +( 1,890 +) +Fair value of plan assets at end of year +28,545 +27,099 +24,197 +Funded status at end of year +$ +( 9,727 +) +$ +( 8,886 +) +$ +( 8,801 +) +Weighted-average assumptions used to determine benefit obligations for the year ended December 31: +Discount rate +2.10 +% +2.95 +% +4.05 +% +The funded status as of December 31, 2020, 2019 and 2018, was $ 9.7 million, $ 8.8 million and $ 8.8 million, respectively and is recognized in our Consolidated Balance Sheets within other long-term liabilities. +The details of net periodic benefit cost for pension benefits included in the accompanying Consolidated Statements of Operations are as follows: +December 31, +(table only in thousands) +2020 +2019 +2018 +Interest cost +$ +1,034 +$ +1,303 +$ +1,190 +Expected return on plan assets +( 1,594 +) +( 1,254 +) +( 1,511 +) +Amortization of net loss +266 +263 +238 +Net periodic benefit (income) cost +$ +( 294 +) +$ +312 +$ +( 83 +) +Other changes in plan assets and benefit obligations recognized in other comprehensive income: +December 31, +(table only in thousands) +2020 +2019 +2018 +Net loss +$ +3,287 +$ +527 +$ +271 +Amortization of net actuarial gain +( 266 +) +( 263 +) +( 238 +) +Total recognized in other comprehensive income (loss) +$ +3,021 +$ +264 +$ +33 +Total recognized in net periodic benefit cost and other comprehensive income (loss) +$ +2,727 +$ +576 +$ +( 50 +) +The $ 3.3 million net loss arising in the year were primarily due to decreases in the discount rate, partially offset by higher actual returns on plan assets. +Weighted-average assumptions used to determine net periodic benefit costs +December 31, +2020 +2019 +2018 +Discount Rate +2.95 % +4.05 % +3.35 % +Expected return on assets +6.00 % +5.35 % +5.75 % +The basis of the long-term rate of return assumption reflects the current asset mix for the pension plan of approximately 30 % to 40 % debt securities and 60 % to 70 % equity securities with assumed average annual returns of approximately 4 % to 6 % for debt securities and 8 % to 12 % for equity securities. The investment portfolio for the pension plan will be adjusted periodically to maintain the current ratios of debt securities and equity securities. Additional consideration is given to the historical returns for the pension plan as well as +F-22 +future long range projections of investment returns for each asset category. The long-term rate of return also considers administrative expenses of the plan. +Benefits under the plan is not based on wages and, therefore, future wage adjustments have no effect on the projected benefit obligation. +During 2020, 2019 and 2018, the Company updated the mortality tables (RP-2019 Total Mortality Table, RP-2018 Total Mortality Table, and RP-2017 Total Mortality Table for each respective year) in the underlying assumptions used to determine the benefit obligation. +Pension plan assets are invested in trusts comprised primarily of investments in various debt and equity funds. A fiduciary committee establishes the target asset mix and monitors asset performance. The expected rate of return on assets includes the determination of a real rate of return for equity and fixed income investment applied to the portfolio based on their relative weighting, increased by an underlying inflation rate. +Our defined benefit pension plan asset allocation by asset category is as follows: +Target +Allocation +Percentage of +Plan Assets +2020 +2020 +2019 +Asset Category: +Cash and cash equivalents +0 % +6 % +2 % +Equity securities +70 % +66 % +73 % +Debt securities +30 % +27 % +25 % +Total +100 % +100 % +100 % +Estimated pension plan cash obligations are $ 2.2 million, $ 2.2 million, $ 2.2 million, $ 2.2 million, and $ 2.2 million for 2021 through 2025, respectively, and a total of $ 10.3 million for the years 2026 through 2030. +Fair Value Measurements of Pension Plan Assets +Following is a description of the valuation methodologies used for pension assets measured at fair value: +• +Cash and cash equivalents: Cash and cash equivalents consist primarily of cash on deposit in money market funds. Cash and cash equivalents are stated at cost, which approximates fair value. +• +Equity securities: Equity securities consist of various managed funds that invest primarily in common stocks. These securities are valued at the net asset value of shares held by the plan at year end. The net asset value is calculated based on the underlying shares and investments held by the funds. +• +Debt securities: Debt securities consist of U.S. government and agency securities, corporate bonds and notes, and managed funds that invest in fixed income securities. U.S governmental and agency securities are valued at closing prices reported in the active market in which the individual securities are traded. Corporate bonds and notes are valued using market inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications. Inputs may be prioritized differently at certain times based on market conditions. Managed funds are valued at the net asset value of shares held by the plan at year end. The net asset value is calculated based on the underlying investments held by the fund. +The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. +The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels. +F-23 +The levels assigned to the defined benefit plan assets as of December 31, 2020, are summarized in the tables below: +(table only in thousands) +Level 1 +Level 2 +Level 3 +Total +Pension assets, at fair value: +Cash and cash equivalents +$ +1,984 +$ +— +$ +— +$ +1,984 +Equity securities +18,987 +— +— +18,987 +Debt securities +7,574 +— +— +7,574 +Total assets +$ +28,545 +$ +— +$ +— +$ +28,545 +The levels assigned to the defined benefit plan assets as of December 31, 2019, are summarized in the tables below: +(table only in thousands) +Level 1 +Level 2 +Level 3 +Total +Pension assets, at fair value: +Cash and cash equivalents +$ +578 +$ +— +$ +— +$ +578 +Equity securities +19,702 +— +— +19,702 +Debt securities +6,819 +— +— +6,819 +Total assets +$ +27,099 +$ +— +$ +— +$ +27,099 +The Company contributes to a number of multiemployer defined benefit pension plans under the terms of collective-bargaining agreements that cover its union-represented employees. The risks of participating in these multiemployer plans are different from single-employer plans in the following aspects: +• +Assets contributed to the multiemployer plan by one employer may be used to provide benefits to employees of other participating employers. +• +If a participating employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. +• +If the Company chooses to stop participating in some of its multiemployer plans, CECO may be required to pay those plans an amount based on the underfunded status of the plan, referred to as a withdrawal liability. +The Company’s participation in these plans for the year ended December 31, 2020, is outlined in the table below. The “EIN/Pension Plan Number” column provides the Employer Identification Number and the three-digit plan number, if applicable. Unless otherwise noted, the most recent Pension Protection Act zone status available in 2020 is for the plan’s year-end at December 31, 2019. The zone status is based on information that the Company received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65% funded, plans in the yellow zone are less than 80% funded, and plans in the green zone are at least 80% funded. The “FIP/RP Status Pending/Implemented” column indicates plans for which a financial improvement plan (FIP) or a rehabilitation plan (RP) is either pending or has been implemented. The last column lists the expiration date(s) of the collective-bargaining agreement(s) to which the plans are subject. +Pension Fund +EIN/Pension +Plan Number +Pension +Protection +Act Zone +Status +2012 +FIF/RP Status Pending/ +Implemented +Surcharge +Imposed +Expiration +of Collective +Bargaining +Agreement +Sheet Metal Workers’ National Pension Fund +52-6112463/001 +Yellow +FIF: Yes -Implemented +RP: Yes - +Implemented +No +Various +Sheet Metal Workers Local 224 Pension Plan +31-6171353/001 +Yellow +FIF: Yes - Implemented +No +May 31, 2022 +Sheet Metal Workers Local No. 177 Pension +Fund +62-6093256/001 +Green +Is not subject +No +April 30, 2023 +Kirk and Blum was listed in the Sheet Metal Workers Local No. 177 Pension Fund’s Form 5500 as providing more than five percent of total contributions for the year ended December 31, 2019. The Company was not listed in any of the other plans’ Forms 5500 as +F-24 +providing more than five percent of the total contributions for the plans and plan years. At the date the financial statements were issued, Forms 5500 were not available for the plan years ended December 31, 20 20 . +We have no current intention of withdrawing from any plan and, therefore, no liability has been provided in the accompanying consolidated financial statements. +Amounts charged to pension expense under the above plans including the multi-employer plans totaled $ 1.0 million, $ 1.7 million and $ 1.4 million in 2020, 2019 and 2018, respectively. +We have a 401(k) savings retirement plan for employees of certain of our subsidiaries. The plan covers substantially all employees who have 30 days of service, and who have attained 18 years of age. The plan allows us to make discretionary contributions and provides for employee salary deferrals of up to 100 %. We made aggregate matching contributions and discretionary contributions of $ 1.6 million, $ 1.7 million, and $ 1.7 million during 2020, 2019 and 2018, respectively. +1 1 . +Leases +On January 1, 2019, we adopted the new lease accounting guidance, ASC 842. The guidance establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Our leasing activity is primarily related to buildings used for manufacturing, warehousing, sales, and administrative activities. We determine if an arrangement is a lease at inception. Many of our lease agreements contain renewal options; however, we do not recognize ROU assets or lease liabilities for renewal periods unless it is determined that we are reasonably certain of renewing the lease at inception or when a triggering event occurs. Some of our lease agreements contain rent escalation clauses, free-rent periods, or other lease concessions. We recognize our minimum rental expense on a straight-line basis based on the fixed components of a lease arrangement. Variable lease costs represent amounts that are not fixed in nature and are not tied to an index or rate, and are recognized as incurred. Our variable lease costs are not material. +In determining our ROU assets and lease liabilities, we apply a discount rate to the minimum lease payments within each lease agreement. ASU 2016-02 requires us to use the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. When we cannot readily determine the discount rate implicit in the lease agreement, we utilize our fully collateralized incremental borrowing rate. To estimate our specific incremental borrowing rates we consider, among other factors, interest rates on our existing credit facilities, risk-free rates, the types of assets being leased, and the term of the leases. +The components of lease expense were as follows: +December 31, +(table only in thousands) +2020 +2019 +Operating lease cost (a) +$ +3,450 +$ +3,612 +Finance lease cost: +Amortization of right-of-use assets +308 +309 +Interest on lease liability +338 +360 +Total finance lease cost +646 +669 +Total lease cost +$ +4,096 +$ +4,281 +(a) includes variable lease costs which are immaterial +Supplemental cash flow information related to leases was as follows: +December 31, +(table only in thousands) +2020 +2019 +Cash paid for amounts included in the measurement of lease liabilities +Operating cash flows from operating leases +$ +3,338 +$ +3,453 +Operating cash flows from finance leases +$ +338 +$ +360 +Financing cash flows from finance leases +$ +467 +$ +478 +Right of use assets obtained in exchange for lease obligations +Operating leases +$ +545 +$ +3,547 +F-25 +Supplemental balance sheet information related to leases was as follows: +December 31, +(table only in thousands) +2020 +2019 +Operating leases +Right-of-use assets from operating leases +$ +11,376 +$ +13,607 +Accounts payable and accrued expenses +$ +2,274 +$ +2,610 +Operating lease liabilities +9,310 +11,116 +Total operating lease liabilities +$ +11,584 +$ +13,726 +Finance leases +Property, plant and equipment, net +$ +2,947 +$ +3,255 +Accounts payable and accrued expenses +$ +557 +$ +516 +Other liabilities +6,783 +7,340 +Total finance lease liabilities +$ +7,340 +$ +7,856 +Weighted-average remaining lease term as of December 31, 2020 were as follows: +Operating leases +12 years +Finance leases +11 years +Weighted-average discount rate +Operating leases +5.0 % +Finance leases +4.5 % +As of December 31, 2020, maturities of lease liabilities were as follows: +(table only in thousands) +Operating Leases +Finance Leases +2021 +2,872 +872 +2022 +2,222 +889 +2023 +2,035 +907 +2024 +1,876 +925 +2025 +1,605 +943 +Thereafter +3,221 +4,541 +Total minimum lease payments +$ +13,831 +$ +9,077 +Less imputed interest +( 2,247 +) +( 1,737 +) +Lease liability +$ +11,584 +$ +7,340 +1 2 . +Commitments and Contingencies +Legal Proceedings +Asbestos cases +Our subsidiary, Met-Pro, beginning in 2002 began to be named in asbestos-related lawsuits filed against a large number of industrial companies including, in particular, those in the pump and fluid handling industries. In management’s opinion, the complaints typically have been vague, general and speculative, alleging that Met-Pro, along with the numerous other defendants, sold unidentified asbestos-containing products and engaged in other related actions which caused injuries (including death) and loss to the plaintiffs. Counsel has advised that more recent cases typically allege more serious claims of mesothelioma. The Company’s insurers have hired attorneys who, together with the Company, are vigorously defending these cases. Many cases have been dismissed after the plaintiff fails to produce evidence of exposure to Met-Pro’s products. In those cases, where evidence has been produced, the Company’s experience has been that the exposure levels are low and the Company’s position has been that its products were not a cause of death, +F-26 +injury or loss. The Company has been dismissed from or settled a large number of these cases. Cumulative settlement payments from 2002 through December 31, 20 20 for cases involving asbestos-related claims were $ 3.1 million which together with all legal fees other than corporate counsel expenses; $ 2.9 million have been paid by the Company’s insurers. The average cost per settled claim, excluding legal fees, was approximately $ 34,000 . +Based upon the most recent information available to the Company regarding such claims, there were a total of 200 cases pending against the Company as of December 31, 2020 (with Illinois, New York, Pennsylvania and West Virginia having the largest number of cases), as compared with 209 cases that were pending as of December 31, 2019. During 2020, 77 new cases were filed against the Company, and the Company was dismissed from 81 cases and settled 5 cases. Most of the pending cases have not advanced beyond the early stages of discovery, although a number of cases are on schedules leading to or are scheduled for trial. The Company believes that its insurance coverage is adequate for the cases currently pending against the Company and for the foreseeable future, assuming a continuation of the current volume, nature of cases and settlement amounts. However, the Company has no control over the number and nature of cases that are filed against it, nor as to the financial health of its insurers or their position as to coverage. The Company also presently believes that none of the pending cases will have a material adverse impact upon the Company’s results of operations, liquidity or financial condition. +Other +The Company is also a party to routine contract and employment-related litigation matters and routine audits of state and local tax returns arising in the ordinary course of its business. +The final outcome and impact of open matters, and related claims and investigations that may be brought in the future, are subject to many variables, and cannot be predicted. In accordance with ASC 450, “Contingencies,” and related guidance, we record reserves for estimated losses relating to claims and lawsuits when available information indicates that a loss is probable and the amount of the loss, or range of loss, can be reasonably estimated. The Company expenses legal costs as they are incurred. +We are not aware of pending claims or assessments, other than as described above, which may have a material adverse impact on our liquidity, financial position, results of operations, or cash flows. +1 3 . +Income Taxes +Income (loss) before income taxes was generated in the United States and globally as follows: +(table only in thousands) +2020 +2019 +2018 +Domestic +$ +3,495 +$ +11,565 +$ +6,230 +Foreign +8,349 +1,779 +( 3,733 +) +$ +11,844 +$ +13,344 +$ +2,497 +Certain of the Company’s undistributed earnings of its foreign subsidiaries are not permanently reinvested, as management intends to repatriate foreign-held cash as needed to meet domestic cash needs for operating, investing, and financing activities. A liability of $ 0.9 million has been recorded for the deferred taxes on such undistributed foreign earnings as of December 31, 2020. The deferred taxes are attributable primarily to the foreign withholding taxes that would become payable should the Company repatriate cash held in its foreign operations. +F-27 +Income tax expense (benefit) consisted of the following for the years ended December 31: +(table only in thousands) +2020 +2019 +2018 +Current: +Federal +$ +( 239 +) +$ +( 4,526 +) +$ +5,166 +State +241 +( 616 +) +1,660 +Foreign +2,632 +1,719 +2,834 +2,634 +( 3,423 +) +9,660 +Deferred: +Federal +1,638 +( 604 +) +1,144 +State +313 +( 220 +) +56 +Foreign +( 913 +) +( 116 +) +( 1,242 +) +1,038 +( 940 +) +( 42 +) +$ +3,672 +$ +( 4,363 +) +$ +9,618 +The income tax expense (benefit) differs from the statutory rate due to the following: +(table only in thousands) +2020 +2019 +2018 +Tax expense at statutory rate +$ +2,487 +$ +2,802 +$ +524 +Increase (decrease) in tax resulting from: +State income tax, net of federal benefit +503 +( 707 +) +1,337 +Change in uncertain tax position reserves +( 115 +) +( 236 +) +73 +Permanent differences related to divestitures +— +( 4,201 +) +7,048 +Other permanent differences +601 +( 842 +) +693 +Impact of rate differences and adjustments +101 +884 +57 +United States tax credits and incentives +153 +( 2,124 +) +( 354 +) +Foreign tax credits and incentives +( 794 +) +( 1,386 +) +( 1,088 +) +Change in valuation allowance +( 218 +) +198 +1,521 +Net deemed distribution on repatriation of foreign earnings +— +— +( 1,713 +) +Foreign withholding taxes on repatriation of foreign earnings +242 +646 +666 +Earnout expense (income) +293 +— +( 69 +) +Investment in joint venture +( 1,341 +) +— +— +Net effect GILTI and FDII +1,598 +399 +( 172 +) +Other +162 +204 +1,095 +$ +3,672 +$ +( 4,363 +) +$ +9,618 +F-28 +Deferred income taxes reflect the future tax consequences of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and tax credit carry forwards. The net deferred tax liabilities consisted of the following at December 31: +(table only in thousands) +2020 +2019 +Gross deferred tax assets: +Accrued expenses +$ +731 +$ +1,167 +Reserves on assets +1,777 +1,566 +Share-based compensation awards +334 +410 +Minimum pension +2,188 +1,946 +Net operating loss carry-forwards +3,531 +3,141 +Tax credit carry-forwards +2,518 +2,940 +Investment in joint venture +1,505 +— +Other +645 +371 +Depreciation +— +140 +Leases +2,556 +2,999 +Valuation allowances +( 5,965 +) +( 5,810 +) +$ +9,820 +$ +8,870 +Gross deferred tax liabilities: +Depreciation +( 1,159 +) +— +Goodwill and intangibles +( 11,565 +) +( 9,855 +) +Prepaid expenses and inventory +( 438 +) +( 554 +) +Withholding tax on unremitted foreign earnings +( 871 +) +( 646 +) +Leases +( 2,602 +) +( 3,010 +) +Revenue recognition +( 155 +) +( 748 +) +( 16,790 +) +( 14,813 +) +Net deferred tax liabilities +$ +( 6,970 +) +$ +( 5,943 +) +As of December 31, 2020, the Company has federal net operating loss carry forwards of $ 0.6 million. Federal net operating losses of $0.1 million will expire in 2037 . The remaining net operating losses can be carried forward indefinitely until the loss is fully recovered. State and local net operating loss carry forwards total $ 49.4 million, which expire from 2021 to 2040 . The Company has recorded a valuation allowance on certain of these net operating loss carry forwards to reflect expected realization. The Company also has net operating loss carry forwards in foreign jurisdictions totaling $ 10.3 million. A full valuation allowance has been established against substantially all of these losses in foreign jurisdictions. As of December 31, 2020 and 2019, the Company has recorded a valuation reserve in the amount of $ 6.0 million and $ 5.8 million, respectively. The changes in the valuation allowance resulted in additional income tax expense (benefit) of $( 0.2 ) million, $ 0.2 million, and $ 1.5 million in 2020, 2019, and 2018, respectively. +In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carry forward periods), projected future taxable income, and tax-planning strategies in making this assessment. Based on this assessment, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2020. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. +The Company accounts for uncertain tax positions pursuant to FASB ASC Topic 740. The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50 % likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. A reconciliation of the beginning and ending amount of uncertain tax position reserves included in other liabilities on the Consolidated Balance Sheets is as follows: +F-29 +(table only in thousands) +2020 +2019 +Balance as of January 1, +$ +254 +$ +939 +Additions for tax positions taken in prior years +2 +4 +Reductions of tax positions taken in prior years +( 117 +) +( 240 +) +Reductions for settlements on tax positions of prior years +— +( 449 +) +Balance as of December 31, +$ +139 +$ +254 +The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. The reserve for uncertain tax positions includes zero and $ 0.1 million of interest and penalties as of December 31, 2020 and 2019, respectively. The favorable settlement of all uncertain tax positions would impact the Company’s effective income tax rate. Tax years going back to 2015 remain open for all significant state and foreign authorities. +1 4 . +Related Party Transactions +During 2020, 2019 and 2018 we paid fees of $ 0.1 million, $ 0.2 million and $ 0.2 million, respectively, for consulting services to Icarus, through which Jason DeZwirek, our Chairman of our Board, provides services. The services described above are based on a verbal agreement with the Company. The Board of Directors approves the above services on an annual basis. +1 5 . +Acquisitions and Joint Ventures +Environmental Integrated Solutions +On June 4, 2020, the Company acquired 100 % of the equity interests of Environmental Integrated Solutions (“EIS”) for $ 10.3 million in cash, which was financed with an additional draw on our revolving credit facility. As additional consideration, the former owners are entitled to earnout payments based upon a multiple of specified financial results through December 31, 2021. Based on projections at the acquisition date, the Company estimated the fair value of the earnout to be $ 0.6 million. During 2020, the Company increased earnout to $ 1.7 million at December 31, 2020 based on the estimated fair value at that date. Of this change, $ 1.2 million is recorded as expense in “Amortization and earnout expenses” on the Consolidated Statement of Operations. The change in fair value was a result of EIS performing above initial acquisition operational expectations. The earnout liability is recorded in “Accounts payable and accrued expenses” on the Consolidated Balance Sheets. +EIS engineers products that clean air through a variety of technologies including volatile organic compounds (“VOC”) abatement, odor control, regenerative thermal oxidizers, and other air pollution control solutions, which complements our Industrial Solutions Segment businesses . The following table summarizes the approximate fair values of the assets acquired and liabilities assumed at the date of closing. +(table only in thousands) +Current assets (including cash of $ 4,212 ) +$ +6,416 +Property and equipment +26 +Other assets +44 +Goodwill +7,022 +Intangible - finite life +4,840 +Total assets acquired +18,348 +Current liabilities assumed +( 6,514 +) +Deferred income tax liability +( 920 +) +Net assets acquired +$ +10,914 +Goodwill recognized represents value the Company expects to be created by combining the various operations of the acquired businesses with the Company’s operations, including the expansion into markets within existing business segments, access to new customers and potential cost savings and synergies. Goodwill related to this acquisition is not deductible for tax purposes. +The Company acquired customer lists and tradename intangible assets valued at $ 4.2 million and $ 0.6 million, respectively. These assets were determined to have useful lives of 10 years. +Acquisition and integration expenses on the Consolidated Statements of Operations are related to acquisition activities, which include retention, legal, accounting, banking, and other expenses. During 2020, EIS accounted for $ 8.1 million in revenue and $( 0.8 ) million of pre-tax loss (inclusive of the earnout adjustment noted above). +F-30 +Mader +On July 31, 2020, the Company entered into the JV Agreement with Mader in which CECO contributed the net assets of its Effox-Flextor damper business and Mader contributed the net assets of their damper business. Under the terms of the JV Agreement, CECO will hold 70 % of the equity in the joint venture, and 50 % voting interest. We determined CECO was the primary beneficiary of this variable interest entity and therefore the 30 % noncontrolling equity interest is in the Consolidated Balance Sheet. The results of the joint venture are included in our Energy Segment. The fair value of Mader’s net assets contributed was $ 1.0 million. As of December 31, 2020 there were $ 6.4 million in current assets, $ 8.9 million in long-lived assets, and $ 7.6 million in total liabilities related to the Effox-Mader joint venture included in our Consolidated Balance Sheets. Since formation, the joint venture has accounted for $ 7.7 million in revenue and $( 0.2 ) million of pre-tax loss. +The following table summarizes the approximate fair values of the assets acquired and liabilities assumed at the JV agreement date. +(table only in thousands) +Current assets (including cash of $ 229 ) +$ +2,040 +Property and equipment +103 +Goodwill +2,085 +Deferred income tax asset +287 +Total assets assumed +4,515 +Current liabilities assumed +( 515 +) +Other liabilities +( 500 +) +Long term debt +( 2,508 +) +Fair value of 30% noncontrolling equity interest in Mader +$ +992 +Goodwill recognized represents value the Company expects to be created by combining the various operations of the joint venture with the Company’s operations, including the expansion into markets within existing business segments, access to new customers and potential cost savings and synergies. Goodwill related to this joint venture is not deductible for tax purposes. +The approximate fair values of the assets acquired and liabilities assumed related to the above acquisition and joint venture are based on preliminary estimates and assumptions. These preliminary estimates and assumptions could change significantly during the purchase price measurement period as we finalize the valuations of the assets acquired and liabilities assumed. Such changes could result in material variances between the Company’s future financial results, including variances in the estimated purchase price, fair values recorded and expenses associated with these items. +The following unaudited pro forma financial information represents the Company’s results of operations as if the EIS acquisition and the joint venture with Mader had occurred on January 1, 2019: +December 31, +(table only in thousands, except per share data) +2020 +2019 +Net sales +$ +329,801 +$ +368,027 +Net income attributable to CECO Environmental Corp +9,728 +26,980 +Earnings per share: +Basic +$ +0.28 +$ +0.77 +Diluted +$ +0.27 +$ +0.76 +The pro forma results have been prepared for informational purposes only and include adjustments to amortize acquired intangible assets with finite life, reflect additional interest expense on debt used to fund the acquisition, and to record the income tax consequences of the pro forma adjustments. These pro forma results do not purport to be indicative of the results of operations that would have occurred had the purchase been made as of the beginning of the periods presented or of the results of operations that may occur in the future. +F-31 +16. Divestitures +Strobic Air Corporation +On March 30, 2018, the Company completed the sale of Strobic Air Corporation (“Strobic”) as part of its strategic decision to exit brands that do not align with the CECO portfolio to increase focus on better serving the energy and industrial solutions and fluid handling markets. The sales price was $ 28.5 million, subject to post-closing purchase price adjustments. The disposition resulted in a gain of $ 6.9 million, comprised of $ 27.9 million of net proceeds received as consideration after post-closing purchase price adjustments less net assets disposed of $ 18.8 million and transaction costs of $ 2.2 million. The net assets disposed of are primarily comprised of $ 13.0 million of goodwill, $ 2.3 million of definite-lived intangible assets and $ 1.2 million of indefinite-lived intangible assets allocated to the Strobic business. Strobic results through the date of disposition are included within income before income taxes in the Consolidated Statement of Operations and are reported within the Fluid Handling Solutions segment. The sale of Strobic did not constitute a significant strategic shift that will have a material impact on the Company’s ongoing operations and financial results. +Keystone Filter +On February 28, 2018, the Company completed the sale of the Keystone Filter brand (“Keystone”) as part of its strategic decision to exit brands that do not align with the CECO portfolio to increase focus on better serving energy and industrial solutions and fluid handling markets. The sales price was $ 7.5 million, subject to post-closing purchase price adjustments. The disposition resulted in a gain of $ 4.3 million, comprised of $ 7.2 million of net proceeds after post-closing purchase price adjustments less net assets disposed of $ 2.7 million and transaction costs of $ 0.2 million. Keystone results are reported within the Fluid Handling Solutions segment through the date of disposition. +Zhongli +On November 27, 2018, the Company completed the sale of Jiangyin Zhongli Industrial Technology Co. Ltd (“Zhongli”), a business in our Energy Solutions segment operating in China, for a price of $ 3.6 million. In the third quarter of 2018, we classified the assets and liabilities of Zhongli as held-for-sale. In connection with classifying this business as held-for-sale, GAAP required us to assess impairment by comparing the estimated selling price, less cost to sell to our carrying value in Zhongli. Based on this analysis, we recorded a $ 15.1 million loss. In 2019, the Company finalized a tax position related to the future carryback of the capital loss recognized in connection with the divestiture, resulting in a $ 4.4 million income tax benefit. The disposal of this business does not constitute a significant strategic shift that will have a material impact on the Company’s ongoing operations and financial results. Zhongli results are reported within the Energy Solutions segment through the date of disposition. +1 7 . +Business Segment Information +The Company’s operations are organized and reviewed by management along its product lines or end markets that the segment serves and are presented in three reportable segments. The results of the segments are reviewed through to the “Income from operations” line on the Consolidated Statements of Operations. The accounting policies of the segments are the same as those in the consolidated financial statements. Except for the information reported on a segment basis, the Company does not accumulate net sales information by product or service and therefore, the Company does not disclose net sales by product or service because to do so would be impractical. +The Company’s reportable segments are organized as groups of similar products and services, as described as follows: +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for clean energy and lower emissions through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings in clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers in the semiconductor manufacturing, electric vehicle production, battery recycling, and wood manufacturing industries to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +F-32 +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +(table only in thousands) +2020 +2019 +2018 +Net Sales (less intra-, inter-segment sales) +Energy Solutions segment +$ +205,494 +$ +210,319 +$ +211,185 +Industrial Solutions segment +74,697 +91,347 +80,699 +Fluid Handling Solutions segment +35,820 +40,203 +45,455 +Net sales +$ +316,011 +$ +341,869 +$ +337,339 +(table only in thousands) +2020 +2019 +2018 +Income from Operations +Energy Solutions segment +$ +34,170 +$ +33,886 +$ +28,797 +Industrial Solutions segment +2,183 +5,679 +6,308 +Fluid Handling Solutions segment +5,037 +5,558 +7,730 +Corporate and Other (1) +( 28,044 +) +( 27,133 +) +( 32,833 +) +Income from operations +$ +13,346 +$ +17,990 +$ +10,002 +(1) +Includes corporate compensation, professional services, information technology, acquisition and integration expenses, and other general, administrative corporate expenses and loss on divestitures. +(table only in thousands) +2020 +2019 +2018 +Property and Equipment Additions +Energy Solutions segment +$ +550 +$ +434 +$ +205 +Industrial Solutions segment +371 +402 +756 +Fluid Handling Solutions segment +978 +3,239 +1,226 +Corporate and Other +2,046 +1,580 +903 +Property and equipment additions +$ +3,945 +$ +5,655 +$ +3,090 +(table only in thousands) +2020 +2019 +2018 +Depreciation and Amortization +Energy Solutions segment +$ +4,957 +$ +6,084 +$ +8,112 +Industrial Solutions segment +1,589 +1,320 +1,067 +Fluid Handling Solutions segment +2,610 +2,795 +3,517 +Corporate and Other +765 +410 +576 +Depreciation and amortization +$ +9,921 +$ +10,609 +$ +13,272 +December 31, +(table only in thousands) +2020 +2019 +Identifiable Assets +Energy Solutions segment +$ +270,573 +$ +254,752 +Industrial Solutions segment +69,465 +64,725 +Fluid Handling Solutions segment +65,739 +71,572 +Corporate and Other (2) +13,537 +17,588 +Identifiable assets +$ +419,314 +$ +408,637 +(2) +Corporate assets primarily consist of cash and income tax related assets. +F-33 +December 31, +(table only in thousands) +2020 +2019 +Goodwill +Energy Solutions segment +$ +99,785 +$ +97,007 +Industrial Solutions segment +30,458 +23,436 +Fluid Handling Solutions segment +31,577 +31,577 +Goodwill +$ +161,820 +$ +152,020 +Intra-segment and Inter-segment Revenues +The Company has divisions that sell to each other within segments (intra-segment sales) and between segments (inter-segment sales) as indicated in the following tables: +Year Ended December 31, 2020 +Less Inter-Segment Sales +(table only in thousands) +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Net Sales to +Outside +Customers +Net Sales +Energy Solutions segment +$ +218,290 +$ +( 11,333 +) +$ +( 725 +) +$ +— +$ +( 738 +) +$ +205,494 +Industrial Solutions segment +88,694 +( 12,749 +) +— +( 1,232 +) +( 16 +) +74,697 +Fluid Handling Solutions segment +36,761 +( 902 +) +( 39 +) +— +— +35,820 +Net Sales +$ +343,745 +$ +( 24,984 +) +$ +( 764 +) +$ +( 1,232 +) +$ +( 754 +) +$ +316,011 +Year Ended December 31, 2019 +Less Inter-Segment Sales +(table only in thousands) +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Net Sales to +Outside +Customers +Net Sales +Energy Solutions segment +$ +217,359 +$ +( 6,650 +) +$ +( 390 +) +$ +— +$ +— +$ +210,319 +Industrial Solutions segment +101,369 +( 8,278 +) +— +( 1,677 +) +( 67 +) +91,347 +Fluid Handling Solutions segment +41,717 +( 1,300 +) +( 214 +) +— +— +40,203 +Net Sales +$ +360,445 +$ +( 16,228 +) +$ +( 604 +) +$ +( 1,677 +) +$ +( 67 +) +$ +341,869 +Year Ended December 31, 2018 +Less Inter-Segment Sales +(table only in thousands) +Total Sales +Intra - Segment +Sales +Industrial +Energy +Fluid +Net Sales to +Outside +Customers +Net Sales +Energy Solutions segment +$ +220,334 +$ +( 7,912 +) +$ +( 1,232 +) +$ +— +$ +( 5 +) +$ +211,185 +Industrial Solutions segment +84,424 +( 3,084 +) +— +( 600 +) +( 41 +) +80,699 +Fluid Handling Solutions segment +47,561 +( 1,483 +) +( 616 +) +( 7 +) +— +45,455 +Net Sales +$ +352,319 +$ +( 12,479 +) +$ +( 1,848 +) +$ +( 607 +) +$ +( 46 +) +$ +337,339 +No single customer represented greater than 10 % of consolidated net sales or accounts receivable for 2020, 2019, or 2018. +For 2020, 2019, and 2018, sales to customers outside the United States, including export sales, accounted for approximately 35 %, 30 %, and 33 %, respectively, of consolidated net sales. The largest portion of export sales in 2020 was destined for Europe ( 11.7 %), and Asia ( 11.4 %). Of consolidated long-lived assets, $ 29.0 million and $ 16.9 million were located outside of the United States as of December 31, 2020 and 2019, respectively. The largest portion of long-lived assets located outside the United States at December 31, 2020 were in Europe ($ 25.4 million). +F-34 \ No newline at end of file diff --git a/raw/filings/0000003197/2020/0001564590-21-010416/filing_metadata.csv b/raw/filings/0000003197/2020/0001564590-21-010416/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..fac9473cc8539f607a38866f3a4ef60e1cafdee5 --- /dev/null +++ b/raw/filings/0000003197/2020/0001564590-21-010416/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003197,CECO,CECO ENVIRONMENTAL CORP,2020,10-K,2021-03-03,2020-12-31,2021-03-03T12:08:40.000Z,0001564590-21-010416,cece-10k_20201231.htm,10-K,19188440,1,1,https://www.sec.gov/Archives/edgar/data/3197/000156459021010416/cece-10k_20201231.htm,https://www.sec.gov/Archives/edgar/data/3197/000156459021010416/ diff --git a/raw/filings/0000003197/2020/0001564590-21-010416/item1.txt b/raw/filings/0000003197/2020/0001564590-21-010416/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..902835b61b6f998d738f091a5d20dd03b0b48b2c --- /dev/null +++ b/raw/filings/0000003197/2020/0001564590-21-010416/item1.txt @@ -0,0 +1,170 @@ +Item 1. +Business +General +CECO Environmental Corp. (“CECO,” “we,” “us,” or the “Company”) is a global leader in industrial air quality and fluid handling serving the energy, industrial and other niche markets through an attractive asset-light business model. We focus on engineering, designing, building, and installing systems that capture, clean and destroy airborne contaminants from industrial facilities as well as equipment that controls emissions from such facilities, as well as fluid handling and filtration systems. CECO provides innovative technology and application expertise that helps companies grow their businesses with safe, clean, and more efficient solutions to help protect our shared environment. +CECO serves diverse industries globally by working to improve air quality, optimize the energy value chain, and provide customized engineered solutions in our customers’ mission critical applications. The industries CECO serves include power generation, petrochemical processing, general industrial, refining, oil & gas, electric vehicle production, poly silicon fabrication, battery recycling, and wastewater treatment, along with a wide range of other industries. +CECO has over $6 billion of installed equipment with end users, which we target to expand and grow a higher recurring revenue of aftermarket products and services. +Our customers include some of the largest natural gas processors, transmission and distribution companies, refineries, power generators, industrial manufacturing, engineering and construction companies, semiconductor manufacturers, compressor manufacturers, metals and minerals, and electric vehicle producers in the world. +We believe our value differentiators include, but are not limited to, our product quality, reliability, on-time delivery and safety, supported by advanced engineering and operational excellence. We believe these are critical in maintaining our competitive position and have adopted a spirit of continuous improvement to ensure we maintain our market leadership position. +Industry Overview +We serve a growing $5 billion dollar global market that is highly fragmented and serves various end markets including power generation, natural gas power plants, petrochemical processing, general industrial, refining, oil & gas and wastewater treatment. +We believe demand for our products and services will continue to be driven by the following factors: +• +Global Focus on Environment. Increased demand for efficient solutions and reduced emissions for clean air remains at the forefront of sustainable production. As our customers and end markets navigate this changing landscape, we are making production cleaner, more efficient and flexible, and workplaces safer, using the same high manufacturing standards our customers expect. Increasingly, society, along with government regulation, call for corporations to commit to the preservation and protection of the environment. We believe that through our air quality and emissions control initiatives, companies want to work with us to protect people and our planet from the harmful effects of industrial processes. +• +Global Economic Conditions. The Company’s businesses are impacted by economic conditions around the globe. Higher economic growth and other factors that would increase industrial gross domestic product and capital expenditures are projected to impact the markets the Company serves and could affect the Company’s businesses by increasing demand for the Company’s products and services. +• +Worldwide Industrialization . Global trade has increased significantly over the last decade and is driven by growth in emerging markets, including China and India, as well as other developing nations in Asia and the Europe, Middle East, and Africa (“EMEA”) region. As a result of globalization, manufacturing that was historically performed domestically continues to migrate to lower cost countries. This movement of the manufacture of goods throughout the world increases demand for industrial ventilation products as new construction continues. We expect that more rigorous environmental regulations will be introduced to create a cleaner working environment and reduce environmental emissions as these economies evolve. +• +Natural Gas Infrastructure . The natural gas industry consists of the exploration, production, processing, transportation, storage and distribution of natural gas. The International Energy Association (“IEA”) projects a pronounced shift in Organization for Economic Cooperation and Development (“OECD”) countries away from oil and coal towards natural gas and renewables. Natural gas continues to be the fuel of choice for the electrical power and industrial sectors in many +2 +of the world’s regions, in part because of its lower carbon intensity compared with coal and oil, which makes it an attractive fuel source in countries where governments are implementing policies to reduce greenhouse gas emissions . +• +Power Generation. Power generation encompasses a broad range of activities related to the production of electricity. The primary types of fossil fuels used to generate electricity are coal, natural gas and nuclear. In the United States, concerns about potential environmental regulations enhance the attractiveness of natural gas-fired power plants compared with coal-fired power plants, which generally have higher pollutant emission rates than natural gas-powered plants. Natural gas-fired power plants have lower initial capital needs and are more flexible in terms of operating times than coal plants. +• +Refining, Oil Production and Petrochemical Processing . Refining, oil production and petrochemical processing involves the producing, refining and processing of fuels and chemicals for use in a variety of applications, such as gasoline, fertilizers and plastics. In response to increasing international demand for petrochemicals and refined products, companies are producing more products from new sources, constructing new refineries and petrochemical processing facilities as well as expanding existing facilities. In many cases, these new and expanded facilities must comply with stricter environmental regulations, which influence both choice of fuel and demand for systems to control exhaust emissions. +• +Stringent Regulatory Environment . The adoption of increasingly stringent environmental regulations globally requires businesses to pay strict attention to environmental protection. Businesses and industries of all types from refineries, power, chemical processes, metals and minerals, energy market and industrial manufacturing must comply with these various international, federal, state and local government regulations or potentially face substantial fines or be forced to suspend production or alter their production processes. These increasingly stringent environmental regulations are a principal factor that drives our business. +These factors, individually or collectively, tend to cause increases in industrial capital spending that are not directly impacted by general economic conditions, expansion, or capacity increases. In contrast, favorable conditions in the economy generally lead to plant expansions and the construction of new industrial sites. However, in a weak economy, customers tend to lengthen the time from their initial inquiry to the purchase order or defer purchases. +Mission and Strategy +Our mission is to help companies grow their business with safe, clean and more efficient solutions that help protect people and our shared environment. +We seek to fulfill this mission through established global leadership in air quality and fluid handling solutions focused on serving the energy, industrial, and other niche markets around the world. We will continue to leverage our innovative technology and application expertise to customers around the world. We work to improve air quality, optimize the energy value chain, and provide custom engineered solutions for applications including power generation, petrochemical processing, general industrial, refining, oil & gas, electric vehicle production, poly silicon fabrication, battery recycling, and wastewater treatment along with a wide range of other applications. +Our strategy to become the global leader in air quality and fluid handling solutions is to drive an operating environment of performance excellence across the Company with a near term focus on targeted value creation enablers, and growth-oriented business segment performance. +We constantly look for opportunities to gain new customers and penetrate geographic locations and end markets with existing products and services or acquire new product or service opportunities. We intend to continue to expand our customer base and end markets and have continued to pursue potential attractive growth opportunities both domestically and internationally. In the past few years, we have expanded our international presence with new sales & engineering hubs in the United Kingdom, Shanghai, Singapore, Pune India, and Dubai. +Four Value Creation Enablers Driving Growth +All four of these are inter-connected and critical to achieving our objectives. +• +Outside-In Leadership is all about an increased attention on our customers and the trends affecting the world around us as we make decisions that enable CECO to be responsive and prepared for growth. +• +Innovation is about us finding better ways to help our customers get their jobs done – whether that is a new product and technology or the way we serve and work with them. +3 +• +Simplification involves aligning and streamlining our operational practices and metrics to match our customers’ key performance indicators (“KPIs”) for success and removing complexity from our systems and structure. +• +Active Portfolio Management dictates a regular evaluation of our business units for market attractiveness and profitability together with scanning the market for attractive potential additions that strengthen the long-term outlook of the Company. +Three Business Segments: +The Company operates and reports in three reportable segments focused on attractive end markets. Each segment is aligned to generate profitable growth for the Company across a targeted industry with a compelling technology and solution set to benefit customers. +• +Energy Solutions segment: Our Energy Solutions segment serves the Energy market, where we are a key part of helping meet the global demand for clean energy and lower emissions through our highly engineered and tailored emissions management, silencers and separation solutions and services. Our offerings improve air quality and solves fluid handling needs with market leading technologies, efficiently designed, and customized solutions for the power generation, oil & gas, and petrochemical industries. +• +Industrial Solutions segment: Our Industrial Solutions segment serves the Air Pollution Control market where our aim is to address the growing need to protect the air we breathe and help our customers’ desires for sustainability upgrades beyond carbon footprint issues. Our offerings in clean air pollution control, collection and ventilation technologies improve air quality with a compelling solution that enable our customers in the semiconductor manufacturing, electric vehicle production, battery recycling, and wood manufacturing industries to reduce their carbon footprint, lower energy consumption, minimize waste and meet compliance targets for toxic emissions, fumes, volatile organic compounds, and industrial odors. +• +Fluid Handling Solutions segment: Our Fluid Handling Solutions segment offers unique pump and filtration solutions that maintain safe and clean operations in some of the most harsh and toxic environments. In this market, we provide solutions for mission-critical applications to a wide variety of industries including, but not limited to, plating and metal finishing, automotive, food and beverage, chemical, petrochemical, pharmaceutical, wastewater treatment, desalination and the aquarium & aquaculture markets. +Competitive Strengths +Leading market position as a complete solution provider . We believe we are a leading provider of critical solutions in industrial air quality and fluid handling. The multi-billion dollar global market is highly fragmented with numerous small and regional contracting firms separately supplying engineering services, fabrication, installation, testing and monitoring, products and spare parts. We offer our customers a complete end-to-end solution, including engineering and project management services, procurement and fabrication, construction and installation, aftermarket support, and sale of consumables, which allows our customers to avoid dealing with multiple vendors when managing projects. +Long-standing experience and customer relationships in growing industry . We have serviced the needs of our target markets for over 50 years. Our extensive experience and expertise in providing diversified solutions enhances our overall customer relationships, and provides us with a competitive advantage in our markets relative to other companies in the industry. We believe this is evidenced by strong relationships with many of our world-class customers. We believe no single competitor has the resources to offer a similar portfolio of product and service capabilities. We offer the depth of a large organization, while our lean organizational structure keeps us close to our customers and markets, allowing us to offer rapid and complete solutions in each unique situation. +Global diversification and broad customer base. The global diversity of our operations and customer base provides us with multiple growth opportunities. As of December 31, 2020, we had a diversified customer base of approximately 5,000 active customers across a range of industries. We believe that the diversity of our customers and end markets mitigates our risk of a potential fluctuation or downturn in demand from any individual industry or particular customer. We believe we have the resources and capabilities to meet the needs of our customers as they upgrade and expand domestically as well as into new international markets. Once systems have been installed and a relationship has been established with the customer, we are often awarded repetitive service and maintenance business as the customers’ processes change and modifications or additions to their systems become necessary. +Experienced management and engineering team. Our senior management team has substantial experience in industrial air quality and fluid handling solutions. The business experience of our management team enables us to pursue our strategy. Our workforce includes +4 +approximately 4 00 engineers, designers, solution experts, and project managers whose significant specialized industry experience and technical expertise enables them to have a deep understanding of the solutions that will best suit the needs of our customers. The experience and stability of our management, operating and engineering teams have been crucial to our growth, developing and maintaining customer relationships, and increasing our market share. +Develop innovative solutions . We leverage our engineering and manufacturing expertise and strong customer relationships to develop new customized products to address the identified needs of our customers or a particular end market. We thoroughly analyze new product opportunities by considering projected demand for the product or service, price point, and expected operating costs, and only pursue those opportunities that we believe will contribute to earnings growth in the near-term. In addition, we continually improve our traditional technologies and adapt them to new industries and processes. +Disciplined acquisition program with successful integration . We believe that we have demonstrated an ability to successfully acquire and integrate companies with complementary product or service offerings. We will continue to seek and execute additional strategic acquisitions and focus on expanding our product service and breadth, as well as entering into new adjacent markets. We believe that the breadth and diversity of our products and services and our ability to deliver full solutions to various end markets provides us with multiple sources of stable growth and a competitive advantage relative to other players in the industry. +Products and Services +We provide a wide spectrum of products and services including dampers and diverters, selective catalytic reduction and selective non-catalytic reduction systems, cyclonic technology, thermal oxidizers, filtration systems, scrubbers, fluid handling equipment and plant engineering services and engineered design build fabrication. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support and single source. +Project Design and Research and Development +We seek to achieve our Outside-In Leadership by understanding our customers’ needs and delivering better outcomes for them by focusing new product development efforts that help protect our shared environment while working to improve a variety of operational outcomes including, but not limited to, facility uptime, production quality, employee safety, equipment protection and process performance. We produce specialized products that are often tailored to the specifications of a customer or application. +We continually collaborate with our customers on their projects to develop the proper solution and ensure customer satisfaction. The project development cycle may follow many different paths depending on the specifics of the job and end market. The cycle can take from one to more than twelve months from concept and design to production but may vary significantly depending on developments that occur during the process, including among others, the emergence of new environmental demands, changes in design specifications and ability to obtain necessary approvals. +Sales, Marketing and Support +Our global selling strategy is to provide a solutions-based approach by being a single source provider of technology products and services. The strategy involves expanding our scope of products and services through selective acquisitions and the formation and integration of new business units. We believe this strategy provides a discernible competitive advantage. We execute this strategy by utilizing our portfolio of in-house technologies and those of third-party equipment suppliers. Many of these have been long-standing relationships, which have evolved from pure supplier roles to value-added business partnerships. This enables us to leverage existing business with selective alliances of suppliers and application specific engineering expertise. Our products primarily compete on the basis of price, performance, speed of delivery, quality, customer support, and single source. Our value proposition to customers is to provide competitively priced, customized solutions. Our industry-specific knowledge, accompanied by our product and service offerings, provides valuable synergies for design innovation. +We sell and market our products and services with our own direct sales force, including employees in the United States, the Netherlands, United Kingdom, Canada, United Arab Emirates, India, Mexico, China, and Singapore, in conjunction with outside sales representatives in North America, South America, Europe, Middle East, Asia, and India. We expect to continue expanding our sales and support capabilities and our network of outside sales representatives in key regions domestically and internationally. +We market our offerings to our customers through a variety of channels including, but not limited to, digital, web, social media, email campaigns, individual customer visits, product announcements, brochures, magazine articles, advertisements and cover or article features in trade journals and other publications. We also participate in public relations and promotional events, including industry tradeshows and technical conferences. +5 +Our customer service organization or sales force provides our customers with technical assistance, use and maintenance information as well as other key information regarding their purchase. We also actively provide our customers with access to key information regarding changes and pending changes in environmental regulations as well as new product or service developments. We believe that maintaining a close relationship with our customers and providing them with the support they request improves their level of satisfaction and enables us to foresee their potential future product needs or service demands. Moreover, this approach can lead to sales of annual service and support contracts as well as consumables. Our website also provides our customers with online tools and technical resources. +Quality Assurance +In engineered systems, quality is defined as system performance. We review with our customers, before the contract is signed, the technical specification and the efficiency of the equipment that will be customized to meet their specific needs. We then review these same parameters internally to assure that warranties will be met. Standard project management and production management tools are used to help ensure that all work is done to specification and that project schedules are met. Equipment is tested at the site to ensure it is functioning properly. +Customers +We are not dependent upon any single customer, and no customer comprised 10% or more of our consolidated revenues for 2020. +Suppliers and Subcontractors +We purchase our raw materials and supplies from a variety of global sources. When possible, we directly secure angle iron and sheet plate products from steel mills, whereas other materials are purchased from a variety of steel service centers. Steel prices have traditionally been volatile, but we typically mitigate the risk of higher prices by including a “surcharge” on our standard products. On contract work, we mitigate the risk of higher prices by including the current price in our estimate and generally include price inflation clauses for protection. +We believe we have a good relationship with our suppliers and do not anticipate any difficulty in continuing to purchase such items on terms acceptable to us. We have not experienced difficulty in procuring a sufficient supply of materials in the past. To the extent that our current suppliers are unable or unwilling to continue to supply us with materials, we believe that we would be able to obtain such materials from other suppliers on acceptable terms. +Typically, on turnkey projects, we subcontract manufacturing, electrical work, concrete work, controls, conveyors and insulation. We use subcontractors with whom we have good working relationships and review each project at the beginning and on an ongoing basis to help ensure that all work is being done according to our specifications. Subcontractors are generally paid when we are paid by our customers according to the terms of our contract with the customer. The Company’s asset-light business model focuses on effective management of subcontractors, which allows the Company to achieve targeted working capital levels through reduction in certain assets and reduced capital expenditures. +Backlog +Backlog (i.e., unfulfilled or remaining performance obligations) represents the sales we expect to recognize for our products and services for which control has not yet transferred to the customer. Backlog was $183.1 million as of December 31, 2020 as compared to $216.6 million as of December 31, 2019, $9.8 million of backlog in total was acquired from the Environmental Integrated Solutions (“EIS”) acquisition and the Mader Holding L.P. (“Mader”) joint venture. In addition, the Company removed $9.2 million of orders in 2020 that were previously disclosed as backlog in prior periods, due to cancellations by industrial customers with exposure to aerospace end markets. Backlog is adjusted on a quarterly basis for adjustments in foreign currency exchange rates. Substantially all backlog is expected to be delivered within 12 to 18 months. Backlog is not defined by United States generally accepted accounting principles (“GAAP”) and our methodology for calculating backlog may not be consistent with methodologies used by other companies. +Competition +The markets we serve are highly fragmented with numerous small and regional participants. We believe no single company competes with us across the full range of our systems and products. Competition in the markets we serve is based on a number of considerations, including timeliness of delivery, technology, applications experience, know-how, reputation, product warranties, service and price. Demand for our product can vary period over period depending on conditions in the markets we serve. We believe our product quality, +6 +reliability, on-time delivery and safety supported by advanced engineering and operational excellence differentiate us from many of our competitors, including those competitors who often offer products at a lower price. +Due to the size and shipping weight of many of our projects, localized manufacturing/fabrication capabilities are very important to our customers. As a result, competition varies widely by region and industry. The market for our engineered products is reasonably competitive and is characterized by technological change, continuously changing environmental regulations, and evolving customer requirements. We believe that the additional competitive factors in our markets include: +• +performance track record; +• +comprehensive portfolio of products with leading technology; +• +brand recognition; +• +high design standard; +• +quality and reliable solutions; +• +on-time delivery; +• +quality customer service and support; and +• +financial and operational stability, including reputation. +We believe we compete favorably with respect to these factors. +Government Regulations +We believe our operations are in compliance with applicable environmental laws and regulations. We believe that changes in environmental laws and regulations create opportunity given the nature of our business. +Our business is subject to numerous laws and regulations. We expect that the change in administration at the federal level will result in an increase in federal regulations applicable to our business. While there are not currently regulations proposed or pending that we believe will result in material capital, operating or other costs to the business at this time, such regulations could be proposed and/or passed into law in 2021 or beyond. Other regulations currently in place could be withdrawn and replaced with more stringent requirements in 2021 or beyond. New laws and regulations and the costs of compliance with such new laws and regulations can only be broadly appraised until their implementation becomes more defined through regulatory guidance and enforcement. +Intellectual Property +We rely on a combination of patent, trademark, copyright and trade secret laws, employee and third-party nondisclosure/confidentiality agreements and license agreements to protect our intellectual property. We sell most of our products under a number of registered trade names, brand names and registered trademarks, which we believe are widely recognized in the industry. While we hold patents within a number of our businesses, we do not view our patents to be material to our business. +Commitment to Values and Ethics +At CECO, we act in accordance with our Code of Business Conduct and Ethics (“Code of Conduct”), which sets forth expectations and guidance for employees to make appropriate decisions. Our Code of Conduct covers topics such as anti-corruption, discrimination, harassment, data privacy, appropriate use of company assets, protecting confidential information, and reporting Code of Conduct violations. The Code of Conduct reflects our commitment to operating in a fair, honest, responsible and ethical manner and also provides direction for reporting complaints in the event of alleged violations of our policies ,including through an anonymous helpline. Our executive officers and managers maintain an “open door” policy, and any form of retaliation is strictly prohibited. +Human Capital Management +CECO recognizes that in order to drive innovation and operational excellence, we must identify, attract, retain and motivate world-class talent. As of December 31, 2020, CECO has approximately 730 employees, across seven countries. One-hundred and fifty of our US employees are unionized in our Pennsylvania, Tennessee and North Carolina facilities. +7 +Talent, Leadership and People Development +To support personal and professional development, we have strategically committed resources to leadership and management development programs, product knowledge, job skills, and compliance training. In 2020, CECO implemented an online learning platform so our employees could continue to enhance their skill sets and knowledge while working remotely due to COVID-19. Our learning platform offers over 16,000 courses and certifications ranging from job function to leadership and resource training. As of December 31, 2020, 72% of CECO’s global workforce registered and engaged with this learning platform. We believe this investment in our team members results in a more knowledgeable and competent workforce while strengthening the commitment between employees and our company. +We provide a variety of resources to help our employees grow in their current roles and build new skills to thrive in the workplace of the future. Strategic talent reviews are conducted annually across all business areas. The Board is updated on the Company’s people strategy on an annual basis, which is refined based on business drivers, market factors and key initiatives designed to drive the corporate strategy and business results, and meets to review our succession planning strategy and leadership pipeline for key roles, taking into account the company’s long-term strategy. +Health and Safety +At CECO, the health and safety of our employees is one of our highest priorities. We believe that all injuries, occupational illnesses and incidents are preventable, and we are committed to operating with a zero-incident culture. Through our environmental, health and safety program we implement policies and training programs, as well as perform self-audits to ensure our colleagues leave the workplace safely every day. To better understand employee safety at the site level, we have implemented safety committees and developed safety scorecards to share best practices between sites. We currently share scorecard information monthly to foster visibility, accountability and commitment across our workplace, communicating and celebrating successful results across the enterprise. In addition to lagging indicators, such as injury performance, the scorecards highlight leading indicators such as safety observations and near-misses, as well as other proactive actions taken at each site to ensure worker safety. For the year ended December 31, 2020, CECO’s domestic Total Recordable Incident Rate (“TRIR”) was 1.9% as compared to our benchmark industry average TRIR of 4.5%. +Our safety focus is also evident in our response to the COVID-19 pandemic around the globe. We implemented all government, federal and state policies, in addition to the following policies and procedures: +• +added work from home flexibility for office job roles; +• +deployed Microsoft Teams world-wide to enable collaboration while ensuring team safety; +• +implemented an Emergency Paid Pandemic Leave policy to encourage those who are sick to stay home; +• +increased cleaning protocols across all locations; +• +initiated regular communication regarding impacts of the COVID-19 pandemic, including health and safety protocols and procedures; +• +implemented a self-certification health assessment for all employees, partners and vendors at our manufacturing facilities (where allowed by local law); +• +established new physical distancing procedures for employees who need to be onsite; +• +provided additional personal protective equipment and cleaning supplies; +• +implemented safety protocols to address actual and suspected COVID-19 cases and potential exposure; +• +prohibited all non-essential domestic and international travel for all employees; +• +required masks to be worn in all locations where allowed by local law; +• +required on site visitors complete a health and travel declaration; and +• +for on site visitors traveling by plane, required a negative Polymerase Chain Reaction test before entering the facility. +CECO manufactures products and performs services deemed essential to critical infrastructure, including manufacturing, and energy, and, as a result, our facilities have continued operating during the COVID-19 pandemic. Importantly, during 2020, our experience and +8 +continuing focus on workplace safety have enabled us to preserve business continuity without sacrificing our commitment to keeping our colleagues and workplace visitors safe during the COVID-19 pandemic. +Diversity, Equity, and an Inclusive Culture +At CECO we believe a diverse and inclusive workforce is critical to inspiring innovative thinking, creative problem-solving, performance, and results, so we cultivate an environment where team members feel valued, engaged, and inspired to give their best. The unique characteristics that shape each individual help inform our decisions as a company, and this mindset allows CECO to realize new opportunities and add value to our customers, partners, and stockholders. +As part of our efforts to expand CECO’s diverse workforce, we are: +• +initiating recruitment efforts to attract and build a more diverse workforce, including expanding career opportunity postings on career websites to diverse job boards, as well as, search engines that aggregate and display job openings by employers, including those dedicated to diverse candidates; +• +implementing training to raise awareness of unconscious bias and further promote personal and professional development; and +• +launching pulse surveys to foster ongoing feedback around our culture, workplace inclusiveness and communications . +CECO’s commitment to expanding our diverse workforce and enhancing our inclusive culture is driven by our recognition that a workplace that is reflective of our global customer base establishes a firm foundation to drive creativity and innovation, which lead to problem solving, development, performance, and business success. +Appointment of Chief Executive Officer +On July 6, 2020, Mr. Todd Gleason started serving as Chief Executive Officer and as a member of the Board of Directors of the Company, succeeding Dennis Sadlowski. See “Executive Officers of CECO” below for Mr. Gleason’s biography. +Executive Officers of CECO +The following are the executive officers of the Company as of February 28, 2021. The terms of all officers expire at the next annual meeting of stockholders and upon the election of the successors of such officers. +Todd Gleason (49) most recently served, from April 2015 to July 2020, as President and Chief Executive Officer of Scientific Analytics Inc., a predictive analytic technologies and services company. Prior to that position, Mr. Gleason served from June 2007 to March 2015 in a number of senior officer and executive positions for Pentair plc, a water treatment company. During his tenure with Pentair, Mr. Gleason served as Senior Vice President and Corporate Officer from January 2013 to March 2015, President, Integration and Standardization from January 2010 to January 2013, and Vice President, Global Growth and Investor Relations from June 2007 to January 2010. Before joining Pentair, Mr. Gleason served as Vice President, Strategy and Investor Relations for American Standard Companies Inc. (later renamed to Trane Inc. prior to its acquisition by Ingersoll-Rand Company Limited), a global, diversified manufacturing company, and in a number of different roles (including as Chief Financial Officer, Honeywell Process Solutions) at Honeywell International Inc., a diversified technology and manufacturing company . Mr. Gleason’s qualifications to sit on the Board include his financial and business background, as well as his extensive executive and leadership experience. +Matthew Eckl (40) has served as our Chief Financial Officer since January 2017. Prior to joining the Company, Mr. Eckl served as Vice President, Finance – Energy Group at Gardner Denver, Inc. from 2012 until January 2017. In this role, he oversaw a $1 billion revenue business group that designs, manufactures, markets and services pumps, fluid transfer equipment and engineered systems for oil & gas and petrochemical industries. Prior to joining Gardner Denver, Mr. Eckl served in various roles of increasing responsibility within General Electric Company, a global digital industrial company, from 2002 until 2012, where he worked with various business groups to integrate new acquisitions and streamline financial reporting processes. Mr. Eckl earned a Bachelor’s degree in Management Information Systems from Pennsylvania State University. +Paul Gohr (39) has served as the Chief Accounting Officer since May 2017. Mr. Gohr previously served as our Vice President of Financial Reporting since joining the Company in September 2014. From 2004 to 2014, Mr. Gohr served in various roles of increasing responsibility within Grant Thornton LLP, a global public accounting firm, most recently as a Senior Manager of Audit Services. While at Grant Thornton LLP, Mr. Gohr served a broad base of both public and private companies with international operations, many of which were acquisitive in nature. Mr. Gohr is a Certified Public Accountant. Mr. Gohr earned a Bachelor’s degree in Business, Accountancy and a Masters of Accountancy degree from Miami University. +9 +Available Information +We use the Investor Relations section of our website, www.cecoenviro.com , as a channel for routine distribution of important information, including news releases, investor presentations and financial information. We post filings as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC, including our annual, quarterly, and current reports on Forms 10-K, 10-Q, and 8-K; proxy statements; and any amendments to those reports or statements. All such postings and filings are available on our website free of charge. The SEC also maintains a website, www.sec.gov, that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The content on any website referred to in this Annual Report on Form 10-K is not incorporated by reference into this Annual Report on Form 10-K unless expressly noted. +10 \ No newline at end of file diff --git a/raw/filings/0000003197/2020/0001564590-21-010416/item13.txt b/raw/filings/0000003197/2020/0001564590-21-010416/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..9b2fd6eedc7b93d843dcf59b531517f24d9123f7 --- /dev/null +++ b/raw/filings/0000003197/2020/0001564590-21-010416/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +44 \ No newline at end of file diff --git a/raw/filings/0000003453/2018/0001558370-19-001448/filing.txt b/raw/filings/0000003453/2018/0001558370-19-001448/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..3c04138a631067c120608e7cb7dc9a26fb0aee89 --- /dev/null +++ b/raw/filings/0000003453/2018/0001558370-19-001448/filing.txt @@ -0,0 +1,6249 @@ +10-K +1 +matx-20181231x10k.htm +10-K +matx_Current_Folio_10K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2018 +OR +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-34187 +Matson, Inc. +(Exact name of registrant as specified in its charter) +Hawaii +99-0032630 +(State or other jurisdiction of +(I.R.S. Employer +incorporation or organization) +Identification No.) +1411 Sand Island Parkway +Honolulu, HI 96819 +(Address of principal executive offices and zip code) +(808) 848-1211 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange +on which registered +Common Stock, without par value +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: +None +Number of shares of Common Stock outstanding at February 20, 2019: +42,826,203 +Aggregate market value of Common Stock held by non-affiliates at June 30, 2018: +$1,614,645,486 +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ☒ +Accelerated filer ☐ +Non-accelerated filer ☐ +Smaller reporting company ☐ +Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +Documents Incorporated By Reference +The following document is incorporated by reference in Part III of the Annual Report on Form 10-K to the extent described therein: Proxy statement for the annual meeting of shareholders of Matson, Inc. to be held April 25, 2019. +Table of Contents +TABLE OF CONTENTS +Page +PART I +Item 1. +Business +1 +A. +Company Overview +1 +B. +Business Description +2 +(1) +Ocean Transportation Segment +2 +(2) +Logistics Segment +9 +C. +Employees and Labor Relations +10 +D. +Available Information +11 +Item 1A. +Risk Factors +11 +Item 1B. +Unresolved Staff Comments +20 +Item 2. +Properties +20 +Item 3. +Legal Proceedings +21 +Item 4. +Mine Safety Disclosures +21 +PART II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +22 +Item 6. +Selected Financial Data +24 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +25 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +37 +Item 8. +Financial Statements and Supplementary Data +38 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +76 +Item 9A. +Controls and Procedures +76 +Conclusion Regarding Effectiveness of Disclosure Controls and Procedures +76 +Internal Control over Financial Reporting +77 +Item 9B. +Other Information +77 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +78 +A. +Directors +78 +B. +Executive Officers +78 +C. +Corporate Governance +78 +D. +Code of Ethics +78 +Item 11. +Executive Compensation +78 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +78 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +78 +Item 14. +Principal Accounting Fees and Services +78 +PART IV +Item 15. +Exhibits and Financial Statement Schedules +79 +A. +Financial Statements +79 +B. +Financial Statement Schedules +79 +C. +Exhibits Required by Item 601 of Regulation S-K +79 +Signatures +85 +i +Table of Contents +MATSON, INC. +FORM 10-K +Annual Report for the Fiscal Year +Ended December 31, 2018 +PART I +ITEM 1. BUSINESS +A. +COMPANY OVERVIEW +Matson, Inc., a holding company incorporated in January 2012 in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information by segment for the three years ended December 31, 2018, see Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates a premium, expedited service from China to Long Beach, California, and also provides services to Okinawa, Japan and various islands in the South Pacific. In addition, subsidiaries of MatNav provide container stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +Matson has a 35 percent ownership interest in SSA Terminals, LLC (“SSAT”), a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc. (“SSA”), a subsidiary of Carrix, Inc. (“Terminal Joint Venture”). SSAT provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including four facilities which are used by MatNav. Matson records its share of income from the Terminal Joint Venture in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +Our Mission and Vision: +Our mission is to move freight better than anyone. Our vision is to create value for our shareholders by: +· +Being our customers’ first choice, +· +Leveraging our core strengths to drive growth and increase profitability, +· +Improving the communities in which we work and live, +· +Being an environmental leader in our industry, and +· +Being a great place to work. +1 +Table of Contents +B. +BUSINESS DESCRIPTION +(1) OCEAN TRANSPORTATION SEGMENT +Ocean Freight Services: +Matson’s Ocean Transportation segment provides the following services: +Ocean Transportation Services: +Hawaii Service: Matson’s Hawaii service provides ocean freight services (lift-on/lift-off, roll-on/roll-off and conventional services) between the ports of Long Beach and Oakland, California; Seattle, Washington; and Honolulu, Hawaii. Matson also operates a network of inter-island barges that provide connecting services from Honolulu, Hawaii to other major ports on the Hawaiian islands of Kauai, Maui and Hawaii. Matson is the largest carrier of ocean cargo between the U.S. West Coast and Hawaii. +Westbound cargo carried by Matson to Hawaii includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, building materials, automobiles and household goods. Matson’s eastbound cargo from Hawaii includes automobiles, household goods, dry containers of mixed commodities and livestock. The majority of Matson’s Hawaii service revenue is derived from the westbound carriage of containerized freight and automobiles. +Alaska Service: Matson’s Alaska service provides ocean freight services (lift-on/lift-off and conventional services) between the port of Tacoma, Washington, and the ports of Anchorage, Kodiak and Dutch Harbor in Alaska. Matson also provides a barge service between Dutch Harbor and Akutan in Alaska, and other transportation services to smaller locations in Alaska. +Northbound cargo to Alaska includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, household goods and automobiles. Southbound cargo from Alaska primarily consists of seafood, household goods and automobiles. +China Service: Matson’s expedited China-Long Beach Express (“CLX”) service is part of an integrated service that carries cargo from Long Beach, California to Honolulu, Hawaii, to Guam, and then to Okinawa, Japan. The vessels continue to the ports of Ningbo and Shanghai in China, where they are loaded with cargo to be discharged primarily in Long Beach, California. These vessels also carry cargo destined for Hawaii which originated in Guam, Micronesia, Japan and China. Matson provides container transshipment services between the CLX ports and many locations in Asia including Hong Kong and Xiamen, China. +Eastbound cargo from China to Long Beach, California consists mainly of garments, footwear and other retail merchandise. Westbound cargo to China and other destinations in Asia consists mainly of recycled materials. +Guam Service: Matson’s Guam service provides weekly services between the U.S West Coast and Guam, as part of its expedited CLX service. Matson also provides weekly connecting service from Guam to the Commonwealth of the Northern Mariana Islands. These services carry cargo similar to the Hawaii service described above. +Japan Service: Matson’s Japan service provides services to the port of Naha in Okinawa, Japan, as part of its expedited CLX service. This service carries mainly general sustenance cargo and household goods supporting the U.S. military. +Micronesia Service: Matson’s Micronesia service provides services between the U.S. West Coast and the islands of Yap, Pohnpei, Chuuk and Kosrae in the Federated States of Micronesia, and the Republic of Palau. Cargo destined for these locations is transshipped through Guam and consists of mainly general sustenance cargo. Matson also operates a direct service between Honolulu, Hawaii and the islands of Kwajalein, Ebeye and Majuro in the Republic of the Marshall Islands with a U.S. flagged vessel. This service carries mainly general sustenance cargo, construction materials, and household goods supporting the U.S. military. +2 +Table of Contents +South Pacific Service: Matson’s New Zealand Express (“NZX”) service provides services carrying general sustenance cargo between Auckland, New Zealand and the South Pacific islands, including Fiji (Suva and Lautoka), Samoa (Apia), American Samoa (Pago Pago), the Cook Islands (Rarotonga and Aitutaki), Tonga (Nukualofa and Vava’u), and Niue. Matson’s NZX service also provides transshipment services to the islands of Tahiti, Vanuatu, Nauru and the Solomon Islands (Honiara). Additionally, Matson also provides slotting arrangements for the transportation of cargo from major ports on the east coast of Australia to ports in the South Pacific islands. The NZX service also distributes and sells domestic bulk fuel to a variety of these islands. +Matson also provides a bi-weekly South Pacific Express (“SPX”) service that connects the U.S. West Coast to ports in the South Pacific islands. Cargo destined for these ports is transshipped from the U.S. West Coast on Matson’s Hawaii and CLX services to a Matson SPX vessel in Honolulu, Hawaii. The SPX vessel then transports the cargo to ports in the South Pacific islands including Tahiti (Papeete), American Samoa (Pago Pago), Samoa (Apia) and Tonga (Nukualofa). Commencing September 2018, the SPX service also provides a bi-monthly service to Christmas Island (Kiritimati) in the Republic of Kiribati. Cargo destined for other ports is transshipped to Matson’s South Pacific service at the port of Apia, Samoa. SPX cargo originating in the South Pacific destined for Hawaii or other locations on the U.S. West Coast is shipped to Honolulu, Hawaii, and then transshipped on Matson vessels to the U.S. West Coast. +Terminal and Other Related Services: +Matson provides container stevedoring, refrigerated cargo services, inland transportation, container equipment maintenance and other terminal services (collectively “terminal services”) for MatNav at terminals located on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai; and in the Alaska terminal locations of Anchorage, Kodiak and Dutch Harbor. Matson also provides terminal services for other ocean carriers at the Alaska terminal locations of Kodiak and Dutch Harbor. +Matson’s Terminal Joint Venture SSAT provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast and to MatNav at four of those facilities, which are Long Beach and Oakland, California; and Seattle and Tacoma, Washington. +Matson utilizes the services of other third-party terminal operators at all of the other ports at which its vessels call. +Vessel Management Services: +Matson contracts with the U.S. Department of Transportation to provide vessel management services to manage and maintain three Ready Reserve Force vessels on behalf of the U.S. Department of Transportation Maritime Administration. +Recent Ocean Transportation Acquisition: +On May 29, 2015, Matson completed its acquisition of Horizon Lines, Inc. (“Horizon”). As a result, Matson acquired Horizon’s Alaska operations and assumed all of Horizon’s non-Hawaii assets and liabilities. +Matson’s Vessel and Equipment Information: +Vessels: +Matson’s fleet includes both owned and chartered vessels. Matson’s owned vessels represent an investment of approximately $1.5 billion. The majority of Matson’s owned vessels are U.S. flagged and Jones Act qualified vessels, and operate in the Hawaii, Guam, Japan, China and Alaska services. During the fourth quarter of 2018, Matson launched MV Daniel K. Inouye , the largest Jones Act container vessel ever built in the U.S. Matson’s non-U.S. flagged vessels operate in the Micronesia and South Pacific services. +3 +Table of Contents +Active and reserve vessels both owned and chartered by Matson as of December 31, 2018 are as follows: +Usable Cargo Capacity +Containers +Vehicles +Maximum +Maximum +Owned/ +Official +Reefer +Year +Speed +Deadweight +Name of Vessels (1) +Chartered +Number +TEUs (2) +Slots +Autos +Built +Length +(Knots) +(Long Tons) +Diesel-Powered +DANIEL K. INOUYE (3) +Owned +1274136 +3,220 +408 +— +2018 +854’ 0” +23.5 +50,794 +MANOA (3) +Owned +651627 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,187 +MAHIMAHI (3) +Owned +653424 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,167 +MANULANI (3) +Owned +1168529 +2,378 +284 +— +2005 +712’ 0” +23.0 +29,517 +MAUNAWILI (3) +Owned +1153166 +2,378 +326 +— +2004 +711’ 9” +23.0 +29,517 +MANUKAI (3) +Owned +1141163 +2,378 +326 +— +2003 +711’ 9” +23.0 +29,517 +R.J. PFEIFFER (3) +Owned +979814 +2,245 +300 +— +1992 +713’ 6” +23.0 +27,100 +MOKIHANA (3) +Owned +655397 +1,994 +354 +1,323 +1983 +860’ 2” +23.0 +29,484 +MAUNALEI (3) +Chartered +1181627 +1,992 +328 +— +2006 +681’ 1” +22.1 +33,771 +MATSON KODIAK (3) +Owned +910308 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON ANCHORAGE (3) +Owned +910306 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON TACOMA (3) +Owned +910307 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +KAMOKUIKI (4) +Owned +9232979 +707 +100 +— +2000 +433’ 9” +17.5 +8,509 +OLOMANA (5) +Chartered +9184225 +645 +120 +— +2004 +388’ 7” +14.0 +8,200 +IMUA II (5) +Chartered +9184237 +630 +90 +— +2005 +388’ 6” +15.0 +8,071 +LILOA II (5) +Chartered +9184249 +630 +90 +— +2004 +388’ 6” +15.0 +8,071 +PAPA MAU (5) +Owned +1559 +521 +68 +— +1999 +381’ 5” +14.0 +5,364 +SAMOANA (5) +Chartered +9164550 +505 +101 +— +2000 +330’ 0” +14.5 +5,550 +MANA (5) +Owned +4958 +384 +60 +— +1997 +329’ 9” +13.0 +4,508 +Steam-Powered +LIHUE (3) +Owned +530137 +2,018 +188 +— +1971 +787’ 8” +21.0 +38,656 +KAUAI (3) +Owned +621042 +1,644 +276 +44 +1980 +720’ 5” +22.0 +26,308 +MATSONIA (3) +Owned +553090 +1,727 +258 +450 +1973 +760’ 0” +21.0 +22,501 +Barges +MAUNA LOA (3) +Chartered +1247426 +500 +78 +— +2013 +362’ 6” +— +12,678 +HALEAKALA (3)(6) +Owned +676972 +335 +78 +— +1984 +350’ 0” +— +4,658 +ILIULIUK BAY (3)(6) +Chartered +1249384 +178 +— +— +2013 +250’ 0” +— +4,138 +WAIALEALE (3)(7) +Owned +978516 +— +36 +230 +1991 +345’ 0” +— +5,621 +(1) +Excludes inactive vessels. +(2) +Twenty-foot Equivalent Units (“TEU”) is a standard measure of cargo volume correlated to a standard 20-foot dry cargo container. +(3) +U.S. flagged and Jones Act qualified vessel or barge. +(4) +U.S. flagged vessel. +(5) +Foreign flagged vessel. +(6) +Lift-on/lift-off barge equipped with cranes. +(7) +Roll-on/roll-off barge. +Hawaii Fleet Renewal Program: +Matson is investing approximately $0.9 billion in the construction of four new vessels to renew its Hawaii fleet and phase-out the use of older steamships that are near the end of their useful life. The first Aloha Class containership, MV Daniel K. Inouye, was delivered on October 31, 2018 and commenced active service in November 2018. Expected delivery dates and specifications of the remaining three vessels currently under construction are as follows: +` +Usable Cargo Capacity +Containers +Vehicles +Maximum +Maximum +Expected +Type of +Official +Reefer +Speed +Deadweight +Name of Vessels +Delivery Date +Vessel +Number +TEUs +Slots +Autos +Length +(Knots) +(Long Tons) +Dual-fuel Capable +Kaimana Hila (1) +Q1 2019 +Containership +1274135 +3,220 +408 +— +854’ 0” +23.5 +53,747 +Lurline (2) +Q4 2019 +Con-Ro +1274143 +2,750 +432 +500 +869’ 5” +23.0 +50,981 +Matsonia (2) +Q3 2020 +Con-Ro +1274123 +2,750 +432 +500 +869’ 5” +23.0 +50,981 +4 +Table of Contents +(1) +The Aloha Class container vessel is being constructed by Philly Shipyard, Inc. (“Philly Shipyard”), with a dual-fuel, liquefied natural gas capable engine. +(2) +The two new Kanaloa Class combination container and roll-on/roll-off (“Con-Ro”) vessels are being constructed by General Dynamics NASSCO (“NASSCO”), with dual-fuel, liquefied natural gas capable engines. +The new vessels are expected to have among the lowest operating cost per TEU capacity of any vessel in the U.S. domestic trades. The cost efficiencies are expected to be driven by increased vessel utilization and by significantly lower fuel consumption, maintenance and repair, and dry-docking costs. Matson also expects to return to an optimal nine vessel Hawaii fleet deployment once MV Lurline is in service. In addition, the new vessels will provide increased capacity over the older vessels that are being replaced. +Actual paid and expected remaining vessel construction obligations based on signed agreements and change orders, excluding owners’ items and capitalized interest, are as follows: +Paid +Outstanding Obligations +Vessel Construction Obligations (in millions) +2018 and Prior +2019 +2020 +Total +Two Aloha Class Container Vessels +$ +386.9 +$ +20.7 +$ +3.9 +$ +411.5 +Two Kanaloa Class Con-Ro Vessels +290.7 +168.2 +57.8 +516.7 +Total +$ +677.6 +$ +188.9 +$ +61.7 +$ +928.2 +Hawaii Terminal Expansion and Modernization Program: +Matson is in the process of renovating its terminal facility at Sand Island, Honolulu, Hawaii. The first phase involves the investment of approximately $60 million and includes the installation of three new 65 long-ton capacity gantry cranes and modifications to upgrade three existing cranes. The first phase also includes upgrades in electrical infrastructure and other modifications to the Sand Island terminal. The first phase is expected to be completed during 2020. +Additional phases will be completed in the 2021 to 2024 timeframe and will be part of a broader terminal expansion and modernization program that Matson is undertaking at its Sand Island terminal. +Equipment: +As a complement to its fleet of vessels, Matson has a variety of equipment including cranes, containers and chassis which represents an investment of approximately $0.5 billion as of December 31, 2018. Matson also leases containers, chassis and other equipment under various operating lease agreements. +Additional information about Matson’s fleet equipment is as follows: +Approx. % +Approx. % +Fleet Equipment +Total (1) +Owned (1) +Leased (1) +Chassis +22,200 +51 +% +49 +% +Dry Containers +36,500 +60 +% +40 +% +Refrigerated Containers +8,100 +43 +% +57 +% +Specialty Equipment (2) +5,700 +82 +% +18 +% +Motor Generators +2,000 +90 +% +10 +% +(1) +Amounts represent approximations of equipment totals and percentage allocations. +(2) +Specialty equipment includes auto frames, flat racks, insulated containers, open top containers, platforms, flat bed trailers and tanks. +Operating Costs: +Major components of Ocean Transportation operating costs are as follows: +Direct Cargo Expense includes terminal handling costs, purchased outside transportation and other related costs. +Vessel Operating Expense includes crew wages and related costs; fuel consumption, pilot, tugs and line related costs; vessel charter expenses; and other vessel related expenses. Matson purchases fuel oil, lubricants and gasoline for its operations and also pays fuel surcharges to other third party transportation providers. +5 +Table of Contents +Operating Overhead includes equipment repair costs, equipment operating lease and repositioning expenses, vessel repair and maintenance costs, dry-docking amortization, insurance, port engineers and other maintenance costs, and other vessel and shoreside related overhead. +Matson’s U.S. flagged vessels must meet specified seaworthiness standards established by U.S. Coast Guard rules and classification society requirements. These standards require vessels to undergo two dry-docking inspections within a five-year period. The majority of Matson’s U.S. flagged vessels used in the Hawaii service are enrolled in the U.S. Coast Guard’s Underwater Survey in Lieu of Dry-docking (“UWILD”) program. The UWILD program allows eligible vessels to meet their intermediate dry-docking requirement with a less costly underwater inspection. +Matson is responsible for ensuring that its non-U.S flagged owned and bareboat chartered vessels meet international standards for seaworthiness, which among other requirements generally mandate that Matson perform two dry-docking inspections every five years. The dry-dockings of Matson’s time chartered vessels are the responsibility of the vessel owners. +Competition: +The following is a summary of major competitors in Matson’s Ocean Transportation segment: +Hawaii Service: Matson’s Hawaii service has one major U.S. flag Jones Act ocean carrier competitor, Pasha Hawaii (“Pasha”), which operates container and roll-on/roll-off services between the ports of Long Beach, Oakland and San Diego, California to Hawaii. There also are two U.S. flag Jones Act barge operators, Aloha Marine Lines and Sause Brothers, which offer barge service between the Pacific Northwest and Hawaii. +Foreign-flag vessels carrying cargo to Hawaii from non-U.S. locations also provide alternatives for companies shipping to Hawaii. Other competitors in the Hawaii service include proprietary operators and contract carriers of bulk cargo. Air freight competition for time-sensitive and perishable cargo exists; however, inroads by such competition in terms of cargo volume are limited by the amount of cargo space available in passenger aircrafts and by the cost of air freight transportation. +Matson vessels are operated on schedules that provide customers, shippers and consignees fixed day-of-the-week sailings from the U.S. West Coast as well as fixed day-of-the-week arrivals in Hawaii. Matson offers four westbound sailings per week, though this amount may be adjusted according to seasonal demand and market conditions. One of Matson’s westbound sailings each week continues on to Guam, Japan and China, so the number of eastbound sailings direct from Hawaii to the U.S. Mainland is three per week. This service is attractive to customers because more frequent sailings permit customers to reduce inventory carrying costs. Matson also competes by offering a more comprehensive service to customers, including: service to and from the three largest U.S. West Coast ports; the most efficient terminal network on the U.S. West Coast provided by Matson’s Terminal Joint Venture partner SSAT; a dedicated inter-island barge network; an award winning customer service team; and its efficiency and experience in handling cargo of all types. +Alaska Service: Matson’s Alaska service has one major U.S. flag Jones Act competitor, Totem Ocean Trailer Express, Inc., which operates a roll-on/roll off service between Tacoma, Washington and Anchorage, Alaska. There are also two U.S. flag Jones Act barge operators, Alaska Marine Lines, which mainly provides services from Seattle, Washington to the main ports of Anchorage and Dutch Harbor, and other locations in Alaska, and Samson Tug & Barge, which mainly serves Western Alaska and other locations. The barge operators have historically shipped lower value commodities that can accommodate a longer transit time, as well as construction materials and other cargo that are not conducive to movement in containers. Foreign-flag vessels provide alternatives for companies shipping cargo (mainly seafood) from the Alaska ports of Kodiak and Dutch Harbor. +Matson offers customers twice weekly scheduled services from Tacoma, Washington to Anchorage and Kodiak, Alaska and weekly service to Dutch Harbor, Alaska. The Company also provides a weekly barge service between Dutch Harbor and Akutan in Alaska. Matson is the only Jones Act containership operator providing service to Kodiak and Dutch Harbor in Alaska, which are the primary loading ports for southbound seafood. Matson offers dedicated terminal services at the Alaska ports of Anchorage, Kodiak and Dutch Harbor performed by MatNav, and at the port of Tacoma, Washington performed by Matson’s Terminal Joint Venture partner SSAT. +6 +Table of Contents +China Service: Major competitors to Matson’s China service include large international carriers such as Maersk, MSC, CMA CGM and its subsidiary APL, Evergreen, China COSCO, ONE (including “K” Line, NYK Line and MOL), OOCL, Hyundai and SM Line. +Matson competes by offering a fast and reliable service from the ports of Ningbo and Shanghai in China to Long Beach, California, providing fixed day arrivals and next-day cargo availability. Matson’s service is further differentiated by offering a dedicated marine terminal in Long Beach, California provided by Matson’s Terminal Joint Venture partner SSAT, an off-dock container yard providing fast truck turn times, and one-stop intermodal connections, and providing state-of-the-art technology and world-class customer service. Matson has offices in Hong Kong, Shenzhen, Xiamen, Ningbo and Shanghai, and has contracted with terminal operators in Ningbo and Shanghai. +Guam Service: Matson’s Guam service has one major competitor, APL, which operates a weekly U.S. flagged container feeder service connecting the U.S. West Coast to Guam and Saipan, via transshipments over Yokohama, Japan and Busan, South Korea. Waterman operates a roll-on/roll-off service which periodically calls at Guam. There are also several foreign carriers that call at Guam from foreign origin ports. +Japan Service: Matson’s Japan service competes primarily with APL, which operates a weekly U.S. flagged containership service from the U.S. West Coast to the Port of Naha, Okinawa, Japan. +Micronesia and the South Pacific Services: Matson’s Micronesia and South Pacific services have competition from a variety of local and international carriers that provide freight services to the area. +Customer Concentration: +Matson serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2018, 2017 and 2016, the Company’s 10 largest Ocean Transportation customers accounted for approximately 24 percent, 23 percent and 24 percent of the Company’s Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Matson’s Ocean Transportation operating revenues. For additional information on Ocean Transportation revenues for the years ended December 31, 2018, 2017 and 2016, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +Seasonality: +Matson’s Ocean Transportation services typically experience seasonality in volume, generally following a pattern of increasing volumes starting in the second quarter of each year, culminating in a peak season throughout the third quarter, with subsequent decline in demand during the fourth and first quarters. This seasonality trend is amplified in the Alaska service primarily due to winter weather and the timing of southbound seafood trade. As a result, earnings tend to follow a similar pattern, offset by periodic vessel dry-docking and other episodic cost factors, which can lead to earnings variability. In addition, in the China trade, volume is driven primarily by U.S. consumer demand for goods during key retail selling seasons while freight rates are impacted mainly by macro supply and demand variables. +Maritime Laws and the Jones Act : +Maritime Laws: All interstate and intrastate marine commerce within the U.S. falls under the Merchant Marine Act of 1920 (commonly referred to as the Jones Act). +The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, be manned predominantly by U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75 percent owned by U.S. citizens. U.S. flagged vessels are generally required to be maintained at higher standards than foreign flagged vessels and are subject to rigorous supervision and inspections by, or on behalf of, the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Under Section 27 of the Jones Act, the carriage of cargo between the U.S. West Coast, Hawaii and Alaska on foreign-built or foreign-documented vessels is prohibited. +7 +Table of Contents +During the years ended December 31, 2018 and 2017, approximately 72 percent of Matson’s Ocean Transportation revenues came from the Hawaii and Alaska trades that were subject to the Jones Act. Matson’s Hawaii and Alaska trade routes are included within the non-contiguous Jones Act market. Hawaii, as an island economy, and Alaska due to its geographical location, are both dependent on ocean transportation. The Jones Act ensures frequent, reliable, roundtrip service to these locations. Matson’s vessels operating in these trade routes are Jones Act qualified. +Matson is a member of the American Maritime Partnership (“AMP”) which supports the retention of the Jones Act and similar cabotage laws. The Jones Act has broad support from both houses of Congress. Matson believes that the ongoing war on terrorism has further solidified political support for U.S. flagged vessels because a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support. AMP seeks to inform elected officials and the public about the economic, national security, commercial, safety and environmental benefits of the Jones Act and similar cabotage laws. Repeal of the Jones Act would allow foreign-flag vessel operators that do not have to abide by all U.S. laws and regulations to sail between U.S. ports in direct competition with Matson and other U.S. domestic operators that must comply with all such laws and regulations. +Other U.S. maritime laws require vessels operating between Guam, a U.S. territory, and U.S. ports to be U.S. flagged and predominantly U.S. crewed, but not U.S. built. +Cabotage laws are not unique to the United States, and similar laws exist around the world in over 90 countries, including regions in which Matson provides ocean transportation services. Any changes in such laws may have an impact on the services provided by Matson in those regions. +Regulations: +Rate Regulations and Fuel Surcharge: Matson is subject to the jurisdiction of the Surface Transportation Board with respect to its domestic ocean rates. A rate in the non-contiguous domestic trade is presumed reasonable and will not be subject to investigation if the aggregate of increases and decreases is not more than 7.5 percent above, or more than 10 percent below, the rate in effect one year before the effective date of the proposed rate, subject to increase or decrease by the percentage change in the U.S. Producer Price Index. Matson generally provides a 30-day notice to customers of any increases in general rates and terminal handling charges, and passes along decreases as soon as possible. +Matson applies a fuel surcharge rate to its Ocean Transportation customers. Changes in the fuel surcharge levels are correlated to prevailing market rates for bunker fuel prices along with other factors related to fuel expense recovery. +Other Regulations: Matson’s Ocean Transportation services engaged in U.S. foreign commerce are subject to the jurisdiction of the Federal Maritime Commission (“FMC”). The FMC is an independent regulatory agency that is responsible for the regulation of ocean-borne international transportation of the U.S. +Environmental Regulations: +Being a leader in environmental stewardship and contributing positively to the communities in which we live and work are core values at Matson. Matson’s vessels transit through some of the most environmentally sensitive areas in the United States including the Hawaiian islands and the coasts of California, Oregon, Washington and Alaska. Matson is focused in particular on reducing transportation emissions, including carbon dioxide, nitrous oxide, particulate matter and sulfur dioxide, through improvements in vessel fuel consumption and truck efficiency, and the development of more fuel-efficient transportation solutions. Matson further contributes positively to the environment by testing and deploying cutting edge technologies which are applied to our modernized fleet. +Vessel Emissions Regulations : The International Maritime Organization (“IMO”) is a specialized agency of the United Nations responsible for regulating shipping. Effective January 1, 2020, the IMO has imposed a worldwide regulation that requires all vessels to burn compliant fuel oil with a maximum sulfur content of 0.5 percent. With respect to North America, the U.S. Environmental Protection Agency (“EPA”) received approval from the IMO, in coordination with Environment Canada, to designate all waters, with certain limited exceptions, within 200 nautical miles of U.S. and Canadian coast lines as designated emission control areas (“ECAs”). Beginning January 1, 2015, EPA regulations reduced the maximum sulfur emissions permitted in designated ECAs from 1.0 percent to 0.1 percent. +8 +Table of Contents +Matson’s three diesel-powered vessels in its Alaska service operate a substantial portion of their voyages in ECAs. Matson successfully installed exhaust gas cleaning systems (commonly referred to as “scrubbers”) on these vessels to be in compliance with the IMO and EPA ECA regulations. +Matson’s Hawaii and CLX vessels operate a portion of their voyages in ECAs. Matson’s four new Hawaii vessels can burn low sulfur fuels enabling the vessels to be compliant with the new IMO and EPA ECA regulations. Following the delivery of MV Lurline in the fourth quarter of 2019, Matson expects to phase out the use of all three remaining steamships by the end of 2019. In addition, Matson has announced plans to install scrubbers on three additional diesel-powered vessels used in the Hawaii and CLX services to be completed during 2019 and early 2020. Matson continues to develop solutions and apply other operating strategies to comply with emissions regulations on its other vessels in use in the Hawaii and CLX services, and other services. +Other Environmental Regulations: Matson’s operations are required to comply with other environmental regulations and requirements including the O il Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. The Company actively monitors its operations to ensure compliance with these and other regulations. +For more information on Matson’s environmental stewardship initiatives, including its environmental goals, see https://www.matson.com/corporate/about_us/environmental.html. The contents of our website are not incorporated by reference into this Form 10-K. +(2) LOGISTICS SEGMENT +Logistics Services: +Matson’s Logistics segment provides the following services: +Transportation Brokerage Services: Matson Logistics’ transportation brokerage services provide intermodal rail, highway, and other third-party logistics services for North American customers and international ocean carrier customers, including MatNav. Matson Logistics is able to reduce transportation costs for its customers through volume purchases of rail, motor carrier and ocean transportation services, augmented by services such as shipment tracking and tracing, and single-vendor invoicing. Matson Logistics operates customer service centers and has sales offices throughout North America. +Freight Forwarding Services: Matson Logistics provides LCL consolidation and freight forwarding services primarily to the Alaska market through its wholly owned subsidiary, Span Alaska. Span Alaska’s business aggregates LCL freight at its main cross-dock facility in Auburn, Washington for consolidation and shipment to a network of cross-dock facilities in Alaska. Span Alaska also provides trucking services to its Auburn cross-dock facility and from its Alaska based cross-dock facilities to final customer destinations in Alaska. +Warehousing and Distribution Services: Matson Logistics operates two warehouses in Georgia and two warehouses in Northern California providing warehousing, value-added packaging and distribution services. +Supply Chain Management and Other Services: Matson Logistics’ supply chain management provides customers with a variety of logistics services including purchase order management, customs brokerage, LCL and full container load NVOCC freight forwarding services. +Investment in Anchorage Cross-dock Facility: Span Alaska is in the process of constructing a new 54,000 square foot cross-dock facility to consolidate its Anchorage operations that currently operate from two smaller leased facilities. The new cross-dock facility is expected to be completed by the end of 2019 and is expected to improve Span Alaska’s operating efficiency while providing additional capacity for long-term growth. +Recent Logistics Acquisition: On August 4, 2016, Matson Logistics completed its acquisition of Span Alaska. For additional information about this acquisition, see Note 18 to the Consolidated Financial Statements in Item 8 of Part II below. +9 +Table of Contents +Operating Costs: +Matson Logistics’ operating costs primarily consist of the costs of purchased transportation, leases of warehouses and other facility operating costs, salaries and benefits, and other operating overhead. +Competition: +Matson Logistics competes with hundreds of local, regional, national and international companies that provide transportation and third-party logistics services. The industry is highly fragmented and, therefore, competition varies by geography and areas of service. +Matson Logistics’ transportation brokerage services competes most directly with C.H. Robinson Worldwide, the Hub Group, and other freight brokers and intermodal marketing companies, and asset-invested market leaders such as J.B. Hunt. Competition is differentiated by the depth, scale and scope of customer relationships; vendor relationships and rates; network capacity; real-time visibility into the movement of customers’ goods; and other technology solutions. Additionally, while Matson Logistics primarily provides surface transportation brokerage, it also competes to a lesser degree with other forms of transportation for the movement of cargo. +Matson Logistics’ freight forwarding services compete most directly with a variety of freight forwarding companies that operate within Alaska including Carlile, Lynden, American Fast Freight and Alaska Traffic Company. +Customer Concentration: +Matson Logistics serves customers in numerous industries and geographical locations. In 2018, 2017 and 2016, the Company’s 10 largest logistics customers accounted for approximately 23 percent, 19 percent and 22 percent of Matson Logistics’ revenue, respectively. None of these customers individually account for more than 10 percent of Matson Logistics’ operating revenues. For additional information on Logistics revenues for the years ended December 31, 2018, 2017 and 2016, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +Seasonality: +Matson’s Logistics services are generally not significantly impacted by seasonality factors, except for its freight forwarding service to Alaska which is affected by the winter weather, the cyclical nature of the oil and construction industries, and the seasonal nature of the tourism industry. +C. +EMPLOYEES AND LABOR RELATIONS +Employees: +As of December 31, 2018, Matson and its subsidiaries had 2,007 employees, of which 786 employees were covered by collective bargaining agreements with shoreside and offshore unions. These numbers do not include billets on vessels discussed below, employees of SSAT, or other non-employees, such as agents, temporary workers and contractors. +Matson’s active fleet employed seagoing personnel in 339 billets at December 31, 2018. Each billet corresponds to a position on a vessel that typically is filled by two or more employees because seagoing personnel rotate between active sea-duty and time ashore. These amounts exclude billets related to two reserve vessels as of December 31, 2018 and Matson’s foreign flagged chartered vessels where the vessel owner is responsible for its seagoing personnel. Matson’s vessel management services also employed personnel in 28 billets at December 31, 2018. +Bargaining Agreements: +Matson and SSAT are members of the Pacific Maritime Association (“PMA”), which on behalf of its members negotiates collective bargaining agreements with the International Longshore and Warehouse Union (“ILWU”) on the U.S. Pacific Coast. The PMA/ILWU collective bargaining agreements cover substantially all U.S. West Coast longshore +10 +Table of Contents +labor. In August 2017, the ILWU agreed to extend its contract with the PMA to July 1, 2022. Matson also has collective bargaining agreements with other unions that expire at various dates in the future. +Matson’s seagoing employees are represented by unions for both unlicensed and licensed crew members. Matson also has collective bargaining agreements with these unions that expire at various dates in the future. +Certain collective bargaining agreements expire during 2019. While Matson believes that it will be able to renegotiate these collective bargaining agreements with its various unions as they expire without any significant impact on its operations, no assurance can be given that such agreements will be reached without slow-downs, strikes, lock-out or other disruptions that may adversely impact Matson’s operations. +Multi-employer Pension and Post-retirement Plans: +Matson contributes to a number of multi-employer pension and post-retirement plans. Matson has no present intention of withdrawing from, and does not anticipate the termination of any of the multi-employer pension plans that it contributes to (see Notes 11 and 12 to the Consolidated Financial Statements in Item 8 of Part II below for a discussion of withdrawal liabilities under certain multi-employer pension plans). +D. +AVAILABLE INFORMATION +Matson makes available, free of charge on or through its Internet website, Matson’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the U.S. Securities and Exchange Commission (“SEC”). The address of Matson’s Internet website is www.matson.com. The contents of our website are not incorporated by reference into this Form 10-K. +The SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding Matson and other issuers that file electronically with the SEC. The address of the SEC’s Internet website is www.sec.gov. +ITEM 1A. RISK FACTORS +The Company’s business faces the risks set forth below, which may adversely affect our business, financial condition and operating results. All forward-looking statements made by the Company or on the Company’s behalf are qualified by the risks described below. +Risks Relating To Operations +Changes in U.S., global, regional economic conditions or governmental policies that result in a decrease in consumer confidence or market demand for the Company’s services and products in Hawaii and Alaska, the U.S. Mainland, Guam, Asia or the South Pacific may adversely affect the Company’s financial position, results of operations, liquidity, or cash flows. +A weakening of domestic or global economies may adversely impact the level of freight volumes and freight rates. Within the U.S., a weakening of economic drivers in Hawaii and Alaska, which include tourism, military spending, construction starts, personal income growth and employment, or the weakening of consumer confidence, market demand, the economy in the U.S. Mainland, or the effect of a change in the strength of the U.S. dollar against other foreign currencies, may further reduce the demand for goods to and from Asia, Hawaii and Alaska, adversely affecting inland and ocean transportation volumes or rates. In addition, overcapacity in the global or transpacific ocean transportation markets, a change in the cost of goods or currency exchange rates, imposition of tariffs, or a change in international trade policies may adversely affect freight volumes and rates in the Company’s China service. +The Company may face new or increased competition. +The Company may face new competition by established or start-up shipping operators that enter the Company’s markets. The entry of a new competitor or the addition of new vessels or capacity by existing competition on any of the +11 +Table of Contents +Company’s routes could result in a significant increase in available shipping capacity that could have an adverse effect on volumes and rates. For example, in December 2016, the Company’s major competitor in the Guam service upgraded its U.S. flagged feeder containership from a bi‑weekly service to a weekly service connecting the U.S. West Coast to Guam and Saipan via transshipments over Yokohama, Japan and Busan, South Korea. As a result of this and other potential competitor actions, the Company could experience a reduction in profitability. +The loss of or damage to key agent or customer relationships may adversely affect the Company’s business. +The Company’s businesses are dependent on their relationships with agents and customers, and derive a significant portion of their revenues from the Company’s largest customers. The Company could be adversely affected by any changes in the services provided, or changes to the costs of services provided by agents. Relationships with railroads and shipping companies and agents are important in the Company’s intermodal business as well as in the Guam, Micronesia, Japan and South Pacific services. +The Company’s business also relies on its relationships with the military, freight forwarders, large retailers and consumer goods and automobile manufacturers, as well as other larger customers. In 2018, the Company’s Ocean Transportation segment’s 10 largest customers accounted for approximately 24 percent of the business’ revenue. In 2018, the Company’s Logistics segment’s 10 largest customers accounted for approximately 23 percent of the business’ revenue. The loss of or damage to any of these key relationships may adversely affect the Company’s business and revenue. +The Company is dependent upon key vendors and third-parties for equipment, capacity and services essential to operate its business, and if the Company fails to secure sufficient third-party services, its business could be adversely affected. +The Company’s businesses are dependent upon key vendors who provide rail, truck and ocean transportation services. If the Company cannot secure sufficient transportation equipment, capacity or services from these third-parties at reasonable prices or rates to meet its or its customers’ needs and schedules, customers may seek to have their transportation and logistics needs met by others on a temporary or permanent basis. If this were to occur, the Company’s business, consolidated results of operations and financial condition could be adversely affected. +An increase in fuel prices, changes in the Company’s ability to collect fuel surcharges, and/or the cost or limited availability of required fuels on the U.S. West Coast may adversely affect the Company’s profits. +Fuel is a significant operating expense for the Company’s Ocean Transportation business. The price and supply of fuel are unpredictable and fluctuate based on events beyond the Company’s control. Increases in the price of fuel may adversely affect the Company’s results of operations. Increases in fuel costs also can lead to increases in other expenses such as energy costs and costs to purchase outside transportation services. In the Company’s Ocean Transportation and Logistics services segments, the Company utilizes fuel related surcharges, although increases in the fuel surcharge may adversely affect the Company’s competitive position and may not correspond exactly with the timing of increases in fuel expense. Changes in the Company’s ability to collect fuel surcharges also may adversely affect its results of operations. +Effective January 1, 2020, the IMO has imposed a world-wide regulation that all ships must burn compliant fuel oil with a maximum sulfur content of ≤0.5 percent. While 0.1 percent low-sulfur distillate fuel is currently available, supplies of low-sulfur residual fuel may be limited. Distillate and residual compliant fuels are more costly compared to scrubber technology and prolonged use on some Matson vessels could degrade engine performance or lead to higher maintenance costs. Matson successfully operates scrubbers in the Alaska service and has announced plans to install scrubbers on three additional vessels that operate in the CLX service. Scrubbers allow vessels to continue to burn high sulfur fuel oil and comply with IMO 2020 regulations. Matson’s new Aloha and Kanaloa class vessel engines can burn fuel compliant with IMO 2020 regulations, including liquefied natural gas (“LNG”) although they are not currently outfitted for LNG. The LNG infrastructure is lacking in major U.S. West Coast ports and it is unclear when this infrastructure may be constructed and operational. The Company’s ability to recover the higher costs of IMO 2020 compliant fuel through fuel surcharges, the availability of compliant low-sulfur residual fuel, and the potential impact on vessel performance and maintenance costs may adversely affect the Company’s operations, business and profit. +12 +Table of Contents +Work stoppages or other labor disruptions caused by unionized workers of the Company, other workers or their unions in related industries may adversely affect the Company’s operations. +As of December 31, 2018, Matson and its subsidiaries had 2,007 regular employees, of which 786 employees were covered by collective bargaining agreements with unions. In addition, at December 31, 2018, the active Matson fleet employed seagoing personnel in 339 billets, and vessel management services employed personnel in 28 billets. Such employees are also subject to collective bargaining agreements. Furthermore, the Company relies on the services of third-parties including SSAT that employ persons covered by collective bargaining agreements. For additional information on collective bargaining agreements with unions, see Item1. C. Employees and Labor Relations of Part I above. +The Company could be adversely affected by actions taken by employees of the Company or other companies in related industries against efforts by management to control labor costs, restrain wage or benefit increases or modify work practices. Strikes and disruptions may occur as a result of the failure of Matson or other companies in its industry to negotiate collective bargaining agreements with such unions successfully. +In addition, any slow-downs, strikes, lock-outs or other disruptions, including limits to availability of labor through trade union hiring halts could have an adverse impact on Matson’s or SSAT’s operations. +The Company is susceptible to weather, natural disasters and other operating risks. +The Company’s operations are vulnerable to disruption as a result of weather and natural disasters, such as bad weather at sea, hurricanes, typhoons, tsunamis, floods and earthquakes. Such events will interfere with the Company’s ability to provide on-time scheduled service, resulting in increased expenses and potential loss of business associated with such events. In addition, severe weather and natural disasters can result in interference with the Company’s terminal operations, and may cause serious damage to its vessels and cranes, loss or damage to containers, cargo and other equipment, and loss of life or physical injury to its employees, all of which could have an adverse effect on the Company’s business. +The Company’s vessels and their cargoes are also subject to operating risks such as mechanical failure, collisions and human error. The occurrence of any of these events may result in damage to or loss of vessels or other property, or injury or death of people. If any of these events were to occur, the Company could be exposed to reputational harm and liability for resulting damages and possible penalties that, pursuant to typical maritime industry policies, it must pay and then seek reimbursement from its insurer. Affected vessels may also be removed from service and thus would be unavailable for income-generating activity. +The Company maintains casualty and liability insurance policies, which are generally subject to large retentions and deductibles. Some types of losses, such as losses resulting from a port blockage, generally, are not insured. In some cases the Company retains the entire risk of loss because it is not economically prudent to purchase insurance coverage or because of the perceived remoteness of the risk. Other risks are uninsured because insurance coverage may not be commercially available. Finally, the Company retains all risk of loss that exceeds the limits of its insurance. +The Company’s significant operating agreements and leases could be replaced on less favorable terms or may not be replaced. +The significant operating agreements and leases of the Company in its various businesses expire at various points in the future and may not be replaced or could be replaced on less favorable terms, thereby adversely affecting the Company’s future financial position, results of operations and cash flows. For example, o n November 26, 2018, a wholly-owned subsidiary of the Company entered into agreements whereby MV Maunalei , a U.S. flagged and Jones Act qualified vessel, was sold for $106.0 million and leased back from the buyer under an operating lease agreement. While the agreements contain customary representations, warranties and covenants, there remain risks that the lessor could lose its Jones Act status, that the Company could not replace MV Maunalei in the event it is no longer Jones Act eligible, or if elected, that the Company would not be able to repurchase MV Maunalei at the end of the lease term. +13 +Table of Contents +The Company may face unexpected dry-docking or repair costs for its vessels. +We routinely engage shipyards to dry-dock our vessels for regulatory compliance and to provide repair and maintenance. Vessels may also have to be dry-docked or repaired at sea in the event of accidents or other unforeseen damage. The cost of repairs are difficult to predict with certainty and can be substantial. Large dry-docking and other repair expenses could adversely affect the Company’s results of operations and cash flows. In addition, the time when a vessel is out of service for maintenance is determined by a number of factors, including regulatory deadlines, market conditions, shipyard availability and customer requirements, and accordingly, the length of time that a vessel may be out of service may be longer than anticipated, which could adversely affect the Company’s business, financial condition, results of operations and cash flows. +If we are not able to use our information technology and communications systems effectively, our ability to conduct business might be negatively impacted. +The Company is highly dependent on the proper functioning of our information technology systems to enable operations and compete effectively. Our information technology systems rely on third-party service providers for access to the Internet, satellite-based communications systems, the electric grid, database storage facilities and telecommunications providers. We have no control over the operations of these third-party service providers. If our information technology and communications systems experience reliability issues, integration or compatibility concerns or if our third-party providers are unable to perform effectively or experience disruptions or failures, there could be an adverse impact on the availability and functioning of our information technology and communications systems, which could lead to business disruption or inefficiencies, reputational harm or loss of customers that could have an adverse effect on our business. +Our information technology systems may be exposed to cybersecurity risks and other disruptions that could impair the Company’s ability to operate and adversely affect its business. +The Company relies extensively on its information technology systems and third-party service providers including cloud services for accounting, billing, disbursement, cargo booking and tracking, vessel scheduling and stowage, equipment tracking, customer service, banking, payroll and employee communication systems. The Company also collects, stores and transmits sensitive data, including its proprietary business information and that of its customers, and personally identifiable information of its customers and employees. Despite our continuous efforts to make investments in our information technology systems and system-wide data security program, the implementation of security measures to protect our data and infrastructure against breaches and other cyber threats, and our use of internal processes and controls designed to protect the security and availability of our systems, our information technology and communication systems may be vulnerable to cybersecurity risks such as computer viruses, hacking, malware, denial of service attacks, cyber terrorism, circumvention of security systems, malfeasance, breaches due to employee error, natural disasters, telecommunications failure, or other catastrophic events at the Company’s facilities, aboard its vessels or at third-party locations. +Any failure, breach or unauthorized access to the Company’s or third-party systems could result in the loss of confidential, sensitive or proprietary information, interruptions in its service or production or otherwise impact our ability to conduct business operations, and could result in potential reductions in revenue and profits, damage to its reputation or liability. +Loss of the Company’s key personnel could adversely affect its business. +The Company’s future success will depend, in significant part, upon the continued services of its key personnel, including its senior management and skilled employees. The loss of the services of key personnel could adversely affect the Company’s future operating results because of such employees’ experience and knowledge of the Company’s business and customer relationships. If key employees depart, the Company may incur significant costs to replace them. Additionally, the Company’s ability to execute its business model could be impaired if it cannot replace them in a timely manner. The Company does not maintain key person insurance on any of its key personnel. +14 +Table of Contents +The Company is involved in a joint venture and is subject to risks associated with joint venture relationships. +The Company is involved in a terminal joint venture, SSAT (and through SSAT, other joint ventures at U.S. West Coast terminals), and may initiate future joint venture projects. A joint venture involves certain risks such as: +· +The Company may not have voting control over the joint venture; +· +The Company may not be able to maintain good relationships with its joint venture partner; +· +A joint venture partner at any time may have economic or business interests that are inconsistent with the Company’s; +· +A joint venture partner may fail to fund its share of capital for operations or to fulfill its other commitments, including providing accurate and timely accounting and financial information to the Company; +· +The joint venture may experience operating difficulties and financial losses, which may lead to asset write-downs or impairment charges that could negatively impact the operating results of the joint venture and the Company; +· +The joint venture or venture partner could lose key personnel; +· +A joint venture partner could become bankrupt requiring the Company to assume all risks and capital requirements related to the joint venture project, and the related bankruptcy proceedings could have an adverse impact on the operation of the partnership or joint venture; and +· +Actions of the joint venture may result in reputational harm to the Company. +In addition, the Company relies on the terminal joint venture, SSAT, and SSA for its stevedoring services at the ports of Long Beach and Oakland, California, and Seattle and Tacoma, Washington on the U.S. West Coast. The Company could be adversely affected by any changes in the services provided, or to the costs of such services provided by the Company’s terminal joint venture, SSAT, and SSA. +The Company is subject to risks associated with conducting business in foreign shipping markets. +Matson’s China, Micronesia, Japan and South Pacific services are subject to risks associated with conducting business in a foreign shipping market, which include: +· +Challenges associated with operating in foreign countries and doing business and developing relationships with foreign companies; +· +Challenges in working with and maintaining good relationships with business associates in our foreign operations; +· +Difficulties in staffing and managing foreign operations; +· +Our ability to be in compliance with U.S. and foreign legal and regulatory restrictions, including compliance with the Foreign Corrupt Practices Act and foreign laws that prohibit corrupt payments to government officials; +· +Global vessel overcapacity that may lead to decreases in volumes and shipping rates; +· +Not having continued access to existing port facilities; +· +Competition with established and new carriers; +· +Changes in vessel deployment by competitors that impact the Company’s services; +· +Currency exchange rate fluctuations and our ability to manage these fluctuations; +· +Political and economic instability; +· +Dynamics involving U.S. trade relations with other countries, including measures such as the imposition of tariffs or other governmental actions, all of which may affect the Company’s operations; and +· +Challenges caused by cultural differences. +Any of these risks has the potential to adversely affect the Company’s operating results. +The Company is subject to risks related to a marine accident or spill event. +The Company’s vessel and terminal operations could be faced with a maritime accident, oil or other spill, or other environmental mishap. Such event may lead to personal injury, loss of life, damage of property, pollution and suspension of operations. As a result, such event could have an adverse effect on the Company’s business. +15 +Table of Contents +The Company’s Shipbuilding Agreements with Philly Shipyard and NASSCO are subject to risks. +On November 6, 2013, MatNav and Philly Shipyard entered into definitive agreements pursuant to which Philly Shipyard will construct two new 3,600-TEU sized Aloha Class dual-fuel capable containerships. The first vessel, MV Daniel K. Inouye , was delivered on October 31, 2018. It is expected that the second vessel will be delivered in the first quarter of 2019. On August 25, 2016, MatNav and NASSCO entered into a definitive agreement pursuant to which NASSCO will construct two new 3,500-TEU sized Kanaloa Class dual-fuel capable container and roll-on/roll-off vessels, with expected delivery dates at the end of 2019 and 2020. Failure of any party to the shipbuilding agreements to fulfill its obligations under the agreements could have an adverse effect on the Company’s financial position and results of operations. Such a failure could happen for a variety of reasons, including but not limited to (i) delivery delays, (ii) delivery of vessels that fail to meet any of the required operating specifications (for example, capacity, fuel efficiency or speed), (iii) events in Korea which prevent one or more significant subcontractors to each of, Philly Shipyard or NASSCO from performing, or (iv) the insolvency of, or the refusal or inability to perform for any reason, by Philly Shipyard, NASSCO, or any of their respective subcontractors. Significant delays in the delivery of the new vessels could limit our ability to replace aging steamships without substantial modifications, which could also have an adverse impact on our business plans, financial condition and results of operations. +The Company’s terminals in Hawaii and Alaska require modernization. +We are investing approximately $60 million, including the installation of three new gantry cranes and upgrade of three existing cranes, as part of the first phase of a broader project to expand and improve the Company’s Sand Island terminal in Honolulu Harbor. We have also begun discussions with state and local authorities in Anchorage, Alaska regarding upgrades to those terminal and port facilities. Regulatory, construction or other delays or cost overruns related to the expansion and modernization of the terminals could have an adverse impact on our business plans, financial condition and results of operations. +Heightened security measures, war, actual or threatened terrorist attacks, efforts to combat terrorism and other acts of violence may adversely impact the Company’s operations and profitability. +War, terrorist attacks and other acts of violence may cause consumer confidence and spending to decrease, or may affect the ability or willingness of tourists to travel to Hawaii, Guam or Alaska, thereby adversely affecting those economies and the Company. Additionally, future terrorist attacks could increase volatility in the U.S. and worldwide financial markets. Acts of war or terrorism may be directed at the Company’s shipping operations, or may cause the U.S. government to take control of Matson’s vessels for military operation. Heightened security measures potentially slow the movement and increase the cost of freight through U.S. or foreign ports, across borders or on U.S. or foreign railroads or highways and could adversely affect the Company’s business and results of operations. +Acquisitions may have an adverse effect on the Company’s business. +The Company’s growth strategy includes expansion through acquisitions, including, for example, the Company’s acquisitions of Horizon in 2015 and Span Alaska in 2016 . Acquisitions may result in difficulties in assimilating acquired assets or companies, and may result in the diversion of the Company’s capital and its management attention from other business issues and opportunities. The Company may not be able to integrate companies that it acquires successfully, including their personnel, financial systems, distribution, operations and general operating procedures. The Company may also encounter challenges in achieving appropriate internal control over financial reporting in connection with the integration of an acquired company. The Company may pay a premium for an acquisition, resulting in goodwill that may later be determined to be impaired, adversely affecting the Company’s financial condition and results of operations. +The Horizon and Span Alaska acquisitions may expose us to unknown liabilities. +We acquired Horizon subject to all of the liabilities and obligations of its non-Hawaii business, including any remaining liabilities and obligations associated with its Puerto Rico operations, which Horizon ceased during the first quarter of 2015. Similarly, in August 2016, we acquired Span Alaska subject to all of its liabilities and obligations. The disposition of these liabilities, and any other obligations that are unknown to the Company, including contingent liabilities, could have an adverse effect on the Company’s financial condition and results of operations. +16 +Table of Contents +We may continue to be exposed to risks and liabilities related to Horizon’s former Hawaii business. +Pasha acquired Horizon’s former Hawaii business immediately before we acquired Horizon, and Pasha assumed substantially all liabilities and obligations related to Horizon’s Hawaii business and agreed to perform various covenants. In some cases however, Horizon, as the original contracting party, may remain primarily responsible for such assumed Hawaii liabilities and obligations. The Company may incur losses related to such assumed Hawaii liabilities and obligations. +We may be required to record a significant charge to earnings if recorded intangible assets associated with the Horizon and Span Alaska acquisitions became impaired. +We recorded significant intangible assets related to goodwill and customer relationships arising from the Horizon and Span Alaska acquisitions. We are required to test goodwill for impairment annually, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Factors that could lead to an impairment of goodwill or intangible customer relationships include any significant adverse changes affecting the reporting unit’s financial condition, results of operations, and future cash flows. +Risks Relating to Financial Matters +A deterioration of the Company’s credit profile, disruptions of the credit markets or higher interest rates could restrict its ability to access the debt capital markets or increase the cost of debt. +Deterioration in the Company’s credit profile may have an adverse effect on the Company’s ability to access the private or public debt markets and also may increase its borrowing costs. If the Company’s credit profile deteriorates significantly, its access to the debt capital markets or its ability to renew its committed lines of credit may become restricted, or the Company may not be able to refinance debt at the same levels or on the same terms. Because the Company relies on its ability to draw on its revolving credit facilities to support its operations, when required, any volatility in the credit and financial markets that prevents the Company from accessing funds (for example, a lender that does not fulfill its lending obligation) could have an adverse effect on the Company’s financial condition and cash flows. Additionally, the Company’s credit agreements generally include an increase in borrowing rates if the Company’s credit profile deteriorates. Furthermore, the Company incurs interest under its revolving credit facilities based on floating rates. Floating rate debt creates higher debt service requirements if market interest rates increase, as was the case in connection with the U.S. Federal Reserve’s interest rate increases in 2018, which would adversely affect the Company’s cash flow and results of operations. +Failure to comply with certain restrictive financial covenants contained in the Company’s credit facilities could preclude the payment of dividends, impose restrictions on the Company’s business segments, capital resources or other activities or otherwise adversely affect the Company. +The Company’s credit facilities contain certain restrictive financial covenants, the most restrictive of which include a maximum ratio of debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”), a minimum ratio of EBITDA to interest expense, the maintenance of no more than a maximum amount of priority debt as a percentage of consolidated tangible assets, and the maintenance of minimum shareholders’ equity. If the Company does not maintain these and other required covenants, and a breach of such covenants is not cured timely or waived by the lenders resulting in a default, the Company’s access to credit may be limited or terminated, dividends may be suspended, and the lenders could declare any outstanding amounts due and payable. The Company’s continued ability to borrow under its credit facilities is subject to compliance with these financial and other non-financial covenants. +The Company’s effective income tax rate may vary. +Various internal and external factors may have favorable or unfavorable, material or immaterial effects on the Company’s effective income tax rate and, therefore, impact the Company’s net income and earnings per share. These factors include, but are not limited to changes in tax rates; changes in tax laws, regulations, and rulings; changes in interpretations of existing tax laws, regulations and rulings; changes in the evaluation of the Company’s ability to realize deferred tax assets, and changes in uncertain tax positions; changes in accounting principles; changes in current pre-tax +17 +Table of Contents +income as well as changes in forecasted pre-tax income; changes in the level of CCF deductions, non-deductible expenses, and expenses eligible for tax credits; changes in the mix of earnings among countries with varying tax rates; and acquisitions and changes in the Company’s corporate structure. These factors may result in periodic revisions to our effective income tax rate, which could affect the Company’s cash flow and results of operations. +Changes in the value of pension assets, or a change in pension law or key assumptions, may adversely affect the Company’s financial performance. +The amount of the Company’s employee pension and post-retirement benefit costs and obligations are calculated on assumptions used in the relevant actuarial calculations. Adverse changes in any of these assumptions due to economic or other factors, changes in discount rates, higher health care costs, or lower actual or expected returns on plan assets, may adversely affect the Company’s operating results, cash flows, and financial condition. In addition, a change in federal law, including changes to the Employee Retirement Income Security Act or Pension Benefit Guaranty Corporation premiums, may adversely affect the Company’s single-employer and multi-employer pension plans and plan funding. These factors, as well as a decline in the fair value of pension plan assets, may put upward pressure on the cost of providing pension and medical benefits and may increase future pension expense and required funding contributions. There can be no assurance that the Company will be successful in limiting future cost and expense increases, and continued upward pressure in costs and expenses could further reduce the profitability of the Company’s businesses. +The Company may have exposure under its multi-employer pension and post-retirement plans in which it participates that extends beyond its funding obligation with respect to the Company’s employees. +The Company contributes to various multi-employer pension plans. In the event of a partial or complete withdrawal by the Company from any plan that is underfunded, the Company would be liable for a proportionate share of such plan’s unfunded vested benefits (see Note 11 to the Consolidated Financial Statements in Item 8 of Part II below). Based on the limited information available from plan administrators, which the Company cannot independently validate, the Company believes that its portion of the contingent liability in the case of a full withdrawal or termination may be material to its financial position and results of operations. If any other contributing employer withdraws from any plan that is underfunded, and such employer (or any member of its controlled group) cannot satisfy its obligations under the plan at the time of withdrawal, then the Company, along with the other remaining contributing employers, would be liable for its proportionate share of such plan’s unfunded vested benefits. In addition, if a multi-employer plan fails to satisfy the minimum funding requirements, the Internal Revenue Service will impose certain penalties and taxes. +Risks Relating to Legal and Legislative Matters +Compliance with safety and environmental protection and other governmental requirements may adversely affect our operations. +The shipping industry in general, our business and the operation of our vessels and terminals in particular are affected by extensive and changing safety, environmental protection and other international, national, State and local governmental laws and regulations, including the following: laws pertaining to air emissions; wastewater discharges; the transportation, handling and disposal of solid and hazardous materials, oil and oil-related products, hazardous substances and wastes; the investigation and remediation of contamination; and health, safety and the protection of the environment and natural resources. For example, our U.S. flagged vessels generally must be maintained “in class” and are subject to periodic inspections by the American Bureau of Shipping or similar classification societies, and must be periodically inspected by, or on behalf of, the United States Coast Guard. Federal environmental laws and certain State laws require us, as a vessel operator, to comply with numerous environmental regulations and to obtain certificates of financial responsibility and to adopt procedures for oil and hazardous substance spill prevention, response and clean up. +In complying with these laws, we have incurred expenses and may incur future expenses for vessel modifications, changes in operating procedures and undergoing additional oversight inspections. Changes in enforcement policies for existing requirements and additional laws and regulations adopted in the future could limit our ability to do business or further increase the cost of our doing business. Our vessels’ operating certificates and licenses are renewed periodically during the required annual surveys of the vessels. However, there can be no assurance that such certificates and licenses will be renewed, even though Matson maintains extensive programs and policies to ensure such renewal. Also, in the future, we may have to alter existing equipment, add new equipment, or change operating procedures for our vessels to +18 +Table of Contents +comply with changes in governmental regulations, safety or other equipment standards to meet our customers’ changing needs. If any such costs are material, they could adversely affect our financial condition. +We are subject to regulation and liability under environmental laws that could result in substantial fines and penalties that may have a material adverse effect on our results of operations. +The U.S. Act to Prevent Pollution from vessels, which implements the International Maritime Pollution (MARPOL) treaty, and the Oil Pollution Act of 1990, among many other laws, treaties and regulations, provides for severe civil and criminal penalties related to vessel-generated pollution for incidents in U.S. waters within three nautical miles and in some cases within the 200-mile exclusive economic zone. The EPA requires vessels to obtain coverage under a general permit and to comply with inspection, monitoring, discharge, recordkeeping and reporting requirements. Matson’s vessels operate within sulfur emission control areas (SECAs) or emission control areas (ECAs). If our vessels are not operated in accordance with these requirements, including waivers, permits or record keeping and other reporting requirements, such violations could result in substantial fines or penalties that could have a material adverse effect on our results of operations and our business. +The Company is subject to, and may in the future be subject to disputes, legal or other proceedings, and government inquiries or investigations that could have an adverse effect on the Company. +The nature of the Company’s business exposes it to the potential for disputes, legal or other proceedings, and government inquiries or investigations relating to antitrust matters, labor and employment matters, personal injury and property damage, environmental and other matters, as discussed in the other risk factors disclosed in this section or in other Company filings with the SEC. For example, Matson is a common carrier, whose tariffs, rates, rules and practices in dealing with its customers are governed by extensive and complex foreign, federal, state and local regulations, which may be the subject of disputes or administrative or judicial proceedings. If these disputes develop into proceedings, these proceedings, individually or collectively, could involve or result in significant expenditures or losses by the Company, or result in significant changes to Matson’s tariffs, rates, rules and practices in dealing with its customers, all of which could have an adverse effect on the Company’s future operating results, including profitability, cash flows and financial condition. +Repeal, substantial amendment, or waiver of the Jones Act or its application would have an adverse effect on the Company’s business. +If the Jones Act was to be repealed, substantially amended, or waived and, as a consequence, competitors were to enter the Hawaii or Alaska markets with lower operating costs by utilizing their ability to acquire and operate foreign-flag and foreign-built vessels, the Company’s business would be adversely affected. In addition, the Company’s advantage as a U.S. citizen operator of Jones Act vessels could be eroded by periodic efforts and attempts by foreign interests to circumvent certain aspects of the Jones Act. If maritime cabotage services were included in the General Agreement on Trade in Services, the North American Free Trade Agreement, the United States-Mexico-Canada Agreement, the U.S.‑EU Trade Agreement or other international trade agreements, or if the restrictions contained in the Jones Act were otherwise altered, the shipping of cargo between covered U.S. ports could be opened to foreign-flag or foreign-built vessels. +Non-compliance with, or changes to, federal, state or local law or regulations, including passage of climate change legislation or regulation, may adversely affect the Company’s business. +The Company is subject to federal, state and local laws and regulations, including cabotage laws, government rate regulations, and environmental regulations including those relating to air quality initiatives at port locations, including but not limited to, the Oil Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. Continued compliance with these laws and regulations may result in additional costs and changes in operating procedures that may adversely affect the Company’s business. Non-compliance with, or changes to, the laws and regulations governing the Company’s business could impose significant additional costs on the Company and adversely affect the Company’s financial condition and results of operations. In addition, changes in environmental laws impacting the business, including passage of climate change legislation or other regulatory initiatives that restrict emissions of greenhouse gasses such as a “cap and trade” system of allowances and credits, if enacted, may require costly vessel modifications, the use of higher-priced fuel and changes in operating practices that may not be recoverable +19 +Table of Contents +through increased payments from customers. Further changes to these laws and regulations could adversely affect the Company. +Risks Related to Capital Structure +The Company’s business could be adversely affected if the Company were determined not to be a U.S. citizen under the Jones Act. +Certain provisions of the Company’s articles of incorporation protect the Company’s ability to maintain its status as a U.S. citizen under the Jones Act. Although the Company is a U.S. citizen under the Jones Act, if non-U.S. citizens were able to defeat such articles of incorporation restrictions and own in the aggregate more than 25 percent of the Company’s common stock, the Company would no longer be considered as a U.S. citizen under the Jones Act. Such an event could result in the Company’s ineligibility to engage in coastwise trade and the imposition of substantial penalties against it, including seizure or forfeiture of its vessels, which could have an adverse effect on the Company’s financial condition and results of operation. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +Matson leases terminal facilities including office and storage space at the following locations: +Ocean Transportation Services +Terminal Location +Description of Facility +Acreage +Hawaii +Honolulu, Hawaii +Terminal facility +105 +West Oahu, Hawaii +Terminal storage +7 +Alaska +Anchorage, Alaska +Terminal facility +38 +Kodiak, Alaska +Terminal facility +6 +Dutch Harbor, Alaska +Terminal facility +18 +Guam +Polaris Point, Guam +Terminal storage +30 +The Company is currently renewing certain terminal leases which expire during 2019. The Company expects to be able to renew these leases as they expire on similar terms to those that currently exist within these lease agreements. The Company’s other primary terminal facilities located at the ports of Oakland and Long Beach, California, and the ports of Seattle and Tacoma, Washington are leased by the Company’s Terminal Joint Venture, SSAT. +20 +Table of Contents +The Company’s other significant facilities are as follows: +Other Significant Facilities +Description of Facility +Square Footage +U.S. Office Locations: +Honolulu, Hawaii +Corporate headquarters +16,444 +Oakland, California +Office +48,162 +Phoenix, Arizona +Office +27,986 +Oakbrook Terrace, Illinois +Office +17,004 +Concord, California +Office +7,974 +Asan, Guam +Office +5,000 +Renton, Washington +Office +3,770 +Atlanta, Georgia +Office +3,685 +Akron, Ohio +Office +3,500 +Cerritos, California +Office +1,628 +Hilo, Hawaii +Office +1,205 +Foreign Office Locations: +Shanghai, China +Office +7,240 +Auckland, New Zealand +Office +3,832 +Ningbo, China +Office +2,103 +Hong Kong, China +Office +1,535 +Xiamen, China +Office +1,399 +Shenzhen, China +Office +1,065 +Warehouses, Cross-dock and Storage Facilities: +Pooler, Georgia +Warehouse +710,844 +Oakland, California +Warehouse +400,000 +Pooler, Georgia +Warehouse +324,832 +Oakland, California +Warehouse +132,000 +Tacoma, Washington +Warehouse +80,000 +Piti, Guam +Warehouse +62,478 +Auburn, Washington +Cross-dock +51,250 +Anchorage, Alaska +Cross-dock +23,680 +Anchorage, Alaska +Cross-dock +13,954 +Fairbanks, Alaska +Cross-dock +6,000 +Soldotna, Alaska +Cross-dock +5,400 +Kodiak, Alaska +Cross-dock +4,000 +Auburn, Washington +Cross-dock +2,500 +Wasilla, Alaska +Cross-dock +2,000 +Alameda, California +Storage +53,785 +ITEM 3. LEGAL PROCEEDINGS +Environmental Matters: The Company’s Ocean Transportation segment has certain risks that could result in expenditures for environmental remediation. The Company believes that based on all information available to it, the Company is currently in compliance, in all material respects, with applicable environmental laws and regulations. +Other Matters: The Company and its subsidiaries are parties to, or may be contingently liable in connection with other legal actions arising in the normal course of their businesses, the outcomes of which, in the opinion of management after consultation with counsel, would not have a material effect on the Company’s financial condition, results of operations, or cash flows. +ITEM 4. MINE SAFETY DISCLOSURES +Not Applicable. +21 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +General Information: Matson’s common stock is traded on the New York Stock Exchange under the ticker symbol “MATX”. As of February 20, 2019, there were 2,236 shareholders of record of Matson common stock. +Stockholder Return Performance Graph and Trading Information: The following information in this Item 5 shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933. +The cumulative total return listed below assumed an initial investment of $100 and reinvestment of dividends at each fiscal end and measures the performance of this investment as of the last trading day in the month of December for each of the five years ended December 31, 2018. The graph is a historical representation of past performance only and is not necessarily indicative of future performance. +* $100 invested on December 31, 2013 in stock or index, including reinvestment of dividends. +Trading volume averaged 232,289 shares a day in 2018, compared with 241,338 shares a day in 2017 and 279,852 shares a day in 2016, as reported by the New York Stock Exchange. +22 +Table of Contents +Dividends: Dividends declared per share of common stock by the Company for each fiscal quarter during 2017 and 2018, were as follows: +Dividends +2017 +Declared +First Quarter +$ +0.19 +Second Quarter +$ +0.19 +Third Quarter +$ +0.20 +Fourth Quarter +$ +0.20 +2018 +First Quarter +$ +0.20 +Second Quarter +$ +0.20 +Third Quarter +$ +0.21 +Fourth Quarter +$ +0.21 +Matson’s Board of Directors also declared a cash dividend of $0.21 per share for the first quarter 2019, payable on March 7, 2019 to shareholders of record on February 7, 2019. Although Matson expects to continue paying quarterly cash dividends on its common stock, the declaration and payment of dividends are subject to the discretion of the Board of Directors and will depend upon Matson’s financial condition, results of operations, cash requirements and other factors deemed relevant by the Board of Directors. +Share Repurchases: On November 4, 2015, the Company announced that Matson’s Board of Directors had approved a share repurchase program of up to 3.0 million shares of common stock through November 2, 2018. Shares could be repurchased in the open market from time to time, and may be made pursuant to a trading plan in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934. During the fourth quarter ended December 31, 2018, no shares were repurchased, excluding shares withheld for employee taxes upon vesting of share-based awards. The maximum number of remaining shares that could have been purchased under the share repurchase program was 1,151,288 as of November 2, 2018, when the program expired. +Equity Compensation Plan Information: The following table sets forth, as of December 31, 2018, certain information regarding Matson’s equity compensation plan: +Number of shares +Number of shares +remaining available for +to be issued +Weighted-average +future issuance under +upon exercise of +exercise price of +equity compensation +outstanding options, +outstanding options, +plans (excluding shares +Plan Category +warrants and rights +warrants and rights +reflected in column (a)) +(a) +(b) +(c) +Equity compensation plans approved by shareholders +954,365 +(1) +$ +21.81 +(2) +1,617,553 +(3) +Equity compensation plans not approved by shareholders +— +$ +— +— +Total +954,365 +$ +21.81 +1,617,553 +(1) +In addition to 195,776 shares subject to outstanding stock option awards, includes 427,828 shares subject to unvested restricted stock unit awards and 330,761 shares subject to unvested Performance Share awards. +(2) +As restricted stock unit and Performance Share awards do not have exercise prices, the weighted average exercise price is computed using only outstanding stock option awards. +(3) +These shares are available for issuance under the Company’s 2016 Incentive Compensation Plan. +23 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +The comparative selected financial data of the Company is presented for each of the five years in the period ended December 31, 2018. The information should be read in conjunction with Item 8, “Financial Statements and Supplementary Data,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. All fiscal years include 52 weeks, except for the year ended December 31, 2016 which includes 53 weeks: +(In millions, except shareholders of record and per-share amounts) +2018 +2017 +2016 +2015 +2014 +Operating Revenue: (1) +Ocean Transportation +$ +1,641.3 +$ +1,571.8 +$ +1,541.1 +$ +1,498.0 +$ +1,278.4 +Logistics +581.5 +475.1 +400.5 +386.9 +435.8 +Total Operating Revenue +$ +2,222.8 +$ +2,046.9 +$ +1,941.6 +$ +1,884.9 +$ +1,714.2 +Operating and Net Income: (1) +Ocean Transportation (2)(3) +$ +131.1 +$ +126.4 +$ +144.5 +$ +192.3 +$ +130.9 +Logistics (3) +32.7 +20.9 +12.2 +8.8 +8.7 +Total Operating Income (3) +163.8 +147.3 +156.7 +201.1 +139.6 +Interest expense +(18.7) +(24.2) +(24.1) +(18.5) +(17.3) +Other income (expense), net (3) +2.6 +2.1 +(2.1) +(4.8) +0.4 +Income before Income Taxes +147.7 +125.2 +130.5 +177.8 +122.7 +Income taxes (4)(5) +(38.7) +105.8 +(49.1) +(74.8) +(51.9) +Net Income (5) +$ +109.0 +$ +231.0 +$ +81.4 +$ +103.0 +$ +70.8 +Identifiable Assets: (1) +Ocean Transportation (5)(6) +$ +2,071.6 +$ +1,941.5 +$ +1,726.3 +$ +1,605.1 +$ +1,313.9 +Logistics +358.8 +310.1 +293.3 +68.8 +87.9 +Total Assets (5) +$ +2,430.4 +$ +2,251.6 +$ +2,019.6 +$ +1,673.9 +$ +1,401.8 +Capital Expenditure (7): +Ocean Transportation +$ +385.4 +$ +305.3 +$ +179.1 +$ +67.5 +$ +27.8 +Logistics +15.8 +1.7 +0.3 +0.3 +0.1 +Total Capital Expenditures +$ +401.2 +$ +307.0 +$ +179.4 +$ +67.8 +$ +27.9 +Depreciation and Amortization: +Ocean Transportation +$ +87.0 +$ +93.3 +$ +92.6 +$ +81.4 +$ +66.6 +Logistics +7.4 +7.9 +4.5 +2.0 +3.1 +94.4 +101.2 +97.1 +83.4 +69.7 +Deferred Dry-docking Amortization — Ocean Transportation +37.4 +46.2 +38.9 +23.1 +21.1 +Total Depreciation and Amortization +$ +131.8 +$ +147.4 +$ +136.0 +$ +106.5 +$ +90.8 +Earnings Per Share in Net Income: +Basic (5) +$ +2.55 +$ +5.38 +$ +1.89 +$ +2.37 +$ +1.65 +Diluted (5) +2.53 +5.35 +1.87 +2.34 +1.63 +Cash dividends per share declared +$ +0.82 +$ +0.78 +$ +0.74 +$ +0.70 +$ +0.66 +As of December 31: +Total debt obligations — including current portion +$ +856.4 +$ +857.1 +$ +738.9 +$ +429.9 +$ +373.6 +Total Shareholders' equity (5) +$ +755.3 +$ +677.2 +$ +494.9 +$ +450.6 +$ +363.8 +Shares outstanding +42.7 +42.5 +42.9 +43.5 +43.2 +(1) +2015 and subsequent selected financial data includes the operations of Horizon acquired as of May 29, 2015, and Span Alaska acquired as of August 4, 2016. +(2) +The Ocean Transportation segment includes $36.8 million, $28.2 million, $15.8 million, $16.5 million and $6.6 million of equity in income from the Company’s Terminal Joint Venture, SSAT, for 2018, 2017, 2016, 2015 and 2014, respectively. +(3) +Amounts for the years ended December 31, 2017, 2016, 2015 and 2014 have been adjusted to reflect the adoption of ASU 2017-07 as described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +(4) +Income taxes for the years ended December 31, 2018 and 2017 includes a non-cash income tax (expense)/benefit of $(2.9) million and $154.0 million, respectively, related to the remeasurement of the Company’s deferred assets and liabilities and other discrete adjustments as a result of applying the Tax Cut and Jobs Act of 2017. +(5) +Amounts for the years ended December 31, 2017, 2016 and 2015 have been adjusted for an immaterial correction of an error as described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +(6) +The Ocean Transportation segment includes $87.0 million, $93.2 million, $82.4 million, $66.4 million, and $64.4 million related to the Company’s Terminal Joint Venture investment as of December 31, 2018, 2017, 2016, 2015, and 2014, respectively. +(7) +Excludes expenditures related to Matson’s acquisition of Horizon and Span Alaska which are classified as payments for acquisitions in Cash Flows used in Investing Activities within the Consolidated Statements of Cash Flows. +24 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +FORWARD-LOOKING STATEMENTS AND RISK FACTORS +The Company, from time to time, may make or may have made certain forward-looking statements, whether orally or in writing, such as forecasts and projections of the Company’s future performance or statements of management’s plans and objectives. These statements are “forward-looking” statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be contained in, among other things, SEC filings such as Forms 10-K, 10-Q and 8-K, the Annual Report to Shareholders, press releases made by the Company, the Company’s Internet websites (including websites of its subsidiaries), and oral statements made by the officers of the Company. Except for historical information contained in these written or oral communications, such communications contain forward-looking statements. These include, for example, all references to 2019 or future years. New risk factors emerge from time to time and it is not possible for the Company to predict all such risk factors, nor can it assess the impact of all such risk factors on the Company’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Accordingly, forward-looking statements cannot be relied upon as a guarantee of future results and involve a number of risks and uncertainties that could cause actual results to differ materially from those projected in the statements, including but not limited to the factors that are described in Part I, Item 1A under the caption of “Risk Factors” of this Form 10-K, which section is incorporated herein by reference. The Company is not required, and undertakes no obligation, to revise or update forward-looking statements or any factors that may affect actual results, whether as a result of new information, future events, or circumstances occurring after the date of this report. +OVERVIEW +Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a discussion of the Company’s financial condition, results of operations, liquidity and certain other factors that may affect its future results from the perspective of management. The discussion that follows is intended to provide information that will assist in understanding the changes in the Company’s Consolidated Financial Statements from year to year, the primary factors that accounted for those changes, and how certain accounting principles, policies and estimates affect the Company’s Consolidated Financial Statements. MD&A is provided as a supplement to, and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes to the Consolidated Financial Statements in Item 8 of Part II below. MD&A is presented in the following sections: +· +Business Outlook +· +Consolidated Results of Operations +· +Analysis of Operating Revenue and Income by Segment +· +Liquidity and Capital Resources +· +Contractual Obligations, Commitments, Contingencies and Off-Balance Sheet Arrangements +· +Critical Accounting Estimates +· +Other Matters +25 +Table of Contents +BUSINESS OUTLOOK +The following is the Company’s fourth quarter 2018 discussion and 2019 outlook: +Ocean Transportation: The Company’s container volume in the Hawaii service in the fourth quarter 2018 was flat year-over-year despite modest growth in the Hawaii economy supported primarily by healthy tourism activity and low unemployment. The Company expects volume in 2019 to approximate the level achieved in 2018, reflecting modest economic growth in Hawaii and stable market share. +In China, the Company’s container volume in the fourth quarter 2018 was 3.8 percent higher year-over-year as the Company experienced elevated demand for its service late in the quarter during a period that is traditionally not as strong. The Company continued to realize a sizeable rate premium in the fourth quarter 2018 and achieved average freight rates higher than the fourth quarter 2017. For 2019, the Company expects a lower contribution from its China tradelane following an exceptionally strong performance in 2018 with lower average freight rates and modestly lower volume than the levels achieved in 2018. +In Guam, the Company’s container volume in the fourth quarter 2018 was 10.6 percent higher year-over-year primarily due to typhoon relief volume. For 2019, the Company expects modestly lower volume as the highly competitive environment remains. +In Alaska, the Company’s container volume for the fourth quarter 2018 was 4.2 percent higher year-over-year due to higher northbound volume. For 2019, the Company expects volume to be modestly higher than the level achieved in 2018 with higher northbound volume supported by improving economic conditions in Alaska and higher southbound volume due to stronger seafood harvest levels than in 2018. +The contribution in the fourth quarter 2018 from the Company’s SSAT terminal joint venture investment was $0.9 million lower than the fourth quarter 2017 due primarily to higher operating costs, partially offset by higher revenue resulting from higher lift volume. For 2019, the Company expects the contribution from SSAT to be lower as a result of lower lift volume coming off an exceptionally strong lift volume level in 2018. +As a result of the business outlook noted above, the Company expects full year 2019 Ocean Transportation operating income to approximate the $131.1 million achieved in 2018 after taking into account a full year net operating expense impact of $7.2 million associated with the sale and leaseback of MV Maunalei , as further described below. In the first quarter 2019, the Company expects Ocean Transportation operating income will be approximately $10 million, which is lower than the level achieved in the first quarter 2018 primarily due to the unfavorable comparisons from the absence of positive one-time items at SSAT in the year ago period and Alaska northbound volume associated with the dry-docking of a competitor’s vessel in the first quarter last year, as well as the effect of the aforementioned vessel sale and leaseback. +Logistics: In the fourth quarter 2018, operating income for the Company’s Logistics segment was $4.4 million higher than in the fourth quarter 2017 due to improved performance across all of the service lines. The Company expects Logistics’ operating income for the full year 2019 to approximate the level achieved in 2018 of $32.7 million. In the first quarter 2019, the Company expects operating income to be moderately higher than the level achieved in the first quarter 2018. +Depreciation and Amortization: For the full year 2019, the Company expects depreciation and amortization expense to be approximately $130 million, inclusive of dry-docking amortization of approximately $31 million . +EBITDA: While the Company expects net income in 2019 to decline year-over-year, we expect EBITDA in 2019 to be approximately $286 million, which is approximately the level achieved in 2018 after taking into account the full year impact in 2018 of the $12.0 million of lease expense related to the sale and leaseback of MV Maunalei . As previously disclosed on November 27, 2018, a subsidiary of Matson entered into an agreement whereby MV Maunalei was sold for approximately $106.0 million, and subsequently leased back from the buyer under an operating lease agreement. As a result of this transaction, the Company expects on an annual basis $12.0 million in lease expense and $4.8 million in lower depreciation and amortization expense (including dry-docking amortization), resulting in $7.2 million in lower operating income. +26 +Table of Contents +Other Income (Expense): The Company expects full year 2019 other income (expense) to be approximately $2.7 million in income, which is attributable to other component costs related to the Company’s pension and post-retirement plans. +Interest Expense: The Company expects interest expense for the full year 2019 to be approximately $24 million. +Income Taxes: In the fourth quarter 2018, the Company’s effective tax rate was 23.4 percent. For the full year 2019, the Company expects its effective tax rate to be approximately 26.0 percent, which excludes a positive non-cash adjustment of $2.9 million expected in the first quarter of 2019 related to the reversal of a Tax Act expense adjustment in 2018. +Capital and Vessel Dry-docking Expenditures: For the full year 2018, the Company made other capital expenditure payments of $62.6 million, capitalized vessel construction expenditures of $338.6 million, and dry-docking payments of $19.2 million. For the full year 2019, the Company expects to make other capital expenditure payments, including maintenance capital expenditures, of approximately $120 million, vessel construction expenditures (including capitalized interest and owner’s items) of approximately $225 million, and dry-docking payments of approximately $12 million. The level of other capital expenditures, including maintenance capital expenditures, for 2019 is higher than our targeted annual maintenance level of approximately $50 million due to the installation of three new cranes, refurbishment of three existing cranes, and the infrastructure upgrade at the Sand Island terminal; the scrubber installation on three vessels in the China service; and the construction of a new cross-dock facility in Anchorage for Span Alaska. +CONSOLIDATED RESULTS OF OPERATIONS +The following analysis of the financial condition and results of operations of Matson should be read in conjunction with the Consolidated Financial Statements in Item 8 of Part II below (Income taxes, net income and earnings per-share amounts for the year ended December 31, 2017 have been adjusted for an immaterial correction of an error as described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II below). +Consolidated Results: 2018 compared with 2017: +Years Ended December 31, +(Dollars in millions, except per-share amounts) +2018 +2017 +Change +Operating revenue +$ +2,222.8 +$ +2,046.9 +$ +175.9 +8.6 +% +Operating costs and expenses +(2,059.0) +(1,899.6) +(159.4) +8.4 +% +Operating income +163.8 +147.3 +16.5 +11.2 +% +Interest expense +(18.7) +(24.2) +5.5 +(22.7) +% +Other income (expense), net +2.6 +2.1 +0.5 +23.8 +% +Income before income taxes +147.7 +125.2 +22.5 +18.0 +% +Income taxes +(38.7) +105.8 +(144.5) +(136.6) +% +Net income +$ +109.0 +$ +231.0 +$ +(122.0) +(52.8) +% +Basic earnings per-share +$ +2.55 +$ +5.38 +$ +(2.83) +(52.6) +% +Diluted earnings per-share +$ +2.53 +$ +5.35 +$ +(2.82) +(52.7) +% +Fiscal Year: Fiscal years ended December 31, 2018 and 2017 include 52 weeks. +Consolidated Operating Revenue for the year ended December 31, 2018 increased $175.9 million, or 8.6 percent, compared to the prior year. The increase was due to an increase of $69.5 million and $106.4 million in revenues for Ocean Transportation and Logistics, respectively. +Operating Costs and Expenses for the year ended December 31, 2018 increased $159.4 million, or 8.4 percent, compared to the prior year. The increase was due to an increase of $64.8 million and $94.6 million in operating costs and expenses for Ocean Transportation and Logistics, respectively. +Operating Income for the year ended December 31, 2018 increased $16.5 million, or 11.2 percent, compared to the prior year. The increase was due to an increase of $4.7 million and $11.8 million in operating income for Ocean Transportation and Logistics, respectively. +27 +Table of Contents +The reasons for changes in operating revenue, operating costs and expenses, and operating income are described below, by business segment, in the Analysis of Operating Revenue and Income by Segment. +Interest Expense was $18.7 million for the year ended December 31, 2018 compared to $24.2 million for the year ended December 31, 2017. The reduction in interest expense was due to higher capitalized interest related to the construction of new vessels. +Other Income (Expense), net was $2.6 million for the year ended December 31, 2018, compared to $2.1 million for the year ended December 31, 2017, and relates to the amortization of certain components of net periodic benefit costs or gains related to the Company’s pension and post-retirement plans. +Income Taxes during the year ended December 31, 2018 was an expense of $38.7 million, or 26.2 percent of income before income taxes, as compared to a non-cash income tax benefit of $105.8 million, or 84.5 percent of income before income taxes in the prior year. The non-cash income tax benefit for the year ended December 31, 2017 included the benefit of $154.0 million related to the remeasurement of the Company’s deferred assets and liabilities, and other discrete tax adjustments resulting from applying the Tax Cuts and Jobs Act of 2017 (the “Tax Act”). Excluding the impact of the Tax Act, adjusted income tax expense would have been $48.2 million, or 38.5 percent of income before income taxes, for the year ended December 31, 2017. The 2018 income tax rate is lower than the adjusted 2017 income tax rate primarily due to a reduction in federal tax rate from 35 percent in 2017 to 21 percent in 2018, offset by $2.9 million, or 2.0 percent of non-cash expense related to discrete tax adjustments resulting from applying the Tax Act in 2018. +Net Income during the year ended December 31, 2018 decreased $122.0 million, or 52.8 percent, compared to the prior year. +Consolidated Results: 2017 compared with 2016: +Years Ended December 31, +(Dollars in millions, except per-share amounts) +2017 +2016 +Change +Operating revenue +$ +2,046.9 +$ +1,941.6 +$ +105.3 +5.4 +% +Operating costs and expenses +(1,899.6) +(1,784.9) +(114.7) +6.4 +% +Operating income +147.3 +156.7 +(9.4) +(6.0) +% +Interest expense +(24.2) +(24.1) +(0.1) +0.4 +% +Other income (expense), net +2.1 +(2.1) +4.2 +(200.0) +% +Income before income taxes +125.2 +130.5 +(5.3) +(4.1) +% +Income taxes +105.8 +(49.1) +154.9 +(315.5) +% +Net income +$ +231.0 +$ +81.4 +$ +149.6 +183.8 +% +Basic earnings per-share +$ +5.38 +$ +1.89 +$ +3.49 +184.7 +% +Diluted earnings per-share +$ +5.35 +$ +1.87 +$ +3.48 +186.1 +% +Fiscal Year: Fiscal year ended December 31, 2017 and 2016 include 52 weeks and 53 weeks, respectively. +Consolidated Operating Revenue for the year ended December 31, 2017 increased $105.3 million, or 5.4 percent, compared to the prior year due to increases of $30.7 million and $74.6 million in Ocean Transportation and Logistics revenues, respectively. +Operating Costs and Expenses for the year ended December 31, 2017 increased $114.7 million, or 6.4 percent, compared to the prior year. The increase was due to an increase of $48.8 million and $65.9 million in operating costs and expenses for Ocean Transportation and Logistics, respectively. +Operating Income for the year ended December 31, 2017 decreased $9.4 million, or 6.0 percent, compared to the prior year. The decrease was due to a decrease of $18.1 million for Ocean Transportation, partially offset by an increase of $8.7 million for Logistics in operating income. +The reasons for changes in operating revenue, operating costs and expenses, and operating income are described below, by business segment, in the Analysis of Operating Revenue and Income by Segment. +28 +Table of Contents +Interest Expense was $24.2 million for the year ended December 31, 2017, compared to $24.1 million for the year ended December 31, 2016. The increase in interest expense was due to higher borrowings as a result of recent acquisitions and vessel construction payments, offset by higher capitalized interest. +Other Income (Expense), net for the year ended December 31, 2017 was income of $2.1 million, compared to expense of $2.1 million for the year ended December 31, 2016, and relates to the amortization of certain components of net periodic benefit costs or gains related to the Company’s pension and post-retirement plans. +Income Taxes during the year ended December 31, 2017 was a non-cash income tax benefit of $105.8 million, or 84.5 percent of income before income taxes, as compared to income tax expense of $49.1 million, or 37.6 percent of income before income taxes in the prior year. The non-cash income tax benefit includes the benefit of $154.0 million related to the remeasurement of the Company’s deferred assets and liabilities, and other discrete tax adjustments resulting from applying the Tax Act as of December 31, 2017. Excluding the impact of the Tax Act, adjusted income tax expense would have been $48.2 million, or 38.5 percent of income before income taxes for the year ended December 31, 2017. The adjusted 2017 income tax rate would have been higher than the 2016 income tax rate as the 2016 income tax rate was favorably impacted by the release of unrecognized tax benefit reserves during 2016. +Net Income during the year ended December 31, 2017 increased $149.6 million, or 183.8 percent, compared to the prior year. +ANALYSIS OF OPERATING REVENUE AND INCOME BY SEGMENT +Additional detailed information related to the operations and financial performance of the Company’s reportable segments is included in Part II Item 6 and Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. The following information should be read in relation to the information contained in those sections. +Ocean Transportation: 2018 compared with 2017: +Years Ended December 31, +(Dollars in millions) +2018 +2017 +Change +Ocean Transportation revenue +$ +1,641.3 +$ +1,571.8 +$ +69.5 +4.4 +% +Operating costs and expenses +(1,510.2) +(1,445.4) +(64.8) +4.5 +% +Operating income +$ +131.1 +$ +126.4 +$ +4.7 +3.7 +% +Operating income margin +8.0 +% +8.0 +% +Volume (Forty-foot equivalent units (FEU) except for automobiles) (1) +Hawaii containers +148,700 +149,800 +(1,100) +(0.7) +% +Hawaii automobiles +63,100 +67,000 +(3,900) +(5.8) +% +Alaska containers +69,100 +67,400 +1,700 +2.5 +% +China containers +61,600 +66,000 +(4,400) +(6.7) +% +Guam containers +19,700 +20,300 +(600) +(3.0) +% +Other containers (2) +16,300 +11,700 +4,600 +39.3 +% +(1) +Approximate volumes included for the period are based on the voyage departure date, but revenue and operating income are adjusted to reflect the percentage of revenue and operating income earned during the reporting period for voyages in transit at the end of each reporting period. +(2) +Includes containers from services in various islands in Micronesia and the South Pacific, and in Okinawa, Japan. +Ocean Transportation revenue increased $69.5 million, or 4.4 percent, during the year ended December 31, 2018, compared with the year ended December 31, 2017. This increase was primarily due to higher fuel surcharge revenue, higher average freight rates in China and higher revenue in Japan, partially offset by lower revenue in Guam. +On a year-over-year FEU basis, Hawaii container volume decreased by 0.7 percent primarily due to lower eastbound volume; Alaska volume increased by 2.5 percent primarily due to an increase in northbound volume, partially offset by a decrease in southbound volume as a result of a weaker-than-expected seafood season compared with the very strong seafood harvest levels in 2017; China volume was 6.7 percent lower due to fewer sailings and lower volume during the Lunar New Year period; Guam volume was 3.0 percent lower primarily due to increased competition; and Other containers volume increased 39.3 percent largely due to the Japan service. +29 +Table of Contents +Ocean Transportation operating income increased $4.7 million, or 3.7 percent, during the year ended December 31, 2018, compared with the year ended December 31, 2017. This increase was primarily due to higher average rates in China and Hawaii and a higher contribution from SSAT, partially offset by higher terminal handling costs and a lower contribution from Guam. +The Company’s SSAT terminal joint venture investment contributed $36.8 million during the year ended December 31, 2018, compared to a contribution of $28.2 million during the year ended December 31, 2017. The increase was primarily attributable to higher lift volume. +Ocean Transportation: 2017 compared with 2016: +Years Ended December 31, +(Dollars in millions) +2017 +2016 (3) +Change +Ocean Transportation revenue +$ +1,571.8 +$ +1,541.1 +$ +30.7 +2.0 +% +Operating costs and expenses +(1,445.4) +(1,396.6) +(48.8) +3.5 +% +Operating income +$ +126.4 +$ +144.5 +$ +(18.1) +(12.5) +% +Operating income margin +8.0 +% +9.4 +% +Volume (Forty-foot equivalent units (FEU) except for automobiles) (1) +Hawaii containers +149,800 +160,200 +(10,400) +(6.5) +% +Hawaii automobiles +67,000 +75,200 +(8,200) +(10.9) +% +Alaska containers +67,400 +68,400 +(1,000) +(1.5) +% +China containers +66,000 +61,600 +4,400 +7.1 +% +Guam containers +20,300 +24,800 +(4,500) +(18.1) +% +Other containers (2) +11,700 +10,500 +1,200 +11.4 +% +(1) +Approximate volumes included for the period are based on the voyage departure date, but revenue and operating income are adjusted to reflect the percentage of revenue and operating income earned during the reporting period for voyages in transit at the end of each reporting period. +(2) +Includes containers from services in various islands in Micronesia and the South Pacific, and in Okinawa, Japan. +(3) +2016 includes the benefit of a 53 rd week. +Ocean Transportation revenue increased $30.7 million, or 2.0 percent, during the year ended December 31, 2017, compared with the year ended December 31, 2016. This increase was primarily due to higher fuel surcharge revenue and higher average freight rates in China, partially offset by lower construction-related volume, one less week and the absence of competitive volume gains in Hawaii and lower volume in Guam due to competitive losses and one less week. +On a year-over-year FEU basis, Hawaii container volume decreased by 6.5 percent primarily due to lower construction-related volume, one less week, and the absence of competitive volume gains in the prior year; Alaska volume decreased by 1.5 percent primarily due to one less week, partially offset by higher southbound volume attributable to the stronger seafood season; China volume was 7.1 percent higher due to stronger demand for the Company’s expedited service and additional sailings during the year; and Guam volume was 18.1 percent lower due to competitive losses and one less week. +Ocean Transportation operating income decreased $18.1 million, or 12.5 percent, during the year ended December 31, 2017, compared with the year ended December 31, 2016. This decrease was primarily due to lower volumes in Hawaii, higher terminal handling costs and lower volume in Guam, partially offset by higher average freight rates in China, a higher contribution from SSAT, and favorable timing of fuel surcharge collections. +The Company’s SSAT terminal joint venture investment contributed $28.2 million during the year ended December 31, 2017, compared to a $15.8 million contribution in the year ended December 31, 2016. The increase was primarily attributable to improved lift volume. +Logistics: 2018 compared with 2017: +Years Ended December 31, +(Dollars in millions) +2018 +2017 +Change +Logistics revenue +$ +581.5 +$ +475.1 +$ +106.4 +22.4 +% +Operating costs and expenses +(548.8) +(454.2) +(94.6) +20.8 +% +Operating income +$ +32.7 +$ +20.9 +$ +11.8 +56.5 +% +Operating income margin +5.6 +% +4.4 +% +30 +Table of Contents +Logistics revenue increased $106.4 million, or 22.4 percent, during the year ended December 31, 2018, compared with the year ended December 31, 2017. This increase was primarily due to higher transportation brokerage revenue. +Logistics operating income increased $11.8 million, or 56.5 percent, for the year ended December 31, 2018, compared with the year ended December 31, 2017. The increase was primarily due to higher contributions from transportation brokerage and freight forwarding. +Logistics: 2017 compared with 2016: +Years Ended December 31, +(Dollars in millions) +2017 +2016 +Change +Logistics Revenue (1) +$ +475.1 +$ +400.5 +$ +74.6 +18.6 +% +Operating costs and expenses (1) +(454.2) +(388.3) +(65.9) +17.0 +% +Operating income (1) +$ +20.9 +$ +12.2 +$ +8.7 +71.3 +% +Operating income margin (1) +4.4 +% +3.0 +% +(1) +Logistics operating results include Span Alaska operating results from the date of acquisition on August 4, 2016. +Logistics revenue increased $74.6 million, or 18.6 percent, during the year ended December 31, 2017, compared with the year ended December 31, 2016. This increase was primarily due to the inclusion of freight forwarding revenue from the acquired Span Alaska business, higher intermodal volumes, and higher fuel surcharge revenue. +Logistics operating income increased $8.7 million, or 71.3 percent, during the year ended December 31, 2017, compared with the year ended December 31, 2016. The increase was primarily due to the inclusion of freight forwarding operating results attributable to the acquired Span Alaska business, partially offset by lower intermodal yield. +LIQUIDITY AND CAPITAL RESOURCES +Sources of liquidity available to the Company at December 31, 2018 compared to December 31, 2017, were as follows: +Cash and Cash Equivalents, Restricted Cash and Accounts Receivable : Cash and cash equivalents, restricted cash and accounts receivable, net, as of December 31, 2018 and 2017 is as follows: +As of December 31, +(In millions) +2018 +2017 +Change +Cash and cash equivalents +$ +19.6 +$ +19.8 +$ +(0.2) +Restricted cash +$ +4.9 +$ +— +$ +4.9 +Accounts receivable, net (1) +$ +223.7 +$ +194.6 +$ +29.1 +(1) +Eligible accounts receivable of $1.0 million and $134.8 million at December 31, 2018 and 2017, respectively, were assigned to the CCF. +Changes in the Company’s cash, cash equivalents and restricted cash for the years ended December 31, 2018, 2017 and 2016 were as follows: +As of December 31, +(In millions) +2018 +2017 +2016 +2018-2017 +2017-2016 +Net cash provided by operating activities (1) +$ +305.0 +$ +224.9 +$ +157.8 +$ +80.1 +$ +67.1 +Net cash used in investing activities (2) +(260.3) +(276.9) +(320.7) +16.6 +43.8 +Net cash (used in) provided by financing activities (3) +(40.0) +57.9 +151.3 +(97.9) +(93.4) +Net increase (decrease) in cash, cash equivalents and restricted cash +4.7 +5.9 +(11.6) +(1.2) +17.5 +Cash, cash equivalents, and restricted cash, beginning of the period +19.8 +13.9 +25.5 +5.9 +(11.6) +Cash, cash equivalents, and restricted cash, end of the period +$ +24.5 +$ +19.8 +$ +13.9 +$ +4.7 +$ +5.9 +31 +Table of Contents +(1) +Changes in Net Cash Provided by Operating Activities: Changes in net cash provided by operating activities for the years ended December 31, 2018, 2017 and 2016 were as follows: +Change +(In millions) +2018-2017 +2017-2016 +Net income from operations +$ +(122.0) +$ +149.6 +Non-cash deferred income taxes +157.2 +(152.6) +Other non-cash related changes, net +(19.5) +11.5 +Equity income and distributions from Terminal Joint Venture +15.9 +5.1 +Deferred dry-docking payments +35.4 +4.6 +Accounts receivable, net +(24.0) +(19.5) +Prepaid expenses and other assets +(10.2) +28.0 +Accounts payable, accruals and other liabilities +50.8 +18.3 +Other long-term liabilities +(3.5) +22.1 +Total +$ +80.1 +$ +67.1 +The change in deferred income taxes is primarily related to the remeasurement of the Company’s deferred assets and liabilities, and other discrete tax adjustments resulting from applying the Tax Act as of December 31, 2017. The Company’s share of income from the Terminal Joint Venture was $36.8 million during the year ended December 31, 2018, compared to $28.2 million in the prior year, while distributions from the Terminal Joint Venture increased to $42.0 million during the year ended December 31, 2018, compared to $17.5 million of distributions received in the prior year. Decrease in deferred dry-docking payments was due to fewer dry-docking activities during the year ended December 31, 2018, compared to the prior year. Changes in accounts receivable are due to increases in the amount of revenue invoiced and the timing of collections as of December 31, 2018, compared to the prior year. Changes in prepaid expenses and other assets are due to the timing of prepaid income taxes, changes in the amount of insurance related receivables and changes in other prepaid amounts as of December 31, 2018, compared to the prior year. Changes in accounts payable, accruals and other liabilities for the year ended December 31, 2018, compared to the prior year are due to the timing of payments associated with those liabilities. +(2) +Changes in Net Cash Used in Investing Activities: Changes in net cash used in investing activities for the years ended December 31, 2018, 2017 and 2016 were as follows: +Change +(In millions) +2018-2017 +2017-2016 +Capitalized vessel construction expenditures +$ +(86.6) +$ +(157.5) +Cash deposits into CCF +(168.6) +(48.0) +Withdrawals from CCF +139.2 +109.5 +Other capital expenditures +(7.6) +29.9 +Proceeds from disposal of property and equipment, net +136.5 +(2.7) +Proceeds from sale of other investments +3.7 +— +Payments for membership interests in Span Alaska, net of cash acquired +— +112.6 +Total +$ +16.6 +$ +43.8 +Capitalized vessel construction expenditures (including capitalized interest and owners’ items) was $338.6 million for the year ended December 31, 2018, compared to $252.0 million in the year ended December 31, 2017. The increase in capitalized vessel construction expenditures (including cash deposited into the CCF less cash withdrawals from the CCF which are used for vessel construction related payments) is due to the timing of progress payments related to the construction of four new vessels. Other capital expenditures (excluding capitalized vessel construction expenditures) was $62.6 million for the year ended December 31, 2018, compared to $55.0 million for the year ended December 31, 2017. The increase was primarily due to higher levels of capital expenditures during the year ended December 31, 2018, including capital expenditures related to the Hawaii Sand Island terminal and the Anchorage cross-dock facility, compared to the prior year. Proceeds from the disposal of property and equipment was $136.3 million for the year ended December 31, 2018, included net proceeds of approximately $106.0 million from the sale and leaseback of a vessel, and $28.4 million from other container and equipment sale and leaseback transactions entered into during 2018. There were no sale and leaseback transactions in 2017. Proceeds from the sale of investments of $3.7 million related to the surrender of life insurance policies. +32 +Table of Contents +There were no acquisition related payments during the years ended December 31, 2018 and 2017. During the year ended December 31, 2016, the Company paid $112.6 million related to the acquisition of Span Alaska (see Note 18 to the Consolidated Financial Statements in Item 8 of Part II below for additional information on the Company’s acquisitions). +(3) +Changes Net Cash Used in Financing Activities: Changes in net cash used in financing activities for the years ended December 31, 2018, 2017 and 2016 were as follows: +Change +(In millions) +2018-2017 +2017-2016 +Proceeds received from issuance of fixed interest debt +$ +— +$ +(275.0) +Repayments of fixed interest debt and capital leases +1.1 +(9.6) +Borrowings under revolving credit facility, net +(120.0) +95.0 +Repurchase of Matson common stock +19.3 +18.7 +Dividends paid +(1.6) +(1.6) +Payments of Span Alaska debt +— +81.9 +Change in other payments, net +3.3 +(2.8) +Total +$ +(97.9) +$ +(93.4) +Changes in the Company’s debt are described below. During the year ended December 31, 2017, the Company repurchased $19.3 million of Matson stock. There was no repurchase of Matson stock during the year ended December 31, 2018. Dividends paid was $35.4 million for the year ended December 31, 2018, compared to $33.8 million for the year ended December 31, 2017. There were no payments of acquisition related debt during the years ended December 31, 2018 or 2017. During the year ended December 31, 2016, the Company repaid all of Span Alaska’s outstanding debt of $81.9 million (see Note 18 to the Consolidated Financial Statements in Item 8 of Part II below for additional information on the Company’s acquisitions). +Debt: Total debt as of December 31, 2018 and 2017 is as follows: +As of December 31, +(In millions) +2018 +2017 +Change +Revolving credit facility +$ +235.0 +$ +205.0 +$ +30.0 +Fixed interest debt +621.4 +652.1 +(30.7) +Total Debt +$ +856.4 +$ +857.1 +$ +(0.7) +Total debt decreased by $0.7 million during the year ended December 31, 2018, compared to the prior year. Changes in debt primarily related to a net increase in revolving credit facility borrowing of $30.0 million, primarily used to fund progress payments related to the construction of four new vessels, offset by repayments of fixed interest debt of $30.7 million. +As of December 31, 2018, the Company had $304.0 million of remaining availability under the revolving credit facility, with a maturity date of June 29, 2022. The Company’s debt is described in Note 8 to the Consolidated Financial Statements in Item 8 of Part II. +Working Capital: The Company had negative working capital of $52.4 million at December 31, 2018, compared to negative working capital of $20.3 million at December 31, 2017. +33 +Table of Contents +CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS +Contractual Obligations: +At December 31, 2018, the Company had the following estimated contractual obligations: +Payment Due By Period +Contractual Obligations (in millions) +2019 +2020-2021 +2022-2023 +Thereafter +Total +Vessel construction obligations (1) +$ +188.9 +$ +61.7 +$ +— +$ +— +$ +250.6 +Total debt obligations (2) +42.1 +102.6 +354.8 +356.9 +856.4 +Estimated interest on debt (3) +33.0 +60.1 +37.3 +68.0 +198.4 +Vendor and other obligations (4) +29.4 +— +— +— +29.4 +Qualified defined benefit pension obligations (5) +13.2 +27.3 +28.6 +75.0 +144.1 +Non-qualified pension obligations (5) +1.8 +0.4 +2.1 +0.1 +4.4 +Post-retirement benefit obligations (5) +1.2 +2.3 +2.4 +5.8 +11.7 +Multi-employer withdrawal obligations (6) +10.8 +8.2 +8.2 +68.0 +95.2 +Operating lease obligations (7) +68.3 +104.0 +65.2 +83.6 +321.1 +Total +$ +388.7 +$ +366.6 +$ +498.6 +$ +657.4 +$ +1,911.3 +(1) +Vessel construction obligations represent contractual agreements entered into for the construction of new vessels. +(2) +Total debt obligations include principal repayments of outstanding debt and capital leases (see Note 8 to the Consolidated Financial Statements in Item 8 of Part II below for additional information about debt). +(3) +Estimated interest on debt is determined based on: (i) the stated interest rate for fixed debt, and (ii) the estimated variable interest on revolving credit facility assuming the balance at December 31, 2018 remains outstanding until maturity. +(4) +Vendor and other obligations include: (i) non-cancellable contractual capital project obligations (excluding vessel construction obligations shown in (1) above); (ii) dry-docking related obligations; and (iii) other contractual obligations. Amounts are considered obligations if a contract has been agreed to specifying significant terms of the contract, and the amounts are not reflected in the Consolidated Balance Sheets. +(5) +Qualified defined benefit pension, non-qualified pension and post-retirement benefit obligations include estimated payments for the next ten years. The amounts noted in the column labeled “Thereafter” comprises estimated benefit payments for 2024 through 2028 (see Note 11 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(6) +Multi-employer withdrawal obligations relate to the discounted liability associated with Horizon’s mass withdrawal from Puerto Rico’s multi-employer ILA-PRSSA and the partial withdrawal liability associated with the Local 153 Fund of the OPEIU (see Note 12 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(7) +Operating lease obligations primarily consist of real estate and terminal leases, vessel charter leases, operations equipment and other leases entered into under non-cancellable arrangements that do not transfer the rights and risks of ownership to the Company (see Note 9 to the Consolidated Financial Statements in Item 8 of Part II below for additional information). +Estimated timing and amount of payments related to unrecognized tax benefits of $15.1 million as of December 31, 2018 are excluded from the table due to the uncertainty of such timing and payments, if any. +Commitments, Contingencies and Off-Balance Sheet Arrangements: +Commitments and Contingencies: A description of other commitments and contingencies is set forth in Note 9, Note 11 and Note 17 to the Consolidated Financial Statements in Item 8 of Part II below, and is incorporated herein by reference. +Off-balance sheet Arrangements: Except as described below, the Company is not party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, results in operations or cash flows. +Future minimum payments under operating leases are $321.1 million as of December 31, 2018. In addition, the Company provided a lessor with a maximum residual value guarantee related to the lease of a vessel. Additional information related to leases and the vessel lease guarantee is set forth in Note 9 to the Consolidated Financial Statements in Item 8 of Part II below, and is incorporated herein by reference. +34 +Table of Contents +CRITICAL ACCOUNTING ESTIMATES +The Company’s significant accounting policies are described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. The preparation of Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America, upon which the Company’s Management Discussion and Analysis of Financial Condition and Results of Operations is based, requires that management exercise judgment when making accounting estimates about future events that may affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Future events and their effects cannot be determined with certainty and actual results will, inevitably, differ from those accounting estimates. These differences could be material. +The Company considers an accounting estimate to be critical if: (i)(a) the accounting estimate requires the Company to make assumptions that are difficult or subjective about matters that were highly uncertain at the time that the accounting estimate was made, (b) changes in the estimate are reasonably likely to occur in periods after the period in which the estimate was made, or (c) use of different estimates by the Company could have been used; and (ii) changes in those accounting estimates would have had a material impact on the financial condition or results of operations of the Company. The critical accounting estimates inherent in the preparation of the Company’s Consolidated Financial Statements are described below. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors. +Impairment of Long-Lived Assets, Intangible Assets and Goodwill: The Company evaluates its long-lived assets, intangible assets and goodwill for possible impairment in the fourth quarter, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value is less than its carrying amount. The Company has reporting units within the Ocean Transportation and Logistics reportable segments. +Long-lived Assets and Finite-lived Intangible Assets: Long-lived assets and finite-lived intangible assets are grouped at the lowest level reporting unit for which identifiable cash flows are available. In evaluating impairment, the estimated future undiscounted cash flows generated by each of these asset groups is compared with the carrying value recorded for each asset group to determine if its carrying value is not recoverable. If this review determines that the amount recorded will not be recovered, the amount recorded for the asset group is reduced to its estimated fair value. These asset impairment analyses are highly subjective because they require management to make assumptions and apply considerable judgments to, among other things, estimates of the timing and amount of future cash flows, expected useful lives of the assets, uncertainty about future events, including changes in economic conditions, changes in operating performance, changes in the use of the assets, and ongoing costs of maintenance and improvements of the assets, and thus, the accounting estimates may change from period to period. If management uses different assumptions or if different conditions occur in future periods, the Company’s financial condition or its future operating results could be materially impacted. The Company has evaluated its long-lived assets and finite lived intangible assets for impairment and determined that the fair values are not less than the carrying amounts. No impairment charges related to long-lived assets and finite-lived intangible assets were recorded for the years ended December 31, 2018, 2017, and 2016. +Indefinite-life Intangible Assets and Goodwill: The Company’s intangible assets include goodwill, customer relationships and a trade name. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of earnings before income taxes, depreciation and amortization (“EBITDA”). The discounted cash flow approach requires the Company to use a number of assumptions, including market factors specific to the business, the amount and timing of estimated future cash flows to be generated by the business over an extended period of time, long-term growth rates for the business, and a discount rate that considers the risks related to the amount and timing of the cash flows. Although the assumptions used by the Company in its discounted cash flow model are consistent with the assumptions the Company used to generate its internal strategic plans and forecasts, significant judgment is required to estimate the amount and timing of future cash flows from the reporting unit and the risk of achieving those cash flows. When using market multiples of EBITDA, the Company makes judgments about the comparability of multiples in closed and proposed transactions. Accordingly, changes in assumptions and estimates, including, but not limited to, changes driven by external factors, such as industry and economic trends, and those driven by internal factors, such as changes in the Company’s business strategy and its internal forecasts, could have a material effect on the Company’s financial condition or its future operating results. The Company has evaluated its indefinite-life intangible assets and goodwill for impairment and determined that the respective fair value of goodwill attributed to the Ocean Transportation and the Logistics reporting units exceeded the +35 +Table of Contents +carrying amount as of the date of the impairment review. No impairment charges of indefinite-life intangible assets and goodwill were recorded for the years ended December 31, 2018, 2017 and 2016. +Legal Contingencies: The Company’s results of operations could be affected by significant litigation adverse to the Company, including, but not limited to, liability claims, antitrust claims, claims related to coastwise trading matters, lawsuits involving private plaintiffs or government agencies, and environment related matters. The Company records accruals for legal matters when the information available indicates that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Management makes adjustments to these accruals to reflect the impact and status of negotiations, settlements, rulings, advice of outside legal counsel and other information and events that may pertain to a particular matter. In making determinations of likely outcomes of litigation matters, the Company considers many factors. These factors include, but are not limited to, the nature of specific claims including un-asserted claims, the Company’s experience with similar types of claims, the jurisdiction in which the matter is filed, input from outside legal counsel, the likelihood of resolving the matter through alternative dispute resolution mechanisms and the matter’s current status. Predicting the outcome of claims and lawsuits, and estimating related costs and exposure involves substantial uncertainties that could cause actual costs to vary materially from those estimates. +Uninsured Risks and Related Liabilities: The Company is uninsured for certain risks but when feasible, many risks are mitigated by insurance. The Company purchases insurance with deductibles or self-insured retentions. Such insurance includes, but is not limited to, employee health, workers’ compensation, marine liability, auto liability and physical damage to inland property, equipment and vessels. For certain risks, the Company elects to not purchase insurance because of excessive cost of insurance or the perceived remoteness of the risk. In addition, the Company retains all risk of loss that exceeds the limits of the Company’s insurance policies. +When estimating its reserves for uninsured risks and related liabilities, the Company considers a number of factors, including historical claims experience, demographic factors, current trends, and analyses provided by independent third-parties. Periodically, management reviews its assumptions and estimates used to determine the adequacy of the Company’s reserves for uninsured risks and related liabilities. The Company’s uninsured risks and related liabilities contain uncertainties because management is required to apply judgment and make long-term assumptions to estimate the ultimate cost to settle reported claims, and of claims incurred but not reported, as of the balance sheet date. If management uses different assumptions or if different conditions occur in future periods, the Company’s financial condition or its future operating results could be materially impacted. +Pension and Post-Retirement Estimates: The estimation of the Company’s pension and post-retirement benefit expenses and liabilities requires that the Company make various assumptions. These assumptions include factors such as discount rates, expected long-term rate of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates and expected contributions. Actual results that differ from the assumptions made could materially affect the Company’s financial condition or its future operating results. The effects of changing assumptions are included in unamortized net gains and losses, which directly affect accumulated other comprehensive income (loss). Additionally, these unamortized gains and losses are amortized and reclassified to income (loss) over future periods. +Additional information about the Company’s benefit plans and assumptions used is included in Note 11 to the Consolidated Financial Statements in Item 8 of Part II below. +Income Taxes: The Company makes certain estimates and judgments in determining income tax expense for Consolidated Financial Statement purposes. These estimates and judgments are applied in the calculation of taxable income, tax credits, tax benefits and deductions, and in the calculation of certain deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue, costs and expenses for tax purposes. Deferred tax assets and liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. Significant changes to these estimates may result in an increase or decrease to the Company’s income taxes in a subsequent period. +The Company records a valuation allowance if, based on the weight of available evidence, management believes that it is more likely than not that some portion or all of a recorded deferred tax asset would not be realized in future periods. +The Company’s valuation allowance against deferred tax assets was $11.5 million and $13.0 million at December 31, 2018 and 2017, respectively, and related to accumulated operating losses of a foreign subsidiary and various state net operating losses that the Company determined may not be realized in future periods. +36 +Table of Contents +The calculation of deferred tax assets and liabilities may be impacted by various factors including but not limited to changes in tax rates; changes in tax laws, regulations, and rulings; changes in interpretations of existing tax laws, regulations and rulings; and changes in the evaluation of the Company’s ability to realize deferred tax assets including operating loss and tax credit carryforwards. Deferred tax assets and deferred tax liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. On December 22, 2017, the Tax Act was signed into law. The Tax Act includes numerous changes in existing tax law, including a reduction in the federal corporate income tax rate from 35 percent to 21 percent. The rate reduction and other changes took effect on January 1, 2018. Other changes such as remeasurement of deferred tax assets and liabilities are effective as of the fourth quarter of 2017. +In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertain tax positions taken or expected to be taken with respect to the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could materially impact the Company’s financial condition or its future operating results. +Additional information about the Company’s income taxes is included in Note 10 to the Consolidated Financial Statements in Item 8 of Part II below. +OTHER MATTERS +New Accounting Pronouncements: See Note 2 to the Consolidated Financial Statements in Item 8 of Part II below for additional information on new accounting pronouncements. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Debt and Interest Rate Risks: The Company is exposed to changes in interest rates, primarily as a result of its borrowing and investing activities used to maintain liquidity and to fund business operations, including borrowings under its revolving credit facility. In order to manage its exposure to changes in interest rates, the Company utilizes a balanced mix of both fixed-rate and variable-rate debt with various maturity dates. The nature and amount of the Company’s outstanding debt is expected to fluctuate as a result of future business requirements, market conditions and other factors. The Company’s outstanding variable and fixed rate debt was $235.0 million and $621.4 million as of December 31, 2018, and $205.0 million and $652.1 million as of December 31, 2017, respectively. Additional information about the Company’s debt is included in Note 8 to the Consolidated Financial Statements in Item 8 of Part II below. +Other than in certain events of default, the Company is not obligated to prepay its variable and fixed rate debt prior to maturity. For fixed rate debt, changes in market interest rates would not affect the Company’s financial condition or results of operations. For variable rate debt, a 100 basis point increase in the variable interest rate would have an impact on the Company’s results of operations for 2018 of approximately $2.4 million, assuming the December 31, 2018 balance of the variable rate debt was outstanding throughout 2018. This change is not expected to have a material impact on the fair value of the Company’s variable rate debt. +Investment Risks: From time to time, the Company may invest its excess cash in short-term money market funds that purchase government securities or corporate debt securities, or in other deposit products allowed under the Company’s Cash Investment Policy. These money market funds and deposits maintain a weighted average maturity of less than 90 days, and accordingly, a one percent change in interest rates is not expected to have a material impact on the fair value of these investments or on interest income. The Company had a nominal amount on deposit in money market funds as of December 31, 2018 and 2017. +Through its Capital Construction Fund (“CCF”), the Company may, from time to time, invest in money market funds or other eligible investments. The Company’s cash deposits in the CCF at December 31, 2018 was nominal, and for the year ended December 31, 2017 was $0.9 million. +Foreign Currency Risks: The Company has no material exposure to foreign currency risks, although it is indirectly affected by changes in currency rates to the extent that changes in rates affect tourism in Hawaii, Guam, Alaska and other locations. Transactions related to its China service are primarily denominated in U.S. dollars, and therefore, a one percent change in the Chinese Yuan exchange rate would not have a material effect on the Company’s results of operations. Transactions related to the Company’s South Pacific service are primarily denominated in New Zealand dollars. However, a one percent change in the New Zealand dollar exchange rate is not expected to have a material effect on the Company’s results of operations. +37 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Page +Management’s Annual Report on Internal Control Over Financial Reporting +39 +Report of Independent Registered Public Accounting Firm +40 +Consolidated Statements of Income and Comprehensive Income +41 +Consolidated Balance Sheets +42 +Consolidated Statements of Cash Flows +43 +Consolidated Statements of Shareholders’ Equity +44 +Notes to Consolidated Financial Statements +45 +1. +Description of the Business +45 +2. +Significant Accounting Policies +45 +3. +Reportable Segments +52 +4. +Investment in Terminal Joint Venture +54 +5. +Property and Equipment +54 +6. +Goodwill and Intangible Assets +55 +7. +Capital Construction Fund +56 +8. +Debt +57 +9. +Leases +59 +10. +Income Taxes +60 +11. +Pension and Post-Retirement Plans +63 +12. +Multi-Employer Withdrawal Liabilities +70 +13. +Accumulated Other Comprehensive Income (Loss) +71 +14. +Earnings Per-Share +71 +15. +Share-Based Awards +71 +16. +Fair Value of Financial Instruments +73 +17. +Commitments and Contingencies +73 +18. +Business Combinations +74 +19. +Quarterly Information (Unaudited) +75 +38 +Table of Contents +MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of Matson, Inc. and subsidiaries (the “Company”) has the responsibility for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as a process designed by, or under the supervision of, the company’s principal executive and principal financial officers and effected by the company’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that: +· +Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the company; +· +Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and +· +Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting only provides reasonable assurance with respect to financial statement presentation and preparation. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2018. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013) . Based on its assessment, management believes that, as of December 31, 2018, the Company’s internal control over financial reporting is effective. The Company’s independent registered public accounting firm, Deloitte & Touche LLP, has issued an attestation report on the Company’s internal control over financial reporting. +/s/ Matthew J. Cox +/s/ Joel M. Wine +Matthew J. Cox +Joel M. Wine +Chairman and Chief Executive Officer +Senior Vice President and Chief Financial Officer +March 4, 2019 +March 4, 2019 +39 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholders of Matson, Inc. +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of Matson, Inc. and subsidiaries (the "Company") as of December 31, 2018 and 2017, the related consolidated statements of income and comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2018, and the related notes (collectively referred to as the “financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the criteria established in Internal Control — Integrated Framework (2013) issued by COSO. +Basis for Opinions +The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ Deloitte & Touche LLP +Honolulu, Hawaii +March 4, 2019 +We have served as the Company’s auditor since at least 1976; however, an earlier year could not be reliably determined. +40 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME +Years Ended December 31, +(In millions, except per-share amounts) +2018 +2017 +2016 +Operating Revenue: +Ocean Transportation +$ +1,641.3 +$ +1,571.8 +$ +1,541.1 +Logistics +581.5 +475.1 +400.5 +Total Operating Revenue +2,222.8 +2,046.9 +1,941.6 +Costs and Expenses: +Operating costs +(1,875.0) +(1,721.0) +(1,617.6) +Equity in income of Terminal Joint Venture +36.8 +28.2 +15.8 +Selling, general and administrative +(220.8) +(206.8) +(183.1) +Total Costs and Expenses +(2,059.0) +(1,899.6) +(1,784.9) +Operating Income +163.8 +147.3 +156.7 +Interest expense +(18.7) +(24.2) +(24.1) +Other income (expense), net +2.6 +2.1 +(2.1) +Income before Income Taxes +147.7 +125.2 +130.5 +Income taxes +(38.7) +105.8 +(49.1) +Net Income +$ +109.0 +$ +231.0 +$ +81.4 +Other Comprehensive Income (Loss), Net of Income Taxes: +Net Income +$ +109.0 +$ +231.0 +$ +81.4 +Other Comprehensive Income (Loss): +Net gain in prior service cost +— +0.8 +24.1 +Amortization of prior service cost +(4.7) +(4.0) +(2.2) +Amortization of net loss +1.1 +1.7 +1.2 +Other adjustments +— +0.2 +0.2 +Total Other Comprehensive Income (Loss) +(3.6) +(1.3) +23.3 +Comprehensive Income +$ +105.4 +$ +229.7 +$ +104.7 +Basic Earnings Per-Share: +$ +2.55 +$ +5.38 +$ +1.89 +Diluted Earnings Per-Share: +$ +2.53 +$ +5.35 +$ +1.87 +Weighted Average Number of Shares Outstanding: +Basic +42.7 +42.9 +43.1 +Diluted +43.0 +43.2 +43.5 +See Notes to Consolidated Financial Statements. +41 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +As of December 31, +(In millions) +2018 +2017 +ASSETS +Current Assets: +Cash and cash equivalents +$ +19.6 +$ +19.8 +Accounts receivable, net +223.7 +194.6 +Prepaid expenses and other assets +75.1 +51.6 +Total current assets +318.4 +266.0 +Long-term Assets: +Investment in Terminal Joint Venture +87.0 +93.2 +Property and equipment, net +1,366.6 +1,165.7 +Goodwill +327.8 +327.8 +Intangible assets, net +214.0 +225.2 +Deferred dry-docking costs, net +67.1 +89.2 +Other long-term assets +49.5 +84.5 +Total long-term assets +2,112.0 +1,985.6 +Total Assets +$ +2,430.4 +$ +2,251.6 +LIABILITIES AND SHAREHOLDERS’ EQUITY +Current Liabilities: +Current portion of debt +$ +42.1 +$ +30.8 +Accounts payable +246.8 +175.1 +Accruals and other liabilities +81.9 +80.4 +Total current liabilities +370.8 +286.3 +Long-term Liabilities: +Long-term debt +814.3 +826.3 +Deferred income taxes +312.7 +283.6 +Other long-term liabilities +177.3 +178.2 +Total long-term liabilities +1,304.3 +1,288.1 +Commitments and Contingencies (Note 17) +Shareholders’ Equity: +Common stock - common stock without par value; authorized, 150.0 million shares ($0.75 stated value per share); outstanding, 42.7 million shares in 2018 and 42.5 million shares in 2017 +32.0 +31.9 +Additional paid in capital +297.8 +289.7 +Accumulated other comprehensive loss, net +(34.5) +(24.9) +Retained earnings +460.0 +380.5 +Total shareholders’ equity +755.3 +677.2 +Total Liabilities and Shareholders’ Equity +$ +2,430.4 +$ +2,251.6 +See Notes to Consolidated Financial Statements. +42 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Cash Flows From Operating Activities: +Net income +$ +109.0 +$ +231.0 +$ +81.4 +Reconciling adjustments: +Depreciation and amortization +94.4 +101.2 +97.1 +Deferred income taxes +29.3 +(127.9) +24.7 +(Gain) Loss on disposal of property and equipment +(1.9) +3.0 +0.9 +Share-based compensation expense +12.1 +11.1 +11.2 +Equity in income of Terminal Joint Venture +(36.8) +(28.2) +(15.8) +Distributions from Terminal Joint Venture +42.0 +17.5 +— +Tax benefit from equity issuance +— +— +2.2 +Tax benefit from stock-based compensation +— +— +(0.3) +Changes in assets and liabilities: +Accounts receivable, net +(29.1) +(5.1) +14.4 +Deferred dry-docking payments +(19.2) +(54.6) +(59.2) +Deferred dry-docking amortization +37.4 +46.2 +38.9 +Prepaid expenses and other assets +4.2 +14.4 +(13.6) +Accounts payable, accruals and other liabilities +71.2 +20.4 +2.1 +Other long-term liabilities +(7.6) +(4.1) +(26.2) +Net cash provided by operating activities +305.0 +224.9 +157.8 +Cash Flows From Investing Activities: +Capitalized vessel construction expenditure +(338.6) +(252.0) +(94.5) +Other capital expenditures +(62.6) +(55.0) +(84.9) +Proceeds from (payments for) disposal of property and equipment +136.3 +(0.2) +2.5 +Cash deposits into Capital Construction Fund +(340.0) +(171.4) +(123.4) +Withdrawals from Capital Construction Fund +340.9 +201.7 +92.2 +Proceeds from sale of other investments +3.7 +— +— +Payments for membership interests in Span Alaska, net of cash acquired +— +— +(112.6) +Net cash used in investing activities +(260.3) +(276.9) +(320.7) +Cash Flows From Financing Activities: +Proceeds from issuance of debt +— +— +275.0 +Repayments of debt +(30.0) +(30.0) +(20.5) +Repayment of capital leases +(0.7) +(1.8) +(1.7) +Proceeds from revolving credit facility +963.9 +469.0 +1,103.0 +Repayments of revolving credit facility +(933.9) +(319.0) +(1,048.0) +Payment of financing costs +— +(1.7) +— +Proceeds from issuance of common stock +0.7 +1.9 +1.2 +Dividends paid +(35.4) +(33.8) +(32.2) +Repurchase of Matson common stock +— +(19.3) +(38.0) +Tax withholding related to net share settlements of restricted stock units +(4.6) +(7.4) +(5.9) +Tax benefit from stock-based compensation +— +— +0.3 +Payments of Span Alaska debt +— +— +(81.9) +Net cash (used in) provided by financing activities +(40.0) +57.9 +151.3 +Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash +4.7 +5.9 +(11.6) +Cash, Cash Equivalents and Restricted Cash, Beginning of the Year +19.8 +13.9 +25.5 +Cash, Cash Equivalents and Restricted Cash, End of the Year +$ +24.5 +$ +19.8 +$ +13.9 +Reconciliation of Cash, Cash Equivalents, and Restricted Cash, at End of the Year: +Cash and Cash Equivalents +$ +19.6 +$ +19.8 +$ +13.9 +Restricted Cash +4.9 +— +— +Total Cash, Cash Equivalents and Restricted Cash, End of the Year +$ +24.5 +$ +19.8 +$ +13.9 +Supplemental Cash Flow Information: +Interest paid, net of capitalized interest +$ +18.3 +$ +23.9 +$ +21.6 +Income tax paid, net of income tax refunds +$ +5.2 +$ +2.6 +$ +15.6 +Non-cash Information: +Capital expenditures included in accounts payable, accruals and other liabilities +$ +4.1 +$ +1.2 +$ +4.1 +See Notes to Consolidated Financial Statements. +43 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +For the three years ended December 31, 2018 +Accumulated +Common Stock +Additional +Other +Stated +Paid In +Comprehensive +Retained +(In millions, except per-share amounts) +Shares +Value +Capital +Income (Loss) +Earnings +Total +Balance at December 31, 2015 +43.5 +$ +32.6 +$ +287.9 +$ +(46.9) +$ +177.0 +$ +450.6 +Net income +— +— +— +— +81.4 +81.4 +Other comprehensive income, net of tax +— +— +— +23.3 +— +23.3 +Tax benefit from stock-based compensation and share withholding +— +— +2.2 +— +— +2.2 +Share-based compensation +— +— +11.2 +— +— +11.2 +Shares issued, net of shares withheld for employee taxes +0.3 +0.2 +(4.9) +— +— +(4.7) +Shares repurchased +(0.9) +(0.7) +(6.6) +— +(29.6) +(36.9) +Dividends ($0.74 per share) +— +— +— +— +(32.2) +(32.2) +Balance at December 31, 2016 +42.9 +32.1 +289.8 +(23.6) +196.6 +494.9 +Net income +— +— +— +— +231.0 +231.0 +Other comprehensive loss, net of tax +— +— +— +(1.3) +— +(1.3) +Share-based compensation +— +— +11.1 +— +— +11.1 +Shares issued, net of shares withheld for employee taxes +0.3 +0.3 +(5.7) +— +— +(5.4) +Shares repurchased +(0.7) +(0.5) +(5.5) +— +(13.3) +(19.3) +Dividends ($0.78 per share) +— +— +— +— +(33.8) +(33.8) +Balance at December 31, 2017 +42.5 +31.9 +289.7 +(24.9) +380.5 +677.2 +Net income +— +— +— +— +109.0 +109.0 +Other comprehensive loss, net of tax +— +— +— +(9.6) +6.0 +(3.6) +Share-based compensation +— +— +12.1 +— +— +12.1 +Shares issued, net of shares withheld for employee taxes +0.2 +0.1 +(4.0) +— +— +(3.9) +Shares repurchased +— +— +— +— +(0.1) +(0.1) +Dividends ($0.82 per share) +— +— +— +— +(35.4) +(35.4) +Balance at December 31, 2018 +42.7 +$ +32.0 +$ +297.8 +$ +(34.5) +$ +460.0 +$ +755.3 +See Notes to Consolidated Financial Statements. +44 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. DESCRIPTION OF THE BUSINESS +Matson, Inc., a holding company incorporated in January 2012 in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information on the Company’s reportable segments for the three years ended December 31, 2018, see Note 3. +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates a premium, expedited service from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific. In addition, subsidiaries of MatNav provide container stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +Matson has a 35 percent ownership interest in SSA Terminals, LLC (“SSAT”), a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc. (“SSA”), a subsidiary of Carrix, Inc. (“Terminal Joint Venture”). SSAT provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including four facilities which are used by MatNav. Matson records its share of income from the Terminal Joint Venture in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively “Transportation Brokerage” services); (ii) less-than-container load consolidation (“LCL”) and freight forwarding services (collectively “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +Recent Acquisition: On August 4, 2016, Matson Logistics completed its acquisition of Span Intermediate, LLC (“Span Alaska”), a market leading provider of LCL consolidation and freight forwarding services to Alaska (the “Span Alaska Acquisition”) (see Note 18). +2. SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation: The Consolidated Financial Statements include the accounts of Matson, Inc. and all wholly-owned subsidiaries, after elimination of intercompany amounts and transactions. Significant investments in businesses, partnerships, and limited liability companies in which the Company does not have a controlling financial interest, but has the ability to exercise significant influence, are accounted for under the equity method. A controlling financial interest is one in which the Company has a majority voting interest or one in which the Company is the primary beneficiary of a variable interest entity. The Company accounts for its investment in the Terminal Joint Venture using the equity method of accounting (see Note 4). The Consolidated Financial Statements include the accounts and activities of Span Alaska from acquisition date on August 4, 2016 (see Note 18). +Fiscal Year: The period end for Matson, Inc. is December 31. The period end for MatNav occurred on the last Friday in December, except for Matson Logistics Warehousing, Inc. whose period closed on December 31. Included in these Consolidated Financial Statements are 52 weeks in the 2018 and 2017 fiscal years, and 53 weeks in the 2016 fiscal year, for MatNav. +45 +Table of Contents +Foreign Currency Transactions: The United States (U.S.) dollar is the functional currency for substantially all of the financial statements of the Company’s foreign subsidiaries. Foreign currency denominated assets and liabilities of the Company’s foreign subsidiaries are translated into U.S. dollars at exchange rates existing at the respective balance sheet dates. Translation adjustments resulting from fluctuations in exchange rates are recorded as a component of accumulated other comprehensive loss (gain) within shareholders’ equity. The Company translates the result of operations of its foreign subsidiaries at the average exchange rate during the respective periods. Gains and losses resulting from foreign currency transactions are included in selling, general and administrative costs in the Consolidated Statements of Income and Comprehensive Income. +Use of Estimates: The preparation of the Consolidated Financial Statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported. Estimates and assumptions are used for, but not limited to: impairment of investments; impairment of long-lived assets, intangible assets and goodwill; capitalized interest; allowance for doubtful accounts; legal contingencies; uninsured risks and related liabilities; accrual estimates; pension and post-retirement estimates; multi-employer withdrawal liabilities; and income taxes. Future results could be materially affected if actual results differ from these estimates and assumptions. +Immaterial Correction of an Error in Previously Issued Financial Statements: Subsequent to the filing of the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, the Company determined that it had incurred a partial withdrawal liability related to the Office & Professional Employees International Union (“OPEIU”), Local 153 Pension Fund (the “Local 153 Fund”). The partial withdrawal liability resulted from a decline in the number of contribution base units related to the Local 153 Fund caused by Horizon Lines, Inc. (“Horizon”) terminating all of its operations in Puerto Rico during the first quarter of 2015, prior to the Company acquiring Horizon on May 29, 2015. +Accordingly, the Company corrected this error by recording an increase in other long-term liabilities of $6.7 million, a reduction in deferred income taxes of $2.6 million, and a corresponding net adjustment to goodwill of $4.1 million for the years ended December 31, 2015, 2016 and 2017. For the year ended December 31, 2017, the $2.6 million deferred income taxes adjustment was reduced by $1.0 million to reflect the remeasurement tax effects resulting from the Tax Cut and Jobs Act of 2017 (the “Tax Act”). This had the corresponding effect of increasing income taxes and decreasing net income by $1.0 million during the year ended December 31, 2107. There was no impact to net income for any other years presented. The misstatement had no net impact on the Company’s Consolidated Statements of Cash Flows. The Company believes the correction of this error is immaterial to previously issued Consolidated Financial Statements for all prior periods. +Cash, Cash Equivalents and Restricted Cash: Cash equivalents consist of highly-liquid investments with original maturities of three months or less. The Company carries these investments at cost, which approximates fair value. Outstanding checks in excess of funds on deposit totaled $16.4 million and $18.7 million at December 31, 2018 and 2017, respectively, and are included in current liabilities in the Consolidated Balance Sheets. Restricted cash relates to amounts that are subject to contractual restrictions and are not readily available. Restricted cash was $4.9 million at December 31, 2018, and is included in prepaid expenses and other assets in the Consolidated Balance Sheet. There were no restricted cash amounts at December 31, 2017. +Accounts Receivable, net: Accounts receivable represents amounts due from trade customers arising in the normal course of business. Accounts receivable are shown net of allowance for doubtful accounts receivable in the Consolidated Balance Sheets. At December 31, 2018, and 2017, the Company had assigned $1.0 million and $134.8 million of eligible accounts receivable, respectively, to the Capital Construction Fund (see Note 7). +Allowance for Doubtful Accounts : Allowance for doubtful accounts receivable is established by management based on estimates of collectability. Estimates of collectability are principally based on an evaluation of the current financial condition of the customer and the potential risks to collection, the customer’s payment history and other factors which are regularly monitored by the Company. +46 +Table of Contents +Changes in the allowance for doubtful accounts receivable for the three years ended December 31, 2018, 2017 and 2016 were as follows: +Balance at +Expense +Write-offs +Balance at +Year (in millions) +Beginning of Year +(Recovery) (1) +and Other +End of Year +2018 +$ +4.6 +$ +0.8 +$ +(0.6) +$ +4.8 +2017 +$ +4.2 +$ +1.0 +$ +(0.6) +$ +4.6 +2016 +$ +6.6 +$ +(0.3) +$ +(2.1) +$ +4.2 +(1) +Expense is shown net of amounts recovered from previously reserved doubtful accounts. +Prepaid Expenses and Other Assets: Prepaid expenses and other assets consist of the following at December 31, 2018 and 2017: +As of December 31, +Prepaid Expenses and Other Assets (in millions) +2018 +2017 +Income tax receivables +$ +26.8 +$ +2.6 +Prepaid fuel +16.3 +14.4 +Prepaid insurance and insurance related receivables +12.6 +19.3 +Prepaid operating expenses +6.8 +6.3 +Restricted cash - vessel construction obligations +4.9 +— +Other +7.7 +9.0 +Total +$ +75.1 +$ +51.6 +Other Long-Term Assets: Other long-term assets consist of the following at December 31, 2018 and 2017: +As of December 31, +Other Long-Term Assets (in millions) +2018 +2017 +Income tax receivables +$ +21.5 +$ +50.2 +Vessel and equipment spare parts +13.1 +12.7 +Insurance related receivables +11.2 +12.9 +Deferred Charges and other +3.7 +7.8 +Capital construction fund - cash on deposit (see Note 7) +— +0.9 +Total +$ +49.5 +$ +84.5 +Impairment of Terminal Joint Venture Investment: The Company’s investment in its Terminal Joint Venture, a related party, is reviewed for impairment annually, or whenever there is evidence that fair value may be below its carrying cost. No impairment was identified during the years ended December 31, 2018, 2017 and 2016. +Property and Equipment: Property and equipment are stated at cost. Certain costs incurred in the development of internal-use software are capitalized. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of property and equipment range up to the following maximum life: +Classification +Life +Vessels +40 years +Machinery and equipment +30 years +Terminal facilities +35 years +Capitalized Interest: The Company entered into agreements with shipyards for the construction of four new vessels to be utilized within the Company’s operations (see Note 5). The Company is funding the construction of these vessels through borrowings and cash flows generated by the Company. The Company determined that the construction of these vessels are considered qualifying assets for the purposes of capitalizing interest on these assets. +The Company’s policy is to capitalize interest costs during the period the qualified assets are being readied for their intended use. The amount of capitalized interest is calculated based on the amount of payments incurred related to the construction of these vessels using a weighted average interest rate. The weighted average interest rate is determined using the Company’s average borrowings outstanding during the period. Capitalized interest is included in vessel construction in progress in property and equipment in the Company’s Consolidated Balance Sheets (see Note 5). During +47 +Table of Contents +the years ended December 31, 2018, 2017 and 2016, the Company capitalized $18.7 million, $7.5 million and $2.1 million of interest related to the construction of new vessels, respectively. +Deferred Dry-docking Costs: U.S. flagged vessels must meet specified seaworthiness standards established by U.S. Coast Guard rules and classification society rules. These standards require U.S. flagged vessels to undergo two dry-docking inspections within a five-year period, with a maximum of 36 months between them. However, U.S. flagged vessels that are enrolled in the U.S. Coast Guard’s Underwater Survey in Lieu of Dry-docking (“UWILD”) program are allowed to have their Intermediate Survey dry-docking requirement met with a less costly underwater inspection. Non-U.S. flag vessels are required to meet applicable classification society rules and their own Port State standards for seaworthiness, which also mandate vessels to undergo two dry-docking inspections every five years. +The Company is responsible for maintaining its vessels in compliance with U.S. and international standards. As costs associated with dry-docking inspections provide future economic benefits to the Company through continued operation of the vessels, the costs are deferred and amortized until the next regulatory scheduled dry-docking, which is usually over a two to five-year period. Amortization of deferred dry-docking costs are charged to operating expenses of the Ocean Transportation segment in the Consolidated Statements of Income and Comprehensive Income. Routine vessel maintenance and repairs are charged to expense as incurred. +Goodwill and Intangible Assets: Goodwill and intangible assets arise as a result of acquisitions made by the Company (see Notes 6 and 18). Intangible assets consists of customer relationships which are being amortized using the straight-line method over the expected useful lives ranging from 3 to 21 years, and a trade name that has an indefinite life. +Impairment of Long-Lived Assets, Intangible Assets and Goodwill : The Company evaluates its long-lived assets, including intangible assets and goodwill for possible impairment in the fourth quarter, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value is less than its carrying amount. The Company has reporting units within the Ocean Transportation and Logistics reportable segments. +Long-lived Assets and Finite-lived Intangible Assets: Long-lived assets and finite-lived intangible assets are grouped at the lowest level for which identifiable cash flows are available. In evaluating impairment, the estimated future undiscounted cash flows generated by each of these asset groups is compared with the amount recorded for each asset group to determine if its carrying value is not recoverable. If this review determines that the amount recorded will not be recovered, the amount recorded for the asset group is reduced to its estimated fair value. No impairment charges of long-lived assets and finite-lived intangible assets were recorded for the years ended December 31, 2018, 2017 and 2016. +Indefinite-life Intangible Assets and Goodwill: In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of earnings before interest, taxes, depreciation and amortization. Based upon the Company’s evaluation of its indefinite-life intangible assets and goodwill for impairment, the Company determined that the fair value of each reporting unit exceeds book value. No impairment charges of indefinite-life intangible assets and goodwill were recorded for the years ended December 31, 2018, 2017 and 2016. +Accruals and other liabilities: Accruals and other liabilities consist of the following at December 31, 2018 and 2017: +As of December 31, +Accruals and Other Liabilities (in millions) +2018 +2017 +Payroll and vacation related accruals +$ +25.7 +$ +24.7 +Employee incentives and other related accruals +19.5 +17.4 +Uninsured risks and related liabilities - short term +9.9 +15.4 +Deferred revenues +5.7 +5.0 +Interest on debt +5.1 +5.4 +Multi-employer withdrawal liabilities - short term (see Note 12) +10.8 +4.1 +Pension and post-retirement liabilities - short term (see Note 11) +3.0 +3.0 +Other short-term liabilities +2.2 +5.4 +Total +$ +81.9 +$ +80.4 +48 +Table of Contents +Other long-term liabilities: Other long-term liabilities consist of the following at December 31, 2018 and 2017: +As of December 31, +Other Long-Term Liabilities (in millions) +2018 +2017 +Pension and post-retirement liabilities (see Note 11) +$ +79.4 +$ +75.1 +Multi-employer withdrawal liability (see Note 12) +56.6 +65.1 +Uninsured risks and related liabilities +27.3 +29.5 +Other long-term liabilities +14.0 +8.5 +Total +$ +177.3 +$ +178.2 +Pension and Post-Retirement Plans: The Company is a member of the Pacific Maritime Association (“PMA”) and the Hawaii Stevedoring Industry Committee, which negotiate multi-employer pension plans covering certain shoreside bargaining unit personnel. The Company directly negotiates multi-employer pension plans covering other bargaining unit personnel. Pension costs are accrued in accordance with contribution rates established by the PMA, the parties to a plan or the trustees of a plan. Several trusteed, non-contributory, single-employer defined benefit plans and defined contribution plans cover substantially all other employees. +The estimation of the Company’s pension and post-retirement benefit expenses and liabilities requires that the Company make various assumptions. These assumptions include factors such as discount rates, expected long-term rate of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates, and expected contributions. Actual results that differ from the assumptions made could materially affect the Company’s financial condition or its future operating results. Additional information about the Company’s pension and post-retirement plans is included in Note 11. +Uninsured Risks and Related Liabilities: The Company is uninsured for certain risks but when feasible, many risks are mitigated by insurance. The Company purchases insurance with deductibles or self-insured retentions. Such insurance includes, but is not limited to, employee health, workers’ compensation, marine liability, auto liability and physical damage to inland property, equipment and vessels. For certain risks, the Company elects to not purchase insurance because of excessive cost of insurance or the perceived remoteness of the risk. In addition, the Company retains all risk of loss that exceeds the limits of the Company’s insurance policies. +When estimating its reserves for uninsured risks and related liabilities, the Company considers a number of factors, including historical claims experience, demographic factors, current trends, and analyses provided by independent third-parties. Periodically, management reviews its assumptions and estimates used to determine the adequacy of the Company’s reserves for uninsured risks and related liabilities. +Leases: The Company recognizes operating lease expense on a straight-line basis over the lease term. The Company’s operating leases are more fully described in Note 9. The Company’s capital leases are de minimis and are included as part of the Company’s debt (see Note 8). +Recognition of Revenues and Expenses: Revenue in the Company’s Consolidated Financial Statements is presented net of elimination of intercompany transactions. The following is a description of the Company’s principal revenue generating activities by segment, and the Company’s revenue recognition policy for each activity for the periods presented: +Year Ended December 31, +Ocean Transportation (in millions) (1) +2018 +2017 +2016 +Ocean Transportation services +$ +1,599.3 +$ +1,531.8 +$ +1,504.5 +Terminal and other related services +23.0 +23.5 +22.9 +Fuel sales +12.2 +9.9 +7.5 +Vessel management and related services +6.8 +6.6 +6.2 +Total +$ +1,641.3 +$ +1,571.8 +$ +1,541.1 +(1) +Ocean Transportation revenue transactions are primarily denominated in U.S. dollars except for less than 3 percent of Ocean Transportation services revenue and fuel sales revenue categories which are denominated in foreign currencies. +49 +Table of Contents +§ +Ocean Transportation services revenue is recognized ratably over the duration of a voyage based on the relative transit time completed in each reporting period. Vessel operating costs and other ocean transportation operating costs, such as terminal operating overhead and general and administrative expenses, are charged to operating costs as incurred. +§ +Terminal and other related services revenue is recognized as the services are performed. +§ +Fuel sale revenue is recognized when the Company has completed delivery of the product to the customer in accordance with the terms and conditions of the contract. +§ +Vessel management and related services revenue is recognized in proportion to the services completed. +Year Ended December 31, +Logistics (in millions) (1) +2018 +2017 +2016 +Transportation Brokerage and Freight Forwarding services +$ +549.1 +$ +445.1 +$ +373.7 +Warehouse and distribution services +19.1 +17.5 +19.7 +Supply chain management and other services +13.3 +12.5 +7.1 +Total +$ +581.5 +$ +475.1 +$ +400.5 +(1) +Logistics revenue transactions are primarily denominated in U.S. dollars except for less than 3 percent of transportation brokerage and freight forwarding services revenue, and supply chain management and other services revenue categories which are denominated in foreign currencies. +§ +Transportation Brokerage and Freight Forwarding services revenue consists of amounts billed to customers for services provided. The primary costs include third-party purchased transportation services, labor and equipment costs. Revenue and the related purchased third-party transportation costs are recognized over the duration of a delivery based upon the relative transit time completed in each reporting period. Labor and other operating costs are expensed as incurred. The Company reports revenue on a gross basis as the Company serves as the principal in these transactions because it is responsible for fulfilling the contractual arrangements with the customer and has latitude in establishing prices. +§ +Warehousing and distribution services revenue consist of amounts billed to customers for storage, handling, and value-added packaging of customer merchandise. Storage revenue is recognized in the month the service is provided to the customer. Storage expenses are recognized as incurred. Other warehousing and distribution services revenue and expense are recognized in proportion to the services performed. +§ +Supply chain management and other services revenue and related costs are recognized in proportion to the services performed. +The Company generally invoices its customers at the commencement of the voyage or the transportation service being provided, or as other services are being performed. Revenue is deferred when services are invoiced in advance to the customer. The Company’s receivables are classified as short-term as collection terms are for periods of less than one year. The Company expenses sales commissions and contract acquisition costs as incurred because the amounts are generally immaterial. These expenses are included in selling, general and administration expenses in the Consolidated Statements of Income and Comprehensive Income. +Customer Concentration: The Ocean Transportation segment serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2018, 2017 and 2016, the 10 largest Ocean Transportation customers accounted for approximately 24 percent, 23 percent and 24 percent of Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Ocean Transportation operating revenues. +The Logistics segment serves customers in numerous industries and geographical locations. In 2018, 2017 and 2016, the 10 largest logistics customers accounted for approximately 23 percent, 19 percent and 22 percent of Logistics revenue, respectively. None of these customers individually account for more than 10 percent of Logistics operating revenues. +Dividends: The Company recognizes dividends as a liability when approved by the Board of Directors. +Share-Based Compensation: The Company records compensation expense for all share-based awards made to employees and directors. The Company’s various stock-based compensation plans are more fully described in Note 15. +Income Taxes: The Company makes certain estimates and judgments in determining income tax expense for Consolidated Financial Statement purposes. These estimates and judgments are applied in the calculation of taxable +50 +Table of Contents +income, tax credits, tax benefits and deductions, and in the calculation of certain deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue, costs and expenses for tax purposes. Deferred tax assets and liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. +The Company records a valuation allowance if, based on the weight of available evidence, management believes that it is more likely than not that some portion or all of a recorded deferred tax asset would not be realized in future periods. Significant changes to these estimates may result in an increase or decrease to the Company’s income taxes in a subsequent period. The Company’s income taxes are more fully described in Note 10. +Rounding: Amounts in the Consolidated Financial Statements and Notes to the Consolidated Financial Statements are rounded to millions, except for per-share calculations and percentages which were determined based on amounts before rounding. Accordingly, a recalculation of some per-share amounts and percentages, if based on the reported data, may be slightly different. +New Accounting Pronouncements : +Leases (Topic 842) (“ASU 2016-02”) : In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-02 which requires lessees to record operating and finance leases on their balance sheet and disclose information related to such arrangements. ASU 2016-02 states that a lessee would recognize a lease liability for the lease payment obligation, and a right-of-use asset for the underlying leased asset for the period of the lease term. For an operating lease, the recognition of lease expense in the income statement is expected to be similar to current practice. The new standard is effective for interim and annual periods beginning on or after December 15, 2018. A modified retrospective transition approach is required. +The Company will adopt ASU 2016-02 effective January 1, 2019 and plans to make the following elections: +· +Apply the transition requirements at the effective date of January 1, 2019, with the effects, if any, of initially applying ASU 2016-02 to be recognized as a cumulative-effect adjustment to retained earnings in the period of adoption; +· +The package of practical expedient permitted under the transition guidance which allows the historical lease classification and initial direct costs to be carried forward; +· +Elect the short-term lease exception which allows the Company to exclude leases with an initial term of one year or less from recognition; +· +Elect to separate non-lease components; and +· +Elect to use a portfolio approach in applying discount rates to leases based upon the lease terms in the following categories: (i) one to five years; (ii) six to ten years; (iii) eleven to fifteen years; and (iv) sixteen years and greater, regardless of the type of asset. +The Company plans to use its estimated incremental borrowing rate based on information available at the date of adoption in calculating the present value of its existing lease payments. The incremental borrowing rate will be determined using the U.S. Treasury rate adjusted to account for the Company’s credit rating and the collateralized nature of operating leases. +The Company estimates that upon adoption, it will initially record a right-of-use asset of approximately $252.9 million, and a corresponding current and long-term lease liability of approximately $54.2 million and $206.4 million, respectively. The Company will also record a cumulative-effect adjustment of approximately $5.9 million to increase beginning retained earnings at January 1, 2019, as a result of adopting ASU 2016-02. The Company does not believe that the adoption of ASU 2016-02 will have any significant impact on the Company’s current earnings, liquidity or existing debt covenant requirements. The Company’s finance leases and sub-lease income are nominal to the Company’s Consolidated Financial Statements. +Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) : In June 2016, the FASB issued ASU 2016‑13 which amends the current approach to estimate credit losses on certain financial assets, including trade and other receivables, available-for-sale securities and other financial instruments. ASU 2016‑13 requires entities to establish a valuation allowance for the expected lifetime losses of certain financial instruments. Subsequent changes in +51 +Table of Contents +the valuation allowance are recorded in current earnings and reversal of previous losses is permitted. The new standard is effective for interim and annual periods beginning on or after December 15, 2019, and early adoption is permitted. The Company is in the process of evaluating this new standard, but does not expect the adoption of ASU 2016‑13 to have a significant impact on the Company’s Consolidated Financial Statements. +Revenues from Contracts with Customers (Topic 606) (“ASU 2014-09”): The Company adopted ASU 2014-09 during the three months ended March 31, 2018 using the modified retrospective method. Prior to adopting ASU 2014-09, the Company performed a review of its revenue contracts and evaluated the Company’s current accounting policies and procedures for recognizing revenues in the Company’s Consolidated Financial Statements, and compared these to the new requirements of ASU 2014-09. In addition, the Company identified the performance obligations and consideration applicable under each contract. +Based upon this evaluation, the Company determined that the impact of adopting ASU 2014-09 was de minimis because the analysis of the Company’s contracts under ASU 2014-09 supports the recognition of revenue over time as the service is performed, which is consistent with the Company’s current revenue recognition accounting policy. The majority of the Company’s contracts require the Company to provide ocean and logistics transportation services to its customers. Such services are provided by the Company over a period of time, generally, when cargo is being delivered from source to destination point, or as the service is being performed. These performance obligations are completed in a short period of time due to the nature of the services provided by the Company. Under the new standard, revenues from the majority of the Company’s contracts will continue to be recognized over time as the customer simultaneously receives and consumes the benefit of these services as described in ASU 2014-09. +Income Statement – Reporting Comprehensive Income (Topic 220) (“ASU 2018-02”): ASU 2018-02 allows a reclassification from accumulated other comprehensive income (loss) to retained earnings for the remeasurement tax effects resulting from the Tax Act. The Company elected to early adopt ASU 2018-02 during the three months ended March 31, 2018, and recorded a reclassification adjustment of $6.0 million between accumulated other comprehensive income (loss) and retained earnings (see Note 13). +Compensation – Retirement Benefits (Topic 715), Improving the Presentation of Net Periodic Pension Cost and Benefit Cost (“ASU 2017-07”): ASU 2017-07 requires employers that sponsor defined benefit pension and post-retirement plans to present the service cost component of net benefit cost in the same income statement line item as other employee compensation costs arising from services rendered, and that only the service cost component will be eligible for capitalization. The other components of the net periodic benefit cost must be presented separately from the line item that includes the service cost component and outside of the income from operations subtotal. +The Company adopted ASU 2017-07 during the three months ended March 31, 2018. To conform prior year amounts to current period presentation as required by ASU 2017-07, the Company recorded retrospective adjustments and reclassified $2.1 million of income and $2.1 million of expense from costs and expenses, to other income (expense), net in the Consolidated Statement of Income and Comprehensive Income for the years ended December 31, 2017 and 2016, respectively. There was no change to income before income taxes for all years presented as a result of adopting ASU 2017‑07. +Simplifying the Test for Goodwill Impairment (“ ASU 2017-04”) : ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating step two from the goodwill impairment test. The Company early adopted ASU 2017-04 during the three months ended December 31, 2018. The adoption of this ASU had no impact on the Company’s Consolidated Financial Statements. +3. REPORTABLE SEGMENTS +Reportable segments are components of an enterprise that engage in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. The Company’s chief operating decision maker is its Chief Executive Officer. +The Company consists of two reportable segments, Ocean Transportation and Logistics, which are further described in Note 1. Reportable segments are measured based on operating income. In arrangements where the customer purchases +52 +Table of Contents +ocean transportation and logistics services, the revenues are allocated to each reportable segment based upon the contractual amounts for each type of service. The Company’s Terminal Joint Venture segment has been aggregated into the Company’s Ocean Transportation segment due to the operations of the Terminal Joint Venture being an integral part of the Company’s Ocean Transportation business (see Note 4). Included in the reportable segment information below are 52 weeks in the 2018 and 2017 fiscal years, and 53 weeks in the 2016 fiscal year. +The Company’s Ocean Transportation segment provides ocean transportation services to the Logistics segment, and the Logistics segment provides logistics services to the Ocean Transportation segment. Accordingly, inter-segment revenue of $95.4 million, $81.3 million and $62.0 million for the years ended December 31, 2018, 2017 and 2016, respectively, have been eliminated from Logistics’ operating revenues due to the nature of how those services were performed. +Reportable segment financial information for the years ended December 31, 2018, 2017 and 2016, and identifiable asset segment information at December 31, 2018 and 2017, are as follows: +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Operating Revenue: +Ocean Transportation +$ +1,641.3 +$ +1,571.8 +$ +1,541.1 +Logistics +581.5 +475.1 +400.5 +Total Operating Revenue +$ +2,222.8 +$ +2,046.9 +$ +1,941.6 +Operating Income: +Ocean Transportation (1) +$ +131.1 +$ +126.4 +$ +144.5 +Logistics (2) +32.7 +20.9 +12.2 +Total Operating Income +163.8 +147.3 +156.7 +Interest expense, net +(18.7) +(24.2) +(24.1) +Other income (expense), net +2.6 +2.1 +(2.1) +Income before Income Taxes +147.7 +125.2 +130.5 +Income taxes (3) +(38.7) +105.8 +(49.1) +Net Income (3) +$ +109.0 +$ +231.0 +$ +81.4 +Capital Expenditures: +Ocean Transportation +$ +385.4 +$ +305.3 +$ +179.1 +Logistics +15.8 +1.7 +0.3 +Total Capital Expenditures +$ +401.2 +$ +307.0 +$ +179.4 +Depreciation and Amortization: +Ocean Transportation +$ +87.0 +$ +93.3 +$ +92.6 +Logistics +7.4 +7.9 +4.5 +94.4 +101.2 +97.1 +Deferred dry-docking amortization - Ocean Transportation +37.4 +46.2 +38.9 +Total Depreciation and Amortization +$ +131.8 +$ +147.4 +$ +136.0 +(1) +Ocean Transportation segment information includes $36.8 million, $28.2 million, and $15.8 million of equity in income from the Company’s equity investment in SSAT for the years ended December 31, 2018, 2017, and 2016, respectively. +(2) +Logistics segment information includes the operations of Span Alaska acquired as of August 4, 2016. +(3) +Income taxes and net income were adjusted for an immaterial correction of an error for the year ended December 31, 2017 (see Note 2). +As of December 31, +(In millions) +2018 +2017 +Identifiable Assets: +Ocean Transportation (1) (2) +$ +2,071.6 +$ +1,941.5 +Logistics +358.8 +310.1 +Total Assets (2) +$ +2,430.4 +$ +2,251.6 +(1) +The Ocean Transportation segment includes $87.0 million and $93.2 million related to the Company’s equity investment in SSAT as of December 31, 2018 and 2017, respectively. +(2) +Amounts as of December 31, 2017 have been adjusted for an immaterial correction of an error (see Note 2). +53 +Table of Contents +4. INVESTMENT IN TERMINAL JOINT VENTURE +The Company accounts for its 35 percent ownership interest in the Terminal Joint Venture using the equity method of accounting. The Company records its share of income from the Terminal Joint Venture in costs and expenses within the Ocean Transportation segment due to operations of the Terminal Joint Venture being an integral part of the Company’s Ocean Transportation business. The Company’s investment in the Terminal Joint Venture was $87.0 million and $93.2 million at December 31, 2018 and 2017, respectively. +The Company’s share of income recorded in the Consolidated Statements of Income and Comprehensive Income and dividends received by the Company during the years ended December 31, 2018, 2017 and 2016 are as follows: +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Company's share of net income +$ +36.8 +$ +28.2 +$ +15.8 +Distributions received +$ +42.0 +$ +17.5 +$ +— +The Company’s Ocean Transportation segment operating costs include $213.4 million, $181.3 million and $177.8 million for the years ended December 31, 2018, 2017 and 2016, respectively, for terminal services provided by SSAT. Accounts payable and accrued liabilities in the Consolidated Balance Sheets include $59.2 million and $22.8 million for terminal services payable to SSAT at December 31, 2018 and 2017, respectively. +A summary of the condensed balance sheets of SSAT at December 31, 2018 and 2017 is as follows: +As of December 31, +Condensed Balance Sheets (in millions) +2018 +2017 +Current assets +$ +310.4 +$ +181.0 +Non-current assets +152.1 +161.8 +Total Assets +$ +462.5 +$ +342.8 +Current liabilities +$ +71.0 +$ +65.3 +Non-current liabilities +156.2 +23.8 +Equity +235.3 +253.7 +Total Liabilities and Equity +$ +462.5 +$ +342.8 +A summary of the condensed statements of operating income and net income of SSAT for years ended December 31, 2018, 2017 and 2016 are as follows: +Years Ended December 31, +Condensed Statements of Operating Income and Net Income (in millions) +2018 +2017 +2016 +Operating revenue +$ +1,074.2 +$ +933.5 +$ +740.9 +Operating costs and expenses +963.7 +850.2 +706.5 +Operating income +110.5 +83.3 +34.4 +Net Income (1) +$ +104.9 +$ +80.9 +$ +45.1 +(1) Includes earnings from equity method investments held by SSAT less earnings allocated to non-controlling interests. +5. PROPERTY AND EQUIPMENT +Property and equipment at December 31, 2018 and 2017, and depreciation expense for the years ended December 31, 2018, 2017 and 2016 is as following: +As of December 31, 2018 +As of December 31, 2017 +Accumulated +Accumulated +(In millions) +Cost +Depreciation +Net Book Value +Cost +Depreciation +Net Book Value +Vessels +$ +1,489.2 +847.1 +$ +642.1 +$ +1,433.6 +$ +893.2 +$ +540.4 +Containers and equipment +513.6 +362.9 +150.7 +543.0 +349.0 +194.0 +Terminal facilities and other property +66.0 +38.6 +27.4 +64.8 +36.3 +28.5 +Vessel construction in progress +487.2 +— +487.2 +376.6 +— +376.6 +Other construction in progress +59.2 +— +59.2 +26.2 +— +26.2 +Total +$ +2,615.2 +$ +1,248.6 +$ +1,366.6 +$ +2,444.2 +$ +1,278.5 +$ +1,165.7 +54 +Table of Contents +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Depreciation expense +$ +80.5 +$ +86.7 +$ +86.0 +Vessel construction in progress represents progress payments for the construction of four new vessels, and other related costs. During the year ended December 31, 2018, the construction of the first vessel was completed and the vessel was placed into service resulting in approximately $233.0 million, including $12.8 million of capitalized interest, transferred from Vessel construction in progress category to Vessels category within Property and Equipment. As of December 31, 2018 and 2017, vessel construction in progress costs included capitalized interest of $16.3 million and $10.4 million, respectively. +Property and equipment includes assets subject to capital leases with a net book value of $0.1 million and $4.9 million, net of accumulated depreciation of $0.7 million and $3.8 million at December 31, 2018 and 2017, respectively. Depreciation of assets subject to capital leases recorded in the Consolidated Statement of Income and Comprehensive Income was $0.5 million, $1.5 million and $1.2 million for the years ended December 31, 2018, 2017 and 2016, respectively. +6. GOODWILL AND INTANGIBLE ASSETS +Goodwill by segment as of December 31, 2018 and 2017 consist of the following: +Ocean +(In millions) +Transportation +Logistics +Total +Goodwill +$ +222.6 +$ +105.2 +$ +327.8 +Intangible assets by segment as of December 31, 2018 and 2017 consist of the following: +As of December 31, 2018 +As of December 31, 2017 +Gross +Accumulated +Gross +Accumulated +(In millions) +Amount +Amortization +Net Book Value +Amount +Amortization +Net Book Value +Ocean Transportation - Customer relationships +$ +140.6 +$ +24.4 +$ +116.2 +$ +140.6 +$ +17.8 +$ +122.8 +Logistics: +Customer relationships +90.1 +19.6 +70.5 +90.1 +15.0 +75.1 +Trade name +27.3 +— +27.3 +27.3 +— +27.3 +Total Logistics +117.4 +19.6 +97.8 +117.4 +15.0 +102.4 +Total +$ +258.0 +$ +44.0 +$ +214.0 +$ +258.0 +$ +32.8 +$ +225.2 +Ocean Transportation intangible assets of $140.6 million relates to customer relationships acquired as part of the acquisition of Horizon Lines, Inc. (“Horizon”) on May 29, 2015, and is being amortized over 21 years. Logistics intangible assets include $79.3 million of customer relationships which are being amortized over 20 years, and $27.3 million of an indefinite life trade name, acquired as part of the Span Alaska Acquisition (see Note 18). The remaining Logistics customer relationships of $10.8 million are being amortized over a period of up to 13 years. +Intangible assets related amortization expense for 2018, 2017, and 2016, is as follows: +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Amortization expense +$ +11.2 +$ +11.4 +$ +9.1 +55 +Table of Contents +As of December 31, 2018, estimated amortization expense related to customer relationships intangible assets during the next five years and thereafter are as follows: +Customer +Year (in millions) +Relationships +2019 +$ +11.0 +2020 +11.0 +2021 +10.9 +2022 +10.7 +2023 +10.7 +Thereafter +132.4 +Total +$ +186.7 +7. CAPITAL CONSTRUCTION FUND +The Company is party to an agreement with the U.S. Department of Transportation, Maritime Administration (“MARAD”) that established a Capital Construction Fund (“CCF”) program under provisions of the Merchant Marine Act of 1936, as amended (the “Merchant Marine Act”). The CCF program was created to assist owners and operators of U.S. flag vessels in raising capital necessary for the modernization and expansion of the U.S. merchant marine fleet. CCF funds may be used for the acquisition, construction, or reconstruction of vessels, and for repayment of existing vessel indebtedness through the deferment of federal income taxes on certain deposits of monies and other property placed into the CCF. Qualified withdrawals from the CCF must be used for investment in vessels built in the U.S. and used between covered U.S. ports as described by the Merchant Marine Act, and for other qualifying expenditures (see Item 1 of Part 1 for additional information on Maritime Laws and the Jones Act). Participants of the CCF must also meet certain U.S. citizenship requirements. +Deposits into the CCF are limited by certain applicable earnings and other conditions. Such deposits, once made, are available as tax deductions in the Company’s income tax provision. Qualified withdrawals from the CCF do not give rise to a current income tax liability, but reduce the depreciable basis of the vessels or certain related equipment for income tax purposes. However, if withdrawals are made from the CCF for general corporate purposes or other non-qualified purposes, or upon termination of the agreement, they are taxable with interest payable from the year of deposit. +Deposits not committed for qualified purposes within 25 years from the date of deposit will be treated as non-qualified withdrawals over the subsequent five years. Under the terms of the CCF agreement, the Company may designate certain qualified earnings as “accrued deposits” or may designate, as obligations of the CCF, qualified withdrawals to reimburse qualified expenditures initially made with operating funds. Such accrued deposits to, and withdrawals from, the CCF are reflected in the Consolidated Balance Sheets either as obligations of the Company’s current assets or as receivables from the CCF. +As of December 31, 2018 and 2017, $1.0 million and $134.8 million, respectively, of eligible accounts receivable were assigned to the CCF. Due to the nature of the assignment of eligible accounts receivable into the CCF, such assigned amounts are classified as part of accounts receivable in the Consolidated Balance Sheets. At December 31, 2017, the Company had $0.9 million on deposit in the CCF invested in a money market fund which is classified as other long-term assets in the Company’s Consolidated Balance Sheets. The amount on deposit in the CCF at December 31, 2018 was nominal. +56 +Table of Contents +8. DEBT +At December 31, 2018 and 2017, the Company’s debt consisted of the following: +As of December 31, +(In millions) +2018 +2017 +Private Placement Term Loans: +5.79 %, payable through 2020 +$ +10.5 +$ +17.5 +3.66 %, payable through 2023 +41.0 +50.1 +4.16 %, payable through 2027 +44.5 +49.8 +3.37 %, payable through 2027 +75.0 +75.0 +3.14 %, payable through 2031 +200.0 +200.0 +4.31 %, payable through 2032 +32.7 +35.1 +4.35 %, payable through 2044 +100.0 +100.0 +3.92 %, payable through 2045 +71.4 +73.2 +Title XI Bonds: +5.34 %, payable through 2028 +22.0 +24.2 +5.27 %, payable through 2029 +24.2 +26.4 +Revolving credit facility, maturity date of June 29, 2022 +235.0 +205.0 +Capital leases +0.1 +0.8 +Total Debt +856.4 +857.1 +Less: Current portion +(42.1) +(30.8) +Total Long-term Debt +$ +814.3 +$ +826.3 +The following is a description of the Company’s debt: +Private Placement Term Loans : The 5.79 percent notes payable through 2020 are amortized by semi-annual principal payments of $3.5 million plus interest. +During the second quarter of 2012, the Company issued $170.0 million of unsecured notes, which funded in three tranches, $77.5 million at an interest rate of 3.66 percent, $55.0 million at an interest rate of 4.16 percent, and $37.5 million at an interest rate of 4.31 percent (the “2012 Notes”). Interest is payable semi-annually. The 2012 Notes began to amortize in 2015 with aggregate semi-annual payments of $4.6 million which continued through 2016, followed by $8.4 million in 2017 through mid-year 2023, $3.8 million through mid-year 2027, and $1.2 million thereafter. +In January 2014, the Company issued $100.0 million of 30-year senior unsecured notes at an interest rate of 4.35 percent, payable semi-annually (the “2014 Notes”). The 2014 Notes will begin to amortize in 2021, with annual principal payments of $5.0 million in 2021, $7.5 million in 2022 and 2023, $10.0 million from 2024 to 2027, and $8.0 million in 2028. Starting in 2029, and in each year thereafter until 2044, annual principal payments will be $2.0 million. +In July 2015, the Company issued $75.0 million of 30-year senior unsecured notes at an interest rate of 3.92 percent, payable semi-annually (the “2015 Notes”). The 2015 Notes began to amortize in 2017, with annual principal payments of approximately $1.8 million through 2019. During the years 2020 to 2026, the annual principal payments will range between approximately $1.3 million and $8.0 million. Starting in 2027, and in each year thereafter, the annual principal payments will be approximately $1.5 million. +In September 2016, the Company issued $200.0 million of 15-year senior unsecured notes (the “Series D Notes”) at an interest rate of 3.14 percent, payable semi-annually. The Series D Notes will begin to amortize in 2019, with semi-annual principal payments of $6.0 million in 2019, and $9.2 million during the years 2020 to 2023. Starting in 2024, and in each year thereafter through maturity in 2031, the semi-annual principal payments will be $7.15 million. +In December 2016, the Company issued $75 million of 11-year senior unsecured notes at an interest rate of 3.37 percent, payable semi-annual (the "Series A Notes"). The Series A Notes will begin to amortize in 2021, with principal payments of $5.8 million in 2021 and $11.5 million per year, paid semi-annually, from 2022 through 2027. +Title XI Bonds: In September 2003, the Company issued $55.0 million in U.S. Government guaranteed vessel finance bonds (Title XI) to partially finance the delivery of MV Manukai . The secured bonds have a final maturity in +57 +Table of Contents +September 2028 with a coupon of 5.34 percent. The bonds are amortized by semi-annual payments of $1.1 million plus interest. In August 2004, the Company issued $55.0 million of U.S. Government guaranteed vessel finance bonds (Title XI) to partially finance the delivery of MV Maunawili . The secured bonds have a final maturity in July 2029 with a coupon of 5.27 percent. The bonds are amortized by semi-annual payments of $1.1 million plus interest. +Revolving Credit Facility: On June 29, 2017 (the “Closing Date”), the Company entered into an amended and restated credit agreement that provides the Company with additional sources of liquidity for working capital, capital expenditures and investment opportunities, and amends and restates the Company’s previously amended and restated credit agreement (the “Credit Agreement” or the “revolving credit facility”). The Credit Agreement expires on June 29, 2022, and provides for committed aggregate borrowing of up to $650 million, with an uncommitted option to increase the aggregate borrowing by up to $250 million. The aggregate borrowing within the Credit Agreement includes a $100 million sublimit for the issuance of standby and commercial letters of credit, and a $50 million sublimit for swing line loans. The Company may prepay any amounts outstanding under the Credit Agreement without premium or penalty. All obligations of the Company under the Credit Agreement are guaranteed by Matson’s principal operating subsidiary MatNav and by certain other subsidiaries. +Depending on the Company’s consolidated net leverage ratio, borrowings under the Credit Agreement bear interest at either LIBOR plus a margin of between 1.00 percent and 1.75 percent or the base rate plus a margin of between zero percent and 0.75 percent. Letters of credit are subject to fees based on the Company’s consolidated net leverage ratio at a rate of between 1.00 percent and 1.75 percent. The Company also pays a commitment fee of between 0.15 percent and 0.30 percent depending on the Company’s consolidated net leverage ratio. +As of December 31, 2018, the Company had $304.0 million of remaining availability under the Credit Agreement. The Company used $7.9 million of the sub-limit for letters of credit outstanding as of December 31, 2018. Based upon the Company’s consolidated net leverage ratio, the interest rate applicable to revolving credit facility borrowings was approximately 3.92 percent at December 31, 2018. +Amendments to Existing Private Placement Term Loan Facilities and New Shelf Facilities (“Private Loan Facilities”): On June 29, 2017, the Company and the holders of the Company’s term loans entered into amendments (collectively, the “2017 Amendments”) to each of the term loan agreements and amendments thereto, previously issued prior to the Closing Date. The 2017 Amendments provide for amendments to certain covenants and other terms, including (at the Company’s option under certain circumstances) adjustments to the required consolidated leverage ratio, and, in connection with the exercise of such option, the payment of additional interest for certain pre-defined periods. Interest rates and other substantive terms remained unchanged. +Debt Covenants : The Credit Agreement and Private Loan Facilities (collectively, the “Agreements”) contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, limitations on certain other indebtedness, loans and investments, liens, mergers, asset sales, and transactions with affiliates as defined within the Agreements. The Agreements also contain customary events of default. A brief description of the principal covenants contained in the Agreements includes, but is not limited to the following (as defined within the Agreements): +§ +Minimum Consolidated Interest Coverage Ratio as of the end of any fiscal quarter is not permitted to be less than 3.50 to 1.0; +§ +Maximum Consolidated Leverage Ratio as of the end of any fiscal quarter is not permitted to exceed 3.25 to 1.0, subject to the Company’s election of specific exceptions in which the Maximum Consolidated Leverage Ratio is not permitted to exceed 3.75 to 1.0 for certain pre-defined periods as described in the Agreements; +§ +The principal amount of Priority Debt: (i) is not permitted to exceed 20 percent of Consolidated Tangible Assets at any time (subject to a reduction to 17.5 percent upon the earlier of December 31, 2017, or upon the occurrence of certain events), and; (ii) the principal amount of Priority Debt that is not Title XI Priority Debt at any time is not permitted to exceed 10 percent of Consolidated Tangible Assets. +Principal covenants generally will restrict the incurrence of liens except for permitted liens, which include, without limitation, liens securing Title XI Debt up to certain thresholds, as defined within the agreements. The Company was in compliance with these covenants as of December 31, 2018. +58 +Table of Contents +Capital Leases: The Company’s capital lease obligations represent leasing of containers and other equipment, and have been classified as current and long-term debt in the Company’s Consolidated Balance Sheets. +Debt Guarantees: All of the Company’s debt as of December 31, 2018 was unsecured, except for $46.2 million in Title XI bonds, all of which are guaranteed by the Company’s significant subsidiaries. All of the Company’s debt is fixed rate debt except for borrowings under the revolving credit facility. +Debt Maturities: At December 31, 2018, debt maturities during the next five years and thereafter are as follows: +Year (in millions) +Total +2019 +$ +42.1 +2020 +48.4 +2021 +54.2 +2022 +294.9 +2023 +59.9 +Thereafter +356.9 +Total debt +$ +856.4 +9. LEASES +The Company has a variety of different types of operating leases, the specific terms and conditions of which vary from lease to lease. Certain operating lease agreements include terms such as (i) renewal and early termination options; (ii) early buy-out and purchase options; and (iii) rent escalation clauses. The lease agreements also include provisions for the maintenance of the leased asset and payment of lease related costs. The Company reviews the specific terms and conditions of each lease and, as appropriate, notifies the lessor of any intent to exercise any option in accordance with the terms of the lease. In the normal course of business, the Company expects to be able to renew or replace most of its operating leases by other similar leases as they expire. Except for the vessel lease guaranty described below, the Company’s leases do not contain any residual value guarantees. The lease type and estimated maximum terms of the Company’s operating leases are as following: +Lease Type: +Life +Real estate and terminal leases +65 years +Vessel charter leases +10 years +Operations equipment and other leases +8 years +Rent expense recorded in costs and expenses in the Consolidated Statements of Income and Comprehensive Income from operating leases and other non-lease agreements are as follows: +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Real estate and terminal leases +$ +25.6 +$ +26.4 +$ +25.4 +Vessel charter leases +21.4 +21.4 +16.4 +Operations equipment and other leases +26.8 +26.0 +27.9 +Other rent expense +68.1 +54.9 +49.9 +Total +$ +141.9 +$ +128.7 +$ +119.6 +Future minimum payments under operating lease agreements at December 31, 2018 are as follows: +Year (in millions) +Total +2019 +$ +68.3 +2020 +59.2 +2021 +44.8 +2022 +34.7 +2023 +30.5 +Thereafter +83.6 +Total minimum lease payments +$ +321.1 +59 +Table of Contents +Vessel Charter and Buyer-Lessor Guaranty +Vessel Charter: On November 26, 2018, a wholly-owned subsidiary of the Company entered into agreements whereby a vessel, MV Maunalei , owned by the subsidiary, was sold for $106.0 million and subsequently leased back from the buyer-lessor under a Bareboat Charter Agreement (the “Charter”). The transaction qualified for sale and leaseback treatment under ASC 840, Leases , with the Charter treated as an operating lease for accounting purposes. Lease payments are approximately $3.0 million per quarter, and the base term of the Charter is five years with a two year end-of-term renewal option. Total future minimum lease payments were $59.9 million at December 31, 2018, and are included in the future minimum payments table above. The Company recorded a net deferred gain of $2.3 million related to this sale and leaseback during the year ended December 31, 2018, and is included in other long-term liabilities in the Consolidated Balance Sheet. +Prior to the expiration of the base term of the Charter, the subsidiary may, at its option, elect to: (i) purchase the vessel at the option price; (ii) exercise the option to renew the Charter for an additional two years; or (iii) remarket the vessel to sell to a third-party on behalf of the buyer-lessor. The purchase option price is $68.9 million after the base term and $58.3 million after the extended term. The Charter also includes a maximum residual value guarantee amount of $50.9 million after five years, or $47.7 million after the extended term. Proceeds from the sale of the vessel reduces the subsidiary’s residual value guarantee. +Buyer-Lessor Guaranty: Matson, Inc. provided the buyer-lessor with a guaranty of all obligations of the wholly-owned subsidiary related to the Charter as defined in the guaranty agreement. +10. INCOME TAXES +Income Taxes: On December 22, 2017, the Tax Act was signed into law and included numerous changes in existing tax law, including a reduction in the federal corporate income tax rate from 35 percent to 21 percent. The rate reduction and other changes took effect on January 1, 2018. Other changes such as remeasurement of deferred tax assets and liabilities were effective as of the fourth quarter of 2017. Also, on December 22, 2017, the Securities Exchange Commission (“SEC”) staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. As of December 31, 2018, the Company has completed its assessment of the impact of the Tax Act. +In connection with the Company’s analysis of the impact of the Tax Act, the Company recorded a net tax benefit of $154.0 million related to the remeasurement and other discrete adjustments to the Company’s deferred tax assets and liabilities during the year ended December 31, 2017. In addition, the Company recorded a non-cash tax adjustment of $2.9 million that increased current income taxes during the year ended December 31, 2018. This adjustment related to the application of an estimated 6.2 percent sequestration on alternative minimum tax (AMT) refunds for the years 2018 to 2021. On January 19, 2019, the Internal Revenue Service issued new guidance indicating that sequestration would not apply to refundable AMT credits. In accordance with this new guidance, the Company will record a non-cash adjustment of $2.9 million that will reduce current income taxes during the three months ending March 31, 2019. +Income taxes for the years ended December 31, 2018, 2017 and 2016 consisted of the following: +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Current: +Federal +$ +2.4 +$ +21.6 +$ +10.5 +State +2.1 +2.2 +(1.3) +Discrete adjustments related to the Tax Act (1) +2.9 +— +— +Total +7.4 +23.8 +9.2 +Deferred: +Deferred tax expense +31.3 +24.4 +39.9 +Remeasurement and discrete adjustments related to the Tax Act (2) +— +(154.0) +— +Total +31.3 +(129.6) +39.9 +Total income taxes +$ +38.7 +$ +(105.8) +$ +49.1 +60 +Table of Contents +(1) +Current income taxes for the year ended December 31, 2018 includes a non-cash income tax expense of $2.9 million, which relates to discrete adjustments as a result of applying the provisions of the Tax Act. +(2) +Deferred income taxes for the year ended December 31, 2017 includes a non-cash income tax benefit of $154.0 million, which relates to the remeasurement of the Company’s deferred tax assets and liabilities and other discrete adjustments as a result of applying the provisions of the Tax Act. +Income taxes for the years ended December 31, 2018, 2017, and 2016, differs from amounts computed by applying the statutory federal rate to income before income taxes for the following reasons: +Years Ended December 31, +2018 +2017 +2016 +Computed federal income tax expense +21.0 +% +35.0 +% +35.0 +% +State income tax +3.4 +% +2.6 +% +1.8 +% +Valuation allowance +(0.7) +% +1.4 +% +0.3 +% +Foreign taxes +0.6 +% +0.1 +% +0.4 +% +Remeasurement and discrete adjustments related to the Tax Act (1) +2.0 +% +(123.0) +% +— +% +Share-based payments +0.1 +% +(1.4) +% +— +% +Other — net +(0.2) +% +0.8 +% +0.1 +% +Effective income tax rate +26.2 +% +(84.5) +% +37.6 +% +(1) +Effective income tax rate for the year ended December 31, 2018 and 2017 includes the impact of a non-cash income tax expense of $2.9 million, or 2.0 percent, and a non-cash income tax benefit of $154.0 million, or (123.0 percent), respectively, related to the remeasurement of the Company’s deferred assets and liabilities and other discrete adjustments as a result of applying the provisions of the Tax Act. +The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2018 and 2017, were as follows: +As of December 31, +(In millions) +2018 +2017 +Deferred tax assets: +Benefit plans +$ +45.6 +$ +44.2 +Federal net operating losses +15.2 +21.6 +Insurance reserves +5.6 +6.8 +State net operating losses +7.4 +7.4 +Foreign losses +5.1 +6.6 +U.S. State alternative minimum tax credits +5.9 +4.2 +Allowance for doubtful accounts +1.1 +0.9 +Other +1.8 +1.9 +Total deferred tax assets +87.7 +93.6 +Valuation allowance +(11.5) +(13.0) +Total deferred tax assets, net of valuation allowance +76.2 +80.6 +Deferred tax liabilities: +Basis differences for property and equipment +302.1 +254.4 +Lease financing +26.0 +— +Capital Construction Fund +7.0 +54.2 +Intangibles +38.4 +36.4 +Deferred revenue +3.0 +6.9 +Terminal Joint Venture investment +11.4 +9.6 +Reserves +1.0 +2.7 +Total deferred tax liabilities +388.9 +364.2 +Deferred tax liability, net +$ +312.7 +$ +283.6 +The Company’s income taxes payable has been reduced by the tax benefits from share-based compensation. The Company receives an income tax benefit for exercised stock options calculated as the difference between the fair market value of the stock issued at the time of exercise and the option exercise price, tax-effected. The Company also receives an income tax benefit for non-vested stock when it vests, measured at the fair market value of the stock at the time of vesting, tax-effected. The net tax benefits from share-based transactions were $2.2 million for 2016, and the portion of the tax benefit related to the excess of the amount reported as the tax deduction over expense was reflected as an increase to additional paid-in-capital in the 2016 Consolidated Statements of Shareholders’ Equity. +61 +Table of Contents +Valuation Allowance: Valuation allowances recorded against the Company’s foreign income tax net operating losses (“NOLs”) and a portion of the state income tax NOLs were $11.5 million and $13.0 million as of December 31, 2018 and 2017, respectively. The Company believes that it is more likely than not that the benefit from these amounts will not be realized. The Company recorded adjustments to its valuation allowance of ($1.1) million, $1.7 million and $0.4 million during the years ended December 31, 2018, 2017 and 2016, respectively. +Net Operating Losses and Tax Credit Carryforwards: The Company’s NOLs and tax credit carryforwards at December 31, 2018 and 2017, were as follows: +(In millions) +Expiration Date +2018 +2017 +U.S. Federal income tax NOLs +Various dates beginning in 2027 +$ +74.5 +$ +183.8 +U.S. State income tax NOLs +Various dates beginning in 2032 +$ +189.2 +$ +192.3 +Foreign income tax NOLs +No expiration date +$ +18.4 +$ +23.7 +U.S. State alternative minimum tax credit +No expiration date +$ +5.9 +$ +4.2 +The U.S. federal and state income tax NOLs in the Company’s filed income tax returns include unrecognized tax benefits. The deferred tax assets recognized for those NOLs are presented net of these unrecognized tax benefits. As a result of changes in tax legislation, the use of a portion of the Company’s domestic NOL and tax credit carryforwards may be limited in future periods. Further, a portion of the federal and state income tax NOLs and tax credit carryforwards may expire before being applied to reduce future income tax liabilities. +Unrecognized Tax Benefits: Total unrecognized benefits represent the amount that, if recognized, would favorably affect the Company’s incomes taxes and effective tax rate in future periods. The Company does not expect a material change in gross unrecognized benefits in the next twelve months. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows: +Unrecognized Tax Benefits (in millions) +Amount +Balance at December 31, 2015 +$ +22.1 +Changes in tax positions of prior years, net +(1.1) +Reductions for lapse of statute of limitations +(0.6) +Balance at December 31, 2016 +20.4 +Changes in tax positions of prior years, net +1.1 +Reductions for lapse of statute of limitations +(0.1) +Revaluation of unrecognized tax benefits due to the Tax Act (1) +(5.5) +Balance at December 31, 2017 +15.9 +Changes in tax positions of prior years, net +(0.3) +Reductions for lapse of statute of limitations +(0.5) +Balance at December 31, 2018 +$ +15.1 +(1) +Amount relates to the impact of applying the Tax Act during the year ended December 31, 2017. +Included in the balance of unrecognized tax benefits at December 31, 2018 are potential benefits of $13.7 million that, if recognized, would affect the Company’s income taxes and effective tax rate. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income taxes. To the extent interest and penalties are not ultimately assessed with respect to the settlement of uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the Company’s income taxes. Interest accrued related to the balance of unrecognized tax benefits totaled $0.4 million and $0.5 million as of December 31, 2018 and 2017, respectively. +The Company is no longer subject to U.S. federal income tax audits for years before 2014. The Company is routinely involved in state, local income and excise tax audits, and foreign tax audits. +62 +Table of Contents +11. PENSION AND POST-RETIREMENT PLANS +Non-bargaining Plans: +The Company has two funded qualified single-employer defined benefit pension plans that cover certain non‑bargaining unit employees and bargaining unit employees. In addition, the Company has plans that provide certain retiree health care and life insurance benefits to substantially all salaried, non-bargaining employees hired before 2008 and to certain bargaining unit employees. Employees are generally eligible for such benefits upon retirement and completion of a specified number of years of service. The Company does not pre-fund these health care and life insurance benefits, and has the right to modify or terminate certain of these plans in the future. Most non-bargaining retirees pay a portion of the benefit costs. +Plan Administration, Investments and Asset Allocations: The Company has a Benefits Investment Committee that meets regularly with investment advisors to establish investment policies, direct investments and select investment options for the qualified plans. The Benefits Investment Committee is also responsible for appointing investment managers and monitoring their performance. The Company’s investment policy permits investments in marketable equity securities, such as domestic and foreign stocks, domestic and foreign bonds, venture capital, real estate investments, and cash equivalents. The Company’s investment policy does not permit direct investment in certain types of assets, such as options or commodities, or the use of certain strategies, such as short selling or the purchase of securities on margin. +The Company’s investment strategy for its qualified pension plan assets is to achieve a diversified mix of investments that provides for long-term growth at an acceptable level of risk, and to provide sufficient liquidity to fund ongoing benefit payments. The Company has engaged a number of investment managers to implement various investment strategies to achieve the desired asset class mix, liquidity and risk diversification objectives. +The Company’s target and actual asset allocations at December 31, 2018 and 2017 were as follows: +Asset Categories +Target +2018 +2017 +Domestic equity securities +53 +% +57 +% +59 +% +International equity securities +15 +% +16 +% +17 +% +Debt securities +22 +% +19 +% +17 +% +Real estate +5 +% +7 +% +6 +% +Other and cash +5 +% +1 +% +1 +% +Total +100 +% +100 +% +100 +% +The Company’s investments in equity securities primarily include domestic large-cap and mid-cap companies, but also includes an allocation to small-cap and international equity securities. Equity investments do not include any direct holdings of the Company’s stock but may include such holdings to the extent that the stock is included as part of certain mutual fund holdings. Debt securities include investment-grade and high-yield corporate bonds from diversified industries, mortgage-backed securities, and U.S. Treasuries. Other types of investments include funds that invest in commercial real estate assets, and to a lesser extent, private equity investments in technology companies. All assets within specific funds are allocated to the target asset allocation of the fund. +The expected return on plan assets is principally based on the Company’s historical returns combined with the Company’s long-term future expectations regarding asset class returns, the mix of plan assets, and inflation assumptions. Actual return on plan assets for the periods presented are as follows: +Actual Return on Plan Assets +Returns +One-year return +(6.5) +% +Three-year return +5.1 +% +Five-year return +3.8 +% +Long-term average return (since plan inception in 1989) +7.9 +% +The Company’s pension plan assets are held in a master trust and are stated at estimated fair values of the underlying investments. Purchases and sales of securities are recorded on a trade-date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date. +63 +Table of Contents +Equity Securities: Domestic and international common stocks are valued by obtaining quoted prices on recognized and highly liquid exchanges. +Fixed Income Securities: Corporate bonds and U.S. government treasury and agency securities are valued based upon the closing price reported in the market in which the security is traded. U.S. government agency and corporate asset-backed securities may utilize models, such as a matrix pricing model, that incorporate other observable inputs when broker/dealer quotes are not available, such as cash flow, security structure, or market information. +Real Estate, Private Equity and Insurance Contract Interests: The fair value of real estate, private equity and insurance contract interests are determined by the issuer based on the unit values of the funds. Unit values are determined by dividing the fund’s net assets by the number of units outstanding at the valuation date. Fair value for underlying investments in real estate is determined through independent property appraisals. Fair value of underlying investments in private equity is determined based on information provided by the general partner taking into consideration the purchase price of the underlying securities, developments concerning the investee company subsequent to the acquisition of the investment, financial data and projections of the investee company provided by the general partner, and such other factors as the general partner deems relevant. Insurance contracts are principally invested in real estate assets, which are valued based upon independent appraisals. +The fair values of the Company’s pension plan assets at December 31, 2018 and 2017 by asset category, were as follows: +Fair Value Measurements at December 31, 2018 +Quoted Prices in +Significant +Significant +Active Markets +Observable +Unobservable +Asset Category (in millions) +Total +(Level 1) +Inputs (Level 2) +Inputs (Level 3) +Cash +$ +6.2 +$ +6.2 +$ +— +$ +— +Equity securities: +U.S. large-cap +50.6 +24.9 +25.7 +— +U.S. mid- and small-cap +38.4 +25.8 +12.6 +— +International large-cap +18.0 +— +18.0 +— +International small-cap +8.1 +— +8.1 +— +Fixed income securities: +U.S. Treasuries +8.0 +— +8.0 +— +Municipal bonds +0.1 +— +0.1 +— +Investment grade U.S. corporate bonds +20.8 +— +20.8 +— +High-yield U.S. corporate bonds +0.5 +— +0.5 +— +Other types of investments: +Real estate partnership interests +11.6 +— +— +11.6 +Total +$ +162.3 +$ +56.9 +$ +93.8 +$ +11.6 +64 +Table of Contents +Fair Value Measurements at December 31, 2017 +Quoted Prices in +Significant +Significant +Active Markets +Observable +Unobservable +Asset Category (in millions) +Total +(Level 1) +Inputs (Level 2) +Inputs (Level 3) +Cash +$ +6.6 +$ +6.6 +$ +— +$ +— +Equity securities: +U.S. large-cap +66.0 +28.1 +37.9 +— +U.S. mid- and small-cap +42.6 +28.3 +14.3 +— +International large-cap +21.6 +— +21.6 +— +International small-cap +9.5 +— +9.5 +— +Fixed income securities: +U.S. Treasuries +8.0 +— +8.0 +— +Municipal bonds +0.1 +— +0.1 +— +Investment grade U.S. corporate bonds +17.5 +— +17.5 +— +High-yield U.S. corporate bonds +3.6 +— +3.6 +— +Other types of investments: +Real estate partnership interests +11.1 +— +— +11.1 +Private equity partnership interests +0.1 +— +— +0.1 +Total +$ +186.7 +$ +63.0 +$ +112.5 +$ +11.2 +The table below presents a reconciliation of all pension plan investments measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2018 and 2017: +Fair Value Measurements Using Significant +Unobservable Inputs (Level 3) +(In millions) +Real Estate +Private Equity +Total +Balance at December 31, 2016 +$ +10.8 +$ +0.1 +$ +10.9 +Actual return (loss) on plan assets: +Assets held at the reporting date +0.3 +0.1 +0.4 +Assets sold during the period +0.5 +(0.1) +0.4 +Purchases, sales and settlements, net +(0.5) +— +(0.5) +Balance at December 31, 2017 +11.1 +0.1 +11.2 +Actual return (loss) on plan assets: +Assets held at the reporting date +0.5 +0.5 +1.0 +Assets sold during the period +0.5 +(0.4) +0.1 +Purchases, sales and settlements, net +(0.5) +(0.2) +(0.7) +Balance at December 31, 2018 +$ +11.6 +$ +— +$ +11.6 +Contributions to each of the qualified single-employer defined benefit pension plans are determined annually by the Company’s pension administrative committee, based upon the actuarially determined minimum required contribution under the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended, the Pension Protection Act of 2006, and the maximum deductible contribution allowed for tax purposes. In 2017 and 2016, the Company contributed $3.0 million and $7.5 million, respectively, in pension contributions in these plans. There was no pension contribution to these plans in 2018. The Company’s funding policy is to contribute cash to its pension plans so that it meets at least the minimum contribution requirements. +The benefit formulas for employees who are members of collective bargaining units are determined according to the collective bargaining agreements, either using final average pay as the base or a flat dollar amount per year of service. +Effective December 31, 2011, the Company froze benefit accruals under the final average pay formula for salaried, non-bargaining unit employees hired before January 1, 2008 and transitioned them to the same cash balance formula for employees hired on or after January 1, 2008. Retirement benefits under the cash balance formula are based on a fixed percentage of employee eligible compensation, plus interest. The plan interest credit rate will vary from year to year based on the ten-year U.S. Treasury rate. +Benefit Plan Assets and Obligations: The measurement date for the Company’s benefit plan disclosures is December 31 of each year. +65 +Table of Contents +The status of the funded qualified defined benefit pension plans and the unfunded post-retirement benefit plans at December 31, 2018 and 2017 are shown below: +Post-retirement +Pension Benefits +Benefits +December 31, +December 31, +(In millions) +2018 +2017 +2018 +2017 +Change in Benefit Obligation: +Benefit obligation at beginning of year +$ +232.1 +$ +225.4 +$ +27.7 +$ +25.2 +Service cost +4.4 +4.0 +0.6 +0.5 +Interest cost +8.6 +9.7 +1.0 +1.1 +Plan participants’ contributions +— +— +0.9 +1.1 +Plan settlements +— +(0.3) +— +— +Actuarial (gain) loss +(14.1) +13.9 +(6.2) +1.9 +Benefits paid, net of subsidies received +(12.0) +(18.9) +(1.8) +(2.1) +Expenses paid +(1.6) +(1.7) +— +— +Benefit obligation at end of year +217.4 +232.1 +22.2 +27.7 +Change in Plan Assets: +Fair value of plan assets at beginning of year +186.7 +178.8 +— +— +Actual return on plan assets +(10.9) +25.8 +— +— +Plan participants’ contributions +— +— +0.9 +1.1 +Plan settlements +— +(0.3) +— +— +Employer contributions +— +3.0 +0.9 +1.0 +Benefits paid, net of subsidies received +(12.0) +(18.9) +(1.8) +(2.1) +Expenses paid +(1.6) +(1.7) +— +— +Fair value of plan assets at end of year +162.2 +186.7 +— +— +Funded Status and Recognized Liability +$ +(55.2) +$ +(45.4) +$ +(22.2) +$ +(27.7) +Qualified pension and post-retirement benefits plans liabilities recognized in the Consolidated Balance Sheets and expenses recognized in accumulated other comprehensive income (loss) at December 31, 2018 and 2017 were as follows: +Post-retirement +Pension Benefits +Benefits +December 31, +December 31, +(In millions) +2018 +2017 +2018 +2017 +Non-current assets +$ +0.8 +$ +0.5 +$ +— +$ +— +Current liabilities +— +— +(1.2) +(1.2) +Non-current liabilities, net +(56.0) +(45.9) +(21.0) +(26.5) +Total +$ +(55.2) +$ +(45.4) +$ +(22.2) +$ +(27.7) +Net loss, net of taxes +$ +(61.8) +$ +(46.9) +$ +(0.1) +$ +(4.6) +Prior service credit, net of taxes +6.0 +6.3 +21.8 +20.2 +Total +$ +(55.8) +$ +(40.6) +$ +21.7 +$ +15.6 +The information for qualified defined benefit pension plans with an accumulated benefit obligation in excess of plan assets at December 31, 2018 and 2017 is shown below: +(In millions) +2018 +2017 +Projected benefit obligation +$ +215.9 +$ +229.9 +Accumulated benefit obligation +$ +215.6 +$ +229.6 +Fair value of plan assets +$ +159.9 +$ +184.7 +The estimated net loss and prior service credit for the qualified pension plans that will be amortized from accumulated other comprehensive income (loss) is a net periodic cost of $2.2 million, net of tax, in 2019. The estimated net loss and prior service credit for the post-retirement benefit plans that will be amortized from accumulated other comprehensive income (loss) is a net periodic benefit of $2.8 million, net of tax, in 2019. +66 +Table of Contents +Unrecognized gains and losses of the post-retirement benefit plans are amortized over five years. Although current health care costs are expected to increase, the Company attempts to mitigate these increases by maintaining caps on certain of its benefit plans, using lower cost health care plan options where possible, requiring that certain groups of employees pay a portion of their benefit costs, self‑insuring for certain insurance plans, encouraging wellness programs for employees, and implementing measures to mitigate future benefit cost increases. +Components of the net periodic benefit cost and other amounts recognized in other comprehensive income (loss) for the qualified pension plans and the post-retirement benefit plans during 2018, 2017, and 2016 were as follows: +Pension Benefits +Post-retirement Benefits +December 31, +December 31, +(In millions) +2018 +2017 +2016 +2018 +2017 +2016 +Components of Net Periodic Benefit Cost (Benefit): +Service cost +$ +4.4 +$ +4.0 +$ +3.9 +$ +0.6 +$ +0.5 +$ +1.5 +Interest cost +8.6 +9.7 +9.7 +1.0 +1.1 +2.7 +Expected return on plan assets +(13.5) +(13.5) +(13.4) +— +— +— +Amortization of net loss +4.6 +5.1 +5.5 +1.5 +1.2 +1.2 +Amortization of prior service credit +(2.3) +(2.3) +(2.3) +(3.8) +(3.8) +(1.4) +Net periodic benefit cost +$ +1.8 +$ +3.0 +$ +3.4 +$ +(0.7) +$ +(1.0) +$ +4.0 +Other Changes in Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income, net of tax: +Net loss (gain) +$ +7.8 +$ +0.8 +$ +1.6 +$ +(4.7) +$ +1.1 +$ +1.2 +New prior service cost (credit) +— +— +— +— +— +(23.4) +Amortization of net loss +(3.5) +(3.1) +(3.3) +(1.1) +(0.7) +(0.8) +Amortization of prior service credit +1.7 +1.4 +1.4 +2.8 +2.3 +0.9 +Total recognized in other comprehensive (income) loss +$ +6.0 +$ +(0.9) +$ +(0.3) +$ +(3.0) +$ +2.7 +$ +(22.1) +Total recognized in net periodic benefit cost and other comprehensive (income) loss +$ +7.8 +$ +2.1 +$ +3.1 +$ +(3.7) +$ +1.7 +$ +(18.1) +The weighted average assumptions used to determine benefit information during 2018, 2017, and 2016, were as follows: +Pension Benefits +Post-retirement Benefits +December 31, +December 31, +2018 +2017 +2016 +2018 +2017 +2016 +Discount rate (1) +4.40 +% +3.80 +% +4.40 +% +4.50 +% +3.90 +% +4.60 +% +Expected return on plan assets +7.50 +% +7.75 +% +8.00 +% +Rate of compensation increase +3.00 +% +3.00 +% +3.00 +% +3.00 +% +3.00 +% +3.00 +% +Initial health care cost trend rate: +Pre-65 group +6.00 +% +6.30 +% +6.60 +% +Post-65 group +6.30 +% +6.80 +% +7.20 +% +Ultimate health care cost trend rate +4.40 +% +4.40 +% +4.40 +% +Year ultimate health care cost trend rate is reached: +Pre-65 group +2037 +2037 +2037 +Post-65 group +2036 +2036 +2036 +(1) +The Company derives a single equivalent rate utilizing a yield curve constructed from a portfolio of high-quality corporate bonds with various maturities. +67 +Table of Contents +If the assumed health care cost trend rate were increased or decreased one percentage point, the accumulated post-retirement benefit obligation, as of December 31, 2018, 2017, and 2016 and the net periodic post-retirement benefit cost for 2018, 2017 and 2016, would have increased or decreased as follows: +Post-retirement Benefits +One Percentage Point +Increase +Decrease +(In millions) +2018 +2017 +2016 +2018 +2017 +2016 +Effect on total of service cost and interest cost components +$ +0.3 +$ +0.3 +$ +0.9 +$ +(0.2) +$ +(0.2) +$ +(0.7) +Effect on post-retirement benefit obligation +$ +2.6 +$ +4.0 +$ +11.5 +$ +(2.0) +$ +(3.0) +$ +(8.3) +Non-qualified Pension Plans: The Company has non-qualified supplemental pension plans covering certain employees and retirees, which provide for incremental pension payments from the Company’s general funds so that total pension benefits would be substantially equal to amounts that would have been payable from the Company’s qualified pension plans if it were not for limitations imposed by income tax law. A few employees and retirees receive additional supplemental pension benefits. Non-qualified pension plan liabilities recognized in the Consolidated Balance Sheets and expenses recognized in accumulated other comprehensive income (loss) at December 31, 2018 and 2017 are as follows: +Non-qualified +Pension Benefits +December 31, +(In millions) +2018 +2017 +Current liabilities +$ +(1.8) +$ +(1.8) +Non-current liabilities, net +(2.4) +(2.7) +Total +$ +(4.2) +$ +(4.5) +Net loss, net of taxes +$ +(0.4) +$ +(0.6) +Prior service credit, net of taxes +0.3 +0.3 +Total +$ +(0.1) +$ +(0.3) +Discount rates of 4.0 percent and 3.2 percent were used in determining the 2018 and 2017 non-qualified pension plan obligations, respectively. The estimated net loss and prior service credit for the non-qualified pension plans that will be amortized from accumulated other comprehensive income (loss) in 2019 is nominal. +Estimated Benefit Payments: The estimated future benefit payments for the next ten years as of December 31, 2018 were as follows: +Non-qualified +Pension +Pension +Post-retirement +Year (in millions) +Benefits +Benefits +Benefits (1) +2019 +$ +13.2 +$ +1.8 +$ +1.2 +2020 +13.5 +0.4 +1.1 +2021 +13.8 +— +1.2 +2022 +14.1 +0.3 +1.2 +2023 +14.5 +1.8 +1.2 +2024-2028 +75.0 +0.1 +5.8 +Total +$ +144.1 +$ +4.4 +$ +11.7 +(1) +Net of plan participants’ contributions and Medicare Part D subsidies. +Defined Contribution Plans: The Company sponsors defined contribution plans that qualify under Sections 401(a) and 401(k) of the Internal Revenue Code. The Company may make discretionary matching contributions equal to a specified percentage of each participant’s 401(k) contributions. For the year ended December 31, 2018, the Company provided matching contributions of up to 3 percent of eligible employee compensation. The Company’s matching contributions expensed in 2018, 2017 and 2016 was $2.4 million, $2.4 million and $2.1 million, respectively. +The Company may also provide a discretionary profit sharing contribution under the qualified defined contribution plans, to salaried, non-bargaining unit employees, if both a minimum threshold of Company performance is achieved and the Board has approved the profit sharing contribution. For certain eligible employees, supplemental profit sharing contributions are credited under a non-qualified plan to be paid after separation from service from the Company’s general funds so that total profit sharing contributions would be substantially equal to amounts that would have been +68 +Table of Contents +contributed to the Company’s qualified defined contribution plans if it were not for limitations imposed by income tax law. Discretionary profit sharing contributions expensed in 2018 and 2017 were $1.4 million and $2.3 million, respectively. There were no discretionary profit sharing contributions expensed in 2016. +Multi-employer Bargaining Plans: +The Company contributes to multi-employer defined benefit pension plans under the terms of collective-bargaining agreements that cover its bargaining unit employees. Contributions are generally based on amounts paid for union labor or cargo volume. The risks of participating in multi-employer plans are different from single-employer plans because assets contributed to the multi-employer plan by one employer may be used to provide benefits to employees of other participating employers. Additionally, if one employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. +The multi-employer pension plans are subject to the plan termination insurance provisions of ERISA and are paying premiums to the Pension Benefit Guaranty Corporation (“PBGC”). The statutes provide that an employer who withdraws from, or significantly reduces its contribution obligation to, a multi-employer plan generally will be required to continue funding its proportional share of the plan’s unfunded vested benefits. As of December 31, 2018, the Company’s estimated benefit plan withdrawal obligations were $244.2 million. Except as described in Note 12, no withdrawal obligations have been recorded by the Company in the Consolidated Balance Sheets at December 31, 2018 and 2017, as the Company has no present intention of withdrawing from and does not anticipate termination of any of these plans. +Information regarding the Company’s participation in multi-employer pension plans is outlined in the table below. The “EIN/Pension Plan Number” column provides the Employer Identification Number (“EIN”) and the three-digit plan number, if applicable. Unless otherwise noted, the most recent Pension Protection Act zone status available in 2018 and 2017 is for the plan’s year-end at December 31, 2018 and 2017, respectively. The zone status is based on information that the Company received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65 percent funded, plans in the yellow zone are less than 80 percent funded, and plans in the green zone are at least 80 percent funded. The funding improvement plan (“FIP”) or rehabilitation plan (“RP”) column indicates the status which is either pending or has been implemented. The last column lists the expiration dates of the collective-bargaining agreements to which the plans are subject. +Pension +Protection Act +Zone as of +FIP/RP Status +Contributions of Matson +EIN/Pension +December 31, +Pending/ +5% +(in millions) +Surcharge +Expiration +Pension Funds +Plan Number +Notes +2018 +2017 +Implemented +Contributor +2018 +2017 +2016 +Imposed +Date (5) +American Radio Association Pension Fund +13-6161999-001 +Green +Green +Implemented +Yes +$ +1.0 +$ +1.0 +$ +— +No +8/15/2021 +Hawaii Terminals Multiemployer Pension Plan +20-0389370-001 +Yellow +Yellow +Implemented +Yes +5.7 +5.7 +5.3 +No +6/30/2019 +Hawaii Stevedoring Multiemployer Retirement Plan +99-0314293-001 +Yellow +Yellow +Implemented +Yes +4.3 +3.8 +3.5 +No +6/30/2019 +Master, Mates and Pilots Pension Plan +13-6372630-001 +Green +Green +No +Yes +3.0 +3.0 +3.1 +No +6/15/2027, +6/15/2028 +Masters, Mates and Pilots Adjustable Pension Plan +37-1719247-001 +(1) +(1) +No +Yes +1.7 +1.7 +1.8 +No +6/15/2027, +6/15/2028 +MEBA Pension Trust - Defined Benefit Plan +51-6029896-001 +(2) +Green +Green +No +Yes +4.0 +4.4 +4.1 +No +6/15/2022, +6/15/2028 +OCU Trust Pension Plan +26-1574440-001 +Green +Green +No +No +0.2 +0.2 +0.2 +No +6/30/2023 +MFOW Supplementary Pension Plan +94-6201677-001 +Green +Green +No +Yes +— +— +— +No +6/30/2021 +SIU Pacific District Pension Plan +94-6061923-001 +Green +Green +No +Yes +1.2 +0.7 +0.6 +No +6/30/2021 +Alaska Teamster - Employer Pension Plan +92-6003463-024 +(3) +Red +Red +Implemented +Yes +1.9 +2.4 +2.6 +Yes +6/30/2019, +6/30/2020, +6/30/2021 +All Alaska Longshore Pension Plan +91-6085352-001 +(3) +Green +Green +No +Yes +1.0 +0.1 +0.1 +No +6/30/2020 +Western Conference of Teamsters Pension Plan +91-6145047-001 +(3) +Green +Green +No +No +1.4 +1.3 +1.3 +No +3/31/2023 +Western Conference of Teamsters Supplemental Benefit Trust +95-3746907-001 +(3) +Green +Green +No +No +— +— +— +No +3/31/2023 +OPEIU Local 153 Pension Plan +13-2864289-001 +(3) +Red +Red +Implemented +No +0.1 +0.1 +0.1 +No +11/09/2020 +Seafarers Pension Trust +13-6100329-001 +(3) (4) +Green +Green +No +No +— +— +— +No +6/30/2022 +Total +$ +25.5 +$ +24.4 +$ +22.7 +(1) +The Plan is not subject to the PPA funding requirements under IRS Section 432 as the Plan was not in effect on July 16, 2006. +69 +Table of Contents +(2) +In 2012, the Company agreed to contribute at least 11.7 percent of total wages paid to employees in covered Marine Engineer Benefits Association (“MEBA”) employment to the MEBA Pension Trust by a reallocation of the total labor cost under the collective bargaining agreement. The pension contribution rate was determined by the plan’s actuary to be necessary to maintain full funding of the pension plan and is fully offset by a reallocation of wages and other benefits. +(3) +Matson's contributions to these plans commenced after the acquisition of Horizon on May 29, 2015. +(4) +The Company does not make contributions directly to the Seafarers Pension Plan. Instead, contributions are made to the Seafarers Health and Benefits Plan, and are subsequently re-allocated to the Seafarers Pension Plan at the discretion of the plan Trustee. +(5) +Represents the expiration date of the collective bargaining agreement. +The Company also contributes to multi-employer plans that provide post-retirement health and other benefits other than pensions under the terms of collective-bargaining agreements. Benefits provided to active and retired employees and their eligible dependents under these plans include medical, dental, vision and prescription drug. These plans are not subject to the PBGC plan termination and withdrawal liability provisions of ERISA applicable to multi-employer defined benefit pension plans. Contributions to these multi-employer postretirement health and other benefits were $30.0 million, $27.0 million and $22.5 million in 2018, 2017 and 2016, respectively. +Multi-employer Defined Contribution Plans: The Company contributes to six multi-employer defined contribution pension plans. These plans are not subject to the withdrawal liability provisions of ERISA or the PBGC applicable to multi-employer defined benefit pension plans. Contributions made to these plans by the Company were $4.8 million, $5.0 million and $5.3 million in 2018, 2017 and 2016, respectively. +12. MULTI-EMPLOYER WITHDRAWAL LIABILITIES +Horizon ceased all of its operations in Puerto Rico during the first quarter of 2015, which resulted in a mass withdrawal from its multi-employer ILA-PRSSA pension fund. The Company assumed this liability as part of the acquisition of Horizon on May 29, 2015. The Company estimated the mass withdrawal liability based upon the required undiscounted quarterly payment of approximately $1.0 million to be paid to the ILA-PRSSA pension fund over a period which ends in March 2040, discounted to present value using the Company’s incremental borrowing rate. Future estimated annual payments to be paid to the ILA-PRSSA pension fund as of December 31, 2018 were as follows: +Year (in millions) +Total +2019 +$ +4.1 +2020 +4.1 +2021 +4.1 +2022 +4.1 +2023 +4.1 +Thereafter +68.0 +Total remaining future undiscounted payments due to the ILA-PRSSA pension fund +88.5 +Less: amount representing interest +(27.8) +Present value of multi-employer withdrawal liability +60.7 +Current portion of multi-employer withdrawal liability (see Note 2) +(4.1) +Long-term portion of multi-employer withdrawal liability (see Note 2) +$ +56.6 +Furthermore, the Company assumed a partial withdrawal liability related to the Local 153 Fund of the OPEIU. The partial withdrawal liability resulted from a decline in the number of contribution base units related to the Local 153 Fund caused by Horizon terminating all of its operations in Puerto Rico during the first quarter of 2015. The Company included the estimated partial withdrawal liability of $6.7 million within accruals and other liabilities in the Consolidated Balance Sheet as of December 31, 2018, based upon the expected timing of the payment. The same amount was included in long-term liabilities in the Consolidated Balance Sheet as of December 31, 2017. +70 +Table of Contents +13. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) +Changes in accumulated other comprehensive income (loss) by component, net of tax, are as follows: +Non- +Accumulated +Post- +Qualified +Other +Pension +Retirement +Pension +Comprehensive +(In millions) +Benefits +Benefits +Benefits +Other +Income (Loss) +Balance at December 31, 2016 +$ +(41.4) +$ +18.1 +$ +(0.4) +$ +0.1 +$ +(23.6) +Net gain in prior service costs +— +0.7 +— +0.1 +0.8 +Amortization of prior service cost +(1.4) +(2.5) +(0.1) +— +(4.0) +Amortization of net loss (gain) +2.2 +(0.7) +0.2 +— +1.7 +Other adjustments +— +— +— +0.2 +0.2 +Balance at December 31, 2017 +(40.6) +15.6 +(0.3) +0.4 +(24.9) +Reclassification adjustment related to the Tax Act (1) +(9.2) +3.4 +(0.2) +— +(6.0) +Amortization of prior service cost +(1.7) +(2.9) +(0.1) +— +(4.7) +Amortization of net loss (gain) +(4.3) +5.6 +0.5 +(0.7) +1.1 +Balance at December 31, 2018 +$ +(55.8) +$ +21.7 +$ +(0.1) +$ +(0.3) +$ +(34.5) +(1) +Reclassification from accumulated other comprehensive income (loss) to retained earnings for the remeasurement tax effects resulting from applying the Tax Act in accordance with ASU 2018-02. +Other comprehensive income (loss) in the Consolidated Statements of Income and Comprehensive Income are shown net of tax benefit (expense) of $0.2 million, $(4.4) million and $(14.2) million for the years ended December 2018, 2017, and 2016, respectively. +14. EARNINGS PER-SHARE +Basic earnings per share are determined by dividing net income by the weighted-average common shares outstanding during the year. The calculation of diluted earnings per share includes the dilutive effect of unexercised non-qualified stock options and non-vested stock units. The computation of weighted average dilutive shares outstanding excluded a nominal amount of anti-dilutive non-qualified stock options for each of the years 2018, 2017, and 2016. +The denominator used to compute basic and diluted earnings per share for the years ended December 31, 2018, 2017 and 2016 are as follows: +Year Ended December 31, 2018 +Year Ended December 31, 2017 +Year Ended December 31, 2016 +Weighted +Per +Weighted +Per +Weighted +Per +Average +Common +Average +Common +Average +Common +Net +Common +Share +Net +Common +Share +Net +Common +Share +(In millions, except per-share amounts) +Income +Shares +Amount +Income +Shares +Amount +Income +Shares +Amount +Basic: +$ +109.0 +42.7 +$ +2.55 +$ +231.0 +42.9 +$ +5.38 +$ +81.4 +43.1 +$ +1.89 +Effect of Dilutive Securities: +0.3 +(0.02) +0.3 +(0.03) +0.4 +(0.02) +Diluted: +$ +109.0 +43.0 +$ +2.53 +$ +231.0 +43.2 +$ +5.35 +$ +81.4 +43.5 +$ +1.87 +15. SHARE-BASED AWARDS +The Company has share-based compensation plans which are described as follows: +2016 Incentive Compensation Plan: The 2016 Incentive Compensation Plan (the “2016 Plan”) serves as a successor to the 2007 Incentive Compensation Plan and all other predecessor plans. No further grants will be made under the predecessor stock option plans. Under the 2016 Plan, 2.5 million shares of common stock were reserved for issuance. Shareholders approved the 2016 Plan at the 2016 Annual Meeting of Shareholders. +The 2016 Plan consists of four separate incentive compensation programs: (i) the discretionary grant program, (ii) the stock issuance program, (iii) the incentive bonus program and (iv) the automatic grant program for the non‑employee +71 +Table of Contents +members of the Company’s Board of Directors. Share-based compensation is generally awarded under three of the four programs, as more fully described below. +Discretionary Grant Program — Under the Discretionary Grant Program, stock options may be granted with an exercise price no less than 100 percent of the fair market value (defined as the closing market price) of the Company’s common stock on the date of the grant. Options generally become exercisable ratably over three years and have a maximum contractual term of 10 years. +Stock Issuance Program — Under the Stock Issuance Program, shares of common stock, restricted stock units or performance shares may be granted. Time-based equity awards generally vest ratably over three years. Provided certain three-year performance targets are achieved, performance-based equity awards generally vest on the three-year anniversary date of the grant. +Automatic Grant Program — At each annual shareholder meeting, non-employee directors will receive an award of restricted stock units that entitle the holder to an equivalent number of shares of common stock upon vesting, under the automatic grant program. Awards of restricted stock units granted under the program generally vest on the one-year anniversary of the grant date. +The shares of common stock authorized to be issued under the 2016 Plan may be drawn from shares of the Company’s authorized but unissued common stock or from shares of its common stock that the Company acquires, including shares purchased on the open market or in private transactions. +Share-based compensation expense and other information related to share-based awards for the years ended December 31, 2018, 2017 and 2016 are as follows: +Years Ended December 31, +Share-based compensation expense, net of estimated forfeitures (in millions) +2018 +2017 +2016 +Share-based compensation expense +$ +12.1 +$ +11.1 +$ +9.8 +Intrinsic value of options exercised +$ +0.5 +$ +0.7 +$ +2.0 +Tax benefit realized upon stock vesting +$ +2.7 +$ +6.8 +$ +5.9 +Fair value of stock vested +$ +10.8 +$ +17.3 +$ +15.8 +As of December 31, 2018, there was no unrecognized compensation cost related to non-vested stock options. As of December 31, 2018, unrecognized compensation cost related to non-vested restricted stock units and performance-based equity awards were $11.6 million. Unrecognized compensation cost is expected to be recognized over a weighted average period of approximately 1.7 years. +Activity in the Company’s stock option plans for the year ended December 31, 2018, was as follows (in thousands, except weighted average exercise price and weighted average contractual life): +Weighted +Weighted +Average +Average +Aggregate +2007 Plan +Exercise +Contractual +Intrinsic +Shares +Price +Life +Value +Outstanding at December 31, 2017 +235 +$ +21.54 +Exercised +(39) +$ +20.18 +Outstanding at December 31, 2018 +196 +$ +21.81 +2.6 +$ +1,998 +Exercisable at December 31, 2018 +196 +$ +21.81 +2.6 +$ +1,998 +The following table summarizes non-vested restricted stock unit activity through December 31, 2018, (in thousands, except weighted average grant-date fair value amounts): +2007 Plan +2016 Plan +Total +Weighted +Restricted +Restricted +Restricted +Average Grant- +Stock Units +Stock Units +Stock Units +Date Fair Value +Outstanding at December 31, 2017 +377 +309 +686 +$ +36.41 +Granted +— +384 +384 +$ +31.15 +Settlement of Performance Shares (1) +60 +— +60 +$ +36.97 +Vested +(268) +(78) +(346) +$ +36.24 +Canceled +(5) +(20) +(25) +$ +34.49 +Outstanding at December 31, 2018 +164 +595 +759 +$ +33.92 +(1) +Represents 2015 Performance Shares paid out above target. +72 +Table of Contents +16. FAIR VALUE OF FINANCIAL INSTRUMENTS +The Company values its financial instruments based on the fair value hierarchy of valuation techniques for fair value measurements. Level 1 inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability. If the technique used to measure fair value includes inputs from multiple levels of the fair value hierarchy, the lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy. +The Company uses Level 1 inputs for the fair values of its cash, cash equivalents and restricted cash, and Level 2 inputs for its capital construction fund – cash on deposit, and variable and fixed rate debt. The fair values of cash, cash equivalents and restricted cash, and variable rate debt approximate their carrying values due to the nature of the instruments. The fair value of fixed rate debt is calculated based upon interest rates available for debt with terms and maturities similar to the Company’s existing debt arrangements. +The carrying value and fair value of the Company’s financial instruments as of December 31, 2018 and 2017 are as follows: +Quoted Prices in +Significant +Significant +Total +Active Markets +Observable +Unobservable +Carrying Value +Total +(Level 1) +Inputs (Level 2) +Inputs (Level 3) +(In millions) +December 31, 2018 +Fair Value Measurements at December 31, 2018 +Cash and cash equivalents +$ +19.6 +$ +19.6 +$ +19.6 +$ +— +$ +— +Restricted cash +4.9 +4.9 +4.9 +— +— +Variable rate debt +235.0 +235.0 +— +235.0 +— +Fixed rate debt +621.4 +584.5 +— +584.5 +— +(In millions) +December 31, 2017 +Fair Value Measurements at December 31, 2017 +Cash and cash equivalents +$ +19.8 +$ +19.8 +$ +19.8 +$ +— +$ +— +CCF – cash on deposit +0.9 +0.9 +— +0.9 +— +Variable rate debt +205.0 +205.0 +— +205.0 +— +Fixed rate debt +652.1 +651.4 +— +651.4 +— +17. COMMITMENTS AND CONTINGENCIES +Commitments and contractual obligations, excluding debt obligations (see Note 8), lease commitments (see Note 9), pension and post-retirement plan commitments, and multi-employer bargaining plan withdrawal obligations (see Note 11 and 12), are as follows as of December 31, 2018: +Commitments and Contractual Obligations (in millions) +Total +Standby letters of credit (1) +$ +7.9 +Bonds (2) +$ +33.3 +Vessel construction obligations (3) +$ +250.6 +Vendor and other obligations (4) +$ +29.4 +(1) +Standby letters of credit are required for the Company’s uninsured workers’ compensation and other insurance programs, and other needs. +(2) +Bonds are required for U.S. Customs and other related matters. +(3) +Vessel construction obligations represent remaining contractual obligations entered into for the construction of new vessels. +(4) +Vendor and other obligations include: (i) non-cancellable contractual capital project obligations (excluding vessel construction obligations); (ii) dry-docking related obligations; and (iii) other contractual obligations. +These amounts are not recorded on the Company’s Consolidated Balance Sheets and it is not expected that the Company or its subsidiaries will be called upon to advance funds under these commitments. +73 +Table of Contents +Contingencies: Contingencies and other litigation related matters are described as follows: +Environmental Matters: The Company’s Ocean Transportation segment has certain risks that could result in expenditures for environmental remediation. The Company believes that based on all information available to it, the Company is currently in compliance, in all material respects, with applicable environmental laws and regulations. +Other Matters: The Company and its subsidiaries are parties to, or may be contingently liable in connection with other legal actions arising in the normal course of their businesses, the outcomes of which, in the opinion of management after consultation with counsel, would not have a material effect on the Company’s financial condition, results of operations, or cash flows. +18. BUSINESS COMBINATION S +Span Alaska Acquisition: On August 4, 2016 (the “Effective Date”), Matson Logistics completed the purchase of 100 percent of the membership interests of Span Alaska pursuant to the terms of the Membership Interest Purchase Agreement, dated July 18, 2016. At the Effective Date, Span Alaska became a wholly-owned subsidiary of Matson Logistics. Span Alaska is an asset-light logistics company providing freight forwarding services primarily to the Alaska market. Span Alaska consolidates freight in Auburn, Washington, for shipment to Alaska and distribution through a network of terminals in Anchorage, Fairbanks, Wasilla, Kenai, Juneau and Kodiak. Span Alaska’s operations are recorded within the Logistics segment of the Company. +Total consideration paid by the Company on the Effective Date for the membership interests in Span Alaska including the repayment of Span Alaska’s debt and accrued interest, is as follows: +Consideration (in millions) +Total +Membership interests +$ +117.0 +Span Alaska’s debt and accrued interest +81.9 +Total +$ +198.9 +The Span Alaska acquisition was accounted for as a business combination in accordance with ASC 805, Business Combinations (“ASC 805”). The assets acquired and liabilities assumed in the Span Alaska acquisition were recorded based on fair value estimates as of the Effective Date, with the remaining unallocated purchase price recorded as goodwill. Such fair value estimates require significant judgment, and include estimates used in the valuation of property and equipment, and intangible assets. The Company finalized its purchase accounting for the Span Alaska acquisition as of December 31, 2016. +The following table summarizes the final fair values assigned to Span Alaska’s assets acquired and liabilities assumed at the Effective Date: +Purchase Price Allocation (in millions) +Final +Cash and cash equivalents +$ +4.4 +Accounts receivable +11.1 +Prepaid and other current assets +0.9 +Property and equipment +8.1 +Intangibles – Customer relationships +79.3 +Intangibles – Trade name +27.3 +Other long-term assets +0.1 +Accounts payable +(3.3) +Accruals and other current liabilities +(6.4) +Capital lease obligations +(1.2) +Span Alaska’s debt and accrued interest +(81.9) +Total identifiable assets less liabilities +38.4 +Total consideration for membership interests +(117.0) +Goodwill +$ +78.6 +74 +Table of Contents +The Company's Consolidated Statements of Income and Comprehensive Income for the year ended December 31, 2018, 2017 and 2016 include operating revenue of $66.5 million, $59.1 million and $22.8 million (after elimination of intercompany revenue), and operating income of $16.7 million, $12.8 million and $3.5 million, respectively, from Span Alaska’s operations. One-time acquisition related costs of approximately $3.0 million incurred as a result of the Span Alaska acquisition, is included in selling, general and administrative costs in the Consolidated Statements of Income and Comprehensive Income for the year ended December 31, 2016. One-time acquisition related costs incurred post December 31, 2016 were de minimis. +Pro Forma Financial Information (Unaudited): +The following unaudited pro forma financial information presents the combined operating results of the Company and Span Alaska, as if the Span Alaska acquisition had been completed at the beginning of the period presented below. The unaudited pro forma financial information includes the accounting effects of the business combination, including the amortization of intangible assets, depreciation of property and equipment, and interest expense. Unaudited pro forma operating revenue is presented after elimination of intercompany revenue. +The unaudited pro forma financial information is presented for informational purposes only and is not indicative of the result of operations that would have been achieved if the Span Alaska acquisitions had taken place at the beginning of the period presented, nor should it be taken as an indication of our future consolidated results of operations. +(In millions, except per-share amount) +Year Ended December 31, 2016 +Pro Forma Combined: +Operating revenue +$ +1,974.2 +Net income after income taxes +$ +86.0 +Basic Earnings Per-Share: +$ +2.00 +Diluted Earnings Per-Share: +$ +1.98 +Weighted-Average Number of Shares Outstanding: +Basic +43.1 +Diluted +43.5 +19. QUARTERLY INFORMATION (Unaudited) +Segment results by quarter for 2018 and 2017 are as follows: +Quarters in the Year Ended December 31, 2018 +(In millions, except per-share amounts) +Q1 +Q2 +Q3 +Q4 +Operating Revenue: +Ocean Transportation +$ +379.3 +$ +406.6 +$ +437.3 +$ +418.1 +Logistics +132.1 +150.5 +152.1 +146.8 +Total Operating Revenue +$ +511.4 +$ +557.1 +$ +589.4 +$ +564.9 +Operating Income: +Ocean Transportation +$ +24.5 +$ +36.5 +$ +48.7 +$ +21.4 +Logistics +4.2 +9.5 +9.9 +9.1 +Total Operating Income +28.7 +46.0 +58.6 +30.5 +Interest expense, net +(5.0) +(5.0) +(4.4) +(4.3) +Other income (expense), net +0.8 +0.4 +0.7 +0.7 +Income before Income Taxes +24.5 +41.4 +54.9 +26.9 +Income Taxes +(10.3) +(8.8) +(13.3) +(6.3) +Net Income +$ +14.2 +$ +32.6 +$ +41.6 +$ +20.6 +Basic Earnings Per Share: +$ +0.33 +$ +0.76 +$ +0.97 +$ +0.48 +Diluted Earnings Per Share: +$ +0.33 +$ +0.76 +$ +0.97 +$ +0.48 +75 +Table of Contents +Quarters in the Year Ended December 31, 2017 +(In millions, except per-share amounts) +Q1 +Q2 +Q3 +Q4 (1) +Operating Revenue: +Ocean Transportation +$ +370.0 +$ +392.7 +$ +419.2 +$ +389.9 +Logistics +104.4 +119.8 +124.7 +126.2 +Total Operating Revenue +$ +474.4 +$ +512.5 +$ +543.9 +$ +516.1 +Operating Income: +Ocean Transportation +$ +15.3 +$ +40.0 +$ +51.0 +$ +20.1 +Logistics +1.9 +7.0 +7.3 +4.7 +Total Operating Income +17.2 +47.0 +58.3 +24.8 +Interest expense, net +(6.3) +(6.3) +(6.2) +(5.4) +Other income (expense), net +(0.8) +(1.1) +3.5 +0.5 +Income before Income Taxes +10.1 +39.6 +55.6 +19.9 +Income Taxes +(3.1) +(15.6) +(21.5) +146.0 +Net Income +$ +7.0 +$ +24.0 +$ +34.1 +$ +165.9 +Basic Earnings Per Share: +$ +0.16 +$ +0.56 +$ +0.79 +$ +3.90 +Diluted Earnings Per Share: +$ +0.16 +$ +0.55 +$ +0.79 +$ +3.88 +(1) +Income taxes, net income and per-share amounts were adjusted for an immaterial correction of an error in the quarter ended December 31, 2017 (see Note 2). +The following infrequent transactions impacted the Company’s quarterly segment results during the years ended December 31, 2018 and 2017: +Quarters in the Year Ended December 31, 2018 +(In millions) +Q1 +Q2 +Q3 +Q4 +Income taxes - Discrete adjustments related to the Tax Act (1) +$ +(3.3) +$ +0.2 +$ +— +$ +0.2 +(1) +Amounts relate to discrete adjustments as a result of applying the Tax Act during the year ended December 31, 2018. +Quarters in the Year Ended December 31, 2017 +(In millions) +Q1 +Q2 +Q3 +Q4 +Income taxes - Remeasurement and discrete adjustments related to the Tax Act (2) +$ +— +$ +— +$ +— +$ +154.0 +(2) +Amount relates to the remeasurement of the Company’s deferred assets and liabilities, and other discrete adjustments as a result of applying the Tax Act during the year ended December 31, 2017. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Conclusion Regarding Effectiveness of Disclosure Controls and Procedures +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective. +76 +Table of Contents +Internal Control over Financial Reporting +See page 39 for management’s annual report on internal control over financial reporting, which is incorporated herein by reference. +See page 40 for the attestation report of the independent registered public accounting firm on the Company’s internal control over financial reporting, which is incorporated herein by reference. +There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company’s fiscal fourth quarter ended December 31, 2018, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +ITEM 9B. OTHER INFORMATION +None. +77 +Table of Contents +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +A. Directors +The information about the Directors of Matson required under this item will be included under the section captioned “Election of Directors” in Matson’s Proxy Statement for the 2019 Annual Meeting of Shareholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2018 (“Matson’s 2019 Proxy Statement”), which section is incorporated herein by reference. +B. Executive Officers +The information about the executive officers of Matson required under this item will be included under the subsection captioned “Executive Officers” in Matson’s 2019 Proxy Statement, which subsection is incorporated herein by reference. +C. Corporate Governance +The information about the Audit Committee of the Matson Board of Directors and compliance with Section 16(a) of the Exchange Act, will be included under the subsections captioned “Board of Directors and Committees of Board” and “Section 16(a) Beneficial Ownership Reporting Compliance” in Matson’s 2019 Proxy Statement, which subsections are incorporated herein by reference. +D. Code of Ethics +The information about Matson’s Code of Ethics required under this item will be included under the subsection captioned “Code of Ethics” in Matson’s 2019 Proxy Statement, which subsection is incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION +The information required under this item will be included under the section captioned “Executive Compensation” and the subsections captioned “Compensation of Directors” and “Pay Risk Assessment” in Matson’s 2019 Proxy Statement, which section and subsections are incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information required under this item will be included under the section captioned “Security Ownership of Certain Shareholders” and the subsections captioned “Security Ownership of Directors and Executive Officers” in Matson’s 2019 Proxy Statement, which section and subsections are incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information required under this item will be included in the section captioned “Election of Directors” and the subsection captioned “Certain Relationships and Transactions” in Matson’s 2019 Proxy Statement, which section and subsection are incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information concerning principal accountant fees and services required under this item will be included under the sections captioned “Audit Committee Report” and “Ratification of Appointment of Independent Registered Public Accounting Firm” in Matson’s 2019 Proxy Statement, which sections are incorporated herein by reference. +78 +Table of Contents +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +A. Financial Statements +The Consolidated Financial Statements are set forth in Item 8 of Part II above. +B. Financial Statement Schedules +Except as described below, all schedules are omitted because of the absence of the conditions under which they are required or because the information called for is included in the Consolidated Financial Statements or notes thereto. +At December 31, 2018, the Company’s investment in the Terminal Joint Venture, SSAT, exceeded the 10.0 percent and 20.0 percent thresholds in at least one of the tests under Rule 3-09 and Rule 4-08(g) of Regulation S-X, and as such the audited financial statements of the Terminal Joint Venture are required to be filed as financial statement schedules herein within 90 days of SSAT’s fiscal year end, which is January 31. Accordingly, the financial statements of the Terminal Joint Venture will be filed via an amendment to this Annual Report on Form 10-K on or before May 1, 2019. +C. Exhibits Required by Item 601 of Regulation S - K +Exhibits not filed herewith are incorporated by reference to the exhibit number and previous filing shown in parentheses. All previous exhibits were filed with the Securities and Exchange Commission in Washington, D.C. +Exhibits filed pursuant to the Securities Exchange Act of 1934 were filed under file number 001-34187. Shareholders may obtain copies of exhibits for a copying and handling charge of $0.15 per page by writing to, Corporate Secretary, Matson, Inc., 555 12th Street, Oakland, California 94607. +2 +Plan of acquisition, reorganization, arrangement, liquidation or succession. +2.1 +Agreement and Plan of Merger, dated as of November 11, 2014, by and among Matson Navigation Company, Inc., Hogan Acquisition Inc. and Horizon Lines, Inc. (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated November 11, 2014). +2.2 +Amendment No. 1 to Agreement and Plan of Merger, dated as of February 13, 2015, by and among Matson Navigation Company, Inc., Hogan Acquisition Inc. and Horizon Lines, Inc. (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated February 17, 2015). +2.3 +Contribution, Assumption and Purchase Agreement, dated as of November 11, 2014, by and among The Pasha Group, SR Holding LLC, Horizon Lines, Inc. and Sunrise Operations LLC (incorporated by reference to Exhibit 2.2 of Horizon Lines, Inc.’s Form 8-K dated November 11, 2014). +2.4 +Amendment No. 1 to the Contribution, Assumption and Purchase Agreement, dated as of May 29, 2015, by and among The Pasha Group, SR Holding LLC, Horizon Lines, Inc. and Sunrise Operations LLC (incorporated by reference to Exhibit 2.2 of Matson’s Form 10-Q for the quarter ended June 30, 2015). +2.5 +Membership Interest Purchase Agreement, dated as of July 18, 2016, by and between Matson Logistics, Inc. and Span Holdings, LLC (incorporated by reference to Exhibit 2.1 of Matson’s Form 8‑K dated July 18, 2016). +3 +Articles of incorporation and bylaws. +3.1 +Amended and Restated Articles of Incorporation of Matson, Inc. (incorporated by reference to Exhibit 3.1 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +79 +Table of Contents +3.2 +Articles of Amendment to Change Corporate Name (incorporated by reference to Exhibit 4.2 of Matson’s Form S-8 dated October 26, 2012). +3.3 +Amended and Restated Bylaws of Matson, Inc. (as amended as of November 6, 2013) (incorporated by reference to Exhibit 3.1 of Matson’s Form 10-Q for the quarter ended September 30, 2013). +10 +Material contracts. +10.1 +Amended and Restated Credit Agreement among Matson, Inc., Bank of America, N.A., as the Agent, and the lenders thereto, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated June 29, 2017). +10.2 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated June 29, 2017). +10.3 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.3 of Matson’s Form 8-K dated June 29, 2017). +10.4 +Amendment to Third Amended and Restated Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.4 of Matson’s Form 8-K dated June 29, 2017). +10.5 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.5 of Matson’s Form 8-K dated June 29, 2017). +10.6 +Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of December 21, 2016 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated December 21, 2016). +10.7 +Third Amended and Restated Note Purchase and Private Shelf Agreement among Matson, Inc. and the purchasers party thereto, dated as of September 14, 2016 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated September 14, 2016). +10.8 +Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of July 30, 2015 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated August 3, 2015). +10.9 +Amendment to the Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of July 30, 2015 (incorporated by reference to Exhibit 10.3 of Matson’s Form 8-K dated August 3, 2015). +10.10 +First Amendment to Note Purchase Agreement amount Matson, Inc. and the purchasers party thereto, dated as of October 1, 2015 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated October 2, 2015). +10.11 +Note Purchase Agreement among Matson, Inc., and the purchasers party thereto, dated as of November 5, 2013 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated January 29, 2014). +10.12 +Amended and Restated Limited Liability Company Agreement of SSA Terminals, LLC by and between SSA Ventures, Inc. and Matson Ventures, Inc., dated as of April 24, 2002 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.1 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +10.13 +Parent Company Agreement, dated as of April 24, 2002, by and among SSA Pacific Terminals, Inc., formerly known as Stevedoring Services of America, Inc., SSA Ventures, Inc., Matson Navigation Company, Inc. and Matson Ventures, Inc. (incorporated by reference to Exhibit 10.2 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +80 +Table of Contents +10.14 +Security Agreement between Matson Navigation Company, Inc. and the United States of America, with respect to $55 million of Title XI ship financing bonds, dated July 29, 2004 (incorporated by reference to Exhibit 10.a.(xxvi) of Alexander & Baldwin, Inc.’s Form 10-Q for the quarter ended September 30, 2004). +10.15 +Amendment No. 1 dated September 21, 2007, to Security Agreement between Matson Navigation Company, Inc. and the United States of America, with respect to $55 million of Title XI ship financing bonds, dated July 29, 2004 (incorporated by reference to Exhibit 10.a.(xxx) of Alexander & Baldwin, Inc.’s Form 10-Q for the quarter ended September 30, 2007). +10.16* +Matson, Inc. 2007 Incentive Compensation Plan, amended and restated, effective January 29, 2015 (incorporated by reference to Exhibit 10.13 of Matson’s Form 10-K for the year ended December 31, 2014). +10.17* +Form of Notice of Performance Share Award Grant (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated January 29, 2013). +10.18* +Form of Matson, Inc. Performance Share Award Agreement (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated January 29, 2013). +10.19* +Form of Notice of Stock Option Grant (incorporated by reference to Exhibit 99.2 to Matson’s Form S‑8 dated October 26, 2012). +10.20* +Form of Stock Option Agreement for Non-Executive Employees (incorporated by reference to Exhibit 99.3 of Matson’s Form S-8 dated October 26, 2012). +10.21* +Form of Stock Option Agreement for Executive Employees (incorporated by reference to Exhibit 99.4 of Matson’s Form S-8 dated October 26, 2012). +10.22* +Form of Notice of Time-Based Restricted Stock Unit Grant (incorporated by reference to Exhibit 99.5 of Matson’s Form S-8 dated October 26, 2012). +10.23* +Form of Time-Based Restricted Stock Unit Agreement for Non-Executive Employees (incorporated by reference to Exhibit 99.6 of Matson’s Form S-8 dated October 26, 2012). +10.24* +Form of Time-Based Restricted Stock Unit Agreement for Executive Employees (incorporated by reference to Exhibit 99.7 of Matson’s Form S-8 dated October 26, 2012). +10.25* +Form of Amended and Restated Restricted Stock Unit Award Agreement for Non-Employee Directors (No Deferral) (incorporated by reference to Exhibit 10.20 of Matson’s Form 10-K for the year ended December 31, 2013). +10.26* +Form of Amended and Restated Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election) (incorporated by reference to Exhibit 10.21 of Matson’s Form 10-K for the year ended December 31, 2013). +10.27* +Form of Anti-Dilution Adjustment Amendment to Restricted Stock Unit Award Agreements (incorporated by reference to Exhibit 99.10 of Matson’s Form S-8 dated October 26, 2012). +10.28* +Form of Anti-Dilution Adjustment Amendment to Stock Option Agreements (incorporated by reference to Exhibit 99.11 of Matson’s Form S-8 dated October 26, 2012). +10.29* +Form of Stock Option Assumption Agreement (incorporated by reference to Exhibit 99.4 of Post‑Effective Amendment No. 2 to Alexander & Baldwin, Inc.’s Form S-8 dated June 6, 2012). +10.30* +Special Form of Stock Option Assumption Agreement (incorporated by reference to Exhibit 99.6 of Post‑Effective Amendment No. 2 to Alexander & Baldwin, Inc.’s Form S-8 dated June 6, 2012). +81 +Table of Contents +10.31* +Matson, Inc. Deferred Compensation Plan for Outside Directors (incorporated by reference to Exhibit 10.34 of Matson’s Form 10-K for the year ended December 31, 2012). +10.32* +Matson, Inc. Excess Benefits Plan, amended and restated effective August 27, 2014 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated August 28, 2014). +10.33*,** +Matson, Inc. Executive Survivor/Retirement Benefit Plan (formerly known as the Alexander & Baldwin, Inc. Executive Survivor/Retirement Benefit Plan), amended and restated effective June 29, 2012. +10.34* +Matson, Inc. 1985 Supplemental Executive Retirement Plan (formerly known as the Alexander & Baldwin, Inc. 1985 Supplemental Executive Retirement Plan), amended and restated effective as of January 1, 2008 (incorporated by reference to Exhibit 10.b.1.(lii) of Alexander & Baldwin, Inc.’s Form 10-K for the year ended December 31, 2011). +10.35* +Amendment No. 1 to the Matson, Inc. 1985 Supplemental Executive Retirement Plan (formerly known as the Alexander & Baldwin, Inc. 1985 Supplemental Executive Retirement Plan), effective as of December 31, 2011 (incorporated by reference to Exhibit 10.b.1.(liii) of Alexander & Baldwin, Inc.’s Form 10-K for the year ended December 31, 2011). +10.36* +Amendment No. 2 to the Matson, Inc. 1985 Supplemental Executive Retirement Plan (formerly known as the Alexander & Baldwin, Inc. 1985 Supplemental Executive Retirement Plan), effective as of January 1, 2012 (incorporated by reference to Exhibit 10.b.1.(liv) of Alexander &Baldwin, Inc.’s Form 10-K for the year ended December 31, 2011). +10.37* +Form of Letter Agreement entered into with certain executive officers (incorporated by reference to Exhibit 10.45 of Matson’s Form 10-K for the year ended December 31, 2012). +10.38* +Schedule identifying executive officers who have entered into Form of Letter Agreement (incorporated by reference to Exhibit 10.42 of Matson’s Form 10-K for the year ended December 31, 2014). +10.39* +Form of Letter Agreement entered into with executive officer (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated October 24, 2014). +10.40* +Letter Agreement Counter Party (incorporated by reference to Exhibit 10.2 of Matson’s Form 8‑K dated October 24, 2014). +10.41* +Form of Letter Agreement entered into with executive officer (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated April 6, 2015). +10.42* +Letter Agreement Counter Parties (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated April 6, 2015). +10.43* +Form of Letter Agreement entered into with an officer (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated May 1, 2018). +10.44* +Letter Agreement Counter Parties (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated May 1, 2018). +10.45* +Matson, Inc. Executive Severance Plan (incorporated by reference to Exhibit 10.47 of Matson’s Form 10-K for the year ended December 31, 2012). +10.46* +Matson, Inc. Cash Incentive Plan (incorporated by reference to Exhibit 10.49 of Matson’s Form 10-K for the year ended December 31, 2012). +82 +Table of Contents +10.47* +Matson, Inc. Deferred Compensation Plan (incorporated by reference to Exhibit 10.51 of Matson’s Form 10-K for the year ended December 31, 2012). +10.48 +Shipbuilding Contract, by and between Aker Philadelphia Shipyard, Inc. and Matson Navigation Company, Inc., dated as of November 6, 2013 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.56 of Matson’s Form 10-K for the year ended December 31, 2013). +10.49 +Shipbuilding Contract, by and between Aker Philadelphia Shipyard, Inc. and Matson Navigation Company, Inc., dated as of November 6, 2013 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.57 of Matson’s Form 10-K for the year ended December 31, 2013). +10.50 +Guaranty Agreement by Aker Philadelphia Shipyard ASA, in favor of Matson Navigation Company, Inc., dated as of November 6, 2013 (incorporated by reference to Exhibit 10.58 of Matson’s Form 10‑K for the year ended December 31, 2013). +10.51 +Contract for Construction of Two Vessels, dated as of August 25, 2016, by and between Matson Navigation Company, Inc. and National Steel and Shipbuilding Company (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.1 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +10.52 +Purchaser’s Corporate Guaranty Agreement, by Matson, Inc., dated as of August 25, 2016 (incorporated by reference to Exhibit 10.2 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +10.53 +Contractor’s Corporate Guaranty Agreement, by General Dynamics Corporation, dated as of August 25, 2016 (incorporated by reference to Exhibit 10.3 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +10.54 +Form of Capital Construction Fund Agreement with Matson Navigation Company, as amended by Addendums No. 2, No. 5, No. 18, No. 20 and No. 31, thereto (incorporated by reference to Exhibit 10.60 of Matson’s Form 10-K for the year ended December 31, 2013). +10.55 +Form of Voting Agreement, dated as of November 11, 2014, among Matson Navigation Company, Inc. and certain holders of voting securities of Horizon Lines, Inc. (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated November 11, 2014). +10.56* +Matson, Inc. 2016 Incentive Compensation Plan, amended as of October 25, 2017 (incorporated by reference to Exhibit 10.56 of Matson’s Form 10-K for the year ended December 31, 2017). +10.57* +Amended and Restated Matson, Inc. Cash Incentive Plan, effective January 1, 2016 (incorporated by reference to Exhibit 10.63 of Matson’s Form 10-K for the year ended December 31, 2016). +10.58* +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (No Deferral) (incorporated by reference to Exhibit 10.64 of Matson’s Form 10-K for the year ended December 31, 2016). +10.59* +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election) (incorporated by reference to Exhibit 10.65 of Matson’s Form 10-K for the year ended December 31, 2016). +10.60* +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Non-Executive Employees (incorporated by reference to Exhibit 10.60 of Matson’s Form 10-K for the year ended December 31, 2017). +83 +Table of Contents +10.61* +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Executive Employees (incorporated by reference to Exhibit 10.61 of Matson’s Form 10-K for the year ended December 31, 2017). +10.62* +Form of 2016 Plan Performance Share Award Agreement for Non-Executive Employees (incorporated by reference to Exhibit 10.62 of Matson’s Form 10-K for the year ended December 31, 2017). +10.63* +Form of 2016 Plan Performance Share Award Agreement for Executive Employees (incorporated by reference to Exhibit 10.63 of Matson’s Form 10-K for the year ended December 31, 2017). +10.64* +Form of Notice of 2016 Plan Performance Share Award Grant for Non-Executive Employees (incorporated by reference to Exhibit 10.70 of Matson’s Form 10-K for the year ended December 31, 2016). +10.65* +Form of Notice of 2016 Plan Performance Share Award Grant for Executive Employees (incorporated by reference to Exhibit 10.71 of Matson’s Form 10-K for the year ended December 31, 2016). +10.66* +Form of Notice of 2016 Time-Based Restricted Stock Unit Award Grant for Non-Executive Employees (incorporated by reference to Exhibit 10.72 of Matson’s Form 10-K for the year ended December 31, 2016). +10.67* +Form of Notice of 2016 Time-Based Restricted Stock Unit Award Grant for Executive Employees (incorporated by reference to Exhibit 10.73 of Matson’s Form 10-K for the year ended December 31, 2016). +10.68* +Addendum to Award Agreements for Outstanding Equity Awards, effective as of October 25, 2017 (incorporated by reference to Exhibit 10.68 of Matson’s Form 10-K for the year ended December 31, 2017) +21** +Matson, Inc. Subsidiaries as of February 15, 2019. +23** +Consent of Deloitte & Touche, LLP dated March 4, 2019. +31.1** +Certification of Chief Executive Officer, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +31.2** +Certification of Chief Financial Officer, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32*** +Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101.INS** +XBRL Instance Document +101.SCH** +XBRL Taxonomy Extension Schema Document +101.CAL** +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF** +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB** +XBRL Taxonomy Extension Label Linkbase Document +101.PRE** +XBRL Taxonomy Extension Presentation Linkbase Document +* Indicates management contract or compensatory plan or arrangement. +** Filed herewith. +*** Furnished herewith. +84 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +MATSON, INC. +(Registrant) +Date: March 4, 2019 +/s/ Matthew J. Cox +Matthew J. Cox +Chairman and +Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Matthew J. Cox +Chairman and Chief Executive Officer +March 4, 2019 +Matthew J. Cox +/s/ W. Blake Baird +Director +March 4, 2019 +W. Blake Baird +/s/ Michael J. Chun +Director +March 4, 2019 +Michael J. Chun +/s/ Thomas B. Fargo +Director +March 4, 2019 +Thomas B. Fargo +/s/ Mark H. Fukunaga +Director +March 4, 2019 +Mark H. Fukunaga +/s/ Stanley M. Kuriyama +Director +March 4, 2019 +Stanley M. Kuriyama +/s/ Constance H. Lau +Director +March 4, 2019 +Constance H. Lau +/s/ Joel M. Wine +Senior Vice President and Chief Financial Officer +March 4, 2019 +Joel M. Wine +/s/ Kevin L. Stuck +Vice President and Controller (principal accounting officer) +March 4, 2019 +Kevin L. Stuck +***** +85 \ No newline at end of file diff --git a/raw/filings/0000003453/2018/0001558370-19-001448/filing_metadata.csv b/raw/filings/0000003453/2018/0001558370-19-001448/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..64b675f7b21e97c6d3599a8c241e0baec049a89a --- /dev/null +++ b/raw/filings/0000003453/2018/0001558370-19-001448/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003453,MATX,"Matson, Inc.",2018,10-K,2019-03-04,2018-12-31,2019-03-04T11:25:17.000Z,0001558370-19-001448,matx-20181231x10k.htm,10-K,24465045,1,0,https://www.sec.gov/Archives/edgar/data/3453/000155837019001448/matx-20181231x10k.htm,https://www.sec.gov/Archives/edgar/data/3453/000155837019001448/ diff --git a/raw/filings/0000003453/2018/0001558370-19-001448/item1.txt b/raw/filings/0000003453/2018/0001558370-19-001448/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..e0a4d6cf90afd1e3bf9652a4c6b3295c4ebdf9d2 --- /dev/null +++ b/raw/filings/0000003453/2018/0001558370-19-001448/item1.txt @@ -0,0 +1,579 @@ +ITEM 1. BUSINESS +A. +COMPANY OVERVIEW +Matson, Inc., a holding company incorporated in January 2012 in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information by segment for the three years ended December 31, 2018, see Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates a premium, expedited service from China to Long Beach, California, and also provides services to Okinawa, Japan and various islands in the South Pacific. In addition, subsidiaries of MatNav provide container stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +Matson has a 35 percent ownership interest in SSA Terminals, LLC (“SSAT”), a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc. (“SSA”), a subsidiary of Carrix, Inc. (“Terminal Joint Venture”). SSAT provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including four facilities which are used by MatNav. Matson records its share of income from the Terminal Joint Venture in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +Our Mission and Vision: +Our mission is to move freight better than anyone. Our vision is to create value for our shareholders by: +· +Being our customers’ first choice, +· +Leveraging our core strengths to drive growth and increase profitability, +· +Improving the communities in which we work and live, +· +Being an environmental leader in our industry, and +· +Being a great place to work. +1 +Table of Contents +B. +BUSINESS DESCRIPTION +(1) OCEAN TRANSPORTATION SEGMENT +Ocean Freight Services: +Matson’s Ocean Transportation segment provides the following services: +Ocean Transportation Services: +Hawaii Service: Matson’s Hawaii service provides ocean freight services (lift-on/lift-off, roll-on/roll-off and conventional services) between the ports of Long Beach and Oakland, California; Seattle, Washington; and Honolulu, Hawaii. Matson also operates a network of inter-island barges that provide connecting services from Honolulu, Hawaii to other major ports on the Hawaiian islands of Kauai, Maui and Hawaii. Matson is the largest carrier of ocean cargo between the U.S. West Coast and Hawaii. +Westbound cargo carried by Matson to Hawaii includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, building materials, automobiles and household goods. Matson’s eastbound cargo from Hawaii includes automobiles, household goods, dry containers of mixed commodities and livestock. The majority of Matson’s Hawaii service revenue is derived from the westbound carriage of containerized freight and automobiles. +Alaska Service: Matson’s Alaska service provides ocean freight services (lift-on/lift-off and conventional services) between the port of Tacoma, Washington, and the ports of Anchorage, Kodiak and Dutch Harbor in Alaska. Matson also provides a barge service between Dutch Harbor and Akutan in Alaska, and other transportation services to smaller locations in Alaska. +Northbound cargo to Alaska includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, household goods and automobiles. Southbound cargo from Alaska primarily consists of seafood, household goods and automobiles. +China Service: Matson’s expedited China-Long Beach Express (“CLX”) service is part of an integrated service that carries cargo from Long Beach, California to Honolulu, Hawaii, to Guam, and then to Okinawa, Japan. The vessels continue to the ports of Ningbo and Shanghai in China, where they are loaded with cargo to be discharged primarily in Long Beach, California. These vessels also carry cargo destined for Hawaii which originated in Guam, Micronesia, Japan and China. Matson provides container transshipment services between the CLX ports and many locations in Asia including Hong Kong and Xiamen, China. +Eastbound cargo from China to Long Beach, California consists mainly of garments, footwear and other retail merchandise. Westbound cargo to China and other destinations in Asia consists mainly of recycled materials. +Guam Service: Matson’s Guam service provides weekly services between the U.S West Coast and Guam, as part of its expedited CLX service. Matson also provides weekly connecting service from Guam to the Commonwealth of the Northern Mariana Islands. These services carry cargo similar to the Hawaii service described above. +Japan Service: Matson’s Japan service provides services to the port of Naha in Okinawa, Japan, as part of its expedited CLX service. This service carries mainly general sustenance cargo and household goods supporting the U.S. military. +Micronesia Service: Matson’s Micronesia service provides services between the U.S. West Coast and the islands of Yap, Pohnpei, Chuuk and Kosrae in the Federated States of Micronesia, and the Republic of Palau. Cargo destined for these locations is transshipped through Guam and consists of mainly general sustenance cargo. Matson also operates a direct service between Honolulu, Hawaii and the islands of Kwajalein, Ebeye and Majuro in the Republic of the Marshall Islands with a U.S. flagged vessel. This service carries mainly general sustenance cargo, construction materials, and household goods supporting the U.S. military. +2 +Table of Contents +South Pacific Service: Matson’s New Zealand Express (“NZX”) service provides services carrying general sustenance cargo between Auckland, New Zealand and the South Pacific islands, including Fiji (Suva and Lautoka), Samoa (Apia), American Samoa (Pago Pago), the Cook Islands (Rarotonga and Aitutaki), Tonga (Nukualofa and Vava’u), and Niue. Matson’s NZX service also provides transshipment services to the islands of Tahiti, Vanuatu, Nauru and the Solomon Islands (Honiara). Additionally, Matson also provides slotting arrangements for the transportation of cargo from major ports on the east coast of Australia to ports in the South Pacific islands. The NZX service also distributes and sells domestic bulk fuel to a variety of these islands. +Matson also provides a bi-weekly South Pacific Express (“SPX”) service that connects the U.S. West Coast to ports in the South Pacific islands. Cargo destined for these ports is transshipped from the U.S. West Coast on Matson’s Hawaii and CLX services to a Matson SPX vessel in Honolulu, Hawaii. The SPX vessel then transports the cargo to ports in the South Pacific islands including Tahiti (Papeete), American Samoa (Pago Pago), Samoa (Apia) and Tonga (Nukualofa). Commencing September 2018, the SPX service also provides a bi-monthly service to Christmas Island (Kiritimati) in the Republic of Kiribati. Cargo destined for other ports is transshipped to Matson’s South Pacific service at the port of Apia, Samoa. SPX cargo originating in the South Pacific destined for Hawaii or other locations on the U.S. West Coast is shipped to Honolulu, Hawaii, and then transshipped on Matson vessels to the U.S. West Coast. +Terminal and Other Related Services: +Matson provides container stevedoring, refrigerated cargo services, inland transportation, container equipment maintenance and other terminal services (collectively “terminal services”) for MatNav at terminals located on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai; and in the Alaska terminal locations of Anchorage, Kodiak and Dutch Harbor. Matson also provides terminal services for other ocean carriers at the Alaska terminal locations of Kodiak and Dutch Harbor. +Matson’s Terminal Joint Venture SSAT provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast and to MatNav at four of those facilities, which are Long Beach and Oakland, California; and Seattle and Tacoma, Washington. +Matson utilizes the services of other third-party terminal operators at all of the other ports at which its vessels call. +Vessel Management Services: +Matson contracts with the U.S. Department of Transportation to provide vessel management services to manage and maintain three Ready Reserve Force vessels on behalf of the U.S. Department of Transportation Maritime Administration. +Recent Ocean Transportation Acquisition: +On May 29, 2015, Matson completed its acquisition of Horizon Lines, Inc. (“Horizon”). As a result, Matson acquired Horizon’s Alaska operations and assumed all of Horizon’s non-Hawaii assets and liabilities. +Matson’s Vessel and Equipment Information: +Vessels: +Matson’s fleet includes both owned and chartered vessels. Matson’s owned vessels represent an investment of approximately $1.5 billion. The majority of Matson’s owned vessels are U.S. flagged and Jones Act qualified vessels, and operate in the Hawaii, Guam, Japan, China and Alaska services. During the fourth quarter of 2018, Matson launched MV Daniel K. Inouye , the largest Jones Act container vessel ever built in the U.S. Matson’s non-U.S. flagged vessels operate in the Micronesia and South Pacific services. +3 +Table of Contents +Active and reserve vessels both owned and chartered by Matson as of December 31, 2018 are as follows: +Usable Cargo Capacity +Containers +Vehicles +Maximum +Maximum +Owned/ +Official +Reefer +Year +Speed +Deadweight +Name of Vessels (1) +Chartered +Number +TEUs (2) +Slots +Autos +Built +Length +(Knots) +(Long Tons) +Diesel-Powered +DANIEL K. INOUYE (3) +Owned +1274136 +3,220 +408 +— +2018 +854’ 0” +23.5 +50,794 +MANOA (3) +Owned +651627 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,187 +MAHIMAHI (3) +Owned +653424 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,167 +MANULANI (3) +Owned +1168529 +2,378 +284 +— +2005 +712’ 0” +23.0 +29,517 +MAUNAWILI (3) +Owned +1153166 +2,378 +326 +— +2004 +711’ 9” +23.0 +29,517 +MANUKAI (3) +Owned +1141163 +2,378 +326 +— +2003 +711’ 9” +23.0 +29,517 +R.J. PFEIFFER (3) +Owned +979814 +2,245 +300 +— +1992 +713’ 6” +23.0 +27,100 +MOKIHANA (3) +Owned +655397 +1,994 +354 +1,323 +1983 +860’ 2” +23.0 +29,484 +MAUNALEI (3) +Chartered +1181627 +1,992 +328 +— +2006 +681’ 1” +22.1 +33,771 +MATSON KODIAK (3) +Owned +910308 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON ANCHORAGE (3) +Owned +910306 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON TACOMA (3) +Owned +910307 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +KAMOKUIKI (4) +Owned +9232979 +707 +100 +— +2000 +433’ 9” +17.5 +8,509 +OLOMANA (5) +Chartered +9184225 +645 +120 +— +2004 +388’ 7” +14.0 +8,200 +IMUA II (5) +Chartered +9184237 +630 +90 +— +2005 +388’ 6” +15.0 +8,071 +LILOA II (5) +Chartered +9184249 +630 +90 +— +2004 +388’ 6” +15.0 +8,071 +PAPA MAU (5) +Owned +1559 +521 +68 +— +1999 +381’ 5” +14.0 +5,364 +SAMOANA (5) +Chartered +9164550 +505 +101 +— +2000 +330’ 0” +14.5 +5,550 +MANA (5) +Owned +4958 +384 +60 +— +1997 +329’ 9” +13.0 +4,508 +Steam-Powered +LIHUE (3) +Owned +530137 +2,018 +188 +— +1971 +787’ 8” +21.0 +38,656 +KAUAI (3) +Owned +621042 +1,644 +276 +44 +1980 +720’ 5” +22.0 +26,308 +MATSONIA (3) +Owned +553090 +1,727 +258 +450 +1973 +760’ 0” +21.0 +22,501 +Barges +MAUNA LOA (3) +Chartered +1247426 +500 +78 +— +2013 +362’ 6” +— +12,678 +HALEAKALA (3)(6) +Owned +676972 +335 +78 +— +1984 +350’ 0” +— +4,658 +ILIULIUK BAY (3)(6) +Chartered +1249384 +178 +— +— +2013 +250’ 0” +— +4,138 +WAIALEALE (3)(7) +Owned +978516 +— +36 +230 +1991 +345’ 0” +— +5,621 +(1) +Excludes inactive vessels. +(2) +Twenty-foot Equivalent Units (“TEU”) is a standard measure of cargo volume correlated to a standard 20-foot dry cargo container. +(3) +U.S. flagged and Jones Act qualified vessel or barge. +(4) +U.S. flagged vessel. +(5) +Foreign flagged vessel. +(6) +Lift-on/lift-off barge equipped with cranes. +(7) +Roll-on/roll-off barge. +Hawaii Fleet Renewal Program: +Matson is investing approximately $0.9 billion in the construction of four new vessels to renew its Hawaii fleet and phase-out the use of older steamships that are near the end of their useful life. The first Aloha Class containership, MV Daniel K. Inouye, was delivered on October 31, 2018 and commenced active service in November 2018. Expected delivery dates and specifications of the remaining three vessels currently under construction are as follows: +` +Usable Cargo Capacity +Containers +Vehicles +Maximum +Maximum +Expected +Type of +Official +Reefer +Speed +Deadweight +Name of Vessels +Delivery Date +Vessel +Number +TEUs +Slots +Autos +Length +(Knots) +(Long Tons) +Dual-fuel Capable +Kaimana Hila (1) +Q1 2019 +Containership +1274135 +3,220 +408 +— +854’ 0” +23.5 +53,747 +Lurline (2) +Q4 2019 +Con-Ro +1274143 +2,750 +432 +500 +869’ 5” +23.0 +50,981 +Matsonia (2) +Q3 2020 +Con-Ro +1274123 +2,750 +432 +500 +869’ 5” +23.0 +50,981 +4 +Table of Contents +(1) +The Aloha Class container vessel is being constructed by Philly Shipyard, Inc. (“Philly Shipyard”), with a dual-fuel, liquefied natural gas capable engine. +(2) +The two new Kanaloa Class combination container and roll-on/roll-off (“Con-Ro”) vessels are being constructed by General Dynamics NASSCO (“NASSCO”), with dual-fuel, liquefied natural gas capable engines. +The new vessels are expected to have among the lowest operating cost per TEU capacity of any vessel in the U.S. domestic trades. The cost efficiencies are expected to be driven by increased vessel utilization and by significantly lower fuel consumption, maintenance and repair, and dry-docking costs. Matson also expects to return to an optimal nine vessel Hawaii fleet deployment once MV Lurline is in service. In addition, the new vessels will provide increased capacity over the older vessels that are being replaced. +Actual paid and expected remaining vessel construction obligations based on signed agreements and change orders, excluding owners’ items and capitalized interest, are as follows: +Paid +Outstanding Obligations +Vessel Construction Obligations (in millions) +2018 and Prior +2019 +2020 +Total +Two Aloha Class Container Vessels +$ +386.9 +$ +20.7 +$ +3.9 +$ +411.5 +Two Kanaloa Class Con-Ro Vessels +290.7 +168.2 +57.8 +516.7 +Total +$ +677.6 +$ +188.9 +$ +61.7 +$ +928.2 +Hawaii Terminal Expansion and Modernization Program: +Matson is in the process of renovating its terminal facility at Sand Island, Honolulu, Hawaii. The first phase involves the investment of approximately $60 million and includes the installation of three new 65 long-ton capacity gantry cranes and modifications to upgrade three existing cranes. The first phase also includes upgrades in electrical infrastructure and other modifications to the Sand Island terminal. The first phase is expected to be completed during 2020. +Additional phases will be completed in the 2021 to 2024 timeframe and will be part of a broader terminal expansion and modernization program that Matson is undertaking at its Sand Island terminal. +Equipment: +As a complement to its fleet of vessels, Matson has a variety of equipment including cranes, containers and chassis which represents an investment of approximately $0.5 billion as of December 31, 2018. Matson also leases containers, chassis and other equipment under various operating lease agreements. +Additional information about Matson’s fleet equipment is as follows: +Approx. % +Approx. % +Fleet Equipment +Total (1) +Owned (1) +Leased (1) +Chassis +22,200 +51 +% +49 +% +Dry Containers +36,500 +60 +% +40 +% +Refrigerated Containers +8,100 +43 +% +57 +% +Specialty Equipment (2) +5,700 +82 +% +18 +% +Motor Generators +2,000 +90 +% +10 +% +(1) +Amounts represent approximations of equipment totals and percentage allocations. +(2) +Specialty equipment includes auto frames, flat racks, insulated containers, open top containers, platforms, flat bed trailers and tanks. +Operating Costs: +Major components of Ocean Transportation operating costs are as follows: +Direct Cargo Expense includes terminal handling costs, purchased outside transportation and other related costs. +Vessel Operating Expense includes crew wages and related costs; fuel consumption, pilot, tugs and line related costs; vessel charter expenses; and other vessel related expenses. Matson purchases fuel oil, lubricants and gasoline for its operations and also pays fuel surcharges to other third party transportation providers. +5 +Table of Contents +Operating Overhead includes equipment repair costs, equipment operating lease and repositioning expenses, vessel repair and maintenance costs, dry-docking amortization, insurance, port engineers and other maintenance costs, and other vessel and shoreside related overhead. +Matson’s U.S. flagged vessels must meet specified seaworthiness standards established by U.S. Coast Guard rules and classification society requirements. These standards require vessels to undergo two dry-docking inspections within a five-year period. The majority of Matson’s U.S. flagged vessels used in the Hawaii service are enrolled in the U.S. Coast Guard’s Underwater Survey in Lieu of Dry-docking (“UWILD”) program. The UWILD program allows eligible vessels to meet their intermediate dry-docking requirement with a less costly underwater inspection. +Matson is responsible for ensuring that its non-U.S flagged owned and bareboat chartered vessels meet international standards for seaworthiness, which among other requirements generally mandate that Matson perform two dry-docking inspections every five years. The dry-dockings of Matson’s time chartered vessels are the responsibility of the vessel owners. +Competition: +The following is a summary of major competitors in Matson’s Ocean Transportation segment: +Hawaii Service: Matson’s Hawaii service has one major U.S. flag Jones Act ocean carrier competitor, Pasha Hawaii (“Pasha”), which operates container and roll-on/roll-off services between the ports of Long Beach, Oakland and San Diego, California to Hawaii. There also are two U.S. flag Jones Act barge operators, Aloha Marine Lines and Sause Brothers, which offer barge service between the Pacific Northwest and Hawaii. +Foreign-flag vessels carrying cargo to Hawaii from non-U.S. locations also provide alternatives for companies shipping to Hawaii. Other competitors in the Hawaii service include proprietary operators and contract carriers of bulk cargo. Air freight competition for time-sensitive and perishable cargo exists; however, inroads by such competition in terms of cargo volume are limited by the amount of cargo space available in passenger aircrafts and by the cost of air freight transportation. +Matson vessels are operated on schedules that provide customers, shippers and consignees fixed day-of-the-week sailings from the U.S. West Coast as well as fixed day-of-the-week arrivals in Hawaii. Matson offers four westbound sailings per week, though this amount may be adjusted according to seasonal demand and market conditions. One of Matson’s westbound sailings each week continues on to Guam, Japan and China, so the number of eastbound sailings direct from Hawaii to the U.S. Mainland is three per week. This service is attractive to customers because more frequent sailings permit customers to reduce inventory carrying costs. Matson also competes by offering a more comprehensive service to customers, including: service to and from the three largest U.S. West Coast ports; the most efficient terminal network on the U.S. West Coast provided by Matson’s Terminal Joint Venture partner SSAT; a dedicated inter-island barge network; an award winning customer service team; and its efficiency and experience in handling cargo of all types. +Alaska Service: Matson’s Alaska service has one major U.S. flag Jones Act competitor, Totem Ocean Trailer Express, Inc., which operates a roll-on/roll off service between Tacoma, Washington and Anchorage, Alaska. There are also two U.S. flag Jones Act barge operators, Alaska Marine Lines, which mainly provides services from Seattle, Washington to the main ports of Anchorage and Dutch Harbor, and other locations in Alaska, and Samson Tug & Barge, which mainly serves Western Alaska and other locations. The barge operators have historically shipped lower value commodities that can accommodate a longer transit time, as well as construction materials and other cargo that are not conducive to movement in containers. Foreign-flag vessels provide alternatives for companies shipping cargo (mainly seafood) from the Alaska ports of Kodiak and Dutch Harbor. +Matson offers customers twice weekly scheduled services from Tacoma, Washington to Anchorage and Kodiak, Alaska and weekly service to Dutch Harbor, Alaska. The Company also provides a weekly barge service between Dutch Harbor and Akutan in Alaska. Matson is the only Jones Act containership operator providing service to Kodiak and Dutch Harbor in Alaska, which are the primary loading ports for southbound seafood. Matson offers dedicated terminal services at the Alaska ports of Anchorage, Kodiak and Dutch Harbor performed by MatNav, and at the port of Tacoma, Washington performed by Matson’s Terminal Joint Venture partner SSAT. +6 +Table of Contents +China Service: Major competitors to Matson’s China service include large international carriers such as Maersk, MSC, CMA CGM and its subsidiary APL, Evergreen, China COSCO, ONE (including “K” Line, NYK Line and MOL), OOCL, Hyundai and SM Line. +Matson competes by offering a fast and reliable service from the ports of Ningbo and Shanghai in China to Long Beach, California, providing fixed day arrivals and next-day cargo availability. Matson’s service is further differentiated by offering a dedicated marine terminal in Long Beach, California provided by Matson’s Terminal Joint Venture partner SSAT, an off-dock container yard providing fast truck turn times, and one-stop intermodal connections, and providing state-of-the-art technology and world-class customer service. Matson has offices in Hong Kong, Shenzhen, Xiamen, Ningbo and Shanghai, and has contracted with terminal operators in Ningbo and Shanghai. +Guam Service: Matson’s Guam service has one major competitor, APL, which operates a weekly U.S. flagged container feeder service connecting the U.S. West Coast to Guam and Saipan, via transshipments over Yokohama, Japan and Busan, South Korea. Waterman operates a roll-on/roll-off service which periodically calls at Guam. There are also several foreign carriers that call at Guam from foreign origin ports. +Japan Service: Matson’s Japan service competes primarily with APL, which operates a weekly U.S. flagged containership service from the U.S. West Coast to the Port of Naha, Okinawa, Japan. +Micronesia and the South Pacific Services: Matson’s Micronesia and South Pacific services have competition from a variety of local and international carriers that provide freight services to the area. +Customer Concentration: +Matson serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2018, 2017 and 2016, the Company’s 10 largest Ocean Transportation customers accounted for approximately 24 percent, 23 percent and 24 percent of the Company’s Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Matson’s Ocean Transportation operating revenues. For additional information on Ocean Transportation revenues for the years ended December 31, 2018, 2017 and 2016, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +Seasonality: +Matson’s Ocean Transportation services typically experience seasonality in volume, generally following a pattern of increasing volumes starting in the second quarter of each year, culminating in a peak season throughout the third quarter, with subsequent decline in demand during the fourth and first quarters. This seasonality trend is amplified in the Alaska service primarily due to winter weather and the timing of southbound seafood trade. As a result, earnings tend to follow a similar pattern, offset by periodic vessel dry-docking and other episodic cost factors, which can lead to earnings variability. In addition, in the China trade, volume is driven primarily by U.S. consumer demand for goods during key retail selling seasons while freight rates are impacted mainly by macro supply and demand variables. +Maritime Laws and the Jones Act : +Maritime Laws: All interstate and intrastate marine commerce within the U.S. falls under the Merchant Marine Act of 1920 (commonly referred to as the Jones Act). +The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, be manned predominantly by U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75 percent owned by U.S. citizens. U.S. flagged vessels are generally required to be maintained at higher standards than foreign flagged vessels and are subject to rigorous supervision and inspections by, or on behalf of, the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Under Section 27 of the Jones Act, the carriage of cargo between the U.S. West Coast, Hawaii and Alaska on foreign-built or foreign-documented vessels is prohibited. +7 +Table of Contents +During the years ended December 31, 2018 and 2017, approximately 72 percent of Matson’s Ocean Transportation revenues came from the Hawaii and Alaska trades that were subject to the Jones Act. Matson’s Hawaii and Alaska trade routes are included within the non-contiguous Jones Act market. Hawaii, as an island economy, and Alaska due to its geographical location, are both dependent on ocean transportation. The Jones Act ensures frequent, reliable, roundtrip service to these locations. Matson’s vessels operating in these trade routes are Jones Act qualified. +Matson is a member of the American Maritime Partnership (“AMP”) which supports the retention of the Jones Act and similar cabotage laws. The Jones Act has broad support from both houses of Congress. Matson believes that the ongoing war on terrorism has further solidified political support for U.S. flagged vessels because a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support. AMP seeks to inform elected officials and the public about the economic, national security, commercial, safety and environmental benefits of the Jones Act and similar cabotage laws. Repeal of the Jones Act would allow foreign-flag vessel operators that do not have to abide by all U.S. laws and regulations to sail between U.S. ports in direct competition with Matson and other U.S. domestic operators that must comply with all such laws and regulations. +Other U.S. maritime laws require vessels operating between Guam, a U.S. territory, and U.S. ports to be U.S. flagged and predominantly U.S. crewed, but not U.S. built. +Cabotage laws are not unique to the United States, and similar laws exist around the world in over 90 countries, including regions in which Matson provides ocean transportation services. Any changes in such laws may have an impact on the services provided by Matson in those regions. +Regulations: +Rate Regulations and Fuel Surcharge: Matson is subject to the jurisdiction of the Surface Transportation Board with respect to its domestic ocean rates. A rate in the non-contiguous domestic trade is presumed reasonable and will not be subject to investigation if the aggregate of increases and decreases is not more than 7.5 percent above, or more than 10 percent below, the rate in effect one year before the effective date of the proposed rate, subject to increase or decrease by the percentage change in the U.S. Producer Price Index. Matson generally provides a 30-day notice to customers of any increases in general rates and terminal handling charges, and passes along decreases as soon as possible. +Matson applies a fuel surcharge rate to its Ocean Transportation customers. Changes in the fuel surcharge levels are correlated to prevailing market rates for bunker fuel prices along with other factors related to fuel expense recovery. +Other Regulations: Matson’s Ocean Transportation services engaged in U.S. foreign commerce are subject to the jurisdiction of the Federal Maritime Commission (“FMC”). The FMC is an independent regulatory agency that is responsible for the regulation of ocean-borne international transportation of the U.S. +Environmental Regulations: +Being a leader in environmental stewardship and contributing positively to the communities in which we live and work are core values at Matson. Matson’s vessels transit through some of the most environmentally sensitive areas in the United States including the Hawaiian islands and the coasts of California, Oregon, Washington and Alaska. Matson is focused in particular on reducing transportation emissions, including carbon dioxide, nitrous oxide, particulate matter and sulfur dioxide, through improvements in vessel fuel consumption and truck efficiency, and the development of more fuel-efficient transportation solutions. Matson further contributes positively to the environment by testing and deploying cutting edge technologies which are applied to our modernized fleet. +Vessel Emissions Regulations : The International Maritime Organization (“IMO”) is a specialized agency of the United Nations responsible for regulating shipping. Effective January 1, 2020, the IMO has imposed a worldwide regulation that requires all vessels to burn compliant fuel oil with a maximum sulfur content of 0.5 percent. With respect to North America, the U.S. Environmental Protection Agency (“EPA”) received approval from the IMO, in coordination with Environment Canada, to designate all waters, with certain limited exceptions, within 200 nautical miles of U.S. and Canadian coast lines as designated emission control areas (“ECAs”). Beginning January 1, 2015, EPA regulations reduced the maximum sulfur emissions permitted in designated ECAs from 1.0 percent to 0.1 percent. +8 +Table of Contents +Matson’s three diesel-powered vessels in its Alaska service operate a substantial portion of their voyages in ECAs. Matson successfully installed exhaust gas cleaning systems (commonly referred to as “scrubbers”) on these vessels to be in compliance with the IMO and EPA ECA regulations. +Matson’s Hawaii and CLX vessels operate a portion of their voyages in ECAs. Matson’s four new Hawaii vessels can burn low sulfur fuels enabling the vessels to be compliant with the new IMO and EPA ECA regulations. Following the delivery of MV Lurline in the fourth quarter of 2019, Matson expects to phase out the use of all three remaining steamships by the end of 2019. In addition, Matson has announced plans to install scrubbers on three additional diesel-powered vessels used in the Hawaii and CLX services to be completed during 2019 and early 2020. Matson continues to develop solutions and apply other operating strategies to comply with emissions regulations on its other vessels in use in the Hawaii and CLX services, and other services. +Other Environmental Regulations: Matson’s operations are required to comply with other environmental regulations and requirements including the O il Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. The Company actively monitors its operations to ensure compliance with these and other regulations. +For more information on Matson’s environmental stewardship initiatives, including its environmental goals, see https://www.matson.com/corporate/about_us/environmental.html. The contents of our website are not incorporated by reference into this Form 10-K. +(2) LOGISTICS SEGMENT +Logistics Services: +Matson’s Logistics segment provides the following services: +Transportation Brokerage Services: Matson Logistics’ transportation brokerage services provide intermodal rail, highway, and other third-party logistics services for North American customers and international ocean carrier customers, including MatNav. Matson Logistics is able to reduce transportation costs for its customers through volume purchases of rail, motor carrier and ocean transportation services, augmented by services such as shipment tracking and tracing, and single-vendor invoicing. Matson Logistics operates customer service centers and has sales offices throughout North America. +Freight Forwarding Services: Matson Logistics provides LCL consolidation and freight forwarding services primarily to the Alaska market through its wholly owned subsidiary, Span Alaska. Span Alaska’s business aggregates LCL freight at its main cross-dock facility in Auburn, Washington for consolidation and shipment to a network of cross-dock facilities in Alaska. Span Alaska also provides trucking services to its Auburn cross-dock facility and from its Alaska based cross-dock facilities to final customer destinations in Alaska. +Warehousing and Distribution Services: Matson Logistics operates two warehouses in Georgia and two warehouses in Northern California providing warehousing, value-added packaging and distribution services. +Supply Chain Management and Other Services: Matson Logistics’ supply chain management provides customers with a variety of logistics services including purchase order management, customs brokerage, LCL and full container load NVOCC freight forwarding services. +Investment in Anchorage Cross-dock Facility: Span Alaska is in the process of constructing a new 54,000 square foot cross-dock facility to consolidate its Anchorage operations that currently operate from two smaller leased facilities. The new cross-dock facility is expected to be completed by the end of 2019 and is expected to improve Span Alaska’s operating efficiency while providing additional capacity for long-term growth. +Recent Logistics Acquisition: On August 4, 2016, Matson Logistics completed its acquisition of Span Alaska. For additional information about this acquisition, see Note 18 to the Consolidated Financial Statements in Item 8 of Part II below. +9 +Table of Contents +Operating Costs: +Matson Logistics’ operating costs primarily consist of the costs of purchased transportation, leases of warehouses and other facility operating costs, salaries and benefits, and other operating overhead. +Competition: +Matson Logistics competes with hundreds of local, regional, national and international companies that provide transportation and third-party logistics services. The industry is highly fragmented and, therefore, competition varies by geography and areas of service. +Matson Logistics’ transportation brokerage services competes most directly with C.H. Robinson Worldwide, the Hub Group, and other freight brokers and intermodal marketing companies, and asset-invested market leaders such as J.B. Hunt. Competition is differentiated by the depth, scale and scope of customer relationships; vendor relationships and rates; network capacity; real-time visibility into the movement of customers’ goods; and other technology solutions. Additionally, while Matson Logistics primarily provides surface transportation brokerage, it also competes to a lesser degree with other forms of transportation for the movement of cargo. +Matson Logistics’ freight forwarding services compete most directly with a variety of freight forwarding companies that operate within Alaska including Carlile, Lynden, American Fast Freight and Alaska Traffic Company. +Customer Concentration: +Matson Logistics serves customers in numerous industries and geographical locations. In 2018, 2017 and 2016, the Company’s 10 largest logistics customers accounted for approximately 23 percent, 19 percent and 22 percent of Matson Logistics’ revenue, respectively. None of these customers individually account for more than 10 percent of Matson Logistics’ operating revenues. For additional information on Logistics revenues for the years ended December 31, 2018, 2017 and 2016, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +Seasonality: +Matson’s Logistics services are generally not significantly impacted by seasonality factors, except for its freight forwarding service to Alaska which is affected by the winter weather, the cyclical nature of the oil and construction industries, and the seasonal nature of the tourism industry. +C. +EMPLOYEES AND LABOR RELATIONS +Employees: +As of December 31, 2018, Matson and its subsidiaries had 2,007 employees, of which 786 employees were covered by collective bargaining agreements with shoreside and offshore unions. These numbers do not include billets on vessels discussed below, employees of SSAT, or other non-employees, such as agents, temporary workers and contractors. +Matson’s active fleet employed seagoing personnel in 339 billets at December 31, 2018. Each billet corresponds to a position on a vessel that typically is filled by two or more employees because seagoing personnel rotate between active sea-duty and time ashore. These amounts exclude billets related to two reserve vessels as of December 31, 2018 and Matson’s foreign flagged chartered vessels where the vessel owner is responsible for its seagoing personnel. Matson’s vessel management services also employed personnel in 28 billets at December 31, 2018. +Bargaining Agreements: +Matson and SSAT are members of the Pacific Maritime Association (“PMA”), which on behalf of its members negotiates collective bargaining agreements with the International Longshore and Warehouse Union (“ILWU”) on the U.S. Pacific Coast. The PMA/ILWU collective bargaining agreements cover substantially all U.S. West Coast longshore +10 +Table of Contents +labor. In August 2017, the ILWU agreed to extend its contract with the PMA to July 1, 2022. Matson also has collective bargaining agreements with other unions that expire at various dates in the future. +Matson’s seagoing employees are represented by unions for both unlicensed and licensed crew members. Matson also has collective bargaining agreements with these unions that expire at various dates in the future. +Certain collective bargaining agreements expire during 2019. While Matson believes that it will be able to renegotiate these collective bargaining agreements with its various unions as they expire without any significant impact on its operations, no assurance can be given that such agreements will be reached without slow-downs, strikes, lock-out or other disruptions that may adversely impact Matson’s operations. +Multi-employer Pension and Post-retirement Plans: +Matson contributes to a number of multi-employer pension and post-retirement plans. Matson has no present intention of withdrawing from, and does not anticipate the termination of any of the multi-employer pension plans that it contributes to (see Notes 11 and 12 to the Consolidated Financial Statements in Item 8 of Part II below for a discussion of withdrawal liabilities under certain multi-employer pension plans). +D. +AVAILABLE INFORMATION +Matson makes available, free of charge on or through its Internet website, Matson’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the U.S. Securities and Exchange Commission (“SEC”). The address of Matson’s Internet website is www.matson.com. The contents of our website are not incorporated by reference into this Form 10-K. +The SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding Matson and other issuers that file electronically with the SEC. The address of the SEC’s Internet website is www.sec.gov. \ No newline at end of file diff --git a/raw/filings/0000003453/2018/0001558370-19-001448/item13.txt b/raw/filings/0000003453/2018/0001558370-19-001448/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..f91a3d5b96d4cfc9f001df9d5a7eaf6e084a6cc1 --- /dev/null +++ b/raw/filings/0000003453/2018/0001558370-19-001448/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +78 \ No newline at end of file diff --git a/raw/filings/0000003453/2019/0001558370-20-001757/filing.txt b/raw/filings/0000003453/2019/0001558370-20-001757/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..f4623d70a47427554ac66994b6541a1e203b1376 --- /dev/null +++ b/raw/filings/0000003453/2019/0001558370-20-001757/filing.txt @@ -0,0 +1,12267 @@ +P2Y us-gaap:LiabilitiesCurrent us-gaap:OtherLiabilitiesNoncurrent 0000003453 --12-31 2019 FY false P7Y6M P6Y 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specified in its charter) +​ +Hawaii +​ +99-0032630 +(State or other jurisdiction of +​ +(I.R.S. Employer +incorporation or organization) +​ +Identification No.) +​ +1411 Sand Island Parkway +Honolulu , HI 96819 +(Address of principal executive offices and zip code) +​ +( 808 ) 848-1211 +(Registrant’s telephone number, including area code) +​ +Securities registered pursuant to Section 12(b) of the Act: +​ +Title of each class +Trading Symbol(s) +Name of each exchange on which registered +Common Stock, without par value +MATX +New York Stock Exchange +​ +​ +Securities registered pursuant to Section 12(g) of the Act: +None +​ +Number of shares of Common Stock outstanding at February 24, 2020: +43,040,657 +​ +Aggregate market value of Common Stock held by non-affiliates at June 30, 2019: +$ 1,642,293,968 +​ +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ⌧ No ◻ +​ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ◻ No ⌧ +​ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No ◻ +​ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ⌧ No ◻ +​ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +​ +Large accelerated filer ☒ +Accelerated filer ☐ +Non-accelerated filer ☐ +Smaller reporting company ☐ +​ +Emerging growth company ☐ +​ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻ +​ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +​ +Documents Incorporated By Reference +​ +The following document is incorporated by reference in Part III of the Annual Report on Form 10-K to the extent described therein: Proxy statement for the annual meeting of shareholders of Matson, Inc. to be held April 23, 2020. +​ +​ +​ +​ +Table of Contents +TABLE OF CONTENTS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Page +​ +​ +​ +​ +​ +​ +PART I +​ +​ +​ +​ +​ +Item 1. +​ +Business +1 +​ +A. +Company Overview +1 +​ +B. +Business Description +2 +​ +​ +(1) +Ocean Transportation Segment +2 +​ +​ +(2) +Logistics Segment +8 +​ +C. +Employees and Labor Relations +10 +​ +D. +Available Information +10 +Item 1A. +​ +Risk Factors +10 +Item 1B. +​ +Unresolved Staff Comments +20 +Item 2. +​ +Properties +20 +Item 3. +​ +Legal Proceedings +20 +Item 4. +​ +Mine Safety Disclosures +21 +​ +​ +​ +​ +​ +​ +PART II +​ +​ +​ +​ +​ +Item 5. +​ +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +22 +Item 6. +​ +Selected Financial Data +24 +Item 7. +​ +Management’s Discussion and Analysis of Financial Condition and Results of Operations +25 +Item 7A. +​ +Quantitative and Qualitative Disclosures About Market Risk +35 +Item 8. +​ +Financial Statements and Supplementary Data +36 +Item 9. +​ +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +73 +Item 9A. +​ +Controls and Procedures +73 +​ +​ +Conclusion Regarding Effectiveness of Disclosure Controls and Procedures +73 +​ +​ +Internal Control over Financial Reporting +73 +Item 9B. +​ +Other Information +73 +​ +​ +​ +​ +​ +​ +PART III +​ +​ +​ +​ +​ +Item 10. +​ +Directors, Executive Officers and Corporate Governance +74 +​ +A. +Directors +74 +​ +B. +Executive Officers +74 +​ +C. +Corporate Governance +74 +​ +D. +Code of Ethics +74 +Item 11. +​ +Executive Compensation +74 +Item 12. +​ +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +74 +Item 13. +​ +Certain Relationships and Related Transactions, and Director Independence +74 +Item 14. +​ +Principal Accounting Fees and Services +74 +​ +​ +​ +​ +​ +​ +PART IV +​ +​ +​ +​ +​ +Item 15. +​ +Exhibits and Financial Statement Schedules +75 +​ +A. +Financial Statements +75 +​ +B. +Financial Statement Schedules +75 +​ +C. +Exhibits Required by Item 601 of Regulation S-K +75 +​ +​ +​ +​ +Signatures +80 +​ +​ +​ +​ +i +​ +Table of Contents +MATSON, INC. +​ +FORM 10-K +​ +Annual Report for the Fiscal Year +Ended December 31, 2019 +​ +PART I +​ +ITEM 1. BUSINESS +​ +A. COMPANY OVERVIEW +​ +Matson, Inc., a holding company incorporated in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information by segment for the three years ended December 31, 2019, see Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates a premium, expedited service from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific. In addition, subsidiaries of MatNav provide container stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +​ +Matson has a 35 percent ownership interest in SSA Terminals, LLC, a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc., a subsidiary of Carrix, Inc. (“SSAT”). SSAT provides terminal and stevedoring services to various carriers at eight terminal facilities on the U.S. West Coast, including four facilities dedicated for MatNav’s use. Matson records its share of income from SSAT in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +​ +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively, “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively, “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +​ +Our Mission and Vision: +​ +Our mission is to move freight better than anyone. Our vision is to create value for our shareholders by: +​ +◾ Being our customers’ first choice, +◾ Leveraging our core strengths to drive growth and increase profitability, +◾ Improving the communities in which we work and live, +◾ Being an environmental leader in our industry, and +◾ Being a great place to work. +​ +1 +​ +Table of Contents +B. BUSINESS DESCRIPTION +​ +(1) +OCEAN TRANSPORTATION SEGMENT +​ +Ocean Transportation Services: +​ +Matson’s Ocean Transportation segment provides the following services: +​ +Hawaii Service: Matson’s Hawaii service provides ocean carriage (lift-on/lift-off, roll-on/roll-off and conventional services) between the ports of Long Beach and Oakland, California; Seattle, Washington; and Honolulu, Hawaii. Matson also operates a network of inter-island barges that provide connecting services from its hub at Honolulu, Oahu to other major Hawaii ports on the islands of Hawaii, Maui and Kauai. Matson is the largest carrier of ocean cargo between the U.S. West Coast and Hawaii. +​ +Westbound cargo carried by Matson to Hawaii includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, building materials, automobiles and household goods. Matson’s eastbound cargo from Hawaii includes automobiles, household goods, dry containers of mixed commodities and livestock. The majority of Matson’s Hawaii service revenue is derived from the westbound carriage of containerized freight and automobiles. +​ +China Service: Matson’s expedited China-Long Beach Express (“CLX”) is part of an integrated service that carries cargo from Long Beach, California to Honolulu, Hawaii, to Guam, and then to Okinawa, Japan. The vessels continue to Ningbo and Shanghai, China, where they are loaded with cargo to be discharged primarily in Long Beach, California. These vessels also carry cargo destined for Hawaii which originated in Guam, Micronesia, Japan and China. Matson provides container transshipment services from many locations in Asia including Hong Kong and Xiamen, China to the ports of Ningbo and Shanghai, China. +​ +Eastbound cargo from China to Long Beach, California consists mainly of garments, footwear, e-commerce and other retail merchandise. Westbound cargo to China and other destinations in Asia consists mainly of recycling materials. +​ +Guam Service: Matson’s Guam service provides weekly carriage between the U.S West Coast and Guam, as part of its expedited CLX service. Matson also provides weekly connecting service from Guam to the Commonwealth of the Northern Mariana Islands. Cargo destined to these markets is similar to that described in the “Hawaii Service” section above. +​ +Japan Service: Matson’s Japan service provides carriage to the port of Naha in Okinawa, Japan, as part of its expedited CLX service. This service carries mainly general sustenance cargo and household goods supporting the U.S. military. +​ +Micronesia Service: Matson’s Micronesia service provides carriage between the U.S. West Coast and the islands of Kwajalein, Ebeye and Majuro in the Republic of the Marshall Islands, the islands of Yap, Pohnpei, Chuuk and Kosrae in the Federated States of Micronesia, and the Republic of Palau. Cargo destined for these locations is transshipped through Guam and consists mainly of general sustenance cargo. +​ +Alaska Service: Matson’s Alaska service provides ocean carriage (lift-on/lift-off and conventional services) between the port of Tacoma, Washington, and the ports of Anchorage, Kodiak and Dutch Harbor, Alaska. Matson also provides a barge service between Dutch Harbor and Akutan in Alaska, and transportation services to other locations in Alaska including the Kenai Peninsula, Fairbanks and the North Slope. +​ +Northbound cargo to Alaska includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, household goods and automobiles. Southbound cargo from Alaska primarily consists of seafood, household goods and automobiles. +​ +South Pacific Service: Matson’s New Zealand Express (“NZX”) service provides carriage of general sustenance cargo between Auckland, New Zealand and select islands in the South Pacific, including Fiji (Suva and Lautoka), Samoa (Apia), American Samoa (Pago Pago), the Cook Islands (Rarotonga and Aitutaki), Tonga (Nukualofa and Vava’u), and Niue. Matson’s NZX service also provides transshipment services to the islands of Nauru and the Solomon Islands +2 +​ +Table of Contents +(Honiara). Additionally, Matson provides slot charter arrangements for the transportation of cargo from major ports on the east coast of Australia to ports in the South Pacific islands. The NZX service also distributes and sells domestic bulk fuel to a variety of these islands. +​ +Matson’s South Pacific Express (“SPX”) service provides carriage of general sustenance cargo from the U.S. West Coast to ports in the South Pacific islands using vessel sharing agreements with other carriers. The SPX service provides direct calls to Tahiti (Papeete), American Samoa (Pago Pago) and Samoa (Apia) in the South Pacific. Cargo destined for other ports including Tonga (Nukualofa) and the Cook Islands (Rarotonga and Aitutaki) is then transshipped in Apia, Samoa to the NZX service for delivery to its final destination. Northbound SPX cargo originating in the South Pacific is transshipped from the NZX with other carriers to the U.S. West Coast. Cargo destined for Hawaii or Seattle is further transshipped in Oakland, California for delivery to its final destination. +​ +Terminal and Other Related Services: +​ +Matson provides container stevedoring, refrigerated cargo services, inland transportation, container equipment maintenance and other terminal services (collectively, “terminal services”) at terminals located on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai; and in the Alaska terminal locations of Anchorage, Kodiak and Dutch Harbor. +​ +SSAT provides terminal and stevedoring services to various carriers at eight terminal facilities on the U.S. West Coast, including four facilities dedicated for MatNav’s use, in Long Beach and Oakland, California; and in Seattle and Tacoma, Washington. +​ +Matson utilizes the services of other third-party terminal operators at all of the other ports served by its vessels. +​ +Vessel Management Services: +​ +Matson contracts with the U.S. Department of Transportation to provide vessel management services to manage and maintain three Ready Reserve Force vessels on behalf of the U.S. Department of Transportation Maritime Administration. +​ +​ +3 +​ +Table of Contents +Vessel Information: +​ +Vessels: +​ +Matson’s fleet includes both owned and chartered vessels. Matson’s owned vessels represent an investment of approximately $1.7 billion. The majority of Matson’s owned vessels are U.S. flagged and Jones Act qualified vessels, and operate in the Hawaii, China, Guam, Japan, Micronesia and Alaska services. Details of Matson’s active and reserve vessels, and vessel under construction as of December 31, 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Usable Cargo Capacity +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Containers +​ +Vehicles +​ +​ +​ +​ +​ +Maximum +​ +Maximum +​ +Owned/ +Official +​ +Reefer +Year +Speed +Deadweight +Name of Vessels (1) +​ +Chartered +​ +Number +​ +TEUs (2) +​ +Slots +​ +Autos +​ +Built +​ +Length +​ +(Knots) +​ +(Long Tons) +Diesel-Powered +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +DANIEL K. INOUYE (3) +​ +Owned +​ +1274136 +3,220 +408 +​ +— +2018 +854’ 0” +23.5 +50,794 +KAIMANA HILA (3) +​ +Owned +​ +1274135 +​ +3,220 +​ +408 +​ +— +​ +2019 +​ +854’ 0” +​ +23.5 +​ +53,747 +LURLINE (3)(8) +​ +Owned +​ +1274143 +​ +2,750 +​ +432 +​ +500 +​ +2019 +​ +869’ 5” +​ +23.0 +​ +50,562 +MANOA (3) +Owned +651627 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,187 +MAHIMAHI (3) +Owned +653424 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,167 +MANULANI (3) +Owned +1168529 +2,378 +284 +— +2005 +712’ 0” +23.0 +29,517 +MAUNAWILI (3) +Owned +1153166 +2,378 +326 +— +2004 +711’ 9” +23.0 +29,517 +MANUKAI (3) +Owned +1141163 +2,378 +326 +— +2003 +711’ 9” +23.0 +29,517 +R.J. PFEIFFER (3) +Owned +979814 +2,245 +300 +— +1992 +713’ 6” +23.0 +27,100 +MOKIHANA (3) +Owned +655397 +1,994 +354 +1,323 +1983 +860’ 2” +23.0 +29,484 +MAUNALEI (3) +Chartered +1181627 +1,992 +328 +— +2006 +681’ 1” +22.1 +33,771 +MATSON KODIAK (3) +Owned +910308 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON ANCHORAGE (3) +Owned +910306 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON TACOMA (3) +Owned +910307 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +KAMOKUIKI (4) +Owned +9232979 +707 +100 +— +2000 +433’ 9” +17.5 +8,509 +OLOMANA (5) +​ +Chartered +​ +9184225 +​ +645 +​ +120 +​ +— +​ +2004 +​ +388’ 7” +​ +14.0 +​ +8,200 +IMUA II (5)(10) +Chartered +9184237 +630 +90 +— +2005 +388’ 6” +15.0 +8,071 +LILOA II (5) +Chartered +9184249 +630 +90 +— +2004 +388’ 6” +15.0 +8,071 +PAPA MAU (5) +Owned +1559 +521 +68 +— +1999 +381’ 5” +14.0 +5,364 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Barges +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +MAUNA LOA (3) +Chartered +1247426 +500 +78 +— +2013 +362’ 6” +— +12,678 +HALEAKALA (3)(6) +Owned +676972 +335 +78 +— +1984 +350’ 0” +— +4,658 +ILIULIUK BAY (3)(6) +Chartered +1249384 +178 +— +— +2013 +250’ 0” +— +4,138 +WAIALEALE (3)(7) +Owned +978516 +— +36 +230 +1991 +345’ 0” +— +5,621 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Vessel under Construction +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +MATSONIA (3)(9) +​ +Owned +1274123 +​ +2,750 +​ +432 +​ +500 +​ +2020 +​ +869’ 5” +​ +23.0 +​ +50,562 +(1) Excludes inactive vessels ( SS Lihue , SS Kauai and SS Matsonia ). +(2) Twenty-foot Equivalent Units (“TEU”) is a standard measure of cargo volume correlated to a standard 20-foot dry cargo container. +(3) U.S. flagged and Jones Act qualified vessel or barge. +(4) U.S. flagged vessel. +(5) Foreign flagged vessel. +(6) Lift-on/lift-off barge equipped with a crane. +(7) Roll-on/roll-off barge. +(8) Commenced active service in January 2020. +(9) Expected delivery date during the fourth quarter of 2020. +(10) Vessel is sub-chartered to another shipping company commencing January 2020. +​ +Fleet Renewal Program: +​ +Matson has invested approximately $0.9 billion in the construction of four new vessels. The two Aloha Class containerships, Daniel K. Inouye and Kaimana Hila , commenced active service in November 2018 and April 2019, respectively. The first of two Kanaloa Class combination container and roll-on/roll-off vessels, Lurline , commenced active service in January 2020. Delivery of the second Kanaloa Class vessel, Matsonia , is expected during the fourth quarter of 2020. +​ +4 +​ +Table of Contents +With the delivery of Lurline , Matson returned to a nine-ship deployment serving the Hawaii market commencing in early January of 2020. +​ +Vessel Emission Regulations: +​ +Being a leader in environmental stewardship is one of Matson’s core values. Matson vessels transit through some of the most environmentally sensitive areas in the United States including the Hawaiian Islands and the coasts of California, Oregon, Washington and Alaska. Matson is focused in particular on reducing transportation emissions, including carbon dioxide, nitrous oxide, particulate matter and sulfur dioxide through improvements in vessel fuel consumption and the development of more fuel-efficient transportation solutions. Matson further contributes positively to the environment by testing and deploying leading technologies as the fleet is modernized. +​ +The International Maritime Organization (“IMO”), to which the U.S. and over 100 other countries are signatories, is a specialized agency of the United Nations that sets international environmental standards applicable to vessels operating under the flag of any signatory country. Effective January 1, 2020, the IMO has imposed regulations that generally require all vessels to burn fuel oil with a maximum sulfur content of ≤0.5 percent (“IMO 2020”). There are three main options for a vessel to meet the new IMO 2020 requirements: (1) burn low sulfur fuel oil (“LSFO”), (2) install exhaust gas cleaning systems (commonly referred to as “scrubbers”) on vessels to purify high sulfur fuel oil (“HSFO”), or (3) switch to lower emission fuels such as liquefied natural gas (“LNG”), which requires converting existing vessels or constructing new vessels with LNG-compatible engines and fuel tanks. With respect to North America, all waters, with certain limited exceptions, within 200 nautical miles of U.S. and Canadian coastlines have been designated emission control areas (“ECAs”). Since January 1, 2015, U.S. Environmental Protection Agency regulations have reduced the fuel oil maximum sulfur content in designated ECAs to ≤0.1 percent. +​ +All of Matson’s vessels in the Alaska and Hawaii services are compliant with IMO 2020 and ECA regulations and can use LSFO. In the Alaska service, Matson has installed scrubbers on its three diesel-powered vessels to allow them to use HSFO and still comply with IMO 2020 and ECA regulations. In the Hawaii service, Matson has announced plans to install scrubbers on six diesel-powered vessels to allow them to use HSFO and comply with IMO 2020 and ECA regulations. Installation of scrubbers on the first two of these vessels was completed during 2019, with the remaining four expected to be completed during 2020. Matson’s new Aloha and Kanaloa Class vessels burn compliant LSFO. These new vessels are also equipped with dual-fuel engines and can be converted to run on LNG. All of Matson’s other vessels will use LSFO to meet IMO 2020 and ECA emission standards. +​ +Hawaii Terminal Expansion and Modernization Program: +​ +During 2020, Matson expects to complete the first phase of renovating its terminal facility at Sand Island, Honolulu, Hawaii. The first phase involves the investment of approximately $60 million and includes the installation of three new 65 long-ton capacity gantry cranes and modifications to upgrade three existing cranes. The first phase also includes upgrades in electrical infrastructure and other modifications to the Sand Island terminal. +​ +Additional phases are expected to be completed from 2021 through 2024 as part of a broader terminal expansion and modernization program at Matson’s Sand Island terminal. +​ +Ocean Transportation Equipment: +​ +As a complement to its fleet of vessels, Matson has a variety of equipment including cranes, containers and chassis which represents an investment of approximately $0.5 billion as of December 31, 2019. Matson also leases containers, chassis and other equipment under various operating lease agreements. +​ +Operating Costs: +​ +Major components of Matson’s Ocean Transportation operating costs are as follows: +​ +Direct Cargo Expense includes terminal handling costs, purchased outside transportation and other related costs. +​ +5 +​ +Table of Contents +Vessel Operating Expense includes crew wages and related costs; fuel consumption, pilot, tugs and line related costs; vessel charter expenses; and other vessel related expenses. Matson purchases fuel oil, lubricants and gasoline for its operations and also pays fuel-related surcharges to other third party transportation providers. +​ +Operating Overhead includes equipment repair costs, equipment operating lease and repositioning expenses, vessel repair and maintenance costs, dry-docking amortization, insurance, port engineers and other maintenance costs, and other vessel and shoreside related overhead. +​ +Competition: +​ +The following is a summary of major competitors in Matson’s Ocean Transportation segment: +​ +Hawaii Service: Matson’s Hawaii service has one major U.S. flag Jones Act ocean carrier competitor, Pasha Hawaii (“Pasha”), which operates container and roll-on/roll-off services between the ports of Long Beach, Oakland and San Diego, California to Hawaii. There also are two U.S. flag Jones Act barge operators, Aloha Marine Lines and Sause Brothers, which offer barge service between the Pacific Northwest and Hawaii. +​ +Foreign-flag vessels carrying cargo to Hawaii from non-U.S. locations also provide alternatives for companies shipping to Hawaii. Other competitors in the Hawaii service include proprietary operators and contract carriers of bulk cargo. Airfreight competition for time-sensitive cargo exists; however, cargo volume has been limited primarily due to the cost of airfreight transportation. +​ +Matson vessels are operated on schedules that provide customers, shippers and consignees fixed day-of-the-week sailings from the U.S. West Coast as well as fixed day-of-the-week arrivals in Hawaii. Matson offers five westbound departures per week, though this amount may be adjusted according to market conditions. One of Matson’s westbound sailings each week continues from Honolulu on to Guam, Japan and China. Matson offers two weekly eastbound departures from Honolulu to the U.S. Mainland. These sailings call on three U.S. West Coast ports each week. Matson’s frequent sailings permit customers to reduce inventory carrying costs. Matson also competes by offering a more comprehensive service to customers, including: service to and from the three largest U.S. West Coast ports; the most efficient terminal network on the U.S. West Coast provided by SSAT; a dedicated inter-island barge network; a world-class customer service team; and its efficiency and experience in handling cargo of all types. +​ +Alaska Service: Matson’s Alaska service has one major U.S. flag Jones Act competitor, Totem Ocean Trailer Express, Inc., which operates a roll-on/roll off service between Tacoma, Washington and Anchorage, Alaska. There are also two U.S. flag Jones Act barge operators, Alaska Marine Lines, which mainly provides services from Seattle, Washington to the ports of Anchorage and Dutch Harbor, and other locations in Alaska, and Samson Tug & Barge, which mainly serves Western Alaska and other locations. The barge operators have historically shipped lower value commodities that can accommodate a longer transit time, as well as construction materials and other cargo that are not conducive to movement in containers. Foreign-flag vessels provide alternatives for companies shipping cargo (mainly seafood) from the Alaska ports of Kodiak and Dutch Harbor. +​ +Matson offers customers twice weekly scheduled service from Tacoma, Washington to Anchorage and Kodiak, Alaska and weekly service to Dutch Harbor, Alaska. The Company also provides a barge service between Dutch Harbor and Akutan in Alaska. Matson is the only Jones Act containership operator providing service to Kodiak and Dutch Harbor in Alaska, which are the primary loading ports for southbound seafood. Matson offers dedicated terminal services at the Alaska ports of Anchorage, Kodiak and Dutch Harbor performed by MatNav, and at the port of Tacoma, Washington performed by SSAT. +​ +China Service: Major competitors to Matson’s China service include large international carriers such as ONE (formerly “K” Line, NYK Line and MOL), Maersk, CMA CGM and its subsidiary APL, Evergreen, COSCO and SM Line. +​ +Matson competes by offering a fast and reliable service from the ports of Ningbo and Shanghai in China to Long Beach, California, providing fixed day arrivals and next-day cargo availability. Matson’s service is further differentiated by offering a dedicated marine terminal in Long Beach, California operated by SSAT, an off-dock container yard providing fast truck turn times, dedicated chassis, one-stop intermodal connections, and providing world-class customer service. +6 +​ +Table of Contents +Matson has offices located in Hong Kong, Shenzhen, Xiamen, Ningbo and Shanghai, and has contracted with terminal operators in Ningbo and Shanghai. +​ +Guam Service: Matson’s Guam service has one major competitor, APL, which operates a weekly U.S. flagged container feeder service connecting the U.S. West Coast to Guam and Saipan, via transshipments over Yokohama, Japan. Waterman operates a roll-on/roll-off service, which periodically calls at Guam. There are also several foreign carriers, including APL, that call at Guam from foreign origin ports. +​ +Japan Service: Matson’s Japan service competes primarily with APL, which operates a weekly U.S. flagged containership service from the U.S. West Coast to the port of Naha, Okinawa, Japan. +​ +Micronesia and South Pacific Services: Matson’s Micronesia and South Pacific services have competition from a variety of local and international carriers that provide freight services to the area. +​ +Customer Concentration: +​ +Matson serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2019, 2018 and 2017, the Company’s 10 largest Ocean Transportation customers accounted for approximately 23 percent, 24 percent and 23 percent of the Company’s Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Matson’s Ocean Transportation operating revenues. For additional information on Ocean Transportation revenues for the years ended December 31, 2019, 2018 and 2017, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +Matson’s Ocean Transportation services typically experience seasonality in volume, generally following a pattern of increasing volumes starting in the second quarter of each year, culminating in a peak season throughout the third quarter, with subsequent decline in demand during the fourth and first quarters. This seasonality trend is amplified in the Alaska service primarily due to winter weather and the timing of southbound seafood trade. As a result, earnings tend to follow a similar pattern, offset by periodic vessel dry-docking and other episodic cost factors, which can lead to earnings variability. In addition, in the China trade, volume is driven primarily by U.S. consumer demand for goods during key retail selling seasons while freight rates are impacted mainly by macro supply and demand variables. +​ +Maritime Laws and the Jones Act : +​ +Maritime Laws: All interstate and intrastate marine commerce within the U.S. falls under the Merchant Marine Act of 1920 (commonly referred to as the Jones Act). +​ +The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, be manned predominantly by U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75 percent owned by U.S. citizens. U.S. flagged vessels are generally required to be maintained at higher standards than foreign flagged vessels and are subject to rigorous supervision and inspections by, or on behalf of, the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Under Section 27 of the Jones Act, the carriage of cargo between the U.S. West Coast, Hawaii and Alaska on foreign-built or foreign-documented vessels is prohibited. +​ +During the years ended December 31, 2019, 2018 and 2017, approximately 72 percent of Matson’s Ocean Transportation revenues came from the Hawaii and Alaska trades that were subject to the Jones Act. Matson’s Hawaii and Alaska trade routes are included within the non-contiguous Jones Act market. Hawaii, as an island economy, and Alaska due to its geographical location, are both dependent on ocean transportation. The Jones Act ensures frequent, reliable, roundtrip service to these locations. Matson’s vessels operating in these trade routes are Jones Act qualified. +​ +Matson is a member of the American Maritime Partnership (“AMP”) which supports the retention of the Jones Act and similar cabotage laws. The Jones Act has broad support from both houses of Congress. Matson believes that the ongoing war on terrorism and geopolitical environment have further solidified political support for U.S. flagged vessels +7 +​ +Table of Contents +because a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support. AMP seeks to inform elected officials and the public about the economic, national security, commercial, safety and environmental benefits of the Jones Act and similar cabotage laws. Repeal of the Jones Act would allow foreign-flag vessel operators that do not have to abide by all U.S. laws and regulations to sail between U.S. ports in direct competition with Matson and other U.S. domestic operators that must comply with all such laws and regulations. +​ +Other U.S. maritime laws require vessels operating between Guam, a U.S. territory, and U.S. ports to be U.S. flagged and predominantly U.S. crewed, but not U.S. built. +​ +Cabotage laws are not unique to the United States, and similar laws exist around the world in over 90 countries, including regions in which Matson provides ocean transportation services. Any changes in such laws may have an impact on the services provided by Matson in those regions. +​ +Rate Regulations and Fuel-Related Surcharges: +​ +Matson is subject to the jurisdiction of the Surface Transportation Board with respect to its domestic ocean rates. A rate in the non-contiguous domestic trade is presumed reasonable and will not be subject to investigation if the aggregate of increases and decreases is not more than 7.5 percent above, or more than 10 percent below, the rate in effect one year before the effective date of the proposed rate, subject to increase or decrease by the percentage change in the U.S. Producer Price Index. Matson generally provides a 30-day notice to customers of any increases in general rates and other charges, and passes along decreases as soon as possible. +​ +Matson’s Ocean Transportation services engaged in U.S.-foreign commerce are subject to the jurisdiction of the Federal Maritime Commission (“FMC”). The FMC is a federal independent regulatory agency that is responsible for the regulation of international oceanborne transportation to and from the U.S. +​ +Matson applies a fuel-related surcharge rate to its Ocean Transportation customers. Changes in the fuel-related surcharge levels are correlated to market rates for bunker fuel prices along with other factors related to fuel expense recovery. +​ +Other Environmental Regulations: +​ +In addition to the vessel emission regulations discussed above, Matson’s operations are required to comply with other environmental regulations and requirements including the O il Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. The Company actively monitors its operations to ensure compliance with these and other regulations. +​ +For more information on Matson’s environmental stewardship initiatives, including its environmental goals, see https://www.matson.com/corporate/about_us/environmental.html . The contents of our website are not incorporated by reference into this Form 10-K. +​ +(2) +LOGISTICS SEGMENT +​ +Logistics Services: +​ +Matson Logistics provides the following services: +Transportation Brokerage Services: Matson Logistics provides intermodal rail, highway, and other third-party logistics services for North American customers and international ocean carrier customers, including MatNav. Matson Logistics strives to reduce transportation costs for its customers through volume purchases of rail, motor carrier and ocean transportation services, augmented by services such as shipment tracking and tracing, and single-vendor invoicing. Matson Logistics operates customer service centers and has sales offices throughout North America. +8 +​ +Table of Contents +Freight Forwarding Services: Matson Logistics provides LCL consolidation and freight forwarding services primarily to the Alaska market through its wholly owned subsidiary, Span Intermediate, LLC (“Span Alaska”). Span Alaska’s business aggregates LCL freight at its cross-dock facility in Auburn, Washington for consolidation and shipment to a network of cross-dock facilities in Alaska. Span Alaska also provides trucking services to its Auburn cross-dock facility and from its Alaska based cross-dock facilities to final customer destinations in Alaska. +Warehousing and Distribution Services: Matson Logistics operates two warehouses in Georgia and two warehouses in Northern California providing warehousing, value-added packaging and distribution services. +​ +Supply Chain Management and Other Services: Matson Logistics provides customers with a variety of logistics services including purchase order management, customs brokerage, LCL and full container load NVOCC freight forwarding services. Matson Logistics operates a customer service center in Shanghai, China to support its supply chain operations in North America, China and other locations. +​ +Investment in Anchorage Service Center: +​ +During the fourth quarter of 2019, Span Alaska completed the construction of a new 54,000 square foot cross-dock facility (“Anchorage Service Center”) to consolidate its Anchorage operations that previously operated from two smaller leased facilities. The Anchorage Service Center is expected to improve Span Alaska’s operating efficiency while providing additional capacity for long-term growth. +​ +Operating Costs: +​ +Matson Logistics’ operating costs primarily consist of the costs of purchased transportation, leases of warehouses, cross-dock and other facility operating costs, salaries and benefits, and other operating overhead. +​ +Competition: +​ +Matson Logistics competes with hundreds of local, regional, national and international companies that provide transportation and third-party logistics services. The industry is highly fragmented and, therefore, competition varies by geography and areas of service. +​ +Matson Logistics’ transportation brokerage services competes most directly with C.H. Robinson Worldwide, the Hub Group, XPO and other freight brokers and intermodal marketing companies, and asset-invested market leaders such as J.B. Hunt. Competition is differentiated by the depth, scale and scope of customer relationships; vendor relationships and rates; network capacity; real-time visibility into the movement of customers’ goods; and other technology solutions. Additionally, while Matson Logistics primarily provides surface transportation brokerage, it also competes to a lesser degree with other forms of transportation for the movement of cargo. +​ +Matson Logistics’ freight forwarding services compete most directly with a variety of freight forwarding companies that operate within Alaska including Carlile, Lynden, American Fast Freight and Alaska Traffic Company. +​ +Customer Concentration: +​ +Matson Logistics serves customers in numerous industries and geographical locations. In 2019, 2018 and 2017, the Company’s 10 largest logistics customers accounted for approximately 21 percent, 23 percent and 19 percent of Matson Logistics’ revenue, respectively. None of these customers individually accounts for more than 10 percent of Matson Logistics’ operating revenues. For additional information on Logistics revenues for the years ended December 31, 2019, 2018 and 2017, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +Matson Logistics’ services are generally not significantly impacted by seasonality factors, except for its freight forwarding service to Alaska which is affected by the winter weather, the cyclical nature of the oil and construction industries, and the seasonal nature of the tourism industry. +​ +9 +​ +Table of Contents +C. EMPLOYEES AND LABOR RELATIONS +​ +Employees: +​ +As of December 31, 2019, Matson and its subsidiaries had 1,988 employees, of which 794 employees were covered by collective bargaining agreements with shoreside unions. These numbers do not include billets on vessels discussed below, employees of SSAT, or other non-employees, such as agents, temporary workers and contractors. +​ +Matson’s fleet of active vessels require 298 billets to operate these vessels. Each billet corresponds to a position on a vessel that typically is filled by two or more employees because seagoing personnel rotate between active sea-duty and time ashore. These amounts exclude billets related to Matson’s foreign flagged chartered vessels where the vessel owner is responsible for its seagoing personnel. Matson’s vessel management services also employed personnel in 28 billets to manage three vessels. +​ +Bargaining Agreements: +​ +Matson’s shoreside and seagoing employees are represented by a variety of unions. Matson has collective bargaining agreements with these unions that expire at various dates in the future. While Matson believes that it will be able to renegotiate these collective bargaining agreements with its various unions as they expire without any significant impact on its operations, no assurance can be given that such agreements will be reached without slow-downs, strikes, lockouts or other disruptions that may adversely impact Matson’s operations. +​ +Additionally, Matson and SSAT are members of the Pacific Maritime Association (“PMA”), which on behalf of its members negotiates collective bargaining agreements with the International Longshore and Warehouse Union (“ILWU”) on the U.S. West Coast. The PMA/ILWU collective bargaining agreements cover substantially all U.S. West Coast longshore labor. In August 2017, the ILWU agreed to extend its contract with the PMA to July 1, 2022. +​ +Multi-employer Pension and Post-retirement Plans: +​ +Matson contributes to a number of multi-employer pension and post-retirement plans. Matson has no present intention of withdrawing from, and does not anticipate the termination of any of the multi-employer pension plans to which it contributes (see Notes 11 and 12 to the Consolidated Financial Statements in Item 8 of Part II below for a discussion of withdrawal liabilities under certain multi-employer pension plans). +​ +D. AVAILABLE INFORMATION +​ +Matson makes available, free of charge on or through its Internet website, Matson’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such material with, or furnishes them to, the U.S. Securities and Exchange Commission (“SEC”). The address of Matson’s Internet website is www.matson.com. The contents of our website are not incorporated by reference into this Form 10-K. +​ +The SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding Matson and other issuers that file electronically with the SEC. The address of the SEC’s Internet website is www.sec.gov. +​ +ITEM 1A. RISK FACTORS +​ +The Company’s business faces the risks set forth below, which may adversely affect our business, financial condition and operating results. All forward-looking statements made by the Company or on the Company’s behalf are qualified by the risks described below. +​ +10 +​ +Table of Contents +Risks Related to the Jones Act +​ +Repeal, substantial amendment, or waiver of the Jones Act or its application would have an adverse effect on the Company’s business. +​ +If the Jones Act was to be repealed, substantially amended, or waived and, as a consequence, competitors were to enter the Hawaii or Alaska markets with lower operating costs by utilizing their ability to acquire and operate foreign-flag and foreign-built vessels, the Company’s business would be adversely affected. In addition, the Company’s advantage as a U.S. citizen operator of Jones Act vessels would be eroded if periodic efforts and attempts by foreign interests to circumvent certain aspects of the Jones Act were ever successful. If maritime cabotage services were included in the General Agreement on Trade in Services, the North American Free Trade Agreement, the United States-Mexico-Canada Agreement, the U.S.-EU Trade Agreement or other international trade agreements, or if the restrictions contained in the Jones Act were otherwise altered, the shipping of cargo between covered U.S. ports could be opened to foreign-flag or foreign-built vessels or would have other adverse impacts. +​ +The Company’s business would be adversely affected if the Company were determined not to be a U.S. citizen under the Jones Act. +​ +Certain provisions of the Company’s articles of incorporation protect the Company’s ability to maintain its status as a U.S. citizen under the Jones Act. Although the Company is a U.S. citizen under the Jones Act, if non-U.S. citizens were able to defeat such articles of incorporation restrictions and own in the aggregate more than 25 percent of the Company’s common stock, the Company would no longer be considered as a U.S. citizen under the Jones Act. Such an event could result in the Company’s ineligibility to engage in coastwise trade and the imposition of substantial penalties against it, including seizure or forfeiture of its vessels, which would have an adverse effect on the Company’s financial condition and results of operation. +​ +Risks Related To Operations +​ +Changes in U.S., global, regional economic conditions or governmental policies that result in a decrease in consumer confidence or market demand for the Company’s services and products in Hawaii and Alaska, the U.S. Mainland, Guam, Asia or the South Pacific may adversely affect the Company’s financial position, results of operations, liquidity, or cash flows. +​ +A weakening of domestic or global economies may adversely impact the level of freight volumes and freight rates. Within the U.S., a weakening of economic drivers in Hawaii and Alaska, which include tourism, military spending, construction starts, personal income growth and employment, or the weakening of consumer confidence, market demand, the economy in the U.S. Mainland, or the effect of a change in the strength of the U.S. dollar against other foreign currencies, may further reduce the demand for goods to and from Asia, Hawaii and Alaska, adversely affecting inland and ocean transportation volumes or rates. In addition, overcapacity in the global or transpacific ocean transportation markets, a change in the cost of goods or currency exchange rates, imposition of tariffs and uncertainty of tariff rates, or a change in international trade policies may adversely affect freight volumes and rates in the Company’s China service. +​ +The Company may face new or increased competition. +​ +The Company may face new competition by established or start-up shipping operators that enter the Company’s markets. The entry of a new competitor or the addition of new vessels or capacity by existing competition on any of the Company’s routes could result in a significant increase in available shipping capacity that could have an adverse effect on our volumes and rates. For example, in December 2016, the Company’s major competitor in the Guam service upgraded its U.S. flagged feeder containership from a bi- weekly service to a weekly service connecting the U.S. West Coast to Guam and Saipan via transshipments over Yokohama, Japan. As a result of this and other potential competitor actions, the Company could experience a reduction in profitability. +​ +11 +​ +Table of Contents +The loss of or damage to key customer or agent relationships may adversely affect the Company’s business. +​ +The Company’s businesses are dependent on their relationships with customers and agents, and derive a significant portion of their revenues from the Company’s largest customers. The Company’s business relies on its relationships with the U.S. military, freight forwarders, large retailers and consumer goods and automobile manufacturers, as well as other larger customers. In 2019, the Company’s Ocean Transportation segment’s 10 largest customers accounted for approximately 23 percent of the business’ revenue. In 2019, the Company’s Logistics segment’s 10 largest customers accounted for approximately 21 percent of the business’ revenue. +​ +The Company could also be adversely affected by any changes in the services, or changes to the costs of services, provided by agents. Relationships with railroads and shipping companies and agents are important in the Company’s intermodal business as well as in the Guam, Micronesia, Japan and South Pacific services. +​ +The loss of or damage to any of these key relationships may adversely affect the Company’s business and revenue. +​ +The Company is dependent upon key vendors and third-parties for equipment, capacity and services essential to operate its business, and if the Company fails to secure sufficient third-party services, its business could be adversely affected. +​ +The Company’s businesses are dependent upon key vendors who provide rail, truck and ocean transportation services. If the Company cannot secure sufficient transportation equipment, capacity or services from these third-parties at reasonable prices or rates to meet its or its customers’ needs and schedules, customers may seek to have their transportation and logistics needs met by others on a temporary or permanent basis. If this were to occur, the Company’s business, consolidated results of operations and financial condition could be adversely affected. +​ +An increase in fuel prices, changes in the Company’s ability to collect fuel-related surcharges, and/or the cost or limited availability of required fuels on the U.S. West Coast may adversely affect the Company’s profits. +​ +Fuel is a significant operating expense for the Company’s Ocean Transportation business. The price and supply of fuel are unpredictable and fluctuate based on events beyond the Company’s control. Increases in the price of fuel may adversely affect the Company’s results of operations. Increases in fuel costs also can lead to increases in other expenses such as energy costs and costs to purchase outside transportation services. In the Company’s Ocean Transportation and Logistics services segments, the Company utilizes fuel-related surcharges, although increases in the fuel-related surcharge may adversely affect the Company’s competitive position and may not correspond exactly with the timing of increases in fuel expense. Changes in the Company’s ability to collect fuel-related surcharges also may adversely affect its results of operations. +​ +Effective January 1, 2020, the IMO has imposed a world-wide regulation that generally requires that all ships must burn compliant fuel oil with a maximum sulfur content of ≤0.5 percent. Currently, LSFO is priced significantly higher than HSFO due to the need to refine the oil and the lack of sufficient quantities of LSFO on a global basis. While the Company has entered into contracts to secure LSFO on the U.S. West Coast, there is no guarantee that sufficient quantities will be available at a reasonable cost. In addition, prolonged use of LSFO on some Matson vessels could degrade engine performance or lead to higher maintenance costs. While Matson has announced plans to install scrubbers on additional vessels, there may be delays or other unexpected complications. The Company’s ability to recover the higher costs of IMO 2020 compliant fuel through fuel-related surcharges, the availability of LSFO, and the potential impact on vessel performance and maintenance costs may adversely affect the Company’s operations, business and profit. +​ +Work stoppages or other labor disruptions caused by unionized workers of the Company, other workers or their unions in related industries may adversely affect the Company’s operations. +​ +As of December 31, 2019, Matson and its subsidiaries had 1,988 employees, of which 794 employees were covered by collective bargaining agreements with shoreside unions. In addition, Matson’s fleet of active vessels require 298 billets to operate these vessels. Matson’s vessel management services also employed personnel in 28 billets to manage three vessels. Such employees are also subject to collective bargaining agreements. Furthermore, the Company relies on the services of third- parties including SSAT that employ persons covered by collective bargaining agreements. For +12 +​ +Table of Contents +additional information on collective bargaining agreements with unions, see Item1. C. Employees and Labor Relations of Part I above. +​ +The Company could be adversely affected by actions taken by employees of the Company or other companies in related industries against efforts by management of the Company or other companies to control labor costs, restrain wage or benefit increases or modify work practices. Strikes and disruptions may occur as a result of the failure of Matson or other companies in its industry to negotiate collective bargaining agreements with such unions successfully. +​ +In addition, any slow-downs, strikes, lock-outs or other disruptions, including limits to availability of labor through trade union hiring halls could have an adverse impact on Matson’s or SSAT’s operations. +​ +The Company is susceptible to weather, natural disasters and other operating risks. +​ +The Company’s operations are vulnerable to disruption as a result of weather, natural disasters and other climate driven events, such as bad weather at sea, hurricanes, typhoons, tsunamis, floods and earthquakes. Such events will interfere with the Company’s ability to provide on-time scheduled service, resulting in increased expenses and potential loss of business associated with such events. In addition, severe weather and natural disasters can result in interference with the Company’s terminal operations, and may cause serious damage to its vessels and cranes, loss or damage to containers, cargo and other equipment, and loss of life or physical injury to its employees, all of which could have an adverse effect on the Company’s business. These impacts could be particularly acute in certain ports in Alaska where the Company is dependent on a single crane. +​ +The Company’s vessels and their cargoes are also subject to operating risks such as mechanical failure, collisions and human error. The occurrence of any of these events may result in damage to or loss of vessels or other property, or injury or death of people. If any of these events were to occur, the Company could be exposed to reputational harm and liability for resulting damages and possible penalties that, pursuant to typical maritime industry policies, it must pay and then seek reimbursement from its insurer. Affected vessels may also be removed from service and thus would be unavailable for income-generating activity. +​ +The Company maintains casualty and liability insurance policies, which are generally subject to large retentions and deductibles. Some types of losses, such as losses resulting from a port blockage, generally, are not insured. In some cases the Company retains the entire risk of loss because it is not economically prudent to purchase insurance coverage or because of the perceived remoteness of the risk. Other risks are uninsured because insurance coverage may not be commercially available. Finally, the Company retains all risk of loss that exceeds the limits of its insurance. +​ +We face risks related to actual or threatened health epidemics, pandemics or other major health crises, which could significantly disrupt our business. +​ +Our business could be impacted adversely by the effects of public health epidemics, pandemics or other major heath crises (which we refer to collectively as public health crises). Actual or threatened public health crises may have a number of adverse impacts, including volatility in the global economy, impacts to our customers’ business operations, reduced tourism in the markets we serve, or significant disruptions in ocean-borne transportation of goods, logistics demand and supply chain activity, caused by a variety of factors such as quarantines, factory and office closures, port closures, or other government-imposed restrictions, any of which could adversely impact our business, financial condition, operating results and cash flows. +​ +For example, on January 30, 2020, the World Health Organization declared COVID- 19 a Public Health Emergency of International Concern. On January 31, 2020, the U.S. Department of State raised their travel advisory for mainland China from Level 3 (reconsider travel) to Level 4 (do not travel ). The outbreak of COVID- 19 has harmed the Chinese economy, shut down business operations in China and disrupted manufacturing, travel, drayage of containers, and transportation of goods within and from China. A reduction or delay in container volume from China resulting from decreased manufacturing activity, lower transportation demand or service disruptions from restrictions related to COVID- 19 could adversely affect volumes or rates in our CLX service, Matson Logistics’ business related to China, and/or SSAT lift volume at its U.S. West Coast terminals. Our operations in China may also be impacted adversely if our employees’ ability to travel to or within China is restricted or they are otherwise unable to perform their duties. Spread of COVID-19 may reduce tourism to Hawaii, Alaska and/or Guam and thereby lead to reduced demand for +13 +​ +Table of Contents +freight that we would otherwise carry. In addition, vessel drydockings and scrubber installations could also be delayed or become more expensive if Chinese shipyards are unable to accommodate demand. The continued spread of COVID-19 or the occurrence of other public health crises may adversely impact our business, financial condition, operating results and cash flows. +​ +The Company’s significant operating agreements and leases could be replaced on less favorable terms or may not be replaced when they expire. +​ +The significant operating agreements and leases of the Company in its various businesses expire at various points in the future and may not be replaced or could be replaced on less favorable terms, thereby adversely affecting the Company’s future financial position, results of operations and cash flows. For example, on November 26, 2018, a wholly-owned subsidiary of the Company entered into agreements whereby Maunalei , a U.S. flagged and Jones Act qualified vessel, was sold for $106.0 million and leased back from the buyer under an operating lease agreement. While the agreements contain customary representations, warranties and covenants, there remain risks that (a) the lessor could lose its Jones Act status, (b) that the Company could not replace Maunalei in the event it is no longer Jones Act eligible, or (c) if the repurchase option is elected, that the Company would not be able to consummate the repurchase of Maunalei at the end of the lease term. +​ +The Company may face unexpected dry-docking or repair costs for its vessels. +​ +We routinely engage shipyards to dry-dock our vessels for regulatory compliance and to provide repair and maintenance. Vessels may also have to be dry-docked or repaired at sea in the event of accidents or other unforeseen damage. We also operate a number of older active and reserve vessels that may require more frequent and extensive maintenance. The cost of repairs are difficult to predict with certainty and can be substantial. Large dry-docking and other repair expenses could adversely affect the Company’s results of operations and cash flows. In addition, the time when a vessel is out of service for maintenance is determined by a number of factors, including regulatory deadlines, market conditions, shipyard availability and customer requirements, and accordingly, the length of time that a vessel may be out of service may be longer than anticipated, which could adversely affect the Company’s business, financial condition, results of operations and cash flows. +​ +If we are not able to use our information technology and communications systems effectively, our ability to conduct business might be negatively impacted. +​ +The Company is highly dependent on the proper functioning of our information technology systems to enable operations and compete effectively. We regularly update our information technology systems or implement new systems which could cause substantial business interruption. There is no assurance that the systems upgrades or new systems will meet our current or future business needs, or that they will operate as designed. Our information technology systems also rely on third-party service providers for access to the Internet, satellite-based communications systems, the electric grid, database storage facilities and telecommunications providers. We have no control over the operations of these third-party service providers. If our information technology and communications systems experience reliability issues, integration or compatibility concerns or if our third-party providers are unable to perform effectively or experience disruptions or failures, there could be an adverse impact on the availability and functioning of our information technology and communications systems, which could lead to business disruption or inefficiencies, reputational harm or loss of customers that could have an adverse effect on our business. +​ +Our information technology systems have in the past and may in the future be exposed to cybersecurity risks and other disruptions that could impair the Company’s ability to operate and adversely affect its business. +​ +The Company relies extensively on its information technology systems and third-party service providers including cloud services for accounting, billing, disbursement, cargo booking and tracking, vessel scheduling and stowage, equipment tracking, customer service, banking, payroll and employee communication systems. The Company also collects, stores and transmits sensitive data, including its proprietary business information and that of its customers, and personally identifiable information of its customers and employees. Despite our continuous efforts to make investments in our information technology systems and system-wide data security program, the implementation of security measures to protect our data and infrastructure against breaches and other cyber threats, and our use of internal processes and controls designed to protect the security and availability of our systems, we have in the past experienced and may in the +14 +​ +Table of Contents +future experience cybersecurity risks such as computer viruses, hacking, malware, denial of service attacks, cyber terrorism, circumvention of security systems, malfeasance, breaches due to employee error, natural disasters, telecommunications failure, or other catastrophic events at the Company’s facilities, aboard its vessels or at third-party locations. +​ +Any failure, breach or unauthorized access to the Company’s or third-party systems could result in the loss of confidential, sensitive or proprietary information, interruptions in its service or production or otherwise impact our ability to conduct business operations, and could result in potential reductions in revenue and profits, damage to its reputation or liability. +​ +Loss of the Company’s key personnel could adversely affect its business. +​ +The Company’s future success will depend, in significant part, upon the continued services of its key personnel, including its senior management and skilled employees. The loss of the services of key personnel could adversely affect the Company’s future operating results because of such employees’ experience and knowledge of the Company’s business and customer relationships. If key employees depart, the Company may incur significant costs to replace them. Additionally, the Company’s ability to execute its business model could be impaired if it cannot replace them in a timely manner. The Company does not maintain key person insurance on any of its key personnel. +​ +The Company is involved in a joint venture and is subject to risks associated with joint venture relationships. +​ +The Company is involved in a terminal joint venture, SSAT (and through SSAT, other joint ventures at U.S. West Coast terminals), and may initiate future joint venture projects. A joint venture involves certain risks such as: +​ +● The Company may not have voting control over the joint venture; +● The Company may not be able to maintain good relationships with its joint venture partner; +● A joint venture partner at any time may have economic or business interests that are inconsistent with the Company’s; +● A joint venture partner may fail to fund its share of capital for operations or to fulfill its other commitments, including providing accurate and timely accounting and financial information to the Company; +● The joint venture may experience operating difficulties and financial losses, which may lead to asset write-downs or impairment charges that could negatively impact the operating results of the joint venture and the Company; +● The joint venture or venture partner could lose key personnel; +● A joint venture partner could become bankrupt requiring the Company to assume all risks and capital requirements related to the joint venture project, and the related bankruptcy proceedings could have an adverse impact on the operation of the partnership or joint venture; and +● Actions of the joint venture may result in reputational harm to the Company. +​ +In addition, the Company relies on SSAT for its stevedoring services at the ports of Long Beach and Oakland, California, and Seattle and Tacoma, Washington on the U.S. West Coast. The Company could be adversely affected by any changes in the services provided, or to the costs of such services provided by SSAT. +​ +The Company is subject to risks associated with conducting business in foreign shipping markets. +​ +Matson’s China, Micronesia, Japan and South Pacific services are subject to risks associated with conducting business in a foreign shipping market, which include: +​ +● Challenges associated with operating in foreign countries and doing business and developing relationships with foreign companies; +● Challenges in working with and maintaining good relationships with business associates in our foreign operations; +● Difficulties in staffing and managing foreign operations; +● Our ability to be in compliance with U.S. and foreign legal and regulatory restrictions, including compliance with the Foreign Corrupt Practices Act and foreign laws that prohibit corrupt payments to government officials; +● Global vessel overcapacity that may lead to decreases in volumes and shipping rates; +● Not having continued access to existing port facilities; +15 +​ +Table of Contents +● Competition with established and new carriers; +● Changes in vessel deployment by competitors that impact the Company’s services; +● Currency exchange rate fluctuations and our ability to manage these fluctuations; +● Political and economic instability; +● Dynamics involving U.S. trade relations with other countries, including measures such as the imposition of tariffs at varying levels or other governmental actions, all of which may affect the Company’s operations; and +● Challenges caused by cultural differences. +​ +Any of these risks has the potential to adversely affect the Company’s operating results. +​ +The Company is subject to risks related to an accident or spill event. +​ +The Company’s vessel and terminal operations could be faced with a maritime accident, oil or other spill, or other environmental mishap. Such event may lead to personal injury, loss of life, damage of property, pollution and suspension of operations. As a result, such event could have an adverse effect on the Company’s business. +​ +The Company’s Shipbuilding Agreement with NASSCO is subject to risks. +​ +On August 25, 2016, MatNav and NASSCO entered into a definitive agreement pursuant to which NASSCO will construct two new 3,500-TEU sized Kanaloa Class dual-fuel capable container and roll-on/roll-off vessels. The first vessel, Lurline , was delivered on December 26, 2019. The second vessel, Matsonia , is expected to be delivered in the fourth quarter of 2020. Failure of any party to the shipbuilding agreement to fulfill its obligations under the agreement could have an adverse effect on the Company’s financial position and results of operations. Such a failure could happen for a variety of reasons, including but not limited to (i) delivery delays, (ii) delivery of vessels that fail to meet any of the required operating specifications (for example, capacity, fuel efficiency or speed), (iii) events which prevent one or more significant subcontractors from performing, or (iv) the refusal or inability of NASSCO or any of its subcontractors to perform for any reason. +​ +The Company’s terminals in Hawaii and Alaska require modernization. +​ +We are investing approximately $60 million, including the installation of three new gantry cranes and upgrade of three existing cranes, as part of the first phase of a broader project to expand and improve the Company’s Sand Island terminal in Honolulu Harbor. We have also begun discussions with state and local authorities in Anchorage, Alaska regarding upgrades to those terminal and port facilities. Regulatory, construction or other delays or cost overruns related to the expansion and modernization of the terminals could have an adverse impact on our business plans, financial condition and results of operations. In addition, the terminal modernization programs may not result in improved operational productivity or generate expected returns. +​ +Heightened security measures, war, actual or threatened terrorist attacks, efforts to combat terrorism and other acts of violence may adversely impact the Company’s operations and profitability. +​ +War, terrorist attacks and other acts of violence may cause consumer confidence and spending to decrease, or may affect the ability or willingness of tourists to travel to Hawaii, Guam or Alaska, thereby adversely affecting those economies and the Company. Additionally, future terrorist attacks could increase volatility in the U.S. and worldwide financial markets. Acts of war or terrorism may be directed at the Company’s shipping operations, or may cause the U.S. government to take control of Matson’s vessels for military operation. Heightened security measures potentially slow the movement and increase the cost of freight through U.S. or foreign ports, across borders or on U.S. or foreign railroads or highways and could adversely affect the Company’s business and results of operations. +​ +Acquisitions may have an adverse effect on the Company’s business. +​ +The Company’s growth strategy includes expansion through acquisitions, including, for example, the Company’s acquisitions of Horizon Lines, Inc. (“Horizon”) in 2015 and Span Alaska in 2016. Acquisitions may result in difficulties in assimilating acquired assets or companies, and may result in the diversion of the Company’s capital and its management attention from other business issues and opportunities. The Company may not be able to integrate companies that it acquires successfully, including their personnel, financial systems, distribution, operations and general +16 +​ +Table of Contents +operating procedures. The Company may also encounter challenges in achieving appropriate internal control over financial reporting in connection with the integration of an acquired company. The Company may pay a premium for an acquisition, resulting in goodwill that may later be determined to be impaired, adversely affecting the Company’s financial condition and results of operations. +​ +The Horizon and Span Alaska acquisitions may expose us to unknown liabilities. +​ +We acquired Horizon subject to all of the liabilities and obligations of its non-Hawaii business, including any remaining liabilities and obligations associated with its Puerto Rico operations, which Horizon ceased during the first quarter of 2015. Similarly, in August 2016, we acquired Span Alaska subject to all of its liabilities and obligations. The disposition of these liabilities, and any other obligations that are unknown to the Company, including contingent liabilities, could have an adverse effect on the Company’s financial condition and results of operations. +​ +We may continue to be exposed to risks and liabilities related to Horizon’s former Hawaii business. +​ +Pasha acquired Horizon’s former Hawaii business immediately before we acquired Horizon, and Pasha assumed substantially all liabilities and obligations related to Horizon’s Hawaii business and agreed to perform various covenants. In some cases, however, Horizon, as the original contracting party, may remain primarily responsible for such assumed Hawaii liabilities and obligations. The Company may incur losses related to such assumed Hawaii liabilities and obligations. +​ +We may be required to record a significant charge to earnings if recorded intangible assets associated with the Horizon and Span Alaska acquisitions become impaired. +​ +We recorded significant intangible assets related to goodwill, customer relationships and trade name arising from the Horizon and Span Alaska acquisitions. We are required to test goodwill for impairment annually, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Factors that could lead to an impairment of goodwill or intangible customer relationships include any significant adverse changes affecting the reporting unit’s financial condition, results of operations, and future cash flows. +​ +Risks Related to Financial Matters +​ +A deterioration of the Company’s credit profile, disruptions of the credit markets or higher interest rates could restrict its ability to access the debt capital markets or increase the cost of debt. +​ +Deterioration in the Company’s credit profile may have an adverse effect on the Company’s ability to access the private or public debt markets and also may increase its borrowing costs. If the Company’s credit profile deteriorates significantly, its access to the debt capital markets or its ability to renew its committed lines of credit may become restricted, or the Company may not be able to refinance debt at the same levels or on the same terms. Because the Company relies on its ability to draw on its revolving credit facilities to support its operations when required, any volatility in the credit and financial markets that prevents the Company from accessing funds (for example, a lender that does not fulfill its lending obligation) could have an adverse effect on the Company’s financial condition and cash flows. Additionally, the Company’s credit agreements generally include an increase in borrowing rates if the Company’s credit profile deteriorates. Furthermore, the Company incurs interest under its revolving credit facilities based on floating rates. Floating rate debt creates higher debt service requirements if market interest rates increase, as was the case in connection with the U.S. Federal Reserve’s interest rate increases in 2018, which would adversely affect the Company’s cash flow and results of operations. In addition, as the floating rate on certain borrowings under our revolving credit facility is tied to LIBOR, the uncertainty regarding the future of LIBOR as well as the transition from LIBOR to an alternate benchmark rate or rates could pose funding risks for the Company and adversely affect the Company’s financing costs. +​ +17 +​ +Table of Contents +Failure to comply with certain restrictive financial covenants contained in the Company’s credit facilities could preclude the payment of dividends, impose restrictions on the Company’s business segments, capital resources or other activities or otherwise adversely affect the Company. +​ +The Company’s credit facilities contain certain restrictive financial covenants, the most restrictive of which include a maximum ratio of debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”), a minimum ratio of EBITDA to interest expense, the maintenance of no more than a maximum amount of priority debt as a percentage of consolidated tangible assets, and the maintenance of minimum shareholders’ equity. If the Company does not maintain these and other required covenants, and a breach of such covenants is not cured timely or waived by the lenders resulting in a default, the Company’s access to credit may be limited or terminated, dividends may be suspended, and the lenders could declare any outstanding amounts due and payable. The Company’s continued ability to borrow under its credit facilities is subject to compliance with these financial and other non-financial covenants. +​ +The Company’s effective income tax rate may vary. +​ +Various internal and external factors may have favorable or unfavorable material or immaterial effects on the Company’s effective income tax rate and, therefore, impact the Company’s net income and earnings per share. These factors include, but are not limited to changes in tax rates; changes in tax laws, regulations, and rulings; changes in interpretations of existing tax laws, regulations and rulings; changes in the evaluation of the Company’s ability to realize deferred tax assets, and changes in uncertain tax positions; changes in accounting principles; changes in current pre-tax income as well as changes in forecasted pre-tax income; changes in the level of Capital Construction Fund (“CCF”) deductions, non-deductible expenses, and expenses eligible for tax credits; changes in the mix of earnings among countries with varying tax rates; and acquisitions and changes in the Company’s corporate structure. These factors may result in periodic revisions to our effective income tax rate, which could affect the Company’s cash flow and results of operations. +​ +Changes in the value of pension assets, or a change in pension law or key assumptions, may adversely affect the Company’s financial performance. +​ +The amount of the Company’s employee pension and post-retirement benefit costs and obligations is calculated on assumptions used in the relevant actuarial calculations. Adverse changes in any of these assumptions due to economic or other factors, changes in discount rates, higher health care costs, or lower actual or expected returns on plan assets, may adversely affect the Company’s operating results, cash flows, and financial condition. In addition, a change in federal law, including changes to the Employee Retirement Income Security Act or Pension Benefit Guaranty Corporation premiums, may adversely affect the Company’s single-employer and multi-employer pension plans and plan funding. These factors, as well as a decline in the fair value of pension plan assets, may put upward pressure on the cost of providing pension and medical benefits and may increase future pension expense and required funding contributions. There can be no assurance that the Company will be successful in limiting future cost and expense increases, and continued upward pressure in costs and expenses could further reduce the profitability of the Company’s businesses. +​ +The Company may have exposure under its multi-employer pension and post-retirement plans in which it participates that extends beyond its funding obligation with respect to the Company’s employees. +​ +The Company contributes to various multi-employer pension plans. In the event of a partial or complete withdrawal by the Company from any plan that is underfunded, the Company would be liable for a proportionate share of such plan’s unfunded vested benefits (see Note 11 to the Consolidated Financial Statements in Item 8 of Part II below). Based on the limited information available from plan administrators, which the Company cannot independently validate, the Company believes that its portion of the contingent liability in the case of a full withdrawal or termination may be material to its financial position and results of operations. If any other contributing employer withdraws from any plan that is underfunded, and such employer (or any member of its controlled group) cannot satisfy its obligations under the plan at the time of withdrawal, then the Company, along with the other remaining contributing employers, would be liable for its proportionate share of such plan’s unfunded vested benefits. In addition, if a multi-employer plan fails to satisfy the minimum funding requirements, the Internal Revenue Service will impose certain penalties and taxes. +​ +18 +​ +Table of Contents +Risks Related to Legal and Legislative Matters +​ +Compliance with safety and environmental protection and other governmental requirements may adversely affect our operations. +​ +The shipping industry in general, our business and the operation of our vessels and terminals in particular are affected by extensive and changing safety, environmental protection and other international, national, State and local governmental laws and regulations, including the following: laws pertaining to air emissions; wastewater discharges; the transportation, handling and disposal of solid and hazardous materials, oil and oil-related products, hazardous substances and wastes; the investigation and remediation of contamination; and health, safety and the protection of the environment and natural resources. For example, our U.S. flagged vessels generally must be maintained “in class” and are subject to periodic inspections by the American Bureau of Shipping or similar classification societies, and must be periodically inspected by, or on behalf of, the United States Coast Guard. We are subject to IMO regulations, including the new IMO 2020 regulations limiting the sulfur content of fuel oil. Federal environmental laws and certain State laws also require us, as a vessel operator, to comply with numerous environmental regulations and to obtain certificates of financial responsibility and to adopt procedures for oil and hazardous substance spill prevention, response and clean up. +​ +In complying with these laws, we have incurred expenses and may incur future expenses for vessel modifications, changes in operating procedures and undergoing additional oversight inspections. Changes in enforcement policies for existing requirements and additional laws and regulations adopted in the future could limit our ability to do business or further increase the cost of our doing business. Our vessels’ operating certificates and licenses are renewed periodically during the required annual surveys of the vessels. However, there can be no assurance that such certificates and licenses will be renewed, even though Matson maintains extensive programs and policies to ensure such renewal. Also, in the future, we may have to alter existing equipment, add new equipment, or change operating procedures for our vessels to comply with changes in governmental regulations, safety or other equipment standards to meet our customers’ changing needs. If any such costs are material, they could adversely affect our financial condition. +​ +We are subject to regulation and liability under environmental laws that could result in substantial fines and penalties that may have a material adverse effect on our results of operations. +​ +The U.S. Act to Prevent Pollution from vessels, which implements the International Maritime Pollution (MARPOL) treaty, and the Oil Pollution Act of 1990, among many other laws, treaties and regulations, provides for severe civil and criminal penalties related to vessel-generated pollution for incidents in U.S. waters within three nautical miles and in some cases within the 200-mile exclusive economic zone. The EPA requires vessels to obtain coverage under a general permit and to comply with inspection, monitoring, discharge, recordkeeping and reporting requirements. Matson’s vessels operate within emission control areas. If our vessels are not operated in accordance with these requirements, including waivers, permits or recordkeeping and other reporting requirements, such violations could result in substantial fines or penalties that could have a material adverse effect on our results of operations and our business. +​ +The Company is subject to, and may in the future be subject to disputes, legal or other proceedings, and government inquiries or investigations that could have an adverse effect on the Company. +​ +The nature of the Company’s business exposes it to the potential for disputes, legal or other proceedings, and government inquiries or investigations relating to antitrust matters, labor and employment matters, personal injury and property damage, environmental and other matters, as discussed in the other risk factors disclosed in this section or in other Company filings with the SEC. For example, Matson is a common carrier, whose tariffs, rates, rules and practices in dealing with its customers are governed by extensive and complex foreign, federal, state and local regulations, which may be the subject of disputes or administrative or judicial proceedings. If these disputes develop into proceedings, these proceedings, individually or collectively, could involve or result in significant expenditures or losses by the Company, or result in significant changes to Matson’s tariffs, rates, rules and practices in dealing with its customers, all of which could have an adverse effect on the Company’s future operating results, including profitability, cash flows and financial condition. +​ +19 +​ +Table of Contents +Non-compliance with, or changes to, federal, state or local law or regulations, including passage of climate change legislation or regulation, may adversely affect the Company’s business. +​ +The Company is subject to federal, state and local laws and regulations, including cabotage laws, government rate regulations, and environmental regulations including those relating to air quality initiatives at port locations, including but not limited to, the Oil Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. Continued compliance with these laws and regulations may result in additional costs and changes in operating procedures that may adversely affect the Company’s business. Non-compliance with, or changes to, the laws and regulations governing the Company’s business could impose significant additional costs on the Company and adversely affect the Company’s financial condition and results of operations. In addition, changes in environmental laws impacting the business, including passage of climate change legislation or other regulatory initiatives that restrict emissions of greenhouse gasses such as a “cap and trade” system of allowances and credits, if enacted, may require costly vessel modifications, the use of higher-priced fuel and changes in operating practices that may not be recoverable through increased payments from customers. Further changes to these laws and regulations could adversely affect the Company. +​ +​ +ITEM 1B. UNRESOLVED STAFF COMMENTS +​ +None. +​ +​ +ITEM 2. PROPERTIES +​ +Matson leases terminal facilities including office and storage space at the following material locations: +​ +​ +​ +​ +​ +​ +​ +Terminal Location +​ +Description of Facility +Acreage +Honolulu, Hawaii +​ +Terminal facility +105 +Anchorage, Alaska +​ +Terminal facility +38 +Dutch Harbor, Alaska +​ +Terminal facility +18 +Kodiak, Alaska +​ +Terminal facility +6 +Tacoma, Washington +​ +Terminal facility +​ +13 +​ +Polaris Point, Guam +​ +Terminal storage +​ +30 +​ +The Company is currently renewing certain terminal leases which expire during 2020. The Company expects to be able to renew these leases as they expire on similar terms to those that currently exist within these lease agreements. The Company’s other primary terminal facilities located at the ports of Oakland and Long Beach, California, and the ports of Seattle and Tacoma, Washington are leased by SSAT. +​ +Other material facilities used in the Company’s operations include the following: +​ +​ +​ +​ +​ +​ +​ +Other Material Facilities +Description of Facility +Square Footage +Pooler, Georgia +Warehouse +710,844 +​ +Oakland, California +Warehouse +406,463 +​ +Pooler, Georgia +Warehouse +324,832 +​ +Oakland, California +Warehouse +132,000 +​ +Piti, Guam +​ +Warehouse +​ +62,478 +​ +Anchorage, Alaska +​ +Office / Cross-dock +​ +54,000 +​ +Auburn, Washington +Office / Cross-dock +51,250 +​ +​ +​ +​ +ITEM 3. LEGAL PROCEEDINGS +​ +Environmental Matters: The Company’s Ocean Transportation segment has certain risks that could result in expenditures for environmental remediation. The Company believes that based on all information available to it, the Company is currently in compliance, in all material respects, with applicable environmental laws and regulations. +​ +20 +​ +Table of Contents +Other Matters: The Company and its subsidiaries are parties to, or may be contingently liable in connection with, other legal actions arising in the normal course of their businesses, the outcomes of which, in the opinion of management after consultation with counsel, would not have a material effect on the Company’s financial condition, results of operations, or cash flows. +​ +​ +ITEM 4. MINE SAFETY DISCLOSURES +​ +Not Applicable. +​ +21 +​ +Table of Contents +PART II +​ +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +​ +General Information: Matson’s common stock is traded on the New York Stock Exchange under the ticker symbol “MATX”. As of February 24, 2020, there were 2,156 shareholders of record of Matson common stock. +​ +Stockholder Return Performance Graph and Trading Information: The following information in this Item 5 shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933. +​ +The cumulative total return listed below assumed an initial investment of $100 and reinvestment of dividends at each fiscal end and measures the performance of this investment as of the last trading day in the month of December for each of the five years ended December 31, 2019. The graph is a historical representation of past performance only and is not necessarily indicative of future performance. +​ +* +$100 invested on December 31, 2014 in stock or index, including reinvestment of dividends. +​ +Trading volume averaged 155,804 shares a day in 2019, compared with 232,289 shares a day in 2018 and 241,338 shares a day in 2017, as reported by the New York Stock Exchange. +​ +​ +22 +​ +Table of Contents +Dividends: Dividends declared per share of common stock by the Company for each fiscal quarter during 2018 and 2019 were as follows: +​ +​ +​ +​ +​ +Dividends +2018 +​ +Declared +First Quarter +​ +$ +0.20 +Second Quarter +​ +$ +0.20 +Third Quarter +​ +$ +0.21 +Fourth Quarter +​ +$ +0.21 +2019 +​ +​ +​ +First Quarter +​ +$ +0.21 +Second Quarter +​ +$ +0.21 +Third Quarter +​ +$ +0.22 +Fourth Quarter +​ +$ +0.22 +​ +Matson’s Board of Directors also declared a cash dividend of $0.22 per share for the first quarter 2020, payable on March 5, 2020 to shareholders of record on February 6, 2020. Although Matson expects to continue paying quarterly cash dividends on its common stock, the declaration and payment of dividends are subject to the discretion of the Board of Directors and will depend upon Matson’s financial condition, results of operations, cash requirements and other factors deemed relevant by the Board of Directors. +​ +Equity Compensation Plan Information: The following table sets forth, as of December 31, 2019, certain information regarding Matson’s equity compensation plan: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Number of shares +​ +​ +​ +Number of shares +​ +​ +remaining available for +​ +​ +​ +to be issued +​ +​ +Weighted-average +​ +future issuance under +​ +​ +​ +upon exercise of +​ +​ +exercise price of +​ +equity compensation +​ +​ +​ +outstanding options, +​ +​ +outstanding options, +​ +plans (excluding shares +​ +Plan Category +​ +warrants and rights +​ +​ +warrants and rights +​ +reflected in column (a)) +​ +​ +​ +(a) +​ +​ +​ +(b) +​ +​ +(c) +​ +​ +Equity compensation plans approved by shareholders +​ +950,864 +(1) +​ +$ +22.30 +(2) +​ +1,359,020 +(3) +​ +Equity compensation plans not approved by shareholders +​ +— +​ +​ +​ +— +​ +— +​ +​ +Total +​ +950,864 +​ +​ +$ +22.30 +​ +1,359,020 +​ +​ +(1) In addition to 173,128 shares subject to outstanding stock option awards, this also includes 417,693 shares subject to unvested restricted stock unit awards and 360,043 shares subject to unvested Performance Share awards. +(2) As restricted stock unit and Performance Share awards do not have exercise prices, the weighted average exercise price is computed using only outstanding stock option awards. +(3) These shares are available for issuance under the Company’s 2016 Incentive Compensation Plan. +​ +​ +23 +​ +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +​ +The comparative selected financial data of the Company is presented for each of the five years in the period ended December 31, 2019. The information should be read in conjunction with Item 8, “Financial Statements and Supplementary Data,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. All fiscal years include 52 weeks, except for the year ended December 31, 2016 which includes 53 weeks: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions, except per share amounts) +2019 +2018 +2017 +2016 +2015 +Operating Revenue: (1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +$ +1,571.8 +​ +$ +1,541.1 +​ +$ +1,498.0 +​ +Logistics +​ +536.5 +​ +581.5 +​ +475.1 +​ +400.5 +​ +386.9 +​ +Total Operating Revenue +​ +$ +2,203.1 +​ +$ +2,222.8 +​ +$ +2,046.9 +​ +$ +1,941.6 +​ +$ +1,884.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating and Net Income: (1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (2) +​ +$ +90.8 +​ +$ +131.1 +​ +$ +126.4 +​ +$ +144.5 +​ +$ +192.3 +​ +Logistics +​ +38.3 +​ +32.7 +​ +20.9 +​ +12.2 +​ +8.8 +​ +Total Operating Income +​ +129.1 +​ +163.8 +​ +147.3 +​ +156.7 +​ +201.1 +​ +Interest expense +​ +(22.5) +​ +(18.7) +​ +(24.2) +​ +(24.1) +​ +(18.5) +​ +Other income (expense), net +​ +1.2 +​ +2.6 +​ +2.1 +​ +(2.1) +​ +(4.8) +​ +Income before Income Taxes +​ +107.8 +​ +147.7 +​ +125.2 +​ +130.5 +​ +177.8 +​ +Income taxes (3) +​ +(25.1) +​ +(38.7) +​ +105.8 +​ +(49.1) +​ +(74.8) +​ +Net Income +​ +$ +82.7 +​ +$ +109.0 +​ +$ +231.0 +​ +$ +81.4 +​ +$ +103.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Identifiable Assets: (1)(6) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (4) +​ +$ +2,424.5 +​ +$ +2,071.6 +​ +$ +1,941.5 +​ +$ +1,726.3 +​ +$ +1,605.1 +​ +Logistics +​ +420.9 +​ +358.8 +​ +310.1 +​ +293.3 +​ +68.8 +​ +Total Assets +​ +$ +2,845.4 +​ +$ +2,430.4 +​ +$ +2,251.6 +​ +$ +2,019.6 +​ +$ +1,673.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capital Expenditure: (5) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +294.5 +​ +$ +385.4 +​ +$ +305.3 +​ +$ +179.1 +​ +$ +67.5 +​ +Logistics +​ +15.8 +​ +15.8 +​ +1.7 +​ +0.3 +​ +0.3 +​ +Total Capital Expenditures +​ +$ +310.3 +​ +$ +401.2 +​ +$ +307.0 +​ +$ +179.4 +​ +$ +67.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and Amortization: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +93.6 +​ +$ +87.0 +​ +$ +93.3 +​ +$ +92.6 +​ +$ +81.4 +​ +Logistics +​ +6.8 +​ +7.4 +​ +7.9 +​ +4.5 +​ +2.0 +​ +​ +​ +​ +100.4 +​ +​ +94.4 +​ +​ +101.2 +​ +​ +97.1 +​ +​ +83.4 +​ +Deferred Dry-docking Amortization — Ocean Transportation +​ +​ +34.3 +​ +​ +37.4 +​ +​ +46.2 +​ +​ +38.9 +​ +​ +23.1 +​ +Total Depreciation and Amortization +​ +$ +134.7 +​ +$ +131.8 +​ +$ +147.4 +​ +$ +136.0 +​ +$ +106.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings Per Share in Net Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic +​ +$ +1.93 +​ +$ +2.55 +​ +$ +5.38 +​ +$ +1.89 +​ +$ +2.37 +​ +Diluted +​ +$ +1.91 +​ +$ +2.53 +​ +$ +5.35 +​ +$ +1.87 +​ +$ +2.34 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash dividends per share declared +​ +$ +0.86 +​ +$ +0.82 +​ +$ +0.78 +​ +$ +0.74 +​ +$ +0.70 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total debt obligations — including current portion +​ +$ +958.4 +​ +$ +856.4 +​ +$ +857.1 +​ +$ +738.9 +​ +$ +429.9 +​ +Total Shareholders' equity +​ +$ +805.7 +​ +$ +755.3 +​ +$ +677.2 +​ +$ +494.9 +​ +$ +450.6 +​ +Shares outstanding +​ +42.9 +​ +42.7 +​ +42.5 +​ +42.9 +​ +43.5 +​ +(1) 2015 and subsequent selected financial data includes the operations of Horizon acquired as of May 29, 2015, and Span Alaska acquired as of August 4, 2016. +(2) The Ocean Transportation segment includes $20.8 million, $36.8 million, $28.2 million, $15.8 million and $16.5 million of equity in income from the Company’s investment in SSAT, for 2019, 2018, 2017, 2016 and 2015, respectively. +(3) Income taxes for the years ended December 31, 2019, 2018 and 2017 include a non-cash income tax (expense)/benefit of $2.9 million, $(2.9) million and $154.0 million, respectively, related to the remeasurement of the Company’s deferred assets and liabilities and other discrete adjustments as a result of applying the Tax Cut and Jobs Act of 2017. +(4) The Ocean Transportation segment includes $76.2 million, $87.0 million, $93.2 million, $82.4 million and $66.4 million related to the Company’s investment in SSAT as of December 31, 2019, 2018, 2017, 2016 and 2015, respectively. +(5) Excludes expenditures related to Matson’s acquisition of Horizon and Span Alaska which were classified as payments for acquisitions in Cash Flows used in Investing Activities within the Consolidated Statements of Cash Flows. +(6) Identifiable assets for 2019 includes Operating lease right of use assets resulting from the adoption of the new lease accounting standard. +​ +24 +​ +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +​ +FORWARD-LOOKING STATEMENTS AND RISK FACTORS +​ +The Company, from time to time, may make or may have made certain forward-looking statements, whether orally or in writing, such as forecasts and projections of the Company’s future performance or statements of management’s plans and objectives. These statements are “forward-looking” statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be contained in, among other things, SEC filings such as Forms 10-K, 10-Q and 8-K, the Annual Report to Shareholders, press releases made by the Company, the Company’s Internet websites (including websites of its subsidiaries), and oral statements made by the officers of the Company. Except for historical information contained in these written or oral communications, such communications contain forward-looking statements. These include, for example, all references to 2020 or future years. New risk factors emerge from time to time and it is not possible for the Company to predict all such risk factors, nor can it assess the impact of all such risk factors on the Company’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Accordingly, forward-looking statements cannot be relied upon as a guarantee of future results and involve a number of risks and uncertainties that could cause actual results to differ materially from those projected in the statements, including but not limited to the factors that are described in Part I, Item 1A under the caption of “Risk Factors” of this Form 10-K, which section is incorporated herein by reference. The Company is not required, and undertakes no obligation, to revise or update forward-looking statements or any factors that may affect actual results, whether as a result of new information, future events, or circumstances occurring after the date of this report. +​ +OVERVIEW +​ +Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a discussion of the Company’s financial condition, results of operations, liquidity and certain other factors that may affect its future results from the perspective of management. The discussion that follows is intended to provide information that will assist in understanding the changes in the Company’s Consolidated Financial Statements from year to year, the primary factors that accounted for those changes, and how certain accounting principles, policies and estimates affect the Company’s Consolidated Financial Statements. MD&A is provided as a supplement to, and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes to the Consolidated Financial Statements in Item 8 of Part II below. Discussion and analysis of the financial condition and results of operations of Matson for the years ended December 31, 2018 and 2017 can be found in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 , filed with the SEC on March 4, 2019. +​ +MD&A is presented in the following sections: +​ +◾ Business Outlook +◾ Consolidated Results of Operations +◾ Analysis of Operating Revenue and Income by Segment +◾ Liquidity and Capital Resources +◾ Contractual Obligations, Commitments, Contingencies and Off-Balance Sheet Arrangements +◾ Critical Accounting Estimates +◾ Other Matters +​ +​ +25 +​ +Table of Contents +BUSINESS OUTLOOK +​ +The following is the Company’s fourth quarter 2019 discussion and 2020 outlook: +​ +Ocean Transportation: The Company’s container volume in the Hawaii service in the fourth quarter 2019 was 1.1 percent higher year-over-year primarily due to positive container market growth. Although Hawaii’s rate of economic growth is expected to continue slowing, recent increases in key economic factors, such as construction activity and visitor traffic, are expected to support continued GDP growth. The Company expects volume in 2020 to be higher compared to the level achieved in 2019, reflecting favorable economic conditions in Hawaii and stable market share. +​ +In China, the Company’s container volume in the fourth quarter 2019 was 4.3 percent higher year-over-year primarily due to larger vessel capacity deployed in the tradelane coupled with strong demand for Matson’s differentiated service. Matson continued to realize a sizeable rate premium in the fourth quarter 2019 and achieved average freight rates that were modestly lower than the exceptional level achieved in the fourth quarter 2018. In the fourth quarter of 2018, the Company experienced unusually strong performance as a result of the U.S.-China trade situation. For 2020, the Company expects to face challenging conditions in the first half of the year as a result of COVID-19, but expects the second half of the year to be comparable to the strong performance achieved in the second half of 2019. Therefore, the Company expects volume in 2020 to be modestly lower than the prior year and average freight rates in 2020 to approximate the levels achieved in 2019. +​ +In Guam, the Company’s container volume in the fourth quarter 2019 was 7.7 percent lower on a year-over-year basis primarily due to typhoon relief volume in the year ago period. For 2020, the Company expects volume to approximate the level achieved last year and expects the highly competitive environment to remain. +​ +In Alaska, the Company’s container volume for the fourth quarter 2019 declined 0.7 percent year-over-year. The Company experienced slightly lower northbound volume and modestly higher southbound volume compared to the levels achieved in fourth quarter 2018. For 2020, the Company expects volume to be modestly higher than the level achieved in 2019, with higher northbound volume, including volume in the first quarter related to the dry-docking of a competitor’s vessel, and slightly lower southbound volume compared to the levels achieved in 2019. +​ +The contribution in the fourth quarter 2019 from the Company’s SSAT joint venture investment was $5.0 million lower than the fourth quarter 2018. The decrease was primarily due to higher terminal operating costs and lower lift volume. For 2020, the Company expects the contribution from SSAT to be lower due to lower lift volume primarily driven by the negative effects of COVID-19, partially offset by improved operating cost efficiencies. +​ +As a result of the business outlook noted above, the Company expects full year 2020 Ocean Transportation operating income to be higher than the $90.8 million achieved in 2019. In the first quarter 2020, the Company expects Ocean Transportation operating income to be approximately breakeven versus the $9.4 million achieved in the year ago period. The vast majority of the estimated $15 million COVID-19 financial impact is factored into the Ocean Transportation operating income outlook for the first quarter 2020. +​ +Logistics: In the fourth quarter 2019, operating income for the Company’s Logistics segment was $1.5 million lower compared to the operating income achieved in the fourth quarter 2018. For 2020, the Company expects Logistics operating income to be lower than the level achieved in 2019 of $38.3 million. In the first quarter 2020, the Company expects Logistics operating income to be lower than the $8.1 million achieved in the first quarter 2019. The full year 2020 and first quarter 2020 operating income outlook includes a modest negative financial impact from COVID-19. +​ +Depreciation and Amortization: For the full year 2020, the Company expects depreciation and amortization expense to be approximately $135 million, inclusive of dry-docking amortization of approximately $25 million. +​ +Other Income (Expense): The Company expects full year 2020 other income (expense) to be approximately $2 million in income, which is attributable to other component costs related to the Company’s pension and post-retirement plans. +​ +Interest Expense: The Company expects interest expense for the full year 2020 to be approximately $33 million. +​ +26 +​ +Table of Contents +Income Taxes: In the fourth quarter 2019, the Company’s effective tax rate was 22.4 percent. For the full year 2020, the Company expects its effective tax rate to be approximately 26.0 percent. +​ +Net Income, Operating Income and EBITDA: The Company expects net income in 2020 to be flat year-over-year and expects consolidated operating income and EBITDA in 2020 to be approximately $143 million and $280 million, respectively, including approximately $15 million negative impact from COVID-19. +​ +Capital and Vessel Dry-docking Expenditures: For the full year 2019, the Company made other capital expenditure payments of $91.2 million, capitalized vessel construction expenditures of $219.1 million, and dry-docking payments of $25.9 million. For the full year 2020, the Company expects to make other capital expenditure payments, including maintenance capital expenditures, of approximately $110 million, vessel construction expenditures (including capitalized interest and owner’s items) of approximately $75 million, and dry-docking payments of approximately $15 million. +​ +CONSOLIDATED RESULTS OF OPERATIONS +​ +The following analysis of the financial condition and results of operations of Matson for the years ended December 31, 2019 and 2018 should be read in conjunction with the Consolidated Financial Statements in Item 8 of Part II below. +​ +Consolidated Results: 2019 compared with 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(Dollars in millions, except per share amounts) +​ +2019 +​ +2018 +​ +Change +Operating revenue +$ +2,203.1 +$ +2,222.8 +$ +(19.7) +(0.9) +% +Operating costs and expenses +​ +(2,074.0) +​ +(2,059.0) +​ +(15.0) +0.7 +% +Operating income +​ +129.1 +​ +163.8 +​ +(34.7) +(21.2) +% +Interest expense +​ +(22.5) +​ +(18.7) +​ +(3.8) +20.3 +% +Other income (expense), net +​ +1.2 +​ +2.6 +​ +(1.4) +(53.8) +% +Income before income taxes +​ +107.8 +​ +147.7 +​ +(39.9) +(27.0) +% +Income taxes +​ +(25.1) +​ +(38.7) +​ +13.6 +(35.1) +% +Net income +​ +$ +82.7 +​ +$ +109.0 +​ +$ +(26.3) +(24.1) +% +Basic earnings per share +​ +$ +1.93 +​ +$ +2.55 +​ +$ +(0.62) +(24.3) +% +Diluted earnings per share +​ +$ +1.91 +​ +$ +2.53 +​ +$ +(0.62) +(24.5) +% +​ +Fiscal Year: Fiscal years ended December 31, 2019 and 2018 include 52 weeks. +​ +Consolidated Operating Revenue for the year ended December 31, 2019 decreased $19.7 million, or 0.9 percent, compared to the prior year. The decrease was due to an increase in Ocean Transportation revenue of $25.3 million offset by a decrease in Logistics revenue of $45.0 million. +​ +Operating Costs and Expenses for the year ended December 31, 2019 increased $15.0 million, or 0.7 percent, compared to the prior year. The increase was due to an increase in Ocean Transportation operating costs and expenses of $65.6 million which was partially offset by a decrease in Logistics operating costs and expenses of $50.6 million. +​ +Operating Income for the year ended December 31, 2019 decreased $34.7 million, or 21.2 percent, compared to the prior year. The decrease was due to a decrease in Ocean Transportation operating income of $40.3 million which was partially offset by an increase in Logistics operating income of $5.6 million. +​ +The reasons for changes in operating revenue, operating costs and expenses, and operating income are described below, by business segment, in the Analysis of Operating Revenue and Income by Segment. +​ +Interest Expense was $22.5 million for the year ended December 31, 2019, compared to $18.7 million in the prior year. The increase in interest expense was due to higher interest on increased borrowings under the revolving credit facility and a lower offset amount of capitalized interest associated with the new vessel construction. +​ +Other Income (Expense), net was $1.2 million for the year ended December 31, 2019, compared to $2.6 million in the prior year, and relates to the amortization of certain components of net periodic benefit costs or gains related to the Company’s pension and post-retirement plans. +27 +​ +Table of Contents +​ +Income Taxes for the year ended December 31, 2019 was $25.1 million, or 23.3 percent of income before income taxes, compared to $38.7 million, or 26.2 percent of income before income taxes in the prior year. The 2019 income tax rate is lower than the 2018 income tax rate primarily due to $2.9 million, or 2.7 percent of non-cash benefit included in income tax expense in 2019, compared to a $2.9 million, or 2.0 percent of non-cash expense included in income tax expense in 2018 related to discrete tax adjustments resulting from applying the Tax Cuts and Jobs Act of 2017 (the “Tax Act”). +​ +Net Income during the year ended December 31, 2019 decreased $26.3 million, or 24.1 percent, compared to the prior year. +​ +ANALYSIS OF OPERATING REVENUE AND INCOME BY SEGMENT +​ +The following analysis of operating revenue and income by segment for the years ended December 31, 2019 and 2018 should be read in conjunction with the Company’s reportable segments information included in Item 6 of Part II and Note 3 to the Consolidated Financial Statements in Item 8 of Part II. +​ +Ocean Transportation: 2019 compared with 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(Dollars in millions) +2019 +2018 +Change +Ocean Transportation revenue +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +$ +25.3 +​ +1.5 +% +Operating costs and expenses +​ +(1,575.8) +​ +(1,510.2) +​ +(65.6) +​ +4.3 +% +Operating income +​ +$ +90.8 +​ +$ +131.1 +​ +$ +(40.3) +​ +(30.7) +% +Operating income margin +​ +5.4 +% +8.0 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Volume (Forty-foot equivalent units (FEU), except for automobiles) (1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Hawaii containers +​ +146,600 +​ +148,700 +​ +(2,100) +​ +(1.4) +% +Hawaii automobiles +​ +62,900 +​ +63,100 +​ +(200) +​ +(0.3) +% +Alaska containers +​ +69,400 +​ +69,100 +​ +300 +​ +0.4 +% +China containers +​ +64,000 +​ +61,600 +​ +2,400 +​ +3.9 +% +Guam containers +​ +19,400 +​ +19,700 +​ +(300) +​ +(1.5) +% +Other containers (2) +​ +16,900 +​ +16,300 +​ +600 +​ +3.7 +% +(1) Approximate volumes included for the period are based on the voyage departure date, but revenue and operating income are adjusted to reflect the percentage of revenue and operating income earned during the reporting period for voyages in transit at the end of each reporting period. +(2) Includes containers from services in various islands in Micronesia and the South Pacific, and Okinawa, Japan. +​ +Ocean Transportation revenue increased $25.3 million, or 1.5 percent, during the year ended December 31, 2019, compared with the year ended December 31, 2018. The increase was primarily due to higher freight revenue in Alaska, higher freight rates in Hawaii, and higher revenue in China, partially offset by lower container volume in Hawaii and lower fuel-related surcharge revenue. +​ +On a year-over-year FEU basis, Hawaii container volume decreased 1.4 percent primarily due to negative container market growth and weather-related impacts in the first quarter of 2019; Alaska volume increased by 0.4 percent primarily due to higher northbound volume, partially offset by northbound volume related to the dry-docking of a competitor’s vessel in the year ago period and lower southbound volume; China volume was 3.9 percent higher primarily due to stronger volume post Lunar New Year; Guam volume was 1.5 percent lower primarily due to typhoon relief volume in fourth quarter 2018; and Other containers volume increased 3.7 percent. +​ +Ocean Transportation operating income decreased $40.3 million, or 30.7 percent, during the year ended December 31, 2019, compared with the year ended December 31, 2018. The decrease was primarily due to higher terminal handling costs, higher vessel operating costs (including Maunalei lease expense), and a lower contribution from SSAT, partially offset by a higher contribution from the Alaska service. +​ +The Company’s SSAT terminal joint venture investment contributed $20.8 million during the year ended December 31, 2019, compared to a contribution of $36.8 million during the year ended December 31, 2018. The decrease was primarily due to higher terminal operating costs and the absence of favorable one-time items in the year ago period, partially offset by higher lift volume. +28 +​ +Table of Contents +​ +Logistics: 2019 compared with 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(Dollars in millions) +2019 +2018 +Change +Logistics revenue +​ +$ +536.5 +​ +$ +581.5 +$ +(45.0) +​ +(7.7) +% +Operating costs and expenses +​ +(498.2) +​ +(548.8) +50.6 +​ +(9.2) +% +Operating income +​ +$ +38.3 +​ +$ +32.7 +$ +5.6 +​ +17.1 +% +Operating income margin +​ +7.1 +% +5.6 +% +​ +​ +​ +​ +​ +​ +Logistics revenue decreased $45.0 million, or 7.7 percent, during the year ended December 31, 2019, compared with the year ended December 31, 2018. The decrease was primarily due to lower transportation brokerage revenue, partially offset by higher freight forwarding revenue. +​ +Logistics operating income increased $5.6 million, or 17.1 percent, for the year ended December 31, 2019, compared with the year ended December 31, 2018. The increase was due primarily to higher contributions from freight forwarding and transportation brokerage. +​ +LIQUIDITY AND CAPITAL RESOURCES +​ +Sources of liquidity available to the Company at December 31, 2019 compared to December 31, 2018, were as follows: +​ +Cash and Cash Equivalents, Restricted Cash and Accounts Receivable : Cash and cash equivalents, restricted cash and accounts receivable, net, as of December 31, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2019 +2018 +Change +Cash and cash equivalents +​ +$ +21.2 +​ +$ +19.6 +​ +$ +1.6 +​ +Restricted cash +​ +$ +7.2 +​ +$ +4.9 +​ +$ +2.3 +​ +Accounts receivable, net (1) +​ +$ +205.9 +​ +$ +223.7 +​ +$ +(17.8) +​ +(1) Eligible accounts receivable of $1.7 million and $1.0 million at December 31, 2019 and 2018, respectively, were assigned to the CCF. +​ +Changes in the Company’s cash, cash equivalents and restricted cash for the years ended December 31, 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2019 +2018 +2017 +2019-2018 +2018-2017 +Net cash provided by operating activities (1) +​ +$ +248.8 +​ +$ +305.0 +​ +$ +224.9 +​ +$ +(56.2) +​ +$ +80.1 +​ +Net cash used in investing activities (2) +​ +(306.9) +​ +(260.3) +​ +(276.9) +​ +(46.6) +​ +16.6 +​ +Net cash provided by (used in) financing activities (3) +​ +62.0 +​ +(40.0) +​ +57.9 +​ +102.0 +​ +(97.9) +​ +Net increase in cash, cash equivalents and restricted cash +​ +3.9 +​ +4.7 +​ +5.9 +​ +(0.8) +​ +(1.2) +​ +Cash, cash equivalents and restricted cash, beginning of the period +​ +24.5 +​ +19.8 +​ +13.9 +​ +4.7 +​ +5.9 +​ +Cash, cash equivalents and restricted cash, end of the period +​ +$ +28.4 +​ +$ +24.5 +​ +$ +19.8 +​ +$ +3.9 +​ +$ +4.7 +​ +29 +​ +Table of Contents +​ +(1) Changes in Net Cash Provided by Operating Activities: Changes in net cash provided by operating activities for the years ended December 31, 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2019-2018 +2018-2017 +Net income from operations +​ +$ +(26.3) +​ +$ +(122.0) +Non-cash deferred income taxes +​ +​ +(5.7) +​ +​ +157.2 +Amortization of operating lease right of use assets +​ +​ +60.7 +​ +​ +— +Other non-cash related changes, net +​ +​ +2.6 +​ +​ +(19.5) +Income and distributions from SSAT, net +​ +​ +(0.8) +​ +15.9 +Operating lease liabilities +​ +(59.9) +​ +​ +— +Deferred dry-docking payments +​ +(6.7) +​ +35.4 +Accounts receivable, net +​ +46.9 +​ +(24.0) +Prepaid expenses and other assets +​ +20.3 +​ +(10.2) +Accounts payable, accruals and other liabilities +​ +(85.1) +​ +50.8 +Other long-term liabilities +​ +(2.2) +​ +(3.5) +Total +​ +$ +(56.2) +​ +$ +80.1 +​ +The change in deferred income taxes is primarily related to the remeasurement of the Company’s deferred assets and liabilities, and other discrete tax adjustments resulting from applying the Tax Act as of December 31, 2017. The change in amortization of operating lease right of use assets and operating lease liabilities relates to the adoption of the new lease accounting standard during the year ended December 31, 2019. The Company’s share of income from SSAT was $20.8 million during the year ended December 31, 2019, compared to $36.8 million in the prior year, while distributions from SSAT was $25.2 million during the year ended December 31, 2019, compared to $42.0 million of distributions received in the prior year. Deferred dry-docking payments were $25.9 million for the year ended December 31, 2019, compared to $19.2 million in the prior year. The increase in deferred dry-docking payments was due to an increase in vessel dry-docking activities during the year ended December 31, 2019, compared to the prior year. Changes in accounts receivable are due to the timing of collections as of December 31, 2019, compared to the prior year. Changes in prepaid expenses and other assets are due to the timing of prepaid income taxes, changes in the amount of insurance related receivables and changes in other prepaid amounts as of December 31, 2019, compared to the prior year. Changes in accounts payable, accruals and other liabilities for the year ended December 31, 2019, compared to the prior year are due to the timing of payments associated with those liabilities. +​ +(2) Changes in Net Cash Used in Investing Activities: Changes in net cash used in investing activities for the years ended December 31, 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2019-2018 +2018-2017 +Capitalized vessel construction expenditures +​ +$ +119.5 +​ +$ +(86.6) +Cash deposits into CCF +​ +243.8 +​ +​ +(168.6) +Withdrawals from CCF +​ +​ +(244.7) +​ +​ +139.2 +Other capital expenditures +​ +​ +(28.6) +​ +​ +(7.6) +Proceeds from disposal of property and equipment, net +​ +(132.9) +​ +​ +136.5 +Proceeds from sale of other investments +​ +​ +(3.7) +​ +​ +3.7 +Total +​ +$ +(46.6) +​ +$ +16.6 +​ +Capitalized vessel construction expenditures (including capitalized interest and owners’ items) was $219.1 million for the year ended December 31, 2019, compared to $338.6 million in the prior year. The decrease in capitalized vessel construction expenditures (including cash deposited into the CCF less cash withdrawals from the CCF which are used for vessel construction related payments) is due to a reduction in progress payments related to the construction of new vessels. Other capital expenditures (excluding capitalized vessel construction expenditures) was $91.2 million for the year ended December 31, 2019, compared to $62.6 million for the prior year. The increase was primarily due to higher levels of capital expenditures related to the installation of scrubbers on vessels, the Hawaii Sand Island terminal expansion and modernization program, and the construction of the Anchorage Service Center during the year ended December 31, 2019, compared to the prior year. Proceeds from the disposal of property and equipment was $3.4 million for the year ended December 31, 2019, compared to $136.3 million for the prior year. Disposals of property and equipment during the year ended December 31, 2018 included net proceeds of approximately $106.0 million from the +30 +​ +Table of Contents +sale and leaseback of a vessel, and $28.4 million from other container and equipment sale and leaseback transactions. There were no sale and leaseback transactions in 2019. Proceeds from the sale of other investments of $3.7 million for the year ended December 31, 2018 related to the surrender of life insurance policies. There were no sales of other investments during the year ended December 31, 2019. +​ +(3) Changes in Net Cash Provided by (Used in) Financing Activities: Changes in net cash provided by (used in) financing activities for the years ended December 31, 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2019-2018 +2018-2017 +Repayments of fixed interest debt and capital leases +​ +$ +(11.4) +​ +$ +1.1 +Borrowings under revolving credit facility, net +​ +​ +114.1 +​ +​ +(120.0) +Repurchase of Matson common stock +​ +​ +— +​ +​ +19.3 +Dividends paid +​ +​ +(1.8) +​ +​ +(1.6) +Change in other payments, net +​ +1.1 +​ +​ +3.3 +Total +​ +$ +102.0 +​ +$ +(97.9) +​ +Repayments of fixed interest debt and capital leases increased to $42.1 million for the year ended December 31, 2019, compared to $30.7 million in the prior year due to scheduled fixed interest debt payments. Net borrowings from the Company’s revolving credit facility was $144.1 million for the year ended December 31, 2019, compared to $30.0 million in the prior year. The increase in borrowing under the revolving credit facility was primarily due to vessel construction payments and other capital expenditure. There was no repurchase of Matson stock during the years ended December 31, 2019 or 2018. During the year ended December 31, 2017, the Company repurchased $19.3 million of Matson stock. Dividends paid was $37.2 million for the year ended December 31, 2019, compared to $35.4 million for the year ended December 31, 2018. +​ +Debt: Total debt as of December 31, 2019 and 2018 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2019 +2018 +Change +Revolving credit facility +​ +$ +379.1 +​ +$ +235.0 +​ +$ +144.1 +Fixed interest debt +​ +​ +579.3 +​ +​ +621.4 +​ +​ +(42.1) +Total Debt +​ +$ +958.4 +​ +$ +856.4 +​ +$ +102.0 +​ +Total debt increased by $102.0 million during the year ended December 31, 2019, compared to the prior year. The increase in the Company’s revolving credit facility was primarily due to the funding of progress payments related to the construction of new vessels and other capital expenditure during the year ended December 31, 2019. The reduction in fixed interest debt was due to scheduled debt payments made during the year ended December 31, 2019. +​ +As of December 31, 2019, the Company had $75.1 million of remaining availability under the revolving credit facility, with a maturity date of June 29, 2022. The Company’s debt is described in Note 8 to the Consolidated Financial Statements in Item 8 of Part II. +​ +Working Capital: The Company had working capital deficiency of $147.1 million at December 31, 2019, compared to working capital deficiency of $52.4 million at December 31, 2018. The increase in working capital deficiency at December 31, 2019 is partially due to the recording of the short-term portion of operating lease liabilities of $66.6 million as of December 31, 2019, in accordance with the adoption of the new lease accounting standard, and a $17.8 million decrease in accounts receivable. Working capital is impacted by the timing of collections associated with accounts receivable and other assets, and the timing of payments associated with accounts payable, accruals and other liabilities. +​ +31 +​ +Table of Contents +CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS +​ +Contractual Obligations: +​ +At December 31, 2019, the Company had the following estimated contractual obligations: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Payment Due By Period +​ +​ +​ +Contractual Obligations (in millions) +2020 +2021-2022 +2023-2024 +Thereafter +Total +Vessel construction obligations (1) +​ +$ +64.8 +​ +$ +— +​ +$ +— +​ +$ +— +​ +$ +64.8 +​ +Total debt obligations (2) +​ +48.4 +​ +493.2 +​ +115.7 +​ +301.1 +​ +958.4 +​ +Estimated interest on debt (3) +​ +36.0 +​ +56.6 +​ +28.3 +​ +55.0 +​ +175.9 +​ +Vendor and other obligations (4) +​ +29.6 +​ +— +​ +— +​ +— +​ +29.6 +​ +Qualified defined benefit pension obligations (5) +​ +13.6 +​ +28.1 +​ +29.3 +​ +76.2 +​ +147.2 +​ +Non-qualified pension obligations (5) +​ +2.2 +​ +— +​ +2.1 +​ +0.5 +​ +4.8 +​ +Post-retirement benefit obligations (5) +​ +1.0 +​ +2.1 +​ +2.4 +​ +5.7 +​ +11.2 +​ +Multi-employer withdrawal obligations (6) +​ +10.8 +​ +8.2 +​ +8.2 +​ +63.9 +​ +91.1 +​ +Operating lease obligations (7) +​ +75.9 +​ +98.7 +​ +61.0 +​ +78.7 +​ +314.3 +​ +Total +​ +$ +282.3 +​ +$ +686.9 +​ +$ +247.0 +​ +$ +581.1 +​ +$ +1,797.3 +​ +(1) Vessel construction obligations represent contractual agreements entered into for the construction of new vessels. +(2) Total debt obligations include principal repayments of outstanding debt (see Note 8 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(3) Estimated interest on debt is determined based on: (i) the stated interest rate for fixed debt, and (ii) the estimated variable interest on revolving credit facility assuming the balance at December 31, 2019 remains outstanding until maturity. +(4) Vendor and other obligations include: (i) non-cancellable contractual capital project obligations (excluding vessel construction obligations shown in (1) above); (ii) dry-docking related obligations; and (iii) other contractual obligations. Amounts are considered obligations if a contract has been agreed to specifying significant terms of the contract, and the amounts are not reflected in the Consolidated Balance Sheets. +(5) Qualified defined benefit pension, non-qualified pension and post-retirement benefit obligations include estimated payments for the next ten years. The amounts noted in the column labeled “Thereafter” represent estimated benefit payments for 2025 through 2029 (see Note 11 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(6) Multi-employer withdrawal obligations relate to the discounted liability associated with Horizon’s mass withdrawal from Puerto Rico’s multi-employer ILA-PRSSA and the partial withdrawal liability associated with the Local 153 Fund of the OPEIU (see Note 12 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(7) Operating lease obligations primarily consist of real estate and terminal leases, vessel charter leases, operations equipment and other leases entered into under non-cancellable arrangements (see Note 9 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +​ +Estimated timing and amount of payments related to unrecognized tax benefits of $16.4 million as of December 31, 2019 are excluded from the table due to the uncertainty of such timing and payments, if any. +​ +Commitments, Contingencies and Off-Balance Sheet Arrangements: +​ +Commitments and Contingencies: A description of other commitments and contingencies is set forth in Note 9, Note 11 and Note 17 to the Consolidated Financial Statements in Item 8 of Part II below, and is incorporated herein by reference. +​ +Off-balance sheet Arrangements: Except as described below, the Company is not party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, results of operations or cash flows. +​ +Future minimum payments under operating leases are $314.3 million as of December 31, 2019. In addition, the Company provided a lessor with a maximum residual value guarantee related to the lease of a vessel. Additional information related to leases and the vessel lease guarantee is set forth in Note 9 to the Consolidated Financial Statements in Item 8 of Part II below, and is incorporated herein by reference. +​ +​ +32 +​ +Table of Contents +CRITICAL ACCOUNTING ESTIMATES +​ +The Company’s significant accounting policies are described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. The preparation of Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America, upon which the Company’s Management Discussion and Analysis of Financial Condition and Results of Operations is based, requires that management exercise judgment when making accounting estimates about future events that may affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Future events and their effects cannot be determined with certainty and actual results will, inevitably, differ from those accounting estimates. These differences could be material. +​ +The Company considers an accounting estimate to be critical if: (i)(a) the accounting estimate requires the Company to make assumptions that are difficult or subjective about matters that were highly uncertain at the time that the accounting estimate was made, (b) changes in the estimate are reasonably likely to occur in periods after the period in which the estimate was made, or (c) use of different estimates by the Company could have been used; and (ii) changes in those accounting estimates would have had a material impact on the financial condition or results of operations of the Company. The critical accounting estimates inherent in the preparation of the Company’s Consolidated Financial Statements are described below. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors. +​ +Long-Lived Assets, Intangible Assets and Goodwill: The Company evaluates its long-lived assets, intangible assets and goodwill for possible impairment in the fourth quarter, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value is less than its carrying amount. The Company has reporting units within the Ocean Transportation and Logistics reportable segments. +​ +Long-lived Assets and Finite-lived Intangible Assets: Long-lived assets and finite-lived intangible assets are grouped at the lowest level reporting unit for which identifiable cash flows are available. In evaluating for impairment, the estimated future undiscounted cash flows generated by each of these asset groups are compared with the carrying value recorded for each asset group to determine if its carrying value is recoverable. If this review determines that the amount recorded will not be recovered, the amount recorded for the asset group is reduced to its estimated fair value. These asset impairment analyses are highly subjective because they require management to make assumptions and apply considerable judgments to, among other things, estimates of the timing and amount of future cash flows, expected useful lives of the assets, potential impact of future events, including changes in economic conditions and operating performance, and future costs of maintenance and improvements of the assets. If management uses different assumptions or if different conditions occur in future periods, the Company’s financial condition or its future operating results could be materially impacted. The Company has evaluated its long-lived assets and finite-lived intangible assets for impairment and determined that there was no impairment for the years ended December 31, 2019, 2018 and 2017. +​ +Indefinite-life Intangible Assets and Goodwill: The Company’s intangible assets include goodwill, customer relationships and a trade name, and are grouped at the lowest level reporting unit for which identifiable cash flows are available. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of earnings before interest, income taxes, depreciation and amortization (“EBITDA”). The discounted cash flow approach requires the Company to use a number of assumptions, including market factors specific to the business, the amount and timing of estimated future cash flows generated by the business over an extended period of time, long-term growth rates for the business, and a discount rate that considers the risks related to the amount and timing of the cash flows. Although the assumptions used by the Company in its discounted cash flow model are consistent with the assumptions the Company used to generate its internal strategic plans and forecasts, significant judgment is required to estimate the amount and timing of future cash flows from the reporting unit and the risk of achieving those cash flows. When using market multiples of EBITDA, the Company makes judgments about the comparability of multiples in closed and proposed transactions. Accordingly, changes in assumptions and estimates, including, but not limited to, changes driven by external factors, such as industry and economic trends, and those driven by internal factors, such as changes in the Company’s business strategy and its internal forecasts, could have a material effect on the Company’s financial condition or its future operating results. The Company has evaluated its indefinite-life intangible assets and goodwill for impairment and determined that there was no impairment for the years ended December 31, 2019, 2018 and 2017. +​ +33 +​ +Table of Contents +Uninsured Risks and Related Liabilities: The Company is uninsured for certain risks but when feasible, many of these risks are mitigated by insurance. The Company purchases insurance with deductibles or self-insured retentions. Such insurance includes, but is not limited to, employee health, workers’ compensation, marine liability, cybersecurity, auto liability and physical damage to property and equipment. For certain risks, the Company elects to not purchase insurance because of the excessive cost of such insurance or the perceived remoteness of the risk. In addition, the Company retains all risk of loss that exceeds the limits of the Company’s insurance policies. +​ +When estimating its reserves for uninsured risks and related liabilities, the Company considers a number of factors, including historical claims experience, demographic factors, current trends, and analyses provided by independent third-parties. Periodically, management reviews its assumptions and estimates used to determine the adequacy of the Company’s reserves for uninsured risks and related liabilities. The Company’s uninsured risks and related liabilities contain uncertainties because management is required to apply judgment and make long-term assumptions to estimate the ultimate cost to settle reported claims, and of claims incurred but not reported, as of the balance sheet date. If management uses different assumptions or if different conditions occur in future periods, the Company’s financial condition or its future operating results could be materially impacted. +​ +Pension and Post-Retirement Plans: The estimation of the Company’s pension and post-retirement benefit expenses and liabilities requires the Company to make various assumptions. These assumptions include factors such as discount rates, expected long-term rate of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates and expected contributions. Actual results that differ from the assumptions made could materially affect the Company’s financial condition or its future operating results. The effects of changing assumptions are included in unamortized net gains and losses, which directly affect accumulated other comprehensive income (loss). Additionally, these unamortized gains and losses are amortized and reclassified to income (loss) over future periods. +​ +Additional information about the Company’s pension and post-retirement plans and assumptions used is included in Note 11 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Income Taxes: The Company’s income tax expense requires the Company to make various estimates and judgments. These estimates and judgments are applied in the calculation of taxable income, tax credits, tax benefits and deductions, and in the calculation of certain deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue, costs and expenses for tax purposes. The calculation of deferred tax assets and liabilities may be impacted by various factors including but not limited to changes in tax rates; changes in tax laws, regulations, and rulings; changes in interpretations of existing tax laws, regulations and rulings; and changes in the evaluation of the Company’s ability to realize deferred tax assets including operating loss and tax credit carryforwards. Deferred tax assets and liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. Significant changes to these estimates may result in an increase or decrease to the Company’s income taxes in a subsequent period. +​ +The Company records a valuation allowance if, based on the weight of available evidence, management believes that it is more likely than not that some portion or all of a recorded deferred tax asset would not be realized in future periods. +​ +Additional information about the Company’s income taxes is included in Note 10 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +OTHER MATTERS +​ +New Accounting Pronouncements: See Note 2 to the Consolidated Financial Statements in Item 8 of Part II below for additional information on new accounting pronouncements. +​ +​ +34 +​ +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +​ +Debt and Interest Rate Risks: The Company is exposed to changes in interest rates, primarily as a result of its borrowing and investing activities used to maintain liquidity and to fund business operations, including borrowings under its revolving credit facility and private placement term loans. In order to manage its exposure to changes in interest rates, the Company utilizes a balanced mix of both fixed-rate and variable-rate debt with various maturity dates. The nature and amount of the Company’s outstanding debt are expected to fluctuate as a result of future business requirements, market conditions and other factors. The Company’s outstanding variable and fixed rate debt was $379.1 million and $579.3 million as of December 31, 2019, and $235.0 million and $621.4 million as of December 31, 2018, respectively. +​ +Other than in certain events of default, the Company is not obligated to prepay its variable and fixed rate debt prior to maturity. For fixed rate debt, changes in market interest rates would not affect the Company’s financial condition or results of operations. For variable rate debt, a 100 basis point increase in the variable interest rate would have an impact on the Company’s results of operations for 2019 of approximately $3.8 million, assuming the December 31, 2019 balance of the variable rate debt was outstanding throughout the year. This change is not expected to have a material impact on the fair value of the Company’s variable rate debt. +​ +Interest on borrowing from some of the Company’s debt is calculated based upon a London Interbank Offered Rate (“LIBOR”) benchmark interest rate measurement. It is anticipated that the use of LIBOR will be discontinued during the year ending 2021. The expected discontinuation of LIBOR will require the Company and its lenders to transition from a LIBOR measurement to an alternative benchmark interest rate. The transition from LIBOR to another benchmark rate or rates could have an adverse impact on the Company’s outstanding debt that currently use LIBOR as a benchmark rate, and ultimately, adversely affect the Company’s financial condition and results of operations. +​ +Additional information about the Company’s debt is included in Note 8 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Investment Risks: From time to time, the Company may invest its excess cash in short-term money market funds that purchase government securities or corporate debt securities, or in other deposit products allowed under the Company’s Cash Investment Policy. These money market funds and deposits maintain a weighted average maturity of less than 90 days, and accordingly, a one percent change in interest rates is not expected to have a material impact on the fair value of these investments or on interest income. The Company had a nominal amount on deposit in money market funds as of December 31, 2019 and 2018. +​ +Through its Capital Construction Fund (“CCF”), the Company may, from time to time, invest in money market funds or other eligible investments. The Company’s cash deposits in the CCF as of December 31, 2019 and 2018 were nominal. +​ +Foreign Currency Risks: The Company has no material exposure to foreign currency risks, although it is indirectly affected by changes in currency rates to the extent that changes in rates affect tourism in Hawaii, Guam, Alaska and other locations. Transactions related to the Company’s China service are primarily denominated in U.S. dollars, and therefore, a one percent change in the Chinese Yuan exchange rate would not have a material effect on the Company’s results of operations. Transactions related to the Company’s South Pacific service are primarily denominated in New Zealand dollars. However, a one percent change in the New Zealand dollar exchange rate is not expected to have a material effect on the Company’s results of operations. +​ +​ +​ +​ +35 +​ +Table of Contents +​ +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +​ +​ +​ +​ +​ +Page +Management’s Annual Report on Internal Control Over Financial Reporting +37 +Report of Independent Registered Public Accounting Firm +38 +Consolidated Statements of Income and Comprehensive Income +40 +Consolidated Balance Sheets +41 +Consolidated Statements of Cash Flows +42 +Consolidated Statements of Shareholders’ Equity +43 +​ +​ +Notes to Consolidated Financial Statements +44 +1. +Description of the Business +44 +2. +Significant Accounting Policies +44 +3. +Reportable Segments +49 +4. +Investment in SSAT +51 +5. +Property and Equipment +52 +6. +Goodwill and Intangible Assets +52 +7. +Capital Construction Fund +53 +8. +Debt +54 +9. +Leases +56 +10. +Income Taxes +58 +11. +Pension and Post-Retirement Plans +61 +12. +Multi-Employer Withdrawal Liabilities +68 +13. +Accumulated Other Comprehensive Income (Loss) +68 +14. +Earnings Per Share +69 +15. +Share-Based Awards +69 +16. +Fair Value of Financial Instruments +70 +17. +Commitments and Contingencies +71 +18. +Quarterly Information (Unaudited) +72 +​ +​ +36 +​ +Table of Contents +MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +​ +The management of Matson, Inc. and subsidiaries (the “Company”) has the responsibility for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as a process designed by, or under the supervision of, the company’s principal executive and principal financial officers and effected by the company’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that: +​ +● Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the company; +​ +● Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and +​ +● Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. +​ +Because of its inherent limitations, internal control over financial reporting only provides reasonable assurance with respect to financial statement presentation and preparation. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +​ +Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2019. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013) . Based on its assessment, management believes that, as of December 31, 2019, the Company’s internal control over financial reporting is effective. The Company’s independent registered public accounting firm, Deloitte & Touche LLP, has issued an attestation report on the Company’s internal control over financial reporting. +​ +​ +/s/ Matthew J. Cox +​ +/s/ Joel M. Wine +Matthew J. Cox +​ +Joel M. Wine +Chairman and Chief Executive Officer +​ +Senior Vice President and Chief Financial Officer +February 28, 2020 +​ +February 28, 2020 +​ +​ +​ +37 +​ +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +​ +To the Board of Directors and Shareholders of Matson, Inc. +​ +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of Matson, Inc. and subsidiaries (the “ Company”) as of December 31, 2019 and 2018, the related consolidated statements of income and comprehensive income, shareholders' equity, and cash flows, for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the “financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +​ +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control — Integrated Framework (2013) issued by COSO. +​ +Change in Accounting Principle +As discussed in Note 9 to the financial statements, effective January 1, 2019, the Company adopted FASB ASC Topic 842, Leases , using the modified retrospective approach. +​ +Basis for Opinions +The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +​ +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +​ +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +​ +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +​ +38 +​ +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +​ +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +​ +Goodwill – Span Alaska Reporting Unit — Refer to Notes 2 and 6 to the financial statements +​ +Critical Audit Matter Description +​ +The Company’s evaluation of goodwill for impairment involves the comparison of the fair value of each reporting unit to its carrying value. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of EBITDA. The discounted cash flow approach requires the Company to make several business assumptions related to discount rates and forecasts of future revenues. Changes in assumptions and estimates, including, but not limited to, changes driven by external factors, such as industry and economic trends, and those driven by internal factors, such as changes in the Company’s business strategy and its internal forecasts, could have a material effect on either the fair value, the amount of any goodwill impairment charge, or both. The goodwill balance was $327.8 million as of December 31, 2019, of which $78.6 million is allocated to a reporting unit in the Logistics reportable segment, resulting from the acquisition of Span Intermediate, LLC (“Span Alaska”) in fiscal year 2016. The Company has evaluated its goodwill for impairment as part of its annual assessment in fiscal year 2019 and determined that the fair value of the Span Alaska reporting unit exceeded the carrying amount as of the date of the impairment review. +​ +We identified goodwill related to Span Alaska as a critical audit matter because of the significant estimates and assumptions management made to estimate the fair value of Span Alaska. Specifically, due to the sensitivity of Span Alaska’s operations to changes in the Alaskan economy, performing audit procedures to evaluate the reasonableness of management’s estimates and assumptions related to forecasts of future revenues and selection of the discount rate, required a high degree of auditor judgment and an increased extent of effort, including the need to involve our fair value specialists. +​ +How the Critical Audit Matter Was Addressed in the Audit +​ +Our audit procedures related to the forecasts of future revenue, specifically as they relate to Span Alaska, and the selection of the discount rate for Span Alaska included the following, among others: +​ +● We tested the effectiveness of controls over management’s goodwill impairment evaluation, including those over the forecasts of future revenue and the selection of the discount rate. +● We evaluated management’s ability to accurately forecast future revenue by comparing actual results to management’s historical forecasts. +● We evaluated the reasonableness of management’s revenue forecast by comparing the forecasts to (1) historical revenues and operating margins, (2) internal communications to management and the Board of Directors, (3) external communications made by management to analysts and investors, (4) trends in the logistics industry and (5) trends in the Alaskan economy. +● With the assistance of our fair value specialists, we evaluated the reasonableness of the discount rate, including testing the source information underlying the determination of the discount rate, testing the mathematical accuracy of the calculation, and developing a range of independent estimates and comparing those to the discount rate selected by management. +​ +​ +/s/ Deloitte & Touche LLP +​ +San Francisco, California +​ +February 28, 2020 +​ +​ +​ +We have served as the Company’s auditor since at least 1976; however, an earlier year could not be reliably determined. +​ +​ +​ +​ +39 +​ +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions, except per share amounts) +2019 +2018 +2017 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +$ +1,571.8 +​ +Logistics +​ +536.5 +​ +581.5 +​ +475.1 +​ +Total Operating Revenue +​ +2,203.1 +​ +2,222.8 +​ +2,046.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Costs and Expenses: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating costs +​ +( 1,878.0 ) +​ +( 1,875.0 ) +​ +( 1,721.0 ) +​ +Income from SSAT +​ +20.8 +​ +36.8 +​ +28.2 +​ +Selling, general and administrative +​ +( 216.8 ) +​ +( 220.8 ) +​ +( 206.8 ) +​ +Total Costs and Expenses +​ +( 2,074.0 ) +​ +( 2,059.0 ) +​ +( 1,899.6 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating Income +​ +129.1 +​ +163.8 +​ +147.3 +​ +Interest expense +​ +( 22.5 ) +​ +( 18.7 ) +​ +( 24.2 ) +​ +Other income (expense), net +​ +1.2 +​ +2.6 +​ +​ +2.1 +​ +Income before Income Taxes +​ +107.8 +​ +147.7 +​ +125.2 +​ +Income taxes +​ +( 25.1 ) +​ +( 38.7 ) +​ +105.8 +​ +Net Income +​ +$ +82.7 +​ +$ +109.0 +​ +$ +231.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other Comprehensive Income (Loss), Net of Income Taxes: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Income +​ +$ +82.7 +​ +$ +109.0 +​ +$ +231.0 +​ +Other Comprehensive Income (Loss): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net gain in prior service cost +​ +— +​ +— +​ +0.8 +​ +Amortization of prior service cost +​ +( 4.5 ) +​ +( 4.7 ) +​ +( 4.0 ) +​ +Amortization of net loss +​ +2.7 +​ +1.1 +​ +1.7 +​ +Other adjustments +​ +( 0.6 ) +​ +— +​ +0.2 +​ +Total Other Comprehensive (Loss) Income +​ +( 2.4 ) +​ +( 3.6 ) +​ +( 1.3 ) +​ +Comprehensive Income +​ +$ +80.3 +​ +$ +105.4 +​ +$ +229.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Share +​ +$ +1.93 +​ +$ +2.55 +​ +$ +5.38 +​ +Diluted Earnings Per Share +​ +$ +1.91 +​ +$ +2.53 +​ +$ +5.35 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted Average Number of Shares Outstanding: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic +​ +42.8 +​ +42.7 +​ +42.9 +​ +Diluted +​ +43.3 +​ +43.0 +​ +43.2 +​ +​ +See Notes to Consolidated Financial Statements. +​ +40 +​ +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2019 +2018 +ASSETS +​ +​ +​ +​ +​ +​ +​ +Current Assets: +​ +​ +​ +​ +​ +​ +​ +Cash and cash equivalents +​ +$ +21.2 +​ +$ +19.6 +​ +Accounts receivable, net +​ +205.9 +​ +223.7 +​ +Prepaid expenses and other assets +​ +62.5 +​ +75.1 +​ +Total current assets +​ +289.6 +​ +318.4 +​ +Long-term Assets: +​ +​ +​ +​ +​ +​ +​ +Investment in SSAT +​ +76.2 +​ +87.0 +​ +Property and equipment, net +​ +1,598.1 +​ +1,366.6 +​ +Operating lease right of use assets +​ +​ +256.1 +​ +​ +— +​ +Goodwill +​ +327.8 +​ +327.8 +​ +Intangible assets, net +​ +​ +202.9 +​ +​ +214.0 +​ +Deferred dry-docking costs, net +​ +​ +56.9 +​ +​ +67.1 +​ +Other long-term assets +​ +37.8 +​ +49.5 +​ +Total long-term assets +​ +​ +2,555.8 +​ +​ +2,112.0 +​ +Total Assets +​ +$ +2,845.4 +​ +$ +2,430.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +LIABILITIES AND SHAREHOLDERS’ EQUITY +​ +​ +​ +​ +​ +​ +​ +Current Liabilities: +​ +​ +​ +​ +​ +​ +​ +Current portion of debt +​ +$ +48.4 +​ +$ +42.1 +​ +Accounts payable and accruals +​ +235.7 +​ +246.8 +​ +Operating lease liabilities +​ +​ +66.6 +​ +​ +— +​ +Other liabilities +​ +86.0 +​ +81.9 +​ +Total current liabilities +​ +436.7 +​ +370.8 +​ +Long-term Liabilities: +​ +​ +​ +​ +​ +​ +​ +Long-term debt +​ +910.0 +​ +814.3 +​ +Long-term operating lease liabilities +​ +​ +198.0 +​ +​ +— +​ +Deferred income taxes +​ +337.6 +​ +312.7 +​ +Other long-term liabilities +​ +​ +157.4 +​ +​ +177.3 +​ +Total long-term liabilities +​ +1,603.0 +​ +1,304.3 +​ +Commitments and Contingencies +​ +​ +​ +​ +​ +​ +​ +Shareholders’ Equity: +​ +​ +​ +​ +​ +​ +​ +Common stock - common stock without par value; authorized, 150.0 million shares ($ 0.75 stated value per share); outstanding, 42.9 million shares in 2019 and 42.7 million shares in 2018 +​ +32.2 +​ +32.0 +​ +Additional paid in capital +​ +306.2 +​ +297.8 +​ +Accumulated other comprehensive loss, net +​ +( 36.9 ) +​ +( 34.5 ) +​ +Retained earnings +​ +504.2 +​ +460.0 +​ +Total shareholders’ equity +​ +805.7 +​ +755.3 +​ +Total Liabilities and Shareholders’ Equity +​ +$ +2,845.4 +​ +$ +2,430.4 +​ +​ +See Notes to Consolidated Financial Statements. +​ +41 +​ +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Cash Flows From Operating Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net income +​ +$ +82.7 +​ +$ +109.0 +​ +$ +231.0 +​ +Reconciling adjustments: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and amortization +​ +100.4 +​ +94.4 +​ +101.2 +​ +Amortization of operating lease right of use assets +​ +​ +60.7 +​ +​ +— +​ +​ +— +​ +Deferred income taxes +​ +23.6 +​ +29.3 +​ +( 127.9 ) +​ +Loss (Gain) on disposal of property and equipment +​ +( 1.4 ) +​ +( 1.9 ) +​ +3.0 +​ +Share-based compensation expense +​ +11.3 +​ +12.1 +​ +11.1 +​ +Income from SSAT +​ +( 20.8 ) +​ +( 36.8 ) +​ +( 28.2 ) +​ +Distributions from SSAT +​ +25.2 +​ +42.0 +​ +17.5 +​ +Changes in assets and liabilities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accounts receivable, net +​ +17.8 +​ +( 29.1 ) +​ +( 5.1 ) +​ +Deferred dry-docking payments +​ +( 25.9 ) +​ +( 19.2 ) +​ +( 54.6 ) +​ +Deferred dry-docking amortization +​ +34.3 +​ +37.4 +​ +46.2 +​ +Prepaid expenses and other assets +​ +24.5 +​ +4.2 +​ +14.4 +​ +Accounts payable, accruals and other liabilities +​ +( 13.9 ) +​ +71.2 +​ +20.4 +​ +Operating lease liabilities +​ +​ +( 59.9 ) +​ +​ +— +​ +​ +— +​ +Other long-term liabilities +​ +( 9.8 ) +​ +( 7.6 ) +​ +( 4.1 ) +​ +Net cash provided by operating activities +​ +248.8 +​ +305.0 +​ +224.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flows From Investing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capitalized vessel construction expenditure +​ +​ +( 219.1 ) +​ +​ +( 338.6 ) +​ +​ +( 252.0 ) +​ +Other capital expenditures +​ +( 91.2 ) +​ +( 62.6 ) +​ +( 55.0 ) +​ +Proceeds from (payments for) disposal of property and equipment +​ +3.4 +​ +136.3 +​ +( 0.2 ) +​ +Cash deposits into Capital Construction Fund +​ +( 96.2 ) +​ +( 340.0 ) +​ +( 171.4 ) +​ +Withdrawals from Capital Construction Fund +​ +96.2 +​ +340.9 +​ +201.7 +​ +Proceeds from sale of other investments +​ +— +​ +3.7 +​ +— +​ +Net cash used in investing activities +​ +( 306.9 ) +​ +( 260.3 ) +​ +( 276.9 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flows From Financing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Repayments of debt +​ +​ +( 42.0 ) +​ +( 30.0 ) +​ +( 30.0 ) +​ +Repayment of capital leases +​ +​ +( 0.1 ) +​ +( 0.7 ) +​ +( 1.8 ) +​ +Proceeds from revolving credit facility +​ +​ +622.1 +​ +963.9 +​ +469.0 +​ +Repayments of revolving credit facility +​ +​ +( 478.0 ) +​ +​ +( 933.9 ) +​ +​ +( 319.0 ) +​ +Payment of financing costs +​ +​ +— +​ +— +​ +( 1.7 ) +​ +Proceeds from issuance of common stock +​ +​ +0.3 +​ +0.7 +​ +1.9 +​ +Dividends paid +​ +​ +( 37.2 ) +​ +( 35.4 ) +​ +( 33.8 ) +​ +Repurchase of Matson common stock +​ +​ +— +​ +​ +— +​ +​ +( 19.3 ) +​ +Tax withholding related to net share settlements of restricted stock units +​ +​ +( 3.1 ) +​ +​ +( 4.6 ) +​ +​ +( 7.4 ) +​ +Net cash provided by (used in) financing activities +​ +62.0 +​ +( 40.0 ) +​ +57.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Increase in Cash, Cash Equivalents and Restricted Cash +​ +3.9 +​ +4.7 +​ +5.9 +​ +Cash, Cash Equivalents and Restricted Cash, Beginning of the Year +​ +24.5 +​ +19.8 +​ +13.9 +​ +Cash, Cash Equivalents and Restricted Cash, End of the Year +​ +$ +28.4 +​ +$ +24.5 +​ +$ +19.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Reconciliation of Cash, Cash Equivalents, and Restricted Cash, at End of the Year: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash and Cash Equivalents +​ +$ +21.2 +​ +$ +19.6 +​ +$ +19.8 +​ +Restricted Cash +​ +​ +7.2 +​ +​ +4.9 +​ +​ +— +​ +Total Cash, Cash Equivalents and Restricted Cash, End of the Year +​ +$ +28.4 +​ +$ +24.5 +​ +$ +19.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Cash Flow Information: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Interest paid, net of capitalized interest +​ +$ +22.0 +​ +$ +18.3 +​ +$ +23.9 +​ +Income tax paid, net of income tax refunds +​ +$ +( 24.2 ) +​ +$ +5.2 +​ +$ +2.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non-cash Information: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capital expenditures included in accounts payable, accruals and other liabilities +​ +$ +8.5 +​ +$ +4.1 +​ +$ +1.2 +​ +​ +See Notes to Consolidated Financial Statements. +​ +42 +​ +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +For the three years ended December 31, 2019 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accumulated +​ +​ +​ +​ +​ +​ +​ +​ +Common Stock +​ +Additional +​ +Other +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Stated +​ +Paid In +​ +Comprehensive +​ +Retained +​ +​ +​ +(In millions, except per share amounts) +Shares +Value +Capital +Income (Loss) +Earnings +Total +Balance at December 31, 2016 +42.9 +​ +$ +32.1 +$ +289.8 +​ +$ +( 23.6 ) +​ +$ +196.6 +​ +$ +494.9 +​ +Net income +— +​ +— +— +​ +— +​ +231.0 +​ +231.0 +​ +Other comprehensive income (loss), net of tax +— +​ +— +— +​ +( 1.3 ) +​ +— +​ +( 1.3 ) +​ +Share-based compensation +— +​ +— +11.1 +​ +— +​ +— +​ +11.1 +​ +Shares issued, net of shares withheld for employee taxes +0.3 +​ +0.3 +( 5.7 ) +​ +— +​ +— +​ +( 5.4 ) +​ +Shares repurchased +​ +( 0.7 ) +​ +​ +( 0.5 ) +​ +​ +( 5.5 ) +​ +​ +— +​ +​ +( 13.3 ) +​ +​ +( 19.3 ) +​ +Dividends ($ 0.78 per share) +— +​ +— +— +​ +— +​ +( 33.8 ) +​ +( 33.8 ) +​ +Balance at December 31, 2017 +42.5 +​ +​ +31.9 +​ +289.7 +​ +​ +( 24.9 ) +​ +​ +380.5 +​ +​ +677.2 +​ +Net income +— +​ +— +— +​ +— +​ +109.0 +​ +109.0 +​ +Other comprehensive income (loss), net of tax +​ +— +​ +— +— +​ +( 9.6 ) +​ +6.0 +​ +( 3.6 ) +​ +Share-based compensation +— +​ +— +12.1 +​ +— +​ +— +​ +12.1 +​ +Shares issued, net of shares withheld for employee taxes +0.2 +​ +0.1 +( 4.0 ) +​ +— +​ +— +​ +( 3.9 ) +​ +Shares repurchased +​ +— +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 0.1 ) +​ +​ +( 0.1 ) +​ +Dividends ($ 0.82 per share) +— +​ +— +— +​ +— +​ +( 35.4 ) +​ +( 35.4 ) +​ +Balance at December 31, 2018 +42.7 +​ +​ +32.0 +​ +297.8 +​ +​ +( 34.5 ) +​ +​ +460.0 +​ +​ +755.3 +​ +Net income +— +​ +— +— +​ +— +​ +82.7 +​ +82.7 +​ +Adoption of new lease accounting standard (see Note 9) +​ +— +​ +— +— +​ +— +​ +4.4 +​ +4.4 +​ +Other comprehensive income (loss), net of tax +— +​ +— +— +​ +( 2.4 ) +​ +— +​ +( 2.4 ) +​ +Share-based compensation +— +​ +— +11.3 +​ +— +​ +— +​ +11.3 +​ +Shares issued, net of shares withheld for employee taxes +0.2 +​ +​ +0.2 +​ +( 2.9 ) +​ +— +​ +— +​ +( 2.7 ) +​ +Dividends ($ 0.86 per share) +— +​ +— +— +​ +— +​ +( 37.3 ) +​ +( 37.3 ) +​ +SSAT’s adoption of new lease accounting standard (see Note 4) +​ +— +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 5.6 ) +​ +​ +( 5.6 ) +​ +Balance at December 31, 2019 +42.9 +​ +$ +32.2 +$ +306.2 +​ +$ +( 36.9 ) +​ +$ +504.2 +​ +$ +805.7 +​ +​ +See Notes to Consolidated Financial Statements. +​ +43 +​ +Table of Contents +MATSON, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +​ +1. +DESCRIPTION OF THE BUSINESS +​ +Matson, Inc., a holding company incorporated in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information on the Company’s reportable segments for the three years ended December 31, 2019, see Note 3. +​ +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates a premium, expedited service from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific. In addition, subsidiaries of MatNav provide container stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +​ +Matson has a 35 percent ownership interest in SSA Terminals, LLC, a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc., a subsidiary of Carrix, Inc. (“SSAT”). SSAT provides terminal and stevedoring services to various carriers at eight terminal facilities on the U.S. West Coast, including four facilities dedicated for MatNav’s use. Matson records its share of income from SSAT in Costs and Expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +​ +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively, “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively, “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +​ +​ +2. +SIGNIFICANT ACCOUNTING POLICIES +​ +Principles of Consolidation: The Consolidated Financial Statements include the accounts of Matson, Inc. and all wholly-owned subsidiaries, after elimination of intercompany amounts and transactions. Significant investments in businesses, partnerships, and limited liability companies in which the Company does not have a controlling financial interest, but has the ability to exercise significant influence, are accounted for under the equity method. The Company accounts for its investment in SSAT using the equity method of accounting (see Note 4). +​ +Fiscal Year: The year end for Matson is December 31. The period end for MatNav occurred on the last Friday in December, except for Matson Logistics Warehousing, Inc. whose period closed on December 31. Included in these Consolidated Financial Statements are 52 weeks in the 2019, 2018 and 2017 fiscal years for MatNav. +​ +Foreign Currency Transactions: The United States (U.S.) dollar is the functional currency for substantially all of the financial statements of the Company’s foreign subsidiaries. Foreign currency denominated assets and liabilities of the Company’s foreign subsidiaries are translated into U.S. dollars at exchange rates existing at the respective balance sheet dates. Translation adjustments resulting from fluctuations in exchange rates are recorded as a component of accumulated other comprehensive loss (gain) within shareholders’ equity. The Company translates the result of operations of its foreign subsidiaries at the average exchange rate during the respective periods. Gains and losses resulting from foreign currency transactions are included in Costs and Expenses in the Consolidated Statements of Income and Comprehensive Income. +44 +​ +Table of Contents +​ +Use of Estimates: The preparation of the Consolidated Financial Statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported. Estimates and assumptions are used for, but not limited to: impairment of investments; impairment of long-lived assets, intangible assets and goodwill; capitalized interest; allowance for doubtful accounts; legal contingencies; uninsured risks and related liabilities; accrual estimates; pension and post-retirement estimates; multi-employer withdrawal liabilities; operating lease assets and liabilities; and income taxes. Future results could be materially affected if actual results differ from these estimates and assumptions. +​ +Cash, Cash Equivalents and Restricted Cash: Cash equivalents consist of highly-liquid investments with original maturities of three months or less. The Company carries these investments at cost, which approximates fair value. Outstanding checks in excess of funds on deposit totaled $ 13.8 million and $ 16.4 million at December 31, 2019 and 2018, respectively, and are included in current liabilities in the Consolidated Balance Sheets. Restricted cash relates to amounts that are subject to contractual restrictions and are not readily available. At December 31, 2019 and 2018, restricted cash was $ 7.2 million and $ 4.9 million, respectively, and are included in prepaid expenses and other assets in the Consolidated Balance Sheets. +​ +Accounts Receivable, net: Accounts receivable represent amounts due from trade customers arising in the normal course of business. Accounts receivable are shown net of allowance for doubtful accounts receivable in the Consolidated Balance Sheets. Allowance for doubtful accounts receivable is established by management based on estimates of collectability. Estimates of collectability are principally based on an evaluation of the current financial condition of the customer and the potential risks to collection, the customer’s payment history, expected future credit losses and other factors which are regularly monitored by the Company. +​ +Changes in the allowance for doubtful accounts receivable for the three years ended December 31, 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance at +​ +Write-offs +Balance at +Year (in millions) +Beginning of Year +Expense (1) +and Other +End of Year +2019 +​ +$ +4.8 +​ +$ +0.6 +​ +$ +( 1.1 ) +​ +$ +4.3 +​ +2018 +​ +$ +4.6 +​ +$ +0.8 +​ +$ +( 0.6 ) +​ +$ +4.8 +​ +2017 +​ +$ +4.2 +​ +$ +1.0 +​ +$ +( 0.6 ) +​ +$ +4.6 +​ +(1) Expense is shown net of amounts recovered from previously reserved doubtful accounts. +​ +Prepaid Expenses and Other Assets: Prepaid expenses and other assets consist of the following at December 31, 2019 and 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Prepaid Expenses and Other Assets (in millions) +2019 +2018 +Prepaid fuel +​ +$ +13.7 +​ +$ +16.3 +​ +Prepaid insurance and insurance related receivables +​ +13.4 +​ +12.6 +​ +Income tax receivables +​ +​ +12.8 +​ +​ +26.8 +​ +Restricted cash - vessel construction obligations +​ +​ +7.2 +​ +​ +4.9 +​ +Prepaid operating expenses +​ +​ +5.7 +​ +​ +6.8 +​ +Other +​ +9.7 +​ +7.7 +​ +Total +​ +$ +62.5 +​ +$ +75.1 +​ +​ +Other Long-Term Assets: Other long-term assets consist of the following at December 31, 2019 and 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Other Long-Term Assets (in millions) +2019 +2018 +Vessel and equipment spare parts +​ +$ +12.4 +​ +$ +13.1 +​ +Income tax receivables +​ +​ +11.5 +​ +​ +21.5 +​ +Insurance related receivables +​ +​ +10.6 +​ +​ +11.2 +​ +Deferred charges and other +​ +3.3 +​ +3.7 +​ +Total +​ +$ +37.8 +​ +$ +49.5 +​ +​ +45 +​ +Table of Contents +Impairment of SSAT: The Company’s investment in SSAT, a related party, is reviewed for impairment annually, or whenever there is evidence that fair value may be below its carrying cost. No impairment was identified during the years ended December 31, 2019, 2018 and 2017. +​ +Property and Equipment: Property and equipment is stated at cost. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of property and equipment range up to the following maximum life: +​ +​ +​ +​ +​ +Classification +Life +Vessels +40 years +​ +Machinery and equipment +30 years +​ +Terminal facilities +35 years +​ +​ +Capitalized Interest: The Company capitalizes interest costs during the period the qualified assets are being readied for their intended use. The Company determined that the vessel construction costs are considered qualifying assets for the purposes of capitalizing interest on these assets. The amount of capitalized interest is calculated based on the amount of payments incurred related to the construction of these vessels using a weighted average interest rate. The weighted average interest rate is determined using the Company’s average borrowings outstanding during the period. Capitalized interest is included in vessel construction in progress in property and equipment in the Company’s Consolidated Balance Sheets (see Note 5). During the years ended December 31, 2019, 2018 and 2017, the Company capitalized $ 15.6 million, $ 18.7 million and $ 7.5 million of interest related to the construction of new vessels, respectively. +​ +Leases: The Company adopted Accounting Standards Codification (“ASC”) 842, Leases (“ASC 842”) on January 1, 2019. ASC 842 requires lessees to record leases on their balance sheets but recognize the expenses in their income statements in a manner similar to pre-adoption practice. ASC 842 states that a lessee would recognize a lease liability for the obligation to make lease payments, and a right-of-use asset for the underlying leased asset for the period of the lease term. Refer to Note 9 for additional information on the Company’s adoption of ASC 842 and other lease related disclosures. +​ +Deferred Dry-docking Costs: U.S. flagged vessels must meet specified seaworthiness standards established by U.S. Coast Guard rules and classification society rules. These standards require U.S. flagged vessels to undergo two dry-docking inspections within a five-year period, with a maximum of 36 months between them. However, U.S. flagged vessels that are enrolled in the U.S. Coast Guard’s Underwater Survey in Lieu of Dry-docking (“UWILD”) program are allowed to have their Intermediate Survey dry-docking requirement met with a less costly underwater inspection. Non-U.S. flag vessels are required to meet applicable classification society rules and their own local standards for seaworthiness, which also mandate vessels to undergo two dry-docking inspections every five years . +​ +The Company is responsible for maintaining its vessels in compliance with U.S. and international standards. As costs associated with dry-docking inspections provide future economic benefits to the Company through continued operation of the vessels, the costs are deferred and amortized until the scheduled date of the next required dry-docking, which is usually over a two to five-year period. Amortization of deferred dry-docking costs are charged to operating expenses of the Ocean Transportation segment in the Consolidated Statements of Income and Comprehensive Income. Routine vessel maintenance and repairs are charged to expense as incurred. +​ +Goodwill and Intangible Assets: Goodwill and intangible assets arise as a result of acquisitions made by the Company (see Note 6). Intangible assets consist of customer relationships which are being amortized using the straight-line method over the expected useful lives ranging up to 21 years, and a trade name that has an indefinite life. +​ +Impairment of Long-Lived Assets, Intangible Assets and Goodwill : The Company evaluates its long-lived assets, intangible assets and goodwill for possible impairment in the fourth quarter, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value is less than its carrying amount. The Company has reporting units within the Ocean Transportation and Logistics reportable segments. +​ +Long-lived assets and finite-lived intangible assets are grouped at the lowest level reporting unit for which identifiable cash flows are available. In evaluating for impairment, the estimated future undiscounted cash flows generated by each of these asset groups are compared with the carrying value recorded for each asset group to determine if its carrying +46 +​ +Table of Contents +value is recoverable. If this review determines that the amount recorded will not be recovered, the amount recorded for the asset group is reduced to its estimated fair value. No impairment charges of long-lived assets and finite-lived intangible assets were recorded for the years ended December 31, 2019, 2018 and 2017. +​ +Indefinite-life intangible assets and goodwill are grouped at the lowest level reporting unit for which identifiable cash flows are available. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of earnings before interest, taxes, depreciation and amortization. Based upon the Company’s evaluation of its indefinite-life intangible assets and goodwill for impairment, the Company determined that the fair value of each reporting unit exceeds book value. No impairment charges of indefinite-life intangible assets and goodwill were recorded for the years ended December 31, 2019, 2018 and 2017. +​ +Other liabilities: Other liabilities consist of the following at December 31, 2019 and 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Other Liabilities (in millions) +2019 +2018 +Payroll and vacation +​ +$ +28.5 +$ +25.7 +​ +Employee incentives and other +​ +​ +14.7 +​ +​ +19.5 +​ +Uninsured risks and related liabilities - short term +​ +​ +12.6 +​ +​ +9.9 +​ +Multi-employer withdrawal liabilities - short term (see Note 12) +​ +​ +10.8 +​ +​ +10.8 +​ +Deferred revenues +​ +​ +6.9 +​ +​ +5.7 +​ +Interest on debt +​ +​ +4.9 +​ +​ +5.1 +​ +Pension and post-retirement liabilities - short term (see Note 11) +​ +​ +3.1 +​ +​ +3.0 +​ +Other short-term liabilities +​ +​ +4.5 +​ +​ +2.2 +​ +Total +​ +$ +86.0 +$ +81.9 +​ +​ +Other long-term liabilities: Other long-term liabilities consist of the following at December 31, 2019 and 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Other Long-Term Liabilities (in millions) +2019 +2018 +Pension and post-retirement liabilities (see Note 11) +​ +$ +73.4 +​ +$ +79.4 +​ +Multi-employer withdrawal liability (see Note 12) +​ +​ +54.8 +​ +​ +56.6 +​ +Uninsured risks and related liabilities +​ +​ +26.6 +​ +​ +27.3 +​ +Other long-term liabilities +​ +2.6 +​ +14.0 +​ +Total +​ +$ +157.4 +​ +$ +177.3 +​ +​ +Pension and Post-Retirement Plans: The Company is a member of the Pacific Maritime Association (“PMA”) and the Hawaii Stevedoring Industry Committee, which negotiate multi-employer pension plans covering certain shoreside bargaining unit personnel. The Company directly negotiates multi-employer pension plans covering other bargaining unit personnel. Pension costs are accrued in accordance with contribution rates established by the PMA, the parties to a plan or the trustees of a plan. Several trusteed, non-contributory, single-employer defined benefit plans and defined contribution plans cover substantially all other employees. +​ +The estimation of the Company’s pension and post-retirement benefit expenses and liabilities requires that the Company make various assumptions. These assumptions include factors such as discount rates, expected long-term rates of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates, and expected contributions. Actual results that differ from the assumptions made could materially affect the Company’s financial condition or its future operating results. Additional information about the Company’s pension and post-retirement plans is included in Note 11. +​ +Uninsured Risks and Related Liabilities: The Company is uninsured for certain risks but when feasible, many of these risks are mitigated by insurance. The Company purchases insurance with deductibles or self-insured retentions. Such insurance includes, but is not limited to, employee health, workers’ compensation, marine liability, cybersecurity, auto liability and physical damage to property and equipment. For certain risks, the Company elects to not purchase insurance because of the excessive cost of insurance or the perceived remoteness of the risk. In addition, the Company retains all risk of loss that exceeds the limits of the Company’s insurance policies. +​ +47 +​ +Table of Contents +When estimating its reserves for uninsured risks and related liabilities, the Company considers a number of factors, including historical claims experience, demographic factors, current trends, and analyses provided by independent third-parties. Periodically, management reviews its assumptions and estimates used to determine the adequacy of the Company’s reserves for uninsured risks and related liabilities. +​ +Recognition of Revenues and Expenses: Revenue in the Company’s Consolidated Financial Statements is presented net of elimination of intercompany transactions. The following is a description of the Company’s principal revenue generating activities by segment, and the Company’s revenue recognition policy for each activity for the periods presented: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31, +Ocean Transportation (in millions) (1) +​ +2019 +​ +2018 +​ +2017 +Ocean Transportation services +​ +​ +$ +1,625.8 +​ +$ +1,599.3 +​ +$ +1,531.8 +​ +Terminal and other related services +​ +​ +​ +24.8 +​ +​ +23.0 +​ +​ +23.5 +​ +Fuel sales +​ +​ +​ +10.1 +​ +​ +12.2 +​ +​ +9.9 +​ +Vessel management and related services +​ +​ +​ +5.9 +​ +​ +6.8 +​ +​ +6.6 +​ +Total +​ +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +$ +1,571.8 +​ +(1) Ocean Transportation revenue transactions are primarily denominated in U.S. dollars except for less than 3 percent of Ocean Transportation services revenue and fuel sales revenue categories which are denominated in foreign currencies. +​ +◾ Ocean Transportation services revenue is recognized ratably over the duration of a voyage based on the relative transit time completed in each reporting period. Vessel operating costs and other ocean transportation operating costs, such as terminal operating overhead and general and administrative expenses, are charged to operating costs as incurred. +◾ Terminal and other related services revenue is recognized as the services are performed. Related costs are recognized as incurred. +◾ Fuel sales revenue and related costs are recognized when the Company has completed delivery of the product to the customer in accordance with the terms and conditions of the contract. +◾ Vessel management and related services revenue is recognized in proportion to the services completed. Related costs are recognized as incurred. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31, +​ +Logistics (in millions) (1) +​ +​ +2019 +​ +2018 +​ +2017 +​ +Transportation Brokerage and Freight Forwarding services +​ +​ +$ +504.8 +​ +$ +549.1 +​ +$ +445.1 +​ +Warehouse and distribution services +​ +​ +​ +20.6 +​ +​ +19.1 +​ +​ +17.5 +​ +Supply chain management and other services +​ +​ +11.1 +​ +13.3 +​ +12.5 +​ +Total +​ +​ +$ +536.5 +​ +$ +581.5 +​ +$ +475.1 +​ +(1) Logistics revenue transactions are primarily denominated in U.S. dollars except for less than 3 percent of transportation brokerage and freight forwarding services revenue, and supply chain management and other services revenue categories which are denominated in foreign currencies. +​ +◾ Transportation Brokerage and Freight Forwarding services revenue consists of amounts billed to customers for services provided. The primary costs include third-party purchased transportation services, labor and equipment. Revenue and the related purchased third-party transportation costs are recognized over the duration of a delivery based upon the relative transit time completed in each reporting period. Labor and other operating costs are expensed as incurred. The Company reports revenue on a gross basis as the Company serves as the principal in these transactions because it is responsible for fulfilling the contractual arrangements with the customer and has latitude in establishing prices. +◾ Warehousing and distribution services revenue consist of amounts billed to customers for storage, handling, and value-added packaging of customer merchandise. Storage revenue is recognized in the month the service is provided to the customer. Storage related costs are recognized as incurred. Other warehousing and distribution services revenue and related costs are recognized in proportion to the services performed. +◾ Supply chain management and other services revenue, and related costs are recognized in proportion to the services performed. +​ +The Company generally invoices its customers at the commencement of the voyage or the transportation service being provided, or as other services are being performed. Revenue is deferred when services are invoiced in advance to the customer. The Company’s receivables are classified as short-term as collection terms are for periods of less than one +48 +​ +Table of Contents +year. The Company expenses sales commissions and contract acquisition costs as incurred because the amounts are generally immaterial. These expenses are included in selling, general and administration expenses in the Consolidated Statements of Income and Comprehensive Income. +​ +Customer Concentration: The Ocean Transportation segment serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2019, 2018 and 2017, the 10 largest Ocean Transportation customers accounted for approximately 23 percent, 24 percent and 23 percent of Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Ocean Transportation operating revenues. +​ +The Logistics segment serves customers in numerous industries and geographical locations. In 2019, 2018 and 2017, the 10 largest Logistics customers accounted for approximately 21 percent, 23 percent and 19 percent of Logistics revenue, respectively. None of these customers individually account for more than 10 percent of Logistics operating revenues. +​ +Dividends: The Company recognizes dividends as a liability when approved by the Board of Directors. +​ +Share-Based Compensation: The Company records compensation expense for all share-based awards made to employees and directors. The Company’s various stock-based compensation plans are more fully described in Note 15. +​ +Income Taxes: The estimate of the Company’s income tax expense requires the Company to make various estimates and judgments. These estimates and judgments are applied in the calculation of taxable income, tax credits, tax benefits and deductions, and in the calculation of certain deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue, costs and expenses for tax purposes. Deferred tax assets and liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. +​ +The Company records a valuation allowance if, based on the weight of available evidence, management believes that it is more likely than not that some portion or all of a recorded deferred tax asset would not be realized in future periods. The Company’s income taxes are more fully described in Note 10. +​ +Rounding: Amounts in the Consolidated Financial Statements and Notes to the Consolidated Financial Statements are rounded to millions, except for per share calculations and percentages which were determined based on amounts before rounding. Accordingly, a recalculation of some per-share amounts and percentages, if based on the reported data, may be slightly different. +​ +New Accounting Pronouncements : +​ +Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) : In June 2016, the FASB issued ASU 2016- 13 which amends the current approach to estimate credit losses on certain financial assets, including trade and other receivables, available-for-sale securities and other financial instruments. ASU 2016- 13 requires entities to establish a valuation allowance for the expected lifetime losses of certain financial instruments. Subsequent changes in the valuation allowance are recorded in current earnings and reversal of previous losses is permitted. The new standard is effective for interim and annual periods beginning on or after December 15, 2019, and early adoption is permitted. The Company is in the process of evaluating this new standard, but does not expect the adoption of ASU 2016-13 to have a significant impact on the Company’s Consolidated Financial Statements. +​ +​ +3. REPORTABLE SEGMENTS +​ +Reportable segments are components of an enterprise that engage in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. The Company’s chief operating decision maker is its Chief Executive Officer. +​ +The Company consists of two reportable segments, Ocean Transportation and Logistics, which are further described in Note 1. Reportable segments are measured based on operating income. In arrangements where the customer purchases ocean transportation and logistics services, the revenues are allocated to each reportable segment based upon the contractual amounts for each type of service. The Company’s SSAT segment has been aggregated into the Company’s +49 +​ +Table of Contents +Ocean Transportation segment due to the operations of SSAT being an integral part of the Company’s Ocean Transportation business (see Note 4). +​ +The Company’s Ocean Transportation segment provides ocean transportation services to the Logistics segment, and the Logistics segment provides logistics services to the Ocean Transportation segment in certain transactions. Accordingly, inter-segment revenue of $ 102.3 million, $ 95.4 million and $ 81.3 million for the years ended December 31, 2019, 2018 and 2017, respectively, have been eliminated from operating revenues in the table below. +​ +Reportable segment financial information for the years ended December 31, 2019, 2018 and 2017, and identifiable asset segment information at December 31, 2019 and 2018, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (1) +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +$ +1,571.8 +Logistics (2) +​ +536.5 +​ +581.5 +​ +475.1 +Total Operating Revenue +​ +$ +2,203.1 +​ +$ +2,222.8 +​ +$ +2,046.9 +Operating Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (3) +​ +$ +90.8 +​ +$ +131.1 +​ +$ +126.4 +Logistics +​ +38.3 +​ +32.7 +​ +20.9 +Total Operating Income +​ +129.1 +​ +163.8 +​ +147.3 +Interest expense, net +​ +( 22.5 ) +​ +( 18.7 ) +​ +( 24.2 ) +Other income (expense), net +​ +1.2 +​ +2.6 +​ +2.1 +Income before Income Taxes +​ +107.8 +​ +147.7 +​ +125.2 +Income taxes +​ +( 25.1 ) +​ +( 38.7 ) +​ +105.8 +Net Income +​ +$ +82.7 +​ +$ +109.0 +​ +$ +231.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capital Expenditures: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +294.5 +​ +$ +385.4 +​ +$ +305.3 +Logistics +​ +15.8 +​ +15.8 +​ +1.7 +Total Capital Expenditures +​ +$ +310.3 +​ +$ +401.2 +​ +$ +307.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and Amortization: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +93.6 +​ +$ +87.0 +​ +$ +93.3 +Logistics +​ +6.8 +​ +7.4 +​ +7.9 +​ +​ +​ +100.4 +​ +​ +94.4 +​ +​ +101.2 +Deferred dry-docking amortization - Ocean Transportation +​ +​ +34.3 +​ +​ +37.4 +​ +​ +46.2 +Total Depreciation and Amortization +​ +$ +134.7 +​ +$ +131.8 +​ +$ +147.4 +(1) Ocean Transportation operating revenue excludes inter-segment revenue of $ 52.8 million, $ 51.7 million and $ 40.3 million for the years ended December 31, 2019, 2018 and 2017, respectively. +(2) Logistics operating revenue excludes inter-segment revenue of $ 49.5 million, $ 43.7 million and $ 41.0 million for the years ended December 31, 2019, 2018 and 2017, respectively. +(3) Ocean Transportation segment information includes $ 20.8 million, $ 36.8 million, and $ 28.2 million of equity in income from the Company’s equity investment in SSAT for the years ended December 31, 2019, 2018 and 2017, respectively. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2019 +2018 +Identifiable Assets: +​ +​ +​ +​ +​ +​ +Ocean Transportation (1) +​ +$ +2,424.5 +​ +$ +2,071.6 +Logistics +​ +420.9 +​ +358.8 +Total Assets +​ +$ +2,845.4 +​ +$ +2,430.4 +(1) The Ocean Transportation segment includes $ 76.2 million and $ 87.0 million related to the Company’s equity investment in SSAT as of December 31, 2019 and 2018, respectively. +​ +​ +​ +50 +​ +Table of Contents +4. +INVESTMENT IN SSAT +​ +The Company accounts for its 35 percent ownership interest in SSAT using the equity method of accounting. The Company records its share of income from SSAT in costs and expenses within the Ocean Transportation segment due to operations of SSAT being an integral part of the Company’s Ocean Transportation business. The Company’s investment in SSAT was $ 76.2 million and $ 87.0 million at December 31, 2019 and 2018, respectively. +​ +The Company’s share of income recorded in the Consolidated Statements of Income and Comprehensive Income and dividends received by the Company during the years ended December 31, 2019, 2018 and 2017 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Company's share of net income +​ +$ +20.8 +​ +$ +36.8 +​ +$ +28.2 +​ +Distributions received +​ +$ +25.2 +​ +$ +42.0 +​ +$ +17.5 +​ +​ +SSAT adopted the new lease accounting standard ASC 842 during the year ended December 31, 2019. As part of the adoption, the Company recorded a net adjustment that reduced retained earnings by $ 5.6 million representing its portion of SSAT’s total impact of adopting the new lease accounting standard. +​ +The Company’s Ocean Transportation segment operating costs include $ 218.7 million, $ 213.4 million and $ 181.3 million for the years ended December 31, 2019, 2018 and 2017, respectively, for terminal services provided by SSAT. Accounts payable and accrued liabilities in the Consolidated Balance Sheets include $ 63.6 million and $ 59.2 million for terminal services payable to SSAT at December 31, 2019 and 2018, respectively. +​ +A summary of the condensed balance sheets of SSAT at December 31, 2019 and 2018 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +Condensed Balance Sheets (in millions) +2019 +2018 +Current assets +​ +$ +300.8 +​ +$ +310.4 +​ +Non-current assets (1) +​ +1,283.0 +​ +152.1 +​ +Total Assets +​ +$ +1,583.8 +​ +$ +462.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Current liabilities (1) +​ +$ +201.9 +​ +$ +71.0 +​ +Non-current liabilities (1) +​ +1,179.2 +​ +156.2 +​ +Equity +​ +202.7 +​ +235.3 +​ +Total Liabilities and Equity +​ +$ +1,583.8 +​ +$ +462.5 +​ +(1) Non-current assets, current liabilities and non-current liabilities include $ 1,117.0 million, $ 135.7 million and $ 1,033.1 million at December 31, 2019, respectively, related to operating lease right of use assets and operating lease liabilities recorded as a result of the adoption of the new lease accounting standard during the year ended December 31, 2019. +​ +A summary of the condensed statements of operating income and net income of SSAT for years ended December 31, 2019, 2018 and 2017 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +​ +Condensed Statements of Operating Income and Net Income (in millions) +2019 +2018 +2017 +Operating revenue +​ +$ +1,098.3 +​ +$ +1,074.2 +​ +$ +933.5 +​ +Operating costs and expenses +​ +1,035.3 +​ +963.7 +​ +850.2 +​ +Operating income +​ +63.0 +​ +110.5 +​ +83.3 +​ +Net Income (1) +​ +$ +57.2 +​ +$ +104.9 +​ +$ +80.9 +​ +(1) +Includes earnings from equity method investments held by SSAT less earnings allocated to non-controlling interests. +​ +​ +​ +51 +​ +Table of Contents +5. +PROPERTY AND EQUIPMENT +​ +Property and equipment at December 31, 2019 and 2018, and depreciation expense for the years ended December 31, 2019, 2018 and 2017 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, 2019 +​ +As of December 31, 2018 +​ +​ +​ +Accumulated +​ +​ +​ +Accumulated +​ +(In millions) +​ +Cost +​ +Depreciation +​ +Net Book Value +​ +Cost +​ +Depreciation +​ +Net Book Value +Vessels +​ +$ +1,653.5 +​ +$ +818.5 +​ +$ +835.0 +​ +​ +$ +1,489.2 +​ +$ +847.1 +​ +$ +642.1 +​ +Containers and equipment +​ +544.5 +​ +​ +378.8 +​ +165.7 +​ +​ +513.6 +​ +362.9 +​ +150.7 +​ +Terminal facilities and other property +​ +114.4 +​ +​ +41.3 +​ +73.1 +​ +​ +66.0 +​ +38.6 +​ +27.4 +​ +Vessel construction in progress +​ +​ +488.9 +​ +​ +— +​ +​ +488.9 +​ +​ +​ +487.2 +​ +​ +— +​ +​ +487.2 +​ +Other construction in progress +​ +35.4 +​ +​ +— +​ +35.4 +​ +​ +59.2 +​ +— +​ +59.2 +​ +Total +​ +$ +2,836.7 +​ +$ +1,238.6 +​ +$ +1,598.1 +​ +​ +$ +2,615.2 +​ +$ +1,248.6 +​ +$ +1,366.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Depreciation expense +​ +$ +86.3 +​ +$ +80.5 +​ +$ +86.7 +​ +​ +Property and equipment included assets subject to capital leases with a net book value of $ 0.1 million, net of accumulated depreciation of $ 0.7 million at December 31, 2018. There were no capital leases outstanding as of December 31, 2019. Depreciation of assets subject to capital leases recorded in the Consolidated Statement of Income and Comprehensive Income was $ 0.5 million and $ 1.5 million for the years ended December 31, 2018 and 2017, respectively. +​ +​ +6. +GOODWILL AND INTANGIBLE ASSETS +​ +Goodwill by segment as of December 31, 2019 and 2018 consists of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean +​ +​ +​ +​ +​ +​ +(In millions) +Transportation +Logistics +Total +Goodwill +​ +$ +222.6 +​ +$ +105.2 +​ +$ +327.8 +​ +Logistics goodwill of $ 105.2 million includes $ 78.6 million acquired as part of the acquisition of Span Intermediate, LLC (“Span Alaska”) in August 2016 that was allocated to the Span Alaska reporting unit, and $ 26.6 million relates to other Logistics acquisitions that were allocated to the Logistics reporting unit. +​ +Intangible assets by segment as of December 31, 2019 and 2018 consist of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, 2019 +​ +As of December 31, 2018 +​ +​ +Gross +​ +Accumulated +​ +​ +​ +​ +Gross +​ +Accumulated +​ +​ +​ +(In millions) +Amount +Amortization +Net Book Value +Amount +Amortization +Net Book Value +Ocean Transportation - Customer relationships +​ +$ +140.6 +​ +$ +31.2 +​ +$ +109.4 +​ +​ +$ +140.6 +​ +$ +24.4 +​ +$ +116.2 +​ +Logistics: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Customer relationships +​ +​ +90.1 +​ +​ +23.9 +​ +​ +66.2 +​ +​ +​ +90.1 +​ +​ +19.6 +​ +​ +70.5 +​ +Trade name +​ +27.3 +​ +​ +— +​ +​ +27.3 +​ +​ +27.3 +​ +​ +— +​ +​ +27.3 +​ +Total Logistics +​ +117.4 +​ +​ +23.9 +​ +​ +93.5 +​ +​ +117.4 +​ +​ +19.6 +​ +​ +97.8 +​ +Total +​ +$ +258.0 +​ +$ +55.1 +​ +$ +202.9 +​ +​ +$ +258.0 +​ +$ +44.0 +​ +$ +214.0 +​ +​ +Ocean Transportation intangible assets of $ 140.6 million relate to customer relationships acquired as part of the acquisition of Horizon Lines, Inc. (“Horizon”) on May 29, 2015, and are being amortized over 21 years. Logistics intangible assets include $ 79.3 million of customer relationships which are being amortized over 20 years, and $ 27.3 million of an indefinite life trade name, both acquired as part of the Span Alaska acquisition. The remaining Logistics customer relationships of $ 10.8 million are being amortized over a period of up to 13 years. +​ +52 +​ +Table of Contents +Intangible assets related amortization expense for 2019, 2018 and 2017, is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Amortization expense +​ +$ +11.1 +​ +$ +11.2 +​ +$ +11.4 +​ +​ +As of December 31, 2019, estimated amortization expense related to customer relationships intangible assets during the next five years and thereafter is as follows: +​ +​ +​ +​ +​ +​ +​ +Customer +​ +Year (in millions) +​ +Relationships +2020 +​ +$ +11.0 +​ +2021 +​ +10.9 +​ +2022 +​ +10.7 +​ +2023 +​ +10.7 +​ +2024 +​ +10.7 +​ +Thereafter +​ +121.6 +​ +Total +​ +$ +175.6 +​ +​ +​ +​ +7. +CAPITAL CONSTRUCTION FUND +​ +The Company is party to an agreement with the U.S. Department of Transportation, Maritime Administration (“MARAD”) that established a Capital Construction Fund (“CCF”) program under provisions of the Merchant Marine Act of 1936, as amended (the “Merchant Marine Act”). The CCF program was created to assist owners and operators of U.S. flag vessels in raising capital necessary for the modernization and expansion of the U.S. merchant marine fleet. CCF funds may be used for the acquisition, construction, or reconstruction of vessels, and for repayment of existing vessel indebtedness through the deferment of federal income taxes on certain deposits of monies and other property placed into the CCF. Qualified withdrawals from the CCF must be used for investment in vessels built in the U.S. and used between covered U.S. ports as described by the Merchant Marine Act, and for other qualifying expenditures (see Item 1 of Part 1 for additional information on Maritime Laws and the Jones Act). Participants of the CCF must also meet certain U.S. citizenship requirements. +​ +Deposits into the CCF are limited by certain applicable earnings and other conditions. Such deposits, once made, are available as tax deductions in the Company’s income tax provision. Qualified withdrawals from the CCF do not give rise to a current income tax liability, but reduce the depreciable basis of the vessels or certain related equipment for income tax purposes. However, if withdrawals are made from the CCF for general corporate purposes or other non-qualified purposes, or upon termination of the agreement, they are taxable with interest payable from the year of deposit. +​ +Deposits not committed for qualified purposes within 25 years from the date of deposit will be treated as non-qualified withdrawals over the subsequent five years . Under the terms of the CCF agreement, the Company may designate certain qualified earnings as “accrued deposits” or may designate, as obligations of the CCF, qualified withdrawals to reimburse qualified expenditures initially made with operating funds. Such accrued deposits to, and withdrawals from, the CCF are reflected in the Consolidated Balance Sheets either as obligations of the Company’s current assets or as receivables from the CCF. +​ +As of December 31, 2019 and 2018, $ 1.7 million and $ 1.0 million, respectively, of eligible accounts receivable were assigned to the CCF. Due to the nature of the assignment of eligible accounts receivable into the CCF, such assigned amounts are classified as part of accounts receivable in the Consolidated Balance Sheets. At December 31, 2019 and 2018, the amounts on deposit in the CCF invested in a money market fund, which is classified as other long-term assets in the Company’s Consolidated Balance Sheets, were nominal. +​ +53 +​ +Table of Contents +8. +DEBT +​ +At December 31, 2019 and 2018, the Company’s debt consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +(In millions) +2019 +2018 +Private Placement Term Loans: +​ +​ +​ +​ +​ +​ +​ +5.79 %, payable through 2020 +​ +$ +3.5 +​ +$ +10.5 +​ +3.66 %, payable through 2023 +​ +31.9 +​ +41.0 +​ +4.16 %, payable through 2027 +​ +39.3 +​ +44.5 +​ +3.37 %, payable through 2027 +​ +​ +75.0 +​ +​ +75.0 +​ +3.14 %, payable through 2031 +​ +​ +188.0 +​ +​ +200.0 +​ +4.31 %, payable through 2032 +​ +30.3 +​ +32.7 +​ +4.35 %, payable through 2044 +​ +​ +100.0 +​ +​ +100.0 +​ +3.92 %, payable through 2045 +​ +​ +69.5 +​ +​ +71.4 +​ +Title XI Debt: +​ +​ +​ +​ +​ +​ +​ +5.34 %, payable through 2028 +​ +19.8 +​ +22.0 +​ +5.27 %, payable through 2029 +​ +22.0 +​ +24.2 +​ +Revolving credit facility, maturity date of June 29, 2022 +​ +379.1 +​ +235.0 +​ +Capital leases +​ +— +​ +0.1 +​ +Total Debt +​ +958.4 +​ +856.4 +​ +Less: Current portion +​ +( 48.4 ) +​ +( 42.1 ) +​ +Total Long-term Debt +​ +$ +910.0 +​ +$ +814.3 +​ +​ +The following is a description of the Company’s debt: +​ +Private Placement Term Loans : The 5.79 percent notes payable through 2020 are amortized by semi-annual principal payments of $ 3.5 million plus interest. +​ +During the second quarter of 2012, the Company issued $ 170.0 million of unsecured notes, which funded in three tranches, $ 77.5 million at an interest rate of 3.66 percent, $ 55.0 million at an interest rate of 4.16 percent, and $ 37.5 million at an interest rate of 4.31 percent (the “2012 Notes”). Principal and interest are payable semi-annually. The 2012 Notes began to amortize in 2015 with aggregate semi-annual payments of $ 4.6 million which continued through 2016, followed by $ 8.4 million in 2017 through mid-year 2023, $ 3.8 million through mid-year 2027, and $ 1.2 million thereafter. +​ +In January 2014, the Company issued $ 100.0 million of 30 -year senior unsecured notes at an interest rate of 4.35 percent, payable semi-annually (the “2014 Notes”). The 2014 Notes will begin to amortize in 2021, with annual principal payments of $ 5.0 million in 2021, $ 7.5 million in 2022 and 2023, $ 10.0 million from 2024 to 2027, and $ 8.0 million in 2028. Starting in 2029, and in each year thereafter until 2044, annual principal payments will be $ 2.0 million. +​ +In July 2015, the Company issued $ 75.0 million of 30 -year senior unsecured notes at an interest rate of 3.92 percent, payable semi-annually (the “2015 Notes”). The 2015 Notes began to amortize in 2017, with annual principal payments of approximately $ 1.8 million through 2019. During the years 2020 to 2026, the annual principal payments will range between approximately $ 1.3 million and $ 8.0 million. Starting in 2027, and in each year thereafter, the annual principal payments will be approximately $ 1.5 million. +​ +In September 2016, the Company issued $ 200.0 million of 15 -year senior unsecured notes (the “Series D Notes”) at an interest rate of 3.14 percent, payable semi-annually. The Series D Notes began to amortize in 2019, with semi-annual principal payments of $ 6.0 million. During the years 2020 through 2023, semi-annual principal payments will be $ 9.2 million. Starting in 2024, and in each year thereafter through maturity in 2031, the semi-annual principal payments will be $ 7.15 million. +​ +In December 2016, the Company issued $ 75 million of 11 -year senior unsecured notes at an interest rate of 3.37 percent, payable semi-annually (the "Series A Notes"). The Series A Notes will begin to amortize in 2021, with principal payments of $ 5.8 million in 2021 and $ 11.5 million per year, paid semi-annually, from 2022 through 2027. +54 +​ +Table of Contents +​ +Title XI Debt: In September 2003, MatNav issued $ 55.0 million in U.S. Government guaranteed vessel finance bonds (Title XI) to finance the delivery of Manukai . The secured bonds have a final maturity in September 2028 with a coupon rate of 5.34 percent. The bonds are amortized by semi-annual payments of $ 1.1 million plus interest. In August 2004, MatNav issued $ 55.0 million of U.S. Government guaranteed vessel finance bonds (Title XI) to finance the delivery of Maunawili . The secured bonds have a final maturity in July 2029 with a coupon rate of 5.27 percent. The bonds are amortized by semi-annual payments of $ 1.1 million plus interest. +​ +Revolving Credit Facility: On June 29, 2017 (the “Closing Date”), the Company entered into an amended and restated credit agreement that provides the Company with additional sources of liquidity for working capital, capital expenditures and investment opportunities, and amends and restates the Company’s previously amended and restated credit agreement (the “Credit Agreement” or the “revolving credit facility”). The Credit Agreement expires on June 29, 2022, and provides for committed aggregate borrowing of up to $ 650 million, with an uncommitted option to increase the aggregate borrowing by up to $ 250 million. The aggregate borrowing within the Credit Agreement includes a $ 100 million sublimit for the issuance of standby and commercial letters of credit, and a $ 50 million sublimit for swing line loans. The Company may prepay any amounts outstanding under the Credit Agreement without premium or penalty. All obligations of the Company under the Credit Agreement are guaranteed by Matson’s principal operating subsidiary MatNav and by certain other subsidiaries. +​ +Depending on the Company’s consolidated net leverage ratio, borrowings under the Credit Agreement bear interest at either LIBOR plus a margin of between 1.00 percent and 1.75 percent or the base rate plus a margin of between zero percent and 0.75 percent. Letters of credit are subject to fees based on the Company’s consolidated net leverage ratio at a rate of between 1.00 percent and 1.75 percent. The Company also pays a commitment fee of between 0.15 percent and 0.30 percent depending on the Company’s consolidated net leverage ratio. +​ +As of December 31, 2019, the Company had $ 75.1 million of remaining availability under the Credit Agreement. The Company used $ 7.7 million of the sublimit for letters of credit outstanding as of December 31, 2019. Based on the Company’s consolidated net leverage ratio, which stipulates borrowing margins, the interest rate applicable to revolving credit facility usage was approximately 3.33 percent at December 31, 2019. +​ +Amendments to Existing Private Placement Term Loan Facilities and New Shelf Facilities (“Private Loan Facilities”): On June 29, 2017, the Company and the holders of the Company’s term loans entered into amendments (collectively, the “2017 Amendments”) to each of the term loan agreements and amendments thereto, previously issued prior to the Closing Date. The 2017 Amendments provide for amendments to certain covenants and other terms, including (at the Company’s option under certain circumstances) adjustments to the required consolidated leverage ratio, and, in connection with the exercise of such option, the payment of additional interest for certain pre-defined periods. Interest rates and other substantive terms remained unchanged. +​ +Interest Rates: The Company incurs interest on debt based upon the levels of outstanding borrowings throughout the year and the related interest rates as described above. Interest rates on the private placement term loans increase when the Company elects for Special Relief Periods to the maximum consolidated leverage ratio as defined within the 2017 Amendments. +​ +Debt Covenants in the Private Placement Term Loans and the Revolving Credit Facility : The Credit Agreement and Private Loan Facilities (collectively, the “Private Debt Agreements”) contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, limitations on certain other indebtedness, loans and investments, liens, mergers, asset sales, and transactions with affiliates as defined within the Private Debt Agreements. The Private Debt Agreements also contain customary events of default, including cross defaults to other material indebtedness, including the Title XI Debt (as defined below). A brief description of the principal covenants contained in the Private Debt Agreements includes, but is not limited to the following (as defined within the Agreements): +​ +◾ Minimum Consolidated Interest Coverage Ratio as of the end of any fiscal quarter is not permitted to be less than 3.50 to 1.0; +◾ Maximum Consolidated Leverage Ratio as of the end of any fiscal quarter is not permitted to exceed 3.25 to 1.0, subject to the Company’s election of Special Relief Periods in which the Maximum Consolidated Leverage Ratio is +55 +​ +Table of Contents +not permitted to exceed 3.75 to 1.0 as described in the Private Debt Agreements; +◾ The principal amount of Priority Debt: (i) is not permitted to exceed 20 percent of Consolidated Tangible Assets at any time (subject to a reduction to 17.5 percent upon the earlier of December 31, 2017, or upon the occurrence of certain events), and; (ii) the principal amount of Priority Debt that is not Title XI Priority Debt at any time is not permitted to exceed 10 percent of Consolidated Tangible Assets. +​ +Principal covenants generally will restrict the incurrence of liens except for permitted liens, which include, without limitation, liens securing Title XI Debt up to certain thresholds, as defined within the Private Debt Agreements. The Company was in compliance with these covenants as of December 31, 2019. +​ +Debt Covenants in the Title XI Debt Agreements: The Title XI debt agreements contain customary representations and warranties as well as affirmative and negative covenants, defaults and other provisions typical for MARAD-guaranteed financings of this type, with definitions and limitations as defined within the Title XI debt agreements. These covenants include, among other things, minimum working capital and net worth requirements, limitations on certain other indebtedness, loans and investments, liens, mergers, asset sales, sale and leaseback transactions, and transactions with affiliates as defined within the Title XI debt agreements. Certain of the covenants in the Title XI debt agreements are applicable only upon and during the continuance of either (i) an event of default or (ii) the failure of MatNav to meet certain financial requirements. +​ +Capital Leases: The Company’s capital lease obligations represent leasing of containers and other equipment, and have been classified as current and long-term debt in the Company’s Consolidated Balance Sheets. As of December 31, 2019, there were no capital lease obligations. +​ +Debt Security and Guarantees: All of the debt of the Company and MatNav, including related guarantees, as of December 31, 2019 was unsecured, except for the Title XI Debt. +​ +Debt Maturities: At December 31, 2019, debt maturities during the next five years and thereafter are as follows: +​ +​ +​ +​ +​ +​ +Year (in millions) +Total +2020 +​ +$ +48.4 +​ +2021 +​ +54.2 +​ +2022 +​ +439.0 +​ +2023 +​ +59.9 +​ +2024 +​ +55.8 +​ +Thereafter +​ +301.1 +​ +Total debt +​ +$ +958.4 +​ +​ +​ +​ +9. +LEASES +​ +New Lease Accounting Standard: The Company adopted the new lease accounting standard ASC 842 on January 1, 2019, and made the following elections: +​ +◾ Applied the transition requirements that resulted in a cumulative-effect adjustment of $ 4.4 million recorded to retained earnings at January 1, 2019, due to the elimination of deferred gains from the Company’s sale and leaseback transactions recorded in the Consolidated Balance Sheet as of December 31, 2018; +◾ Elected to apply the package of practical expedient permitted under the transition guidance which allows, among other things, the historical lease classification and initial direct costs to be carried forward; +◾ Elected the short-term lease exception which allows the Company to exclude leases with an initial term of one year or less from recognition on the Consolidated Balance Sheets; +◾ Elected to separate non-lease components by underlying asset class for real estate and terminal leases and operations equipment leases; and +◾ Elected to use a portfolio approach in applying discount rates to leases based upon the lease terms in the following categories: (i) one to five years; (ii) six to ten years; (iii) eleven to fifteen years; and (iv) sixteen years and greater, regardless of the type of underlying asset class. +​ +56 +​ +Table of Contents +Upon adoption of ASC 842, the Company recorded a right-of-use asset of $ 251.4 million and a corresponding operating lease liability of $ 259.1 million at January 1, 2019. As part of the adoption, the Company recorded a net adjustment to retained earnings of $ 4.4 million at January 1, 2019. The adoption of ASC 842 did not have a significant impact on the Company’s current earnings, liquidity or existing debt covenant requirements. Significant assumptions and judgments made in applying the new lease accounting standard include determining the Company’s incremental borrowing rate and evaluating the probability of exercising lease options. +​ +Description of Operating Leases: The Company has different types of operating leases, the specific terms and conditions of which vary from lease to lease. Certain operating lease agreements include terms such as: (i) renewal and early termination options; (ii) early buy-out and purchase options; and (iii) rent escalation clauses. The lease agreements also include provisions for the maintenance of the leased asset and payment of lease related costs. The Company reviews the specific terms and conditions of each lease and, as appropriate, notifies the lessor of any intent to exercise any option in accordance with the terms of the lease. In the normal course of business, the Company expects to be able to renew or replace most of its operating leases with other similar leases as they expire. Except for the residual value guarantee described below, the Company’s leases do not contain any other residual value guarantees. +​ +The Company’s sub-lease income was nominal to the Company’s Consolidated Statements of Income and Comprehensive Income for the year ended December 31, 2019. The Company did not have any finance leases during the year ended December 31, 2019. Certain of the Company’s lease agreements include rental payments that may be adjusted in the future based on economic conditions and others include rental payments adjusted periodically for inflation. Variable lease expense is disclosed for the adjusted portion of such payments. +​ +The lease type by underlying asset class and maximum terms of the Company’s operating leases are as follows: +​ +​ +​ +​ +Lease Type: +Life +Real estate and terminal leases +65 years +Vessel charter leases +10 years +Operations equipment and other leases +8 years +​ +Incremental Borrowing Rate: As most of the Company’s operating leases do not provide an implicit rate, the Company uses an estimated incremental borrowing rate based on information available at the date of adoption and subsequent lease commencement dates in calculating the present value of its operating lease liabilities. The incremental borrowing rate is determined using the U.S. Treasury rate adjusted to account for the Company’s credit rating and the collateralized nature of operating leases. +​ +Components of Lease Cost: Components of lease cost recorded in the Company’s Consolidated Statement of Income and Comprehensive Income for the year ended December 31, 2019 consisted of the following: +​ +​ +​ +​ +​ +​ +Year Ended +​ +December 31, +(In millions) +​ +2019 +Operating lease cost +​ +$ +71.4 +Short-term lease cost +​ +5.9 +Variable lease cost +​ +0.4 +Total lease cost +​ +$ +77.7 +​ +Other Lease Information: Other information related to the Company’s operating leases for the year ended December 31, 2019 is as follows: +​ +​ +​ +​ +​ +​ +Year Ended +​ +December 31, +(In millions) +​ +2019 +Cash paid for amounts included in operating lease liabilities +​ +$ +71.3 +Right of use assets obtained in the exchange for new operating lease liabilities +​ +$ +65.3 +​ +​ +​ +​ +​ +​ +As of +​ +December 31, 2019 +Weighted-average remaining operating lease term +​ +​ +7.5 years +Weighted-average incremental borrowing rate +​ +​ +4.2 % +​ +57 +​ +Table of Contents +Maturities of operating lease liabilities at December 31, 2019 are as follows: +​ +​ +​ +​ +​ +​ +As of +Year (in millions) +December 31, 2019 +2020 +​ +$ +75.9 +2021 +​ +55.1 +2022 +​ +43.6 +2023 +​ +38.0 +2024 +​ +23.0 +Thereafter +​ +78.7 +Total lease payments +​ +​ +314.3 +Less: Interest +​ +​ +( 49.7 ) +Present value of operating lease liabilities +​ +​ +264.6 +Less: Short-term portion +​ +​ +( 66.6 ) +Long-term operating lease liabilities +​ +$ +198.0 +​ +Future minimum payments under operating lease agreements at December 31, 2018 are as follows: +​ +​ +​ +​ +​ +Year (in millions) +​ +Total +2019 +​ +$ +68.3 +2020 +​ +59.2 +2021 +​ +44.8 +2022 +​ +34.7 +2023 +​ +30.5 +Thereafter +​ +83.6 +Total minimum lease payments +​ +$ +321.1 +​ +Vessel Charter and Buyer-Lessor Guaranty +​ +Vessel Charter: On November 26, 2018, a wholly-owned subsidiary of the Company entered into agreements whereby a vessel, Maunalei , owned by the subsidiary, was sold for $ 106.0 million and subsequently leased back from the buyer-lessor under a Bareboat Charter Agreement (the “Charter”). The transaction qualified for sale and leaseback treatment under ASC 840, Leases , with the Charter treated as an operating lease for accounting purposes. Lease payments are approximately $ 3.0 million per quarter, and the base term of the Charter is five years with a two year end-of-term renewal option . Total future minimum lease payments were $ 47.9 million at December 31, 2019, and are included in the maturities of operating lease liabilities table at December 31, 2019. +​ +Prior to the expiration of the base term of the Charter, the subsidiary may, at its option, elect to: (i) purchase the vessel at the option price; (ii) exercise the option to renew the Charter for an additional two years; or (iii) remarket the vessel to sell to a third-party on behalf of the buyer-lessor. The purchase option price is $ 68.9 million after the base term and $ 58.3 million after the extended term. The Charter also includes a maximum residual value guarantee amount of $ 50.9 million after five years, or $ 47.7 million after the extended term. Proceeds from the sale of the vessel reduces the subsidiary’s residual value guarantee. +​ +Buyer-Lessor Guaranty: Matson, Inc. provided the buyer-lessor with a guaranty of all obligations of the wholly-owned subsidiary related to the Charter as defined in the guaranty agreement. +​ +​ +10. +INCOME TAXES +​ +Income Taxes: On December 22, 2017, the Tax Act was signed into law and included numerous changes to existing tax law, including a reduction in the federal corporate income tax rate from 35 percent to 21 percent. The rate reduction and other changes took effect on January 1, 2018. Other changes such as remeasurement of deferred tax assets and liabilities were effective as of the fourth quarter of 2017. +​ +In connection with the Company’s analysis of the impact of the Tax Act, the Company recorded a net tax benefit of $ 154.0 million related to the remeasurement and other discrete adjustments to the Company’s deferred tax assets and liabilities during the year ended December 31, 2017. In addition, the Company recorded a non-cash tax adjustment of +58 +​ +Table of Contents +$ 2.9 million that increased current income taxes during the year ended December 31, 2018. This adjustment related to the application of an estimated 6.2 percent sequestration on alternative minimum tax (AMT) refunds for the years 2018 to 2021. On January 19, 2019, the Internal Revenue Service issued new guidance indicating that sequestration would not apply to refundable AMT credits. In accordance with this new guidance, the Company recorded a non-cash tax adjustment of $ 2.9 million that reduced current income taxes during the year ended December 31, 2019. +​ +Income taxes for the years ended December 31, 2019, 2018 and 2017 consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Current: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Federal +​ +$ +0.2 +​ +$ +1.5 +​ +$ +21.1 +​ +State +​ +3.2 +​ +2.1 +​ +2.2 +​ +Foreign +​ +​ +1.3 +​ +​ +0.9 +​ +​ +0.5 +​ +Discrete adjustments related to the Tax Act (1) +​ +​ +( 2.9 ) +​ +​ +2.9 +​ +​ +— +​ +Total +​ +1.8 +​ +7.4 +​ +23.8 +​ +Deferred: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax expense +​ +​ +23.3 +​ +​ +31.3 +​ +​ +24.4 +​ +Remeasurement and discrete adjustments related to the Tax Act (2) +​ +​ +— +​ +​ +— +​ +​ +( 154.0 ) +​ +Total +​ +23.3 +​ +31.3 +​ +( 129.6 ) +​ +Total income taxes +​ +$ +25.1 +​ +$ +38.7 +​ +$ +( 105.8 ) +​ +(1) Current income taxes for the years ended December 31, 2019 and 2018 include a non-cash income tax benefit of $ 2.9 million and a non-cash income tax expense of $ 2.9 million, respectively, which relates to discrete adjustments as a result of applying the provisions of the Tax Act. +(2) Deferred income taxes for the year ended December 31, 2017 includes a non-cash income tax benefit of $ 154.0 million, which relates to the remeasurement of the Company’s deferred tax assets and liabilities and other discrete adjustments as a result of applying the provisions of the Tax Act. +​ +Income taxes for the years ended December 31, 2019, 2018 and 2017 differ from amounts computed by applying the statutory federal rate to income before income taxes for the following reasons: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +​ +2019 +2018 +2017 +Computed federal income tax expense +21.0 +% +21.0 +% +35.0 +% +State income tax +4.1 +% +3.4 +% +2.6 +% +Valuation allowance +( 0.3 ) +% +( 0.7 ) +% +1.4 +% +Foreign taxes +1.2 +% +0.6 +% +0.1 +% +Remeasurement and discrete adjustments related to the Tax Act (1) +( 2.7 ) +% +2.0 +% +( 123.0 ) +% +Share-based payments +( 0.1 ) +% +0.1 +% +( 1.4 ) +% +Other — net +0.1 +% +( 0.2 ) +% +0.8 +% +Effective income tax rate +23.3 +% +26.2 +% +( 84.5 ) +% +(1) Effective income tax rate for the years ended December 31, 2019, 2018 and 2017 includes the impact of a non-cash income tax benefit of $ 2.9 million, or 2.7 percent, a non-cash income tax expense of $ 2.9 million, or 2.0 percent, and a non-cash income tax benefit of $ 154.0 million, or 123.0 percent, respectively, related to the remeasurement of the Company’s deferred assets and liabilities and other discrete adjustments as a result of applying the provisions of the Tax Act. +​ +59 +​ +Table of Contents +The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2019 and 2018, were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2019 +2018 +Deferred tax assets: +​ +​ +​ +​ +​ +​ +​ +Operating lease liabilities +​ +$ +63.1 +​ +$ +— +​ +Pension and post-retirement plans +​ +​ +19.2 +​ +​ +20.2 +​ +Multi-employer withdrawal liabilities +​ +​ +16.1 +​ +​ +16.6 +​ +Federal net operating losses +​ +​ +14.3 +​ +​ +15.2 +​ +State net operating losses +​ +​ +7.3 +​ +​ +7.4 +​ +U.S. State alternative minimum tax credits +​ +6.7 +​ +5.9 +​ +Insurance reserves +​ +5.9 +​ +5.6 +​ +Deferred compensation +​ +5.8 +​ +​ +7.0 +​ +Foreign losses +​ +3.9 +​ +5.1 +​ +Other +​ +2.0 +​ +4.7 +​ +Total deferred tax assets +​ +144.3 +​ +87.7 +​ +Valuation allowance +​ +​ +( 10.6 ) +​ +​ +( 11.5 ) +​ +Total deferred tax assets, net of valuation allowance +​ +​ +133.7 +​ +​ +76.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax liabilities: +​ +​ +​ +​ +​ +​ +​ +Basis differences for property and equipment +​ +319.2 +​ +302.1 +​ +Operating lease right of use assets +​ +61.1 +​ +— +​ +Intangibles +​ +​ +39.7 +​ +​ +38.4 +​ +Lease financing +​ +​ +23.7 +​ +​ +26.0 +​ +Capital Construction Fund +​ +12.5 +​ +​ +7.0 +​ +Investment in SSAT +​ +7.4 +​ +11.4 +​ +Other +​ +​ +7.7 +​ +​ +4.0 +​ +Total deferred tax liabilities +​ +471.3 +​ +388.9 +​ +Deferred tax liability, net +​ +$ +337.6 +​ +$ +312.7 +​ +​ +Valuation Allowance: Valuation allowances recorded against the Company’s foreign income tax net operating losses (“NOLs”) and a portion of the state income tax NOLs were $ 10.6 million and $ 11.5 million as of December 31, 2019 and 2018, respectively. The Company believes that it is more likely than not that the benefit from these amounts will not be realized. The Company recorded a decrease (increase) to its valuation allowance of $ 0.9 million, ($ 1.1 ) million and $ 1.7 million during the years ended December 31, 2019, 2018 and 2017, respectively. +​ +Net Operating Losses and Tax Credit Carryforwards: The Company’s NOLs and tax credit carryforwards at December 31, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +​ +Expiration Date +2019 +2018 +U.S. Federal income tax NOLs +​ +Various dates beginning in 2027 +​ +$ +71.2 +​ +$ +74.5 +U.S. State income tax NOLs (1) +​ +Various dates beginning in 2032 +​ +$ +184.5 +​ +$ +189.2 +U.S. State alternative minimum tax credit +​ +No expiration date +​ +$ +6.7 +​ +$ +5.9 +Foreign income tax NOLs (2) +​ +No expiration date +​ +$ +14.0 +​ +$ +18.4 +(1) The Company does not expect to benefit from $ 157.9 million and $ 152.0 million of U.S. State income tax NOLs as of December 31, 2019 and 2018, respectively. +(2) The Company has recorded a valuation allowance of $ 14.0 million and $ 18.4 million against the foreign income tax NOLs as of December 31, 2019 and 2018, respectively. +​ +The U.S. federal and state income tax NOLs in the Company’s filed income tax returns include unrecognized tax benefits. The deferred tax assets recognized for those NOLs are presented net of these unrecognized tax benefits. As a result of changes in tax legislation, the use of a portion of the Company’s domestic NOL and tax credit carryforwards may be limited in future periods. Further, a portion of the federal and state income tax NOLs and tax credit carryforwards may expire before being applied to reduce future income tax liabilities. +60 +​ +Table of Contents +​ +Unrecognized Tax Benefits: Total unrecognized benefits represent the amount that, if recognized, would favorably affect the Company’s incomes taxes and effective tax rate in future periods. The Company does not expect a material change in gross unrecognized benefits in the next twelve months. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows: +​ +​ +​ +​ +​ +​ +Unrecognized Tax Benefits (in millions) +Amount +Balance at December 31, 2016 +​ +$ +20.4 +​ +Changes in tax positions of prior years, net +​ +1.1 +​ +Reductions for lapse of statute of limitations +​ +​ +( 0.1 ) +​ +Revaluation of unrecognized tax benefits due to the Tax Act (1) +​ +​ +( 5.5 ) +​ +Balance at December 31, 2017 +​ +15.9 +​ +Changes in tax positions of prior years, net +​ +( 0.3 ) +​ +Reductions for lapse of statute of limitations +​ +​ +( 0.5 ) +​ +Balance at December 31, 2018 +​ +15.1 +​ +Changes in tax positions of prior years, net +​ +2.1 +​ +Reductions for lapse of statute of limitations +​ +​ +( 0.8 ) +​ +Balance at December 31, 2019 +​ +$ +16.4 +​ +(1) Amount relates to the impact of applying the Tax Act during the year ended December 31, 2017. +​ +Included in the balance of unrecognized tax benefits at December 31, 2019 are potential benefits of $ 13.5 million that, if recognized, would affect the Company’s income taxes and effective tax rate. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income taxes. To the extent interest and penalties are not ultimately assessed with respect to the settlement of uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the Company’s income taxes. Interest accrued related to the balance of unrecognized tax benefits totaled $ 0.1 million and $ 0.4 million as of December 31, 2019 and 2018, respectively. +​ +The Company is no longer subject to U.S. federal income tax audits for years before 2014. The Company is routinely involved in state, local income and excise tax audits, and foreign tax audits. +​ +​ +11. +PENSION AND POST-RETIREMENT PLANS +​ +Non-bargaining Plans: +​ +The Company has two funded qualified single-employer defined benefit pension plans that cover certain non- bargaining unit employees and bargaining unit employees. In addition, the Company has plans that provide certain retiree health care and life insurance benefits to substantially all salaried, non-bargaining employees hired before 2008 and to certain bargaining unit employees. Employees are generally eligible for such benefits upon retirement and completion of a specified number of years of service. The Company does not pre-fund these health care and life insurance benefits, and has the right to modify or terminate certain of these plans in the future. Most non-bargaining retirees pay a portion of the benefit costs. +​ +Plan Administration, Investments and Asset Allocations: The Company has a Benefits Investment Committee that meets regularly with investment advisors to establish investment policies, direct investments and select investment options for the qualified plans. The Benefits Investment Committee is also responsible for appointing investment managers and monitoring their performance. The Company’s investment policy permits investments in marketable equity securities, such as domestic and foreign stocks, domestic and foreign bonds, venture capital, real estate investments, and cash equivalents. The Company’s investment policy does not permit direct investment in certain types of assets, such as options or commodities, or the use of certain strategies, such as short selling or the purchase of securities on margin. +​ +The Company’s investment strategy for its qualified pension plan assets is to achieve a diversified mix of investments that provides for long-term growth at an acceptable level of risk, and to provide sufficient liquidity to fund ongoing benefit payments. The Company has engaged a number of investment managers to implement various investment strategies to achieve the desired asset class mix, liquidity and risk diversification objectives. +61 +​ +Table of Contents +​ +The Company’s target and actual asset allocations at December 31, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Asset Categories +Target +2019 +2018 +Domestic equity securities +53 +% +59 +% +57 +% +International equity securities +15 +% +17 +% +16 +% +Debt securities +22 +% +17 +% +19 +% +Real estate +5 +% +6 +% +7 +% +Other and cash +5 +% +1 +% +1 +% +Total +100 +% +100 +% +100 +% +​ +The Company’s investments in equity securities primarily include domestic large-cap and mid-cap companies, but also includes an allocation to small-cap and international equity securities. Equity investments do not include any direct holdings of the Company’s stock but may include such holdings to the extent that the stock is included as part of certain mutual fund holdings. Debt securities include investment-grade and high-yield corporate bonds from diversified industries, mortgage-backed securities, and U.S. Treasuries. Other types of investments include funds that invest in commercial real estate assets, and to a lesser extent, private equity investments in technology companies. All assets within specific funds are allocated to the target asset allocation of the fund. +​ +The expected return on plan assets is principally based on the Company’s historical returns combined with the Company’s long-term future expectations regarding asset class returns, the mix of plan assets, and inflation assumptions. Actual return on plan assets for the periods presented are as follows: +​ +​ +​ +​ +​ +Actual Return on Plan Assets +Returns +One-year return +22.5 +% +Three-year return +9.5 +% +Five-year return +6.9 +% +Long-term average return (since plan inception in 1989) +8.4 +% +​ +The Company’s pension plan assets are held in a master trust and are stated at estimated fair values of the underlying investments. Purchases and sales of securities are recorded on a trade-date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date. +​ +Equity Securities: Domestic and international common stocks are valued by obtaining quoted prices on recognized and highly liquid exchanges. +​ +Fixed Income Securities: Corporate bonds and U.S. government treasury and agency securities are valued based upon the closing price reported in the market in which the security is traded. U.S. government agency and corporate asset-backed securities may utilize models, such as a matrix pricing model, that incorporate other observable inputs when broker/dealer quotes are not available, such as cash flow, security structure, or market information. +​ +Real Estate and Private Equity Funds: The fair value of real estate and private equity funds are determined by the issuer based on their net asset value (“NAV”). NAV is determined by dividing the fund’s net assets, as recorded in the fund’s audited financial statements, by the number of units outstanding at the valuation date. Fair value for underlying investments in real estate is determined through independent property appraisals. Fair value of underlying investments in private equity funds is determined based on information provided by the general partner taking into consideration the purchase price of the underlying securities, developments concerning the investee company subsequent to the acquisition of the investment, financial data and projections of the investee company provided by the general partner, and such other factors as the general partner deems relevant. +​ +62 +​ +Table of Contents +The fair values of the Company’s pension plan assets at December 31, 2019 and 2018 by asset category, were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair Value Measurements at December 31, 2019 +​ +​ +​ +Quoted Prices in +Significant +Significant +​ +​ +​ +​ +​ +Active Markets +​ +Observable +​ +Unobservable +Asset Category (in millions) +​ +Total +​ +(Level 1) +​ +Inputs (Level 2) +​ +Inputs (Level 3) +Cash +​ +$ +6.3 +​ +$ +6.3 +​ +$ +— +​ +$ +— +​ +Equity securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large-cap +​ +62.4 +​ +23.7 +​ +38.7 +​ +— +​ +U.S. mid- and small-cap +​ +49.6 +​ +33.9 +​ +15.7 +​ +— +​ +International large-cap +​ +6.6 +​ +— +​ +6.6 +​ +— +​ +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. Treasuries +​ +14.1 +​ +— +​ +14.1 +​ +— +​ +Investment grade U.S. corporate bonds +​ +​ +18.2 +​ +— +​ +18.2 +​ +— +​ +High-yield U.S. corporate bonds +​ +0.1 +​ +— +​ +0.1 +​ +— +​ +Total +​ +​ +157.3 +​ +$ +63.9 +​ +$ +93.4 +​ +$ +— +​ +Investment measured at NAV (1) +​ +​ +37.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total plan assets +​ +$ +194.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair Value Measurements at December 31, 2018 +​ +​ +​ +Quoted Prices in +Significant +Significant +​ +​ +​ +​ +​ +Active Markets +​ +Observable +​ +Unobservable +Asset Category (in millions) +​ +Total +​ +(Level 1) +​ +Inputs (Level 2) +​ +Inputs (Level 3) +Cash +​ +$ +6.2 +​ +$ +6.2 +​ +$ +— +​ +$ +— +​ +Equity securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large-cap +​ +50.6 +​ +24.9 +​ +25.7 +​ +— +​ +U.S. mid- and small-cap +​ +38.4 +​ +25.8 +​ +12.6 +​ +— +​ +International large-cap +​ +5.5 +​ +— +​ +5.5 +​ +— +​ +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. Treasuries +​ +8.0 +​ +— +​ +8.0 +​ +— +​ +Municipal bonds +​ +0.1 +​ +— +​ +0.1 +​ +— +​ +Investment grade U.S. corporate bonds +​ +20.8 +​ +— +​ +20.8 +​ +— +​ +High-yield U.S. corporate bonds +​ +0.5 +​ +— +​ +0.5 +​ +— +​ +Total +​ +​ +130.1 +​ +$ +56.9 +​ +$ +73.2 +​ +$ +— +​ +Investment measured at NAV (1) +​ +​ +32.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total plan assets +​ +$ +162.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(1) Real estate and private equity funds for which fair value is measured using the NAV per share as a practical expedient are not leveled within the fair value hierarchy and are included as a reconciling item to total plan assets. +​ +Contributions to each of the qualified single-employer defined benefit pension plans are determined annually by the Company’s pension administrative committee, based upon the actuarially determined minimum required contribution under the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended, the Pension Protection Act of 2006, and the maximum deductible contribution allowed for tax purposes. The Company’s funding policy is to contribute cash to its pension plans so that it meets at least the minimum contribution requirements. In 2019 and 2017, the Company contributed $ 10.0 million and $ 3.0 million, respectively, in pension contributions in these plans. There was no pension contribution to these plans in 2018. +​ +The benefit formulas for employees who are members of collective bargaining units are determined according to the collective bargaining agreements, either using final average pay as the base or a flat dollar amount per year of service. +​ +Effective December 31, 2011, the Company froze benefit accruals under the final average pay formula for salaried, non-bargaining unit employees hired before January 1, 2008 and transitioned them to the same cash balance formula for employees hired on or after January 1, 2008. Retirement benefits under the cash balance formula are based on a fixed percentage of employee eligible compensation, plus interest. The plan interest credit rate will vary from year to year based on the ten-year U.S. Treasury rate. +​ +63 +​ +Table of Contents +Benefit Plan Assets and Obligations: The measurement date for the Company’s benefit plan disclosures is December 31 of each year. +​ +The status of the funded qualified defined benefit pension plans and the unfunded post-retirement benefit plans at December 31, 2019 and 2018 are shown below: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Post-retirement +​ +​ +Pension Benefits +​ +Benefits +​ +​ +December 31, +​ +December 31, +​ +(In millions) +2019 +2018 +2019 +2018 +Change in Benefit Obligation: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Benefit obligation at beginning of year +​ +$ +217.4 +​ +$ +232.1 +​ +$ +22.2 +​ +$ +27.7 +​ +Service cost +​ +4.7 +​ +4.4 +​ +0.4 +​ +0.6 +​ +Interest cost +​ +9.3 +​ +8.6 +​ +0.9 +​ +1.0 +​ +Plan participants’ contributions +​ +— +​ +— +​ +0.8 +​ +0.9 +​ +Actuarial (gain) loss +​ +22.2 +​ +( 14.1 ) +​ +3.4 +​ +( 6.2 ) +​ +Benefits paid, net of subsidies received +​ +( 12.2 ) +​ +( 12.0 ) +​ +( 1.7 ) +​ +( 1.8 ) +​ +Expenses paid +​ +( 1.5 ) +​ +( 1.6 ) +​ +— +​ +— +​ +Benefit obligation at end of year +​ +​ +239.9 +​ +​ +217.4 +​ +​ +26.0 +​ +​ +22.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change in Plan Assets: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of plan assets at beginning of year +​ +​ +162.2 +​ +​ +186.7 +​ +​ +— +​ +​ +— +​ +Actual return on plan assets +​ +36.3 +​ +( 10.9 ) +​ +— +​ +— +​ +Plan participants’ contributions +​ +— +​ +— +​ +0.8 +​ +0.9 +​ +Employer contributions +​ +10.0 +​ +— +​ +0.9 +​ +0.9 +​ +Benefits paid, net of subsidies received +​ +( 12.2 ) +​ +( 12.0 ) +​ +( 1.7 ) +​ +( 1.8 ) +​ +Expenses paid +​ +( 1.5 ) +​ +( 1.6 ) +​ +— +​ +— +​ +Fair value of plan assets at end of year +​ +194.8 +​ +162.2 +​ +— +​ +— +​ +Funded Status and Recognized Liability +​ +$ +( 45.1 ) +​ +$ +( 55.2 ) +​ +$ +( 26.0 ) +​ +$ +( 22.2 ) +​ +​ +Qualified pension and post-retirement benefits plans liabilities recognized in the Consolidated Balance Sheets and expenses recognized in accumulated other comprehensive income (loss) at December 31, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Post-retirement +​ +​ +Pension Benefits +​ +Benefits +​ +​ +December 31, +​ +December 31, +​ +(In millions) +2019 +2018 +2019 +2018 +Non-current assets +​ +$ +1.0 +​ +$ +0.8 +​ +$ +— +​ +$ +— +​ +Current liabilities +​ +​ +— +​ +​ +— +​ +​ +( 1.0 ) +​ +​ +( 1.2 ) +​ +Non-current liabilities, net +​ +( 46.1 ) +​ +( 56.0 ) +​ +( 25.0 ) +​ +( 21.0 ) +​ +Total +​ +$ +( 45.1 ) +​ +$ +( 55.2 ) +​ +$ +( 26.0 ) +​ +$ +( 22.2 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net loss, net of taxes +​ +$ +( 56.2 ) +​ +$ +( 61.8 ) +​ +$ +( 2.8 ) +​ +$ +( 0.1 ) +​ +Prior service credit, net of taxes +​ +4.3 +​ +6.0 +​ +19.1 +​ +21.8 +​ +Total +​ +$ +( 51.9 ) +​ +$ +( 55.8 ) +​ +$ +16.3 +​ +$ +21.7 +​ +​ +The information for qualified defined benefit pension plans with an accumulated benefit obligation in excess of plan assets at December 31, 2019 and 2018 is shown below: +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +2019 +2018 +Projected benefit obligation +​ +$ +238.3 +​ +$ +215.9 +​ +Accumulated benefit obligation +​ +$ +237.9 +​ +$ +215.6 +​ +Fair value of plan assets +​ +$ +192.2 +​ +$ +159.9 +​ +​ +The estimated net loss and prior service credit for the qualified pension plans that will be amortized from accumulated other comprehensive income (loss) is a net periodic cost of $ 1.5 million, net of tax, in 2020. The estimated net loss and prior service credit for the post-retirement benefit plans that will be amortized from accumulated other comprehensive income (loss) is a net periodic benefit credit of $ 2.3 million, net of tax, in 2020. +64 +​ +Table of Contents +​ +Unrecognized gains and losses of the post-retirement benefit plans are amortized over five years . Although current health care costs are expected to increase, the Company attempts to mitigate these increases by maintaining caps on certain of its benefit plans, using lower cost health care plan options where possible, requiring that certain groups of employees pay a portion of their benefit costs, self-insuring for certain insurance plans, encouraging wellness programs for employees, and implementing measures to mitigate future benefit cost increases. +​ +Components of the net periodic benefit cost and other amounts recognized in other comprehensive income (loss) for the qualified pension plans and the post-retirement benefit plans during 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pension Benefits +​ +Post-retirement Benefits +​ +​ +December 31, +​ +December 31, +​ +(In millions) +2019 +2018 +2017 +2019 +2018 +2017 +Components of Net Periodic Benefit Cost (Benefit): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Service cost +​ +$ +4.7 +​ +$ +4.4 +​ +$ +4.0 +​ +$ +0.4 +​ +$ +0.6 +​ +$ +0.5 +​ +Interest cost +​ +9.3 +​ +8.6 +​ +9.7 +​ +0.9 +​ +1.0 +​ +1.1 +​ +Expected return on plan assets +​ +( 11.9 ) +​ +( 13.5 ) +​ +( 13.5 ) +​ +— +​ +— +​ +— +​ +Amortization of net loss +​ +5.2 +​ +4.6 +​ +5.1 +​ +( 0.1 ) +​ +1.5 +​ +1.2 +​ +Amortization of prior service credit +​ +( 2.3 ) +​ +( 2.3 ) +​ +( 2.3 ) +​ +( 3.8 ) +​ +( 3.8 ) +​ +( 3.8 ) +​ +Net periodic benefit cost +​ +​ +5.0 +​ +​ +1.8 +​ +​ +3.0 +​ +​ +( 2.6 ) +​ +​ +( 0.7 ) +​ +​ +( 1.0 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other Changes in Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income, net of tax: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net loss (gain) +​ +​ +( 1.7 ) +​ +​ +7.8 +​ +​ +0.8 +​ +​ +2.5 +​ +​ +( 4.7 ) +​ +​ +1.1 +​ +Amortization of net (loss) gain +​ +( 3.9 ) +​ +( 3.5 ) +​ +( 3.1 ) +​ +0.2 +​ +( 1.1 ) +​ +( 0.7 ) +​ +Amortization of prior service credit +​ +1.7 +​ +1.7 +​ +1.4 +​ +2.8 +​ +2.8 +​ +2.3 +​ +Total recognized in other comprehensive (income) loss +​ +​ +( 3.9 ) +​ +​ +6.0 +​ +​ +( 0.9 ) +​ +​ +5.5 +​ +​ +( 3.0 ) +​ +​ +2.7 +​ +Total recognized in net periodic benefit cost and other comprehensive (income) loss +​ +$ +1.1 +​ +$ +7.8 +​ +$ +2.1 +​ +$ +2.9 +​ +$ +( 3.7 ) +​ +$ +1.7 +​ +​ +The weighted average assumptions used to determine benefit information during 2019, 2018 and 2017 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pension Benefits +​ +Post-retirement Benefits +​ +​ +December 31, +​ +December 31, +​ +​ +2019 +2018 +2017 +2019 +2018 +2017 +Discount rate (1) +3.40 +% +4.40 +% +3.80 +% +3.50 +% +4.50 +% +3.90 +% +Expected return on plan assets +7.50 +% +7.50 +% +7.75 +% +​ +​ +​ +​ +​ +​ +Rate of compensation increase +3.00 +% +3.00 +% +3.00 +% +3.00 +% +3.00 +% +3.00 +% +Initial health care cost trend rate: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pre-65 group +​ +​ +​ +​ +​ +​ +​ +5.70 +% +6.00 +% +6.30 +% +Post-65 group +​ +​ +​ +​ +​ +​ +​ +5.90 +% +6.30 +% +6.80 +% +Ultimate health care cost trend rate +​ +​ +​ +​ +​ +​ +​ +4.40 +% +4.40 +% +4.40 +% +Year ultimate health care cost trend rate is reached: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pre-65 group +​ +​ +​ +​ +​ +​ +​ +2037 +​ +2037 +​ +2037 +​ +Post-65 group +​ +​ +​ +​ +​ +​ +​ +2036 +​ +2036 +​ +2036 +​ +(1) The Company derives a single equivalent rate utilizing a yield curve constructed from a portfolio of high-quality corporate bonds with various maturities. +​ +If the assumed health care cost trend rate were increased or decreased one percentage point, the accumulated post-retirement benefit obligation, as of December 31, 2019, 2018 and 2017 and the net periodic post-retirement benefit cost for 2019, 2018 and 2017, would have increased or decreased as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Post-retirement Benefits +​ +​ +One Percentage Point +​ +​ +Increase +​ +Decrease +(In millions) +2019 +2018 +2017 +2019 +2018 +2017 +Effect on total of service cost and interest cost components +​ +$ +0.2 +​ +$ +0.3 +​ +$ +0.3 +​ +$ +( 0.2 ) +​ +$ +( 0.2 ) +​ +$ +( 0.2 ) +​ +Effect on post-retirement benefit obligation +​ +$ +3.3 +​ +$ +2.6 +​ +$ +4.0 +​ +$ +( 2.6 ) +​ +$ +( 2.0 ) +​ +$ +( 3.0 ) +​ +​ +65 +​ +Table of Contents +Non-qualified Pension Plans: The Company has non-qualified supplemental pension plans covering certain employees and retirees, which provide for incremental pension payments from the Company’s general funds so that total pension benefits would be substantially equal to amounts that would have been payable from the Company’s qualified pension plans if it were not for limitations imposed by income tax law. A few employees and retirees receive additional supplemental pension benefits. Non-qualified pension plan liabilities recognized in the Consolidated Balance Sheets and expenses recognized in accumulated other comprehensive income (loss) at December 31, 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non-qualified +​ +Pension Benefits +​ +December 31, +​ +(In millions) +​ +2019 +2018 +Current liabilities +​ +$ +( 2.1 ) +​ +$ +( 1.8 ) +​ +Non-current liabilities, net +​ +​ +( 2.3 ) +​ +​ +( 2.4 ) +​ +Total +​ +$ +( 4.4 ) +​ +$ +( 4.2 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net loss, net of taxes +​ +$ +( 0.6 ) +​ +$ +( 0.4 ) +​ +Prior service credit, net of taxes +​ +​ +0.2 +​ +​ +0.3 +​ +Total +​ +$ +( 0.4 ) +​ +$ +( 0.1 ) +​ +​ +Discount rates of 2.8 percent and 4.0 percent were used in determining the 2019 and 2018 non-qualified pension plan obligations, respectively. The estimated net loss and prior service credit for the non-qualified pension plans that will be amortized from accumulated other comprehensive income (loss) in 2020 is nominal. +​ +Estimated Benefit Payments: The estimated future benefit payments for the next ten years as of December 31, 2019 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non-qualified +​ +​ +​ +​ +Pension +​ +Pension +​ +Post-retirement +​ +Year (in millions) +​ +Benefits +​ +Benefits +​ +Benefits (1) +2020 +​ +$ +13.6 +​ +$ +2.2 +​ +$ +1.0 +​ +2021 +​ +13.9 +​ +— +​ +1.0 +​ +2022 +​ +14.2 +​ +— +​ +1.1 +​ +2023 +​ +14.6 +​ +2.1 +​ +1.2 +​ +2024 +​ +14.7 +​ +— +​ +1.2 +​ +2025-2029 +​ +​ +76.2 +​ +​ +0.5 +​ +​ +5.7 +​ +Total +​ +$ +147.2 +​ +$ +4.8 +​ +$ +11.2 +​ +(1) Net of plan participants’ contributions and Medicare Part D subsidies. +​ +Defined Contribution Plans: The Company sponsors defined contribution plans that qualify under Sections 401(a) and 401(k) of the Internal Revenue Code. The Company may make discretionary matching contributions equal to a specified percentage of each participant’s 401(k) contributions and makes other non-discretionary contributions. For the year ended December 31, 2019, the Company provided discretionary matching contributions of up to 3 percent of eligible employee compensation. The Company’s matching contributions expensed in 2019, 2018 and 2017 were $ 2.9 million, $ 2.4 million and $ 2.4 million, respectively. +​ +The Company may also provide a discretionary profit sharing contribution under the qualified defined contribution plans, to salaried, non-bargaining unit employees, if both a minimum threshold of Company performance is achieved and the Board has approved the profit sharing contribution. For certain eligible employees, supplemental profit sharing contributions are credited under a non-qualified plan to be paid after separation from service from the Company’s general funds so that total profit sharing contributions would be substantially equal to amounts that would have been contributed to the Company’s qualified defined contribution plans if it were not for limitations imposed by income tax law. Discretionary profit sharing contributions expensed in 2019, 2018 and 2017 were $ 0.5 million, $ 1.4 million and $ 2.3 million, respectively. +​ +Multi-employer Bargaining Plans: +​ +The Company contributes to multi-employer defined benefit pension plans under the terms of collective-bargaining agreements that cover its bargaining unit employees. Contributions are generally based on amounts paid for union labor +66 +​ +Table of Contents +or cargo volume. The risks of participating in multi-employer plans are different from single-employer plans because assets contributed to the multi-employer plan by one employer may be used to provide benefits to employees of other participating employers. Additionally, if one employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. +​ +The multi-employer pension plans are subject to the plan termination insurance provisions of ERISA and are paying premiums to the Pension Benefit Guaranty Corporation (“PBGC”). The statutes provide that an employer who withdraws from, or significantly reduces its contribution obligation to, a multi-employer plan generally will be required to continue funding its proportional share of the plan’s unfunded vested benefits. As of December 31, 2019, the Company’s estimated benefit plan withdrawal obligations were $ 266.7 million. Except as described in Note 12, no withdrawal obligations have been recorded by the Company in the Consolidated Balance Sheets at December 31, 2019 and 2018, as the Company has no present intention of withdrawing from and does not anticipate termination of any of these plans. +​ +Information regarding the Company’s participation in multi-employer pension plans is outlined in the table below. The “EIN/Pension Plan Number” column provides the Employer Identification Number (“EIN”) and the three-digit plan number, if applicable. Unless otherwise noted, the most recent Pension Protection Act zone status available in 2019 and 2018 is for the plan’s year-end at December 31, 2019 and 2018, respectively. The zone status is based on information that the Company received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65 percent funded; plans in the orange zone are both a) less than 80 percent funded and b) have an accumulated/expected funding deficiency in any of the next six plan years, net of any amortization extensions; plans in the yellow zone meet either one of the criteria mentioned in the orange zone; and plans in the green zone are at least 80 percent funded. The funding improvement plan (“FIP”) or rehabilitation plan (“RP”) column indicates the status which is either pending or has been implemented. The last column lists the expiration dates of the collective-bargaining agreements to which the plans are subject. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pension +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Protection Act +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Zone as of +​ +FIP/RP Status +​ +​ +​ +Contributions of Matson +​ +​ +​ +​ +​ +​ +EIN/Pension +​ +​ +​ +December 31, +​ +Pending/ +​ +5% +​ +(in millions) +​ +Surcharge +​ +Expiration +Pension Funds +Plan Number +Notes +2019 +2018 +Implemented +Contributor +2019 +2018 +2017 +Imposed +Date (3) +American Radio Association Pension Fund +13-6161999-001 +​ +​ +Green +Green +Implemented +​ +Yes +​ +$ +1.1 +​ +$ +1.0 +​ +$ +1.0 +No +6/15/2028 +​ +Hawaii Terminals Multiemployer Pension Plan +20-0389370-001 +​ +​ +Orange +Yellow +Implemented +​ +Yes +​ +​ +5.7 +​ +​ +5.7 +​ +​ +5.7 +No +6/30/2022 +​ +Hawaii Stevedoring Multiemployer Retirement Plan +99-0314293-001 +​ +​ +Yellow +Yellow +Implemented +​ +Yes +​ +4.4 +​ +4.3 +​ +3.8 +No +6/30/2022 +​ +Master, Mates and Pilots Pension Plan +13-6372630-001 +​ +​ +​ +Green +Green +No +​ +Yes +​ +3.4 +​ +3.0 +​ +3.0 +No +​ +6/15/2027, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/15/2028 +​ +Masters, Mates and Pilots Adjustable Pension Plan +37-1719247-001 +​ +​ +​ +(1) +(1) +No +​ +Yes +​ +1.9 +​ +1.7 +​ +1.7 +No +​ +6/15/2027, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/15/2028 +​ +MEBA Pension Trust - Defined Benefit Plan +51-6029896-001 +​ +​ +​ +Green +Green +No +​ +Yes +​ +4.3 +​ +4.0 +​ +4.4 +No +6/15/2022, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/15/2028 +​ +OCU Trust Pension Plan +26-1574440-001 +​ +​ +​ +Green +Green +No +​ +No +​ +0.2 +​ +0.2 +​ +0.2 +No +6/30/2023 +​ +MFOW Supplementary Pension Plan +​ +94-6201677-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +Yes +​ +​ +0.1 +​ +​ +— +​ +​ +— +​ +No +​ +6/30/2021 +​ +SIU Pacific District Pension Plan +​ +94-6061923-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +Yes +​ +​ +1.5 +​ +​ +1.2 +​ +​ +0.7 +​ +No +​ +6/30/2021 +​ +Alaska Teamster - Employer Pension Plan +​ +92-6003463-024 +​ +​ +​ +Red +​ +Red +​ +Implemented +​ +Yes +​ +​ +1.9 +​ +​ +1.9 +​ +​ +2.4 +​ +Yes +​ +6/30/2020, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/30/2021, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/30/2022, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/30/2023 +​ +All Alaska Longshore Pension Plan +​ +91-6085352-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +Yes +​ +​ +1.2 +​ +​ +1.0 +​ +​ +0.1 +​ +No +​ +6/30/2020 +​ +Western Conference of Teamsters Pension Plan +​ +91-6145047-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +No +​ +​ +1.5 +​ +​ +1.4 +​ +​ +1.3 +​ +No +​ +3/31/2023 +​ +Western Conference of Teamsters Supplemental Benefit Trust +​ +95-3746907-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +No +​ +​ +— +​ +​ +— +​ +​ +— +​ +No +​ +3/31/2023 +​ +OPEIU Local 153 Pension Plan +​ +13-2864289-001 +​ +​ +​ +Red +​ +Red +​ +Implemented +​ +No +​ +​ +0.1 +​ +​ +0.1 +​ +​ +0.1 +​ +No +​ +11/09/2020 +​ +Seafarers Pension Trust +​ +13-6100329-001 +​ +(2) +​ +Green +​ +Green +​ +No +​ +No +​ +​ +— +​ +​ +— +​ +​ +— +​ +No +​ +6/30/2022 +​ +Total +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +27.3 +​ +$ +25.5 +​ +$ +24.4 +​ +​ +​ +​ +​ +(1) The Plan is not subject to the PPA funding requirements under IRS Section 432 as the Plan was not in effect on July 16, 2006. +(2) The Company does not make contributions directly to the Seafarers Pension Plan. Instead, contributions are made to the Seafarers Health and Benefits Plan, and are subsequently re-allocated to the Seafarers Pension Plan at the discretion of the plan Trustee. +(3) Represents the expiration date of the collective bargaining agreement. +​ +The Company also contributes to multi-employer plans that provide post-retirement health and other benefits other than pensions under the terms of collective-bargaining agreements. Benefits provided to active and retired employees and their eligible dependents under these plans include medical, dental, vision and prescription drug. These plans are not subject to the PBGC plan termination and withdrawal liability provisions of ERISA applicable to multi-employer +67 +​ +Table of Contents +defined benefit pension plans. Contributions to these multi-employer postretirement health and other benefits were $ 32.8 million, $ 30.0 million and $ 27.0 million in 2019, 2018 and 2017, respectively. +​ +Multi-employer Defined Contribution Plans: The Company contributes to six multi-employer defined contribution pension plans. These plans are not subject to the withdrawal liability provisions of ERISA or the PBGC applicable to multi-employer defined benefit pension plans. Contributions made to these plans by the Company were $ 5.3 million, $ 4.8 million and $ 5.0 million in 2019, 2018 and 2017, respectively. +​ +​ +12. +MULTI-EMPLOYER WITHDRAWAL LIABILITIES +​ +Horizon ceased all of its operations in Puerto Rico during the first quarter of 2015, which resulted in a mass withdrawal from its multi-employer ILA-PRSSA pension fund. The Company assumed this liability as part of the acquisition of Horizon on May 29, 2015. The Company estimated the mass withdrawal liability based upon the required undiscounted quarterly payment of approximately $ 1.0 million to be paid to the ILA-PRSSA pension fund over a period which ends in March 2040, discounted to present value using the Company’s incremental borrowing rate. Future estimated annual payments to be paid to the ILA-PRSSA pension fund as of December 31, 2019 were as follows: +​ +​ +​ +​ +​ +Year (in millions) +​ +Total +2020 +$ +4.1 +2021 +​ +​ +4.1 +2022 +​ +​ +4.1 +2023 +​ +​ +4.1 +2024 +​ +​ +4.1 +Thereafter +​ +​ +63.9 +Total remaining future undiscounted payments due to the ILA-PRSSA pension fund +​ +​ +84.4 +Less: amount representing interest +​ +​ +( 25.5 ) +Present value of multi-employer withdrawal liability +​ +​ +58.9 +Current portion of multi-employer withdrawal liability (see Note 2) +​ +​ +( 4.1 ) +Long-term portion of multi-employer withdrawal liability (see Note 2) +$ +54.8 +​ +Furthermore, the Company assumed a partial withdrawal liability related to the Local 153 Fund of the OPEIU. The partial withdrawal liability resulted from a decline in the number of contribution base units related to the Local 153 Fund caused by Horizon terminating all of its operations in Puerto Rico during the first quarter of 2015. The Company included the partial withdrawal liability of $ 6.7 million within other liabilities in the Consolidated Balance Sheets as of December 31, 2019 and 2018. +​ +​ +13. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) +​ +Changes in accumulated other comprehensive income (loss) by component, net of tax, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non- +​ +​ +Accumulated +​ +​ +​ +​ +​ +Post- +​ +Qualified +​ +​ +​ +​ +Other +​ +​ +Pension +​ +Retirement +​ +Pension +​ +​ +​ +​ +Comprehensive +(In millions) +​ +Benefits +​ +Benefits +​ +Benefits +​ +Other +​ +Income (Loss) +Balance at December 31, 2017 +​ +$ +( 40.6 ) +​ +$ +15.6 +​ +$ +( 0.3 ) +​ +$ +0.4 +​ +$ +( 24.9 ) +​ +Reclassification adjustment related to the Tax Act (1) +​ +​ +( 9.2 ) +​ +​ +3.4 +​ +​ +( 0.2 ) +​ +​ +— +​ +​ +( 6.0 ) +​ +Amortization of prior service cost +​ +( 1.7 ) +​ +​ +( 2.9 ) +​ +​ +( 0.1 ) +​ +​ +— +​ +( 4.7 ) +​ +Amortization of net loss (gain) +​ +​ +( 4.3 ) +​ +​ +5.6 +​ +​ +0.5 +​ +​ +( 0.7 ) +​ +1.1 +​ +Balance at December 31, 2018 +​ +( 55.8 ) +​ +21.7 +​ +( 0.1 ) +​ +( 0.3 ) +​ +( 34.5 ) +​ +Amortization of prior service cost +​ +( 1.7 ) +​ +​ +( 2.6 ) +​ +​ +( 0.1 ) +​ +​ +( 0.1 ) +​ +( 4.5 ) +​ +Amortization of net loss (gain) +​ +5.6 +​ +​ +( 2.8 ) +​ +​ +( 0.2 ) +​ +​ +0.1 +​ +2.7 +​ +Other adjustments +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 0.6 ) +​ +( 0.6 ) +​ +Balance at December 31, 2019 +​ +$ +( 51.9 ) +​ +$ +16.3 +​ +$ +( 0.4 ) +​ +$ +( 0.9 ) +​ +$ +( 36.9 ) +​ +(1) Reclassification from accumulated other comprehensive income (loss) to retained earnings for the remeasurement tax effects resulting from applying the Tax Act in accordance with ASU 2018-02. +68 +​ +Table of Contents +​ +Other comprehensive income (loss) in the Consolidated Statements of Income and Comprehensive Income is shown net of tax benefit (expense) of $( 0.3 ) million, $ 0.2 million and $( 4.4 ) million for the years ended December 2019, 2018 and 2017, respectively. +​ +​ +​ +14. EARNINGS PER SHARE +​ +Basic earnings per share are determined by dividing net income by the weighted-average common shares outstanding during the year. The calculation of diluted earnings per share includes the dilutive effect of unexercised non-qualified stock options and non-vested stock units. The computation of weighted average dilutive shares outstanding excluded a nominal amount of anti-dilutive non-qualified stock options for each of the years 2019, 2018 and 2017. +​ +The denominators used to compute basic and diluted earnings per share for the years ended December 31, 2019, 2018 and 2017 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31, 2019 +​ +Year Ended December 31, 2018 +​ +Year Ended December 31, 2017 +​ +​ +​ +Weighted +Per +​ +​ +Weighted +Per +​ +​ +Weighted +Per +​ +​ +​ +​ +​ +Average +​ +Common +​ +​ +​ +​ +Average +​ +Common +​ +​ +​ +​ +Average +​ +Common +​ +​ +Net +​ +Common +​ +Share +​ +Net +​ +Common +​ +Share +​ +Net +​ +Common +​ +Share +(In millions, except per share amounts) +​ +Income +​ +Shares +​ +Amount +​ +Income +​ +Shares +​ +Amount +​ +Income +​ +Shares +​ +Amount +Basic: +​ +$ +82.7 +42.8 +​ +$ +1.93 +​ +$ +109.0 +42.7 +​ +$ +2.55 +​ +$ +231.0 +42.9 +​ +$ +5.38 +​ +Effect of Dilutive Securities: +​ +​ +​ +0.5 +​ +​ +( 0.02 ) +​ +​ +​ +0.3 +​ +​ +( 0.02 ) +​ +​ +​ +0.3 +​ +​ +( 0.03 ) +​ +Diluted: +​ +$ +82.7 +​ +43.3 +​ +$ +1.91 +​ +$ +109.0 +​ +43.0 +​ +$ +2.53 +​ +$ +231.0 +​ +43.2 +​ +$ +5.35 +​ +​ +​ +​ +15. +SHARE-BASED AWARDS +​ +The Company has share-based compensation plans which are described as follows: +​ +2016 Incentive Compensation Plan: The 2016 Incentive Compensation Plan (the “2016 Plan”) serves as a successor to the 2007 Incentive Compensation Plan and all other predecessor plans. No further grants will be made under the predecessor stock option plans. Under the 2016 Plan, 2.5 million shares of common stock were reserved for issuance. Shareholders approved the 2016 Plan at the 2016 Annual Meeting of Shareholders. +​ +The 2016 Plan consists of four separate incentive compensation programs: (i) the discretionary grant program, (ii) the stock issuance program, (iii) the incentive bonus program, and (iv) the automatic grant program for the non- employee members of the Company’s Board of Directors. Share-based compensation is generally awarded under three of the four programs, as more fully described below. +​ +Discretionary Grant Program — Under the Discretionary Grant Program, stock options may be granted with an exercise price no less than 100 percent of the fair market value (defined as the closing market price) of the Company’s common stock on the date of the grant. Options generally become exercisable ratably over three years and have a maximum contractual term of 10 years . +​ +Stock Issuance Program — Under the Stock Issuance Program, shares of common stock, restricted stock units or performance shares may be granted. Time-based equity awards generally vest ratably over three years . Provided certain three-year performance targets are achieved, performance-based equity awards generally vest on the three-year anniversary date of the grant. +​ +Automatic Grant Program — At each annual shareholder meeting, non-employee directors will receive an award of restricted stock units that entitle the holder to an equivalent number of shares of common stock upon vesting, under the automatic grant program. Awards of restricted stock units granted under the program generally vest on the one-year anniversary of the grant date. +​ +The shares of common stock authorized to be issued under the 2016 Plan may be drawn from shares of the Company’s authorized but unissued common stock or from shares of its common stock that the Company acquires, including shares purchased on the open market or in private transactions. +​ +69 +​ +Table of Contents +Share-based compensation expense and other information related to share-based awards for the years ended December 31, 2019, 2018 and 2017 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +Share-based compensation expense, net of estimated forfeitures (in millions) +2019 +2018 +2017 +Share-based compensation expense +​ +$ +11.3 +​ +$ +12.1 +​ +$ +11.1 +​ +Intrinsic value of options exercised +​ +$ +0.5 +​ +$ +0.5 +​ +$ +0.7 +​ +Tax benefit realized upon stock vesting +​ +$ +2.0 +​ +$ +2.7 +​ +$ +6.8 +​ +Fair value of stock vested +​ +$ +8.2 +​ +$ +10.8 +​ +$ +17.3 +​ +​ +As of December 31, 2019, there was no unrecognized compensation cost related to non-vested stock options. As of December 31, 2019, unrecognized compensation cost related to non-vested restricted stock units and performance-based equity awards was $ 11.7 million. Unrecognized compensation cost is expected to be recognized over a weighted average period of approximately 1.7 years. +​ +Stock option activity for the year ended December 31, 2019 was as follows (in thousands, except weighted average exercise price and weighted average contractual life): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted +Weighted +​ +​ +​ +​ +​ +Average +​ +Average +​ +Aggregate +​ +​ +2007 Plan +​ +Exercise +​ +Contractual +​ +Intrinsic +​ +​ +Shares +​ +Price +​ +Life +​ +Value +Outstanding at December 31, 2018 +196 +$ +21.81 +​ +​ +​ +​ +​ +​ +Exercised +( 23 ) +​ +$ +18.12 +​ +​ +​ +​ +​ +​ +Outstanding at December 31, 2019 +173 +$ +22.30 +1.7 +​ +$ +3,203 +​ +Exercisable at December 31, 2019 +173 +$ +22.30 +1.7 +​ +$ +3,203 +​ +​ +The following table summarizes non-vested restricted stock unit activity through December 31, 2019 (in thousands, except weighted average grant-date fair value amounts): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2007 Plan +2016 Plan +Total +Weighted +​ +​ +Restricted +​ +Restricted +​ +Restricted +​ +Average Grant- +​ +​ +​ +Stock Units +​ +Stock Units +​ +Stock Units +​ +Date Fair Value +Outstanding at December 31, 2018 +164 +595 +759 +​ +$ +33.92 +​ +Granted +​ +— +​ +363 +​ +363 +​ +$ +33.65 +​ +Settlement of Performance Shares (1) +​ +( 66 ) +​ +— +​ +( 66 ) +​ +$ +37.68 +​ +Vested +​ +( 90 ) +​ +( 150 ) +​ +( 240 ) +​ +$ +34.36 +​ +Canceled +​ +— +​ +( 38 ) +​ +( 38 ) +​ +$ +33.17 +​ +Outstanding at December 31, 2019 +8 +770 +778 +​ +$ +33.39 +​ +(1) Represents 2016 Performance Shares paid out below target. +​ +​ +16. FAIR VALUE OF FINANCIAL INSTRUMENTS +​ +The Company values its financial instruments based on the fair value hierarchy of valuation techniques for fair value measurements. Level 1 inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability. If the technique used to measure fair value includes inputs from multiple levels of the fair value hierarchy, the lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy. +​ +The Company uses Level 1 inputs for the fair values of its cash, cash equivalents and restricted cash, and Level 2 inputs for its variable and fixed rate debt. The fair values of cash, cash equivalents and restricted cash, and variable rate debt approximate their carrying values due to the nature of the instruments. The fair value of fixed rate debt is calculated based upon interest rates available for debt with terms and maturities similar to the Company’s existing debt arrangements. +​ +70 +​ +Table of Contents +The carrying value and fair value of the Company’s financial instruments as of December 31, 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quoted Prices in +​ +Significant +​ +Significant +​ +​ +​ +Total +​ +​ +​ +Active Markets +​ +Observable +​ +Unobservable +​ +​ +Carrying Value +Total +(Level 1) +Inputs (Level 2) +Inputs (Level 3) +​ +(In millions) +​ +December 31, 2019 +​ +Fair Value Measurements at December 31, 2019 +​ +Cash and cash equivalents +​ +$ +21.2 +​ +$ +21.2 +​ +$ +21.2 +​ +$ +— +​ +$ +— +​ +Restricted cash +​ +$ +7.2 +​ +$ +7.2 +​ +$ +7.2 +​ +$ +— +​ +$ +— +​ +Variable rate debt +​ +$ +379.1 +​ +$ +379.1 +​ +$ +— +​ +$ +379.1 +​ +$ +— +​ +Fixed rate debt +​ +$ +579.3 +​ +$ +585.9 +​ +$ +— +​ +$ +585.9 +​ +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +​ +December 31, 2018 +​ +Fair Value Measurements at December 31, 2018 +​ +Cash and cash equivalents +$ +19.6 +$ +19.6 +$ +19.6 +$ +— +$ +— +​ +Restricted cash +​ +$ +4.9 +​ +$ +4.9 +​ +$ +4.9 +​ +$ +— +​ +$ +— +​ +Variable rate debt +​ +$ +235.0 +​ +$ +235.0 +​ +$ +— +​ +$ +235.0 +​ +$ +— +​ +Fixed rate debt +​ +$ +621.4 +​ +$ +584.5 +​ +$ +— +​ +$ +584.5 +​ +$ +— +​ +​ +​ +​ +17. +COMMITMENTS AND CONTINGENCIES +​ +Commitments and contractual obligations, excluding debt obligations (see Note 8), lease commitments (see Note 9), pension and post-retirement plan commitments, and multi-employer bargaining plan withdrawal obligations (see Note 11 and 12), are as follows as of December 31, 2019: +​ +​ +​ +​ +​ +​ +Commitments and Contractual Obligations (in millions) +Total +Standby letters of credit (1) +​ +$ +7.7 +​ +Bonds (2) +​ +$ +33.1 +​ +Vessel construction obligations (3) +​ +$ +64.8 +​ +Vendor and other obligations (4) +​ +$ +29.6 +​ +(1) Standby letters of credit are required for the Company’s uninsured workers’ compensation and other insurance programs, and other needs. +(2) Bonds are required for U.S. Customs and other related matters. +(3) Vessel construction obligations represent remaining contractual obligations entered into for the construction of new vessels. +(4) Vendor and other obligations include: (i) non-cancellable contractual capital project obligations (excluding vessel construction obligations); (ii) dry-docking related obligations; and (iii) other contractual obligations. +​ +These amounts are not recorded on the Company’s Consolidated Balance Sheets and it is not expected that the Company or its subsidiaries will be called upon to advance funds under these commitments. +​ +Contingencies: Contingencies and other litigation related matters are described as follows: +​ +Environmental Matters: The Company’s Ocean Transportation segment has certain risks that could result in expenditures for environmental remediation. The Company believes that based on all information available to it, the Company is currently in compliance, in all material respects, with applicable environmental laws and regulations. +​ +Other Matters: The Company and its subsidiaries are parties to, or may be contingently liable in connection with other legal actions arising in the normal course of their businesses, the outcomes of which, in the opinion of management after consultation with counsel, would not have a material effect on the Company’s financial condition, results of operations, or cash flows. +​ +​ +​ +71 +​ +Table of Contents +18. +QUARTERLY INFORMATION (Unaudited) +​ +Segment results by quarter for 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2019 +(In millions, except per share amounts) +Q1 +Q2 +Q3 +Q4 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +397.9 +​ +$ +415.4 +​ +$ +437.2 +​ +$ +416.1 +​ +Logistics +​ +134.5 +​ +142.5 +​ +134.9 +​ +124.6 +​ +Total Operating Revenue +​ +$ +532.4 +​ +$ +557.9 +​ +$ +572.1 +​ +$ +540.7 +​ +Operating Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +9.4 +​ +$ +19.7 +​ +$ +43.9 +​ +$ +17.8 +​ +Logistics +​ +8.1 +​ +11.3 +​ +11.3 +​ +7.6 +​ +Total Operating Income +​ +17.5 +​ +31.0 +​ +55.2 +​ +25.4 +​ +Interest expense, net +​ +( 4.6 ) +​ +( 6.1 ) +​ +( 6.2 ) +​ +( 5.6 ) +​ +Other income (expense), net +​ +​ +0.6 +​ +​ +0.8 +​ +​ +( 0.5 ) +​ +​ +0.3 +​ +Income before Income Taxes +​ +13.5 +​ +25.7 +​ +48.5 +​ +20.1 +​ +Income Taxes +​ +( 1.0 ) +​ +( 7.3 ) +​ +( 12.3 ) +​ +( 4.5 ) +​ +Net Income +​ +$ +12.5 +​ +$ +18.4 +​ +$ +36.2 +​ +$ +15.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Share: +​ +$ +0.29 +​ +$ +0.43 +​ +$ +0.84 +​ +$ +0.36 +​ +Diluted Earnings Per Share: +​ +$ +0.29 +​ +$ +0.43 +​ +$ +0.84 +​ +$ +0.36 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2018 +(In millions, except per share amounts) +Q1 +Q2 +Q3 +Q4 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +379.3 +​ +$ +406.6 +​ +$ +437.3 +​ +$ +418.1 +​ +Logistics +​ +132.1 +​ +150.5 +​ +152.1 +​ +146.8 +​ +Total Operating Revenue +​ +$ +511.4 +​ +$ +557.1 +​ +$ +589.4 +​ +$ +564.9 +​ +Operating Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +24.5 +​ +$ +36.5 +​ +$ +48.7 +​ +$ +21.4 +​ +Logistics +​ +4.2 +​ +9.5 +​ +9.9 +​ +9.1 +​ +Total Operating Income +​ +28.7 +​ +46.0 +​ +58.6 +​ +30.5 +​ +Interest expense, net +​ +( 5.0 ) +​ +( 5.0 ) +​ +( 4.4 ) +​ +( 4.3 ) +​ +Other income (expense), net +​ +​ +0.8 +​ +​ +0.4 +​ +​ +0.7 +​ +​ +0.7 +​ +Income before Income Taxes +​ +24.5 +​ +41.4 +​ +54.9 +​ +26.9 +​ +Income Taxes +​ +( 10.3 ) +​ +( 8.8 ) +​ +( 13.3 ) +​ +( 6.3 ) +​ +Net Income +​ +$ +14.2 +​ +$ +32.6 +​ +$ +41.6 +​ +$ +20.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Share: +​ +$ +0.33 +​ +$ +0.76 +​ +$ +0.97 +​ +$ +0.48 +​ +Diluted Earnings Per Share: +​ +$ +0.33 +​ +$ +0.76 +​ +$ +0.97 +​ +$ +0.48 +​ +​ +The following infrequent transactions impacted the Company’s quarterly segment results during the years ended December 31, 2019 and 2018: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2019 +(In millions) +Q1 +Q2 +Q3 +Q4 +Income taxes - Discrete adjustments related to the Tax Act (1) +​ +$ +2.9 +​ +$ +— +​ +$ +— +​ +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2018 +(In millions) +Q1 +Q2 +Q3 +Q4 +Income taxes - Discrete adjustments related to the Tax Act (1) +​ +$ +( 3.3 ) +​ +$ +0.2 +​ +$ +— +​ +$ +0.2 +​ +(1) Amounts relate to discrete adjustments as a result of applying the Tax Act during the years ended December 31, 2019 and 2018. +​ +72 +​ +Table of Contents +​ +​ +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +​ +None. +​ +ITEM 9A. CONTROLS AND PROCEDURES +​ +Conclusion Regarding Effectiveness of Disclosure Controls and Procedures +​ +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective. +​ +Internal Control over Financial Reporting +​ +See page 37 for management’s annual report on internal control over financial reporting, which is incorporated herein by reference. +​ +See page 38 for the attestation report of the independent registered public accounting firm on the Company’s internal control over financial reporting, which is incorporated herein by reference. +​ +There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company’s fiscal fourth quarter ended December 31, 2019, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +​ +ITEM 9B. OTHER INFORMATION +​ +None. +​ +73 +​ +Table of Contents +PART III +​ +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +​ +A. +Directors +​ +The information about the Directors of Matson required under this item will be included under the section captioned “Election of Directors” in Matson’s Proxy Statement for the 2020 Annual Meeting of Shareholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2019 (“Matson’s 2020 Proxy Statement”), which section is incorporated herein by reference. +​ +B. +Executive Officers +​ +The information about the executive officers of Matson required under this item will be included under the subsection captioned “Executive Officers” in Matson’s 2020 Proxy Statement, which subsection is incorporated herein by reference. +​ +C. +Corporate Governance +​ +The information about the Audit Committee of the Matson Board of Directors and compliance with Section 16(a) of the Exchange Act, will be included under the subsections captioned “Board of Directors and Committees of Board” and “Delinquent Section 16(a) Reports” in Matson’s 2020 Proxy Statement, which subsections are incorporated herein by reference. +​ +D. +Code of Ethics +​ +The information about Matson’s Code of Ethics required under this item will be included under the subsection captioned “Code of Ethics” in Matson’s 2020 Proxy Statement, which subsection is incorporated herein by reference. +​ +ITEM 11. EXECUTIVE COMPENSATION +​ +The information required under this item will be included under the section captioned “Executive Compensation” and the subsections captioned “Compensation of Directors” and “Pay Risk Assessment” in Matson’s 2020 Proxy Statement, which section and subsections are incorporated herein by reference. +​ +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +​ +The information required under this item will be included under the section captioned “Security Ownership of Certain Shareholders” and the subsections captioned “Security Ownership of Directors and Executive Officers” in Matson’s 2020 Proxy Statement, which section and subsections are incorporated herein by reference. +​ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +​ +The information required under this item will be included in the section captioned “Election of Directors” and the subsection captioned “Certain Relationships and Transactions” in Matson’s 2020 Proxy Statement, which section and subsection are incorporated herein by reference. +​ +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +​ +The information concerning principal accountant fees and services required under this item will be included under the sections captioned “Audit Committee Report” and “Ratification of Appointment of Independent Registered Public Accounting Firm” in Matson’s 2020 Proxy Statement, which sections are incorporated herein by reference. +​ +74 +​ +Table of Contents +PART IV +​ +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +​ +A. +Financial Statements +​ +The Consolidated Financial Statements are set forth in Item 8 of Part II above. +​ +B. +Financial Statement Schedules +​ +Except as described below, all schedules are omitted because of the absence of the conditions under which they are required or because the information called for is included in the Consolidated Financial Statements or notes thereto. +​ +At December 31, 2019, the Company’s investment in SSAT exceeded the 10.0 percent and 20.0 percent thresholds in at least one of the tests under Rule 3-09 and Rule 4-08(g) of Regulation S-X, and as such the audited financial statements of SSAT are required to be filed as financial statement schedules herein within 90 days of SSAT’s fiscal year end, which is January 31. Accordingly, the financial statements of SSAT will be filed via an amendment to this Annual Report on Form 10-K on or before April 30, 2020. +​ +C. +Exhibits Required by Item 601 of Regulation S - K +​ +Exhibits not filed herewith are incorporated by reference to the exhibit number and previous filing shown in parentheses. All previous exhibits were filed with the Securities and Exchange Commission in Washington, D.C. +​ +Exhibits filed pursuant to the Securities Exchange Act of 1934 were filed under file number 001-34187. Shareholders may obtain copies of exhibits for a copying and handling charge of $0.15 per page by writing to, Corporate Secretary, Matson, Inc., 555 12th Street, Oakland, California 94607. +​ +​ +2 +Plan of acquisition, reorganization, arrangement, liquidation or succession. +​ +​ +2.1 +Agreement and Plan of Merger, dated as of November 11, 2014, by and among Matson Navigation Company, Inc., Hogan Acquisition Inc. and Horizon Lines, Inc. (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated November 11, 2014). +​ +​ +2.2 +Amendment No. 1 to Agreement and Plan of Merger, dated as of February 13, 2015, by and among Matson Navigation Company, Inc., Hogan Acquisition Inc. and Horizon Lines, Inc. (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated February 17, 2015). +​ +​ +2.3 +Contribution, Assumption and Purchase Agreement, dated as of November 11, 2014, by and among The Pasha Group, SR Holding LLC, Horizon Lines, Inc. and Sunrise Operations LLC (incorporated by reference to Exhibit 2.2 of Horizon Lines, Inc.’s Form 8-K dated November 13, 2014). +​ +​ +2.4 +Amendment No. 1 to the Contribution, Assumption and Purchase Agreement, dated as of May 29, 2015, by and among The Pasha Group, SR Holding LLC, Horizon Lines, Inc. and Sunrise Operations LLC (incorporated by reference to Exhibit 2.2 of Matson’s Form 10-Q for the quarter ended June 30, 2015). +​ +​ +2.5 +Membership Interest Purchase Agreement, dated as of July 18, 2016, by and between Matson Logistics, Inc. and Span Holdings, LLC (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated July 19, 2016). +​ +​ +3 +Articles of incorporation and bylaws. +​ +​ +3.1 +Amended and Restated Articles of Incorporation of Matson, Inc. (incorporated by reference to Exhibit 3.1 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +​ +​ +75 +​ +Table of Contents +3.2 +Articles of Amendment to Change Corporate Name (incorporated by reference to Exhibit 4.2 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +3.3 +Amended and Restated Bylaws of Matson, Inc. (as amended as of November 6, 2013) (incorporated by reference to Exhibit 3.1 of Matson’s Form 10-Q for the quarter ended September 30, 2013). +​ +​ +4** +Description of Registered Securities. +​ +​ +10 +Material contracts. +​ +​ +10.1 +Amended and Restated Credit Agreement among Matson, Inc., Bank of America, N.A., as the Agent, and the lenders thereto, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.2 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.3 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.3 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.4 +Amendment to Third Amended and Restated Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.4 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.5 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.5 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.6 +Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of December 21, 2016 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated December 22, 2016). +​ +​ +10.7 +Third Amended and Restated Note Purchase and Private Shelf Agreement among Matson, Inc. and the purchasers party thereto, dated as of September 14, 2016 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated September 14, 2016). +​ +​ +10.8 +Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of July 30, 2015 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated August 3, 2015). +​ +​ +10.9 +Amendment to the Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of July 30, 2015 (incorporated by reference to Exhibit 10.3 of Matson’s Form 8-K dated August 3, 2015). +​ +​ +10.10 +First Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of October 1, 2015 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated October 2, 2015). +​ +​ +10.11 +Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of November 5, 2013 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated January 29, 2014). +​ +​ +10.12 +Amended and Restated Limited Liability Company Agreement of SSA Terminals, LLC by and between SSA Ventures, Inc. and Matson Ventures, Inc., dated as of April 24, 2002 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.1 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +​ +​ +10.13 +Parent Company Agreement, dated as of April 24, 2002, by and among SSA Pacific Terminals, Inc., formerly known as Stevedoring Services of America, Inc., SSA Ventures, Inc., Matson Navigation +76 +​ +Table of Contents +Company, Inc. and Matson Ventures, Inc. (incorporated by reference to Exhibit 10.2 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +​ +​ +10.14 +Security Agreement between Matson Navigation Company, Inc. and the United States of America, with respect to $55 million of Title XI ship financing bonds, dated July 29, 2004 (incorporated by reference to Exhibit 10.a.(xxvi) of Alexander & Baldwin, Inc.’s Form 10-Q for the quarter ended September 30, 2004). +​ +​ +10.15 +Amendment No. 1 dated September 21, 2007, to Security Agreement between Matson Navigation Company, Inc. and the United States of America, with respect to $55 million of Title XI ship financing bonds, dated July 29, 2004 (incorporated by reference to Exhibit 10.a.(xxx) of Alexander & Baldwin, Inc.’s Form 10-Q for the quarter ended September 30, 2007). +​ +​ +10.16* +Matson, Inc. 2007 Incentive Compensation Plan, amended and restated, effective January 29, 2015 (incorporated by reference to Exhibit 10.13 of Matson’s Form 10-K for the year ended December 31, 2014). +​ +​ +10.17* +Form of Notice of Stock Option Grant (incorporated by reference to Exhibit 99.2 to Matson’s Form S-8 dated October 26, 2012). +​ +​ +10.18* +Form of Stock Option Agreement for Non-Executive Employees (incorporated by reference to Exhibit 99.3 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +10.19* +Form of Stock Option Agreement for Executive Employees (incorporated by reference to Exhibit 99.4 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +10.20* +Form of Amended and Restated Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election) (incorporated by reference to Exhibit 10.21 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.21* +Form of Anti-Dilution Adjustment Amendment to Restricted Stock Unit Award Agreements (incorporated by reference to Exhibit 99.10 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +10.22* +Form of Anti-Dilution Adjustment Amendment to Stock Option Agreements (incorporated by reference to Exhibit 99.11 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +10.23* +Form of Stock Option Assumption Agreement (incorporated by reference to Exhibit 99.4 of Post-Effective Amendment No. 2 to Alexander & Baldwin, Inc.’s Form S-8 dated June 6, 2012). +​ +​ +10.24* +Special Form of Stock Option Assumption Agreement (incorporated by reference to Exhibit 99.6 of Post-Effective Amendment No. 2 to Alexander & Baldwin, Inc.’s Form S-8 dated June 6, 2012). +​ +​ +10.25* +Matson, Inc. Deferred Compensation Plan for Outside Directors (incorporated by reference to Exhibit 10.34 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.26* +Matson, Inc. Excess Benefits Plan, amended and restated effective August 27, 2014 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated August 28, 2014). +​ +​ +10.27* +Form of Letter Agreement entered into with certain executive officers (incorporated by reference to Exhibit 10.45 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.28* +Schedule identifying executive officers who have entered into Form of Letter Agreement (incorporated by reference to Exhibit 10.42 of Matson’s Form 10-K for the year ended December 31, 2014). +​ +​ +10.29* +Form of Letter Agreement entered into with executive officer (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated October 24, 2014). +​ +​ +77 +​ +Table of Contents +10.30*,** +Letter Agreement Counter Party. +​ +​ +10.31* +Matson, Inc. Executive Severance Plan (incorporated by reference to Exhibit 10.47 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.32* +Matson, Inc. Deferred Compensation Plan (incorporated by reference to Exhibit 10.51 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.33 +Shipbuilding Contract, by and between Aker Philadelphia Shipyard, Inc. and Matson Navigation Company, Inc., dated as of November 6, 2013 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.56 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.34 +Shipbuilding Contract, by and between Aker Philadelphia Shipyard, Inc. and Matson Navigation Company, Inc., dated as of November 6, 2013 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.57 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.35 +Guaranty Agreement by Aker Philadelphia Shipyard ASA, in favor of Matson Navigation Company, Inc., dated as of November 6, 2013 (incorporated by reference to Exhibit 10.58 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.36 +Contract for Construction of Two Vessels, dated as of August 25, 2016, by and between Matson Navigation Company, Inc. and National Steel and Shipbuilding Company (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.1 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +​ +​ +10.37 +Purchaser’s Corporate Guaranty Agreement, by Matson, Inc., dated as of August 25, 2016 (incorporated by reference to Exhibit 10.2 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +​ +​ +10.38 +Contractor’s Corporate Guaranty Agreement, by General Dynamics Corporation, dated as of August 25, 2016 (incorporated by reference to Exhibit 10.3 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +​ +​ +10.39 +Form of Capital Construction Fund Agreement with Matson Navigation Company, as amended by Addendums No. 2, No. 5, No. 18, No. 20 and No. 31, thereto (incorporated by reference to Exhibit 10.60 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.40 +Form of Voting Agreement, dated as of November 11, 2014, among Matson Navigation Company, Inc. and certain holders of voting securities of Horizon Lines, Inc. (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated November 11, 2014). +​ +​ +10.41* +Matson, Inc. 2016 Incentive Compensation Plan, amended as of October 25, 2017 (incorporated by reference to Exhibit 10.56 of Matson’s Form 10-K for the year ended December 31, 2017). +​ +​ +10.42* +Amended and Restated Matson, Inc. Cash Incentive Plan, effective January 1, 2016 (incorporated by reference to Exhibit 10.63 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.43* +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (No Deferral) (incorporated by reference to Exhibit 10.64 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.44* +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election) (incorporated by reference to Exhibit 10.65 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +78 +​ +Table of Contents +10.45* +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Non-Executive Employees (incorporated by reference to Exhibit 10.60 of Matson’s Form 10-K for the year ended December 31, 2017) . +​ +​ +10.46* +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Executive Employees (incorporated by reference to Exhibit 10.61 of Matson’s Form 10-K for the year ended December 31, 2017) . +​ +​ +10.47* +Form of 2016 Plan Performance Share Award Agreement for Non-Executive Employees (incorporated by reference to Exhibit 10.62 of Matson’s Form 10-K for the year ended December 31, 2017) . +​ +​ +10.48* +Form of 2016 Plan Performance Share Award Agreement for Executive Employees (incorporated by reference to Exhibit 10.63 of Matson’s Form 10-K for the year ended December 31, 2017) . +​ +​ +10.49* +Form of Notice of 2016 Plan Performance Share Award Grant for Non-Executive Employees (incorporated by reference to Exhibit 10.70 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.50* +Form of Notice of 2016 Plan Performance Share Award Grant for Executive Employees (incorporated by reference to Exhibit 10.71 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.51* +Form of Notice of 2016 Time-Based Restricted Stock Unit Award Grant for Non-Executive Employees (incorporated by reference to Exhibit 10.72 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.52* +Form of Notice of 2016 Time-Based Restricted Stock Unit Award Grant for Executive Employees (incorporated by reference to Exhibit 10.73 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.53* +Addendum to Award Agreements for Outstanding Equity Awards, effective as of October 25, 2017 (incorporated by reference to Exhibit 10.68 of Matson’s Form 10-K for the year ended December 31, 2017) +​ +​ +21** +Matson, Inc. Subsidiaries as of February 19, 2020. +​ +​ +23** +Consent of Deloitte & Touche, LLP dated February 28, 2020. +​ +​ +31.1** +Certification of Chief Executive Officer, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +​ +​ +31.2** +Certification of Chief Financial Officer, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +​ +​ +32*** +Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +​ +​ +​ +​ +101.INS** +XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH** +XBRL Taxonomy Extension Schema Document +101.CAL** +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF** +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB** +XBRL Taxonomy Extension Label Linkbase Document +101.PRE** +XBRL Taxonomy Extension Presentation Linkbase Document +104** +Cover Page Interactive Data File – the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +* Indicates management contract or compensatory plan or arrangement. +** Filed herewith. +*** Furnished herewith. +79 +​ +Table of Contents +​ +​ +SIGNATURES +​ +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +​ +​ +​ +MATSON, INC. +​ +(Registrant) +​ +​ +Date: February 28, 2020 +/s/ Matthew J. Cox +​ +Matthew J. Cox +​ +Chairman and +​ +Chief Executive Officer +​ +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. +​ +Signature +​ +Title +​ +Date +​ +​ +​ +​ +​ +/s/ Matthew J. Cox +​ +Chairman and Chief Executive Officer +​ +February 28, 2020 +Matthew J. Cox +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Blake Baird +​ +Director +​ +February 28, 2020 +W. Blake Baird +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Thomas B. Fargo +​ +Director +​ +February 28, 2020 +Thomas B. Fargo +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Mark H. Fukunaga +​ +Director +​ +February 28, 2020 +Mark H. Fukunaga +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Stanley M. Kuriyama +​ +Director +​ +February 28, 2020 +Stanley M. Kuriyama +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Constance H. Lau +​ +Director +​ +February 28, 2020 +Constance H. Lau +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Jenai S. Wall +​ +Director +​ +February 28, 2020 +Jenai S. Wall +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Joel M. Wine +​ +Senior Vice President and Chief Financial Officer +​ +February 28, 2020 +Joel M. Wine +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Kevin L. Stuck +​ +Vice President and Controller (principal accounting officer) +​ +February 28, 2020 +Kevin L. Stuck +​ +​ +​ +​ +​ +***** +​ +​ +​ +80 +​ \ No newline at end of file diff --git a/raw/filings/0000003453/2019/0001558370-20-001757/filing_metadata.csv b/raw/filings/0000003453/2019/0001558370-20-001757/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..f68c22664fd82c84f32e2fb2a5ccce55cb86f414 --- /dev/null +++ b/raw/filings/0000003453/2019/0001558370-20-001757/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003453,MATX,"Matson, Inc.",2019,10-K,2020-02-28,2019-12-31,2020-02-28T20:00:10.000Z,0001558370-20-001757,matx-20191231x10kddf34b.htm,10-K,20221776,1,1,https://www.sec.gov/Archives/edgar/data/3453/000155837020001757/matx-20191231x10kddf34b.htm,https://www.sec.gov/Archives/edgar/data/3453/000155837020001757/ diff --git a/raw/filings/0000003453/2019/0001558370-20-001757/item1.txt b/raw/filings/0000003453/2019/0001558370-20-001757/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..ffac0b04a5d71f82d6f63ed8ca3668dd1b5b508f --- /dev/null +++ b/raw/filings/0000003453/2019/0001558370-20-001757/item1.txt @@ -0,0 +1,718 @@ +ITEM 1. BUSINESS +​ +A. COMPANY OVERVIEW +​ +Matson, Inc., a holding company incorporated in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information by segment for the three years ended December 31, 2019, see Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates a premium, expedited service from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific. In addition, subsidiaries of MatNav provide container stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +​ +Matson has a 35 percent ownership interest in SSA Terminals, LLC, a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc., a subsidiary of Carrix, Inc. (“SSAT”). SSAT provides terminal and stevedoring services to various carriers at eight terminal facilities on the U.S. West Coast, including four facilities dedicated for MatNav’s use. Matson records its share of income from SSAT in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +​ +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively, “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively, “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +​ +Our Mission and Vision: +​ +Our mission is to move freight better than anyone. Our vision is to create value for our shareholders by: +​ +◾ Being our customers’ first choice, +◾ Leveraging our core strengths to drive growth and increase profitability, +◾ Improving the communities in which we work and live, +◾ Being an environmental leader in our industry, and +◾ Being a great place to work. +​ +1 +​ +Table of Contents +B. BUSINESS DESCRIPTION +​ +(1) +OCEAN TRANSPORTATION SEGMENT +​ +Ocean Transportation Services: +​ +Matson’s Ocean Transportation segment provides the following services: +​ +Hawaii Service: Matson’s Hawaii service provides ocean carriage (lift-on/lift-off, roll-on/roll-off and conventional services) between the ports of Long Beach and Oakland, California; Seattle, Washington; and Honolulu, Hawaii. Matson also operates a network of inter-island barges that provide connecting services from its hub at Honolulu, Oahu to other major Hawaii ports on the islands of Hawaii, Maui and Kauai. Matson is the largest carrier of ocean cargo between the U.S. West Coast and Hawaii. +​ +Westbound cargo carried by Matson to Hawaii includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, building materials, automobiles and household goods. Matson’s eastbound cargo from Hawaii includes automobiles, household goods, dry containers of mixed commodities and livestock. The majority of Matson’s Hawaii service revenue is derived from the westbound carriage of containerized freight and automobiles. +​ +China Service: Matson’s expedited China-Long Beach Express (“CLX”) is part of an integrated service that carries cargo from Long Beach, California to Honolulu, Hawaii, to Guam, and then to Okinawa, Japan. The vessels continue to Ningbo and Shanghai, China, where they are loaded with cargo to be discharged primarily in Long Beach, California. These vessels also carry cargo destined for Hawaii which originated in Guam, Micronesia, Japan and China. Matson provides container transshipment services from many locations in Asia including Hong Kong and Xiamen, China to the ports of Ningbo and Shanghai, China. +​ +Eastbound cargo from China to Long Beach, California consists mainly of garments, footwear, e-commerce and other retail merchandise. Westbound cargo to China and other destinations in Asia consists mainly of recycling materials. +​ +Guam Service: Matson’s Guam service provides weekly carriage between the U.S West Coast and Guam, as part of its expedited CLX service. Matson also provides weekly connecting service from Guam to the Commonwealth of the Northern Mariana Islands. Cargo destined to these markets is similar to that described in the “Hawaii Service” section above. +​ +Japan Service: Matson’s Japan service provides carriage to the port of Naha in Okinawa, Japan, as part of its expedited CLX service. This service carries mainly general sustenance cargo and household goods supporting the U.S. military. +​ +Micronesia Service: Matson’s Micronesia service provides carriage between the U.S. West Coast and the islands of Kwajalein, Ebeye and Majuro in the Republic of the Marshall Islands, the islands of Yap, Pohnpei, Chuuk and Kosrae in the Federated States of Micronesia, and the Republic of Palau. Cargo destined for these locations is transshipped through Guam and consists mainly of general sustenance cargo. +​ +Alaska Service: Matson’s Alaska service provides ocean carriage (lift-on/lift-off and conventional services) between the port of Tacoma, Washington, and the ports of Anchorage, Kodiak and Dutch Harbor, Alaska. Matson also provides a barge service between Dutch Harbor and Akutan in Alaska, and transportation services to other locations in Alaska including the Kenai Peninsula, Fairbanks and the North Slope. +​ +Northbound cargo to Alaska includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, household goods and automobiles. Southbound cargo from Alaska primarily consists of seafood, household goods and automobiles. +​ +South Pacific Service: Matson’s New Zealand Express (“NZX”) service provides carriage of general sustenance cargo between Auckland, New Zealand and select islands in the South Pacific, including Fiji (Suva and Lautoka), Samoa (Apia), American Samoa (Pago Pago), the Cook Islands (Rarotonga and Aitutaki), Tonga (Nukualofa and Vava’u), and Niue. Matson’s NZX service also provides transshipment services to the islands of Nauru and the Solomon Islands +2 +​ +Table of Contents +(Honiara). Additionally, Matson provides slot charter arrangements for the transportation of cargo from major ports on the east coast of Australia to ports in the South Pacific islands. The NZX service also distributes and sells domestic bulk fuel to a variety of these islands. +​ +Matson’s South Pacific Express (“SPX”) service provides carriage of general sustenance cargo from the U.S. West Coast to ports in the South Pacific islands using vessel sharing agreements with other carriers. The SPX service provides direct calls to Tahiti (Papeete), American Samoa (Pago Pago) and Samoa (Apia) in the South Pacific. Cargo destined for other ports including Tonga (Nukualofa) and the Cook Islands (Rarotonga and Aitutaki) is then transshipped in Apia, Samoa to the NZX service for delivery to its final destination. Northbound SPX cargo originating in the South Pacific is transshipped from the NZX with other carriers to the U.S. West Coast. Cargo destined for Hawaii or Seattle is further transshipped in Oakland, California for delivery to its final destination. +​ +Terminal and Other Related Services: +​ +Matson provides container stevedoring, refrigerated cargo services, inland transportation, container equipment maintenance and other terminal services (collectively, “terminal services”) at terminals located on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai; and in the Alaska terminal locations of Anchorage, Kodiak and Dutch Harbor. +​ +SSAT provides terminal and stevedoring services to various carriers at eight terminal facilities on the U.S. West Coast, including four facilities dedicated for MatNav’s use, in Long Beach and Oakland, California; and in Seattle and Tacoma, Washington. +​ +Matson utilizes the services of other third-party terminal operators at all of the other ports served by its vessels. +​ +Vessel Management Services: +​ +Matson contracts with the U.S. Department of Transportation to provide vessel management services to manage and maintain three Ready Reserve Force vessels on behalf of the U.S. Department of Transportation Maritime Administration. +​ +​ +3 +​ +Table of Contents +Vessel Information: +​ +Vessels: +​ +Matson’s fleet includes both owned and chartered vessels. Matson’s owned vessels represent an investment of approximately $1.7 billion. The majority of Matson’s owned vessels are U.S. flagged and Jones Act qualified vessels, and operate in the Hawaii, China, Guam, Japan, Micronesia and Alaska services. Details of Matson’s active and reserve vessels, and vessel under construction as of December 31, 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Usable Cargo Capacity +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Containers +​ +Vehicles +​ +​ +​ +​ +​ +Maximum +​ +Maximum +​ +Owned/ +Official +​ +Reefer +Year +Speed +Deadweight +Name of Vessels (1) +​ +Chartered +​ +Number +​ +TEUs (2) +​ +Slots +​ +Autos +​ +Built +​ +Length +​ +(Knots) +​ +(Long Tons) +Diesel-Powered +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +DANIEL K. INOUYE (3) +​ +Owned +​ +1274136 +3,220 +408 +​ +— +2018 +854’ 0” +23.5 +50,794 +KAIMANA HILA (3) +​ +Owned +​ +1274135 +​ +3,220 +​ +408 +​ +— +​ +2019 +​ +854’ 0” +​ +23.5 +​ +53,747 +LURLINE (3)(8) +​ +Owned +​ +1274143 +​ +2,750 +​ +432 +​ +500 +​ +2019 +​ +869’ 5” +​ +23.0 +​ +50,562 +MANOA (3) +Owned +651627 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,187 +MAHIMAHI (3) +Owned +653424 +2,824 +408 +— +1982 +860’ 2” +23.0 +30,167 +MANULANI (3) +Owned +1168529 +2,378 +284 +— +2005 +712’ 0” +23.0 +29,517 +MAUNAWILI (3) +Owned +1153166 +2,378 +326 +— +2004 +711’ 9” +23.0 +29,517 +MANUKAI (3) +Owned +1141163 +2,378 +326 +— +2003 +711’ 9” +23.0 +29,517 +R.J. PFEIFFER (3) +Owned +979814 +2,245 +300 +— +1992 +713’ 6” +23.0 +27,100 +MOKIHANA (3) +Owned +655397 +1,994 +354 +1,323 +1983 +860’ 2” +23.0 +29,484 +MAUNALEI (3) +Chartered +1181627 +1,992 +328 +— +2006 +681’ 1” +22.1 +33,771 +MATSON KODIAK (3) +Owned +910308 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON ANCHORAGE (3) +Owned +910306 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +MATSON TACOMA (3) +Owned +910307 +1,668 +280 +— +1987 +710’ 0” +20.0 +37,473 +KAMOKUIKI (4) +Owned +9232979 +707 +100 +— +2000 +433’ 9” +17.5 +8,509 +OLOMANA (5) +​ +Chartered +​ +9184225 +​ +645 +​ +120 +​ +— +​ +2004 +​ +388’ 7” +​ +14.0 +​ +8,200 +IMUA II (5)(10) +Chartered +9184237 +630 +90 +— +2005 +388’ 6” +15.0 +8,071 +LILOA II (5) +Chartered +9184249 +630 +90 +— +2004 +388’ 6” +15.0 +8,071 +PAPA MAU (5) +Owned +1559 +521 +68 +— +1999 +381’ 5” +14.0 +5,364 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Barges +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +MAUNA LOA (3) +Chartered +1247426 +500 +78 +— +2013 +362’ 6” +— +12,678 +HALEAKALA (3)(6) +Owned +676972 +335 +78 +— +1984 +350’ 0” +— +4,658 +ILIULIUK BAY (3)(6) +Chartered +1249384 +178 +— +— +2013 +250’ 0” +— +4,138 +WAIALEALE (3)(7) +Owned +978516 +— +36 +230 +1991 +345’ 0” +— +5,621 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Vessel under Construction +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +MATSONIA (3)(9) +​ +Owned +1274123 +​ +2,750 +​ +432 +​ +500 +​ +2020 +​ +869’ 5” +​ +23.0 +​ +50,562 +(1) Excludes inactive vessels ( SS Lihue , SS Kauai and SS Matsonia ). +(2) Twenty-foot Equivalent Units (“TEU”) is a standard measure of cargo volume correlated to a standard 20-foot dry cargo container. +(3) U.S. flagged and Jones Act qualified vessel or barge. +(4) U.S. flagged vessel. +(5) Foreign flagged vessel. +(6) Lift-on/lift-off barge equipped with a crane. +(7) Roll-on/roll-off barge. +(8) Commenced active service in January 2020. +(9) Expected delivery date during the fourth quarter of 2020. +(10) Vessel is sub-chartered to another shipping company commencing January 2020. +​ +Fleet Renewal Program: +​ +Matson has invested approximately $0.9 billion in the construction of four new vessels. The two Aloha Class containerships, Daniel K. Inouye and Kaimana Hila , commenced active service in November 2018 and April 2019, respectively. The first of two Kanaloa Class combination container and roll-on/roll-off vessels, Lurline , commenced active service in January 2020. Delivery of the second Kanaloa Class vessel, Matsonia , is expected during the fourth quarter of 2020. +​ +4 +​ +Table of Contents +With the delivery of Lurline , Matson returned to a nine-ship deployment serving the Hawaii market commencing in early January of 2020. +​ +Vessel Emission Regulations: +​ +Being a leader in environmental stewardship is one of Matson’s core values. Matson vessels transit through some of the most environmentally sensitive areas in the United States including the Hawaiian Islands and the coasts of California, Oregon, Washington and Alaska. Matson is focused in particular on reducing transportation emissions, including carbon dioxide, nitrous oxide, particulate matter and sulfur dioxide through improvements in vessel fuel consumption and the development of more fuel-efficient transportation solutions. Matson further contributes positively to the environment by testing and deploying leading technologies as the fleet is modernized. +​ +The International Maritime Organization (“IMO”), to which the U.S. and over 100 other countries are signatories, is a specialized agency of the United Nations that sets international environmental standards applicable to vessels operating under the flag of any signatory country. Effective January 1, 2020, the IMO has imposed regulations that generally require all vessels to burn fuel oil with a maximum sulfur content of ≤0.5 percent (“IMO 2020”). There are three main options for a vessel to meet the new IMO 2020 requirements: (1) burn low sulfur fuel oil (“LSFO”), (2) install exhaust gas cleaning systems (commonly referred to as “scrubbers”) on vessels to purify high sulfur fuel oil (“HSFO”), or (3) switch to lower emission fuels such as liquefied natural gas (“LNG”), which requires converting existing vessels or constructing new vessels with LNG-compatible engines and fuel tanks. With respect to North America, all waters, with certain limited exceptions, within 200 nautical miles of U.S. and Canadian coastlines have been designated emission control areas (“ECAs”). Since January 1, 2015, U.S. Environmental Protection Agency regulations have reduced the fuel oil maximum sulfur content in designated ECAs to ≤0.1 percent. +​ +All of Matson’s vessels in the Alaska and Hawaii services are compliant with IMO 2020 and ECA regulations and can use LSFO. In the Alaska service, Matson has installed scrubbers on its three diesel-powered vessels to allow them to use HSFO and still comply with IMO 2020 and ECA regulations. In the Hawaii service, Matson has announced plans to install scrubbers on six diesel-powered vessels to allow them to use HSFO and comply with IMO 2020 and ECA regulations. Installation of scrubbers on the first two of these vessels was completed during 2019, with the remaining four expected to be completed during 2020. Matson’s new Aloha and Kanaloa Class vessels burn compliant LSFO. These new vessels are also equipped with dual-fuel engines and can be converted to run on LNG. All of Matson’s other vessels will use LSFO to meet IMO 2020 and ECA emission standards. +​ +Hawaii Terminal Expansion and Modernization Program: +​ +During 2020, Matson expects to complete the first phase of renovating its terminal facility at Sand Island, Honolulu, Hawaii. The first phase involves the investment of approximately $60 million and includes the installation of three new 65 long-ton capacity gantry cranes and modifications to upgrade three existing cranes. The first phase also includes upgrades in electrical infrastructure and other modifications to the Sand Island terminal. +​ +Additional phases are expected to be completed from 2021 through 2024 as part of a broader terminal expansion and modernization program at Matson’s Sand Island terminal. +​ +Ocean Transportation Equipment: +​ +As a complement to its fleet of vessels, Matson has a variety of equipment including cranes, containers and chassis which represents an investment of approximately $0.5 billion as of December 31, 2019. Matson also leases containers, chassis and other equipment under various operating lease agreements. +​ +Operating Costs: +​ +Major components of Matson’s Ocean Transportation operating costs are as follows: +​ +Direct Cargo Expense includes terminal handling costs, purchased outside transportation and other related costs. +​ +5 +​ +Table of Contents +Vessel Operating Expense includes crew wages and related costs; fuel consumption, pilot, tugs and line related costs; vessel charter expenses; and other vessel related expenses. Matson purchases fuel oil, lubricants and gasoline for its operations and also pays fuel-related surcharges to other third party transportation providers. +​ +Operating Overhead includes equipment repair costs, equipment operating lease and repositioning expenses, vessel repair and maintenance costs, dry-docking amortization, insurance, port engineers and other maintenance costs, and other vessel and shoreside related overhead. +​ +Competition: +​ +The following is a summary of major competitors in Matson’s Ocean Transportation segment: +​ +Hawaii Service: Matson’s Hawaii service has one major U.S. flag Jones Act ocean carrier competitor, Pasha Hawaii (“Pasha”), which operates container and roll-on/roll-off services between the ports of Long Beach, Oakland and San Diego, California to Hawaii. There also are two U.S. flag Jones Act barge operators, Aloha Marine Lines and Sause Brothers, which offer barge service between the Pacific Northwest and Hawaii. +​ +Foreign-flag vessels carrying cargo to Hawaii from non-U.S. locations also provide alternatives for companies shipping to Hawaii. Other competitors in the Hawaii service include proprietary operators and contract carriers of bulk cargo. Airfreight competition for time-sensitive cargo exists; however, cargo volume has been limited primarily due to the cost of airfreight transportation. +​ +Matson vessels are operated on schedules that provide customers, shippers and consignees fixed day-of-the-week sailings from the U.S. West Coast as well as fixed day-of-the-week arrivals in Hawaii. Matson offers five westbound departures per week, though this amount may be adjusted according to market conditions. One of Matson’s westbound sailings each week continues from Honolulu on to Guam, Japan and China. Matson offers two weekly eastbound departures from Honolulu to the U.S. Mainland. These sailings call on three U.S. West Coast ports each week. Matson’s frequent sailings permit customers to reduce inventory carrying costs. Matson also competes by offering a more comprehensive service to customers, including: service to and from the three largest U.S. West Coast ports; the most efficient terminal network on the U.S. West Coast provided by SSAT; a dedicated inter-island barge network; a world-class customer service team; and its efficiency and experience in handling cargo of all types. +​ +Alaska Service: Matson’s Alaska service has one major U.S. flag Jones Act competitor, Totem Ocean Trailer Express, Inc., which operates a roll-on/roll off service between Tacoma, Washington and Anchorage, Alaska. There are also two U.S. flag Jones Act barge operators, Alaska Marine Lines, which mainly provides services from Seattle, Washington to the ports of Anchorage and Dutch Harbor, and other locations in Alaska, and Samson Tug & Barge, which mainly serves Western Alaska and other locations. The barge operators have historically shipped lower value commodities that can accommodate a longer transit time, as well as construction materials and other cargo that are not conducive to movement in containers. Foreign-flag vessels provide alternatives for companies shipping cargo (mainly seafood) from the Alaska ports of Kodiak and Dutch Harbor. +​ +Matson offers customers twice weekly scheduled service from Tacoma, Washington to Anchorage and Kodiak, Alaska and weekly service to Dutch Harbor, Alaska. The Company also provides a barge service between Dutch Harbor and Akutan in Alaska. Matson is the only Jones Act containership operator providing service to Kodiak and Dutch Harbor in Alaska, which are the primary loading ports for southbound seafood. Matson offers dedicated terminal services at the Alaska ports of Anchorage, Kodiak and Dutch Harbor performed by MatNav, and at the port of Tacoma, Washington performed by SSAT. +​ +China Service: Major competitors to Matson’s China service include large international carriers such as ONE (formerly “K” Line, NYK Line and MOL), Maersk, CMA CGM and its subsidiary APL, Evergreen, COSCO and SM Line. +​ +Matson competes by offering a fast and reliable service from the ports of Ningbo and Shanghai in China to Long Beach, California, providing fixed day arrivals and next-day cargo availability. Matson’s service is further differentiated by offering a dedicated marine terminal in Long Beach, California operated by SSAT, an off-dock container yard providing fast truck turn times, dedicated chassis, one-stop intermodal connections, and providing world-class customer service. +6 +​ +Table of Contents +Matson has offices located in Hong Kong, Shenzhen, Xiamen, Ningbo and Shanghai, and has contracted with terminal operators in Ningbo and Shanghai. +​ +Guam Service: Matson’s Guam service has one major competitor, APL, which operates a weekly U.S. flagged container feeder service connecting the U.S. West Coast to Guam and Saipan, via transshipments over Yokohama, Japan. Waterman operates a roll-on/roll-off service, which periodically calls at Guam. There are also several foreign carriers, including APL, that call at Guam from foreign origin ports. +​ +Japan Service: Matson’s Japan service competes primarily with APL, which operates a weekly U.S. flagged containership service from the U.S. West Coast to the port of Naha, Okinawa, Japan. +​ +Micronesia and South Pacific Services: Matson’s Micronesia and South Pacific services have competition from a variety of local and international carriers that provide freight services to the area. +​ +Customer Concentration: +​ +Matson serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2019, 2018 and 2017, the Company’s 10 largest Ocean Transportation customers accounted for approximately 23 percent, 24 percent and 23 percent of the Company’s Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Matson’s Ocean Transportation operating revenues. For additional information on Ocean Transportation revenues for the years ended December 31, 2019, 2018 and 2017, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +Matson’s Ocean Transportation services typically experience seasonality in volume, generally following a pattern of increasing volumes starting in the second quarter of each year, culminating in a peak season throughout the third quarter, with subsequent decline in demand during the fourth and first quarters. This seasonality trend is amplified in the Alaska service primarily due to winter weather and the timing of southbound seafood trade. As a result, earnings tend to follow a similar pattern, offset by periodic vessel dry-docking and other episodic cost factors, which can lead to earnings variability. In addition, in the China trade, volume is driven primarily by U.S. consumer demand for goods during key retail selling seasons while freight rates are impacted mainly by macro supply and demand variables. +​ +Maritime Laws and the Jones Act : +​ +Maritime Laws: All interstate and intrastate marine commerce within the U.S. falls under the Merchant Marine Act of 1920 (commonly referred to as the Jones Act). +​ +The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, be manned predominantly by U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75 percent owned by U.S. citizens. U.S. flagged vessels are generally required to be maintained at higher standards than foreign flagged vessels and are subject to rigorous supervision and inspections by, or on behalf of, the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Under Section 27 of the Jones Act, the carriage of cargo between the U.S. West Coast, Hawaii and Alaska on foreign-built or foreign-documented vessels is prohibited. +​ +During the years ended December 31, 2019, 2018 and 2017, approximately 72 percent of Matson’s Ocean Transportation revenues came from the Hawaii and Alaska trades that were subject to the Jones Act. Matson’s Hawaii and Alaska trade routes are included within the non-contiguous Jones Act market. Hawaii, as an island economy, and Alaska due to its geographical location, are both dependent on ocean transportation. The Jones Act ensures frequent, reliable, roundtrip service to these locations. Matson’s vessels operating in these trade routes are Jones Act qualified. +​ +Matson is a member of the American Maritime Partnership (“AMP”) which supports the retention of the Jones Act and similar cabotage laws. The Jones Act has broad support from both houses of Congress. Matson believes that the ongoing war on terrorism and geopolitical environment have further solidified political support for U.S. flagged vessels +7 +​ +Table of Contents +because a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support. AMP seeks to inform elected officials and the public about the economic, national security, commercial, safety and environmental benefits of the Jones Act and similar cabotage laws. Repeal of the Jones Act would allow foreign-flag vessel operators that do not have to abide by all U.S. laws and regulations to sail between U.S. ports in direct competition with Matson and other U.S. domestic operators that must comply with all such laws and regulations. +​ +Other U.S. maritime laws require vessels operating between Guam, a U.S. territory, and U.S. ports to be U.S. flagged and predominantly U.S. crewed, but not U.S. built. +​ +Cabotage laws are not unique to the United States, and similar laws exist around the world in over 90 countries, including regions in which Matson provides ocean transportation services. Any changes in such laws may have an impact on the services provided by Matson in those regions. +​ +Rate Regulations and Fuel-Related Surcharges: +​ +Matson is subject to the jurisdiction of the Surface Transportation Board with respect to its domestic ocean rates. A rate in the non-contiguous domestic trade is presumed reasonable and will not be subject to investigation if the aggregate of increases and decreases is not more than 7.5 percent above, or more than 10 percent below, the rate in effect one year before the effective date of the proposed rate, subject to increase or decrease by the percentage change in the U.S. Producer Price Index. Matson generally provides a 30-day notice to customers of any increases in general rates and other charges, and passes along decreases as soon as possible. +​ +Matson’s Ocean Transportation services engaged in U.S.-foreign commerce are subject to the jurisdiction of the Federal Maritime Commission (“FMC”). The FMC is a federal independent regulatory agency that is responsible for the regulation of international oceanborne transportation to and from the U.S. +​ +Matson applies a fuel-related surcharge rate to its Ocean Transportation customers. Changes in the fuel-related surcharge levels are correlated to market rates for bunker fuel prices along with other factors related to fuel expense recovery. +​ +Other Environmental Regulations: +​ +In addition to the vessel emission regulations discussed above, Matson’s operations are required to comply with other environmental regulations and requirements including the O il Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. The Company actively monitors its operations to ensure compliance with these and other regulations. +​ +For more information on Matson’s environmental stewardship initiatives, including its environmental goals, see https://www.matson.com/corporate/about_us/environmental.html . The contents of our website are not incorporated by reference into this Form 10-K. +​ +(2) +LOGISTICS SEGMENT +​ +Logistics Services: +​ +Matson Logistics provides the following services: +Transportation Brokerage Services: Matson Logistics provides intermodal rail, highway, and other third-party logistics services for North American customers and international ocean carrier customers, including MatNav. Matson Logistics strives to reduce transportation costs for its customers through volume purchases of rail, motor carrier and ocean transportation services, augmented by services such as shipment tracking and tracing, and single-vendor invoicing. Matson Logistics operates customer service centers and has sales offices throughout North America. +8 +​ +Table of Contents +Freight Forwarding Services: Matson Logistics provides LCL consolidation and freight forwarding services primarily to the Alaska market through its wholly owned subsidiary, Span Intermediate, LLC (“Span Alaska”). Span Alaska’s business aggregates LCL freight at its cross-dock facility in Auburn, Washington for consolidation and shipment to a network of cross-dock facilities in Alaska. Span Alaska also provides trucking services to its Auburn cross-dock facility and from its Alaska based cross-dock facilities to final customer destinations in Alaska. +Warehousing and Distribution Services: Matson Logistics operates two warehouses in Georgia and two warehouses in Northern California providing warehousing, value-added packaging and distribution services. +​ +Supply Chain Management and Other Services: Matson Logistics provides customers with a variety of logistics services including purchase order management, customs brokerage, LCL and full container load NVOCC freight forwarding services. Matson Logistics operates a customer service center in Shanghai, China to support its supply chain operations in North America, China and other locations. +​ +Investment in Anchorage Service Center: +​ +During the fourth quarter of 2019, Span Alaska completed the construction of a new 54,000 square foot cross-dock facility (“Anchorage Service Center”) to consolidate its Anchorage operations that previously operated from two smaller leased facilities. The Anchorage Service Center is expected to improve Span Alaska’s operating efficiency while providing additional capacity for long-term growth. +​ +Operating Costs: +​ +Matson Logistics’ operating costs primarily consist of the costs of purchased transportation, leases of warehouses, cross-dock and other facility operating costs, salaries and benefits, and other operating overhead. +​ +Competition: +​ +Matson Logistics competes with hundreds of local, regional, national and international companies that provide transportation and third-party logistics services. The industry is highly fragmented and, therefore, competition varies by geography and areas of service. +​ +Matson Logistics’ transportation brokerage services competes most directly with C.H. Robinson Worldwide, the Hub Group, XPO and other freight brokers and intermodal marketing companies, and asset-invested market leaders such as J.B. Hunt. Competition is differentiated by the depth, scale and scope of customer relationships; vendor relationships and rates; network capacity; real-time visibility into the movement of customers’ goods; and other technology solutions. Additionally, while Matson Logistics primarily provides surface transportation brokerage, it also competes to a lesser degree with other forms of transportation for the movement of cargo. +​ +Matson Logistics’ freight forwarding services compete most directly with a variety of freight forwarding companies that operate within Alaska including Carlile, Lynden, American Fast Freight and Alaska Traffic Company. +​ +Customer Concentration: +​ +Matson Logistics serves customers in numerous industries and geographical locations. In 2019, 2018 and 2017, the Company’s 10 largest logistics customers accounted for approximately 21 percent, 23 percent and 19 percent of Matson Logistics’ revenue, respectively. None of these customers individually accounts for more than 10 percent of Matson Logistics’ operating revenues. For additional information on Logistics revenues for the years ended December 31, 2019, 2018 and 2017, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +Matson Logistics’ services are generally not significantly impacted by seasonality factors, except for its freight forwarding service to Alaska which is affected by the winter weather, the cyclical nature of the oil and construction industries, and the seasonal nature of the tourism industry. +​ +9 +​ +Table of Contents +C. EMPLOYEES AND LABOR RELATIONS +​ +Employees: +​ +As of December 31, 2019, Matson and its subsidiaries had 1,988 employees, of which 794 employees were covered by collective bargaining agreements with shoreside unions. These numbers do not include billets on vessels discussed below, employees of SSAT, or other non-employees, such as agents, temporary workers and contractors. +​ +Matson’s fleet of active vessels require 298 billets to operate these vessels. Each billet corresponds to a position on a vessel that typically is filled by two or more employees because seagoing personnel rotate between active sea-duty and time ashore. These amounts exclude billets related to Matson’s foreign flagged chartered vessels where the vessel owner is responsible for its seagoing personnel. Matson’s vessel management services also employed personnel in 28 billets to manage three vessels. +​ +Bargaining Agreements: +​ +Matson’s shoreside and seagoing employees are represented by a variety of unions. Matson has collective bargaining agreements with these unions that expire at various dates in the future. While Matson believes that it will be able to renegotiate these collective bargaining agreements with its various unions as they expire without any significant impact on its operations, no assurance can be given that such agreements will be reached without slow-downs, strikes, lockouts or other disruptions that may adversely impact Matson’s operations. +​ +Additionally, Matson and SSAT are members of the Pacific Maritime Association (“PMA”), which on behalf of its members negotiates collective bargaining agreements with the International Longshore and Warehouse Union (“ILWU”) on the U.S. West Coast. The PMA/ILWU collective bargaining agreements cover substantially all U.S. West Coast longshore labor. In August 2017, the ILWU agreed to extend its contract with the PMA to July 1, 2022. +​ +Multi-employer Pension and Post-retirement Plans: +​ +Matson contributes to a number of multi-employer pension and post-retirement plans. Matson has no present intention of withdrawing from, and does not anticipate the termination of any of the multi-employer pension plans to which it contributes (see Notes 11 and 12 to the Consolidated Financial Statements in Item 8 of Part II below for a discussion of withdrawal liabilities under certain multi-employer pension plans). +​ +D. AVAILABLE INFORMATION +​ +Matson makes available, free of charge on or through its Internet website, Matson’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such material with, or furnishes them to, the U.S. Securities and Exchange Commission (“SEC”). The address of Matson’s Internet website is www.matson.com. The contents of our website are not incorporated by reference into this Form 10-K. +​ +The SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding Matson and other issuers that file electronically with the SEC. The address of the SEC’s Internet website is www.sec.gov. +​ \ No newline at end of file diff --git a/raw/filings/0000003453/2019/0001558370-20-001757/item13.txt b/raw/filings/0000003453/2019/0001558370-20-001757/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..49cc98c0a0cc2e50e3c1ab68577f46ee8cf30850 --- /dev/null +++ b/raw/filings/0000003453/2019/0001558370-20-001757/item13.txt @@ -0,0 +1,4 @@ +Item 13. +​ +Certain Relationships and Related Transactions, and Director Independence +74 \ No newline at end of file diff --git a/raw/filings/0000003453/2020/0001558370-21-001909/filing.txt b/raw/filings/0000003453/2020/0001558370-21-001909/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..25818bf5099dedd96bcf50d2bb6bd12a4c6b74c3 --- /dev/null +++ b/raw/filings/0000003453/2020/0001558370-21-001909/filing.txt @@ -0,0 +1,12159 @@ +P2Y us-gaap:LiabilitiesCurrent 0000003453 --12-31 2020 FY false P6Y 0.8 15800000 16600000 0000003453 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transition period from to +​ +Commission file number 001-34187 +​ +Matson, Inc. +(Exact name of registrant as specified in its charter) +​ +Hawaii +​ +99-0032630 +(State or other jurisdiction of +​ +(I.R.S. Employer +incorporation or organization) +​ +Identification No.) +​ +1411 Sand Island Parkway +Honolulu , HI 96819 +(Address of principal executive offices) (Zip code) +​ +( 808 ) 848-1211 +(Registrant’s telephone number, including area code) +​ +Securities registered pursuant to Section 12(b) of the Act: +​ +Title of each class +Trading Symbol(s) +Name of each exchange on which registered +Common Stock, without par value +MATX +New York Stock Exchange +​ +​ +Securities registered pursuant to Section 12(g) of the Act: +None +​ +Number of shares of Common Stock outstanding at February 19, 2021: +43,435,106 +​ +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ⌧ No ◻ +​ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ◻ No ⌧ +​ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No ◻ +​ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ⌧ No ◻ +​ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +​ +Large accelerated filer ☒ +Accelerated filer ☐ +Non-accelerated filer ☐ +Smaller reporting company ☐ +​ +Emerging growth company ☐ +​ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻ +​ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ +​ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +​ +Aggregate market value of Common Stock held by non-affiliates at June 30, 2020: +$ 1,233,205,504 +​ +Documents Incorporated By Reference +​ +The following document is incorporated by reference in Part III of the Annual Report on Form 10-K to the extent described therein: Proxy statement for the annual meeting of shareholders of Matson, Inc. to be held April 22, 2021. +​ +​ +​ +​ +Table of Contents +TABLE OF CONTENTS +​ +​ +​ +​ +​ +​ +​ +​ +Page +​ +​ +​ +​ +​ +​ +PART I +​ +​ +​ +​ +​ +Item 1. +​ +Business +1 +​ +A. +Company Overview +1 +​ +B. +Business Description +2 +​ +​ +(1) +Ocean Transportation Segment +2 +​ +​ +(2) +Logistics Segment +8 +​ +C. +Employees and Labor Relations +9 +​ +D. +Available Information +12 +Item 1A. +​ +Risk Factors +12 +Item 1B. +​ +Unresolved Staff Comments +21 +Item 2. +​ +Properties +22 +Item 3. +​ +Legal Proceedings +22 +Item 4. +​ +Mine Safety Disclosures +22 +​ +​ +​ +​ +​ +​ +PART II +​ +​ +​ +​ +​ +Item 5. +​ +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +23 +Item 6. +​ +Selected Financial Data +25 +Item 7. +​ +Management’s Discussion and Analysis of Financial Condition and Results of Operations +26 +Item 7A. +​ +Quantitative and Qualitative Disclosures About Market Risk +35 +Item 8. +​ +Financial Statements and Supplementary Data +36 +Item 9. +​ +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +74 +Item 9A. +​ +Controls and Procedures +74 +​ +​ +Conclusion Regarding Effectiveness of Disclosure Controls and Procedures +74 +​ +​ +Internal Control over Financial Reporting +74 +Item 9B. +​ +Other Information +74 +​ +​ +​ +​ +​ +PART III +​ +​ +​ +​ +​ +Item 10. +​ +Directors, Executive Officers and Corporate Governance +75 +​ +A. +Directors +75 +​ +B. +Information About Our Executive Officers +75 +​ +C. +Corporate Governance +75 +​ +D. +Code of Ethics +75 +Item 11. +​ +Executive Compensation +75 +Item 12. +​ +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +75 +Item 13. +​ +Certain Relationships and Related Transactions, and Director Independence +76 +Item 14. +​ +Principal Accountant Fees and Services +76 +​ +​ +​ +​ +​ +​ +PART IV +​ +​ +​ +​ +​ +Item 15. +​ +Exhibits and Financial Statement Schedules +77 +​ +A. +Financial Statements +77 +​ +B. +Financial Statement Schedules +77 +​ +C. +Exhibits Required by Item 601 of Regulation S-K +77 +​ +​ +​ +​ +Item 16. +​ +Form 10-K Summary +81 +​ +​ +​ +​ +Signatures +82 +​ +​ +​ +i +Table of Contents +MATSON, INC. +​ +FORM 10-K +​ +Annual Report for the Fiscal Year +Ended December 31, 2020 +​ +PART I +​ +ITEM 1. BUSINESS +​ +A. COMPANY OVERVIEW +​ +Matson, Inc., a holding company incorporated in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information by segment for the three years ended December 31, 2020, see Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates two premium, expedited services from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific, and operates an international export service from Dutch Harbor to Asia. In addition, subsidiaries of MatNav provide stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +​ +Matson has a 35 percent ownership interest in SSA Terminals, LLC, a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc., a subsidiary of Carrix, Inc. (“SSAT”). SSAT currently provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including three facilities dedicated for MatNav’s use. Matson records its share of income from SSAT in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +​ +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively, “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively, “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +​ +Our Mission and Vision: +​ +Our mission is to move freight better than anyone. Our vision is to create value for our shareholders by: +​ +◾ Being our customers’ first choice, +◾ Leveraging our core strengths to drive growth and increase profitability, +◾ Improving the communities in which we work and live, +◾ Being an environmental leader in our industry, and +◾ Being a great place to work. +​ +1 +Table of Contents +B. BUSINESS DESCRIPTION +​ +(1) +OCEAN TRANSPORTATION SEGMENT +​ +Ocean Transportation Services: +​ +Matson’s Ocean Transportation segment provides the following services: +​ +Hawaii Service: Matson’s Hawaii service provides ocean carriage (lift-on/lift-off, roll-on/roll-off and conventional services) between the ports of Long Beach and Oakland, California; Tacoma, Washington; and Honolulu, Hawaii. Matson also operates a network of inter-island barges that provide connecting services from its hub at Honolulu to other major Hawaii ports on the islands of Hawaii, Maui and Kauai. Matson is the largest carrier of ocean cargo between the U.S. West Coast and Hawaii. +​ +Westbound cargo carried by Matson to Hawaii includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, building materials, automobiles and household goods. Matson’s eastbound cargo from Hawaii includes automobiles, household goods, dry containers of mixed commodities and livestock. The majority of Matson’s Hawaii service revenue is derived from the westbound carriage of containerized freight. +​ +China Service: Matson’s expedited China-Long Beach Express (“CLX”) service is part of an integrated service that carries cargo from Long Beach, California to Honolulu, Hawaii, to Guam, and then to Okinawa, Japan. The vessels continue to Ningbo and Shanghai, China, where they are loaded with cargo to be discharged primarily in Long Beach, California at a Matson-exclusive terminal, operated by SSAT. These vessels also carry cargo destined for Hawaii which originated in Guam, Micronesia, Japan and China. Matson provides container transshipment services from many locations in Asia including Hong Kong and Xiamen, China to the U.S. via the ports of Ningbo and Shanghai, China. +​ +In May 2020, as a result of increased market demand, Matson launched its new China-Long Beach Express Plus (“CLX+”) service. CLX+ vessels operate as a second weekly vessel from China to Long Beach, California, operating back-to-back with the CLX vessels, which together represent Matson’s expedited China service. +​ +Eastbound cargo from China to Long Beach, California consists mainly of garments, e- commerce, consumer electronics, footwear and other merchandise. On our CLX service, westbound cargo to China and other destinations in Asia consists mainly of recycling materials. +​ +Guam Service: Matson’s Guam service provides weekly carriage between the U.S West Coast and Guam, as part of its CLX service. Matson also provides weekly connecting service from Guam to the Commonwealth of the Northern Mariana Islands. Cargo destined to these markets is similar to that described under “Hawaii Service” above. +​ +Japan Service: Matson’s Japan service provides carriage to the port of Naha in Okinawa, Japan, as part of its CLX service. This service carries mainly general sustenance cargo and household goods supporting the U.S. military. +​ +Micronesia Service: Matson’s Micronesia service provides carriage between the U.S. West Coast and the islands of Kwajalein, Ebeye and Majuro in the Republic of the Marshall Islands, the islands of Yap, Pohnpei, Chuuk and Kosrae in the Federated States of Micronesia, and the Republic of Palau. Cargo destined for these locations is transshipped through Guam and consists mainly of general sustenance cargo. +​ +Alaska Service: Matson’s Alaska service provides ocean carriage (lift-on/lift-off and conventional services) between the port of Tacoma, Washington, and the ports of Anchorage, Kodiak and Dutch Harbor, Alaska. Matson also provides a barge service between Dutch Harbor and Akutan in Alaska, and transportation services to other locations in Alaska including the Kenai Peninsula, Fairbanks and the North Slope. +​ +Northbound cargo to Alaska consists mainly of dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, household goods and automobiles. Southbound cargo from Alaska primarily consists of seafood, household goods and automobiles. +​ +2 +Table of Contents +In September 2020, Matson launched its new Alaska-Asia Express (“AAX”) service that provides carriage of dry and frozen seafood from Dutch Harbor, Alaska to Ningbo and Shanghai, China. The AAX service utilizes CLX+ vessels on their westbound trip to China. Matson also provides transshipment services from Ningbo and Shanghai, China to other locations in Asia. Other Alaska cargo may be shipped on the AAX service utilizing Matson’s Alaska vessels and transshipment services in Dutch Harbor. +​ +South Pacific Service: Matson’s New Zealand Express (“NZX”) service provides carriage of general sustenance cargo between Auckland, New Zealand and select islands in the South Pacific, including Fiji (Suva and Lautoka), Samoa (Apia), American Samoa (Pago Pago), the Cook Islands (Rarotonga and Aitutaki), Tonga (Nukualofa and Vava’u), and Niue. Matson’s NZX service also provides transshipment services to the islands of Nauru and the Solomon Islands (Honiara). Additionally, Matson provides slot charter arrangements for the transportation of cargo from major ports on the east coast of Australia to ports in the South Pacific islands. The NZX service also distributes and sells domestic bulk fuel to a variety of these islands. +​ +Matson’s South Pacific Express (“SPX”) service provides carriage of general sustenance cargo from the U.S. West Coast to ports in the South Pacific islands using vessel sharing agreements with other carriers. The SPX service provides direct calls to Tahiti (Papeete), American Samoa (Pago Pago) and Samoa (Apia) in the South Pacific. Cargo destined for other ports including Tonga (Nukualofa) and the Cook Islands (Rarotonga and Aitutaki) is then transshipped in Apia, Samoa to the NZX service for delivery to its final destination. Northbound SPX cargo originating in the South Pacific is transshipped from the NZX service with other carriers to the U.S. West Coast. Cargo destined for Hawaii or Washington is further transshipped in Oakland, California for delivery to its final destination. +​ +Terminal and Other Related Services: +​ +Matson provides stevedoring, refrigerated cargo services, inland transportation, container equipment maintenance and other terminal services (collectively, “terminal services”) at terminals located on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai; and in the Alaska terminal locations of Anchorage, Kodiak and Dutch Harbor. +​ +SSAT currently provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including three facilities dedicated for MatNav’s use, in Long Beach and Oakland, California; and in Tacoma, Washington. +​ +Matson utilizes the services of other third-party terminal operators at all of the other ports served by its vessels. +​ +Vessel Management Services: +​ +Matson contracts with the U.S. Department of Transportation to provide vessel management services to manage and maintain three Ready Reserve Force vessels on behalf of the U.S. Department of Transportation Maritime Administration. +​ +​ +Vessel Information: +​ +Vessels: +​ +Matson’s fleet includes both owned and chartered vessels. Matson’s owned vessels represent an investment of approximately $2.2 billion. The majority of Matson’s owned vessels are U.S. flagged and Jones Act qualified vessels, +3 +Table of Contents +and operate in the Hawaii, China, Guam, Japan, Micronesia and Alaska services. Details of Matson’s active and reserve vessels as of December 31, 2020 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Usable Cargo Capacity +​ +​ +​ +Vessel +​ +​ +​ +​ +​ +​ +​ +​ +Containers +​ +Vehicles +​ +​ +​ +Design +​ +Maximum +​ +Year +Official +​ +Reefer +Speed +Deadweight +Name of Vessels +​ +Built +​ +Number +​ +TEUs (1) +​ +Slots +​ +Autos +​ +Length +​ +(Knots) (2) +​ +(Long Tons) +Vessels-Owned: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +DANIEL K. INOUYE (3) +​ +2018 +1274136 +3,220 +408 +​ +— +854’ 0” +23.5 +50,794 +KAIMANA HILA (3) +​ +2019 +​ +1274135 +​ +3,220 +​ +408 +​ +— +​ +854’ 0” +​ +23.5 +53,747 +MANOA (3)(8) +1982 +651627 +2,824 +408 +— +860’ 2” +23.0 +30,187 +MAHIMAHI (3) +1982 +653424 +2,824 +408 +— +860’ 2” +23.0 +30,167 +LURLINE (3) +​ +2019 +​ +1274143 +​ +2,750 +​ +432 +​ +500 +​ +869’ 5” +​ +23.0 +​ +50,562 +MATSONIA (3) +​ +2020 +​ +1274123 +​ +2,750 +​ +432 +​ +500 +​ +869’ 5” +​ +23.0 +​ +50,562 +MANULANI (3)(8) +2005 +1168529 +2,378 +284 +— +712’ 0” +22.5 +29,517 +MAUNAWILI (3)(8) +2004 +1153166 +2,378 +326 +— +711’ 9” +22.5 +29,517 +MANUKAI (3)(8) +2003 +1141163 +2,378 +326 +— +711’ 9” +22.5 +29,517 +R.J. PFEIFFER (3)(8) +1992 +979814 +2,245 +300 +— +713’ 6” +23.0 +27,100 +MOKIHANA (3) +1983 +655397 +1,994 +354 +1,323 +860’ 2” +23.0 +29,484 +MATSON KODIAK (3)(8) +1987 +910308 +1,668 +280 +— +710’ 0” +20.0 +37,473 +MATSON ANCHORAGE (3)(8) +1987 +910306 +1,668 +280 +— +710’ 0” +20.0 +37,473 +MATSON TACOMA (3)(8) +1987 +910307 +1,668 +280 +— +710’ 0” +20.0 +37,473 +KAMOKUIKI (4) +2000 +9232979 +707 +100 +— +433’ 9” +17.5 +8,509 +OLOMANA (5) +​ +2004 +​ +9184225 +​ +645 +​ +120 +​ +— +​ +388’ 7” +​ +14.0 +​ +8,200 +ISLAND CHIEF (5) +2005 +9184237 +630 +90 +— +388’ 6” +15.0 +8,071 +PAPA MAU (5) +1999 +9141704 +521 +68 +— +381’ 5” +14.0 +5,364 +Vessels-Chartered: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +CO OSAKA (5)(9) +​ +2008 +​ +9400291 +​ +4,504 +​ +400 +​ +— +​ +852’ 4” +​ +22.0 +​ +50,554 +NAVIOS FELICITAS (5)(9) +​ +2010 +​ +9395953 +​ +4,360 +​ +326 +​ +— +​ +849’ 4” +​ +24.0 +​ +52,315 +NAVIOS AMARANTH (5)(9) +​ +2007 +​ +9334143 +​ +4,253 +​ +400 +​ +— +​ +855’ 2” +​ +24.3 +​ +50,629 +NAVIOS VERANO (5)(9) +​ +2006 +​ +9308015 +​ +3,461 +​ +550 +​ +— +​ +783’ 8” +​ +23.0 +​ +42,806 +CAPT. THANASIS (5)(9) +​ +2005 +​ +9294159 +​ +2,824 +​ +586 +​ +— +​ +728’ 10” +​ +21.0 +​ +39,383 +BOMAR BELLINI (5)(9) +​ +2007 +​ +9338084 +​ +2,824 +​ +586 +​ +— +​ +788’ 10” +​ +22.0 +​ +39,276 +MAUNALEI (3)(8) +2006 +1181627 +1,992 +328 +— +681’ 1” +22.1 +33,771 +LILOA II (5) +2004 +9184249 +630 +90 +— +388’ 6” +15.0 +​ +8,071 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Barges-Owned: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +HALEAKALA (3)(6) +1984 +676972 +335 +78 +— +350’ 0” +— +4,658 +WAIALEALE (3)(7) +1991 +978516 +— +36 +230 +345’ 0” +— +5,621 +Barges-Chartered: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +MAUNA LOA (3) +2013 +1247426 +500 +78 +— +362’ 6” +— +12,678 +ILIULIUK BAY (3)(6) +2013 +1249384 +178 +— +— +250’ 0” +— +4,138 +(1) Twenty-foot Equivalent Units (“TEU”) is a standard measure of cargo volume correlated to a standard 20-foot dry cargo container. +(2) Vessel Design Speed may vary from the operating speed of the vessel. +(3) U.S. flagged and Jones Act qualified vessel or barge. +(4) U.S. flagged vessel. +(5) Foreign flagged vessel. +(6) Lift-on/lift-off barge equipped with a crane. +(7) Roll-on/roll-off barge. +(8) Vessel installed with exhaust gas cleaning systems (commonly referred to as “scrubbers”). +(9) Vessels used in the CLX+ service are chartered and may be replaced by other similar vessels. +​ +Fleet Renewal Program: +​ +Matson has completed its investment of $1,024 million in the construction of four new vessels, including owner’s items and capitalized interest. The two Aloha Class containerships, Daniel K. Inouye and Kaimana Hila , commenced active service in November 2018 and April 2019, respectively. The two Kanaloa Class combination container and roll-on/roll-off vessels, Lurline and Matsonia commenced active service in January 2020 and December 2020, respectively. +​ +4 +Table of Contents +Vessel Emission Regulations: +​ +Being a leader in environmental stewardship is one of Matson’s core values. Matson’s vessels transit through some of the most environmentally sensitive areas in the United States including the Hawaiian Islands and the coasts of California, Oregon, Washington and Alaska. Matson is focused in particular on reducing transportation emissions, including carbon dioxide, nitrous oxide, particulate matter and sulfur dioxide through improvements in vessel fuel consumption and the development of more fuel-efficient transportation solutions. Matson further contributes positively to the environment by testing and deploying leading technologies as the fleet is modernized. +​ +The International Maritime Organization (“IMO”), to which the U.S. and over 100 other countries are signatories, is a specialized agency of the United Nations that sets international environmental standards applicable to vessels operating under the flag of any signatory country. Effective January 1, 2020, the IMO imposed regulations that generally require all vessels to burn fuel oil with a maximum sulfur content of ≤0.5 percent (“IMO 2020”). There are three main options for a vessel to meet the IMO 2020 requirements: (1) burn low sulfur fuel oil (“LSFO”), (2) install exhaust gas cleaning systems (commonly referred to as “scrubbers”) on vessels to reduce sulfur emissions from high sulfur fuel oil (“HSFO”), or (3) switch to lower emission fuels such as liquefied natural gas (“LNG”), which requires converting existing vessels or constructing new vessels with LNG-compatible engines and fuel tanks. With respect to North America, all waters, with certain limited exceptions, within 200 nautical miles of U.S. and Canadian coastlines have been designated emission control areas (“ECAs”). Since January 1, 2015, U.S. Environmental Protection Agency regulations have reduced the fuel oil maximum sulfur content in designated ECAs to ≤0.1 percent or the equivalent emissions by the use of scrubbers. In addition, since August 1, 2012, the California Air Resource Board and U.S. Environmental Protection Agency under the Vessel General Permit regulations have reduced the fuel oil maximum sulfur content to ≤0.1 percent within 24 miles of the California coastline and within Puget Sound. +​ +All of Matson’s vessels in the Alaska and Hawaii services are operating in compliance with IMO 2020 and ECA regulations as applicable, and can use LSFO. In the Alaska and Hawaii services, Matson installed scrubbers on nine diesel-powered vessels to allow them to use HSFO and still comply with IMO 2020 and ECA regulations. Matson also maintains two reserve vessels which may operate as dry-dock relief or for emergency activation purposes under an approved ECA permit enabling the use of fuel oil with a maximum sulfur content of ≤0.5 percent within the North America ECA. Matson’s new Aloha and Kanaloa Class vessels burn compliant LSFO. These new vessels are also equipped with dual-fuel engines and can be converted to run on LNG. All of Matson’s other vessels use LSFO to meet IMO 2020 and ECA emission standards. +​ +Hawaii Terminal Modernization and Expansion Program: +​ +Matson has completed the first phase of modernizing and renovating its terminal facility at Sand Island, Honolulu, Hawaii, an investment of approximately $60 million. In 2020, Matson completed the installation of three new 65 long- ton capacity gantry cranes, upgraded and renovated three existing cranes, demolished four outdated cranes, and installed upgrades to the electrical infrastructure at the terminal. As part of the second phase, Matson expects to install a new redundant main switchgear, complete the augmentation of its existing backup power generators, install new fuel storage tanks and a battery energy storage system, and perform other upgrades at the terminal. Matson expects to begin the second phase during the second half of 2021 and to complete it within two years. The final phase is expected to begin in 2024 as part of a broader terminal expansion and modernization program at the terminal. +​ +Ocean Transportation Equipment: +​ +As a complement to its fleet of vessels, Matson owns a variety of equipment including cranes, terminal equipment, containers and chassis, which represents an investment of approximately $0.6 billion as of December 31, 2020. Matson also leases containers, chassis and other equipment under various operating lease agreements. +​ +Operating Costs: +​ +Major components of Matson’s Ocean Transportation operating costs are as follows: +​ +Direct Cargo Expense includes terminal handling costs including labor, purchased outside transportation and other related costs. +​ +5 +Table of Contents +Vessel Operating Expense includes crew wages and related costs; fuel, pilots, tugs and line related costs; vessel charter expenses; and other vessel operating related expenses. Matson purchases fuel oil, lubricants and gasoline for its operations and also pays fuel-related surcharges to other third party transportation providers. +​ +Operating Overhead includes equipment repair costs, equipment lease and repositioning expenses, vessel repair and maintenance costs, depreciation and dry-docking amortization, insurance, port engineers and other maintenance costs, and other vessel and shoreside related overhead. +​ +Competition: +​ +The following is a summary of major competitors in Matson’s Ocean Transportation segment: +​ +Hawaii Service: Matson’s Hawaii service has one major U.S. flagged Jones Act competitor, Pasha Hawaii (“Pasha”), which operates container and roll-on/roll-off services between the ports of Long Beach, Oakland and San Diego, California to Hawaii. A U.S. flagged Jones Act barge operator, Aloha Marine Lines, also offers barge service between the Pacific Northwest and Hawaii. +​ +Foreign-flagged vessels carrying cargo to Hawaii from non-U.S. locations also provide alternatives for companies shipping to Hawaii. Other competitors in the Hawaii service include proprietary operators and contract carriers of bulk cargo. Airfreight competition for time-sensitive cargo exists; however, cargo volume has been limited primarily due to the cost of airfreight transportation. +​ +Matson operates three strings of vessels to Hawaii. These strings provide customers an industry-leading five departures from ports on the U.S. West Coast to Hawaii every week – two each from Long Beach and Oakland, California and one from Tacoma, Washington. Each of these strings operates on a fixed day-of-the-week schedule. One of the vessel strings continues from Honolulu on to Guam, Japan and China before returning to Long Beach. The remaining two strings offer eastbound Hawaii shippers twice weekly departures from Honolulu to the U.S. Mainland, providing customers service to the same three U.S. West Coast ports. Matson’s frequent sailings and punctuality permit customers to reduce inventory carrying costs. Matson also competes by offering the most comprehensive service to customers, including: the only container service to and from the three largest U.S. West Coast ports; the most efficient terminal network on the U.S. West Coast provided by SSAT; a dedicated inter-island barge network which is integrated with Matson’s line haul schedule; weekly roll-on roll-off service from Long Beach and Oakland; a world-class customer service team; and efficiency and experience in handling cargo of all types. +​ +Alaska Service: Matson’s Alaska service has one major U.S. flagged Jones Act competitor, Totem Ocean Trailer Express, Inc., which operates a roll-on/roll off service between Tacoma, Washington and Anchorage, Alaska. There are also two U.S. flagged Jones Act barge operators, Alaska Marine Lines, which mainly provides services from Seattle, Washington to the ports of Anchorage and Dutch Harbor, and other locations in Alaska, and Samson Tug & Barge, which mainly serves Western Alaska and other locations. The barge operators have historically shipped lower value commodities that can accommodate a longer transit time, as well as construction materials and other cargo that are not conducive to movement in containers. Foreign-flagged vessels provide alternatives for companies shipping cargo (mainly seafood) from the Alaska ports of Kodiak and Dutch Harbor. Matson’s AAX service has two major competitors, CMA CGM and Maersk Lines, which provide services between Dutch Harbor, Alaska and Asia. +​ +Matson offers customers twice weekly scheduled service from Tacoma, Washington to Anchorage and Kodiak, Alaska and weekly service to Dutch Harbor, Alaska. The Company also provides a barge service between Dutch Harbor and Akutan in Alaska. Matson is the only Jones Act containership operator providing service to Kodiak and Dutch Harbor in Alaska, which are the primary loading ports for southbound seafood. Matson offers dedicated terminal services at the Alaska ports of Anchorage, Kodiak and Dutch Harbor performed by MatNav, and at the port of Tacoma, Washington performed by SSAT. +​ +China Service: Major competitors to Matson’s China service include large international carriers such as ONE (formerly “K” Line, NYK Line and MOL), Maersk, CMA CGM, Evergreen, COSCO, and ZIM. +​ +Matson’s China service competes by offering fast and reliable service from the ports of Ningbo and Shanghai in China to Long Beach, California, and providing fixed day arrivals and next-day cargo availability. Matson’s service is further differentiated by SSAT’s best-in-class stevedoring services, access to Shippers Transport Express and off-dock container +6 +Table of Contents +yards enabling fast truck turn times, Matson-dedicated equipment including chassis to speed cargo availability, one-stop intermodal connections, and providing world-class customer service. Matson has offices located in Hong Kong, Shenzhen, Xiamen, Ningbo and Shanghai, and has contracted with terminal operators in Ningbo and Shanghai. +​ +Guam Service: Matson’s Guam service has one major competitor, APL, which operates a weekly U.S. flagged container feeder service connecting the U.S. West Coast to Guam and Saipan, via transshipments primarily over Busan, South Korea. Waterman operates a roll-on/roll-off service, which periodically calls at Guam. There are also several foreign carriers, including CMA CGM, that call at Guam from foreign origin ports. +​ +Japan Service: Matson’s Japan service competes primarily with APL, which operates a weekly U.S. flagged containership service from the U.S. West Coast to the port of Naha, Okinawa, Japan. +​ +Micronesia and South Pacific Services: Matson’s Micronesia and South Pacific services have competition from a variety of local and international carriers that provide freight services to the area. +​ +Customer Concentration: +​ +Matson serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2020, 2019 and 2018, the Company’s 10 largest Ocean Transportation customers accounted for approximately 22 percent, 23 percent and 24 percent of the Company’s Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Matson’s Ocean Transportation operating revenues. For additional information on Ocean Transportation revenues for the years ended December 31, 2020, 2019 and 2018, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +Matson’s Ocean Transportation services typically experience seasonality in volume, generally following a pattern of increasing volumes starting in the second quarter of each year, culminating in a peak season throughout the third quarter, with subsequent decline in demand during the fourth and first quarters. This seasonality trend is amplified in the Alaska service primarily due to winter weather and the timing of southbound seafood trade. As a result, earnings tend to follow a similar pattern, offset by periodic vessel dry-docking and other episodic cost factors, which can lead to earnings variability. In addition, in the China trade, volume is typically driven primarily by U.S. consumer demand for goods during key retail selling seasons. Freight rates are impacted mainly by macro supply and demand variables. +​ +Maritime Laws and the Jones Act : +​ +Maritime Laws: All interstate and intrastate marine commerce within the U.S. falls under the Merchant Marine Act of 1920 (commonly referred to as the Jones Act). +​ +The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, be manned predominantly by U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75 percent owned by U.S. citizens. U.S. flagged vessels are generally required to be maintained at higher standards than foreign flagged vessels and are subject to rigorous supervision and inspections by, or on behalf of, the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Under Section 27 of the Jones Act, the carriage of cargo between the U.S. West Coast, Hawaii and Alaska on foreign-built or foreign-documented vessels is prohibited. +​ +During the years ended December 31, 2020, 2019 and 2018, approximately 62 percent, 72 percent and 72 percent, respectively, of Matson’s Ocean Transportation revenues came from the Hawaii and Alaska trades that were subject to the Jones Act. Matson’s Hawaii and Alaska trade routes are included within the non-contiguous Jones Act market. The commerce of both Hawaii, as an island economy, and Alaska, due to its geographical location, are dependent on ocean transportation. The Jones Act ensures frequent, reliable, roundtrip service to these locations. Matson’s vessels operating in these trade routes are Jones Act qualified. +​ +Matson is a member of the American Maritime Partnership (“AMP”) which supports the retention of the Jones Act and similar cabotage laws. The Jones Act has broad support from both houses of Congress and the Executive Branch. +7 +Table of Contents +Matson believes that the ongoing war on terrorism and geopolitical environment have further solidified political support for U.S. flagged vessels because a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support. AMP seeks to inform elected officials and the public about the economic, national security, commercial, safety and environmental benefits of the Jones Act and similar cabotage laws. Repeal of the Jones Act would allow foreign-flagged vessel operators that do not have to abide by all U.S. laws and regulations to sail between U.S. ports in direct competition with Matson and other U.S. domestic operators that must comply with all such laws and regulations. +​ +Other U.S. maritime laws require vessels operating between Guam, a U.S. territory, and U.S. ports to be U.S. flagged and predominantly U.S. crewed, but not U.S. built. +​ +Cabotage laws are not unique to the United States, and similar laws exist around the world in over 90 countries, including regions in which Matson provides ocean transportation services. Any changes in such laws may have an impact on the services provided by Matson in those regions. For a discussion of the risks arising from the Jones Act and other regulations, see Part I, Item 1A of this Form 10-K. +​ +Rate Regulations and Fuel-Related Surcharges: +​ +Matson is subject to the jurisdiction of the Surface Transportation Board with respect to its domestic ocean rates. A rate in the non-contiguous domestic trade is presumed reasonable and will not be subject to investigation if the aggregate of increases and decreases is not more than 7.5 percent above, or more than 10 percent below, the rate in effect one year before the effective date of the proposed rate, subject to increase or decrease by the percentage change in the U.S. Producer Price Index. Matson generally provides a 30-day notice to customers of any increases in general rates and other charges, and passes along decreases as soon as possible. +​ +Matson’s Ocean Transportation services engaged in U.S.-foreign commerce are subject to the jurisdiction of the Federal Maritime Commission (“FMC”). The FMC is a federal independent regulatory agency that is responsible for the regulation of international ocean-borne transportation to and from the U.S. +​ +Matson applies a fuel-related surcharge rate to its Ocean Transportation customers. Changes in the fuel-related surcharge levels are correlated to market rates for bunker fuel prices along with other factors related to fuel expense recovery. +​ +Other Environmental Regulations: +​ +In addition to the vessel emission regulations discussed above, Matson’s operations are required to comply with other environmental regulations and requirements including the Oil Pollution Act of 1990, the Comprehensive Environmental Response Compensation & Liability Act of 1980, the Rivers and Harbors Act of 1899, the Clean Water Act, the Invasive Species Act and the Clean Air Act. Matson is also subject to state regulations affecting terminal and vessel emissions, such as the requirement to shut down vessel auxiliary engines while at berth at California ports and switch to electrical power. The Company actively monitors its operations to address compliance with these and other regulations. +​ +For more information on Matson’s environmental stewardship initiatives, including its environmental goals, see Matson’s Sustainability Report and other information available at www.matson.com/sustainability. The website is provided for convenience only, and the contents of our website do not constitute a part of and are not incorporated by reference into this Form 10-K. +​ +(2) +LOGISTICS SEGMENT +​ +Logistics Services: +​ +Matson Logistics provides the following services: +Transportation Brokerage Services: Matson Logistics provides intermodal rail, highway, and other third-party logistics services for North American customers and international ocean carrier customers, including MatNav. Matson Logistics strives to reduce transportation costs for its customers through volume purchases of rail, motor carrier and ocean +8 +Table of Contents +transportation services, augmented by services such as shipment tracking and tracing, and single-vendor invoicing. Matson Logistics operates customer service centers and has sales offices throughout North America. +Freight Forwarding Services: Matson Logistics provides LCL consolidation and freight forwarding services primarily to the Alaska market through its wholly owned subsidiary, Span Intermediate, LLC (“Span Alaska”). Span Alaska’s business aggregates LCL freight at its cross-dock facility in Auburn, Washington for consolidation and shipment to its service center in Anchorage and a network of other facilities in Alaska. Span Alaska also provides trucking services to its Auburn cross-dock facility and from its Alaska based cross-dock facilities to final customer destinations in Alaska. +Warehousing and Distribution Services: Matson Logistics operates two warehouses in Georgia and two warehouses in Northern California providing warehousing, value-added packaging and distribution services. +​ +Supply Chain Management and Other Services: Matson Logistics provides customers with a variety of logistics services including purchase order management, customs brokerage, LCL and full container load NVOCC freight forwarding services. Matson Logistics has supply chain operations in North America, China and other locations. +​ +Operating Costs: +​ +Matson Logistics’ operating costs primarily consist of the costs of purchased transportation, leases of warehouses, cross-dock and other facility operating costs, salaries and benefits, and other operating overhead. +​ +Competition: +​ +Matson Logistics competes with hundreds of local, regional, national and international companies that provide transportation and third-party logistics services. The industry is highly fragmented and, therefore, competition varies by geography and areas of service. +​ +Matson Logistics’ transportation brokerage services compete most directly with C.H. Robinson Worldwide, the Hub Group, XPO and other freight brokers and intermodal marketing companies, and asset-invested market leaders such as J.B. Hunt. Competition is differentiated by the depth, scale and scope of customer relationships; vendor relationships and rates; network capacity; real-time visibility into the movement of customers’ goods; and other technology solutions. Additionally, while Matson Logistics primarily provides surface transportation brokerage, it also competes to a lesser degree with other forms of transportation for the movement of cargo. +​ +Matson Logistics’ freight forwarding services compete most directly with a variety of freight forwarding companies that operate within Alaska including Carlile, Lynden, American Fast Freight and Alaska Traffic Company. +​ +Customer Concentration: +​ +Matson Logistics serves customers in numerous industries and geographical locations. In 2020, 2019 and 2018, the Company’s 10 largest logistics customers accounted for approximately 19 percent, 21 percent and 23 percent of Matson Logistics’ revenue, respectively. None of these customers individually accounts for more than 10 percent of Matson Logistics’ operating revenues. For additional information on Logistics revenues for the years ended December 31, 2020, 2019 and 2018, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +In general, Matson Logistics’ services are not significantly impacted by seasonality factors, with the exception of its freight forwarding service to Alaska which may be affected by winter weather and the seasonal nature of the tourism industry. +​ +C. EMPLOYEES AND LABOR RELATIONS +​ +Human Capital Strategy: +​ +In support of Matson’s vision to be a great place to work for all employees, the Company focuses on a variety of human capital programs that have been developed to attract, retain and motivate its employee workforce. As a company that +9 +Table of Contents +operates in various global locations, the Company’s human capital programs are designed to reflect the unique market practices in each geographic location. The Company’s success depends on employing a diverse, talented and engaged workforce that reflects its local communities, supports an environment of high standards and performance, and thrives in the Company’s collaborative and respectful culture. +​ +During 2020, Matson had 4,149 employees worldwide, of which 128 employees were based in international locations and 2,953 employees were covered by collective bargaining agreements with unions. These numbers include seagoing personnel who rotate through billets (as described below) and temporary employees, but do not include employees of SSAT or other non-employee affiliates such as agents and contractors. In prior years, Matson reported the number of regular shoreside employees only and excluded seagoing personnel and temporary employees. The composition of Matson’s workforce by geography is as follows: +​ +​ +Matson’s fleet of active vessels requires 317 billets to operate. Each billet corresponds to a position on a vessel that typically is filled by two or more employees because seagoing personnel rotate between active sea-duty and time ashore. These amounts exclude billets related to Matson’s foreign flagged chartered vessels where the vessel owner is responsible for its seagoing personnel. Matson’s vessel management services also employed personnel in 32 billets to manage three U.S. government vessels. +​ +Diversity, Equity and Inclusion: +​ +For many years, Matson has been committed to improving diversity, providing equal pay for equal work and creating an inclusive culture. According to the U.S. Bureau of Labor Statistics, traditionally the shipping industry's workforce has been predominately represented by white males. While Matson’s workforce is representative of many of the communities where it operates, the Company believes it can do more to change the status quo within the Company and industry. +​ +The composition of Matson’s domestic shoreside workforce by gender and race in 2020 is as follows (data for seagoing personnel is not available to the Company): +​ +​ +The composition of management positions within Matson’s domestic shoreside workforce by gender and race in 2020 is as follows (data for seagoing personnel is not available to the Company): +​ +​ +In 2020, the Company continued to advance many of its diversity, equity and inclusion efforts. This includes continuing its efforts to analyze pay among various employee groups to confirm pay equity across the Company. Externally, the Company is supporting programs intended to help build a diverse talent pool for Matson and its industry. In 2020, the Company committed $100,000 toward creation of new Matson scholarships to be offered in conjunction with +10 +Table of Contents +approximately 15 higher education institutions and maritime academies in its communities with the goal of increasing diversity among those pursuing studies in transportation and logistics. Separately, the Company has committed more than $200,000 to expand its paid internship program with the goal of increasing exposure to the Company and industry among a diverse group of students in its various regional locations. +​ +Total Rewards Programs: +​ +Matson provides a highly competitive and balanced total rewards program designed to attract, retain and motivate its employees . While factors such as job, location and business unit ultimately determine which plans an employee may be eligible for participation, the Company’s total rewards offering includes market competitive base salaries, cash and equity incentives, recognition awards, health and welfare benefits, and employee and employer funded retirement plans. The Company believes that management level positions should have a portion of pay aligned with its short- and long-term business objectives. Accordingly, the Company’s total rewards program contains several pay-for-performance components tied to individual, business unit and company performance, as well as Matson stock price performance. +​ +Succession and Career Planning: +​ +Matson’s workforce is characterized by uniquely skilled, long-tenured employees. To create career pathways for future leaders while planning for the loss of retiring employees, the Company takes a proactive approach to succession and career planning. The Company focuses on providing the next generation of promising talent with the tools they need to build their own careers at Matson. In 2019 and 2020, 40 percent and 53 percent of open positions, respectively, were filled through internal promotions. The Company also provided more than 2,250 hours of employee training and development, while giving regular performance reviews to its non-union workforce. +​ +For more information on Matson’s human capital programs, please see our Sustainability Report which is available at www.matson.com/sustainability . This website is provided for convenience only, and the contents of our website do not constitute a part of and are not incorporated by reference into this Form 10-K. +​ +Bargaining Agreements: +​ +Matson’s shoreside and seagoing employees are represented by a variety of unions. As shown in the chart below, union employees comprise 71% of Matson’s global workforce. +​ +​ +Matson has collective bargaining agreements with these unions that expire at various dates in the future. While Matson believes that it will be able to renegotiate these collective bargaining agreements with its various unions as they expire without any significant impact on its operations, no assurance can be given that such agreements will be reached without slow-downs, strikes, lockouts or other disruptions that may adversely impact Matson’s operations. For a discussion of the risks arising from the negotiation of collective bargaining agreements, see Part I, Item 1A of this Form 10-K. +​ +Additionally, Matson and SSAT are members of the Pacific Maritime Association (“PMA”), which on behalf of its members negotiates collective bargaining agreements with the International Longshore and Warehouse Union (“ILWU”) on the U.S. West Coast. The PMA/ILWU collective bargaining agreements cover substantially all U.S. West Coast longshore labor. In August 2017, the ILWU agreed to extend its contract with the PMA to July 1, 2022. +​ +Multi-employer Pension and Post-retirement Plans: +​ +Matson contributes to a number of multi-employer pension and post-retirement plans. Matson has no present intention of withdrawing from, and does not anticipate the termination of any of the multi-employer pension plans to which it contributes (see Notes 11 and 12 to the Consolidated Financial Statements in Item 8 of Part II below for a discussion of withdrawal liabilities under certain multi-employer pension plans). +11 +Table of Contents +​ +D. AVAILABLE INFORMATION +​ +Matson makes available, free of charge on or through its Internet website, Matson’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such material with, or furnishes them to, the U.S. Securities and Exchange Commission (“SEC”). The address of Matson’s Internet website is www.matson.com. This website is provided for convenience only, and the contents of our website do not constitute a part of and are not incorporated by reference into this Form 10-K. +​ +The SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding Matson and other issuers that file electronically with the SEC. The address of the SEC’s Internet website is www.sec.gov. +​ +​ +ITEM 1A. RISK FACTORS +​ +The following material factors, events and uncertainties may make an investment in the Company speculative or risky and should be reviewed carefully. The Company’s business faces the material risks set forth below; however, these risk factors do not identify all risks the Company faces, and additional risks or uncertainties that are currently unknown or are not currently believed to be material may occur or become material. The occurrence of these or the events and uncertainties described below may, in ways the Company may not be able to accurately predict, recognize, or control, adversely affect the Company’s business, financial condition, operating results, cash flows, liquidity, demand, revenue, growth, prospects, reputation, or stock price. All forward-looking statements made by the Company or on the Company’s behalf are qualified by the risks described below. +​ +Risks Related to the Jones Act +​ +Repeal, substantial amendment, or waiver of the Jones Act or its application would have an adverse effect on the Company’s business. +​ +The Merchant Marine Act of 1920 (commonly referred to as the Jones Act) regulates all interstate and intrastate marine commerce within the U.S. If the Jones Act was to be repealed, substantially amended, or waived and, as a consequence, competitors were to enter the Hawaii or Alaska markets with lower operating costs by utilizing their ability to acquire and operate foreign-flagged and foreign- built vessels and/or being exempt from other U.S. regulations, the Company’s business would be adversely affected. In addition, the Company’s position as a U.S. citizen operator of Jones Act vessels would be negatively impacted if periodic efforts and attempts by foreign interests to circumvent certain aspects of the Jones Act were ever successful. If maritime cabotage services were included in the General Agreement on Trade in Services, the United States-Mexico-Canada Agreement, the U.S.-EU Trade Agreement or other international trade agreements, or if the restrictions contained in the Jones Act were otherwise altered, the shipping of cargo between covered U.S. ports could be opened to foreign-flagged or foreign- built vessels and could have other adverse impacts. In the past, the Prime Minister of the United Kingdom has suggested that the Jones Act should be a topic of trade negotiations between the U.S. and European Union. +​ +The Company’s business would be adversely affected if the Company were determined not to be a U.S. citizen under the Jones Act. +​ +Certain provisions of the Company’s articles of incorporation protect the Company’s ability to maintain its status as a U.S. citizen under the Jones Act. If non-U.S. citizens were able to defeat such articles of incorporation restrictions and own in the aggregate more than 25 percent of the Company’s common stock, the Company would no longer be considered as a U.S. citizen under the Jones Act. Such an event could result in the Company’s ineligibility to engage in coastwise trade and the imposition of substantial penalties against it, including seizure or forfeiture of its vessels. +​ +12 +Table of Contents +Risks Related to the Company’s Operations +​ +The Company’s results of operations have been adversely affected and could in the future be materially adversely impacted by the COVID-19 pandemic and its related economic effects. +​ +The COVID- 19 pandemic has harmed the U.S. and global economies, shut down or limited many business operations and disrupted manufacturing, supply chains, travel, drayage of containers, and transportation of goods. In the United States and in many other countries worldwide, public health officials and state and local governments have recommended or mandated precautions to mitigate the spread of COVID- 19. The full impact of such disruptions on the Company’s business remains uncertain. +​ +The pandemic has severely reduced tourism and is expected to continue to limit tourism in the markets the Company serves, including Hawaii, Guam and Alaska, and has led to reduced demand for freight that the Company would otherwise carry. In addition, the global macroeconomic effects of the pandemic and related impacts on the Company’s customers’ business operations, including financial difficulties or bankruptcies, may persist for an indefinite period, even after the pandemic has subsided. +​ +In the Company’s China service, as a result of the pandemic, the Company has experienced increased demand for its expedited ocean services; however, as the pandemic subsides and supply and demand trends normalize, it is uncertain whether the high volumes and rates the Company has seen can be maintained in the future. In addition, the high volumes of freight from China have contributed to an industry-wide shortage of containers and chassis and congestion at U.S. West Coast ports. There have also been labor shortages at U.S. ports related to record cargo volume and outbreaks of COVID-19. If the Company cannot secure sufficient equipment or unload vessels on a timely basis to meet customer’ needs and schedules, customers may seek to have their transportation and logistics needs met by others on a temporary or permanent basis. +​ +The Company’s operations have also been impacted. The Company’s employees are also restricted in their ability to travel. The Company may be further impacted if its employees are otherwise unable to perform their duties, including mariners aboard our vessels, or if the Company’s terminals are temporarily closed due to a COVID-19 outbreak. Some vessel dry-dockings could also be delayed or become more expensive if shipyards are unable to accommodate demand or obtain parts or if necessary personnel are not allowed to travel to the shipyards. +​ +Due to the continuing uncertainty around the duration, breadth and severity of the COVID-19 pandemic, including the potential for resurgences or mutations of the virus, the actions taken to contain the virus or treat its impact, including the availability, distribution, efficacy and public acceptance of vaccines, and the impact of economic stimulus measures, the ultimate impact on the Company’s business, financial condition, operating results or cash flows cannot be reasonably estimated at this time. Additional or unforeseen effects from the COVID-19 pandemic may give rise to additional risks or instigate or amplify the other risks described throughout these Risk Factors. +​ +Changes in economic conditions or governmental policies have resulted in a decrease in consumer confidence and market demand for the Company’s services and products in certain markets and have adversely affected the Company’s financial position, results of operations, liquidity, or cash flows. +​ +Within the U.S., a weakening of economic drivers in Hawaii and Alaska, which include tourism, military spending, construction starts, personal income growth and employment, the weakening of consumer confidence, market demand, and the economy in the U.S. Mainland, and the effect of a change in the strength of the U.S. dollar against other foreign currencies, have reduced the demand for goods, adversely affecting inland and ocean transportation volumes or rates. For example, the uncertainties regarding the COVID-19 pandemic and other restrictions have severely decreased tourism, weakened consumer demand in certain segments, increased unemployment, and contributed to an economic downturn in the U.S., impacting freight volumes and revenues. The decline in the price of oil due to the oil trade wars and reduced demand from the decline in air or car travel in response to COVID-19 will further impact the Alaska economy, which in turn could impact the Company’s business. In addition, overcapacity in the global or transpacific ocean transportation markets, a change in the cost of goods or currency exchange rates, imposition of tariffs and uncertainties regarding tariff rates, or a change in international trade policies could adversely affect freight volumes and rates in the Company’s China service. +​ +13 +Table of Contents +The shipping industry is competitive and the Company has been impacted by new or increased competition. +​ +The Company may face new competition by established or start-up shipping operators that enter the Company’s markets. The shipping industry is competitive with limited barriers to entry as ocean carriers can shift vessels in and out of tradelanes or charter vessels to manage capacity and meet customer demands. For example, in May 2020, the Company’s major competitor in the China service upsized its expedited service from China to the U.S. West Coast. The entry of a new competitor or the addition of new vessels or capacity by existing competition on any of the Company’s routes could result in a significant increase in available shipping capacity that could have an adverse effect on the Company’s volumes and rates. +​ +The loss of or damage to key customer or agent relationships may adversely affect the Company’s business. +​ +The Company’s businesses are dependent on their relationships with customers and agents, and derive a significant portion of their revenues from the Company’s largest customers. The Company’s business relies on its relationships with the U.S. military, freight forwarders, large retailers and consumer goods and automobile manufacturers, as well as other larger customers. For more information regarding the Company’s significant customers, see the discussion in Part I, Item 1 of this Annual Report. +​ +The Company could also be adversely affected by any changes in the services, or changes to the costs of services, provided by third party vendors such as railroads, terminals, agents and shipping companies, including charter vessel owners. Service structures and relationships with these parties are important in the Company’s intermodal business, as well as in the China, Guam, Micronesia, Japan, Alaska export and South Pacific services. +​ +The loss of or damage to any of these key relationships may adversely affect the Company’s business and revenue. +​ +The Company is dependent upon key vendors and third-parties for equipment, capacity and services essential to operate its business, and if the Company fails to secure sufficient third-party services, its business could be adversely affected. +​ +The Company’s businesses are dependent upon key vendors who provide rail, truck and ocean transportation services. If the Company cannot secure sufficient transportation equipment, capacity or services from these third-parties at reasonable prices or rates to meet its or its customers’ needs and schedules, customers may seek to have their transportation and logistics needs met by others on a temporary or permanent basis. If this were to occur, the Company’s business, results of operations and financial condition could be adversely affected. +​ +An increase in fuel prices, changes in the Company’s ability to collect fuel-related surcharges, and/or the cost or limited availability of required fuels on the U.S. West Coast may adversely affect the Company’s profits. +​ +Fuel is a significant operating expense for the Company’s Ocean Transportation business. The price and supply of fuel are unpredictable and fluctuate based on events beyond the Company’s control. Increases in the price of fuel may adversely affect the Company’s results of operations. Increases in fuel costs also can lead to increases in other expenses, such as energy costs and costs to purchase outside transportation services. In the Company’s Ocean Transportation and Logistics services segments, the Company utilizes fuel-related surcharges, although increases in the fuel-related surcharge may adversely affect the Company’s competitive position and may not correspond exactly with the timing of increases in fuel expense. Changes in the Company’s ability to collect fuel-related surcharges also may adversely affect its results of operations. +​ +Effective January 1, 2020, the IMO imposed a world-wide regulation generally requiring that all ships burn compliant fuel oil with a maximum sulfur content of less than or equal to 0.5 percent. Currently, LSFO is typically priced higher than HSFO due to the need for further oil refinement. In some market instances, the prices between the two products could be inverted. There is no guarantee that the Company’s contracts to secure LSFO on the U.S. West Coast will secure quantities in sufficient amounts and at a reasonable cost. In addition, prolonged use of LSFO on some Matson vessels could degrade engine performance or lead to higher maintenance costs. There may also be delays or other unexpected complications in connection with Matson’s announced plans to install a scrubber on at least one additional vessel. The Company’s ability to recover the higher costs of IMO 2020 compliant fuel through fuel-related surcharges, the availability of LSFO, and the potential impact on vessel performance may adversely affect the Company’s operations, business and profit. +14 +Table of Contents +​ +The Company’s operations are susceptible to weather, natural disasters, maritime accidents, spill events and other operating risks. +​ +The Company’s operations are vulnerable to disruption as a result of weather, natural disasters and other climate-driven events, such as bad weather at sea, hurricanes, typhoons, tsunamis, floods and earthquakes, as well as a maritime accident, oil or other spill, or other environmental mishap. Climate change has increased and may continue to increase the frequency, severity and uncertainty of such events. Such events interfere with the Company’s ability to provide on-time scheduled service, resulting in increased expenses and potential loss of business associated with such events. In addition, severe weather and natural disasters can result in interference with the Company’s terminal operations and may cause serious damage to its vessels and cranes. These impacts could be particularly acute in certain ports in Alaska where the Company is dependent on a single crane. The Company’s vessels and their cargoes are also subject to operating risks such as mechanical failure, collisions and human error. +​ +The occurrence of any of these events may result in damage to or loss of vessels, containers, cargo and other equipment, loss of life or physical injury to its employees or people, pollution and suspension of operations. These events can expose the Company to reputational harm and liability for resulting damages and possible penalties that, pursuant to typical maritime industry policies, it must pay and then seek reimbursement from its insurer. Affected vessels may also be removed from service and thus would be unavailable for income-generating activity. +​ +The Company’s casualty and liability insurance policies are generally subject to large retentions and deductibles and may not cover all losses the Company may incur. Some types of losses, such as losses resulting from a port blockage, generally, are not insured. In some cases the Company retains the entire risk of loss because it is not economically prudent to purchase insurance coverage or because of the perceived remoteness of the risk. Other risks are uninsured because insurance coverage may not be commercially available. Finally, the Company retains all risk of loss that exceeds the limits of its insurance. +​ +In addition to the COVID-19 pandemic, the Company faces risks related to actual or threatened health epidemics, pandemics or other major health crises, which could significantly disrupt the Company’s business. +​ +The Company’s business could be impacted adversely by the effects of public health epidemics, pandemics or other major heath crises (which the Company refers to collectively as public health crises). Actual or threatened public health crises may have a number of adverse impacts, including volatility in the global economy, impacts to the Company’s customers’ business operations, reduced tourism in the markets the Company serves, or significant disruptions in ocean-borne transportation of goods, logistics demand and supply chain activity, caused by a variety of factors such as quarantines, factory and office closures, port closures, or other government-imposed restrictions, any of which could adversely impact the Company’s business, financial condition, operating results and cash flows. +​ +The Company’s significant operating agreements and leases could be replaced on less favorable terms or may not be replaced when they expire. +​ +The significant operating agreements and leases entered into by the Company in its businesses, including those related to terminals, chartered vessels and warehouses as well as those with SSAT, expire at various points in the future and may not be replaced or could be replaced on less favorable terms, thereby adversely affecting the Company’s future financial position, results of operations and cash flows. For example, on November 26, 2018, a wholly-owned subsidiary of the Company entered into agreements whereby Maunalei , a U.S. flagged and Jones Act qualified vessel, was sold for $106.0 million and leased back from the buyer under an operating lease agreement. The customary representations, warranties and covenants contained in the agreements do not eliminate the risks that (a) the lessor could lose its Jones Act status, (b) the Company could not replace Maunalei in the event it is no longer Jones Act eligible, or (c) if the repurchase option is elected, the Company would not be able to consummate the repurchase of Maunalei at the end of the lease term. +​ +The Company may face unexpected dry-docking or repair costs for its vessels. +​ +The Company routinely engage shipyards to dry-dock its vessels for regulatory compliance and to provide repair and maintenance. Vessels may also have to be dry-docked or repaired at sea in the event of accidents or other unforeseen damage. Unexpected dry-dockings or repairs could require the Company to activate a reserve vessel, purchase additional fuel and operate a less-efficient, smaller vessel for a period of time. The Company also operates a number of +15 +Table of Contents +older active and reserve vessels that may require more frequent and extensive maintenance. The cost of repairs are difficult to predict with certainty and can be substantial. In addition, the time when a vessel is out of service for maintenance is determined by a number of factors, including regulatory deadlines, market conditions, shipyard availability and customer requirements, and accordingly, the length of time that a vessel may be out of service may be longer than anticipated, which could adversely affect the Company’s business, financial condition, results of operations and cash flows. +​ +The Company is involved in a joint venture and is subject to risks associated with joint venture relationships. +​ +The Company is involved in a terminal joint venture with SSAT (and through SSAT, other joint ventures at various U.S. West Coast terminals), and may initiate future joint venture projects. A joint venture involves certain risks for the Company such as: +​ +● The Company’s lack of voting control over the joint venture, including the risk that the joint venture takes actions resulting in reputational harm to the Company; +● Misalignment or inconsistency of interests between the Company and the joint venture partner; +● Reliance on the joint venture partner to fund its share of capital or fulfill its other commitments, including the risk that the joint venture partner could become bankrupt; and +● Operating difficulties and financial losses at the joint venture, which may lead to the Company writing down assets or incurring impairment charges. +​ +In addition, the Company relies on SSAT for its stevedoring services at the ports of Long Beach and Oakland, California and Tacoma, Washington on the U.S. West Coast. The Company could be adversely affected by any changes in the services provided, or to the costs of such services provided by SSAT. +​ +The Company is subject to risks associated with conducting business in foreign shipping markets. +​ +Matson’s China, Alaska export, Micronesia, Japan and South Pacific services are subject to risks associated with conducting business in a foreign shipping market, which include: +​ +● Challenges associated with operating in foreign countries and developing relationships with foreign companies, business associates and governments, including as a result of cultural differences; +● Difficulties in staffing and managing foreign operations, including dynamic employment and immigration laws; +● The Company’s ability to comply with U.S. and foreign legal and regulatory restrictions, including anti-corruption laws such as the Foreign Corrupt Practices Act; +● Not having continued access to existing port facilities or feeder vessels; +● The Company’s ability to manage changes in the cost of goods or currency exchange rate fluctuations; +● Political and economic instability; and +● Dynamics involving U.S. trade relations with other countries, including the imposition of or uncertainty associated with the level of tariffs or other governmental actions. +​ +The Company’s terminals in Hawaii and Alaska require modernization. +​ +The Company has completed the first phase of renovating and modernizing its Sand Island terminal in Honolulu Harbor. Significant additional upgrades and projects remain. The Company has also begun discussions with state and local authorities in Anchorage, Alaska regarding upgrades to those terminal and port facilities. Regulatory, construction or other delays or cost overruns related to the expansion and modernization of the terminals could have an adverse impact on the Company’s business plans, financial condition and results of operations. In addition, the terminal modernization programs may not result in improved operational productivity or generate expected returns. +​ +16 +Table of Contents +Heightened security measures, war, actual or threatened terrorist attacks, efforts to combat terrorism and other acts of violence may adversely impact the Company’s operations and profitability. +​ +War, terrorist attacks and other acts of violence may cause consumer confidence and spending to decrease, or may affect the ability or willingness of tourists to travel to Hawaii, Guam or Alaska, thereby adversely affecting those economies and the Company. Additionally, future terrorist attacks could increase volatility in the U.S. and worldwide financial markets. Acts of war or terrorism may be directed at the Company’s shipping operations, or may cause the U.S. government to take control of Matson’s vessels for military operation. Heightened security measures, including customs inspections and related procedures in countries of origin and destination, potentially slow the movement and increase the cost of freight through U.S. or foreign ports, across borders or on U.S. or foreign railroads or highways. +​ +Acquisitions may have an adverse effect on the Company’s business. +​ +The Company’s growth strategy includes expansion through acquisitions, including, for example, the Company’s acquisitions of Horizon Lines, Inc. (“Horizon”) in 2015 and Span Intermediate, LLC (“Span Alaska”) in 2016. There is no assurance that the Company will be successful in identifying, negotiating, or consummating any future acquisitions. Even if suitable candidates are identified, such transactions may result in difficulties in assimilating acquired assets or companies, and may result in the diversion of the Company’s capital and its management attention from other business issues and opportunities. The Company may not be able to integrate companies that it acquires successfully, including their personnel, financial systems, distribution, operations and general operating procedures. The Company may also encounter challenges in achieving appropriate internal control over financial reporting in connection with the integration of an acquired company. The Company may pay a premium for an acquisition, resulting in goodwill that may later be determined to be impaired. +​ +Risks Related to Employees +​ +Work stoppages or other labor disruptions caused by the Company’s unionized workers and other workers or their unions in related industries could adversely affect the Company’s operations. +​ +A significant portion of Matson’s employees are covered by collective bargaining agreements. Furthermore, the Company relies on the services of third- parties, including SSAT, that employ persons covered by collective bargaining agreements. For additional information on collective bargaining agreements with unions, see Item 1.C. Employees and Labor Relations of Part I of this Annual Report. +​ +The Company has been adversely affected by actions taken by employees of the Company or other companies in related industries against efforts by management of the Company or other companies to control labor costs, restrain wage or benefit increases or modify work practices. Strikes and disruptions have occurred as a result of the failure of Matson or other companies in its industry to negotiate collective bargaining agreements with such unions successfully. +​ +In addition, any slow-downs, strikes, lock-outs or other disruptions, including limits on the availability of labor through trade union hiring halls have had and in the future could have an adverse impact on Matson’s or SSAT’s operations. +​ +Loss of the Company’s key personnel or failure to adequately manage human capital could adversely affect its business. +​ +The Company’s future success will depend, in significant part, upon the continued services of its key personnel and skilled employees, including its senior management, as well as key personnel at its joint venture partners. The permanent or temporary loss of the services of key personnel could adversely affect the Company’s future operating results because of such employees’ experience and knowledge of the Company’s business and customer relationships. If key employees depart or are unable to work, the Company may incur significant costs to replace them. Additionally, the Company’s ability to execute its business model could be impaired if it cannot replace such personnel in a timely manner. The Company’s investments in and efforts to manage its human capital, including to maintain a desirable workplace culture, may not be successful in identifying, attracting, developing, motivating, retaining, competing for or replacing qualified personnel. The Company does not maintain key person insurance on any of its key personnel. +​ +17 +Table of Contents +Risks Related to Information Technology +​ +If the Company is not able to use the Company’s information technology and communications systems effectively, the Company’s ability to conduct business might be negatively impacted. +​ +The Company is highly dependent on the proper functioning of our information technology systems to enable operations and compete effectively. The Company regularly updates its information technology systems or implements new systems, which could cause substantial business interruption. There is no assurance that the systems upgrades or new systems will meet our current or future business needs, or that they will operate as designed. For example, the Company is in the midst of a multi-year process to implement a new enterprise resource planning, or ERP, system intended to enhance operating efficiencies and provide more effective management of its business operations. +​ +The Company’s information technology systems also rely on third-party service providers for access to the Internet, satellite-based communications systems, the electric grid, database storage facilities and telecommunications providers. The Company has no control over the operations of these third-party service providers. In the past, disruptions in the Company’s third-party service providers have impacted the Company’s operations, including the Company’s ability to book and manage freight, stow vessels, and process customs declarations. In response to the COVID-19 pandemic and in compliance with guidance from public health officials and state and local governments, many of the Company’s employees are working from home or remotely, increasing the Company’s dependence on its information technology systems and third-party providers. If the Company’s information technology and communications systems experience reliability issues, integration or compatibility concerns or if the Company’s third-party providers are unable to perform effectively or experience disruptions or failures, there could be an adverse impact on the availability and functioning of the Company’s information technology and communications systems, which could lead to business disruption or inefficiencies, reputational harm or loss of customers. +​ +The Company’s information technology systems have in the past and may in the future be exposed to cybersecurity risks and other disruptions that could impair the Company’s ability to operate and adversely affect its business. +​ +The shipping industry is a more frequent target of cyber attacks than some other industries because of the essential nature of these services. The Company relies extensively on its information technology systems and third-party service providers in many aspects of its business, including cloud services for accounting, billing, disbursement, cargo booking and tracking, vessel scheduling and stowage, equipment tracking, customer service, banking, payroll and employee communication systems. The Company also collects, stores and transmits sensitive data, including its proprietary business information and that of its customers, and personally identifiable information of its customers and employees. Despite the Company’s continuous efforts to make investments in the Company’s information technology systems and system-wide data security program, the implementation of security measures to protect the Company’s data and infrastructure against breaches and other cyber threats, and the Company’s use of internal processes and controls designed to protect the security and availability of the Company’s systems, the Company has in the past experienced and may in the future experience cybersecurity risks, such as computer viruses, hacking, malware, denial of service attacks, cyber terrorism, circumvention of security systems, malfeasance, breaches due to employee error, natural disasters, telecommunications failure, or other catastrophic events at the Company’s facilities, aboard its vessels or at third-party locations. +​ +Any failure, breach or unauthorized access to the Company’s systems or those of third-parties on which the Company relies could result in the loss of confidential, sensitive or proprietary information, interruptions in its service or production or otherwise impact the Company’s ability to conduct business operations, and could result in potential reductions in revenue and profits, damage to its reputation or liability. +​ +Risks Related to Financial Matters +​ +The Company may be required to record a significant charge to earnings if recorded intangible assets associated with the Span Alaska acquisition become impaired. +​ +The Company recorded significant intangible assets related to goodwill, customer relationships and trade name arising from the Span Alaska acquisition. The Company is required to test goodwill for impairment annually, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value of a reporting unit is less +18 +Table of Contents +than its carrying amount. Factors that could lead to an impairment of goodwill or intangible customer relationships include any significant adverse changes affecting the reporting unit’s financial condition, results of operations, and future cash flows. +​ +A deterioration of the Company’s credit profile, disruptions of the credit markets or higher interest rates could restrict its ability to access the debt capital markets or increase the cost of debt. +​ +Deterioration in the Company’s credit profile may have an adverse effect on the Company’s ability to access the private or public debt markets and also may increase its borrowing costs. If the Company’s credit profile deteriorates significantly, its access to the debt capital markets or its ability to renew its committed lines of credit may become restricted, or the Company may not be able to refinance debt at the same levels or on the same terms. Because the Company relies on its ability to draw on its revolving credit facilities to support its operations when required, any volatility in the credit and financial markets that prevents the Company from accessing funds (for example, a lender that does not fulfill its lending obligation) could have an adverse effect on the Company’s financial condition and cash flows. Additionally, the Company’s credit agreements generally include an increase in borrowing rates if the Company’s credit profile deteriorates. Furthermore, the Company incurs interest under its revolving credit facilities based on floating rates. Floating rate debt creates higher debt service requirements if market interest rates increase, as was the case in connection with the U.S. Federal Reserve’s interest rate increases in 2018, which would adversely affect the Company’s cash flow and results of operations. In addition, as the floating rate on certain borrowings under the Company’s revolving credit facility is tied to LIBOR, the uncertainty regarding the future of LIBOR as well as the transition from LIBOR to an alternate benchmark rate or rates could pose funding risks for the Company and adversely affect the Company’s financing costs. Disruptions to the credit markets as a result of the COVID-19 pandemic or other macroeconomic or financial market developments could increase the Company’s cost of capital and limit the Company’s access to capital. +​ +Failure to comply with certain restrictive financial covenants contained in the Company’s credit facilities could preclude the payment of dividends, impose restrictions on the Company’s business segments, capital resources or other activities or otherwise adversely affect the Company. +​ +The Company’s credit facilities contain certain restrictive financial covenants, the most restrictive of which include a maximum ratio of debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”), a minimum ratio of EBITDA to interest expense, certain prohibitions on additional priority debt, certain prohibitions on sale leaseback transactions, and the maintenance of minimum shareholders’ equity. If the Company does not maintain these and other required covenants, and a breach of such covenants is not cured timely or waived by the lenders, resulting in a default, the Company’s access to credit may be limited or terminated, dividends may be suspended, and the lenders could declare any outstanding amounts due and payable. The Company’s continued ability to borrow under its credit facilities is subject to compliance with these financial and other non-financial covenants. +​ +The Company’s effective income tax rate may vary. +​ +Various internal and external factors may have favorable or unfavorable material or immaterial effects on the Company’s effective income tax rate and, therefore, impact the Company’s net income and earnings per share. These factors include, but are not limited to changes in tax rates; changes in tax laws, regulations, and rulings; changes in interpretations of existing tax laws, regulations and rulings; changes in the evaluation of the Company’s ability to realize deferred tax assets, and changes in uncertain tax positions; changes in accounting principles; changes in current pre-tax income as well as changes in forecasted pre-tax income; changes in the level of Capital Construction Fund (“CCF”) deductions, non-deductible expenses, and expenses eligible for tax credits; changes in the mix of earnings among countries with varying tax rates; and acquisitions and changes in the Company’s corporate structure. These factors may result in periodic revisions to the Company’s effective income tax rate, which could affect the Company’s cash flow and results of operations. +​ +Changes in the value of pension assets, or a change in pension law or key assumptions, may adversely affect the Company’s financial performance. +​ +The amount of the Company’s employee pension and post-retirement benefit costs and obligations is calculated on assumptions used in the relevant actuarial calculations. Adverse changes in any of these assumptions due to economic or other factors, changes in discount rates, higher health care costs, or lower actual or expected returns on plan assets, may +19 +Table of Contents +adversely affect the Company’s operating results, cash flows, and financial condition. In addition, a change in federal law, including changes to the Employee Retirement Income Security Act or Pension Benefit Guaranty Corporation premiums, may adversely affect the Company’s single-employer and multi-employer pension plans and plan funding. These factors, as well as a decline in the fair value of pension plan assets, may put upward pressure on the cost of providing pension and medical benefits and may increase future pension expense and required funding contributions. There can be no assurance that the Company will be successful in limiting future cost and expense increases, and continued upward pressure in costs and expenses could further reduce the profitability of the Company’s businesses. +​ +The Company may have exposure under its multi-employer pension and post-retirement plans in which it participates that extends beyond its funding obligation with respect to the Company’s employees. +​ +The Company contributes to various multi-employer pension plans. In the event of a partial or complete withdrawal by the Company from any plan that is underfunded, the Company would be liable for a proportionate share of such plan’s unfunded vested benefits (see Note 11 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report). Based on the limited information available from plan administrators, which the Company cannot independently validate, the Company believes that its portion of the contingent liability in the case of a full withdrawal or termination may be material to its financial position and results of operations. If any other contributing employer withdraws from any plan that is underfunded, and such employer (or any member of its controlled group) cannot satisfy its obligations under the plan at the time of withdrawal, then the Company, along with the other remaining contributing employers, would be liable for its proportionate share of such plan’s unfunded vested benefits. In addition, if any of the multi-employer plans to which the Company contributes fails to satisfy the minimum funding requirements, the Internal Revenue Service will impose certain penalties and taxes on the Company and other contributing employers. +​ +Risks Related to Legal, Regulatory and Compliance Matters +​ +As an ocean transportation and logistics services company, the Company is subject to numerous safety, environmental, and other laws and regulations that impact the Company’s operations, are costly to comply with and expose us to liability. +​ +The Company, including its vessels and terminals, is subject to numerous federal, state and local laws and regulations, including those related to safety, cabotage, equipment standards and government rates. In addition, the Company is subject to environmental laws and regulations, including those relating to air quality initiatives at port locations; air emissions; wastewater discharges; the transportation, handling and disposal of solid and hazardous materials, oil and oil- related products, hazardous substances and wastes; the investigation and remediation of contamination; health, safety and the protection of the environment and natural resources; and climate change, including any regulations, mandates or restrictions related to greenhouse gas emissions, such as a “cap and trade” system of allowances and credits, and energy use. For a discussion of specific laws and regulations, see Part I, Item 1, of this Annual Report. Any changes in applicable laws and regulations, including their enforcement or interpretation, as well as any new laws and regulations that are adopted, including as a result of the recent change in U.S. Presidential Administration, could impose significant additional costs and limitations on the Company’s ability to operate. Such costs may not be recoverable through increased payments from customers. +​ +These laws and regulations require us to obtain certificates of financial responsibility and to adopt procedures for oil and hazardous substance spill prevention, response and clean up, among other requirements impacting the Company’s business. In complying with applicable laws and regulations, the Company has incurred expenses and may incur material future costs and expenses related to vessel and equipment modifications, new equipment, higher-priced fuel, changes in operating practices and procedures, tracking emissions, changing routes, installing scrubbers, adopting or modifying energy sources and undergoing additional oversight inspections, all of which could adversely affect the Company’s business and financial condition. For example, Matson’s vessels operate within emissions control areas, and the Company’s U.S. flagged vessels generally must be maintained “in class” and are subject to periodic inspections by the American Bureau of Shipping or similar classification societies. They also must be periodically inspected by, or on behalf of, the United States Coast Guard. The Company’s vessels’ operating certificates and licenses are renewed periodically during the required annual surveys of the vessels, but there is no assurance that the Company’s programs and policies will be sufficient to have such certificates and licenses renewed. The EPA also requires vessels to obtain coverage under a general permit and to comply with inspection, monitoring, discharge, recordkeeping and reporting requirements. +​ +20 +Table of Contents +These laws and regulations provide for substantial fines, as well as criminal and civil penalties, in the event of any violations of, or non-compliance with, their requirements (including any waivers, permits or recordkeeping and other reporting requirements). Any vessel-generated pollution from incidents in U.S. waters within three nautical miles, and in some cases, within the 200-mile exclusive economic zone, for example, could expose us to such fines or penalties. +​ +The Company is subject to, and may in the future be subject to, disputes, legal or other proceedings, and government inquiries or investigations that could have an adverse effect on the Company. +​ +The nature of the Company’s business exposes it to the potential for disputes, legal or other proceedings, and government inquiries or investigations relating to antitrust matters, labor and employment matters, personal injury and property damage, environmental and other matters, as discussed in the other risk factors disclosed in this section or in other Company filings with the SEC. For example, Matson is a common carrier, whose tariffs, rates, rules and practices in dealing with its customers are governed by extensive and complex foreign, federal, state and local regulations, which may be the subject of disputes or administrative or judicial proceedings. If these disputes develop into proceedings, these proceedings, individually or collectively, could involve or result in significant expenditures or losses by the Company, or result in significant changes to Matson’s tariffs, rates, rules and practices in dealing with its customers. +​ +The Company may continue to be exposed to risks and unknown liabilities related to the Horizon acquisition. +​ +The Company acquired Horizon subject to all of the liabilities and obligations of its non-Hawaii business, including any remaining liabilities and obligations associated with its Puerto Rico operations, which Horizon ceased during the first quarter of 2015. The disposition of these liabilities, and any other obligations that are unknown to the Company, including contingent liabilities, could have an adverse effect on the Company’s financial condition and results of operations. +​ +Pasha acquired Horizon’s former Hawaii business immediately before the Company acquired Horizon, and Pasha assumed substantially all liabilities and obligations related to Horizon’s Hawaii business and agreed to perform various covenants. In some cases, however, Horizon, as the original contracting party, may remain primarily responsible for such assumed Hawaii liabilities and obligations. The Company may incur losses related to such assumed Hawaii liabilities and obligations. +​ +​ +ITEM 1B. UNRESOLVED STAFF COMMENTS +​ +None. +​ +21 +Table of Contents +ITEM 2. PROPERTIES +​ +Matson leases terminal facilities including office and storage space. Material terminal facilities, which are used by the Company’s Ocean Transportation segment, include the following locations: +​ +​ +​ +​ +​ +Terminal Location +Acreage +Honolulu, Hawaii +105 +Anchorage, Alaska +38 +Dutch Harbor, Alaska +18 +Kodiak, Alaska +6 +Tacoma, Washington +​ +14 +​ +Polaris Point, Guam +​ +30 +​ +The Company is currently renewing certain terminal leases which expired during 2020. The Company expects to be able to renew these leases on similar terms to those that existed within the previous lease agreements. The Company’s other primary terminal facilities located at the ports of Oakland and Long Beach, California, and Tacoma, Washington are leased by SSAT. +​ +Other material facilities used in the Company’s operations by both of the Company’s segments include the following: +​ +​ +​ +​ +​ +​ +​ +Other Material Facilities +Description of Facility +Square Footage +Pooler, Georgia +Warehouse +710,844 +​ +Oakland, California +Warehouse +406,463 +​ +Pooler, Georgia +Warehouse +324,832 +​ +Oakland, California +Warehouse +132,000 +​ +Piti, Guam +​ +Warehouse +​ +62,478 +​ +Anchorage, Alaska +​ +Office / Cross-dock +​ +54,000 +​ +Auburn, Washington +Office / Cross-dock +51,250 +​ +​ +​ +​ +ITEM 3. LEGAL PROCEEDINGS +​ +Environmental Matters: The Company’s Ocean Transportation segment has certain risks that could result in expenditures for environmental remediation. The Company believes that based on all information available to it, the Company is currently in compliance, in all material respects, with applicable environmental laws and regulations. +​ +In accordance with SEC rules, with respect to administrative or judicial proceedings involving the environment, the Company has determined that in future filings it will disclose any such proceeding if it reasonably believes such proceeding will result in monetary sanctions, exclusive of interest and costs, at or in excess of $1 million. The Company believes that such threshold is reasonably designed to result in disclosure of environmental proceedings that are material to its business or financial condition. +​ +Other Matters: The Company and its subsidiaries are parties to, or may be contingently liable in connection with, other legal actions arising in the normal course of their businesses, the outcomes of which, in the opinion of management after consultation with counsel, would not have a material effect on the Company’s financial condition, results of operations, or cash flows. +​ +​ +ITEM 4. MINE SAFETY DISCLOSURES +​ +Not Applicable. +​ +22 +Table of Contents +PART II +​ +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +​ +General Information: Matson’s common stock is traded on the New York Stock Exchange under the ticker symbol “MATX”. As of February 19, 2021, there were 2,103 shareholders of record of Matson common stock. +​ +Stockholder Return Performance Graph and Trading Information: The following information in this Item 5 shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933. +​ +The cumulative total return listed below assumed an initial investment of $100 and reinvestment of dividends at each fiscal end and measures the performance of this investment as of the last trading day in the month of December for each of the five years ended December 31, 2020. The graph is a historical representation of past performance only and is not necessarily indicative of future performance. +* +$100 invested on December 31, 2015 in stock or index, including reinvestment of dividends. +​ +Trading volume averaged 234,930 shares a day in 2020, compared with 155,804 shares a day in 2019 and 232,289 shares a day in 2018, as reported by the New York Stock Exchange. +​ +​ +23 +Table of Contents +Dividends: Dividends declared per share of common stock by the Company for each fiscal quarter during 2019 and 2020 were as follows: +​ +​ +​ +​ +​ +Dividends +2019 +​ +Declared +First Quarter +​ +$ +0.21 +Second Quarter +​ +$ +0.21 +Third Quarter +​ +$ +0.22 +Fourth Quarter +​ +$ +0.22 +2020 +​ +​ +​ +First Quarter +​ +$ +0.22 +Second Quarter +​ +$ +0.22 +Third Quarter +​ +$ +0.23 +Fourth Quarter +​ +$ +0.23 +​ +Matson’s Board of Directors also declared a cash dividend of $0.23 per share for the first quarter 2021, payable on March 4, 2021 to shareholders of record on February 11, 2021. Although Matson expects to continue paying quarterly cash dividends on its common stock, the declaration and payment of dividends are subject to the discretion of the Board of Directors and will depend upon Matson’s financial condition, results of operations, cash requirements and other factors deemed relevant by the Board of Directors. +​ +​ +​ +​ +24 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +​ +The comparative selected financial data of the Company is presented for each of the five years in the period ended December 31, 2020. The information should be read in conjunction with Item 8, “Financial Statements and Supplementary Data,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. All fiscal years include 52 weeks, except for the year ended December 31, 2016 which includes 53 weeks: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions, except per share amounts) +2020 +2019 +2018 +2017 +2016 +Operating Revenue: (1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +1,853.9 +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +$ +1,571.8 +​ +$ +1,541.1 +​ +Logistics +​ +529.4 +​ +536.5 +​ +581.5 +​ +475.1 +​ +400.5 +​ +Total Operating Revenue +​ +$ +2,383.3 +​ +$ +2,203.1 +​ +$ +2,222.8 +​ +$ +2,046.9 +​ +$ +1,941.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating and Net Income: (1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (2) +​ +$ +244.8 +​ +$ +90.8 +​ +$ +131.1 +​ +$ +126.4 +​ +$ +144.5 +​ +Logistics +​ +35.5 +​ +38.3 +​ +32.7 +​ +20.9 +​ +12.2 +​ +Total Operating Income +​ +280.3 +​ +129.1 +​ +163.8 +​ +147.3 +​ +156.7 +​ +Interest expense +​ +(27.4) +​ +(22.5) +​ +(18.7) +​ +(24.2) +​ +(24.1) +​ +Other income (expense), net +​ +6.1 +​ +1.2 +​ +2.6 +​ +2.1 +​ +(2.1) +​ +Income before Income Taxes +​ +259.0 +​ +107.8 +​ +147.7 +​ +125.2 +​ +130.5 +​ +Income taxes (3) +​ +(65.9) +​ +(25.1) +​ +(38.7) +​ +105.8 +​ +(49.1) +​ +Net Income +​ +$ +193.1 +​ +$ +82.7 +​ +$ +109.0 +​ +$ +231.0 +​ +$ +81.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Identifiable Assets: (1)(6) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (4) +​ +$ +2,431.1 +​ +$ +2,424.5 +​ +$ +2,071.6 +​ +$ +1,941.5 +​ +$ +1,726.3 +​ +Logistics +​ +469.5 +​ +420.9 +​ +358.8 +​ +310.1 +​ +293.3 +​ +Total Assets +​ +$ +2,900.6 +​ +$ +2,845.4 +​ +$ +2,430.4 +​ +$ +2,251.6 +​ +$ +2,019.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capital Expenditure: (5) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +190.0 +​ +$ +294.5 +​ +$ +385.4 +​ +$ +305.3 +​ +$ +179.1 +​ +Logistics +​ +2.3 +​ +15.8 +​ +15.8 +​ +1.7 +​ +0.3 +​ +Total Capital Expenditures +​ +$ +192.3 +​ +$ +310.3 +​ +$ +401.2 +​ +$ +307.0 +​ +$ +179.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and Amortization: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +107.4 +​ +$ +93.6 +​ +$ +87.0 +​ +$ +93.3 +​ +$ +92.6 +​ +Logistics +​ +7.5 +​ +6.8 +​ +7.4 +​ +7.9 +​ +4.5 +​ +​ +​ +​ +114.9 +​ +​ +100.4 +​ +​ +94.4 +​ +​ +101.2 +​ +​ +97.1 +​ +Deferred Dry-docking Amortization — Ocean Transportation +​ +​ +25.1 +​ +​ +34.3 +​ +​ +37.4 +​ +​ +46.2 +​ +​ +38.9 +​ +Total Depreciation and Amortization +​ +$ +140.0 +​ +$ +134.7 +​ +$ +131.8 +​ +$ +147.4 +​ +$ +136.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Earnings Per Share in Net Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic +​ +$ +4.48 +​ +$ +1.93 +​ +$ +2.55 +​ +$ +5.38 +​ +$ +1.89 +​ +Diluted +​ +$ +4.44 +​ +$ +1.91 +​ +$ +2.53 +​ +$ +5.35 +​ +$ +1.87 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash dividends per share declared +​ +$ +0.90 +​ +$ +0.86 +​ +$ +0.82 +​ +$ +0.78 +​ +$ +0.74 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total debt obligations — including current portion +​ +$ +744.8 +​ +$ +958.4 +​ +$ +856.4 +​ +$ +857.1 +​ +$ +738.9 +​ +Total Shareholders' equity +​ +$ +961.2 +​ +$ +805.7 +​ +$ +755.3 +​ +$ +677.2 +​ +$ +494.9 +​ +Shares outstanding +​ +43.2 +​ +42.9 +​ +42.7 +​ +42.5 +​ +42.9 +​ +(1) 2016 and subsequent selected financial data includes the operation of Span Alaska acquired as of August 4, 2016. +(2) The Ocean Transportation segment includes $26.3 million, $20.8 million, $36.8 million, $28.2 million and $15.8 million of equity in income from the Company’s investment in SSAT, for 2020, 2019, 2018, 2017 and 2016, respectively. +(3) Income taxes for the years ended December 31, 2019, 2018 and 2017 include a non-cash income tax (expense)/benefit of $2.9 million, $(2.9) million and $154.0 million, respectively, related to the remeasurement of the Company’s deferred assets and liabilities and other discrete adjustments as a result of applying the Tax Cut and Jobs Act of 2017. +(4) The Ocean Transportation segment includes $48.7 million, $76.2 million, $87.0 million, $93.2 million and $82.4 million related to the Company’s investment in SSAT as of December 31, 2020, 2019, 2018, 2017 and 2016, respectively. +(5) Excludes expenditures related to Matson’s acquisition of Span Alaska which were classified as payments for acquisitions in Cash Flows used in Investing Activities within the Consolidated Statements of Cash Flows. +(6) Identifiable assets for 2020 and 2019 includes Operating lease right of use assets resulting from the adoption of the lease accounting standard in 2019. +​ +25 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +​ +FORWARD-LOOKING STATEMENTS AND RISK FACTORS +​ +The Company, from time to time, may make or may have made certain forward-looking statements, whether orally or in writing, such as forecasts and projections of the Company’s future performance or statements of management’s plans and objectives. These statements are “forward-looking” statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be contained in, among other things, SEC filings such as Forms 10-K, 10-Q and 8-K, the Annual Report to Shareholders, press releases made by the Company, the Company’s Internet websites (including websites of its subsidiaries), and oral statements made by the officers of the Company. Except for historical information contained in these written or oral communications, such communications contain forward-looking statements. These include, for example, all references to 2021 or future years. New risk factors emerge from time to time and it is not possible for the Company to predict all such risk factors, nor can it assess the impact of all such risk factors on the Company’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Accordingly, forward-looking statements cannot be relied upon as a guarantee of future results and involve a number of risks and uncertainties that could cause actual results to differ materially from those projected in the statements, including but not limited to the factors that are described in Part I, Item 1A under the caption of “Risk Factors” of this Form 10-K, which section is incorporated herein by reference. The Company is not required, and undertakes no obligation, to revise or update forward-looking statements or any factors that may affect actual results, whether as a result of new information, future events, or circumstances occurring after the date of this report. +​ +OVERVIEW +​ +Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a discussion of the Company’s financial condition, results of operations, liquidity and certain other factors that may affect its future results from the perspective of management. The discussion that follows is intended to provide information that will assist in understanding the changes in the Company’s Consolidated Financial Statements from year to year, the primary factors that accounted for those changes, and how certain accounting principles, policies and estimates affect the Company’s Consolidated Financial Statements. MD&A is provided as a supplement to, and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes to the Consolidated Financial Statements in Item 8 of Part II below. Discussion and analysis of the financial condition and results of operations of Matson for the years ended December 31, 2019 and 2018 can be found in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 , filed with the SEC on February 28, 2020. +​ +MD&A is presented in the following sections: +​ +◾ Fourth Quarter 2020 Discussion and Update on Business Conditions +◾ Consolidated Results of Operations +◾ Analysis of Operating Revenue and Income by Segment +◾ Liquidity and Capital Resources +◾ Contractual Obligations, Commitments, Contingencies and Off-Balance Sheet Arrangements +◾ Critical Accounting Estimates +◾ Other Matters +​ +​ +26 +Table of Contents +Fourth Quarter 2020 Discussion and Update on Business Conditions +​ +Ocean Transportation: The Company’s container volume in the Hawaii service in the fourth quarter 2020 was 0.8 percent higher year-over-year primarily due to an additional westbound sailing and higher demand for sustenance and home improvement goods, partially offset by lower tourism activity as a result of the pandemic. The State of Hawaii eased visitor travel restrictions to the islands in October and saw an improvement in the daily passenger counts, but tourism activity remained significantly below the levels achieved in the prior year period. Tourism levels are expected to remain low until the pandemic subsides and to have a meaningfully negative impact on Hawaii’s economy. +​ +In China, the Company’s container volume in the fourth quarter 2020 was 139.1 percent higher year-over-year due to volume from the CLX+ service in addition to higher volume on the CLX service as a result of our increased capacity in the tradelane. Matson continued to realize a rate premium in the fourth quarter 2020 and achieved average freight rates that were higher than in the year ago period . The Company expects elevated consumption of e-commerce and other commodities coupled with other supply and demand factors in the tradelane to largely remain favorable in the first half of 2021 as the pandemic persists. As the pandemic subsides with widespread vaccination, we expect some of the supply and demand factors that we are currently benefitting from to remain and continue to drive demand for our CLX and CLX+ services. +​ +In Guam, the Company’s container volume in the fourth quarter 2020 increased 4.2 percent year-over-year primarily due to higher demand for sustenance and home improvement goods, partially offset by lower tourism activity as a result of the pandemic. In the near-term, we expect depressed tourism levels to have a negative impact on the Guam economy. +​ +In Alaska, the Company’s container volume for the fourth quarter 2020 increased 18.9 percent year-over-year as a result of higher northbound volume primarily due to two additional sailings and higher demand for sustenance and home improvement goods, and modestly higher southbound volume. The Alaska economy continues to be negatively impacted by the economic effects from the COVID-19 pandemic and a low oil price environment. In the near-term, we expect the economy to slowly recover, but remain challenged until the pandemic subsides. +​ +The contribution in the fourth quarter 2020 from the Company’s SSAT joint venture investment was $10.9 million, or $7.9 million higher than the fourth quarter 2019. The increase was driven by higher lift volume. +​ +Logistics: In the fourth quarter 2020, operating income for the Company’s Logistics segment was $9.6 million, or $2.0 million higher compared to the operating income achieved in the fourth quarter 2019. The increase was due primarily to a higher contribution from transportation brokerage as a result of elevated goods consumption and inventory restocking and tight supply and demand fundamentals in our core markets. +​ +CONSOLIDATED RESULTS OF OPERATIONS +​ +The following analysis of the financial results of operations of Matson for the years ended December 31, 2020 and 2019 should be read in conjunction with the Consolidated Financial Statements in Item 8 of Part II below. +​ +Consolidated Results: 2020 compared with 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(Dollars in millions, except per share amounts) +​ +2020 +​ +2019 +​ +Change +Operating revenue +$ +2,383.3 +$ +2,203.1 +$ +180.2 +8.2 +% +Operating costs and expenses +​ +(2,103.0) +​ +(2,074.0) +​ +(29.0) +1.4 +% +Operating income +​ +280.3 +​ +129.1 +​ +151.2 +117.1 +% +Interest expense +​ +(27.4) +​ +(22.5) +​ +(4.9) +21.8 +% +Other income (expense), net +​ +6.1 +​ +1.2 +​ +4.9 +408.3 +% +Income before income taxes +​ +259.0 +​ +107.8 +​ +151.2 +140.3 +% +Income taxes +​ +(65.9) +​ +(25.1) +​ +(40.8) +162.5 +% +Net income +​ +$ +193.1 +​ +$ +82.7 +​ +$ +110.4 +133.5 +% +Basic earnings per share +​ +$ +4.48 +​ +$ +1.93 +​ +$ +2.55 +132.1 +% +Diluted earnings per share +​ +$ +4.44 +​ +$ +1.91 +​ +$ +2.53 +132.5 +% +​ +27 +Table of Contents +Fiscal Year: Fiscal years ended December 31, 2020 and 2019 include 52 weeks. +​ +Consolidated Operating Revenue for the year ended December 31, 2020 increased $180.2 million, or 8.2 percent, compared to the prior year. The increase was due to an increase in Ocean Transportation revenue of $187.3 million offset by a decrease in Logistics revenue of $7.1 million. +​ +Operating Costs and Expenses for the year ended December 31, 2020 increased $29.0 million, or 1.4 percent, compared to the prior year. The increase was due to an increase in Ocean Transportation operating costs and expenses of $33.3 million which was partially offset by a decrease in Logistics operating costs and expenses of $4.3 million. +​ +Operating Income for the year ended December 31, 2020 increased $151.2 million, or 117.1 percent, compared to the prior year. The increase was due to an increase in Ocean Transportation operating income of $154.0 million which was partially offset by an decrease in Logistics operating income of $2.8 million. +​ +The reasons for changes in operating revenue, operating costs and expenses, and operating income are described below, by business segment, in the Analysis of Operating Revenue and Income by Segment. +​ +Interest Expense was $27.4 million for the year ended December 31, 2020, compared to $22.5 million in the prior year. The increase in interest expense was due to a lower offset amount of capitalized interest associated with new vessel construction, partially offset by a reduction in outstanding debt. +​ +Other Income (Expense), net was $6.1 million for the year ended December 31, 2020, compared to $1.2 million in the prior year, and relates to the amortization of certain components of net periodic benefit costs or gains related to the Company’s pension and post-retirement plans, and interest income received from income tax refunds. The increase in Other income (expense) was due to favorable adjustments reflected in the Company’s pension and post-retirement plan liabilities and higher interest received from income tax refunds during the year ended December 31, 2020. +​ +Income Taxes for the year ended December 31, 2020 were $65.9 million, or 25.4 percent of income before income taxes, compared to $25.1 million, or 23.3 percent of income before income taxes in the prior year. The 2019 income tax rate benefited from a $2.9 million, or 2.7 percent of non-cash benefit included in income tax expense, resulting from applying the Tax Cuts and Jobs Act of 2017 (the “Tax Act”). +​ +Net Income during the year ended December 31, 2020 increased $110.4 million, or 133.5 percent, compared to the prior year. +​ +ANALYSIS OF OPERATING REVENUE AND INCOME BY SEGMENT +​ +The following analysis of operating revenue and income by segment for the years ended December 31, 2020 and 2019 should be read in conjunction with the Company’s reportable segments information included in Item 6 of Part II and Note 3 to the Consolidated Financial Statements in Item 8 of Part II. +​ +Ocean Transportation: 2020 compared with 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(Dollars in millions) +2020 +2019 +Change +Ocean Transportation revenue +​ +$ +1,853.9 +​ +$ +1,666.6 +​ +$ +187.3 +​ +11.2 +% +Operating costs and expenses +​ +(1,609.1) +​ +(1,575.8) +​ +(33.3) +​ +2.1 +% +Operating income +​ +$ +244.8 +​ +$ +90.8 +​ +$ +154.0 +​ +169.6 +% +Operating income margin +​ +13.2 +% +5.4 +% +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Volume (Forty-foot equivalent units (FEU), except for automobiles) (1) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Hawaii containers +​ +145,700 +​ +146,600 +​ +(900) +​ +(0.6) +% +Hawaii automobiles +​ +46,600 +​ +62,900 +​ +(16,300) +​ +(25.9) +% +Alaska containers +​ +72,600 +​ +69,400 +​ +3,200 +​ +4.6 +% +China containers +​ +118,900 +​ +64,000 +​ +54,900 +​ +85.8 +% +Guam containers +​ +18,900 +​ +19,400 +​ +(500) +​ +(2.6) +% +Other containers (2) +​ +17,500 +​ +16,900 +​ +600 +​ +3.6 +% +(1) Approximate volumes included for the period are based on the voyage departure date, but revenue and operating income are adjusted to reflect the percentage of revenue and operating income earned during the reporting period for voyages in transit at the end of each reporting period. +(2) Includes containers from services in various islands in Micronesia and the South Pacific, and Okinawa, Japan. +28 +Table of Contents +​ +Ocean Transportation revenue increased $187.3 million, or 11.2 percent, during the year ended December 31, 2020, compared with the year ended December 31, 2019. The increase was primarily due to higher freight revenue in the China service, including revenue associated with the CLX+ service, partially offset by lower fuel-related surcharge revenue and lower revenue in Hawaii. +​ +On a year-over-year FEU basis, Hawaii container volume decreased 0.6 percent primarily due to lower volume as a result of the pandemic and its effects on tourism, partially offset by volume associated with the dry-docking of one of Pasha’s vessels in the second quarter and higher demand for sustenance and home improvement goods; Alaska volume increased by 4.6 percent primarily due to higher northbound volume, including volume associated with the dry-docking of a competitor’s vessel and one additional sailing, partially offset by modestly lower southbound volume; China volume was 85.8 percent higher primarily due to volume from the CLX+ service in addition to higher volume on the CLX service as a result of our increased capacity in the tradelane; Guam volume was 2.6 percent lower primarily due to lower demand for retail-related goods resulting from the pandemic and its related effects; and Other container volume increased 3.6 percent. +​ +Ocean Transportation operating income increased $154.0 million, or 169.6 percent, during the year ended December 31, 2020, compared with the year ended December 31, 2019. The increase was primarily due to a higher contribution from the China service, including the contribution from the CLX+ service, and lower vessel operating costs, including the impact of one less vessel operating in the Hawaii service, partially offset by a lower contribution from the Hawaii service. +​ +The Company’s SSAT terminal joint venture investment contributed $26.3 million during the year ended December 31, 2020, compared to a contribution of $20.8 million during the year ended December 31, 2019. The increase was largely attributable to lower operating costs. +​ +Logistics: 2020 compared with 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(Dollars in millions) +2020 +2019 +Change +Logistics revenue +​ +$ +529.4 +​ +$ +536.5 +$ +(7.1) +​ +(1.3) +% +Operating costs and expenses +​ +(493.9) +​ +(498.2) +4.3 +​ +(0.9) +% +Operating income +​ +$ +35.5 +​ +$ +38.3 +$ +(2.8) +​ +(7.3) +% +Operating income margin +​ +6.7 +% +7.1 +% +​ +​ +​ +​ +​ +​ +Logistics revenue decreased $7.1 million, or 1.3 percent, during the year ended December 31, 2020, compared with the year ended December 31, 2019. The decrease was primarily due to lower transportation brokerage and freight forwarding revenue. +​ +Logistics operating income decreased $2.8 million, or 7.3 percent, for the year ended December 31, 2020, compared with year ended December 31, 2019. The decrease was due primarily to a lower contribution from freight forwarding. +​ +LIQUIDITY AND CAPITAL RESOURCES +​ +Sources of liquidity available to the Company at December 31, 2020 compared to December 31, 2019, were as follows: +​ +Cash and Cash Equivalents, Restricted Cash and Accounts Receivable : Cash and cash equivalents, restricted cash and accounts receivable, net, as of December 31, 2020 and 2019 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2020 +2019 +Change +Cash and cash equivalents +​ +$ +14.4 +​ +$ +21.2 +​ +$ +(6.8) +​ +Restricted cash +​ +$ +5.3 +​ +$ +7.2 +​ +$ +(1.9) +​ +Accounts receivable, net (1) +​ +$ +253.4 +​ +$ +205.9 +​ +$ +47.5 +​ +(1) Eligible accounts receivable of $1.7 million at December 31, 2020 and 2019 were assigned to the CCF. +​ +29 +Table of Contents +Changes in the Company’s cash, cash equivalents and restricted cash for the years ended December 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2020 +2019 +2018 +2020-2019 +2019-2018 +Net cash provided by operating activities (1) +​ +$ +429.8 +​ +$ +248.8 +​ +$ +305.0 +​ +$ +181.0 +​ +$ +(56.2) +Net cash used in investing activities (2) +​ +(177.0) +​ +(306.9) +​ +(260.3) +​ +129.9 +​ +(46.6) +Net cash provided by (used in) financing activities (3) +​ +(261.5) +​ +62.0 +​ +(40.0) +​ +(323.5) +​ +102.0 +Net (decrease) increase in cash, cash equivalents and restricted cash +​ +(8.7) +​ +3.9 +​ +4.7 +​ +(12.6) +​ +(0.8) +Cash, cash equivalents and restricted cash, beginning of the period +​ +28.4 +​ +24.5 +​ +19.8 +​ +3.9 +​ +4.7 +Cash, cash equivalents and restricted cash, end of the period +​ +$ +19.7 +​ +$ +28.4 +​ +$ +24.5 +​ +$ +(8.7) +​ +$ +3.9 +​ +(1) Changes in Net Cash Provided by Operating Activities: Changes in net cash provided by operating activities for the years ended December 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2020-2019 +2019-2018 +Net income from operations +​ +$ +110.4 +​ +$ +(26.3) +Non-cash deferred income taxes +​ +​ +28.5 +​ +​ +(5.7) +Other non-cash related changes, net +​ +​ +17.0 +​ +​ +2.6 +Amortization of operating lease right of use assets +​ +​ +14.1 +​ +​ +60.7 +Income and distributions from SSAT, net +​ +​ +24.7 +​ +(0.8) +Operating lease liabilities +​ +(16.0) +​ +​ +(59.9) +Deferred dry-docking payments +​ +9.1 +​ +(6.7) +Accounts receivable, net +​ +(65.8) +​ +46.9 +Prepaid expenses and other assets +​ +(2.6) +​ +20.3 +Accounts payable, accruals and other liabilities +​ +58.7 +​ +(85.1) +Other long-term liabilities +​ +2.9 +​ +(2.2) +Total +​ +$ +181.0 +​ +$ +(56.2) +​ +The change in the amortization of operating lease right of use assets and operating lease liabilities primarily relates to the timing of adopting the lease accounting standard during the year ended December 31, 2019. The Company’s share of income from SSAT was $26.3 million during the year ended December 31, 2020, compared to $20.8 million in the prior year, while distributions from SSAT was $55.4 million during the year ended December 31, 2020, compared to $25.2 million of distributions received in the prior year. Deferred dry-docking payments were $16.8 million for the year ended December 31, 2020, compared to $25.9 million in the prior year. The decrease in deferred dry-docking payments was due to a reduction in vessel dry-docking activities during the year ended December 31, 2020, compared to the prior year. Changes in accounts receivable are primarily due to increased revenues during the year ended December 31, 2020, compared to the prior year, and also due to the timing of collections as of December 31, 2020, compared to the prior year. Changes in prepaid expenses and other assets are due to the timing of prepaid income taxes, changes in the amount of insurance related receivables and changes in other prepaid amounts as of December 31, 2020, compared to the prior year. Changes in accounts payable, accruals and other liabilities are primarily due to increased operating costs during the year ended December 31, 2020, compared to the prior year, and also due to the timing of payments associated with those liabilities. +​ +(2) Changes in Net Cash Used in Investing Activities: Changes in net cash used in investing activities for the years ended December 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2020-2019 +2019-2018 +Capitalized vessel construction expenditures +​ +$ +131.3 +​ +$ +119.5 +Cash deposits into CCF +​ +(36.2) +​ +​ +243.8 +Withdrawals from CCF +​ +​ +36.2 +​ +​ +(244.7) +Other capital expenditures +​ +​ +(13.3) +​ +​ +(28.6) +Proceeds from disposal of property and equipment, net +​ +11.9 +​ +​ +(132.9) +Proceeds from sale of other investments +​ +​ +— +​ +​ +(3.7) +Total +​ +$ +129.9 +​ +$ +(46.6) +​ +Capitalized vessel construction expenditures (including capitalized interest and owners’ items) was $87.8 million for the year ended December 31, 2020, compared to $219.1 million in the prior year. The decrease in capitalized vessel +30 +Table of Contents +construction expenditures (including cash deposited into the CCF less cash withdrawals from the CCF which are used for vessel construction related payments) is due to fewer progress payments related to the construction of new vessels during 2020, compared to the prior year. Other capital expenditures (excluding capitalized vessel construction expenditures) was $104.5 million for the year ended December 31, 2020, compared to $91.2 million for the prior year. The increase was primarily due to higher levels of capital expenditures related to the installation of scrubbers on vessels and the Hawaii Sand Island terminal expansion and modernization program during the year ended December 31, 2020, compared to the prior year. Proceeds from the disposal of property and equipment was $15.3 million for the year ended December 31, 2020, compared to $3.4 million for the prior year. Disposals of property and equipment during the year ended December 31, 2020 included net proceeds of approximately $14.3 million from the sale and leaseback of container and equipment. +​ +(3) Changes in Net Cash Provided by (Used in) Financing Activities: Changes in net cash provided by (used in) financing activities for the years ended December 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change +(In millions) +2020-2019 +2019-2018 +Proceeds received from issuance of fixed interest debt +​ +$ +325.5 +​ +$ +— +Repayments of fixed interest debt and capital leases +​ +​ +(174.4) +​ +​ +(11.4) +Repayments and borrowings under revolving credit facility, net +​ +​ +(451.4) +​ +​ +114.1 +Payment of financing costs +​ +​ +(18.5) +​ +​ +— +Change in other payments, net +​ +(4.7) +​ +​ +(0.7) +Total +​ +$ +(323.5) +​ +$ +102.0 +​ +During the year ended December 31, 2020, the Company received $325.5 million of proceeds from two new Title XI debt issuances, paid $47.1 million in scheduled principal payments, and prepaid $169.5 million of private debt at par, compared to $42.1 million in scheduled principal payments in the prior year. Net repayments of the Company’s revolving credit facility totaled $307.3 million for the year ended December 31, 2020, compared to net borrowings of $144.1 million in the prior year. The decrease in borrowing under the revolving credit facility was primarily due to an increase in cash provided by operating activities, proceeds from the issuance of Title XI debt, and a reduction in vessel construction payments. The Company paid $18.5 million in financing costs related to the Title XI debt issuance during the year ended December 31, 2020. No financing costs were incurred in the prior year. +​ +Debt: Total debt as of December 31, 2020 and 2019 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +(In millions) +2020 +2019 +Change +​ +Revolving credit facility +​ +$ +71.8 +​ +$ +379.1 +​ +$ +(307.3) +​ +Fixed interest debt +​ +​ +688.3 +​ +​ +579.3 +​ +​ +109.0 +​ +Total Debt +​ +$ +760.1 +​ +$ +958.4 +​ +$ +(198.3) +​ +​ +Total debt decreased by $198.3 million during the year ended December 31, 2020 compared to the prior year. The decrease in the Company’s revolving credit facility during the year ended December 31, 2020 was primarily due to increased cash provided by operating activities, a reduction in progress payments related to the construction of new vessels, and proceeds from new Title XI financing that was used to pay down the revolving credit facility. The increase in fixed interest debt was due to the new Title XI financing agreements entered into during 2020 which were partially offset by scheduled debt payments made during the year ended December 31, 2020. +​ +As of December 31, 2020, the Company had $570.1 million of unused capacity under the revolving credit facility, which matures on June 29, 2022. The leverage ratio under the debt agreements as of December 31, 2020 was approximately 1.7 times. The Company’s debt is described in Note 8 to the Consolidated Financial Statements in Item 8 of Part II. +​ +Working Capital: The Company had a working capital deficiency of $205.6 million at December 31, 2020, compared to a working capital deficiency of $147.1 million at December 31, 2019. Working capital is impacted by the use of cash to reduce the Company’s long-term revolving credit facility as of December 31, 2020, by the amount and timing of collections associated with accounts receivable and other assets, and by the amount and timing of payments associated with accounts payable, accruals and other liabilities. Working capital deficiency increased as of December 31, 2020, primarily due to the reduction in prepaid expenses and other assets as a result of the collection of income tax and insurance receivables, and an increase in other liabilities due to employee incentives and other accruals. +31 +Table of Contents +​ +Capital Expenditures: In 2021, the Company expects to make the following capital expenditures: (i) maintenance related capital expenditures of approximately $60 - $70 million; (ii) acquisition of equipment to support growth in the CLX+ and AAX services of approximately $55 million; (iii) construction of a new barge of approximately $25 million; and (iv) dry-dock scrubber installation costs of approximately $20 million. Such capital expenditures are expected to be financed through cash provided by operating activities and the Company’s revolving credit facility. +​ +CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS +​ +Contractual Obligations: +​ +At December 31, 2020, the Company had the following estimated contractual obligations: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Payment Due By Period +​ +​ +​ +Contractual Obligations (in millions) +2021 +2022-2023 +2024-2025 +Thereafter +Total +Total debt obligations (1) +​ +$ +59.2 +​ +$ +197.2 +​ +$ +103.4 +​ +$ +400.3 +​ +$ +760.1 +​ +Operating lease obligations (2) +​ +80.5 +​ +100.5 +​ +55.7 +​ +65.6 +​ +302.3 +​ +Estimated interest on debt (3) +​ +19.2 +​ +29.1 +​ +​ +21.0 +​ +44.2 +​ +113.5 +​ +Qualified defined benefit pension obligations (4) +​ +14.0 +​ +29.0 +​ +29.6 +​ +76.2 +​ +148.8 +​ +Multi-employer withdrawal obligations (5) +​ +10.6 +​ +8.2 +​ +8.2 +​ +59.7 +​ +86.7 +​ +Vendor and other obligations (6) +​ +67.2 +​ +1.9 +​ +— +​ +— +​ +69.1 +​ +Post-retirement benefit obligations (4) +​ +1.0 +​ +2.0 +​ +2.2 +​ +5.5 +​ +10.7 +​ +Non-qualified pension obligations (4) +​ +1.7 +​ +2.2 +​ +— +​ +0.6 +​ +4.5 +​ +Total +​ +$ +253.4 +​ +$ +370.1 +​ +$ +220.1 +​ +$ +652.1 +​ +$ +1,495.7 +​ +(1) Total debt obligations include principal repayments of outstanding debt (see Note 8 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(2) Operating lease obligations primarily consist of real estate and terminal leases, vessel charter leases, operations equipment and other leases entered into under non-cancellable arrangements (see Note 9 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(3) Estimated interest on debt is determined based on: (i) the stated interest rate for fixed debt, and (ii) the estimated variable interest on revolving credit facility assuming the balance at December 31, 2020 remains outstanding until maturity. +(4) Qualified defined benefit pension, non-qualified pension and post-retirement benefit obligations include estimated payments for the next ten years. The amounts noted in the column labeled “Thereafter” represent estimated benefit payments for 2026 through 2030 (see Note 11 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(5) Multi-employer withdrawal obligations relate to the discounted liability associated with Horizon’s mass withdrawal from Puerto Rico’s multi-employer ILA-PRSSA and the partial withdrawal liability associated with the Local 153 Fund of the OPEIU (see Note 12 to the Consolidated Financial Statements in Item 8 of Part II below, for additional information). +(6) Vendor and other obligations include: (i) non-cancellable contractual capital project obligations; (ii) dry-docking related obligations; and (iii) other contractual obligations. Amounts are considered obligations if a contract has been agreed to specifying significant terms of the contract, and the amounts are not reflected in the Consolidated Balance Sheets. +​ +Estimated timing and amount of payments related to unrecognized tax benefits of $18.3 million as of December 31, 2020 are excluded from the table due to the uncertainty of such timing and payments, if any. +​ +Commitments, Contingencies and Off-Balance Sheet Arrangements: +​ +Commitments and Contingencies: A description of other commitments and contingencies is set forth in Note 9, Note 11 and Note 17 to the Consolidated Financial Statements in Item 8 of Part II below, and is incorporated herein by reference. +​ +Off-balance sheet Arrangements: Except as described below, the Company is not party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, results of operations or cash flows. +​ +Future minimum payments under operating leases are $302.3 million as of December 31, 2020. In addition, the Company provided a lessor with a maximum residual value guarantee related to the lease of a vessel. Additional information related to leases and the vessel lease guarantee is set forth in Note 9 to the Consolidated Financial Statements in Item 8 of Part II below, and is incorporated herein by reference. +​ +32 +Table of Contents +​ +CRITICAL ACCOUNTING POLICIES AND ESTIMATES +​ +The Company’s significant accounting policies are described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. The preparation of Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America, upon which the Company’s Management Discussion and Analysis of Financial Condition and Results of Operations is based, requires that management exercise judgment when making accounting estimates about future events that may affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Future events and their effects cannot be determined with certainty and actual results will, inevitably, differ from those accounting estimates. These differences could be material. +​ +The Company considers an accounting estimate to be critical if: (i)(a) the accounting estimate requires the Company to make assumptions that are difficult or subjective about matters that were highly uncertain at the time that the accounting estimate was made, (b) changes in the estimate are reasonably likely to occur in periods after the period in which the estimate was made, or (c) use of different estimates by the Company could have been used; and (ii) changes in those accounting estimates would have had a material impact on the financial condition or results of operations of the Company. The critical accounting policies and estimates inherent in the preparation of the Company’s Consolidated Financial Statements are described below. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors. +​ +Long-Lived Assets, Intangible Assets and Goodwill: The Company evaluates its long-lived assets, intangible assets and goodwill for possible impairment in the fourth quarter, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value is less than its carrying amount. The Company has reporting units within the Ocean Transportation and Logistics reportable segments. +​ +Long-lived Assets and Finite-lived Intangible Assets: Long-lived assets and finite-lived intangible assets are grouped at the lowest level reporting unit for which identifiable cash flows are available. In evaluating for impairment, the estimated future undiscounted cash flows generated by each of these asset groups are compared with the carrying value recorded for each asset group to determine if its carrying value is recoverable. If this review determines that the amount recorded will not be recovered, the amount recorded for the asset group is reduced to its estimated fair value. These asset impairment analyses are highly subjective because they require management to make assumptions and apply considerable judgments to, among other things, estimates of the timing and amount of future cash flows, expected useful lives of the assets, potential impact of future events, including changes in economic conditions and operating performance, and future costs of maintenance and improvements of the assets. If management uses different assumptions or if different conditions occur in future periods, the Company’s financial condition or its future operating results could be materially impacted. The Company has evaluated its long-lived assets and finite-lived intangible assets for impairment and determined that there was no impairment for the years ended December 31, 2020, 2019 and 2018. +​ +Indefinite-life Intangible Assets and Goodwill: The Company’s intangible assets include goodwill, customer relationships and a trade name, and are grouped at the lowest level reporting unit for which identifiable cash flows are available. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of earnings before interest, income taxes, depreciation and amortization (“EBITDA”). The discounted cash flow approach requires the Company to use a number of assumptions, including market factors specific to the business, the amount and timing of estimated future cash flows generated by the business over an extended period of time, long-term growth rates for the business, and a discount rate that considers the risks related to the amount and timing of the cash flows. Although the assumptions used by the Company in its discounted cash flow model are consistent with the assumptions the Company used to generate its internal strategic plans and forecasts, significant judgment is required to estimate the amount and timing of future cash flows from the reporting unit and the risk of achieving those cash flows. When using market multiples of EBITDA, the Company makes judgments about the comparability of multiples in closed and proposed transactions. Accordingly, changes in assumptions and estimates, including, but not limited to, changes driven by external factors, such as industry and economic trends, and those driven by internal factors, such as changes in the Company’s business strategy and its internal forecasts, could have a material effect on the Company’s financial condition or its future operating results. The Company has evaluated its indefinite-life intangible assets and goodwill for impairment and determined that there was no impairment for the years ended December 31, 2020, 2019 and 2018. +​ +33 +Table of Contents +Insurance Related Liabilities: The Company is uninsured for certain risks but when feasible, many of these risks are mitigated by insurance. The Company purchases insurance with deductibles or self-insured retentions. Such insurance includes, but is not limited to, employee health, workers’ compensation, marine liability, cybersecurity, auto liability and physical damage to property and equipment. For certain risks, the Company elects to not purchase insurance because of the excessive cost of such insurance or the perceived remoteness of the risk. In addition, the Company retains all risk of loss that exceeds the limits of the Company’s insurance policies, or for other risks where insurance is not commercially available. +​ +When estimating its reserves for retained risks and related liabilities, the Company considers a number of factors, including historical claims experience, demographic factors, current trends, and analyses provided by independent third-parties. Periodically, management reviews its assumptions and estimates used to determine the adequacy of the Company’s reserves for retained risks and other related liabilities. The Company’s retained risks and other related liabilities contain uncertainties because management is required to apply judgment and make long-term assumptions to estimate the ultimate cost to settle reported claims, and of claims incurred but not reported, as of the balance sheet date. If management uses different assumptions or if different conditions occur in future periods, the Company’s financial condition or its future operating results could be materially impacted. +​ +Pension and Post-Retirement Plans: The estimation of the Company’s pension and post-retirement benefit expenses and liabilities requires the Company to make various assumptions. These assumptions include factors such as discount rates, expected long-term rate of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates and expected contributions. Actual results that differ from the assumptions made could materially affect the Company’s financial condition or its future operating results. The effects of changing assumptions are included in unamortized net gains and losses, which directly affect accumulated other comprehensive income (loss). Additionally, these unamortized gains and losses are amortized and reclassified to income (loss) over future periods. +​ +Additional information about the Company’s pension and post-retirement plans and assumptions used is included in Note 11 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Income Taxes: The Company’s income tax expense requires the Company to make various estimates and judgments. These estimates and judgments are applied in the calculation of taxable income, tax credits, tax benefits and deductions, and in the calculation of certain deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue, costs and expenses for tax purposes. The calculation of deferred tax assets and liabilities may be impacted by various factors including but not limited to changes in tax rates; changes in tax laws, regulations, and rulings; changes in interpretations of existing tax laws, regulations and rulings; and changes in the evaluation of the Company’s ability to realize deferred tax assets including operating loss and tax credit carryforwards. Deferred tax assets and liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. Significant changes to these estimates may result in an increase or decrease to the Company’s income taxes in a subsequent period. +​ +The Company records a valuation allowance if, based on the weight of available evidence, management believes that it is more likely than not that some portion or all of a recorded deferred tax asset would not be realized in future periods. +​ +Additional information about the Company’s income taxes is included in Note 10 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +OTHER MATTERS +​ +New Accounting Pronouncements: See Note 2 to the Consolidated Financial Statements in Item 8 of Part II below for additional information on new accounting pronouncements. +​ +​ +34 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +​ +Debt and Interest Rate Risks: The Company is exposed to changes in interest rates, primarily as a result of its borrowing and investing activities used to maintain liquidity and to fund business operations, including borrowings under its revolving credit facility and private placement term loans. In order to manage its exposure to changes in interest rates, the Company utilizes a balanced mix of both fixed-rate and variable-rate debt with various maturity dates. The nature and amount of the Company’s outstanding debt are expected to fluctuate as a result of future business requirements, market conditions and other factors. The Company’s outstanding variable and fixed rate debt was $71.8 million and $688.3 million as of December 31, 2020, and $379.1 million and $579.3 million as of December 31, 2019, respectively. +​ +Other than in certain events of default, the Company is not obligated to prepay its variable and fixed rate debt prior to maturity. For fixed rate debt, changes in market interest rates would not affect the Company’s financial condition or results of operations. For variable rate debt, a 100 basis point increase in the variable interest rate would have an impact on the Company’s results of operations for 2020 of approximately $0.7 million, assuming the December 31, 2020 balance of the variable rate debt was outstanding throughout the year. This change is not expected to have a material impact on the fair value of the Company’s variable rate debt. +​ +Interest on certain borrowings by the Company is calculated using the London Interbank Offered Rate (“LIBOR”). Current expectations are that the use of LIBOR will be discontinued as a benchmark interest rate by mid-2023. The expected discontinuation of LIBOR will require the Company and its lenders to transition from a LIBOR measurement to an alternative benchmark interest rate. The transition from LIBOR to another benchmark rate or rates could have an adverse impact on the cost of certain borrowings by the Company that currently use LIBOR as a benchmark rate, and ultimately, adversely affect the Company’s financial condition and results of operations. +​ +Additional information about the Company’s debt is included in Note 8 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Investment Risks: From time to time, the Company may invest its excess cash in short-term money market funds that purchase government securities or corporate debt securities, or in other deposit products allowed under the Company’s Cash Investment Policy. These money market funds and deposits maintain a weighted average maturity of less than 90 days, and accordingly, a one percent change in interest rates is not expected to have a material impact on the fair value of these investments or on interest income. The Company had a nominal amount on deposit in money market funds as of December 31, 2020 and 2019. +​ +Through the CCF, the Company may, from time to time, invest in money market funds or other eligible investments. The Company’s cash deposits in the CCF as of December 31, 2020 and 2019 were nominal. +​ +Foreign Currency Risks: The Company has no material exposure to foreign currency risks, although it is indirectly affected by changes in currency rates to the extent that changes in rates affect tourism in Hawaii, Guam, Alaska and other locations. Transactions related to the Company’s China service are primarily denominated in U.S. dollars, and therefore, a one percent change in the Chinese Yuan exchange rate would not have a material effect on the Company’s results of operations. Transactions related to the Company’s South Pacific service are primarily denominated in New Zealand dollars. However, a one percent change in the New Zealand dollar exchange rate is not expected to have a material effect on the Company’s results of operations. +​ +​ +35 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +​ +​ +​ +​ +​ +Page +Management’s Annual Report on Internal Control Over Financial Reporting +37 +Report of Independent Registered Public Accounting Firm +38 +Consolidated Statements of Income and Comprehensive Income +40 +Consolidated Balance Sheets +41 +Consolidated Statements of Cash Flows +42 +Consolidated Statements of Shareholders’ Equity +43 +​ +​ +Notes to Consolidated Financial Statements +44 +1. +Description of the Business +44 +2. +Significant Accounting Policies +44 +3. +Reportable Segments +50 +4. +Investment in SSAT +51 +5. +Property and Equipment +52 +6. +Goodwill and Intangible Assets +52 +7. +Capital Construction Fund +53 +8. +Debt +54 +9. +Leases +58 +10. +Income Taxes +60 +11. +Pension and Post-Retirement Plans +62 +12. +Multi-Employer Withdrawal Liabilities +69 +13. +Accumulated Other Comprehensive Income (Loss) +69 +14. +Earnings Per Share +70 +15. +Share-Based Awards +70 +16. +Fair Value of Financial Instruments +71 +17. +Commitments and Contingencies +72 +18. +Quarterly Information (Unaudited) +73 +​ +​ +36 +Table of Contents +MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +​ +The management of Matson, Inc. and subsidiaries (the “Company”) has the responsibility for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as a process designed by, or under the supervision of, the company’s principal executive and principal financial officers and effected by the company’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that: +​ +● Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the company; +​ +● Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and +​ +● Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. +​ +Because of its inherent limitations, internal control over financial reporting only provides reasonable assurance with respect to financial statement presentation and preparation. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +​ +Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013) . Based on its assessment, management believes that, as of December 31, 2020, the Company’s internal control over financial reporting is effective. The Company’s independent registered public accounting firm, Deloitte & Touche LLP, has issued an attestation report on the Company’s internal control over financial reporting. +​ +​ +/s/ Matthew J. Cox +​ +/s/ Joel M. Wine +Matthew J. Cox +​ +Joel M. Wine +Chairman and Chief Executive Officer +​ +Executive Vice President and Chief Financial Officer +February 26, 2021 +​ +February 26, 2021 +​ +​ +​ +37 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +​ +To the Board of Directors and Shareholders of Matson, Inc. +​ +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of Matson, Inc. and subsidiaries (the “ Company”) as of December 31, 2020 and 2019, the related consolidated statements of income and comprehensive income, shareholders' equity, and cash flows, for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the “financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +​ +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by COSO. +​ +Basis for Opinions +The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +​ +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +​ +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +​ +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +​ +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +​ +38 +Table of Contents +Critical Audit Matter +​ +The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +​ +Goodwill – Span Alaska Reporting Unit — Refer to Notes 2 and 6 to the financial statements +​ +Critical Audit Matter Description +​ +The Company’s evaluation of goodwill for impairment involves the comparison of the fair value of each reporting unit to its carrying value. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of EBITDA. The discounted cash flow approach requires the Company to make several business assumptions related to discount rates and forecasts of future revenues. Changes in assumptions and estimates, including, but not limited to, changes driven by external factors, such as industry and economic trends, and those driven by internal factors, such as changes in the Company’s business strategy and its internal forecasts, could have a material effect on either the fair value, the amount of any goodwill impairment charge, or both. The goodwill balance was $327.8 million as of December 31, 2020, of which $78.6 million is allocated to a reporting unit in the Logistics reportable segment, resulting from the acquisition of Span Intermediate, LLC (“Span Alaska”) in fiscal year 2016. The Company has evaluated its goodwill for impairment as part of its annual assessment in fiscal year 2020 and determined that the fair value of the Span Alaska reporting unit exceeded the carrying amount as of the date of the impairment review. +​ +We identified goodwill related to Span Alaska as a critical audit matter because of the significant estimates and assumptions management made to estimate the fair value of Span Alaska. Specifically, due to the sensitivity of Span Alaska’s operations to changes in the Alaskan economy, performing audit procedures to evaluate the reasonableness of management’s estimates and assumptions related to forecasts of future revenues and selection of the discount rate, required a high degree of auditor judgment and an increased extent of effort, including the need to involve our fair value specialists. +​ +How the Critical Audit Matter Was Addressed in the Audit +​ +Our audit procedures related to the forecasts of future revenue, specifically as they relate to Span Alaska, and the selection of the discount rate for Span Alaska included the following, among others: +​ +● We tested the effectiveness of controls over management’s goodwill impairment evaluation, including those over the forecasts of future revenue and the selection of the discount rate. +● We evaluated management’s ability to accurately forecast future revenue by comparing actual results to management’s historical forecasts. +● We evaluated the reasonableness of management’s revenue forecast by comparing the forecasts to (1) historical revenues and operating margins, (2) internal communications to management and the Board of Directors, (3) external communications made by management to analysts and investors, (4) trends in the logistics industry and (5) trends in the Alaskan economy. +● With the assistance of our fair value specialists, we evaluated the reasonableness of the discount rate, including testing the source information underlying the determination of the discount rate, testing the mathematical accuracy of the calculation, and developing a range of independent estimates and comparing those to the discount rate selected by management. +​ +​ +/s/ Deloitte & Touche LLP +​ +San Francisco, California +​ +February 26, 2021 +​ +​ +​ +We have served as the Company’s auditor since at least 1976; however, an earlier year could not be reliably determined. +​ +​ +​ +​ +39 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions, except per share amounts) +2020 +2019 +2018 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +1,853.9 +​ +$ +1,666.6 +​ +$ +1,641.3 +​ +Logistics +​ +529.4 +​ +536.5 +​ +581.5 +​ +Total Operating Revenue +​ +2,383.3 +​ +2,203.1 +​ +2,222.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Costs and Expenses: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating costs +​ +( 1,904.3 ) +​ +( 1,878.0 ) +​ +( 1,875.0 ) +​ +Income from SSAT +​ +26.3 +​ +20.8 +​ +36.8 +​ +Selling, general and administrative +​ +( 225.0 ) +​ +( 216.8 ) +​ +( 220.8 ) +​ +Total Costs and Expenses +​ +( 2,103.0 ) +​ +( 2,074.0 ) +​ +( 2,059.0 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Operating Income +​ +280.3 +​ +129.1 +​ +163.8 +​ +Interest expense +​ +( 27.4 ) +​ +( 22.5 ) +​ +( 18.7 ) +​ +Other income (expense), net +​ +6.1 +​ +1.2 +​ +​ +2.6 +​ +Income before Income Taxes +​ +259.0 +​ +107.8 +​ +147.7 +​ +Income taxes +​ +( 65.9 ) +​ +( 25.1 ) +​ +( 38.7 ) +​ +Net Income +​ +$ +193.1 +​ +$ +82.7 +​ +$ +109.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other Comprehensive Income (Loss), Net of Income Taxes: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net Income +​ +$ +193.1 +​ +$ +82.7 +​ +$ +109.0 +​ +Other Comprehensive Income (Loss): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Amortization of prior service cost +​ +( 4.7 ) +​ +( 4.5 ) +​ +( 4.7 ) +​ +Amortization of net loss +​ +( 9.4 ) +​ +2.7 +​ +1.1 +​ +Other adjustments +​ +0.2 +​ +( 0.6 ) +​ +— +​ +Total Other Comprehensive Income (Loss) +​ +( 13.9 ) +​ +( 2.4 ) +​ +( 3.6 ) +​ +Comprehensive Income +​ +$ +179.2 +​ +$ +80.3 +​ +$ +105.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Share +​ +$ +4.48 +​ +$ +1.93 +​ +$ +2.55 +​ +Diluted Earnings Per Share +​ +$ +4.44 +​ +$ +1.91 +​ +$ +2.53 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted Average Number of Shares Outstanding: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic +​ +43.1 +​ +42.8 +​ +42.7 +​ +Diluted +​ +43.5 +​ +43.3 +​ +43.0 +​ +​ +See Notes to Consolidated Financial Statements. +​ +40 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2020 +2019 +ASSETS +​ +​ +​ +​ +​ +​ +​ +Current Assets: +​ +​ +​ +​ +​ +​ +​ +Cash and cash equivalents +​ +$ +14.4 +​ +$ +21.2 +​ +Accounts receivable, net of allowance for credit loss of $ 6.3 million and $ 4.3 million, respectively +​ +253.4 +​ +205.9 +​ +Prepaid expenses and other assets +​ +38.1 +​ +62.5 +​ +Total current assets +​ +305.9 +​ +289.6 +​ +Long-term Assets: +​ +​ +​ +​ +​ +​ +​ +Investment in SSAT +​ +48.7 +​ +76.2 +​ +Property and equipment, net +​ +1,689.9 +​ +1,598.1 +​ +Operating lease right of use assets +​ +​ +251.4 +​ +​ +256.1 +​ +Goodwill +​ +327.8 +​ +327.8 +​ +Intangible assets, net +​ +​ +192.0 +​ +​ +202.9 +​ +Deferred dry-docking costs, net +​ +​ +51.9 +​ +​ +56.9 +​ +Other long-term assets +​ +33.0 +​ +37.8 +​ +Total long-term assets +​ +​ +2,594.7 +​ +​ +2,555.8 +​ +Total Assets +​ +$ +2,900.6 +​ +$ +2,845.4 +​ +​ +​ +​ +​ +​ +​ +​ +​ +LIABILITIES AND SHAREHOLDERS’ EQUITY +​ +​ +​ +​ +​ +​ +​ +Current Liabilities: +​ +​ +​ +​ +​ +​ +​ +Current portion of debt +​ +$ +59.2 +​ +$ +48.4 +​ +Accounts payable and accruals +​ +283.1 +​ +235.7 +​ +Operating lease liabilities +​ +​ +72.4 +​ +​ +66.6 +​ +Other liabilities +​ +96.8 +​ +86.0 +​ +Total current liabilities +​ +511.5 +​ +436.7 +​ +Long-term Liabilities: +​ +​ +​ +​ +​ +​ +​ +Long-term debt, net of deferred loan fees +​ +685.6 +​ +910.0 +​ +Long-term operating lease liabilities +​ +​ +186.9 +​ +​ +198.0 +​ +Deferred income taxes +​ +389.6 +​ +337.6 +​ +Other long-term liabilities +​ +​ +165.8 +​ +​ +157.4 +​ +Total long-term liabilities +​ +1,427.9 +​ +1,603.0 +​ +Commitments and Contingencies (see Note 17) +​ +​ +​ +​ +​ +​ +​ +Shareholders’ Equity: +​ +​ +​ +​ +​ +​ +​ +Common stock - common stock without par value; authorized, 150.0 million shares ($ 0.75 stated value per share); outstanding, 43.2 million shares in 2020 and 42.9 million shares in 2019 +​ +32.4 +​ +32.2 +​ +Additional paid in capital +​ +321.5 +​ +306.2 +​ +Accumulated other comprehensive loss, net +​ +( 50.8 ) +​ +( 36.9 ) +​ +Retained earnings +​ +658.1 +​ +504.2 +​ +Total shareholders’ equity +​ +961.2 +​ +805.7 +​ +Total Liabilities and Shareholders’ Equity +​ +$ +2,900.6 +​ +$ +2,845.4 +​ +​ +See Notes to Consolidated Financial Statements. +​ +41 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2020 +2019 +2018 +Cash Flows From Operating Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net income +​ +$ +193.1 +​ +$ +82.7 +​ +$ +109.0 +​ +Reconciling adjustments: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and amortization +​ +114.9 +​ +100.4 +​ +94.4 +​ +Amortization of operating lease right of use assets +​ +​ +74.8 +​ +​ +60.7 +​ +​ +— +​ +Deferred income taxes +​ +52.1 +​ +23.6 +​ +29.3 +​ +Loss (Gain) on disposal of property and equipment +​ +2.8 +​ +( 1.4 ) +​ +( 1.9 ) +​ +Share-based compensation expense +​ +18.8 +​ +11.3 +​ +12.1 +​ +Income from SSAT +​ +( 26.3 ) +​ +( 20.8 ) +​ +( 36.8 ) +​ +Distributions from SSAT +​ +55.4 +​ +25.2 +​ +42.0 +​ +Changes in assets and liabilities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accounts receivable, net +​ +( 48.0 ) +​ +17.8 +​ +( 29.1 ) +​ +Deferred dry-docking payments +​ +( 16.8 ) +​ +( 25.9 ) +​ +( 19.2 ) +​ +Deferred dry-docking amortization +​ +25.1 +​ +34.3 +​ +37.4 +​ +Prepaid expenses and other assets +​ +21.9 +​ +24.5 +​ +4.2 +​ +Accounts payable, accruals and other liabilities +​ +44.8 +​ +( 13.9 ) +​ +71.2 +​ +Operating lease liabilities +​ +​ +( 75.9 ) +​ +​ +( 59.9 ) +​ +​ +— +​ +Other long-term liabilities +​ +( 6.9 ) +​ +( 9.8 ) +​ +( 7.6 ) +​ +Net cash provided by operating activities +​ +429.8 +​ +248.8 +​ +305.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flows From Investing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capitalized vessel construction expenditure +​ +​ +( 87.8 ) +​ +​ +( 219.1 ) +​ +​ +( 338.6 ) +​ +Other capital expenditures +​ +( 104.5 ) +​ +( 91.2 ) +​ +( 62.6 ) +​ +Proceeds from disposal of property and equipment +​ +15.3 +​ +3.4 +​ +136.3 +​ +Cash deposits into Capital Construction Fund +​ +( 132.4 ) +​ +( 96.2 ) +​ +( 340.0 ) +​ +Withdrawals from Capital Construction Fund +​ +132.4 +​ +96.2 +​ +340.9 +​ +Proceeds from sale of other investments +​ +— +​ +— +​ +3.7 +​ +Net cash used in investing activities +​ +( 177.0 ) +​ +( 306.9 ) +​ +( 260.3 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash Flows From Financing Activities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Proceeds from issuance of debt +​ +​ +325.5 +​ +​ +— +​ +​ +— +​ +Repayments of debt +​ +​ +( 216.5 ) +​ +( 42.1 ) +​ +( 30.7 ) +​ +Proceeds from revolving credit facility +​ +​ +648.0 +​ +622.1 +​ +963.9 +​ +Repayments of revolving credit facility +​ +​ +( 955.3 ) +​ +​ +( 478.0 ) +​ +​ +( 933.9 ) +​ +Payment of financing costs +​ +​ +( 18.5 ) +​ +— +​ +— +​ +Proceeds from issuance of common stock +​ +​ +0.1 +​ +0.3 +​ +0.7 +​ +Dividends paid +​ +​ +( 39.2 ) +​ +( 37.2 ) +​ +( 35.4 ) +​ +Tax withholding related to net share settlements of restricted stock units +​ +​ +( 5.6 ) +​ +​ +( 3.1 ) +​ +​ +( 4.6 ) +​ +Net cash provided by (used in) financing activities +​ +( 261.5 ) +​ +62.0 +​ +( 40.0 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net (Decrease) Increase in Cash, Cash Equivalents and Restricted Cash +​ +( 8.7 ) +​ +3.9 +​ +4.7 +​ +Cash, Cash Equivalents and Restricted Cash, Beginning of the Year +​ +28.4 +​ +24.5 +​ +19.8 +​ +Cash, Cash Equivalents and Restricted Cash, End of the Year +​ +$ +19.7 +​ +$ +28.4 +​ +$ +24.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Reconciliation of Cash, Cash Equivalents, and Restricted Cash, at End of the Year: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Cash and Cash Equivalents +​ +$ +14.4 +​ +$ +21.2 +​ +$ +19.6 +​ +Restricted Cash +​ +​ +5.3 +​ +​ +7.2 +​ +​ +4.9 +​ +Total Cash, Cash Equivalents and Restricted Cash, End of the Year +​ +$ +19.7 +​ +$ +28.4 +​ +$ +24.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Supplemental Cash Flow Information: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Interest paid, net of capitalized interest +​ +$ +26.2 +​ +$ +22.0 +​ +$ +18.3 +​ +Income tax paid, net of income tax refunds +​ +$ +( 16.1 ) +​ +$ +( 24.2 ) +​ +$ +5.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non-cash Information: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capital expenditures included in accounts payable, accruals and other liabilities +​ +$ +24.7 +​ +$ +8.5 +​ +$ +4.1 +​ +​ +See Notes to Consolidated Financial Statements. +​ +42 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +For the three years ended December 31, 2020 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Accumulated +​ +​ +​ +​ +​ +​ +​ +​ +Common Stock +​ +Additional +​ +Other +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Stated +​ +Paid In +​ +Comprehensive +​ +Retained +​ +​ +​ +(In millions, except per share amounts) +Shares +Value +Capital +Income (Loss) +Earnings +Total +Balance at December 31, 2017 +42.5 +​ +$ +31.9 +$ +289.7 +​ +$ +( 24.9 ) +​ +$ +380.5 +​ +$ +677.2 +​ +Net income +— +​ +— +— +​ +— +​ +109.0 +​ +109.0 +​ +Other comprehensive income (loss), net of tax +— +​ +— +— +​ +( 9.6 ) +​ +6.0 +​ +( 3.6 ) +​ +Share-based compensation +— +​ +— +12.1 +​ +— +​ +— +​ +12.1 +​ +Shares issued, net of shares withheld for employee taxes +0.2 +​ +0.1 +( 4.0 ) +​ +— +​ +— +​ +( 3.9 ) +​ +Shares repurchased +​ +— +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 0.1 ) +​ +​ +( 0.1 ) +​ +Dividends ($ 0.82 per share) +— +​ +— +— +​ +— +​ +( 35.4 ) +​ +( 35.4 ) +​ +Balance at December 31, 2018 +42.7 +​ +​ +32.0 +​ +297.8 +​ +​ +( 34.5 ) +​ +​ +460.0 +​ +​ +755.3 +​ +Net income +— +​ +— +— +​ +— +​ +82.7 +​ +82.7 +​ +Adoption of new lease accounting standard +​ +— +​ +— +— +​ +— +​ +4.4 +​ +​ +4.4 +​ +Other comprehensive income (loss), net of tax +​ +— +​ +— +— +​ +( 2.4 ) +​ +​ +​ +( 2.4 ) +​ +Share-based compensation +— +​ +— +11.3 +​ +— +​ +— +​ +11.3 +​ +Shares issued, net of shares withheld for employee taxes +0.2 +​ +​ +0.2 +​ +( 2.9 ) +​ +— +​ +— +​ +( 2.7 ) +​ +Dividends ($ 0.86 per share) +— +​ +— +— +​ +— +​ +( 37.3 ) +​ +( 37.3 ) +​ +SSAT’s adoption of new lease accounting standard +​ +— +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 5.6 ) +​ +​ +( 5.6 ) +​ +Balance at December 31, 2019 +42.9 +​ +​ +32.2 +​ +306.2 +​ +​ +( 36.9 ) +​ +​ +504.2 +​ +​ +805.7 +​ +Net income +— +​ +— +— +​ +— +​ +193.1 +​ +193.1 +​ +Other comprehensive income (loss), net of tax +— +​ +— +— +​ +( 13.9 ) +​ +— +​ +( 13.9 ) +​ +Share-based compensation +— +​ +— +18.8 +​ +— +​ +— +​ +18.8 +​ +Shares issued, net of shares withheld for employee taxes +0.3 +​ +​ +0.2 +​ +( 3.5 ) +​ +— +​ +( 2.2 ) +​ +( 5.5 ) +​ +Equity interest in SSAT +​ +— +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +2.2 +​ +​ +2.2 +​ +Dividends ($ 0.90 per share) +— +​ +— +— +​ +— +​ +( 39.2 ) +​ +( 39.2 ) +​ +Balance at December 31, 2020 +43.2 +​ +$ +32.4 +$ +321.5 +​ +$ +( 50.8 ) +​ +$ +658.1 +​ +$ +961.2 +​ +​ +See Notes to Consolidated Financial Statements. +​ +43 +Table of Contents +MATSON, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +​ +1. +DESCRIPTION OF THE BUSINESS +​ +Matson, Inc., a holding company incorporated in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information on the Company’s reportable segments for the three years ended December 31, 2020, see Note 3. +​ +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates two premium, expedited services from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific, and operates an international export service from Dutch Harbor to Asia. In addition, subsidiaries of MatNav provide stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +​ +Matson has a 35 percent ownership interest in SSA Terminals, LLC, a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc., a subsidiary of Carrix, Inc. (“SSAT”). SSAT currently provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including three facilities dedicated for MatNav’s use. Matson records its share of income from SSAT in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +​ +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively, “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively, “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +​ +​ +2. +SIGNIFICANT ACCOUNTING POLICIES +​ +Principles of Consolidation: The Consolidated Financial Statements include the accounts of Matson, Inc. and all wholly-owned subsidiaries, after elimination of intercompany amounts and transactions. Significant investments in businesses, partnerships, and limited liability companies in which the Company does not have a controlling financial interest, but has the ability to exercise significant influence, are accounted for under the equity method. The Company accounts for its investment in SSAT using the equity method of accounting (see Note 4). +​ +Fiscal Year: The year end for Matson is December 31. The period end for MatNav occurred on the last Friday in December, except for Matson Logistics Warehousing, Inc. and Matson South Pacific Holdco Limited whose period closed on December 31. Included in these Consolidated Financial Statements are 52 weeks in the 2020, 2019 and 2018 fiscal years for MatNav. +​ +Foreign Currency Transactions: The United States (U.S.) dollar is the functional currency for substantially all of the financial statements of the Company’s foreign subsidiaries. Foreign currency denominated assets and liabilities of the Company’s foreign subsidiaries are translated into U.S. dollars at exchange rates existing at the respective balance sheet dates. Translation adjustments resulting from fluctuations in exchange rates are recorded as a component of accumulated other comprehensive loss (gain) within shareholders’ equity. The Company translates the result of operations of its foreign subsidiaries at the average exchange rate during the respective periods. Gains and losses +44 +Table of Contents +resulting from foreign currency transactions are included in Costs and Expenses in the Consolidated Statements of Income and Comprehensive Income. +​ +Use of Estimates: The preparation of the Consolidated Financial Statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported. Estimates and assumptions are used for, but not limited to: impairment of investments; impairment of long-lived assets, intangible assets and goodwill; capitalized interest; allowance for doubtful accounts; legal contingencies; insurance reserves and other related liabilities; accrual estimates; pension and post-retirement estimates; multi-employer withdrawal liabilities; operating lease assets and liabilities; and income taxes. Future results could be materially affected if actual results differ from these estimates and assumptions. +​ +Cash, Cash Equivalents and Restricted Cash: Cash equivalents consist of highly-liquid investments with original maturities of three months or less. The Company carries these investments at cost, which approximates fair value. Outstanding checks in excess of funds on deposit totaled $ 19.9 million and $ 13.8 million at December 31, 2020 and 2019, respectively, and are included in current liabilities in the Consolidated Balance Sheets. Restricted cash relates to amounts that are subject to contractual restrictions and are not readily available. At December 31, 2020 and 2019, restricted cash was $ 5.3 million and $ 7.2 million, respectively, and are included in prepaid expenses and other assets in the Consolidated Balance Sheets. +​ +Accounts Receivable, net: Accounts receivable represent amounts due from trade customers arising in the normal course of business. Accounts receivable are shown net of allowance for doubtful accounts receivable in the Consolidated Balance Sheets. Allowance for doubtful accounts receivable is established by management based on estimates of collectability. Estimates of collectability are principally based on an evaluation of the current financial condition of the customer and the potential risks to collection, the customer’s payment history, expected future credit losses and other factors which are regularly monitored by the Company. +​ +Changes in the allowance for doubtful accounts receivable for the three years ended December 31, 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Balance at +​ +Write-offs +Balance at +Year (in millions) +Beginning of Year +Expense (1) +and Other +End of Year +2020 +​ +$ +4.3 +​ +$ +2.9 +​ +$ +( 0.9 ) +​ +$ +6.3 +​ +2019 +​ +$ +4.8 +​ +$ +0.6 +​ +$ +( 1.1 ) +​ +$ +4.3 +​ +2018 +​ +$ +4.6 +​ +$ +0.8 +​ +$ +( 0.6 ) +​ +$ +4.8 +​ +(1) Expense is shown net of amounts recovered from previously reserved doubtful accounts. +​ +Prepaid Expenses and Other Assets: Prepaid expenses and other assets consist of the following at December 31, 2020 and 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Prepaid Expenses and Other Assets (in millions) +2020 +2019 +Prepaid fuel +​ +$ +10.8 +​ +$ +13.7 +​ +Prepaid insurance and insurance related receivables +​ +7.5 +​ +13.4 +​ +Prepaid operating expenses +​ +​ +5.4 +​ +​ +5.7 +​ +Restricted cash - vessel construction obligations +​ +​ +5.3 +​ +​ +7.2 +​ +Income tax receivables +​ +​ +0.3 +​ +​ +12.8 +​ +Other +​ +8.8 +​ +9.7 +​ +Total +​ +$ +38.1 +​ +$ +62.5 +​ +​ +Deferred Loan Fees: The Company records deferred loan fees, excluding those related to the revolving credit facility, as a reduction to Total Debt in the Company’s Consolidated Balance Sheets in accordance with Accounting Standards Update (“ASU”) 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). These costs are being amortized over the life of the related debt using the effective interest method (see Note 8). +​ +Deferred loan fees related to the Company’s revolving credit facility are recorded in other long-term assets in the Company’s Consolidated Balance Sheets, and are amortized using the straight-line method as the difference between that and the use of the effective interest method is not material. +45 +Table of Contents +Other Long-Term Assets: Other long-term assets consist of the following at December 31, 2020 and 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Other Long-Term Assets (in millions) +2020 +2019 +Vessel and equipment spare parts +​ +$ +11.5 +​ +$ +12.4 +​ +Insurance related receivables +​ +​ +10.5 +​ +​ +10.6 +​ +Deferred loan fees +​ +2.7 +​ +2.1 +​ +Cloud computing software costs +​ +2.4 +​ +— +​ +Income tax receivables +​ +​ +2.1 +​ +​ +11.5 +​ +Other +​ +​ +3.8 +​ +​ +1.2 +​ +Total +​ +$ +33.0 +​ +$ +37.8 +​ +​ +Property and Equipment: Property and equipment is stated at cost. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of property and equipment range up to the following maximum life: +​ +​ +​ +​ +​ +Classification +Life +Vessels +40 years +​ +Machinery and equipment +30 years +​ +Terminal facilities +35 years +​ +​ +Capitalized Interest: The Company capitalizes interest costs during the period the qualified assets are being readied for their intended use. The Company determined that the vessel construction costs are considered qualifying assets for the purposes of capitalizing interest on these assets. The amount of capitalized interest is calculated based on the amount of payments incurred related to the construction of these vessels using a weighted average interest rate. The weighted average interest rate is determined using the Company’s average borrowings outstanding during the period. Capitalized interest is included in vessel construction in progress in property and equipment in the Company’s Consolidated Balance Sheets (see Note 5). During the years ended December 31, 2020, 2019 and 2018, the Company capitalized $ 7.4 million, $ 15.6 million and $ 18.7 million of interest related to the construction of new vessels, respectively. +​ +Leases: The Company adopted Accounting Standards Codification (“ASC”) 842, Leases (“ASC 842”) on January 1, 2019. ASC 842 requires lessees to record leases on their balance sheets but recognize the expenses in their income statements in a manner similar to pre-adoption practice. ASC 842 states that a lessee would recognize a lease liability for the obligation to make lease payments, and a right-of-use asset for the underlying leased asset for the period of the lease term. Refer to Note 9 for additional information on the Company’s lease related disclosures. +​ +Deferred Dry-docking Costs: U.S. flagged vessels must meet specified seaworthiness standards established by U.S. Coast Guard rules and classification society rules. These standards require U.S. flagged vessels to undergo two dry-docking inspections within a five-year period, with a maximum of 36 months between them. However, U.S. flagged vessels that are enrolled in the U.S. Coast Guard’s Underwater Survey in Lieu of Dry-docking (“UWILD”) program are allowed to have their Intermediate Survey dry-docking requirement met with a less costly underwater inspection. Non-U.S. flagged vessels are required to meet applicable classification society rules and their own local standards for seaworthiness, which also mandate vessels to undergo two dry-docking inspections every five years . +​ +The Company is responsible for maintaining its vessels in compliance with U.S. and international standards. As costs associated with dry-docking inspections provide future economic benefits to the Company through continued operation of the vessels, the costs are deferred and amortized until the scheduled date of the next required dry-docking, which is usually over a two to five-year period. Amortization of deferred dry-docking costs are charged to operating expenses of the Ocean Transportation segment in the Consolidated Statements of Income and Comprehensive Income. Routine vessel maintenance and repairs are charged to expense as incurred. +​ +Goodwill and Intangible Assets: Goodwill and intangible assets arise as a result of acquisitions made by the Company (see Note 6). Intangible assets consist of customer relationships which are being amortized using the straight-line method over the expected useful lives ranging up to 21 years , and a trade name that has an indefinite life. +​ +Impairment Evaluation of Long-Lived Assets, Intangible Assets and Goodwill : The Company evaluates its long-lived assets, intangible assets and goodwill for possible impairment in the fourth quarter, or whenever events or changes in circumstances indicate that it is more likely than not that the fair value is less than its carrying amount. The Company has reporting units within the Ocean Transportation and Logistics reportable segments. +46 +Table of Contents +​ +Long-lived assets and finite-lived intangible assets are grouped at the lowest level reporting unit for which identifiable cash flows are available. In evaluating for impairment, the estimated future undiscounted cash flows generated by each of these asset groups are compared with the carrying value recorded for each asset group to determine if its carrying value is recoverable. If this review determines that the amount recorded will not be recovered, the amount recorded for the asset group is reduced to its estimated fair value. No impairment charges of long-lived assets and finite-lived intangible assets were recorded for the years ended December 31, 2020, 2019 and 2018. +​ +Indefinite-life intangible assets and goodwill are grouped at the lowest level reporting unit for which identifiable cash flows are available. In estimating the fair value of a reporting unit, the Company uses a combination of a discounted cash flow model and fair value based on market multiples of earnings before interest, taxes, depreciation and amortization. Based upon the Company’s evaluation of its indefinite-life intangible assets and goodwill for impairment, the Company determined that the fair value of each reporting unit exceeds book value. No impairment charges of indefinite-life intangible assets and goodwill were recorded for the years ended December 31, 2020, 2019 and 2018. +​ +Impairment Evaluation of SSAT: The Company’s investment in SSAT, a related party, is evaluated for impairment whenever there is evidence of impairment during the reporting period. If any impairment is identified, the Company evaluates if the decrease in the fair value of the investment below its carrying value is other-than-temporary. No impairment was identified during the years ended December 31, 2020, 2019 and 2018. +​ +Other Liabilities: Other liabilities consist of the following at December 31, 2020 and 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Other Liabilities (in millions) +2020 +2019 +Payroll and vacation +​ +$ +29.2 +$ +28.5 +​ +Employee incentives and other +​ +​ +25.9 +​ +​ +14.7 +​ +Multi-employer withdrawal liabilities - short term (see Note 12) +​ +​ +10.6 +​ +​ +10.8 +​ +Income tax liabilities +​ +​ +11.7 +​ +​ +2.3 +​ +Insurance reserves and other related liabilities - short term +​ +​ +7.0 +​ +​ +12.6 +​ +Deferred revenues +​ +​ +4.2 +​ +​ +6.9 +​ +Interest on debt +​ +​ +3.4 +​ +​ +4.9 +​ +Pension and post-retirement liabilities - short term (see Note 11) +​ +​ +2.7 +​ +​ +3.1 +​ +Other short-term liabilities +​ +​ +2.1 +​ +​ +2.2 +​ +Total +​ +$ +96.8 +$ +86.0 +​ +​ +Other Long-Term Liabilities: Other long-term liabilities consist of the following at December 31, 2020 and 2019: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +Other Long-Term Liabilities (in millions) +2020 +2019 +Pension and post-retirement liabilities (see Note 11) +​ +$ +82.0 +​ +$ +73.4 +​ +Multi-employer withdrawal liability (see Note 12) +​ +​ +52.8 +​ +​ +54.8 +​ +Insurance reserves and other related liabilities +​ +​ +25.4 +​ +​ +26.6 +​ +Other long-term liabilities +​ +5.6 +​ +2.6 +​ +Total +​ +$ +165.8 +​ +$ +157.4 +​ +​ +Pension and Post-Retirement Plans: The Company is a member of the Pacific Maritime Association (“PMA”) and the Hawaii Stevedoring Industry Committee, which negotiate multi-employer pension plans covering certain shoreside bargaining unit personnel. The Company directly negotiates multi-employer pension plans covering other bargaining unit personnel. Pension costs are accrued in accordance with contribution rates established by the PMA, the parties to a plan or the trustees of a plan. Several trusteed, non-contributory, single-employer defined benefit plans and defined contribution plans cover substantially all other employees. +​ +The estimation of the Company’s pension and post-retirement benefit expenses and liabilities requires that the Company make various assumptions. These assumptions include factors such as discount rates, expected long-term rates of return on pension plan assets, salary growth, health care cost trend rates, inflation, retirement rates, mortality rates, and expected contributions. Actual results that differ from the assumptions made could materially affect the Company’s financial condition or its future operating results. Additional information about the Company’s pension and post-retirement plans is included in Note 11. +​ +47 +Table of Contents +Insurance Related Liabilities: The Company is uninsured for certain risks but when feasible, many of these risks are mitigated by insurance. The Company purchases insurance with deductibles or self-insured retentions. Such insurance includes, but is not limited to, employee health, workers’ compensation, marine liability, cybersecurity, auto liability and physical damage to property and equipment. For certain risks, the Company elects to not purchase insurance because of the excessive cost of insurance or the perceived remoteness of the risk. In addition, the Company retains all risk of loss that exceeds the limits of the Company’s insurance policies, or for other risks where insurance is not commercially available. +​ +When estimating its reserves for retained risks and related liabilities, the Company considers a number of factors, including historical claims experience, demographic factors, current trends, and analyses provided by independent third-parties. Periodically, management reviews its assumptions and estimates used to determine the adequacy of the Company’s reserves for retained risks and other related liabilities. +​ +Recognition of Revenues and Expenses: Revenue in the Company’s Consolidated Financial Statements is presented net of elimination of intercompany transactions. The following is a description of the Company’s principal revenue generating activities by segment, and the Company’s revenue recognition policy for each activity for the periods presented: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31, +Ocean Transportation (in millions) (1) +​ +2020 +​ +2019 +​ +2018 +Ocean Transportation services +​ +$ +1,821.7 +​ +$ +1,625.8 +​ +$ +1,599.3 +Terminal and other related services +​ +​ +19.1 +​ +​ +24.8 +​ +​ +23.0 +Fuel sales +​ +​ +7.3 +​ +​ +10.1 +​ +​ +12.2 +Vessel management and related services +​ +​ +5.8 +​ +​ +5.9 +​ +​ +6.8 +Total +​ +$ +1,853.9 +​ +$ +1,666.6 +​ +$ +1,641.3 +(1) Ocean Transportation revenue transactions are primarily denominated in U.S. dollars except for less than 3 percent of Ocean Transportation services revenue and fuel sales revenue categories which are denominated in foreign currencies. +​ +◾ Ocean Transportation services revenue is recognized ratably over the duration of a voyage based on the relative transit time completed in each reporting period. Vessel operating costs and other ocean transportation operating costs, such as terminal operating overhead and selling, general and administrative expenses, are charged to operating costs as incurred. +◾ Terminal and other related services revenue is recognized as the services are performed. Related costs are recognized as incurred. +◾ Fuel sales revenue and related costs are recognized when the Company has completed delivery of the product to the customer in accordance with the terms and conditions of the contract. +◾ Vessel management and related services revenue is recognized in proportion to the services completed. Related costs are recognized as incurred. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31, +Logistics (in millions) (1) +​ +2020 +​ +2019 (2) +​ +2018 (2) +Transportation Brokerage and Freight Forwarding services +​ +$ +477.0 +​ +$ +489.0 +​ +$ +532.5 +Warehouse and distribution services +​ +​ +36.2 +​ +​ +34.1 +​ +​ +33.8 +Supply chain management and other services +​ +16.2 +​ +13.4 +​ +15.2 +Total +​ +$ +529.4 +​ +$ +536.5 +​ +$ +581.5 +(1) Logistics revenue transactions are primarily denominated in U.S. dollars except for approximately 3 percent of transportation brokerage and freight forwarding services revenue, and supply chain management and other services revenue categories which are denominated in foreign currencies. +(2) The Company has reclassified $ 15.8 million and $ 16.6 million from transportation brokerage and freight forwarding services to warehouse and distribution services, and supply chain management and other services for the years ended December 31, 2019 and 2018 , respectively, to be consistent with its current period presentation. There was no change in total Logistics revenue for the years ended December 31, 2019 and 2018. +​ +◾ Transportation Brokerage and Freight Forwarding services revenue consists of amounts billed to customers for services provided. The primary costs include third-party purchased transportation services, agent commissions, labor and equipment. Revenue and the related purchased third-party transportation costs are recognized over the duration of a delivery based upon the relative transit time completed in each reporting period. Labor, agent commissions, and other operating costs are expensed as incurred. The Company reports revenue on a gross basis as the Company serves as the principal in these transactions because it is responsible for fulfilling the contractual arrangements with the customer and has latitude in establishing prices. +48 +Table of Contents +◾ Warehousing and distribution services revenue consist of amounts billed to customers for storage, handling, and value-added packaging of customer merchandise. Storage revenue is recognized in the month the service is provided to the customer. Storage related costs are recognized as incurred. Other warehousing and distribution services revenue and related costs are recognized in proportion to the services performed. +◾ Supply chain management and other services revenue, and related costs are recognized in proportion to the services performed. +​ +The Company generally invoices its customers at the commencement of the voyage or the transportation service being provided, or as other services are being performed. Revenue is deferred when services are invoiced in advance to the customer. The Company’s receivables are classified as short-term as collection terms are for periods of less than one year. The Company expenses sales commissions and contract acquisition costs as incurred because the amounts are generally immaterial. These expenses are included in selling, general and administration expenses in the Consolidated Statements of Income and Comprehensive Income. +​ +Customer Concentration: The Ocean Transportation segment serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2020, 2019 and 2018, the 10 largest Ocean Transportation customers accounted for approximately 22 percent, 23 percent and 24 percent of Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Ocean Transportation operating revenues. +​ +The Logistics segment serves customers in numerous industries and geographical locations. In 2020, 2019 and 2018, the 10 largest Logistics customers accounted for approximately 19 percent, 21 percent and 23 percent of Logistics revenue, respectively. None of these customers individually account for more than 10 percent of Logistics operating revenues. +​ +Dividends: The Company recognizes dividends as a liability when approved by the Board of Directors. +​ +Share-Based Compensation: The Company records compensation expense for all share-based awards made to employees and directors. The Company’s various stock-based compensation plans are more fully described in Note 15. +​ +Income Taxes: The estimate of the Company’s income tax expense requires the Company to make various estimates and judgments. These estimates and judgments are applied in the calculation of taxable income, tax credits, tax benefits and deductions, and in the calculation of certain deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue, costs and expenses for tax purposes. Deferred tax assets and liabilities are adjusted to the extent necessary to reflect tax rates expected to be in effect when the temporary differences reverse. +​ +The Company records a valuation allowance if, based on the weight of available evidence, management believes that it is more likely than not that some portion or all of a recorded deferred tax asset would not be realized in future periods. The Company’s income taxes are more fully described in Note 10. +​ +Rounding: Amounts in the Consolidated Financial Statements and Notes to the Consolidated Financial Statements are rounded to millions, except for per share calculations and percentages which were determined based on amounts before rounding. Accordingly, a recalculation of some per-share amounts and percentages, if based on the reported data, may be slightly different. +​ +New Accounting Pronouncements : +​ +Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) : In June 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016- 13 which amends the current approach to estimate credit losses on certain financial assets, including trade and other receivables, available-for-sale securities and other financial instruments. ASU 2016- 13 requires entities to establish a valuation allowance for the expected lifetime losses of certain financial instruments. Subsequent changes in the valuation allowance are recorded in current earnings and reversal of previous losses is permitted. The new standard was effective for interim and annual periods beginning on or after December 15, 2019. +​ +The Company adopted ASU 2016- 13 effective January 1, 2020 using the modified retrospective approach. Upon adoption, the Company included an evaluation of expected future credit losses as part of its estimate for determining the allowance for doubtful accounts. The impact of this change was not material to the Company’s allowance for doubtful accounts receivable in the Consolidated Financial Statements. +​ +49 +Table of Contents +Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract (“ASU 2018-15”): In August 2018, FASB issued ASU 2018-15 which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing costs incurred to develop or obtain internal-use software. The Company adopted ASU 2018-15 on a prospective basis effective January 1, 2020. During the year ended December 31, 2020, the Company capitalized costs of $ 2.4 million related to cloud computing arrangements and which were included in other long-term assets on the Company’s Consolidated Balance Sheets as of December 31, 2020. +​ +3. REPORTABLE SEGMENTS +​ +Reportable segments are components of an enterprise that engage in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. The Company’s chief operating decision maker is its Chief Executive Officer. +​ +The Company consists of two reportable segments, Ocean Transportation and Logistics, which are further described in Note 1. Reportable segments are measured based on operating income. In arrangements where the customer purchases ocean transportation and logistics services, the revenues are allocated to each reportable segment based upon the contractual amounts for each type of service. The Company’s SSAT segment has been aggregated into the Company’s Ocean Transportation segment due to the operations of SSAT being an integral part of the Company’s Ocean Transportation business (see Note 4). +​ +The Company’s Ocean Transportation segment provides ocean transportation services to the Logistics segment, and the Logistics segment provides logistics services to the Ocean Transportation segment in certain transactions. Accordingly, inter-segment revenue of $ 115.5 million, $ 102.3 million and $ 95.4 million for the years ended December 31, 2020, 2019 and 2018, respectively, have been eliminated from operating revenues in the table below. +​ +Reportable segment financial information for the years ended December 31, 2020, 2019 and 2018, and identifiable asset segment information at December 31, 2020 and 2019, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2020 +2019 +2018 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (1) +​ +$ +1,853.9 +​ +$ +1,666.6 +​ +$ +1,641.3 +Logistics (2) +​ +529.4 +​ +536.5 +​ +581.5 +Total Operating Revenue +​ +$ +2,383.3 +​ +$ +2,203.1 +​ +$ +2,222.8 +Operating Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation (3) +​ +$ +244.8 +​ +$ +90.8 +​ +$ +131.1 +Logistics +​ +35.5 +​ +38.3 +​ +32.7 +Total Operating Income +​ +280.3 +​ +129.1 +​ +163.8 +Interest expense, net +​ +( 27.4 ) +​ +( 22.5 ) +​ +( 18.7 ) +Other income (expense), net +​ +6.1 +​ +1.2 +​ +2.6 +Income before Income Taxes +​ +259.0 +​ +107.8 +​ +147.7 +Income taxes +​ +( 65.9 ) +​ +( 25.1 ) +​ +( 38.7 ) +Net Income +​ +$ +193.1 +​ +$ +82.7 +​ +$ +109.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Capital Expenditures: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +190.0 +​ +$ +294.5 +​ +$ +385.4 +Logistics +​ +2.3 +​ +15.8 +​ +15.8 +Total Capital Expenditures +​ +$ +192.3 +​ +$ +310.3 +​ +$ +401.2 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Depreciation and Amortization: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +107.4 +​ +$ +93.6 +​ +$ +87.0 +Logistics +​ +7.5 +​ +6.8 +​ +7.4 +​ +​ +​ +114.9 +​ +​ +100.4 +​ +​ +94.4 +Deferred dry-docking amortization - Ocean Transportation +​ +​ +25.1 +​ +​ +34.3 +​ +​ +37.4 +Total Depreciation and Amortization +​ +$ +140.0 +​ +$ +134.7 +​ +$ +131.8 +(1) Ocean Transportation operating revenue excludes inter-segment revenue of $ 59.1 million, $ 52.8 million and $ 51.7 million for the years ended December 31, 2020, 2019 and 2018, respectively. +50 +Table of Contents +(2) Logistics operating revenue excludes inter-segment revenue of $ 56.4 million, $ 49.5 million and $ 43.7 million for the years ended December 31, 2020, 2019 and 2018, respectively. +(3) Ocean Transportation segment information includes $ 26.3 million, $ 20.8 million, and $ 36.8 million of equity in income from the Company’s equity investment in SSAT for the years ended December 31, 2020, 2019 and 2018, respectively. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2020 +2019 +Identifiable Assets: +​ +​ +​ +​ +​ +​ +Ocean Transportation (1) +​ +$ +2,431.1 +​ +$ +2,424.5 +Logistics +​ +469.5 +​ +420.9 +Total Assets +​ +$ +2,900.6 +​ +$ +2,845.4 +(1) The Ocean Transportation segment includes $ 48.7 million and $ 76.2 million related to the Company’s equity investment in SSAT as of December 31, 2020 and 2019, respectively. +​ +​ +​ +​ +4. +INVESTMENT IN SSAT +​ +The Company accounts for its 35 percent ownership interest in SSAT using the equity method of accounting. The Company records its share of income from SSAT in costs and expenses within the Ocean Transportation segment due to operations of SSAT being an integral part of the Company’s Ocean Transportation business. The Company’s investment in SSAT was $ 48.7 million and $ 76.2 million at December 31, 2020 and 2019, respectively. During the year ended December 31, 2020, the Company recorded an increase of $ 2.2 million in its investment in SSAT and a corresponding increase in retained earnings related to the formation of a new subsidiary of SSAT, whose controlling interest is retained by SSAT. +​ +The Company’s share of income recorded in the Consolidated Statements of Income and Comprehensive Income and dividends received by the Company during the years ended December 31, 2020, 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2020 +2019 +2018 +Company's share of net income +​ +$ +26.3 +​ +$ +20.8 +​ +$ +36.8 +​ +Distributions received +​ +$ +55.4 +​ +$ +25.2 +​ +$ +42.0 +​ +​ +The Company’s Ocean Transportation segment operating costs include $ 251.6 million, $ 218.7 million and $ 213.4 million for the years ended December 31, 2020, 2019 and 2018, respectively, for terminal services provided by SSAT. Accounts payable and accrued liabilities in the Consolidated Balance Sheets include $ 29.8 million and $ 63.6 million for terminal services payable to SSAT at December 31, 2020 and 2019, respectively. +​ +A summary of the condensed balance sheets of SSAT at December 31, 2020 and 2019 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +Condensed Balance Sheets (in millions) +2020 +2019 +Current assets +​ +$ +294.3 +​ +$ +300.8 +​ +Non-current assets +​ +1,249.5 +​ +1,283.0 +​ +Total Assets +​ +$ +1,543.8 +​ +$ +1,583.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Current liabilities +​ +$ +238.2 +​ +$ +201.9 +​ +Non-current liabilities +​ +1,179.9 +​ +1,179.2 +​ +Equity +​ +125.7 +​ +202.7 +​ +Total Liabilities and Equity +​ +$ +1,543.8 +​ +$ +1,583.8 +​ +​ +51 +Table of Contents +A summary of the condensed statements of operating income and net income of SSAT for years ended December 31, 2020, 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +​ +Condensed Statements of Operating Income and Net Income (in millions) +2020 +2019 +2018 +Operating revenue +​ +$ +1,091.6 +​ +$ +1,098.3 +​ +$ +1,074.2 +​ +Operating costs and expenses +​ +1,003.2 +​ +1,035.3 +​ +963.7 +​ +Operating income +​ +88.4 +​ +63.0 +​ +110.5 +​ +Net Income (1) +​ +$ +76.6 +​ +$ +57.2 +​ +$ +104.9 +​ +(1) +Includes earnings from equity method investments held by SSAT less earnings allocated to non-controlling interests. +​ +​ +​ +5. +PROPERTY AND EQUIPMENT +​ +Property and equipment at December 31, 2020 and 2019, and depreciation expense for the years ended December 31, 2020, 2019 and 2018 is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, 2020 +​ +As of December 31, 2019 +​ +​ +​ +Accumulated +​ +​ +​ +Accumulated +​ +(In millions) +​ +Cost +​ +Depreciation +​ +Net Book Value +​ +Cost +​ +Depreciation +​ +Net Book Value +Vessels +​ +$ +2,191.6 +​ +$ +785.5 +​ +$ +1,406.1 +​ +​ +$ +1,653.5 +​ +$ +818.5 +​ +$ +835.0 +​ +Containers and equipment +​ +572.3 +​ +​ +391.8 +​ +180.5 +​ +​ +544.5 +​ +378.8 +​ +165.7 +​ +Terminal facilities and other property +​ +119.8 +​ +​ +45.1 +​ +74.7 +​ +​ +114.4 +​ +41.3 +​ +73.1 +​ +Vessel construction in progress +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +​ +488.9 +​ +​ +— +​ +​ +488.9 +​ +Other construction in progress +​ +28.6 +​ +​ +— +​ +28.6 +​ +​ +35.4 +​ +— +​ +35.4 +​ +Total +​ +$ +2,912.3 +​ +$ +1,222.4 +​ +$ +1,689.9 +​ +​ +$ +2,836.7 +​ +$ +1,238.6 +​ +$ +1,598.1 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2020 +2019 +2018 +Depreciation expense +​ +$ +97.1 +​ +$ +86.3 +​ +$ +80.5 +​ +​ +​ +​ +6. +GOODWILL AND INTANGIBLE ASSETS +​ +Goodwill by segment as of December 31, 2020 and 2019 consists of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean +​ +​ +​ +​ +​ +​ +(In millions) +Transportation +Logistics +Total +Goodwill +​ +$ +222.6 +​ +$ +105.2 +​ +$ +327.8 +​ +Logistics goodwill of $ 105.2 million includes $ 78.6 million acquired as part of the acquisition of Span Intermediate, LLC (“Span Alaska”) in August 2016 that was allocated to the Span Alaska reporting unit, and $ 26.6 million relates to other Logistics acquisitions that were allocated to the Logistics reporting unit. +​ +Intangible assets by segment as of December 31, 2020 and 2019 consist of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, 2020 +​ +As of December 31, 2019 +​ +​ +Gross +​ +Accumulated +​ +​ +​ +​ +Gross +​ +Accumulated +​ +​ +​ +(In millions) +Amount +Amortization +Net Book Value +Amount +Amortization +Net Book Value +Ocean Transportation - Customer relationships +​ +$ +140.6 +​ +$ +37.9 +​ +$ +102.7 +​ +​ +$ +140.6 +​ +$ +31.2 +​ +$ +109.4 +​ +Logistics: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Customer relationships +​ +​ +90.1 +​ +​ +28.1 +​ +​ +62.0 +​ +​ +​ +90.1 +​ +​ +23.9 +​ +​ +66.2 +​ +Trade name +​ +27.3 +​ +​ +— +​ +​ +27.3 +​ +​ +27.3 +​ +​ +— +​ +​ +27.3 +​ +Total Logistics +​ +117.4 +​ +​ +28.1 +​ +​ +89.3 +​ +​ +117.4 +​ +​ +23.9 +​ +​ +93.5 +​ +Total +​ +$ +258.0 +​ +$ +66.0 +​ +$ +192.0 +​ +​ +$ +258.0 +​ +$ +55.1 +​ +$ +202.9 +​ +​ +Ocean Transportation intangible assets of $ 140.6 million relate to customer relationships acquired as part of the acquisition of Horizon Lines, Inc. (“Horizon”) on May 29, 2015, and are being amortized over 21 years . Logistics intangible assets include $ 79.3 million of customer relationships which are being amortized over 20 years , and +52 +Table of Contents +$ 27.3 million of an indefinite life trade name, both acquired as part of the Span Alaska acquisition. The remaining Logistics customer relationships of $ 10.8 million are being amortized over a period of up to 13 years . +​ +Intangible assets related amortization expense for 2020, 2019 and 2018, is as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2020 +2019 +2018 +Amortization expense +​ +$ +10.9 +​ +$ +11.1 +​ +$ +11.2 +​ +​ +As of December 31, 2020, estimated amortization expense related to customer relationship intangible assets during the next five years and thereafter is as follows: +​ +​ +​ +​ +​ +​ +​ +Customer +​ +Year (in millions) +​ +Relationships +2021 +​ +$ +10.9 +​ +2022 +​ +10.7 +​ +2023 +​ +10.7 +​ +2024 +​ +10.7 +​ +2025 +​ +10.7 +​ +Thereafter +​ +111.0 +​ +Total +​ +$ +164.7 +​ +​ +​ +​ +7. +CAPITAL CONSTRUCTION FUND +​ +The Company is party to an agreement with the U.S. Department of Transportation, Maritime Administration (“MARAD”) that established a Capital Construction Fund (“CCF”) program under provisions of the Merchant Marine Act of 1936, as amended (the “Merchant Marine Act”). The CCF program was created to assist owners and operators of U.S. flagged vessels in raising capital necessary for the modernization and expansion of the U.S. merchant marine fleet. CCF funds may be used for the acquisition, construction, or reconstruction of vessels, and for repayment of existing vessel indebtedness through the deferment of federal income taxes on certain deposits of monies and other property placed into the CCF. Qualified withdrawals from the CCF must be used for investment in vessels built in the U.S. and used between covered U.S. ports as described by the Merchant Marine Act, and for other qualifying expenditures (see Item 1 of Part 1 for additional information on Maritime Laws and the Jones Act). Participants of the CCF must also meet certain U.S. citizenship requirements. +​ +Deposits into the CCF are limited by certain applicable earnings and other conditions. Such deposits, once made, are available as tax deductions in the Company’s income tax provision. Qualified withdrawals from the CCF do not give rise to a current income tax liability, but reduce the depreciable basis of the vessels or certain related equipment for income tax purposes. However, if withdrawals are made from the CCF for general corporate purposes or other non-qualified purposes, or upon termination of the agreement, they are taxable with interest payable from the year of deposit. +​ +Deposits not committed for qualified purposes within 25 years from the date of deposit will be treated as non-qualified withdrawals over the subsequent five years . Under the terms of the CCF agreement, the Company may designate certain qualified earnings as “accrued deposits” or may designate, as obligations of the CCF, qualified withdrawals to reimburse qualified expenditures initially made with operating funds. Such accrued deposits to, and withdrawals from, the CCF are reflected in the Consolidated Balance Sheets either as obligations of the Company’s current assets or as receivables from the CCF. +​ +As of December 31, 2020 and 2019, $ 1.7 million of eligible accounts receivable were assigned to the CCF. Due to the nature of the assignment of eligible accounts receivable into the CCF, such assigned amounts are classified as part of accounts receivable in the Consolidated Balance Sheets. At December 31, 2020 and 2019, the amounts on deposit in the CCF invested in a money market fund, which is classified as other long-term assets in the Company’s Consolidated Balance Sheets, were nominal. +​ +​ +53 +Table of Contents +8. +DEBT +​ +At December 31, 2020 and 2019, the Company’s debt consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +(In millions) +2020 +2019 +Private Placement Term Loans: +​ +​ +​ +​ +​ +​ +​ +5.79 %, payable through 2020 +​ +$ +— +​ +$ +3.5 +​ +3.66 %, payable through 2023 +​ +22.8 +​ +31.9 +​ +4.16 %, payable through 2027 +​ +34.0 +​ +39.3 +​ +3.37 %, payable through 2027 +​ +​ +75.0 +​ +​ +75.0 +​ +3.14 %, payable through 2031 +​ +​ +169.6 +​ +​ +188.0 +​ +4.31 %, payable through 2032 +​ +27.9 +​ +30.3 +​ +4.35 %, payable through 2044 +​ +​ +— +​ +​ +100.0 +​ +3.92 %, payable through 2045 +​ +​ +— +​ +​ +69.5 +​ +Title XI Debt: +​ +​ +​ +​ +​ +​ +​ +5.34 %, payable through 2028 +​ +17.6 +​ +19.8 +​ +5.27 %, payable through 2029 +​ +19.8 +​ +22.0 +​ +1.22 %, payable through 2043 +​ +​ +182.0 +​ +​ +— +​ +1.35 %, payable through 2044 +​ +​ +139.6 +​ +​ +— +​ +Revolving credit facility, maturity date of June 29, 2022 +​ +71.8 +​ +379.1 +​ +Total Debt +​ +760.1 +​ +958.4 +​ +Less: Current portion +​ +( 59.2 ) +​ +( 48.4 ) +​ +Total Long-term Debt +​ +​ +700.9 +​ +​ +910.0 +​ +Less: Deferred loan fees +​ +​ +( 15.3 ) +​ +​ +— +​ +Total Long-term Debt, net of deferred loan fees +​ +$ +685.6 +​ +$ +910.0 +​ +​ +The following is a description of the Company’s debt: +​ +Private Placement Term Loans : The 5.79 percent notes payable through 2020 are amortized by semi-annual principal payments of $ 3.5 million plus interest. These notes were fully paid off during the year ended December 31, 2020. +​ +During the second quarter of 2012, the Company issued $ 170.0 million of unsecured notes, which funded in three tranches, $ 77.5 million at an interest rate of 3.66 percent, $ 55.0 million at an interest rate of 4.16 percent, and $ 37.5 million at an interest rate of 4.31 percent (the “2012 Notes”). Principal and interest are payable semi-annually. The 2012 Notes began to amortize in 2015 with aggregate semi-annual payments of $ 4.6 million which continued through 2016, followed by $ 8.4 million in 2017 through mid-year 2023, $ 3.8 million through mid-year 2027, and $ 1.2 million thereafter. +​ +In January 2014, the Company issued $ 100.0 million of 30 -year senior unsecured notes at an interest rate of 4.35 percent, payable semi-annually. These notes were fully paid off during the year ended December 31, 2020. +​ +In July 2015, the Company issued $ 75.0 million of 30 -year senior unsecured notes at an interest rate of 3.92 percent, payable semi-annually. These notes were fully paid off during the year ended December 31, 2020. +​ +In September 2016, the Company issued $ 200.0 million of 15 -year senior unsecured notes (the “Series D Notes”) at an interest rate of 3.14 percent, payable semi-annually. The Series D Notes began to amortize in 2019, with semi-annual principal payments of $ 6.0 million. During the years 2020 through 2023, semi-annual principal payments will be $ 9.2 million. Starting in 2024, and in each year thereafter through maturity in 2031, the semi-annual principal payments will be $ 7.15 million. +​ +In December 2016, the Company issued $ 75 million of 11 -year senior unsecured notes at an interest rate of 3.37 percent, payable semi-annually (the “Series A Notes”). The Series A Notes will begin to amortize in 2021, with principal payments of $ 5.8 million in 2021 and $ 11.5 million per year, paid semi-annually, from 2022 through 2027. +​ +Existing and 2020 Title XI Bonds: In September 2003, MatNav issued $ 55.0 million in U.S. Government guaranteed ship financing bonds (Title XI) to finance the delivery of Manukai (the “Manukai Title XI Bonds”). The Manukai Title XI Bonds have a final maturity in September 2028 with a coupon rate of 5.34 percent. The Manukai Title XI Bonds are +54 +Table of Contents +amortized by semi-annual payments of $ 1.1 million plus interest. In August 2004, MatNav issued $ 55.0 million of U.S. Government guaranteed ship financing bonds (Title XI) to finance the delivery of Maunawili (the “Maunawili Title XI Bonds”, and together with the Manukai Title XI Bonds, the “Existing Title XI Bonds”). The Maunawili Title XI Bonds have a final maturity in July 2029 with a coupon rate of 5.27 percent. The Maunawili Title XI Bonds are amortized by semi-annual payments of $ 1.1 million plus interest. +​ +On April 27, 2020, MatNav issued $ 185.9 million in U.S. Government guaranteed vessel financing bonds to partially refinance debt incurred in connection with the construction of Daniel K. Inouye (the “DKI Title XI Debt”). A fee of approximately $ 8.7 million was paid to MARAD out of the proceeds at closing. The secured DKI Title XI Debt matures on October 15, 2043 and has a cash interest rate of 1.22 percent, payable semi-annually in arrears on April 15 and October 15, commencing on October 15, 2020, together with a principal payment of approximately $ 4.0 million. +​ +On June 22, 2020, MatNav issued $ 139.6 million in U.S. Government guaranteed vessel financing bonds to partially refinance debt incurred in connection with the construction of Kaimana Hila (the “KMH Title XI Debt”, and together with the DKI Title XI Debt, the “2020 Title XI Debt”). A fee of approximately $ 6.7 million was paid to MARAD out of the proceeds at closing. The secured KMH Title XI Debt matures on March 15, 2044 and has a cash interest rate of 1.35 percent, payable semi-annually in arrears on March 15 and September 15, commencing on September 15, 2020, together with a principal payment of approximately $ 3.0 million. +​ +MatNav may prepay any amounts outstanding under the 2020 Title XI Debt agreements subject to a potential prepayment premium or other adjustment, in accordance with the 2020 Title XI Debt agreements. Once amounts under the 2020 Title XI Debt are repaid, they may not be reborrowed. Mandatory prepayments are required under certain limited circumstances, including specified casualty events with respect to the vessels Daniel K. Inouye and Kaimana Hila (the “Vessels”). +​ +Revolving Credit Facility: On June 29, 2017, the Company entered into an amended and restated credit agreement that provides the Company with additional sources of liquidity for working capital, capital expenditures and investment opportunities, and amends and restates the Company’s previously amended and restated credit agreement (the “Credit Agreement” or the “revolving credit facility”). The Credit Agreement expires on June 29, 2022, and provides for committed aggregate borrowing of up to $ 650 million, with an uncommitted option to increase the aggregate borrowing by up to $ 250 million. The aggregate borrowing within the Credit Agreement includes a $ 100 million sublimit for the issuance of standby and commercial letters of credit, and a $ 50 million sublimit for swing line loans. The Company may prepay any amounts outstanding under the Credit Agreement without premium or penalty. All obligations of the Company under the Credit Agreement are guaranteed by MatNav and certain other subsidiaries. +​ +On March 31, 2020, the Company entered into a First Amendment to Amended and Restated Credit Agreement (the “Credit Agreement Amendment”). The Credit Agreement Amendment provides for amendments to certain covenants and other terms, including increasing the permitted consolidated leverage ratio from March 31, 2020 to December 30, 2021, amending the pricing grid to provide for pricing ranging from, at the Company’s election, LIBOR plus a margin between 1.75 percent and 3.50 percent, or a base rate plus a margin between 0.75 percent and 2.50 percent depending on the Company’s consolidated net leverage ratio; providing for additional limitations on stock redemptions and repurchases, sale leaseback transactions and asset sales during the period from March 31, 2020 through December 30, 2021; and providing for additional limitations on the incurrence of priority debt through December 21, 2027. In addition, the Credit Agreement Amendment adds a “most favored lender” provision for the benefit of the lenders with respect to the Company’s Private Debt Agreements (as defined below). Pursuant to the Credit Agreement Amendment, commencing March 31, 2020, borrowings under the Credit Agreement bear interest at either LIBOR plus a margin of between 1.75 percent and 3.50 percent or the base rate plus a margin of between 0.75 percent and 2.50 percent. Letters of credit are subject to fees based on the Company’s consolidated net leverage ratio at a rate of between 1.75 percent and 3.50 percent, and the Company also pays a commitment fee of between 0.25 percent and 0.55 percent depending on the Company’s consolidated net leverage ratio. +​ +As of December 31, 2020, the Company had $ 570.1 million of remaining borrowing availability under the revolving credit facility. The Company had $ 8.1 million of letters of credit outstanding as of December 31, 2020. Based on the Company’s consolidated net leverage ratio, which stipulates borrowing margins, the interest rate applicable to revolving credit facility was approximately 2.50 percent at December 31, 2020. +​ +55 +Table of Contents +Amendments to Existing Private Placement Term Loan Facilities and New Shelf Facilities (“Private Loan Facilities”): On June 29, 2017, the Company and the holders of the Company’s term loans entered into amendments (collectively, the “2017 Amendments”) to each of Company’s Private Loan Facilities. The 2017 Amendments provide for amendments to certain covenants and other terms, including (at the Company’s option under certain circumstances) adjustments to the required consolidated leverage ratio, and, in connection with the exercise of such option, the payment of additional interest for certain pre-defined periods. +​ +On March 31, 2020, the Company and the holders of notes party thereto entered into amendments (collectively, the “2020 Amendments”) to each of the Company’s Private Loan Facilities. The 2020 Amendments modify certain covenants and other terms, including increasing the permitted consolidated leverage ratio from March 31, 2020 to December 30, 2021; providing for additional quarterly interest enhancement payments based on the Company’s consolidated leverage ratio from the quarter ended March 31, 2020 through the quarters ending December 31, 2021; providing for an additional 25 basis points of interest on the notes commencing on January 1, 2022 (subject to termination of such incremental interest upon the Company meeting a consolidated leverage ratio of less than 3:00 to 1:00 for two consecutive fiscal quarters); providing for additional fee payments to be made for the quarters ending June 30, 2021 and September 30, 2021; providing for prepayment at par at the option of the holders with proceeds of certain 2020 Title XI Debt and dispositions of capital assets; providing for additional limitations on stock redemptions and repurchases, sale leaseback transactions and asset sales during the period from March 31, 2020 through and including December 30, 2021; and providing for additional limitations on incurrence of priority debt through December 21, 2027. In addition, the 2020 Amendments add a “most favored lender” provision for the benefit of the noteholders with respect to the other Private Debt Agreements. +​ +Debt Maturities: At December 31, 2020, debt maturities during the next five years and thereafter are as follows: +​ +​ +​ +​ +​ +​ +​ +As of +Year (in millions) +December 31, 2020 +2021 +​ +$ +59.2 +2022 +​ +136.8 +2023 +​ +60.4 +2024 +​ +51.7 +2025 +​ +51.7 +Thereafter +​ +400.3 +Total Debt +​ +$ +760.1 +​ +Deferred Loan Fees: Activity relating to deferred loan fees for the year ended December 31, 2020 are as follows: +​ +​ +​ +​ +​ +Deferred Loan Fees (in millions) +Amount +Deferred financing costs related to Title XI bonds and private placement debt amendments +​ +$ +16.5 +Deferred fees expensed related to the redemption of private placement debt +​ +​ +( 0.3 ) +Amortization expense for the year ended December 31, 2020 +​ +( 0.9 ) +Balance at December 31, 2020 +​ +$ +15.3 +​ +As of December 31, 2020, amortization expense relating to deferred loan fees during the next five years and thereafter are as follows: +​ +​ +​ +​ +​ +Year (in millions) +Amount +2021 +​ +$ +1.5 +2022 +​ +1.2 +2023 +​ +1.1 +2024 +​ +1.1 +2025 +​ +1.0 +Thereafter +​ +9.4 +Total amortization expense of deferred loan fees +​ +$ +15.3 +​ +Debt Covenants in the Private Placement Term Loans and the Revolving Credit Facility : The Credit Agreement and Private term loan facilities (collectively, the “Private Debt Agreements”) contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, limitations on certain other indebtedness, loans and investments, liens, mergers, asset sales, and transactions with affiliates as defined within the Private Debt +56 +Table of Contents +Agreements. The Private Debt Agreements also contain customary events of default, including cross defaults to other material indebtedness, including the Existing Title XI Bonds and the 2020 Title XI Debt. A brief description of the principal covenants contained in the Private Debt Agreements includes, but is not limited to the following (as defined within the Private Debt Agreements): +​ +◾ Minimum Consolidated Interest Coverage Ratio as of the end of any fiscal quarter is not permitted to be less than 3.50 to 1.0; +◾ Maximum Consolidated Leverage Ratio as of the end of any fiscal quarter is not permitted to exceed the ratios specified in the Private Debt Agreements for the applicable quarter; and +◾ No Priority Debt may be incurred other than: (i) an aggregate of $ 331,000,000 principal amount of Title XI Priority Debt and (ii) Priority Debt incurred by Foreign Subsidiaries in an aggregate principal amount not to exceed $ 20,000,000 . +​ +Principal covenants generally will restrict the incurrence of liens except for permitted liens, which include, without limitation, liens securing Title XI debt up to certain permitted amounts, as defined within the Private Debt Agreements. The Company was in compliance with these covenants as of December 31, 2020. +​ +Debt Covenants in Existing Title XI Bonds and 2020 Title XI Debt Agreements: The Existing Title XI Bonds contain customary representations and warranties as well as affirmative and negative covenants, defaults and other provisions typical for MARAD-guaranteed financings of this type, with definitions and limitations as defined within the Existing Title XI Bonds. These covenants include, among other things, minimum working capital and net worth requirements, limitations on certain other indebtedness, loans and investments, liens, mergers, asset sales, sale and leaseback transactions, and transactions with affiliates as defined within the Existing Title XI Bonds. Certain of the covenants in the Existing Title XI Bonds are applicable only upon and during the continuance of either (i) an event of default or (ii) the failure of MatNav to meet certain financial requirements. +​ +The 2020 Title XI Debt agreements contain customary representations and warranties as well as affirmative and negative covenants, defaults and other provisions typical for MARAD-guaranteed financings of this type, with definitions, limitations and financial tests all as negotiated between MatNav and MARAD. As part of the 2020 Title XI Debt agreements, certain covenants contained in the Existing Title XI Bonds were eliminated. The covenants in the 2020 Title XI Debt agreements include, among other things, limitations on certain other indebtedness, loans and investments, liens, mergers, asset sales, sale-leasebacks, and transactions with affiliates as defined within the 2020 Title XI Debt agreements. Certain of the covenants in the 2020 Title XI Debt agreements are applicable only upon and during the continuance of either (i) an event of default or (ii) the failure of either the Company or MatNav to meet certain supplemental financial tests. +​ +● The supplemental financial tests applicable to MatNav include maintenance of a working capital minimum of $ 1 , and maintenance of a long term debt to net worth ratio of greater than or equal to 2.0 to 1.0; and +● The supplemental financial tests applicable to the Company include maintenance of a net worth greater than or equal to 90 % of the net worth of the Company as set forth in the most recent audited financial statements prior to closing of the issuance of the 2020 Title XI Bonds and compliance with the leverage ratio set forth in the Company’s Credit Agreement. +​ +Debt Security and Guarantees: All of the debt of the Company and MatNav, including related guarantees, as of December 31, 2020 was unsecured, except for the Existing Title XI Bonds and the 2020 Title XI Debt. +​ +Under the 2020 Title XI Debt agreements, MARAD has guaranteed certain obligations of MatNav. MatNav has agreed to reimburse MARAD for any payments it makes under the MARAD guaranty, and MatNav’s obligations to MARAD with respect to the 2020 Title XI Debt are secured by a mortgage on the Vessels and certain other related assets (the “Collateral”), as well as the Existing Vessels (as defined below). In addition, MatNav’s obligations to MARAD with respect to the 2020 Title XI Debt are guaranteed by the Company under an Affiliate Guaranty (the “Guaranty”). +​ +The 2020 Title XI Debt agreements also provide that the two vessels securing MatNav’s Existing Title XI Bonds – Manukai and Maunawili (the “Existing Vessels”) – also secure the 2020 Title XI Bonds until the Existing Title XI Debt are retired in 2028 and 2029, respectively, subject to certain exceptions. +​ +​ +​ +​ +57 +Table of Contents +9. +LEASES +​ +The Company adopted the lease accounting standard ASC 842 on January 1, 2019. As part of the adoption, the Company recorded a net adjustment to retained earnings of $ 4.4 million at January 1, 2019. Significant assumptions and judgments made in applying the new lease accounting standard include determining the Company’s incremental borrowing rate and evaluating the probability of exercising lease options. +​ +Description of Operating Leases: The Company has different types of operating leases, the specific terms and conditions of which vary from lease to lease. Certain operating lease agreements include terms such as: (i) renewal and early termination options; (ii) early buy-out and purchase options; and (iii) rent escalation clauses. The lease agreements also include provisions for the maintenance of the leased asset and payment of lease related costs. The Company reviews the specific terms and conditions of each lease and, as appropriate, notifies the lessor of any intent to exercise any option in accordance with the terms of the lease. In the normal course of business, the Company expects to be able to renew or replace most of its operating leases with other similar leases as they expire. Except for the residual value guarantee described below, the Company’s leases do not contain any other residual value guarantees. +​ +The Company’s sub-lease income was nominal to the Company’s Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2020 and 2019. The Company did not have any finance leases during the years ended December 31, 2020 and 2019. Certain of the Company’s lease agreements include rental payments that may be adjusted in the future based on economic conditions and others include rental payments adjusted periodically for inflation. Variable lease expense is disclosed for the adjusted portion of such payments. +​ +The lease type by underlying asset class and maximum terms of the Company’s operating leases are as follows: +​ +​ +​ +​ +Lease Type: +Term +Real estate and terminal leases +65 years +Vessel charter leases +10 years +Operations equipment and other leases +8 years +​ +Incremental Borrowing Rate: As most of the Company’s operating leases do not provide an implicit rate, the Company uses an estimated incremental borrowing rate based on information available at the date of adoption and subsequent lease commencement dates in calculating the present value of its operating lease liabilities. The incremental borrowing rate is determined using the U.S. Treasury rate adjusted to account for the Company’s credit rating and the collateralized nature of operating leases. +​ +Components of Lease Cost: Components of lease cost recorded in the Company’s Consolidated Statement of Income and Comprehensive Income for the years ended December 31, 2020 and 2019 consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended +​ +​ +December 31, +(In millions) +2020 +​ +2019 +Operating lease cost +​ +$ +83.1 +​ +$ +71.4 +Short-term lease cost +​ +10.6 +​ +5.9 +Variable lease cost +​ +0.8 +​ +0.4 +Total lease cost +​ +$ +94.5 +​ +$ +77.7 +​ +Other Lease Information: Other information related to the Company’s operating leases for the years ended December 31, 2020 and 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended +​ +​ +December 31, +(In millions) +2020 +​ +2019 +Cash paid for amounts included in operating lease liabilities +​ +$ +83.6 +​ +$ +71.3 +Right of use assets obtained in the exchange for new operating lease liabilities +​ +$ +70.1 +​ +$ +65.3 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +​ +​ +2020 +2019 +Weighted average remaining operating lease term +​ +​ +7.0 years +​ +​ +7.5 years +Weighted average incremental borrowing rate +​ +​ +3.7 % +​ +​ +4.2 % +​ +58 +Table of Contents +Maturities of operating lease liabilities at December 31, 2020 are as follows: +​ +​ +​ +​ +​ +​ +As of +Year (in millions) +December 31, 2020 +2021 +​ +$ +80.5 +2022 +​ +53.2 +2023 +​ +47.3 +2024 +​ +31.8 +2025 +​ +23.9 +Thereafter +​ +65.6 +Total lease payments +​ +​ +302.3 +Less: Interest +​ +​ +( 43.0 ) +Present value of operating lease liabilities +​ +​ +259.3 +Less: Short-term portion +​ +​ +( 72.4 ) +Long-term operating lease liabilities +​ +$ +186.9 +​ +Sale and Leaseback of Equipment: On March 25, 2020, the Company entered into an agreement for the sale and leaseback of multiple tranches of chassis and container equipment. The net proceeds from the sales were $ 14.3 million, and the gain on the disposal of the equipment was not material to the Company’s Consolidated Financial Statements. The Company subsequently leased back the equipment under a five-year operating lease agreement, and the obligations under the lease are included in the maturities of operating lease liabilities table above. +​ +Vessel Charter and Buyer-Lessor Guaranty +​ +Vessel Charter: On November 26, 2018, a wholly-owned subsidiary of the Company entered into agreements whereby a vessel, Maunalei , owned by the subsidiary, was sold for $ 106.0 million and subsequently leased back from the buyer-lessor under a Bareboat Charter Agreement (the “Charter”). The transaction qualified for sale and leaseback treatment under ASC 840, Leases , with the Charter treated as an operating lease for accounting purposes. Lease payments are approximately $ 3.0 million per quarter, and the base term of the Charter is five years with a two year end-of-term renewal option . Total future minimum lease payments were $ 36.0 million at December 31, 2020, and the obligations under the lease are included in the maturities of operating lease liabilities table above. +​ +Prior to the expiration of the base term of the Charter, the subsidiary may, at its option, elect to: (i) purchase the vessel at the option price; (ii) exercise the option to renew the Charter for an additional two years; or (iii) remarket the vessel to sell to a third-party on behalf of the buyer-lessor. The purchase option price is $ 68.9 million after the base term and $ 58.3 million after the extended term. The Charter also includes a maximum residual value guarantee amount of $ 50.9 million after five years, or $ 47.7 million after the extended term. Proceeds from the sale of the vessel reduces the subsidiary’s residual value guarantee. +​ +Buyer-Lessor Guaranty: Matson, Inc. provided the buyer-lessor with a guaranty of all obligations of the wholly-owned subsidiary related to the Charter as defined in the guaranty agreement. +​ +​ +59 +Table of Contents +10. +INCOME TAXES +​ +Income Taxes: On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was signed into law and included numerous changes to existing tax law, including a reduction in the federal corporate income tax rate from 35 percent to 21 percent. The rate reduction and other changes took effect on January 1, 2018. Other changes such as remeasurement of deferred tax assets and liabilities were effective as of the fourth quarter of 2017. +​ +Income taxes for the years ended December 31, 2020, 2019 and 2018 consisted of the following: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +(In millions) +2020 +2019 +2018 +Current: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Federal +​ +$ +— +​ +$ +0.2 +​ +$ +1.5 +​ +State +​ +8.7 +​ +3.2 +​ +2.1 +​ +Foreign +​ +​ +1.4 +​ +​ +1.3 +​ +​ +0.9 +​ +Discrete adjustments related to the Tax Act (1) +​ +​ +— +​ +​ +( 2.9 ) +​ +​ +2.9 +​ +Total +​ +10.1 +​ +1.8 +​ +7.4 +​ +Deferred: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax expense +​ +​ +55.8 +​ +​ +23.3 +​ +​ +31.3 +​ +Total income taxes +​ +$ +65.9 +​ +$ +25.1 +​ +$ +38.7 +​ +(1) Current income taxes for the years ended December 31, 2019 and 2018 include a non-cash income tax benefit of $ 2.9 million and a non-cash income tax expense of $ 2.9 million, respectively, which relates to discrete adjustments as a result of applying the provisions of the Tax Act. +​ +Income taxes for the years ended December 31, 2020, 2019 and 2018 differ from amounts computed by applying the statutory federal rate to income before income taxes for the following reasons: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +​ +2020 +2019 +2018 +Computed federal income tax expense +21.0 +% +21.0 +% +21.0 +% +State income tax +3.5 +% +4.1 +% +3.4 +% +Valuation allowance +( 0.2 ) +% +( 0.3 ) +% +( 0.7 ) +% +Foreign taxes +0.6 +% +1.2 +% +0.6 +% +Remeasurement and discrete adjustments related to the Tax Act (1) +— +% +( 2.7 ) +% +2.0 +% +Share-based payments +( 0.5 ) +% +( 0.1 ) +% +0.1 +% +Other — net +1.0 +% +0.1 +% +( 0.2 ) +% +Effective income tax rate +25.4 +% +23.3 +% +26.2 +% +(1) Effective income tax rate for the years ended December 31, 2019 and 2018 includes the impact of a non-cash income tax benefit of $ 2.9 million, or 2.7 percent, and a non-cash income tax expense of $ 2.9 million, or 2.0 percent, respectively, which related to certain discrete adjustments as a result of applying the provisions of the Tax Act. +​ +60 +Table of Contents +The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2020 and 2019, were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +As of December 31, +(In millions) +2020 +2019 +Deferred tax assets: +​ +​ +​ +​ +​ +​ +​ +Operating lease liabilities +​ +$ +63.5 +​ +$ +63.1 +​ +Pension and post-retirement plans +​ +​ +21.7 +​ +​ +19.2 +​ +Multi-employer withdrawal liabilities +​ +​ +15.6 +​ +​ +16.1 +​ +Federal net operating losses +​ +​ +0.9 +​ +​ +14.3 +​ +State net operating losses +​ +​ +7.5 +​ +​ +7.3 +​ +U.S. State alternative minimum tax credits +​ +4.4 +​ +6.7 +​ +Insurance reserves +​ +5.3 +​ +5.9 +​ +Deferred compensation +​ +8.2 +​ +​ +5.8 +​ +Other +​ +10.4 +​ +5.9 +​ +Total deferred tax assets +​ +137.5 +​ +144.3 +​ +Valuation allowance +​ +​ +( 10.0 ) +​ +​ +( 10.6 ) +​ +Total deferred tax assets, net of valuation allowance +​ +​ +127.5 +​ +​ +133.7 +​ +​ +​ +​ +​ +​ +​ +​ +​ +Deferred tax liabilities: +​ +​ +​ +​ +​ +​ +​ +Basis differences for property and equipment +​ +372.4 +​ +319.2 +​ +Operating lease right of use assets +​ +61.5 +​ +61.1 +​ +Intangibles +​ +​ +40.5 +​ +​ +39.7 +​ +Lease financing +​ +​ +22.0 +​ +​ +23.7 +​ +Capital Construction Fund +​ +6.7 +​ +​ +12.5 +​ +Investment in SSAT +​ +7.4 +​ +7.4 +​ +Other +​ +​ +6.6 +​ +​ +7.7 +​ +Total deferred tax liabilities +​ +517.1 +​ +471.3 +​ +Deferred tax liability, net +​ +$ +389.6 +​ +$ +337.6 +​ +​ +Valuation Allowance: Valuation allowances recorded against the Company’s foreign income tax net operating losses (“NOLs”) and a portion of the state income tax NOLs were $ 10.0 million and $ 10.6 million as of December 31, 2020 and 2019, respectively. The Company believes that it is more likely than not that the benefit from these amounts will not be realized. The Company recorded a decrease (increase) to its valuation allowance of $ 0.6 million, $ 0.9 million and ($ 1.1 ) million during the years ended December 31, 2020, 2019 and 2018, respectively. +​ +Net Operating Losses and Tax Credit Carryforwards: The Company’s NOLs and tax credit carryforwards at December 31, 2020 and 2019 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +​ +Expiration Date +2020 +2019 +U.S. Federal income tax NOLs +​ +Various dates beginning in 2027 +​ +$ +7.6 +​ +$ +71.2 +U.S. State income tax NOLs (1) +​ +Various dates beginning in 2032 +​ +$ +185.9 +​ +$ +184.5 +U.S. State alternative minimum tax credit +​ +No expiration date +​ +$ +4.0 +​ +$ +6.7 +Foreign income tax NOLs +​ +No expiration date +​ +$ +11.9 +​ +$ +14.0 +(1) The Company does not expect to benefit from $ 157.9 million and $ 157.9 million of U.S. State income tax NOLs as of December 31, 2020 and 2019, respectively. +​ +The U.S. federal and state income tax NOLs in the Company’s filed income tax returns include unrecognized tax benefits. The deferred tax assets recognized for those NOLs are presented net of these unrecognized tax benefits. As a result of changes in tax legislation, the use of a portion of the Company’s domestic NOL and tax credit carryforwards may be limited in future periods. Further, a portion of the federal and state income tax NOLs and tax credit carryforwards may expire before being applied to reduce future income tax liabilities. +​ +Unrecognized Tax Benefits: Total unrecognized benefits represent the amount that, if recognized, would favorably affect the Company’s incomes taxes and effective tax rate in future periods. The Company does not expect a material +61 +Table of Contents +change in gross unrecognized benefits in the next twelve months. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows: +​ +​ +​ +​ +​ +​ +Unrecognized Tax Benefits (in millions) +Amount +Balance at December 31, 2017 +​ +$ +15.9 +​ +Changes in tax positions of prior years, net +​ +( 0.3 ) +​ +Reductions for lapse of statute of limitations +​ +​ +( 0.5 ) +​ +Balance at December 31, 2018 +​ +15.1 +​ +Changes in tax positions of prior years, net +​ +2.1 +​ +Reductions for lapse of statute of limitations +​ +​ +( 0.8 ) +​ +Balance at December 31, 2019 +​ +16.4 +​ +Changes in tax positions of prior years, net +​ +2.1 +​ +Reductions for lapse of statute of limitations +​ +​ +( 0.2 ) +​ +Balance at December 31, 2020 +​ +$ +18.3 +​ +​ +Included in the balance of unrecognized tax benefits at December 31, 2020 are potential benefits of $ 18.3 million that, if recognized, would affect the Company’s income taxes and effective tax rate. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income taxes. To the extent interest and penalties are not ultimately assessed with respect to the settlement of uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the Company’s income taxes. Interest accrued related to the balance of unrecognized tax benefits totaled $ 0.1 million as of December 31, 2020 and 2019. +​ +The Company is no longer subject to U.S. federal income tax audits for years before 2015. The Company is routinely involved in federal, state, local income and excise tax audits, and foreign tax audits. +​ +​ +11. +PENSION AND POST-RETIREMENT PLANS +​ +Non-bargaining Plans: +​ +The Company has two funded qualified single-employer defined benefit pension plans that cover certain non- bargaining unit employees and bargaining unit employees. In addition, the Company has plans that provide certain retiree health care and life insurance benefits to substantially all salaried, non-bargaining employees hired before 2008 and to certain bargaining unit employees. Employees are generally eligible for such benefits upon retirement and completion of a specified number of years of service. The Company does not pre-fund these health care and life insurance benefits, and has the right to modify or terminate certain of these plans in the future. Most non-bargaining retirees pay a portion of the benefit costs. +​ +Plan Administration, Investments and Asset Allocations: The Company has a Benefits Investment Committee that meets regularly with investment advisors to establish investment policies, direct investments and select investment options for the qualified plans. The Benefits Investment Committee is also responsible for appointing investment managers and monitoring their performance. The Company’s investment policy permits investments in marketable equity securities, such as domestic and foreign stocks, domestic and foreign bonds, venture capital, real estate investments, and cash equivalents. The Company’s investment policy does not permit direct investment in certain types of assets, such as options or commodities, or the use of certain strategies, such as short selling or the purchase of securities on margin. +​ +The Company’s investment strategy for its qualified pension plan assets is to achieve a diversified mix of investments that provides for long-term growth at an acceptable level of risk, and to provide sufficient liquidity to fund ongoing benefit payments. The Company has engaged a number of investment managers to implement various investment strategies to achieve the desired asset class mix, liquidity and risk diversification objectives. +​ +62 +Table of Contents +The Company’s target and actual asset allocations at December 31, 2020 and 2019 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Asset Categories +Target +2020 +2019 +Domestic equity securities +53 +% +60 +% +59 +% +International equity securities +15 +% +17 +% +17 +% +Debt securities +22 +% +17 +% +17 +% +Real estate +5 +% +5 +% +6 +% +Other and cash +5 +% +1 +% +1 +% +Total +100 +% +100 +% +100 +% +​ +The Company’s investments in equity securities primarily include domestic large-cap and mid-cap companies, but also includes an allocation to small-cap and international equity securities. Equity investments do not include any direct holdings of the Company’s stock but may include such holdings to the extent that the stock is included as part of certain mutual fund holdings. Debt securities include investment-grade and high-yield corporate bonds from diversified industries, mortgage-backed securities, and U.S. Treasuries. Other types of investments include funds that invest in commercial real estate assets. All assets within specific funds are allocated to the target asset allocation of the fund. +​ +The expected return on plan assets is principally based on the Company’s historical returns combined with the Company’s long-term future expectations regarding asset class returns, the mix of plan assets, and inflation assumptions. Actual return on plan assets for the periods presented are as follows: +​ +​ +​ +​ +​ +Actual Return on Plan Assets +Returns +One-year return +12.0 +% +Three-year return +8.7 +% +Five-year return +9.8 +% +Long-term average return (since plan inception in 1989) +8.5 +% +​ +The Company’s pension plan assets are held in a master trust and are stated at estimated fair values of the underlying investments. Purchases and sales of securities are recorded on a trade-date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date. +​ +Equity Securities: Domestic and international common stocks are valued by obtaining quoted prices on recognized and highly liquid exchanges. +​ +Fixed Income Securities: Corporate bonds and U.S. government treasury and agency securities are valued based upon the closing price reported in the market in which the security is traded. U.S. government agency and corporate asset-backed securities may utilize models, such as a matrix pricing model, that incorporate other observable inputs when broker/dealer quotes are not available, such as cash flow, security structure, or market information. +​ +Real Estate Funds: The fair value of real estate funds is determined by the issuer based on their net asset value (“NAV”). NAV is determined by dividing the fund’s net assets, as recorded in the fund’s audited financial statements, by the number of units outstanding at the valuation date. Fair value for underlying investments in real estate is determined through independent property appraisals. +​ +63 +Table of Contents +The fair values of the Company’s pension plan assets at December 31, 2020 and 2019 by asset category were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair Value Measurements at December 31, 2020 +​ +​ +​ +Quoted Prices in +Significant +Significant +​ +​ +​ +​ +​ +Active Markets +​ +Observable +​ +Unobservable +Asset Category (in millions) +​ +Total +​ +(Level 1) +​ +Inputs (Level 2) +​ +Inputs (Level 3) +Cash +​ +$ +3.8 +​ +$ +3.8 +​ +$ +— +​ +$ +— +​ +Equity securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large-cap +​ +71.3 +​ +28.9 +​ +42.4 +​ +— +​ +U.S. mid- and small-cap +​ +54.3 +​ +36.2 +​ +18.1 +​ +— +​ +International large-cap +​ +7.0 +​ +— +​ +7.0 +​ +— +​ +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. Treasuries +​ +12.0 +​ +— +​ +12.0 +​ +— +​ +Investment grade U.S. corporate bonds +​ +​ +22.5 +​ +— +​ +22.5 +​ +— +​ +Total +​ +​ +170.9 +​ +$ +68.9 +​ +$ +102.0 +​ +$ +— +​ +Investment measured at NAV (1) +​ +​ +41.9 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total plan assets +​ +$ +212.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair Value Measurements at December 31, 2019 +​ +​ +​ +Quoted Prices in +Significant +Significant +​ +​ +​ +​ +​ +Active Markets +​ +Observable +​ +Unobservable +Asset Category (in millions) +​ +Total +​ +(Level 1) +​ +Inputs (Level 2) +​ +Inputs (Level 3) +Cash +​ +$ +6.3 +​ +$ +6.3 +​ +$ +— +​ +$ +— +​ +Equity securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. large-cap +​ +62.4 +​ +23.7 +​ +38.7 +​ +— +​ +U.S. mid- and small-cap +​ +49.6 +​ +33.9 +​ +15.7 +​ +— +​ +International large-cap +​ +6.6 +​ +— +​ +6.6 +​ +— +​ +Fixed income securities: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +U.S. Treasuries +​ +14.1 +​ +— +​ +14.1 +​ +— +​ +Investment grade U.S. corporate bonds +​ +18.2 +​ +— +​ +18.2 +​ +— +​ +High-yield U.S. corporate bonds +​ +0.1 +​ +— +​ +0.1 +​ +— +​ +Total +​ +​ +157.3 +​ +$ +63.9 +​ +$ +93.4 +​ +$ +— +​ +Investment measured at NAV (1) +​ +​ +37.5 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Total plan assets +​ +$ +194.8 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(1) Real estate funds for which fair value is measured using the NAV per share as a practical expedient are not leveled within the fair value hierarchy and are included as a reconciling item to total plan assets. +​ +Contributions to each of the qualified single-employer defined benefit pension plans are determined annually by the Company’s pension administrative committee, based upon the actuarially determined minimum required contribution under the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended, the Pension Protection Act of 2006, and the maximum deductible contribution allowed for tax purposes. The Company’s funding policy is to contribute cash to its pension plans so that it meets at least the minimum contribution requirements. In 2020 and 2019, the Company contributed $ 9.0 million and $ 10.0 million, respectively, in pension contributions in these plans. There were no contributions to the plans in 2018. +​ +The benefit formulas for employees who are members of collective bargaining units are determined according to the collective bargaining agreements, either using final average pay as the base or a flat dollar amount per year of service. +​ +Effective December 31, 2011, the Company froze benefit accruals under the final average pay formula for salaried, non-bargaining unit employees hired before January 1, 2008 and transitioned them to the same cash balance formula for employees hired on or after January 1, 2008. Retirement benefits under the cash balance formula are based on a fixed percentage of employee eligible compensation, plus interest. The plan interest credit rate will vary from year to year based on the ten-year U.S. Treasury rate. +​ +Benefit Plan Assets and Obligations: The measurement date for the Company’s benefit plan disclosures is December 31 of each year. +​ +64 +Table of Contents +The status of the funded qualified defined benefit pension plans and the unfunded post-retirement benefit plans at December 31, 2020 and 2019 are shown below: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Post-retirement +​ +​ +Pension Benefits +​ +Benefits +​ +​ +December 31, +​ +December 31, +​ +(In millions) +2020 +2019 +2020 +2019 +Change in Benefit Obligation: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Benefit obligation at beginning of year +​ +$ +239.9 +​ +$ +217.4 +​ +$ +26.0 +​ +$ +22.2 +​ +Service cost +​ +5.1 +​ +4.7 +​ +0.5 +​ +0.4 +​ +Interest cost +​ +7.9 +​ +9.3 +​ +0.8 +​ +0.9 +​ +Plan participants’ contributions +​ +— +​ +— +​ +0.8 +​ +0.8 +​ +Actuarial loss +​ +23.9 +​ +22.2 +​ +2.7 +​ +3.4 +​ +Benefits paid, net of subsidies received +​ +( 12.5 ) +​ +( 12.2 ) +​ +( 1.7 ) +​ +( 1.7 ) +​ +Expenses paid +​ +( 1.2 ) +​ +( 1.5 ) +​ +— +​ +— +​ +Benefit obligation at end of year +​ +​ +263.1 +​ +​ +239.9 +​ +​ +29.1 +​ +​ +26.0 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Change in Plan Assets: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Fair value of plan assets at beginning of year +​ +​ +194.8 +​ +​ +162.2 +​ +​ +— +​ +​ +— +​ +Actual return on plan assets +​ +22.7 +​ +36.3 +​ +— +​ +— +​ +Plan participants’ contributions +​ +— +​ +— +​ +0.8 +​ +0.8 +​ +Employer contributions +​ +9.0 +​ +10.0 +​ +0.9 +​ +0.9 +​ +Benefits paid, net of subsidies received +​ +( 12.5 ) +​ +( 12.2 ) +​ +( 1.7 ) +​ +( 1.7 ) +​ +Expenses paid +​ +( 1.2 ) +​ +( 1.5 ) +​ +— +​ +— +​ +Fair value of plan assets at end of year +​ +212.8 +​ +194.8 +​ +— +​ +— +​ +Funded Status and Recognized Liability +​ +$ +( 50.3 ) +​ +$ +( 45.1 ) +​ +$ +( 29.1 ) +​ +$ +( 26.0 ) +​ +​ +Qualified pension and post-retirement benefits plans liabilities recognized in the Consolidated Balance Sheets and expenses recognized in accumulated other comprehensive income (loss) at December 31, 2020 and 2019 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Post-retirement +​ +​ +Pension Benefits +​ +Benefits +​ +​ +December 31, +​ +December 31, +​ +(In millions) +2020 +2019 +2020 +2019 +Non-current assets +​ +$ +1.0 +​ +$ +1.0 +​ +$ +— +​ +$ +— +​ +Current liabilities +​ +​ +— +​ +​ +— +​ +​ +( 1.0 ) +​ +​ +( 1.0 ) +​ +Non-current liabilities, net +​ +( 51.3 ) +​ +( 46.1 ) +​ +( 28.1 ) +​ +( 25.0 ) +​ +Total +​ +$ +( 50.3 ) +​ +$ +( 45.1 ) +​ +$ +( 29.1 ) +​ +$ +( 26.0 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net loss, net of taxes +​ +$ +( 64.2 ) +​ +$ +( 56.2 ) +​ +$ +( 4.4 ) +​ +$ +( 2.8 ) +​ +Prior service credit, net of taxes +​ +2.5 +​ +4.3 +​ +16.6 +​ +19.1 +​ +Total +​ +$ +( 61.7 ) +​ +$ +( 51.9 ) +​ +$ +12.2 +​ +$ +16.3 +​ +​ +The information for qualified defined benefit pension plans with an accumulated benefit obligation in excess of plan assets at December 31, 2020 and 2019 are shown below: +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +2020 +2019 +Projected benefit obligation +​ +$ +261.4 +​ +$ +238.3 +​ +Accumulated benefit obligation +​ +$ +260.9 +​ +$ +237.9 +​ +Fair value of plan assets +​ +$ +210.0 +​ +$ +192.2 +​ +​ +Unrecognized gains and losses of the post-retirement benefit plans are amortized over five years . Although current health care costs are expected to increase, the Company attempts to mitigate these increases by maintaining caps on certain of its benefit plans, using lower cost health care plan options where possible, requiring that certain groups of employees pay a portion of their benefit costs, self-insuring for certain insurance plans, encouraging wellness programs for employees, and implementing measures to mitigate future benefit cost increases. +​ +65 +Table of Contents +Components of the net periodic benefit cost and other amounts recognized in other comprehensive income (loss) for the qualified pension plans and the post-retirement benefit plans during 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pension Benefits +​ +Post-retirement Benefits +​ +​ +December 31, +​ +December 31, +​ +(In millions) +2020 +2019 +2018 +2020 +2019 +2018 +Components of Net Periodic Benefit Cost (Benefit): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Service cost +​ +$ +5.1 +​ +$ +4.7 +​ +$ +4.4 +​ +$ +0.5 +​ +$ +0.4 +​ +$ +0.6 +​ +Interest cost +​ +7.9 +​ +9.3 +​ +8.6 +​ +0.8 +​ +0.9 +​ +1.0 +​ +Expected return on plan assets +​ +( 14.0 ) +​ +( 11.9 ) +​ +( 13.5 ) +​ +— +​ +— +​ +— +​ +Amortization of net loss (gain) +​ +4.5 +​ +5.2 +​ +4.6 +​ +0.5 +​ +( 0.1 ) +​ +1.5 +​ +Amortization of prior service credit +​ +( 2.3 ) +​ +( 2.3 ) +​ +( 2.3 ) +​ +( 3.7 ) +​ +( 3.8 ) +​ +( 3.8 ) +​ +Net periodic benefit cost +​ +​ +1.2 +​ +​ +5.0 +​ +​ +1.8 +​ +​ +( 1.9 ) +​ +​ +( 2.6 ) +​ +​ +( 0.7 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Other Changes in Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income, net of tax: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net loss (gain) +​ +​ +11.4 +​ +​ +( 1.7 ) +​ +​ +7.8 +​ +​ +2.0 +​ +​ +2.5 +​ +​ +( 4.7 ) +​ +Amortization of net (loss) gain +​ +( 3.4 ) +​ +( 3.9 ) +​ +( 3.5 ) +​ +( 0.3 ) +​ +0.2 +​ +( 1.1 ) +​ +Amortization of prior service credit +​ +1.7 +​ +1.7 +​ +1.7 +​ +2.8 +​ +2.8 +​ +2.8 +​ +Total recognized in other comprehensive loss (income) +​ +​ +9.7 +​ +​ +( 3.9 ) +​ +​ +6.0 +​ +​ +4.5 +​ +​ +5.5 +​ +​ +( 3.0 ) +​ +Total recognized in net periodic benefit cost and other comprehensive loss (income) +​ +$ +10.9 +​ +$ +1.1 +​ +$ +7.8 +​ +$ +2.6 +​ +$ +2.9 +​ +$ +( 3.7 ) +​ +​ +The weighted average assumptions used to determine benefit information during 2020, 2019 and 2018 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pension Benefits +​ +Post-retirement Benefits +​ +​ +December 31, +​ +December 31, +​ +​ +2020 +2019 +2018 +2020 +2019 +2018 +Discount rate (1) +2.50 +% +3.40 +% +4.40 +% +2.70 +% +3.50 +% +4.50 +% +Expected return on plan assets +7.25 +% +7.50 +% +7.50 +% +​ +​ +​ +​ +​ +​ +Rate of compensation increase +3.00 +% +3.00 +% +3.00 +% +3.00 +% +3.00 +% +3.00 +% +Cash balance interest credit rate +​ +0.75 - 3.25 +% +1.75 - 3.75 +% +3.01 +% +​ +​ +​ +​ +​ +​ +Initial health care cost trend rate: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pre-65 group +​ +​ +​ +​ +​ +​ +​ +5.30 +% +5.70 +% +6.00 +% +Post-65 group +​ +​ +​ +​ +​ +​ +​ +5.40 +% +5.90 +% +6.30 +% +Ultimate health care cost trend rate +​ +​ +​ +​ +​ +​ +​ +4.40 +% +4.40 +% +4.40 +% +Year ultimate health care cost trend rate is reached: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pre-65 group +​ +​ +​ +​ +​ +​ +​ +2037 +​ +2037 +​ +2037 +​ +Post-65 group +​ +​ +​ +​ +​ +​ +​ +2036 +​ +2036 +​ +2036 +​ +(1) The Company derives a single equivalent rate utilizing a yield curve constructed from a portfolio of high-quality corporate bonds with various maturities. +​ +66 +Table of Contents +Non-qualified Pension Plans: The Company has non-qualified supplemental pension plans covering certain employees and retirees, which provide for incremental pension payments from the Company’s general funds so that total pension benefits would be substantially equal to amounts that would have been payable from the Company’s qualified pension plans if it were not for limitations imposed by income tax law. A few employees and retirees receive additional supplemental pension benefits. Non-qualified pension plan liabilities recognized in the Consolidated Balance Sheets and expenses recognized in accumulated other comprehensive income (loss) at December 31, 2020 and 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non-qualified +​ +Pension Benefits +​ +December 31, +​ +(In millions) +​ +2020 +2019 +Current liabilities +​ +$ +( 1.7 ) +​ +$ +( 2.1 ) +​ +Non-current liabilities, net +​ +​ +( 2.6 ) +​ +​ +( 2.3 ) +​ +Total +​ +$ +( 4.3 ) +​ +$ +( 4.4 ) +​ +​ +​ +​ +​ +​ +​ +​ +​ +Net loss, net of taxes +​ +$ +( 0.8 ) +​ +$ +( 0.6 ) +​ +Prior service credit, net of taxes +​ +​ +0.1 +​ +​ +0.2 +​ +Total +​ +$ +( 0.7 ) +​ +$ +( 0.4 ) +​ +​ +Discount rates of 1.8 percent and 2.8 percent were used in determining the 2020 and 2019 non-qualified pension plan obligations, respectively. +​ +Estimated Benefit Payments: The estimated future benefit payments for the next ten years as of December 31, 2020 were as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non-qualified +​ +​ +​ +​ +Pension +​ +Pension +​ +Post-retirement +​ +Year (in millions) +​ +Benefits +​ +Benefits +​ +Benefits (1) +2021 +​ +$ +14.0 +​ +$ +1.7 +​ +$ +1.0 +​ +2022 +​ +14.4 +​ +— +​ +1.0 +​ +2023 +​ +14.6 +​ +2.2 +​ +1.0 +​ +2024 +​ +14.7 +​ +— +​ +1.1 +​ +2025 +​ +14.9 +​ +— +​ +1.1 +​ +2026-2030 +​ +​ +76.2 +​ +​ +0.6 +​ +​ +5.5 +​ +Total +​ +$ +148.8 +​ +$ +4.5 +​ +$ +10.7 +​ +(1) Net of plan participants’ contributions and Medicare Part D subsidies. +​ +Defined Contribution Plans: The Company sponsors defined contribution plans that qualify under Sections 401(a) and 401(k) of the Internal Revenue Code. The Company may make discretionary matching contributions equal to a specified percentage of each participant’s 401(k) contributions and makes other non-discretionary contributions. For the year ended December 31, 2020, the Company provided discretionary matching contributions of up to 3 percent of eligible employee compensation. The Company’s matching contributions expensed in 2020, 2019 and 2018 were $ 3.0 million, $ 2.9 million and $ 2.4 million, respectively. +​ +The Company may also provide a discretionary profit sharing contribution under the qualified defined contribution plans, to salaried, non-bargaining unit employees, if both a minimum threshold of Company performance is achieved and the Board has approved the profit sharing contribution. For certain eligible employees, supplemental profit sharing contributions are credited under a non-qualified plan to be paid after separation from service from the Company’s general funds so that total profit sharing contributions would be substantially equal to amounts that would have been contributed to the Company’s qualified defined contribution plans if it were not for limitations imposed by income tax law. Discretionary profit sharing contributions expensed in 2020, 2019 and 2018 were $ 2.2 million, $ 0.5 million and $ 1.4 million, respectively. +​ +Multi-employer Bargaining Plans: +​ +The Company contributes to multi-employer defined benefit pension plans under the terms of collective-bargaining agreements that cover its bargaining unit employees. Contributions are generally based on amounts paid for union labor or cargo volume. The risks of participating in multi-employer plans are different from single-employer plans because assets contributed to the multi-employer plan by one employer may be used to provide benefits to employees of other +67 +Table of Contents +participating employers. Additionally, if one employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. +​ +The multi-employer pension plans are subject to the plan termination insurance provisions of ERISA and are paying premiums to the Pension Benefit Guaranty Corporation (“PBGC”). The statutes provide that an employer who withdraws from, or significantly reduces its contribution obligation to, a multi-employer plan generally will be required to continue funding its proportional share of the plan’s unfunded vested benefits. As of December 31, 2020, the Company’s estimated benefit plan withdrawal obligations were $ 260.0 million. Except as described in Note 12, no withdrawal obligations have been recorded by the Company in the Consolidated Balance Sheets at December 31, 2020 and 2019, as the Company has no present intention of withdrawing from and does not anticipate termination of any of these plans. +​ +Information regarding the Company’s participation in multi-employer pension plans is outlined in the table below. The “EIN/Pension Plan Number” column provides the Employer Identification Number (“EIN”) and the three-digit plan number, if applicable. Unless otherwise noted, the most recent Pension Protection Act zone status available in 2020 and 2019 is for the plan’s year-end at December 31, 2020 and 2019, respectively. The zone status is based on information that the Company received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65 percent funded; plans in the orange zone are both a) less than 80 percent funded and b) have an accumulated/expected funding deficiency in any of the next six plan years, net of any amortization extensions; plans in the yellow zone meet either one of the criteria mentioned in the orange zone; and plans in the green zone are at least 80 percent funded. The funding improvement plan (“FIP”) or rehabilitation plan (“RP”) column indicates the status which is either pending or has been implemented. The last column lists the expiration dates of the collective-bargaining agreements to which the plans are subject. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Pension +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Protection Act +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Zone as of +​ +FIP/RP Status +​ +​ +​ +Contributions of Matson +​ +​ +​ +​ +​ +​ +EIN/Pension +​ +​ +​ +December 31, +​ +Pending/ +​ +5% +​ +(in millions) +​ +Surcharge +​ +Expiration +Pension Funds +Plan Number +Notes +2020 +2019 +Implemented +Contributor +2020 +2019 +2018 +Imposed +Date (2) +American Radio Association Pension Fund +13-6161999-001 +​ +​ +Green +Green +Implemented +​ +Yes +​ +$ +1.0 +​ +$ +1.1 +​ +$ +1.0 +No +6/15/2028 +​ +Hawaii Terminals Multiemployer Pension Plan +20-0389370-001 +​ +(1) +​ +Yellow +Orange +Implemented +​ +Yes +​ +​ +5.8 +​ +​ +5.7 +​ +​ +5.7 +No +6/30/2022 +​ +Hawaii Stevedoring Multiemployer Retirement Plan +99-0314293-001 +​ +(1) +​ +Green +Yellow +Implemented +​ +Yes +​ +4.6 +​ +4.4 +​ +4.3 +No +6/30/2022 +​ +Master, Mates and Pilots Pension Plan +13-6372630-001 +​ +​ +​ +Green +Green +No +​ +Yes +​ +3.2 +​ +3.4 +​ +3.0 +No +​ +6/15/2027, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/15/2028 +​ +Masters, Mates and Pilots Adjustable Pension Plan +37-1719247-001 +​ +​ +​ +Green +Green +No +​ +Yes +​ +1.8 +​ +1.9 +​ +1.7 +No +​ +6/15/2027, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/15/2028 +​ +MEBA Pension Trust - Defined Benefit Plan +51-6029896-001 +​ +​ +​ +Green +Green +No +​ +Yes +​ +4.1 +​ +4.3 +​ +4.0 +No +6/15/2022, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/15/2028 +​ +OCU Pension Trust Plan +26-1574440-001 +​ +​ +​ +Green +Green +No +​ +No +​ +0.2 +​ +0.2 +​ +0.2 +No +6/30/2023 +​ +MFOW Supplementary Pension Plan +​ +94-6201677-001 +​ +​ +​ +Yellow +​ +Green +​ +No +​ +Yes +​ +​ +0.1 +​ +​ +0.1 +​ +​ +— +​ +No +​ +6/30/2021 +​ +SIU Pacific District Pension Plan +​ +94-6061923-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +Yes +​ +​ +1.3 +​ +​ +1.5 +​ +​ +1.2 +​ +No +​ +6/30/2021 +​ +Alaska Teamster - Employer Pension Plan +​ +92-6003463-024 +​ +​ +​ +Red +​ +Red +​ +Implemented +​ +Yes +​ +​ +3.3 +​ +​ +1.9 +​ +​ +1.9 +​ +Yes +​ +6/30/2021, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/30/2022, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/30/2023, +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +6/30/2024 +​ +All Alaska Longshore Pension Plan +​ +91-6085352-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +Yes +​ +​ +1.3 +​ +​ +1.2 +​ +​ +1.0 +​ +No +​ +6/30/2022 +​ +Western Conference of Teamsters Pension Plan +​ +91-6145047-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +No +​ +​ +1.6 +​ +​ +1.5 +​ +​ +1.4 +​ +No +​ +3/31/2023 +​ +Western Conference of Teamsters Supplemental Benefit Trust +​ +95-3746907-001 +​ +​ +​ +Green +​ +Green +​ +No +​ +No +​ +​ +— +​ +​ +— +​ +​ +— +​ +No +​ +3/31/2023 +​ +OPEIU Local 153 Pension Plan +​ +13-2864289-001 +​ +​ +​ +Red +​ +Red +​ +Implemented +​ +No +​ +​ +0.1 +​ +​ +0.1 +​ +​ +0.1 +​ +No +​ +11/9/2023 +​ +Seafarers Pension Plan +​ +13-6100329-001 +​ +(3) +​ +Green +​ +Green +​ +No +​ +No +​ +​ +— +​ +​ +— +​ +​ +— +​ +No +​ +6/30/2022 +​ +Total +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +$ +28.4 +​ +$ +27.3 +​ +$ +25.5 +​ +​ +​ +​ +​ +(1) The Hawaii Terminals Multiemployer Pension Plan merged into the Hawaii Stevedoring Multiemployer Retirement Plan effective January 1, 2021 and formally known as the Hawaii Longshore Pension Plan. +(2) Represents the expiration date of the collective bargaining agreement. +(3) The Company does not make contributions directly to the Seafarers Pension Plan. Instead, contributions are made to the Seafarers Health and Benefits Plan, and are subsequently re-allocated to the Seafarers Pension Plan at the discretion of the plan Trustee. +​ +The Company also contributes to multi-employer plans that provide post-retirement health and other benefits other than pensions under the terms of collective-bargaining agreements. Benefits provided to active and retired employees and their eligible dependents under these plans include medical, dental, vision and prescription drug. These plans are not subject to the PBGC plan termination and withdrawal liability provisions of ERISA applicable to multi-employer defined benefit pension plans. Contributions for these multi-employer postretirement health and other benefits were $ 32.5 million, $ 32.8 million and $ 30.0 million in 2020, 2019 and 2018, respectively. +​ +68 +Table of Contents +Multi-employer Defined Contribution Plans: The Company contributes to six multi-employer defined contribution pension plans. These plans are not subject to the withdrawal liability provisions of ERISA or the PBGC applicable to multi-employer defined benefit pension plans. Contributions made to these plans by the Company were $ 5.1 million, $ 5.3 million and $ 4.8 million in 2020, 2019 and 2018, respectively. +​ +​ +12. +MULTI-EMPLOYER WITHDRAWAL LIABILITIES +​ +Horizon ceased all of its operations in Puerto Rico during the first quarter of 2015, which resulted in a mass withdrawal from its multi-employer ILA-PRSSA pension fund. The Company assumed this liability as part of the acquisition of Horizon on May 29, 2015. The Company estimated the mass withdrawal liability based upon the required undiscounted quarterly payment of approximately $ 1.0 million to be paid to the ILA-PRSSA pension fund over a period which ends in March 2040, discounted to present value using the Company’s incremental borrowing rate. Future estimated annual payments to be paid to the ILA-PRSSA pension fund as of December 31, 2020 were as follows: +​ +​ +​ +​ +​ +Year (in millions) +​ +Total +2021 +$ +4.1 +2022 +​ +​ +4.1 +2023 +​ +​ +4.1 +2024 +​ +​ +4.1 +2025 +​ +​ +4.1 +Thereafter +​ +​ +59.7 +Total remaining future undiscounted payments due to the ILA-PRSSA pension fund +​ +​ +80.2 +Less: amount representing interest +​ +​ +( 23.3 ) +Present value of multi-employer withdrawal liability +​ +​ +56.9 +Current portion of multi-employer withdrawal liability (see Note 2) +​ +​ +( 4.1 ) +Long-term portion of multi-employer withdrawal liability (see Note 2) +$ +52.8 +​ +Furthermore, the Company assumed a partial withdrawal liability related to the Local 153 Fund of the OPEIU. The partial withdrawal liability resulted from a decline in the number of contribution base units related to the Local 153 Fund caused by Horizon terminating all of its operations in Puerto Rico during the first quarter of 2015. The Company included the partial withdrawal liability of $ 6.5 million and $ 6.7 million within other current liabilities in the Consolidated Balance Sheets as of December 31, 2020 and 2019, respectively. +​ +​ +​ +13. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) +​ +Changes in accumulated other comprehensive income (loss) by component, net of tax, are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Non- +​ +​ +Accumulated +​ +​ +​ +​ +​ +Post- +​ +Qualified +​ +​ +​ +​ +Other +​ +​ +Pension +​ +Retirement +​ +Pension +​ +​ +​ +​ +Comprehensive +(In millions) +​ +Benefits +​ +Benefits +​ +Benefits +​ +Other +​ +Income (Loss) +Balance at December 31, 2018 +​ +$ +( 55.8 ) +​ +$ +21.7 +​ +$ +( 0.1 ) +​ +$ +( 0.3 ) +​ +$ +( 34.5 ) +​ +Amortization of prior service cost +​ +( 1.7 ) +​ +​ +( 2.6 ) +​ +​ +( 0.1 ) +​ +​ +( 0.1 ) +​ +( 4.5 ) +​ +Amortization of net loss (gain) +​ +​ +5.6 +​ +​ +( 2.8 ) +​ +​ +( 0.2 ) +​ +​ +0.1 +​ +2.7 +​ +Other adjustments +​ +​ +— +​ +— +​ +— +​ +( 0.6 ) +​ +( 0.6 ) +​ +Balance at December 31, 2019 +​ +( 51.9 ) +​ +16.3 +​ +( 0.4 ) +​ +( 0.9 ) +​ +( 36.9 ) +​ +Amortization of prior service cost +​ +( 1.8 ) +​ +​ +( 2.8 ) +​ +​ +( 0.1 ) +​ +​ +— +​ +( 4.7 ) +​ +Amortization of net loss (gain) +​ +( 8.0 ) +​ +​ +( 1.3 ) +​ +​ +( 0.1 ) +​ +​ +— +​ +( 9.4 ) +​ +Foreign currency exchange +​ +​ +— +​ +​ +— +​ +​ +— +​ +​ +0.5 +​ +​ +0.5 +​ +Other adjustments +​ +— +​ +​ +— +​ +​ +— +​ +​ +( 0.3 ) +​ +( 0.3 ) +​ +Balance at December 31, 2020 +​ +$ +( 61.7 ) +​ +$ +12.2 +​ +$ +( 0.6 ) +​ +$ +( 0.7 ) +​ +$ +( 50.8 ) +​ +​ +Other comprehensive income (loss) in the Consolidated Statements of Income and Comprehensive Income is shown net of tax benefit (expense) of $ 4.2 million, $( 0.3 ) million and $ 0.2 million for the years ended December 2020, 2019 and 2018, respectively. +​ +69 +Table of Contents +​ +​ +14. EARNINGS PER SHARE +​ +Basic earnings per share are determined by dividing net income by the weighted-average common shares outstanding during the year. The calculation of diluted earnings per share includes the dilutive effect of unexercised non-qualified stock options and non-vested stock units. The computation of weighted average dilutive shares outstanding excluded a nominal amount of anti-dilutive non-qualified stock options for each of the years 2020, 2019 and 2018. +​ +The denominators used to compute basic and diluted earnings per share for the years ended December 31, 2020, 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Year Ended December 31, 2020 +​ +Year Ended December 31, 2019 +​ +Year Ended December 31, 2018 +​ +​ +​ +Weighted +Per +​ +​ +Weighted +Per +​ +​ +Weighted +Per +​ +​ +​ +​ +​ +Average +​ +Common +​ +​ +​ +​ +Average +​ +Common +​ +​ +​ +​ +Average +​ +Common +​ +​ +Net +​ +Common +​ +Share +​ +Net +​ +Common +​ +Share +​ +Net +​ +Common +​ +Share +(In millions, except per share amounts) +​ +Income +​ +Shares +​ +Amount +​ +Income +​ +Shares +​ +Amount +​ +Income +​ +Shares +​ +Amount +Basic: +​ +$ +193.1 +43.1 +​ +$ +4.48 +​ +$ +82.7 +42.8 +​ +$ +1.93 +​ +$ +109.0 +42.7 +​ +$ +2.55 +​ +Effect of Dilutive Securities: +​ +​ +​ +0.4 +​ +​ +( 0.04 ) +​ +​ +​ +0.5 +​ +​ +( 0.02 ) +​ +​ +​ +0.3 +​ +​ +( 0.02 ) +​ +Diluted: +​ +$ +193.1 +​ +43.5 +​ +$ +4.44 +​ +$ +82.7 +​ +43.3 +​ +$ +1.91 +​ +$ +109.0 +​ +43.0 +​ +$ +2.53 +​ +​ +​ +​ +15. +SHARE-BASED AWARDS +​ +The Company has share-based compensation plans which are described as follows: +​ +2016 Incentive Compensation Plan: The 2016 Incentive Compensation Plan (the “2016 Plan”) serves as a successor to the 2007 Incentive Compensation Plan and all other predecessor plans. No further grants will be made under the predecessor stock option plans. Under the 2016 Plan, 2.5 million shares of common stock were reserved for issuance. Shareholders approved the 2016 Plan at the 2016 Annual Meeting of Shareholders. +​ +The 2016 Plan consists of four separate incentive compensation programs: (i) the discretionary grant program, (ii) the stock issuance program, (iii) the incentive bonus program, and (iv) the automatic grant program for the non- employee members of the Company’s Board of Directors. Share-based compensation is generally awarded under three of the four programs, as more fully described below. +​ +Discretionary Grant Program — Under the Discretionary Grant Program, stock options may be granted with an exercise price no less than 100 percent of the fair market value (defined as the closing market price) of the Company’s common stock on the date of the grant. Options generally become exercisable ratably over three years and have a maximum contractual term of 10 years . +​ +Stock Issuance Program — Under the Stock Issuance Program, shares of common stock, restricted stock units or performance shares may be granted. Time-based equity awards generally vest ratably over three years . Provided certain three-year performance targets are achieved, performance-based equity awards generally vest on the three-year anniversary date of the grant. +​ +Automatic Grant Program — At each annual shareholder meeting, non-employee directors will receive an award of restricted stock units that entitle the holder to an equivalent number of shares of common stock upon vesting, under the automatic grant program. Awards of restricted stock units granted under the program generally vest on the one-year anniversary of the grant date. +​ +The shares of common stock authorized to be issued under the 2016 Plan may be drawn from shares of the Company’s authorized but unissued common stock or from shares of its common stock that the Company acquires, including shares purchased on the open market or in private transactions. +​ +70 +Table of Contents +Share-based compensation expense and other information related to share-based awards for the years ended December 31, 2020, 2019 and 2018 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Years Ended December 31, +Share-based compensation expense, net of estimated forfeitures (in millions) +2020 +2019 +2018 +Share-based compensation expense +​ +$ +18.8 +​ +$ +11.3 +​ +$ +12.1 +​ +Intrinsic value of options exercised +​ +$ +5.8 +​ +$ +0.5 +​ +$ +0.5 +​ +Tax benefit realized upon stock vesting +​ +$ +3.3 +​ +$ +2.0 +​ +$ +2.7 +​ +Fair value of stock vested +​ +$ +13.1 +​ +$ +8.2 +​ +$ +10.8 +​ +​ +As of December 31, 2020, there was no unrecognized compensation cost related to non-vested stock options. As of December 31, 2020, unrecognized compensation cost related to non-vested restricted stock units and performance-based equity awards was $ 17.7 million. Unrecognized compensation cost is expected to be recognized over a weighted average period of approximately 1.7 years. +​ +Stock option activity for the year ended December 31, 2020 was as follows (in thousands, except weighted average exercise price and weighted average contractual life): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Weighted +Weighted +​ +​ +​ +​ +​ +Average +​ +Average +​ +Aggregate +​ +​ +2007 Plan +​ +Exercise +​ +Contractual +​ +Intrinsic +​ +​ +Shares +​ +Price +​ +Life +​ +Value +Outstanding at December 31, 2019 +173 +$ +22.30 +​ +​ +​ +​ +​ +​ +Exercised +( 172 ) +​ +$ +22.31 +​ +​ +​ +​ +​ +​ +Outstanding at December 31, 2020 +1 +$ +20.84 +0.1 +​ +$ +35 +​ +Exercisable at December 31, 2020 +1 +$ +20.84 +0.1 +​ +$ +35 +​ +​ +The following table summarizes non-vested restricted stock unit activity through December 31, 2020 (in thousands, except weighted average grant-date fair value amounts): +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +2007 Plan +2016 Plan +Total +Weighted +​ +​ +Restricted +​ +Restricted +​ +Restricted +​ +Average Grant- +​ +​ +​ +Stock Units +​ +Stock Units +​ +Stock Units +​ +Date Fair Value +Outstanding at December 31, 2019 +8 +770 +778 +​ +$ +33.39 +​ +Granted +​ +— +​ +341 +​ +341 +​ +​ +38.68 +​ +Settlement of Performance Shares (1) +​ +— +​ +38 +​ +38 +​ +​ +36.55 +​ +Vested +​ +( 5 ) +​ +( 339 ) +​ +( 344 ) +​ +​ +34.86 +​ +Canceled +​ +— +​ +( 21 ) +​ +( 21 ) +​ +​ +34.59 +​ +Outstanding at December 31, 2020 +3 +789 +792 +​ +$ +35.14 +​ +(1) Represents shares paid out above target. +​ +​ +16. FAIR VALUE OF FINANCIAL INSTRUMENTS +​ +The Company values its financial instruments based on the fair value hierarchy of valuation techniques for fair value measurements. Level 1 inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability. If the technique used to measure fair value includes inputs from multiple levels of the fair value hierarchy, the lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy. +​ +The Company uses Level 1 inputs for the fair values of its cash, cash equivalents and restricted cash, and Level 2 inputs for its variable and fixed rate debt. The fair values of cash, cash equivalents and restricted cash, and variable rate debt approximate their carrying values due to the nature of the instruments. The fair value of fixed rate debt is calculated based upon interest rates available for debt with terms and maturities similar to the Company’s existing debt arrangements. +​ +71 +Table of Contents +The carrying value and fair value of the Company’s financial instruments as of December 31, 2020 and 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quoted Prices in +​ +Significant +​ +Significant +​ +​ +​ +Total +​ +​ +​ +Active Markets +​ +Observable +​ +Unobservable +​ +​ +Carrying Value +Total +(Level 1) +Inputs (Level 2) +Inputs (Level 3) +​ +(In millions) +​ +December 31, 2020 +​ +Fair Value Measurements at December 31, 2020 +​ +Cash and cash equivalents +​ +$ +14.4 +​ +$ +14.4 +​ +$ +14.4 +​ +$ +— +​ +$ +— +​ +Restricted cash +​ +$ +5.3 +​ +$ +5.3 +​ +$ +5.3 +​ +$ +— +​ +$ +— +​ +Variable rate debt +​ +$ +71.8 +​ +$ +71.8 +​ +$ +— +​ +$ +71.8 +​ +$ +— +​ +Fixed rate debt +​ +$ +688.3 +​ +$ +686.7 +​ +$ +— +​ +$ +686.7 +​ +$ +— +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +(In millions) +December 31, 2019 +​ +Fair Value Measurements at December 31, 2019 +​ +Cash and cash equivalents +​ +$ +21.2 +​ +$ +21.2 +$ +21.2 +​ +$ +— +​ +$ +— +​ +Restricted cash +​ +$ +7.2 +​ +$ +7.2 +​ +$ +7.2 +​ +$ +— +​ +$ +— +​ +Variable rate debt +​ +$ +379.1 +​ +$ +379.1 +​ +$ +— +​ +$ +379.1 +​ +$ +— +​ +Fixed rate debt +​ +$ +579.3 +​ +$ +585.9 +​ +$ +— +​ +$ +585.9 +​ +$ +— +​ +​ +​ +​ +​ +​ +17. +COMMITMENTS AND CONTINGENCIES +​ +Commitments and contractual obligations, excluding debt obligations (see Note 8), lease commitments (see Note 9), pension and post-retirement plan commitments, and multi-employer bargaining plan withdrawal obligations (see Note 11 and 12), are as follows as of December 31, 2020: +​ +​ +​ +​ +​ +​ +Commitments and Contractual Obligations (in millions) +Total +Standby letters of credit (1) +​ +$ +8.1 +​ +Bonds (2) +​ +$ +33.2 +​ +Vendor and other obligations (3) +​ +$ +69.1 +​ +(1) Standby letters of credit are required for the Company’s uninsured workers’ compensation and other insurance programs, and other needs. +(2) Bonds are required for U.S. Customs and other related matters. +(3) Vendor and other obligations include: (i) non-cancellable contractual capital project obligations; (ii) dry-docking related obligations; and (iii) other contractual obligations. Amounts are considered obligations if a contract has been agreed to specifying significant terms of the contract, and the amounts are not reflected in the Consolidated Balance Sheets. +​ +These amounts are not recorded on the Company’s Consolidated Balance Sheets and it is not expected that the Company or its subsidiaries will be called upon to advance funds under these commitments. +​ +Contingencies: Contingencies and other litigation related matters are described as follows: +​ +Environmental Matters: The Company’s Ocean Transportation segment has certain risks that could result in expenditures for environmental remediation. The Company believes that based on all information available to it, the Company is currently in compliance, in all material respects, with applicable environmental laws and regulations. +​ +Other Matters: The Company and its subsidiaries are parties to, or may be contingently liable in connection with other legal actions arising in the normal course of their businesses, the outcomes of which, in the opinion of management after consultation with counsel, would not have a material effect on the Company’s financial condition, results of operations, or cash flows. +​ +​ +​ +72 +Table of Contents +18. +QUARTERLY INFORMATION (Unaudited) +​ +Segment results by quarter for 2020 and 2019 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2020 +(In millions, except per share amounts) +Q1 +Q2 +Q3 +Q4 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +400.9 +​ +$ +410.8 +​ +$ +498.3 +​ +$ +543.9 +​ +Logistics +​ +113.0 +​ +113.3 +​ +146.9 +​ +156.2 +​ +Total Operating Revenue +​ +$ +513.9 +​ +$ +524.1 +​ +$ +645.2 +​ +$ +700.1 +​ +Operating Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +7.9 +​ +$ +42.3 +​ +$ +86.5 +​ +$ +108.1 +​ +Logistics +​ +5.1 +​ +8.9 +​ +11.9 +​ +9.6 +​ +Total Operating Income +​ +13.0 +​ +51.2 +​ +98.4 +​ +117.7 +​ +Interest expense, net +​ +( 8.6 ) +​ +( 8.2 ) +​ +( 5.7 ) +​ +( 4.9 ) +​ +Other income (expense), net +​ +​ +0.6 +​ +​ +1.5 +​ +​ +2.4 +​ +​ +1.6 +​ +Income before Income Taxes +​ +5.0 +​ +44.5 +​ +95.1 +​ +114.4 +​ +Income Taxes +​ +( 1.2 ) +​ +( 11.7 ) +​ +( 24.2 ) +​ +( 28.8 ) +​ +Net Income +​ +$ +3.8 +​ +$ +32.8 +​ +$ +70.9 +​ +$ +85.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Share: +​ +$ +0.09 +​ +$ +0.76 +​ +$ +1.65 +​ +$ +1.99 +​ +Diluted Earnings Per Share: +​ +$ +0.09 +​ +$ +0.76 +​ +$ +1.63 +​ +$ +1.96 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2019 +(In millions, except per share amounts) +Q1 +Q2 +Q3 +Q4 +Operating Revenue: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +397.9 +​ +$ +415.4 +​ +$ +437.2 +​ +$ +416.1 +​ +Logistics +​ +134.5 +​ +142.5 +​ +134.9 +​ +124.6 +​ +Total Operating Revenue +​ +$ +532.4 +​ +$ +557.9 +​ +$ +572.1 +​ +$ +540.7 +​ +Operating Income: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Ocean Transportation +​ +$ +9.4 +​ +$ +19.7 +​ +$ +43.9 +​ +$ +17.8 +​ +Logistics +​ +8.1 +​ +11.3 +​ +11.3 +​ +7.6 +​ +Total Operating Income +​ +17.5 +​ +31.0 +​ +55.2 +​ +25.4 +​ +Interest expense, net +​ +( 4.6 ) +​ +( 6.1 ) +​ +( 6.2 ) +​ +( 5.6 ) +​ +Other income (expense), net +​ +​ +0.6 +​ +​ +0.8 +​ +​ +( 0.5 ) +​ +​ +0.3 +​ +Income before Income Taxes +​ +13.5 +​ +25.7 +​ +48.5 +​ +20.1 +​ +Income Taxes +​ +( 1.0 ) +​ +( 7.3 ) +​ +( 12.3 ) +​ +( 4.5 ) +​ +Net Income +​ +$ +12.5 +​ +$ +18.4 +​ +$ +36.2 +​ +$ +15.6 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Basic Earnings Per Share: +​ +$ +0.29 +​ +$ +0.43 +​ +$ +0.84 +​ +$ +0.36 +​ +Diluted Earnings Per Share: +​ +$ +0.29 +​ +$ +0.43 +​ +$ +0.84 +​ +$ +0.36 +​ +​ +The following infrequent transactions impacted the Company’s quarterly segment results during the year ended December 31, 2019. There were no infrequent transactions recorded during the year ended December 31, 2020. +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Quarters in the Year Ended December 31, 2019 +(In millions) +Q1 +Q2 +Q3 +Q4 +Income taxes - Discrete adjustments related to the Tax Act (1) +​ +$ +2.9 +​ +$ +— +​ +$ +— +​ +$ +— +​ +(1) Amounts relate to discrete adjustments as a result of applying the Tax Act during the year ended December 31, 2019. +​ +​ +​ +73 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +​ +None. +​ +ITEM 9A. CONTROLS AND PROCEDURES +​ +Conclusion Regarding Effectiveness of Disclosure Controls and Procedures +​ +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective. +​ +Internal Control over Financial Reporting +​ +See page 37 for management’s annual report on internal control over financial reporting, which is incorporated herein by reference. +​ +See page 38 for the attestation report of the independent registered public accounting firm on the Company’s internal control over financial reporting, which is incorporated herein by reference. +​ +There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company’s fiscal fourth quarter ended December 31, 2020, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +​ +ITEM 9B. OTHER INFORMATION +​ +None. +​ +74 +Table of Contents +PART III +​ +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +​ +A. +Directors +​ +The information about the Directors of Matson required under this item will be included under the section captioned “Election of Directors” in Matson’s Proxy Statement for the 2021 Annual Meeting of Shareholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2020 (“Matson’s 2021 Proxy Statement”), which section is incorporated herein by reference. +​ +B. +Information About Our Executive Officers +​ +The information about the executive officers of Matson required under this item will be included under the subsection captioned “Executive Officers” in Matson’s 2021 Proxy Statement, which subsection is incorporated herein by reference. +​ +C. +Corporate Governance +​ +The information about the Audit Committee of the Matson Board of Directors and compliance with Section 16(a) of the Exchange Act, will be included under the subsections captioned “Board of Directors and Committees of Board” and, if applicable, “Delinquent Section 16(a) Reports” in Matson’s 2021 Proxy Statement, which subsections are incorporated herein by reference. +​ +D. +Code of Ethics +​ +The information about Matson’s Code of Ethics required under this item will be included under the subsection captioned “Code of Ethics” in Matson’s 2021 Proxy Statement, which subsection is incorporated herein by reference. +​ +ITEM 11. EXECUTIVE COMPENSATION +​ +The information required under this item will be included under the section captioned “Executive Compensation” and the subsections captioned “Compensation of Directors” and “Pay Risk Assessment” in Matson’s 2021 Proxy Statement, which section and subsections are incorporated herein by reference. +​ +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +​ +Equity Compensation Plan Information: The following table sets forth, as of December 31, 2020, certain information regarding Matson’s equity compensation plan: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Number of shares +​ +​ +​ +Number of shares +​ +​ +remaining available for +​ +​ +​ +to be issued +​ +​ +Weighted-average +​ +future issuance under +​ +​ +​ +upon exercise of +​ +​ +exercise price of +​ +equity compensation +​ +​ +​ +outstanding options, +​ +​ +outstanding options, +​ +plans (excluding shares +​ +Plan Category +​ +warrants and rights +​ +​ +warrants and rights +​ +reflected in column (a)) +​ +​ +​ +(a) +​ +​ +​ +(b) +​ +​ +(c) +​ +​ +Equity compensation plans approved by shareholders +​ +793,080 +(1) +​ +$ +20.84 +(2) +​ +1,000,659 +(3) +​ +Equity compensation plans not approved by shareholders +​ +— +​ +​ +​ +— +​ +— +​ +​ +Total +​ +793,080 +​ +​ +$ +20.84 +​ +1,000,659 +​ +​ +(1) In addition to 982 shares subject to outstanding stock option awards, this also includes 413,237 shares subject to unvested restricted stock unit awards and 378,861 shares subject to unvested Performance Share awards. +(2) As restricted stock unit and Performance Share awards do not have exercise prices, the weighted average exercise price is computed using only outstanding stock option awards. +(3) These shares are available for issuance under the Company’s 2016 Incentive Compensation Plan. +​ +Other information required under this item will be included under the section captioned “Security Ownership of Certain Shareholders” and the subsections captioned “Security Ownership of Directors and Executive Officers” in Matson’s 2021 Proxy Statement, which section and subsections are incorporated herein by reference. +75 +Table of Contents +​ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +​ +The information required under this item will be included in the section captioned “Election of Directors” and the subsection captioned “Certain Relationships and Transactions” in Matson’s 2021 Proxy Statement, which section and subsection are incorporated herein by reference. +​ +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES +​ +The information concerning principal accountant fees and services required under this item will be included under the sections captioned “Audit Committee Report” and “Ratification of Appointment of Independent Registered Public Accounting Firm” in Matson’s 2021 Proxy Statement, which sections are incorporated herein by reference. +​ +76 +Table of Contents +PART IV +​ +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +​ +A. +Financial Statements +​ +The Consolidated Financial Statements are set forth in Item 8 of Part II above. +​ +B. +Financial Statement Schedules +​ +All schedules are omitted because of the absence of the conditions under which they are required or because the information called for is included in the Consolidated Financial Statements or notes thereto. +​ +C. +Exhibits Required by Item 601 of Regulation S - K +​ +Exhibits not filed herewith are incorporated by reference to the exhibit number and previous filing shown in parentheses. All previous exhibits were filed with the Securities and Exchange Commission in Washington, D.C. +​ +Exhibits filed pursuant to the Securities Exchange Act of 1934 were filed under file number 001-34187. Shareholders may obtain copies of exhibits for a copying and handling charge of $0.15 per page by writing to, Corporate Secretary, Matson, Inc., 555 12th Street, Oakland, California 94607. +​ +​ +2 +Plan of acquisition, reorganization, arrangement, liquidation or succession. +​ +​ +2.1 +Agreement and Plan of Merger, dated as of November 11, 2014, by and among Matson Navigation Company, Inc., Hogan Acquisition Inc. and Horizon Lines, Inc. (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated November 11, 2014). +​ +​ +2.2 +Amendment No. 1 to Agreement and Plan of Merger, dated as of February 13, 2015, by and among Matson Navigation Company, Inc., Hogan Acquisition Inc. and Horizon Lines, Inc. (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated February 17, 2015). +​ +​ +2.3 +Contribution, Assumption and Purchase Agreement, dated as of November 11, 2014, by and among The Pasha Group, SR Holding LLC, Horizon Lines, Inc. and Sunrise Operations LLC (incorporated by reference to Exhibit 2.2 of Horizon Lines, Inc.’s Form 8-K dated November 13, 2014). +​ +​ +2.4 +Amendment No. 1 to the Contribution, Assumption and Purchase Agreement, dated as of May 29, 2015, by and among The Pasha Group, SR Holding LLC, Horizon Lines, Inc. and Sunrise Operations LLC (incorporated by reference to Exhibit 2.2 of Matson’s Form 10-Q for the quarter ended June 30, 2015). +​ +​ +2.5 +Membership Interest Purchase Agreement, dated as of July 18, 2016, by and between Matson Logistics, Inc. and Span Holdings, LLC (incorporated by reference to Exhibit 2.1 of Matson’s Form 8-K dated July 19, 2016). +​ +​ +3 +Articles of incorporation and bylaws. +​ +​ +3.1 +Amended and Restated Articles of Incorporation of Matson, Inc. (incorporated by reference to Exhibit 3.1 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +​ +​ +3.2 +Articles of Amendment to Change Corporate Name (incorporated by reference to Exhibit 4.2 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +3.3 +Amended and Restated Bylaws of Matson, Inc. (as amended as of November 6, 2013) (incorporated by reference to Exhibit 3.1 of Matson’s Form 10-Q for the quarter ended September 30, 2013). +​ +​ +4 +Description of Registered Securities (incorporated by reference to Exhibit 4 of Matson’s Form 10-K for the year ended December 31, 2019). +​ +​ +77 +Table of Contents +10 +Material contracts. +​ +​ +10.1 +Amended and Restated Credit Agreement among Matson, Inc., Bank of America, N.A., as the Agent, and the lenders thereto, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.2 +Amendment to Third Amended and Restated Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.4 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.3 +Amendment to Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of June 29, 2017 (incorporated by reference to Exhibit 10.5 of Matson’s Form 8-K dated June 30, 2017). +​ +​ +10.4 +Note Purchase Agreement among Matson, Inc. and the purchasers party thereto, dated as of December 21, 2016 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated December 22, 2016). +​ +​ +10.5 +Third Amended and Restated Note Purchase and Private Shelf Agreement among Matson, Inc. and the purchasers party thereto, dated as of September 14, 2016 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated September 14, 2016). +​ +​ +10.6 +First Amendment to Amended and Restated Credit Agreement among Matson, Inc., Bank of America, N.A. as the Agent, and the lenders thereto, dated as of March 31, 2020 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated April 6, 2020). +​ +​ +10.7 +Amendment to Third Amended and Restated Note Purchase and Private Shelf Agreement among Matson, Inc. and the purchasers named therein, dated as of March 31, 2020 (incorporated by reference to Exhibit 10.4 of Matson’s Form 8-K dated April 6, 2020). +​ +​ +10.8 +Amendment to December 21, 2016 Note Purchase Agreement among Matson, Inc. and the purchasers named therein, dated as of March 31, 2020 (incorporated by reference to Exhibit 10.5 of Matson’s Form 8-K dated April 6, 2020). +​ +​ +10.9 +Amended and Restated Limited Liability Company Agreement of SSA Terminals, LLC by and between SSA Ventures, Inc. and Matson Ventures, Inc., dated as of April 24, 2002 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.1 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +​ +​ +10.10 +Parent Company Agreement, dated as of April 24, 2002, by and among SSA Pacific Terminals, Inc., formerly known as Stevedoring Services of America, Inc., SSA Ventures, Inc., Matson Navigation Company, Inc. and Matson Ventures, Inc. (incorporated by reference to Exhibit 10.2 of Matson’s Form 10-Q for the quarter ended June 30, 2012). +​ +​ +10.11 +Security Agreement between Matson Navigation Company, Inc. and the United States of America, with respect to $55 million of Title XI ship financing bonds, dated July 29, 2004 (incorporated by reference to Exhibit 10.a.(xxvi) of Alexander & Baldwin, Inc.’s Form 10-Q for the quarter ended September 30, 2004). +​ +​ +10.12 +Amendment No. 1 dated September 21, 2007, to Security Agreement between Matson Navigation Company, Inc. and the United States of America, with respect to $55 million of Title XI ship financing bonds, dated July 29, 2004 (incorporated by reference to Exhibit 10.a.(xxx) of Alexander & Baldwin, Inc.’s Form 10-Q for the quarter ended September 30, 2007). +​ +​ +10.13* +Matson, Inc. 2007 Incentive Compensation Plan, amended and restated, effective January 29, 2015 (incorporated by reference to Exhibit 10.13 of Matson’s Form 10-K for the year ended December 31, 2014). +​ +​ +78 +Table of Contents +10.14* +Form of Amended and Restated Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election) (incorporated by reference to Exhibit 10.21 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.15* +Form of Anti-Dilution Adjustment Amendment to Restricted Stock Unit Award Agreements (incorporated by reference to Exhibit 99.10 of Matson’s Form S-8 dated October 26, 2012). +​ +​ +10.16* +Matson, Inc. Deferred Compensation Plan for Outside Directors (incorporated by reference to Exhibit 10.34 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.17 +Consolidated Agreement, Contract No. MA-14454 dated as of April 27, 2020 among Matson Navigation Company, Inc., the United States of America, represented by the Maritime Administrator of the Maritime Administration and, with respect to certain provisions, Matson, Inc. (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated April 30, 2020). +​ +​ +10.18 +Note Purchase Agreement dated as of April 27, 2020 among Matson Navigation Company, Inc., the United States of America, represented by the Maritime Administrator of the Maritime Administration and the Federal Financing Bank (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated April 30, 2020). +​ +​ +10.19 +Affiliate Guaranty dated as of April 27, 2020 executed by Matson, Inc. (incorporated by reference to Exhibit 10.3 of Matson’s Form 8-K dated April 30, 2020). +​ +​ +10.20 +Amendment No. 1 dated June 22, 2020, to Consolidated Agreement, Contract No. MA-14454 dated as of April 27, 2020 among Matson Navigation Company, Inc., the United States of America, represented by the Maritime Administrator of the Maritime Administration and, with respect to certain provisions, Matson, Inc. (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated June 25, 2020). +​ +​ +10.21 +Note Purchase Agreement dated as of June 22, 2020 among Matson Navigation Company, Inc., the United States of America, represented by the Maritime Administrator of the Maritime Administration and the Federal Financing Bank (incorporated by reference to Exhibit 10.2 of Matson’s Form 8-K dated June 25, 2020). +​ +​ +10.22 +Amendment dated June 22, 2020 to Affiliate Guaranty dated as of April 27, 2020 executed by Matson, Inc. and consented to by MARAD (incorporated by reference to Exhibit 10.3 of Matson’s Form 8-K dated June 25, 2020). +​ +​ +10.23* +Matson, Inc. Excess Benefits Plan, amended and restated effective August 27, 2014 (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated August 28, 2014). +​ +​ +10.24* +Form of Letter Agreement entered into with certain executive officers (incorporated by reference to Exhibit 10.45 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.25* +Schedule identifying executive officers who have entered into Form of Letter Agreement (incorporated by reference to Exhibit 10.42 of Matson’s Form 10-K for the year ended December 31, 2014). +​ +​ +10.26* +Form of Letter Agreement entered into with executive officer (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated October 24, 2014). +​ +​ +10.27*,** +Letter Agreement Counter Party. +​ +​ +10.28*,** +Amended and Restated Matson, Inc. Executive Severance Plan. +​ +​ +10.29* +Matson, Inc. Deferred Compensation Plan (incorporated by reference to Exhibit 10.51 of Matson’s Form 10-K for the year ended December 31, 2012). +​ +​ +10.30*,** +Amendment No. 1 to the Matson, Inc. Deferred Compensation Plan. +​ +​ +79 +Table of Contents +10.31 +Shipbuilding Contract, by and between Aker Philadelphia Shipyard, Inc. and Matson Navigation Company, Inc., dated as of November 6, 2013 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.56 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.32 +Shipbuilding Contract, by and between Aker Philadelphia Shipyard, Inc. and Matson Navigation Company, Inc., dated as of November 6, 2013 (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.57 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.33 +Guaranty Agreement by Aker Philadelphia Shipyard ASA, in favor of Matson Navigation Company, Inc., dated as of November 6, 2013 (incorporated by reference to Exhibit 10.58 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.34 +Contract for Construction of Two Vessels, dated as of August 25, 2016, by and between Matson Navigation Company, Inc. and National Steel and Shipbuilding Company (certain portions of this exhibit have been omitted pursuant to a confidential treatment request submitted to the Commission) (incorporated by reference to Exhibit 10.1 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +​ +​ +10.35 +Purchaser’s Corporate Guaranty Agreement, by Matson, Inc., dated as of August 25, 2016 (incorporated by reference to Exhibit 10.2 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +​ +​ +10.36 +Contractor’s Corporate Guaranty Agreement, by General Dynamics Corporation, dated as of August 25, 2016 (incorporated by reference to Exhibit 10.3 of Matson’s Form 10-Q for the quarter ended September 30, 2016). +​ +​ +10.37 +Form of Capital Construction Fund Agreement with Matson Navigation Company, as amended by Addendums No. 2, No. 5, No. 18, No. 20 and No. 31, thereto (incorporated by reference to Exhibit 10.60 of Matson’s Form 10-K for the year ended December 31, 2013). +​ +​ +10.38 +Form of Voting Agreement, dated as of November 11, 2014, among Matson Navigation Company, Inc. and certain holders of voting securities of Horizon Lines, Inc. (incorporated by reference to Exhibit 10.1 of Matson’s Form 8-K dated November 11, 2014). +​ +​ +10.39* +Matson, Inc. 2016 Incentive Compensation Plan, amended as of October 25, 2017 (incorporated by reference to Exhibit 10.56 of Matson’s Form 10-K for the year ended December 31, 2017). +​ +​ +10.40* +Amended and Restated Matson, Inc. Cash Incentive Plan, effective January 1, 2016 (incorporated by reference to Exhibit 10.63 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.41* +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (No Deferral) (incorporated by reference to Exhibit 10.64 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.42* +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election) (incorporated by reference to Exhibit 10.65 of Matson’s Form 10-K for the year ended December 31, 2016). +​ +​ +10.43* +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Non-Executive Employees (incorporated by reference to Exhibit 10.60 of Matson’s Form 10-K for the year ended December 31, 2017). +​ +​ +10.44* +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Executive Employees (incorporated by reference to Exhibit 10.61 of Matson’s Form 10-K for the year ended December 31, 2017). +​ +​ +80 +Table of Contents +10.45* +Form of 2016 Plan Performance Share Award Agreement for Non-Executive Employees (incorporated by reference to Exhibit 10.62 of Matson’s Form 10-K for the year ended December 31, 2017). +​ +​ +10.46* +Form of 2016 Plan Performance Share Award Agreement for Executive Employees (incorporated by reference to Exhibit 10.63 of Matson’s Form 10-K for the year ended December 31, 2017). +​ +​ +10.47*,** +Form of 2016 Plan Performance Share Award Agreement for Executive Employees (ROIC). +​ +​ +10.48*,** +Form of 2016 Plan Performance Share Award Agreement for Executive Employees (TSR). +​ +​ +10.49*,** +Form of 2016 Plan Performance Share Award Agreement for Non-Executive Employees. +​ +​ +10.50*,** +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Executive Employees. +​ +​ +10.51*,** +Form of 2016 Plan Time-Based Restricted Stock Unit Agreement for Non-Executive Employees. +​ +​ +10.52*,** +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (No Deferral). +​ +​ +10.53*,** +Form of 2016 Plan Restricted Stock Unit Award Agreement for Non-Employee Directors (Deferral Election). +​ +​ +21** +Matson, Inc. Subsidiaries as of December 31, 2020. +​ +​ +23** +Consent of Deloitte & Touche, LLP dated February 26, 2021. +​ +​ +31.1** +Certification of Chief Executive Officer, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +​ +​ +31.2** +Certification of Chief Financial Officer, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +​ +​ +32*** +Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +​ +​ +​ +​ +101.INS** +Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH** +Inline XBRL Taxonomy Extension Schema Document +101.CAL** +Inline XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF** +Inline XBRL Taxonomy Extension Definition Linkbase Document +101.LAB** +Inline XBRL Taxonomy Extension Label Linkbase Document +101.PRE** +Inline XBRL Taxonomy Extension Presentation Linkbase Document +104** +Cover Page Interactive Data File – the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +* Indicates management contract or compensatory plan or arrangement. +** Filed herewith. +*** Furnished herewith. +​ +​ +​ +​ +ITEM 16. FORM 10-K SUMMARY +​ +None. +​ +81 +Table of Contents +SIGNATURES +​ +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +​ +​ +​ +MATSON, INC. +​ +(Registrant) +​ +​ +Date: February 26, 2021 +/s/ Matthew J. Cox +​ +Matthew J. Cox +​ +Chairman and +​ +Chief Executive Officer +​ +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. +​ +Signature +​ +Title +​ +Date +​ +​ +​ +​ +​ +/s/ Matthew J. Cox +​ +Chairman and Chief Executive Officer +​ +February 26, 2021 +Matthew J. Cox +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Meredith J. Ching +​ +Director +​ +February 26, 2021 +Meredith J. Ching +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Thomas B. Fargo +​ +Director +​ +February 26, 2021 +Thomas B. Fargo +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Mark H. Fukunaga +​ +Director +​ +February 26, 2021 +Mark H. Fukunaga +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Stanley M. Kuriyama +​ +Director +​ +February 26, 2021 +Stanley M. Kuriyama +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Constance H. Lau +​ +Director +​ +February 26, 2021 +Constance H. Lau +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Jenai S. Wall +​ +Director +​ +February 26, 2021 +Jenai S. Wall +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Joel M. Wine +​ +Executive Vice President and Chief Financial Officer +​ +February 26, 2021 +Joel M. Wine +​ +​ +​ +​ +​ +​ +​ +​ +​ +/s/ Kevin L. Stuck +​ +Vice President and Controller (principal accounting officer) +​ +February 26, 2021 +Kevin L. Stuck +​ +​ +​ +​ +​ +***** +​ +​ +​ +82 \ No newline at end of file diff --git a/raw/filings/0000003453/2020/0001558370-21-001909/filing_metadata.csv b/raw/filings/0000003453/2020/0001558370-21-001909/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..fa85bc348124e27a6115adf813b0dc973709b5ab --- /dev/null +++ b/raw/filings/0000003453/2020/0001558370-21-001909/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003453,MATX,"Matson, Inc.",2020,10-K,2021-02-26,2020-12-31,2021-02-26T11:09:12.000Z,0001558370-21-001909,matx-20201231x10k.htm,10-K,21867921,1,1,https://www.sec.gov/Archives/edgar/data/3453/000155837021001909/matx-20201231x10k.htm,https://www.sec.gov/Archives/edgar/data/3453/000155837021001909/ diff --git a/raw/filings/0000003453/2020/0001558370-21-001909/item1.txt b/raw/filings/0000003453/2020/0001558370-21-001909/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..9127fea1ce4c71f809aa87c52b942671ebea8064 --- /dev/null +++ b/raw/filings/0000003453/2020/0001558370-21-001909/item1.txt @@ -0,0 +1,684 @@ +ITEM 1. BUSINESS +​ +A. COMPANY OVERVIEW +​ +Matson, Inc., a holding company incorporated in the State of Hawaii, and its subsidiaries (“Matson” or the “Company”), is a leading provider of ocean transportation and logistics services. The Company consists of two segments, Ocean Transportation and Logistics. For financial information by segment for the three years ended December 31, 2020, see Note 3 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Ocean Transportation: Matson’s Ocean Transportation business is conducted through Matson Navigation Company, Inc. (“MatNav”), a wholly-owned subsidiary of Matson, Inc. Founded in 1882, MatNav provides a vital lifeline of ocean freight transportation services to the domestic non-contiguous economies of Hawaii, Alaska and Guam, and to other island economies in Micronesia. MatNav also operates two premium, expedited services from China to Long Beach, California, and provides services to Okinawa, Japan and various islands in the South Pacific, and operates an international export service from Dutch Harbor to Asia. In addition, subsidiaries of MatNav provide stevedoring, refrigerated cargo services, inland transportation and other terminal services for MatNav and other ocean carriers on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai, and in the Alaska locations of Anchorage, Kodiak and Dutch Harbor. +​ +Matson has a 35 percent ownership interest in SSA Terminals, LLC, a joint venture between Matson Ventures, Inc., a wholly-owned subsidiary of MatNav, and SSA Ventures, Inc., a subsidiary of Carrix, Inc. (“SSAT”). SSAT currently provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including three facilities dedicated for MatNav’s use. Matson records its share of income from SSAT in costs and expenses in the Consolidated Statements of Income and Comprehensive Income, and within the Ocean Transportation segment due to the nature of SSAT’s operations. +​ +Logistics: Matson’s Logistics business is conducted through Matson Logistics, Inc. (“Matson Logistics”), a wholly-owned subsidiary of MatNav. Established in 1987, Matson Logistics is an asset-light business that provides a variety of logistics services to its customers including: (i) multimodal transportation brokerage of domestic and international rail intermodal services, long-haul and regional highway trucking services, specialized hauling, flat-bed and project services, less-than-truckload services, and expedited freight services (collectively, “Transportation Brokerage” services); (ii) less-than-container load (“LCL”) consolidation and freight forwarding services (collectively, “Freight Forwarding” services); (iii) warehousing and distribution services; and (iv) supply chain management, non-vessel operating common carrier (“NVOCC”) freight forwarding and other services. +​ +Our Mission and Vision: +​ +Our mission is to move freight better than anyone. Our vision is to create value for our shareholders by: +​ +◾ Being our customers’ first choice, +◾ Leveraging our core strengths to drive growth and increase profitability, +◾ Improving the communities in which we work and live, +◾ Being an environmental leader in our industry, and +◾ Being a great place to work. +​ +1 +Table of Contents +B. BUSINESS DESCRIPTION +​ +(1) +OCEAN TRANSPORTATION SEGMENT +​ +Ocean Transportation Services: +​ +Matson’s Ocean Transportation segment provides the following services: +​ +Hawaii Service: Matson’s Hawaii service provides ocean carriage (lift-on/lift-off, roll-on/roll-off and conventional services) between the ports of Long Beach and Oakland, California; Tacoma, Washington; and Honolulu, Hawaii. Matson also operates a network of inter-island barges that provide connecting services from its hub at Honolulu to other major Hawaii ports on the islands of Hawaii, Maui and Kauai. Matson is the largest carrier of ocean cargo between the U.S. West Coast and Hawaii. +​ +Westbound cargo carried by Matson to Hawaii includes dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, building materials, automobiles and household goods. Matson’s eastbound cargo from Hawaii includes automobiles, household goods, dry containers of mixed commodities and livestock. The majority of Matson’s Hawaii service revenue is derived from the westbound carriage of containerized freight. +​ +China Service: Matson’s expedited China-Long Beach Express (“CLX”) service is part of an integrated service that carries cargo from Long Beach, California to Honolulu, Hawaii, to Guam, and then to Okinawa, Japan. The vessels continue to Ningbo and Shanghai, China, where they are loaded with cargo to be discharged primarily in Long Beach, California at a Matson-exclusive terminal, operated by SSAT. These vessels also carry cargo destined for Hawaii which originated in Guam, Micronesia, Japan and China. Matson provides container transshipment services from many locations in Asia including Hong Kong and Xiamen, China to the U.S. via the ports of Ningbo and Shanghai, China. +​ +In May 2020, as a result of increased market demand, Matson launched its new China-Long Beach Express Plus (“CLX+”) service. CLX+ vessels operate as a second weekly vessel from China to Long Beach, California, operating back-to-back with the CLX vessels, which together represent Matson’s expedited China service. +​ +Eastbound cargo from China to Long Beach, California consists mainly of garments, e- commerce, consumer electronics, footwear and other merchandise. On our CLX service, westbound cargo to China and other destinations in Asia consists mainly of recycling materials. +​ +Guam Service: Matson’s Guam service provides weekly carriage between the U.S West Coast and Guam, as part of its CLX service. Matson also provides weekly connecting service from Guam to the Commonwealth of the Northern Mariana Islands. Cargo destined to these markets is similar to that described under “Hawaii Service” above. +​ +Japan Service: Matson’s Japan service provides carriage to the port of Naha in Okinawa, Japan, as part of its CLX service. This service carries mainly general sustenance cargo and household goods supporting the U.S. military. +​ +Micronesia Service: Matson’s Micronesia service provides carriage between the U.S. West Coast and the islands of Kwajalein, Ebeye and Majuro in the Republic of the Marshall Islands, the islands of Yap, Pohnpei, Chuuk and Kosrae in the Federated States of Micronesia, and the Republic of Palau. Cargo destined for these locations is transshipped through Guam and consists mainly of general sustenance cargo. +​ +Alaska Service: Matson’s Alaska service provides ocean carriage (lift-on/lift-off and conventional services) between the port of Tacoma, Washington, and the ports of Anchorage, Kodiak and Dutch Harbor, Alaska. Matson also provides a barge service between Dutch Harbor and Akutan in Alaska, and transportation services to other locations in Alaska including the Kenai Peninsula, Fairbanks and the North Slope. +​ +Northbound cargo to Alaska consists mainly of dry containers of mixed commodities, refrigerated commodities, packaged foods and beverages, retail merchandise, household goods and automobiles. Southbound cargo from Alaska primarily consists of seafood, household goods and automobiles. +​ +2 +Table of Contents +In September 2020, Matson launched its new Alaska-Asia Express (“AAX”) service that provides carriage of dry and frozen seafood from Dutch Harbor, Alaska to Ningbo and Shanghai, China. The AAX service utilizes CLX+ vessels on their westbound trip to China. Matson also provides transshipment services from Ningbo and Shanghai, China to other locations in Asia. Other Alaska cargo may be shipped on the AAX service utilizing Matson’s Alaska vessels and transshipment services in Dutch Harbor. +​ +South Pacific Service: Matson’s New Zealand Express (“NZX”) service provides carriage of general sustenance cargo between Auckland, New Zealand and select islands in the South Pacific, including Fiji (Suva and Lautoka), Samoa (Apia), American Samoa (Pago Pago), the Cook Islands (Rarotonga and Aitutaki), Tonga (Nukualofa and Vava’u), and Niue. Matson’s NZX service also provides transshipment services to the islands of Nauru and the Solomon Islands (Honiara). Additionally, Matson provides slot charter arrangements for the transportation of cargo from major ports on the east coast of Australia to ports in the South Pacific islands. The NZX service also distributes and sells domestic bulk fuel to a variety of these islands. +​ +Matson’s South Pacific Express (“SPX”) service provides carriage of general sustenance cargo from the U.S. West Coast to ports in the South Pacific islands using vessel sharing agreements with other carriers. The SPX service provides direct calls to Tahiti (Papeete), American Samoa (Pago Pago) and Samoa (Apia) in the South Pacific. Cargo destined for other ports including Tonga (Nukualofa) and the Cook Islands (Rarotonga and Aitutaki) is then transshipped in Apia, Samoa to the NZX service for delivery to its final destination. Northbound SPX cargo originating in the South Pacific is transshipped from the NZX service with other carriers to the U.S. West Coast. Cargo destined for Hawaii or Washington is further transshipped in Oakland, California for delivery to its final destination. +​ +Terminal and Other Related Services: +​ +Matson provides stevedoring, refrigerated cargo services, inland transportation, container equipment maintenance and other terminal services (collectively, “terminal services”) at terminals located on the Hawaiian islands of Oahu, Hawaii, Maui and Kauai; and in the Alaska terminal locations of Anchorage, Kodiak and Dutch Harbor. +​ +SSAT currently provides terminal and stevedoring services to various carriers at seven terminal facilities on the U.S. West Coast, including three facilities dedicated for MatNav’s use, in Long Beach and Oakland, California; and in Tacoma, Washington. +​ +Matson utilizes the services of other third-party terminal operators at all of the other ports served by its vessels. +​ +Vessel Management Services: +​ +Matson contracts with the U.S. Department of Transportation to provide vessel management services to manage and maintain three Ready Reserve Force vessels on behalf of the U.S. Department of Transportation Maritime Administration. +​ +​ +Vessel Information: +​ +Vessels: +​ +Matson’s fleet includes both owned and chartered vessels. Matson’s owned vessels represent an investment of approximately $2.2 billion. The majority of Matson’s owned vessels are U.S. flagged and Jones Act qualified vessels, +3 +Table of Contents +and operate in the Hawaii, China, Guam, Japan, Micronesia and Alaska services. Details of Matson’s active and reserve vessels as of December 31, 2020 are as follows: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Usable Cargo Capacity +​ +​ +​ +Vessel +​ +​ +​ +​ +​ +​ +​ +​ +Containers +​ +Vehicles +​ +​ +​ +Design +​ +Maximum +​ +Year +Official +​ +Reefer +Speed +Deadweight +Name of Vessels +​ +Built +​ +Number +​ +TEUs (1) +​ +Slots +​ +Autos +​ +Length +​ +(Knots) (2) +​ +(Long Tons) +Vessels-Owned: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +DANIEL K. INOUYE (3) +​ +2018 +1274136 +3,220 +408 +​ +— +854’ 0” +23.5 +50,794 +KAIMANA HILA (3) +​ +2019 +​ +1274135 +​ +3,220 +​ +408 +​ +— +​ +854’ 0” +​ +23.5 +53,747 +MANOA (3)(8) +1982 +651627 +2,824 +408 +— +860’ 2” +23.0 +30,187 +MAHIMAHI (3) +1982 +653424 +2,824 +408 +— +860’ 2” +23.0 +30,167 +LURLINE (3) +​ +2019 +​ +1274143 +​ +2,750 +​ +432 +​ +500 +​ +869’ 5” +​ +23.0 +​ +50,562 +MATSONIA (3) +​ +2020 +​ +1274123 +​ +2,750 +​ +432 +​ +500 +​ +869’ 5” +​ +23.0 +​ +50,562 +MANULANI (3)(8) +2005 +1168529 +2,378 +284 +— +712’ 0” +22.5 +29,517 +MAUNAWILI (3)(8) +2004 +1153166 +2,378 +326 +— +711’ 9” +22.5 +29,517 +MANUKAI (3)(8) +2003 +1141163 +2,378 +326 +— +711’ 9” +22.5 +29,517 +R.J. PFEIFFER (3)(8) +1992 +979814 +2,245 +300 +— +713’ 6” +23.0 +27,100 +MOKIHANA (3) +1983 +655397 +1,994 +354 +1,323 +860’ 2” +23.0 +29,484 +MATSON KODIAK (3)(8) +1987 +910308 +1,668 +280 +— +710’ 0” +20.0 +37,473 +MATSON ANCHORAGE (3)(8) +1987 +910306 +1,668 +280 +— +710’ 0” +20.0 +37,473 +MATSON TACOMA (3)(8) +1987 +910307 +1,668 +280 +— +710’ 0” +20.0 +37,473 +KAMOKUIKI (4) +2000 +9232979 +707 +100 +— +433’ 9” +17.5 +8,509 +OLOMANA (5) +​ +2004 +​ +9184225 +​ +645 +​ +120 +​ +— +​ +388’ 7” +​ +14.0 +​ +8,200 +ISLAND CHIEF (5) +2005 +9184237 +630 +90 +— +388’ 6” +15.0 +8,071 +PAPA MAU (5) +1999 +9141704 +521 +68 +— +381’ 5” +14.0 +5,364 +Vessels-Chartered: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +CO OSAKA (5)(9) +​ +2008 +​ +9400291 +​ +4,504 +​ +400 +​ +— +​ +852’ 4” +​ +22.0 +​ +50,554 +NAVIOS FELICITAS (5)(9) +​ +2010 +​ +9395953 +​ +4,360 +​ +326 +​ +— +​ +849’ 4” +​ +24.0 +​ +52,315 +NAVIOS AMARANTH (5)(9) +​ +2007 +​ +9334143 +​ +4,253 +​ +400 +​ +— +​ +855’ 2” +​ +24.3 +​ +50,629 +NAVIOS VERANO (5)(9) +​ +2006 +​ +9308015 +​ +3,461 +​ +550 +​ +— +​ +783’ 8” +​ +23.0 +​ +42,806 +CAPT. THANASIS (5)(9) +​ +2005 +​ +9294159 +​ +2,824 +​ +586 +​ +— +​ +728’ 10” +​ +21.0 +​ +39,383 +BOMAR BELLINI (5)(9) +​ +2007 +​ +9338084 +​ +2,824 +​ +586 +​ +— +​ +788’ 10” +​ +22.0 +​ +39,276 +MAUNALEI (3)(8) +2006 +1181627 +1,992 +328 +— +681’ 1” +22.1 +33,771 +LILOA II (5) +2004 +9184249 +630 +90 +— +388’ 6” +15.0 +​ +8,071 +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +Barges-Owned: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +HALEAKALA (3)(6) +1984 +676972 +335 +78 +— +350’ 0” +— +4,658 +WAIALEALE (3)(7) +1991 +978516 +— +36 +230 +345’ 0” +— +5,621 +Barges-Chartered: +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +​ +MAUNA LOA (3) +2013 +1247426 +500 +78 +— +362’ 6” +— +12,678 +ILIULIUK BAY (3)(6) +2013 +1249384 +178 +— +— +250’ 0” +— +4,138 +(1) Twenty-foot Equivalent Units (“TEU”) is a standard measure of cargo volume correlated to a standard 20-foot dry cargo container. +(2) Vessel Design Speed may vary from the operating speed of the vessel. +(3) U.S. flagged and Jones Act qualified vessel or barge. +(4) U.S. flagged vessel. +(5) Foreign flagged vessel. +(6) Lift-on/lift-off barge equipped with a crane. +(7) Roll-on/roll-off barge. +(8) Vessel installed with exhaust gas cleaning systems (commonly referred to as “scrubbers”). +(9) Vessels used in the CLX+ service are chartered and may be replaced by other similar vessels. +​ +Fleet Renewal Program: +​ +Matson has completed its investment of $1,024 million in the construction of four new vessels, including owner’s items and capitalized interest. The two Aloha Class containerships, Daniel K. Inouye and Kaimana Hila , commenced active service in November 2018 and April 2019, respectively. The two Kanaloa Class combination container and roll-on/roll-off vessels, Lurline and Matsonia commenced active service in January 2020 and December 2020, respectively. +​ +4 +Table of Contents +Vessel Emission Regulations: +​ +Being a leader in environmental stewardship is one of Matson’s core values. Matson’s vessels transit through some of the most environmentally sensitive areas in the United States including the Hawaiian Islands and the coasts of California, Oregon, Washington and Alaska. Matson is focused in particular on reducing transportation emissions, including carbon dioxide, nitrous oxide, particulate matter and sulfur dioxide through improvements in vessel fuel consumption and the development of more fuel-efficient transportation solutions. Matson further contributes positively to the environment by testing and deploying leading technologies as the fleet is modernized. +​ +The International Maritime Organization (“IMO”), to which the U.S. and over 100 other countries are signatories, is a specialized agency of the United Nations that sets international environmental standards applicable to vessels operating under the flag of any signatory country. Effective January 1, 2020, the IMO imposed regulations that generally require all vessels to burn fuel oil with a maximum sulfur content of ≤0.5 percent (“IMO 2020”). There are three main options for a vessel to meet the IMO 2020 requirements: (1) burn low sulfur fuel oil (“LSFO”), (2) install exhaust gas cleaning systems (commonly referred to as “scrubbers”) on vessels to reduce sulfur emissions from high sulfur fuel oil (“HSFO”), or (3) switch to lower emission fuels such as liquefied natural gas (“LNG”), which requires converting existing vessels or constructing new vessels with LNG-compatible engines and fuel tanks. With respect to North America, all waters, with certain limited exceptions, within 200 nautical miles of U.S. and Canadian coastlines have been designated emission control areas (“ECAs”). Since January 1, 2015, U.S. Environmental Protection Agency regulations have reduced the fuel oil maximum sulfur content in designated ECAs to ≤0.1 percent or the equivalent emissions by the use of scrubbers. In addition, since August 1, 2012, the California Air Resource Board and U.S. Environmental Protection Agency under the Vessel General Permit regulations have reduced the fuel oil maximum sulfur content to ≤0.1 percent within 24 miles of the California coastline and within Puget Sound. +​ +All of Matson’s vessels in the Alaska and Hawaii services are operating in compliance with IMO 2020 and ECA regulations as applicable, and can use LSFO. In the Alaska and Hawaii services, Matson installed scrubbers on nine diesel-powered vessels to allow them to use HSFO and still comply with IMO 2020 and ECA regulations. Matson also maintains two reserve vessels which may operate as dry-dock relief or for emergency activation purposes under an approved ECA permit enabling the use of fuel oil with a maximum sulfur content of ≤0.5 percent within the North America ECA. Matson’s new Aloha and Kanaloa Class vessels burn compliant LSFO. These new vessels are also equipped with dual-fuel engines and can be converted to run on LNG. All of Matson’s other vessels use LSFO to meet IMO 2020 and ECA emission standards. +​ +Hawaii Terminal Modernization and Expansion Program: +​ +Matson has completed the first phase of modernizing and renovating its terminal facility at Sand Island, Honolulu, Hawaii, an investment of approximately $60 million. In 2020, Matson completed the installation of three new 65 long- ton capacity gantry cranes, upgraded and renovated three existing cranes, demolished four outdated cranes, and installed upgrades to the electrical infrastructure at the terminal. As part of the second phase, Matson expects to install a new redundant main switchgear, complete the augmentation of its existing backup power generators, install new fuel storage tanks and a battery energy storage system, and perform other upgrades at the terminal. Matson expects to begin the second phase during the second half of 2021 and to complete it within two years. The final phase is expected to begin in 2024 as part of a broader terminal expansion and modernization program at the terminal. +​ +Ocean Transportation Equipment: +​ +As a complement to its fleet of vessels, Matson owns a variety of equipment including cranes, terminal equipment, containers and chassis, which represents an investment of approximately $0.6 billion as of December 31, 2020. Matson also leases containers, chassis and other equipment under various operating lease agreements. +​ +Operating Costs: +​ +Major components of Matson’s Ocean Transportation operating costs are as follows: +​ +Direct Cargo Expense includes terminal handling costs including labor, purchased outside transportation and other related costs. +​ +5 +Table of Contents +Vessel Operating Expense includes crew wages and related costs; fuel, pilots, tugs and line related costs; vessel charter expenses; and other vessel operating related expenses. Matson purchases fuel oil, lubricants and gasoline for its operations and also pays fuel-related surcharges to other third party transportation providers. +​ +Operating Overhead includes equipment repair costs, equipment lease and repositioning expenses, vessel repair and maintenance costs, depreciation and dry-docking amortization, insurance, port engineers and other maintenance costs, and other vessel and shoreside related overhead. +​ +Competition: +​ +The following is a summary of major competitors in Matson’s Ocean Transportation segment: +​ +Hawaii Service: Matson’s Hawaii service has one major U.S. flagged Jones Act competitor, Pasha Hawaii (“Pasha”), which operates container and roll-on/roll-off services between the ports of Long Beach, Oakland and San Diego, California to Hawaii. A U.S. flagged Jones Act barge operator, Aloha Marine Lines, also offers barge service between the Pacific Northwest and Hawaii. +​ +Foreign-flagged vessels carrying cargo to Hawaii from non-U.S. locations also provide alternatives for companies shipping to Hawaii. Other competitors in the Hawaii service include proprietary operators and contract carriers of bulk cargo. Airfreight competition for time-sensitive cargo exists; however, cargo volume has been limited primarily due to the cost of airfreight transportation. +​ +Matson operates three strings of vessels to Hawaii. These strings provide customers an industry-leading five departures from ports on the U.S. West Coast to Hawaii every week – two each from Long Beach and Oakland, California and one from Tacoma, Washington. Each of these strings operates on a fixed day-of-the-week schedule. One of the vessel strings continues from Honolulu on to Guam, Japan and China before returning to Long Beach. The remaining two strings offer eastbound Hawaii shippers twice weekly departures from Honolulu to the U.S. Mainland, providing customers service to the same three U.S. West Coast ports. Matson’s frequent sailings and punctuality permit customers to reduce inventory carrying costs. Matson also competes by offering the most comprehensive service to customers, including: the only container service to and from the three largest U.S. West Coast ports; the most efficient terminal network on the U.S. West Coast provided by SSAT; a dedicated inter-island barge network which is integrated with Matson’s line haul schedule; weekly roll-on roll-off service from Long Beach and Oakland; a world-class customer service team; and efficiency and experience in handling cargo of all types. +​ +Alaska Service: Matson’s Alaska service has one major U.S. flagged Jones Act competitor, Totem Ocean Trailer Express, Inc., which operates a roll-on/roll off service between Tacoma, Washington and Anchorage, Alaska. There are also two U.S. flagged Jones Act barge operators, Alaska Marine Lines, which mainly provides services from Seattle, Washington to the ports of Anchorage and Dutch Harbor, and other locations in Alaska, and Samson Tug & Barge, which mainly serves Western Alaska and other locations. The barge operators have historically shipped lower value commodities that can accommodate a longer transit time, as well as construction materials and other cargo that are not conducive to movement in containers. Foreign-flagged vessels provide alternatives for companies shipping cargo (mainly seafood) from the Alaska ports of Kodiak and Dutch Harbor. Matson’s AAX service has two major competitors, CMA CGM and Maersk Lines, which provide services between Dutch Harbor, Alaska and Asia. +​ +Matson offers customers twice weekly scheduled service from Tacoma, Washington to Anchorage and Kodiak, Alaska and weekly service to Dutch Harbor, Alaska. The Company also provides a barge service between Dutch Harbor and Akutan in Alaska. Matson is the only Jones Act containership operator providing service to Kodiak and Dutch Harbor in Alaska, which are the primary loading ports for southbound seafood. Matson offers dedicated terminal services at the Alaska ports of Anchorage, Kodiak and Dutch Harbor performed by MatNav, and at the port of Tacoma, Washington performed by SSAT. +​ +China Service: Major competitors to Matson’s China service include large international carriers such as ONE (formerly “K” Line, NYK Line and MOL), Maersk, CMA CGM, Evergreen, COSCO, and ZIM. +​ +Matson’s China service competes by offering fast and reliable service from the ports of Ningbo and Shanghai in China to Long Beach, California, and providing fixed day arrivals and next-day cargo availability. Matson’s service is further differentiated by SSAT’s best-in-class stevedoring services, access to Shippers Transport Express and off-dock container +6 +Table of Contents +yards enabling fast truck turn times, Matson-dedicated equipment including chassis to speed cargo availability, one-stop intermodal connections, and providing world-class customer service. Matson has offices located in Hong Kong, Shenzhen, Xiamen, Ningbo and Shanghai, and has contracted with terminal operators in Ningbo and Shanghai. +​ +Guam Service: Matson’s Guam service has one major competitor, APL, which operates a weekly U.S. flagged container feeder service connecting the U.S. West Coast to Guam and Saipan, via transshipments primarily over Busan, South Korea. Waterman operates a roll-on/roll-off service, which periodically calls at Guam. There are also several foreign carriers, including CMA CGM, that call at Guam from foreign origin ports. +​ +Japan Service: Matson’s Japan service competes primarily with APL, which operates a weekly U.S. flagged containership service from the U.S. West Coast to the port of Naha, Okinawa, Japan. +​ +Micronesia and South Pacific Services: Matson’s Micronesia and South Pacific services have competition from a variety of local and international carriers that provide freight services to the area. +​ +Customer Concentration: +​ +Matson serves customers in numerous industries and carries a wide variety of cargo, mitigating its dependence upon any single customer or single type of cargo. In 2020, 2019 and 2018, the Company’s 10 largest Ocean Transportation customers accounted for approximately 22 percent, 23 percent and 24 percent of the Company’s Ocean Transportation revenue, respectively. None of these customers individually account for more than 10 percent of Matson’s Ocean Transportation operating revenues. For additional information on Ocean Transportation revenues for the years ended December 31, 2020, 2019 and 2018, see Note 2 to the Consolidated Financial Statements in Item 8 of Part II below. +​ +Seasonality: +​ +Matson’s Ocean Transportation services typically experience seasonality in volume, generally following a pattern of increasing volumes starting in the second quarter of each year, culminating in a peak season throughout the third quarter, with subsequent decline in demand during the fourth and first quarters. This seasonality trend is amplified in the Alaska service primarily due to winter weather and the timing of southbound seafood trade. As a result, earnings tend to follow a similar pattern, offset by periodic vessel dry-docking and other episodic cost factors, which can lead to earnings variability. In addition, in the China trade, volume is typically driven primarily by U.S. consumer demand for goods during key retail selling seasons. Freight rates are impacted mainly by macro supply and demand variables. +​ +Maritime Laws and the Jones Act : +​ +Maritime Laws: All interstate and intrastate marine commerce within the U.S. falls under the Merchant Marine Act of 1920 (commonly referred to as the Jones Act). +​ +The Jones Act is a long-standing cornerstone of U.S. maritime policy. Under the Jones Act, all vessels transporting cargo between covered U.S. ports must, subject to limited exceptions, be built in the U.S., registered under the U.S. flag, be manned predominantly by U.S. crews, and owned and operated by U.S.-organized companies that are controlled and 75 percent owned by U.S. citizens. U.S. flagged vessels are generally required to be maintained at higher standards than foreign flagged vessels and are subject to rigorous supervision and inspections by, or on behalf of, the U.S. Coast Guard, which requires appropriate certifications and background checks of the crew members. Under Section 27 of the Jones Act, the carriage of cargo between the U.S. West Coast, Hawaii and Alaska on foreign-built or foreign-documented vessels is prohibited. +​ +During the years ended December 31, 2020, 2019 and 2018, approximately 62 percent, 72 percent and 72 percent, respectively, of Matson’s Ocean Transportation revenues came from the Hawaii and Alaska trades that were subject to the Jones Act. Matson’s Hawaii and Alaska trade routes are included within the non-contiguous Jones Act market. The commerce of both Hawaii, as an island economy, and Alaska, due to its geographical location, are dependent on ocean transportation. The Jones Act ensures frequent, reliable, roundtrip service to these locations. Matson’s vessels operating in these trade routes are Jones Act qualified. +​ +Matson is a member of the American Maritime Partnership (“AMP”) which supports the retention of the Jones Act and similar cabotage laws. The Jones Act has broad support from both houses of Congress and the Executive Branch. +7 +Table of Contents +Matson believes that the ongoing war on terrorism and geopolitical environment have further solidified political support for U.S. flagged vessels because a vital and dedicated U.S. merchant marine is a cornerstone for a strong homeland defense, as well as a critical source of trained U.S. mariners for wartime support. AMP seeks to inform elected officials and the public about the economic, national security, commercial, safety and environmental benefits of the Jones Act and similar cabotage laws. Repeal of the Jones Act would allow foreign-flagged vessel operators that do not have to abide by all U.S. laws and regulations to sail between U.S. ports in direct competition with Matson and other U.S. domestic operators that must comply with all such laws and regulations. +​ +Other U.S. maritime laws require vessels operating between Guam, a U.S. territory, and U.S. ports to be U.S. flagged and predominantly U.S. crewed, but not U.S. built. +​ +Cabotage laws are not unique to the United States, and similar laws exist around the world in over 90 countries, including regions in which Matson provides ocean transportation services. Any changes in such laws may have an impact on the services provided by Matson in those regions. For a discussion of the risks arising from the Jones Act and other regulations, see Part I, \ No newline at end of file diff --git a/raw/filings/0000003453/2020/0001558370-21-001909/item13.txt b/raw/filings/0000003453/2020/0001558370-21-001909/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..08c6865cbd86c2fd9a0facd69895ecad3e5a2a0a --- /dev/null +++ b/raw/filings/0000003453/2020/0001558370-21-001909/item13.txt @@ -0,0 +1,4 @@ +Item 13. +​ +Certain Relationships and Related Transactions, and Director Independence +76 \ No newline at end of file diff --git a/raw/filings/0000003499/2018/0000003499-19-000004/filing.txt b/raw/filings/0000003499/2018/0000003499-19-000004/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..8f18a89911cc81f34994e3709408f322820322aa --- /dev/null +++ b/raw/filings/0000003499/2018/0000003499-19-000004/filing.txt @@ -0,0 +1,3252 @@ +10-K +1 +alx10-k123118.htm +10-K +Document +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10‑K +☒ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +For the Fiscal Year Ended: +December 31, 2018 +OR +☐ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +For the transition period from +to +Commission File Number: +001-06064 +ALEXANDER’S, INC. +(Exact name of registrant as specified in its charter) +Delaware +51-0100517 +(State or other jurisdiction of incorporation or organization) +(IRS Employer Identification No.) +210 Route 4 East, Paramus, New Jersey +07652 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code +(201) 587-8541 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, $1 par value per share +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: NONE +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +YES ☒ NO ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. +YES ☐ NO ☒ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +YES ☒ NO ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +☒ Yes ☐ No +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S‑K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10‑K or any amendment to this Form 10‑K. ☒ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a +smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +☒ Large Accelerated Filer +☐ Accelerated Filer +☐ Non-Accelerated Filer (Do not check if smaller reporting company) +☐ Smaller Reporting Company +☐ Emerging Growth Company +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ +The aggregate market value of the voting and non-voting shares of common stock held by non-affiliates of the registrant, (i.e., by persons other than officers and directors of Alexander’s, Inc.) was $810,094,000 at June 30, 2018. +As of January 31, 2019, there were 5,107,290 shares of the registrant’s common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III : Portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on May 16, 2019. +INDEX +Item +Financial Information: +Page Number +Part I. +1. +Business +5 +1A. +Risk Factors +7 +1B. +Unresolved Staff Comments +18 +2. +Properties +19 +3. +Legal Proceedings +21 +4. +Mine Safety Disclosures +21 +Part II. +5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +22 +6. +Selected Financial Data +24 +7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +25 +7A. +Quantitative and Qualitative Disclosures about Market Risk +36 +8. +Financial Statements and Supplementary Data +37 +9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +58 +9A. +Controls and Procedures +58 +9B. +Other Information +61 +Part III. +10. +Directors, Executive Officers and Corporate Governance (1) +61 +11. +Executive Compensation (1) +62 +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters (1) +62 +13. +Certain Relationships and Related Transactions, and Director Independence (1) +62 +14. +Principal Accounting Fees and Services (1) +62 +Part IV. +15. +Exhibits, Financial Statement Schedules +63 +16. +Form 10-K Summary +73 +Signatures +74 +__________________________ +(1) These items are omitted in part or in whole because the registrant will file a definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 with the Securities and Exchange Commission no later than 120 days after December 31, 2018 , portions of which are incorporated by reference herein. +3 +FORWARD-LOOKING STATEMENTS +Certain statements contained herein constitute forward-looking statements as such term is defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not guarantees of future performance. They represent our intentions, plans, expectations and beliefs and are subject to numerous assumptions, risks and uncertainties. Our future results, financial condition and business may differ materially from those expressed in these forward-looking statements. You can find many of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” or other similar expressions in this Annual Report on Form 10‑K. We also note the following forward-looking statements: in the case of our development projects, the estimated completion date, estimated project costs and costs to complete; and estimates of dividends on shares of our common stock. Many of the factors that will determine the outcome of these and our other forward-looking statements are beyond our ability to control or predict. For a further discussion of factors that could materially affect the outcome of our forward-looking statements, see “Item 1A - Risk Factors” in this Annual Report on Form 10‑K. +For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You are cautioned not to place undue reliance on our forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or the date of any document incorporated by reference. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to release publicly, any revisions to our forward-looking statements to reflect events or circumstances occurring after the date of this Annual Report on Form 10-K. +4 +PART I +ITEM 1. BUSINESS +GENERAL +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”) incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• +731 Lexington Avenue, a 1,311,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 889,000 and 174,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot (83,000 square feet), The Container Store (34,000 square feet) and Hennes & Mauritz (27,000 square feet) are the principal retail tenants; +• +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On January 10, 2019, Kohl’s announced that it plans to close and sublease its store at the property; Kohl’s remains obligated to us under its lease which expires in January 2031. On September 18, 2017, Toys “R” Us, Inc. (“Toys”), a one-third owned affiliate of Vornado as of December 31, 2018, filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its 47,000 square foot lease at the property ($2,600,000 of annual revenue) and possession of the space was returned to us; +• +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• +Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA Property, Inc.; and +• +Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• +Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +Relationship with Vornado +We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements which expire in March of each year and are automatically renewable. Vornado is a fully-integrated REIT with significant experience in managing, leasing, developing, and operating retail and office properties. +5 +Relationship with Vornado - continued +As of December 31, 2018 , Vornado owned 32.4% of our outstanding common stock. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2018, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.2% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Significant Tenant +Bloomberg accounted for revenue of $107,356,000, $105,224,000 and $104,590,000 in the years ended December 31, 2018 , 2017 , and 2016 , respectively, representing approximately 46% of our total revenues in each year. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Competition +We operate in a highly competitive environment. All of our properties are located in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Principal factors of competition are the amount of rent charged, attractiveness of location and quality and breadth of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Employees +We currently have 70 employees. +Executive Office +Our executive office is located at 210 Route 4 East, Paramus, New Jersey, 07652 and our telephone number is (201) 587-8541. +Available Information +Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, as well as Reports on Forms 3, 4 and 5 regarding officers, directors, and 10% beneficial owners filed or furnished pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, are available free of charge on our website (www.alx-inc.com) as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Also available on our website are copies of our Audit Committee Charter, Compensation Committee Charter, Code of Business Conduct and Ethics and Corporate Governance Guidelines. In the event of any changes to these items, revised copies will be made available on our website. Copies of these documents are also available directly from us, free of charge. +In May 2009, Vornado and Interstate each filed with the SEC an amendment to their respective Schedule 13D indicating that they, as a group, own 47.2% of our common stock. This ownership level, together with the shares owned by Messrs. Roth, Mandelbaum and Wight, makes us a “controlled” company for the purposes of the New York Stock Exchange, Inc.’s Corporate Governance Standards (the “NYSE Rules”). This means that we are not required to, among other things, have a majority of the members of our Board of Directors be independent under the NYSE Rules, have all of the members of our Compensation Committee be independent under the NYSE Rules or to have a Nominating Committee. While we have voluntarily complied with a majority of the independence requirements of the NYSE Rules, we are under no obligation to do so and this situation may change at any time. +6 +ITEM 1A. RISK FACTORS +Material factors that may adversely affect our business, operations and financial condition are summarized below. The risks and uncertainties described herein may not be the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business, operations and financial condition. See “Forward-Looking Statements” contained herein on page 4. +OUR INVESTMENTS ARE CONCENTRATED IN THE GREATER NEW YORK CITY METROPOLITAN AREA. CIRCUMSTANCES AFFECTING THIS AREA GENERALLY COULD ADVERSELY AFFECT OUR BUSINESS. +All of our properties are in the greater New York City metropolitan area and are affected by the economic cycles and risks inherent in that area. +All of our revenues come from properties located in the greater New York City metropolitan area. Real estate markets are subject to economic downturns and we cannot predict how economic conditions will impact this market in either the short or long term. Declines in the economy or declines in the real estate market in this area could hurt our financial performance and the value of our properties. In addition to the factors affecting the national economic condition generally, the factors affecting economic conditions in this area include: +• +financial performance and productivity of the media, advertising, professional services, financial, technology, retail, insurance and real estate industries; +• +business layoffs or downsizing; +• +industry slowdowns; +• +relocations of businesses; +• +changing demographics; +• +increased telecommuting and use of alternative work places; +• +changes in the number of domestic and international tourists to our markets (including, as a result of changes in the relative strengths of world currencies); +• +infrastructure quality; +• +changes in the rates or treatment of the deductibility of state and local taxes; and +• +any oversupply of, or reduced demand for, real estate. +It is impossible for us to assess the future effects of trends in the economic and investment climates of the greater New York City metropolitan region, and more generally of the United States, on the real estate market in this area. Local, national or global economic downturns could negatively affect our business and profitability. +We are subject to risks that affect the general and New York City retail environments. +Certain of our properties are New York City retail properties. As such, these properties are affected by the general and New York City retail environments, including the level of consumer spending and consumer confidence, change in relative strengths of world currencies, the threat of terrorism, increasing competition from discount retailers, outlet malls, retail websites and catalog companies and the impact of technological change upon the retail environment generally. These factors could adversely affect the financial condition of our retail tenants, or result in the bankruptcy of such tenants, and the willingness of retailers to lease space in our retail locations. +Terrorist attacks may adversely affect the value of our properties and our ability to generate cash flow. +All of our properties are located in the greater New York City metropolitan area, and our most significant property, 731 Lexington Avenue, is located on Lexington Avenue and 59 th Street in Manhattan. In response to a terrorist attack or the perceived threat of terrorism, tenants in this area may choose to relocate their businesses to less populated, lower-profile areas of the United States that may be perceived to be less likely targets of future terrorist activity and fewer customers may choose to patronize businesses in this area. This, in turn, could trigger a decrease in the demand for space in these markets, which could increase vacancies in our properties and force us to lease our properties on less favorable terms. Furthermore, we may experience increased costs for security, equipment and personnel. As a result, the value of our properties and the level of our revenues could decline materially. +7 +Natural disasters and the effects of climate change could have a concentrated impact on the area which we operate and could adversely impact our results. +Our investments are in the greater New York City metropolitan area and since they are concentrated along the Eastern Seaboard, natural disasters, including hurricanes, could impact our properties. Potentially adverse consequences of “global warming” could similarly have an impact on our properties. Over time, these conditions could result in declining demand for office space in our buildings or the inability of us to operate the buildings at all. Climate change may also have indirect effects on our business by increasing the cost of (or making unavailable) property insurance on terms we find acceptable, increasing the cost of energy at our properties and requiring us to expend funds as we seek to repair and protect our properties against such risks. The incurrence of these losses, costs or business interruptions may adversely affect our operating and financial results. +REAL ESTATE INVESTMENTS’ VALUE AND INCOME FLUCTUATE DUE TO VARIOUS FACTORS. +The value of real estate fluctuates depending on conditions in the general economy and the real estate business. These conditions may also adversely impact our revenues and cash flows. +The factors that affect the value of our real estate include, among other things: +• +global, national, regional and local economic conditions; +• +competition from other available space; +• +local conditions such as an oversupply of space or a reduction in demand for real estate in the area; +• +how well we manage our properties; +• +the development and/or redevelopment of our properties; +• +changes in market rental rates; +• +the timing and costs associated with property improvements and rentals; +• +whether we are able to pass all or portions of any increases in operating costs through to tenants; +• +changes in real estate taxes and other expenses; +• +whether tenants and users such as customers and shoppers consider a property attractive; +• +changes in consumer preferences adversely affecting retailers and retail store values; +• +changes in space utilization by our tenants due to technology, economic conditions and business environment; +• +the financial condition of our tenants, including the extent of tenant bankruptcies or defaults; +• +trends in office real estate; +• +the impact on our retail tenants and demand for retail space at our properties due to increased competition from online shopping; +• +availability of financing on acceptable terms or at all; +• +inflation or deflation; +• +fluctuations in interest rates; +• +our ability to obtain adequate insurance; +• +changes in zoning laws and taxation; +• +government regulation; +• +consequences of any armed conflict involving, or terrorist attack against, the United States or individual acts of violence in public spaces, including retail centers; +• +potential liability under environmental or other laws or regulations; +• +natural disasters; +• +general competitive factors; and +• +climate changes. +The rents we receive and the occupancy levels at our properties may decline as a result of adverse changes in any of these factors. If our rental revenues and/or occupancy levels decline, we generally would expect to have less cash available to pay our indebtedness and for distribution to our stockholders. In addition, some of our major expenses, including mortgage payments, real estate taxes and maintenance costs generally do not decline when the related rents decline. +8 +Capital markets and economic conditions can materially affect our liquidity, financial condition and results of operations as well as the value of an investment in our debt and equity securities. +There are many factors that can affect the value of our equity securities and any debt securities we may issue in the future, including the state of the capital markets and economy. Demand for office and retail space may decline nationwide due to an economic downturn, bankruptcies, downsizing, layoffs and cost cutting. Government action or inaction may adversely affect the state of the capital markets. The cost and availability of credit may be adversely affected by illiquid credit markets and wider credit spreads, which may adversely affect our liquidity and financial condition, including our results of operations, and the liquidity and financial condition of our tenants. Our inability or the inability of our tenants to timely refinance maturing liabilities and access the capital markets to meet liquidity needs may materially affect our financial condition and results of operations and the value of our equity securities and any debt securities we may issue in the future. +U.S. federal tax reform legislation now and in the future could affect REITs generally, the geographic markets in which we operate, the trading of our shares and our results of operations, both positively and negatively, in ways that are difficult to anticipate. +The Tax Cuts and Jobs Act of 2017 (the “2017 Act”) represented sweeping tax reform legislation that made significant changes to corporate and individual tax rates and the calculation of taxes, as well as international tax rules. As a REIT, we are generally not required to pay federal taxes otherwise applicable to regular corporations if we comply with the various tax regulations governing REITs. Shareholders, however, are generally required to pay taxes on REIT dividends. The 2017 Act and future tax reform legislation could impact our share price or how shareholders and potential investors view an investment in REITs. For example, the decrease in corporate tax rates in the 2017 Act could decrease the attractiveness of the REIT structure relative to companies that are not organized as REITs. In addition, while certain elements of the 2017 Act do not impact us directly as a REIT, they could impact the geographic markets in which we operate as well as our tenants in ways, both positive and negative, that are difficult to anticipate. For example, the limitation in the 2017 Act on the deductibility of certain state and local taxes may make operating in jurisdictions that impose such taxes at higher rates less desirable than operating in jurisdictions imposing such taxes at lower rates. The overall impact of the 2017 Act also depends on the future interpretations and regulations that may be issued by U.S. tax authorities, and it is possible that future guidance could adversely impact us. +Real estate is a competitive business. +We compete with a large number of real estate property owners and developers, some of which may be willing to accept lower returns on their investments. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. +We may be adversely affected by trends in office real estate. +Telecommuting, flexible work schedules, open workplaces and teleconferencing are becoming more common. These practices enable businesses to reduce their office space requirements. There is also an increasing trend among some businesses to utilize shared office spaces and co-working spaces. A continuation of these trends could, over time, erode the overall demand for office space and, in turn, place downward pressure on occupancy, rental rates and property valuations. +We depend on leasing space to tenants on economically favorable terms and collecting rent from tenants who may not be able to pay. +Our financial results depend significantly on leasing space in our properties to tenants on economically favorable terms. In addition, because a majority of our income is derived from renting real property, our income, funds available to pay indebtedness and for distributions to stockholders will decrease if certain of our tenants cannot pay their rent or if we are not able to maintain our occupancy levels on favorable terms. If a tenant does not pay its rent, we might not be able to enforce our rights as landlord without delays and might incur substantial legal and other costs. During periods of economic adversity for retailers or otherwise, there may be an increase in the number of tenants that cannot pay their rent, become insolvent or file for bankruptcy, all of which can result in an increase in vacancy rates and lower income and funds available to pay indebtedness and for distributions to stockholders. +9 +Bankruptcy or insolvency of tenants may decrease our revenues, net income and available cash. +From time to time, some of our tenants have declared bankruptcy, and other tenants may declare bankruptcy or become insolvent in the future. The bankruptcy or insolvency of a major tenant could cause us to have difficulty leasing the remainder of the affected property. Our leases generally do not contain restrictions designed to ensure the creditworthiness of our tenants. As a result, the bankruptcy or insolvency of a major tenant or multiple tenants could result in a lower level of net income and funds available to pay our indebtedness or make distributions to stockholders. +We depend upon anchor tenants to attract shoppers at our Rego Park I and II retail properties and decisions made by these tenants, or adverse developments in the businesses of these tenants, could materially affect our financial condition and results of operations. +Our Rego Park I and II retail properties are anchored by well-known department stores and other tenants who generate shopping traffic. The value of these properties would be adversely affected if our anchor tenants failed to meet their contractual obligations, sought concessions in order to continue operations or ceased their operations, including as a result of bankruptcy. If the level of sales of stores operating in our properties were to decline significantly due to economic conditions, increased competition from online shopping, closing of anchors or for other reasons, tenants may be unable to pay their minimum rents or expense recovery charges. In the event of a default by a tenant or anchor, we may experience delays and costs in enforcing our rights as landlord. Additionally, closure of an anchor or major tenant could result in lease terminations by, or reductions of rent from, other tenants if the other tenants’ leases have co-tenancy clauses. On April 4, 2017, Sears closed its 195,000 square foot store at our Rego Park I shopping center ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. On January 10, 2019, Kohl’s announced that it plans to close and sublease its 133,000 square foot store at our Rego Park II shopping center; Kohl’s remains obligated to us under its lease which expires in January 2031. +We may be unable to renew leases or relet space as leases expire. +When our tenants decide not to renew their leases upon their expiration, we may not be able to relet the space. Even if tenants do renew or we can relet the space, the terms of renewal or reletting, taking into account among other things, the cost of improvements to the property and leasing commissions, may be less favorable than the terms in the expired leases. In addition, changes in space utilization by our tenants may impact our ability to renew or relet space without the need to incur substantial costs in renovating or redesigning the internal configuration of the relevant property. If we are unable to promptly renew the leases or relet the space at similar rates or if we incur substantial costs in renewing or reletting the space, our cash flow and ability to service debt obligations and pay dividends and distributions to stockholders could be adversely affected. +731 Lexington Avenue accounts for a substantial portion of our revenues. Loss of or damage to the building would adversely affect our financial condition and results of operations. +731 Lexington Avenue accounted for revenue of $151,834,000, $148,324,000 and $147,567,000 in the years ended December 31, 2018 , 2017 , and 2016 , respectively, representing approximately 65%, 64% and 65% of our total revenues in each year, respectively. Loss of or damage to the building in excess of our insurance coverage, including as a result of a terrorist attack, would adversely affect our results of operations and financial condition. +Bloomberg represents a significant portion of our revenues. Loss of Bloomberg as a tenant or deterioration in Bloomberg’s credit quality could adversely affect our financial condition and results of operations. +Bloomberg accounted for revenue of $107,356,000, $105,224,000 and $104,590,000 in the years ended December 31, 2018 , 2017 , and 2016 , respectively, representing approximately 46% of our total revenues in each year. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. +We face risks associated with our tenants being designated “Prohibited Persons” by the Office of Foreign Assets Control and similar requirements. +Pursuant to Executive Order 13224 and other laws, the Office of Foreign Assets Control of the United States Department of the Treasury (“OFAC”) maintains a list of persons designated as terrorists or who are otherwise blocked or banned (“Prohibited Persons”) from conducting business or engaging in transactions in the United States and thereby restricts our doing business with such persons. In addition, our leases, loans and other agreements may require us to comply with OFAC and related requirements, and any failure to do so may result in a breach of such agreements. If a tenant or other party with whom we conduct business is placed on the OFAC list or is otherwise a party with whom we are prohibited from doing business, we may be required to terminate the lease or other agreement or face other penalties. Any such termination could result in a loss of revenue or otherwise negatively affect our financial results and cash flows. +10 +Our business and operations would suffer in the event of system failures. +Despite system redundancy, the implementation of security measures and the existence of a disaster recovery plan for our internal information technology systems, our systems are vulnerable to damages from any number of sources, including computer viruses, unauthorized access, energy blackouts, natural disasters, terrorism, war and telecommunication failures. Any system failure or accident that causes interruptions in our operations could result in a material disruption to our business. We may also incur additional costs to remedy damages caused by such disruptions. +The occurrence of cyber incidents, or a deficiency in our cyber security, could negatively impact our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships or reputation, all of which could negatively impact our financial results. +We face risks associated with security breaches, whether through cyber attacks or cyber intrusions over the Internet, malware, computer viruses, attachments to e-mails, persons who access our systems from inside or outside our organization, and other significant disruptions of our IT networks and related systems. The risk of a security breach or disruption, particularly through cyber attack or cyber intrusion, including by computer hackers, foreign governments and cyber terrorists, has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased. Although we have not experienced cyber incidents that are individually, or in the aggregate, material, we have experienced cyber attacks in the past, which have thus far been mitigated by preventative, detective, and responsive measures that we have put in place. Our IT networks and related systems are essential to the operation of our business and our ability to perform day-to-day operations (including managing our building systems) and, in some cases, may be critical to the operations of certain of our tenants. Although we make efforts to maintain the security and integrity of these types of IT networks and related systems, and we have implemented various measures to manage the risk of a security breach or disruption, there can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not be successful or damaging. Unauthorized parties, whether within or outside our company, may disrupt or gain access to our systems, or those of third parties with whom we do business, through human error, misfeasance, fraud, trickery, or other forms of deceit, including break-ins, use of stolen credentials, social engineering, phishing, computer viruses or other malicious codes, and similar means of unauthorized and destructive tampering. Even the most well protected information, networks, systems and facilities remain potentially vulnerable because the techniques used in such attempted security breaches evolve and generally are not recognized until launched against a target, and in some cases are designed to not be detected and, in fact, may not be detected. Accordingly, we may be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, and thus it is impossible for us to entirely mitigate this risk. +A security breach or other significant disruption involving our IT networks and related systems could disrupt the proper functioning of our networks and systems and therefore our operations and/or those of certain of our tenants; result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information of ours or others, which others could use to compete against us or which could expose us to damage claims by third-parties for disruptive, destructive or otherwise harmful purposes and outcomes; result in our inability to maintain the building systems relied upon by our tenants for the efficient use of their leased space; require significant management attention and resources to remedy any damages that result; subject us to litigation claims for breach of contract, damages, credits, fines, penalties, governmental investigations and enforcement actions or termination of leases or other agreements; or damage our reputation among our tenants and investors generally. Any or all of the foregoing could have a material adverse effect on our results of operations, financial condition and cash flows. +A cyber attack could interfere with our ability to comply with the financial reporting requirements, which could adversely affect us. A cyber attack could also compromise the confidential information of our employees, tenants, customers and vendors. A successful attack could disrupt and materially affect our business operations, including damaging relationships with tenants, customers and vendors. Any compromise of our information security systems could also result in a violation of applicable privacy and other laws, significant legal and financial exposure, damage to our reputation, loss or misuse of the information (which may be confidential, proprietary and/or commercially sensitive in nature) and a loss of confidence in our security measures, which could harm our business. +11 +We may incur significant costs to comply with environmental laws and environmental contamination may impair our ability to lease and/or sell real estate. +Our operations and properties are subject to various federal, state and local laws and regulations concerning the protection of the environment, including air and water quality, hazardous or toxic substances and health and safety. Under some environmental laws, a current or previous owner or operator of real estate may be required to investigate and clean up hazardous or toxic substances released at a property. The owner or operator may also be held liable to a governmental entity or to third parties for property damage or personal injuries and for investigation and clean-up costs incurred by those parties because of the contamination. These laws often impose liability without regard to whether the owner or operator knew of the release of the substances or caused the release. The presence of contamination or the failure to remediate contamination may also impair our ability to sell or lease real estate or to borrow using the real estate as collateral. Other laws and regulations govern indoor and outdoor air quality including those that can require the abatement or removal of asbestos-containing materials in the event of damage, demolition, renovation or remodeling and also govern emissions of and exposure to asbestos fibers in the air. The maintenance and removal of lead paint and certain electrical equipment containing polychlorinated biphenyls (PCBs) are also regulated by federal and state laws. We are also subject to risks associated with human exposure to chemical or biological contaminants such as molds, pollens, viruses and bacteria which, above certain levels, can be alleged to be connected to allergic or other health effects and symptoms in susceptible individuals. We could incur fines for environmental compliance and be held liable for the costs of remedial action with respect to the foregoing regulated substances or related claims arising out of environmental contamination or human exposure to contamination at or from our properties. +Each of our properties has been subjected to varying degrees of environmental assessment. To date, these environmental assessments have not revealed any environmental condition material to our business. However, identification of new compliance concerns or undiscovered areas of contamination, changes in the extent or known scope of contamination, human exposure to contamination or changes in clean-up or compliance requirements could result in significant costs to us. +In addition, we may become subject to costs or taxes, or increases therein, associated with natural resource or energy usage (such as a “carbon tax”). These costs or taxes could increase our operating costs and decrease the cash available to pay our obligations or distribute to equity holders. +Some of our potential losses may not be covered by insurance. +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $323,000 deductible and 19% of the balance of a covered loss, and the Federal government is responsible for the remaining 81% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +12 +Compliance or failure to comply with the Americans with Disabilities Act (“ADA”) or other safety regulations and requirements could result in substantial costs. +The ADA generally requires that public buildings, including our properties, meet certain federal requirements related to access and use by disabled persons. Noncompliance could result in the imposition of fines by the federal government or the award of damages to private litigants and/or legal fees to their counsel. If, under the ADA, we are required to make substantial alterations and capital expenditures in one or more of our properties, including the removal of access barriers, it could adversely affect our financial condition and results of operations, as well as the amount of cash available for distribution to stockholders. +Our properties are subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements. If we fail to comply with these requirements, we could incur fines or private damage awards. We do not know whether existing requirements will change or whether compliance with future requirements will require significant unanticipated expenditures that will affect our cash flow and results of operations. +Changes in the method pursuant to which the LIBOR rates are determined and potential phasing out of LIBOR after 2021 may affect our financial results. +The chief executive of the United Kingdom Financial Conduct Authority (“FCA”), which regulates LIBOR, has recently announced that the FCA intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. It is not possible to predict the effect of these changes, other reforms or the establishment of alternative reference rates in the United Kingdom or elsewhere. Furthermore, in the United States, efforts to identify a set of alternative U.S. dollar reference interest rates include proposals by the Alternative Reference Rates Committee of the Federal Reserve Board and the Federal Reserve Bank of New York. On August 24, 2017, the Federal Reserve Board requested public comment on a proposal by the Federal Reserve Bank of New York, in cooperation with the Office of Financial Research, to produce three new reference rates intended to serve as alternatives to LIBOR. These alternative rates are based on overnight repurchase agreement transactions secured by U.S. Treasury Securities. +Any changes announced by the FCA, other regulators or any other successor governance or oversight body, or future changes adopted by such body, in the method pursuant to which the LIBOR rates are determined may result in a sudden or prolonged increase or decrease in the reported LIBOR rates. If that were to occur, the level of interest payments we incur may change. In addition, although certain of our LIBOR based obligations provide for alternative methods of calculating the interest rate payable on certain of our obligations if LIBOR is not reported, which include requesting certain rates from major reference banks in London or New York, or alternatively using LIBOR for the immediately preceding interest period or using the initial interest rate, as applicable, uncertainty as to the extent and manner of future changes may result in interest rates and/or payments that are higher than, lower than or that do not otherwise correlate over time with the interest rates and/or payments that would have been made on our obligations if LIBOR rate was available in its current form. +WE MAY ACQUIRE OR SELL ASSETS OR DEVELOP PROPERTIES. OUR FAILURE OR INABILITY TO CONSUMMATE THESE TRANSACTIONS OR MANAGE THE RESULTS OF THESE TRANSACTIONS COULD ADVERSELY AFFECT OUR OPERATIONS AND FINANCIAL RESULTS. +We may acquire, develop, or redevelop properties and this may create risks. +Although our stated business strategy is not to engage in acquisitions, we may acquire or develop properties when we believe that an acquisition or development project is otherwise consistent with our business strategy. We may not succeed in (i) developing, redeveloping or acquiring properties; (ii) completing these activities on time or within budget; and (iii) leasing or selling developed, redeveloped or acquired properties at amounts sufficient to cover our costs. Competition in these activities could also significantly increase our costs. Difficulties in integrating acquisitions may prove costly or time-consuming and could divert management’s attention. Acquisitions or developments in new markets or types of properties where we do not have the same level of market knowledge may result in weaker than anticipated performance. We may also abandon acquisition or development opportunities that we have begun pursuing and consequently fail to recover expenses already incurred. Furthermore, we may be exposed to the liabilities of properties acquired, some of which we may not be aware of at the time of acquisition. +It may be difficult to buy and sell real estate quickly, which may limit our flexibility. +Real estate investments are relatively difficult to buy and sell quickly. Consequently, we may have limited ability to vary our portfolio promptly in response to changes in economic or other conditions. Moreover, our ability to buy, sell, or finance real estate assets may be adversely affected during periods of uncertainty or unfavorable conditions in the credit markets as we, or potential buyers of our assets, may experience difficulty in obtaining financing. +13 +We have an investment in marketable equity securities. The value of this investment may decline as a result of operating performance or economic or market conditions. +We have an investment in Macerich, a retail shopping center company. As of December 31, 2018 , this investment had a carrying amount of $23,166,000. A decline in the value of this investment due to, among other reasons, Macerich’s operating performance or economic or market conditions, would result in recognized GAAP losses, which could be material. +OUR ORGANIZATIONAL AND FINANCIAL STRUCTURE GIVES RISE TO OPERATIONAL AND FINANCIAL RISKS. +Substantially all of our assets are owned by subsidiaries. We depend on dividends and distributions from these subsidiaries. The creditors of these subsidiaries are entitled to amounts payable to them by the subsidiaries before the subsidiaries may pay any dividends or distributions to us. +Substantially all of our properties and assets are held through our subsidiaries. We depend on cash distributions and dividends from our subsidiaries for substantially all of our cash flow. The creditors of each of our direct and indirect subsidiaries are entitled to payment of that subsidiary’s obligations to them when due and payable before that subsidiary may make distributions or dividends to us. Thus, our ability to pay dividends, if any, to our security holders depends on our subsidiaries’ ability to first satisfy their obligations to their creditors and our ability to satisfy our obligations, if any, to our creditors. +In addition, our participation in any distribution of the assets of any of our direct or indirect subsidiaries upon the liquidation, reorganization or insolvency of the subsidiary, is only after the claims of the creditors, including trade creditors, and preferred security holders, if any, of the applicable direct or indirect subsidiaries are satisfied. +Our existing financing documents contain covenants and restrictions that may restrict our operational and financial flexibility. +As of December 31, 2018 , we had outstanding mortgage indebtedness of $1,170,544,000, secured by three of our properties. These mortgages contain covenants that limit our ability to incur additional indebtedness on these properties, provide for lender approval of tenants’ leases in certain circumstances, and provide for yield maintenance or defeasance premiums to prepay them. These mortgages may significantly restrict our operational and financial flexibility. In addition, if we were to fail to perform our obligations under existing indebtedness or become insolvent or were liquidated, secured creditors would be entitled to payment in full from the proceeds of the sale of the pledged assets prior to any proceeds being paid to other creditors or to any holders of our securities. In such an event, it is possible that we would have insufficient assets remaining to make payments to other creditors or to any holders of our securities. +We have a substantial amount of indebtedness that could affect our future operations. +As of December 31, 2018 , total debt outstanding was $1,170,544,000. We are subject to the risks normally associated with debt financing, including the risk that our cash flow from operations will be insufficient to meet required debt service. Our debt service costs generally will not be reduced if developments in the market or at our properties, such as the entry of new competitors or the loss of major tenants, cause a reduction in the income from our properties. Should such events occur, our operations may be adversely affected. If a property is mortgaged to secure payment of indebtedness and income from such property is insufficient to pay that indebtedness, the property could be foreclosed upon by the mortgagee resulting in a loss of income and a decline in our total asset value. +We have outstanding debt, and the amount of debt and its cost may increase and refinancing may not be available on acceptable terms. +As of December 31, 2018 , total debt outstanding was $1,170,544,000 and our ratio of total debt to total enterprise value was 47.9%. “Enterprise value” means the market equity value of our common stock, plus debt, less cash and cash equivalents at such date. In addition, we have significant debt service obligations. For the year ended December 31, 2018 , our scheduled cash payments for principal and interest were $41,881,000. In the future, we may incur additional debt, and thus increase the ratio of total debt to total enterprise value. If our level of indebtedness increases, there may be an increased risk of default which could adversely affect our financial condition and results of operations. In addition, in a rising interest rate environment, the cost of refinancing our existing debt and any new debt or market rate security or instrument may increase. Continued uncertainty in the equity and credit markets may negatively impact our ability to obtain financing on reasonable terms or at all, which may negatively affect our ability to refinance our debt. +14 +We might fail to qualify or remain qualified as a REIT, and may be required to pay income taxes at corporate rates. +Although we believe that we will remain organized and will continue to operate so as to qualify as a REIT for federal income tax purposes, we might fail to remain qualified. Qualification as a REIT for federal income tax purposes is governed by highly technical and complex provisions of the Internal Revenue Code (the “Code”) for which there are only limited judicial or administrative interpretations and depends on various facts and circumstances that are not entirely within our control. In addition, legislation, new regulations, administrative interpretations or court decisions may significantly change the relevant tax laws and/or the federal income tax consequences of qualifying as a REIT. If, with respect to any taxable year, we fail to maintain our qualification as a REIT and do not qualify under statutory relief provisions, we could not deduct distributions to stockholders in computing our taxable income and would have to pay federal income tax on our taxable income at regular corporate rates. The federal income tax payable would include any applicable alternative minimum tax. If we had to pay federal income tax, the amount of money available to distribute to stockholders and pay our indebtedness would be reduced for the year or years involved, and we would no longer be required to make distributions to stockholders in that taxable year and in future years until we were able to qualify as a REIT and did so. In addition, we would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost, unless we were entitled to relief under the relevant statutory provisions. +We face possible adverse changes in tax laws, which may result in an increase in our tax liability. +From time to time changes in tax laws or regulations are enacted, which may result in an increase in our tax liability. The shortfall in tax revenues for states and municipalities in recent years may lead to an increase in the frequency and size of such changes. If such changes occur, we may be required to pay additional taxes on our assets or income. These increased tax costs could adversely affect our financial condition and results of operations and the amount of cash available for payment of dividends. +Loss of our key personnel could harm our operations and adversely affect the value of our common stock. +We are dependent on the efforts of Steven Roth, our Chief Executive Officer. Although we believe that we could find a replacement, the loss of his services could harm our operations and adversely affect the value of our common stock. +15 +ALEXANDER’S CHARTER DOCUMENTS AND APPLICABLE LAW MAY HINDER ANY ATTEMPT TO ACQUIRE US. +Provisions in Alexander’s certificate of incorporation and by laws, as well as provisions of the Code and Delaware corporate law, may delay or prevent a change in control of the Company or a tender offer, even if such action might be beneficial to stockholders, and limit the stockholders’ opportunity to receive a potential premium for their shares of common stock over then prevailing market prices. +Primarily to facilitate maintenance of its qualification as a REIT, Alexander’s certificate of incorporation generally prohibits ownership, directly, indirectly or beneficially, by any single stockholder of more than 9.9% of the outstanding shares of preferred stock of any class or 4.9% of outstanding common stock of any class. The Board of Directors may waive or modify these ownership limits with respect to one or more persons if it is satisfied that ownership in excess of these limits will not jeopardize Alexander’s status as a REIT for federal income tax purposes. In addition, the Board of Directors has, subject to certain conditions and limitations, exempted Vornado and certain of its affiliates from these ownership limitations. Stock owned in violation of these ownership limits will be subject to the loss of rights and other restrictions. These ownership limits may have the effect of inhibiting or impeding a change in control. +Alexander’s Board of Directors is divided into three classes of directors. Directors of each class are chosen for three-year staggered terms. Staggered terms of directors may have the effect of delaying or preventing changes in control or management, even though changes in management or a change in control might be in the best interest of our stockholders. +In addition, Alexander’s charter documents authorize the Board of Directors to: +• +cause Alexander’s to issue additional authorized but unissued common stock or preferred stock; +• +classify or reclassify, in one or more series, any unissued preferred stock; and +• +set the preferences, rights and other terms of any classified or reclassified stock that Alexander’s issues. +The Board of Directors could establish a series of preferred stock with terms that could delay, deter or prevent a change in control of Alexander’s or other transaction that might involve a premium price or otherwise be in the best interest of our stockholders, although the Board of Directors does not, at present, intend to establish a series of preferred stock of this kind. Alexander’s charter documents contain other provisions that may delay, deter or prevent a change in control of the Company or other transaction that might involve a premium price or otherwise be in the best interest of our stockholders. +In addition, Vornado, Interstate and its three general partners (each of whom are both trustees of Vornado and Directors of Alexander’s) together beneficially own approximately 58.6% of our outstanding shares of common stock. This degree of ownership is likely to reduce the possibility of a tender offer or an attempt to change control of the Company by a third party. +We may change our policies without obtaining the approval of our stockholders. +Our operating and financial policies, including our policies with respect to acquisitions of real estate or other assets, growth, operations, indebtedness, capitalization and dividends, are exclusively determined by our Board of Directors. Accordingly, our stockholders do not control these policies. +16 +OUR OWNERSHIP STRUCTURE AND RELATED-PARTY TRANSACTIONS MAY GIVE RISE TO CONFLICTS OF INTEREST. +Steven Roth, Vornado and Interstate may exercise substantial influence over us. They and some of our other directors and officers have interests or positions in other entities that may compete with us. +As of December 31, 2018 , Interstate and its partners owned approximately 7.1% of the common shares of beneficial interest of Vornado and approximately 26.2% of our outstanding common stock. Steven Roth, David Mandelbaum and Russell B. Wight, Jr. are the partners of Interstate. Mr. Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Chairman of the Board of Trustees and Chief Executive Officer of Vornado and the Managing General Partner of Interstate. Mr. Wight and Mr. Mandelbaum are both trustees of Vornado and members of our Board of Directors. In addition, Vornado manages and leases the real estate assets of Interstate. +As of December 31, 2018 , Vornado owned 32.4% of our outstanding common stock, in addition to the 26.2% owned by Interstate and its partners. In addition to the relationships described in the immediately preceding paragraph, Dr. Richard West is a trustee of Vornado and a member of our Board of Directors and Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco is our Chief Financial Officer and the Executive Vice President - Chief Accounting Officer of Vornado. +Because of their overlapping interests, Vornado, Mr. Roth, Interstate and the other individuals noted in the preceding paragraphs may have substantial influence over Alexander’s, and on the outcome of any matters submitted to Alexander’s stockholders for approval. In addition, certain decisions concerning our operations or financial structure may present conflicts of interest among Vornado, Messrs. Roth, Mandelbaum and Wight and Interstate and other security holders. Vornado, Mr. Roth and Interstate may, in the future, engage in a wide variety of activities in the real estate business which may result in conflicts of interest with respect to matters affecting us, such as, which of these entities or persons, if any, may take advantage of potential business opportunities, the business focus of these entities, the types of properties and geographic locations in which these entities make investments, potential competition between business activities conducted, or sought to be conducted, by us, competition for properties and tenants, possible corporate transactions such as acquisitions, and other strategic decisions affecting the future of these entities. +There may be conflicts of interest between Vornado, its affiliates and us. +Vornado manages, develops and leases our properties under agreements that have one-year terms expiring in March of each year, which are automatically renewable. Because we share common senior management with Vornado and because four of the trustees of Vornado are on our Board of Directors, the terms of the foregoing agreements and any future agreements may not be comparable to those we could have negotiated with an unaffiliated third party. +For a description of Interstate’s ownership of Vornado and Alexander’s, see “Steven Roth, Vornado and Interstate may exercise substantial influence over us. They and some of our other directors and officers have interests or positions in other entities that may compete with us.” above. +17 +THE NUMBER OF SHARES OF ALEXANDER’S COMMON STOCK AND THE MARKET FOR THOSE SHARES GIVE RISE TO VARIOUS RISKS. +The trading price of our common shares has been volatile and may continue to fluctuate. +The trading price of our common shares has been volatile and may continue to fluctuate widely as a result of a number of factors, many of which are outside of our control. In addition, the stock market is subject to fluctuations in the share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations have in the past and may in the future adversely affect the market price of our common shares. Among the factors that could affect the price of our common shares are: +• +our financial condition and performance; +• +the financial condition of our tenants, including the extent of tenant bankruptcies or defaults; +• +actual or anticipated quarterly fluctuations in our operating results and financial condition; +• +our dividend policy; +• +the reputation of REITs and real estate investments generally and the attractiveness of REIT equity securities in comparison to other equity securities, including securities issued by other real estate companies, and fixed income securities; +• +uncertainty and volatility in the equity and credit markets; +• +fluctuations in interest rates; +• +changes in revenue or earnings estimates or publication of research reports and recommendations by financial analysts or actions taken by rating agencies with respect to our securities or those of other REITs; +• +failure to meet analysts’ revenue or earnings estimates; +• +speculation in the press or investment community; +• +strategic actions by us or our competitors, such as acquisitions or restructurings; +• +the extent of institutional investor interest in us; +• +the extent of short-selling of our common shares and the shares of our competitors; +• +fluctuations in the stock price and operating results of our competitors; +• +general financial and economic market conditions and, in particular, developments related to market conditions for REITs and other real estate related companies; +• +domestic and international economic factors unrelated to our performance; +• +changes in tax laws and rules; and +• +all other risk factors addressed elsewhere in this Annual Report on Form 10-K. +A significant decline in our stock price could result in substantial losses for stockholders. +Alexander’s has additional shares of its common stock available for future issuance, which could decrease the market price of the common stock currently outstanding. +The interest of our current stockholders could be diluted if we issue additional equity securities. As of December 31, 2018 , we had authorized but unissued 4,826,550 shares of common stock, par value of $1.00 per share and 3,000,000 shares of preferred stock, par value $1.00 per share; of which 10,057 shares of common stock are reserved for issuance upon redemption of the deferred stock units previously granted to our Board of Directors. In addition, 495,730 shares are available for future grant under the terms of our 2016 Omnibus Stock Plan. These awards may be granted in the form of options, restricted stock, stock appreciation rights, deferred stock units, or other equity-based interests, and if granted, would reduce that number of shares available for future grants, provided however that an award that may be settled only in cash, would not reduce the number of shares available under the plan. We cannot predict the impact that future issuances of common or preferred stock or any exercise of outstanding options or grants of additional equity-based interests would have on the market price of our common stock. +ITEM 1B. UNRESOLVED STAFF COMMENTS +There are no unresolved comments from the staff of the Securities and Exchange Commission as of the date of this Annual Report on Form 10-K. +18 +ITEM 2. PROPERTIES +The following table shows the location, ownership, approximate size (excluding parking garages) and occupancy of each of our properties as of December 31, 2018 . +Average +Annualized +Lease Expiration (s) +Land +Building +Occupancy +Rent Per +Original +Option +Property +Acreage +Square Feet +Rate +Square Foot +(1) +Tenants +Term +(2) +Term +(3) +Operating Properties: +731 Lexington Avenue +New York, New York +Office +889,000 +100% +$ +117.66 +Bloomberg L.P. +2029 +2039 +Retail +83,000 +The Home Depot +2025 +2035 +34,000 +The Container Store +2021 +N/A +27,000 +Hennes & Mauritz +2019 +N/A +30,000 +Various +Various +Various +174,000 +99% +193.81 +1.9 +1,063,000 +Rego Park I +Queens, New York +50,000 +Burlington +2022 +2027 +46,000 +Bed Bath & Beyond +2021 +N/A +36,000 +Marshalls +2021 +N/A +16,000 +Old Navy +2021 +N/A +195,000 +(4) +N/A +N/A +4.8 +343,000 +43% +46.93 +Rego Park II +Queens, New York +145,000 +Costco +2034 +2059 +135,000 +Century 21 +2031 +2051 +133,000 +Kohl’s (5) +2031 +2051 +47,000 +(6) +N/A +N/A +149,000 +Various +Various +Various +6.6 +609,000 +100% +44.73 +The Alexander apartment tower, 312 units +Queens, New York +— +255,000 +96% +45.09 +(7) +Residential +(8) +N/A +Paramus +Paramus, New Jersey +30.3 +— +100% +— +IKEA (ground lessee) +2041 +N/A +Flushing +Queens, New York (9) +1 +167,000 +100% +18.22 +New World Mall LLC +2027 +2037 +Property to be Developed: +Rego Park III, adjacent to Rego Park II +Queens, New York +3.2 +— +— +— +— +— +— +2,437,000 +(1) +Represents the contractual weighted average rent per square foot, which excludes the impact of tenant concessions (such as free rent) and tenant reimbursements, as of December 31, 2018. For a discussion of our leasing activity, see Item 7 - Overview - Square Footage, Occupancy and Leasing Activity. +(2) +Represents the year in which the tenant’s lease expires, without consideration of any renewal or extension options. Lease expiration dates are based on non-cancelable lease terms and do not extend beyond any early termination rights that tenants may have under their lease. +(3) +Represents the year in which the tenant’s lease expires if all renewal or extension options are exercised. +(4) +Formerly occupied by Sears. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. +(5) +On January 10, 2019, Kohl’s announced that it plans to close and sublease its store at the property; Kohl’s remains obligated to us under its lease which expires in January 2031. +(6) +Formerly occupied by Toys. On September 18, 2017, Toys filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its lease and possession of the space was returned to us. Occupied by a temporary tenant as of December 31, 2018. +(7) +Average monthly rent per unit is $3,075. +(8) +Residential tenants have one or two year leases. +(9) +Ground leased through January 2027 with one 10-year extension option. +19 +Operating Properties +731 Lexington Avenue +731 Lexington Avenue, a 1,311,000 square foot multi-use building, comprises the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan, New York, and is situated in the heart of one of Manhattan’s busiest business and shopping districts, with convenient access to several subway and bus lines. The property is located across the street from Bloomingdale’s flagship store and only a few blocks away from Fifth Avenue and 57 th Street. The building contains 889,000 and 174,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg occupies all of the office space. The Home Depot (83,000 square feet), The Container Store (34,000 square feet) and Hennes & Mauritz (27,000 square feet) are the principal retail tenants. +The office portion of 731 Lexington Avenue is encumbered by a mortgage loan with a balance of $500,000,000 as of December 31, 2018 . The interest-only loan is at LIBOR plus 0.90% (3.36% as of December 31, 2018 ) and matures in June 2020, with four one-year extension options. In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. +The retail portion of 731 Lexington Avenue is encumbered by a mortgage loan with a balance of $350,000,000 as of December 31, 2018 . The interest-only loan is at LIBOR plus 1.40% ( 3.78% as of December 31, 2018 ) and matures in August 2020, with two one-year extension options. +Rego Park I +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls. The center contains a parking deck (1,241 spaces) that provides for paid parking. +Rego Park II +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On January 10, 2019, Kohl’s announced that it plans to close and sublease its store at the property; Kohl’s remains obligated to us under its lease which expires in January 2031. On September 18, 2017, Toys, a one-third owned affiliate of Vornado as of December 31, 2018, filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its 47,000 square foot lease at the property ($2,600,000 of annual revenue) and possession of the space was returned to us. The center contains a parking deck (1,326 spaces) that provides for paid parking. +This center is encumbered by a mortgage loan with a balance of $252,544,000 as of December 31, 2018 . The loan bears interest at LIBOR plus 1.35% (3.87% as of December 31, 2018 ) and matures in December 2025. We hold a $195,708,000 participation in the loan at LIBOR plus 1.35%. +The Alexander Apartment Tower +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet. +20 +Operating Properties - continued +Paramus +We own 30.3 acres of land located at the intersection of Routes 4 and 17 in Paramus, New Jersey. The land is located directly across from the Garden State Plaza regional shopping mall and is within two miles of three other regional shopping malls and ten miles of New York City. The land has been ground leased to IKEA Property, Inc. since 2001. The lease expires in 2041, with a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. +Flushing +Flushing is located on Roosevelt Avenue and Main Street in the downtown, commercial section of Flushing, Queens, New York. Roosevelt Avenue and Main Street are active shopping districts and there are many national retailers located in the area. A subway entrance is located directly in front of the property with bus service across the street. The property comprises a four-floor building containing 167,000 square feet and a parking garage, which is sub-leased to New World Mall LLC for the remainder of our ground lease term, which expires in 2027 and has one 10-year extension option. +Property to be Developed +Rego Park III +We own a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, New York, at the intersection of Junction Boulevard and the Horace Harding Service Road. The land is currently being used for paid public parking. In 2016, the Company began the entitlement process. +ITEM 3. LEGAL PROCEEDINGS +We are from time to time involved in legal actions arising in the ordinary course of business. In our opinion, after consultation with our legal counsel, the outcome of such matters will not have a material effect on our financial condition, results of operations or cash flows. +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4 million and future damages it estimated would not be less than $25 million. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +21 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on the New York Stock Exchange under the symbol “ALX.” +As of January 31, 2019, there were 220 holders of record of our common stock. +Recent Sales of Unregistered Securities +During 2018 , we did not sell any unregistered securities. +Information relating to compensation plans under which our equity securities are authorized for issuance is set forth under Part III, Item 12 of this Annual Report on Form 10-K and such information is incorporated by reference herein. +Recent Purchases of Equity Securities +During 2018 , we did not repurchase any of our equity securities. +22 +Performance Graph +The following graph is a comparison of the five-year cumulative return of our common stock, the Standard & Poor’s 500 Index (the “S&P 500 Index”) and the National Association of Real Estate Investment Trusts’ (“NAREIT”) All Equity Index, a peer group index. The graph assumes that $100 was invested on December 31, 2013 in our common stock, the S&P 500 Index and the NAREIT All Equity Index and that all dividends were reinvested without the payment of any commissions. There can be no assurance that the performance of our stock will continue in line with the same or similar trends depicted in the graph below. +2013 +2014 +2015 +2016 +2017 +2018 +Alexander’s +$ +100 +$ +137 +$ +125 +$ +144 +$ +139 +$ +113 +S&P 500 Index +100 +114 +115 +129 +157 +150 +The NAREIT All Equity Index +100 +128 +132 +143 +155 +149 +23 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth selected financial and operating data. This data should be read in conjunction with the consolidated financial statements and notes thereto and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. This data may not be comparable to, or indicative of, future operating results. +Year Ended December 31, +(Amounts in thousands, except per share amounts) +2018 +2017 +2016 +2015 +2014 +Total revenues +$ +232,825 +$ +230,574 +$ +226,936 +$ +207,915 +$ +200,814 +Income from continuing operations (1) +$ +56,641 +$ +80,509 +$ +86,477 +$ +76,907 +$ +67,396 +(Loss) income from discontinued operations +(23,797 +) +— +— +— +529 +Net income +$ +32,844 +$ +80,509 +$ +86,477 +$ +76,907 +$ +67,925 +Income per common share: +Income from continuing operations - basic +$ +11.07 +$ +15.74 +$ +16.91 +$ +15.04 +$ +13.19 +Income from continuing operations - diluted +11.07 +15.74 +16.91 +15.04 +13.19 +Net income per common share - basic +6.42 +15.74 +16.91 +15.04 +13.29 +Net income per common share - diluted +6.42 +15.74 +16.91 +15.04 +13.29 +Dividends per common share +$ +18.00 +$ +17.00 +$ +16.00 +$ +14.00 +$ +13.00 +Balance sheet data: +Total assets +$ +1,481,257 +$ +1,632,395 +$ +1,451,230 +$ +1,447,808 +$ +1,418,392 +Real estate, at cost +1,027,691 +1,037,368 +1,033,551 +1,029,472 +993,927 +Accumulated depreciation and amortization +297,421 +283,044 +252,737 +225,533 +210,025 +Mortgages payable, net of deferred debt issuance costs +1,161,534 +1,240,222 +1,052,359 +1,053,262 +1,027,956 +Total equity +285,092 +343,955 +352,845 +352,880 +348,399 +(1) +2018 includes $11,990 from the decrease in the fair value of marketable securities resulting from a new GAAP accounting standard effective January 1, 2018. Previously, changes in the fair value of marketable securities were recognized through “accumulated other comprehensive (loss) income” on our consolidated balance sheets and did not impact our consolidated statements of income. +24 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Overview +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. +We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Year Ended December 31, 2018 Financial Results Summary +Net income for the year ended December 31, 2018 was $32,844,000 or $6.42 per diluted share, compared to $80,509,000, or $15.74 per diluted share for the year ended December 31, 2017 . Net income for the year ended December 31, 2018 included (i) $23,797,000, or $4.65 per diluted share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza Regional Shopping Center (“Kings Plaza”) which is being contested and (ii) $11,990,000, or $2.34 per diluted share, from the decrease in the fair value of marketable securities resulting from a new GAAP accounting standard effective January 1, 2018. Previously, changes in the fair value of marketable securities were recognized through “accumulated other comprehensive (loss) income” on our consolidated balance sheets and did not impact our consolidated statements of income. +Funds from operations (“FFO”) (non-GAAP) for the year ended December 31, 2018 was $77,429,000, or $15.13 per diluted share, compared to $114,908,000, or $22.46 per diluted share for the year ended December 31, 2017 . FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the contested Kings Plaza transfer taxes. +Quarter Ended December 31, 2018 Financial Results Summary +Net income for the quarter ended December 31, 2018 was $9,971,000, or $1.95 per diluted share, compared to $17,883,000, or $3.50 per diluted share for the quarter ended December 31, 2017 . Net income for the quarter ended December 31, 2018 included $6,429,000, or $1.26 per diluted share, from the decrease in the fair value of marketable securities. +FFO (non-GAAP) for the quarter ended December 31, 2018 was $24,158,000, or $4.72 per diluted share, compared to $28,062,000, or $5.49 per diluted share for the quarter ended December 31, 2017 . +Square Footage, Occupancy and Leasing Activity +As of December 31, 2018 , our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2018 , our properties had an occupancy rate of 91.4%. +25 +Overview - continued +Real Property Transfer Tax Litigation +In 2012, we sold Kings Plaza and paid real property transfer taxes to New York City in connection with the sale. In 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional New York City real property transfer tax amount, including interest, which we are contesting. +In 2014, in a case with similar facts, the NYC DOF issued a Notice of Determination to a Vornado joint venture assessing an additional New York City real property transfer tax amount, including interest. In January 2017, a New York City administrative law judge made a determination upholding the Vornado joint venture’s position that such additional real property transfer taxes were not due. On February 16, 2018, the New York City Tax Appeals Tribunal (the “Tribunal”) overturned the January 2017 determination. The Vornado joint venture is appealing the Tribunal’s decision to the Appellate Division of the Supreme Court of the State of New York which is scheduled to be heard in the first half of 2019. +In 2018, based on the precedent of the Tribunal’s decision, we recorded an expense for the potential additional real property transfer taxes of $23,797,000 ($15,874,000 of real property transfer tax and $7,923,000 of interest) and paid this amount in order to stop the interest from accruing. Our case is on hold pending the outcome of the Vornado joint venture’s appeal. +Tenant Matters +On April 4, 2017, Sears closed its 195,000 square foot store at our Rego Park I shopping center ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. Consequently, we wrote off the remaining balance of the Sears receivable arising from the straight-lining of rent of $2,973,000 during the year ended December 31, 2018. In addition, we accelerated depreciation and amortization of the remaining balance of $312,000 of deferred leasing costs during the year ended December 31, 2018 . +On September 18, 2017, Toys filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ($2,600,000 of annual revenue) and possession of the space was returned to us. Consequently, we accelerated depreciation and amortization of the remaining balances of $588,000 of tenant improvements and $215,000 of deferred leasing costs during the year ended December 31, 2018. We also wrote off the Toys receivable arising from the straight-lining of rent of $500,000 during the year ended December 31, 2018 . +On January 10, 2019, Kohl’s announced that it plans to close and sublease its 133,000 square foot store at our Rego Park II shopping center; Kohl’s remains obligated to us under its lease which expires in January 2031. +Financing +On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. +On December 12, 2018, we completed a $252,544,000 refinancing of our Rego Park II shopping center. The interest-only loan is at LIBOR plus 1.35% (3.87% as of December 31, 2018) and matures in December 2025. The previous loan bore interest at LIBOR plus 1.85% and was scheduled to mature in January 2019. As of December 31, 2018, we hold a $195,708,000 participation in the mortgage loan, earning interest at LIBOR plus 1.35%. The participation in the previous mortgage loan earned interest at LIBOR plus 1.60%. +Significant Tenant +Bloomberg accounted for revenue of $107,356,000, $105,224,000 and $104,590,000 in the years ended December 31, 2018, 2017 and 2016, respectively, representing approximately 46% of our total revenues in each year. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +26 +Critical Accounting Policies and Estimates +Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 – Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. +Real Estate +Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2018 and 2017, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $730,270,000 and $754,324,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. +Our properties and related intangible assets, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. +Allowance for Doubtful Accounts +We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ($671,000 and $1,501,000 as of December 31, 2018 and 2017, respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. +27 +Critical Accounting Policies and Estimates - continued +Revenue Recognition +Our revenues consist of property rentals and expense reimbursements. We have the following revenue sources and revenue recognition policies: +• +Base Rent is revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. +• +Percentage Rent is revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). +• +Parking Revenue arising from the rental of parking space at our properties. This income is recognized as the services are provided. +• +Operating Expense Reimbursements is revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of our properties. Revenue is recognized in the same period as the related expenses are incurred. +• +Tenant Services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred. +Before we recognize revenue, we assess, among other things, its collectibility. If our assessment of the collectibility of revenue changes, the impact on our consolidated financial statements could be material. +Income Taxes +We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 – 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. +28 +Results of Operations – Year Ended December 31, 2018 compared to December 31, 2017 +Property Rentals +Property rentals were $152,795,000 in the year ended December 31, 2018 , compared to $152,857,000 in the prior year, a decrease of $62,000. This decrease was primarily due to lower revenue from Sears at our Rego Park I property and Toys at our Rego Park II property, partially offset by higher revenue from a new restaurant tenant at our 731 Lexington Avenue property. +Expense Reimbursements +Tenant expense reimbursements were $80,030,000 in the year ended December 31, 2018 , compared to $77,717,000 in the prior year, an increase of $2,313,000. This increase was primarily due to higher real estate taxes and higher operating expenses. +Operating Expenses +Operating expenses were $93,775,000 in the year ended December 31, 2018 , compared to $85,127,000 in the prior year, an increase of $8,648,000. This increase was primarily due to (i) higher bad debt expense of $4,406,000, (ii) higher real estate taxes of $2,180,000 and (iii) higher operating expenses of $1,664,000. +Depreciation and Amortization +Depreciation and amortization was $33,089,000 in the year ended December 31, 2018 , compared to $34,925,000 in the prior year, a decrease of $1,836,000. This decrease was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in 2017. +General and Administrative Expenses +General and administrative expenses were $5,339,000 in the year ended December 31, 2018 , compared to $5,252,000 in the prior year, an increase of $87,000. +Interest and Other Income, net +Interest and other income, net was $12,546,000 in the year ended December 31, 2018 , compared to $6,716,000 in the prior year, an increase of $5,830,000. This increase was primarily due to (i) $4,673,000 of higher interest income from the Rego Park II loan participation entered into in July 2017 and (ii) $3,693,000 of higher interest income due to an increase in average interest rates, partially offset by (iii) $1,600,000 of expense from a litigation settlement and (iv) $760,000 of lower interest income due to lower average investment balances. +Interest and Debt Expense +Interest and debt expense was $44,533,000 in the year ended December 31, 2018 , compared to $31,474,000 in the prior year, an increase of $13,059,000. This increase was primarily due to (i) $8,482,000 resulting from an increase in average LIBOR, (ii) $2,620,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,641,000 of higher amortization of debt issuance costs. +Change in Fair Value of Marketable Securities +Change in fair value of marketable securities was an expense of $11,990,000 in the year ended December 31, 2018, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively, on 535,265 shares owned. See Note 5 – Marketable Securities , to our consolidated financial statements in this Annual Report on Form 10-K. +Income Taxes +Income tax expense was $4,000 in the year ended December 31, 2018 , compared to $3,000 in the prior year. +Loss from Discontinued Operations +Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to a payment of potential additional real property transfer taxes from the 2012 sale of Kings Plaza which is being contested. See Note 6 – Discontinued Operations , to our consolidated financial statements in this Annual Report on Form 10-K. +29 +Results of Operations – Year Ended December 31, 2017 compared to December 31, 2016 +Property Rentals +Property rentals were $152,857,000 in the year ended December 31, 2017, compared to $151,444,000 in the prior year, an increase of $1,413,000. This increase was primarily due to higher rental income of $3,730,000 from The Alexander apartment tower, which was placed in service in phases beginning July 2015 and leased up to stabilization in September 2016, partially offset by income of $2,257,000 in 2016 resulting from a tenant lease termination at our Rego Park II property. +Expense Reimbursements +Tenant expense reimbursements were $77,717,000 in the year ended December 31, 2017, compared to $75,492,000 in the prior year, an increase of $2,225,000. This increase was primarily due to higher real estate taxes and higher operating expenses. +Operating Expenses +Operating expenses were $85,127,000 in the year ended December 31, 2017, compared to $82,232,000 in the prior year, an increase of $2,895,000. This increase was primarily due to (i) higher real estate taxes of $3,267,000 and (ii) higher operating expenses of $903,000, partially offset by (iii) lower marketing costs for The Alexander apartment tower of $1,098,000 and (iv) lower bad debt expense of $504,000. +Depreciation and Amortization +Depreciation and amortization was $34,925,000 in the year ended December 31, 2017, compared to $33,807,000 in the prior year, an increase of $1,118,000. This increase was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in 2017, partially offset by additional depreciation and amortization of tenant improvements and deferred leasing costs of $1,077,000 in 2016 related to a tenant lease termination at our Rego Park II property. +General and Administrative Expenses +General and administrative expenses were $5,252,000 in the year ended December 31, 2017, compared to $5,436,000 in the prior year, a decrease of $184,000. This decrease was primarily due to lower director’s fees and stock-based compensation expense as a result of having one less member on our Board of Directors in 2017. +Interest and Other Income, net +Interest and other income, net was $6,716,000 in the year ended December 31, 2017, compared to $3,305,000 in the prior year, an increase of $3,411,000. This increase was primarily due to higher interest income of (i) $2,453,000 from the Rego Park II loan participation, (ii) $1,418,000 from an increase in the average interest rates and (iii) $216,000 from an increase in the average investment balances, partially offset by (iv) lower income of $429,000 in connection with bankruptcy recoveries and (v) income of $367,000 in 2016 from a cost reimbursement settlement with a retail tenant at our 731 Lexington Avenue property. +Interest and Debt Expense +Interest and debt expense was $31,474,000 in the year ended December 31, 2017, compared to $22,241,000 in the prior year, an increase of $9,233,000. This increase was primarily due to (i) $5,289,000 resulting from an increase in average LIBOR, (ii) $2,658,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,188,000 of higher amortization of debt issuance costs. +Income Taxes +Income tax expense was $3,000 in the year ended December 31, 2017, compared to $48,000 in the prior year. +30 +Related Party Transactions +Vornado +As of December 31, 2018 , Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 4 – Related Party Transactions , to our consolidated financial statements in this Annual Report on Form 10-K. +Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2018 , Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.2% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Toys +Our affiliate, Vornado, owned 32.5% of Toys as of December 31, 2018. On February 1, 2019, in connection with the Toys Chapter 11 bankruptcy, the plan of reorganization for Toys was declared effective and Vornado’s ownership in Toys was canceled and Toys’ Board of Directors was dissolved. Joseph Macnow, Vornado’s Executive Vice President and Chief Financial Officer and Wendy A. Silverstein, a member of our Board of Directors, represented Vornado as members of Toys’ Board of Directors. Also in connection with the Toys Chapter 11 bankruptcy, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ($2,600,000 of annual revenue) effective June 30, 2018 and possession of the space was returned to us. Consequently, we accelerated depreciation and amortization of the remaining balances of $588,000 of tenant improvements and $215,000 of deferred leasing costs during the year ended December 31, 2018 . We also wrote off the Toys receivable arising from the straight-lining of rent of $500,000 during the year ended December 31, 2018 . +Liquidity and Capital Resources +Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization and capital expenditures. +Dividends +On January 16, 2019, we set our regular quarterly dividend to $4.50 per share (an indicated annual rate of $18.00 per share). The dividend, when declared by the Board of Directors for all of 2019, will require us to pay out approximately $92,100,000. +Financing Activities and Contractual Obligations +On June 1, 2017, we completed a $500,000,000 refinancing of the office portion of 731 Lexington Avenue. The interest-only loan is at LIBOR plus 0.90% (3.36% as of December 31, 2018) and matures in June 2020, with four one-year extension options. In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. The property was previously encumbered by a $300,000,000 interest-only mortgage at LIBOR plus 0.95% which was scheduled to mature in March 2021. +On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. +31 +Liquidity and Capital Resources - continued +On December 12, 2018, we completed a $252,544,000 refinancing of our Rego Park II shopping center. The interest-only loan is at LIBOR plus 1.35% (3.87% as of December 31, 2018) and matures in December 2025. The previous loan bore interest at LIBOR plus 1.85% and was scheduled to mature in January 2019. As of December 31, 2018, we hold a $195,708,000 participation in the mortgage loan, earning interest at LIBOR plus 1.35%. The participation in the previous mortgage loan earned interest at LIBOR plus 1.60%. +Below is a summary of our outstanding debt and maturities as of December 31, 2018 . We may refinance our maturing debt as it comes due or choose to repay it. +Balance +Interest Rate +Maturity (1) +(Amounts in thousands) +Paramus +$ +68,000 +4.72 +% +Oct. 2021 +731 Lexington Avenue, retail space (2) +350,000 +3.78 +% +Aug. 2022 +731 Lexington Avenue, office space (3) +500,000 +3.36 +% +Jun. 2024 +Rego Park II shopping center (4) +252,544 +3.87 +% +Dec. 2025 +Total +1,170,544 +Deferred debt issuance costs, net of accumulated amortization of $9,212 +(9,010 +) +Total, net +$ +1,161,534 +(1) Represents the extended maturity where we have the unilateral right to extend. +(2) Interest at LIBOR plus 1.40%. +(3) Interest at LIBOR plus 0.90%. +(4) Interest at LIBOR plus 1.35%. See above for details of our Rego Park II loan participation. +Below is a summary of our contractual obligations and commitments as of December 31, 2018 . +Less than +One to +Three to +More than +(Amounts in thousands) +Total +One Year +Three Years +Five Years +Five Years +Contractual obligations (principal and interest) (1) : +Long-term debt obligations +$ +1,388,931 +$ +43,602 +$ +154,502 +$ +411,860 +$ +778,967 +Operating lease obligations +6,467 +800 +1,600 +1,600 +2,467 +$ +1,395,398 +$ +44,402 +$ +156,102 +$ +413,460 +$ +781,434 +Commitments: +Standby letters of credit +$ +1,030 +$ +1,020 +$ +10 +$ +— +$ +— +(1) +Interest on variable rate debt is computed using rates in effect as of December 31, 2018 . +Commitments and Contingencies +Insurance +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $323,000 deductible and 19% of the balance of a covered loss, and the Federal government is responsible for the remaining 81% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +32 +Liquidity and Capital Resources - continued +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Rego Park I Litigation +In June 2014, Sears filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4 million and future damages it estimated would not be less than $25 million. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +Paramus +In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. +Letters of Credit +Approximately $1,030,000 of standby letters of credit were outstanding as of December 31, 2018 . +Other +We received $165,000, $396,000 and $825,000 from bankruptcy recoveries during the years ended December 31, 2018, 2017 and 2016, respectively, which is included as “interest and other income, net” in our consolidated statements of income. +There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. +33 +Liquidity and Capital Resources - continued +Cash Flows for the Year Ended December 31, 2018 +Cash and cash equivalents and restricted cash were $289,495,000 at December 31, 2018 , compared to $393,279,000 at December 31, 2017 , a decrease of $103,784,000. This decrease resulted from (i) $176,185,000 of net cash used in financing activities and (ii) $1,137,000 of net cash used in investing activities, partially offset by (iii) $73,538,000 of net cash provided by operating activities. +Net cash used in financing activities of $176,185,000 was primarily comprised of net debt repayments of $81,896,000 (primarily the refinancing and subsequent repayment of the mortgage loan on our Rego Park I shopping center) and dividends paid of $92,100,000. +Net cash used in investing activities of $1,137,000 was comprised of construction in progress and real estate additions of $3,966,000, partially offset by repayment of Rego Park II loan participation of $2,829,000. +Net cash provided by operating activities of $73,538,000 was comprised of (i) net income of $32,844,000 and (ii) adjustments for non-cash items of $56,807,000, partially offset by (iii) the net change in operating assets and liabilities of $16,113,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,499,000, (ii) the change in fair value of marketable securities of $11,990,000, (iii) straight-lining of rental income of $5,924,000 and (iv) stock-based compensation expense of $394,000. +Cash Flows for the Year Ended December 31, 2017 +Cash and cash equivalents and restricted cash were $393,279,000 at December 31, 2017, compared to $374,678,000 at December 31, 2016, an increase of $18,601,000. This increase resulted from (i) $123,426,000 of net cash provided by operating activities and (ii) $97,146,000 of net cash provided by financing activities, partially offset by (iii) $201,971,000 of net cash used in investing activities. +Net cash provided by operating activities of $123,426,000 was comprised of (i) net income of $80,509,000 and (ii) adjustments for non-cash items of $43,372,000, partially offset by (iii) the net change in operating assets and liabilities of $455,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,681,000, (ii) straight-lining of rental income of $4,297,000 and (iii) stock-based compensation expense of $394,000. +Net cash provided by financing activities of $97,146,000 was primarily comprised of (i) $500,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue, partially offset by (ii) debt repayments of $303,707,000 (primarily the repayment of the former loan on the office portion of 731 Lexington Avenue) and (iii) dividends paid of $86,961,000. +Net cash used in investing activities of $201,971,000 was comprised of (i) Rego Park II loan participation of $200,000,000 and (ii) construction in progress and real estate additions of $3,434,000, partially offset by (iii) principal repayment proceeds from the Rego Park II loan participation of $1,463,000. +Cash Flows for the Year Ended December 31, 2016 +Cash and cash equivalents and restricted cash were $374,678,000 at December 31, 2016, compared to $344,656,000 at December 31, 2015, an increase of $30,022,000. This increase resulted from (i) $130,820,000 of net cash provided by operating activities, partially offset by (ii) $85,292,000 of net cash used in financing activities and (iii) $15,506,000 of net cash used in investing activities. +Net cash provided by operating activities of $130,820,000 was comprised of (i) net income of $86,477,000, (ii) adjustments for non-cash items of $39,171,000, and (iii) the net change in operating assets and liabilities of $5,172,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $36,374,000, (ii) straight-lining of rental income of $2,347,000 and (iii) stock-based compensation expense of $450,000. +Net cash used in financing activities of $85,292,000 was primarily comprised of dividends paid of $81,822,000. +Net cash used in investing activities of $15,506,000 was comprised of construction in progress and real estate additions of $15,506,000 (primarily related to The Alexander apartment tower), including the payment of a development fee to Vornado of $5,784,000. +34 +Funds from Operations (“FFO”) (non-GAAP) +FFO is computed in accordance with the December 2018 restated definition adopted by the Board of Governors of NAREIT. NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciable real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. +In accordance with the NAREIT December 2018 restated definition of FFO, we have elected to exclude the mark-to-market adjustments of marketable securities from the calculation of FFO. Our FFO for the nine months ended September 30, 2018 has been adjusted to exclude the $5,561,000, or $1.08 per diluted share, from the decrease in fair value of marketable securities previously reported. Net income for the year and quarter ended December 31, 2018 included $11,990,000, or $2.34 per diluted share, and $6,429,000, or $1.26 per diluted share, respectively, from the decrease in fair value of marketable securities. +FFO (non-GAAP) for the years and quarters ended December 31, 2018 and 2017 +FFO (non-GAAP) for the year ended December 31, 2018 was $77,429,000, or $15.13 per diluted share, compared to $114,908,000, or $22.46 per diluted share for the year ended December 31, 2017 . FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza which is being contested. +FFO (non-GAAP) for the quarter ended December 31, 2018 was $24,158,000, or $4.72 per diluted share, compared to $28,062,000, or $5.49 per diluted share for the quarter ended December 31, 2017 . +The following table reconciles our net income to FFO (non-GAAP): +For the Year Ended +For the Three Months Ended +(Amounts in thousands, except share and per share amounts) +December 31, +December 31, +2018 +2017 +2018 +2017 +Net income +$ +32,844 +$ +80,509 +$ +9,971 +$ +17,883 +Depreciation and amortization of real property +32,595 +34,399 +7,758 +10,179 +Change in fair value of marketable securities +11,990 +— +6,429 +— +FFO (non-GAAP) +$ +77,429 +$ +114,908 +$ +24,158 +$ +28,062 +FFO per diluted share (non-GAAP) +$ +15.13 +$ +22.46 +$ +4.72 +$ +5.49 +Weighted average shares used in computing FFO per diluted share +5,116,838 +5,115,501 +5,117,347 +5,115,982 +35 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +We have exposure to fluctuations in interest rates, which are sensitive to many factors that are beyond our control. Our exposure to a change in interest rates is summarized in the table below. +2018 +2017 +December 31, Balance +Weighted Average Interest Rate +Effect of 1% Change in Base Rates +December 31, Balance +Weighted Average Interest Rate +(Amounts in thousands, except per share amounts) +Variable rate +$ +1,102,544 +3.61% +$ +11,025 +$ +1,106,194 +2.75% +Fixed rate +68,000 +4.72% +— +146,246 +1.54% +$ +1,170,544 +3.67% +$ +11,025 +$ +1,252,440 +2.61% +Total effect on diluted earnings per share +$ +2.15 +As of December 31, 2018 we had an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. +Fair Value of Debt +The fair value of our consolidated debt is calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist. As of December 31, 2018 and 2017 , the estimated fair value of our consolidated debt was $1,165,000,000 and $1,239,000,000, respectively. Our fair value estimates, which are made at the end of the reporting period, may be different from the amounts that may ultimately be realized upon the disposition of our financial instruments. +36 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Index to Consolidated Financial Statements +Page +Number +Report of Independent Registered Public Accounting Firm +38 +Consolidated Balance Sheets as of December 31, 2018 and 2017 +39 +Consolidated Statements of Income for the +Years Ended December 31, 2018, 2017 and 2016 +40 +Consolidated Statements of Comprehensive Income for the +Years Ended December 31, 2018, 2017 and 2016 +41 +Consolidated Statements of Changes in Equity for the +Years Ended December 31, 2018, 2017 and 2016 +42 +Consolidated Statements of Cash Flows for the +Years Ended December 31, 2018, 2017 and 2016 +43 +Notes to Consolidated Financial Statements +44 +37 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and the Board of Directors of +Alexander’s, Inc. +Paramus, New Jersey +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Alexander’s, Inc. and subsidiaries (the “Company”) as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, changes in equity, and cash flows, for each of the three years in the period ended December 31, 2018, and the related notes and the schedules listed in the Index at Item 15 (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 11, 2019, expressed an unqualified opinion on the Company’s internal control over financial reporting. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ DELOITTE & TOUCHE LLP +Parsippany, New Jersey +February 11, 2019 +We have served as the Company’s auditor since 1969. +38 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +(Amounts in thousands, except share and per share amounts) +December 31, +ASSETS +2018 +2017 +Real estate, at cost: +Land +$ +44,971 +$ +44,971 +Buildings and leasehold improvements +978,474 +988,846 +Development and construction in progress +4,246 +3,551 +Total +1,027,691 +1,037,368 +Accumulated depreciation and amortization +(297,421 +) +(283,044 +) +Real estate, net +730,270 +754,324 +Cash and cash equivalents +283,056 +307,536 +Restricted cash +6,439 +85,743 +Rego Park II loan participation +195,708 +198,537 +Marketable securities +23,166 +35,156 +Tenant and other receivables, net of allowance for doubtful accounts of $671 and $1,501, respectively +4,075 +2,693 +Receivable arising from the straight-lining of rents +168,789 +174,713 +Deferred lease and other property costs, net, including unamortized leasing fees to Vornado of +$31,039 and $35,152, respectively +40,669 +45,790 +Other assets +29,085 +27,903 +$ +1,481,257 +$ +1,632,395 +LIABILITIES AND EQUITY +Mortgages payable, net of deferred debt issuance costs +$ +1,161,534 +$ +1,240,222 +Amounts due to Vornado +708 +2,490 +Accounts payable and accrued expenses +30,889 +42,827 +Other liabilities +3,034 +2,901 +Total liabilities +1,196,165 +1,288,440 +Commitments and contingencies +Preferred stock: $1.00 par value per share; authorized, 3,000,000 shares; +issued and outstanding, none +— +— +Common stock: $1.00 par value per share; authorized, 10,000,000 shares; +issued, 5,173,450 shares; outstanding, 5,107,290 shares +5,173 +5,173 +Additional capital +31,971 +31,577 +Retained earnings +248,443 +302,543 +Accumulated other comprehensive (loss) income +(127 +) +5,030 +285,460 +344,323 +Treasury stock: 66,160 shares, at cost +(368 +) +(368 +) +Total equity +285,092 +343,955 +$ +1,481,257 +$ +1,632,395 +See notes to consolidated financial statements. +39 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +(Amounts in thousands, except share and per share amounts) +Year Ended December 31, +2018 +2017 +2016 +REVENUES +Property rentals +$ +152,795 +$ +152,857 +$ +151,444 +Expense reimbursements +80,030 +77,717 +75,492 +Total revenues +232,825 +230,574 +226,936 +EXPENSES +Operating, including fees to Vornado of $4,700, $4,671 and $4,590, respectively +93,775 +85,127 +82,232 +Depreciation and amortization +33,089 +34,925 +33,807 +General and administrative, including management fees to Vornado of $2,380 +in each year +5,339 +5,252 +5,436 +Total expenses +132,203 +125,304 +121,475 +OPERATING INCOME +100,622 +105,270 +105,461 +Interest and other income, net +12,546 +6,716 +3,305 +Interest and debt expense +(44,533 +) +(31,474 +) +(22,241 +) +Change in fair value of marketable securities (see Note 5) +(11,990 +) +— +— +Income before income taxes +56,645 +80,512 +86,525 +Income tax expense +(4 +) +(3 +) +(48 +) +Income from continuing operations +56,641 +80,509 +86,477 +Loss from discontinued operations (see Note 6) +(23,797 +) +— +— +Net income +$ +32,844 +$ +80,509 +$ +86,477 +Income per common share - basic and diluted: +Income from continuing operations +$ +11.07 +$ +15.74 +$ +16.91 +Loss from discontinued operations (see Note 6) +(4.65 +) +— +— +Net income per common share +$ +6.42 +$ +15.74 +$ +16.91 +Weighted average shares outstanding- basic and diluted +5,116,838 +5,115,501 +5,114,084 +See notes to consolidated financial statements. +40 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +(Amounts in thousands) +Year Ended December 31, +2018 +2017 +2016 +Net income +$ +32,844 +$ +80,509 +$ +86,477 +Other comprehensive (loss) income: +Change in fair value of marketable securities (see Note 5) +— +(2,762 +) +(5,273 +) +Change in value of interest rate cap +(1 +) +(70 +) +133 +Comprehensive income +$ +32,843 +$ +77,677 +$ +81,337 +See notes to consolidated financial statements. +41 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +(Amounts in thousands) +Accumulated +Other +Comprehensive +Income (Loss) +Common Stock +Additional +Capital +Retained +Earnings +Treasury +Stock +Total +Equity +Shares +Amount +Balance, December 31, 2015 +5,173 +$ +5,173 +$ +30,739 +$ +304,340 +$ +13,002 +$ +(374 +) +$ +352,880 +Net income +— +— +— +86,477 +— +— +86,477 +Dividends paid +— +— +— +(81,822 +) +— +— +(81,822 +) +Change in fair value of marketable securities +— +— +— +— +(5,273 +) +— +(5,273 +) +Change in fair value of interest rate cap +— +— +— +— +133 +— +133 +Deferred stock unit grants +— +— +450 +— +— +— +450 +Balance, December 31, 2016 +5,173 +5,173 +31,189 +308,995 +7,862 +(374 +) +352,845 +Net income +— +— +— +80,509 +— +— +80,509 +Dividends paid +— +— +— +(86,961 +) +— +— +(86,961 +) +Change in fair value of marketable securities +— +— +— +— +(2,762 +) +— +(2,762 +) +Change in fair value of interest rate cap +— +— +— +— +(70 +) +(70 +) +Deferred stock unit grants +— +— +394 +— +— +— +394 +Other +— +— +(6 +) +— +— +6 +— +Balance, December 31, 2017 +5,173 +5,173 +31,577 +302,543 +5,030 +(368 +) +343,955 +Net income +— +— +— +32,844 +— +— +32,844 +Dividends paid +— +— +— +(92,100 +) +— +— +(92,100 +) +Cumulative effect of change in accounting +principle (see Note 2) +— +— +— +5,156 +(5,156 +) +— +— +Change in fair value of interest rate cap +— +— +— +— +(1 +) +— +(1 +) +Deferred stock unit grants +— +— +394 +— +— +— +394 +Balance, December 31, 2018 +5,173 +$ +5,173 +$ +31,971 +$ +248,443 +$ +(127 +) +$ +(368 +) +$ +285,092 +See notes to consolidated financial statements. +42 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(Amounts in thousands) +Year Ended December 31, +2018 +2017 +2016 +CASH FLOWS FROM OPERATING ACTIVITIES +Net income +$ +32,844 +$ +80,509 +$ +86,477 +Adjustments to reconcile net income to net cash provided by operating activities: +Depreciation and amortization, including amortization of debt issuance costs +38,499 +38,681 +36,374 +Straight-lining of rental income +5,924 +4,297 +2,347 +Stock-based compensation expense +394 +394 +450 +Change in fair value of marketable securities (see Note 5) +11,990 +— +— +Change in operating assets and liabilities: +Tenant and other receivables, net +(1,382 +) +363 +958 +Other assets +(1,197 +) +(2,627 +) +(9,894 +) +Amounts due to Vornado +(1,907 +) +1,626 +(1,913 +) +Accounts payable and accrued expenses +(11,760 +) +211 +16,049 +Other liabilities +133 +(28 +) +(28 +) +Net cash provided by operating activities +73,538 +123,426 +130,820 +CASH FLOWS FROM INVESTING ACTIVITIES +Construction in progress and real estate additions +(3,966 +) +(3,434 +) +(15,506 +) +Rego Park II loan participation +— +(200,000 +) +— +Repayment of Rego Park II loan participation +2,829 +1,463 +— +Net cash used in investing activities +(1,137 +) +(201,971 +) +(15,506 +) +CASH FLOWS FROM FINANCING ACTIVITIES +Debt repayments +(160,142 +) +(303,707 +) +(3,440 +) +Proceeds from borrowing +78,246 +500,000 +— +Dividends paid +(92,100 +) +(86,961 +) +(81,822 +) +Debt issuance costs +(2,189 +) +(12,186 +) +(30 +) +Net cash (used in) provided by financing activities +(176,185 +) +97,146 +(85,292 +) +Net (decrease) increase in cash and cash equivalents and restricted cash +(103,784 +) +18,601 +30,022 +Cash and cash equivalents and restricted cash at beginning of year +393,279 +374,678 +344,656 +Cash and cash equivalents and restricted cash at end of year +$ +289,495 +$ +393,279 +$ +374,678 +RECONCILIATION OF CASH AND CASH EQUIVALENTS AND RESTRICTED CASH +Cash and cash equivalents at beginning of year +$ +307,536 +$ +288,926 +$ +259,349 +Restricted cash at beginning of year +85,743 +85,752 +85,307 +Cash and cash equivalents and restricted cash at beginning of year +$ +393,279 +$ +374,678 +$ +344,656 +Cash and cash equivalents at end of year +$ +283,056 +$ +307,536 +$ +288,926 +Restricted cash at end of year +6,439 +85,743 +85,752 +Cash and cash equivalents and restricted cash at end of year +$ +289,495 +$ +393,279 +$ +374,678 +SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION +Cash payments for interest +$ +38,231 +$ +26,994 +$ +19,517 +NON-CASH TRANSACTIONS +Write-off of fully amortized and/or depreciated assets +$ +16,090 +$ +4,265 +$ +1,691 +Liability for real estate additions, including $125, $21 and $54 for development fees due to +Vornado in 2018, 2017 and 2016, respectively +631 +705 +322 +See notes to consolidated financial statements. +43 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• +731 Lexington Avenue, a 1,311,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 889,000 and 174,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot ( 83,000 square feet), The Container Store ( 34,000 square feet) and Hennes & Mauritz ( 27,000 square feet) are the principal retail tenants; +• +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ( $10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On January 10, 2019, Kohl’s announced that it plans to close and sublease its store at the property; Kohl’s remains obligated to us under its lease which expires in January 2031. On September 18, 2017, Toys “R” Us, Inc. (“Toys”), a one-third owned affiliate of Vornado as of December 31, 2018, filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its 47,000 square foot lease at the property ( $2,600,000 of annual revenue) and possession of the space was returned to us; +• +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• +Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA Property, Inc.; and +• +Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• +Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +We have determined that our properties have similar economic characteristics and meet the criteria that permit the properties to be aggregated into one reportable segment (the leasing, management, development and redeveloping of properties in the greater New York City metropolitan area). Our chief operating decision-maker assesses and measures segment operating results based on a performance measure referred to as net operating income at the individual operating segment. Net operating income for each property represents net rental revenues less operating expenses. +44 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation – The accompanying consolidated financial statements include our accounts and those of our consolidated subsidiaries. All intercompany amounts have been eliminated. Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Certain prior year balances have been reclassified in order to conform to the current year presentation. +Recently Issued Accounting Literature – In May 2014, the Financial Accounting Standards Board (“FASB”) issued an update (“ASU 2014-09”) establishing Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers (“ASC 606”). ASU 2014-09, as amended by subsequent ASUs on the topic, establishes a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most of the existing revenue recognition guidance. This standard, which is effective for interim and annual reporting periods in fiscal years that begin after December 15, 2017, requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services and also requires certain additional disclosures. We adopted this standard effective January 1, 2018 using the modified retrospective approach, which allows us to apply the new standard to all existing contracts not yet completed as of the effective date and record a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. The adoption of this standard did not have a material impact on our consolidated financial statements. +In January 2016, the FASB issued an update (“ASU 2016-01”) Recognition and Measurement of Financial Assets and Financial Liabilities to ASC Topic 825, Financial Instruments (“ASC 825”). ASU 2016-01 amends certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2017. We adopted this update effective January 1, 2018 using the modified retrospective approach. While the adoption of this update requires us to continue to measure “marketable securities” at fair value at each reporting date, the changes in fair value will be recognized in current period earnings as opposed to “other comprehensive (loss) income.” As a result, on January 1, 2018 we recorded an increase to retained earnings of $5,156,000 to recognize the unrealized gains previously recorded within “accumulated other comprehensive (loss) income.” For the year ended December 31, 2018 we recorded a decrease in the fair value of our marketable securities of $11,990,000 , resulting from The Macerich Company’s (“Macerich”) closing share price of $43.28 as of December 31, 2018, compared to $65.68 as of December 31, 2017. +In February 2016, the FASB issued an update (“ASU 2016-02”) establishing ASC Topic 842, Leases (“ASC 842”), as amended by subsequent ASUs on the topic, which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. ASU 2016-02 requires lessees to apply a two-method approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase. Lessees are required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases. Lessees will recognize expense based on the effective interest method for finance leases or on a straight-line basis for operating leases. The accounting applied by the lessor is largely unchanged from that applied under the existing lease standard. We adopted this standard effective January 1, 2019. We completed our evaluation of the overall impact of the adoption of ASU 2016-02 on our consolidated financial statements and accounting policies. In transitioning to ASC 842, we elected to use the practical expedient package available to us and did not elect to use hindsight. For our Flushing property ground lease, which is classified as an operating lease, we will be required to record a right-of-use asset and lease liability equal to the present value of the remaining minimum lease payments, and will continue to recognize expense on a straight-line basis upon adoption of this standard. On January 1, 2019, we recorded the Flushing right-of-use asset and corresponding lease liability of approximately $5,400,000 as a result of the adoption of this standard. +In February 2017, the FASB issued an update (“ASU 2017-05”) Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets to ASC Subtopic 610-20, Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets . ASU 2017-05 clarifies the scope of recently established guidance on nonfinancial asset derecognition, as well as the accounting for partial sales of nonfinancial assets. This update conforms the derecognition guidance on nonfinancial assets with the model for transactions in ASC 606. ASU 2017-05 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2017. We adopted this update effective January 1, 2018 using the modified retrospective approach to all contracts not yet completed. The adoption of this update did not have a material impact on our consolidated financial statements. +45 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued +In August 2017, the FASB issued an update (“ASU 2017-12”) Targeted Improvements to Accounting for Hedging Activities to ASC Topic 815, Derivatives and Hedging (“ASC 815”). ASU 2017-12 amends the hedge accounting recognition and presentation requirements in ASC 815. The update is intended to more closely align hedge accounting with companies’ risk management strategies, simplify the application of hedge accounting and increase transparency as to the scope and results of hedge programs. The update ASU 2017-12 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2018, with early adoption permitted. We elected to early adopt ASU 2017-12 effective January 1, 2018 using the modified retrospective approach. The adoption of this update did not have a material impact on our consolidated financial statements. +In August 2018, the FASB issued an update (“ASU 2018-13”) Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement to ASC Topic 820, Fair Value Measurement (“ASC 820”). ASU 2018-13 modifies the disclosure requirements for fair value measurements by removing, modifying, and/or adding certain disclosures. ASU 2018-13 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2019. An entity is permitted to early adopt by modifying existing disclosures and delay adoption of the additional disclosures until the effective date. The adoption of this update is not expected to have a material impact on our consolidated financial statements and disclosures. +In October 2018, the FASB issued an update (“ASU 2018-16”) Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes to ASC 815. ASU 2018-16 expands the list of U.S. benchmark interest rates permitted in the application of hedge accounting by adding the OIS rate based on SOFR as an eligible benchmark interest rate. ASU 2018-16 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2018, with early adoption permitted. We adopted this update effective January 1, 2019. The adoption of this update did not have a material impact on our consolidated financial statements. +Real Estate – Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2018 and 2017 , the carrying amount of our real estate, net of accumulated depreciation and amortization, was $730,270,000 and $754,324,000 , respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. +Our properties and related intangible assets, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. +46 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued +Cash and Cash Equivalents – Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and are carried at cost, which approximates fair value, due to their short-term maturities. The majority of our cash and cash equivalents consist of (i) deposits at major commercial banks, which may at times exceed the Federal Deposit Insurance Corporation limit, (ii) United States Treasury Bills, (iii) money market funds, which invest in United States Treasury Bills and (iv) certificates of deposit placed through an account registry service (“CDARS”). To date we have not experienced any losses on our invested cash. +Restricted Cash – Restricted cash primarily consists of security deposits and other cash escrowed under loan agreements for debt service, real estate taxes, property insurance and capital improvements. Prior to repayment in June 2018, restricted cash also consisted of cash held in a non-interest bearing escrow account in connection with our Rego Park I 100% cash collateralized mortgage. +Marketable Securities – Our marketable securities consist of common shares of Macerich (NYSE: MAC), which are classified as available-for-sale. Available-for-sale securities are presented at fair value on our consolidated balance sheets. Prior to January 1, 2018, unrealized gains and losses resulting from the mark-to-market of these securities were included in “other comprehensive (loss) income.” Effective January 1, 2018, changes in the fair value of these securities are recognized in current period earnings in accordance with ASC 825 (see Note 5). +Allowance for Doubtful Accounts – We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ( $671,000 and $1,501,000 as of December 31, 2018 and 2017 , respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. +Deferred Charges – Direct financing costs are deferred and amortized over the terms of the related agreements as a component of interest and debt expense. Direct costs related to leasing activities are capitalized and amortized on a straight-line basis over the lives of the related leases. All other deferred charges are amortized on a straight-line basis, which approximates the effective interest rate method, in accordance with the terms of the agreements to which they relate. +Income Taxes – We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 – 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. Dividends distributed for the year ended December 31, 2018 were characterized, for federal income tax purposes, as 100.0% ordinary income. Dividends distributed for the year ended December 31, 2017 were characterized, for federal income tax purposes, as 99.5% ordinary income and 0.5% long-term capital gain income. Dividends distributed for the year ended December 31, 2016 were categorized, for federal income tax purposes, as 97.7% ordinary income and 2.3% long-term capital gain income. +The following table reconciles our net income to estimated taxable income for the years ended December 31, 2018 , 2017 and 2016 . +(Unaudited and in thousands) +Year Ended December 31, +2018 +2017 +2016 +Net income +$ +32,844 +$ +80,509 +$ +86,477 +Straight-line rent adjustments +5,870 +4,250 +2,347 +Depreciation and amortization timing differences +(6,586 +) +3,084 +(14,534 +) +Change in fair value of marketable securities (see Note 5) +11,990 +— +— +Loss from discontinued operations (see Note 6) +23,797 +— +— +Other +440 +(343 +) +2,975 +Estimated taxable income +$ +68,355 +$ +87,500 +$ +77,265 +As of December 31, 2018 , the net basis of our assets and liabilities for tax purposes is approximately $186,559,000 lower than the amount reported for financial statement purposes. +47 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +3. REVENUE RECOGNITION +Our revenues consist of property rentals and expense reimbursements. We have the following revenue sources and revenue recognition policies: +• +Base Rent is revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. +• +Percentage Rent is revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). +• +Parking Revenue arising from the rental of parking spaces at our properties. This income is recognized as the services are provided. +• +Operating Expense Reimbursements is revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of our properties. Revenue is recognized in the same period as the related expenses are incurred. +• +Tenant Services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred. +Parking revenue and tenant services income represent revenue recognized from contracts with customers and are recognized in accordance with ASC 606. Base rent, percentage rent and operating expense reimbursements are recognized in accordance with ASC Topic 840, Leases . +The following is a summary of revenue sources for the years ended December 31, 2018, 2017 and 2016. +For the Year Ended December 31, +(Amounts in thousands) +2018 +2017 +2016 +Base rent +$ +146,881 +$ +146,833 +$ +145,293 +Percentage rent +234 +174 +182 +Parking revenue +5,680 +5,850 +5,969 +Property rentals +152,795 +152,857 +151,444 +Operating expense reimbursements +76,273 +73,757 +71,699 +Tenant services +3,757 +3,960 +3,793 +Expense reimbursements +80,030 +77,717 +75,492 +Total revenues +$ +232,825 +$ +230,574 +$ +226,936 +48 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +4. RELATED PARTY TRANSACTIONS +Vornado +As of December 31, 2018 , Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to the agreements described below, which expire in March of each year and are automatically renewable. +Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2018 , Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.2% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Management and Development Agreements +We pay Vornado an annual management fee equal to the sum of (i) $2,800,000 , (ii) 2% of gross revenue from the Rego Park II shopping center, (iii) $0.50 per square foot of the tenant-occupied office and retail space at 731 Lexington Avenue, and (iv) $315,000 , escalating at 3% per annum, for managing the common area of 731 Lexington Avenue. Vornado is also entitled to a development fee equal to 6% of development costs, as defined. +Leasing and Other Agreements +Vornado also provides us with leasing services for a fee of 3% of rent for the first ten years of a lease term, 2% of rent for the eleventh through the twentieth year of a lease term, and 1% of rent for the twenty-first through thirtieth year of a lease term, subject to the payment of rents by tenants. In the event third-party real estate brokers are used, the fees to Vornado increase by 1% and Vornado is responsible for the fees to the third-party real estate brokers. +Vornado is also entitled to a commission upon the sale of any of our assets equal to 3% of gross proceeds, as defined, for asset sales less than $50,000,000 and 1% of gross proceeds, as defined, for asset sales of $50,000,000 or more. +We also have agreements with Building Maintenance Services, a wholly owned subsidiary of Vornado, to supervise (i) cleaning, engineering and security services at our Lexington Avenue property and (ii) security services at our Rego Park I and Rego Park II properties and The Alexander apartment tower. +The following is a summary of fees to Vornado under the various agreements discussed above. +Year Ended December 31, +(Amounts in thousands) +2018 +2017 +2016 +Company management fees +$ +2,800 +$ +2,800 +$ +2,800 +Development fees +125 +29 +194 +Leasing fees +13 +1,829 +7,401 +Property management, cleaning, engineering +and security fees +4,101 +4,114 +4,033 +$ +7,039 +$ +8,772 +$ +14,428 +As of December 31, 2018 , the amounts due to Vornado were $549,000 for management, property management, cleaning, engineering and security fees; $146,000 for development fees; and $13,000 for leasing fees. As of December 31, 2017 , the amounts due to Vornado were $1,811,000 for leasing fees; $658,000 for management, property management, cleaning, engineering and security fees; and $21,000 for development fees. +49 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +4. RELATED PARTY TRANSACTIONS - continued +Toys +Our affiliate, Vornado, owned 32.5% of Toys as of December 31, 2018. On February 1, 2019, in connection with the Toys Chapter 11 bankruptcy, the plan of reorganization for Toys was declared effective and Vornado’s ownership in Toys was canceled and Toys’ Board of Directors was dissolved. Joseph Macnow, Vornado’s Executive Vice President and Chief Financial Officer and Wendy A. Silverstein, a member of our Board of Directors, represented Vornado as members of Toys’ Board of Directors. Also in connection with the Toys Chapter 11 bankruptcy, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ( $2,600,000 of annual revenue) effective June 30, 2018 and possession of the space was returned to us. Consequently, we accelerated depreciation and amortization of the remaining balances of $588,000 of tenant improvements and $215,000 of deferred leasing costs during the year ended December 31, 2018. We also wrote off the Toys receivable arising from the straight-lining of rent of $500,000 during the year ended December 31, 2018. +5. MARKETABLE SECURITIES +As of December 31, 2018 and 2017 , we owned 535,265 common shares of Macerich. These shares have an economic cost of $56.05 per share, or $30,000,000 in the aggregate. As of December 31, 2018 and 2017 , the fair value of these shares was $23,166,000 and $35,156,000 , respectively, based on Macerich’s closing share price of $43.28 per share and $65.68 per share, respectively. These shares are included in “marketable securities” on our consolidated balance sheets and are classified as available-for-sale. Available-for-sale securities are presented at fair value on our consolidated balance sheets. Prior to January 1, 2018, unrealized gains and losses resulting from the mark-to-market of these securities were included in “other comprehensive (loss) income.” Effective January 1, 2018, changes in the fair value of these securities are recognized in current period earnings in accordance with ASC 825. For the year ended December 31, 2018 we recorded a decrease in the fair value of our marketable securities of $11,990,000 , resulting from Macerich’s closing share price of $43.28 as of December 31, 2018, compared to $65.68 as of December 31, 2017. +6. DISCONTINUED OPERATIONS +In 2012, we sold the Kings Plaza Regional Shopping Center (“Kings Plaza”) and paid real property transfer taxes to New York City in connection with the sale. In 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional New York City real property transfer tax amount, including interest, which we are contesting. +In 2014, in a case with similar facts, the NYC DOF issued a Notice of Determination to a Vornado joint venture assessing an additional New York City real property transfer tax amount, including interest. In January 2017, a New York City administrative law judge made a determination upholding the Vornado joint venture’s position that such additional real property transfer taxes were not due. On February 16, 2018, the New York City Tax Appeals Tribunal (the “Tribunal”) overturned the January 2017 determination. The Vornado joint venture is appealing the Tribunal’s decision to the Appellate Division of the Supreme Court of the State of New York which is scheduled to be heard in the first half of 2019. +In 2018, based on the precedent of the Tribunal’s decision, we recorded an expense for the potential additional real property transfer taxes of $23,797,000 ( $15,874,000 of real property transfer tax and $7,923,000 of interest) and paid this amount in order to stop the interest from accruing. Our case is on hold pending the outcome of the Vornado joint venture’s appeal. +As the results related to Kings Plaza were previously classified as discontinued operations, we have classified the expense as “loss from discontinued operations” on our consolidated statement of income for the year ended December 31, 2018 in accordance with the provisions of ASC Topic 360, Property, Plant and Equipment . +50 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +7. MORTGAGES PAYABLE +On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90% . +On December 12, 2018, we completed a $252,544,000 refinancing of our Rego Park II shopping center. The interest-only loan is at LIBOR plus 1.35% ( 3.87% as of December 31, 2018) and matures in December 2025. The previous loan bore interest at LIBOR plus 1.85% and was scheduled to mature in January 2019. +The following is a summary of our outstanding mortgages payable. We may refinance our maturing debt as it comes due or choose to repay it. +Interest Rate at December 31, 2018 +Balance at December 31, +(Amounts in thousands) +Maturity (1) +2018 +2017 +First mortgages secured by: +Paramus +Oct. 2021 +4.72% +$ +68,000 +$ +68,000 +731 Lexington Avenue, retail space (2) +Aug. 2022 +3.78% +350,000 +350,000 +731 Lexington Avenue, office space (3) +Jun. 2024 +3.36% +500,000 +500,000 +Rego Park II shopping center +Dec. 2025 +3.87% +252,544 +(4) +256,194 +Rego Park I shopping center (100% cash +collateralized) (5) +— +— +— +78,246 +Total +1,170,544 +1,252,440 +Deferred debt issuance costs, net of accumulated +amortization of $9,212 and $6,315, respectively +(9,010 +) +(12,218 +) +$ +1,161,534 +$ +1,240,222 +(1) +Represents the extended maturity where we have the unilateral right to extend. +(2) +Interest at LIBOR plus 1.40%. +(3) +Interest at LIBOR plus 0.90%. +(4) +Interest at LIBOR plus 1.35%. See Note 8 for details of our Rego Park II loan participation. +(5) +Refinanced on May 11, 2018 and repaid on June 6, 2018. +All of our debt is secured by mortgages and/or pledges of the stock of the subsidiaries holding the properties. The net carrying value of real estate collateralizing the debt amounted to $589,492,000 as of December 31, 2018 . Our existing financing documents contain covenants that limit our ability to incur additional indebtedness on these properties, and in certain circumstances, provide for lender approval of tenants’ leases and yield maintenance to prepay them. As of December 31, 2018 , the principal repayments for the next five years and thereafter are as follows: +(Amounts in thousands) +Year Ending December 31, +Amount +2019 +$ +— +2020 +— +2021 +68,000 +2022 +350,000 +2023 +— +Thereafter +752,544 +51 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +8. REGO PARK II LOAN PARTICIPATION +We hold a participation in the Rego Park II shopping center loan and are entitled to interest at LIBOR plus 1.35% ( 3.87% as of December 31, 2018). The participation in the previous loan, which was refinanced on December 12, 2018, earned interest at LIBOR plus 1.60% . As of December 31, 2018 and 2017, our loan participation balance was $195,708,000 and $198,537,000 , respectively, and the investment is presented as “Rego Park II loan participation” on our consolidated balance sheets. Interest earned on the loan participation is recognized as “interest and other income, net” on our consolidated statements of income for the years ended December 31, 2018 and 2017. +9. FAIR VALUE MEASUREMENTS +ASC 820 defines fair value and establishes a framework for measuring fair value. ASC 820 establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three levels: Level 1 – quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities; Level 2 – observable prices that are based on inputs not quoted in active markets, but corroborated by market data; and Level 3 – unobservable inputs that are used when little or no market data is available. The fair value hierarchy gives the highest priority to Level 1 inputs and the lowest priority to Level 3 inputs. In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as consider counterparty credit risk in our assessment of fair value. +Financial Assets and Liabilities Measured at Fair Value +Financial assets measured at fair value on our consolidated balance sheets as of December 31, 2018 and 2017 consist of marketable securities and an interest rate cap, which are presented in the table below based on their level in the fair value hierarchy. There were no financial liabilities measured at fair value as of December 31, 2018 and 2017 . +As of December 31, 2018 +(Amounts in thousands) +Total +Level 1 +Level 2 +Level 3 +Marketable securities +$ +23,166 +$ +23,166 +$ +— +$ +— +Interest rate cap (included in other assets) +— +— +— +— +Total assets +$ +23,166 +$ +23,166 +$ +— +$ +— +As of December 31, 2017 +(Amounts in thousands) +Total +Level 1 +Level 2 +Level 3 +Marketable securities +$ +35,156 +$ +35,156 +$ +— +$ +— +Interest rate cap (included in other assets) +6 +— +6 +— +Total assets +$ +35,162 +$ +35,156 +$ +6 +$ +— +52 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +9. FAIR VALUE MEASUREMENTS - continued +Financial Assets and Liabilities not Measured at Fair Value +Financial assets and liabilities that are not measured at fair value on our consolidated balance sheets include cash equivalents, the Rego Park II loan participation and mortgages payable. Cash equivalents are carried at cost, which approximates fair value due to their short-term maturities and are classified as Level 1. The fair values of the Rego Park II loan participation and our mortgages payable are calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist, and are classified as Level 2. The table below summarizes the carrying amount and fair value of these financial instruments as of December 31, 2018 and 2017 . +As of December 31, 2018 +As of December 31, 2017 +Carrying +Fair +Carrying +Fair +(Amounts in thousands) +Amount +Value +Amount +Value +Assets: +Cash equivalents +$ +173,858 +$ +173,858 +$ +273,914 +$ +273,914 +Rego Park II loan participation +195,708 +196,000 +198,537 +198,000 +$ +369,566 +$ +369,858 +$ +472,451 +$ +471,914 +Liabilities: +Mortgages payable (excluding deferred debt issuance costs, net) +$ +1,170,544 +$ +1,165,000 +$ +1,252,440 +$ +1,239,000 +10. LEASES +As Lessor +We lease space to tenants in an office building and in retail centers. The rental terms range from approximately 5 to 25 years . The leases provide for the payment of fixed base rents payable monthly in advance as well as reimbursements of real estate taxes, insurance and maintenance costs. Retail leases may also provide for the payment by the lessee of additional rents based on a percentage of their sales. We also lease residential space at The Alexander apartment tower with 1 or 2 year lease terms. +Future base rental revenue under these non-cancelable operating leases is as follows: +(Amounts in thousands) +Year Ending December 31, +Amount +2019 +$ +138,784 +2020 +131,647 +2021 +120,450 +2022 +111,532 +2023 +111,962 +Thereafter +671,111 +These future minimum amounts do not include additional rents based on a percentage of retail tenants’ sales. These rents were $234,000 , $174,000 and $182,000 , respectively, for the years ended December 31, 2018 , 2017 and 2016 . +53 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +10. LEASES - continued +Bloomberg accounted for revenue of $107,356,000 , $105,224,000 and $104,590,000 in the years ended December 31, 2018, 2017 and 2016, respectively, representing approximately 46% of our total revenues in each year. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +As Lessee +We are a tenant under a long-term ground lease at our Flushing property, which expires in 2027 and has one 10 -year extension option. In accordance with ASC 842, on January 1, 2019 we recorded a right-of-use asset and lease liability related to this ground lease equal to the present value of the remaining minimum lease payments of approximately $5,400,000 . Future lease payments under this operating lease, excluding the extension option, are as follows: +(Amounts in thousands) +Year Ending December 31, +Amount +2019 +$ +800 +2020 +800 +2021 +800 +2022 +800 +2023 +800 +Thereafter +2,467 +Rent expense was $746,000 in each of the years ended December 31, 2018 , 2017 and 2016 . +11. STOCK-BASED COMPENSATION +We account for stock-based compensation in accordance with ASC Topic 718, Compensation - Stock Compensation . Our 2016 Omnibus Stock Plan (the “Plan”) provides for grants of incentive and non-qualified stock options, restricted stock, stock appreciation rights, deferred stock units (“DSUs”) and performance shares, as defined, to the directors, officers and employees of the Company and Vornado. +On May 17, 2018, we granted each of the members of our Board of Directors 195 DSUs with a grant date fair value of $56,250 per grant, or $394,000 in the aggregate. The DSUs entitle the holders to receive shares of the Company’s common stock without the payment of any consideration. The DSUs vested immediately and accordingly, were expensed on the date of grant, but the shares of common stock underlying the DSUs are not deliverable to the grantee until the grantee is no longer serving on the Company’s Board of Directors. As of December 31, 2018, there were 10,057 DSUs outstanding and 495,730 shares were available for future grant under the Plan. +54 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +12. COMMITMENTS AND CONTINGENCIES +Insurance +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $323,000 deductible and 19% of the balance of a covered loss, and the Federal government is responsible for the remaining 81% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Paramus +In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000 . The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72% , which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000 . If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20 -year lease term. +Rego Park I Litigation +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4 million and future damages it estimated would not be less than $25 million . In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonably possible losses, if any, is not expected to be greater than $650,000 . On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +On April 4, 2017, Sears closed its 195,000 square foot store at the property ( $10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. Consequently, we wrote off the remaining balance of the Sears receivable arising from the straight-lining of rent of $2,973,000 during the year ended December 31, 2018. In addition, we accelerated depreciation and amortization of the remaining balance of $312,000 of deferred leasing costs during the year ended December 31, 2018. +55 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +12. COMMITMENTS AND CONTINGENCIES - continued +Tenant Matter +On January 10, 2019, Kohl’s announced that it plans to close and sublease its 133,000 square foot store at our Rego Park II shopping center; Kohl’s remains obligated to us under its lease which expires in January 2031. +Letters of Credit +Approximately $1,030,000 of standby letters of credit were issued and outstanding as of December 31, 2018 . +Other +We received approximately $165,000 , $396,000 and $825,000 from bankruptcy recoveries during the years ended December 31, 2018 , 2017 and 2016 , respectively, which is included as “interest and other income, net” in our consolidated statements of income. +There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. +13. MULTIEMPLOYER BENEFIT PLANS +Our subsidiaries make contributions to certain multiemployer defined benefit plans (“Multiemployer Pension Plans”) and health plans (“Multiemployer Health Plans”) for our union represented employees, pursuant to the respective collective bargaining agreements. +Multiemployer Pension Plans +Multiemployer Pension Plans differ from single-employer pension plans in that (i) contributions to multiemployer plans may be used to provide benefits to employees of other participating employers and (ii) if other participating employers fail to make their contributions, each of our subsidiaries may be required to bear their pro rata share of unfunded obligations. If a participating subsidiary withdraws from a plan in which it participates, it may be subject to a withdrawal liability. As of December 31, 2018 , our subsidiaries’ participation in these plans were not significant to our consolidated financial statements. +In the years ended December 31, 2018 , 2017 and 2016 our subsidiaries contributed $161,000 , $162,000 and $147,000 , respectively, towards Multiemployer Pension Plans. Our subsidiaries’ contributions did not represent more than 5% of total employer contributions in any of these plans for the years ended December 31, 2018 , 2017 and 2016 . +Multiemployer Health Plans +Multiemployer Health Plans in which our subsidiaries participate provide health benefits to eligible active and retired employees. In the years ended December 31, 2018 , 2017 and 2016 our subsidiaries contributed $649,000 , $619,000 and $539,000 , respectively, towards these plans. +56 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +14. EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted income per share, including a reconciliation of net income and the number of shares used in computing basic and diluted income per share. Basic income per share is determined using the weighted average shares of common stock (including DSUs) outstanding during the period. Diluted income per share is determined using the weighted average shares of common stock (including DSUs) outstanding during the period, and assumes all potentially dilutive securities were converted into common shares at the earliest date possible. There were no potentially dilutive securities outstanding during the years ended December 31, 2018 , 2017 and 2016 . +For the Year Ended December 31, +(Amounts in thousands, except share and per share amounts) +2018 +2017 +2016 +Income from continuing operations +$ +56,641 +$ +80,509 +$ +86,477 +Loss from discontinued operations (see Note 6) +(23,797 +) +— +— +Net income +$ +32,844 +$ +80,509 +$ +86,477 +Weighted average shares outstanding – basic and diluted +5,116,838 +5,115,501 +5,114,084 +Income from continuing operations +$ +11.07 +$ +15.74 +$ +16.91 +Loss from discontinued operations (see Note 6) +(4.65 +) +— +— +Net income per common share – basic and diluted +$ +6.42 +$ +15.74 +$ +16.91 +15. SUMMARY OF QUARTERLY RESULTS (UNAUDITED) +Net Income (Loss) Per Common Share (1) +(Amounts in thousands, except per share amounts) +Revenues +Net Income (Loss) +Basic +Diluted +2018 +December 31 +$ +57,567 +$ +9,971 +$ +1.95 +$ +1.95 +September 30 +59,125 +15,003 +2.93 +2.93 +June 30 +58,253 +17,570 +3.43 +3.43 +March 31 +57,880 +(9,700 +) +(2) +(1.90 +) +(2) +(1.90 +) +(2) +2017 +December 31 +$ +58,061 +$ +17,883 +$ +3.50 +$ +3.50 +September 30 +58,094 +20,299 +3.97 +3.97 +June 30 +57,190 +20,660 +4.04 +4.04 +March 31 +57,229 +21,667 +4.24 +4.24 +_______________________ +(1) +The total for the year may differ from the sum of the quarters as a result of weighting. +(2) +Includes $23,797, or $4.65 per common share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza which is being contested. +57 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures – Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective. +Internal Control Over Financial Reporting – There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934, as amended) during the fourth quarter of the fiscal year to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +58 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER +FINANCIAL REPORTING +The management of Alexander’s, Inc., together with its consolidated subsidiaries (the “Company”), is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. +As of December 31, 2018 , management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the framework established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2018 is effective. +The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2018 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report appearing on page 60 of this Annual Report on Form 10-K, which expresses an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2018 . +59 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and the Board of Directors of +Alexander’s, Inc. +Paramus, New Jersey +Opinion on Internal Control over Financial Reporting +We have audited the internal control over financial reporting of Alexander’s, Inc. and subsidiaries (the “Company”) as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended December 31, 2018, of the Company and our report dated February 11, 2019, expressed an unqualified opinion on those financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ DELOITTE & TOUCHE LLP +Parsippany, New Jersey +February 11, 2019 +60 +ITEM 9B. OTHER INFORMATION +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Information relating to our directors, including our audit committee and audit committee financial expert, will be contained in a definitive Proxy Statement involving the election of directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. We will file the Proxy Statement with the Securities and Exchange Commission no later than 120 days after December 31, 2018. Such information is incorporated by reference herein. Also incorporated herein by reference is the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement. +The following is a list of the names, ages, principal occupations and positions with us of our executive officers and the positions held by such officers during the past five years. +PRINCIPAL OCCUPATION, POSITION AND OFFICE +Name +Age +(Current and during past five years with the Company unless otherwise stated) +Steven Roth +77 +Chairman of the Board since May 2004 and Chief Executive Officer since March 1995; Chairman of the Board of Vornado Realty Trust since May 1989; Chief Executive Officer of Vornado Realty Trust since April 2013 and from May 1989 to May 2009; a Trustee of Vornado Realty Trust since 1979; and Managing General Partner of Interstate Properties. +Matthew Iocco +48 +Chief Financial Officer since April 2017; Executive Vice President - Chief Accounting Officer of Vornado Realty Trust since May 2015; and Senior Vice President - Chief Accounting Officer of Vornado Realty Trust from May 2012 to May 2015. +We have a code of business conduct and ethics that applies to, among others, our Chief Executive Officer and Chief Financial Officer. The code is posted on our website at www.alx-inc.com. We intend to satisfy our disclosure obligation regarding amendments and waivers of this code applicable to our Chief Executive Officer and Chief Financial Officer by posting such information on our website. +61 +ITEM 11. EXECUTIVE COMPENSATION +Information relating to executive compensation will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Information relating to security ownership of certain beneficial owners and management and related stockholder matters, except as set forth below, will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +Equity Compensation Plan Information +The following table provides information as of December 31, 2018, regarding our equity compensation. +Plan Category +(a) +Number of securities +to be issued upon +exercise of +outstanding options, +warrants and rights +Weighted-average +exercise price of +outstanding options, +warrants and rights +Number of securities +remaining available for +future issuance under +equity compensation +plans (excluding +securities reflected in +column (a)) +Equity compensation plans approved by security holders +10,057 +$ +— +495,730 +Equity compensation plans not approved by security holders +N/A +N/A +N/A +Total +10,057 +$ +— +495,730 +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Information relating to certain relationships and related transactions and director independence will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +Information relating to principal accounting fees and services will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +62 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) The following documents are filed as part of this Annual Report on Form 10-K. +1. The consolidated financial statements are set forth in Item 8 of this Annual Report on Form 10-K. +2. The following financial statement schedules should be read in conjunction with the financial statements included in Item 8 of this Annual Report on Form 10-K. +Pages in this +Annual Report +on Form 10-K +Schedule II – Valuation and Qualifying Accounts – years ended +December 31, 2018, 2017 and 2016 +64 +Schedule III – Real Estate and Accumulated Depreciation as of +December 31, 2018, 2017 and 2016 +65 +All other financial statement schedules are omitted because they are not applicable, not required, or the information is included elsewhere in the consolidated financial statements or the notes thereto. +63 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE II +VALUATION AND QUALIFYING ACCOUNTS +(Amounts in thousands) +Column A +Column B +Column C +Column D +Column E +Description +Balance at +Beginning +of Year +Additions: +Charged +Against +Operations +Deductions: +Uncollectible +Accounts +Written Off +Balance at End of Year +Allowance for doubtful accounts: +Year Ended December 31, 2018 +$ +1,501 +$ +4,459 +$ +(5,289 +) +$ +671 +Year Ended December 31, 2017 +$ +1,473 +$ +53 +$ +(25 +) +$ +1,501 +Year Ended December 31, 2016 +$ +918 +$ +557 +$ +(2 +) +$ +1,473 +64 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE III +REAL ESTATE AND ACCUMULATED DEPRECIATION +December 31, 2018 +(Amounts in thousands) +COLUMN A +COLUMN B +COLUMN C +COLUMN D +COLUMN E +COLUMN F +COLUMN G +COLUMN H +COLUMN I +Gross Amount at Which +Life on which Depreciation in Latest Income Statement is Computed +Initial Cost to Company (1) +Costs +Capitalized +Subsequent +to Acquisition +Carried at Close of Period +Accumulated +Depreciation +and +Amortization +Buildings +and Leasehold +Improvements +Buildings +and Leasehold +Improvements +Development +and +Construction +In Progress +Date of +Construction +Date +Acquired (1) +Description +Encumbrances (2) +Land +Land +Total (3) +New York, NY +Rego Park I +$ +— +$ +1,647 +$ +8,953 +$ +54,456 +$ +1,647 +$ +62,836 +$ +573 +$ +65,056 +$ +34,987 +1959 +1992 +3-39 years +Rego Park II +252,544 +(4) +3,127 +1,467 +387,884 +3,127 +389,191 +160 +392,478 +93,011 +2009 +1992 +3-40 years +The Alexander apartment tower +— +— +— +119,112 +— +119,112 +— +119,112 +13,631 +2016 +1992 +3-39 years +Rego Park III +— +779 +— +4,016 +779 +503 +3,513 +4,795 +259 +N/A +1992 +5-15 years +Flushing +— +— +1,660 +(107 +) +— +1,553 +— +1,553 +1,028 +1975 (5) +1992 +N/A +Lexington Avenue +850,000 +14,432 +12,355 +405,989 +27,497 +405,279 +— +432,776 +154,505 +2003 +1992 +9-39 years +Paramus, NJ +68,000 +1,441 +— +10,313 +11,754 +— +— +11,754 +— +N/A +1992 +N/A +Other Properties +— +167 +1,804 +(1,804 +) +167 +— +— +167 +— +N/A +1992 +N/A +TOTAL +$ +1,170,544 +$ +21,593 +$ +26,239 +$ +979,859 +$ +44,971 +$ +978,474 +$ +4,246 +$ +1,027,691 +$ +297,421 +(1) Initial cost is as of May 15, 1992 (the date on which the Company commenced its real estate operations). +(2) Excludes deferred debt issuance costs, net of $9,010. +(3) The net basis of the Company’s assets and liabilities for tax purposes is approximately $186,559 lower than the amount reported for financial statement purposes. +(4) We hold a $195,708 participation in the loan. +(5) Represents the date the lease was acquired. +65 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE III +REAL ESTATE AND ACCUMULATED DEPRECIATION +(Amounts in thousands) +December 31, +2018 +2017 +2016 +REAL ESTATE: +Balance at beginning of period +$ +1,037,368 +$ +1,033,551 +$ +1,029,472 +Changes during the period: +Land +— +— +— +Buildings and leasehold improvements +3,218 +3,046 +12,464 +Development and construction in progress +695 +771 +(6,706 +) +1,041,281 +1,037,368 +1,035,230 +Less: Fully depreciated assets +(13,590 +) +— +(1,679 +) +Balance at end of period +$ +1,027,691 +$ +1,037,368 +$ +1,033,551 +ACCUMULATED DEPRECIATION: +Balance at beginning of period +$ +283,044 +$ +252,737 +$ +225,533 +Additions charged to operating expenses +27,967 +30,307 +28,883 +311,011 +283,044 +254,416 +Less: Fully depreciated assets +(13,590 +) +— +(1,679 +) +Balance at end of period +$ +297,421 +$ +283,044 +$ +252,737 +66 +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES - continued +(b) Exhibits +Exhibit No. +3.1 +- +Amended and Restated Certificate of Incorporation. Incorporated herein by reference from Exhibit 3.1 to the registrant’s Registration Statement on Form S-3 filed on September 20, 1995 +* +3.2 +- +By-laws, as amended. Incorporated herein by reference from Exhibit 3(ii) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2000 +* +10.1 +- +Real Estate Retention Agreement dated as of July 20, 1992, between Vornado Realty Trust and Keen Realty Consultants, Inc., each as special real estate consultants, and the Company. Incorporated herein by reference from Exhibit 10(i)(O) to the registrant’s Annual Report on Form 10-K for the fiscal year ended July 25, 1992 +* +10.2 +- +Extension Agreement to the Real Estate Retention Agreement, dated as of February 6, 1995, between the Company and Vornado Realty Trust. Incorporated herein by reference from Exhibit 10(i)(G)(2) to the registrant’s Annual Report on Form 10-K for the year ended December 31, 1994 +* +10.3 +- +Agreement of Lease dated as of April 30, 2001 between Seven Thirty One Limited Partnership, landlord, and Bloomberg L.P., tenant. Incorporated herein by reference from Exhibit 10(v) B to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001, filed on August 2, 2001 +* +10.4 +- +Lease dated as of October 2, 2001 by and between ALX of Paramus LLC, as Landlord, and IKEA Property, Inc. as Tenant. Incorporated herein by reference from Exhibit 10(v)(C)(4) to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2001, filed on March 13, 2002 +* +10.5 +- +First Amendment to Real Estate Retention Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc. and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10(i)(E)(3) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.6 +- +59th Street Real Estate Retention Agreement, dated as of July 3, 2002, by and between Vornado Realty, L.P., 731 Residential LLC and 731 Commercial LLC. Incorporated herein by reference from Exhibit 10(i)(E)(4) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.7 +- +Amended and Restated Management and Development Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10(i)(F)(1) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.8 +- +Limited Liability Company Operating Agreement of 731 Residential LLC, dated as of July 3, 2002, among 731 Residential Holding LLC, as the sole member, Domenic A. Borriello, as an Independent Manager and Kim Lutthang, as an Independent Manager. Incorporated herein by reference from Exhibit 10(i)(A)(1) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.9 +- +Limited Liability Company Operating Agreement of 731 Commercial LLC, dated as of July 3, 2002, among 731 Commercial Holding LLC, as the sole member, Domenic A. Borriello, as an Independent Manager and Kim Lutthang, as an Independent Manager. Incorporated herein by reference from Exhibit 10(i)(A)(2) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.10 +- +Reimbursement Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc., 731 Commercial LLC, 731 Residential LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10(i)(C)(8) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +___________________ +* +Incorporated by reference. +67 +10.11 +- +First Amendment of Lease, dated as of April 19, 2002, between Seven Thirty One Limited Partnership, landlord and Bloomberg L.P., tenant. Incorporated herein by reference from Exhibit 10(v)(B)(2) to the registrant’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2002, filed on August 7, 2002 +* +10.12 +- +Second Amendment to Real Estate Retention Agreement, dated as of January 1, 2007, by and between Alexander’s, Inc. and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.64 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on February 26, 2007 +* +10.13 +- +Amendment to 59th Street Real Estate Retention agreement, dated as of January 1, 2007, by and among Vornado Realty L.P., 731 Retail One LLC, 731 Restaurant LLC, 731 Office One LLC and 731 Office Two LLC. Incorporated herein by reference from Exhibit 10.65 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on February 26, 2007 +* +10.14 +- +First Amendment to Amended and Restated Management and Development Agreement, dated as of July 6, 2005, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.52 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 +* +10.15 +- +Second Amendment to Amended and Restated Management and Development Agreement, dated as of December 20, 2007, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.53 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 +* +10.16 +- +Third Amendment to Real Estate Retention Agreement, dated as of December 20, 2007, by and between Alexander’s, Inc., and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 +* +10.17 +- +Loan Agreement dated as of March 10, 2009 between Alexander’s Rego Shopping Center Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.18 +- +Amended and Restated Mortgage, Security Agreement, Fixture Filing and Assignment of Leases and Rentals by and between Alexander’s Rego Shopping Center, Inc. as Borrower and U.S. Bank National Association as Lender, dated as of March 10, 2009. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.19 +- +Amended and Restated Promissory Note dated as of March 10, 2009, by Alexander’s Rego Shopping Center Inc., in favor of U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.20 +- +Cash Pledge Agreement dated as of March 10, 2009, executed by Alexander’s Rego Shopping Center Inc. to and for the benefit of U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.21 +- +Lease dated as of February 7, 2005, by and between 731 Office One LLC, as Landlord, and Citibank, N.A., as Tenant. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.22 +- +Assignment and Assumption and Consent Agreement, dated as of March 25, 2009, by and between 731 Office One LLC, as Landlord, Citicorp North America, Inc., as Assignor, and Bloomberg L.P., as Assignee. Incorporated herein by reference from Exhibit 10.60 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +__________________ +* +Incorporated by reference. +68 +10.23 +- +Third Amendment to Amended and Restated Management and Development Agreement, dated as of November 30, 2011, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.49 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2011, filed on February 27, 2012 +* +10.24 +- +First Omnibus Loan Modification and Extension Agreement dated March 12, 2012 by and between Alexander’s Rego Shopping Center, Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, filed on May 7, 2012 +* +10.25 +- +Mortgage Modification Agreement dated March 12, 2012 by and between Alexander’s Rego Shopping Center, Inc., as Mortgagor and U.S. Bank National Association, as Mortgagee. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, filed on May 7, 2012 +* +10.26 +- +Fourth Amendment to Amended and Restated Management and Development Agreement, dated as of August 1, 2012, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.2 to the registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, filed on November 1, 2012 +* +10.27 +- +Contribution Agreement and Joint Escrow Instructions, dated as of October 21, 2012, by and between Alexander’s Kings Plaza LLC, Alexander’s of Kings LLC and Kings Parking LLC, and Brooklyn Kings Plaza LLC. Incorporated herein by reference from Exhibit 10.53 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2012, filed on February 26, 2013 +* +10.28 +- +Fifth Amendment to Amended and Restated Management and Development Agreement, dated as of December 1, 2012, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.54 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2012, filed on February 26, 2013 +* +10.29 +- +Second Omnibus Loan Modification and Extension Agreement, dated March 8, 2013, by and between Alexander’s Rego Shopping Center, Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, filed on May 6, 2013 +* +10.30 +- +Second Mortgage Modification Agreement, dated March 8, 2013, by and between Alexander’s Rego Shopping Center, Inc., as Mortgagor and U.S. Bank National Association, as Mortgagee. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, filed on May 6, 2013 +* +10.31 +- +Loan Agreement, date as of February 28, 2014, by and between 731 Office One LLC, as Borrower, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.32 +- +Consolidated, Amended and Restated Promissory Note, dated as of February 28, 2014, by and between 731 Office One LLC, as Borrower, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.33 +- +Amended and Restated Mortgage, Assignment of Leases and Rents and Security Agreement, dated as of February 28, 2014, by and between 731 Office One LLC, as Mortgagor, and German American Capital Corporation, as Mortgagee. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.34 +- +Assignment of Leases and Rents dated as of February 28, 2014, by and between 731 Office One LLC, as Assignor, and German American Capital Corporation, as Assignee. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +__________________ +* +Incorporated by reference. +69 +10.35 +- +Guaranty of Recourse Obligations dated as of February 28, 2014, by and between Alexander’s, Inc., as Guarantor, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.5 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.36 +- +Environmental Indemnity Agreement dated as of February 28, 2014, by and between 731 Office One LLC, as Indemnitor, and German American Capital Corporation, as Indemnitee. Incorporated herein by reference from Exhibit 10.6 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.37 +- +Termination Agreement dated as of February 28, 2014, by and among 731 Office One LLC, Alexander’s Management LLC, Vornado Realty L.P., 731 Office Two LLC, 731 Residential LLC, 731 Commercial LLC, 731 Retail One LLC and 731 Restaurant LLC. Incorporated herein by reference from Exhibit 10.7 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.38 +- +Real Estate Sub-Retention Agreement dated as of February 28, 2014, by and between Alexander’s Management LLC, as Agent, and Vornado Realty L.P., as Sub-Agent. Incorporated herein by reference from Exhibit 10.8 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.39 +- +Sixth Amendment to Amended and Restated Management and Development Agreement, dated as of March 21, 2014, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.9 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.40 +- +Rego Park II Residential Management and Development Agreement, dated as of March 21, 2014 by and between Alexander’s of Rego Residential LLC and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.10 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.41 +- +Fourth Amendment to Real Estate Retention Agreement, dated December 22, 2014 by and between Alexander’s, Inc. and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.42 +- +Second Amendment to 59th Street Real Estate Retention Agreement, dated December 22, 2014 by and between 731 Retail One LLC, 731 Restaurant LLC, 731 Office Two LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.43 +- +First Amendment to Rego II Real Estate Sub-Retention Agreement, dated December 22, 2014 by and between Alexander’s, Inc. and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.44 +- +First Amendment to Real-Estate Sub-Retention Agreement, dated December 22, 2014 by and between Alexander’s Management LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.45 +- +Third Omnibus Loan Modification and Extension Agreement, dated March 10, 2015, by and between Alexander’s Rego Shopping Center, Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015, filed on May 4, 2015 +* +10.46 +- +Third Mortgage Modification Agreement, dated March 10, 2015, by and between Alexander’s Rego Shopping Center, Inc., as Mortgagor and U. S. Bank National Association, as Mortgagee. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015, filed on May 4, 2015 +* +__________________ +* +Incorporated by reference. +70 +10.47 +- +Loan Agreement, dated as of August 5, 2015, by and between 731 Retail One LLC and 731 Commercial LLC, as Borrower, and JPMorgan Chase Bank, N.A., Wells Fargo Bank, N.A., and Landesbank Baden-Württemberg, New York Branch, as Lenders. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2015, filed on November 2, 2015 +* +10.48 ++ +- +Second Amendment of Lease, dated as of the 12th of January 2016 between 731 Office One LLC and Bloomberg L.P. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 +* +10.49 +- +Fourth Omnibus Loan Modification and Extension Agreement, dated and made effective as of March 8, 2016, by and between Alexander’s Rego Shopping Center and U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 +* +10.50 +- +Fourth Mortgage Modification Agreement, dated and made effective as of March 8, 2016, by and between Alexander’s Rego Shopping Center and U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 +* +10.51 +** +- +Form of Alexander’s Inc. 2016 Omnibus Stock Plan Deferred Stock Unit Grant Agreement between the Company and certain employees. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2016, filed on August 1, 2016 +* +10.52 +- +Loan Agreement, dated as of June 1, 2017, between 731 Office One LLC, as Borrower, and Deutsche Bank AG, New York Branch and Citigroup Global Markets Realty Corp. collectively, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2017, filed on July 31, 2017 +* +10.53 +- +Fifth Omnibus Loan Modification and Extension Agreement, dated and made effective as of March 12, 2018, by and between Alexander’s Rego Shopping Center, Inc., as Borrower, and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2018, filed on April 30, 2018 +* +10.54 +- +Sixth Omnibus Loan Modification and Extension Agreement, dated and made effective as of April 12, 2018, by and between Alexander’s Rego Shopping Center, Inc., as Borrower, and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2018, filed on April 30, 2018 +* +10.55 +- +Amended and Restated Loan and Security Agreement, dated and made effective as of December 12, 2018, by and between Rego II Borrower LLC, as Borrower, and Bank of China, New York Branch, as Lender +*** +10.56 +- +Second Amended and Restated Promissory Note, dated December 12, 2018, by and between Rego II Borrower LLC, as Maker, and Bank of China, New York Branch, as Lender +*** +10.57 +- +Second Amended and Restated Mortgage, Assignment of Leases and Rents and Security Agreement, dated December 12, 2018, by and between Rego II Borrower LLC, as Mortgagor, and Bank of China, New York Branch, as Mortgagee +*** +10.58 +- +Amended and Restated Guaranty of Recourse Carveouts, dated December 12, 2018, by Alexander’s, Inc., as Guarantor, to and for the benefit of Bank of China, New York Branch, as Lender +*** +__________________ +* +Incorporated by reference. +** +Management contract or compensatory agreement. +*** +Filed herewith. ++ +Portions of this exhibit have been omitted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission under Rule 24b-2. The omitted confidential material has been filed separately. The location of the redacted confidential information is indicated in the exhibit as “redacted.” +71 +10.59 +- +Amended and Restated Environmental Indemnity Agreement, dated December 12, 2018, among Rego II Borrower LLC and Alexander’s, Inc., individually or collectively as Indemnitor, in favor of Bank of China, New York Branch, as Lender +*** +10.60 +- +Amended and Restated Participation and Servicing Agreement for Amended and Restated Loan and Security Agreement, dated December 12, 2018, between Bank of China, New York Branch, individually as Lender, Initial A-1 Holder and as the Agent for the Holders, and Alexander’s of Rego Park II Participating Lender LLC, individually as Initial A-2 Holder +*** +21 +- +Subsidiaries of Registrant +*** +23 +- +Consent of Independent Registered Public Accounting Firm +*** +31.1 +- +Rule 13a-14 (a) Certification of the Chief Executive Officer +*** +31.2 +- +Rule 13a-14 (a) Certification of the Chief Financial Officer +*** +32.1 +- +Section 1350 Certification of the Chief Executive Officer +*** +32.2 +- +Section 1350 Certification of the Chief Financial Officer +*** +101.INS +- +XBRL Instance Document +*** +101.SCH +- +XBRL Taxonomy Extension Schema +*** +101.CAL +- +XBRL Taxonomy Extension Calculation Linkbase +*** +101.DEF +- +XBRL Taxonomy Extension Definition Linkbase +*** +101.LAB +- +XBRL Taxonomy Extension Label Linkbase +*** +101.PRE +- +XBRL Taxonomy Extension Presentation Linkbase +*** +__________________ +*** +Filed herewith. +72 +ITEM 16. FORM 10-K SUMMARY +None. +73 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ALEXANDER’S, INC. +(Registrant) +Date: February 11, 2019 +By: +/s/ Matthew Iocco +Matthew Iocco, Chief Financial Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +By: +/s/Steven Roth +Chairman of the Board of Directors and +February 11, 2019 +(Steven Roth) +Chief Executive Officer +(Principal Executive Officer) +By: +/s/Matthew Iocco +Chief Financial Officer +February 11, 2019 +(Matthew Iocco) +(Principal Financial and Accounting Officer) +By: +/s/Thomas R. DiBenedetto +Director +February 11, 2019 +(Thomas R. DiBenedetto) +By: +/s/David Mandelbaum +Director +February 11, 2019 +(David Mandelbaum) +By: +/s/Wendy Silverstein +Director +February 11, 2019 +(Wendy Silverstein) +By: +/s/Arthur Sonnenblick +Director +February 11, 2019 +(Arthur Sonnenblick) +By: +/s/Richard R. West +Director +February 11, 2019 +(Richard R. West) +By: +/s/Russell B. Wight Jr. +Director +February 11, 2019 +(Russell B. Wight Jr.) +74 \ No newline at end of file diff --git a/raw/filings/0000003499/2018/0000003499-19-000004/filing_metadata.csv b/raw/filings/0000003499/2018/0000003499-19-000004/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..bd55421ad7886624194f1d93253f12593bb750b3 --- /dev/null +++ b/raw/filings/0000003499/2018/0000003499-19-000004/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003499,ALX,ALEXANDERS INC,2018,10-K,2019-02-11,2018-12-31,2019-02-11T13:22:18.000Z,0000003499-19-000004,alx10-k123118.htm,10-K,11770006,1,0,https://www.sec.gov/Archives/edgar/data/3499/000000349919000004/alx10-k123118.htm,https://www.sec.gov/Archives/edgar/data/3499/000000349919000004/ diff --git a/raw/filings/0000003499/2018/0000003499-19-000004/item1.txt b/raw/filings/0000003499/2018/0000003499-19-000004/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..21ba57412eb18fdfbc1140c56f80a85a10ea0d3a --- /dev/null +++ b/raw/filings/0000003499/2018/0000003499-19-000004/item1.txt @@ -0,0 +1,37 @@ +ITEM 1. BUSINESS +GENERAL +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”) incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• +731 Lexington Avenue, a 1,311,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 889,000 and 174,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot (83,000 square feet), The Container Store (34,000 square feet) and Hennes & Mauritz (27,000 square feet) are the principal retail tenants; +• +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On January 10, 2019, Kohl’s announced that it plans to close and sublease its store at the property; Kohl’s remains obligated to us under its lease which expires in January 2031. On September 18, 2017, Toys “R” Us, Inc. (“Toys”), a one-third owned affiliate of Vornado as of December 31, 2018, filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its 47,000 square foot lease at the property ($2,600,000 of annual revenue) and possession of the space was returned to us; +• +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• +Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA Property, Inc.; and +• +Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• +Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +Relationship with Vornado +We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements which expire in March of each year and are automatically renewable. Vornado is a fully-integrated REIT with significant experience in managing, leasing, developing, and operating retail and office properties. +5 +Relationship with Vornado - continued +As of December 31, 2018 , Vornado owned 32.4% of our outstanding common stock. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2018, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.2% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Significant Tenant +Bloomberg accounted for revenue of $107,356,000, $105,224,000 and $104,590,000 in the years ended December 31, 2018 , 2017 , and 2016 , respectively, representing approximately 46% of our total revenues in each year. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Competition +We operate in a highly competitive environment. All of our properties are located in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Principal factors of competition are the amount of rent charged, attractiveness of location and quality and breadth of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Employees +We currently have 70 employees. +Executive Office +Our executive office is located at 210 Route 4 East, Paramus, New Jersey, 07652 and our telephone number is (201) 587-8541. +Available Information +Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, as well as Reports on Forms 3, 4 and 5 regarding officers, directors, and 10% beneficial owners filed or furnished pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, are available free of charge on our website (www.alx-inc.com) as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Also available on our website are copies of our Audit Committee Charter, Compensation Committee Charter, Code of Business Conduct and Ethics and Corporate Governance Guidelines. In the event of any changes to these items, revised copies will be made available on our website. Copies of these documents are also available directly from us, free of charge. +In May 2009, Vornado and Interstate each filed with the SEC an amendment to their respective Schedule 13D indicating that they, as a group, own 47.2% of our common stock. This ownership level, together with the shares owned by Messrs. Roth, Mandelbaum and Wight, makes us a “controlled” company for the purposes of the New York Stock Exchange, Inc.’s Corporate Governance Standards (the “NYSE Rules”). This means that we are not required to, among other things, have a majority of the members of our Board of Directors be independent under the NYSE Rules, have all of the members of our Compensation Committee be independent under the NYSE Rules or to have a Nominating Committee. While we have voluntarily complied with a majority of the independence requirements of the NYSE Rules, we are under no obligation to do so and this situation may change at any time. +6 \ No newline at end of file diff --git a/raw/filings/0000003499/2018/0000003499-19-000004/item13.txt b/raw/filings/0000003499/2018/0000003499-19-000004/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..58fa04d1a93dde64541578acc149d190287577c5 --- /dev/null +++ b/raw/filings/0000003499/2018/0000003499-19-000004/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Information relating to certain relationships and related transactions and director independence will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. 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+2019-01-01 +2019-12-31 +0000003499 +us-gaap:LandImprovementsMember +2017-01-01 +2017-12-31 +0000003499 +us-gaap:BuildingImprovementsMember +2019-01-01 +2019-12-31 +0000003499 +us-gaap:BuildingImprovementsMember +2018-01-01 +2018-12-31 +0000003499 +us-gaap:LandImprovementsMember +2018-01-01 +2018-12-31 +0000003499 +us-gaap:ConstructionInProgressMember +2017-01-01 +2017-12-31 +alx:property +xbrli:pure +utreg:acre +utreg:sqft +alx:option +alx:segment +alx:unit +iso4217:USD +xbrli:shares +iso4217:USD +utreg:sqft +alx:condomium_unit +alx:fire +iso4217:USD +xbrli:shares +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +☑ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +For the Fiscal Year Ended: +December 31, 2019 +OR +☐ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +For the transition period from +to +Commission File Number: +001-06064 +ALEXANDERS INC +(Exact name of registrant as specified in its charter) +Delaware +51-0100517 +(State or other jurisdiction of incorporation or organization) +(IRS Employer Identification No.) +210 Route 4 East, +Paramus, +New Jersey +07652 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code +(201) +587-8541 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol(s) +Name of each exchange on which registered +Common Stock, $1 par value per share +ALX +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: NONE +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ☑ No ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. +Yes ☐ No ☑ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes ☑ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +☑ Yes ☐ No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a +smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +☑ +Large Accelerated Filer +☐ +Accelerated Filer +☐ +Non-Accelerated Filer +☐ +Smaller Reporting Company +☐ +Emerging Growth Company +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☑ +The aggregate market value of the voting and non-voting shares of common stock held by non-affiliates of the registrant, (i.e., by persons other than officers and directors of Alexander’s, Inc.) was $ 785,470,000 at June 30, 2019. +As of January 31, 2020, there were 5,107,290 shares of the registrant’s common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III : Portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on May 14, 2020. +INDEX +Item +Financial Information: +Page Number +Part I. +1. +Business +5 +1A. +Risk Factors +7 +1B. +Unresolved Staff Comments +18 +2. +Properties +19 +3. +Legal Proceedings +21 +4. +Mine Safety Disclosures +21 +Part II. +5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +22 +6. +Selected Financial Data +24 +7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +25 +7A. +Quantitative and Qualitative Disclosures about Market Risk +35 +8. +Financial Statements and Supplementary Data +36 +9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +58 +9A. +Controls and Procedures +58 +9B. +Other Information +61 +Part III. +10. +Directors, Executive Officers and Corporate Governance (1) +61 +11. +Executive Compensation (1) +62 +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters (1) +62 +13. +Certain Relationships and Related Transactions, and Director Independence (1) +62 +14. +Principal Accounting Fees and Services (1) +62 +Part IV. +15. +Exhibits, Financial Statement Schedules +63 +16. +Form 10-K Summary +72 +Signatures +73 +__________________________ +(1) These items are omitted in part or in whole because the registrant will file a definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 with the Securities and Exchange Commission no later than 120 days after December 31, 2019 , portions of which are incorporated by reference herein. +3 +FORWARD-LOOKING STATEMENTS +Certain statements contained herein constitute forward-looking statements as such term is defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not guarantees of future performance. They represent our intentions, plans, expectations and beliefs and are subject to numerous assumptions, risks and uncertainties. Our future results, financial condition and business may differ materially from those expressed in these forward-looking statements. You can find many of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” or other similar expressions in this Annual Report on Form 10‑K. We also note the following forward-looking statements: in the case of our development projects, the estimated completion date, estimated project costs and costs to complete; and estimates of dividends on shares of our common stock. Many of the factors that will determine the outcome of these and our other forward-looking statements are beyond our ability to control or predict. For a further discussion of factors that could materially affect the outcome of our forward-looking statements, see “Item 1A - Risk Factors” in this Annual Report on Form 10‑K. +For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You are cautioned not to place undue reliance on our forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or the date of any document incorporated by reference. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to release publicly, any revisions to our forward-looking statements to reflect events or circumstances occurring after the date of this Annual Report on Form 10-K. +4 +PART I +ITEM 1. BUSINESS +GENERAL +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”) incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• +731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot (83,000 square feet) and The Container Store (34,000 square feet) are the principal retail tenants; +• +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. On September 23, 2019, we leased 113,000 square feet at the property to IKEA Property, Inc. (“IKEA”), replacing a significant portion of the space formerly occupied by Sears. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On April 13, 2019, Kohl’s closed its store at the property. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031; +• +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• +Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA; and +• +Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• +Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +Relationship with Vornado +We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements which expire in March of each year and are automatically renewable. Vornado is a fully-integrated REIT with significant experience in managing, leasing, developing, and operating retail and office properties. +5 +Relationship with Vornado - continued +As of December 31, 2019 , Vornado owned 32.4% of our outstanding common stock. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2019, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Significant Tenant +Bloomberg accounted for revenue of $109,113,000, $107,356,000 and $105,224,000 in the years ended December 31, 2019 , 2018 , and 2017 , respectively, representing approximately 48%, 46% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Competition +We operate in a highly competitive environment. All of our properties are located in the greater New York City metropolitan area. We compete with a large number of real estate investors, property owners and developers. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Employees +We currently have 69 employees. +Executive Office +Our executive office is located at 210 Route 4 East, Paramus, New Jersey, 07652 and our telephone number is (201) 587-8541. +Available Information +Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as well as Reports on Forms 3, 4 and 5 regarding officers, directors, and 10% beneficial owners filed or furnished pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, are available free of charge on our website (www.alx-inc.com) as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Also available on our website are copies of our Audit Committee Charter, Compensation Committee Charter, Code of Business Conduct and Ethics and Corporate Governance Guidelines. In the event of any changes to these items, revised copies will be made available on our website. Copies of these documents are also available directly from us, free of charge. +In May 2009, Vornado and Interstate each filed with the SEC an amendment to their respective Schedule 13D indicating that they, as a group, own 47.2% of our common stock. This ownership level, together with the shares owned by Messrs. Roth, Mandelbaum and Wight, makes us a “controlled” company for the purposes of the New York Stock Exchange, Inc.’s Corporate Governance Standards (the “NYSE Rules”). This means that we are not required to, among other things, have a majority of the members of our Board of Directors be independent under the NYSE Rules, have all of the members of our Compensation Committee be independent under the NYSE Rules or to have a Nominating Committee. While we have voluntarily complied with a majority of the independence requirements of the NYSE Rules, we are under no obligation to do so and this situation may change at any time. +6 +ITEM 1A. RISK FACTORS +Material factors that may adversely affect our business, operations and financial condition are summarized below. The risks and uncertainties described herein may not be the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business, operations and financial condition. See “Forward-Looking Statements” contained herein on page 4. +OUR INVESTMENTS ARE CONCENTRATED IN THE GREATER NEW YORK CITY METROPOLITAN AREA. CIRCUMSTANCES AFFECTING THIS AREA GENERALLY COULD ADVERSELY AFFECT OUR BUSINESS. +All of our properties are in the greater New York City metropolitan area and are affected by the economic cycles and risks inherent in that area. +All of our revenues come from properties located in the greater New York City metropolitan area. Real estate markets are subject to economic downturns and we cannot predict how economic conditions will impact this market in either the short or long term. Declines in the economy or declines in the real estate market in this area could hurt our financial performance and the value of our properties. In addition to the factors affecting the national economic condition generally, the factors affecting economic conditions in this area include: +• +financial performance and productivity of the media, advertising, professional services, financial, technology, retail, insurance and real estate industries; +• +business layoffs or downsizing; +• +industry slowdowns; +• +relocations of businesses; +• +changing demographics; +• +increased telecommuting and use of alternative work places; +• +changes in the number of domestic and international tourists to our markets (including as a result of changes in the relative strengths of world currencies); +• +infrastructure quality; +• +changes in the rates or treatment of the deductibility of state and local taxes; and +• +any oversupply of, or reduced demand for, real estate. +It is impossible for us to predict the future or the effect of trends in the economic and investment climates of the greater New York City metropolitan region, and more generally of the United States, on the real estate market in this area. Local, national or global economic downturns could negatively affect our business and profitability. +We are subject to risks that affect the general and New York City retail environments. +Certain of our properties are New York City retail properties. As such, these properties are affected by the general and New York City retail environments, including the level of consumer spending and consumer confidence, New York City tourism, the threat of terrorism, increasing competition from on-line retailers, other retailers and outlet malls and the impact of technological change upon the retail environment generally. These factors could adversely affect the financial condition of our retail tenants, or result in the bankruptcy of such tenants, and the willingness of retailers to lease space in our retail locations, which could have an adverse effect on our business and profitability. +Terrorist attacks may adversely affect the value of our properties and our ability to generate cash flow. +All of our properties are located in the greater New York City metropolitan area, and our most significant property, 731 Lexington Avenue, is located on Lexington Avenue and 59 th Street in Manhattan. In response to a terrorist attack or the perceived threat of terrorism, tenants in this area may choose to relocate their businesses to less populated, lower-profile areas of the United States that may be perceived to be less likely targets of future terrorist activity and fewer customers may choose to patronize businesses in this area. This, in turn, could trigger a decrease in the demand for space in these markets, which could increase vacancies in our properties and force us to lease our properties on less favorable terms. Furthermore, we may experience increased costs for security, equipment and personnel. As a result, the value of our properties and the level of our revenues could decline materially. +7 +Natural disasters and the effects of climate change could have a concentrated impact on the area which we operate and could adversely impact our results. +Our investments are in the greater New York City metropolitan area and since they are concentrated along the Eastern Seaboard, natural disasters, including hurricanes, could cause significant damage to our properties and the surrounding environment or area. Potentially adverse consequences of “global warming,” including rising sea levels, could similarly have an impact on our properties and the economy of the greater New York City metropolitan area in which we operate. Over time, these conditions could result in declining demand for office space in our buildings or the inability of us to operate the buildings at all. Climate change may also have indirect effects on our business by increasing the cost of (or making unavailable) property insurance on terms we find acceptable, increasing the cost of energy at our properties and requiring us to expend funds as we seek to repair and protect our properties against such risks. The incurrence of these losses, costs or business interruptions may adversely affect our operating and financial results. +REAL ESTATE INVESTMENTS’ VALUE AND INCOME FLUCTUATE DUE TO VARIOUS FACTORS. +Our performance and the value of an investment in us are subject to risks associated with our real estate assets and with the real estate industry. +The value of our real estate and the value of an investment in us fluctuates depending on conditions in the general economy and the real estate business. These conditions may also adversely impact our revenues and cash flows. +The factors that affect the value of our real estate include, among other things: +• +global, national, regional and local economic conditions; +• +competition from other available space; +• +local conditions such as an oversupply of space or a reduction in demand for real estate in the area; +• +how well we manage our properties; +• +the development and/or redevelopment of our properties; +• +changes in market rental rates; +• +the timing and costs associated with property improvements and rentals; +• +whether we are able to pass all or portions of any increases in operating costs through to tenants; +• +changes in real estate taxes and other expenses; +• +the ability of state and local governments to operate within their budgets; +• +whether tenants and users such as customers and shoppers consider a property attractive; +• +changes in consumer preferences adversely affecting retailers and retail store values; +• +changes in space utilization by our tenants due to technology, economic conditions and business environment; +• +the financial condition of our tenants, including the extent of tenant bankruptcies or defaults; +• +consequences of any armed conflict involving, or terrorist attack against, the United States or individual acts of violence in public spaces; +• +trends in office real estate; +• +the impact on our retail tenants and demand for retail space at our properties due to increased competition from online shopping; +• +availability of financing on acceptable terms or at all; +• +inflation or deflation; +• +fluctuations in interest rates; +• +our ability to obtain adequate insurance; +• +changes in zoning laws and taxation; +• +government regulation; +• +potential liability under environmental or other laws or regulations; +• +natural disasters; +• +general competitive factors; and +• +climate changes. +The rents we receive and the occupancy levels at our properties may decline as a result of adverse changes in any of these factors. If our rental revenues and/or occupancy levels decline, we generally would expect to have less cash available for operating costs, to pay our indebtedness and for distribution to our stockholders. In addition, some of our major expenses, including mortgage payments, real estate taxes and maintenance costs generally do not decline when the related rents decline. +8 +Capital markets and economic conditions can materially affect our liquidity, financial condition and results of operations as well as the value of an investment in our debt and equity securities. +There are many factors that can affect the value of our equity securities and any debt securities we may issue in the future, including the state of the capital markets and economy. Demand for office and retail space typically declines nationwide due to an economic downturn, bankruptcies, downsizing, layoffs and cost cutting. Government action or inaction may adversely affect the state of the capital markets. The cost and availability of credit may be adversely affected by illiquid credit markets and wider credit spreads, which may adversely affect our liquidity and financial condition, including our results of operations, and the liquidity and financial condition of our tenants. Our inability or the inability of our tenants to timely refinance maturing liabilities and access the capital markets to meet liquidity needs may materially affect our financial condition and results of operations and the value of our equity securities and any debt securities we may issue in the future. +U.S. federal tax reform legislation now and in the future could affect REITs generally, the geographic markets in which we operate, the trading of our shares and our results of operations, both positively and negatively, in ways that are difficult to anticipate. +The Tax Cuts and Jobs Act of 2017 (the “2017 Act”) represented sweeping tax reform legislation that made significant changes to corporate and individual tax rates and the calculation of taxes, as well as international tax rules. As a REIT, we are generally not required to pay federal taxes otherwise applicable to regular corporations if we comply with the various tax regulations governing REITs. Shareholders, however, are generally required to pay taxes on REIT dividends. The 2017 Act and future tax reform legislation could impact our share price or how shareholders and potential investors view an investment in REITs. For example, the decrease in corporate tax rates in the 2017 Act could decrease the attractiveness of the REIT structure relative to companies that are not organized as REITs. In addition, while certain elements of the 2017 Act do not impact us directly as a REIT, they could impact the geographic markets in which we operate as well as our tenants in ways, both positive and negative, that are difficult to anticipate. For example, the limitation in the 2017 Act on the deductibility of certain state and local taxes may make operating in jurisdictions that impose such taxes at higher rates less desirable than operating in jurisdictions imposing such taxes at lower rates. The overall impact of the 2017 Act also depends on the future interpretations and regulations that may be issued by U.S. tax authorities, and it is possible that future guidance could adversely impact us. +Real estate is a competitive business and that competition may adversely impact us. +We compete with a large number of real estate investors, property owners and developers, some of which may be willing to accept lower returns on their investments. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Substantially all of our properties face competition from similar properties in the same market, which may adversely impact the rents we can charge at those properties and our results of operations. +We may be adversely affected by trends in office real estate. +Telecommuting, flexible work schedules, open workplaces and teleconferencing are becoming more common. These practices enable businesses to reduce their office space requirements. There is also an increasing trend among some businesses to utilize shared office spaces and co-working spaces. A continuation of these trends could, over time, erode the overall demand for office space and, in turn, place downward pressure on occupancy, rental rates and property valuations. +We depend on leasing space to tenants on economically favorable terms and collecting rent from tenants who may not be able to pay. +Our financial results depend significantly on leasing space in our properties to tenants on economically favorable terms. In addition, because a majority of our income is derived from renting real property, our income, funds available to pay indebtedness and for distributions to stockholders will decrease if certain of our tenants cannot pay their rent or if we are not able to maintain our occupancy levels on favorable terms. If a tenant does not pay its rent, we might not be able to enforce our rights as landlord without delays and might incur substantial legal and other costs. Even if we are able to enforce our rights, a tenant may not have recoverable assets. +Bankruptcy or insolvency of tenants may decrease our revenues, net income and available cash. +From time to time, some of our tenants have declared bankruptcy, and other tenants may declare bankruptcy or become insolvent in the future. The bankruptcy or insolvency of a major tenant could cause us to suffer lower revenues and operational difficulties, including leasing the remainder of the property. As a result, the bankruptcy or insolvency of a major tenant or multiple tenants could result in decreased net income and funds available to pay our indebtedness or make distributions to stockholders. +9 +We depend upon anchor tenants to attract shoppers at our Rego Park I and II retail properties and decisions made by these tenants, or adverse developments in the businesses of these tenants, could materially affect our financial condition and results of operations. +Our Rego Park I and II retail properties are anchored by well-known department stores and other tenants who generate shopping traffic. The value of these properties would be adversely affected if our anchor tenants failed to meet their contractual obligations, sought concessions in order to continue operations or ceased their operations, including as a result of bankruptcy. If the level of sales of stores operating in our properties were to decline significantly due to economic conditions, increased competition from online shopping, closing of anchors or for other reasons, tenants may be unable to pay their minimum rents or expense recovery charges. In the event of a default by a tenant or anchor, we may experience delays and costs in enforcing our rights as landlord. Additionally, closure of an anchor or major tenant could result in lease terminations by, or reductions of rent from, other tenants if the other tenants’ leases have co-tenancy clauses. On April 4, 2017, Sears closed its 195,000 square foot store at our Rego Park I shopping center ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. On April 13, 2019, Kohl’s closed its 133,000 square foot store at our Rego Park II shopping center. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031. +We may be unable to renew leases or relet space as leases expire. +When our tenants decide not to renew their leases upon their expiration, we may not be able to relet the space. Even if tenants do renew or we can relet the space, the terms of renewal or reletting, considering among other things, the cost of improvements to the property and leasing commissions, may be less favorable than the terms in the expired leases. In addition, changes in space utilization by our tenants may impact our ability to renew or relet space without the need to incur substantial costs in renovating or redesigning the internal configuration of the relevant property. If we are unable to promptly renew the leases or relet the space at similar rates or if we incur substantial costs in renewing or reletting the space, our cash flow and ability to service debt obligations and pay dividends and distributions to stockholders could be adversely affected. +731 Lexington Avenue accounts for a substantial portion of our revenues. Loss of or damage to the building would adversely affect our financial condition and results of operations. +731 Lexington Avenue accounted for revenue of $153,797,000, $151,834,000 and $148,324,000 in the years ended December 31, 2019 , 2018 , and 2017 , respectively, representing approximately 68%, 65% and 64% of our total revenues in each year, respectively. Loss of or damage to the building in excess of our insurance coverage, including as a result of a terrorist attack, would adversely affect our results of operations and financial condition. +Bloomberg represents a significant portion of our revenues. Loss of Bloomberg as a tenant or deterioration in Bloomberg’s credit quality could adversely affect our financial condition and results of operations. +Bloomberg accounted for revenue of $109,113,000, $107,356,000 and $105,224,000 in the years ended December 31, 2019 , 2018 , and 2017 , respectively, representing approximately 48%, 46% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. +10 +The occurrence of cyber incidents, or a deficiency in our cyber security, as well as other disruptions of our IT networks and related systems, could negatively impact our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships or reputation, all of which could negatively impact our financial results. +We face risks associated with security breaches, whether through cyber attacks or cyber intrusions over the Internet, malware, computer viruses, attachments to e-mails, persons who access our systems from inside or outside our organization, and other significant disruptions of our IT networks and related systems. The risk of a security breach or disruption, particularly through cyber attack or cyber intrusion, including by computer hackers, foreign governments and cyber terrorists, has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased. Although we have not experienced cyber incidents that are individually, or in the aggregate, material, we have experienced cyber attacks in the past, which have thus far been mitigated by preventative, detective, and responsive measures that we have put in place. Our IT networks and related systems are essential to the operation of our business and our ability to perform day-to-day operations (including managing our building systems) and, in some cases, may be critical to the operations of certain of our tenants. Although we make efforts to maintain the security and integrity of these types of IT networks and related systems, and we have implemented various measures to manage the risk of a security breach or disruption, there can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not be successful or damaging. Unauthorized parties, whether within or outside our company, may disrupt or gain access to our systems, or those of third parties with whom we do business, through human error, misfeasance, fraud, trickery, or other forms of deceit, including break-ins, use of stolen credentials, social engineering, phishing, computer viruses or other malicious codes, and similar means of unauthorized and destructive tampering. Even the most well protected information, networks, systems and facilities remain potentially vulnerable because the techniques used in such attempted security breaches evolve and generally are not recognized until launched against a target, and in some cases are designed to not be detected and, in fact, may not be detected. Accordingly, we may be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, and thus it is impossible for us to entirely mitigate this risk. +A security breach or other significant disruption involving our IT networks and related systems could disrupt the proper functioning of our networks and systems and therefore our operations and/or those of certain of our tenants; result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information of ours or others, which others could use to compete against us or which could expose us to damage claims by third-parties for disruptive, destructive or otherwise harmful purposes and outcomes; result in our inability to maintain the building systems relied upon by our tenants for the efficient use of their leased space; require significant management attention and resources to remedy any damages that result; subject us to litigation claims for breach of contract, damages, credits, fines, penalties, governmental investigations and enforcement actions or termination of leases or other agreements; or damage our reputation among our tenants and investors generally. Any or all of the foregoing could have a material adverse effect on our results of operations, financial condition and cash flows. +A cyber attack or systems failure could interfere with our ability to comply with financial reporting requirements, which could adversely affect us. A cyber attack could also compromise the confidential information of our employees, tenants, customers and vendors. A successful attack could disrupt and materially affect our business operations, including damaging relationships with tenants, customers and vendors. Any compromise of our information security systems could also result in a violation of applicable privacy and other laws, significant legal and financial exposure, damage to our reputation, loss or misuse of the information (which may be confidential, proprietary and/or commercially sensitive in nature) and a loss of confidence in our security measures, which could harm our business. +11 +Some of our potential losses may not be covered by insurance. +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $268,000 deductible and 20% of the balance of a covered loss, and the Federal government is responsible for the remaining 80% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Compliance or failure to comply with the Americans with Disabilities Act (“ADA”) or other safety regulations and requirements could result in substantial costs. +The ADA generally requires that public buildings, including our properties, meet certain Federal requirements related to access and use by disabled persons. Noncompliance could result in the imposition of fines by the Federal government or the award of damages to private litigants and/or legal fees to their counsel. If, under the ADA, we are required to make substantial alterations and capital expenditures in one or more of our properties, including the removal of access barriers, it could adversely affect our financial condition and results of operations, as well as the amount of cash available for distribution to stockholders. +Our properties are subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements. If we fail to comply with these requirements, we could incur fines or private damage awards. We do not know whether existing requirements will change or whether compliance with future requirements will require significant unanticipated expenditures that will affect our cash flow and results of operations. +Changes in the method pursuant to which the LIBOR rates are determined and phasing out of LIBOR after 2021 may affect our financial results. +The chief executive of the United Kingdom Financial Conduct Authority (“FCA”), which regulates the London Interbank Offered Rate (“LIBOR”), announced that the FCA intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. In response, the Federal Reserve Board and the Federal Reserve Bank of New York organized the Alternative Reference Rates Committee which identified the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative to USD-LIBOR in derivatives and other financial contracts. It is not possible to predict the effect of these changes, including when LIBOR will cease to be available or when there will be sufficient liquidity in the SOFR markets. +We have outstanding debt with variable rates based on LIBOR. In the transition from the use of LIBOR to SOFR or other alternatives, the level of interest payments we incur may change. In addition, although certain of our LIBOR based obligations provide for alternative methods of calculating the related interest rate payable (including transition to an alternative benchmark rate) if LIBOR is not reported, uncertainty as to the extent and manner of future changes may result in interest rates and/or payments that are higher than, lower than or that do not otherwise correlate over time with the interest rates and/or payments that would have been made on our obligations if LIBOR was available in its current form. Use of alternative interest rates or other LIBOR reforms could result in increased volatility or a tightening of credit markets which could adversely affect our ability to obtain cost-effective financing. +12 +We may incur significant costs to comply with environmental laws and environmental contamination may impair our ability to lease and/or sell real estate. +Our operations and properties are subject to various federal, state and local laws and regulations concerning the protection of the environment, including air and water quality, hazardous or toxic substances and health and safety. Under some environmental laws, a current or previous owner or operator of real estate may be required to investigate and clean up hazardous or toxic substances released at a property. The owner or operator may also be held liable to a governmental entity or to third parties for property damage or personal injuries and for investigation and clean-up costs incurred by those parties because of the contamination. These laws often impose liability without regard to whether the owner or operator knew of the release of the substances or caused the release. The presence of contamination or the failure to remediate contamination may also impair our ability to sell or lease real estate or to borrow using the real estate as collateral. Other laws and regulations govern indoor and outdoor air quality including those that can require the abatement or removal of asbestos-containing materials in the event of damage, demolition, renovation or remodeling and govern emissions of and exposure to asbestos fibers in the air. The maintenance and removal of lead paint and certain electrical equipment containing polychlorinated biphenyls (PCBs) are also regulated by federal and state laws. We are also subject to risks associated with human exposure to chemical or biological contaminants such as molds, pollens, viruses and bacteria which, above certain levels, can be alleged to be connected to allergic or other health effects and symptoms in susceptible individuals. We could incur fines for environmental compliance and be held liable for the costs of remedial action with respect to the foregoing regulated substances or related claims arising out of environmental contamination or human exposure to contamination at or from our properties. +Each of our properties has been subjected to varying degrees of environmental assessment. To date, these environmental assessments have not revealed any environmental condition material to our business. However, identification of new compliance concerns or undiscovered areas of contamination, changes in the extent or known scope of contamination, human exposure to contamination or changes in clean-up or compliance requirements could result in significant costs to us. +In addition, we may become subject to costs or taxes, or increases therein, associated with natural resource or energy usage (such as a “carbon tax”). These costs or taxes could increase our operating costs and decrease the cash available to pay our obligations or distribute to stockholders. +We face risks associated with our tenants being designated “Prohibited Persons” by the Office of Foreign Assets Control and similar requirements. +Pursuant to Executive Order 13224 and other laws, the Office of Foreign Assets Control of the United States Department of the Treasury (“OFAC”) maintains a list of persons designated as terrorists or who are otherwise blocked or banned (“Prohibited Persons”) from conducting business or engaging in transactions in the United States and thereby restricts our doing business with such persons. In addition, our leases, loans and other agreements may require us to comply with OFAC and related requirements, and any failure to do so may result in a breach of such agreements. If a tenant or other party with whom we conduct business is placed on the OFAC list or is otherwise a party with whom we are prohibited from doing business, we may be required to terminate the lease or other agreement or face other penalties. Any such termination could result in a loss of revenue or otherwise negatively affect our financial results and cash flows. +WE MAY ACQUIRE OR SELL ASSETS OR DEVELOP PROPERTIES. OUR FAILURE OR INABILITY TO CONSUMMATE THESE TRANSACTIONS OR MANAGE THE RESULTS OF THESE TRANSACTIONS COULD ADVERSELY AFFECT OUR OPERATIONS AND FINANCIAL RESULTS. +We may acquire, develop, or redevelop properties and this may create risks. +Although our stated business strategy is not to engage in acquisitions, we may acquire or develop properties when we believe that an acquisition or development project is otherwise consistent with our business strategy. We may not succeed in (i) developing, redeveloping or acquiring properties; (ii) completing these activities on time or within budget; and (iii) leasing or selling developed, redeveloped or acquired properties at amounts sufficient to cover our costs. Competition in these activities could also significantly increase our costs. Difficulties in integrating acquisitions may prove costly or time-consuming and could divert management’s attention. Acquisitions or developments in new markets or types of properties where we do not have the same level of market knowledge may result in weaker than anticipated performance. We may also abandon acquisition or development opportunities that we have begun pursuing and consequently fail to recover expenses already incurred. Furthermore, we may be exposed to the liabilities of properties acquired, some of which we may not be aware of at the time of acquisition. +13 +We are exposed to risks associated with property redevelopment and repositioning that could adversely affect us, including our financial condition and results of operations. +We continue to engage in redevelopment and repositioning activities with respect to our properties, and, accordingly, we are subject to certain risks, which could adversely affect us, including our financial condition and results of operations. These risks include, without limitation, (i) the availability and pricing of financing on favorable terms or at all; (ii) the availability and timely receipt of zoning and other regulatory approvals; (iii) the potential for the fluctuation of occupancy rates and rents at redeveloped properties, which may result in our investment not being profitable; (iv) start up, repositioning and redevelopment costs may be higher than anticipated; (v) cost overruns and untimely completion of construction (including risks beyond our control, such as weather or labor conditions, or material shortages); (vi) the potential that we may fail to recover expenses already incurred if we abandon development or redevelopment opportunities after we begin to explore them; (vii) the potential that we may expend funds on and devote management time to projects which we do not complete; (viii) the inability to lease a property on schedule or at all, resulting in increased construction or redevelopment costs; and (ix) the possibility that properties will be leased at below expected rental rates. These risks could result in substantial unanticipated delays or expenses and could prevent the initiation or the completion of redevelopment activities, any of which could have an adverse effect on our financial condition, results of operations, cash flow, the market value of our common shares and ability to satisfy our principal and interest obligations and to make distributions to our stockholders. +It may be difficult to sell real estate quickly, which may limit our flexibility. +Real estate investments are relatively illiquid. Consequently, we may have limited ability to dispose of assets in our portfolio promptly in response to changes in economic or other conditions which could have an adverse effect on our sources of working capital and our ability to satisfy our debt obligations. +We have an investment in marketable equity securities. The value of this investment may decline as a result of operating performance or economic or market conditions. +We have an investment in The Macerich Company (“Macerich”), a retail shopping center company. As of December 31, 2019 , this investment had a carrying amount of $14,409,000. A decline in the value of this investment due to, among other reasons, Macerich’s operating performance or economic or market conditions, would result in recognized GAAP losses, which could be material. +OUR ORGANIZATIONAL AND FINANCIAL STRUCTURE GIVES RISE TO OPERATIONAL AND FINANCIAL RISKS. +Substantially all of our assets are owned by subsidiaries. We depend on dividends and distributions from these subsidiaries. The creditors of these subsidiaries are entitled to amounts payable to them by the subsidiaries before the subsidiaries may pay any dividends or distributions to us. +Substantially all of our properties and assets are held through our subsidiaries. We depend on cash distributions and dividends from our subsidiaries for substantially all of our cash flow. The creditors of each of our direct and indirect subsidiaries are entitled to payment of that subsidiary’s obligations to them when due and payable before that subsidiary may make distributions or dividends to us. Thus, our ability to pay dividends, if any, to our security holders depends on our subsidiaries’ ability to first satisfy their obligations to their creditors and our ability to satisfy our obligations, if any, to our creditors. +In addition, our participation in any distribution of the assets of any of our direct or indirect subsidiaries upon the liquidation, reorganization or insolvency of the subsidiary, is only after the claims of the creditors, including trade creditors, and preferred security holders, if any, of the applicable direct or indirect subsidiaries are satisfied. +Our existing financing documents contain covenants and restrictions that may restrict our operational and financial flexibility. +As of December 31, 2019 , we had outstanding mortgage indebtedness of $974,836,000, secured by three of our properties. These mortgages contain covenants that limit our ability to incur additional indebtedness on these properties, provide for lender approval of tenants’ leases in certain circumstances, and provide for yield maintenance or defeasance premiums to prepay them. These mortgages may significantly restrict our operational and financial flexibility. In addition, if we were to fail to perform our obligations under existing indebtedness or become insolvent or were liquidated, secured creditors would be entitled to payment in full from the proceeds of the sale of the pledged assets prior to any proceeds being paid to other creditors or to any holders of our securities. In such an event, it is possible that we would have insufficient assets remaining to make payments to other creditors or to any holders of our securities. +14 +We have a substantial amount of indebtedness that could affect our future operations. +As of December 31, 2019 , total debt outstanding was $974,836,000. We are subject to the risks normally associated with debt financing, including the risk that our cash flow from operations will be insufficient to meet required debt service. Our debt service costs generally will not be reduced if developments in the market or at our properties, such as the entry of new competitors or the loss of major tenants, cause a reduction in the income from our properties. Should such events occur, our operations may be adversely affected. If a property is mortgaged to secure payment of indebtedness and income from such property is insufficient to pay that indebtedness, the property could be foreclosed upon by the mortgagee resulting in a loss of income and a decline in our total asset value. +We have outstanding debt, and the amount of debt and its cost may increase and refinancing may not be available on acceptable terms. +As of December 31, 2019 , total debt outstanding was $974,836,000 and our ratio of total debt to total enterprise value was 41.2%. “Enterprise value” means the market equity value of our common stock, plus debt, less cash and cash equivalents at such date. In addition, we have significant debt service obligations. For the year ended December 31, 2019 , our scheduled cash payments for principal and interest were $34,669,000. In the future, we may incur additional debt, and thus increase the ratio of total debt to total enterprise value. If our level of indebtedness increases, there may be an increased risk of default which could adversely affect our financial condition and results of operations. In addition, in a rising interest rate environment, the cost of refinancing our existing debt and any new debt or market rate security or instrument may increase. Continued uncertainty in the equity and credit markets may negatively impact our ability to obtain financing on reasonable terms or at all, which may negatively affect our ability to refinance our debt. +We might fail to qualify or remain qualified as a REIT, and may be required to pay federal income taxes at corporate rates. +Although we believe that we will remain organized and will continue to operate so as to qualify as a REIT for federal income tax purposes, we might fail to remain qualified. Qualification as a REIT for federal income tax purposes is governed by highly technical and complex provisions of the Internal Revenue Code (the “Code”) for which there are only limited judicial or administrative interpretations and depends on various facts and circumstances that are not entirely within our control. In addition, legislation, new regulations, administrative interpretations or court decisions may significantly change the relevant tax laws and/or the federal income tax consequences of qualifying as a REIT. If, with respect to any taxable year, we fail to maintain our qualification as a REIT and do not qualify under statutory relief provisions, we could not deduct distributions to stockholders in computing our taxable income and would have to pay federal income tax on our taxable income at regular corporate rates. The federal income tax payable would include any applicable alternative minimum tax. If we had to pay federal income tax, the amount of money available to distribute to stockholders and pay our indebtedness would be reduced for the year or years involved, and we would no longer be required to make distributions to stockholders in that taxable year and in future years until we were able to qualify as a REIT and did so. In addition, we would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost, unless we were entitled to relief under the relevant statutory provisions. +We may face possible adverse changes in federal tax laws, which may result in an increase in our tax liability. +At any time, the U.S. federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. We cannot predict if or when any new U.S. federal income tax law, regulation, or administrative interpretation, or any amendment to any existing U.S. federal income tax law, Treasury regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation, or interpretation may take effect retroactively. Alexander’s, its taxable REIT subsidiaries, and our security holders could be adversely affected by any such change in, or any new, U.S. federal income tax law, Treasury regulation or administrative interpretation. +15 +We may face possible adverse state and local tax audits and changes in state and local tax law. +Because we are organized and qualify as a REIT, we are generally not subject to federal income taxes, but we are subject to certain state and local taxes. In the normal course of business, certain entities through which we own real estate either have undergone, or are currently undergoing, tax audits. Although we believe that we have substantial arguments in favor of our positions in the ongoing audits, in some instances there is no controlling precedent or interpretive guidance on the specific point at issue. There can be no assurance that ongoing and future audits will not occur with increased frequency or that the ultimate result of such audits will not have a material adverse effect on our results of operations. +From time to time changes in state and local tax laws or regulations are enacted, which may result in an increase in our tax liability. A shortfall in tax revenues for states and municipalities in which we operate may lead to an increase in the frequency and size of such changes. If such changes occur, we may be required to pay additional taxes on our assets or income. These increased tax costs could adversely affect our financial condition and results of operations and the amount of cash available for the payment of dividends and distributions to our stockholders. +Loss of our key personnel could harm our operations and adversely affect the value of our common stock. +We are dependent on the efforts of Steven Roth, our Chief Executive Officer. Although we believe that we could find a replacement, the loss of his services could harm our operations and adversely affect the value of our common stock. +ALEXANDER’S CHARTER DOCUMENTS AND APPLICABLE LAW MAY HINDER ANY ATTEMPT TO ACQUIRE US. +Provisions in Alexander’s certificate of incorporation and by laws, as well as provisions of the Code and Delaware corporate law, may delay or prevent a change in control of the Company or a tender offer, even if such action might be beneficial to stockholders, and limit the stockholders’ opportunity to receive a potential premium for their shares of common stock over then prevailing market prices. +Primarily to facilitate maintenance of its qualification as a REIT, Alexander’s certificate of incorporation generally prohibits ownership, directly, indirectly or beneficially, by any single stockholder of more than 9.9% of the outstanding shares of preferred stock of any class or 4.9% of outstanding common stock of any class. The Board of Directors may waive or modify these ownership limits with respect to one or more persons if it is satisfied that ownership in excess of these limits will not jeopardize Alexander’s status as a REIT for federal income tax purposes. In addition, the Board of Directors has, subject to certain conditions and limitations, exempted Vornado and certain of its affiliates from these ownership limitations. Stock owned in violation of these ownership limits will be subject to the loss of rights and other restrictions. These ownership limits may have the effect of inhibiting or impeding a change in control. +Alexander’s Board of Directors is divided into three classes of directors. Directors of each class are chosen for three-year staggered terms. Staggered terms of directors may have the effect of delaying or preventing changes in control or management, even though changes in management or a change in control might be in the best interest of our stockholders. +In addition, Alexander’s charter documents authorize the Board of Directors to: +• +cause Alexander’s to issue additional authorized but unissued common stock or preferred stock; +• +classify or reclassify, in one or more series, any unissued preferred stock; and +• +set the preferences, rights and other terms of any classified or reclassified stock that Alexander’s issues. +The Board of Directors could establish a series of preferred stock with terms that could delay, deter or prevent a change in control of Alexander’s or other transaction that might involve a premium price or otherwise be in the best interest of our stockholders, although the Board of Directors does not, at present, intend to establish a series of preferred stock of this kind. Alexander’s charter documents contain other provisions that may delay, deter or prevent a change in control of the Company or other transaction that might involve a premium price or otherwise be in the best interest of our stockholders. +In addition, Vornado, Interstate and its three general partners (each of whom are both trustees of Vornado and Directors of Alexander’s) together beneficially own approximately 58.5% of our outstanding shares of common stock. This degree of ownership is likely to reduce the possibility of a tender offer or an attempt to change control of the Company by a third party. +16 +We may change our policies without obtaining the approval of our stockholders. +Our operating and financial policies, including our policies with respect to acquisitions of real estate or other assets, growth, operations, indebtedness, capitalization and dividends, are exclusively determined by our Board of Directors. Accordingly, our stockholders do not control these policies. +OUR OWNERSHIP STRUCTURE AND RELATED-PARTY TRANSACTIONS MAY GIVE RISE TO CONFLICTS OF INTEREST. +Steven Roth, Vornado and Interstate may exercise substantial influence over us. They and some of our other directors and officers have interests or positions in other entities that may compete with us. +As of December 31, 2019 , Interstate and its partners owned approximately 7.1% of the common shares of beneficial interest of Vornado and approximately 26.1% of our outstanding common stock. Steven Roth, David Mandelbaum and Russell B. Wight, Jr. are the partners of Interstate. Mr. Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Chairman of the Board of Trustees and Chief Executive Officer of Vornado and the Managing General Partner of Interstate. Mr. Wight and Mr. Mandelbaum are both trustees of Vornado and members of our Board of Directors. In addition, Vornado manages and leases the real estate assets of Interstate. +As of December 31, 2019 , Vornado owned 32.4% of our outstanding common stock, in addition to the 26.1% owned by Interstate and its partners. In addition to the relationships described in the immediately preceding paragraph, Dr. Richard West is a trustee of Vornado and a member of our Board of Directors and Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco is our Chief Financial Officer and the Executive Vice President - Chief Accounting Officer of Vornado. +Because of their overlapping interests, Vornado, Mr. Roth, Interstate and the other individuals noted in the preceding paragraphs may have substantial influence over Alexander’s, and on the outcome of any matters submitted to Alexander’s stockholders for approval. In addition, certain decisions concerning our operations or financial structure may present conflicts of interest among Vornado, Messrs. Roth, Mandelbaum and Wight and Interstate and other security holders. Vornado, Mr. Roth and Interstate may, in the future, engage in a wide variety of activities in the real estate business which may result in conflicts of interest with respect to matters affecting us, such as, which of these entities or persons, if any, may take advantage of potential business opportunities, the business focus of these entities, the types of properties and geographic locations in which these entities make investments, potential competition between business activities conducted, or sought to be conducted, by us, competition for properties and tenants, possible corporate transactions such as acquisitions, and other strategic decisions affecting the future of these entities. +There may be conflicts of interest between Vornado, its affiliates and us. +Vornado manages, develops and leases our properties under agreements that have one-year terms expiring in March of each year, which are automatically renewable. Because we share common senior management with Vornado and because four of the trustees of Vornado are on our Board of Directors, the terms of the foregoing agreements and any future agreements may not be comparable to those we could have negotiated with an unaffiliated third party. +For a description of Interstate’s ownership of Vornado and Alexander’s, see “Steven Roth, Vornado and Interstate may exercise substantial influence over us. They and some of our other directors and officers have interests or positions in other entities that may compete with us.” above. +17 +THE NUMBER OF SHARES OF ALEXANDER’S COMMON STOCK AND THE MARKET FOR THOSE SHARES GIVE RISE TO VARIOUS RISKS. +The trading price of our common shares has been volatile and may continue to fluctuate. +The trading price of our common shares has been volatile and may continue to fluctuate widely as a result of several factors, many of which are outside of our control. In addition, the stock market is subject to fluctuations in the share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations have in the past and may in the future adversely affect the market price of our common shares. Among the factors that could affect the price of our common shares are: +• +our financial condition and performance; +• +the financial condition of our tenants, including the extent of tenant bankruptcies or defaults; +• +actual or anticipated quarterly fluctuations in our operating results and financial condition; +• +our dividend policy; +• +the reputation of REITs and real estate investments generally and the attractiveness of REIT equity securities in comparison to other equity securities, including securities issued by other real estate companies, and fixed income securities; +• +uncertainty and volatility in the equity and credit markets; +• +fluctuations in interest rates; +• +changes in revenue or earnings estimates or publication of research reports and recommendations by financial analysts or actions taken by rating agencies with respect to our securities or those of other REITs; +• +failure to meet analysts’ revenue or earnings estimates; +• +speculation in the press or investment community; +• +strategic actions by us or our competitors, such as acquisitions or restructurings; +• +the extent of institutional investor interest in us; +• +the extent of short-selling of our common shares and the shares of our competitors; +• +fluctuations in the stock price and operating results of our competitors; +• +general financial and economic market conditions and, in particular, developments related to market conditions for REITs and other real estate related companies; +• +domestic and international economic factors unrelated to our performance; +• +changes in tax laws and rules; and +• +all other risk factors addressed elsewhere in this Annual Report on Form 10-K. +A significant decline in our stock price could result in substantial losses for stockholders. +Alexander’s has additional shares of its common stock available for future issuance, which could decrease the market price of the common stock currently outstanding. +The interest of our current stockholders could be diluted if we issue additional equity securities. As of December 31, 2019 , we had authorized but unissued 4,826,550 shares of common stock, par value of $1.00 per share and 3,000,000 shares of preferred stock, par value $1.00 per share; of which 11,408 shares of common stock are reserved for issuance upon redemption of the deferred stock units previously granted to our Board of Directors. In addition, 494,379 shares are available for future grant under the terms of our 2016 Omnibus Stock Plan. These awards may be granted in the form of options, restricted stock, stock appreciation rights, deferred stock units, or other equity-based interests, and if granted, would reduce that number of shares available for future grants, provided however that an award that may be settled only in cash, would not reduce the number of shares available under the plan. We cannot predict the impact that future issuances of common or preferred stock or any exercise of outstanding options or grants of additional equity-based interests would have on the market price of our common stock. +ITEM 1B. UNRESOLVED STAFF COMMENTS +There are no unresolved comments from the staff of the Securities and Exchange Commission as of the date of this Annual Report on Form 10-K. +18 +ITEM 2. PROPERTIES +The following table shows the location, ownership, approximate size (excluding parking garages) and occupancy of each of our properties as of December 31, 2019 . +Square Feet +Weighted +Under +Average +Development Or +In Service +Escalated +Lease Expiration(s) +Land +Total +Not Available +Occupancy +Annual +Original +Option +Property +Acreage +Property +In Service +For Lease +Rate +Rent PSF (1) +Tenants +Term (2) +Term (3) +Operating Properties: +731 Lexington Avenue +New York, NY +Office +920,000 +896,000 +24,000 +100% +$ +121.81 +Bloomberg L.P. +2029 +2039 +Retail +83,000 +83,000 +— +The Home Depot +2025 +2035 +34,000 +34,000 +— +The Container Store +2021 +N/A +38,000 +38,000 +— +Various +Various +Various +155,000 +155,000 +— +93% +277.36 +1.9 +1,075,000 +1,051,000 +24,000 +Rego Park I +Queens, NY +113,000 +— +113,000 +IKEA (4) +2025 +(5) +2030 +50,000 +50,000 +— +Burlington +2022 +2027 +46,000 +46,000 +— +Bed Bath & Beyond +2021 +N/A +36,000 +36,000 +— +Marshalls +2032 +N/A +16,000 +16,000 +— +Old Navy +2021 +N/A +82,000 +— +82,000 +(6) +N/A +N/A +4.8 +343,000 +148,000 +195,000 +100% +53.18 +Rego Park II +Queens, NY +145,000 +145,000 +— +Costco +2034 +2059 +135,000 +135,000 +— +Century 21 +2031 +2051 +133,000 +133,000 +— +Kohl’s (7) +2031 +2051 +196,000 +196,000 +— +Various +Various +Various +6.6 +609,000 +609,000 +— +92% +59.78 +The Alexander apartment tower, 312 units +Queens, NY +— +255,000 +255,000 +— +94% +46.19 +(8) +Residential +(9) +N/A +Paramus +Paramus, NJ +30.3 +— +— +— +100% +— +IKEA (ground lessee) +2041 +N/A +Flushing +Queens, NY (10) +1 +167,000 +167,000 +— +100% +29.18 +New World Mall LLC +2027 +2037 +Property to be Developed: +Rego Park III, adjacent to Rego Park II +Queens, NY +3.2 +— +— +— +— +— +— +— +— +2,449,000 +2,230,000 +219,000 +(1) +Represents the weighted average escalated annual rent per square foot, which includes tenant reimbursements and excludes the impact of tenant concessions (such as free rent), as of December 31, 2019. For a discussion of our leasing activity, see Item 7 - Overview - Square Footage, Occupancy and Leasing Activity. +(2) +Represents the year in which the tenant’s lease expires, without consideration of any renewal or extension options. Lease expiration dates are based on non-cancelable lease terms and do not extend beyond any early termination rights that the tenant may have under its lease. +(3) +Represents the year in which the tenant’s lease expires if all renewal or extension options are exercised. +(4) +On September 23, 2019, we entered into a lease agreement with IKEA, replacing a significant portion of the space formerly occupied by Sears. Currently out of service due to redevelopment. +(5) +IKEA has the option to terminate its lease after the fifth year of the lease term subject to payment to us of the lesser of $10,000,000 or the amount of rent due under the remaining term. +(6) +Formerly occupied by Sears. Currently out of service due to redevelopment. +(7) +On April 13, 2019, Kohl’s closed its store at the property. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031. +(8) +Average monthly rent per unit is $3,150. +(9) +Residential tenants have one or two year leases. +(10) +Ground leased through January 2027 with one 10-year extension option. +19 +Operating Properties +731 Lexington Avenue +731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprises the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan, New York, and is situated in the heart of one of Manhattan’s busiest business and shopping districts, with convenient access to several subway and bus lines. The property is located across the street from Bloomingdale’s flagship store and only a few blocks away from Fifth Avenue and 57 th Street. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg occupies all of the office space. The Home Depot (83,000 square feet) and The Container Store (34,000 square feet) are the principal retail tenants. +The office portion of 731 Lexington Avenue is encumbered by a mortgage loan with a balance of $500,000,000 as of December 31, 2019 . The interest-only loan is at LIBOR plus 0.90% (2.64% as of December 31, 2019 ) and matures in June 2020, with four one-year unilateral extension options. In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. +The retail portion of 731 Lexington Avenue is encumbered by a mortgage loan with a balance of $350,000,000 as of December 31, 2019 . The interest-only loan is at LIBOR plus 1.40% (3.10 % as of December 31, 2019 ) and matures in August 2020, with two one-year conditional extension options. +Rego Park I +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. On September 23, 2019, we leased 113,000 square feet at the property to IKEA, replacing a significant portion of the space formerly occupied by Sears. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls. The center contains a parking deck (1,241 spaces) that provides for paid parking. +Rego Park II +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On April 13, 2019, Kohl’s closed its store at the property. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031. The center contains a parking deck (1,326 spaces) that provides for paid parking. +This center is encumbered by a mortgage loan in the amount of $252,544,000. The interest-only loan is at LIBOR plus 1.35% (3.15% as of December 31, 2019 ) and matures in December 2025. As of December 31, 2019, we have a participation in the mortgage in the amount of $195,708,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $56,836,000. On February 14, 2020, we reduced our participation in the mortgage loan to $50,000,000 and received cash proceeds of approximately $145,000,000. +The Alexander Apartment Tower +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet. +20 +Operating Properties - continued +Paramus +We own 30.3 acres of land located at the intersection of Routes 4 and 17 in Paramus, New Jersey. The land is located directly across from the Garden State Plaza regional shopping mall and is within two miles of three other regional shopping malls and ten miles of New York City. The land has been ground leased to IKEA Property, Inc. since 2001. The lease expires in 2041, with a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. +Flushing +Flushing is located on Roosevelt Avenue and Main Street in the downtown, commercial section of Flushing, Queens, New York. Roosevelt Avenue and Main Street are active shopping districts and there are many national retailers located in the area. A subway entrance is located directly in front of the property with bus service across the street. The property comprises a four-floor building containing 167,000 square feet and a parking garage, which is sub-leased to New World Mall LLC for the remainder of our ground lease term, which expires in 2027 and has one 10-year extension option. +Property to be Developed +Rego Park III +We own a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, New York, at the intersection of Junction Boulevard and the Horace Harding Service Road. The land is currently being used for paid public parking. In 2016, the Company started the entitlement process. +ITEM 3. LEGAL PROCEEDINGS +We are from time to time involved in legal actions arising in the ordinary course of business. In our opinion, after consultation with our legal counsel, the outcome of such matters will not have a material effect on our financial condition, results of operations or cash flows. +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4,000,000 and future damages it estimated would not be less than $25,000,000. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +21 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on the New York Stock Exchange under the symbol “ALX.” +As of January 31, 2020, there were 212 holders of record of our common stock. +Recent Sales of Unregistered Securities +During 2019 , we did not sell any unregistered securities. +Information relating to compensation plans under which our equity securities are authorized for issuance is set forth under Part III, Item 12 of this Annual Report on Form 10-K and such information is incorporated by reference herein. +Recent Purchases of Equity Securities +During 2019 , we did not repurchase any of our equity securities. +22 +Performance Graph +The following graph is a comparison of the five-year cumulative return of our common stock, the Standard & Poor’s 500 Index (the “S&P 500 Index”) and the National Association of Real Estate Investment Trusts’ (“NAREIT”) All Equity Index, a peer group index. The graph assumes that $100 was invested on December 31, 2014 in our common stock, the S&P 500 Index and the NAREIT All Equity Index and that all dividends were reinvested without the payment of any commissions. There can be no assurance that the performance of our stock will continue in line with the same or similar trends depicted in the graph below. +2014 +2015 +2016 +2017 +2018 +2019 +Alexander’s +$ +100 +$ +91 +$ +105 +$ +102 +$ +82 +$ +94 +S&P 500 Index +100 +101 +114 +138 +132 +174 +The NAREIT All Equity Index +100 +103 +112 +121 +116 +150 +23 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets forth selected financial and operating data. This data should be read in conjunction with the consolidated financial statements and notes thereto and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. This data may not be comparable to, or indicative of, future operating results. +Year Ended December 31, +(Amounts in thousands, except per share amounts) +2019 +2018 +2017 +2016 +2015 +Total revenues +$ +226,350 +$ +232,825 +$ +230,574 +$ +226,936 +$ +207,915 +Income from continuing operations (1) +$ +60,075 +$ +56,641 +$ +80,509 +$ +86,477 +$ +76,907 +Loss from discontinued operations +— +(23,797 +) +— +— +— +Net income +$ +60,075 +$ +32,844 +$ +80,509 +$ +86,477 +$ +76,907 +Income per common share: +Income from continuing operations - basic +$ +11.74 +$ +11.07 +$ +15.74 +$ +16.91 +$ +15.04 +Income from continuing operations - diluted +11.74 +11.07 +15.74 +16.91 +15.04 +Net income per common share - basic +11.74 +6.42 +15.74 +16.91 +15.04 +Net income per common share - diluted +11.74 +6.42 +15.74 +16.91 +15.04 +Dividends per common share +$ +18.00 +$ +18.00 +$ +17.00 +$ +16.00 +$ +14.00 +Balance sheet data: +Total assets (2) (3) +$ +1,265,511 +$ +1,285,549 +$ +1,632,395 +$ +1,451,230 +$ +1,447,808 +Real estate, at cost +1,041,342 +1,027,691 +1,037,368 +1,033,551 +1,029,472 +Accumulated depreciation and amortization +324,499 +297,421 +283,044 +252,737 +225,533 +Mortgages payable, net of deferred debt issuance costs (2) +970,961 +965,826 +1,240,222 +1,052,359 +1,053,262 +Total equity +253,515 +285,092 +343,955 +352,845 +352,880 +(1) +2019 and 2018 include $8,757 and $11,990 of expense, respectively, from the decrease in the fair value of marketable securities. Prior to January 1, 2018, changes in the fair value of marketable securities were recognized through “accumulated other comprehensive loss” on our consolidated balance sheets and did not impact our consolidated statements of income. +(2) +Subsequent to the issuance of our consolidated financial statements for the year ended December 31, 2018, we determined that the $195,708 participation in our Rego Park II shopping center mortgage loan was incorrectly classified as an asset, presented as “Rego Park II loan participation,” instead of as a reduction to “mortgages payable, net of deferred debt issuance costs” on our consolidated balance sheet as of December 31, 2018. Accordingly, our consolidated balance sheet for the year ended December 31, 2018 has been restated to reclassify $195,708 from “Rego Park II loan participation” to “mortgages payable, net of deferred debt issuance costs.” See Note 2 - Summary of Significant Accounting Policies to our consolidated financial statements in this Annual Report on Form 10-K for additional information. +(3) +On January 1, 2019 we adopted Accounting Standards Codification Topic 842, Leases, which required us to record a right-of-use asset of $4,529 as of December 31, 2019. See Note 2 - Summary of Significant Accounting Policies and Note 9 - Leases to our consolidated financial statements in this Annual Report on Form 10-K for additional information. +24 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Overview +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. +We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Year Ended December 31, 2019 Financial Results Summary +Net income for the year ended December 31, 2019 was $60,075,000 or $11.74 per diluted share, compared to $32,844,000, or $6.42 per diluted share for the year ended December 31, 2018 . Net income for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza Regional Shopping Center (“Kings Plaza”). +Funds from operations (“FFO”) (non-GAAP) for the year ended December 31, 2019 was $99,670,000, or $19.47 per diluted share, compared to $77,429,000, or $15.13 per diluted share for the year ended December 31, 2018 . FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the Kings Plaza transfer taxes. +Quarter Ended December 31, 2019 Financial Results Summary +Net income for the quarter ended December 31, 2019 was $14,434,000, or $2.82 per diluted share, compared to $9,971,000, or $1.95 per diluted share for the quarter ended December 31, 2018 . +FFO (non-GAAP) for the quarter ended December 31, 2019 was $24,626,000, or $4.81 per diluted share, compared to $24,158,000, or $4.72 per diluted share for the quarter ended December 31, 2018 . +Square Footage, Occupancy and Leasing Activity +As of December 31, 2019, our portfolio was comprised of seven properties aggregating 2,449,000 square feet, of which 2,230,000 square feet was in service and 219,000 square feet (primarily the former Sears space at our Rego Park I shopping center) was out of service due to redevelopment. The in service square feet was 96.5% occupied as of December 31, 2019. +On September 23, 2019, we entered into a 10-year lease agreement with IKEA for 113,000 square feet at our Rego Park I shopping center, replacing a significant portion of the space formerly occupied by Sears. IKEA has the option to terminate this lease after the fifth year of the lease term subject to payment to us of the lesser of $10,000,000 or the amount of rent due under the remaining term. +Financing +On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. +On December 12, 2018, we completed a refinancing of our Rego Park II shopping center in the amount of $252,544,000. The interest-only loan is at LIBOR plus 1.35% (3.15% as of December 31, 2019) and matures in December 2025. As of December 31, 2019, we have a participation in the mortgage in the amount of $195,708,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $56,836,000. On February 14, 2020, we reduced our participation in the mortgage loan to $50,000,000 and received cash proceeds of approximately $145,000,000. +25 +Overview - continued +Significant Tenant +Bloomberg accounted for revenue of $109,113,000, $107,356,000, and $105,224,000 in the years ended December 31, 2019, 2018 and 2017, respectively, representing approximately 48%, 46% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +On June 28, 2019, we entered into a lease agreement with Bloomberg for an additional 49,000 square feet at our 731 Lexington Avenue property. +Critical Accounting Policies and Estimates +Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 – Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. +Real Estate +Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2019 and 2018, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $716,843,000 and $730,270,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. +Our properties, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset, including an estimated terminal value calculated using an appropriate capitalization rate. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. +26 +Critical Accounting Policies and Estimates - continued +Revenue Recognition +Our rental revenues include revenues from the leasing of space to tenants at our properties and revenues from parking and tenant services. We have the following revenue recognition policies: +• Lease revenues from the leasing of space to tenants at our properties. Revenues derived from base rent are recognized over the non-cancelable term of the related leases on a straight-line basis which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the underlying asset is available for use by the lessee. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. Revenues derived from the reimbursement of real estate taxes, insurance expenses and common area maintenance expenses are generally recognized in the same period as the related expenses are incurred. As lessor, we have elected to combine the lease components (base and variable rent), non-lease components (reimbursements of common area maintenance expenses) and reimbursement of real estate taxes and insurance expenses from our operating lease agreements and account for the components as a single lease component in accordance with ASC Topic 842, Leases (“ASC 842”). +• Parking revenue arising from the rental of parking spaces at our properties. This income is recognized as the services are transferred in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). +• +Tenant services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred in accordance with ASC 606. +Income Taxes +We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 – 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. +27 +Results of Operations – Year Ended December 31, 2019 compared to December 31, 2018 +Rental Revenues +Rental revenues were $226,350,000 in the year ended December 31, 2019 , compared to $232,825,000 in the prior year, a decrease of $6,475,000. This decrease was primarily due to the Sears vacancy effective October 2018 at our Rego Park I property. +Operating Expenses +Operating expenses were $89,738,000 in the year ended December 31, 2019 , compared to $93,775,000 in the prior year, a decrease of $4,037,000. This decrease was primarily due to bad debt expense in the prior year of $4,459,000, primarily due to the Sears bankruptcy and lease termination. +Depreciation and Amortization +Depreciation and amortization was $31,351,000 in the year ended December 31, 2019 , compared to $33,089,000 in the prior year, a decrease of $1,738,000. This decrease was primarily due to acceleration of depreciation and amortization in the prior year related to the Toys “R” Us, Inc. (“Toys”) bankruptcy and lease termination at our Rego Park II property. +General and Administrative Expenses +General and administrative expenses were $5,772,000 in the year ended December 31, 2019 , compared to $5,343,000 in the prior year, an increase of $429,000. This increase was primarily due to higher professional fees. +Interest and Other Income, net +Interest and other income, net was $8,244,000 in the year ended December 31, 2019 , compared to $12,546,000 in the prior year, a decrease of $4,302,000. This decrease was primarily due to (i) $7,126,000 of interest income in the prior year from our Rego Park II loan participation (on December 12, 2018, we refinanced our $252,544,000 Rego Park II shopping center mortgage loan and GAAP required that our $195,708,000 loan participation be treated as an extinguishment of debt), partially offset by (ii) $1,364,000 of higher interest income due to an increase in average interest rates and (iii) $1,600,000 of expense in the prior year from a litigation settlement. +Interest and Debt Expense +Interest and debt expense was $38,901,000 in the year ended December 31, 2019 , compared to $44,533,000 in the prior year, a decrease of $5,632,000. This decrease was primarily due to $7,178,000 of lower interest expense due to the refinancing of our Rego Park II shopping center loan, partially offset by $1,810,000 of higher interest expense resulting from an increase in average interest rates. +Change in Fair Value of Marketable Securities +Change in fair value of marketable securities was an expense of $8,757,000 in the year ended December 31, 2019, resulting from Macerich’s closing share prices of $26.92 and $43.28 as of December 31, 2019 and 2018, respectively, on 535,265 shares owned. Change in fair value of marketable securities was an expense of $11,990,000 in the prior year, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively. +Loss from Discontinued Operations +Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to an expense for potential additional real property transfer taxes from the 2012 sale of Kings Plaza. See Note 6 – Discontinued Operations , to our consolidated financial statements in this Annual Report on Form 10-K. +28 +Results of Operations – Year Ended December 31, 2018 compared to December 31, 2017 +Rental Revenues +Rental revenues were $232,825,000 in the year ended December 31, 2018, compared to $230,574,000 in the prior year, an increase of $2,251,000. This increase was primarily due to (i) higher revenue from a new restaurant tenant at our 731 Lexington property and (ii) higher expense reimbursements, partially offset by (iii) lower revenue from Sears at our Rego Park I property and Toys at our Rego Park II property. +Operating Expenses +Operating expenses were $93,775,000 in the year ended December 31, 2018, compared to $85,127,000 in the prior year, an increase of $8,648,000. This increase was primarily due to (i) higher bad debt expense of $4,406,000, (ii) higher real estate taxes of $2,180,000 and (iii) higher operating expenses of $1,664,000. +Depreciation and Amortization +Depreciation and amortization was $33,089,000 in the year ended December 31, 2018, compared to $34,925,000 in the prior year, a decrease of $1,836,000. This decrease was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in 2017. +General and Administrative Expenses +General and administrative expenses were $5,343,000 in the year ended December 31, 2018, compared to $5,255,000 in the prior year, an increase of $88,000. +Interest and Other Income, net +Interest and other income, net was $12,546,000 in the year ended December 31, 2018, compared to $6,716,000 in the prior year, an increase of $5,830,000. This increase was primarily due to (i) $4,673,000 of higher interest income from the Rego Park II loan participation entered into in July 2017 and (ii) $3,693,000 of higher interest income due to an increase in average interest rates, partially offset by (iii) $1,600,000 of expense in 2018 from a litigation settlement and (iv) $760,000 of lower interest income due to lower average investment balances. +Interest and Debt Expense +Interest and debt expense was $44,533,000 in the year ended December 31, 2018, compared to $31,474,000 in the prior year, an increase of $13,059,000. This increase was primarily due to (i) $8,482,000 resulting from an increase in average interest rates, (ii) $2,620,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,641,000 of higher amortization of debt issuance costs. +Change in Fair Value of Marketable Securities +Change in fair value of marketable securities was an expense of $11,990,000 in the year ended December 31, 2018, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively, on 535,265 shares owned. +Loss from Discontinued Operations +Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to an expense for potential additional real property transfer taxes from the 2012 sale of Kings Plaza. See Note 6 – Discontinued Operations , to our consolidated financial statements in this Annual Report on Form 10-K. +29 +Related Party Transactions +Vornado +As of December 31, 2019 , Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 4 – Related Party Transactions , to our consolidated financial statements in this Annual Report on Form 10-K. +Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2019 , Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Toys +Our affiliate, Vornado, owned 32.5% of Toys as of December 31, 2018. On February 1, 2019, in connection with the Toys Chapter 11 bankruptcy, the plan of reorganization for Toys was declared effective and Vornado’s ownership in Toys was canceled and Toys’ Board of Directors was dissolved. Joseph Macnow, Vornado’s Executive Vice President and Chief Financial Officer and Wendy A. Silverstein, a member of our Board of Directors, represented Vornado as members of Toys’ Board of Directors. Also in connection with the Toys Chapter 11 bankruptcy, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ($2,600,000 of annual revenue) effective June 30, 2018 and possession of the space was returned to us. +Liquidity and Capital Resources +Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders and capital expenditures. +Dividends +On January 15, 2020, we set our regular quarterly dividend to $4.50 per share (an indicated annual rate of $18.00 per share). The dividend, if declared by the Board of Directors for all of 2020, would require us to pay out approximately $92,100,000. +Financing Activities and Contractual Obligations +On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. +On December 12, 2018, we completed a refinancing of our Rego Park II shopping center in the amount of $252,544,000. The interest-only loan is at LIBOR plus 1.35% (3.15% as of December 31, 2019) and matures in December 2025. As of December 31, 2019, we have a participation in the mortgage in the amount of $195,708,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $56,836,000. On February 14, 2020, we reduced our participation in the mortgage loan to $50,000,000 and received cash proceeds of approximately $145,000,000. +30 +Liquidity and Capital Resources - continued +Below is a summary of our outstanding debt and maturities as of December 31, 2019 . We may refinance our maturing debt as it comes due or choose to repay it. +Balance +Interest Rate +Maturity +(Amounts in thousands) +Paramus +$ +68,000 +4.72 +% +Oct. 2021 +731 Lexington Avenue, retail condominium (1) +350,000 +3.10 +% +Aug. 2022 +731 Lexington Avenue, office condominium (2) +500,000 +2.64 +% +Jun. 2024 +Rego Park II shopping center (3) +56,836 +3.15 +% +Dec. 2025 +Total +974,836 +Deferred debt issuance costs, net of accumulated amortization of $14,362 +(3,875 +) +Total, net +$ +970,961 +(1) Interest at LIBOR plus 1.40%. Maturity date represents the extended maturity based on our conditional right to extend. +(2) Interest at LIBOR plus 0.90%. Maturity date represents the extended maturity based on our unilateral right to extend. +(3) Interest at LIBOR plus 1.35%. The amount of this loan is net of our $195,708 loan participation (see Note 2 - Summary of Significant Accounting Policies, to our consolidated financial statements in this Annual Report on Form 10-K). +Below is a summary of our contractual obligations and commitments as of December 31, 2019 . +Less than +One to +Three to +More than +(Amounts in thousands) +Total +One Year +Three Years +Five Years +Five Years +Contractual obligations (1) (principal and interest) (2) : +Long-term debt obligations (3) +$ +1,079,915 +$ +29,525 +$ +469,147 +$ +522,592 +$ +58,651 +Operating lease obligations +5,600 +800 +1,600 +1,600 +1,600 +$ +1,085,515 +$ +30,325 +$ +470,747 +$ +524,192 +$ +60,251 +Commitments: +Standby letters of credit +$ +1,030 +$ +960 +$ +70 +$ +— +$ +— +(1) +Excludes committed tenant-related obligations as timing and amounts of payments are uncertain and may only be due upon satisfactory performance of certain conditions. +(2) +Principal repayments based on extended loan maturity dates. Interest on variable rate debt is computed using rates in effect as of December 31, 2019. +(3) +Net of loan participation and related interest. +Commitments and Contingencies +Insurance +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $268,000 deductible and 20% of the balance of a covered loss, and the Federal government is responsible for the remaining 80% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +31 +Liquidity and Capital Resources - continued +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Paramus +In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. +Rego Park I Litigation +In June 2014, Sears filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4,000,000 and future damages it estimated would not be less than $25,000,000. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +Tenant Matter +On April 13, 2019, Kohl’s closed its 133,000 square foot store at our Rego Park II shopping center. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031. +Letters of Credit +Approximately $1,030,000 of standby letters of credit were issued and outstanding as of December 31, 2019 . +Other +There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. +32 +Liquidity and Capital Resources - continued +Cash Flows for the Year Ended December 31, 2019 +Cash and cash equivalents and restricted cash were $313,977,000 at December 31, 2019 , compared to $289,495,000 at December 31, 2018 , an increase of $24,482,000. This increase resulted from (i) $126,070,000 of net cash provided by operating activities, partially offset by (ii) $92,139,000 of net cash used in financing activities and (iii) $9,449,000 of net cash used in investing activities. +Net cash provided by operating activities of $126,070,000 was comprised of (i) net income of $60,075,000, (ii) adjustments for non-cash items of $48,079,000 and (iii) the net change in operating assets and liabilities of $17,916,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $36,515,000, (ii) the change in fair value of marketable securities of $8,757,000, (iii) straight-lining of rental income of $2,413,000 and (iv) stock-based compensation expense of $394,000. +Net cash used in financing activities was primarily comprised of dividends paid of $92,124,000. +Net cash used in investing activities was comprised of construction in progress and real estate additions of $9,449,000. +Cash Flows for the Year Ended December 31, 2018 +Cash and cash equivalents and restricted cash were $289,495,000 at December 31, 2018, compared to $393,279,000 at December 31, 2017, a decrease of $103,784,000. This decrease resulted from (i) $176,185,000 of net cash used in financing activities and (ii) $1,137,000 of net cash used in investing activities, partially offset by (iii) $73,538,000 of net cash provided by operating activities. +Net cash used in financing activities of $176,185,000 was primarily comprised of net debt repayments of $81,896,000 (primarily the refinancing and subsequent repayment of the mortgage loan on our Rego Park I shopping center) and dividends paid of $92,100,000. +Net cash used in investing activities of $1,137,000 was comprised of construction in progress and real estate additions of $3,966,000, partially offset by repayment of Rego Park II loan participation of $2,829,000. +Net cash provided by operating activities of $73,538,000 was comprised of (i) net income of $32,844,000 and (ii) adjustments for non-cash items of $56,807,000, partially offset by (iii) the net change in operating assets and liabilities of $16,113,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,499,000, (ii) the change in fair value of marketable securities of $11,990,000, (iii) straight-lining of rental income of $5,924,000 and (iv) stock-based compensation expense of $394,000. +Cash Flows for the Year Ended December 31, 2017 +Cash and cash equivalents and restricted cash were $393,279,000 at December 31, 2017, compared to $374,678,000 at December 31, 2016, an increase of $18,601,000. This increase resulted from (i) $123,426,000 of net cash provided by operating activities and (ii) $97,146,000 of net cash provided by financing activities, partially offset by (iii) $201,971,000 of net cash used in investing activities. +Net cash provided by operating activities of $123,426,000 was comprised of (i) net income of $80,509,000 and (ii) adjustments for non-cash items of $43,372,000, partially offset by (iii) the net change in operating assets and liabilities of $455,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,681,000, (ii) straight-lining of rental income of $4,297,000 and (iii) stock-based compensation expense of $394,000. +Net cash provided by financing activities of $97,146,000 was primarily comprised of (i) $500,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue, partially offset by (ii) debt repayments of $303,707,000 (primarily the repayment of the former loan on the office portion of 731 Lexington Avenue) and (iii) dividends paid of $86,961,000. +Net cash used in investing activities of $201,971,000 was comprised of (i) Rego Park II loan participation of $200,000,000 and (ii) construction in progress and real estate additions of $3,434,000, partially offset by (iii) principal repayment proceeds from the Rego Park II loan participation of $1,463,000. +33 +Funds from Operations (“FFO”) (non-GAAP) +FFO is computed in accordance with the December 2018 restated definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciable real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. +FFO (non-GAAP) for the years and quarters ended December 31, 2019 and 2018 +FFO (non-GAAP) for the year ended December 31, 2019 was $99,670,000, or $19.47 per diluted share, compared to $77,429,000, or $15.13 per diluted share for the year ended December 31, 2018 . FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza. +FFO (non-GAAP) for the quarter ended December 31, 2019 was $24,626,000, or $4.81 per diluted share, compared to $24,158,000, or $4.72 per diluted share for the quarter ended December 31, 2018 . +The following table reconciles our net income to FFO (non-GAAP): +For the Year Ended +For the Three Months Ended +(Amounts in thousands, except share and per share amounts) +December 31, +December 31, +2019 +2018 +2019 +2018 +Net income +$ +60,075 +$ +32,844 +$ +14,434 +$ +9,971 +Depreciation and amortization of real property +30,838 +32,595 +7,692 +7,758 +Change in fair value of marketable securities +8,757 +11,990 +2,500 +6,429 +FFO (non-GAAP) +$ +99,670 +$ +77,429 +$ +24,626 +$ +24,158 +FFO per diluted share (non-GAAP) +$ +19.47 +$ +15.13 +$ +4.81 +$ +4.72 +Weighted average shares used in computing FFO per diluted share +5,118,198 +5,116,838 +5,118,698 +5,117,347 +34 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +We have exposure to fluctuations in interest rates, which are sensitive to many factors that are beyond our control. Our exposure to a change in interest rates is summarized in the table below. +2019 +2018 +December 31, Balance +Weighted Average Interest Rate +Effect of 1% Change in Base Rates +December 31, Balance +Weighted Average Interest Rate +(Amounts in thousands, except per share amounts) +Variable rate +$ +906,836 +2.85% +$ +9,068 +$ +906,836 +3.55% +Fixed rate +68,000 +4.72% +— +68,000 +4.72% +$ +974,836 +2.98% +$ +9,068 +$ +974,836 +3.64% +Total effect on diluted earnings per share +$ +1.77 +As of December 31, 2019 we had an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. +Fair Value of Debt +The fair value of our consolidated debt is calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist. As of December 31, 2019 and 2018 , the estimated fair value of our consolidated debt was $974,000,000 and $969,000,000, respectively. Our fair value estimates, which are made at the end of the reporting period, may be different from the amounts that may ultimately be realized upon the disposition of our financial instruments. +35 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Index to Consolidated Financial Statements +Page +Number +Report of Independent Registered Public Accounting Firm +37 +Consolidated Balance Sheets as of December 31, 2019 and 2018 +39 +Consolidated Statements of Income for the +Years Ended December 31, 2019, 2018 and 2017 +40 +Consolidated Statements of Comprehensive Income for the +Years Ended December 31, 2019, 2018 and 2017 +41 +Consolidated Statements of Changes in Equity for the +Years Ended December 31, 2019, 2018 and 2017 +42 +Consolidated Statements of Cash Flows for the +Years Ended December 31, 2019, 2018 and 2017 +43 +Notes to Consolidated Financial Statements +44 +36 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and the Board of Directors of +Alexander’s, Inc. +Paramus, New Jersey +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Alexander’s, Inc. and subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, changes in equity, and cash flows, for each of the three years in the period ended December 31, 2019, and the related notes and the schedules listed in the Index at Item 15 (collectively, the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 18, 2020, expressed an unqualified opinion on the Company’s internal control over financial reporting. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the US federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Real Estate - Refer to Note 2 to the financial statements +Critical Audit Matter Description +The Company’s real estate assets are evaluated for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company’s evaluation of the recoverability of real estate assets involves the comparison of undiscounted future cash flows expected to be generated by each real estate asset over the Company’s estimated holding period to the respective carrying amount. The Company’s undiscounted future cash flow analyses require management to make certain estimates, including estimated terminal values determined using appropriate capitalization rates. +37 +Given that the Company’s estimated capitalization rates used in the evaluation of impairment of real estate assets is a significant assumption made by management, performing audit procedures to evaluate the reasonableness of management’s undiscounted future cash flow analyses required a high degree of auditor judgment and an increased extent of effort, including the need to involve our fair value specialists. +How the Critical Audit Matter Was Addressed in the Audit +Our audit procedures related to the determination of capitalization rates included the following, among others: +• +We tested the design and operating effectiveness of controls over impairment, including those of determining the appropriate capitalization rates. +• +With the assistance of our fair value specialists, we evaluated the capitalization rates for real estate assets with possible impairment indicators by evaluating the source information and assumptions used by management. +• +We evaluated the reasonableness of management’s capitalization rates used by developing independent estimates of capitalization rates, focusing on geographical location and property type, and comparing our independent estimates to those used by the Company. +/s/ DELOITTE & TOUCHE LLP +Parsippany, New Jersey +February 18, 2020 +We have served as the Company’s auditor since 1969. +38 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +(Amounts in thousands, except share and per share amounts) +December 31, +ASSETS +2019 +2018 +Real estate, at cost: +Land +$ +44,971 +$ +44,971 +Buildings and leasehold improvements +984,053 +978,474 +Development and construction in progress +12,318 +4,246 +Total +1,041,342 +1,027,691 +Accumulated depreciation and amortization +( 324,499 +) +( 297,421 +) +Real estate, net +716,843 +730,270 +Cash and cash equivalents +298,063 +283,056 +Restricted cash +15,914 +6,439 +Marketable securities +14,409 +23,166 +Tenant and other receivables +6,092 +4,075 +Receivable arising from the straight-lining of rents +166,376 +168,789 +Deferred lease and other property costs, net, including unamortized leasing fees to Vornado of +$32,374 and $31,039, respectively +41,123 +40,669 +Other assets +6,691 +29,085 +$ +1,265,511 +$ +1,285,549 +LIABILITIES AND EQUITY +Mortgages payable, net of deferred debt issuance costs +$ +970,961 +$ +965,826 +Amounts due to Vornado +1,426 +708 +Accounts payable and accrued expenses +31,756 +30,889 +Other liabilities +7,853 +3,034 +Total liabilities +1,011,996 +1,000,457 +Commitments and contingencies +Preferred stock: $1.00 par value per share; authorized, 3,000,000 shares; +issued and outstanding, none +— +— +Common stock: $1.00 par value per share; authorized, 10,000,000 shares; +issued, 5,173,450 shares; outstanding, 5,107,290 shares +5,173 +5,173 +Additional capital +32,365 +31,971 +Retained earnings +216,394 +248,443 +Accumulated other comprehensive loss +( 49 +) +( 127 +) +253,883 +285,460 +Treasury stock: 66,160 shares, at cost +( 368 +) +( 368 +) +Total equity +253,515 +285,092 +$ +1,265,511 +$ +1,285,549 +See notes to consolidated financial statements. +39 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +(Amounts in thousands, except share and per share amounts) +Year Ended December 31, +2019 +2018 +2017 +REVENUES +Rental revenues +$ +226,350 +$ +232,825 +$ +230,574 +EXPENSES +Operating, including fees to Vornado of $5,386, $4,700 and $4,671, respectively +( 89,738 +) +( 93,775 +) +( 85,127 +) +Depreciation and amortization +( 31,351 +) +( 33,089 +) +( 34,925 +) +General and administrative, including management fees to Vornado of $2,380 +in each year +( 5,772 +) +( 5,343 +) +( 5,255 +) +Total expenses +( 126,861 +) +( 132,207 +) +( 125,307 +) +Interest and other income, net +8,244 +12,546 +6,716 +Interest and debt expense +( 38,901 +) +( 44,533 +) +( 31,474 +) +Change in fair value of marketable securities (see Note 5) +( 8,757 +) +( 11,990 +) +— +Income from continuing operations +60,075 +56,641 +80,509 +Loss from discontinued operations (see Note 6) +— +( 23,797 +) +— +Net income +$ +60,075 +$ +32,844 +$ +80,509 +Income per common share - basic and diluted: +Income from continuing operations +$ +11.74 +$ +11.07 +$ +15.74 +Loss from discontinued operations (see Note 6) +— +( 4.65 +) +— +Net income per common share +$ +11.74 +$ +6.42 +$ +15.74 +Weighted average shares outstanding- basic and diluted +5,118,198 +5,116,838 +5,115,501 +See notes to consolidated financial statements. +40 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +(Amounts in thousands) +Year Ended December 31, +2019 +2018 +2017 +Net income +$ +60,075 +$ +32,844 +$ +80,509 +Other comprehensive income (loss): +Change in fair value of marketable securities (see Note 5) +— +— +( 2,762 +) +Change in value of interest rate cap +78 +( 1 +) +( 70 +) +Comprehensive income +$ +60,153 +$ +32,843 +$ +77,677 +See notes to consolidated financial statements. +41 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +(Amounts in thousands) +Accumulated +Other +Comprehensive +Income (Loss) +Common Stock +Additional +Capital +Retained +Earnings +Treasury +Stock +Total +Equity +Shares +Amount +Balance, December 31, 2016 +5,173 +$ +5,173 +$ +31,189 +$ +308,995 +$ +7,862 +$ +( 374 +) +$ +352,845 +Net income +— +— +— +80,509 +— +— +80,509 +Dividends paid ($17.00 per common share) +— +— +— +( 86,961 +) +— +— +( 86,961 +) +Change in fair value of marketable securities +— +— +— +— +( 2,762 +) +— +( 2,762 +) +Change in fair value of interest rate cap +— +— +— +— +( 70 +) +— +( 70 +) +Deferred stock unit grants +— +— +394 +— +— +— +394 +Other +— +— +( 6 +) +— +— +6 +— +Balance, December 31, 2017 +5,173 +5,173 +31,577 +302,543 +5,030 +( 368 +) +343,955 +Net income +— +— +— +32,844 +— +— +32,844 +Dividends paid ($18.00 per common share) +— +— +— +( 92,100 +) +— +— +( 92,100 +) +Cumulative effect of change in accounting +principle +— +— +— +5,156 +( 5,156 +) +— +— +Change in fair value of interest rate cap +— +— +— +— +( 1 +) +( 1 +) +Deferred stock unit grants +— +— +394 +— +— +— +394 +Balance, December 31, 2018 +5,173 +5,173 +31,971 +248,443 +( 127 +) +( 368 +) +285,092 +Net income +— +— +— +60,075 +— +— +60,075 +Dividends paid ($18.00 per common share) +— +— +— +( 92,124 +) +— +— +( 92,124 +) +Change in fair value of interest rate cap +— +— +— +— +78 +— +78 +Deferred stock unit grants +— +— +394 +— +— +— +394 +Balance, December 31, 2019 +5,173 +$ +5,173 +$ +32,365 +$ +216,394 +$ +( 49 +) +$ +( 368 +) +$ +253,515 +See notes to consolidated financial statements. +42 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(Amounts in thousands) +Year Ended December 31, +2019 +2018 +2017 +CASH FLOWS FROM OPERATING ACTIVITIES +Net income +$ +60,075 +$ +32,844 +$ +80,509 +Adjustments to reconcile net income to net cash provided by operating activities: +Depreciation and amortization, including amortization of debt issuance costs +36,515 +38,499 +38,681 +Straight-lining of rental income +2,413 +5,924 +4,297 +Stock-based compensation expense +394 +394 +394 +Change in fair value of marketable securities +8,757 +11,990 +— +Change in operating assets and liabilities: +Tenant and other receivables, net +( 2,017 +) +( 1,382 +) +363 +Other assets +21,553 +( 1,197 +) +( 2,627 +) +Amounts due to Vornado +789 +( 1,907 +) +1,626 +Accounts payable and accrued expenses +( 1,800 +) +( 11,760 +) +211 +Other liabilities +( 609 +) +133 +( 28 +) +Net cash provided by operating activities +126,070 +73,538 +123,426 +CASH FLOWS FROM INVESTING ACTIVITIES +Construction in progress and real estate additions +( 9,449 +) +( 3,966 +) +( 3,434 +) +Rego Park II loan participation +— +— +( 200,000 +) +Repayment of Rego Park II loan participation +— +2,829 +1,463 +Net cash used in investing activities +( 9,449 +) +( 1,137 +) +( 201,971 +) +CASH FLOWS FROM FINANCING ACTIVITIES +Dividends paid +( 92,124 +) +( 92,100 +) +( 86,961 +) +Debt issuance costs +( 15 +) +( 2,189 +) +( 12,186 +) +Debt repayments +— +( 160,142 +) +( 303,707 +) +Proceeds from borrowing +— +78,246 +500,000 +Net cash (used in) provided by financing activities +( 92,139 +) +( 176,185 +) +97,146 +Net increase (decrease) in cash and cash equivalents and restricted cash +24,482 +( 103,784 +) +18,601 +Cash and cash equivalents and restricted cash at beginning of year +289,495 +393,279 +374,678 +Cash and cash equivalents and restricted cash at end of year +$ +313,977 +$ +289,495 +$ +393,279 +RECONCILIATION OF CASH AND CASH EQUIVALENTS AND RESTRICTED CASH +Cash and cash equivalents at beginning of year +$ +283,056 +$ +307,536 +$ +288,926 +Restricted cash at beginning of year +6,439 +85,743 +85,752 +Cash and cash equivalents and restricted cash at beginning of year +$ +289,495 +$ +393,279 +$ +374,678 +Cash and cash equivalents at end of year +$ +298,063 +$ +283,056 +$ +307,536 +Restricted cash at end of year +15,914 +6,439 +85,743 +Cash and cash equivalents and restricted cash at end of year +$ +313,977 +$ +289,495 +$ +393,279 +SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION +Cash payments for interest +$ +34,669 +$ +38,231 +$ +26,994 +NON-CASH TRANSACTIONS +Lease liability arising from the recognition of right-of-use asset +$ +5,428 +$ +— +$ +— +Liability for real estate additions, including $18, $125 and $21 for development fees due to +Vornado in 2019, 2018 and 2017, respectively +3,191 +631 +705 +Reclassification of prepaid real estate taxes to construction in progress for property in +redevelopment +1,466 +— +— +Write-off of fully amortized and/or depreciated assets +— +16,090 +4,265 +Derecognition of Rego Park II loan participation asset (see Note 2) +— +195,708 +— +See notes to consolidated financial statements. +43 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• +731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot ( 83,000 square feet) and The Container Store ( 34,000 square feet) are the principal retail tenants; +• +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ( $ 10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. On September 23, 2019, we leased 113,000 square feet at the property to IKEA Property, Inc. (“IKEA”), replacing a significant portion of the space formerly occupied by Sears. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On April 13, 2019, Kohl’s closed its store at the property. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031; +• +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• +Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA; and +• +Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• +Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +We have determined that our properties have similar economic characteristics and meet the criteria that permit the properties to be aggregated into one reportable segment (the leasing, management, development and redeveloping of properties in the greater New York City metropolitan area). Our chief operating decision-maker assesses and measures segment operating results based on a performance measure referred to as net operating income at the individual operating segment. Net operating income for each property represents net rental revenues less operating expenses. +44 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation – The accompanying consolidated financial statements include our accounts and those of our consolidated subsidiaries. All intercompany amounts have been eliminated. Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Certain prior year balances have been reclassified in order to conform to the current year presentation. +Subsequent to the issuance of our consolidated financial statements for the year ended December 31, 2018, we determined that the $ 195,708,000 participation in our Rego Park II shopping center mortgage loan was incorrectly classified as an asset, presented as “Rego Park II loan participation,” instead of as a reduction to “mortgages payable, net of deferred debt issuance costs” on our consolidated balance sheet as of December 31, 2018. On December 12, 2018, we refinanced this mortgage loan and the interest rate on the existing loan participation was adjusted to equal the interest rate on the refinanced loan. Consequently, we should have considered $ 195,708,000 of the Rego Park II shopping center mortgage loan liability extinguished as the participation interest is considered the reacquisition of our debt. Accordingly, our consolidated balance sheet for the year ended December 31, 2018 has been restated to reclassify $ 195,708,000 from “Rego Park II loan participation” to “mortgages payable, net of deferred debt issuance costs.” This reclassification had no material impact to our consolidated statements of income, comprehensive income, changes in equity or statement of cash flows for the year ended December 31, 2018. +Certain prior year balances have been reclassified in order to conform to the current period presentation. For the years ended December 31, 2018 and 2017, “property rentals” of $ 152,795,000 and $ 152,857,000 , respectively, and “expense reimbursements” of $ 80,030,000 and $ 77,717,000 , respectively, were grouped into “rental revenues” on our consolidated statements of income in accordance with Accounting Standards Codification (“ASC”) Topic 205 Presentation of Financial Statements. +Recently Issued Accounting Literature – In February 2016, the Financial Accounting Standards Board (“FASB”) issued an update (“ASU 2016-02”) establishing ASC Topic 842, Leases (“ASC 842”), as amended by subsequent ASUs on the topic, which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. ASU 2016-02 requires lessees to apply a two- method approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase. Lessees are required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months. Lease liabilities equal the present value of future lease payments. Right-of-use assets equal the lease liabilities adjusted for accrued rent expense, initial direct costs, lease incentives and prepaid lease payments. Leases with a term of 12 months or less will be accounted for similar to the previously existing guidance for operating leases. Lessees will recognize expense based on the effective interest method for finance leases or on a straight-line basis for operating leases. The accounting applied by the lessor is largely unchanged from that applied under ASC Topic 840, Leases (“ASC 840”). We adopted this standard effective January 1, 2019 using the modified retrospective approach. In transitioning to ASC 842, we elected to use the practical expedient package available to us and did not elect to use hindsight. These elections have been applied consistently to all of our leases. On January 1, 2019, for our Flushing property ground lease, which is classified as an operating lease, we recorded a right- of-use asset of $ 5,058,000 (included in “other assets”) and a lease liability of $ 5,428,000 (included in “other liabilities”) (see Note 9 - Leases ). +In June 2016, the FASB issued an update (“ASU 2016-13”) Measurement of Credit Losses on Financial Instruments establishing ASC Topic 326, Financial Instruments - Credit Losses , as amended by subsequent ASUs on the topic. ASU 2016-13 changes how entities will account for credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The guidance replaces the current “incurred loss” model with an “expected loss” model that requires consideration of a broader range of information to estimate expected credit losses over the lifetime of the financial asset. ASU 2016-13 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2019. We are currently evaluating the impact of the adoption of ASU 2016-13 on our consolidated financial statements, but do not believe the adoption of this standard will have a material impact on our consolidated financial statements. +In August 2018, the FASB issued an update (“ASU 2018-13”) Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement to ASC Topic 820, Fair Value Measurement (“ASC 820”). ASU 2018-13 modifies the disclosure requirements for fair value measurements by removing, modifying, and/or adding certain disclosures. ASU 2018-13 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2019. We elected to early adopt ASU 2018-13 effective January 1, 2019. The adoption of this update did not have a material impact on our consolidated financial statements and disclosures. +45 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued +In October 2018, the FASB issued an update (“ASU 2018-16”) Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes to ASC 815. ASU 2018-16 expands the list of U.S. benchmark interest rates permitted in the application of hedge accounting by adding the OIS rate based on SOFR as an eligible benchmark interest rate. ASU 2018-16 is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2018, with early adoption permitted. We adopted this update effective January 1, 2019. The adoption of this update did not have a material impact on our consolidated financial statements. +Real Estate – Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2019 and 2018 , the carrying amount of our real estate, net of accumulated depreciation and amortization, was $ 716,843,000 and $ 730,270,000 , respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. +Our properties, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset, including an estimated terminal value calculated using an appropriate capitalization rate. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. +Cash and Cash Equivalents – Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and are carried at cost, which approximates fair value, due to their short-term maturities. The majority of our cash and cash equivalents consist of (i) deposits at major commercial banks, which may at times exceed the Federal Deposit Insurance Corporation limit, (ii) United States Treasury Bills, (iii) money market funds, which invest in United States Treasury Bills and (iv) certificates of deposit placed through an account registry service (“CDARS”). To date we have not experienced any losses on our invested cash. +Restricted Cash – Restricted cash primarily consists of security deposits and other cash escrowed under loan agreements, including for debt service, real estate taxes, property insurance and capital improvements. +Marketable Securities – Our marketable securities consist of common shares of The Macerich Company (“Macerich”) (NYSE: MAC), which are classified as available-for-sale. Available-for-sale securities are presented at fair value on our consolidated balance sheets. Prior to January 1, 2018, unrealized gains and losses resulting from the mark-to-market of these securities were included in “other comprehensive income (loss).” Effective January 1, 2018, changes in the fair value of these securities are recognized in current period earnings in accordance with ASC Topic 825 (“ASC 825”), Financial Instruments (see Note 5). +Deferred Charges – Direct financing costs are deferred and amortized over the terms of the related agreements as a component of interest and debt expense. Direct costs related to leasing activities are capitalized and amortized on a straight-line basis over the lives of the related leases. All other deferred charges are amortized on a straight-line basis, which approximates the effective interest rate method, in accordance with the terms of the agreements to which they relate. +46 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued +Income Taxes – We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 – 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90 % of our taxable income to stockholders each year. We distribute to our stockholders 100 % of our taxable income and therefore, no provision for Federal income taxes is required. Dividends distributed for the year ended December 31, 2019 were characterized, for federal income tax purposes, as 99.6 % ordinary income and 0.4 % long-term capital gain income. Dividends distributed for the year ended December 31, 2018 were characterized, for federal income tax purposes, as 100.0 % ordinary income. Dividends distributed for the year ended December 31, 2017 were categorized, for federal income tax purposes, as 99.5 % ordinary income and 0.5 % long-term capital gain income. +The following table reconciles our net income to estimated taxable income for the years ended December 31, 2019 , 2018 and 2017 . +(Unaudited and in thousands) +Year Ended December 31, +2019 +2018 +2017 +Net income +$ +60,075 +$ +32,844 +$ +80,509 +Straight-line rent adjustments +2,359 +5,870 +4,250 +Depreciation and amortization timing differences +2,751 +( 6,586 +) +3,084 +Change in fair value of marketable securities (see Note 5) +8,757 +11,990 +— +Loss from discontinued operations (see Note 6) +— +23,797 +— +Other +137 +440 +( 343 +) +Estimated taxable income +$ +74,079 +$ +68,355 +$ +87,500 +As of December 31, 2019 , the net basis of our assets and liabilities for tax purposes is approximately $ 171,331,000 lower than the amount reported for financial statement purposes. +47 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +3. REVENUE RECOGNITION +Our rental revenues include revenues from the leasing of space to tenants at our properties and revenues from parking and tenant services. We have the following revenue recognition policies: +• +Lease revenues from the leasing of space to tenants at our properties. Revenues derived from base rent are recognized over the non-cancelable term of the related leases on a straight-line basis which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the underlying asset is available for use by the lessee. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. Revenues derived from the reimbursement of real estate taxes, insurance expenses and common area maintenance expenses are generally recognized in the same period as the related expenses are incurred. As lessor, we have elected to combine the lease components (base and variable rent), non-lease components (reimbursements of common area maintenance expenses) and reimbursement of real estate taxes and insurance expenses from our operating lease agreements and account for the components as a single lease component in accordance with ASC 842. +• Parking revenue arising from the rental of parking spaces at our properties. This income is recognized as the services are transferred in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). +• +Tenant services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred in accordance with ASC 606. +The following is a summary of revenue sources for the years ended December 31, 2019, 2018 and 2017. +For the Year Ended December 31, +(Amounts in thousands) +2019 +2018 +2017 +Lease revenues +$ +217,251 +$ +223,388 +$ +220,764 +Parking revenue +5,608 +5,680 +5,850 +Tenant services +3,491 +3,757 +3,960 +Rental revenues +$ +226,350 +$ +232,825 +$ +230,574 +The components of lease revenues for the year ended December 31, 2019 are as follows: +(Amounts in thousands) +For the Year Ended December 31, 2019 +Fixed lease revenues +$ +142,679 +Variable lease revenues +74,572 +Lease revenues +$ +217,251 +48 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +4. RELATED PARTY TRANSACTIONS +Vornado +As of December 31, 2019 , Vornado owned 32.4 % of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to the agreements described below, which expire in March of each year and are automatically renewable. +Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2019 , Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1 % of our outstanding common stock, in addition to the 2.3 % they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Management and Development Agreements +We pay Vornado an annual management fee equal to the sum of (i) $ 2,800,000 , (ii) 2 % of gross revenue from the Rego Park II shopping center, (iii) $ 0.50 per square foot of the tenant-occupied office and retail space at 731 Lexington Avenue, and (iv) $ 324,000 , escalating at 3 % per annum, for managing the common area of 731 Lexington Avenue. Vornado is also entitled to a development fee equal to 6 % of development costs, as defined. +Leasing and Other Agreements +Vornado also provides us with leasing services for a fee of 3 % of rent for the first ten years of a lease term, 2 % of rent for the eleventh through the twentieth year of a lease term, and 1 % of rent for the twenty-first through thirtieth year of a lease term, subject to the payment of rents by tenants. In the event third-party real estate brokers are used, the fees to Vornado increase by 1 % and Vornado is responsible for the fees to the third-party real estate brokers. +Vornado is also entitled to a commission upon the sale of any of our assets equal to 3 % of gross proceeds, as defined, for asset sales less than $ 50,000,000 and 1 % of gross proceeds, as defined, for asset sales of $ 50,000,000 or more. +We also have agreements with Building Maintenance Services, a wholly owned subsidiary of Vornado, to supervise (i) cleaning, engineering and security services at our Lexington Avenue property and (ii) security services at our Rego Park I and Rego Park II properties and The Alexander apartment tower. +The following is a summary of fees to Vornado under the various agreements discussed above. +Year Ended December 31, +(Amounts in thousands) +2019 +2018 +2017 +Company management fees +$ +2,800 +$ +2,800 +$ +2,800 +Development fees +29 +125 +29 +Leasing fees +4,786 +13 +1,829 +Property management, cleaning, engineering +and security fees +5,015 +4,101 +4,114 +$ +12,630 +$ +7,039 +$ +8,772 +As of December 31, 2019 , the amounts due to Vornado were $ 795,000 for management, property management, cleaning, engineering and security fees; $ 563,000 for leasing fees; and $ 68,000 for development fees. As of December 31, 2018 , the amounts due to Vornado were $ 549,000 for management, property management, cleaning, engineering and security fees; $ 146,000 for development fees; and $ 13,000 for leasing fees. +49 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +4. RELATED PARTY TRANSACTIONS - continued +Toys “R” Us, Inc. (“Toys”) +Our affiliate, Vornado, owned 32.5 % of Toys as of December 31, 2018. On February 1, 2019, in connection with the Toys Chapter 11 bankruptcy, the plan of reorganization for Toys was declared effective and Vornado’s ownership in Toys was canceled and Toys’ Board of Directors was dissolved. Joseph Macnow, Vornado’s Executive Vice President and Chief Financial Officer and Wendy A. Silverstein, a member of our Board of Directors, represented Vornado as members of Toys’ Board of Directors. Also in connection with the Toys Chapter 11 bankruptcy, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ( $ 2,600,000 of annual revenue) effective June 30, 2018 and possession of the space was returned to us. +5. MARKETABLE SECURITIES +As of December 31, 2019 and 2018 , we owned 535,265 common shares of Macerich. These shares have an economic cost of $ 56.05 per share, or $ 30,000,000 in the aggregate. As of December 31, 2019 and 2018 , the fair value of these shares was $ 14,409,000 and $ 23,166,000 , respectively, based on Macerich’s closing share price of $ 26.92 per share and $ 43.28 per share, respectively. These shares are included in “marketable securities” on our consolidated balance sheets and are classified as available-for-sale. Available-for-sale securities are presented at fair value on our consolidated balance sheets and gains and losses resulting from the mark-to-market of these securities are recognized in current period earnings. Prior to January 1, 2018, unrealized gains and losses resulting from the mark-to-market of these securities were included in “other comprehensive income (loss).” Effective January 1, 2018, changes in the fair value of these securities are recognized in current period earnings in accordance with ASC 825. +6. DISCONTINUED OPERATIONS +In 2012, we sold the Kings Plaza Regional Shopping Center (“Kings Plaza”) and paid real property transfer taxes to New York City in connection with the sale. In 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional New York City real property transfer tax amount, including interest. +In 2014, in a case with similar facts, the NYC DOF issued a Notice of Determination to a Vornado joint venture assessing an additional New York City real property transfer tax amount, including interest. In January 2017, a New York City administrative law judge made a determination upholding the Vornado joint venture’s position that such additional real property transfer taxes were not due. On February 16, 2018, the New York City Tax Appeals Tribunal (the “Tribunal”) overturned the January 2017 determination. The Vornado joint venture appealed the Tribunal’s decision to the Appellate Division of the Supreme Court of the +State of New York and on April 25, 2019, the Tribunal’s decision was unanimously upheld. The Vornado joint venture filed a motion to reargue the Appellate Division’s decision or for leave to appeal to the New York State Court of Appeals. On December 12, 2019, that motion was denied and the case can no longer be appealed. +Based on the precedent of the Tribunal’s decision, we accrued an expense for the potential additional real property transfer taxes of $ 23,797,000 ( $ 15,874,000 of real property transfer tax and $ 7,923,000 of interest) during the three months ended March 31, 2018. On April 5, 2018, we paid this amount in order to stop the interest from accruing. As the results related to Kings Plaza were previously classified as discontinued operations, we have classified the expense as “loss from discontinued operations” on our consolidated statement of income for the year ended December 31, 2018 in accordance with the provisions of ASC Topic 360, Property, Plant and Equipment . We are currently evaluating our options relating to this matter. +50 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +7. MORTGAGES PAYABLE +On October 3, 2018, we extended our mortgage loan on our Paramus property. The $ 68,000,000 interest-only loan has a fixed rate of 4.72 % and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90 % . The tenant pays all of the interest on this mortgage loan as part of its rent. +On December 12, 2018, we completed a refinancing of our Rego Park II shopping center in the amount of $ 252,544,000 . The interest-only loan is at LIBOR plus 1.35 % ( 3.15 % as of December 31, 2019) and matures in December 2025. As of December 31, 2019, we have a participation in the mortgage in the amount of $ 195,708,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $ 56,836,000 . On February 14, 2020, we reduced our participation in the mortgage loan to $ 50,000,000 and received cash proceeds of approximately $ 145,000,000 . +The following is a summary of our outstanding mortgages payable. We may refinance our maturing debt as it comes due or choose to repay it. +Interest Rate at December 31, 2019 +Balance at December 31, +(Amounts in thousands) +Maturity +2019 +2018 +First mortgages secured by: +Paramus +Oct. 2021 +4.72 % +$ +68,000 +$ +68,000 +731 Lexington Avenue, retail condominium (1) +Aug. 2022 +3.10 % +350,000 +350,000 +731 Lexington Avenue, office condominium (2) +Jun. 2024 +2.64 % +500,000 +500,000 +Rego Park II shopping center (3) +Dec. 2025 +3.15 % +56,836 +56,836 +Total +974,836 +974,836 +Deferred debt issuance costs, net of accumulated +amortization of $14,362 and $9,212, respectively +( 3,875 +) +( 9,010 +) +$ +970,961 +$ +965,826 +(1) +Interest at LIBOR plus 1.40%. Maturity date represents the extended maturity based on our conditional right to extend. +(2) +Interest at LIBOR plus 0.90%. Maturity date represents the extended maturity based on our unilateral right to extend. +(3) +Interest at LIBOR plus 1.35%. The amount of this loan is net of our $195,708 loan participation (see Note 2 - Summary of Significant Accounting Policies ). +All of our debt is secured by mortgages and/or pledges of the stock of the subsidiaries holding the properties. The net carrying value of real estate collateralizing the debt amounted to $ 573,975,000 as of December 31, 2019 . Our existing financing documents contain covenants that limit our ability to incur additional indebtedness on these properties, and in certain circumstances, provide for lender approval of tenants’ leases and yield maintenance to prepay them. As of December 31, 2019 , the principal repayments (based on the extended loan maturity dates) for the next five years and thereafter are as follows: +(Amounts in thousands) +Year Ending December 31, +Amount +2020 +$ +— +2021 +68,000 +2022 +350,000 +2023 +— +2024 +500,000 +Thereafter +56,836 +51 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +8. FAIR VALUE MEASUREMENTS +ASC 820 defines fair value and establishes a framework for measuring fair value. ASC 820 establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three levels: Level 1 – quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities; Level 2 – observable prices that are based on inputs not quoted in active markets, but corroborated by market data; and Level 3 – unobservable inputs that are used when little or no market data is available. The fair value hierarchy gives the highest priority to Level 1 inputs and the lowest priority to Level 3 inputs. In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as consider counterparty credit risk in our assessment of fair value. +Financial Assets and Liabilities Measured at Fair Value +Financial assets measured at fair value on our consolidated balance sheets as of December 31, 2019 and 2018 consist of marketable securities, which are presented in the table below based on their level in the fair value hierarchy, and an interest rate cap, which fair value was insignificant as of December 31, 2019 and 2018. There were no financial liabilities measured at fair value as of December 31, 2019 and 2018 . +As of December 31, 2019 +(Amounts in thousands) +Total +Level 1 +Level 2 +Level 3 +Marketable securities +$ +14,409 +$ +14,409 +$ +— +$ +— +As of December 31, 2018 +(Amounts in thousands) +Total +Level 1 +Level 2 +Level 3 +Marketable securities +$ +23,166 +$ +23,166 +$ +— +$ +— +Financial Assets and Liabilities not Measured at Fair Value +Financial assets and liabilities that are not measured at fair value on our consolidated balance sheets include cash equivalents and mortgages payable. Cash equivalents are carried at cost, which approximates fair value due to their short-term maturities and are classified as Level 1. The fair value of our mortgages payable is calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist, and is classified as Level 2. The table below summarizes the carrying amount and fair value of these financial instruments as of December 31, 2019 and 2018 . +As of December 31, 2019 +As of December 31, 2018 +Carrying +Fair +Carrying +Fair +(Amounts in thousands) +Amount +Value +Amount +Value +Assets: +Cash equivalents +$ +263,688 +$ +263,688 +$ +173,858 +$ +173,858 +Liabilities: +Mortgages payable (excluding deferred debt issuance costs, net) +$ +974,836 +$ +974,000 +$ +974,836 +$ +969,000 +52 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +9. LEASES +As Lessor +We lease space to tenants under operating leases in an office building and in retail centers. The rental terms range from approximately 5 to 25 years. The leases provide for the payment of fixed base rents payable monthly in advance as well as reimbursements of real estate taxes, insurance and maintenance costs. Retail leases may also provide for the payment by the lessee of additional rents based on a percentage of their sales. We also lease residential space at The Alexander apartment tower with 1 or 2 year lease terms. We have elected to account for lease revenues (including fixed and variable rent) and the reimbursement of common area maintenance expenses as a single lease component presented as “rental revenues” in our consolidated statements of income. +Under ASC 842, we must assess on an individual lease basis whether it is probable that we will collect the future lease payments. We consider the tenant’s payment history and current credit status when assessing collectability. When collectability is not deemed probable, we write-off the tenant’s receivables, including straight-line rent receivable, and limit lease income to cash received. Changes to the collectability of our operating leases are recorded as adjustments to “rental revenues” on our consolidated statements of income, which resulted in a decrease in income of $ 209,000 for the year ended December 31, 2019. As a result, there is no allowance for doubtful accounts as of December 31, 2019. The table below summarizes our allowance for doubtful accounts as of December 31, 2018 and 2017. +(Amounts in thousands) +Balance at +Beginning +of Year +Additions: +Charged +Against +Operations +Deductions: +Uncollectible +Accounts +Written Off +Balance at End of Year +Allowance for doubtful accounts: +Year Ended December 31, 2018 +$ +1,501 +$ +4,459 +$ +( 5,289 +) +$ +671 +Year Ended December 31, 2017 +$ +1,473 +$ +53 +$ +( 25 +) +$ +1,501 +Future undiscounted cash flows under our non-cancelable operating leases are as follows: +Under ASC 842 +(Amounts in thousands) +As of December 31, 2019 +For the year ending December 31, +2020 +$ +141,875 +2021 +134,877 +2022 +127,691 +2023 +129,054 +2024 +137,234 +Thereafter +624,239 +Under ASC 840 +(Amounts in thousands) +As of December 31, 2018 +For the year ending December 31, +2019 +$ +138,784 +2020 +131,647 +2021 +120,450 +2022 +111,532 +2023 +111,962 +Thereafter +671,111 +These amounts do not include reimbursements or additional rents based on a percentage of retail tenants’ sales. +53 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +9. LEASES - continued +Bloomberg accounted for revenue of $ 109,113,000 , $ 107,356,000 , and $ 105,224,000 in the years ended December 31, 2019, 2018 and 2017, respectively, representing approximately 48 % , 46 % and 46 % of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +On June 28, 2019, we entered into a lease agreement with Bloomberg for an additional 49,000 square feet at our 731 Lexington Avenue property +As Lessee +We are the lessee under a ground lease at our Flushing property, classified as an operating lease, which expires in 2027 and has one 10 -year extension option. On January 1, 2019, we recorded a right-of-use asset and lease liability related to this ground lease equal to the present value of the remaining minimum lease payments. As of December 31, 2019, the right-of-use asset of $ 4,529,000 and the lease liability of $ 4,845,000 , are included in “other assets” and “other liabilities,” respectively, on our consolidated balance sheet. The discount rate applied to measure the right-of-use asset and lease liability is based on the incremental borrowing rate (“IBR”) for the property of 4.53 % . We initially consider the general economic environment and factor in various financing and asset specific adjustments so that the IBR is appropriate to the intended use of the underlying lease. As we did not elect to apply hindsight, the lease term assumption determined under ASC 840 was carried forward and applied in calculating our lease liability recorded under ASC 842. +Future lease payments under this operating lease, excluding the extension option, are as follows: +Under ASC 842 +(Amounts in thousands) +As of December 31, 2019 +For the year ending December 31, +2020 +$ +800 +2021 +800 +2022 +800 +2023 +800 +2024 +800 +Thereafter +1,600 +Total undiscounted cash flows +5,600 +Present value discount +( 755 +) +Lease liability as of December 31, 2019 +$ +4,845 +Under ASC 840 +(Amounts in thousands) +As of December 31, 2018 +For the year ending December 31, +2019 +$ +800 +2020 +800 +2021 +800 +2022 +800 +2023 +800 +Thereafter +2,467 +We recognize rent expense as a component of “operating” expenses on our consolidated statements of income on a straight-line basis. Rent expense was $ 746,000 in each of the years ended December 31, 2019, 2018 and 2017, respectively. Cash paid for rent expense was $ 800,000 , $ 800,000 and $ 792,000 in the years ended December 31, 2019, 2018 and 2017, respectively. +54 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +10. STOCK-BASED COMPENSATION +We account for stock-based compensation in accordance with ASC Topic 718, Compensation - Stock Compensation . Our 2016 Omnibus Stock Plan (the “Plan”) provides for grants of incentive and non-qualified stock options, restricted stock, stock appreciation rights, deferred stock units (“DSUs”) and performance shares, as defined, to the directors, officers and employees of the Company and Vornado. +On May 16, 2019, we granted each of the members of our Board of Directors 193 DSUs with a grant date fair value of $ 56,250 per grant, or $ 394,000 in the aggregate. The DSUs entitle the holders to receive shares of the Company’s common stock without the payment of any consideration. The DSUs vested immediately and accordingly, were expensed on the date of grant, but the shares of common stock underlying the DSUs are not deliverable to the grantee until the grantee is no longer serving on the Company’s Board of Directors. As of December 31, 2019, there were 11,408 DSUs outstanding and 494,379 shares were available for future grant under the Plan. +11. COMMITMENTS AND CONTINGENCIES +Insurance +We maintain general liability insurance with limits of $ 300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $ 1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $ 1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $ 268,000 deductible and 20 % of the balance of a covered loss, and the Federal government is responsible for the remaining 80 % of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Paramus +In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $ 75,000,000 . The property is encumbered by a $ 68,000,000 interest-only mortgage loan with a fixed rate of 4.72 % , which matures in October 2021. The annual triple-net rent is the sum of $ 700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $ 7,000,000 and recognize a gain on sale of land of approximately $ 60,000,000 . If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $ 68,000,000 over the remaining 20 -year lease term. +55 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +11. COMMITMENTS AND CONTINGENCIES - continued +Rego Park I Litigation +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $ 4,000,000 and future damages it estimated would not be less than $ 25,000,000 . In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $ 650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonably possible losses, if any, is not expected to be greater than $ 650,000 . +On April 4, 2017, Sears closed its 195,000 square foot store at the property ( $ 10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. +Letters of Credit +Approximately $ 1,030,000 of standby letters of credit were issued and outstanding as of December 31, 2019 . +Other +There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. +12. MULTIEMPLOYER BENEFIT PLANS +Our subsidiaries make contributions to certain multiemployer defined benefit plans (“Multiemployer Pension Plans”) and health plans (“Multiemployer Health Plans”) for our union represented employees, pursuant to the respective collective bargaining agreements. +Multiemployer Pension Plans +Multiemployer Pension Plans differ from single-employer pension plans in that (i) contributions to multiemployer plans may be used to provide benefits to employees of other participating employers and (ii) if other participating employers fail to make their contributions, each of our subsidiaries may be required to bear their pro rata share of unfunded obligations. If a participating subsidiary withdraws from a plan in which it participates, it may be subject to a withdrawal liability. As of December 31, 2019 , our subsidiaries’ participation in these plans were not significant to our consolidated financial statements. +In the years ended December 31, 2019 , 2018 and 2017 our subsidiaries contributed $ 172,000 , $ 161,000 and $ 162,000 , respectively, towards Multiemployer Pension Plans. Our subsidiaries’ contributions did not represent more than 5% of total employer contributions in any of these plans for the years ended December 31, 2019 , 2018 and 2017 . +Multiemployer Health Plans +Multiemployer Health Plans in which our subsidiaries participate provide health benefits to eligible active and retired employees. In the years ended December 31, 2019 , 2018 and 2017 our subsidiaries contributed $ 686,000 , $ 649,000 and $ 619,000 , respectively, towards these plans. +56 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +13. EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted income per share, including a reconciliation of net income and the number of shares used in computing basic and diluted income per share. Basic income per share is determined using the weighted average shares of common stock (including DSUs) outstanding during the period. Diluted income per share is determined using the weighted average shares of common stock (including DSUs) outstanding during the period, and assumes all potentially dilutive securities were converted into common shares at the earliest date possible. There were no potentially dilutive securities outstanding during the years ended December 31, 2019 , 2018 and 2017 . +For the Year Ended December 31, +(Amounts in thousands, except share and per share amounts) +2019 +2018 +2017 +Income from continuing operations +$ +60,075 +$ +56,641 +$ +80,509 +Loss from discontinued operations (see Note 6) +— +( 23,797 +) +— +Net income +$ +60,075 +$ +32,844 +$ +80,509 +Weighted average shares outstanding – basic and diluted +5,118,198 +5,116,838 +5,115,501 +Income from continuing operations +$ +11.74 +$ +11.07 +$ +15.74 +Loss from discontinued operations (see Note 6) +— +( 4.65 +) +— +Net income per common share – basic and diluted +$ +11.74 +$ +6.42 +$ +15.74 +14. SUMMARY OF QUARTERLY RESULTS (UNAUDITED) +Net Income (Loss) Per Common Share (1) +(Amounts in thousands, except per share amounts) +Revenues +Net Income (Loss) +Basic +Diluted +2019 +December 31 +$ +55,880 +$ +14,434 +$ +2.82 +$ +2.82 +September 30 +57,760 +16,493 +3.22 +3.22 +June 30 +55,932 +11,283 +2.20 +2.20 +March 31 +56,778 +17,865 +3.49 +3.49 +2018 +December 31 +$ +57,567 +$ +9,971 +$ +1.95 +$ +1.95 +September 30 +59,125 +15,003 +2.93 +2.93 +June 30 +58,253 +17,570 +3.43 +3.43 +March 31 +57,880 +( 9,700 +) +(2) +( 1.90 +) +(2) +( 1.90 +) +(2) +_______________________ +(1) +The total for the year may differ from the sum of the quarters as a result of weighting. +(2) +Includes $23,797, or $4.65 per common share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza. +57 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures – Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective. +Internal Control Over Financial Reporting – There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended) during the fourth quarter of the fiscal year to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +58 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER +FINANCIAL REPORTING +The management of Alexander’s, Inc., together with its consolidated subsidiaries (the “Company”), is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. +As of December 31, 2019 , management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the framework established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2019 is effective. +The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2019 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report appearing on page 60 of this Annual Report on Form 10-K, which expresses an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2019 . +59 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and the Board of Directors of +Alexander’s, Inc. +Paramus, New Jersey +Opinion on Internal Control over Financial Reporting +We have audited the internal control over financial reporting of Alexander’s, Inc. and subsidiaries (the “Company”) as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended December 31, 2019, of the Company and our report dated February 18, 2020, expressed an unqualified opinion on those financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the US federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ DELOITTE & TOUCHE LLP +Parsippany, New Jersey +February 18, 2020 +60 +ITEM 9B. OTHER INFORMATION +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Information relating to our directors, including our audit committee and audit committee financial expert, will be contained in a definitive Proxy Statement involving the election of directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. We will file the Proxy Statement with the Securities and Exchange Commission no later than 120 days after December 31, 2019. Such information is incorporated by reference herein. Also incorporated herein by reference is the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement. +Executive Officers of the Registrant +The following is a list of the names, ages, principal occupations and positions with us of our executive officers and the positions held by such officers during the past five years. +PRINCIPAL OCCUPATION, POSITION AND OFFICE +Name +Age +(Current and during past five years with the Company unless otherwise stated) +Steven Roth +78 +Chairman of the Board since May 2004 and Chief Executive Officer since March 1995; Chairman of the Board of Vornado Realty Trust since May 1989; Chief Executive Officer of Vornado Realty Trust since April 2013 and from May 1989 to May 2009; a Trustee of Vornado Realty Trust since 1979; and Managing General Partner of Interstate Properties. +Matthew Iocco +49 +Chief Financial Officer since April 2017; Executive Vice President - Chief Accounting Officer of Vornado Realty Trust since May 2015; and Senior Vice President - Chief Accounting Officer of Vornado Realty Trust from May 2012 to May 2015. +We have a code of business conduct and ethics that applies to, among others, our Chief Executive Officer and Chief Financial Officer. The code is posted on our website at www.alx-inc.com. We intend to satisfy our disclosure obligation regarding amendments and waivers of this code applicable to our Chief Executive Officer and Chief Financial Officer by posting such information on our website. +61 +ITEM 11. EXECUTIVE COMPENSATION +Information relating to executive compensation will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Information relating to security ownership of certain beneficial owners and management and related stockholder matters, except as set forth below, will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +Equity Compensation Plan Information +The following table provides information as of December 31, 2019, regarding our equity compensation. +Plan Category +(a) +Number of securities +to be issued upon +exercise of +outstanding options, +warrants and rights +Weighted-average +exercise price of +outstanding options, +warrants and rights +Number of securities +remaining available for +future issuance under +equity compensation +plans (excluding +securities reflected in +column (a)) +Equity compensation plans approved by security holders +11,408 +$ +— +494,379 +Equity compensation plans not approved by security holders +N/A +N/A +N/A +Total +11,408 +$ +— +494,379 +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Information relating to certain relationships and related transactions and director independence will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +Information relating to principal accounting fees and services will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +62 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) The following documents are filed as part of this Annual Report on Form 10-K. +1. The consolidated financial statements are set forth in Item 8 of this Annual Report on Form 10-K. +2. The following financial statement schedule should be read in conjunction with the financial statements included in Item 8 of this Annual Report on Form 10-K. +Pages in this +Annual Report +on Form 10-K +Schedule III – Real Estate and Accumulated Depreciation as of +December 31, 2019, 2018 and 2017 +64-65 +All other financial statement schedules are omitted because they are not applicable, not required, or the information is included elsewhere in the consolidated financial statements or the notes thereto. +63 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE III +REAL ESTATE AND ACCUMULATED DEPRECIATION +December 31, 2019 +(Amounts in thousands) +COLUMN A +COLUMN B +COLUMN C +COLUMN D +COLUMN E +COLUMN F +COLUMN G +COLUMN H +COLUMN I +Gross Amount at Which +Life on which Depreciation in Latest Income Statement is Computed +Initial Cost to Company (1) +Costs +Capitalized +Subsequent +to Acquisition +Carried at Close of Period +Accumulated +Depreciation +and +Amortization +Buildings +and Leasehold +Improvements +Buildings +and Leasehold +Improvements +Development +and +Construction +In Progress +Date of +Construction +Date +Acquired (1) +Description +Encumbrances (2) +Land +Land +Total (3) +New York, NY +Rego Park I +$ +— +$ +1,647 +$ +8,953 +$ +61,930 +$ +1,647 +$ +62,822 +$ +8,061 +$ +72,530 +$ +36,790 +1959 +1992 +3-39 years +Rego Park II +56,836 +(4) +3,127 +1,467 +388,349 +3,127 +389,782 +34 +392,943 +103,688 +2009 +1992 +3-40 years +The Alexander apartment tower +— +— +— +119,112 +— +119,112 +— +119,112 +17,405 +2016 +1992 +3-39 years +Rego Park III +— +779 +— +4,297 +779 +503 +3,794 +5,076 +290 +N/A +1992 +5-15 years +Flushing +— +— +1,660 +( 107 +) +— +1,553 +— +1,553 +1,087 +1975 (5) +1992 +N/A +Lexington Avenue +850,000 +14,432 +12,355 +411,420 +27,497 +410,281 +429 +438,207 +165,239 +2003 +1992 +9-39 years +Paramus, NJ +68,000 +1,441 +— +10,313 +11,754 +— +— +11,754 +— +N/A +1992 +N/A +Other Properties +— +167 +1,804 +( 1,804 +) +167 +— +— +167 +— +N/A +1992 +N/A +TOTAL +$ +974,836 +$ +21,593 +$ +26,239 +$ +993,510 +$ +44,971 +$ +984,053 +$ +12,318 +$ +1,041,342 +$ +324,499 +(1) Initial cost is as of May 15, 1992 (the date on which the Company commenced its real estate operations). +(2) Excludes deferred debt issuance costs, net of $3,875. +(3) The net basis of the Company’s assets and liabilities for tax purposes is approximately $171,331 lower than the amount reported for financial statement purposes. +(4) The amount of this loan is net of our $195,708 loan participation. +(5) Represents the date the lease was acquired. +64 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE III +REAL ESTATE AND ACCUMULATED DEPRECIATION +(Amounts in thousands) +December 31, +2019 +2018 +2017 +REAL ESTATE: +Balance at beginning of period +$ +1,027,691 +$ +1,037,368 +$ +1,033,551 +Changes during the period: +Land +— +— +— +Buildings and leasehold improvements +5,579 +3,218 +3,046 +Development and construction in progress +8,072 +695 +771 +1,041,342 +1,041,281 +1,037,368 +Less: Fully depreciated assets +— +( 13,590 +) +— +Balance at end of period +$ +1,041,342 +$ +1,027,691 +$ +1,037,368 +ACCUMULATED DEPRECIATION: +Balance at beginning of period +$ +297,421 +$ +283,044 +$ +252,737 +Additions charged to operating expenses +27,078 +27,967 +30,307 +324,499 +311,011 +283,044 +Less: Fully depreciated assets +— +( 13,590 +) +— +Balance at end of period +$ +324,499 +$ +297,421 +$ +283,044 +65 +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES - continued +(b) Exhibits +Exhibit No. +3.1 +- +Amended and Restated Certificate of Incorporation. Incorporated herein by reference from Exhibit 3.1 to the registrant’s Registration Statement on Form S-3 filed on September 20, 1995 +* +3.2 +- +By-laws, as amended. Incorporated herein by reference from Exhibit 3(ii) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2000 +* +4 +- +Description of the Alexander’s, Inc. securities registered pursuant to Section 12 of the Securities Exchange Act +*** +10.1 +- +Real Estate Retention Agreement dated as of July 20, 1992, between Vornado Realty Trust and Keen Realty Consultants, Inc., each as special real estate consultants, and the Company. Incorporated herein by reference from Exhibit 10(i)(O) to the registrant’s Annual Report on Form 10-K for the fiscal year ended July 25, 1992 +* +10.2 +- +Extension Agreement to the Real Estate Retention Agreement, dated as of February 6, 1995, between the Company and Vornado Realty Trust. Incorporated herein by reference from Exhibit 10(i)(G)(2) to the registrant’s Annual Report on Form 10-K for the year ended December 31, 1994 +* +10.3 +- +Agreement of Lease dated as of April 30, 2001 between Seven Thirty One Limited Partnership, landlord, and Bloomberg L.P., tenant. Incorporated herein by reference from Exhibit 10(v) B to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001, filed on August 2, 2001 +* +10.4 +- +Lease dated as of October 2, 2001 by and between ALX of Paramus LLC, as Landlord, and IKEA Property, Inc. as Tenant. Incorporated herein by reference from Exhibit 10(v)(C)(4) to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2001, filed on March 13, 2002 +* +10.5 +- +First Amendment to Real Estate Retention Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc. and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10(i)(E)(3) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.6 +- +59th Street Real Estate Retention Agreement, dated as of July 3, 2002, by and between Vornado Realty, L.P., 731 Residential LLC and 731 Commercial LLC. Incorporated herein by reference from Exhibit 10(i)(E)(4) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.7 +- +Amended and Restated Management and Development Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10(i)(F)(1) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.8 +- +Limited Liability Company Operating Agreement of 731 Residential LLC, dated as of July 3, 2002, among 731 Residential Holding LLC, as the sole member, Domenic A. Borriello, as an Independent Manager and Kim Lutthang, as an Independent Manager. Incorporated herein by reference from Exhibit 10(i)(A)(1) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.9 +- +Limited Liability Company Operating Agreement of 731 Commercial LLC, dated as of July 3, 2002, among 731 Commercial Holding LLC, as the sole member, Domenic A. Borriello, as an Independent Manager and Kim Lutthang, as an Independent Manager. Incorporated herein by reference from Exhibit 10(i)(A)(2) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +___________________ +* +Incorporated by reference. +*** +Filed herewith. +66 +10.10 +- +Reimbursement Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc., 731 Commercial LLC, 731 Residential LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10(i)(C)(8) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 +* +10.11 +- +First Amendment of Lease, dated as of April 19, 2002, between Seven Thirty One Limited Partnership, landlord and Bloomberg L.P., tenant. Incorporated herein by reference from Exhibit 10(v)(B)(2) to the registrant’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2002, filed on August 7, 2002 +* +10.12 +- +Second Amendment to Real Estate Retention Agreement, dated as of January 1, 2007, by and between Alexander’s, Inc. and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.64 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on February 26, 2007 +* +10.13 +- +Amendment to 59th Street Real Estate Retention agreement, dated as of January 1, 2007, by and among Vornado Realty L.P., 731 Retail One LLC, 731 Restaurant LLC, 731 Office One LLC and 731 Office Two LLC. Incorporated herein by reference from Exhibit 10.65 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on February 26, 2007 +* +10.14 +- +First Amendment to Amended and Restated Management and Development Agreement, dated as of July 6, 2005, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.52 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 +* +10.15 +- +Second Amendment to Amended and Restated Management and Development Agreement, dated as of December 20, 2007, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.53 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 +* +10.16 +- +Third Amendment to Real Estate Retention Agreement, dated as of December 20, 2007, by and between Alexander’s, Inc., and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 +* +10.17 +- +Loan Agreement dated as of March 10, 2009 between Alexander’s Rego Shopping Center Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.18 +- +Amended and Restated Mortgage, Security Agreement, Fixture Filing and Assignment of Leases and Rentals by and between Alexander’s Rego Shopping Center, Inc. as Borrower and U.S. Bank National Association as Lender, dated as of March 10, 2009. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.19 +- +Amended and Restated Promissory Note dated as of March 10, 2009, by Alexander’s Rego Shopping Center Inc., in favor of U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.20 +- +Cash Pledge Agreement dated as of March 10, 2009, executed by Alexander’s Rego Shopping Center Inc. to and for the benefit of U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.21 +- +Lease dated as of February 7, 2005, by and between 731 Office One LLC, as Landlord, and Citibank, N.A., as Tenant. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +__________________ +* +Incorporated by reference. +67 +10.22 +- +Assignment and Assumption and Consent Agreement, dated as of March 25, 2009, by and between 731 Office One LLC, as Landlord, Citicorp North America, Inc., as Assignor, and Bloomberg L.P., as Assignee. Incorporated herein by reference from Exhibit 10.60 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 +* +10.23 +- +Third Amendment to Amended and Restated Management and Development Agreement, dated as of November 30, 2011, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.49 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2011, filed on February 27, 2012 +* +10.24 +- +First Omnibus Loan Modification and Extension Agreement dated March 12, 2012 by and between Alexander’s Rego Shopping Center, Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, filed on May 7, 2012 +* +10.25 +- +Mortgage Modification Agreement dated March 12, 2012 by and between Alexander’s Rego Shopping Center, Inc., as Mortgagor and U.S. Bank National Association, as Mortgagee. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, filed on May 7, 2012 +* +10.26 +- +Fourth Amendment to Amended and Restated Management and Development Agreement, dated as of August 1, 2012, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.2 to the registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, filed on November 1, 2012 +* +10.27 +- +Contribution Agreement and Joint Escrow Instructions, dated as of October 21, 2012, by and between Alexander’s Kings Plaza LLC, Alexander’s of Kings LLC and Kings Parking LLC, and Brooklyn Kings Plaza LLC. Incorporated herein by reference from Exhibit 10.53 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2012, filed on February 26, 2013 +* +10.28 +- +Fifth Amendment to Amended and Restated Management and Development Agreement, dated as of December 1, 2012, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.54 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2012, filed on February 26, 2013 +* +10.29 +- +Second Omnibus Loan Modification and Extension Agreement, dated March 8, 2013, by and between Alexander’s Rego Shopping Center, Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, filed on May 6, 2013 +* +10.30 +- +Second Mortgage Modification Agreement, dated March 8, 2013, by and between Alexander’s Rego Shopping Center, Inc., as Mortgagor and U.S. Bank National Association, as Mortgagee. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, filed on May 6, 2013 +* +10.31 +- +Loan Agreement, date as of February 28, 2014, by and between 731 Office One LLC, as Borrower, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.32 +- +Consolidated, Amended and Restated Promissory Note, dated as of February 28, 2014, by and between 731 Office One LLC, as Borrower, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.33 +- +Amended and Restated Mortgage, Assignment of Leases and Rents and Security Agreement, dated as of February 28, 2014, by and between 731 Office One LLC, as Mortgagor, and German American Capital Corporation, as Mortgagee. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +__________________ +* +Incorporated by reference. +68 +10.34 +- +Assignment of Leases and Rents dated as of February 28, 2014, by and between 731 Office One LLC, as Assignor, and German American Capital Corporation, as Assignee. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.35 +- +Guaranty of Recourse Obligations dated as of February 28, 2014, by and between Alexander’s, Inc., as Guarantor, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.5 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.36 +- +Environmental Indemnity Agreement dated as of February 28, 2014, by and between 731 Office One LLC, as Indemnitor, and German American Capital Corporation, as Indemnitee. Incorporated herein by reference from Exhibit 10.6 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.37 +- +Termination Agreement dated as of February 28, 2014, by and among 731 Office One LLC, Alexander’s Management LLC, Vornado Realty L.P., 731 Office Two LLC, 731 Residential LLC, 731 Commercial LLC, 731 Retail One LLC and 731 Restaurant LLC. Incorporated herein by reference from Exhibit 10.7 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.38 +- +Real Estate Sub-Retention Agreement dated as of February 28, 2014, by and between Alexander’s Management LLC, as Agent, and Vornado Realty L.P., as Sub-Agent. Incorporated herein by reference from Exhibit 10.8 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.39 +- +Sixth Amendment to Amended and Restated Management and Development Agreement, dated as of March 21, 2014, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.9 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.40 +- +Rego Park II Residential Management and Development Agreement, dated as of March 21, 2014 by and between Alexander’s of Rego Residential LLC and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.10 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 +* +10.41 +- +Fourth Amendment to Real Estate Retention Agreement, dated December 22, 2014 by and between Alexander’s, Inc. and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.42 +- +Second Amendment to 59th Street Real Estate Retention Agreement, dated December 22, 2014 by and between 731 Retail One LLC, 731 Restaurant LLC, 731 Office Two LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.43 +- +First Amendment to Rego II Real Estate Sub-Retention Agreement, dated December 22, 2014 by and between Alexander’s, Inc. and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.44 +- +First Amendment to Real-Estate Sub-Retention Agreement, dated December 22, 2014 by and between Alexander’s Management LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 +* +10.45 +- +Third Omnibus Loan Modification and Extension Agreement, dated March 10, 2015, by and between Alexander’s Rego Shopping Center, Inc., as Borrower and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015, filed on May 4, 2015 +* +10.46 +- +Third Mortgage Modification Agreement, dated March 10, 2015, by and between Alexander’s Rego Shopping Center, Inc., as Mortgagor and U. S. Bank National Association, as Mortgagee. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015, filed on May 4, 2015 +* +__________________ +* +Incorporated by reference. +69 +10.47 +- +Loan Agreement, dated as of August 5, 2015, by and between 731 Retail One LLC and 731 Commercial LLC, as Borrower, and JPMorgan Chase Bank, N.A., Wells Fargo Bank, N.A., and Landesbank Baden-Württemberg, New York Branch, as Lenders. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2015, filed on November 2, 2015 +* +10.48 ++ +- +Second Amendment of Lease, dated as of the 12th of January 2016 between 731 Office One LLC and Bloomberg L.P. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 +* +10.49 +- +Fourth Omnibus Loan Modification and Extension Agreement, dated and made effective as of March 8, 2016, by and between Alexander’s Rego Shopping Center and U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 +* +10.50 +- +Fourth Mortgage Modification Agreement, dated and made effective as of March 8, 2016, by and between Alexander’s Rego Shopping Center and U.S. Bank National Association. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 +* +10.51 +** +- +Form of Alexander’s Inc. 2016 Omnibus Stock Plan Deferred Stock Unit Grant Agreement between the Company and certain employees. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2016, filed on August 1, 2016 +* +10.52 +- +Loan Agreement, dated as of June 1, 2017, between 731 Office One LLC, as Borrower, and Deutsche Bank AG, New York Branch and Citigroup Global Markets Realty Corp. collectively, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2017, filed on July 31, 2017 +* +10.53 +- +Fifth Omnibus Loan Modification and Extension Agreement, dated and made effective as of March 12, 2018, by and between Alexander’s Rego Shopping Center, Inc., as Borrower, and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2018, filed on April 30, 2018 +* +10.54 +- +Sixth Omnibus Loan Modification and Extension Agreement, dated and made effective as of April 12, 2018, by and between Alexander’s Rego Shopping Center, Inc., as Borrower, and U.S. Bank National Association, as Lender. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2018, filed on April 30, 2018 +* +10.55 +- +Amended and Restated Loan and Security Agreement, dated and made effective as of December 12, 2018, by and between Rego II Borrower LLC, as Borrower, and Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 +* +10.56 +- +Second Amended and Restated Promissory Note, dated December 12, 2018, by and between Rego II Borrower LLC, as Maker, and Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 +* +10.57 +- +Second Amended and Restated Mortgage, Assignment of Leases and Rents and Security Agreement, dated December 12, 2018, by and between Rego II Borrower LLC, as Mortgagor, and Bank of China, New York Branch, as Mortgagee. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 +* +__________________ +* +Incorporated by reference. +** +Management contract or compensatory agreement. ++ +Portions of this exhibit have been omitted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission under Rule 24b-2. The omitted confidential material has been filed separately. The location of the redacted confidential information is indicated in the exhibit as “redacted.” +70 +10.58 +- +Amended and Restated Guaranty of Recourse Carveouts, dated December 12, 2018, by Alexander’s, Inc., as Guarantor, to and for the benefit of Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 +* +10.59 +- +Amended and Restated Environmental Indemnity Agreement, dated December 12, 2018, among Rego II Borrower LLC and Alexander’s, Inc., individually or collectively as Indemnitor, in favor of Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 +* +10.60 +- +Amended and Restated Participation and Servicing Agreement for Amended and Restated Loan and Security Agreement, dated December 12, 2018, between Bank of China, New York Branch, individually as Lender, Initial A-1 Holder and as the Agent for the Holders, and Alexander’s of Rego Park II Participating Lender LLC, individually as Initial A-2 Holder. Incorporated herein by reference from Exhibit 10.60 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 +* +10.61 +- +Waiver and Amendment No. 1 to Loan Agreement, dated October 10, 2019, by and among 731 Retail One LLC and 731 Commercial LLC, as Borrower, and JPMorgan Chase Bank, N.A., Wells Fargo Bank, N.A., and Landesbank Baden-Württemberg, New York Branch, as Lenders +*** +21 +- +Subsidiaries of Registrant +*** +23 +- +Consent of Independent Registered Public Accounting Firm +*** +31.1 +- +Rule 13a-14 (a) Certification of the Chief Executive Officer +*** +31.2 +- +Rule 13a-14 (a) Certification of the Chief Financial Officer +*** +32.1 +- +Section 1350 Certification of the Chief Executive Officer +*** +32.2 +- +Section 1350 Certification of the Chief Financial Officer +*** +101 +- +The following financial information from the Alexander’s, Inc. Annual Report on Form 10-K for the year ended December 31, 2019 formatted in Inline Extensible Business Reporting Language (iXBRL) includes: (i) consolidated balance sheets, (ii) consolidated statements of income, (iii) consolidated statements of comprehensive income, (iv) consolidated statements of changes in equity, (v) consolidated statements of cash flows and (vi) the notes to the consolidated financial statements +*** +104 +- +The cover page from the Alexander’s, Inc. Annual Report on Form 10-K for the year ended December 31, 2019, formatted as Inline XBRL and contained in Exhibit 101 +*** +__________________ +* +Incorporated by reference. +*** +Filed herewith. +71 +ITEM 16. FORM 10-K SUMMARY +None. +72 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ALEXANDER’S, INC. +(Registrant) +Date: February 18, 2020 +By: +/s/ Matthew Iocco +Matthew Iocco, Chief Financial Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +By: +/s/Steven Roth +Chairman of the Board of Directors and +February 18, 2020 +(Steven Roth) +Chief Executive Officer +(Principal Executive Officer) +By: +/s/Matthew Iocco +Chief Financial Officer +February 18, 2020 +(Matthew Iocco) +(Principal Financial and Accounting Officer) +By: +/s/Thomas R. DiBenedetto +Director +February 18, 2020 +(Thomas R. DiBenedetto) +By: +/s/David Mandelbaum +Director +February 18, 2020 +(David Mandelbaum) +By: +/s/Wendy Silverstein +Director +February 18, 2020 +(Wendy Silverstein) +By: +/s/Arthur Sonnenblick +Director +February 18, 2020 +(Arthur Sonnenblick) +By: +/s/Richard R. West +Director +February 18, 2020 +(Richard R. West) +By: +/s/Russell B. Wight Jr. +Director +February 18, 2020 +(Russell B. Wight Jr.) +73 \ No newline at end of file diff --git a/raw/filings/0000003499/2019/0000003499-20-000005/filing_metadata.csv b/raw/filings/0000003499/2019/0000003499-20-000005/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..7d639b1a45e93fbe9e5c46ff919bf804960c02df --- /dev/null +++ b/raw/filings/0000003499/2019/0000003499-20-000005/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003499,ALX,ALEXANDERS INC,2019,10-K,2020-02-18,2019-12-31,2020-02-18T13:20:36.000Z,0000003499-20-000005,alx10-k123119.htm,10-K,9367286,1,1,https://www.sec.gov/Archives/edgar/data/3499/000000349920000005/alx10-k123119.htm,https://www.sec.gov/Archives/edgar/data/3499/000000349920000005/ diff --git a/raw/filings/0000003499/2019/0000003499-20-000005/item1.txt b/raw/filings/0000003499/2019/0000003499-20-000005/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..8508984b75cca46aec2924ee94ca633a6a1c0e14 --- /dev/null +++ b/raw/filings/0000003499/2019/0000003499-20-000005/item1.txt @@ -0,0 +1,37 @@ +ITEM 1. BUSINESS +GENERAL +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”) incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• +731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot (83,000 square feet) and The Container Store (34,000 square feet) are the principal retail tenants; +• +Rego Park I, a 343,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. On April 4, 2017, Sears closed its 195,000 square foot anchor store at the property ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. On September 23, 2019, we leased 113,000 square feet at the property to IKEA Property, Inc. (“IKEA”), replacing a significant portion of the space formerly occupied by Sears. The center is also anchored by a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco, a 135,000 square foot Century 21 and a 133,000 square foot Kohl’s. On April 13, 2019, Kohl’s closed its store at the property. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031; +• +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• +Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA; and +• +Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• +Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +Relationship with Vornado +We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements which expire in March of each year and are automatically renewable. Vornado is a fully-integrated REIT with significant experience in managing, leasing, developing, and operating retail and office properties. +5 +Relationship with Vornado - continued +As of December 31, 2019 , Vornado owned 32.4% of our outstanding common stock. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2019, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Significant Tenant +Bloomberg accounted for revenue of $109,113,000, $107,356,000 and $105,224,000 in the years ended December 31, 2019 , 2018 , and 2017 , respectively, representing approximately 48%, 46% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Competition +We operate in a highly competitive environment. All of our properties are located in the greater New York City metropolitan area. We compete with a large number of real estate investors, property owners and developers. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Employees +We currently have 69 employees. +Executive Office +Our executive office is located at 210 Route 4 East, Paramus, New Jersey, 07652 and our telephone number is (201) 587-8541. +Available Information +Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as well as Reports on Forms 3, 4 and 5 regarding officers, directors, and 10% beneficial owners filed or furnished pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, are available free of charge on our website (www.alx-inc.com) as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Also available on our website are copies of our Audit Committee Charter, Compensation Committee Charter, Code of Business Conduct and Ethics and Corporate Governance Guidelines. In the event of any changes to these items, revised copies will be made available on our website. Copies of these documents are also available directly from us, free of charge. +In May 2009, Vornado and Interstate each filed with the SEC an amendment to their respective Schedule 13D indicating that they, as a group, own 47.2% of our common stock. This ownership level, together with the shares owned by Messrs. Roth, Mandelbaum and Wight, makes us a “controlled” company for the purposes of the New York Stock Exchange, Inc.’s Corporate Governance Standards (the “NYSE Rules”). This means that we are not required to, among other things, have a majority of the members of our Board of Directors be independent under the NYSE Rules, have all of the members of our Compensation Committee be independent under the NYSE Rules or to have a Nominating Committee. While we have voluntarily complied with a majority of the independence requirements of the NYSE Rules, we are under no obligation to do so and this situation may change at any time. +6 \ No newline at end of file diff --git a/raw/filings/0000003499/2019/0000003499-20-000005/item13.txt b/raw/filings/0000003499/2019/0000003499-20-000005/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..58fa04d1a93dde64541578acc149d190287577c5 --- /dev/null +++ b/raw/filings/0000003499/2019/0000003499-20-000005/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Information relating to certain relationships and related transactions and director independence will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. \ No newline at end of file diff --git a/raw/filings/0000003499/2020/0000003499-21-000005/filing.txt b/raw/filings/0000003499/2020/0000003499-21-000005/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..fa059c2fbb07d77f1d3dec3d4101d894843876dd --- /dev/null +++ b/raw/filings/0000003499/2020/0000003499-21-000005/filing.txt @@ -0,0 +1,1452 @@ +alx-20201231 +0000003499 2020 FY false --12-31 us-gaap:AccountingStandardsUpdate201601Member 2025-12-12 2024-06-11 2025-08-05 2021-10-04 2027-11-01 13,034 14,362 LIBOR 1.40 1.72 LIBOR 0.90 LIBOR 1.35 195,708 50,000 us-gaap:OtherAssets us-gaap:OtherLiabilities December 01, 2027 October 4, 2021 0000003499 2020-01-01 2020-12-31 iso4217:USD 0000003499 2020-06-30 xbrli:shares 0000003499 2021-01-31 0000003499 2020-12-31 0000003499 2019-12-31 iso4217:USD xbrli:shares 0000003499 2019-01-01 2019-12-31 0000003499 2018-01-01 2018-12-31 0000003499 us-gaap:CommonStockMember 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us-gaap:LandImprovementsMember 2018-01-01 2018-12-31 0000003499 us-gaap:BuildingImprovementsMember 2020-01-01 2020-12-31 0000003499 us-gaap:BuildingImprovementsMember 2019-01-01 2019-12-31 0000003499 us-gaap:BuildingImprovementsMember 2018-01-01 2018-12-31 0000003499 us-gaap:ConstructionInProgressMember 2020-01-01 2020-12-31 0000003499 us-gaap:ConstructionInProgressMember 2019-01-01 2019-12-31 0000003499 us-gaap:ConstructionInProgressMember 2018-01-01 2018-12-31 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +☑ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +For the Fiscal Year Ended: December 31 , 2020 +OR +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +For the transition period from to +Commission File Number: 001-06064 +ALEXANDERS INC +(Exact name of registrant as specified in its charter) +Delaware 51-0100517 +(State or other jurisdiction of incorporation or organization) (IRS Employer Identification No.) +210 Route 4 East, Paramus, New Jersey 07652 +(Address of principal executive offices) (Zip Code) +Registrant’s telephone number, including area code (201) 587-8541 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol(s) Name of each exchange on which registered +Common Stock, $1 par value per share ALX New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: NONE +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ☐ No ☑ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. +Yes ☐ No ☑ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes ☑ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +☑ Yes ☐ No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a +smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +☐ Large Accelerated Filer ☑ Accelerated Filer +☐ Non-Accelerated Filer +☐ +Smaller Reporting Company +☐ +Emerging Growth Company +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. +Yes ☑ No ☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☑ +The aggregate market value of the voting and non-voting shares of common stock held by non-affiliates of the registrant, (i.e., by persons other than officers and directors of Alexander’s, Inc.) was $ 511,231,000 at June 30, 2020. +As of January 31, 2021, there were 5,107,290 shares of the registrant’s common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III : Portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on May 20, 2021. +INDEX +Item Financial Information: Page Number +Part I. 1. Business +5 +1A. Risk Factors +7 +1B. Unresolved Staff Comments +20 +2. Properties +21 +3. Legal Proceedings +24 +4. Mine Safety Disclosures +24 +Part II. 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +25 +6. Selected Financial Data +26 +7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +27 +7A. Quantitative and Qualitative Disclosures about Market Risk +38 +8. Financial Statements and Supplementary Data +39 +9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +59 +9A. Controls and Procedures +59 +9B. Other Information +62 +Part III. 10. +Directors, Executive Officers and Corporate Governance (1) +62 +11. +Executive Compensation (1) +63 +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters (1) +63 +13. +Certain Relationships and Related Transactions, and Director Independence (1) +63 +14. +Principal Accounting Fees and Services (1) +63 +Part IV. 15. Exhibits, Financial Statement Schedules +64 +16. Form 10-K Summary +73 +Signatures +74 +__________________________ +(1) These items are omitted in part or in whole because the registrant will file a definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 with the Securities and Exchange Commission no later than 120 days after December 31, 2020, portions of which are incorporated by reference herein. +3 +FORWARD-LOOKING STATEMENTS +Certain statements contained herein constitute forward-looking statements as such term is defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not guarantees of future performance. They represent our intentions, plans, expectations and beliefs and are subject to numerous assumptions, risks and uncertainties. Our future results, financial condition and business may differ materially from those expressed in these forward-looking statements. You can find many of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” or other similar expressions in this Annual Report on Form 10‑K. We also note the following forward-looking statements: in the case of our development projects, the estimated completion date, estimated project costs and costs to complete; and estimates of dividends on shares of our common stock. Many of the factors that will determine the outcome of these and our other forward-looking statements are beyond our ability to control or predict. For a further discussion of factors that could materially affect the outcome of our forward-looking statements, see “Item 1A - Risk Factors” in this Annual Report on Form 10‑K. +Currently, one of the most significant factors is the ongoing adverse effect of the COVID-19 pandemic on our business, financial condition, results of operations, cash flows, operating performance and the effect it has had and may continue to have on our tenants, the global, national, regional and local economies and financial markets and the real estate market in general. The extent of the impact of the COVID-19 pandemic will depend on future developments, including the duration of the pandemic, which are highly uncertain at this time, but that impact could be material. Moreover, you are cautioned that the COVID-19 pandemic will heighten many of the risks identified in “Item 1A. – Risk Factors” in this Annual Report on Form 10-K. +For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You are cautioned not to place undue reliance on our forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or the date of any document incorporated by reference. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to release publicly, any revisions to our forward-looking statements to reflect events or circumstances occurring after the date of this Annual Report on Form 10-K. +4 +PART I +ITEM 1. BUSINESS +General +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”) incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• 731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot (83,000 square feet) is the principal retail tenant; +• Rego Park I, a 338,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. The center is anchored by a 112,000 square foot IKEA, a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco and a 133,000 square foot Kohl’s, which has been subleased. On September 10, 2020, Century 21 ($6,400,000 of annual revenue) filed for Chapter 11 bankruptcy and closed its 135,000 square foot store on December 7, 2020; +• The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is ground leased to IKEA; and +• Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +Relationship with Vornado +We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements which expire in March of each year and are automatically renewable. Vornado is a fully-integrated REIT with significant experience in managing, leasing, developing, and operating office and retail properties. +As of December 31, 2020, Vornado owned 32.4% of our outstanding common stock. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2020, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +5 +Significant Tenant +Bloomberg accounted for revenue of $109,066,000, $109,113,000 and $107,356,000 in the years ended December 31, 2020, 2019, and 2018, respectively, representing approximately 55%, 48% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Competition +We operate in a highly competitive environment. All of our properties are located in the greater New York City metropolitan area. We compete with a large number of real estate investors, property owners and developers. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Human Capital Resources +Since we are externally managed by Vornado, we do not have separate employees that provide management, leasing and development services. We currently have 70 property-level employees who provide cleaning, engineering and security services. Our employees are managed by Vornado in accordance with its employee policies and they have access to Vornado’s benefits, training and other programs. +Executive Office +Our executive office is located at 210 Route 4 East, Paramus, New Jersey, 07652 and our telephone number is (201) 587-8541. +Available Information +Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as well as Reports on Forms 3, 4 and 5 regarding officers, directors, and 10% beneficial owners filed or furnished pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, are available free of charge on our website (www.alx-inc.com) as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Also available on our website are copies of our Audit Committee Charter, Compensation Committee Charter, Code of Business Conduct and Ethics and Corporate Governance Guidelines. In the event of any changes to these items, revised copies will be made available on our website. Copies of these documents are also available directly from us, free of charge. +In May 2009, Vornado and Interstate each filed with the SEC an amendment to their respective Schedule 13D indicating that they, as a group, own 47.2% of our common stock. This ownership level, together with the shares owned by Messrs. Roth, Mandelbaum and Wight, makes us a “controlled” company for the purposes of the New York Stock Exchange, Inc.’s Corporate Governance Standards (the “NYSE Rules”). This means that we are not required to, among other things, have a majority of the members of our Board of Directors be independent under the NYSE Rules, have all of the members of our Compensation Committee be independent under the NYSE Rules or to have a Nominating Committee. While we have voluntarily complied with a majority of the independence requirements of the NYSE Rules, we are under no obligation to do so and this situation may change at any time. +6 +ITEM 1A. RISK FACTORS +Material factors that may adversely affect our business, operations and financial condition are summarized below. The risks and uncertainties described herein may not be the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business, operations and financial condition. See “Forward-Looking Statements” contained herein on page 4. +RISKS RELATED TO OUR PROPERTIES AND INDUSTRY +Our business, financial condition, results of operations and cash flows have been and are expected to continue to be adversely affected by the recent COVID-19 pandemic and the impact could be material to us. +Our business has been adversely affected by the ongoing COVID-19 pandemic. In March 2020, our “non-essential” retail tenants were ordered to temporarily close and although substantially all re-opened in the latter part of June 2020, there are limitations on occupancy and other restrictions that affect their ability to resume full operations and impact their financial health. In limited circumstances, we have agreed to and may continue to agree to rent deferrals and abatements for certain of our tenants. +Numerous Federal, state, local and industry-initiated efforts may also affect our ability to collect rent or enforce remedies for the failure to pay rent. Certain of our tenants may incur significant costs or losses as a result of the COVID-19 pandemic and/or incur other liabilities related to shelter-in-place orders, quarantines, infection or other related factors. Tenants that experience deteriorating financial conditions may be unwilling or unable to pay rent on a timely basis, or at all. Specifically, on September 10, 2020, Century 21, which leased 135,000 square feet at our Rego Park II shopping center, filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. +The COVID-19 pandemic has also caused, and is likely to continue to cause, severe economic, market or other disruptions worldwide. Conditions in the bank lending, capital and other financial markets may deteriorate as a result of the pandemic, our access to capital and other sources of funding may become constrained and the ratios of our debt to asset values may deteriorate, which could adversely affect the availability and terms of future borrowings, renewals or refinancings. In addition, the deterioration of global, national, regional and local economic conditions as a result of the pandemic may ultimately decrease occupancy and/or rent levels across our portfolio as tenants reduce or defer their spending, which may result in less cash flow available for operating costs, to pay our indebtedness and for distribution to our stockholders and the impact could be material. In addition, the value of our real estate assets may decline, which may result in non-cash impairment charges in future periods and the impact could be material. The extent of the COVID-19 pandemic’s effect on our operational and financial performance will depend on future developments, including the duration, spread and intensity of the outbreak and governmental responses thereto, all of which are uncertain and difficult to predict. Due to the speed with which the situation is developing, we are not able at this time to estimate the ultimate effect of these factors on our business, but the adverse impact on our business, results of operations, financial condition and cash flows could be material. +7 +All of our properties are in the greater New York City metropolitan area and are affected by the economic cycles and risks inherent in that area. +All of our revenues come from properties located in the greater New York City metropolitan area. Real estate markets are subject to economic downturns and we cannot predict how economic conditions will impact this market in either the short or long term. Recent declines in the economy and declines in the real estate market in this area, have hurt and could continue to hurt, our financial performance and the value of our properties. In addition to the factors affecting the national economic condition generally, the factors affecting economic conditions in this area include: +• financial performance and productivity of the media, advertising, professional services, financial, technology, retail, insurance and real estate industries; +• the impact of the COVID-19 pandemic; +• business layoffs or downsizing; +• industry slowdowns; +• relocations of businesses; +• changing demographics; +• increased telecommuting and use of alternative work places; +• changes in the number of domestic and international tourists to our markets (including as a result of changes in the relative strengths of world currencies); +• infrastructure quality; +• changes in the rates or treatment of the deductibility of state and local taxes; and +• any oversupply of, or reduced demand for, real estate. +It is impossible for us to predict the future or the effect of trends in the economic and investment climates of the greater New York City metropolitan region, and more generally of the United States, on the real estate market in this area. Local, national or global economic downturns could negatively affect our business and profitability. +We may be adversely affected by trends in office real estate. +Work from home, flexible work schedules, open workplaces and teleconferencing are becoming more common and are expected to accelerate as a result of the COVID-19 pandemic. These practices may enable businesses to reduce their office space requirements. There is also an increasing trend among some businesses to utilize shared office spaces and co-working spaces. A continuation of these trends could, over time, erode the overall demand for office space and, in turn, place downward pressure on occupancy, rental rates and property valuations. +We are subject to risks that affect the general and New York City retail environments. +Certain of our properties are New York City retail properties. As such, these properties are affected by the general and New York City retail environments, including the level of consumer spending and consumer confidence, New York City tourism, the threat of terrorism, the impact of the COVID-19 pandemic, increasing competition from on-line retailers, other retailers and outlet malls and the impact of technological change upon the retail environment generally. For a number of our tenants that operate retail businesses involving high contact interactions with their customers, the negative impact of the COVID-19 pandemic on their business has been particularly severe and the recovery more difficult, with customer traffic down significantly. Furthermore, it is unknowable whether consumers’ retail habits will return to norms that existed prior to the COVID-19 pandemic. These factors could adversely affect the financial condition of our retail tenants, or result in the bankruptcy of such tenants, and the willingness of retailers to lease space in our retail locations, which could have an adverse effect on our business and profitability. +Terrorist attacks may adversely affect the value of our properties and our ability to generate cash flow. +All of our properties are located in the greater New York City metropolitan area, and our most significant property, 731 Lexington Avenue, is located on Lexington Avenue and 59 th Street in Manhattan. In response to a terrorist attack or the perceived threat of terrorism, tenants in this area may choose to relocate their businesses to less populated, lower-profile areas of the United States that may be perceived to be less likely targets of future terrorist activity and fewer customers may choose to patronize businesses in this area. This, in turn, could trigger a decrease in the demand for space in these markets, which could increase vacancies in our properties and force us to lease our properties on less favorable terms. Furthermore, we may experience increased costs for security, equipment and personnel. As a result, the value of our properties and the level of our revenues could decline materially. +8 +Natural disasters and the effects of climate change could have a concentrated impact on the area which we operate and could adversely impact our results. +Our investments are in the greater New York City metropolitan area and since they are concentrated along the Eastern Seaboard, natural disasters, including hurricanes, could cause significant damage to our properties and the surrounding environment or area. Potentially adverse consequences of “global warming,” including rising sea levels, could similarly have an impact on our properties and the economy of the greater New York City metropolitan area in which we operate. Government efforts to combat climate change may impact the cost of operating our properties and real estate in the New York City metropolitan area. Over time, these conditions could result in declining demand for office space in our buildings or the inability of us to operate the buildings at all. Climate change may also have indirect effects on our business by increasing the cost of (or making unavailable) property insurance on terms we find acceptable, increasing the cost of energy at our properties and requiring us to expend funds as we seek to repair and protect our properties against such risks. The incurrence of these losses, costs or business interruptions may adversely affect our operating and financial results. +Our performance and the value of an investment in us are subject to risks associated with our real estate assets and with the real estate industry. +The value of our real estate and the value of an investment in us fluctuates depending on conditions in the general economy and the real estate business. These conditions may also adversely impact our revenues and cash flows. +The factors that affect the value of our real estate include, among other things: +• global, national, regional and local economic conditions; +• the impact of the COVID-19 pandemic; +• competition from other available space; +• local conditions such as an oversupply of space or a reduction in demand for real estate in the area; +• how well we manage our properties; +• the development and/or redevelopment of our properties; +• changes in market rental rates; +• the timing and costs associated with property improvements and rentals; +• whether we are able to pass all or portions of any increases in operating costs through to tenants; +• political and regulatory conditions; +• changes in real estate taxes and other expenses; +• the ability of state and local governments to operate within their budgets; +• whether tenants and users such as customers and shoppers consider a property attractive; +• changes in consumer preferences adversely affecting retailers and retail store values; +• changes in space utilization by our tenants due to technology, economic conditions and business environment; +• the financial condition of our tenants, including the extent of tenant bankruptcies or defaults; +• consequences of any armed conflict involving, or terrorist attack against, the United States or individual acts of violence in public spaces; +• trends in office real estate; +• the impact on our retail tenants and demand for retail space at our properties due to increased competition from online shopping; +• availability of financing on acceptable terms or at all; +• inflation or deflation; +• fluctuations in interest rates; +• our ability to obtain adequate insurance; +• changes in zoning laws and taxation; +• government regulation; +• potential liability under environmental or other laws or regulations; +• natural disasters; +• general competitive factors; and +• climate changes. +The rents we receive and the occupancy levels at our properties may decline as a result of adverse changes in any of these factors. If our rental revenues and/or occupancy levels decline, we generally would expect to have less cash available for operating costs, to pay our indebtedness and for distribution to our stockholders. In addition, some of our major expenses, including mortgage payments, real estate taxes and maintenance costs generally do not decline when the related rents decline. +9 +Real estate is a competitive business and that competition may adversely impact us. +We compete with a large number of real estate investors, property owners and developers, some of which may be willing to accept lower returns on their investments. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Substantially all of our properties face competition from similar properties in the same market, which may adversely impact the rents we can charge at those properties and our results of operations. +We depend on leasing space to tenants on economically favorable terms and collecting rent from tenants who may not be able to pay. +Our financial results depend significantly on leasing space in our properties to tenants on economically favorable terms. In addition, because a majority of our income is derived from renting real property, our income, funds available to pay indebtedness and for distributions to stockholders will decrease if certain of our tenants cannot pay their rent or if we are not able to maintain our occupancy levels on favorable terms. If a tenant does not pay its rent, we might not be able to enforce our rights as landlord without delays and might incur substantial legal and other costs. As a result of the COVID-19 pandemic, Federal, state and local regulations and economic conditions have affected our ability to collect rent or enforce remedies for the failure to pay rent. Even if we are able to enforce our rights, a tenant may not have recoverable assets. Additionally, in limited circumstances, we have agreed and may continue to agree to rent deferrals and abatements for certain of our tenants. +Bankruptcy or insolvency of tenants may decrease our revenues, net income and available cash. +From time to time, some of our tenants have declared bankruptcy, and other tenants may declare bankruptcy or become insolvent in the future. On September 10, 2020, Century 21, which leased 135,000 square feet at our Rego Park II shopping center ($6,400,000 of annual revenue), filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. The bankruptcy or insolvency of a major tenant could cause us to suffer lower revenues and operational difficulties, including leasing the remainder of the property. As a result, the bankruptcy or insolvency of a major tenant or multiple tenants could result in decreased revenues, net income and funds available to pay our indebtedness or make distributions to stockholders. +We depend upon anchor tenants to attract shoppers at our Rego Park I and II retail properties and decisions made by these tenants, or adverse developments in the businesses of these tenants, could materially affect our financial condition and results of operations. +Our Rego Park I and II retail properties are anchored by well-known department stores and other tenants who generate shopping traffic. The value of these properties would be adversely affected if our anchor tenants failed to meet their contractual obligations, sought concessions in order to continue operations or ceased their operations, including as a result of bankruptcy. If the level of sales of stores operating in our properties were to decline significantly due to economic conditions, increased competition from online shopping, closing of anchors or for other reasons, tenants may be unable to pay their minimum rents or expense recovery charges. In the event of a default by a tenant or anchor, we may experience delays and costs in enforcing our rights as landlord. Additionally, closure of an anchor or major tenant could result in lease terminations by, or reductions of rent from, other tenants if the other tenants’ leases have co-tenancy clauses. On September 10, 2020, Century 21, which leased 135,000 square feet at our Rego Park II shopping center ($6,400,000 of annual revenue), filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. +We may be unable to renew leases or relet space as leases expire. +When our tenants decide not to renew their leases upon their expiration, we may not be able to relet the space. Even if tenants do renew or we can relet the space, the terms of renewal or reletting, considering among other things, the cost of improvements to the property and leasing commissions, may be less favorable than the terms in the expired leases. In addition, changes in space utilization by our tenants may impact our ability to renew or relet space without the need to incur substantial costs in renovating or redesigning the internal configuration of the relevant property. If we are unable to promptly renew the leases or relet the space at similar rates or if we incur substantial costs in renewing or reletting the space, our cash flow and ability to service debt obligations and pay dividends and distributions to stockholders could be adversely affected. +731 Lexington Avenue accounts for a substantial portion of our revenues. Loss of or damage to the building would adversely affect our financial condition and results of operations. +731 Lexington Avenue accounted for revenue of $137,718,000, $153,797,000 and $151,834,000 in the years ended December 31, 2020, 2019, and 2018, respectively, representing approximately 69%, 68% and 65% of our total revenues in each year, respectively. Loss of or damage to the building in excess of our insurance coverage, including as a result of a terrorist attack, would adversely affect our results of operations and financial condition. +10 +Bloomberg represents a significant portion of our revenues. Loss of Bloomberg as a tenant or deterioration in Bloomberg’s credit quality could adversely affect our financial condition and results of operations. +Bloomberg accounted for revenue of $109,066,000, $109,113,000 and $107,356,000 in the years ended December 31, 2020, 2019, and 2018, respectively, representing approximately 55%, 48% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. +RISKS RELATED TO OUR OPERATIONS AND STRATEGIES +We may acquire, develop, or redevelop properties and this may create risks. +Although our stated business strategy is not to engage in acquisitions, we may acquire, develop or redevelop properties when we believe that an acquisition, development or redevelopment project is otherwise consistent with our business strategy. We may not succeed in (i) developing, redeveloping or acquiring properties; (ii) completing these activities on time or within budget; and (iii) leasing or selling developed, redeveloped or acquired properties at amounts sufficient to cover our costs. Competition in these activities could also significantly increase our costs. Difficulties in integrating acquisitions may prove costly or time-consuming and could divert management’s attention. Acquisitions, developments or redevelopments in new markets or types of properties where we do not have the same level of market knowledge may result in weaker than anticipated performance. We may also abandon acquisition, development or redevelopment opportunities that we have begun pursuing and consequently fail to recover expenses already incurred. Furthermore, we may be exposed to the liabilities of properties acquired, some of which we may not be aware of at the time of acquisition. +We are exposed to risks associated with property redevelopment and repositioning that could adversely affect us, including our financial condition and results of operations. +We continue to engage in redevelopment and repositioning activities with respect to our properties, and, accordingly, we are subject to certain risks, which could adversely affect us, including our financial condition and results of operations. These risks include, without limitation, (i) the availability and pricing of financing on favorable terms or at all; (ii) the availability and timely receipt of zoning and other regulatory approvals; (iii) the potential for the fluctuation of occupancy rates and rents at redeveloped properties, which may result in our investment not being profitable; (iv) start up, repositioning and redevelopment costs may be higher than anticipated; (v) cost overruns and untimely completion of construction (including risks beyond our control, such as weather or labor conditions, or material shortages); (vi) the potential that we may fail to recover expenses already incurred if we abandon development or redevelopment opportunities after we begin to explore them; (vii) the potential that we may expend funds on and devote management time to projects which we do not complete; (viii) the inability to lease a property on schedule or at all, resulting in increased construction or redevelopment costs; and (ix) the possibility that properties will be leased at below expected rental rates. These risks could result in substantial unanticipated delays or expenses and could prevent the initiation or the completion of redevelopment activities, any of which could have an adverse effect on our financial condition, results of operations, cash flow, the market value of our common shares and ability to satisfy our principal and interest obligations and to make distributions to our stockholders. +It may be difficult to sell real estate timely, which may limit our flexibility. +Real estate investments are relatively illiquid. Consequently, we may have limited ability to dispose of assets in our portfolio promptly in response to changes in economic or other conditions which could have an adverse effect on our sources of working capital and our ability to satisfy our debt obligations. +We have an investment in marketable equity securities. The value of this investment may decline as a result of operating performance or economic or market conditions. +We have an investment in The Macerich Company (“Macerich”), a retail shopping center company. As of December 31, 2020, this investment had a carrying amount of $6,024,000. A decline in the value of this investment due to, among other reasons, Macerich’s operating performance or economic or market conditions, would result in recognized GAAP losses, which could be material. +11 +RISKS RELATED TO OUR INDEBTEDNESS AND ACCESS TO CAPITAL +Substantially all of our assets are owned by subsidiaries. We depend on dividends and distributions from these subsidiaries. The creditors of these subsidiaries are entitled to amounts payable to them by the subsidiaries before the subsidiaries may pay any dividends or distributions to us. +Substantially all of our properties and assets are held through our subsidiaries. We depend on cash distributions and dividends from our subsidiaries for substantially all of our cash flow. The creditors of each of our direct and indirect subsidiaries are entitled to payment of that subsidiary’s obligations to them when due and payable before that subsidiary may make distributions or dividends to us. Thus, our ability to pay dividends, if any, to our security holders depends on our subsidiaries’ ability to first satisfy their obligations to their creditors and our ability to satisfy our obligations, if any, to our creditors. +In addition, our participation in any distribution of the assets of any of our direct or indirect subsidiaries upon the liquidation, reorganization or insolvency of the subsidiary, is only after the claims of the creditors, including trade creditors, and preferred security holders, if any, of the applicable direct or indirect subsidiaries are satisfied. +Our existing financing documents contain covenants and restrictions that may restrict our operational and financial flexibility. +As of December 31, 2020, we had outstanding mortgage indebtedness of $1,164,544,000, secured by four of our properties. These mortgages contain covenants that limit our ability to incur additional indebtedness on these properties, provide for lender approval of tenants’ leases in certain circumstances, and provide for yield maintenance or defeasance premiums to prepay them. These mortgages may significantly restrict our operational and financial flexibility. In addition, if we were to fail to perform our obligations under existing indebtedness or become insolvent or were liquidated, secured creditors would be entitled to payment in full from the proceeds of the sale of the pledged assets prior to any proceeds being paid to other creditors or to any holders of our securities. In such an event, it is possible that we would have insufficient assets remaining to make payments to other creditors or to any holders of our securities. +We have a substantial amount of indebtedness that could affect our future operations. +As of December 31, 2020, total debt outstanding was $1,164,544,000. We are subject to the risks normally associated with debt financing, including the risk that our cash flow from operations will be insufficient to meet required debt service. Our debt service costs generally will not be reduced if developments in the market or at our properties, such as the entry of new competitors or the loss of major tenants, cause a reduction in the income from our properties. Should such events occur, our operations may be adversely affected. If a property is mortgaged to secure payment of indebtedness and income from such property is insufficient to pay that indebtedness, the property could be foreclosed upon by the mortgagee resulting in a loss of income and a decline in our total asset value. +We have outstanding debt, and the amount of debt and its cost may increase and refinancing may not be available on acceptable terms. +As of December 31, 2020, total debt outstanding was $1,164,544,000 and our ratio of total debt to total enterprise value was 54.1%. “Enterprise value” means the market equity value of our common stock, plus debt, less cash and cash equivalents at such date. In addition, we have significant debt service obligations. For the year ended December 31, 2020, our cash payments for principal and interest were $72,476,000. In the future, we may incur additional debt, and thus increase the ratio of total debt to total enterprise value. If our level of indebtedness increases, there may be an increased risk of default which could adversely affect our financial condition and results of operations. In addition, in a rising interest rate environment, the cost of refinancing our existing debt and any new debt or market rate security or instrument may increase. Continued uncertainty in the equity and credit markets may negatively impact our ability to obtain financing on reasonable terms or at all, which may negatively affect our ability to refinance our debt. +RISKS RELATED TO OUR ORGANIZATION AND STRUCTURE +Loss of our key personnel could harm our operations and adversely affect the value of our common stock. +We are dependent on the efforts of Steven Roth, our Chief Executive Officer. Although we believe that we could find a replacement, the loss of his services could harm our operations and adversely affect the value of our common stock. +12 +Alexander’s charter documents and applicable law may hinder any attempt to acquire us. +Provisions in Alexander’s certificate of incorporation and by laws, as well as provisions of the Internal Revenue Code (the “Code”) and Delaware corporate law, may delay or prevent a change in control of the Company or a tender offer, even if such action might be beneficial to stockholders, and limit the stockholders’ opportunity to receive a potential premium for their shares of common stock over then prevailing market prices. +Primarily to facilitate maintenance of its qualification as a REIT, Alexander’s certificate of incorporation generally prohibits ownership, directly, indirectly or beneficially, by any single stockholder of more than 9.9% of the outstanding shares of preferred stock of any class or 4.9% of outstanding common stock of any class. The Board of Directors may waive or modify these ownership limits with respect to one or more persons if it is satisfied that ownership in excess of these limits will not jeopardize Alexander’s status as a REIT for federal income tax purposes. In addition, the Board of Directors has, subject to certain conditions and limitations, exempted Vornado and certain of its affiliates from these ownership limitations. Stock owned in violation of these ownership limits will be subject to the loss of rights and other restrictions. These ownership limits may have the effect of inhibiting or impeding a change in control. +Alexander’s Board of Directors is divided into three classes of directors. Directors of each class are chosen for three-year staggered terms. Staggered terms of directors may have the effect of delaying or preventing changes in control or management, even though changes in management or a change in control might be in the best interest of our stockholders. +In addition, Alexander’s charter documents authorize the Board of Directors to: +• cause Alexander’s to issue additional authorized but unissued common stock or preferred stock; +• classify or reclassify, in one or more series, any unissued preferred stock; and +• set the preferences, rights and other terms of any classified or reclassified stock that Alexander’s issues. +The Board of Directors could establish a series of preferred stock with terms that could delay, deter or prevent a change in control of Alexander’s or other transaction that might involve a premium price or otherwise be in the best interest of our stockholders, although the Board of Directors does not, at present, intend to establish a series of preferred stock of this kind. Alexander’s charter documents contain other provisions that may delay, deter or prevent a change in control of the Company or other transaction that might involve a premium price or otherwise be in the best interest of our stockholders. +In addition, Vornado, Interstate and its three general partners (each of whom are both trustees of Vornado and Directors of Alexander’s) together beneficially own approximately 58.5% of our outstanding shares of common stock. This degree of ownership is likely to reduce the possibility of a tender offer or an attempt to change control of the Company by a third party. +We may change our policies without obtaining the approval of our stockholders. +Our operating and financial policies, including our policies with respect to acquisitions of real estate or other assets, growth, operations, indebtedness, capitalization and dividends, are exclusively determined by our Board of Directors. Accordingly, our stockholders do not control these policies. +13 +Steven Roth, Vornado and Interstate may exercise substantial influence over us. They and some of our other directors and officers have interests or positions in other entities that may compete with us. +As of December 31, 2020, Interstate and its partners owned approximately 7.0% of the common shares of beneficial interest of Vornado and approximately 26.1% of our outstanding common stock. Steven Roth, David Mandelbaum and Russell B. Wight, Jr. are the partners of Interstate. Mr. Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Chairman of the Board of Trustees and Chief Executive Officer of Vornado and the Managing General Partner of Interstate. Mr. Wight and Mr. Mandelbaum are both trustees of Vornado and members of our Board of Directors. In addition, Vornado manages and leases the real estate assets of Interstate. +As of December 31, 2020, Vornado owned 32.4% of our outstanding common stock, in addition to the 26.1% owned by Interstate and its partners. In addition to the relationships described in the immediately preceding paragraph, Dr. Richard West and Mandakini Puri are both trustees of Vornado and members of our Board of Directors and Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Because of their overlapping interests, Vornado, Mr. Roth, Interstate and the other individuals noted in the preceding paragraphs may have substantial influence over Alexander’s, and on the outcome of any matters submitted to Alexander’s stockholders for approval. In addition, certain decisions concerning our operations or financial structure may present conflicts of interest among Vornado, Messrs. Roth, Mandelbaum and Wight and Interstate and other security holders. Vornado, Mr. Roth and Interstate may, in the future, engage in a wide variety of activities in the real estate business which may result in conflicts of interest with respect to matters affecting us, such as, which of these entities or persons, if any, may take advantage of potential business opportunities, the business focus of these entities, the types of properties and geographic locations in which these entities make investments, potential competition between business activities conducted, or sought to be conducted, by us, competition for properties and tenants, possible corporate transactions such as acquisitions, and other strategic decisions affecting the future of these entities. +There may be conflicts of interest between Vornado, its affiliates and us. +Vornado manages, develops and leases our properties under agreements that have one-year terms expiring in March of each year, which are automatically renewable. Because we share common senior management with Vornado and because five of the trustees of Vornado are on our Board of Directors, the terms of the foregoing agreements and any future agreements may not be comparable to those we could have negotiated with an unaffiliated third party. +For a description of Interstate’s ownership of Vornado and Alexander’s, see “Steven Roth, Vornado and Interstate may exercise substantial influence over us. They and some of our other directors and officers have interests or positions in other entities that may compete with us.” above. +14 +RISKS RELATED TO OUR COMMON SHARES +The trading price of our common shares has been volatile and may continue to fluctuate. +The trading price of our common shares has been volatile and may continue to fluctuate widely as a result of several factors, many of which are outside of our control. In addition, the stock market is subject to fluctuations in the share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations have in the past and may in the future adversely affect the market price of our common shares. Among the factors that could affect the price of our common shares are: +• our financial condition and performance; +• the financial condition of our tenants, including the extent of tenant bankruptcies or defaults; +• the impact of the COVID-19 pandemic; +• actual or anticipated quarterly fluctuations in our operating results and financial condition; +• our dividend policy; +• the reputation of REITs and real estate investments generally and the attractiveness of REIT equity securities in comparison to other equity securities, including securities issued by other real estate companies, and fixed income securities; +• uncertainty and volatility in the equity and credit markets; +• fluctuations in interest rates; +• changes in revenue or earnings estimates or publication of research reports and recommendations by financial analysts or actions taken by rating agencies with respect to our securities or those of other REITs; +• failure to meet analysts’ revenue or earnings estimates; +• speculation in the press or investment community; +• strategic actions by us or our competitors, such as acquisitions or restructurings; +• the extent of institutional investor interest in us; +• the extent of short-selling of our common shares and the shares of our competitors; +• fluctuations in the stock price and operating results of our competitors; +• general financial and economic market conditions and, in particular, developments related to market conditions for REITs and other real estate related companies; +• domestic and international economic factors unrelated to our performance; +• changes in tax laws and rules; and +• all other risk factors addressed elsewhere in this Annual Report on Form 10-K. +A significant decline in our stock price could result in substantial losses for stockholders. +Alexander’s has additional shares of its common stock available for future issuance, which could decrease the market price of the common stock currently outstanding. +The interest of our current stockholders could be diluted if we issue additional equity securities. As of December 31, 2020, we had authorized but unissued 4,826,550 shares of common stock, par value of $1.00 per share and 3,000,000 shares of preferred stock, par value $1.00 per share; of which 14,916 shares of common stock are reserved for issuance upon redemption of the deferred stock units previously granted to our Board of Directors. In addition, 490,871 shares are available for future grant under the terms of our 2016 Omnibus Stock Plan. These awards may be granted in the form of options, restricted stock, stock appreciation rights, deferred stock units, or other equity-based interests, and if granted, would reduce that number of shares available for future grants, provided however that an award that may be settled only in cash, would not reduce the number of shares available under the plan. We cannot predict the impact that future issuances of common or preferred stock or any exercise of outstanding options or grants of additional equity-based interests would have on the market price of our common stock. +15 +RISKS RELATED TO REGULATORY COMPLIANCE +We might fail to qualify or remain qualified as a REIT, and may be required to pay federal income taxes at corporate rates. +Although we believe that we will remain organized and will continue to operate so as to qualify as a REIT for federal income tax purposes, we might fail to remain qualified. Qualification as a REIT for federal income tax purposes is governed by highly technical and complex provisions of the Code for which there are only limited judicial or administrative interpretations and depends on various facts and circumstances that are not entirely within our control. In addition, legislation, new regulations, administrative interpretations or court decisions may significantly change the relevant tax laws and/or the federal income tax consequences of qualifying as a REIT. If, with respect to any taxable year, we fail to maintain our qualification as a REIT and do not qualify under statutory relief provisions, we could not deduct distributions to stockholders in computing our taxable income and would have to pay federal income tax on our taxable income at regular corporate rates. The federal income tax payable would include any applicable alternative minimum tax. If we had to pay federal income tax, the amount of money available to distribute to stockholders and pay our indebtedness would be reduced for the year or years involved, and we would no longer be required to make distributions to stockholders in that taxable year and in future years until we were able to qualify as a REIT and did so. In addition, we would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost, unless we were entitled to relief under the relevant statutory provisions. +We may face possible adverse changes in federal tax laws, which may result in an increase in our tax liability. +At any time, the U.S. federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. We cannot predict if or when any new U.S. federal income tax law, regulation, or administrative interpretation, or any amendment to any existing U.S. federal income tax law, Treasury regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation, or interpretation may take effect retroactively. Alexander’s, its taxable REIT subsidiaries, and our security holders could be adversely affected by any such change in, or any new, U.S. federal income tax law, Treasury regulation or administrative interpretation. +We may incur significant costs to comply with environmental laws and environmental contamination may impair our ability to lease and/or sell real estate. +Our operations and properties are subject to various federal, state and local laws and regulations concerning the protection of the environment, including air and water quality, hazardous or toxic substances and health and safety. Under some environmental laws, a current or previous owner or operator of real estate may be required to investigate and clean up hazardous or toxic substances released at a property. The owner or operator may also be held liable to a governmental entity or to third parties for property damage or personal injuries and for investigation and clean-up costs incurred by those parties because of the contamination. These laws often impose liability without regard to whether the owner or operator knew of the release of the substances or caused the release. The presence of contamination or the failure to remediate contamination may also impair our ability to sell or lease real estate or to borrow using the real estate as collateral. Other laws and regulations govern indoor and outdoor air quality including those that can require the abatement or removal of asbestos-containing materials in the event of damage, demolition, renovation or remodeling and govern emissions of and exposure to asbestos fibers in the air. The maintenance and removal of lead paint and certain electrical equipment containing polychlorinated biphenyls (PCBs) are also regulated by federal and state laws. We are also subject to risks associated with human exposure to chemical or biological contaminants such as molds, pollens, viruses and bacteria which, above certain levels, can be alleged to be connected to allergic or other health effects and symptoms in susceptible individuals. We could incur fines for environmental compliance and be held liable for the costs of remedial action with respect to the foregoing regulated substances or related claims arising out of environmental contamination or human exposure to contamination at or from our properties. +Each of our properties has been subjected to varying degrees of environmental assessment. To date, these environmental assessments have not revealed any environmental condition material to our business. However, identification of new compliance concerns or undiscovered areas of contamination, changes in the extent or known scope of contamination, human exposure to contamination or changes in clean-up or compliance requirements could result in significant costs to us. +In addition, we may become subject to costs or taxes, or increases therein, associated with natural resource or energy usage (such as a “carbon tax”). These costs or taxes could increase our operating costs and decrease the cash available to pay our obligations or distribute to stockholders. +16 +We face risks associated with our tenants being designated “Prohibited Persons” by the Office of Foreign Assets Control and similar requirements. +Pursuant to Executive Order 13224 and other laws, the Office of Foreign Assets Control of the United States Department of the Treasury (“OFAC”) maintains a list of persons designated as terrorists or who are otherwise blocked or banned (“Prohibited Persons”) from conducting business or engaging in transactions in the United States and thereby restricts our doing business with such persons. In addition, our leases, loans and other agreements may require us to comply with OFAC and related requirements, and any failure to do so may result in a breach of such agreements. If a tenant or other party with whom we conduct business is placed on the OFAC list or is otherwise a party with whom we are prohibited from doing business, we may be required to terminate the lease or other agreement or face other penalties. Any such termination could result in a loss of revenue or otherwise negatively affect our financial results and cash flows. +We may face possible adverse state and local tax audits and changes in state and local tax law. +Because we are organized and qualify as a REIT, we are generally not subject to federal income taxes, but we are subject to certain state and local taxes. In the normal course of business, certain entities through which we own real estate have undergone tax audits. There can be no assurance that future audits will not occur with increased frequency or that the ultimate result of such audits will not have a material adverse effect on our results of operations. +From time to time changes in state and local tax laws or regulations are enacted, which may result in an increase in our tax liability. A shortfall in tax revenues for states and municipalities in which we operate may lead to an increase in the frequency and size of such changes. If such changes occur, we may be required to pay additional taxes on our assets or income. These increased tax costs could adversely affect our financial condition and results of operations and the amount of cash available for the payment of dividends and distributions to our stockholders. +Compliance or failure to comply with the Americans with Disabilities Act (“ADA”) or other safety regulations and requirements could result in substantial costs. +The ADA generally requires that public buildings, including our properties, meet certain Federal requirements related to access and use by disabled persons. Noncompliance could result in the imposition of fines by the Federal government or the award of damages to private litigants and/or legal fees to their counsel. If, under the ADA, we are required to make substantial alterations and capital expenditures in one or more of our properties, including the removal of access barriers, it could adversely affect our financial condition and results of operations, as well as the amount of cash available for distribution to stockholders. +Our properties are subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements. If we fail to comply with these requirements, we could incur fines or private damage awards. We do not know whether existing requirements will change or whether compliance with future requirements will require significant unanticipated expenditures that will affect our cash flow and results of operations. +17 +GENERAL RISKS +The occurrence of cyber incidents, or a deficiency in our cyber security, as well as other disruptions of our IT networks and related systems, could negatively impact our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships or reputation, all of which could negatively impact our financial results. +We face risks associated with security breaches, whether through cyber attacks or cyber intrusions over the Internet, malware, computer viruses, attachments to e-mails, persons who access our systems from inside or outside our organization, and other significant disruptions of our IT networks and related systems. The risk of a security breach or disruption, particularly through cyber attack or cyber intrusion, including by computer hackers, foreign governments and cyber terrorists, has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased. Although we have not experienced cyber incidents that are individually, or in the aggregate, material, we have experienced cyber attacks in the past, which have thus far been mitigated by preventative, detective, and responsive measures that we have put in place. Our IT networks and related systems are essential to the operation of our business and our ability to perform day-to-day operations (including managing our building systems) and, in some cases, may be critical to the operations of certain of our tenants. Although we make efforts to maintain the security and integrity of these types of IT networks and related systems, and we have implemented various measures to manage the risk of a security breach or disruption, there can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not be successful or damaging. Unauthorized parties, whether within or outside our company, may disrupt or gain access to our systems, or those of third parties with whom we do business, through human error, misfeasance, fraud, trickery, or other forms of deceit, including break-ins, use of stolen credentials, social engineering, phishing, computer viruses or other malicious codes, and similar means of unauthorized and destructive tampering. Even the most well protected information, networks, systems and facilities remain potentially vulnerable because the techniques used in such attempted security breaches evolve and generally are not recognized until launched against a target, and in some cases are designed to not be detected and, in fact, may not be detected. Accordingly, we may be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, and thus it is impossible for us to entirely mitigate this risk. +A security breach or other significant disruption involving our IT networks and related systems could disrupt the proper functioning of our networks and systems and therefore our operations and/or those of certain of our tenants; result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information of ours or others, which others could use to compete against us or which could expose us to damage claims by third-parties for disruptive, destructive or otherwise harmful purposes and outcomes; result in our inability to maintain the building systems relied upon by our tenants for the efficient use of their leased space; require significant management attention and resources to remedy any damages that result; subject us to litigation claims for breach of contract, damages, credits, fines, penalties, governmental investigations and enforcement actions or termination of leases or other agreements; or damage our reputation among our tenants and investors generally. Any or all of the foregoing could have a material adverse effect on our results of operations, financial condition and cash flows. +A cyber attack or systems failure could interfere with our ability to comply with financial reporting requirements, which could adversely affect us. A cyber attack could also compromise the confidential information of our employees, tenants, customers and vendors. A successful attack could disrupt and materially affect our business operations, including damaging relationships with tenants, customers and vendors. Any compromise of our information security systems could also result in a violation of applicable privacy and other laws, significant legal and financial exposure, damage to our reputation, loss or misuse of the information (which may be confidential, proprietary and/or commercially sensitive in nature) and a loss of confidence in our security measures, which could harm our business. +18 +Capital markets and economic conditions can materially affect our liquidity, financial condition and results of operations as well as the value of an investment in our debt and equity securities. +There are many factors that can affect the value of our equity securities and any debt securities we may issue in the future, including the state of the capital markets and economy. Demand for office and retail space typically declines nationwide due to an economic downturn, bankruptcies, downsizing, layoffs and cost cutting. Government action or inaction may adversely affect the state of the capital markets. The cost and availability of credit may be adversely affected by illiquid credit markets and wider credit spreads, which may adversely affect our liquidity and financial condition, including our results of operations, and the liquidity and financial condition of our tenants. Our inability or the inability of our tenants to timely refinance maturing liabilities and access the capital markets to meet liquidity needs may materially affect our financial condition and results of operations and the value of our equity securities and any debt securities we may issue in the future. +Some of our potential losses may not be covered by insurance. +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, of which the first $1,000,000 includes communicable disease coverage, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties and excluding communicable disease coverage. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $275,000 deductible and 20% of the balance of a covered loss, and the Federal government is responsible for the remaining 80% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +The principal amounts of our mortgage loans are non-recourse to us and the loans contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +19 +Changes in the method pursuant to which the LIBOR rates are determined and phasing out of LIBOR after 2021 may affect our financial results. +The chief executive of the United Kingdom Financial Conduct Authority (“FCA”), which regulates the London Interbank Offered Rate (“LIBOR”), announced that the FCA intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. In response, the Federal Reserve Board and the Federal Reserve Bank of New York organized the Alternative Reference Rates Committee which identified the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative to USD-LIBOR in derivatives and other financial contracts. In November 2020, the ICE Benchmark Administration Limited, the benchmark administrator for USD LIBOR rates, proposed extending the publication of certain commonly used USD LIBOR settings until June 30, 2023 and the FCA issued a statement supporting such proposal. In connection with this proposal, certain U.S. banking regulators issued guidance strongly encouraging banks to generally cease entering into new contracts referencing USD LIBOR as soon as practicable and in any event by December 31, 2021. It is not possible to predict the effect of these changes, including when LIBOR will cease to be available or when there will be sufficient liquidity in the SOFR markets. +We have outstanding debt with variable rates based on LIBOR. In the transition from the use of LIBOR to SOFR or other alternatives, the level of interest payments we incur may change. In addition, although certain of our LIBOR based obligations provide for alternative methods of calculating the related interest rate payable (including transition to an alternative benchmark rate) if LIBOR is not reported, uncertainty as to the extent and manner of future changes may result in interest rates and/or payments that are higher than, lower than or that do not otherwise correlate over time with the interest rates and/or payments that would have been made on our obligations if LIBOR was available in its current form. Use of alternative interest rates or other LIBOR reforms could result in increased volatility or a tightening of credit markets which could adversely affect our ability to obtain cost-effective financing. In addition, the transition of our existing LIBOR financing agreements to alternative benchmarks may result in unanticipated changes to the overall interest rate paid on our liabilities. +ITEM 1B. UNRESOLVED STAFF COMMENTS +There are no unresolved comments from the staff of the Securities and Exchange Commission as of the date of this Annual Report on Form 10-K. +20 +ITEM 2. PROPERTIES +The following table shows the location, ownership, approximate size (excluding parking garages) and occupancy of each of our properties as of December 31, 2020. +Square Feet Weighted +Under Average +Development Or In Service Escalated Lease Expiration(s) +Land Total Not Available Occupancy Annual Original Option +Property Acreage Property In Service For Lease Rate +Rent PSF (1) +Tenants +Term (2) +Term (3) +Operating Properties: +731 Lexington Avenue +New York, NY +Office 920,000 920,000 — 100% $130.00 Bloomberg L.P. 2029 2039 +Retail 83,000 83,000 — The Home Depot 2025 2035 +34,000 34,000 — The Container Store 2021 N/A +38,000 38,000 — Various Various Various +155,000 155,000 — 93% 278.46 +1.9 1,075,000 1,075,000 — +Rego Park I +Queens, NY +112,000 112,000 — IKEA 2025 (4) 2030 +50,000 50,000 — Burlington 2027 N/A +46,000 46,000 — Bed Bath & Beyond 2026 N/A +36,000 36,000 — Marshalls 2032 N/A +16,000 16,000 — Old Navy 2022 N/A +78,000 — 78,000 (5) N/A N/A +4.8 338,000 260,000 78,000 100% 53.58 +Rego Park II +Queens, NY +145,000 145,000 — Costco 2034 2059 +135,000 135,000 — +Century 21 (6) +2031 2051 +133,000 133,000 — +Kohl’s (7) +2031 2051 +196,000 196,000 — Various Various Various +6.6 609,000 609,000 — 96% 59.73 +The Alexander apartment tower, 312 units +Queens, NY — 255,000 255,000 — 82% +46.26 (8) +Residential (9) N/A +Paramus +Paramus, NJ 30.3 — — — 100% — IKEA (ground lessee) 2041 (10) N/A +Flushing +Queens, NY (11) +1 167,000 167,000 — 100% 32.09 New World Mall LLC 2027 2037 +Property to be Developed: +Rego Park III, adjacent to Rego Park II +Queens, NY 3.2 — — — — — — — — +2,444,000 2,366,000 78,000 +(1) Represents the weighted average escalated annual rent per square foot, which includes tenant reimbursements and excludes the impact of tenant concessions (such as free rent), as of December 31, 2020. For a discussion of our leasing activity, see Item 7 - Overview - Square Footage, Occupancy and Leasing Activity. +(2) Represents the year in which the tenant’s lease expires, without consideration of any renewal or extension options. Lease expiration dates are based on non-cancelable lease terms and do not extend beyond any early termination rights that the tenant may have under its lease. +(3) Represents the year in which the tenant’s lease expires if all renewal or extension options are exercised. +(4) IKEA has the option to terminate its lease after the fifth year of the lease term subject to payment to us of the lesser of $10,000,000 or the amount of rent due under the remaining term. +(5) Formerly occupied by Sears. Currently out of service due to redevelopment. +(6) +On September 10, 2020, Century 21 filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. +(7) Subleased through remaining original lease term. +(8) Average monthly rent per unit is $3,212. +(9) Residential tenants have one or two year leases. +(10) IKEA’s lease has a purchase option in October 2021. +(11) Ground leased through January 2027 with one 10-year extension option. +21 +Operating Properties +731 Lexington Avenue +731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprises the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan, New York, and is situated in the heart of one of Manhattan’s busiest business and shopping districts, with convenient access to several subway and bus lines. The property is located across the street from Bloomingdale’s flagship store and only a few blocks away from Fifth Avenue and 57 th Street. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg occupies all of the office space. The Home Depot (83,000 square feet) is the principal retail tenant. +The office portion of 731 Lexington Avenue is encumbered by a mortgage loan with a balance of $500,000,000 which matures in June 2021, with three one-year unilateral extension options. The interest-only loan is at LIBOR plus 0.90% (1.06% as of December 31, 2020). In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. +The retail portion of 731 Lexington Avenue is encumbered by a mortgage loan with a balance of $300,000,000 which matures in August 2025. The interest-only loan is at LIBOR plus 1.40% (1.55% as of December 31, 2020) which is subject to an interest rate swap with a fixed rate of 1.72%. +Rego Park I +Rego Park I, a 338,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens, New York. The center is anchored by a 112,000 square foot IKEA, a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls. The center contains a parking deck (1,241 spaces) that provides for paid parking. +Rego Park II +Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens, New York. The center is anchored by a 145,000 square foot Costco and a 133,000 square foot Kohl’s, which has been subleased. On September 10, 2020, Century 21 ($6,400,000 of annual revenue) filed for Chapter 11 bankruptcy and closed its 135,000 square foot store on December 7, 2020. The center contains a parking deck (1,326 spaces) that provides for paid parking. +This center is encumbered by a mortgage loan in the amount of $252,544,000 which matures in December 2025. The interest-only loan is at LIBOR plus 1.35% (1.50% as of December 31, 2020). As of December 31, 2020, we have a participation in the mortgage in the amount of $50,000,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $202,544,000. +The Alexander Apartment Tower +The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet. +The property is encumbered by a mortgage loan in the amount of $94,000,000 which matures in November 2027. The interest-only loan has a fixed rate of 2.63%. +22 +Operating Properties - continued +Paramus +We own 30.3 acres of land located at the intersection of Routes 4 and 17 in Paramus, New Jersey. The land is located directly across from the Garden State Plaza regional shopping mall and is within two miles of three other regional shopping malls and ten miles of New York City. The land has been ground leased to IKEA since 2001. The lease expires in 2041, with a purchase option in October 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. +Flushing +Our Flushing property is located on Roosevelt Avenue and Main Street in the downtown, commercial section of Flushing, Queens, New York. Roosevelt Avenue and Main Street are active shopping districts and there are many national retailers located in the area. A subway entrance is located directly in front of the property with bus service across the street. The property comprises a four-floor building containing 167,000 square feet and a parking garage, which is sub-leased to New World Mall LLC for the remainder of our ground lease term, which expires in January 2027 and has one 10-year extension option. +Property to be Developed +Rego Park III +We own a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, New York, at the intersection of Junction Boulevard and the Horace Harding Service Road. The land is currently being used for paid public parking. In 2016, the Company started the entitlement process. +23 +ITEM 3. LEGAL PROCEEDINGS +We are from time to time involved in legal actions arising in the ordinary course of business. In our opinion, after consultation with our legal counsel, the outcome of such matters will not have a material effect on our financial condition, results of operations or cash flows. +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to the 195,000 square foot store that Sears formerly leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4,000,000 and future damages it estimated would not be less than $25,000,000. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonably possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +24 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is listed on the New York Stock Exchange under the symbol “ALX.” +As of January 31, 2021, there were 206 holders of record of our common stock. +Recent Sales of Unregistered Securities +None. +Information relating to compensation plans under which our equity securities are authorized for issuance is set forth under Part III, Item 12 of this Annual Report on Form 10-K and such information is incorporated by reference herein. +Recent Purchases of Equity Securities +None. +25 +Performance Graph +The following graph is a comparison of the five-year cumulative return of our common stock, the Standard & Poor’s 500 Index (the “S&P 500 Index”) and the National Association of Real Estate Investment Trusts’ (“NAREIT”) All Equity Index, a peer group index. The graph assumes that $100 was invested on December 31, 2015 in our common stock, the S&P 500 Index and the NAREIT All Equity Index and that all dividends were reinvested without the payment of any commissions. There can be no assurance that the performance of our stock will continue in line with the same or similar trends depicted in the graph below. +2015 2016 2017 2018 2019 2020 +Alexander’s $ 100 $ 116 $ 112 $ 90 $ 103 $ 92 +S&P 500 Index 100 112 136 130 171 203 +The NAREIT All Equity Index 100 109 118 113 146 138 +ITEM 6. SELECTED FINANCIAL DATA +None. +26 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Overview +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. +We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +In January 2021, the SEC issued Final Rule Release No. 33-10890, Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information . This rule, which became effective on February 10, 2021, adopts amendments to modernize, simplify and enhance certain financial disclosure requirements in Regulation S-K. Specifically, the amendments eliminate the requirement for Selected Financial Data, streamline the requirement to disclose Supplementary Financial Information, and amend our Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”). We early adopted the amendments to two items resulting in the elimination of Item 301, Selected Financial Data , and the omission of Item 302(a), Supplementary Financial Information . The amendments to Item 303(a)(b) MD&A , will be adopted in our Form 10-K for the year ended December 31, 2021. +COVID-19 Pandemic +Our business has been adversely affected by the ongoing COVID-19 pandemic. In March 2020, our “non-essential” retail tenants were ordered to temporarily close and although substantially all re-opened in the latter part of June 2020, there are limitations on occupancy and other restrictions that affect their ability to resume full operations. +In limited circumstances, we have agreed to and may continue to agree to rent deferrals and abatements for certain of our tenants. We have made the policy election available to us based on the Financial Accounting Standards Board’s (“FASB”) guidance for leases during the COVID-19 pandemic, which allows us to continue recognizing rental revenue for rent deferral agreements and to recognize rent abatements as a reduction to rental revenue in the period granted. See Note 3 - Summary of Significant Accounting Policies, to our consolidated financial statements in this Annual Report on Form 10-K for additional information. +Overall, we have collected approximately 95% of rent billed for the quarter ended December 31, 2020 (96% including rent deferrals under agreements which generally require repayment in monthly installments over a period of time not to exceed twelve months), including 100% for our office tenant, approximately 90% for our retail tenants (91% including rent deferrals) and approximately 98% for our residential tenants. +On September 10, 2020, Century 21, which leased 135,000 square feet at our Rego Park II shopping center ($6,400,000 of annual revenue), filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. +Based on our assessment of the probability of collecting rent from certain tenants, we have written off as uncollectible tenant receivables of $4,122,000 during the year ended December 31, 2020, resulting in a reduction of rental revenues. Of this amount, $2,716,000 is attributable to Century 21. In addition, we have written off receivables arising from the straight-lining of rents related to these tenants of $10,837,000 during the year ended December 31 2020, resulting in a reduction of rental revenues. Of this amount, $5,919,000 is attributable to Century 21. Prospectively, revenue recognition for these tenants will be based on actual amounts received. +27 +Overview - continued +Year Ended December 31, 2020 Financial Results Summary +Net income for the year ended December 31, 2020 was $41,939,000 or $8.19 per diluted share, compared to $60,075,000, or $11.74 per diluted share for the year ended December 31, 2019. +Funds from operations (“FFO”) (non-GAAP) for the year ended December 31, 2020 was $82,509,000, or $16.11 per diluted share, compared to $99,670,000, or $19.47 per diluted share for the year ended December 31, 2019. +Quarter Ended December 31, 2020 Financial Results Summary +Net income for the quarter ended December 31, 2020 was $18,432,000, or $3.60 per diluted share, compared to $14,434,000, or $2.82 per diluted share for the quarter ended December 31, 2019. +FFO (non-GAAP) for the quarter ended December 31, 2020 was $25,407,000, or $4.96 per diluted share, compared to $24,626,000, or $4.81 per diluted share for the quarter ended December 31, 2019. +Square Footage, Occupancy and Leasing Activity +As of December 31, 2020, our portfolio was comprised of seven properties aggregating 2,444,000 square feet, of which 2,366,000 square feet was in service and 78,000 square feet (a portion of our Rego Park I shopping center) was out of service due to redevelopment. The in service square feet was 97% occupied as of December 31, 2020. +Financing Activity +On February 14, 2020, we reduced our participation in our Rego Park II shopping center loan to $50,000,000 and received cash proceeds of approximately $145,000,000. +On September 14, 2020, we amended and extended the $350,000,000 mortgage loan on the retail condominium of our 731 Lexington Avenue property. Under the terms of the amendment, we paid down the loan by $50,000,000 to $300,000,000, extended the maturity date to August 2025 and guaranteed the interest payments and certain leasing costs. The principal of the loan is non-recourse to us. The interest-only loan is at LIBOR plus 1.40% (1.55% as of December 31, 2020) which is subject to an interest rate swap with a fixed rate of 1.72%. +On October 23, 2020, we completed a financing of The Alexander apartment tower in the amount of $94,000,000. The interest-only loan has a fixed rate of 2.63% and matures in November 2027. +Significant Tenant +Bloomberg accounted for revenue of $109,066,000, $109,113,000, and $107,356,000 in the years ended December 31, 2020, 2019 and 2018, respectively, representing approximately 55%, 48% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Critical Accounting Policies and Estimates +Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 3 – Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. +28 +Critical Accounting Policies and Estimates - continued +Real Estate +Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2020 and 2019, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $720,921,000 and $716,843,000, respectively. Maintenance and repairs are generally expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. +Our properties, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset, including an estimated terminal value calculated using an appropriate capitalization rate. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. +Revenue Recognition +Our rental revenues include revenues from the leasing of space to tenants at our properties and revenues from parking and tenant services. We have the following revenue recognition policies: +• Lease revenues from the leasing of space to tenants at our properties. Revenues derived from base rent are recognized over the non-cancelable term of the related leases on a straight-line basis which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the underlying asset is available for use by the lessee. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. Revenues derived from the reimbursement of real estate taxes, insurance expenses and common area maintenance expenses are generally recognized in the same period as the related expenses are incurred. As lessor, we have elected to combine the lease components (base and variable rent), non-lease components (reimbursements of common area maintenance expenses) and reimbursement of real estate taxes and insurance expenses from our operating lease agreements and account for the components as a single lease component in accordance with ASC Topic 842, Leases (“ASC 842”). +• Parking revenue arising from the rental of parking spaces at our properties. This income is recognized as the services are transferred in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). +• Tenant services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred in accordance with ASC 606. +Under ASC 842, we must assess on an individual lease basis whether it is probable that we will collect substantially all of the future lease payments. We consider the tenant’s payment history and current credit status when assessing collectability. When collectability is not deemed probable, we write-off the tenant’s receivables, including straight-line rent receivable, and limit lease income to cash received. We recognize changes in the collectability assessment of our operating leases as adjustments to rental revenues. +29 +Critical Accounting Policies and Estimates - continued +Income Taxes +We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 – 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. +30 +Results of Operations – Year Ended December 31, 2020 compared to December 31, 2019 +Rental Revenues +Rental revenues were $199,142,000 in the year ended December 31, 2020, compared to $226,350,000 in the prior year, a decrease of $27,208,000. This decrease was primarily due to (i) $10,837,000 from the write-off of receivables arising from the straight-lining of rents from certain of our retail tenants, of which $5,919,000 is attributable to Century 21, (ii) $10,512,000 from retail tenant vacancies at our 731 Lexington Avenue property and (iii) $5,590,000 of lower rental income from certain of our retail tenants which were deemed uncollectible, of which $3,036,000 is attributable to Century 21. +Operating Expenses +Operating expenses were $88,403,000 in the year ended December 31, 2020, compared to $89,738,000 in the prior year, a decrease of $1,335,000. This decrease was primarily due to lower operating expenses subject to recovery, including utilities and common area maintenance. +Depreciation and Amortization +Depreciation and amortization was $32,357,000 in the year ended December 31, 2020, compared to $31,351,000 in the prior year, an increase of $1,006,000. This increase is primarily due to the acceleration of amortization of deferred leasing costs related to Century 21 at our Rego Park II property. +General and Administrative Expenses +General and administrative expenses were $6,307,000 in the year ended December 31, 2020, compared to $5,772,000 in the prior year, an increase of $535,000. This increase was primarily due to higher stock-based compensation expense in connection with the fair value of deferred stock units granted to a newly appointed member of our Board of Directors during the second quarter of 2020, comprised of an initial award of $150,000 and a $56,000 annual award and $245,000 due to higher professional fees. +Interest and Other Income, net +Interest and other income, net was $2,667,000 in the year ended December 31, 2020, compared to $8,244,000 in the prior year, a decrease of $5,577,000. This decrease was primarily due to $5,216,000 of lower interest income due to a decrease in interest rates. +Interest and Debt Expense +Interest and debt expense was $24,204,000 in the year ended December 31, 2020, compared to $38,901,000 in the prior year, a decrease of $14,697,000. This decrease was primarily due to $15,149,000 of lower interest expense due to a decrease in LIBOR. +Change in Fair Value of Marketable Securities +Change in fair value of marketable securities was an expense of $8,599,000 in the year ended December 31, 2020, consisting of $8,698,000 resulting from a decrease in Macerich’s share price of $16.25 on 535,265 shares owned, partially offset by $99,000 resulting from an increase in Macerich’s share price of $3.37 on 29,347 shares owned. Change in fair value of marketable securities was an expense of $8,757,000 in the prior year, resulting from a decrease in Macerich’s share prices of $16.36 on 535,265 shares owned. +31 +Results of Operations – Year Ended December 31, 2019 compared to December 31, 2018 +Rental Revenues +Rental revenues were $226,350,000 in the year ended December 31, 2019, compared to $232,825,000 in the prior year, a decrease of $6,475,000. This decrease was primarily due to the Sears vacancy effective October 2018 at our Rego Park I property. +Operating Expenses +Operating expenses were $89,738,000 in the year ended December 31, 2019, compared to $93,775,000 in the prior year, a decrease of $4,037,000. This decrease was primarily due to bad debt expense in 2018 of $4,459,000, primarily due to the Sears bankruptcy and lease termination. +Depreciation and Amortization +Depreciation and amortization was $31,351,000 in the year ended December 31, 2019, compared to $33,089,000 in the prior year, a decrease of $1,738,000. This decrease was primarily due to acceleration of depreciation and amortization in 2018 related to the Toys “R” Us, Inc. bankruptcy and lease termination at our Rego Park II property. +General and Administrative Expenses +General and administrative expenses were $5,772,000 in the year ended December 31, 2019, compared to $5,343,000 in the prior year, an increase of $429,000. This increase was primarily due to higher professional fees. +Interest and Other Income, net +Interest and other income, net was $8,244,000 in the year ended December 31, 2019, compared to $12,546,000 in the prior year, a decrease of $4,302,000. This decrease was primarily due to (i) $7,126,000 of interest income in 2018 from our Rego Park II loan participation (on December 12, 2018, we refinanced our $252,544,000 Rego Park II shopping center mortgage loan and GAAP required that our loan participation be treated as an extinguishment of debt), partially offset by (ii) $1,364,000 of higher interest income due to an increase in average interest rates and (iii) $1,600,000 of expense in 2018 from a litigation settlement. +Interest and Debt Expense +Interest and debt expense was $38,901,000 in the year ended December 31, 2019, compared to $44,533,000 in the prior year, a decrease of $5,632,000. This decrease was primarily due to $7,178,000 of lower interest expense due to the refinancing of our Rego Park II shopping center loan, partially offset by $1,810,000 of higher interest expense resulting from an increase in average interest rates. +Change in Fair Value of Marketable Securities +Change in fair value of marketable securities was an expense of $8,757,000 in the year ended December 31, 2019, resulting from Macerich’s closing share prices of $26.92 and $43.28 as of December 31, 2019 and 2018, respectively, on 535,265 shares owned. Change in fair value of marketable securities was an expense of $11,990,000 in the prior year, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively. +Loss from Discontinued Operations +Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to an expense for potential additional real property transfer taxes from the 2012 sale of the Kings Plaza Regional Shopping Center (“Kings Plaza”). See Note 7 – Discontinued Operations , to our consolidated financial statements in this Annual Report on Form 10-K. +32 +Related Party Transactions +Vornado +As of December 31, 2020, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 5 – Related Party Transactions , to our consolidated financial statements in this Annual Report on Form 10-K. +Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2020, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Liquidity and Capital Resources +Rental revenue is our primary source of cash flow and is dependent on a number of factors, including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. As a result of the COVID-19 pandemic, in limited circumstances, we have agreed to and may continue to agree to rent deferrals and abatements for certain of our tenants. Overall, we have collected approximately 95% of rent billed for the quarter ended December 31, 2020 (96% including rent deferrals under agreements which generally require repayment in monthly installments over a period of time not to exceed twelve months), including 100% for our office tenant, approximately 90% for our retail tenants (91% including rent deferrals) and approximately 98% for our residential tenants. On September 10, 2020, Century 21, which leased 135,000 square feet at our Rego Park II shopping center ($6,400,000 of annual revenue), filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. +As of December 31, 2020, we had $455,901,000 of liquidity comprised of $449,877,000 of cash and cash equivalents and restricted cash and $6,024,000 of marketable securities. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization and capital expenditures. We may refinance our maturing debt as it comes due or choose to pay it down. However, there can be no assurance that additional financing or capital will be available to refinance our debt, or that the terms will be acceptable or advantageous to us. The challenges posed by the COVID-19 pandemic and the impact on our business and cash flows are evolving rapidly and cannot be predicted at this time but that impact could be material. Consequently, we will continue to evaluate our liquidity and financial position on an ongoing basis. +Dividends +On January 20, 2021, our Board of Directors declared a regular quarterly dividend to $4.50 per share (an indicated annual rate of $18.00 per share). The dividend, if declared by the Board of Directors at the same rate for all of 2021, would require us to pay out approximately $92,200,000. +Financing Activity and Contractual Obligations +On February 14, 2020, we reduced our participation in our Rego Park II shopping center loan to $50,000,000 and received cash proceeds of approximately $145,000,000. +On September 14, 2020, we amended and extended the $350,000,000 mortgage loan on the retail condominium of our 731 Lexington Avenue property. Under the terms of the amendment, we paid down the loan by $50,000,000 to $300,000,000, extended the maturity date to August 2025 and guaranteed the interest payments and certain leasing costs. The principal of the loan is non-recourse to us. The interest-only loan is at LIBOR plus 1.40% (1.55% as of December 31, 2020) which is subject to an interest rate swap with a fixed rate of 1.72%. +33 +Liquidity and Capital Resources - continued +On October 23, 2020, we completed a financing of The Alexander apartment tower in the amount of $94,000,000. The interest-only loan has a fixed rate of 2.63% and matures in November 2027. +Below is a summary of our outstanding debt and maturities as of December 31, 2020. We may refinance our maturing debt as it comes due or choose to repay it. +Balance Interest Rate Maturity +(Amounts in thousands) +Paramus $ 68,000 4.72 % Oct. 04, 2021 +731 Lexington Avenue, office condominium (1) +500,000 1.06 % Jun. 11, 2024 +731 Lexington Avenue, retail condominium (2) +300,000 1.55 % Aug. 05, 2025 +Rego Park II shopping center (3) +202,544 1.50 % Dec. 12, 2025 +The Alexander apartment tower 94,000 2.63 % Nov. 01, 2027 +Total 1,164,544 +Deferred debt issuance costs, net of accumulated amortization of $13,034 (8,374) +Total, net $ 1,156,170 +(1) Interest at LIBOR plus 0.90%. Maturity date represents the extended maturity based on our unilateral right to extend. +(2) Interest at LIBOR plus 1.40% which is subject to an interest rate swap with a fixed rate of 1.72%. +(3) Interest at LIBOR plus 1.35%. The amount of this loan is net of our $50,000 loan participation. +Below is a summary of our contractual obligations and commitments as of December 31, 2020. +Less than One to Three to More than +(Amounts in thousands) Total One Year Three Years Five Years Five Years +Contractual obligations (1) (principal and interest) (2) : +Long-term debt obligations (3) +$ 1,241,929 $ 86,617 $ 32,384 $ 1,024,327 $ 98,601 +Operating lease obligations 4,800 800 1,600 1,600 800 +Purchase obligations, primarily construction commitments 4,523 4,523 — — — +$ 1,251,252 $ 91,940 $ 33,984 $ 1,025,927 $ 99,401 +Commitments: +Standby letters of credit $ 960 $ 950 $ 10 $ — $ — +(1) Excludes committed tenant-related obligations as timing and amounts of payments are uncertain and may only be due upon satisfactory performance of certain conditions. +(2) Principal repayments based on extended loan maturity dates. Interest on variable rate debt is computed using rates in effect as of December 31, 2020. +(3) Net of loan participation and related interest. +34 +Liquidity and Capital Resources - continued +Commitments and Contingencies +Insurance +We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, of which the first $1,000,000 includes communicable disease coverage, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties and excluding communicable disease coverage. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $275,000 deductible and 20% of the balance of a covered loss, and the Federal government is responsible for the remaining 80% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +The principal amounts of our mortgage loans are non-recourse to us and the loans contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Paramus +In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA. The lease expires in 2041, with a purchase option in October 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. +Rego Park I Litigation +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to the 195,000 square foot store that Sears formerly leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4,000,000 and future damages it estimated would not be less than $25,000,000. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonably possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +35 +Liquidity and Capital Resources - continued +Kings Plaza Transfer Tax +In 2012, we sold Kings Plaza and paid real property transfer taxes to New York City in connection with the sale. In 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional New York City real property transfer tax amount, including interest. +In 2014, in a case with similar facts, the NYC DOF issued a Notice of Determination to a Vornado joint venture assessing an additional New York City real property transfer tax amount, including interest. In January 2017, a New York City administrative law judge made a determination upholding the Vornado joint venture’s position that such additional real property transfer taxes were not due. On February 16, 2018, the New York City Tax Appeals Tribunal (the “Tribunal”) overturned the January 2017 determination. The Vornado joint venture appealed the Tribunal’s decision to the Appellate Division of the Supreme Court of the State of New York and on April 25, 2019, the Tribunal’s decision was unanimously upheld. The Vornado joint venture filed a motion to reargue the Appellate Division’s decision or for leave to appeal to the New York State Court of Appeals. On December 12, 2019, that motion was denied and the case can no longer be appealed. Based on the precedent of the Tribunal’s decision, we paid the additional real property transfer taxes of $23,797,000 ($15,874,000 of real property transfer tax and $7,923,000 of interest) on April 5, 2018. On January 12, 2021, we decided not to further contest the additional real property transfer taxes paid in connection with the sale of Kings Plaza. +Letters of Credit +Approximately $960,000 of standby letters of credit were issued and outstanding as of December 31, 2020. +Other +There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. +Cash Flows for the Year Ended December 31, 2020 +Cash and cash equivalents and restricted cash were $449,877,000 at December 31, 2020, compared to $313,977,000 at December 31, 2019, an increase of $135,900,000. This increase resulted from (i) $78,066,000 of net cash provided by operating activities and (ii) $90,294,000 of net cash provided by financing activities, partially offset by (iii) $32,460,000 of net cash used in investing activities. +Net cash provided by operating activities of $78,066,000 was comprised of (i) net income of $41,939,000 and (ii) adjustments for non-cash items of $69,330,000, partially offset by (iii) the net change in operating assets and liabilities of $33,203,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $35,121,000, (ii) straight-lining of rental income of $21,102,000, (iii) the change in fair value of marketable securities of $8,599,000, (iv) write-off of tenant receivables of $4,122,000 and (v) stock-based compensation expense of $600,000, partially offset by (vi) $214,000 of dividends received in stock from Macerich. +Net cash provided by financing activities was primarily comprised of (i) proceeds from the reduction of our participation in our Rego Park II mortgage loan of $145,708,000 and (ii) proceeds from the financing of The Alexander apartment tower of $94,000,000, partially offset by (iii) dividends paid of $92,168,000 and (iv) debt repayments of $50,000,000. +Net cash used in investing activities was comprised of construction in progress, real estate additions and other of $32,460,000. +36 +Liquidity and Capital Resources - continued +Cash Flows for the Year Ended December 31, 2019 +Cash and cash equivalents and restricted cash were $313,977,000 at December 31, 2019, compared to $289,495,000 at December 31, 2018, an increase of $24,482,000. This increase resulted from (i) $126,070,000 of net cash provided by operating activities, partially offset by (ii) $92,139,000 of net cash used in financing activities and (iii) $9,449,000 of net cash used in investing activities. +Net cash provided by operating activities of $126,070,000 was comprised of (i) net income of $60,075,000, (ii) adjustments for non-cash items of $48,079,000 and (iii) the net change in operating assets and liabilities of $17,916,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $36,515,000, (ii) the change in fair value of marketable securities of $8,757,000, (iii) straight-lining of rental income of $2,413,000 and (iv) stock-based compensation expense of $394,000. +Net cash used in financing activities was primarily comprised of dividends paid of $92,124,000. +Net cash used in investing activities was comprised of construction in progress and real estate additions of $9,449,000. +Cash Flows for the Year Ended December 31, 2018 +Cash and cash equivalents and restricted cash were $289,495,000 at December 31, 2018, compared to $393,279,000 at December 31, 2017, a decrease of $103,784,000. This decrease resulted from (i) $176,185,000 of net cash used in financing activities and (ii) $1,137,000 of net cash used in investing activities, partially offset by (iii) $73,538,000 of net cash provided by operating activities. +Net cash used in financing activities of $176,185,000 was primarily comprised of net debt repayments of $81,896,000 (primarily the refinancing and subsequent repayment of the mortgage loan on our Rego Park I shopping center) and dividends paid of $92,100,000. +Net cash used in investing activities of $1,137,000 was comprised of construction in progress and real estate additions of $3,966,000, partially offset by repayment of Rego Park II loan participation of $2,829,000. +Net cash provided by operating activities of $73,538,000 was comprised of (i) net income of $32,844,000 and (ii) adjustments for non-cash items of $56,807,000, partially offset by (iii) the net change in operating assets and liabilities of $16,113,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,499,000, (ii) the change in fair value of marketable securities of $11,990,000, (iii) straight-lining of rental income of $5,924,000 and (iv) stock-based compensation expense of $394,000. +Funds from Operations (“FFO”) (non-GAAP) +FFO is computed in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciable real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. +FFO (non-GAAP) for the years and quarters ended December 31, 2020 and 2019 +FFO (non-GAAP) for the year ended December 31, 2020 was $82,509,000, or $16.11 per diluted share, compared to $99,670,000, or $19.47 per diluted share for the year ended December 31, 2019. +FFO (non-GAAP) for the quarter ended December 31, 2020 was $25,407,000, or $4.96 per diluted share, compared to $24,626,000, or $4.81 per diluted share for the quarter ended December 31, 2019. +37 +Funds from Operations (“FFO”) (non-GAAP) - continued +The following table reconciles our net income to FFO (non-GAAP): +For the Year Ended For the Three Months Ended +(Amounts in thousands, except share and per share amounts) December 31, December 31, +2020 2019 2020 2019 +Net income $ 41,939 $ 60,075 $ 18,432 $ 14,434 +Depreciation and amortization of real property 31,971 30,838 9,165 7,692 +Change in fair value of marketable securities 8,599 8,757 (2,190) 2,500 +FFO (non-GAAP) $ 82,509 $ 99,670 $ 25,407 $ 24,626 +FFO per diluted share (non-GAAP) $ 16.11 $ 19.47 $ 4.96 $ 4.81 +Weighted average shares used in computing FFO per diluted share +5,120,922 5,118,198 5,122,206 5,118,698 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +We have exposure to fluctuations in interest rates, which are sensitive to many factors that are beyond our control. Our exposure to a change in interest rates is summarized in the table below. +2020 2019 +December 31, Balance Weighted Average Interest Rate Effect of 1% Change in Base Rates December 31, Balance Weighted Average Interest Rate +(Amounts in thousands, except per share amounts) +Variable rate $ 1,002,544 1.30% $ 10,025 $ 906,836 2.85% +Fixed rate 162,000 3.51% — 68,000 4.72% +$ 1,164,544 1.60% $ 10,025 $ 974,836 2.98% +Total effect on diluted earnings per share $ 1.96 +We have an interest rate cap relating to the mortgage loan on the office condominium of our 731 Lexington Avenue property with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. +We have an interest rate swap relating to the mortgage loan on the retail condominium of our 731 Lexington Avenue property with a notional amount of $300,000,000 that swaps LIBOR plus 1.40% for a fixed rate of 1.72%. +Fair Value of Debt +The fair value of our consolidated debt is calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist. As of December 31, 2020 and 2019, the estimated fair value of our consolidated debt was $1,130,000,000 and $974,000,000, respectively. Our fair value estimates, which are made at the end of the reporting period, may be different from the amounts that may ultimately be realized upon the disposition of our financial instruments. +38 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Index to Consolidated Financial Statements Page +Number +Report of Independent Registered Public Accounting Firm +40 +Consolidated Balance Sheets as of December 31, 2020 and 2019 +42 +Consolidated Statements of Income for the +Years Ended December 31, 2020, 2019 and 2018 +43 +Consolidated Statements of Comprehensive Income for the +Years Ended December 31, 2020, 2019 and 2018 +44 +Consolidated Statements of Changes in Equity for the +Years Ended December 31, 2020, 2019 and 2018 +45 +Consolidated Statements of Cash Flows for the +Years Ended December 31, 2020, 2019 and 2018 +46 +Notes to Consolidated Financial Statements +47 +39 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and the Board of Directors of Alexander’s, Inc. +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Alexander’s, Inc. and subsidiaries (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and the schedules listed in the Index at Item 15 (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 16, 2021, expressed an unqualified opinion on the Company's internal control over financial reporting. +Basis for Opinion +These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Real Estate - Refer to Note 3 to the financial statements +Critical Audit Matter Description +The Company’s real estate assets are individually evaluated for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. The Company’s evaluation of the recoverability of real estate assets involves the comparison of undiscounted future cash flows expected to be generated by each real estate asset over the Company’s estimated holding period to the respective carrying amount. The Company’s undiscounted future cash flow analyses require management to make significant estimates, including estimated terminal values determined using appropriate capitalization rates. +40 +Given the Company’s estimated capitalization rates used in the evaluation of impairment of real estate assets is a significant assumption made by management, performing audit procedures to evaluate the reasonableness of management’s undiscounted future cash flow analyses required a high degree of auditor judgment and an increased extent of effort, including the need to involve our fair value specialists. +How the Critical Audit Matter Was Addressed in the Audit +Our audit procedures related to the Company’s estimated capitalization rates used in the evaluation of impairment of real estate assets included the following, among others: +• We tested the effectiveness of controls over management’s evaluation of the recoverability of real estate, including controls over management’s determination of the reasonableness of the applicable capitalization rates. +• Inquired with management regarding their determination of the capitalization rates, including considerations related to the impact of COVID-19 and evaluating the consistency of the capitalization rates used with evidence obtained in other areas of the audit. +• With the assistance of our fair value specialists, we evaluated the reasonableness of the Company’s estimated capitalization rates by: +◦ Testing the source information underlying the determination of the capitalization rates by evaluating the reasonableness of the capitalization rates used by management with independent market data, focusing on key factors, including the impact of COVID-19, geographical location, tenant composition, and property type. +◦ Developing a range of independent estimates of capitalization rates and comparing those to the capitalization rates utilized by management. +/s/ DELOITTE & TOUCHE LLP +New York, New York +February 16, 2021 +We have served as the Company’s auditor since 1969. +41 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +(Amounts in thousands, except share and per share amounts) +December 31, +ASSETS 2020 2019 +Real estate, at cost: +Land $ 44,971 $ 44,971 +Buildings and leasehold improvements 1,014,311 984,053 +Development and construction in progress 11,761 12,318 +Total 1,071,043 1,041,342 +Accumulated depreciation and amortization ( 350,122 ) ( 324,499 ) +Real estate, net 720,921 716,843 +Cash and cash equivalents 428,710 298,063 +Restricted cash 21,167 15,914 +Marketable securities 6,024 14,409 +Tenant and other receivables 8,116 6,092 +Receivable arising from the straight-lining of rents 145,274 166,376 +Deferred lease costs, net, including unamortized leasing fees to Vornado of +$ 27,851 and $ 32,374 , respectively +36,524 41,123 +Other assets 37,402 6,691 +$ 1,404,138 $ 1,265,511 +LIABILITIES AND EQUITY +Mortgages payable, net of deferred debt issuance costs $ 1,156,170 $ 970,961 +Amounts due to Vornado 1,516 1,426 +Accounts payable and accrued expenses 35,342 31,756 +Other liabilities 7,882 7,853 +Total liabilities 1,200,910 1,011,996 +Commitments and contingencies +Preferred stock: $ 1.00 par value per share; authorized, 3,000,000 shares; +issued and outstanding, none +— — +Common stock: $ 1.00 par value per share; authorized, 10,000,000 shares; +issued, 5,173,450 shares; outstanding, 5,107,290 shares +5,173 5,173 +Additional capital 32,965 32,365 +Retained earnings 166,165 216,394 +Accumulated other comprehensive loss ( 707 ) ( 49 ) +203,596 253,883 +Treasury stock: 66,160 shares, at cost +( 368 ) ( 368 ) +Total equity 203,228 253,515 +$ 1,404,138 $ 1,265,511 +See notes to consolidated financial statements. +42 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +(Amounts in thousands, except share and per share amounts) +Year Ended December 31, +2020 2019 2018 +REVENUES +Rental revenues $ 199,142 $ 226,350 $ 232,825 +EXPENSES +Operating, including fees to Vornado of $ 5,429 , $ 5,386 and $ 4,700 , respectively +( 88,403 ) ( 89,738 ) ( 93,775 ) +Depreciation and amortization ( 32,357 ) ( 31,351 ) ( 33,089 ) +General and administrative, including management fees to Vornado of $ 2,380 +in each year ( 6,307 ) ( 5,772 ) ( 5,343 ) +Total expenses ( 127,067 ) ( 126,861 ) ( 132,207 ) +Interest and other income, net 2,667 8,244 12,546 +Interest and debt expense ( 24,204 ) ( 38,901 ) ( 44,533 ) +Change in fair value of marketable securities (see Note 6) ( 8,599 ) ( 8,757 ) ( 11,990 ) +Income from continuing operations 41,939 60,075 56,641 +Loss from discontinued operations (see Note 7) — — ( 23,797 ) +Net income $ 41,939 $ 60,075 $ 32,844 +Income per common share - basic and diluted: +Income from continuing operations $ 8.19 $ 11.74 $ 11.07 +Loss from discontinued operations (see Note 7) — — ( 4.65 ) +Net income per common share $ 8.19 $ 11.74 $ 6.42 +Weighted average shares outstanding - basic and diluted 5,120,922 5,118,198 5,116,838 +See notes to consolidated financial statements. +43 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +(Amounts in thousands) +Year Ended December 31, +2020 2019 2018 +Net income $ 41,939 $ 60,075 $ 32,844 +Other comprehensive (loss) income: +Change in fair value of interest rate derivatives ( 658 ) 78 ( 1 ) +Comprehensive income $ 41,281 $ 60,153 $ 32,843 +See notes to consolidated financial statements. +44 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +(Amounts in thousands) +Accumulated +Other +Comprehensive +Income (Loss) +Common Stock Additional +Capital Retained +Earnings Treasury +Stock Total +Equity +Shares Amount +Balance, December 31, 2017 5,173 $ 5,173 $ 31,577 $ 302,543 $ 5,030 $ ( 368 ) $ 343,955 +Net income — — — 32,844 — — 32,844 +Dividends paid ($ 18.00 per common share) +— — — ( 92,100 ) — — ( 92,100 ) +Cumulative effect of change in accounting principle — — — 5,156 ( 5,156 ) — — +Change in fair value of interest rate derivatives — — — — ( 1 ) — ( 1 ) +Deferred stock unit grants — — 394 — — — 394 +Balance, December 31, 2018 5,173 5,173 31,971 248,443 ( 127 ) ( 368 ) 285,092 +Net income — — — 60,075 — — 60,075 +Dividends paid ($ 18.00 per common share) +— — — ( 92,124 ) — — ( 92,124 ) +Change in fair value of interest rate derivatives — — — — 78 — 78 +Deferred stock unit grants — — 394 — — — 394 +Balance, December 31, 2019 5,173 5,173 32,365 216,394 ( 49 ) ( 368 ) 253,515 +Net income — — — 41,939 — — 41,939 +Dividends paid ($ 18.00 per common share) +— — — ( 92,168 ) — — ( 92,168 ) +Change in fair value of interest rate derivatives — — — — ( 658 ) — ( 658 ) +Deferred stock unit grants — — 600 — — — 600 +Balance, December 31, 2020 5,173 $ 5,173 $ 32,965 $ 166,165 $ ( 707 ) $ ( 368 ) $ 203,228 +See notes to consolidated financial statements. +45 +ALEXANDER’S, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(Amounts in thousands) +Year Ended December 31, +2020 2019 2018 +CASH FLOWS FROM OPERATING ACTIVITIES +Net income $ 41,939 $ 60,075 $ 32,844 +Adjustments to reconcile net income to net cash provided by operating activities: +Depreciation and amortization, including amortization of debt issuance costs 35,121 36,515 38,499 +Straight-lining of rents 21,102 2,413 5,924 +Write-off of tenant receivables 4,122 — — +Stock-based compensation expense 600 394 394 +Change in fair value of marketable securities 8,599 8,757 11,990 +Dividends received in stock ( 214 ) — — +Change in operating assets and liabilities: +Tenant and other receivables, net ( 6,146 ) ( 2,017 ) ( 1,382 ) +Other assets ( 28,378 ) 21,553 ( 1,197 ) +Amounts due to Vornado ( 402 ) 789 ( 1,907 ) +Accounts payable and accrued expenses 2,361 ( 1,800 ) ( 11,760 ) +Other liabilities ( 638 ) ( 609 ) 133 +Net cash provided by operating activities 78,066 126,070 73,538 +CASH FLOWS FROM INVESTING ACTIVITIES +Construction in progress, real estate additions and other ( 32,460 ) ( 9,449 ) ( 3,966 ) +Repayment of Rego Park II loan participation — — 2,829 +Net cash used in investing activities ( 32,460 ) ( 9,449 ) ( 1,137 ) +CASH FLOWS FROM FINANCING ACTIVITIES +Dividends paid ( 92,168 ) ( 92,124 ) ( 92,100 ) +Debt issuance costs ( 7,246 ) ( 15 ) ( 2,189 ) +Debt repayments ( 50,000 ) — ( 160,142 ) +Proceeds from borrowings 239,708 — 78,246 +Net cash provided by (used in) financing activities 90,294 ( 92,139 ) ( 176,185 ) +Net increase (decrease) in cash and cash equivalents and restricted cash 135,900 24,482 ( 103,784 ) +Cash and cash equivalents and restricted cash at beginning of year 313,977 289,495 393,279 +Cash and cash equivalents and restricted cash at end of year $ 449,877 $ 313,977 $ 289,495 +RECONCILIATION OF CASH AND CASH EQUIVALENTS AND RESTRICTED CASH +Cash and cash equivalents at beginning of year $ 298,063 $ 283,056 $ 307,536 +Restricted cash at beginning of year 15,914 6,439 85,743 +Cash and cash equivalents and restricted cash at beginning of year $ 313,977 $ 289,495 $ 393,279 +Cash and cash equivalents at end of year $ 428,710 $ 298,063 $ 283,056 +Restricted cash at end of year 21,167 15,914 6,439 +Cash and cash equivalents and restricted cash at end of year $ 449,877 $ 313,977 $ 289,495 +SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION +Cash payments for interest $ 22,476 $ 34,669 $ 38,231 +NON-CASH TRANSACTIONS +Liability for real estate additions, including $ 489 , $ 18 and $ 125 for development fees due to +Vornado in 2020, 2019 and 2018, respectively $ 4,955 $ 3,191 $ 631 +Write-off of fully amortized and/or depreciated assets 876 — 16,090 +Reclassification of prepaid real estate taxes to construction in progress for property in +redevelopment — 1,466 — +Lease liability arising from the recognition of right-of-use asset — 5,428 — +Derecognition of Rego Park II loan participation asset — — 195,708 +See notes to consolidated financial statements. +46 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. ORGANIZATION +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• 731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot ( 83,000 square feet) is the principal retail tenant; +• Rego Park I, a 338,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. The center is anchored by a 112,000 square foot IKEA, a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco and a 133,000 square foot Kohl’s, which has been subleased. On September 10, 2020, Century 21 ($ 6,400,000 of annual revenue) filed for Chapter 11 bankruptcy and closed its 135,000 square foot store on December 7, 2020; +• The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is leased to IKEA; and +• Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +We have determined that our properties have similar economic characteristics and meet the criteria that permit the properties to be aggregated into one reportable segment (the leasing, management, development and redeveloping of properties in the greater New York City metropolitan area). Our chief operating decision-maker assesses and measures segment operating results based on a performance measure referred to as net operating income at the individual operating segment. Net operating income for each property represents net rental revenues less operating expenses. +47 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +2. COVID-19 PANDEMIC +Our business has been adversely affected by the ongoing COVID-19 pandemic. In March 2020, our “non-essential” retail tenants were ordered to temporarily close and although substantially all re-opened in the latter part of June 2020, there are limitations on occupancy and other restrictions that affect their ability to resume full operations. +In limited circumstances, we have agreed to and may continue to agree to rent deferrals and abatements for certain of our tenants. We have made the policy election available to us based on the Financial Accounting Standards Board’s (“FASB”) guidance for leases during the COVID-19 pandemic, which allows us to continue recognizing rental revenue for rent deferral agreements and to recognize rent abatements as a reduction to rental revenue in the period granted. See Note 3 - Summary of Significant Accounting Policies for additional information. +Overall, we have collected approximately 95 % of rent billed for the quarter ended December 31, 2020 ( 96 % including rent deferrals under agreements which generally require repayment in monthly installments over a period of time not to exceed twelve months), including 100 % for our office tenant, approximately 90 % for our retail tenants ( 91 % including rent deferrals) and approximately 98 % for our residential tenants. +On September 10, 2020, Century 21, which leased 135,000 square feet at our Rego Park II shopping center ($ 6,400,000 of annual revenue), filed for Chapter 11 bankruptcy and closed its store on December 7, 2020. +Based on our assessment of the probability of collecting rent from certain tenants, we have written off as uncollectible tenant receivables of $ 4,122,000 during the year ended December 31, 2020, resulting in a reduction of rental revenues. Of this amount, $ 2,716,000 is attributable to Century 21. In addition, we have written off receivables arising from the straight-lining of rents related to these tenants of $ 10,837,000 during the year ended December 31 2020, resulting in a reduction of rental revenues. Of this amount, $ 5,919,000 is attributable to Century 21. Prospectively, revenue recognition for these tenants will be based on actual amounts received. +3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation – The accompanying consolidated financial statements include our accounts and those of our consolidated subsidiaries. All intercompany amounts have been eliminated. Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. +Certain prior year balances have been reclassified in order to conform to the current period presentation. For the year ended December 31, 2018, “property rentals” of $ 152,795,000 and “expense reimbursements” of $ 80,030,000 were grouped into “rental revenues” on our consolidated statements of income in accordance with Accounting Standards Codification (“ASC”) Topic 205 Presentation of Financial Statements. +Recently Issued Accounting Literature – In March 2020, the FASB issued an update (“ASU 2020-04”) establishing ASC Topic 848, Reference Rate Reform. ASU 2020-04 contains practical expedients for reference rate reform related activities that impact debt, leases, derivatives and other contracts. The guidance in ASU 2020-04 is optional and may be elected over time as reference rate reform activities occur. We are currently evaluating the impact of the guidance and our options related to the practical expedients. +In April 2020, the FASB issued a Staff Q&A on accounting for leases during the COVID-19 pandemic, focused on the application of lease guidance in ASC Topic 842, Leases (“ASC 842”). The Staff Q&A states that it would be acceptable to make a policy election regarding rent concessions resulting from COVID-19, which would not require entities to account for these rent concessions as lease modifications when total cash flows resulting from the modified contract are “substantially the same or less” than the cash flows in the original contract. Entities making the election will continue to recognize rental revenue on a straight-line basis for qualifying concessions. In limited circumstances, we granted temporary rent deferrals and rent abatements to certain tenants as a result of the COVID-19 pandemic. We have made a policy election in accordance with the Staff Q&A allowing us to not account for these rent concessions as lease modifications. Accordingly, rent abatements are recognized as reductions to “rental revenues” during the period in which they were granted. Rent deferrals result in an increase to “tenant and other receivables” during the deferral period with no impact on rental revenue recognition. For any concessions that do not meet the guidance contained in the Staff Q&A, the modification guidance in accordance with ASC 842 will be applied. See Note 2 - COVID-19 Pandemic for further details. +48 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued +Real Estate – Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2020 and 2019, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $ 720,921,000 and $ 716,843,000 , respectively. Maintenance and repairs are generally expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. +Our properties, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset, including an estimated terminal value calculated using an appropriate capitalization rate. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. +Revenue Recognition – Our rental revenues include revenues from the leasing of space to tenants at our properties and revenues from parking and tenant services. We have the following revenue recognition policies: +• Lease revenues from the leasing of space to tenants at our properties. Revenues derived from base rent are recognized over the non-cancelable term of the related leases on a straight-line basis which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the underlying asset is available for use by the lessee. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. Revenues derived from the reimbursement of real estate taxes, insurance expenses and common area maintenance expenses are generally recognized in the same period as the related expenses are incurred. As lessor, we have elected to combine the lease components (base and variable rent), non-lease components (reimbursements of common area maintenance expenses) and reimbursement of real estate taxes and insurance expenses from our operating lease agreements and account for the components as a single lease component in accordance with ASC 842. +• Parking revenue arising from the rental of parking spaces at our properties. This income is recognized as the services are transferred in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). +• Tenant services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred in accordance with ASC 606. +Under ASC 842, we must assess on an individual lease basis whether it is probable that we will collect substantially all of the future lease payments. We consider the tenant’s payment history and current credit status when assessing collectability. When collectability is not deemed probable, we write-off the tenant’s receivables, including straight-line rent receivable, and limit lease income to cash received. We recognize changes in the collectability assessment of our operating leases as adjustments to rental revenues. +Prior to the adoption of ASC 842, we maintained an allowance for doubtful accounts for estimated losses on receivables under our lease agreements, including receivables arising from the straight-lining of rent. During the year ended December 31, 2018, we had $ 4,459,000 of additions charged against operations and $ 5,289,000 of uncollectible accounts written off, with an ending allowance for doubtful accounts balance of $ 671,000 as of December 31, 2018. +49 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued +Cash and Cash Equivalents – Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and are carried at cost, which approximates fair value, due to their short-term maturities. The majority of our cash and cash equivalents consist of (i) deposits at major commercial banks, which may at times exceed the Federal Deposit Insurance Corporation limit, (ii) United States Treasury Bills, (iii) money market funds, which invest in United States Treasury Bills and (iv) certificates of deposit placed through an account registry service (“CDARS”). To date we have not experienced any losses on our invested cash. +Restricted Cash – Restricted cash primarily consists of security deposits and other cash escrowed under loan agreements, including for debt service, real estate taxes, property insurance and capital improvements. +Marketable Securities – Our marketable securities consist of common shares of The Macerich Company (“Macerich”) (NYSE: MAC). These shares are presented at fair value on our consolidated balance sheets and gains and losses resulting from the mark-to-market of these securities are recognized in current period earnings in accordance with ASC Topic 825 (“ASC 825”), Financial Instruments (see Note 6). +Deferred Charges – Direct financing costs are deferred and amortized over the terms of the related agreements as a component of interest and debt expense. Direct costs related to leasing activities are capitalized and amortized on a straight-line basis over the lives of the related leases. All other deferred charges are amortized on a straight-line basis, which approximates the effective interest rate method, in accordance with the terms of the agreements to which they relate. +Income Taxes – We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 – 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90 % of our taxable income to stockholders each year. We distribute to our stockholders 100 % of our taxable income and therefore, no provision for Federal income taxes is required. Dividends distributed for the year ended December 31, 2020 were characterized, for federal income tax purposes, as 100.0 % ordinary income. Dividends distributed for the year ended December 31, 2019 were characterized, for federal income tax purposes, as 99.6 % ordinary income and 0.4 % long-term capital gain income. Dividends distributed for the year ended December 31, 2018 were categorized, for federal income tax purposes, as 100.0 % ordinary income. +The following table reconciles our net income to estimated taxable income for the years ended December 31, 2020, 2019 and 2018. +(Unaudited and in thousands) Year Ended December 31, +2020 2019 2018 +Net income $ 41,939 $ 60,075 $ 32,844 +Straight-line rent adjustments 21,048 2,359 5,870 +Depreciation and amortization 2,112 2,751 ( 6,586 ) +Change in fair value of marketable securities (see Note 6) 8,599 8,757 11,990 +Loss from discontinued operations (see Note 7) — — 23,797 +Other 7,677 137 440 +Estimated taxable income $ 81,375 $ 74,079 $ 68,355 +As of December 31, 2020, the net basis of our assets and liabilities for tax purposes is approximately $ 139,364,000 lower than the amount reported for financial statement purposes. +50 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +4. REVENUE RECOGNITION +The following is a summary of revenue sources for the years ended December 31, 2020, 2019 and 2018. +Year Ended December 31, +(Amounts in thousands) 2020 2019 2018 +Lease revenues (1) +$ 191,416 $ 217,251 $ 223,388 +Parking revenue 4,207 5,608 5,680 +Tenant services 3,519 3,491 3,757 +Rental revenues $ 199,142 $ 226,350 $ 232,825 +(1) Reduced by $ 14,959 and $ 209 for the years ended December 31, 2020 and 2019, respectively, for the write-off of lease receivables deemed uncollectable (primarily write-offs of receivables arising from the straight-lining of rents). +The components of lease revenues for the years ended December 31, 2020 and 2019 are as follows: +Year Ended December 31, +(Amounts in thousands) 2020 2019 +Fixed lease revenues $ 120,395 $ 142,679 +Variable lease revenues 71,021 74,572 +Lease revenues $ 191,416 $ 217,251 +5. RELATED PARTY TRANSACTIONS +Vornado +As of December 31, 2020, Vornado owned 32.4 % of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to the agreements described below, which expire in March of each year and are automatically renewable. +Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2020, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1 % of our outstanding common stock, in addition to the 2.3 % they indirectly own through Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +Management and Development Agreements +We pay Vornado an annual management fee equal to the sum of (i) $ 2,800,000 , (ii) 2 % of gross revenue from the Rego Park II shopping center, (iii) $ 0.50 per square foot of the tenant-occupied office and retail space at 731 Lexington Avenue, and (iv) $ 334,000 , escalating at 3 % per annum, for managing the common area of 731 Lexington Avenue. Vornado is also entitled to a development fee equal to 6 % of development costs, as defined. +Leasing and Other Agreements +Vornado also provides us with leasing services for a fee of 3 % of rent for the first ten years of a lease term, 2 % of rent for the eleventh through the twentieth year of a lease term, and 1 % of rent for the twenty-first through thirtieth year of a lease term, subject to the payment of rents by tenants. In the event third-party real estate brokers are used, the fees to Vornado increase by 1 % and Vornado is responsible for the fees to the third-party real estate brokers. +Vornado is also entitled to a commission upon the sale of any of our assets equal to 3 % of gross proceeds, as defined, for asset sales less than $ 50,000,000 and 1 % of gross proceeds, as defined, for asset sales of $ 50,000,000 or more. +We also have agreements with Building Maintenance Services, a wholly owned subsidiary of Vornado, to supervise (i) cleaning, engineering and security services at our Lexington Avenue property and (ii) security services at our Rego Park I and Rego Park II properties and The Alexander apartment tower. +51 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +5. RELATED PARTY TRANSACTIONS - continued +The following is a summary of fees to Vornado under the various agreements discussed above. +Year Ended December 31, +(Amounts in thousands) 2020 2019 2018 +Company management fees $ 2,800 $ 2,800 $ 2,800 +Development fees 489 29 125 +Leasing fees 276 4,786 13 +Property management, cleaning, engineering +and security fees 5,051 5,015 4,101 +$ 8,616 $ 12,630 $ 7,039 +As of December 31, 2020, the amounts due to Vornado were $ 845,000 for management, property management, cleaning, engineering and security fees; $ 557,000 for development fees; and $ 114,000 for leasing fees. As of December 31, 2019, the amounts due to Vornado were $ 795,000 for management, property management, cleaning, engineering and security fees; $ 68,000 for development fees; and $ 563,000 for leasing fees. +6. MARKETABLE SECURITIES +As of December 31, 2020 and 2019, we owned 564,612 and 535,265 common shares, respectively, of Macerich. The increase in shares owned was due to a dividend received in stock from Macerich during the year ended December 31, 2020. As of December 31, 2020 and 2019, the fair value of these shares was $ 6,024,000 and $ 14,409,000 , respectively, based on Macerich’s closing share price of $ 10.67 per share and $ 26.92 per share, respectively. These shares are presented at fair value as “marketable securities” on our consolidated balance sheets and the gains and losses resulting from the mark-to-market of these securities are recognized in current period earnings. +7. DISCONTINUED OPERATIONS +In 2012, we sold the Kings Plaza Regional Shopping Center (“Kings Plaza”) and paid real property transfer taxes to New York City in connection with the sale. In 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional New York City real property transfer tax amount, including interest. +In 2014, in a case with similar facts, the NYC DOF issued a Notice of Determination to a Vornado joint venture assessing an additional New York City real property transfer tax amount, including interest. In January 2017, a New York City administrative law judge made a determination upholding the Vornado joint venture’s position that such additional real property transfer taxes were not due. On February 16, 2018, the New York City Tax Appeals Tribunal (the “Tribunal”) overturned the January 2017 determination. The Vornado joint venture appealed the Tribunal’s decision to the Appellate Division of the Supreme Court of the State of New York and on April 25, 2019, the Tribunal’s decision was unanimously upheld. The Vornado joint venture filed a motion to reargue the Appellate Division’s decision or for leave to appeal to the New York State Court of Appeals. On December 12, 2019, that motion was denied and the case can no longer be appealed. +Based on the precedent of the Tribunal’s decision, we accrued an expense for the potential additional real property transfer taxes of $ 23,797,000 ($ 15,874,000 of real property transfer tax and $ 7,923,000 of interest) during the three months ended March 31, 2018. On April 5, 2018, we paid this amount in order to stop the interest from accruing. As the results related to Kings Plaza were previously classified as discontinued operations, we have classified the expense as “loss from discontinued operations” on our consolidated statement of income for the year ended December 31, 2018 in accordance with the provisions of ASC Topic 360, Property, Plant and Equipment . On January 12, 2021, we decided not to further contest the additional real property transfer taxes paid in connection with the sale of Kings Plaza. +52 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +8. MORTGAGES PAYABLE +On February 14, 2020, we reduced our participation in our Rego Park II shopping center loan to $ 50,000,000 and received cash proceeds of approximately $ 145,000,000 . +On September 14, 2020, we amended and extended the $ 350,000,000 mortgage loan on the retail condominium of our 731 Lexington Avenue property. Under the terms of the amendment, we paid down the loan by $ 50,000,000 to $ 300,000,000 , extended the maturity date to August 2025 and guaranteed the interest payments and certain leasing costs. The principal of the loan is non-recourse to us. The interest-only loan is at LIBOR plus 1.40 % ( 1.55 % as of December 31, 2020) which is subject to an interest rate swap with a fixed rate of 1.72 %. +On October 23, 2020, we completed a financing of The Alexander apartment tower in the amount of $ 94,000,000 . The interest-only loan has a fixed rate of 2.63 % and matures in November 2027. +The following is a summary of our outstanding mortgages payable. We may refinance our maturing debt as it comes due or choose to repay it. +Interest Rate at December 31, 2020 Balance at December 31, +(Amounts in thousands) Maturity 2020 2019 +First mortgages secured by: +Paramus Oct. 04, 2021 4.72 % $ 68,000 $ 68,000 +731 Lexington Avenue, office condominium (1) +Jun. 11, 2024 1.06 % 500,000 500,000 +731 Lexington Avenue, retail condominium (2) +Aug. 05, 2025 1.55 % 300,000 350,000 +Rego Park II shopping center (3) +Dec. 12, 2025 1.50 % 202,544 56,836 +The Alexander apartment tower Nov. 01, 2027 2.63 % 94,000 — +Total 1,164,544 974,836 +Deferred debt issuance costs, net of accumulated +amortization of $ 13,034 and $ 14,362 , respectively +( 8,374 ) ( 3,875 ) +$ 1,156,170 $ 970,961 +(1) +Interest at LIBOR plus 0.90 %. Maturity date represents the extended maturity based on our unilateral right to extend. +(2) +Interest at LIBOR plus 1.40 % which is subject to an interest rate swap with a fixed rate of 1.72 %. +(3) +Interest at LIBOR plus 1.35 %. The amount of this loan is net of our loan participation of $ 50,000 and $ 195,708 as of December 31, 2020 and 2019, respectively. +All of our debt is secured by mortgages and/or pledges of the stock of the subsidiaries holding the properties. The net carrying value of real estate collateralizing the debt amounted to $ 657,800,000 as of December 31, 2020. Our existing financing documents contain covenants that limit our ability to incur additional indebtedness on these properties, and in certain circumstances, provide for lender approval of tenants’ leases and yield maintenance to prepay them. As of December 31, 2020, the principal repayments (based on the extended loan maturity dates) for the next five years and thereafter are as follows: +(Amounts in thousands) +Year Ending December 31, Amount +2021 $ 68,000 +2022 — +2023 — +2024 500,000 +2025 502,544 +Thereafter 94,000 +53 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +9. FAIR VALUE MEASUREMENTS +ASC Topic 820, Fair Value Measurement (“ASC 820”) defines fair value and establishes a framework for measuring fair value. ASC 820 establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three levels: Level 1 – quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities; Level 2 – observable prices that are based on inputs not quoted in active markets, but corroborated by market data; and Level 3 – unobservable inputs that are used when little or no market data is available. The fair value hierarchy gives the highest priority to Level 1 inputs and the lowest priority to Level 3 inputs. In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as consider counterparty credit risk in our assessment of fair value. +Financial Assets and Liabilities Measured at Fair Value +Financial assets measured at fair value on our consolidated balance sheets as of December 31, 2020 and 2019 consist of marketable securities which are presented in the table below based on their level in the fair value hierarchy, and an interest rate cap, the fair value of which was insignificant as of December 31, 2020 and 2019. Financial liabilities measured at fair value on our consolidated balance sheet as of December 31, 2020 consist of an interest rate swap which is presented in the table below based on its level in the fair value hierarchy. +As of December 31, 2020 +(Amounts in thousands) Total Level 1 Level 2 Level 3 +Assets: +Marketable securities $ 6,024 $ 6,024 $ — $ — +Liabilities: +Interest rate swap (included in other liabilities) $ 667 $ — $ 667 $ — +As of December 31, 2019 +(Amounts in thousands) Total Level 1 Level 2 Level 3 +Assets: +Marketable securities $ 14,409 $ 14,409 $ — $ — +Financial Assets and Liabilities not Measured at Fair Value +Financial assets and liabilities that are not measured at fair value on our consolidated balance sheets include cash equivalents and mortgages payable. Cash equivalents are carried at cost, which approximates fair value due to their short-term maturities and are classified as Level 1. The fair value of our mortgages payable is calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist, and is classified as Level 2. The table below summarizes the carrying amount and fair value of these financial instruments as of December 31, 2020 and 2019. +As of December 31, 2020 As of December 31, 2019 +Carrying Fair Carrying Fair +(Amounts in thousands) Amount Value Amount Value +Assets: +Cash equivalents $ 393,070 $ 393,070 $ 263,688 $ 263,688 +Liabilities: +Mortgages payable (excluding deferred debt issuance costs, net) $ 1,164,544 $ 1,130,000 $ 974,836 $ 974,000 +54 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +10. LEASES +As Lessor +We lease space to tenants under operating leases in an office building and in retail centers. The rental terms range from approximately 5 to 25 years. The leases provide for the payment of fixed base rents payable monthly in advance as well as reimbursements of real estate taxes, insurance and maintenance costs. Retail leases may also provide for the payment by the lessee of additional rents based on a percentage of their sales. We also lease residential space at The Alexander apartment tower with 1 or 2 year lease terms. We have elected to account for lease revenues (including fixed and variable rent) and the reimbursement of common area maintenance expenses as a single lease component presented as “rental revenues” on our consolidated statements of income. +Future undiscounted cash flows under our contractual non-cancelable operating leases are as follows: +(Amounts in thousands) As of December 31, 2020 +For the year ending December 31, +2021 $ 132,812 +2022 126,002 +2023 127,115 +2024 135,274 +2025 124,595 +Thereafter 475,364 +These amounts do not include reimbursements or additional rents based on a percentage of retail tenants’ sales. +Bloomberg accounted for revenue of $ 109,066,000 , $ 109,113,000 , and $ 107,356,000 in the years ended December 31, 2020, 2019 and 2018, respectively, representing approximately 55 %, 48 % and 46 % of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +As Lessee +We are the lessee under a ground lease at our Flushing property, classified as an operating lease, which expires in 2027 and has one 10 -year extension option. On January 1, 2019, we recorded a right-of-use asset and lease liability related to this ground lease equal to the present value of the remaining minimum lease payments. As of December 31, 2020, the right-of-use asset of $ 3,974,000 and the lease liability of $ 4,236,000 , are included in “ other assets ” and “ other liabilities ,” respectively, on our consolidated balance sheet. The discount rate applied to measure the right-of-use asset and lease liability is based on the incremental borrowing rate (“IBR”) for the property of 4.53 %. We considered the general economic environment and factored in various financing and asset specific adjustments so that the IBR was appropriate to the intended use of the underlying lease. As we did not elect to apply hindsight, the lease term assumption determined under ASC Topic 840, Leases was carried forward and applied in calculating our lease liability recorded under ASC 842. +55 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +10. LEASES - continued +Future lease payments under this operating lease, excluding the extension option, are as follows: +(Amounts in thousands) As of December 31, 2020 +For the year ending December 31, +2021 $ 800 +2022 800 +2023 800 +2024 800 +2025 800 +Thereafter 800 +Total undiscounted cash flows 4,800 +Present value discount ( 564 ) +Lease liability as of December 31, 2020 $ 4,236 +We recognize rent expense as a component of “operating” expenses on our consolidated statements of income on a straight-line basis. Rent expense was $ 746,000 in each of the years ended December 31, 2020, 2019 and 2018, respectively. Cash paid for rent expense was $ 800,000 in each of the years ended December 31, 2020, 2019 and 2018, respectively. +11. STOCK-BASED COMPENSATION +We account for stock-based compensation in accordance with ASC Topic 718, Compensation – Stock Compensation (“ASC 718”). Our 2016 Omnibus Stock Plan (the “Plan”) provides for grants of incentive and non-qualified stock options, restricted stock, stock appreciation rights, deferred stock units (“DSUs”) and performance shares, as defined, to the directors, officers and employees of the Company and Vornado. +In May 2020, we granted each of the members of our Board of Directors 329 DSUs with a market value of $ 75,000 per grant. The grant date fair value of these awards was $ 56,250 per grant, or $ 450,000 in the aggregate, in accordance with ASC 718. In addition, 876 DSUs, constituting an initial award with a market value of $ 200,000 , were granted to a newly appointed Director. The grant date fair value of this award was $ 150,000 in accordance with ASC 718. The DSUs entitle the holders to receive shares of the Company’s common stock without the payment of any consideration. The DSUs vested immediately and accordingly, were expensed on the date of grant, but the shares of common stock underlying the DSUs are not deliverable to the grantee until the grantee is no longer serving on the Company’s Board of Directors. As of December 31, 2020, there were 14,916 DSUs outstanding and 490,871 shares were available for future grant under the Plan. +56 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +12. COMMITMENTS AND CONTINGENCIES +Insurance +We maintain general liability insurance with limits of $ 300,000,000 per occurrence and per property, of which the first $ 1,000,000 includes communicable disease coverage, and all-risk property and rental value insurance coverage with limits of $ 1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties and excluding communicable disease coverage. +Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $ 1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $ 275,000 deductible and 20 % of the balance of a covered loss, and the Federal government is responsible for the remaining 80 % of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. +We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. +The principal amounts of our mortgage loans are non-recourse to us and the loans contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. +Paramus +In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA. The lease expires in 2041, with a purchase option in October 2021 for $ 75,000,000 . The property is encumbered by a $ 68,000,000 interest-only mortgage loan with a fixed rate of 4.72 %, which matures in October 2021. The annual triple-net rent is the sum of $ 700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $ 7,000,000 and recognize a gain on sale of land of approximately $ 60,000,000 . If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $ 68,000,000 over the remaining 20 -year lease term. +Rego Park I Litigation +In June 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to the 195,000 square foot store that Sears formerly leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $ 4,000,000 and future damages it estimated would not be less than $ 25,000,000 . In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $ 650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonably possible losses, if any, is not expected to be greater than $ 650,000 . On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. +Letters of Credit +Approximately $ 960,000 of standby letters of credit were issued and outstanding as of December 31, 2020. +Other +There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. +57 +ALEXANDER’S, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) +13. MULTIEMPLOYER BENEFIT PLANS +Our subsidiaries make contributions to certain multiemployer defined benefit plans (“Multiemployer Pension Plans”) and health plans (“Multiemployer Health Plans”) for our union represented employees, pursuant to the respective collective bargaining agreements. +Multiemployer Pension Plans +Multiemployer Pension Plans differ from single-employer pension plans in that (i) contributions to multiemployer plans may be used to provide benefits to employees of other participating employers and (ii) if other participating employers fail to make their contributions, each of our subsidiaries may be required to bear their pro rata share of unfunded obligations. If a participating subsidiary withdraws from a plan in which it participates, it may be subject to a withdrawal liability. As of December 31, 2020, our subsidiaries’ participation in these plans were not significant to our consolidated financial statements. +In the years ended December 31, 2020, 2019 and 2018 our subsidiaries contributed $ 191,000 , $ 172,000 and $ 161,000 , respectively, towards Multiemployer Pension Plans. Our subsidiaries’ contributions did not represent more than 5% of total employer contributions in any of these plans for the years ended December 31, 2020, 2019 and 2018. +Multiemployer Health Plans +Multiemployer Health Plans in which our subsidiaries participate provide health benefits to eligible active and retired employees. In the years ended December 31, 2020, 2019 and 2018 our subsidiaries contributed $ 672,000 , $ 686,000 and $ 649,000 , respectively, towards these plans. +14. EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted income per share, including a reconciliation of net income and the number of shares used in computing basic and diluted income per share. Basic income per share is determined using the weighted average shares of common stock (including DSUs) outstanding during the period. Diluted income per share is determined using the weighted average shares of common stock (including DSUs) outstanding during the period, and assumes all potentially dilutive securities were converted into common shares at the earliest date possible. There were no potentially dilutive securities outstanding during the years ended December 31, 2020, 2019 and 2018. +Year Ended December 31, +(Amounts in thousands, except share and per share amounts) 2020 2019 2018 +Income from continuing operations $ 41,939 $ 60,075 $ 56,641 +Loss from discontinued operations (see Note 7) — — ( 23,797 ) +Net income $ 41,939 $ 60,075 $ 32,844 +Weighted average shares outstanding – basic and diluted 5,120,922 5,118,198 5,116,838 +Income from continuing operations $ 8.19 $ 11.74 $ 11.07 +Loss from discontinued operations (see Note 7) — — ( 4.65 ) +Net income per common share – basic and diluted $ 8.19 $ 11.74 $ 6.42 +58 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures – Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective. +Internal Control Over Financial Reporting – There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended) during the fourth quarter of the fiscal year to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +59 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER +FINANCIAL REPORTING +The management of Alexander’s, Inc., together with its consolidated subsidiaries (the “Company”), is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. +As of December 31, 2020, management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the framework established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2020 is effective. +The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2020 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report appearing on page 61 of this Annual Report on Form 10-K, which expresses an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2020. +60 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and the Board of Directors of Alexander’s, Inc. +Opinion on Internal Control over Financial Reporting +We have audited the internal control over financial reporting of Alexander’s, Inc. and subsidiaries (the “Company”) as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO. +We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended December 31, 2020, of the Company and our report dated February 16, 2021, expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ DELOITTE & TOUCHE LLP +New York, New York +February 16, 2021 +61 +ITEM 9B. OTHER INFORMATION +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Information relating to our directors, including our audit committee and audit committee financial expert, will be contained in a definitive Proxy Statement involving the election of directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. We will file the Proxy Statement with the Securities and Exchange Commission no later than 120 days after December 31, 2020. Such information is incorporated by reference herein. Also incorporated herein by reference is the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement. +Executive Officers of the Registrant +The following is a list of the names, ages, principal occupations and positions with us of our executive officers and the positions held by such officers during the past five years. +PRINCIPAL OCCUPATION, POSITION AND OFFICE +Name Age (Current and during past five years with the Company unless otherwise stated) +Steven Roth 79 Chairman of the Board since May 2004 and Chief Executive Officer since March 1995; Chairman of the Board of Vornado Realty Trust since May 1989; Chief Executive Officer of Vornado Realty Trust since April 2013 and from May 1989 to May 2009; a Trustee of Vornado Realty Trust since 1979; and Managing General Partner of Interstate Properties. +Matthew Iocco 50 Chief Financial Officer since April 2017; Executive Vice President - Chief Accounting Officer of Vornado Realty Trust since May 2015; and Senior Vice President - Chief Accounting Officer of Vornado Realty Trust from May 2012 to May 2015. +We have a code of business conduct and ethics that applies to, among others, our Chief Executive Officer and Chief Financial Officer. The code is posted on our website at www.alx-inc.com. We intend to satisfy our disclosure obligation regarding amendments and waivers of this code applicable to our Chief Executive Officer and Chief Financial Officer by posting such information on our website. +62 +ITEM 11. EXECUTIVE COMPENSATION +Information relating to executive compensation will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Information relating to security ownership of certain beneficial owners and management and related stockholder matters, except as set forth below, will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +Equity Compensation Plan Information +The following table provides information as of December 31, 2020, regarding our equity compensation. +Plan Category (a) +Number of securities +to be issued upon +exercise of +outstanding options, +warrants and rights Weighted-average +exercise price of +outstanding options, +warrants and rights Number of securities +remaining available for +future issuance under +equity compensation +plans (excluding +securities reflected in +column (a)) +Equity compensation plans approved by security holders 14,916 $ — 490,871 +Equity compensation plans not approved by security holders N/A N/A N/A +Total 14,916 $ — 490,871 +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Information relating to certain relationships and related transactions and director independence will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +Information relating to principal accounting fees and services will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. +63 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) The following documents are filed as part of this Annual Report on Form 10-K. +1. The consolidated financial statements are set forth in Item 8 of this Annual Report on Form 10-K. +2. The following financial statement schedule should be read in conjunction with the financial statements included in Item 8 of this Annual Report on Form 10-K. +Pages in this +Annual Report +on Form 10-K +Schedule III – Real Estate and Accumulated Depreciation as of +December 31, 2020, 2019 and 2018 65-66 +All other financial statement schedules are omitted because they are not applicable, not required, or the information is included elsewhere in the consolidated financial statements or the notes thereto. +64 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE III +REAL ESTATE AND ACCUMULATED DEPRECIATION +December 31, 2020 +(Amounts in thousands) +COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F COLUMN G COLUMN H COLUMN I +Gross Amount at Which Life on which Depreciation in Latest Income Statement is Computed +Initial Cost to Company (1) +Costs +Capitalized +Subsequent +to Acquisition Carried at Close of Period Accumulated +Depreciation +and +Amortization +Buildings +and Leasehold +Improvements Buildings +and Leasehold +Improvements Development +and +Construction +In Progress +Date of +Construction +Date +Acquired (1) +Description +Encumbrances (2) +Land Land +Total (3) +New York, NY +Rego Park I $ — $ 1,647 $ 8,953 $ 84,261 $ 1,647 $ 86,721 $ 6,493 $ 94,861 $ 38,451 1959 1992 +3 - 39 years +Rego Park II 202,544 (4) 3,127 1,467 389,150 3,127 390,114 503 393,744 113,318 2009 1992 +3 - 40 years +The Alexander apartment tower 94,000 — — 119,112 — 119,112 — 119,112 21,028 2016 1992 +3 - 39 years +Rego Park III — 779 — 5,292 779 527 4,765 6,071 325 N/A 1992 +5 - 15 years +Flushing — — 1,660 ( 107 ) — 1,553 — 1,553 1,146 +1975 (5) +1992 N/A +Lexington Avenue 800,000 14,432 12,355 416,994 27,497 416,284 — 443,781 175,854 2003 1992 +9 - 39 years +Paramus, NJ 68,000 1,441 — 10,313 11,754 — — 11,754 — N/A 1992 N/A +Other Properties — 167 1,804 ( 1,804 ) 167 — — 167 — N/A 1992 N/A +TOTAL $ 1,164,544 $ 21,593 $ 26,239 $ 1,023,211 $ 44,971 $ 1,014,311 $ 11,761 $ 1,071,043 $ 350,122 +(1) Initial cost is as of May 15, 1992 (the date on which the Company commenced its real estate operations). +(2) Excludes deferred debt issuance costs, net of $ 8,374 . +(3) The net basis of the Company’s assets and liabilities for tax purposes is approximately $ 139,364 lower than the amount reported for financial statement purposes. +(4) The amount of this loan is net of our $ 50,000 loan participation. +(5) Represents the date the lease was acquired. +65 +ALEXANDER’S, INC. AND SUBSIDIARIES +SCHEDULE III +REAL ESTATE AND ACCUMULATED DEPRECIATION +(Amounts in thousands) +December 31, +2020 2019 2018 +REAL ESTATE: +Balance at beginning of period $ 1,041,342 $ 1,027,691 $ 1,037,368 +Changes during the period: +Land — — — +Buildings and leasehold improvements 31,134 5,579 3,218 +Development and construction in progress ( 557 ) 8,072 695 +1,071,919 1,041,342 1,041,281 +Less: Fully depreciated assets ( 876 ) — ( 13,590 ) +Balance at end of period $ 1,071,043 $ 1,041,342 $ 1,027,691 +ACCUMULATED DEPRECIATION: +Balance at beginning of period $ 324,499 $ 297,421 $ 283,044 +Additions charged to operating expenses 26,499 27,078 27,967 +350,998 324,499 311,011 +Less: Fully depreciated assets ( 876 ) — ( 13,590 ) +Balance at end of period $ 350,122 $ 324,499 $ 297,421 +66 +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES - continued +(b) Exhibits +Exhibit No. +3.1 +- Amended and Restated Certificate of Incorporation. Incorporated herein by reference from Exhibit 3.1 to the registrant’s Registration Statement on Form S-3 filed on September 20, 1995 * +3.2 +- By-laws, as amended. Incorporated herein by reference from Exhibit 3(ii) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2000 * +4 +- Description of the Alexander’s, Inc. securities registered pursuant to Section 12 of the Securities Exchange Act *** +10.1 - Real Estate Retention Agreement dated as of July 20, 1992, between Vornado Realty Trust and Keen Realty Consultants, Inc., each as special real estate consultants, and the Company. Incorporated herein by reference from Exhibit 10(i)(O) to the registrant’s Annual Report on Form 10-K for the fiscal year ended July 25, 1992 * +10.2 +- Extension Agreement to the Real Estate Retention Agreement, dated as of February 6, 1995, between the Company and Vornado Realty Trust. Incorporated herein by reference from Exhibit 10(i)(G)(2) to the registrant’s Annual Report on Form 10-K for the year ended December 31, 1994 * +10.3 +- Agreement of Lease dated as of April 30, 2001 between Seven Thirty One Limited Partnership, landlord, and Bloomberg L.P., tenant. Incorporated herein by reference from Exhibit 10(v) B to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001, filed on August 2, 2001 * +10.4 +- Lease dated as of October 2, 2001 by and between ALX of Paramus LLC, as Landlord, and IKEA Property, Inc. as Tenant. Incorporated herein by reference from Exhibit 10(v)(C)(4) to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2001, filed on March 13, 2002 * +10.5 +- First Amendment to Real Estate Retention Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc. and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10(i)(E)(3) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 * +10.6 +- 59th Street Real Estate Retention Agreement, dated as of July 3, 2002, by and between Vornado Realty, L.P., 731 Residential LLC and 731 Commercial LLC. Incorporated herein by reference from Exhibit 10(i)(E)(4) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 * +10.7 +- Amended and Restated Management and Development Agreement, dated as of July 3, 2002, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10(i)(F)(1) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 * +10.8 +- Limited Liability Company Operating Agreement of 731 Residential LLC, dated as of July 3, 2002, among 731 Residential Holding LLC, as the sole member, Domenic A. Borriello, as an Independent Manager and Kim Lutthang, as an Independent Manager. Incorporated herein by reference from Exhibit 10(i)(A)(1) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 * +10.9 +- Limited Liability Company Operating Agreement of 731 Commercial LLC, dated as of July 3, 2002, among 731 Commercial Holding LLC, as the sole member, Domenic A. Borriello, as an Independent Manager and Kim Lutthang, as an Independent Manager. Incorporated herein by reference from Exhibit 10(i)(A)(2) to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed on August 7, 2002 * +___________________ +* Incorporated by reference. +*** Filed herewith. +67 +10.10 +- First Amendment of Lease, dated as of April 19, 2002, between Seven Thirty One Limited Partnership, landlord and Bloomberg L.P., tenant. Incorporated herein by reference from Exhibit 10(v)(B)(2) to the registrant’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2002, filed on August 7, 2002 * +10.11 +- Second Amendment to Real Estate Retention Agreement, dated as of January 1, 2007, by and between Alexander’s, Inc. and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.64 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on February 26, 2007 * +10.12 +- Amendment to 59th Street Real Estate Retention agreement, dated as of January 1, 2007, by and among Vornado Realty L.P., 731 Retail One LLC, 731 Restaurant LLC, 731 Office One LLC and 731 Office Two LLC. Incorporated herein by reference from Exhibit 10.65 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2006, filed on February 26, 2007 * +10.13 +- First Amendment to Amended and Restated Management and Development Agreement, dated as of July 6, 2005, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.52 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 * +10.14 +- Second Amendment to Amended and Restated Management and Development Agreement, dated as of December 20, 2007, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.53 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 * +10.15 +- Third Amendment to Real Estate Retention Agreement, dated as of December 20, 2007, by and between Alexander’s, Inc., and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Annual Report on Form 10-K, for the year ended December 31, 2007, filed on February 25, 2008 * +10.16 +- Lease dated as of February 7, 2005, by and between 731 Office One LLC, as Landlord, and Citibank, N.A., as Tenant. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 * +10.17 +- Assignment and Assumption and Consent Agreement, dated as of March 25, 2009, by and between 731 Office One LLC, as Landlord, Citicorp North America, Inc., as Assignor, and Bloomberg L.P., as Assignee. Incorporated herein by reference from Exhibit 10.60 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2009, filed on May 4, 2009 * +10.18 +- Third Amendment to Amended and Restated Management and Development Agreement, dated as of November 30, 2011, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.49 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2011, filed on February 27, 2012 * +10.19 +- Fourth Amendment to Amended and Restated Management and Development Agreement, dated as of August 1, 2012, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.2 to the registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, filed on November 1, 2012 * +10.20 +- Fifth Amendment to Amended and Restated Management and Development Agreement, dated as of December 1, 2012, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.54 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2012, filed on February 26, 2013 * +__________________ +* Incorporated by reference. +68 +10.21 +- Loan Agreement, date as of February 28, 2014, by and between 731 Office One LLC, as Borrower, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.22 +- Consolidated, Amended and Restated Promissory Note, dated as of February 28, 2014, by and between 731 Office One LLC, as Borrower, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.23 +- Amended and Restated Mortgage, Assignment of Leases and Rents and Security Agreement, dated as of February 28, 2014, by and between 731 Office One LLC, as Mortgagor, and German American Capital Corporation, as Mortgagee. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.24 +- Assignment of Leases and Rents dated as of February 28, 2014, by and between 731 Office One LLC, as Assignor, and German American Capital Corporation, as Assignee. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.25 +- Guaranty of Recourse Obligations dated as of February 28, 2014, by and between Alexander’s, Inc., as Guarantor, and German American Capital Corporation, as Lender. Incorporated herein by reference from Exhibit 10.5 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.26 +- Environmental Indemnity Agreement dated as of February 28, 2014, by and between 731 Office One LLC, as Indemnitor, and German American Capital Corporation, as Indemnitee. Incorporated herein by reference from Exhibit 10.6 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.27 +- Termination Agreement dated as of February 28, 2014, by and among 731 Office One LLC, Alexander’s Management LLC, Vornado Realty L.P., 731 Office Two LLC, 731 Residential LLC, 731 Commercial LLC, 731 Retail One LLC and 731 Restaurant LLC. Incorporated herein by reference from Exhibit 10.7 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.28 +- Real Estate Sub-Retention Agreement dated as of February 28, 2014, by and between Alexander’s Management LLC, as Agent, and Vornado Realty L.P., as Sub-Agent. Incorporated herein by reference from Exhibit 10.8 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.29 +- Sixth Amendment to Amended and Restated Management and Development Agreement, dated as of March 21, 2014, by and between Alexander’s, Inc., the subsidiaries party thereto and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.9 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.30 +- Rego Park II Residential Management and Development Agreement, dated as of March 21, 2014 by and between Alexander’s of Rego Residential LLC and Vornado Management Corp. Incorporated herein by reference from Exhibit 10.10 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, filed on May 5, 2014 * +10.31 +- Fourth Amendment to Real Estate Retention Agreement, dated December 22, 2014 by and between Alexander’s, Inc. and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 * +10.32 +- Second Amendment to 59th Street Real Estate Retention Agreement, dated December 22, 2014 by and between 731 Retail One LLC, 731 Restaurant LLC, 731 Office Two LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 * +__________________ +* Incorporated by reference. +69 +10.33 +- First Amendment to Rego II Real Estate Sub-Retention Agreement, dated December 22, 2014 by and between Alexander’s, Inc. and Vornado Realty L.P. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 * +10.34 +- First Amendment to Real-Estate Sub-Retention Agreement, dated December 22, 2014 by and between Alexander’s Management LLC and Vornado Realty, L.P. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed on February 17, 2015 * +10.35 +- Loan Agreement, dated as of August 5, 2015, by and between 731 Retail One LLC and 731 Commercial LLC, as Borrower, and JPMorgan Chase Bank, N.A., Wells Fargo Bank, N.A., and Landesbank Baden-Württemberg, New York Branch, as Lenders. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2015, filed on November 2, 2015 * +10.36 ++ - Second Amendment of Lease, dated as of the 12th of January 2016 between 731 Office One LLC and Bloomberg L.P. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2016, filed on May 2, 2016 * +10.37 +** - Form of Alexander’s Inc. 2016 Omnibus Stock Plan Deferred Stock Unit Grant Agreement between the Company and certain employees. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2016, filed on August 1, 2016 * +10.38 +- Loan Agreement, dated as of June 1, 2017, between 731 Office One LLC, as Borrower, and Deutsche Bank AG, New York Branch and Citigroup Global Markets Realty Corp. collectively, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2017, filed on July 31, 2017 +* +10.39 +- Amended and Restated Loan and Security Agreement, dated and made effective as of December 12, 2018, by and between Rego II Borrower LLC, as Borrower, and Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.55 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 * +10.40 +- Second Amended and Restated Promissory Note, dated December 12, 2018, by and between Rego II Borrower LLC, as Maker, and Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.56 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 * +10.41 +- Second Amended and Restated Mortgage, Assignment of Leases and Rents and Security Agreement, dated December 12, 2018, by and between Rego II Borrower LLC, as Mortgagor, and Bank of China, New York Branch, as Mortgagee. Incorporated herein by reference from Exhibit 10.57 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 * +10.42 +- Amended and Restated Guaranty of Recourse Carveouts, dated December 12, 2018, by Alexander’s, Inc., as Guarantor, to and for the benefit of Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.58 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 * +10.43 +- Amended and Restated Environmental Indemnity Agreement, dated December 12, 2018, among Rego II Borrower LLC and Alexander’s, Inc., individually or collectively as Indemnitor, in favor of Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.59 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 * +__________________ +* Incorporated by reference. +** Management contract or compensatory agreement. ++ Portions of this exhibit have been omitted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission under Rule 24b-2. The omitted confidential material has been filed separately. The location of the redacted confidential information is indicated in the exhibit as “redacted.” +70 +10.44 +- Amended and Restated Participation and Servicing Agreement for Amended and Restated Loan and Security Agreement, dated December 12, 2018, between Bank of China, New York Branch, individually as Lender, Initial A-1 Holder and as the Agent for the Holders, and Alexander’s of Rego Park II Participating Lender LLC, individually as Initial A-2 Holder. Incorporated herein by reference from Exhibit 10.60 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, filed on February 11, 2019 * +10.45 +- Waiver and Amendment No. 1 to Loan Agreement, dated October 10, 2019, by and among 731 Retail One LLC and 731 Commercial LLC, as Borrower, and JPMorgan Chase Bank, N.A., Wells Fargo Bank, N.A., and Landesbank Baden-Württemberg, New York Branch, as Lenders. Incorporated herein by reference from Exhibit 10.61 to the registrant’s Annual Report on Form 10-K for the year ended December 31, 2019, filed on February 18, 2020 * +10.46 +- First Amendment to Amended and Restated Loan and Security Agreement, dated February 14, 2020, by and between Rego II Borrower LLC, as Borrower and Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, filed on May 4, 2020 * +10.47 +- Amendment and Reaffirmation of Guaranty and Environmental Indemnity Agreement, dated February 14, 2020, by and between Alexander’s, Inc., as Guarantor, and Bank of China, New York Branch, as Lender. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, filed on May 4, 2020 * +10.48 +- Second Amended and Restated Participation and Servicing Agreement for Amended and Restated Loan and Security Agreement, dated February 14, 2020, between Bank of China, New York Branch, individually as Lender, Initial A-1 Holder and as the Agent for the Holders, and Alexander’s of Rego Park II Participating Lender LLC, individually as Initial A-2 Holder. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, filed on May 4, 2020 * +10.49 +- Omnibus Amendment to Loan Documents and Reaffirmation of Borrower and Guarantor, dated September 14, 2020, by and between 731 Retail One LLC and 731 Commercial LLC as Borrower, Alexander’s, Inc. as Guarantor, JPMorgan Chase Bank, N.A. as Administrative Agent on behalf of the Lenders, and the Lenders. Incorporated herein by reference from Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2020, filed on November 2, 2020 * +10.50 +- Amended and Restated Mortgage, Assignment of Leases and Rents, Security Agreement and Fixture Filing, dated September 14, 2020, by and between 731 Retail One LLC and 731 Commercial LLC as mortgagor and JPMorgan Chase Bank, N.A. as mortgagee and as Administrative Agent for the benefit of the Lenders. Incorporated herein by reference from Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2020, filed on November 2, 2020 * +10.51 +- Interest Guaranty, dated September 14, 2020, made by Alexander’s, Inc. as Guarantor to JPMorgan Chase Bank, N.A. as Administrative Agent for the benefit of the Lenders. Incorporated herein by reference from Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2020, filed on November 2, 2020 * +10.52 +- Leasing Costs Guaranty, dated September 14, 2020, made by Alexander’s, Inc. as Guarantor to JPMorgan Chase Bank, N.A. as Administrative Agent for the benefit of the Lenders. Incorporated herein by reference from Exhibit 10.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2020, filed on November 2, 2020 * +10.53 +- Second Amendment to Amended and Restated Loan and Security Agreement, dated October 23, 2020, by and between Rego II Borrower LLC, as Borrower and Bank of China, New York Branch, as Lender *** +21 +- Subsidiaries of Registrant *** +23 +- Consent of Independent Registered Public Accounting Firm *** +__________________ +* Incorporated by reference. +*** Filed herewith. +71 +31.1 +- Rule 13a-14 (a) Certification of the Chief Executive Officer *** +31.2 +- Rule 13a-14 (a) Certification of the Chief Financial Officer *** +32.1 +- Section 1350 Certification of the Chief Executive Officer *** +32.2 +- Section 1350 Certification of the Chief Financial Officer *** +101 - The following financial information from the Alexander’s, Inc. Annual Report on Form 10-K for the year ended December 31, 2020 formatted in Inline Extensible Business Reporting Language (iXBRL) includes: (i) consolidated balance sheets, (ii) consolidated statements of income, (iii) consolidated statements of comprehensive income, (iv) consolidated statements of changes in equity, (v) consolidated statements of cash flows and (vi) the notes to the consolidated financial statements *** +104 - The cover page from the Alexander’s, Inc. Annual Report on Form 10-K for the year ended December 31, 2020, formatted as Inline XBRL and contained in Exhibit 101 *** +__________________ +*** Filed herewith. +72 +ITEM 16. FORM 10-K SUMMARY +None. +73 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ALEXANDER’S, INC. +(Registrant) +Date: February 16, 2021 By: /s/ Matthew Iocco +Matthew Iocco, Chief Financial Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature Title Date +By: /s/Steven Roth Chairman of the Board of Directors and February 16, 2021 +(Steven Roth) Chief Executive Officer +(Principal Executive Officer) +By: /s/Matthew Iocco Chief Financial Officer +February 16, 2021 +(Matthew Iocco) (Principal Financial and Accounting Officer) +By: /s/Thomas R. DiBenedetto Director February 16, 2021 +(Thomas R. DiBenedetto) +By: /s/David Mandelbaum Director February 16, 2021 +(David Mandelbaum) +By: /s/Mandakini Puri Director February 16, 2021 +(Mandakini Puri) +By: /s/Wendy Silverstein Director February 16, 2021 +(Wendy Silverstein) +By: /s/Arthur Sonnenblick Director February 16, 2021 +(Arthur Sonnenblick) +By: /s/Richard R. West Director February 16, 2021 +(Richard R. West) +By: /s/Russell B. Wight Jr. Director February 16, 2021 +(Russell B. Wight Jr.) +74 \ No newline at end of file diff --git a/raw/filings/0000003499/2020/0000003499-21-000005/filing_metadata.csv b/raw/filings/0000003499/2020/0000003499-21-000005/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..6ad304328db610abc31d2be512d73f515e3eb651 --- /dev/null +++ b/raw/filings/0000003499/2020/0000003499-21-000005/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003499,ALX,ALEXANDERS INC,2020,10-K,2021-02-16,2020-12-31,2021-02-16T13:14:29.000Z,0000003499-21-000005,alx-20201231.htm,10-K,7992320,1,1,https://www.sec.gov/Archives/edgar/data/3499/000000349921000005/alx-20201231.htm,https://www.sec.gov/Archives/edgar/data/3499/000000349921000005/ diff --git a/raw/filings/0000003499/2020/0000003499-21-000005/item1.txt b/raw/filings/0000003499/2020/0000003499-21-000005/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..071ac7fd589791ea22d759f041fa6ee6c3761bca --- /dev/null +++ b/raw/filings/0000003499/2020/0000003499-21-000005/item1.txt @@ -0,0 +1,29 @@ +ITEM 1. BUSINESS +General +Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”) incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). +We have seven properties in the greater New York City metropolitan area consisting of: +Operating properties +• 731 Lexington Avenue, a 1,323,000 square foot multi-use building, comprising the entire block bounded by Lexington Avenue, East 59 th Street, Third Avenue and East 58 th Street in Manhattan. The building contains 920,000 and 155,000 of net rentable square feet of office and retail space, respectively, which we own, and 248,000 square feet of residential space consisting of 105 condominium units, which we sold. Bloomberg L.P. (“Bloomberg”) occupies all of the office space. The Home Depot (83,000 square feet) is the principal retail tenant; +• Rego Park I, a 338,000 square foot shopping center, located on Queens Boulevard and 63 rd Road in Queens. The center is anchored by a 112,000 square foot IKEA, a 50,000 square foot Burlington, a 46,000 square foot Bed Bath & Beyond and a 36,000 square foot Marshalls; +• Rego Park II, a 609,000 square foot shopping center, adjacent to the Rego Park I shopping center in Queens. The center is anchored by a 145,000 square foot Costco and a 133,000 square foot Kohl’s, which has been subleased. On September 10, 2020, Century 21 ($6,400,000 of annual revenue) filed for Chapter 11 bankruptcy and closed its 135,000 square foot store on December 7, 2020; +• The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet; +• Paramus, located at the intersection of Routes 4 and 17 in Paramus, New Jersey, consists of 30.3 acres of land that is ground leased to IKEA; and +• Flushing, a 167,000 square foot building, located on Roosevelt Avenue and Main Street in Queens, that is sub-leased to New World Mall LLC for the remainder of our ground lease term. +Property to be developed +• Rego Park III, a 140,000 square foot land parcel adjacent to the Rego Park II shopping center in Queens, at the intersection of Junction Boulevard and the Horace Harding Service Road. +Relationship with Vornado +We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements which expire in March of each year and are automatically renewable. Vornado is a fully-integrated REIT with significant experience in managing, leasing, developing, and operating office and retail properties. +As of December 31, 2020, Vornado owned 32.4% of our outstanding common stock. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2020, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. +5 +Significant Tenant +Bloomberg accounted for revenue of $109,066,000, $109,113,000 and $107,356,000 in the years ended December 31, 2020, 2019, and 2018, respectively, representing approximately 55%, 48% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. +Competition +We operate in a highly competitive environment. All of our properties are located in the greater New York City metropolitan area. We compete with a large number of real estate investors, property owners and developers. Principal factors of competition are rents charged, attractiveness of location, the quality of the property and the breadth and the quality of services provided. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. +Human Capital Resources +Since we are externally managed by Vornado, we do not have separate employees that provide management, leasing and development services. We currently have 70 property-level employees who provide cleaning, engineering and security services. Our employees are managed by Vornado in accordance with its employee policies and they have access to Vornado’s benefits, training and other programs. +Executive Office +Our executive office is located at 210 Route 4 East, Paramus, New Jersey, 07652 and our telephone number is (201) 587-8541. +Available Information +Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as well as Reports on Forms 3, 4 and 5 regarding officers, directors, and 10% beneficial owners filed or furnished pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, are available free of charge on our website (www.alx-inc.com) as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Also available on our website are copies of our Audit Committee Charter, Compensation Committee Charter, Code of Business Conduct and Ethics and Corporate Governance Guidelines. In the event of any changes to these items, revised copies will be made available on our website. Copies of these documents are also available directly from us, free of charge. +In May 2009, Vornado and Interstate each filed with the SEC an amendment to their respective Schedule 13D indicating that they, as a group, own 47.2% of our common stock. This ownership level, together with the shares owned by Messrs. Roth, Mandelbaum and Wight, makes us a “controlled” company for the purposes of the New York Stock Exchange, Inc.’s Corporate Governance Standards (the “NYSE Rules”). This means that we are not required to, among other things, have a majority of the members of our Board of Directors be independent under the NYSE Rules, have all of the members of our Compensation Committee be independent under the NYSE Rules or to have a Nominating Committee. While we have voluntarily complied with a majority of the independence requirements of the NYSE Rules, we are under no obligation to do so and this situation may change at any time. +6 \ No newline at end of file diff --git a/raw/filings/0000003499/2020/0000003499-21-000005/item13.txt b/raw/filings/0000003499/2020/0000003499-21-000005/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..58fa04d1a93dde64541578acc149d190287577c5 --- /dev/null +++ b/raw/filings/0000003499/2020/0000003499-21-000005/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Information relating to certain relationships and related transactions and director independence will be contained in the Proxy Statement referred to in “Item 10. Directors, Executive Officers and Corporate Governance” of this Annual Report on Form 10-K. Such information is incorporated by reference herein. \ No newline at end of file diff --git a/raw/filings/0000003545/2018/0000003545-18-000108/filing.txt b/raw/filings/0000003545/2018/0000003545-18-000108/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..f7c9c7ab0a3312a91b44605246f92dec43ba43d2 --- /dev/null +++ b/raw/filings/0000003545/2018/0000003545-18-000108/filing.txt @@ -0,0 +1,4958 @@ +10-K +1 +alco-93018x10k.htm +10-K +Document +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +þ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended September 30, 2018 +or +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period +from____________________ +to______________________ +Commission File Number: 0-261 +Alico, Inc. +( Exact name of registrant as specified in its charter ) +Florida +59-0906081 +( State or other jurisdiction of +incorporation or organization ) +( I.R.S. Employer Identification No. ) +10070 Daniels Interstate Court, +Suite 100, Fort Myers, FL +33913 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: 239-226-2000 +SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: +Title of class: +Name of each exchange on which registered: +COMMON CAPITAL STOCK, $1.00 Par value +NASDAQ +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No þ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that such registrant was required to file such reports), and (2) has been subject to such filings requirements for the past 90 days. Yes þ No ¨ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 or Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “non-accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act (Check one): +Large accelerated filer +¨ +Accelerated filer +þ +Non-accelerated filer +¨ +Smaller Reporting Company +¨ +Emerging Growth Company +¨ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes ¨ No þ +The aggregate market value of the voting and nonvoting common equity held by non-affiliates based on the closing price, as quoted on the NASDAQ Global Market as of March 29, 2018 (the last business day of Alico’s most recently completed second fiscal quarter) was $89,596,038 . Solely for the purposes of this calculation, the registrant has elected to treat all executives, officers and greater than 10% stockholders as affiliates of the registrant. There were 7,454,795 shares of common stock outstanding at December 3, 2018 . +Documents Incorporated by Reference: +Portions of the Proxy Statement of Registrant for the 2019 Annual Meeting of Stockholders (to be filed with the Commission under Regulation 14A within 120 days after the end of the Registrant's fiscal year), are incorporated by reference in Part III of this report. +ALICO, INC. +FORM 10-K +For the fiscal year ended September 30, 2018 +PART I +Item 1. Business +1 +Item 1A. Risk Factors +8 +Item 1B. Unresolved Staff Comments +17 +Item 2. Properties +17 +Item 3. Legal Proceedings +17 +Item 4. Mine Safety Disclosures +18 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +19 +Item 6. Selected Financial Data +22 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +24 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +41 +Item 8. Financial Statements and Supplementary Data +42 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +81 +Item 9A. Controls and Procedures +81 +Item 9B. Other Information +81 +PART III +Item 10. Directors, Executive Officers and Corporate Governance +82 +Item 11. Executive Compensation +82 +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +82 +Item 13. Certain Relationships and Related Transactions, and Director Independence +82 +Item 14. Principal Accountants Fees and Services +82 +PART IV +Item 15. Exhibits, Financial Statement Schedules +83 +Signatures +88 +Cautionary Statement +This Annual Report on Form 10-K contains certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). They are based on management’s current expectations and assumptions regarding our business and performance, the economy and other future conditions and forecasts of future events, circumstances and results. These forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements often include words such as “may,” “will,” “could,” “should,” “would,” “believes,” “expects,” “anticipates”, “estimates”, “projects,” “intends,” “plans” and other words and terms of similar substance in connection with discussions of future operating or financial performance. Such forward-looking statements include, but are not limited to, statements regarding future actions, business plans and prospects, prospective products, trends, future performance or results of current and anticipated products, sales efforts, expenses, interest rates, the outcome of contingencies, such as legal proceedings, plans relating to dividends, government regulations, the adequacy of our liquidity to meet our needs for the foreseeable future and our expectations regarding market conditions. +As with any projection or forecast, forward-looking statements are inherently susceptible to uncertainty and changes in circumstances. Our actual results may vary materially from those expressed or implied in our forward-looking statements. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements. +We undertake no obligation to update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K filed with the Securities and Exchange Commission ("SEC"). We provide in Item 1A, “Risk Factors,” a cautionary discussion of certain risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. In addition, the operation and results of our business are subject to risks and uncertainties identified elsewhere in this Annual Report on Form 10-K as well as general risks and uncertainties such as those relating to general economic conditions. You should understand that it is not possible to predict or identify all such risks. Consequently, you should not consider such discussion to be a complete discussion of all potential risks or uncertainties. +PART I +Item 1. Business +Alico, Inc. (“Alico”) was incorporated under the laws of the state of Florida in 1960. Collectively with its subsidiaries (the "Company", "we", "us" or "our"), our business and operations are described below. For detailed financial information with respect to our business and our operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included in Item 7 in this Annual Report on Form 10-K, and the accompanying Consolidated Financial Statements and the related Notes therein, which are included in Item 8. In addition, general information concerning our Company can be found on our website, the internet address of which is http://www.alicoinc.com . All of our filings with the Securities and Exchange Commission (the "SEC") including, but not limited to, the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are available free of charge on our website as soon as reasonably practicable after such material is electronically filed or furnished with the SEC. Our recent press releases and information regarding corporate governance, including the charters of our audit, compensation, executive and nominating governance committees, as well as our code of business conduct and ethics are also available to be viewed or downloaded electronically at http://www.alicoinc.com . The information on our website is not part of this report or any other report we file with or furnish to the SEC. +Overview +Alico is an agribusiness with a legacy of achievement and innovation in citrus and conservation. The Company owns approximately 117,000 acres of land in eight Florida counties (Charlotte, Collier, DeSoto, Glades, Hardee, Hendry, Highlands and Polk) including approximately 90,000 acres of mineral rights. Our principal lines of business are citrus groves and conservation. +During the fiscal year ended September 30, 2015, the Company acquired three Florida citrus properties for total consideration of approximately $363,000,000. These acquisitions made Alico one of the largest citrus producers in the United States of America. +Alico, Inc. operates two divisions: Alico Citrus, a citrus producer, and Alico Water Resources, a leading water storage and environmental services division. +The Company manages its land based upon its primary usage and reviews its performance based upon two primary classifications - Alico Citrus and Alico Water Resources and Other Operations . Other Operations includes lease for grazing rights, a lease to a third party of an aggregate mine and leases of oil extraction rights to third parties, farm lease revenue, the generation of revenues from sod and tree sales and rental income for office space. Alico presents its financial results and the related discussion based upon its two business segments: (i) Alico Citrus and (ii) Water Resources and Other Operations . +Recent Developments +Water Storage Contract Approval +In December 2012, the South Florida Water Management District (“SFWMD” or "District") issued a solicitation request for projects to be considered for the Northern Everglades Payment for Environmental Services Program ("Program"). In March 2013, the Company submitted its response proposing a dispersed water management project on a portion of its ranch land. The environmental services project ("Water Project") encompasses a large-scale water storage/nutrient load reduction project over approximately half of the Company's 72,000-acre ranch located in southern Hendry County. The Water Project has the ability to retain 94,000-acre feet of water, making it one of the largest private storage projects proposed to date and the largest within the Caloosahatchee River watershed. The Water Project was approved by the South Florida Water Management District in late 2014, and the Company's engineering and environmental consultants immediately began working on a detailed design. As a result of the uniqueness of the project site, which consists of over 11,000 acres of wetlands and several cultural resource sites, considerable effort has been undertaken over the past 3.5 years in securing necessary regulatory approvals for the project from both the State of Florida and the federal government. In addition, the project requires close coordination with adjacent landowners, as well as the water control districts that serve those landowner/properties. On September 29, 2015, the SFWMD amended the contract to extend it for an additional year. In 2016, the Florida Department of Environmental Protection included the project in the State’s Northern Everglades Public-Private Partnership Program. +The contract term is eleven years and allows up to one year for implementation (design, permitting, construction and construction completion certification) and ten years of operation, whereby the Company will provide water retention services. Payment for these services includes an amount not to exceed $4,000,000 of reimbursement for implementation. In addition, the contract provides an annual fixed payment of $12,000,000 for operations and maintenance costs, as long as the project is in compliance with the contract and subject to annual District Board approval of funding. The contract specifies that the District Board has to approve +1 +the payments annually through its budget process and there can be no assurance that it will approve the annual fixed payments. The Florida budget for the state’s 2018/2019 fiscal year as approved included Save Our Everglades trust/legacy Florida funding for the Program. On September 19, 2018 the SFWMD issued a press release announcing the issuance of an Environmental Resource Permit for Alico. The SFWMD release also stated that (i) the issuance of the permit cleared the path for Alico to deliver a dispersed water storage project in the Caloosahatchee Watershed, (ii) Alico has all necessary state approvals to proceed, and (iii) the project is expected to be operational within one year from the start of construction, which is contingent on Alico securing additional local and federal approvals. These approvals include a compatible use agreement from the Natural Resources Conservation Service, as well as approvals from the local water control districts. Construction will begin immediately upon receipt of permits. Annual fixed payments will not commence until completion of construction. The Company anticipates receiving all necessary regulatory approvals within the next four to six months. The Company has not recognized any revenue to date from the contract. Operating expenses were approximately $1,619,000 , $1,794,000 and $2,322,000 for each of the three years ended September 30, 2018 , 2017 and 2016 , respectively. +Tender Offer +On September 5, 2018, the Board of Directors approved and Alico announced the commencement of an issuer offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, upon the terms and subject to the conditions described in the Offer to Purchase dated September 5, 2018, Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors, LLC, Alico’s largest stockholder since 2013, participated in the Tender Offer and sold a small percentage of its holdings of the Company’s common stock. Members of neither the management team nor the Board of Directors sold any shares directly to the Tender Offer. +Hurricane Irma +Florida’s citrus industry was hit hard by the impacts of Hurricane Irma during the 2017-2018 season. Alico’s 2018 production was down by approximately 36% from the prior season. While we lost a small percentage of trees, the force and duration of the storm impacted the majority of the groves. Based upon prior experience with serious storms of this nature, we expect it will take at least two seasons for the groves to recover to pre-hurricane production levels. We finished with production of 4,827,000 boxes in fiscal year 2018 and anticipate an increase in production in fiscal year 2019 to 6,300,000-6,600,000 boxes and a return to pre-hurricane production levels by fiscal year 2020, which is approximately 7,900,000 boxes. +Through November 30, 2018, the Company received insurance proceeds relating to Hurricane Irma of approximately $477,000 for property and casualty damage claims and approximately $8,952,000 for crop claims, which have been recorded in operating expenses. The Company has additional property and casualty claims outstanding and is awaiting determination of additional proceeds, if any, to be received. In addition to the commercial insurance claims which have been submitted, the Company may be eligible for Irma federal relief programs distributed by the Farm Service Agency under the 2017 Wildfires and Hurricane Indemnity Program (2017 WHIP) as well as block grants that will be administered through the State of Florida. The specifics of the programs are still being finalized and at this time, the Company cannot determine the amount of federal relief funds which will be received or when these funds will be disbursed. +Alico 2.0 Modernization Program +On November 16, 2017, we announced the Alico 2.0 Modernization Program (“Alico 2.0”). This program is transforming three legacy businesses (Alico, Orange Co., and Silver Nip) into a single efficient enterprise, Alico Citrus, so we will remain one of the leaders in the U.S. citrus industry. This initiative explored every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. +Under this program, we expected to reduce citrus total expenses per acre to $2,164/acre and the cost to produce a pound solid to $1.56 when Alico 2.0 is fully implemented in 2020. These efficiencies are being achieved through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. We have also deployed a more efficient labor model that is consistent and uniform for field staffing and grove operating programs and aligns with the geographical footprint of the citrus groves. +In combination with these efforts, the Company is working to maintain operational efficiencies and deploy its resources to solidify the Company's position as a leader in the recovering citrus industry. +2 +Alico 2.0 also led us to decide to divest assets that generated low rates of return and shut down parts of our operations that were not profitable. Alico Citrus has shut down its nursery in Gainesville, Florida, is in the process of selling its trailers and has either sold or is in the process of selling real estate assets that are not strategic to our business plan. +In January 2018, the Company sold its breeding herd and leased grazing rights on the Alico Ranch to a third party operator. However, the Company continues to own the property and continues to conduct its long-term water dispersement program and wildlife management programs. As part of the sales transaction, the Company expensed all inventory costs that were accumulated at the date of sale. +Alico 2.0 also included an enhanced program to plant more citrus trees. The Company planted over 400,000 trees in fiscal year 2018 to help position the Company for future production growth beyond 2020. The Company believes that its current acreage can produce 10,000,000 boxes per year on a sustained basis, even in an environment where citrus greening continues. +Termination Proceedings against Mr. Remy W. Trafelet +On November 19, 2018, Alico, with unanimous approval of the members of the Board of Directors, other than Remy W. Trafelet, notified Mr. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors, that it intends to consider terminating his employment for “cause” pursuant to the terms of his employment agreement with the Company and option agreements entered into under the Company's Stock Incentive Plan of 2015 (collectively, the “Compensation Documents”). As required by the Compensation Documents, the Company will schedule a special meeting of the Board of Directors at a future date, at which meeting Mr. Trafelet and his counsel (if he so elects) may meet with the Board of Directors to address this matter. The Board of Directors will make its final determination as to Mr. Trafelet’s employment following such meeting. Mr. Trafelet has been placed on paid administrative leave pending the outcome of these proceedings. On November 28, 2018, the parties in the Florida Litigation (as defined below) stipulated to an order which provides, among other things, that pending the resolution of the Delaware Litigation (as defined below), the Board of Directors shall not take any action out of the routine day-to-day operations conducted in the ordinary course of business, including removing any corporate officers or directors from positions held as of November 27, 2018. For more information, see Item 3, "Legal Proceedings." +Appointment of Interim President +In connection with the commencement of the termination proceedings against Mr. Trafelet, Benjamin D. Fishman, a current member of the Board of Directors, was appointed to serve as Interim President of the Company, effective as of November 19, 2018. Henry R. Slack, the Company's Executive Chairman, and Mr. Fishman will manage the Company during the pendency of the termination proceedings. Neither Mr. Slack nor Mr. Fishman will receive any incremental compensation for their service during this period. In connection with assuming such interim role, Mr. Fishman has stepped down from the Audit Committee of the Board of Directors, and Mr. Andrew Krusen has assumed the Chairmanship of the Audit Committee. +Operating Segments +Operating segments are defined in Financial Accounting Standards Board ("FASB") - Accounting Standards Codification ("ASC") ASC Topic 280, "Segment Reporting" as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. For the fiscal years ended September 30, 2018 and 2017 the Company’s CODM assessed performance and allocated resources based on two operating segments: (i) Alico Citrus and (ii) Water Resources and Other Operations . +Commencing in Alico's fiscal year 2018, the Company operates two business segments related to its various land holdings, as follows: +• +Alico Citrus includes activities related to planting, owning, cultivating and/or managing citrus groves in order to produce fruit for sale to fresh and processed citrus markets, including activities related to the purchase and resale of fruit and value-added services, which include contracting for the harvesting, marketing and hauling of citrus. +• +Water Resources and Other Operations consists of activities related to water conservation, leasing of grazing rights, mining royalties and other less significant lines of business. Also included are activities related to owning and/or leasing improved farmland. Improved farmland is acreage that has been converted, or is permitted to be converted, from native pasture and which may have various improvements including irrigation, drainage and roads. +Prior to the sale of the breeding herd in January 2018, the Company’s business also included cattle ranching. +3 +The Land We Manage +We regularly review our land holdings to determine the best use of each parcel based upon our management expertise. Our total return profile is a combination of operating income potential and long-term appreciation. Land holdings not meeting our total return criteria are considered surplus to our operations and will be sold or exchanged for land considered to be more compatible with our business objectives and total return profile. +Our land holdings and the operating activities in which we engage are categorized in the following table: +Gross Acreage +Operating Activities +Alico Citrus +Citrus Groves +44,983 +Citrus Cultivation +Citrus Nursery +22 +Citrus Tree Development +45,005 +Water Resources and Other Operations +Ranch +70,322 +Leasing and Conservation +Other Land +1,434 +Mining lease; Office +Total +116,761 +Alico Citrus +We own and manage citrus land in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties and engage in the cultivation of citrus trees to produce citrus for delivery to the fresh and processed citrus markets. Alico citrus groves total approximately 45,000 gross acres or 38.5% of our land holdings. +Our citrus acreage is detailed in the following table: +Net Plantable +Producing +Developing +Fallow +Total Plantable +Support & Other +Gross +DeSoto County +14,980 +1,096 +482 +16,558 +4,650 +21,208 +Polk County +4,576 +— +— +4,576 +2,229 +6,805 +Collier County +4,261 +— +— +4,261 +2,905 +7,166 +Hendry County +3,546 +57 +175 +3,778 +1,707 +5,485 +Charlotte County +1,729 +— +138 +1,867 +676 +2,543 +Highlands County +1,063 +— +— +1,063 +161 +1,224 +Hardee County +403 +— +— +403 +171 +574 +Total +30,558 +1,153 +795 +32,506 +12,499 +45,005 +Of the approximately 45,000 gross acres of citrus land we own and manage, approximately 12,500 acres are classified as support acreage. Support acreage includes acres used for roads, barns, water detention, water retention and drainage ditches integral to the cultivation of citrus trees, but which are not capable of directly producing fruit. In addition, we own a small citrus tree nursery and utilize the trees produced in our own operations. The approximately 32,500 remaining acres are classified as net plantable acres. Net plantable acres are those that are capable of directly producing fruit. These include acres that are currently producing, acres that are developing (acres that are planted with trees too young to commercially produce fruit) and acres that are fallow. +Our Alico Citrus business segment cultivates citrus trees to produce citrus for delivery to the processed and fresh citrus markets. Our sales to the processed market were approximately 93.7%, 91.7% and 86.9% of Alico Citrus revenues for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. We produce Early and Mid-Season varieties, primarily Hamlin oranges, as well as a Valencia variety for the processed market. We deliver our fruit to the processors in boxes which each contains approximately 90 pounds of oranges. Because the processors convert the majority of the citrus crop into orange juice, they generally do not buy their citrus on a per box basis, but rather on a pound solids basis, which is the measure of the soluble solids (sugars and acids) +4 +contained in one box of citrus fruit. We produced approximately 26,513,000 , 42,611,000 , and 51,404,000 pound solids for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively, from boxes delivered to processing plants of approximately 4,702,000 , 7,259,000 and 8,829,000 , respectively. As previously indicated, the falloff is fiscal year 2018 was in large part attributable to the impact of Hurricane Irma. +The average pound solids per box was 5.64, 5.87 and 5.82 for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +We generally use multi-year contracts with citrus processors that include pricing structures based on a minimum (“floor”) price with a price increase (“rise”) based on market conditions. Therefore, if pricing in the market is favorable relative to our floor price, we benefit from the incremental difference between the floor and the final market price. +Our citrus produced for the processed citrus market in fiscal year 2018-2019 under our largest agreement will be under minimum floor price ranging from $2.05 to $2.15 per pound solid and rise price from $2.50 to $2.65 per pound solid. Under this agreement, if the market price exceeds the rise prices, then 50% of the excess will be added to the rise price. Under our next largest agreement, our citrus produced will be under a minimum floor price of $2.60 per pound solid and rise price of $3.30 per pound solid. We believe that other markets are available for our citrus products; however, new arrangements may be less favorable than our current contracts. +Our sales to the fresh citrus market constituted approximately 2.6%, 4.6% and 3.8% of our Alico Citrus revenues for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. We produce numerous varieties for the fresh fruit market including grapefruit, navel and other fresh varieties. Generally, our fresh fruit is sold to packing houses by the box and the packing houses are responsible for the harvest and haul of these boxes. We produced approximately 125,000 , 328,000 and 402,000 fresh fruit boxes for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. The majority of our citrus harvested for the fresh citrus market in fiscal year 2018-2019 is under fixed price contracts. +Revenues from our Alico Citrus operations were approximately 96.1% , 95.1% and 95.2% of our total operating revenues for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +Water Resources and Other Operations +We own and manage land in Collier, Glades, and Hendry Counties and engaged in cattle grazing and sales, sod and native plant sales, and still continue with land leasing for recreational and grazing purposes, conservation, and mining activities. Our Water Resources and Other Operations land holdings total approximately 72,000 gross acres, or 61.5% of our total acreage. +Our Water Resources and Other Operations acreage is detailed in the following table as of September 30, 2018 : +Acreage +Hendry County +67,208 +Glades County +526 +Collier County +4,022 +Total +71,756 +In January 2018, the Company sold its breeding herd and leased grazing rights on the Alico Ranch to a third party operator. The +Company continues to own the property and conduct its long-term water dispersement program and wildlife management programs. As part of the sales transaction, the Company expensed all cattle inventory costs that were accumulated at the date of sale. +In fiscal year 2017, our cattle operation was engaged in the production of beef cattle in Hendry and Collier Counties. The breeding herd consisted of approximately 8,700 cows and bulls. We primarily sold our calves to feed yards and yearling grazing operations in the United States. We also sold cattle through local livestock auction markets and to contract cattle buyers in the United States. These buyers provided ready markets for our cattle. Revenues from Water Resources and Other Operations were approximately 3.9%, 4.9% and 4.8% of total operating revenues for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +Our Strategy +Our core business strategy is to maximize stockholder value through continuously improving the return on our invested capital, either by holding and managing our existing land through skilled agricultural production, leasing, or other opportunistic means +5 +of monetization, disposing of under productive land or business units and acquiring new land or operations with appreciation potential. +Our objectives are to produce the highest quality agricultural products, create innovative land uses, opportunistically acquire and convert undervalued assets, sell under-productive land and other assets not meeting our total return profile, generate recurring and sustainable profit with the appropriate balance of risk and reward, and exceed the expectations of stockholders, customers, clients and partners. +Our strategy is based on best management practices of our agricultural operations and the environmental and conservation stewardship of our land and natural resources. We manage our land in a sustainable manner and evaluate the effect of changing land uses while considering new opportunities. Our commitment to environmental stewardship is fundamental to the Company’s core beliefs. +Seasonal Nature of Business +As with any agribusiness enterprise, our agribusiness operations and revenues are predominantly seasonal in nature. The following table illustrates the seasonality of our agribusiness revenues: +Fiscal Year +Q1 +Q2 +Q3 +Q4 +Ending 12/31 +Ending 3/31 +Ending 6/30 +Ending 9/30 +Oct +Nov +Dec +Jan +Feb +Mar +Apr +May +Jun +Jul +Aug +Sept +Harvest Fresh and Early/Mid Varieties of Oranges +Harvest Valencia Oranges +Significant Customers +Revenue from Tropicana represented approximately 87%, 86% and 32.5% of our consolidated revenue for the fiscal years ended September 30, 2018, 2017 and 2016, respectively. The revenue in fiscal year 2018 from Tropicana was generated primarily from two separate contracts. This revenue was generated from the sale of our citrus product in the processed market. No other customer provided more than 6% of our consolidated revenue in fiscal year 2018 or 2017. In the fiscal year 2016, 34.2% of the revenue was obtained through Minute Maid. +Competition +The orange and specialty citrus markets are intensely competitive, but no single producer has any significant market power over any market segments, as is consistent with the production of most agricultural commodities. Citrus is grown domestically in several states including Florida, California, Arizona and Texas, as well as foreign countries, most notably Brazil. Competition is impacted by several factors including quality, production, demand, brand recognition, market prices, weather, disease, export/import restrictions and foreign currency exchange rates. +Environmental Regulations +Our operations are subject to various federal, state and local laws regulating the discharge of materials into the environment. Management believes we are in compliance with all such rules including permitting and reporting requirements. Historically, compliance with environmental regulations has not had a material impact on our financial position, results of operations or cash flows. +Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. In addition, we require lessees of our property to comply with environmental regulations as a condition of leasing. +6 +Employees +As of September 30, 2018 , we had 233 full-time employees. Our employees work in the following divisions: +Alico Citrus +212 +Water Resources and Other Operations +0 +Corporate, General, Administrative and Other +21 +Total employees +233 +None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good. +Capital Resources and Raw Materials +Management believes that the Company will be able to meet its working capital requirements for at least the next 12 months, and over the long term, through internally generated funds, cash flows from operations, the sale of under-productive land and other assets, our existing lines of credit and access to capital markets. The Company has commitments that provide for lines of revolving credit that are available for our general and corporate use. +Raw materials needed to cultivate the various crops grown by the Company consist primarily of fertilizers, herbicides and fuel and are readily available from local suppliers. +Available Information +We provide electronic copies of our SEC filings free of charge upon request. Any information posted on or linked from our website is not incorporated by reference in this Annual Report on Form 10-K. The SEC also maintains a website at http://www.sec.gov , which contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. +7 +Item 1A. Risk Factors +Our business and results of operations are subject to numerous risks and uncertainties, many of which are beyond our control. The following is a description of the known factors that we believe may materially affect our business, financial condition, results of operations or cash flows. They should be considered carefully, in addition to the information set forth elsewhere in this Annual Report on Form 10-K, including Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8, Financial Statements and Supplementary Data, including the related Notes to the Consolidated Financial Statements in making any investment decisions with respect to our securities. Additional risks or uncertainties that are not currently known to us that we currently deem to be immaterial or that could apply to any company could also materially adversely affect our business, financial condition, results of operations or cash flows. +Risks Related to our Business +Adverse weather conditions, natural disasters and other natural conditions, including the effects of climate change, could impose significant costs and losses on our business. +Fresh produce is vulnerable to adverse weather conditions, including windstorms, floods, drought and temperature extremes, which are quite common and may occur with higher frequency or be less predictable in the future due to the effects of climate change. Unfavorable growing conditions can reduce both crop size and crop quality. In extreme cases, entire harvests may be lost in some geographic areas. Citrus groves are subject to damage from frost and freezes, and this has happened periodically in the recent past, including most recently the impact from Hurricane Irma. In some cases, the fruit is damaged or ruined; in the case of extended periods of cold, the trees can also be damaged or killed. These factors can increase costs, decrease revenues and lead to additional charges to earnings, which may have a material adverse effect on our business, results of operations, financial condition and cash flows. +Our citrus groves are subject to damage and loss from disease including but not limited to citrus greening and citrus canker which could negatively impact our business, financial condition, results of operations and cash flows. +Our citrus groves are subject to damage and loss from diseases such as citrus greening and citrus canker. Each of these diseases is widespread in Florida and exists in our citrus groves and in the areas where our citrus groves are located. The success of our citrus business is directly related to the viability and health of our citrus groves. +Citrus greening is one of the most serious citrus plant diseases in the world. Once a tree is infected, its productivity generally decreases. While the disease poses no threat to humans or animals, it has devastated citrus crops throughout the United States and abroad. Named for its green, misshapen fruit, citrus greening disease has now killed millions of citrus plants in the southeastern United States and has spread across the entire country. Infected trees produce fruits that are green, misshapen and bitter, unsuitable for sale as fresh fruit or for juice. Infected trees can die within a few years. At the present time, there is no known cure for citrus greening once trees have become infected. Primarily, as a result of citrus greening, orange production in the State of Florida has continued to drop. According to the U.S. Department of Agriculture, Florida had its smallest orange harvest in 54 years in the 2017-2018 harvest season. The USDA's forecast of approximately 77,000,000 boxes of oranges for the 2018-2019 season is down more than 48.7% from the approximately 150,000,000 boxes during the 2004-05 season when citrus greening was discovered. +Citrus canker is a disease affecting citrus species and is caused by a bacterium which is spread by contact with infected trees or by windblown transmission. There is no known cure for citrus canker at present although some management practices, including the use of copper-based bactericides, can mitigate its spread and lessen its effect on infected trees; however, there is no assurance that currently available technologies will control such disease effectively. +Both of these diseases pose a significant threat to the Florida citrus industry and to our citrus groves. While we use best management practices to attempt to control diseases and their spread, there can be no assurance that our mitigation efforts will be successful. These diseases can significantly increase our costs which could materially adversely affect our business, financial condition, results of operations and cash flows. Our citrus groves produce the significant majority of our annual operating revenues. A significant reduction in available citrus from our citrus groves could decrease our operating revenues and materially adversely affect our business, financial condition, results of operations and cash flows. +8 +Our citrus groves are geographically concentrated in Florida and the effects of adverse weather conditions including hurricanes and tropical storms could adversely affect our results of operations, financial position and cash flows. +Our citrus operations are concentrated in central and south Florida with our groves located in parcels in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties. Because our groves are located in close proximity to each other, the impact of adverse weather conditions may be material to our results of operations, financial position and cash flows. Florida is particularly susceptible to the occurrence of hurricanes and tropical storms. Depending on where any particular hurricane or tropical storm makes landfall, our properties could experience significant, if not catastrophic damage. Hurricanes and tropical storms have the potential to destroy crops and impact citrus production through the loss of fruit and destruction of trees and/or plants either as a result of high winds or through the spread of windblown disease. Such damage could materially affect our citrus operations and could result in a loss of operating revenues from those products for a multi-year period. We seek to minimize hurricane risk by the purchase of insurance contracts, but the majority of our crops remain uninsured. In addition to hurricanes and tropical storms, the occurrence of other natural disasters and climate conditions in Florida, such as tornadoes, floods, freezes, unusually heavy or prolonged rain, droughts and heat waves, could have a material adverse effect on our operations and our ability to realize income from our crops or properties. +During September 2017, we experienced significant fruit loss as a result of Hurricane Irma, which negatively impacted both the Company's revenues and earnings for fiscal year 2018, and will most likely negatively impact the Company's revenues and earnings, to a lesser degree, for fiscal year 2019. +A significant portion of our revenues are derived from our citrus business and any adverse event affecting such business could disproportionately harm our business. +Our revenues from our citrus business were approximately 96.1% , 95.1% and 95.2% of our operating revenues in fiscal years 2018 , 2017 and 2016 , respectively. Our citrus division is one of the largest citrus producers in the United States and because of the significance of the revenues derived from this business, we are more vulnerable to adverse events or market conditions affecting our citrus business which could have a significant impact on our overall results of operations, financial condition and cash flows. +We depend on our relationship with Tropicana for a significant portion of our business. Any disruption in this relationship could harm our sales. Additionally, if certain criteria are not met under one of our contracts with Tropicana, we could experience a significant reduction in revenues and cash flows. +The Company's contracts with Tropicana accounted for 86.6% , 85.6% and 32.5% of the Company's revenues in fiscal years 2018 , 2017 and 2016 , respectively. The revenue for Tropicana is generated among several contracts. Should there be any change in our current relationship structure, whereby they do not buy our oranges, we would need to find replacement buyers to purchase our remaining crop, which could take time and expense and may result in less favorable terms of sale. The loss of Tropicana as a customer or significant reduction in business with Tropicana may cause a material adverse impact to our financial position, results of operations and cash flows. +Our agricultural products are subject to supply and demand pricing which is not predictable. +Agricultural operations traditionally provide almost all of our operating revenues with citrus being the largest portion and are subject to supply and demand pricing. While according to Nielsen data consumer demand for orange juice has decreased significantly to its lowest level in almost a decade, we have been able to offset the impact of such decline with higher prices based on a lower supply of available oranges. However, there can be no assurance that we will be able to continue to do so if demand continues to decline. Although our processed citrus is subject to minimum pricing, we are unable to predict with certainty the final price we will receive for our products. In some instances the harvest and growth cycle will dictate when such products must be marketed which may or may not be advantageous in obtaining the best price. Excessive supplies tend to cause severe price competition and lower prices for the commodity affected. Limited supply of certain agricultural commodities due to world and domestic market conditions can cause commodity prices to rise in certain situations. We attempt to mitigate these risks by using contracts with citrus processors that include pricing structures based on a minimum (“floor”) price and with a price increase (“rise”) if market prices exceed the floor price. +There is no assurance that Alico 2.0 will provide the cost savings that we expect, or that we will fully realize the benefits we expect from the program. +On November 16, 2017, we announced Alico 2.0, which we expect will result in a significant citrus grove cost savings and a decline in Alico Citrus’ general and administrative expenses. There is no assurance that our Alico 2.0 will provide the cost savings that we expect, or that we will fully realize the benefits we expect from the program. +9 +If we are unable to successfully develop and execute our strategic growth initiatives, or if they do not adequately address the challenges or opportunities we face, our business, financial condition and prospects may be adversely affected. +Our success is dependent, in part, on our ability to identify, develop and execute appropriate strategic growth initiatives that will enable us to achieve sustainable growth in the long term. The implementation of our strategic initiatives is subject to both the risks affecting our business generally and the inherent risks associated with implementing new strategies. These strategic initiatives may not be successful in generating revenues or improving operating profit and, if they are, it may take longer than anticipated. As a result and depending on evolving conditions and opportunities, we may need to adjust our strategic initiatives and such changes could be substantial, including modifying or terminating one or more of such initiatives. Termination of such initiatives may require us to write down or write off the value of our investments in them. Transition and changes in our strategic initiatives may also create uncertainty in our employees, customers and partners that could adversely affect our business and revenues. In addition, we may incur higher than expected or unanticipated costs in implementing our strategic initiatives, attempting to attract revenue opportunities or changing our strategies. There is no assurance that the implementation of any strategic growth initiative will be successful, and we may not realize anticipated benefits at levels we project or at all, which would adversely affect our business, financial condition and prospects. +We are subject to the risk of product contamination and product liability claims. +The sale of agricultural products for human consumption involves the risk of injury to consumers. Such injuries may result from tampering by unauthorized third parties, product contamination or spoilage, including the presence of foreign objects, substances, chemicals, other agents, or residues introduced during the growing, storage, handling or transportation phases. While we are subject to governmental inspection and regulations and believe our facilities comply in all material respects with all applicable laws and regulations, we cannot be sure that our agricultural products will not cause a health-related illness in the future or that we will not be subject to claims or lawsuits relating to such matters. Even if a product liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused illness or injury could adversely affect our reputation with existing and potential customers and our corporate and brand image. Moreover, claims or liabilities of this sort might not be covered by our insurance or by any rights of indemnity or contribution that we may have against others. We maintain product liability insurance, however, we cannot be sure that we will not incur claims or liabilities for which we are not insured or that exceed the amount of our insurance coverage. +Our agricultural operations are subject to water use regulations restricting our access to water. +Our operations are dependent upon the availability of adequate surface and underground water. The availability of water is regulated by the state of Florida through water management districts which have jurisdiction over various geographic regions in which our lands are located. Currently, we have permits in place for the next 15 to 20 years for the use of underground and surface water which are adequate for our agricultural needs. +Surface water in Hendry County, where much of our agricultural land is located, comes from Lake Okeechobee via the Caloosahatchee River and a system of canals used to irrigate such land. The Army Corps of Engineers controls the level of Lake Okeechobee and ultimately determines the availability of surface water even though the use of water has been permitted by the state of Florida through the water management district. The Army Corps of Engineers decided in 2010 to lower the permissible level of Lake Okeechobee in response to concerns about the ability of the levee surrounding the lake to restrain rising waters which could result from hurricanes. Changes in availability of surface water use may result during times of drought, because of lower lake levels and could materially adversely affect our agricultural operations, financial condition, results of operations and cash flows. +Changes in immigration laws could impact our ability to harvest our crops. +We engage third parties to provide personnel for our harvesting operations. The availability and number of such workers is subject to decrease if there are changes in the U.S. immigration laws. Immigration reform and enforcement is currently attracting significant attention in the current U.S. administration and U.S. Congress, with enforcement operations taking place across the country, resulting in arrests and detentions of unauthorized workers. If new immigration legislation is enacted in the U.S. and/or if enforcement actions are taken against available personnel, such legislation and/or enforcement activities may contain provisions that could significantly reduce the number and availability of workers. Termination of a significant number of personnel who are found to be unauthorized workers or the scarcity of other available personnel to harvest our agricultural products could cause harvesting costs to increase or could lead to the loss of product that is not timely harvested which could have a material adverse effect to our citrus grove business, financial condition, results of operations and cash flows. +10 +Our acquisition of additional agricultural assets and other businesses could pose risks. +We seek to opportunistically acquire new agricultural assets from time to time that we believe would complement our business. For example, in fiscal year 2015 we acquired three Florida citrus properties, including Orange-Co and Silver Nip Citrus, which resulted in our citrus division being one of the largest citrus producers in the United States. While we expect that our past and future acquisitions will successfully complement our business, we may fail to realize all of the anticipated benefits of these acquisitions, which could reduce our anticipated results. We cannot assure that we will be able to successfully identify suitable acquisition opportunities, negotiate appropriate acquisition terms, or obtain any financing that may be needed to consummate such acquisitions or complete proposed acquisitions. Acquisitions by us could result in accounting changes, potentially dilutive issuances of equity securities, increased debt and contingent liabilities, reduce the amount of cash available for dividends, debt service payments, integration issues and diversion of management’s attention, any of which could adversely affect our business, results of operations, financial condition, and cash flows. We may be unable to successfully realize the financial, operational, and other benefits we anticipate from our acquisitions and our failure to do so could adversely affect our business, results of operations, financial condition and cash flows. +Dispositions of our assets may adversely affect our future results of operations. +We also routinely evaluate the benefits of disposing of certain of our assets which could include the exit from lines of business. For example, in November of 2014 we sold significant sugarcane assets and we are no longer involved in the sugarcane business and in January of 2018 we sold our breeding herd and no longer engage in cattle operations. While such dispositions increase the amount of cash available to us, it could also result in a potential loss of significant operating revenues and income streams that we might not be able to replace, makes our business less diversified and could ultimately have a negative impact on our results of operations, financial condition and cash flows. +If a transaction intended to qualify as a Section 1031 Exchange is later determined to be taxable, we may face adverse consequences, and if the laws applicable to such transactions are amended or repealed, we may not be able to dispose of properties on a tax deferred basis. +From time to time we dispose of properties in transactions that are intended to qualify as Section 1031 Exchanges. It is possible that the qualification of a transaction as a Section 1031 Exchange could be successfully challenged and determined to be currently taxable and we could also be required to pay interest and penalties. As a result, we may be required to borrow funds in order to pay additional income taxes, and the payment of such taxes could cause us to have less cash available. Moreover, it is possible that legislation could be enacted that could modify or repeal the laws with respect to Section 1031 Exchanges, which could make it more difficult or not possible for us to dispose of properties on a tax deferred basis. +We may undertake one or more significant corporate transactions that may not achieve their intended results, may adversely affect our financial condition and our results of operations or result in unforeseeable risks to our business. +We continuously evaluate the acquisition or disposition of operating businesses and assets and may in the future undertake one or more significant transactions. Any such acquisitive transaction could be material to our business and could take any number of forms, including mergers, acquisitions, joint ventures and the purchase of equity interests. The consideration for such acquisitive transactions may include, among other things, cash, common stock or equity interests in the Company or our subsidiaries, or a contribution of property or equipment to obtain equity interests, and in conjunction with a transaction we might incur additional indebtedness. We also routinely evaluate the benefits of disposing of certain assets. Such dispositions could take the form of asset sales, mergers or sales of equity interests. +These transactions may present significant risks such as insufficient assets to offset liabilities assumed, potential loss of significant operating revenues and income streams, increased or unexpected expenses, inadequate return of capital, regulatory or compliance issues, the triggering of certain financial covenants in our debt instruments (including accelerated repayment) and unidentified issues not discovered in due diligence. In addition, such transactions could distract management from current operations. As a result of the risks inherent in such transactions, we cannot guarantee that any such transaction will ultimately result in the realization of its anticipated benefits or that it will not have a material adverse impact on our business, financial condition, results of operations or cash flows. If we were to complete such an acquisition, disposition, investment or other strategic transaction, we may require additional debt or equity financing that could result in a significant increase in our amount of debt and our debt service obligations or the number of outstanding shares of our common stock, thereby diluting holders of our common stock outstanding prior to such acquisition. +11 +Our citrus business is seasonal. +Our citrus groves produce the majority of our annual operating revenues and the citrus business is seasonal because it is tied to the growing and picking seasons. Historically, the second and third quarters of our fiscal year generally produce the majority of our annual revenues, and our working capital requirements are typically greater in the first and fourth quarters of our fiscal year coinciding with our planting cycles. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year or in future quarters. If our operating revenues in the second and third quarters are lower than expected, it would have a disproportionately large adverse impact on our annual operating results. +We face significant competition in our agricultural operations. +We face significant competition in our agricultural operations both from domestic and foreign producers and do not have any branded products. Foreign growers generally have an equal or lower cost of production, less environmental regulation and in some instances, greater resources and market flexibility than us. Because foreign growers have greater flexibility as to when they enter the U.S. market, we cannot always predict the impact these competitors will have on our business and results of operations. The competition we face from foreign suppliers of orange juice is mitigated by a governmentally imposed tariff on orange imports. Accordingly, a reduction in the government’s orange juice tariff could adversely impact our results of operations. +Climate change, or legal, regulatory, or market measures to address climate change, may negatively affect our business and operations. +There is growing concern that carbon dioxide and other greenhouse gases in the atmosphere may have an adverse impact on global temperatures, weather patterns, and the frequency and severity of extreme weather and natural disasters. In the event that such climate change has a negative effect on the productivity of our citrus groves, it could have an adverse impact on our business and results of operations. The increasing concern over climate change also may result in more regional, federal, and/or global legal and regulatory requirements to reduce or mitigate the effects of greenhouse gases. In the event that such regulation is enacted, we may experience significant increases in our costs of operations. In particular, increasing regulation of fuel emissions could substantially increase the distribution and supply chain costs associated with our products. As a result, climate change could negatively affect our business and operations. +Increases in labor, personnel and benefits costs could adversely affect our operating results. +We primarily utilize labor contractors to harvest and deliver our fruit to outside packing facilities. Our employees and contractors are in demand by other agribusinesses and other industries. Shortages of labor, particularly as a result of the recent low unemployment rate in the United States and in Florida in particular, could delay our harvesting or orange processing activities or could result in increases in labor costs. +We and our labor contractors are subject to government mandated wage and benefit laws and regulations. In addition, current or future federal or state healthcare legislation and regulation, including the Affordable Care Act, may increase our medical costs or the medical costs of our labor contractors that could be passed on to us. +We benefit from reduced real estate taxes due to the agricultural classification of a majority of our land. Changes in the classification or valuation methods employed by county property appraisers could cause significant changes in our real estate property tax liabilities. +In the fiscal years ended September 30, 2018 , 2017 and 2016 we paid approximately $3,089,000 , $3,106,000 and $3,196,000 , respectively, in real estate taxes, respectively. These taxes were based upon the agricultural use (“Green Belt”) values determined by the county property appraisers in which counties we own land, of approximately $104,017,000 , $105,496,000 and $89,922,000 for each of the fiscal years ended September 30, 2018 , 2017 and 2016 respectively, which differs significantly from the fair values determined by the county property appraisers of approximately $537,183,000 , $539,790,000 and $533,617,000 , respectively. Changes in state law or county policy regarding the granting of agricultural classification or calculation of "Green Belt" values or average millage rates could significantly impact our results of operations, cash flows and/or financial position. +Liability for the use of fertilizers, pesticides, herbicides and other potentially hazardous substances could increase our costs. +Our agricultural business involves the use of herbicides, fertilizers and pesticides, some of which may be considered hazardous or toxic substances. We may be deemed liable and have to pay for the costs or damages associated with the improper application, accidental release or the use or misuse of such substances. Our insurance may not be adequate to cover such costs or damages, or may not continue to be available at a price or under terms that are satisfactory to us. In such cases, if we are required to pay +12 +significant costs or damages, it could materially adversely affect our business, results of operations, financial condition and cash flows. +Compliance with applicable environmental laws may substantially increase our costs of doing business which could reduce our profits. +We are subject to various laws and regulations relating to the operation of our properties, which are administered by numerous federal, state and local governmental agencies. We face a potential for environmental liability by virtue of our ownership of real estate property. If hazardous substances (including herbicides and pesticides used by us or by any persons leasing our lands) are discovered emanating from any of our lands and the release of such substances presents a threat of harm to the public health or the environment, we may be held strictly liable for the cost of remediation of these hazardous substances. In addition, environmental laws that apply to a given site can vary greatly according to the site’s location, its present and former uses, and other factors such as the presence of wetlands or endangered species on the site. Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. Furthermore, we require lessees of our properties to comply with environmental regulations as a condition of leasing. We also purchase insurance for environmental liability when it is available; however, these insurance contracts may not be adequate to cover such costs or damages or may not continue to be available at prices and terms that would be satisfactory. It is possible that in some cases the cost of compliance with these environmental laws could exceed the value of a particular tract of land, make it unsuitable for use in what would otherwise be its highest and best use, and/or be significant enough that it would materially adversely affect us. +Our business may be adversely affected if we lose key employees. +We depend to a large extent on the services of certain key management personnel. These individuals have extensive experience and expertise in the business lines and segments in which they work. The loss of any of these individuals could have a material adverse effect on our businesses. We do not maintain key-man life insurance with respect to any of our employees. Our success will be dependent on our ability to continue to attract, employ and retain skilled personnel in our business lines and segments. +Inflation can have a significant adverse effect on our operations. +Inflation can have a major impact on our citrus operations. The citrus operations are most affected by escalating costs and unpredictable revenues and very high irrigation water costs. High fixed water costs related to our citrus lands will continue to adversely affect earnings. Prices received for many of our products are dependent upon prevailing market conditions and commodity prices. Therefore, it is difficult for us to accurately predict revenue, just as we cannot pass on cost increases caused by general inflation, except to the extent reflected in market conditions and commodity prices. +We incur increased costs as a result of being a publicly traded company. +As a company with publicly traded securities, we have incurred, and will continue to incur, significant legal, accounting and other expenses. In addition, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, as well as rules promulgated by the SEC and Nasdaq, requires us to adopt corporate governance practices applicable to U.S. public companies. These laws, rules and regulations may increase our legal and financial compliance costs, which could adversely affect the trading price of our common stock. +System security risks, data protection breaches, cyber-attacks and systems integration issues could disrupt our internal operations or services provided to customers, and any such disruption could reduce our expected revenues, increase our expenses, damage our reputation and adversely affect our stock price. +Computer programmers and hackers may be able to penetrate our network security and misappropriate or compromise our confidential information or that of third parties, create system disruptions or cause shutdowns. Computer programmers and hackers also may be able to develop and deploy viruses, worms, and other malicious software programs that attack our systems and databases or otherwise exploit any security vulnerabilities of our systems and databases. In addition, sophisticated hardware and operating system software and applications that we develop internally or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate cyber or other security problems, bugs, viruses, worms, malicious software programs and security vulnerabilities could be significant, and our efforts to address these problems may not be successful and could result in interruptions, delays, cessation of service and loss of existing or potential customers that may impede our sales, distribution or other critical functions. +13 +Portions of our Information Technology infrastructure also may experience interruptions, delays or cessations of service or produce errors in connection with systems integration or migration work that takes place from time to time. We may not be successful in implementing new systems and transitioning data, which could cause business disruptions and be more expensive, time consuming, disruptive and resource-intensive. Such disruptions could adversely impact our ability to track sales and could interrupt other operational or financial processes, which in turn could adversely affect our financial results, stock price and reputation. +Risks Related to Our Indebtedness +We maintain a significant amount of indebtedness which could adversely affect our financial condition, results of operations or cash flows and may limit our operational and financing flexibility and negatively impact our business. +As of September 30, 2018 we had approximately $177,000,000 in principal amount of indebtedness outstanding under our secured credit facilities and line of credit and an additional $82,000,000 is available under our revolving lines of credit. Our loan agreements, and other debt instruments we may enter into in the future, may have negative consequences to us and could limit our business because we will use a substantial portion of our cash flows from operations to pay debt service costs which will reduce the funds available to us for corporate and general expenses and it may make us more vulnerable to economic downturns and adverse developments in our business. Our loan agreements require us to comply with various restrictive covenants and some contain financial covenants that require us to comply with specified financial ratios and tests. Our failure to meet these covenants could result in default under these loan agreements and would result in a cross-default under other loan agreements. In the event of a default and our inability to obtain a waiver of the default, all amounts outstanding under loan agreements could be declared immediately due and payable. Our loan agreements also contain various covenants that limit our ability to engage in specified types of transactions. We expect that we will depend primarily upon our citrus operations to provide funds to pay our corporate and general expenses and to pay any amounts that may become due under any credit facilities and any other indebtedness we may incur. In addition, there are factors beyond our control that could negatively affect our citrus business revenue stream. Our ability to make these payments depends on our future performance, which will be affected by various financial, business, macroeconomic and other factors, many of which we cannot control. +Some of our debt is based on variable rates of interest, which could result in higher interest expenses in the event of an increase in the interest rates. +Our credit facility and certain of our term loans that we have currently bear interest at variable rates, which will generally change as interest rates change. We bear the risk that the rates we are charged by our lenders will increase faster than the earnings and cash flow of our business, which could reduce profitability, adversely affect our ability to service our debt, cause us to breach covenants contained in our credit facility and term loans, any of which could materially adversely affect our business, financial condition, results of operations and cash flows. +Risks Related to our Common Stock +Our largest stockholder has the ability to exert significant influence over our business and its interests may conflict with or differ from the interests of our other stockholders. +As of December 3, 2018, 734 Investors, LLC (“734 Investors”) beneficially owns approximately 43.0% of our outstanding common stock. Accordingly, 734 Investors has the ability to exert significant influence over our business and may make decisions with which other stockholders may disagree, including, among other things, delaying or discouraging a change of control of our Company or a potential merger, consolidation, tender offer, takeover or other business combination. +We have been advised that, on November 19, 2018, the members of 734 Investors passed a resolution by written consent to remove 734 Agriculture, LLC (“734 Agriculture”) as managing member of 734 Investors, and to designate Arlon Valencia Holdings, LLC as the new managing member of 734 Investors (the "734 Consent"). On November 20, 2018, 734 Agriculture filed a lawsuit contesting the 734 Consent in the Delaware Court of Chancery (the "Delaware Court"), captioned 734 Agriculture v. Arlon Valencia Holdings, LLC, C.A. No. 2018-0844-JTL. +On December 5, 2018, the Delaware Court entered a stipulated status quo order which provides, among other things, that 734 Agriculture shall serve as the managing member of 734 Investors during the pendency of the Delaware Litigation (as defined below). The status quo order also provides that 734 Agriculture shall not take any actions outside of the ordinary course of business of 734 Investors without the consent of two-thirds of the membership interests of 734 Investors, including exercising any voting rights with respect to any shares of the Company’s common stock beneficially owned by 734 Investors. +14 +Due to the inherent uncertainties of litigation, we cannot predict the outcome of this litigation at this time, and we can give no assurance that this litigation will not have a material adverse effect on our financial position or results of operations. For more information regarding legal proceedings, see Item 3, “Legal Proceedings.” +The interests of 734 Investors could conflict with or differ from the interests of our other stockholders. Additionally, potential conflicts of interest could exist if we enter into any related party transactions with 734 Investors. +Although we are no longer a “Controlled Company” under Nasdaq Listing Rules, we may continue to rely on exemptions from certain corporate governance requirements during a limited transition period. +As of November 19, 2018, we no longer qualify as a “Controlled Company” under Nasdaq listing rules. Although we currently comply with certain of the Nasdaq listing rules applicable to companies that are not Controlled Companies, there are certain exemptions for Controlled Companies that we no longer benefit from, including that the Nasdaq listing rules require that each of the compensation and nominating and governance committees be composed of at least a majority of independent directors within 90 days of the date on which we no longer qualified as a “Controlled Company” and that each such committee be composed entirely of independent directors within one year of such date. During these transition periods, we will continue to qualify for and may continue to utilize the available exemptions from certain corporate governance requirements as permitted by the Nasdaq listing rules. Accordingly, during these transition periods, you may not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements in the Nasdaq listing rules, which could make our common stock less attractive to some investors or otherwise harm our stock price. +Sales of substantial amounts of our outstanding common stock by our largest stockholder could adversely affect the market price of our common stock. +Our largest stockholder, 734 Investors, beneficially owns approximately 43.0% of our outstanding common stock as of December 3, 2018 . Our common stock is thinly traded and our common stock prices can fluctuate significantly. As such, sales of substantial amounts of our common stock into the public market by 734 Investors or perceptions that significant sales could occur, could adversely affect the market price of our common stock. +Our common stock has low trading volume. +Although our common stock trades on the Nasdaq Global Market, it is thinly traded and our average daily trading volume is low compared to the number of shares of common stock we have outstanding. The low trading volume of our common stock can cause our stock price to fluctuate significantly as well as make it difficult for a stockholder to sell their common shares quickly. As a result of our stock being thinly traded and/or our low stock price, institutional investors might not be interested in owning our common stock. +We may not be able to continue to pay or maintain our cash dividends on our common stock and the failure to do so may negatively affect our share price. +We have historically paid regular quarterly dividends to the holders of our common stock. Our ability to pay cash dividends depends on, among other things, our cash flows from operations, our cash requirements, our financial condition, the degree to which we are/or become leveraged, contractual restrictions binding on us, provisions of applicable law and other factors that our Board of Directors may deem relevant. There can be no assurance that we will generate sufficient cash from continuing operations in the future, or have sufficient cash surplus or net profits to pay dividends on our common stock. Our dividend policy is based upon our directors’ current assessment of our business and the environment in which we operate and that assessment could change based on business developments (which could, for example, increase our need for capital expenditures) or new growth opportunities. Our Board of Directors may, in its discretion, decrease the level of cash dividends or entirely discontinue the payment of cash dividends. The reduction or elimination of cash dividends may negatively affect the market price of our common stock. +There can be no assurance that we will resume the repurchase of shares of our common stock. +In fiscal year 2017, our Board of Directors authorized the repurchase of up to $7,000,000 of the Company’s common stock in two separate authorizations. In March 2017, our Board of Directors authorized the repurchase of up to $5,000,000 of the Company’s common stock beginning March 9, 2017 and continuing through March 9, 2019. In May 2017, our Board of Directors authorized the repurchase of up to an additional $2,000,000 of the Company’s common stock beginning May 24, 2017 and continuing through May 24, 2019. Our share repurchase program does not obligate us to repurchase any specific number of shares and may be suspended from time to time or terminated at any time prior to its expiration. As of June 29, 2018 the Company suspended its stock repurchase activity; however if the Company chooses to resume repurchasing stock it has $1,676,443 available to repurchase +15 +stock under the 2017 Authorization. There can be no assurance that we will repurchase shares in the future in any particular amounts or at all. A reduction in, or elimination of, share repurchases could have a negative effect on our share price. +16 +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +As of September 30, 2018 , Alico owned approximately 117,000 acres of land located in eight counties in Florida. Acreage in each county and the primary classification with respect to the present use of these properties is shown in the following table: +Total +Hendry +Polk +Collier +DeSoto +Glades +Charlotte +Hardee +Highlands +Alico Citrus: +Citrus Groves +44,983 +5,485 +6,805 +7,166 +21,186 +— +2,543 +574 +1,224 +Citrus Nursery +22 +— +— +— +22 +— +— +— +— +Total Citrus Groves +45,005 +5,485 +6,805 +7,166 +21,208 +— +2,543 +574 +1,224 +Water Resources and Other Operations +70,322 +66,300 +— +4,022 +— +— +— +— +— +Mining +526 +— +— +— +— +526 +— +— +— +Other +908 +908 +— +— +— +— +— +— +— +Total +116,761 +72,693 +6,805 +11,188 +21,208 +526 +2,543 +574 +1,224 +Approximately 60,000 acres of the properties listed are encumbered by credit agreements totaling approximately $177,000,000 as of September 30, 2018 . For a more detailed description of the credit agreements and collateral please see Note 6. “Long-Term Debt and Lines of Credit” to the Company’s fiscal year 2018 consolidated financial statements. +The Company currently collects mining royalties on approximately 526 acres of land located in Glades County, Florida. These royalties do not represent a significant portion of operating revenues or gross profits. +Item 3. Legal Proceedings +Florida Litigation +On November 16, 2018, 734 Agriculture, RCF 2014 Legacy LLC, Delta Offshore Master II, LTD. and Mr. Remy W. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors, filed a lawsuit against Messrs. George R. Brokaw, Henry R. Slack, W. Andrew Krusen and Greg Eisner, members of the Board of Directors, in the Circuit Court (the “Circuit Court”) for Hillsborough County, Florida (the “Florida Litigation”). The plaintiffs in the Florida Litigation seek, among other things, a declaration that (1) a purported stockholder action by written consent, delivered to the Company in the name of 734 Investors and the plaintiffs in the Florida Litigation on November 11, 2018 (the “Purported Consent”) is valid and binding, (2) the resolutions passed at a meeting of the Board of Directors on November 12, 2018, to, among other things, constitute an ad hoc committee of the Board of Directors to consider, evaluate and make any and all determinations, and to take any and all actions, on behalf of the Board of Directors, in connection with the Purported Consent are null and void and (3) the four defendants in the Florida Litigation were properly removed from the Board of Directors by the Purported Consent. On November 27, 2018, the Circuit Court denied without prejudice plaintiffs’ motion for a temporary restraining order and affirmative injunction restoring Mr. Remy W. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. +On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provides, pending the resolution of the Delaware Litigation (as defined below), that (1) the record date for the Purported Consent is stayed indefinitely, and (2) Mr. Trafelet and the Company’s Board of Directors shall not take any action out of routine day-to-day operations conducted in the ordinary course of business, including any action to change the corporate governance of Alico or removing any corporate officers or directors from positions held as of November 27, 2018. +Due to the inherent uncertainties of litigation, we cannot predict the outcome of the Florida Litigation at this time, and we can give no assurance that the Florida Litigation will not have a material adverse effect on our financial position or results of operations. +Delaware Litigation +On November 20, 2018, members of 734 Investors filed a lawsuit against 734 Agriculture and Mr. Remy W. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors in the Delaware Court of Chancery (the "Delaware Court"), captioned Arlon Valencia Holdings v. Trafelet, C.A. No. 2018-0842-JTL (the “Members’ Delaware Litigation”). The plaintiffs seek, among other things, a declaration that (1) 734 Agriculture was validly replaced as the managing member of 734 Investors pursuant to the Amended and Restated Limited Liability Company Operating Agreement of 734 Investors (the “LLC Agreement”) and the 734 Consent (described above), and (2) the Purported Consent is invalid under the LLC Agreement. +Also on November 20, 2018, 734 Agriculture filed a lawsuit contesting the 734 Consent in the Delaware Court, captioned 734 Agriculture v. Arlon Valencia Holdings, LLC, C.A. No. 2018-0844-JTL (the “734 Delaware Litigation”). On November 27, 2018, the Delaware Court entered a stipulated order consolidating the Members’ Delaware Litigation and the 734 Delaware Litigation into a single lawsuit, captioned In re 734 Investors, LLC Litigation, Consol. C.A. No. 2018-0844-JTL (the consolidated suit, the “Delaware Litigation”). +On December 5, 2018, the Delaware Court entered a stipulated status quo order which provides, among other things, that 734 Agriculture shall serve as the managing member of 734 Investors during the pendency of the Delaware Litigation. The status quo order also provides that 734 Agriculture shall not take any actions outside of the ordinary course of business of 734 Investors without the consent of two-thirds of the membership interests of 734 Investors, including exercising any voting rights with respect to any shares of the Company’s common stock beneficially owned by 734 Investors. +Due to the inherent uncertainties of litigation, we cannot predict the outcome of the Delaware Litigation at this time, and we can give no assurance that Delaware Litigation will not have a material adverse effect on our financial position or results of operations. +From time to time, Alico may be involved in litigation relating to claims arising out of its operations in the normal course of business. There are no current legal proceedings to which the Company is a party to or of which any of its property is subject to that it believes will have a material adverse effect on its financial condition, results of operations or cash flows. +Item 4. Mine Safety Disclosures +Not Applicable. +18 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Common Stock +Our common stock is traded on the Nasdaq Global Market under the symbol ALCO. +Holders +On December 3, 2018 our stock transfer records indicated there were 202 holders of record of our common stock. The number of registered holders includes banks and brokers who act as nominee, each of whom may represent more than one stockholder. +Dividend Policy +The declaration and amount of any actual cash dividend are in the sole discretion of our Board of Directors and are subject to numerous factors that ordinarily affect dividend policy, including the results of our operations and financial position, as well as general economic and business conditions. +The following table presents cash dividends per share of our common stock declared in fiscal years ended September 30, 2018 , 2017 and 2016 : +Declaration Date +Record Date +Payment Date +Per Common Share +December 11, 2015 +December 31, 2015 +January 15, 2016 +$0.06 +March 8, 2016 +March 31, 2016 +April 15, 2016 +$0.06 +May 11, 2016 +June 30, 2016 +July 15, 2016 +$0.06 +September 6, 2016 +September 30, 2016 +October 14, 2016 +$0.06 +November 30, 2016 +December 30, 2016 +January 16, 2017 +$0.06 +February 23, 2017 +March 31, 2017 +April 14, 2017 +$0.06 +May 23, 2017 +June 30, 2017 +July 15, 2017 +$0.06 +September 15, 2017 +September 29, 2017 +October 16, 2017 +$0.06 +November 6, 2017 +December 29, 2017 +January 16, 2018 +$0.06 +March 14, 2018 +March 30, 2018 +April 13, 2018 +$0.06 +June 11, 2018 +June 29, 2018 +July 13, 2018 +$0.06 +September 4, 2018 +September 28, 2018 +October 12, 2018 +$0.06 +19 +Stock Performance Graph +The graph below represents our common stock performance, comparing the value of $100 invested on September 30, 2013 in our common stock, the S&P 500 Index, the S&P Agricultural Products Index and a Company-constructed peer group, which includes Forestar Group, Inc., Limoneira Company, The St. Joe Company, Tejon Ranch Co. and Texas Pacific Land Trust. +INDEXED RETURNS +Base Period Sept 13 +Years Ending +Company Name / Index +Sept 14 +Sept 15 +Sept 16 +Sept 17 +Sept 18 +Alico, Inc. +100 +93.42 +100.04 +66.73 +85.53 +85.33 +S&P 500 Index +100 +119.73 +119.00 +137.36 +162.92 +192.10 +S&P Agricultural Products Index +100 +132.51 +113.95 +131.39 +134.56 +151.60 +Peer Group +100 +117.68 +96.58 +115.42 +155.67 +261.70 +(Includes reinvestment of dividends) +20 +Equity Compensation Arrangements +Effective January 27, 2015, the Board of Directors adopted the 2015 Stock Incentive Plan (the “2015 Plan”) which provides for up to 1,250,000 shares of the Company’s common stock to be available for issuance to provide a long-term incentive plan for officers, employees, directors and/or consultants to directly link incentives to stockholders' value. The 2015 Plan was approved by stockholders in February 2015. The adoption of the 2015 Plan supersedes the 2013 Incentive Equity Plan, which had been in place since April 2013. +The following table illustrates the common shares remaining available for future issuance under the 2015 Plan: +Number of securities to +be issued upon exercise +of outstanding options, +warrants and rights +Weighted-average +exercise price of +outstanding options, +warrants and rights +Number of securities +remaining available for +future issuance under +equity plans +Plan Category: +Equity compensation plans approved by security holders +675,000 +$ +30.02 +557,500 +Equity compensation plans not approved by security holders +— +N/A +— +Total +675,000 +$ +30.02 +557,500 +In November 2017, the Company awarded 5,000 restricted shares to one senior executive under the 2015 Plan. +In September 2018, the Company awarded 300,000 stock options to two senior executives under the 2015 Plan. Additionally, in September 2018, two other senior executives forfeited an aggregate of 375,000 stock options, which were originally issued under the 2015 Plan and no replacement options were granted. +In October 2018, the Company awarded 10,000 stock options to one senior executive under the 2015 Plan. +Recent Sale of Unregistered Securities +None. +Issuer Repurchases of Equity Securities +In fiscal year 2017, Alico's Board of Directors authorized the repurchase of up to $7,000,000 of the Company’s common stock in two separate authorizations (the "2017 Authorization"). In March 2017, Alico's Board of Directors authorized the repurchase of up to $5,000,000 of the Company’s common stock beginning March 9, 2017 and continuing through March 9, 2019. In May 2017, Alico's Board of Directors authorized the repurchase of up to an additional $2,000,000 of the Company’s common stock beginning May 24, 2017 and continuing through May 24, 2019. Alico's share repurchase program does not obligate the Company to repurchase any specific number of shares and may be suspended from time to time or terminated at any time prior to its expiration. There can be no assurance that the Company will repurchase shares in the future in any particular amounts or at all. A reduction in, or elimination of, share repurchases could have a negative effect on the Company's share price. +In fiscal year 2016, Alico's Board of Directors authorized the repurchase of up to 50,000 shares of the Company’s outstanding common stock beginning February 18, 2016 and continuing through February 17, 2017 (the "2016 Authorization"). For the fiscal year ended September 30, 2017, the Company did not purchase any shares in accordance with the 2016 Authorization. +We adopted Rule 10b5-1 share repurchase plan under the Securities Exchange Act of 1934 (the “Plan”) in connection with share repurchase authorizations. The Plan allows us to repurchase our shares of common stock at times when it otherwise might be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. Because repurchases under the Plan are subject to certain pricing parameters, there is no guarantee as to the exact number of common shares that will be repurchased under the Plan or that there will be any repurchases pursuant to the Plan. Subject to applicable regulations, we may elect to amend or cancel the Plan at our discretion. +21 +The following table summarizes our purchases of our common stock by month for the 4 th quarter in fiscal year 2018 under the 2017 Authorization: +Total Number of +Shares Purchased +Average Price +Paid Per Share +Total Shares Purchased As Part of Publicly Announced Plan or Program +Maximum +Number of Shares (or approximate dollar value) +that May Yet Be +Purchased Under the +Plan or Program +Date (month ended): +July 31, 2018 +— +$ +— +— +$1,676,443 +August 31, 2018 +— +$ +— +— +$1,676,443 +September 30, 2018 +— +$ +— +— +$1,676,443 +The Company purchased 72,266 shares of common stock in the open market in fiscal year 2018 under the 2017 Authorization at a weighted average price of $31.27 per common share. +As of June 29, 2018 the Company suspended its stock repurchase activity; however if the Company chooses to resume repurchasing stock it has $1,676,443 available to repurchase stock under the 2017 Authorization. +On September 5, 2018, the Board of Directors approved and Alico announced the commencement of an issuer offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company has elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors, Alico’s largest stockholder since 2013, participated in the Tender Offer and sold a small percentage of its holdings. +Item 6. Selected Financial Data +The following tables present selected historical consolidated financial information as of and for each of the fiscal years in the five-year period ended September 30, 2018 . The Consolidated Financial Statements as of and for the fiscal years ended September 30, 2018 , 2017 , 2016 , 2015 and 2014 include combined financial statement balances with Silver Nip Citrus, as result of our common control acquisition in February 2015. +The selected historical financial data presented below should be reviewed in conjunction with our Consolidated Financial Statements and the accompanying Notes thereto, included elsewhere in this Annual Report on Form 10-K. +22 +(in thousands, except per share amounts) +September 30, +2018 +2017 +2016 +2015 +2014 +Selected Statement of Operations Information: +Operating revenues +$ +81,281 +$ +129,829 +$ +144,196 +$ +153,126 +$ +104,003 +Income (loss) from operations +$ +10,535 +$ +(6,094 +) +$ +21,846 +$ +18,964 +$ +9,383 +Net income (loss) attributable to common stockholders +$ +13,050 +$ +(9,451 +) +$ +6,993 +$ +13,214 +$ +9,495 +Basic earnings (loss) per common share +$ +1.59 +$ +(1.14 +) +$ +0.84 +$ +1.64 +$ +1.29 +Diluted earnings (loss) per common share +$ +1.57 +$ +(1.14 +) +$ +0.84 +$ +1.64 +$ +1.29 +Cash dividends declared per common share +$ +0.24 +$ +0.24 +$ +0.24 +$ +0.24 +$ +0.24 +Selected Balance Sheet Information: +Cash and cash equivalents and restricted cash +$ +32,260 +$ +3,395 +$ +6,625 +$ +5,474 +$ +31,130 +Property and equipment, net +$ +340,403 +$ +349,337 +$ +379,247 +$ +381,099 +$ +142,610 +Total assets +$ +423,422 +$ +419,182 +$ +455,445 +$ +460,088 +$ +273,613 +Current portion of long-term debt +$ +5,275 +$ +4,550 +$ +4,493 +$ +4,511 +$ +3,581 +Long-term debt, net of current portion +$ +169,074 +$ +181,926 +$ +192,726 +$ +200,970 +$ +58,444 +Total Alico, Inc. stockholders' equity +$ +172,117 +$ +160,641 +$ +173,490 +$ +170,704 +$ +162,487 +Noncontrolling interest +$ +5,478 +$ +4,728 +$ +4,773 +$ +4,807 +$ +— +During the fiscal year ended September 30, 2014, net income includes the gain on sale of assets of approximately $7,748,000 related primarily to the Polk and Martin County land sales and a gain on settlement of contingent consideration of $6,000,000. +During the fiscal year ended September 30, 2015, net income includes the gain on sale of assets of approximately $13,590,000 related to the sale of real estate, approximately $8,366,000 of interest expense, approximately $1,051,000 loss on extinguishment of debt related to the refinancing of our debt obligations, approximately $1,145,000 gain on bargain purchase related to acquisition of citrus business and an impairment charge of approximately $541,000 on an asset held for sale. +During the fiscal year ended September 30, 2016, net income includes the gain on sale of assets of approximately $618,000 related to the sale of real estate and approximately $9,893,000 of interest expense. +During the fiscal year ended September 30, 2017, net loss includes inventory casualty loss and net realizable adjustment of approximately $14,688,000 as a result of Hurricane Irma, additional asset impairments of long-lived assets of approximately $9,346,000, and interest expense of approximately $9,141,000. The net loss was partially offset by a gain on sale of assets of approximately $2,181,000. +During the fiscal year ended September 30, 2018, net income includes the gain on sale of assets of approximately $11,041,000 related to the sale of real estate, property and equipment and assets held for sale. Net income also includes insurance proceeds received in the amount of approximately $9,429,000 relating to damages from Hurricane Irma. Additionally, net income includes the offsetting effect of approximately $8,561,000 of interest expense and $3,349,000 of impairments relating to net realizable adjustment on inventory and long-lived assets. +23 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +The following discussion and analysis should be read in conjunction with the accompanying Consolidated Financial Statements and related Notes thereto. +Cautionary Statement Regarding Forward-Looking Information +We provide forward-looking information in this Annual Report on Form 10-K, particularly in this Management’s Discussion and Analysis and Results of Operations, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Any statements in this Annual Report on Form 10-K that are not historical facts are forward-looking statements. These forward-looking statements are based on Alico’s current expectations about future events and can be identified by terms such as “plans,” “expect,” “may,” "anticipate,” “intend,” “should be,” “will be” “is likely to,” “believes,” and similar expressions referring to future periods. Alico believes the expectations reflected in the forward-looking statements are reasonable but cannot guarantee future results, level of activity, performance or achievements. Actual results may differ materially from those expressed or implied in the forward-looking statements. Therefore, Alico cautions you against relying on any of these forward-looking statements. Factors which may cause future outcomes to differ materially from those foreseen in forward-looking statements include, but are not limited to: changes in laws, regulation and rules; weather conditions that affect production, transportation, storage, demand, import and export of fresh product and its by-products, increased pressure from diseases including citrus greening and citrus canker, as well as insects and other pests; disruption of water supplies or changes in water allocations; pricing and supply of raw materials and products; market responses to industry volume pressures; pricing and supply of energy; changes in interest rates; availability of financing for land development activities and other growth opportunities; onetime events; acquisitions and divestitures; seasonality; our ability to achieve the anticipated cost savings under the Alico 2.0 Modernization Program; customer concentration; labor disruptions; inability to pay debt obligations; inability to engage in certain transactions due to restrictive covenants in debt instruments; government restrictions on land use; changes in agricultural land values; market and pricing risks due to concentrated ownership of stock; the Company's receipt of future funding from the state of Florida in connection with water retention projects; any Federal relief received in the future by the Company in connection with Hurricane Irma; any reduction in the public float resulting from the Tender Offer or any subsequent repurchases of common stock by the Company; recent changes in the Equity Plan awards to Employees; continuation of the Company's dividend policy; expressed desire of certain of our stockholders to liquidate their shareholdings by virtue of past market sales of common stock by sales of common stock into the Tender Offer or by way of future transactions; decreased cash availability as a result of closing the Tender Offer and effectuating share repurchases; political changes and economic crises; competitive actions by other companies; changes in dividends; increased competition from international companies; changes in environmental regulations and their impact on farming practices; the land ownership policies of governments, changes in government farm programs and policies, international reaction to such programs, changes in pricing calculations with our customers; fluctuations in the value of the U. S. dollar, interest rates, inflation and deflation rates; changes in and effects of crop insurance programs, global trade agreements, trade restrictions and tariffs; and soil conditions, harvest yields, prices for commodities, and crop production expenses. These assumptions are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements due to numerous factors, including those Risks Factors included in Part I, Item 1A and elsewhere in this Annual Report on Form 10-K. +Introduction +Alico, Inc. (“Alico”), together with its subsidiaries (collectively, the “Company", "we", "us" or "our”), is a holding company with assets and related operations in agriculture, land management and natural resources. We are a Florida agribusiness and land management company with a legacy of achievement and innovation in citrus, cattle and resource conservation. We own approximately 117,000 acres of land in eight Florida counties which includes approximately 90,000 acres of mineral rights. Our principal lines of business are now citrus groves and water storage and other operations, which include environmental services, land leasing and related support operations. Prior to the sale of our breeding herd in January 2018, the Company’s business line also included cattle ranching. Our mission is to create value for our customers and stockholders by managing existing lands to their optimal current income and total returns. Alico opportunistically acquires new agricultural assets and produces high quality agricultural products while exercising responsible environmental stewardship. +Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of results of operations, financial condition and changes in financial condition for the periods presented. This MD&A is organized as follows: +24 +• +Business Overview. This section provides a general description of our business, as well as other matters that we believe are important in understanding our results of operations and financial condition. +• +Consolidated Results of Operations. This section provides an analysis of our results of operations for the three fiscal years ended September 30, 2018 . Our discussion is presented on a consolidated basis and includes discussion on future trends by segment. +• +Liquidity and Capital Resources. This section provides an analysis of our cash flows for the three fiscal years ended September 30, 2018 and our outstanding debt, commitments and cash resources as of September 30, 2018 . +• +Critical Accounting Policies. This section identifies those accounting policies that we consider important to our results of operations and financial condition, require significant judgment and involve significant management estimates. Our significant accounting policies, including those considered to be critical accounting policies, are summarized in Note 2, "Summary of Significant Accounting Policies," to the accompanying Consolidated Financial Statements. +Business Overview +Business Description +The Company generates operating revenues primarily from the sale of its citrus products. Prior to the sale of its breeding herd in January 2018, the Company also generated revenues from its cattle ranching operations. The Company now operates as two segments and substantially all of its operating revenues are generated in the United States. During the fiscal year ended September 30, 2018 , the Company generated operating revenues of approximately $81,281,000 , income from operations of approximately $10,535,000 , and net income attributable to common stockholders of approximately $13,050,000 . Cash provided by operating activities was approximately $19,055,000 during the fiscal year ended September 30, 2018 . +Fiscal Year Highlights and Other Developments +Water Storage Contract Approval +In December 2012, the South Florida Water Management District (“SFWMD” or "District") issued a solicitation request for projects to be considered for the Northern Everglades Payment for Environmental Services Program ("Program"). In March 2013, the Company submitted its response proposing a dispersed water management project on a portion of its ranch land. The environmental services dispersed water management project ("Water Project") encompasses a large-scale water storage/nutrient load reduction project over approximately half of the Company's 72,000-acre ranch located in southern Hendry County. The Water Project has the ability to store/treat retain 94,000-acre feet of water, making it one of the largest private storage projects proposed to date and the largest within the Caloosahatchee River watershed. The Water Project was approved by the South Florida Water Management District in late 2014, and the Company's engineering and environmental consultants immediately began working on a detailed design. As a result of the uniqueness of the project site, which consists of over 11,000 acres of wetlands and several cultural resource sites, considerable effort has been undertaken over the past 3.5 years in securing necessary regulatory approvals for the project from both the State of Florida and the federal government. In addition, the project requires close coordination with adjacent landowners, as well as the water control districts that serve those landowner/properties. On September 29, 2015, the SFWMD amended the contract to extend it for an additional year. In 2016, the Florida Department of Environmental Protection included the project in the State’s Northern Everglades Public-Private Partnership Program. +The contract term is eleven years and allows up to one year for implementation (design, permitting, construction and construction completion certification) and ten years of operation, whereby the Company will provide water retention services. Payment for these services includes an amount not to exceed $4,000,000 of reimbursement for implementation. In addition, the contract provides an annual fixed payment of $12,000,000 for operations and maintenance costs, as long as the project is in compliance with the contract and subject to annual District Board approval of funding. The contract specifies that the District Board has to approve the payments annually through its budget process and there can be no assurance that it will approve the annual fixed payments. The Florida budget for the state’s 2018/2019 fiscal year as approved included Save Our Everglades trust/legacy Florida funding for the Program. On September 19, 2018 the SFWMD issued a press release announcing the issuance of an Environmental Resource Permit for Alico. The SFWMD release also stated that (i) the issuance of the permit cleared the path for Alico to deliver a dispersed water storage project in the Caloosahatchee Watershed, (ii) Alico has all necessary state approvals to proceed, and (iii) the project is expected to be operational within one year from the start of construction, which is contingent on Alico securing additional local and federal approvals. These approvals include a compatible use agreement from the Natural Resources Conservation Service, as well as approvals from the local water control districts. Permitting is currently underway with construction to follow will begin immediately upon receipt of permits. Annual fixed payments will not commence until completion of construction. The Company +25 +anticipates receiving all necessary regulatory approvals within the next four to six months. The Company has not recognized any revenue to date from the contract. Operating expenses were approximately $1,619,000 , $1,794,000 and $2,322,000 for each of the three years ended September 30, 2018 , 2017 and 2016 , respectively. +Tender Offer +On September 5, 2018 the Board of Directors approved and Alico announced the commencement of an issuer tender offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, upon the terms and subject to the conditions described in the Offer to Purchase dated September 5, 2018 Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors LLC, Alico’s largest stockholder since 2013, participated in the Tender Offer and sold a small percentage of its holdings. Members of neither the management team nor the Board of Directors sold any shares directly in the tender offer. +Hurricane Irma +Florida’s citrus industry was hit hard by the recent impacts of Hurricane Irma. Alico’s production was down by approximately 36% from the prior season. While the Company lost a small percentage of trees, the force and duration of the storm impacted the majority of the groves. Based upon prior experience with serious storms of this nature, Alico expects it will take at least two seasons for the groves to recover to pre-hurricane production levels. The Company finished with production of 4,827,000 boxes in fiscal year 2018 and anticipates an increase in production in fiscal year 2019 to 6,300,000-6,600,000 boxes and a return to pre-hurricane production levels by fiscal year 2020, which is approximately 7,900,000. +Through November 30, 2018, the Company received insurance proceeds relating to Hurricane Irma of approximately $477,000 for property and casualty damage claims and approximately $8,952,000 for crop claims, which have been recorded in operating expenses. The Company has additional property and casualty claims outstanding and is awaiting determination of additional proceeds, if any, to be received. +In addition to the commercial insurance claims which have been submitted, the Company may be eligible for Irma federal relief programs distributed by the Farm Service Agency under the 2017 Wildfires and Hurricane Indemnity Program (2017 WHIP) as well as block grants that will be administered through the State of Florida. The specifics of the programs are still being finalized and at this time, the Company cannot determine the amount of federal relief funds which will be received or when these funds will be disbursed. +Alico 2.0 Modernization Program +On November 16, 2017, we announced the Alico 2.0 Modernization Program (“Alico 2.0”). This program is transforming three legacy businesses (Alico, Orange Co., and Silver Nip) into a single efficient enterprise, Alico Citrus, so we will remain one of the leaders in the U.S. citrus industry. This initiative explored every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. +Under this program, we expected to reduce citrus total expenses per acre to $2,164/acre and the cost to produce a pound solid to $1.56 when Alico 2.0 is fully implemented in 2020. These efficiencies are being achieved through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. We have also deployed a more efficient labor model that is consistent and uniform for field staffing and grove operating programs and aligns with the geographical footprint of the citrus groves. +The Company is working to maintain operational efficiencies and deploy its resources to solidify the Company's position as a leader in the recovering citrus industry. +Alico 2.0 also led us to decide to divest assets that generated low rates of return and shut down parts of our operations that were not profitable. Alico Citrus has shut down its nursery in Gainesville, Florida, is in the process of selling its trailers and has either sold or in the process of selling real estate assets that are not strategic to our business plan. +In January 2018, we ceased our direct cattle operations at Alico Ranch. The ranch had been a landholding for us for generations, but, even when profitable, ranch operations generated a minimal rate of return on capital. We continue to own the property and +26 +continue to conduct our long-term water dispersement program and wildlife management programs, and we now lease the ranch to a third-party operator instead of conducting our own cattle operations. All of these decisions enabled additional investment in the citrus business and redeployment of capital elsewhere. +The Company planted over 400,000 trees in fiscal year 2018, to help position the Company for future production growth which is expected to drive growth beyond 2020. The Company believes that its current acreage can produce 10,000,000 boxes per year on a sustained basis, even in an environment where citrus greening continues. +27 +Consolidated Results of Operations +The following discussion provides an analysis of Alico's results of operations and should be read in conjunction with the accompanying Consolidated Statements of Operations for the years ended September 30, 2018 , 2017 and 2016 : +(in thousands) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2018 +2017 +$ +% +2017 +2016 +$ +% +Operating revenues: +Alico Citrus +$ +78,121 +$ +123,441 +$ +(45,320 +) +(36.7 +)% +$ +123,441 +$ +137,282 +$ +(13,841 +) +(10.1 +)% +Water Resources and Other Operations +3,160 +6,388 +(3,228 +) +(50.5 +)% +6,388 +6,914 +(526 +) +(7.6 +)% +Total operating revenues +81,281 +129,829 +(48,548 +) +(37.4 +)% +129,829 +144,196 +(14,367 +) +(10.0 +)% +Gross profit (loss): +Alico Citrus +26,412 +11,494 +14,918 +129.8 +% +11,494 +34,935 +(23,441 +) +(67.1 +)% +Water Resources and Other Operations +(819 +) +(2,564 +) +1,745 +(68.1 +)% +(2,564 +) +124 +(2,688 +) +NM +Total gross profit +25,593 +8,930 +16,663 +186.6 +% +8,930 +35,059 +(26,129 +) +(74.5 +)% +General and administrative expenses +15,058 +15,024 +34 +0.2 +% +15,024 +13,213 +1,811 +13.7 +% +Income (loss) from operations +10,535 +(6,094 +) +16,629 +(272.9 +)% +(6,094 +) +21,846 +(27,940 +) +(127.9 +)% +Total other income (expense), net +2,655 +(7,248 +) +9,903 +(136.6 +)% +(7,248 +) +(9,366 +) +2,118 +(22.6 +)% +Income (loss) before income taxes +13,190 +(13,342 +) +26,532 +(198.9 +)% +(13,342 +) +12,480 +(25,822 +) +(206.9 +)% +Provision (benefit) for income taxes +390 +(3,846 +) +4,236 +(110.1 +)% +(3,846 +) +5,521 +(9,367 +) +(169.7 +)% +Net income (loss) +12,800 +(9,496 +) +22,296 +(234.8 +)% +(9,496 +) +6,959 +(16,455 +) +(236.5 +)% +Net loss attributable to noncontrolling interests +250 +45 +205 +NM +45 +34 +11 +32.4 +% +Net income (loss) attributable to Alico, Inc. common stockholders +$ +13,050 +$ +(9,451 +) +$ +22,501 +(238.1 +)% +$ +(9,451 +) +$ +6,993 +$ +(16,444 +) +(235.1 +)% +NM - Not Meaningful +The following table presents our operating revenues, by segment, as a percentage of total operating revenues for the fiscal years ended September 30, 2018 , 2017 and 2016 : +Fiscal Year Ended +September 30, +2018 +2017 +2016 +Operating revenues: +Alico Citrus +96.1 +% +95.1 +% +95.2 +% +Water Resources and Other Operations +3.9 +% +4.9 +% +4.8 +% +Total operating revenues +100.0 +% +100.0 +% +100.0 +% +28 +The following discussion provides an analysis of the Company's operating segments: +Alico Citrus +The table below presents key operating measures for the fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands, except per box and per pound solids data) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2018 +2017 +Unit +% +2017 +2016 +Unit +% +Operating Revenues: +Early and Mid-Season +$ +24,309 +$ +45,999 +$ +(21,690 +) +(47.2 +)% +$ +45,999 +$ +43,909 +$ +2,090 +4.8 +% +Valencias +48,865 +67,146 +(18,281 +) +(27.2 +)% +67,146 +75,311 +(8,165 +) +(10.8 +)% +Fresh Fruit +2,054 +5,735 +(3,681 +) +(64.2 +)% +5,735 +5,173 +562 +10.9 +% +Purchase and Resale of Fruit +809 +2,331 +(1,522 +) +(65.3 +)% +2,331 +8,188 +(5,857 +) +(71.5 +)% +Other +2,084 +2,230 +(146 +) +(6.5 +)% +2,230 +4,701 +(2,471 +) +(52.6 +)% +Total +$ +78,121 +$ +123,441 +$ +(45,320 +) +(36.7 +)% +$ +123,441 +$ +137,282 +$ +(13,841 +) +(10.1 +)% +Boxes Harvested: +Early and Mid-Season +1,811 +3,215 +(1,404 +) +(43.7 +)% +3,215 +3,634 +(419 +) +(11.5 +)% +Valencias +2,891 +4,044 +(1,153 +) +(28.5 +)% +4,044 +5,195 +(1,151 +) +(22.2 +)% +Total Processed +4,702 +7,259 +(2,557 +) +(35.2 +)% +7,259 +8,829 +(1,570 +) +(17.8 +)% +Fresh Fruit +125 +328 +(203 +) +(61.9 +)% +328 +402 +(74 +) +(18.4 +)% +Total +4,827 +7,587 +(2,760 +) +(36.4 +)% +7,587 +9,231 +(1,644 +) +(17.8 +)% +Pound Solids Produced: +Early and Mid-Season +9,194 +17,950 +(8,756 +) +(48.8 +)% +17,950 +20,167 +(2,217 +) +(11.0 +)% +Valencias +17,319 +24,661 +(7,342 +) +(29.8 +)% +24,661 +31,237 +(6,576 +) +(21.1 +)% +Total +26,513 +42,611 +(16,098 +) +(37.8 +)% +42,611 +51,404 +(8,793 +) +(17.1 +)% +Pound Solids per Box: +Early and Mid-Season +5.07 +5.58 +(0.51 +) +(9.1 +)% +5.58 +5.55 +0.03 +0.5 +% +Valencias +5.99 +6.10 +(0.11 +) +(1.8 +)% +6.10 +6.01 +0.09 +1.5 +% +Price per Pound Solids: +Early and Mid-Season +$ +2.64 +$ +2.56 +$ +0.08 +3.1 +% +$ +2.56 +$ +2.18 +$ +0.38 +17.4 +% +Valencias +$ +2.82 +$ +2.72 +$ +0.10 +3.7 +% +$ +2.72 +$ +2.41 +$ +0.31 +12.9 +% +Price per Box: +Fresh Fruit +$ +16.43 +$ +17.48 +$ +(1.05 +) +(6.0 +)% +$ +17.48 +$ +12.85 +$ +4.63 +36.0 +% +Operating Expenses: +Cost of Sales +$ +46,477 +$ +84,909 +$ +(38,432 +) +(45.3 +)% +$ +84,909 +$ +64,824 +$ +20,085 +31.0 +% +Harvesting and Hauling +12,921 +21,520 +(8,599 +) +(40.0 +)% +21,520 +25,949 +(4,429 +) +(17.1 +)% +Purchase and Resale of Fruit +562 +2,134 +(1,572 +) +(73.7 +)% +2,134 +7,815 +(5,681 +) +(72.7 +)% +Other +(8,251 +) +3,384 +(11,635 +) +(343.8 +)% +3,384 +3,759 +(375 +) +(10.0 +)% +Total +$ +51,709 +$ +111,947 +$ +(60,238 +) +(53.8 +)% +$ +111,947 +$ +102,347 +$ +9,600 +9.4 +% +Gross Profit +$ +26,412 +$ +11,494 +$ +14,918 +$ +11,494 +$ +34,935 +$ +(23,441 +) +Our citrus groves produce the majority of our annual operating revenues and the citrus grove business is seasonal because it is tied to the growing and harvest season. Historically, the second and third quarters of Alico's fiscal year produce the majority of the annual revenues, and working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with the growing cycles. +The Company sells its Early and Mid-Season and Valencia oranges to processors that convert the majority of the citrus crop into orange juice. They generally buy the citrus on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of fruit. Fresh fruit is generally sold to packing houses that purchase the citrus on a per box basis. Other revenues consist of third-party grove caretaking and the purchase and reselling of fruit. +29 +Alico's operating expenses consist primarily of cost of sales and harvesting and hauling costs. Cost of sales represents the cost of maintaining the citrus groves for the preceding calendar year and does not vary in relation to production. Harvesting and hauling costs represent the costs of bringing citrus product to processors and varies based upon the number of boxes produced. Other expenses include the period costs of third-party grove caretaking and the purchase and reselling of fruit. +The decrease in revenues for the fiscal year ended September 30, 2018 , compared to the fiscal year ended September 30, 2017 , was primarily due to the impact of Hurricane Irma. The Company experienced a greater amount of fruit drop from the impact of Hurricane Irma and consequently harvested approximately 2,557,000 fewer processed boxes in fiscal year 2018, as compared to the same period in fiscal year 2017. The Company also saw an overall decrease in pound solids per box which went from 5.87 in the fiscal year ended September 2017 to 5.64 in the fiscal year ended September 30, 2018 . The Company did experience a smaller fruit drop with respect to its Valencia fruit which is harvested later in the year as compared to the Early and Mid-Season variety and as such realized a smaller overall reduction in boxes produced. In addition, the decrease in revenue, to a smaller extent, was due to fewer boxes of fresh fruit being sold for the fiscal year ended September 30, 2018. The decrease in revenues from purchase and resale of fruit and other revenues reflects the Company’s decision to reduce third party fruit purchases and third party caretaking services. +The decrease in revenues for the fiscal year ended September 30, 2017, as compared to the fiscal year ended September 30, 2016, was primarily due to the harvesting of approximately 1,570,000 fewer processed boxes of fruit, partially offset by higher pound solids per box and higher price per pound solids. The decrease in revenues from purchase and resale of fruit and other revenues reflects the Company’s decision to reduce third party fruit purchases and third-party caretaking services. +Total processed boxes harvested in fiscal year 2018 declined by approximately 35.2% , as compared to fiscal year 2017 . Pound solids per box decreased by approximately 9.1% and approximately 1.8% for the Early and Mid-Season and Valencia oranges, respectively. The combination of these items resulted in approximately 16,098,000 less pound solids sold in fiscal year 2018 , as compared to fiscal year 2017 . +Total processed boxes harvested in fiscal year 2017 declined by approximately 17.8% , as compared to fiscal year 2016 . Pound solids per box increased by approximately 0.5% and 1.5% for the Early and Mid-Season and Valencia oranges, respectively, which resulted in approximately 8,793,000 less pound solids sold in fiscal year 2017 , as compared to fiscal year 2016 . +The decline in boxes harvested and pound solids produced for fiscal year 2018, as compared to fiscal year 2017, was primarily driven by the impact of Hurricane Irma, which occurred in September 2017. +The decline in boxes harvested and pound solids produced for fiscal year 2017, as compared to fiscal year 2016, is believed to be mainly driven by growing season fluctuations in production which may have been attributable to various factors, including extreme weather patterns such as a drought and higher than normal temperatures during the Early and Mid-season harvest impacting all varieties. Other factors included changes in weather impacting bloom, horticultural practices, and the effects of diseases and pests, including citrus greening. The industry and the Company both continue to experience premature fruit drop, as well as smaller-sized fruit as a result of the factors described above. +The USDA, in its November 9, 2018 Citrus Crop Forecast for the 2018-19 harvest season, indicated its expectation that the Florida orange crop will increase from approximately 45,000,000 boxes for the 2017-18 crop year to approximately 77,000,000 boxes for the 2018-19 crop year, an increase of approximately 71.1% . The significant increase is the result of 2017-18 harvest season being impacted by Hurricane Irma and the related fruit loss experienced. The 2017-18 Florida orange crop declined by approximately 23,700,000 boxes, or approximately 34.5%, compared to the 2016-17 crop. +The Company originally estimated its fiscal year 2018 processed boxes would decrease by approximately 40-45% compared to processed boxes for fiscal year 2017. Based on the harvesting of fruit, the Company’s actual box production was down approximately 36% . The improvement from these estimates is the result of the Valencia variety fruit experiencing less fruit drop then was anticipated upon making the estimate in production. For the fiscal year 2019, the Company anticipates there will be an increase in processed boxes. +The increase in gross profit for fiscal year 2018, as compared to fiscal year 2017, was primarily driven by a decrease in operating expenses, which was partially offset by a reduction in revenues. The decrease in operating costs is due to (i) the Company allocating a smaller amount of its accumulated costs to its cost of goods sold, (ii) less harvesting cost incurred due to fewer boxes being harvested, and (iii) the Company receiving approximately $9,429,000 of insurance proceeds. Partially offsetting this decrease in operating expenses, along with the reduction in revenue, was impairment charges of approximately $3,349,000 relating to net realizable adjustment on inventory and long-lived assets. The decrease in revenue is primarily a result of the impact of Hurricane Irma. +30 +The decrease in gross profit for fiscal year 2017, as compared to fiscal year 2016, related primarily to decreased revenues of approximately $13,841,000 discussed above, and the recording of an inventory casualty loss of approximately $13,489,000 relating to fruit loss as a result of Hurricane Irma. +In November 2017, the Company announced Alico 2.0. This initiative explored every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. As previously mentioned, under this program the Company expects to reduce total expenses per acre to $2,164/acre when Alico 2.0 is fully implemented over the next two years. Overall, the program should reduce the Company’s cost to produce a pound solid from $2.14 to $1.56. This efficiency is being achieved through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. The Company will also deploy a more efficient labor model that is consistent and uniform for field staffing and grove operating programs, and aligns with the geographical footprint of the citrus groves. However, there can be no assurance that the anticipated cost savings will be realized under Alico 2.0. +Water Resources and Other Operations +The table below presents key operating measures for the fiscal years ended September 30, 2018 , 2017 and 2016: +(in thousands) +Fiscal Year Ended September 30, +Change +Fiscal Year Ended September 30, +Change +2018 +2017 +$ +% +2017 +2016 +$ +% +Revenue From: +Land and other leasing +$ +2,872 +$ +2,294 +$ +578 +25.2 +% +$ +2,294 +$ +2,097 +$ +197 +9.4 +% +Sale of Calves and Culls +57 +3,732 +(3,675 +) +(98.5 +)% +3,732 +4,604 +(872 +) +(18.9 +)% +Other +231 +362 +(131 +) +(36.2 +)% +362 +213 +149 +70.0 +% +Total +$ +3,160 +$ +6,388 +$ +(3,228 +) +(50.5 +)% +$ +6,388 +$ +6,914 +$ +(526 +) +(7.6 +)% +Operating Expenses: +Land and other leasing +$ +1,072 +$ +466 +$ +606 +130.0 +% +$ +466 +$ +695 +$ +(229 +) +(32.9 +)% +Sale of Calves and Culls +1,075 +3,527 +(2,452 +) +(69.5 +)% +3,527 +3,694 +(167 +) +(4.5 +)% +Water Conservation +1,619 +1,794 +(175 +) +(9.8 +)% +1,794 +2,322 +(528 +) +(22.7 +)% +Other +213 +3,165 +(2,952 +) +(93.3 +)% +3,165 +79 +3,086 +NM +Total +$ +3,979 +$ +8,952 +$ +(4,973 +) +(55.6 +)% +$ +8,952 +$ +6,790 +$ +2,162 +31.8 +% +Gross Profit +$ +(819 +) +$ +(2,564 +) +$ +1,745 +(68.1 +)% +$ +(2,564 +) +$ +124 +$ +(2,688 +) +NM +NM - Not Meaningful +Land and other leasing include lease income from a lease for grazing rights, a lease to a third party of an aggregate mine and leases of oil extraction rights to third parties, farm lease revenue, the generation of revenues from sod and tree sales and rental income for office space. +The decrease in revenues from Water Resources and Other Operations is primarily due to selling of Alico's cattle herd in January 2018. All inventory costs that were accumulated at the date of sale were expensed. As part of this transaction, the Company entered into a long-term leasing arrangement with the purchaser for the grazing rights on the Ranch that provides an annual revenue stream of approximately $1,200,000. The Company continues to own the property and continues to conduct its long-term water dispersement program and wildlife management programs. As a result of these changes, Alico renamed this division to Alico Water Resources to reflect its focus on water storage and nutrient reduction. Alico believes that its dispersed water storage project is the largest and most cost-effective project of its kind in the United States, and believes, once permits from state and federal agencies have been approved, the project will store and prevent large volumes of water from entering the Caloosahatchee River, will remove substantial amounts of nitrogen from the watershed, and will help to rehydrate natural systems that eventually flow south into the Everglades. +31 +The decrease in revenues from the sale of calves and culls in fiscal year 2017, as compared to fiscal year 2016, is primarily due to a decrease in price per pound. The decrease in gross profit for fiscal year 2017, as compared to fiscal year 2016, relates primarily to certain impairments which were recorded on assets associated with the Ranch. +Water storage and conservation +In December 2012, the South Florida Water Management District ("SFWMD") issued a solicitation request for projects to be considered for the Northern Everglades Payment for Environmental Services Program. In March 2013, the Company submitted its response proposing a dispersed water management project on a portion of its ranch land. +On December 11, 2014, the SFWMD approved a contract with the Company. The contract term is eleven years and allows up to one year for implementation (design, permitting, construction and construction completion certification) and ten years of operation, whereby the Company will provide water retention services. Payment for these services includes an amount not to exceed $4,000,000 of reimbursement for implementation. In addition, it provides for an annual fixed payment of $12,000,000 for operations and maintenance costs, as long as the project is in compliance with the contract and subject to annual District Board approval of funding. The contract specifies that the District Board has to approve the payments annually and there can be no assurance that it will approve the annual fixed payments. The approved Florida budget for the state’s 2018/2019 fiscal year included funding for the Program, and on September 19, 2018 the SFWMD issued a press release announcing the issuance of an Environmental Resource Permit for Alico. The SFWMD release also stated that (i) the issuance of the permit cleared the path for Alico to deliver a dispersed water storage project in the Caloosahatchee Watershed, (ii) Alico has all necessary state approvals to proceed, and (iii) the project is expected to be operational within one year from the start of construction, which is contingent on Alico securing additional local and federal approvals. These approvals include a compatible use agreement from the Natural Resources Conservation Service, as well as approvals from the local water control districts. Operating expenses were approximately $1,619,000 , $1,794,000 , and $2,322,000 for each of the three years ended September 30, 2018 , 2017 and 2016 , respectively. +During fiscal year 2017, Alico recorded an impairment of two abandoned mines in the amount of approximately $3,165,000 based on independent third-party assessments, and the Company's decision to not pursue a Natural Resource business initiative. +General and Administrative +General and administrative expenses for the fiscal year ended September 30, 2018 was approximately $15,058,000 , compared to approximately $15,024,000 for the fiscal year ended September 30, 2017 . +The slight increase in general and administrative expenses in fiscal year 2018, as compared to the same period in fiscal year 2017, primarily relates to increases in bonus awards provided to senior executives and managers, an acceleration of stock compensation expense as a result of two senior executives forfeiting a portion of their stock options, costs related to the Tender Offer which commenced in September 2018 and an increase in rent, which commenced October 30, 2017, as a result of the Company selling its office building in Fort Myers, FL, and leasing back a portion of the space. These items resulted in an aggregate increase in general and administrative expenses of approximately $2,700,000. These increases were offset by decreases primarily attributable to salary and stock compensation expenses incurred with respect to employment agreements executed for new executives in the fiscal year 2017 which did not occur in the fiscal year 2018, a reduction of expenses incurred relating to separation and consulting arrangements, as well as a reduction in bad debt expense and recruiting fees. +The increase in general and administrative expenses in fiscal year 2017, as compared to fiscal year ended 2016, primarily relates to salary and stock compensation expenses incurred with respect to employment agreements executed for new executives during the year. In addition, the Company also entered into a separation and consulting agreement with a departing executive. These items resulted in an increase of approximately $2,100,000 over the prior year. See Note 15. “Related Party Transactions” in the Notes to the Consolidated Financial Statements for further discussion. Also, the Company wrote off certain advances made related to excavating work in the amount of approximately $312,000. +32 +Other Income (Expense), net +Other income (expense), net, for the fiscal year ended September 30, 2018 and 2017 was approximately $2,655,000 and approximately $(7,248,000) , respectively. The shift from other expense, net to other income, net is primarily due to recording a higher gain on sale of real estate, property and equipment and assets held for sale. For the fiscal year ended September 30, 2018, the Company sold certain properties and equipment which included its corporate office building in Fort Myers, Florida, its Gal Hog property and a land parcel within its East Ranch resulting in gains of approximately $1,751,000, $6,709,000 and $1,759,000, respectively. During the fiscal year ended September 30, 2017, the Company sold land and facilities in Hendry County, Florida, which resulted in a gain of approximately $1,371,000. Additionally, the Company incurred less interest expense of approximately $580,000 due to the continued pay-down of its long-term debt, as well as a prepayment made on a loan of approximately $4,453,000 with the proceeds from the asset sales. +Other expense, decreased by approximately $2,118,000 in fiscal year 2017, as compared to fiscal year 2016, primarily due to an increase in gain on sale of real estate of $1,563,000 and a decrease in interest expense of $752,000. During the fiscal year 2017, the Company sold land and facilities located in Hendry County, Florida which resulted in a gain on sale of approximately $1,371,000. The decrease in interest expense is due to the Company continuing to pay down its term loan, which was partially offset by an increase in interest rates. +Provision (benefit) for Income Taxes +For the fiscal years ended September 30, 2018 , 2017 and 2016 , the provision (benefit) for income taxes was approximately $390,000 , $(3,846,000) , and $5,521,000 , respectively, and the related effective income tax rates were approximately 2.96%, 28.83% and 44.20%, respectively. The change in the provision for income taxes for the fiscal year ended September 30, 2018, as compared to fiscal year 2017, primarily resulted from (i) the Company generating net income, (ii) a one-time non-cash deferred income tax benefit of approximately $9,847,000 resulting from the remeasurement of the Company's net deferred tax liabilities due to the 21% corporate tax rate that was enacted December 22, 2017, and (iii) a valuation allowance on its capital loss carryforward, which expired at September 30, 2018, of approximately $5,634,000, resulting in an additional income tax expense. The changes in the provision for income taxes for the fiscal year ended September 30, 2017, as compared to the fiscal year 2016, was primarily related to changes in taxable income (loss). +Seasonality +Historically, the second and third quarters of Alico's fiscal year produce the majority of its annual revenue. Working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with harvesting cycles. However, in the fiscal year 2018, due to the impact of Hurricane Irma, the boxes were harvested earlier in the season than normal and therefore the Company realized a greater amount of revenue in the first two quarters of fiscal year 2018. As a result, the working capital requirements varied from the typical trends it has historically experienced in past years. The Company anticipates the historic seasonality it has experienced will return in fiscal year 2019. +Because of the seasonality of the business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year. +33 +Liquidity and Capital Resources +A comparative balance sheet summary is presented in the following table: +(in thousands) +September 30, +2018 +2017 +Change +Cash and cash equivalents and restricted cash +$ +32,260 +$ +3,395 +$ +28,865 +Total current assets +$ +72,240 +$ +66,489 +$ +5,751 +Total current liabilities +$ +21,498 +$ +15,983 +$ +5,515 +Working capital +$ +50,742 +$ +50,506 +$ +236 +Total assets +$ +423,422 +$ +419,182 +$ +4,240 +Term loans and line of credit +$ +177,034 +$ +186,476 +$ +(9,442 +) +Current ratio +3.36 to 1 +4.16 to 1 +Alico's business has historically generated positive net cash flows from operating activities. Sources of cash primarily include cash flows from operations, sales of under-performing land and other assets, amounts available under the Company's credit facilities and access to capital markets. Access to additional borrowings under revolving lines of credit is subject to the satisfaction of customary borrowing conditions. As a public company, Alico may have access to other sources of capital. However, access to, and availability of, financing on acceptable terms in the future will be affected by many factors, including (i) financial condition, prospects and credit rating, (ii) liquidity of the overall capital markets and (iii) the state of the economy. There can be no assurance that the Company will continue to have access to the capital markets on acceptable terms, or at all. +The principal uses of cash that affect Alico's liquidity position include the following: operating expenses including employee costs, the cost of maintaining the citrus groves, harvesting and hauling of citrus products, capital expenditures, stock repurchases, dividends, and debt service costs including interest and principal payments on term loans and other credit facilities. +Management believes that a combination of cash-on-hand, cash generated from operations and availability under the Company's lines of credit will provide sufficient liquidity to service the principal and interest payments on its indebtedness and will satisfy working capital requirements and capital expenditures for at least the next twelve months and over the long term. Alico has a $70,000,000 working capital line of credit, of which approximately $57,015,000 is available for general use as of September 30, 2018 , and a $25,000,000 revolving line of credit, of which $25,000,000 is available for general use as of September 30, 2018 (see Note 6. “Long-Term Debt and Lines of Credit" to the accompanying Consolidated Financial Statements). If the Company pursues significant growth opportunities in the future, it could have a material adverse impact on its cash balances and may need to finance such activities by drawing funds from its lines of credit or by obtaining additional debt or equity financing. There can be no assurance that additional financing will be available to the Company when needed or, if available, that it can be obtained on commercially reasonable terms. Any inability to obtain additional financing could impact Alico's ability to pursue different growth opportunities. +Alico's level of debt could have important consequences on its business, including, but not limited to, increasing vulnerability to general adverse economic and industry conditions, limiting cash flow availability to fund future investments, capital expenditures, working capital, business activities and other general corporate requirements and limiting flexibility in planning for, or reacting to, changes in the business and the industry in which the Company operates. +Cash Management Impacts +Cash and cash equivalents and restricted cash increased approximately $28,865,000 as of September 30, 2018 , as compared to September 30, 2017 . Cash and cash equivalents decreased by approximately $3,230,000 as of September 30, 2017 , as compared to September 30, 2016 . The components of these changes are discussed below. +34 +Consolidated Statements of Cash Flows +The following table details the items contributing to the changes in cash and cash equivalents and restricted cash for fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands) +Fiscal Year Ended September 30, +% Change +2018 +2017 +2016 +2018 vs 2017 +2017 vs 2016 +Net cash provided by operating activities +$ +19,055 +$ +28,229 +$ +30,357 +(32.5 +)% +(7.0 +)% +Net cash provided by (used in) investing activities +22,447 +(10,085 +) +(13,034 +) +(322.6 +)% +(22.6 +)% +Net cash used in financing activities +(12,637 +) +(21,374 +) +(16,172 +) +(40.9 +)% +32.2 +% +Net increase (decrease) in cash and cash equivalents and restricted cash +$ +28,865 +$ +(3,230 +) +$ +1,151 +Net Cash Provided By Operating Activities +The following table details the items contributing to Net Cash Provided by Operating Activities for the fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands) +Fiscal Year Ended September 30, +Fiscal Year Ended September 30, +2018 +2017 +Change +2017 +2016 +Change +Net income (loss) +$ +12,800 +$ +(9,496 +) +$ +22,296 +$ +(9,496 +) +$ +6,959 +$ +(16,455 +) +Gain on sale of sugarcane land +(967 +) +(538 +) +(429 +) +(538 +) +(618 +) +80 +Depreciation, depletion and amortization +13,756 +15,226 +(1,470 +) +15,226 +15,382 +(156 +) +Loss on breeding herd sales +13 +337 +(324 +) +337 +296 +41 +Deferred income tax (benefit) expense +(1,955 +) +(3,948 +) +1,993 +(3,948 +) +5,277 +(9,225 +) +Cash surrender value +(27 +) +(15 +) +(12 +) +(15 +) +(20 +) +5 +Deferred retirement benefits +(41 +) +(102 +) +61 +(102 +) +65 +(167 +) +Magnolia Fund undistributed (earnings) loss +(8 +) +202 +(210 +) +202 +103 +99 +(Gain) loss on sale of real estate, property and equipment and assets held for sale +(10,281 +) +(1,373 +) +(8,908 +) +(1,373 +) +147 +(1,520 +) +Inventory casualty loss +— +13,489 +(13,489 +) +13,489 +— +13,489 +Inventory net realizable value adjustment +1,115 +1,199 +(84 +) +1,199 +— +1,199 +Impairment of long-lived assets and assets held for sale +2,234 +9,346 +(7,112 +) +9,346 +— +9,346 +Loss on disposal of property and equipment +207 +— +207 +— +— +— +Non-cash interest expense on deferred gain on sugarcane land +1,361 +1,413 +(52 +) +1,413 +1,406 +7 +Bad debt expense +24 +312 +(288 +) +312 +— +312 +Stock-based compensation expense +2,613 +1,653 +960 +1,653 +924 +729 +Other, including working capital changes +(1,789 +) +524 +(2,313 +) +524 +436 +88 +Net cash provided by operating activities +$ +19,055 +$ +28,229 +$ +(9,174 +) +$ +28,229 +$ +30,357 +$ +(2,128 +) +The decrease in net cash provided by operating activities for the fiscal year ended September 30, 2018, as compared to the same period in the fiscal year 2017, was primarily due to the effect of the Company recognizing a greater gain on the sale of real estate, property and equipment and assets held for sale as a result of the Company’s decision to divest itself from several non-core and underperforming assets during the fiscal year 2018. Additionally, the Company experienced a decrease in working capital as +35 +compared to the previous fiscal year. This is primarily the result of the Company having a smaller increase in accounts receivable due to lower revenues earned, and experiencing a smaller decrease in inventory levels due the Company taking an impairment on its inventory levels at September 30, 2017, which directly impacted the change for the fiscal year ended September 30, 2018. This decrease was partially offset by an increase in net income. +The decrease in net cash provided by operating activities for the fiscal year ended September 30, 2017 compared to the fiscal year ended September 30, 2016 was primarily due to a decrease in net income and deferred tax expense and was substantially offset by the Company recording an inventory casualty loss, which was the direct result of Hurricane Irma, and other impairments recorded on certain assets held for sale and other fixed assets (see Note 3. “Inventories” in the Notes the Consolidated Financial Statements for further discussion on inventory casualty loss). +Net Cash Provided By (Used In) Investing Activities +The following table details the items contributing to Net Cash Provided By (Used In) Investing Activities for the fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands) +Fiscal Year Ended September 30, +Fiscal Year Ended September 30, +2018 +2017 +Change +2017 +2016 +Change +Capital expenditures +$ +(16,352 +) +$ +(13,353 +) +$ +(2,999 +) +$ +(13,353 +) +$ +(14,305 +) +$ +952 +Net proceeds from sale of real estate, property and equipment and assets held for sale +39,780 +2,944 +36,836 +2,944 +799 +2,145 +Other +(981 +) +324 +(1,305 +) +324 +472 +(148 +) +Net cash provided by (used in) investing activities +$ +22,447 +$ +(10,085 +) +$ +32,532 +$ +(10,085 +) +$ +(13,034 +) +$ +2,949 +The increase in net cash provided by (used in) investing activities for the fiscal year ended September 30, 2018, as compared to the fiscal year ended September 30, 2017, was primarily due to proceeds received from the sale of certain assets during the fiscal year 2018. This increase was partially offset by greater capital expenditures in the fiscal year 2018, as compared to the same period in the prior year, as a result of the Company’s decision to plant more trees. +The decrease in net cash used in investing activities for the fiscal year ended September 30, 2017, as compared to the fiscal year ended September 30, 2016, was primarily due to proceeds from the sale of land and facilities located in Hendry County, Florida of approximately $2,200,000. This was partially offset by the reduction of capital expenditures of approximately $1,000,000. +36 +Net Cash Used In Financing Activities +The following table details the items contributing to Net Cash Used In Financing Activities for the fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands) +Fiscal Year Ended September 30, +Fiscal Year Ended September 30, +2018 +2017 +Change +2017 +2016 +Change +Proceeds from term loans +$ +— +$ +— +$ +— +$ +— +$ +2,500 +$ +(2,500 +) +Principal payments on revolving line of credit +(25,600 +) +(70,770 +) +45,170 +(70,770 +) +(53,882 +) +(16,888 +) +Borrowings on revolving line of credit +28,285 +65,770 +(37,485 +) +65,770 +58,882 +6,888 +Principal payments on term loans +(12,127 +) +(10,743 +) +(1,384 +) +(10,743 +) +(10,761 +) +18 +Contingent consideration paid +— +— +— +— +(7,500 +) +7,500 +Treasury stock purchases +(2,215 +) +(3,064 +) +849 +(3,064 +) +(3,141 +) +77 +Dividends paid +(1,972 +) +(1,987 +) +15 +(1,987 +) +(1,993 +) +6 +Capital contribution received from noncontrolling interest +1,000 +— +1,000 +— +— +— +Capital lease obligation principal payments +(8 +) +(580 +) +572 +(580 +) +(277 +) +(303 +) +Net cash used in financing activities +$ +(12,637 +) +$ +(21,374 +) +$ +8,737 +$ +(21,374 +) +$ +(16,172 +) +$ +(5,202 +) +The decrease in net cash used in financing activities for the fiscal year ended September 30, 2018, as compared to the fiscal year ended September 30, 2017, was primarily due to decreased repayments on the revolving line of credit, which was partially offset by less borrowings being made on the revolving lines of credit. Additionally, greater principal payments were made on the term loans of approximately $4,453,000 from a portion of the proceeds from the sale of assets, which was offset by the Company electing not to make its scheduled principal payment on certain other term loans for the first and second quarter of fiscal year 2018 of approximately $3,100,000, as it utilized its prepayment to satisfy its payment requirement. +The increase in net cash used in financing activities for the fiscal year ended September 30, 2017, as compared to the fiscal year ended September 30, 2016, was primarily a result of the Company paying down, on a net basis, its revolving line of credit during fiscal year ended September 2017, while during the fiscal year ended September 30, 2016 the Company drew cash, on a net basis, under its revolving line of credit. This decrease was partially offset as a result of the Company paying a $7,500,000 contingent consideration relating to the acquisition of Orange-Co during the fiscal year ended September 30, 2016. +The Company had $2,685,000 of outstanding amounts due under its revolving credit lines at September 30, 2018. With respect to the WCLC line of credit agreement with Rabo Agrifinance, Inc. (“Rabo”), the Company executed an amendment to extend the due date to November 1, 2021. +On October 3, 2018, the Company completed a tender offer of 752,234 shares at a price of $34.00 per share aggregating a cash utilization of $25,575,956. +The WCLC agreement provides for Rabo to issue up to $20,000,000 in letters of credit on the Company’s behalf. As of September 30, 2018, there was approximately $10,300,000 in outstanding letters of credit, which correspondingly reduced Alico's availability under the line of credit. +During the next twelve months the Company anticipates it will make capital expenditures of approximately $16,000,000 - $17,000,000. The majority of these capital expenditures are expected to primarily relate to the purchasing and planting of additional trees. +Contractual Obligations and Off Balance Sheet Arrangements +Alico has various contractual obligations which are fixed and determinable. The following table presents the Company's significant contractual obligations and commercial commitments on an undiscounted basis as of September 30, 2018 and the future periods in which such obligations are expected to be settled in cash. +37 +(in thousands) +Payments Due by Period +Total +<1 Year +1-3 Years +3-5 Years +5+ Years +Long-Term Debt +$ +177,034 +$ +5,275 +$ +25,953 +$ +24,195 +$ +121,611 +Interest on Long-Term Debt +53,195 +7,290 +12,784 +10,689 +22,432 +Retirement Benefits +5,739 +345 +5,394 +— +— +Consulting/Non-Compete Agreement +25 +25 +— +— +— +Operating Leases +843 +319 +335 +189 +— +Tree Purchase Commitments +2,161 +2,161 +— +— +— +Total +$ +238,997 +$ +15,415 +$ +44,466 +$ +35,073 +$ +144,043 +Purchase Commitments +Alico, through its wholly owned subsidiary Alico Fruit Company, previously entered into contracts for the purchase of citrus fruit during the normal course of its business. These obligations were typically covered by sales agreements. Alico Fruit Company is no longer engaged in contracted purchase and resale of fruit and there were no obligations outstanding at September 30, 2018 . +Alico enters into fruit marketing agreements to purchase fruit from certain third party growers as well as contracting caretaking services to these growers. These obligations are typically covered by sales and caretaking agreements. +During the fiscal year 2018, the Company entered into contracts to purchase citrus trees, which are anticipated to be delivered in fiscal year 2019. As of September 30, 2018, the Company had approximately $2,161,000 of outstanding commitments for these purchases that are to be paid upon delivery of the citrus trees. +Critical Accounting Policies +Alico's Consolidated Financial Statements are prepared in accordance with U.S. GAAP, which requires management to make estimates, judgments and assumptions that affect the amounts reported in those financial statements and accompanying notes. Management considers an accounting policy to be critical if it is important to the Company's financial condition and results of operations and if it requires significant judgment and estimates on the part of management in its application. Alico considers policies relating to the following matters to be critical accounting policies: +Revenue Recognition +Revenues from agricultural crops are recognized at the time the crop is harvested and delivered to the customer. The Company recognizes revenues from cattle sales at the time the cattle are delivered. Management reviews the reasonableness of the revenue accruals quarterly based on buyers’ and processors’ advances to growers, cash and futures markets and experience in the industry. Adjustments are made throughout the fiscal year to these estimates as more current relevant industry information becomes available. Differences between the estimates and the final realization of revenues can be significant and can be either positive or negative. During the periods presented in this Annual Report on Form 10-K, no material adjustments were made to the reported revenues from our crops. +Alico Fruit Company ("AFC") operations primarily consist of providing supply chain management services to Alico, as well as to other citrus growers in the state of Florida. AFC also purchases and resells citrus fruit; in these transactions, AFC (i) acts as a principal; (ii) takes title to the products; and (iii) has the risks and rewards of ownership, including the risk of loss for collection, delivery or returns. Therefore, AFC recognizes revenues based on the gross amounts due from customers for its marketing activities. Supply chain management service revenues are recognized when the services are performed. +Inventories +The costs of growing crops, including but not limited to labor, fertilization, fuel, crop nutrition and irrigation, are capitalized into inventory throughout the respective crop year. Such costs are expensed as cost of sales when the crops are harvested and are recorded as operating expenses in the Consolidated Statements of Operations. Inventories are stated at the lower of cost or net realizable value. The cost for unharvested citrus crops is based on accumulated production costs incurred during the period from +38 +January 1 through the balance sheet date. The cost of the beef cattle inventory is based on the accumulated cost of developing such animals for sale from July 1 through the balance sheet date. +Property and Equipment +Property and equipment are stated at cost, net of accumulated depreciation and amortization. Major improvements are capitalized while maintenance and repairs are expensed in the period the cost is incurred. Costs related to the development of citrus groves, through planting of trees, are capitalized. Such costs include land clearing, excavation and construction of ditches, dikes, roads and reservoirs among other costs. After the planting, caretaking costs or pre-productive maintenance costs are capitalized for four years. After four years, a grove is considered to have reached maturity and the accumulated costs are depreciated over 25 years, except for land clearing and excavation, which are considered costs of land and not depreciated. +The breeding herd consisted of purchased animals and animals raised on the Company’s ranches. Purchased animals were stated at the cost of acquisition. The cost of animals raised on the ranch was based on the accumulated cost of developing such animals for productive use. The breeding herd was sold in January 2018. +Income Taxes +The Company uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statements and the income tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates on deferred income tax assets and liabilities is recognized in income or loss in the period that includes the enactment date. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on the Company’s income tax provision and net income or loss in the period the determination is made. As of September 30, 2018 and 2017 , the Company did not record a valuation allowance on deferred tax assets. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. +The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which a change in judgment occurs. The Company records interest related to unrecognized tax benefits in income tax expense. +Impairment of Long-Lived Assets +The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company records impairment losses on long-lived assets used in operations, other than goodwill, when events and circumstances indicate that the asset or asset group might be impaired and the estimated cash flows (undiscounted and without interest charges) to be generated by those assets or asset group over the remaining lives of the assets are less than the carrying amounts of those assets. In calculating impairments and the estimated cash flows, the Company assigns its asset groups by determining the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other Company assets. The net carrying values of assets or asset groups not recoverable are reduced to their fair values. Our cash flow estimates are based on historical results adjusted to reflect our best estimates of future market conditions and operating conditions. As of September 30, 2018 and 2017 , long-lived assets were comprised of property and equipment. +Fair Value Measurements +The carrying amounts in the balance sheets for operating accounts receivable, accounts payable and accrued liabilities approximate fair value because of the immediate or short term maturity of these items. The carrying amounts reported for our long-term debt approximates fair value as our borrowings with commercial lenders are at interest rates that vary with market conditions and fixed rates that approximate market rates for comparable loans. +Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Assets and liabilities measured at fair value are categorized into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Assets and liabilities +39 +are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows: +Level 1- Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities. +Level 2- Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly. +Level 3- Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date. +Impact of Accounting Pronouncements +See Item 8. "Financial Statements and Supplemental Data" - Note 1. "Description of Business and Basis of Presentation" for additional information about the impact of accounting pronouncements. +Subsequent Events +Termination Proceedings against Mr. Remy W. Trafelet +On November 19, 2018, Alico, with unanimous approval of the members of the Board of Directors, other than Remy W. Trafelet, notified Mr. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors, that it intends to consider terminating his employment for “cause” pursuant to the terms of his employment agreement with the Company and option agreements entered into under the Company's Stock Incentive Plan of 2015 (collectively, the “Compensation Documents”). +As required by the Compensation Documents, the Company will schedule a special meeting of the Board of Directors at a future date, at which meeting Mr. Trafelet and his counsel (if he so elects) may meet with the Board of Directors to address this matter. The Board of Directors will make its final determination as to Mr. Trafelet’s employment following such meeting. Mr. Trafelet has been placed on paid administrative leave pending the outcome of these proceedings. On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provides, among other things, that pending the resolution of the Delaware Litigation, the Board of Directors shall not take any action out of the routine day-to-day operations conducted in the ordinary course of business, including removing any corporate officers or directors from positions held as of November 27, 2018. For more information, see Item 3, "Legal Proceedings." +Appointment of Interim President +In connection with the commencement of the termination proceedings against Mr. Trafelet, Benjamin D. Fishman, a current member of the Board of Directors, was appointed to serve as Interim President of the Company, effective as of November 19, 2018. Henry R. Slack, the Company's Executive Chairman, and Mr. Fishman will manage the Company during the pendency of the termination proceedings. Neither Mr. Slack nor Mr. Fishman will receive any incremental compensation for their service during this period. In connection with assuming such interim role, Mr. Fishman has stepped down from the Audit Committee of the Board of Directors, and Mr. Andrew Krusen has assumed the Chairmanship of the Audit Committee. +40 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +Market Risk - Market risk represents the potential loss resulting from adverse changes in the value of financial instruments, either derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates, commodity prices, and equity security prices. The Company handles market risks in accordance with its established policies; however, Alico does not enter into derivatives or other financial instruments for trading or speculative purposes. The Company does consider, on occasion, the need to enter into financial instruments to manage and reduce the impact of changes in interest rates; however, the Company entered into no such instruments during the three-year period ended September 30, 2018 . The Company held various financial instruments as of September 30, 2018 and 2017 , consisting of financial assets and liabilities reported in the Company’s Consolidated Balance Sheets and off-balance sheet exposures resulting from letters of credit issued for the benefit of Alico. +Interest Rate Risk - The Company is subject to interest rate risk from the utilization of financial instruments such as term loan debt and other borrowings. The Company’s primary long-term obligations are fixed rate debts subject to fair value risk due to interest rate fluctuations. The Company believes that the carrying value of our long-term debt approximates fair value given the stability of market interest rates. +The Company is also subject to interest rate risk on its variable rate debt. A one-percentage-point increase in prevailing interest rates would have increased interest expense on our variable rate debt obligations by approximately $598,000 for the fiscal year ended September 30, 2018 . +Foreign-Exchange Rate Risk - The Company currently has no exposure to foreign-exchange rate risk because all of its financial transactions are denominated in U.S. dollars. +Commodity Price Risk - The Company has no financial instruments subject to commodity price risk. +Equity Security Price Risk - None of the Company’s financial instruments have potential exposure to equity security price risk. +41 +Item 8. Financial Statements and Supplementary Data +Index to Consolidated Financial Statements +Page +Report of Independent Registered Public Accounting Firm +43 +Consolidated Financial Statements: +Consolidated Balance Sheets +45 +Consolidated Statements of Operations +46 +Consolidated Statements of Changes in Equity +47 +Consolidated Statements of Cash Flows +48 +Notes to Consolidated Financial Statements +50 +All schedules are omitted for the reason that they are not applicable or the required information is included in the financial statements or notes. +42 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Alico, Inc. +Opinions on the Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Alico, Inc. and subsidiaries (the Company) as of September 30, 2018 and 2017 , and the related consolidated statements of operations, changes in equity and cash flows for each of the three years in the period ended September 30, 2018 , and the related notes (collectively, the financial statements). We also have audited the Company’s internal control over financial reporting as of September 30, 2018 , based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 30, 2018 and 2017 , and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2018 , in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2018 , based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. +Basis for Opinions +The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding +43 +prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ RSM US LLP +We have served as the Company's auditor since 2007. +Orlando, Florida +December 6, 2018 +44 +ALICO, INC. +CONSOLIDATED BALANCE SHEETS +(in thousands, except share amounts) +September 30, +2018 +2017 +ASSETS +Current assets: +Cash and cash equivalents +$ +25,260 +$ +3,395 +Accounts receivable, net +2,544 +4,286 +Inventories +41,033 +36,204 +Assets held for sale +1,391 +20,983 +Prepaid expenses and other current assets +2,012 +1,621 +Total current assets +72,240 +66,489 +Restricted cash +7,000 +— +Property and equipment, net +340,403 +349,337 +Goodwill +2,246 +2,246 +Deferred financing costs, net of accumulated amortization +136 +262 +Other non-current assets +1,397 +848 +Total assets +$ +423,422 +$ +419,182 +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable +$ +3,764 +$ +3,192 +Accrued liabilities +9,226 +6,781 +Income taxes payable +2,320 +— +Long-term debt, current portion +5,275 +4,550 +Other current liabilities +913 +1,460 +Total current liabilities +21,498 +15,983 +Long-term debt: +Principal +169,074 +181,926 +Less: deferred financing costs, net +(1,563 +) +(1,767 +) +Long-term debt less deferred financing costs, net +167,511 +180,159 +Lines of credit +2,685 +— +Deferred income tax liability +25,153 +27,108 +Deferred gain on sale +24,928 +26,440 +Deferred retirement obligations, net of current portion +4,052 +4,123 +Total liabilities +245,827 +253,813 +Commitments and Contingencies (Note 16) +Stockholders' equity: +Preferred stock, no par value, 1,000,000 shares authorized; none issued +— +— +Common stock, $1.00 par value, 15,000,000 shares authorized; 8,416,145 and 8,416,145 shares issued and 8,199,957 and 8,238,830 shares outstanding at September 30, 2018 and 2017, respectively +8,416 +8,416 +Additional paid in capital +20,126 +18,694 +Treasury stock, at cost, 216,188 and 177,315 shares held at September 30, 2018 and 2017, respectively +(7,536 +) +(6,502 +) +Retained earnings +151,111 +140,033 +Total Alico stockholders' equity +172,117 +160,641 +Noncontrolling interest +5,478 +4,728 +Total stockholders' equity +177,595 +165,369 +Total liabilities and stockholders' equity +$ +423,422 +$ +419,182 +See accompanying notes to the Consolidated Financial Statements. +45 +ALICO, INC. +CONSOLIDATED STATEMENTS OF OPERATIONS +(in thousands, except per share amounts) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Operating revenues: +Alico Citrus +$ +78,121 +$ +123,441 +$ +137,282 +Water Resources and Other Operations +3,160 +6,388 +6,914 +Total operating revenues +81,281 +129,829 +144,196 +Operating expenses: +Alico Citrus +51,709 +111,947 +102,347 +Water Resources and Other Operations +3,979 +8,952 +6,790 +Total operating expenses +55,688 +120,899 +109,137 +Gross profit +25,593 +8,930 +35,059 +General and administrative expenses +15,058 +15,024 +13,213 +Income (loss) from operations +10,535 +(6,094 +) +21,846 +Other income (expense): +Investment and interest (loss) income, net +39 +(148 +) +— +Interest expense +(8,561 +) +(9,141 +) +(9,893 +) +Gain on sale of real estate, property and equipment and assets held for sale +11,041 +2,181 +618 +Other income (expense), net +136 +(140 +) +(91 +) +Total other income (expense), net +2,655 +(7,248 +) +(9,366 +) +Income (loss) before income taxes +13,190 +(13,342 +) +12,480 +Provision (benefit) for income taxes +390 +(3,846 +) +5,521 +Net income (loss) +12,800 +(9,496 +) +6,959 +Net loss attributable to noncontrolling interests +250 +45 +34 +Net income (loss) attributable to Alico, Inc. common stockholders +$ +13,050 +$ +(9,451 +) +$ +6,993 +Per share information attributable to Alico, Inc. common stockholders: +Earnings (loss) per common share: +Basic +$ +1.59 +$ +(1.14 +) +$ +0.84 +Diluted +$ +1.57 +$ +(1.14 +) +$ +0.84 +Weighted-average number of common shares outstanding: +Basic +8,232 +8,300 +8,303 +Diluted +8,301 +8,300 +8,311 +Cash dividends declared per common share +$ +0.24 +$ +0.24 +$ +0.24 +See accompanying notes to the Consolidated Financial Statements . +46 +ALICO, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +(in thousands) +Common Stock +Additional Paid In Capital +Treasury Stock +Retained Earnings +Total Alico, Inc. Equity +Noncontrolling Interest +Total Equity +Shares +Amount +Balance at September 30, 2015 +8,416 +$ +8,416 +$ +19,795 +$ +(3,962 +) +$ +146,455 +$ +170,704 +$ +4,807 +$ +175,511 +Net income (loss) +— +— +— +— +6,993 +6,993 +(34 +) +6,959 +Dividends +— +— +— +— +(1,990 +) +(1,990 +) +— +(1,990 +) +Treasury stock purchases +— +— +— +(3,141 +) +— +(3,141 +) +— +(3,141 +) +Contingent consideration +— +— +(1,483 +) +1,483 +— +— +— +— +Stock-based compensation: +Directors +— +— +(307 +) +1,035 +46 +774 +— +774 +Executives +— +— +150 +— +— +150 +— +150 +Balance at September 30, 2016 +8,416 +8,416 +18,155 +(4,585 +) +151,504 +173,490 +4,773 +178,263 +Net loss +— +— +— +— +(9,451 +) +(9,451 +) +(45 +) +(9,496 +) +Dividends +— +— +— +— +(1,987 +) +(1,987 +) +— +(1,987 +) +Treasury stock purchases +— +— +— +(3,064 +) +— +(3,064 +) +— +(3,064 +) +Stock-based compensation: +Directors +— +— +(374 +) +1,147 +— +773 +— +773 +Executives +— +— +880 +— +— +880 +— +880 +Other +— +— +33 +— +(33 +) +— +— +— +Balance at September 30, 2017 +8,416 +8,416 +18,694 +(6,502 +) +140,033 +160,641 +4,728 +165,369 +Net income (loss) +— +— +— +— +13,050 +13,050 +(250 +) +12,800 +Dividends +— +— +— +— +(1,972 +) +(1,972 +) +— +(1,972 +) +Treasury stock purchases +— +— +— +(2,215 +) +— +(2,215 +) +— +(2,215 +) +Capital contribution received from noncontrolling interest funding +— +— +— +— +— +— +1,000 +1,000 +Stock-based compensation: +Directors +— +— +(322 +) +1,181 +— +859 +— +859 +Executives +— +— +1,754 +— +— +1,754 +— +1,754 +Balance at September 30, 2018 +8,416 +$ +8,416 +$ +20,126 +$ +(7,536 +) +$ +151,111 +$ +172,117 +$ +5,478 +$ +177,595 +See accompanying notes to Consolidated Financial Statements. +47 +ALICO, INC. +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Cash flows from operating activities: +Net income (loss) +$ +12,800 +$ +(9,496 +) +$ +6,959 +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Gain on sale of sugarcane land +(967 +) +(538 +) +(618 +) +Depreciation, depletion and amortization +13,756 +15,226 +15,382 +Loss on breeding herd sales +13 +337 +296 +Deferred income tax (benefit) expense +(1,955 +) +(3,948 +) +5,277 +Cash surrender value +(27 +) +(15 +) +(20 +) +Deferred retirement benefits +(41 +) +(102 +) +65 +Magnolia Fund undistributed (earnings) loss +(8 +) +202 +103 +(Gain) loss on sale of real estate, property and equipment and assets held for sale +(10,281 +) +(1,373 +) +147 +Inventory casualty loss +— +13,489 +— +Inventory net realizable value adjustment +1,115 +1,199 +— +Impairment of long-lived assets and assets held for sale +2,234 +9,346 +— +Loss on disposal of property and equipment +207 +— +— +Non-cash interest expense on deferred gain on sugarcane land +1,361 +1,413 +1,406 +Bad debt expense +24 +312 +— +Stock-based compensation expense +2,613 +1,653 +924 +Changes in operating assets and liabilities: +Accounts receivable +1,718 +142 +(1,707 +) +Inventories +(6,554 +) +3,724 +(196 +) +Prepaid expenses +177 +(604 +) +(1,758 +) +Income tax receivable +(15 +) +1,013 +1,074 +Other assets +23 +333 +821 +Accounts payable and accrued expenses +2,987 +(2,895 +) +3,720 +Income tax payable +2,320 +— +— +Other liabilities +(2,445 +) +(1,189 +) +(1,518 +) +Net cash provided by operating activities +$ +19,055 +$ +28,229 +$ +30,357 +Cash flows from investing activities: +Purchases of property and equipment +$ +(16,352 +) +$ +(13,353 +) +$ +(14,305 +) +Return on investment in Magnolia Fund +25 +324 +171 +Net proceeds from sales of property and equipment and assets held for sale +37,969 +760 +799 +Proceeds from surrender of life insurance policies +— +— +297 +Net proceeds from sales of real estate +1,811 +2,184 +— +Deposit on purchase of citrus trees +(431 +) +— +— +Notes receivable +(575 +) +— +— +Other +— +— +4 +Net cash provided by (used in) investing activities +$ +22,447 +$ +(10,085 +) +$ +(13,034 +) +48 +Fiscal Year Ended September 30, +2018 +2017 +2016 +Cash flows from financing activities: +Proceeds from term loans +$ +— +$ +— +$ +2,500 +Principal payments on revolving line of credit +(25,600 +) +(70,770 +) +(53,882 +) +Borrowings on revolving line of credit +28,285 +65,770 +58,882 +Principal payments on term loans +(12,127 +) +(10,743 +) +(10,761 +) +Contingent consideration paid +— +— +(7,500 +) +Treasury stock purchases +(2,215 +) +(3,064 +) +(3,141 +) +Dividends paid +(1,972 +) +(1,987 +) +(1,993 +) +Capital contribution received from noncontrolling interest +1,000 +— +— +Capital lease obligation principal payments +(8 +) +(580 +) +(277 +) +Net cash used in financing activities +$ +(12,637 +) +$ +(21,374 +) +$ +(16,172 +) +Net increase (decrease) in cash and cash equivalents and restricted cash +$ +28,865 +$ +(3,230 +) +$ +1,151 +Cash and cash equivalents and restricted cash at beginning of the year +3,395 +6,625 +5,474 +Cash and cash equivalents and restricted cash at end of the year +$ +32,260 +$ +3,395 +$ +6,625 +Supplemental disclosure of cash flow information: +Cash paid for interest, net of amount capitalized +$ +7,654 +$ +7,534 +$ +7,530 +Cash paid (refunded) for income taxes, net of income tax +$ +25 +$ +(911 +) +$ +(878 +) +Supplemental disclosure of non-cash investing and financing activities: +Dividend declared but unpaid +$ +492 +$ +494 +$ +498 +See accompanying notes to the Consolidated Financial Statements. +49 +ALICO, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +September 30, 2018 , 2017 and 2016 +Note 1. Description of Business and Basis of Presentation +Description of Business +Alico, Inc. (“Alico”), together with its subsidiaries (collectively, the “Company", "we", "us" or "our”), is a Florida agribusiness and land management company owning approximately 117,000 acres of land throughout Florida, including approximately 90,000 acres of mineral rights. The Company manages its land based upon its primary usage, and reviews its performance based upon two primary classifications - Alico Citrus and Water Resources and Other Operations . Financial results are presented based upon its two business segments ( Alico Citrus and Water Resources and Other Operations ). +Basis of Presentation +The Company has prepared the accompanying financial statements on a consolidated basis. These accompanying Consolidated Financial Statements, which are referred to herein as the “Financial Statements”, have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). All significant intercompany transactions and account balances between the consolidated businesses have been eliminated. +Segments +Operating segments are defined in the criteria established under the Financial Accounting Standards Board - Accounting Standards Codification (“FASB ASC”) Topic 280 as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: Alico Citrus and Water Resources and Other Operations . As a result of the sale of the Company’s breeding herd in January 2018, the Company is no longer in the cattle ranching business and has revised its reportable segments to most accurately reflect the current operations and the information regularly reviewed by the CODM. The segment data for all prior periods disclosed have been presented on the same basis as the current fiscal year. +Principles of Consolidation +The Financial Statements include the accounts of Alico, Inc. and the accounts of all the subsidiaries in which a controlling interest is held by the Company. Under U.S. GAAP, consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. The Company’s subsidiaries include: Alico Land Development, Inc., Alico-Agri, Ltd., Alico Plant World, LLC, Alico Fruit Company, LLC, Alico Citrus Nursery, LLC, Alico Chemical Sales, LLC, 734 Citrus Holdings LLC and subsidiaries, Alico Fresh Fruit LLC, Alico Skink Mitigation, LLC and Citree Holdings 1, LLC. The Company considers the criteria established under FASB ASC Topic 810, “Consolidations” in its consolidation process. All significant intercompany balances and transactions have been eliminated in consolidation. +Use of Estimates +The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the accompanying Financial Statements, the disclosure of contingent assets and liabilities in the Financial Statements and the accompanying Notes, and the reported amounts of revenues and expenses and cash flows during the periods presented. Actual results could differ from those estimates based upon future events. The Company evaluates estimates on an ongoing basis. The estimates are based on current and expected economic conditions, historical experience, the experience and judgment of the Company’s management and various other specific assumptions that the Company believes to be reasonable. The Company may employ outside experts to assist in the Company’s evaluations. +Noncontrolling Interest in Consolidated Affiliate +The Financial Statements include all assets and liabilities of the less-than- 100% -owned affiliate the Company controls, Citree Holdings I, LLC (“Citree”). Accordingly, the Company has recorded a noncontrolling interest in the equity of such entity. Citree +50 +had net losses of $511,854 , $91,432 , and $69,230 for the fiscal years ended September 30, 2018 , 2017 , and 2016 , respectively, of which $261,046 , $46,630 , and $35,307 was attributable to the Company for the fiscal years ended September 30, 2018 , 2017 , and 2016 , respectively. +Recent Accounting Pronouncements +In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, and has subsequently issued several supplemental and/or clarifying ASU’s (collectively, “ASC 606”), which prescribes a comprehensive new revenue recognition standard that supersedes previously existing revenue recognition guidance. The new model provides a five-step analysis in determining when and how revenue is recognized. The core principle of the new guidance is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also requires new, expanded disclosures regarding revenue recognition. The standard allows initial application to be performed retrospectively to each period presented or as a modified retrospective adjustment as of the date of adoption. ASC 606, also provides for certain practical expedients, including the option to expense as incurred the incremental costs of obtaining a contract, if the contract period is for one year or less, and policy elections regarding shipping and handling that provides the option to account for shipping and handling costs as contract fulfillment costs. +The Company adopted ASC 606 effective October 1, 2018, the first day of our 2019 fiscal year, using the modified retrospective method. The implementation of ASC 606 did not require an adjustment to the opening balance of retained earnings as of October 1, 2018. +The adoption of this ASU will result in increased disclosure, including qualitative and quantitative disclosures about the nature, amount timing and uncertainty of revenue and cash flows arising from contracts with customers. +In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)." This guidance will require entities that enter into leases as a lessee to recognize right-of-use assets and lease liabilities for those leases classified as operating leases under previous GAAP. The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. The Company is currently evaluating the impact this guidance will have on our Financial Statements, and it will become effective for Alico October 1, 2019. +In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230).” This ASU will provide guidance on the presentation and classification of specific cash flow items to improve consistency within the statement of cash flows. This ASU is effective for the Company for our fiscal year beginning October 1, 2018. Although permitted, the Company did not choose to elect early adoption. This ASU would impact the Company by requiring certain proceeds from insurance claims relating to property and crop damage to be reported in the statement of cash flows from investing activities in the Consolidated Statement of Cash Flows. +In October 2016, the FASB issued ASU 2016-16, “Intra-Entity Transfers of Assets Other Than Inventory” (ASC Topic 740, Income Taxes), which will require an entity to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. This ASU is effective for the Company on October 1, 2018. This guidance is not expected to have a significant impact on our Financial Statements. +In January 2017, the FASB issued ASU 2017-04, “Intangibles-Goodwill and Other” (Topic 350) which simplifies the accounting for goodwill impairment. The updated guidance eliminates Step 2 of the impairment test, which requires entities to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value, determined in Step 1. This guidance will become effective for us in fiscal years beginning after December 15, 2019, including interim periods within those reporting periods. We will adopt this guidance using a prospective approach. Earlier adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. We are currently evaluating the impact on our consolidated financial statements. +In February 2017, the FASB issued ASU 2017-05, “Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets" (Subtopic 610-20): The ASU clarifies that ASC 610-20 applies to the derecognition of nonfinancial assets and in substance nonfinancial assets unless other specific guidance applies. As a result, it will not apply to the derecognition of businesses, nonprofit activities, or financial assets (including equity method investments), or to contracts with customers. The ASU also clarifies that an in substance nonfinancial asset is an asset or group of assets for which substantially all of the fair value consists of nonfinancial assets and the group or subsidiary is not a business. +In addition, transfers of nonfinancial assets to another entity in exchange for a noncontrolling ownership interest in that entity will be accounted for under ASC 610-20, removing specific guidance on such partial exchanges from ASC 845, Nonmonetary +51 +Transactions . +As a result of the ASU, guidance specific to real estate sales in ASC 360-20 will be eliminated. As such, sales and partial sales of real estate assets will now be subject to the same derecognition model as all other nonfinancial assets. +The ASU will also impact the accounting for partial sales of nonfinancial assets (including in substance real estate). When an entity transfers its controlling interest in a nonfinancial asset, but retains a noncontrolling ownership interest, the entity will measure the retained interest at fair value. This will result in full gain/loss recognition upon the sale of a controlling interest in a nonfinancial asset. Current guidance generally prohibits gain recognition on the retained interest. +The ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those years and thus is effective for the Company for our fiscal year beginning October 1, 2018. The ASU will be applied prospectively to any transaction occurring from the date of adoption. The Company continues to evaluate the impact that the adoption of this ASU might have on our consolidated financial statements as it relates to the deferred gain on the sale of the Company’s sugarcane lands (see Note 8. “Deferred Gain on Sale”). +In May 2017, the FASB issued ASU 2017-09, “Compensation-Stock Compensation” (Topic 718) which clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. ASU 2017-09 will reduce diversity in practice and result in fewer changes to the terms of an award being accounted for as modifications. Under ASU 2017-09, an entity will not apply modification accounting to a share-based payment award if the award's fair value, vesting conditions and classification as an equity or liability instrument are the same immediately before and after the change. ASU 2017-09 will be applied prospectively to awards modified on or after the adoption date. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017 and thus is effective for the Company for our fiscal year beginning October 1, 2018. We do not expect this new guidance to have a material impact on our consolidated financial statements. +In May 2017, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash” which clarifies the diversity in the classification and presentation of changes in restricted cash on the statement of cash flows under Topic 230, Statement of Cash Flows. Under ASU 2016-18, an entity will be required within the statement of cash flows to explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017 and thus is effective for the Company for our fiscal year beginning October 1, 2018. Early adoption is permitted and the Company, as such, has adopted this guidance as of September 30, 2018. +The Company has reviewed other recently issued accounting standards which have not yet been adopted in order to determine their potential effect, if any, on the results of operations or financial condition. Based on the review of these other recently issued standards, the Company does not currently believe that any of those accounting pronouncements will have a significant effect on its current or future financial position, results of operations, cash flows or disclosures. +Reclassifications +Certain prior year amounts have been reclassified in the accompanying Financial Statements for consistent presentation to the current period. These reclassifications had no impact on net income, equity, cash flows or working capital as previously reported. +Seasonality +The Company is primarily engaged in the production of fruit for sale to citrus markets, which is of a seasonal nature, and subject to the influence of natural phenomena and wide price fluctuations. Historically, the second and third quarters of our fiscal year generally produce the majority of our annual revenue, and working capital requirements are typically greater in the first and fourth quarters of the fiscal year. The results of the reported periods herein are not necessarily indicative of the results for any other interim periods or the entire fiscal year. +52 +Note 2. Summary of Significant Accounting Policies +Business Combinations +The Company accounts for its business acquisitions under the acquisition method of accounting as indicated in FASB ASC 805, “Business Combinations”, which requires the acquiring entity in a business combination to recognize the fair value of all assets acquired, liabilities assumed and any noncontrolling interest in the acquiree, and establishes the acquisition date as the fair value measurement point. Accordingly, the Company recognizes assets acquired and liabilities assumed in business combinations, including contingent assets and liabilities and noncontrolling interest in the acquiree, based on fair value estimates as of the date of acquisition. In accordance with FASB ASC 805, the Company recognizes and measures goodwill, if any, as of the acquisition date, as the excess of the fair value of the consideration paid over the fair value of the identified net assets acquired. +When Alico acquires a business from an entity under common control, whereby the companies are ultimately controlled by the same party or parties both before and after the transaction, it is treated similar to the pooling of interests method of accounting. The assets and liabilities are recorded at the transferring entity’s historical cost instead of reflecting the fair value of assets and liabilities. +Revenue Recognition +Revenues from agricultural crops are recognized at the time the crop is harvested and delivered to the customer. Receivables from crops sold are recorded for the estimated proceeds to be received from the customer. On a quarterly basis, management reviews the reasonableness of the revenues accrued based on buyers’ and processors’ advances to growers, cash and futures markets and experience in the industry. Adjustments are made throughout the year to these estimates as more current relevant industry information becomes available. Differences between the estimates and the final realization of revenues can be significant and can be either an increase or decrease to reported revenues. During the periods presented in this report, no material adjustments were made to the reported revenues of the Company’s crops. +During the time that Alico was engaged in the business of raising and selling cattle, Alico recognized revenues from cattle sales at the time the cattle were delivered. +Alico Fruit Company, LLC ("AFC") operations primarily consist of providing supply chain management services to Alico, as well as to other citrus growers and processors in the state of Florida. AFC also purchases and resells citrus fruit; in these transactions, AFC (i) acts as a principal; (ii) takes title to the products; and (iii) has the risks and rewards of ownership, including the risk of loss for collection, delivery or returns. Therefore, AFC recognizes revenues based on the gross amounts due from customers for its marketing activities. Supply chain management services revenues are recognized when the services are performed. +Fair Value of Financial Instruments +The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities approximate their fair values due to the short term and immediate nature of these financial instruments. The carrying amounts of our debt approximates fair value as the debt is with commercial lenders at interest rates that vary with market conditions or have fixed rates that approximate market rates for obligations with similar terms and maturities (see Note 9. “Fair Value Measurements”). +Cash and Cash Equivalents +The Company considers cash in banks and highly liquid instruments with an original maturity of three months or less to be cash and cash equivalents. At various times throughout the fiscal year, and as of September 30, 2018 , some accounts held at financial institutions were in excess of the federally insured limit of $250,000. The Company has not experienced any losses on these accounts and believes credit risk to be minimal. +Restricted Cash +Restricted cash is comprised of cash received from the sale of certain assets in which the use of funds is restricted. For certain sale transactions, the Company sells property which serves as collateral for specific debt obligations. As a result, the sale proceeds can only be used to purchase like-kind citrus groves which is acceptable to the debt holder. If the restricted cash is not used for such purchases within a twelve month period, it will be used to pay down principal on Company debt. Based on the contractual uses of restricted cash, these amounts have been classified as non-current. +53 +Accounts receivable +Accounts receivable from customers are generated from revenues based on the sale of citrus, cattle, leasing and other transactions. The Company grants credit in the course of its operations to third party customers. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company provides an allowance for doubtful accounts for amounts which are not probable of collection. The estimate, evaluated quarterly by the Company, is based on historical collection experience, current macroeconomic climate and market conditions and a review of the current status of each customer’s account. Changes in the financial viability of significant customers and worsening of economic conditions may require changes to its estimate of the recoverability of the receivables. Such changes in estimates are recorded in the period in which these changes become known. The allowance for doubtful accounts is included in general and administrative expenses in the Consolidated Statements of Operations. +The following table presents accounts receivable, net as of September 30, 2018 and 2017 : +(in thousands) +September 30, +2018 +2017 +Accounts receivable +$ +2,577 +$ +4,314 +Allowance for doubtful accounts +(33 +) +(28 +) +Accounts receivable, net +$ +2,544 +$ +4,286 +Concentrations +Accounts receivable from the Company’s major customers as of September 30, 2018 and 2017 and revenue from such customers for the fiscal years ended September 30, 2018 , 2017 and 2016 , are as follows: +(in thousands) +Accounts Receivable +Revenue +% of Total Revenue +2018 +2017 +2018 +2017 +2016 +2018 +2017 +2016 +Tropicana +$ +1,797 +$ +2,506 +$ +70,396 +$ +111,197 +$ +46,898 +86.6 +% +85.6 +% +32.5 +% +Cutrale Citrus Juice +$ +— +$ +— +$ +— +$ +1,364 +$ +22,735 +— +% +1.1 +% +15.8 +% +Minute Maid +$ +— +$ +— +$ +— +$ +— +$ +49,271 +— +% +— +% +34.2 +% +The citrus industry is subject to various factors over which growers have limited or no control, including weather conditions, disease, pestilence, water supply and market price fluctuations. Market prices are highly sensitive to aggregate domestic and foreign crop sizes, as well as factors including, but not limited to, weather and competition from foreign countries. +Real Estate +In recognizing revenues from land sales, the Company applies specific revenue recognition criteria, in accordance with U.S. GAAP, to determine when land sales revenues can be recorded. For example, in order to fully recognize a gain resulting from a real estate transaction, the sale must be consummated with a sufficient down payment of at least 20% to 25% of the sales price depending upon the type and timeframe for development of the property sold and any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold. When these criteria are not met, the Company recognizes a gain proportionate to collections utilizing either the installment method or deposit method as appropriate. +Inventories +The costs of growing crops, including but not limited to labor, fertilization, fuel, crop nutrition and irrigation, are capitalized into inventory throughout the respective crop year. Such costs are expensed as cost of sales when the crops are harvested and are recorded as operating expenses in the Consolidated Statements of Operations. Inventories are stated at the lower of cost or net realizable value. The cost for unharvested citrus crops is based on accumulated production costs incurred during the period from January 1 through the balance sheet date. The cost of the beef cattle inventory was based on the accumulated cost of developing such animals for sale from July 1 through the balance sheet date (see Note 3. “Inventories”). The breeding herd was sold in January 2018 (see Note 4. “Assets Held For Sale”). +54 +Property and Equipment +Property and equipment are stated at cost, net of accumulated depreciation, depletion and amortization. Major improvements are capitalized while expenditures for maintenance and repairs are expensed when incurred. Costs related to the development of citrus groves through planting of trees are capitalized. Such costs include land clearing, excavation and construction of ditches, dikes, roads, and reservoirs, among other costs. After the planting, caretaking costs or pre-productive maintenance costs are capitalized for four years. After four years, a planting is considered to have reached maturity and the accumulated costs are depreciated over 25 years, except for land clearing and excavation, which are considered costs of land and not depreciated. +The breeding herd consisted of purchased animals and animals raised on the Company’s ranches. Purchased animals were stated at the cost of acquisition. The cost of animals raised on the ranch was based on the accumulated cost of developing such animals for productive use. The breeding herd was sold in January 2018 (see Note 4. “Assets Held For Sale”). +Real estate costs incurred for the acquisition, development and construction of real estate projects are capitalized. +Depreciation is provided on a straight-line basis over the estimated useful lives of the depreciable assets, with the exception of leasehold improvements and assets acquired through capital leases, which are depreciated over their estimated useful lives if the lease transfers ownership or contains a bargain purchase option, otherwise the term of the lease. +The estimated useful lives for property and equipment are primarily as follows: +Citrus trees +25 years +Equipment and other facilities +3-20 years +Buildings and improvements +25-39 years +Changes in circumstances, such as technological advances or changes to our business model or capital strategy could result in the actual useful lives differing from the original estimates. In those cases where the Company determines that the useful life of property and equipment should be shortened, Alico depreciates the asset over its revised estimated remaining useful life, thereby increasing depreciation expense (see Note 5. “Property and Equipment, Net”). +Impairment of Long-Lived Assets +The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company records impairment losses on long-lived assets used in operations, or asset group, when events and circumstances indicate that the assets might be impaired and the estimated cash flows (undiscounted and without interest charges) to be generated by those assets or asset group over the remaining lives of the assets or asset group are less than the carrying amounts of those assets. In calculating impairments and the estimated cash flows, the Company assigns its asset groups by determining the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other Company assets. The net carrying values of assets or asset group not recoverable are reduced to their fair values. Alico's cash flow estimates are based on historical results adjusted to reflect best estimates of future market conditions and operating conditions. As of September 30, 2018 and 2017, the Company recorded impairments to its long-lived assets (see Note 5. “Property and Equipment, Net”). As of September 30, 2018 and 2017 , long-lived assets were comprised of property and equipment. +Goodwill and Intangible Assets +Goodwill represents the excess of the purchase price of acquired businesses over the fair value of the assets acquired less liabilities assumed in connection with such acquisition. In accordance with the provisions of ASC 350, Intangibles-Goodwill and Other, goodwill and intangible assets with indefinite useful lives acquired in an acquisition are not amortized, but instead are tested for impairment at least annually, on the same date, or more frequently should an event occur or circumstances indicate that the carrying amount may be impaired. Such events or circumstances may be a significant change in business climate, economic and industry trends, legal factors, negative operating performance indicators, significant competition, changes in strategy or disposition of a reporting unit or a portion thereof. +In the evaluation of goodwill for impairment, Alico has the option to perform a qualitative assessment to determine whether further impairment testing is necessary or to perform a quantitative assessment by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Under the qualitative assessment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. If, under +55 +the quantitative assessment, the fair value of a reporting unit is less than its carrying amount, then the amount of the impairment loss, if any, must be measured under step two of the impairment analysis. In step two of the analysis, Alico would record an impairment loss equal to the excess of the carrying value of the reporting unit’s goodwill over its implied fair value, should such a circumstance arise. As of September 30, 2018 and 2017 , no impairment was required. +Other Non-Current Assets +Other non-current assets primarily include investments owned in agricultural cooperatives, cash surrender value on life insurance and equity investment in affiliate (Magnolia). Investments in stock related to agricultural cooperatives are carried at cost. +Income Taxes +The Company uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statements and the income tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates on deferred income tax assets and liabilities is recognized in income or loss in the period that includes the enactment date. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on the Company’s income tax provision and net income or loss in the period the determination is made. For the fiscal year ended September 30, 2018 and 2017, the Company recorded a valuation allowances of $5,634,000 and $581,000 , respectively, relating to the unutilized capital loss carryforwards which expired. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. +The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which a change in judgment occurs. The Company records interest related to unrecognized tax benefits in income tax expense. +Earnings per Share +Basic earnings per share for our common stock is calculated by dividing net income attributable to Alico common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per common share is similarly calculated, except that the calculation includes the dilutive effect of the assumed issuance of shares of common stock issuable under equity-based compensation plans in accordance with the treasury stock method, or any other type of securities convertible into common stock, except where the inclusion of such common shares would have an anti-dilutive effect. +The following table presents a reconciliation of basic to diluted weighted average common shares outstanding for fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Weighted Average Common Shares Outstanding - Basic +8,232 +8,300 +8,303 +Effect of dilutive securities - stock options and unrestricted stock +69 +— +8 +Weighted Average Common Shares Outstanding - Diluted +8,301 +8,300 +8,311 +For the fiscal years ended September 30, 2018 and 2017 , the Company issued 300,000 and 750,000 , respectively, stock options to certain executives of the Company. There were no employee stock options granted for the fiscal year ended September 30, 2016 . Non-vested restricted shares of common stock entitle the holder to receive non-forfeitable dividends upon issuance and are included in the calculation of diluted earnings per common share. For the fiscal year ended September 30, 2018 , the Company had certain stock options that were excluded from the diluted earnings per share because they were anti-dilutive. For the fiscal year ended September 30, 2016, there were no anti-dilutive equity awards or convertible securities that were excluded from the calculation of diluted earnings per common share. +56 +Stock-Based Compensation +Stock-based compensation is measured based on the fair value of the equity award at the grant date and is typically expensed on a straight-line basis over the vesting period. Upon the vesting of restricted stock, the Company issues common stock from common shares held in treasury. +Total stock-based compensation expense for the three years ended September 30, 2018 in general and administrative expense was as follows: +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Stock compensation expense: +Executives +$ +1,754 +$ +880 +$ +150 +Board of Directors +859 +773 +774 +Total stock compensation expense +$ +2,613 +$ +1,653 +$ +924 +Equity Method Investments and Variable Interest Entities +The Company evaluates the method of accounting for investments in which it does not hold an equity interest of at least 50% based on the amount of control it exercises over the operations of the investee, exposure to losses in excess of its investment, the ability to significantly influence the investee and whether the Company is the primary beneficiary of the investee. Investments not qualifying for consolidation are accounted for under the equity method whereby the ongoing investment in the entity, consisting of its initial investment adjusted for distributions, gains and losses of the entity are classified as a single line in the balance sheet and as a non-operating item in the statements of operation. +In May 2010, the Company invested $12,150,000 to obtain a 39% limited partner equity interest in Magnolia TC 2, LLC (“Magnolia”), a Florida limited liability company whose primary business activity is acquiring tax certificates issued by various counties in the state of Florida on properties which have property tax delinquencies. Revenues are recognized by Magnolia when the interest obligation under the tax certificates it holds becomes a fixed amount. In order to redeem a tax certificate in Florida, a minimum of 5% of the face amount of the certificate (delinquent taxes) must be paid to the certificate holder regardless of the amount of time the certificate has been outstanding. Expenses include an acquisition fee of 1% , interest expense, a monthly management fee and other administrative costs. The investment in Magnolia is accounted for in accordance with the equity method of accounting, whereby the Company records its 39% interest in the reported income or loss of the fund each quarter and is included in other non-current assets in the Consolidated Balance Sheets. Based on the September 30, 2018 unaudited internal financial statements of Magnolia, the Company recognized net investment gain of approximately $8,000 for the fiscal year ended September 30, 2018. The Company recognized net investment loss of approximately $202,000 and approximately $103,000 for the fiscal years ended September 30, 2017 and 2016, respectively. Net investment income is included in Investment and interest income (loss), net in the Consolidated Statements of Operations. Magnolia made certain distributions during the fiscal years ended September 30, 2018 , 2017 and 2016 ; the Company’s share of those distributions was approximately $25,000 , $324,000 , and $171,000 , respectively. At September 30, 2018 , the Company did not have an investment in Magnolia. +57 +Note 3. Inventories +Inventories consist of the following at September 30, 2018 and September 30, 2017 : +(in thousands) +September 30, +2018 +2017 +Unharvested fruit crop on the trees +$ +39,888 +$ +32,145 +Beef cattle +— +1,954 +Other +1,145 +2,105 +Total inventories +$ +41,033 +$ +36,204 +In September 2017, the State of Florida’s citrus business, including the Company’s unharvested citrus crop, was significantly impacted by Hurricane Irma. The impact of Hurricane Irma resulted in the premature drop of unharvested fruit and damage to citrus trees, which will impact fruit production until such time as the citrus trees recover, potentially through the 2018/2019 harvest season. The Company undertook a process to estimate the amount of inventory casualty loss as of the date of Hurricane Irma. Such process included a number of factors including: (1) touring all of the citrus groves by operational personnel to assess the estimated fruit drop by grove and the impact of damage to the citrus trees; (2) consideration of independent estimates of the reduced citrus production for the State of Florida; and (3) an estimate of fruit the Company expects to produce for the 2017/2018 harvest season after Hurricane Irma. As a result, the Company recorded a casualty loss to reduce the carrying value of unharvested fruit crop on trees inventory by approximately $13,489,000 . +During the fiscal year ended September 30, 2018 , the Company received insurance proceeds relating to Hurricane Irma of approximately $477,000 for property and casualty damage claims, and approximately $8,952,000 for crop claims, which have been recorded as contra-expenses in operating expenses. The Company has additional property and casualty insurance claims outstanding, and is awaiting determination of what additional proceeds are to be received, if any. Insurance proceeds are recorded in the period they are both probable and reasonably estimable. +In addition to the remaining commercial insurance claims which have been submitted, the Company may be eligible for Irma federal relief programs distributed by the Farm Service Agency under the 2017 Wildfires and Hurricane Indemnity Program (2017 WHIP) as well as block grants that will be administered through the State of Florida. The specifics of these programs are still being finalized, and at this time the Company cannot determine the amount of federal relief funds, if any, which will be received, or when these funds will be disbursed. +After determining and applying the amount of loss due to shrinkage to the inventory value, the Company evaluated the remaining inventory and determined an additional reduction was necessary in the amounts of $1,115,000 and $1,199,000 to properly reflect the net realizable value of such inventory at September 30, 2018 and September 30, 2017 , respectively. +58 +Note 4. Assets Held For Sale +The following assets have been classified as assets held for sale as of September 30, 2018 and September 30, 2017 : +(in thousands) +Carrying Value +Twelve Months Ended September 30, +2018 +2017 +Office Building +$ +— +$ +3,214 +Nursery - Gainesville +— +6,500 +Chancey Bay +— +4,179 +Gal Hog +— +70 +Breeding Herd +— +5,858 +Trailers +456 +1,162 +Frostproof Parcels +176 +— +East Ranch Parcels +759 +— +Total Assets Held For Sale +$ +1,391 +$ +20,983 +On May 2, 2018, the Company sold its Gal Hog property for approximately $7,300,000 and recognized a gain of approximately $6,709,000 . +On February 12, 2018, the Company sold its property at Chancey Bay for approximately $4,200,000 and realized a loss of approximately $51,000 . As part of the transaction, the Company paid the purchaser rent of $200,000 in exchange for Alico retaining the rights of harvesting and selling of the fruit in the 2017/2018 harvest season. +On February 9, 2018, the Company sold its nursery located in Gainesville for approximately $6,500,000 and realized a gain of approximately $111,000 . +On January 25, 2018, the Company sold its breeding herd to a third party for approximately $7,800,000 . As part of this transaction, the purchaser is leasing grazing and other rights on the Alico Ranch from the Company at a rate of $100,000 per month. Upon the sale of a parcel within the East Ranch, the lease rate was adjusted to $98,750 per month. +On January 19, 2018, the Company sold certain trailers to a third party for $500,000 . The Company received $125,000 and the remaining portion is to be paid in accordance with the terms of a promissory note, which bears interest at 5% and is payable in equal monthly amortization payments over a period of three years. During the fourth quarter 2018, the Company sold additional trailers for $31,000 . +On October 30, 2017, the Company sold its corporate office building in Fort Myers, Florida for $5,300,000 and realized a gain of approximately $1,751,000 . The sales agreement provides that the Company lease back a portion of the office space for five years. Such lease is classified as an operating lease. +The Company recorded an impairment loss of approximately $150,000 and $4,131,000 for the fiscal years ended September 30, +2018 and 2017, respectively, on those assets classified as assets held for sale as of September 30, 2018 and 2017, respectively. These impairments are included in operating expenses on the Consolidated Statements of Operations. +The Company has used a portion of the proceeds to pay down debt (see Note 6. "Long-Term Debt and Lines of Credit") and repurchase common shares, and plans to use the remaining cash proceeds from the sale of these assets towards future working capital requirements and other corporate purposes. +59 +Note 5. Property and Equipment, Net +Property and equipment, net consists of the following at September 30, 2018 and September 30, 2017 : +(in thousands) +September 30, +2018 +2017 +Citrus trees +$ +264,714 +$ +258,949 +Equipment and other facilities +53,544 +54,592 +Buildings and improvements +8,052 +8,835 +Total depreciable properties +326,310 +322,376 +Less: accumulated depreciation and depletion +(91,858 +) +(82,443 +) +Net depreciable properties +234,452 +239,933 +Land and land improvements +105,951 +109,404 +Net property and equipment +$ +340,403 +$ +349,337 +On September 29, 2018, the Company sold its property at Island Pond for $7,900,000 . As Island Pond was collateralized under one of the Company’s loan documents, $7,000,000 of the proceeds is restricted in use (see Note 2. “Summary of Significant Accounting Policies”). +On September 28, 2018, the Company sold a parcel within the East Ranch for $1,920,000 and realized a gain of $1,759,000 . +On March 30, 2018, the Company sold property located on its Winter Haven location for approximately $225,000 and recognized a loss of approximately $50,000 . This asset was classified as an asset held for sale during the first quarter of fiscal year 2018. +On March 15, 2018, the Company sold certain parcels comprised of citrus trees and land located on its Ranch One grove for approximately $586,000 , and recognized a loss of approximately $87,000 . +On February 2, 2017, the Company sold 49 acres of land and facilities in Hendry County, Florida, to its former tenant for $2,200,000 , resulting in a gain of approximately $1,371,000 , which is included in gain on sale of real estate on the Consolidated Statement of Operations for the fiscal year ended September 30, 2017. +During the fiscal year ended September 30, 2018, the Company recorded impairments aggregating to approximately $2,084,000 ; $1,032,000 relating to Island Pond and $1,052,000 relating to certain citrus trees damaged by Hurricane Irma and from other natural attrition. +During the fiscal year ended September 30, 2017, the Company recorded impairments aggregating to approximately $5,215,000 on certain mines located within its properties and other property and equipment related to the Company's decision to phase out its operation at one of its nurseries. +These impairments incurred for the fiscal years ended September 30, 2018 and 2017 are included in operating expenses on the Consolidated Statements of Operations. +60 +Note 6. Long-Term Debt and Lines of Credit +The following table summarizes long-term debt and related deferred financing costs, net of accumulated amortization, at September 30, 2018 and September 30, 2017 : +September 30, 2018 +September 30, 2017 +Principal +Deferred Financing Costs, Net +Principal +Deferred Financing Costs, Net +(in thousands) +Long-term debt, net of current portion: +Met Fixed-Rate Term Loans +$ +95,938 +$ +836 +$ +99,062 +$ +954 +Met Variable-Rate Term Loans +46,719 +385 +49,594 +439 +Met Citree Term Loan +4,925 +44 +5,000 +49 +Pru Loans A & B +17,417 +241 +23,030 +258 +Pru Loan E +4,675 +17 +4,895 +25 +Pru Loan F +4,675 +40 +4,895 +42 +174,349 +1,563 +186,476 +1,767 +Less current portion +5,275 +— +4,550 +— +Long-term debt +$ +169,074 +$ +1,563 +$ +181,926 +$ +1,767 +The following table summarizes lines of credit and related deferred financing costs, net of accumulated amortization, at September 30, 2018 and September 30, 2017 : +September 30, 2018 +September 30, 2017 +Principal +Deferred Financing Costs, Net +Principal +Deferred Financing Costs, Net +(in thousands) +Lines of Credit: +RLOC +$ +— +$ +58 +$ +— +$ +109 +WCLC +2,685 +78 +— +153 +Lines of Credit +$ +2,685 +$ +136 +$ +— +$ +262 +Future maturities of long-term debt and line of credit as of September 30, 2018 are as follows: +(in thousands) +Due within one year +$ +5,275 +Due between one and two years +10,963 +Due between two and three years +14,990 +Due between three and four years +13,440 +Due between four and five years +10,755 +Due beyond five years +121,611 +Total future maturities +$ +177,034 +61 +Interest costs expensed and capitalized were as follows: +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Interest expense +$ +8,561 +$ +9,141 +$ +9,893 +Interest capitalized +933 +294 +172 +Total +$ +9,494 +$ +9,435 +$ +10,065 +Debt +The Company refinanced its outstanding debt obligations on December 3, 2014 in connection with an acquisition. These credit facilities initially included $125,000,000 in fixed interest rate term loans (“Met Fixed-Rate Term Loans”), $57,500,000 in variable interest rate term loans (“Met Variable-Rate Term Loans”), a $25,000,000 revolving line of credit (“RLOC”) with Metropolitan Life Insurance Company and New England Life Insurance Company (collectively “Met”), and a $70,000,000 working capital line of credit (“WCLC”) with Rabo Agrifinance, Inc. (“Rabo”). +The term loans and RLOC are secured by real property. The security for the term loans and RLOC consists of approximately 38,200 gross acres of citrus groves and 5,762 gross acres of ranch land. The WCLC is collateralized by the Company’s current assets and certain other personal property owned by the Company. +The term loans, collectively, are subject to quarterly principal payments of $2,281,250 , and mature November 1, 2029 . The Met Fixed-Rate Term Loans bear interest at 4.15% per annum, and the Met Variable-Rate Term Loans bear interest at a rate equal to 90 day LIBOR plus 165 basis points (the “LIBOR spread”). The LIBOR spread is subject to adjustment by the lender beginning May 1, 2017 and is subject to further adjustment every two years thereafter until maturity. Interest on the term loans is payable quarterly. +The interest rates on the Met Variable-Rate Term Loans were 3.99% per annum and 2.96% per annum as of September 30, 2018 and September 30, 2017 , respectively. +The Company may prepay up to $8,750,000 of the Met Fixed-Rate Term Loan principal annually without penalty, and any such prepayments may be applied to reduce subsequent mandatory principal payments. The maximum annual prepayment was made for calendar year 2015. During the first and second quarters of fiscal year 2018, the Company elected not to make its principal payment and utilized its prepayment to satisfy its principal payment requirements for such quarters. At September 30, 2018 , the Company had $5,625,000 remaining available to reduce future mandatory principal payments should the Company elect to do so. The Met Variable-Rate Term Loans may be prepaid without penalty. +The RLOC bears interest at a floating rate equal to 90 day LIBOR plus 165 basis points, payable quarterly. The LIBOR spread was adjusted by the lender on May 1, 2017 and is subject to further adjustment every two years thereafter. Outstanding principal, if any, is due at maturity on November 1, 2019. The RLOC is subject to an annual commitment fee of 25 basis points on the unused portion of the line of credit. The RLOC is available for funding general corporate needs. The variable interest rate was 3.99% per annum and 2.96% per annum as of September 30, 2018 and September 30, 2017 , respectively. Availability under the RLOC was $25,000,000 as of September 30, 2018 . +The WCLC is a revolving credit facility and is available for funding working capital and general corporate requirements. The interest rate on the WCLC is based on one month LIBOR, plus a spread, which is adjusted quarterly, based on the Company's debt service coverage ratio for the preceding quarter and can vary from 175 to 250 basis points. The rate is currently at LIBOR plus 175 basis points. The variable interest rate was 3.85% per annum and 2.99% per annum as of September 30, 2018 and September 30, 2017 , respectively. The WCLC agreement was amended on September 20, 2018, and the primary terms of the amendment were an extension of the maturity to November 1, 2021. There were no changes to the commitment amount or interest rate. Availability under the WCLC was approximately $57,015,000 as of September 30, 2018 . +The WCLC is subject to a quarterly commitment fee on the daily unused availability under the line computed as the commitment amount less the aggregate of the outstanding loans and outstanding letters of credit. The commitment fee is adjusted quarterly based on Alico's debt service coverage ratio for the preceding quarter and can vary from a minimum of 20 basis points to a maximum of 30 basis points. Commitment fees to date have been charged at 20 basis points. +62 +As of September 30, 2018 , there was an outstanding balance on the WCLC of $2,685,000 . The WCLC agreement provides for Rabo to issue up to $20,000,000 in letters of credit on the Company’s behalf. As of September 30, 2018 , there was approximately $10,300,000 in outstanding letters of credit, which correspondingly reduced the Company's availability under the line of credit. +In 2014, the Company capitalized approximately $2,834,000 of debt financing costs related to the refinancing. These costs, together with approximately $339,000 of costs related to the retired debt, are being amortized to interest expense over the applicable terms of the loans. Additionally, approximately $123,000 of financing costs were incurred for the fiscal year ended September 30, 2018 and September 30, 2017, respectively, in connection with letters of credit. These costs are also being amortized to interest expense over the applicable terms of the obligations. The unamortized balance of deferred financing costs related to the financing above was approximately $1,357,000 and $1,655,000 at September 30, 2018 and 2017 , respectively. +The credit facilities above are subject to various covenants including the following financial covenants: (i) minimum debt service coverage ratio of 1.10 to 1.00, (ii) tangible net worth of at least $160,000,000 increased annually by 10% of consolidated net income for the preceding year, or approximately $162,300,000 for the year ending September 30, 2018 , (iii) minimum current ratio of 1.50 to 1.00, (iv) debt to total assets ratio not greater than .625 to 1.00, and, solely in the case of the WCLC, (v) a limit on capital expenditures of $30,000,000 per fiscal year. As of September 30, 2018 , the Company was in compliance with these financial covenants. +Credit facilities also include a Met Life term loan collateralized by real estate owned by Citree ("Met Citree Loan"). This is a $5,000,000 credit facility that bears interest at a fixed rate of 5.28% per annum. At September 30, 2018 and 2017, there was an outstanding balance of $4,925,000 and $5,000,000 , respectively. The loan matures in February 2029. The unamortized balance of deferred financing costs related to this loan was approximately $44,000 and $49,000 at September 30, 2018 and 2017 , respectively. +Silver Nip Citrus Debt +There are two fixed-rate term loans, with an original combined balance of $27,550,000 , bearing interest at 5.35% per annum ("Pru Loans A & B"). Principal of $290,000 is payable quarterly, together with accrued interest. The Company may prepay up to $5,000,000 of principal without penalty. On February 15, 2015, Silver Nip Citrus made a prepayment of $750,000 . In addition, the Company made prepayments of approximately $4,453,000 in the second fiscal quarter of 2018 with the sale of certain properties which were collateralized under these loans. As such, the Company exceeded the allowed $5,000,000 prepayment by approximately $203,000 and was required to make a premium payment of approximately $22,000 . The loans are collateralized by real estate in Collier, Hardee, Highlands and Polk Counties, Florida and mature on June 1, 2029 and June 1, 2033, respectively. +Silver Nip Citrus entered into two additional fixed-rate term loans with Prudential to finance the acquisition of a 1,500 acre citrus grove on September 4, 2014. Each loan was in the original amount of $5,500,000 . Principal of $55,000 per loan is payable quarterly, together with accrued interest. One loan bears interest at 3.85% per annum (Pru Loan E"), while the other bears interest at 3.45% per annum ("Pru Loan F"). The interest rate on Pru Loan E is subject to adjustment on September 1, 2019 and every year thereafter until maturity. Both loans are collateralized by real estate in Charlotte County, Florida. Pru Note E matures September 1, 2021, and Pru Note F matures September 1, 2039. +The Silver Nip Citrus credit agreements were amended on December 1, 2016. The primary terms of the amendments were (1) the Company provided a limited $8,000,000 guaranty of the Silver Nip debt, (2) the limited personal guarantees provided by George Brokaw, Remy W. Trafelet and Clayton Wilson prior to the Company’s merger with Silver Nip Citrus, and also totaling $8,000,000 , were released and (3) the consolidated current ratio covenant requirement, measured on an annual basis, was reduced from 1.50 to 1.00 to 1.00 to 1.00. Silver Nip Citrus was in compliance with the current ratio covenant as of September 30, 2018 , the most recent measurement date. +The unamortized balance of deferred financing costs related to the Silver Nip Citrus debt was approximately $298,000 and $325,000 at September 30, 2018 and 2017 , respectively. +63 +Note 7. Accrued Liabilities +Accrued Liabilities consist of the following at September 30, 2018 and September 30, 2017 : +(in thousands) +September 30, +2018 +2017 +Ad valorem taxes +$ +2,196 +$ +2,648 +Accrued interest +1,191 +1,165 +Accrued employee wages and benefits +3,115 +1,320 +Inventory received but not invoiced +726 +— +Accrued dividends +492 +494 +Current portion of deferred retirement obligations +345 +315 +Accrued insurance +223 +166 +Accrued tender offer consulting charges +274 +— +Other accrued liabilities +664 +673 +Total accrued liabilities +$ +9,226 +$ +6,781 +Note 8. Deferred Gain on Sale +Deferred gain on sale consists of the following at September 30, 2018 and September 30, 2017 : +(in thousands) +September 30, +2018 +2017 +Deferred gain on sale +$ +26,167 +$ +27,482 +Annual guarantee payment, net +(1,239 +) +(1,042 +) +Total deferred gain on sale +$ +24,928 +$ +26,440 +Estimated payments over the remaining term of the post-closing agreement arising out of the 2014 sale of property to Global Ag Properties, LLC are summarized in the following table. +(in thousands) +2019 +$ +2,871 +2020 +3,264 +2021 +3,681 +2022 +4,123 +2023 +4,572 +Thereafter +13,804 +Total +$ +32,315 +These estimated payments represent undiscounted cash flows. +On November 21, 2014, the Company completed the sale of approximately 36,000 acres of land used for sugarcane production and land leasing in Hendry County, Florida to Global Ag Properties, LLC (“Global”) for approximately $97,900,000 in cash. It had previously leased approximately 30,600 of these acres to United States Sugar Corporation (the “USSC Lease”). The USSC Lease was assigned to Global in conjunction with the land sale. +The sales price is subject to post-closing adjustments over a ten year period. The Company realized a gain of approximately $42,753,000 on the sale. Initially, $29,140,000 of the gain was deferred due to the Company’s continuing involvement in the property pursuant to a post-closing agreement and the potential price adjustments. The deferral represents the Company’s estimate +64 +of the maximum exposure to loss as a result of the continuing involvement (see below). A net gain of approximately $13,613,000 was recognized at the time of the sale. +The Company estimated its maximum exposure to loss over the ten year period to total approximately $42,172,000 on an aggregate undiscounted basis. This estimated maximum exposure to loss was discounted at five percent to determine the initial deferred gain. In May 2018 , 2017 and 2016 the Company made payments of $1,889,000 and $1,580,000 and $1,702,000 , respectively, to Global pursuant to the sales contract. The amount of USSC’s lease is tied to the market price of sugar, and the Company's payment is required annually in advance, to supplement the lease paid by USSC in the event that the sugar prices are below certain thresholds. The Company has recognized approximately $1,361,000 , $1,413,000 and $1,406,000 in interest expense and approximately $967,000 , $538,000 and $618,000 of the deferred gain for the fiscal years ended September 30, 2018 , 2017 and 2016, respectively. +Note 9. Fair Value Measurements +The Company complies with the provisions of FASB ASC 820 “Fair Value Measurements” for its financial and non-financial assets and liabilities. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring or nonrecurring basis. The majority of the carrying amounts of the Company’s assets and liabilities including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities as of September 30, 2018 and 2017 , approximate their fair value because of the immediate or short term maturity of these financial instruments. The carrying amounts reported for long-term debt approximates fair value as the Company’s borrowings with commercial lenders are at interest rates that vary with market conditions and fixed rates that approximate market rates for similar obligations. The majority of our non-financial instruments, which include inventories and property and equipment, are not required to be carried at fair value on a recurring basis. The Company has certain assets classified as Assets Held for Sale which have been recorded at the lower of carrying value or the estimated fair value less costs to sell. +ASC 820 clarifies that fair value is an exit price representing the amount that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, ASC 820 establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value as follows: +The following table represents certain assets held for sale as of September 30, 2018, which have been measured at fair value on a non-recurring basis (see Note 4. for complete listing of assets held for sale): +• +Level 1- Observable inputs such as quoted prices in active markets; +• +Level 2- Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and +• +Level 3- Unobservable inputs in which there is little or no market data, such as internally-developed valuation models which require the reporting entity to develop its own assumptions. +The following table represents certain assets held for sale as of September 30, 2018 , which have been measured at fair value on a non-recurring basis (see Note 4. Assets Held for Sale): +Fair Value Hierarchy +Carrying Value +Adjustment to Fair Value +Fair Value +Trailers +Level 3 +$ +606 +$ +150 +$ +456 +The following table represents certain assets held for sale as of September 30, 2017, which have been measured at fair value on a non-recurring basis (see Note 4. "Assets Held For Sale"): +Fair Value Hierarchy +Carrying Value +Adjustment to Fair Value +Fair Value +Nursery - Gainesville +Level 3 +$ +10,107 +$ +3,607 +$ +6,500 +Chancey Bay +Level 3 +$ +4,587 +$ +408 +$ +4,179 +Trailers +Level 3 +$ +1,278 +$ +116 +$ +1,162 +65 +There were no gains or losses included in earnings attributable to changes in unrealized gains or losses relating to the Company’s assets for the fiscal years ended as of September 30, 2018 and 2017 . +The Company uses third-party service providers to assist in the evaluation of investments. For investment valuations, current market interest rates, quality estimates by rating agencies and valuation estimates by active market participants were used to determine values. Deferred retirement benefits were valued based on actuarial data, contracted payment schedules and an estimated discount rate of 4.08% and 4.08% as of September 30, 2018 and 2017 , respectively. +Note 10. Common Stock and Options +Effective January 27, 2015, the Company’s Board of Directors adopted the 2015 Stock Incentive Plan (the “2015 Plan”) which provides for up to 1,250,000 common shares available for issuance to provide a long-term incentive plan for officers, employees, directors and/or consultants to directly link incentives to stockholder value. The 2015 Plan was approved by the Company’s stockholders in February 2015. The Company’s 2015 Plan provides for grants to executives in various forms including restricted shares of the Company’s common stock and stock options. Awards are discretionary and are determined by the Compensation Committee of the Board of Directors. Awards vest based upon service conditions. Non-vested restricted shares generally vest over requisite service periods of one to six years from the date of grant. +Restricted Stock +In November 2017, the Company awarded 5,000 restricted shares of the Company’s common stock (“Restricted Stock”) to one senior executive under the 2015 Plan at a weighted average fair value of $31.95 per common share, vesting over two and a half years. +The following table represents a summary of the status of the Company’s nonvested shares is as follows: +Nonvested Shares +Shares +Weighted-Average Grant Date Fair Value +Nonvested Shares at September 30, 2015 +12,500 +$ +49.49 +Granted during fiscal year 2016 +— +— +Vested during fiscal year 2016 +(2,233 +) +$ +49.50 +Forfeited during fiscal year 2016 +— +— +Nonvested Shares at September 30, 2016 +10,267 +$ +49.49 +Granted during fiscal year 2017 +— +— +Vested during fiscal year 2017 +(4,933 +) +$ +49.58 +Forfeited during fiscal year 2017 +— +— +Nonvested Shares at September 30, 2017 +5,334 +$ +49.39 +Granted during fiscal year 2018 +5,000 +$ +31.95 +Vested during fiscal year 2018 +(3,001 +) +$ +39.70 +Forfeited during fiscal year 2018 +— +— +Nonvested Shares at September 30, 2018 +7,333 +$ +41.46 +Stock compensation expense related to the Restricted Stock totaled approximately $137,000 , $264,000 and $150,000 for the fiscal years ended September 30, 2018 , 2017 and 2016, respectively. +There was approximately $172,000 and $149,000 of unrecognized stock compensation costs related to the Restricted Stock grants at September 30, 2018 and 2017 , respectively. +66 +Stock Options +Stock option grants of 210,000 options to Mr. Trafelet and 90,000 options to Mr. Kiernan (collectively, the “2018 Option Grants”) were granted on September 7, 2018. The option exercise price for these options was set at $33.60 , the closing price on September 7, 2018. The 2018 Option Grants will vest as follows: (i) 25% of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $35.00 ; (ii) 25% of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $40.00 ; (iii) 25% of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $45.00 ; and (iv) 25% of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 12 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2021 then any unvested options will be forfeited. The 2018 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2018, the Company’s stock was trading at $33.80 per share, and during fiscal year 2018 the stock did not trade above $35.00 per share; accordingly, none of the stock options are vested at September 30, 2018. +Stock option grants of 300,000 options to Mr. Trafelet and 225,000 options to each of Messrs. Slack and Brokaw (collectively, the “2016 Option Grants”) were granted on December 31, 2016. The option exercise price for these options was set at $27.15 , the closing price on December 31, 2016. The 2016 Option Grants will vest as follows: (i) 25% of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $60.00 ; (ii) 25% of the options will vest if such price exceeds $75.00 ; (iii) 25% of the options will vest if such price exceeds $90.00 ; and (iv) 25% of the options will vest if such price exceeds $105.00 . If the applicable stock price hurdles have not been achieved by (A) the second anniversary of the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by the fifth anniversary of the grant date (or the fourth anniversary of the grant date, in the case of the tranche described in clause (i) above), then any unvested options will be forfeited. The 2016 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2018 , the Company’s stock was trading at $33.80 per share, and during fiscal year 2018 the stock did not trade above $60.00 per share; accordingly, none of the stock options are vested at September 30, 2018 . +Additionally, 187,500 shares of the 2016 Option Grants made to each of Messrs. Slack and Brokaw were forfeited on September 5, 2018 and no replacement options were granted. As such, the remaining unrecognized expense associated with these options of approximately $783,000 was accelerated and recorded for the fiscal year ended September 30, 2018 . +The following table represents a summary of the Company’s stock option activity: +Number of Options +Weighted Average Exercise Price +Weighted Average Remaining Contractual Term (years) +Aggregate Intrinsic Value +Balance - September 30, 2016 +— +$ +— +0.00 +— +Granted during fiscal year 2017 +750,000 +$ +27.15 +3.33 +— +Forfeitures/expired in fiscal year 2017 +— +$ +— +0.00 +— +Exercised during fiscal year 2017 +— +$ +— +0.00 +— +Balance - September 30, 2017 +750,000 +$ +27.15 +2.58 +— +Granted during fiscal year 2018 +300,000 +$ +33.60 +3.25 +— +Forfeitures/expired in fiscal year 2018 +(375,000 +) +$ +27.15 +1.86 +— +Exercised during fiscal year 2018 +— +$ +— +0.00 +— +Balance - September 30, 2018 +675,000 +$ +30.02 +2.22 +— +67 +Stock compensation expense related to the options totaled approximately $1,617,000 and $616,000 for the fiscal years ended September 30, 2018 and 2017 , respectively. No stock compensation expense related to options was recorded for the fiscal year ended September 30, 2016. +At September 30, 2018 and 2017 , there was approximately $2,174,000 and $2,030,000 , respectively, of total unrecognized stock compensation costs related to nonvested share-based compensation for the option grants. +The fair value of the 2016 Option Grants and 2018 Option Grants was estimated on the date of grant using a Monte Carlo valuation model that uses the assumptions noted in the following table. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding; the range given below results from different time-frames for the various market conditions being met. +2018 Option Grant +Expected Volatility +30.0 +% +Expected Term (in years) +3.32 +Risk Free Rate +2.80 +% +The weighted-average grant-date fair value of the 2018 Option Grants was $7.40 . There were no additional stock options granted or exercised for the fiscal year ended September 30, 2018. +2016 Option Grant +Expected Volatility +32.19 +% +Expected Term (in years) +2.6 - 4.0 +Risk Free Rate +2.45 +% +The weighted-average grant-date fair value of the 2016 Option Grants was $3.53 . There were no additional stock options granted, exercised or forfeited for the fiscal year ended September 30, 2017. +As of September 30, 2018 , there remained 557,500 common shares available for issuance under the 2015 Plan. +Note 11. Treasury Stock +In fiscal year 2017, the Board of Directors authorized the repurchase of up to $7,000,000 of the Company’s common stock in two separate authorizations (collectively, the "2017 Authorization"). In March 2017, the Board of Directors authorized the repurchase of up to $5,000,000 of the Company’s common stock beginning March 9, 2017, and continuing through March 9, 2019. In May 2017, the Board of Directors authorized the repurchase of up to an additional $2,000,000 of the Company’s common stock beginning May 24, 2017, and continuing through May 24, 2019. The stock repurchases made under this repurchase were made through open market transactions at times and in such amounts as the Company’s broker determined subject to the provisions of SEC Rule 10b-18. +In September 2013, the Board of Directors authorized the repurchase of up to 105,000 shares of the Company’s common stock beginning in November 2013 and continuing through April 2018. In fiscal year 2016, the Board of Directors authorized the repurchase of up to 50,000 shares of the Company’s outstanding common stock beginning February 18, 2016 and continuing through February 17, 2017 (the "2016 Authorization"). In fiscal year 2015, the Board of Directors authorized the repurchase of up to 170,000 shares of the Company’s common stock beginning March 25, 2015, and continuing through December 31, 2016. +During fiscal year 2018, the Company purchased 72,266 shares at a cost of $2,214,756 under the 2017 Authorization. As of June 29, 2018, the Company suspended its stock repurchase activity; however, if the Company chooses to resume repurchasing stock it has $1,676,443 available to repurchase stock under the 2017 Authorization. +68 +The following table illustrates the Company’s treasury stock purchases for the fiscal years ended September 30, 2018 , 2017 and 2016 : +(in thousands, except share amounts) +Total Number of +Shares Purchased +Average Price +Paid Per Share +Total Shares Purchased as Part of Publicly Announced Plan or Program +Total Dollar Value of Shares Purchased +Fiscal Year Ended September 30,: +2018 +72,266 +$ +30.65 +722,406 +$ +2,215 +2017 +104,145 +$ +29.42 +650,140 +$ +3,064 +2016 +78,446 +$ +40.04 +545,995 +$ +3,141 +The following table outlines the Company’s treasury stock transactions during the past three fiscal years: +(in thousands, except share amounts) +Shares +Cost +Balance at September 30, 2015 +90,565 +$ +3,962 +Purchased +78,446 +3,141 +Issued to Employees and Directors +(35,478 +) +(1,035 +) +Issued to former Silver Nip Citrus equity holders +(32,923 +) +(1,483 +) +Balance at September 30, 2016 +100,610 +4,585 +Purchased +104,145 +3,064 +Issued to Employees and Directors +(27,440 +) +(1,147 +) +Balance at September 30, 2017 +177,315 +6,502 +Purchased +72,266 +2,215 +Issued to Employees and Directors +(33,393 +) +(1,181 +) +Balance at September 30, 2018 +216,188 +$ +7,536 +69 +Note 12. Income Taxes +The provision (benefit) for income tax for the years ended September 30, 2018 , 2017 and 2016 consists of the following: +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Current: +Federal income tax +$ +1,961 +$ +102 +$ +244 +State income tax +384 +— +— +Total current +2,345 +102 +244 +Deferred: +Federal income tax +(3,917 +) +(3,286 +) +4,538 +State income tax +1,962 +(662 +) +739 +Total deferred +(1,955 +) +(3,948 +) +5,277 +Provision (benefit) for income taxes +$ +390 +$ +(3,846 +) +$ +5,521 +Income tax provision (benefit) attributable to income from continuing operations differed from the amount computed by applying the statutory federal income tax rate of 24.53% , based on a blended rate calculation, to income (loss) before income taxes for the fiscal year ended September 30, 2018 and 35% for the fiscal years ended September 30, 2017 and 2016 as a result of the following: +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Tax at the statutory federal rate +$ +3,198 +$ +(4,670 +) +$ +4,382 +Increase (decrease) resulting from: +State income taxes, net of federal benefit +857 +(402 +) +457 +Permanent and other reconciling items, net +221 +548 +773 +Expiration of capital loss carryforward +5,634 +581 +— +Reduction in deferred tax liability resulting from the Act +(9,847 +) +— +— +Stock option cancellation +347 +— +— +Other +(20 +) +97 +(91 +) +Provision (benefit) for income taxes +$ +390 +$ +(3,846 +) +$ +5,521 +70 +The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of September 30, 2018 , and 2017 are presented below: +(in thousands) +September 30, +2018 +2017 +Deferred tax assets: +Deferred retirement benefits +$ +1,114 +$ +1,712 +Investment in Citree +89 +45 +Deferred gain recognition +6,318 +10,199 +Goodwill +20,095 +33,233 +Inventories +711 +6,435 +Stock compensation +261 +292 +Accrued bonus +612 +248 +Capital loss carryforwards +— +9,462 +Tax credits +28 +293 +Net operating losses +— +3,160 +Intangibles +620 +1,027 +Other +190 +332 +Total deferred tax assets +30,038 +66,438 +Deferred tax liabilities: +Revenue recognized from citrus and sugarcane +162 +357 +Property and equipment +54,925 +91,995 +Accrual-to-cash method +— +950 +Prepaid insurance +104 +220 +Investment in Magnolia +— +24 +Total deferred tax liabilities +55,191 +93,546 +Net deferred income tax liabilities +$ +(25,153 +) +$ +(27,108 +) +On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act contains significant changes to corporate taxes, including a permanent reduction of the U.S. corporate tax rate from 35% to 21% effective January 1, 2018. The Company’s statutory rate for fiscal year ended September 30, 2018 was 24.53% , based on a fiscal year blended rate calculation. The 21% U.S. corporate tax rate will apply to fiscal years ending September 30, 2019 and each year thereafter. +Additionally, the Act requires a one-time remeasurement of certain tax related assets and liabilities. During the first fiscal quarter ended December 31, 2017, the Company made certain estimates related to the impact of the Act, including the remeasurement of deferred taxes at the new expected tax rate and a revised effective tax rate for the fiscal year ended September 30, 2018. The amounts recorded for the fiscal year ended September 30, 2018 for the remeasurement of deferred taxes principally relate to the reduction in the U.S. corporate income tax rate. For the fiscal year ended September 30, 2018, the Company has recorded a tax benefit of approximately $9,847,000 to account for these deferred tax impacts. +71 +Note 13. Segment Information +Segments +Operating segments are defined in the criteria established under the Financial Accounting Standards Board - Accounting Standards Codification (“FASB ASC”) Topic 280 as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: Alico Citrus and Water Resources and Other Operations . +Total revenues represent sales to unaffiliated customers, as reported in the Consolidated Statements of Operations. Goods and services produced by these segments are sold to wholesalers and processors in the United States who prepare the products for consumption. The Company evaluates the segments’ performance based on direct margins (gross profit) from operations before general and administrative expenses, interest expense, other income (expense) and income taxes, not including nonrecurring gains and losses. +72 +Information by operating segment is as follows: +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Revenues: +Alico Citrus +$ +78,121 +$ +123,441 +$ +137,282 +Water Resources and Other Operations +3,160 +6,388 +6,914 +Total revenues +81,281 +129,829 +144,196 +Operating expenses: +Alico Citrus +51,709 +111,947 +102,347 +Water Resources and Other Operations +3,979 +8,952 +6,790 +Total operating expenses +55,688 +120,899 +109,137 +Gross profit (loss): +Alico Citrus +26,412 +11,494 +34,935 +Water Resources and Other Operations +(819 +) +(2,564 +) +124 +Total gross profit (loss) +$ +25,593 +$ +8,930 +$ +35,059 +Capital expenditures: +Alico Citrus +$ +15,968 +$ +11,738 +$ +10,393 +Water Resources and Other Operations +304 +646 +2,293 +Other Capital Expenditures +80 +969 +1,619 +Total capital expenditures +$ +16,352 +$ +13,353 +$ +14,305 +Depreciation, depletion and amortization: +Alico Citrus +$ +13,467 +$ +14,054 +$ +13,982 +Water Resources and Other Operations +219 +652 +932 +Other Depreciation, Depletion and Amortization +70 +520 +468 +Total depreciation, depletion and amortization +$ +13,756 +$ +15,226 +$ +15,382 +(in thousands) +September 30, +2018 +2017 +Assets: +Alico Citrus +$ +405,752 +$ +387,972 +Water Resources and Other Operations +15,904 +24,819 +Other Corporate Assets +1,766 +6,391 +Total Assets +$ +423,422 +$ +419,182 +73 +Note 14. Employee Benefits Plans +Management Security Plan +The management security plan (“MSP”) is a nonqualified, noncontributory defined supplemental deferred retirement benefit plan for a select group of management personnel. The MSP provides a fixed supplemental retirement benefit for 180 months . The MSP was frozen as of September 30, 2017. As a result, no new participants are being added to the MSP and no further benefits are accumulating. The MSP benefit expense and the projected management security plan benefit obligation are determined using assumptions as of the end of the year. The weighted-average discount rate used to compute the obligation was 4.08% and 4.08% in fiscal years 2018 and 2017 , respectively. +Actuarial gains or losses are recognized when incurred; therefore, the end of year benefit obligation is the same as the accrued benefit costs recognized in the Consolidated Balance Sheets. +The amount of MSP benefit expense charged to costs and expenses was as follows: +(in thousands) +Fiscal Year Ended September 30, +2018 +2017 +2016 +Service cost +$ +— +$ +200 +$ +213 +Interest cost +293 +140 +210 +Recognized actuarial gain (loss) adjustment +16 +(78 +) +(5 +) +Total +$ +309 +$ +262 +$ +418 +The following provides a roll-forward of the MSP benefit obligation: +(in thousands) +September 30, +2018 +2017 +Change in projected benefit obligation: +Benefit obligation at beginning of year +$ +4,438 +$ +4,543 +Service cost +— +200 +Interest cost +293 +140 +Benefits paid +(350 +) +(367 +) +Recognized actuarial gain (loss) adjustment +16 +(78 +) +Benefit obligation at end of year +$ +4,397 +$ +4,438 +Funded status at end of year +$ +(4,397 +) +$ +(4,438 +) +Effective September 30, 2018, the Company terminated the MSP. Under the MSP termination, payout for benefits covered under the applicable Internal Revenue Code regulations cannot commence until at least twelve months following plan termination decision, but must be fully paid out within twenty-four ( 24 ) months following plan termination. The MSP is unfunded and benefits are paid as they become due. The estimated future benefit payments under the plan for the next twelve months is approximately $357,000 . +The Company has established a “Rabbi Trust” to provide for the funding of accrued benefits under the MSP. According to the terms of the Rabbi Trust, funding is voluntary until a change of control of the Company as defined in the Management Security Plan Trust Agreement occurs. Upon a change of control, funding is triggered. As of September 30, 2018 , the Rabbi Trust had no assets, and no change of control had occurred. +Profit Sharing and 401(k) Plans +The Company maintains a 401(k) employee savings plan for eligible employees, which provides up to a 4% matching contribution payable on employee payroll deferrals. The Company’s matching funds vest to the employee immediately, pursuant to a safe +74 +harbor election effective in October 2012. The Company’s contribution to the plan was approximately $342,000 , $445,000 and $401,000 for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +The Profit Sharing Plan (“Plan”) is fully funded by contributions from the Company. Contributions to the Plan are discretionary and determined annually by the Company’s Board of Directors. Contributions to employee accounts are based on the participant’s compensation. The Company’s paid contribution to the Profit Sharing Plan was $0 , $378,000 , and $291,000 for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +Note 15. Related Party Transactions +Clayton G. Wilson +The Company entered into a Separation and Consulting Agreement with Clayton G. Wilson (the “Separation and Consulting Agreement”), pursuant to which Mr. Wilson stepped down as Chief Executive Officer of the Company effective as of December 31, 2016. Under the Separation and Consulting Agreement, Mr. Wilson also acknowledged and agreed that he will continue to be bound by the restrictive covenants set forth in his Employment Agreement with the Company. The Separation and Consulting Agreement provides that, subject to his execution, delivery, and non-revocation of a general release of claims in favor of the Company, Mr. Wilson will be entitled to vesting of any unvested portion of the restricted stock award granted to him under his Employment Agreement. In addition, the Separation and Consulting Agreement provides that Mr. Wilson serve as a consultant to the Company during 2017 and received an aggregate consulting fee of $750,000 for such services ( $200,000 paid in an initial lump sum, $275,000 paid in a lump sum on July 1, 2017, and $275,000 paid in six equal monthly installments commencing July 31, 2017 and ended December 31, 2017). As of September 30, 2017, the Company satisfied its obligation to Mr. Wilson in full, including a prepayment of $187,500 . The Company expensed $187,500 and $562,500 for the fiscal years ended September 30, 2018 and September 30, 2017, respectively. Mr. Wilson resigned as a member of the Company’s Board of Directors effective February 27, 2017. +Remy W. Trafelet, Henry R. Slack, and George R. Brokaw +On December 31, 2016, the Company entered into new employment agreements (collectively, the “Employment Agreements”) with each of Remy W. Trafelet, Henry R. Slack, and George R. Brokaw (collectively, the “Executives”). Mr. Trafelet serves as the President and Chief Executive Officer of the Company, Mr. Slack serves as the Executive Chairman of the Company, and Mr. Brokaw serves as the Executive Vice Chairman of the Company, and each of them continues to serve on the Company’s Board of Directors. The Employment Agreements provide for an annual base salary of $400,000 in the case of Mr. Trafelet and $250,000 in the case of each of Messrs. Slack and Brokaw and, additionally, provided for payment to the Executives an amount in cash equal to $400,000 to Mr. Trafelet and $250,000 to each of Messrs. Slack and Brokaw within five business days of December 31, 2016. +The Employment Agreements also provide that, if the applicable Executive’s employment is terminated by the Company without “cause” or the applicable Executive resigns with “good reason” (as each such term is defined in the Employment Agreements), then, subject to his execution, delivery, and non-revocation of a general release of claims in favor of the Company, the Executive will be entitled to cash severance in an amount equal to 24 months (in the case of Mr. Trafelet) or 18 months (in the case of Messrs. Slack and Brokaw) of the Executive’s annual base salary. +The Employment Agreement includes various restrictive covenants in favor of the Company, including a confidentiality covenant, a nondisparagement covenant, and 12 -month post-termination noncompetition and customer and employee nonsolicitation covenants. +As of June 26, 2017, both Messrs. Slack and Brokaw have agreed to waive payment of their salary. +JD Alexander +On November 6, 2013, JD Alexander tendered his resignation as Chief Executive Officer, and as an employee of the Company, subject to and effective immediately after the Closing of the Share Purchase transaction on November 19, 2013. Mr. Alexander’s resignation included a waiver of any rights to any payments under his Change-in-Control Agreement with the Company. On November 6, 2013, the Company and Mr. Alexander also entered into a Consulting and Non-Competition Agreement under which (i) Mr. Alexander will provide consulting services to the Company during the two -year period after the Closing, (ii) Mr. Alexander agreed to be bound by certain non-competition covenants relating to the Company’s citrus operations and non-solicitation and non-interference covenants for a period of two years after the Closing, and (iii) the Company paid Mr. Alexander for such services +75 +and covenants $2,000,000 in twenty-four monthly installments. The Company expensed approximately $0 , $0 and $167,000 under the Consulting and Non-Competition Agreement for the fiscal years ended September 30, 2018 , 2017 and 2016 . +Ken Smith +On March 20, 2015, Ken Smith tendered his resignation as Chief Operating Officer, and as an employee of the Company. Mr. Smith’s resignation included a waiver of any rights to any payments under his Change-in-Control Agreement with the Company. On March 20, 2015, the Company and Mr. Smith also entered into a Consulting and Non-Competition Agreement under which (i) Mr. Smith will provide consulting services to the Company during the three -year period after the resignation date, (ii) Mr. Smith agreed to be bound by certain non-competition covenants relating to the Company’s citrus operations and non-solicitation and non-interference covenants for a period of two years after the resignation date, and (iii) the Company paid Mr. Smith $925,000 for such services and covenants. The Company expensed approximately $0 , $100,000 and $200,000 under the Consulting and Non-Competition Agreement for fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +W. Mark Humphrey +On June 1, 2015, W. Mark Humphrey tendered his resignation as Senior Vice President and Chief Financial Officer, and as an employee of the Company. On June 1, 2015, the Company and Mr. Humphrey entered into a Separation and Consulting Agreement under which (i) Mr. Humphrey will provide consulting services to the Company for a one -year period after his resignation, and (ii) Mr. Humphrey will be entitled to the following benefits: (a) $100,000 in cash in a lump sum and (b) a consulting fee of $350,000 payable monthly during the period commencing on his resignation date and ending on the first anniversary of his resignation date. The Company expensed approximately $0 , $0 and $238,000 under the Separation and Consulting Agreement for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. On June 1, 2015 the Company appointed John E. Kiernan to serve as Senior Vice President and Chief Financial Officer. Effective September 1, 2015, Mr. Humphrey was appointed to serve as Senior Vice President and Chief Accounting Officer, and continued to receive monthly payments under The Consulting Agreement through the first anniversary of his resignation date. Mr. Humphrey resigned as Senior Vice President and Chief Accounting Officer and as an employee of the Company effective April 3, 2017. +Shared Services Agreement +The Company has a shared services agreement with Trafelet Brokaw & Co., LLC (“TBCO”), whereby the Company will reimburse TBCO for use of office space and various administrative and support services. The annual cost of the office and services is approximately $618,000 . The agreement will expire in December 2018. The Company expensed approximately $592,000 , $564,000 and $479,000 under the Shared Services Agreement for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. As of September 30, 2018 and 2017 , the Company had outstanding amounts due of approximately $163,000 and $148,000 , respectively. +Note 16. Commitments and Contingencies +Operating Leases +The Company has obligations under various non-cancelable long-term operating leases for equipment. In addition, the Company has various obligations under other equipment leases of less than one year. +Total rent expense was approximately $1,062,000 , $725,000 , and $667,000 for the years ended September 30, 2018 , 2017 and 2016 , respectively. +76 +The future minimum annual rental payments under non-cancelable operating leases are as follows: +(in thousands) +2019 +$ +319 +2020 +166 +2021 +169 +2022 +175 +2023 +14 +Total +$ +843 +Purchase Commitments +During fiscal year 2018 , the Company entered into contracts to purchase citrus trees. As of September 30, 2018 , the Company had approximately $2,161,000 relating to outstanding commitments for these purchases that will be paid upon delivery of the remaining citrus trees. +Letters of Credit +The Company has outstanding standby letters of credit in the total amount of approximately $10,300,000 at September 30, 2018 and September 30, 2017 , respectively, to secure its various contractual obligations. +Legal Proceedings +Florida Litigation +On November 16, 2018, 734 Agriculture, RCF 2014 Legacy LLC, Delta Offshore Master II, LTD. and Mr. Remy W. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors, filed a lawsuit against Messrs. George R. Brokaw, Henry R. Slack, W. Andrew Krusen and Greg Eisner, members of the Board of Directors, in the Circuit Court (the “Circuit Court”) for Hillsborough County, Florida (the “Florida Litigation”). The plaintiffs in the Florida Litigation seek, among other things, a declaration that (1) a purported stockholder action by written consent, delivered to the Company in the name of 734 Investors and the plaintiffs in the Florida Litigation on November 11, 2018 (the “Purported Consent”) is valid and binding, (2) the resolutions passed at a meeting of the Board of Directors on November 12, 2018, to, among other things, constitute an ad hoc committee of the Board of Directors to consider, evaluate and make any and all determinations, and to take any and all actions, on behalf of the Board of Directors, in connection with the Purported Consent are null and void and (3) the four defendants in the Florida Litigation were properly removed from the Board of Directors by the Purported Consent. On November 27, 2018, the Circuit Court denied without prejudice plaintiffs’ motion for a temporary restraining order and an affirmative injunction restoring Mr. Remy W. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. +On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provides, pending the resolution of the Delaware Litigation (as defined below), that (1) the record date for the Purported Consent is stayed indefinitely, and (2) Mr. Trafelet and the Company’s Board of Directors shall not take any action out of routine day-to-day operations conducted in the ordinary course of business, including any action to change the corporate governance of Alico or removing any corporate officers or directors from positions held as of November 27, 2018. +Due to the inherent uncertainties of litigation, we cannot predict the outcome of the Florida Litigation at this time, and we can give no assurance that the Florida Litigation will not have a material adverse effect on our financial position or results of operations. +Delaware Litigation +On November 20, 2018, members of 734 Investors filed a lawsuit against 734 Agriculture and Mr. Remy W. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors in the Delaware Court of Chancery (the "Delaware Court"), captioned Arlon Valencia Holdings v. Trafelet, C.A. No. 2018-0842-JTL (the “Members’ Delaware Litigation”). The plaintiffs seek, among other things, a declaration that (1) 734 Agriculture was validly replaced as the managing member of 734 Investors pursuant to the Amended and Restated Limited Liability Company Operating Agreement of 734 Investors (the “LLC Agreement”) and the 734 Consent (described above), and (2) the Purported Consent is invalid under the LLC Agreement. +77 +Also on November 20, 2018, 734 Agriculture filed a lawsuit contesting the 734 Consent in the Delaware Court, captioned 734 Agriculture v. Arlon Valencia Holdings, LLC, C.A. No. 2018-0844-JTL (the “734 Delaware Litigation”). On November 27, 2018, the Delaware Court entered a stipulated order consolidating the Members’ Delaware Litigation and the 734 Delaware Litigation into a single lawsuit, captioned In re 734 Investors, LLC Litigation, Consol. C.A. No. 2018-0844-JTL (the consolidated suit, the “Delaware Litigation”). +On December 5, 2018, the Delaware Court entered a stipulated status quo order which provides, among other things, that 734 Agriculture shall serve as the managing member of 734 Investors during the pendency of the Delaware Litigation. The status quo order also provides that 734 Agriculture shall not take any actions outside of the ordinary course of business of 734 Investors without the consent of two-thirds of the membership interests of 734 Investors, including exercising any voting rights with respect to any shares of the Company’s common stock beneficially owned by 734 Investors. +Due to the inherent uncertainties of litigation, we cannot predict the outcome of the Delaware Litigation at this time, and we can give no assurance that Delaware Litigation will not have a material adverse effect on our financial position or results of operations. +From time to time, Alico may be involved in litigation relating to claims arising out of its operations in the normal course of business. There are no other current legal proceedings to which the Company is a party to or of which any of its property is subject to that it believes will have a material adverse effect on its business financial position or results of operations. +78 +Note 17. Selected Quarterly Financial Data (unaudited) +Summarized quarterly financial data for the fiscal years ended September 30, 2018 , and 2017 are computed independently each quarter, therefore, the sum of the quarter amounts may not equal the total amount for the respective year due to rounding as follows: +(in thousands, except per share amounts) +Fiscal Quarter Ended +December 31, +March 31, +June 30, +September 30, +2017 +2016 +2018 +2017 +2018 +2017 +2018 +2017 +Total operating revenue +$ +17,533 +$ +17,445 +$ +35,600 +$ +56,200 +$ +26,517 +$ +51,518 +$ +1,631 +$ +4,666 +Total operating expenses +16,951 +14,692 +27,767 +41,684 +14,603 +36,510 +(3,633 +) +28,013 +Gross profit +582 +2,753 +7,833 +14,516 +11,914 +15,008 +5,264 +(23,347 +) +General and administrative +3,886 +3,788 +3,073 +3,399 +2,955 +3,709 +5,144 +4,128 +Other (expense) income, net +(375 +) +(1,981 +) +(2,140 +) +(912 +) +5,074 +(2,162 +) +96 +(2,193 +) +Income (loss) before income taxes +(3,679 +) +(3,016 +) +2,620 +10,205 +14,033 +9,137 +216 +(29,668 +) +Income tax expense (benefit) +(12,417 +) +(1,273 +) +8,150 +4,321 +4,941 +3,665 +(284 +) +(10,559 +) +Net income (loss) +8,738 +(1,743 +) +(5,530 +) +5,884 +9,092 +5,472 +500 +(19,109 +) +Net loss attributable to noncontrolling interests +8 +8 +16 +(51 +) +8 +7 +218 +81 +Net income (loss) attributable to Alico Inc. common stockholders +$ +8,746 +$ +(1,735 +) +$ +(5,514 +) +$ +5,833 +$ +9,100 +$ +5,479 +$ +718 +$ +(19,028 +) +Earnings per share: +Basic +$ +1.06 +$ +(0.21 +) +$ +(0.67 +) +$ +0.70 +$ +1.11 +$ +0.66 +$ +0.09 +$ +(2.29 +) +Diluted +$ +1.05 +$ +(0.21 +) +$ +(0.67 +) +$ +0.70 +$ +1.09 +$ +0.66 +$ +0.09 +$ +(2.29 +) +Note - Total operating expenses for the fiscal quarter ended September 30, 2017 include an inventory casualty loss and net realizable value adjustment of approximately $14,688,000 and impairments of long-lived assets of approximately $9,346,000 . Total operating expenses for the fiscal quarter ended June 30, 2018 include insurance proceeds relating to Hurricane Irma of $477,000 for property and casualty damage claims and $3,726,000 for crop claims. Total operating expenses for the fiscal quarter ended September 30, 2018 included insurance proceeds relating to the Hurricane Irma of $5,226,000 for crop damage claims (see Note 3. “Inventories”, Note 4. “Assets Held For Sale” and Note 5. “Property and Equipment, Net” for further information). +79 +Note 18. Subsequent Events +On October 3, 2018, the Company completed a tender offer of 752,234 shares at a price of $34.00 per share aggregating $25,575,956 . 734 Investors, Alico's largest stockholder since 2013, participated in the tender offer and sold a small percentage of its holdings. +A stock option grant of 10,000 options was made to Mr. Kiernan on October 25, 2018. The option price was set at $33.34 , the closing price on October 25, 2018. This grant will vest as follows: (i) 3,333 options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $40.00 ; (ii) 3,333 options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $45.00 ; and (iii) 3,334 options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 12 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2021 then any unvested options will be forfeited. This grant will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. +80 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedures +(a) +Evaluation of Disclosure Controls and Procedures. +Our Principal Executive Officer and Chief Financial Officer have evaluated the effectiveness of the our disclosure controls and procedures as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) as of the end of the period covered by this report. Based on this evaluation, our Principal Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective. +(b) +Changes in Internal Control over Financial Reporting. +During the fourth fiscal quarter ended September 30, 2018 , there were no changes in our internal controls over financial reporting that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting. +(c) +Management Report on Internal Control Over Financial Reporting +Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that: +(i) +pertain to the maintenance of records, that in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(ii) +provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(iii) +provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Management assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2018 . In making this assessment, management used the criteria described in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). +Based on our assessment and those criteria, management concluded that our internal control over financial reporting was effective as of September 30, 2018 . Management reviewed the results of their assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of September 30, 2018 has been audited by RSM US LLP, an independent registered public accounting firm, as stated in their attestation report which is included herein. +Item 9B. Other Information +None. +81 +PART III +Certain information required by Part III is omitted from this Annual Report on Form 10-K because we will file a definitive Proxy Statement for the 2019 Annual Meeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, (the “Proxy Statement”), not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and the applicable information included in the Proxy Statement is incorporated herein by reference. +Item 10. Directors, Executive Officers and Corporate Governance +Information concerning our directors and nominees and other information as required by this item are hereby incorporated by reference from our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Code of Ethics +We have adopted a Code of Business Conduct and Ethics that is intended to serve as a code of ethics for purposes of Item 406 of Regulation S-K. Our Code of Business Conduct and Ethics is posed on our website www.alicoinc.com (at the Investor homepage under "Corporate Governance") and we intend to disclose on our website any amendments to, or waiver from, such code. +Item 11. Executive Compensation +The information required by Item 11 regarding executive compensation is included under the headings “Compensation Discussion and Analysis,” “Compensation Committee Report” and “Compensation Committee Interlocks and Insider Participation” in our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +Information concerning the ownership of certain beneficial owners and management and related stockholder matters is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 13. Certain Relationships and Related Transactions, and Director Independence +The information concerning relationships and related transactions is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 14. Principal Accountants Fees and Services +Information concerning principal accounting fees and services is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +82 +PART IV +Item 15. Exhibits, Financial Statement Schedules +(a) +Documents filed as part of this report +(1) +Financial Statements: +Our Consolidated Financial Statements are included in Part II, Item 8 of this Annual Report on Form 10-K. +(2) +Financial Statement Schedules: +Financial statement schedules are omitted as the required information is either inapplicable or the information is presented in our Consolidated Financial Statements or notes thereto. +(3) +Exhibits +The exhibits listed in the Exhibit Index in (b) below are filed or incorporated by reference as part of this Annual Report on Form 10-K. +(b) +Exhibit Index +83 +Exhibit +Number +Exhibit Index +2.1 +*** +Asset Purchase Agreement, dated as of December 1, 2014, by and among Alico, Inc., Orange-Co, LP, and, solely with respect to certain sections thereof, Orange-Co, LLC and Tamiami Citrus, LLC. (incorporated by reference to Exhibit 2.1 of Alico’s filing on Form 8-K dated December 5, 2014) +2.2 +*** +Agreement and Plan of Merger, dated as of December 2, 2014, by and among Alico, Inc., 734 Sub, LLC, 734 Citrus Holdings, LLC, and, solely with respect to certain sections thereof, 734 Agriculture, LLC, Rio Verde Ventures, LLC and Clayton G. Wilson (incorporated by reference to Exhibit 2.2 of Alico’s filing on Form 8-K dated December 5, 2014) +3.1 +Restated Certificate of Incorporation, dated February 17, 1972 (incorporated by reference to Exhibit 3.1 of Alico's filing on Form 10-K dated December 11, 2017) +3.2 +Certificate of Amendment to Certificate of Incorporation, dated January 14, 1974 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.3 +Amendment to Articles of Incorporation, dated January 14, 1987 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.4 +Amendment to Articles of Incorporation, dated December 27, 1988 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.5 +By-Laws of Alico, Inc., amended and restated (incorporated by reference to Exhibit 3.1 of the Company’s current report on Form 8-K, filed with the Commission on January 25, 2013) +10.1 +Credit Agreement dated as of December 1, 2014, by and between Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, L.L.C., Alico Land Development, Inc., and Alico Citrus Nursery, L.L.C., as Borrowers and Rabo Agrifinance, Inc., as Lender (incorporated by reference to Exhibit 10.2 of Alico's filing on Form 8-K dated December 5, 2014) +10.2 +Purchase and Sale Agreement dated August 7, 2014 (incorporated by reference to Exhibit 10.10 of Alico’s filing on Form 10-K dated December 12, 2014) +10.3 +* +Form of Indemnification Agreement (incorporated by reference to Exhibit 10.5 of the Company’s quarterly report on Form 10-Q filed with the Commission on May 6, 2013) +10.4 +* +Management Security Plan(s) Trust Agreement (incorporated by reference to Exhibit 10.6 of the Company’s quarterly report on Form 10-Q filed with the Commission on May 6, 2013) +10.5 +Agricultural Lease Agreement dated May 19, 2014 between Alico, Inc. and United States Sugar Corporation. (incorporated by reference to Exhibit 10.1 of the Company’s quarterly report on Form 10-Q filed with the Commission on August 11, 2014) +10.6 +*** +First Amended and Restated Credit Agreement, dated as of December 1, 2014, by and among Alico, Inc., Alico Land Development, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Metropolitan Life Insurance Company, and New England Life Insurance Company (incorporated by reference to Exhibit 10.1 of Alico’s filing on Form 8-K dated December 5, 2014) +10.7 +*** +Credit Agreement dated as of December 1, 2014, by and between Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development, Inc., and Alico Citrus Nursery, LLC, as Borrowers and Rabo Agrifinance, Inc., as Lender (incorporated by reference to Exhibit 10.2 of Alico’s filing on Form 8-K dated December 5, 2014) +10.8 +Shared Services Agreement by and between Alico, Inc. and Trafelet Brokaw Capital Management, L.P. dated July 23, 2018 (incorporated by reference to Exhibit 10.1 of Alico's filing on Form 10-Q dated August 6, 2018) +10.9 +Loan Agreement, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (the "Prudential Loan Agreement") (incorporated by reference to Exhibit 10.16 of Alico’s filing on Form 10-K dated December 10, 2015) +10.10 +Promissory Note A, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.17 of Alico’s filing on Form 10-K dated December 10, 2015) +10.11 +Promissory Note B, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.18 of Alico’s filing on Form 10-K dated December 10, 2015) +84 +10.12 +Promissory Note C, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.19 of Alico’s filing on Form 10-K dated December 10, 2015) +10.13 +First Amendment to Loan Agreement, dated March 26, 2013 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.20 of Alico’s filing on Form 10-K dated December 10, 2015) +10.14 +Promissory Note D, dated March 26, 2013, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.21 of Alico’s filing on Form 10-K dated December 10, 2015) +10.15 +Loan Agreement, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC ("Loan E and F") (incorporated by reference to Exhibit 10.22 of Alico’s filing on Form 10-K dated December 10, 2015) +10.16 +Promissory Note E, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.23 of Alico’s filing on Form 10-K dated December 10, 2015) +10.17 +Promissory Note F, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.24 of Alico’s filing on Form 10-K dated December 10, 2015) +10.18 +First Amendment to Loan Agreement, dated April 23, 2015 (Loan E and F) (incorporated by reference to Exhibit 10.25 of Alico’s filing on Form 10-K dated December 10, 2015) +10.19 +Second Amendment to the Loan Agreement, dated September 4, 2014 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.26 of Alico’s filing on Form 10-K dated December 10, 2015) +10.20 +Third Amendment to the Loan Agreement, dated April 23, 2015 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.27 of Alico’s filing on Form 10-K dated December 10, 2015) +10.21 +Cancellation and Termination of Note D, dated April 23, 2015, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.28 of Alico’s filing on Form 10-K dated December 10, 2015) +10.22 +First Amendment to Credit Agreement and Consent with Rabo Agrifinance, Inc. dated February 26, 2015 (incorporated by reference to Exhibit 10.29 of Alico’s filing on Form 10-K dated December 10, 2015) +10.23 +Second Amendment to Credit Agreement with Rabo Agrifinance, Inc. dated July 16, 2015 (incorporated by reference to Exhibit 10.30 of Alico’s filing on Form 10-K dated December 10, 2015) +10.24 +Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company, dated February 1, 2015 (incorporated by reference to Exhibit 10.31 of Alico’s filing on Form 10-K dated December 10, 2015) +10.25 +Second Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated August 12, 2015 (incorporated by reference to Exhibit 10.32 of Alico’s filing on Form 10-K dated December 10, 2015) +10.26 +Third Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 30, 2016 (incorporated by reference to Exhibit 10.33 of Alico's filing on Form 10-K dated December 6, 2016) +10.27 +Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 30, 2016 (incorporated by reference to Exhibit 10.34 of Alico's filing on Form 10-K dated December 6, 2016) +85 +10.28 +Supplement No. 1 dated as of September 30, 2016, to the Security Agreement dated as of December 1, 2014 by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) (incorporated by reference to Exhibit 10.35 of Alico's filing on Form 10-K dated December 6, 2016) +10.29 +Employment Agreement dated June 1, 2015 between Alico, Inc. and John Kiernan (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the Commission on June 1, 2015) +10.30 +Separation and Consulting Agreement dated December 31, 2016 between Alico, Inc. and Clayton G. Wilson (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the Commission on January 4, 2017) +10.31 +Employment Agreement dated December 31, 2016 between Alico, Inc. and Remy W. Trafelet (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed with the Commission on January 4, 2017) +10.32 +Employment Agreement dated December 31, 2016 between Alico, Inc. and Henry R. Slack (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed with the Commission on January 4, 2017) +10.33 +Employment Agreement dated March 27, 2013 between Alico, Inc. and George R. Brokaw (incorporated by reference to Exhibit 10.4 of the Company’s Form 8-K filed with the Commission on January 4, 2017) +10.34 +Offer of Employment Letter dated June 16, 2017 between Richard Rallo and Alico, Inc. (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the Commission on August 7, 2017) +10.35 +Fourth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 6, 2017 (incorporated by reference to Exhibit 10.38 of Alico's filing on Form 10-K dated December 11, 2017) +10.36 +Second Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 6, 2017 (incorporated by reference to Exhibit 10.39 of Alico's filing on Form 10-K dated December 11, 2017) +10.37 +Fifth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated October 30, 2017 +10.38 +Sixth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated July 18, 2018 +10.39 +Seventh Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 26, 2018 +10.40 +Third Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 26, 2018 +21.0 +Subsidiaries of the Registrant +23.0 +Consent of Independent Registered Public Accounting Firm +31.1 +Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Rule 13a-14(a) certification +31.2 +Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Rule 13a-14(a) certification +32.1 +Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 +32.2 +Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 +101 +101.INS +** +XBRL Instance Document +101.SCH +** +XBRL Taxonomy Extension Schema Document +101.CAL +** +XBRL Taxonomy Calculation Linkbase Document +86 +101.DEF +** +XBRL Taxonomy Definition Linkbase Document +101.LAB +XBRL Taxonomy Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* +Denotes a management contract or compensatory plan, contract or arrangement. +** +In accordance with Rule 406T of Regulation S-T, these XBRL (eXtensible Business Reporting Language) documents are furnished and not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability under these sections. +*** +Certain schedules and exhibits have been omitted from this filing pursuant to Item 601(b) (2) of Regulation S-K. The Company will furnish supplemental copies of any such schedules or exhibits to the SEC upon request. +87 +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ALICO, INC. (Registrant) +December 6, 2018 +By: +/s/ Henry R. Slack +Henry R. Slack +Executive Chairman +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated: +December 6, 2018 +Executive Chairman and Director (Principal Executive Officer) +/s/ Henry R. Slack +Henry R. Slack +December 6, 2018 +Chief Financial Officer and Executive Vice President (Principal Financial and Accounting Officer) +/s/ John E. Kiernan +John E. Kiernan +December 6, 2018 +Director +/s/ George R. Brokaw +George R. Brokaw +December 6, 2018 +Director +/s/ R. Greg Eisner +R. Greg Eisner +December 6, 2018 +Director +/s/ Benjamin D. Fishman +Benjamin D. Fishman +December 6, 2018 +Director +/s/ W. Andrew Krusen +W. Andrew Krusen +December 6, 2018 +Director +/s/ Joseph S. Sambuco +Joseph S. Sambuco +88 \ No newline at end of file diff --git a/raw/filings/0000003545/2018/0000003545-18-000108/filing_metadata.csv b/raw/filings/0000003545/2018/0000003545-18-000108/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..723f149fa930acd89c2ec95eccda7b65c4683c88 --- /dev/null +++ b/raw/filings/0000003545/2018/0000003545-18-000108/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003545,ALCO,"ALICO, INC.",2018,10-K,2018-12-06,2018-09-30,2018-12-06T21:58:38.000Z,0000003545-18-000108,alco-93018x10k.htm,10-K,12379414,1,0,https://www.sec.gov/Archives/edgar/data/3545/000000354518000108/alco-93018x10k.htm,https://www.sec.gov/Archives/edgar/data/3545/000000354518000108/ diff --git a/raw/filings/0000003545/2018/0000003545-18-000108/item1.txt b/raw/filings/0000003545/2018/0000003545-18-000108/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..10336ae200f4125f58b4f548d5b2d535bab18b13 --- /dev/null +++ b/raw/filings/0000003545/2018/0000003545-18-000108/item1.txt @@ -0,0 +1,207 @@ +Item 1. Business +Alico, Inc. (“Alico”) was incorporated under the laws of the state of Florida in 1960. Collectively with its subsidiaries (the "Company", "we", "us" or "our"), our business and operations are described below. For detailed financial information with respect to our business and our operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included in Item 7 in this Annual Report on Form 10-K, and the accompanying Consolidated Financial Statements and the related Notes therein, which are included in Item 8. In addition, general information concerning our Company can be found on our website, the internet address of which is http://www.alicoinc.com . All of our filings with the Securities and Exchange Commission (the "SEC") including, but not limited to, the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are available free of charge on our website as soon as reasonably practicable after such material is electronically filed or furnished with the SEC. Our recent press releases and information regarding corporate governance, including the charters of our audit, compensation, executive and nominating governance committees, as well as our code of business conduct and ethics are also available to be viewed or downloaded electronically at http://www.alicoinc.com . The information on our website is not part of this report or any other report we file with or furnish to the SEC. +Overview +Alico is an agribusiness with a legacy of achievement and innovation in citrus and conservation. The Company owns approximately 117,000 acres of land in eight Florida counties (Charlotte, Collier, DeSoto, Glades, Hardee, Hendry, Highlands and Polk) including approximately 90,000 acres of mineral rights. Our principal lines of business are citrus groves and conservation. +During the fiscal year ended September 30, 2015, the Company acquired three Florida citrus properties for total consideration of approximately $363,000,000. These acquisitions made Alico one of the largest citrus producers in the United States of America. +Alico, Inc. operates two divisions: Alico Citrus, a citrus producer, and Alico Water Resources, a leading water storage and environmental services division. +The Company manages its land based upon its primary usage and reviews its performance based upon two primary classifications - Alico Citrus and Alico Water Resources and Other Operations . Other Operations includes lease for grazing rights, a lease to a third party of an aggregate mine and leases of oil extraction rights to third parties, farm lease revenue, the generation of revenues from sod and tree sales and rental income for office space. Alico presents its financial results and the related discussion based upon its two business segments: (i) Alico Citrus and (ii) Water Resources and Other Operations . +Recent Developments +Water Storage Contract Approval +In December 2012, the South Florida Water Management District (“SFWMD” or "District") issued a solicitation request for projects to be considered for the Northern Everglades Payment for Environmental Services Program ("Program"). In March 2013, the Company submitted its response proposing a dispersed water management project on a portion of its ranch land. The environmental services project ("Water Project") encompasses a large-scale water storage/nutrient load reduction project over approximately half of the Company's 72,000-acre ranch located in southern Hendry County. The Water Project has the ability to retain 94,000-acre feet of water, making it one of the largest private storage projects proposed to date and the largest within the Caloosahatchee River watershed. The Water Project was approved by the South Florida Water Management District in late 2014, and the Company's engineering and environmental consultants immediately began working on a detailed design. As a result of the uniqueness of the project site, which consists of over 11,000 acres of wetlands and several cultural resource sites, considerable effort has been undertaken over the past 3.5 years in securing necessary regulatory approvals for the project from both the State of Florida and the federal government. In addition, the project requires close coordination with adjacent landowners, as well as the water control districts that serve those landowner/properties. On September 29, 2015, the SFWMD amended the contract to extend it for an additional year. In 2016, the Florida Department of Environmental Protection included the project in the State’s Northern Everglades Public-Private Partnership Program. +The contract term is eleven years and allows up to one year for implementation (design, permitting, construction and construction completion certification) and ten years of operation, whereby the Company will provide water retention services. Payment for these services includes an amount not to exceed $4,000,000 of reimbursement for implementation. In addition, the contract provides an annual fixed payment of $12,000,000 for operations and maintenance costs, as long as the project is in compliance with the contract and subject to annual District Board approval of funding. The contract specifies that the District Board has to approve +1 +the payments annually through its budget process and there can be no assurance that it will approve the annual fixed payments. The Florida budget for the state’s 2018/2019 fiscal year as approved included Save Our Everglades trust/legacy Florida funding for the Program. On September 19, 2018 the SFWMD issued a press release announcing the issuance of an Environmental Resource Permit for Alico. The SFWMD release also stated that (i) the issuance of the permit cleared the path for Alico to deliver a dispersed water storage project in the Caloosahatchee Watershed, (ii) Alico has all necessary state approvals to proceed, and (iii) the project is expected to be operational within one year from the start of construction, which is contingent on Alico securing additional local and federal approvals. These approvals include a compatible use agreement from the Natural Resources Conservation Service, as well as approvals from the local water control districts. Construction will begin immediately upon receipt of permits. Annual fixed payments will not commence until completion of construction. The Company anticipates receiving all necessary regulatory approvals within the next four to six months. The Company has not recognized any revenue to date from the contract. Operating expenses were approximately $1,619,000 , $1,794,000 and $2,322,000 for each of the three years ended September 30, 2018 , 2017 and 2016 , respectively. +Tender Offer +On September 5, 2018, the Board of Directors approved and Alico announced the commencement of an issuer offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, upon the terms and subject to the conditions described in the Offer to Purchase dated September 5, 2018, Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors, LLC, Alico’s largest stockholder since 2013, participated in the Tender Offer and sold a small percentage of its holdings of the Company’s common stock. Members of neither the management team nor the Board of Directors sold any shares directly to the Tender Offer. +Hurricane Irma +Florida’s citrus industry was hit hard by the impacts of Hurricane Irma during the 2017-2018 season. Alico’s 2018 production was down by approximately 36% from the prior season. While we lost a small percentage of trees, the force and duration of the storm impacted the majority of the groves. Based upon prior experience with serious storms of this nature, we expect it will take at least two seasons for the groves to recover to pre-hurricane production levels. We finished with production of 4,827,000 boxes in fiscal year 2018 and anticipate an increase in production in fiscal year 2019 to 6,300,000-6,600,000 boxes and a return to pre-hurricane production levels by fiscal year 2020, which is approximately 7,900,000 boxes. +Through November 30, 2018, the Company received insurance proceeds relating to Hurricane Irma of approximately $477,000 for property and casualty damage claims and approximately $8,952,000 for crop claims, which have been recorded in operating expenses. The Company has additional property and casualty claims outstanding and is awaiting determination of additional proceeds, if any, to be received. In addition to the commercial insurance claims which have been submitted, the Company may be eligible for Irma federal relief programs distributed by the Farm Service Agency under the 2017 Wildfires and Hurricane Indemnity Program (2017 WHIP) as well as block grants that will be administered through the State of Florida. The specifics of the programs are still being finalized and at this time, the Company cannot determine the amount of federal relief funds which will be received or when these funds will be disbursed. +Alico 2.0 Modernization Program +On November 16, 2017, we announced the Alico 2.0 Modernization Program (“Alico 2.0”). This program is transforming three legacy businesses (Alico, Orange Co., and Silver Nip) into a single efficient enterprise, Alico Citrus, so we will remain one of the leaders in the U.S. citrus industry. This initiative explored every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. +Under this program, we expected to reduce citrus total expenses per acre to $2,164/acre and the cost to produce a pound solid to $1.56 when Alico 2.0 is fully implemented in 2020. These efficiencies are being achieved through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. We have also deployed a more efficient labor model that is consistent and uniform for field staffing and grove operating programs and aligns with the geographical footprint of the citrus groves. +In combination with these efforts, the Company is working to maintain operational efficiencies and deploy its resources to solidify the Company's position as a leader in the recovering citrus industry. +2 +Alico 2.0 also led us to decide to divest assets that generated low rates of return and shut down parts of our operations that were not profitable. Alico Citrus has shut down its nursery in Gainesville, Florida, is in the process of selling its trailers and has either sold or is in the process of selling real estate assets that are not strategic to our business plan. +In January 2018, the Company sold its breeding herd and leased grazing rights on the Alico Ranch to a third party operator. However, the Company continues to own the property and continues to conduct its long-term water dispersement program and wildlife management programs. As part of the sales transaction, the Company expensed all inventory costs that were accumulated at the date of sale. +Alico 2.0 also included an enhanced program to plant more citrus trees. The Company planted over 400,000 trees in fiscal year 2018 to help position the Company for future production growth beyond 2020. The Company believes that its current acreage can produce 10,000,000 boxes per year on a sustained basis, even in an environment where citrus greening continues. +Termination Proceedings against Mr. Remy W. Trafelet +On November 19, 2018, Alico, with unanimous approval of the members of the Board of Directors, other than Remy W. Trafelet, notified Mr. Trafelet, the Company's President and Chief Executive Officer and a member of the Board of Directors, that it intends to consider terminating his employment for “cause” pursuant to the terms of his employment agreement with the Company and option agreements entered into under the Company's Stock Incentive Plan of 2015 (collectively, the “Compensation Documents”). As required by the Compensation Documents, the Company will schedule a special meeting of the Board of Directors at a future date, at which meeting Mr. Trafelet and his counsel (if he so elects) may meet with the Board of Directors to address this matter. The Board of Directors will make its final determination as to Mr. Trafelet’s employment following such meeting. Mr. Trafelet has been placed on paid administrative leave pending the outcome of these proceedings. On November 28, 2018, the parties in the Florida Litigation (as defined below) stipulated to an order which provides, among other things, that pending the resolution of the Delaware Litigation (as defined below), the Board of Directors shall not take any action out of the routine day-to-day operations conducted in the ordinary course of business, including removing any corporate officers or directors from positions held as of November 27, 2018. For more information, see Item 3, "Legal Proceedings." +Appointment of Interim President +In connection with the commencement of the termination proceedings against Mr. Trafelet, Benjamin D. Fishman, a current member of the Board of Directors, was appointed to serve as Interim President of the Company, effective as of November 19, 2018. Henry R. Slack, the Company's Executive Chairman, and Mr. Fishman will manage the Company during the pendency of the termination proceedings. Neither Mr. Slack nor Mr. Fishman will receive any incremental compensation for their service during this period. In connection with assuming such interim role, Mr. Fishman has stepped down from the Audit Committee of the Board of Directors, and Mr. Andrew Krusen has assumed the Chairmanship of the Audit Committee. +Operating Segments +Operating segments are defined in Financial Accounting Standards Board ("FASB") - Accounting Standards Codification ("ASC") ASC Topic 280, "Segment Reporting" as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. For the fiscal years ended September 30, 2018 and 2017 the Company’s CODM assessed performance and allocated resources based on two operating segments: (i) Alico Citrus and (ii) Water Resources and Other Operations . +Commencing in Alico's fiscal year 2018, the Company operates two business segments related to its various land holdings, as follows: +• +Alico Citrus includes activities related to planting, owning, cultivating and/or managing citrus groves in order to produce fruit for sale to fresh and processed citrus markets, including activities related to the purchase and resale of fruit and value-added services, which include contracting for the harvesting, marketing and hauling of citrus. +• +Water Resources and Other Operations consists of activities related to water conservation, leasing of grazing rights, mining royalties and other less significant lines of business. Also included are activities related to owning and/or leasing improved farmland. Improved farmland is acreage that has been converted, or is permitted to be converted, from native pasture and which may have various improvements including irrigation, drainage and roads. +Prior to the sale of the breeding herd in January 2018, the Company’s business also included cattle ranching. +3 +The Land We Manage +We regularly review our land holdings to determine the best use of each parcel based upon our management expertise. Our total return profile is a combination of operating income potential and long-term appreciation. Land holdings not meeting our total return criteria are considered surplus to our operations and will be sold or exchanged for land considered to be more compatible with our business objectives and total return profile. +Our land holdings and the operating activities in which we engage are categorized in the following table: +Gross Acreage +Operating Activities +Alico Citrus +Citrus Groves +44,983 +Citrus Cultivation +Citrus Nursery +22 +Citrus Tree Development +45,005 +Water Resources and Other Operations +Ranch +70,322 +Leasing and Conservation +Other Land +1,434 +Mining lease; Office +Total +116,761 +Alico Citrus +We own and manage citrus land in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties and engage in the cultivation of citrus trees to produce citrus for delivery to the fresh and processed citrus markets. Alico citrus groves total approximately 45,000 gross acres or 38.5% of our land holdings. +Our citrus acreage is detailed in the following table: +Net Plantable +Producing +Developing +Fallow +Total Plantable +Support & Other +Gross +DeSoto County +14,980 +1,096 +482 +16,558 +4,650 +21,208 +Polk County +4,576 +— +— +4,576 +2,229 +6,805 +Collier County +4,261 +— +— +4,261 +2,905 +7,166 +Hendry County +3,546 +57 +175 +3,778 +1,707 +5,485 +Charlotte County +1,729 +— +138 +1,867 +676 +2,543 +Highlands County +1,063 +— +— +1,063 +161 +1,224 +Hardee County +403 +— +— +403 +171 +574 +Total +30,558 +1,153 +795 +32,506 +12,499 +45,005 +Of the approximately 45,000 gross acres of citrus land we own and manage, approximately 12,500 acres are classified as support acreage. Support acreage includes acres used for roads, barns, water detention, water retention and drainage ditches integral to the cultivation of citrus trees, but which are not capable of directly producing fruit. In addition, we own a small citrus tree nursery and utilize the trees produced in our own operations. The approximately 32,500 remaining acres are classified as net plantable acres. Net plantable acres are those that are capable of directly producing fruit. These include acres that are currently producing, acres that are developing (acres that are planted with trees too young to commercially produce fruit) and acres that are fallow. +Our Alico Citrus business segment cultivates citrus trees to produce citrus for delivery to the processed and fresh citrus markets. Our sales to the processed market were approximately 93.7%, 91.7% and 86.9% of Alico Citrus revenues for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. We produce Early and Mid-Season varieties, primarily Hamlin oranges, as well as a Valencia variety for the processed market. We deliver our fruit to the processors in boxes which each contains approximately 90 pounds of oranges. Because the processors convert the majority of the citrus crop into orange juice, they generally do not buy their citrus on a per box basis, but rather on a pound solids basis, which is the measure of the soluble solids (sugars and acids) +4 +contained in one box of citrus fruit. We produced approximately 26,513,000 , 42,611,000 , and 51,404,000 pound solids for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively, from boxes delivered to processing plants of approximately 4,702,000 , 7,259,000 and 8,829,000 , respectively. As previously indicated, the falloff is fiscal year 2018 was in large part attributable to the impact of Hurricane Irma. +The average pound solids per box was 5.64, 5.87 and 5.82 for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +We generally use multi-year contracts with citrus processors that include pricing structures based on a minimum (“floor”) price with a price increase (“rise”) based on market conditions. Therefore, if pricing in the market is favorable relative to our floor price, we benefit from the incremental difference between the floor and the final market price. +Our citrus produced for the processed citrus market in fiscal year 2018-2019 under our largest agreement will be under minimum floor price ranging from $2.05 to $2.15 per pound solid and rise price from $2.50 to $2.65 per pound solid. Under this agreement, if the market price exceeds the rise prices, then 50% of the excess will be added to the rise price. Under our next largest agreement, our citrus produced will be under a minimum floor price of $2.60 per pound solid and rise price of $3.30 per pound solid. We believe that other markets are available for our citrus products; however, new arrangements may be less favorable than our current contracts. +Our sales to the fresh citrus market constituted approximately 2.6%, 4.6% and 3.8% of our Alico Citrus revenues for the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. We produce numerous varieties for the fresh fruit market including grapefruit, navel and other fresh varieties. Generally, our fresh fruit is sold to packing houses by the box and the packing houses are responsible for the harvest and haul of these boxes. We produced approximately 125,000 , 328,000 and 402,000 fresh fruit boxes for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. The majority of our citrus harvested for the fresh citrus market in fiscal year 2018-2019 is under fixed price contracts. +Revenues from our Alico Citrus operations were approximately 96.1% , 95.1% and 95.2% of our total operating revenues for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +Water Resources and Other Operations +We own and manage land in Collier, Glades, and Hendry Counties and engaged in cattle grazing and sales, sod and native plant sales, and still continue with land leasing for recreational and grazing purposes, conservation, and mining activities. Our Water Resources and Other Operations land holdings total approximately 72,000 gross acres, or 61.5% of our total acreage. +Our Water Resources and Other Operations acreage is detailed in the following table as of September 30, 2018 : +Acreage +Hendry County +67,208 +Glades County +526 +Collier County +4,022 +Total +71,756 +In January 2018, the Company sold its breeding herd and leased grazing rights on the Alico Ranch to a third party operator. The +Company continues to own the property and conduct its long-term water dispersement program and wildlife management programs. As part of the sales transaction, the Company expensed all cattle inventory costs that were accumulated at the date of sale. +In fiscal year 2017, our cattle operation was engaged in the production of beef cattle in Hendry and Collier Counties. The breeding herd consisted of approximately 8,700 cows and bulls. We primarily sold our calves to feed yards and yearling grazing operations in the United States. We also sold cattle through local livestock auction markets and to contract cattle buyers in the United States. These buyers provided ready markets for our cattle. Revenues from Water Resources and Other Operations were approximately 3.9%, 4.9% and 4.8% of total operating revenues for each of the fiscal years ended September 30, 2018 , 2017 and 2016 , respectively. +Our Strategy +Our core business strategy is to maximize stockholder value through continuously improving the return on our invested capital, either by holding and managing our existing land through skilled agricultural production, leasing, or other opportunistic means +5 +of monetization, disposing of under productive land or business units and acquiring new land or operations with appreciation potential. +Our objectives are to produce the highest quality agricultural products, create innovative land uses, opportunistically acquire and convert undervalued assets, sell under-productive land and other assets not meeting our total return profile, generate recurring and sustainable profit with the appropriate balance of risk and reward, and exceed the expectations of stockholders, customers, clients and partners. +Our strategy is based on best management practices of our agricultural operations and the environmental and conservation stewardship of our land and natural resources. We manage our land in a sustainable manner and evaluate the effect of changing land uses while considering new opportunities. Our commitment to environmental stewardship is fundamental to the Company’s core beliefs. +Seasonal Nature of Business +As with any agribusiness enterprise, our agribusiness operations and revenues are predominantly seasonal in nature. The following table illustrates the seasonality of our agribusiness revenues: +Fiscal Year +Q1 +Q2 +Q3 +Q4 +Ending 12/31 +Ending 3/31 +Ending 6/30 +Ending 9/30 +Oct +Nov +Dec +Jan +Feb +Mar +Apr +May +Jun +Jul +Aug +Sept +Harvest Fresh and Early/Mid Varieties of Oranges +Harvest Valencia Oranges +Significant Customers +Revenue from Tropicana represented approximately 87%, 86% and 32.5% of our consolidated revenue for the fiscal years ended September 30, 2018, 2017 and 2016, respectively. The revenue in fiscal year 2018 from Tropicana was generated primarily from two separate contracts. This revenue was generated from the sale of our citrus product in the processed market. No other customer provided more than 6% of our consolidated revenue in fiscal year 2018 or 2017. In the fiscal year 2016, 34.2% of the revenue was obtained through Minute Maid. +Competition +The orange and specialty citrus markets are intensely competitive, but no single producer has any significant market power over any market segments, as is consistent with the production of most agricultural commodities. Citrus is grown domestically in several states including Florida, California, Arizona and Texas, as well as foreign countries, most notably Brazil. Competition is impacted by several factors including quality, production, demand, brand recognition, market prices, weather, disease, export/import restrictions and foreign currency exchange rates. +Environmental Regulations +Our operations are subject to various federal, state and local laws regulating the discharge of materials into the environment. Management believes we are in compliance with all such rules including permitting and reporting requirements. Historically, compliance with environmental regulations has not had a material impact on our financial position, results of operations or cash flows. +Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. In addition, we require lessees of our property to comply with environmental regulations as a condition of leasing. +6 +Employees +As of September 30, 2018 , we had 233 full-time employees. Our employees work in the following divisions: +Alico Citrus +212 +Water Resources and Other Operations +0 +Corporate, General, Administrative and Other +21 +Total employees +233 +None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good. +Capital Resources and Raw Materials +Management believes that the Company will be able to meet its working capital requirements for at least the next 12 months, and over the long term, through internally generated funds, cash flows from operations, the sale of under-productive land and other assets, our existing lines of credit and access to capital markets. The Company has commitments that provide for lines of revolving credit that are available for our general and corporate use. +Raw materials needed to cultivate the various crops grown by the Company consist primarily of fertilizers, herbicides and fuel and are readily available from local suppliers. +Available Information +We provide electronic copies of our SEC filings free of charge upon request. Any information posted on or linked from our website is not incorporated by reference in this Annual Report on Form 10-K. The SEC also maintains a website at http://www.sec.gov , which contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. +7 \ No newline at end of file diff --git a/raw/filings/0000003545/2018/0000003545-18-000108/item13.txt b/raw/filings/0000003545/2018/0000003545-18-000108/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..9709427b9d359d43f3d868a04f0313906c92e7e7 --- /dev/null +++ b/raw/filings/0000003545/2018/0000003545-18-000108/item13.txt @@ -0,0 +1,2 @@ +Item 13. 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COMMISSION +Washington, D.C. 20549 +FORM 10-K +☑ +Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the Fiscal Year Ended +September 30, 2019 +or +☐ +Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the transition period +from____________________ +to_________________________ +Commission File Number: 0-261 +ALICO, INC. +( Exact name of registrant as specified in its charter ) +Florida +59-0906081 +( State or other jurisdiction of +incorporation or organization ) +( I.R.S. Employer Identification No. ) +10070 Daniels Interstate Court +Suite 100 +Fort Myers +FL +33913 +(Address of principal executive offices) +(Zip Code) +(239) +226-2000 +(Registrant’s telephone number, including area code ) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol(s) +Name of each exchange on which registered +Common Stock +ALCO +NASDAQ Global Select Market +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +☐ Yes ☑ No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +☐ Yes ☑ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☑ Yes ☐ No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☑ Yes ☐ No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one): +Large Accelerated Filer +☐ +Accelerated Filer +☑ +Non-accelerated filer +☐ +Smaller Reporting Company +☐ +Emerging Growth Company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑ +The aggregate market value of the voting and nonvoting common equity held by non-affiliates based on the closing price, as quoted on the Nasdaq Global Select Market as of March 29, 2019 (the last business day of Alico’s most recently completed second fiscal quarter) was $ 95,991,356 . Solely for the purposes of this calculation, the registrant has elected to treat all executives, officers and greater than 10% stockholders as affiliates of the registrant. There were 7,475,200 shares of common stock outstanding at December 2, 2019 . +Documents Incorporated by Reference: +Portions of the Proxy Statement of Registrant for the 2020 Annual Meeting of Stockholders (to be filed with the SEC under Regulation 14A within 120 days after the end of the Registrant's fiscal year), are incorporated by reference in Part III of this report. +1 +ALICO, INC. +FORM 10-K +For the fiscal year ended September 30, 2019 +PART I +Item 1. Business +1 +Item 1A. Risk Factors +7 +Item 1B. Unresolved Staff Comments +16 +Item 2. Properties +16 +Item 3. Legal Proceedings +16 +Item 4. Mine Safety Disclosures +18 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +19 +Item 6. Selected Financial Data +22 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +24 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +42 +Item 8. Financial Statements and Supplementary Data +43 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +80 +Item 9A. Controls and Procedures +80 +Item 9B. Other Information +80 +PART III +Item 10. Directors, Executive Officers and Corporate Governance +82 +Item 11. Executive Compensation +82 +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +82 +Item 13. Certain Relationships and Related Transactions and Director Independence +83 +Item 14. Principal Accountants Fees and Services +83 +PART IV +Item 15. Exhibits, Financial Statement Schedules +84 +Item 16. 10-K Summary +84 +Signatures +89 +2 +Cautionary Statement +This Annual Report on Form 10-K contains certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). They are based on management’s current expectations and assumptions regarding our business and performance, the economy and other future conditions and forecasts of future events, circumstances and results. These forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements often include words such as “may,” “will,” “could,” “should,” “would,” “believes,” “expects,” “anticipates”, “estimates”, “projects,” “intends,” “plans” and other words and terms of similar substance in connection with discussions of future operating or financial performance. Such forward-looking statements include, but are not limited to, statements regarding future actions, business plans and prospects, prospective products, trends, future performance or results of current and anticipated products, sales efforts, expenses, interest rates, the outcome of contingencies, such as legal proceedings, plans relating to dividends, government regulations, the adequacy of our liquidity to meet our needs for the foreseeable future and our expectations regarding market conditions. +As with any projection or forecast, forward-looking statements are inherently susceptible to uncertainty and changes in circumstances. Our actual results may vary materially from those expressed or implied in our forward-looking statements. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements. +We undertake no obligation to update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K filed with the U.S. Securities and Exchange Commission ("SEC"). We provide in Item 1A, “Risk Factors,” a cautionary discussion of certain risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. In addition, the operation and results of our business are subject to risks and uncertainties identified elsewhere in this Annual Report on Form 10-K as well as general risks and uncertainties such as those relating to general economic conditions. You should understand that it is not possible to predict or identify all such risks. Consequently, you should not consider such discussion to be a complete discussion of all potential risks or uncertainties. +3 +PART I +Item 1. Business +Alico, Inc. (“Alico”) was incorporated under the laws of the state of Florida in 1960. Collectively with its subsidiaries (the "Company", "we", "us" or "our"), our business and operations are described below. For detailed financial information with respect to our business and our operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included in Item 7 in this Annual Report on Form 10-K, and the accompanying Consolidated Financial Statements and the related Notes, which are included in Item 8. In addition, general information concerning our Company can be found on our website, the internet address of which is http://www.alicoinc.com . All of our filings with the U.S. Securities and Exchange Commission (the "SEC") including, but not limited to, the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are available free of charge on our website as soon as reasonably practicable after such material is electronically filed or furnished with the SEC. Our recent press releases and information regarding corporate governance, including the charters of our audit, compensation, executive and nominating governance committees, as well as our code of business conduct and ethics are also available to be viewed or downloaded electronically at http://www.alicoinc.com . Unless explicitly stated herein, the information on our website is not incorporated by reference into this Annual Report on Form 10-K and the Company disclaims any such incorporation by reference. +Overview +Alico is an agribusiness with a legacy of achievement and innovation in citrus and conservation. The Company owns approximately 111,000 acres of land in eight Florida counties (Charlotte, Collier, DeSoto, Glades, Hardee, Hendry, Highlands and Polk) including approximately 90,000 acres of mineral rights. Our principal lines of business are citrus groves and conservation. +Alico is one of the largest citrus producers in the United States of America. +Alico, Inc. operates two divisions: Alico Citrus, a citrus producer, and Water Resources and Other Operations, a leading water storage and environmental services division. +The Company manages its land based upon its primary usage and reviews its performance based upon two primary classifications - Alico Citrus and Water Resources and Other Operations. Other Operations includes a lease for grazing rights, hunting leases, a lease to a third party of an aggregate mine and leases of oil extraction rights to third parties, farm lease revenue and rental income for office space. Alico presents its financial results and the related discussion based upon its two business segments: (i) Alico Citrus and (ii) Water Resources and Other Operations. +Recent Developments +Alico 2.0 Modernization Program +On November 16, 2017, we announced the Alico 2.0 Modernization Program (“Alico 2.0”). This program was intended to transform three legacy businesses (Alico, Orange Co., and Silver Nip) into a single efficient enterprise, Alico Citrus, so we would remain one of the leaders in the U.S. citrus industry. This initiative was to explore every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. +Under this program, Alico expected to reduce its operating costs. Alico has executed on the efficiencies identified and has improved margins through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. We have also deployed a more efficient labor model that is consistent and uniform for field staffing and grove operations and is aligned with the geographical footprint of the citrus groves. This effort has helped to transition us to a high-quality, low-cost producer of citrus now and for future years to come. +In combination with these efforts, the Company worked to maintain operational efficiencies and deploy its resources to solidify the Company's position as a leader in the recovering citrus industry. +Under Alico 2.0, we also decided to divest assets that generated low rates of return and shut down parts of our operations that were not profitable. As a result of Alico 2.0, Alico has generated cash of approximately $57,800,000 through September 30, 2019 from asset sales. This has been facilitated through (i) the sale of its nursery in Gainesville, Florida, (ii) the sale of certain +1 +underperforming groves, (ii) the sale of its breeding herd, (iv) the sale of certain parcels of land on its Ranch, (v) the sale of certain trailers related to our logistics division, and (vi) the sale of certain real estate assets that were not strategic to our business plan. +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third party operator. However, the Company continues to own the property and continues to conduct its long-term dispersed water program and wildlife management programs. +Alico 2.0 also included an enhanced program to plant more citrus trees. The Company planted over 400,000 trees in both the fiscal years ended September 30, 2019 and 2018 to help position the Company for future production growth. +Tender Offer +On September 5, 2018, the Board of Directors approved and Alico announced the commencement of an issuer offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, upon the terms and subject to the conditions described in the Offer to Purchase dated September 5, 2018, Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors, LLC, (“734 Investors”) Alico’s largest stockholder from 2013 until November 12, 2019, participated in the Tender Offer by selling a small percentage of its holdings of the Company’s common stock. Members of neither the management team nor the Board of Directors sold any shares directly to the Tender Offer. +Termination Proceedings against Mr. Remy W. Trafelet +On November 19, 2018, Alico, with unanimous approval of the members of the Board of Directors, other than Remy W. Trafelet, notified Mr. Trafelet, who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, that it intended to consider terminating his employment for “cause” pursuant to the terms of his employment agreement with the Company and option agreements entered into under the Company's Stock Incentive Plan of 2015 (collectively, the “Compensation Documents”). On November 28, 2018, the parties in the Florida Litigation (as defined below) stipulated to an order which provided, among other things, that pending the resolution of the Delaware Litigation (as defined below), the Board of Directors would not take any action out of the routine day-to-day operations conducted in the ordinary course of business, including removing any corporate officers or directors from positions held as of November 27, 2018. +As described in “Note 16. Commitments and Contingencies” to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K, the parties to the Florida Litigation entered into the Alico Settlement Agreement wherein the parties agreed to promptly dismiss all claims in the Florida Litigation, including those related to the termination proceedings against Mr. Trafelet, and Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and a member of the Company’s Board of Directors, effective upon the execution of the Alico Settlement Agreement. +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into the Consulting Agreement with Mr. Trafelet and 3584, Inc. (the "Consultant"). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $400,000. If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24-month term. +In addition, as contemplated by the Alico Settlement Agreement, the Company entered into the Registration Rights Agreement with Mr. Trafelet, relating to the Registrable Securities. The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +Management and Board Changes +On April 11, 2019, the Board of Directors announced the appointment of Mr. John E. Kiernan as President and Chief Executive Officer and Mr. Richard Rallo as Chief Financial Officer, both effective July 1, 2019. Additionally, Mr. Benjamin D. Fishman, the Company’s current Interim President, agreed to resign from this position effective July 1, 2019. In addition, on April 11, 2019, Mr. Henry A. Slack, the current Executive Chairman of the Board, informed the Board that he agreed to step down as Executive +2 +Chairman of the Board, effective July 1, 2019. Mr. Slack’s decision to step down as Executive Chairman of the Board was not the result of any disagreement with the Company on any matter relating to the Company’s operations, policies or practices. Mr. Slack will remain a member of the Board of Directors. The Board appointed Mr. Benjamin D. Fishman, the Company’s current Interim President, to the role of non-employee Executive Chairman of the Board, effective July 1, 2019. +On April 29, 2019, the Board of Directors appointed Mr. Toby K. Purse as a member of the Board of Directors, to serve until the 2020 annual meeting of the Company’s shareholders or until his earlier death, resignation, or removal in accordance with the Amended and Restated Bylaws of the Company. The Board of Directors has affirmatively determined that Mr. Purse qualifies as an independent director under the rules of the Nasdaq Stock Exchange and as defined under applicable law. Mr. Purse has also been appointed to serve as a member of the audit committee of the Board of Directors. +Federal Relief Program +The Company is eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fourth quarter of fiscal year 2019 and for the fiscal year ended September 30, 2019, the Company received approximately $15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and a portion of the Part 2 reimbursement under the three-part program. Subsequent to fiscal year end 2019, the Company received additional proceeds of approximately $4,136,000 under the Florida CRBG program. This represents another portion of the Part 2 reimbursement under the three-part program. The timing and amount to be received under the remaining portion of the Part 2 and the Part 3 of the program, if any, has not been finalized. +Distribution of Shares by 734 Investors +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +The Land We Manage +We regularly review our land holdings to determine the best use of each parcel based upon our management expertise. Our total return profile is a combination of operating income potential and long-term appreciation. Land holdings not meeting our total return criteria are considered surplus to our operations and will be sold or exchanged for land considered to be more compatible with our business objectives and total return profile. +Our land holdings and the operating activities in which we engage are categorized in the following table: +Gross Acreage +Operating Activities +Alico Citrus +Citrus Groves +45,151 +Citrus Cultivation +Citrus Nursery +22 +Citrus Tree Development +45,173 +Water Resources and Other Operations +Ranch +64,782 +Leasing and Conservation +Other Land +1,446 +Mining Lease and Office +66,228 +Total +111,401 +Alico Citrus +We own and manage citrus land in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties and engage in the cultivation of citrus trees to produce citrus for delivery to the fresh and processed citrus markets. Alico citrus groves total approximately 45,173 gross acres or 40.5% of our land holdings. +3 +Our citrus acreage is detailed in the following table: +Net Plantable +Producing +Developing +Fallow +Total Plantable +Support & Other +Gross +DeSoto County +15,180 +1,096 +482 +16,758 +4,650 +21,408 +Polk County +4,545 +— +— +4,545 +2,228 +6,773 +Collier County +4,261 +— +— +4,261 +2,905 +7,166 +Hendry County +3,546 +57 +175 +3,778 +1,707 +5,485 +Charlotte County +1,729 +— +138 +1,867 +676 +2,543 +Highlands County +1,063 +— +— +1,063 +161 +1,224 +Hardee County +403 +— +— +403 +171 +574 +Total +30,727 +1,153 +795 +32,675 +12,498 +45,173 +Of the 45,173 gross acres of citrus land we own and manage, approximately 12,498 acres are classified as support and other acreage. Support and other acreage includes acres used for roads, barns, water detention, water retention and drainage ditches integral to the cultivation of citrus trees, but which are not capable of directly producing fruit. In addition, we own a small citrus tree nursery and utilize the trees produced in our own operations. The 32,675 remaining acres are classified as net plantable acres. Net plantable acres are those that are capable of directly producing fruit. These include acres that are currently producing, acres that are developing (acres that are planted with trees too young to commercially produce fruit) and acres that are fallow. +Our Alico Citrus business segment cultivates citrus trees to produce citrus for delivery to the processed and fresh citrus markets. Our sales to the processed market were approximately 95.0%, 93.7% and 91.7% of Alico Citrus revenues for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. We produce Early and Mid-Season varieties, primarily Hamlin oranges, as well as a Valencia variety for the processed market. We deliver our fruit to the processors in boxes which each contains approximately 90 pounds of oranges. Because the processors convert the majority of the citrus crop into orange juice, they generally do not buy their citrus on a per box basis, but rather on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of citrus fruit. We produced approximately 46,727,000, 26,513,000 and 42,611,000 pound solids for the fiscal years ended September 30, 2019, 2018 and 2017, respectively, from boxes delivered to processing plants of approximately 7,904,000, 4,702,000 and 7,259,000, respectively. As previously indicated, the falloff in fiscal year 2018 was mostly attributable to the impact of Hurricane Irma. +The average pound solids per box was 5.91, 5.64 and 5.87 for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +We generally use multi-year contracts with citrus processors that include pricing structures based on a minimum (“floor”) price with a price increase (“rise”) based on market conditions. Therefore, if pricing in the market is favorable relative to our floor price, we benefit from the incremental difference between the floor and the final market price. +Our citrus produced for the processed citrus market in fiscal year 2019-2020 under our largest agreement is subject to minimum floor price ranging from $2.05 to $2.15 per pound solid and rise price from $2.50 to $2.65 per pound solid. Under this agreement, if the market price is below the floor prices or exceeds the rise prices, then 50% of the shortfall or excess will be deducted from the floor price or added to the rise price. Under our next largest agreement, our citrus produced is subject to a minimum floor price of $2.60 per pound solid and rise price of $3.00 per pound solid. We believe that other markets are available for our citrus products; however, new arrangements may be less favorable than our current contracts. +Our sales to the fresh citrus market constituted approximately 3.0%, 2.6% and 4.6% of our Alico Citrus revenues for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. We produce numerous varieties for the fresh fruit market including grapefruit, navel and other fresh varieties. Generally, our fresh fruit is sold to packing houses by the box and the packing houses are responsible for the harvest and haul of these boxes. We produced approximately 210,000, 125,000 and 328,000 fresh fruit boxes for each of the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +Revenues from our Alico Citrus operations were approximately 97.4%, 96.1% and 95.1% of our total operating revenues for each of the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +4 +Water Resources and Other Operations +We own and manage land in Collier, Glades, and Hendry Counties and are engaged in land leasing for recreational and grazing purposes, conservation, and mining activities. Our Water Resources and Other Operations land holdings total 66,228 gross acres, or 59.5% of our total acreage. +Our Water Resources and Other Operations acreage is detailed in the following table as of September 30, 2019: +Acreage +Hendry County +61,680 +Glades County +526 +Collier County +4,022 +Total +66,228 +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third party operator. The Company continues to own the property and conduct its long-term dispersed water program and wildlife management programs. As part of the sales transaction, the Company expensed all cattle inventory costs that were accumulated at the date of sale. +In fiscal year 2017, our cattle operation was engaged in the production of beef cattle in Hendry and Collier Counties. The breeding herd consisted of approximately 8,700 cows and bulls. We primarily sold our calves to feed yards and yearling grazing operations in the United States. We also sold cattle through local livestock auction markets and to contract cattle buyers in the United States. These buyers provided ready markets for our cattle. Revenues from Water Resources and Other Operations were approximately 2.6%, 3.9% and 4.9% of total operating revenues for each of the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +Our Strategy +Our core business strategy is to maximize stockholder value through continuously improving the return on our invested capital, either by holding and managing our existing land through skilled agricultural production, leasing, or other opportunistic means of monetization, disposing of under productive land or business units and acquiring new land or operations with appreciation potential. +Our objectives are to produce the highest quality agricultural products, create innovative land uses, opportunistically acquire and convert undervalued assets, sell under-productive land and other assets not meeting our total return profile, generate recurring and sustainable profit with the appropriate balance of risk and reward, and exceed the expectations of stockholders, customers, clients and partners. +Our strategy is based on best management practices of our agricultural operations and the environmental and conservation stewardship of our land and natural resources. We manage our land in a sustainable manner and evaluate the effect of changing land uses while considering new opportunities. Our commitment to environmental stewardship is fundamental to the Company’s core beliefs. +Seasonal Nature of Business +As with any agribusiness enterprise, our agribusiness operations and revenues are predominantly seasonal in nature. The following table illustrates the seasonality of our agribusiness revenues: +Fiscal Year +Q1 +Q2 +Q3 +Q4 +Ending 12/31 +Ending 3/31 +Ending 6/30 +Ending 9/30 +Oct +Nov +Dec +Jan +Feb +Mar +Apr +May +Jun +Jul +Aug +Sept +Harvest Fresh and Early/Mid Varieties of Oranges +Harvest Valencia Oranges +5 +Significant Customers +Revenue from Tropicana represented approximately 89%, 87% and 86% of our consolidated revenue for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. The revenue in fiscal year 2019 from Tropicana was generated primarily from two separate contracts. This revenue was generated from the sale of our citrus product in the processed market. No other single customer provided more than 10% of our consolidated revenue in fiscal year 2019, 2018 or 2017. +Competition +The orange and specialty citrus markets are intensely competitive, but no single producer has any significant market power over any market segments, as is consistent with the production of most agricultural commodities. Citrus is grown domestically in several states including Florida, California, Arizona and Texas, as well as foreign countries, most notably Brazil. Competition is impacted by several factors including quality, production, demand, brand recognition, market prices, weather, disease, export/import restrictions and foreign currency exchange rates. +Environmental Regulations +Our operations are subject to various federal, state and local laws regulating the discharge of materials into the environment. Management believes we are in compliance with all such rules including permitting and reporting requirements. Historically, compliance with environmental regulations has not had a material impact on our financial position, results of operations or cash flows. +Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. In addition, we require lessees of our property to comply with environmental regulations as a condition of leasing. +Employees +As of September 30, 2019, we had 235 full-time employees. Our employees work in the following divisions: +Alico Citrus +214 +Water Resources and Other Operations +0 +Corporate, General, Administrative and Other +21 +Total employees +235 +None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good. +Capital Resources and Raw Materials +Management believes that the Company will be able to meet its working capital requirements for at least the next 12 months, and over the long term, through internally generated funds, cash flows from operations, the sale of under-productive land and other assets, our existing lines of credit and access to capital markets. The Company has commitments that provide for lines of revolving credit that are available for our general and corporate use. +Raw materials needed to cultivate the various crops grown by the Company consist primarily of fertilizers, herbicides, insecticides and fuel and are readily available from local suppliers. +Available Information +We will provide electronic copies of our SEC filings free of charge upon request. Additionally, our reports, amendments thereto, proxy statements and other information are also made available, free of charge, on our investor relations website at ir.alicoinc.com as soon as reasonably practicable after we electronically file or furnish such information with the SEC. Any information posted on or linked from our website is not incorporated by reference in this Annual Report on Form 10-K. The SEC also maintains a website at http://www.sec.gov , which contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. +6 +Item 1A. Risk Factors +Our business and results of operations are subject to numerous risks and uncertainties, many of which are beyond our control. The following is a description of the known factors that we believe may materially affect our business, financial condition, results of operations or cash flows. They should be considered carefully, in addition to the information set forth elsewhere in this Annual Report on Form 10-K, including Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8, Financial Statements and Supplementary Data, including the related Notes to the Consolidated Financial Statements in making any investment decisions with respect to our securities. Additional risks or uncertainties that are not currently known to us that we currently deem to be immaterial or that could apply to any company could also materially adversely affect our business, financial condition, results of operations or cash flows. +Risks Related to our Business +Adverse weather conditions, natural disasters and other natural conditions, including the effects of climate change, could impose significant costs and losses on our business. +Fresh produce is vulnerable to adverse weather conditions, including windstorms, floods, drought and temperature extremes, which are quite common and may occur with higher frequency or be less predictable in the future due to the effects of climate change. Unfavorable growing conditions can reduce both crop size and crop quality. In extreme cases, entire harvests may be lost in some geographic areas. Citrus groves are subject to damage from frost and freezes, and this has happened periodically in the recent past, including most recently the impact from Hurricane Irma. In some cases, the fruit is damaged or ruined; in the case of extended periods of cold, the trees can also be damaged or killed. These factors can increase costs, decrease revenues and lead to additional charges to earnings, which may have a material adverse effect on our business, results of operations, financial condition and cash flows. +Our citrus groves are subject to damage and loss from disease including but not limited to citrus greening and citrus canker which could negatively impact our business, financial condition, results of operations and cash flows. +Our citrus groves are subject to damage and loss from diseases such as citrus greening and citrus canker. Each of these diseases is widespread in Florida and exists in our citrus groves and in the areas where our citrus groves are located. The success of our citrus business is directly related to the viability and health of our citrus groves. +Citrus greening is one of the most serious citrus plant diseases in the world. Once a tree is infected, its productivity generally decreases. While the disease poses no threat to humans or animals, it has devastated citrus crops throughout the United States and abroad. Named for its green, misshapen fruit, citrus greening disease has now killed millions of citrus plants in the southeastern United States and has spread across the entire country. Infected trees produce fruits that are green, misshapen and bitter, unsuitable for sale as fresh fruit or for juice. Infected trees can die within a few years. At the present time, there is no known cure for citrus greening once trees have become infected. Primarily, as a result of citrus greening, orange production in the State of Florida has continued to drop. +Citrus canker is a disease affecting citrus species and is caused by a bacterium which is spread by contact with infected trees or by windblown transmission. There is no known cure for citrus canker at present although some management practices, including the use of copper-based bactericides, can mitigate its spread and lessen its effect on infected trees; however, there is no assurance that currently available technologies will control such disease effectively. +Both of these diseases pose a significant threat to the Florida citrus industry and to our citrus groves. While we use best management practices to attempt to control diseases and their spread, there can be no assurance that our mitigation efforts will be successful. These diseases can significantly increase our costs which could materially adversely affect our business, financial condition, results of operations and cash flows. Our citrus groves produce the significant majority of our annual operating revenues. A significant reduction in available citrus from our citrus groves could decrease our operating revenues and materially adversely affect our business, financial condition, results of operations and cash flows. +Our citrus groves are geographically concentrated in Florida and the effects of adverse weather conditions including hurricanes and tropical storms could adversely affect our results of operations, financial position and cash flows. +Our citrus operations are concentrated in central and south Florida with our groves located in parcels in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties. Because our groves are located in close proximity to each other, the impact of adverse weather conditions may be material to our results of operations, financial position and cash flows. Florida is particularly susceptible to the occurrence of hurricanes and tropical storms. Depending on where any particular hurricane or tropical storm +7 +makes landfall, our properties could experience significant, if not catastrophic damage. Hurricanes and tropical storms have the potential to destroy crops and impact citrus production through the loss of fruit and destruction of trees and/or plants either as a result of high winds or through the spread of windblown disease. Such damage could materially affect our citrus operations and could result in a loss of operating revenues from those products for a multi-year period. We seek to minimize hurricane risk by the purchase of insurance contracts, but the majority of our crops remain uninsured. In addition to hurricanes and tropical storms, the occurrence of other natural disasters and climate conditions in Florida, such as tornadoes, floods, freezes, unusually heavy or prolonged rain, droughts and heat waves, could have a material adverse effect on our operations and our ability to realize income from our crops or properties. +A significant portion of our revenues are derived from our citrus business and any adverse event affecting such business could disproportionately harm our business. +Our revenues from our citrus business were approximately 97.4%, 96.1% and 95.1% of our operating revenues in fiscal years 2019, 2018 and 2017, respectively. Our citrus division is one of the largest citrus producers in the United States and because of the significance of the revenues derived from this business, we are more vulnerable to adverse events or market conditions affecting our citrus business which could have a significant impact on our overall results of operations, financial condition and cash flows. +Our business is highly competitive and we cannot assure you that we will maintain our current market share. +Many companies compete in our different businesses and offer products that are similar to our products or are direct competitors to our products. We face strong competition from these and other companies engaged in the agricultural product business. +Important factors with respect to our competitors include the following: +• +Some of our competitors may have greater operating flexibility and, in certain cases, this may permit them +• +to respond better or more quickly to changes in the industry. +• +We cannot predict the pricing or promotional actions of our competitors or whether those actions will have a negative effect on us. +• +Our competitors may have access to substantially greater financial resources, deeper management and agricultural resources, regional, national or global areas that offer agricultural advantages, and enhanced public visibility or reputations. +There can be no assurance that we will continue to compete effectively with our present and future competitors, and our ability to compete could be materially adversely affected by our debt levels and debt service requirements. +We depend on our relationship with Tropicana for a significant portion of our business. Any disruption in this relationship could harm our sales. Additionally, if certain criteria are not met under one of our contracts with Tropicana, we could experience a significant reduction in revenues and cash flows. +The Company's contracts with Tropicana accounted for 88.6%, 86.6% and 85.6% of the Company's revenues in fiscal years 2019, 2018 and 2017, respectively. The revenue for Tropicana is primarily generated from two contracts. Should there be any change in our current relationship structure, whereby they do not buy our oranges, we would need to find replacement buyers to purchase our remaining crop, which could take time and expense and may result in less favorable terms of sale. The loss of Tropicana as a customer or significant reduction in business with Tropicana may cause a material adverse impact to our financial position, results of operations and cash flows. +Our agricultural products are subject to supply and demand pricing which is not predictable. +Agricultural operations traditionally provide almost all of our operating revenues with citrus being the largest portion and are subject to supply and demand pricing. While according to Nielsen data consumer demand for orange juice has decreased significantly to its lowest level in almost a decade, we have been able to offset the impact of such decline with higher prices based on a lower supply of available oranges. However, there can be no assurance that we will be able to continue to do so if demand continues to decline. Although our processed citrus is subject to minimum pricing, we are unable to predict with certainty the final price we will receive for our products. In some instances the harvest and growth cycle will dictate when such products must be marketed which may or may not be advantageous in obtaining the best price. Excessive supplies tend to cause severe price competition and lower prices for the commodity affected. Limited supply of certain agricultural commodities due to world and domestic market conditions can cause commodity prices to rise in certain situations. +8 +There is no assurance that Alico 2.0 will continue to provide the cost savings that we have achieved. +On November 16, 2017, we announced Alico 2.0, which we expect will result in a significant citrus grove cost savings and a decline in Alico Citrus’ general and administrative expenses. While the Company has executed on its Alico 2.0 initiatives and achieved significant grove cost savings, there is no assurance that we can maintain these cost levels. +If we are unable to successfully develop and execute our strategic growth initiatives, or if they do not adequately address the challenges or opportunities we face, our business, financial condition and prospects may be adversely affected. +Our success is dependent, in part, on our ability to identify, develop and execute appropriate strategic growth initiatives that will enable us to achieve sustainable growth in the long term. The implementation of our strategic initiatives is subject to both the risks affecting our business generally and the inherent risks associated with implementing new strategies. These strategic initiatives may not be successful in generating revenues or improving operating profit and, if they are, it may take longer than anticipated. As a result and depending on evolving conditions and opportunities, we may need to adjust our strategic initiatives and such changes could be substantial, including modifying or terminating one or more of such initiatives. Termination of such initiatives may require us to write down or write off the value of our investments in them. Transition and changes in our strategic initiatives may also create uncertainty in our employees, customers and partners that could adversely affect our business and revenues. In addition, we may incur higher than expected or unanticipated costs in implementing our strategic initiatives, attempting to attract revenue opportunities or changing our strategies. There is no assurance that the implementation of any strategic growth initiative will be successful, and we may not realize anticipated benefits at levels we project or at all, which would adversely affect our business, financial condition and prospects. +We are subject to the risk of product contamination and product liability claims. +The sale of agricultural products for human consumption involves the risk of injury to consumers. Such injuries may result from tampering by unauthorized third parties, product contamination or spoilage, including the presence of foreign objects, substances, chemicals, other agents, or residues introduced during the growing, storage, handling or transportation phases. While we are subject to governmental inspection and regulations and believe our facilities comply in all material respects with all applicable laws and regulations, we cannot be sure that our agricultural products will not cause a health-related illness in the future or that we will not be subject to claims or lawsuits relating to such matters. Even if a product liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused illness or injury could adversely affect our reputation with existing and potential customers and our corporate and brand image. Moreover, claims or liabilities of this sort might not be covered by our insurance or by any rights of indemnity or contribution that we may have against others. We maintain product liability insurance, however, we cannot be sure that we will not incur claims or liabilities for which we are not insured or that exceed the amount of our insurance coverage. +Our agricultural operations are subject to water use regulations restricting our access to water. +Our operations are dependent upon the availability of adequate surface and underground water. The availability of water is regulated by the state of Florida through water management districts which have jurisdiction over various geographic regions in which our lands are located. Currently, we have permits in place for the next 15 to 20 years for the use of underground and surface water which are adequate for our agricultural needs. +Surface water in Hendry County, where much of our agricultural land is located, comes from Lake Okeechobee via the Caloosahatchee River and a system of canals used to irrigate such land. The Army Corps of Engineers controls the level of Lake Okeechobee and ultimately determines the availability of surface water even though the use of water has been permitted by the state of Florida through the water management district. The Army Corps of Engineers decided in 2010 to lower the permissible level of Lake Okeechobee in response to concerns about the ability of the levee surrounding the lake to restrain rising waters which could result from hurricanes. Changes in availability of surface water use may result during times of drought, because of lower lake levels and could materially adversely affect our agricultural operations, financial condition, results of operations and cash flows. +Changes in immigration laws could impact our ability to harvest our crops. +We engage third parties to provide personnel for our harvesting operations. The availability and number of such workers is subject to decrease if there are changes in the U.S. immigration laws. Immigration reform and enforcement is currently attracting significant attention in the current U.S. administration and U.S. Congress, with enforcement operations taking place across the country, resulting in arrests and detentions of unauthorized workers. If new immigration legislation is enacted in the U.S. and/or if enforcement actions are taken against available personnel, such legislation and/or enforcement activities may contain provisions +9 +that could significantly reduce the number and availability of workers. Termination of a significant number of personnel who are found to be unauthorized workers or the scarcity of other available personnel to harvest our agricultural products could cause harvesting costs to increase or could lead to the loss of product that is not timely harvested which could have a material adverse effect to our citrus grove business, financial condition, results of operations and cash flows. +Our acquisition of additional agricultural assets and other businesses could pose risks. +We seek to opportunistically acquire new agricultural assets from time to time that we believe would complement our business. For example, in fiscal year 2015 we acquired three Florida citrus properties, including Orange-Co and Silver Nip Citrus, which resulted in our citrus division being one of the largest citrus producers in the United States. While we expect that our past and future acquisitions will successfully complement our business, we may fail to realize all of the anticipated benefits of these acquisitions, which could reduce our anticipated results. We cannot assure that we will be able to successfully identify suitable acquisition opportunities, negotiate appropriate acquisition terms, or obtain any financing that may be needed to consummate such acquisitions or complete proposed acquisitions. Acquisitions by us could result in accounting changes, potentially dilutive issuances of equity securities, increased debt and contingent liabilities, reduce the amount of cash available for dividends, debt service payments, integration issues and diversion of management’s attention, any of which could adversely affect our business, results of operations, financial condition, and cash flows. We may be unable to successfully realize the financial, operational, and other benefits we anticipate from our acquisitions and our failure to do so could adversely affect our business, results of operations, financial condition and cash flows. +Dispositions of our assets may adversely affect our future results of operations. +We also routinely evaluate the benefits of disposing of certain of our assets which could include the exit from lines of business. For example, in November of 2014 we sold significant sugarcane assets and we are no longer involved in the sugarcane business and in January of 2018 we sold our breeding herd and no longer engage in cattle operations. While such dispositions increase the amount of cash available to us, it could also result in a potential loss of significant operating revenues and income streams that we might not be able to replace, makes our business less diversified and could ultimately have a negative impact on our results of operations, financial condition and cash flows. +If a transaction intended to qualify as a Section 1031 Exchange is later determined to be taxable, we may face adverse consequences, and if the laws applicable to such transactions are amended or repealed, we may not be able to dispose of properties on a tax deferred basis. +From time to time we dispose of properties in transactions that are intended to qualify as Section 1031 Exchanges. It is possible that the qualification of a transaction as a Section 1031 Exchange could be successfully challenged and determined to be currently taxable and we could also be required to pay interest and penalties. As a result, we may be required to borrow funds in order to pay additional income taxes, and the payment of such taxes could cause us to have less cash available. Moreover, it is possible that legislation could be enacted that could modify or repeal the laws with respect to Section 1031 Exchanges, which could make it more difficult or not possible for us to dispose of properties on a tax deferred basis. +We may undertake one or more significant corporate transactions that may not achieve their intended results, may adversely affect our financial condition and our results of operations or result in unforeseeable risks to our business. +We continuously evaluate the acquisition or disposition of operating businesses and assets and may in the future undertake one or more significant transactions. Any such acquisitive transaction could be material to our business and could take any number of forms, including mergers, acquisitions, joint ventures and the purchase of equity interests. The consideration for such acquisitive transactions may include, among other things, cash, common stock or equity interests in the Company or our subsidiaries, or a contribution of property or equipment to obtain equity interests, and in conjunction with a transaction we might incur additional indebtedness. We also routinely evaluate the benefits of disposing of certain assets. Such dispositions could take the form of asset sales, mergers or sales of equity interests. +These transactions may present significant risks such as insufficient assets to offset liabilities assumed, potential loss of significant operating revenues and income streams, increased or unexpected expenses, inadequate return of capital, regulatory or compliance issues, the triggering of certain financial covenants in our debt instruments (including accelerated repayment) and unidentified issues not discovered in due diligence. In addition, such transactions could distract management from current operations. As a result of the risks inherent in such transactions, we cannot guarantee that any such transaction will ultimately result in the realization of its anticipated benefits or that it will not have a material adverse impact on our business, financial condition, results of operations or cash flows. If we were to complete such an acquisition, disposition, investment or other strategic transaction, we may require additional debt or equity financing that could result in a significant increase in our amount of debt and our debt service obligations +10 +or the number of outstanding shares of our common stock, thereby diluting holders of our common stock outstanding prior to such acquisition. +Our citrus business is seasonal. +Our citrus groves produce the majority of our annual operating revenues and the citrus business is seasonal because it is tied to the growing and picking seasons. Historically, the second and third quarters of our fiscal year generally produce the majority of our annual revenues, and our working capital requirements are typically greater in the first and fourth quarters of our fiscal year coinciding with our planting cycles. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year or in future quarters. If our operating revenues in the second and third quarters are lower than expected, it would have a disproportionately large adverse impact on our annual operating results. +We face significant competition in our agricultural operations. +We face significant competition in our agricultural operations both from domestic and foreign producers and do not have any branded products. Foreign growers generally have an equal or lower cost of production, less environmental regulation and in some instances, greater resources and market flexibility than us. Because foreign growers have greater flexibility as to when they enter the U.S. market, we cannot always predict the impact these competitors will have on our business and results of operations. The competition we face from certain foreign suppliers of orange juice is mitigated by a governmentally imposed tariff on orange imports. Accordingly, a reduction in the government’s orange juice tariff could adversely impact our results of operations. +Our earnings are sensitive to fluctuations in market supply and prices and demand for our products. +Excess supplies often cause severe price competition in our industry. Growing conditions in various parts of the world, particularly weather conditions such as windstorms, floods, droughts and freezes, as well as diseases and pests, are primary factors affecting market prices because of their influence on the supply and quality of product. +Fresh produce is highly perishable and generally must be brought to market and sold soon after harvest. Many of the items involved in our business, such as oranges, must be sold more quickly than other produce our competitors may produce, such as lemons. As such, our competitors may be able to maintain certain items they produce in inventory for longer periods than we are able to maintain our inventory which may offer our competitors strategic advantages when they respond to fluctuations in market supply and demand that are not available to us. +In addition, general public perceptions regarding the quality, safety or health risks associated with particular food products could reduce demand and prices for some of our products. To the extent that consumer preferences evolve away from products that we produce for health or other reasons, and we are unable to modify our products or to develop products that satisfy new consumer preferences, there will be a decreased demand for our products. If excess supplies do exist, this could result in reduced pricing or unusable inventory which could adversely impact our results of operations. +Climate change, or legal, regulatory, or market measures to address climate change, may negatively affect our business and operations. +There is growing concern that carbon dioxide and other greenhouse gases in the atmosphere may have an adverse impact on global temperatures, weather patterns, and the frequency and severity of extreme weather and natural disasters. In the event that such climate change has a negative effect on the productivity of our citrus groves, it could have an adverse impact on our business and results of operations. The increasing concern over climate change also may result in more regional, federal, and/or global legal and regulatory requirements to reduce or mitigate the effects of greenhouse gases. In the event that such regulation is enacted, we may experience significant increases in our costs of operations. In particular, increasing regulation of fuel emissions could substantially increase the distribution and supply chain costs associated with our products. As a result, climate change could negatively affect our business and operations. +Increases in labor, personnel and benefits costs could adversely affect our operating results. +We primarily utilize labor contractors to harvest and deliver our fruit to outside packing facilities. Our employees and contractors are in demand by other agribusinesses and other industries. Shortages of labor, particularly as a result of the recent low unemployment rate in the United States and in Florida in particular, could delay our harvesting or orange processing activities or could result in increases in labor costs. +11 +We and our labor contractors are subject to government mandated wage and benefit laws and regulations. In addition, current or future federal or state healthcare legislation and regulation, including the Affordable Care Act, may increase our medical costs or the medical costs of our labor contractors that could be passed on to us. +Increases in commodity or raw product costs, such as fuel and chemical costs, could adversely affect our operating results. +Many factors may affect the cost and supply of citrus, including external conditions, commodity market fluctuations, changes in governmental laws and regulations, tariffs, agricultural programs, severe and prolonged weather conditions and natural disasters. Increased costs for products can negatively impact our operating results and there can be no assurance that they will not adversely affect our operating results in the future. +We are subject to transportation risks. +We depend on third party providers of transportation and have no control over such third parties. An extended interruption in our ability to harvest and haul our products could have a material adverse effect on our business, financial condition and results of operations. Similarly, any extended disruption in the distribution of our products could have a material adverse effect on our business, financial condition and results of operations. While we believe we are adequately insured and would attempt to transport our products by alternative means if we were to experience an interruption due to strike, natural disasters or otherwise, we cannot be sure that we would be able to do so or be successful in doing so in a timely and cost-effective manner. +We benefit from reduced real estate taxes due to the agricultural classification of a majority of our land. Changes in the classification or valuation methods employed by county property appraisers could cause significant changes in our real estate property tax liabilities. +In the fiscal years ended September 30, 2019, 2018 and 2017 we paid approximately $2,755,000, $3,089,000 and $3,106,000 in real estate taxes, respectively. These taxes were based upon the agricultural use (“Green Belt”) values determined by the county property appraisers in which counties we own land, of approximately $91,312,000, $104,017,000 and $105,496,000 for each of the fiscal years ended September 30, 2019, 2018 and 2017 respectively, which differs significantly from the fair values determined by the county property appraisers of approximately $514,330,000, $537,183,000 and $539,790,000, respectively. Changes in state law or county policy regarding the granting of agricultural classification or calculation of "Green Belt" values or average millage rates could significantly impact our results of operations, cash flows and/or financial position. +Liability for the use of fertilizers, pesticides, herbicides and other potentially hazardous substances could increase our costs. +Our agricultural business involves the use of herbicides, fertilizers and pesticides, some of which may be considered hazardous or toxic substances. We may be deemed liable and have to pay for the costs or damages associated with the improper application, accidental release or the use or misuse of such substances. Our insurance may not be adequate to cover such costs or damages, or may not continue to be available at a price or under terms that are satisfactory to us. In such cases, if we are required to pay significant costs or damages, it could materially adversely affect our business, results of operations, financial condition and cash flows. +Compliance with applicable environmental laws may substantially increase our costs of doing business which could reduce our profits. +We are subject to various laws and regulations relating to the operation of our properties, which are administered by numerous federal, state and local governmental agencies. We face a potential for environmental liability by virtue of our ownership of real estate property. If hazardous substances (including herbicides and pesticides used by us or by any persons leasing our lands) are discovered emanating from any of our lands and the release of such substances presents a threat of harm to the public health or the environment, we may be held strictly liable for the cost of remediation of these hazardous substances. In addition, environmental laws that apply to a given site can vary greatly according to the site’s location, its present and former uses, and other factors such as the presence of wetlands or endangered species on the site. Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. Furthermore, we require lessees of our properties to comply with environmental regulations as a condition of leasing. We also purchase insurance for environmental liability when it is available; however, these insurance contracts may not be adequate to cover such costs or damages or may not continue to be available at prices and terms that would be satisfactory. It is possible that in some cases the cost of compliance with these environmental laws could exceed the value of a particular tract of land, make it unsuitable for use in what would otherwise be its highest and best use, and/or be significant enough that it would materially adversely affect us. +12 +Our business may be adversely affected if we lose key employees. +We depend to a large extent on the services of certain key management personnel. These individuals have extensive experience and expertise in the business lines and segments in which they work. The loss of any of these individuals could have a material adverse effect on our businesses. We do not maintain key-man life insurance with respect to any of our employees. Our success will be dependent on our ability to continue to attract, employ and retain skilled personnel in our business lines and segments. +Inflation can have a significant adverse effect on our operations. +Inflation can have a major impact on our citrus operations. The citrus operations are most affected by escalating costs and unpredictable revenues and very high irrigation water costs. High fixed water costs related to our citrus lands will continue to adversely affect earnings. Prices received for many of our products are dependent upon prevailing market conditions and commodity prices. Therefore, it is difficult for us to accurately predict revenue, just as we cannot pass on cost increases caused by general inflation, except to the extent reflected in market conditions and commodity prices. +We incur increased costs as a result of being a publicly traded company. +As a company with publicly traded securities, we have incurred, and will continue to incur, significant legal, accounting and other expenses. In addition, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, as well as rules promulgated by the SEC and Nasdaq, requires us to adopt corporate governance practices applicable to U.S. public companies. These laws, rules and regulations may increase our legal and financial compliance costs, which could adversely affect the trading price of our common stock. +System security risks, data protection breaches, cyber-attacks and systems integration issues could disrupt our internal operations or services provided to customers, and any such disruption could reduce our expected revenues, increase our expenses, damage our reputation and adversely affect our stock price. +Computer programmers and hackers may be able to penetrate our network security and misappropriate or compromise our confidential information or that of third parties, create system disruptions or cause shutdowns. Computer programmers and hackers also may be able to develop and deploy viruses, worms, and other malicious software programs that attack our systems and databases or otherwise exploit any security vulnerabilities of our systems and databases. In addition, sophisticated hardware and operating system software and applications that we develop internally or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate cyber or other security problems, bugs, viruses, worms, malicious software programs and security vulnerabilities could be significant, and our efforts to address these problems may not be successful and could result in interruptions, delays, cessation of service and loss of existing or potential customers that may impede our sales, distribution or other critical functions. +Portions of our information technology infrastructure also may experience interruptions, delays or cessations of service or produce errors in connection with systems integration or migration work that takes place from time to time. We may not be successful in implementing new systems and transitioning data, which could cause business disruptions and be more expensive, time consuming, disruptive and resource-intensive. Such disruptions could adversely impact our ability to track sales and could interrupt other operational or financial processes, which in turn could adversely affect our financial results, stock price and reputation. +Risks Related to Our Indebtedness +We maintain a significant amount of indebtedness which could adversely affect our financial condition, results of operations or cash flows and may limit our operational and financing flexibility and negatively impact our business. +As of September 30, 2019, we had approximately $163,000,000 in principal amount of indebtedness outstanding under our secured credit facilities and line of credit and an additional $94,500,000 is available under our revolving lines of credit. Our loan agreements, and other debt instruments we may enter into in the future, may have negative consequences to us and could limit our business because we will use a substantial portion of our cash flows from operations to pay debt service costs which will reduce the funds available to us for corporate and general expenses and it may make us more vulnerable to economic downturns and adverse developments in our business. Our loan agreements require us to comply with various restrictive covenants and some contain financial covenants that require us to comply with specified financial ratios and tests. Our failure to meet these covenants could result in default under these loan agreements and would result in a cross-default under other loan agreements. In the event of a default and our inability to obtain a waiver of the default, all amounts outstanding under loan agreements could be declared immediately due and payable. Our loan agreements also contain various covenants that limit our ability to engage in specified +13 +types of transactions. We expect that we will depend primarily upon our citrus operations to provide funds to pay our corporate and general expenses and to pay any amounts that may become due under any credit facilities and any other indebtedness we may incur. In addition, there are factors beyond our control that could negatively affect our citrus business revenue stream. Our ability to make these payments depends on our future performance, which will be affected by various financial, business, macroeconomic and other factors, many of which we cannot control. +We may be unable to generate sufficient cash flow to service our debt obligations. +To service our debt, we require a significant amount of cash. Our ability to generate cash, make scheduled payments or refinance our obligations depends on our successful financial and operating performance. Our financial and operating performance, cash flow and capital resources depend upon prevailing economic conditions and various financial, business and other factors, many of which are beyond our control. These factors include among others: +• +economic and competitive conditions +• +changes in laws and regulations +• +operating difficulties, increased operating costs or pricing pressures we may experience; and +• +delays in implementing any strategic projects +If our cash flow and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell material assets or operations, obtain additional capital or restructure our debt. If we are required to take any actions referred to above, it could have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure investors that we would be able to take any of these actions on terms acceptable to us, or at all, or that these actions would enable us to continue to satisfy our capital requirements or that these actions would be permitted under the terms of our various debt agreements. +Some of our debt is based on variable rates of interest, which could result in higher interest expenses in the event of an increase in the interest rates. +Our credit facility and certain of our term loans that we have currently bear interest at variable rates, which will generally change as interest rates change. We bear the risk that the rates we are charged by our lenders will increase faster than the earnings and cash flow of our business, which could reduce profitability, adversely affect our ability to service our debt, cause us to breach covenants contained in our credit facility and term loans, any of which could materially adversely affect our business, financial condition, results of operations and cash flows. +Risks Related to our Common Stock +Our common stock has low trading volume and the distribution of all of the shares of our common stock owned by 734 Investors to its members has the effect of increasing the Company’s public float and such increase may have a material adverse effect on the market price of our common stock. +Although our common stock trades on the Nasdaq Global Select Market, it is thinly traded and our average daily trading volume is low compared to the number of shares of common stock we have outstanding. The low trading volume of our common stock can cause our stock price to fluctuate significantly as well as make it difficult for a stockholder to sell their common shares quickly. As a result of our stock being thinly traded and/or our low stock price, institutional investors might not be interested in owning our common stock. +On November 12, 2019, 734 Investors effected a distribution of all of the shares of our common stock owned by 734 Investors to its members. The distribution of Alico shares of common stock by 734 Investors to its members has the effect of increasing the Company’s public float and such increase may have a material adverse effect on the market price of the common stock, which in turn could have a material adverse effect on our ability to obtain future funding, if needed, as well as create a potential market overhang. +We may not be able to continue to pay or maintain our cash dividends on our common stock and the failure to do so may negatively affect our share price. +We have historically paid regular quarterly dividends to the holders of our common stock. Our ability to pay cash dividends depends on, among other things, our cash flows from operations, our cash requirements, our financial condition, the degree to which we are/or become leveraged, contractual restrictions binding on us, provisions of applicable law and other factors that our Board of Directors may deem relevant. There can be no assurance that we will generate sufficient cash from continuing operations in the +14 +future, or have sufficient cash surplus or net profits to pay dividends on our common stock. Our dividend policy is based upon our directors’ current assessment of our business and the environment in which we operate and that assessment could change based on business developments (which could, for example, increase our need for capital expenditures) or new growth opportunities. Our Board of Directors may, in its discretion, decrease the level of cash dividends or entirely discontinue the payment of cash dividends. The reduction or elimination of cash dividends may negatively affect the market price of our common stock. +There can be no assurance that we will resume the repurchase of shares of our common stock. +In fiscal year 2017, our Board of Directors authorized the repurchase of up to $7,000,000 of the Company’s common stock in two separate authorizations. In March 2017, our Board of Directors authorized the repurchase of up to $5,000,000 of the Company’s common stock beginning March 9, 2017 and continued through March 9, 2019. In May 2017, our Board of Directors authorized the repurchase of up to an additional $2,000,000 of the Company’s common stock beginning May 24, 2017 and continued through May 24, 2019. There can be no assurance that we will repurchase shares in the future in any particular amounts or at all. A reduction in, or elimination of, share repurchases could have a negative effect on our share price. +If we were to conduct a tender offer or engage in a share repurchase program, holders of our securities would be subject to certain risks associated with a decrease in the outstanding number of shares of our common stock. +In September 2018 the Company announced the commencement of the Tender Offer. During the Tender Offer the Company repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. While we have no plans to conduct another tender offer at this time, we may conduct another tender offer or engage in the repurchase of our shares in the future. Shareholders could be adversely affected by a reduction in our “public float,” that is, the number of shares owned by outside shareholders and available for trading in the securities markets, if the Company makes future tender offers or private or open market repurchases of its shares. Although the Company is not currently pursuing a tender offer, there are no assurances that our Board of Directors will not authorize the Company to do so in the future. Engaging in a tender offer or repurchase program in the future could have a negative effect on our share price. +15 +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +As of September 30, 2019, Alico owned 111,401 acres of land located in eight counties in Florida. Acreage in each county and the primary classification with respect to the present use of these properties is shown in the following table: +Total +Hendry +Polk +Collier +DeSoto +Glades +Charlotte +Hardee +Highlands +Alico Citrus: +Citrus Groves +45,151 +5,485 +6,773 +7,166 +21,386 +— +2,543 +574 +1,224 +Citrus Nursery +22 +— +— +— +22 +— +— +— +— +Total Citrus Groves +45,173 +5,485 +6,773 +7,166 +21,408 +— +2,543 +574 +1,224 +Water Resources and Other Operations +64,782 +60,760 +— +4,022 +— +— +— +— +— +Mining +526 +— +— +— +— +526 +— +— +— +Other +920 +920 +— +— +— +— +— +— +— +Total +111,401 +67,165 +6,773 +11,188 +21,408 +526 +2,543 +574 +1,224 +Approximately 51,000 acres of the properties listed are encumbered by credit agreements totaling approximately $163,000,000 as of September 30, 2019. For a more detailed description of the credit agreements and collateral please see Note 6. “Long-Term Debt and Lines of Credit” to the Company’s fiscal year 2019 consolidated financial statements. +The Company currently collects mining royalties on approximately 526 acres of land located in Glades County, Florida. These royalties do not represent a significant portion of operating revenues or gross profits. +Item 3. Legal Proceedings +Florida Litigation +On November 16, 2018, 734 Agriculture, RCF 2014 Legacy LLC, Delta Offshore Master II, LTD. and Mr. Remy W. Trafelet (the “Trafelet Parties”), who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, filed a lawsuit against Messrs. George R. Brokaw, Henry R. Slack, W. Andrew Krusen and Greg Eisner, members of the Board of Directors, in the Circuit Court (the “Circuit Court”) for Hillsborough County, Florida (the “Florida Litigation”). The Trafelet Parties sought, among other things, a declaration that (1) a purported stockholder action by written consent, delivered to the Company in the name of 734 Investors and the plaintiffs in the Florida Litigation on November 11, 2018 (the “Purported Consent”) was valid and binding, (2) the resolutions passed at a meeting of the Board of Directors on November 12, 2018, to, among other things, constitute an ad hoc committee of the Board of Directors to consider, evaluate and make any and all determinations, and to take any and all actions, on behalf of the Board of Directors, in connection with the Purported Consent were null and void and (3) the four defendants in the Florida Litigation were properly removed from the Board of Directors by the Purported Consent. On November 27, 2018, the Circuit Court denied without prejudice plaintiffs’ motion for a temporary restraining order and an affirmative injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. +On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provided, pending the resolution of the Delaware Litigation (as defined below), that (1) the record date for the Purported Consent was stayed indefinitely, and (2) Mr. Trafelet and the Company’s Board of Directors should not take any action out of routine day-to-day operations conducted in the ordinary course of business, including any action to change the corporate governance of Alico or removing any corporate officers or directors from positions held as of November 27, 2018. +On December 6, 2018, the Trafelet Parties filed an amended complaint in the Florida Litigation which added the Company and Benjamin D. Fishman, a member of the Board of Directors, as defendants. On December 21, 2018, the Trafelet Parties filed a +16 +renewed motion for a preliminary injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. On January 14, 2019, the defendants in the Florida Litigation filed an opposition to plaintiffs’ renewed motion for a preliminary injunction. On January 18, 2019, the defendants in the Florida Litigation filed a motion to dismiss the plaintiffs’ amended complaint. +On February 11, 2019, the parties to the Florida Litigation entered into a settlement agreement (the “Alico Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Florida Litigation. Pursuant to the Alico Settlement Agreement, Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and as a member of the Board of Directors, effective upon the execution of the Alico Settlement Agreement. +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into a consulting agreement (the “Consulting Agreement”) with Mr. Trafelet and 3584 Inc., an entity controlled by Mr. Trafelet (the “Consultant”). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $400,000. If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24-month term. As such, the Company recorded the $800,000 as expense in the quarter ended March 31, 2019. +In addition, on February 11, 2019, as contemplated by the Alico Settlement Agreement, the Company entered into a Registration Rights Agreement (the “Registration Rights Agreement”) with Mr. Trafelet, relating to the shares of the Company’s common stock directly held by the Trafelet Parties as of February 11, 2019 (the “Registrable Securities”). The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +Delaware Litigation +On November 20, 2018, members of 734 Investors filed a lawsuit against 734 Agriculture and Mr. Trafelet, who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors in the Delaware Court of Chancery (the "Delaware Court"), captioned Arlon Valencia Holdings v. Trafelet, C.A. No. 2018-0842-JTL (the “Members’ Delaware Litigation”). The plaintiffs sought, among other things, a declaration that (1) 734 Agriculture was validly replaced as the managing member of 734 Investors pursuant to the Amended and Restated Limited Liability Company Operating Agreement of 734 Investors (the “LLC Agreement”) and the November 19, 2018 resolution by written consent to remove 734 Agriculture as managing member of 734 Investors, and to designate Arlon Valencia Holdings, LLC as the new managing member of 734 Investors (the “734 Consent"), and (2) the Purported Consent was invalid under the LLC Agreement. +Also, on November 20, 2018, 734 Agriculture filed a lawsuit contesting the 734 Consent in the Delaware Court, captioned 734 Agriculture v. Arlon Valencia Holdings, LLC, C.A. No. 2018-0844-JTL (the “734 Delaware Litigation”). On November 27, 2018, the Delaware Court entered a stipulated order consolidating the Members’ Delaware Litigation and the 734 Delaware Litigation into a single lawsuit, captioned In re 734 Investors, LLC Litigation, Consol. C.A. No. 2018-0844-JTL (the consolidated suit, the “Delaware Litigation”). +On December 5, 2018, the Delaware Court entered a stipulated status quo order which provided, among other things, that 734 Agriculture was to serve as the managing member of 734 Investors during the pendency of the Delaware Litigation. The status quo order also provided that 734 Agriculture would not be permitted to take any actions outside of the ordinary course of business of 734 Investors without the consent of two-thirds of the membership interests of 734 Investors, including exercising any voting rights with respect to any shares of the Company’s common stock beneficially owned by 734 Investors. +On February 11, 2019, Mr. Trafelet, 734 Agriculture, 734 Investors, and certain members of 734 Investors entered into a settlement agreement (the “734 Investors Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Delaware Litigation. Pursuant to the 734 Investors Settlement Agreement, 734 Agriculture resigned as Managing Member of 734 Investors and Arlon Valencia Holdings, LLC was confirmed as Managing Member of 734 Investors. +From time to time, Alico may be involved in litigation relating to claims arising out of its operations in the normal course of business. There are no other current legal proceedings to which the Company is a party or of which any of its property is subject that it believes will have a material adverse effect on its financial position, results of operations or cash flows. +17 +Item 4. Mine Safety Disclosures +Not Applicable. +18 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Common Stock +Our common stock is traded on the Nasdaq Global Select Market under the symbol ALCO. +Holders +On December 2, 2019 our stock transfer records indicated there were 220 holders of record of our common stock. The number of registered holders includes banks and brokers who act as nominee for “street name” or beneficial holders, each of whom may represent more than one stockholder. +Dividend Policy +The declaration and amount of any actual cash dividend are in the sole discretion of our Board of Directors and are subject to numerous factors that ordinarily affect dividend policy, including the results of our operations and financial position, as well as general economic and business conditions. +The following table presents cash dividends per share of our common stock declared in fiscal years ended September 30, 2019, 2018 and 2017: +Declaration Date +Record Date +Payment Date +Per Common Share +November 30, 2016 +December 30, 2016 +January 16, 2017 +$0.06 +February 23, 2017 +March 31, 2017 +April 14, 2017 +$0.06 +May 23, 2017 +June 30, 2017 +July 15, 2017 +$0.06 +September 15, 2017 +September 29, 2017 +October 16, 2017 +$0.06 +November 6, 2017 +December 29, 2017 +January 16, 2018 +$0.06 +March 14, 2018 +March 30, 2018 +April 13, 2018 +$0.06 +June 11, 2018 +June 29, 2018 +July 13, 2018 +$0.06 +September 4, 2018 +September 28, 2018 +October 12, 2018 +$0.06 +December 14, 2018 +December 28, 2018 +January 11, 2019 +$0.06 +March 15, 2019 +March 29, 2019 +April 12, 2019 +$0.06 +June 14, 2019 +June 28, 2019 +July 12, 2019 +$0.06 +September 13, 2019 +September 27, 2019 +October 11, 2019 +$0.06 +19 +Stock Performance Graph +The graph below represents our common stock performance, comparing the value of $100 invested on September 30, 2014 in our common stock, the S&P 500 Index, the S&P Agricultural Products Index and a Company-constructed peer group, which includes Forestar Group, Inc., Limoneira Company, The St. Joe Company, Tejon Ranch Co. and Texas Pacific Land Trust. +INDEXED RETURNS +Base Period Sept 14 +Years Ending +Company Name / Index +Sept 15 +Sept 16 +Sept 17 +Sept 18 +Sept 19 +Alico, Inc. +100 +107.08 +71.44 +91.56 +91.33 +92.66 +S&P 500 Index +100 +99.39 +114.72 +136.07 +160.44 +167.27 +S&P Agricultural Products Index +100 +86.00 +99.15 +101.54 +114.41 +96.77 +Peer Group +100 +82.07 +99.66 +134.39 +219.29 +174.48 +(Includes reinvestment of dividends) +Recent Sale of Unregistered Securities +None. +20 +Issuer Repurchases of Equity Securities +In fiscal year 2017, Alico's Board of Directors authorized the repurchase of up to $7,000,000 of the Company’s common stock in two separate authorizations (the "2017 Authorization"). In March 2017, Alico's Board of Directors authorized the repurchase of up to $5,000,000 of the Company’s common stock beginning March 9, 2017 and continued through March 9, 2019. In May 2017, Alico's Board of Directors authorized the repurchase of up to an additional $2,000,000 of the Company’s common stock beginning May 24, 2017 and continued through May 24, 2019. There can be no assurance that the Company will repurchase shares in the future in any particular amounts or at all. A reduction in, or elimination of, share repurchases could have a negative effect on the Company's share price. +In fiscal year 2016, Alico's Board of Directors authorized the repurchase of up to 50,000 shares of the Company’s outstanding common stock beginning February 18, 2016 and continued through February 17, 2017 (the "2016 Authorization"). For the fiscal year ended September 30, 2017, the Company did not purchase any shares in accordance with the 2016 Authorization. +We adopted Rule 10b5-1 share repurchase plan under the Securities Exchange Act of 1934 (the “Plan”) in connection with share repurchase authorizations. The Plan allows us to repurchase our shares of common stock at times when it otherwise might be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. Because repurchases under the Plan are subject to certain pricing parameters, there is no guarantee as to the exact number of common shares that will be repurchased under the Plan or that there will be any repurchases pursuant to the Plan. +There were no purchases of common stock for the 4 th quarter in fiscal year 2019 under the 2017 Authorization or otherwise. As a result of the 2017 Authorization expiring on May 24, 2019, there is no availability to repurchase shares of common stock under the 2017 Authorization. +The Company purchased 72,266 shares of common stock in the open market in fiscal year 2018 under the 2017 Authorization at a weighted average price of $30.65 per common share. +On October 3, 2018, the Company completed a tender offer of 752,234 shares at a price of $34.00 per share aggregating $25,575,956 . 734 Investors, Alico's largest stockholder from 2013 until November 12, 2019, participated in the tender offer by selling a small percentage of its holdings. +21 +Item 6. Selected Financial Data +The following tables present selected historical consolidated financial information as of and for each of the fiscal years in the five-year period ended September 30, 2019. The Consolidated Financial Statements as of and for the fiscal years ended September 30, 2019, 2018, 2017, 2016 and 2015 include combined financial statement balances with Silver Nip Citrus, as a result of our common control acquisition in February 2015. +The selected historical financial data presented below should be reviewed in conjunction with our Consolidated Financial Statements and the accompanying Notes thereto, included elsewhere in this Annual Report on Form 10-K. +(in thousands, except per share amounts) +September 30, +2019 +2018 +2017 +2016 +2015 +Selected Statement of Operations Information: +Operating revenues +$ +122,251 +$ +81,281 +$ +129,829 +$ +144,196 +$ +153,126 +Income (loss) from operations +$ +45,214 +$ +10,535 +$ +(6,094 +) +$ +21,846 +$ +18,964 +Net income (loss) attributable to common stockholders +$ +37,833 +$ +13,050 +$ +(9,451 +) +$ +6,993 +$ +13,214 +Basic earnings (loss) per common share +$ +5.06 +$ +1.59 +$ +(1.14 +) +$ +0.84 +$ +1.64 +Diluted earnings (loss) per common share +$ +5.05 +$ +1.57 +$ +(1.14 +) +$ +0.84 +$ +1.64 +Cash dividends declared per common share +$ +0.24 +$ +0.24 +$ +0.24 +$ +0.24 +$ +0.24 +Selected Balance Sheet Information: +Cash and cash equivalents and restricted cash +$ +23,838 +$ +32,260 +$ +3,395 +$ +6,625 +$ +5,474 +Property and equipment, net +$ +345,648 +$ +340,403 +$ +349,337 +$ +379,247 +$ +381,099 +Total assets +$ +417,388 +$ +423,422 +$ +419,182 +$ +455,445 +$ +460,088 +Current portion of long-term debt +$ +5,338 +$ +5,275 +$ +4,550 +$ +4,493 +$ +4,511 +Long-term debt, net of current portion +$ +158,111 +$ +169,074 +$ +181,926 +$ +192,726 +$ +200,970 +Total Alico, Inc. stockholders' equity +$ +194,303 +$ +172,117 +$ +160,641 +$ +173,490 +$ +170,704 +Noncontrolling interest +$ +5,095 +$ +5,478 +$ +4,728 +$ +4,773 +$ +4,807 +For the fiscal year ended September 30, 2015, net income includes the gain on sale of assets of approximately $13,590,000 related to the sale of real estate, approximately $8,366,000 of interest expense, approximately $1,051,000 loss on extinguishment of debt related to the refinancing of our debt obligations, approximately $1,145,000 gain on bargain purchase related to acquisition of citrus business and an impairment charge of approximately $541,000 on an asset held for sale. +For the fiscal year ended September 30, 2016, net income includes the gain on sale of assets of approximately $618,000 related to the sale of real estate and approximately $9,893,000 of interest expense. +For the fiscal year ended September 30, 2017, net loss includes inventory casualty loss and net realizable adjustment of approximately $14,688,000 as a result of Hurricane Irma, additional asset impairments of long-lived assets of approximately $9,346,000, and interest expense of approximately $9,141,000. The net loss was partially offset by a gain on sale of assets of approximately $2,181,000. +For the fiscal year ended September 30, 2018, net income includes the gain on sale of assets of approximately $11,041,000 related to the sale of real estate, property and equipment and assets held for sale, and insurance proceeds received in the amount of approximately $9,429,000 relating to damages from Hurricane Irma. Net income also includes a one-time non-cash deferred income tax benefit of approximately $9,847,000, which resulted from the remeasurement of the Company's net deferred tax liabilities due to the 21% corporate tax rate that was enacted December 22, 2017, and the expiration of a capital loss carryforward, which expired at September 30, 2018, of approximately $5,634,000, resulting in an additional income tax expense. Additionally, net income includes approximately $8,561,000 of interest expense and $3,349,000 of impairments relating to net realizable adjustment on inventory and long-lived assets. +22 +For the fiscal year ended September 30, 2019, net income includes a gain on sale of assets of approximately $13,166,000 related to the sale of real estate, property and equipment and assets held for sale. Net income also includes insurance proceeds received of approximately $486,000 in additional property and casualty claims reimbursement relating to Hurricane Irma and federal relief proceeds of approximately $15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program relating to Hurricane Irma. Additionally, net income includes approximately $7,180,000 of interest expense and $1,204,000 relating to net realizable adjustment on inventory and impairments of long-lived assets. +23 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +The following discussion and analysis should be read in conjunction with the accompanying Consolidated Financial Statements and related Notes thereto. +Cautionary Statement Regarding Forward-Looking Information +We provide forward-looking information in this Annual Report on Form 10-K, particularly in this Management’s Discussion and Analysis and Results of Operations, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Any statements in this Annual Report on Form 10-K that are not historical facts are forward-looking statements. Forward-looking statements include, but are not limited to, statements that express our intentions, beliefs, expectations, strategies, predictions or any other statements relating to our future activities or other future events or conditions. These statements are based on our current expectations, estimates and projections about our business based, in part, on assumptions made by our management and can be identified by terms such as “plans,” “expect,” “may,” "anticipate,” “intend,” “should be,” “will be” “is likely to,” “believes,” and similar expressions referring to future periods. Alico believes the expectations reflected in the forward-looking statements are reasonable but cannot guarantee future results, level of activity, performance or achievements. Actual results may differ materially from those expressed or implied in the forward-looking statements. Therefore, Alico cautions you against relying on any of these forward-looking statements. Factors which may cause future outcomes to differ materially from those foreseen in forward-looking statements include, but are not limited to: changes in laws, regulation and rules; weather conditions that affect production, transportation, storage, demand, import and export of fresh product and their by-products; increased pressure from diseases including citrus greening and citrus canker, as well as insects and other pests; disruption of water supplies or changes in water allocations; market pricing of citrus; pricing and supply of raw materials and products; market responses to industry volume pressures; pricing and supply of energy; changes in interest rates; availability of financing for land development activities and other growth and corporate opportunities; onetime events; acquisitions and divestitures; seasonality; our ability to achieve the anticipated cost savings under the Alico 2.0 Modernization program; labor disruptions; inability to pay debt obligations; inability to engage in certain transactions due to restrictive covenants in debt instruments; government restrictions on land use; changes in agricultural land values; market and pricing risks due to concentrated ownership of stock market and pricing risks due to concentrated ownership of stock; the Company's receipt of future funding from the state of Florida in connection with water retention projects; any Federal relief received in the future by the Company in connection with Hurricane Irma; any reduction in the public float resulting from the 2018 tender offer or any subsequent repurchases of common stock by the Company; recent changes in the Equity Plan awards to Employees; continuation of the Company's dividend policy; expressed desire of certain of our stockholders to liquidate their shareholdings by virtue of past market sales of common stock by sales of common stock or by way of future transactions; political changes and economic crises; competitive actions by other companies; changes in dividends; increased competition from international companies; changes in environmental regulations and their impact on farming practices; the ability to secure permits for the Water Storage Contract and Project from the South Florida Water Management District; the land ownership policies of governments; changes in government farm programs and policies and international reaction to such programs; changes in pricing calculations with our customers; fluctuations in the value of the U. S. dollar, interest rates, inflation and deflation rates; changes in and effects of crop insurance programs, global trade agreements, trade restrictions and tariffs; and soil conditions, harvest yields, prices for commodities, and crop production expenses. These assumptions are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements due to numerous factors, including those Risks Factors included in Part I, Item 1A and elsewhere in this Annual Report on Form 10-K. +24 +Introduction +Alico, Inc. (“Alico”), together with its subsidiaries (collectively, the “Company", "we", "us" or "our”), is a holding company with assets and related operations in agriculture, land management and natural resources. We are a Florida agribusiness and land management company with a legacy of achievement and innovation in citrus, cattle and resource conservation. We own approximately 111,000 acres of land in eight Florida counties which includes approximately 90,000 acres of mineral rights. Our principal lines of business are now citrus groves and water storage and other operations, which include environmental services, land leasing and related support operations. Prior to the sale of our breeding herd in January 2018, the Company’s business line also included cattle ranching. Our mission is to create value for our customers and stockholders by managing existing lands to their optimal current income and total returns. Alico opportunistically acquires new agricultural assets and produces high quality agricultural products while exercising responsible environmental stewardship. +Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of results of operations, financial condition and changes in financial condition for the periods presented. This MD&A is organized as follows: +• +Business Overview. This section provides a general description of our business, as well as other matters that we believe are important in understanding our results of operations and financial condition. +• +Consolidated Results of Operations. This section provides an analysis of our results of operations for the three fiscal years ended September 30, 2019. Our discussion is presented on a consolidated basis and includes discussion on future trends by segment. +• +Liquidity and Capital Resources. This section provides an analysis of our cash flows for each of the three fiscal years ended September 30, 2019 and our outstanding debt, commitments and cash resources as of September 30, 2019. +• +Critical Accounting Policies. This section identifies those accounting policies that we consider important to our results of operations and financial condition, require significant judgment and involve significant management estimates. Our significant accounting policies, including those considered to be critical accounting policies, are summarized in Note 2, "Summary of Significant Accounting Policies," to the accompanying Consolidated Financial Statements. +Business Overview +Business Description +Alico, Inc., together with its subsidiaries (collectively, “Alico”, the “Company”, “we”, “us” or “our”) generates operating revenues primarily from the sale of its citrus products and grazing and hunting leasing. The Company operates as two business segments and all of its operating revenues are generated in the United States. During the fiscal year ended September 30, 2019, the Company generated operating revenues of approximately $122,251,000 , income from operations of approximately $45,214,000 , and net income attributable to common stockholders of approximately $37,833,000 . Cash provided by operating activities was approximately $48,832,000 during the fiscal year ended September 30, 2019. +Fiscal Year Highlights and Other Developments +Alico 2.0 Modernization Program +On November 16, 2017, we announced the Alico 2.0 Modernization Program (“Alico 2.0”). This program was intended to transform three legacy businesses (Alico, Orange Co., and Silver Nip) into a single efficient enterprise, Alico Citrus, so we would remain one of the leaders in the U.S. citrus industry. This initiative was to explore every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. +Under this program, Alico expected to reduce its operating costs. Alico has executed on the efficiencies identified and has improved margins through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. We have also deployed a more efficient labor model that is consistent and uniform for field staffing and grove operations and is aligned with the geographical footprint of the citrus groves. This effort has helped to transition us to a high-quality, low-cost producer of citrus which we anticipate will continue for future years to come. +25 +In combination with these efforts, the Company worked to maintain operational efficiencies and deploy its resources to solidify the Company's position as a leader in the recovering citrus industry. +Under Alico 2.0, we also decided to divest assets that generated low rates of return and shut down parts of our operations that were not profitable. Alico Citrus has generated cash of $57,800,000, under Alico 2.0 through September 30, 2019. This has been facilitated through (i) the shut down and sale of its nursery in Gainesville, Florida, (ii) the sale of certain underperforming groves, (ii) the sale of its breeding herd, (iv) the sale of certain parcels of land on its Ranch, (v) the sale of certain trailers related to our logistics division, and (vi) the sale of certain real estate assets that were not strategic to our business plan. +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third party operator. However, the Company continues to own the property and continues to conduct its long-term dispersed water program and wildlife management programs. +Alico 2.0 also included an enhanced program to plant more citrus trees. The Company planted over 400,000 trees in both fiscal year 2019 and 2018 to help position the Company for future production growth. +Tender Offer +On September 5, 2018, the Board of Directors approved and Alico announced the commencement of an issuer offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, upon the terms and subject to the conditions described in the Offer to Purchase dated September 5, 2018, including the ability to increase the aggregate value of shares purchased, Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors, LLC, Alico’s largest stockholder from 2013 until November 12, 2019, participated in the Tender Offer by selling a small percentage of its holdings of the Company’s common stock. Members of neither the management team nor the Board of Directors sold any shares directly in the Tender Offer. +Termination Proceedings against Mr. Remy W. Trafelet +On November 19, 2018, Alico, with unanimous approval of the members of the Board of Directors, other than Remy W. Trafelet, notified Mr. Trafelet, who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, that it intended to consider terminating his employment for “cause” pursuant to the terms of his employment agreement with the Company and option agreements entered into under the Company's Stock Incentive Plan of 2015 (collectively, the “Compensation Documents”). On November 28, 2018, the parties in the Florida Litigation (as defined below) stipulated to an order which provided, among other things, that pending the resolution of the Delaware Litigation (as defined below), the Board of Directors would not take any action out of the routine day-to-day operations conducted in the ordinary course of business, including removing any corporate officers or directors from positions held as of November 27, 2018. +As described in “Note 16. Commitments and Contingencies” to the condensed consolidated financial statements in Part II Item 8, of this Annual Report on Form 10-K, on February 11, 2019, the parties to the Florida Litigation entered into the Alico Settlement Agreement wherein the parties agreed to promptly dismiss all claims in the Florida Litigation, including those related to the termination proceedings against Mr. Trafelet, and Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and a member of the Company’s Board of Directors, effective upon the execution of the Alico Settlement Agreement. +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into the Consulting Agreement with Mr. Trafelet and 3584, Inc. (the "Consultant"). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $400,000. If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24-month term. +In addition, as contemplated by the Alico Settlement Agreement, the Company entered into the Registration Rights Agreement with Mr. Trafelet, relating to the Registrable Securities. The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +26 +Management and Board Changes +On April 11, 2019, the Board of Directors announced the appointment of Mr. John E. Kiernan as President and Chief Executive Officer and Mr. Richard Rallo as Chief Financial Officer, both effective July 1, 2019. Additionally, Mr. Benjamin D. Fishman, the Company’s current Interim President, agreed to resign from this position effective July 1, 2019. In addition, on April 11, 2019, Mr. Henry A. Slack, the current Executive Chairman of the Board, informed the Board that he agreed to step down as Executive Chairman of the Board, effective July 1, 2019. Mr. Slack’s decision to step down as Executive Chairman of the Board was not the result of any disagreement with the Company on any matter relating to the Company’s operations, policies or practices. Mr. Slack will remain a member of the Board of Directors. The Board appointed Mr. Benjamin D. Fishman, the Company’s current Interim President, to the role of non-employee Executive Chairman of the Board, effective July 1, 2019. +On April 29, 2019, the Board of Directors appointed Mr. Toby K. Purse as a member of the Board of Directors, to serve until the 2020 annual meeting of the Company’s shareholders or until his earlier death, resignation, or removal in accordance with the Amended and Restated Bylaws of the Company. The Board of Directors has affirmatively determined that Mr. Purse qualifies as an independent director under the rules of the Nasdaq Stock Exchange and as defined under applicable law. Mr. Purse has also been appointed to serve as a member of the audit committee of the Board of Directors. +Federal Relief Program +The Company is eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fourth quarter of 2019 and for the fiscal year ended September 30, 2019, the Company received approximately $15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and a portion of the Part 2 reimbursement under a three-part program. Subsequent to fiscal year end 2019, the Company received additional proceeds of approximately $4,136,000 under the Florida CRBG program. This represents another portion of the Part 2 reimbursement under a three-part program. The timing and amount to be received under the remaining portion of Part 2 and Part 3 of the program, if any, has not been finalized. +Distribution of Shares by 734 Investors +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +27 +Condensed Consolidated Results of Operations +The following discussion provides an analysis of Alico's results of operations and should be read in conjunction with the accompanying Consolidated Statements of Operations for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2019 +2018 +$ +% +2018 +2017 +$ +% +Operating revenues: +Alico Citrus +$ +119,031 +$ +78,121 +$ +40,910 +52.4 +% +$ +78,121 +$ +123,441 +$ +(45,320 +) +(36.7 +)% +Water Resources and Other Operations +3,220 +3,160 +60 +1.9 +% +3,160 +6,388 +(3,228 +) +(50.5 +)% +Total operating revenues +122,251 +81,281 +40,970 +50.4 +% +81,281 +129,829 +(48,548 +) +(37.4 +)% +Gross profit (loss): +Alico Citrus +59,437 +26,412 +33,025 +125.0 +% +26,412 +11,494 +14,918 +129.8 +% +Water Resources and Other Operations +923 +(819 +) +1,742 +(212.7 +)% +(819 +) +(2,564 +) +1,745 +(68.1 +)% +Total gross profit +60,360 +25,593 +34,767 +135.8 +% +25,593 +8,930 +16,663 +186.6 +% +General and administrative expenses +15,146 +15,058 +88 +0.6 +% +15,058 +15,024 +34 +NM +Income (loss) from operations +45,214 +10,535 +34,679 +329.2 +% +10,535 +(6,094 +) +16,629 +(272.9 +)% +Total other income (expense) +5,019 +2,655 +2,364 +89.0 +% +2,655 +(7,248 +) +9,903 +(136.6 +)% +Income (loss) before income taxes +50,233 +13,190 +37,043 +280.8 +% +13,190 +(13,342 +) +26,532 +(198.9 +)% +Income tax provision (benefit) +12,783 +390 +12,393 +NM +390 +(3,846 +) +4,236 +(110.1 +)% +Net income (loss) +37,450 +12,800 +24,650 +192.6 +% +12,800 +(9,496 +) +22,296 +(234.8 +)% +Net loss attributable to noncontrolling interests +383 +250 +133 +53.2 +% +250 +45 +205 +455.6 +% +Net income (loss) attributable to Alico, Inc. common stockholders +$ +37,833 +$ +13,050 +$ +24,783 +189.9 +% +$ +13,050 +$ +(9,451 +) +$ +22,501 +(238.1 +)% +NM - Not meaningful +The following table presents our operating revenues, by segment, as a percentage of total operating revenues for the fiscal years ended September 30, 2019, 2018 and 2017: +Fiscal Year Ended +September 30, +2019 +2018 +2017 +Operating revenues: +Alico Citrus +97.4 +% +96.1 +% +95.1 +% +Water Resources and Other Operations +2.6 +% +3.9 +% +4.9 +% +Total operating revenues +100.0 +% +100.0 +% +100.0 +% +28 +The following discussion provides an analysis of the Company's operating segments: +Alico Citrus +The table below presents key operating measures for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands, except per box and per pound solids data) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2019 +2018 +Unit +% +2018 +2017 +Unit +% +Operating Revenues: +Early and Mid-Season +$ +39,574 +$ +24,309 +$ +15,265 +62.8 +% +$ +24,309 +$ +45,999 +$ +(21,690 +) +(47.2 +)% +Valencias +73,480 +48,865 +24,615 +50.4 +% +48,865 +67,146 +(18,281 +) +(27.2 +)% +Fresh Fruit +3,629 +2,054 +1,575 +76.7 +% +2,054 +5,735 +(3,681 +) +(64.2 +)% +Purchase and Resale of Fruit +943 +809 +134 +16.6 +% +809 +2,331 +(1,522 +) +(65.3 +)% +Other +1,405 +2,084 +(679 +) +(32.6 +)% +2,084 +2,230 +(146 +) +(6.5 +)% +Total +$ +119,031 +$ +78,121 +$ +40,910 +52.4 +% +$ +78,121 +$ +123,441 +$ +(45,320 +) +(36.7 +)% +Boxes Harvested: +Early and Mid-Season +3,114 +1,811 +1,303 +71.9 +% +1,811 +3,215 +(1,404 +) +(43.7 +)% +Valencias +4,790 +2,891 +1,899 +65.7 +% +2,891 +4,044 +(1,153 +) +(28.5 +)% +Total Processed +7,904 +4,702 +3,202 +68.1 +% +4,702 +7,259 +(2,557 +) +(35.2 +)% +Fresh Fruit +210 +125 +85 +68.0 +% +125 +328 +(203 +) +(61.9 +)% +Total +8,114 +4,827 +3,287 +68.1 +% +4,827 +7,587 +(2,760 +) +(36.4 +)% +Pound Solids Produced: +Early and Mid-Season +16,873 +9,194 +7,679 +83.5 +% +9,194 +17,950 +(8,756 +) +(48.8 +)% +Valencias +29,854 +17,319 +12,535 +72.4 +% +17,319 +24,661 +(7,342 +) +(29.8 +)% +Total +46,727 +26,513 +20,214 +76.2 +% +26,513 +42,611 +(16,098 +) +(37.8 +)% +Pound Solids per Box: +Early and Mid-Season +5.42 +5.07 +0.35 +6.9 +% +5.07 +5.58 +(0.51 +) +(9.1 +)% +Valencias +6.23 +5.99 +0.24 +4.0 +% +5.99 +6.10 +(0.11 +) +(1.8 +)% +Price per Pound Solids: +Early and Mid-Season +$ +2.35 +$ +2.64 +$ +(0.29 +) +(11.0 +)% +$ +2.64 +$ +2.56 +$ +0.08 +3.1 +% +Valencias +$ +2.46 +$ +2.82 +$ +(0.36 +) +(12.8 +)% +$ +2.82 +$ +2.72 +$ +0.10 +3.7 +% +Price per Box: +Fresh Fruit +$ +17.28 +$ +16.43 +$ +0.85 +5.2 +% +$ +16.43 +$ +17.48 +$ +(1.05 +) +(6.0 +)% +Operating Expenses: +Cost of Sales +$ +52,037 +$ +46,477 +$ +5,560 +12.0 +% +$ +46,477 +$ +84,909 +$ +(38,432 +) +(45.3 +)% +Harvesting and Hauling +22,208 +12,921 +9,287 +71.9 +% +12,921 +21,520 +(8,599 +) +(40.0 +)% +Purchase and Resale of Fruit +659 +562 +97 +17.3 +% +562 +2,134 +(1,572 +) +(73.7 +)% +Other +(15,310 +) +(8,251 +) +(7,059 +) +85.6 +% +(8,251 +) +3,384 +(11,635 +) +(343.8 +)% +Total +$ +59,594 +$ +51,709 +$ +7,885 +15.2 +% +$ +51,709 +$ +111,947 +$ +(60,238 +) +(53.8 +)% +Gross Profit +$ +59,437 +$ +26,412 +$ +33,025 +$ +26,412 +$ +11,494 +$ +14,918 +29 +Our citrus groves produce the majority of our annual operating revenues and the citrus grove business is seasonal because it is tied to the growing and harvest season. Historically, the second and third quarters of Alico's fiscal year produce the majority of the annual revenues and working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with the growing cycles. +The Company sells its Early and Mid-Season and Valencia oranges to processors that convert the majority of the citrus crop into orange juice. They generally buy the citrus on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of fruit. Fresh fruit is generally sold to packing houses that purchase the citrus on a per box basis. Other revenues consist of third-party grove caretaking and the purchase and reselling of fruit. +Alico's operating expenses consist primarily of cost of sales and harvesting and hauling costs. Cost of sales represents the cost of maintaining the citrus groves for the preceding calendar year and does not vary in relation to production. Harvesting and hauling costs represent the costs of bringing citrus product to processors and varies based upon the number of boxes produced. Other expenses include the period costs of third-party grove caretaking and the purchase and reselling of fruit. +The increase in revenues for the fiscal year ended September 30, 2019, compared to the fiscal year ended September 30, 2018, was primarily related to the negative impact of Hurricane Irma on the prior fiscal year harvest. As a result of Hurricane Irma, which occurred in September 2017, the Company experienced a greater amount of fruit drop and consequently harvested approximately 3,202,000 fewer boxes in fiscal year 2018, as compared to the fiscal year 2019. The Company also saw an overall increase in pound solids per box in the fiscal year 2019, which was 5.91 as compared to 5.64 for the fiscal year 2018. In addition, the increase in revenue, to a smaller extent, was due to a greater number of boxes of fresh fruit being sold for the fiscal year 2019. +The decrease in revenues for the fiscal year ended September 30, 2018, compared to the fiscal year ended September 30, 2017, was primarily due to the impact of Hurricane Irma. The Company experienced a greater amount of fruit drop from the impact of Hurricane Irma and consequently harvested approximately 2,557,000 fewer processed boxes in fiscal year 2018, as compared to the same period in fiscal year 2017. The Company also saw an overall decrease in pound solids per box which went from 5.87 in the fiscal year ended September 30, 2017 to 5.64 in the fiscal year ended September 30, 2018. The Company did experience a smaller fruit drop with respect to its Valencia fruit which is harvested later in the year as compared to the Early and Mid-Season variety and as such realized a smaller overall reduction in boxes produced. In addition, the decrease in revenue, to a smaller extent, was due to fewer boxes of fresh fruit being sold for the fiscal year ended September 30, 2018. The decrease in revenues from purchase and resale of fruit and other revenues reflects the Company’s decision to reduce third party fruit purchases and third party caretaking services. +Total processed boxes harvested in fiscal year 2019 increased by approximately 68.1%, as compared to fiscal year 2018. Pound solids per box increased by approximately 6.9% and approximately 4.0% for the Early and Mid-Season and Valencia oranges, respectively. The combination of these items resulted in approximately 20,214,000 of additional pound solids sold in fiscal year 2019, as compared to fiscal year 2018. +Total processed boxes harvested in fiscal year 2018 declined by approximately 35.2%, as compared to fiscal year 2017. Pound solids per box decreased by approximately 9.1% and approximately 1.8% for the Early and Mid-Season and Valencia oranges, respectively. The combination of these items resulted in approximately 16,098,000 less pound solids sold in fiscal year 2018, as compared to fiscal year 2017. +The USDA, in its November 8, 2019 Citrus Crop Forecast for the 2019-20 harvest season, indicated its expectation that the Florida orange crop will increase from approximately 71,600,000 boxes for the 2018-19 crop year to approximately 74,000,000 boxes for the 2019-20 crop year, an increase of approximately 3.4%. While the production is estimated to be slightly higher than in the prior year, the Company anticipates there will be a continued reduction in the market prices in the 2019-20 harvest season as a result of excess supply from domestic and international growers. +The Company originally estimated its fiscal year 2019 processed boxes would increase by approximately 31%-37% compared to processed boxes for fiscal year 2018. Based on the harvesting of fruit, the Company increased processed box production for fiscal year 2019 by approximately 68% compared to processed boxes for fiscal year 2018. The improvement is the result of both the Early & Mid-season and Valencia variety fruit experiencing less fruit drop then was anticipated upon making the estimate in production. +The increase in gross profit for fiscal year 2019, as compared to fiscal year 2018, was primarily a result of (i) increased citrus revenue and (ii) proceeds received under CRBG program relating to Hurricane Irma, which was recorded as a reduction of operating costs. The increase in operating expenses was due to the increased harvesting and hauling costs, which is the direct result of increased citrus processed box production and (ii) the Company allocating a greater amount of its accumulated costs to its cost of goods sold. Partially offsetting this increase in operating expenses was the Company received a greater amount of funds through the CRBG +30 +and insurance claim reimbursement relating to Hurricane Irma in fiscal year 2019, as compared to the same period in fiscal year 2018. +The increase in gross profit for fiscal year 2018, as compared to fiscal year 2017, was primarily driven by a decrease in operating expenses, which was partially offset by a reduction in revenues. The decrease in operating costs is due to (i) the Company allocating a smaller amount of accumulated costs to cost of goods sold, (ii) less harvesting and hauling costs incurred due to fewer boxes being harvested, and (iii) the Company receiving approximately $9,429,000 of insurance proceeds. Partially offsetting this decrease in operating expenses, along with the reduction in revenue, was impairment charges of approximately $3,349,000 relating to net realizable adjustment on inventory and long-lived assets. The decrease in revenue is primarily a result of the impact of Hurricane Irma. +Water Resources and Other Operations +The table below presents key operating measures for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2019 +2018 +$ +% +2018 +2017 +$ +% +Revenue From: +Land and other leasing +$ +2,787 +$ +2,595 +$ +192 +7.4 +% +$ +2,595 +$ +2,294 +$ +301 +13.1 +% +Sale of calves and culls +— +57 +(57 +) +(100.0 +)% +57 +3,732 +(3,675 +) +(98.5 +)% +Other +433 +508 +(75 +) +(14.8 +)% +508 +362 +146 +40.3 +% +Total +$ +3,220 +$ +3,160 +$ +60 +1.9 +% +$ +3,160 +$ +6,388 +$ +(3,228 +) +(50.5 +)% +Operating Expenses: +Land and other leasing +$ +1,047 +$ +1,072 +$ +(25 +) +(2.3 +)% +$ +1,072 +$ +466 +$ +606 +130.0 +% +Cost of calves sold +— +1,075 +(1,075 +) +(100.0 +)% +1,075 +3,527 +(2,452 +) +(69.5 +)% +Water conservation +1,206 +1,619 +(413 +) +(25.5 +)% +1,619 +1,794 +(175 +) +(9.8 +)% +Other +44 +213 +(169 +) +(79.3 +)% +213 +3,165 +(2,952 +) +(93.3 +)% +Total +$ +2,297 +$ +3,979 +$ +(1,682 +) +(42.3 +)% +$ +3,979 +$ +8,952 +$ +(4,973 +) +(55.6 +)% +Gross Profit (loss) +$ +923 +$ +(819 +) +$ +1,742 +$ +(819 +) +$ +(2,564 +) +$ +1,745 +NM - Not meaningful +Land and other leasing includes lease income from a lease for grazing rights, hunting leases, a lease to a third party of an aggregate mine and leases of oil extraction rights to third parties, and farm lease revenue. +The slight increase in revenues from Water Resources and Other Operations for the fiscal year ended September 30, 2019 is primarily due to the Company recording a full year of grazing lease revenue in fiscal year 2019, while only recording nine months of revenue as the lease for these grazing rights was executed on January 8, 2018, at the time of the sale of the cattle herd. Partially offsetting this increase was a decrease in farm lease revenue as a result of a lease not being renewed in fiscal year 2019. The Company continues to own the property and conduct its dispersed long-term water program and wildlife management programs. +The decrease in revenues from Water Resources and Other Operations for the fiscal year 2018, as compared to fiscal year 2017, was primarily due to selling of Alico's cattle herd in January 2018. All inventory costs that were accumulated at the date of sale were expensed. As part of this transaction, the Company entered into a long-term leasing arrangement with the purchaser for the grazing rights on the Ranch that provides an annual revenue stream of approximately $1,200,000. As a result of these changes, Alico renamed this division to Water Resources and Other Operations to reflect its focus on water storage and nutrient reduction. Alico believes that its dispersed water storage project is the largest and most cost-effective project of its kind in the United States, and believes, once permits from state and federal agencies have been approved, the project will store and prevent large volumes of water from entering the Caloosahatchee River, will remove substantial amounts of nitrogen from the watershed, and will help to rehydrate natural systems that eventually flow south into the Everglades. +31 +Water storage and conservation +In December 2012, the South Florida Water Management District ("SFWMD") issued a solicitation request for projects to be considered for the Northern Everglades Payment for Environmental Services Program. In March 2013, the Company submitted its response proposing a dispersed water management project on a portion of its Ranch land to reduce harmful discharges to the Caloosahatchee Estuary. +On December 11, 2014, the SFWMD approved a contract with the Company. The contract term is eleven years and allows up to one year for implementation (design, permitting, construction and construction completion certification) and ten years of operation, whereby the Company will provide water retention services. Payment includes an amount not to exceed $4,000,000 of reimbursement for implementation. In addition, it provides for an annual fixed payment of $12,000,000 for operations and maintenance costs, as long as the project is in compliance with the contract and subject to annual District Board approval of funding. The contract specifies that the District Board has to approve the payments annually and there can be no assurance that it will approve the annual fixed payments. On September 19, 2018, the SFWMD issued a press release announcing the issuance of an Environmental Resource Permit for Alico. The SFWMD release also stated that (i) the issuance of the permit cleared the path for Alico to deliver a regional dispersed water storage project in the Caloosahatchee Watershed that has the opportunity to significantly reduce excessive Lake Okeechobee releases and storm water runoff to the Caloosahatchee Estuary, (ii) Alico has all necessary state approvals to proceed, and (iii) the project is expected to be operational within one year from the start of construction, which is contingent on Alico securing additional local and federal approvals. These approvals include a compatible use agreement from the Natural Resources Conservation Service, as well as approvals from the local water control districts. The project has made substantial progress toward receiving federal authorization from the US Army Corps of Engineers which includes consultation with US Fish & Wildlife Service and the Tribes of Florida. The approved Florida budget for the state’s 2019/2020 fiscal year included funding for the Program. Operating expenses were approximately $1,206,000, $1,619,000 and $1,794,000 for each of the three fiscal years ended September 30, 2019, 2018 and 2017, respectively. +General and Administrative +General and administrative expenses for the fiscal year ended September 30, 2019 was approximately $15,146,000 , compared to approximately $15,058,000 for the fiscal year ended September 30, 2018. +The slight increase in general and administrative expenses for the fiscal year ended September 30, 2019, as compared to the fiscal year ended September 30, 2018, was primarily due to an increase in professional fees, relating to a corporate litigation matter, of approximately $2,300,000 during the fiscal year ended September 30, 2019. This litigation has been resolved with a settlement being reached on February 11, 2019. The Company does not anticipate further professional fees relating to this litigation. Additionally, as part of this settlement, the Company recorded consulting and separation fees of $800,000 during the fiscal year ended September 30, 2019. The Company also recorded a one-time pension expense related to its deferred retirement benefit plan of approximately $965,000 in fiscal year 2019. Partially offsetting these increases were decreases in expenses relating to (i) a reduction in stock compensation expense of $823,000 as a result of a former senior executive forfeiting his stock options as part of the settled litigation, (ii) a reduction in rent expense of approximately $450,000 as a result of the Company not renewing its lease for office space in New York City, (iii) an acceleration of stock compensation expense in fiscal year 2018 of approximately $782,000 as a result of two senior executives forfeiting a portion of their stock options, and (iv) a reduction in payroll costs of approximately $1,261,000 . The reduction in payroll costs was primarily from (i) a reduction in separation expenses of approximately $388,000 ; (ii) a reduction in accrual for paid-time-off of approximately $100,000 ; and (iii) a reduction in executive compensation expense of approximately $725,000 relating to the resignation of a former senior executive. +The slight increase in general and administrative expenses in fiscal year 2018, as compared to the same period in fiscal year 2017, primarily relates to increases in (i) bonus awards provided to senior executives and managers, (ii) an acceleration of stock compensation expense as a result of two senior executives forfeiting a portion of their stock options, (iii) costs related to the Tender Offer which commenced in September 2018 and (iv) an increase in rent, which commenced October 30, 2017, as a result of the Company selling its office building in Fort Myers, FL, and leasing back a portion of the space. These items resulted in an aggregate increase in general and administrative expenses of approximately $2,700,000. These increases were offset by decreases primarily attributable to salary and stock compensation expenses incurred with respect to employment agreements executed for new executives in the fiscal year 2017 which did not occur in the fiscal year 2018, a reduction of expenses incurred relating to separation and consulting arrangements, as well as a reduction in bad debt expense and recruiting fees. +Other (Expense) Income +Other income for the fiscal years ended September 30, 2019 and 2018 was approximately $5,019,000 and approximately $2,665,000 , respectively. The increase in other income was primarily due to the Company recording a higher gain on sale of real estate, property +32 +and equipment and assets held for sale in fiscal year 2019, as compared to fiscal year 2018. In fiscal year 2019, the Company recorded a gain of approximately $13,166,000, which was generated primarily for the sale of land on its West Ranch in September 2019. For the fiscal year ended September 30, 2018, the Company recorded a gain of $11,041,000 on the sale of real estate, property and equipment and assets held for sale, which included its corporate office building in Fort Myers, Florida, its Gal Hog property and a land parcel within its East Ranch resulting in gains of approximately $1,751,000, $6,709,000 and $1,759,000, respectively. Additionally, the Company incurred less interest expense of approximately $1,400,000 in fiscal year 2019, as compared to fiscal year 2018, primarily due to the Company recording imputed interest expense during the fiscal year ended September 30, 2018 relating to its Sugarcane transaction, which was terminated in fiscal year 2019. +Other income (expense), net, for the fiscal year ended September 30, 2018 and 2017 was approximately $2,655,000 and approximately $(7,248,000), respectively. The shift from other expense, net to other income, net is primarily due to recording a higher gain on sale of real estate, property and equipment and assets held for sale. For the fiscal year ended September 30, 2018, the Company sold certain properties and equipment which included its corporate office building in Fort Myers, Florida, its Gal Hog property and a land parcel within its East Ranch resulting in gains of approximately $1,751,000, $6,709,000 and $1,759,000, respectively. During the fiscal year ended September 30, 2017, the Company sold land and facilities in Hendry County, Florida, which resulted in a gain of approximately $1,371,000. Additionally, the Company incurred less interest expense of approximately $580,000 due to the continued pay-down of its long-term debt, as well as a prepayment made on a loan of approximately $4,453,000 with the proceeds from the asset sales. +Income Taxes +For the fiscal years ended September 30, 2019, 2018 and 2017, the provision (benefit) for income taxes was approximately $12,783,000 , $390,000 and $(3,846,000) , respectively, and the related effective income tax rates were approximately 25.45%, 2.96% and 28.83%, respectively. The change in the tax provision for the fiscal year ended September 30, 2019 is the result of the Company generating greater net income during the current fiscal year as compared to the prior fiscal year. Additionally, a one-time non-cash deferred income tax benefit of approximately $9,847,000 was recorded in fiscal year 2018 which resulted from the remeasurement of the Company's net deferred tax liabilities due to the 21% corporate tax rate that was enacted December 22, 2017, and the expiration of its capital loss carryforward, which expired at September 30, 2018, of approximately $5,634,000 was recorded in fiscal year 2018, resulting in an additional income tax expense. +The change in the provision for income taxes for the fiscal year ended September 30, 2018, as compared to fiscal year 2017, primarily resulted from (i) the Company generating net income, (ii) a one-time non-cash deferred income tax benefit of approximately $9,847,000 resulting from the remeasurement of the Company's net deferred tax liabilities due to the 21% corporate tax rate that was enacted December 22, 2017, and (iii) the expiration of its capital loss carryforward, which expired at September 30, 2018, of approximately $5,634,000, resulting in an additional income tax expense. +Seasonality +The Company is primarily engaged in the production of fruit for sale to citrus markets, which is of a seasonal nature, and subject to the influence of natural phenomena and wide price fluctuations. Historically, the second and third quarters of Alico's fiscal year produce the majority of the Company's annual revenue. Working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with harvesting cycles. Because of the seasonality of the business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year. +33 +Liquidity and Capital Resources +A comparative balance sheet summary is presented in the following table: +(in thousands) +September 30, +2019 +2018 +Change +Cash and cash equivalents and restricted cash +$ +23,838 +$ +32,260 +$ +(8,422 +) +Total current assets +$ +61,977 +$ +71,061 +$ +(9,084 +) +Total current liabilities +$ +28,951 +$ +21,476 +$ +7,475 +Working capital +$ +33,026 +$ +49,585 +$ +(16,559 +) +Total assets +$ +417,388 +$ +423,422 +$ +(6,034 +) +Principal amount of term loans and lines of credit +$ +163,449 +$ +177,034 +$ +(13,585 +) +Current ratio +2.14 to 1 +3.31 to 1 +Alico's business has historically generated positive net cash flows from operating activities. Sources of cash primarily include cash flows from operations, sales of under-performing land and other assets, amounts available under the Company's credit facilities and access to capital markets. Access to additional borrowings under revolving lines of credit is subject to the satisfaction of customary borrowing conditions. As a public company, Alico may have access to other sources of capital. However, access to, and availability of, financing on acceptable terms in the future will be affected by many factors, including (i) financial condition, prospects and credit rating, (ii) liquidity of the overall capital markets and (iii) the state of the economy. There can be no assurance that the Company will continue to have access to the capital markets on acceptable terms, or at all. +The principal uses of cash that affect Alico's liquidity position include the following: operating expenses including employee costs, the cost of maintaining the citrus groves, harvesting and hauling of citrus products, capital expenditures, stock repurchases, dividends, and debt service costs including interest and principal payments on term loans and other credit facilities. +Management believes that a combination of cash-on-hand, cash generated from operations, asset sales and availability under the Company's lines of credit will provide sufficient liquidity to service the principal and interest payments on its indebtedness, and will satisfy working capital requirements and capital expenditures for at least the next twelve months and over the long term. Alico has a $70,000,000 working capital line of credit, of which approximately $69,540,000 is available for general use as of September 30, 2019 , and a $25,000,000 revolving line of credit, all of which is available for general use as of September 30, 2019 (see Note 6. “Long-Term Debt and Lines of Credit" to the accompanying Consolidated Financial Statements). If the Company pursues significant growth and other corporate opportunities, it could have a material adverse impact on its cash balances, and may need to finance such activities by drawing down monies under its lines of credit or by obtaining additional debt or equity financing. There can be no assurance that additional financing will be available to the Company when needed or, if available, that it can be obtained on commercially reasonable terms. Any inability to obtain additional financing could impact Alico's ability to pursue different growth and other corporate opportunities. +The level of debt could have important consequences on Alico's business, including, but not limited to, increasing its vulnerability to general adverse economic and industry conditions, limiting the availability of cash flow to fund future investments, capital expenditures, working capital, business activities and other general corporate requirements, and limiting flexibility in planning for, or reacting to, changes in its business and industry. +Cash Management Impacts +Cash and cash equivalents and restricted cash decreased from approximately $32,260,000 as of September 30, 2018 to approximately $23,838,000 as of September 30, 2019. Cash and cash equivalents and restricted cash increased by approximately $28,865,000 as of September 30, 2018, as compared to September 30, 2017. The components of these changes are discussed below. +34 +Consolidated Statements of Cash Flows +The following table details the items contributing to the changes in cash and cash equivalents and restricted cash for fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Net cash provided by operating activities +$ +48,832 +$ +18,578 +$ +27,481 +Net cash (used in) provided by investing activities +(4,960 +) +22,924 +(9,337 +) +Net cash used in financing activities +(52,294 +) +(12,637 +) +(21,374 +) +Net (decrease) increase in cash and cash equivalents and restricted cash +$ +(8,422 +) +$ +28,865 +$ +(3,230 +) +Net Cash Provided By Operating Activities +The following table details the items contributing to Net Cash Provided By Operating Activities for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended September 30, +Fiscal Year Ended September 30, +2019 +2018 +Change +2018 +2017 +Change +Net income (loss) +$ +37,450 +$ +12,800 +$ +24,650 +$ +12,800 +$ +(9,496 +) +$ +22,296 +Deferred gain on sale of sugarcane land +— +(967 +) +967 +(967 +) +(538 +) +(429 +) +Depreciation, depletion and amortization +13,924 +13,756 +168 +13,756 +15,226 +(1,470 +) +Loss on breeding herd sales +— +13 +(13 +) +13 +337 +(324 +) +Deferred income tax expense (benefit) +3,267 +(1,955 +) +5,222 +(1,955 +) +(3,948 +) +1,993 +Cash surrender value +11 +(27 +) +38 +(27 +) +(15 +) +(12 +) +Deferred retirement benefits +829 +(41 +) +870 +(41 +) +(102 +) +61 +Magnolia Fund undistributed loss (earnings) +— +(8 +) +8 +(8 +) +202 +(210 +) +Gain on sale of real estate, property and equipment and assets held for sale +(13,166 +) +(10,281 +) +(2,885 +) +(10,281 +) +(1,373 +) +(8,908 +) +Inventory net realizable value adjustment +808 +1,115 +(307 +) +1,115 +1,199 +(84 +) +Inventory casualty loss +— +— +— +— +13,489 +(13,489 +) +Loss on disposal of property and equipment +— +207 +(207 +) +207 +— +207 +Change in fair value of derivatives +989 +— +989 +— +— +— +Impairment of long-lived assets +396 +2,234 +(1,838 +) +2,234 +9,346 +(7,112 +) +Non-cash interest expense on deferred gain on sugarcane land +— +1,361 +(1,361 +) +1,361 +1,413 +(52 +) +Insurance proceeds received for damage to property and equipment +(486 +) +(477 +) +(9 +) +(477 +) +— +(477 +) +Bad debt expense +— +24 +(24 +) +24 +312 +(288 +) +Stock-based compensation expense +824 +2,613 +(1,789 +) +2,613 +1,653 +960 +Change in working capital +3,986 +(1,789 +) +5,775 +(1,789 +) +(224 +) +(1,565 +) +Net cash provided by operating activities +$ +48,832 +$ +18,578 +$ +30,254 +$ +18,578 +$ +27,481 +$ +(8,903 +) +The increase in net cash provided by operating activities for the fiscal year ended September 30, 2019, as compared to the same period in fiscal year 2018, was primarily due to (i) an increase in net income which was primarily driven by increased citrus sales and the receipt of federal disaster relief funds relating to Hurricane Irma, and (ii) an increase in working capital, which is due to a decrease in accounts receivable and an increase in income taxes payable. +The decrease in net cash provided by operating activities for the fiscal year ended September 30, 2018, as compared to the same period in the fiscal year 2017, was primarily due to the effect of the Company recognizing a greater gain on the sale of real estate, +35 +property and equipment and assets held for sale as a result of the Company’s decision to divest itself from several non-core and underperforming assets during the fiscal year 2018. Additionally, the Company experienced a decrease in working capital as compared to the previous fiscal year. This is primarily the result of the Company having a smaller increase in accounts receivable due to lower revenues earned, and experiencing a smaller decrease in inventory levels due the Company taking an impairment on its inventory levels at September 30, 2017, which directly impacted the change for the fiscal year ended September 30, 2018. This decrease was partially offset by an increase in net income. +Due to the seasonal nature of Alico's business, working capital requirements are typically greater in the first and fourth quarters of its fiscal year. Cash flows from operating activities typically improve in the second and third fiscal quarters, as sales of its harvested citrus are made. +Net Cash (Used In) Provided By Investing Activities +The following table details the items contributing to Net Cash (Used In) Provided By Investing Activities for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended September 30, +Fiscal Year Ended September 30, +2019 +2018 +Change +2018 +2017 +Change +Purchases of property and equipment +(20,000 +) +(16,352 +) +(3,648 +) +(16,352 +) +(13,353 +) +(2,999 +) +Return on investment in Magnolia Fund +— +25 +(25 +) +25 +324 +(299 +) +Net proceeds from sale of property and equipment and assets held for sale +14,602 +37,969 +(23,367 +) +37,969 +760 +37,209 +Net proceeds from sale of real estate +— +1,811 +(1,811 +) +1,811 +2,184 +(373 +) +Insurance proceeds received for damage to property and equipment +486 +477 +9 +477 +— +477 +Change in deposits on purchase of citrus trees +(108 +) +(431 +) +323 +(431 +) +748 +(1,179 +) +Advances on notes receivables, net +60 +(575 +) +635 +(575 +) +— +(575 +) +Net cash (used in) provided by investing activities +$ +(4,960 +) +$ +22,924 +$ +(27,884 +) +$ +22,924 +$ +(9,337 +) +$ +32,261 +The change from net cash provided by investing activities for the fiscal year ended September 30, 2018 to net cash used in investing activities for the fiscal year ended September 30, 2019 was primarily due to a decrease in proceeds received on the sale of certain assets sold during fiscal year 2019, as compared to fiscal year 2018. This is due to the Company divesting of several more assets in fiscal year 2018, as compared to fiscal year 2019 (see Note 4. “Assets Held for Sale” and Note 5. “Property & Equipment, Net” to the accompanying Consolidated Financial Statements). In addition, the shift, to a smaller extent, was due to an increase in capital expenditures which was driven by the purchase of certain land blocks within its existing grove location. +The increase in net cash provided by (used in) investing activities for the fiscal year ended September 30, 2018, as compared to the fiscal year ended September 30, 2017, was primarily due to proceeds received from the sale of certain assets during the fiscal year 2018. This increase was partially offset by greater capital expenditures in the fiscal year 2018, as compared to the same period in the prior fiscal year, as a result of the Company’s decision to plant more trees. +36 +Net Cash Used In Financing Activities +The following table details the items contributing to Net Cash Used In Financing Activities for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended September 30, +Fiscal Year Ended September 30, +2019 +2018 +Change +2018 +2017 +Change +Repayments on revolving lines of credit +$ +(89,231 +) +$ +(25,600 +) +$ +(63,631 +) +$ +(25,600 +) +$ +(70,770 +) +$ +45,170 +Borrowings on revolving lines of credit +86,546 +28,285 +58,261 +28,285 +65,770 +(37,485 +) +Principal payments on term loans +(10,900 +) +(12,127 +) +1,227 +(12,127 +) +(10,743 +) +(1,384 +) +Treasury stock purchases +(25,576 +) +(2,215 +) +(23,361 +) +(2,215 +) +(3,064 +) +849 +Payment on termination of sugarcane agreement +(11,300 +) +— +(11,300 +) +— +— +— +Dividends paid +(1,833 +) +(1,972 +) +139 +(1,972 +) +(1,987 +) +15 +Capital contribution received from noncontrolling interest +— +1,000 +(1,000 +) +1,000 +— +1,000 +Capital lease obligation payments +— +(8 +) +8 +(8 +) +(580 +) +572 +Net cash used in financing activities +$ +(52,294 +) +$ +(12,637 +) +$ +(39,657 +) +$ +(12,637 +) +$ +(21,374 +) +$ +8,737 +The increase in net cash used in financing activities for the fiscal year ended September 30, 2019, as compared to the fiscal year ended September 30, 2018, was primarily due to the Company purchasing 752,234 common shares through a tender offer, for an aggregate amount of approximately $25,576,000 , terminating its 2014 Post-Closing Agreement relating to sugarcane transaction pursuant to which the Company paid approximately $11,300,000 , and paying down, net of borrowings, of its revolving line of credit by approximately $2,265,000. +The decrease in net cash used in financing activities for the fiscal year ended September 30, 2018, as compared to the fiscal year ended September 30, 2017, was primarily due to decreased repayments on the revolving line of credit, which was partially offset by less borrowings being made on the revolving lines of credit. Additionally, greater principal payments were made on the term loans of approximately $4,453,000 from a portion of the proceeds from the sale of assets, which was offset by the Company electing not to make its scheduled principal payment on certain other term loans for the first and second quarter of fiscal year 2018 of approximately $3,100,000, as it utilized its prepayment to satisfy its payment requirement. +Alico had no amount outstanding on its revolving lines of credit as of September 30, 2019 . +The WCLC line of credit agreement provides for Rabo Agrifinance, Inc. to issue up to $2,000,000 in letters of credit on the Company’s behalf. As of September 30, 2019 , there was approximately $460,000 in outstanding letters of credit, which correspondingly slightly reduced Alico's availability under the line of credit. +Off Balance Sheet Arrangements +None +Contractual Obligations +Alico has various contractual obligations which are fixed and determinable. The following table presents the Company's significant contractual obligations and commercial commitments on an undiscounted basis as of September 30, 2019 and the future periods in which such obligations are expected to be settled in cash. +37 +(in thousands) +Payments Due by Period +Total +<1 Year +1-3 Years +3-5 Years +5+ Years +Long-Term Debt +$ +163,449 +$ +5,338 +$ +25,745 +$ +21,510 +$ +110,856 +Interest on Long-Term Debt +48,117 +6,764 +12,120 +10,188 +19,045 +Retirement Benefits +5,876 +5,876 +— +— +— +Consulting/Non-Compete Agreement +546 +400 +146 +— +— +Operating Leases +550 +191 +344 +15 +— +Tree Purchase Commitments +1,603 +1,603 +— +— +— +Total +$ +220,141 +$ +20,172 +$ +38,355 +$ +31,713 +$ +129,901 +Purchase Commitments +The Company enters into contracts for the purchase of citrus trees during the normal course of its business. As of September 30, 2019 , the Company had approximately $1,603,000 relating to outstanding commitments for these purchases, which will be paid upon delivery. +Impact of Inflation and Changing Prices +Our financial statements included in this Annual Report on Form 10-K have been prepared in accordance with U.S. GAAP, which requires us to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession generally are not considered. The primary effect of inflation on our operations is reflected in increased operating costs. In our management’s opinion, changes in interest rates affect the financial condition to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities. +38 +Critical Accounting Policies +Alico's Consolidated Financial Statements are prepared in accordance with U.S. GAAP, which requires management to make estimates, judgments and assumptions that affect the amounts reported in those financial statements and accompanying notes. Management considers an accounting policy to be critical if it is important to the Company's financial condition and results of operations and if it requires significant judgment and estimates on the part of management in its application. Alico considers policies relating to the following matters to be critical accounting policies: +Revenue Recognition +The Company recognizes revenue at the amount it expects to be entitled to be paid, determined when control of the products or services is transferred to its customers, which occurs upon delivery of and acceptance of the fruit by the customer and the Company has a right to payment. The Company recognized revenues from cattle sales at the time the cattle were delivered. Management reviews the reasonableness of the revenue accruals quarterly based on buyers’ and processors’ advances to growers, cash and futures markets and experience in the industry. Adjustments are made throughout the fiscal year to these estimates as more current relevant industry information becomes available. Differences between the estimates and the final realization of revenues can be significant and can be either positive or negative. During the periods presented in this Annual Report on Form 10-K, no material adjustments were made to the reported revenues from our crops. +Alico Fruit Company ("AFC") operations primarily consist of providing supply chain management services to Alico, as well as to other citrus growers in the state of Florida. AFC also purchases and resells citrus fruit; in these transactions, AFC (i) acts as a principal; (ii) takes title to the products; and (iii) has the risks and rewards of ownership, including the risk of loss for collection, delivery or returns. Therefore, AFC recognizes revenues based on the gross amounts due from customers for its marketing activities. Supply chain management service revenues are recognized when the services are performed. +Inventories +The costs of growing crops, including but not limited to labor, fertilization, fuel, crop nutrition and irrigation, are capitalized into inventory throughout the respective crop year. Such costs are expensed as cost of sales when the crops are harvested and are recorded as operating expenses in the Consolidated Statements of Operations. Inventories are stated at the lower of cost or net realizable value. The cost for unharvested citrus crops is based on accumulated production costs incurred during the period from January 1 through the balance sheet date. +Property and Equipment +Property and equipment are stated at cost, net of accumulated depreciation and amortization. Major improvements are capitalized while maintenance and repairs are expensed in the period the cost is incurred. Costs related to the development of citrus groves, through planting of trees, are capitalized. Such costs include land clearing, excavation and construction of ditches, dikes, roads and reservoirs among other costs. After the planting, caretaking costs or pre-productive maintenance costs are capitalized for four years. After four years, a grove is considered to have reached maturity and the accumulated costs are depreciated over 25 years, except for land clearing and excavation, which are considered costs of land and not depreciated. +The breeding herd consisted of purchased animals and animals raised on the Company’s ranches. Purchased animals were stated at the cost of acquisition. The cost of animals raised on the Ranch was based on the accumulated cost of developing such animals for productive use. The breeding herd was sold in January 2018. +Income Taxes +The Company uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statements and the income tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates on deferred income tax assets and liabilities is recognized in income or loss in the period that includes the enactment date. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on the Company’s income tax provision and net income or loss in the period the determination is made. For the fiscal years ended September 30, 2019, 2018 and 2017, the Company recorded valuation allowances of $0, $5,634,000 and $0, respectively, relating to the unutilized capital +39 +loss carryforwards which expired. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. +The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which a change in judgment occurs. The Company records interest related to unrecognized tax benefits in income tax expense. +Impairment of Long-Lived Assets +The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company records impairment losses on long-lived assets used in operations, other than goodwill, when events and circumstances indicate that the asset or asset group might be impaired and the estimated cash flows (undiscounted and without interest charges) to be generated by those assets or asset group over the remaining lives of the assets are less than the carrying amounts of those assets. In calculating impairments and the estimated cash flows, the Company assigns its asset groups by determining the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other Company assets. The net carrying values of assets or asset groups not recoverable are reduced to their fair values. Our cash flow estimates are based on historical results adjusted to reflect our best estimates of future market conditions and operating conditions. As of September 30, 2019 and 2018, long-lived assets were comprised of property and equipment. +Fair Value Measurements +The carrying amounts in the balance sheets for operating accounts receivable, accounts payable and accrued liabilities approximate fair value because of the immediate or short term maturity of these items. The carrying amounts reported for our long-term debt approximates fair value as our borrowings with commercial lenders are at interest rates that vary with market conditions and fixed rates that approximate market rates for comparable loans. +Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Assets and liabilities measured at fair value are categorized into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows: +Level 1- Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities. +Level 2- Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly. +Level 3- Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date. +Impact of Accounting Pronouncements +See Item 8. "Financial Statements and Supplemental Data" - Note 1. "Description of Business and Basis of Presentation" for additional information about the impact of accounting pronouncements. +Subsequent Events +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +On December 5, 2019, the Board of Directors of the Company declared a first quarter of fiscal year 2020 cash dividend of $0.09 per share on its outstanding common stock to be paid to shareholders of record as of December 27, 2019, with payment expected on January 10, 2020. +40 +Compensatory Arrangements of Certain Officers. +On December 2, 2019, the Company entered into a new employment agreement (the “Rallo Employment Agreement”) with Richard Rallo. Mr. Rallo serves as Chief Financial Officer of the Company. The Rallo Employment Agreement provides for an annual base salary of $275,000. Mr. Rallo is eligible for an annual incentive compensation award with an annual target opportunity in an amount equal to 40% of his annual base salary. +The Rallo Employment Agreement also provides that, if Mr. Rallo’s employment is terminated by the Company without “cause” or Mr. Rallo resigns with “good reason” (as each such term is defined in the Rallo Employment Agreement), then, subject to his execution, delivery, and non-revocation of a general release of claims in favor of the Company, Mr. Rallo will be entitled to (i) cash severance in an amount equal to 12 months of the annual base salary, (ii) the Accrued Obligations (as defined in the Rallo Employment Agreement) in a cash lump sum within 30 days after the date of termination, (iii) any rights or payments that are vested benefits or that Mr. Rallo is otherwise entitled to receive at or subsequent to the date of termination under any employee benefit plan or any other contract or agreement with the Company, and (iv) any Annual Bonus (as defined in the Rallo Employment Agreement) that has been earned but not paid as of the date of termination. +The Rallo Employment Agreement includes various restrictive covenants in favor of the Company, including a confidentiality covenant, a non-disparagement covenant, and 12-month post-termination noncompetition and customer and employee non-solicitation covenants. +In addition to his position as Chief Financial Officer, Mr. Rallo retains his position as the Company’s Principal Accounting Officer. +The foregoing description of the Rallo Employment Agreement does not purport to be complete and is qualified in its entirety by reference to the complete text of the Rallo Employment agreement, which is attached hereto as Exhibit 10.37 to this Annual Report on Form 10-K and is incorporated herein by reference. +41 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +Market Risk - Market risk represents the potential loss resulting from adverse changes in the value of financial instruments, either derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates, commodity prices, and equity security prices. The Company handles market risks in accordance with its established policies; however, Alico does not enter into derivatives or other financial instruments for trading or speculative purposes. The Company does consider, on occasion, the need to enter into financial instruments to manage and reduce the impact of changes in interest rates; however, the Company entered into no such instruments during the three-year period ended September 30, 2019. The Company held various financial instruments as of September 30, 2019 and 2018, consisting of financial assets and liabilities reported in the Company’s Consolidated Balance Sheets and off-balance sheet exposures resulting from letters of credit issued for the benefit of Alico. +Interest Rate Risk - The Company is subject to interest rate risk from the utilization of financial instruments such as term loan debt and other borrowings. The Company’s primary long-term obligations are fixed rate debts subject to fair value risk due to interest rate fluctuations. The Company believes that the carrying value of our long-term debt approximates fair value given the stability of market interest rates. +The Company is also subject to interest rate risk on its variable rate debt. A one-percentage-point increase in prevailing interest rates would have increased interest expense on our variable rate debt obligations by approximately $3,475,000 for the fiscal year ended September 30, 2019. +Foreign-Exchange Rate Risk - The Company currently has no exposure to foreign-exchange rate risk because all of its financial transactions are denominated in U.S. dollars. +Commodity Price Risk - The Company has no financial instruments subject to commodity price risk. +Equity Security Price Risk - None of the Company’s financial instruments have potential exposure to equity security price risk. +42 +Item 8. Financial Statements and Supplementary Data +Index to Consolidated Financial Statements +Page +Report of Independent Registered Public Accounting Firm +44 +Consolidated Financial Statements: +Consolidated Balance Sheets +46 +Consolidated Statements of Operations +47 +Consolidated Statements of Changes in Equity +48 +Consolidated Statements of Cash Flows +49 +Notes to Consolidated Financial Statements +51 +All schedules are omitted for the reason that they are not applicable or the required information is included in the financial statements or notes. +43 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Alico, Inc. +Opinions on the Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Alico, Inc. and subsidiaries (the Company) as of September 30, 2019 and 2018, and the related consolidated statements of operations, changes in equity and cash flows for each of the three years in the period ended September 30, 2019, and the related notes (collectively, the financial statements). We also have audited the Company’s internal control over financial reporting as of September 30, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 30, 2019 and 2018, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2019, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. +Basis for Opinions +The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +44 +/s/ RSM US LLP +We have served as the Company's auditor since 2007. +Orlando, Florida +December 5, 2019 +45 +ALICO, INC. +CONSOLIDATED BALANCE SHEETS +(in thousands, except share amounts) +September 30, +2019 +2018 +ASSETS +Current assets: +Cash and cash equivalents +$ +18,630 +$ +25,260 +Accounts receivable, net +713 +2,544 +Inventories +40,143 +41,033 +Assets held for sale +1,442 +1,391 +Prepaid expenses and other current assets +1,049 +833 +Total current assets +61,977 +71,061 +Restricted cash +5,208 +7,000 +Property and equipment, net +345,648 +340,403 +Goodwill +2,246 +2,246 +Other non-current assets +2,309 +2,712 +Total assets +$ +417,388 +$ +423,422 +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable +$ +4,163 +$ +3,764 +Accrued liabilities +7,769 +8,881 +Long-term debt, current portion +5,338 +5,275 +Deferred retirement obligations, current portion +5,226 +345 +Income taxes payable +5,536 +2,320 +Other current liabilities +919 +891 +Total current liabilities +28,951 +21,476 +Long-term debt: +Principal amount, net of current portion +158,111 +169,074 +Less: deferred financing costs, net +( 1,369 +) +( 1,563 +) +Long-term debt less current portion and deferred financing costs, net +156,742 +167,511 +Lines of credit +— +2,685 +Deferred income tax liabilities, net +32,125 +25,153 +Deferred gain on sale +— +24,928 +Deferred retirement obligations +— +4,052 +Other liabilities +172 +22 +Total liabilities +217,990 +245,827 +Commitments and Contingencies (Note 16) +Stockholders' equity: +Preferred stock, no par value, 1,000,000 shares authorized; none issued +— +— +Common stock, $1.00 par value, 15,000,000 shares authorized; 8,416,145 shares issued and 7,476,513 and 8,199,957 shares outstanding at September 30, 2019 and September 30, 2018, respectively +8,416 +8,416 +Additional paid in capital +19,781 +20,126 +Treasury stock, at cost, 939,632 and 216,188 shares held at September 30, 2019 and September 30, 2018, respectively +( 31,943 +) +( 7,536 +) +Retained earnings +198,049 +151,111 +Total Alico stockholders' equity +194,303 +172,117 +Noncontrolling interest +5,095 +5,478 +Total stockholders' equity +199,398 +177,595 +Total liabilities and stockholders' equity +$ +417,388 +$ +423,422 +See accompanying notes to the consolidated financial statements. +46 +ALICO, INC. +CONSOLIDATED STATEMENTS OF OPERATIONS +(in thousands, except per share amounts) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Operating revenues: +Alico Citrus +$ +119,031 +$ +78,121 +$ +123,441 +Water Resources and Other Operations +3,220 +3,160 +6,388 +Total operating revenues +122,251 +81,281 +129,829 +Operating expenses: +Alico Citrus +59,594 +51,709 +111,947 +Water Resources and Other Operations +2,297 +3,979 +8,952 +Total operating expenses +61,891 +55,688 +120,899 +Gross profit +60,360 +25,593 +8,930 +General and administrative expenses +15,146 +15,058 +15,024 +Income (loss) from operations +45,214 +10,535 +( 6,094 +) +Other income (expense): +Investment and interest income (loss), net +49 +39 +( 148 +) +Interest expense +( 7,180 +) +( 8,561 +) +( 9,141 +) +Gain on sale of real estate, property and equipment and assets held for sale +13,166 +11,041 +2,181 +Change in fair value of derivatives +( 989 +) +— +— +Other (loss) income, net +( 27 +) +136 +( 140 +) +Total other income (expense) +5,019 +2,655 +( 7,248 +) +Income (loss) before income taxes +50,233 +13,190 +( 13,342 +) +Income tax provision (benefit) +12,783 +390 +( 3,846 +) +Net income (loss) +37,450 +12,800 +( 9,496 +) +Net loss attributable to noncontrolling interests +383 +250 +45 +Net income (loss) attributable to Alico, Inc. common stockholders +$ +37,833 +$ +13,050 +$ +( 9,451 +) +Per share information attributable to Alico, Inc. common stockholders: +Earnings (loss) per common share: +Basic +$ +5.06 +$ +1.59 +$ +( 1.14 +) +Diluted +$ +5.05 +$ +1.57 +$ +( 1.14 +) +Weighted-average number of common shares outstanding: +Basic +7,472 +8,232 +8,300 +Diluted +7,493 +8,301 +8,300 +Cash dividends declared per common share +$ +0.24 +$ +0.24 +$ +0.24 +See accompanying notes to the consolidated financial statements . +47 +ALICO, INC. +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +(in thousands) +Common stock +Additional Paid-In +Treasury +Retained +Total Alico, Inc. +Non-controlling +Total +Shares +Amount +Capital +Stock +Earnings +Equity +Interest +Equity +Balance at September 30, 2016 +8,416 +$ +8,416 +$ +18,155 +$ +( 4,585 +) +$ +151,504 +$ +173,490 +$ +4,773 +$ +178,263 +Net loss +— +— +— +— +( 9,451 +) +( 9,451 +) +( 45 +) +( 9,496 +) +Dividends +— +— +— +— +( 1,987 +) +( 1,987 +) +— +( 1,987 +) +Treasury stock purchases +— +— +— +( 3,064 +) +— +( 3,064 +) +— +( 3,064 +) +Stock-based compensation: +Directors +— +— +( 374 +) +1,147 +— +773 +— +773 +Executives +— +— +880 +— +— +880 +— +880 +Other +— +— +33 +— +( 33 +) +— +— +— +Balance at September 30, 2017 +8,416 +8,416 +18,694 +( 6,502 +) +140,033 +160,641 +4,728 +165,369 +Net income (loss) +— +— +— +— +13,050 +13,050 +( 250 +) +12,800 +Dividends +— +— +— +— +( 1,972 +) +( 1,972 +) +— +( 1,972 +) +Treasury stock purchases +— +— +— +( 2,215 +) +— +( 2,215 +) +— +( 2,215 +) +Capital contribution received from noncontrolling interest funding +— +— +— +— +— +— +1,000 +1,000 +Stock-based compensation: +Directors +— +— +( 322 +) +1,181 +— +859 +— +859 +Executives +— +— +1,754 +— +— +1,754 +— +1,754 +Balance at September 30, 2018 +8,416 +8,416 +20,126 +( 7,536 +) +151,111 +172,117 +5,478 +177,595 +Net income (loss) +— +— +— +— +37,833 +37,833 +( 383 +) +37,450 +Dividends +— +— +— +— +( 1,792 +) +( 1,792 +) +— +( 1,792 +) +Treasury stock purchases +— +— +— +( 25,576 +) +— +( 25,576 +) +— +( 25,576 +) +ASC 610-20 adoption +— +— +— +— +10,897 +10,897 +— +10,897 +Stock-based compensation: +Directors +— +— +( 300 +) +1,169 +— +869 +— +869 +Executives +— +— +778 +— +— +778 +— +778 +Executive forfeiture +— +— +( 823 +) +— +— +( 823 +) +— +( 823 +) +Balance at September 30, 2019 +8,416 +$ +8,416 +$ +19,781 +$ +( 31,943 +) +$ +198,049 +$ +194,303 +$ +5,095 +$ +199,398 +See accompanying notes to the consolidated financial statements . +48 +ALICO, INC. +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Net cash provided by operating activities: +Net income (loss) +$ +37,450 +$ +12,800 +$ +( 9,496 +) +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Deferred gain on sale of sugarcane land +— +( 967 +) +( 538 +) +Depreciation, depletion and amortization +13,924 +13,756 +15,226 +Loss on breeding herd sales +— +13 +337 +Deferred income tax expense (benefit) +3,267 +( 1,955 +) +( 3,948 +) +Cash surrender value +11 +( 27 +) +( 15 +) +Deferred retirement benefits +829 +( 41 +) +( 102 +) +Magnolia Fund undistributed loss (earnings) +— +( 8 +) +202 +Gain on sale of real estate, property and equipment and assets held for sale +( 13,166 +) +( 10,281 +) +( 1,373 +) +Inventory casualty loss +— +— +13,489 +Inventory net realizable value adjustment +808 +1,115 +1,199 +Loss on disposal of property and equipment +— +207 +— +Change in fair value of derivatives +989 +— +— +Impairment of long-lived assets +396 +2,234 +9,346 +Non-cash interest expense on deferred gain on sugarcane land +— +1,361 +1,413 +Insurance proceeds received for damage to property and equipment +( 486 +) +( 477 +) +— +Bad debt expense +— +24 +312 +Stock-based compensation expense +824 +2,613 +1,653 +Changes in operating assets and liabilities: +Accounts receivable +1,531 +1,718 +142 +Inventories +82 +( 6,554 +) +3,724 +Prepaid expenses +( 211 +) +177 +( 604 +) +Income tax receivable +15 +( 15 +) +1,013 +Other assets +288 +23 +( 415 +) +Accounts payable and accrued liabilities +( 1,113 +) +2,987 +( 2,895 +) +Income tax payable +3,216 +2,320 +— +Other liabilities +178 +( 2,445 +) +( 1,189 +) +Net cash provided by operating activities +48,832 +18,578 +27,481 +Cash flows from investing activities: +Purchases of property and equipment +( 20,000 +) +( 16,352 +) +( 13,353 +) +Return on investment in Magnolia Fund +— +25 +324 +Net proceeds from sale of property and equipment and assets held for sale +14,602 +37,969 +760 +Net proceeds from sale of real estate +— +1,811 +2,184 +Insurance proceeds received for damage to property and equipment +486 +477 +— +Change in deposits on purchase of citrus trees +( 108 +) +( 431 +) +748 +Advances on notes receivables, net +60 +( 575 +) +— +49 +Net cash (used in) provided by investing activities +( 4,960 +) +22,924 +( 9,337 +) +Cash flows from financing activities: +Repayments on revolving lines of credit +( 89,231 +) +( 25,600 +) +( 70,770 +) +Borrowings on revolving lines of credit +86,546 +28,285 +65,770 +Principal payments on term loans +( 10,900 +) +( 12,127 +) +( 10,743 +) +Treasury stock purchases +( 25,576 +) +( 2,215 +) +( 3,064 +) +Payment on termination of sugarcane agreement +( 11,300 +) +— +— +Dividends paid +( 1,833 +) +( 1,972 +) +( 1,987 +) +Capital contribution received from noncontrolling interest +— +1,000 +— +Capital lease obligation payments +— +( 8 +) +( 580 +) +Net cash used in financing activities +( 52,294 +) +( 12,637 +) +( 21,374 +) +Net (decrease) increase in cash and cash equivalents and restricted cash +( 8,422 +) +28,865 +( 3,230 +) +Cash and cash equivalents and restricted cash at beginning of the period +32,260 +3,395 +6,625 +Cash and cash equivalents and restricted cash at end of the period +$ +23,838 +$ +32,260 +$ +3,395 +Supplemental disclosure of cash flow information: +Cash paid for interest; net of amount capitalized +$ +6,940 +$ +6,721 +$ +7,240 +Cash paid (refunded) for income taxes +$ +6,285 +$ +25 +$ +( 911 +) +Supplemental disclosure of non-cash investing and financing activities: +Dividend declared but unpaid +$ +449 +$ +492 +$ +494 +See accompanying notes to the consolidated financial statements. +50 +ALICO, INC. +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +Note 1. Description of Business and Basis of Presentation +Description of Business +Alico, Inc., together with its subsidiaries (collectively, “Alico”, the “Company", "we", "us" or "our”), is a Florida agribusiness and land management company owning approximately 111,000 acres of land throughout Florida, including approximately 90,000 acres of mineral rights. The Company manages its land based upon its primary usage, and reviews its performance based upon two primary classifications: (i) Alico Citrus and (ii) Water Resources and Other Operations . Financial results are presented based upon its two business segments ( Alico Citrus and Water Resources and Other Operations ). +Basis of Presentation +The Company has prepared the accompanying financial statements on a consolidated basis. These accompanying Consolidated Financial Statements, which are referred to herein as the “Financial Statements”, have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). All significant intercompany transactions and account balances between the consolidated businesses have been eliminated. +Segments +Operating segments are defined in the criteria established under the Financial Accounting Standards Board - Accounting Standards Codification (“FASB ASC”) Topic 280 as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: (i) Alico Citrus and (ii) Water Resources and Other Operations . +Principles of Consolidation +The Financial Statements include the accounts of Alico and the accounts of all the subsidiaries in which a controlling interest is held by the Company. Under U.S. GAAP, consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. The Company’s subsidiaries include: Alico Land Development, Inc., Alico-Agri, Ltd., Alico Plant World, LLC, Alico Fruit Company, LLC, Alico Citrus Nursery, LLC, Alico Chemical Sales, LLC, 734 Citrus Holdings, LLC and subsidiaries, Alico Fresh Fruit, LLC, Alico Skink Mitigation, LLC and Citree Holdings 1, LLC (“Citree”). The Company considers the criteria established under FASB ASC Topic 810, “Consolidations” in its consolidation process. All significant intercompany balances and transactions have been eliminated in consolidation. +Use of Estimates +The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the accompanying Financial Statements, the disclosure of contingent assets and liabilities in the Financial Statements and the accompanying Notes, and the reported amounts of revenues and expenses and cash flows during the periods presented. Actual results could differ from those estimates. The Company evaluates estimates on an ongoing basis. The estimates are based on current and expected economic conditions, historical experience, the experience and judgment of the Company’s management and various other specific assumptions that the Company believes to be reasonable. +Noncontrolling Interest in Consolidated Subsidiary +The Financial Statements include all assets and liabilities of the less-than- 100% -owned subsidiary the Company controls, Citree. Accordingly, the Company has recorded a noncontrolling interest in the equity of such entity. Citree had net losses of approximately $ 781,783 , $ 511,854 and $ 91,432 for the fiscal years ended September 30, 2019 , 2018 and 2017 , respectively, of which $ 398,709 , $ 261,046 and $ 46,630 was attributable to the Company for the fiscal years ended September 30, 2019, 2018, and 2017, respectively. +51 +Recent Accounting Pronouncements +In February 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842).” This guidance will require entities that enter into leases as a lessee to recognize right-of-use assets and lease liabilities for those leases classified as operating leases under previous U.S. GAAP. The accounting applied by a lessor is largely unchanged from that applied under previous U.S. GAAP. The Company anticipates recording a Right of Use Asset (“ROU”) and related liability of approximately $ 511,000 upon the adoption of the new standard on October 1, 2019. Additionally, the Company will record an impairment to the ROU for approximately $ 87,000 . Topic 842 becomes effective for Alico beginning October 1, 2019. +In January 2017, the FASB issued ASU 2017-04, “Intangibles-Goodwill and Other” (Topic 350), which simplifies the accounting for goodwill impairment. The updated guidance eliminates Step 2 of the impairment test, which requires entities to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value, determined in Step 1. This guidance will become effective for us in the fiscal years beginning after December 15, 2019, including interim periods within those reporting periods. We will adopt this guidance using a prospective approach. Earlier adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 will have a material impact on its consolidated financial statements and will adopt the standard effective October 1, 2020. +In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurements” ( “ ASU 2018-13 ” ), which aims to improve the overall usefulness of disclosures to financial statement users and reduce unnecessary costs to companies when preparing fair value measurement disclosures. ASU 2018-13 is effective for annual and interim periods in the fiscal years beginning after December 15, 2019. Early adoption is permitted. Retrospective adoption is required, except for certain disclosures, which will be required to be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. The Company does not expect the adoption of ASU 2018-13 will have a material impact on its consolidated financial statements and will adopt the standard effective October 1, 2020. +In November 2018, the FASB issued ASU 2018-19, “Codification Improvements to Topic 326, Financial Instruments-Credit Losses.” ASU 2018-19 clarifies that receivables arising from operating leases are not within the scope of Subtopic 326-20. Instead, impairment of receivables arising from operating leases should be accounted for in accordance with Leases (Topic 842). The standard is effective for us on October 1, 2020, with early adoption permitted. The Company does not expect the adoption of ASU 2018-19 to have a material impact on the unaudited consolidated financial statements of the Company. Information regarding the adoption of ASU 2016-02 is described above. +The Company has reviewed other recently issued accounting standards which have not yet been adopted in order to determine their potential effect, if any, on the results of operations or financial condition. Based on the review of these other recently issued standards, the Company does not currently believe that any of those accounting pronouncements will have a significant effect on its current or future financial position, results of operations, cash flows or disclosures. +Recently Adopted Accounting Pronouncements +In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” , and subsequently issued several supplemental and/or clarifying ASU’s (collectively, “ASC 606”), which prescribes a comprehensive new revenue recognition standard that supersedes previously existing revenue recognition guidance. The new model provides a five-step analysis in determining when and how revenue is recognized. The core principle of the new guidance is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also requires new, expanded disclosures regarding revenue recognition. The standard allows initial application to be performed retrospectively to each period presented or as a modified retrospective adjustment as of the date of adoption. ASC 606, also provides for certain practical expedients, including the option to expense as incurred the incremental costs of obtaining a contract, if the contract period is for one year or less, and policy elections regarding shipping and handling that provides the option to account for shipping and handling costs as contract fulfillment costs. The Company adopted ASC 606 effective October 1, 2018, the first day of our 2019 fiscal year, using the modified retrospective method. The implementation of ASC 606 did not require an adjustment to the opening balance of retained earnings as of October 1, 2018 (see Note 2. “Revenue Recognition”). +In February 2017, the FASB issued ASU 2017-05, “Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets” (ASC 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets. This standard clarifies the scope and application of ASC 610-20 on the sale, transfer, and derecognition of nonfinancial assets and in substance nonfinancial assets to non-customers, including partial sales. It also provides guidance on how gains and +52 +losses on transfers of nonfinancial assets and in substance nonfinancial assets to non-customers are recognized. The standard also clarifies the derecognition of businesses is under the scope of ASC 810. The standard was required to be adopted concurrently with ASC 606, however an entity did not have to apply the same transition method as ASC 606. The Company adopted ASC 610-20 (“ASC 610-20”) effective October 1, 2018, the first day of our 2019 fiscal year, using the modified retrospective method. The implementation of ASC 610-20 resulted in an adjustment to increase the opening balance of retained earnings by $ 10,897,000 , net of taxes, as of October 1, 2018 (see Note 8. “Deferred Gain on Sale”). As a result of the ASU, guidance specific to real estate sales in ASC 360-20 will be eliminated. As such, sales and partial sales of real estate assets will now be subject to the same derecognition model as all other nonfinancial assets. +The ASU will also impact the accounting for partial sales of nonfinancial assets (including in substance real estate). When an entity transfers its controlling interest in a nonfinancial asset, but retains a noncontrolling ownership interest, the entity will measure the retained interest at fair value. This will result in full gain/loss recognition upon the sale of a controlling interest in a nonfinancial asset. Current guidance generally prohibits gain recognition on the retained interest. +The ASU was effective for fiscal years beginning after December 15, 2017, and interim periods within those years and thus was effective for the Company for our fiscal year beginning October 1, 2018. The ASU will be applied prospectively to any transaction occurring from the date of adoption. The Company adopted ASU 360-20 effective October 1, 2018. The new guidance did not have a material impact on our consolidated financial statements as it relates to the deferred gain on the sale of the Company’s sugarcane lands (see Note 8. “Deferred Gain on Sale”). +In May 2017, the FASB issued ASU 2017-09, “Compensation-Stock Compensation” (Topic 718) which clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. ASU 2017-09 will reduce diversity in practice and result in fewer changes to the terms of an award being accounted for as modifications. Under ASU 2017-09, an entity will not apply modification accounting to a share-based payment award if the award's fair value, vesting conditions and classification as an equity or liability instrument are the same immediately before and after the change. ASU 2017-09 will be applied prospectively to awards modified on or after the adoption date. The guidance was effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017 and thus was effective for the Company for our fiscal year beginning October 1, 2018. The Company adopted ASU 2017-09 effective October 1, 2018. The new guidance did not have a material impact on our consolidated financial statements +In May 2017, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash” which clarifies the diversity in the classification and presentation of changes in restricted cash on the statement of cash flows under Topic 230, Statement of Cash Flows. Under ASU 2016-18, an entity will be required within the statement of cash flows to explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. The Company adopted ASU 2016-18 effective September 30, 2018 and has properly presented restricted cash within the statement of cash flows. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017 and thus is effective for the Company for our fiscal year beginning October 1, 2018. Early adoption is permitted and the Company, as such, has adopted this guidance as of October 1, 2017. +In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230).” This ASU will provide guidance on the presentation and classification of specific cash flow items to improve consistency within the statement of cash flows. This ASU is effective for the Company for our fiscal year beginning October 1, 2019 with early adoption permitted. The Company adopted ASU 2016-15 effective September 30, 2019 and the impact under this ASU is that the Company reported certain proceeds from insurance claims relating to property and equipment in the statement of cash flows as investing activities in the Consolidated Statement of Cash Flows. +Reclassifications +Certain prior year amounts have been reclassified in the accompanying Financial Statements for consistent presentation to the current period. These reclassifications had no impact on net income, equity, cash flows or working capital as previously reported. +Seasonality +The Company is primarily engaged in the production of fruit for sale to citrus markets, which is of a seasonal nature, and subject to the influence of natural phenomena and wide price fluctuations. Historically, the second and third quarters of Alico's fiscal year produce the majority of the Company's annual revenue. Working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with harvesting cycles. Because of the seasonality of the business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year. +53 +Note 2. Summary of Significant Accounting Policies +Revenue Recognition +Revenues are derived from the sale of processed fruit, fresh fruit, other citrus revenue, leasing revenue and other water and resource revenues. The majority of the revenue is generated from the sale of citrus fruit to processing facilities and fresh fruit sales. The Company recognizes revenue at the amount it expects to be entitled to be paid, determined when control of the products or services is transferred to its customers, which occurs upon delivery of and acceptance of the fruit by the customer and the Company has a right to payment. +The Company has identified one performance obligation as the delivery of fruit to the processing facility (or harvesting of the citrus in the case of fresh fruit) of the customer for each separate variety of fruit identified in the contract. The Company initially recognizes revenue in an amount which is estimated based on contractual and market prices, if such market price falls within the range (known as “floor” and “ceiling” prices) identified in the specific contracts. Additionally, the Company also has a contractual agreement whereby revenue is determined based on applying a cost-plus structure methodology. As such, since these contracts contain elements of variable consideration, the Company recognizes this variable consideration by using the expected value method. On a quarterly basis, management reviews the reasonableness of the revenues accrued based on buyers’ and processors’ advances to growers, cash and futures markets and experience in the industry. Adjustments are made throughout the year to these estimates as more current relevant industry information becomes available. Differences between the estimates and the final realization of revenues at the close of the harvesting season can result in either an increase or decrease to reported revenues. During the periods presented, no material adjustments were made to the reported citrus revenues. +Receivables under contracts, whereby pricing is based on contractual and market prices, are primarily paid at the floor amount and are collected within seven days after the harvest week. Any adjustments to pricing as a result of changes in market prices are collected or paid thirty to sixty days after final market pricing is published. Receivables under contracts, whereby pricing is based off a cost-plus structure methodology, are paid at the final prior year rate. Any adjustments to pricing as a result of the cost-plus calculation are collected or paid upon finalization of the calculation and agreement by both parties. As of September 30, 2019 , and 2018, the Company had total receivables relating to sales of citrus of $ 160,000 and $ 1,912,000 , respectively, recorded in Accounts Receivable, net, in the Condensed Consolidated Balance Sheets. +Disaggregated Revenue +Revenues disaggregated by significant products and services for the fiscal years ended September 30, 2019 , 2018 and 2017 are as follows: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Alico Citrus +Early and Mid-Season +$ +39,574 +$ +24,309 +$ +45,999 +Valencias +73,480 +48,865 +67,146 +Fresh Fruit +3,629 +2,054 +5,735 +Other +2,348 +2,893 +4,561 +Total +$ +119,031 +$ +78,121 +$ +123,441 +Water Resources and Other Operations +Land and other leasing +$ +2,787 +$ +2,595 +$ +2,294 +Sale of calves and culls +— +57 +3,732 +Other +433 +508 +362 +Total +$ +3,220 +$ +3,160 +$ +6,388 +Total Revenues +$ +122,251 +$ +81,281 +$ +129,829 +During the time that Alico was engaged in the business of raising and selling cattle, Alico recognized revenues from cattle sales at the time the cattle were delivered. +54 +Alico Fruit Company, LLC ("AFC") operations primarily consist of providing supply chain management services to Alico, as well as to other citrus growers and processors in the state of Florida. AFC also purchases and resells citrus fruit; in these transactions, AFC (i) acts as a principal; (ii) takes title to the products; and (iii) has the risks and rewards of ownership, including the risk of loss for collection, delivery or returns. Therefore, AFC recognizes revenues based on the gross amounts due from customers for its marketing activities. Supply chain management services revenues are recognized when the services are performed. +Fair Value of Financial Instruments +The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities approximate their fair values due to the short term and immediate nature of these financial instruments. The carrying amounts of our debt approximates fair value as the debt is with commercial lenders at interest rates that vary with market conditions or have fixed rates that approximate market rates for obligations with similar terms and maturities (see Note 9. “Fair Value Measurements”). +Cash and Cash Equivalents +The Company considers cash in banks and highly liquid instruments with an original maturity of three months or less to be cash and cash equivalents. At various times throughout the fiscal year, and as of September 30, 2019, some accounts held at financial institutions were in excess of the federally insured limit of $250,000. The Company has not experienced any losses on these accounts and believes credit risk to be minimal. +Restricted Cash +Restricted cash is comprised of cash received from the sale of certain assets in which the use of funds is restricted. For certain sales transactions, the Company sells property which serves as collateral for specific debt obligations. As a result, the sale proceeds can only be used to purchase like-kind citrus groves acceptable to the debt holder or to pay down existing debt obligations. During fiscal year ended September 30, 2019, the Company utilized restricted cash of $ 1,800,000 towards the purchase of citrus groves. Such purchases are included as part of the collateral under certain debt obligations. If the remaining restricted cash is not used as of September 30, 2020, it will be used to pay down principal on Company debt. Based on the contractual uses of restricted cash, these amounts have been classified as non-current. +Accounts receivable +Accounts receivable from customers are generated from revenues based on the sale of citrus, leasing and other transactions. The Company grants credit in the course of its operations to third party customers. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company provides an allowance for doubtful accounts for amounts which are not probable of collection. The estimate, evaluated quarterly by the Company, is based on historical collection experience, current macroeconomic climate and market conditions and a review of the current status of each customer’s account. Changes in the financial viability of significant customers and worsening of economic conditions may require changes to its estimate of the recoverability of the receivables. Such changes in estimates are recorded in the period in which these changes become known. The bad debt expense is included in general and administrative expenses in the Consolidated Statements of Operations. +The following table presents accounts receivable, net as of September 30, 2019 and 2018: +(in thousands) +September 30, +2019 +2018 +Accounts receivable +$ +746 +$ +2,577 +Allowance for doubtful accounts +( 33 +) +( 33 +) +Accounts receivable, net +$ +713 +$ +2,544 +55 +Concentrations +Accounts receivable from the Company’s major customer as of September 30, 2019 and 2018 and revenue from such customers for the fiscal years ended September 30, 2019, 2018 and 2017, are as follows: +(in thousands) +Accounts Receivable +Revenue +% of Total Revenue +2019 +2018 +2019 +2018 +2017 +2019 +2018 +2017 +Tropicana +$ +— +$ +1,797 +$ +108,318 +$ +70,396 +$ +111,197 +88.6 +% +86.6 +% +85.6 +% +The citrus industry is subject to various factors over which growers have limited or no control, including weather conditions, disease, pestilence, water supply and market price fluctuations. Market prices are highly sensitive to aggregate domestic and foreign crop sizes, as well as factors including, but not limited to, weather and competition from foreign countries. +Real Estate +In recognizing revenues from land sales, the Company applies specific revenue recognition criteria, in accordance with U.S. GAAP, to determine when land sales revenues can be recorded. For example, in order to fully recognize a gain resulting from a real estate transaction, the sale must be consummated with a sufficient down payment of at least 20 % to 25 % of the sales price depending upon the type and timeframe for development of the property sold and any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold. When these criteria are not met, the Company recognizes a gain proportionate to collections utilizing either the installment method or deposit method as appropriate. +Inventories +The costs of growing crops, including but not limited to labor, fertilization, fuel, crop nutrition, irrigation and depreciation, are capitalized into inventory throughout the respective crop year. Such costs are expensed as cost of sales when the crops are harvested and are recorded as operating expenses in the Consolidated Statements of Operations. Inventories are stated at the lower of cost or net realizable value. The cost for unharvested citrus crops is based on accumulated production costs incurred during the period from January 1 through the balance sheet date. +Property and Equipment +Property and equipment are stated at cost, net of accumulated depreciation, depletion and amortization. Major improvements are capitalized while expenditures for maintenance and repairs are expensed when incurred. Costs related to the development of citrus groves through planting of trees are capitalized. Such costs include land clearing, excavation and construction of ditches, dikes, roads, and reservoirs, among other costs. After the planting, caretaking costs or pre-productive maintenance costs are capitalized for 4 years . After 4 years , a planting is considered to have reached maturity and the accumulated costs are depreciated over 25 years , except for land clearing and excavation, which are considered costs of land and not depreciated. +Real estate costs incurred for the acquisition, development and construction of real estate projects are capitalized. +Depreciation is provided on a straight-line basis over the estimated useful lives of the depreciable assets, with the exception of leasehold improvements and assets acquired through capital leases, which are depreciated over their estimated useful lives if the lease transfers ownership or contains a bargain purchase option, otherwise the term of the lease. +The estimated useful lives for property and equipment are primarily as follows: +Citrus trees +25 years +Equipment and other facilities +3-20 years +Buildings and improvements +25-39 years +Changes in circumstances, such as technological advances or changes to our business model or capital strategy could result in the actual useful lives differing from the original estimates. In those cases where the Company determines that the useful life of property and equipment should be shortened, Alico depreciates the asset over its revised estimated remaining useful life, thereby increasing depreciation expense (see Note 5. “Property and Equipment, Net”). +56 +Impairment of Long-Lived Assets +The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company records impairment losses on long-lived assets used in operations, or asset group, when events and circumstances indicate that the assets might be impaired and the estimated cash flows (undiscounted and without interest charges) to be generated by those assets or asset group over the remaining lives of the assets or asset group are less than the carrying amounts of those assets. In calculating impairments and the estimated cash flows, the Company assigns its asset groups by determining the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other Company assets. The net carrying values of assets or asset group not recoverable are reduced to their fair values. Alico's cash flow estimates are based on historical results adjusted to reflect best estimates of future market conditions and operating conditions. For fiscal years ended September 30, 2019, 2018 and 2017, the Company recorded impairments to its long-lived assets (see Note 5. “Property and Equipment, Net”). As of September 30, 2019, 2018 and 2017, long-lived assets were comprised of property and equipment. +Goodwill and Intangible Assets +Goodwill represents the excess of the purchase price of acquired businesses over the fair value of the assets acquired less liabilities assumed in connection with such acquisition. In accordance with the provisions of ASC 350, Intangibles-Goodwill and Other, goodwill and intangible assets with indefinite useful lives acquired in an acquisition are not amortized, but instead are tested for impairment at least annually, on the same date, or more frequently should an event occur or circumstances indicate that the carrying amount may be impaired. Such events or circumstances may be a significant change in business climate, economic and industry trends, legal factors, negative operating performance indicators, significant competition, changes in strategy or disposition of a reporting unit or a portion thereof. +In the evaluation of goodwill for impairment, Alico has the option to perform a qualitative assessment to determine whether further impairment testing is necessary or to perform a quantitative assessment by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Under the qualitative assessment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. If, under the quantitative assessment, the fair value of a reporting unit is less than it's carrying amount, then the amount of the impairment loss, if any, must be measured under step two of the impairment analysis. In step two of the analysis, Alico would record an impairment loss equal to the excess of the carrying value of the reporting unit’s goodwill over its implied fair value, should such a circumstance arise. As of September 30, 2019 and 2018, no impairment was required. +Other Non-Current Assets +Other non-current assets primarily include investments owned in agricultural cooperatives, cash surrender value on life insurance, and deposits on the purchase of citrus trees. Investments in stock related to agricultural cooperatives are carried at cost. +Income Taxes +The Company uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statements and the income tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates on deferred income tax assets and liabilities is recognized in income or loss in the period that includes the enactment date. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on the Company’s income tax provision and net income or loss in the period the determination is made. For the fiscal years ended September 30, 2019, 2018 and 2017, the Company recorded valuation allowances of $ 0 , $ 5,634,000 and $ 581,000 , respectively, relating to the unutilized capital loss carryforwards which expired. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. +The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which a change in judgment occurs. The Company records interest related to unrecognized tax benefits in income tax expense. +57 +Earnings per Share +Basic earnings per share for our common stock is calculated by dividing net income attributable to Alico common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per common share is similarly calculated, except that the calculation includes the dilutive effect of the assumed issuance of shares of common stock issuable under equity-based compensation plans in accordance with the treasury stock method, or any other type of securities convertible into common stock, except where the inclusion of such common shares would have an anti-dilutive effect. +The following table presents a reconciliation of basic to diluted weighted average common shares outstanding for fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Weighted Average Common Shares Outstanding - Basic +7,472 +8,232 +8,300 +Effect of dilutive securities - stock options and unrestricted stock +21 +69 +— +Weighted Average Common Shares Outstanding - Diluted +7,493 +8,301 +8,300 +For the fiscal years ended September 30, 2019, 2018 and 2017, the Company issued 10,000 , 300,000 and 750,000 , respectively, stock options to certain executives of the Company. Non-vested restricted shares of common stock entitle the holder to receive non-forfeitable dividends upon issuance and are included in the calculation of diluted earnings per common share. For the fiscal year ended September 30, 2017, the Company had stock options that were excluded from the diluted earnings per share because they were anti-dilutive. +Stock-Based Compensation +Stock-based compensation is measured based on the fair value of the equity award at the grant date and is typically expensed on a straight-line basis over the vesting period. Upon the vesting of restricted stock, the Company issues common stock from common shares held in treasury. +Total stock-based compensation expense for the three years ended September 30, 2019 in general and administrative expense was as follows: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Stock compensation expense: +Executives +$ +778 +$ +1,754 +$ +880 +Executive forfeitures +( 823 +) +— +— +Board of Directors +869 +859 +773 +Total stock compensation expense +$ +824 +$ +2,613 +$ +1,653 +58 +Note 3. Inventories +Inventories consist of the following at September 30, 2019 and 2018 : +(in thousands) +September 30, +2019 +2018 +Unharvested fruit crop on the trees +$ +39,276 +$ +39,888 +Other +867 +1,145 +Total inventories +$ +40,143 +$ +41,033 +The Company records its inventory at the lower of cost or net realizable value. For the fiscal years ended September 30, 2019 and 2018 , the Company recorded adjustments to reduce inventory to net realizable value of approximately $ 808,000 and $ 1,115,000 respectively. These adjustments to inventory are included in operating expenses in the Consolidated Statements of Operations. +In September 2017, the State of Florida’s citrus business, including the Company’s unharvested citrus crop, was significantly impacted by Hurricane Irma. The impact of Hurricane Irma resulted in the premature drop of unharvested fruit and damage to citrus trees, which will impact fruit production until such time as the citrus trees recover, potentially through the 2018/2019 harvest season. The Company undertook a process to estimate the amount of inventory casualty loss as of the date of Hurricane Irma. Such process included a number of factors including: (1) touring all of the citrus groves by operational personnel to assess the estimated fruit drop by grove and the impact of damage to the citrus trees; (2) consideration of independent estimates of the reduced citrus production for the State of Florida; and (3) an estimate of fruit the Company expects to produce for the 2017/2018 harvest season after Hurricane Irma. As a result, the Company recorded a casualty loss to reduce the carrying value of unharvested fruit crop on trees inventory by approximately $ 13,489,000 . +During the fiscal year ended September 30, 2019, the Company received insurance proceeds relating to Hurricane Irma of approximately $ 486,000 in additional property and casualty claims reimbursement. There are no further property and casualty or crop insurance claims pending relating to Hurricane Irma. During the fiscal year ended September 30, 2018, the Company received insurance proceeds relating to Hurricane Irma of approximately $ 477,000 for property and casualty damage claims and approximately $ 8,952,000 for crop claims. These insurance proceeds are included as a reduction to operating expenses in the Consolidated Statements of Operations. +The Company is eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fourth quarter of fiscal year 2019 and for the fiscal year ended September 30, 2019, the Company received approximately $ 15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and a portion of the Part 2 reimbursement under the three-part program. The timing and amount to be received under the remaining portion of the Part 2 and the Part 3 of the program has not been finalized. These federal relief proceeds are included as a reduction to operating expenses in the Consolidated Statements of Operations. +On November 7, 2019 and November 18, 2019, the Company received additional proceeds of approximately $ 163,800 and approximately $ 3,973,000 , respectively, under the Florida CRBG program. This represents another portion of the Part 2 reimbursement under the three-part program. +59 +Note 4. Assets Held for Sale +In accordance with its strategy to dispose of non-core and under-performing assets, the following assets have been classified as assets held for sale as of September 30, 2019 and September 30, 2018 : +(in thousands) +Carrying Value +Fiscal Year Ended September 30, +2019 +2018 +East Ranch +$ +1,442 +$ +759 +Trailers +— +456 +Frostproof Parcels +— +176 +Total Assets Held For Sale +$ +1,442 +$ +1,391 +During the fiscal year ended September 30, 2019, the Company sold certain trailers for approximately $ 47,000 , and reclassified the remaining Assets Held for Sale to property and equipment, as management has determined not to offer for sale the remaining trailers. +On October 30, 2018, the Company sold certain parcels at Frostproof for approximately $ 206,000 and realized a gain of approximately $ 12,000 . +On May 2, 2018, the Company sold its Gal Hog property for approximately $ 7,300,000 and recognized a gain of approximately $ 6,709,000 . +On February 12, 2018, the Company sold its property at Chancey Bay for approximately $ 4,200,000 and realized a loss of approximately $ 51,000 . As part of the transaction, the Company agreed to pay the purchaser rent of $ 200,000 in exchange for Alico retaining the rights of harvesting and selling of the fruit in the 2017/2018 harvest season. +On February 9, 2018, the Company sold its nursery located in Gainesville for approximately $ 6,500,000 and realized a gain of approximately $ 111,000 . +On January 25, 2018, the Company sold its breeding herd to a third party for approximately $ 7,800,000 and realized a gain of approximately $ 1,759,000 . As part of this transaction, the purchaser is also leasing grazing and other rights on the Ranch from the Company at a rate of $ 100,000 per month. Upon the sale of a parcel within the East Ranch, the lease rate was adjusted to $ 98,750 per month. +On January 19, 2018, the Company sold certain trailers to a third party for $ 500,000 . The Company received $ 125,000 and the remaining portion is to be paid in accordance with a promissory note, which bears interest at 5 % , over three years . +On October 30, 2017, the Company sold its corporate office building in Fort Myers, Florida for $ 5,300,000 and realized a gain of approximately $ 1,751,000 . The sales agreement provides that the Company lease back a portion of the office space for five years . Such lease is classified as an operating lease. +The Company recorded an impairment loss of approximately $ 152,000 and $ 150,000 for the fiscal years ended September 30, 2019 and 2018, respectively. These impairments are included in operating expenses on the Consolidated Statements of Operations. +The Company has used a portion of the proceeds to pay down debt (see Note 6. "Long-Term Debt and Lines of Credit") and repurchase common shares and plans to use the remaining cash proceeds from the sale of these assets to pay down debt and to fund future working capital requirements and other corporate purposes. +60 +Note 5. Property and Equipment, Net +Property and equipment, net consists of the following at September 30, 2019 and September 30, 2018 : +(in thousands) +September 30, +2019 +2018 +Citrus trees +$ +281,149 +$ +264,714 +Equipment and other facilities +54,622 +53,544 +Buildings and improvements +8,224 +8,052 +Total depreciable properties +343,995 +326,310 +Less: accumulated depreciation and depletion +( 104,169 +) +( 91,858 +) +Net depreciable properties +239,826 +234,452 +Land and land improvements +105,822 +105,951 +Property and equipment, net +$ +345,648 +$ +340,403 +During the fiscal year ended September 30, 2019 , the Company purchased 203 acres of citrus blocks for approximately $ 1,950,000 . These purchases were made from grove owners from within the Company’s existing grove locations. In April 2019, the lender, PGIM Real Estate Finance, LLC (“Prudential”), agreed to accept those purchases completed through April 2019 as substitute collateral and release $ 1,800,000 from restricted cash, which was completed in the fourth quarter of fiscal year 2019. Subsequent to April 2019, there were two additional purchases of Citrus blocks for approximately $ 100,000 that are not included as part of the substitution collateral. +On September 27, 2019, the Company sold approximately 5,500 acres from its West Ranch for approximately $ 14,775,000 and realized a gain on sale of approximately $ 13,033,000 . Upon the sale of these acres, the lease rate pertaining to the grazing and other rights was adjusted from $ 98,750 to $ 80,000 per month, as this space was previously being leased to a third party. +On September 29, 2018, the Company sold its property at Island Pond for $ 7,900,000 . As Island Pond was collateralized under one of the Company’s loan documents, $ 7,000,000 of the proceeds was restricted in use. +On September 28, 2018, The Company sold a parcel within the East Ranch for approximately $ 1,920,000 and realized a gain of approximately $ 1,759,000 . +On March 30, 2018, the Company sold property located on its Winterhaven location for approximately $ 225,000 and recognized a loss of approximately $ 50,000 . +On March 15, 2018, the Company sold certain parcels comprised of citrus trees and land located on its Ranch One grove for approximately $ 586,000 and recognized a loss of approximately $ 87,000 . +On February 2, 2017, the Company sold 49 acres of land and facilities in Hendry County, Florida, to its former tenant for $ 2,200,000 , resulting in a gain of approximately $ 1,371,000 . +During fiscal year ended September 30, 2019, the Company recorded impairments approximately $ 244,000 relating to the loss of citrus trees. During the fiscal year ended September 30, 2018, the Company recorded impairments aggregating to approximately $ 2,084,000 , which consisted of $ 1,032,000 relating to Island Pond and $ 1,052,000 relating to certain citrus trees damaged by Hurricane Irma and from other natural attrition. +61 +Note 6. Long-Term Debt and Lines of Credit +The following table summarizes long-term debt and related deferred financing costs, net of accumulated amortization at September 30, 2019 and September 30, 2018 : +September 30, 2019 +September 30, 2018 +(in thousands) +Principal +Deferred Financing Costs, Net +Principal +Deferred Financing Costs, Net +Long-term debt, net of current portion: +Met Fixed-Rate Term Loans +$ +89,688 +$ +724 +$ +95,938 +$ +836 +Met Variable-Rate Term Loans +43,844 +334 +46,719 +385 +Met Citree Term Loan +4,750 +40 +4,925 +44 +Pru Loans A & B +16,257 +224 +17,417 +241 +Pru Loan E +4,455 +9 +4,675 +17 +Pru Loan F +4,455 +38 +4,675 +40 +163,449 +1,369 +174,349 +1,563 +Less current portion +5,338 +— +5,275 +— +Long-term debt +$ +158,111 +$ +1,369 +$ +169,074 +$ +1,563 +The following table summarizes lines of credit and related deferred financing costs, net of accumulated amortization at September 30, 2019 and September 30, 2018 : +September 30, 2019 +September 30, 2018 +(in thousands) +Principal +Deferred Financing Costs, Net +Principal +Deferred Financing Costs, Net +Lines of Credit: +RLOC +$ +— +$ +8 +$ +— +$ +58 +WCLC +— +— +2,685 +78 +Lines of Credit +$ +— +$ +8 +$ +2,685 +$ +136 +Future maturities of long-term debt as of September 30, 2019 are as follows: +(in thousands) +Due within one year +$ +5,338 +Due between one and two years +14,990 +Due between two and three years +10,755 +Due between three and four years +10,755 +Due between four and five years +10,755 +Due beyond five years +110,856 +Total future maturities +$ +163,449 +62 +Interest costs expensed and capitalized were as follows: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Interest expense +$ +7,180 +$ +8,561 +$ +9,141 +Interest capitalized +1,019 +933 +294 +Total +$ +8,199 +$ +9,494 +$ +9,435 +Debt +The Company's credit facilities consist of $ 125,000,000 in fixed interest rate term loans (“Met Fixed-Rate Term Loans”), $ 57,500,000 in variable interest rate term loans (“Met Variable-Rate Term Loans”), a $ 25,000,000 revolving line of credit (“RLOC”) with Metropolitan Life Insurance Company and New England Life Insurance Company (collectively “Met”), and a $ 70,000,000 working capital line of credit (“WCLC”) with Rabo Agrifinance, Inc. (“Rabo”). +The term loans and RLOC are secured by real property. The security for the term loans and RLOC consists of approximately 38,200 gross acres of citrus groves and 5,800 gross acres of Ranch land. The WCLC is collateralized by the Company’s current assets and certain other personal property owned by the Company. +The term loans, collectively, are subject to quarterly principal payments of $ 2,281,250 , and mature November 1, 2029 . The Met Fixed-Rate Term Loans bear interest at 4.15 % per annum, and the Met Variable-Rate Term Loans bear interest at a rate equal to 90 day LIBOR plus 165 basis points (the “LIBOR spread”). The LIBOR spread is subject to adjustment by Met beginning May 1, 2017 and is subject to further adjustment every two years thereafter until maturity. No adjustment was made at May 1, 2019. Interest on the term loans is payable quarterly. The interest rates on the Met Variable-Rate Term Loans were 3.91 % per annum and 3.99 % per annum as of September 30, 2019 and September 30, 2018 , respectively. +The Company may prepay up to $ 8,750,000 of the Met Fixed-Rate Term Loan principal annually without penalty, and any such prepayments may be applied to reduce subsequent mandatory principal payments. The maximum annual prepayment was made for calendar year 2015. During the first and second quarter of fiscal year 2018, the Company elected not to make its principal payment and utilized a portion of its 2015 prepayment to satisfy its principal payment requirements for such quarters. At September 30, 2019 , the Company had $ 5,625,000 remaining available from its 2015 prepayment to reduce future mandatory principal payments should the Company elect to do so. The Met Variable-Rate Term Loans may be prepaid without penalty. +The RLOC bears interest at a floating rate equal to 90 day LIBOR plus 165 basis points, payable quarterly. The LIBOR spread was adjusted by the lender on May 1, 2017 and is subject to further adjustment every two years thereafter. No adjustment was made at May 1, 2019. In October 2019, the RLOC agreement was modified to extend the current maturity of November 1, 2019 to November 1, 2029. The RLOC is subject to an annual commitment fee of 25 basis points on the unused portion of the line of credit. The RLOC is available for funding general corporate needs. The variable interest rate was 3.91 % and 3.99 % per annum as of September 30, 2019 and September 30, 2018 , respectively. Availability under the RLOC was $ 25,000,000 as of September 30, 2019 . +The WCLC is a revolving credit facility and is available for funding working capital and general corporate requirements. The interest rate on the WCLC is based on the one month LIBOR, plus a spread, which is adjusted quarterly, based on the Company's debt service coverage ratio for the preceding quarter and can vary from 175 to 250 basis points. The rate is currently at LIBOR plus 175 basis points. The variable interest rate was 3.85 % and 3.85 % per annum as of September 30, 2019 and September 30, 2018 , respectively. The WCLC agreement was amended on September 20, 2018, and the primary terms of the amendment were an extension of the maturity to November 1, 2021. There were no changes to the commitment amount or interest rate. Availability under the WCLC was approximately $ 69,540,000 and $ 57,015,000 as of September 30, 2019 and September 30, 2018 , respectively. +The WCLC is subject to a quarterly commitment fee on the daily unused availability under the line computed as the commitment amount less the aggregate of the outstanding loans and outstanding letters of credit. The commitment fee is adjusted quarterly based on Alico's debt service coverage ratio for the preceding quarter and can vary from a minimum of 20 basis points to a maximum of 30 basis points. Commitment fees to date have been charged at 20 basis points. +There were no amounts outstanding on the WCLC at September 30, 2019 . The WCLC agreement provides for Rabo to issue up to $ 2,000,000 , reduced from $ 20,000,000 during fiscal year 2019, in letters of credit on the Company’s behalf. As of September 30, 2019 , there was approximately $ 460,000 in outstanding letters of credit, which correspondingly reduced the Company's availability under the line of credit. +63 +In 2014, the Company capitalized approximately $ 2,834,000 of debt financing costs related to the refinancing. These costs, together with approximately $ 339,000 of costs related to the retired debt, are being amortized to interest expense over the applicable terms of the loans. Additionally, approximately $ 133,000 and $ 123,000 of financing costs were incurred for the fiscal year ended September 30, 2019 and 2018, respectively, in connection with letters of credit. The costs incurred during fiscal year 2019 are included in other noncurrent assets and will be moved to deferred financing and amortized to interest expense over the applicable terms of the obligations upon completion of the modified agreements, which was in October 2019. All previous costs are included in deferred financing and being amortized to interest expense over the applicable terms of the obligations. The unamortized balance of deferred financing costs related to the financing above was approximately $ 1,066,000 and approximately $ 1,357,000 at September 30, 2019 and September 30, 2018 , respectively. +These credit facilities noted above are subject to various covenants including the following financial covenants: (i) minimum debt service coverage ratio of 1.10 to 1.00, (ii) tangible net worth of at least $ 160,000,000 increased annually by 10 % of consolidated net income for the preceding years, or approximately $ 163,522,000 for the year ended September 30, 2019, (iii) minimum current ratio of 1.50 to 1.00, (iv) debt to total assets ratio not greater than .625 to 1.00, and, solely in the case of the WCLC, (v) a limit on capital expenditures of $ 30,000,000 per fiscal year. As of September 30, 2019 , the Company was in compliance with all of the financial covenants. +Credit facilities also include a Met Life term loan collateralized by 1,200 gross acres of citrus grove owned by Citree ("Met Citree Loan"). This is a $ 5,000,000 credit facility that bears interest at a fixed rate of 5.28 % per annum. Principal and interest payments are made on a quarterly basis. At September 30, 2019 and 2018, there was an outstanding balance of $ 4,750,000 and $ 4,925,000 , respectively. The loan matures in February 2029. The unamortized balance of deferred financing costs related to this loan was approximately $ 40,000 and $ 44,000 at September 30, 2019 and 2018, respectively. +Transition from LIBOR +The Company is currently evaluating the impact of the transition from LIBOR as an interest rate benchmark to other potential alternative reference rates. Currently, the Company has debt instruments in place that reference LIBOR-based rates. The transition from LIBOR is estimated to take place in 2021 and management will continue to actively assess the related opportunities and risks involved in this transition. +Silver Nip Citrus Debt +There are two fixed-rate term loans, with an original combined balance of $ 27,550,000 , bearing interest at 5.35 % per annum (“Pru Loans A & B”). Principal of $ 290,000 is payable quarterly, together with accrued interest. On February 15, 2015, 734 Citrus Holdings, LLC d/b/a Silver Nip Citrus (“Silver Nip Citrus”) made a prepayment of $ 750,000 . In addition, the Company made prepayments of approximately $ 4,453,000 in the second fiscal quarter of 2018 with proceeds from the sale of certain properties, which were collateralized under these loans. The Company may prepay up to $ 5,000,000 of principal without penalty. As such, the Company exceeded the allowed $ 5,000,000 prepayment by approximately $ 203,000 and was required to make a premium payment of approximately $ 22,000 . The loans are collateralized by approximately 5,700 of citrus groves in Collier, Hardee, Highlands and Polk Counties, Florida and mature on June 1, 2029 and June 1, 2033, respectively. +Silver Nip Citrus entered into two additional fixed-rate term loans with Prudential to finance the acquisition of a 1,500 acre citrus grove on September 4, 2014. Each loan was in the original amount of $ 5,500,000 . Principal of $ 55,000 per loan is payable quarterly, together with accrued interest. One loan bears interest at 3.85 % per annum (“Pru Loan E”), while the other bears interest at 3.45 % per annum (“Pru Loan F”). The interest rate on Pru Loan E is subject to adjustment on September 1, 2019 and every year thereafter until maturity. No adjustment was made at September 1, 2019. Both loans are collateralized by approximately 1,500 gross acres of citrus groves in Charlotte County, Florida. Pru Note E matures September 1, 2021, and Pru Note F matures September 1, 2039. +In November 2019, the Company prepaid one of its fixed-rate term loans with Prudential in full in the amount of $ 4,455,000 . As a result of this prepayment, the Company’s required annual principal payments will be reduced by $ 220,000 per annum. +The Silver Nip Citrus credit agreements are subject to a financial covenant whereby the consolidated current ratio requirement is 1.00 to 1.00 . Silver Nip Citrus was in compliance with the current ratio covenant as of September 30, 2019 . +The unamortized balance of deferred financing costs related to the Silver Nip Citrus debt was approximately $ 271,000 and $ 298,000 at September 30, 2019 and 2018, respectively. +64 +Note 7. Accrued Liabilities +Accrued liabilities consist of the following at September 30, 2019 and September 30, 2018 : +(in thousands) +September 30, +2019 +2018 +Ad valorem taxes +$ +2,117 +$ +2,196 +Accrued interest +1,110 +1,191 +Accrued employee wages and benefits +2,525 +3,115 +Inventory received but not invoiced +— +726 +Accrued dividends +448 +492 +Accrued contractual obligation associated with sale of real estate +402 +— +Consulting and separation charges +400 +— +Accrued insurance +544 +223 +Accrued tender offer consulting charges +— +274 +Other accrued liabilities +223 +664 +Total accrued liabilities +$ +7,769 +$ +8,881 +Note 8. Deferred Gain on Sale +Deferred gain on sale consists of the following at September 30, 2019 and September 30, 2018: +(in thousands) +September 30, +2019 +2018 +Deferred gain on sale +$ +— +$ +26,167 +Annual guarantee payment, net +— +( 1,239 +) +Total deferred gain on sale +$ +— +$ +24,928 +On November 21, 2014, the Company completed the sale of approximately 36,000 acres of land used for sugarcane production and land leasing in Hendry County, Florida to Global Ag Properties, LLC (“Global”) for approximately $ 97,900,000 in cash. +The sales price was subject to post-closing adjustments over a ten year period. The Company realized a gain of approximately $ 42,753,000 on the sale. Initially, $ 29,140,000 of the gain was deferred due to the Company’s continuing involvement in the property pursuant to a post-closing agreement and the potential price adjustments. The deferral represented the Company’s estimate of the maximum exposure to loss as a result of the continuing involvement. A net gain of approximately $ 13,613,000 was recognized at the time of the sale. +On October 1, 2018, the Company adopted ASC 610-20 and reevaluated the original post closing agreement under the guidance of ASC 610-20. As such, the Company recorded a derivative asset and derivative liabilities, which resulted in an increase to retained earnings of $ 10,897,000 , net of taxes. This adjustment consisted of recording a derivative asset in the amount of $ 3,553,000 relating to potential payments due Alico from Global Ag Properties USA, LLC (“Global Ag”) and a derivative liability of $ 13,864,000 relating to potential payments due Global Ag from Alico. In the first quarter ended December 31, 2018, the Company recorded a loss of $ 956,000 , which reflects the change in fair value of the derivative asset and derivative liabilities. In the three months ended March 31, 2019, the Company recorded an additional loss of $ 33,000 . +On December 7, 2018, the Company and Global Ag entered into a Termination of Post Closing Agreement (the “2018 Post Closing Agreement”), pursuant to which the parties thereto agreed to certain terms and conditions under which a Post Closing Agreement, dated as of November 21, 2014 (the “2014 Post Closing Agreement”), may be terminated prior to the expiration of its stated term and with the payment of certain termination payments. The 2014 Post Closing Agreement was entered into in connection with the November 21, 2014 closing (the “Land Disposition”) of the sale by Alico to Global Ag of certain land used for sugarcane production and land leasing in Hendry County, Florida (the “Land”). +The 2014 Post Closing Agreement contained obligations, including possible payments by Alico and by Global Ag to each other over a ten year period following the closing of the Land Disposition, with the payments each year being based on the difference, +65 +if any, between certain computed amounts. Since the time of the closing of the Land Disposition and up through March 11, 2019, the computations have resulted in payments being made each year by Alico to Global Ag., which have aggregated approximately $ 6,518,000 . +The 2018 Post Closing Agreement provided for (i) the termination of the 2014 Post Closing Agreement following the satisfaction of certain terms and conditions set forth in the termination agreement and (ii) the deposit by wire transfer into escrow of an aggregate of $ 11,300,000 following notification by Global Ag to Alico of the closing date of a sale of the Land by Global Ag to a third party. The conditions to the termination of the 2014 Post Closing Agreement and the payment of funds to Global Ag included (a) Global Ag’s assignment to the third party buyer, and such third party buyer’s assumption, of certain specified water management obligations, irrigation and drainage easement obligations, access easements obligations and obligations under a certain option to purchase certain railroad property owned by Alico, (b) delivery to the escrow agent of all instruments and consideration required to consummate the closing by Global Ag of the sale of the Land to the third party buyer, and (c) delivery to the escrow agent of copies of a water management project cooperation agreement running in favor of Alico and signed by Global Ag and the third party buyer. +On March 11, 2019, the 2018 Post Closing Agreement was completed. As such, all the conditions of the termination of the 2014 Post Closing Agreement, mentioned above, were met with the sale of the sugarcane land to a third party. As a result, the Company does not have any future liabilities or commitments to Global Ag in connection with the 2014 Post Closing Agreement. +Note 9. Fair Value Measurements +The Company complies with the provisions of FASB ASC 820 “Fair Value Measurements” for its financial and non-financial assets and liabilities. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring or nonrecurring basis. +ASC 820 clarifies that fair value is an exit price representing the amount that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, ASC 820 establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value as follows: +• +Level 1- Observable inputs such as quoted prices in active markets; +• +Level 2- Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and +• +Level 3- Unobservable inputs in which there is little or no market data, such as internally developed valuation models which require the reporting entity to develop its own assumptions. +As of September 30, 2019, the Company did no t have any assets held for sale that had been measured at fair value on a non-recurring basis. +The following table represents certain assets held for sale as of September 30, 2018, which have been measured at fair value on a non-recurring basis (see Note 4. "Assets Held for Sale"): +Fair Value Hierarchy +Carrying Value +Adjustment to Fair Value +Fair Value +Trailers +Level 3 +$ +606 +$ +150 +$ +456 +The Company uses third-party service providers to assist in the evaluation of investments. For investment valuations, current market interest rates, quality estimates by rating agencies and valuation estimates by active market participants were used to determine values. Deferred retirement benefits were valued based on actuarial data, contracted payment schedules and an estimated discount rate of 4.08 % and 4.08 % as of September 30, 2019 and 2018, respectively. +66 +Note 10. Common Stock and Options +Effective January 27, 2015, the Company’s Board of Directors adopted the 2015 Stock Incentive Plan (the “2015 Plan”) which provides for up to 1,250,000 common shares available for issuance to provide a long-term incentive plan for officers, employees, directors and/or consultants to directly link incentives to stockholder value. The 2015 Plan was approved by the Company’s stockholders in February 2015. The Company’s 2015 Plan provides for grants to executives in various forms including restricted shares of the Company’s common stock and stock options. Awards are discretionary and are determined by the Compensation Committee of the Board of Directors. Awards vest based upon service conditions. Non-vested restricted shares generally vest over requisite service periods of one to six years from the date of grant. +Restricted Stock +In November 2017, a senior executive was awarded 5,000 restricted shares of the Company’s common stock (“Restricted Stock”) under the 2015 Plan at a weighted average fair value of $ 31.95 per common share, vesting over 2.5 years . +The following table represents a summary of the status of the Company’s nonvested shares: +Nonvested Shares +Shares +Weighted-Average Grant Date Fair Value +Nonvested Shares at September 30, 2016 +10,267 +$ +49.49 +Granted during fiscal year 2017 +— +— +Vested during fiscal year 2017 +( 4,933 +) +49.58 +Forfeited during fiscal year 2017 +— +— +Nonvested Shares at September 30, 2017 +5,334 +49.39 +Granted during fiscal year 2018 +5,000 +31.95 +Vested during fiscal year 2018 +( 3,001 +) +39.70 +Forfeited during fiscal year 2018 +— +— +Nonvested Shares at September 30, 2018 +7,333 +41.46 +Granted during fiscal year 2019 +— +— +Vested during fiscal year 2019 +( 1,667 +) +31.95 +Forfeited during fiscal year 2019 +— +— +Nonvested Shares at September 30, 2019 +5,666 +$ +44.26 +Stock compensation expense related to the Restricted Stock totaled approximately $ 104,000 , $ 137,000 and $ 264,000 for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. There was approximately $ 69,000 and $ 172,000 of total unrecognized stock compensation costs related to unvested stock compensation for the Restricted Stock grants at September 30, 2019 and September 30, 2018, respectively. The total unrecognized compensation cost is expected to be recognized over a weighted-average period of 0.75 years . +During the fiscal year ended September 30, 2019, 1,667 shares vested aggregating a value of approximately $ 53,000 . +Stock Option Grant +Stock option grants of 10,000 options to Mr. John Kiernan (the “2019 Option Grants”) were granted on October 25, 2018. The option exercise price for these options was set at $ 33.34 , the closing price on October 25, 2018. The 2019 Option Grants will vest as follows: (i) 3,333 of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 40.00 ; (ii) 3,333 of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 45.00 ; (iii) 3,334 of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 12 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2021 then any unvested options will be forfeited. The 2019 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection +67 +with a change in control of the Company. As of September 30, 2019 , the Company’s stock was trading at $ 34.02 per share, and during the fiscal year ended September 30, 2019 , the stock did not trade above $ 40.00 per share; accordingly, none of the stock options are vested at September 30, 2019 . +Stock option grants of 210,000 options to Mr. Remy Trafelet and 90,000 options to Mr. John Kiernan (collectively, the “2018 Option Grants”) were granted on September 7, 2018. The option exercise price for these options was set at $ 33.60 , the closing price on September 7, 2018. The 2018 Option Grants will vest as follows: (i) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 35.00 ; (ii) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 40.00 ; (iii) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 45.00 ; and (iv) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 12 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2021 then any unvested options will be forfeited. The 2018 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2019 , the Company’s stock was trading at $ 34.02 per share, and during the fiscal ended September 30, 2019 , the stock did not trade above $ 35.00 per share; accordingly, none of the stock options are vested at September 30, 2019 . As set forth below, more than a majority of the 2018 Option Grants issued to Mr. Trafelet were forfeited and the vesting conditions of the remainder were modified, all pursuant to the Settlement Agreement, as defined below. +A stock option grant of 300,000 options in the case of Mr. Trafelet and 225,000 options in the case of each of Mr. Henry Slack and Mr. George Brokaw (collectively, the “2016 Option Grants”) were granted on December 31, 2016. The option price was set at $ 27.15 , the closing price on December 31, 2016. The 2016 Option Grants will vest as follows: (i) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20 -trading day period exceeds $ 60.00 ; (ii) 25 % of the options will vest if such price exceeds $ 75.00 ; (iii) 25 % of the options will vest if such price exceeds $ 90.00 ; and (iv) 25 % of the options will vest if such price exceeds $ 105.00 . If the applicable stock price hurdles have not been achieved by (A) the second anniversary of the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by the fifth anniversary of the grant date (or the fourth anniversary of the grant date, in the case of the tranche described in clause (i) above), then any unvested options will be forfeited. The 2016 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2019 , the Company’s stock was trading at $ 34.02 per share, and during the fiscal year ended September 30, 2019 , the stock did not trade above $ 60.00 per share; accordingly, none of the stock options are vested at September 30, 2019 . As set forth below, all of the 2016 Option Grants issued to Mr. Trafelet were forfeited pursuant to the Settlement Agreement, as defined below. +Additionally, 187,500 shares of the 2016 Option Grants made to each of Messrs. Slack and Brokaw were forfeited on September 5, 2018 and no replacement options were granted. As such, the remaining unrecognized expense associated with these options of approximately $ 783,000 was accelerated and recorded for the fiscal year ended September 30, 2018 . +Pursuant to a Settlement Agreement (described in Note 15. “Related Party Transactions”), which was unanimously approved by the Board of Directors, Mr. Trafelet agreed to voluntarily resign from his roles as President and Chief Executive Officer and a director of the Company. Under the Settlement Agreement, Mr. Trafelet forfeited (i) all of the 2016 Option Grants granted to him and (ii) all of the 2018 Option Grants granted to him in September 2018, other than 26,250 stock options that will vest if the minimum price of Alico's common stock over 20 consecutive trading days exceeds $ 35.00 per share and 26,250 stock options that will vest if the minimum price of Alico's common stock over 20 consecutive trading days exceeds $ 40.00 per share (“2019 Modified Option Grant”), in each case, by the first anniversary of the date of the Settlement Agreement (collectively, the "Retained Options"). Any Retained Options that vest in accordance with their terms will expire on the date that is six months following the date on which the Retained Option vests, and any Retained Options that do not vest by the first anniversary of the Settlement Agreement will be forfeited as of such first anniversary. As a result of the forfeited stock options, the Company reversed $ 823,000 of previously recorded stock compensation expense during the year ended September 30, 2019, which is recorded as a reduction of General and Administrative expense. +Forfeitures of all stock options were recognized as incurred. +68 +The following table represents a summary of the Company’s stock option activity: +Weighted Average +Weighted +Remaining +Aggregate +Number of +Average Exercise +Contractual Term +Intrinsic +Options +Price +(years) +Value +Balance - September 30, 2017 +750,000 +$ +27.15 +2.58 +— +Granted during fiscal year 2018 +300,000 +33.60 +3.25 +— +Forfeitures/expired in fiscal year 2018 +( 375,000 +) +27.15 +1.86 +— +Exercised during fiscal year 2018 +— +— +— +— +Balance - September 30, 2018 +675,000 +30.02 +2.22 +— +Granted during fiscal year 2019 +10,000 +33.34 +2.25 +— +Forfeitures/expired in fiscal year 2019 +( 457,500 +) +29.37 +1.78 +— +Exercised during fiscal year 2019 +— +— +— +— +Balance - September 30, 2019 +227,500 +$ +31.46 +1.22 +— +Stock compensation expense related to the options totaled approximately $ 674,000 , $ 1,617,000 and $ 616,000 for the fiscal years ended September 30, 2019 , 2018 and 2017, respectively. +At September 30, 2019 and September 30, 2018 , there was approximately $ 502,000 and $ 2,174,000 , respectively, of total unrecognized stock compensation costs related to unvested share-based compensation for the option grants. The total unrecognized compensation cost is expected to be recognized over a weighted-average period of 1.29 years . +The fair value of the 2019, 2018 and 2016 Option Grants was estimated on the date of grant using a Monte Carlo valuation model that uses the assumptions noted in the following table. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding; the range given below results from different timeframes for the various market conditions being met. +2019 Modified Option Grant +Expected Volatility +25.0 +% +Expected Term (in years) +1.50 +Risk Free Rate +2.52 +% +The weighted-average grant-date fair value of the 2019 Modified Option Grant was $ 1.40 . +2019 Option Grants +Expected Volatility +30.0 +% +Expected Term (in years) +4.09 +Risk Free Rate +2.95 +% +The weighted-average grant-date fair value of the 2019 Option Grants was $ 7.10 . +2018 Option Grants +Expected Volatility +30.0 +% +Expected Term (in years) +3.32 +Risk Free Rate +2.80 +% +The weighted-average grant-date fair value of the 2018 Option Grants was $ 7.40 . +69 +2016 Option Grants +Expected Volatility +32.2 +% +Expected Term (in years) +2.6 - 4.0 +Risk Free Rate +2.45 +% +The weighted-average grant-date fair value of the 2016 Option Grants was $ 3.53 . There were no additional stock options granted or exercised for the fiscal year ended September 30, 2019 . +As of September 30, 2019 , there remained 1,005,000 common shares available for issuance under the 2015 Plan. +Note 11. Treasury Stock +In fiscal year 2017, the Board of Directors authorized the repurchase of up to $ 7,000,000 of the Company’s common stock in two separate authorizations (collectively, the "2017 Authorization"). In March 2017, the Board of Directors authorized the repurchase of up to $ 5,000,000 of the Company’s common stock beginning March 9, 2017 and continuing through March 9, 2019. In May 2017, the Board of Directors authorized the repurchase of up to an additional $ 2,000,000 of the Company’s common stock beginning May 24, 2017 and continuing through May 24, 2019. The stock repurchases made under this repurchase were made through open market transactions at times and in such amounts as the Company’s broker determined subject to the provisions of SEC Rule 10b-18. +During fiscal year 2018, the Company purchased 72,266 shares at a cost of $ 2,214,756 under the 2017 Authorization. As of June 29, 2018, the Company suspended its stock repurchase activity. For the fiscal year ended September 30, 2019, the Company did not purchase any shares under the 2017 Authorization. As the 2017 Authorization expired in May 2019, the Company has no funds available under this plan to repurchase stock. +On October 3, 2018, the Company completed a tender offer of 752,234 shares at a price of $ 34.00 per share aggregating $ 25,575,956 . 734 Investors, Alico's largest stockholder from 2013 until November 12, 2019, participated in the tender offer by selling a small percentage of its holdings. +In September 2013, the Board of Directors authorized the repurchase of up to 105,000 shares of the Company’s common stock beginning in November 2013 and continuing through April 2018. In fiscal year 2016, the Board of Directors authorized the repurchase of up to 50,000 shares of the Company’s outstanding common stock beginning February 18, 2016 and continuing through February 17, 2017 (the "2016 Authorization"). In fiscal year 2015, the Board of Directors authorized the repurchase of up to 170,000 shares of the Company’s common stock beginning March 25, 2015 and continuing through December 31, 2016. +The following table illustrates the Company’s treasury stock purchases for the fiscal years ended September 30, 2019, 2018 and 2017: +(in thousands, except share amounts) +Total Number of +Shares Purchased +Average Price +Paid Per Share +Total Shares Purchased as Part of Publicly Announced Plan or Program +Total Dollar Value of Shares Purchased +Fiscal Year Ended September 30,: +2019 +752,234 +$ +34.00 +1,474,640 +$ +25,576 +2018 +72,266 +$ +30.65 +722,406 +$ +2,215 +2017 +104,145 +$ +29.42 +650,140 +$ +3,064 +70 +The following table outlines the Company’s treasury stock transactions during the past three fiscal years: +(in thousands, except share amounts) +Shares +Cost +Balance at September 30, 2016 +100,610 +$ +4,585 +Purchased +104,145 +3,064 +Issued to Employees and Directors +( 27,440 +) +( 1,147 +) +Balance at September 30, 2017 +177,315 +6,502 +Purchased +72,266 +2,215 +Issued to Employees and Directors +( 33,393 +) +( 1,181 +) +Balance at September 30, 2018 +216,188 +7,536 +Purchased +752,234 +25,576 +Issued to Employees and Directors +( 28,790 +) +( 1,169 +) +Balance at September 30, 2019 +939,632 +$ +31,943 +Note 12. Income Taxes +On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act contains significant changes to corporate taxes, including a permanent reduction of the U.S. corporate tax rate from 35% to 21% effective January 1, 2018. The Company’s statutory rate for the fiscal year ended September 30, 2018 was 24.5% , based on a fiscal year blended rate calculation. The 21% U.S. corporate tax rate is fully applicable to the fiscal year ended September 30, 2019 and each year thereafter. +The Act required a one-time remeasurement of certain tax related assets and liabilities. During the first quarter ended December 31, 2017, the Company made certain estimates related to the impact of the Act including the remeasurement of deferred taxes at the new expected tax rate and a revised effective tax rate for the year ended September 30, 2018. For the fiscal year ended September 30, 2018, the Company has recorded a tax benefit of approximately $ 9,847,000 to account for these deferred tax impacts. +In October 2019, the Internal Revenue Service concluded their audit of the September 30, 2015 tax year with no changes. The Federal and state filings remain subject to examination by tax authorities for tax periods ending after September 30, 2015. +The income tax provision (benefit) for the years ended September 30, 2019, 2018 and 2017 consists of the following: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Current: +Federal income tax +$ +7,314 +$ +1,961 +$ +102 +State income tax +2,202 +384 +— +Total current +9,516 +2,345 +102 +Deferred: +Federal income tax +2,995 +( 3,917 +) +( 3,286 +) +State income tax +272 +1,962 +( 662 +) +Total deferred +3,267 +( 1,955 +) +( 3,948 +) +Income tax provision (benefit) +$ +12,783 +$ +390 +$ +( 3,846 +) +71 +Income tax provision (benefit) attributable to income (loss) before income taxes differed from the amount computed by applying the statutory federal income tax rate of 21 % , 24.53 % and 35 % to income (loss) before income taxes for the fiscal years ended September 30, 2019, September 30, 2018 and September 30, 2017, respectively, as a result of the following: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Income tax (benefit) at the statutory federal rate +$ +10,587 +$ +3,198 +$ +( 4,670 +) +Increase (decrease) resulting from: +State income taxes, net of federal benefit +1,947 +857 +( 402 +) +Permanent and other reconciling items, net +166 +221 +548 +Expiration of capital loss carryforward +— +5,634 +581 +Reduction in deferred tax liability resulting from the Act +— +( 9,847 +) +— +Stock option cancellation +— +347 +— +Other +83 +( 20 +) +97 +Income taxes provision (benefit) +$ +12,783 +$ +390 +$ +( 3,846 +) +The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of September 30, 2019, and 2018 are presented below: +(in thousands) +September 30, +2019 +2018 +Deferred tax assets: +Deferred retirement benefits +$ +1,325 +$ +1,114 +Investment in Citree +— +89 +Deferred gain recognition +— +6,318 +Goodwill +18,244 +20,095 +Inventories +930 +711 +Stock compensation +237 +261 +Accrued bonus +— +612 +Tax credits +— +28 +Intangibles +565 +620 +Other +168 +190 +Total deferred tax assets +21,469 +30,038 +Deferred tax liabilities: +Revenue recognized from citrus and sugarcane +— +162 +Property and equipment +52,551 +54,925 +Investment in Citree +909 +— +Prepaid insurance +134 +104 +Total deferred tax liabilities +53,594 +55,191 +Net deferred income tax liabilities +$ +( 32,125 +) +$ +( 25,153 +) +72 +Note 13. Segment Information +Segments +Operating segments are defined in the criteria established under the Financial Accounting Standards Board - Accounting Standards Codification (“FASB ASC”) Topic 280 as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: Alico Citrus and Water Resources and Other Operations. +Total revenues represent sales to unaffiliated customers, as reported in the Consolidated Statements of Operations. Goods and services produced by these segments are sold to wholesalers and processors in the United States who prepare the products for consumption. The Company evaluates the segments’ performance based on direct margins (gross profit) from operations before general and administrative expenses, interest expense, other income (expense) and income taxes, not including nonrecurring gains and losses. +Information by operating segment is as follows: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Revenues: +Alico Citrus +$ +119,031 +$ +78,121 +$ +123,441 +Water Resources and Other Operations +3,220 +3,160 +6,388 +Total revenues +122,251 +81,281 +129,829 +Operating expenses: +Alico Citrus +59,594 +51,709 +111,947 +Water Resources and Other Operations +2,297 +3,979 +8,952 +Total operating expenses +61,891 +55,688 +120,899 +Gross profit (loss): +Alico Citrus +59,437 +26,412 +11,494 +Water Resources and Other Operations +923 +( 819 +) +( 2,564 +) +Total gross profit +60,360 +25,593 +8,930 +Capital expenditures: +Alico Citrus +20,000 +15,968 +11,738 +Water Resources and Other Operations +— +304 +646 +Other Capital Expenditures +— +80 +969 +Total capital expenditures +20,000 +16,352 +13,353 +Depreciation, depletion and amortization: +Alico Citrus +12,935 +12,546 +14,054 +Water Resources and Other Operations +173 +219 +652 +Other Depreciation, Depletion and Amortization +816 +991 +520 +Total depreciation, depletion and amortization +$ +13,924 +$ +13,756 +$ +15,226 +73 +(in thousands) +September 30, +2019 +2018 +Assets: +Alico Citrus +$ +401,212 +$ +405,752 +Water Resources and Other Operations +15,332 +15,904 +Other Corporate Assets +844 +1,766 +Total Assets +$ +417,388 +$ +423,422 +Note 14. Employee Benefits Plans +Management Security Plan +The management security plan (“MSP”) is a nonqualified, noncontributory defined supplemental deferred retirement benefit plan for a select group of management personnel. The MSP provides a fixed supplemental retirement benefit for 180 months. The MSP was frozen as of September 30, 2017. As a result, no new participants are being added to the MSP and no further benefits are accumulating. The MSP benefit expense and the projected management security plan benefit obligation are determined using assumptions as of the end of the year. The weighted-average discount rate used to compute the obligation was 4.08 % and 4.08 % in fiscal years 2019 and 2018, respectively. +Actuarial gains or losses are recognized when incurred; therefore, the end of year benefit obligation is the same as the accrued benefit costs recognized in the Consolidated Balance Sheets. +The amount of MSP benefit expense charged to costs and expenses was as follows: +(in thousands) +Fiscal Year Ended September 30, +2019 +2018 +2017 +Service cost +$ +— +$ +— +$ +200 +Interest cost +171 +293 +140 +MSP termination adjustments +985 +— +— +Recognized actuarial gain (loss) adjustment +13 +16 +( 78 +) +Total +$ +1,169 +$ +309 +$ +262 +The following provides a roll-forward of the MSP benefit obligation: +(in thousands) +September 30, +2019 +2018 +Change in projected benefit obligation: +Benefit obligation at beginning of year +$ +4,397 +$ +4,438 +Interest cost +171 +293 +Benefits paid +( 340 +) +( 350 +) +MSP termination adjustments +985 +— +Recognized actuarial gain adjustment +13 +16 +Benefit obligation at end of year +$ +5,226 +$ +4,397 +Funded status at end of year +$ +( 5,226 +) +$ +( 4,397 +) +Effective September 30, 2018, the Company terminated the MSP. Under the MSP termination, payout for benefits covered under the applicable Internal Revenue Code regulations cannot commence until at least twelve months following plan termination decision, but must be fully paid out within twenty-four ( 24 ) months following plan termination. The Company has determined to pay out a lump sum under the Equivalent Annuity approach, whereby the payout under this approach would mitigate participants tax burden. In essence, the Company would be covering the amount needed to purchase an annuity providing the same after-tax benefit as if the plan was not terminated. As a result, the Company recorded an additional liability of approximately $ 720,000 . +74 +The Company has established a “Rabbi Trust” to provide for the funding of accrued benefits under the MSP. According to the terms of the Rabbi Trust, funding is voluntary until a change of control of the Company as defined in the Management Security Plan Trust Agreement occurs. Upon a change of control, funding is triggered. As of September 30, 2019, the Rabbi Trust had no assets, and no change of control had occurred. +Profit Sharing and 401(k) Plans +The Company maintains a 401(k) employee savings plan for eligible employees, which provides up to a 4 % matching contribution payable on employee payroll deferrals. The Company’s matching funds vest to the employee immediately, pursuant to a safe harbor election effective in October 2012. The Company’s contribution to the plan was approximately $ 380,000 , $ 342,000 and $ 445,000 for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +The Profit Sharing Plan (“Plan”) is fully funded by contributions from the Company. Contributions to the Plan are discretionary and determined annually by the Company’s Board of Directors. Contributions to employee accounts are based on the participant’s compensation. The Company’s paid contribution to the Profit Sharing Plan was $ 0 , $ 0 and $ 378,000 for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +Note 15. Related Party Transactions +Clayton G. Wilson +The Company entered into a Separation and Consulting Agreement with Clayton G. Wilson (the “Separation and Consulting Agreement”), pursuant to which Mr. Wilson stepped down as Chief Executive Officer of the Company effective as of December 31, 2016. Under the Separation and Consulting Agreement, Mr. Wilson also acknowledged and agreed that he would continue to be bound by the restrictive covenants set forth in his Employment Agreement with the Company. The Separation and Consulting Agreement provided that, subject to his execution, delivery, and non-revocation of a general release of claims in favor of the Company, Mr. Wilson would be entitled to vesting of any unvested portion of the restricted stock award granted to him under his Employment Agreement. In addition, the Separation and Consulting Agreement provided that Mr. Wilson serve as a consultant to the Company during 2017 and would receive an aggregate consulting fee of $ 750,000 for such services (payable $ 200,000 in an initial lump sum, $ 275,000 in a lump sum on July 1, 2017, and $ 275,000 in six equal monthly installments commencing July 31, 2017 and ending December 31, 2017). As of December 31, 2017, the Company satisfied its obligation to Mr. Wilson in full. The Company expensed approximately $ 0 , $ 187,500 and $ 562,500 under the Separation and Consulting Agreement for the fiscal years ended September 30, 2019 , 2018 and 2017, respectively. Mr. Wilson resigned as a member of the Company’s Board of Directors effective February 27, 2017. +Henry R. Slack and George R. Brokaw +On December 31, 2016, the Company entered into new employment agreements (collectively, the “Employment Agreements”) with Henry R. Slack, and George R. Brokaw. Mr. Slack previously served as the Executive Chairman of the Company, and Mr. Brokaw currently serves as the Executive Vice Chairman of the Company, and each of them continues to serve on the Company’s Board of Directors. The Employment Agreements provided for an annual base salary of $ 250,000 in the case of Mr. Slack and provides for an annual base salary of $ 250,000 in the case of Mr. Brokaw. +Beginning June 26, 2017, both Messrs. Slack and Brokaw agreed to waive payment of their salaries. +Effective July 1, 2019, Mr. Slack resigned his employment with the Company as Executive Chairman. Mr. Slack continues to serve on the Board of the Company. +Remy W. Trafelet +As described above, on February 11, 2019 and as contemplated by the Alico Settlement Agreement, Mr. Trafelet submitted to the Board his resignation as President and Chief Executive Officer of the Company and a member of the Board, effective upon the execution of the Alico Settlement Agreement. Also, on February 11, 2019, as contemplated by the Settlement Agreement, the Company entered into a consulting agreement (the "Consulting Agreement") with Mr. Trafelet and 3584 Inc., an entity controlled by Mr. Trafelet (the "Consultant"). Pursuant to the Consulting Agreement, Mr. Trafelet will make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant will receive an annual consulting fee of $ 400,000 . As of September 30, 2019 , the Company has paid approximately $ 254,000 towards these consulting fees. If the Company terminates the consulting period (other than in certain specified +75 +circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24 -month term. +Ken Smith +On March 20, 2015, Ken Smith tendered his resignation as Chief Operating Officer, and as an employee of the Company. Mr. Smith’s resignation included a waiver of any rights to any payments under his Change-in-Control Agreement with the Company. On March 20, 2015, the Company and Mr. Smith also entered into a Consulting and Non-Competition Agreement under which (i) Mr. Smith will provide consulting services to the Company during the three -year period after the resignation date, (ii) Mr. Smith agreed to be bound by certain non-competition covenants relating to the Company’s citrus operations and non-solicitation and non-interference covenants for a period of two years after the resignation date, and (iii) the Company paid Mr. Smith $ 925,000 for such services and covenants. The Company expensed approximately $ 0 , $ 0 and $ 100,000 under the Consulting and Non-Competition Agreement for fiscal years ended September 30, 2019, 2018 and 2017, respectively. +Shared Services Agreement +The Company had a shared services agreement with Trafelet Brokaw Capital Management, L.P. (“TBCM”), whereby the Company reimbursed TBCM for use of office space and various administrative and support services. The agreement expired December 31, 2018 and was not extended or renewed. The annual cost of the office and services was approximately $ 618,000 . The Company expensed approximately $ 155,000 , $ 592,000 and $ 564,000 for the fiscal years ended September 30, 2019 , 2018 and 2017, respectively. As of September 30, 2019 and 2018 , the Company had outstanding amounts due of approximately $ 0 and $ 163,000 , respectively. +Capital Contribution +On April 16, 2018, all operating partners of Citree received a funding notice relating to an additional Cash Capital Contribution (“Contribution”) requirement of approximately $ 2,041,000 as a result of Hurricane Irma, which reduced the amount of crop available for sale in the 2017-2018 harvest season and the Company’s adoption of a more extensive caretaking plan focused on limiting the impact of citrus greening. The Company’s portion of the Contribution was approximately $ 1,041,000 and was funded on April 27, 2018. The remaining portion of the Contribution of $ 1,000,000 was funded by the noncontrolling parties. +Distribution of Shares by Alico’s Largest Shareholder +On November 12, 2019, 734 Investors, the Company’s largest shareholder, distributed the 3,173,405 shares of Company common stock held by it, on a pro rata basis, to its members. We understand this share distribution was made in anticipation of the dissolution of 734 Investors later this year. Transfers of these shares are not registered on any current Alico registration statement, but the shares are potentially transferable pursuant to Rule 144, subject to certain customary restrictions. +Note 16. Commitments and Contingencies +Operating Leases +The Company has obligations under various non-cancelable long-term operating leases primarily for office space and equipment. In addition, the Company has various obligations under other equipment leases of less than one year. +Total rent expense was approximately $ 450,000 , $ 1,062,000 and $ 725,000 for the years ended September 30, 2019 , 2018 and 2017, respectively. +76 +The future minimum annual rental payments under non-cancelable operating leases are as follows: +(in thousands) +2020 +$ +191 +2021 +169 +2022 +175 +2023 +15 +Total +$ +550 +Purchase Commitments +The Company enters into contracts for the purchase of citrus trees during the normal course of its business. As of September 30, 2019, the Company had approximately $ 1,603,000 relating to outstanding commitments for these purchases that will be paid upon delivery of the remaining citrus trees. +Letters of Credit +The Company had outstanding standby letters of credit in the total amount of approximately $ 460,000 and $ 10,300,000 at September 30, 2019 and September 30, 2018 , respectively, to secure its various contractual obligations. Upon the completion of the 2018 Post Closing Agreement (and corresponding termination of the 2014 Post Closing Agreement), the Company terminated its $ 9,800,000 standby letter of credit associated with the Global Ag Land Disposition transaction (see Note 8. “Deferred Gain on Sale”). +Legal Proceedings +Florida Litigation +On November 16, 2018, 734 Agriculture, RCF 2014 Legacy LLC, Delta Offshore Master II, LTD. and Mr. Remy W. Trafelet (the “Trafelet Parties”), who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, filed a lawsuit against Messrs. George R. Brokaw, Henry R. Slack, W. Andrew Krusen and Greg Eisner, members of the Board of Directors, in the Circuit Court (the “Circuit Court”) for Hillsborough County, Florida (the “Florida Litigation”). The Trafelet Parties sought, among other things, a declaration that (1) a purported stockholder action by written consent, delivered to the Company in the name of 734 Investors and the plaintiffs in the Florida Litigation on November 11, 2018 (the “Purported Consent”) was valid and binding, (2) the resolutions passed at a meeting of the Board of Directors on November 12, 2018, to, among other things, constitute an ad hoc committee of the Board of Directors to consider, evaluate and make any and all determinations, and to take any and all actions, on behalf of the Board of Directors, in connection with the Purported Consent were null and void and (3) the four defendants in the Florida Litigation were properly removed from the Board of Directors by the Purported Consent. On November 27, 2018, the Circuit Court denied without prejudice plaintiffs’ motion for a temporary restraining order and an affirmative injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. +On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provided, pending the resolution of the Delaware Litigation (as defined below), that (1) the record date for the Purported Consent was stayed indefinitely, and (2) Mr. Trafelet and the Company’s Board of Directors should not take any action out of routine day-to-day operations conducted in the ordinary course of business, including any action to change the corporate governance of Alico or removing any corporate officers or directors from positions held as of November 27, 2018. +On December 6, 2018, the Trafelet Parties filed an amended complaint in the Florida Litigation which added the Company and Benjamin D. Fishman, a member of the Board of Directors, as defendants. On December 21, 2018, the Trafelet Parties filed a renewed motion for a preliminary injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. On January 14, 2019, the defendants in the Florida Litigation filed an opposition to plaintiffs’ renewed motion for a preliminary injunction. On January 18, 2019, the defendants in the Florida Litigation filed a motion to dismiss the plaintiffs’ amended complaint. +On February 11, 2019, the parties to the Florida Litigation entered into a settlement agreement (the “Alico Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Florida Litigation. Pursuant to the Alico Settlement Agreement, +77 +Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and as a member of the Board of Directors, effective upon the execution of the Alico Settlement Agreement. +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into a consulting agreement (the “Consulting Agreement”) with Mr. Trafelet and 3584 Inc., an entity controlled by Mr. Trafelet (the “Consultant”). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $ 400,000 . If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24 -month term. As such, the Company recorded the $ 800,000 as an expense for the fiscal year ended September 30, 2019. +In addition, on February 11, 2019, as contemplated by the Alico Settlement Agreement, the Company entered into a Registration Rights Agreement (the “Registration Rights Agreement”) with Mr. Trafelet, relating to the shares of the Company’s common stock directly held by the Trafelet Parties as of February 11, 2019 (the “Registrable Securities”). The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +Delaware Litigation +On November 20, 2018, members of 734 Investors filed a lawsuit against 734 Agriculture and Mr. Trafelet, who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors in the Delaware Court of Chancery (the "Delaware Court"), captioned Arlon Valencia Holdings v. Trafelet, C.A. No. 2018-0842-JTL (the “Members’ Delaware Litigation”). The plaintiffs sought, among other things, a declaration that (1) 734 Agriculture was validly replaced as the managing member of 734 Investors pursuant to the Amended and Restated Limited Liability Company Operating Agreement of 734 Investors (the “LLC Agreement”) and November 19, 2018 resolution by written consent to remove 734 Agriculture as managing member of 734 Investors, and to designate Arlon Valencia Holdings, LLC as the new managing member of 734 Investors (the “734 Consent”), and (2) the Purported Consent was invalid under the LLC Agreement. +Also, on November 20, 2018, 734 Agriculture filed a lawsuit contesting the 734 Consent in the Delaware Court, captioned 734 Agriculture v. Arlon Valencia Holdings, LLC, C.A. No. 2018-0844-JTL (the “734 Delaware Litigation”). On November 27, 2018, the Delaware Court entered a stipulated order consolidating the Members’ Delaware Litigation and the 734 Delaware Litigation into a single lawsuit, captioned In re 734 Investors, LLC Litigation, Consol. C.A. No. 2018-0844-JTL (the consolidated suit, the “Delaware Litigation”). +On December 5, 2018, the Delaware Court entered a stipulated status quo order which provided, among other things, that 734 Agriculture was to serve as the managing member of 734 Investors during the pendency of the Delaware Litigation. The status quo order also provided that 734 Agriculture would not be permitted to take any actions outside of the ordinary course of business of 734 Investors without the consent of two-thirds of the membership interests of 734 Investors, including exercising any voting rights with respect to any shares of the Company’s common stock beneficially owned by 734 Investors. +On February 11, 2019, Mr. Trafelet, 734 Agriculture, 734 Investors, and certain members of 734 Investors entered into a settlement agreement (the “734 Investors Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Delaware Litigation. Pursuant to the 734 Investors Settlement Agreement, 734 Agriculture resigned as Managing Member of 734 Investors and Arlon Valencia Holdings, LLC was confirmed as Managing Member of 734 Investors. +From time to time, Alico may be involved in litigation relating to claims arising out of its operations in the normal course of business. There are no other current legal proceedings to which the Company is a party or of which any of its property is subject that it believes will have a material adverse effect on its financial position, results of operations or cash flows. +Note 17. Subsequent Event +On December 5, 2019, the Board of Directors of the Company declared a first quarter of fiscal year 2020 cash dividend of $ 0.09 per share on its outstanding common stock to be paid to shareholders of record as of December 27, 2019, with payment expected on January 10, 2020. +78 +Note 18. Selected Quarterly Financial Data (unaudited) +Summarized quarterly financial data for the fiscal years ended September 30, 2019, and 2018 are computed independently each quarter, therefore, the sum of the quarter amounts may not equal the total amount for the respective year due to rounding as follows: +(in thousands, except per share amounts) +Fiscal Quarter Ended +December 31, +March 31, +June 30, +September 30, +2018 +2017 +2019 +2018 +2019 +2018 +2019 +2018 +Total operating revenues +$ +14,779 +$ +17,533 +$ +48,521 +$ +35,600 +$ +57,565 +$ +26,517 +$ +1,386 +$ +1,631 +Total operating expenses +11,597 +16,951 +32,207 +27,767 +31,561 +14,603 +( 13,474 +) +( 3,633 +) +Gross profit +3,182 +582 +16,314 +7,833 +26,004 +11,914 +14,860 +5,264 +General and administrative expenses +3,450 +3,886 +4,654 +3,073 +2,682 +2,955 +4,360 +5,144 +Other (expense) income, net +( 2,864 +) +( 375 +) +( 1,972 +) +( 2,140 +) +( 1,623 +) +5,074 +11,478 +96 +Income (loss) before income taxes +( 3,132 +) +( 3,679 +) +9,688 +2,620 +21,699 +14,033 +21,978 +216 +Income tax (benefit) expense +( 629 +) +( 12,417 +) +2,228 +8,150 +5,483 +4,941 +5,701 +( 284 +) +Net (loss) income +( 2,503 +) +8,738 +7,460 +( 5,530 +) +16,216 +9,092 +16,277 +500 +Net loss attributable to noncontrolling interests +36 +8 +87 +16 +28 +8 +232 +218 +Net income (loss) attributable to Alico Inc. common stockholders +$ +( 2,467 +) +$ +8,746 +$ +7,547 +$ +( 5,514 +) +$ +16,244 +$ +9,100 +$ +16,509 +$ +718 +Earnings per share: +Basic +$ +( 0.33 +) +$ +1.06 +$ +1.01 +$ +( 0.67 +) +$ +2.17 +$ +1.11 +$ +2.21 +$ +0.09 +Diluted +$ +( 0.33 +) +$ +1.05 +$ +1.01 +$ +( 0.67 +) +$ +2.17 +$ +1.09 +$ +2.21 +$ +0.09 +Total operating expenses for the fiscal quarter ended June 30, 2018 include insurance proceeds relating to Hurricane Irma of $ 477,000 for property and casualty damage claims and $ 3,726,000 for crop claims. Total operating expenses for the fiscal quarter ended September 30, 2018 included insurance proceeds relating to the Hurricane Irma of $ 5,226,000 for crop damage claims. Total operating expenses for the fiscal quarter ended September 30, 2019 includes insurance proceeds received of approximately $ 486,000 in additional property and casualty claims reimbursement relating to Hurricane Irma and block grants of approximately $ 15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program relating to Hurricane Irma. General and administrative expenses for the fiscal quarter ended September 30, 2019 include pension expense of $ 935,000 relating to termination of employee benefit plan (see Note 14. “Employee Benefit Plans” for further detail). Other income for the fiscal quarter ended September 30, 2019 includes a gain on sale of assets of approximately $ 13,166,000 (see Note 3. “Inventories”, Note 4. “Assets Held For Sale” and Note 5. “Property and Equipment, Net” for further information). +79 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedures +(a) +Evaluation of Disclosure Controls and Procedures. +Our Principal Executive Officer and Chief Financial Officer have evaluated the effectiveness of the our disclosure controls and procedures as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) as of the end of the period covered by this report. Based on this evaluation, our Principal Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective. +(b) +Changes in Internal Control over Financial Reporting. +During the fourth fiscal quarter ended September 30, 2019, there were no changes in our internal controls over financial reporting that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting. +(c) +Management Report on Internal Control Over Financial Reporting +Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that: +(i) +pertain to the maintenance of records, that in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(ii) +provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(iii) +provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Management assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2019. In making this assessment, management used the criteria described in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). +Based on our assessment and those criteria, management concluded that our internal control over financial reporting was effective as of September 30, 2019. Management reviewed the results of their assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of September 30, 2019 has been audited by RSM US LLP, an independent registered public accounting firm, as stated in their attestation report which is included herein. +Item 9B. Other Information +Item 5.02 Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; +Compensatory Arrangements of Certain Officers. +(e) +On December 2, 2019, the Company entered into a new employment agreement (the “Rallo Employment Agreement”) with Richard Rallo. Mr. Rallo serves as Chief Financial Officer of the Company. The Rallo Employment Agreement provides for an annual base salary of $275,000. Mr. Rallo is eligible for an annual incentive compensation award with an annual target opportunity in an amount equal to 40% of his annual base salary. +The Rallo Employment Agreement also provides that, if Mr. Rallo’s employment is terminated by the Company without “cause” or Mr. Rallo resigns with “good reason” (as each such term is defined in the Rallo Employment Agreement), then, subject to his +80 +execution, delivery, and non-revocation of a general release of claims in favor of the Company, Mr. Rallo will be entitled to (i) cash severance in an amount equal to 12 months of the annual base salary, (ii) the Accrued Obligations (as defined in the Rallo Employment Agreement) in a cash lump sum within 30 days after the date of termination, (iii) any rights or payments that are vested benefits or that Mr. Rallo is otherwise entitled to receive at or subsequent to the date of termination under any employee benefit plan or any other contract or agreement with the Company, and (iv) any Annual Bonus (as defined in the Rallo Employment Agreement) that has been earned but not paid as of the date of termination. +The Rallo Employment Agreement includes various restrictive covenants in favor of the Company, including a confidentiality covenant, a non-disparagement covenant, and 12-month post-termination noncompetition and customer and employee non-solicitation covenants. +In addition to his position as Chief Financial Officer, Mr. Rallo retains his position as the Company’s Principal Accounting Officer. +The foregoing description of the Rallo Employment Agreement does not purport to be complete and is qualified in its entirety by reference to the complete text of the Rallo Employment agreement, which is attached hereto as Exhibit 10.37 to this Annual Report on Form 10-K and is incorporated herein by reference. +81 +PART III +Certain information required by Part III is omitted from this Annual Report on Form 10-K because we will file a definitive Proxy Statement for the 2020 Annual Meeting of Stockholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, (the “Proxy Statement”), not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and the applicable information included in the Proxy Statement is incorporated herein by reference. +Item 10. Directors, Executive Officers and Corporate Governance +Information concerning our directors and nominees and other information as required by this item are hereby incorporated by reference from our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Code of Ethics +We have adopted a Code of Business Conduct and Ethics that is intended to serve as a code of ethics for purposes of Item 406 of Regulation S-K. Our Code of Business Conduct and Ethics is posed on our website http://www.alicoinc.com (at the Investor homepage under "Corporate Governance") and we intend to disclose on our website any amendments to, or waiver from, such code. +Item 11. Executive Compensation +The information required by Item 11 regarding executive compensation is included under the headings “Compensation Discussion and Analysis,” “Compensation Committee Report” and “Compensation Committee Interlocks and Insider Participation” in our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +Information concerning the ownership of certain beneficial owners and management and related stockholder matters is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Equity Compensation Arrangements +Effective January 27, 2015, the Board of Directors adopted the 2015 Stock Incentive Plan (the “2015 Plan”) which provides for up to 1,250,000 shares of the Company’s common stock to be available for issuance to provide a long-term incentive plan for officers, employees, directors and/or consultants to directly link incentives to stockholders' value. The 2015 Plan was approved by stockholders in February 2015. +The following table illustrates the common shares remaining available for future issuance under the 2015 Plan as of September +30, 2019: +Number of securities to +be issued upon exercise +of outstanding options, +warrants and rights +Weighted-average +exercise price of +outstanding options, +warrants and rights +Number of securities +remaining available for +future issuance under +equity plans +Plan Category: +Equity compensation plans approved by security holders +227,500 +$ +31.46 +1,005,000 +Equity compensation plans not approved by security holders +— +N/A +— +Total +227,500 +$ +31.46 +1,005,000 +In November 2017, the Company awarded 5,000 restricted shares to one senior executive under the 2015 Plan. +In September 2018, the Company awarded 300,000 stock options to two senior executives under the 2015 Plan. Additionally, in September 2018, two other senior executives forfeited an aggregate of 375,000 stock options, which were originally issued under the 2015 Plan and no replacement options were granted. +In October 2018, the Company awarded 10,000 stock options to one senior executive under the 2015 Plan. +82 +In February 2019, pursuant to a settlement agreement, a senior executive of the Company forfeited an aggregate of 457,500 stock options, which were originally issued under the 2015 Plan and no replacement options were granted. +Item 13. Certain Relationships and Related Transactions and Director Independence +The information concerning relationships and related transactions is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 14. Principal Accountants Fees and Services +Information concerning principal accounting fees and services is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +83 +PART IV +Item 15. Exhibits, Financial Statement Schedules +(a) +Documents filed as part of this report +(1) +Financial Statements: +Our Consolidated Financial Statements are included in Part II, Item 8 of this Annual Report on Form 10-K. +(2) +Financial Statement Schedules: +Financial statement schedules are omitted as the required information is either inapplicable or the information is presented in our Consolidated Financial Statements or notes thereto. +(3) +Exhibits +The exhibits listed in the Exhibit Index in (b) below are filed or incorporated by reference as part of this Annual Report on Form 10-K. +(b) +Exhibit Index +Item 16. Form 10-K Summary +Not applicable. +Exhibit +Number +Exhibit Index +2.1 +*** +Asset Purchase Agreement, dated as of December 1, 2014, by and among Alico, Inc., Orange-Co, LP, and, solely with respect to certain sections thereof, Orange-Co, LLC and Tamiami Citrus, LLC. (incorporated by reference to Exhibit 2.1 of Alico’s filing on Form 8-K dated December 5, 2014) +2.2 +*** +Agreement and Plan of Merger, dated as of December 2, 2014, by and among Alico, Inc., 734 Sub, LLC, 734 Citrus Holdings, LLC, and, solely with respect to certain sections thereof, 734 Agriculture, LLC, Rio Verde Ventures, LLC and Clayton G. Wilson (incorporated by reference to Exhibit 2.2 of Alico’s filing on Form 8-K dated December 5, 2014) +3.1 +Restated Certificate of Incorporation, dated February 17, 1972 (incorporated by reference to Exhibit 3.1 of Alico's filing on Form 10-K dated December 11, 2017) +3.2 +Certificate of Amendment to Certificate of Incorporation, dated January 14, 1974 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.3 +Amendment to Articles of Incorporation, dated January 14, 1987 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.4 +Amendment to Articles of Incorporation, dated December 27, 1988 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.5 +By-Laws of Alico, Inc., amended and restated (incorporated by reference to Exhibit 3.5 of the Company’s quarterly report on Form 10-Q, filed with the SEC on August 6, 2019) +10.1 +Credit Agreement dated as of December 1, 2014, by and between Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, L.L.C., Alico Land Development, Inc., and Alico Citrus Nursery, L.L.C., as Borrowers and Rabo Agrifinance, Inc., as Lender (incorporated by reference to Exhibit 10.2 of Alico's filing on Form 8-K dated December 5, 2014) +84 +10.2 +Purchase and Sale Agreement dated August 7, 2014 (incorporated by reference to Exhibit 10.10 of Alico’s filing on Form 10-K dated December 12, 2014) +10.3 +* +Form of Indemnification Agreement (incorporated by reference to Exhibit 10.5 of the Company’s quarterly report on Form 10-Q filed with the SEC on May 6, 2013) +10.4 +* +Management Security Plan(s) Trust Agreement (incorporated by reference to Exhibit 10.6 of the Company’s quarterly report on Form 10-Q filed with the SEC on May 6, 2013) +10.5 +Agricultural Lease Agreement dated May 19, 2014 between Alico, Inc. and United States Sugar Corporation. (incorporated by reference to Exhibit 10.1 of the Company’s quarterly report on Form 10-Q filed with the SEC on August 11, 2014) +10.6 +*** +First Amended and Restated Credit Agreement, dated as of December 1, 2014, by and among Alico, Inc., Alico Land Development, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Metropolitan Life Insurance Company, and New England Life Insurance Company (incorporated by reference to Exhibit 10.1 of Alico’s filing on Form 8-K dated December 5, 2014) +10.7 +*** +Credit Agreement dated as of December 1, 2014, by and between Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development, Inc., and Alico Citrus Nursery, LLC, as Borrowers and Rabo Agrifinance, Inc., as Lender (incorporated by reference to Exhibit 10.2 of Alico’s filing on Form 8-K dated December 5, 2014) +10.8 +Shared Services Agreement by and between Alico, Inc. and Trafelet Brokaw Capital Management, L.P. dated July 23, 2018 (incorporated by reference to Exhibit 10.1 of Alico's filing on Form 10-Q dated August 6, 2018) +10.9 +Loan Agreement, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (the "Prudential Loan Agreement") (incorporated by reference to Exhibit 10.16 of Alico’s filing on Form 10-K dated December 10, 2015) +10.10 +Promissory Note A, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.17 of Alico’s filing on Form 10-K dated December 10, 2015) +10.11 +Promissory Note B, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.18 of Alico’s filing on Form 10-K dated December 10, 2015) +10.12 +Promissory Note C, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.19 of Alico’s filing on Form 10-K dated December 10, 2015) +10.13 +First Amendment to Loan Agreement, dated March 26, 2013 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.20 of Alico’s filing on Form 10-K dated December 10, 2015) +10.14 +Promissory Note D, dated March 26, 2013, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.21 of Alico’s filing on Form 10-K dated December 10, 2015) +10.15 +Loan Agreement, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC ("Loan E and F") (incorporated by reference to Exhibit 10.22 of Alico’s filing on Form 10-K dated December 10, 2015) +10.16 +Promissory Note E, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.23 of Alico’s filing on Form 10-K dated December 10, 2015) +10.17 +Promissory Note F, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.24 of Alico’s filing on Form 10-K dated December 10, 2015) +10.18 +First Amendment to Loan Agreement, dated April 23, 2015 (Loan E and F) (incorporated by reference to Exhibit 10.25 of Alico’s filing on Form 10-K dated December 10, 2015) +10.19 +Second Amendment to the Loan Agreement, dated September 4, 2014 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.26 of Alico’s filing on Form 10-K dated December 10, 2015) +85 +10.20 +Third Amendment to the Loan Agreement, dated April 23, 2015 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.27 of Alico’s filing on Form 10-K dated December 10, 2015) +10.21 +Cancellation and Termination of Note D, dated April 23, 2015, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.28 of Alico’s filing on Form 10-K dated December 10, 2015) +10.22 +First Amendment to Credit Agreement and Consent with Rabo Agrifinance, Inc. dated February 26, 2015 (incorporated by reference to Exhibit 10.29 of Alico’s filing on Form 10-K dated December 10, 2015) +10.23 +Second Amendment to Credit Agreement with Rabo Agrifinance, Inc. dated July 16, 2015 (incorporated by reference to Exhibit 10.30 of Alico’s filing on Form 10-K dated December 10, 2015) +10.24 +Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company, dated February 1, 2015 (incorporated by reference to Exhibit 10.31 of Alico’s filing on Form 10-K dated December 10, 2015) +10.25 +Second Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated August 12, 2015 (incorporated by reference to Exhibit 10.32 of Alico’s filing on Form 10-K dated December 10, 2015) +10.26*** +Third Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated November 4, 2019 +10.27 +Fourth Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated October 2, 2019 +10.28 +Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 30, 2016 (incorporated by reference to Exhibit 10.34 of Alico's filing on Form 10-K dated December 6, 2016) +10.29 +Second Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 6, 2017 (incorporated by reference to Exhibit 10.39 of Alico's filing on Form 10-K dated December 11, 2017) +10.30 +Third Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 26, 2018 (incorporated by reference to Exhibit 10.40 of Alico’s filing on Form 10-K dated December 6, 2018) +10.31* +Employment Agreement dated June 1, 2015 between Alico, Inc. and John Kiernan (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the SEC on June 1, 2015) +10.32* +Separation and Consulting Agreement dated December 31, 2016 between Alico, Inc. and Clayton G. Wilson (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.33* +Employment Agreement dated December 31, 2016 between Alico, Inc. and Remy W. Trafelet (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.34* +Employment Agreement dated December 31, 2016 between Alico, Inc. and Henry R. Slack (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.35* +Employment Agreement dated March 27, 2013 between Alico, Inc. and George R. Brokaw (incorporated by reference to Exhibit 10.4 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.36* +Offer of Employment Letter dated June 16, 2017 between Richard Rallo and Alico, Inc. (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the SEC on August 7, 2017) +10.37* +Employment Agreement dated December 2, 2019 between Alico, Inc. and Richard Rallo +10.38 +Supplement No. 1 dated as of September 30, 2016, to the Security Agreement dated as of December 1, 2014 by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) (incorporated by reference to Exhibit 10.35 of Alico's filing on Form 10-K dated December 6, 2016) +86 +10.39 +Third Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 30, 2016 (incorporated by reference to Exhibit 10.33 of Alico's filing on Form 10-K dated December 6, 2016) +10.40 +Fourth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 6, 2017 (incorporated by reference to Exhibit 10.38 of Alico's filing on Form 10-K dated December 11, 2017) +10.41 +Fifth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated October 30, 2017 (incorporated by reference to Exhibit 10.37 of Alico’s filing on Form 10-K dated December 6, 2018) +10.42 +Sixth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated July 18, 2018 (incorporated by reference to Exhibit 10.38 of Alico’s filing on Form 10-K dated December 6, 2018) +10.43 +Seventh Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 26, 2018 (incorporated by reference to Exhibit 10.39 of Alico’s filing on Form 10-K dated December 6, 2018) +10.44 +Eighth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated August 29, 2019 +10.45 +Settlement Agreement and Release, dated as of February 11, 2019, by and among Alico, Inc., George R. Brokaw, R. Greg Eisner, Benjamin D. Fishman, W. Andrew Krusen, Henry R. Slack, Remy W. Trafelet , 734 Agriculture, LLC, RCF 2014 Legacy LLC and Delta Offshore Master II, LTD (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 11, 2019.) +10.46 +Registration Rights Agreement, dated as of February 11, 2019, by and between Alico, Inc. and Remy W. Trafelet (incorporated by reference from Exhibit C to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 11, 2019). +10.47 +Consulting Agreement, dated as of February 11, 2019, by and among Alico, Inc., 3584 Inc., and Remy W. Trafelet (incorporated by reference from Exhibit B to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 11, 2019). +10.48 +* +Alico, Inc. Stock Incentive Plan of 2015 (incorporated by reference from Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the SEC on January 28, 2015). +21.0 +Subsidiaries of the Registrant +23.0 +Consent of Independent Registered Public Accounting Firm +31.1 +Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Rule 13a-14(a) certification +31.2 +Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Rule 13a-14(a) certification +32.1 +Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 +32.2 +Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 +101 +101.INS +** +XBRL Instance Document +101.SCH +** +XBRL Taxonomy Extension Schema Document +101.CAL +** +XBRL Taxonomy Calculation Linkbase Document +101.DEF +** +XBRL Taxonomy Definition Linkbase Document +101.LAB +XBRL Taxonomy Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* +Denotes a management contract or compensatory plan, contract or arrangement. +87 +** +In accordance with Rule 406T of Regulation S-T, these XBRL (eXtensible Business Reporting Language) documents are furnished and not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability under these sections. +*** +Certain schedules and exhibits have been omitted from this filing pursuant to Item 601(b) (2) of Regulation S-K. The Company will furnish supplemental copies of any such schedules or exhibits to the SEC upon request. +88 +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ALICO, INC. (Registrant) +December 5, 2019 +By: +/s/ John E. Kiernan +John E. Kiernan +President and Chief Executive Officer (Principal Executive Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated: +December 5, 2019 +President and Chief Executive Officer (Principal Executive Officer) +/s/ John E. Kiernan +John E. Kiernan +December 5, 2019 +Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) +/s/ Richard Rallo +Richard Rallo +December 5, 2019 +Director: Executive Chairman +/s/ Benjamin D. Fishman +Benjamin D. Fishman +December 5, 2019 +Director +/s/ George R. Brokaw +George R. Brokaw +December 5, 2019 +Director +/s/ R. Greg Eisner +R. Greg Eisner +December 5, 2019 +Director +/s/ Henry R. Slack +Henry R. Slack +December 5, 2019 +Director +/s/ W. Andrew Krusen +W. Andrew Krusen +December 5, 2019 +Director +/s/ Toby K. Purse +Toby K. Purse +89 \ No newline at end of file diff --git a/raw/filings/0000003545/2019/0000003545-19-000143/filing_metadata.csv b/raw/filings/0000003545/2019/0000003545-19-000143/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..7435ec35966523385acbb2efbba1fd17b81e7b58 --- /dev/null +++ b/raw/filings/0000003545/2019/0000003545-19-000143/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003545,ALCO,"ALICO, INC.",2019,10-K,2019-12-05,2019-09-30,2019-12-05T21:48:28.000Z,0000003545-19-000143,alco-93019x10k.htm,10-K,13804660,1,1,https://www.sec.gov/Archives/edgar/data/3545/000000354519000143/alco-93019x10k.htm,https://www.sec.gov/Archives/edgar/data/3545/000000354519000143/ diff --git a/raw/filings/0000003545/2019/0000003545-19-000143/item1.txt b/raw/filings/0000003545/2019/0000003545-19-000143/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..81e65da147e5eae285256747f6d37d921c2cba1b --- /dev/null +++ b/raw/filings/0000003545/2019/0000003545-19-000143/item1.txt @@ -0,0 +1,199 @@ +Item 1. Business +Alico, Inc. (“Alico”) was incorporated under the laws of the state of Florida in 1960. Collectively with its subsidiaries (the "Company", "we", "us" or "our"), our business and operations are described below. For detailed financial information with respect to our business and our operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included in Item 7 in this Annual Report on Form 10-K, and the accompanying Consolidated Financial Statements and the related Notes, which are included in Item 8. In addition, general information concerning our Company can be found on our website, the internet address of which is http://www.alicoinc.com . All of our filings with the U.S. Securities and Exchange Commission (the "SEC") including, but not limited to, the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are available free of charge on our website as soon as reasonably practicable after such material is electronically filed or furnished with the SEC. Our recent press releases and information regarding corporate governance, including the charters of our audit, compensation, executive and nominating governance committees, as well as our code of business conduct and ethics are also available to be viewed or downloaded electronically at http://www.alicoinc.com . Unless explicitly stated herein, the information on our website is not incorporated by reference into this Annual Report on Form 10-K and the Company disclaims any such incorporation by reference. +Overview +Alico is an agribusiness with a legacy of achievement and innovation in citrus and conservation. The Company owns approximately 111,000 acres of land in eight Florida counties (Charlotte, Collier, DeSoto, Glades, Hardee, Hendry, Highlands and Polk) including approximately 90,000 acres of mineral rights. Our principal lines of business are citrus groves and conservation. +Alico is one of the largest citrus producers in the United States of America. +Alico, Inc. operates two divisions: Alico Citrus, a citrus producer, and Water Resources and Other Operations, a leading water storage and environmental services division. +The Company manages its land based upon its primary usage and reviews its performance based upon two primary classifications - Alico Citrus and Water Resources and Other Operations. Other Operations includes a lease for grazing rights, hunting leases, a lease to a third party of an aggregate mine and leases of oil extraction rights to third parties, farm lease revenue and rental income for office space. Alico presents its financial results and the related discussion based upon its two business segments: (i) Alico Citrus and (ii) Water Resources and Other Operations. +Recent Developments +Alico 2.0 Modernization Program +On November 16, 2017, we announced the Alico 2.0 Modernization Program (“Alico 2.0”). This program was intended to transform three legacy businesses (Alico, Orange Co., and Silver Nip) into a single efficient enterprise, Alico Citrus, so we would remain one of the leaders in the U.S. citrus industry. This initiative was to explore every aspect of Alico’s citrus and ranch operations, including corporate and operational cost structures, grove costs, purchasing and procurement, non-performing and under-performing assets, professional fees, and human resources efficiency. +Under this program, Alico expected to reduce its operating costs. Alico has executed on the efficiencies identified and has improved margins through better purchasing, more precise application of selected fertilizers and chemicals, outsourcing work such as harvesting, hauling, and certain caretaking tasks, and by streamlining grove management. We have also deployed a more efficient labor model that is consistent and uniform for field staffing and grove operations and is aligned with the geographical footprint of the citrus groves. This effort has helped to transition us to a high-quality, low-cost producer of citrus now and for future years to come. +In combination with these efforts, the Company worked to maintain operational efficiencies and deploy its resources to solidify the Company's position as a leader in the recovering citrus industry. +Under Alico 2.0, we also decided to divest assets that generated low rates of return and shut down parts of our operations that were not profitable. As a result of Alico 2.0, Alico has generated cash of approximately $57,800,000 through September 30, 2019 from asset sales. This has been facilitated through (i) the sale of its nursery in Gainesville, Florida, (ii) the sale of certain +1 +underperforming groves, (ii) the sale of its breeding herd, (iv) the sale of certain parcels of land on its Ranch, (v) the sale of certain trailers related to our logistics division, and (vi) the sale of certain real estate assets that were not strategic to our business plan. +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third party operator. However, the Company continues to own the property and continues to conduct its long-term dispersed water program and wildlife management programs. +Alico 2.0 also included an enhanced program to plant more citrus trees. The Company planted over 400,000 trees in both the fiscal years ended September 30, 2019 and 2018 to help position the Company for future production growth. +Tender Offer +On September 5, 2018, the Board of Directors approved and Alico announced the commencement of an issuer offer (the “Tender Offer”) to purchase up to $19,999,990 in value of shares of its common stock at a purchase price of $34.00 per share. On October 3, 2018, upon the terms and subject to the conditions described in the Offer to Purchase dated September 5, 2018, Alico repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. Included in the 752,234 shares were 163,999 shares that the Company elected to purchase pursuant to its right to purchase up to an additional 2% of its outstanding shares of common stock. 734 Investors, LLC, (“734 Investors”) Alico’s largest stockholder from 2013 until November 12, 2019, participated in the Tender Offer by selling a small percentage of its holdings of the Company’s common stock. Members of neither the management team nor the Board of Directors sold any shares directly to the Tender Offer. +Termination Proceedings against Mr. Remy W. Trafelet +On November 19, 2018, Alico, with unanimous approval of the members of the Board of Directors, other than Remy W. Trafelet, notified Mr. Trafelet, who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, that it intended to consider terminating his employment for “cause” pursuant to the terms of his employment agreement with the Company and option agreements entered into under the Company's Stock Incentive Plan of 2015 (collectively, the “Compensation Documents”). On November 28, 2018, the parties in the Florida Litigation (as defined below) stipulated to an order which provided, among other things, that pending the resolution of the Delaware Litigation (as defined below), the Board of Directors would not take any action out of the routine day-to-day operations conducted in the ordinary course of business, including removing any corporate officers or directors from positions held as of November 27, 2018. +As described in “Note 16. Commitments and Contingencies” to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K, the parties to the Florida Litigation entered into the Alico Settlement Agreement wherein the parties agreed to promptly dismiss all claims in the Florida Litigation, including those related to the termination proceedings against Mr. Trafelet, and Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and a member of the Company’s Board of Directors, effective upon the execution of the Alico Settlement Agreement. +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into the Consulting Agreement with Mr. Trafelet and 3584, Inc. (the "Consultant"). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $400,000. If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24-month term. +In addition, as contemplated by the Alico Settlement Agreement, the Company entered into the Registration Rights Agreement with Mr. Trafelet, relating to the Registrable Securities. The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +Management and Board Changes +On April 11, 2019, the Board of Directors announced the appointment of Mr. John E. Kiernan as President and Chief Executive Officer and Mr. Richard Rallo as Chief Financial Officer, both effective July 1, 2019. Additionally, Mr. Benjamin D. Fishman, the Company’s current Interim President, agreed to resign from this position effective July 1, 2019. In addition, on April 11, 2019, Mr. Henry A. Slack, the current Executive Chairman of the Board, informed the Board that he agreed to step down as Executive +2 +Chairman of the Board, effective July 1, 2019. Mr. Slack’s decision to step down as Executive Chairman of the Board was not the result of any disagreement with the Company on any matter relating to the Company’s operations, policies or practices. Mr. Slack will remain a member of the Board of Directors. The Board appointed Mr. Benjamin D. Fishman, the Company’s current Interim President, to the role of non-employee Executive Chairman of the Board, effective July 1, 2019. +On April 29, 2019, the Board of Directors appointed Mr. Toby K. Purse as a member of the Board of Directors, to serve until the 2020 annual meeting of the Company’s shareholders or until his earlier death, resignation, or removal in accordance with the Amended and Restated Bylaws of the Company. The Board of Directors has affirmatively determined that Mr. Purse qualifies as an independent director under the rules of the Nasdaq Stock Exchange and as defined under applicable law. Mr. Purse has also been appointed to serve as a member of the audit committee of the Board of Directors. +Federal Relief Program +The Company is eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fourth quarter of fiscal year 2019 and for the fiscal year ended September 30, 2019, the Company received approximately $15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and a portion of the Part 2 reimbursement under the three-part program. Subsequent to fiscal year end 2019, the Company received additional proceeds of approximately $4,136,000 under the Florida CRBG program. This represents another portion of the Part 2 reimbursement under the three-part program. The timing and amount to be received under the remaining portion of the Part 2 and the Part 3 of the program, if any, has not been finalized. +Distribution of Shares by 734 Investors +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +The Land We Manage +We regularly review our land holdings to determine the best use of each parcel based upon our management expertise. Our total return profile is a combination of operating income potential and long-term appreciation. Land holdings not meeting our total return criteria are considered surplus to our operations and will be sold or exchanged for land considered to be more compatible with our business objectives and total return profile. +Our land holdings and the operating activities in which we engage are categorized in the following table: +Gross Acreage +Operating Activities +Alico Citrus +Citrus Groves +45,151 +Citrus Cultivation +Citrus Nursery +22 +Citrus Tree Development +45,173 +Water Resources and Other Operations +Ranch +64,782 +Leasing and Conservation +Other Land +1,446 +Mining Lease and Office +66,228 +Total +111,401 +Alico Citrus +We own and manage citrus land in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties and engage in the cultivation of citrus trees to produce citrus for delivery to the fresh and processed citrus markets. Alico citrus groves total approximately 45,173 gross acres or 40.5% of our land holdings. +3 +Our citrus acreage is detailed in the following table: +Net Plantable +Producing +Developing +Fallow +Total Plantable +Support & Other +Gross +DeSoto County +15,180 +1,096 +482 +16,758 +4,650 +21,408 +Polk County +4,545 +— +— +4,545 +2,228 +6,773 +Collier County +4,261 +— +— +4,261 +2,905 +7,166 +Hendry County +3,546 +57 +175 +3,778 +1,707 +5,485 +Charlotte County +1,729 +— +138 +1,867 +676 +2,543 +Highlands County +1,063 +— +— +1,063 +161 +1,224 +Hardee County +403 +— +— +403 +171 +574 +Total +30,727 +1,153 +795 +32,675 +12,498 +45,173 +Of the 45,173 gross acres of citrus land we own and manage, approximately 12,498 acres are classified as support and other acreage. Support and other acreage includes acres used for roads, barns, water detention, water retention and drainage ditches integral to the cultivation of citrus trees, but which are not capable of directly producing fruit. In addition, we own a small citrus tree nursery and utilize the trees produced in our own operations. The 32,675 remaining acres are classified as net plantable acres. Net plantable acres are those that are capable of directly producing fruit. These include acres that are currently producing, acres that are developing (acres that are planted with trees too young to commercially produce fruit) and acres that are fallow. +Our Alico Citrus business segment cultivates citrus trees to produce citrus for delivery to the processed and fresh citrus markets. Our sales to the processed market were approximately 95.0%, 93.7% and 91.7% of Alico Citrus revenues for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. We produce Early and Mid-Season varieties, primarily Hamlin oranges, as well as a Valencia variety for the processed market. We deliver our fruit to the processors in boxes which each contains approximately 90 pounds of oranges. Because the processors convert the majority of the citrus crop into orange juice, they generally do not buy their citrus on a per box basis, but rather on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of citrus fruit. We produced approximately 46,727,000, 26,513,000 and 42,611,000 pound solids for the fiscal years ended September 30, 2019, 2018 and 2017, respectively, from boxes delivered to processing plants of approximately 7,904,000, 4,702,000 and 7,259,000, respectively. As previously indicated, the falloff in fiscal year 2018 was mostly attributable to the impact of Hurricane Irma. +The average pound solids per box was 5.91, 5.64 and 5.87 for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +We generally use multi-year contracts with citrus processors that include pricing structures based on a minimum (“floor”) price with a price increase (“rise”) based on market conditions. Therefore, if pricing in the market is favorable relative to our floor price, we benefit from the incremental difference between the floor and the final market price. +Our citrus produced for the processed citrus market in fiscal year 2019-2020 under our largest agreement is subject to minimum floor price ranging from $2.05 to $2.15 per pound solid and rise price from $2.50 to $2.65 per pound solid. Under this agreement, if the market price is below the floor prices or exceeds the rise prices, then 50% of the shortfall or excess will be deducted from the floor price or added to the rise price. Under our next largest agreement, our citrus produced is subject to a minimum floor price of $2.60 per pound solid and rise price of $3.00 per pound solid. We believe that other markets are available for our citrus products; however, new arrangements may be less favorable than our current contracts. +Our sales to the fresh citrus market constituted approximately 3.0%, 2.6% and 4.6% of our Alico Citrus revenues for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. We produce numerous varieties for the fresh fruit market including grapefruit, navel and other fresh varieties. Generally, our fresh fruit is sold to packing houses by the box and the packing houses are responsible for the harvest and haul of these boxes. We produced approximately 210,000, 125,000 and 328,000 fresh fruit boxes for each of the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +Revenues from our Alico Citrus operations were approximately 97.4%, 96.1% and 95.1% of our total operating revenues for each of the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +4 +Water Resources and Other Operations +We own and manage land in Collier, Glades, and Hendry Counties and are engaged in land leasing for recreational and grazing purposes, conservation, and mining activities. Our Water Resources and Other Operations land holdings total 66,228 gross acres, or 59.5% of our total acreage. +Our Water Resources and Other Operations acreage is detailed in the following table as of September 30, 2019: +Acreage +Hendry County +61,680 +Glades County +526 +Collier County +4,022 +Total +66,228 +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third party operator. The Company continues to own the property and conduct its long-term dispersed water program and wildlife management programs. As part of the sales transaction, the Company expensed all cattle inventory costs that were accumulated at the date of sale. +In fiscal year 2017, our cattle operation was engaged in the production of beef cattle in Hendry and Collier Counties. The breeding herd consisted of approximately 8,700 cows and bulls. We primarily sold our calves to feed yards and yearling grazing operations in the United States. We also sold cattle through local livestock auction markets and to contract cattle buyers in the United States. These buyers provided ready markets for our cattle. Revenues from Water Resources and Other Operations were approximately 2.6%, 3.9% and 4.9% of total operating revenues for each of the fiscal years ended September 30, 2019, 2018 and 2017, respectively. +Our Strategy +Our core business strategy is to maximize stockholder value through continuously improving the return on our invested capital, either by holding and managing our existing land through skilled agricultural production, leasing, or other opportunistic means of monetization, disposing of under productive land or business units and acquiring new land or operations with appreciation potential. +Our objectives are to produce the highest quality agricultural products, create innovative land uses, opportunistically acquire and convert undervalued assets, sell under-productive land and other assets not meeting our total return profile, generate recurring and sustainable profit with the appropriate balance of risk and reward, and exceed the expectations of stockholders, customers, clients and partners. +Our strategy is based on best management practices of our agricultural operations and the environmental and conservation stewardship of our land and natural resources. We manage our land in a sustainable manner and evaluate the effect of changing land uses while considering new opportunities. Our commitment to environmental stewardship is fundamental to the Company’s core beliefs. +Seasonal Nature of Business +As with any agribusiness enterprise, our agribusiness operations and revenues are predominantly seasonal in nature. The following table illustrates the seasonality of our agribusiness revenues: +Fiscal Year +Q1 +Q2 +Q3 +Q4 +Ending 12/31 +Ending 3/31 +Ending 6/30 +Ending 9/30 +Oct +Nov +Dec +Jan +Feb +Mar +Apr +May +Jun +Jul +Aug +Sept +Harvest Fresh and Early/Mid Varieties of Oranges +Harvest Valencia Oranges +5 +Significant Customers +Revenue from Tropicana represented approximately 89%, 87% and 86% of our consolidated revenue for the fiscal years ended September 30, 2019, 2018 and 2017, respectively. The revenue in fiscal year 2019 from Tropicana was generated primarily from two separate contracts. This revenue was generated from the sale of our citrus product in the processed market. No other single customer provided more than 10% of our consolidated revenue in fiscal year 2019, 2018 or 2017. +Competition +The orange and specialty citrus markets are intensely competitive, but no single producer has any significant market power over any market segments, as is consistent with the production of most agricultural commodities. Citrus is grown domestically in several states including Florida, California, Arizona and Texas, as well as foreign countries, most notably Brazil. Competition is impacted by several factors including quality, production, demand, brand recognition, market prices, weather, disease, export/import restrictions and foreign currency exchange rates. +Environmental Regulations +Our operations are subject to various federal, state and local laws regulating the discharge of materials into the environment. Management believes we are in compliance with all such rules including permitting and reporting requirements. Historically, compliance with environmental regulations has not had a material impact on our financial position, results of operations or cash flows. +Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. In addition, we require lessees of our property to comply with environmental regulations as a condition of leasing. +Employees +As of September 30, 2019, we had 235 full-time employees. Our employees work in the following divisions: +Alico Citrus +214 +Water Resources and Other Operations +0 +Corporate, General, Administrative and Other +21 +Total employees +235 +None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good. +Capital Resources and Raw Materials +Management believes that the Company will be able to meet its working capital requirements for at least the next 12 months, and over the long term, through internally generated funds, cash flows from operations, the sale of under-productive land and other assets, our existing lines of credit and access to capital markets. The Company has commitments that provide for lines of revolving credit that are available for our general and corporate use. +Raw materials needed to cultivate the various crops grown by the Company consist primarily of fertilizers, herbicides, insecticides and fuel and are readily available from local suppliers. +Available Information +We will provide electronic copies of our SEC filings free of charge upon request. Additionally, our reports, amendments thereto, proxy statements and other information are also made available, free of charge, on our investor relations website at ir.alicoinc.com as soon as reasonably practicable after we electronically file or furnish such information with the SEC. Any information posted on or linked from our website is not incorporated by reference in this Annual Report on Form 10-K. The SEC also maintains a website at http://www.sec.gov , which contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. +6 \ No newline at end of file diff --git a/raw/filings/0000003545/2019/0000003545-19-000143/item13.txt b/raw/filings/0000003545/2019/0000003545-19-000143/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..f160f06b1a102cbad2b6c9b2e26d62a5674f5fe8 --- /dev/null +++ b/raw/filings/0000003545/2019/0000003545-19-000143/item13.txt @@ -0,0 +1,2 @@ +Item 13. 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Exchange Act of 1934 +For the Fiscal Year Ended September 30, 2020 +or +☐ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 +For the transition period +from ____________________to_________________________ +Commission File Number: 0-261 +ALICO, INC. +( Exact name of registrant as specified in its charter ) +Florida +59-0906081 +( State or other jurisdiction of +incorporation or organization ) +( I.R.S. Employer Identification No. ) +10070 Daniels Interstate Court +Suite 100 Fort Myers FL +33913 +(Address of principal executive offices) +(Zip Code) +( 239 ) 226-2000 +(Registrant’s telephone number, including area code ) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol(s) +Name of each exchange on which registered +Common Stock +ALCO +NASDAQ Global Select Market +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +☐ Yes ☑ No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +☐ Yes ☑ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☑ Yes ☐ No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☑ Yes ☐ No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one): +Large Accelerated Filer +☐ +Accelerated Filer +☑ +Non-accelerated filer +☐ +Smaller Reporting Company +☐ +Emerging Growth Company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☑ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑ +The aggregate market value of the voting and nonvoting common equity held by non-affiliates based on the closing price, as quoted on the Nasdaq Global Select Market as of March 31, 2020 (the last business day of Alico’s most recently completed second fiscal quarter) was $ 162,656,988 . Solely for the purposes of this calculation, the registrant has elected to treat all executives, officers and greater than 10% stockholders as affiliates of the registrant. There were 7,506,160 shares of common stock outstanding at December 4, 2020. +Documents Incorporated by Reference: +Portions of the Proxy Statement of Registrant for the 2021 Annual Meeting of Shareholders (to be filed with the SEC under Regulation 14A within 120 days after the end of the Registrant's fiscal year), are incorporated by reference in Part III of this report. +ALICO, INC. +FORM 10-K +For the fiscal year ended September 30, 2020 +PART I +Item 1. Business +4 +Item 1A. Risk Factors +11 +Item 1B. Unresolved Staff Comments +20 +Item 2. Properties +20 +Item 3. Legal Proceedings +20 +Item 4. Mine Safety Disclosures +21 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +22 +Item 6. Selected Financial Data +25 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +26 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +40 +Item 8. Financial Statements and Supplementary Data +40 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +75 +Item 9A. Controls and Procedures +75 +Item 9B. Other Information +75 +PART III +Item 10. Directors, Executive Officers and Corporate Governance +76 +Item 11. Executive Compensation +76 +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +76 +Item 13. Certain Relationships and Related Transactions and Director Independence +77 +Item 14. Principal Accountants Fees and Services +77 +PART IV +Item 15. Exhibits, Financial Statement Schedules +78 +Item 16. 10-K Summary +81 +Signatures +82 +2 +Cautionary Statement +This Annual Report on Form 10-K contains certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). They are based on management’s current expectations and assumptions regarding our business and performance, the economy and other future conditions and forecasts of future events, circumstances and results. These forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements often include words such as “may,” “will,” “could,” “should,” “would,” “believes,” “expects,” “anticipates”, “estimates”, “projects,” “intends,” “plans” and other words and terms of similar substance in connection with discussions of future operating or financial performance. Such forward-looking statements include, but are not limited to, statements regarding future actions, business plans and prospects, prospective products, trends, future performance or results of current and anticipated products, sales efforts, expenses, interest rates, the outcome of contingencies, such as legal proceedings, plans relating to dividends, government regulations, the adequacy of our liquidity to meet our needs for the foreseeable future and our expectations regarding market conditions. +As with any projection or forecast, forward-looking statements are inherently susceptible to uncertainty and changes in circumstances. Our actual results may vary materially from those expressed or implied in our forward-looking statements. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements. +We undertake no obligation to update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K filed with the U.S. Securities and Exchange Commission ("SEC"). We provide in Item 1A, “Risk Factors,” a cautionary discussion of certain risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. In addition, the operation and results of our business are subject to risks and uncertainties identified elsewhere in this Annual Report on Form 10-K as well as general risks and uncertainties such as those relating to general economic conditions. You should understand that it is not possible to predict or identify all such risks. Consequently, you should not consider such discussion to be a complete discussion of all potential risks or uncertainties. +3 +PART I +Item 1. Business +Alico, Inc. (“Alico”) was incorporated under the laws of the state of Florida in 1960. Collectively with its subsidiaries (the "Company", "we", "us" or "our"), our business and operations are described below. For detailed financial information with respect to our business and our operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included in Item 7 in this Annual Report on Form 10-K, and the accompanying Consolidated Financial Statements and the related Notes, which are included in Item 8. In addition, general information concerning our Company can be found on our website, the internet address of which is http://www.alicoinc.com . All of our filings with the U.S. Securities and Exchange Commission (the "SEC") including, but not limited to, the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are available free of charge on our website as soon as reasonably practicable after such material is electronically filed or furnished with the SEC. Our recent press releases and information regarding corporate governance, including the charters of our audit, compensation, executive and nominating governance committees, as well as our code of business conduct and ethics are also available to be viewed or downloaded electronically at http://www.alicoinc.com . Unless explicitly stated herein, the information on our website is not incorporated by reference into this Annual Report on Form 10-K and the Company disclaims any such incorporation by reference. +Overview +Alico is an agribusiness with a legacy of achievement and innovation in citrus and conservation. The Company owns approximately 100,000 acres of land in eight Florida counties (Charlotte, Collier, DeSoto, Glades, Hardee, Hendry, Highlands and Polk), holding mineral rights on approximately 90,000 acres of those owned acres. Our principal lines of business are citrus groves and conservation. +Alico is one of the largest citrus producers in the United States of America. +Alico, Inc. operates two divisions: Alico Citrus, a citrus producer, and Land Management and Other Operations, which includes land conservation, encompassing environmental services, land leasing and related support operations. +The Company manages its land based upon its primary usage and reviews its performance based upon two primary classifications - Alico Citrus and Land Management and Other Operations. Land Management and Other Operations include leases for grazing rights, hunting leases, a farm lease, a lease to a third party of an aggregate mine, leases of oil extraction rights to third parties, and other miscellaneous operations generating income. Alico presents its financial results and the related discussion based upon its two business segments: (i) Alico Citrus and (ii) Land Management and Other Operations. +Recent Developments +The COVID-19 Pandemic +On March 11, 2020, the World Health Organization declared the current novel coronavirus outbreak (“COVID-19”) to be a global pandemic. In response to this declaration and the rapid spread of COVID-19 within the United States, federal, state and local governments throughout the country have imposed varying degrees of restrictions on social and commercial activity to promote social distancing in an effort to slow the spread of the illness. These measures have had a significant adverse impact upon many sectors of the economy, including certain agriculture businesses. +During March 2020, as a precautionary measure to ensure financial flexibility and maintain maximum liquidity in response to the COVID-19 pandemic, the Company implemented several measures that we believed would ensure sufficient liquidity for the next several months, including drawing down an aggregate of $70,000,000 on its revolving credit facilities. This decision was made to safeguard the Company’s liquidity and to increase available cash on hand in the event that a more protracted COVID-19 outbreak were to put a significant strain on the financial institutions and their ability to loan funds. As of September 30, 2020, the Company, believing that, despite the protracted COVID-19 outbreak, the financial institution industry was experiencing less negative impact from the outbreak than originally expected, proceeded to pay down the majority of the amounts drawn under its revolving credit facilities. +Additionally, for the protection of our employees in accordance with the Centers For Disease Control and Prevention (CDC) guidelines, the Company arranged to have the majority of office personnel work remotely, has taken steps to allow and encourage greater separation for our employed and contracted field workers and has worked with its harvesters, haulers and suppliers to minimize interactions. The Company continues to assess the situation on a routine basis. +To date, the Company has experienced no material adverse impacts from this pandemic. +4 +Sale and Purchase of Land +On September 11, 2020, the Company sold approximately 10,700 acres on the western part of Alico Ranch to the State of Florida for $28,500,000. A portion of these proceeds were used to purchase approximately 3,280 gross citrus acres for $16,450,000 on October 30, 2020. The purchase of these gross citrus acres was structured to allow the Company to defer income taxes of approximately $4,000,000 from the gain on sale of the approximate 10,700 acres sold to the State of Florida. +Citrus Grove Management Agreement +On July 16, 2020, the Company executed an agreement with an affiliated group of third parties to provide citrus grove caretaking and harvest and haul management services for approximately 7,000 acres owned by such third parties. Pursuant to this agreement, the Company is to be reimbursed by the third parties for all of its costs incurred related to providing these services and also receives a management fee based on acres covered under this agreement. +Agreements with Tropicana +On each of May 18, 2020 and May 20, 2020, the Company entered into a new agreement to supply Tropicana, its largest customer, with citrus fruit. These new agreements are effective October 1, 2020, conclude on July 31, 2024, and succeed an existing agreement that expired at the end of September 2020. +Federal Relief Program +The Company has been eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fiscal years ended September 30, 2020 and 2019, the Company received approximately $4,629,000 and $15,597,000, respectively, under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and Part 2 reimbursement under a three-part program. The timing and amount to be received under Part 3 of the program, if any, has not been finalized. +Distribution of Shares by 734 Investors +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +Employee and Board of Directors Matters +On August 6, 2020, the Board of Directors (the “Board”) of the Company increased the number of its directors by two and appointed Mr. Adam Putnam and Ms. Kate English as directors, each to serve until the 2021 annual meeting of the Company’s shareholders or until his or her earlier death, resignation, or removal in accordance with the Amended and Restated Bylaws of the Company. +In December 2019, Mr. George R. Brokaw, the then Executive Vice Chairman, informed the Board of Directors that he would voluntarily step down as Executive Vice Chairman effective December 31, 2019 and that change has taken effect. After the effectiveness of this change, Mr. Brokaw has remained a member of the Board of Directors. +Effective February 27, 2020 (which was immediately after the 2020 Annual Meeting of Shareholders), by way of action that has been taken by and at the direction of the Board of Directors, Benjamin D. Fishman, the non-employee Executive Chairman, became the Chairman of the Board. Mr. Fishman has remained a non-employee director. +The Land We Manage +We regularly review our land holdings to determine the best use of each parcel based upon our management expertise. Our total return profile is a combination of operating income potential and long-term appreciation. Land holdings not meeting our total return criteria are considered surplus to our operations and efforts are being made to sell such land holdings or to exchange such land holdings for land considered to be more compatible with our business objectives and total return profile. +5 +Our land holdings and the operating activities in which we engage are categorized in the following table: +Gross Acreage +Operating Activities +Alico Citrus +Citrus Groves +45,485 +Citrus Cultivation +Citrus Nursery +22 +Citrus Tree Development +45,507 +Land Management and Other Operations +Ranch +52,807 +Leasing and Conservation +Other Land +1,446 +Mining Lease and Office +54,253 +Total +99,760 +Alico Citrus +We own and manage citrus land in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties in the State of Florida and engage in the cultivation of citrus trees to produce citrus for delivery to the fresh and processed citrus markets. Alico citrus groves total approximately 45,507 gross acres or 45.6% of our land holdings. The Company also manages approximately 7,200 acres of citrus land on behalf of third-party grove owners in addition to the 45,507 gross acres owned by Alico. +Our citrus acreage is further detailed in the following table: +Net Plantable +Producing +Developing +Fallow +Total +Plantable +Support +& Other +Gross +DeSoto County +15,180 +1,096 +482 +16,758 +4,650 +21,408 +Polk County +4,870 +— +— +4,870 +2,237 +7,107 +Collier County +4,261 +— +— +4,261 +2,905 +7,166 +Hendry County +3,546 +57 +175 +3,778 +1,707 +5,485 +Charlotte County +1,729 +— +138 +1,867 +676 +2,543 +Highlands County +1,063 +— +— +1,063 +161 +1,224 +Hardee County +403 +— +— +403 +171 +574 +Total +31,052 +1,153 +795 +33,000 +12,507 +45,507 +Of the 45,507 gross acres of citrus land we own and manage, approximately 12,507 acres are classified as support and other acreage. Support and other acreage include acres used for roads, barns, water detention, water retention and drainage ditches integral to the cultivation of citrus trees, but which are not capable of directly producing fruit. In addition, we own a small citrus tree nursery of approximately 22 acres and utilize the trees produced in our own operations. The 32,978 remaining acres are classified as net plantable acres. Net plantable acres are those that are capable of directly producing fruit. These include acres that are currently producing, acres that are developing (i.e., acres that are planted with trees too young to commercially produce fruit) and acres that are fallow. +In an effort to replace trees lost in Hurricane Irma and increase the density of our citrus groves, Alico has planted more than 1.3 million new trees over the past four years. This level of planting has been substantially higher than the normal level of tree attrition. We will continue to evaluate the density throughout our groves and determine the appropriate tree plantings moving forward. Typically, citrus trees become fruit bearing approximately four years after planting and peak around seven to eight years after planting. +Our Alico Citrus business segment cultivates citrus trees to produce citrus for delivery to the processed and fresh citrus markets. Our sales to the processed market were approximately 91.0%, 95.0%, and 93.7% of Alico Citrus revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. We produce Early and Mid-Season varieties, primarily Hamlin oranges, as well as a Valencia variety for the processed market. We deliver our fruit to the processors in boxes which each contains approximately 90 pounds of oranges. Because the processors convert the majority of the citrus crop into orange juice, they generally do not buy their citrus on a per box basis, but rather on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of citrus fruit. We produced approximately 43,578,000, 46,727,000, and 26,513,000 pound solids for the fiscal years ended September 30, 2020, 2019 and 2018, respectively, from boxes delivered to processing plants of approximately 7,311,000, 7,904,000, and 4,702,000, respectively. As previously indicated, the falloff in fiscal year 2018 was mostly attributable to the impact of Hurricane Irma. +6 +The average pound solids per box was 5.96, 5.91, and 5.64 for the fiscal years ended September 30, 20 20 , 201 9 and 201 8 , respectively. +We generally use multi-year contracts with citrus processors that include pricing structures based on a floor and ceiling price. Therefore, if pricing in the market is favorable relative to our floor price, we benefit from the incremental difference between the floor and the final market price to the extent it does not exceed the ceiling price. +Our citrus produced for the processed citrus market in fiscal year 2020 under our largest agreement was subject to floor prices and ceiling prices. Under this agreement, if the market price was below the floor prices or exceeded the ceiling prices, then 50% of the shortfall or excess was deducted from the floor price or added to the ceiling price. Under our next largest agreement, our citrus produced is subject to a minimum floor price and maximum ceiling price and is a based on a cost-plus structure. +On each of May 18, 2020 and May 20, 2020, the Company entered into two new agreements to supply Tropicana, its largest customer, with citrus fruit. These new agreements are effective October 1, 2020, conclude on July 31, 2024, and succeeded our existing largest agreement with this customer which expired at the end of September 2020. +Although we believe other markets and customers are available for our citrus products, we also believe that new arrangements in these other markets or with other customers may be less favorable than our current contracts. +Our sales to the fresh citrus market constituted approximately 2.6%, 3.0%, and 2.6% of our Alico Citrus revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. We produce numerous varieties for the fresh fruit market including grapefruit, navel and other fresh varieties. Generally, our fresh fruit is sold to packing houses by the box and the packing houses are responsible for the harvest and haul of these boxes. We produced approximately 267,000, 210,000, and 125,000 fresh fruit boxes for each of the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +On July 16, 2020, the Company executed an agreement with an affiliated group of third parties to provide citrus grove caretaking and harvest and haul management services (“Grove Management Services”) for approximately 7,000 acres owned by such third parties. Under the terms of the agreement, the Company is reimbursed by the third parties for all of its costs incurred related to providing these services and also is to receive a management fee based on acres covered under this agreement. The Company, prior to this agreement, was already providing Grove Management Services to several small third-party grove owners on acres within the Company’s groves and continues to provide such services. Revenues generated from our Grove Management Services were approximately 5.1%, 1.1% and 2.3% of our total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Revenues from our Alico Citrus operations were approximately 96.6%, 97.4%, and 96.1% of our total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Land Management and Other Operations +We own and manage land in Collier, Glades, and Hendry Counties and are engaged in land leasing for recreational and grazing purposes, conservation, and mining activities. Our Land Management and Other Operations land holdings total 54,253 gross acres, or 54.4% of our total acreage. +Our Land Management and Other Operations acreage is detailed in the following table as of September 30, 2020: +Acreage +Hendry County +49,705 +Glades County +526 +Collier County +4,022 +Total +54,253 +On September 11, 2020, the Company sold approximately 10,700 acres on the western part of Alico Ranch to the State of Florida. Because the acres involved in the sale would have been critical to our planned dispersed water storage project, the Company has decided to no longer pursue permit approval activities for this project. As a result of this decision to no longer pursue permit approval activities for this project, the Company has renamed this segment Land Management and Other Operations to better reflect the components of this segment. The Company did not generate any revenue from the dispersed water storage project and incurred expenses of $1,346,000, $1,206,000 and $1,619,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +7 +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third - party operator. The Company continues to own the property and conduct its long-term dispersed water program and wildlife management programs. As part of the sales transaction, the Company expensed all cattle inventory costs that were accumulated at the date of sale. +Revenues from Land Management and Other Operations were approximately 3.4%, 2.6%, and 3.9% of total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Our Strategy +Our core business strategy is to maximize stockholder value through continuously improving the return on our invested capital, either by holding and managing our existing land through skilled agricultural production, leasing, or other opportunistic means of monetization, disposing of under productive land or business units and acquiring new land or operations with appreciation potential. +Our objectives are to produce the highest quality agricultural products, create innovative land uses, opportunistically acquire and convert undervalued assets, sell under-productive land and other assets not meeting our total return profile, generate recurring and sustainable profit with the appropriate balance of risk and reward, and exceed the expectations of shareholders, customers, clients and partners. +Our strategy is based on best management practices of our agricultural operations and the environmental and conservation stewardship of our land and natural resources. We try to manage our land in a sustainable manner and evaluate the effect of changing land uses while considering new opportunities. Our commitment to environmental stewardship is fundamental to the Company’s core beliefs. +Intellectual Property +While we consider our various intellectual property to be valued assets, we do not believe that our competitive position or our operations are dependent upon or would be materially impacted by any single piece of intellectual property or group of related intellectual property registrations or rights. +Seasonal Nature of Business +As with any agribusiness enterprise, our agribusiness operations and revenues are predominantly seasonal in nature. The following table illustrates the seasonality of our agribusiness revenues: +Fiscal Year +Q1 +Q2 +Q3 +Q4 +Ending 12/31 +Ending 3/31 +Ending 6/30 +Ending 9/30 +Oct +Nov +Dec +Jan +Feb +Mar +Apr +May +Jun +Jul +Aug +Sept +Harvest Fresh and Early/Mid Varieties of Oranges +X +X +X +X +Harvest Valencia Oranges +X +X +X +X +Significant Customers +Revenue from Tropicana represented approximately 87%, 89%, and 87% of our consolidated revenue for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. The revenue in fiscal year 2020 from Tropicana was generated primarily from two separate contracts. This revenue was generated from the sale of our citrus product in the processed market. No other single customer provided more than 10% of our consolidated revenue in fiscal years 2020, 2019 or 2018. +Competition +The orange and specialty citrus markets are intensely competitive, but no single producer has any significant market power over any market segments, as is consistent with the production of most agricultural commodities. Citrus is grown domestically in several states including Florida, California, Arizona and Texas, as well as foreign countries, most notably Brazil and Mexico. Competition is impacted by several factors including quality, production, demand, brand recognition, market prices, weather, disease, export/import restrictions and foreign currency exchange rates. +8 +Governmental Regulations +Our operations are subject to various federal, state and local laws regulating the discharge of materials into the environment. Management believes we are in material compliance with all such rules including permitting and reporting requirements. Historically, compliance with environmental regulations has not had a material impact on our financial position, results of operations or cash flows. +Management monitors environmental legislation and requirements and makes every reasonable effort to remain in compliance with such regulations. In addition, we require in our leases that lessees of our property comply with environmental regulations as a condition of leasing. +We are subject to other laws of the United States and the rules and regulations of various governing bodies within the United States, which may differ among jurisdictions. Compliance with these laws, rules and regulation has not had, and is not expected to have, a material effect on our capital expenditures, results of operations and competitive position as compared to prior periods. +Human Capital +Supporting our people is a fundamental value for Alico. We believe the Company’s success depends on its ability to attract, develop and retain key personnel. The skills, experience and industry knowledge of our employees and the employees of our independent contractors, particularly our key employees, significantly benefit our operations and performance. The Company's management oversees various employee initiatives and also monitors the effectiveness of the personnel provided by independent contractors with which we contract for certain harvesting and hauling services. +Health and safety in the workplace for our employees and personnel provided by independent contractors with which we contract is one of the Company’s core values. Hazards in the workplace are actively identified and management tracks incidents so remedial actions can be taken to improve workplace safety. The COVID-19 pandemic has underscored for us the importance of keeping our employees and the personnel provided by independent contractors safe and healthy. In response to the pandemic, the Company has taken actions aligned with the Centers for Disease Control and Prevention to protect its workforce so that its workforce can more safely and effectively perform their work. +Employee levels are managed to align with the pace of business and takes into account the services that are performed for us by our independent contractors. We rely on our independent contractors to manage their respective employee levels so that the harvesting and hauling services they are obligated to perform for us are consistent with the contractual obligations of these independent contractors and enable us to satisfy our harvesting and hauling needs. Management believes that through its own employees, coupled with the human capital supplied by its independent contractors, it has sufficient human capital to operate its business successfully. Management believes that the Company's employee relations are favorable, that its relations with its independent contractors is favorable and that the relations that the independent contractors and the Company has with the employees of the independent contractors is favorable. +We believe in a culture of equity, diversity and inclusion. We are also committed to advancing safe and respectful work environments where our employees are invited to bring their talents, backgrounds and expertise to bear on the success of our business and where every person has the opportunity to thrive personally and professionally. +As of September 30, 2020, we had 251 full-time employees. Our employees work in the following divisions: +Alico Citrus +230 +Land Management and Other Operations (1) +0 +Corporate, General, Administrative and Other +21 +Total employees +251 +(1) +There is one employee who is included in Corporate, General, Administrative and Other who oversees the Land Management and Other operations. +None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good. +Capital Resources and Raw Materials +Management believes that the Company will be able to meet its working capital requirements for at least the next 12 months, and over the long term, through internally generated funds, cash flows from operations, the sale of under-productive land and other assets, our existing lines of credit and access to capital markets. The Company has commitments that provide for lines of revolving credit that are available for our general and corporate use. +9 +Raw materials needed to cultivate the various crops grown by the Company consist primarily of fertilizers, herbicides, insecticides and fuel and are readily available from local suppliers. +Available Information +We will provide electronic copies of our SEC filings free of charge upon request. Additionally, our reports, amendments thereto, proxy statements and other information are also made available, free of charge, on our investor relations website at ir.alicoinc.com as soon as reasonably practicable after we electronically file or furnish such information with the SEC. Any information posted on or linked from our website is not incorporated by reference in this Annual Report on Form 10-K. The SEC also maintains a website at http://www.sec.gov , which contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. +10 +Item 1A. Ri sk Factors +Our business and results of operations are subject to numerous risks and uncertainties, many of which are beyond our control. The following is a description of key known factors that we believe may materially affect our business, financial condition, results of operations or cash flows. They should be considered carefully, in addition to the information set forth elsewhere in this Annual Report on Form 10-K, including Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8, Financial Statements and Supplementary Data, including the related Notes to the Consolidated Financial Statements in making any investment decisions with respect to our securities. Additional risks or uncertainties that are not currently known to us that we currently deem to be immaterial or that could apply to any company could also materially adversely affect our business, financial condition, results of operations or cash flows. +Risks Related to our Business +The COVID-19 pandemic has caused significant economic instability and uncertainty and may have an adverse effect on our business, results of operations and financial condition. +The COVID-19 pandemic has caused economic instability and uncertainty globally and may have a material adverse impact, on our business. +Potential negative impacts of the pandemic include, but are not limited to, the following: +• +Reduction in customer demand for citrus products and decreased consumer spending levels, which could materially and adversely affect our results of operations; +• +Potential disruption of services on which we rely to deliver our harvested citrus to producers and fulfilling deliveries to production plants, any of which could materially and adversely affect our business or reputation; +• +We may be unable to obtain financing in the current economic environment on terms that are favorable or acceptable to us, or at all, which could impair our cash flows and restrict our ability to execute on our strategic initiatives and react to changes in our business or the environment; +• +There could be increased volatility in our stock price related to the pandemic, which could result in the loss of some or all of the value of an investment in the Company; +• +Our ability to maintain our workforce during these uncertain times, which could materially and adversely affect our results of operations; +• +Increase in employee absenteeism due to fear of infection, which could materially and adversely affect our results of operations; +• +Increase in possible lawsuits or regulatory actions due to COVID-19 spread in the workplace which could materially and adversely affect our results of operations; +• +Spread of COVID-19 in our workplace, which could materially and adversely affect our business and reputation; +• +Increase in the possibility of cybersecurity-related events such as COVID-19 themed phishing attacks and other security challenges, particularly as attributable to a substantial number of our employees and suppliers working remotely, which could materially and adversely affect our business and reputation; and +• +Adverse impact on the productivity of management and our employees that are working remotely, including an impact on our ability to maintain our financial reporting processes and related controls and our ability to manage complex accounting issues presented by the COVID-19 pandemic which could materially and adversely affect our business and reputation. +Our business operations could be significantly harmed by natural disasters or global epidemics. +Our business could be adversely affected by natural disasters such as epidemics, outbreaks or other health crisis. An outbreak of avian flu or H1N1 flu in the human population, or another similar health crisis, such as the current COVID-19 pandemic referred to above, could adversely affect economies and financial markets, particularly those in the United States. Moreover, any related disruptions to transportation or the free movement of persons could hamper our operations and force us to close our offices temporarily. +11 +The occurrence of any of the foregoing or other natural or man-made disasters could cause damage or disruption to us, our employees, operations, markets and customers, which could result in significant delays in deliveries or substantial shortages of our products and adversely affect our business results of operations, financial condition or prospects. +Adverse weather conditions, natural disasters and other natural conditions, including the effects of climate change, could impose significant costs and losses on our business. +Fresh produce is vulnerable to adverse weather conditions, including windstorms, floods, drought and temperature extremes, which are quite common and may occur with higher frequency or be less predictable in the future due to the effects of climate change. Unfavorable growing conditions can reduce both crop size and crop quality. In extreme cases, entire harvests may be lost in some geographic areas. Citrus groves are subject to damage from frost and freezes, and this has happened periodically in the recent past, including most recently the impact from Hurricane Irma. In some cases, the fruit is damaged or ruined; in the case of extended periods of cold, the trees can also be damaged or killed. These factors can increase costs, decrease revenues and lead to additional charges to earnings, which may have a material adverse effect on our business, results of operations, financial condition and cash flows. +Our citrus groves are subject to damage and loss from disease including but not limited to citrus greening and citrus canker which could negatively impact our business, financial condition, results of operations and cash flows. +Our citrus groves are subject to damage and loss from diseases such as citrus greening and citrus canker. Each of these diseases is widespread in Florida and exists in our citrus groves and in the areas where our citrus groves are located. The success of our citrus business is directly related to the viability and health of our citrus groves. +Citrus greening is one of the most serious citrus plant diseases in the world. Once a tree is infected, its productivity generally decreases. While the disease poses no threat to humans or animals, it has devastated citrus crops throughout the United States and abroad. Named for its green, misshapen fruit, citrus greening disease has now killed millions of citrus plants in the southeastern United States and has spread across the entire country. Infected trees produce fruits that are green, misshapen and bitter, unsuitable for sale as fresh fruit or for juice. Infected trees can die within a few years. At the present time, there is no known cure for citrus greening once trees have become infected. Primarily, as a result of citrus greening, orange production in the State of Florida has continued to drop. +Citrus canker is a disease affecting citrus species and is caused by a bacterium which is spread by contact with infected trees or by windblown transmission. There is no known cure for citrus canker at present although some management practices, including the use of copper-based bactericides, can mitigate its spread and lessen its effect on infected trees; however, there is no assurance that currently available technologies will control such disease effectively. +Both of these diseases pose a significant threat to the Florida citrus industry and to our citrus groves. While we try to use best management practices to attempt to control diseases and their spread, there can be no assurance that our mitigation efforts will be successful. These diseases can significantly increase our costs which could materially adversely affect our business, financial condition, results of operations and cash flows. Our citrus groves produce the significant majority of our annual operating revenues. A significant reduction in available citrus from our citrus groves could decrease our operating revenues and materially adversely affect our business, financial condition, results of operations and cash flows. +Our citrus groves are geographically concentrated in Florida and the effects of adverse weather conditions including hurricanes and tropical storms could adversely affect our results of operations, financial position and cash flows. +Our citrus operations are concentrated in central and south Florida with our groves located in parcels in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties. Because our groves are located in close proximity to each other, the impact of adverse weather conditions may be material to our results of operations, financial position and cash flows. Florida is particularly susceptible to the occurrence of hurricanes and tropical storms. Depending on where any particular hurricane or tropical storm makes landfall, our properties could experience significant, if not catastrophic damage. Hurricanes and tropical storms have the potential to destroy crops and impact citrus production through the loss of fruit and destruction of trees and/or plants either as a result of high winds or through the spread of windblown disease. Such damage could materially affect our citrus operations and could result in a loss of operating revenues from those products for a multi-year period. We seek to minimize hurricane risk by the purchase of insurance contracts, but the majority of our crops remain uninsured. In addition to hurricanes and tropical storms, the occurrence of other natural disasters and climate conditions in Florida, such as tornadoes, floods, freezes, unusually heavy or prolonged rain, droughts and heat waves, could have a material adverse effect on our operations and our ability to realize income from our crops or properties. +12 +A significant portion of our revenues are derived from our citrus business and any adverse event affecting such business could disproportionately harm our business. +Our revenues from our citrus business were approximately 96.6%, 97.4%, and 96.1% of our operating revenues in fiscal years 2020, 2019 and 2018, respectively. Our citrus division is one of the largest citrus producers in the United States and because of the significance of the revenues derived from this business, we are more vulnerable to adverse events or market conditions affecting our citrus business which could have a significant impact on our overall results of operations, financial condition and cash flows. +Our failure to effectively perform grove management functions or to effectively manage an expanded portfolio of groves could materially and adversely affect our business, financial condition, and results of operations. +Recently, we have significantly expanded the number of grove acres that we are managing for third parties. If we are unable to effectively perform grove management services for both our own groves and the groves owned by third parties at the level and/or the cost that we expect, or if we were to fail to allocate sufficient resources to meet the grove management of our own groves and the groves owned by these third parties, it could adversely affect our performance and reputation. Our ability to perform the grove management services will be affected by various factors, including, among other things, our ability to maintain sufficient personnel and retain key personnel and the number of acres and groves that we will manage. Increases in the number of acres and groves we are managing have required us to hire a greater number of additional qualified personnel. No assurance can be made that we will continue to be successful in attracting and retaining skilled personnel or in integrating any new personnel into our organization. +Our business is highly competitive and we cannot assure you that we will maintain our current market share. +Many companies compete in our different businesses and offer products that are similar to our products or are direct competitors to our products. We face strong competition from these and other companies engaged in the agricultural product business. +Important factors with respect to our competitors include the following: +• +Some of our competitors may have greater operating flexibility and, in certain cases, this may permit them +• +to respond better or more quickly to changes in the industry. +• +We cannot predict the pricing or promotional actions of our competitors or whether those actions will have a negative effect on us. +• +Our competitors may have access to substantially greater financial resources, deeper management and agricultural resources, regional, national or global areas that offer agricultural advantages, and enhanced public visibility or reputations. +There can be no assurance that we will continue to compete effectively with our present and future competitors, and our ability to compete could be materially adversely affected by our debt levels and debt service requirements. +We depend on our relationship with Tropicana for a significant portion of our business. Any disruption in this relationship could harm our sales. Additionally, if certain criteria are not met under one of our contracts with Tropicana, we could experience a significant reduction in revenues and cash flows. +The Company's contracts with Tropicana accounted for 86.9%, 88.6%, and 86.6% of the Company's revenues in fiscal years 2020, 2019 and 2018, respectively. The revenue for Tropicana is primarily generated from two contracts. Should there be any change in our current relationship structure, whereby they do not buy our oranges, we would need to find replacement buyers to purchase our remaining crop, which could take time and expense and may result in less favorable terms of sale. The loss of Tropicana as a customer or significant reduction in business with Tropicana may cause a material adverse impact to our financial position, results of operations and cash flows. +Our agricultural products are subject to supply and demand pricing which is not predictable. +Agricultural operations traditionally provide almost all of our operating revenues with citrus being the largest portion and are subject to supply and demand pricing. Prior to this current fiscal year, according to Nielsen data, consumer demand for orange juice had decreased significantly to its lowest level in almost a decade; however, we have been able to offset the impact of such decline with higher prices based on a lower supply of available oranges. Although the demand for orange juice has increased in this latest year, it is uncertain as to whether such increased demand can be maintained, whether we will see a return to a decline in the future and whether, if there were to be such a decline, the impact could be again offset by higher prices. In particular, although our processed citrus is subject to minimum pricing, we are unable to predict with certainty the final price we will receive for our products. In some instances, the harvest and growth cycle will dictate when such products must be marketed which +13 +may or may not be advantageous in obtaining the best price. Excessive supplies tend to cause severe price competition and lower prices for the commodity affected. Limited supply of certain agricultural commodities due to world and domestic market conditions can cause commodity prices to rise in certain situations. +If we are unable to successfully develop and execute our strategic growth initiatives, or if they do not adequately address the challenges or opportunities we face, our business, financial condition and prospects may be adversely affected. +Our success is dependent, in part, on our ability to identify, develop and execute appropriate strategic growth initiatives that will enable us to achieve sustainable growth in the long term. The implementation of our strategic initiatives is subject to both the risks affecting our business generally and the inherent risks associated with implementing new strategies. These strategic initiatives may not be successful in generating revenues or improving operating profit and, if they are, it may take longer than anticipated. As a result, and depending on evolving conditions and opportunities, we may need to adjust our strategic initiatives and such changes could be substantial, including modifying or terminating one or more of such initiatives. Termination of such initiatives may require us to write down or write off the value of our investments in them. Transition and changes in our strategic initiatives may also create uncertainty in our employees, customers and partners that could adversely affect our business and revenues. In addition, we may incur higher than expected or unanticipated costs in implementing our strategic initiatives, attempting to attract revenue opportunities or changing our strategies. There can be no assurance that the implementation of any strategic growth initiative will be successful, and we may not realize anticipated benefits at levels we project or at all, which would adversely affect our business, financial condition and prospects. +We are subject to the risk of product contamination and product liability claims. +The sale of agricultural products for human consumption involves the risk of injury to consumers. Such injuries may result from tampering by unauthorized third parties, product contamination or spoilage, including the presence of foreign objects, substances, chemicals, other agents, or residues introduced during the growing, storage, handling or transportation phases. While we are subject to governmental inspection and regulations and believe our facilities comply in all material respects with all applicable laws and regulations, we cannot be sure that our agricultural products will not cause a health-related illness in the future or that we will not be subject to claims or lawsuits relating to such matters. Even if a product liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused illness or injury could adversely affect our reputation with existing and potential customers and our corporate and brand image. Moreover, claims or liabilities of this sort might not be covered or fully covered by our insurance or by any rights of indemnity or contribution that we may have against others. We maintain product liability insurance; however, we cannot be sure that we will not incur claims or liabilities for which we are not insured or that exceed the amount of our insurance coverage. +Our agricultural operations are subject to water use regulations restricting our access to water. +Our operations are dependent upon the availability of adequate surface and underground water. The availability of water is regulated by the state of Florida through water management districts which have jurisdiction over various geographic regions in which our lands are located. Currently, we have permits in place for the next 15 to 20 years for the use of underground and surface water which are believed to be adequate for our agricultural needs. +Surface water in Hendry County, where much of our agricultural land is located, comes from Lake Okeechobee via the Caloosahatchee River and a system of canals used to irrigate such land. The Army Corps of Engineers controls the level of Lake Okeechobee and ultimately determines the availability of surface water even though the use of water has been permitted by the state of Florida through the water management district. The Army Corps of Engineers decided in 2010 to lower the permissible level of Lake Okeechobee in response to concerns about the ability of the levee surrounding the lake to restrain rising waters which could result from hurricanes. Changes in availability of surface water use may result during times of drought, because of lower lake levels and could materially adversely affect our agricultural operations, financial condition, results of operations and cash flows. +Changes in immigration laws could impact our ability to harvest our crops. +We engage third parties to provide personnel for our harvesting operations. The availability and number of such workers is subject to decrease if there are changes in the U.S. immigration laws. Immigration reform and enforcement has been attracting significant attention from the U.S. Government (particularly in the current U.S. administration and U.S. Congress), with enforcement operations taking place across the country, resulting in arrests and detentions of unauthorized workers. It remains unclear how the next U.S. administration will approach immigration reform and enforcement. However, if new immigration legislation is enacted in the U.S. and/or if enforcement actions are taken against available personnel, such legislation and/or enforcement activities may contain provisions that could significantly reduce the number and availability of workers. Termination of a significant number of personnel who might be found to be unauthorized workers or the scarcity of other available personnel to harvest our agricultural products could cause harvesting costs to increase or could lead to the loss of product that is not timely harvested which could have a material adverse effect to our citrus grove business, financial condition, results of operations and cash flows. +14 +Our acquisition of additional agricultural assets and other businesses could pose risks. +We seek to opportunistically acquire new agricultural assets from time to time that we believe would complement our business. For example, (i) in fiscal year 2015, we acquired three Florida citrus properties, including Orange-Co and Silver Nip Citrus, which resulted in our citrus division being one of the largest citrus producers in the United States, and (ii) in October 2020 we acquired another Florida citrus property. While we expect that our past and future acquisitions will successfully complement our business, we may fail to realize all of the anticipated benefits of these acquisitions, which could reduce our anticipated results. We cannot assure that we will be able to successfully identify suitable acquisition opportunities, negotiate appropriate acquisition terms, or obtain any financing that may be needed to consummate such acquisitions or complete proposed acquisitions. Acquisitions by us could result in accounting changes, potentially dilutive issuances of equity securities, increased debt and contingent liabilities, reduce the amount of cash available for dividends, debt service payments, integration issues and diversion of management’s attention, any of which could adversely affect our business, results of operations, financial condition, and cash flows. We may be unable to successfully realize the financial, operational, and other benefits we anticipate from our acquisitions and our failure to do so could adversely affect our business, results of operations, financial condition and cash flows. +Dispositions of our assets may adversely affect our future results of operations. +We also routinely evaluate the benefits of disposing of certain of our assets which could include the exit from lines of business. For example, in November of 2014, we sold significant sugarcane assets and we are no longer involved in the sugarcane business and, in January of 2018, we sold our breeding herd and no longer engage in cattle operations. Most recently, we sold certain ranch acres to the State of Florida because these acres would have been critically important for carrying out the Company’s planned dispersed water storage project, the Company is no longer are pursuing permit approval relating to this dispersed water storage project. While such dispositions increase the amount of cash available to us, it could also result in a potential loss of significant operating revenues and income streams that we might not be able to replace, makes our business less diversified and could ultimately have a negative impact on our results of operations, financial condition and cash flows. +If a transaction intended to qualify as a Section 1031 Exchange is later determined to be taxable, we may face adverse consequences, and if the laws applicable to such transactions are amended or repealed, we may not be able to dispose of properties in the future on a tax deferred basis. +From time to time we dispose of properties in transactions that are intended to qualify as Section 1031 Exchanges under the federal income tax law. It is possible that the qualification of a transaction as a Section 1031 Exchange could be successfully challenged and determined to be currently taxable and we could also be required to pay interest and penalties. As a result, we may be required to borrow funds in order to pay additional income taxes, and the payment of such taxes could cause us to have less cash available. Moreover, it is possible that legislation could be enacted that could modify or repeal the laws with respect to Section 1031 Exchanges, which could make it more difficult or not possible for us to dispose of properties in the future on a tax deferred basis. +We may undertake one or more significant corporate transactions that may not achieve their intended results, may adversely affect our financial condition and our results of operations or result in unforeseeable risks to our business. +We continuously evaluate the acquisition or disposition of operating businesses and assets and may in the future undertake one or more significant transactions. Any such acquisitive transaction could be material to our business and could take any number of forms, including mergers, acquisitions, joint ventures and the purchase of equity interests. The consideration for such acquisitive transactions may include, among other things, cash, common stock or equity interests in the Company or our subsidiaries, or a contribution of property or equipment to obtain equity interests, and in conjunction with a transaction we might incur additional indebtedness. We also routinely evaluate the benefits of disposing of certain assets. Such dispositions could take the form of asset sales, mergers or sales of equity interests. +These transactions may present significant risks such as insufficient assets to offset liabilities assumed, potential loss of significant operating revenues and income streams, increased or unexpected expenses, inadequate return of capital, regulatory or compliance issues, the triggering of certain financial covenants in our debt instruments (including accelerated repayment) and unidentified issues not discovered in due diligence. In addition, such transactions could distract management from current operations. As a result of the risks inherent in such transactions, we cannot guarantee that any such transaction will ultimately result in the realization of its anticipated benefits or that it will not have a material adverse impact on our business, financial condition, results of operations or cash flows. If we were to complete such an acquisition, disposition, investment or other strategic transaction, we may require additional debt or equity financing that could result in a significant increase in our amount of debt and our debt service obligations or the number of outstanding shares of our common stock, thereby diluting holders of our common stock outstanding prior to such acquisition. +Our citrus business is seasonal. +Our citrus groves produce the majority of our annual operating revenues and the citrus business is seasonal because it is tied to the growing and picking seasons. Historically, the second and third quarters of our fiscal year generally produce the majority of our annual revenues, and our working capital requirements are typically greater in the first and fourth quarters of our fiscal year coinciding with our planting cycles. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year or in +15 +future quarters. If our operating revenues in the second and third quarters are lower than expected, it would have a disproportionately large adverse impact on our annual operating results. +We face significant competition in our agricultural operations. +We face significant competition in our agricultural operations both from domestic and foreign producers and do not have any branded products. Foreign growers generally have an equal or lower cost of production, less environmental regulation and in some instances, greater resources and market flexibility than us. Because foreign growers have greater flexibility as to when they enter the U.S. market, we cannot always predict the impact these competitors will have on our business and results of operations. The competition we face from certain foreign suppliers of orange juice is mitigated by a governmentally imposed tariff on orange imports. Accordingly, a reduction in the government’s orange juice tariff could adversely impact our results of operations. +Our earnings are sensitive to fluctuations in market supply and prices and demand for our products. +Excess supplies often cause severe price competition in our industry. Growing conditions in various parts of the world, particularly weather conditions such as windstorms, floods, droughts and freezes, as well as diseases and pests, are primary factors affecting market prices because of their influence on the supply and quality of product. +Fresh produce is highly perishable and generally must be brought to market and sold soon after harvest. Many of the items involved in our business, such as oranges, must be sold more quickly than other produce our competitors may produce, such as lemons. As such, our competitors may be able to maintain certain items they produce in inventory for longer periods than we are able to maintain our inventory which may offer our competitors strategic advantages when they respond to fluctuations in market supply and demand that are not available to us. +In addition, general public perceptions regarding the quality, safety or health risks associated with particular food products could reduce demand and prices for some of our products. To the extent that consumer preferences evolve away from products that we produce for health or other reasons, and we are unable to modify our products or to develop products that satisfy new consumer preferences, there will be a decreased demand for our products. If excess supplies do exist, this could result in reduced pricing or unusable inventory which could adversely impact our results of operations. +Climate change, or legal, regulatory, or market measures to address climate change, may negatively affect our business and operations. +There is growing concern that carbon dioxide and other greenhouse gases in the atmosphere may have an adverse impact on global temperatures, weather patterns, and the frequency and severity of extreme weather and natural disasters. In the event that such climate change has a negative effect on the productivity of our citrus groves, it could have an adverse impact on our business and results of operations. The increasing concern over climate change also may result in more regional, federal, and/or global legal and regulatory requirements to reduce or mitigate the effects of greenhouse gases. In the event that such regulation is enacted, we may experience significant increases in our costs of operations. In particular, increasing regulation of fuel emissions could substantially increase the distribution and supply chain costs associated with our products. As a result, climate change could negatively affect our business and operations. +Increases in labor, personnel and benefits costs could adversely affect our operating results. +We primarily utilize labor contractors to harvest and deliver our fruit to outside packing facilities. Our employees and contractors are in demand by other agribusinesses and other industries. Shortages of labor, particularly as a result of the recent low unemployment rate in the United States and in Florida in particular, could delay our harvesting or orange processing activities or could result in increases in labor costs. +We and our labor contractors are subject to government mandated wage and benefit laws and regulations. In addition, current or future federal or state healthcare legislation and regulation, including the Affordable Care Act, may increase our medical costs or the medical costs of our labor contractors that could be passed on to us. +Increases in commodity or raw product costs, such as fuel and chemical costs, could adversely affect our operating results. +Many factors may affect the cost and supply of citrus, including external conditions, commodity market fluctuations, changes in governmental laws and regulations, tariffs, agricultural programs, severe and prolonged weather conditions and natural disasters. Increased costs for products can negatively impact our operating results and there can be no assurance that they will not adversely affect our operating results in the future. +We are subject to transportation risks. +We depend on third party providers of transportation and have no control over such third parties. An extended interruption in our ability to harvest and haul our products could have a material adverse effect on our business, financial condition and results of operations. Similarly, any extended disruption in the distribution of our products could have a material adverse effect on our business, financial condition and results of operations. +16 +While we believe we are adequately insured and would attempt to transport our products by alternative means if we were to experience an interruption due to strike, natural disasters or otherwise, we cannot be sure that we would be able to do so or be successful in doing so in a timely and cost-effective manner. +We benefit from reduced real estate taxes due to the agricultural classification of a majority of our land. Changes in the classification or valuation methods employed by county property appraisers could cause significant changes in our real estate property tax liabilities. +In the fiscal years ended September 30, 2020, 2019 and 2018 we paid approximately $2,714,000, $2,755,000, and $3,089,000 in real estate taxes, respectively. These taxes were based upon the agricultural use (“Green Belt”) values determined by the county property appraisers in which counties we own land, of approximately $87,976,000, $91,312,000, and $104,017,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively, which differs significantly from the fair values determined by the county property appraisers of approximately $463,799,000, $514,330,000, and $537,183,000, respectively. Changes in state law or county policy regarding the granting of agricultural classification or calculation of "Green Belt" values or average millage rates could significantly impact our results of operations, cash flows and/or financial position. +Liability for the use of fertilizers, pesticides, herbicides and other potentially hazardous substances could increase our costs. +Our agricultural business involves the use of herbicides, fertilizers and pesticides, some of which may be considered hazardous or toxic substances. We may be deemed liable and have to pay for the costs or damages associated with the improper application, accidental release or the use or misuse of such substances. Our insurance may not be adequate to cover such costs or damages, or may not continue to be available at a price or under terms that are satisfactory to us. In such cases, if we are required to pay significant costs or damages, it could materially adversely affect our business, results of operations, financial condition and cash flows. +Compliance with applicable environmental laws may substantially increase our costs of doing business which could reduce our profits. +We are subject to various laws and regulations relating to the operation of our properties, which are administered by numerous federal, state and local governmental agencies. We face a potential for environmental liability by virtue of our ownership of real estate property. If hazardous substances (including herbicides and pesticides used by us or by any persons leasing our lands) are discovered emanating from any of our lands and the release of such substances presents a threat of harm to the public health or the environment, we may be held strictly liable for the cost of remediation of these hazardous substances. In addition, environmental laws that apply to a given site can vary greatly according to the site’s location, its present and former uses, and other factors such as the presence of wetlands or endangered species on the site. Management monitors environmental legislation and requirements and makes every effort to remain in compliance with such regulations. Furthermore, we require lessees of our properties to comply with environmental regulations as a condition of leasing. We also purchase insurance for environmental liability when it is available; however, these insurance contracts may not be adequate to cover such costs or damages or may not continue to be available at prices and terms that would be satisfactory. It is possible that in some cases the cost of compliance with these environmental laws could exceed the value of a particular tract of land, make it unsuitable for use in what would otherwise be its highest and best use, and/or be significant enough that it would materially adversely affect us. +Our business may be adversely affected if we lose key employees. +We depend to a large extent on the services of certain key management personnel. These individuals have extensive experience and expertise in the business lines and segments in which they work. The loss of any of these individuals could have a material adverse effect on our businesses. We do not maintain key-man life insurance with respect to any of our employees. Our success will be dependent on our ability to continue to attract, employ and retain skilled personnel in our business lines and segments. +Inflation can have a significant adverse effect on our operations. +Inflation can have a major impact on our citrus operations. The citrus operations are most affected by escalating costs and unpredictable revenues and very high irrigation water costs. High fixed water costs related to our citrus lands will continue to adversely affect earnings. Prices received for many of our products are dependent upon prevailing market conditions and commodity prices. Therefore, it is difficult for us to accurately predict revenue, just as we cannot pass on cost increases caused by general inflation, except to the extent reflected in market conditions and commodity prices. +We incur increased costs as a result of being a publicly traded company. +As a company with publicly traded securities, we have incurred, and will continue to incur, significant legal, accounting and other expenses. In addition, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, as well as rules promulgated by the SEC and Nasdaq, requires us to adopt corporate governance practices applicable to U.S. public companies. These laws, rules and regulations may increase our legal and financial compliance costs, which could adversely affect the trading price of our common stock. +17 +System security risks, data protection breaches, cyber-attacks and systems integration issues could disrupt our internal operations or services provided to customers, and any such disruption could reduce our expected revenues, increase our expenses, damage our reputation and adversely affect our stock price. +Computer programmers and hackers may be able to penetrate our network security and misappropriate or compromise our confidential information or that of third parties, create system disruptions or cause shutdowns. Computer programmers and hackers also may be able to develop and deploy viruses, worms, and other malicious software programs that attack our systems and databases or otherwise exploit any security vulnerabilities of our systems and databases. In addition, sophisticated hardware and operating system software and applications that we develop internally or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate cyber or other security problems, bugs, viruses, worms, malicious software programs and security vulnerabilities could be significant, and our efforts to address these problems may not be successful and could result in interruptions, delays, cessation of service and loss of existing or potential customers that may impede our sales, distribution or other critical functions. +Portions of our information technology infrastructure also may experience interruptions, delays or cessations of service or produce errors in connection with systems integration or migration work that takes place from time to time. We may not be successful in implementing new systems and transitioning data, which could cause business disruptions and be more expensive, time consuming, disruptive and resource-intensive. Such disruptions could adversely impact our ability to track sales and could interrupt other operational or financial processes, which in turn could adversely affect our financial results, stock price and reputation. +Risks Related to Our Indebtedness +We maintain a significant amount of indebtedness which could adversely affect our financial condition, results of operations or cash flows and may limit our operational and financing flexibility and negatively impact our business. +As of September 30, 2020, we had approximately $151,000,000 in principal amount of indebtedness outstanding under our secured credit facilities and line of credit and an additional availability of approximately $91,659,000 is available under our revolving lines of credit. Our loan agreements, as well as other debt instruments we may enter into in the future, may have negative consequences to us and could limit our business because we will use a substantial portion of our cash flows from operations to pay debt service costs which will reduce the funds available to us for corporate and general expenses and it may make us more vulnerable to economic downturns and adverse developments in our business. Our loan agreements require us to comply with various restrictive covenants and some contain financial covenants that require us to comply with specified financial ratios and tests. Our failure to meet these covenants could result in default under these loan agreements and would result in a cross-default under other loan agreements. In the event of a default and our inability to obtain a waiver of the default, all amounts outstanding under loan agreements could be declared immediately due and payable. Our loan agreements also contain various covenants that limit our ability to engage in specified types of transactions. We expect that we will depend primarily upon our citrus operations to provide funds to pay our corporate and general expenses and to pay any amounts that may become due under any credit facilities and any other indebtedness we may incur. In addition, there are factors beyond our control that could negatively affect our citrus business revenue stream. Our ability to make these payments depends on our future performance, which will be affected by various financial, business, macroeconomic and other factors, many of which we cannot control. +We may be unable to generate sufficient cash flow to service our debt obligations. +To service our debt, we require a significant amount of cash. Our ability to generate cash, make scheduled payments or refinance our obligations depends on our successful financial and operating performance. Our financial and operating performance, cash flow and capital resources depend upon prevailing economic conditions and various financial, business and other factors, many of which are beyond our control. These factors include among others: +• +economic and competitive conditions +• +changes in laws and regulations +• +operating difficulties, increased operating costs or pricing pressures we may experience; and +• +delays in implementing any strategic projects +If our cash flow and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell material assets or operations, obtain additional capital or restructure our debt. If we are required to take any actions referred to above, it could have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure investors that we would be able to take any of these actions on terms acceptable to us, or at all, or that these actions would enable us to continue to satisfy our capital requirements or that these actions would be permitted under the terms of our various debt agreements. +18 +Some of our debt is based on variable rates of interest, which could result in higher interest expenses in the event of an increase in the interest rates. +Our credit facility and certain of our term loans that we have currently bear interest at variable rates, which will generally change as interest rates change. We bear the risk that the rates we are charged by our lenders will increase faster than the earnings and cash flow of our business, which could reduce profitability, adversely affect our ability to service our debt, cause us to breach covenants contained in our credit facility and term loans, any of which could materially adversely affect our business, financial condition, results of operations and cash flows. +Risks Related to our Common Stock +Our common stock has low trading volume and the distribution of all of the shares of our common stock owned by 734 Investors to its members has the effect of increasing the Company’s public float and such increase may have a material adverse effect on the market price of our common stock. +Although our common stock trades on the Nasdaq Global Select Market, it is thinly traded and our average daily trading volume is low compared to the number of shares of common stock we have outstanding. The low trading volume of our common stock can cause our stock price to fluctuate significantly as well as make it difficult for a shareholder to sell their common shares quickly. As a result of our stock being thinly traded and/or our low stock price, institutional investors might not be interested in owning our common stock, which in turn could have a material adverse effect on our ability to obtain future funding, if needed, as well as create a potential market overhang. +On November 12, 2019, 734 Investors effected a distribution of all of the shares of our common stock owned by 734 Investors to its members. The distribution of Alico shares of common stock by 734 Investors to its members has the effect of increasing the Company’s public float and such increase, although it may increase the trading volume and thus reduce some of the trading volume risk described above, may at the same time over the short term have a material adverse effect on the market price of the common stock if too many members of 734 Investors seek to liquidate their shares over a short period. +We may not be able to continue to pay or maintain our cash dividends on our common stock and the failure to do so may negatively affect our share price. +We have historically paid regular quarterly dividends to the holders of our common stock. Our ability to pay cash dividends depends on, among other things, our cash flows from operations, our cash requirements, our financial condition, the degree to which we are/or become leveraged, contractual restrictions binding on us, provisions of applicable law and other factors that our Board of Directors may deem relevant. There can be no assurance that we will generate sufficient cash from continuing operations in the future, or have sufficient cash surplus or net profits to pay dividends on our common stock. Our dividend policy is based upon our directors’ current assessment of our business and the environment in which we operate and that assessment could change based on business developments (which could, for example, increase our need for capital expenditures) or new growth opportunities. Our Board of Directors may, in its discretion, decrease the level of cash dividends or entirely discontinue the payment of cash dividends. The reduction or elimination of cash dividends may negatively affect the market price of our common stock. +There can be no assurance that we will resume the repurchase of shares of our common stock. +In fiscal year 2017, our Board of Directors authorized the repurchase of up to $7,000,000 of the Company’s common stock in two separate authorizations. In March 2017, our Board of Directors authorized the repurchase of up to $5,000,000 of the Company’s common stock beginning March 9, 2017 and continued through March 9, 2019. In May 2017, our Board of Directors authorized the repurchase of up to an additional $2,000,000 of the Company’s common stock beginning May 24, 2017 and continued through May 24, 2019. There can be no assurance that we will repurchase shares in the future in any particular amounts or at all. A reduction in, or elimination of, share repurchases could have a negative effect on our share price. +If we were to conduct another tender offer or engage in an additional share repurchase program, holders of our securities would be subject to certain risks associated with a decrease in the outstanding number of shares of our common stock. +In September 2018 the Company announced the commencement of the Tender Offer. During the Tender Offer the Company repurchased an aggregate of 752,234 shares at a price of $34.00 per share aggregating $25,575,956. These shares represented approximately 9.2% of the total number of shares of the Company’s common stock issued and outstanding as of October 2, 2018. While we have no plans to conduct another tender offer at this time, we may conduct another tender offer or engage in the repurchase of our shares in the future. Shareholders could be adversely affected by a reduction in our “public float,” that is, the number of shares owned by outside shareholders and available for trading in the securities markets, if the Company makes future tender offers or private or open market repurchases of its shares. Although the Company is not currently pursuing a tender offer or repurchase program, there are no assurances that our Board of Directors will not authorize the Company to do so in the future. Engaging in a tender offer or repurchase program in the future could have a negative effect on our share price. +19 +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +As of September 30, 2020, Alico owned 99,760 acres of land located in eight counties in Florida. Acreage in each county and the primary classification with respect to the present use of these properties is shown in the following table: +Total +Hendry +Polk +Collier +DeSoto +Glades +Charlotte +Hardee +Highlands +Alico Citrus: +Citrus Groves +45,485 +5,485 +7,107 +7,166 +21,386 +— +2,543 +574 +1,224 +Citrus Nursery +22 +— +— +— +22 +— +— +— +— +Total Citrus Groves +45,507 +5,485 +7,107 +7,166 +21,408 +— +2,543 +574 +1,224 +Land Management and Other Operations +52,807 +48,785 +— +4,022 +— +— +— +— +— +Mining +526 +— +— +— +— +526 +— +— +— +Other +920 +920 +— +— +— +— +— +— +— +Total +99,760 +55,190 +7,107 +11,188 +21,408 +526 +2,543 +574 +1,224 +Approximately 51,300 acres of the properties listed are encumbered by credit agreements totaling approximately $151,000,000 as of September 30, 2020. For a more detailed description of the credit agreements and collateral please see Note 6. “Long-Term Debt and Lines of Credit” to the Company’s fiscal year 2020 consolidated financial statements. +The Company currently collects mining royalties on approximately 526 acres of the land included in the table above and located in Glades County, Florida. These royalties do not represent a significant portion of operating revenues or gross profits. +Item 3. Legal Proceedings +Florida Litigation +On November 16, 2018, 734 Agriculture, RCF 2014 Legacy LLC, Delta Offshore Master II, LTD. and Mr. Remy W. Trafelet (the “Trafelet Parties”), who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, filed a lawsuit against Messrs. George R. Brokaw, Henry R. Slack, W. Andrew Krusen and Greg Eisner, members of the Board of Directors, in the Circuit Court (the “Circuit Court”) for Hillsborough County, Florida (the “Florida Litigation”). The Trafelet Parties sought, among other things, a declaration that (1) a purported stockholder action by written consent, delivered to the Company in the name of 734 Investors and the plaintiffs in the Florida Litigation on November 11, 2018 (the “Purported Consent”) was valid and binding, (2) the resolutions passed at a meeting of the Board of Directors on November 12, 2018, to, among other things, constitute an ad hoc committee of the Board of Directors to consider, evaluate and make any and all determinations, and to take any and all actions, on behalf of the Board of Directors, in connection with the Purported Consent were null and void and (3) the four defendants in the Florida Litigation were properly removed from the Board of Directors by the Purported Consent. On November 27, 2018, the Circuit Court denied without prejudice plaintiffs’ motion for a temporary restraining order and an affirmative injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. +On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provided that (1) the record date for the Purported Consent was stayed indefinitely, and (2) Mr. Trafelet and the Company’s Board of Directors should not take any action out of routine day-to-day operations conducted in the ordinary course of business, including any action to change the corporate governance of Alico or removing any corporate officers or directors from positions held as of November 27, 2018. +On December 6, 2018, the Trafelet Parties filed an amended complaint in the Florida Litigation which added the Company and Benjamin D. Fishman, a member of the Board of Directors, as defendants. On December 21, 2018, the Trafelet Parties filed a renewed motion for a preliminary injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. On January 14, 2019, the defendants in the Florida Litigation filed an opposition to plaintiffs’ renewed motion for a preliminary injunction. On January 18, 2019, the defendants in the Florida Litigation filed a motion to dismiss the plaintiffs’ amended complaint. +On February 11, 2019, the parties to the Florida Litigation entered into a settlement agreement (the “Alico Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Florida Litigation. Pursuant to the Alico Settlement Agreement, Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and as a member of the Board of Directors, effective upon the execution of the Alico Settlement Agreement. +20 +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into a consulting agreement (the “Consulting Agreement”) with Mr. Trafelet and 3584 Inc., an entity controlled by Mr. Trafelet (the “Consultant”). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $400,000. If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24-month term. As such, the Company recorded the $800,000 as expense in the quarter ended March 31, 2019. +In addition, on February 11, 2019, as contemplated by the Alico Settlement Agreement, the Company entered into a Registration Rights Agreement (the “Registration Rights Agreement”) with Mr. Trafelet, relating to the shares of the Company’s common stock directly held by the Trafelet Parties as of February 11, 2019 (the “Registrable Securities”). The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +From time to time, Alico may be involved in litigation relating to claims arising out of its operations in the normal course of business. There are no other current legal proceedings to which the Company is a party or of which any of its property is subject that it believes will have a material adverse effect on its financial position, results of operations or cash flows. +Item 4. Mine Safety Disclosures +Not Applicable. +21 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Common Stock +Our common stock is traded on the Nasdaq Global Select Market under the symbol ALCO. +Holders +On December 4, 2020, our stock transfer records indicated there were 216 holders of record of our common stock. A greater number of holders of our common stock are “street name” or beneficial holders, whose shares are held by banks, brokers and other financial institutions. +Dividend Policy +The declaration and amount of any actual cash dividend are in the sole discretion of our Board of Directors and are subject to numerous factors that ordinarily affect dividend policy, including the results of our operations and financial position, as well as general economic and business conditions. +The following table presents cash dividends per share of our common stock declared in fiscal years ended September 30, 2020, 2019 and 2018: +Declaration Date +Record Date +Payment Date +Per Common Share +November 6, 2017 +December 29, 2017 +January 16, 2018 +$ +0.06 +March 14, 2018 +March 30, 2018 +April 13, 2018 +$ +0.06 +June 11, 2018 +June 29, 2018 +July 13, 2018 +$ +0.06 +September 4, 2018 +September 28, 2018 +October 12, 2018 +$ +0.06 +December 14, 2018 +December 28, 2018 +January 11, 2019 +$ +0.06 +March 15, 2019 +March 29, 2019 +April 12, 2019 +$ +0.06 +June 14, 2019 +June 28, 2019 +July 12, 2019 +$ +0.06 +September 13, 2019 +September 27, 2019 +October 11, 2019 +$ +0.06 +December 5, 2019 +December 27, 2019 +January 10, 2020 +$ +0.09 +March 13, 2020 +March 27, 2020 +April 10, 2020 +$ +0.09 +June 11, 2020 +June 26, 2020 +July 10, 2020 +$ +0.09 +September 11, 2020 +September 25, 2020 +October 9, 2020 +$ +0.09 +22 +Stock Performance Graph +The graph below represents our common stock performance, comparing the value of $100 invested on September 30, 2015 in our common stock, the S&P 500 Index, the S&P Agricultural Products Index and a Company-constructed peer group, which includes Forestar Group, Inc., Limoneira Company, The St. Joe Company, Tejon Ranch Co. and Texas Pacific Land Trust. +INDEXED RETURNS +Base +Period +Years Ending +Company Name / Index +Sept 15 +Sept 16 +Sept 17 +Sept 18 +Sept 19 +Sept 20 +Alico, Inc. +100 +66.71 +85.51 +85.29 +86.54 +73.67 +S&P 500 Index +100 +115.43 +136.91 +161.43 +168.30 +193.80 +S&P Agricultural Products Index +100 +115.30 +118.08 +133.04 +112.52 +133.78 +Peer Group +100 +121.43 +163.75 +267.21 +212.60 +173.86 +(Includes reinvestment of dividends) +23 +Recent Sale of Unregistered Securities +None. +Issuer Repurchases of Equity Securities +We adopted Rule 10b5-1 share repurchase plan under the Securities Exchange Act of 1934 (the “Plan”) in connection with share repurchase authorizations. The Plan allows us to repurchase our shares of common stock at times when it otherwise might be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. Because repurchases under the Plan are subject to certain pricing parameters, there is no guarantee as to the exact number of common shares that will be repurchased under the Plan or that there will be any repurchases pursuant to the Plan. +(a) +(b) +(c) +(d) +Period +Total number of shares (or units) purchased (1) +Average price paid per share (or unit) +Total number of shares (or units) purchased as part of publicly announced plans or programs +Maximum number (or approximate dollar value) of shares (or units) that may yet be purchased under the plans or programs +10/01/2019 - 10/31/2019 +7,000 +$ +33.95 +— +— +Total +7,000 +$ +33.95 +— +— +(1) +On October 10, 2019, the Board of Directors authorized the repurchase of up to 7,000 shares of the Company's common stock from 734 Investors in a privately negotiated repurchase of shares. The Company entered into a repurchase agreement with 734 Investors to repurchase 7,000 shares of the Company's common stock on October 15, 2019. +24 +Item 6. Selected Financial Data +The following tables present selected historical consolidated financial information as of and for each of the fiscal years in the five-year period ended September 30, 2020. The Consolidated Financial Statements as of and for the fiscal years ended September 30, 2020, 2019, 2018, 2017 and 2016. +The selected historical financial data presented below should be reviewed in conjunction with our Consolidated Financial Statements and the accompanying Notes thereto, included elsewhere in this Annual Report on Form 10-K. +(in thousands, except per share amounts) +September 30, +2020 +2019 +2018 +2017 +2016 +Selected Statements of Operations Information: +Operating revenues +$ +92,507 +$ +122,251 +$ +81,281 +$ +129,829 +$ +144,196 +Income (loss) from operations +$ +6,921 +$ +45,214 +$ +10,535 +$ +(6,094 +) +$ +21,846 +Net income (loss) attributable to common stockholders +$ +23,662 +$ +37,833 +$ +13,050 +$ +(9,451 +) +$ +6,993 +Basic earnings (loss) per common share +$ +3.16 +$ +5.06 +$ +1.59 +$ +(1.14 +) +$ +0.84 +Diluted earnings (loss) per common share +$ +3.16 +$ +5.05 +$ +1.57 +$ +(1.14 +) +$ +0.84 +Cash dividends declared per common share +$ +0.36 +$ +0.24 +$ +0.24 +$ +0.24 +$ +0.24 +Selected Balance Sheet Information: +Cash and cash equivalents and restricted cash +$ +19,687 +$ +23,838 +$ +32,260 +$ +3,395 +$ +6,625 +Property and equipment, net +$ +350,061 +$ +345,648 +$ +340,403 +$ +349,337 +$ +379,247 +Total assets +$ +423,937 +$ +417,388 +$ +423,422 +$ +419,182 +$ +455,445 +Current portion of long-term debt +$ +9,145 +$ +5,338 +$ +5,275 +$ +4,550 +$ +4,493 +Long-term debt, net of current portion +$ +139,106 +$ +158,111 +$ +169,074 +$ +181,926 +$ +192,726 +Total Alico, Inc. stockholders' equity +$ +216,341 +$ +194,303 +$ +172,117 +$ +160,641 +$ +173,490 +Noncontrolling interest +$ +5,441 +$ +5,095 +$ +5,478 +$ +4,728 +$ +4,773 +For the fiscal year ended September 30, 2016, net income includes the gain on sale of assets of approximately $618,000 related to the sale of real estate and approximately $9,893,000 of interest expense. +For the fiscal year ended September 30, 2017, net loss includes inventory casualty loss and net realizable adjustment of approximately $14,688,000 as a result of Hurricane Irma, additional asset impairments of long-lived assets of approximately $9,346,000, and interest expense of approximately $9,141,000. The net loss was partially offset by a gain on sale of assets of approximately $2,181,000. +For the fiscal year ended September 30, 2018, net income includes the gain on sale of assets of approximately $11,041,000 related to the sale of real estate, property and equipment and assets held for sale, and insurance proceeds received in the amount of approximately $9,429,000 relating to damages from Hurricane Irma. Net income also includes a one-time non-cash deferred income tax benefit of approximately $9,847,000, which resulted from the remeasurement of the Company's net deferred tax liabilities due to the 21% corporate tax rate that was enacted December 22, 2017, and the expiration of a capital loss carryforward, which expired at September 30, 2018, of approximately $5,634,000, resulting in an additional income tax expense. Additionally, net income includes approximately $8,561,000 of interest expense and $3,349,000 of impairments relating to net realizable adjustment on inventory and long-lived assets. +For the fiscal year ended September 30, 2019, net income includes a gain on sale of assets of approximately $13,166,000 related to the sale of real estate, property and equipment and assets held for sale. Net income also includes insurance proceeds received of approximately $486,000 in additional property and casualty claims reimbursement relating to Hurricane Irma and federal relief proceeds of approximately $15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program relating to Hurricane Irma. Additionally, net income includes approximately $7,180,000 of interest expense and $1,204,000 relating to net realizable adjustment on inventory and impairments of long-lived assets. +For the fiscal year ended September 30, 2020, net income includes a gain on sale of assets of approximately $30,424,000 related to the sale of real estate, property and equipment and assets held for sale. Net income also includes federal relief proceeds of approximately $4,629,000 under the Florida CRBG program relating to Hurricane Irma. Additionally, net income includes approximately $5,981,000 of interest expense and $1,321,000 relating to impairments of long-lived assets. +25 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +The following discussion and analysis should be read in conjunction with the accompanying Consolidated Financial Statements and related Notes thereto. +Cautionary Statement Regarding Forward-Looking Information +We provide forward-looking information in this Annual Report on Form 10-K, particularly in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Any statements in this Annual Report on Form 10-K that are not historical facts are forward-looking statements. Forward-looking statements include, but are not limited to, statements that express our intentions, beliefs, expectations, strategies, predictions or any other statements relating to our future activities or other future events or conditions. These statements are based on our current expectations, estimates and projections about our business based, in part, on assumptions made by our management and can be identified by terms such as “plans,” “expect,” “may,” "anticipate,” “intend,” “should be,” “will be” “is likely to,” “believes,” and similar expressions referring to future periods. Alico believes the expectations reflected in the forward-looking statements are reasonable but cannot guarantee future results, level of activity, performance or achievements. Actual results may differ materially from those expressed or implied in the forward-looking statements. Therefore, Alico cautions you against relying on any of these forward-looking statements. Factors which may cause future outcomes to differ materially from those foreseen in forward-looking statements include, but are not limited to: changes in laws, regulation and rules; weather conditions that affect production, transportation, storage, demand, import and export of fresh product and their by-products; increased pressure from diseases including citrus greening and citrus canker, as well as insects and other pests; disruption of water supplies or changes in water allocations; market pricing of citrus; pricing and supply of raw materials and products; market responses to industry volume pressures; pricing and supply of energy; changes in interest rates; availability of financing for land development activities and other growth and corporate opportunities; onetime events; acquisitions and divestitures; seasonality; labor disruptions; inability to pay debt obligations; inability to engage in certain transactions due to restrictive covenants in debt instruments; government restrictions on land use; changes in agricultural land values; impact of the COVID-19 outbreak and coronavirus pandemic on our agriculture operations, including without limitation demand for product, supply chain, health and availability of our labor force, the labor force of contractors we engage, and the labor force of our competitors; other risks related to the duration and severity of the COVID-19 outbreak and coronavirus pandemic and its impact on Alico’s business; the impact of the COVID-19 outbreak and coronavirus pandemic on the U.S. and global economies and financial markets; access to governmental loans and incentives; any reduction in the public float resulting from repurchases of common stock by Alico; changes in equity awards to employees; whether the Company's dividend policy, including its recent increased dividend amounts, is continued; expressed desire of certain of our shareholders to liquidate their shareholdings by virtue of past market sales of common stock, by sales of common stock or by way of future transactions; political changes and economic crises; competitive actions by other companies; increased competition from international companies; changes in environmental regulations and their impact on farming practices; the land ownership policies of governments; changes in government farm programs and policies and international reaction to such programs; changes in pricing calculations with our customers; fluctuations in the value of the U.S. dollar, interest rates, inflation and deflation rates; length of terms of contracts with customers; and changes in and effects of crop insurance programs, global trade agreements, trade restrictions and tariffs; and soil conditions, harvest yields, prices for commodities, and crop production expenses. These forward-looking statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements due to numerous factors, including those Risks Factors included in Part I, Item 1A and elsewhere in this Annual Report on Form 10-K. +26 +Introduction +Alico, Inc. (“Alico”), together with its subsidiaries (collectively, the “Company", "we", "us" or "our”), is a holding company with assets and related operations in agriculture, land management and natural resources. We are a Florida agribusiness and land management company with a legacy of achievement and innovation in citrus, cattle and resource conservation. We own approximately 100,000 acres of land in eight Florida counties, holding mineral rights on approximately 90,000 of those owned acres. Our principal lines of business are now citrus groves and land management and other operations, which include land conservation, encompassing environmental services, land leasing and related support operations. Prior to the sale of certain ranch land to the State of Florida in September 2020, the Company’s business line also included Water Resources. Prior to the sale of our breeding herd in January 2018, the Company’s business line also included cattle ranching. Our mission is to create value for our customers and shareholders by managing existing lands to their optimal current income and total returns. Alico opportunistically acquires new agricultural assets and produces high quality agricultural products while exercising responsible environmental stewardship. Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of results of operations, financial condition and changes in financial condition for the periods presented. This MD&A is organized as follows: +• +Business Overview. This section provides a general description of our business, as well as other matters that we believe are important in understanding our results of operations and financial condition. +• +Consolidated Results of Operations. This section provides an analysis of our results of operations for each of the three fiscal years ended September 30, 2020. Our discussion is presented on a consolidated basis and includes discussion on future trends by segment. +• +Liquidity and Capital Resources. This section provides an analysis of our cash flows for each of the three fiscal years ended September 30, 2020 and our outstanding debt, commitments and cash resources as of September 30, 2020. +• +Critical Accounting Policies. This section identifies those accounting policies that we consider important to our results of operations and financial condition, require significant judgment and involve significant management estimates. Our significant accounting policies, including those considered to be critical accounting policies, are summarized in Note 2, “Summary of Significant Accounting Policies,” to the accompanying Consolidated Financial Statements. +Business Overview +Business Description +Alico, Inc., together with its subsidiaries (collectively, “Alico”, the “Company”, “we”, “us” or “our”) generates operating revenues primarily from the sale of its citrus products and grazing and hunting leasing. The Company operates as two business segments and all of its operating revenues are generated in the United States. For the fiscal year ended September 30, 2020, the Company generated operating revenues of approximately $92,507,000, income from operations of approximately $6,921,000, and net income attributable to common stockholders of approximately $23,662,000. Cash provided by operating activities was approximately $1,049,000 for the fiscal year ended September 30, 2020. +Fiscal Year Highlights and Other Developments +The COVID-19 Pandemic +On March 11, 2020, the World Health Organization declared the current novel coronavirus outbreak (“COVID-19”) to be a global pandemic. In response to this declaration and the rapid spread of COVID-19 within the United States, federal, state and local governments throughout the country have imposed varying degrees of restrictions on social and commercial activity to promote social distancing in an effort to slow the spread of the illness. These measures have had a significant adverse impact upon many sectors of the economy, including certain agriculture businesses. +During March 2020, as a precautionary measure to ensure financial flexibility and maintain maximum liquidity in response to the COVID-19 pandemic, the Company implemented several measures that we believe would help ensure sufficient liquidity for the next several months, including drawing down an aggregate of $70,000,000 on its revolving credit facilities. This decision was made to safeguard the Company’s liquidity and to increase available cash on hand in the event that a more protracted COVID-19 outbreak were to put a significant strain on the financial institutions and their ability to loan funds. As of September 30, 2020, the Company, believing that despite the protracted COVID-19 outbreak, the financial institutions industry was experiencing less negative impact from the outbreak than originally expected, proceeded to pay down the majority of the amounts drawn under its revolving credit facilities. +27 +Additionally, for the protection of our employees per the Centers For Disease Control and Prevention (CDC) guidelines, the Company arranged to have the majority of office personnel work remotely, has taken steps to allow and encourage greater separation for our employed and contracted field workers and has worked with its harvesters, haulers and suppliers to minimize interactions. The Company continues to assess the situation on a routine basis. +To date, the Company has experienced no material adverse impacts from this pandemic. +Citrus Grove Management Agreement +On July 16, 2020, the Company executed an agreement with an affiliated group of third parties to provide citrus grove caretaking and harvest and haul management services for approximately 7,000 acres owned by such third parties. Pursuant to this agreement, the Company is to be reimbursed by the third parties for all of its costs incurred related to providing these services and also is to receive a management fee based on acres covered under this agreement. +Agreements with Tropicana +On each of May 18, 2020 and May 20, 2020, the Company entered into a new agreement to supply Tropicana, its largest customer, with citrus fruit. These new agreements are effective October 1, 2020, conclude on July 31, 2024, and succeed an existing agreement that expired at the end of September 2020. +Federal Relief Program +The Company is eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fiscal year ended September 30, 2020 and 2019, the Company received approximately $4,629,000 and $15,597,000, respectively, under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and Part 2 reimbursement under a three-part program. The timing and amount to be received under Part 3 of the program, if any, has not been finalized. +Distribution of Shares by 734 Investors +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +Employee and Board of Directors Matters +On August 6, 2020, the Board of Directors increased the number of its directors by two and appointed Mr. Adam Putnam and Ms. Kate English as directors, each to serve until the 2021 annual meeting of the Company’s shareholders or until his or her earlier death, resignation, or removal in accordance with the Amended and Restated Bylaws of the Company. +In December 2019, Mr. George R. Brokaw, the then Executive Vice Chairman, informed the Board of Directors that he would voluntarily step down as Executive Vice Chairman effective December 31, 2019 and that change has taken effect. After the effectiveness of this change, Mr. Brokaw has remained a member of the Board of Directors. +Effective February 27, 2020 (which was immediately after the 2020 Annual Meeting of Shareholders), by way of action that has been taken by and at the direction of the Board of Directors, Benjamin D. Fishman, the non-employee Executive Chairman, became the Chairman of the Board. Mr. Fishman has remained a non-employee director. +28 +Condensed Consolidated Results of Operations +The following discussion provides an analysis of Alico's results of operations and should be read in conjunction with the accompanying Consolidated Statements of Operations for the fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2020 +2019 +$ +% +2019 +2018 +$ +% +Operating revenues: +Alico Citrus +$ +89,369 +$ +119,031 +$ +(29,662 +) +(24.9 +)% +$ +119,031 +$ +78,121 +$ +40,910 +52.4 +% +Land Management and Other Operations +3,138 +3,220 +(82 +) +(2.5 +)% +3,220 +3,160 +60 +1.9 +% +Total operating revenues +92,507 +122,251 +(29,744 +) +(24.3 +)% +122,251 +81,281 +40,970 +50.4 +% +Gross profit (loss): +Alico Citrus +17,088 +59,437 +(42,349 +) +(71.3 +)% +59,437 +26,412 +33,025 +125.0 +% +Land Management and Other Operations +831 +923 +(92 +) +(10.0 +)% +923 +(819 +) +1,742 +NM +Total gross profit +17,919 +60,360 +(42,441 +) +(70.3 +)% +60,360 +25,593 +34,767 +135.8 +% +General and administrative expenses +10,998 +15,146 +(4,148 +) +(27.4 +)% +15,146 +15,058 +88 +0.6 +% +Income from operations +6,921 +45,214 +(38,293 +) +(84.7 +)% +45,214 +10,535 +34,679 +NM +Total other income, net +24,456 +5,019 +19,437 +NM +5,019 +2,655 +2,364 +89.0 +% +Income before income taxes +31,377 +50,233 +(18,856 +) +(37.5 +)% +50,233 +13,190 +37,043 +NM +Income tax provision +7,663 +12,783 +(5,120 +) +(40.1 +)% +12,783 +390 +12,393 +NM +Net income +23,714 +37,450 +(13,736 +) +(36.7 +)% +37,450 +12,800 +24,650 +192.6 +% +Net (income) loss attributable to noncontrolling interests +(52 +) +383 +(435 +) +NM +383 +250 +133 +53.2 +% +Net income attributable to Alico, Inc. common stockholders +$ +23,662 +$ +37,833 +$ +(14,171 +) +(37.5 +)% +$ +37,833 +$ +13,050 +$ +24,783 +189.9 +% +NM - Not meaningful +The following table presents our operating revenues, by segment, as a percentage of total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018: +Fiscal Year Ended +September 30, +2020 +2019 +2018 +Operating revenues: +Alico Citrus +96.6 +% +97.4 +% +96.1 +% +Land Management and Other Operations +3.4 +% +2.6 +% +3.9 +% +Total operating revenues +100.0 +% +100.0 +% +100.0 +% +29 +The following discussion provides an analysis of the Company's operating segments: +Alico Citrus +(in thousands, except per box and per pound solids data) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2020 +2019 +Unit +% +2019 +2018 +Unit +% +Operating Revenues: +Early and Mid-Season +$ +31,303 +$ +39,574 +$ +(8,271 +) +(20.9 +)% +$ +39,574 +$ +24,309 +$ +15,265 +62.8 +% +Valencias +50,060 +73,480 +(23,420 +) +(31.9 +)% +73,480 +48,865 +24,615 +50.4 +% +Fresh Fruit +2,321 +3,629 +(1,308 +) +(36.0 +)% +3,629 +2,054 +1,575 +76.7 +% +Grove Management Services +4,599 +1,342 +3,257 +NM +1,342 +1,808 +(466 +) +(25.8 +)% +Purchase and Resale of Fruit +850 +943 +(93 +) +(9.9 +)% +943 +809 +134 +16.6 +% +Other +236 +63 +173 +NM +63 +276 +(213 +) +(77.2 +)% +Total +$ +89,369 +$ +119,031 +$ +(29,662 +) +(24.9 +)% +$ +119,031 +$ +78,121 +$ +40,910 +52.4 +% +Boxes Harvested: +Early and Mid-Season +3,146 +3,114 +32 +1.0 +% +3,114 +1,811 +1,303 +71.9 +% +Valencias +4,165 +4,790 +(625 +) +(13.0 +)% +4,790 +2,891 +1,899 +65.7 +% +Total Processed +7,311 +7,904 +(593 +) +(7.5 +)% +7,904 +4,702 +3,202 +68.1 +% +Fresh Fruit +267 +210 +57 +27.1 +% +210 +125 +85 +68.0 +% +Total +7,578 +8,114 +(536 +) +(6.6 +)% +8,114 +4,827 +3,287 +68.1 +% +Pound Solids Produced: +Early and Mid- Season +17,947 +16,873 +1,074 +6.4 +% +16,873 +9,194 +7,679 +83.5 +% +Valencias +25,631 +29,854 +(4,223 +) +(14.1 +)% +29,854 +17,319 +12,535 +72.4 +% +Total +43,578 +46,727 +(3,149 +) +(6.7 +)% +46,727 +26,513 +20,214 +76.2 +% +Pound Solids per Box: +Early and Mid-Season +5.70 +5.42 +0.28 +5.2 +% +5.42 +5.07 +0.35 +6.9 +% +Valencias +6.15 +6.23 +(0.08 +) +(1.3 +)% +6.23 +5.99 +0.24 +4.0 +% +Price per Pound Solids: +Early and Mid-Season +$ +1.74 +$ +2.35 +$ +(0.61 +) +(26.0 +)% +$ +2.35 +$ +2.64 +$ +(0.29 +) +(11.0 +)% +Valencias +$ +1.95 +$ +2.46 +$ +(0.51 +) +(20.7 +)% +$ +2.46 +$ +2.82 +$ +(0.36 +) +(12.8 +)% +Price per Box: +Fresh Fruit +$ +8.69 +$ +17.28 +$ +(8.59 +) +(49.7 +)% +$ +17.28 +$ +16.43 +$ +0.85 +5.2 +% +Operating Expenses: +Cost of Sales +$ +52,492 +$ +52,037 +$ +455 +0.9 +% +$ +52,037 +$ +46,477 +$ +5,560 +12.0 +% +Harvesting and Hauling +19,897 +22,079 +(2,182 +) +(9.9 +)% +22,079 +12,821 +9,258 +72.2 +% +Grove Management Services +3,817 +774 +3,043 +NM +774 +1,177 +(403 +) +(34.2 +)% +Purchase and Resale of Fruit +704 +788 +(84 +) +(10.7 +)% +788 +662 +126 +19.0 +% +Other +(4,629 +) +(16,084 +) +11,455 +(71.2 +)% +(16,084 +) +(9,428 +) +(6,656 +) +70.6 +% +Total +$ +72,281 +$ +59,594 +$ +12,687 +21.3 +% +$ +59,594 +$ +51,709 +$ +7,885 +15.2 +% +Gross Profit +$ +17,088 +$ +59,437 +$ +(42,349 +) +(71.3 +)% +$ +59,437 +$ +26,412 +$ +33,025 +125.0 +% +NM - Not meaningful +Our citrus groves produce the majority of our annual operating revenues and the citrus grove business is seasonal because it is tied to the growing and harvest season. Historically, the second and third quarters of Alico's fiscal year produce the majority of the annual revenues and working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with the growing cycles. +The Company sells its Early and Mid-Season and Valencia oranges to processors that convert the majority of the citrus crop into orange juice. They generally buy the citrus on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of fruit. Fresh fruit is generally sold to packing houses that purchase the citrus on a per box basis. Other revenues consist of third-party grove caretaking and the purchase and reselling of fruit. +30 +Alico's operating expenses consist primarily of cost of sales and harvesting and hauling costs. Cost of sales represents the cost of maintaining the citrus groves for the preceding calendar year and does not vary in relation to production. Harvesting and hauling costs represent the costs of bringing citrus product to processors and varies based upon the number of boxes produced. Other expenses include the period costs of third-party grove caretaking and the purchase and reselling of fruit. +The decrease in revenue for the fiscal year ended September 30, 2020, compared to the fiscal year ended September 30, 2019 was due to a decrease in the price per pound solids as well as a decrease in aggregate processed box production. The decrease in the price per pound solids in the market place was a result of excess supply from domestic and international growers. The decrease in aggregate processed box production was the result of greater fruit drop and smaller fruit size of Valencias in the current harvest season as compared to the prior harvest season, offset in part by an increase in processed box production of the Early and Mid-season fruit. +As previously disclosed, the Company anticipated a reduction in the market prices throughout the 2019-20 harvest season as a result of the excess supply from domestic and international growers. However, due to an increase in the consumption of Not from Concentrate Orange Juice ("NFC"), as indicated in the published Nielsen data, since March 2020, inventory levels have decreased and, as a result, the Company anticipates that market pricing will improve in the 2020-21 harvest season. +The Company completed its harvest season in the middle of May 2020 and was able to complete the harvest without any negative impact from the COVID-19 pandemic. +The increase in revenues for the fiscal year ended September 30, 2019, compared to the fiscal year ended September 30, 2018, was primarily related to the negative impact of Hurricane Irma on the prior fiscal year harvest. As a result of Hurricane Irma, which occurred in September 2017, the Company experienced a greater amount of fruit drop and consequently harvested approximately 3,202,000 fewer boxes in fiscal year 2018, as compared to fiscal year 2019. The Company also saw an overall increase in pound solids per box in fiscal year 2019, which was 5.91 as compared to 5.64 for fiscal year 2018. In addition, the increase in revenue, to a smaller extent, was due to a greater number of boxes of fresh fruit being sold in fiscal year 2019. +Total processed boxes harvested in fiscal year 2020 decreased by approximately 7.5%, as compared to fiscal year 2019. Pound solids increased by approximately 6.4% and decreased by approximately 14.1% for the Early and Mid-Season and Valencia oranges, respectively. The combination of these items resulted in approximately 3,149,000 fewer pound solids sold in fiscal year 2020, as compared to fiscal year 2019. +Total processed boxes harvested in fiscal year 2019 increased by approximately 68.1%, as compared to fiscal year 2018. Pound solids increased by approximately 6.9% and approximately 4.0% for the Early and Mid-Season and Valencia oranges, respectively. The combination of these items resulted in approximately 20,214,000 of additional pound solids sold in fiscal year 2019, as compared to fiscal year 2018. +The USDA, in its November 10, 2020 Citrus Crop Forecast for the 2020-21 harvest season, indicated its expectation that the Florida orange crop will decrease from approximately 67,300,000 boxes for the 2019-20 crop year to approximately 57,000,000 boxes for the 2020-21 crop year, a decrease of approximately 15.3%. As production is estimated to be lower than in the prior year, the Company anticipates there will be an increase in market prices in the 2020-21 harvest season primarily driven by an increase in demand for NFC orange juice, which will more than offset the negative impact from the estimated decline in production. +The increase in operating expenses for the fiscal year 2020, as compared to the fiscal year 2019, primarily relates to the Company receiving less federal relief proceeds through the Florida CRBG program relating to Hurricane Irma, which are recorded as a reduction of operating expenses, during fiscal year 2020, as compared to fiscal year 2019. The Company received proceeds of approximately $4,629,000 and $15,597,000 through the Florida CRBG program relating to Hurricane Irma during the fiscal years ended September 30, 2020 and 2019, respectively. Additionally, the Company recorded additional grove management services expense of approximately $3.0 million. Partially offsetting this decrease in operating expenses was a reduction in harvesting and hauling costs experienced by the Company as a result of fewer processed boxes being harvested during the fiscal year ended September 30, 2020 as compared to the same period in the prior year. +On July 16, 2020, the Company executed an agreement with an affiliated group of third parties to provide citrus grove caretaking and harvest and haul management services for approximately 7,000 acres owned by such third parties. Under the terms of this agreement, the Company is to be reimbursed by the third parties for all of its costs incurred related to providing these services and also is to receive a management fee based on acres covered under this agreement. As the Company provides these citrus grove caretaking management services, the Company will be recording both an increase in revenues and expenses. For the fourth quarter ended September 30, 2020, the Company recorded approximately $3,300,000 of operating revenue, including the management fee, and approximately $3,000,000 of operating expenses relating to this arrangement. +31 +Land Management and Other Operations +The table below presents key operating measures for the fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands) +Fiscal Year Ended +Fiscal Year Ended +September 30, +Change +September 30, +Change +2020 +2019 +$ +% +2019 +2018 +$ +% +Revenue From: +Land and other leasing +$ +2,683 +$ +2,787 +$ +(104 +) +(3.7 +)% +$ +2,787 +$ +2,595 +$ +192 +7.4 +% +Sale of calves and culls +— +— +— +NM +— +57 +(57 +) +(100.0 +)% +Other +455 +433 +22 +5.1 +% +433 +508 +(75 +) +(14.8 +)% +Total +$ +3,138 +$ +3,220 +$ +(82 +) +(2.5 +)% +$ +3,220 +$ +3,160 +$ +60 +1.9 +% +Operating Expenses: +Land and other leasing +$ +955 +$ +1,047 +$ +(92 +) +(8.8 +)% +$ +1,047 +$ +1,072 +$ +(25 +) +(2.3 +)% +Cost of calves sold +— +— +— +NM +— +1,075 +(1,075 +) +(100.0 +)% +Water conservation +1,346 +1,206 +140 +11.6 +% +1,206 +1,619 +(413 +) +(25.5 +)% +Other +6 +44 +(38 +) +(86.4 +)% +44 +213 +(169 +) +(79.3 +)% +Total +$ +2,307 +$ +2,297 +$ +10 +0.4 +% +$ +2,297 +$ +3,979 +$ +(1,682 +) +(42.3 +)% +Gross Profit (loss) +$ +831 +$ +923 +$ +(92 +) +(10.0 +)% +$ +923 +$ +(819 +) +$ +1,742 +NM +NM - Not meaningful +Land and other leasing include lease income from leases for grazing rights, hunting leases, a farm lease, a lease to a third party of an aggregate mine, leases of oil extraction rights to third parties, and other miscellaneous income. +The slight decrease in revenues from Land Management and Other Operations for the fiscal year ended September 30, 2020 is primarily due to a reduction in the leased acreage relating to a cattle grazing lease. The reduction in the leased acreage was due to certain acres, which were included under this lease arrangement, having been sold in September 2019. +On September 11, 2020, the Company sold approximately 10,700 acres on the western part of Alico Ranch to the State of Florida. Because the acres involved in the sale would have been critical to our planned dispersed water storage project, the Company has decided to no longer pursue permit approval activities for this particular project. As a result of this decision, the Company wrote-down approximately $598,000 of assets relating to this project during the fourth quarter of the fiscal year ended September 30, 2020. The Company anticipates that it will have no further expenses incurred relating to the dispersed water storage project moving forward. +The slight increase in revenues from Land Management and Other Operations for the fiscal year ended September 30, 2019 is primarily due to the Company recording a full year of grazing lease revenue in fiscal year 2019, while only recording nine months of revenue as the lease for these grazing rights was executed on January 8, 2018, at the time of the sale of the cattle herd. Partially offsetting this increase was a decrease in farm lease revenue as a result of a lease not being renewed in fiscal year 2019. +General and Administrative +General and administrative expenses for the fiscal year ended September 30, 2020 was approximately $10,998,000, compared to approximately $15,146,000 for the fiscal year ended September 30, 2019. +The decrease in general and administrative expenses for the fiscal year ended September 30, 2020, as compared to the fiscal year ended September 30, 2019, was primarily due to professional fees, relating to a corporate litigation matter, of approximately $2,300,000 being incurred for the fiscal year ended September 30, 2019. This litigation was settled and no further expenses were incurred relating to this matter during the fiscal year ended September 30, 2020. Additionally, as part of this settlement, the Company recorded consulting and separation fees of $800,000 during the fiscal year ended September 30, 2019. The Company also experienced a reduction due to (i) a one-time pension expense related to its deferred retirement benefit plan of approximately $965,000 in fiscal year 2019, (ii) a reduction in payroll expenses for the fiscal year ended September 30, 2020 of approximately $331,000 relating to one of the senior managers resigning in December 2019 and a reduction in bonuses granted to senior management, (iii) a decrease in stock compensation expense of approximately $204,000 as a result of certain stock options expense being accelerated in fiscal year ended September 30, 2020 and (iv) other smaller decreases in rent, consulting and Board of Director fees aggregating approximately $445,000. Partially offsetting these decreases was a lower amount of stock compensation expense of $823,000 recognized in fiscal year ended September 30, 2019 as a result of a former senior executive forfeiting his stock options as part of the settled litigation and an increase in Directors and Officers insurance of approximately $247,000. +32 +The slight increase in general and administrative expenses for the fiscal year ended September 30, 2019, as compared to the fiscal year ended September 30, 2018, was primarily due to an increase in professional fees, relating to a corporate litigation matter, of approximately $2,300,000 during the fiscal year ended September 30, 2019. This litigation has been resolved with a settlement being reached on February 11, 2019. The Company does not anticipate further professional fees relating to this litigation. Additionally, as part of this settlement, the Company recorded consulting and separation fees of $800,000 during the fiscal year ended September 30, 2019. The Company also recorded a one-time pension expense related to its deferred retirement benefit plan of approximately $965,000 in fiscal year 2019. Partially offsetting these increases wer e decreases in expenses due to (i) a reduction in stock compensation expense of $823,000 as a result of a former senior executive forfeiting his stock options as part of the settled litigation, (ii) a reduction in rent expense of approximately $450,000 as a result of the Company not renewing its lease for office space in New York City, (iii) an acceleration of stock compensation expense in fiscal year 2018 of approximately $782,000 as a result of two senior executives forfeiting a portion of their stock options, and (iv) a reduction in payroll costs of approximately $1,261,000. The reduction in payroll costs was primarily from (i) a reduction in separation expenses of approximately $388,000; (ii) a reduction in accrual for paid-time-off of approximately $100,000; and (iii) a reduction in executive compensation expense of approximately $725,000 relating to the resignation of a former senior executive. +Other Income, net +Other income, net, for the fiscal years ended September 30, 2020 and 2019 was approximately $24,456,000 and approximately $5,019,000, respectively. The increase in other income, net was primarily due to the Company recording a higher gain on sale of real estate, property and equipment and assets held for sale in fiscal year 2020, as compared to fiscal year 2019. In fiscal year 2020, the Company recorded a gain of approximately $30,424,000, which was generated primarily from the sale of land on its West Ranch in September 2020 to the State of Florida. For the fiscal year ended September 30, 2019, the Company recorded a gain of approximately $13,166,000, which was generated primarily for the sale of land on its West Ranch in September 2019. Additionally, the Company recognized a reduction of approximately $1,199,000 in interest expense in fiscal year 2020 as a result of (i) the reduction of its long-term debt attributable to making its mandatory principal payments, (ii) the Company prepaying approximately $4,455,000 on its debt obligations and (iii) a reduction in interest rates. +Other income, net for the fiscal years ended September 30, 2019 and 2018 was approximately $5,019,000 and approximately $2,655,000, respectively. The increase in other income, net was primarily due to the Company recording a higher gain on sale of real estate, property and equipment and assets held for sale in fiscal year 2019, as compared to fiscal year 2018. In fiscal year 2019, the Company recorded a gain of approximately $13,166,000, which was generated primarily for the sale of land on its West Ranch in September 2019. For the fiscal year ended September 30, 2018, the Company recorded a gain of $11,041,000 on the sale of real estate, property and equipment and assets held for sale, which included its corporate office building in Fort Myers, Florida, its Gal Hog property and a land parcel within its East Ranch resulting in gains of approximately $1,751,000, $6,709,000 and $1,759,000, respectively. Additionally, the Company incurred less interest expense of approximately $1,381,000 in fiscal year 2019, as compared to fiscal year 2018, primarily due to the Company recording imputed interest expense during the fiscal year ended September 30, 2018 relating to its Sugarcane transaction, which was terminated in fiscal year 2019. +Income Taxes +For the fiscal years ended September 30, 2020, 2019 and 2018, the provision for income taxes was approximately $7,663,000, $12,783,000 and $390,000, respectively, and the related effective income tax rates were approximately 24.50%, 25.45% and 2.96%, respectively. The change in the tax provision for the fiscal year ended September 30, 2020 is the result of the Company generating less net income during the current fiscal year as compared to the prior fiscal year. +The change in the tax provision for the fiscal year ended September 30, 2019 was the result of the Company generating greater net income during fiscal year 2019, as compared to the prior fiscal year. Additionally, a one-time non-cash deferred income tax benefit of approximately $9,847,000 was recorded in fiscal year 2018 which resulted from the remeasurement of the Company's net deferred tax liabilities due to the 21% corporate tax rate that was enacted December 22, 2017, and an effect of the expiration of its capital loss carryforward, which expired at September 30, 2018, of approximately $5,634,000 which was recorded in fiscal year 2018, thus resulting in an additional income tax expense. +Seasonality +The Company is primarily engaged in the production of fruit for sale to citrus markets, which is of a seasonal nature, and subject to the influence of natural phenomena and wide price fluctuations. Historically, the second and third quarters of Alico's fiscal year produce the majority of the Company's annual revenue. Working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with harvesting cycles. Because of the seasonality of the business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year. +33 +Liquidity and Capital Resources +A comparative balance sheet summary is presented in the following table: +(in thousands) +September 30, +2020 +2019 +Change +Cash and cash equivalents and restricted cash +$ +19,687 +$ +23,838 +$ +(4,151 +) +Total current assets +$ +51,899 +$ +61,977 +$ +(10,078 +) +Total current liabilities +$ +21,158 +$ +28,951 +$ +(7,793 +) +Working capital +$ +30,741 +$ +33,026 +$ +(2,285 +) +Total assets +$ +423,937 +$ +417,388 +$ +6,549 +Principal amount of term loans and lines of credit +$ +148,251 +$ +163,449 +$ +(15,198 +) +Current ratio +2.45 to 1 +2.14 to 1 +Alico's business has historically generated positive net cash flows from operating activities. Sources of cash primarily include cash flows from operations, sales of under-performing land and other assets, amounts available under the Company's credit facilities and access to capital markets. Access to additional borrowings under revolving lines of credit is subject to the satisfaction of customary borrowing conditions. As a public company, Alico may have access to other sources of capital. However, access to, and availability of, financing on acceptable terms in the future will be affected by many factors, including (i) financial condition, prospects and credit rating, (ii) liquidity of the overall capital markets and (iii) the state of the economy. There can be no assurance that the Company will continue to have access to the capital markets on acceptable terms, or at all. +The principal uses of cash that affect Alico's liquidity position include the following: operating expenses including employee costs, the cost of maintaining the citrus groves, harvesting and hauling of citrus products, capital expenditures, stock repurchases, dividends, debt service costs including interest and principal payments on term loans and other credit facilities and acquisitions. +Management believes that a combination of cash-on-hand, cash generated from operations, asset sales and availability under the Company's lines of credit will provide sufficient liquidity to service the principal and interest payments on its indebtedness, and will satisfy working capital requirements and capital expenditures for at least the next twelve months and over the long term. Alico has a $70,000,000 working capital line of credit, of which approximately $66,659,000 is available for general use as of September 30, 2020, and a $25,000,000 revolving line of credit, all of which is available for general use as of September 30, 2020 (see Note 6. “Long-Term Debt and Lines of Credit" to the accompanying Consolidated Financial Statements). If the Company pursues significant growth and other corporate opportunities, it could have a material adverse impact on its cash balances, and may need to finance such activities by drawing down monies under its lines of credit or by obtaining additional debt or equity financing. There can be no assurance that additional financing will be available to the Company when needed or, if available, that it can be obtained on commercially reasonable terms. Any inability to obtain additional financing could impact Alico's ability to pursue different growth and other corporate opportunities. +The level of debt could have important consequences on Alico's business, including, but not limited to, increasing its vulnerability to general adverse economic and industry conditions, limiting the availability of cash flow to fund future investments, capital expenditures, working capital, business activities and other general corporate requirements, and limiting flexibility in planning for, or reacting to, changes in its business and industry. +Cash Management Impacts +Cash and cash equivalents and restricted cash decreased from approximately $23,838,000 as of September 30, 2019 to approximately $19,687,000 as of September 30, 2020. Cash and cash equivalents and restricted cash decreased from approximately $32,260,000 as of September 30, 2018 to approximately $23,838,000 as of September 30, 2019. The components of these changes are discussed below. +34 +Consolidated Statements of Cash Flows +The following table details the items contributing to the changes in cash and cash equivalents and restricted cash for fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Net cash provided by operating activities +$ +1,049 +$ +48,832 +$ +18,578 +Net cash provided by (used in) investing activities +9,489 +(4,960 +) +22,924 +Net cash used in financing activities +(14,689 +) +(52,294 +) +(12,637 +) +Net (decrease) increase in cash and cash equivalents and restricted cash +$ +(4,151 +) +$ +(8,422 +) +$ +28,865 +Net Cash Provided By Operating Activities +(in thousands) +Fiscal Year Ended +September 30, +Fiscal Year Ended +September 30, +2020 +2019 +Change +2019 +2018 +Change +Net income +$ +23,714 +$ +37,450 +$ +(13,736 +) +$ +37,450 +$ +12,800 +$ +24,650 +Deferred gain on sale of sugarcane land +— +— +— +— +(967 +) +967 +Depreciation, depletion and amortization +14,520 +13,924 +596 +13,924 +13,756 +168 +Deferred income tax expense (benefit) +7,603 +3,267 +4,336 +3,267 +(1,955 +) +5,222 +Cash surrender value +(10 +) +11 +(21 +) +11 +(27 +) +38 +Deferred retirement benefits +(5,226 +) +829 +(6,055 +) +829 +(41 +) +870 +Gain on sale of real estate, property and equipment and assets held for sale +(30,424 +) +(13,166 +) +(17,258 +) +(13,166 +) +(10,281 +) +(2,885 +) +Inventory net realizable value adjustment +— +808 +(808 +) +808 +1,115 +(307 +) +Loss on disposal of property and equipment +659 +— +659 +— +207 +(207 +) +Change in fair value of derivatives +— +989 +(989 +) +989 +— +989 +Impairment of long-lived assets +1,321 +396 +925 +396 +2,234 +(1,838 +) +Impairment of right-of-use asset +87 +— +87 +— +— +— +Non-cash interest expense on deferred gain on sugarcane land +— +— +— +— +1,361 +(1,361 +) +Insurance proceeds received for damage to property and equipment +— +(486 +) +486 +(486 +) +(477 +) +(9 +) +Stock-based compensation expense +1,306 +824 +482 +824 +2,613 +(1,789 +) +Other +— +— +— +— +29 +(29 +) +Change in working capital +(12,501 +) +3,986 +(16,487 +) +3,986 +(1,789 +) +5,775 +Net cash provided by operating activities +$ +1,049 +$ +48,832 +$ +(47,783 +) +$ +48,832 +$ +18,578 +$ +30,254 +The decrease in net cash provided by operating activities for the fiscal year ended September 30, 2020, as compared to the same period in fiscal year 2019, was primarily due to (i) an increase in gain on sale of real estate, property and equipment and assets held for sale in the fiscal year ended September 30, 2020, relating to the sale of certain sections of the West Ranch, (ii) a decrease in net income, which was primarily driven by decreased citrus sales, (iii) a decrease in the deferred retirement benefit as a result of the Company terminating its pension plan and paying all participants on August 30, 2020 and (iv) a decrease in working capital as a result of the payment of income taxes and an increase in accounts receivable related to the Company’s grove management services whereby the Company pays all growing costs and then is reimbursed in the future from proceeds of fruit sales of the third-party. +The increase in net cash provided by operating activities for the fiscal year ended September 30, 2019, as compared to the same period in fiscal year 2018, was primarily due to (i) an increase in net income which was primarily driven by increased citrus sales and the receipt of federal disaster relief funds relating to Hurricane and (ii) an increase in working capital, which is due to a decrease in accounts receivable and an increase in income taxes payable. +Due to the seasonal nature of Alico's business, working capital requirements are typically greater in the first and fourth quarters of its fiscal year. Cash flows from operating activities typically improve in the second and third fiscal quarters, as sales of its harvested citrus are made. +35 +Net Cash Provided By (Used In) Investing Activities +The following table details the items contributing to Net Cash Provided By (Used In) Investing Activities for the fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands) +Fiscal Year Ended +September 30, +Fiscal Year Ended +September 30, +2020 +2019 +Change +2019 +2018 +Change +Purchases of property and equipment +$ +(21,705 +) +$ +(20,000 +) +$ +(1,705 +) +$ +(20,000 +) +$ +(16,352 +) +$ +(3,648 +) +Net proceeds from sale of real estate, property and equipment and assets held for sale +31,541 +14,602 +16,939 +14,602 +39,780 +(25,178 +) +Insurance proceeds received for damage to property and equipment +— +486 +(486 +) +486 +477 +9 +Change in deposits on purchase of citrus trees +(458 +) +(108 +) +(350 +) +(108 +) +(431 +) +323 +Advances on notes receivables, net +136 +60 +76 +60 +(575 +) +635 +Other +(25 +) +— +(25 +) +— +25 +(25 +) +Net cash provided by (used in) investing activities +$ +9,489 +$ +(4,960 +) +$ +14,449 +$ +(4,960 +) +$ +22,924 +$ +(27,884 +) +The shift from net cash used in investing activities for the fiscal year ended September 30, 2019 to net cash provided by investing activities for the fiscal year ended September 30, 2020 was primarily due to an increase in proceeds received on the sale of certain assets sold during fiscal year 2020, as compared to fiscal year 2019. This is due to the Company divesting of more acres of land in fiscal year 2020, as compared to fiscal year 2019 (see Note 4. “Assets Held for Sale” and Note 5. “Property & Equipment, Net” to the accompanying Consolidated Financial Statements). +The change from net cash provided by investing activities for the fiscal year ended September 30, 2018 to net cash used in investing activities for the fiscal year ended September 30, 2019 was primarily due to a decrease in proceeds received on the sale of certain assets sold during fiscal year 2019, as compared to fiscal year 2018. This is due to the Company divesting of several more assets in fiscal year 2018, as compared to fiscal year 2019 (see Note 4. “Assets Held for Sale” and Note 5. “Property & Equipment, Net” to the accompanying Consolidated Financial Statements). In addition, the shift, to a smaller extent, was due to an increase in capital expenditures which was driven by the purchase of certain land blocks within its existing grove location. +Net Cash Used In Financing Activities +The following table details the items contributing to Net Cash Used In Financing Activities for the fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands) +Fiscal Year Ended +September 30, +Fiscal Year Ended +September 30, +2020 +2019 +Change +2019 +2018 +Change +Repayments on revolving lines of credit +$ +(114,581 +) +$ +(89,231 +) +$ +(25,350 +) +$ +(89,231 +) +$ +(25,600 +) +$ +(63,631 +) +Borrowings on revolving lines of credit +117,523 +86,546 +30,977 +86,546 +28,285 +58,261 +Principal payments on term loans +(15,198 +) +(10,900 +) +(4,298 +) +(10,900 +) +(12,127 +) +1,227 +Treasury stock purchases +(238 +) +(25,576 +) +25,338 +(25,576 +) +(2,215 +) +(23,361 +) +Payment on termination of sugarcane agreement +— +(11,300 +) +11,300 +(11,300 +) +— +(11,300 +) +Deferred Financing costs +(23 +) +— +(23 +) +— +— +— +Dividends paid +(2,466 +) +(1,833 +) +(633 +) +(1,833 +) +(1,972 +) +139 +Capital contribution received from noncontrolling interest +294 +— +294 +— +1,000 +(1,000 +) +Capital lease obligation payments +— +— +— +— +(8 +) +8 +Net cash used in financing activities +$ +(14,689 +) +$ +(52,294 +) +$ +37,605 +$ +(52,294 +) +$ +(12,637 +) +$ +(39,657 +) +The decrease in net cash used in financing activities for the fiscal year ended September 30, 2020, as compared to the fiscal year ended September 30, 2019, was primarily due to the Company repurchasing its common shares through a tender offer in October 2018 for an aggregate approximate amount of $25,576,000 and the termination of its 2014 Post-Closing Agreement in March 2019 pursuant to which the Company paid $11,300,000. Partially offsetting this shift was a prepayment of one of its long-term debt obligations in November 2019 in the amount of $4,455,000. +36 +The increase in net cash used in financing activities for the fiscal year ended September 30, 2019, as compared to the fiscal year ended September 30, 2018, was primarily due to the Company purchasing 752,234 common shares through a tender offer, for an aggregate amount of approximately $25,576,000, the termination of its 2014 Post-Closing Agreement relating to sugarcane transaction pursuant to which the Company paid approximately $11,300,000, and a pay down, net of borrowings, of its revolving line of credit by approximately $2,265,000. +Alico had approximately $2,942,000 outstanding on its revolving lines of credit as of September 30, 2020 and approximately $91,659,000 remaining availability. +The WCLC line of credit agreement provides for Rabo Agrifinance, Inc. to issue up to $2,000,000 in letters of credit on the Company’s behalf. As of September 30, 2020, there was approximately $399,000 in outstanding letters of credit, which correspondingly slightly reduced Alico's availability under the line of credit. +Off-Balance Sheet Arrangements +None +Contractual Obligations +Alico has various contractual obligations which are fixed and determinable. The following table presents the Company's significant contractual obligations and commercial commitments on an undiscounted basis as of September 30, 2020 and the future periods in which such obligations are expected to be settled in cash. +(in thousands) +Payments Due by Period +Total +<1 Year +1-3 Years +3-5 Years +5+ Years +Long-Term Debt +$ +148,251 +$ +9,145 +$ +21,070 +$ +21,070 +$ +96,966 +Interest on Long-Term Debt +33,964 +5,235 +9,254 +7,634 +11,841 +Consulting/Non-Compete Agreement +146 +146 +— +— +— +Operating Leases +891 +519 +324 +48 +— +Tree Purchase Commitments +3,014 +3,014 +— +— +— +Total +$ +186,266 +$ +18,059 +$ +30,648 +$ +28,752 +$ +108,807 +Purchase Commitments +The Company enters into contracts for the purchase of citrus trees during the normal course of its business. As of September 30, 2020, the Company had approximately $3,014,000 relating to outstanding commitments for these purchases, which will be paid upon delivery. +Impact of Inflation and Changing Prices +Our financial statements included in this Annual Report on Form 10-K have been prepared in accordance with U.S. GAAP, which requires us to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession generally are not considered. The primary effect of inflation on our operations is reflected in increased operating costs. In our management’s opinion, changes in interest rates affect the financial condition to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities. +Critical Accounting Policies +Alico's Consolidated Financial Statements are prepared in accordance with U.S. GAAP, which requires management to make estimates, judgments and assumptions that affect the amounts reported in those financial statements and accompanying notes. Management considers an accounting policy to be critical if it is important to the Company's financial condition and results of operations and if it requires significant judgment and estimates on the part of management in its application. Alico considers policies relating to the following matters to be critical accounting policies: +37 +Revenue Recognition +The Company recognizes revenue at the amount it expects to be entitled to be paid, determined when control of the products or services is transferred to its customers, which occurs upon delivery of and acceptance of the fruit by the customer and the Company has a right to payment. For grove management services, the Company recognizes operating revenue, including a management fee, when services are rendered and consumed. The Company recognized revenues from cattle sales at the time the cattle were delivered. Management reviews the reasonableness of the revenue accruals quarterly based on buyers’ and processors’ advances to growers, cash and futures markets and experience in the industry. Adjustments are made throughout the fiscal year to these estimates as more current relevant industry information becomes available. Differences between the estimates and the final realization of revenues can be significant and can be either positive or negative. During the periods presented in this Annual Report on Form 10-K, no material adjustments were made to the reported revenues from our crops. +Inventories +The costs of growing crops, including but not limited to labor, fertilization, fuel, crop nutrition and irrigation, are capitalized into inventory throughout the respective crop year. Such costs are expensed as cost of sales when the crops are harvested and are recorded as operating expenses in the Consolidated Statements of Operations. Inventories are stated at the lower of cost or net realizable value. The cost for unharvested citrus crops is based on accumulated production costs incurred during the period from January 1 through the balance sheet date. +Property and Equipment +Property and equipment are stated at cost, net of accumulated depreciation and amortization. Major improvements are capitalized while maintenance and repairs are expensed in the period the cost is incurred. Costs related to the development of citrus groves, through planting of trees, are capitalized. Such costs include land clearing, excavation and construction of ditches, dikes, roads and reservoirs among other costs. After the planting, caretaking costs or pre-productive maintenance costs are capitalized for four years. After four years, a grove is considered to have reached maturity and the accumulated costs are depreciated over 25 years, except for land clearing and excavation, which are considered costs of land and not depreciated. +Income Taxes +The Company uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statements and the income tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates on deferred income tax assets and liabilities is recognized in income or loss in the period that includes the enactment date. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on the Company’s income tax provision and net income or loss in the period the determination is made. For the fiscal years ended September 30, 2020, 2019 and 2018, the Company recorded valuation allowances of $0, $0, and $5,634,000, respectively, relating to the unutilized capital loss carryforwards which expired. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. +The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which a change in judgment occurs. The Company records interest related to unrecognized tax benefits in income tax expense. +Impairment of Long-Lived Assets +The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company records impairment losses on long-lived assets used in operations, other than goodwill, when events and circumstances indicate that the asset or asset group might be impaired and the estimated cash flows (undiscounted and without interest charges) to be generated by those assets or asset group over the remaining lives of the assets are less than the carrying amounts of those assets. In calculating impairments and the estimated cash flows, the Company assigns its asset groups by determining the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other Company assets. The net carrying values of assets or asset groups not recoverable are reduced to their fair values. Our cash flow estimates are based on historical results adjusted to reflect our best estimates of future market conditions and operating conditions. As of September 30, 2020 and 2019, long-lived assets were comprised of property and equipment. +38 +Fair Value Measurements +The carrying amounts in the balance sheets for operating accounts receivable, accounts payable and accrued liabilities approximate fair value because of the immediate or short-term maturity of these items. The carrying amounts reported for our long-term debt approximates fair value as our borrowings with commercial lenders are at interest rates that vary with market conditions and fixed rates that approximate market rates for comparable loans. +Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Assets and liabilities measured at fair value are categorized into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows: +Level 1- Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities. +Level 2- Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly. +Level 3- Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date. +Impact of Accounting Pronouncements +See Item 8. "Financial Statements and Supplemental Data" - Note 1. "Description of Business and Basis of Presentation" for additional information about the impact of accounting pronouncements. +Subsequent Events +On December 2, 2020, the Board of Directors of the Company declared a cash dividend for the first quarter of fiscal year 2021 of $0.18 per share on its outstanding common stock to be paid to shareholders of record as of December 24, 2020, with payment expected on January 8, 2021. +In November 2020, the Company awarded 5,885 shares of restricted stock to certain officers and managers under the 2015 Plan. +Compensatory Arrangements of Certain Officers. +On December 2, 2019, the Company entered into a new employment agreement (the “Rallo Employment Agreement”) with Richard Rallo. Mr. Rallo serves as Chief Financial Officer of the Company. The Rallo Employment Agreement provides for an annual base salary of $275,000. Mr. Rallo is eligible for an annual incentive compensation award with an annual target opportunity in an amount equal to 40% of his annual base salary. +The Rallo Employment Agreement also provides that, if Mr. Rallo’s employment is terminated by the Company without “cause” or Mr. Rallo resigns with “good reason” (as each such term is defined in the Rallo Employment Agreement), then, subject to his execution, delivery, and non-revocation of a general release of claims in favor of the Company, Mr. Rallo will be entitled to (i) cash severance in an amount equal to 12 months of the annual base salary, (ii) the Accrued Obligations (as defined in the Rallo Employment Agreement) in a cash lump sum within 30 days after the date of termination, (iii) any rights or payments that are vested benefits or that Mr. Rallo is otherwise entitled to receive at or subsequent to the date of termination under any employee benefit plan or any other contract or agreement with the Company, and (iv) any Annual Bonus (as defined in the Rallo Employment Agreement) that has been earned but not paid as of the date of termination. +The Rallo Employment Agreement includes various restrictive covenants in favor of the Company, including a confidentiality covenant, a non-disparagement covenant, and 12-month post-termination noncompetition and customer and employee non-solicitation covenants. +In addition to his position as Chief Financial Officer, Mr. Rallo retains his position as the Company’s Principal Accounting Officer. +The foregoing description of the Rallo Employment Agreement does not purport to be complete and is qualified in its entirety by reference to the complete text of the Rallo Employment agreement, which is attached hereto as Exhibit 10.37 to this Annual Report on Form 10-K and is incorporated herein by reference. +39 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +Market Risk - Market risk represents the potential loss resulting from adverse changes in the value of financial instruments, either derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates, commodity prices, and equity security prices. The Company handles market risks in accordance with its established policies; however, Alico does not enter into derivatives or other financial instruments for trading or speculative purposes. The Company does consider, on occasion, the need to enter into financial instruments to manage and reduce the impact of changes in interest rates; however, the Company entered into no such instruments during the three-year period ended September 30, 2020. The Company held various financial instruments as of September 30, 2020 and 2019, consisting of financial assets and liabilities reported in the Company’s Consolidated Balance Sheets and off-balance sheet exposures resulting from letters of credit issued for the benefit of Alico. +Interest Rate Risk - The Company is subject to interest rate risk from the utilization of financial instruments such as term loan debt and other borrowings. The Company’s primary long-term obligations are fixed rate debts subject to fair value risk due to interest rate fluctuations. The Company believes that the carrying value of our long-term debt approximates fair value given the stability of market interest rates. +The Company is also subject to interest rate risk on its variable rate debt. A one-percentage-point increase in prevailing interest rates would have increased interest expense on our variable rate debt obligations by approximately $424,000 for the fiscal year ended September 30, 2020. +Foreign-Exchange Rate Risk - The Company currently has no exposure to foreign-exchange rate risk because all of its financial transactions are denominated in U.S. dollars. +Commodity Price Risk - The Company has no financial instruments subject to commodity price risk. +Equity Security Price Risk - None of the Company’s financial instruments have potential exposure to equity security price risk. +Item 8. Financial Statements and Supplementary Data +40 +Index to Consolidated Financial Statements +Page +Report of Independent Registered Public Accounting Firm +42 +Consolidated Financial Statements: +Consolidated Balance Sheets +43 +Consolidated Statements of Operations +44 +Consolidated Statements of Changes in Equity +45 +Consolidated Statements of Cash Flows +46 +Notes to Consolidated Financial Statements +47 +All schedules are omitted for the reason that they are not applicable or the required information is included in the financial statements or notes. +41 +Report of Independent Registered Public Accounting Firm +To the Stockholders and the Board of Directors of Alico, Inc. +Opinions on the Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Alico, Inc. and subsidiaries (the Company) as of September 30, 2020 and 2019, and the related consolidated statements of operations, changes in equity and cash flows for each of the three years in the period ended September 30, 2020, and the related notes (collectively, the financial statements). We also have audited the Company’s internal control over financial reporting as of September 30, 2020, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 30, 2020 and 2019, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2020, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2020, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. +Basis for Opinions +The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ RSM US LLP +We have served as the Company's auditor since 2007. +Orlando, Florida +December 8, 2020 +42 +ALICO, INC. +CONSOLIDATED BALANCE SHEETS +(in thousands, except share amounts) +September 30, +2020 +2019 +ASSETS +Current assets: +Cash and cash equivalents +$ +3,163 +$ +18,630 +Accounts receivable, net +4,347 +713 +Inventories +40,855 +40,143 +Income tax receivable +781 +— +Assets held for sale +1,366 +1,442 +Prepaid expenses and other current assets +1,387 +1,049 +Total current assets +51,899 +61,977 +Restricted cash +16,524 +5,208 +Property and equipment, net +350,061 +345,648 +Goodwill +2,246 +2,246 +Other non-current assets +3,207 +2,309 +Total assets +$ +423,937 +$ +417,388 +LIABILITIES AND STOCKHOLDERS' EQUITY +Current liabilities: +Accounts payable +$ +3,533 +$ +4,163 +Accrued liabilities +7,095 +7,769 +Long-term debt, current portion +9,145 +5,338 +Deferred retirement obligations, current portion +— +5,226 +Income taxes payable +— +5,536 +Other current liabilities +1,385 +919 +Total current liabilities +21,158 +28,951 +Long-term debt: +Principal amount, net of current portion +139,106 +158,111 +Less: deferred financing costs, net +( 1,151 +) +( 1,369 +) +Long-term debt less current portion and deferred financing costs, net +137,955 +156,742 +Lines of credit +2,942 +— +Deferred income tax liabilities, net +39,728 +32,125 +Other liabilities +372 +172 +Total liabilities +202,155 +217,990 +Commitments and Contingencies (Note 15) +Stockholders' equity: +Preferred stock, no par value, 1,000,000 shares authorized; no ne issued +— +— +Common stock, $ 1.00 par value, 15,000,000 shares authorized; 8,416,145 shares issued and 7,492,524 and 7,476,513 shares outstanding at September 30, 2020 and September 30, 2019, respectively +8,416 +8,416 +Additional paid in capital +19,685 +19,781 +Treasury stock, at cost, 923,621 and 939,632 shares held at September 30, 2020 and September 30, 2019, respectively +( 30,779 +) +( 31,943 +) +Retained earnings +219,019 +198,049 +Total Alico stockholders' equity +216,341 +194,303 +Noncontrolling interest +5,441 +5,095 +Total stockholders' equity +221,782 +199,398 +Total liabilities and stockholders' equity +$ +423,937 +$ +417,388 +See accompanying notes to the consolidated financial statements. +43 +ALICO, INC. +CONSOLIDATED STATEMENTS OF OPERATIONS +(in thousands, except per share amounts) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Operating revenues: +Alico Citrus +$ +89,369 +$ +119,031 +$ +78,121 +Land Management and Other Operations +3,138 +3,220 +3,160 +Total operating revenues +92,507 +122,251 +81,281 +Operating expenses: +Alico Citrus +72,281 +59,594 +51,709 +Land Management and Other Operations +2,307 +2,297 +3,979 +Total operating expenses +74,588 +61,891 +55,688 +Gross profit +17,919 +60,360 +25,593 +General and administrative expenses +10,998 +15,146 +15,058 +Income from operations +6,921 +45,214 +10,535 +Other income (expense): +Investment and interest income, net +98 +49 +39 +Interest expense +( 5,981 +) +( 7,180 +) +( 8,561 +) +Gain on sale of real estate, property and equipment and assets held for sale +30,424 +13,166 +11,041 +Change in fair value of derivatives +— +( 989 +) +— +Other (expense) income, net +( 85 +) +( 27 +) +136 +Total other income, net +24,456 +5,019 +2,655 +Income before income taxes +31,377 +50,233 +13,190 +Income tax provision +7,663 +12,783 +390 +Net income +23,714 +37,450 +12,800 +Net (income) loss attributable to noncontrolling interests +( 52 +) +383 +250 +Net income attributable to Alico, Inc. common stockholders +$ +23,662 +$ +37,833 +$ +13,050 +Per share information attributable to Alico, Inc. common stockholders: +Earnings per common share: +Basic +$ +3.16 +$ +5.06 +$ +1.59 +Diluted +$ +3.16 +$ +5.05 +$ +1.57 +Weighted-average number of common shares outstanding: +Basic +7,484 +7,472 +8,232 +Diluted +7,496 +7,493 +8,301 +Cash dividends declared per common share +$ +0.36 +$ +0.24 +$ +0.24 +See accompanying notes to the consolidated financial statements . +44 +ALICO, INC. +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +(in thousands) +Common stock +Additional +Paid-In +Treasury +Retained +Total +Alico, Inc. +Non- +controlling +Total +Shares +Amount +Capital +Stock +Earnings +Equity +Interest +Equity +September 30, 2017 +8,416 +$ +8,416 +$ +18,694 +$ +( 6,502 +) +$ +140,033 +$ +160,641 +$ +4,728 +$ +165,369 +Net income (loss) +— +— +— +— +13,050 +13,050 +( 250 +) +12,800 +Dividends +— +— +— +— +( 1,972 +) +( 1,972 +) +— +( 1,972 +) +Treasury stock purchases +— +— +— +( 2,215 +) +— +( 2,215 +) +— +( 2,215 +) +Capital contribution received from noncontrolling interest funding +— +— +— +— +— +— +1,000 +1,000 +Stock-based compensation: +Directors +— +— +( 322 +) +1,181 +— +859 +— +859 +Executives +— +— +1,754 +— +— +1,754 +— +1,754 +September 30, 2018 +8,416 +8,416 +20,126 +( 7,536 +) +151,111 +172,117 +5,478 +177,595 +Net income (loss) +— +— +— +— +37,833 +37,833 +( 383 +) +37,450 +Dividends +— +— +— +— +( 1,792 +) +( 1,792 +) +— +( 1,792 +) +Treasury stock purchases +— +— +— +( 25,576 +) +— +( 25,576 +) +— +( 25,576 +) +ASC 610-20 adoption +— +— +— +— +10,897 +10,897 +— +10,897 +Stock-based compensation: +Directors +— +— +( 300 +) +1,169 +— +869 +— +869 +Executives +— +— +778 +— +— +778 +— +778 +Executive forfeiture +— +— +( 823 +) +— +— +( 823 +) +— +( 823 +) +September 30, 2019 +8,416 +8,416 +19,781 +( 31,943 +) +198,049 +194,303 +5,095 +199,398 +Net income +— +— +— +— +23,662 +23,662 +52 +23,714 +Dividends +— +— +— +— +( 2,692 +) +( 2,692 +) +— +( 2,692 +) +Treasury stock purchases +— +— +— +( 238 +) +— +( 238 +) +— +( 238 +) +Capital contribution received from noncontrolling interest funding +— +— +— +— +— +— +294 +294 +Stock-based compensation: +Directors +— +— +( 669 +) +1,402 +— +733 +— +733 +Executives and managers +— +— +573 +— +— +573 +— +573 +September 30, 2020 +8,416 +$ +8,416 +$ +19,685 +$ +( 30,779 +) +$ +219,019 +$ +216,341 +$ +5,441 +$ +221,782 +See accompanying notes to the consolidated financial statements . +45 +ALICO, INC. +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Net cash provided by operating activities: +Net income +$ +23,714 +$ +37,450 +$ +12,800 +Adjustments to reconcile net income to net cash provided by operating activities: +Deferred gain on sale of sugarcane land +— +— +( 967 +) +Depreciation, depletion and amortization +14,520 +13,924 +13,756 +Deferred income tax expense (benefit) +7,603 +3,267 +( 1,955 +) +Cash surrender value +( 10 +) +11 +( 27 +) +Deferred retirement benefits +( 5,226 +) +829 +( 41 +) +Gain on sale of real estate, property and equipment and assets held for sale +( 30,424 +) +( 13,166 +) +( 10,281 +) +Inventory net realizable value adjustment +— +808 +1,115 +Loss on disposal of property and equipment +659 +— +207 +Change in fair value of derivatives +— +989 +— +Impairment of long-lived assets +1,321 +396 +2,234 +Impairment of right-of-use-asset +87 +— +— +Non-cash interest expense on deferred gain on sugarcane land +— +— +1,361 +Insurance proceeds received for damage to property and equipment +— +( 486 +) +( 477 +) +Stock-based compensation expense +1,306 +824 +2,613 +Other +— +— +29 +Changes in operating assets and liabilities: +Accounts receivable +( 3,634 +) +1,531 +1,718 +Inventories +( 712 +) +82 +( 6,554 +) +Prepaid expenses +( 135 +) +( 211 +) +177 +Income tax receivable +( 781 +) +15 +( 15 +) +Other assets +( 839 +) +288 +23 +Accounts payable and accrued liabilities +( 1,530 +) +( 1,113 +) +2,987 +Income tax payable +( 5,536 +) +3,216 +2,320 +Other liabilities +666 +178 +( 2,445 +) +Net cash provided by operating activities +1,049 +48,832 +18,578 +Cash flows from investing activities: +Purchases of property and equipment +( 21,705 +) +( 20,000 +) +( 16,352 +) +Net proceeds from sale of real estate, property and equipment and assets held for sale +31,541 +14,602 +39,780 +Insurance proceeds received for damage to property and equipment +— +486 +477 +Change in deposits on purchase of citrus trees +( 458 +) +( 108 +) +( 431 +) +Advances on notes receivables, net +136 +60 +( 575 +) +Other +( 25 +) +— +25 +Net cash provided by (used in) investing activities +9,489 +( 4,960 +) +22,924 +Cash flows from financing activities: +Repayments on revolving lines of credit +( 114,581 +) +( 89,231 +) +( 25,600 +) +Borrowings on revolving lines of credit +117,523 +86,546 +28,285 +Principal payments on term loans +( 15,198 +) +( 10,900 +) +( 12,127 +) +Treasury stock purchases +( 238 +) +( 25,576 +) +( 2,215 +) +Payment on termination of sugarcane agreement +— +( 11,300 +) +— +Dividends paid +( 2,466 +) +( 1,833 +) +( 1,972 +) +Deferred financing costs +( 23 +) +— +— +Capital contribution received from noncontrolling interest +294 +— +1,000 +Capital lease obligation payments +— +— +( 8 +) +Net cash used in financing activities +( 14,689 +) +( 52,294 +) +( 12,637 +) +Net (decrease) increase in cash and cash equivalents and restricted cash +( 4,151 +) +( 8,422 +) +28,865 +Cash and cash equivalents and restricted cash at beginning of the period +23,838 +32,260 +3,395 +Cash and cash equivalents and restricted cash at end of the period +$ +19,687 +$ +23,838 +$ +32,260 +Supplemental disclosure of cash flow information: +Cash paid for interest, net of amount capitalized +$ +5,614 +$ +6,940 +$ +6,721 +Cash paid for income taxes +$ +6,403 +$ +6,285 +$ +25 +Supplemental disclosure of non-cash investing and financing activities: +Dividend declared but unpaid +$ +674 +$ +449 +$ +492 +See accompanying notes to the consolidated financial statements. +46 +ALICO, INC. +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +Note 1. Description of Business and Basis of Presentation +Description of Business +Alico, Inc., together with its subsidiaries (collectively, “Alico”, the “Company", "we", "us" or "our”), is a Florida agribusiness and land management company owning approximately 100,000 acres of land throughout Florida, holding mineral rights on approximately 90,000 of those owned acres. The Company manages its land based upon its primary usage, and reviews its performance based upon two primary classifications: (i) Alico Citrus and (ii) Land Management and Other Operations. Financial results are presented based upon its two business segments (Alico Citrus and Land Management and Other Operations). +Basis of Presentation +The Company has prepared the accompanying financial statements on a consolidated basis. These accompanying Consolidated Financial Statements, which are referred to herein as the “Financial Statements”, have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). All significant intercompany transactions and account balances between the consolidated businesses have been eliminated. +Segments +Operating segments are defined in the criteria established under the Financial Accounting Standards Board - Accounting Standards Codification (“FASB ASC”) Topic 280 as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: (i) Alico Citrus and (ii) Land Management and Other Operations. +Principles of Consolidation +The Financial Statements include the accounts of Alico and the accounts of all the subsidiaries in which a controlling interest is held by the Company. Under U.S. GAAP, consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. The Company’s subsidiaries include: Alico Land Development, Inc., Alico-Agri, Ltd., Alico Plant World, LLC, Alico Fruit Company, LLC, Alico Citrus Nursery, LLC, Alico Chemical Sales, LLC, 734 Citrus Holdings, LLC and subsidiaries, Alico Fresh Fruit, LLC, Alico Skink Mitigation, LLC and Citree Holdings 1, LLC (“Citree”). The Company considers the criteria established under FASB ASC Topic 810, “Consolidations” in its consolidation process. All significant intercompany balances and transactions have been eliminated in consolidation. +Use of Estimates +The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the accompanying Financial Statements, the disclosure of contingent assets and liabilities in the Financial Statements and the accompanying Notes, and the reported amounts of revenues and expenses and cash flows during the periods presented. Actual results could differ from those estimates. The Company evaluates estimates on an ongoing basis. The estimates are based on current and expected economic conditions, historical experience, the experience and judgment of the Company’s management and various other specific assumptions that the Company believes to be reasonable. +Noncontrolling Interest in Consolidated Subsidiary +The Financial Statements include all assets and liabilities of the less-than-100%-owned subsidiary the Company controls, Citree. Accordingly, the Company has recorded a noncontrolling interest in the equity of such entity. Citree had net income of $ 107,051 for the fiscal year ended September 30, 2020 and net losses of $ 781,783 , and $ 511,854 for the fiscal years ended September 30, 2019 and 2018, respectively, of which $ 54,596 of net income and $ 398,709 and $ 261,046 of net losses was attributable to the Company for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. The shift to net income for the fiscal year ended September 30, 2020 was the result of reimbursements received under the federal relief program relating to Hurricane Irma, aggregating approximately $ 493,000 . +47 +Recent Accounting Pronouncements +In January 2017, the FASB issued ASU 2017-04, “Intangibles-Goodwill and Other” (Topic 350), which simplifies the accounting for goodwill impairment. The updated guidance eliminates Step 2 of the impairment test, which requires entities to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value, determined in Step 1. This guidance will become effective for us in the fiscal years beginning after December 15, 2019, including interim periods within those reporting periods. We will adopt this guidance using a prospective approach. Earlier adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 will have a material impact on its consolidated financial statements and will adopt the standard effective October 1, 2020. +In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurements” ( “ ASU 2018-13 ” ), which aims to improve the overall usefulness of disclosures to financial statement users and reduce unnecessary costs to companies when preparing fair value measurement disclosures. ASU 2018-13 is effective for annual and interim periods in the fiscal years beginning after December 15, 2019. Early adoption is permitted. Retrospective adoption is required, except for certain disclosures, which will be required to be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. The Company does not expect the adoption of ASU 2018-13 will have a material impact on its consolidated financial statements and will adopt the standard effective October 1, 2020. +In November 2018, the FASB issued ASU 2018-19, “Codification Improvements to Topic 326, Financial Instruments-Credit Losses.” ASU 2018-19 clarifies that receivables arising from operating leases are not within the scope of Subtopic 326-20. Instead, impairment of receivables arising from operating leases should be accounted for in accordance with Leases (Topic 842). The standard is effective for the Company on October 1, 2020, with early adoption permitted. The Company does not expect the adoption of ASU 2018-19 to have a material impact on the consolidated financial statements of the Company. +In December 2019, the FASB issued ASU 2019-12, which simplifies the accounting for income taxes by removing certain exceptions to the general principles in the existing guidance for income taxes and making other minor improvements. The amendments in the ASU are effective for the Company on October 1, 2021. The Company does not expect the adoption of ASU 2019-12 will have a material impact on its consolidated financial statements and will adopt the standard effective October 1, 2021. +In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which provides temporary optional expedients and exceptions for applying generally accepted accounting principles to contracts, hedging relationships and other transactions affected by reference rate reform. The Company’s floating rate notes and variable funding notes bear interest at fluctuating interest rates based on LIBOR. If LIBOR ceases to exist, the Company may need to renegotiate its loan agreements and the Company cannot predict what alternative index would be negotiated with its lenders. ASU 2020-04 is currently effective and upon adoption may be applied prospectively to contract modifications made on or before December 31, 2022. The Company is currently assessing the impact of adopting this standard and the impact on its consolidated financial statements. +The Company has reviewed other recently issued accounting standards which have not yet been adopted in order to determine their potential effect, if any, on the results of operations or financial condition. Based on the review of these other recently issued standards, the Company does not currently believe that any of those accounting pronouncements will have a significant effect on its current or future financial position, results of operations, cash flows or disclosures. +Recently Adopted Accounting Pronouncements +In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” , and subsequently issued several supplemental and/or clarifying ASU’s (collectively, “ASC 606”), which prescribes a comprehensive new revenue recognition standard that supersedes previously existing revenue recognition guidance. The new model provides a five-step analysis in determining when and how revenue is recognized. The core principle of the new guidance is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also requires new, expanded disclosures regarding revenue recognition. The standard allows initial application to be performed retrospectively to each period presented or as a modified retrospective adjustment as of the date of adoption. ASC 606 also provides for certain practical expedients, including the option to expense as incurred the incremental costs of obtaining a contract, if the contract period is for one year or less, and policy elections regarding shipping and handling that provides the option to account for shipping and handling costs as contract fulfillment costs. The Company adopted ASC 606 effective October 1, 2018, the first day of its 2019 fiscal year, using the modified retrospective method. The implementation of ASC 606 did not require an adjustment to the opening balance of retained earnings as of October 1, 2018 (see Note 2. “Revenue Recognition”). +48 +In February 2017, the FASB issued ASU 2017-05, “Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets” (ASC 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets. This standard clarifies the scope and application of ASC 610-20 on the sale, transfer, and derecognition of nonfinancial assets and in substance nonfinancial assets to non-customers, including partial sales. It also provides guidance on how gains and losses on transfers of nonfinancial assets and in substance nonfinancial assets to non-customers are recognized. The standard also clarifies the derecognition of businesses is under the scope of ASC 810. The standard was required to be adopted concurrently with ASC 606, however an entity did not have to apply the same transition method as ASC 606. The Company adopted ASC 610-20 (“ASC 610-20”) effective October 1, 2018, the first day of its 2019 fiscal year, using the modified retrospective method. The implementation of ASC 610-20 resulted in an adjustment to increase the opening balance of retained earnings by $ 10,897,000 , net of taxes, as of October 1, 2018. As a result of the ASU 610-20, guidance specific to real estate sales in ASC 360-20 will be eliminated. As such, sales and partial sales of real estate assets will now be subject to the same derecognition model as all other nonfinancial assets. +The ASU 610-20 will also impact the accounting for partial sales of nonfinancial assets (including in substance real estate). When an entity transfers its controlling interest in a nonfinancial asset, but retains a noncontrolling ownership interest, the entity will measure the retained interest at fair value. This will result in full gain/loss recognition upon the sale of a controlling interest in a nonfinancial asset. Current guidance generally prohibits gain recognition on the retained interest. +The ASU 610-20 was effective for fiscal years beginning after December 15, 2017, and interim periods within those years and thus was effective for the Company for our fiscal year beginning October 1, 2018. The ASU 610-20 will be applied prospectively to any transaction occurring from the date of adoption. The Company adopted ASU 360-20 effective October 1, 2018. The new guidance did not have a material impact on the Company’s consolidated financial statements as it relates to the deferred gain on the sale of the Company’s sugarcane lands (see Note 8. “Deferred Gain on Sale”). +In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230).” This ASU will provide guidance on the presentation and classification of specific cash flow items to improve consistency within the statement of cash flows. This ASU is effective for the Company for our fiscal year beginning October 1, 2019 with early adoption permitted. The Company adopted ASU 2016-15 effective September 30, 2019 and the impact under this ASU is that the Company reported certain proceeds from insurance claims relating to property and equipment in the statement of cash flows as investing activities in the Consolidated Statement of Cash Flows. +Leases +In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842).” This guidance requires entities that sign leases as a lessee to recognize right-of-use assets and lease liabilities for those leases classified as operating leases under previous U.S. GAAP. The accounting applied by a lessor is largely unchanged from that applied under previous U.S. GAAP. The Company adopted ASU 2016-02 on October 1, 2019. +The Company determines whether an arrangement is a lease at inception. The Company’s leases consist of operating lease arrangements for certain office space, tractor leases and IT facilities. When these lease arrangements include lease and non-lease components, the Company accounts for lease components and non-lease components (e.g. common area maintenance) separately based on their relative standalone prices. +Any lease arrangements with an initial term of 12 months or less are not recorded on the Company’s Condensed Consolidated Balance Sheets, and it recognizes lease cost for these lease arrangements on a straight-line basis over the lease term. Many lease arrangements provide the options to exercise one or more renewal terms or to terminate the lease arrangement. The Company includes these options when it will be reasonably certain to exercise them in the lease term used to establish the right-of-use assets and lease liabilities. Generally, lease agreements do not include an option to purchase the leased asset, residual value guarantees or material restrictive covenants. +As most of our lease arrangements do not provide an implicit interest rate, the Company applies an incremental borrowing rate based on the information available at the commencement date of the lease arrangement to determine the present value of lease payments. +No lease costs associated with finance leases and sale-leaseback transactions occurred and our lease income associated with lessor and sublease arrangements are not material to our Consolidated Financial Statements. +49 +Our operating leases are reported in our Consolidated Balance Sheets as follows: +(in thousands) +September 30, +Operating lease components +Classification +2020 +Right-of-use assets +Other non-current assets +$ +774 +Current lease liabilities +Other current liabilities +$ +512 +Non-current lease liabilities +Other liabilities +$ +356 +Our operating leases cost components are reported in our Consolidated Statements of Operations as follows: +(in thousands) +September 30, +Operating lease components +Classification +2020 +Operating lease costs +General and administrative expenses +$ +246 +Operating lease right-of-use asset impairment +Other expense +$ +87 +Future maturities of our operating lease obligations as of September 30, 2020 by fiscal year are as follows: +(in thousands) +2021 +$ +519 +2022 +324 +2023 +48 +Total noncancelable future lease obligations +$ +891 +Less: Interest +( 24 +) +Present value of lease obligations +$ +867 +The weighted-average remaining lease term and weighted-average discount rate for our operating leases are as follows: +September 30, +2020 +Weighted-average remaining lease term +1.61 years +Weighted-average discount rate +3.1 +% +Cash flow information related to leases consists of the following: +(in thousands) +September 30, +2020 +Cash paid for amounts included in the measurement of lease liabilities: +Operating cash flows from operating leases +$ +247 +Right-of-use assets obtained in exchange for lease obligations: +Operating leases +$ +1,095 +The COVID-19 Pandemic +On March 11, 2020, the World Health Organization declared the current novel coronavirus outbreak (“COVID-19”) to be a global pandemic. In response to this declaration and the rapid spread of COVID-19 within the United States, federal, state and local governments throughout the country have imposed varying degrees of restrictions on social and commercial activity to promote social distancing in an effort to slow the spread of the illness. These measures have had a significant adverse impact upon many sectors of the economy, including certain agriculture businesses. To date, the Company has experienced no material adverse impact from this pandemic. +50 +Reclassifications +Certain prior year amounts have been reclassified in the accompanying Financial Statements for consistent presentation to the current period. These reclassifications had no impact on net income, equity, cash flows or working capital as previously reported. +Seasonality +The Company is primarily engaged in the production of fruit for sale to citrus markets, which is of a seasonal nature, and subject to the influence of natural phenomena and wide price fluctuations. Historically, the second and third quarters of Alico's fiscal year produce the majority of the Company's annual revenue. Working capital requirements are typically greater in the first and fourth quarters of the fiscal year, coinciding with harvesting cycles. Because of the seasonality of the business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year. +Note 2. Summary of Significant Accounting Policies +Revenue Recognition +Revenues are derived from the sale of processed fruit, fresh fruit, other citrus revenue, leasing revenue and other resource revenues. The majority of the revenue is generated from the sale of citrus fruit to processing facilities, fresh fruit sales and grove management services. +For fruit sales, the Company recognizes revenue at the amount it expects to be entitled to be paid, determined when control of the products or services is transferred to its customers, which occurs upon delivery of and acceptance of the fruit by the customer and the Company has a right to payment. +The Company has identified one performance obligation as the delivery of fruit to the processing facility (or harvesting of the citrus in the case of fresh fruit) of the customer for each separate variety of fruit identified in the contract. The Company initially recognizes revenue in an amount which is estimated based on contractual and market prices, if such market price falls within the range (known as “floor” and “ceiling” prices) identified in the specific contracts. Additionally, the Company also has a contractual agreement whereby revenue is determined based on applying a cost-plus structure methodology. As such, since these contracts contain elements of variable consideration, the Company recognizes this variable consideration by using the expected value method. On a quarterly basis, management reviews the reasonableness of the revenues accrued based on buyers’ and processors’ advances to growers, cash and futures markets and experience in the industry. Adjustments are made throughout the year to these estimates as more current relevant industry information becomes available. Differences between the estimates and the final realization of revenues at the close of the harvesting season can result in either an increase or decrease to reported revenues. During the periods presented, no material adjustments were made to the reported citrus revenues. +Receivables under contracts, whereby pricing is based on contractual and market prices, are primarily paid at the floor amount and are collected within seven days after the harvest week. Any adjustments to pricing as a result of changes in market prices are collected or paid thirty to sixty days after final market pricing is published. Receivables under contracts, whereby pricing is based off a cost-plus structure methodology, are paid at the final prior year rate. Any adjustments to pricing as a result of the cost-plus calculation are collected or paid upon finalization of the calculation and agreement by both parties. As of September 30, 2020 and 2019, the Company had total receivables relating to sales of citrus of $ 584,000 and $ 160,000 , respectively, recorded in Accounts Receivable, net, in the Consolidated Balance Sheets. +For grove management services, the Company has identified one performance obligation relating to the management of the third party’s groves. Grove management services include caretaking of the citrus groves, harvesting and hauling of citrus, management and coordination of citrus sales and other related activities. The Company is reimbursed for expenses incurred in the execution of its management duties and the Company receives a per acre management fee. The Company recognizes operating revenue, including a management fee, and corresponding operating expenses when services are rendered and consumed. +51 +Disaggregated Revenue +Revenues disaggregated by significant products and services for the fiscal years ended September 30, 2020, 2019 and 2018 are as follows: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Alico Citrus +Early and Mid-Season +$ +31,303 +$ +39,574 +$ +24,309 +Valencias +50,060 +73,480 +48,865 +Fresh fruit +2,321 +3,629 +2,054 +Grove management services +4,599 +1,342 +1,808 +Other +1,086 +1,006 +1,085 +Total +$ +89,369 +$ +119,031 +$ +78,121 +Land Management and Other Operations +Land and other leasing +$ +2,683 +$ +2,787 +$ +2,595 +Sale of calves and culls +— +— +57 +Other +455 +433 +508 +Total +$ +3,138 +$ +3,220 +$ +3,160 +Total Revenues +$ +92,507 +$ +122,251 +$ +81,281 +During the time that Alico was engaged in the business of raising and selling cattle, Alico recognized revenues from cattle sales at the time the cattle were delivered. +Fair Value of Financial Instruments +The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities approximate their fair values due to the short term and immediate nature of these financial instruments. The carrying amounts of the Company’s debt approximates fair value as the debt is with commercial lenders at interest rates that vary with market conditions or have fixed rates that approximate market rates for obligations with similar terms and maturities (see Note 8. “Fair Value Measurements”). +Cash and Cash Equivalents +The Company considers cash in banks and highly liquid instruments with an original maturity of three months or less to be cash and cash equivalents. At various times throughout the fiscal year, and as of September 30, 2020, some accounts held at financial institutions were in excess of the federally insured limit of $ 250,000 . The Company has not experienced any losses on these accounts and believes credit risk to be minimal. +Restricted Cash +Restricted cash is comprised of certain cash receipts from the sale of property which was being held specifically for the purpose of deferring a tax impact on the gain on sale of the property and other cash received from the sale of certain assets in which the use of funds were restricted. +In September 2020, the Company sold certain sections of the West Ranch, from which a portion of the net cash proceeds amounting to $ 16,524,000 were being held by a qualified intermediary in coordination to purchase a like-kind asset and defer a portion of the gain on sale of the ranch land. Such funds were included in restricted cash. In October 2020, the Company closed on a purchase of a like-kind asset and used all of these net cash proceeds which was being held by the intermediary (see Note 17. “Subsequent Events”). +For certain sales transactions, the Company sells property which serves as collateral for specific debt obligations. As a result, the sale proceeds are only permitted to be used to purchase like-kind citrus groves acceptable to the debt holder or to pay down existing debt obligations and thus are included in restricted cash. For the fiscal year ended September 30, 2019, the Company utilized restricted cash of $ 1,800,000 towards the purchase of citrus groves. Such purchases are included as part of the collateral under certain debt obligations. Additionally, in November 2019, the Company utilized restricted cash to pay down existing debt, including outstanding interest on such debt, in the amount of $ 4,489,000 . In July 2020, the remaining restricted cash of approximately $ 719,000 relating to collateral property under debt obligations, including interest earned in the account, was released without further obligation to the Company. +52 +Accounts receivable +Accounts receivable from customers are generated from revenues based on the sale of citrus, grove management, leasing and other transactions. The Company grants credit in the course of its operations to third party customers. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company provides an allowance for doubtful accounts for amounts which are not probable of collection. The estimate, evaluated quarterly by the Company, is based on historical collection experience, current macroeconomic climate and market conditions and a review of the current status of each customer’s account. Changes in the financial viability of significant customers and worsening of economic conditions may require changes to its estimate of the recoverability of the receivables. Such changes in estimates are recorded in the period in which these changes become known. The bad debt expense is included in general and administrative expenses in the Consolidated Statements of Operations. +The following table presents accounts receivable, net as of September 30, 2020 and 2019: +(in thousands) +September 30, +2020 +2019 +Accounts receivable +$ +4,384 +$ +746 +Allowance for doubtful accounts +( 37 +) +( 33 +) +Accounts receivable, net +$ +4,347 +$ +713 +Concentrations +Accounts receivable from the Company’s major customer as of September 30, 2020 and 2019 and revenue from such customers for the fiscal years ended September 30, 2020, 2019 and 2018, are as follows: +(in thousands) +Accounts Receivable +Revenue +% of Total Revenue +2020 +2019 +2020 +2019 +2018 +2020 +2019 +2018 +Tropicana +$ +— +$ +— +$ +80,388 +$ +108,318 +$ +70,396 +86.9 +% +88.6 +% +86.6 +% +The citrus industry is subject to various factors over which growers have limited or no control, including weather conditions, disease, pestilence, water supply and market price fluctuations. Market prices are highly sensitive to aggregate domestic and foreign crop sizes, as well as factors including, but not limited to, weather and competition from foreign countries. +Real Estate +In recognizing revenues from land sales, the Company applies specific revenue recognition criteria, in accordance with U.S. GAAP, to determine when land sales revenues can be recorded. For example, in order to fully recognize a gain resulting from a real estate transaction, the sale must be consummated with a sufficient down payment of at least 20 % to 25 % of the sales price depending upon the type and timeframe for development of the property sold and any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold. When these criteria are not met, the Company recognizes a gain proportionate to collections utilizing either the installment method or deposit method as appropriate. +Inventories +The costs of growing crops, including but not limited to labor, fertilization, fuel, crop nutrition, irrigation, and depreciation, are capitalized into inventory throughout the respective crop year. Such costs are expensed as cost of sales when the crops are harvested and are recorded as operating expenses in the Consolidated Statements of Operations. Inventories are stated at the lower of cost or net realizable value. The cost for unharvested citrus crops is based on accumulated production costs incurred during the period from January 1 through the balance sheet date. +Property and Equipment +Property and equipment are stated at cost, net of accumulated depreciation, depletion and amortization. Major improvements are capitalized while expenditures for maintenance and repairs are expensed when incurred. Costs related to the development of citrus groves through planting of trees are capitalized. Such costs include land clearing, excavation and construction of ditches, dikes, roads, and reservoirs, among other costs. After the planting, caretaking costs or pre-productive maintenance costs are capitalized for 4 years. After 4 years, a planting is considered to have reached maturity and the accumulated costs are depreciated over 25 years, except for land clearing and excavation, which are considered costs of land and not depreciated. +53 +Real estate costs incurred for the acquisition, development and construction of real estate projects are capitalized. +Depreciation is provided on a straight-line basis over the estimated useful lives of the depreciable assets, with the exception of leasehold improvements and assets acquired through capital leases, which are depreciated over their estimated useful lives if the lease transfers ownership or contains a bargain purchase option, otherwise the term of the lease. +The estimated useful lives for property and equipment are primarily as follows: +Citrus trees +25 years +Equipment and other facilities +3 - 20 years +Buildings and improvements +25 - 39 years +Changes in circumstances, such as technological advances or changes to our business model or capital strategy could result in the actual useful lives differing from the original estimates. In those cases where the Company determines that the useful life of property and equipment should be shortened, Alico depreciates the asset over its revised estimated remaining useful life, thereby increasing depreciation expense (see Note 5. “Property and Equipment, Net”). +Impairment of Long-Lived Assets +The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The Company records impairment losses on long-lived assets used in operations, or asset group, when events and circumstances indicate that the assets might be impaired and the estimated cash flows (undiscounted and without interest charges) to be generated by those assets or asset group over the remaining lives of the assets or asset group are less than the carrying amounts of those assets. In calculating impairments and the estimated cash flows, the Company assigns its asset groups by determining the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other Company assets. The net carrying values of assets or asset group not recoverable are reduced to their fair values. Alico's cash flow estimates are based on historical results adjusted to reflect best estimates of future market conditions and operating conditions. For fiscal years ended September 30, 2020, 2019 and 2018, the Company recorded impairments to its long-lived assets (see Note 5. “Property and Equipment, Net”). As of September 30, 2020 and 2019, long-lived assets were comprised of property and equipment. +Goodwill and Intangible Assets +Goodwill represents the excess of the purchase price of acquired businesses over the fair value of the assets acquired less liabilities assumed in connection with such acquisition. In accordance with the provisions of ASC 350, Intangibles-Goodwill and Other, goodwill and intangible assets with indefinite useful lives acquired in an acquisition are not amortized, but instead are tested for impairment at least annually, on the same date, or more frequently should an event occur or circumstances indicate that the carrying amount may be impaired. Such events or circumstances may be a significant change in business climate, economic and industry trends, legal factors, negative operating performance indicators, significant competition, changes in strategy or disposition of a reporting unit or a portion thereof. +In the evaluation of goodwill for impairment, Alico has the option to perform a qualitative assessment to determine whether further impairment testing is necessary or to perform a quantitative assessment by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Under the qualitative assessment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. If, under the quantitative assessment, the fair value of a reporting unit is less than its carrying amount, then the amount of the impairment loss, if any, must be measured under step two of the impairment analysis. In step two of the analysis, Alico would record an impairment loss equal to the excess of the carrying value of the reporting unit’s goodwill over its implied fair value, should such a circumstance arise. As of September 30, 2020 and 2019, no impairment was required. +Other Non-Current Assets +Other non-current assets primarily include investments owned in agricultural cooperatives, cash surrender value on life insurance, and deposits on the purchase of citrus trees. Investments in stock related to agricultural cooperatives are carried at cost. +54 +Income Taxes +The Company uses the asset and liability method of accounting for deferred income taxes. The provision for income taxes includes income taxes currently payable and those deferred as a result of temporary differences between the financial statements and the income tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates on deferred income tax assets and liabilities is recognized in income or loss in the period that includes the enactment date. A valuation allowance is provided to reduce deferred tax assets to the amount of future tax benefit when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Projected future taxable income and ongoing tax planning strategies are considered and evaluated when assessing the need for a valuation allowance. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on the Company’s income tax provision and net income or loss in the period the determination is made. For the fiscal years ended September 30, 2020, 2019 and 2018, the Company recorded valuation allowances of $ 0 , $ 0 , and $ 5,634,000 , respectively, relating to the unutilized capital loss carryforwards which expired. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. +The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which a change in judgment occurs. The Company records interest related to unrecognized tax benefits in income tax expense. +Earnings per Share +Basic earnings per share for the Company’s common stock is calculated by dividing net income attributable to Alico common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per common share is similarly calculated, except that the calculation includes the dilutive effect of the assumed issuance of shares of common stock issuable under equity-based compensation plans in accordance with the treasury stock method, or any other type of securities convertible into common stock, except where the inclusion of such common shares would have an anti-dilutive effect. +The following table presents a reconciliation of basic to diluted weighted average common shares outstanding for fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Weighted Average Common Shares Outstanding - Basic +7,484 +7,472 +8,232 +Effect of dilutive securities - stock options and unrestricted stock +12 +21 +69 +Weighted Average Common Shares Outstanding - Diluted +7,496 +7,493 +8,301 +For the fiscal years ended September 30, 2020, 2019 and 2018, respectively, the Company issued 118,000 , 10,000 , and 300,000 , respectively, stock options to certain executives and managers of the Company. Non-vested restricted shares of common stock entitle the holder to receive non-forfeitable dividends upon issuance and are included in the calculation of diluted earnings per common share. +Stock-Based Compensation +Stock-based compensation is measured based on the fair value of the equity award at the grant date and is typically expensed on a straight-line basis over the vesting period. Upon the vesting of restricted stock, the Company issues common stock from common shares held in treasury. +Total stock-based compensation expense for the three years ended September 30, 2020, 2019 and 2018 in general and administrative expense was as follows: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Stock-based compensation expense: +Executives +$ +497 +$ +778 +$ +1,754 +Management +76 +— +— +Executive forfeitures +— +( 823 +) +— +Board of Directors +733 +869 +859 +Total stock-based compensation expense +$ +1,306 +$ +824 +$ +2,613 +55 +Note 3. Inventories +Inventories consist of the following at September 30, 2020 and 2019: +(in thousands) +September 30, +2020 +2019 +Unharvested fruit crop on the trees +$ +40,265 +$ +39,276 +Other +590 +867 +Total inventories +$ +40,855 +$ +40,143 +The Company records its inventory at the lower of cost or net realizable value. For the fiscal year ended September 30, 2019, the Company recorded adjustments of approximately $ 808,000 to reduce inventory to net realizable value. This adjustment to inventory is included in operating expenses in the Consolidated Statement of Operations. +In September 2017, the State of Florida’s citrus business, including the Company’s unharvested citrus crop, was significantly impacted by Hurricane Irma. The impact of Hurricane Irma resulted in the premature drop of unharvested fruit and damage to citrus trees. +The Company is eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fourth quarter of fiscal year 2019 and for the fiscal year ended September 30, 2019, the Company received approximately $ 15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and a portion of the Part 2 reimbursement under the three-part program. For the fiscal year ended September 30, 2020, the Company received additional proceeds of approximately $ 4,629,000 under the Florida CRBG program. This represented the remaining portion of Part 2 reimbursement under the three-part program. The timing and amount to be received under Part 3 of the program has not been finalized. These federal relief proceeds are included as a reduction to operating expenses in the Consolidated Statements of Operations. +For the fiscal year ended September 30, 2019, the Company received insurance proceeds relating to Hurricane Irma of approximately $ 486,000 in additional property and casualty claims reimbursement. For the fiscal year ended September 30, 2018, the Company received insurance proceeds relating to Hurricane Irma of approximately $ 477,000 for property and casualty damage claims and approximately $ 8,952,000 for crop claims. These insurance proceeds are included as a reduction to operating expenses in the Consolidated Statements of Operations. There are no further property and casualty or crop insurance claims pending relating to Hurricane Irma. +Note 4. Assets Held for Sale +In accordance with its strategy to dispose of non-core and under-performing assets, the following assets have been classified as assets held for sale as of September 30, 2020 and September 30, 2019: +(in thousands) +Carrying Value +Fiscal Year Ended September 30, +2020 +2019 +East Ranch +$ +1,366 +$ +1,442 +Total Assets Held For Sale +$ +1,366 +$ +1,442 +On September 10, 2020, the State of Florida purchased, under the Florida Forever program, approximately 10,702 acres of the Alico Ranch for approximately $ 28,500,000 pursuant to an option agreement entered between the State of Florida and the Company. The Company recognized a gain of approximately $ 27,470,000 , which is included in Gain on sale of real estate, property and equipment and assets held for sale in the Consolidated Statements of Operations. The Company subsequently used a portion of the net cash proceeds to purchase a like-kind asset in October 2020, which allowed the Company to defer a portion of the tax impact of the gain on sale of the ranch land (see Note 17. “Subsequent Events”). +On March 27, 2020, the Company sold certain sections at the East Ranch for approximately $ 2,980,000 and realized a gain of approximately $ 2,748,000 . The Company subsequently used substantially all of the net cash proceeds to purchase a like-kind asset in May 2020, which will allow the Company to defer substantially all of the tax impact of the gain on sale of the ranch land. +For the fiscal year ended September 30, 2019, the Company sold certain trailers for approximately $ 47,000 , and reclassified the remaining Assets Held for Sale to property and equipment, as management has determined not to offer the remaining trailers for sale. +On October 30, 2018, the Company sold certain parcels at Frostproof for approximately $ 206,000 and realized a gain of approximately $ 12,000 . +56 +On May 2, 2018, the Company sold its Gal Hog property for approximately $ 7,300,000 and recognized a gain of approximately $ 6,709,000 . +On February 12, 2018, the Company sold its property at Chancey Bay for approximately $ 4,200,000 and realized a loss of approximately $ 51,000 . As part of the transaction, the Company agreed to pay the purchaser rent of $ 200,000 in exchange for the Company retaining the rights of harvesting and selling of the fruit in the 2017/2018 harvest season. +On February 9, 2018, the Company sold its nursery located in Gainesville for approximately $ 6,500,000 and realized a gain of approximately $ 111,000 . +On January 25, 2018, the Company sold its breeding herd to a third party for approximately $ 7,800,000 and realized a gain of approximately $ 1,759,000 . As part of this transaction, the purchaser is also leasing from the Company grazing and other rights on the Alico Ranch at a rate of $ 100,000 per month. Upon the sale of a parcel within the East Ranch, the lease rate was adjusted to $ 98,750 per month. +On January 19, 2018, the Company sold certain trailers to a third party for $ 500,000 . The Company received $ 125,000 and the remaining portion is to be paid in accordance with a promissory note, which bears interest at 5 %, over three years . +On October 30, 2017, the Company sold its corporate office building in Fort Myers, Florida for $ 5,300,000 and realized a gain of approximately $ 1,751,000 . The sales agreement provides that the Company lease back a portion of the office space for five years . Such lease is classified as an operating lease. +The Company recorded no impairment loss during the fiscal year ended September 30, 2020. The Company recorded an impairment loss of approximately $ 152,000 and $ 150,000 for the fiscal years ended September 30, 2019 and 2018, respectively. These impairment losses were included in operating expenses on the Consolidated Statements of Operations. +The Company has already used a portion of the proceeds from these various asset sales to pay down debt (see Note 6. "Long-Term Debt and Lines of Credit") and to purchase citrus groves and plans to use the remaining cash proceeds from the sale of these assets to purchase other citrus groves, pay down other debt and to fund future working capital requirements and for other corporate purposes. +Note 5. Property and Equipment, Net +Property and equipment, net consists of the following at September 30, 2020 and September 30, 2019: +(in thousands) +September 30, +2020 +2019 +Citrus trees +$ +296,012 +$ +281,149 +Equipment and other facilities +55,593 +54,622 +Buildings and improvements +8,128 +8,224 +Total depreciable properties +359,733 +343,995 +Less: accumulated depreciation and depletion +( 115,440 +) +( 104,169 +) +Net depreciable properties +244,293 +239,826 +Land and land improvements +105,768 +105,822 +Property and equipment, net +$ +350,061 +$ +345,648 +On June 1, 2020, the Company sold approximately 30 ranch acres to an employee for approximately $ 122,000 and recognized a gain of approximately $ 83,000 . +On May 4, 2020, the Company purchased 334 citrus acres for approximately $ 2,850,000 . This acquisition complements the Company’s existing citrus acres as these acres are located adjacent to existing groves in the Frostproof area. Additionally, this purchase was part of a like-kind exchange transaction, which allowed the Company to defer taxes relating to the sale of certain sections of the East Ranch. +For the fiscal year ended September 30, 2019, the Company purchased 203 acres of citrus blocks for approximately $ 1,950,000 . These purchases were made from grove owners from within the Company’s existing grove locations. In April 2019, the lender, PGIM Real Estate Finance, LLC (“Prudential”), agreed to accept those purchases completed through April 2019 as substitute collateral and release $ 1,800,000 from restricted cash, which was completed in the fourth quarter of fiscal year 2019. After April 2019, there were two additional purchases of Citrus blocks for approximately $ 100,000 that are not included as part of the substitution collateral. +57 +On September 27, 2019, the Company sold approximately 5,500 acres from its West Ranch for approximately $ 14,775,000 and realized a gain on sale of approximately $ 13,033,000 . Upon the sale of these acres, the lease rate pertaining to the grazing and other rights was adjusted from $ 98,750 to $ 80,000 per month, as space on these acres was previously being leased to a third party. +On September 29, 2018, the Company sold its property at Island Pond for $ 7,900,000 . As the Island Pond property was collateralized under one of the Company’s loan documents, $ 7,000,000 of the proceeds was restricted in use. +On September 28, 2018, The Company sold a parcel within the East Ranch for approximately $ 1,920,000 and realized a gain of approximately $ 1,759,000 . +On March 30, 2018, the Company sold property located on its Winter Haven location for approximately $ 225,000 and recognized a loss of approximately $ 50,000 . +On March 15, 2018, the Company sold certain parcels comprised of citrus trees and land located on its Ranch One grove for approximately $ 586,000 and recognized a loss of approximately $ 87,000 . +For fiscal years ended September 30, 2020, 2019 and 2018, the Company recorded impairments of approximately $ 723,000 , $ 244,000 and $ 2,084,000 , respectively, relating to the loss of citrus trees. +As a result of the sale of a portion of the Alico Ranch to the State of Florida comprising approximately 10,700 acres on the western part of the ranch and because the sale of those acres affected the proposed dispersed water management project, the Company decided to suspend all permit approval activities for its dispersed water management project and the Company wrote-down approximately $ 598,000 of assets relating to this project during the fourth quarter of the fiscal year ended September 30, 2020. +Note 6. Long-Term Debt and Lines of Credit +The following table summarizes long-term debt and related deferred financing costs, net of accumulated amortization at September 30, 2020 and September 30, 2019: +September 30, 2020 +September 30, 2019 +(in thousands) +Principal +Deferred +Financing +Costs, Net +Principal +Deferred +Financing +Costs, Net +Long-term debt, net of current portion: +Met Fixed-Rate Term Loans +$ +83,438 +$ +621 +$ +89,688 +$ +724 +Met Variable-Rate Term Loans +40,969 +286 +43,844 +334 +Met Citree Term Loan +4,512 +36 +4,750 +40 +Pru Loans A & B +15,097 +207 +16,257 +224 +Pru Loan E +4,235 +1 +4,455 +9 +Pru Loan F +— +— +4,455 +38 +148,251 +1,151 +163,449 +1,369 +Less current portion +9,145 +— +5,338 +— +Long-term debt +$ +139,106 +$ +1,151 +$ +158,111 +$ +1,369 +58 +The following table summarizes lines of credit and related deferred financing costs, net of accumulated amortization at September 30, 2020 and September 30, 2019: +September 30, 2020 +September 30, 2019 +(in thousands) +Principal +Deferred +Financing +Costs, Net +Principal +Deferred +Financing +Costs, Net +Lines of Credit: +RLOC +$ +— +$ +141 +$ +— +$ +8 +WCLC +2,942 +— +— +— +Lines of Credit +$ +2,942 +$ +141 +$ +— +$ +8 +Future maturities of long-term debt and lines of credit as of September 30, 2020 are as follows: +(in thousands) +September 30, 2020 +Due within one year +$ +9,145 +Due between one and two years +10,535 +Due between two and three years +10,535 +Due between three and four years +13,477 +Due between four and five years +10,535 +Due beyond five years +96,966 +Total future maturities +$ +151,193 +Interest costs expensed and capitalized were as follows: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Interest expense +$ +5,981 +$ +7,180 +$ +8,561 +Interest capitalized +1,228 +1,019 +933 +Total +$ +7,209 +$ +8,199 +$ +9,494 +Debt +The Company's credit facilities consist of $ 125,000,000 in fixed interest rate term loans (“Met Fixed-Rate Term Loans”), $ 57,500,000 in variable interest rate term loans (“Met Variable-Rate Term Loans”), a $ 25,000,000 revolving line of credit (“RLOC”) with Metropolitan Life Insurance Company and New England Life Insurance Company (collectively “Met”), and a $ 70,000,000 working capital line of credit (“WCLC”) with Rabo Agrifinance, Inc. (“Rabo”). +The term loans and RLOC are secured by real property. The security for the term loans and RLOC consists of approximately 38,200 gross acres of citrus groves and 5,800 gross acres of Ranch land. The WCLC is collateralized by the Company’s current assets and certain other personal property owned by the Company. +The term loans, collectively, are subject to quarterly principal payments of $ 2,281,250 , and mature November 1, 2029. The Met Fixed-Rate Term Loans bear interest at 4.15 % per annum, and the Met Variable-Rate Term Loans bear interest at a rate equal to 90 day LIBOR plus 165 basis points (the “LIBOR spread”). The LIBOR spread is subject to adjustment by Met beginning May 1, 2017 and is subject to further adjustment every two years thereafter until maturity. No adjustment in the LIBOR spread was made at May 1, 2019. Interest on the term loans is payable quarterly. The interest rates on the Met Variable-Rate Term Loans were 1.91 % per annum and 3.91 % per annum as of September 30, 2020 and September 30, 2019, respectively. +The Company may prepay up to $ 8,750,000 of the Met Fixed-Rate Term Loan principal annually without penalty, and any such prepayments may be applied to reduce subsequent mandatory principal payments. The maximum annual prepayment was made for calendar year 2015. During the first and second quarter of fiscal year 2018, the Company elected not to make its principal payment and utilized a portion of its 2015 prepayment to satisfy its principal payment requirements for such quarters. At September 30, 2020, the Company had $ 5,625,000 , available from its 2015 prepayment to reduce future mandatory principal payments should the Company elect to do so. The Met Variable-Rate Term Loans may be prepaid without penalty. +59 +In March 2020, as a precautionary measure, the Company drew down an aggregate of $ 70,000,000 on its revolving credit facilities; $ 20,000,000 on its RLOC and $ 50,000,000 on its WCLC. This decision was made to safeguard the Company’s liquidity and to increase available cash on hand in the event of a more protracted COVID-19 outbreak. As of September 30, 2020, the Company had paid back a majority of the balances on these credit facilities. +The RLOC bears interest at a floating rate equal to 90 day LIBOR plus 165 basis points, payable quarterly. The LIBOR spread was adjusted by the lender on May 1, 2017 and is subject to further adjustment every two years thereafter. No adjustment in the LIBOR spread was made at May 1, 2019. In October 2019, the RLOC agreement was modified to extend the current maturity of November 1, 2019 to November 1, 2029. The RLOC is subject to an annual commitment fee of 25 basis points on the unused portion of the line of credit. The RLOC is available for funding general corporate needs. The variable interest rate was 1.91 % per annum and 3.91 % per annum as of September 30, 2020 and September 30, 2019, respectively. Availability under the RLOC was $ 25,000,000 as of September 30, 2020. +The WCLC is a revolving credit facility and is available for funding working capital and general corporate requirements. The interest rate on the WCLC is based on the one month LIBOR, plus a spread, which is adjusted quarterly, based on the Company's debt service coverage ratio for the preceding quarter and can vary from 175 to 250 basis points. The rate is currently at LIBOR plus 175 basis points. The variable interest rate was 1.90 % per annum and 3.85 % per annum as of September 30, 2020 and September 30, 2019, respectively. The WCLC agreement was amended on August 25, 2020, and the primary terms of the amendment were an extension of the maturity to November 1, 2023. There were no changes to the commitment amount or interest rate. Availability under the WCLC was approximately $ 66,659,000 and $ 69,540,000 as of September 30, 2020 and September 30, 2019, respectively. +The WCLC is subject to a quarterly commitment fee on the daily unused availability under the line computed as the commitment amount less the aggregate of the outstanding loans and outstanding letters of credit. The commitment fee is adjusted quarterly based on Alico's debt service coverage ratio for the preceding quarter and can vary from a minimum of 20 basis points to a maximum of 30 basis points. Commitment fees to date have been charged at 20 basis points. +There was approximately $ 2,942,000 outstanding on the WCLC at September 30, 2020. The WCLC agreement provides for Rabo to issue up to $ 2,000,000 , reduced from $ 20,000,000 during fiscal year 2019, in letters of credit on the Company’s behalf. As of September 30, 2020, there was approximately $ 399,000 in outstanding letters of credit, which correspondingly reduced the Company's availability under the line of credit. +In 2014, the Company capitalized approximately $ 2,834,000 of debt financing costs related to the refinancing. These costs, together with approximately $ 339,000 of costs related to the retired debt, are being amortized to interest expense over the applicable terms of the loans. Additionally, approximately $ 23,000 and $ 133,000 of financing costs were incurred for the fiscal years ended September 30, 2020 and 2019, respectively, in connection with letters of credit. All previous costs are included in deferred financing costs and being amortized to interest expense over the applicable terms of the obligations. The unamortized balance of deferred financing costs related to the financing above was approximately $ 1,048,000 and approximately $ 1,066,000 at September 30, 2020 and September 30, 2019, respectively. +These credit facilities noted above are subject to various covenants including the following financial covenants: (i) minimum debt service coverage ratio of 1.10 to 1.00, (ii) tangible net worth of at least $ 160,000,000 increased annually by 10 % of consolidated net income for the preceding years, or approximately $ 167,336,000 for the year ended September 30, 2020, (iii) minimum current ratio of 1.50 to 1.00, (iv) debt to total assets ratio not greater than .625 to 1.00, and, (v) solely in the case of the WCLC, a limit on capital expenditures of $ 30,000,000 per fiscal year. As of September 30, 2020, the Company was in compliance with all of the financial covenants. +Credit facilities also include a Met Life term loan collateralized by 1,200 gross acres of citrus grove owned by Citree ("Met Citree Loan"). This is a $ 5,000,000 credit facility that bears interest at a fixed rate of 5.28 % per annum. Principal and interest payments are made on a quarterly basis. At September 30, 2020 and 2019, there was an outstanding balance of $ 4,512,000 and $ 4,750,000 , respectively. The loan matures in February 2029. The unamortized balance of deferred financing costs related to this loan was approximately $ 36,000 and $ 40,000 at September 30, 2020 and 2019, respectively. +Transition from LIBOR +The Company is currently evaluating the impact of the transition from LIBOR as an interest rate benchmark to other potential alternative reference rates. Currently, the Company has debt instruments in place that reference LIBOR-based rates. The transition from LIBOR is estimated to take place in 2022 and management will continue to actively assess the related opportunities and risks involved in this transition. +Silver Nip Citrus Debt +There are two fixed-rate term loans, with an original combined balance of $ 27,550,000 , bearing interest at 5.35 % per annum (“Pru Loans A & B”). Principal of $ 290,000 is payable quarterly, together with accrued interest. On February 15, 2015, 734 Citrus Holdings, LLC d/b/a Silver Nip Citrus (“Silver Nip Citrus”) made a prepayment of $ 750,000 . In addition, the Company made prepayments of approximately $ 4,453,000 in the +60 +second fiscal quarter of 2018 with proceeds from the sale of certain properties, which were collateralized under these loans. The Company may prepay up to $5,000,000 of principal without penalty. As such, the Company exceeded the allowed $ 5,000,000 prepayment by approximately $ 203,000 and was required to make a premium payment of approximately $ 22,000 . The loans are collateralized by approximately 5,700 of citrus groves in Collier, Hardee, Highlands and Polk Counties, Florida and mature on June 1, 2029 and June 1, 2033, respectively. +Silver Nip Citrus entered into two additional fixed-rate term loans with Prudential to finance the acquisition of a 1,500 acre citrus grove on September 4, 2014. Each loan was in the original amount of $ 5,500,000 with principal of $ 55,000 per loan being payable quarterly, together with accrued interest. One loan bears interest at 3.85 % per annum (“Pru Loan E”), while the other bore interest at 3.45 % per annum (“Pru Loan F”). The interest rate on Pru Loan E is subject to adjustment on September 1, 2019 and every year thereafter until maturity. No adjustment was made at September 1, 2019. Both loans were collateralized by approximately 1,500 gross acres of citrus groves in Charlotte County, Florida. Pru Loan E matures September 1, 2021, and Pru Loan F was scheduled to mature September 1, 2039. +In November 2019, the Company prepaid Pru Loan F in full by paying the then existing principal balance of $ 4,455,000 . As a result of this prepayment, the Company’s required annual principal payments on its Pru Loans was reduced by $ 220,000 per annum. +The Silver Nip Citrus credit agreements are subject to a financial covenant whereby the consolidated current ratio requirement is 1.00 to 1.00. Silver Nip Citrus was in compliance with the current ratio covenant as of September 30, 2020. +The unamortized balance of deferred financing costs related to the Silver Nip Citrus debt was approximately $ 208,000 and $ 271,000 at September 30, 2020 and 2019, respectively. +Note 7. Accrued Liabilities +Accrued liabilities consist of the following at September 30, 2020 and September 30, 2019: +(in thousands) +September 30, +2020 +2019 +Ad valorem taxes +$ +2,057 +$ +2,117 +Accrued interest +1,020 +1,110 +Accrued employee wages and benefits +2,214 +2,525 +Accrued dividends +674 +448 +Accrued contractual obligation associated with sale of real estate +— +402 +Consulting and separation charges +146 +400 +Accrued insurance +636 +544 +Other accrued liabilities +348 +223 +Total accrued liabilities +$ +7,095 +$ +7,769 +Note 8. Fair Value Measurements +The Company complies with the provisions of FASB ASC 820 “Fair Value Measurements” for its financial and non-financial assets and liabilities. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring or nonrecurring basis. +ASC 820 clarifies that fair value is an exit price representing the amount that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, ASC 820 establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value as follows: +• +Level 1- Observable inputs such as quoted prices in active markets; +• +Level 2- Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and +• +Level 3- Unobservable inputs in which there is little or no market data, such as internally developed valuation models which require the reporting entity to develop its own assumptions. +61 +As of September 30, 2020 and 2019, the Company did no t have any assets held for sale that had been measured at fair value on a non-recurring basis. +Management Security Plan +During August 2020, the Company paid out a lump sum of approximately $ 5,175,000 to all beneficiaries in the Management Security Plan, following the equivalent annuity approach. The Company used a third-party service provider to assist in the evaluation of investments in this plan. For prior year investment valuations, the Company used current market interest rates, quality estimates by rating agencies and valuation estimates by active market participants in order to determine values. As of September 30, 2020, due to the lump sum payment made in August 2020, the deferred retirements benefit was zero . As of September 30, 2019, deferred retirement benefits were valued based on actuarial data, contracted payment schedules and an estimated discount rate of 4.08 %. +Note 9. Common Stock and Options +Effective January 27, 2015, the Company’s Board of Directors adopted the 2015 Stock Incentive Plan (the “2015 Plan”) which provides for up to 1,250,000 common shares available for issuance to provide a long-term incentive plan for officers, employees, directors and/or consultants to directly link incentives to stockholder value. The 2015 Plan was approved by the Company’s stockholders in February 2015. The Company’s 2015 Plan provides for grants to executives in various forms including restricted shares of the Company’s common stock and stock options. Awards are discretionary and are determined by the Compensation Committee of the Board of Directors. Awards vest based upon service conditions. Non-vested restricted shares generally vest over requisite service periods of one to six years from the date of grant. +Restricted Stock +In November 2017, a senior executive was awarded 5,000 restricted shares of the Company’s common stock (“Restricted Stock”) under the 2015 Plan at a weighted average fair value of $ 31.95 per common share, vesting over 2.5 years. +The following table represents a summary of the status of the Company’s nonvested shares: +Nonvested Shares +Shares +Weighted- +Average +Grant Date +Fair Value +Nonvested Shares at September 30, 2017 +5,334 +$ +49.39 +Granted during fiscal year 2018 +5,000 +31.95 +Vested during fiscal year 2018 +( 3,001 +) +39.70 +Forfeited during fiscal year 2018 +— +— +Nonvested Shares at September 30, 2018 +7,333 +41.46 +Granted during fiscal year 2019 +— +— +Vested during fiscal year 2019 +( 1,667 +) +31.95 +Forfeited during fiscal year 2019 +— +— +Nonvested Shares at September 30, 2019 +5,666 +44.26 +Granted during fiscal year 2020 +— +— +Vested during fiscal year 2020 +( 5,666 +) +44.26 +Forfeited during fiscal year 2020 +— +— +Nonvested Shares at September 30, 2020 +— +$ +— +Stock compensation expense related to the Restricted Stock totaled approximately $ 69,000 , $ 104,000 , and $ 137,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. There was approximately $ 0 and $ 69,000 of total unrecognized stock compensation costs related to unvested stock compensation for the Restricted Stock grants at September 30, 2020 and September 30, 2019, respectively. +For the fiscal year ended September 30, 2020, 5,666 shares with a grant date fair value of approximately $ 251,000 became fully vested. +For the fiscal year ended September 30, 2019, 1,667 shares with a grant date fair value of approximately $ 53,000 became fully vested. +62 +Stock Option Grant +Stock option grants of 118,000 options to certain Officers and Managers of the Company (collectively the “2020 Option Grants”) were granted on October 11, 2019. The option exercise price was set at $ 33.96 , the closing price on October 11, 2019. The 2020 Option Grants will vest as follows: (i) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 35.00 ; (ii) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 40.00 ; (iii) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 45.00 ; and (iv) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the termination of employment, if the employment is terminated due to death or disability, (B) the date that is 12 months following the termination of employment, if the employment is terminated by the Company without cause, by the employee with good reason, or due to the employee’s retirement, or (C) the date of the termination of employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2022 then any unvested options will be forfeited. The 2020 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2020, the Company’s stock closed at $ 28.62 per share. For the fiscal year ended September 30, 2020, the Company’s common stock traded above $ 35.00 per share for twenty consecutive days. Accordingly, 25 % of the 2020 Option Grants are vested at September 30, 2020 and the corresponding stock option expense was recognized during the fiscal year ended September 30, 2020. +Stock option grants of 10,000 options to Mr. John Kiernan (the “2019 Option Grants”) were granted on October 25, 2018. The option exercise price for these options was set at $ 33.34 , the closing price on October 25, 2018. The 2019 Option Grants will vest as follows: (i) 3,333 of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 40.00 ; (ii) 3,333 of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 45.00 ; (iii) 3,334 of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 12 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2021 then any unvested options will be forfeited. The 2019 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2020, the Company’s common stock was trading at $ 28.62 per share, and during the fiscal year ended September 30, 2020, the stock did not trade above $ 40.00 per share; accordingly, no ne of the stock options are vested at September 30, 2020. +Stock option grants of 210,000 options to Mr. Remy Trafelet and 90,000 options to Mr. John Kiernan (collectively, the “2018 Option Grants”) were granted on September 7, 2018. The option exercise price for these options was set at $ 33.60 , the closing price on September 7, 2018. The 2018 Option Grants will vest as follows: (i) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 35.00 ; (ii) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 40.00 ; (iii) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 45.00 ; and (iv) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 50.00 . If the applicable stock price hurdles have not been achieved by (A) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 12 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by December 31, 2021 then any unvested options will be forfeited. The 2018 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2020, the Company’s common stock was trading at $ 28.62 per share. For the fiscal year ended September 30, 2020, the stock traded above $ 35.00 per share for a consecutive twenty days; accordingly, 25 % of Mr. Kiernan's 2018 Option Grants are vested at September 30, 2020 and the corresponding stock option expense was recognized during the fiscal year ended September 30, 2020. As set forth below, more than a majority of the 2018 original Option Grants issued to Mr. Trafelet were forfeited and the vesting conditions of the remainder were modified, all pursuant to the Alico Settlement Agreement, as defined below, and the remaining 2018 original Option Grants, both vested and unvested, have since been forfeited or expired. +A stock option grant of 300,000 options in the case of Mr. Trafelet and 225,000 options in the case of each of Mr. Henry Slack and Mr. George Brokaw (collectively, the “2016 Option Grants”) were granted on December 31, 2016. The option price was set at $ 27.15 , the closing price on December 31, 2016. The 2016 Option Grants will vest as follows: (i) 25 % of the options will vest if the price of the Company’s common stock during a consecutive 20-trading day period exceeds $ 60.00 ; (ii) 25 % of the options will vest if such price exceeds $ 75.00 ; (iii) 25 % of the options will vest if such price exceeds $ 90.00 ; and (iv) 25 % of the options will vest if such price exceeds $ 105.00 . If the applicable stock price hurdles have not been achieved by (A) the second anniversary of the Executive’s termination of employment, if the Executive’s employment is terminated due to death or disability, (B) the date that is 18 months following the Executive’s termination of employment, if the Executive’s employment is terminated by the Company without cause, by the Executive with good reason, or due to the Executive’s retirement, or (C) the date +63 +of the termination of the Executive’s employment for any other reason, then any unvested options will be forfeited. In addition, if the applicable stock price hurdles have not been achieved by the fifth anniversary of the grant date (or the fourth anniversary of the grant date, in the case of the tranche described in clause (i) above), then any unvested options will be forfeited. The 2016 Option Grants will also become vested to the extent that the applicable stock price hurdles are satisfied in connection with a change in control of the Company. As of September 30, 2020, the Company’s stock was trading at $ 28.62 per share, and since the date of grant the Company’s common stock did not trade above $ 60.00 per share; accordingly, no ne of the 2016 Option Grants are vested at September 30, 2020. As set forth below, all of the 2016 Option Grants issued to Mr. Trafelet were forfeited pursuant to the Alico Settlement Agreement, as defined below. +Additionally, 187,500 shares of the 2016 Option Grants made to each of Messrs. Slack and Brokaw were forfeited on September 5, 2018 and no replacement options were granted. As such, the remaining unrecognized expense associated with these options of approximately $ 783,000 was accelerated and recorded for the fiscal year ended September 30, 2018. +Pursuant to a Settlement Agreement (described in Note 14. “Related Party Transactions”), which was unanimously approved by the Board of Directors, Mr. Trafelet agreed to voluntarily resign from his roles as President and Chief Executive Officer and a director of the Company. Under the Settlement Agreement, Mr. Trafelet forfeited (i) all of the 2016 Option Grants granted to him and (ii) all of the 2018 Option Grants granted to him in September 2018, other than 26,250 stock options that would vest if the minimum price of Alico's common stock over 20 consecutive trading days exceeds $ 35.00 per share and 26,250 stock options that would vest if the minimum price of Alico's common stock over 20 consecutive trading days exceeds $ 40.00 per share (“2019 Modified Option Grant”), but, in each case, only if such conditions were satisfied by the first anniversary of the date of the Settlement Agreement (collectively, the "Retained Options"). Any Retained Options that vested in accordance with their terms will expire on the date that is six months following the date on which the Retained Option vests, and any Retained Options that did not vest by the first anniversary of the Alico Settlement Agreement would be forfeited as of such first anniversary. As of September 30, 2020, the Company’s stock was trading at $ 28.62 per share. During the fiscal year ended September 30, 2020, the Company’s common stock traded above $ 35.00 per share for a consecutive twenty days ; accordingly, 26,250 stock options from the 2019 Modified Option Grants vested, however, since these Modified Options were not exercised within six months following the date on which the Retained Option vested, they were forfeited. Additionally, since the Company’s common stock did not trade above $ 40.00 per share for a consecutive twenty days by the first anniversary of the date of the Alico Settlement Agreement, the other 26,250 stock options from the 2019 Modified Option Grants were forfeited. +Forfeitures of all stock options were recognized as incurred. +The following table represents a summary of the Company’s stock option activity: +Number of +Options +Weighted +Average +Exercise +Price +Weighted +Average +Remaining +Contractual +Term +(years) +Aggregate +Intrinsic +Value +Balance - September 30, 2018 +675,000 +$ +30.02 +2.22 +— +Granted during fiscal year 2019 +10,000 +33.34 +2.25 +— +Forfeitures/expired during fiscal year 2019 +( 457,500 +) +29.37 +1.78 +— +Exercised during fiscal year 2019 +— +— +— +— +Balance - September 30, 2019 +227,500 +31.46 +1.22 +— +Granted during fiscal year 2020 +118,000 +33.96 +2.25 +— +Forfeitures/expired during fiscal year 2020 +( 52,500 +) +33.60 +— +— +Exercised during fiscal year 2020 +— +— +— +— +Balance - September 30, 2020 +293,000 +32.09 +1.79 +— +Stock compensation expense related to the options totaled approximately $ 504,000 , $ 674,000 and $ 1,617,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +At September 30, 2020 and September 30, 2019, there was approximately $ 376,000 and $ 502,000 , respectively, of total unrecognized stock compensation costs related to unvested share-based compensation for the option grants. The total unrecognized compensation cost as of September 30, 2020 is expected to be recognized over a weighted-average period of 1.72 years. +The fair value of the 2020, 2019, and 2018 Option Grants was estimated on the date of grant using a Monte Carlo valuation model that uses the assumptions noted in the following table. The expected term of options granted is derived from the output of the option valuation model and +64 +represents the period of time that options granted are expected to be outstanding; the range given below results from different timeframes for the various market conditions being met. +2020 Option Grant +Expected Volatility +26.0 +% +Expected Term (in years) +3.61 +Risk Free Rate +1.60 +% +The weighted-average grant-date fair value of the 2020 Option Grant was $ 3.20 . +2019 Modified Option Grant +Expected Volatility +25.0 +% +Expected Term (in years) +1.50 +Risk Free Rate +2.52 +% +The weighted-average grant-date fair value of the 2019 Modified Option Grant was $ 1.40 . +2019 Option Grants +Expected Volatility +30.0 +% +Expected Term (in years) +4.09 +Risk Free Rate +2.95 +% +The weighted-average grant-date fair value of the 2019 Option Grants was $ 7.10 . +2018 Option Grants +Expected Volatility +30.0 +% +Expected Term (in years) +3.32 +Risk Free Rate +2.80 +% +The weighted-average grant-date fair value of the 2018 Option Grants was $ 7.40 . +As of September 30, 2020, there remained 939,500 common shares available for issuance under the 2015 Plan. +Note 10. Treasury Stock +In fiscal year 2017, the Board of Directors authorized the repurchase of up to $ 7,000,000 of the Company’s common stock in two separate authorizations (collectively, the "2017 Authorization"). In March 2017, the Board of Directors authorized the repurchase of up to $ 5,000,000 of the Company’s common stock beginning March 9, 2017 and continuing through March 9, 2019. In May 2017, the Board of Directors authorized the repurchase of up to an additional $ 2,000,000 of the Company’s common stock beginning May 24, 2017 and continuing through May 24, 2019. The stock repurchases made under this repurchase were made through open market transactions at times and in such amounts as the Company’s broker determined subject to the provisions of SEC Rule 10b-18. +During fiscal year 2018, the Company purchased 72,266 shares at a cost of $ 2,214,756 under the 2017 Authorization. As of June 29, 2018, the Company suspended its stock repurchase activity. For the fiscal year ended September 30, 2019, the Company did not purchase any shares under the 2017 Authorization. As the 2017 Authorization expired in May 2019, the Company has no funds available under this plan to repurchase stock. +On October 3, 2018, the Company completed a tender offer of 752,234 shares at a price of $ 34.00 per share aggregating $ 25,575,956 . 734 Investors, Alico's largest stockholder from 2013 until November 12, 2019, participated in the tender offer by selling a small percentage of its holdings. +65 +On October 10, 2019, the Board of Directors authorized the repurchase of up to 7,000 shares of the Company’s common stock from 734 Investors in a privately negotiated repurchase of shares. On October 15, 2019, the Company entered into a repurchase agreement to repurchase a total of 7,000 shares of the Company’s common stock from 734 Investors, effective October 15, 2019. +In September 2013, the Board of Directors authorized the repurchase of up to 105,000 shares of the Company’s common stock beginning in November 2013 and continuing through April 2018. +The following table illustrates the Company’s treasury stock purchases for the fiscal years ended September 30, 2020, 2019 and 2018: +(in thousands, except share amounts) +Total +Number of +Shares +Purchased +Average +Price +Paid +Per Share +Total Shares +Purchased +as Part of +Publicly +Announced +Plan or +Program +Total Dollar +Value of +Shares +Purchased +Fiscal Year Ended September 30,: +2020 +7,000 +$ +33.95 +1,481,640 +$ +238 +2019 +752,234 +$ +34.00 +1,474,640 +$ +25,576 +2018 +72,266 +$ +30.65 +722,406 +$ +2,215 +The following table outlines the Company’s treasury stock transactions during the past three fiscal years: +(in thousands, except share amounts) +Shares +Cost +Balance at September 30, 2017 +177,315 +$ +6,502 +Purchased +72,266 +2,215 +Issued to Employees and Directors +( 33,393 +) +( 1,181 +) +Balance at September 30, 2018 +216,188 +7,536 +Purchased +752,234 +25,576 +Issued to Employees and Directors +( 28,790 +) +( 1,169 +) +Balance at September 30, 2019 +939,632 +31,943 +Purchased +7,000 +238 +Issued to Employees and Directors +( 23,011 +) +( 1,402 +) +Balance at September 30, 2020 +923,621 +$ +30,779 +Note 11. Income Taxes +On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act contains significant changes to corporate taxes, including a permanent reduction of the U.S. corporate tax rate from 35% to 21% effective January 1, 2018. The Company’s statutory rate for the fiscal year ended September 30, 2018 was 24.5%, based on a fiscal year blended rate calculation. The 21% U.S. corporate tax rate is fully applicable to the fiscal year ended September 30, 2019 and each year thereafter. +The Act required a one-time remeasurement of certain tax related assets and liabilities. During the first quarter ended December 31, 2017, the Company made certain estimates related to the impact of the Act including the remeasurement of deferred taxes at the new expected tax rate and a revised effective tax rate for the year ended September 30, 2018. For the fiscal year ended September 30, 2018, the Company recorded a tax benefit of approximately $ 9,847,000 to account for these deferred tax impacts. +In October 2019, the Internal Revenue Service concluded their audit of the September 30, 2015 tax year with no changes. The Federal and State filings remain subject to examination by tax authorities for tax periods ending after September 30, 2015. +66 +The income tax provision for the years ended September 30, 2020, 2019 and 2018 consists of the following: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Current: +Federal income tax +$ +131 +$ +7,314 +$ +1,961 +State income tax +( 71 +) +2,202 +384 +Total current +60 +9,516 +2,345 +Deferred: +Federal income tax +6,151 +2,995 +( 3,917 +) +State income tax +1,452 +272 +1,962 +Total deferred +7,603 +3,267 +( 1,955 +) +Income tax provision +$ +7,663 +$ +12,783 +$ +390 +Income tax provision attributable to income before income taxes differed from the amount computed by applying the statutory federal income tax rate of 21 %, 21 % and 24.53 % to income before income taxes for the fiscal years ended September 30, 2020, September 30, 2019 and September 30, 2018, respectively, as a result of the following: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Income tax at the statutory federal rate +$ +6,568 +$ +10,587 +$ +3,198 +Increase (decrease) resulting from: +State income taxes, net of federal benefit +1,217 +1,947 +857 +Permanent and other reconciling items, net +170 +166 +221 +Expiration of capital loss carryforward +— +— +5,634 +Reduction in deferred tax liability resulting from the Act +— +— +( 9,847 +) +State rate change +( 156 +) +— +— +Stock option cancellation +— +— +347 +Other +( 136 +) +83 +( 20 +) +Income tax provision +$ +7,663 +$ +12,783 +$ +390 +The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of September 30, 2020, and 2019 are presented below: +(in thousands) +September 30, +2020 +2019 +Deferred tax assets: +Deferred retirement benefits +$ +— +$ +1,325 +Goodwill +16,304 +18,244 +Inventories +813 +930 +Stock compensation +314 +237 +Intangibles +508 +565 +Other +203 +168 +Total deferred tax assets +18,142 +21,469 +Deferred tax liabilities: +Property and equipment +56,707 +52,551 +Investment in Citree +1,016 +909 +Prepaid insurance +147 +134 +Total deferred tax liabilities +57,870 +53,594 +Net deferred income tax liabilities +$ +( 39,728 +) +$ +( 32,125 +) +67 +Note 12. Segment Information +Segments +Operating segments are defined in the criteria established under the FASB ASC Topic 280 as components of public entities that engage in business activities from which they may earn revenues and incur expenses for which separate financial information is available and which is evaluated regularly by the Company’s chief operating decision maker (“CODM”) in deciding how to assess performance and allocate resources. The Company’s CODM assesses performance and allocates resources based on two operating segments: Alico Citrus and Land Management and Other Operations (see name change explanation below). +As a result of the Company selling approximately 10,700 acres on the western part of Alico Ranch to the State of Florida and because a sale of those acres affected the proposed dispersed water management project, the Company decided to suspend all permit approval activities for its dispersed water management project. This has resulted in a change in the financial reporting to the CODM. Therefore, the Company has renamed the “Water Resources and Other Operations” segment to “Land Management and Other Operations”. +Total revenues represent sales to unaffiliated customers, as reported in the Consolidated Statements of Operations. Goods and services produced by these segments are sold to wholesalers and processors in the United States who prepare the products for consumption. The Company evaluates the segments’ performance based on direct margins (gross profit) from operations before general and administrative expenses, interest expense, other income (expense) and income taxes, not including nonrecurring gains and losses. +Information by operating segment is as follows: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Revenues: +Alico Citrus +$ +89,369 +$ +119,031 +$ +78,121 +Land Management and Other Operations +3,138 +3,220 +3,160 +Total revenues +92,507 +122,251 +81,281 +Operating expenses: +Alico Citrus +72,281 +59,594 +51,709 +Land Management and Other Operations +2,307 +2,297 +3,979 +Total operating expenses +74,588 +61,891 +55,688 +Gross profit (loss): +Alico Citrus +17,088 +59,437 +26,412 +Land Management and Other Operations +831 +923 +( 819 +) +Total gross profit +17,919 +60,360 +25,593 +Capital expenditures: +Alico Citrus +21,705 +20,000 +15,968 +Land Management and Other Operations +— +— +304 +Other Capital Expenditures +— +— +80 +Total capital expenditures +21,705 +20,000 +16,352 +Depreciation, depletion and amortization: +Alico Citrus +13,822 +12,935 +12,546 +Land Management and Other Operations +185 +173 +219 +Other Depreciation, Depletion and Amortization +513 +816 +991 +Total depreciation, depletion and amortization +$ +14,520 +$ +13,924 +$ +13,756 +68 +(in thousands) +September 30, +2020 +2019 +Assets: +Alico Citrus +$ +406,763 +$ +401,212 +Land Management and Other Operations +15,367 +15,332 +Other Corporate Assets +1,807 +844 +Total Assets +$ +423,937 +$ +417,388 +Note 13. Employee Benefits Plans +Management Security Plan +The management security plan (“MSP”) was a nonqualified, noncontributory defined supplemental deferred retirement benefit plan for a select group of management personnel. The MSP was set up to provide a fixed supplemental retirement benefit for 180 months. The MSP was frozen as of September 30, 2017. As a result, no new participants were being added to the MSP and no further benefits were accumulating. +The MSP benefit expense and the projected management security plan benefit obligation were determined using assumptions as of the end of the respective year. The weighted-average discount rate used to compute the obligation was 4.08 % in fiscal year 2019. +Actuarial gains or losses were recognized when incurred; therefore, the end of year benefit obligation was the same as the accrued benefit costs recognized in the Consolidated Balance Sheets. +The amount of MSP benefit expense charged to costs and expenses was as follows: +(in thousands) +Fiscal Year Ended September 30, +2020 +2019 +2018 +Service cost +$ +— +$ +— +$ +— +Interest cost +195 +171 +293 +MSP termination adjustments +— +985 +— +Recognized actuarial gain (loss) adjustment +12 +13 +16 +Total +$ +207 +$ +1,169 +$ +309 +The following provides a roll-forward of the MSP benefit obligation: +(in thousands) +September 30, +2020 +2019 +Change in projected benefit obligation: +Benefit obligation at beginning of year +$ +5,226 +$ +4,397 +Interest cost +195 +171 +Benefits paid +( 258 +) +( 340 +) +MSP termination adjustments +— +985 +MSP termination benefits payment +( 5,175 +) +— +Recognized actuarial gain adjustment +12 +13 +Benefit obligation at end of year +$ +— +$ +5,226 +Funded status at end of year +$ +— +$ +( 5,226 +) +Effective September 30, 2018, the Company terminated the MSP. Under the MSP termination, payout for benefits covered utilizing the applicable Internal Revenue Code regulations were not able to be commenced until at least twelve months following plan termination decision, but needed to be fully paid out within twenty-four (24) months following plan termination. During August 2020, the Company caused the MSP to pay the lump sum termination benefits of approximately $ 5,175,000 to all MSP beneficiaries. +During the fiscal year ended September 30, 2019, the Company determined to pay out a lump sum under the equivalent annuity approach, whereby the payout under this approach was designed to mitigate participants tax burden. Under this approach, the Company would cover the amount needed to purchase an annuity providing the same after-tax benefit as if the plan was never terminated. As a result, the Company recorded an additional liability of approximately $ 720,000 . +69 +The Company ha d established a “Rabbi Trust” to provide for the potential funding of accrued benefits under the MSP. According to the terms of the Rabbi Trust, funding wa s voluntary until a change of control of the Company as defined in the Management Security Plan Trust Agreement occurs. Upon a change of control, funding would be triggered. As of September 30, 20 20 , the Rabbi Trust had no assets, and no change of control had occurred. +Profit Sharing and 401(k) Plans +The Company maintains a 401(k) employee savings plan for eligible employees, which provides up to a 4 % matching contribution payable on employee payroll deferrals. The Company’s matching funds vest to the employee immediately, pursuant to a safe harbor election effective in October 2012. The Company’s contribution to the plan was approximately $ 397,000 , $ 380,000 and $ 342,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +The Company also maintains a Profit Sharing Plan (“Plan”) that is fully funded by contributions from the Company. Contributions to the Plan are discretionary and determined annually by the Company’s Board of Directors. Contributions to employee accounts are based on the participant’s compensation. The Company did not contribute to the Plan for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Note 14. Related Party Transactions +Clayton G. Wilson +The Company entered into a Separation and Consulting Agreement with Clayton G. Wilson (the “Separation and Consulting Agreement”), pursuant to which Mr. Wilson stepped down as Chief Executive Officer of the Company effective as of December 31, 2016. Under the Separation and Consulting Agreement, Mr. Wilson also acknowledged and agreed that he would continue to be bound by the restrictive covenants set forth in his Employment Agreement with the Company. The Separation and Consulting Agreement provided that, subject to his execution, delivery, and non-revocation of a general release of claims in favor of the Company, Mr. Wilson would be entitled to vesting of any unvested portion of the restricted stock award granted to him under his Employment Agreement. In addition, the Separation and Consulting Agreement provided that Mr. Wilson serve as a consultant to the Company during 2017 and would receive an aggregate consulting fee of $ 750,000 for such services (payable $ 200,000 in an initial lump sum, $ 275,000 in a lump sum on July 1, 2017, and $ 275,000 in six equal monthly installments commencing July 31, 2017 and ending December 31, 2017). As of December 31, 2017, the Company satisfied its obligation to Mr. Wilson in full. The Company expensed approximately $ 0 , $ 0 and $ 187,500 under the Separation and Consulting Agreement for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. Mr. Wilson resigned as a member of the Company’s Board of Directors effective February 27, 2017. +Henry R. Slack and George R. Brokaw +On December 31, 2016, the Company entered into new employment agreements (collectively, the “Employment Agreements”) with Henry R. Slack, and George R. Brokaw. Mr. Slack previously served as the Executive Chairman of the Company, and Mr. Brokaw previously served as the Executive Vice Chairman of the Company, and each of them continues to serve on the Company’s Board of Directors. The Employment Agreements provided for an annual base salary of $ 250,000 in the case of Mr. Slack and provides for an annual base salary of $ 250,000 in the case of Mr. Brokaw. +Beginning June 26, 2017, both Messrs. Slack and Brokaw agreed to waive payment of their salaries. +Effective July 1, 2019, Mr. Slack resigned his employment with the Company as Executive Chairman. Effective December 31, 2019, Mr. Brokaw resigned his employment with the Company as Executive Vice Chairman. Mr. Slack and Mr. Brokaw continue to serve on the Board of the Company. +Remy W. Trafelet +As described above, on February 11, 2019 and as contemplated by the Alico Settlement Agreement, Mr. Trafelet submitted to the Board his resignation as President and Chief Executive Officer of the Company and a member of the Board, effective upon the execution of the Alico Settlement Agreement. Also, on February 11, 2019, as contemplated by the Settlement Agreement, the Company entered into a consulting agreement (the "Consulting Agreement") with Mr. Trafelet and 3584 Inc., an entity controlled by Mr. Trafelet (the "Consultant"). Pursuant to the Consulting Agreement, Mr. Trafelet will make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant will receive an annual consulting fee of $ 400,000 . The Company recorded an expense of $ 800,000 , representing the full amount due under the agreement, in fiscal year 2019 upon the execution of the agreement. The Company has paid approximately $ 400,000 and $ 254,000 in consulting fees for the fiscal years ended September 30, 2020 and 2019, respectively. If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described above. +70 +Shared Services Agreement +The Company had a shared services agreement with Trafelet Brokaw Capital Management, L.P. (“TBCM”), whereby the Company reimbursed TBCM for use of office space and various administrative and support services. The agreement expired December 31, 2018 and was not extended or renewed. The annual cost of the office and services was approximately $ 618,000 . The Company expensed approximately $ 0 , $ 155,000 and $ 592,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. As of September 30, 2020 and 2019, the Company did no t have any outstanding amounts with TBCM. +Capital Contribution +On September 10, 2020, all operating partners of Citree received a funding notice relating to an additional Cash Capital Contribution (“Contribution”) requirement of approximately $ 600,000 as a result of trees producing limited revenue because they are still in early stage development, a reduction in market price for citrus fruit for the 2019/20 harvest season due to excess inventories and the adoption of a more extensive caretaking plan focused on limiting the impact of citrus greening. The Company’s portion of the Contribution was approximately $ 306,000 and was funded on September 24, 2020. The remaining portion of the Contribution of $ 294,000 was funded by the noncontrolling parties. +On April 16, 2018, all operating partners of Citree received a funding notice relating to an additional Cash Capital Contribution requirement of approximately $ 2,041,000 as a result of Hurricane Irma, which reduced the amount of crop available for sale in the 2017/2018 harvest season and the Company’s adoption of a more extensive caretaking plan focused on limiting the impact of citrus greening. The Company’s portion of the Contribution was approximately $ 1,041,000 and was funded on April 27, 2018. The remaining portion of the Contribution of $ 1,000,000 was funded by the noncontrolling parties. +Distribution of Shares by Alico’s Largest Shareholder +On November 12, 2019, 734 Investors, the Company’s largest shareholder, distributed the 3,173,405 shares of Company common stock held by it, on a pro rata basis, to its members. The Company understands that this share distribution was made in anticipation of a subsequent dissolution of 734 Investors. Transfers of these shares are not registered on any current Alico registration statement, but the shares are potentially transferable pursuant to Rule 144, subject to certain customary restrictions. +Note 15. Commitments and Contingencies +Operating Leases +The Company has obligations under various non-cancelable long-term operating leases primarily for office space and equipment. In addition, the Company has various obligations under other equipment leases of less than one year. +Total rent expense was approximately $ 308,000 , $ 450,000 and $ 1,062,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +The future minimum annual rental payments under non-cancelable operating leases are as follows: +(in thousands) +2021 +$ +519 +2022 +324 +2023 +48 +Total +$ +891 +Purchase Commitments +The Company enters into contracts for the purchase of citrus trees during the normal course of its business. As of September 30, 2020, the Company had approximately $ 3,014,000 relating to outstanding commitments for these purchases that will be paid upon delivery of the remaining citrus trees. +Letters of Credit +The Company had outstanding standby letters of credit in the total amount of approximately $ 399,000 and $ 460,000 at September 30, 2020 and September 30, 2019, respectively, to secure its various contractual obligations. +71 +Legal Proceedings +Florida Litigation +On November 16, 2018, 734 Agriculture, RCF 2014 Legacy LLC, Delta Offshore Master II, LTD. and Mr. Remy W. Trafelet (the “Trafelet Parties”), who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors, filed a lawsuit against Messrs. George R. Brokaw, Henry R. Slack, W. Andrew Krusen and Greg Eisner, members of the Board of Directors, in the Circuit Court (the “Circuit Court”) for Hillsborough County, Florida (the “Florida Litigation”). The Trafelet Parties sought, among other things, a declaration that (1) a purported stockholder action by written consent, delivered to the Company in the name of 734 Investors and the plaintiffs in the Florida Litigation on November 11, 2018 (the “Purported Consent”) was valid and binding, (2) the resolutions passed at a meeting of the Board of Directors on November 12, 2018, to, among other things, constitute an ad hoc committee of the Board of Directors to consider, evaluate and make any and all determinations, and to take any and all actions, on behalf of the Board of Directors, in connection with the Purported Consent were null and void and (3) the four defendants in the Florida Litigation were properly removed from the Board of Directors by the Purported Consent. On November 27, 2018, the Circuit Court denied without prejudice plaintiffs’ motion for a temporary restraining order and an affirmative injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. +On November 28, 2018, the parties in the Florida Litigation stipulated to an order which provided, pending the resolution of the Delaware Litigation (as defined below), that (1) the record date for the Purported Consent was stayed indefinitely, and (2) Mr. Trafelet and the Company’s Board of Directors should not take any action out of routine day-to-day operations conducted in the ordinary course of business, including any action to change the corporate governance of Alico or removing any corporate officers or directors from positions held as of November 27, 2018. +On December 6, 2018, the Trafelet Parties filed an amended complaint in the Florida Litigation which added the Company and Benjamin D. Fishman, a member of the Board of Directors, as defendants. On December 21, 2018, the Trafelet Parties filed a renewed motion for a preliminary injunction restoring Mr. Trafelet from administrative leave to active status in his capacity as President and CEO of the Company. On January 14, 2019, the defendants in the Florida Litigation filed an opposition to plaintiffs’ renewed motion for a preliminary injunction. On January 18, 2019, the defendants in the Florida Litigation filed a motion to dismiss the plaintiffs’ amended complaint. +On February 11, 2019, the parties to the Florida Litigation entered into a settlement agreement (the “Alico Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Florida Litigation. Pursuant to the Alico Settlement Agreement, Mr. Trafelet agreed to voluntarily resign as President and Chief Executive Officer and as a member of the Board of Directors, effective upon the execution of the Alico Settlement Agreement. +As contemplated by the Alico Settlement Agreement, on February 11, 2019, the Company entered into a consulting agreement (the “Consulting Agreement”) with Mr. Trafelet and 3584 Inc., an entity controlled by Mr. Trafelet (the “Consultant”). Pursuant to the Consulting Agreement, Mr. Trafelet agreed to make himself available to provide consulting services to the Company through the Consultant for up to 24 months. In exchange for the consulting services, the Consultant is receiving an annual consulting fee of $ 400,000 . If the Company terminates the consulting period (other than in certain specified circumstances), the Company will continue to pay the consulting fees described in the immediately preceding sentence through the balance of the 24-month term. As such, the Company recorded the $ 800,000 as an expense for the fiscal year ended September 30, 2019. +In addition, on February 11, 2019, as contemplated by the Alico Settlement Agreement, the Company entered into a Registration Rights Agreement (the “Registration Rights Agreement”) with Mr. Trafelet, relating to the shares of the Company’s common stock directly held by the Trafelet Parties as of February 11, 2019 (the “Registrable Securities”). The Registration Rights Agreement required the Company to, among other things and subject to the terms and conditions thereof, use reasonable best efforts to file with the SEC a registration statement on Form S-3 covering the resale of the Registrable Securities. On October 10, 2019, Mr. Trafelet executed a waiver whereby he waived the S-3 Registration Rights but maintained all other rights arising under the Registration Rights Agreement and all rights arising under Section 14 of the Alico Settlement Agreement. +Delaware Litigation +On November 20, 2018, members of 734 Investors filed a lawsuit against 734 Agriculture and Mr. Trafelet, who was at the time the Company's President and Chief Executive Officer and a member of the Board of Directors in the Delaware Court of Chancery (the "Delaware Court"), captioned Arlon Valencia Holdings v. Trafelet, C.A. No. 2018-0842-JTL (the “Members’ Delaware Litigation”). The plaintiffs sought, among other things, a declaration that (1) 734 Agriculture was validly replaced as the managing member of 734 Investors pursuant to the Amended and Restated Limited Liability Company Operating Agreement of 734 Investors (the “LLC Agreement”) and November 19, 2018 resolution by written consent to remove 734 Agriculture as managing member of 734 Investors, and to designate Arlon Valencia Holdings, LLC as the new managing member of 734 Investors (the “734 Consent”), and (2) the Purported Consent was invalid under the LLC Agreement. +72 +Also, on November 20, 2018, 734 Agriculture filed a lawsuit contesting the 734 Consent in the Delaware Court, captioned 734 Agriculture v. Arlon Valencia Holdings, LLC, C.A. No. 2018-0844-JTL (the “734 Delaware Litigation”). On November 27, 2018, the Delaware Court entered a stipulated order consolidating the Members’ Delaware Litigation and the 734 Delaware Litigation into a single lawsuit, captioned In re 734 Investors, LLC Litigation, Consol. C.A. No. 2018-0844-JTL (the consolidated suit, the “Delaware Litigation”). +On December 5, 2018, the Delaware Court entered a stipulated status quo order which provided, among other things, that 734 Agriculture was to serve as the managing member of 734 Investors during the pendency of the Delaware Litigation. The status quo order also provided that 734 Agriculture would not be permitted to take any actions outside of the ordinary course of business of 734 Investors without the consent of two-thirds of the membership interests of 734 Investors, including exercising any voting rights with respect to any shares of the Company’s common stock beneficially owned by 734 Investors. +On February 11, 2019, Mr. Trafelet, 734 Agriculture, 734 Investors, and certain members of 734 Investors entered into a settlement agreement (the “734 Investors Settlement Agreement”) wherein the parties agreed to promptly dismiss all claims in the Delaware Litigation. Pursuant to the 734 Investors Settlement Agreement, 734 Agriculture resigned as Managing Member of 734 Investors and Arlon Valencia Holdings, LLC was confirmed as Managing Member of 734 Investors. +From time to time, Alico may be involved in litigation relating to claims arising out of its operations in the normal course of business. There are no current legal proceedings to which the Company is a party or of which any of its property is subject that it believes will have a material adverse effect on its financial position, results of operations or cash flows. +Note 16. Selected Quarterly Financial Data (unaudited) +Summarized quarterly financial data for the fiscal years ended September 30, 2020, and 2019 are computed independently each quarter, therefore, the sum of the quarter amounts may not equal the total amount for the respective year due to rounding as follows: +(in thousands, except per share amounts) +Fiscal Quarter Ended +December 31, +March 31, +June 30, +September 30, +2019 +2018 +2020 +2019 +2020 +2019 +2020 +2019 +Total operating revenues +$ +11,005 +$ +14,779 +$ +50,515 +$ +48,521 +$ +26,122 +$ +57,565 +$ +4,865 +$ +1,386 +Total operating expenses +5,391 +11,597 +43,898 +32,207 +19,902 +31,561 +5,397 +( 13,474 +) +Gross profit (loss) +5,614 +3,182 +6,617 +16,314 +6,220 +26,004 +( 532 +) +14,860 +General and administrative expenses +2,760 +3,450 +2,953 +4,654 +2,556 +2,682 +2,729 +4,360 +Other (expense) income, net +( 1,595 +) +( 2,864 +) +1,398 +( 1,972 +) +( 1,405 +) +( 1,623 +) +26,058 +11,478 +Income (loss) before income taxes +1,259 +( 3,132 +) +5,062 +9,688 +2,259 +21,699 +22,797 +21,978 +Income tax (benefit) expense +361 +( 629 +) +1,496 +2,228 +171 +5,483 +5,635 +5,701 +Net (loss) income +898 +( 2,503 +) +3,566 +7,460 +2,088 +16,216 +17,162 +16,277 +Net (income) loss attributable to noncontrolling interests +( 107 +) +36 +5 +87 +8 +28 +42 +232 +Net income (loss) attributable to Alico Inc. common stockholders +$ +791 +$ +( 2,467 +) +$ +3,571 +$ +7,547 +$ +2,096 +$ +16,244 +$ +17,204 +$ +16,509 +Earnings (loss) per share: +Basic +$ +0.11 +$ +( 0.33 +) +$ +0.48 +$ +1.01 +$ +0.28 +$ +2.17 +$ +2.29 +$ +2.21 +Diluted +$ +0.11 +$ +( 0.33 +) +$ +0.48 +$ +1.01 +$ +0.28 +$ +2.17 +$ +2.29 +$ +2.21 +Total operating expenses for the fiscal quarter ended September 30, 2019 includes insurance proceeds received of approximately $ 486,000 in additional property and casualty claims reimbursement relating to Hurricane Irma (see Note 3. “Inventories”) and block grants of approximately $ 15,597,000 under the Florida Citrus Recovery Block Grant (“CRBG”) program relating to Hurricane Irma. General and administrative expenses for the fiscal quarter ended September 30, 2019 include pension expense of $ 935,000 relating to termination of employee benefit plan (see Note 13. “Employee Benefit Plans” for further detail). Other income for the fiscal quarter ended September 30, 2019 includes a gain on sale of assets of approximately $ 13,166,000 (see Note 4. “Assets Held For Sale” and Note 5. “Property and Equipment, Net” for further information). Operating revenues and operating expenses for the fiscal quarter ended September 30, 2020 include approximately $ 3,246,000 and approximately $ 2,951,000 , respectively, relating to the grove management services being provided to a third-party. Other income for the fiscal quarter ended September 30, 2020 includes a gain on sale of assets of approximately $ 27,470,000 (see Note 4. “Assets Held For Sale” and Note 5. “Property and Equipment, Net” for further information). +73 +Note 17. Subsequent Event +On December 2, 2020, the Board of Directors of the Company declared a first quarter of fiscal year 2021 cash dividend of $ 0.18 per share on its outstanding common stock to be paid to shareholders of record as of December 24, 2020, with payment expected on January 8, 2021. +In November 2020, the Company awarded 5,885 shares of restricted stock to certain officers and managers under the 2015 Plan. +On October 30, 2020, the Company purchased approximately 3,280 gross citrus acres located in Hendry County for a purchase price of $ 16.5 million. +74 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +None. +Item 9A. Controls and Procedures +(a) +Evaluation of Disclosure Controls and Procedures. +Our Principal Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) as of the end of the period covered by this report. Based on this evaluation, our Principal Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective. +(b) +Changes in Internal Control over Financial Reporting. +During the fourth fiscal quarter ended September 30, 2020, there were no changes in our internal controls over financial reporting that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting. +(c) +Management Report on Internal Control Over Financial Reporting +Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that: +(i) +pertain to the maintenance of records, that in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; +(ii) +provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +(iii) +provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Management assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2020. In making this assessment, management used the criteria described in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). +Based on our assessment and those criteria, management concluded that our internal control over financial reporting was effective as of September 30, 2020. Management reviewed the results of their assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of September 30, 2020 has been audited by RSM US LLP, an independent registered public accounting firm, as stated in their attestation report which is included herein. +Item 9B. Other Information +None. +75 +PART III +Certain information required by Part III is omitted from this Annual Report on Form 10-K because we will file a definitive Proxy Statement for the 2021 Annual Meeting of Shareholders pursuant to Regulation 14A of the Securities Exchange Act of 1934, (the “Proxy Statement”), not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and the applicable information included in the Proxy Statement is incorporated herein by reference. +Item 10. Directors, Executive Officers and Corporate Governance +Information concerning our directors and nominees and other information as required by this Item 10 are hereby incorporated by reference from our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Code of Ethics +We have adopted a Code of Business Conduct and Ethics that is intended to serve as a code of ethics for purposes of Item 406 of Regulation S-K. Our Code of Business Conduct and Ethics is posted on our website http://www.alicoinc.com (at the Investor homepage under "Corporate Governance") and we intend to disclose on our website any amendments to, or waiver from, such code. +Item 11. Executive Compensation +The information required by Item 11 regarding executive compensation is included under the headings “Compensation Discussion and Analysis,” “Compensation Committee Report” and “Compensation Committee Interlocks and Insider Participation” in the Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +Information concerning the ownership of certain beneficial owners and management and related stockholder matters as required by this Item 12 is hereby incorporated by reference to the Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Equity Compensation Arrangements +Effective January 27, 2015, the Board of Directors adopted the 2015 Stock Incentive Plan (the “2015 Plan”) which provides for up to 1,250,000 shares of the Company’s common stock to be available for issuance to provide a long-term incentive plan for officers, employees, directors and/or consultants to directly link incentives to stockholders' value. The 2015 Plan was approved by stockholders in February 2015. +The following table illustrates the common shares remaining available for future issuance under the 2015 Plan as of September 30, 2020: +Number of securities to +be issued upon exercise +of outstanding options, +warrants and rights +Weighted-average +exercise price of +outstanding options, +warrants and rights +Number of securities +remaining available for +future issuance under +equity plans +Plan Category: +Equity compensation plans approved by security holders +293,000 +$ +32.09 +939,500 +Equity compensation plans not approved by security holders +— +N/A +— +Total +293,000 +$ +32.09 +939,500 +In November 2017, the Company awarded 5,000 restricted shares to one senior executive under the 2015 Plan. +In September 2018, the Company awarded 300,000 stock options to two senior executives under the 2015 Plan. Additionally, in September 2018, two other senior executives forfeited an aggregate of 375,000 stock options, which were originally issued under the 2015 Plan and no replacement options were granted. +In October 2018, the Company awarded 10,000 stock options to one senior executive under the 2015 Plan. +76 +In October 2019, the Company awarded 118,000 stock options to senior managers and certain other managers under the 2015 Plan. Additionally, in each of February 2020 and August 2020, one former senior executive forfeited 26,250 stock options, aggregating 52,500 in total, which were originally issued under the 2015 Plan and no replacement options were granted. +In February 2019, pursuant to a settlement agreement, a senior executive of the Company forfeited an aggregate of 457,500 stock options, which were originally issued under the 2015 Plan and no replacement options were granted. +Item 13. Certain Relationships and Related Transactions and Director Independence +The information concerning relationships and related transactions as required by this Item 13 is hereby incorporated by reference to our Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +Item 14. Principal Accountants Fees and Services +Information concerning principal accounting fees and services as required by this Item 14 is hereby incorporated by reference to the Proxy Statement to be filed with the SEC pursuant to Regulation 14A. +77 +PART IV +Item 15. Exhibits, Financial Statement Schedules +(a) +Documents filed as part of this report +(1) +Financial Statements: +Our Consolidated Financial Statements are included in Part II, Item 8 of this Annual Report on Form 10-K. +(2) +Financial Statement Schedules: +Financial statement schedules are omitted as the required information is either inapplicable or the information is presented in our Consolidated Financial Statements or notes thereto. +(3) +Exhibits +The exhibits listed in the Exhibit Index in (b) below are filed or incorporated by reference as part of this Annual Report on Form 10-K. +(b) +Exhibit Index +Exhibit +Number +Exhibit Index +2.1*** +Asset Purchase Agreement, dated as of December 1, 2014, by and among Alico, Inc., Orange-Co, LP, and, solely with respect to certain sections thereof, Orange-Co, LLC and Tamiami Citrus, LLC. (incorporated by reference to Exhibit 2.1 of Alico’s filing on Form 8-K dated December 5, 2014) +2.2*** +Agreement and Plan of Merger, dated as of December 2, 2014, by and among Alico, Inc., 734 Sub, LLC, 734 Citrus Holdings, LLC, and, solely with respect to certain sections thereof, 734 Agriculture, LLC, Rio Verde Ventures, LLC and Clayton G. Wilson (incorporated by reference to Exhibit 2.2 of Alico’s filing on Form 8-K dated December 5, 2014) +3.1 +Restated Certificate of Incorporation, dated February 17, 1972 (incorporated by reference to Exhibit 3.1 of Alico's filing on Form 10-K dated December 11, 2017) +3.2 +Certificate of Amendment to Certificate of Incorporation, dated January 14, 1974 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.3 +Amendment to Articles of Incorporation, dated January 14, 1987 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.4 +Amendment to Articles of Incorporation, dated December 27, 1988 (incorporated by reference to Alico’s Registration Statement on Form S-8, dated December 21, 2005, Registration No. 333-130575) +3.5 +By-Laws of Alico, Inc., amended and restated (incorporated by reference to Exhibit 3.5 of the Company’s quarterly report on Form 10-Q, filed with the SEC on August 6, 2019) +4.1 +Description of Securities +10.1 +Credit Agreement dated as of December 1, 2014, by and between Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, L.L.C., Alico Land Development, Inc., and Alico Citrus Nursery, L.L.C., as Borrowers and Rabo Agrifinance, Inc., as Lender (incorporated by reference to Exhibit 10.2 of Alico's filing on Form 8-K dated December 5, 2014) +10.2 +Purchase and Sale Agreement dated August 7, 2014 (incorporated by reference to Exhibit 10.10 of Alico’s filing on Form 10-K dated December 12, 2014) +10.3* +Form of Indemnification Agreement (incorporated by reference to Exhibit 10.5 of the Company’s quarterly report on Form 10-Q filed with the SEC on May 6, 2013) +10.4* +Management Security Plan(s) Trust Agreement (incorporated by reference to Exhibit 10.6 of the Company’s quarterly report on Form 10-Q filed with the SEC on May 6, 2013) +10.5 +Agricultural Lease Agreement dated May 19, 2014 between Alico, Inc. and United States Sugar Corporation. (incorporated by reference to Exhibit 10.1 of the Company’s quarterly report on Form 10-Q filed with the SEC on August 11, 2014) +10.6*** +First Amended and Restated Credit Agreement, dated as of December 1, 2014, by and among Alico, Inc., Alico Land Development, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Metropolitan Life Insurance Company, and New England Life Insurance Company (incorporated by reference to Exhibit 10.1 of Alico’s filing on Form 8-K dated December 5, 2014) +10.7*** +Credit Agreement dated as of December 1, 2014, by and between Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development, Inc., and Alico Citrus Nursery, LLC, as Borrowers and Rabo Agrifinance, Inc., as Lender (incorporated by reference to Exhibit 10.2 of Alico’s filing on Form 8-K dated December 5, 2014) +78 +10.8 +Shared Services Agreement by and between Alico, Inc. and Trafelet Brokaw Capital Management, L.P. dated July 23, 2018 (incorporated by reference to Exhibit 10.1 of Alico's filing on Form 10-Q dated August 6, 2018) +10.9 +Loan Agreement, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (the "Prudential Loan Agreement") (incorporated by reference to Exhibit 10.16 of Alico’s filing on Form 10-K dated December 10, 2015) +10.10 +Promissory Note A, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.17 of Alico’s filing on Form 10-K dated December 10, 2015) +10.11 +Promissory Note B, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.18 of Alico’s filing on Form 10-K dated December 10, 2015) +10.12 +Promissory Note C, dated December 31, 2012, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.19 of Alico’s filing on Form 10-K dated December 10, 2015) +10.13 +First Amendment to Loan Agreement, dated March 26, 2013 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.20 of Alico’s filing on Form 10-K dated December 10, 2015) +10.14 +Promissory Note D, dated March 26, 2013, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.21 of Alico’s filing on Form 10-K dated December 10, 2015) +10.15 +Loan Agreement, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC ("Loan E and F") (incorporated by reference to Exhibit 10.22 of Alico’s filing on Form 10-K dated December 10, 2015) +10.16 +Promissory Note E, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.23 of Alico’s filing on Form 10-K dated December 10, 2015) +10.17 +Promissory Note F, dated September 4, 2014, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.24 of Alico’s filing on Form 10-K dated December 10, 2015) +10.18 +First Amendment to Loan Agreement, dated April 23, 2015 (Loan E and F) (incorporated by reference to Exhibit 10.25 of Alico’s filing on Form 10-K dated December 10, 2015) +10.19 +Second Amendment to the Loan Agreement, dated September 4, 2014 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.26 of Alico’s filing on Form 10-K dated December 10, 2015) +10.20 +Third Amendment to the Loan Agreement, dated April 23, 2015 (Prudential Loan Agreement) (incorporated by reference to Exhibit 10.27 of Alico’s filing on Form 10-K dated December 10, 2015) +10.21 +Cancellation and Termination of Note D, dated April 23, 2015, by and among 734 Citrus Holdings, LLC, 734 LMC Groves, LLC, 734 Co-Op Groves, LLC, 734 BLP Groves, LLC, 734 Harvest LLC and Prudential Mortgage Capital Company, LLC (incorporated by reference to Exhibit 10.28 of Alico’s filing on Form 10-K dated December 10, 2015) +10.22 +First Amendment to Credit Agreement and Consent with Rabo Agrifinance, Inc. dated February 26, 2015 (incorporated by reference to Exhibit 10.29 of Alico’s filing on Form 10-K dated December 10, 2015) +10.23 +Second Amendment to Credit Agreement with Rabo Agrifinance, Inc. dated July 16, 2015 (incorporated by reference to Exhibit 10.30 of Alico’s filing on Form 10-K dated December 10, 2015) +10.24 +Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company, dated February 1, 2015 (incorporated by reference to Exhibit 10.31 of Alico’s filing on Form 10-K dated December 10, 2015) +10.25 +Second Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated August 12, 2015 (incorporated by reference to Exhibit 10.32 of Alico’s filing on Form 10-K dated December 10, 2015) +10.26*** +Third Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated November 4, 2019 (incorporated by reference to Exhibit 10.26 of Alico’s filing on Form 10-K dated December 5, 2019) +10.27 +Fourth Amendment to First Amended and Restated Credit Agreement with Metropolitan Life Insurance Company and New England Life Insurance Company dated October 2, 2019 (incorporated by reference to Exhibit 10.27 of Alico’s filing on Form 10-K dated December 5, 2019) +10.28 +Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 30, 2016 (incorporated by reference to Exhibit 10.34 of Alico's filing on Form 10-K dated December 6, 2016) +10.29 +Second Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 6, 2017 (incorporated by reference to Exhibit 10.39 of Alico's filing on Form 10-K dated December 11, 2017) +79 +10.30 +Third Renewal Promissory Note by Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., and Alico Citrus Nursery, LLC in favor of Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 26, 2018 (incorporated by reference to Exhibit 10.40 of Alico’s filing on Form 10-K dated December 6, 2018) +10.31* +Employment Agreement dated June 1, 2015 between Alico, Inc. and John Kiernan (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the SEC on June 1, 2015) +10.32* +Separation and Consulting Agreement dated December 31, 2016 between Alico, Inc. and Clayton G. Wilson (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.33* +Employment Agreement dated December 31, 2016 between Alico, Inc. and Remy W. Trafelet (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.34* +Employment Agreement dated December 31, 2016 between Alico, Inc. and Henry R. Slack (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.35* +Employment Agreement dated March 27, 2013 between Alico, Inc. and George R. Brokaw (incorporated by reference to Exhibit 10.4 of the Company’s Form 8-K filed with the SEC on January 4, 2017) +10.36* +Employment Agreement dated December 2, 2019 between Alico, Inc. and Richard Rallo (incorporated by reference to Exhibit 10.37 of Alico’s filing on Form 10-K dated December 5, 2019) +10.37 +Supplement No. 1 dated as of September 30, 2016, to the Security Agreement dated as of December 1, 2014 by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) (incorporated by reference to Exhibit 10.35 of Alico's filing on Form 10-K dated December 6, 2016) +10.38 +Third Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 30, 2016 (incorporated by reference to Exhibit 10.33 of Alico's filing on Form 10-K dated December 6, 2016) +10.39 +Fourth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 6, 2017 (incorporated by reference to Exhibit 10.38 of Alico's filing on Form 10-K dated December 11, 2017) +10.40 +Fifth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated October 30, 2017 (incorporated by reference to Exhibit 10.37 of Alico’s filing on Form 10-K dated December 6, 2018) +10.41 +Sixth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated July 18, 2018 (incorporated by reference to Exhibit 10.38 of Alico’s filing on Form 10-K dated December 6, 2018) +10.42 +Seventh Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated September 26, 2018 (incorporated by reference to Exhibit 10.39 of Alico’s filing on Form 10-K dated December 6, 2018) +10.43 +Eighth Amendment to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated August 29, 2019 (incorporated by reference to Exhibit 10.44 of Alico’s filing on Form 10-K dated December 5, 2019) +10.44 +Ninth Amendment and Waiver to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated June 26, 2020 (incorporated by reference to Exhibit 10.1 of Alico’s filing on Form 10-Q dated August 6, 2020) +10.45 +Tenth Amendment and Waiver to Credit Agreement by and among Alico, Inc., Alico-Agri, Ltd., Alico Plant World, L.L.C., Alico Fruit Company, LLC, Alico Land Development Inc., Alico Citrus Nursery, LLC and Rabo Agrifinance, LLC (f/k/a Rabo Agrifinance, Inc.) dated August 25, 2020 +10.46 +Settlement Agreement and Release, dated as of February 11, 2019, by and among Alico, Inc., George R. Brokaw, R. Greg Eisner, Benjamin D. Fishman, W. Andrew Krusen, Henry R. Slack, Remy W. Trafelet , 734 Agriculture, LLC, RCF 2014 Legacy LLC and Delta Offshore Master II, LTD (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 11, 2019.) +10.47 +Registration Rights Agreement, dated as of February 11, 2019, by and between Alico, Inc. and Remy W. Trafelet (incorporated by reference from Exhibit C to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 11, 2019). +10.48 +Consulting Agreement, dated as of February 11, 2019, by and among Alico, Inc., 3584 Inc., and Remy W. Trafelet (incorporated by reference from Exhibit B to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 11, 2019). +10.49* +Alico, Inc. Stock Incentive Plan of 2015 (incorporated by reference from Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the SEC on January 28, 2015). +10.50* +Form of Nonqualified Stock Option Agreement +10.51* +Form of Incentive Stock Option Agreement +10.52* +Form of Restricted Stock Agreement +10.53+ +Alico, Inc. Orange Purchase Agreement R512 - May 20, 2020 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on May 21, 2019) +80 +10.54 + +Alico, Inc. Orange Purchase Agreement R514 - May 18, 2020 (incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K filed with the SEC on May 21, 2019) +10.55 +Option Agreement for sale and purchase (incorporate by reference to Exhibit 10.4 of Alico’s filing on Form 10-Q dated August 6, 2020) +21.0 +Subsidiaries of the Registrant +23.0 +Consent of Independent Registered Public Accounting Firm +31.1 +Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Rule 13a-14(a) certification +31.2 +Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Rule 13a-14(a) certification +32.1 +Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 +32.2 +Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 +101.INS** +Inline XBRL Instance Document +101.SCH** +Inline XBRL Taxonomy Extension Schema Document +101.CAL** +Inline XBRL Taxonomy Calculation Linkbase Document +101.DEF** +Inline XBRL Taxonomy Definition Linkbase Document +101.LAB +Inline XBRL Taxonomy Label Linkbase Document +101.PRE +Inline XBRL Taxonomy Extension Presentation Linkbase Document +104 +The cover page for the Company’s Annual Report on Form 10-K for the year ended September 30, 2020, has been formatted in Inline XBRL +* +Denotes a management contract or compensatory plan, contract or arrangement. +** +In accordance with Rule 406T of Regulation S-T, these XBRL (eXtensible Business Reporting Language) documents are furnished and not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability under these sections. +*** +Certain schedules and exhibits have been omitted from this filing pursuant to Item 601(b) (2) of Regulation S-K. The Company will furnish supplemental copies of any such schedules or exhibits to the SEC upon request. ++ +Pursuant to Item 601(b)(10)(iv) of Regulation S-K promulgated by the SEC, certain portions of this exhibit have been redacted. The Company hereby agrees to furnish supplementally to the SEC, upon its request, an unredacted copy of this exhibit. +Item 16. Form 10-K Summary +Not applicable. +81 +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ALICO, INC. (Registrant) +December 8, 2020 +By: +/s/ John E. Kiernan +John E. Kiernan +President and Chief Executive Officer (Principal Executive Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated: +December 8, 2020 +President and Chief Executive Officer (Principal Executive Officer) +/s/ John E. Kiernan +John E. Kiernan +December 8, 2020 +Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) +/s/ Richard Rallo +Richard Rallo +December 8, 2020 +Director: Executive Chairman +/s/ Benjamin D. Fishman +Benjamin D. Fishman +December 8, 2020 +Director +/s/ George R. Brokaw +George R. Brokaw +December 8, 2020 +Director +/s/ R. Greg Eisner +R. Greg Eisner +December 8, 2020 +Director +/s/ Henry R. Slack +Henry R. Slack +December 8, 2020 +Director +/s/ W. Andrew Krusen +W. Andrew Krusen +December 8, 2020 +Director +/s/ Toby K. Purse +Toby K. Purse +December 8, 2020 +Director +/s/ Katherine English +Katherine English +December 8, 2020 +Director +/s/ Adam Putnam +Adam Putnam +82 \ No newline at end of file diff --git a/raw/filings/0000003545/2020/0001564590-20-056379/filing_metadata.csv b/raw/filings/0000003545/2020/0001564590-20-056379/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..b2dca120e6b857b8980667eb2c3e63625a22cba4 --- /dev/null +++ b/raw/filings/0000003545/2020/0001564590-20-056379/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003545,ALCO,"ALICO, INC.",2020,10-K,2020-12-08,2020-09-30,2020-12-08T13:06:35.000Z,0001564590-20-056379,alco-10k_20200930.htm,10-K,18961621,1,1,https://www.sec.gov/Archives/edgar/data/3545/000156459020056379/alco-10k_20200930.htm,https://www.sec.gov/Archives/edgar/data/3545/000156459020056379/ diff --git a/raw/filings/0000003545/2020/0001564590-20-056379/item1.txt b/raw/filings/0000003545/2020/0001564590-20-056379/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..072513c3fac80a93c03a4e6cedffeadc33b26974 --- /dev/null +++ b/raw/filings/0000003545/2020/0001564590-20-056379/item1.txt @@ -0,0 +1,220 @@ +Item 1. Business +Alico, Inc. (“Alico”) was incorporated under the laws of the state of Florida in 1960. Collectively with its subsidiaries (the "Company", "we", "us" or "our"), our business and operations are described below. For detailed financial information with respect to our business and our operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included in Item 7 in this Annual Report on Form 10-K, and the accompanying Consolidated Financial Statements and the related Notes, which are included in Item 8. In addition, general information concerning our Company can be found on our website, the internet address of which is http://www.alicoinc.com . All of our filings with the U.S. Securities and Exchange Commission (the "SEC") including, but not limited to, the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are available free of charge on our website as soon as reasonably practicable after such material is electronically filed or furnished with the SEC. Our recent press releases and information regarding corporate governance, including the charters of our audit, compensation, executive and nominating governance committees, as well as our code of business conduct and ethics are also available to be viewed or downloaded electronically at http://www.alicoinc.com . Unless explicitly stated herein, the information on our website is not incorporated by reference into this Annual Report on Form 10-K and the Company disclaims any such incorporation by reference. +Overview +Alico is an agribusiness with a legacy of achievement and innovation in citrus and conservation. The Company owns approximately 100,000 acres of land in eight Florida counties (Charlotte, Collier, DeSoto, Glades, Hardee, Hendry, Highlands and Polk), holding mineral rights on approximately 90,000 acres of those owned acres. Our principal lines of business are citrus groves and conservation. +Alico is one of the largest citrus producers in the United States of America. +Alico, Inc. operates two divisions: Alico Citrus, a citrus producer, and Land Management and Other Operations, which includes land conservation, encompassing environmental services, land leasing and related support operations. +The Company manages its land based upon its primary usage and reviews its performance based upon two primary classifications - Alico Citrus and Land Management and Other Operations. Land Management and Other Operations include leases for grazing rights, hunting leases, a farm lease, a lease to a third party of an aggregate mine, leases of oil extraction rights to third parties, and other miscellaneous operations generating income. Alico presents its financial results and the related discussion based upon its two business segments: (i) Alico Citrus and (ii) Land Management and Other Operations. +Recent Developments +The COVID-19 Pandemic +On March 11, 2020, the World Health Organization declared the current novel coronavirus outbreak (“COVID-19”) to be a global pandemic. In response to this declaration and the rapid spread of COVID-19 within the United States, federal, state and local governments throughout the country have imposed varying degrees of restrictions on social and commercial activity to promote social distancing in an effort to slow the spread of the illness. These measures have had a significant adverse impact upon many sectors of the economy, including certain agriculture businesses. +During March 2020, as a precautionary measure to ensure financial flexibility and maintain maximum liquidity in response to the COVID-19 pandemic, the Company implemented several measures that we believed would ensure sufficient liquidity for the next several months, including drawing down an aggregate of $70,000,000 on its revolving credit facilities. This decision was made to safeguard the Company’s liquidity and to increase available cash on hand in the event that a more protracted COVID-19 outbreak were to put a significant strain on the financial institutions and their ability to loan funds. As of September 30, 2020, the Company, believing that, despite the protracted COVID-19 outbreak, the financial institution industry was experiencing less negative impact from the outbreak than originally expected, proceeded to pay down the majority of the amounts drawn under its revolving credit facilities. +Additionally, for the protection of our employees in accordance with the Centers For Disease Control and Prevention (CDC) guidelines, the Company arranged to have the majority of office personnel work remotely, has taken steps to allow and encourage greater separation for our employed and contracted field workers and has worked with its harvesters, haulers and suppliers to minimize interactions. The Company continues to assess the situation on a routine basis. +To date, the Company has experienced no material adverse impacts from this pandemic. +4 +Sale and Purchase of Land +On September 11, 2020, the Company sold approximately 10,700 acres on the western part of Alico Ranch to the State of Florida for $28,500,000. A portion of these proceeds were used to purchase approximately 3,280 gross citrus acres for $16,450,000 on October 30, 2020. The purchase of these gross citrus acres was structured to allow the Company to defer income taxes of approximately $4,000,000 from the gain on sale of the approximate 10,700 acres sold to the State of Florida. +Citrus Grove Management Agreement +On July 16, 2020, the Company executed an agreement with an affiliated group of third parties to provide citrus grove caretaking and harvest and haul management services for approximately 7,000 acres owned by such third parties. Pursuant to this agreement, the Company is to be reimbursed by the third parties for all of its costs incurred related to providing these services and also receives a management fee based on acres covered under this agreement. +Agreements with Tropicana +On each of May 18, 2020 and May 20, 2020, the Company entered into a new agreement to supply Tropicana, its largest customer, with citrus fruit. These new agreements are effective October 1, 2020, conclude on July 31, 2024, and succeed an existing agreement that expired at the end of September 2020. +Federal Relief Program +The Company has been eligible for Hurricane Irma federal relief programs for block grants that are being administered through the State of Florida. During the fiscal years ended September 30, 2020 and 2019, the Company received approximately $4,629,000 and $15,597,000, respectively, under the Florida Citrus Recovery Block Grant (“CRBG”) program. This represents the Part 1 and Part 2 reimbursement under a three-part program. The timing and amount to be received under Part 3 of the program, if any, has not been finalized. +Distribution of Shares by 734 Investors +On November 14, 2019, 734 Investors filed a Form 4 and an amendment to Schedule 13D with the SEC disclosing that on November 12, 2019, it distributed all of its shares of Company common stock previously held by it, consisting of 3,173,405 shares, on a pro rata basis, to its members. Prior to such distribution, 734 Investors was the Company’s largest shareholder. +Employee and Board of Directors Matters +On August 6, 2020, the Board of Directors (the “Board”) of the Company increased the number of its directors by two and appointed Mr. Adam Putnam and Ms. Kate English as directors, each to serve until the 2021 annual meeting of the Company’s shareholders or until his or her earlier death, resignation, or removal in accordance with the Amended and Restated Bylaws of the Company. +In December 2019, Mr. George R. Brokaw, the then Executive Vice Chairman, informed the Board of Directors that he would voluntarily step down as Executive Vice Chairman effective December 31, 2019 and that change has taken effect. After the effectiveness of this change, Mr. Brokaw has remained a member of the Board of Directors. +Effective February 27, 2020 (which was immediately after the 2020 Annual Meeting of Shareholders), by way of action that has been taken by and at the direction of the Board of Directors, Benjamin D. Fishman, the non-employee Executive Chairman, became the Chairman of the Board. Mr. Fishman has remained a non-employee director. +The Land We Manage +We regularly review our land holdings to determine the best use of each parcel based upon our management expertise. Our total return profile is a combination of operating income potential and long-term appreciation. Land holdings not meeting our total return criteria are considered surplus to our operations and efforts are being made to sell such land holdings or to exchange such land holdings for land considered to be more compatible with our business objectives and total return profile. +5 +Our land holdings and the operating activities in which we engage are categorized in the following table: +Gross Acreage +Operating Activities +Alico Citrus +Citrus Groves +45,485 +Citrus Cultivation +Citrus Nursery +22 +Citrus Tree Development +45,507 +Land Management and Other Operations +Ranch +52,807 +Leasing and Conservation +Other Land +1,446 +Mining Lease and Office +54,253 +Total +99,760 +Alico Citrus +We own and manage citrus land in DeSoto, Polk, Collier, Hendry, Charlotte, Highlands, and Hardee Counties in the State of Florida and engage in the cultivation of citrus trees to produce citrus for delivery to the fresh and processed citrus markets. Alico citrus groves total approximately 45,507 gross acres or 45.6% of our land holdings. The Company also manages approximately 7,200 acres of citrus land on behalf of third-party grove owners in addition to the 45,507 gross acres owned by Alico. +Our citrus acreage is further detailed in the following table: +Net Plantable +Producing +Developing +Fallow +Total +Plantable +Support +& Other +Gross +DeSoto County +15,180 +1,096 +482 +16,758 +4,650 +21,408 +Polk County +4,870 +— +— +4,870 +2,237 +7,107 +Collier County +4,261 +— +— +4,261 +2,905 +7,166 +Hendry County +3,546 +57 +175 +3,778 +1,707 +5,485 +Charlotte County +1,729 +— +138 +1,867 +676 +2,543 +Highlands County +1,063 +— +— +1,063 +161 +1,224 +Hardee County +403 +— +— +403 +171 +574 +Total +31,052 +1,153 +795 +33,000 +12,507 +45,507 +Of the 45,507 gross acres of citrus land we own and manage, approximately 12,507 acres are classified as support and other acreage. Support and other acreage include acres used for roads, barns, water detention, water retention and drainage ditches integral to the cultivation of citrus trees, but which are not capable of directly producing fruit. In addition, we own a small citrus tree nursery of approximately 22 acres and utilize the trees produced in our own operations. The 32,978 remaining acres are classified as net plantable acres. Net plantable acres are those that are capable of directly producing fruit. These include acres that are currently producing, acres that are developing (i.e., acres that are planted with trees too young to commercially produce fruit) and acres that are fallow. +In an effort to replace trees lost in Hurricane Irma and increase the density of our citrus groves, Alico has planted more than 1.3 million new trees over the past four years. This level of planting has been substantially higher than the normal level of tree attrition. We will continue to evaluate the density throughout our groves and determine the appropriate tree plantings moving forward. Typically, citrus trees become fruit bearing approximately four years after planting and peak around seven to eight years after planting. +Our Alico Citrus business segment cultivates citrus trees to produce citrus for delivery to the processed and fresh citrus markets. Our sales to the processed market were approximately 91.0%, 95.0%, and 93.7% of Alico Citrus revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. We produce Early and Mid-Season varieties, primarily Hamlin oranges, as well as a Valencia variety for the processed market. We deliver our fruit to the processors in boxes which each contains approximately 90 pounds of oranges. Because the processors convert the majority of the citrus crop into orange juice, they generally do not buy their citrus on a per box basis, but rather on a pound solids basis, which is the measure of the soluble solids (sugars and acids) contained in one box of citrus fruit. We produced approximately 43,578,000, 46,727,000, and 26,513,000 pound solids for the fiscal years ended September 30, 2020, 2019 and 2018, respectively, from boxes delivered to processing plants of approximately 7,311,000, 7,904,000, and 4,702,000, respectively. As previously indicated, the falloff in fiscal year 2018 was mostly attributable to the impact of Hurricane Irma. +6 +The average pound solids per box was 5.96, 5.91, and 5.64 for the fiscal years ended September 30, 20 20 , 201 9 and 201 8 , respectively. +We generally use multi-year contracts with citrus processors that include pricing structures based on a floor and ceiling price. Therefore, if pricing in the market is favorable relative to our floor price, we benefit from the incremental difference between the floor and the final market price to the extent it does not exceed the ceiling price. +Our citrus produced for the processed citrus market in fiscal year 2020 under our largest agreement was subject to floor prices and ceiling prices. Under this agreement, if the market price was below the floor prices or exceeded the ceiling prices, then 50% of the shortfall or excess was deducted from the floor price or added to the ceiling price. Under our next largest agreement, our citrus produced is subject to a minimum floor price and maximum ceiling price and is a based on a cost-plus structure. +On each of May 18, 2020 and May 20, 2020, the Company entered into two new agreements to supply Tropicana, its largest customer, with citrus fruit. These new agreements are effective October 1, 2020, conclude on July 31, 2024, and succeeded our existing largest agreement with this customer which expired at the end of September 2020. +Although we believe other markets and customers are available for our citrus products, we also believe that new arrangements in these other markets or with other customers may be less favorable than our current contracts. +Our sales to the fresh citrus market constituted approximately 2.6%, 3.0%, and 2.6% of our Alico Citrus revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. We produce numerous varieties for the fresh fruit market including grapefruit, navel and other fresh varieties. Generally, our fresh fruit is sold to packing houses by the box and the packing houses are responsible for the harvest and haul of these boxes. We produced approximately 267,000, 210,000, and 125,000 fresh fruit boxes for each of the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +On July 16, 2020, the Company executed an agreement with an affiliated group of third parties to provide citrus grove caretaking and harvest and haul management services (“Grove Management Services”) for approximately 7,000 acres owned by such third parties. Under the terms of the agreement, the Company is reimbursed by the third parties for all of its costs incurred related to providing these services and also is to receive a management fee based on acres covered under this agreement. The Company, prior to this agreement, was already providing Grove Management Services to several small third-party grove owners on acres within the Company’s groves and continues to provide such services. Revenues generated from our Grove Management Services were approximately 5.1%, 1.1% and 2.3% of our total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Revenues from our Alico Citrus operations were approximately 96.6%, 97.4%, and 96.1% of our total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Land Management and Other Operations +We own and manage land in Collier, Glades, and Hendry Counties and are engaged in land leasing for recreational and grazing purposes, conservation, and mining activities. Our Land Management and Other Operations land holdings total 54,253 gross acres, or 54.4% of our total acreage. +Our Land Management and Other Operations acreage is detailed in the following table as of September 30, 2020: +Acreage +Hendry County +49,705 +Glades County +526 +Collier County +4,022 +Total +54,253 +On September 11, 2020, the Company sold approximately 10,700 acres on the western part of Alico Ranch to the State of Florida. Because the acres involved in the sale would have been critical to our planned dispersed water storage project, the Company has decided to no longer pursue permit approval activities for this project. As a result of this decision to no longer pursue permit approval activities for this project, the Company has renamed this segment Land Management and Other Operations to better reflect the components of this segment. The Company did not generate any revenue from the dispersed water storage project and incurred expenses of $1,346,000, $1,206,000 and $1,619,000 for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +7 +In January 2018, the Company sold its breeding herd and leased grazing rights on the Ranch to a third - party operator. The Company continues to own the property and conduct its long-term dispersed water program and wildlife management programs. As part of the sales transaction, the Company expensed all cattle inventory costs that were accumulated at the date of sale. +Revenues from Land Management and Other Operations were approximately 3.4%, 2.6%, and 3.9% of total operating revenues for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. +Our Strategy +Our core business strategy is to maximize stockholder value through continuously improving the return on our invested capital, either by holding and managing our existing land through skilled agricultural production, leasing, or other opportunistic means of monetization, disposing of under productive land or business units and acquiring new land or operations with appreciation potential. +Our objectives are to produce the highest quality agricultural products, create innovative land uses, opportunistically acquire and convert undervalued assets, sell under-productive land and other assets not meeting our total return profile, generate recurring and sustainable profit with the appropriate balance of risk and reward, and exceed the expectations of shareholders, customers, clients and partners. +Our strategy is based on best management practices of our agricultural operations and the environmental and conservation stewardship of our land and natural resources. We try to manage our land in a sustainable manner and evaluate the effect of changing land uses while considering new opportunities. Our commitment to environmental stewardship is fundamental to the Company’s core beliefs. +Intellectual Property +While we consider our various intellectual property to be valued assets, we do not believe that our competitive position or our operations are dependent upon or would be materially impacted by any single piece of intellectual property or group of related intellectual property registrations or rights. +Seasonal Nature of Business +As with any agribusiness enterprise, our agribusiness operations and revenues are predominantly seasonal in nature. The following table illustrates the seasonality of our agribusiness revenues: +Fiscal Year +Q1 +Q2 +Q3 +Q4 +Ending 12/31 +Ending 3/31 +Ending 6/30 +Ending 9/30 +Oct +Nov +Dec +Jan +Feb +Mar +Apr +May +Jun +Jul +Aug +Sept +Harvest Fresh and Early/Mid Varieties of Oranges +X +X +X +X +Harvest Valencia Oranges +X +X +X +X +Significant Customers +Revenue from Tropicana represented approximately 87%, 89%, and 87% of our consolidated revenue for the fiscal years ended September 30, 2020, 2019 and 2018, respectively. The revenue in fiscal year 2020 from Tropicana was generated primarily from two separate contracts. This revenue was generated from the sale of our citrus product in the processed market. No other single customer provided more than 10% of our consolidated revenue in fiscal years 2020, 2019 or 2018. +Competition +The orange and specialty citrus markets are intensely competitive, but no single producer has any significant market power over any market segments, as is consistent with the production of most agricultural commodities. Citrus is grown domestically in several states including Florida, California, Arizona and Texas, as well as foreign countries, most notably Brazil and Mexico. Competition is impacted by several factors including quality, production, demand, brand recognition, market prices, weather, disease, export/import restrictions and foreign currency exchange rates. +8 +Governmental Regulations +Our operations are subject to various federal, state and local laws regulating the discharge of materials into the environment. Management believes we are in material compliance with all such rules including permitting and reporting requirements. Historically, compliance with environmental regulations has not had a material impact on our financial position, results of operations or cash flows. +Management monitors environmental legislation and requirements and makes every reasonable effort to remain in compliance with such regulations. In addition, we require in our leases that lessees of our property comply with environmental regulations as a condition of leasing. +We are subject to other laws of the United States and the rules and regulations of various governing bodies within the United States, which may differ among jurisdictions. Compliance with these laws, rules and regulation has not had, and is not expected to have, a material effect on our capital expenditures, results of operations and competitive position as compared to prior periods. +Human Capital +Supporting our people is a fundamental value for Alico. We believe the Company’s success depends on its ability to attract, develop and retain key personnel. The skills, experience and industry knowledge of our employees and the employees of our independent contractors, particularly our key employees, significantly benefit our operations and performance. The Company's management oversees various employee initiatives and also monitors the effectiveness of the personnel provided by independent contractors with which we contract for certain harvesting and hauling services. +Health and safety in the workplace for our employees and personnel provided by independent contractors with which we contract is one of the Company’s core values. Hazards in the workplace are actively identified and management tracks incidents so remedial actions can be taken to improve workplace safety. The COVID-19 pandemic has underscored for us the importance of keeping our employees and the personnel provided by independent contractors safe and healthy. In response to the pandemic, the Company has taken actions aligned with the Centers for Disease Control and Prevention to protect its workforce so that its workforce can more safely and effectively perform their work. +Employee levels are managed to align with the pace of business and takes into account the services that are performed for us by our independent contractors. We rely on our independent contractors to manage their respective employee levels so that the harvesting and hauling services they are obligated to perform for us are consistent with the contractual obligations of these independent contractors and enable us to satisfy our harvesting and hauling needs. Management believes that through its own employees, coupled with the human capital supplied by its independent contractors, it has sufficient human capital to operate its business successfully. Management believes that the Company's employee relations are favorable, that its relations with its independent contractors is favorable and that the relations that the independent contractors and the Company has with the employees of the independent contractors is favorable. +We believe in a culture of equity, diversity and inclusion. We are also committed to advancing safe and respectful work environments where our employees are invited to bring their talents, backgrounds and expertise to bear on the success of our business and where every person has the opportunity to thrive personally and professionally. +As of September 30, 2020, we had 251 full-time employees. Our employees work in the following divisions: +Alico Citrus +230 +Land Management and Other Operations (1) +0 +Corporate, General, Administrative and Other +21 +Total employees +251 +(1) +There is one employee who is included in Corporate, General, Administrative and Other who oversees the Land Management and Other operations. +None of our employees are subject to a collective bargaining agreement. We believe that our relations with our employees are good. +Capital Resources and Raw Materials +Management believes that the Company will be able to meet its working capital requirements for at least the next 12 months, and over the long term, through internally generated funds, cash flows from operations, the sale of under-productive land and other assets, our existing lines of credit and access to capital markets. The Company has commitments that provide for lines of revolving credit that are available for our general and corporate use. +9 +Raw materials needed to cultivate the various crops grown by the Company consist primarily of fertilizers, herbicides, insecticides and fuel and are readily available from local suppliers. +Available Information +We will provide electronic copies of our SEC filings free of charge upon request. Additionally, our reports, amendments thereto, proxy statements and other information are also made available, free of charge, on our investor relations website at ir.alicoinc.com as soon as reasonably practicable after we electronically file or furnish such information with the SEC. Any information posted on or linked from our website is not incorporated by reference in this Annual Report on Form 10-K. The SEC also maintains a website at http://www.sec.gov , which contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. +10 \ No newline at end of file diff --git a/raw/filings/0000003545/2020/0001564590-20-056379/item13.txt b/raw/filings/0000003545/2020/0001564590-20-056379/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..b0dab2c25fa471346fd130a8e247ea00e7fce647 --- /dev/null +++ b/raw/filings/0000003545/2020/0001564590-20-056379/item13.txt @@ -0,0 +1,2 @@ +Item 13. Certain Relationships and Related Transactions and Director Independence +77 \ No newline at end of file diff --git a/raw/filings/0000003570/2018/0000003570-19-000030/filing.txt b/raw/filings/0000003570/2018/0000003570-19-000030/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..13b9efaece8ce6621adb59d19ab8fbbc765be1b3 --- /dev/null +++ b/raw/filings/0000003570/2018/0000003570-19-000030/filing.txt @@ -0,0 +1,6150 @@ +10-K +1 +cei2018form10-k.htm +10-K +Document +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2018 +or +¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-16383 +CHENIERE ENERGY, INC. +(Exact name of registrant as specified in its charter) +Delaware +95-4352386 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +700 Milam Street, Suite 1900 +Houston, Texas +77002 +(Address of principal executive offices) +(Zip code) +Registrant’s telephone number, including area code: (713) 375-5000 +Securities registered pursuant to Section 12(b) of the Act: +Common Stock, $ 0.003 par value +NYSE American +(Title of each class) +(Name of each exchange on which registered) +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No o +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No o +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Act. +Large accelerated filer x +Accelerated filer o +Non-accelerated filer o +Smaller reporting company o +Emerging growth company o +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x +The aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant was approximately $16.0 billion as of June 30, 2018 . +257,415,723 shares of the registrant’s Common Stock, $0.003 par value, were outstanding as of February 20, 2019 . +Documents incorporated by reference: The definitive proxy statement for the registrant’s Annual Meeting of Stockholders (to be filed within 120 days of the close of the registrant’s fiscal year) is incorporated by reference into Part III. +CHENIERE ENERGY, INC. +TABLE OF CONTENTS +PART I +Items 1. and 2. Business and Properties +1 +Item 1A. Risk Factors +16 +Item 1B. Unresolved Staff Comments +31 +Item 3. Legal Proceedings +31 +Item 4. Mine Safety Disclosure +32 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +33 +Item 6. Selected Financial Data +35 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +36 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +58 +Item 8. Financial Statements and Supplementary Data +60 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +110 +Item 9A. Controls and Procedures +110 +Item 9B. Other Information +110 +PART III +PART IV +Item 15. Exhibits and Financial Statement Schedules +111 +Item 16. Form 10-K Summary +132 +Signatures +133 +i +DEFINITIONS +As used in this annual report, the terms listed below have the following meanings: +Common Industry and Other Terms +Bcf +billion cubic feet +Bcf/d +billion cubic feet per day +Bcf/yr +billion cubic feet per year +Bcfe +billion cubic feet equivalent +DOE +U.S. Department of Energy +EPC +engineering, procurement and construction +FERC +Federal Energy Regulatory Commission +FTA countries +countries with which the United States has a free trade agreement providing for national treatment for trade in natural gas +GAAP +generally accepted accounting principles in the United States +Henry Hub +the final settlement price (in USD per MMBtu) for the New York Mercantile Exchange’s Henry Hub natural gas futures contract for the month in which a relevant cargo’s delivery window is scheduled to begin +LIBOR +London Interbank Offered Rate +LNG +liquefied natural gas, a product of natural gas that, through a refrigeration process, has been cooled to a liquid state, which occupies a volume that is approximately 1/600th of its gaseous state +MMBtu +million British thermal units, an energy unit +mtpa +million tonnes per annum +non-FTA countries +countries with which the United States does not have a free trade agreement providing for national treatment for trade in natural gas and with which trade is permitted +SEC +U.S. Securities and Exchange Commission +SPA +LNG sale and purchase agreement +TBtu +trillion British thermal units, an energy unit +Train +an industrial facility comprised of a series of refrigerant compressor loops used to cool natural gas into LNG +TUA +terminal use agreement +ii +Abbreviated Legal Entity Structure +The following diagram depicts our abbreviated legal entity structure as of December 31, 2018 , including our ownership of certain subsidiaries, and the references to these entities used in this annual report: +Unless the context requires otherwise, references to “ Cheniere ,” the “Company,” “we,” “us” and “our” refer to Cheniere Energy, Inc. and its consolidated subsidiaries, including our publicly traded subsidiary, Cheniere Partners . +During the year ended December 31, 2018 , we closed the merger of Cheniere Energy Partners LP Holdings, LLC (“Cheniere Holdings”) with and into our wholly owned subsidiary. As a result of the merger, Cheniere Holdings is no longer a publicly-traded company. +Unless the context requires otherwise, references to the “CCH Group” refer to CCH HoldCo II , CCH HoldCo I , CCH , CCL and CCP , collectively. +iii +CAUTIONARY STATEMENT +REGARDING FORWARD-LOOKING STATEMENTS +This annual report contains certain statements that are, or may be deemed to be, “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) , and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) . All statements, other than statements of historical or present facts or conditions, included herein or incorporated herein by reference are “forward-looking statements.” Included among “forward-looking statements” are, among other things: +• +statements that we expect to commence or complete construction of our proposed LNG terminals, liquefaction facilities, pipeline facilities or other projects, or any expansions or portions thereof, by certain dates, or at all; +• +statements regarding future levels of domestic and international natural gas production, supply or consumption or future levels of LNG imports into or exports from North America and other countries worldwide or purchases of natural gas, regardless of the source of such information, or the transportation or other infrastructure or demand for and prices related to natural gas, LNG or other hydrocarbon products; +• +statements regarding any financing transactions or arrangements, or our ability to enter into such transactions; +• +statements relating to the construction of our Trains and pipelines, including statements concerning the engagement of any EPC contractor or other contractor and the anticipated terms and provisions of any agreement with any EPC or other contractor, and anticipated costs related thereto; +• +statements regarding any SPA or other agreement to be entered into or performed substantially in the future, including any revenues anticipated to be received and the anticipated timing thereof, and statements regarding the amounts of total LNG regasification, natural gas liquefaction or storage capacities that are, or may become, subject to contracts; +• +statements regarding counterparties to our commercial contracts, construction contracts, and other contracts; +• +statements regarding our planned development and construction of additional Trains and pipelines, including the financing of such Trains or pipelines; +• +statements that our Trains, when completed, will have certain characteristics, including amounts of liquefaction capacities; +• +statements regarding our business strategy, our strengths, our business and operation plans or any other plans, forecasts, projections, or objectives, including anticipated revenues, capital expenditures, maintenance and operating costs and cash flows, any or all of which are subject to change; +• +statements regarding legislative, governmental, regulatory, administrative or other public body actions, approvals, requirements, permits, applications, filings, investigations, proceedings or decisions; +• +statements regarding marketing of volumes expected to be made available to our integrated marketing function; and +• +any other statements that relate to non-historica l or future information. +All of these types of statements, other than statements of historical or present facts or conditions, are forward-looking statements. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “could,” “should,” “achieve,” “anticipate,” “believe,” “contemplate,” “continue,” “estimate,” “expect,” “intend,” “plan,” “potential,” “predict,” “project,” “pursue,” “target,” the negative of such terms or other comparable terminology. The forward-looking statements contained in this annual report are largely based on our expectations, which reflect estimates and assumptions made by our management. These estimates and assumptions reflect our best judgment based on currently known market conditions and other factors. Although we believe that such estimates are reasonable, they are inherently uncertain and involve a number of risks and uncertainties beyond our control. In addition, assumptions may prove to be inaccurate. We caution that the forward-looking statements contained in this annual report are not guarantees of future performance and that such statements may not be realized or the forward-looking statements or events may not occur. Actual results may differ materially from those anticipated or implied in forward-looking statements as a result of a variety of factors described in this annual report and in the other reports and other information that we file with the SEC. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these risk factors. These forward-looking statements speak only as of the date made, and other than as required by law, we undertake no obligation to update or revise any forward-looking statement or provide reasons why actual results may differ, whether as a result of new information, future events or otherwise. +iv +PART I +ITEMS 1. AND 2. +BUSINESS AND PROPERTIES +General +Cheniere, a Delaware corporation, was organized in 1983 and is a Houston-based energy company primarily engaged in LNG-related businesses. Our vision is to provide clean, secure and affordable energy to the world, while responsibly delivering a reliable, competitive and integrated source of LNG, in a safe and rewarding work environment. We own and operate the Sabine Pass LNG terminal in Louisiana through our ownership interest in and management agreements with Cheniere Partners, which is a publicly traded limited partnership that we created in 2007. As of December 31, 2018 , we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We are currently developing and constructing two natural gas liquefaction and export facilities. The liquefaction of natural gas into LNG allows it to be shipped economically from areas of the world where natural gas is abundant and inexpensive to produce to other areas where natural gas demand and infrastructure exist to economically justify the use of LNG. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners is developing, constructing and operating natural gas liquefaction facilities (the “SPL Project”) at the Sabine Pass LNG terminal adjacent to the existing regasification facilities through a wholly owned subsidiary, SPL. Cheniere Partners plans to construct up to six Trains, which are in various stages of development, construction and operations. Trains 1 through 4 are operational, Train 5 is undergoing commissioning and Train 6 is being commercialized and has all necessary regulatory approvals in place. Each Train is expected to have a nominal production capacity, which is prior to adjusting for planned maintenance, production reliability, potential overdesign and debottlenecking opportunities, of approximately 4.5 mtpa of LNG per Train, and run rate adjusted nominal production capacity of approximately 4.5 to 4.9 mtpa of LNG per Train. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ wholly owned subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 16.9 Bcfe , two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4.0 Bcf/d . Cheniere Partners also owns a 94-mile pipeline that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”) through a wholly owned subsidiary, CTPL. +We are developing and constructing a second natural gas liquefaction and export facility at the Corpus Christi LNG terminal near Corpus Christi, Texas and operate a 23-mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the liquefaction facilities, the “CCL Project”) through our wholly owned subsidiaries CCL and CCP, respectively. The CCL Project is being developed in stages with the first phase being three Trains (“Phase 1”), with expected aggregate nominal production capacity, which is prior to adjusting for planned maintenance, production reliability, potential overdesign and debottlenecking opportunities, of approximately 13.5 mtpa of LNG, three LNG storage tanks with aggregate capacity of approximately 10.1 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. The first stage (“Stage 1”) includes Trains 1 and 2, two LNG storage tanks, one complete marine berth and a second partial berth and all of the CCL Project ’s necessary infrastructure facilities. The second stage (“Stage 2”) includes Train 3, one LNG storage tank and the completion of the second partial berth. Trains 1 and 2 are undergoing commissioning and Train 3 is under construction. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) and filed an application with FERC in June 2018 for seven midscale Trains with an expected aggregate nominal production capacity of approximately 9.5 mtpa and one LNG storage tank. +We remain focused on expansion of our existing sites by leveraging existing infrastructure. We are also in various stages of developing other projects, including infrastructure projects in support of natural gas supply and LNG demand, which, among other things, will require acceptable commercial and financing arrangements before we make a final investment decision (“ FID ”). We have made an equity investment in Midship Holdings, LLC (“Midship Holdings”), which manages the business and affairs of Midship Pipeline Company, LLC (“Midship Pipeline”). Midship Pipeline is developing a pipeline (the “Midship Project”) with expected capacity of up to 1.44 million Dekatherms per day that will connect new gas production in the Anadarko Basin to Gulf Coast markets, including markets serving the SPL Project and the CCL Project . Construction of the Midship Project will commence based upon, among other things, obtaining the required authorization from the FERC and adequate financing to construct the proposed project. +1 +Although results are consolidated for financial reporting, Cheniere, Cheniere Partners, SPL and the CCH Group operate with independent capital structures. The following diagram depicts our abbreviated capital structure as of December 31, 2018 : +Our Business Strategy +Our primary business strategy is to be a full service LNG provider to worldwide end-use customers. We accomplish this objective by developing LNG and natural gas infrastructure facilities and: +• +achieving the date of first commercial delivery for our SPA customers; +• +safely, efficiently and reliably maintaining and operating our assets; +• +completing construction and commencing operation of Train 5 of the SPL Project and the first three Trains of the CCL Project; +• +making LNG available to our SPA customers to generate steady and reliable revenues and operating cash flows; +• +obtaining the requisite long-term commercial contracts and financing to reach an FID regarding Train 6 of the SPL Project; +• +further expanding and optimizing the SPL Project and the CCL Project by leveraging existing infrastructure; +• +developing business relationships for the marketing of LNG volumes expected to be made available to our integrated marketing function and additional LNG liquefaction projects or expansions; +• +expanding our existing asset base through acquisitions or development of complementary businesses or assets across the LNG value chain; and +• +maintaining a flexible capital structure to finance the acquisition, development, construction and operation of the energy assets needed to supply our customers. +LNG Terminals +We began developing our first LNG terminal in 1999 and were among the first companies to secure sites and commence development of new LNG terminals in North America. We are currently focusing our development efforts on two LNG terminal +2 +projects currently under construction: the Sabine Pass LNG terminal and the Corpus Christi LNG terminal. Through Cheniere Partners, we are developing, constructing and operating the SPL Project and have constructed and are operating regasification facilities at the Sabine Pass LNG terminal. As of December 31, 2018 , we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We currently own a 100% interest in the CCL Project . +Sabine Pass LNG Terminal +Liquefaction Facilities +We are developing, constructing and operating the SPL Project at the Sabine Pass LNG terminal adjacent to the existing regasification facilities. We have received authorization from the FERC to site, construct and operate Trains 1 through 6. We have achieved substantial completion of Trains 1, 2, 3 and 4 of the SPL Project and commenced operating activities in May 2016, September 2016, March 2017 and October 2017, respectively. Train 5 of the SPL Project is undergoing commissioning and the following table summarizes the status as of December 31, 2018 : +SPL Train 5 +Overall project completion percentage +99.7% +Completion percentage of: +Engineering +100% +Procurement +100% +Subcontract work +98.0% +Construction +99.6% +Date of expected substantial completion +1Q 2019 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal: +• +Trains 1 through 4— FTA countries for a 30-year term, which commenced on May 15, 2016, and non-FTA countries for a 20-year term, which commenced on June 3, 2016, in an amount up to a combined total of the equivalent of 16 mtpa (approximately 803 Bcf/yr of natural gas). +• +Trains 1 through 4— FTA countries for a 25-year term and non-FTA countries for a 20-year term in an amount up to a combined total of the equivalent of approximately 203 Bcf/yr of natural gas (approximately 4 mtpa). +• +Trains 5 and 6— FTA countries and non-FTA countries for a 20-year term, in an amount up to a combined total of 503.3 Bcf/yr of natural gas (approximately 10 mtpa). +In each case, the terms of these authorizations begin on the earlier of the date of first export thereunder or the date specified in the particular order, which ranges from five to 10 years from the date the order was issued. In addition, SPL received an order providing for a three-year makeup period with respect to each of the non-FTA orders for LNG volumes SPL was authorized but unable to export during any portion of the initial 20-year export period of such order. +In January 2018, the DOE issued orders authorizing SPL to export domestically produced LNG by vessel from the Sabine Pass LNG terminal to FTA countries and non-FTA countries over a two-year period commencing January 2018, in an aggregate amount up to the equivalent of 600 Bcf of natural gas (however, exports under this order, when combined with exports under the orders above, may not exceed 1,509 Bcf/yr ). +Customers +SPL has entered into fixed price SPA s with terms of at least 20 years (plus extension rights) with six third parties for Trains 1 through 5 of the SPL Project , to make available an aggregate amount of LNG that is between approximately 80% to 95% of the expected aggregate adjusted nominal production capacity from these Trains. Under these SPA s, the customers will purchase LNG from SPL for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub . In certain circumstances, the customers may elect to cancel or suspend deliveries of LNG cargoes, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under SPL’s SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as +3 +the variable fee component of the price under SPL’s SPAs. The variable fees under SPL’s SPAs were sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation related to, and operating and maintenance costs to produce, the LNG to be sold under each such SPA. The SPA s and contracted volumes to be made available under the SPA s are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. Under SPL’s SPA with BG Gulf Coast LNG, LLC (“BG”) , BG has contracted for volumes related to Trains 3 and 4, for which the obligation to make volumes related to Train 3 available to BG has commenced and the obligation to make volumes related to Train 4 available to BG is expected to commence approximately one year after the date of first commercial delivery under SPL’s SPA with GAIL (India) Limited (“GAIL”) for Train 4. +In aggregate, the annual fixed fee portion to be paid by the third-party SPA customers is approximately $2.2 billion for Trains 1 through 3 and the SPA with GAIL for Train 4, increasing to $2.3 billion upon the date of first commercial delivery of Train 4 under the SPA with BG and to $2.9 billion upon the date of first commercial delivery of Train 5, with the applicable fixed fees starting from the date of first commercial delivery from the applicable Train, as specified in each SPA. +The annual contracted cash flows from fixed fees of each buyer of LNG under SPL’s third-party SPAs that constitute more than 10% of SPL’s aggregate fixed fees under all its SPAs are: +• +approximately $720 million from BG , which is guaranteed by BG Energy Holdings Limited; +• +approximately $550 million from Korea Gas Corporation (“KOGAS”) ; +• +approximately $550 million from GAIL ; and +• +approximately $450 million from Naturgy LNG GOM, Limited (formerly known as Gas Natural Fenosa LNG GOM, Limited) (“Naturgy”) , which is guaranteed by Naturgy Energy Group, S.A. (formerly known as Gas Natural SDG S.A.). +SPL also has SPAs with Total Gas & Power North America, Inc. (“Total”) , which is guaranteed by Total S.A., and Centrica plc with annual aggregate fixed fees of approximately $590 million. In addition, Cheniere Marketing has entered into an SPA with SPL to purchase, at Cheniere Marketing’s option, any LNG produced by SPL in excess of that required for other customers. +During the year ended December 31, 2018 , four customers, BG and its affiliates, Naturgy , KOGAS and GAIL , individually accounted for more than 10% of our total revenues from external customers at 18% , 14% , 19% and 13% , respectively. During the year ended December 31, 2017, four customers, BG and its affiliates, Naturgy , KOGAS and JERA Co., Inc., individually accounted for more than 10% of our total revenues from external customers at 24%, 14%, 14% and 17%, respectively. During the year ended December 31, 2016, two customers, BG and its affiliates and Kansai Electric Power Co., Inc. and its affiliates, individually accounted for more than 10% of our total revenues from external customers at 39% and 13%, respectively. +Natural Gas Transportation, Storage and Supply +To ensure SPL is able to transport adequate natural gas feedstock to the Sabine Pass LNG terminal, it has entered into transportation precedent and other agreements to secure firm pipeline transportation capacity with CTPL and third-party pipeline companies. SPL has entered into firm storage services agreements with third parties to assist in managing variability in natural gas needs for the SPL Project . SPL has also entered into enabling agreements and long-term natural gas supply contracts with third parties in order to secure natural gas feedstock for the SPL Project . As of December 31, 2018 , SPL had secured up to approximately 3,464 TBtu of natural gas feedstock through long-term and short-term natural gas supply contracts. +Construction +SPL entered into lump sum turnkey contracts with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Trains 1 through 6 of the SPL Project , under which Bechtel charges a lump sum for all work performed and generally bears project cost risk unless certain specified events occur, in which case Bechtel may cause SPL to enter into a change order, or SPL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 5 of the SPL Project is approximately $3.1 billion reflecting amounts incurred under change orders through December 31, 2018 . Total expected capital costs for Trains 1 through 5 are estimated to be between $12.5 billion and $13.5 billion before financing costs and between $17.5 billion and $18.5 billion after financing costs including, in each case, estimated owner’s costs and contingencies. The total contract price of the EPC contract for Train 6 of the SPL Project is approximately $2.5 billion , including estimated costs for an optional third marine berth. +4 +Final Investment Decision on Train 6 +SPL has issued limited notices to proceed to Bechtel for the commencement of certain engineering, procurement and site works for Train 6 of the SPL Project and a schedule for completion has been established. FID and full notice to proceed for Train 6 of the SPL Project will be contingent upon, among other things, entering into acceptable commercial arrangements and obtaining adequate financing to construct Train 6. +Regasification Facilities +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4.0 Bcf/d and aggregate LNG storage capacity of approximately 16.9 Bcfe . Approximately 2.0 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term third-party TUA s, under which SPLNG’s customers are required to pay fixed monthly fees, whether or not they use the LNG terminal. Each of Total and Chevron U.S.A. Inc. (“Chevron”) has reserved approximately 1.0 Bcf/d of regasification capacity and is obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually for 20 years that commenced in 2009. Total S.A. has guaranteed Total ’s obligations under its TUA up to $2.5 billion, subject to certain exceptions, and Chevron Corporation has guaranteed Chevron ’s obligations under its TUA up to 80% of the fees payable by Chevron . +The remaining approximately 2.0 Bcf/d of capacity has been reserved under a TUA by SPL. SPL is obligated to make monthly capacity payments to SPLNG aggregating approximately $250 million annually, continuing until at least May 2036. SPL entered into a partial TUA assignment agreement with Total , whereby upon substantial completion of Train 3 of the SPL Project , SPL gained access to a portion of Total ’s capacity and other services provided under Total ’s TUA with SPLNG. Upon substantial completion of Train 5, SPL will gain access to substantially all of Total ’s capacity. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Trains 5 and 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA. During the years ended December 31, 2018 and 2017 , SPL recorded $30 million and $23 million , respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Under each of these TUA s, SPLNG is entitled to retain 2% of the LNG delivered to the Sabine Pass LNG terminal. +Corpus Christi LNG Terminal +Liquefaction Facilities +The CCL Project is being developed and constructed at the Corpus Christi LNG terminal. We have received authorization from the FERC to site, construct and operate Stages 1 and 2 of the CCL Project . The following table summarizes the overall project status of the CCL Project as of December 31, 2018 : +CCL Stage 1 +CCL Stage 2 +Overall project completion percentage +96.7% +42.0% +Completion percentage of: +Engineering +100% +87.0% +Procurement +100% +63.0% +Subcontract work +89.5% +8.5% +Construction +93.1% +11.7% +Expected date of substantial completion +Train 1 +1Q 2019 +Train 3 +2H 2021 +Train 2 +2H 2019 +Separate from the CCH Group, we are also developing Corpus Christi Stage 3 , adjacent to the CCL Project . We filed an application with FERC in June 2018 for seven midscale Trains with an expected aggregate nominal production capacity of approximately 9.5 mtpa and one LNG storage tank. +5 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Corpus Christi LNG terminal: +• +CCL Project— FTA countries for a 25-year term and to non-FTA countries for a 20-year term up to a combined total of the equivalent of 767 Bcf/yr (approximately 15 mtpa) of natural gas. +• +Corpus Christi Stage 3 —FTA countries for a 20-year term in an amount equivalent to 514 Bcf/yr (approximately 10 mtpa) of natural gas (the “Stage 3 FTA”). The application for authorization to export that same 514 Bcf/yr of domestically produced LNG by vessel to non-FTA countries is currently pending before the DOE (the “Stage 3 Non-FTA”). +In each case, the terms of these authorizations begin on the earlier of the date of first export thereunder or the date specified in the particular order, which ranges from seven to 10 years from the date the order was issued. +In June 2018, we requested that DOE vacate the Stage 3 FTA and permit us to withdraw the pending Stage 3 Non-FTA. These requests were made due to certain changes to Corpus Christi Stage 3. +In conjunction with the submission in June 2018 of our FERC application for Corpus Christi Stage 3 , we submitted a new application for long-term multi-contract authorization to export up to a combined total of 582.14 Bcf/yr (approximately 11.45 mtpa) of natural gas to FTA countries for a 25-year term and to non-FTA countries for a 20-year term. The term of each authorization is expected to begin on the earlier of the date of first commercial export of LNG produced by Corpus Christi Stage 3 or the date which is seven years from the issuance of such authorizations. +Customers +CCL has entered into fixed price SPA s generally with terms of 20 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project , to make available an aggregate amount of LNG that is between approximately 75% to 85% of the expected aggregate adjusted nominal production capacity from these Trains. Under these SPAs, the customers will purchase LNG from CCL for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. In certain circumstances, the customers may elect to cancel or suspend deliveries of LNG cargoes, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under our SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under our SPAs . The variable fee under CCL’s SPAs entered into in connection with the development of the CCL Project was sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation related to, and operating and maintenance costs to produce, the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery for the applicable Train, as specified in each SPA. +In aggregate, the minimum fixed fee portion to be paid by the third-party SPA customers is approximately $550 million for Train 1 and increasing to approximately $1.4 billion for Train 2, in each case upon the date of first commercial delivery for the respective Train, and further increasing to approximately $1.8 billion following the substantial completion of Train 3 of the CCL Project. +The annual contracted cash flows from fixed fees of each buyer of LNG under CCL’s third-party SPAs that constitute more than 10% of CCL’s aggregate fixed fees under all its SPAs for Trains 1 through 3 of the CCL Project are: +• +approximately $410 million from Endesa S.A.; +• +approximately $280 million from PT Pertamina (Persero); and +• +approximately $270 million from Naturgy , which is guaranteed by Naturgy Energy Group, S.A. +The average annual contracted cash flow from fixed fees from buyers under all of our other third-party SPAs for Trains 1 through 3 of the CCL Project is approximately $790 million. +In addition, Cheniere Marketing has entered into SPAs with CCL to purchase 15 TBtu per annum of LNG and any LNG produced by CCL in excess of that required for other customers at Cheniere Marketing’s option. +6 +Natural Gas Transportation, Storage and Supply +To ensure CCL is able to transport adequate natural gas feedstock to the Corpus Christi LNG terminal, it has entered into transportation precedent agreements to secure firm pipeline transportation capacity with CCP and certain third-party pipeline companies. CCL has entered into a firm storage services agreement with a third party to assist in managing variability in natural gas needs for the CCL Project . CCL has also entered into enabling agreements and long-term natural gas supply contracts with third parties, and will continue to enter into such agreements, in order to secure natural gas feedstock for the CCL Project . As of December 31, 2018 , CCL had secured up to approximately 2,801 TBtu of natural gas feedstock through long-term natural gas supply contracts, a portion of which is subject to the achievement of certain project milestones and other conditions precedent. +Construction +CCL entered into separate lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Stages 1 and 2 of the CCL Project under which Bechtel charges a lump sum for all work performed and generally bears project cost risk unless certain specified events occur, in which case Bechtel may cause CCL to enter into a change order, or CCL agrees with Bechtel to a change order. +The total contract prices of the EPC contract for Stage 1 and the EPC contract for Stage 2, which do not include the Corpus Christi Pipeline , are approximately $7.8 billion and $2.4 billion , respectively, reflecting amounts incurred under change orders through December 31, 2018 . Total expected capital costs for Trains 1 through 3 are estimated to be between $11.0 billion and $12.0 billion before financing costs and between $15.0 billion and $16.0 billion after financing costs including, in each case, estimated owner’s costs and contingencies. +Pipeline Facilities +In December 2014, the FERC issued a certificate of public convenience and necessity under Section 7(c) of the Natural Gas Act of 1938, as amended (the “NGA”), authorizing CCP to construct and operate the Corpus Christi Pipeline. The Corpus Christi Pipeline is designed to transport 2.25 Bcf/d of natural gas feedstock required by the CCL Project from the existing regional natural gas pipeline grid. The construction of the Corpus Christi Pipeline commenced in January 2017 and was completed in the second quarter of 2018. +Competition +SPL has entered into fixed price SPA s with terms of at least 20 years (plus extension rights) with six third parties for Trains 1 through 5 of the SPL Project , to make available an aggregate amount of LNG that is between approximately 80% to 95% of the expected aggregate adjusted nominal production capacity from these Trains. CCL has entered into fixed price SPA s generally with terms of 20 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project , to make available an aggregate amount of LNG that is between approximately 75% to 85% of the expected aggregate adjusted nominal production capacity from these Trains. Each customer will be required to pay an escalating fixed fee for its annual contract quantity even if it elects not to purchase any LNG from us. +If and when SPL or CCL need to replace any existing SPA or enter into new SPAs, they will compete on the basis of price per contracted volume of LNG with each other and other natural gas liquefaction projects throughout the world. Revenues associated with any incremental volumes, including those sold by our integrated marketing function discussed above, will also be subject to market-based price competition. Many of the companies with which we compete are major energy corporations with longer operating histories, more development experience, greater name recognition, greater financial, technical and marketing resources and greater access to markets than us. +SPLNG currently does not experience competition for its terminal capacity because the entire approximately 4.0 Bcf/d of regasification capacity that is available at the Sabine Pass LNG terminal has been fully contracted. If and when SPLNG has to replace any TUAs, it will compete with other then-existing LNG terminals for customers. +7 +Governmental Regulation +Our LNG terminals are subject to extensive regulation under federal, state and local statutes, rules, regulations and laws. These laws require that we engage in consultations with appropriate federal and state agencies and that we obtain and maintain applicable permits and other authorizations. This regulatory requirement increases the cost of construction and operation, and failure to comply with such laws could result in substantial penalties and/or loss of necessary authorizations. +Federal Energy Regulatory Commission +The design, construction and operation of our liquefaction facilities, the export of LNG and the transportation of natural gas through the Creole Trail Pipeline and the Corpus Christi Pipeline are highly regulated activities. Under the NGA, the FERC’s jurisdiction generally extends to the transportation of natural gas in interstate commerce, to the sale in interstate commerce of natural gas for resale for ultimate consumption for domestic, commercial, industrial or any other use and to natural gas companies engaged in such transportation or sale. However, the FERC’s jurisdiction does not extend to the production, gathering, local distribution or export of natural gas. +In general, the FERC’s authority to regulate interstate natural gas pipelines and the services that they provide includes: +• +rates and charges, and terms and conditions for natural gas transportation and related services; +• +the certification and construction of new facilities; +• +the extension and abandonment of services and facilities; +• +the administration of accounting and financial reporting regulations, including the maintenance of accounts and records; +• +the acquisition and disposition of facilities; +• +the initiation and discontinuation of services; and +• +various other matters. +In addition, under the NGA, our pipelines are not permitted to unduly discriminate or grant undue preference as to rates or the terms and conditions of service to any shipper, including its own marketing affiliate. The FERC has the authority to grant certificates allowing construction and operation of facilities used in interstate gas transportation and authorizing the provision of services. +In order to site, construct and operate our LNG terminals, we received and are required to maintain authorizations from the FERC under Section 3 of the NGA as well as several other material governmental and regulatory approvals and permits. The Energy Policy Act of 2005 (the “EPAct”) amended Section 3 of the NGA to establish or clarify the FERC’s exclusive authority to approve or deny an application for the siting, construction, expansion or operation of LNG terminals, although except as specifically provided in the EPAct, nothing in the EPAct is intended to affect otherwise applicable law related to any other federal or state agency’s authorities or responsibilities related to LNG terminals. The FERC issued final orders in April and July 2012 approving our application for an order under Section 3 of the NGA authorizing the siting, construction and operation of Trains 1 through 4 of the SPL Project (and related facilities). Subsequently, the FERC issued written approval to commence site preparation work for Trains 1 through 4. In October 2012, we applied to amend the FERC approval to reflect certain modifications to the SPL Project, and in August 2013, the FERC issued an order approving the modifications. In October 2013, we applied to further amend the FERC approval, requesting authorization to increase the total permitted LNG production capacity of Trains 1 through 4 from the then authorized 803 Bcf/yr to 1,006 Bcf/yr so as to more accurately reflect the estimated maximum LNG production capacity of Trains 1 through 4. In February 2014, the FERC issued an order approving the October 2013 application (the “February 2014 Order”). A party to the proceeding requested a rehearing of the February 2014 Order, and in September 2014, the FERC issued an order denying the rehearing request (the “FERC Order Denying Rehearing”). The party petitioned the U.S. Court of Appeals for the District of Columbia Circuit (the “Court of Appeals”) to review the February 2014 Order and the FERC Order Denying Rehearing. The court denied the petition in June 2016. In September 2013, we filed an application with the FERC for authorization to add Trains 5 and 6 to the SPL Project, which was granted by the FERC in an order issued in April 2015 and an order denying rehearing issued in June 2015. These orders are not subject to appellate court review. +In December 2014, the FERC issued an order granting CCL authorization under Section 3 of the NGA to site, construct and operate Stage 1 and Stage 2 of the CCL Project and issued a certificate of public convenience and necessity under Section 7(c) of +8 +the NGA authorizing CCP to construct and operate the Corpus Christi Pipeline (the “December 2014 Order”). A party to the proceeding requested a rehearing of the December 2014 Order, and in May 2015, the FERC denied rehearing (the “Order Denying Rehearing”). The party petitioned the Court of Appeals to review the December 2014 Order and the Order Denying Rehearing, and that petition was denied on November 4, 2016. +In 2002, the FERC concluded that it would apply light-handed regulation over the rates, terms and conditions agreed to by parties for LNG terminalling services, such that LNG terminal owners would not be required to provide open-access service at non-discriminatory rates or maintain a tariff or rate schedule on file with the FERC, as distinguished from the requirements applied to our FERC-regulated natural gas pipeline. The EPAct codified the FERC’s policy, but those provisions expired on January 1, 2015. Nonetheless, we see no indication that the FERC intends to modify its longstanding policy of light-handed regulation of LNG terminals. +In order to construct, own, operate and maintain the Creole Trail Pipeline, CTPL received a certificate of public convenience and necessity from the FERC under Section 7 of the NGA. The FERC’s approval under Section 7 of the NGA, as well as several other material governmental and regulatory approvals and permits, may be required prior to making any modifications to the Creole Trail Pipeline as it is a regulated, interstate natural gas pipeline. In 2013, the FERC also approved CTPL’s application for authorization to construct, own, operate and maintain certain new facilities in order to enable bi-directional natural gas flow on the Creole Trail Pipeline system to allow for the delivery of up to 1,530,000 dekatherms per day of feed gas to the SPL Project. In November 2013, CTPL received approval from the Louisiana Department of Environmental Quality (“LDEQ”) for the proposed modifications and, with subsequent final FERC clearance, construction was completed in 2015. In September 2013, we filed an application with the FERC for authorization to construct and operate an extension and expansion of the Creole Trail Pipeline and related facilities in order to deliver additional domestic natural gas supplies to the SPL Project, which was granted by the FERC in an order issued in April 2015 and an order denying rehearing issued in June 2015. These orders are not subject to appellate court review. +The FERC’s Standards of Conduct apply to interstate pipelines that conduct transmission transactions with an affiliate that engages in marketing functions. Interstate pipelines must treat all transmission customers on a not unduly discriminatory basis. The general principles of the Standards of Conduct are: (1) independent functioning, which requires transmission function employees to function independently of marketing function employees; (2) no-conduit rule, which prohibits passing transmission function information to marketing function employees; and (3) transparency, which imposes posting requirements to detect undue preference due to the improper disclosure of non-public transmission function information. Our pipelines have established the required policies and procedures to comply with the FERC’s Standards of Conduct and are subject to audit by the FERC to review compliance, policies and their training programs. +Several other material governmental and regulatory approvals and permits will be required throughout the life of our liquefaction projects. In addition, the FERC orders require us to comply with certain ongoing conditions and obtain certain additional FERC and other regulatory agency approvals as construction progresses. To date, we have been able to obtain these approvals as needed and the need for these approvals has not materially affected our construction progress. Throughout the life of our LNG terminals and our pipelines, we will be subject to regular reporting requirements to the FERC, the U.S. Department of Transportation’s (“DOT”) Pipeline and Hazardous Materials Safety Administration (“PHMSA”) and applicable federal and state regulatory agencies regarding the operation and maintenance of our facilities. +The FERC’s jurisdiction under the NGA allows it to impose civil and criminal penalties for any violations of the NGA and any rules, regulations or orders of the FERC up to approximately $1.3 million per day per violation, including any conduct that violates the NGA’s prohibition against market manipulation. We are permitted to make sales of natural gas for resale in interstate commerce pursuant to a blanket marketing certificate automatically granted by the FERC to our marketing affiliates. Our sales of natural gas will be affected by the availability, terms and cost of pipeline transportation. As noted above, the price and terms of access to pipeline transportation are subject to extensive federal and state regulation. +DOE Export License +The DOE has authorized the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal as discussed in Sabine Pass LNG Terminal — Liquefaction Facilities and the Corpus Christi LNG terminal as discussed in Corpus Christi LNG Terminal — Liquefaction Facilities. Although it is not expected to occur, the loss of an export authorization could be a force majeure event under our SPAs. +9 +Exports of natural gas to FTA countries are “deemed to be consistent with the public interest” and authorization to export LNG to FTA countries shall be granted by the DOE without “modification or delay.” FTA countries which currently import LNG include Canada, Chile, Colombia, Dominican Republic, Israel, Jordan, Mexico, Panama, Singapore and South Korea. Exports of natural gas to non-FTA countries are considered by the DOE in the context of a comment period whereby interveners are provided the opportunity to assert that such authorization would not be consistent with the public interest. +Pipelines +The Creole Trail Pipeline and the Corpus Christi Pipeline are also subject to regulation by the PHMSA, pursuant to which the PHMSA has established requirements relating to the design, installation, testing, construction, operation, replacement and management of pipeline facilities. +The Pipeline Safety Improvement Act of 2002, as amended (“PSIA”), which is administered by the PHMSA Office of Pipeline Safety, governs the areas of testing, education, training and communication. The PSIA requires pipeline companies to perform extensive integrity tests on natural gas transportation pipelines that exist in high population density areas designated as “high consequence areas.” Pipeline companies are required to perform the integrity tests on a seven-year cycle. The risk ratings are based on numerous factors, including the population density in the geographic regions served by a particular pipeline, as well as the age and condition of the pipeline and its protective coating. Testing consists of hydrostatic testing, internal electronic testing, or direct assessment of the piping. In addition to the pipeline integrity tests, pipeline companies must implement a qualification program to make certain that employees are properly trained. Pipeline operators also must develop integrity management programs for gas transportation pipelines, which requires pipeline operators to perform ongoing assessments of pipeline integrity; identify and characterize applicable threats to pipeline segments that could impact a high consequence area; improve data collection, integration and analysis; repair and remediate the pipeline, as necessary; and implement preventive and mitigation actions. +In 2009, the PHMSA issued a final rule (known as “Control Room Management/Human Factors Rule”) that became effective in 2010 requiring pipeline operators to write and institute certain control room procedures that address human factors and fatigue management. +In March 2015, PHMSA issued a final rule amending the pipeline safety regulations to update and clarify certain regulatory requirements, including who can perform post-construction inspections on transmission pipelines. In September 2015, PHMSA issued a rule indefinitely delaying the effective date for the amendment to the regulation regarding post-construction inspections. +In May 2015, PHMSA issued a notice of proposed rulemaking proposing to amend gas pipeline safety regulations regarding plastic piping systems used in gas services, including the installation of plastic pipe used for gas transmission lines. The PHMSA has not finalized any of the regulations proposed in this notice. +In July 2015, PHMSA issued a notice of proposed rulemaking proposing to add a specific timeframe for operators’ notification of accidents or incidents, as well as amending the safety regulations regarding operator qualification requirements by expanding the requirements to include new construction and certain previously excluded operation and maintenance tasks, requiring a program effectiveness review and adding new recordkeeping requirements. In January 2017, PHMSA issued a final rule (effective as of March 24, 2017) adding a specific time frame for operators’ notification of accidents or incidents but delayed final action on the proposed operator qualification requirements until a later date. +In April 2016, the PHMSA issued a notice of proposed rulemaking addressing changes to the regulations governing the safety of gas transmission pipelines. Specifically, PHMSA is considering certain integrity management requirements for “moderate consequence areas,” requiring an integrity verification process for specific categories of pipelines, and mandating more explicit requirements for the integration of data from integrity assessments to an operator’s compliance procedures. The PHMSA is also considering whether to revise requirements for corrosion control and expanding the definition of regulated gathering lines. These notices of proposed rulemaking are still pending at the PHMSA. The PHMSA has not finalized any of the regulations proposed in this notice. +Natural Gas Pipeline Safety Act of 1968 (“NGPSA”) +Louisiana and Texas administer federal pipeline safety standards under the NGPSA, which requires certain pipelines to comply with safety standards in constructing and operating the pipelines and subjects the pipelines to regular inspections. Failure to comply with the NGPSA may result in the imposition of administrative, civil and criminal sanctions. +10 +Pipeline Safety, Regulatory Certainty and Job Creation Act of 2011 +The Creole Trail Pipeline and Corpus Christi Pipeline are also subject to the Pipeline Safety, Regulatory Certainty and Job Creation Act of 2011, which regulates safety requirements in the design, construction, operation and maintenance of interstate natural gas transmission facilities. Under the Pipeline Safety, Regulatory Certainty and Job Creation Act of 2011, PHMSA has civil penalty authority up to approximately $200,000 per day per violation (increased from the prior $100,000), with a maximum of approximately $2 million in civil penalties for any related series of violations (increased from the prior $1 million). +Other Governmental Permits, Approvals and Authorizations +The construction and operation of the Sabine Pass LNG terminal and the CCL Project require additional federal permits, orders, approvals and consultations required by federal agencies, including the DOT, Advisory Council on Historic Preservation, U.S. Army Corps of Engineers (“USACE”), U.S. Department of Commerce, National Marine Fisheries Services, U.S. Department of the Interior, U.S. Fish and Wildlife Service, Environmental Protection Agency (the “EPA”) and U.S. Department of Homeland Security. +Three significant permits are the USACE Section 404 of the Clean Water Act/Section 10 of the Rivers and Harbors Act Permit (the “Section 10/404 Permit”), the Clean Air Act Title V Operating Permit (the “Title V Permit”) and the Prevention of Significant Deterioration Permit (the “PSD Permit”), of which the latter two permits are issued by the LDEQ for the Sabine Pass LNG terminal and CTPL and by the Texas Commission on Environmental Quality (“TCEQ”) for the CCL Project. +The Sabine Pass LNG terminal’s Section 10/404 Permit authorizing construction of Trains 1 through 4 was received from the USACE in March 2012. A modification to the Section 10/404 Permit, to address wetlands impacted by the construction of Trains 5 and 6, was issued by the USACE in June 2015. The USACE acted in the capacity as a cooperating agency in the review process under the National Environmental Policy Act of 1969. The LDEQ issued amended PSD and Title V Permits in September 2017 to reflect certain facility modifications, updated emissions and as-built capacity factors. In October 2018, Sabine Pass LNG Terminal applied to the LDEQ for another amendment to its PSD and Title V Permits to reflect certain facility modifications and as-built reconciliation revisions. +An application for an amendment to CCL’s Section 10/404 Permit to authorize construction of the CCL Project was issued by the USACE in July 2014 and subsequently modified in October 2014. The TCEQ issued amended PSD permits for criteria pollutants and greenhouse gas (“GHG”) in July 2018 to reflect updates related to refined operational direction and changes that were made during the design and procurement process. +The LDEQ issued an administrative amendment to the Title V Permit for CTPL in February 2017 to correct permit representations. In April 2018, CTPL applied to the LDEQ for another amendment to the Title V Permit to update permit representations. +The TCEQ issued an amended Air Standard Permit for the Corpus Christi Pipeline compressor station at Sinton, Texas in November 2018 for modifications to the facility and to update permit representations. +LDEQ issued a modification of the wastewater discharge permit to Sabine Pass LNG Terminal in December 2017 to include wastewaters generated with respect to the anticipated operations of Trains 5 and 6 of the SPL Project. CCL was issued a waste water discharge permit in October 2017 authorizing discharges from the CCL Project. +Commodity Futures Trading Commission (“CFTC”) +The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amended the Commodity Exchange Act to provide for federal regulation of the over-the-counter derivatives market and entities, such as us, that participate in that market. The regulatory regime created by the Dodd-Frank Act is designed primarily to (1) regulate certain participants in the swaps markets, including entities falling within the categories of “Swap Dealer” and “Major Swap Participant,” (2) require clearing and exchange trading of standardized swaps of certain classes as designated by the CFTC, (3) increase swap market transparency through robust reporting and recordkeeping requirements, (4) reduce financial risks in the derivatives market by imposing margin or collateral requirements on both cleared and, in certain cases, uncleared swaps, (5) provide the CFTC with expanded authority to establish position limits on certain physical commodity futures and options contracts and their economically +11 +equivalent swaps as it finds necessary and appropriate and (6) otherwise enhance the rulemaking and enforcement authority of the CFTC and the SEC regarding the derivatives markets. Most of the regulations are already in effect, while other rules and regulations, including the proposed margin rules, position limits, and commodity clearing requirements, remain to be finalized or effectuated. Therefore, the impact of those rules and regulations on our business continues to be uncertain. +A provision of the Dodd-Frank Act requires the CFTC, in order to diminish or prevent excessive speculation in commodity markets, to adopt rules, as it finds necessary and appropriate, imposing new position limits on certain physical commodity futures contracts and options thereon, as well as economically equivalent swaps traded on registered swap trading platforms and on over-the-counter swaps that perform a significant price discovery function with respect to certain markets. In that regard, the CFTC has re-proposed position limits rules that would modify and expand the applicability of limits on speculative positions in certain physical commodity futures contracts, and economically equivalent futures, options and swaps for or linked to certain physical commodities, including Henry Hub natural gas, that market participants may hold, subject to limited exemptions for certain bona fide hedging and other types of transactions. It is uncertain at this time whether, when and in what form the CFTC’s proposed new position limits rules may become final and effective. +Pursuant to rules adopted by the CFTC, certain interest rate swaps and index credit default swaps must be cleared through a derivatives clearing organization and executed on an exchange or swap execution facility. The CFTC has not yet proposed to designate swaps in any other asset classes, including swaps relating to physical commodities, for mandatory clearing and trade execution, but could do so in the future. Although we expect to qualify for the end-user exception from the mandatory clearing and exchange-trading requirements applicable to any swaps that we enter into to hedge our commercial risks, the mandatory clearing and exchange-trading requirements may apply to other market participants, including our counterparties (who may be registered as Swap Dealers), with respect to other swaps, and the application of such rules may change the market cost and general availability in the market of swaps of the type we enter into to hedge our commercial risks and, thus, the cost and availability of the swaps that we use for hedging. +As required by provisions of the Dodd-Frank Act, the CFTC and federal banking regulators have adopted rules to require Swap Dealers and Major Swap Participants, including those that are regulated financial institutions, to collect initial and/or variation margin with respect to uncleared swaps from their counterparties that are financial end users, registered swap dealers or major swap participants. These rules, which, as to the collection of initial margin, are being phased in, do not require collection of margin from non-financial-entity end users who qualify for the end user exception from the mandatory clearing requirement or from non-financial end users or certain other counterparties in certain instances. We expect to qualify as such a non-financial-entity end user with respect to the swaps that we enter into to hedge our commercial risks. +Any new rules or changes to existing rules promulgated under the Dodd-Frank Act could (1) impair the availability of derivatives, (2) materially increase the cost of, or decrease the liquidity of, the derivatives we use to hedge, (3) significantly alter the terms and conditions of derivatives and (4) potentially increase our exposure to less creditworthy counterparties. Further, any resulting reduction in the use of derivatives could make cash flow more volatile and less predictable, which in turn could adversely affect our ability to plan for and fund capital expenditures. +Pursuant to the Dodd-Frank Act, the CFTC has adopted additional anti-manipulation and anti-disruptive trading practices regulations that prohibit, among other things, manipulative, deceptive or fraudulent schemes or material misrepresentation in the futures, options, swaps and cash markets. In addition, separate from the Dodd-Frank Act, our use of futures and options on commodities is subject to the Commodity Exchange Act and CFTC regulations, as well as the rules of futures exchanges on which any of these instruments are executed. Should we violate any of these laws and regulations, we could be subject to a CFTC or an exchange enforcement action and material penalties, possibly resulting in changes in the rates we can charge. +Federal Energy Regulatory Commission (FERC) +As referenced above, the FERC also enforces any market manipulation concerns under the EPAct 2005. +United Kingdom (UK)/European Regulations +Our EU trading activities, which are primarily established in the UK, are subject to a number of EU-wide and UK specific laws and regulations. These are described further below: +12 +European Market Infrastructure Regulation (“EMIR”) +EMIR is an EU regulation (with text that is relevant across the European Economic Area (“EEA”)) designed to increase the transparency and stability of the EEA derivatives markets, including by: (1) imposing requirements on market participants trading derivatives, including relating to reporting, clearing and risk mitigation; and (2) imposing rules and standards that apply to central counterparties (i.e. clearing houses) and trade repositories. The precise impact of these rules will depend on a number of factors, including the regulatory status of the counterparty that is trading derivative instruments, as well as the volume and types of instruments it is trading. We currently are categorized under EMIR as a non-financial counterparty below the clearing threshold, which is a type of market participant subject to a lower regulatory burden. However, were we to engage in activities that resulted in a change to our status, we could be subject to more onerous regulations (including clearing and margining) which could significantly increase the cost of our derivatives trading activity, and materially alter the terms of the derivatives contracts we enter into. +Regulation on Wholesale Energy Market Integrity and Transparency (“REMIT”) +REMIT is an EU regulation (with EEA relevance) that prohibits market manipulation and insider trading in European wholesale energy markets and imposes various obligations on participants in these markets. Market participants, such as us, cannot use inside information (i.e., non-public information that would likely have a significant effect on the price of wholesale energy products if it were made public) to (1) buy or sell wholesale energy products for their own account or on behalf of a third party, directly or indirectly; (2) induce others to buy or sell wholesale energy products based on inside information; or (3) disclose such inside information to any other person except in the normal course of employment. A market participant is also prohibited from manipulating or attempting to manipulate any wholesale energy market, and is required to publicly disclose inside information which it possesses in respect of business or facilities which it or its affiliates either owns or controls, or for whose operational matters it or they are responsible, either in whole or in part. +Markets in Financial Instruments Directive and Regulation (“MiFID II”) +MiFID II consists of an EU directive regulation, and a number of delegated acts, rules, and guidance, that replaced the original 2004 Markets in Financial Instruments Directive (“MiFID”). MiFID II (with relevance throughout the EEA), sets forth an EEA-wide financial services framework, including rules for firms engaging in investment services and activities in connection with certain financial instruments in the EEA. Firms engaging in such activities must be authorized unless an exemption applies. +We are eligible to trade on our own account in commodity derivatives as a result of the “ancillary activity” exemption under MiFID II. To avail ourselves of this exemption, amongst other things, we must be able to demonstrate, on the basis of a methodology set out in certain delegated MiFID II text, that our activities in commodity derivatives are ancillary to the main business of our group. Provided we meet the requirements, we must notify the UK regulator that we are availing ourselves of this exemption on an annual basis. If, in the future, we are no longer able to meet the requirements of the “ancillary activity” exemption, and no other exemption is available to us, we would be required to become authorized as an investment firm under MiFID II. This may result in us being subject to the regulatory capital requirements under the EU’s Capital Requirements Directive IV. +Market Abuse Regulation (“MAR”) +MAR is intended to update and strengthen the existing EU market abuse framework and applies to all financial instruments listed or traded on EU trading venues as well as other over-the-counter (“OTC”) financial instruments priced on, or impacting, the trading venue contract. Generally, MAR applies to entities trading on, or in a manner that impacts EU markets. MAR contains a number of “insider dealing” and “market manipulation” (including “attempted manipulation”) based offences. Under MAR, any person professionally arranging or executing transactions in financial instruments is required to establish and maintain effective arrangements, systems and procedures to detect and report suspicious orders and transactions. +UK-Specific Rules +In addition to the various EU/EEA rules described above, other UK-specific laws, such as the UK’s Financial Services and Markets Act of 200 (“FSMA”) and Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”), also apply to our trading activities. +13 +Any violation of the foregoing laws and regulations could result in investigations, and possible fine and penalties, and in some scenarios, criminal offenses. +Environmental Regulation +Our LNG terminals are subject to various federal, state and local laws and regulations relating to the protection of the environment and natural resources. These environmental laws and regulations require significant expenditures for compliance, can affect the cost and output of operations and may impose substantial penalties for non-compliance and substantial liabilities for pollution. Many of these laws and regulations, such as those noted below, restrict or prohibit impacts to the environment or the types, quantities and concentration of substances that can be released into the environment and can lead to substantial administrative, civil and criminal fines and penalties for non-compliance. +Clean Air Act (“CAA”) +Our LNG terminals are subject to the federal CAA and comparable state and local laws. We may be required to incur certain capital expenditures over the next several years for air pollution control equipment in connection with maintaining or obtaining permits and approvals addressing air emission-related issues. We do not believe, however, that our operations, or the construction and operations of our liquefaction facilities, will be materially and adversely affected by any such requirements. +In 2009, the EPA promulgated and finalized the Mandatory Greenhouse Gas Reporting Rule for multiple sections of the economy. This rule requires mandatory reporting of GHG emissions from stationary sources, including fuel combustion sources. In 2010, the EPA expanded the rule to include reporting obligations for LNG terminals. In addition, the EPA has defined GHG emissions thresholds that would subject GHG emissions from new and modified industrial sources to regulation if the source is subject to PSD Permit requirements due to its emissions of non-GHG criteria pollutants. The Obama Administration took several actions intended to limit GHG emissions, including regulating emissions from new and existing Electricity Generating Units and from new and modified oil and gas operations. The timing, extent and impact of these rules and other Obama Administration initiatives remain uncertain as the Trump Administration has undertaken steps to delay their implementation, and to review, repeal and potentially replace them. On October 10, 2017, EPA issued a proposal to repeal the Clean Power Plan after concluding the October 2015 final rule exceeds EPA’s statutory authority under the CAA. In August 2018, the EPA proposed the Affordable Clean Energy rule as a replacement for the Clean Power Plan, which requires states to develop plans to implement certain performance standards within three years after the Final Rule is published in the Federal Register . Many of the Trump Administration’s efforts to rollback Obama Administration actions have been challenged in court. +From time to time, Congress has considered proposed legislation directed at reducing GHG emissions. In addition, many states have already taken regulatory action to monitor and/or reduce emissions of GHGs, primarily through the development of GHG emission inventories or regional GHG cap and trade programs. It is not possible at this time to predict how future regulations or legislation may address GHG emissions and impact our business. However, future regulations and laws could result in increased compliance costs or additional operating restrictions and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Coastal Zone Management Act (“CZMA”) +The siting and construction of our LNG terminals within the coastal zone is subject to the requirements of the CZMA. The CZMA is administered by the states (in Louisiana, by the Department of Natural Resources, and in Texas, by the General Land Office). This program is implemented to ensure that impacts to coastal areas are consistent with the intent of the CZMA to manage the coastal areas. +Clean Water Act (“CWA”) +Our LNG terminals are subject to the federal CWA and analogous state and local laws. The CWA imposes strict controls on the discharge of pollutants into the navigable waters of the United States, including discharges of wastewater and storm water runoff and fill/discharges into waters of the United States. Permits must be obtained prior to discharging pollutants into state and federal waters. The CWA is administered by the EPA, the USACE and by the states (in Louisiana, by the LDEQ, and in Texas, by the TCEQ and the Railroad Commission of Texas ). +14 +Resource Conservation and Recovery Act (“RCRA”) +The federal RCRA and comparable state statutes govern the generation, handling and disposal of solid and hazardous wastes and require corrective action for releases into the environment. In the event such wastes are generated in connection with our facilities, we will be subject to regulatory requirements affecting the handling, transportation, treatment, storage and disposal of such wastes. +Protection of Species, Habitats and Wetlands +Various federal and state statutes, such as the Endangered Species Act (the “ESA”), the Migratory Bird Treaty Act, the CWA and the Oil Pollution Act, prohibit certain activities that may adversely affect endangered or threatened animal, fish and plant species and/or their designated habitats, wetlands, or other natural resources. If one of our LNG terminals or pipelines adversely affects a protected species or its habitat, we may be required to develop and follow a plan to avoid those impacts. In that case, siting, construction or operation may be delayed or restricted and cause us to incur increased costs. +In July 2018, the U.S. Fish and Wildlife Service (the “FWS”) announced a series of proposed changes to the rules implementing the ESA, including proposed revisions to the regulations governing interagency cooperation, listing species and delisting critical habitat, and prohibitions related to threatened wildlife and plants. The proposed revisions are intended to streamline these processes and create more flexibility for the FWS when making ESA-related decisions. It is not possible at this time to predict how such changes, if adopted, would impact our business. +In addition, in December 2017, the Department of Interior’s (“DOI’s”) Solicitor’s Office issued an official opinion that the Migratory Bird Treaty Act’s broad prohibition on “taking” migratory birds applies only to affirmative actions and does not include incidental taking. In April 2018 the FWS issued guidance consistent with the DOI’s opinion. The opinion has been challenged in court. +Market Factors +Our ability to enter into additional long-term SPAs to underpin the development of additional Trains, sell any quantities of LNG available under the SPAs with Cheniere Marketing, or develop new projects is subject to market factors. These factors include changes in worldwide supply and demand for natural gas, LNG and substitute products, the relative prices for natural gas, crude oil and substitute products in North America and international markets, the rate of fuel switching for power generation from coal, nuclear or oil to natural gas and economic growth in developing countries. In addition, our ability to obtain additional funding to execute our business strategy is subject to the investment community’s appetite for investment in LNG and natural gas infrastructure and our ability to access capital markets. +We expect that global demand for natural gas and LNG will continue to increase as nations seek more abundant, reliable and environmentally cleaner fuel alternatives to oil and coal. Global demand for natural gas is projected by the International Energy Agency to grow by approximately 19 trillion cubic feet (“Tcf”) between 2017 and 2025, with LNG’s share growing from about 10% in 2017 to about 15% of the global gas market in 2025. Wood Mackenzie Limited forecasts that global demand for LNG will increase by approximately 60%, from approximately 287 mtpa, or 13.8 Tcf in 2017, to approximately 461 mtpa, or 22.1 Tcf, in 2025, and that LNG production from existing operational facilities and new facilities already under construction will be able to supply the market with approximately 413 mtpa in 2025, resulting in a market need for construction of an additional approximately 48 mtpa of LNG production. We believe the capital and operating costs of the uncommitted capacity of our SPL Project, CCL Project and Corpus Christi Stage 3 are competitive with new proposed projects globally and we are well-positioned to capture a portion of this incremental market need. +We have limited exposure to the decline in oil prices as we have contracted a significant portion of our LNG production capacity under long-term sale and purchase agreements. These agreements contain fixed fees that are required to be paid even if the customers elect to cancel or suspend delivery of LNG cargoes. We have contracted an aggregate amount of LNG that is between approximately 80% to 95% of the expected aggregate adjusted nominal production capacity for Trains 1 through 5 of the SPL Project with third-party customers. We have contracted an aggregate amount of LNG that is between approximately 75% to 85% of the expected aggregate adjusted nominal production capacity of Trains 1 through 3 of the CCL Project with third-party customers. As of January 31, 2019, U.S. natural gas prices indicate that LNG exported from the U.S. continues to be competitively priced, supporting the opportunity for U.S. LNG to fill uncontracted future demand through the execution of long-term, medium-term and short-term contracting of LNG from our terminals. +15 +Subsidiaries +Our assets are generally held by or under our subsidiaries. We conduct most of our business through these subsidiaries, including the development, construction and operation of our LNG terminal business and the development and operation of our LNG and natural gas marketing business. +Employees +We had 1,372 full-time employees at January 31, 2019 . +Available Information +Our common stock has been publicly traded since March 24, 2003 and is traded on the NYSE American under the symbol “LNG.” Our principal executive offices are located at 700 Milam Street, Suite 1900, Houston, Texas 77002, and our telephone number is (713) 375-5000. Our internet address is www.cheniere.com. We provide public access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after we electronically file those materials with, or furnish those materials to, the SEC under the Exchange Act . These reports may be accessed free of charge through our internet website. We make our website content available for informational purposes only. The website should not be relied upon for investment purposes and is not incorporated by reference into this Form 10-K. +We will also make available to any stockholder, without charge, copies of our annual report on Form 10-K as filed with the SEC. For copies of this, or any other filing, please contact: Cheniere Energy, Inc., Investor Relations Department, 700 Milam Street Suite 1900, Houston, Texas 77002 or call (713) 375-5000. The SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers. +ITEM 1A. +RISK FACTORS +The following are some of the important factors that could affect our financial performance or could cause actual results to differ materially from estimates or expectations contained in our forward-looking statements. We may encounter risks in addition to those described below. Additional risks and uncertainties not currently known to us, or that we currently deem to be immaterial, may also impair or adversely affect our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +The risk factors in this report are grouped into the following categories: +• +Risks Relating to Our Financial Matters; +• +Risks Relating to Our LNG Terminal Operations and Commercialization; +• +Risks Relating to Our LNG Business in General; and +• +Risks Relating to Our Business in General. +Risks Relating to Our Financial Matters +Our existing level of cash resources and significant debt could cause us to have inadequate liquidity and could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +As of December 31, 2018 , we had $981 million of cash and cash equivalents, $2.2 billion of current restricted cash and $29.2 billion of total debt outstanding on a consolidated basis (before unamortized premium, discount and debt issuance costs), excluding $741 million aggregate outstanding letters of credit. We incur, and will incur, significant interest expense relating to the assets at the Sabine Pass and Corpus Christi LNG terminals, and we anticipate needing to incur additional debt to finance the construction of Train 6 of the SPL Project. Our ability to fund our capital expenditures and refinance our indebtedness will depend on our ability to access additional project financing as well as the debt and equity capital markets. A variety of factors beyond our control could impact the availability or cost of capital, including domestic or international economic conditions, increases in key benchmark interest rates and/or credit spreads, the adoption of new or amended banking or capital market laws or regulations and the repricing of market risks and volatility in capital and financial markets. Our financing costs could increase or future +16 +borrowings or equity offerings may be unavailable to us or unsuccessful, which could cause us to be unable to pay or refinance our indebtedness or to fund our other liquidity needs. We also rely on borrowings under our credit facilities to fund our capital expenditures. If any of the lenders in the syndicates backing these facilities was unable to perform on its commitments, we may need to seek replacement financing, which may not be available as needed, or may be available in more limited amounts or on more expensive or otherwise unfavorable terms. +We have not been profitable historically. We may not achieve profitability or generate positive operating cash flow in the future. +We had net losses attributable to common stockholders of $393 million and $610 million for the years ended December 31, 2017 and 2016, respectively. In the future, we may incur operating losses and experience negative operating cash flow. We may not be able to reduce costs, increase revenues or reduce our debt service obligations sufficiently to maintain our cash resources, which could cause us to have inadequate liquidity to continue our business. +We will continue to incur significant capital and operating expenditures while we develop and construct the SPL Project, the CCL Project and other projects. Any delays beyond the expected development period for these projects could cause, and could increase the level of, our operating losses and negative operating cash flows. Our future liquidity may also be affected by the timing of construction financing availability in relation to the incurrence of construction costs and other outflows and by the timing of receipt of cash flows under third-party agreements in relation to the incurrence of project and operating expenses. Moreover, many factors (including factors beyond our control) could result in a disparity between liquidity sources and cash needs, including factors such as construction delays and breaches of agreements. Our ability to generate any significant positive operating cash flow and achieve profitability in the future is dependent on our ability to successfully and timely complete and operate the applicable project. +We may sell equity or equity-related securities or assets, including equity interests in Cheniere Partners. Such sales could dilute our stockholders’ proportionate indirect interests in our assets, business operations and proposed liquefaction and other projects of Cheniere Partners or other subsidiaries, and could adversely affect the market price of our common stock. +We have pursued and are pursuing a number of alternatives in order to finance the construction of Train 6 of the SPL Project, including potential issuances and sales of additional equity or equity-related securities by us or Cheniere Partners. Such sales, in one or more transactions, could dilute our stockholders’ proportionate indirect interests in our assets, business operations and proposed projects of Cheniere Partners, including the SPL Project, or in other subsidiaries or projects, including the CCL Project. In addition, such sales, or the anticipation of such sales, could adversely affect the market price of our common stock. +Our stockholders may experience dilution upon the conversion of our convertible notes. +In November 2014, we issued an aggregate principal amount of $1.0 billion Convertible Unsecured Notes due 2021 (the “2021 Cheniere Convertible Unsecured Notes”) to RRJ Capital II Ltd, Baytree Investments (Mauritius) Pte Ltd and Seatown Lionfish Pte. Ltd. In March 2015, we issued $625 million aggregate principal amount of 4.25% Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”) to certain investors through a registered direct offering. In May 2015, CCH HoldCo II issued $1.0 billion aggregate principal amount of 11.0% Convertible Senior Secured Notes due 2025 (the “2025 CCH HoldCo II Convertible Senior Notes” and together with the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes , the “Convertible Notes” ) to EIG Management Company, LLC. +We have the option to satisfy the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes conversion obligations with cash, common stock or a combination thereof. The 2025 CCH HoldCo II Convertible Senior Notes conversion obligations must be satisfied with common stock. The 2021 Cheniere Convertible Unsecured Notes are convertible at an initial conversion price of $93.64. Prior to December 15, 2044, the 2045 Cheniere Convertible Senior Notes will be convertible upon the occurrence of certain conditions, and on and after such date they will become freely convertible. The 2045 Cheniere Convertible Senior Notes will become convertible into the common stock of Cheniere at an initial conversion price of $138.38 per share. Provided the total market capitalization of Cheniere at that time is not less than $10.0 billion, the 2025 CCH HoldCo II Convertible Senior Notes will be convertible at CCH HoldCo II’s option on or after the later of (1) March 1, 2020 and (2) the substantial completion of Train 2 of the CCL Project (the “Eligible Conversion Date”) . The conversion price for 2025 CCH HoldCo II Convertible Senior Notes converted at CCH HoldCo II’s option is the lower of (1) a 10% discount to the average of the daily volume-weighted average price (“VWAP”) of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided and (2) a 10% discount to the closing price of our common stock on the trading day preceding the date on which notice of conversion is provided. At the option of the holders, the 2025 CCH HoldCo II Convertible +17 +Senior Notes are convertible on or after the six-month anniversary of the Eligible Conversion Date , provided the total market capitalization of Cheniere at that time is not less than $10.0 billion, at a conversion price equal to the average of the daily VWAP of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided. +The conversion of some or all of the Convertible Notes into shares of our common stock will dilute the ownership percentages and voting power of our existing stockholders. Based on the initial conversion price, if we elect to satisfy the entire conversion obligations of the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes with common stock, an aggregate of approximately 19.1 million shares of our common stock would be issued upon the conversion, assuming the notes are converted at maturity and all interest on the notes is paid in kind for the 2021 Cheniere Convertible Unsecured Notes . Because the conversion rate for the 2025 CCH HoldCo II Convertible Senior Notes will depend on the price of our common stock at the time of conversion, we cannot meaningfully estimate the number of shares of our common stock, if any, that would be issued upon the conversion of such notes; however, under these convertible notes, a maximum of 47,108,466 shares of our common stock (subject to adjustment in the event of a stock split) may be issued in the aggregate upon the conversion of all of the 2025 CCH HoldCo II Convertible Senior Notes . Any sales in the public market of the shares issuable upon conversion of the Convertible Notes could adversely affect the prevailing market prices of our common stock. In addition, the existence of the Convertible Notes may encourage short selling by market participants because the conversion of the Convertible Notes could be used to satisfy short positions, or the anticipated conversion of the Convertible Notes into shares of our common stock could depress the price of our common stock. +Our ability to generate cash is substantially dependent upon the performance by customers under long-term contracts that we have entered into, and we could be materially and adversely affected if any customer fails to perform its contractual obligations for any reason. +Our future results and liquidity are substantially dependent upon performance by our customers to make payments under long-term contracts. As of December 31, 2018 , SPL had SPAs with seven third-party customers, CCL had SPAs with nine third-party customers and our integrated marketing function had a limited number of SPAs with third-party customers. In addition, SPLNG had TUAs with two third-party customers. We are dependent on each customer’s continued willingness and ability to perform its obligations under its SPA or TUA. We are exposed to the credit risk of any guarantor of these customers’ obligations under their respective agreements in the event that we must seek recourse under a guaranty. If any customer fails to perform its obligations under its SPA or TUA, our business, contracts, financial condition, operating results, cash flow, liquidity and prospects could be materially and adversely affected, even if we were ultimately successful in seeking damages from that customer or its guarantor for a breach of the agreement. +Each of our customer contracts is subject to termination under certain circumstances. +Each of the SPAs contains various termination rights allowing our customers to terminate their SPAs, including, without limitation: (1) upon the occurrence of certain events of force majeure; (2) if we fail to make available specified scheduled cargo quantities; and (3) delays in the commencement of commercial operations. We may not be able to replace these SPAs on desirable terms, or at all, if they are terminated. +Each of SPLNG’s long-term TUAs contains various termination rights. For example, each customer may terminate its TUA if the Sabine Pass LNG terminal experiences a force majeure delay for longer than 18 months, fails to redeliver a specified amount of natural gas in accordance with the customer’s redelivery nominations or fails to accept and unload a specified number of the customer’s proposed LNG cargoes. SPLNG may not be able to replace these TUAs on desirable terms, or at all, if they are terminated. +Our subsidiaries may be restricted under the terms of their indebtedness from making distributions under certain circumstances, which may limit Cheniere Partners’ ability to pay or increase distributions to us or inhibit our access to cash flows from the CCL Project and could materially and adversely affect us. +The agreements governing our subsidiaries’ indebtedness restrict payments that our subsidiaries can make to Cheniere Partners or us in certain events and limit the indebtedness that our subsidiaries can incur. For example, SPL is restricted from making distributions under agreements governing its indebtedness generally until, among other requirements, deposits are made into debt service reserve accounts and a debt service coverage ratio of 1.25:1.00 is satisfied. +18 +CCH is generally restricted from making distributions under agreements governing its indebtedness until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project, funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25:1.00. +CCH HoldCo II is restricted from making distributions to Cheniere under agreements governing its indebtedness generally until, among other requirements, Trains 1 and 2 of the CCL Project are in commercial operation and a historical debt service coverage ratio and a projected fixed debt services coverage ratio of 1.20:1.00 are achieved. +Our subsidiaries’ inability to pay distributions to Cheniere Partners or us to incur additional indebtedness as a result of the foregoing restrictions in the agreements governing their indebtedness may inhibit Cheniere Partners’ ability to pay or increase distributions to us and its other unitholders or inhibit our access to cash flows from the CCL Project, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Restrictions in agreements governing us and our subsidiaries’ indebtedness may prevent us and our subsidiaries from engaging in certain beneficial transactions. +In addition to restrictions on the ability of us, Cheniere Partners, SPL, CCH and CCH HoldCo II to make distributions or incur additional indebtedness, the agreements governing our indebtedness also contain various other covenants that may prevent us from engaging in beneficial transactions, including limitations on our ability to: +• +make certain investments; +• +purchase, redeem or retire equity interests; +• +issue preferred stock; +• +sell or transfer assets; +• +incur liens; +• +enter into transactions with affiliates; +• +consolidate, merge, sell or lease all or substantially all of our assets; and +• +enter into sale and leaseback transactions. +Our use of hedging arrangements may adversely affect our future operating results or liquidity. +To reduce our exposure to fluctuations in the price, volume and timing risk associated with the purchase of natural gas, we use futures, swaps and option contracts traded or cleared on the Intercontinental Exchange and the New York Mercantile Exchange or over-the-counter options and swaps with other natural gas merchants and financial institutions. Hedging arrangements could expose us to risk of financial loss in some circumstances, including when: +• +expected supply is less than the amount hedged; +• +the counterparty to the hedging contract defaults on its contractual obligations; or +• +there is a change in the expected differential between the underlying price in the hedging agreement and actual prices received. +The use of derivatives also may require the posting of cash collateral with counterparties, which can impact working capital when commodity prices change. +The swaps regulatory and other provisions of the Dodd-Frank Act and the rules adopted thereunder and other regulations, including EMIR and REMIT, could adversely affect our ability to hedge risks associated with our business and our operating results and cash flows. +The provisions of the Dodd-Frank Act and the rules adopted and to be adopted by the CFTC , the SEC and other federal regulators establishing federal regulation of the OTC derivatives market and entities like us that participate in that market may adversely affect our ability to manage certain of our risks on a cost effective basis. Such laws and regulations may also adversely affect our ability to execute our strategies with respect to hedging our exposure to variability in expected future cash flows +19 +attributable to the future sale of our LNG inventory and to price risk attributable to future purchases of natural gas to be utilized as fuel to operate our LNG terminals and to secure natural gas feedstock for our liquefaction facilities. +The CFTC has re-proposed position limits rules that would modify and expand the applicability of position limits on the amounts of certain speculative futures contracts, as well as economically equivalent options, futures and swaps for or linked to certain physical commodities, including Henry Hub natural gas, that market participants may hold, subject to limited exemptions for certain bona fide hedging positions and other types of transactions. To the extent the revised CFTC position limits proposal becomes final, our ability to execute our hedging strategies described above could be limited. It is uncertain at this time whether, when and in what form the CFTC’s proposed new position limits rules may become final and effective. +Under the Dodd-Frank Act and the rules adopted thereunder, we may be required to clear through a derivatives clearing organization any swaps into which we enter that fall within a class of swaps designated by the CFTC for mandatory clearing and we could have to execute trades in such swaps on certain trading platforms or exchanges. The CFTC has designated certain interest rate swaps and index credit default swaps for mandatory clearing, but has not yet finalized rules designating any physical commodity swaps, for mandatory clearing or mandatory exchange trading. Although we expect to qualify for the end-user exception from the mandatory clearing and trade execution requirements for our swaps entered into to hedge our commercial risks, if we fail to qualify for that exception as to any swap we enter into and have to clear that swap through a derivatives clearing organization, we could be required to post margin with respect to such swap, our cost of entering into and maintaining such swap could increase and we would not enjoy the same flexibility with the cleared swaps that we enjoy with the uncleared OTC swaps we enter into. Moreover, the application of the mandatory clearing and trade execution requirements to other market participants, such as swap dealers, may change the market cost and general availability in the market of swaps of the type we enter into to hedge our commercial risks and, thus, the cost and availability of the swaps that we use for hedging. +As required by the Dodd-Frank Act, the CFTC and federal banking regulators have adopted rules to require certain market participants to collect and post initial and/or variation margin with respect to uncleared swaps from their counterparties that are financial end users and certain registered swap dealers and major swap participants. Although we believe we will not be required to post margin with respect to any uncleared swaps we enter into in the future, were we required to post margin as to our uncleared swaps in the future, our cost of entering into and maintaining swaps would be increased. Our counterparties that are subject to the regulations imposing the Basel III capital requirements on them may increase the cost to us of entering into swaps with them or, although not required to collect margin from us under the margin rules, contractually require us to post collateral with them in connection with such swaps in order to offset their increased capital costs or to reduce their capital costs to maintain those swaps on their balance sheets. +The Dodd-Frank Act also imposes other regulatory requirements on swaps market participants, including end users of swaps, such as regulations relating to swap documentation, reporting and recordkeeping, and certain business conduct rules applicable to swap dealers and major swap participants. Together with the Basel III capital requirements on certain swaps market participants, the regulatory requirements of the Dodd-Frank Act and the rules thereunder relating to swaps and derivatives market participants could significantly increase the cost of derivative contracts (including through requirements to post margin or collateral), materially alter the terms of derivative contracts, reduce the availability of derivatives to protect against certain risks that we encounter and reduce our ability to monetize or restructure our existing derivative contracts and to execute our hedging strategies. If, as a result of the swaps regulatory regime discussed above, we were to reduce our use of swaps to hedge our risks, such as commodity price risks that we encounter in our operations, our operating results and cash flows may become more volatile and could be otherwise adversely affected. +The Federal Reserve Board also has proposed rules that would limit certain physical commodity activities of financial holding companies. Such rules, if adopted, may adversely affect our ability to execute our strategies by restricting our available counterparties for certain types of transactions, limiting our ability to obtain certain services, and reducing liquidity in physical and financial markets. It is uncertain at this time whether, when and in what form the Federal Reserve’s proposed rules regarding financial holding companies may become final and effective. +European and UK-specific regulations, including but not limited to EMIR, MiFID II, REMIT, MAR, FSMA and RAO, govern our trading activities and our compliance with such laws may result in increased costs and risks to the business similar to the impacts stated above with respect to Dodd-Frank. The increased costs may also have an adverse impact on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Further, any violation of the foregoing laws and regulations could result in investigations, and possible fines and penalties, and in some scenarios, criminal offenses. +20 +Further, given the current lack of clarity relating to the terms on which the United Kingdom will exit the European Union (“Brexit”), including the impact such withdrawal will have on parties subject to the referenced regulations, additional regulatory risks may result. However, until the terms of a final agreement between the United Kingdom and European Union have been agreed, it is impossible at this point to address with certainty the impact of Brexit on our operations. +We expect that our hedging activities will remain subject to significant and developing regulations and regulatory oversight. However, the full impact of the various U.S. (and non-U.S.) regulatory developments in connection with these activities will not be known with certainty until such derivatives market regulations are fully implemented and related market practices and structures are fully developed. +Risks Relating to Our LNG Terminal Operations and Commercialization +Operation of the Sabine Pass LNG terminal, the SPL Project and the CCL Project, our pipelines and other facilities that we may construct involves significant risks. +As more fully discussed in these Risk Factors, the Sabine Pass LNG terminal, the SPL Project and the CCL Project, our pipelines and our other existing and proposed LNG facilities face operational risks, including the following: +• +the facilities’ performing below expected levels of efficiency; +• +breakdown or failures of equipment; +• +operational errors by vessel or tug operators; +• +operational errors by us or any contracted facility operator; +• +labor disputes; and +• +weather-related interruptions of operations. +Cost overruns and delays in the completion of one or more Trains, as well as difficulties in obtaining sufficient financing to pay for such costs and delays, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +The actual construction costs of the Trains may be significantly higher than our current estimates as a result of many factors, including change orders under existing or future EPC contracts resulting from the occurrence of certain specified events that may give Bechtel the right to cause us to enter into change orders or resulting from changes with which we otherwise agree. We have already experienced increased costs due to change orders. As construction progresses, we may decide or be forced to submit change orders to our contractor that could result in longer construction periods, higher construction costs or both, including change orders to comply with existing or future environmental or other regulations. +Delays in the construction of one or more Trains beyond the estimated development periods, as well as change orders to the EPC contracts with Bechtel or any future EPC contract related to additional Trains, could increase the cost of completion beyond the amounts that we estimate, which could require us to obtain additional sources of financing to fund our operations until the applicable liquefaction project is fully constructed (which could cause further delays). Our ability to obtain financing that may be needed to provide additional funding to cover increased costs will depend, in part, on factors beyond our control. Accordingly, we may not be able to obtain financing on terms that are acceptable to us, or at all. Even if we are able to obtain financing, we may have to accept terms that are disadvantageous to us or that may have a material adverse effect on our current or future business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Delays in the completion of one or more Trains could lead to reduced revenues or termination of one or more of the SPAs by our customers. +Any delay in completion of a Train could cause a delay in the receipt of revenues projected therefrom or cause a loss of one or more customers in the event of significant delays. In particular, each of our SPAs provides that the customer may terminate that SPA if the relevant Train does not timely commence commercial operations. As a result, any significant construction delay, whatever the cause, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +21 +Our ability to complete development of additional Trains will be contingent on our ability to obtain additional funding. If we are unable to obtain sufficient funding, we may be unable to fully execute our business strategy. +We will require significant additional funding to be able to commence construction of Train 6 of the SPL Project, which we may not be able to obtain at a cost that results in positive economics, or at all. The inability to achieve acceptable funding may cause a delay in the development of additional Trains, and we may not be able to complete our business plan. Even if we are able to obtain funding, the funding may be inadequate to cover any increases in costs or delays in completion of Train 6 of the SPL Project, which may cause a delay in the receipt of revenues projected therefrom or cause a loss of one or more future customers in the event of significant delays. As a result, any significant construction delay, whatever the cause, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Hurricanes or other disasters could result in an interruption of our operations, a delay in the completion of our liquefaction projects, higher construction costs and the deferral of the dates on which payments are due to us under the SPAs, all of which could adversely affect us. +In August and September of 2005, Hurricanes Katrina and Rita, respectively, damaged coastal and inland areas located in Texas, Louisiana, Mississippi and Alabama, resulting in the temporary suspension of construction of the Sabine Pass LNG terminal. In September 2008, Hurricane Ike struck the Texas and Louisiana coasts, and the Sabine Pass LNG terminal experienced minor damage. In August 2017, Hurricane Harvey struck the Texas and Louisiana coasts, and the Sabine Pass LNG terminal experienced a temporary suspension in construction and LNG loading operations. Construction on the Corpus Christi LNG terminal was also suspended. +Future storms and related storm activity and collateral effects, or other disasters such as explosions, fires, floods or accidents, could result in damage to, or interruption of operations at, the Sabine Pass LNG terminal or related infrastructure, as well as delays or cost increases in the construction and the development of the SPL Project, the CCL Project or our other facilities. Changes in the global climate may have significant physical effects, such as increased frequency and severity of storms, floods and rising sea levels; if any such effects were to occur, they could have an adverse effect on our coastal operations. +Failure to obtain and maintain approvals and permits from governmental and regulatory agencies with respect to the design, construction and operation of our facilities and the development and operation of our pipelines could impede operations and construction and could have a material adverse effect on us. +The design, construction and operation of interstate natural gas pipelines, LNG terminals, including the SPL Project and the CCL Project and other facilities, and the import and export of LNG and the transportation of natural gas, are highly regulated activities. Approvals of the FERC and DOE under Section 3 and Section 7 of the NGA, as well as several other material governmental and regulatory approvals and permits, including several under the CAA and the CWA, are required in order to construct and operate an LNG facility and an interstate natural gas pipeline and export LNG. Although the FERC has issued orders under Section 3 of the NGA authorizing the siting, construction and operation of six Trains and related facilities of the SPL Project and three Trains and related facilities of the CCL Project and Section 7 of the NGA authorizing the construction and operation of the Creole Trail Pipeline and the Corpus Christi Pipeline, the FERC orders require us to comply with certain ongoing conditions and obtain certain additional approvals in conjunction with ongoing construction and operations of our liquefaction and pipeline facilities. We will be required to obtain similar approvals and permits with respect to any expansion or modification of our liquefaction and pipeline facilities. We cannot control the outcome of the FERC’s or the DOE’s review and approval processes. Certain of these governmental permits, approvals and authorizations are or may be subject to rehearing requests, appeals and other challenges. +Authorizations obtained from the FERC, DOE and other federal and state regulatory agencies also contain ongoing conditions, and additional approval and permit requirements may be imposed. We do not know whether or when any such approvals or permits can be obtained, or whether any existing or potential interventions or other actions by third parties will interfere with our ability to obtain and maintain such permits or approvals. If we are unable to obtain and maintain the necessary approvals and permits, including as a result of untimely notices or filings, we may not be able to recover our investment in our projects. Additionally, government disruptions, such as a U.S. government shutdown, may delay or halt our ability to obtain and maintain necessary approvals and permits. There is no assurance that we will obtain and maintain these governmental permits, approvals and authorizations, or that we will be able to obtain them on a timely basis, and failure to obtain and maintain any of these permits, approvals or authorizations could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +22 +We are dependent on Bechtel and other contractors for the successful completion of the SPL Project and the CCL Project. +Timely and cost-effective completion of the SPL Project and the CCL Project in compliance with agreed specifications is central to our business strategy and is highly dependent on the performance of Bechtel and our other contractors under their agreements. The ability of Bechtel and our other contractors to perform successfully under their agreements is dependent on a number of factors, including their ability to: +• +design and engineer each Train to operate in accordance with specifications; +• +engage and retain third-party subcontractors and procure equipment and supplies; +• +respond to difficulties such as equipment failure, delivery delays, schedule changes and failure to perform by subcontractors, some of which are beyond their control; +• +attract, develop and retain skilled personnel, including engineers; +• +post required construction bonds and comply with the terms thereof; +• +manage the construction process generally, including coordinating with other contractors and regulatory agencies; and +• +maintain their own financial condition, including adequate working capital. +Although some agreements may provide for liquidated damages if the contractor fails to perform in the manner required with respect to certain of its obligations, the events that trigger a requirement to pay liquidated damages may delay or impair the operation of the SPL Project and the CCL Project, and any liquidated damages that we receive may not be sufficient to cover the damages that we suffer as a result of any such delay or impairment. The obligations of Bechtel and our other contractors to pay liquidated damages under their agreements are subject to caps on liability, as set forth therein. +Furthermore, we may have disagreements with our contractors about different elements of the construction process, which could lead to the assertion of rights and remedies under their contracts and increase the cost of the SPL Project and the CCL Project or result in a contractor’s unwillingness to perform further work on the SPL Project and the CCL Project. If any contractor is unable or unwilling to perform according to the negotiated terms and timetable of its respective agreement for any reason or terminates its agreement, we would be required to engage a substitute contractor. This would likely result in significant project delays and increased costs, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We are relying on third-party engineers to estimate the future capacity ratings and performance capabilities of the SPL Project and the CCL Project, and these estimates may prove to be inaccurate. +We are relying on third parties, principally Bechtel, for the design and engineering services underlying our estimates of the future capacity ratings and performance capabilities of the SPL Project and the CCL Project. If any Train, when actually constructed, fails to have the capacity ratings and performance capabilities that we intend, our estimates may not be accurate. Failure of any of our Trains to achieve our intended capacity ratings and performance capabilities could prevent us from achieving the commercial start dates under our SPAs and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +If third-party pipelines and other facilities interconnected to our pipelines and facilities are or become unavailable to transport natural gas, this could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We depend upon third-party pipelines and other facilities that provide gas delivery options to our liquefaction facilities and pipelines. If the construction of new or modified pipeline connections is not completed on schedule or any pipeline connection were to become unavailable for current or future volumes of natural gas due to repairs, damage to the facility, lack of capacity or any other reason, our ability to meet our SPA obligations and continue shipping natural gas from producing regions or to end markets could be restricted, thereby reducing our revenues which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +23 +We may not be able to purchase or receive physical delivery of sufficient natural gas to satisfy our delivery obligations under the SPAs, which could have a material adverse effect on us. +Under the SPAs with our customers, we are required to make available to them a specified amount of LNG at specified times. However, we may not be able to purchase or receive physical delivery of sufficient quantities of natural gas to satisfy those obligations, which may provide affected SPA customers with the right to terminate their SPAs. Our failure to purchase or receive physical delivery of sufficient quantities of natural gas could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Our interstate natural gas pipelines and their FERC gas tariffs are subject to FERC regulation. +Our interstate natural gas pipelines are subject to regulation by the FERC under the NGA and the Natural Gas Policy Act of 1978 (the “NGPA”). The FERC regulates the transportation of natural gas in interstate commerce, including the construction and operation of pipelines, the rates, terms and conditions of service and abandonment of facilities. Under the NGA, the rates charged by our interstate natural gas pipelines must be just and reasonable, and we are prohibited from unduly preferring or unreasonably discriminating against any person with respect to pipeline rates or terms and conditions of service. If we fail to comply with all applicable statutes, rules, regulations and orders, our interstate pipelines could be subject to substantial penalties and fines. +In addition, as a natural gas market participant, should we fail to comply with all applicable FERC-administered statutes, rules, regulations and orders, we could be subject to substantial penalties and fines. Under the EPAct, the FERC has civil penalty authority under the NGA and the NGPA to impose penalties for current violations of up to $1.3 million per day for each violation. +Pipeline safety integrity programs and repairs may impose significant costs and liabilities on us. +The PHMSA requires pipeline operators to develop integrity management programs to comprehensively evaluate certain areas along their pipelines and to take additional measures to protect pipeline segments located in “high consequence areas” where a leak or rupture could potentially do the most harm. As an operator, we are required to: +• +perform ongoing assessments of pipeline integrity; +• +identify and characterize applicable threats to pipeline segments that could impact a “high consequence area”; +• +improve data collection, integration and analysis; +• +repair and remediate the pipeline as necessary; and +• +implement preventative and mitigating actions. +We are required to maintain pipeline integrity testing programs that are intended to assess pipeline integrity. Any repair, remediation, preventative or mitigating actions may require significant capital and operating expenditures. Should we fail to comply with applicable statutes and the Office of Pipeline Safety’s rules and related regulations and orders, we could be subject to significant penalties and fines. +Any reduction in the capacity of, or the allocations to, interconnecting, third-party pipelines could cause a reduction of volumes transported in our pipelines, which would adversely affect our revenues and cash flow. +We are dependent upon third-party pipelines and other facilities to provide delivery options to and from our pipelines. If any pipeline connection were to become unavailable for volumes of natural gas due to repairs, damage to the facility, lack of capacity or any other reason, our ability to continue shipping natural gas to end markets could be restricted, thereby reducing our revenues. Any permanent interruption at any key pipeline interconnect which causes a material reduction in volumes transported on our pipelines could have a material adverse effect on our business, financial condition, operating results, cash flow, liquidity and prospects. +24 +Our business could be materially and adversely affected if we lose the right to situate our pipelines on property owned by third parties. +We do not own the land on which our pipelines are situated, and we are subject to the possibility of increased costs to retain necessary land use rights. If we were to lose these rights or be required to relocate our pipelines, our business could be materially and adversely affected. +Any failure to perform by our counterparties under agreements may adversely affect our operating results, liquidity and access to financing. +Our integrated marketing function involves our entering into various purchase and sale, hedging and other transactions with numerous third parties (commonly referred to as “counterparties”). In such arrangements, we are exposed to the performance and credit risks of our counterparties, including the risk that one or more counterparties fails to perform its obligation to make deliveries of commodities and/or to make payments. These risks may increase during periods of commodity price volatility. Defaults by suppliers and other counterparties may adversely affect our operating results, liquidity and access to financing. +We may not be able to contract with customers to sell LNG produced in excess of the aggregate annual contract quantities committed to SPL’s and CCL’s third-party SPAs. +We expect to sell any LNG produced in excess of the aggregate annual contract quantity committed to SPL’s and CCL’s third-party SPAs through our integrated marketing function. We are developing a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide, which is primarily sourced by LNG produced by the SPL Project and the CCL Project in excess of the contract quantities committed to SPL’s and CCL’s third party SPAs, supplemented by volume procured from other locations worldwide, as needed. Failure to secure buyers for a sufficient amount of LNG could materially and adversely affect our operating results, cash flows and liquidity. +Risks Relating to Our LNG Businesses in General +We may not construct or operate all of our proposed LNG facilities or Trains or any additional LNG facilities or Trains beyond those currently planned, which could limit our growth prospects. +We may not construct some of our proposed LNG facilities or Trains, whether due to lack of commercial interest or inability to obtain financing or otherwise. Our ability to develop additional liquefaction facilities will also depend on the availability and pricing of LNG and natural gas in North America and other places around the world. Competitors may have longer operating histories, more development experience, greater name recognition, larger staffs and substantially greater financial, technical and marketing resources and access to sources of natural gas and LNG than we do. If we are unable or unwilling to construct and operate additional LNG facilities, our prospects for growth will be limited. +Our cost estimates for Trains are subject to change as a result of cost overruns, change orders under existing or future construction contracts, changes in commodity prices (particularly nickel and steel), escalating labor costs and the potential need for additional funds to be expended to maintain construction schedules. In the event we experience cost overruns, delays or both, the amount of funding needed to complete a Train could exceed our available funds and result in our failure to complete such Train and thereby negatively impact our business and limit our growth prospects. +Cyclical or other changes in the demand for and price of LNG and natural gas may adversely affect our LNG business and the performance of our customers and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Our LNG business and the development of domestic LNG facilities and projects generally is based on assumptions about the future availability and price of natural gas and LNG and the prospects for international natural gas and LNG markets. Natural gas and LNG prices have been, and are likely to continue to be, volatile and subject to wide fluctuations in response to one or more of the following factors: +• +additions to competitive regasification capacity in North America, Europe, Asia and other markets, which could divert LNG from the Sabine Pass LNG terminal and the Corpus Christi LNG terminal; +• +competitive liquefaction capacity in North America; +25 +• +insufficient or oversupply of natural gas liquefaction or receiving capacity worldwide; +• +insufficient LNG tanker capacity; +• +weather conditions; +• +reduced demand and lower prices for natural gas; +• +increased natural gas production deliverable by pipelines, which could suppress demand for LNG; +• +decreased oil and natural gas exploration activities, which may decrease the production of natural gas; +• +cost improvements that allow competitors to offer LNG regasification services or provide natural gas liquefaction capabilities at reduced prices; +• +changes in supplies of, and prices for, alternative energy sources such as coal, oil, nuclear, hydroelectric, wind and solar energy, which may reduce the demand for natural gas; +• +changes in regulatory, tax or other governmental policies regarding imported or exported LNG, natural gas or alternative energy sources, which may reduce the demand for imported or exported LNG and/or natural gas; +• +political conditions in natural gas producing regions; +• +adverse relative demand for LNG compared to other markets, which may decrease LNG imports into or exports from North America; and +• +cyclical trends in general business and economic conditions that cause changes in the demand for natural gas. +Adverse trends or developments affecting any of these factors could result in decreases in the price of LNG and/or natural gas, which could materially and adversely affect the performance of our customers, and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Failure of imported or exported LNG to be a competitive source of energy for international markets could adversely affect our customers and could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Operations of the SPL Project are, and operations at the CCL Project will be, dependent upon the ability of our SPA customers to deliver LNG supplies from the United States, which is primarily dependent upon LNG being a competitive source of energy internationally. The success of our business plan is dependent, in part, on the extent to which LNG can, for significant periods and in significant volumes, be supplied from North America and delivered to international markets at a lower cost than the cost of alternative energy sources. Through the use of improved exploration technologies, additional sources of natural gas may be discovered outside the United States, which could increase the available supply of natural gas outside the United States and could result in natural gas in those markets being available at a lower cost than LNG exported to those markets. +Although SPL has entered into arrangements to utilize up to approximately three-quarters of the regasification capacity at the Sabine Pass LNG terminal in connection with operations of the SPL Project, operations at the Sabine Pass LNG terminal are dependent, in part, upon the ability of our TUA customers to import LNG supplies into the United States, which is primarily dependent upon LNG being a competitive source of energy in North America. In North America, due mainly to a historically abundant supply of natural gas and discoveries of substantial quantities of unconventional, or shale, natural gas, imported LNG has not developed into a significant energy source. The success of the regasification services component of our business plan is dependent, in part, on the extent to which LNG can, for significant periods and in significant volumes, be produced internationally and delivered to North America at a lower cost than the cost to produce some domestic supplies of natural gas, or other alternative energy sources. Through the use of improved exploration technologies, additional sources of natural gas have recently been and may continue to be discovered in North America, which could further increase the available supply of natural gas and could result in natural gas being available at a lower cost than imported LNG. +Political instability in foreign countries that import or export natural gas, or strained relations between such countries and the United States, may also impede the willingness or ability of LNG purchasers or suppliers and merchants in such countries to import or export LNG from or to the United States. Furthermore, some foreign purchasers or suppliers of LNG may have economic or other reasons to obtain their LNG from, or direct their LNG to, non-U.S. markets or from or to our competitors’ liquefaction or regasification facilities in the United States. +26 +In addition to natural gas, LNG also competes with other sources of energy, including coal, oil, nuclear, hydroelectric, wind and solar energy. LNG from the SPL Project and the CCL Project also competes with other sources of LNG, including LNG that is priced to indices other than Henry Hub. Some of these sources of energy may be available at a lower cost than LNG from the SPL Project and the CCL Project in certain markets. The cost of LNG supplies from the United States, including the SPL Project and the CCL Project , may also be impacted by an increase in natural gas prices in the United States. +As a result of these and other factors, LNG may not be a competitive source of energy in the United States or internationally. The failure of LNG to be a competitive supply alternative to local natural gas, oil and other alternative energy sources in markets accessible to our customers could adversely affect the ability of our customers to deliver LNG from the United States or to the United States on a commercial basis. Any significant impediment to the ability to deliver LNG to or from the United States generally, or to the Sabine Pass LNG terminal or from the SPL Project and the CCL Project specifically, could have a material adverse effect on our customers and on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Various economic and political factors could negatively affect the development, construction and operation of LNG facilities, including the SPL Project, the CCL Project and expansion projects, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Commercial development of an LNG facility takes a number of years, requires a substantial capital investment and may be delayed by factors such as: +• +increased construction costs; +• +economic downturns, increases in interest rates or other events that may affect the availability of sufficient financing for LNG projects on commercially reasonable terms; +• +decreases in the price of LNG, which might decrease the expected returns relating to investments in LNG projects; +• +the inability of project owners or operators to obtain governmental approvals to construct or operate LNG facilities; +• +political unrest or local community resistance to the siting of LNG facilities due to safety, environmental or security concerns; and +• +any significant explosion, spill or similar incident involving an LNG facility or LNG vessel. +There may be shortages of LNG vessels worldwide, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +The construction and delivery of LNG vessels require significant capital and long construction lead times, and the availability of the vessels could be delayed to the detriment of our business and our customers because of: +• +an inadequate number of shipyards constructing LNG vessels and a backlog of orders at these shipyards; +• +political or economic disturbances in the countries where the vessels are being constructed; +• +changes in governmental regulations or maritime self-regulatory organizations; +• +work stoppages or other labor disturbances at the shipyards; +• +bankruptcy or other financial crisis of shipbuilders; +• +quality or engineering problems; +• +weather interference or a catastrophic event, such as a major earthquake, tsunami or fire; and +• +shortages of or delays in the receipt of necessary construction materials. +We may not be able to secure firm pipeline transportation capacity on economic terms that is sufficient to meet our feed gas transportation requirements, which could have a material adverse effect on us. +We have contracted for firm capacity for our natural gas feedstock transportation requirements for Trains 1 through 5 of the SPL Project and Trains 1 through 3 of the CCL Project. We cannot control the regulatory and permitting approvals or third parties’ construction times. If and when we need to replace one or more of our agreements with these interconnecting pipelines, we may +27 +not be able to do so on commercially reasonable terms or at all, which could impair our ability to fulfill our obligations under certain of our SPAs and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We face competition based upon the international market price for LNG. +Our liquefaction projects are subject to the risk of LNG price competition at times when we need to replace any existing SPA, whether due to natural expiration, default or otherwise, or enter into new SPAs. Factors relating to competition may prevent us from entering into a new or replacement SPA on economically comparable terms as existing SPAs, or at all. Such an event could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Factors which may negatively affect potential demand for LNG from our liquefaction projects are diverse and include, among others: +• +increases in worldwide LNG production capacity and availability of LNG for market supply; +• +increases in demand for LNG but at levels below those required to maintain current price equilibrium with respect to supply; +• +increases in the cost to supply natural gas feedstock to our liquefaction projects; +• +decreases in the cost of competing sources of natural gas or alternate fuels such as coal, heavy fuel oil and diesel; +• +decreases in the price of non-U.S. LNG, including decreases in price as a result of contracts indexed to lower oil prices; +• +increases in capacity and utilization of nuclear power and related facilities; and +• +displacement of LNG by pipeline natural gas or alternate fuels in locations where access to these energy sources is not currently available. +Terrorist attacks, cyber incidents or military campaigns may adversely impact our business. +A terrorist attack, cyber incident or military incident involving an LNG facility, our infrastructure or an LNG vessel may result in delays in, or cancellation of, construction of new LNG facilities, including one or more of the Trains, which would increase our costs and decrease our cash flows. A terrorist incident or cyber incident may also result in temporary or permanent closure of our existing facilities, which could increase our costs and decrease our cash flows, depending on the duration and timing of the closure. Our operations could also become subject to increased governmental scrutiny that may result in additional security measures at a significant incremental cost to us. In addition, the threat of terrorism and the impact of military campaigns may lead to continued volatility in prices for natural gas that could adversely affect our business and our customers, including their ability to satisfy their obligations to us under our commercial agreements. Instability in the financial markets as a result of terrorism, cyber incidents or war could also materially adversely affect our ability to raise capital. The continuation of these developments may subject our construction and our operations to increased risks, as well as increased costs, and, depending on their ultimate magnitude, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Risks Relating to Our Business in General +We are subject to significant operating hazards and uninsured risks, one or more of which may create significant liabilities and losses for us. +The construction and operation of our LNG terminals and our pipelines are, and will be, subject to the inherent risks associated with these types of operations, including explosions, pollution, release of toxic substances, fires, hurricanes and adverse weather conditions and other hazards, each of which could result in significant delays in commencement or interruptions of operations and/or in damage to or destruction of our facilities or damage to persons and property. In addition, our operations and the facilities and vessels of third parties on which our operations are dependent face possible risks associated with acts of aggression or terrorism. +We do not, nor do we intend to, maintain insurance against all of these risks and losses. We may not be able to maintain desired or required insurance in the future at rates that we consider reasonable. The occurrence of a significant event not fully insured or indemnified against could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +28 +Existing and future environmental and similar laws and governmental regulations could result in increased compliance costs or additional operating costs or construction costs and restrictions. +Our business is and will be subject to extensive federal, state and local laws, rules and regulations applicable to our construction and operation activities relating to, among other things, air quality, water quality, waste management, natural resources, and health and safety. Many of these laws and regulations, such as the CAA, the Oil Pollution Act, the CWA and the RCRA, and analogous state laws and regulations, restrict or prohibit the types, quantities and concentration of substances that can be released into the environment in connection with the construction and operation of our facilities, and require us to maintain permits and provide governmental authorities with access to our facilities for inspection and reports related to our compliance. In addition, certain laws and regulations authorize regulators having jurisdiction over our LNG terminals and pipelines, including FERC and PHMSA, to issue compliance orders, which may restrict or limit operations or increase compliance or operating costs. Violation of these laws and regulations could lead to substantial liabilities, fines and penalties or to capital expenditures that could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Federal and state laws impose liability, without regard to fault or the lawfulness of the original conduct, for the release of certain types or quantities of hazardous substances into the environment. As the owner and operator of our facilities, we could be liable for the costs of cleaning up hazardous substances released into the environment at or from our facilities and for resulting damage to natural resources. +In October 2015, the EPA promulgated a final rule to implement the Obama Administration’s Clean Power Plan, which is designed to reduce GHG emissions from power plants in the United States. In February 2016, the U.S. Supreme Court stayed the final rule, effectively suspending the duty to comply with the rule until certain legal challenges are resolved. On October 10, 2017, EPA issued a proposal to repeal the Clean Power Plan after concluding the October 2015 final rule exceeds EPA’s statutory authority under the CAA. In August 2018, the EPA proposed the Affordable Clean Energy rule as a replacement for the Clean Power Plan, which requires states to develop plans to implement certain performance standards within three years after the Final Rule is published in the Federal Register. The Trump Administration announced in June 2017 that the United States would withdraw from the Paris Accord, an international agreement within the United Nations Framework Convention on Climate Change under which the Obama Administration committed the United States to reducing its economy-wide GHG emission by 26-28% below 2005 levels by 2025. Other federal and state initiatives may be considered in the future to address GHG emissions through, for example, United States treaty commitments, direct regulation, a carbon emissions tax, or cap-and-trade programs. Such initiatives could affect the demand for or cost of natural gas, which we consume at our terminals, or could increase compliance costs for our operations. +Other future legislation and regulations, such as those relating to the transportation and security of LNG imported to or exported from our terminals, could cause additional expenditures, restrictions and delays in our business and to our proposed construction, the extent of which cannot be predicted and which may require us to limit substantially, delay or cease operations in some circumstances. Revised, reinterpreted or additional laws and regulations that result in increased compliance costs or additional operating or construction costs and restrictions could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +A major health and safety incident relating to our business could be costly in terms of potential liabilities and reputational damages. +Health and safety performance is critical to the success of all areas of our business. Any failure in health and safety performance may result in personal harm or injury, penalties for non-compliance with relevant regulatory requirements or litigation, and a failure that results in a significant health and safety incident is likely to be costly in terms of potential liabilities. Such a failure could generate public concern and have a corresponding impact on our reputation and our relationships with relevant regulatory agencies and local communities, which in turn could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We may experience increased labor costs, and the unavailability of skilled workers or our failure to attract and retain qualified personnel could adversely affect us. In addition, changes in our senior management or other key personnel could affect our business results. +We are dependent upon the available labor pool of skilled employees. We compete with other energy companies and other employers to attract and retain qualified personnel with the technical skills and experience required to construct and operate our +29 +facilities and pipelines and to provide our customers with the highest quality service. Our affiliates who hire personnel on our behalf are also subject to the Fair Labor Standards Act, which governs such matters as minimum wage, overtime and other working conditions. A shortage in the labor pool of skilled workers or other general inflationary pressures or changes in applicable laws and regulations could make it more difficult for us to attract and retain qualified personnel and could require an increase in the wage and benefits packages that we offer, thereby increasing our operating costs. Any increase in our operating costs could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We depend on our executive officers for various activities. We do not maintain key person life insurance policies on any of our personnel. Although we have arrangements relating to compensation and benefits with certain of our executive officers, we do not have any employment contracts or other agreements with key personnel other than our employment agreement with our President and Chief Executive Officer binding them to provide services for any particular term. The loss of the services of any of these individuals could have a material adverse effect on our business. +Our lack of diversification could have an adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Substantially all of our anticipated revenue in 2019 will be dependent upon our two facilities, the Sabine Pass LNG terminal located in southern Louisiana and the Corpus Christi LNG terminal in Texas. Due to our lack of asset and geographic diversification, an adverse development at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, including the related pipelines, or in the LNG industry, would have a significantly greater impact on our financial condition and operating results than if we maintained more diverse assets and operating areas. +We may incur impairments to goodwill or long-lived assets. +We test our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. We test goodwill for impairment annually during the fourth quarter, or more frequently as circumstances dictate. Significant negative industry or economic trends, including a significant decline in the market price of our common stock, reduced estimates of future cash flows for our business or disruptions to our business could lead to an impairment charge of our long-lived assets, including goodwill. Our valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and to rely heavily on projections of future operating performance. Projections of future operating results and cash flows may vary significantly from results. In addition, if our analysis results in an impairment to our goodwill or long-lived assets, we may be required to record a charge to earnings in our Consolidated Financial Statements during a period in which such impairment is determined to exist, which may negatively impact our operating results. +The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future. Our stockholders could lose all or part of their investment. +The market price of our common stock has historically experienced and may continue to experience volatility. For example, during the three-year period ended December 31, 2018 , the market price of our common stock ranged between $22.80 and $71.03. Such fluctuations may continue as a result of a variety of factors, some of which are beyond our control, including: +• +domestic and worldwide supply of and demand for natural gas and corresponding fluctuations in the price of natural gas; +• +fluctuations in our quarterly or annual financial results or those of other companies in our industry; +• +issuance of additional equity securities which causes further dilution to stockholders; +• +sales of a high volume of shares of our common stock by our stockholders; +• +operating and stock price performance of companies that investors deem comparable to us; +• +events affecting other companies that the market deems comparable to us; +• +changes in government regulation or proposals applicable to us; +• +actual or potential non-performance by any customer or a counterparty under any agreement; +• +announcements made by us or our competitors of significant contracts; +30 +• +changes in accounting standards, policies, guidance, interpretations or principles; +• +general conditions in the industries in which we operate; +• +general economic conditions; +• +the failure of securities analysts to cover our common stock or changes in financial or other estimates by analysts; and +• +other factors described in these “Risk Factors.” +In addition, the United States securities markets have experienced significant price and volume fluctuations. These fluctuations have often been unrelated to the operating performance of companies in these markets. Market fluctuations and broad market, economic and industry factors may negatively affect the price of our common stock, regardless of our operating performance. If we were to be the object of securities class litigation as a result of volatility in our common stock price or for other reasons, it could result in substantial diversion of our management’s attention and resources, which could negatively affect our financial results. +ITEM 1B. +UNRESOLVED STAFF COMMENTS +None. +ITEM 3. LEGAL PROCEEDINGS +We may in the future be involved as a party to various legal proceedings, which are incidental to the ordinary course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities on the eventual disposition of these matters. +LDEQ Matter +Certain of our subsidiaries are in discussions with the LDEQ to resolve self-reported deviations arising from operation of the Sabine Pass LNG terminal and the commissioning of the SPL Project, and relating to certain requirements under its Title V Permit. The matter involves deviations self-reported to LDEQ pursuant to the Title V Permit and covering the time period from January 1, 2012 through March 25, 2016. On April 11, 2016, certain of our subsidiaries received a Consolidated Compliance Order and Notice of Potential Penalty (the “Compliance Order”) from LDEQ covering deviations self-reported during that time period. Certain of our subsidiaries continue to work with LDEQ to resolve the matters identified in the Compliance Order. We do not expect that any ultimate sanction will have a material adverse impact on our financial results. +PHMSA Matters +In February 2018, PHMSA issued a Corrective Action Order (the “CAO”) to SPL in connection with a minor LNG leak from one tank and minor vapor release from a second tank at the Sabine Pass LNG terminal. These two tanks have been taken out of operational service while we conduct analysis, repair and remediation. On April 20, 2018, SPL and PHMSA executed a Consent Agreement and Order (the “Consent Order”) that replaces and supersedes the CAO. We continue to work with PHMSA and other appropriate regulatory authorities to address the matters identified in the Consent Order. We do not expect that the Consent Order and related analysis, repair and remediation will have a material adverse impact on our financial results or operations. +In February 2018, PHMSA issued a Notice of Probable Violation, Proposed Civil Penalty and Proposed Compliance Order (“the NOPV”) to CCP alleging probable violations of federal pipeline safety regulations relating to welding during the construction of the pipeline and proposes civil penalties totaling $0.2 million. We worked with PHMSA to address the matters in the NOPV. In September 2018, PHMSA withdrew the proposed civil penalty and NOPV and closed the case citing no further safety concern regarding the welds at CCP. +Parallax Litigation +In 2015, our wholly owned subsidiary, Cheniere LNG Terminals, LLC (“CLNGT”), entered into discussions with Parallax Enterprises, LLC (“Parallax Enterprises”) regarding the potential joint development of two liquefaction plants in Louisiana (the “Potential Liquefaction Transactions”). While the parties negotiated regarding the Potential Liquefaction Transactions, CLNGT +31 +loaned Parallax Enterprises approximately $46 million , as reflected in a secured note dated April 23, 2015, as amended on June 30, 2015, September 30, 2015 and November 4, 2015 (the “Secured Note”). The Secured Note was secured by all assets of Parallax Enterprises and its subsidiary entities. On June 30, 2015, Parallax Enterprises’ parent entity, Parallax Energy LLC (“Parallax Energy”), executed a Pledge and Guarantee Agreement further securing repayment of the Secured Note by providing a parent guaranty and a pledge of all of the equity of Parallax Enterprises in satisfaction of the Secured Note (the “Pledge Agreement”). CLNGT and Parallax Enterprises never executed a definitive agreement to pursue the Potential Liquefaction Transactions. The Secured Note matured on December 11, 2015, and Parallax Enterprises failed to make payment. On February 3, 2016, CLNGT filed an action against Parallax Energy, Parallax Enterprises and certain of Parallax Enterprises’ subsidiary entities, styled Cause No. 4:16-cv-00286, Cheniere LNG Terminals, LLC v. Parallax Energy LLC, et al., in the United States District Court for the Southern District of Texas (the “Texas Federal Suit”). CLNGT asserted claims in the Texas Federal Suit for (1) recovery of all amounts due under the Secured Note and (2) declaratory relief establishing that CLNGT is entitled to enforce its rights under the Secured Note and Pledge Agreement in accordance with each instrument’s terms and that CLNGT has no obligations of any sort to Parallax Enterprises concerning the Potential Liquefaction Transactions. On March 11, 2016, Parallax Enterprises and the other defendants in the Texas Federal Suit moved to dismiss the suit for lack of subject matter jurisdiction. On August 2, 2016, the court denied the defendants’ motion to dismiss without prejudice and permitted the parties to pursue jurisdictional discovery. +On March 11, 2016, Parallax Enterprises filed a suit against us and CLNGT styled Civil Action No. 62-810, Parallax Enterprises LLP v. Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC, in the 25th Judicial District Court of Plaquemines Parish, Louisiana (the “Louisiana Suit”), wherein Parallax Enterprises asserted claims for breach of contract, fraudulent inducement, negligent misrepresentation, detrimental reliance, unjust enrichment and violation of the Louisiana Unfair Trade Practices Act. Parallax Enterprises predicated its claims in the Louisiana Suit on an allegation that we and CLNGT breached a purported agreement to jointly develop the Potential Liquefaction Transactions. Parallax Enterprises sought $400 million in alleged economic damages and rescission of the Secured Note. On April 15, 2016, we and CLNGT removed the Louisiana Suit to the United States District Court for the Eastern District of Louisiana, which subsequently transferred the Louisiana Suit to the United States District Court for the Southern District of Texas, where it was assigned Civil Action No. 4:16-cv-01628 and transferred to the same judge presiding over the Texas Federal Suit for coordinated handling. On August 22, 2016, Parallax Enterprises voluntarily dismissed all claims asserted against CLNGT and us in the Louisiana Suit without prejudice to refiling. +On July 27, 2017, the Parallax entities named as defendants in the Texas Federal Suit reurged their motion to dismiss and simultaneously filed counterclaims against CLNGT and third party claims against us for breach of contract, breach of fiduciary duty, promissory estoppel, quantum meruit and fraudulent inducement of the Secured Note and Pledge Agreement, based on substantially the same factual allegations Parallax Enterprises made in the Louisiana Suit. These Parallax entities also simultaneously filed an action styled Cause No. 2017-49685, Parallax Enterprises, LLC, et al. v. Cheniere Energy, Inc., et al., in the 61st District Court of Harris County, Texas (the “Texas State Suit”), which asserts substantially the same claims these entities asserted in the Texas Federal Suit. On July 31, 2017, CLNGT withdrew its opposition to the dismissal of the Texas Federal Suit without prejudice on jurisdictional grounds and the federal court subsequently dismissed the Texas Federal Suit without prejudice. We and CLNGT simultaneously filed an answer and counterclaims in the Texas State Suit, asserting the same claims CLNGT had previously asserted in the Texas Federal Suit. Additionally, CLNGT filed third party claims against Parallax principals Martin Houston, Christopher Bowen Daniels, Howard Candelet and Mark Evans, as well as Tellurian Investments, Inc., Driftwood LNG, LLC, Driftwood LNG Pipeline LLC and Tellurian Services LLC, formerly known as Parallax Services LLC, including claims for tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, fraudulent transfer, conspiracy/aiding and abetting. Discovery in the Texas State Suit is ongoing. Trial is currently set for June 2019. +On February 15, 2019, we filed an action with CLNGT against Charif Souki, our former Chairman of the Board and Chief Executive Officer, styled, Cause No. 2019-11529, Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC v. Charif Souki , in the 55th District Court of Harris County, Texas, which asserts claims of breach of fiduciary duties, fraudulent transfer, tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, and conspiracy/aiding and abetting. +We do not expect that the resolution of any of the foregoing litigation will have a material adverse impact on our financial results. +ITEM 4. +MINE SAFETY DISCLOSURE +Not applicable. +32 +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER +Market Information, Holders and Dividends +Our common stock has traded on the NYSE American under the symbol “LNG” since March 24, 2003. As of February 20, 2019 , we had 257.4 million shares of common stock outstanding held by 109 record owners. +We have never paid a cash dividend on our common stock. We currently intend to retain earnings to finance the growth and development of our business and plan to communicate capital allocation policy decisions during 2019. Any future change in our dividend policy will be made at the discretion of our Board of Directors (our “Board”) in light of our financial condition, capital requirements, earnings, prospects and any restrictions under any financing agreements, as well as other factors our Board deems relevant. +Purchase of Equity Securities by the Issuer and Affiliated Purchasers +The following table summarizes stock repurchases for the three months ended December 31, 2018 : +Period +Total Number of Shares Purchased (1) +Average Price Paid Per Share (2) +Total Number of Shares Purchased as a Part of Publicly Announced Plans +Maximum Number of Units That May Yet Be Purchased Under the Plans +October 1 - 31, 2018 +133,205 +$65.85 +— +— +November 1 - 30, 2018 +14,623 +$61.65 +— +— +December 1 - 31, 2018 +1,108 +$61.37 +— +— +(1) +Represents shares surrendered to us by participants in our share-based compensation plans to settle the participants’ personal tax liabilities that resulted from the lapsing of restrictions on shares awarded to the participants under these plans. +(2) +The price paid per share was based on the closing trading price of our common stock on the dates on which we repurchased shares from the participants under our share-based compensation plans. +For additional information, see Note 15—Share-Based Compensation of our Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. +33 +Total Stockholder Return +The following is a customized peer group consisting of 29 companies (the “New Peer Group”) that were selected because they are publicly traded companies that have: (1) comparable Global Industries Classification Standards, (2) similar market capitalization, (3) similar enterprise values and (4) similar operating characteristics and capital intensity: +New Peer Group +Air Products and Chemicals, Inc. (APD) +Kinder Morgan, Inc. (KMI) +Anadarko Petroleum Corporation (APC) +LyondellBasell Industries N.V. (LYB) +Andeavor (ANDV) +Marathon Oil Corporation (MRO) +Apache Corporation (APA) +Marathon Petroleum Corporation (MPC) +Baker Hughes, a GE company (BHGE) +Noble Energy, Inc. (NBL) +Concho Resources Inc. (CXO) +Occidental Petroleum Corporation (OXY) +ConocoPhillips (COP) +ONEOK, Inc. (OKE) +Continental Resources, Inc. (CLR) +Phillips 66 (PSX) +Devon Energy Corporation (DVN) +Pioneer Natural Resources Company (PXD) +Enterprise Products Partners L.P. (EPD) +Praxair, Inc. (PX) +EOG Resources, Inc. (EOG) +Schlumberger Limited (SLB) +EQT Corporation (EQT) +Suncor Energy Inc. (SU) +Freeport-McMoRan Inc. (FCX) +Valero Energy Corporation (VLO) +Halliburton Company (HAL) +The Williams Companies, Inc. (WMB) +Hess Corporation (HES) +The New Peer Group companies were revised during 2018. Our previous peer group consisted of the following 17 companies (the “Old Peer Group”): +Old Peer Group +Ameren Corporation (AEE) +PG&E Corporation (PCG) +Calpine Corp. (CPN) +Public Service Enterprise Group Inc. (PEG) +CMS Energy Corp. (CMS) +Sempra Energy (SRE) +Dominion Resources, Inc. (D) +Targa Resources Corp. (TRGP) +DTE Energy Company (DTE) +TransCanada Corporation (TRP) +Dynegy Inc. (DYN) +MarkWest Energy Partners, L.P. (MWE) +Enterprise Products Partners L.P. (EPD) +Spectra Energy Corp (SE) +Magellan Midstream Partners, L.P. (MMP) +Enbridge (ENB) +ONEOK, Inc. (OKE) +The following graph compares the five-year total return on our common stock, the S&P 500 Index, the New Peer Group and the Old Peer Group. The graph was constructed on the assumption that $100 was invested in our common stock, the S&P 500 Index, the New Peer Group and the Old Peer Group on December 31, 2013 and that any dividends were fully reinvested. +Company / Index +2013 +2014 +2015 +2016 +2017 +2018 +Cheniere Energy, Inc. +100.00 +163.27 +86.39 +96.08 +124.86 +137.27 +S&P 500 Index +100.00 +113.69 +115.26 +129.05 +157.22 +150.33 +New Peer Group +100.00 +96.50 +77.10 +105.03 +109.89 +86.74 +Old Peer Group +100.00 +121.50 +98.35 +120.50 +126.61 +116.16 +34 +ITEM 6. +SELECTED FINANCIAL DATA +Selected financial data set forth below are derived from our audited Consolidated Financial Statements for the periods indicated (in millions, except per share data). The financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and the accompanying notes thereto included elsewhere in this report. +Year Ended December 31, +2018 +2017 +2016 +2015 +2014 +Revenues +$ +7,987 +$ +5,601 +$ +1,283 +$ +271 +$ +268 +Income (loss) from operations +2,024 +1,388 +(30 +) +(449 +) +(272 +) +Interest expense, net of capitalized interest +(875 +) +(747 +) +(488 +) +(322 +) +(181 +) +Net income (loss) attributable to common stockholders +471 +(393 +) +(610 +) +(975 +) +(548 +) +Net income (loss) per share attributable to common stockholders—basic +$ +1.92 +$ +(1.68 +) +$ +(2.67 +) +$ +(4.30 +) +$ +(2.44 +) +Net income (loss) per share attributable to common stockholders—diluted +$ +1.90 +$ +(1.68 +) +$ +(2.67 +) +$ +(4.30 +) +$ +(2.44 +) +Weighted average number of common shares outstanding—basic +245.6 +233.1 +228.8 +226.9 +224.3 +Weighted average number of common shares outstanding—diluted +248.0 +233.1 +228.8 +226.9 +224.3 +December 31, +2018 +2017 +2016 +2015 +2014 +Property, plant and equipment, net +$ +27,245 +$ +23,978 +$ +20,635 +$ +16,194 +$ +9,247 +Total assets +31,987 +27,906 +23,703 +18,809 +12,433 +Current debt, net +239 +— +247 +1,673 +— +Long-term debt, net +28,179 +25,336 +21,688 +14,920 +9,665 +35 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Introduction +The following discussion and analysis presents management’s view of our business, financial condition and overall performance and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes. This information is intended to provide investors with an understanding of our past performance, current financial condition and outlook for the future. Our discussion and analysis includes the following subjects: +• +Overview of Business +• +Overview of Significant Events +• +Liquidity and Capital Resources +• +Contractual Obligations +• +Results of Operations +• +Off-Balance Sheet Arrangements +• +Summary of Critical Accounting Estimates +• +Recent Accounting Standards +Overview of Business +Cheniere, a Delaware corporation, is a Houston-based energy company primarily engaged in LNG-related businesses. Our vision is to provide clean, secure and affordable energy to the world, while responsibly delivering a reliable, competitive and integrated source of LNG, in a safe and rewarding work environment. We own and operate the Sabine Pass LNG terminal in Louisiana through our ownership interest in and management agreements with Cheniere Partners, which is a publicly traded limited partnership that we created in 2007. As of December 31, 2018 , we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We are currently developing and constructing two natural gas liquefaction and export facilities. The liquefaction of natural gas into LNG allows it to be shipped economically from areas of the world where natural gas is abundant and inexpensive to produce to other areas where natural gas demand and infrastructure exist to economically justify the use of LNG. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners is developing, constructing and operating natural gas liquefaction facilities (the “SPL Project”) at the Sabine Pass LNG terminal adjacent to the existing regasification facilities through a wholly owned subsidiary, SPL. Cheniere Partners plans to construct up to six Trains, which are in various stages of development, construction and operations. Trains 1 through 4 are operational, Train 5 is undergoing commissioning and Train 6 is being commercialized and has all necessary regulatory approvals in place. Each Train is expected to have a nominal production capacity, which is prior to adjusting for planned maintenance, production reliability, potential overdesign and debottlenecking opportunities, of approximately 4.5 mtpa of LNG per Train, and run rate adjusted nominal production capacity of approximately 4.5 to 4.9 mtpa of LNG per Train. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ wholly owned subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 16.9 Bcfe , two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4.0 Bcf/d . Cheniere Partners also owns a 94-mile pipeline that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”) through a wholly owned subsidiary, CTPL. +We are developing and constructing a second natural gas liquefaction and export facility at the Corpus Christi LNG terminal near Corpus Christi, Texas, and operate a 23-mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the liquefaction facilities, the “CCL Project”) through our wholly owned subsidiaries CCL and CCP, respectively. The CCL Project is being developed in stages with the first phase being three Trains (“Phase 1”), with expected aggregate nominal production capacity, which is prior to adjusting for planned maintenance, production reliability, potential overdesign and debottlenecking opportunities, of approximately 13.5 mtpa of LNG, three LNG storage tanks with aggregate capacity of approximately 10.1 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. The first stage (“Stage 1”) includes Trains 1 and +36 +2, two LNG storage tanks, one complete marine berth and a second partial berth and all of the CCL Project ’s necessary infrastructure facilities. The second stage (“Stage 2”) includes Train 3, one LNG storage tank and the completion of the second partial berth. Trains 1 and 2 are undergoing commissioning and Train 3 is under construction. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) and filed an application with FERC in June 2018 for seven midscale Trains with an expected aggregate nominal production capacity of approximately 9.5 mtpa and one LNG storage tank. +We remain focused on expansion of our existing sites by leveraging existing infrastructure. We are also in various stages of developing other projects, including infrastructure projects in support of natural gas supply and LNG demand, which, among other things, will require acceptable commercial and financing arrangements before we make a final investment decision (“ FID ”). We have made an equity investment in Midship Holdings, LLC (“Midship Holdings”), which manages the business and affairs of Midship Pipeline Company, LLC (“Midship Pipeline”). Midship Pipeline is developing a pipeline (the “Midship Project”) with expected capacity of up to 1.44 million Dekatherms per day that will connect new gas production in the Anadarko Basin to Gulf Coast markets, including markets serving the SPL Project and the CCL Project . Construction of the Midship Project will commence based upon, among other things, obtaining the required authorization from the FERC and adequate financing to construct the proposed project. +Overview of Significant Events +Our significant accomplishments since January 1, 2018 and through the filing date of this Form 10-K include the following: +Strategic +• +In November 2018, SPL entered into an EPC contract with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for Train 6 of the SPL Project. SPL also issued limited notices to proceed to Bechtel to commence early engineering, procurement and site works. +• +In May 2018, our board of directors made a positive FID with respect to Stage 2 of the CCL Project and issued a full notice to proceed to Bechtel under the EPC contract for Stage 2. +• +In June 2018, we filed an application with the FERC with respect to Corpus Christi Stage 3 , consisting of seven midscale liquefaction Trains with an expected aggregate nominal production capacity of approximately 9.5 mtpa and one LNG storage tank. +• +We entered into the following agreements: +◦ +In December 2018, SPL entered into a 20-year SPA with PETRONAS LNG Ltd., subject to conditions precedent including FID of Train 6 of the SPL Project , for the sale of approximately 1.1 mtpa of LNG on a free on board (“FOB”) basis, with deliveries commencing following date of first commercial delivery for Train 6 of the SPL Project . +◦ +In November 2018, we entered into a 24-year SPA with Polish state-owned oil and gas company Polskie Gornictwo Naftowe i Gazownictwo S.A. for the sale of approximately 1.45 mtpa of LNG on a delivered ex-ship (“DES”) basis. Deliveries will commence in 2019, with the full annual quantity commencing in 2023. +◦ +In September 2018, we entered into a 15-year SPA with Vitol Inc. for the sale of approximately 0.7 mtpa of LNG beginning in 2018 on a FOB basis. +◦ +In August 2018, we entered into a 25-year SPA with CPC Corporation, Taiwan for the sale of approximately 2.0 mtpa of LNG beginning in 2021 on a DES basis. +◦ +In February 2018, we entered into two SPAs with PetroChina International Company Limited, a subsidiary of China National Petroleum Corporation, for the sale of approximately 1.2 mtpa of LNG through 2043 on both FOB and DES bases, with a portion of the supply beginning in 2018 and the balance beginning in 2023. +◦ +In January 2018, we entered into a 15-year SPA with Trafigura Pte Ltd for the sale of approximately 1.0 mtpa of LNG beginning in 2019 on a FOB basis. +37 +Operational +• +As of February 20, 2019, over 575 cumulative LNG cargoes have been produced, loaded and exported from the SPL Project and the CCL Project , with more than 270 cargoes in 2018 alone from the SPL Project , with deliveries to 32 countries and regions worldwide. +• +In November 2018 and December 2018, SPL and CCL commenced production and shipment of LNG commissioning cargoes from Train 5 of the SPL Project and Train 1 of the CCL Project , respectively. +Financial +• +We completed the following debt transactions: +◦ +In December 2018, we amended and restated our existing revolving credit facility (“ Cheniere Revolving Credit Facility ”) to, among other changes, increase total commitments under the Cheniere Revolving Credit Facility to $1.25 billion, reduce the interest rate and extend the maturity date to December 2022. Borrowings will be used to fund the development of the CCL Project and, provided that certain conditions are met, for our general corporate purposes. +◦ +In September 2018, Cheniere Partners issued an aggregate principal amount of $1.1 billion of 5.625% Senior Notes due 2026 (the “2026 CQP Senior Notes”) . Net proceeds of the offering of approximately $1.1 billion, after deducting commissions, fees and expenses, were used to prepay all of the outstanding indebtedness under Cheniere Partners’ credit facilities (the “CQP Credit Facilities”) . As of December 31, 2018 , only a $115 million revolving credit facility, which is currently undrawn, remains as part of the CQP Credit Facilities . +◦ +In June 2018, CCH amended and restated its working capital facility (“CCH Working Capital Facility”) to increase total commitments under the CCH Working Capital Facility to $1.2 billion . Borrowings will be used for certain working capital requirements related to developing and placing the CCL Project into operations and for related business purposes. +◦ +In May 2018, CCH amended and restated its existing credit facilities (the “CCH Credit Facility”) to increase total commitments under the CCH Credit Facility to $6.1 billion. Borrowings will be used to fund a portion of the costs of developing, constructing and placing into service the three Trains and the related facilities of the CCL Project and for related business purposes. +• +In September 2018, we closed the previously announced merger of Cheniere Holdings with our wholly owned subsidiary. As a result of the merger, all of the publicly-held shares of Cheniere Holdings not owned by us were canceled and shareholders received 0.4750 shares of our common stock for each publicly-held share of Cheniere Holdings. +• +We reached the following contractual milestones: +◦ +In June 2018, the date of first commercial delivery was reached under the 20-year SPA with BG Gulf Coast LNG, LLC (“BG”) relating to Train 3 of the SPL Project . +◦ +In March 2018, the date of first commercial delivery was reached under the 20-year SPA with GAIL (India) Limited (“GAIL”) relating to Train 4 of the SPL Project . +Liquidity and Capital Resources +Although results are consolidated for financial reporting, Cheniere, Cheniere Partners, SPL and the CCH Group operate with independent capital structures. We expect the cash needs for at least the next twelve months will be met for each of these independent capital structures as follows: +• +SPL through project debt and borrowings and operating cash flows; +• +Cheniere Partners through operating cash flows from SPLNG, SPL and CTPL and debt or equity offerings; +• +CCH Group through project debt and borrowings and equity contributions from Cheniere; and +• +Cheniere through project financing, existing unrestricted cash, debt and equity offerings by us or our subsidiaries, operating cash flows, services fees from Cheniere Partners and our other subsidiaries and distributions from our investment in Cheniere Partners. +38 +The following table provides a summary of our liquidity position at December 31, 2018 and 2017 (in millions): +December 31, +2018 +2017 +Cash and cash equivalents +$ +981 +$ +722 +Restricted cash designated for the following purposes: +SPL Project +756 +544 +Cheniere Partners and cash held by guarantor subsidiaries +785 +1,045 +CCL Project +289 +227 +Other +345 +75 +Available commitments under the following credit facilities: +$1.2 billion SPL Working Capital Facility (“SPL Working Capital Facility”) +775 +470 +CQP Credit Facilities +115 +220 +CCH Credit Facility +982 +2,087 +CCH Working Capital Facility +716 +186 +$1.25 billion Cheniere Revolving Credit Facility +1,250 +750 +For additional information regarding our debt agreements, see Note 12—Debt of our Notes to Consolidated Financial Statements. +Cheniere +Convertible Notes +In November 2014, we issued an aggregate principal amount of $1.0 billion of Convertible Unsecured Notes due 2021 (the “2021 Cheniere Convertible Unsecured Notes”) . The 2021 Cheniere Convertible Unsecured Notes are convertible at the option of the holder into our common stock at the then applicable conversion rate, provided that the closing price of our common stock is greater than or equal to the conversion price on the date of conversion. In March 2015, we issued $625 million aggregate principal amount of 4.25% Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”) . We have the right, at our option, at any time after March 15, 2020, to redeem all or any part of the 2045 Cheniere Convertible Senior Notes at a redemption price equal to the accreted amount of the 2045 Cheniere Convertible Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to such redemption date. We have the option to satisfy the conversion obligation for the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes with cash, common stock or a combination thereof. +Cheniere Revolving Credit Facility +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $750 million to $1.25 billion . The Cheniere Revolving Credit Facility is intended to fund, through loans and letters of credit, equity capital contributions to CCH HoldCo II and its subsidiaries for the development of the CCL Project and, provided that certain conditions are met, for general corporate purposes. +The Cheniere Revolving Credit Facility matures on December 13, 2022 and contains representations, warranties and affirmative and negative covenants customary for companies like us with lenders of the type participating in the Cheniere Revolving Credit Facility that limit our ability to make restricted payments, including distributions, unless certain conditions are satisfied, as well as limitations on indebtedness, guarantees, hedging, liens, investments and affiliate transactions. Under the Cheniere Revolving Credit Facility , we are required to ensure that the sum of our unrestricted cash and the amount of undrawn commitments under the Cheniere Revolving Credit Facility is at least equal to the lesser of (1) 20% of the commitments under the Cheniere Revolving Credit Facility and (2) $200 million (the “Liquidity Covenant”). +From and after the time at which certain specified conditions are met (the “Trigger Point”), we will have increased flexibility under the Cheniere Revolving Credit Facility to, among other things, (1) make restricted payments and (2) raise incremental commitments. The Trigger Point will occur once (1) completion has occurred for each of Train 1 of the CCL Project (as defined in the CCH Indenture) and Train 5 of the SPL Project (as defined in SPL’s common terms agreement), (2) the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is less than or equal to 10% of aggregate commitments under the Cheniere Revolving Credit Facility and (3) we elect on a go-forward basis to be governed by a non-consolidated leverage ratio covenant not to exceed 5.75 :1.00 (the “Springing Leverage Covenant”), which following such election will apply at any time that the aggregate principal amount of outstanding loans plus drawn and +39 +unreimbursed letters of credit under the Cheniere Revolving Credit Facility is greater than 30% of aggregate commitments under the Cheniere Revolving Credit Facility . Following the Trigger Point, at any time that the Springing Leverage Covenant is in effect, the Liquidity Covenant will not apply. +The Cheniere Revolving Credit Facility is secured by a first priority security interest (subject to permitted liens and other customary exceptions) in substantially all of our assets, including our interests in our direct subsidiaries (excluding CCH HoldCo II and certain other subsidiaries). +Cash Receipts from Subsidiaries +Our ownership interest in the Sabine Pass LNG terminal is held through Cheniere Partners. As of December 31, 2018 , we owned a 48.6% limited partner interest in Cheniere Partners in the form of 104.5 million common units and 135.4 million subordinated units. We also own 100% of the general partner interest and the incentive distribution rights in Cheniere Partners. We are eligible to receive quarterly equity distributions from Cheniere Partners related to our ownership interests and our incentive distribution rights. +We also receive fees for providing management services to some of our subsidiaries. We received $76 million , $106 million and $119 million in total service fees from these subsidiaries during the years ended December 31, 2018, 2017 and 2016 , respectively. +Cheniere Partners +CQP Senior Notes +In September 2018, Cheniere Partners issued an aggregate principal amount of $1.1 billion of the 2026 CQP Senior Notes . The $1.5 billion of 5.250% Senior Notes due 2025 (the “2025 CQP Senior Notes”) and the 2026 CQP Senior Notes (collectively, the “CQP Senior Notes”) are jointly and severally guaranteed by each of Cheniere Partners’ subsidiaries other than SPL (the “CQP Guarantors”) and, subject to certain conditions governing its guarantee, Sabine Pass LP. The CQP Senior Notes are governed by the same base indenture (the “CQP Base Indenture”) . The 2025 CQP Senior Notes are further governed by the First Supplemental Indenture (together with the CQP Base Indenture, the “2025 CQP Notes Indenture”) and the 2026 CQP Senior Notes are further governed by the Second Supplemental Indenture (together with the CQP Base Indenture, the “2026 CQP Notes Indenture”). The 2025 CQP Notes Indenture and the 2026 CQP Notes Indenture contain customary terms and events of default and certain covenants that, among other things, limit the ability of Cheniere Partners and the CQP Guarantors to incur liens and sell assets, enter into transactions with affiliates, enter into sale-leaseback transactions and consolidate, merge or sell, lease or otherwise dispose of all or substantially all of the applicable entity’s properties or assets. +At any time prior to October 1, 2020 for the 2025 CQP Senior Notes and October 1, 2021 for the 2026 CQP Senior Notes , Cheniere Partners may redeem all or a part of the applicable CQP Senior Notes at a redemption price equal to 100% of the aggregate principal amount of the CQP Senior Notes redeemed, plus the “applicable premium” set forth in the respective indentures governing the CQP Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to October 1, 2020 for the 2025 CQP Senior Notes and October 1, 2021 for the 2026 CQP Senior Notes , Cheniere Partners may redeem up to 35% of the aggregate principal amount of the CQP Senior Notes with an amount of cash not greater than the net cash proceeds from certain equity offerings at a redemption price equal to 105.250% of the aggregate principal amount of the 2025 CQP Senior Notes and 105.625% of the aggregate principal amount of the 2026 CQP Senior Notes redeemed, plus accrued and unpaid interest, if any, to the date of redemption. Cheniere Partners also may at any time on or after October 1, 2020 through the maturity date of October 1, 2025 for the 2025 CQP Senior Notes and October 1, 2021 through the maturity date of October 1, 2026 for the 2026 CQP Senior Notes , redeem the CQP Senior Notes , in whole or in part, at the redemption prices set forth in the respective indentures governing the CQP Senior Notes . +The CQP Senior Notes are Cheniere Partners’ senior obligations, ranking equally in right of payment with Cheniere Partners’ other existing and future unsubordinated debt and senior to any of its future subordinated debt. After applying the proceeds from the 2026 CQP Senior Notes , the CQP Senior Notes became unsecured. In the event that the aggregate amount of Cheniere Partners’ secured indebtedness and the secured indebtedness of the CQP Guarantors (other than the CQP Senior Notes or any other series of notes issued under the CQP Base Indenture ) outstanding at any one time exceeds the greater of (1) $1.5 billion and (2) 10% of net tangible assets, the CQP Senior Notes will be secured to the same extent as such obligations under the CQP Credit Facilities . The obligations under the CQP Credit Facilities are secured on a first-priority basis (subject to permitted encumbrances) with liens on (1) substantially all the existing and future tangible and intangible assets and rights of Cheniere Partners and the CQP Guarantors +40 +and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the CQP Credit Facilities) and (2) substantially all of the real property of SPLNG (except for excluded properties referenced in the CQP Credit Facilities). The liens securing the CQP Senior Notes , if applicable, will be shared equally and ratably (subject to permitted liens) with the holders of other senior secured obligations, which include the CQP Credit Facilities obligations and any future additional senior secured debt obligations. +CQP Credit Facilities +In February 2016, Cheniere Partners entered into the CQP Credit Facilities . The CQP Credit Facilities originally consisted of: (1) a $450 million CTPL tranche term loan that was used to prepay the $400 million term loan facility in February 2016, (2) an approximately $2.1 billion SPLNG tranche term loan that was used to repay and redeem in November 2016 the approximately $2.1 billion of the senior notes previously issued by SPLNG, (3) a $125 million facility that could be used to satisfy a six-month debt service reserve requirement and (4) a $115 million revolving credit facility that may be used for general business purposes. In September 2017 and September 2018, Cheniere Partners issued the 2025 CQP Senior Notes and the 2026 CQP Senior Notes , respectively, and the net proceeds were used to prepay the outstanding term loans under the CQP Credit Facilities . As of December 31, 2018 , only a $115 million revolving credit facility, which is currently undrawn, remains as part of the CQP Credit Facilities . +The CQP Credit Facilities mature on February 25, 2020. Any outstanding balance may be repaid, in whole or in part, at any time without premium or penalty, except for interest hedging and interest rate breakage costs. The CQP Credit Facilities contain conditions precedent for extensions of credit, as well as customary affirmative and negative covenants and limit Cheniere Partners’ ability to make restricted payments, including distributions, to once per fiscal quarter as long as certain conditions are satisfied. Under the CQP Credit Facilities , Cheniere Partners is required to hedge not less than 50% of the variable interest rate exposure on its projected aggregate outstanding balance, maintain a minimum debt service coverage ratio of at least 1.15x at the end of each fiscal quarter beginning March 31, 2019 and have a projected debt service coverage ratio of 1.55x in order to incur additional indebtedness to refinance a portion of the existing obligations. +The CQP Credit Facilities are unconditionally guaranteed by each subsidiary of Cheniere Partners other than (1) SPL and (2) certain subsidiaries of Cheniere Partners owning other development projects, as well as certain other specified subsidiaries and members of the foregoing entities. +Sabine Pass LNG Terminal +Liquefaction Facilities +We are developing, constructing and operating the SPL Project at the Sabine Pass LNG terminal adjacent to the existing regasification facilities. We have received authorization from the FERC to site, construct and operate Trains 1 through 6. We have achieved substantial completion of Trains 1, 2, 3 and 4 of the SPL Project and commenced operating activities in May 2016, September 2016, March 2017 and October 2017, respectively. Train 5 of the SPL Project is undergoing commissioning and the following table summarizes the status as of December 31, 2018 : +SPL Train 5 +Overall project completion percentage +99.7% +Completion percentage of: +Engineering +100% +Procurement +100% +Subcontract work +98.0% +Construction +99.6% +Date of expected substantial completion +1Q 2019 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal: +• +Trains 1 through 4— FTA countries for a 30-year term, which commenced on May 15, 2016, and non-FTA countries for a 20-year term, which commenced on June 3, 2016, in an amount up to a combined total of the equivalent of 16 mtpa (approximately 803 Bcf/yr of natural gas). +41 +• +Trains 1 through 4— FTA countries for a 25-year term and non-FTA countries for a 20-year term in an amount up to a combined total of the equivalent of approximately 203 Bcf/yr of natural gas (approximately 4 mtpa). +• +Trains 5 and 6— FTA countries and non-FTA countries for a 20-year term, in an amount up to a combined total of 503.3 Bcf/yr of natural gas (approximately 10 mtpa). +In each case, the terms of these authorizations begin on the earlier of the date of first export thereunder or the date specified in the particular order, which ranges from five to 10 years from the date the order was issued. In addition, SPL received an order providing for a three-year makeup period with respect to each of the non-FTA orders for LNG volumes SPL was authorized but unable to export during any portion of the initial 20-year export period of such order. +In January 2018, the DOE issued orders authorizing SPL to export domestically produced LNG by vessel from the Sabine Pass LNG terminal to FTA countries and non-FTA countries over a two-year period commencing January 2018, in an aggregate amount up to the equivalent of 600 Bcf of natural gas (however, exports under this order, when combined with exports under the orders above, may not exceed 1,509 Bcf/yr ). +Customers +SPL has entered into fixed price SPA s with terms of at least 20 years (plus extension rights) with six third parties for Trains 1 through 5 of the SPL Project , to make available an aggregate amount of LNG that is between approximately 80% to 95% of the expected aggregate adjusted nominal production capacity from these Trains. Under these SPA s, the customers will purchase LNG from SPL for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub . In certain circumstances, the customers may elect to cancel or suspend deliveries of LNG cargoes, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under SPL’s SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under SPL’s SPAs. The variable fees under SPL’s SPAs were sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation related to, and operating and maintenance costs to produce, the LNG to be sold under each such SPA. The SPA s and contracted volumes to be made available under the SPA s are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. Under SPL’s SPA with BG , BG has contracted for volumes related to Trains 3 and 4, for which the obligation to make volumes related to Train 3 available to BG has commenced and the obligation to make volumes related to Train 4 available to BG is expected to commence approximately one year after the date of first commercial delivery under SPL’s SPA with GAIL for Train 4. +In aggregate, the annual fixed fee portion to be paid by the third-party SPA customers is approximately $2.2 billion for Trains 1 through 3 and the SPA with GAIL for Train 4, increasing to $2.3 billion upon the date of first commercial delivery of Train 4 under the SPA with BG and to $2.9 billion upon the date of first commercial delivery of Train 5, with the applicable fixed fees starting from the date of first commercial delivery from the applicable Train, as specified in each SPA. +In addition, Cheniere Marketing has entered into an SPA with SPL to purchase, at Cheniere Marketing’s option, any LNG produced by SPL in excess of that required for other customers. +Natural Gas Transportation, Storage and Supply +To ensure SPL is able to transport adequate natural gas feedstock to the Sabine Pass LNG terminal, it has entered into transportation precedent and other agreements to secure firm pipeline transportation capacity with CTPL and third-party pipeline companies. SPL has entered into firm storage services agreements with third parties to assist in managing variability in natural gas needs for the SPL Project . SPL has also entered into enabling agreements and long-term natural gas supply contracts with third parties in order to secure natural gas feedstock for the SPL Project . As of December 31, 2018 , SPL had secured up to approximately 3,464 TBtu of natural gas feedstock through long-term and short-term natural gas supply contracts. +Construction +SPL entered into lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Trains 1 through 6 of the SPL Project , under which Bechtel charges a lump sum for all work performed and generally bears project cost +42 +risk unless certain specified events occur, in which case Bechtel may cause SPL to enter into a change order, or SPL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 5 of the SPL Project is approximately $3.1 billion reflecting amounts incurred under change orders through December 31, 2018 . Total expected capital costs for Trains 1 through 5 are estimated to be between $12.5 billion and $13.5 billion before financing costs and between $17.5 billion and $18.5 billion after financing costs including, in each case, estimated owner’s costs and contingencies. The total contract price of the EPC contract for Train 6 of the SPL Project is approximately $2.5 billion , including estimated costs for an optional third marine berth. +Final Investment Decision on Train 6 +SPL has issued limited notices to proceed to Bechtel for the commencement of certain engineering, procurement and site works for Train 6 of the SPL Project and a schedule for completion has been established. FID and full notice to proceed for Train 6 of the SPL Project will be contingent upon, among other things, entering into acceptable commercial arrangements and obtaining adequate financing to construct Train 6. +Regasification Facilities +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4.0 Bcf/d and aggregate LNG storage capacity of approximately 16.9 Bcfe . Approximately 2.0 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term third-party TUA s, under which SPLNG’s customers are required to pay fixed monthly fees, whether or not they use the LNG terminal. Each of Total Gas & Power North America, Inc. (“Total”) and Chevron U.S.A. Inc. (“Chevron”) has reserved approximately 1.0 Bcf/d of regasification capacity and is obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually for 20 years that commenced in 2009. Total S.A. has guaranteed Total ’s obligations under its TUA up to $2.5 billion, subject to certain exceptions, and Chevron Corporation has guaranteed Chevron ’s obligations under its TUA up to 80% of the fees payable by Chevron . +The remaining approximately 2.0 Bcf/d of capacity has been reserved under a TUA by SPL. SPL is obligated to make monthly capacity payments to SPLNG aggregating approximately $250 million annually, continuing until at least May 2036. SPL entered into a partial TUA assignment agreement with Total , whereby upon substantial completion of Train 3 of the SPL Project , SPL gained access to a portion of Total ’s capacity and other services provided under Total ’s TUA with SPLNG. Upon substantial completion of Train 5, SPL will gain access to substantially all of Total ’s capacity. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Trains 5 and 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA. During the years ended December 31, 2018 and 2017 , SPL recorded $30 million and $23 million , respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Under each of these TUA s, SPLNG is entitled to retain 2% of the LNG delivered to the Sabine Pass LNG terminal. +Capital Resources +We currently expect that SPL’s capital resources requirements with respect to the SPL Project will be financed through project debt and borrowings and cash flows under the SPA s. We believe that with the net proceeds of borrowings, available commitments under the SPL Working Capital Facility and cash flows from operations , we will have adequate financial resources available to complete Train 5 of the SPL Project and to meet our currently anticipated capital, operating and debt service requirements. SPL began generating cash flows from operations from the SPL Project in May 2016, when Train 1 achieved substantial completion and initiated operating activities. Trains 2, 3 and 4 subsequently achieved substantial completion in September 2016, March 2017 and October 2017, respectively. We realized offsets to LNG terminal costs of $107 million, $320 million and $214 million in the years ended December 31, 2018, 2017 and 2016 , respectively, that were related to the sale of commissioning cargoes because these amounts were earned or loaded prior to the start of commercial operations of the respective Train during the testing phase for its construction. Additionally, SPLNG generates cash flows from the TUAs, as discussed above. +43 +The following table provides a summary of our capital resources from borrowings and available commitments for the Sabine Pass LNG Terminal, excluding equity contributions to our subsidiaries and cash flows from operations (as described in Sources and Uses of Cash ), at December 31, 2018 and 2017 (in millions): +December 31, +2018 +2017 +Senior notes (1) +$ +16,250 +$ +15,150 +Credit facilities outstanding balance (2) +— +1,090 +Letters of credit issued (3) +425 +730 +Available commitments under credit facilities (3) +775 +470 +Total capital resources from borrowings and available commitments (4) +$ +17,450 +$ +17,440 +(1) +Includes SPL’s 5.625% Senior Secured Notes due 2021, 6.25% Senior Secured Notes due 2022, 5.625% Senior Secured Notes due 2023, 5.75% Senior Secured Notes due 2024, 5.625% Senior Secured Notes due 2025, 5.875% Senior Secured Notes due 2026 (the “2026 SPL Senior Notes”) , 5.00% Senior Secured Notes due 2027 (the “2027 SPL Senior Notes”) , 4.200% Senior Secured Notes due 2028 (the “2028 SPL Senior Notes”) and 5.00% Senior Secured Notes due 2037 (the “2037 SPL Senior Notes”) (collectively, the “SPL Senior Notes”) and Cheniere Partners’ 2025 CQP Senior Notes and 2026 CQP Senior Notes . +(2) +Includes outstanding balance under the SPL Working Capital Facility and CTPL and SPLNG tranche term loans outstanding under the CQP Credit Facilities. +(3) +Consists of SPL Working Capital Facility . Does not include the letters of credit issued or available commitments under the CQP Credit Facilities , which are not specifically for the Sabine Pass LNG Terminal. +(4) +Does not include Cheniere’s additional borrowings from the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes , which may be used for the Sabine Pass LNG Terminal. +For additional information regarding our debt agreements related to the Sabine Pass LNG Terminal, see Note 12—Debt of our Notes to Consolidated Financial Statements. +SPL Senior Notes +The SPL Senior Notes are secured on a pari passu first-priority basis by a security interest in all of the membership interests in SPL and substantially all of SPL’s assets. +At any time prior to three months before the respective dates of maturity for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes and 2037 SPL Senior Notes , in which case the time period is six months before the respective dates of maturity), SPL may redeem all or part of such series of the SPL Senior Notes at a redemption price equal to the “make-whole” price (except for the 2037 SPL Senior Notes , in which case the redemption price is equal to the “optional redemption” price) set forth in the respective indentures governing the SPL Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. SPL may also, at any time within three months of the respective maturity dates for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes and 2037 SPL Senior Notes , in which case the time period is within six months of the respective dates of maturity), redeem all or part of such series of the SPL Senior Notes at a redemption price equal to 100% of the principal amount of such series of the SPL Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +Both the indenture governing the 2037 SPL Senior Notes (the “ 2037 SPL Senior Notes Indenture”) and the common indenture governing the remainder of the SPL Senior Notes (the “SPL Indenture”) include restrictive covenants. SPL may incur additional indebtedness in the future, including by issuing additional notes, and such indebtedness could be at higher interest rates and have different maturity dates and more restrictive covenants than the current outstanding indebtedness of SPL, including the SPL Senior Notes and the SPL Working Capital Facility . Under the 2037 SPL Senior Notes Indenture and the SPL Indenture , SPL may not make any distributions until, among other requirements, deposits are made into debt service reserve accounts as required and a debt service coverage ratio test of 1.25:1.00 is satisfied. Semi-annual principal payments for the 2037 SPL Senior Notes are due on March 15 and September 15 of each year beginning September 15, 2025. +44 +SPL Working Capital Facility +In September 2015, SPL entered into the SPL Working Capital Facility , which is intended to be used for loans to SPL (“SPL Working Capital Loans”) , the issuance of letters of credit on behalf of SPL, as well as for swing line loans to SPL (“SPL Swing Line Loans”) , primarily for certain working capital requirements related to developing and placing into operation the SPL Project . SPL may, from time to time, request increases in the commitments under the SPL Working Capital Facility of up to $760 million and, upon the completion of the debt financing of Train 6 of the SPL Project , request an incremental increase in commitments of up to an additional $390 million. As of December 31, 2018 and 2017 , SPL had $775 million and $470 million of available commitments and $425 million and $730 million aggregate amount of issued letters of credit under the SPL Working Capital Facility , respectively. SPL did no t have any amounts outstanding under the SPL Working Capital Facility as of both December 31, 2018 and 2017 . +The SPL Working Capital Facility matures on December 31, 2020, and the outstanding balance may be repaid, in whole or in part, at any time without premium or penalty upon three business days’ notice. Loans deemed made in connection with a draw upon a letter of credit have a term of up to one year. SPL Swing Line Loans terminate upon the earliest of (1) the maturity date or earlier termination of the SPL Working Capital Facility , (2) the date 15 days after such SPL Swing Line Loan is made and (3) the first borrowing date for a SPL Working Capital Loan or SPL Swing Line Loan occurring at least three business days following the date the SPL Swing Line Loan is made. SPL is required to reduce the aggregate outstanding principal amount of all SPL Working Capital Loans to zero for a period of five consecutive business days at least once each year. +The SPL Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of SPL under the SPL Working Capital Facility are secured by substantially all of the assets of SPL as well as all of the membership interests in SPL on a pari passu basis with the SPL Senior Notes . +Corpus Christi LNG Terminal +Liquefaction Facilities +The CCL Project is being developed and constructed at the Corpus Christi LNG terminal. We have received authorization from the FERC to site, construct and operate Stages 1 and 2 of the CCL Project . The following table summarizes the overall project status of the CCL Project as of December 31, 2018 : +CCL Stage 1 +CCL Stage 2 +Overall project completion percentage +96.7% +42.0% +Completion percentage of: +Engineering +100% +87.0% +Procurement +100% +63.0% +Subcontract work +89.5% +8.5% +Construction +93.1% +11.7% +Expected date of substantial completion +Train 1 +1Q 2019 +Train 3 +2H 2021 +Train 2 +2H 2019 +Separate from the CCH Group, we are also developing Corpus Christi Stage 3 , adjacent to the CCL Project . We filed an application with FERC in June 2018 for seven midscale Trains with an expected aggregate nominal production capacity of approximately 9.5 mtpa and one LNG storage tank. +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Corpus Christi LNG terminal: +• +CCL Project— FTA countries for a 25-year term and to non-FTA countries for a 20-year term up to a combined total of the equivalent of 767 Bcf/yr (approximately 15 mtpa) of natural gas. +• +Corpus Christi Stage 3 —FTA countries for a 20-year term in an amount equivalent to 514 Bcf/yr (approximately 10 mtpa) of natural gas (the “Stage 3 FTA”). The application for authorization to export that same 514 Bcf/yr of domestically produced LNG by vessel to non-FTA countries is currently pending before the DOE (the “Stage 3 Non-FTA”). +In each case, the terms of these authorizations begin on the earlier of the date of first export thereunder or the date specified in the particular order, which ranges from seven to 10 years from the date the order was issued. +45 +In June 2018, we requested that DOE vacate the Stage 3 FTA and permit us to withdraw the pending Stage 3 Non-FTA. These requests were made due to certain changes to Corpus Christi Stage 3. +In conjunction with the submission in June 2018 of our FERC application for Corpus Christi Stage 3 , we submitted a new application for long-term multi-contract authorization to export up to a combined total of 582.14 Bcf/yr (approximately 11.45 mtpa) of natural gas to FTA countries for a 25-year term and to non-FTA countries for a 20-year term. The term of each authorization is expected to begin on the earlier of the date of first commercial export of LNG produced by Corpus Christi Stage 3 or the date which is seven years from the issuance of such authorizations. +Customers +CCL has entered into fixed price SPA s generally with terms of 20 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project , to make available an aggregate amount of LNG that is between approximately 75% to 85% of the expected aggregate adjusted nominal production capacity from these Trains. Under these SPAs, the customers will purchase LNG from CCL for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. In certain circumstances, the customers may elect to cancel or suspend deliveries of LNG cargoes, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under our SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under our SPAs . The variable fee under CCL’s SPAs entered into in connection with the development of the CCL Project was sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation related to, and operating and maintenance costs to produce, the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery for the applicable Train, as specified in each SPA. +In aggregate, the minimum fixed fee portion to be paid by the third-party SPA customers is approximately $550 million for Train 1 and increasing to approximately $1.4 billion for Train 2, in each case upon the date of first commercial delivery for the respective Train, and further increasing to approximately $1.8 billion following the substantial completion of Train 3 of the CCL Project. +In addition, Cheniere Marketing has entered into SPAs with CCL to purchase 15 TBtu per annum of LNG and any LNG produced by CCL in excess of that required for other customers at Cheniere Marketing’s option. +Natural Gas Transportation, Storage and Supply +To ensure CCL is able to transport adequate natural gas feedstock to the Corpus Christi LNG terminal, it has entered into transportation precedent agreements to secure firm pipeline transportation capacity with CCP and certain third-party pipeline companies. CCL has entered into a firm storage services agreement with a third party to assist in managing variability in natural gas needs for the CCL Project . CCL has also entered into enabling agreements and long-term natural gas supply contracts with third parties, and will continue to enter into such agreements, in order to secure natural gas feedstock for the CCL Project . As of December 31, 2018 , CCL had secured up to approximately 2,801 TBtu of natural gas feedstock through long-term natural gas supply contracts, a portion of which is subject to the achievement of certain project milestones and other conditions precedent. +Construction +CCL entered into separate lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Stages 1 and 2 of the CCL Project under which Bechtel charges a lump sum for all work performed and generally bears project cost risk unless certain specified events occur, in which case Bechtel may cause CCL to enter into a change order, or CCL agrees with Bechtel to a change order. +The total contract prices of the EPC contract for Stage 1 and the EPC contract for Stage 2, which do not include the Corpus Christi Pipeline , are approximately $7.8 billion and $2.4 billion , respectively, reflecting amounts incurred under change orders through December 31, 2018 . Total expected capital costs for Trains 1 through 3 are estimated to be between $11.0 billion and $12.0 +46 +billion before financing costs and between $15.0 billion and $16.0 billion after financing costs including, in each case, estimated owner’s costs and contingencies. +Pipeline Facilities +In December 2014, the FERC issued a certificate of public convenience and necessity under Section 7(c) of the Natural Gas Act of 1938, as amended, authorizing CCP to construct and operate the Corpus Christi Pipeline. The Corpus Christi Pipeline is designed to transport 2.25 Bcf/d of natural gas feedstock required by the CCL Project from the existing regional natural gas pipeline grid. The construction of the Corpus Christi Pipeline commenced in January 2017 and was completed in the second quarter of 2018. +Capital Resources +We expect to finance the construction costs of the CCL Project from one or more of the following: project financing, operating cash flows from CCL and CCP and equity contributions to our subsidiaries. We realized offsets to LNG terminal costs of $33 million in the year ended December 31, 2018 that were related to the sale of commissioning cargoes because these amounts were earned or loaded prior to the start of commercial operations of Train 1 during the testing phase for its construction. The following table provides a summary of our capital resources from borrowings and available commitments for the CCL Project, excluding equity contributions to our subsidiaries, at December 31, 2018 and 2017 (in millions): +December 31, +2018 +2017 +Senior notes (1) +$ +4,250 +$ +4,250 +11.0% Convertible Senior Secured Notes due 2025 (2) +1,000 +1,000 +Credit facilities outstanding balance (3) +5,324 +2,485 +Letters of credit issued (3) +316 +164 +Available commitments under credit facilities (3) +1,698 +2,273 +Total capital resources from borrowings and available commitments (4) +$ +12,588 +$ +10,172 +(1) +Includes CCH’s 7.000% Senior Secured Notes due 2024 (the “2024 CCH Senior Notes”) , 5.875% Senior Secured Notes due 2025 (the “2025 CCH Senior Notes”) and 5.125% Senior Secured Notes due 2027 (the “2027 CCH Senior Notes”) (collectively, the “CCH Senior Notes”) . +(2) +Aggregate original principal amount before debt discount and debt issuance costs. +(3) +Includes CCH Credit Facility and CCH Working Capital Facility . +(4) +Does not include Cheniere’s additional borrowings from 2021 Cheniere Convertible Unsecured Notes , 2045 Cheniere Convertible Senior Notes and Cheniere Revolving Credit Facility , which may be used for the CCL Project . +For additional information regarding our debt agreements related to the CCL Project , see Note 12—Debt of our Notes to Consolidated Financial Statements. +2025 CCH HoldCo II Convertible Senior Notes +In May 2015, CCH HoldCo II issued $1.0 billion aggregate principal amount of 11.0% Convertible Senior Secured Notes due 2025 (the “2025 CCH HoldCo II Convertible Senior Notes”) on a private placement basis. The 2025 CCH HoldCo II Convertible Senior Notes are convertible at the option of CCH HoldCo II or the holders, provided that various conditions are met. CCH HoldCo II is restricted from making distributions to Cheniere under agreements governing its indebtedness generally until, among other requirements, Trains 1 and 2 of the CCL Project are in commercial operation and a historical debt service coverage ratio and a projected fixed debt service coverage ratio of 1.20:1.00 are achieved. +In May 2018, the amended and restated note purchase agreement under which the 2025 CCH HoldCo II Convertible Senior Notes were issued was subsequently amended in connection with commercialization and financing of Train 3 of the CCL Project and to provide the note holders with certain prepayment rights related thereto consistent with those under the CCH Credit Facility. All terms of the 2025 CCH HoldCo II Convertible Senior Notes substantially remained unchanged. +47 +CCH Senior Notes +The CCH Senior Notes are jointly and severally guaranteed by CCH’s subsidiaries, CCL, CCP and Corpus Christi Pipeline GP, LLC (the “CCH Guarantors”) . The indenture governing the CCH Senior Notes (the “CCH Indenture”) contains customary terms and events of default and certain covenants that, among other things, limit CCH’s ability and the ability of CCH’s restricted subsidiaries to: incur additional indebtedness or issue preferred stock; make certain investments or pay dividends or distributions on membership interests or subordinated indebtedness or purchase, redeem or retire membership interests; sell or transfer assets, including membership or partnership interests of CCH’s restricted subsidiaries; restrict dividends or other payments by restricted subsidiaries to CCH or any of CCH’s restricted subsidiaries; incur liens; enter into transactions with affiliates; dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of the properties or assets of CCH and its restricted subsidiaries taken as a whole; or permit any CCH Guarantor to dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of its properties and assets. +At any time prior to six months before the respective dates of maturity for each series of the CCH Senior Notes , CCH may redeem all or part of such series of the CCH Senior Notes at a redemption price equal to the “make-whole” price set forth in the CCH Indenture , plus accrued and unpaid interest, if any, to the date of redemption. CCH also may at any time within six months of the respective dates of maturity for each series of the CCH Senior Notes , redeem all or part of such series of the CCH Senior Notes , in whole or in part, at a redemption price equal to 100% of the principal amount of the CCH Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +CCH Credit Facility +In May 2018, CCH amended and restated the CCH Credit Facility to increase total commitments under the CCH Credit Facility from $4.6 billion to $6.1 billion. The obligations of CCH under the CCH Credit Facility are secured by a first priority lien on substantially all of the assets of CCH and its subsidiaries and by a pledge by CCH HoldCo I of its limited liability company interests in CCH. As of December 31, 2018 and 2017 , CCH had $1.0 billion and $2.1 billion of available commitments and $5.2 billion and $2.5 billion of loans outstanding under the CCH Credit Facility , respectively. +The CCH Credit Facility matures on June 30, 2024, with principal payments due quarterly commencing on the earlier of (1) the first quarterly payment date occurring more than three calendar months following the completion of the CCL Project as defined in the common terms agreement and (2) a set date determined by reference to the date under which a certain LNG buyer linked to the last Train of the CCL Project to become operational is entitled to terminate its SPA for failure to achieve the date of first commercial delivery for that agreement. Scheduled repayments will be based upon a 19 -year tailored amortization, commencing the first full quarter after the completion of Trains 1 through 3 and designed to achieve a minimum projected fixed debt service coverage ratio of 1.50 :1. +Under the CCH Credit Facility , CCH is required to hedge not less than 65% of the variable interest rate exposure of its senior secured debt. CCH is restricted from making certain distributions under agreements governing its indebtedness generally until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project , funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25:1.00. +CCH Working Capital Facility +In June 2018, CCH amended and restated the CCH Working Capital Facility to increase total commitments under the CCH Working Capital Facility from $350 million to $1.2 billion. The CCH Working Capital Facility is intended to be used for loans to CCH (“CCH Working Capital Loans”) and the issuance of letters of credit on behalf of CCH for certain working capital requirements related to developing and placing into operations the CCL Project and for related business purposes. Loans under the CCH Working Capital Facility are guaranteed by the CCH Guarantors . CCH may, from time to time, request increases in the commitments under the CCH Working Capital Facility of up to the maximum allowed for working capital under the Common Terms Agreement that was entered into concurrently with the CCH Credit Facility . As of December 31, 2018 and 2017 , CCH had $716 million and $186 million of available commitments, $316 million and $164 million aggregate amount of issued letters of credit and $168 million and no loans outstanding under the CCH Working Capital Facility , respectively. +The CCH Working Capital Facility matures on June 29, 2023, and CCH may prepay the CCH Working Capital Loans and loans made in connection with a draw upon any letter of credit (“CCH LC Loans”) at any time without premium or penalty upon +48 +three business days’ notice and may re-borrow at any time. CCH LC Loans have a term of up to one year. CCH is required to reduce the aggregate outstanding principal amount of all CCH Working Capital Loans to zero for a period of five consecutive business days at least once each year. +The CCH Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of CCH under the CCH Working Capital Facility are secured by substantially all of the assets of CCH and the CCH Guarantors as well as all of the membership interests in CCH and each of the CCH Guarantors on a pari passu basis with the CCH Senior Notes and the CCH Credit Facility . +Restrictive Debt Covenants +As of December 31, 2018 , each of our issuers was in compliance with all covenants related to their respective debt agreements. +Marketing +We market and sell LNG produced by the SPL Project and the CCL Project that is not required for other customers through our integrated marketing function. We are developing a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide, which is primarily sourced by LNG produced by the SPL Project and the CCL Project but supplemented by volume procured from other locations worldwide, as needed. As of December 31, 2018 , we have sold or have options to sell approximately 5,582 TBtu of LNG to be delivered to customers between 2019 and 2045. The cargoes have been sold either on a free on board (“FOB”) basis (delivered to the customer at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal) or a delivered at terminal (“DAT”) basis (delivered to the customer at their LNG receiving terminal). We have chartered LNG vessels to be utilized in DAT transactions. In addition, we have entered into a long-term agreement to sell LNG cargoes on a DAT basis that is conditioned upon the buyer achieving certain milestones. +Cheniere Marketing entered into uncommitted trade finance facilities with available commitments of $370 million as of December 31, 2018 , primarily to be used for the purchase and sale of LNG for ultimate resale in the course of its operations. The finance facilities are intended to be used for advances, guarantees or the issuance of letters of credit or standby letters of credit on behalf of Cheniere Marketing. As of December 31, 2018 and 2017 , Cheniere Marketing had $31 million and $2 million , respectively, in standby letters of credit and guarantees outstanding under the finance facilities. As of December 31, 2018 and 2017 , Cheniere Marketing had $71 million and zero , respectively, in loans outstanding under the finance facilities. Cheniere Marketing pays interest or fees on utilized commitments. +Corporate and Other Activities +We are required to maintain corporate and general and administrative functions to serve our business activities described above. We are also in various stages of developing other projects, including infrastructure projects in support of natural gas supply and LNG demand, which, among other things, will require acceptable commercial and financing arrangements before we make an FID . We have made an equity investment in Midship Pipeline, which is developing a pipeline with expected capacity of up to 1.44 million Dekatherms per day that will connect new gas production in the Anadarko Basin to Gulf Coast markets, including markets serving the SPL Project and the CCL Project . +49 +Sources and Uses of Cash +The following table summarizes the sources and uses of our cash, cash equivalents and restricted cash for the years ended December 31, 2018, 2017 and 2016 (in millions). The table presents capital expenditures on a cash basis; therefore, these amounts differ from the amounts of capital expenditures, including accruals, which are referred to elsewhere in this report. Additional discussion of these items follows the table. +Year Ended December 31, +2018 +2017 +2016 +Operating cash flows +$ +1,990 +$ +1,231 +$ +(404 +) +Investing cash flows +(3,654 +) +(3,381 +) +(4,413 +) +Financing cash flows +2,207 +2,936 +4,908 +Net increase in cash, cash equivalents and restricted cash +543 +786 +91 +Cash, cash equivalents and restricted cash—beginning of period +2,613 +1,827 +1,736 +Cash, cash equivalents and restricted cash—end of period +$ +3,156 +$ +2,613 +$ +1,827 +Operating Cash Flows +Our operating cash flows during the years ended December 31, 2018, 2017 and 2016 were net inflows of $1,990 million and $1,231 million and a net outflow of $404 million , respectively. The $759 million increase in operating cash inflows in 2018 compared to 2017 was primarily related to increased cash receipts from the sale of LNG cargoes, partially offset by increased operating costs and expenses as a result of the additional Trains that were operating at the SPL Project in 2018. We had four Trains operational for the entire year during the year ended December 31, 2018 , we had two Trains operational for the entire year and two Trains operational partially during the year ended December 31, 2017 and two Trains operational partially during the year ended December 31, 2016. The $1.6 billion increase in operating cash inflows in 2017 compared to 2016 was primarily related to increased cash receipts from the sale of LNG cargoes, partially offset by increased operating costs and expenses as a result of the of additional Trains that were operating at the SPL Project in 2017. During the year ended December 31, 2016, Train 1 was operating for seven months and Train 2 was operating for less than four months. +Investing Cash Flows +Investing cash net outflows during the years ended December 31, 2018, 2017 and 2016 were $3,654 million , $3,381 million and $4,413 million , respectively, and were primarily used to fund the construction costs for the SPL Project and the CCL Project . These costs are capitalized as construction-in-process until achievement of substantial completion. Additionally, during the year ended December 31, 2018, we invested an additional $25 million in our equity method investment Midship Holdings, offset primarily by proceeds of $12 million from the sale of our cost method investments. During the year ended December 31, 2017, we invested an additional $41 million in Midship Holdings and made payments of $19 million, primarily for infrastructure to support the CCL Project and other capital projects. Partially offsetting these cash outflows during the year ended December 31, 2017, was a $36 million receipt from the return of collateral payments previously paid for the CCL Project. Partially offsetting these cash outflows was a $36 million receipt during the year ended December 31, 2017 from the return of collateral payments previously paid for the CCL Project. During the years ended December 31, 2016, we used $57 million primarily for collateral payments for the CCL Project, payments to municipal water districts for water system enhancements to increase potable water supply to our export terminals, payments made for capital assets purchased pursuant to information technology services agreements and for investments made in unconsolidated entities. +Financing Cash Flows +Financing cash net inflows during the year ended December 31, 2018 were $2,207 million , primarily as a result of: +• +issuance of an aggregate principal amount of $1.1 billion of the 2026 CQP Senior Notes , which was used to prepay $1.1 billion of the outstanding borrowings under the CQP Credit Facilities ; +• +$2.9 billion of borrowings and $281 million in repayments under the CCH Credit Facility ; +• +$188 million of borrowings and $20 million in repayments under the CCH Working Capital Facility ; +• +$71 million of net borrowings related to our Cheniere Marketing trade financing facilities; +50 +• +$66 million of debt issuance costs related to up-front fees paid upon the closing of these transactions; +• +$17 million in debt extinguishment costs related to the prepayments of the CQP Credit Facilities and the CCH Credit Facility ; +• +$576 million of distributions and dividends to non-controlling interest by Cheniere Partners and Cheniere Holdings; +• +$20 million paid for tax withholdings for share-based compensation; and +• +$7 million of transaction costs to acquire additional interest of Cheniere Holdings. +Financing cash net inflows during the year ended December 31, 2017 were $2,936 million , primarily as a result of: +• +issuances of SPL’s senior notes for an aggregate principal amount $2.15 billion; +• +$55 million of borrowings and $369 million of repayments made under the credit facilities SPL entered into in June 2015 (the “SPL Credit Facilities”) ; +• +$110 million of borrowings and $334 million of repayments made under the SPL Working Capital Facility ; +• +$1.5 billion of borrowings under the CCH Credit Facility ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2027 CCH Senior Notes , which was used to prepay $1.4 billion of outstanding borrowings under the CCH Credit Facility ; +• +$24 million of borrowings and $24 million of repayments made under the CCH Working Capital Facility ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2025 CQP Senior Notes , which was used to prepay $1.5 billion of the outstanding borrowings under the CQP Credit Facilities ; +• +$24 million in net repayments made under the Cheniere Marketing trade finance facilities; +• +$89 million of debt issuance and deferred financing costs related to up-front fees paid upon the closing of these transactions; +• +$185 million of distributions and dividends to non-controlling interest by Cheniere Partners and Cheniere Holdings; and +• +$12 million paid for tax withholdings for share-based compensation. +Financing cash net inflows during the year ended December 31, 2016 were $4,908 million , primarily as a result of: +• +$2.6 billion of borrowings under the CQP Credit Facilities used to prepay the $400 million CTPL term loan facility and redeem and repay $2.1 billion of the senior notes previously issued by SPLNG; +• +$2.0 billion of borrowings under the SPL Credit Facilities ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2026 SPL Senior Notes in June 2016, which was used to prepay $1.3 billion of the outstanding borrowings under the SPL Credit Facilities ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2027 SPL Senior Notes in September 2016, which was used to prepay $1.2 billion of the outstanding borrowings under the SPL Credit Facilities and pay a portion of the capital costs in connection with the construction of Trains 1 through 5 of the SPL Project; +• +$474 million of borrowings and $265 million of repayments made under the SPL Working Capital Facility; +• +$2.1 billion of borrowings under the CCH Credit Facility ; +• +issuances of aggregate principal amounts of $1.25 billion of the 2024 CCH Senior Notes and $1.5 billion of the 2025 CCH Senior Notes in December 2016, which were used to prepay $2.4 billion of the outstanding borrowings under the CCH Credit Facility ; +• +$24 million in net borrowings under the Cheniere Marketing trade finance facilities; +• +$172 million of debt issuance costs related to up-front fees paid upon the closing of these transactions; +• +$14 million of debt extinguishment costs paid in connection with redemptions and prepayments of outstanding borrowings; +51 +• +$80 million of distributions and dividends to non-controlling interest by Cheniere Partners and Cheniere Holdings; and +• +$20 million paid for tax withholdings for share-based compensation. +Contractual Obligations +We are committed to make cash payments in the future pursuant to certain of our contracts. The following table summarizes certain contractual obligations in place as of December 31, 2018 (in millions): +Payments Due By Period (1) +Total +2019 +2020 - 2021 +2022 - 2023 +Thereafter +Debt (2) +$ +29,395 +$ +168 +$ +3,368 +$ +2,500 +$ +23,359 +Interest payments (2) +10,258 +1,480 +3,102 +2,776 +2,900 +Construction obligations (3) +1,525 +980 +545 +— +— +Purchase obligations (4) +11,848 +3,218 +3,444 +1,828 +3,358 +Capital lease obligations (5) +98 +5 +10 +10 +73 +Operating lease obligations (6) +2,329 +380 +422 +528 +999 +Obligations to related parties (7) +96 +2 +19 +19 +56 +Other obligations (8) +286 +20 +63 +74 +129 +Total +$ +55,835 +$ +6,253 +$ +10,973 +$ +7,735 +$ +30,874 +(1) +Agreements in force as of December 31, 2018 that have terms dependent on project milestone dates are based on the estimated dates as of December 31, 2018 . +(2) +Based on the total debt balance, scheduled maturities and interest rates in effect at December 31, 2018 . See Note 12—Debt of our Notes to Consolidated Financial Statements. +(3) +Construction obligations primarily relate to the EPC contracts for the SPL Project and the CCL Project . The estimated remaining cost pursuant to our EPC contracts as of December 31, 2018 is included for Trains with respect to which we have made an FID to commence construction; the EPC contract termination amount is included for Trains with respect to which we have not made an FID. A discussion of these obligations can be found at Note 19—Commitments and Contingencies of our Notes to Consolidated Financial Statements. +(4) +Purchase obligations consist of contracts for which conditions precedent have been met, and primarily relate to natural gas supply, transportation and storage services for the SPL Project and the CCL Project . As project milestones and other conditions precedent are achieved, our obligations are expected to increase accordingly. +(5) +Capital lease obligations consist of tug leases related to the CCL Project , as further discussed in Note 18—Leases of our Notes to Consolidated Financial Statements. +(6) +Operating lease obligations primarily relate to LNG vessel time charters, land sites related to the SPL Project and the CCL Project and corporate office leases, and includes payments for certain non-lease components. A discussion of these obligations can be found in Note 18—Leases of our Notes to Consolidated Financial Statements. +(7) +Obligations to Midship Pipeline Company, LLC under CCL’s transportation precedent agreement to secure firm pipeline transportation capacity for the CCL Project . +(8) +Other obligations primarily relate to agreements with certain local taxing jurisdictions, and are based on estimated tax obligations as of December 31, 2018 . Also included are payments for non-lease components related to our capital lease obligations. +In addition, in the ordinary course of business, we maintain letters of credit and have certain cash restricted in support of certain performance obligations of our subsidiaries. As of December 31, 2018 , we had $741 million aggregate amount of issued letters of credit under our credit facilities and $2.2 billion of current restricted cash. For more information, see Note 3—Restricted Cash of our Notes to Consolidated Financial Statements. +52 +Results of Operations +The following table summarizes the volumes of operational and commissioning LNG cargoes that were loaded from the SPL Project and the CCL Project recognized on our Consolidated Financial Statements during the year ended December 31, 2018 : +Year Ended December 31, 2018 +(in TBtu) +Operational +Commissioning +Volumes loaded during the current period +955 +20 +Volumes loaded during the prior period but recognized during the current period +43 +— +Less: volumes loaded during the current period and in transit at the end of the period +(25 +) +(3 +) +Total volumes recognized in the current period +973 +17 +Our consolidated net income attributable to common stockholders was $471 million , or $1.92 per share—basic and $1.90 per share—diluted, in the year ended December 31, 2018 , compared to net loss attributable to common stockholders of $393 million , or $1.68 per share (basic and diluted), in the year ended December 31, 2017 . This $864 million increase in net income attributable to common stockholders in 2018 is primarily attributable to increased income from operations due to additional Trains operating between the periods, decreased loss on modification or extinguishment of debt and increased derivative gain, net, which were partially offset by decreased net income attributable to non-controlling interest and increased interest expense, net of amounts capitalized. +Our consolidated net loss attributable to common stockholders was $610 million, or $2.67 per share (basic and diluted), in the year ended December 31, 2016. The $217 million decrease in net loss in 2017 compared to 2016 was primarily a result of increased income from operations, which was partially offset by increased allocation of net income to non-controlling interest and increased interest expense, net of amounts capitalized. +Revenues +Year Ended December 31, +(in millions) +2018 +2017 +Change +2016 +Change +LNG revenues +$ +7,572 +$ +5,317 +$ +2,255 +$ +1,016 +$ +4,301 +Regasification revenues +261 +260 +1 +259 +1 +Other revenues +142 +21 +121 +8 +13 +Other—related party +12 +3 +9 +— +3 +Total revenues +$ +7,987 +$ +5,601 +$ +2,386 +$ +1,283 +$ +4,318 +2018 vs. 2017 and 2017 vs. 2016 +We begin recognizing LNG revenues from the SPL Project following the substantial completion and the commencement of operating activities of the respective Trains. We had four Trains operational for the entire year during the year ended December 31, 2018 , we had two Trains operational for the entire year and two Trains operational partially during the year ended December 31, 2017 and two Trains operational partially during the year ended December 31, 2016. The increase in revenues during each of the years was primarily attributable to the increased volume of LNG sold following the achievement of substantial completion of these Trains. There was an additional increase during the year ended December 31, 2018 from the comparable period in 2017 due to an increase in sub-chartering revenues, which is included in other revenues. There was an additional increase during the year ended year ended December 31, 2017 from the comparable period in 2016 due to increased revenues per MMBtu as a result of shift in sales made at current market prices by our integrated marketing function to sales made under our long-term SPA. We expect our LNG revenues to increase in the future upon Train 5 of the SPL Project and Trains 1 through 3 of the CCL Project becoming operational. +Prior to substantial completion of a Train, amounts received from the sale of commissioning cargoes from that Train are offset against LNG terminal construction-in-process, because these amounts are earned or loaded during the testing phase for the construction of that Train. During the years ended December 31, 2018, 2017 and 2016 , we realized offsets to LNG terminal costs of $140 million corresponding to 17 TBtu of LNG, $320 million corresponding to 51 TBtu of LNG and $214 million corresponding to 45 TBtu of LNG that were related to the sale of commissioning cargoes from the SPL Project and the CCL Project . +53 +The following table presents the components of LNG revenues and the corresponding LNG volumes sold. +Year Ended December 31, +2018 +2017 +2016 +LNG revenues (in millions) : +LNG from the SPL Project sold under SPL’s third party long-term SPAs +$ +4,677 +$ +2,588 +$ +458 +LNG from the SPL Project sold by our integrated marketing function +1,987 +1,756 +319 +LNG procured from third parties +745 +981 +236 +Other revenues and derivative gains (losses) +163 +(8 +) +3 +Total LNG revenues +$ +7,572 +$ +5,317 +$ +1,016 +Volumes sold as LNG revenues (in TBtu) : +LNG from the SPL Project sold under SPL’s third party long-term SPAs +750 +427 +85 +LNG from the SPL Project sold by our integrated marketing function +223 +233 +47 +LNG procured from third parties +84 +98 +26 +Total volumes sold as LNG revenues +1,057 +758 +158 +Operating costs and expenses +Year Ended December 31, +(in millions) +2018 +2017 +Change +2016 +Change +Cost of sales +$ +4,597 +$ +3,120 +$ +1,477 +$ +582 +$ +2,538 +Operating and maintenance expense +613 +446 +167 +216 +230 +Development expense +7 +10 +(3 +) +7 +3 +Selling, general and administrative expense +289 +256 +33 +260 +(4 +) +Depreciation and amortization expense +449 +356 +93 +174 +182 +Restructuring expense +— +6 +(6 +) +61 +(55 +) +Impairment expense and loss on disposal of assets +8 +19 +(11 +) +13 +6 +Total operating costs and expenses +$ +5,963 +$ +4,213 +$ +1,750 +$ +1,313 +$ +2,900 +2018 vs. 2017 and 2017 vs. 2016 +Our total operating costs and expenses increased during the year ended December 31, 2018 from the years ended December 31, 2017 and 2016, primarily as a result of additional Trains that were operating between each of the periods. +Cost of sales increased during the year ended December 31, 2018 from the comparable periods in 2017 and 2016, primarily as a result of the increase in operating Trains between each of the periods. Cost of sales includes costs incurred directly for the production and delivery of LNG from the SPL Project , to the extent those costs are not utilized for the commissioning process. The increase during the year ended December 31, 2018 from the comparable period in 2017 was primarily related to the increase in the volume of natural gas feedstock related to our LNG sales. The increase during the year ended December 31, 2017 from the comparable period in 2016 was primarily related to the increase in both the volume and pricing of natural gas feedstock related to our LNG sales and cost of LNG procured from third parties. Cost of sales also includes gains and losses from derivatives associated with economic hedges to secure natural gas feedstock for the SPL Project and CCL Project , vessel charter costs, port and canal fees, variable transportation and storage costs and other costs to convert natural gas into LNG. +Operating and maintenance expense increased during the year ended December 31, 2018 from the comparable periods in 2017 and 2016, as a result of the increase in operating Trains between each of the periods. Operating and maintenance expense primarily includes costs associated with operating and maintaining the SPL Project and CCL Project . The increase during the year ended December 31, 2018 from the comparable periods in 2017 and 2016 was primarily related to third-party service and maintenance contract costs, payroll and benefit costs of operations personnel, and natural gas transportation and storage capacity demand charges. Operating and maintenance expense also includes TUA reservation charges as a result of payments under the partial TUA assignment agreement with Total, insurance and regulatory costs and other operating costs. +Depreciation and amortization expense increased during the year ended December 31, 2018 from the comparable periods in 2017 and 2016 as a result of an increased number of operational Trains, as the assets related to the Trains of the SPL Project +54 +began depreciating upon reaching substantial completion and the assets related to Corpus Christi Pipeline began depreciating upon completion of the construction. +Impairment expense and loss on disposal of assets decreased during the year ended December 31, 2018 compared to the years ended December 31, 2017 and 2016. The impairment expense and loss on disposal of assets recognized during the year ended December 31, 2018 related to the write down of prepaid assets. The impairment expense and loss on disposal of assets recognized during the years ended December 31, 2017 and 2016 related to write down of assets used in non-core operations outside of our liquefaction activities. The impairment expense and loss on disposal of assets recognized during the year ended December 31, 2017 also included $6 million related to damaged infrastructure as an effect of Hurricane Harvey. +We expect our operating costs and expenses to generally increase in the future upon Train 5 of the SPL Project achieving substantial completion, although certain costs will not proportionally increase with the number of operational Trains as cost efficiencies will be realized, as well as upon Trains 1 through 3 of the CCL Project becoming operational. +Other expense (income) +Year Ended December 31, +(in millions) +2018 +2017 +Change +2016 +Change +Interest expense, net of capitalized interest +$ +875 +$ +747 +$ +128 +$ +488 +$ +259 +Loss on modification or extinguishment of debt +27 +100 +(73 +) +135 +(35 +) +Derivative loss (gain), net +(57 +) +(7 +) +(50 +) +10 +(17 +) +Other income +(48 +) +(18 +) +(30 +) +— +(18 +) +Total other expense +$ +797 +$ +822 +$ +(25 +) +$ +633 +$ +189 +2018 vs. 2017 +Interest expense, net of capitalized interest, increased during the year ended December 31, 2018 compared to the year ended December 31, 2017 , as a result of increased outstanding debt (before unamortized premium, discount and debt issuance costs, net) from $26.1 billion as of December 31, 2017 to $29.2 billion as of December 31, 2018 primarily due to increased borrowings under the CCH Credit Facility , as well as a decrease in the portion of total interest costs that could be capitalized as additional Trains of the SPL Project completed construction between the periods. For the years ended December 31, 2018 and 2017 , we incurred $1.7 billion and $1.5 billion of total interest cost, respectively, of which we capitalized $803 million and $779 million , respectively, which was primarily related to the construction of the SPL Project and the CCL Project. +Loss on modification or extinguishment of debt decreased during the year ended December 31, 2018 , as compared to the year ended December 31, 2017 . Loss on modification or extinguishment of debt recognized in 2018 was attributable to the incurrence of third party fees and write off of unamortized debt issuance costs of (1) $15 million recognized in June 2018 upon amendment and restatement of the CCH Credit Facility and (2) $12 million recognized in September 2018 upon termination of approximately $1.2 billion of commitments under the CQP Credit Facilities in connection with the issuance of the 2026 CQP Senior Notes. Loss on modification or extinguishment of debt recognized in 2017 was attributable to the write-offs of debt issuance costs of (1) $42 million in March 2017 upon termination of the remaining available balance of $1.6 billion under the SPL Credit Facilities in connection with the issuance of the 2028 SPL Senior Notes and the 2037 SPL Senior Notes ; (2) $33 million in May 2017 upon the prepayment of approximately $1.4 billion of outstanding borrowings under the CCH Credit Facility in connection with the issuance of the 2027 CCH Senior Notes; and (3) $25 million in September 2017 related to the prepayment of $1.5 billion of the outstanding indebtedness under the CQP Credit Facilities in connection with the issuance of the 2025 CQP Senior Notes. +Derivative gain, net increased during the year ended December 31, 2018 compared to the year ended December 31, 2017 , primarily due to a favorable shift in the long-term forward LIBOR curve between the periods. During the year ended December 31, 2018 , we also received $5 million of proceeds in June 2018 upon the termination of interest rate swaps associated with the amendment and restatement of the CCH Credit Facility and $28 million of proceeds in October 2018 upon the termination of the interest rate swaps (“CQP Interest Rate Derivatives”) previously held to hedge a portion of the variable interest payments on its CQP Credit Facilities . During the year ended December 31, 2017 , we paid $7 million upon the termination of interest rate swaps associated with the termination of the SPL Credit Facilities and a $13 million in May 2017 in conjunction with the termination of approximately $1.4 billion of commitments under the CCH Credit Facility . +55 +Other income increased during the year ended December 31, 2018 as compared to the year ended December 31, 2017 , primarily due to an increase in interest income earned on our cash and cash equivalents. +2017 vs. 2016 +Interest expense, net of capitalized interest, increased during the year ended December 31, 2017 compared to the year ended December 31, 2016, primarily as a result of an increase in our indebtedness outstanding (before unamortized premium, discount and debt issuance costs, net), from $22.7 billion as of December 31, 2016 to $26.1 billion as of December 31, 2017, and a decrease in the portion of total interest costs that could be capitalized as Trains 1 through 4 of the SPL Project completed construction. For the year ended December 31, 2016, we incurred $1.3 billion of total interest cost, of which we capitalized $813 million which was primarily related to the construction of the SPL Project and the CCL Project. +Loss on modification or extinguishment of debt decreased during the year ended December 31, 2017, as compared to the year ended December 31, 2016. Loss on modification or extinguishment of debt during the year ended December 31, 2016 was attributable to (1) $63 million write-off of debt issuance costs related to the $2.4 billion prepayment of outstanding borrowings under the CCH Credit Facility in connection with the issuance of the 2024 CCH Senior Notes and the 2025 CCH Senior Notes, (2) $52 million write-off of debt issuance costs and payment of fees related to the $2.6 billion prepayment of outstanding borrowings and termination of commitments under the SPL Credit Facilities in connection with the issuance of the 2026 SPL Senior Notes and the 2027 SPL Senior Notes and (3) $20 million write-off of debt issuance costs and unamortized discount in connection with the prepayment of the CTPL term loan facility and the redemption of the senior notes due 2020 previously issued by SPLNG. +Derivative gain, net increased from a loss during year ended December 31, 2016 to a gain during the year ended December 31, 2017, primarily due to a favorable shift in the long-term forward LIBOR curve between the periods. +Income tax provision +Year Ended December 31, +(in millions) +2018 +2017 +Change +2016 +Change +Income (loss) before income taxes and non-controlling interest +$ +1,227 +$ +566 +$ +661 +$ +(663 +) +$ +1,229 +Income tax provision +27 +3 +24 +2 +1 +Effective tax rate +2.2 +% +0.5 +% +(0.3 +)% +2018 vs. 2017 and 2017 vs. 2016 +Changes in the income tax recorded between comparative periods are primarily attributable to fluctuations in the profitability of our U.K. integrated marketing function. The effective tax rates during each of the years ended December 31, 2018, 2017 and 2016 were lower than the 21%, 35% and 35% federal statutory rates during the years ended December 31, 2018, 2017 and 2016 , respectively, primarily as a result of maintaining a valuation allowance against our federal and state net deferred tax assets. Given our current and anticipated future earnings, we believe that there is a reasonable possibility that within the next 12 to 24 months, sufficient positive evidence may become available to allow us to conclude that a significant portion of the valuation allowance will no longer be needed. The release of the valuation allowance would result in the recognition of certain deferred tax assets and an income tax benefit in the period the release is recorded. However, the precise timing and amount of the valuation allowance release are subject to change on the basis of the level of profitability that we are able to achieve. +Net income (loss) attributable to non-controlling interest +Year Ended December 31, +(in millions) +2018 +2017 +Change +2016 +Change +Net income (loss) attributable to non-controlling interest +$ +729 +$ +956 +$ +(227 +) +$ +(55 +) +$ +1,011 +2018 vs. 2017 +Net income attributable to non-controlling interest decreased during the year ended December 31, 2018 from the year ended December 31, 2017 due to the nonrecurrence of non-cash amortization of the beneficial conversion feature on Cheniere Partners’ +56 +Class B units that occurred during the comparable period in 2017, which was partially offset by the increase in consolidated net income recognized by Cheniere Partners in which the non-controlling interests are held, adjusting for the increase in the share of Cheniere Partners’ net income that is attributed to non-controlling interest holders as a result of changes in ownership percentages between years. Net income attributable to non-controlling interest during the year ended December 31, 2017 included approximately $748 million due to amortization of the beneficial conversion feature on Cheniere Partners’ Class B units, which ceased upon the conversion of Cheniere Partners’ Class B units into common units. The consolidated net income recognized by Cheniere Partners increased from $490 million in the year ended December 31, 2017 to $1.3 billion in the year ended December 31, 2018 , primarily as a result of the additional Trains that were operating at the SPL Project between the periods. Partially offsetting the decrease in net income attributable to non-controlling interest was an increase in ownership percentage by non-controlling interest holders between the periods as a result of the conversion of Cheniere Partners’ Class B units into common units on August 2, 2017. +We expect the portion of our net income attributable to non-controlling interest to generally decrease in the future as a result of our merger with Cheniere Holdings, in which all publicly-held shares of Cheniere Holdings were canceled and the non-controlling interest in Cheniere Holdings was reduced to zero. +2017 vs. 2016 +Net income attributable to non-controlling interest increased during the year ended December 31, 2017 from the year ended 2016 was primarily due to the amortization of the beneficial conversion feature on Cheniere Partners’ Class B units and the increase in consolidated net income recognized by Cheniere Partners in which the non-controlling interest is held. Net income attributable to non-controlling interest was increased by $714 million for non-cash amortization of the beneficial conversion feature on Cheniere Partners’ Class B units during the year ended December 31, 2017. Although the amortization of the beneficial conversion feature on Cheniere Partners’ Class B units ceased upon the conversion of these units into common units on August 2, 2017, the share of Cheniere Partners’ net income (loss) that is attributed to non-controlling interest holders increased from that date to December 31, 2017 as a result of the increased ownership percentage by non-controlling interest holders. The consolidated net income recognized by Cheniere Partners increased from a net loss of $171 million in the year ended December 31, 2016 to net income of $490 million in the year ended December 31, 2017, primarily due to the increase in income from operations as a result of the additional Trains that were operating at the SPL Project between the periods, which was partially offset by increased interest expense, net of amounts capitalized. +Off-Balance Sheet Arrangements +We have interests in an unconsolidated variable interest entity (“VIE”) as discussed in Note 8—Other Non-Current Assets of our Notes to Consolidated Financial Statements in this annual report, which we consider to be an off-balance sheet arrangement. We believe that this VIE does not have a current or future material effect on our consolidated financial position or operating results. +Summary of Critical Accounting Estimates +The preparation of Consolidated Financial Statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Management evaluates its estimates and related assumptions regularly, including those related to the valuation of derivative instruments, properties, plant and equipment and income taxes. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. Management considers the following to be its most critical accounting estimates that involve significant judgment. +Derivative Instruments +All derivative instruments, other than those that satisfy specific exceptions, are recorded at fair value. We record changes in the fair value of our derivative positions based on the value for which the derivative instrument could be exchanged between willing parties. If market quotes are not available to estimate fair value, management’s best estimate of fair value is based on the quoted market price of derivatives with similar characteristics or determined through industry-standard valuation approaches. Such evaluations may involve significant judgment and the results are based on expected future events or conditions, particularly for those valuations using inputs unobservable in the market. +Our derivative instruments consist of interest rate swaps, financial commodity derivative contracts transacted in an over-the-counter market, index-based physical commodity contracts and foreign currency exchange (“FX”) contracts. We value +57 +our interest rate swaps using observable inputs including interest rate curves, risk adjusted discount rates, credit spreads and other relevant data. Valuation of our financial commodity derivative contracts is determined using observable commodity price curves and other relevant data. Valuation of our index-based physical commodity contracts is developed through the use of internal models which are impacted by inputs that may be unobservable in the marketplace, market transactions and other relevant data. We estimate the fair values of our FX derivative instruments using observable FX rates and other relevant data. +Gains and losses on derivative instruments are recognized in earnings. The ultimate fair value of our derivative instruments is uncertain, and we believe that it is reasonably possible that a change in the estimated fair value could occur in the near future as interest rates, commodity prices and FX rates change. +Income Taxes +Deferred income tax assets and liabilities are recognized for temporary differences between the basis of assets and liabilities for financial reporting and tax purposes. Deferred tax assets are reduced by a valuation allowance if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. In determining the need for a valuation allowance we consider current and historical financial results, expectations for future taxable income and the availability of tax planning strategies that can be implemented, if necessary, to realize deferred tax assets. We have recorded a full valuation allowance on our net federal and state deferred tax assets as of both December 31, 2018 and 2017 . We intend to maintain a valuation allowance on our net federal and state deferred tax assets until there is sufficient evidence to support the reversal of these allowances. +We recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The largest amount of the tax benefit that is greater than 50 percent likely of being effectively settled is recorded. Changes in these unrecognized tax benefits may result from remeasurement of amounts expected to be realized, settlements with tax authorities and expiration of statutes of limitations. +See Note 14—Income Taxes of our Notes to Consolidated Financial Statements for further discussion of our accounting for income taxes. +Recent Accounting Standards +For descriptions of recently issued accounting standards, see Note 22—Recent Accounting Standards of our Notes to Consolidated Financial Statements. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Cash Investments +We have cash investments that we manage based on internal investment guidelines that emphasize liquidity and preservation of capital. Such cash investments are stated at historical cost, which approximates fair market value on our Consolidated Balance Sheets. +Marketing and Trading Commodity Price Risk +We have entered into commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the SPL Project and the CCL Project (“Liquefaction Supply Derivatives”) . We have also entered into financial derivatives to hedge the exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG (“LNG Trading Derivatives”) . In order to test the sensitivity of the fair value of the Liquefaction Supply Derivatives and the LNG Trading Derivatives to changes in underlying commodity prices, management modeled a 10% change in the commodity price for natural gas for each delivery location and a 10% change in the commodity price for LNG, respectively, as follows (in millions): +December 31, 2018 +December 31, 2017 +Fair Value +Change in Fair Value +Fair Value +Change in Fair Value +Liquefaction Supply Derivatives +$ +(42 +) +$ +6 +$ +55 +$ +5 +LNG Trading Derivatives +(24 +) +9 +(8 +) +2 +58 +Interest Rate Risk +We are exposed to interest rate risk primarily when we incur debt related to project financing. Interest rate risk is managed in part by replacing outstanding floating-rate debt with fixed-rate debt with varying maturities. CCH has also entered into interest rate swaps to hedge the exposure to volatility in a portion of the floating-rate interest payments under the CCH Credit Facility (“CCH Interest Rate Derivatives”). CQP previously had the CQP Interest Rate Derivatives to hedge the exposure to volatility in a portion of the floating-rate interest payments under the CQP Credit Facilities . In order to test the sensitivity of the fair value of the CCH Interest Rate Derivatives to changes in interest rates, management modeled a 10% change in the forward 1-month LIBOR curve across the remaining terms of the CCH Interest Rate Derivatives as follows (in millions): +December 31, 2018 +December 31, 2017 +Fair Value +Change in Fair Value +Fair Value +Change in Fair Value +CCH Interest Rate Derivatives +$ +18 +$ +37 +$ +(32 +) +$ +44 +Foreign Currency Exchange Risk +We have entered into FX contracts to hedge exposure to currency risk associated with operations in countries outside of the United States (“FX Derivatives”) . In order to test the sensitivity of the fair value of the FX Derivatives to changes in FX rates, management modeled a 10% change in FX rate between the U.S. dollar and the applicable foreign currencies as follows (in millions): +December 31, 2018 +December 31, 2017 +Fair Value +Change in Fair Value +Fair Value +Change in Fair Value +FX Derivatives +$ +15 +$ +1 +$ +(1 +) +$ +— +See Note 7—Derivative Instruments for additional details about our derivative instruments. +59 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +CHENIERE ENERGY, INC. AND SUBSIDIARIES +Management’s Report to the Stockholders of Cheniere Energy, Inc. +61 +Reports of Independent Registered Public Accounting Firm +62 +Consolidated Balance Sheets +64 +Consolidated Statements of Operations +65 +Consolidated Statements of Stockholders’ Equity +66 +Consolidated Statements of Cash Flows +67 +Notes to Consolidated Financial Statements +68 +Supplemental Information to Consolidated Financial Statements—Summarized Quarterly Financial Data +109 +60 +MANAGEMENT’S REPORT TO THE STOCKHOLDERS OF CHENIERE ENERGY, INC. +Management’s Report on Internal Control Over Financial Reporting +As management, we are responsible for establishing and maintaining adequate internal control over financial reporting for Cheniere Energy, Inc. and its subsidiaries (“Cheniere”). In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we have conducted an assessment, including testing using the criteria in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Cheniere’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and, even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. +Based on our assessment, we have concluded that Cheniere maintained effective internal control over financial reporting as of December 31, 2018 , based on criteria in Internal Control—Integrated Framework (2013) issued by the COSO. +Cheniere’s independent registered public accounting firm, KPMG LLP, has issued an audit report on Cheniere’s internal control over financial reporting as of December 31, 2018 , which is contained in this Form 10-K. +Management’s Certifications +The certifications of Cheniere’s Chief Executive Officer and Chief Financial Officer required by the Sarbanes-Oxley Act of 2002 have been included as Exhibits 31 and 32 in Cheniere’s Form 10-K. +CHENIERE ENERGY, INC. +By: +/s/ Jack A. Fusco +By: +/s/ Michael J. Wortley +Jack A. Fusco +Michael J. Wortley +President and Chief Executive Officer +(Principal Executive Officer) +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +61 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and Board of Directors +Cheniere Energy, Inc.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of Cheniere Energy, Inc. and subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedule I (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 25, 2019 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Change in Accounting Principle +As discussed in Note 2 to the consolidated financial statements, the Company has changed its method of accounting for revenue recognition in 2018, 2017 and 2016 due to the adoption of ASU 2014-09, Revenue from Contracts with Customers (Topic 606) , and subsequent amendments thereto. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ KPMG LLP +KPMG LLP +We have served as the Company’s auditor since 2014. +Houston, Texas +February 25, 2019 +62 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and Board of Directors +Cheniere Energy, Inc.: +Opinion on Internal Control Over Financial Reporting +We have audited Cheniere Energy, Inc.’s and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedule I (collectively, the consolidated financial statements), and our report dated February 25, 2019 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +KPMG LLP +Houston, Texas +February 25, 2019 +63 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +(in millions, except share data) +December 31, +2018 +2017 +ASSETS +Current assets +Cash and cash equivalents +$ +981 +$ +722 +Restricted cash +2,175 +1,880 +Accounts and other receivables +581 +369 +Accounts receivable—related party +4 +2 +Inventory +316 +243 +Derivative assets +63 +57 +Other current assets +114 +96 +Total current assets +4,234 +3,369 +Non-current restricted cash +— +11 +Property, plant and equipment, net +27,245 +23,978 +Debt issuance costs, net +72 +149 +Non-current derivative assets +54 +34 +Goodwill +77 +77 +Other non-current assets, net +305 +288 +Total assets +$ +31,987 +$ +27,906 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities +Accounts payable +$ +58 +$ +25 +Accrued liabilities +1,169 +1,078 +Current debt +239 +— +Deferred revenue +139 +111 +Derivative liabilities +128 +37 +Other current liabilities +9 +— +Total current liabilities +1,742 +1,251 +Long-term debt, net +28,179 +25,336 +Non-current capital lease obligations +57 +— +Non-current derivative liabilities +22 +19 +Other non-current liabilities +58 +60 +Commitments and contingencies (see Note 19) +Stockholders’ equity +Preferred stock, $0.0001 par value, 5.0 million shares authorized, none issued +— +— +Common stock, $0.003 par value +Authorized: 480.0 million shares at December 31, 2018 and 2017 +Issued: 269.8 million shares and 250.1 million shares at December 31, 2018 and 2017, respectively +Outstanding: 257.0 million shares and 237.6 million shares at December 31, 2018 and 2017, respectively +1 +1 +Treasury stock: 12.8 million shares and 12.5 million shares at December 31, 2018 and 2017, respectively, at cost +(406 +) +(386 +) +Additional paid-in-capital +4,035 +3,248 +Accumulated deficit +(4,156 +) +(4,627 +) +Total stockholders’ deficit +(526 +) +(1,764 +) +Non-controlling interest +2,455 +3,004 +Total equity +1,929 +1,240 +Total liabilities and equity +$ +31,987 +$ +27,906 +The accompanying notes are an integral part of these consolidated financial statements. +64 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +(in millions, except per share data) +Year Ended December 31, +2018 +2017 +2016 +Revenues +LNG revenues +$ +7,572 +$ +5,317 +$ +1,016 +Regasification revenues +261 +260 +259 +Other revenues +142 +21 +8 +Other—related party +12 +3 +— +Total revenues +7,987 +5,601 +1,283 +Operating costs and expenses +Cost of sales (excluding depreciation and amortization expense shown separately below) +4,597 +3,120 +582 +Operating and maintenance expense +613 +446 +216 +Development expense +7 +10 +7 +Selling, general and administrative expense +289 +256 +260 +Depreciation and amortization expense +449 +356 +174 +Restructuring expense +— +6 +61 +Impairment expense and loss on disposal of assets +8 +19 +13 +Total operating costs and expenses +5,963 +4,213 +1,313 +Income (loss) from operations +2,024 +1,388 +(30 +) +Other income (expense) +Interest expense, net of capitalized interest +(875 +) +(747 +) +(488 +) +Loss on modification or extinguishment of debt +(27 +) +(100 +) +(135 +) +Derivative gain (loss), net +57 +7 +(10 +) +Other income +48 +18 +— +Total other expense +(797 +) +(822 +) +(633 +) +Income (loss) before income taxes and non-controlling interest +1,227 +566 +(663 +) +Income tax provision +(27 +) +(3 +) +(2 +) +Net income (loss) +1,200 +563 +(665 +) +Less: net income (loss) attributable to non-controlling interest +729 +956 +(55 +) +Net income (loss) attributable to common stockholders +$ +471 +$ +(393 +) +$ +(610 +) +Net income (loss) per share attributable to common stockholders—basic (1) +$ +1.92 +$ +(1.68 +) +$ +(2.67 +) +Net income (loss) per share attributable to common stockholders—diluted (1) +$ +1.90 +$ +(1.68 +) +$ +(2.67 +) +Weighted average number of common shares outstanding—basic +245.6 +233.1 +228.8 +Weighted average number of common shares outstanding—diluted +248.0 +233.1 +228.8 +(1) +Earnings per share in the table may not recalculate exactly due to rounding because it is calculated based on whole numbers, not the rounded numbers presented. +The accompanying notes are an integral part of these consolidated financial statements. +65 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(in millions) +Total Stockholders’ Equity +Common Stock +Treasury Stock +Additional Paid-in Capital +Accumulated Deficit +Non-controlling Interest +Total +Equity +Shares +Par Value Amount +Shares +Amount +Balance at December 31, 2015 +235.6 +$ +1 +11.6 +$ +(354 +) +$ +3,076 +$ +(3,624 +) +$ +2,464 +$ +1,563 +Issuances of restricted stock +0.4 +— +— +— +— +— +— +— +Issuance of stock to acquire additional interest in Cheniere Holdings +3.0 +— +— +— +94 +— +(94 +) +— +Forfeitures of restricted stock +(0.4 +) +— +— +— +— +— +— +— +Share-based compensation +— +— +— +— +40 +— +— +40 +Shares repurchased related to share-based compensation +(0.6 +) +— +0.6 +(20 +) +— +— +— +(20 +) +Loss attributable to non-controlling interest +— +— +— +— +— +— +(55 +) +(55 +) +Equity portion of convertible notes, net +— +— +— +— +1 +— +— +1 +Distributions and dividends to non-controlling interest +— +— +— +— +— +— +(80 +) +(80 +) +Net loss +— +— +— +— +— +(610 +) +— +(610 +) +Balance at December 31, 2016 +238.0 +1 +12.2 +(374 +) +3,211 +(4,234 +) +2,235 +839 +Issuances of restricted stock +0.1 +— +— +— +— +— +— +— +Issuance of stock to acquire additional interest in Cheniere Holdings +— +— +— +— +2 +— +(2 +) +— +Forfeitures of restricted stock +(0.2 +) +— +— +— +— +— +— +— +Share-based compensation +— +— +— +— +34 +— +— +34 +Shares repurchased related to share-based compensation +(0.3 +) +— +0.3 +(12 +) +— +— +— +(12 +) +Net income attributable to non-controlling interest +— +— +— +— +— +— +956 +956 +Equity portion of convertible notes, net +— +— +— +— +1 +— +— +1 +Distributions and dividends to non-controlling interest +— +— +— +— +— +— +(185 +) +(185 +) +Net loss +— +— +— +— +— +(393 +) +— +(393 +) +Balance at December 31, 2017 +237.6 +1 +12.5 +(386 +) +3,248 +(4,627 +) +3,004 +1,240 +Vesting of restricted stock units +0.5 +— +— +— +— +— +— +— +Issuance of stock to acquire additional interest in Cheniere Holdings and other merger related adjustments +19.2 +— +— +— +694 +— +(702 +) +(8 +) +Share-based compensation +— +— +— +— +90 +— +— +90 +Shares repurchased related to share-based compensation +(0.3 +) +— +0.3 +(20 +) +— +— +— +(20 +) +Net income attributable to non-controlling interest +— +— +— +— +— +— +729 +729 +Equity portion of convertible notes, net +— +— +— +— +3 +— +— +3 +Distributions and dividends to non-controlling interest +— +— +— +— +— +— +(576 +) +(576 +) +Net income +— +— +— +— +— +471 +— +471 +Balance at December 31, 2018 +257.0 +$ +1 +12.8 +$ +(406 +) +$ +4,035 +$ +(4,156 +) +$ +2,455 +$ +1,929 +The accompanying notes are an integral part of these consolidated financial statements. +66 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in millions) +Year Ended December 31, +2018 +2017 +2016 +Cash flows from operating activities +Net income (loss) +$ +1,200 +$ +563 +$ +(665 +) +Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: +Depreciation and amortization expense +449 +356 +174 +Share-based compensation expense +113 +91 +101 +Non-cash interest expense +74 +75 +77 +Amortization of debt issuance costs, deferred commitment fees, premium and discount +69 +69 +62 +Loss on modification or extinguishment of debt +27 +100 +135 +Total losses (gains) on derivatives, net +51 +62 +(28 +) +Net cash provided by (used for) settlement of derivative instruments +17 +(106 +) +(45 +) +Impairment expense and loss on disposal of assets +8 +19 +13 +Other +(10 +) +(4 +) +4 +Changes in operating assets and liabilities: +Accounts and other receivables +(131 +) +(139 +) +(207 +) +Accounts receivable—related party +(2 +) +(2 +) +— +Inventory +(73 +) +(73 +) +(119 +) +Accounts payable and accrued liabilities +188 +225 +64 +Deferred revenue +26 +34 +42 +Other, net +(16 +) +(39 +) +(12 +) +Net cash provided by (used in) operating activities +1,990 +1,231 +(404 +) +Cash flows from investing activities +Property, plant and equipment, net +(3,643 +) +(3,357 +) +(4,356 +) +Investment in equity method investment +(25 +) +(41 +) +— +Other +14 +17 +(57 +) +Net cash used in investing activities +(3,654 +) +(3,381 +) +(4,413 +) +Cash flows from financing activities +Proceeds from issuances of debt +4,285 +6,854 +12,865 +Repayments of debt +(1,391 +) +(3,632 +) +(7,671 +) +Debt issuance and deferred financing costs +(66 +) +(89 +) +(172 +) +Debt extinguishment costs +(17 +) +— +(14 +) +Distributions and dividends to non-controlling interest +(576 +) +(185 +) +(80 +) +Payments related to tax withholdings for share-based compensation +(20 +) +(12 +) +(20 +) +Other +(8 +) +— +— +Net cash provided by financing activities +2,207 +2,936 +4,908 +Net increase in cash, cash equivalents and restricted cash +543 +786 +91 +Cash, cash equivalents and restricted cash—beginning of period +2,613 +1,827 +1,736 +Cash, cash equivalents and restricted cash—end of period +$ +3,156 +$ +2,613 +$ +1,827 +Balances per Consolidated Balance Sheets: +December 31, +2018 +2017 +Cash and cash equivalents +$ +981 +$ +722 +Restricted cash +2,175 +1,880 +Non-current restricted cash +— +11 +Total cash, cash equivalents and restricted cash +$ +3,156 +$ +2,613 +The accompanying notes are an integral part of these consolidated financial statements. +67 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +NOTE 1—ORGANIZATION AND NATURE OF OPERATIONS +Cheniere, a Delaware corporation, is a Houston-based energy company primarily engaged in LNG-related businesses. We own and operate the Sabine Pass LNG terminal in Louisiana through our ownership interest in and management agreements with Cheniere Partners, which is a publicly traded limited partnership that we created in 2007. As of December 31, 2018 , we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We are currently developing and constructing two natural gas liquefaction and export facilities. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners is developing, constructing and operating natural gas liquefaction facilities (the “SPL Project”) at the Sabine Pass LNG terminal adjacent to the existing regasification facilities (described below) through a wholly owned subsidiary, SPL. Cheniere Partners plans to construct up to six Trains, which are in various stages of development, construction and operations. Trains 1 through 4 are operational, Train 5 is undergoing commissioning and Train 6 is being commercialized and has all necessary regulatory approvals in place. Each Train is expected to have a nominal production capacity, which is prior to adjusting for planned maintenance, production reliability, potential overdesign and debottlenecking opportunities, of approximately 4.5 mtpa of LNG per Train, and run rate adjusted nominal production capacity of approximately 4.5 to 4.9 mtpa of LNG per Train. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ wholly owned subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 16.9 Bcfe , two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4.0 Bcf/d . Cheniere Partners also owns a 94 -mile pipeline that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”) through a wholly owned subsidiary, CTPL. +We are developing and constructing a second natural gas liquefaction and export facility at the Corpus Christi LNG terminal near Corpus Christi, Texas, and operate a 23 -mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the liquefaction facilities, the “CCL Project”) through our wholly owned subsidiaries CCL and CCP, respectively. The CCL Project is being developed in stages with the first phase being three Trains (“Phase 1”), with expected aggregate nominal production capacity, which is prior to adjusting for planned maintenance, production reliability, potential overdesign and debottlenecking opportunities, of approximately 13.5 mtpa of LNG, three LNG storage tanks with aggregate capacity of approximately 10.1 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. The first stage includes Trains 1 and 2 , two LNG storage tanks, one complete marine berth and a second partial berth and all of the CCL Project ’s necessary infrastructure facilities (“Stage 1”) . The second stage includes Train 3, one LNG storage tank and the completion of the second partial berth (“Stage 2”) . Trains 1 and 2 are undergoing commissioning and Train 3 is under construction. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project and filed an application with FERC in June 2018 for seven midscale Trains with an expected aggregate nominal production capacity of approximately 9.5 mtpa and one LNG storage tank. +We remain focused on expansion of our existing sites by leveraging existing infrastructure. We are also in various stages of developing other projects, including infrastructure projects in support of natural gas supply and LNG demand, which, among other things, will require acceptable commercial and financing arrangements before we make a final investment decision (“FID”) . +NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +Our Consolidated Financial Statements have been prepared in accordance with GAAP . The Consolidated Financial Statements include the accounts of Cheniere, its majority owned subsidiaries and entities in which it holds a controlling interest, including the accounts of Cheniere Partners and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Investments in non-controlled entities, over which Cheniere has the ability to exercise significant influence over operating and financial policies, are accounted for using the equity method. In applying the equity method of accounting, the investments are initially recognized at cost, and subsequently adjusted for our proportionate share of earnings, losses and distributions. Investments in non-controlled entities, over which Cheniere does not have the ability to +68 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +exercise significant influence, are accounted for using the cost method. Under the cost method the investments are initially recognized at cost and dividends received from the accumulated earnings of an investee are recorded as income. Dividends received in excess of the accumulated earnings of an investee are recorded as a reduction in the investment. We periodically assess our cost method investments for indicators of impairment. An impairment is recorded if an indicator is identified, the carrying value of our investment exceeds its fair value, and the impairment is considered to be other than temporary. Investments accounted for using the equity method and cost method are reported as a component of other assets. +We make a determination at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a variable interest entity (“VIE”). Generally, a VIE is an entity that does not have sufficient equity at risk to finance its activities without additional subordinated financial support from other parties, whose equity investors lack any characteristics of a controlling financial interest or which was established with non-substantive voting. We consolidate VIEs when we are deemed to be the primary beneficiary. The primary beneficiary of a VIE is the party that both: (1) has the power to make decisions that most significantly affect the economic performance of the VIE and (2) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. If we are not deemed to be the primary beneficiary of a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP . +Certain reclassifications have been made to conform prior period information to the current presentation. The reclassifications did not have a material effect on our consolidated financial position, results of operations or cash flows. +On January 1, 2018, we adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606) , and subsequent amendments thereto (“ASC 606”) using the full retrospective method. We have elected to adopt the new accounting standard retrospectively and have recast the accompanying Consolidated Financial Statements to reflect the adoption of ASC 606 for all periods presented. The adoption of ASC 606 did not impact our previously reported Consolidated Financial Statements in any prior period nor did it result in a cumulative effect adjustment to retained earnings. +Use of Estimates +The preparation of Consolidated Financial Statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Management evaluates its estimates and related assumptions regularly, including those related to the recoverability of property, plant and equipment, goodwill, derivative instruments, asset retirement obligations (“AROs”) , income taxes including valuation allowances for deferred tax assets, share-based compensation and fair value measurements. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. +Fair Value +Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Hierarchy Levels 1, 2 and 3 are terms for the priority of inputs to valuation approaches used to measure fair value. Hierarchy Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Hierarchy Level 2 inputs are inputs other than quoted prices included within Level 1 that are directly or indirectly observable for the asset or liability. Hierarchy Level 3 inputs are inputs that are not observable in the market. +In determining fair value, we use observable market data when available, or models that incorporate observable market data. In addition to market information, we incorporate transaction-specific details that, in management’s judgment, market participants would take into account in measuring fair value. We maximize the use of observable inputs and minimize our use of unobservable inputs in arriving at fair value estimates. +Recurring fair-value measurements are performed for derivative instruments as disclosed in Note 7—Derivative Instruments . The carrying amount of cash and cash equivalents, restricted cash, accounts receivable and accounts payable reported on the Consolidated Balance Sheets approximates fair value. The fair value of debt is the estimated amount we would have to pay to repurchase our debt in the open market, including any premium or discount attributable to the difference between the stated interest rate and market interest rate at each balance sheet date. Debt fair values, as disclosed in Note 12—Debt , are based on quoted market prices for identical instruments, if available, or based on valuations of similar debt instruments using observable or unobservable inputs. Non-financial assets and liabilities initially measured at fair value include certain assets and liabilities acquired in a business combination, intangible assets, goodwill and AROs. +69 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Revenue Recognition +We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. Revenues from the sale of LNG are recognized as LNG revenues, including LNG revenues generated by our integrated marketing function which are reported on a gross or net basis based on an assessment of whether it is acting as the principal or the agent in the transaction. LNG regasification capacity payments are recognized as regasification revenues. See Note 13—Revenues from Contracts with Customers for further discussion of revenues. +Cash and Cash Equivalents +We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. +Restricted Cash +Restricted cash consists of funds that are contractually restricted as to usage or withdrawal and have been presented separately from cash and cash equivalents on our Consolidated Balance Sheets. +Accounts and Notes Receivable +Accounts and notes receivable are reported net of allowances for doubtful accounts. Notes receivable that are not classified as trade receivables are recorded within other current assets in our Consolidated Balance Sheets. Impaired receivables are specifically identified and evaluated for expected losses. The expected loss on impaired receivables is primarily determined based on the debtor’s ability to pay and the estimated value of any collateral. We did no t recognize any impairment expense related to accounts and notes receivable during the years ended December 31, 2018, 2017 and 2016 . +Inventory +LNG and natural gas inventory are recorded at the lower of weighted average cost and net realizable value. Materials and other inventory are recorded at the lower of cost and net realizable value and subsequently charged to expense when issued. +Accounting for LNG Activities +Generally, we begin capitalizing the costs of our LNG terminals once the individual project meets the following criteria: (1) regulatory approval has been received, (2) financing for the project is available and (3) management has committed to commence construction. Prior to meeting these criteria, most of the costs associated with a project are expensed as incurred. These costs primarily include professional fees associated with front-end engineering and design work, costs of securing necessary regulatory approvals and other preliminary investigation and development activities related to our LNG terminals. +Generally, costs that are capitalized prior to a project meeting the criteria otherwise necessary for capitalization include: land and lease option costs that are capitalized as property, plant and equipment and certain permits that are capitalized as other non-current assets. The costs of lease options are amortized over the life of the lease once obtained. If no land or lease is obtained, the costs are expensed. +Property, Plant and Equipment +Property, plant and equipment are recorded at cost. Expenditures for construction and commissioning activities, major renewals and betterments that extend the useful life of an asset are capitalized, while expenditures for maintenance and repairs (including those for planned major maintenance projects) to maintain property, plant and equipment in operating condition are generally expensed as incurred. We realize offsets to LNG terminal costs for sales of commissioning cargoes that were earned or loaded prior to the start of commercial operations of the respective Train during the testing phase for its construction. We depreciate our property, plant and equipment using the straight-line depreciation method. Upon retirement or other disposition of property, plant and equipment, the cost and related accumulated depreciation are removed from the account, and the resulting gains or losses are recorded in impairment expense and loss (gain) on disposal of assets. +70 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Management tests property, plant and equipment for impairment whenever events or changes in circumstances have indicated that the carrying amount of property, plant and equipment might not be recoverable. Assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets for purposes of assessing recoverability. Recoverability generally is determined by comparing the carrying value of the asset to the expected undiscounted future cash flows of the asset. If the carrying value of the asset is not recoverable, the amount of impairment loss is measured as the excess, if any, of the carrying value of the asset over its estimated fair value. We did no t recognize any impairment expense related to property, plant and equipment during the year ended December 31, 2018. +During the year ended December 31, 2017, we recognized $6 million of impairment expense related to damaged infrastructure as an effect of Hurricane Harvey and $6 million of impairment expense related to write down of assets used in non-core operations outside of our liquefaction activities. +During the year ended December 31, 2016, we recorded $10 million of impairment expense related to a corporate airplane that was written down to fair value based on market-based appraisals, which was ultimately sold by the end of the year. The impairment was recognized due to the potential disposition of the airplane in connection with the Company having initiated organizational changes and the associated operational focus for financially disciplined investment. +Interest Capitalization +We capitalize interest and other related debt costs during the construction period of our LNG terminals and related pipelines as construction-in-process. Upon commencement of operations, these costs are transferred out of construction-in-process into terminal and interconnecting pipeline facilities assets and are amortized over the estimated useful life of the asset. +Regulated Natural Gas Pipelines +The Creole Trail Pipeline and Corpus Christi Pipeline are subject to the jurisdiction of the FERC in accordance with the Natural Gas Act of 1938 and the Natural Gas Policy Act of 1978. The economic effects of regulation can result in a regulated company recording as assets those costs that have been or are expected to be approved for recovery from customers, or recording as liabilities those amounts that are expected to be required to be returned to customers, in a rate-setting process in a period different from the period in which the amounts would be recorded by an unregulated enterprise. Accordingly, we record assets and liabilities that result from the regulated rate-making process that may not be recorded under GAAP for non-regulated entities. We continually assess whether regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes and recent rate orders applicable to other regulated entities. Based on this continual assessment, we believe the existing regulatory assets are probable of recovery. These regulatory assets and liabilities are primarily classified in our Consolidated Balance Sheets as other assets and other liabilities. We periodically evaluate their applicability under GAAP and consider factors such as regulatory changes and the effect of competition. If cost-based regulation ends or competition increases, we may have to reduce our asset balances to reflect a market basis less than cost and write off the associated regulatory assets and liabilities. +Items that may influence our assessment are: +• +inability to recover cost increases due to rate caps and rate case moratoriums; +• +inability to recover capitalized costs, including an adequate return on those costs through the rate-making process and the FERC proceedings; +• +excess capacity; +• +increased competition and discounting in the markets we serve; and +• +impacts of ongoing regulatory initiatives in the natural gas industry. +Natural gas pipeline costs include amounts capitalized as an Allowance for Funds Used During Construction (“AFUDC”). The rates used in the calculation of AFUDC are determined in accordance with guidelines established by the FERC. AFUDC represents the cost of debt and equity funds used to finance our natural gas pipeline additions during construction. AFUDC is capitalized as a part of the cost of our natural gas pipelines. Under regulatory rate practices, we generally are permitted to recover AFUDC, and a fair return thereon, through our rate base after our natural gas pipelines are placed in service. +71 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Derivative Instruments +We use derivative instruments to hedge our exposure to cash flow variability from interest rate, commodity price and foreign currency exchange (“FX”) rate risk. Derivative instruments are recorded at fair value and included in our Consolidated Balance Sheets as assets or liabilities depending on the derivative position and the expected timing of settlement, unless they satisfy criteria for and we elect the normal purchases and sales exception. When we have the contractual right and intend to net settle, derivative assets and liabilities are reported on a net basis. +Changes in the fair value of our derivative instruments are recorded in earnings, unless we elect to apply hedge accounting and meet specified criteria, including completing contemporaneous hedge documentation. We did no t have any derivative instruments designated as cash flow hedges during the years ended December 31, 2018, 2017 and 2016 . See Note 7—Derivative Instruments for additional details about our derivative instruments. +Concentration of Credit Risk +Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents and restricted cash. We maintain cash balances at financial institutions, which may at times be in excess of federally insured levels. We have not incurred losses related to these balances to date. +The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. Certain of our commodity derivative transactions are executed through over-the-counter contracts which are subject to nominal credit risk as these transactions are settled on a daily margin basis with investment grade financial institutions. Collateral deposited for such contracts is recorded within other current assets. Our interest rate and FX derivative instruments are placed with investment grade financial institutions whom we believe are acceptable credit risks. We monitor counterparty creditworthiness on an ongoing basis; however, we cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, we may be limited in our ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, we may not realize the benefit of some of our derivative instruments. +SPL has entered into fixed price SPAs with terms of at least 20 years with seven unaffiliated third parties, CCL has entered into fixed price SPAs generally with terms of 20 years with nine unaffiliated third parties and our integrated marketing function has entered into a limited number of long-term SPAs with unaffiliated third parties. We are dependent on the respective customers’ creditworthiness and their willingness to perform under their respective SPAs. See Note 20—Customer Concentration for additional details about our customer concentration. +SPLNG has entered into two long-term TUAs with unaffiliated third parties for regasification capacity at the Sabine Pass LNG terminal. SPLNG is dependent on the respective customers’ creditworthiness and their willingness to perform under their respective TUAs. SPLNG has mitigated this credit risk by securing TUAs for a significant portion of its regasification capacity with creditworthy third-party customers with a minimum Standard & Poor’s rating of A. +Goodwill +Goodwill is the excess of acquisition cost of a business over the estimated fair value of net assets acquired. Goodwill is not amortized but is tested for impairment at least annually or more frequently if events or circumstances indicate goodwill is more likely than not impaired. Goodwill impairment evaluation requires a comparison of the estimated fair value of a reporting unit to its carrying value. Cheniere tests goodwill for impairment by either performing a qualitative assessment or a quantitative test. The qualitative assessment is an assessment of historical information and relevant events and circumstances to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. Cheniere may elect not to perform the qualitative assessment and instead perform a quantitative impairment test. Significant judgment is required in estimating the fair value of the reporting unit and performing goodwill impairment tests. +As a result of finalization of organizational changes to simplify our corporate structure, improve our operational efficiencies and implement a strategy for sustainable, long-term stockholder value creation through financially disciplined development, construction, operation and investment, we revised the way we manage our business, which resulted in a change in our reporting units. Accordingly, Cheniere reallocated goodwill to our single reporting unit following finalization of organizational changes. We performed our annual goodwill impairment test on October 1st using a quantitative assessment and concluded that the estimated fair value of our reporting unit substantially exceeded its carrying value and, therefore, goodwill was not impaired. Judgments and assumptions are inherent in our estimate of future cash flows used to determine the estimate of the reporting unit’s fair value. +72 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The use of alternate judgments and/or assumptions could result in the recognition of impairment charges in the Consolidated Financial Statements. A lower fair value estimate in the future for our reporting unit could result in an impairment of goodwill. Factors that could trigger a lower fair value estimate include significant negative industry or economic trends, cost increases, disruptions to our business, regulatory or political environment changes or other unanticipated events. There were no changes in the carrying value of goodwill during the year ended December 31, 2018 . +Debt +Our debt consists of current and long-term secured debt securities, convertible debt securities and credit facilities with banks and other lenders. Debt issuances are placed directly by us or through securities dealers or underwriters and are held by institutional and retail investors. +Debt is recorded on our Consolidated Balance Sheets at par value adjusted for unamortized discount or premium and net of unamortized debt issuance costs related to term notes. Discounts, premiums and debt issuance costs directly related to the issuance of debt are amortized over the life of the debt and are recorded in interest expense, net of capitalized interest using the effective interest method. Gains and losses on the extinguishment of debt are recorded in gain (loss) on modification or extinguishment of debt on our Consolidated Statements of Operations. +Debt issuance costs consist primarily of arrangement fees, professional fees, legal fees and printing costs. These costs are recorded as a direct deduction from the debt liability unless incurred in connection with a line of credit arrangement, in which case they are presented as an asset on our Consolidated Balance Sheets. Debt issuance costs are amortized to interest expense or property, plant and equipment over the term of the related debt facility. Upon early retirement of debt or amendment to a debt agreement, certain fees are written off to loss on modification or extinguishment of debt. +Asset Retirement Obligations +We recognize AROs for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset and for conditional AROs in which the timing or method of settlement are conditional on a future event that may or may not be within our control. The fair value of a liability for an ARO is recognized in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is depreciated over the estimated useful life of the asset. +We have no t recorded an ARO associated with the Sabine Pass LNG terminal. Based on the real property lease agreements at the Sabine Pass LNG terminal, at the expiration of the term of the leases we are required to surrender the LNG terminal in good working order and repair, with normal wear and tear and casualty expected. Our property lease agreements at the Sabine Pass LNG terminal have terms of up to 90 years including renewal options. We have determined that the cost to surrender the Sabine Pass LNG terminal in good order and repair, with normal wear and tear and casualty expected, is immaterial. +We have no t recorded an ARO associated with the Creole Trail Pipeline or the Corpus Christi Pipeline. We believe that it is not feasible to predict when the natural gas transportation services provided by the Creole Trail Pipeline or the Corpus Christi Pipeline will no longer be utilized. In addition, our right-of-way agreements associated with the Creole Trail Pipeline and the Corpus Christi Pipeline have no stipulated termination dates. We intend to operate the Creole Trail Pipeline and the Corpus Christi Pipeline as long as supply and demand for natural gas exists in the United States and intend to maintain it regularly. +Share-based Compensation +We have awarded share-based compensation in the form of stock, restricted stock, restricted stock units, performance stock units and phantom units that are more fully described in Note 15—Share-based Compensation . We recognize share-based compensation based upon the estimated fair value of awards. The recognition period for these costs begins at either the applicable service inception date or grant date and continues throughout the requisite service period. For equity-classified share-based compensation awards (which include stock, restricted stock, restricted stock units and performance stock units to employees and non-employee directors), compensation cost is recognized based on the grant-date fair value reduced by the present value of dividends expected to be paid on the underlying shares during the requisite service period, discounted at the appropriate risk-free interest rate and not subsequently remeasured. The fair value is recognized as expense (net of any capitalization) using the straight-line basis for awards that vest based solely on service conditions and using the accelerated recognition method for awards that +73 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +vest based on performance conditions. For awards with both time and performance-based conditions, we generally recognize compensation cost based on the probable outcome of the performance condition at each reporting period. For liability-classified share-based compensation awards (which include phantom units), compensation cost is initially recognized on the grant date using estimated payout levels, and subsequently adjusted quarterly to reflect the updated estimated payout levels based on the changes in the our stock price. We account for forfeitures as they occur. +Non-controlling Interests +When we consolidate a subsidiary, we include 100% of the assets, liabilities, revenues and expenses of the subsidiary in our Consolidated Financial Statements, even if we own less than 100% of the subsidiary. Non-controlling interests represent third-party ownership in the net assets of our consolidated subsidiaries and are presented as a component of equity. Changes in our ownership interests in subsidiaries that do not result in deconsolidation are generally recognized within equity. See Note 9—Non-controlling Interest for additional details about our non-controlling interest. +Income Taxes +Provisions for income taxes are based on taxes payable or refundable for the current year and deferred taxes on temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements. Deferred tax assets and liabilities are included in the Consolidated Financial Statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the current period’s provision for income taxes. A valuation allowance is recorded to reduce the carrying value of our deferred tax assets when it is more likely than not that a portion or all of the deferred tax assets will expire before realization of the benefit or future deductibility is not probable. +We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the tax position. +Net Income (Loss) Per Share +Net income (loss) per share (“EPS”) is computed in accordance with GAAP. Basic EPS excludes dilution and is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS reflects potential dilution and is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period increased by the number of additional common shares that would have been outstanding if the potential common shares had been issued and were dilutive. The dilutive effect of unvested stock is calculated using the treasury-stock method and the dilutive effect of convertible securities is calculated using the if-converted method. +Business Segment +We have determined that we operate as a single operating and reportable segment. Our chief operating decision maker makes resource allocation decisions and assesses performance based on financial information presented on a consolidated basis in the delivery of an integrated source of LNG to our customers. +74 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 3—RESTRICTED CASH +Restricted cash consists of funds that are contractually restricted as to usage or withdrawal and have been presented separately from cash and cash equivalents on our Consolidated Balance Sheets. As of December 31, 2018 and 2017 , restricted cash consisted of the following (in millions): +December 31, +2018 +2017 +Current restricted cash +SPL Project +$ +756 +$ +544 +Cheniere Partners and cash held by guarantor subsidiaries +785 +1,045 +CCL Project +289 +227 +Cash held by our subsidiaries restricted to Cheniere +345 +64 +Total current restricted cash +$ +2,175 +$ +1,880 +Non-current restricted cash +Other +$ +— +$ +11 +Pursuant to the accounts agreements entered into with the collateral trustees for the benefit of SPL’s debt holders and CCH’s debt holders, SPL and CCH are required to deposit all cash received into reserve accounts controlled by the collateral trustees. The usage or withdrawal of such cash is restricted to the payment of liabilities related to the SPL Project and the CCL Project and other restricted payments. +Under Cheniere Partners’ credit facilities (the “CQP Credit Facilities”) , Cheniere Partners and each of its subsidiaries other than SPL, as guarantor subsidiaries, are subject to limitations on the use of cash under the terms of the CQP Credit Facilities and the related depositary agreement governing the extension of credit to Cheniere Partners. Specifically, Cheniere Partners may only withdraw funds from collateral accounts held at a designated depositary bank on a limited basis and for specific purposes, including for the payment of operating expenses of Cheniere Partners and its guarantor subsidiaries. In addition, distributions and capital expenditures may only be made quarterly and are subject to certain restrictions. +NOTE 4—ACCOUNTS AND OTHER RECEIVABLES +As of December 31, 2018 and 2017 , accounts and other receivables consisted of the following (in millions): +December 31, +2018 +2017 +Trade receivables +SPL +$ +330 +$ +185 +Cheniere Marketing +205 +163 +Other accounts receivable +46 +21 +Total accounts and other receivables +$ +581 +$ +369 +NOTE 5—INVENTORY +As of December 31, 2018 and 2017 , inventory consisted of the following (in millions): +December 31, +2018 +2017 +Natural gas +$ +30 +$ +17 +LNG +24 +44 +LNG in-transit +173 +130 +Materials and other +89 +52 +Total inventory +$ +316 +$ +243 +75 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 6—PROPERTY, PLANT AND EQUIPMENT +As of December 31, 2018 and 2017 , property, plant and equipment, net consisted of the following (in millions): +December 31, +2018 +2017 +LNG terminal costs +LNG terminal and interconnecting pipeline facilities +$ +13,386 +$ +12,687 +LNG site and related costs +86 +86 +LNG terminal construction-in-process +14,864 +11,932 +Accumulated depreciation +(1,299 +) +(882 +) +Total LNG terminal costs, net +27,037 +23,823 +Fixed assets and other +Computer and office equipment +17 +14 +Furniture and fixtures +22 +19 +Computer software +100 +92 +Leasehold improvements +41 +41 +Land +59 +59 +Other +21 +16 +Accumulated depreciation +(111 +) +(86 +) +Total fixed assets and other, net +149 +155 +Assets under capital lease +Tug vessels +60 +— +Accumulated depreciation +(1 +) +— +Total assets under capital lease, net +59 +— +Property, plant and equipment, net +$ +27,245 +$ +23,978 +Depreciation expense was $445 million , $354 million and $173 million during the years ended December 31, 2018, 2017 and 2016 , respectively. +We realize offsets to LNG terminal costs for sales of commissioning cargoes that were earned or loaded prior to the start of commercial operations of the respective Train during the testing phase for its construction. We realized offsets to LNG terminal costs of $140 million , $320 million and $214 million in the years ended December 31, 2018, 2017 and 2016 , respectively, for sales of commissioning cargoes from the SPL Project and the CCL Project . +LNG Terminal Costs +Our LNG terminals are depreciated using the straight-line depreciation method applied to groups of LNG terminal assets with varying useful lives. The identifiable components of our LNG terminals with similar estimated useful lives have a depreciable range between 6 and 50 years, as follows: +Components +Useful life (yrs) +LNG storage tanks +50 +Natural gas pipeline facilities +40 +Marine berth, electrical, facility and roads +35 +Water pipelines +30 +Regasification processing equipment +30 +Sendout pumps +20 +Liquefaction processing equipment +6-50 +Other +15-30 +Fixed Assets and Other +Our fixed assets and other are recorded at cost and are depreciated on a straight-line method based on estimated lives of the individual assets or groups of assets. +76 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 7—DERIVATIVE INSTRUMENTS +We have entered into the following derivative instruments that are reported at fair value: +• +interest rate swaps to hedge the exposure to volatility in a portion of the floating-rate interest payments under certain credit facilities (“Interest Rate Derivatives”) ; +• +commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the SPL Project and the CCL Project (“Physical Liquefaction Supply Derivatives”) and associated economic hedges (“Financial Liquefaction Supply Derivatives,” and collectively with the Physical Liquefaction Supply Derivatives, the “Liquefaction Supply Derivatives”) ; +• +financial derivatives to hedge the exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG (“LNG Trading Derivatives”) ; and +• +FX contracts to hedge exposure to currency risk associated with both LNG Trading Derivatives and operations in countries outside of the United States (“FX Derivatives”) . +We recognize our derivative instruments as either assets or liabilities and measure those instruments at fair value. None of our derivative instruments are designated as cash flow hedging instruments, and changes in fair value are recorded within our Consolidated Statements of Operations to the extent not utilized for the commissioning process. +The following table shows the fair value of our derivative instruments that are required to be measured at fair value on a recurring basis as of December 31, 2018 and 2017 , which are classified as derivative assets , non-current derivative assets , derivative liabilities or non-current derivative liabilities in our Consolidated Balance Sheets (in millions). +Fair Value Measurements as of +December 31, 2018 +December 31, 2017 +Quoted Prices in Active Markets +(Level 1) +Significant Other Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Quoted Prices in Active Markets +(Level 1) +Significant Other Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +CCH Interest Rate Derivatives asset (liability) +$ +— +$ +18 +$ +— +$ +18 +$ +— +$ +(32 +) +$ +— +$ +(32 +) +CQP Interest Rate Derivatives asset +— +— +— +— +— +21 +— +21 +Liquefaction Supply Derivatives asset (liability) +6 +(19 +) +(29 +) +(42 +) +2 +10 +43 +55 +LNG Trading Derivatives asset (liability) +1 +(25 +) +— +(24 +) +(13 +) +5 +— +(8 +) +FX Derivatives asset (liability) +— +15 +— +15 +— +(1 +) +— +(1 +) +We value our Interest Rate Derivatives using an income-based approach utilizing observable inputs to the valuation model including interest rate curves, risk adjusted discount rates, credit spreads and other relevant data. We value our LNG Trading Derivatives and our Liquefaction Supply Derivatives using a market based approach incorporating present value techniques, as needed, using observable commodity price curves, when available, and other relevant data. We value our FX Derivatives with a market approach using observable FX rates and other relevant data. +The fair value of our Physical Liquefaction Supply Derivatives is predominantly driven by market commodity basis prices and, as applicable to our natural gas supply contracts, our assessment of the associated conditions precedent, including evaluating whether the respective market is available as pipeline infrastructure is developed. Upon the satisfaction of conditions precedent, including completion and placement into service of relevant pipeline infrastructure to accommodate marketable physical gas flow, we recognize a gain or loss based on the fair value of the respective natural gas supply contracts. +We include a portion of our Physical Liquefaction Supply Derivatives as Level 3 within the valuation hierarchy as the fair value is developed through the use of internal models which may be impacted by inputs that are unobservable in the marketplace. The curves used to generate the fair value of our Physical Liquefaction Supply Derivatives are based on basis adjustments applied to forward curves for a liquid trading point. In addition, there may be observable liquid market basis information in the near term, +77 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +but terms of a Physical Liquefaction Supply Derivatives contract may exceed the period for which such information is available, resulting in a Level 3 classification. In these instances, the fair value of the contract incorporates extrapolation assumptions made in the determination of the market basis price for future delivery periods in which applicable commodity basis prices were either not observable or lacked corroborative market data. As of December 31, 2018 and 2017 , some of our Physical Liquefaction Supply Derivatives existed within markets for which the pipeline infrastructure is under development to accommodate marketable physical gas flow. +The Level 3 fair value measurements of natural gas positions within our Physical Liquefaction Supply Derivatives could be materially impacted by a significant change in certain natural gas market basis spreads due to the contractual notional amount represented by our Level 3 positions, which is a substantial portion of our overall Physical Liquefaction Supply Derivatives portfolio. The following table includes quantitative information for the unobservable inputs for our Level 3 Physical Liquefaction Supply Derivatives as of December 31, 2018 : +Net Fair Value Liability +(in millions) +Valuation Approach +Significant Unobservable Input +Significant Unobservable Inputs Range +Physical Liquefaction Supply Derivatives +$(29) +Market approach incorporating present value techniques +Basis Spread +$(0.980) - $0.085 +The following table shows the changes in the fair value of our Level 3 Physical Liquefaction Supply Derivatives during the years ended December 31, 2018, 2017 and 2016 (in millions): +Year Ended December 31, +2018 +2017 +2016 +Balance, beginning of period +$ +43 +$ +79 +$ +32 +Realized and mark-to-market gains (losses): +Included in cost of sales (1) +(13 +) +(37 +) +48 +Purchases and settlements: +Purchases +(31 +) +14 +1 +Settlements (1) +(29 +) +(12 +) +(2 +) +Transfers out of Level 3 (2) +1 +(1 +) +— +Balance, end of period +$ +(29 +) +$ +43 +$ +79 +Change in unrealized gains (losses) relating to instruments still held at end of period +$ +(13 +) +$ +(37 +) +$ +49 +(1) +Does not include the decrease in fair value of $1 million related to the realized gains capitalized during the year ended December 31, 2016. +(2) +Transferred to Level 2 as a result of observable market for the underlying natural gas purchase agreements. +Derivative assets and liabilities arising from our derivative contracts with the same counterparty are reported on a net basis, as all counterparty derivative contracts provide for net settlement. The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments in instances when our derivative instruments are in an asset position. Additionally, we evaluate our own ability to meet our commitments in instances where our derivative instruments are in a liability position. Our derivative instruments are subject to contractual provisions which provide for the unconditional right of set-off for all derivative assets and liabilities with a given counterparty in the event of default. +Interest Rate Derivatives +CCH has entered into interest rate swaps (“CCH Interest Rate Derivatives”) to hedge a portion of the variable interest payments on its credit facility (the “CCH Credit Facility”) . In June 2018, CCH settled a portion of the CCH Interest Rate Derivatives and received proceeds of $5 million upon the termination of interest rate swaps associated with the amendment of the CCH Credit Facility , as discussed in Note 12—Debt . In May 2017, CCH settled a portion of the CCH Interest Rate Derivatives and paid $13 million in conjunction with the termination of approximately $1.4 billion of commitments under the CCH Credit Facility . +78 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Cheniere Partners previously had interest rate swaps (“CQP Interest Rate Derivatives”) to hedge a portion of the variable interest payments on its CQP Credit Facilities , based on a portion of the expected outstanding borrowings over the term of the CQP Credit Facilities . In September 2018, Cheniere Partners terminated approximately $1.2 billion of commitments under the CQP Credit Facilities , as discussed in Note 12—Debt . In October 2018, Cheniere Partners terminated the CQP Interest Rate Derivatives related to the CQP Credit Facilities , which resulted in proceeds of $28 million . +SPL previously had interest rate swaps (“SPL Interest Rate Derivatives”) to protect against volatility of future cash flows and hedge a portion of the variable interest payments on the credit facilities it entered into in June 2015 (the “SPL Credit Facilities”), based on a portion of the expected outstanding borrowings over the term of the SPL Credit Facilities. In March 2017, SPL settled the SPL Interest Rate Derivatives and paid $7 million in conjunction with the termination of approximately $1.6 billion of commitments under the SPL Credit Facilities . +As of December 31, 2018 , we had the following Interest Rate Derivatives outstanding: +Initial Notional Amount +Maximum Notional Amount +Effective Date +Maturity Date +Weighted Average Fixed Interest Rate Paid +Variable Interest Rate Received +CCH Interest Rate Derivatives +$29 million +$4.7 billion +May 20, 2015 +May 31, 2022 +2.30% +One-month LIBOR +The following table shows the fair value and location of our Interest Rate Derivatives on our Consolidated Balance Sheets (in millions): +December 31, 2018 +December 31, 2017 +CCH Interest Rate Derivatives +CQP Interest Rate Derivatives +Total +CCH Interest Rate Derivatives +CQP Interest Rate Derivatives +Total +Consolidated Balance Sheet Location +Derivative assets +$ +10 +$ +— +$ +10 +$ +— +$ +7 +$ +7 +Non-current derivative assets +8 +— +8 +3 +14 +17 +Total derivative assets +18 +— +18 +3 +21 +24 +Derivative liabilities +— +— +— +(20 +) +— +(20 +) +Non-current derivative liabilities +— +— +— +(15 +) +— +(15 +) +Total derivative liabilities +— +— +— +(35 +) +— +(35 +) +Derivative asset (liability), net +$ +18 +$ +— +$ +18 +$ +(32 +) +$ +21 +$ +(11 +) +The following table shows the changes in the fair value and settlements of our Interest Rate Derivatives recorded in derivative gain (loss), net on our Consolidated Statements of Operations during the years ended December 31, 2018, 2017 and 2016 (in millions): +Year Ended December 31, +2018 +2017 +2016 +CCH Interest Rate Derivatives gain (loss) +$ +43 +$ +3 +$ +(16 +) +CQP Interest Rate Derivatives gain +14 +6 +12 +SPL Interest Rate Derivatives loss +— +(2 +) +(6 +) +Commodity Derivatives +Liquefaction Supply Derivatives +SPL and CCL have entered into primarily index-based physical natural gas supply contracts and associated economic hedges to purchase natural gas for the commissioning and operation of the SPL Project and the CCL Project. The terms of the physical natural gas supply contracts range up to eight years, some of which commence upon the satisfaction of certain conditions precedent. +79 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Our Financial Liquefaction Supply Derivatives are executed through over-the-counter contracts which are subject to nominal credit risk as these transactions are settled on a daily margin basis with investment grade financial institutions. We are required by these financial institutions to use margin deposits as credit support for our Financial Liquefaction Supply Derivatives activities. +LNG Trading Derivatives +We have entered into, and may from time to time enter into, financial LNG Trading Derivatives in the form of swaps, forwards, options or futures to economically hedge exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG. We have entered into LNG Trading Derivatives to secure a fixed price position to minimize future cash flow variability associated with LNG purchase and sale transactions. +The following table shows the fair value and location of our Liquefaction Supply Derivatives and LNG Trading Derivatives (collectively, “Commodity Derivatives”) on our Consolidated Balance Sheets (in millions, except notional amount): +December 31, 2018 +December 31, 2017 +Liquefaction Supply Derivatives (1) +LNG Trading Derivatives (2) +Total +Liquefaction Supply Derivatives (1) +LNG Trading Derivatives (2) +Total +Consolidated Balance Sheet Location +Derivative assets +$ +13 +$ +24 +$ +37 +$ +41 +$ +9 +$ +50 +Non-current derivative assets +46 +— +46 +17 +— +17 +Total derivative assets +59 +24 +83 +58 +9 +67 +Derivative liabilities +(79 +) +(48 +) +(127 +) +— +(17 +) +(17 +) +Non-current derivative liabilities +(22 +) +— +(22 +) +(3 +) +— +(3 +) +Total derivative liabilities +(101 +) +(48 +) +(149 +) +(3 +) +(17 +) +(20 +) +Derivative asset (liability), net +$ +(42 +) +$ +(24 +) +$ +(66 +) +$ +55 +$ +(8 +) +$ +47 +Notional amount, net (in TBtu) (3) +5,832 +12 +2,539 +25 +(1) +Does not include collateral calls of $5 million and $1 million for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of December 31, 2018 and 2017 , respectively. +(2) +Does not include collateral of $9 million and $28 million deposited for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of December 31, 2018 and 2017 , respectively. +(3) +SPL had secured up to approximately 3,464 TBtu and 2,214 TBtu and CCL had secured up to approximately 2,801 TBtu and 2,024 TBtu of natural gas feedstock through natural gas supply contracts as of December 31, 2018 and 2017 , respectively. +The following table shows the changes in the fair value, settlements and location of our Commodity Derivatives recorded on our Consolidated Statements of Operations during the years ended December 31, 2018, 2017 and 2016 (in millions): +Consolidated Statements of Operations Location (1) +Year Ended December 31, +2018 +2017 +2016 +LNG Trading Derivatives loss +LNG revenues +$ +(25 +) +$ +(44 +) +$ +(4 +) +Liquefaction Supply Derivatives loss (2) +LNG revenues +(1 +) +— +— +Liquefaction Supply Derivatives gain (loss) (2) +Cost of sales +(100 +) +(24 +) +42 +(1) +Fair value fluctuations associated with commodity derivative activities are classified and presented consistently with the item economically hedged and the nature and intent of the derivative instrument. +(2) +Does not include the realized value associated with derivative instruments that settle through physical delivery. +80 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +FX Derivatives +Cheniere Marketing has entered into FX Derivatives to protect against the volatility in future cash flows attributable to changes in international currency exchange rates. The FX Derivatives economically hedge the foreign currency exposure arising from cash flows expended for both physical and financial LNG transactions and selling, general and administrative expenses related to operations in countries outside of the United States. +The following table shows the fair value and location of our FX Derivatives on our Consolidated Balance Sheets (in millions): +Fair Value Measurements as of +Consolidated Balance Sheet Location +December 31, 2018 +December 31, 2017 +FX Derivatives +Derivative assets +$ +16 +$ +— +FX Derivatives +Derivative liabilities +(1 +) +— +FX Derivatives +Non-current derivative liabilities +— +(1 +) +The total notional amount of our FX Derivatives was $379 million and $27 million as of December 31, 2018 and 2017 , respectively. +The following table shows the changes in the fair value of our FX Derivatives recorded on our Consolidated Statements of Operations during the years ended December 31, 2018, 2017 and 2016 (in millions): +Year Ended December 31, +Statement of Operations Location +2018 +2017 +2016 +FX Derivatives gain (loss) +LNG revenues +$ +18 +$ +(1 +) +$ +— +FX Derivatives loss +Other income +— +— +(1 +) +Consolidated Balance Sheet Presentation +Our derivative instruments are presented on a net basis on our Consolidated Balance Sheets as described above. The following table shows the fair value of our derivatives outstanding on a gross and net basis (in millions): +Gross Amounts Recognized +Gross Amounts Offset in the Consolidated Balance Sheets +Net Amounts Presented in the Consolidated Balance Sheets +Offsetting Derivative Assets (Liabilities) +As of December 31, 2018 +CCH Interest Rate Derivatives +$ +19 +$ +(1 +) +$ +18 +Liquefaction Supply Derivatives +95 +(36 +) +59 +Liquefaction Supply Derivatives +(121 +) +20 +(101 +) +LNG Trading Derivatives +112 +(88 +) +24 +LNG Trading Derivatives +(92 +) +44 +(48 +) +FX Derivatives +30 +(14 +) +16 +FX Derivatives +(2 +) +1 +(1 +) +As of December 31, 2017 +CCH Interest Rate Derivatives +$ +3 +$ +— +$ +3 +CCH Interest Rate Derivatives +(35 +) +— +(35 +) +CQP Interest Rate Derivatives +21 +— +21 +Liquefaction Supply Derivatives +64 +(6 +) +58 +Liquefaction Supply Derivatives +(3 +) +— +(3 +) +LNG Trading Derivatives +9 +— +9 +LNG Trading Derivatives +(37 +) +20 +(17 +) +FX Derivatives +(1 +) +— +(1 +) +81 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 8—OTHER NON-CURRENT ASSETS +As of December 31, 2018 and 2017 , other non-current assets, net consisted of the following (in millions): +December 31, +2018 +2017 +Advances made under EPC and non-EPC contracts +$ +14 +$ +26 +Advances made to municipalities for water system enhancements +90 +97 +Advances and other asset conveyances to third parties to support LNG terminals +54 +48 +Tax-related payments and receivables +21 +29 +Equity method investments +94 +64 +Other +32 +24 +Total other non-current assets, net +$ +305 +$ +288 +Equity Method Investments +Our equity method investments consist of interests in privately-held companies. In 2017, we acquired an equity interest in Midship Holdings, LLC (“Midship Holdings”), which manages the business and affairs of Midship Pipeline Company, LLC (“Midship Pipeline”). Midship Pipeline is pursuing the development, construction, operation and maintenance of an approximately 200 -mile natural gas pipeline project (the “Midship Project”) that connects new production in the Anadarko Basin to Gulf Coast markets. Midship Holdings entered into agreements with investment funds managed by EIG Global Energy Partners (“EIG”) under which EIG-managed funds committed to make an investment of up to $500 million (the “EIG Investment”) in the Midship Project, subject to the terms and conditions contained in the applicable agreements. The EIG Investment, when combined with equity contributed by us, is intended to ensure the Midship Project has the equity funding expected to be required to develop and construct the project. Construction of the Midship Project will commence based upon, among other things, obtaining the required authorization from the FERC and adequate financing to construct the proposed project. +We have determined that Midship Holdings is a VIE because it is thinly capitalized at formation such that the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support. We do not consolidate Midship Holdings because we do not have power to direct the activities that most significantly impact its economic performance. We continually monitor both consolidated and unconsolidated VIEs to determine if any events have occurred that could cause a change in our identification of a VIE or determination of the primary beneficiary to a VIE. We account for our investment in Midship Holdings under the equity method as we have the ability to exercise significant influence over the operating and financial policies of Midship Holdings through our non-controlling voting rights on its board of managers. Our investment in Midship Holdings was $85 million and $55 million at December 31, 2018 and 2017 , respectively. Our obligations to make additional investments in Midship Holdings are not significant. +Cheniere LNG O&M Services, LLC (“O&M Services”), our wholly owned subsidiary, provides the development, construction, operation and maintenance services associated with the Midship Project pursuant to agreements in which O&M Services receives an agreed upon fee and reimbursement of costs incurred. O&M Services recorded $12 million and $3 million in the years ended December 31, 2018 and 2017 , respectively, of revenues in other—related party and $4 million and $2 million of accounts receivable—related party as of December 31, 2018 and 2017 , respectively, for services provided to Midship Pipeline under these agreements. CCL has entered into a transportation precedent agreement and a negotiated rate agreement with Midship Pipeline to secure firm pipeline transportation capacity for a period of 10 years following commencement of the Midship Project. In May 2018, CCL issued a letter of credit to Midship Pipeline for drawings up to an aggregate maximum amount of $16 million . Midship Pipeline had no t made any drawings on this letter of credit as of December 31, 2018 . +NOTE 9—NON-CONTROLLING INTEREST +As of December 31, 2018 and 2017 , we and Cheniere Holdings, respectively, owned a 48.6% limited partner interest in Cheniere Partners in the form of 104.5 million common units and 135.4 million subordinated units, with the remaining non-controlling interest held by Blackstone CQP Holdco ( “Blackstone CQP Holdco” ) and the public. As of December 31, 2017 , we owned 82.7% of Cheniere Holdings. Prior to the mandatory conversion of Cheniere Partners’ Class B units (“Class B units”) on August 2, 2017, Cheniere Holdings owned a 55.9% limited partner interest in Cheniere Partners in the form of 12.0 million common units, 45.3 million Class B units and 135.4 million subordinated units, with the remaining non-controlling interest held by Blackstone +82 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +CQP Holdco and the public. We also own 100% of the general partner interest and the incentive distribution rights in Cheniere Partners. +During the year ended December 31, 2018 , we acquired 17.3% of additional interest in Cheniere Holdings previously held by the public, and closed the merger of Cheniere Holdings with and into our wholly owned subsidiary. As a result of the merger, all of the publicly-held shares of Cheniere Holdings not owned by us were canceled and shareholders other than Cheniere received shares of our common stock in a stock-for-share exchange. Because the transactions represented a combination of ownership interests under common control, changes in Cheniere’s ownership interest in Cheniere Holdings were accounted for as an equity transaction and no gain or loss was recognized. +NOTE 10—VARIABLE INTEREST ENTITIES +Cheniere Partners is a limited partnership formed by us in 2006 to own and operate the Sabine Pass LNG terminal and related assets. Cheniere Partners GP, our wholly owned subsidiary, is the general partner of Cheniere Partners. In 2012, Cheniere Partners, Cheniere and Blackstone CQP Holdco entered into a unit purchase agreement whereby Cheniere Partners sold 100.0 million Class B units to Blackstone CQP Holdco in a private placement. The board of directors of Cheniere Partners GP was modified to include three directors appointed by Blackstone CQP Holdco, four directors appointed by us and four independent directors mutually agreed upon by Blackstone CQP Holdco and us and appointed by us. In addition, we provided Blackstone CQP Holdco with a right to maintain one board seat on our Board of Directors (our “Board”) . A quorum of Cheniere Partners GP directors consists of a majority of all directors, including at least two directors appointed by Blackstone CQP Holdco , two directors appointed by us and two independent directors. Blackstone CQP Holdco will no longer be entitled to appoint Cheniere Partners GP directors in the event that Blackstone CQP Holdco’s ownership in Cheniere Partners is less than: (1) 20% of outstanding common units, subordinated units and Class B units and (2) 50.0 million Class B units. +We have determined that Cheniere Partners GP is a VIE and that we, as the holder of the equity at risk, do not have a controlling financial interest due to the rights held by Blackstone CQP Holdco. However, we continue to consolidate Cheniere Partners as a result of Blackstone CQP Holdco’s right to maintain one board seat on our Board which creates a de facto agency relationship between Blackstone CQP Holdco and us. GAAP requires that when a de facto agency relationship exists, one of the members of the de facto agency relationship must consolidate the VIE based on certain criteria. As a result, we consolidate Cheniere Partners in our Consolidated Financial Statements. +In addition, we have an equity method investment in Midship Holdings, which we have determined to be a VIE but do not consolidate in our Consolidated Financial Statements. See Note 8—Other Non-current Assets for further discussion of our determination of Midship Holdings as an unconsolidated VIE. +NOTE 11—ACCRUED LIABILITIES +As of December 31, 2018 and 2017 , accrued liabilities consisted of the following (in millions): +December 31, +2018 +2017 +Interest costs and related debt fees +$ +233 +$ +397 +Accrued natural gas purchases +610 +298 +LNG terminals and related pipeline costs +125 +192 +Compensation and benefits +117 +141 +Accrued LNG inventory +14 +1 +Other accrued liabilities +70 +49 +Total accrued liabilities +$ +1,169 +$ +1,078 +83 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 12—DEBT +As of December 31, 2018 and 2017 , our debt consisted of the following (in millions): +December 31, +2018 +2017 +Long-term debt: +SPL +5.625% Senior Secured Notes due 2021 (“2021 SPL Senior Notes”) +$ +2,000 +$ +2,000 +6.25% Senior Secured Notes due 2022 (“2022 SPL Senior Notes”) +1,000 +1,000 +5.625% Senior Secured Notes due 2023 (“2023 SPL Senior Notes”) +1,500 +1,500 +5.75% Senior Secured Notes due 2024 (“2024 SPL Senior Notes”) +2,000 +2,000 +5.625% Senior Secured Notes due 2025 (“2025 SPL Senior Notes”) +2,000 +2,000 +5.875% Senior Secured Notes due 2026 (“2026 SPL Senior Notes”) +1,500 +1,500 +5.00% Senior Secured Notes due 2027 (“2027 SPL Senior Notes”) +1,500 +1,500 +4.200% Senior Secured Notes due 2028 (“2028 SPL Senior Notes”) +1,350 +1,350 +5.00% Senior Secured Notes due 2037 (“2037 SPL Senior Notes”) +800 +800 +Cheniere Partners +5.250% Senior Notes due 2025 (“2025 CQP Senior Notes”) +1,500 +1,500 +5.625% Senior Notes due 2026 (“2026 CQP Senior Notes”) +1,100 +— +CQP Credit Facilities +— +1,090 +CCH +7.000% Senior Secured Notes due 2024 (“2024 CCH Senior Notes”) +1,250 +1,250 +5.875% Senior Secured Notes due 2025 (“2025 CCH Senior Notes”) +1,500 +1,500 +5.125% Senior Secured Notes due 2027 (“2027 CCH Senior Notes”) +1,500 +1,500 +CCH Credit Facility +5,156 +2,485 +CCH HoldCo II +11.0% Convertible Senior Secured Notes due 2025 (“2025 CCH HoldCo II Convertible Senior Notes”) +1,455 +1,305 +Cheniere +4.875% Convertible Unsecured Notes due 2021 (“2021 Cheniere Convertible Unsecured Notes”) +1,218 +1,161 +4.25% Convertible Senior Notes due 2045 (“2045 Cheniere Convertible Senior Notes”) +625 +625 +$1.25 billion Cheniere Revolving Credit Facility (“Cheniere Revolving Credit Facility”) +— +— +Unamortized premium, discount and debt issuance costs, net +(775 +) +(730 +) +Total long-term debt, net +28,179 +25,336 +Current debt: +$1.2 billion SPL Working Capital Facility (“SPL Working Capital Facility”) +— +— +$1.2 billion CCH Working Capital Facility (“CCH Working Capital Facility”) +168 +— +Cheniere Marketing trade finance facilities +71 +— +Total current debt +239 +— +Total debt, net +$ +28,418 +$ +25,336 +Below is a schedule of future principal payments that we are obligated to make, based on current construction schedules, on our outstanding debt at December 31, 2018 (in millions): +Years Ending December 31, +Principal Payments +2019 +$ +239 +2020 +— +2021 +3,218 +2022 +1,000 +2023 +1,500 +Thereafter +23,236 +Total +$ +29,193 +84 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Senior Notes +SPL Senior Notes +The terms of the 2021 SPL Senior Notes, 2022 SPL Senior Notes, 2023 SPL Senior Notes, 2024 SPL Senior Notes, 2025 SPL Senior Notes, 2026 SPL Senior Notes, 2027 SPL Senior Notes and 2028 SPL Senior Notes (collectively with the 2037 SPL Senior Notes, the “SPL Senior Notes”) are governed by a common indenture (the “SPL Indenture”) and the terms of the 2037 SPL Senior Notes are governed by a separate indenture (the “2037 SPL Senior Notes Indenture”). Both the SPL Indenture and the 2037 SPL Senior Notes Indenture contain customary terms and events of default and certain covenants that, among other things, limit SPL’s ability and the ability of SPL’s restricted subsidiaries to incur additional indebtedness or issue preferred stock, make certain investments or pay dividends or distributions on capital stock or subordinated indebtedness or purchase, redeem or retire capital stock, sell or transfer assets, including capital stock of SPL’s restricted subsidiaries, restrict dividends or other payments by restricted subsidiaries, incur liens, enter into transactions with affiliates, dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of SPL’s assets and enter into certain LNG sales contracts. Subject to permitted liens, the SPL Senior Notes are secured on a pari passu first-priority basis by a security interest in all of the membership interests in SPL and substantially all of SPL’s assets. SPL may not make any distributions until, among other requirements, deposits are made into debt service reserve accounts as required and a debt service coverage ratio test of 1.25 :1.00 is satisfied. Semi-annual principal payments for the 2037 SPL Senior Notes are due on March 15 and September 15 of each year beginning September 15, 2025. Interest on the SPL Senior Notes is payable semi-annually in arrears. +At any time prior to three months before the respective dates of maturity for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes, 2027 SPL Senior Notes, 2028 SPL Senior Notes and 2037 SPL Senior Notes, in which case the time period is six months before the respective dates of maturity), SPL may redeem all or part of such series of the SPL Senior Notes at a redemption price equal to the “make-whole” price (except for the 2037 SPL Senior Notes, in which case the redemption price is equal to the “optional redemption” price) set forth in the respective indentures governing the SPL Senior Notes, plus accrued and unpaid interest, if any, to the date of redemption. SPL may also, at any time within three months of the respective maturity dates for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes, 2027 SPL Senior Notes, 2028 SPL Senior Notes and 2037 SPL Senior Notes, in which case the time period is within six months of the respective dates of maturity), redeem all or part of such series of the SPL Senior Notes at a redemption price equal to 100% of the principal amount of such series of the SPL Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +CQP Senior Notes +In September 2018, Cheniere Partners issued an aggregate principal amount of $1.1 billion of the 2026 CQP Senior Notes . Net proceeds of the offering of approximately $1.1 billion , after deducting the initial purchasers’ commissions and estimated fees and expenses, were used to prepay all of the outstanding indebtedness under the CQP Credit Facilities , resulting in the recognition of debt modification and extinguishment costs of $12 million for the year ended December 31, 2018 relating to the incurrence of third party fees and write off of unamortized debt issuance costs. Borrowings under the 2026 CQP Senior Notes accrue interest at a fixed rate of 5.625% . +The 2025 CQP Senior Notes and the 2026 CQP Senior Notes (collectively, the “CQP Senior Notes”) are jointly and severally guaranteed by each of Cheniere Partners’ subsidiaries other than SPL (the “CQP Guarantors”) and, subject to certain conditions governing its guarantee, Sabine Pass LP. The CQP Senior Notes are governed by the same base indenture (the “CQP Base Indenture”) . The 2025 CQP Senior Notes are further governed by the First Supplemental Indenture (together with the CQP Base Indenture, the “2025 CQP Notes Indenture”) and the 2026 CQP Senior Notes are further governed by the Second Supplemental Indenture (together with the CQP Base Indenture, the “2026 CQP Notes Indenture”). The 2025 CQP Notes Indenture and the 2026 CQP Notes Indenture contain customary terms and events of default and certain covenants that, among other things, limit the ability of Cheniere Partners and the CQP Guarantors to incur liens and sell assets, enter into transactions with affiliates, enter into sale-leaseback transactions and consolidate, merge or sell, lease or otherwise dispose of all or substantially all of the applicable entity’s properties or assets. Interest on the CQP Senior Notes is payable semi-annually in arrears. +At any time prior to October 1, 2020 for the 2025 CQP Senior Notes and October 1, 2021 for the 2026 CQP Senior Notes , Cheniere Partners may redeem all or a part of the applicable CQP Senior Notes at a redemption price equal to 100% of the aggregate principal amount of the CQP Senior Notes redeemed, plus the “applicable premium” set forth in the respective indentures governing +85 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +the CQP Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to October 1, 2020 for the 2025 CQP Senior Notes and October 1, 2021 for the 2026 CQP Senior Notes , Cheniere Partners may redeem up to 35% of the aggregate principal amount of the CQP Senior Notes with an amount of cash not greater than the net cash proceeds from certain equity offerings at a redemption price equal to 105.250% of the aggregate principal amount of the 2025 CQP Senior Notes and 105.625% of the aggregate principal amount of the 2026 CQP Senior Notes redeemed, plus accrued and unpaid interest, if any, to the date of redemption. Cheniere Partners also may at any time on or after October 1, 2020 through the maturity date of October 1, 2025 for the 2025 CQP Senior Notes and October 1, 2021 through the maturity date of October 1, 2026 for the 2026 CQP Senior Notes , redeem the CQP Senior Notes , in whole or in part, at the redemption prices set forth in the respective indentures governing the CQP Senior Notes . +The CQP Senior Notes are Cheniere Partners’ senior obligations, ranking equally in right of payment with Cheniere Partners’ other existing and future unsubordinated debt and senior to any of its future subordinated debt. After applying the proceeds from the 2026 CQP Senior Notes , the CQP Senior Notes became unsecured. In the event that the aggregate amount of Cheniere Partners’ secured indebtedness and the secured indebtedness of the CQP Guarantors (other than the CQP Senior Notes or any other series of notes issued under the CQP Base Indenture ) outstanding at any one time exceeds the greater of (1) $1.5 billion and (2) 10% of net tangible assets, the CQP Senior Notes will be secured to the same extent as such obligations under the CQP Credit Facilities . The obligations under the CQP Credit Facilities are secured on a first-priority basis (subject to permitted encumbrances) with liens on (1) substantially all the existing and future tangible and intangible assets and rights of Cheniere Partners and the CQP Guarantors and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the CQP Credit Facilities) and (2) substantially all of the real property of SPLNG (except for excluded properties referenced in the CQP Credit Facilities). The liens securing the CQP Senior Notes , if applicable, will be shared equally and ratably (subject to permitted liens) with the holders of other senior secured obligations, which include the CQP Credit Facilities obligations and any future additional senior secured debt obligations. +In connection with the closing of the 2026 CQP Senior Notes offering, Cheniere Partners and the CQP Guarantors entered into a registration rights agreement (the “CQP Registration Rights Agreement”) . Under the CQP Registration Rights Agreement , Cheniere Partners and the CQP Guarantors have agreed to file with the SEC and cause to become effective a registration statement relating to an offer to exchange any and all of the 2026 CQP Senior Notes for a like aggregate principal amount of debt securities of Cheniere Partners with terms identical in all material respects to the 2026 CQP Senior Notes sought to be exchanged (other than with respect to restrictions on transfer or to any increase in annual interest rate), within 360 days after the notes issuance date of September 11, 2018. Under specified circumstances, Cheniere Partners and the CQP Guarantors have also agreed to cause to become effective a shelf registration statement relating to resales of the 2026 CQP Senior Notes . Cheniere Partners will be obligated to pay additional interest on the 2026 CQP Senior Notes if it fails to comply with its obligation to register the 2026 CQP Senior Notes within the specified time period. +CCH Senior Notes +The 2024 CCH Senior Notes, 2025 CCH Senior Notes and 2027 CCH Senior Notes (collectively, the “CCH Senior Notes”) are jointly and severally guaranteed by CCH’s subsidiaries, CCL, CCP and Corpus Christi Pipeline GP, LLC (the “CCH Guarantors”). The indenture governing the CCH Senior Notes (the “CCH Indenture”) contains customary terms and events of default and certain covenants that, among other things, limit CCH’s ability and the ability of CCH’s restricted subsidiaries to: incur additional indebtedness or issue preferred stock; make certain investments or pay dividends or distributions on membership interests or subordinated indebtedness or purchase, redeem or retire membership interests; sell or transfer assets, including membership or partnership interests of CCH’s restricted subsidiaries; restrict dividends or other payments by restricted subsidiaries to CCH or any of CCH’s restricted subsidiaries; incur liens; enter into transactions with affiliates; dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of the properties or assets of CCH and its restricted subsidiaries taken as a whole; or permit any CCH Guarantor to dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of its properties and assets. Interest on the CCH Senior Notes is payable semi-annually in arrears. +At any time prior to six months before the respective dates of maturity for each series of the CCH Senior Notes, CCH may redeem all or part of such series of the CCH Senior Notes at a redemption price equal to the “make-whole” price set forth in the CCH Indenture, plus accrued and unpaid interest, if any, to the date of redemption. CCH also may at any time within six months of the respective dates of maturity for each series of the CCH Senior Notes, redeem all or part of such series of the CCH Senior Notes, in whole or in part, at a redemption price equal to 100% of the principal amount of the CCH Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +86 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Credit Facilities +Below is a summary of our credit facilities outstanding as of December 31, 2018 (in millions): +SPL Working Capital Facility +CQP Credit Facilities +CCH Credit Facility +CCH Working Capital Facility +Cheniere Revolving Credit Facility +Original facility size +$ +1,200 +$ +2,800 +$ +8,404 +$ +350 +$ +750 +Incremental commitments +— +— +1,566 +850 +500 +Less: +Outstanding balance +— +— +5,156 +168 +— +Commitments prepaid or terminated +— +2,685 +3,832 +— +— +Letters of credit issued +425 +— +— +316 +— +Available commitment +$ +775 +$ +115 +$ +982 +$ +716 +$ +1,250 +Interest rate +LIBOR plus 1.75% or base rate plus 0.75% +2.25% of the undrawn portion with a 0.50% step-up beginning on February 25, 2019 +LIBOR plus 1.75% or base rate plus 0.75% +LIBOR plus 1.25% - 1.75% or base rate plus 0.25% - 0.75% +LIBOR plus 1.75% - 2.50% or base rate plus 0.75% - 1.50% +Maturity date +December 31, 2020, with various terms for underlying loans +February 25, 2020 +June 30, 2024 +June 29, 2023 +December 13, 2022 +As of December 31, 2018 , the weighted average interest rate on our current debt was 5.47% . +SPL Working Capital Facility +In September 2015, SPL entered into the SPL Working Capital Facility, which is intended to be used for loans to SPL (“SPL Working Capital Loans”), the issuance of letters of credit on behalf of SPL, as well as for swing line loans to SPL (“SPL Swing Line Loans”), primarily for certain working capital requirements related to developing and placing into operation the SPL Project. SPL may, from time to time, request increases in the commitments under the SPL Working Capital Facility of up to $760 million and, upon the completion of the debt financing of Train 6 of the SPL Project, request an incremental increase in commitments of up to an additional $390 million . +Loans under the SPL Working Capital Facility accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of the senior facility agent’s published prime rate, the federal funds effective rate, as published by the Federal Reserve Bank of New York, plus 0.50% and one month LIBOR plus 0.50% ), plus the applicable margin. The applicable margin for LIBOR loans under the SPL Working Capital Facility is 1.75% per annum, and the applicable margin for base rate loans under the SPL Working Capital Facility is 0.75% per annum. Interest on SPL Swing Line Loans and loans deemed made in connection with a draw upon a letter of credit (“SPL LC Loans”) is due and payable on the date the loan becomes due. Interest on LIBOR loans is due and payable at the end of each applicable LIBOR period, and interest on base rate loans is due and payable at the end of each fiscal quarter. However, if such base rate loan is converted into a LIBOR loan, interest is due and payable on that date. Additionally, if the loans become due prior to such periods, the interest also becomes due on that date. +SPL pays (1) a commitment fee equal to an annual rate of 0.70% on the average daily amount of the excess of the total commitment amount over the principal amount outstanding without giving effect to any outstanding SPL Swing Line Loans and (2) a letter of credit fee equal to an annual rate of 1.75% of the undrawn portion of all letters of credit issued under the SPL Working Capital Facility. If draws are made upon a letter of credit issued under the SPL Working Capital Facility and SPL does not elect for such draw (an “SPL LC Draw”) to be deemed an SPL LC Loan, SPL is required to pay the full amount of the SPL LC Draw on or prior to the business day following the notice of the SPL LC Draw. An SPL LC Draw accrues interest at an annual rate of 2.0% plus the base rate. As of December 31, 2018 , no SPL LC Draws had been made upon any letters of credit issued under the SPL Working Capital Facility. +The SPL Working Capital Facility matures on December 31, 2020, and the outstanding balance may be repaid, in whole or in part, at any time without premium or penalty upon three business days’ notice. SPL LC Loans have a term of up to one year. SPL Swing Line Loans terminate upon the earliest of (1) the maturity date or earlier termination of the SPL Working Capital Facility, (2) the date 15 days after such SPL Swing Line Loan is made and (3) the first borrowing date for a SPL Working Capital +87 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Loan or SPL Swing Line Loan occurring at least three business days following the date the SPL Swing Line Loan is made. SPL is required to reduce the aggregate outstanding principal amount of all SPL Working Capital Loans to zero for a period of five consecutive business days at least once each year. +The SPL Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of SPL under the SPL Working Capital Facility are secured by substantially all of the assets of SPL as well as all of the membership interests in SPL on a pari passu basis with the SPL Senior Notes. +CQP Credit Facilities +In February 2016, Cheniere Partners entered into the CQP Credit Facilities . The CQP Credit Facilities originally consisted of: (1) a $450 million CTPL tranche term loan that was used to prepay the $400 million term loan facility in February 2016, (2) an approximately $2.1 billion SPLNG tranche term loan that was used to repay and redeem in November 2016 the approximately $2.1 billion of the senior notes previously issued by SPLNG, (3) a $125 million facility that could be used to satisfy a six -month debt service reserve requirement and (4) a $115 million revolving credit facility that may be used for general business purposes. In September 2017 and September 2018, Cheniere Partners issued the 2025 CQP Senior Notes and the 2026 CQP Senior Notes , respectively, and the net proceeds were used to prepay the outstanding term loans under the CQP Credit Facilities . As of December 31, 2018 , only a $115 million revolving credit facility, which is currently undrawn, remains as part of the CQP Credit Facilities . Cheniere Partners pays a commitment fee equal to an annual rate of 40% of the margin for LIBOR loans multiplied by the average daily amount of the undrawn commitment, payable quarterly in arrears. The revolving credit facility is available for the issuance of letters of credit, which incurs a fee equal to an annual rate of 2.25% of the undrawn portion with a 0.50% step-up beginning on February 25, 2019. +The CQP Credit Facilities mature on February 25, 2020. Any outstanding balance may be repaid, in whole or in part, at any time without premium or penalty, except for interest hedging and interest rate breakage costs. The CQP Credit Facilities contain conditions precedent for extensions of credit, as well as customary affirmative and negative covenants and limit Cheniere Partners’ ability to make restricted payments, including distributions, to once per fiscal quarter as long as certain conditions are satisfied. Under the CQP Credit Facilities , Cheniere Partners is required to hedge not less than 50% of the variable interest rate exposure on its projected aggregate outstanding balance, maintain a minimum debt service coverage ratio of at least 1.15 x at the end of each fiscal quarter beginning March 31, 2019 and have a projected debt service coverage ratio of 1.55 x in order to incur additional indebtedness to refinance a portion of the existing obligations. +The CQP Credit Facilities are unconditionally guaranteed by each subsidiary of Cheniere Partners other than (1) SPL and (2) certain subsidiaries of Cheniere Partners owning other development projects, as well as certain other specified subsidiaries and members of the foregoing entities. +CCH Credit Facility +In May 2018, CCH amended and restated the CCH Credit Facility to increase total commitments under the CCH Credit Facility from $4.6 billion to $6.1 billion . Borrowings are used to fund a portion of the costs of developing, constructing and placing into service the three Trains and the related facilities of the CCL Project and for related business purposes. +The CCH Credit Facility matures on June 30, 2024 , with principal payments due quarterly commencing on the earlier of (1) the first quarterly payment date occurring more than three calendar months following the completion of the CCL Project as defined in the common terms agreement and (2) a set date determined by reference to the date under which a certain LNG buyer linked to the last Train of the CCL Project to become operational is entitled to terminate its SPA for failure to achieve the date of first commercial delivery for that agreement. Scheduled repayments will be based upon a 19 -year tailored amortization, commencing the first full quarter after the completion of Trains 1 through 3 and designed to achieve a minimum projected fixed debt service coverage ratio of 1.50 :1. +Loans under the CCH Credit Facility accrue interest at a variable rate per annum equal to, at CCH’s election, LIBOR or the base rate (determined by reference to the applicable agent’s prime rate), plus the applicable margin. The applicable margin for LIBOR loans is 1.75% and for base rate loans is 0.75% . Interest on LIBOR loans is due and payable at the end of each applicable interest period and interest on base rate loans is due and payable at the end of each quarter. The CCH Credit Facility also requires +88 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +CCH to pay a commitment fee at a rate per annum equal to 40% of the margin for LIBOR loans, multiplied by the outstanding undrawn debt commitments. +The obligations of CCH under the CCH Credit Facility are secured by a first priority lien on substantially all of the assets of CCH and its subsidiaries and by a pledge by CCH HoldCo I of its limited liability company interests in CCH, on a pari passu basis with the CCH Senior Notes and the CCH Credit Facility. +Under the CCH Credit Facility , CCH is required to hedge not less than 65% of the variable interest rate exposure of its senior secured debt. CCH is restricted from making certain distributions under agreements governing its indebtedness generally until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project, funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25 :1.00. +The amendment and restatement of the CCH Credit Facility resulted in the recognition of $15 million of debt modification and extinguishment costs during the year ended December 31, 2018 relating to the incurrence of third party fees and write off of unamortized debt issuance costs. CCH was required to pay certain upfront fees to the agents and lenders under the CCH Credit Facility together with additional transaction fees and expenses in the aggregate amount of $53 million during the year ended December 31, 2018 . +CCH Working Capital Facility +In June 2018, CCH amended and restated the CCH Working Capital Facility to increase total commitments under the CCH Working Capital Facility from $350 million to $1.2 billion . The CCH Working Capital Facility is intended to be used for loans to CCH (“CCH Working Capital Loans”) and the issuance of letters of credit on behalf of CCH for certain working capital requirements related to developing and placing into operations the CCL Project and for related business purposes. Loans under the CCH Working Capital Facility are guaranteed by the CCH Guarantors . CCH may, from time to time, request increases in the commitments under the CCH Working Capital Facility of up to the maximum allowed for working capital under the Common Terms Agreement that was entered into concurrently with the CCH Credit Facility . +Loans under the CCH Working Capital Facility , including CCH Working Capital Loans and loans made in connection with a draw upon any letter of credit (“CCH LC Loans” and collectively, the “Revolving Loans”) accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of (1) the prime rate, (2) the federal funds rate plus 0.50% and (3) one month LIBOR plus 0.50% ) plus the applicable margin. The applicable margin for LIBOR Revolving Loans ranges from 1.25% to 1.75% per annum, and the applicable margin for base rate Revolving Loans ranges from 0.25% to 0.75% per annum. Interest on Revolving Loans is due and payable on the date the loan becomes due. Interest on LIBOR Revolving Loans is due and payable at the end of each LIBOR period, and interest on base rate Revolving Loans is due and payable at the end of each quarter. +CCH pays (1) a commitment fee equal to an annual rate of 40% of the applicable margin for LIBOR Revolving Loans on the average daily amount of the excess of the total commitment amount over the principal amount outstanding, (2) a letter of credit fee equal to an annual rate equal to the applicable margin for LIBOR Revolving Loans on the undrawn portion of all letters of credit issued under the CCH Working Capital Facility and (3) a letter of credit fronting fee equal to an annual rate of 0.20% of the undrawn portion of all fronted letters of credit. Each of these fees is payable quarterly in arrears. +If draws are made upon a letter of credit issued under the CCH Working Capital Facility and CCH does not elect for such draw (a “CCH LC Draw”) to be deemed a CCH LC Loan, CCH is required to pay the full amount of the CCH LC Draw on or prior to the business day following the notice of the CCH LC Draw. A CCH LC Draw accrues interest at an annual rate of 2.00% plus the base rate. +CCH was required to pay certain upfront fees to the agents and lenders under the CCH Working Capital Facility together with additional transaction fees and expenses in the aggregate amount of $14 million during the year ended December 31, 2018 . +The CCH Working Capital Facility matures on June 29, 2023 and CCH may prepay the Revolving Loans at any time without premium or penalty upon three business days’ notice and may re-borrow at any time. CCH LC Loans have a term of up to one year. CCH is required to reduce the aggregate outstanding principal amount of all CCH Working Capital Loans to zero for a period of five consecutive business days at least once each year. +89 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The CCH Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of CCH under the CCH Working Capital Facility are secured by substantially all of the assets of CCH and the CCH Guarantors as well as all of the membership interests in CCH and each of the CCH Guarantors on a pari passu basis with the CCH Senior Notes and the CCH Credit Facility . +Cheniere Revolving Credit Facility +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $750 million to $1.25 billion . The Cheniere Revolving Credit Facility is intended to fund, through loans and letters of credit, equity capital contributions to CCH HoldCo II and its subsidiaries for the development of the CCL Project and, provided that certain conditions are met, for general corporate purposes. +The Cheniere Revolving Credit Facility matures on December 13, 2022 and contains representations, warranties and affirmative and negative covenants customary for companies like us with lenders of the type participating in the Cheniere Revolving Credit Facility that limit our ability to make restricted payments, including distributions, unless certain conditions are satisfied, as well as limitations on indebtedness, guarantees, hedging, liens, investments and affiliate transactions. Under the Cheniere Revolving Credit Facility , we are required to ensure that the sum of our unrestricted cash and the amount of undrawn commitments under the Cheniere Revolving Credit Facility is at least equal to the lesser of (1) 20% of the commitments under the Cheniere Revolving Credit Facility and (2) $200 million (the “Liquidity Covenant”). +From and after the time at which certain specified conditions are met (the “Trigger Point”), we will have increased flexibility under the Cheniere Revolving Credit Facility to, among other things, (1) make restricted payments and (2) raise incremental commitments. The Trigger Point will occur once (1) completion has occurred for each of Train 1 of the CCL Project (as defined in the CCH Indenture) and Train 5 of the SPL Project (as defined in SPL’s common terms agreement), (2) the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is less than or equal to 10% of aggregate commitments under the Cheniere Revolving Credit Facility and (3) we elect on a go-forward basis to be governed by a non-consolidated leverage ratio covenant not to exceed 5.75 :1.00 (the “Springing Leverage Covenant”), which following such election will apply at any time that the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is greater than 30% of aggregate commitments under the Cheniere Revolving Credit Facility . Following the Trigger Point, at any time that the Springing Leverage Covenant is in effect, the Liquidity Covenant will not apply. +Loans under the Cheniere Revolving Credit Facility accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of (1) the prime rate, (2) the federal funds rate plus 0.50% and (3) one month LIBOR plus 1.00% ), plus the applicable margin. The applicable margin for LIBOR loans ranges from 1.75% to 2.50% per annum, and the applicable margin for base rate loans ranges from 0.75% to 1.50% per annum, in each case, based on the credit ratings then in effect assigned to loans under the Cheniere Revolving Credit Facility . Interest on LIBOR loans is due and payable at the end of each LIBOR period, and interest on base rate loans is due and payable at the end of each calendar quarter. We will also pay (1) prior to the Trigger Point, a commitment fee on the average daily amount of undrawn commitments at an annual rate of 0.75% , payable quarterly in arrears and (2) from and after the Trigger Point, a commitment fee on the average daily amount of undrawn commitments at a rate equal to 30% multiplied by the applicable margin for LIBOR loans then in effect. We will also pay a letter of credit fee at an annual rate equal to the applicable margin for LIBOR loans on the undrawn portion of all letters of credit issued under the Cheniere Revolving Credit Facility . Draws on any letters of credit will accrue interest at an annual rate equal to the base rate plus 2.0% . +The Cheniere Revolving Credit Facility is secured by a first priority security interest (subject to permitted liens and other customary exceptions) in substantially all of our assets, including our interests in our direct subsidiaries (excluding CCH HoldCo II and certain other subsidiaries). +90 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Convertible Notes +Below is a summary of our convertible notes outstanding as of December 31, 2018 (in millions): +2021 Cheniere Convertible Unsecured Notes +2025 CCH HoldCo II Convertible Senior Notes +2045 Cheniere Convertible Senior Notes +Aggregate original principal +$ +1,000 +$ +1,000 +$ +625 +Debt component, net of discount and debt issuance costs +$ +1,126 +$ +1,432 +$ +310 +Equity component +$ +209 +$ +— +$ +194 +Maturity date +May 28, 2021 +May 13, 2025 +March 15, 2045 +Contractual interest rate +4.875 +% +11.0 +% +4.25 +% +Effective interest rate (1) +8.4 +% +11.9 +% +9.4 +% +Remaining debt discount and debt issuance costs amortization period (2) +2.4 years +1.8 years +26.2 years +(1) +Rate to accrete the discounted carrying value of the convertible notes to the face value over the remaining amortization period. +(2) +We amortize any debt discount and debt issuance costs using the effective interest over the period through contractual maturity except for the 2025 CCH HoldCo II Convertible Senior Notes , which are amortized through the date they are first convertible by holders into our common stock. +2021 Cheniere Convertible Unsecured Notes +In November 2014, we issued the 2021 Cheniere Convertible Unsecured Notes on a private placement basis in reliance on the exemption from registration provided for under section 4(a)(2) of the Securities Act and Regulation S promulgated thereunder. The 2021 Cheniere Convertible Unsecured Notes accrue interest at a rate of 4.875% per annum, which is payable in kind semi-annually in arrears by increasing the principal amount of the 2021 Cheniere Convertible Unsecured Notes outstanding. Beginning one year after the closing date, the 2021 Cheniere Convertible Unsecured Notes will be convertible at the option of the holder into our common stock at the then applicable conversion rate, provided that the closing price of our common stock is greater than or equal to the conversion price on the conversion date. The initial conversion price was $93.64 and is subject to adjustment upon the occurrence of certain specified events. We have the option to satisfy the conversion obligation with cash, common stock or a combination thereof. +Under GAAP, certain convertible debt instruments that may be settled in cash upon conversion are required to be separately accounted for as liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. We determined that the fair value of the debt component was $809 million and the residual value of the equity component was $191 million as of the issuance date. As of December 31, 2018 and 2017 , the carrying value of the equity component was $209 million and $206 million , respectively. The debt component is accreted to the total principal amount due at maturity by amortizing the debt discount. The effective rate of interest to amortize the debt discount and debt issuance costs was approximately 8.4% and 8.3% as of December 31, 2018 and 2017 , respectively. As of December 31, 2018 , the if-converted value of the 2021 Cheniere Convertible Unsecured Notes did not exceed the principal balance. +2025 CCH HoldCo II Convertible Senior Notes +In May 2015, CCH HoldCo II issued the 2025 CCH HoldCo II Convertible Senior Notes on a private placement basis in reliance on the exemption from registration provided for under section 4(a)(2) of the Securities Act . The 2025 CCH HoldCo II Convertible Senior Notes were issued pursuant to the amended and restated note purchase agreement entered into among CCH HoldCo II, EIG Management Company, LLC, The Bank of New York Mellon, us and the note purchasers. The $1.0 billion principal of the 2025 CCH HoldCo II Convertible Senior Notes are being used to partially fund costs associated with Stage 1 and Stage 2 of the CCL Project. The 2025 CCH HoldCo II Convertible Senior Notes bear interest at a rate of 11.0% per annum, which is payable quarterly in arrears. Prior to the substantial completion of Train 2 of the CCL Project, interest on the 2025 CCH HoldCo II Convertible Senior Notes will be paid entirely in kind. Following this date, the interest generally must be paid in cash; however, a portion of the interest may be paid in kind under certain specified circumstances. The 2025 CCH HoldCo II Convertible Senior +91 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Notes are secured by a pledge by us of 100% of the equity interests in CCH HoldCo II, and a pledge by CCH HoldCo II of 100% of the equity interests in CCH HoldCo I. +At CCH HoldCo II’s option, the outstanding 2025 CCH HoldCo II Convertible Senior Notes are convertible into our common stock, provided the total market capitalization of Cheniere at that time is not less than $10.0 billion , on or after the later of (1) March 1, 2020 and (2) the substantial completion of Train 2 of the CCL Project (the “Eligible Conversion Date”). The conversion price for 2025 CCH HoldCo II Convertible Senior Notes converted at CCH HoldCo II’s option is the lower of (1) a 10% discount to the average of the daily volume-weighted average price (“VWAP”) of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided and (2) a 10% discount to the closing price of our common stock on the trading day preceding the date on which notice of conversion is provided. At the option of the holders, the 2025 CCH HoldCo II Convertible Senior Notes are convertible on or after the six -month anniversary of the Eligible Conversion Date, provided the total market capitalization of Cheniere at that time is not less than $10.0 billion , at a conversion price equal to the average of the daily VWAP of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided. Conversions are also subject to various limitations and conditions. +CCH HoldCo II is restricted from making distributions to Cheniere under agreements governing its indebtedness generally until, among other requirements, Trains 1 and 2 of the CCL Project are in commercial operation and a historical debt service coverage ratio and a projected fixed debt services coverage ratio of 1.20 :1.00 are achieved. +In May 2018, the amended and restated note purchase agreement under which the 2025 CCH HoldCo II Convertible Senior Notes were issued was subsequently amended in connection with commercialization and financing of Train 3 of the CCL Project and to provide the note holders with certain prepayment rights related thereto. +2045 Cheniere Convertible Senior Notes +In March 2015, we issued the 2045 Cheniere Convertible Senior Notes to certain investors through a registered direct offering. The 2045 Cheniere Convertible Senior Notes were issued with an original issue discount of 20% and accrue interest at a rate of 4.25% per annum, which is payable semi-annually in arrears. We have the right, at our option, at any time after March 15, 2020, to redeem all or any part of the 2045 Cheniere Convertible Senior Notes at a redemption price payable in cash equal to the accreted amount of the 2045 Cheniere Convertible Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to such redemption date. The conversion rate will initially equal 7.2265 shares of our common stock per $1,000 principal amount of the 2045 Cheniere Convertible Senior Notes, which corresponds to an initial conversion price of approximately $138.38 per share of our common stock. The conversion rate is subject to adjustment upon the occurrence of certain specified events. We have the option to satisfy the conversion obligation with cash, common stock or a combination thereof. +We determined that the fair value of the debt component of the 2045 Cheniere Convertible Senior Notes was $304 million and the residual value of the equity component was $196 million as of the issuance date, excluding debt issuance costs and original issue discount. As of both December 31, 2018 and 2017 , the carrying value of the equity component was $194 million . The debt component is accreted to the total principal amount due at maturity by amortizing the debt discount and debt issuance costs. The effective rate of interest to amortize the debt discount and debt issuance costs was approximately 9.4% as of both December 31, 2018 and 2017 . As of December 31, 2018 , the if-converted value of the 2045 Cheniere Convertible Senior Notes did not exceed the principal balance. +Restrictive Debt Covenants +As of December 31, 2018 , each of our issuers was in compliance with all covenants related to their respective debt agreements. +92 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Interest Expense +Total interest expense, including interest expense related to our convertible notes, consisted of the following (in millions): +Year Ended December 31, +2018 +2017 +2016 +Interest cost on convertible notes: +Interest per contractual rate +$ +237 +$ +219 +$ +202 +Amortization of debt discount +35 +29 +31 +Amortization of debt issuance costs +9 +7 +5 +Total interest cost related to convertible notes +281 +255 +238 +Interest cost on capital lease +1 +— +— +Interest cost on debt excluding capital lease and convertible notes +1,396 +1,271 +1,063 +Total interest cost +1,678 +1,526 +1,301 +Capitalized interest +(803 +) +(779 +) +(813 +) +Total interest expense, net +$ +875 +$ +747 +$ +488 +Fair Value Disclosures +The following table shows the carrying amount, which is net of unamortized premium, discount and debt issuance costs, and estimated fair value of our debt (in millions): +December 31, 2018 +December 31, 2017 +Carrying +Amount +Estimated +Fair Value +Carrying +Amount +Estimated +Fair Value +Senior notes (1) +$ +19,466 +$ +19,901 +$ +18,350 +$ +20,075 +2037 SPL Senior Notes (2) +791 +817 +790 +871 +Credit facilities (3) +5,294 +5,294 +3,574 +3,574 +2021 Cheniere Convertible Unsecured Notes (2) +1,126 +1,236 +1,040 +1,136 +2025 CCH HoldCo II Convertible Senior Notes (2) +1,432 +1,612 +1,273 +1,535 +2045 Cheniere Convertible Senior Notes (4) +310 +431 +309 +447 +(1) +Includes 2021 SPL Senior Notes , 2022 SPL Senior Notes , 2023 SPL Senior Notes , 2024 SPL Senior Notes , 2025 SPL Senior Notes , 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes , 2025 CQP Senior Notes , 2026 CQP Senior Notes , 2024 CCH Senior Notes , 2025 CCH Senior Notes and 2027 CCH Senior Notes . The Level 2 estimated fair value was based on quotes obtained from broker-dealers or market makers of these senior notes and other similar instruments. +(2) +The Level 3 estimated fair value was calculated based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including our stock price and interest rates based on debt issued by parties with comparable credit ratings to us and inputs that are not observable in the market. +(3) +Includes SPL Working Capital Facility , CQP Credit Facilities , CCH Credit Facility , CCH Working Capital Facility , Cheniere Revolving Credit Facility and Cheniere Marketing trade finance facilities . The Level 3 estimated fair value approximates the principal amount because the interest rates are variable and reflective of market rates and the debt may be repaid, in full or in part, at any time without penalty. +(4) +The Level 1 estimated fair value was based on unadjusted quoted prices in active markets for identical liabilities that we had the ability to access at the measurement date. +93 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 13—REVENUES FROM CONTRACTS WITH CUSTOMERS +The following table represents a disaggregation of revenue earned from contracts with customers during the years ended December 31, 2018, 2017 and 2016 (in millions): +Year Ended December 31, +2018 +2017 +2016 +LNG revenues +$ +7,440 +$ +5,342 +$ +1,015 +Regasification revenues +261 +260 +259 +Other revenues (1) +142 +21 +8 +Other—related party +12 +3 +— +Total revenues from customers +7,855 +5,626 +1,282 +Gains (losses) from derivative instruments (2) +132 +(25 +) +1 +Total revenues +$ +7,987 +$ +5,601 +$ +1,283 +(1) +Includes $101 million in sub-chartering revenues for the year ended December 31, 2018. +(2) +Includes the realized value associated with a portion of derivative instruments that settle through physical delivery. +LNG Revenues +We have entered into numerous SPAs with third party customers for the sale of LNG on a free on board (“FOB”) (delivered to the customer at either the Sabine Pass or Corpus Christi LNG terminal) or delivered at terminal (“DAT”) (delivered to the customer at their LNG receiving terminal) basis. Our customers generally purchase LNG for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. The fixed fee component is the amount payable to us regardless of a cancellation or suspension of LNG cargo deliveries by the customers. The variable fee component is the amount generally payable to us only upon delivery of LNG plus all future adjustments to the fixed fee for inflation. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +We intend to primarily use LNG sourced from our Sabine Pass or Corpus Christi terminals to provide contracted volumes to our customers. However, we supplement this LNG with volumes procured from third parties. LNG revenues recognized from LNG that was procured from third parties was $745 million , $981 million and $236 million for the years ended December 31, 2018, 2017 and 2016 , respectively. +Revenues from the sale of LNG are recognized at a point in time when the LNG is delivered to the customer, either at the Sabine Pass or Corpus Christi LNG terminal or at the customer’s LNG receiving terminal, based on the terms of the contract, which is the point legal title, physical possession and the risks and rewards of ownership transfer to the customer. Each individual molecule of LNG is viewed as a separate performance obligation. The stated contract price (including both fixed and variable fees) per MMBtu in each LNG sales arrangement is representative of the stand-alone selling price for LNG at the time the sale was negotiated. We have concluded that the variable fees meet the exception for allocating variable consideration to specific parts of the contract. As such, the variable consideration for these contracts is allocated to each distinct molecule of LNG and recognized when that distinct molecule of LNG is delivered to the customer. Because of the use of the exception, variable consideration related to the sale of LNG is also not included in the transaction price. +When we sell LNG on a DAT basis, we consider all transportation costs, including vessel chartering, loading/unloading and canal fees, as fulfillment costs and not as separate services provided to the customer within the arrangement, regardless of whether or not such activities occur prior to or after the customer obtains control of the LNG. We expense fulfillment costs as incurred unless otherwise dictated by GAAP. +Fees received pursuant to SPAs are recognized as LNG revenues only after substantial completion of the respective Train. Prior to substantial completion, sales generated during the commissioning phase are offset against the cost of construction for the respective Train, as the production and removal of LNG from storage is necessary to test the facility and bring the asset to the condition necessary for its intended use. +94 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Regasification Revenues +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4.0 Bcf/d. Approximately 2.0 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term TUAs with unaffiliated third-party customers, under which they are required to pay fixed monthly fees regardless of their use of the LNG terminal. Each of the customers has reserved approximately 1.0 Bcf/d of regasification capacity. The customers are each obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually for 20 years that commenced in 2009, which is representative of fixed consideration in the contract. A portion of this fee is adjusted annually for inflation which is considered variable consideration. The remaining capacity of the Sabine Pass LNG terminal has been reserved by SPL, for which the associated revenues are eliminated in consolidation. +Because SPLNG is continuously available to provide regasification service on a daily basis with the same pattern of transfer, we have concluded that SPLNG provides a single performance obligation to its customers on a continuous basis over time. We have determined that an output method of recognition based on elapsed time best reflects the benefits of this service to the customer and accordingly, LNG regasification capacity reservation fees are recognized as regasification revenues on a straight-line basis over the term of the respective TUAs. We have concluded that the inflation element within the contract meets the exception for allocating variable consideration to specific parts of the contract and accordingly the inflation adjustment is not included in the transaction price and will be recognized over the year in which the inflation adjustment relates on a straight-line basis. +In 2012, SPL entered into a partial TUA assignment agreement with Total Gas & Power North America, Inc. (“Total”) , whereby SPL would progressively gain access to Total ’s capacity and other services provided under its TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Trains 5 and 6. +Upon substantial completion of Train 3 of the SPL Project , which was in March 2017, SPL gained access to a portion of Total ’s capacity and other services provided under Total ’s TUA with SPLNG. Upon substantial completion of Train 5, SPL will gain access to substantially all of Total ’s capacity. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA and we continue to recognize the payments received from Total as revenue. During the years ended December 31, 2018 and 2017 , SPL recorded $30 million and $23 million , respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Deferred Revenue Reconciliation +The following table reflects the changes in our contract liabilities, which we classify as deferred revenue on our Consolidated Balance Sheets (in millions): +Year Ended December 31, +2018 +2017 +Deferred revenues, beginning of period +$ +111 +$ +78 +Cash received but not yet recognized +139 +111 +Revenue recognized from prior period deferral +(111 +) +(78 +) +Deferred revenues, end of period +$ +139 +$ +111 +We record deferred revenue when we receive consideration, or such consideration is unconditionally due from a customer, prior to transferring goods or services to the customer under the terms of a sales contract. Changes in deferred revenue during the years ended December 31, 2018 and 2017 are primarily attributable to differences between the timing of revenue recognition and the receipt of advance payments related to delivery of LNG under certain SPAs. +95 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Transaction Price Allocated to Future Performance Obligations +Because many of our sales contracts have long-term durations, we are contractually entitled to significant future consideration which we have not yet recognized as revenue. The following table discloses the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of December 31, 2018 and 2017 : +December 31, 2018 +December 31, 2017 +Unsatisfied Transaction Price (in billions) +Weighted Average Recognition Timing (years) (1) +Unsatisfied Transaction Price (in billions) +Weighted Average Recognition Timing (years) (1) +LNG revenues +$ +106.6 +11 +$ +83.7 +11 +Regasification revenues +2.6 +6 +2.9 +6 +Total revenues +$ +109.2 +$ +86.6 +(1) +The weighted average recognition timing represents an estimate of the number of years during which we shall have recognized half of the unsatisfied transaction price. +We have elected the following exemptions which omit certain potential future sources of revenue from the table above: +(1) +We omit from the table above all performance obligations that are part of a contract that has an original expected duration of one year or less. +(2) +We omit from the table above all variable consideration that is allocated entirely to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise to transfer a distinct good or service that forms part of a single performance obligation when that performance obligation qualifies as a series. The table above excludes all variable consideration under our SPAs and TUAs. The amount of revenue from variable fees that is not included in the transaction price will vary based on the future prices of Henry Hub throughout the contract terms, to the extent customers elect to take delivery of their LNG, and adjustments to the consumer price index. Certain of our contracts contain additional variable consideration based on the outcome of contingent events and the movement of various indexes. We have not included such variable consideration in the transaction price to the extent the consideration is considered constrained due to the uncertainty of ultimate pricing and receipt. Approximately 56% of our LNG revenues from contracts with a duration of over one year during each of the years ended December 31, 2018 and 2017 and approximately 3% and 2% of our regasification revenues were related to variable consideration received from customers during the years ended December 31, 2018 and 2017 , respectively. +We have entered into contracts to sell LNG that are conditioned upon one or both of the parties achieving certain milestones such as reaching FID on a certain liquefaction Train, obtaining financing or achieving substantial completion of a Train and any related facilities. These contracts are considered completed contracts for revenue recognition purposes and are included in the transaction price above when the conditions are considered probable of being met. +NOTE 14—INCOME TAXES +Components of income (loss) before income taxes and non-controlling interest on our Consolidated Statements of Operations for the years ended December 31, 2018, 2017 and 2016 are as follows (in millions): +Year Ended December 31, +2018 +2017 +2016 +U.S. +$ +997 +$ +30 +$ +(611 +) +International +230 +536 +(52 +) +Total income (loss) before income taxes and non-controlling interest +$ +1,227 +$ +566 +$ +(663 +) +96 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Income tax provision included in our reported net income (loss) consisted of the following (in millions): +Year Ended December 31, +2018 +2017 +2016 +Current: +Federal +$ +— +$ +— +$ +— +State +2 +— +— +Foreign +30 +6 +— +Total current +32 +6 +— +Deferred: +Federal +— +— +— +State +— +— +— +Foreign +(5 +) +(3 +) +2 +Total deferred +(5 +) +(3 +) +2 +Total income tax provision +$ +27 +$ +3 +$ +2 +The reconciliation of the federal statutory income tax rate to our effective income tax rate is as follows: +Year Ended December 31, +2018 +2017 +2016 +U.S. federal statutory tax rate +21.0 +% +35.0 +% +35.0 +% +Non-controlling interest +(11.4 +)% +2.9 +% +(2.1 +)% +State tax rate +(0.4 +)% +(0.2 +)% +1.8 +% +U.S. tax reform rate change +— +% +71.4 +% +— +% +Share-based compensation +(0.5 +)% +(6.2 +)% +— +% +Nondeductible interest expense +2.6 +% +8.5 +% +(6.6 +)% +Foreign earnings taxed in the U.S. +1.4 +% +— +% +— +% +Foreign rate differential +(1.1 +)% +(0.7 +)% +(1.2 +)% +Other +0.4 +% +(0.5 +)% +0.3 +% +Valuation allowance +(9.8 +)% +(109.7 +)% +(27.5 +)% +Effective tax rate +2.2 +% +0.5 +% +(0.3 +)% +97 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Significant components of our deferred tax assets and liabilities at December 31, 2018 and 2017 are as follows (millions): +December 31, +2018 +2017 +Deferred tax assets +Net operating loss carryforwards and credits +Federal +$ +848 +$ +936 +Foreign +7 +6 +State +189 +184 +Federal and state tax credits +28 +22 +Disallowed business interest expense carryforward +19 +— +Deferred gain +46 +46 +Other +50 +77 +Less: valuation allowance +(686 +) +(806 +) +Total deferred tax assets +501 +465 +Deferred tax liabilities +Investment in limited partnership +(375 +) +(391 +) +Convertible debt +(59 +) +(65 +) +Property, plant and equipment +(48 +) +(6 +) +Other +(11 +) +— +Total deferred tax liabilities +(493 +) +(462 +) +Net deferred tax assets +$ +8 +$ +3 +The federal deferred tax assets presented above do not include the state tax benefits as our net deferred state tax assets are offset with a full valuation allowance. +At December 31, 2018 , we had federal and state net operating loss (“NOL”) carryforwards of approximately $4.3 billion and $2.4 billion , respectively. These NOL carryforwards will expire between 2021 and 2038. At December 31, 2018 , we had federal and state tax credit carryforwards of $25 million and $3 million , respectively. The federal tax credit carryforwards include investment tax credit carryforwards of $14 million related to capital equipment placed in service by Cheniere Partners. We account for our federal investment tax credits under the flow-through method. The federal and state tax credit carryforwards will expire between 2027 and 2037. +Under the Tax Cuts and Jobs Act, for taxable years beginning after December 31, 2017, our deduction for business interest is limited to the sum of our business interest income plus 30% of our adjusted taxable income. For the purposes of this limitation, adjusted taxable income is computed without regard to any business interest expense or business interest income, and in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion. However, recently issued proposed Treasury Regulations provide that depreciation, amortization, or depletion expense that is capitalized to inventory, is not treated as depreciation, amortization, or depletion deduction for purposes of computing adjusted taxable income. Although the regulations are not final, we have elected to adopt the proposed Treasury Regulations for the tax year ended December 31, 2018. As a result, at December 31, 2018, we had disallowed business interest expense of $92 million that can be carried forward indefinitely. +Due to historical losses and other available evidence related to our ability to generate taxable income, we have maintained a valuation allowance against our net federal and state deferred tax assets as of December 31, 2018 and 2017 . We will continue to evaluate the realizability of our deferred tax assets in the future. Release of the U.K. NOL valuation allowance resulted in a $5 million deferred tax benefit for the tax year ended December 31, 2018 . The decrease in the valuation allowance was $120 million for the year ended December 31, 2018 . +98 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Changes in the balance of unrecognized tax benefits are as follows (in millions): +Year Ended December 31, +2018 +2017 +Balance at beginning of the year +$ +62 +$ +103 +Additions based on tax positions related to current year +— +— +Additions for tax positions of prior years +— +— +Reductions for tax positions of prior years +(1 +) +(1 +) +Settlements +— +— +U.S. tax reform rate change +— +(40 +) +Balance at end of the year +$ +61 +$ +62 +Any settlement of uncertain tax positions would result in an adjustment to our NOL carryforward which, if utilized, will reduce taxable income in a future year. As a result, the tabular rollforward reflects the unrecognized tax benefits at the reduced corporate income tax rate of 21% . +Our effective tax rate will not be affected if the unrecognized federal income tax benefits provided above were recognized. Currently, we do not recognize any accrued liabilities, interest and penalties associated with the unrecognized tax benefits provided above in our Consolidated Statements of Operations or our Consolidated Balance Sheets because any settlement of uncertain tax positions would result in an adjustment to our NOL carryforward. We recognize interest and penalties related to income tax matters as part of income tax expense. +We experienced an ownership change within the provisions of U.S. Internal Revenue Code (“IRC”) Section 382 in 2008, 2010 and 2012. An analysis of the annual limitation on the utilization of our NOLs was performed in accordance with IRC Section 382. It was determined that IRC Section 382 will not limit the use of our NOLs over the carryover period. We will continue to monitor trading activity in our shares which may cause an additional ownership change which could ultimately affect our ability to fully utilize our existing NOL carryforwards. +We are subject to tax in the U.S. and various state and foreign jurisdictions. We remain subject to periodic audits and reviews by taxing authorities; however, we did not have any open income tax audits as of December 31, 2018 . Federal and state tax returns for the years after 2014 remain open for examination. Tax authorities may have the ability to review and adjust carryover attributes that were generated prior to these periods if utilized in an open tax year. +NOTE 15—SHARE-BASED COMPENSATION +We have granted restricted stock shares, restricted stock units, performance stock units and phantom units to employees and non-employee directors under the Amended and Restated 2003 Stock Incentive Plan, as amended (the “2003 Plan”) , the 2011 Incentive Plan, as amended (the “2011 Plan”) , the 2015 Employee Inducement Incentive Plan (the “Inducement Plan”) and the 2015 Long-Term Cash Incentive Plan. +Total share-based compensation consisted of the following (in millions): +Year Ended December 31, +2018 +2017 +2016 +Share-based compensation costs, pre-tax: +Equity awards +$ +89 +$ +34 +$ +41 +Liability awards +48 +80 +76 +Total share-based compensation +137 +114 +117 +Capitalized share-based compensation +(24 +) +(23 +) +(16 +) +Total share-based compensation expense +$ +113 +$ +91 +$ +101 +Tax benefit associated with share-based compensation expense +$ +6 +$ +5 +$ +— +99 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The total unrecognized compensation cost at December 31, 2018 relating to non-vested share-based compensation arrangements consisted of the following: +Unrecognized Compensation Cost +(in millions) +Recognized over a weighted average period +(years) +Restricted Stock Share Awards +$ +2 +0.3 +Restricted Share Unit and Performance Stock Unit Awards +$ +136 +1.7 +Phantom Units Awards +$ +11 +1.4 +Restricted Stock Share Awards +Restricted stock share awards are awards of common stock that are subject to restrictions on transfer and to a risk of forfeiture if the recipient terminates employment with us prior to the lapse of the restrictions. These awards vest based on service conditions ( one , two , three or four -year service periods) and performance conditions. All performance conditions of the awards have been achieved as of December 31, 2018 . +The 2003 Plan and 2011 Plan provide for the issuance of 21.0 million shares and 35.0 million shares, respectively, of our common stock that may be in the form of various share-based performance awards deemed by the Compensation Committee of our Board (the “Compensation Committee”). +The Inducement Plan initially provided for the issuance of up to 1.0 million shares of our common stock in the form of stock-based awards deemed by the Compensation Committee to provide us with an opportunity to attract employees. As of December 31, 2018 , 0.2 million shares of restricted stock have been granted under the Inducement Plan. In December 2016, the Compensation Committee recommended, and our Board approved, reducing the remaining shares available for issuance under the Inducement Plan to zero . +The table below provides a summary of our restricted stock outstanding (in millions, except for per share information): +Shares +Weighted Average Grant Date Fair Value Per Share +Non-vested at January 1, 2018 +2.2 +$ +24.29 +Granted +— +— +Vested +(2.1 +) +24.03 +Forfeited +— +— +Non-vested at December 31, 2018 +0.1 +$ +45.77 +The fair value of restricted stock share awards vested for the years ended December 31, 2018, 2017 and 2016 were $53 million , $78 million and $36 million , respectively. +Restricted Share Unit and Performance Stock Unit Awards +Restricted stock units are stock awards that vest over a two - to three -year service period and entitle the holder to receive shares of our common stock upon vesting, subject to restrictions on transfer and to a risk of forfeiture if the recipient terminates employment with us prior to the lapse of the restrictions. Performance stock units provide for three -year cliff vesting with payouts based on our cumulative distributable cash flow per share from January 1, 2018 through December 31, 2020 compared to a pre-established performance target. The number of shares that may be earned at the end of the vesting period ranges from 50 to 200 percent of the target award amount if the threshold performance is met. Both restricted stock units and performance stock units will be settled in Cheniere common stock (on a one-for-one basis) and are classified as equity awards. +In January 2017, the issuance of awards with respect to 7.8 million shares of common stock available for issuance under the 2011 Plan was approved at a special meeting of our shareholders. +100 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The table below provides a summary of our restricted share unit and performance stock unit awards outstanding assuming payout at target for awards containing performance conditions (in millions, except for per unit information): +Units +Weighted Average Grant Date Fair Value Per Unit +Non-vested at January 1, 2018 +1.3 +$ +47.18 +Granted (1) +2.6 +59.50 +Vested +(0.4 +) +48.40 +Forfeited +(0.1 +) +53.92 +Non-vested at December 31, 2018 +3.4 +$ +56.29 +(1) +This number excludes 0.2 million performance stock units, which represent the maximum number of common units that would be issued if the maximum level of performance under the target awards amount is achieved. +The table below provides a summary of restricted share unit and performance stock unit awards issued: +Year Ended December 31, +2018 +2017 +2016 +Units issued (in millions) +2.6 +1.4 +— +Weighted average grant date fair value per unit +$ +59.50 +$ +47.16 +$ +— +Fair value of units vested (in millions) +$ +22 +$ +1 +$ +— +Phantom Units Awards +Phantom units are share-based awards granted to employees over a vesting period that entitle the grantee to receive the cash equivalent to the value of a share of our common stock upon each vesting. We did no t issue any phantom units to our employees and non-employee directors during the years ended December 31, 2018 and 2017 . During the year ended December 31, 2016, we issued 1.8 million phantom units to our employees and non-employee directors. Phantom units are not eligible to receive quarterly distributions. These awards vest based on service conditions ( two , three or four -year service periods). +The table below provides a summary of our phantom units outstanding (in millions): +Units +Non-vested at January 1, 2018 +1.8 +Granted +— +Vested +(1.5 +) +Forfeited +— +Non-vested at December 31, 2018 +0.3 +The value of phantom units vested during the years ended December 31, 2018, 2017 and 2016 was $91 million , $86 million and $78 million , respectively. +NOTE 16—EMPLOYEE BENEFIT PLAN +We have a defined contribution plan (“401(k) Plan”) which allows eligible employees to contribute up to 75% of their compensation up to the IRS maximum. We match each employee’s deferrals (contributions) up to 6% of compensation and may make additional contributions at our discretion. Employees are immediately vested in the contributions made by us. Our contributions to the 401(k) Plan were $9 million , $7 million and $6 million for the years ended December 31, 2018, 2017 and 2016 , respectively. We have made no discretionary contributions to the 401(k) Plan to date. +101 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 17— NET INCOME (LOSS) PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS +The following table reconciles basic and diluted weighted average common shares outstanding for the years ended December 31, 2018, 2017 and 2016 (in millions, except per share data): +Year Ended December 31, +2018 +2017 +2016 +Weighted average common shares outstanding: +Basic +245.6 +233.1 +228.8 +Dilutive unvested stock +2.4 +— +— +Diluted +248.0 +233.1 +228.8 +Basic net income (loss) per share attributable to common stockholders +$ +1.92 +$ +(1.68 +) +$ +(2.67 +) +Diluted net income (loss) per share attributable to common stockholders +$ +1.90 +$ +(1.68 +) +$ +(2.67 +) +Potentially dilutive securities that were not included in the diluted net income (loss) per share computations because their effects would have been anti-dilutive were as follows (in millions): +Year Ended December 31, +2018 +2017 +2016 +Unvested stock (1) +0.8 +3.4 +0.6 +Convertible notes (2) +17.5 +16.9 +16.3 +Total potentially dilutive common shares +18.3 +20.3 +16.9 +(1) +Does not include 0.4 million shares, 0.2 million shares and 5.0 million shares for each of the years ended December 31, 2018, 2017 and 2016 , of unvested stock because the performance conditions had not yet been satisfied as of December 31, 2018 , 2017 and 2016, respectively. +(2) +Includes number of shares in aggregate issuable upon conversion of the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes . There were no shares included in the computation of diluted net income (loss) per share for the 2025 CCH HoldCo II Convertible Senior Notes because substantive non-market-based contingencies underlying the eligible conversion date have not been met as of December 31, 2018 . +NOTE 18—LEASES +During the years ended December 31, 2018, 2017 and 2016 , we recognized rental expense for all operating leases of $335 million , $199 million and $86 million , respectively, related primarily to LNG vessel time charters, office space and land sites. Our land site leases for the Sabine Pass LNG terminal have initial terms varying up to 30 years with multiple options to renew up to an additional 60 years. +Future annual minimum lease payments, excluding inflationary adjustments, for operating leases are as follows (in millions): +Years Ending December 31, +Operating Leases (1) +2019 (2) +$ +380 +2020 +184 +2021 +238 +2022 +264 +2023 +264 +Thereafter +999 +Total +$ +2,329 +(1) +Includes certain lease option renewals that are reasonably assured and payments for certain non-lease components . +(2) +Does not include $43 million in aggregate payments we will receive from our LNG vessel time charter subleases. +102 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Capital Leases +In December 2015, we entered into a lease agreement for marine services related to the CCL Project that was classified as a capital lease. The service term of this lease commenced at various times during the year ended December 31, 2018 , and the tug vessels received under the agreement are recorded within property, plant and equipment, net on our Consolidated Balance Sheets. +Future annual minimum lease payments, excluding inflationary adjustments, for capital leases are as follows (in millions): +Years Ending December 31, +Capital Leases +2019 +$ +5 +2020 +5 +2021 +5 +2022 +5 +2023 +5 +Thereafter +73 +Total minimum lease payments (1) +98 +Less: amount representing imputed interest +(39 +) +Present value of minimum lease payment +59 +Less: current portion of capital lease obligations +(2 +) +Non-current portion of capital lease obligations +$ +57 +(1) +Does not include payments for non-lease components of $98 million . +NOTE 19—COMMITMENTS AND CONTINGENCIES +We have various contractual obligations which are recorded as liabilities in our Consolidated Financial Statements. Other items, such as certain purchase commitments and other executed contracts which do not meet the definition of a liability as of December 31, 2018 , are not recognized as liabilities but require disclosures in our Consolidated Financial Statements. +LNG Terminal Commitments and Contingencies +Obligations under EPC Contracts +SPL has lump sum turnkey contracts with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Train 5 and Train 6 of the SPL Project. The EPC contract prices for Train 5 of the SPL Project and Train 6 of the SPL Project are approximately $3.1 billion and $2.5 billion , respectively, reflecting amounts incurred under change orders through December 31, 2018 , and including estimated costs for an optional third marine berth. +CCL has lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Stage 1 and Stage 2 of the CCL Project. The EPC contract prices for Stage 1 of the CCL Project and Stage 2 of the CCL Project are approximately $7.8 billion and $2.4 billion , respectively, reflecting amounts incurred under change orders through December 31, 2018 . +SPL and CCL have the right to terminate each of its respective EPC contracts for its convenience, in which case Bechtel will be paid (1) the portion of the contract price for the work performed, (2) costs reasonably incurred by Bechtel on account of such termination and demobilization and (3) a lump sum of up to $30 million depending on the termination date. +Obligations under SPAs +SPL and CCL have third-party SPAs which obligate SPL and CCL, respectively, to purchase and liquefy sufficient quantities of natural gas to deliver contracted volumes of LNG to the customers’ vessels, subject to completion of construction of applicable specified Trains of the SPL Project or the CCL Project. In addition, our integrated marketing function has third-party SPAs which obligate us to deliver contracted volumes of LNG to the customers’ vessels or to the customers at their LNG receiving terminals. +103 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Obligations under LNG TUAs +SPLNG has third-party TUAs with Total and Chevron U.S.A. Inc. to provide berthing for LNG vessels and for the unloading, storage and regasification of LNG at the Sabine Pass LNG terminal. +Obligations under Natural Gas Supply, Transportation and Storage Service Agreements +SPL and CCL primarily have index-based physical natural gas supply contracts to secure natural gas feedstock for the SPL Project and the CCL Project, respectively. The terms of these contracts range up to eight years, some of which commence upon the satisfaction of certain conditions precedent. As of December 31, 2018 , SPL and CCL have secured up to approximately 3,464 TBtu and 2,801 TBtu, respectively, of natural gas feedstock through natural gas supply contracts, a portion of which are considered purchase obligations if the conditions precedent are met. +Additionally, SPL and CCL have transportation and storage service agreements for the SPL Project and the CCL Project, respectively. The initial terms of the transportation agreements range up to 20 years for the SPL Project the CCL Project, with renewal options for certain contracts, and commence upon the occurrence of conditions precedent. The term of the storage service agreements for the SPL Project ranges up to ten years and the term of the storage service agreements for the CCL Project ranges up to five years. +As of December 31, 2018 , the obligations of SPL and CCL under natural gas supply, transportation and storage service agreements for contracts in which conditions precedent were met were as follows (in millions): +Years Ending December 31, +Payments Due (1) +2019 +$ +3,148 +2020 +1,991 +2021 +1,452 +2022 +1,010 +2023 +818 +Thereafter +3,355 +Total +$ +11,774 +(1) +Pricing of natural gas supply contracts are variable based on market commodity basis prices adjusted for basis spread . Amounts included are based on prices and basis spreads as of December 31, 2018 . +Restricted Net Assets +At December 31, 2018 , our restricted net assets of consolidated subsidiaries were approximately $1.6 billion . +Other Commitments +In the ordinary course of business, we have entered into certain multi-year licensing and service agreements, none of which are considered material to our financial position. Additionally, we have various lease commitments, as disclosed in Note 18—Leases . +Legal Proceedings +We may in the future be involved as a party to various legal proceedings, which are incidental to the ordinary course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities on the eventual disposition of these matters. +Parallax Litigation +In 2015, our wholly owned subsidiary, Cheniere LNG Terminals, LLC (“CLNGT”), entered into discussions with Parallax Enterprises, LLC (“Parallax Enterprises”) regarding the potential joint development of two liquefaction plants in Louisiana (the +104 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +“Potential Liquefaction Transactions”). While the parties negotiated regarding the Potential Liquefaction Transactions, CLNGT loaned Parallax Enterprises approximately $46 million , as reflected in a secured note dated April 23, 2015, as amended on June 30, 2015, September 30, 2015 and November 4, 2015 (the “Secured Note”). The Secured Note was secured by all assets of Parallax Enterprises and its subsidiary entities. On June 30, 2015, Parallax Enterprises’ parent entity, Parallax Energy LLC (“Parallax Energy”), executed a Pledge and Guarantee Agreement further securing repayment of the Secured Note by providing a parent guaranty and a pledge of all of the equity of Parallax Enterprises in satisfaction of the Secured Note (the “Pledge Agreement”). CLNGT and Parallax Enterprises never executed a definitive agreement to pursue the Potential Liquefaction Transactions. The Secured Note matured on December 11, 2015, and Parallax Enterprises failed to make payment. On February 3, 2016, CLNGT filed an action against Parallax Energy, Parallax Enterprises and certain of Parallax Enterprises’ subsidiary entities, styled Cause No. 4:16-cv-00286, Cheniere LNG Terminals, LLC v. Parallax Energy LLC, et al., in the United States District Court for the Southern District of Texas (the “Texas Federal Suit”). CLNGT asserted claims in the Texas Federal Suit for (1) recovery of all amounts due under the Secured Note and (2) declaratory relief establishing that CLNGT is entitled to enforce its rights under the Secured Note and Pledge Agreement in accordance with each instrument’s terms and that CLNGT has no obligations of any sort to Parallax Enterprises concerning the Potential Liquefaction Transactions. On March 11, 2016, Parallax Enterprises and the other defendants in the Texas Federal Suit moved to dismiss the suit for lack of subject matter jurisdiction. On August 2, 2016, the court denied the defendants’ motion to dismiss without prejudice and permitted the parties to pursue jurisdictional discovery. +On March 11, 2016, Parallax Enterprises filed a suit against us and CLNGT styled Civil Action No. 62-810, Parallax Enterprises LLP v. Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC, in the 25th Judicial District Court of Plaquemines Parish, Louisiana (the “Louisiana Suit”), wherein Parallax Enterprises asserted claims for breach of contract, fraudulent inducement, negligent misrepresentation, detrimental reliance, unjust enrichment and violation of the Louisiana Unfair Trade Practices Act. Parallax Enterprises predicated its claims in the Louisiana Suit on an allegation that we and CLNGT breached a purported agreement to jointly develop the Potential Liquefaction Transactions. Parallax Enterprises sought $400 million in alleged economic damages and rescission of the Secured Note. On April 15, 2016, we and CLNGT removed the Louisiana Suit to the United States District Court for the Eastern District of Louisiana, which subsequently transferred the Louisiana Suit to the United States District Court for the Southern District of Texas, where it was assigned Civil Action No. 4:16-cv-01628 and transferred to the same judge presiding over the Texas Federal Suit for coordinated handling. On August 22, 2016, Parallax Enterprises voluntarily dismissed all claims asserted against CLNGT and us in the Louisiana Suit without prejudice to refiling. +On July 27, 2017, the Parallax entities named as defendants in the Texas Federal Suit reurged their motion to dismiss and simultaneously filed counterclaims against CLNGT and third party claims against us for breach of contract, breach of fiduciary duty, promissory estoppel, quantum meruit and fraudulent inducement of the Secured Note and Pledge Agreement, based on substantially the same factual allegations Parallax Enterprises made in the Louisiana Suit. These Parallax entities also simultaneously filed an action styled Cause No. 2017-49685, Parallax Enterprises, LLC, et al. v. Cheniere Energy, Inc., et al., in the 61st District Court of Harris County, Texas (the “Texas State Suit”), which asserts substantially the same claims these entities asserted in the Texas Federal Suit. On July 31, 2017, CLNGT withdrew its opposition to the dismissal of the Texas Federal Suit without prejudice on jurisdictional grounds and the federal court subsequently dismissed the Texas Federal Suit without prejudice. We and CLNGT simultaneously filed an answer and counterclaims in the Texas State Suit, asserting the same claims CLNGT had previously asserted in the Texas Federal Suit. Additionally, CLNGT filed third party claims against Parallax principals Martin Houston, Christopher Bowen Daniels, Howard Candelet and Mark Evans, as well as Tellurian Investments, Inc., Driftwood LNG, LLC, Driftwood LNG Pipeline LLC and Tellurian Services LLC, formerly known as Parallax Services LLC, including claims for tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, fraudulent transfer, conspiracy/aiding and abetting. Discovery in the Texas State Suit is ongoing. Trial is currently set for June 2019. +On February 15, 2019, we filed an action with CLNGT against Charif Souki, our former Chairman of the Board and Chief Executive Officer, styled, Cause No. 2019-11529, Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC v. Charif Souki , in the 55th District Court of Harris County, Texas, which asserts claims of breach of fiduciary duties, fraudulent transfer, tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, and conspiracy/aiding and abetting. +We do not expect that the resolution of any of the foregoing litigation will have a material adverse impact on our financial results. +105 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 20—CUSTOMER CONCENTRATION +The following table shows customers with revenues of 10% or greater of total revenues from external customers and customers with accounts receivable balances of 10% or greater of total accounts receivable from external customers: +Percentage of Total Revenues from External Customers +Percentage of Accounts Receivable from External Customers +Year Ended December 31, +December 31, +2018 +2017 +2016 +2018 +2017 +Customer A +18% +24% +39% +21% +28% +Customer B +14% +14% +* +14% +16% +Customer C +19% +14% +—% +18% +14% +Customer D +13% +* +* +* +—% +Customer E +* +17% +—% +—% +—% +Customer F +* +* +* +* +15% +Customer G +* +* +* +10% +—% +Customer H +* +* +13% +—% +—% +* Less than 10% +The following table shows revenues from external customers attributable to the country in which the revenues were derived (in millions). We attribute revenues from external customers to the country in which the party to the applicable agreement has its principal place of business. Substantially all of our long-lived assets are located in the United States. +Revenues from External Customers +Year Ended December 31, +2018 +2017 +2016 +United States +$ +1,911 +$ +1,592 +$ +769 +South Korea +1,517 +762 +— +Ireland +1,098 +787 +63 +India +1,048 +48 +23 +Japan +193 +1,246 +162 +Other countries +2,220 +1,166 +266 +Total +$ +7,987 +$ +5,601 +$ +1,283 +NOTE 21—SUPPLEMENTAL CASH FLOW INFORMATION +The following table provides supplemental disclosure of cash flow information (in millions): +Year Ended December 31, +2018 +2017 +2016 +Cash paid during the period for interest, net of amounts capitalized +$ +707 +$ +305 +$ +66 +Non-cash investing and financing activities: +Issuance of stock to acquire additional interest in Cheniere Holdings +702 +2 +94 +Contribution of assets to equity method investee +— +14 +— +Acquisition of assets under capital lease +60 +— +— +The balance in property, plant and equipment, net funded with accounts payable and accrued liabilities was $420 million , $521 million and $395 million as of December 31, 2018 , 2017 and 2016, respectively. +106 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 22—RECENT ACCOUNTING STANDARDS +The following table provides a brief description of a recent accounting standard that had not been adopted by us as of December 31, 2018 : +Standard +Description +Expected Date of Adoption +Effect on our Consolidated Financial Statements or Other Significant Matters +ASU 2016-02, Leases (Topic 842) , and subsequent amendments thereto +This standard requires a lessee to recognize leases on its balance sheet by recording a lease liability representing the obligation to make future lease payments and a right-of-use asset representing the right to use the underlying asset for the lease term. A lessee is permitted to make an election not to recognize lease assets and liabilities for leases with a term of 12 months or less. The standard also modifies the definition of a lease and requires expanded disclosures. This guidance may be early adopted, and may be adopted using either a modified retrospective approach to apply the standard at the beginning of the earliest period presented in the financial statements or an optional transition approach to apply the standard at the date of adoption with no retrospective adjustments to prior periods. Certain additional practical expedients are also available. +January 1, 2019 +We will adopt this standard on January 1, 2019 using the optional transition approach to apply the standard at the beginning of the first quarter of 2019 with no retrospective adjustments to prior periods. The adoption of the standard will result in the recognition of right-of-use assets and lease liabilities for operating leases of approximately $550 million on our Consolidated Balance Sheets, with no material impact on our Consolidated Statements of Operations or Consolidated Statements of Cash Flows. The adoption of this standard will also result in additional disclosures including the significant judgments and assumptions used in applying the standard. When we adopt this standard we will elect the practical expedients to (1) carryforward prior conclusions related to lease identification and classification for existing leases, (2) combine lease and non-lease components of an arrangement for all classes of leased assets, (3) omit short-term leases with a term of 12 months or less from recognition on the balance sheet and (4) carryforward our existing accounting for land easements not previously accounted for as leases. +107 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Additionally, the following table provides a brief description of recent accounting standards that were adopted by us during the reporting period: +Standard +Description +Date of Adoption +Effect on our Consolidated Financial Statements or Other Significant Matters +ASU 2014-09, Revenue from Contracts with Customers (Topic 606) , and subsequent amendments thereto +This standard provides a single, comprehensive revenue recognition model which replaces and supersedes most existing revenue recognition guidance and requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard requires that the costs to obtain and fulfill contracts with customers should be recognized as assets and amortized to match the pattern of transfer of goods or services to the customer if expected to be recoverable. The standard also requires enhanced disclosures. This guidance may be adopted either retrospectively to each prior reporting period presented subject to allowable practical expedients (“full retrospective approach”) or as a cumulative-effect adjustment as of the date of adoption (“modified retrospective approach”). +January 1, 2018 +We adopted this guidance on January 1, 2018, using the full retrospective method. The adoption of this guidance represents a change in accounting principle that will provide financial statement readers with enhanced disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The adoption of this guidance did not impact our previously reported Consolidated Financial Statements in any prior period nor did it result in a cumulative effect adjustment to retained earnings. See Note 13—Revenues from Contracts with Customers for additional disclosures. +ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory +This standard requires the immediate recognition of the tax consequences of intercompany asset transfers other than inventory. This guidance may be early adopted, but only at the beginning of an annual period, and must be adopted using a modified retrospective approach. +January 1, 2018 +The adoption of this guidance did not have an impact on our Consolidated Financial Statements or related disclosures. +108 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS +SUMMARIZED QUARTERLY FINANCIAL DATA +(unaudited) +Summarized Quarterly Financial Data—(in millions, except per share amounts) +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Year ended December 31, 2018: +Revenues +$ +2,242 +$ +1,543 +$ +1,819 +$ +2,383 +Income from operations +747 +336 +425 +516 +Net income +600 +150 +227 +223 +Net income (loss) attributable to common stockholders +357 +(18 +) +65 +67 +Net income (loss) per share attributable to common stockholders—basic (1) +1.52 +(0.07 +) +0.26 +0.26 +Net income (loss) per share attributable to common stockholders—diluted (1) +1.50 +(0.07 +) +0.26 +0.26 +Year ended December 31, 2017: +Revenues +$ +1,211 +$ +1,241 +$ +1,403 +$ +1,746 +Income from operations +376 +274 +297 +441 +Net income +172 +21 +90 +280 +Net income (loss) attributable to common stockholders +54 +(285 +) +(289 +) +127 +Net income (loss) per share attributable to common stockholders—basic and diluted (1) +0.23 +(1.23 +) +(1.24 +) +0.54 +(1) +The sum of the quarterly net income (loss) per share—basic and diluted may not equal the full year amount as the computations of the weighted average common shares outstanding for basic and diluted shares outstanding for each quarter and the full year are performed independently. +109 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. +CONTROLS AND PROCEDURES +Evaluation of Disclosure Controls and Procedures +Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. +Based on their evaluation as of the end of the fiscal year ended December 31, 2018 , our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act ) are effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are (1) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and (2) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. +During the most recent fiscal quarter, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +Management’s Report on Internal Control Over Financial Reporting +Our Management’s Report on Internal Control Over Financial Reporting is included in our Consolidated Financial Statements on page 61 and is incorporated herein by reference. +ITEM 9B. +OTHER INFORMATION +None. +PART III +Pursuant to paragraph 3 of General Instruction G to Form 10-K, the information required by Items 10 through 14 of Part III of this Report is incorporated by reference from Cheniere’s definitive proxy statement, which is to be filed pursuant to Regulation 14A within 120 days after the end of Cheniere’s fiscal year ended December 31, 2018 . +110 +PART IV +ITEM 15. +EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +(a) +Financial Statements, Schedules and Exhibits +(1) +Financial Statements—Cheniere Energy, Inc. and Subsidiaries: +Management’s Report to the Stockholders of Cheniere Energy, Inc. +61 +Reports of Independent Registered Public Accounting Firm +62 +Consolidated Balance Sheets +64 +Consolidated Statements of Operations +65 +Consolidated Statements of Stockholders’ Equity +66 +Consolidated Statements of Cash Flows +67 +Notes to Consolidated Financial Statements +68 +Supplemental Information to Consolidated Financial Statements—Quarterly Financial Data +109 +(2) +Financial Statement Schedules: +Schedule I—Condensed Financial Information of Registrant for the years ended December 31, 2018, 2017 and 2016 +127 +(3) +Exhibits: +Certain of the agreements filed as exhibits to this Form 10-K contain representations, warranties, covenants and conditions by the parties to the agreements that have been made solely for the benefit of the parties to the agreement. These representations, warranties, covenants and conditions: +• +should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate; +• +may have been qualified by disclosures that were made to the other parties in connection with the negotiation of the agreements, which disclosures are not necessarily reflected in the agreements; +• +may apply standards of materiality that differ from those of a reasonable investor; and +• +were made only as of specified dates contained in the agreements and are subject to subsequent developments and changed circumstances. +Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. These agreements are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Investors should not rely on them as statements of fact. +Exhibit No. +Description +2.1 +Amended and Restated Purchase and Sale Agreement, dated as of August 9, 2012, by and among Cheniere Partners, Cheniere Pipeline Company, Grand Cheniere Pipeline, LLC and the Company (Incorporated by reference to Exhibit 10.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on August 9, 2012) +3.1 +Restated Certificate of Incorporation of the Company (Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2004 (SEC File No. 001-16383), filed on August 10, 2004) +3.2 +Certificate of Amendment of Restated Certificate of Incorporation of the Company (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on February 8, 2005) +111 +Exhibit No. +Description +3.3 +Certificate of Amendment of Restated Certificate of Incorporation of the Company (Incorporated by reference to Exhibit 4.3 to the Company’s Registration Statement on Form S-8 (SEC File No. 333-160017), filed on June 16, 2009) +3.4 +Certificate of Amendment of Restated Certificate of Incorporation of the Company (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on June 7, 2012) +3.5 +Certificate of Amendment of Restated Certificate of Incorporation of the Company (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on February 5, 2013) +3.6 +Bylaws of the Company, as amended and restated December 9, 2015 (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on December 15, 2015) +3.7 +Amendment No. 1 to the Amended and Restated Bylaws of the Company, dated September 15, 2016 (Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on September 19, 2016) +4.1 +Specimen Common Stock Certificate of the Company (Incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (SEC File No. 333-10905), filed on August 27, 1996) +4.2 +Indenture, dated as of February 1, 2013, by and among SPL, the guarantors that may become party thereto from time to time and The Bank of New York Mellon, as trustee (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on February 4, 2013) +4.3 +Form of 5.625% Senior Secured Note due 2021 (Included as Exhibit A-1 to Exhibit 4.2 above) +4.4 +First Supplemental Indenture, dated as of April 16, 2013, between SPL and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on April 16, 2013) +4.5 +Second Supplemental Indenture, dated as of April 16, 2013, between SPL and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on April 16, 2013) +4.6 +Form of 5.625% Senior Secured Note due 2023 (Included as Exhibit A-1 to Exhibit 4.5 above) +4.7 +Third Supplemental Indenture, dated as of November 25, 2013, between SPL and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on November 25, 2013) +4.8 +Form of 6.25% Senior Secured Note due 2022 (Included as Exhibit A-1 to Exhibit 4.7 above) +4.9 +Fourth Supplemental Indenture, dated as of May 20, 2014, between SPL and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on May 22, 2014) +4.10 +Form of 5.750% Senior Secured Note due 2024 (Included as Exhibit A-1 to Exhibit 4.9 above) +4.11 +Fifth Supplemental Indenture, dated as of May 20, 2014, between SPL and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on May 22, 2014) +4.12 +Form of 5.625% Senior Secured Note due 2023 (Included as Exhibit A-1 to Exhibit 4.11 above) +4.13 +Sixth Supplemental Indenture, dated as of March 3, 2015, between SPL and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on March 3, 2015) +4.14 +Form of 5.625% Senior Secured Note due 2025 (Included as Exhibit A-1 to Exhibit 4.13 above) +4.15 +Seventh Supplemental Indenture, dated as of June 14, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on June 14, 2016) +4.16 +Form of 5.875% Senior Secured Note due 2026 (Included as Exhibit A-1 to Exhibit 4.15 above) +4.17 +Eighth Supplemental Indenture, dated as of September 19, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 23, 2016) +4.18 +Ninth Supplemental Indenture, dated as of September 23, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 23, 2016) +4.19 +Form of 5.00% Senior Secured Note due 2027 (Included as Exhibit A-1 to Exhibit 4.18 above) +112 +Exhibit No. +Description +4.20 +Tenth Supplemental Indenture, dated as of March 6, 2017, between SPL and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on March 6, 2017) +4.21 +Form of 4.200% Senior Secured Note due 2028 (Included as Exhibit A-1 to Exhibit 4.20 above) +4.22 +Indenture, dated as of February 24, 2017, between SPL, the guarantors that may become party thereto from time to time and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on February 27, 2017) +4.23 +Form of 5.00% Senior Secured Note due 2037 (Included as Exhibit A-1 to Exhibit 4.22 above) +4.24 +Indenture, dated as of November 28, 2014, by and between the Company, as Issuer, and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on December 2, 2014) +4.25 +Form of 4.875% Unsecured PIK Convertible Note due 2021 (Included as Exhibit A to Exhibit 4.24 above) +4.26 +Indenture, dated as of March 9, 2015, between the Company, the Guarantors and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on March 13, 2015) +4.27 +First Supplemental Indenture, dated as of March 9, 2015, between the Company, as Issuer, and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on March 13, 2015) +4.28 +Form of 4.25% Convertible Senior Note due 2045 (Included as Exhibit A to Exhibit 4.27 above) +4.29 +Indenture, dated as of May 18, 2016, among CCH, as Issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 18, 2016) +4.30 +Form of 7.000% Senior Secured Note due 2024 (Included as Exhibit A-1 to Exhibit 4.29 above) +4.31 +First Supplemental Indenture, dated as of December 9, 2016, among CCH, as Issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on December 9, 2016) +4.32 +Form of 5.875% Senior Secured Note due 2025 (Included as Exhibit A-1 to Exhibit 4.31 above) +4.33 +Second Supplemental Indenture, dated as of May 19, 2017, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as trustee (Incorporated by reference to Exhibit 4.1 to CCH’s Current Report on Form 8-K (SEC File No. 333-215435), filed on May 19, 2017) +4.34 +Form of 5.125% Senior Secured Note due 2027 (Included as Exhibit A-1 to Exhibit 4.33 above) +4.35 +Indenture, dated as of September 18, 2017, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 18, 2017) +4.36 +First Supplemental Indenture, dated as of September 18, 2017, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 18, 2017) +4.37 +Form of 5.250% Senior Note due 2025 (Included as Exhibit A-1 to Exhibit 4.36 above) +4.38 +Second Supplemental Indenture, dated as of September 11, 2018, among Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture (Incorporated by reference to Exhibit 4.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 12, 2018) +4.39 +Form of 5.625% Senior Note due 2026 (Included as Exhibit A-1 to Exhibit 4.38 above) +10.1 +LNG Terminal Use Agreement, dated September 2, 2004, by and between Total LNG USA, Inc. and SPLNG (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 15, 2004) +10.2 +Amendment of LNG Terminal Use Agreement, dated January 24, 2005, by and between Total LNG USA, Inc. and SPLNG (Incorporated by reference to Exhibit 10.40 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on March 10, 2005) +113 +Exhibit No. +Description +10.3 +Amendment of LNG Terminal Use Agreement, dated June 15, 2010, by and between Total Gas & Power North America, Inc. and SPLNG (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on August 6, 2010) +10.4 +Omnibus Agreement, dated September 2, 2004, by and between Total LNG USA, Inc. and SPLNG (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 15, 2004) +10.5 +Parent Guarantee, dated as of November 5, 2004, by Total S.A. in favor of SPLNG (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 15, 2004) +10.6 +Letter Agreement, dated September 11, 2012, between Total Gas & Power North America, Inc. and SPLNG (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Quarterly Report on Form 10-Q (SEC File No. 001-33366), filed on November 2, 2012) +10.7 +LNG Terminal Use Agreement, dated November 8, 2004, between Chevron U.S.A. Inc. and SPLNG (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 15, 2004) +10.8 +Amendment to LNG Terminal Use Agreement, dated December 1, 2005, by and between Chevron U.S.A. Inc. and SPLNG (Incorporated by reference to Exhibit 10.28 to SPLNG’s Registration Statement on Form S-4 (SEC File No. 333-138916), filed on November 22, 2006) +10.9 +Amendment of LNG Terminal Use Agreement, dated June 16, 2010, by and between Chevron U.S.A. Inc. and SPLNG (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on August 6, 2010) +10.10 +Omnibus Agreement, dated November 8, 2004, between Chevron U.S.A. Inc. and SPLNG (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 15, 2004) +10.11 +Guaranty Agreement, dated as of December 15, 2004, from ChevronTexaco Corporation to SPLNG (Incorporated by reference to Exhibit 10.12 to SPLNG’s Registration Statement on Form S-4 (SEC File No. 333-138916), filed on November 22, 2006) +10.12 +Second Amended and Restated LNG Terminal Use Agreement, dated as of July 31, 2012, between SPL and SPLNG (Incorporated by reference to Exhibit 10.1 to SPLNG’s Current Report on Form 8-K (SEC File No. 333-138916), filed on August 6, 2012) +10.13 +Letter Agreement, dated May 28, 2013, by and between SPL and SPLNG (Incorporated by reference to Exhibit 10.1 to SPLNG’s Quarterly Report on Form 10-Q (SEC File No. 333-138916), filed on August 2, 2013) +10.14 +Guarantee Agreement, dated as of July 31, 2012, by Cheniere Partners in favor of SPLNG (Incorporated by reference to Exhibit 10.2 to SPLNG’s Current Report on Form 8-K (SEC File No. 333-138916), filed on August 6, 2012) +10.15† +Cheniere Energy, Inc. 2011 Incentive Plan (as amended through April 13, 2017) (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on August 8, 2017) +10.16† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (US - New Hire) (Incorporated by reference to Exhibit 10.13 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on August 10, 2012) +10.17† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (UK - New Hire) (Incorporated by reference to Exhibit 10.14 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on August 10, 2012) +10.18† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (Director) (Incorporated by reference to Exhibit 10.20 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on July 30, 2015) +10.19† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grades 18-20) (Incorporated by reference to Exhibit 10.37 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.20† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grades 18-20) (Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.21† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 17) (Incorporated by reference to Exhibit 10.38 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +114 +Exhibit No. +Description +10.22† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 17) (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.23† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Key Executive Severance Plan ) (Incorporated by reference to Exhibit 10.39 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.24† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Severance Pay Plan) (Incorporated by reference to Exhibit 10.40 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.25† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 16 and Below) (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.26† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Singapore) (Grade 16 and Below) (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.27† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Chile) (Grade 16 and Below) (Incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.28† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grades 18-20) (Incorporated by reference to Exhibit 10.41 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.29† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grades 18-20) (Incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.30† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 17) (Incorporated by reference to Exhibit 10.42 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.31† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 17) (Incorporated by reference to Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.32† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Key Executive Severance Plan) (Incorporated by reference to Exhibit 10.43 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.33† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Severance Pay Plan) (Incorporated by reference to Exhibit 10.44 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.34† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 16 and Below) (Incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2017) +10.35*† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (2019 Grades 18-20) +10.36† +Form of Milestone Award Letter (Incorporated by reference to Exhibit 10.45 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.37† +Cheniere Energy, Inc. 2014-2018 Long-Term Cash Incentive Program (Incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.38† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Executive) (Incorporated by reference to Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.39† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Non-Executive) (Incorporated by reference to Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.40† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Executive) (Incorporated by reference to Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +115 +Exhibit No. +Description +10.41† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Non-Executive) (Incorporated by reference to Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.42† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Consultant) (Incorporated by reference to Exhibit 10.14 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.43† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Consultant) (Incorporated by reference to Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.44† +Cheniere Energy, Inc. 2015 Employee Inducement Incentive Plan (Incorporated by reference to Exhibit 4.8 to the Company’s Registration Statement on Form S-8 (SEC File No. 333-207651), filed on October 29, 2015) +10.45† +Form of Cheniere Energy, Inc. 2015 Employee Inducement Incentive Plan Restricted Stock Grant - US Form (Incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on October 30, 2015) +10.46† +Amended and Restated Cheniere Energy, Inc. Key Executive Severance Pay Plan (Effective as of January 11, 2018) and Summary Plan Description (Incorporated by reference to Exhibit 10.58 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 21, 2018) +10.47† +Employment Agreement between the Company and Jack A. Fusco, dated May 12, 2016 (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 12, 2016) +10.48† +Cheniere Energy, Inc. Retirement Policy, dated effective February 17, 2017 (Incorporated by reference to Exhibit 10.65 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 24, 2017) +10.49† +Form of Indemnification Agreement for officers of the Company (Incorporated by reference to Exhibit 10.73 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 19, 2016) +10.50† +Form of Indemnification Agreement for directors of the Company (Incorporated by reference to Exhibit 10.74 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 19, 2016) +10.51 +Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, among SPL, as Borrower, the representatives and agents from time to time parties thereto, and Société Générale, as the Common Security Trustee and Intercreditor Agent (Incorporated by reference to Exhibit 10.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on July 1, 2015) +10.52 +Omnibus Amendment, dated as of September 24, 2015, to the Second Amended and Restated Common Terms Agreement among SPL, as Borrower, the representatives and agents from time to time parties thereto, and Société Générale, as the Common Security Trustee and Intercreditor Agent (Incorporated by reference to Exhibit 10.6 to Cheniere Partners’ Quarterly Report on Form 10-Q (SEC File No. 001-33366), filed on October 30, 2015) +10.53 +Administrative Amendment to the Second Amended and Restated Common Terms Agreement, dated as of December 31, 2015, among SPL, Société Générale, as the Commercial Banks Facility Agent, The Korea Development Bank, New York Branch, as the KSURE Covered Facility Agent and Shinhan Bank New York Branch, as KEXIM Facility Agent (Incorporated by reference to Exhibit 10.7 to Cheniere Partners’ Quarterly Report on Form 10-Q (File No. 001-33366), filed on May 5, 2016) +10.54 +Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, among SPL, as Borrower, The Bank of Nova Scotia, as Senior Issuing Bank and Senior Facility Agent, ABN Amro Capital USA LLC, HSBC Bank USA, National Association and ING Capital LLC, as Senior Issuing Banks, Société Générale, as Swing Line Lender and Common Security Trustee, and the senior lenders party thereto from time to time (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 11, 2015) +10.55 +Third Omnibus Amendment, dated as of May 23, 2018 to (a) the Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, by and among SPL, Société Générale, as the Common Security Trustee and as the Intercreditor Agent, The Bank of Nova Scotia, and each other party thereto from time to time and (b) the Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, by and among SPL, Société Générale as the Swing Line Lender and as the Common Security Trustee, The Bank of Nova Scotia as the Senior Issuing Bank and Senior Facility Agent and the other agents and lenders from time to time party thereto (Incorporated by reference to Exhibit 10.3 to Cheniere Partners’ Registration Statement on Form S-4 (SEC File No. 333-225684) filed on June 15, 2018) +116 +Exhibit No. +Description +10.56 +Fourth Omnibus Amendment, dated as of September 17, 2018, to (a) the Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, by and among SPL, as Borrower, Société Générale, as the Common Security Trustee and as the Intercreditor Agent, The Bank of Nova Scotia, as the Secured Debt Holder Group Representative for the Working Capital Debt and other Secured Debt Holder Group Representatives party thereto from time to time, the Secured Hedge Representatives and the Secured Gas Hedge Representatives party thereto from time to time and (b) the Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, by and among SPL, as Borrower, Société Générale as the Swing Line Lender and as the Common Security Trustee, The Bank of Nova Scotia as the Senior Issuing Bank and Senior Facility Agent and the other agents and lenders from time to time party thereto (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 8, 2018) +10.57 +Amended and Restated Subscription Agreement, dated as of November 26, 2014, by and among the Company, RRJ Capital II Ltd, Baytree Investments (Mauritius) Pte Ltd and Seatown Lionfish Pte. Ltd. relating to convertible PIK notes of the Company (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on December 2, 2014) +10.58 +Amended and Restated Term Loan Facility Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the lenders party thereto from time to time and Société Générale as the Term Loan Facility Agent (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 24, 2018) +10.59 +Amended and Restated Common Terms Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, Société Générale, as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, and Société Générale as Intercreditor Agent, and any other facility lenders party thereto from time to time (Incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 24, 2018) +10.60* +First Amendment to the Amended and Restated Common Terms Agreement, dated as of November 28, 2018, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as Intercreditor Agent +10.61 +Amended and Restated Common Security and Account Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the Senior Creditor Group Representatives, Société Générale as the Intercreditor Agent, Société Générale as Security Trustee and Mizuho Bank, Ltd as the Account Bank (Incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 24, 2018) +10.62* +First Amendment to the Amended and Restated Common Security and Account Agreement, dated as of November 28, 2018, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, the Senior Creditor Group Representatives, Société Générale as Intercreditor Agent for the Facility Lenders and any Hedging Banks, Société Générale as Security Trustee, and Mizuho Bank, Ltd. as Account Bank +10.63 +Amended and Restated Pledge Agreement, dated May 22, 2018, among CCH HoldCo I and Société Générale as Security Trustee (Incorporated by reference to Exhibit 10.4 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 24, 2018) +10.64 +Amended and Restated Equity Contribution Agreement, dated May 22, 2018, among CCH and the Company (Incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 24, 2018) +10.65 +Amended and Restated Note Purchase Agreement, dated as of March 1, 2015, by and among CCH HoldCo II, as Issuer, the Company (solely for purposes of acknowledging and agreeing to Section 9 thereof), EIG Management Company, LLC, as administrative agent, The Bank of New York Mellon, as collateral agent, and the note purchasers named therein (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on March 2, 2015) +10.66 +Amendment to Amended and Restated Note Purchase Agreement, dated as of March 16, 2015, by and among CCH HoldCo II, as Issuer, EIG Management Company, LLC, as administrative agent, and the note purchasers named therein (Incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 13, 2015) +10.67 +Amendment 2 to Amended and Restated Note Purchase Agreement, dated as of May 8, 2015, with effect as of May 1, 2015, by and among CCH Hold Co II, as Issuer, the Company, EIG Management Company, LLC, as administrative agent, and the required note holders named therein (Incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 13, 2015) +117 +Exhibit No. +Description +10.68 +Amendment 3 to Amended and Restated Note Purchase Agreement, dated May 22, 2018, among CCH Holdco II, the Company, EIG Management Company and the noteholders identified therein (Incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 24, 2018) +10.69 +Form of 11.0% Senior Secured Note due 2025 (Incorporated by reference to Exhibit 4.4 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 13, 2015) +10.70 +Registration Rights Agreement for 11.0% Senior Secured Notes due 2025, dated May 13, 2015, among the Company, CCH HoldCo II and EIG Management Company, LLC as Agent on behalf of the Note Holders (Incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 13, 2015) +10.71 +Pledge Agreement, dated May 13, 2015, among the Company, EIG Management Company, LLC, as Administrative Agent for the Note Holders, and The Bank of New York Mellon as the Collateral Agent for the Note Holders (Incorporated by reference to Exhibit 10.7 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 13, 2015) +10.72 +Pledge Agreement, dated May 13, 2015, among CCH HoldCo II, EIG Management Company, LLC, as Administrative Agent for the Note Holders, and The Bank of New York Mellon as the Collateral Agent for the Note Holders (Incorporated by reference to Exhibit 10.8 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on May 13, 2015) +10.73 +Amended and Restated Working Capital Facility Agreement, dated June 29, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the lenders party thereto from time to time, the issuing banks party thereto from time to time, the Bank of Nova Scotia as Working Capital Facility Agent, and Société Générale as Security Trustee (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383) filed on July 2, 2018) +10.74 +Credit and Guaranty Agreement, dated as of February 25, 2016, among Cheniere Partners, as Borrower, certain subsidiaries of Cheniere Partners, as Subsidiary Guarantors, the lenders from time to time party thereto, The Bank of Tokyo-Mitsubishi UFJ, Ltd., as Issuing Bank, Administrative Agent and Coordinating Lead Arranger, and certain arrangers and other participants (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on March 2, 2016) +10.75 +Administrative Amendment, dated August 7, 2017, to the Credit and Guaranty Agreement among Cheniere Partners, as Borrower, certain subsidiaries of Cheniere Partners, as Subsidiary Guarantors, the lenders from time to time party thereto, The Bank of Tokyo-Mitsubishi UFJ, Ltd., as Administrative Agent (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 9, 2017) +10.76 +Second Amendment and Consent, dated as of May 23, 2018, amending and modifying the Credit and Guaranty Agreement, dated as of February 25, 2016 by and among Cheniere Partners, MUFG Bank, Ltd., as Administrative Agent, the Lenders party thereto from time to time and each other Person party thereto from time to time (Incorporated by reference to Exhibit 10.2 to Cheniere Partners’ Registration Statement on Form S-4 (SEC File No. 333-225684) filed on June 15, 2018) +10.77 +Depositary Agreement, dated as of February 25, 2016, among Cheniere Partners, as Borrower, certain subsidiaries of Cheniere Partners, as Subsidiary Guarantors, MUFG Union Bank, N.A., as Collateral Agent and Depositary Bank (Incorporated by reference to Exhibit 10.2 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on March 2, 2016) +10.78 +Omnibus Amendment and Waiver, dated as of October 14, 2016, to (a) the Credit and Guaranty Agreement, dated as of February 25, 2016 among Cheniere Partners, as Borrower, The Bank of Tokyo-Mitsubishi UFJ, Ltd., as Administrative Agent, the lenders party thereto from time to time, and each other person party thereto from time to time and to (b) the Depositary Agreement, dated as of February 25, 2016, among Borrower, MUFG Union Bank, N.A., as Collateral Agent and Depositary Agent and each other person party thereto from time to time (Incorporated by reference to Exhibit 10.27 to Cheniere Partners’ Annual Report on Form 10-K (SEC File No. 001-33366), filed on February 24, 2017) +10.79 +Second Omnibus Amendment, dated as of September 28, 2017 to (a) the Credit and Guaranty Agreement, dated as of February 25, 2016, as amended by the Omnibus Amendment and Waiver, dated October 14, 2016, by and among Cheniere Partners, as Borrower, The Bank of Tokyo-Mitsubishi UFJ, Ltd., as Administrative Agent, the lenders party thereto from time to time, and each other person party thereto from time to time, to (b) the Depositary Agreement, dated as of February 25, 2016, as amended by the Omnibus Amendment and Waiver, dated October 14, 2016, by and among Borrower, MUFG Union Bank, N.A., as Collateral Agent and Depositary Agent and each other person party thereto from time to time and to (c) the Intercreditor Agreement, dated as of February 25, 2016 by and among the Borrower, the Administrative Agent, the Collateral Agent, and each other person party thereto from time to time (Incorporated by reference to Exhibit 10.81 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 21, 2018) +118 +Exhibit No. +Description +10.80 +The Amended and Restated Revolving Credit Agreement, dated as of December 13, 2018, among the Company, the Lenders and Issuing Banks party thereto, Goldman Sachs Bank USA, Morgan Stanley Senior Funding, Inc. and SG Americas Securities, LLC, as Coordinating Lead Arrangers, and Société Générale, as Administrative Agent. (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on December 17, 2018) +10.81 +Registration Rights Agreement, dated as of September 11, 2018, among Cheniere Partners, the guarantors party thereto and J.P. Morgan Securities LLC (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on September 12, 2018) +10.82 +Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K/A (SEC File No. 001-33366), filed on July 1, 2015) +10.83 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00001 Currency and Fuel Provisional Sum Adjustment, dated June 25, 2015 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.4 to SPL’s Quarterly Report on Form 10-Q (SEC File No. 333-192373), filed on July 30, 2015) +10.84 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00002 Credit to EPC Contract Value for TSA Work, dated September 17, 2015 (Incorporated by reference to Exhibit 10.2 to SPL’s Quarterly Report on Form 10-Q (SEC File No. 333-192373), filed on October 30, 2015) +10.85 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00003 Perimeter Fencing Scope Removal, East Meter Piping Scope Change, Additional Bathroom Facilities, dated November 18, 2015 (Incorporated by reference to Exhibit 10.45 to SPL’s Annual Report on Form 10-K (SEC File No. 333-192373), filed on February 19, 2016) +10.86 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00004 DOE Regulation Change Impacts, RECON Schedule Change, Addition of Dry Flare Connection, Fuel Gas Supply Transfer to Train 5 and East Meter Fuel Gas, dated February 18, 2016 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.3 to SPL’s Quarterly Report on Form 10-Q (SEC File No. 333-192373), filed on May 5, 2016) +10.87 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00005 Performance and Attendance Bonus (PAB) Incentive Program Provisional Sum, dated March 16, 2016, (ii) the Change Order CO-00006 Additional Bechtel Hours to Support RECON, Temporary Access Rd., Addition of Flash Liquid Expander, Removal of Vibration Monitor System, To-Date Reconciliation of Soils Preparation Provisional Sum, dated March 22, 2016, (iii) the Change Order CO-00007 Additional Support for FERC Document Requests, dated May 10, 2016, (iv) the Change Order CO-00008 Water System Scope Changes and Seal Design & Seal Gas Modification, dated May 4, 2016, (v) the Change Order CO-00009 Re-Orientation of PSV Bypass Valves, dated May 17, 2016 and (vi) the Change Order CO-00010 Deletion of Chlorine Analyzer, dated June 15, 2016 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.4 to SPL’s Quarterly Report on Form 10-Q (SEC File No. 333-192373), filed on August 9, 2016) +10.88 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00011 Site Drainage Design Change: Professional Service Hours, dated July 26, 2016 (Incorporated by reference to Exhibit 10.3 to SPL’s Quarterly Report on Form 10-Q (SEC File No. 333-192373), filed on November 3, 2016) +119 +Exhibit No. +Description +10.89 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00012 Addition of Check Valves to Condensate Lines and Change of Tie-in Point, dated September 12, 2016, (ii) the Change Order CO-00013 LNG Rundown Line Reroute, dated September 12, 2016, (iii) the Change Order CO-00014 Pre-EPC HAZOP Action Item Closure, dated September 27, 2016, (iv) the Change Order CO-00015 Study for Enclosed Ground Flare and Process Flare, dated September 27, 2016, (v) the Change Order CO-00016 Upgrades to Gas Turbine Generators, dated October 19, 2016 and (vi) the Change Order CO-00017 Site Drainage Design Change: Temporary Drainage Implementation, dated December 1, 2016 (Incorporated by reference to Exhibit 10.59 to SPL’s Registration Statement on Form S-4 (SEC File No. 333-215882), filed on February 3, 2017) +10.90 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00018 Stage 3 Process Flare Modification, dated March 10, 2017, (ii) the Change Order CO-00019 Site Drainage Design Change: Permanent Drainage Implementation, dated March 10, 2017 and (iii) the Change Order CO-00020 Soils Provisional Sum Partial True-up RECON 2, dated March 13, 2017 (Incorporated by reference to Exhibit 10.64 to SPL’s Registration Statement on Form S-4 (SEC File No. 333-218646), filed on June 9, 2017) +10.91 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00021 Soils Preparation Provisional Sum Partial True-Up RECON 3, dated August 24, 2017 (Incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 9, 2017) +10.92 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00022 OSHA Handrail and Guardrail Modifications, dated October 24, 2017, (ii) the Change Order CO-00023 Operating Spare Part Provisional Sum Closeout, dated October 31, 2017 and (iii) the Change Order CO-00024, dated November 28, 2017 (Incorporated by reference to Exhibit 10.97 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 21, 2018) +10.93 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00025 BOG and LNG Rundown, dated January 19, 2018, (ii) the Change Order CO-00026 Design Analysis of Existing East & West Jetty Piping and Structure for Simultaneous Loading, dated February 1, 2018, (iii) the Change Order CO-00027 Performance and Attendance Bonus (PAB) Transfer from Stage 2, dated February 1, 2018 and (iv) the Change Order CO-00028 Existing Jetty Structural Steel Supply, dated February 27, 2018 (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2018) +10.94 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00029 Existing Jetty Structural Steel Analysis – Tanks 104 & 105, dated March 28, 2018, (ii) the Change Order CO-00030 Train 5 JT Valve PV-16002 Internals Modification, Eaton Switchgear Bus Repairs & Inspection Isometrics, dated April 18, 2018, (iii) the Change Order CO-00031 Blind and Spacer Set for Feed Gas Header, dated April 18, 2018 and (iv) the Change Order CO-00032 Additional GTG Testing, dated April 18, 2018 (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Registration Statement on S-4 (SEC File No. 333-225684), filed on June 15, 2018) +10.95 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00033 System Inspection Isometrics, dated May 24, 2018, (ii) the Change Order CO-00034 Site Evacuation, dated May 31, 2018, (iii) the Change Order CO-00035 Stage 3 - Existing & Stages 1 and 2 Liquefaction Facility Labor Provisional Sum True-Up, dated June 7, 2018 and (iv) the Change Order CO-00036 General Electric, Instrument and Valve Spares, dated June 7, 2018 (Incorporated by reference to Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on August 9, 2018) +10.96* +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 3 Liquefaction Facility, dated as of May 4, 2015, between SPL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00037 Soils Preparation Provisional Sum Closeout, dated November 29, 2018 +120 +Exhibit No. +Description +10.97 +Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the Securities and Exchange Commission pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383) filed on November 9, 2018) +10.98 +Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on December 10, 2013) +10.99 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00001 Cost Impacts Associated with Delay in NTP, dated March 9, 2015, (ii) the Change Order CO-00002 DLE/IAC Scope Change, dated March 25, 2015, (iii) the Change Order CO-00003 Currency and Fuel Provisional Sum Closures, dated May 13, 2015 and (iv) the Change Order CO-00004 Bridging Extension Through May 17, 2015, dated May 12, 2015 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.22 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on July 30, 2015) +10.100 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00005 Revised Buildings to Include Jetty and Geo-Tech Impact to Buildings, dated June 4, 2015, (ii) the Change Order CO-00006 Marine and Dredging Execution Change, dated June 16, 2015, (iii) the Change Order CO-00007 Temporary Laydown Areas, AEP Substation Relocation, Power Monitoring System for Substation, Bollards for Power Line Poles, Multiplex Interface for AEP Hecker Station, dated June 30, 2015, (iv) the Change Order CO-00008 West Jetty Shroud and Fencing, Temporary Strainers on Loading Arms, Breasting and Mooring Analysis, Addition of Crossbar from Platform at Ethylene Bullets to Platform for PSV Deck, Reduction of Vapor Fence at Bed 22, Relocation of Gangway Tower, Changes in Dolphin Size, dated July 28, 2015, (v) the Change Order CO-00009 Post FEED Studies, dated July 1, 2015, (vi) the Change Order CO-00010 Additional Post FEED Studies, Feed Gas ESD Valve Bypass, Flow Meter on Bog Line, Additional Simulations, FERC #43, dated July 1, 2015, (vii) the Change Order CO-00011 Credit to EPC Contract Value for TSA Work, dated July 7, 2015 and (viii) the Change Order CO-00012 Reduction of Provisional Sum for Operating Spares, Liquid Condensate Tie-In, Automatic Shut-Off Valve in Condensate Truck Fill Line, Firewater Monitor and Hydrant Coverage Test, dated August 11, 2015 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on October 30, 2015) +10.101 +Change order to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00013 Change in FEED Gas Tie-In, Utility Water and Potable Water Tie-In Changes, Ditch Design at Permanent Buildings, Koch Pipeline Cover, Monitoring of Raw Water Lake During Piling, Card Readers and Muster Points, Additional Asphalt in the Temporary Facilities Area, FAA Lighting and Marking, FERC Condition 84, dated October 13, 2015 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.134 to the Company’s Annual Report on Form 10-K (SEC File No. 001-16383), filed on February 19, 2016) +10.102 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00014 Stage 1 Isolation, dated January 11, 2016, (ii) the Change Order CO-00015 IAC Conversion to Lump Sum, dated January 20, 2016 and (iii) the Change Order CO-00016 Permanent Plant Buildings, dated January 20, 2016 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 5, 2016) +121 +Exhibit No. +Description +10.103 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00017 Process and Utility Tie-Ins Studies and Associated Scopes (138 kV Pricing, Transfer Line, Connections for Future LNG Truck Loading Facility), dated May 24, 2016, (ii) the Change Order CO-00018 FERC Conditions 40, 63, 64, 80, dated May 4, 2016, (iii) the Change Order CO-00019 Trelleborg Marine Equipment, BOG Compressor Tie-In, Multiplexer Credit, Additional FERC Hours, dated May 4, 2016 and (iv) the Change Order CO-00020 Impact Due to Overhead Power Transmission Lines on La Quinta Road and Flare System Modification Evaluation, dated May 31, 2016 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on August 9, 2016) +10.104 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00022 Permanent Plant Building Modifications, dated June 20, 2016 and (ii) the Change Order CO-00024 N2 Dewar Interface, Temporary Power to Air Cooler, Condensate Pipeline Maximum Allowable Operating Pressure, dated June 28, 2016 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 3, 2016) +10.105 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00026 Changes to Outfall (P1, P2, and P5) to LaQuinta Ditch, dated August 31, 2016, (ii) the Change Order CO-00028 Anti-Dumping Duties, dated September 26, 2016 and (iii) the Change Order CO-00029 Additional Flare System Evaluation, dated September 26, 2016 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment) (Incorporated by reference to Exhibit 10.12 to CCH’s Registration Statement on Form S-4 (SEC File No. 333-215435), filed on January 5, 2017) +10.106 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00021 Secondary Access Road, DMPA-1 Scope and Use, Credit for Material Disposal, Power Pole Relocation, dated June 29, 2016, (ii) the Change Order CO-00023 Differing Soil Conditions and Bed 24 Over-Excavation Due to Differing Soil Condition, dated June 29, 2016, (iii) the Change Order CO-00025 Priority 6 Roads Differing Soil Conditions and 102-J01 Over-Excavation due to Differing Soil Conditions, dated August 23, 2016, (iv) the Change Order CO-00027 Lines Traversing Laydown Area Access Road and Underground Utilities for Temporary Facilities, dated September 26, 2016 and (v) the Change Order CO-00032 Integrated Security System, dated February 3, 2017 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.45 to Amendment No. 1 to CCH’s Registration Statement on Form S-4/A (SEC File No. 333-215435), filed on March 8, 2017) +10.107 +Change order to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00030, dated November 1, 2016 (Incorporated by reference to Exhibit 10.46 to Amendment No. 1 to CCH’s Registration Statement on Form S-4/A (SEC File No. 333-215435), filed on March 8, 2017) +10.108 +Change order to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: the Change Order CO-00031 Flare System Modification Implementation, dated January 17, 2017 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.48 to Amendment No. 2 to CCH’s Registration Statement on Form S-4/A (SEC File No. 333-215435), filed on March 23, 2017) +10.109 +Change order to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00033 Marine Ground Flare, dated February 27, 2017 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.4 to CCH’s Quarterly Report on Form 10-Q (SEC File No. 333-215435), filed on May 4, 2017) +122 +Exhibit No. +Description +10.110 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00034 Condensate Tie-In, Utility Water Tie-In, and Feed Gas Tie-In Relocation, dated April 18, 2017 and (ii) the Change Order CO-00035 Nitrogen Tie-In Relocation, dated April 21, 2017 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.1 to CCH’s Quarterly Report on Form 10-Q (SEC File No. 333-215435), filed on August 8, 2017) +10.111 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00036 Security Fencing Revisions, 138kV Overhead Power Stop Work, Additional Permanent Plant Access Control System Changes, and Wet/Dry Flare Expansion Loop Relocation, dated August 3, 2017 and (ii) the Change Order CO-00037 9% Nickel Lump Sum Conversion, dated September 14, 2017 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.50 to CCH’s Registration Statement on Form S-4 (SEC File No. 333-221307), filed on November 2, 2017) +10.112 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00038 Settlement of Various Scopes, dated November 10, 2017, (ii) the Change Order CO-00039 OSHA Handrails, East Jetty Scaffold, Attachment Y, and Insurance Provisional Sum, dated February 26, 2018 and (iii) the Change Order CO-00041 GE Service Bulletins and JT Valve Modifications, dated March 6, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2018) +10.113 +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00042 Owner Modification of Warehouse 1 and Laboratory, dated April 30, 2018, (ii) the Change Order CO-00043 Hurricane Harvey Relief and Special Schedule Rewards, dated May 18, 2018, (iii) the Change Order CO-00044 Condensate Takeaway Modifications and Tell-Tale Signs for Leak Detection and Repair, dated June 6, 2018 and (iv) the Change Order CO-00045 Early Turnover of Security Operations Building, dated June 6, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on August 9, 2018) +10.114* +Change orders to the Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 1 Liquefaction Facility, dated as of December 6, 2013, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00040 Hurricane Harvey Recovery Weekend Work, dated April 5, 2018, (ii) the Change Order CO-00046 Early Turnover of Seven Buildings, dated September 12, 2018, (iii) the Change Order CO-00047 System Inspection Isometrics, dated October 3, 2018, (iv) the Change Order CO-00048 Early Turnover of West Jetty, LNG Tank A, Tug Utility Station and Marine Flare, dated November 13, 2018 and (v) the Change Order CO-00049 Early Turnover of WTP, Sanitary, Diesel/Gasoline, and Partial Electrical System, dated December 7, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +10.115 +Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated December 12, 2017, by and between CCL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.23 to Amendment No.1 to CCH’s Annual Report on Form 10-K/A (SEC File No. 333-215435), filed on April 27, 2018) +10.116 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00001 Stage 2 EPC Agreement Revised Table A-2, dated May 18, 2018, (ii) the Change Order CO-00002 Stage 2 EPC Agreement Amended and Restated Attachment C, dated May 18, 2018, (iii) the Change Order CO-00003 Fuel Provisional Sum Adjustment, dated May 24, 2018, (iv) the Change Order CO-00004 Currency Provisional Sum Adjustment, dated May 29, 2018, (v) the Change Order CO-00005 JT Valve Modifications, dated July 10, 2018 and (vi) the Change Order CO-00006 Tank B Soil Conditions, International Building Code, and East Jetty Marine Facility Schedule Acceleration, dated September 5, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 8, 2018) +123 +Exhibit No. +Description +10.117* +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00007 Tell-Tale Signs, Additional Tie-Ins, and System Inspection Isometrics, dated October 15, 2018, (ii) the Change Order CO-00008 Insurance Provisional Sum Interim Adjustment, dated November 19, 2018 and (iii) the Change Order CO-00009 Traffic and Logistics Impacts Due to Enforcement of Electronic Logging Devices, dated November 28, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +10.118 +LNG Sale and Purchase Agreement (FOB), dated November 21, 2011, between SPL (Seller) and Gas Natural Aprovisionamientos SDG S.A. (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on November 21, 2011) +10.119 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated April 3, 2013, between SPL (Seller) and Gas Natural Aprovisionamientos SDG S.A. (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Quarterly Report on Form 10-Q (SEC File No. 001-33366), filed on May 3, 2013) +10.120 +Amendment of LNG Sale and Purchase Agreement (FOB), dated January 12, 2017, between SPL (Seller) and Gas Natural Fenosa LNG GOM, Limited (assignee of Gas Natural Aprovisionamientos SDG S.A.) (Buyer) (Incorporated by reference to Exhibit 10.3 to SPL’s Registration Statement on Form S-4 (SEC File No. 333-215882), filed on February 3, 2017) +10.121 +LNG Sale and Purchase Agreement (FOB), dated December 11, 2011, between SPL (Seller) and GAIL (India) Limited (Buyer) (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on December 12, 2011) +10.122 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 18, 2013, between SPL (Seller) and GAIL (India) Limited (Buyer) (Incorporated by reference to Exhibit 10.18 to Cheniere Partners’ Annual Report on Form 10-K (SEC File No. 001-33366), filed on February 22, 2013) +10.123 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated January 25, 2012, between SPL (Seller) and BG Gulf Coast LNG, LLC (Buyer) (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on January 26, 2012) +10.124 +Letter agreement, dated May 12, 2016, amending the Amended and Restated LNG Sale and Purchase Agreement (FOB) between SPL and BG Gulf Coast LNG, LLC dated January 25, 2012 (Incorporated by reference to Exhibit 10.7 to SPL’s Registration Statement on Form S-4 (SEC File No. 333-215882), filed on February 3, 2017) +10.125 +LNG Sale and Purchase Agreement (FOB), dated January 30, 2012, between SPL (Seller) and Korea Gas Corporation (Buyer) (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on January 30, 2012) +10.126 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 18, 2013, between SPL (Seller) and Korea Gas Corporation (Buyer) (Incorporated by reference to Exhibit 10.19 to Cheniere Partners’ Annual Report on Form 10-K (SEC File No. 001-33366), filed on February 22, 2013) +10.127 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated August 5, 2014, between SPL (Seller) and Cheniere Marketing, LLC (Buyer) (Incorporated by reference to Exhibit 10.1 to SPL’s Current Report on Form 8-K (SEC File No. 333-192373), filed on August 11, 2014) +10.128 +Letter agreement, dated December 8, 2016, amending the Amended and Restated LNG Sale and Purchase Agreement (FOB), dated August 5, 2014, between SPL and Cheniere Marketing International LLP (as assignee of Cheniere Marketing, LLC) (Incorporated by reference to Exhibit 10.14 to SPL’s Annual Report on Form 10-K (SEC File No. 333-192373), filed on February 24, 2017) +10.129 +LNG Sale and Purchase Agreement (FOB), dated April 1, 2014, between CCL (Seller) and Endesa Generación, S.A. (Buyer) (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on April 2, 2014) +10.130 +LNG Sale and Purchase Agreement (FOB), dated April 7, 2014, between CCL (Seller) and Endesa S.A. (Buyer) (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on April 8, 2014) +10.131 +Assignment and Amendment Agreement, dated April 7, 2014, among Endesa Generación S.A., Endesa S.A. and CCL (Incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 1, 2014) +124 +Exhibit No. +Description +10.132 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated July 23, 2015, between Endesa S.A. (Buyer) and CCL (Seller) (Incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on October 30, 2015) +10.133 +Amendment No. 2 of LNG Sale and Purchase Agreement (FOB), dated July 23, 2015, between Endesa S.A. (Buyer) and CCL (Seller) (Incorporated by reference to Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on October 30, 2015) +10.134 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated March 20, 2015, between CCL (Seller) and PT Pertamina (Persero) (Buyer) (Incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on April 30, 2015) +10.135 +Amendment No. 1, dated February 4, 2016, to Amended and Restated LNG Sale and Purchase Agreement (FOB) between CCL and PT Pertamina (Persero), dated March 20, 2015 (Incorporated by reference to Exhibit 10.22 to CCH’s Registration Statement on Form S-4 (SEC File No. 333-215435), filed on January 5, 2017) +10.136 +LNG Sale and Purchase Agreement (FOB), dated June 2, 2014, between CCL (Seller) and Gas Natural Fenosa LNG SL (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on June 2, 2014) +10.137 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 27, 2018, between CCL (Seller) and Gas Natural Fenosa LNG GOM, Limited (Buyer) (Incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on May 4, 2018) +10.138 +Amended and Restated Base LNG Sale and Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP (Incorporated by reference to Exhibit 10.32 to CCH’s Registration Statement on Form S-4 (SEC File No. 333-215435), filed on January 5, 2017) +10.139 +Amendment No. 1, dated June 26, 2015, to Amended and Restated Base LNG Sale and Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP (Incorporated by reference to Exhibit 10.33 to CCH’s Registration Statement on Form S-4 (SEC File No. 333-215435), filed on January 5, 2017) +10.140 +Amendment No. 2, dated December 27, 2016, to Amended and Restated Base LNG Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP (Incorporated by reference to Exhibit 10.34 to CCH’s Registration Statement on Form S-4 (SEC File No. 333-215435), filed on January 5, 2017) +10.141 +Cooperative Endeavor Agreement & Payment in Lieu of Tax Agreement with eleven Cameron Parish taxing authorities, dated October 23, 2007, by and between Cheniere Marketing, Inc. and SPLNG (Incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q (SEC File No. 001-16383), filed on November 6, 2007) +10.142 +Investors’ and Registration Rights Agreement, dated as of July 31, 2012, by and among the Company, Cheniere Energy Partners GP, LLC, Cheniere Partners, Cheniere Class B Units Holdings, LLC, Blackstone CQP Holdco LP and the other investors party thereto from time to time (Incorporated by reference to Exhibit 10.1 to Cheniere Partners’ Current Report on Form 8-K (SEC File No. 001-33366), filed on August 6, 2012) +10.143 +Fourth Amended and Restated Agreement of Limited Partnership of Cheniere Partners, dated February 14, 2017 (Incorporated by reference to Exhibit 3.1 to Cheniere Partners’ Current Report on Form 8-K (File No. 001-33366) filed on February 21, 2017) +10.144 +Amended and Restated Limited Liability Company Agreement of Cheniere GP Holding Company, LLC, dated December 13, 2013 (Incorporated by reference to Exhibit 10.3 to Cheniere Holdings’ Current Report on Form 8-K (SEC File No. 001-36234), filed on December 18, 2013) +10.145 +Nomination and Standstill Agreement, dated August 21, 2015, by and between the Company, Icahn Partners Master Fund LP, Icahn Partners LP, Icahn Onshore LP, Icahn Offshore LP, Icahn Capital LP, IPH GP LLC, Icahn Enterprises Holdings LP, Icahn Enterprises G.P. Inc., Beckton Corp., High River Limited Partnership, Hopper Investments LLC, Barberry Corp., Carl C. Icahn, Jonathan Christodoro and Samuel Merksamer (Incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K (SEC File No. 001-16383), filed on August 24, 2015) +21.1* +Subsidiaries of the Company +23.1* +Consent of KPMG LLP +31.1* +Certification by Chief Executive Officer required by Rule 13a-14(a) and 15d-14(a) under the Exchange Act +31.2* +Certification by Chief Financial Officer required by Rule 13a-14(a) and 15d-14(a) under the Exchange Act +32.1** +Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +125 +Exhibit No. +Description +32.2** +Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +101.INS* +XBRL Instance Document +101.SCH* +XBRL Taxonomy Extension Schema Document +101.CAL* +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF* +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB* +XBRL Taxonomy Extension Labels Linkbase Document +101.PRE* +XBRL Taxonomy Extension Presentation Linkbase Document +* +Filed herewith. +** +Furnished herewith. +† +Management contract or compensatory plan or arrangement. +126 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED BALANCE SHEETS +(in millions) +December 31, +2018 +2017 +ASSETS +Cash and cash equivalents +$ +— +$ +— +Restricted cash +— +— +Other current assets +1 +— +Property, plant and equipment, net +14 +15 +Debt issuance and deferred financing costs, net +21 +12 +Investments in affiliates +883 +(435 +) +Total assets +$ +919 +$ +(408 +) +LIABILITIES AND STOCKHOLDERS’ DEFICIT +Current liabilities +$ +9 +$ +8 +Long-term debt, net +1,436 +1,348 +Stockholders’ deficit +(526 +) +(1,764 +) +Total liabilities and stockholders’ deficit +$ +919 +$ +(408 +) +The accompanying notes are an integral part of these condensed financial statements. +127 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF OPERATIONS +(in millions) +Year Ended December 31, +2018 +2017 +2016 +General and administrative expense +$ +8 +$ +7 +$ +6 +Other income (expense) +Interest expense, net +(128 +) +(118 +) +(104 +) +Interest expense, net—affiliates +— +— +(7 +) +Interest income—affiliates +— +— +24 +Equity income (loss) of affiliates +607 +(268 +) +(517 +) +Total other income (expense) +479 +(386 +) +(604 +) +Net income (loss) attributable to common stockholders +$ +471 +$ +(393 +) +$ +(610 +) +The accompanying notes are an integral part of these condensed financial statements. +128 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF CASH FLOWS +(in millions) +Year Ended December 31, +2018 +2017 +2016 +Net cash provided by (used in) operating activities +$ +48 +$ +(4 +) +$ +(102 +) +Cash flows from investing activities +Investments in affiliates +568 +209 +202 +Net cash provided by investing activities +568 +209 +202 +Cash flows from financing activities +Debt issuance and deferred financing costs +(13 +) +(15 +) +— +Distribution and dividends to non-controlling interest +(576 +) +(185 +) +(80 +) +Payments related to tax withholdings for share-based compensation +(20 +) +(12 +) +(20 +) +Other +(7 +) +— +— +Net cash used in financing activities +(616 +) +(212 +) +(100 +) +Net decrease in cash, cash equivalents and restricted cash +— +(7 +) +— +Cash, cash equivalents and restricted cash—beginning of period +— +7 +7 +Cash, cash equivalents and restricted cash—end of period +$ +— +$ +— +$ +7 +Balances per Condensed Balance Sheets: +December 31 +2018 +2017 +Cash and cash equivalents +$ +— +$ +— +Restricted cash +— +— +Total cash, cash equivalents and restricted cash +$ +— +$ +— +The accompanying notes are an integral part of these condensed financial statements. +129 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS +NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +The Condensed Financial Statements represent the financial information required by Securities and Exchange Commission Regulation S-X 5-04 for Cheniere. +In the Condensed Financial Statements, Cheniere’s investments in affiliates are presented under the equity method of accounting. Under this method, the assets and liabilities of affiliates are not consolidated. The investments in net assets of the affiliates are recorded on the Condensed Balance Sheets. The loss from operations of the affiliates is reported on a net basis as investment in affiliates (investment in and equity in net income (loss) of affiliates). +A substantial amount of Cheniere’s operating, investing and financing activities are conducted by its affiliates. The Condensed Financial Statements should be read in conjunction with Cheniere’s Consolidated Financial Statements. +NOTE 2—DEBT +As of December 31, 2018 and 2017, our debt consisted of the following (in millions): +December 31, +2018 +2017 +Long-term debt: +4.875% Convertible Unsecured Notes due 2021 +$ +1,218 +$ +1,161 +4.25% Convertible Senior Notes due 2045 +625 +625 +$1.25 billion Cheniere Revolving Credit Facility +— +— +Unamortized premium, discount and debt issuance costs, net +(407 +) +(438 +) +Total long-term debt, net +$ +1,436 +$ +1,348 +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $750 million to $1.25 billion . +Below is a schedule of future principal payments that we are obligated to make on our outstanding debt at December 31, 2018 (in millions): +Years Ending December 31, +Principal Payments +2019 +$ +— +2020 +— +2021 +1,218 +2022 +— +2023 +— +Thereafter +625 +Total +$ +1,843 +In October 2016, Cheniere LNG Terminals, LLC (“Cheniere Terminals”), a wholly owned subsidiary of Cheniere, forgave Cheniere’s total previously outstanding current debt—affiliate balance, which was composed of a $94 million note and $57 million in related accumulated interest payable to Cheniere Terminals. This $151 million forgiveness of debt during the year ended December 31, 2016 was recorded as a non-cash equity contribution to our subsidiaries on our Condensed Balance Sheet. +130 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +NOTE 3—GUARANTEES +Obligations under Certain Guarantee Contracts +Cheniere has various financial and performance guarantees and indemnifications which are issued in the normal course of business. These contracts include performance guarantees and stand-by letters of credit. Cheniere enters into these arrangements to facilitate commercial transactions with third parties by enhancing the value of the transaction to the third party. As of December 31, 2018 , outstanding guarantees and other assurances aggregated approximately $494 million of varying duration, consisting of parental guarantees. No liabilities were recognized under these guarantee arrangements as of December 31, 2018 . +NOTE 4 —SUPPLEMENTAL CASH FLOW INFORMATION +The following table provides supplemental disclosure of cash flow information (in millions): +Year Ended December 31, +2018 +2017 +2016 +Cash paid during the period for interest, net of amounts capitalized +$ +32 +$ +31 +$ +20 +Non-cash investing and financing activities: +Non-cash capital distribution (contributions) (1) +607 +(268 +) +(517 +) +Issuance of stock to acquire additional interest in Cheniere Holdings +702 +2 +94 +Non-cash capital contribution from subsidiaries for forgiveness of debt +— +— +151 +Non-cash capital distribution to subsidiaries for forgiveness of debt +— +— +(868 +) +(1) +Amounts represent equity income (losses) of affiliates. +131 +ITEM 16. +FORM 10-K SUMMARY +None. +132 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +CHENIERE ENERGY, INC. +(Registrant) +By: +/s/ Jack A. Fusco +Jack A. Fusco +President and Chief Executive Officer +(Principal Executive Officer) +Date: +February 25, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Jack A. Fusco +President and Chief Executive Officer and Director +(Principal Executive Officer) +February 25, 2019 +Jack A. Fusco +/s/ Michael J. Wortley +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +February 25, 2019 +Michael J. Wortley +/s/ Leonard E. Travis +Vice President and Chief Accounting Officer +(Principal Accounting Officer) +February 25, 2019 +Leonard E. Travis +/s/ G. Andrea Botta +Chairman of the Board +February 25, 2019 +G. Andrea Botta +/s/ Vicky A. Bailey +Director +February 25, 2019 +Vicky A. Bailey +/s/ Nuno Brandolini +Director +February 25, 2019 +Nuno Brandolini +/s/ Andrew Langham +Director +February 25, 2019 +Andrew Langham +/s/ David I. Foley +Director +February 25, 2019 +David I. Foley +/s/ David B. Kilpatrick +Director +February 25, 2019 +David B. Kilpatrick +/s/ Courtney R. Mather +Director +February 25, 2019 +Courtney R. Mather +/s/ Donald F. Robillard, Jr. +Director +February 25, 2019 +Donald F. Robillard, Jr. +/s/ Neal A. Shear +Director +February 25, 2019 +Neal A. 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PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2019 +or +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-16383 +CHENIERE ENERGY, INC. +(Exact name of registrant as specified in its charter) +Delaware +95-4352386 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +700 Milam Street , Suite 1900 +Houston , Texas 77002 +(Address of principal executive offices) (Zip Code) +( 713 ) 375-5000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +Common Stock, $ 0.003 par value +LNG +NYSE American +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer +☒ +Accelerated filer +☐ +Non-accelerated filer +☐ +Smaller reporting company +☐ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ +The aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant was approximately $ 17.5 billion as of June 28, 2019 . +As of February 19, 2020 , the issuer had 254,084,493 shares of Common Stock outstanding. +Documents incorporated by reference: The definitive proxy statement for the registrant’s Annual Meeting of Stockholders (to be filed within 120 days of the close of the registrant’s fiscal year) is incorporated by reference into Part III . +CHENIERE ENERGY, INC. +TABLE OF CONTENTS +PART I +Items 1. and 2. Business and Properties +4 +Item 1A. Risk Factors +19 +Item 1B. Unresolved Staff Comments +34 +Item 3. Legal Proceedings +34 +Item 4. Mine Safety Disclosure +36 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +37 +Item 6. Selected Financial Data +40 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +41 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +65 +Item 8. Financial Statements and Supplementary Data +67 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +119 +Item 9A. Controls and Procedures +119 +Item 9B. Other Information +119 +PART III +PART IV +Item 15. Exhibits and Financial Statement Schedules +120 +Item 16. Form 10-K Summary +141 +Signatures +142 +i +DEFINITIONS +As used in this annual report, the terms listed below have the following meanings: +Common Industry and Other Terms +Bcf +billion cubic feet +Bcf/d +billion cubic feet per day +Bcf/yr +billion cubic feet per year +Bcfe +billion cubic feet equivalent +DOE +U.S. Department of Energy +EPC +engineering, procurement and construction +FERC +Federal Energy Regulatory Commission +FTA countries +countries with which the United States has a free trade agreement providing for national treatment for trade in natural gas +GAAP +generally accepted accounting principles in the United States +Henry Hub +the final settlement price (in USD per MMBtu) for the New York Mercantile Exchange’s Henry Hub natural gas futures contract for the month in which a relevant cargo’s delivery window is scheduled to begin +LIBOR +London Interbank Offered Rate +LNG +liquefied natural gas, a product of natural gas that, through a refrigeration process, has been cooled to a liquid state, which occupies a volume that is approximately 1/600th of its gaseous state +MMBtu +million British thermal units, an energy unit +mtpa +million tonnes per annum +non-FTA countries +countries with which the United States does not have a free trade agreement providing for national treatment for trade in natural gas and with which trade is permitted +SEC +U.S. Securities and Exchange Commission +SPA +LNG sale and purchase agreement +TBtu +trillion British thermal units, an energy unit +Train +an industrial facility comprised of a series of refrigerant compressor loops used to cool natural gas into LNG +TUA +terminal use agreement +1 +Abbreviated Legal Entity Structure +The following diagram depicts our abbreviated legal entity structure as of December 31, 2019 , including our ownership of certain subsidiaries, and the references to these entities used in this annual report: +Unless the context requires otherwise, references to “ Cheniere ,” the “Company,” “we,” “us” and “our” refer to Cheniere Energy, Inc. and its consolidated subsidiaries, including our publicly traded subsidiary, Cheniere Partners . +Unless the context requires otherwise, references to the “CCH Group” refer to CCH HoldCo II , CCH HoldCo I , CCH , CCL and CCP , collectively. +During the year ended December 31, 2018, we closed the merger of Cheniere Energy Partners LP Holdings, LLC (“Cheniere Holdings”) with and into our wholly owned subsidiary. As a result of the merger, Cheniere Holdings is no longer a publicly-traded company. +2 +CAUTIONARY STATEMENT +REGARDING FORWARD-LOOKING STATEMENTS +This annual report contains certain statements that are, or may be deemed to be, “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) , and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) . All statements, other than statements of historical or present facts or conditions, included herein or incorporated herein by reference are “forward-looking statements.” Included among “forward-looking statements” are, among other things: +• +statements that we expect to commence or complete construction of our proposed LNG terminals, liquefaction facilities, pipeline facilities or other projects, or any expansions or portions thereof, by certain dates, or at all; +• +statements regarding future levels of domestic and international natural gas production, supply or consumption or future levels of LNG imports into or exports from North America and other countries worldwide or purchases of natural gas, regardless of the source of such information, or the transportation or other infrastructure or demand for and prices related to natural gas, LNG or other hydrocarbon products; +• +statements regarding any financing transactions or arrangements, or our ability to enter into such transactions; +• +statements regarding the amount and timing of share repurchases; +• +statements relating to the construction of our Trains and pipelines, including statements concerning the engagement of any EPC contractor or other contractor and the anticipated terms and provisions of any agreement with any EPC or other contractor, and anticipated costs related thereto; +• +statements regarding any SPA or other agreement to be entered into or performed substantially in the future, including any revenues anticipated to be received and the anticipated timing thereof, and statements regarding the amounts of total LNG regasification, natural gas liquefaction or storage capacities that are, or may become, subject to contracts; +• +statements regarding counterparties to our commercial contracts, construction contracts and other contracts; +• +statements regarding our planned development and construction of additional Trains or pipelines, including the financing of such Trains or pipelines; +• +statements that our Trains, when completed, will have certain characteristics, including amounts of liquefaction capacities; +• +statements regarding our business strategy, our strengths, our business and operation plans or any other plans, forecasts, projections, or objectives, including anticipated revenues, capital expenditures, maintenance and operating costs and cash flows, any or all of which are subject to change; +• +statements regarding legislative, governmental, regulatory, administrative or other public body actions, approvals, requirements, permits, applications, filings, investigations, proceedings or decisions; +• +statements regarding our anticipated LNG and natural gas marketing activities; and +• +any other statements that relate to non-historica l or future information. +All of these types of statements, other than statements of historical or present facts or conditions, are forward-looking statements. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “could,” “should,” “achieve,” “anticipate,” “believe,” “contemplate,” “continue,” “estimate,” “expect,” “intend,” “plan,” “potential,” “predict,” “project,” “pursue,” “target,” the negative of such terms or other comparable terminology. The forward-looking statements contained in this annual report are largely based on our expectations, which reflect estimates and assumptions made by our management. These estimates and assumptions reflect our best judgment based on currently known market conditions and other factors. Although we believe that such estimates are reasonable, they are inherently uncertain and involve a number of risks and uncertainties beyond our control. In addition, assumptions may prove to be inaccurate. We caution that the forward-looking statements contained in this annual report are not guarantees of future performance and that such statements may not be realized or the forward-looking statements or events may not occur. Actual results may differ materially from those anticipated or implied in forward-looking statements as a result of a variety of factors described in this annual report and in the other reports and other information that we file with the SEC. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these risk factors. These forward-looking statements speak only as of the date made, and other than as required by law, we undertake no obligation to update or revise any forward-looking statement or provide reasons why actual results may differ, whether as a result of new information, future events or otherwise. +3 +PART I +ITEMS 1. AND 2. +BUSINESS AND PROPERTIES +General +Cheniere Energy, Inc. (“Cheniere”) , a Delaware corporation, was organized in 1983 and is a Houston-based energy infrastructure company primarily engaged in LNG-related businesses. We provide clean, secure and affordable LNG to integrated energy companies, utilities and energy trading companies around the world. We aspire to conduct our business in a safe and responsible manner, delivering a reliable, competitive and integrated source of LNG to our customers. We own and operate the Sabine Pass LNG terminal in Louisiana, one of the largest LNG production facilities in the world, through our ownership interest in and management agreements with Cheniere Energy Partners, L.P. (“Cheniere Partners”) , which is a publicly traded limited partnership that we created in 2007. As of December 31, 2019 , we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We also own and operate the Corpus Christi LNG terminal in Texas, which is wholly owned by us. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners, through its subsidiary Sabine Pass Liquefaction, LLC (“SPL”) , is currently operating five natural gas liquefaction Trains and is constructing one additional Train for a total production capacity of approximately 30 mtpa of LNG (the “SPL Project”) at the Sabine Pass LNG terminal. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ subsidiary, Sabine Pass LNG, L.P. (“SPLNG”) , that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 17 Bcfe , two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4 Bcf/d . Cheniere Partners also owns a 94-mile pipeline through its subsidiary, Cheniere Creole Trail Pipeline, L.P. (“CTPL”) , that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”) . +We also own the Corpus Christi LNG terminal near Corpus Christi, Texas, and are currently operating two Trains and are constructing one additional Train for a total production capacity of approximately 15 mtpa of LNG. Additionally, we are operating a 23-mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the Trains, the “CCL Project”) through our subsidiaries Corpus Christi Liquefaction, LLC (“CCL”) and Cheniere Corpus Christi Pipeline, L.P. (“CCP”) , respectively. The CCL Project , once fully constructed, will contain three LNG storage tanks with aggregate capacity of approximately 10 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. +We have contracted approximately 85% of the total production capacity from the SPL Project and the CCL Project (collectively, the “Liquefaction Projects”) on a term basis. This includes volumes contracted under SPAs in which the customers are required to pay a fixed fee with respect to the contracted volumes irrespective of their election to cancel or suspend deliveries of LNG cargoes, as well as volumes contracted under integrated production marketing (“IPM”) gas supply agreements. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) through our subsidiary Cheniere Corpus Christi Liquefaction Stage III, LLC (“CCL Stage III”) for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. We received approval from FERC in November 2019 to site, construct and operate the expansion project. +We remain focused on operational excellence and customer satisfaction. Increasing demand of LNG has allowed us to expand our liquefaction infrastructure in a financially disciplined manner. We hold significant land positions at both the Sabine Pass LNG terminal and the Corpus Christi LNG terminal which provide opportunity for further liquefaction capacity expansion. The development of these sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we can make a final investment decision (“FID”) . +4 +Although results are consolidated for financial reporting, Cheniere, Cheniere Partners, SPL and the CCH Group operate with independent capital structures. The following diagram depicts our abbreviated capital structure as of December 31, 2019 : +Our Business Strategy +Our primary business strategy is to be a full service LNG provider to worldwide end-use customers. We accomplish this objective by owning, constructing and operating LNG and natural gas infrastructure facilities to meet our long-term customers’ energy demands and: +• +safely, efficiently and reliably operating and maintaining our assets; +• +procuring natural gas and pipeline transport capacity to our facilities; +• +commencing commercial delivery for our long-term SPA customers, of which we have initiated for 13 of 19 long-term SPA customers as of December 31, 2019 ; +• +safely, on-time and on-budget completing our expansion construction projects, including the development of Corpus Christi Stage 3 ; +• +maximizing the production of LNG to serve our long-term customers and generating steady and stable revenues and operating cash flows; and +• +maintaining a flexible capital structure to finance the acquisition, development, construction and operation of the energy assets needed to supply our customers. +5 +LNG Terminals and Marketing +We shipped our first LNG cargo in February 2016 and we shipped our 1,000th cargo in January 2020. Cheniere’s LNG has been shipped to over 30 countries and regions around the world. +Sabine Pass LNG Terminal +Liquefaction Facilities +The SPL Project is one of the largest LNG production facilities in the world. Through Cheniere Partners, we are currently operating five Trains and two marine berths at the SPL Project and are constructing one additional Train. We have received authorization from the FERC to site, construct and operate Trains 1 through 6. We have achieved substantial completion of the first five Trains of the SPL Project and commenced commercial operating activities for each Train at various times starting in May 2016. The following table summarizes the project completion and construction status of Train 6 of the SPL Project as of December 31, 2019 : +SPL Train 6 +Overall project completion percentage +43.7% +Completion percentage of: +Engineering +91.5% +Procurement +60.9% +Subcontract work +37.4% +Construction +9.7% +Date of expected substantial completion +1H 2023 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal: +• +Trains 1 through 4— FTA countries for a 30-year term, which commenced in May 2016, and non-FTA countries for a 20-year term, which commenced in June 2016, in an amount up to a combined total of the equivalent of 16 mtpa (approximately 803 Bcf/yr of natural gas). +• +Trains 1 through 4— FTA countries for a 25-year term and non-FTA countries for a 20-year term, both of which commenced in December 2018, in an amount up to a combined total of the equivalent of approximately 203 Bcf/yr of natural gas (approximately 4 mtpa). +• +Trains 5 and 6— FTA countries and non-FTA countries for a 20-year term, which partially commenced in June 2019 and the remainder commenced in September 2019, in an amount up to a combined total of 503.3 Bcf/yr of natural gas (approximately 10 mtpa). +In each case, the terms of these authorizations began on the earlier of the date of first export thereunder or the date specified in the particular order. In addition, SPL received an order providing for a three-year makeup period with respect to each of the non-FTA orders for LNG volumes SPL was authorized but unable to export during any portion of the initial 20-year export period of such order. +The DOE issued orders authorizing SPL to export domestically produced LNG by vessel from the Sabine Pass LNG terminal to FTA countries and non-FTA countries over a two-year period commencing January 2020, in an aggregate amount up to the equivalent of 600 Bcf of natural gas (however, exports under this order, when combined with exports under the orders above, may not exceed 1,509 Bcf/yr ). +An application was filed in September 2019 to authorize additional exports from the SPL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 153 Bcf/yr of natural gas, for a total SPL Project export of approximately 1,662 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the SPL Project of the volumes contemplated in the application. The application is currently pending before DOE. +6 +Customers +SPL has entered into fixed price long-term SPA s generally with terms of 20 years (plus extension rights) with eight third parties for Trains 1 through 6 of the SPL Project . Under these SPA s, the customers will purchase LNG from SPL on a free on board (“FOB”) basis for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub . The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under SPL’s SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under SPL’s SPAs. The variable fees under SPL’s SPAs were generally sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPA s and contracted volumes to be made available under the SPA s are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +In aggregate, the annual fixed fee portion to be paid by the third-party SPA customers is approximately $2.9 billion for Trains 1 through 5. After giving effect to an SPA that Cheniere has committed to provide to SPL by the end of 2020, the annual fixed fee portion to be paid by the third-party SPA customers would increase to at least $3.3 billion , which is expected to occur upon the date of first commercial delivery of Train 6. +In addition, Cheniere Marketing has agreements with SPL to purchase, at Cheniere Marketing’s option, any LNG produced by SPL in excess of that required for other customers. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +The annual contracted cash flows from fixed fees of each buyer of LNG under SPL’s third-party SPAs that constitute more than 10% of SPL’s aggregate fixed fees under all its SPAs are: +• +approximately $720 million from BG Gulf Coast LNG, LLC (“BG”) , which is guaranteed by BG Energy Holdings Limited; +• +approximately $550 million from Korea Gas Corporation (“KOGAS”) ; +• +approximately $550 million from GAIL ; +• +approximately $450 million from Naturgy LNG GOM, Limited (formerly known as Gas Natural Fenosa LNG GOM, Limited) (“Naturgy”) , which is guaranteed by Naturgy Energy Group, S.A. (formerly known as Gas Natural SDG S.A.); and +• +approximately $310 million from Total Gas & Power North America, Inc. (“Total”) , which is guaranteed by Total S.A. +The annual aggregate fixed fees for all of SPL’s other SPAs with third-parties is approximately $490 million, prior to giving effect to an SPA that Cheniere has committed to provide to SPL by the end of 2020. +Natural Gas Transportation, Storage and Supply +To ensure SPL is able to transport adequate natural gas feedstock to the Sabine Pass LNG terminal, it has entered into transportation precedent and other agreements to secure firm pipeline transportation capacity with CTPL and third-party pipeline companies. SPL has entered into firm storage services agreements with third parties to assist in managing variability in natural gas needs for the SPL Project . SPL has also entered into enabling agreements and long-term natural gas supply contracts with third parties in order to secure natural gas feedstock for the SPL Project . As of December 31, 2019 , SPL had secured up to approximately 3,850 TBtu of natural gas feedstock through long-term and short-term natural gas supply contracts with remaining terms that range up to 10 years , a portion of which is subject to conditions precedent. +Construction +SPL entered into lump sum turnkey contracts with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Trains 1 through 6 of the SPL Project , under which Bechtel charges a lump sum for all work +7 +performed and generally bears project cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause SPL to enter into a change order, or SPL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 6 of the SPL Project is approximately $2.5 billion , including estimated costs for an optional third marine berth. As of December 31, 2019 , we have incurred $1.1 billion under this contract. +Regasification Facilities +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4 Bcf/d and aggregate LNG storage capacity of approximately 17 Bcfe . Approximately 2 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term third-party TUA s, under which SPLNG’s customers are required to pay fixed monthly fees, whether or not they use the LNG terminal. Each of Total and Chevron U.S.A. Inc. (“Chevron”) has reserved approximately 1 Bcf/d of regasification capacity and is obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually, prior to inflation adjustments, for 20 years that commenced in 2009. Total S.A. has guaranteed Total ’s obligations under its TUA up to $2.5 billion, subject to certain exceptions, and Chevron Corporation has guaranteed Chevron ’s obligations under its TUA up to 80% of the fees payable by Chevron . +The remaining approximately 2 Bcf/d of capacity has been reserved under a TUA by SPL. SPL is obligated to make monthly capacity payments to SPLNG aggregating approximately $250 million annually, prior to inflation adjustments, continuing until at least May 2036. SPL entered into a partial TUA assignment agreement with Total , whereby upon substantial completion of Train 5 of the SPL Project , SPL gained access to substantially all of Total ’s capacity and other services provided under Total ’s TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Train 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA. During the years ended December 31, 2019, 2018 and 2017 , SPL recorded $104 million , $30 million and $23 million, respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Under each of these TUA s, SPLNG is entitled to retain 2% of the LNG delivered to the Sabine Pass LNG terminal. +Corpus Christi LNG Terminal +Liquefaction Facilities +We are currently operating two Trains and one marine berth at the CCL Project and are constructing one additional Train and marine berth. We have received authorization from the FERC to site, construct and operate Trains 1 through 3 of the CCL Project . We completed construction of Trains 1 and 2 of the CCL Project and commenced commercial operating activities in February 2019 and August 2019, respectively. The following table summarizes the project completion and construction status of Train 3 of the CCL Project , including the related infrastructure, as of December 31, 2019 : +CCL Train 3 +Overall project completion percentage +74.8% +Completion percentage of: +Engineering +98.7% +Procurement +99.5% +Subcontract work +28.3% +Construction +49.5% +Expected date of substantial completion +1H 2021 +Separate from the CCH Group, we are also developing Corpus Christi Stage 3 through our subsidiary CCL Stage III , adjacent to the CCL Project . We received approval from FERC in November 2019 to site, construct and operate seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. +8 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Corpus Christi LNG terminal: +• +CCL Project — FTA countries for a 25-year term and to non-FTA countries for a 20-year term, both of which commenced in June 2019, up to a combined total of the equivalent of 767 Bcf/yr (approximately 15 mtpa) of natural gas. +• +Corpus Christi Stage 3 — FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount equivalent to 582.14 Bcf/yr (approximately 11 mtpa) of natural gas. +In each case, the terms of these authorizations begin on the earlier of the date of first export thereunder or the date specified in the particular order, which ranges from seven to 10 years from the date the order was issued. +An application was filed in September 2019 to authorize additional exports from the CCL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 108 Bcf/yr of natural gas, for a total CCL Project export of 875.16 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the CCL Project of the volumes contemplated in the application. The application is currently pending before DOE. +Customers +CCL has entered into fixed price long-term SPA s generally with terms of 20 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project . Under these SPAs, the customers will purchase LNG from CCL on a FOB basis for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under our SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under our SPAs. The variable fee under CCL’s SPAs entered into in connection with the development of the CCL Project was sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery for the applicable Train, as specified in each SPA. +In aggregate, the minimum fixed fee portion to be paid by the third-party SPA customers is approximately $550 million for Train 1, increasing to approximately $1.4 billion upon the date of first commercial delivery for Train 2 and further increasing to approximately $1.8 billion following the substantial completion of Train 3 of the CCL Project. +The annual contracted cash flows from fixed fees of each buyer of LNG under CCL’s third-party SPAs that constitute more than 10% of CCL’s aggregate fixed fees under all its SPAs for Trains 1 through 3 of the CCL Project are: +• +approximately $410 million from Endesa S.A.; +• +approximately $280 million from PT Pertamina (Persero); and +• +approximately $270 million from Naturgy , which is guaranteed by Naturgy Energy Group, S.A. +The average annual contracted cash flow from fixed fees for all of CCL’s other SPAs with third-parties is approximately $790 million. +In addition, Cheniere Marketing has agreements with CCL to purchase: (1) 15 TBtu per annum of LNG with an approximate term of 23 years , (2) any LNG produced by CCL in excess of that required for other customers at Cheniere Marketing’s option and (3) 0.85 mtpa of LNG with a term of up to seven years associated with an IPM gas supply agreement, as described below. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +Natural Gas Transportation, Storage and Supply +To ensure CCL is able to transport adequate natural gas feedstock to the Corpus Christi LNG terminal, it has entered into transportation precedent agreements to secure firm pipeline transportation capacity with CCP and certain third-party pipeline +9 +companies. CCL has entered into a firm storage services agreement with a third party to assist in managing variability in natural gas needs for the CCL Project . CCL has also entered into enabling agreements and long-term natural gas supply contracts with third parties, and will continue to enter into such agreements, in order to secure natural gas feedstock for the CCL Project . As of December 31, 2019 , CCL had secured up to approximately 2,999 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to eight years , a portion of which is subject to the achievement of certain project milestones and other conditions precedent. +CCL Stage III has also entered into long-term natural gas supply contracts with third parties, and anticipates continuing to enter into such agreements, in order to secure natural gas feedstock for Corpus Christi Stage 3 . As of December 31, 2019 , CCL Stage III had secured up to approximately 2,361 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to approximately 15 years , which is subject to the achievement of certain project milestones and other conditions precedent. +A portion of the natural gas feedstock transactions for CCL and CCL Stage III are IPM transactions, in which the natural gas producers are paid based on a global gas market price less a fixed liquefaction fee and certain costs incurred by us. +Construction +CCL entered into separate lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Trains 1 through 3 of the CCL Project under which Bechtel charges a lump sum for all work performed and generally bears project cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause CCL to enter into a change order, or CCL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 3, which is currently under construction, is approximately $2.4 billion , reflecting amounts incurred under change orders through December 31, 2019 . As of December 31, 2019 , we have incurred $2.0 billion under this contract. +Final Investment Decision for Corpus Christi Stage 3 +FID for Corpus Christi Stage 3 will be subject to, among other things, entering into an EPC contract, obtaining additional commercial support for the project and securing the necessary financing arrangements. +Pipeline Facilities +In December 2014, the FERC issued a certificate of public convenience and necessity under Section 7(c) of the Natural Gas Act of 1938, as amended (the “NGA”), authorizing CCP to construct and operate the Corpus Christi Pipeline. The Corpus Christi Pipeline is designed to transport 2.25 Bcf/d of natural gas feedstock required by the CCL Project from the existing regional natural gas pipeline grid. The construction of the Corpus Christi Pipeline was completed in the second quarter of 2018. +In November 2019, the FERC authorized CCP to construct and operate the pipeline for Corpus Christi Stage 3 . The pipeline will be designed to transport 1.5 Bcf/d of natural gas feedstock required by Corpus Christi Stage 3 from the existing regional natural gas pipeline grid. +Marketing +We market and sell LNG produced by the Liquefaction Projects that is not required for other customers through our integrated marketing function. We have, and continue to develop, a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide. These volumes are expected to be primarily sourced by LNG produced by the Liquefaction Projects but supplemented by volumes procured from other locations worldwide, as needed. As of December 31, 2019 , we have sold or have options to sell approximately 4,935 TBtu of LNG to be delivered to customers between 2020 and 2045, excluding volumes for agreements anticipated to be assigned to SPL in the future. The cargoes have been sold either on a FOB basis (delivered to the customer at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, as applicable) or a delivered at terminal (“DAT”) basis (delivered to the customer at their LNG receiving terminal). We have chartered LNG vessels to be utilized for cargoes sold on a DAT basis. In addition, we have entered into a long-term agreement to sell LNG cargoes on a DAT basis that is conditioned upon the buyer achieving certain milestones. +10 +Significant Customers +The following table shows customers with revenues of 10% or greater of total revenues from external customers: +Percentage of Total Revenues from External Customers +Year Ended December 31, +2019 +2018 +2017 +BG and its affiliates +16% +18% +24% +Naturgy +10% +14% +14% +KOGAS +11% +19% +14% +GAIL +11% +13% +* +JERA Co., Inc. +* +* +17% +* Less than 10% +Competition +If and when SPL, CCL or our integrated marketing function need to replace any existing SPA or enter into new SPAs, they will compete on the basis of price per contracted volume of LNG with each other and other natural gas liquefaction projects throughout the world. Revenues associated with any incremental volumes, including those sold by our integrated marketing function discussed above, will also be subject to market-based price competition. Many of the companies with which we compete are major energy corporations with longer operating histories, more development experience, greater name recognition, greater financial, technical and marketing resources and greater access to markets than us. We have proximity to our customers, with offices located in Houston, London, Singapore, Beijing and Tokyo. +SPLNG currently does not experience competition for its terminal capacity because the entire approximately 4 Bcf/d of regasification capacity that is available at the Sabine Pass LNG terminal has been fully contracted. If and when SPLNG has to replace any TUAs, it will compete with other then-existing LNG terminals for customers. +Governmental Regulation +Our LNG terminals and pipelines are subject to extensive regulation under federal, state and local statutes, rules, regulations and laws. These laws require that we engage in consultations with appropriate federal and state agencies and that we obtain and maintain applicable permits and other authorizations. These regulatory requirements increase the cost of construction and operation, and failure to comply with such laws could result in substantial penalties and/or loss of necessary authorizations. +Federal Energy Regulatory Commission +The design, construction, operation, maintenance and expansion of our liquefaction facilities, the import or export of LNG and the purchase and transportation of natural gas in interstate commerce through our pipelines (including our Creole Trail Pipeline and Corpus Christi Pipeline) are highly regulated activities subject to the jurisdiction of the FERC pursuant to the NGA. Under the NGA, the FERC’s jurisdiction generally extends to the transportation of natural gas in interstate commerce, to the sale for resale of natural gas in interstate commerce, to natural gas companies engaged in such transportation or sale and to the construction, operation, maintenance and expansion of LNG terminals and interstate natural gas pipelines. +The FERC’s authority to regulate interstate natural gas pipelines and the services that they provide generally includes regulation of: +• +rates and charges, and terms and conditions for natural gas transportation, storage and related services; +• +the certification and construction of new facilities and modification of existing facilities; +• +the extension and abandonment of services and facilities; +• +the administration of accounting and financial reporting regulations, including the maintenance of accounts and records; +• +the acquisition and disposition of facilities; +11 +• +the initiation and discontinuation of services; and +• +various other matters. +Under the NGA, our pipelines are not permitted to unduly discriminate or grant undue preference as to rates or the terms and conditions of service to any shipper, including its own marketing affiliate. Those rates, terms and conditions must be public, and on file with the FERC. In contrast to pipeline regulation, the FERC does not require LNG terminal owners to provide open-access services at cost-based or regulated rates. Although the provisions that codified FERC’s policy in this area expired on January 1, 2015, we see no indication that the FERC intends to change its policy in this area. +We are permitted to make sales of natural gas for resale in interstate commerce pursuant to a blanket marketing certificate automatically granted by the FERC to our marketing affiliates. Our sales of natural gas will be affected by the availability, terms and cost of pipeline transportation. As noted above, the price and terms of access to pipeline transportation are subject to extensive federal and state regulation. +In order to site, construct and operate our LNG terminals, we received and are required to maintain authorizations from the FERC under Section 3 of the NGA as well as other material governmental and regulatory approvals and permits. The Energy Policy Act of 2005 (the “EPAct”) amended Section 3 of the NGA to establish or clarify the FERC’s exclusive authority to approve or deny an application for the siting, construction, expansion or operation of LNG terminals, unless specifically provided otherwise in the EPAct, amendments to the NGA. For example, nothing in the EPAct amendments to the NGA were intended to affect otherwise applicable law related to any other federal agency’s authorities or responsibilities related to LNG terminals or those of a state acting under federal law. +The FERC issued final orders in April and July 2012 approving our application for an order under Section 3 of the NGA authorizing the siting, construction and operation of Trains 1 through 4 of the SPL Project (and related facilities). Subsequently, the FERC issued written approval to commence site preparation work for Trains 1 through 4. In October 2012, we applied to amend the FERC approval to reflect certain modifications to the SPL Project, and in August 2013, the FERC issued an order approving the modifications. In October 2013, we applied to further amend the FERC approval, requesting authorization to increase the total permitted LNG production capacity of Trains 1 through 4 from the then authorized 803 Bcf/yr to 1,006 Bcf/yr so as to more accurately reflect the estimated maximum LNG production capacity of Trains 1 through 4. In February 2014, the FERC issued an order approving the October 2013 application (the “February 2014 Order”). A party to the proceeding requested a rehearing of the February 2014 Order, and in September 2014, the FERC issued an order denying the rehearing request (the “FERC Order Denying Rehearing”). The party petitioned the U.S. Court of Appeals for the District of Columbia Circuit (the “Court of Appeals”) to review the February 2014 Order and the FERC Order Denying Rehearing. The court denied the petition in June 2016. In September 2013, we filed an application with the FERC for authorization to add Trains 5 and 6 to the SPL Project, which was granted by the FERC in an order issued in April 2015 and an order denying rehearing issued in June 2015. These orders are not subject to appellate court review. In October of 2018, SPL applied to the FERC for authorization to add a third marine berth to the Sabine Pass LNG terminal facilities. +The Creole Trail Pipeline, which interconnects with the Sabine Pass LNG terminal, holds a certificate of public convenience and necessity from the FERC under Section 7 of the NGA. The FERC’s approval under Section 7 of the NGA, as well as several other material governmental and regulatory approvals and permits, may be required prior to making any modifications to the Creole Trail Pipeline as it is a regulated, interstate natural gas pipeline. In 2013, the FERC approved CTPL’s application for authorization to construct, own, operate and maintain certain new facilities in order to enable bi-directional natural gas flow on the Creole Trail Pipeline system to allow for the delivery of up to 1,530,000 Dekatherms per day of feed gas to the Sabine Pass LNG terminal. In November 2013, CTPL received approval from the Louisiana Department of Environmental Quality (“LDEQ”) for the proposed modifications and, with subsequent final FERC clearance, construction was completed in 2015. In September 2013, we filed an application with the FERC for authorization to construct and operate an extension and expansion of Creole Trail Pipeline and related facilities in order to deliver additional domestic natural gas supplies to the Sabine Pass LNG terminal, which was granted by the FERC in an order issued in April 2015 and an order denying rehearing issued in June 2015. These orders are not subject to appellate court review. +In December 2014, the FERC issued an order granting CCL authorization under Section 3 of the NGA to site, construct and operate Trains 1 through 3 of the CCL Project and issued a certificate of public convenience and necessity under Section 7(c) of the NGA authorizing construction and operation of the Corpus Christi Pipeline (the “December 2014 Order”). A party to the proceeding requested a rehearing of the December 2014 Order, and in May 2015, the FERC denied rehearing (the “Order Denying Rehearing”). The party petitioned the relevant Court of Appeals to review the December 2014 Order and the Order Denying +12 +Rehearing; that petition was denied on November 4, 2016. In June of 2018, CCL Stage III, CCL and CCP filed an application with the FERC for authorization under section 3 of the NGA to site, construct and operate additional facilities for the liquefaction and export of domestically-produced natural gas (“Corpus Christi Stage 3”) at the existing CCL Project . In November 2019, the FERC authorized CCP to construct and operate the pipeline for Corpus Christi Stage 3 . Corpus Christi Stage 3 consists of the addition of seven midscale Trains and related facilities. The order is not subject to appellate court review. +On September 27, 2019, CCL and SPL filed a request with the FERC pursuant to section 3 of the NGA, requesting authorization to increase the total LNG production capacity of each terminal from currently authorized levels to an amount which reflects more accurately the capacity of each facility based on enhancements during the engineering, design and construction process, as well as operational experience to date. The requested authorizations do not involve construction of new facilities. Corresponding applications for authorization to export the incremental volumes were also submitted to the DOE. +The FERC’s Standards of Conduct apply to interstate pipelines that conduct transmission transactions with an affiliate that engages in natural gas marketing functions. The general principles of the FERC Standards of Conduct are: (1) independent functioning, which requires transmission function employees to function independently of marketing function employees; (2) no-conduit rule, which prohibits passing transmission function information to marketing function employees; and (3) transparency, which imposes posting requirements to detect undue preference due to the improper disclosure of non-public transmission function information. We have established the required policies, procedures and training to comply with the FERC’s Standards of Conduct. +All of our FERC construction, operation, reporting, accounting and other regulated activities are subject to audit by the FERC, which may conduct routine or special inspections and issue data requests designed to ensure compliance with FERC rules, regulations, policies and procedures. The FERC’s jurisdiction under the NGA allows it to impose civil and criminal penalties for any violations of the NGA and any rules, regulations or orders of the FERC up to approximately $1.3 million per day per violation, including any conduct that violates the NGA’s prohibition against market manipulation. +Several other material governmental and regulatory approvals and permits will be required throughout the life of our LNG terminals and our pipelines. In addition, our FERC orders require us to comply with certain ongoing conditions, reporting obligations and maintain other regulatory agency approvals throughout the life of our facilities. For example, throughout the life of our LNG terminals and our pipelines, we are subject to regular reporting requirements to the FERC, the Department of Transportation’s (“DOT”) Pipeline and Hazardous Materials Safety Administration (“PHMSA”) and applicable federal and state regulatory agencies regarding the operation and maintenance of our facilities. To date, we have been able to obtain and maintain required approvals as needed, and the need for these approvals and reporting obligations have not materially affected our construction or operations. +DOE Export License +The DOE has authorized the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal as discussed in Sabine Pass LNG Terminal — Liquefaction Facilities and the Corpus Christi LNG terminal as discussed in Corpus Christi LNG Terminal — Liquefaction Facilities. Although it is not expected to occur, the loss of an export authorization could be a force majeure event under our SPAs. +Under Section 3 of the NGA applications for exports of natural gas to FTA countries, which allow for national treatment for trade in natural gas, are “deemed to be consistent with the public interest” and shall be granted by the DOE without “modification or delay.” FTA countries currently recognized by the DOE for exports of LNG include Australia, Bahrain, Canada, Chile, Colombia, Dominican Republic, El Salvador, Guatemala, Jordan, Mexico, Morocco, Nicaragua, Oman, Panama, Peru, Republic of Korea and Singapore. Applications for export of LNG to non-FTA countries are considered by the DOE in a notice and comment proceeding whereby the public and other interveners are provided the opportunity to comment and may assert that such authorization would not be consistent with the public interest. +Pipeline and Hazardous Materials Safety Administration +Our LNG terminals as well as the Creole Trail Pipeline and the Corpus Christi Pipeline are subject to regulation by PHMSA. PHMSA is authorized by the applicable pipeline safety laws to establish minimum safety standards for certain pipelines and LNG facilities. The regulatory standards PHMSA has established are applicable to the design, installation, testing, construction, operation, maintenance and management of natural gas and hazardous liquid pipeline facilities and LNG facilities that affect interstate or foreign commerce. PHMSA has also established training, worker qualification and reporting requirements. +13 +In October 2019, PHMSA published final rules revising its regulations governing the safety of certain gas transmission pipelines (effective July 1, 2020) and established new enforcement procedures for the issuance of temporary emergency orders (effective December 2, 2019). +PHMSA performs inspections of pipeline and LNG facilities and has authority to undertake enforcement actions, including issuance of civil penalties up to approximately $218,000 per day per violation, with a maximum administrative civil penalty of approximately $2 million for any related series of violations. +Other Governmental Permits, Approvals and Authorizations +Construction and operation of the Sabine Pass LNG terminal and the CCL Project require additional permits, orders, approvals and consultations to be issued by various federal and state agencies, including the DOT, U.S. Army Corps of Engineers (“USACE”), U.S. Department of Commerce, National Marine Fisheries Services, U.S. Department of the Interior, U.S. Fish and Wildlife Service, the U.S. Environmental Protection Agency (the “EPA”), U.S. Department of Homeland Security, the LDEQ, the Texas Commission on Environmental Quality (“TCEQ”) and the Railroad Commission of Texas (“RRC”). +The USACE issues its permits under the authority of the Clean Water Act (Section 404) and the Rivers and Harbors Act (Section 10) (the “Section 10/404 Permit”). The EPA administers the Clean Air Act, and has delegated authority to the TCEQ and LDEQ to issue the Title V Operating Permit (the “Title V Permit”) and the Prevention of Significant Deterioration Permit (the “PSD Permit”). These two permits are issued by the LDEQ for the Sabine Pass LNG terminal and CTPL and by the TCEQ for the CCL Project . +Commodity Futures Trading Commission (“CFTC”) +The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amended the Commodity Exchange Act to provide for federal regulation of the over-the-counter derivatives market and entities, such as us, that participate in that market. The regulatory regime created by the Dodd-Frank Act is designed primarily to (1) regulate certain participants in the swaps markets, including entities falling within the categories of “Swap Dealer” and “Major Swap Participant,” (2) require clearing and exchange trading of standardized swaps of certain classes as designated by the CFTC, (3) increase swap market transparency through robust reporting and recordkeeping requirements, (4) reduce financial risks in the derivatives market by imposing margin or collateral requirements on both cleared and, in certain cases, uncleared swaps, (5) provide the CFTC with expanded authority to establish position limits on certain physical commodity futures and options contracts and their economically equivalent swaps as it finds necessary and appropriate and (6) otherwise enhance the rulemaking and enforcement authority of the CFTC and the SEC regarding the derivatives markets. Most of the regulations are already in effect, while other rules and regulations, including the proposed margin rules, position limits and commodity clearing requirements, remain to be finalized or effectuated. Therefore, the impact of those rules and regulations on our business continues to be uncertain. +A provision of the Dodd-Frank Act requires the CFTC, in order to diminish or prevent excessive speculation in commodity markets, to adopt rules, as it finds necessary and appropriate, imposing new position limits on certain physical commodity futures contracts and options thereon, as well as economically equivalent swaps traded on registered swap trading platforms and on over-the-counter swaps that perform a significant price discovery function with respect to certain markets. In that regard, the CFTC has re-proposed position limits rules that would modify and expand the applicability of limits on speculative positions in certain physical commodity futures contracts and economically equivalent futures, options and swaps for or linked to certain physical commodities, including Henry Hub natural gas, that market participants may hold, subject to limited exemptions for certain bona fide hedging and other types of transactions. It is uncertain at this time whether, when and in what form the CFTC’s proposed new position limits rules may become final and effective. +Pursuant to rules adopted by the CFTC, certain interest rate swaps and index credit default swaps must be cleared through a derivatives clearing organization and executed on an exchange or swap execution facility. The CFTC has not yet proposed to designate swaps in any other asset classes, including swaps relating to physical commodities, for mandatory clearing and trade execution, but could do so in the future. Although we expect to qualify for the end-user exception from the mandatory clearing and exchange-trading requirements applicable to any swaps that we enter into to hedge our commercial risks, the mandatory clearing and exchange-trading requirements may apply to other market participants, including our counterparties (who may be registered as Swap Dealers), with respect to other swaps, and the application of such rules may change the market cost and general availability in the market of swaps of the type we enter into to hedge our commercial risks and, thus, the cost and availability of the swaps that we use for hedging. +14 +As required by provisions of the Dodd-Frank Act, the CFTC and federal banking regulators have adopted rules to require Swap Dealers and Major Swap Participants, including those that are regulated financial institutions, to collect initial and/or variation margin with respect to uncleared swaps from their counterparties that are financial end users, registered swap dealers or major swap participants. These rules do not require collection of margin from non-financial-entity end users who qualify for the end user exception from the mandatory clearing requirement or from non-financial end users or certain other counterparties in certain instances. We expect to qualify as such a non-financial-entity end user with respect to the swaps that we enter into to hedge our commercial risks. +Any new rules or changes to existing rules promulgated under the Dodd-Frank Act could (1) impair the availability of derivatives, (2) materially increase the cost of, or decrease the liquidity of, the derivatives we use to hedge, (3) significantly alter the terms and conditions of derivatives and (4) potentially increase our exposure to less creditworthy counterparties. Further, any resulting reduction in the use of derivatives could make cash flow more volatile and less predictable, which in turn could adversely affect our ability to plan for and fund capital expenditures. +Pursuant to the Dodd-Frank Act, the CFTC has adopted additional anti-manipulation and anti-disruptive trading practices regulations that prohibit, among other things, manipulative, deceptive or fraudulent schemes or material misrepresentation in the futures, options, swaps and cash markets. In addition, separate from the Dodd-Frank Act, our use of futures and options on commodities is subject to the Commodity Exchange Act and CFTC regulations, as well as the rules of futures exchanges on which any of these instruments are executed. Should we violate any of these laws and regulations, we could be subject to a CFTC or an exchange enforcement action and material penalties, possibly resulting in changes in the rates we can charge. +United Kingdom /European Regulations +Our European Union (“EU”) trading activities, which are primarily established in the United Kingdom (“UK”), are subject to a number of EU-wide and UK specific laws and regulations. These are described further below: +European Market Infrastructure Regulation (“EMIR”) +EMIR is an EU regulation (with text that is relevant across the European Economic Area (“EEA”)) designed to increase the transparency and stability of the EEA derivatives markets, including by: (1) imposing requirements on market participants trading derivatives, including relating to reporting, clearing and risk mitigation; and (2) imposing rules and standards that apply to central counterparties (i.e. clearing houses) and trade repositories. The precise impact of these rules will depend on a number of factors, including the regulatory status of the counterparty that is trading derivative instruments, as well as the volume and types of instruments it is trading. We currently are categorized under EMIR as a non-financial counterparty below the clearing threshold, which is a type of market participant subject to a lower regulatory burden. However, were we to engage in activities that resulted in a change to our status, we could be subject to more onerous regulations (including clearing and margining) which could significantly increase the cost of our derivatives trading activity, and materially alter the terms of the derivatives contracts we enter into. +Regulation on Wholesale Energy Market Integrity and Transparency (“REMIT”) +REMIT is an EU regulation (with EEA relevance) that prohibits market manipulation and insider trading in European wholesale energy markets and imposes various obligations on participants in these markets. Market participants, such as us, cannot use inside information (i.e., non-public information that would likely have a significant effect on the price of wholesale energy products if it were made public) to (1) buy or sell wholesale energy products for their own account or on behalf of a third party, directly or indirectly; (2) induce others to buy or sell wholesale energy products based on inside information; or (3) disclose such inside information to any other person except in the normal course of employment. A market participant is also prohibited from manipulating or attempting to manipulate any wholesale energy market, and is required to publicly disclose inside information which it possesses in respect of business or facilities which it or its affiliates either owns or controls, or for whose operational matters it or they are responsible, either in whole or in part. +Markets in Financial Instruments Directive and Regulation (“MiFID II”) +MiFID II consists of an EU directive, a regulation and a number of delegated acts, rules and guidance, that replaced the original 2004 Markets in Financial Instruments Directive (“MiFID”). MiFID II (with relevance throughout the EEA), sets forth +15 +an EEA-wide financial services framework, including rules for firms engaging in investment services and activities in connection with certain financial instruments in the EEA. Firms engaging in such activities must be authorized unless an exemption applies. +We are eligible to trade on our own account in commodity derivatives as a result of the “ancillary activity” exemption under MiFID II. To avail ourselves of this exemption, amongst other things, we must be able to demonstrate, on the basis of a methodology set out in certain delegated MiFID II text, that our activities in commodity derivatives are ancillary to the main business of our group. Provided we meet the requirements, we must notify the UK regulator that we are availing ourselves of this exemption on an annual basis. If, in the future, we are no longer able to meet the requirements of the “ancillary activity” exemption, and no other exemption is available to us, we would be required to become authorized as an investment firm under MiFID II. This may result in us being subject to the regulatory capital requirements under the EU’s Capital Requirements Directive IV. +Market Abuse Regulation (“MAR”) +MAR is intended to update and strengthen the existing EU market abuse framework and applies to all financial instruments listed or traded on EU trading venues as well as other over-the-counter (“OTC”) financial instruments priced on, or impacting, the trading venue contract. Generally, MAR applies to entities trading on, or in a manner that impacts EU markets. MAR contains a number of “insider dealing” and “market manipulation” (including “attempted manipulation”) based offences. Under MAR, any person professionally arranging or executing transactions in financial instruments is required to establish and maintain effective arrangements, systems and procedures to detect and report suspicious orders and transactions. +UK-Specific Rules +In addition to the various EU/EEA rules described above, other UK-specific laws, such as the UK’s Financial Services and Markets Act of 200 (“FSMA”) and Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”), also apply to our trading activities. +Any violation of the foregoing laws and regulations could result in investigations, and possible fine and penalties, and in some scenarios, criminal offenses. +Brexit +The UK withdrew from the EU (“Brexit”) on January 31, 2020, and the withdrawal may have an impact on the applicability of the current EU Regulations and Directives that govern our various trading activities. The precise impacts will depend on the negotiations that will occur during the transition period, which is currently scheduled to end on December 31, 2020, as well as other factors that may or may not be addressed during the negotiations. We anticipate that impacts could include a possible requirement to register in the EU for certain activities, the possible reclassification of products traded on UK exchanges for EU purposes and products traded on EU exchanges for UK purposes and possible impacts on our treatment related to various regulatory statuses (e.g., clearing threshold classifications and other safe harbors and exemptions). During this transition period, the UK will continue to be subject to EU Regulations and Rules, with the objective being to provide as smooth a transition as possible for businesses. Until additional clarity surrounding Brexit is obtained, other impacts pertaining to our trading activities could occur. +Environmental Regulation +Our LNG terminals are subject to various federal, state and local laws and regulations relating to the protection of the environment and natural resources. These environmental laws and regulations require significant expenditures for compliance, can affect the cost and output of operations and may impose substantial penalties for non-compliance and substantial liabilities for pollution. Many of these laws and regulations, such as those noted below, restrict or prohibit impacts to the environment or the types, quantities and concentration of substances that can be released into the environment and can lead to substantial administrative, civil and criminal fines and penalties for non-compliance. +Clean Air Act (“CAA”) +Our LNG terminals are subject to the federal CAA and comparable state and local laws. We may be required to incur certain capital expenditures over the next several years for air pollution control equipment in connection with maintaining or obtaining permits and approvals addressing air emission-related issues. We do not believe, however, that our operations, or the construction and operations of our liquefaction facilities, will be materially and adversely affected by any such requirements. +16 +In 2009, the EPA promulgated and finalized the Mandatory Greenhouse Gas Reporting Rule requiring annual reporting of greenhouse gas (“GHG”) emissions from stationary sources in a variety of industries. In 2010, the EPA expanded the rule to include reporting obligations for LNG terminals. In addition, the EPA has defined GHG emissions thresholds that would subject GHG emissions from new and modified industrial sources to regulation if the source is subject to PSD Permit requirements due to its emissions of non-GHG criteria pollutants. While the EPA subsequently took a number of additional actions primarily relating to GHG emissions from the electric power generation and the oil and gas exploration and production industries, those rules have largely been stayed or repealed including by amendments adopted by the EPA on February 23, 2018, additional proposed amendments to new source performance standards for the oil and gas industry on September 24, 2019, and the EPA’s June 19, 2019 adoption of the Affordable Clean Energy rule for power generation. +From time to time, Congress has considered proposed legislation directed at reducing GHG emissions. In addition, many states have already taken regulatory action to monitor and/or reduce emissions of GHGs, primarily through the development of GHG emission inventories or regional GHG cap and trade programs. It is not possible at this time to predict how future regulations or legislation may address GHG emissions and impact our business. However, future regulations and laws could result in increased compliance costs or additional operating restrictions and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Coastal Zone Management Act (“CZMA”) +The siting and construction of our LNG terminals within the coastal zone is subject to the requirements of the CZMA. The CZMA is administered by the states (in Louisiana, by the Department of Natural Resources, and in Texas, by the General Land Office). This program is implemented to ensure that impacts to coastal areas are consistent with the intent of the CZMA to manage the coastal areas. +Clean Water Act (“CWA”) +Our LNG terminals are subject to the federal CWA and analogous state and local laws. The CWA imposes strict controls on the discharge of pollutants into the navigable waters of the United States, including discharges of wastewater and storm water runoff and fill/discharges into waters of the United States. Permits must be obtained prior to discharging pollutants into state and federal waters. The CWA is administered by the EPA, the USACE and by the states (in Louisiana, by the LDEQ, and in Texas, by the TCEQ). +Resource Conservation and Recovery Act (“RCRA”) +The federal RCRA and comparable state statutes govern the generation, handling and disposal of solid and hazardous wastes and require corrective action for releases into the environment. When such wastes are generated in connection with the operations of our facilities, we are subject to regulatory requirements affecting the handling, transportation, treatment, storage and disposal of such wastes. +Protection of Species, Habitats and Wetlands +Various federal and state statutes, such as the Endangered Species Act (the “ESA”), the Migratory Bird Treaty Act (“MBTA”), the CWA and the Oil Pollution Act, prohibit certain activities that may adversely affect endangered or threatened animal, fish and plant species and/or their designated habitats, wetlands, or other natural resources. If one of our LNG terminals or pipelines adversely affects a protected species or its habitat, we may be required to develop and follow a plan to avoid those impacts. In that case, siting, construction or operation may be delayed or restricted and cause us to incur increased costs. +In August 2019, the U.S. Fish and Wildlife Service (the “FWS”) announced a series of changes to the rules implementing the ESA, including revisions to the regulations governing interagency cooperation, listing species and delisting critical habitat, and prohibitions related to threatened wildlife and plants. The revisions are intended to streamline these processes and create more flexibility for the FWS when making ESA-related decisions. +In addition, in December 2017, the Department of Interior’s (“DOI’s”) Solicitor’s Office issued an official opinion that the MBTA’s broad prohibition on “taking” migratory birds applies only to affirmative actions and does prohibit incidental harm. In April 2018, the FWS issued guidance consistent with the DOI’s opinion and on January 30, 2020, the FWS issued a proposed rule defining the scope of the MBTA to cover only actions directed at migratory birds, their nests or their eggs. +17 +We do not believe that our operations, or the construction and operations of our liquefaction facilities, will be materially and adversely affected by these recent regulatory actions. +Market Factors +Our ability to enter into additional long-term SPAs to underpin the development of additional Trains, sale of LNG by Cheniere Marketing, or development of new projects is subject to market factors. These factors include changes in worldwide supply and demand for natural gas, LNG and substitute products, the relative prices for natural gas, crude oil and substitute products in North America and international markets, the rate of fuel switching for power generation from coal, nuclear or oil to natural gas and economic growth in developing countries. In addition, our ability to obtain additional funding to execute our business strategy is subject to the investment community’s appetite for investment in LNG and natural gas infrastructure and our ability to access capital markets. +We expect that global demand for natural gas and LNG will continue to increase as nations seek more abundant, reliable and environmentally cleaner fuel alternatives to oil and coal. Global demand for natural gas is projected by the International Energy Agency to grow by approximately 27 trillion cubic feet (“Tcf”) between 2018 and 2030 and 39 Tcf between 2018 and 2035. LNG’s share is seen growing from about 11% in 2018 to about 16% of the global gas market in 2030 and 18% in 2035. Wood Mackenzie Limited (“WoodMac”) forecasts that global demand for LNG will increase by approximately 79%, from approximately 316 mtpa, or 15.2 Tcf, in 2018, to approximately 566 mtpa, or 27.2 Tcf, in 2030 and to 678 mtpa or 32.6 Tcf in 2035. WoodMac also forecasts LNG production from existing operational facilities and new facilities already under construction will be able to supply the market with approximately 469 mtpa in 2030, declining to 430 mtpa in 2035. This will result in a market need for construction of an additional approximately 97 mtpa of LNG production by 2030 and about 248 mtpa by 2035. We believe the capital and operating costs of the uncommitted capacity of our Liquefaction Projects and Corpus Christi Stage 3 are competitive with new proposed projects globally and we are well-positioned to capture a portion of this incremental market need. +We have limited exposure to the decline in oil prices as we have contracted a significant portion of our LNG production capacity under long-term sale and purchase agreements. These agreements contain fixed fees that are required to be paid even if the customers elect to cancel or suspend delivery of LNG cargoes. We have contracted approximately 85% of the total production capacity from the Liquefaction Projects on a term basis, which includes volumes contracted under SPAs in which the customers are required to pay a fixed fee with respect to the contracted volumes irrespective of their election to cancel or suspend deliveries of LNG cargoes, as well as volumes contracted under IPM gas supply agreements. As of January 31, 2020, U.S. natural gas prices indicate that LNG exported from the U.S. continues to be competitively priced, supporting the opportunity for U.S. LNG to fill uncontracted future demand through the execution of long-term and medium-term contracting of LNG from our terminals. +Subsidiaries +Our assets are generally held by our subsidiaries. We conduct most of our business through these subsidiaries, including the development, construction and operation of our LNG terminal business and the development and operation of our LNG and natural gas marketing business. +Employees +We had 1,530 full-time employees at January 31, 2020 . +Available Information +Our common stock has been publicly traded since March 24, 2003 and is traded on the NYSE American under the symbol “LNG.” Our principal executive offices are located at 700 Milam Street, Suite 1900, Houston, Texas 77002, and our telephone number is (713) 375-5000. Our internet address is www.cheniere.com. We provide public access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after we electronically file those materials with, or furnish those materials to, the SEC under the Exchange Act . These reports may be accessed free of charge through our internet website. We make our website content available for informational purposes only. The website should not be relied upon for investment purposes and is not incorporated by reference into this Form 10-K. +18 +We will also make available to any stockholder, without charge, copies of our annual report on Form 10-K as filed with the SEC. For copies of this, or any other filing, please contact: Cheniere Energy, Inc., Investor Relations Department, 700 Milam Street Suite 1900, Houston, Texas 77002 or call (713) 375-5000. The SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers. +ITEM 1A. +RISK FACTORS +The following are some of the important factors that could affect our financial performance or could cause actual results to differ materially from estimates or expectations contained in our forward-looking statements. We may encounter risks in addition to those described below. Additional risks and uncertainties not currently known to us, or that we currently deem to be immaterial, may also impair or adversely affect our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +The risk factors in this report are grouped into the following categories: +• +Risks Relating to Our Financial Matters; +• +Risks Relating to Our LNG Terminal Operations and Commercialization; +• +Risks Relating to Our LNG Business in General; and +• +Risks Relating to Our Business in General. +Risks Relating to Our Financial Matters +Our existing level of cash resources and significant debt could cause us to have inadequate liquidity and could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +As of December 31, 2019 , we had $2.5 billion of cash and cash equivalents, $520 million of current restricted cash and $31.5 billion of total debt outstanding on a consolidated basis (before unamortized premium, discount and debt issuance costs), excluding $1.5 billion aggregate outstanding letters of credit. We incur, and will incur, significant interest expense relating to the assets at the Sabine Pass and Corpus Christi LNG terminals, and we anticipate needing to incur additional debt to finance the construction of Corpus Christi Stage 3 . Our ability to fund our capital expenditures and refinance our indebtedness will depend on our ability to access additional project financing as well as the debt and equity capital markets. A variety of factors beyond our control could impact the availability or cost of capital, including domestic or international economic conditions, increases in key benchmark interest rates and/or credit spreads, the adoption of new or amended banking or capital market laws or regulations and the repricing of market risks and volatility in capital and financial markets. Our financing costs could increase or future borrowings or equity offerings may be unavailable to us or unsuccessful, which could cause us to be unable to pay or refinance our indebtedness or to fund our other liquidity needs. We also rely on borrowings under our credit facilities to fund our capital expenditures. If any of the lenders in the syndicates backing these facilities was unable to perform on its commitments, we may need to seek replacement financing, which may not be available as needed, or may be available in more limited amounts or on more expensive or otherwise unfavorable terms. +We have not always been profitable historically. We may not achieve profitability or generate positive operating cash flow in the future. +We had net loss attributable to common stockholders of $393 million for the year ended December 31, 2017 and had losses in prior years. In the future, we may incur operating losses and experience negative operating cash flow. We may not be able to reduce costs, increase revenues or reduce our debt service obligations sufficiently to maintain our cash resources, which could cause us to have inadequate liquidity to continue our business. +We will continue to incur significant capital and operating expenditures while we develop and construct the Liquefaction Project s, Corpus Christi Stage 3 and other projects. Any delays beyond the expected development period for these projects could cause operating losses and negative operating cash flows. Our future liquidity may also be affected by the timing of construction financing availability in relation to the incurrence of construction costs and other outflows and by the timing of receipt of cash flows under third-party agreements in relation to the incurrence of project and operating expenses. Moreover, many factors (including factors beyond our control) could result in a disparity between liquidity sources and cash needs, including factors such as construction delays and breaches of agreements. Our ability to generate any significant positive operating cash flow and achieve profitability in the future is dependent on our ability to successfully and timely complete and operate the applicable project. +19 +We may sell equity or equity-related securities or assets, including equity interests in Cheniere Partners. Such sales could dilute our stockholders’ proportionate indirect interests in our assets, business operations and proposed liquefaction and other projects of Cheniere Partners or other subsidiaries, and could adversely affect the market price of our common stock. +We have historically pursued a number of alternatives in order to finance the construction of our Trains, including potential issuances and sales of additional equity or equity-related securities by us or Cheniere Partners. Such sales, in one or more transactions, could dilute our stockholders’ proportionate indirect interests in our assets, business operations and proposed projects of Cheniere Partners, including the SPL Project, or in other subsidiaries or projects, including the CCL Project. In addition, such sales, or the anticipation of such sales, could adversely affect the market price of our common stock. +Our stockholders may experience dilution upon the conversion of our convertible notes. +In November 2014, we issued an aggregate principal amount of $1.0 billion Convertible Unsecured Notes due 2021 (the “2021 Cheniere Convertible Unsecured Notes”) to RRJ Capital II Ltd, Baytree Investments (Mauritius) Pte Ltd and Seatown Lionfish Pte. Ltd. In March 2015, we issued $625 million aggregate principal amount of 4.25% Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”) to certain investors through a registered direct offering. In May 2015, CCH HoldCo II issued $1.0 billion aggregate principal amount of 11.0% Convertible Senior Secured Notes due 2025 (the “ 2025 CCH HoldCo II Convertible Senior Notes ” and together with the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes , the “Convertible Notes” ) to EIG Management Company, LLC. +We have the option to satisfy the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes conversion obligations with cash, common stock or a combination thereof. The 2025 CCH HoldCo II Convertible Senior Notes conversion obligations must be satisfied with common stock. The 2021 Cheniere Convertible Unsecured Notes are convertible at an initial conversion price of $93.64. Prior to December 15, 2044, the 2045 Cheniere Convertible Senior Notes will be convertible upon the occurrence of certain conditions, and on and after such date they will become freely convertible. The 2045 Cheniere Convertible Senior Notes will become convertible into the common stock of Cheniere at an initial conversion price of $138.38 per share. Provided the total market capitalization of Cheniere at that time is not less than $10.0 billion and certain other conditions are satisfied, the 2025 CCH HoldCo II Convertible Senior Notes will be convertible at CCH HoldCo II’s option on or after March 1, 2020 (the “Eligible Conversion Date”) . The conversion price for 2025 CCH HoldCo II Convertible Senior Notes converted at CCH HoldCo II’s option is the lower of (1) a 10% discount to the average of the daily volume-weighted average price (“VWAP”) of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided and (2) a 10% discount to the closing price of our common stock on the trading day preceding the date on which notice of conversion is provided. At the option of the holders, the 2025 CCH HoldCo II Convertible Senior Notes are convertible on or after the six-month anniversary of the Eligible Conversion Date , provided the total market capitalization of Cheniere at that time is not less than $10.0 billion and certain other conditions are satisfied, at a conversion price equal to the average of the daily VWAP of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided. +The conversion of some or all of the Convertible Notes into shares of our common stock will dilute the ownership percentages and voting power of our existing stockholders. Based on the initial conversion price, if we elect to satisfy the entire conversion obligations of the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes with common stock, an aggregate of approximately 19.1 million shares of our common stock would be issued upon the conversion, assuming the notes are converted at maturity and all interest on the notes is paid in kind for the 2021 Cheniere Convertible Unsecured Notes . Because the conversion rate for the 2025 CCH HoldCo II Convertible Senior Notes will depend on the price of our common stock at the time of conversion, we cannot meaningfully estimate the number of shares of our common stock, if any, that would be issued upon the conversion of such notes; however, under these convertible notes, a maximum of 47,108,466 shares of our common stock (subject to adjustment in the event of a stock split) may be issued in the aggregate upon the conversion of all of the 2025 CCH HoldCo II Convertible Senior Notes . Any sales in the public market of the shares issuable upon conversion of the Convertible Notes could adversely affect the prevailing market prices of our common stock. In addition, the existence of the Convertible Notes may encourage short selling by market participants because the conversion of the Convertible Notes could be used to satisfy short positions, or the anticipated conversion of the Convertible Notes into shares of our common stock could depress the price of our common stock. +20 +Our ability to generate cash is substantially dependent upon the performance by customers under long-term contracts that we have entered into, and we could be materially and adversely affected if any customer fails to perform its contractual obligations for any reason. +Our future results and liquidity are substantially dependent upon performance by our customers to make payments under long-term contracts. As of December 31, 2019 , SPL had SPAs with eight third-party customers, CCL had SPAs with nine third-party customers and our integrated marketing function had a limited number of SPAs with third-party customers. In addition, SPLNG had TUAs with two third-party customers. We are dependent on each customer’s continued willingness and ability to perform its obligations under its SPA or TUA. We are exposed to the credit risk of any guarantor of these customers’ obligations under their respective agreements in the event that we must seek recourse under a guaranty. If any customer fails to perform its obligations under its SPA or TUA, our business, contracts, financial condition, operating results, cash flow, liquidity and prospects could be materially and adversely affected, even if we were ultimately successful in seeking damages from that customer or its guarantor for a breach of the agreement. +Each of our customer contracts is subject to termination under certain circumstances. +Each of the SPAs contains various termination rights allowing our customers to terminate their SPAs, including, without limitation: (1) upon the occurrence of certain events of force majeure; (2) if we fail to make available specified scheduled cargo quantities; and (3) delays in the commencement of commercial operations. We may not be able to replace these SPAs on desirable terms, or at all, if they are terminated. +Each of SPLNG’s long-term TUAs contains various termination rights. For example, each customer may terminate its TUA if the Sabine Pass LNG terminal experiences a force majeure delay for longer than 18 months, fails to redeliver a specified amount of natural gas in accordance with the customer’s redelivery nominations or fails to accept and unload a specified number of the customer’s proposed LNG cargoes. SPLNG may not be able to replace these TUAs on desirable terms, or at all, if they are terminated. +Our subsidiaries may be restricted under the terms of their indebtedness from making distributions under certain circumstances, which may limit Cheniere Partners’ ability to pay or increase distributions to us or inhibit our access to cash flows from the CCL Project and could materially and adversely affect us. +The agreements governing our subsidiaries’ indebtedness restrict payments that our subsidiaries can make to Cheniere Partners or us in certain events and limit the indebtedness that our subsidiaries can incur. For example, SPL is restricted from making distributions under agreements governing its indebtedness generally until, among other requirements, deposits are made into debt service reserve accounts and a debt service coverage ratio of 1.25:1.00 is satisfied. +CCH is generally restricted from making distributions under agreements governing its indebtedness until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project, funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25:1.00. +CCH HoldCo II is restricted from making distributions to Cheniere under agreements governing its indebtedness generally until, among other requirements, a historical debt service coverage ratio and a projected fixed debt services coverage ratio of 1.20:1.00 are achieved. +Our subsidiaries’ inability to pay distributions to Cheniere Partners or us or to incur additional indebtedness as a result of the foregoing restrictions in the agreements governing their indebtedness may inhibit Cheniere Partners’ ability to pay or increase distributions to us and its other unitholders or inhibit our access to cash flows from the CCL Project, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +21 +Restrictions in agreements governing us and our subsidiaries’ indebtedness may prevent us and our subsidiaries from engaging in certain beneficial transactions. +In addition to restrictions on the ability of us, Cheniere Partners, SPL, CCH and CCH HoldCo II to make distributions or incur additional indebtedness, the agreements governing our indebtedness also contain various other covenants that may prevent us from engaging in beneficial transactions, including limitations on our ability to: +• +make certain investments; +• +purchase, redeem or retire equity interests; +• +issue preferred stock; +• +sell or transfer assets; +• +incur liens; +• +enter into transactions with affiliates; +• +consolidate, merge, sell or lease all or substantially all of our assets; and +• +enter into sale and leaseback transactions. +Our use of hedging arrangements may adversely affect our future operating results or liquidity. +To reduce our exposure to fluctuations in the price, volume and timing risk associated with the purchase of natural gas, we use futures, swaps and option contracts traded or cleared on the Intercontinental Exchange and the New York Mercantile Exchange or over-the-counter options and swaps with other natural gas merchants and financial institutions. Hedging arrangements could expose us to risk of financial loss in some circumstances, including when: +• +expected supply is less than the amount hedged; +• +the counterparty to the hedging contract defaults on its contractual obligations; or +• +there is a change in the expected differential between the underlying price in the hedging agreement and actual prices received. +The use of derivatives also may require the posting of cash collateral with counterparties, which can impact working capital when commodity prices change. +The regulatory and other provisions of the Dodd-Frank Act and the rules adopted thereunder and other regulations, including EMIR and REMIT, could adversely affect our ability to hedge risks associated with our business and our operating results and cash flows. +The provisions of the Dodd-Frank Act and the rules adopted and to be adopted by the CFTC , the SEC and other federal regulators establishing federal regulation of the OTC derivatives market and entities like us that participate in that market may adversely affect our ability to manage certain of our risks on a cost effective basis. Such laws and regulations may also adversely affect our ability to execute our strategies with respect to hedging our exposure to variability in expected future cash flows attributable to the future sale of our LNG inventory and to price risk attributable to future purchases of natural gas to be utilized as fuel to operate our LNG terminals and to secure natural gas feedstock for our liquefaction facilities. +The CFTC has re-proposed position limits rules that would modify and expand the applicability of position limits on the amounts of certain speculative futures contracts, as well as economically equivalent options, futures and swaps for or linked to certain physical commodities, including Henry Hub natural gas, that market participants may hold, subject to limited exemptions for certain bona fide hedging positions and other types of transactions. To the extent the revised CFTC position limits proposal becomes final, our ability to execute our hedging strategies described above could be limited. It is uncertain at this time whether, when and in what form the CFTC’s proposed new position limits rules may become final and effective. +Under the Dodd-Frank Act and the rules adopted thereunder, certain swaps may be required to be cleared through a derivatives clearing organization. While the CFTC has designated certain interest rate swaps and index credit default swaps for mandatory clearing, it has not yet finalized rules designating any physical commodity swaps, for mandatory clearing or mandatory exchange trading. Further, we qualify for the end-user exception from the mandatory clearing and trade execution requirements for our +22 +swaps entered into to hedge our commercial risks. If we fail to qualify for that exception as to any swap we enter into and have to clear that swap through a derivatives clearing organization, we could be required to post margin (or post higher margin than if we entered into an uncleared OTC swap) with respect to such swap, our cost of entering into and maintaining such swap could increase and we would not enjoy the same flexibility with the cleared swaps that we enjoy with the uncleared OTC swaps we enter into. Moreover, the application of the mandatory clearing and trade execution requirements to other market participants, such as swap dealers, may change the market cost and general availability in the market of swaps of the type we enter into to hedge our commercial risks and, thus, the cost and availability of the swaps that we use for hedging. +As required by the Dodd-Frank Act, the CFTC and federal banking regulators have adopted rules to require certain market participants to collect and post initial and/or variation margin with respect to uncleared swaps from their counterparties that are financial end users and certain registered swap dealers and major swap participants. Although we believe we will not be required to post margin with respect to any uncleared swaps we enter into in the future, were we required to post margin as to our uncleared swaps in the future, our cost of entering into and maintaining swaps would be increased. Our counterparties that are subject to the regulations imposing the Basel III capital requirements on them may increase the cost to us of entering into swaps with them or, although not required to collect margin from us under the margin rules, contractually require us to post collateral with them in connection with such swaps in order to offset their increased capital costs or to reduce their capital costs to maintain those swaps on their balance sheets. +The Dodd-Frank Act also imposes other regulatory requirements on swaps market participants, including end users of swaps, such as regulations relating to swap documentation, reporting and recordkeeping, and certain business conduct rules applicable to swap dealers and major swap participants. Together with the Basel III capital requirements on certain swaps market participants, the regulatory requirements of the Dodd-Frank Act and the rules thereunder relating to swaps and derivatives market participants could significantly increase the cost of derivative contracts (including through requirements to post margin or collateral), materially alter the terms of derivative contracts, reduce the availability of derivatives to protect against certain risks that we encounter and reduce our ability to monetize or restructure our existing derivative contracts and to execute our hedging strategies. If, as a result of the swaps regulatory regime discussed above, we were to reduce our use of swaps to hedge our risks, such as commodity price risks that we encounter in our operations, our operating results and cash flows may become more volatile and could be otherwise adversely affected. +The Federal Reserve Board also has proposed rules that would limit certain physical commodity activities of financial holding companies. Such rules, if adopted, may adversely affect our ability to execute our strategies by restricting our available counterparties for certain types of transactions, limiting our ability to obtain certain services, and reducing liquidity in physical and financial markets. It is uncertain at this time whether, when and in what form the Federal Reserve’s proposed rules regarding financial holding companies may become final and effective. +European and UK-specific regulations, including but not limited to EMIR, MiFID II, REMIT, MAR, FSMA and RAO, govern our trading activities and our compliance with such laws may result in increased costs and risks to the business similar to the impacts stated above with respect to the Dodd-Frank Act. The increased costs may also have an adverse impact on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Further, any violation of the foregoing laws and regulations could result in investigations, and possible fines and penalties, and in some scenarios, criminal offenses. +Further, given the current lack of clarity relating to how UK and EU financial and commodity market regulatory regimes will interact following the UK’s withdrawal from the EU on January 31, 2020, including the impact such withdrawal will have on parties subject to the referenced regulations, additional regulatory risks may result. However, until negotiations between the UK and EU are completed during the transition period, which is currently scheduled to expire on December 31, 2020, it is impossible at this point to address with certainty the impact of Brexit on our operations. +We expect that our hedging activities will remain subject to significant and developing regulations and regulatory oversight. However, the full impact of the various U.S. (and non-U.S.) regulatory developments in connection with these activities will not be known with certainty until such derivatives market regulations are fully implemented and related market practices and structures are fully developed. +23 +Risks Relating to Our LNG Terminal Operations and Commercialization +Operation of the Sabine Pass LNG terminal, the Liquefaction Projects, our pipelines and other facilities that we may construct involves significant risks. +As more fully discussed in these Risk Factors, the Sabine Pass LNG terminal, the Liquefaction Projects , our pipelines and our other existing and proposed LNG facilities face operational risks, including the following: +• +the facilities’ performing below expected levels of efficiency; +• +breakdown or failures of equipment; +• +operational errors by vessel or tug operators; +• +operational errors by us or any contracted facility operator; +• +labor disputes; and +• +weather-related interruptions of operations. +Cost overruns and delays in the completion of one or more Trains, as well as difficulties in obtaining sufficient financing to pay for such costs and delays, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +The actual construction costs of the Trains may be significantly higher than our current estimates as a result of many factors, including change orders under existing or future EPC contracts resulting from the occurrence of certain specified events that may give Bechtel the right to cause us to enter into change orders or resulting from changes with which we otherwise agree. We have already experienced increased costs due to change orders. As construction progresses, we may decide or be forced to submit change orders to our contractor that could result in longer construction periods, higher construction costs or both, including change orders to comply with existing or future environmental or other regulations. +Delays in the construction of one or more Trains beyond the estimated development periods, as well as change orders to the EPC contracts with Bechtel or any future EPC contract related to additional Trains, could increase the cost of completion beyond the amounts that we estimate, which could require us to obtain additional sources of financing to fund our operations until the applicable liquefaction project is fully constructed (which could cause further delays). Our ability to obtain financing that may be needed to provide additional funding to cover increased costs will depend, in part, on factors beyond our control. Accordingly, we may not be able to obtain financing on terms that are acceptable to us, or at all. Even if we are able to obtain financing, we may have to accept terms that are disadvantageous to us or that may have a material adverse effect on our current or future business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Our ability to complete development of additional Trains will be contingent on our ability to obtain additional funding. If we are unable to obtain sufficient funding, we may be unable to fully execute our business strategy. +We will require significant additional funding to be able to commence construction of additional Trains, which we may not be able to obtain at a cost that results in positive economics, or at all. The inability to achieve acceptable funding may cause a delay in the development of additional Trains, and we may not be able to complete our business plan. Even if we are able to obtain funding, the funding may be inadequate to cover any increases in costs or delays in completion of additional Trains, which may cause a delay in the receipt of revenues projected therefrom or cause a loss of one or more future customers in the event of significant delays. As a result, any significant construction delay, whatever the cause, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Hurricanes or other disasters could result in an interruption of our operations, a delay in the completion of our liquefaction projects, damage to our liquefaction projects and increased insurance costs, all of which could adversely affect us. +Hurricanes Katrina and Rita in 2005, Hurricane Ike in 2008 and Hurricane Harvey in 2017 caused temporary suspension in construction of our liquefaction projects or caused minor damage to our liquefaction projects. Future storms and related storm activity and collateral effects, or other disasters such as explosions, fires, floods or accidents, could result in damage to, or interruption of operations at, the Sabine Pass LNG terminal, the Corpus Christi terminal or related infrastructure, as well as delays or cost increases in the construction and the development of the Liquefaction Projects , Corpus Christi Stage 3 or our other facilities +24 +and increase our insurance premiums. The U.S. Global Change Research Program has reported that the U.S.’s energy and transportation systems are expected to be increasingly disrupted by climate change and extreme weather events. An increase in frequency and severity of extreme weather events such as storms, floods, fires and rising sea levels could have an adverse effect on our operations. +Failure to obtain and maintain approvals and permits from governmental and regulatory agencies with respect to the design, construction and operation of our facilities, the development and operation of our pipelines and the export of LNG could impede operations and construction and could have a material adverse effect on us. +The design, construction and operation of interstate natural gas pipelines, LNG terminals, including the Liquefaction Project s, Corpus Christi Stage 3 and other facilities, and the import and export of LNG and the purchase and transportation of natural gas, are highly regulated activities. Approvals of the FERC and DOE under Section 3 and Section 7 of the NGA, as well as several other material governmental and regulatory approvals and permits, including several under the CAA and the CWA, are required in order to construct and operate an LNG facility and an interstate natural gas pipeline and export LNG. Although the FERC has issued orders under Section 3 of the NGA authorizing the siting, construction and operation of the six Trains and related facilities of the SPL Project, the three Trains and related facilities of the CCL Project and the seven midscale Trains and related facilities for Corpus Christi Stage 3 , as well as orders under Section 7 of the NGA authorizing the construction and operation of the Creole Trail Pipeline, the Corpus Christi Pipeline and the pipeline for Corpus Christi Stage 3 , the FERC orders require us to comply with certain ongoing conditions and obtain certain additional approvals in conjunction with ongoing construction and operations of our liquefaction and pipeline facilities. We will be required to obtain similar approvals and permits with respect to any expansion or modification of our liquefaction and pipeline facilities. We cannot control the outcome of the regulatory review and approval processes. Certain of these governmental permits, approvals and authorizations are or may be subject to rehearing requests, appeals and other challenges. +Authorizations obtained from the FERC, DOE and other federal and state regulatory agencies also contain ongoing conditions, and additional approval and permit requirements may be imposed. We do not know whether or when any such approvals or permits can be obtained, or whether any existing or potential interventions or other actions by third parties will interfere with our ability to obtain and maintain such permits or approvals. If we are unable to obtain and maintain the necessary approvals and permits, including as a result of untimely notices or filings, we may not be able to recover our investment in our projects. Additionally, government disruptions, such as a U.S. government shutdown, may delay or halt our ability to obtain and maintain necessary approvals and permits. There is no assurance that we will obtain and maintain these governmental permits, approvals and authorizations, or that we will be able to obtain them on a timely basis, and failure to obtain and maintain any of these permits, approvals or authorizations could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Delays in the completion of one or more Trains could lead to reduced revenues or termination of one or more of the SPAs by our customers. +Any delay in completion of a Train could cause a delay in the receipt of revenues projected therefrom or cause a loss of one or more customers in the event of significant delays. In particular, each of our SPAs provides that the customer may terminate that SPA if the relevant Train does not timely commence commercial operations. As a result, any significant construction delay, whatever the cause, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We are dependent on Bechtel and other contractors for the successful completion of the Liquefaction Projects. +Timely and cost-effective completion of the Liquefaction Projects in compliance with agreed specifications is central to our business strategy and is highly dependent on the performance of Bechtel and our other contractors under their agreements. The ability of Bechtel and our other contractors to perform successfully under their agreements is dependent on a number of factors, including their ability to: +• +design and engineer each Train to operate in accordance with specifications; +• +engage and retain third-party subcontractors and procure equipment and supplies; +• +respond to difficulties such as equipment failure, delivery delays, schedule changes and failure to perform by subcontractors, some of which are beyond their control; +25 +• +attract, develop and retain skilled personnel, including engineers; +• +post required construction bonds and comply with the terms thereof; +• +manage the construction process generally, including coordinating with other contractors and regulatory agencies; and +• +maintain their own financial condition, including adequate working capital. +Although some agreements may provide for liquidated damages if the contractor fails to perform in the manner required with respect to certain of its obligations, the events that trigger a requirement to pay liquidated damages may delay or impair the operation of the Liquefaction Projects , and any liquidated damages that we receive may not be sufficient to cover the damages that we suffer as a result of any such delay or impairment. The obligations of Bechtel and our other contractors to pay liquidated damages under their agreements are subject to caps on liability, as set forth therein. +Furthermore, we may have disagreements with our contractors about different elements of the construction process, which could lead to the assertion of rights and remedies under their contracts and increase the cost of the Liquefaction Projects or result in a contractor’s unwillingness to perform further work on the Liquefaction Projects . If any contractor is unable or unwilling to perform according to the negotiated terms and timetable of its respective agreement for any reason or terminates its agreement, we would be required to engage a substitute contractor. This would likely result in significant project delays and increased costs, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +If third-party pipelines and other facilities interconnected to our pipelines and facilities are or become unavailable to transport natural gas, this could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We depend upon third-party pipelines and other facilities that provide gas delivery options to our liquefaction facilities and pipelines. If the construction of new or modified pipeline connections is not completed on schedule or any pipeline connection were to become unavailable for current or future volumes of natural gas due to repairs, damage to the facility, lack of capacity or any other reason, our ability to meet our SPA obligations and continue shipping natural gas from producing regions or to end markets could be restricted, thereby reducing our revenues which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We may not be able to purchase or receive physical delivery of sufficient natural gas to satisfy our delivery obligations under the SPAs, which could have a material adverse effect on us. +Under the SPAs with our customers, we are required to make available to them a specified amount of LNG at specified times. However, we may not be able to purchase or receive physical delivery of sufficient quantities of natural gas to satisfy those obligations, which may provide affected SPA customers with the right to terminate their SPAs. Our failure to purchase or receive physical delivery of sufficient quantities of natural gas could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Our interstate natural gas pipelines and their FERC gas tariffs are subject to FERC regulation. +Our interstate natural gas pipelines are subject to regulation by the FERC under the NGA and the Natural Gas Policy Act of 1978 (the “NGPA”). The FERC regulates the purchase and transportation of natural gas in interstate commerce, including the construction and operation of pipelines, the rates, terms and conditions of service and abandonment of facilities. Under the NGA, the rates charged by our interstate natural gas pipelines must be just and reasonable, and we are prohibited from unduly preferring or unreasonably discriminating against any person with respect to pipeline rates or terms and conditions of service. If we fail to comply with all applicable statutes, rules, regulations and orders, our interstate pipelines could be subject to substantial penalties and fines. +In addition, as a natural gas market participant, should we fail to comply with all applicable FERC-administered statutes, rules, regulations and orders, we could be subject to substantial penalties and fines. Under the EPAct, the FERC has civil penalty authority under the NGA and the NGPA to impose penalties for current violations of up to $1.3 million per day for each violation. +26 +Pipeline safety integrity programs and repairs may impose significant costs and liabilities on us. +The PHMSA requires pipeline operators to develop integrity management programs to comprehensively evaluate certain areas along their pipelines and to take additional measures to protect pipeline segments located in “high consequence areas” where a leak or rupture could potentially do the most harm. As an operator, we are required to: +• +perform ongoing assessments of pipeline integrity; +• +identify and characterize applicable threats to pipeline segments that could impact a “high consequence area”; +• +improve data collection, integration and analysis; +• +repair and remediate the pipeline as necessary; and +• +implement preventative and mitigating actions. +We are required to maintain pipeline integrity testing programs that are intended to assess pipeline integrity. Any repair, remediation, preventative or mitigating actions may require significant capital and operating expenditures. Should we fail to comply with applicable statutes and the Office of Pipeline Safety’s rules and related regulations and orders, we could be subject to significant penalties and fines. +Any reduction in the capacity of, or the allocations to, interconnecting, third-party pipelines could cause a reduction of volumes transported in our pipelines, which would adversely affect our revenues and cash flow. +We are dependent upon third-party pipelines and other facilities to provide delivery options to and from our pipelines. If any pipeline connection were to become unavailable for volumes of natural gas due to repairs, damage to the facility, lack of capacity or any other reason, our ability to continue shipping natural gas to end markets could be restricted, thereby reducing our revenues. Any permanent interruption at any key pipeline interconnect which causes a material reduction in volumes transported on our pipelines could have a material adverse effect on our business, financial condition, operating results, cash flow, liquidity and prospects. +Our business could be materially and adversely affected if we lose the right to situate our pipelines on property owned by third parties. +We do not own the land on which our pipelines are situated, and we are subject to the possibility of increased costs to retain necessary land use rights. If we were to lose these rights or be required to relocate our pipelines, our business could be materially and adversely affected. +We are relying on estimates for the future capacity ratings and performance capabilities of the Liquefaction Projects, and these estimates may prove to be inaccurate. +We are relying on third parties, principally Bechtel, for the design and engineering services underlying our estimates of the future capacity ratings and performance capabilities of the Liquefaction Projects . If any Train, when actually constructed, fails to have the capacity ratings and performance capabilities that we intend, our estimates may not be accurate. Failure of any of our Trains to achieve our intended capacity ratings and performance capabilities could prevent us from achieving the commercial start dates under our SPAs and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Any failure to perform by our counterparties under agreements may adversely affect our operating results, liquidity and access to financing. +Our integrated marketing function involves our entering into various purchase and sale, hedging and other transactions with numerous third parties (commonly referred to as “counterparties”). In such arrangements, we are exposed to the performance and credit risks of our counterparties, including the risk that one or more counterparties fails to perform its obligation to make deliveries of commodities and/or to make payments. These risks may increase during periods of commodity price volatility. Defaults by suppliers and other counterparties may adversely affect our operating results, liquidity and access to financing. +27 +We may not be able to contract with customers to sell LNG produced in excess of the aggregate annual contract quantities committed to SPL’s and CCL’s third-party SPAs. +We expect to sell any LNG produced in excess of the aggregate annual contract quantity committed to SPL’s and CCL’s third-party SPAs through our integrated marketing function. We are developing a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide, which is primarily sourced by LNG produced by the Liquefaction Projects in excess of the contract quantities committed to SPL’s and CCL’s third party SPAs, supplemented by volume procured from other locations worldwide, as needed. Excess LNG from the Liquefaction Projects competes with other sources of LNG that are priced to indices other than Henry Hub, and any collapse in the spread between global LNG prices and the Henry Hub index could impact the ability of our integrated marketing function to profitably sell any such excess LNG. Failure to secure buyers for a sufficient amount of LNG could materially and adversely affect our operating results, cash flows and liquidity. +Risks Relating to Our LNG Businesses in General +We may not construct or operate all of our proposed LNG facilities or Trains or any additional LNG facilities or Trains beyond those currently planned, which could limit our growth prospects. +We may not construct some of our proposed LNG facilities or Trains, whether due to lack of commercial interest or inability to obtain financing or otherwise. Our ability to develop additional liquefaction facilities will also depend on the availability and pricing of LNG and natural gas in North America and other places around the world. Competitors may have longer operating histories, more development experience, greater name recognition, larger staffs and substantially greater financial, technical and marketing resources and access to sources of natural gas and LNG than we do. If we are unable or unwilling to construct and operate additional LNG facilities, our prospects for growth will be limited. +Our cost estimates for Trains are subject to change as a result of cost overruns, change orders under existing or future construction contracts, changes in commodity prices (particularly nickel and steel), escalating labor costs and the potential need for additional funds to be expended to maintain construction schedules. In the event we experience cost overruns, delays or both, the amount of funding needed to complete a Train could exceed our available funds and result in our failure to complete such Train and thereby negatively impact our business and limit our growth prospects. +Cyclical or other changes in the demand for and price of LNG and natural gas may adversely affect our LNG business and the performance of our customers and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Our LNG business and the development of domestic LNG facilities and projects generally is based on assumptions about the future availability and price of natural gas and LNG, and the prospects for international natural gas and LNG markets. Natural gas and LNG prices have been, and are likely to continue to be, volatile and subject to wide fluctuations in response to one or more of the following factors: +• +additions to competitive regasification capacity in North America, Europe, Asia and other markets, which could divert LNG from the Sabine Pass LNG terminal and the Corpus Christi LNG terminal; +• +competitive liquefaction capacity in North America; +• +insufficient or oversupply of natural gas liquefaction or receiving capacity worldwide; +• +insufficient LNG tanker capacity; +• +weather conditions, including extreme weather events and temperature volatility resulting from climate change; +• +reduced demand and lower prices for natural gas; +• +increased natural gas production deliverable by pipelines, which could suppress demand for LNG; +• +decreased oil and natural gas exploration activities which may decrease the production of natural gas, including as a result of any potential ban on production of natural gas through hydraulic fracturing; +• +cost improvements that allow competitors to offer LNG regasification services or provide natural gas liquefaction capabilities at reduced prices; +28 +• +changes in supplies of, and prices for, alternative energy sources such as coal, oil, nuclear, hydroelectric, wind and solar energy, which may reduce the demand for natural gas; +• +changes in regulatory, tax or other governmental policies regarding imported or exported LNG, natural gas or alternative energy sources, which may reduce the demand for imported or exported LNG and/or natural gas; +• +political conditions in natural gas producing regions; +• +sudden decreases in demand for LNG as a result of natural disasters or public health crises, including the occurrence of a pandemic, and other catastrophic events; +• +adverse relative demand for LNG compared to other markets, which may decrease LNG imports into or exports from North America; and +• +cyclical trends in general business and economic conditions that cause changes in the demand for natural gas. +Adverse trends or developments affecting any of these factors could result in decreases in the price of LNG and/or natural gas, which could materially and adversely affect the performance of our customers, and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Failure of imported or exported LNG to be a competitive source of energy for the United States or international markets could adversely affect our customers and could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Operations of the Liquefaction Projects are dependent upon the ability of our SPA customers to deliver LNG supplies from the United States, which is primarily dependent upon LNG being a competitive source of energy internationally. The success of our business plan is dependent, in part, on the extent to which LNG can, for significant periods and in significant volumes, be supplied from North America and delivered to international markets at a lower cost than the cost of alternative energy sources. Through the use of improved exploration technologies, additional sources of natural gas may be discovered outside the United States, which could increase the available supply of natural gas outside the United States and could result in natural gas in those markets being available at a lower cost than LNG exported to those markets. +Although SPL has entered into arrangements to utilize up to approximately three-quarters of the regasification capacity at the Sabine Pass LNG terminal in connection with operations of the SPL Project, operations at the Sabine Pass LNG terminal are dependent, in part, upon the ability of our TUA customers to import LNG supplies into the United States, which is primarily dependent upon LNG being a competitive source of energy in North America. In North America, due mainly to a historically abundant supply of natural gas and discoveries of substantial quantities of unconventional, or shale, natural gas, imported LNG has not developed into a significant energy source. The success of the regasification services component of our business plan is dependent, in part, on the extent to which LNG can, for significant periods and in significant volumes, be produced internationally and delivered to North America at a lower cost than the cost to produce some domestic supplies of natural gas, or other alternative energy sources. Through the use of improved exploration technologies, additional sources of natural gas have recently been and may continue to be discovered in North America, which could further increase the available supply of natural gas and could result in natural gas being available at a lower cost than imported LNG. +Political instability in foreign countries that import or export natural gas, or strained relations between such countries and the United States, may also impede the willingness or ability of LNG purchasers or suppliers and merchants in such countries to import or export LNG from or to the United States. Furthermore, some foreign purchasers or suppliers of LNG may have economic or other reasons to obtain their LNG from, or direct their LNG to, non-U.S. markets or from or to our competitors’ liquefaction or regasification facilities in the United States. +In addition to natural gas, LNG also competes with other sources of energy, including coal, oil, nuclear, hydroelectric, wind and solar energy. LNG from the Liquefaction Projects also competes with other sources of LNG, including LNG that is priced to indices other than Henry Hub. Some of these sources of energy may be available at a lower cost than LNG from the Liquefaction Project s in certain markets. The cost of LNG supplies from the United States, including the Liquefaction Project s, may also be impacted by an increase in natural gas prices in the United States. +As a result of these and other factors, LNG may not be a competitive source of energy in the United States or internationally. The failure of LNG to be a competitive supply alternative to local natural gas, oil and other alternative energy sources in markets accessible to our customers could adversely affect the ability of our customers to deliver LNG from the United States or to the +29 +United States on a commercial basis. Any significant impediment to the ability to deliver LNG to or from the United States generally, or to the Sabine Pass LNG terminal or the Corpus Christi LNG terminal or from the Liquefaction Projects specifically, could have a material adverse effect on our customers and on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Various economic and political factors could negatively affect the development, construction and operation of LNG facilities, including the Liquefaction Project s and expansion projects, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Commercial development of an LNG facility takes a number of years, requires a substantial capital investment and may be delayed by factors such as: +• +increased construction costs; +• +economic downturns, increases in interest rates or other events that may affect the availability of sufficient financing for LNG projects on commercially reasonable terms; +• +decreases in the price of LNG, which might decrease the expected returns relating to investments in LNG projects; +• +the inability of project owners or operators to obtain governmental approvals to construct or operate LNG facilities; +• +political unrest or local community resistance to the siting of LNG facilities due to safety, environmental or security concerns; and +• +any significant explosion, spill or similar incident involving an LNG facility or LNG vessel. +There may be shortages of LNG vessels worldwide, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +The construction and delivery of LNG vessels require significant capital and long construction lead times, and the availability of the vessels could be delayed to the detriment of our business and our customers because of: +• +an inadequate number of shipyards constructing LNG vessels and a backlog of orders at these shipyards; +• +political or economic disturbances in the countries where the vessels are being constructed; +• +changes in governmental regulations or maritime self-regulatory organizations; +• +work stoppages or other labor disturbances at the shipyards; +• +bankruptcy or other financial crisis of shipbuilders; +• +quality or engineering problems; +• +weather interference or a catastrophic event, such as a major earthquake, tsunami or fire; and +• +shortages of or delays in the receipt of necessary construction materials. +We may not be able to secure firm pipeline transportation capacity on economic terms that is sufficient to meet our feed gas transportation requirements, which could have a material adverse effect on us. +We have contracted for firm capacity for our natural gas feedstock transportation requirements for the Liquefaction Projects and for Corpus Christi Stage 3 . If and when we need to replace one or more of our existing agreements with these interconnecting pipelines, we may not be able to do so on commercially reasonable terms or at all, which could impair our ability to fulfill our obligations under certain of our SPAs and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We face competition based upon the international market price for LNG. +Our liquefaction projects are subject to the risk of LNG price competition at times when we need to replace any existing SPA, whether due to natural expiration, default or otherwise, or enter into new SPAs. Factors relating to competition may prevent us from entering into a new or replacement SPA on economically comparable terms as existing SPAs, or at all. Such an event could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and +30 +prospects. Factors which may negatively affect potential demand for LNG from our liquefaction projects are diverse and include, among others: +• +increases in worldwide LNG production capacity and availability of LNG for market supply; +• +increases in demand for LNG but at levels below those required to maintain current price equilibrium with respect to supply; +• +increases in the cost to supply natural gas feedstock to our liquefaction projects; +• +decreases in the cost of competing sources of natural gas or alternate fuels such as coal, heavy fuel oil and diesel; +• +decreases in the price of non-U.S. LNG, including decreases in price as a result of contracts indexed to lower oil prices; +• +increases in capacity and utilization of nuclear power and related facilities; and +• +displacement of LNG by pipeline natural gas or alternate fuels in locations where access to these energy sources is not currently available. +Terrorist attacks, cyber incidents or military campaigns may adversely impact our business. +A terrorist attack, cyber incident or military incident involving an LNG facility, our infrastructure or an LNG vessel may result in delays in, or cancellation of, construction of new LNG facilities, including one or more of the Trains, which would increase our costs and decrease our cash flows. A terrorist incident or cyber incident may also result in temporary or permanent closure of our existing facilities, which could increase our costs and decrease our cash flows, depending on the duration and timing of the closure. Our operations could also become subject to increased governmental scrutiny that may result in additional security measures at a significant incremental cost to us. In addition, the threat of terrorism and the impact of military campaigns may lead to continued volatility in prices for natural gas that could adversely affect our business and our customers, including their ability to satisfy their obligations to us under our commercial agreements. Instability in the financial markets as a result of terrorism, cyber incidents or war could also materially adversely affect our ability to raise capital. The continuation of these developments may subject our construction and our operations to increased risks, as well as increased costs, and, depending on their ultimate magnitude, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Risks Relating to Our Business in General +We are subject to significant construction and operating hazards and uninsured risks, one or more of which may create significant liabilities and losses for us. +The construction and operation of our LNG terminals and our pipelines are, and will be, subject to the inherent risks associated with these types of operations, including explosions, pollution, release of toxic substances, fires, hurricanes and adverse weather conditions and other hazards, each of which could result in significant delays in commencement or interruptions of operations and/or in damage to or destruction of our facilities or damage to persons and property. In addition, our operations and the facilities and vessels of third parties on which our operations are dependent face possible risks associated with acts of aggression or terrorism. +We do not, nor do we intend to, maintain insurance against all of these risks and losses. We may not be able to maintain desired or required insurance in the future at rates that we consider reasonable. The occurrence of a significant event not fully insured or indemnified against could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Existing and future environmental and similar laws and governmental regulations could result in increased compliance costs or additional operating costs or construction costs and restrictions. +Our business is and will be subject to extensive federal, state and local laws, rules and regulations applicable to our construction and operation activities relating to, among other things, air quality, water quality, waste management, natural resources and health and safety. Many of these laws and regulations, such as the CAA, the Oil Pollution Act, the CWA and the RCRA, and analogous state laws and regulations, restrict or prohibit the types, quantities and concentration of substances that can be released into the environment in connection with the construction and operation of our facilities, and require us to maintain permits and provide governmental authorities with access to our facilities for inspection and reports related to our compliance. In addition, +31 +certain laws and regulations authorize regulators having jurisdiction over the construction and operation of our LNG terminals and pipelines, including FERC and PHMSA, to issue compliance orders, which may restrict or limit operations or increase compliance or operating costs. Violation of these laws and regulations could lead to substantial liabilities, compliance orders, fines and penalties or to capital expenditures that could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Federal and state laws impose liability, without regard to fault or the lawfulness of the original conduct, for the release of certain types or quantities of hazardous substances into the environment. As the owner and operator of our facilities, we could be liable for the costs of cleaning up hazardous substances released into the environment at or from our facilities and for resulting damage to natural resources. +In 2009, the EPA promulgated and finalized the Mandatory Greenhouse Gas Reporting Rule requiring annual reporting of GHG emissions from stationary sources in a variety of industries. In 2010, the EPA expanded the rule to include reporting obligations for LNG terminals. In addition, the EPA has defined GHG emissions thresholds that would subject GHG emissions from new and modified industrial sources to regulation if the source is subject to PSD Permit requirements due to its emissions of non-GHG criteria pollutants. While the EPA subsequently took a number of additional actions primarily relating to GHG emissions from the electric power generation and the oil and gas exploration and production industries, those rules have largely been stayed or repealed including by amendments adopted by the EPA on February 23, 2018, additional proposed amendments to new source performance standards for the oil and gas industry on September 24, 2019 and the EPA’s June 19, 2019 adoption of the Affordable Clean Energy rule for power generation. However, Congress or a future Administration may reverse these decisions. Other federal and state initiatives may be considered in the future to address GHG emissions through, for example, United States treaty commitments, direct regulation, market-based regulations such as a carbon emissions tax or cap-and-trade programs or clean energy standards. Such initiatives could affect the demand for or cost of natural gas, which we consume at our terminals, or could increase compliance costs for our operations. +Other future legislation and regulations, such as those relating to the transportation and security of LNG imported to or exported from our terminals or climate policies of destination countries in relation to their obligations under the Paris Agreement or other national climate change-related policies, could cause additional expenditures, restrictions and delays in our business and to our proposed construction activities, the extent of which cannot be predicted and which may require us to limit substantially, delay or cease operations in some circumstances. Revised, reinterpreted or additional laws and regulations that result in increased compliance costs or additional operating or construction costs and restrictions could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +A major health and safety incident relating to our business could be costly in terms of potential liabilities and reputational damages. +Health and safety performance is critical to the success of all areas of our business. Any failure in health and safety performance may result in personal harm or injury, penalties for non-compliance with relevant regulatory requirements or litigation, and a failure that results in a significant health and safety incident is likely to be costly in terms of potential liabilities. Such a failure could generate public concern and have a corresponding impact on our reputation and our relationships with relevant regulatory agencies and local communities, which in turn could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We may experience increased labor costs, and the unavailability of skilled workers or our failure to attract and retain qualified personnel could adversely affect us. In addition, changes in our senior management or other key personnel could affect our business results. +We are dependent upon the available labor pool of skilled employees. We compete with other energy companies and other employers to attract and retain qualified personnel with the technical skills and experience required to construct and operate our facilities and pipelines and to provide our customers with the highest quality service. Our affiliates who hire personnel on our behalf are also subject to the Fair Labor Standards Act, which governs such matters as minimum wage, overtime and other working conditions. A shortage in the labor pool of skilled workers or other general inflationary pressures or changes in applicable laws and regulations could make it more difficult for us to attract and retain qualified personnel and could require an increase in the wage and benefits packages that we offer, thereby increasing our operating costs. Any increase in our operating costs could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We depend on our executive officers for various activities. We do not maintain key person life insurance policies on any of our personnel. Although we have arrangements relating to compensation and benefits with certain of our executive officers, +32 +we do not have any employment contracts or other agreements with key personnel other than our employment agreement with our President and Chief Executive Officer binding them to provide services for any particular term. The loss of the services of any of these individuals could have a material adverse effect on our business. +Our lack of diversification could have an adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Substantially all of our anticipated revenue in 2020 will be dependent upon our two facilities, the Sabine Pass LNG terminal located in southern Louisiana and the Corpus Christi LNG terminal in Texas. Due to our lack of asset and geographic diversification, an adverse development at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, including the related pipelines, or in the LNG industry, would have a significantly greater impact on our financial condition and operating results than if we maintained more diverse assets and operating areas. +We may incur impairments to goodwill or long-lived assets. +We test our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. We test goodwill for impairment annually during the fourth quarter, or more frequently as circumstances dictate. Significant negative industry or economic trends, including a significant decline in the market price of our common stock, reduced estimates of future cash flows for our business or disruptions to our business could lead to an impairment charge of our long-lived assets, including goodwill. Our valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and to rely heavily on projections of future operating performance. Projections of future operating results and cash flows may vary significantly from results. In addition, if our analysis results in an impairment to our goodwill or long-lived assets, we may be required to record a charge to earnings in our Consolidated Financial Statements during a period in which such impairment is determined to exist, which may negatively impact our operating results. +We cannot guarantee that our share repurchase program will be fully consummated or that it will enhance long-term stockholder value. +In June 2019, our Board authorized a three-year, $1 billion share repurchase program and as of December 31, 2019 , up to $751 million remains available for repurchase. Our share repurchase program does not obligate us to acquire any particular amount of common stock. Our share repurchase program may be modified, suspended or terminated at any time, which may result in a decrease in the trading price of our common stock. +The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future. Our stockholders could lose all or part of their investment. +The market price of our common stock has historically experienced and may continue to experience volatility. For example, during the three-year period ended December 31, 2019 , the market price of our common stock ranged between $40.36 and $71.03. Such fluctuations may continue as a result of a variety of factors, some of which are beyond our control, including: +• +domestic and worldwide supply of and demand for natural gas and corresponding fluctuations in the price of natural gas; +• +fluctuations in our quarterly or annual financial results or those of other companies in our industry; +• +issuance of additional equity securities which causes further dilution to stockholders; +• +sales of a high volume of shares of our common stock by our stockholders; +• +operating and stock price performance of companies that investors deem comparable to us; +• +events affecting other companies that the market deems comparable to us; +• +changes in government regulation or proposals applicable to us; +• +actual or potential non-performance by any customer or a counterparty under any agreement; +• +announcements made by us or our competitors of significant contracts; +• +changes in accounting standards, policies, guidance, interpretations or principles; +33 +• +general conditions in the industries in which we operate; +• +general economic conditions; +• +the failure of securities analysts to cover our common stock or changes in financial or other estimates by analysts; and +• +other factors described in these “Risk Factors.” +In addition, the United States securities markets have experienced significant price and volume fluctuations. These fluctuations have often been unrelated to the operating performance of companies in these markets. Market fluctuations and broad market, economic and industry factors may negatively affect the price of our common stock, regardless of our operating performance. If we were to be the object of securities class litigation as a result of volatility in our common stock price or for other reasons, it could result in substantial diversion of our management’s attention and resources, which could negatively affect our financial results. +ITEM 1B. +UNRESOLVED STAFF COMMENTS +None. +ITEM 3. LEGAL PROCEEDINGS +We may in the future be involved as a party to various legal proceedings, which are incidental to the ordinary course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities on the eventual disposition of these matters. +LDEQ Matter +Certain of our subsidiaries are in discussions with the LDEQ to resolve self-reported deviations arising from operation of the Sabine Pass LNG terminal and the commissioning of the SPL Project, and relating to certain requirements under its Title V Permit. The matter involves deviations self-reported to LDEQ pursuant to the Title V Permit and covering the time period from January 1, 2012 through March 25, 2016. On April 11, 2016, certain of our subsidiaries received a Consolidated Compliance Order and Notice of Potential Penalty (the “Compliance Order”) from LDEQ covering deviations self-reported during that time period. Certain of our subsidiaries continue to work with LDEQ to resolve the matters identified in the Compliance Order. We do not expect that any ultimate sanction will have a material adverse impact on our financial results. +PHMSA Matter +In February 2018, the PHMSA issued a Corrective Action Order (the “CAO”) to SPL in connection with a minor LNG leak from one tank and minor vapor release from a second tank at the Sabine Pass LNG terminal. These two tanks have been taken out of operational service while we conduct analysis, repair and remediation. On April 20, 2018, SPL and PHMSA executed a Consent Agreement and Order (the “Consent Order”) that replaces and supersedes the CAO. On July 9, 2019, PHMSA and FERC issued a joint letter setting out operating conditions required to be met prior to SPL returning the tanks to service. We continue to coordinate with PHMSA and FERC to address the matters relating to the February 2018 leak, including repair approach and related analysis. We do not expect that the Consent Order and related analysis, repair and remediation will have a material adverse impact on our financial results or operations. +Parallax and Related Litigation +In 2015, our wholly owned subsidiary Cheniere LNG Terminals, LLC (“CLNGT”), entered into discussions with Parallax Enterprises, LLC (“Parallax Enterprises”) regarding the potential joint development of two liquefaction plants in Louisiana (the “Potential Liquefaction Transactions”). While the parties negotiated regarding the Potential Liquefaction Transactions, CLNGT loaned Parallax Enterprises approximately $46 million , as reflected in a secured note dated April 23, 2015, as amended on June 30, 2015, September 30, 2015 and November 4, 2015 (the “Secured Note”). The Secured Note was secured by all assets of Parallax Enterprises and its subsidiary entities. On June 30, 2015, Parallax Enterprises’ parent entity, Parallax Energy LLC (“Parallax Energy”), executed a Pledge and Guarantee Agreement further securing repayment of the Secured Note by providing a parent guaranty and a pledge of all of the equity of Parallax Enterprises in satisfaction of the Secured Note (the “Pledge Agreement”). CLNGT and Parallax Enterprises never executed a definitive agreement to pursue the Potential Liquefaction Transactions. The +34 +Secured Note matured on December 11, 2015, and Parallax Enterprises failed to make payment. On February 3, 2016, CLNGT filed an action against Parallax Energy, Parallax Enterprises and certain of Parallax Enterprises’ subsidiary entities, styled Cause No. 4:16-cv-00286, Cheniere LNG Terminals, LLC v. Parallax Energy LLC, et al., in the United States District Court for the Southern District of Texas (the “Texas Federal Suit”). CLNGT asserted claims in the Texas Federal Suit for (1) recovery of all amounts due under the Secured Note and (2) declaratory relief establishing that CLNGT is entitled to enforce its rights under the Secured Note and Pledge Agreement in accordance with each instrument’s terms and that CLNGT has no obligations of any sort to Parallax Enterprises concerning the Potential Liquefaction Transactions. On March 11, 2016, Parallax Enterprises and the other defendants in the Texas Federal Suit moved to dismiss the suit for lack of subject matter jurisdiction. On August 2, 2016, the court denied the defendants’ motion to dismiss without prejudice and permitted the parties to pursue jurisdictional discovery. +On March 11, 2016, Parallax Enterprises filed a suit against us and CLNGT styled Civil Action No. 62-810, Parallax Enterprises LLP v. Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC, in the 25th Judicial District Court of Plaquemines Parish, Louisiana (the “Louisiana Suit”), wherein Parallax Enterprises asserted claims for breach of contract, fraudulent inducement, negligent misrepresentation, detrimental reliance, unjust enrichment and violation of the Louisiana Unfair Trade Practices Act. Parallax Enterprises predicated its claims in the Louisiana Suit on an allegation that we and CLNGT breached a purported agreement to jointly develop the Potential Liquefaction Transactions. Parallax Enterprises sought $400 million in alleged economic damages and rescission of the Secured Note. On April 15, 2016, we and CLNGT removed the Louisiana Suit to the United States District Court for the Eastern District of Louisiana, which subsequently transferred the Louisiana Suit to the United States District Court for the Southern District of Texas, where it was assigned Civil Action No. 4:16-cv-01628 and transferred to the same judge presiding over the Texas Federal Suit for coordinated handling. On August 22, 2016, Parallax Enterprises voluntarily dismissed all claims asserted against CLNGT and us in the Louisiana Suit without prejudice to refiling. +On July 27, 2017, the Parallax entities named as defendants in the Texas Federal Suit reurged their motion to dismiss and simultaneously filed counterclaims against CLNGT and third party claims against us for breach of contract, breach of fiduciary duty, promissory estoppel, quantum meruit and fraudulent inducement of the Secured Note and Pledge Agreement, based on substantially the same factual allegations Parallax Enterprises made in the Louisiana Suit. These Parallax entities also simultaneously filed an action styled Cause No. 2017-49685, Parallax Enterprises, LLC, et al. v. Cheniere Energy, Inc., et al., in the 61st District Court of Harris County, Texas (the “Texas State Suit”), which asserts substantially the same claims these entities asserted in the Texas Federal Suit. On July 31, 2017, CLNGT withdrew its opposition to the dismissal of the Texas Federal Suit without prejudice on jurisdictional grounds and the federal court subsequently dismissed the Texas Federal Suit without prejudice. We and CLNGT simultaneously filed an answer and counterclaims in the Texas State Suit, asserting the same claims CLNGT had previously asserted in the Texas Federal Suit. Additionally, CLNGT filed third party claims against Parallax principals Martin Houston, Christopher Bowen Daniels, Howard Candelet and Mark Evans, as well as Tellurian Investments, Inc., Driftwood LNG, LLC, Driftwood LNG Pipeline LLC and Tellurian Services LLC, formerly known as Parallax Services LLC, including claims for tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, fraudulent transfer, conspiracy/aiding and abetting. +On February 15, 2019, we filed an action with CLNGT against Charif Souki, our former Chairman of the Board and Chief Executive Officer, styled, Cause No. 2019-11529, Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC v. Charif Souki , in the 55th District Court of Harris County, Texas, which asserts claims of breach of fiduciary duties, fraudulent transfer, tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, and conspiracy/aiding and abetting. On April 29, 2019, the court consolidated the Souki matter with the earlier filed pending case against Parallax, Tellurian and the individual defendants in the Texas State Suit. +On January 30, 2020, the parties filed an Agreed Motion to Dismiss and all claims were dismissed with prejudice. +The resolution of the foregoing litigation did not have a material adverse impact on our financial results. +On January 10, 2020, a purported shareholder of Cheniere filed a shareholder derivative action in state court in Houston, Texas. The complaint names as defendants ten of our current directors. The plaintiff alleges that those directors breached their fiduciary duties by abandoning a proposed joint-development arrangement with Parallax in 2015, which later was the subject of a separate lawsuit by Parallax discussed above. According to the complaint, the directors’ alleged breach of their fiduciary duties caused us to incur legal fees in the Parallax action and also exposed us to a potential damages award in the Parallax lawsuit. On January 30, 2020, Parallax voluntarily dismissed with prejudice all claims against us. We do not expect that the resolution of the foregoing litigation will have a material adverse impact on our financial results. +35 +ITEM 4. +MINE SAFETY DISCLOSURE +Not applicable. +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Market Information, Holders and Dividends +Our common stock has traded on the NYSE American under the symbol “LNG” since March 24, 2003. As of February 19, 2020 , we had 254 million shares of common stock outstanding held by 96 record owners. +We have never paid a cash dividend on our common stock. Any future change in our dividend policy will be made at the discretion of our Board of Directors (our “Board”) in light of our financial condition, capital requirements, earnings, prospects and any restrictions under any financing agreements, as well as other factors our Board deems relevant. +Purchase of Equity Securities by the Issuer and Affiliated Purchasers +The following table summarizes stock repurchases for the three months ended December 31, 2019 : +Period +Total Number of Shares Purchased (1) +Average Price Paid Per Share (2) +Total Number of Shares Purchased as a Part of Publicly Announced Plans +Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans (3) +October 1 - 31, 2019 +324,138 +$62.15 +322,000 +$820,860,569 +November 1 - 30, 2019 +372,766 +$60.98 +372,400 +$798,153,446 +December 1 - 31, 2019 +784,815 +$60.33 +783,700 +$750,875,707 +Total +1,481,719 +$60.89 +1,478,100 +(1) +Includes shares surrendered to us by participants in our share-based compensation plans for payment of applicable tax withholdings on the vesting of share-based compensation awards. Associated shares surrendered by participants are repurchased pursuant to terms of the plan and award agreements and not as part of the publicly announced share repurchase plan. +(2) +The price paid per share was based on the average trading price of our common stock on the dates on which we repurchased the shares. +(3) +On June 3, 2019, we announced that our Board authorized a 3-year, $1 billion share repurchase program. For additional information, see Note 18—Share Repurchase Program of our Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. +37 +Total Stockholder Return +The following is a customized peer group consisting of 27 companies (the “New Peer Group”) that were selected because they are publicly traded companies that have: (1) comparable Global Industries Classification Standards, (2) similar market capitalization, (3) similar enterprise values and (4) similar operating characteristics and capital intensity: +New Peer Group +Air Products and Chemicals, Inc. (APD) +LyondellBasell Industries N.V. (LYB) +Apache Corporation (APA) +Marathon Oil Corporation (MRO) +Baker Hughes Company (BKR) +Marathon Petroleum Corporation (MPC) +Concho Resources Inc. (CXO) +Noble Energy, Inc. (NBL) +ConocoPhillips (COP) +Occidental Petroleum Corporation (OXY) +Continental Resources, Inc. (CLR) +ONEOK, Inc. (OKE) +Devon Energy Corporation (DVN) +Phillips 66 (PSX) +Diamondback Energy, Inc. (FANG) +Pioneer Natural Resources Company (PXD) +Enterprise Products Partners L.P. (EPD) +Schlumberger Limited (SLB) +EOG Resources, Inc. (EOG) +Suncor Energy Inc. (SU) +Freeport-McMoRan Inc. (FCX) +Targa Resources Corp. (TRGP) +Halliburton Company (HAL) +Valero Energy Corporation (VLO) +Hess Corporation (HES) +The Williams Companies, Inc. (WMB) +Kinder Morgan, Inc. (KMI) +The New Peer Group companies were revised during 2019. Our previous peer group consisted of 29 companies (the “Old Peer Group”), which excluded Diamondback Energy, Inc. (FANG) and Targa Resources Corp. (TRGP) from the New Peer Group and included Anadarko Petroleum Corporation (APC), Andeavor (ANDV), EQT Corporation (EQT) and Praxair, Inc. (PX). Additionally, Baker Hughes, a GE company (BHGE) changed its name and ticker symbol to Baker Hughes Company (BKR) in October 2019. +The following graph compares the five-year total return on our common stock, the S&P 500 Index, the New Peer Group and the Old Peer Group. The graph was constructed on the assumption that $100 was invested in our common stock, the S&P 500 Index, the New Peer Group and the Old Peer Group on December 31, 2014 and that any dividends were fully reinvested. +Company / Index +2014 +2015 +2016 +2017 +2018 +2019 +Cheniere Energy, Inc. +100.00 +52.91 +58.85 +76.48 +84.08 +86.75 +S&P 500 Index +100.00 +101.37 +113.49 +138.26 +132.19 +173.80 +New Peer Group +100.00 +79.05 +110.62 +115.91 +91.57 +107.19 +Old Peer Group +100.00 +79.89 +108.84 +113.88 +89.89 +103.49 +38 +39 +ITEM 6. +SELECTED FINANCIAL DATA +Selected financial data set forth below are derived from our audited Consolidated Financial Statements for the periods indicated (in millions, except per share data). The financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and the accompanying notes thereto included elsewhere in this report. +Year Ended December 31, +2019 +2018 +2017 +2016 +2015 +Consolidated Statement of Operations Data: +Revenues +$ +9,730 +$ +7,987 +$ +5,601 +$ +1,283 +$ +271 +Income (loss) from operations +2,361 +2,024 +1,388 +(30 +) +(449 +) +Interest expense, net of capitalized interest +(1,432 +) +(875 +) +(747 +) +(488 +) +(322 +) +Net income (loss) attributable to common stockholders +648 +471 +(393 +) +(610 +) +(975 +) +Common Stock Data: +Net income (loss) per share attributable to common stockholders—basic +$ +2.53 +$ +1.92 +$ +(1.68 +) +$ +(2.67 +) +$ +(4.30 +) +Net income (loss) per share attributable to common stockholders—diluted +$ +2.51 +$ +1.90 +$ +(1.68 +) +$ +(2.67 +) +$ +(4.30 +) +Weighted average number of common shares outstanding—basic +256.2 +245.6 +233.1 +228.8 +226.9 +Weighted average number of common shares outstanding—diluted +258.1 +248.0 +233.1 +228.8 +226.9 +December 31, +2019 +2018 +2017 +2016 +2015 +Consolidated Balance Sheet Data: +Property, plant and equipment, net +$ +29,673 +$ +27,245 +$ +23,978 +$ +20,635 +$ +16,194 +Total assets +35,492 +31,987 +27,906 +23,703 +18,809 +Current debt, net +— +239 +— +247 +1,673 +Long-term debt, net +30,774 +28,179 +25,336 +21,688 +14,920 +40 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Introduction +The following discussion and analysis presents management’s view of our business, financial condition and overall performance and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes. This information is intended to provide investors with an understanding of our past performance, current financial condition and outlook for the future. Our discussion and analysis includes the following subjects: +• +Overview of Business +• +Overview of Significant Events +• +Liquidity and Capital Resources +• +Contractual Obligations +• +Results of Operations +• +Off-Balance Sheet Arrangements +• +Summary of Critical Accounting Estimates +• +Recent Accounting Standards +Overview of Business +Cheniere, a Delaware corporation, is a Houston-based energy infrastructure company primarily engaged in LNG-related businesses. We provide clean, secure and affordable LNG to integrated energy companies, utilities and energy trading companies around the world. We aspire to conduct our business in a safe and responsible manner, delivering a reliable, competitive and integrated source of LNG to our customers. We own and operate the Sabine Pass LNG terminal in Louisiana, one of the largest LNG production facilities in the world, through our ownership interest in and management agreements with Cheniere Partners, which is a publicly traded limited partnership that we created in 2007. As of December 31, 2019 , we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We also own and operate the Corpus Christi LNG terminal in Texas, which is wholly owned by us. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners, through its subsidiary SPL, is currently operating five natural gas liquefaction Trains and is constructing one additional Train for a total production capacity of approximately 30 mtpa of LNG (the “SPL Project”) at the Sabine Pass LNG terminal. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 17 Bcfe , two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4 Bcf/d . Cheniere Partners also owns a 94-mile pipeline through its subsidiary, CTPL, that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines. +We also own the Corpus Christi LNG terminal near Corpus Christi, Texas, and are currently operating two Trains and are constructing one additional Train for a total production capacity of approximately 15 mtpa of LNG. Additionally, we are operating a 23-mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the Trains, the “CCL Project”) through our subsidiaries CCL and CCP, respectively. The CCL Project , once fully constructed, will contain three LNG storage tanks with aggregate capacity of approximately 10 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. +We have contracted approximately 85% of the total production capacity from the SPL Project and the CCL Project (collectively, the “Liquefaction Projects”) on a term basis. This includes volumes contracted under SPAs in which the customers are required to pay a fixed fee with respect to the contracted volumes irrespective of their election to cancel or suspend deliveries of LNG cargoes, as well as volumes contracted under integrated production marketing (“IPM”) gas supply agreements. +41 +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) through our subsidiary CCL Stage III for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. We received approval from FERC in November 2019 to site, construct and operate the expansion project. +We remain focused on operational excellence and customer satisfaction. Increasing demand of LNG has allowed us to expand our liquefaction infrastructure in a financially disciplined manner. We hold significant land positions at both the Sabine Pass LNG terminal and the Corpus Christi LNG terminal which provide opportunity for further liquefaction capacity expansion. The development of these sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we can make a final investment decision (“FID”) . +Overview of Significant Events +Our significant events since January 1, 2019 and through the filing date of this Form 10-K include the following: +Strategic +• +In November 2019, we received approval from the FERC to site, construct and operate the Corpus Christi Stage 3 expansion project, which is being developed for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. +• +In September 2019, CCL and CCL Stage III entered into an IPM transaction with EOG Resources, Inc. (“EOG”) to purchase 140,000 MMBtu per day of natural gas, for a term of approximately 15 years beginning in early 2020, at a price based on the Platts Japan Korea Marker (“JKM”), net of a fixed liquefaction fee and certain costs incurred by Cheniere. +• +In May 2019, CCL Stage III entered into an IPM transaction with Apache Corporation to purchase 140,000 MMBtu per day of natural gas, for a term of approximately 15 years, at a price based on international LNG indices, net of a fixed liquefaction fee and certain costs incurred by Cheniere. +• +In May 2019, the board of directors of the general partner of Cheniere Partners made a positive FID with respect to Train 6 of the SPL Project and issued a full notice to proceed with construction to Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) in June 2019. +• +In February 2019, Midship Pipeline Company, LLC (“Midship Pipeline”), in which we hold an equity interest, issued full notice to proceed to construct the Midship natural gas pipeline and related compression and interconnect facilities (the “Midship Project”) following receipt of final Notice to Proceed from the FERC and obtaining financing to construct the Midship Project. +Operational +• +As of February 21, 2020 , over 1,000 cumulative LNG cargoes totaling over 70 million tonnes of LNG have been produced, loaded and exported from the Liquefaction Projects . +• +In March 2019, SPL achieved substantial completion of Train 5 of the SPL Project and commenced operating activities. +• +In February 2019 and August 2019, CCL achieved substantial completion of Trains 1 and 2 of the CCL Project , respectively, and commenced operating activities. +Financial +• +We completed the following debt transactions: +◦ +In November 2019, CCH issued an aggregate principal amount of $1.5 billion of 3.700% Senior Secured Notes due 2029 (the "2029 CCH Senior Notes") . Net proceeds of the offering were used to prepay a portion of the outstanding borrowings under the amended and restated CCH Credit Facility (the “CCH Credit Facility”) . +◦ +In October 2019, CCH issued an aggregate principal amount of $475 million of 3.925% Senior Secured Notes due 2039 (the "3.925% CCH Senior Notes") pursuant to a note purchase agreement with certain accounts managed by BlackRock Real Assets and certain accounts managed by MetLife Investment Management, to prepay a portion of the outstanding indebtedness under the CCH Credit Facility . +◦ +In September 2019, CCH issued an aggregate principal amount of $727 million of 4.80% Senior Secured Notes due 2039 (the “4.80% CCH Senior Notes”) pursuant to a note purchase agreement originally entered into in June +42 +2019 (“CCH Note Purchase Agreement”) with Allianz Global Investors GmbH, to prepay a portion of the outstanding indebtedness under the CCH Credit Facility . +◦ +In September 2019, Cheniere Partners issued an aggregate principal amount of $1.5 billion of 4.500% Senior Notes due 2029 (the “2029 CQP Senior Notes”) to prepay the outstanding balance under the $750 million term loan under Cheniere Partners’ credit facilities (the “2019 CQP Credit Facilities”) , which were entered into in May 2019, and for general corporate purposes, including funding future capital expenditures in connection with the construction of Train 6 at the SPL Project . After applying the proceeds of the 2029 CQP Senior Notes , only a $750 million revolving credit facility, which is currently undrawn, remains as part of the 2019 CQP Credit Facilities . +• +In September 2019, Fitch Ratings (“Fitch”) and S&P Global Ratings each assigned an investment grade rating of BBB- to CCH’s senior secured debt, and Fitch assigned an investment grade issuer default rating of BBB- to CCH . In October 2019, Moody’s Investors Service upgraded its rating of CCH’s senior secured debt from Ba2 to Ba1 (Positive Outlook). +• +In June 2019, we announced a capital allocation framework which prioritizes investments in the growth of our liquefaction platform, improvement of consolidated leverage metrics, and a return of excess capital to shareholders under a three-year, $1.0 billion share repurchase program. We commenced share repurchase activity in the second quarter of 2019 and commenced prepayment of outstanding debt in the third quarter of 2019. +• +We reached the following contractual milestones: +◦ +In September 2019, the date of first commercial delivery was reached under the 20-year SPAs with Centrica plc and Total Gas & Power North America, Inc. (“Total”) relating to Train 5 of the SPL Project . +◦ +In June 2019, the date of first commercial delivery was reached under the 20-year SPAs with Endesa S.A. and PT Pertamina (Persero) relating to Train 1 of the CCL Project . +◦ +In March 2019, the date of first commercial delivery was reached under the 20-year SPA with BG Gulf Coast LNG, LLC relating to Train 4 of the SPL Project . +Liquidity and Capital Resources +Although results are consolidated for financial reporting, Cheniere, Cheniere Partners, SPL and the CCH Group operate with independent capital structures. Our capital requirements include capital and investment expenditures, repayment of long-term debt and repurchase of our shares. We expect the cash needs for at least the next twelve months will be met for each of these independent capital structures as follows: +• +SPL through project debt and borrowings, operating cash flows and equity contributions from Cheniere Partners; +• +Cheniere Partners through operating cash flows from SPLNG, SPL and CTPL and debt or equity offerings; +• +CCH Group through operating cash flows from CCL and CCP, project debt and borrowings and equity contributions from Cheniere; and +• +Cheniere through existing unrestricted cash, debt and equity offerings by us or our subsidiaries, operating cash flows, borrowings, services fees from our subsidiaries and distributions from our investment in Cheniere Partners. +43 +The following table provides a summary of our liquidity position at December 31, 2019 and 2018 (in millions): +December 31, +2019 +2018 +Cash and cash equivalents (1) +$ +2,474 +$ +981 +Restricted cash designated for the following purposes: +SPL Project +181 +756 +Cheniere Partners and cash held by guarantor subsidiaries +— +785 +CCL Project +80 +289 +Other +259 +345 +Available commitments under the following credit facilities: +$1.2 billion SPL Working Capital Facility (“SPL Working Capital Facility”) +786 +775 +2019 CQP Credit Facilities +750 +— +$2.8 billion Cheniere Partners’ Credit Facilities (“2016 CQP Credit Facilities”) +— +115 +CCH Credit Facility +— +982 +$1.2 billion CCH Working Capital Facility (“CCH Working Capital Facility”) +729 +716 +$1.25 billion Cheniere Revolving Credit Facility (“Cheniere Revolving Credit Facility”) +665 +1,250 +(1) +Amounts presented include balances held by our consolidated variable interest entity (“VIE”), Cheniere Partners as discussed in Note 9—Non-controlling Interest and Variable Interest Entity of our Notes to Consolidated Financial Statements. As of December 31, 2019 and 2018 , assets of Cheniere Partners, which are included in our Consolidated Balance Sheets, included $1.8 billion and zero , respectively, of cash and cash equivalents. +Sabine Pass LNG Terminal +Liquefaction Facilities +The SPL Project is one of the largest LNG production facilities in the world. Through Cheniere Partners, we are currently operating five Trains and two marine berths at the SPL Project and are constructing one additional Train. We have received authorization from the FERC to site, construct and operate Trains 1 through 6. We have achieved substantial completion of the first five Trains of the SPL Project and commenced commercial operating activities for each Train at various times starting in May 2016. The following table summarizes the project completion and construction status of Train 6 of the SPL Project as of December 31, 2019 : +SPL Train 6 +Overall project completion percentage +43.7% +Completion percentage of: +Engineering +91.5% +Procurement +60.9% +Subcontract work +37.4% +Construction +9.7% +Date of expected substantial completion +1H 2023 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal: +• +Trains 1 through 4— FTA countries for a 30-year term, which commenced in May 2016, and non-FTA countries for a 20-year term, which commenced in June 2016, in an amount up to a combined total of the equivalent of 16 mtpa (approximately 803 Bcf/yr of natural gas). +• +Trains 1 through 4— FTA countries for a 25-year term and non-FTA countries for a 20-year term, both of which commenced in December 2018, in an amount up to a combined total of the equivalent of approximately 203 Bcf/yr of natural gas (approximately 4 mtpa). +• +Trains 5 and 6— FTA countries and non-FTA countries for a 20-year term, which partially commenced in June 2019 and the remainder commenced in September 2019, in an amount up to a combined total of 503.3 Bcf/yr of natural gas (approximately 10 mtpa). +44 +In each case, the terms of these authorizations began on the earlier of the date of first export thereunder or the date specified in the particular order. In addition, SPL received an order providing for a three-year makeup period with respect to each of the non-FTA orders for LNG volumes SPL was authorized but unable to export during any portion of the initial 20-year export period of such order. +The DOE issued orders authorizing SPL to export domestically produced LNG by vessel from the Sabine Pass LNG terminal to FTA countries and non-FTA countries over a two-year period commencing January 2020, in an aggregate amount up to the equivalent of 600 Bcf of natural gas (however, exports under this order, when combined with exports under the orders above, may not exceed 1,509 Bcf/yr ). +An application was filed in September 2019 to authorize additional exports from the SPL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 153 Bcf/yr of natural gas, for a total SPL Project export of approximately 1,662 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the SPL Project of the volumes contemplated in the application. The application is currently pending before DOE. +Customers +SPL has entered into fixed price long-term SPA s generally with terms of 20 years (plus extension rights) with eight third parties for Trains 1 through 6 of the SPL Project . Under these SPA s, the customers will purchase LNG from SPL on a free on board (“FOB”) basis for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub . The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under SPL’s SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under SPL’s SPAs. The variable fees under SPL’s SPAs were generally sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPA s and contracted volumes to be made available under the SPA s are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +In aggregate, the annual fixed fee portion to be paid by the third-party SPA customers is approximately $2.9 billion for Trains 1 through 5. After giving effect to an SPA that Cheniere has committed to provide to SPL by the end of 2020, the annual fixed fee portion to be paid by the third-party SPA customers would increase to at least $3.3 billion , which is expected to occur upon the date of first commercial delivery of Train 6. +In addition, Cheniere Marketing has agreements with SPL to purchase, at Cheniere Marketing’s option, any LNG produced by SPL in excess of that required for other customers. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +Natural Gas Transportation, Storage and Supply +To ensure SPL is able to transport adequate natural gas feedstock to the Sabine Pass LNG terminal, it has entered into transportation precedent and other agreements to secure firm pipeline transportation capacity with CTPL and third-party pipeline companies. SPL has entered into firm storage services agreements with third parties to assist in managing variability in natural gas needs for the SPL Project . SPL has also entered into enabling agreements and long-term natural gas supply contracts with third parties in order to secure natural gas feedstock for the SPL Project . As of December 31, 2019 , SPL had secured up to approximately 3,850 TBtu of natural gas feedstock through long-term and short-term natural gas supply contracts with remaining terms that range up to 10 years , a portion of which is subject to conditions precedent. +Construction +SPL entered into lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Trains 1 through 6 of the SPL Project , under which Bechtel charges a lump sum for all work performed and generally bears project cost, +45 +schedule and performance risks unless certain specified events occur, in which case Bechtel may cause SPL to enter into a change order, or SPL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 6 of the SPL Project is approximately $2.5 billion , including estimated costs for an optional third marine berth. As of December 31, 2019 , we have incurred $1.1 billion under this contract. +Regasification Facilities +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4 Bcf/d and aggregate LNG storage capacity of approximately 17 Bcfe . Approximately 2 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term third-party TUA s, under which SPLNG’s customers are required to pay fixed monthly fees, whether or not they use the LNG terminal. Each of Total and Chevron U.S.A. Inc. (“Chevron”) has reserved approximately 1 Bcf/d of regasification capacity and is obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually, prior to inflation adjustments, for 20 years that commenced in 2009. Total S.A. has guaranteed Total ’s obligations under its TUA up to $2.5 billion, subject to certain exceptions, and Chevron Corporation has guaranteed Chevron ’s obligations under its TUA up to 80% of the fees payable by Chevron . +The remaining approximately 2 Bcf/d of capacity has been reserved under a TUA by SPL. SPL is obligated to make monthly capacity payments to SPLNG aggregating approximately $250 million annually, prior to inflation adjustments, continuing until at least May 2036. SPL entered into a partial TUA assignment agreement with Total , whereby upon substantial completion of Train 5 of the SPL Project , SPL gained access to substantially all of Total ’s capacity and other services provided under Total ’s TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Train 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA. During the years ended December 31, 2019, 2018 and 2017 , SPL recorded $104 million , $30 million and $23 million, respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Under each of these TUA s, SPLNG is entitled to retain 2% of the LNG delivered to the Sabine Pass LNG terminal. +Capital Resources +We currently expect that SPL’s capital resources requirements with respect to the SPL Project will be financed through project debt and borrowings, cash flows under the SPA s and equity contributions from Cheniere Partners. We believe that with the net proceeds of borrowings, available commitments under the SPL Working Capital Facility , 2019 CQP Credit Facilities , cash flows from operations and equity contributions from Cheniere Partners , SPL will have adequate financial resources available to meet its currently anticipated capital, operating and debt service requirements with respect to Trains 1 through 6 of the SPL Project . Additionally, SPLNG generates cash flows from the TUAs, as discussed above. +The following table provides a summary of our capital resources from borrowings and available commitments for the Sabine Pass LNG Terminal, excluding equity contributions to our subsidiaries and cash flows from operations (as described in Sources and Uses of Cash ), at December 31, 2019 and 2018 (in millions): +December 31, +2019 +2018 +Senior notes (1) +$ +17,750 +$ +16,250 +Credit facilities outstanding balance (2) +— +— +Letters of credit issued (3) +414 +425 +Available commitments under credit facilities (3) +1,536 +775 +Total capital resources from borrowings and available commitments (4) +$ +19,700 +$ +17,450 +(1) +Includes SPL’s 5.625% Senior Secured Notes due 2021, 6.25% Senior Secured Notes due 2022, 5.625% Senior Secured Notes due 2023, 5.75% Senior Secured Notes due 2024, 5.625% Senior Secured Notes due 2025, 5.875% Senior Secured Notes due 2026 (the “2026 SPL Senior Notes”) , 5.00% Senior Secured Notes due 2027 (the “2027 SPL Senior Notes”) , 4.200% Senior Secured Notes due 2028 (the “2028 SPL Senior Notes”) and 5.00% Senior Secured Notes due 2037 (the “2037 SPL Senior Notes”) (collectively, the “SPL Senior Notes”) , as well as CQP’s $1.5 billion of 5.250% Senior Notes +46 +due 2025 (the “2025 CQP Senior Notes”) , $1.1 billion of 5.625% Senior Notes due 2026 (the “2026 CQP Senior Notes”) and the 2029 CQP Senior Notes (collectively, the “CQP Senior Notes”) . +(2) +Includes outstanding balances under the SPL Working Capital Facility and 2019 CQP Credit Facilities , inclusive of any portion of the 2019 CQP Credit Facilities that may be used for general corporate purposes. +(3) +Consists of SPL Working Capital Facility and 2019 CQP Credit Facilities . Balance at December 31, 2018 did not include the letters of credit issued or available commitments under the terminated 2016 CQP Credit Facilities , which were not specifically for the Sabine Pass LNG Terminal. +(4) +Does not include equity contributions that may be available from Cheniere’s borrowings under its convertible notes, which may be used for the Sabine Pass LNG Terminal. +SPL Senior Notes +The SPL Senior Notes are secured on a pari passu first-priority basis by a security interest in all of the membership interests in SPL and substantially all of SPL’s assets. +At any time prior to three months before the respective dates of maturity for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes and 2037 SPL Senior Notes , in which case the time period is six months before the respective dates of maturity), SPL may redeem all or part of such series of the SPL Senior Notes at a redemption price equal to the “make-whole” price (except for the 2037 SPL Senior Notes , in which case the redemption price is equal to the “optional redemption” price) set forth in the respective indentures governing the SPL Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. SPL may also, at any time within three months of the respective maturity dates for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes and 2037 SPL Senior Notes , in which case the time period is within six months of the respective dates of maturity), redeem all or part of such series of the SPL Senior Notes at a redemption price equal to 100% of the principal amount of such series of the SPL Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +Both the indenture governing the 2037 SPL Senior Notes (the “ 2037 SPL Senior Notes Indenture”) and the common indenture governing the remainder of the SPL Senior Notes (the “SPL Indenture”) include restrictive covenants. SPL may incur additional indebtedness in the future, including by issuing additional notes, and such indebtedness could be at higher interest rates and have different maturity dates and more restrictive covenants than the current outstanding indebtedness of SPL, including the SPL Senior Notes and the SPL Working Capital Facility . Under the 2037 SPL Senior Notes Indenture and the SPL Indenture , SPL may not make any distributions until, among other requirements, deposits are made into debt service reserve accounts as required and a debt service coverage ratio test of 1.25:1.00 is satisfied. Semi-annual principal payments for the 2037 SPL Senior Notes are due on March 15 and September 15 of each year beginning September 15, 2025 and are fully amortizing according to a fixed sculpted amortization schedule. +SPL Working Capital Facility +In September 2015, SPL entered into the SPL Working Capital Facility with aggregate commitments of $1.2 billion, which was amended in May 2019 in connection with commercialization and financing of Train 6 of the SPL Project . The SPL Working Capital Facility is intended to be used for loans to SPL (“SPL Working Capital Loans”) , the issuance of letters of credit on behalf of SPL, as well as for swing line loans to SPL (“SPL Swing Line Loans”) , primarily for certain working capital requirements related to developing and placing into operation the SPL Project . SPL may, from time to time, request increases in the commitments under the SPL Working Capital Facility of up to $760 million and incremental increases in commitments of up to an additional $390 million. As of December 31, 2019 and 2018 , SPL had $786 million and $775 million of available commitments and $414 million and $425 million aggregate amount of issued letters of credit under the SPL Working Capital Facility , respectively. SPL did no t have any outstanding borrowings under the SPL Working Capital Facility as of both December 31, 2019 and 2018 . +The SPL Working Capital Facility matures on December 31, 2020, and the outstanding balance may be repaid, in whole or in part, at any time without premium or penalty upon three business days’ notice. Loans deemed made in connection with a draw upon a letter of credit (“SPL LC Loans”) have a term of up to one year. SPL Swing Line Loans terminate upon the earliest of (1) the maturity date or earlier termination of the SPL Working Capital Facility , (2) the date 15 days after such SPL Swing Line Loan is made and (3) the first borrowing date for a SPL Working Capital Loan or SPL Swing Line Loan occurring at least three business days following the date the SPL Swing Line Loan is made. SPL is required to reduce the aggregate outstanding principal amount of all SPL Working Capital Loans to zero for a period of five consecutive business days at least once each year. +47 +The SPL Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of SPL under the SPL Working Capital Facility are secured by substantially all of the assets of SPL as well as all of the membership interests in SPL on a pari passu basis with the SPL Senior Notes . +Cheniere Partners +CQP Senior Notes +The CQP Senior Notes are jointly and severally guaranteed by each of Cheniere Partners’ subsidiaries other than SPL and, subject to certain conditions governing its guarantee, Sabine Pass LP (the “CQP Guarantors”) . The CQP Senior Notes are governed by the same base indenture (the “CQP Base Indenture”) . The 2025 CQP Senior Notes are further governed by the First Supplemental Indenture, the 2026 CQP Senior Notes are further governed by the Second Supplemental Indenture and the 2029 CQP Senior Notes are further governed by the Third Supplemental Indenture. The indentures governing the CQP Senior Notes contain customary terms and events of default and certain covenants that, among other things, limit the ability of Cheniere Partners and the CQP Guarantors to incur liens and sell assets, enter into transactions with affiliates, enter into sale-leaseback transactions and consolidate, merge or sell, lease or otherwise dispose of all or substantially all of the applicable entity’s properties or assets. +At any time prior to October 1, 2020 for the 2025 CQP Senior Notes , October 1, 2021 for the 2026 CQP Senior Notes and October 1, 2024 for the 2029 CQP Senior Notes , Cheniere Partners may redeem all or a part of the applicable CQP Senior Notes at a redemption price equal to 100% of the aggregate principal amount of the CQP Senior Notes redeemed, plus the “applicable premium” set forth in the respective indentures governing the CQP Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to October 1, 2020 for the 2025 CQP Senior Notes , October 1, 2021 for the 2026 CQP Senior Notes and October 1, 2024 for the 2029 CQP Senior Notes , Cheniere Partners may redeem up to 35% of the aggregate principal amount of the CQP Senior Notes with an amount of cash not greater than the net cash proceeds from certain equity offerings at a redemption price equal to 105.250% of the aggregate principal amount of the 2025 CQP Senior Notes , 105.625% of the aggregate principal amount of the 2026 CQP Senior Notes and 104.5% of the aggregate principal amount of the 2029 CQP Senior Notes redeemed, plus accrued and unpaid interest, if any, to the date of redemption. Cheniere Partners also may at any time on or after October 1, 2020 through the maturity date of October 1, 2025 for the 2025 CQP Senior Notes , October 1, 2021 through the maturity date of October 1, 2026 for the 2026 CQP Senior Notes and October 1, 2024 through the maturity date of October 1, 2029 for the 2029 CQP Senior Notes , redeem the CQP Senior Notes , in whole or in part, at the redemption prices set forth in the respective indentures governing the CQP Senior Notes . +The CQP Senior Notes are Cheniere Partners’ senior obligations, ranking equally in right of payment with Cheniere Partners’ other existing and future unsubordinated debt and senior to any of its future subordinated debt. In the event that the aggregate amount of Cheniere Partners’ secured indebtedness and the secured indebtedness of the CQP Guarantors (other than the CQP Senior Notes or any other series of notes issued under the CQP Base Indenture ) outstanding at any one time exceeds the greater of (1) $1.5 billion and (2) 10% of net tangible assets, the CQP Senior Notes will be secured to the same extent as such obligations under the 2019 CQP Credit Facilities . The obligations under the 2019 CQP Credit Facilities are secured on a first-priority basis (subject to permitted encumbrances) with liens on substantially all the existing and future tangible and intangible assets and rights of Cheniere Partners and the CQP Guarantors and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the 2019 CQP Credit Facilities ). The liens securing the CQP Senior Notes , if applicable, will be shared equally and ratably (subject to permitted liens) with the holders of other senior secured obligations, which include the 2019 CQP Credit Facilities obligations and any future additional senior secured debt obligations. +2016 CQP Credit Facilities +In May 2019, Cheniere Partners terminated the remaining commitments under the 2016 CQP Credit Facilities. +2019 CQP Credit Facilities +In May 2019, Cheniere Partners entered into the 2019 CQP Credit Facilities , which consisted of the $750 million term loan (“CQP Term Facility”), which was prepaid and terminated upon issuance of the 2029 CQP Senior Notes in September 2019, and the $750 million revolving credit facility (“CQP Revolving Facility”) . Borrowings under the 2019 CQP Credit Facilities will be used to fund the development and construction of Train 6 of the SPL Project and for general corporate purposes, subject to a sublimit, and the 2019 CQP Credit Facilities are also available for the issuance of letters of credit. +48 +Loans under the 2019 CQP Credit Facilities accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of the prime rate, the federal funds effective rate, as published by the Federal Reserve Bank of New York, plus 0.50%, and the adjusted one-month LIBOR plus 1.0%), plus the applicable margin. Under the CQP Revolving Facility, the applicable margin for LIBOR loans is 1.25% to 2.125% per annum, and the applicable margin for base rate loans is 0.25% to 1.125% per annum, in each case depending on the then-current rating of Cheniere Partners. Interest on LIBOR loans is due and payable at the end of each applicable LIBOR period (and at the end of every three-month period within the LIBOR period, if any), and interest on base rate loans is due and payable at the end of each calendar quarter. +Cheniere Partners pays a commitment fee equal to an annual rate of 30% of the margin for LIBOR loans multiplied by the average daily amount of the undrawn commitment, payable quarterly in arrears. +The 2019 CQP Credit Facilities mature on May 29, 2024. Any outstanding balance may be repaid, in whole or in part, at any time without premium or penalty, except for interest rate breakage costs. The 2019 CQP Credit Facilities contain conditions precedent for extensions of credit, as well as customary affirmative and negative covenants, and limit Cheniere Partners’ ability to make restricted payments, including distributions, to once per fiscal quarter and one true-up per fiscal quarter as long as certain conditions are satisfied. +The 2019 CQP Credit Facilities are unconditionally guaranteed and secured by a first priority lien (subject to permitted encumbrances) on substantially all of Cheniere Partners’ and the CQP Guarantors ’ existing and future tangible and intangible assets and rights and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the 2019 CQP Credit Facilities ). +Corpus Christi LNG Terminal +Liquefaction Facilities +We are currently operating two Trains and one marine berth at the CCL Project and are constructing one additional Train and marine berth. We have received authorization from the FERC to site, construct and operate Trains 1 through 3 of the CCL Project . We completed construction of Trains 1 and 2 of the CCL Project and commenced commercial operating activities in February 2019 and August 2019, respectively. The following table summarizes the project completion and construction status of Train 3 of the CCL Project , including the related infrastructure, as of December 31, 2019 : +CCL Train 3 +Overall project completion percentage +74.8% +Completion percentage of: +Engineering +98.7% +Procurement +99.5% +Subcontract work +28.3% +Construction +49.5% +Expected date of substantial completion +1H 2021 +Separate from the CCH Group, we are also developing Corpus Christi Stage 3 through our subsidiary CCL Stage III , adjacent to the CCL Project . We received approval from FERC in November 2019 to site, construct and operate seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Corpus Christi LNG terminal: +• +CCL Project— FTA countries for a 25-year term and to non-FTA countries for a 20-year term, both of which commenced in June 2019, up to a combined total of the equivalent of 767 Bcf/yr (approximately 15 mtpa) of natural gas. +• +Corpus Christi Stage 3 — FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount equivalent to 582.14 Bcf/yr (approximately 11 mtpa) of natural gas. +In each case, the terms of these authorizations begin on the earlier of the date of first export thereunder or the date specified in the particular order, which ranges from seven to 10 years from the date the order was issued. +49 +An application was filed in September 2019 to authorize additional exports from the CCL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 108 Bcf/yr of natural gas, for a total CCL Project export of 875.16 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the CCL Project of the volumes contemplated in the application. The application is currently pending before DOE. +Customers +CCL has entered into fixed price long-term SPA s generally with terms of 20 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project . Under these SPAs, the customers will purchase LNG from CCL on a FOB basis for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under our SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under our SPAs. The variable fee under CCL’s SPAs entered into in connection with the development of the CCL Project was sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery for the applicable Train, as specified in each SPA. +In aggregate, the minimum fixed fee portion to be paid by the third-party SPA customers is approximately $550 million for Train 1, increasing to approximately $1.4 billion upon the date of first commercial delivery for Train 2 and further increasing to approximately $1.8 billion following the substantial completion of Train 3 of the CCL Project. +In addition, Cheniere Marketing has agreements with CCL to purchase: (1) 15 TBtu per annum of LNG with an approximate term of 23 years , (2) any LNG produced by CCL in excess of that required for other customers at Cheniere Marketing’s option and (3) 0.85 mtpa of LNG with a term of up to seven years associated with the IPM gas supply agreement between CCL and EOG. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +Natural Gas Transportation, Storage and Supply +To ensure CCL is able to transport adequate natural gas feedstock to the Corpus Christi LNG terminal, it has entered into transportation precedent agreements to secure firm pipeline transportation capacity with CCP and certain third-party pipeline companies. CCL has entered into a firm storage services agreement with a third party to assist in managing variability in natural gas needs for the CCL Project . CCL has also entered into enabling agreements and long-term natural gas supply contracts with third parties, and will continue to enter into such agreements, in order to secure natural gas feedstock for the CCL Project . As of December 31, 2019 , CCL had secured up to approximately 2,999 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to eight years , a portion of which is subject to the achievement of certain project milestones and other conditions precedent. +CCL Stage III has also entered into long-term natural gas supply contracts with third parties, and anticipates continuing to enter into such agreements, in order to secure natural gas feedstock for Corpus Christi Stage 3 . As of December 31, 2019 , CCL Stage III had secured up to approximately 2,361 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to approximately 15 years , which is subject to the achievement of certain project milestones and other conditions precedent. +A portion of the natural gas feedstock transactions for CCL and CCL Stage III are IPM transactions, in which the natural gas producers are paid based on a global gas market price less a fixed liquefaction fee and certain costs incurred by us. +Construction +CCL entered into separate lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Trains 1 through 3 of the CCL Project under which Bechtel charges a lump sum for all work performed and generally bears project +50 +cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause CCL to enter into a change order, or CCL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 3, which is currently under construction, is approximately $2.4 billion , reflecting amounts incurred under change orders through December 31, 2019 . As of December 31, 2019 , we have incurred $2.0 billion under this contract. +Final Investment Decision for Corpus Christi Stage 3 +FID for Corpus Christi Stage 3 will be subject to, among other things, entering into an EPC contract, obtaining additional commercial support for the project and securing the necessary financing arrangements. +Pipeline Facilities +In December 2014, the FERC issued a certificate of public convenience and necessity under Section 7(c) of the Natural Gas Act of 1938, as amended, authorizing CCP to construct and operate the Corpus Christi Pipeline. The Corpus Christi Pipeline is designed to transport 2.25 Bcf/d of natural gas feedstock required by the CCL Project from the existing regional natural gas pipeline grid. The construction of the Corpus Christi Pipeline was completed in the second quarter of 2018. +In November 2019, the FERC authorized CCP to construct and operate the pipeline for Corpus Christi Stage 3 . The pipeline will be designed to transport 1.5 Bcf/d of natural gas feedstock required by Corpus Christi Stage 3 from the existing regional natural gas pipeline grid. +Capital Resources +The CCH Group expects to finance the construction costs of the CCL Project from one or more of the following: operating cash flows from CCL and CCP, project debt and equity contributions from Cheniere. The following table provides a summary of the capital resources of the CCH Group from borrowings and available commitments for the CCL Project, excluding equity contributions from Cheniere, at December 31, 2019 and 2018 (in millions): +December 31, +2019 +2018 +Senior notes (1) +$ +6,952 +$ +4,250 +11.0% Convertible Senior Secured Notes due 2025 (2) +1,000 +1,000 +Credit facilities outstanding balance (3) +3,283 +5,324 +Letters of credit issued (3) +471 +316 +Available commitments under credit facilities (3) +729 +1,698 +Total capital resources from borrowings and available commitments (4) +$ +12,435 +$ +12,588 +(1) +Includes CCH’s 7.000% Senior Secured Notes due 2024 (the “2024 CCH Senior Notes”) , 5.875% Senior Secured Notes due 2025 (the “2025 CCH Senior Notes”) , 5.125% Senior Secured Notes due 2027 (the “2027 CCH Senior Notes”) , 2029 CCH Senior Notes , 4.80% CCH Senior Notes and 3.925% CCH Senior Notes (collectively, the “CCH Senior Notes”) . +(2) +Aggregate original principal amount before debt discount and debt issuance costs. +(3) +Includes CCH Credit Facility and CCH Working Capital Facility . +(4) +Does not include equity contributions that may be available from Cheniere’s borrowings under the 2021 Cheniere Convertible Unsecured Notes , 2045 Cheniere Convertible Senior Notes and Cheniere Revolving Credit Facility , which may be used for the CCL Project . +2025 CCH HoldCo II Convertible Senior Notes +In May 2015, CCH HoldCo II issued $1.0 billion aggregate principal amount of 11.0% Convertible Senior Secured Notes due 2025 (the “2025 CCH HoldCo II Convertible Senior Notes”) on a private placement basis. The 2025 CCH HoldCo II Convertible Senior Notes are convertible at the option of CCH HoldCo II or the holders on or after March 1, 2020 and September 1, 2020, respectively, provided the total market capitalization of Cheniere at that time is not less than $10.0 billion and certain other conditions are satisfied. CCH HoldCo II is restricted from making distributions to Cheniere under agreements governing its +51 +indebtedness generally until, among other requirements, a historical debt service coverage ratio and a projected fixed debt service coverage ratio of 1.20:1.00 are achieved. The 2025 CCH HoldCo II Convertible Senior Notes are secured by a pledge by us of 100% of the equity interests in CCH HoldCo II, and a pledge by CCH HoldCo II of 100% of the equity interests in CCH HoldCo I. In addition, the 2025 CCH HoldCo II Convertible Senior Notes are secured by a security interest in the account into which all distributions from CCH HoldCo I to CCH HoldCo II must be deposited. +In May 2018, the amended and restated note purchase agreement under which the 2025 CCH HoldCo II Convertible Senior Notes were issued was subsequently amended in connection with commercialization and financing of Train 3 of the CCL Project and to provide the note holders with certain prepayment rights related thereto consistent with those under the CCH Credit Facility. All terms of the 2025 CCH HoldCo II Convertible Senior Notes substantially remained unchanged. +CCH Senior Notes +The CCH Senior Notes are jointly and severally guaranteed by CCH’s subsidiaries, CCL, CCP and Corpus Christi Pipeline GP, LLC (each a “CCH Guarantor” and collectively, the “CCH Guarantors”) . The indentures governing the CCH Senior Notes contain customary terms and events of default and certain covenants that, among other things, limit CCH’s ability and the ability of CCH’s restricted subsidiaries to: incur additional indebtedness or issue preferred stock; make certain investments or pay dividends or distributions on membership interests or subordinated indebtedness or purchase, redeem or retire membership interests; sell or transfer assets, including membership or partnership interests of CCH’s restricted subsidiaries; restrict dividends or other payments by restricted subsidiaries to CCH or any of CCH’s restricted subsidiaries; incur liens; enter into transactions with affiliates; dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of the properties or assets of CCH and its restricted subsidiaries taken as a whole; or permit any CCH Guarantor to dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of its properties and assets. The covenants included in the respective indentures that govern the CCH Senior Notes are subject to a number of important limitations and exceptions. +The CCH Senior Notes are CCH ’s senior secured obligations, ranking senior in right of payment to any and all of CCH ’s future indebtedness that is subordinated to the CCH Senior Notes and equal in right of payment with CCH ’s other existing and future indebtedness that is senior and secured by the same collateral securing the CCH Senior Notes . The CCH Senior Notes are secured by a first-priority security interest in substantially all of CCH ’s and the CCH Guarantors ’ assets. +At any time prior to six months before the respective dates of maturity for each of the CCH Senior Notes , CCH may redeem all or part of such series of the CCH Senior Notes at a redemption price equal to the “make-whole” price set forth in the appropriate indenture, plus accrued and unpaid interest, if any, to the date of redemption. At any time within six months of the respective dates of maturity for each of the CCH Senior Notes , CCH may redeem all or part of such series of the CCH Senior Notes , in whole or in part, at a redemption price equal to 100% of the principal amount of the CCH Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +CCH Credit Facility +In May 2018, CCH amended and restated the CCH Credit Facility to increase total commitments under the CCH Credit Facility from $4.6 billion to $6.1 billion. The obligations of CCH under the CCH Credit Facility are secured by a first priority lien on substantially all of the assets of CCH and its subsidiaries and by a pledge by CCH HoldCo I of its limited liability company interests in CCH. As of December 31, 2019 and 2018 , CCH had zero and $1.0 billion of available commitments and $3.3 billion and $5.2 billion of loans outstanding under the CCH Credit Facility , respectively. As part of the capital allocation framework announced in June 2019, we prepaid $153 million of outstanding borrowings under the CCH Credit Facility during the year ended December 31, 2019 . +The CCH Credit Facility matures on June 30, 2024, with principal payments due quarterly commencing on the earlier of (1) the first quarterly payment date occurring more than three calendar months following the completion of the CCL Project as defined in the common terms agreement and (2) a set date determined by reference to the date under which a certain LNG buyer linked to the last Train of the CCL Project to become operational is entitled to terminate its SPA for failure to achieve the date of first commercial delivery for that agreement. Scheduled repayments will be based upon a 19-year tailored amortization, commencing the first full quarter after the completion of Trains 1 through 3 and designed to achieve a minimum projected fixed debt service coverage ratio of 1.50:1. +52 +Under the CCH Credit Facility , CCH is required to hedge not less than 65% of the variable interest rate exposure of its senior secured debt. CCH is restricted from making certain distributions under agreements governing its indebtedness generally until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project , funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25:1.00. +CCH Working Capital Facility +In June 2018, CCH amended and restated the CCH Working Capital Facility to increase total commitments under the CCH Working Capital Facility from $350 million to $1.2 billion. The CCH Working Capital Facility is intended to be used for loans to CCH (“CCH Working Capital Loans”) and the issuance of letters of credit on behalf of CCH for certain working capital requirements related to developing and operating the CCL Project and for related business purposes. Loans under the CCH Working Capital Facility are guaranteed by the CCH Guarantors . CCH may, from time to time, request increases in the commitments under the CCH Working Capital Facility of up to the maximum allowed for working capital under the Common Terms Agreement that was entered into concurrently with the CCH Credit Facility . As of December 31, 2019 and 2018 , CCH had $729 million and $716 million of available commitments, $471 million and $316 million aggregate amount of issued letters of credit and zero and $168 million of loans outstanding under the CCH Working Capital Facility , respectively. +The CCH Working Capital Facility matures on June 29, 2023, and CCH may prepay the CCH Working Capital Loans and loans made in connection with a draw upon any letter of credit (“CCH LC Loans”) at any time without premium or penalty upon three business days’ notice and may re-borrow at any time. CCH LC Loans have a term of up to one year. CCH is required to reduce the aggregate outstanding principal amount of all CCH Working Capital Loans to zero for a period of five consecutive business days at least once each year. +The CCH Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of CCH under the CCH Working Capital Facility are secured by substantially all of the assets of CCH and the CCH Guarantors as well as all of the membership interests in CCH and each of the CCH Guarantors on a pari passu basis with the CCH Senior Notes and the CCH Credit Facility . +Cheniere +Convertible Notes +In November 2014, we issued an aggregate principal amount of $1.0 billion of Convertible Unsecured Notes due 2021 (the “2021 Cheniere Convertible Unsecured Notes”) . The 2021 Cheniere Convertible Unsecured Notes are convertible at the option of the holder into our common stock at the then applicable conversion rate, provided that the closing price of our common stock is greater than or equal to the conversion price on the date of conversion. In March 2015, we issued $625 million aggregate principal amount of unsecured 4.25% Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”) . We have the right, at our option, at any time after March 15, 2020, to redeem all or any part of the 2045 Cheniere Convertible Senior Notes at a redemption price equal to the accreted amount of the 2045 Cheniere Convertible Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to such redemption date. We have the option to satisfy the conversion obligation for the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes with cash, common stock or a combination thereof. +Cheniere Revolving Credit Facility +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $750 million to $1.25 billion. The Cheniere Revolving Credit Facility is intended to fund, through loans and letters of credit, equity capital contributions to CCH HoldCo II and its subsidiaries for the development of the CCL Project and, provided that certain conditions are met, for general corporate purposes. +The Cheniere Revolving Credit Facility matures on December 13, 2022 and contains representations, warranties and affirmative and negative covenants customary for companies like us with lenders of the type participating in the Cheniere Revolving Credit Facility that limit our ability to make restricted payments, including distributions, unless certain conditions are satisfied, as well as limitations on indebtedness, guarantees, hedging, liens, investments and affiliate transactions. Under the Cheniere Revolving Credit Facility , we are required to ensure that the sum of our unrestricted cash and the amount of undrawn commitments +53 +under the Cheniere Revolving Credit Facility is at least equal to the lesser of (1) 20% of the commitments under the Cheniere Revolving Credit Facility and (2) $200 million (the “Liquidity Covenant”). +From and after the time at which certain specified conditions are met (the “Trigger Point”), we will have increased flexibility under the Cheniere Revolving Credit Facility to, among other things, (1) make restricted payments and (2) raise incremental commitments. The Trigger Point will occur once (1) completion has occurred for each of Train 1 of the CCL Project (as defined in the CCH Indenture) and Train 5 of the SPL Project (as defined in SPL’s common terms agreement), which has occurred in February 2019 and March 2019, respectively; (2) the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is less than or equal to 10% of aggregate commitments under the Cheniere Revolving Credit Facility and (3) we elect on a go-forward basis to be governed by a non-consolidated leverage ratio covenant not to exceed 5.75:1.00 (the “Springing Leverage Covenant”), which following such election will apply at any time that the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is greater than 30% of aggregate commitments under the Cheniere Revolving Credit Facility . Following the Trigger Point, at any time that the Springing Leverage Covenant is in effect, the Liquidity Covenant will not apply. +The Cheniere Revolving Credit Facility is secured by a first priority security interest (subject to permitted liens and other customary exceptions) in substantially all of our assets, including our interests in our direct subsidiaries (excluding CCH HoldCo II and certain other subsidiaries). +Cash Receipts from Subsidiaries +Our ownership interest in the Sabine Pass LNG terminal is held through Cheniere Partners. As of December 31, 2019 , we owned a 48.6% limited partner interest in Cheniere Partners in the form of 104.5 million common units and 135.4 million subordinated units. We also own 100% of the general partner interest and the incentive distribution rights in Cheniere Partners. We are eligible to receive quarterly equity distributions from Cheniere Partners related to our ownership interests and our incentive distribution rights. +We also receive fees for providing management services to some of our subsidiaries. We received $103 million, $76 million and $106 million in total service fees from these subsidiaries during the years ended December 31, 2019, 2018 and 2017 , respectively. +Share Repurchase Program +On June 3, 2019, we announced that our Board authorized a 3-year, $1.0 billion share repurchase program. During the year ended December 31, 2019 , we repurchased an aggregate of 4.0 million shares of our common stock for $249 million , for a weighted average price per share of $62.27 . As of December 31, 2019 , we had up to $751 million of the share repurchase program available. Under the share repurchase program, repurchases can be made from time to time using a variety of methods, which may include open market purchases, privately negotiated transactions or otherwise, all in accordance with the rules of the SEC and other applicable legal requirements. The timing and amount of any shares of our common stock that are repurchased under the share repurchase program will be determined by our management based on market conditions and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and may be modified, suspended or discontinued at any time or from time to time at our discretion. +Marketing +We market and sell LNG produced by the Liquefaction Projects that is not required for other customers through our integrated marketing function. We have, and continue to develop, a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide. These volumes are expected to be primarily sourced by LNG produced by the Liquefaction Projects but supplemented by volumes procured from other locations worldwide, as needed. As of December 31, 2019 , we have sold or have options to sell approximately 4,935 TBtu of LNG to be delivered to customers between 2020 and 2045, excluding volumes for agreements anticipated to be assigned to SPL in the future. The cargoes have been sold either on a FOB basis (delivered to the customer at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, as applicable) or a delivered at terminal (“DAT”) basis (delivered to the customer at their LNG receiving terminal). We have chartered LNG vessels to be utilized for cargoes sold on a DAT basis. In addition, we have entered into a long-term agreement to sell LNG cargoes on a DAT basis that is conditioned upon the buyer achieving certain milestones. +54 +Cheniere Marketing entered into uncommitted trade finance facilities with available commitments of $420 million as of December 31, 2019 , primarily to be used for the purchase and sale of LNG for ultimate resale in the course of its operations. The finance facilities are intended to be used for advances, guarantees or the issuance of letters of credit or standby letters of credit on behalf of Cheniere Marketing. As of December 31, 2019 and 2018 , Cheniere Marketing had $41 million and $31 million , respectively, in standby letters of credit and guarantees outstanding under the finance facilities. As of December 31, 2018, Cheniere Marketing had $71 million in loans outstanding under the finance facilities. As of December 31, 2019 , there were no loans outstanding under the finance facilities. Cheniere Marketing pays interest or fees on utilized commitments. +Corporate and Other Activities +We are required to maintain corporate and general and administrative functions to serve our business activities described above. The development of our sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we make an FID . +We have made an equity investment in Midship Holdings, LLC (“Midship Holdings”), which manages the business and affairs of Midship Pipeline. Midship Pipeline is constructing the Midship Project with expected capacity of up to 1.44 million Dekatherms per day that will connect new gas production in the Anadarko Basin to Gulf Coast markets, including markets serving the Liquefaction Projects . Construction of the Midship Project commenced in the first quarter of 2019 and is expected to be completed in the first half of 2020. +Restrictive Debt Covenants +As of December 31, 2019 , each of our issuers was in compliance with all covenants related to their respective debt agreements. +LIBOR +The use of LIBOR is expected to be phased out by the end of 2021. It is currently unclear whether LIBOR will be utilized beyond that date or whether it will be replaced by a particular rate. We intend to continue to work with our lenders to pursue any amendments to our debt agreements that are currently subject to LIBOR and will continue to monitor, assess and plan for the phase out of LIBOR. +Sources and Uses of Cash +The following table summarizes the sources and uses of our cash, cash equivalents and restricted cash for the years ended December 31, 2019, 2018 and 2017 (in millions). The table presents capital expenditures on a cash basis; therefore, these amounts differ from the amounts of capital expenditures, including accruals, which are referred to elsewhere in this report. Additional discussion of these items follows the table. +Year Ended December 31, +2019 +2018 +2017 +Operating cash flows +$ +1,833 +$ +1,990 +$ +1,231 +Investing cash flows +(3,163 +) +(3,654 +) +(3,381 +) +Financing cash flows +1,168 +2,207 +2,936 +Net increase (decrease) in cash, cash equivalents and restricted cash +(162 +) +543 +786 +Cash, cash equivalents and restricted cash—beginning of period +3,156 +2,613 +1,827 +Cash, cash equivalents and restricted cash—end of period +$ +2,994 +$ +3,156 +$ +2,613 +Operating Cash Flows +Our operating cash net inflows during the years ended December 31, 2019, 2018 and 2017 were $1,833 million , $1,990 million and $1,231 million , respectively. The $157 million decrease in operating cash inflows in 2019 compared to 2018 was primarily related to increased operating costs and expenses, which were partially offset by increased cash receipts from the sale of LNG cargoes, as a result of the additional Trains that were operating at the Liquefaction Projects in 2019. The $759 million increase in operating cash inflows in 2018 compared to 2017 was primarily related to increased cash receipts from the sale of LNG cargoes, partially offset by increased operating costs and expenses as a result of the additional Trains that were operating at the SPL Project in 2018. +55 +Investing Cash Flows +Investing cash net outflows during the years ended December 31, 2019, 2018 and 2017 were $3,163 million , $3,654 million and $3,381 million , respectively, and were primarily used to fund the construction costs for the Liquefaction Projects . These costs are capitalized as construction-in-process until achievement of substantial completion. Additionally, we invested $105 million in Midship Holdings, our equity method investment, during the year ended December 31, 2019 . During the year ended December 31, 2018 , we invested an additional $25 million in our equity method investment Midship Holdings, offset primarily by proceeds of $12 million from the sale of our other investments. During the year ended December 31, 2017, we invested an additional $41 million in Midship Holdings and made payments of $19 million, primarily for infrastructure to support the CCL Project and other capital projects. Partially offsetting these cash outflows during the year ended December 31, 2017 was a $36 million receipt from the return of collateral payments previously paid for the CCL Project. +Financing Cash Flows +Financing cash net inflows during the year ended December 31, 2019 were $1,168 million , primarily as a result of: +• +issuance of an aggregate principal amount of $1.5 billion of the 2029 CQP Senior Notes , which was used to prepay the outstanding balance of the term loan under the 2019 CQP Credit Facilities ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2029 CCH Senior Notes , $727 million of the 4.80% CCH Senior Notes and $475 million of the 3.925% CCH Senior Notes , which were used to prepay a portion of the outstanding balance of the CCH Credit Facility ; +• +$51 million of debt issuance costs primarily related to up-front fees paid upon the closing of the above transactions; +• +$15 million of debt extinguishment cost related to the issuance of the 2029 CQP Senior Notes and the 2029 CCH Senior Notes ; +• +$982 million of borrowings and $2,855 million of repayments under the CCH Credit Facility ; +• +$730 million of borrowings and repayments under the 2019 CQP Credit Facilities ; +• +$521 million of borrowings and $689 million in repayments under the CCH Working Capital Facility ; +• +$72 million of net repayments related to our Cheniere Marketing trade financing facilities; +• +$590 million of distributions to non-controlling interest by Cheniere Partners; +• +$249 million paid to repurchase approximately 4 million shares of our common stock under the share repurchase program; and +• +$19 million paid for tax withholdings for share-based compensation. +Financing cash net inflows during the year ended December 31, 2018 were $2,207 million , primarily as a result of: +• +issuance of an aggregate principal amount of $1.1 billion of the 2026 CQP Senior Notes , which was used to prepay $1.1 billion of the outstanding borrowings under the 2016 CQP Credit Facilities ; +• +$2.9 billion of borrowings and $281 million in repayments under the CCH Credit Facility ; +• +$188 million of borrowings and $20 million in repayments under the CCH Working Capital Facility ; +• +$71 million of net borrowings related to our Cheniere Marketing trade financing facilities; +• +$66 million of debt issuance costs related to up-front fees paid upon the closing of these transactions; +• +$17 million in debt extinguishment costs related to the prepayments of the 2016 CQP Credit Facilities and the CCH Credit Facility ; +• +$576 million of distributions and dividends to non-controlling interest by Cheniere Partners and Cheniere Holdings; +• +$20 million paid for tax withholdings for share-based compensation; and +• +$7 million of transaction costs to acquire additional interest of Cheniere Holdings. +56 +Financing cash net inflows during the year ended December 31, 2017 were $2,936 million , primarily as a result of: +• +issuances of SPL’s senior notes for an aggregate principal amount $2.15 billion; +• +$55 million of borrowings and $369 million of repayments made under the credit facilities SPL entered into in June 2015 (the “SPL Credit Facilities”) ; +• +$110 million of borrowings and $334 million of repayments made under the SPL Working Capital Facility ; +• +$1.5 billion of borrowings under the CCH Credit Facility ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2027 CCH Senior Notes , which was used to prepay $1.4 billion of outstanding borrowings under the CCH Credit Facility ; +• +$24 million of borrowings and $24 million of repayments made under the CCH Working Capital Facility ; +• +issuance of an aggregate principal amount of $1.5 billion of the 2025 CQP Senior Notes , which was used to prepay $1.5 billion of the outstanding borrowings under the 2016 CQP Credit Facilities ; +• +$24 million in net repayments made under the Cheniere Marketing trade finance facilities; +• +$89 million of debt issuance and deferred financing costs related to up-front fees paid upon the closing of these transactions; +• +$185 million of distributions and dividends to non-controlling interest by Cheniere Partners and Cheniere Holdings; and +• +$12 million paid for tax withholdings for share-based compensation. +Contractual Obligations +We are committed to make cash payments in the future pursuant to certain of our contracts. The following table summarizes certain contractual obligations in place as of December 31, 2019 (in millions): +Payments Due By Period (1) +Total +2020 +2021 - 2022 +2023 - 2024 +Thereafter +Debt (2) +$ +30,610 +$ +— +$ +4,253 +$ +7,779 +$ +18,578 +Interest payments (2) +11,315 +1,633 +3,419 +2,612 +3,651 +Operating lease obligations (3) +530 +250 +78 +42 +160 +Finance lease obligations (4) +187 +11 +20 +20 +136 +Purchase obligations: (5) +Construction obligations (6) +1,301 +726 +534 +41 +— +Natural gas supply, transportation and storage service agreements (7) +13,468 +3,503 +3,943 +2,035 +3,987 +Other purchase obligations (8) +1,658 +224 +299 +298 +837 +Total +$ +59,069 +$ +6,347 +$ +12,546 +$ +12,827 +$ +27,349 +(1) +Agreements in force as of December 31, 2019 that have terms dependent on project milestone dates are based on the estimated dates as of December 31, 2019 . +(2) +Based on the total debt balance, scheduled maturities and fixed or estimated forward interest rates in effect at December 31, 2019 . The repayment of paid in kind interest is included in interest payments. Interest payment obligations exclude adjustments for interest rate swap agreements. A discussion of our debt obligations can be found in Note 11—Debt of our Notes to Consolidated Financial Statements. +(3) +Operating lease obligations primarily relate to LNG vessel time charters, land sites related to the Liquefaction Projects and corporate office leases. Operating lease obligations do not include $2.0 billion of legally binding minimum lease payments for vessel charters which were executed as of December 31, 2019 but will commence between 2020 and 2022 and have fixed minimum lease terms of up to seven years . A discussion of our lease obligations can be found in Note 12—Leases of our Notes to Consolidated Financial Statements. +(4) +Finance lease obligations consist of tug leases related to the CCL Project , as further discussed in Note 12—Leases of our Notes to Consolidated Financial Statements. +57 +(5) +Purchase obligations consist of agreements to purchase goods or services that are enforceable and legally binding that specify fixed or minimum quantities to be purchased. We include only contracts for which conditions precedent have been met. As project milestones and other conditions precedent are achieved, our obligations are expected to increase accordingly. We include contracts for which we have an early termination option if the option is not expected to be exercised. +(6) +Construction obligations primarily consist of the estimated remaining cost pursuant to our EPC contracts as of December 31, 2019 for Trains with respect to which we have made an FID to commence construction. A discussion of these obligations can be found at Note 19—Commitments and Contingencies of our Notes to Consolidated Financial Statements. +(7) +Pricing of natural gas supply agreements are based on estimated forward prices and basis spreads as of December 31, 2019 . +(8) +Other purchase obligations primarily relate to payments under SPL’s partial TUA assignment agreement with Total as discussed in Note 13—Revenues from Contracts with Customers of our Notes to Consolidated Financial Statements. +In addition, as of December 31, 2019 , we had $1,470 million aggregate amount of issued letters of credit under our credit facilities. We also had tax agreements with certain local taxing jurisdictions for an aggregate amount of $212 million to be paid through 2033, based on estimated tax obligations as of December 31, 2019 . +58 +Results of Operations +The following charts summarize the number of Trains that were in operation during the years ended December 31, 2019, 2018 and 2017 and total revenues and total LNG volumes loaded (including both operational and commissioning volumes) for the respective periods: +The following table summarizes the volumes of operational and commissioning LNG cargoes that were loaded from the Liquefaction Projects , which were recognized on our Consolidated Financial Statements during the year ended December 31, 2019 : +Year Ended December 31, 2019 +(in TBtu) +Operational +Commissioning +Volumes loaded during the current period +1,466 +48 +Volumes loaded during the prior period but recognized during the current period +25 +3 +Less: volumes loaded during the current period and in transit at the end of the period +(33 +) +— +Total volumes recognized in the current period +1,458 +51 +Our consolidated net income attributable to common stockholders was $648 million , or $2.53 per share—basic and $2.51 per share—diluted, in the year ended December 31, 2019 , compared to net income attributable to common stockholders of $471 million , or $1.92 per share—basic and $1.90 per share—diluted, in the year ended December 31, 2018 . This $177 million increase +59 +in net income attributable to common stockholders in 2019 was primarily attributable to (1) increased gross margins due to increased volume of LNG sold partially offset by decreased pricing on LNG, (2) increased tax benefit from the release of a significant portion of the valuation allowance previously recorded against our deferred tax assets, (3) increased LNG revenues as a result of derivative gains on commodity derivatives and (4) decreased net income attributable to non-controlling interest, which were partially offset by an increase in (1) interest expense, net of amounts capitalized, (2) operating and maintenance expense, (3) derivative loss, net, associated with our interest rate derivatives, (4) depreciation and amortization expense and (5) loss on equity method investments. +Our consolidated net loss attributable to common stockholders was $393 million , or $1.68 per share (basic and diluted), in the year ended December 31, 2017. This $864 million increase in net income in 2018 compared to 2017 was primarily attributable to (1) increased income from operations due to additional Trains operating between the periods, (2) decreased loss on modification or extinguishment of debt and (3) increased derivative gain, net, which were partially offset by decreased net income attributable to non-controlling interest and increased interest expense, net of amounts capitalized. +We enter into derivative instruments to manage our exposure to (1) changing interest rates, (2) commodity-related marketing and price risks and (3) foreign exchange volatility. Derivative instruments are reported at fair value on our Consolidated Financial Statements. In some cases, the underlying transactions economically hedged receive accrual accounting treatment, whereby revenues and expenses are recognized only upon delivery, receipt or realization of the underlying transaction. Because the recognition of derivative instruments at fair value has the effect of recognizing gains or losses relating to future period exposure, use of derivative instruments may increase the volatility of our results of operations based on changes in market pricing, counterparty credit risk and other relevant factors. +Revenues +Year Ended December 31, +(in millions) +2019 +2018 +Change +2017 +Change +LNG revenues +$ +9,246 +$ +7,572 +$ +1,674 +$ +5,317 +$ +2,255 +Regasification revenues +266 +261 +5 +260 +1 +Other revenues +218 +154 +64 +24 +130 +Total revenues +$ +9,730 +$ +7,987 +$ +1,743 +$ +5,601 +$ +2,386 +2019 vs. 2018 and 2018 vs. 2017 +We begin recognizing LNG revenues from the Liquefaction Projects following the substantial completion and the commencement of operating activities of the respective Trains. The increase in revenues during each of the years was primarily attributable to the increased volume of LNG sold following the achievement of substantial completion of these Trains. The increase in revenue attributable to LNG volume sold during the year ended December 31, 2019 from the comparable period in 2018 was partially offset by decreased LNG revenues per MMBtu, which was primarily affected by market prices realized for volumes sold by our integrated marketing function. Additionally, the increase in other revenues during each of the years was due to an increase in sub-chartering income. We expect our LNG revenues to increase in the future upon Train 6 of the SPL Project and Train 3 of the CCL Project becoming operational, in addition to full year operation of the Trains that were completed during 2019. +Prior to substantial completion of a Train, amounts received from the sale of commissioning cargoes from that Train are offset against LNG terminal construction-in-process, because these amounts are earned or loaded during the testing phase for the construction of that Train. During the years ended December 31, 2019, 2018 and 2017 , we realized offsets to LNG terminal costs of $301 million corresponding to 51 TBtu of LNG, $140 million corresponding to 17 TBtu and $320 million corresponding to 51 TBtu , respectively, that were related to the sale of commissioning cargoes from the Liquefaction Projects . +Also included in LNG revenues are gains and losses from derivative instruments and the sale of natural gas procured for the liquefaction process. We recognized revenues of $693 million , $163 million and a loss of $8 million during the years ended December 31, 2019, 2018 and 2017 , respectively, related to derivative instruments and other revenues from these transactions. +60 +The following table presents the components of LNG revenues and the corresponding LNG volumes sold: +Year Ended December 31, +2019 +2018 +2017 +LNG revenues (in millions) : +LNG from the Liquefaction Projects sold under third party long-term agreements (1) +$ +6,342 +$ +4,762 +$ +2,588 +LNG from the Liquefaction Projects sold by our integrated marketing function under short-term agreements +1,943 +1,902 +1,756 +LNG procured from third parties +268 +745 +981 +Other revenues and derivative gains (losses) +693 +163 +(8 +) +Total LNG revenues +$ +9,246 +$ +7,572 +$ +5,317 +Volumes sold as LNG revenues (in TBtu) : +LNG from the Liquefaction Projects sold under third party long-term agreements (1) +1,090 +761 +427 +LNG from the Liquefaction Projects sold by our integrated marketing function under short-term agreements +368 +212 +233 +LNG procured from third parties +40 +84 +98 +Total volumes sold as LNG revenues +1,498 +1,057 +758 +(1) Long-term agreements include agreements with a tenure of 12 months or more. +Operating costs and expenses +Year Ended December 31, +(in millions) +2019 +2018 +Change +2017 +Change +Cost of sales +$ +5,079 +$ +4,597 +$ +482 +$ +3,120 +$ +1,477 +Operating and maintenance expense +1,154 +613 +541 +446 +167 +Development expense +9 +7 +2 +10 +(3 +) +Selling, general and administrative expense +310 +289 +21 +256 +33 +Depreciation and amortization expense +794 +449 +345 +356 +93 +Restructuring expense +— +— +— +6 +(6 +) +Impairment expense and loss on disposal of assets +23 +8 +15 +19 +(11 +) +Total operating costs and expenses +$ +7,369 +$ +5,963 +$ +1,406 +$ +4,213 +$ +1,750 +2019 vs. 2018 and 2018 vs. 2017 +Our total operating costs and expenses increased during the year ended December 31, 2019 from the years ended December 31, 2018 and 2017, primarily as a result of the increase in operating Trains between each of the periods. During the year ended December 31, 2019 , we further incurred increased third-party service and maintenance costs from turnaround and related activities at the SPL Project . +Cost of sales includes costs incurred directly for the production and delivery of LNG from the Liquefaction Projects , to the extent those costs are not utilized for the commissioning process. Cost of sales increased during the year ended December 31, 2019 from the comparable 2018 and 2017 periods, primarily as a result of the increase in operating Trains between each of the periods. Cost of sales increased during the year ended December 31, 2019 from the year ended December 31, 2018 due to increased volume of natural gas feedstock partially offset by its decreased pricing and increased vessel charter costs. Partially offsetting this increase was increased derivative gains from an increase in fair value of the derivatives associated with economic hedges to secure natural gas feedstock for the Liquefaction Projects , primarily due to a favorable shift in long-term forward prices. Cost of sales also includes port and canal fees, variable transportation and storage costs and the sale of natural gas procured for the liquefaction process and other costs to convert natural gas into LNG. The increase during the year ended December 31, 2018 from the comparable period in 2017 was primarily related to the increase in the volume of natural gas feedstock related to our LNG sales. +Operating and maintenance expense primarily includes costs associated with operating and maintaining the Liquefaction Projects . The increase in operating and maintenance expense during the year ended December 31, 2019 from the comparable 2018 and 2017 periods was primarily as a result of the increase in operating Trains between each of the periods. The increase during the year ended December 31, 2019 from the comparable period in 2018 was primarily related to: (1) increased natural gas transportation and storage capacity demand charges from operating Train 5 of the SPL Project and Trains 1 and 2 of the CCL +61 +Project following the respective substantial completions, (2) increased cost of turnaround and related activities at the SPL Project , (3) increased TUA reservation charges paid to Total from payments under the partial TUA assignment agreement and (4) increased payroll and benefit costs from increased headcount to operate Train 5 of the SPL Project and Trains 1 and 2 of the CCL Project . The increase during the year ended December 31, 2018 from the comparable period in 2017 was primarily related to third-party service and maintenance contract costs, payroll and benefit costs of operations personnel and natural gas transportation and storage capacity demand charges. Operating and maintenance expense also includes insurance and regulatory costs and other operating costs. +Depreciation and amortization expense increased during each of the years ended December 31, 2019, 2018 and 2017 as a result of an increased number of operational Trains, as the related assets began depreciating upon reaching substantial completion. +Impairment expense and loss on disposal of assets increased during the year ended December 31, 2019 compared to the year ended December 31, 2018 . The impairment expense and loss on disposal of assets recognized during the year ended December 31, 2019 was primarily related to the write down of assets used in non-core operations outside of our liquefaction activities, including losses from uncollectible notes receivable. Impairment expense and loss on disposal of assets decreased during the year ended December 31, 2018 from the comparable 2017 period. The impairment expense and loss on disposal of assets recognized during the year ended December 31, 2018 related to the write down of prepaid assets and related to write down of assets used in non-core operations outside of our liquefaction activities during the year ended December 31, 2017. The impairment expense and loss on disposal of assets recognized during the year ended December 31, 2017 also included $6 million related to damaged infrastructure as a result of Hurricane Harvey. +We expect our operating costs and expenses to generally increase in the future upon Train 6 of the SPL Project and Train 3 of the CCL Project achieving substantial completion, although we expect certain costs will not proportionally increase with the number of operational Trains as cost efficiencies will be realized. +Other expense (income) +Year Ended December 31, +(in millions) +2019 +2018 +Change +2017 +Change +Interest expense, net of capitalized interest +$ +1,432 +$ +875 +$ +557 +$ +747 +$ +128 +Loss on modification or extinguishment of debt +55 +27 +28 +100 +(73 +) +Derivative loss (gain), net +134 +(57 +) +191 +(7 +) +(50 +) +Other expense (income) +25 +(48 +) +73 +(18 +) +(30 +) +Total other expense +$ +1,646 +$ +797 +$ +849 +$ +822 +$ +(25 +) +2019 vs. 2018 and 2018 vs. 2017 +Interest expense, net of capitalized interest, increased during the year ended December 31, 2019 from the comparable 2018 and 2017 periods primarily as a result of a decrease in the portion of total interest costs that could be capitalized as additional Trains of the Liquefaction Projects completed construction between the periods. During the years ended December 31, 2019, 2018 and 2017 , we incurred $1.8 billion , $1.7 billion and $1.5 billion of total interest cost, respectively, of which we capitalized $414 million , $803 million and $779 million, respectively, which was primarily related to interest costs incurred for the construction of the Liquefaction Projects . +Loss on modification or extinguishment of debt increased during the year ended December 31, 2019 compared to the year ended December 31, 2018 and decreased between the year ended December 31, 2018 and the year ended December 31, 2017. The loss on modification or extinguishment of debt recognized in each of the years was related to the incurrence of third party fees and write off of unamortized debt issuance costs recognized upon refinancing our credit facilities with senior notes, paydown of our credit facilities as part of the capital allocation framework or upon amendment and restatement of our credit facilities. +Derivative loss, net increased during the year ended December 31, 2019 compared to the year ended December 31, 2018 , primarily due to an unfavorable shift in the long-term forward LIBOR curve between the periods, but decreased compared to the derivative gain during the year ended December 31, 2017 primarily due to a favorable shift in the long-term forward LIBOR curve between the periods. +62 +Other expense increased during the year ended December 31, 2019 compared to the years ended December 31, 2018 and 2017, primarily due to a loss on our equity method investments, which was partially offset by an increase in interest income earned on our cash and cash equivalents and restricted cash. During the year ended December 31, 2019 , we recognized impairment losses of $87 million relating to our investments in certain equity method investees, including Midship Holdings. Impairments were precipitated primarily by cost overruns and extended construction timelines for operating infrastructure of our investees’ projects, resulting in a reduction of the expected fair value of our equity interests. Other income increased during the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily due to an increase in interest income earned on our cash and cash equivalents. +Income tax provision +Year Ended December 31, +(in millions) +2019 +2018 +Change +2017 +Change +Income before income taxes and non-controlling interest +$ +715 +$ +1,227 +$ +(512 +) +$ +566 +$ +661 +Income tax benefit (provision) +517 +(27 +) +544 +(3 +) +(24 +) +Effective tax rate +(72.3 +)% +2.2 +% +0.5 +% +2019 vs. 2018 and 2018 vs. 2017 +The tax benefit of $517 million and effective tax rate of (72.3)% for the year ended December 31, 2019 is primarily attributable to releasing a significant portion of the valuation allowance previously recorded against our deferred tax assets. +We evaluate the recoverability of our deferred tax assets as of each reporting date, weighing all positive and negative evidence, and establish a valuation allowance if we determine that it is more likely than not that some or all of our deferred tax assets will not be realized. The assessment requires significant judgment and is performed in each of our applicable jurisdictions. In making such determination, we consider various factors such as historical profitability, future projections of sustained profitability, reversal of existing deferred tax liabilities, construction and operational milestones reached on our Liquefaction Projects and our long-term SPAs achieving date of first commercial delivery. We recorded a valuation allowance of $686 million in 2018 against our deferred tax assets due to being in a three-year cumulative loss position at the time, in addition to ongoing construction and performance risks related to our Liquefaction Projects . After weighing 2019 positive and negative evidence, we determined that sufficient positive evidence existed to support releasing the valuation allowance against significantly all of our federal deferred tax assets and a portion of our state deferred tax assets. The positive evidence supporting such conclusion included successful completion and subsequent operations of Trains 1 and 2 of the CCL Project and Train 5 of the SPL Project , our transitioning from a three-year cumulative loss position in 2018 to a three-year cumulative income position in 2019, achieving date of first commercial delivery on 12 of our long term customer SPAs and forecasts of sustained future profitability. As a result, we recorded a valuation allowance release of $490 million comprised of a $493 million federal valuation allowance release and a $49 million Louisiana valuation allowance release, partially offset by an increase to the valuation allowance of $52 million in various other state and foreign tax jurisdictions. We maintained a valuation allowance of $196 million at December 31, 2019 primarily against state net operating loss carryforward deferred tax assets, for which we continue to believe the more likely than not recognition threshold was not met. +The tax expense of $27 million and $3 million during the years ended December 31, 2018 and 2017 was primarily due to income earned in the UK related to our integrated marketing function. The effective tax rates during each of the years ended December 31, 2018 and 2017 were lower than the 21% and 35% federal statutory rates for the respective years, primarily as a result of maintaining a valuation allowance against our federal and state net deferred tax assets. +Net income attributable to non-controlling interest +Year Ended December 31, +(in millions) +2019 +2018 +Change +2017 +Change +Net income attributable to non-controlling interest +$ +584 +$ +729 +$ +(145 +) +$ +956 +$ +(227 +) +2019 vs. 2018 +Net income attributable to non-controlling interest decreased during the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to the annualized decrease of non-controlling interest as a result of our merger with Cheniere +63 +Holdings in September 2018, in which all publicly-held shares of Cheniere Holdings were canceled and the non-controlling interest in Cheniere Holdings was reduced to zero. The consolidated net income recognized by Cheniere Partners decreased from $1.3 billion in the year ended December 31, 2018 to $1.2 billion in the year ended December 31, 2019 primarily due a decrease in income from operations from higher operating and maintenance expense and an increase in interest expense, net of capitalized interest and increased depreciation and amortization expense, partially offset by increased margins due to higher volumes of LNG sold but decreased pricing on LNG. +2018 vs. 2017 +Net income attributable to non-controlling interest decreased during the year ended December 31, 2018 from the year ended December 31, 2017 due to the nonrecurrence of non-cash amortization of the beneficial conversion feature on Cheniere Partners’ Class B units that occurred during the comparable period in 2017, which was partially offset by the increase in consolidated net income recognized by Cheniere Partners in which the non-controlling interests are held, adjusting for the increase in the share of Cheniere Partners’ net income that is attributed to non-controlling interest holders as a result of changes in ownership percentages between years. Net income attributable to non-controlling interest during the year ended December 31, 2017 included approximately $748 million due to amortization of the beneficial conversion feature on Cheniere Partners’ Class B units, which ceased upon the conversion of Cheniere Partners’ Class B units into common units. The consolidated net income recognized by Cheniere Partners increased from $490 million in the year ended December 31, 2017 to $1.3 billion in the year ended December 31, 2018, primarily as a result of the additional Trains that were operating at the SPL Project between the periods. Partially offsetting the decrease in net income attributable to non-controlling interest was an increase in ownership percentage by non-controlling interest holders between the periods as a result of the conversion of Cheniere Partners’ Class B units into common units on August 2, 2017. +Off-Balance Sheet Arrangements +As of December 31, 2019 , we had no transactions that met the definition of off-balance sheet arrangements that may have a current or future material effect on our consolidated financial position or operating results. +Summary of Critical Accounting Estimates +The preparation of Consolidated Financial Statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Management evaluates its estimates and related assumptions regularly, including those related to the valuation of derivative instruments. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. Management considers the following to be its most critical accounting estimates that involve significant judgment. +Fair Value of Derivative Instruments +All derivative instruments, other than those that satisfy specific exceptions, are recorded at fair value. We record changes in the fair value of our derivative positions based on the value for which the derivative instrument could be exchanged between willing parties. If market quotes are not available to estimate fair value, management’s best estimate of fair value is based on the quoted market price of derivatives with similar characteristics or determined through industry-standard valuation approaches. Such evaluations may involve significant judgment and the results are based on expected future events or conditions, particularly for those valuations using inputs unobservable in the market. +Our derivative instruments consist of interest rate swaps, financial commodity derivative contracts transacted in an over-the-counter market, physical commodity contracts and foreign currency exchange (“FX”) contracts. We value our interest rate swaps using observable inputs including interest rate curves, risk adjusted discount rates, credit spreads and other relevant data. Valuation of our financial commodity derivative contracts is determined using observable commodity price curves and other relevant data. We estimate the fair values of our FX derivative instruments using observable FX rates and other relevant data. +Valuation of our physical commodity contracts is predominantly driven by observable and unobservable market commodity prices and, as applicable to our natural gas supply contracts, our assessment of the associated events deriving fair value, including evaluating whether the respective market is available as pipeline infrastructure is developed. The fair value of our physical commodity contracts incorporates risk premiums related to the satisfaction of conditions precedent, such as completion and placement into service of relevant pipeline infrastructure to accommodate marketable physical gas flow. A portion of our physical +64 +commodity contracts require us to make critical accounting estimates that involve significant judgment, as the fair value is developed through the use of internal models which incorporate significant unobservable inputs. In instances where observable data is unavailable, consideration is given to the assumptions that market participants would use in valuing the asset or liability. This includes assumptions about market risks, such as future prices of energy units for unobservable periods, liquidity, volatility and contract duration. +Gains and losses on derivative instruments are recognized in earnings. The ultimate fair value of our derivative instruments is uncertain, and we believe that it is reasonably possible that a change in the estimated fair value could occur in the near future as interest rates, commodity prices and FX rates change. +Recent Accounting Standards +For descriptions of recently issued accounting standards, see Note 2—Summary of Significant Accounting Policies of our Notes to Consolidated Financial Statements. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Marketing and Trading Commodity Price Risk +We have entered into commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the SPL Project , the CCL Project and potential future development of Corpus Christi Stage 3 (“Liquefaction Supply Derivatives”) . We have also entered into financial derivatives to hedge the exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG (“LNG Trading Derivatives”) . In order to test the sensitivity of the fair value of the Liquefaction Supply Derivatives and the LNG Trading Derivatives to changes in underlying commodity prices, management modeled a 10% change in the commodity price for natural gas for each delivery location and a 10% change in the commodity price for LNG, respectively, as follows (in millions): +December 31, 2019 +December 31, 2018 +Fair Value +Change in Fair Value +Fair Value +Change in Fair Value +Liquefaction Supply Derivatives +$ +149 +$ +179 +$ +(42 +) +$ +6 +LNG Trading Derivatives +165 +22 +(24 +) +9 +Interest Rate Risk +We are exposed to interest rate risk primarily when we incur debt related to project financing. Interest rate risk is managed in part by replacing outstanding floating-rate debt with fixed-rate debt with varying maturities. CCH has entered into interest rate swaps to hedge the exposure to volatility in a portion of the floating-rate interest payments under the CCH Credit Facility (“CCH Interest Rate Derivatives”) and to hedge against changes in interest rates that could impact anticipated future issuance of debt by CCH (“CCH Interest Rate Forward Start Derivatives”) . In order to test the sensitivity of the fair value of the CCH Interest Rate Derivatives to changes in interest rates, management modeled a 10% change in the forward one-month LIBOR curve across the remaining terms of the CCH Interest Rate Derivatives and CCH Interest Rate Forward Start Derivatives as follows (in millions): +December 31, 2019 +December 31, 2018 +Fair Value +Change in Fair Value +Fair Value +Change in Fair Value +CCH Interest Rate Derivatives +$ +(81 +) +$ +19 +$ +18 +$ +37 +CCH Interest Rate Forward Start Derivatives +(8 +) +15 +— +— +65 +Foreign Currency Exchange Risk +We have entered into foreign currency exchange (“FX”) contracts to hedge exposure to currency risk associated with operations in countries outside of the United States (“FX Derivatives”) . In order to test the sensitivity of the fair value of the FX Derivatives to changes in FX rates, management modeled a 10% change in FX rate between the U.S. dollar and the applicable foreign currencies as follows (in millions): +December 31, 2019 +December 31, 2018 +Fair Value +Change in Fair Value +Fair Value +Change in Fair Value +FX Derivatives +$ +4 +$ +— +$ +15 +$ +1 +See Note 7—Derivative Instruments for additional details about our derivative instruments. +66 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +CHENIERE ENERGY, INC. AND SUBSIDIARIES +Management’s Report to the Stockholders of Cheniere Energy, Inc. +68 +Reports of Independent Registered Public Accounting Firm +69 +Consolidated Balance Sheets +72 +Consolidated Statements of Operations +73 +Consolidated Statements of Stockholders’ Equity +74 +Consolidated Statements of Cash Flows +75 +Notes to Consolidated Financial Statements +76 +Supplemental Information to Consolidated Financial Statements—Summarized Quarterly Financial Data +118 +67 +MANAGEMENT’S REPORT TO THE STOCKHOLDERS OF CHENIERE ENERGY, INC. +Management’s Report on Internal Control Over Financial Reporting +As management, we are responsible for establishing and maintaining adequate internal control over financial reporting for Cheniere Energy, Inc. and its subsidiaries (“Cheniere”). In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we have conducted an assessment, including testing using the criteria in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Cheniere’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and, even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. +Based on our assessment, we have concluded that Cheniere maintained effective internal control over financial reporting as of December 31, 2019 , based on criteria in Internal Control—Integrated Framework (2013) issued by the COSO. +Cheniere’s independent registered public accounting firm, KPMG LLP, has issued an audit report on Cheniere’s internal control over financial reporting as of December 31, 2019 , which is contained in this Form 10-K. +Management’s Certifications +The certifications of Cheniere’s Chief Executive Officer and Chief Financial Officer required by the Sarbanes-Oxley Act of 2002 have been included as Exhibits 31 and 32 in Cheniere’s Form 10-K. +CHENIERE ENERGY, INC. +By: +/s/ Jack A. Fusco +By: +/s/ Michael J. Wortley +Jack A. Fusco +Michael J. Wortley +President and Chief Executive Officer +(Principal Executive Officer) +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +68 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and Board of Directors +Cheniere Energy, Inc.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of Cheniere Energy, Inc. and subsidiaries (the Company) as of December 31, 2019 and 2018 , the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2019 , and the related notes and financial statement schedule I (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018 , and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2019 , in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019 , based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 24, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Change in Accounting Principle +As discussed in Note 2 to the consolidated financial statements, the Company has changed its method of accounting for leases as of January 1, 2019 due to the adoption of ASU 2016-02, Leases (Topic 842), and subsequent amendments thereto. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgment. The communication of critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Fair value of the level 3 physical liquefaction supply derivatives +As discussed in note 7 to the consolidated financial statements, the Company recorded fair value of level 3 physical liquefaction supply derivatives of $138 million, as of December 31, 2019. The physical liquefaction supply derivatives consist of natural gas supply contracts for the operation of the liquefied natural gas facilities. The fair value of the Company’s level 3 physical liquefaction supply derivatives is developed through the use of internal models, using observable and unobservable market commodity prices. +We identified the evaluation of the fair value of the Company’s level 3 physical liquefaction supply derivatives as a critical audit matter. Specifically, there is subjectivity in certain assumptions used to estimate the fair value, such as the use of liquidity assumptions and adjustments for unobservable commodity prices. Additionally, the fair value for certain of the liquefaction +69 +supply derivatives is derived through the use of complex models, which include assumptions for unobservable commodity prices and volatility. +The primary procedures we performed to address this critical audit matter include the following. We tested certain internal controls over the valuation of the level 3 physical liquefaction supply derivatives. This included controls related to the assumptions for significant unobservable inputs and the fair value models. For the level 3 liquefaction supply derivatives selected, we involved valuation professionals with specialized skills who assisted in: +• Assessing the models and volatility used by the Company in its valuation by developing independent fair value estimates and comparing the independently developed estimates to the Company’s fair value estimates, and +• Testing the market unobservable forward price curve adjustments and liquidity assumptions by comparing to market data, such as quoted or published forward prices for similar commodities. +In addition, we evaluated the Company’s assumptions for unobservable commodity prices by comparing to market or third party data, such as adjustments for third party quoted transportation prices. +/s/ KPMG LLP +KPMG LLP +We have served as the Company’s auditor since 2014. +Houston, Texas +February 24, 2020 +70 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and Board of Directors +Cheniere Energy, Inc.: +Opinion on Internal Control Over Financial Reporting +We have audited Cheniere Energy, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2019 , based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019 , based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018 , the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2019 , and the related notes and financial statement schedule I (collectively, the consolidated financial statements), and our report dated February 24, 2020 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +KPMG LLP +Houston, Texas +February 24, 2020 +71 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS (1) +(in millions, except share data) +December 31, +2019 +2018 +ASSETS +Current assets +Cash and cash equivalents +$ +2,474 +$ +981 +Restricted cash +520 +2,175 +Accounts and other receivables +491 +585 +Inventory +312 +316 +Derivative assets +323 +63 +Other current assets +92 +114 +Total current assets +4,212 +4,234 +Property, plant and equipment, net +29,673 +27,245 +Operating lease assets, net +439 +— +Non-current derivative assets +174 +54 +Goodwill +77 +77 +Deferred tax assets +529 +8 +Other non-current assets, net +388 +369 +Total assets +$ +35,492 +$ +31,987 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities +Accounts payable +$ +66 +$ +58 +Accrued liabilities +1,281 +1,169 +Current debt +— +239 +Deferred revenue +161 +139 +Current operating lease liabilities +236 +— +Derivative liabilities +117 +128 +Other current liabilities +13 +9 +Total current liabilities +1,874 +1,742 +Long-term debt, net +30,774 +28,179 +Non-current operating lease liabilities +189 +— +Non-current finance lease liabilities +58 +57 +Non-current derivative liabilities +151 +22 +Other non-current liabilities +11 +58 +Commitments and contingencies (see Note 19) +Stockholders’ equity +Preferred stock, $0.0001 par value, 5.0 million shares authorized, none issued +— +— +Common stock, $0.003 par value, 480.0 million shares authorized +Issued: 270.7 million shares and 269.8 million shares at December 31, 2019 and 2018, respectively +Outstanding: 253.6 million shares and 257.0 million shares at December 31, 2019 and 2018, respectively +1 +1 +Treasury stock: 17.1 million shares and 12.8 million shares at December 31, 2019 and 2018, respectively, at cost +( 674 +) +( 406 +) +Additional paid-in-capital +4,167 +4,035 +Accumulated deficit +( 3,508 +) +( 4,156 +) +Total stockholders’ deficit +( 14 +) +( 526 +) +Non-controlling interest +2,449 +2,455 +Total equity +2,435 +1,929 +Total liabilities and stockholders’ equity +$ +35,492 +$ +31,987 +(1) +Amounts presented include balances held by our consolidated variable interest entity (“VIE”), Cheniere Partners, as further discussed in Note 9— Non-controlling Interest and Variable Interest Entity. As of December 31, 2019 , total assets and liabilities of Cheniere Partners, which are included in our Consolidated Balance Sheets, were $ 19.1 billion and $ 18.6 billion , respectively, including $ 1.8 billion of cash and cash equivalents and $ 0.2 billion of restricted cash. +The accompanying notes are an integral part of these consolidated financial statements. +72 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +(in millions, except per share data) +Year Ended December 31, +2019 +2018 +2017 +Revenues +LNG revenues +$ +9,246 +$ +7,572 +$ +5,317 +Regasification revenues +266 +261 +260 +Other revenues +218 +154 +24 +Total revenues +9,730 +7,987 +5,601 +Operating costs and expenses +Cost of sales (excluding depreciation and amortization expense shown separately below) +5,079 +4,597 +3,120 +Operating and maintenance expense +1,154 +613 +446 +Development expense +9 +7 +10 +Selling, general and administrative expense +310 +289 +256 +Depreciation and amortization expense +794 +449 +356 +Restructuring expense +— +— +6 +Impairment expense and loss on disposal of assets +23 +8 +19 +Total operating costs and expenses +7,369 +5,963 +4,213 +Income from operations +2,361 +2,024 +1,388 +Other income (expense) +Interest expense, net of capitalized interest +( 1,432 +) +( 875 +) +( 747 +) +Loss on modification or extinguishment of debt +( 55 +) +( 27 +) +( 100 +) +Derivative gain (loss), net +( 134 +) +57 +7 +Other income (expense) +( 25 +) +48 +18 +Total other expense +( 1,646 +) +( 797 +) +( 822 +) +Income before income taxes and non-controlling interest +715 +1,227 +566 +Income tax benefit (provision) +517 +( 27 +) +( 3 +) +Net income +1,232 +1,200 +563 +Less: net income attributable to non-controlling interest +584 +729 +956 +Net income (loss) attributable to common stockholders +$ +648 +$ +471 +$ +( 393 +) +Net income (loss) per share attributable to common stockholders—basic (1) +$ +2.53 +$ +1.92 +$ +( 1.68 +) +Net income (loss) per share attributable to common stockholders—diluted (1) +$ +2.51 +$ +1.90 +$ +( 1.68 +) +Weighted average number of common shares outstanding—basic +256.2 +245.6 +233.1 +Weighted average number of common shares outstanding—diluted +258.1 +248.0 +233.1 +(1) +Earnings per share in the table may not recalculate exactly due to rounding because it is calculated based on whole numbers, not the rounded numbers presented. +The accompanying notes are an integral part of these consolidated financial statements. +73 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(in millions) +Total Stockholders’ Equity +Common Stock +Treasury Stock +Additional Paid-in Capital +Accumulated Deficit +Non-controlling Interest +Total +Equity +Shares +Par Value Amount +Shares +Amount +Balance at December 31, 2016 +238.0 +$ +1 +12.2 +$ +( 374 +) +$ +3,211 +$ +( 4,234 +) +$ +2,235 +$ +839 +Issuances of restricted stock +0.1 +— +— +— +— +— +— +— +Issuance of stock to acquire additional interest in Cheniere Holdings +— +— +— +— +2 +— +( 2 +) +— +Forfeitures of restricted stock +( 0.2 +) +— +— +— +— +— +— +— +Share-based compensation +— +— +— +— +34 +— +— +34 +Shares withheld from employees related to share-based compensation, at cost +( 0.3 +) +— +0.3 +( 12 +) +— +— +— +( 12 +) +Net income attributable to non-controlling interest +— +— +— +— +— +— +956 +956 +Equity portion of convertible notes, net +— +— +— +— +1 +— +— +1 +Distributions and dividends to non-controlling interest +— +— +— +— +— +— +( 185 +) +( 185 +) +Net loss +— +— +— +— +— +( 393 +) +— +( 393 +) +Balance at December 31, 2017 +237.6 +1 +12.5 +( 386 +) +3,248 +( 4,627 +) +3,004 +1,240 +Vesting of restricted stock units +0.5 +— +— +— +— +— +— +— +Issuance of stock to acquire additional interest in Cheniere Holdings and other merger related adjustments +19.2 +— +— +— +694 +— +( 702 +) +( 8 +) +Share-based compensation +— +— +— +— +90 +— +— +90 +Shares withheld from employees related to share-based compensation, at cost +( 0.3 +) +— +0.3 +( 20 +) +— +— +— +( 20 +) +Net income attributable to non-controlling interest +— +— +— +— +— +— +729 +729 +Equity portion of convertible notes, net +— +— +— +— +3 +— +— +3 +Distributions and dividends to non-controlling interest +— +— +— +— +— +— +( 576 +) +( 576 +) +Net income +— +— +— +— +— +471 +— +471 +Balance at December 31, 2018 +257.0 +1 +12.8 +( 406 +) +4,035 +( 4,156 +) +2,455 +1,929 +Vesting of restricted stock units +0.9 +— +— +— +— +— +— +— +Share-based compensation +— +— +— +— +131 +— +— +131 +Shares withheld from employees related to share-based compensation, at cost +( 0.3 +) +— +0.3 +( 19 +) +— +— +— +( 19 +) +Shares repurchased, at cost +( 4.0 +) +— +4.0 +( 249 +) +— +— +— +( 249 +) +Net income attributable to non-controlling interest +— +— +— +— +— +— +584 +584 +Equity portion of convertible notes, net +— +— +— +— +1 +— +— +1 +Distributions and dividends to non-controlling interest +— +— +— +— +— +— +( 590 +) +( 590 +) +Net income +— +— +— +— +— +648 +— +648 +Balance at December 31, 2019 +253.6 +$ +1 +17.1 +$ +( 674 +) +$ +4,167 +$ +( 3,508 +) +$ +2,449 +$ +2,435 +The accompanying notes are an integral part of these consolidated financial statements. +74 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in millions) +Year Ended December 31, +2019 +2018 +2017 +Cash flows from operating activities +Net income +$ +1,232 +$ +1,200 +$ +563 +Adjustments to reconcile net income to net cash provided by operating activities: +Depreciation and amortization expense +794 +449 +356 +Share-based compensation expense +131 +113 +91 +Non-cash interest expense +143 +74 +75 +Amortization of debt issuance costs, deferred commitment fees, premium and discount +103 +69 +69 +Non-cash operating lease costs +350 +— +— +Loss on modification or extinguishment of debt +55 +27 +100 +Total losses (gains) on derivatives, net +( 400 +) +51 +62 +Net cash provided by (used for) settlement of derivative instruments +138 +17 +( 106 +) +Impairment expense and loss on disposal of assets +23 +8 +19 +Impairment or loss on equity method investments +88 +— +— +Deferred taxes +( 521 +) +( 5 +) +( 3 +) +Other +— +( 5 +) +( 1 +) +Changes in operating assets and liabilities: +Accounts and other receivables +1 +( 133 +) +( 141 +) +Inventory +11 +( 73 +) +( 73 +) +Other current assets +( 18 +) +( 15 +) +( 34 +) +Accounts payable and accrued liabilities +52 +188 +225 +Deferred revenue +22 +26 +34 +Operating lease liabilities +( 366 +) +— +— +Finance lease liabilities +1 +— +— +Other, net +( 6 +) +( 1 +) +( 5 +) +Net cash provided by operating activities +1,833 +1,990 +1,231 +Cash flows from investing activities +Property, plant and equipment, net +( 3,056 +) +( 3,643 +) +( 3,357 +) +Investment in equity method investment +( 105 +) +( 25 +) +( 41 +) +Other +( 2 +) +14 +17 +Net cash used in investing activities +( 3,163 +) +( 3,654 +) +( 3,381 +) +Cash flows from financing activities +Proceeds from issuances of debt +6,434 +4,285 +6,854 +Repayments of debt +( 4,346 +) +( 1,391 +) +( 3,632 +) +Debt issuance and deferred financing costs +( 51 +) +( 66 +) +( 89 +) +Debt extinguishment costs +( 15 +) +( 17 +) +— +Distributions and dividends to non-controlling interest +( 590 +) +( 576 +) +( 185 +) +Payments related to tax withholdings for share-based compensation +( 19 +) +( 20 +) +( 12 +) +Repurchase of common stock +( 249 +) +— +— +Other +4 +( 8 +) +— +Net cash provided by financing activities +1,168 +2,207 +2,936 +Net increase (decrease) in cash, cash equivalents and restricted cash +( 162 +) +543 +786 +Cash, cash equivalents and restricted cash—beginning of period +3,156 +2,613 +1,827 +Cash, cash equivalents and restricted cash—end of period +$ +2,994 +$ +3,156 +$ +2,613 +Balances per Consolidated Balance Sheets: +December 31, +2019 +2018 +Cash and cash equivalents +$ +2,474 +$ +981 +Restricted cash +520 +2,175 +Total cash, cash equivalents and restricted cash +$ +2,994 +$ +3,156 +The accompanying notes are an integral part of these consolidated financial statements. +75 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +NOTE 1— ORGANIZATION AND NATURE OF OPERATIONS +Cheniere, a Delaware corporation, is a Houston-based energy infrastructure company primarily engaged in LNG-related businesses. We are operating and constructing two natural gas liquefaction and export facilities at Sabine Pass and Corpus Christi. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners, through its subsidiary SPL, is currently operating five natural gas liquefaction Trains and is constructing one additional Train for a total production capacity of approximately 30 mtpa of LNG (the “SPL Project”) at the Sabine Pass LNG terminal. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks, two marine berths and vaporizers. Cheniere Partners also owns a 94 -mile pipeline that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”) through its subsidiary, CTPL. As of December 31, 2019 , we owned 100 % of the general partner interest and 48.6 % of the limited partner interest in Cheniere Partners. +The Corpus Christi LNG terminal is located near Corpus Christi, Texas and is operated and constructed by our subsidiary, CCL. We are currently operating two Trains and are constructing one additional Train for a total production capacity of approximately 15 mtpa of LNG. We also operate a 23 -mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the Trains, the “CCL Project”) through our subsidiary, CCP. The CCL Project , once fully constructed, will contain three LNG storage tanks and two marine berths. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) through our subsidiary CCL Stage III , for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. We received approval from FERC in November 2019 to site, construct and operate the expansion project. +We remain focused on operational excellence and customer satisfaction. Increasing demand of LNG has allowed us to expand our liquefaction infrastructure in a financially disciplined manner. We hold significant land positions at both the Sabine Pass LNG terminal and the Corpus Christi LNG terminal which provide opportunity for further liquefaction capacity expansion. The development of these sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we make a final investment decision (“FID”) . +NOTE 2— SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +Our Consolidated Financial Statements have been prepared in accordance with GAAP . The Consolidated Financial Statements include the accounts of Cheniere, its majority owned subsidiaries and entities in which it holds a controlling interest, including the accounts of Cheniere Partners and its wholly owned subsidiaries. For those consolidated subsidiaries in which our ownership is less than 100%, the portion of the net income or loss attributable to the non-controlling interest is reported as net income (loss) attributable to non-controlling interest on our Consolidated Statement of Operations. All significant intercompany accounts and transactions have been eliminated in consolidation. Investments in non-controlled entities, over which Cheniere has the ability to exercise significant influence over operating and financial policies, are accounted for using the equity method of accounting, with our share of earnings or losses reported in other income (expense) on our Consolidated Statement of Operations. In applying the equity method of accounting, the investments are initially recognized at cost, and subsequently adjusted for our proportionate share of earnings, losses and distributions. Investments accounted for using the equity method of accounting are reported as a component of other noncurrent assets. +We make a determination at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a variable interest entity (“VIE”). Generally, a VIE is an entity that does not have sufficient equity at risk to finance its activities without additional subordinated financial support from other parties, whose equity investors lack any characteristics of a controlling financial interest or which was established with non-substantive voting. We consolidate VIEs when we are deemed to be the primary beneficiary. The primary beneficiary of a VIE is generally the party that both: (1) has the power to make decisions that most significantly affect the economic performance of the VIE and (2) has the +76 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. If we are not deemed to be the primary beneficiary of a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP . +Certain reclassifications have been made to conform prior period information to the current presentation. The reclassifications did not have a material effect on our consolidated financial position, results of operations or cash flows. +Recent Accounting Standards +We adopted Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842) , and subsequent amendments thereto (“ASC 842”) on January 1, 2019 using the optional transition approach to apply the standard at the beginning of the first quarter of 2019 with no retrospective adjustments to prior periods. The adoption of the standard resulted in the recognition of right-of-use assets and lease liabilities for operating leases of approximately $ 550 million on our Consolidated Balance Sheets, with no material impact on our Consolidated Statements of Operations or Consolidated Statements of Cash Flows. We have elected the practical expedients to (1) carryforward prior conclusions related to lease identification and classification for existing leases, (2) combine lease and non-lease components of an arrangement for all classes of leased assets, (3) omit short-term leases with a term of 12 months or less from recognition on the balance sheet and (4) carryforward our existing accounting for land easements not previously accounted for as leases. See Note 12—Leases for additional information on our leases following the adoption of this standard. +In December 2019, the Financial Accounting Standards Board (“FASB”) issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes . The new guidance is designed to simplify the accounting for income taxes by removing certain exceptions related to the general principles in ASU 740, Income Taxes , and to clarify and simplify other aspects of the accounting for income taxes. This guidance changes the methodology for calculating income taxes in an interim period by prospectively requiring reflection of enacted changes in tax laws or rates in the interim period in which such change is enacted. We early adopted this guidance effective December 31, 2019. The adoption of this guidance did not have an impact on our Consolidated Financial Statements or related disclosures. +Use of Estimates +The preparation of Consolidated Financial Statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Management evaluates its estimates and related assumptions regularly, including those related to fair value measurements, revenue recognition, property, plant and equipment, derivative instruments, leases, goodwill, asset retirement obligations (“AROs”) , share-based compensation and income taxes including valuation allowances for deferred tax assets, as further discussed under the respective sections within this note. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. +Fair Value Measurements +Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Hierarchy Levels 1, 2 and 3 are terms for the priority of inputs to valuation approaches used to measure fair value. Hierarchy Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Hierarchy Level 2 inputs are inputs that are directly or indirectly observable for the asset or liability, other than quoted prices included within Level 1. Hierarchy Level 3 inputs are inputs that are not observable in the market. +In determining fair value, we use observable market data when available, or models that incorporate observable market data. In addition to market information, we incorporate transaction-specific details that, in management’s judgment, market participants would take into account in measuring fair value. We maximize the use of observable inputs and minimize our use of unobservable inputs in arriving at fair value estimates. +Recurring fair-value measurements are performed for derivative instruments as disclosed in Note 7—Derivative Instruments . The carrying amount of cash and cash equivalents, restricted cash, accounts receivable and accounts payable reported on the Consolidated Balance Sheets approximates fair value. The fair value of debt is the estimated amount we would have to pay to repurchase our debt in the open market, including any premium or discount attributable to the difference between the stated interest rate and market interest rate at each balance sheet date. Debt fair values, as disclosed in Note 11—Debt , are based on quoted +77 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +market prices for identical instruments, if available, or based on valuations of similar debt instruments using observable or unobservable inputs. Non-financial assets and liabilities initially measured at fair value include intangible assets, goodwill and AROs. +Revenue Recognition +We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. Revenues from the sale of LNG are recognized as LNG revenues, including LNG revenues generated by our integrated marketing function which are reported on a gross or net basis based on an assessment of whether it is acting as the principal or the agent in the transaction. LNG regasification capacity payments are recognized as regasification revenues. See Note 13—Revenues from Contracts with Customers for further discussion of revenues. +Cash and Cash Equivalents +We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. +Restricted Cash +Restricted cash consists of funds that are contractually or legally restricted as to usage or withdrawal and have been presented separately from cash and cash equivalents on our Consolidated Balance Sheets. +Accounts and Notes Receivable +Accounts and notes receivable are reported net of any allowances for doubtful accounts. Notes receivable that are not classified as trade receivables are recorded within other current assets in our Consolidated Balance Sheets, net of any allowances for doubtful accounts. We periodically review the collectability on our accounts receivable and recognize an allowance if there is probability of non-collection, based on historical write-off and customer-specific factors. As of December 31, 2019 and 2018 , we had an allowance on our accounts and notes receivable of zero and $ 30 million , respectively. +Inventory +LNG and natural gas inventory are recorded at the lower of weighted average cost and net realizable value. Materials and other inventory are recorded at the lower of cost and net realizable value and subsequently charged to expense when issued. +Accounting for LNG Activities +Generally, we begin capitalizing the costs of our LNG terminals once the individual project meets the following criteria: (1) regulatory approval has been received, (2) financing for the project is available and (3) management has committed to commence construction. Prior to meeting these criteria, most of the costs associated with a project are expensed as incurred. These costs primarily include professional fees associated with preliminary front-end engineering and design work, costs of securing necessary regulatory approvals and other preliminary investigation and development activities related to our LNG terminals. +Generally, costs that are capitalized prior to a project meeting the criteria otherwise necessary for capitalization include: land acquisition costs, detailed engineering design work and certain permits that are capitalized as other non-current assets. The costs of lease options are amortized over the life of the lease once obtained. If no land or lease is obtained, the costs are expensed. +Property, Plant and Equipment +Property, plant and equipment are recorded at cost. Expenditures for construction and commissioning activities, major renewals and betterments that extend the useful life of an asset are capitalized, while expenditures for maintenance and repairs (including those for planned major maintenance projects) to maintain property, plant and equipment in operating condition are generally expensed as incurred. We realize offsets to LNG terminal costs for sales of commissioning cargoes that were earned or loaded prior to the start of commercial operations of the respective Train during the testing phase for its construction. We depreciate our property, plant and equipment using the straight-line depreciation method. Upon retirement or other disposition of property, +78 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +plant and equipment, the cost and related accumulated depreciation are removed from the account, and the resulting gains or losses are recorded in impairment expense and loss (gain) on disposal of assets. +Management tests property, plant and equipment for impairment whenever events or changes in circumstances have indicated that the carrying amount of property, plant and equipment might not be recoverable. Assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets for purposes of assessing recoverability. Recoverability generally is determined by comparing the carrying value of the asset to the expected undiscounted future cash flows of the asset. If the carrying value of the asset is not recoverable, the amount of impairment loss is measured as the excess, if any, of the carrying value of the asset over its estimated fair value. +During the year ended December 31, 2017, we recognized $ 6 million of impairment expense related to damaged infrastructure as an effect of Hurricane Harvey and $ 6 million of impairment expense related to write down of assets used in non-core operations outside of our liquefaction activities. +Interest Capitalization +We capitalize interest costs during the construction period of our LNG terminals and related assets as construction-in-process. Upon commencement of operations, these costs are transferred out of construction-in-process into terminal and interconnecting pipeline facilities assets and are amortized over the estimated useful life of the asset. +Regulated Natural Gas Pipelines +The Creole Trail Pipeline and Corpus Christi Pipeline are subject to the jurisdiction of the FERC in accordance with the Natural Gas Act of 1938 and the Natural Gas Policy Act of 1978. The economic effects of regulation can result in a regulated company recording as assets those costs that have been or are expected to be approved for recovery from customers, or recording as liabilities those amounts that are expected to be required to be returned to customers, in a rate-setting process in a period different from the period in which the amounts would be recorded by an unregulated enterprise. Accordingly, we record assets and liabilities that result from the regulated rate-making process that may not be recorded under GAAP for non-regulated entities. We continually assess whether regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes and recent rate orders applicable to other regulated entities. Based on this continual assessment, we believe the existing regulatory assets are probable of recovery. These regulatory assets and liabilities are primarily classified in our Consolidated Balance Sheets as other assets and other liabilities. We periodically evaluate their applicability under GAAP and consider factors such as regulatory changes and the effect of competition. If cost-based regulation ends or competition increases, we may have to reduce our asset balances to reflect a market basis less than cost and write off the associated regulatory assets and liabilities. +Items that may influence our assessment are: +• +inability to recover cost increases due to rate caps and rate case moratoriums; +• +inability to recover capitalized costs, including an adequate return on those costs through the rate-making process and the FERC proceedings; +• +excess capacity; +• +increased competition and discounting in the markets we serve; and +• +impacts of ongoing regulatory initiatives in the natural gas industry. +Natural gas pipeline costs include amounts capitalized as an Allowance for Funds Used During Construction (“AFUDC”). The rates used in the calculation of AFUDC are determined in accordance with guidelines established by the FERC. AFUDC represents the cost of debt and equity funds used to finance our natural gas pipeline additions during construction. AFUDC is capitalized as a part of the cost of our natural gas pipelines. Under regulatory rate practices, we generally are permitted to recover AFUDC, and a fair return thereon, through our rate base after our natural gas pipelines are placed in service. +Derivative Instruments +We use derivative instruments to hedge our exposure to cash flow variability from interest rate, commodity price and foreign currency exchange (“FX”) rate risk. Derivative instruments are recorded at fair value and included in our Consolidated Balance Sheets as assets or liabilities depending on the derivative position and the expected timing of settlement, unless they satisfy criteria +79 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +for, and we elect, the normal purchases and sales exception. When we have the contractual right and intend to net settle, derivative assets and liabilities are reported on a net basis. +Changes in the fair value of our derivative instruments are recorded in earnings, unless we elect to apply hedge accounting and meet specified criteria. We did no t have any derivative instruments designated as cash flow or fair value hedges during the years ended December 31, 2019, 2018 and 2017 . See Note 7—Derivative Instruments for additional details about our derivative instruments. +Leases +Following the adoption of ASC 842, we determine if an arrangement is, or contains, a lease at inception of the arrangement. When we determine the arrangement is, or contains, a lease, we classify the lease as either an operating lease or a finance lease. Operating and finance leases are recognized on our Consolidated Balance Sheets by recording a lease liability representing the obligation to make future lease payments and a right-of-use asset representing the right to use the underlying asset for the lease term. Operating and finance lease right-of-use assets and liabilities are generally recognized based on the present value of lease payments over the lease term. In determining the present value of lease payments, we use the implicit interest rate in the lease if readily determinable. In the absence of a readily determinable implicitly interest rate, we discount our expected future lease payments using our relevant subsidiary’s incremental borrowing rate. The incremental borrowing rate is an estimate of the interest rate that a given subsidiary would have to pay to borrow on a collateralized basis over a similar term to that of the lease term. Options to renew a lease are included in the lease term and recognized as part of the right-of-use asset and lease liability, only to the extent they are reasonably certain to be exercised. We have elected practical expedients to (1) omit leases with an initial term of 12 months or less from recognition on our balance sheet and (2) to combine both the lease and non-lease components of an arrangement in calculating the right-of-use asset and lease liability for all classes of leased assets. +Lease expense for operating lease payments is recognized on a straight-line basis over the lease term. Lease expense for finance leases is recognized as the sum of the amortization of the right-of-use assets on a straight-line basis and the interest on lease liabilities using the effective interest method over the lease term. +Operating leases are included in operating lease assets, net, current operating lease liabilities and non-current operating lease liabilities on our Consolidated Balance Sheets. Finance leases are included in property, plant and equipment, net, other current liabilities and non-current finance lease liabilities on our Consolidated Balance Sheets. See Note 12—Leases for additional details about our leases. +Concentration of Credit Risk +Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents, restricted cash, derivative instruments and accounts receivable. We maintain cash balances at financial institutions, which may at times be in excess of federally insured levels. We have not incurred losses related to these balances to date. +The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. Certain of our commodity derivative transactions are executed through over-the-counter contracts which are subject to nominal credit risk as these transactions are settled on a daily margin basis with investment grade financial institutions. Collateral deposited for such contracts is recorded within other current assets. Our interest rate and FX derivative instruments are placed with investment grade financial institutions whom we believe are acceptable credit risks. We monitor counterparty creditworthiness on an ongoing basis; however, we cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, we may be limited in our ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, we may not realize the benefit of some of our derivative instruments. +SPL has entered into fixed price long-term SPAs generally with terms of 20 years with eight third parties, CCL has entered into fixed price long-term SPAs generally with terms of 20 years with nine third parties and our integrated marketing function has entered into a limited number of long-term SPAs with third parties. We are dependent on the respective customers’ creditworthiness and their willingness to perform under their respective SPAs. See Note 20—Customer Concentration for additional details about our customer concentration. +SPLNG has entered into two long-term TUAs with third parties for regasification capacity at the Sabine Pass LNG terminal. SPLNG is dependent on the respective customers’ creditworthiness and their willingness to perform under their respective TUAs. +80 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +SPLNG has mitigated this credit risk by securing TUAs for a significant portion of its regasification capacity with creditworthy third-party customers with a minimum Standard & Poor’s rating of A. +Goodwill +Goodwill is the excess of acquisition cost of a business over the estimated fair value of net assets acquired. Goodwill is not amortized but is tested for impairment at least annually or more frequently if events or circumstances indicate goodwill is more likely than not impaired. Goodwill impairment evaluation requires a comparison of the estimated fair value of a reporting unit to its carrying value. Cheniere tests goodwill for impairment by either performing a qualitative assessment or a quantitative test. The qualitative assessment is an assessment of historical information and relevant events and circumstances to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. Cheniere may elect not to perform the qualitative assessment and instead perform a quantitative impairment test. Significant judgment is required in estimating the fair value of the reporting unit and performing quantitative goodwill impairment tests. +We completed our annual assessment of goodwill impairment as of October 1st by performing a qualitative assessment; the tests indicated it is more likely than not that there was no impairment. Our last quantitative assessment indicated that the reporting unit’s fair value substantially exceeded its carrying value. As discussed above regarding our use of estimates, our judgments and assumptions are inherent in our estimate of future cash flows used to determine the estimate of the reporting unit’s fair value. The use of alternate judgments and/or assumptions could result in the recognition of impairment charges in the Consolidated Financial Statements. A lower fair value estimate in the future for our reporting unit could result in an impairment of goodwill. Factors that could trigger a lower fair value estimate include significant negative industry or economic trends, cost increases, disruptions to our business, regulatory or political environment changes or other unanticipated events. +Debt +Our debt consists of current and long-term secured and unsecured debt securities, convertible debt securities and credit facilities with banks and other lenders. Debt issuances are placed directly by us or through securities dealers or underwriters and are held by institutional and retail investors. +Debt is recorded on our Consolidated Balance Sheets at par value adjusted for unamortized discount or premium and net of unamortized debt issuance costs related to term notes. Debt issuance costs consist primarily of arrangement fees, professional fees, legal fees and printing costs. If debt issuance costs are incurred in connection with a line of credit arrangement or on undrawn funds, they are presented as an asset on our Consolidated Balance Sheets. Discounts, premiums and debt issuance costs directly related to the issuance of debt are amortized over the life of the debt and are recorded in interest expense, net of capitalized interest using the effective interest method. Gains and losses on the extinguishment or modification of debt are recorded in gain (loss) on modification or extinguishment of debt on our Consolidated Statements of Operations. +Asset Retirement Obligations +We recognize AROs for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset and for conditional AROs in which the timing or method of settlement are conditional on a future event that may or may not be within our control. The fair value of a liability for an ARO is recognized in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is depreciated over the estimated useful life of the asset. +We have no t recorded an ARO associated with the Sabine Pass LNG terminal. Based on the real property lease agreements at the Sabine Pass LNG terminal, at the expiration of the term of the leases we are required to surrender the LNG terminal in good working order and repair, with normal wear and tear and casualty expected. Our property lease agreements at the Sabine Pass LNG terminal have terms of up to 90 years including renewal options. We have determined that the cost to surrender the Sabine Pass LNG terminal in good order and repair, with normal wear and tear and casualty expected, is immaterial. +We have no t recorded an ARO associated with the Creole Trail Pipeline or the Corpus Christi Pipeline. We believe that it is not feasible to predict when the natural gas transportation services provided by the Creole Trail Pipeline or the Corpus Christi Pipeline will no longer be utilized. In addition, our right-of-way agreements associated with the Creole Trail Pipeline and the Corpus Christi Pipeline have no stipulated termination dates. We intend to operate the Creole Trail Pipeline and the Corpus Christi Pipeline as long as supply and demand for natural gas exists in the United States and intend to maintain it regularly. +81 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Share-based Compensation +We have awarded share-based compensation in the form of stock, restricted stock, restricted stock units, performance stock units and phantom units that are more fully described in Note 15—Share-based Compensation . We recognize share-based compensation based upon the estimated fair value of awards. The recognition period for these costs begins at either the applicable service inception date or grant date and continues throughout the requisite service period. For equity-classified share-based compensation awards (which include stock, restricted stock, restricted stock units and performance stock units to employees and non-employee directors), compensation cost is recognized based on the grant-date fair value and not subsequently remeasured unless modified. The fair value is recognized as expense (net of any capitalization) using the straight-line basis for awards that vest based solely on service conditions and using the accelerated recognition method for awards that vest based on performance conditions. For awards with both time and performance-based conditions, we generally recognize compensation cost based on the probable outcome of the performance condition at each reporting period. For liability-classified share-based compensation awards (which include phantom units), compensation costs are remeasured at fair value through settlement or maturity. We account for forfeitures as they occur. +Non-controlling Interests +When we consolidate a subsidiary, we include 100% of the assets, liabilities, revenues and expenses of the subsidiary in our Consolidated Financial Statements, even if we own less than 100% of the subsidiary. Non-controlling interests represent third-party ownership in the net assets of our consolidated subsidiaries and are presented as a component of equity. Changes in our ownership interests in subsidiaries that do not result in deconsolidation are generally recognized within equity. See Note 9—Non-controlling Interest and Variable Interest Entities for additional details about our non-controlling interest. +Income Taxes +Provisions for income taxes are based on taxes payable or refundable for the current year and deferred taxes on temporary differences between the tax basis of assets and liabilities and their reported amounts in our Consolidated Financial Statements. Deferred tax assets and liabilities are included in our Consolidated Financial Statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the current period’s provision for income taxes. A valuation allowance is recorded to reduce the carrying value of our deferred tax assets when it is more likely than not that a portion or all of the deferred tax assets will expire before realization of the benefit or future deductibility is not probable. +We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the tax position. +Net Income (Loss) Per Share +Net income (loss) per share attributable to common stockholders (“EPS”) is computed in accordance with GAAP. Basic EPS excludes dilution and is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS reflects potential dilution and is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period increased by the number of additional common shares that would have been outstanding if the potential common shares had been issued. The dilutive effect of unvested stock is calculated using the treasury-stock method and the dilutive effect of convertible securities is calculated using the if-converted method. +Business Segment +We have determined that we operate as a single operating and reportable segment. Our chief operating decision maker makes resource allocation decisions and assesses performance based on financial information presented on a consolidated basis in the delivery of an integrated source of LNG to our customers. +82 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 3— RESTRICTED CASH +Restricted cash consists of funds that are contractually or legally restricted as to usage or withdrawal and have been presented separately from cash and cash equivalents on our Consolidated Balance Sheets. As of December 31, 2019 and 2018 , restricted cash consisted of the following (in millions): +December 31, +2019 +2018 +Current restricted cash +SPL Project +$ +181 +$ +756 +Cheniere Partners and cash held by guarantor subsidiaries +— +785 +CCL Project +80 +289 +Cash held by our subsidiaries restricted to Cheniere +259 +345 +Total current restricted cash +$ +520 +$ +2,175 +Pursuant to the accounts agreements entered into with the collateral trustees for the benefit of SPL’s debt holders and CCH’s debt holders, SPL and CCH are required to deposit all cash received into reserve accounts controlled by the collateral trustees. The usage or withdrawal of such cash is restricted to the payment of liabilities related to the SPL Project and the CCL Project (collectively, the “Liquefaction Projects”) and other restricted payments. +The cash held by Cheniere Partners and its guarantor subsidiaries was restricted in use under the terms of the previous $ 2.8 billion credit facilities (the “2016 CQP Credit Facilities”) and the related depositary agreement governing the extension of credit to Cheniere Partners, but is no longer restricted following the termination of the 2016 CQP Credit Facilities in May 2019. +NOTE 4— ACCOUNTS AND OTHER RECEIVABLES +As of December 31, 2019 and 2018 , accounts and other receivables consisted of the following (in millions): +December 31, +2019 +2018 +Trade receivables +SPL and CCL +$ +328 +$ +330 +Cheniere Marketing +113 +205 +Other accounts receivable +50 +50 +Total accounts and other receivables +$ +491 +$ +585 +NOTE 5— INVENTORY +As of December 31, 2019 and 2018 , inventory consisted of the following (in millions): +December 31, +2019 +2018 +Natural gas +$ +16 +$ +30 +LNG +67 +24 +LNG in-transit +93 +173 +Materials and other +136 +89 +Total inventory +$ +312 +$ +316 +83 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 6— PROPERTY, PLANT AND EQUIPMENT +As of December 31, 2019 and 2018 , property, plant and equipment, net consisted of the following (in millions): +December 31, +2019 +2018 +LNG terminal costs +LNG terminal and interconnecting pipeline facilities +$ +27,305 +$ +13,386 +LNG site and related costs +322 +86 +LNG terminal construction-in-process +3,903 +14,864 +Accumulated depreciation +( 2,049 +) +( 1,299 +) +Total LNG terminal costs, net +29,481 +27,037 +Fixed assets and other +Computer and office equipment +23 +17 +Furniture and fixtures +22 +22 +Computer software +110 +100 +Leasehold improvements +42 +41 +Land +59 +59 +Other +21 +21 +Accumulated depreciation +( 141 +) +( 111 +) +Total fixed assets and other, net +136 +149 +Assets under finance lease +Tug vessels +60 +60 +Accumulated depreciation +( 4 +) +( 1 +) +Total assets under finance lease, net +56 +59 +Property, plant and equipment, net +$ +29,673 +$ +27,245 +Depreciation expense was $ 788 million , $ 445 million and $ 354 million during the years ended December 31, 2019, 2018 and 2017 , respectively. +We realized offsets to LNG terminal costs of $ 301 million , $ 140 million and $ 320 million during the years ended December 31, 2019, 2018 and 2017 , respectively, that were related to the sale of commissioning cargoes because these amounts were earned or loaded prior to the start of commercial operations of the respective Trains of the Liquefaction Projects , during the testing phase for its construction. +LNG Terminal Costs +Our LNG terminals are depreciated using the straight-line depreciation method applied to groups of LNG terminal assets with varying useful lives. The identifiable components of our LNG terminals have depreciable lives between 7 and 50 years , as follows: +Components +Useful life (yrs) +LNG storage tanks +50 +Natural gas pipeline facilities +40 +Marine berth, electrical, facility and roads +35 +Water pipelines +30 +Regasification processing equipment +30 +Sendout pumps +20 +Liquefaction processing equipment +7-50 +Other +10-30 +Fixed Assets and Other +Our fixed assets and other are recorded at cost and are depreciated on a straight-line method based on estimated lives of the individual assets or groups of assets. +84 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 7— DERIVATIVE INSTRUMENTS +We have entered into the following derivative instruments that are reported at fair value: +• +interest rate swaps to hedge the exposure to volatility in a portion of the floating-rate interest payments under CCH’s credit facilities (“CCH Interest Rate Derivatives”) and to hedge against changes in interest rates that could impact anticipated future issuance of debt by CCH (“CCH Interest Rate Forward Start Derivatives”) ; +• +commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the Liquefaction Projects and potential future development of Corpus Christi Stage 3 (“Physical Liquefaction Supply Derivatives”) and associated economic hedges (collectively, the “Liquefaction Supply Derivatives”) ; +• +financial derivatives to hedge the exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG (“LNG Trading Derivatives”) ; and +• +foreign currency exchange (“FX”) contracts to hedge exposure to currency risk associated with both LNG Trading Derivatives and operations in countries outside of the United States (“FX Derivatives”) . +We recognize our derivative instruments as either assets or liabilities and measure those instruments at fair value. None of our derivative instruments are designated as cash flow or fair value hedging instruments, and changes in fair value are recorded within our Consolidated Statements of Operations to the extent not utilized for the commissioning process. +The following table shows the fair value of our derivative instruments that are required to be measured at fair value on a recurring basis as of December 31, 2019 and 2018 , which are classified as derivative assets , non-current derivative assets , derivative liabilities or non-current derivative liabilities in our Consolidated Balance Sheets (in millions): +Fair Value Measurements as of +December 31, 2019 +December 31, 2018 +Quoted Prices in Active Markets +(Level 1) +Significant Other Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Quoted Prices in Active Markets +(Level 1) +Significant Other Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +CCH Interest Rate Derivatives asset (liability) +$ +— +$ +( 81 +) +$ +— +$ +( 81 +) +$ +— +$ +18 +$ +— +$ +18 +CCH Interest Rate Forward Start Derivatives liability +— +( 8 +) +— +( 8 +) +— +— +— +— +Liquefaction Supply Derivatives asset (liability) +5 +6 +138 +149 +6 +( 19 +) +( 29 +) +( 42 +) +LNG Trading Derivatives asset (liability) +— +165 +— +165 +1 +( 25 +) +— +( 24 +) +FX Derivatives asset +— +4 +— +4 +— +15 +— +15 +We value our CCH Interest Rate Derivatives and CCH Interest Rate Forward Start Derivatives using an income-based approach utilizing observable inputs to the valuation model including interest rate curves, risk adjusted discount rates, credit spreads and other relevant data. We value our LNG Trading Derivatives and our Liquefaction Supply Derivatives using a market or option-based approach incorporating present value techniques, as needed, using observable commodity price curves, when available, and other relevant data. We value our FX Derivatives with a market approach using observable FX rates and other relevant data. +The fair value of our Physical Liquefaction Supply Derivatives is predominantly driven by observable and unobservable market commodity prices and, as applicable to our natural gas supply contracts, our assessment of the associated events deriving fair value, including evaluating whether the respective market is available as pipeline infrastructure is developed. The fair value of our Physical Liquefaction Supply Derivatives incorporates risk premiums related to the satisfaction of conditions precedent, such as completion and placement into service of relevant pipeline infrastructure to accommodate marketable physical gas flow. As of December 31, 2019 and 2018 , some of our Physical Liquefaction Supply Derivatives existed within markets for which the pipeline infrastructure was under development to accommodate marketable physical gas flow. +We include a portion of our Physical Liquefaction Supply Derivatives as Level 3 within the valuation hierarchy as the fair value is developed through the use of internal models which incorporate significant unobservable inputs. In instances where observable data is unavailable, consideration is given to the assumptions that market participants would use in valuing the asset +85 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +or liability. This includes assumptions about market risks, such as future prices of energy units for unobservable periods, liquidity, volatility and contract duration. +The Level 3 fair value measurements of natural gas positions within our Physical Liquefaction Supply Derivatives could be materially impacted by a significant change in certain natural gas and international LNG prices. The following table includes quantitative information for the unobservable inputs for our Level 3 Physical Liquefaction Supply Derivatives as of December 31, 2019 : +Net Fair Value Asset +(in millions) +Valuation Approach +Significant Unobservable Input +Significant Unobservable Inputs Range +Physical Liquefaction Supply Derivatives +$ 138 +Market approach incorporating present value techniques +Henry Hub basis spread +$(0.718) - $0.058 +Option pricing model +International LNG pricing spread, relative to Henry Hub (1) +86% - 213% +(1) Spread contemplates U.S. dollar-denominated pricing. +Increases or decreases in basis or pricing spreads, in isolation, would decrease or increase, respectively, the fair value of our Physical Liquefaction Supply Derivatives . +The following table shows the changes in the fair value of our Level 3 Physical Liquefaction Supply Derivatives during the years ended December 31, 2019, 2018 and 2017 (in millions): +Year Ended December 31, +2019 +2018 +2017 +Balance, beginning of period +$ +( 29 +) +$ +43 +$ +79 +Realized and mark-to-market gains (losses): +Included in cost of sales +( 77 +) +( 13 +) +( 37 +) +Purchases and settlements: +Purchases +199 +( 31 +) +14 +Settlements +44 +( 29 +) +( 12 +) +Transfers out of Level 3 (1) +1 +1 +( 1 +) +Balance, end of period +$ +138 +$ +( 29 +) +$ +43 +Change in unrealized losses relating to instruments still held at end of period +$ +( 77 +) +$ +( 13 +) +$ +( 37 +) +(1) Transferred to Level 2 as a result of observable market for the underlying natural gas purchase agreements. +Derivative assets and liabilities arising from our derivative contracts with the same counterparty are reported on a net basis, as all counterparty derivative contracts provide for the unconditional right of set-off in the event of default. The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments in instances when our derivative instruments are in an asset position. Additionally, counterparties are at risk that we will be unable to meet our commitments in instances where our derivative instruments are in a liability position. We incorporate both our own nonperformance risk and the respective counterparty’s nonperformance risk in fair value measurements. In adjusting the fair value of our derivative contracts for the effect of nonperformance risk, we have considered the impact of any applicable credit enhancements, such as collateral postings, set-off rights and guarantees. +Interest Rate Derivatives +CCH has entered into interest rate swaps to protect against volatility of future cash flows and hedge a portion of the variable interest payments on its amended and restated credit facility (the “CCH Credit Facility”) . +In June and July of 2019, we entered into CCH Interest Rate Forward Start Derivatives to hedge against changes in interest rates that could impact anticipated future issuance of debt by CCH, which is anticipated by the end of 2020. In November 2019, CCH settled a portion of the CCH Interest Rate Forward Start Derivatives in conjunction with the prepayment of $ 1.5 billion of +86 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +commitments under the CCH Credit Facility . In June 2018, CCH settled a portion of the CCH Interest Rate Derivatives in conjunction with the amendment of the CCH Credit Facility. +Cheniere Partners previously had interest rate swaps (“CQP Interest Rate Derivatives”) to hedge a portion of the variable interest payments on its credit facilities. In October 2018, Cheniere Partners terminated the CQP Interest Rate Derivatives related to the 2016 CQP Credit Facilities. +In March 2017, SPL previously had interest rate swaps (“SPL Interest Rate Derivatives” and, collectively with the CCH Interest Rate Derivatives, the CCH Interest Rate Forward Start Derivatives and the CQP Interest Rate Derivatives, the “Interest Rate Derivatives”) to protect against volatility of future cash flows and hedge a portion of the variable interest payments on the credit facilities it entered into in June 2015. +As of December 31, 2019 , we had the following Interest Rate Derivatives outstanding: +Notional Amounts +December 31, 2019 +December 31, 2018 +Effective Date +Maturity Date +Weighted Average Fixed Interest Rate Paid +Variable Interest Rate Received +CCH Interest Rate Derivatives +$ 4.5 billion +$ 4.0 billion +May 20, 2015 +May 31, 2022 +2.30 % +One-month LIBOR +CCH Interest Rate Forward Start Derivatives +$ 750 million +— +September 30, 2020 +December 31, 2030 +2.06 % +Three-month LIBOR +The following table shows the fair value and location of the Interest Rate Derivatives on our Consolidated Balance Sheets (in millions): +December 31, 2019 +December 31, 2018 +CCH Interest Rate Derivatives +CCH Interest Rate Forward Start Derivatives +Total +CCH Interest Rate Derivatives +CCH Interest Rate Forward Start Derivatives +Total +Consolidated Balance Sheet Location +Derivative assets +$ +— +$ +— +$ +— +$ +10 +$ +— +$ +10 +Non-current derivative assets +— +— +— +8 +— +8 +Total derivative assets +— +— +— +18 +— +18 +Derivative liabilities +( 32 +) +( 8 +) +( 40 +) +— +— +— +Non-current derivative liabilities +( 49 +) +— +( 49 +) +— +— +— +Total derivative liabilities +( 81 +) +( 8 +) +( 89 +) +— +— +— +Derivative asset (liability), net +$ +( 81 +) +$ +( 8 +) +$ +( 89 +) +$ +18 +$ +— +$ +18 +The following table shows the changes in the fair value and settlements of our Interest Rate Derivatives recorded in derivative gain (loss), net on our Consolidated Statements of Operations during the years ended December 31, 2019, 2018 and 2017 (in millions): +Year Ended December 31, +2019 +2018 +2017 +CCH Interest Rate Derivatives gain (loss) +$ +( 101 +) +$ +43 +$ +3 +CCH Interest Rate Forward Start Derivatives loss +( 33 +) +— +— +CQP Interest Rate Derivatives gain +— +14 +6 +SPL Interest Rate Derivatives loss +— +— +( 2 +) +Commodity Derivatives +SPL, CCL and CCL Stage III have entered into physical natural gas supply contracts and associated economic hedges to purchase natural gas for the commissioning and operation of the Liquefaction Projects and potential future development of Corpus Christi Stage 3, respectively, which are primarily indexed to the natural gas market and international LNG indices. The remaining +87 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +terms of the index-based physical natural gas supply contracts range up to approximately 15 years , some of which commence upon the satisfaction of certain events or states of affairs. +We have entered into, and may from time to time enter into, financial LNG Trading Derivatives in the form of swaps, forwards, options or futures to economically hedge exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG. We have entered into LNG Trading Derivatives to secure a fixed price position to minimize future cash flow variability associated with LNG purchase and sale transactions. +The following table shows the fair value and location of our Liquefaction Supply Derivatives and LNG Trading Derivatives (collectively, “Commodity Derivatives”) on our Consolidated Balance Sheets (in millions, except notional amount): +December 31, 2019 +December 31, 2018 +Liquefaction Supply Derivatives (1) +LNG Trading Derivatives (2) +Total +Liquefaction Supply Derivatives (1) +LNG Trading Derivatives (2) +Total +Consolidated Balance Sheet Location +Derivative assets +$ +93 +$ +225 +$ +318 +$ +13 +$ +24 +$ +37 +Non-current derivative assets +174 +— +174 +46 +— +46 +Total derivative assets +267 +225 +492 +59 +24 +83 +Derivative liabilities +( 16 +) +( 60 +) +( 76 +) +( 79 +) +( 48 +) +( 127 +) +Non-current derivative liabilities +( 102 +) +— +( 102 +) +( 22 +) +— +( 22 +) +Total derivative liabilities +( 118 +) +( 60 +) +( 178 +) +( 101 +) +( 48 +) +( 149 +) +Derivative asset (liability), net +$ +149 +$ +165 +$ +314 +$ +( 42 +) +$ +( 24 +) +$ +( 66 +) +Notional amount, net (in TBtu) (3) +9,177 +4 +5,832 +12 +(1) +Does not include collateral posted with counterparties by us of $ 7 million and $ 5 million for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of December 31, 2019 and 2018 , respectively. Includes derivative assets of $ 3 million and $ 2 million and non-current assets of $ 2 million and $ 3 million as of December 31, 2019 and 2018 , respectively, for a natural gas supply contract CCL has with a related party. +(2) +Does not include collateral posted with counterparties by us of $ 5 million and $ 9 million deposited for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of December 31, 2019 and 2018 , respectively. +(3) +Includes 120 TBtu and 55 TBtu as of December 31, 2019 and 2018 , respectively, for a natural gas supply contract CCL has with a related party. +The following table shows the changes in the fair value, settlements and location of our Commodity Derivatives recorded on our Consolidated Statements of Operations during the years ended December 31, 2019, 2018 and 2017 (in millions): +Consolidated Statements of Operations Location (1) +Year Ended December 31, +2019 +2018 +2017 +LNG Trading Derivatives gain (loss) +LNG revenues +$ +402 +$ +( 25 +) +$ +( 44 +) +LNG Trading Derivatives loss +Cost of sales +( 89 +) +— +— +Liquefaction Supply Derivatives gain (loss) (2) +LNG revenues +2 +( 1 +) +— +Liquefaction Supply Derivatives gain (loss) (2)(3) +Cost of sales +194 +( 100 +) +( 24 +) +(1) +Fair value fluctuations associated with commodity derivative activities are classified and presented consistently with the item economically hedged and the nature and intent of the derivative instrument. +(2) +Does not include the realized value associated with derivative instruments that settle through physical delivery. +(3) +CCL recorded $ 85 million in cost of sales under a natural gas supply contract with a related party during the year ended December 31, 2019 , including $ 1 million of Liquefaction Supply Derivatives loss . As of December 31, 2019 , $ 3 million was included in accrued liabilities related to this contract. CCL did no t have any transactions during the years ended December 31, 2018 and 2017 under this contract. +88 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +FX Derivatives +Cheniere Marketing has entered into FX Derivatives to protect against the volatility in future cash flows attributable to changes in international currency exchange rates. The FX Derivatives economically hedge the foreign currency exposure arising from cash flows expended for both physical and financial LNG transactions. +The following table shows the fair value and location of our FX Derivatives on our Consolidated Balance Sheets (in millions): +Fair Value Measurements as of +Consolidated Balance Sheet Location +December 31, 2019 +December 31, 2018 +FX Derivatives +Derivative assets +$ +5 +$ +16 +FX Derivatives +Derivative liabilities +( 1 +) +( 1 +) +The total notional amount of our FX Derivatives was $ 827 million and $ 379 million as of December 31, 2019 and 2018 , respectively. +The following table shows the changes in the fair value, settlements and location of our FX Derivatives recorded on our Consolidated Statements of Operations during the years ended December 31, 2019, 2018 and 2017 (in millions): +Year Ended December 31, +Consolidated Statements of Operations Location +2019 +2018 +2017 +FX Derivatives gain (loss) +LNG revenues +$ +25 +$ +18 +$ +( 1 +) +Consolidated Balance Sheet Presentation +Our derivative instruments are presented on a net basis on our Consolidated Balance Sheets as described above. The following table shows the fair value of our derivatives outstanding on a gross and net basis (in millions): +Gross Amounts Recognized +Gross Amounts Offset in the Consolidated Balance Sheets +Net Amounts Presented in the Consolidated Balance Sheets +Offsetting Derivative Assets (Liabilities) +As of December 31, 2019 +CCH Interest Rate Derivatives +$ +( 81 +) +$ +— +$ +( 81 +) +CCH Interest Rate Forward Start Derivatives +( 8 +) +— +( 8 +) +Liquefaction Supply Derivatives +281 +( 14 +) +267 +Liquefaction Supply Derivatives +( 126 +) +8 +( 118 +) +LNG Trading Derivatives +229 +( 4 +) +225 +LNG Trading Derivatives +( 60 +) +— +( 60 +) +FX Derivatives +9 +( 4 +) +5 +FX Derivatives +( 6 +) +5 +( 1 +) +As of December 31, 2018 +CCH Interest Rate Derivatives +$ +19 +$ +( 1 +) +$ +18 +Liquefaction Supply Derivatives +95 +( 36 +) +59 +Liquefaction Supply Derivatives +( 121 +) +20 +( 101 +) +LNG Trading Derivatives +112 +( 88 +) +24 +LNG Trading Derivatives +( 92 +) +44 +( 48 +) +FX Derivatives +30 +( 14 +) +16 +FX Derivatives +( 2 +) +1 +( 1 +) +89 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 8— OTHER NON-CURRENT ASSETS +As of December 31, 2019 and 2018 , other non-current assets, net consisted of the following (in millions): +December 31, +2019 +2018 +Advances made to municipalities for water system enhancements +$ +87 +$ +90 +Advances and other asset conveyances to third parties to support LNG terminals +55 +54 +Advances made under EPC and non-EPC contracts +29 +14 +Equity method investments +108 +94 +Debt issuance costs, net +45 +72 +Tax-related payments and receivables +20 +21 +Other +44 +24 +Total other non-current assets, net +$ +388 +$ +369 +Equity Method Investments +Our equity method investments consist of interests in privately-held companies. In 2017, we acquired an equity interest in Midship Holdings, LLC (“Midship Holdings”), which manages the business and affairs of Midship Pipeline Company, LLC (“Midship Pipeline”). Midship Pipeline is currently constructing an approximately 200 -mile natural gas pipeline project (the “Midship Project”) that connects production in the Anadarko Basin to Gulf Coast markets. Midship Holdings entered into agreements with investment funds managed by EIG Global Energy Partners (“EIG”) under which EIG-managed funds committed to make an investment of up to $ 500 million (the “EIG Investment”) in the Midship Project, subject to the terms and conditions contained in the applicable agreements. The EIG Investment, when combined with equity contributed by us, is intended to ensure the Midship Project has the equity funding expected to be required to develop and construct the project. Construction of the Midship Project commenced in the first quarter of 2019. +Subsequent to Midship Project obtaining its financing in the form of credit facilities, in conjunction with existing equity, Midship Holdings was designed to finance its activities without additional subordinated financial support. As a result, Midship Holdings is no longer a variable interest entity. We continue to report Midship Holdings as an equity method investment due to our ability to exercise significant influence over the operating and financial policies of Midship Holdings through our non-controlling voting rights on its board of managers. +During the year ended December 31, 2019 , we recognized impairment losses of $ 87 million relating to our investments in certain equity method investees, including Midship Holdings. Impairments were precipitated primarily by cost overruns and extended construction timelines for operating infrastructure of our investees’ projects, resulting in a reduction of the expected fair value of our equity interests. Impairment losses associated with our equity method investments are presented in other expense (income). +Our investment in Midship Holdings was $ 105 million , net of impairment losses, and $ 85 million at December 31, 2019 and 2018 , respectively. +Cheniere LNG O&M Services, LLC (“O&M Services”), our wholly owned subsidiary provides the development, construction, operation and maintenance services associated with the Midship Project pursuant to agreements in which O&M Services receives an agreed upon fee and reimbursement of costs incurred. O&M Services recorded $ 12 million , $ 12 million and $ 3 million in the years ended December 31, 2019, 2018 and 2017 , respectively, of other revenues and $ 3 million and $ 4 million of accounts receivable as of December 31, 2019 and 2018 , respectively, for services provided to Midship Pipeline under these agreements. CCL has entered into a transportation precedent agreement and a negotiated rate agreement with Midship Pipeline to secure firm pipeline transportation capacity for a period of 10 years following commencement of the Midship Project. In May 2018, CCL issued a letter of credit to Midship Pipeline for drawings up to an aggregate maximum amount of $ 16 million . Midship Pipeline had no t made any drawings on this letter of credit as of December 31, 2019 . +NOTE 9— NON-CONTROLLING INTEREST AND VARIABLE INTEREST ENTITY +We own a 48.6 % limited partner interest in Cheniere Partners in the form of 104.5 million common units and 135.4 million subordinated units, with the remaining non-controlling interest held by Blackstone CQP Holdco LP ( “Blackstone CQP Holdco” ) +90 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +and the public. We also own 100 % of the general partner interest and the incentive distribution rights in Cheniere Partners. Cheniere Partners is accounted for as a consolidated variable interest entity. +Cheniere Partners is a limited partnership formed by us in 2006 to own and operate the Sabine Pass LNG terminal and related assets. Our subsidiary, Cheniere Partners GP, is the general partner of Cheniere Partners. In 2012, Cheniere Partners, Cheniere and Blackstone CQP Holdco entered into a unit purchase agreement whereby Cheniere Partners sold 100.0 million Class B units to Blackstone CQP Holdco in a private placement. The board of directors of Cheniere Partners GP was modified to include three directors appointed by Blackstone CQP Holdco , four directors appointed by us and four independent directors mutually agreed upon by Blackstone CQP Holdco and us and appointed by us. In addition, we provided Blackstone CQP Holdco with a right to maintain one board seat on our Board of Directors (our “Board”) . A quorum of Cheniere Partners GP directors consists of a majority of all directors, including at least two directors appointed by Blackstone CQP Holdco , two directors appointed by us and two independent directors. Blackstone CQP Holdco will no longer be entitled to appoint Cheniere Partners GP directors in the event that Blackstone CQP Holdco ’s ownership in Cheniere Partners is less than 20 % of outstanding common units and subordinated units. +We have determined that Cheniere Partners GP is a VIE and that we, as the holder of the equity at risk, do not have a controlling financial interest due to the rights held by Blackstone CQP Holdco . However, we continue to consolidate Cheniere Partners as a result of Blackstone CQP Holdco ’s right to maintain one board seat on our Board which creates a de facto agency relationship between Blackstone CQP Holdco and us. GAAP requires that when a de facto agency relationship exists, one of the members of the de facto agency relationship must consolidate the VIE based on certain criteria. As a result, we consolidate Cheniere Partners in our Consolidated Financial Statements. +The following table presents the summarized assets and liabilities (in millions) of Cheniere Partners, our consolidated VIE, which are included in our Consolidated Balance Sheets. The assets in the table below may only be used to settle obligations of Cheniere Partners. In addition, there is no recourse to us for the consolidated VIE’s liabilities. The assets and liabilities in the table below include third-party assets and liabilities of Cheniere Partners only and exclude intercompany balances that eliminate in consolidation. +December 31, +2019 +2018 +ASSETS +Current assets +Cash and cash equivalents +$ +1,781 +$ +— +Restricted cash +181 +1,541 +Accounts and other receivables +297 +348 +Other current assets +184 +125 +Total current assets +2,443 +2,014 +Property, plant and equipment, net +16,368 +15,390 +Other non-current assets, net +309 +228 +Total assets +$ +19,120 +$ +17,632 +LIABILITIES +Current liabilities +Accrued liabilities +$ +709 +$ +821 +Other current liabilities +210 +197 +Total current liabilities +919 +1,018 +Long-term debt, net +17,579 +16,066 +Other non-current liabilities +104 +18 +Total liabilities +$ +18,602 +$ +17,102 +91 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 10— ACCRUED LIABILITIES +As of December 31, 2019 and 2018 , accrued liabilities consisted of the following (in millions): +December 31, +2019 +2018 +Interest costs and related debt fees +$ +293 +$ +233 +Accrued natural gas purchases +460 +610 +LNG terminals and related pipeline costs +327 +125 +Compensation and benefits +115 +117 +Accrued LNG inventory +6 +14 +Other accrued liabilities +80 +70 +Total accrued liabilities +$ +1,281 +$ +1,169 +92 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 11— DEBT +As of December 31, 2019 and 2018 , our debt consisted of the following (in millions): +December 31, +2019 +2018 +Long-term debt: +SPL +5.625% Senior Secured Notes due 2021 (“2021 SPL Senior Notes”) +$ +2,000 +$ +2,000 +6.25% Senior Secured Notes due 2022 (“2022 SPL Senior Notes”) +1,000 +1,000 +5.625% Senior Secured Notes due 2023 (“2023 SPL Senior Notes”) +1,500 +1,500 +5.75% Senior Secured Notes due 2024 (“2024 SPL Senior Notes”) +2,000 +2,000 +5.625% Senior Secured Notes due 2025 (“2025 SPL Senior Notes”) +2,000 +2,000 +5.875% Senior Secured Notes due 2026 (“2026 SPL Senior Notes”) +1,500 +1,500 +5.00% Senior Secured Notes due 2027 (“2027 SPL Senior Notes”) +1,500 +1,500 +4.200% Senior Secured Notes due 2028 (“2028 SPL Senior Notes”) +1,350 +1,350 +5.00% Senior Secured Notes due 2037 (“2037 SPL Senior Notes”) +800 +800 +Cheniere Partners +5.250% Senior Notes due 2025 (“2025 CQP Senior Notes”) +1,500 +1,500 +5.625% Senior Notes due 2026 (“2026 CQP Senior Notes”) +1,100 +1,100 +4.500% Senior Notes due 2029 (“2029 CQP Senior Notes”) +1,500 +— +2016 CQP Credit Facilities +— +— +CQP Credit Facilities executed in 2019 (“2019 CQP Credit Facilities”) +— +— +CCH +7.000% Senior Secured Notes due 2024 (“2024 CCH Senior Notes”) +1,250 +1,250 +5.875% Senior Secured Notes due 2025 (“2025 CCH Senior Notes”) +1,500 +1,500 +5.125% Senior Secured Notes due 2027 (“2027 CCH Senior Notes”) +1,500 +1,500 +4.80% Senior Secured Notes due 2039 (“4.80% CCH Senior Notes”) +727 +— +3.925% Senior Secured Notes due 2039 (“3.925% CCH Senior Notes”) +475 +— +3.700% Senior Secured Notes due 2029 (“2029 CCH Senior Notes”) +1,500 +— +CCH Credit Facility +3,283 +5,156 +CCH HoldCo II +11.0% Convertible Senior Secured Notes due 2025 (“2025 CCH HoldCo II Convertible Senior Notes”) +1,578 +1,455 +Cheniere +4.875% Convertible Unsecured Notes due 2021 (“2021 Cheniere Convertible Unsecured Notes”) +1,278 +1,218 +4.25% Convertible Senior Notes due 2045 (“2045 Cheniere Convertible Senior Notes”) +625 +625 +$1.25 billion Cheniere Revolving Credit Facility (“Cheniere Revolving Credit Facility”) +— +— +Unamortized premium, discount and debt issuance costs, net +( 692 +) +( 775 +) +Total long-term debt, net +30,774 +28,179 +Current debt: +$1.2 billion SPL Working Capital Facility (“SPL Working Capital Facility”) +— +— +$1.2 billion CCH Working Capital Facility (“CCH Working Capital Facility”) +— +168 +Cheniere Marketing trade finance facilities +— +71 +Total current debt +— +239 +Total debt, net +$ +30,774 +$ +28,418 +93 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Below is a schedule of future principal payments that we are obligated to make, based on current construction schedules, on our outstanding debt at December 31, 2019 (in millions): +Years Ending December 31, +Principal Payments +2020 +$ +— +2021 +3,413 +2022 +1,119 +2023 +1,633 +2024 +6,146 +Thereafter +19,155 +Total +$ +31,466 +Senior Notes +SPL Senior Notes +The terms of the 2021 SPL Senior Notes, 2022 SPL Senior Notes, 2023 SPL Senior Notes, 2024 SPL Senior Notes, 2025 SPL Senior Notes, 2026 SPL Senior Notes, 2027 SPL Senior Notes and 2028 SPL Senior Notes (collectively with the 2037 SPL Senior Notes , the “SPL Senior Notes” ) are governed by a common indenture (the “SPL Indenture”) and the terms of the 2037 SPL Senior Notes are governed by a separate indenture (the “2037 SPL Senior Notes Indenture”). Both the SPL Indenture and the 2037 SPL Senior Notes Indenture contain customary terms and events of default and certain covenants that, among other things, limit SPL’s ability and the ability of SPL’s restricted subsidiaries to incur additional indebtedness or issue preferred stock, make certain investments or pay dividends or distributions on capital stock or subordinated indebtedness or purchase, redeem or retire capital stock, sell or transfer assets, including capital stock of SPL’s restricted subsidiaries, restrict dividends or other payments by restricted subsidiaries, incur liens, enter into transactions with affiliates, dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of SPL’s assets and enter into certain LNG sales contracts. Subject to permitted liens, the SPL Senior Notes are secured on a pari passu first-priority basis by a security interest in all of the membership interests in SPL and substantially all of SPL’s assets. SPL may not make any distributions until, among other requirements, deposits are made into debt service reserve accounts as required and a debt service coverage ratio test of 1.25 :1.00 is satisfied. Semi-annual principal payments for the 2037 SPL Senior Notes are due on March 15 and September 15 of each year beginning September 15, 2025 and are fully amortizing according to a fixed sculpted amortization schedule. Interest on the SPL Senior Notes is payable semi-annually in arrears. +At any time prior to three months before the respective dates of maturity for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes and 2037 SPL Senior Notes , in which case the time period is six months before the respective dates of maturity), SPL may redeem all or part of such series of the SPL Senior Notes at a redemption price equal to the “make-whole” price (except for the 2037 SPL Senior Notes , in which case the redemption price is equal to the “optional redemption” price) set forth in the respective indentures governing the SPL Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. SPL may also, at any time within three months of the respective maturity dates for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes , 2027 SPL Senior Notes , 2028 SPL Senior Notes and 2037 SPL Senior Notes , in which case the time period is within six months of the respective dates of maturity), redeem all or part of such series of the SPL Senior Notes at a redemption price equal to 100 % of the principal amount of such series of the SPL Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +CQP Senior Notes +In September 2019, Cheniere Partners issued an aggregate principal amount of $ 1.5 billion of the 2029 CQP Senior Notes . The proceeds of the offering were used to prepay the outstanding balance of the $ 750 million term loan under the 2019 CQP Credit Facilities (“CQP Term Facility”) and for general corporate purposes, including funding future capital expenditures in connection with the construction of Train 6 at the SPL Project , resulting in the recognition of debt modification and extinguishment costs of $ 13 million for the year ended December 31, 2019 . Borrowings under the 2029 CQP Senior Notes accrue interest at a fixed rate of 4.500 % per annum. As of December 31, 2019 , only the $ 750 million revolving credit facility (“CQP Revolving Facility”) , all of which is undrawn, remains as part of the 2019 CQP Credit Facilities . +The 2025 CQP Senior Notes , the 2026 CQP Senior Notes and the 2029 CQP Senior Notes (collectively, the “CQP Senior Notes”) are jointly and severally guaranteed by each of Cheniere Partners’ subsidiaries other than SPL and, subject to certain conditions governing its guarantee, Sabine Pass LP (the “CQP Guarantors”) . The CQP Senior Notes are governed by the same +94 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +base indenture (the “CQP Base Indenture”) . The 2025 CQP Senior Notes are further governed by the First Supplemental Indenture, the 2026 CQP Senior Notes are further governed by the Second Supplemental Indenture and the 2029 CQP Senior Notes are further governed by the Third Supplemental Indenture. The indentures governing the CQP Senior Notes contain customary terms and events of default and certain covenants that, among other things, limit the ability of Cheniere Partners and the CQP Guarantors to incur liens and sell assets, enter into transactions with affiliates, enter into sale-leaseback transactions and consolidate, merge or sell, lease or otherwise dispose of all or substantially all of the applicable entity’s properties or assets. Interest on the CQP Senior Notes is payable semi-annually in arrears. +At any time prior to October 1, 2020 for the 2025 CQP Senior Notes , October 1, 2021 for the 2026 CQP Senior Notes and October 1, 2024 for the 2029 CQP Senior Notes , Cheniere Partners may redeem all or a part of the applicable CQP Senior Notes at a redemption price equal to 100 % of the aggregate principal amount of the CQP Senior Notes redeemed, plus the “applicable premium” set forth in the respective indentures governing the CQP Senior Notes , plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to October 1, 2020 for the 2025 CQP Senior Notes , October 1, 2021 for the 2026 CQP Senior Notes and October 1, 2024 for the 2029 CQP Senior Notes , Cheniere Partners may redeem up to 35 % of the aggregate principal amount of the CQP Senior Notes with an amount of cash not greater than the net cash proceeds from certain equity offerings at a redemption price equal to 105.250 % of the aggregate principal amount of the 2025 CQP Senior Notes , 105.625 % of the aggregate principal amount of the 2026 CQP Senior Notes and 104.5 % of the aggregate principal amount of the 2029 CQP Senior Notes redeemed, plus accrued and unpaid interest, if any, to the date of redemption. Cheniere Partners also may at any time on or after October 1, 2020 through the maturity date of October 1, 2025 for the 2025 CQP Senior Notes , October 1, 2021 through the maturity date of October 1, 2026 for the 2026 CQP Senior Notes and October 1, 2024 through the maturity date of October 1, 2029 for the 2029 CQP Senior Notes , redeem the CQP Senior Notes , in whole or in part, at the redemption prices set forth in the respective indentures governing the CQP Senior Notes . +The CQP Senior Notes are Cheniere Partners’ senior obligations, ranking equally in right of payment with Cheniere Partners’ other existing and future unsubordinated debt and senior to any of its future subordinated debt. In the event that the aggregate amount of Cheniere Partners’ secured indebtedness and the secured indebtedness of the CQP Guarantors (other than the CQP Senior Notes or any other series of notes issued under the CQP Base Indenture ) outstanding at any one time exceeds the greater of (1) $ 1.5 billion and (2) 10 % of net tangible assets, the CQP Senior Notes will be secured to the same extent as such obligations under the 2019 CQP Credit Facilities . The obligations under the 2019 CQP Credit Facilities are secured on a first-priority basis (subject to permitted encumbrances) with liens on substantially all the existing and future tangible and intangible assets and rights of Cheniere Partners and the CQP Guarantors and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the 2019 CQP Credit Facilities ). The liens securing the CQP Senior Notes , if applicable, will be shared equally and ratably (subject to permitted liens) with the holders of other senior secured obligations, which include the 2019 CQP Credit Facilities obligations and any future additional senior secured debt obligations. +CCH Senior Notes +In September 2019, CCH issued an aggregate principal amount of $ 727 million of the 4.80% CCH Senior Notes in a private placement conducted pursuant to Section 4(a)(2) of the Securities Act. The 4.80% CCH Senior Notes were issued under an indenture dated as of September 27, 2019 pursuant to a note purchase agreement with the purchasers party thereto and Allianz Global Investors GmbH, as noteholder consultant, originally entered into in June 2019. In October 2019, CCH issued an aggregate principal amount of $ 475 million of the 3.925% CCH Senior Notes in a private placement conducted pursuant to Section 4(a)(2) of the Securities Act. The 3.925% CCH Senior Notes were issued under an indenture dated October 17, 2019 pursuant to a note purchase agreement with the purchasers party thereto and certain accounts managed by BlackRock Real Assets and certain accounts managed by MetLife Investment Management. The 4.80% CCH Senior Notes and the 3.925% CCH Senior Notes accrue interest at a fixed rate of 4.80 % and 3.925 % per annum, respectively, and are fully amortizing according to a fixed sculpted amortization schedule with semi-annual payments of interest starting December 2019 and semi-annual payments of principal starting June 2027. The 4.80% CCH Senior Notes and the 3.925% CCH Senior Notes have a weighted average life of 15 years . +In November 2019, CCH issued an aggregate principal amount of $ 1.5 billion of the 2029 CCH Senior Notes . The 2029 CCH Senior Notes were issued pursuant to the same indenture governing the 2024 CCH Senior Notes, 2025 CCH Senior Notes and 2027 CCH Senior Notes (together with the 2029 CCH Senior Notes, the "144A CCH Senior Notes") . Borrowings under the 2029 CCH Senior Notes accrue interest at a fixed rate of 3.700 % per annum. +The proceeds of the 4.80% CCH Senior Notes , 3.925% CCH Senior Notes and 2029 CCH Senior Notes were used to prepay a portion of the balance outstanding under the CCH Credit Facility , resulting in the recognition of debt modification and +95 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +extinguishment costs of $ 39 million for the year ended December 31, 2019 relating to the write off of unamortized debt discounts and issuance costs. +The 144A CCH Senior Notes , 4.80% CCH Senior Notes and 3.925% CCH Senior Notes (collectively, the “ CCH Senior Notes ”) are jointly and severally guaranteed by CCH’s subsidiaries, CCL, CCP and Corpus Christi Pipeline GP, LLC (the “CCH Guarantors”). The indentures governing the CCH Senior Notes contain customary terms and events of default and certain covenants that, among other things, limit CCH’s ability and the ability of CCH’s restricted subsidiaries to: incur additional indebtedness or issue preferred stock; make certain investments or pay dividends or distributions on membership interests or subordinated indebtedness or purchase, redeem or retire membership interests; sell or transfer assets, including membership or partnership interests of CCH’s restricted subsidiaries; restrict dividends or other payments by restricted subsidiaries to CCH or any of CCH’s restricted subsidiaries; incur liens; enter into transactions with affiliates; dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of the properties or assets of CCH and its restricted subsidiaries taken as a whole; or permit any CCH Guarantor to dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of its properties and assets. Interest on the CCH Senior Notes is payable semi-annually in arrears. +At any time prior to six months before the respective dates of maturity for each of the CCH Senior Notes, CCH may redeem all or part of such series of the CCH Senior Notes at a redemption price equal to the “make-whole” price set forth in the appropriate indenture, plus accrued and unpaid interest, if any, to the date of redemption. At any time within six months of the respective dates of maturity for each of the CCH Senior Notes, CCH may redeem all or part of such series of the CCH Senior Notes, in whole or in part, at a redemption price equal to 100 % of the principal amount of the CCH Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +Credit Facilities +Below is a summary of our credit facilities outstanding as of December 31, 2019 (in millions): +SPL Working Capital Facility +2019 CQP Credit Facilities +CCH Credit Facility +CCH Working Capital Facility +Cheniere Revolving Credit Facility +Original facility size +$ +1,200 +$ +1,500 +$ +8,404 +$ +350 +$ +750 +Incremental commitments +— +— +1,566 +850 +500 +Less: +Outstanding balance +— +— +3,283 +— +— +Commitments prepaid or terminated +— +750 +6,687 +— +— +Letters of credit issued +414 +— +— +471 +585 +Available commitment +$ +786 +$ +750 +$ +— +$ +729 +$ +665 +Interest rate on available balance +LIBOR plus 1.75% or base rate plus 0.75% +LIBOR plus 1.25% - 2.125% or base rate plus 0.25% - 1.125% +LIBOR plus 1.75% or base rate plus 0.75% +LIBOR plus 1.25% - 1.75% or base rate plus 0.25% - 0.75% +LIBOR plus 1.75% - 2.50% or base rate plus 0.75% - 1.50% +Weighted average interest rate of outstanding balance +n/a +n/a +3.55 % +n/a +n/a +Maturity date +December 31, 2020 +May 29, 2024 +June 30, 2024 +June 29, 2023 +December 13, 2022 +SPL Working Capital Facility +In September 2015, SPL entered into the SPL Working Capital Facility with aggregate commitments of $ 1.2 billion , which was amended in May 2019 in connection with commercialization and financing of Train 6 of the SPL Project . The SPL Working Capital Facility is intended to be used for loans to SPL (“SPL Working Capital Loans”), the issuance of letters of credit on behalf of SPL, as well as for swing line loans to SPL (“SPL Swing Line Loans”), primarily for certain working capital requirements related to developing and placing into operation the SPL Project . SPL may, from time to time, request increases in the commitments under the SPL Working Capital Facility of up to $ 760 million and incremental increases in commitments of up to an additional $ 390 million . +Loans under the SPL Working Capital Facility accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of the senior facility agent’s published prime rate, the federal funds effective rate, as published by the Federal Reserve Bank of New York, plus 0.50 % and one month LIBOR plus 0.50 % ), plus the applicable margin. The applicable margin +96 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +for LIBOR loans under the SPL Working Capital Facility is 1.75 % per annum, and the applicable margin for base rate loans under the SPL Working Capital Facility is 0.75 % per annum. Interest on SPL Swing Line Loans and loans deemed made in connection with a draw upon a letter of credit (“SPL LC Loans”) is due and payable on the date the loan becomes due. Interest on LIBOR loans is due and payable at the end of each applicable LIBOR period, and interest on base rate loans is due and payable at the end of each fiscal quarter. However, if such base rate loan is converted into a LIBOR loan, interest is due and payable on that date. Additionally, if the loans become due prior to such periods, the interest also becomes due on that date. +SPL pays (1) a commitment fee equal to an annual rate of 0.70 % on the average daily amount of the excess of the total commitment amount over the principal amount outstanding without giving effect to any outstanding SPL Swing Line Loans and (2) a letter of credit fee equal to an annual rate of 1.75 % of the undrawn portion of all letters of credit issued under the SPL Working Capital Facility . If draws are made upon a letter of credit issued under the SPL Working Capital Facility and SPL does not elect for such draw (an “SPL LC Draw”) to be deemed an SPL LC Loan, SPL is required to pay the full amount of the SPL LC Draw on or prior to the business day following the notice of the SPL LC Draw. An SPL LC Draw accrues interest at an annual rate of 2.0 % plus the base rate. As of December 31, 2019 , no SPL LC Draws had been made upon any letters of credit issued under the SPL Working Capital Facility . +The SPL Working Capital Facility matures on December 31, 2020, and the outstanding balance may be repaid, in whole or in part, at any time without premium or penalty upon three business days’ notice. SPL LC Loans have a term of up to one year . SPL Swing Line Loans terminate upon the earliest of (1) the maturity date or earlier termination of the SPL Working Capital Facility , (2) the date 15 days after such SPL Swing Line Loan is made and (3) the first borrowing date for a SPL Working Capital Loan or SPL Swing Line Loan occurring at least three business days following the date the SPL Swing Line Loan is made. SPL is required to reduce the aggregate outstanding principal amount of all SPL Working Capital Loans to zero for a period of five consecutive business days at least once each year. +The SPL Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of SPL under the SPL Working Capital Facility are secured by substantially all of the assets of SPL as well as all of the membership interests in SPL on a pari passu basis with the SPL Senior Notes. +CQP Credit Facilities +In May 2019, Cheniere Partners terminated the remaining commitments under the 2016 CQP Credit Facilities and entered into the 2019 CQP Credit Facilities , which consisted of the $ 750 million CQP Term Facility, which was prepaid and terminated upon issuance of the 2029 CQP Senior Notes in September 2019, and the $ 750 million CQP Revolving Facility . Borrowings under the 2019 CQP Credit Facilities will be used to fund the development and construction of Train 6 of the SPL Project and for general corporate purposes, subject to a sublimit, and the 2019 CQP Credit Facilities are also available for the issuance of letters of credit. +Loans under the 2019 CQP Credit Facilities accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of the prime rate, the federal funds effective rate, as published by the Federal Reserve Bank of New York, plus 0.50 % , and the adjusted one-month LIBOR plus 1.0 % ), plus the applicable margin. Under the CQP Term Facility, the applicable margin for LIBOR loans was 1.50 % per annum, and the applicable margin for base rate loans was 0.50 % per annum. Under the CQP Revolving Facility, the applicable margin for LIBOR loans is 1.25 % to 2.125 % per annum, and the applicable margin for base rate loans is 0.25 % to 1.125 % per annum, in each case depending on the then-current rating of Cheniere Partners. Interest on LIBOR loans is due and payable at the end of each applicable LIBOR period (and at the end of every three -month period within the LIBOR period, if any), and interest on base rate loans is due and payable at the end of each calendar quarter. +The 2019 CQP Credit Facilities mature on May 29, 2024. Any outstanding balance may be repaid, in whole or in part, at any time without premium or penalty, except for interest rate breakage costs. The 2019 CQP Credit Facilities contain conditions precedent for extensions of credit, as well as customary affirmative and negative covenants, and limit Cheniere Partners’ ability to make restricted payments, including distributions, to once per fiscal quarter and one true-up per fiscal quarter as long as certain conditions are satisfied. +The 2019 CQP Credit Facilities are unconditionally guaranteed and secured by a first priority lien (subject to permitted encumbrances) on substantially all of Cheniere Partners’ and the CQP Guarantors ’ existing and future tangible and intangible assets and rights and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the 2019 CQP Credit Facilities ). +97 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +CCH Credit Facility +In May 2018, CCH amended and restated the CCH Credit Facility to increase total commitments under the CCH Credit Facility from $ 4.6 billion to $ 6.1 billion . Borrowings are used to fund a portion of the costs of developing, constructing and placing into service the three Trains and the related facilities of the CCL Project and for related business purposes. +The CCH Credit Facility matures on June 30, 2024 , with principal payments due quarterly commencing on the earlier of (1) the first quarterly payment date occurring more than three calendar months following the completion of the CCL Project as defined in the common terms agreement and (2) a set date determined by reference to the date under which a certain LNG buyer linked to the last Train of the CCL Project to become operational is entitled to terminate its SPA for failure to achieve the date of first commercial delivery for that agreement. Scheduled repayments will be based upon a 19 -year tailored amortization, commencing the first full quarter after the completion of Trains 1 through 3 and designed to achieve a minimum projected fixed debt service coverage ratio of 1.50 :1. +Loans under the CCH Credit Facility accrue interest at a variable rate per annum equal to, at CCH’s election, LIBOR or the base rate (determined by reference to the applicable agent’s prime rate), plus the applicable margin. The applicable margin for LIBOR loans is 1.75 % and for base rate loans is 0.75 % . Interest on LIBOR loans is due and payable at the end of each applicable interest period and interest on base rate loans is due and payable at the end of each quarter. The CCH Credit Facility also requires CCH to pay a commitment fee at a rate per annum equal to 40 % of the margin for LIBOR loans, multiplied by the outstanding undrawn debt commitments. +The obligations of CCH under the CCH Credit Facility are secured by a first priority lien on substantially all of the assets of CCH and its subsidiaries and by a pledge by CCH HoldCo I of its limited liability company interests in CCH, on a pari passu basis with the CCH Senior Notes and the CCH Working Capital Facility . +Under the CCH Credit Facility , CCH is required to hedge not less than 65 % of the variable interest rate exposure of its senior secured debt. CCH is restricted from making certain distributions under agreements governing its indebtedness generally until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project, funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25 :1.00. +The amendment and restatement of the CCH Credit Facility resulted in the recognition of $ 15 million of debt modification and extinguishment costs during the year ended December 31, 2018 relating to the incurrence of third party fees and write off of unamortized debt issuance costs. CCH was required to pay certain upfront fees to the agents and lenders under the CCH Credit Facility together with additional transaction fees and expenses in the aggregate amount of $ 53 million during the year ended December 31, 2018 . +As part of the capital allocation framework announced in June 2019, we prepaid $ 153 million of outstanding borrowings under the CCH Credit Facility during the year ended December 31, 2019 . The prepayment resulted in the recognition of debt extinguishment costs of $ 3 million for the year ended December 31, 2019 . +CCH Working Capital Facility +In June 2018, CCH amended and restated the CCH Working Capital Facility to increase total commitments under the CCH Working Capital Facility from $ 350 million to $ 1.2 billion . The CCH Working Capital Facility is intended to be used for loans to CCH (“CCH Working Capital Loans”) and the issuance of letters of credit on behalf of CCH for certain working capital requirements related to developing and operating the CCL Project and for related business purposes. Loans under the CCH Working Capital Facility are guaranteed by the CCH Guarantors . CCH may, from time to time, request increases in the commitments under the CCH Working Capital Facility of up to the maximum allowed for working capital under the Common Terms Agreement that was entered into concurrently with the CCH Credit Facility . +Loans under the CCH Working Capital Facility , including CCH Working Capital Loans and loans made in connection with a draw upon any letter of credit (“CCH LC Loans” and collectively, the “Revolving Loans”) accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of (1) the prime rate, (2) the federal funds rate plus 0.50 % and (3) one month LIBOR plus 0.50 % ) plus the applicable margin. The applicable margin for LIBOR Revolving Loans ranges from 1.25 % to 1.75 % per annum, and the applicable margin for base rate Revolving Loans ranges from 0.25 % to 0.75 % per annum. Interest +98 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +on Revolving Loans is due and payable on the date the loan becomes due. Interest on LIBOR Revolving Loans is due and payable at the end of each LIBOR period, and interest on base rate Revolving Loans is due and payable at the end of each quarter. +CCH pays (1) a commitment fee equal to an annual rate of 40 % of the applicable margin for LIBOR Revolving Loans on the average daily amount of the excess of the total commitment amount over the principal amount outstanding, (2) a letter of credit fee equal to an annual rate equal to the applicable margin for LIBOR Revolving Loans on the undrawn portion of all letters of credit issued under the CCH Working Capital Facility and (3) a letter of credit fronting fee equal to an annual rate of 0.20 % of the undrawn portion of all fronted letters of credit. Each of these fees is payable quarterly in arrears. +If draws are made upon a letter of credit issued under the CCH Working Capital Facility and CCH does not elect for such draw (a “CCH LC Draw”) to be deemed a CCH LC Loan, CCH is required to pay the full amount of the CCH LC Draw on or prior to the business day following the notice of the CCH LC Draw. A CCH LC Draw accrues interest at an annual rate of 2.00 % plus the base rate. +CCH was required to pay certain upfront fees to the agents and lenders under the CCH Working Capital Facility together with additional transaction fees and expenses in the aggregate amount of $ 14 million during the year ended December 31, 2018 . +The CCH Working Capital Facility matures on June 29, 2023 and CCH may prepay the Revolving Loans at any time without premium or penalty upon three business days’ notice and may re-borrow at any time. CCH LC Loans have a term of up to one year . CCH is required to reduce the aggregate outstanding principal amount of all CCH Working Capital Loans to zero for a period of five consecutive business days at least once each year. +The CCH Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of CCH under the CCH Working Capital Facility are secured by substantially all of the assets of CCH and the CCH Guarantors as well as all of the membership interests in CCH and each of the CCH Guarantors on a pari passu basis with the CCH Senior Notes and the CCH Credit Facility . +Cheniere Revolving Credit Facility +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $ 750 million to $ 1.25 billion . The Cheniere Revolving Credit Facility is intended to fund, through loans and letters of credit, equity capital contributions to CCH HoldCo II and its subsidiaries for the development of the CCL Project and, provided that certain conditions are met, for general corporate purposes. +The Cheniere Revolving Credit Facility matures on December 13, 2022 and contains representations, warranties and affirmative and negative covenants customary for companies like us with lenders of the type participating in the Cheniere Revolving Credit Facility that limit our ability to make restricted payments, including distributions, unless certain conditions are satisfied, as well as limitations on indebtedness, guarantees, hedging, liens, investments and affiliate transactions. Under the Cheniere Revolving Credit Facility , we are required to ensure that the sum of our unrestricted cash and the amount of undrawn commitments under the Cheniere Revolving Credit Facility is at least equal to the lesser of (1) 20 % of the commitments under the Cheniere Revolving Credit Facility and (2) $ 200 million (the “Liquidity Covenant”). +From and after the time at which certain specified conditions are met (the “Trigger Point”), we will have increased flexibility under the Cheniere Revolving Credit Facility to, among other things, (1) make restricted payments and (2) raise incremental commitments. The Trigger Point will occur once (1) completion has occurred for each of Train 1 of the CCL Project (as defined in the CCH Indenture) and Train 5 of the SPL Project (as defined in SPL’s common terms agreement), which occurred in February 2019 and March 2019, respectively, (2) the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is less than or equal to 10 % of aggregate commitments under the Cheniere Revolving Credit Facility and (3) we elect on a go-forward basis to be governed by a non-consolidated leverage ratio covenant not to exceed 5.75 :1.00 (the “Springing Leverage Covenant”), which following such election will apply at any time that the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is greater than 30 % of aggregate commitments under the Cheniere Revolving Credit Facility . Following the Trigger Point, at any time that the Springing Leverage Covenant is in effect, the Liquidity Covenant will not apply. +Loans under the Cheniere Revolving Credit Facility accrue interest at a variable rate per annum equal to LIBOR or the base rate (equal to the highest of (1) the prime rate, (2) the federal funds rate plus 0.50 % and (3) one month LIBOR plus 1.00 % ), plus +99 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +the applicable margin. The applicable margin for LIBOR loans ranges from 1.75 % to 2.50 % per annum, and the applicable margin for base rate loans ranges from 0.75 % to 1.50 % per annum, in each case, based on the credit ratings then in effect assigned to loans under the Cheniere Revolving Credit Facility . Interest on LIBOR loans is due and payable at the end of each LIBOR period, and interest on base rate loans is due and payable at the end of each calendar quarter. We will also pay (1) prior to the Trigger Point, a commitment fee on the average daily amount of undrawn commitments at an annual rate of 0.75 % , payable quarterly in arrears and (2) from and after the Trigger Point, a commitment fee on the average daily amount of undrawn commitments at a rate equal to 30 % multiplied by the applicable margin for LIBOR loans then in effect. We will also pay a letter of credit fee at an annual rate equal to the applicable margin for LIBOR loans on the undrawn portion of all letters of credit issued under the Cheniere Revolving Credit Facility . Draws on any letters of credit will accrue interest at an annual rate equal to the base rate plus 2.0 % . +The Cheniere Revolving Credit Facility is secured by a first priority security interest (subject to permitted liens and other customary exceptions) in substantially all of our assets, including our interests in our direct subsidiaries (excluding CCH HoldCo II and certain other subsidiaries). +Convertible Notes +Below is a summary of our convertible notes outstanding as of December 31, 2019 (in millions): +2021 Cheniere Convertible Unsecured Notes +2025 CCH HoldCo II Convertible Senior Notes +2045 Cheniere Convertible Senior Notes +Aggregate original principal +$ +1,000 +$ +1,000 +$ +625 +Debt component, net of discount and debt issuance costs +$ +1,221 +$ +1,567 +$ +314 +Equity component +$ +211 +$ +— +$ +194 +Maturity date +May 28, 2021 +May 13, 2025 +March 15, 2045 +Contractual interest rate +4.875 +% +11.0 +% +4.25 +% +Effective interest rate (1) +8.2 +% +12.0 +% +9.4 +% +Remaining debt discount and debt issuance costs amortization period (2) +1.4 years +0.8 years +25.2 years +(1) +Rate to accrete the discounted carrying value of the convertible notes to the face value over the remaining amortization period. +(2) +We amortize any debt discount and debt issuance costs using the effective interest over the period through contractual maturity except for the 2025 CCH HoldCo II Convertible Senior Notes , which are amortized through the date they are first convertible by holders into our common stock. +2021 Cheniere Convertible Unsecured Notes +In November 2014, we issued the 2021 Cheniere Convertible Unsecured Notes on a private placement basis in reliance on the exemption from registration provided for under section 4(a)(2) of the Securities Act and Regulation S promulgated thereunder. The 2021 Cheniere Convertible Unsecured Notes accrue interest at a rate of 4.875 % per annum, which is payable in kind semi-annually in arrears by increasing the principal amount of the 2021 Cheniere Convertible Unsecured Notes outstanding. Beginning one year after the closing date, the 2021 Cheniere Convertible Unsecured Notes will be convertible at the option of the holder into our common stock at the then applicable conversion rate, provided that the closing price of our common stock is greater than or equal to the conversion price on the conversion date. The initial conversion price was $ 93.64 and is subject to adjustment upon the occurrence of certain specified events. We have the option to satisfy the conversion obligation with cash, common stock or a combination thereof. +Under GAAP, certain convertible debt instruments that may be settled in cash upon conversion are required to be separately accounted for as liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. We determined that the fair value of the debt component was $ 809 million and the residual value of the equity component was $ 191 million as of the issuance date. As of December 31, 2019 and 2018 , the carrying value of the equity component was $ 211 million and $ 209 million , respectively. The debt component is accreted to the total principal amount due at maturity by amortizing the debt discount. The effective rate of interest to amortize the debt discount and debt +100 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +issuance costs was approximately 8.2 % and 8.4 % as of December 31, 2019 and 2018 , respectively. As of December 31, 2019 , the if-converted value of the 2021 Cheniere Convertible Unsecured Notes did not exceed the principal balance. +2025 CCH HoldCo II Convertible Senior Notes +In May 2015, CCH HoldCo II issued the 2025 CCH HoldCo II Convertible Senior Notes on a private placement basis in reliance on the exemption from registration provided for under section 4(a)(2) of the Securities Act . The 2025 CCH HoldCo II Convertible Senior Notes were issued pursuant to the amended and restated note purchase agreement entered into among CCH HoldCo II, EIG Management Company, LLC, The Bank of New York Mellon, us and the note purchasers. The $ 1.0 billion principal of the 2025 CCH HoldCo II Convertible Senior Notes are being used to partially fund costs associated with Trains 1 through 3 of the CCL Project. The 2025 CCH HoldCo II Convertible Senior Notes bear interest at a rate of 11.0 % per annum, which is payable quarterly in arrears. Prior to the substantial completion of Train 2 of the CCL Project, interest on the 2025 CCH HoldCo II Convertible Senior Notes was paid entirely in kind. Following this date, the interest generally must be paid in cash; however, a portion of the interest may be paid in kind under certain specified circumstances. The 2025 CCH HoldCo II Convertible Senior Notes are secured by a pledge by us of 100 % of the equity interests in CCH HoldCo II, and a pledge by CCH HoldCo II of 100 % of the equity interests in CCH HoldCo I. In addition, the 2025 CCH HoldCo II Convertible Senior Notes are secured by a security interest in the account into which all distributions from CCH HoldCo I to CCH HoldCo II must be deposited. +At CCH HoldCo II’s option, the outstanding 2025 CCH HoldCo II Convertible Senior Notes are convertible into our common stock on or after March 1, 2020, provided the total market capitalization of Cheniere at that time is not less than $ 10.0 billion and certain other conditions are satisfied (the “Eligible Conversion Date”). The conversion price for 2025 CCH HoldCo II Convertible Senior Notes converted at CCH HoldCo II’s option is the lower of (1) a 10 % discount to the average of the daily volume-weighted average price (“VWAP”) of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided and (2) a 10 % discount to the closing price of our common stock on the trading day preceding the date on which notice of conversion is provided. At the option of the holders, the 2025 CCH HoldCo II Convertible Senior Notes are convertible on or after the six -month anniversary of the Eligible Conversion Date, provided the total market capitalization of Cheniere at that time is not less than $ 10.0 billion and certain other conditions are satisfied, at a conversion price equal to the average of the daily VWAP of our common stock for the 90 trading day period prior to the date on which notice of conversion is provided. Conversions are also subject to various limitations and conditions. +CCH HoldCo II is restricted from making distributions to Cheniere under agreements governing its indebtedness generally until, among other requirements, a historical debt service coverage ratio and a projected fixed debt service coverage ratio of 1.20 :1.00 are achieved. +In May 2018, the amended and restated note purchase agreement under which the 2025 CCH HoldCo II Convertible Senior Notes were issued was subsequently amended in connection with commercialization and financing of Train 3 of the CCL Project and to provide the note holders with certain prepayment rights related thereto. +2045 Cheniere Convertible Senior Notes +In March 2015, we issued the unsecured 2045 Cheniere Convertible Senior Notes to certain investors through a registered direct offering. The 2045 Cheniere Convertible Senior Notes were issued with an original issue discount of 20 % and accrue interest at a rate of 4.25 % per annum, which is payable semi-annually in arrears. We have the right, at our option, at any time after March 15, 2020, to redeem all or any part of the 2045 Cheniere Convertible Senior Notes at a redemption price payable in cash equal to the accreted amount of the 2045 Cheniere Convertible Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to such redemption date. The conversion rate will initially equal 7.2265 shares of our common stock per $1,000 principal amount of the 2045 Cheniere Convertible Senior Notes, which corresponds to an initial conversion price of approximately $ 138.38 per share of our common stock. The conversion rate is subject to adjustment upon the occurrence of certain specified events. We have the option to satisfy the conversion obligation with cash, common stock or a combination thereof. +We determined that the fair value of the debt component of the 2045 Cheniere Convertible Senior Notes was $ 304 million and the residual value of the equity component was $ 196 million as of the issuance date, excluding debt issuance costs and original issue discount. As of both December 31, 2019 and 2018 , the carrying value of the equity component was $ 194 million . The debt component is accreted to the total principal amount due at maturity by amortizing the debt discount and debt issuance costs. The effective rate of interest to amortize the debt discount and debt issuance costs was approximately 9.4 % as of both December 31, +101 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +2019 and 2018 . As of December 31, 2019 , the if-converted value of the 2045 Cheniere Convertible Senior Notes did not exceed the principal balance. +Restrictive Debt Covenants +As of December 31, 2019 , each of our issuers was in compliance with all covenants related to their respective debt agreements. +Interest Expense +Total interest expense, including interest expense related to our convertible notes, consisted of the following (in millions): +Year Ended December 31, +2019 +2018 +2017 +Interest cost on convertible notes: +Interest per contractual rate +$ +256 +$ +237 +$ +219 +Amortization of debt discount +40 +35 +29 +Amortization of debt issuance costs +12 +9 +7 +Total interest cost related to convertible notes +308 +281 +255 +Interest cost on debt and finance leases excluding convertible notes +1,538 +1,397 +1,271 +Total interest cost +1,846 +1,678 +1,526 +Capitalized interest +( 414 +) +( 803 +) +( 779 +) +Total interest expense, net +$ +1,432 +$ +875 +$ +747 +Fair Value Disclosures +The following table shows the carrying amount and estimated fair value of our debt (in millions): +December 31, 2019 +December 31, 2018 +Carrying +Amount +Estimated +Fair Value +Carrying +Amount +Estimated +Fair Value +Senior notes (1) +$ +22,700 +$ +24,650 +$ +19,700 +$ +19,901 +2037 SPL Senior Notes (2) +800 +934 +800 +817 +4.80% CCH Senior Notes (2) +727 +830 +— +— +3.925% CCH Senior Notes (2) +475 +495 +— +— +Credit facilities (3) +3,283 +3,283 +5,395 +5,395 +2021 Cheniere Convertible Unsecured Notes (2) +1,278 +1,312 +1,218 +1,236 +2025 CCH HoldCo II Convertible Senior Notes (2) +1,578 +1,807 +1,455 +1,612 +2045 Cheniere Convertible Senior Notes (4) +625 +498 +625 +431 +(1) +Includes the SPL Senior Notes except the 2037 SPL Senior Notes , the CQP Senior Notes and the 144A CCH Senior Notes . The Level 2 estimated fair value was based on quotes obtained from broker-dealers or market makers of these senior notes and other similar instruments. +(2) +The Level 3 estimated fair value was calculated based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including our stock price and interest rates based on debt issued by parties with comparable credit ratings to us and inputs that are not observable in the market. +(3) +Includes SPL Working Capital Facility , 2016 CQP Credit Facilities , 2019 CQP Credit Facilities , CCH Credit Facility , CCH Working Capital Facility , Cheniere Revolving Credit Facility and Cheniere Marketing trade finance facilities . The Level 3 estimated fair value approximates the principal amount because the interest rates are variable and reflective of market rates and the debt may be repaid, in full or in part, at any time without penalty. +(4) +The Level 1 estimated fair value was based on unadjusted quoted prices in active markets for identical liabilities that we had the ability to access at the measurement date. +102 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 12— LEASES +Our leased assets consist primarily of (1) LNG vessel time charters (“vessel charters”), (2) tug vessels, (3) office space and facilities and (4) land sites, all of which are classified as operating leases except for our tug vessels at the Corpus Christi LNG terminal, which are classified as finance leases. +ASC 842 requires a lessee to recognize leases on its balance sheet by recording a lease liability representing the obligation to make future lease payments and a right-of-use asset representing the right to use the underlying asset for the lease term. As our leases generally do not provide an implicit rate, in order to calculate the lease liability, we discounted our expected future lease payments using our relevant subsidiary’s incremental borrowing rate at the later of January 1, 2019 or the commencement date of the lease. The incremental borrowing rate is an estimate of the rate of interest that a given subsidiary would have to pay to borrow on a collateralized basis over a similar term to that of the lease term. +Many of our leases contain renewal options exercisable at our sole discretion. Options to renew a lease are included in the lease term and recognized as part of the right-of-use asset and lease liability only to the extent they are reasonably certain to be exercised, such as when necessary to satisfy obligations that existed at the execution of the lease or when the non-renewal would otherwise result in a significant economic penalty. +We have elected the practical expedient to omit leases with an initial term of 12 months or less (“short-term lease”) from recognition on the balance sheet. We recognize short-term lease payments on a straight-line basis over the lease term and variable payments under short-term leases in the period in which the obligation is incurred. +Certain of our leases contain non-lease components which are not separated from the lease components when calculating the right-of-use asset and lease liability per our use of the practical expedient to combine both components of an arrangement for all classes of leased assets. +Certain of our leases also contain variable payments, such as inflation, that are not included when calculating the right-of-use asset and lease liability unless the payments are in-substance fixed. +We recognize lease expense for operating leases on a straight-line basis over the lease term. We recognize lease expense for finance leases as the sum of the amortization of the right-of-use asset s on a straight-line basis and the interest on lease liabilities using the effective interest method over the lease term. +The following table shows the classification and location of our right-of-use asset s and lease liabilities on our Consolidated Balance Sheets (in millions): +Consolidated Balance Sheet Location +December 31, 2019 +Right-of-use assets—Operating +Operating lease assets, net +$ +439 +Right-of-use assets—Financing +Property, plant and equipment, net +56 +Total right-of-use assets +$ +495 +Current operating lease liabilities +Current operating lease liabilities +$ +236 +Current finance lease liabilities +Other current liabilities +1 +Non-current operating lease liabilities +Non-current operating lease liabilities +189 +Non-current finance lease liabilities +Non-current finance lease liabilities +58 +Total lease liabilities +$ +484 +103 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table shows the classification and location of our lease cost on our Consolidated Statements of Operations (in millions): +Consolidated Statement of Operations Location +Year Ended December 31, 2019 +Operating lease cost (1) +Operating costs and expenses (2) +$ +612 +Finance lease cost: +Amortization of right-of-use assets +Depreciation and amortization expense +3 +Interest on lease liabilities +Interest expense, net of capitalized interest +10 +Total lease cost +$ +625 +(1) +Includes $ 230 million of short-term lease costs and $ 7 million of variable lease costs paid to the lessor. +(2) +Presented in cost of sales, operating and maintenance expense or selling, general and administrative expense consistent with the nature of the asset under lease. +During the years ended December 31, 2018 and 2017, we recognized rental expense for all operating leases of $ 335 million and $ 199 million , respectively. +Future annual minimum lease payments for operating and finance leases as of December 31, 2019 are as follows (in millions): +Years Ending December 31, +Operating Leases (1) +Finance Leases +2020 +$ +250 +$ +11 +2021 +56 +10 +2022 +22 +10 +2023 +21 +10 +2024 +21 +10 +Thereafter +160 +136 +Total lease payments +530 +187 +Less: Interest +( 105 +) +( 128 +) +Present value of lease liabilities +$ +425 +$ +59 +(1) +Does not include $ 2.0 billion of legally binding minimum lease payments primarily for vessel charters which were executed as of December 31, 2019 but will commence primarily between 2020 and 2022 and have fixed minimum lease terms of up to seven years . +Future annual minimum lease payments for operating and capital leases as of December 31, 2018, prepared in accordance with accounting standards prior to the adoption of ASC 842, were as follows (in millions): +Years Ending December 31, +Operating Leases (1) +Capital Leases (2) +2019 (3) +$ +380 +$ +5 +2020 +184 +5 +2021 +238 +5 +2022 +264 +5 +2023 +264 +5 +Thereafter +999 +73 +Total lease payments +2,329 +98 +Less: Interest +— +( 39 +) +Present value of lease liabilities +$ +2,329 +$ +59 +(1) +Includes certain lease option renewals that are reasonably assured and payments for certain non-lease components . Also includes $ 79 million in payments for short-term leases and $ 1.6 billion in payments for LNG vessel charters which were previously executed but will commence primarily between 2020 and 2021. +(2) +Does not include payments for non-lease components of $ 98 million . +(3) +Does not include $ 43 million in aggregate payments we will receive from our LNG vessel subcharters. +104 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table shows the weighted-average remaining lease term (in years) and the weighted-average discount rate for our operating leases and finance leases: +December 31, 2019 +Operating Leases +Finance Leases +Weighted-average remaining lease term (in years) +8.4 +18.7 +Weighted-average discount rate (1) +5.2 % +16.2 % +(1) +The finance leases commenced prior to the adoption of ASC 842. In accordance with previous accounting guidance, the implied rate is based on the fair value of the underlying assets. +The following table includes other quantitative information for our operating and finance leases (in millions): +Year Ended December 31, 2019 +Cash paid for amounts included in the measurement of lease liabilities: +Operating cash flows from operating leases +$ +389 +Operating cash flows from finance leases +9 +Financing cash flows from finance leases +— +Right-of-use assets obtained in exchange for new operating lease liabilities +235 +LNG Vessel Subcharters +From time to time, we sublease certain LNG vessels under charter to third parties while retaining our existing obligation to the original lessor. We have elected the practical expedient for lessors to combine lease and non-lease components and since the lease component is the predominant component of each arrangement, these subleases are accounted for as operating leases. The subleases have lease terms of up to one year and many contain short-term renewal options exercisable at the discretion of the third party. As of December 31, 2019 , we had $ 9 million in future minimum sublease payments to be received from LNG vessel subcharters, which will be recognized entirely within 2020. We recognize fixed sublease income on a straight-line basis over the lease term of the sublease while variable sublease income is recognized when earned. We recognized $ 144 million of sublease income, including $ 22 million of variable lease payments, during the year ended December 31, 2019 in other revenues on our Consolidated Statements of Operations. +NOTE 13— REVENUES FROM CONTRACTS WITH CUSTOMERS +The following table represents a disaggregation of revenue earned from contracts with customers during the years ended December 31, 2019, 2018 and 2017 (in millions): +Year Ended December 31, +2019 +2018 +2017 +LNG revenues +$ +8,817 +$ +7,581 +$ +5,361 +Regasification revenues +266 +261 +260 +Other revenues +74 +54 +24 +Total revenues from customers +9,157 +7,896 +5,645 +Net derivative gains (losses) (1) +429 +( 9 +) +( 44 +) +Other (2) +144 +100 +— +Total revenues +$ +9,730 +$ +7,987 +$ +5,601 +(1) +See Note 7—Derivative Instruments for additional information about our derivatives. +(2) +Includes revenues from LNG vessel subcharters. See Note 12—Leases for additional information about our subleases. +LNG Revenues +We have entered into numerous SPAs with third party customers for the sale of LNG on a free on board (“FOB”) (delivered to the customer at either the Sabine Pass or Corpus Christi LNG terminal) or delivered at terminal (“DAT”) (delivered to the customer at their LNG receiving terminal) basis. Our customers generally purchase LNG for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal +105 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +to approximately 115 % of Henry Hub. The fixed fee component is the amount payable to us regardless of a cancellation or suspension of LNG cargo deliveries by the customers. The variable fee component is the amount generally payable to us only upon delivery of LNG plus all future adjustments to the fixed fee for inflation. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +We intend to primarily use LNG sourced from our Sabine Pass or Corpus Christi terminals to provide contracted volumes to our customers. However, we supplement this LNG with volumes procured from third parties. LNG revenues recognized from LNG that was procured from third parties was $ 268 million , $ 745 million and $ 981 million for the years ended December 31, 2019, 2018 and 2017 , respectively. +Revenues from the sale of LNG are recognized at a point in time when the LNG is delivered to the customer, either at the Sabine Pass or Corpus Christi LNG terminal or at the customer’s LNG receiving terminal, based on the terms of the contract, which is the point legal title, physical possession and the risks and rewards of ownership transfer to the customer. Each individual molecule of LNG is viewed as a separate performance obligation. The stated contract price (including both fixed and variable fees) per MMBtu in each LNG sales arrangement is representative of the stand-alone selling price for LNG at the time the contract was negotiated. We have concluded that the variable fees meet the exception for allocating variable consideration to specific parts of the contract. As such, the variable consideration for these contracts is allocated to each distinct molecule of LNG and recognized when that distinct molecule of LNG is delivered to the customer. Because of the use of the exception, variable consideration related to the sale of LNG is also not included in the transaction price. +When we sell LNG on a DAT basis, we consider all transportation costs, including vessel chartering, loading/unloading and canal fees, as fulfillment costs and not as separate services provided to the customer within the arrangement, regardless of whether or not such activities occur prior to or after the customer obtains control of the LNG. We expense fulfillment costs as incurred unless otherwise dictated by GAAP. +Fees received pursuant to SPAs are recognized as LNG revenues only after substantial completion of the respective Train. Prior to substantial completion, sales generated during the commissioning phase are offset against the cost of construction for the respective Train, as the production and removal of LNG from storage is necessary to test the facility and bring the asset to the condition necessary for its intended use. +Regasification Revenues +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4 Bcf/d. Approximately 2 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term TUAs with unaffiliated third-party customers, under which they are required to pay fixed monthly fees regardless of their use of the LNG terminal. Each of the customers has reserved approximately 1 Bcf/d of regasification capacity. The customers are each obligated to make monthly capacity payments to SPLNG aggregating approximately $ 125 million annually for 20 years that commenced in 2009, which is representative of fixed consideration in the contract. A portion of this fee is adjusted annually for inflation which is considered variable consideration. The remaining capacity of the Sabine Pass LNG terminal has been reserved by SPL, for which the associated revenues are eliminated in consolidation. +Because SPLNG is continuously available to provide regasification service on a daily basis with the same pattern of transfer, we have concluded that SPLNG provides a single performance obligation to its customers on a continuous basis over time. We have determined that an output method of recognition based on elapsed time best reflects the benefits of this service to the customer and accordingly, LNG regasification capacity reservation fees are recognized as regasification revenues on a straight-line basis over the term of the respective TUAs. +In 2012, SPL entered into a partial TUA assignment agreement with Total Gas & Power North America, Inc. (“Total”) , whereby upon substantial completion of Train 5 of the SPL Project , SPL gained access to substantially all of Total ’s capacity and other services provided under Total ’s TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Train 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA and we continue to recognize the payments received from Total as revenue. +106 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +During the years ended December 31, 2019, 2018 and 2017 , SPL recorded $ 104 million , $ 30 million and $ 23 million , respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Contract Assets and Liabilities +The following table shows our contract assets, which we classify as other non-current assets, net on our Consolidated Balance Sheets (in millions): +December 31, +2019 +2018 +Contract assets +$ +18 +$ +— +Contract assets represent our right to consideration for transferring goods or services to the customer under the terms of a sales contract when the associated consideration is not yet due. Changes in contract assets during the year ended December 31, 2019 were primarily attributable to revenue recognized due to the delivery of LNG under certain SPAs for which the associated consideration was not yet due. +The following table reflects the changes in our contract liabilities, which we classify as deferred revenue on our Consolidated Balance Sheets (in millions): +Year Ended December 31, +2019 +2018 +Deferred revenues, beginning of period +$ +139 +$ +111 +Cash received but not yet recognized +161 +139 +Revenue recognized from prior period deferral +( 139 +) +( 111 +) +Deferred revenues, end of period +$ +161 +$ +139 +We record deferred revenue when we receive consideration, or such consideration is unconditionally due from a customer, prior to transferring goods or services to the customer under the terms of a sales contract. Changes in deferred revenue during the years ended December 31, 2019 and 2018 are primarily attributable to differences between the timing of revenue recognition and the receipt of advance payments related to delivery of LNG under certain SPAs. +Transaction Price Allocated to Future Performance Obligations +Because many of our sales contracts have long-term durations, we are contractually entitled to significant future consideration which we have not yet recognized as revenue. The following table discloses the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of December 31, 2019 and 2018 : +December 31, 2019 +December 31, 2018 +Unsatisfied Transaction Price (in billions) +Weighted Average Recognition Timing (years) (1) +Unsatisfied Transaction Price (in billions) +Weighted Average Recognition Timing (years) (1) +LNG revenues +$ +106.4 +11 +$ +106.6 +11 +Regasification revenues +2.4 +5 +2.6 +6 +Total revenues +$ +108.8 +$ +109.2 +(1) +The weighted average recognition timing represents an estimate of the number of years during which we shall have recognized half of the unsatisfied transaction price. +We have elected the following exemptions which omit certain potential future sources of revenue from the table above: +(1) +We omit from the table above all performance obligations that are part of a contract that has an original expected duration of one year or less. +(2) +The table above excludes substantially all variable consideration under our SPAs and TUAs. We omit from the table above all variable consideration that is allocated entirely to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise to transfer a distinct good or service that forms part of a single performance obligation when that performance obligation qualifies as a series. The amount of revenue from variable fees that is not included in the transaction price will vary based on the future prices of Henry Hub throughout the contract terms, to the extent +107 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +customers elect to take delivery of their LNG, and adjustments to the consumer price index. Certain of our contracts contain additional variable consideration based on the outcome of contingent events and the movement of various indexes. We have not included such variable consideration in the transaction price to the extent the consideration is considered constrained due to the uncertainty of ultimate pricing and receipt. Approximately 52 % and 56 % of our LNG revenues from contracts with a duration of over one year during the years ended December 31, 2019 and 2018 , respectively, were related to variable consideration received from customers. During each of the years ended December 31, 2019 and 2018 , approximately 3 % of our regasification revenues were related to variable consideration received from customers. +We have entered into contracts to sell LNG that are conditioned upon one or both of the parties achieving certain milestones such as reaching FID on a certain liquefaction Train, obtaining financing or achieving substantial completion of a Train and any related facilities. These contracts are considered completed contracts for revenue recognition purposes and are included in the transaction price above when the conditions are considered probable of being met. +NOTE 14— INCOME TAXES +Components of income before income taxes and non-controlling interest on our Consolidated Statements of Operations for the years ended December 31, 2019, 2018 and 2017 are as follows (in millions): +Year Ended December 31, +2019 +2018 +2017 +U.S. +$ +289 +$ +997 +$ +30 +International +426 +230 +536 +Total income before income taxes and non-controlling interest +$ +715 +$ +1,227 +$ +566 +Income tax provision (benefit) included in our reported net income consisted of the following (in millions): +Year Ended December 31, +2019 +2018 +2017 +Current: +Federal +$ +— +$ +— +$ +— +State +— +2 +— +Foreign +4 +30 +6 +Total current +4 +32 +6 +Deferred: +Federal +( 475 +) +— +— +State +( 46 +) +— +— +Foreign +— +( 5 +) +( 3 +) +Total deferred +( 521 +) +( 5 +) +( 3 +) +Total income tax provision (benefit) +$ +( 517 +) +$ +27 +$ +3 +108 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The reconciliation of the federal statutory income tax rate to our effective income tax rate is as follows: +Year Ended December 31, +2019 +2018 +2017 +U.S. federal statutory tax rate +21.0 +% +21.0 +% +35.0 +% +Non-controlling interest +( 17.2 +)% +( 11.4 +)% +2.9 +% +State tax rate +( 5.4 +)% +( 0.4 +)% +( 0.2 +)% +U.S. tax reform rate change +— +% +— +% +71.4 +% +Executive compensation +1.3 +% +0.5 +% +0.9 +% +Share-based compensation +( 0.3 +)% +( 0.5 +)% +( 6.2 +)% +Nondeductible interest expense +5.0 +% +2.6 +% +8.5 +% +Foreign earnings taxed in the U.S. +6.7 +% +1.4 +% +— +% +Foreign rate differential +( 11.4 +)% +( 1.1 +)% +( 0.7 +)% +Tax credits +( 5.2 +)% +( 0.6 +)% +( 1.0 +)% +Other +1.7 +% +0.5 +% +( 0.4 +)% +Valuation allowance +( 68.5 +)% +( 9.8 +)% +( 109.7 +)% +Effective tax rate +( 72.3 +)% +2.2 +% +0.5 +% +Significant components of our deferred tax assets and liabilities at December 31, 2019 and 2018 are as follows (millions): +December 31, +2019 +2018 +Deferred tax assets +Net operating loss carryforwards and credits +Federal +$ +2,860 +$ +848 +Foreign +5 +7 +State +249 +189 +Federal and state tax credits +64 +28 +Disallowed business interest expense carryforward +154 +19 +Deferred gain +46 +46 +Other +97 +50 +Less: valuation allowance +( 196 +) +( 686 +) +Total deferred tax assets +3,279 +501 +Deferred tax liabilities +Investment in limited partnership +( 554 +) +( 375 +) +Convertible debt +( 51 +) +( 59 +) +Property, plant and equipment +( 2,110 +) +( 48 +) +Other +( 35 +) +( 11 +) +Total deferred tax liabilities +( 2,750 +) +( 493 +) +Net deferred tax assets +$ +529 +$ +8 +We recognize deferred tax assets and liabilities for future tax consequences arising from differences between the carrying amounts of existing assets and liabilities under GAAP and their respective tax bases, and for net operating loss (“NOL”) carryforwards and tax credit carryforwards. We evaluate the recoverability of our deferred tax assets as of each reporting date, weighing all positive and negative evidence, and establish a valuation allowance if we determine that it is more likely than not that some or all of our deferred tax assets will not be realized. The assessment requires significant judgment and is performed in each of our applicable jurisdictions. In making such determination, we consider various factors such as historical profitability, future projections of sustained profitability, reversal of existing deferred tax liabilities, construction and operational milestones reached on our Liquefaction Projects and our long-term SPAs achieving date of first commercial delivery. We recorded a valuation allowance of $ 686 million in 2018 against our deferred tax assets due to being in a three -year cumulative loss position at the time, in addition to ongoing construction and performance risks related to our Liquefaction Projects . After weighing 2019 positive and negative evidence, we determined that sufficient positive evidence existed to support releasing the valuation allowance against significantly all of our federal deferred tax assets and a portion of our state deferred tax assets. The positive evidence supporting such conclusion included successful completion and subsequent operations of Trains 1 and 2 of the CCL Project and Train 5 of the SPL Project , our transitioning from a three -year cumulative loss position in 2018 to a three -year cumulative income position +109 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +in 2019, commencing commercial delivery on 13 of our long term customer SPAs and forecasts of sustained future profitability. As a result, we recorded a decrease in valuation allowance of $ 490 million comprised of a $ 493 million federal valuation allowance release and a $ 49 million state valuation allowance release, partially offset by an increase in the valuation allowance of $ 52 million in various other state and foreign tax jurisdictions. We maintained a valuation allowance of $ 196 million at December 31, 2019 primarily against state NOL carryforward deferred tax assets, for which we continue to believe the more likely than not recognition threshold was not met. +At December 31, 2019 , we had federal and state NOL carryforwards of approximately $ 13.6 billion and $ 3.1 billion , respectively. These NOL carryforwards will expire between 2021 and 2039. At December 31, 2019 , we had federal and state tax credit carryforwards of $ 61 million and $ 3 million , respectively. The federal tax credit carryforwards include investment tax credit carryforwards of $ 52 million related to capital equipment placed in service for our Liquefaction Projects . We account for our federal investment tax credits under the flow-through method. The federal and state tax credit carryforwards will expire between 2027 and 2039. +Changes in the balance of unrecognized tax benefits are as follows (in millions): +Year Ended December 31, +2019 +2018 +Balance at beginning of the year +$ +61 +$ +62 +Additions based on tax positions related to current year +— +— +Additions for tax positions of prior years +— +— +Reductions for tax positions of prior years +— +( 1 +) +Settlements +— +— +U.S. tax reform rate change +— +— +Balance at end of the year +$ +61 +$ +61 +If recognized, $ 52 million of unrecognized tax benefits would affect our effective tax rate in future periods. Currently, we do not recognize any accrued liabilities, interest and penalties associated with the unrecognized tax benefits provided above in our Consolidated Statements of Operations or our Consolidated Balance Sheets because any settlement of uncertain tax positions would result in an adjustment to our NOL carryforward. We recognize interest and penalties related to income tax matters as part of income tax expense. +We experienced an ownership change within the provisions of U.S. Internal Revenue Code (“IRC”) Section 382 in 2008, 2010 and 2012. An analysis of the annual limitation on the utilization of our NOLs was performed in accordance with IRC Section 382. It was determined that IRC Section 382 will not limit the use of our NOLs over the carryover period. We continue to monitor trading activity in our shares which may cause an additional ownership change which could ultimately affect our ability to fully utilize our existing NOL carryforwards. +We are subject to tax in the U.S. and various state and foreign jurisdictions and we remain subject to periodic audits and reviews by taxing authorities. Federal and state tax returns for the years after 2015 remain open for examination. Tax authorities may have the ability to review and adjust carryover attributes that were generated prior to these periods if utilized in an open tax year. +NOTE 15— SHARE-BASED COMPENSATION +We have granted restricted stock shares, restricted stock units, performance stock units and phantom units to employees and non-employee directors under the 2011 Incentive Plan, as amended (the “2011 Plan”) and the 2015 Employee Inducement Incentive Plan (“Inducement Plan”). +110 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Total share-based compensation consisted of the following (in millions): +Year Ended December 31, +2019 +2018 +2017 +Share-based compensation costs, pre-tax: +Equity awards +$ +131 +$ +89 +$ +34 +Liability awards +9 +48 +80 +Total share-based compensation +140 +137 +114 +Capitalized share-based compensation +( 9 +) +( 24 +) +( 23 +) +Total share-based compensation expense +$ +131 +$ +113 +$ +91 +Tax benefit associated with share-based compensation expense +$ +14 +$ +6 +$ +5 +The total unrecognized compensation cost at December 31, 2019 relating to non-vested share-based compensation arrangements consisted of the following: +Unrecognized Compensation Cost +(in millions) +Recognized over a weighted average period +(years) +Restricted Stock Share Awards +$ +1 +0.4 +Restricted Share Unit and Performance Stock Unit Awards +$ +145 +1.8 +Phantom Units Awards +$ +3 +0.7 +Restricted Stock Share Awards +Restricted stock share awards are awards of common stock that are subject to restrictions on transfer and to a risk of forfeiture if the recipient terminates employment with us prior to the lapse of the restrictions. These awards vest based on service conditions ( one , two , three or four -year service periods) and performance conditions. All performance conditions of the awards have been achieved as of December 31, 2019 . +The Amended and Restated 2003 Stock Incentive Plan, as amended and 2011 Plan provide for the issuance of 21.0 million shares and 35.0 million shares, respectively, of our common stock that may be in the form of various share-based performance awards deemed by the Compensation Committee of our Board (the “Compensation Committee”). +The Inducement Plan initially provided for the issuance of up to 1.0 million shares of our common stock in the form of stock-based awards deemed by the Compensation Committee to provide us with an opportunity to attract employees. As of December 31, 2019 , 0.2 million shares of restricted stock have been granted under the Inducement Plan. In December 2016, the Compensation Committee recommended, and our Board approved, reducing the remaining shares available for issuance under the Inducement Plan to zero . +The table below provides a summary of our restricted stock outstanding (in millions, except for per share information): +Shares +Weighted Average Grant Date Fair Value Per Share +Non-vested at January 1, 2019 +0.1 +$ +45.77 +Granted +0.0 +67.79 +Vested +( 0.1 +) +46.95 +Forfeited +— +— +Non-vested at December 31, 2019 +0.0 +$ +67.79 +The fair value of restricted stock share awards vested for the years ended December 31, 2019, 2018 and 2017 were $ 3 million , $ 53 million and $ 78 million , respectively. +Restricted Share Unit and Performance Stock Unit Awards +Restricted stock units are stock awards that vest over a service period of three years and entitle the holder to receive shares of our common stock upon vesting, subject to restrictions on transfer and to a risk of forfeiture if the recipient terminates employment with us prior to the lapse of the restrictions. Performance stock units provide for cliff vesting after a period of three years with payouts based on metrics dependent upon market and performance achieved over the defined performance period compared to +111 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +pre-established performance targets. The settlement amounts of the awards are based on market and performance metrics which include cumulative distributable cash flow per share, and in certain circumstances, total shareholder return (“TSR”) of our common stock. Where applicable, the compensation for performance stock units is based on fair value assigned to the market metric of TSR using a Monte Carlo model upon grant, which remains constant through the vesting period, and a performance metric, which will vary due to changing estimates regarding the expected achievement of the performance metric of cumulative distributable cash flow per share. The number of shares that may be earned at the end of the vesting period ranges from 25 % up to 300 % of the target award amount if the threshold performance is met. Both restricted stock units and performance stock units will be settled in Cheniere common stock (on a one-for-one basis) and are classified as equity awards. +In January 2017, the issuance of awards with respect to 7.8 million shares of common stock available for issuance under the 2011 Plan was approved at a special meeting of our shareholders. +The table below provides a summary of our restricted share unit and performance stock unit awards outstanding assuming payout at target for awards containing performance conditions (in millions, except for per unit information): +Units +Weighted Average Grant Date Fair Value Per Unit +Non-vested at January 1, 2019 +3.4 +$ +56.29 +Granted +1.9 +67.47 +Vested +( 0.8 +) +52.87 +Forfeited +( 0.1 +) +60.23 +Non-vested at December 31, 2019 (1) +4.4 +$ +61.68 +(1) +This number excludes 0.8 million performance stock units, which represent the incremental number of common units that would be issued if the maximum level of performance under the target awards amount is achieved. +The table below provides a summary of restricted share unit and performance stock unit awards issued and fair value of units vested: +Year Ended December 31, +2019 +2018 +2017 +Units issued (in millions) +1.9 +2.6 +1.4 +Weighted average grant date fair value per unit +$ +67.47 +$ +59.50 +$ +47.16 +Fair value of units vested (in millions) +$ +45 +$ +22 +$ +1 +Phantom Units Awards +Phantom units are share-based awards granted to employees over a vesting period that entitle the grantee to receive the cash equivalent to the value of a share of our common stock upon each vesting. We did no t issue any phantom units to our employees and non-employee directors during the years ended December 31, 2019, 2018 and 2017 . Phantom units are not eligible to receive quarterly distributions. These awards vest based on service conditions ( two , three or four -year service periods). +The table below provides a summary of our phantom units outstanding (in millions): +Units +Non-vested at January 1, 2019 +0.3 +Granted +— +Vested +( 0.2 +) +Forfeited +— +Non-vested at December 31, 2019 +0.1 +The value of phantom units vested during the years ended December 31, 2019, 2018 and 2017 was $ 11 million , $ 91 million and $ 86 million , respectively. +112 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 16— EMPLOYEE BENEFIT PLAN +We have a defined contribution plan (“401(k) Plan”) which allows eligible employees to contribute up to 75 % of their compensation up to the IRS maximum. We match each employee’s deferrals (contributions) up to 6 % of compensation and may make additional contributions at our discretion. Employees are immediately vested in the contributions made by us. Our contributions to the 401(k) Plan were $ 15 million , $ 9 million and $ 7 million for the years ended December 31, 2019, 2018 and 2017 , respectively. We have made no discretionary contributions to the 401(k) Plan to date. +NOTE 17— NET INCOME (LOSS) PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS +The following table reconciles basic and diluted weighted average common shares outstanding for the years ended December 31, 2019, 2018 and 2017 (in millions, except per share data): +Year Ended December 31, +2019 +2018 +2017 +Weighted average common shares outstanding: +Basic +256.2 +245.6 +233.1 +Dilutive unvested stock +1.9 +2.4 +— +Diluted +258.1 +248.0 +233.1 +Basic net income (loss) per share attributable to common stockholders +$ +2.53 +$ +1.92 +$ +( 1.68 +) +Diluted net income (loss) per share attributable to common stockholders +$ +2.51 +$ +1.90 +$ +( 1.68 +) +Potentially dilutive securities that were not included in the diluted net income (loss) per share computations because their effects would have been anti-dilutive were as follows (in millions): +Year Ended December 31, +2019 +2018 +2017 +Unvested stock (1) +2.3 +0.8 +3.4 +Convertible notes (2) +43.7 +17.5 +16.9 +Total potentially dilutive common shares +46.0 +18.3 +20.3 +(1) +Does not include 0.5 million shares, 0.4 million shares and 0.2 million shares for the years ended December 31, 2019, 2018 and 2017 , respectively, of unvested stock because the performance conditions had not yet been satisfied as of the respective dates. +(2) +Includes number of shares in aggregate issuable upon conversion of the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes for all periods presented and the 2025 CCH HoldCo II Convertible Senior Notes upon the substantial completion of Train 2 of the CCL Project during the year ended December 31, 2019 . +NOTE 18— SHARE REPURCHASE PROGRAM +On June 3, 2019, we announced that our Board authorized a 3 -year, $ 1.0 billion share repurchase program. During the year ended December 31, 2019 , we repurchased an aggregate of 4.0 million shares of our common stock for $ 249 million , for a weighted average price per share of $ 62.27 . +As of December 31, 2019 , we had up to $ 751 million of the share repurchase program available. Under the share repurchase program, repurchases can be made from time to time using a variety of methods, which may include open market purchases, privately negotiated transactions or otherwise, all in accordance with the rules of the SEC and other applicable legal requirements. The timing and amount of any shares of our common stock that are repurchased under the share repurchase program will be determined by our management based on market conditions and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and may be modified, suspended or discontinued at any time or from time to time at our discretion. +113 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 19— COMMITMENTS AND CONTINGENCIES +We have various contractual obligations which are recorded as liabilities in our Consolidated Financial Statements. Other items, such as certain purchase commitments and other executed contracts which do not meet the definition of a liability as of December 31, 2019 , are not recognized as liabilities but require disclosures in our Consolidated Financial Statements. +LNG Terminal Commitments and Contingencies +Obligations under EPC Contracts +SPL has a lump sum turnkey contract with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Train 6 of the SPL Project. The EPC contract price for Train 6 of the SPL Project is approximately $ 2.5 billion , reflecting amounts incurred under change orders through December 31, 2019 , and including estimated costs for an optional third marine berth. As of December 31, 2019 , we have incurred $ 1.1 billion under this contract. +CCL has a lump sum turnkey contract with Bechtel for the engineering, procurement and construction of Train 3 of the CCL Project. The EPC contract price for Train 3 of the CCL Project is approximately $ 2.4 billion , reflecting amounts incurred under change orders through December 31, 2019 . As of December 31, 2019 , we have incurred $ 2.0 billion under this contract. +SPL and CCL have the right to terminate its respective EPC contracts for its convenience, in which case Bechtel will be paid (1) the portion of the contract price for the work performed, (2) costs reasonably incurred by Bechtel on account of such termination and demobilization and (3) a lump sum of up to $ 30 million depending on the termination date. +Obligations under SPAs +SPL and CCL have third-party SPAs which obligate SPL and CCL, respectively, to purchase and liquefy sufficient quantities of natural gas to deliver contracted volumes of LNG to the customers’ vessels, subject to completion of construction of applicable specified Trains of the SPL Project or the CCL Project. In addition, our integrated marketing function has third-party SPAs which obligate us to deliver contracted volumes of LNG to the customers’ vessels or to the customers at their LNG receiving terminals. +Obligations under LNG TUAs +SPLNG has third-party TUAs with Total and Chevron U.S.A. Inc. to provide berthing for LNG vessels and for the unloading, storage and regasification of LNG at the Sabine Pass LNG terminal. +Obligations under Natural Gas Supply, Transportation and Storage Service Agreements +SPL, CCL and CCL Stage III have physical natural gas supply contracts to secure natural gas feedstock for the SPL Project, the CCL Project and potential future development of Corpus Christi Stage 3, respectively. The remaining terms of these contracts range up to 15 years , some of which commence upon the satisfaction of certain events or states of affairs. As of December 31, 2019 , SPL, CCL and CCL Stage III have secured up to approximately 3,850 TBtu, 2,999 TBtu and 2,361 TBtu, respectively, of natural gas feedstock through natural gas supply contracts, a portion of which are considered purchase obligations if the certain events or states of affairs are satisfied. +Additionally, SPL and CCL have natural gas transportation and storage service agreements for the SPL Project and the CCL Project, respectively. The initial terms of the natural gas transportation agreements range up to 20 years for the SPL Project and the CCL Project, with renewal options for certain contracts, and commence upon the occurrence of conditions precedent. The initial term of the natural gas storage service agreements for the SPL Project ranges up to 10 years and the initial term of the natural gas storage service agreements for the CCL Project ranges up to five years . +114 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +As of December 31, 2019 , the obligations of SPL, CCL and CCL Stage III under natural gas supply, transportation and storage service agreements for contracts in which conditions precedent were met were as follows (in millions): +Years Ending December 31, +Payments Due (1) +2020 +$ +3,503 +2021 +2,382 +2022 +1,561 +2023 +1,231 +2024 +804 +Thereafter +3,987 +Total +$ +13,468 +(1) +Pricing of natural gas supply contracts are variable based on market commodity basis prices adjusted for basis spread . Amounts included are based on estimated forward prices and basis spreads as of December 31, 2019 . Some of our contracts may not have been negotiated as part of arranging financing for the underlying assets providing the natural gas supply, transportation and storage services. +Restricted Net Assets +At December 31, 2019 , our restricted net assets of consolidated subsidiaries were approximately $ 1.3 billion . +Other Commitments +In the ordinary course of business, we have entered into certain multi-year licensing and service agreements, none of which are considered material to our financial position. +Environmental and Regulatory Matters +Our LNG terminals and pipelines are subject to extensive regulation under federal, state and local statutes, rules, regulations and laws. These laws require that we engage in consultations with appropriate federal and state agencies and that we obtain and maintain applicable permits and other authorizations. Failure to comply with such laws could result in legal proceedings, which may include substantial penalties. We believe that, based on currently known information, compliance with these laws and regulations will not have a material adverse effect on our results of operations, financial condition or cash flows. +Legal Proceedings +We may in the future be involved as a party to various legal proceedings, which are incidental to the ordinary course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities on the eventual disposition of these matters. +Parallax and Related Litigation +In 2015, our wholly owned subsidiary, Cheniere LNG Terminals, LLC (“CLNGT”), entered into discussions with Parallax Enterprises, LLC (“Parallax Enterprises”) regarding the potential joint development of two liquefaction plants in Louisiana (the “Potential Liquefaction Transactions”). While the parties negotiated regarding the Potential Liquefaction Transactions, CLNGT loaned Parallax Enterprises approximately $ 46 million , as reflected in a secured note dated April 23, 2015, as amended on June 30, 2015, September 30, 2015 and November 4, 2015 (the “Secured Note”). The Secured Note was secured by all assets of Parallax Enterprises and its subsidiary entities. On June 30, 2015, Parallax Enterprises’ parent entity, Parallax Energy LLC (“Parallax Energy”), executed a Pledge and Guarantee Agreement further securing repayment of the Secured Note by providing a parent guaranty and a pledge of all of the equity of Parallax Enterprises in satisfaction of the Secured Note (the “Pledge Agreement”). CLNGT and Parallax Enterprises never executed a definitive agreement to pursue the Potential Liquefaction Transactions. The Secured Note matured on December 11, 2015, and Parallax Enterprises failed to make payment. On February 3, 2016, CLNGT filed an action against Parallax Energy, Parallax Enterprises and certain of Parallax Enterprises’ subsidiary entities, styled Cause No. 4:16-cv-00286, Cheniere LNG Terminals, LLC v. Parallax Energy LLC, et al., in the United States District Court for the Southern District of Texas (the “Texas Federal Suit”). CLNGT asserted claims in the Texas Federal Suit for (1) recovery of all amounts due under the Secured Note and (2) declaratory relief establishing that CLNGT is entitled to enforce its rights under the +115 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Secured Note and Pledge Agreement in accordance with each instrument’s terms and that CLNGT has no obligations of any sort to Parallax Enterprises concerning the Potential Liquefaction Transactions. On March 11, 2016, Parallax Enterprises and the other defendants in the Texas Federal Suit moved to dismiss the suit for lack of subject matter jurisdiction. On August 2, 2016, the court denied the defendants’ motion to dismiss without prejudice and permitted the parties to pursue jurisdictional discovery. +On March 11, 2016, Parallax Enterprises filed a suit against us and CLNGT styled Civil Action No. 62-810, Parallax Enterprises LLP v. Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC, in the 25th Judicial District Court of Plaquemines Parish, Louisiana (the “Louisiana Suit”), wherein Parallax Enterprises asserted claims for breach of contract, fraudulent inducement, negligent misrepresentation, detrimental reliance, unjust enrichment and violation of the Louisiana Unfair Trade Practices Act. Parallax Enterprises predicated its claims in the Louisiana Suit on an allegation that we and CLNGT breached a purported agreement to jointly develop the Potential Liquefaction Transactions. Parallax Enterprises sought $ 400 million in alleged economic damages and rescission of the Secured Note. On April 15, 2016, we and CLNGT removed the Louisiana Suit to the United States District Court for the Eastern District of Louisiana, which subsequently transferred the Louisiana Suit to the United States District Court for the Southern District of Texas, where it was assigned Civil Action No. 4:16-cv-01628 and transferred to the same judge presiding over the Texas Federal Suit for coordinated handling. On August 22, 2016, Parallax Enterprises voluntarily dismissed all claims asserted against CLNGT and us in the Louisiana Suit without prejudice to refiling. +On July 27, 2017, the Parallax entities named as defendants in the Texas Federal Suit reurged their motion to dismiss and simultaneously filed counterclaims against CLNGT and third party claims against us for breach of contract, breach of fiduciary duty, promissory estoppel, quantum meruit and fraudulent inducement of the Secured Note and Pledge Agreement, based on substantially the same factual allegations Parallax Enterprises made in the Louisiana Suit. These Parallax entities also simultaneously filed an action styled Cause No. 2017-49685, Parallax Enterprises, LLC, et al. v. Cheniere Energy, Inc., et al., in the 61st District Court of Harris County, Texas (the “Texas State Suit”), which asserts substantially the same claims these entities asserted in the Texas Federal Suit. On July 31, 2017, CLNGT withdrew its opposition to the dismissal of the Texas Federal Suit without prejudice on jurisdictional grounds and the federal court subsequently dismissed the Texas Federal Suit without prejudice. We and CLNGT simultaneously filed an answer and counterclaims in the Texas State Suit, asserting the same claims CLNGT had previously asserted in the Texas Federal Suit. Additionally, CLNGT filed third party claims against Parallax principals Martin Houston, Christopher Bowen Daniels, Howard Candelet and Mark Evans, as well as Tellurian Investments, Inc., Driftwood LNG, LLC, Driftwood LNG Pipeline LLC and Tellurian Services LLC, formerly known as Parallax Services LLC, including claims for tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement, fraudulent transfer, conspiracy/aiding and abetting. +On February 15, 2019, we filed an action with CLNGT against Charif Souki, our former Chairman of the Board and Chief Executive Officer, styled, Cause No. 2019-11529, Cheniere Energy, Inc. and Cheniere LNG Terminals, LLC v. Charif Souki , in the 55th District Court of Harris County, Texas, which asserts claims of breach of fiduciary duties, fraudulent transfer, tortious interference with CLNGT’s collateral rights under the Secured Note and Pledge Agreement and conspiracy/aiding and abetting. On April 29, 2019, the court consolidated the Souki matter with the earlier filed pending case against Parallax, Tellurian and the individual defendants in the Texas State Suit. +On January 30, 2020, the parties filed an Agreed Motion to Dismiss and all claims were dismissed with prejudice. +The resolution of the foregoing litigation did not have a material adverse impact on our financial results. +On January 10, 2020, a purported shareholder of Cheniere filed a shareholder derivative action in state court in Houston, Texas. The complaint names as defendants ten of our current directors. The plaintiff alleges that those directors breached their fiduciary duties by abandoning a proposed joint-development arrangement with Parallax in 2015, which later was the subject of a separate lawsuit by Parallax discussed above. According to the complaint, the directors’ alleged breach of their fiduciary duties caused us to incur legal fees in the Parallax action and also exposed us to a potential damages award in the Parallax lawsuit. On January 30, 2020, Parallax voluntarily dismissed with prejudice all claims against us. We do not expect that the resolution of the foregoing litigation will have a material adverse impact on our financial results. +116 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 20— CUSTOMER CONCENTRATION +The following table shows customers with revenues of 10% or greater of total revenues from external customers and customers with accounts receivable balances of 10% or greater of total accounts receivable from external customers: +Percentage of Total Revenues from External Customers +Percentage of Accounts Receivable from External Customers +Year Ended December 31, +December 31, +2019 +2018 +2017 +2019 +2018 +Customer A +16 % +18 % +24 % +13 % +21 % +Customer B +10 % +14 % +14 % +* +14 % +Customer C +11 % +19 % +14 % +13 % +18 % +Customer D +11 % +13 % +* +* +* +Customer E +* +* +17 % +— % +— % +Customer F +* +* +* +— % +10 % +* Less than 10% +The following table shows revenues from external customers attributable to the country in which the revenues were derived (in millions). We attribute revenues from external customers to the country in which the party to the applicable agreement has its principal place of business. Substantially all of our long-lived assets are located in the United States. +Revenues from External Customers +Year Ended December 31, +2019 +2018 +2017 +United States +$ +2,807 +$ +1,911 +$ +1,592 +South Korea +1,207 +1,517 +762 +India +1,160 +1,048 +48 +Ireland +989 +1,098 +787 +Spain +598 +— +50 +United Kingdom +559 +155 +102 +Singapore +533 +417 +203 +Japan +157 +193 +1,246 +Other countries +1,720 +1,648 +811 +Total +$ +9,730 +$ +7,987 +$ +5,601 +NOTE 21— SUPPLEMENTAL CASH FLOW INFORMATION +The following table provides supplemental disclosure of cash flow information (in millions): +Year Ended December 31, +2019 +2018 +2017 +Cash paid during the period for interest on debt, net of amounts capitalized +$ +1,126 +$ +707 +$ +305 +Cash paid for income taxes +24 +14 +3 +Non-cash investing and financing activities: +Acquisition of non-controlling interest in Cheniere Holdings +— +702 +2 +Contribution of assets to equity method investee +— +— +14 +Acquisition of assets under capital lease (1) +— +60 +— +(1) +See Note 12—Leases for our supplemental cash flow information related to our leases in 2019 following the adoption of ASC 842. +The balance in property, plant and equipment, net funded with accounts payable and accrued liabilities was $ 473 million , $ 420 million and $ 521 million as of years ended December 31, 2019, 2018 and 2017 , respectively. +117 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS +SUMMARIZED QUARTERLY FINANCIAL DATA +(unaudited) +Summarized Quarterly Financial Data—(in millions, except per share amounts) +First +Quarter +Second +Quarter +Third +Quarter +Fourth +Quarter +Year ended December 31, 2019: +Revenues +$ +2,261 +$ +2,292 +$ +2,170 +$ +3,007 +Income from operations +606 +432 +307 +1,016 +Net income (loss) +337 +2 +( 260 +) +1,153 +Net income (loss) attributable to common stockholders +141 +( 114 +) +( 318 +) +939 +Net income (loss) per share attributable to common stockholders—basic (1) +0.55 +( 0.44 +) +( 1.25 +) +3.70 +Net income (loss) per share attributable to common stockholders—diluted (1) +0.54 +( 0.44 +) +( 1.25 +) +3.34 +Year ended December 31, 2018: +Revenues +$ +2,242 +$ +1,543 +$ +1,819 +$ +2,383 +Income from operations +747 +336 +425 +516 +Net income +600 +150 +227 +223 +Net income (loss) attributable to common stockholders +357 +( 18 +) +65 +67 +Net income (loss) per share attributable to common stockholders—basic (1) +1.52 +( 0.07 +) +0.26 +0.26 +Net income (loss) per share attributable to common stockholders—diluted (1) +1.50 +( 0.07 +) +0.26 +0.26 +(1) +The sum of the quarterly net income (loss) per share—basic and diluted may not equal the full year amount as the computations of the weighted average common shares outstanding for basic and diluted shares outstanding for each quarter and the full year are performed independently. +118 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. +CONTROLS AND PROCEDURES +Evaluation of Disclosure Controls and Procedures +Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. +Based on their evaluation as of the end of the fiscal year ended December 31, 2019 , our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act ) are effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are (1) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and (2) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. +During the most recent fiscal quarter, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +Management’s Report on Internal Control Over Financial Reporting +Our Management’s Report on Internal Control Over Financial Reporting is included in our Consolidated Financial Statements on page 68 and is incorporated herein by reference. +ITEM 9B. +OTHER INFORMATION +None. +PART III +Pursuant to paragraph 3 of General Instruction G to Form 10-K, the information required by Items 10 through 14 of Part III of this Report is incorporated by reference from Cheniere’s definitive proxy statement, which is to be filed pursuant to Regulation 14A within 120 days after the end of Cheniere’s fiscal year ended December 31, 2019 . +119 +PART IV +ITEM 15. +EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +(a) +Financial Statements, Schedules and Exhibits +(1) +Financial Statements—Cheniere Energy, Inc. and Subsidiaries: +Management’s Report to the Stockholders of Cheniere Energy, Inc. +68 +Reports of Independent Registered Public Accounting Firm +69 +Consolidated Balance Sheets +72 +Consolidated Statements of Operations +73 +Consolidated Statements of Stockholders’ Equity +74 +Consolidated Statements of Cash Flows +75 +Notes to Consolidated Financial Statements +76 +Supplemental Information to Consolidated Financial Statements—Quarterly Financial Data +118 +(2) +Financial Statement Schedules: +Schedule I—Condensed Financial Information of Registrant for the years ended December 31, 2019, 2018 and 2017 +133 +(3) +Exhibits: +Certain of the agreements filed as exhibits to this Form 10-K contain representations, warranties, covenants and conditions by the parties to the agreements that have been made solely for the benefit of the parties to the agreement. These representations, warranties, covenants and conditions: +• +should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate; +• +may have been qualified by disclosures that were made to the other parties in connection with the negotiation of the agreements, which disclosures are not necessarily reflected in the agreements; +• +may apply standards of materiality that differ from those of a reasonable investor; and +• +were made only as of specified dates contained in the agreements and are subject to subsequent developments and changed circumstances. +Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. These agreements are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Investors should not rely on them as statements of fact. +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +2.1 +Amended and Restated Purchase and Sale Agreement, dated as of August 9, 2012, by and among Cheniere Partners, Cheniere Pipeline Company, Grand Cheniere Pipeline, LLC and the Company +Cheniere Partners +8-K +10.2 +8/9/2012 +3.1 +Restated Certificate of Incorporation of the Company +Cheniere +10-Q +3.1 +8/10/2004 +3.2 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere +8-K +3.1 +2/8/2005 +3.3 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere +(SEC File No. 333-160017) +S-8 +4.3 +6/16/2009 +3.4 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere +8-K +3.1 +6/7/2012 +120 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +3.5 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere +8-K +3.1 +2/5/2013 +3.6 +Bylaws of the Company, as amended and restated December 9, 2015 +Cheniere +8-K +3.1 +12/15/2015 +3.7 +Amendment No. 1 to the Amended and Restated Bylaws of the Company, dated September 15, 2016 +Cheniere +8-K +3.1 +9/19/2016 +4.1 +Specimen Common Stock Certificate of the Company +Cheniere +(SEC File No. 333-10905) +S-1 +4.1 +8/27/1996 +4.2 +Indenture, dated as of February 1, 2013, by and among SPL, the guarantors that may become party thereto from time to time and The Bank of New York Mellon, as trustee +Cheniere Partners +8-K +4.1 +2/4/2013 +4.3 +Form of 5.625% Senior Secured Note due 2021 (Included as Exhibit A-1 to Exhibit 4.2 above) +Cheniere Partners +8-K +4.1 +2/4/2013 +4.4 +First Supplemental Indenture, dated as of April 16, 2013, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners +8-K +4.1.1 +4/16/2013 +4.5 +Second Supplemental Indenture, dated as of April 16, 2013, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners +8-K +4.1.2 +4/16/2013 +4.6 +Form of 5.625% Senior Secured Note due 2023 (Included as Exhibit A-1 to Exhibit 4.5 above) +Cheniere Partners +8-K +4.1.2 +4/16/2013 +4.7 +Third Supplemental Indenture, dated as of November 25, 2013, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners +8-K +4.1 +11/25/2013 +4.8 +Form of 6.25% Senior Secured Note due 2022 (Included as Exhibit A-1 to Exhibit 4.7 above) +Cheniere Partners +8-K +4.1 +11/25/2013 +4.9 +Fourth Supplemental Indenture, dated as of May 20, 2014, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners +8-K +4.1 +5/22/2014 +4.10 +Form of 5.750% Senior Secured Note due 2024 (Included as Exhibit A-1 to Exhibit 4.9 above) +Cheniere Partners +8-K +4.1 +5/22/2014 +4.11 +Fifth Supplemental Indenture, dated as of May 20, 2014, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners +8-K +4.2 +5/22/2014 +4.12 +Form of 5.625% Senior Secured Note due 2023 (Included as Exhibit A-1 to Exhibit 4.11 above) +Cheniere Partners +8-K +4.2 +5/22/2014 +4.13 +Sixth Supplemental Indenture, dated as of March 3, 2015, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners +8-K +4.1 +3/3/2015 +4.14 +Form of 5.625% Senior Secured Note due 2025 (Included as Exhibit A-1 to Exhibit 4.13 above) +Cheniere Partners +8-K +4.1 +3/3/2015 +4.15 +Seventh Supplemental Indenture, dated as of June 14, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +6/14/2016 +4.16 +Form of 5.875% Senior Secured Note due 2026 (Included as Exhibit A-1 to Exhibit 4.15 above) +Cheniere Partners +8-K +4.1 +6/14/2016 +4.17 +Eighth Supplemental Indenture, dated as of September 19, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +9/23/2016 +4.18 +Ninth Supplemental Indenture, dated as of September 23, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.2 +9/23/2016 +4.19 +Form of 5.00% Senior Secured Note due 2027 (Included as Exhibit A-1 to Exhibit 4.18 above) +Cheniere Partners +8-K +4.2 +9/23/2016 +4.20 +Tenth Supplemental Indenture, dated as of March 6, 2017, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +3/6/2017 +4.21 +Form of 4.200% Senior Secured Note due 2028 (Included as Exhibit A-1 to Exhibit 4.20 above) +Cheniere Partners +8-K +4.1 +3/6/2017 +121 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +4.22 +Indenture, dated as of February 24, 2017, between SPL, the guarantors that may become party thereto from time to time and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +2/27/2017 +4.23 +Form of 5.00% Senior Secured Note due 2037 (Included as Exhibit A-1 to Exhibit 4.22 above) +Cheniere Partners +8-K +4.1 +2/27/2017 +4.24 +Indenture, dated as of November 28, 2014, by and between the Company, as Issuer, and The Bank of New York Mellon, as Trustee +Cheniere +8-K +4.1 +12/2/2014 +4.25 +Form of 4.875% Unsecured PIK Convertible Note due 2021 (Included as Exhibit A to Exhibit 4.24 above) +Cheniere +8-K +4.1 +12/2/2014 +4.26 +Indenture, dated as of March 9, 2015, between the Company, the Guarantors and The Bank of New York Mellon, as Trustee +Cheniere +8-K +4.1 +3/13/2015 +4.27 +First Supplemental Indenture, dated as of March 9, 2015, between the Company, as Issuer, and The Bank of New York Mellon, as Trustee +Cheniere +8-K +4.2 +3/13/2015 +4.28 +Form of 4.25% Convertible Senior Note due 2045 (Included as Exhibit A to Exhibit 4.27 above) +Cheniere +8-K +4.2 +3/13/2015 +4.29 +Indenture, dated as of May 18, 2016, among CCH, as Issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee +Cheniere +8-K +4.1 +5/18/2016 +4.30 +Form of 7.000% Senior Secured Note due 2024 (Included as Exhibit A-1 to Exhibit 4.29 above) +Cheniere +8-K +4.1 +5/18/2016 +4.31 +First Supplemental Indenture, dated as of December 9, 2016, among CCH, as Issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee +Cheniere +8-K +4.1 +12/9/2016 +4.32 +Form of 5.875% Senior Secured Note due 2025 (Included as Exhibit A-1 to Exhibit 4.31 above) +Cheniere +8-K +4.1 +12/9/2016 +4.33 +Second Supplemental Indenture, dated as of May 19, 2017, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as trustee +CCH +8-K +4.1 +5/19/2017 +4.34 +Form of 5.125% Senior Secured Note due 2027 (Included as Exhibit A-1 to Exhibit 4.33 above) +CCH +8-K +4.1 +5/19/2017 +4.35 +Third Supplemental Indenture, dated as of September 6, 2019, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee +CCH +8-K +4.1 +9/12/2019 +4.36 +Fourth Supplemental Indenture, dated as of November 13, 2019, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH +8-K +4.1 +11/13/2019 +4.37 +Indenture, dated as of September 18, 2017, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +9/18/2017 +4.38 +First Supplemental Indenture, dated as of September 18, 2017, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.2 +9/18/2017 +4.39 +Form of 5.250% Senior Note due 2025 (Included as Exhibit A-1 to Exhibit 4.38 above) +Cheniere Partners +8-K +4.2 +9/18/2017 +4.40 +Second Supplemental Indenture, dated as of September 11, 2018, among Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +9/12/2018 +4.41 +Form of 5.625% Senior Note due 2026 (Included as Exhibit A-1 to Exhibit 4.40 above) +Cheniere Partners +8-K +4.1 +9/12/2018 +4.42 +Third Supplemental Indenture, dated as of September 12, 2019, among Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners +8-K +4.1 +9/12/2019 +122 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +4.43 +Indenture, dated as of September 27, 2019, among CCH, as issuer, and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH +8-K +4.1 +9/30/2019 +4.44 +Indenture, dated as of October 17, 2019, among CCH, as issuer, and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH +8-K +4.1 +10/18/2019 +4.45* +Description of the Registrant’s Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934 +10.1 +LNG Terminal Use Agreement, dated September 2, 2004, by and between Total LNG USA, Inc. and SPLNG +Cheniere +10-Q +10.1 +11/15/2004 +10.2 +Amendment of LNG Terminal Use Agreement, dated January 24, 2005, by and between Total LNG USA, Inc. and SPLNG +Cheniere +10-K +10.40 +3/10/2005 +10.3 +Amendment of LNG Terminal Use Agreement, dated June 15, 2010, by and between Total Gas & Power North America, Inc. and SPLNG +Cheniere +10-Q +10.2 +8/6/2010 +10.4 +Omnibus Agreement, dated September 2, 2004, by and between Total LNG USA, Inc. and SPLNG +Cheniere +10-Q +10.2 +11/15/2004 +10.5 +Parent Guarantee, dated as of November 5, 2004, by Total S.A. in favor of SPLNG +Cheniere +10-Q +10.3 +11/15/2004 +10.6 +Letter Agreement, dated September 11, 2012, between Total Gas & Power North America, Inc. and SPLNG +Cheniere Partners +10-Q +10.1 +11/2/2012 +10.7 +LNG Terminal Use Agreement, dated November 8, 2004, between Chevron U.S.A. Inc. and SPLNG +Cheniere +10-Q +10.4 +11/15/2004 +10.8 +Amendment to LNG Terminal Use Agreement, dated December 1, 2005, by and between Chevron U.S.A. Inc. and SPLNG +SPLNG +S-4 +10.28 +11/22/2006 +10.9 +Amendment of LNG Terminal Use Agreement, dated June 16, 2010, by and between Chevron U.S.A. Inc. and SPLNG +Cheniere +10-Q +10.3 +8/6/2010 +10.10 +Omnibus Agreement, dated November 8, 2004, between Chevron U.S.A. Inc. and SPLNG +Cheniere +10-Q +10.5 +11/15/2004 +10.11 +Guaranty Agreement, dated as of December 15, 2004, from ChevronTexaco Corporation to SPLNG +SPLNG +S-4 +10.12 +11/22/2006 +10.12 +Second Amended and Restated LNG Terminal Use Agreement, dated as of July 31, 2012, between SPL and SPLNG +SPLNG +8-K +10.1 +8/6/2012 +10.13 +Letter Agreement, dated May 28, 2013, by and between SPL and SPLNG +SPLNG +10-Q +10.1 +8/2/2013 +10.14 +Guarantee Agreement, dated as of July 31, 2012, by Cheniere Partners in favor of SPLNG +SPLNG +8-K +10.2 +8/6/2012 +10.15† +Cheniere Energy, Inc. 2011 Incentive Plan (as amended through April 13, 2017) +Cheniere +10-Q +10.1 +8/8/2017 +10.16† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (US - New Hire) +Cheniere +8-K +10.13 +8/10/2012 +10.17† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (UK - New Hire) +Cheniere +8-K +10.14 +8/10/2012 +10.18† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (Director) +Cheniere +10-Q +10.20 +7/30/2015 +10.19† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grades 18-20) +Cheniere +10-K +10.37 +2/24/2017 +10.20† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grades 18-20) +Cheniere +10-Q +10.2 +5/4/2017 +10.21† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 17) +Cheniere +10-K +10.38 +2/24/2017 +10.22† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 17) +Cheniere +10-Q +10.3 +5/4/2017 +123 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.23† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Key Executive Severance Plan) +Cheniere +10-K +10.39 +2/24/2017 +10.24† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Severance Pay Plan) +Cheniere +10-K +10.40 +2/24/2017 +10.25† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 16 and Below) +Cheniere +10-Q +10.4 +5/4/2017 +10.26† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Singapore) (Grade 16 and Below) +Cheniere +10-Q +10.5 +5/4/2017 +10.27† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Chile) (Grade 16 and Below) +Cheniere +10-Q +10.6 +5/4/2017 +10.28† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grades 18-20) +Cheniere +10-K +10.41 +2/24/2017 +10.29† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grades 18-20) +Cheniere +10-Q +10.7 +5/4/2017 +10.30† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 17) +Cheniere +10-K +10.42 +2/24/2017 +10.31† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 17) +Cheniere +10-Q +10.8 +5/4/2017 +10.32† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Key Executive Severance Plan) +Cheniere +10-K +10.43 +2/24/2017 +10.33† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Severance Pay Plan) +Cheniere +10-K +10.44 +2/24/2017 +10.34† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 16 and Below) +Cheniere +10-Q +10.9 +5/4/2017 +10.35† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (2019 Grades 18-20) +Cheniere +10-K +10.35 +2/26/2019 +10.36† +Form of Milestone Award Letter +Cheniere +10-K +10.45 +2/24/2017 +10.37† +Cheniere Energy, Inc. 2014-2018 Long-Term Cash Incentive Program +Cheniere +10-Q +10.9 +4/30/2015 +10.38† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Executive) +Cheniere +10-Q +10.10 +4/30/2015 +10.39† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Non-Executive) +Cheniere +10-Q +10.11 +4/30/2015 +10.40† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Executive) +Cheniere +10-Q +10.12 +4/30/2015 +10.41† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Non-Executive) +Cheniere +10-Q +10.13 +4/30/2015 +10.42† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Consultant) +Cheniere +10-Q +10.14 +4/30/2015 +10.43† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Consultant) +Cheniere +10-Q +10.15 +4/30/2015 +10.44† +Cheniere Energy, Inc. 2015 Employee Inducement Incentive Plan +Cheniere +(SEC File No. 333-207651) +S-8 +4.8 +10/29/2015 +10.45† +Form of Cheniere Energy, Inc. 2015 Employee Inducement Incentive Plan Restricted Stock Grant - US Form +Cheniere +10-Q +10.7 +10/30/2015 +124 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.46† +Amended and Restated Cheniere Energy, Inc. Key Executive Severance Pay Plan (Effective August 15, 2019) and Summary Plan Description +Cheniere +10-Q +10.3 +11/1/2019 +10.47† +Employment Agreement between the Company and Jack A. Fusco, dated May 12, 2016 +Cheniere +8-K +10.1 +5/12/2016 +10.48† +Employment Agreement Amendment between the Company and Jack Fusco, dated August 15, 2019 +Cheniere +8-K +10.1 +8/15/2019 +10.49*† +Cheniere Energy, Inc. Amended and Restated Retirement Policy, dated effective August 15, 2019 +10.50† +Form of Indemnification Agreement for officers of the Company +Cheniere +10-K +10.73 +2/19/2016 +10.51† +Form of Indemnification Agreement for directors of the Company +Cheniere +10-K +10.74 +2/19/2016 +10.52† +Letter Agreement between the Company and Douglas Shanda, dated November 1, 2019 +Cheniere +8-K +10.1 +11/1/2019 +10.53 +Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, among SPL, as Borrower, the representatives and agents from time to time parties thereto, and Société Générale, as the Common Security Trustee and Intercreditor Agent +Cheniere Partners +8-K +10.2 +7/1/2015 +10.54 +Omnibus Amendment, dated as of September 24, 2015, to the Second Amended and Restated Common Terms Agreement among SPL, as Borrower, the representatives and agents from time to time parties thereto, and Société Générale, as the Common Security Trustee and Intercreditor Agent +Cheniere Partners +10-Q +10.6 +10/30/2015 +10.55 +Administrative Amendment to the Second Amended and Restated Common Terms Agreement, dated as of December 31, 2015, among SPL, Société Générale, as the Commercial Banks Facility Agent, The Korea Development Bank, New York Branch, as the KSURE Covered Facility Agent and Shinhan Bank New York Branch, as KEXIM Facility Agent +Cheniere Partners +10-Q +10.7 +5/5/2016 +10.56 +Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, among SPL, as Borrower, The Bank of Nova Scotia, as Senior Issuing Bank and Senior Facility Agent, ABN Amro Capital USA LLC, HSBC Bank USA, National Association and ING Capital LLC, as Senior Issuing Banks, Société Générale, as Swing Line Lender and Common Security Trustee, and the senior lenders party thereto from time to time +Cheniere Partners +8-K +10.1 +9/11/2015 +10.57 +Third Omnibus Amendment, dated as of May 23, 2018 to (a) the Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, by and among SPL, Société Générale, as the Common Security Trustee and as the Intercreditor Agent, The Bank of Nova Scotia, and each other party thereto from time to time and (b) the Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, by and among SPL, Société Générale as the Swing Line Lender and as the Common Security Trustee, The Bank of Nova Scotia as the Senior Issuing Bank and Senior Facility Agent and the other agents and lenders from time to time party thereto +Cheniere Partners +(SEC File No. 333-225684) +S-4 +10.3 +6/15/2018 +125 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.58 +Fourth Omnibus Amendment, dated as of September 17, 2018, to (a) the Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, by and among SPL, as Borrower, Société Générale, as the Common Security Trustee and as the Intercreditor Agent, The Bank of Nova Scotia, as the Secured Debt Holder Group Representative for the Working Capital Debt and other Secured Debt Holder Group Representatives party thereto from time to time, the Secured Hedge Representatives and the Secured Gas Hedge Representatives party thereto from time to time and (b) the Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, by and among SPL, as Borrower, Société Générale as the Swing Line Lender and as the Common Security Trustee, The Bank of Nova Scotia as the Senior Issuing Bank and Senior Facility Agent and the other agents and lenders from time to time party thereto +Cheniere +10-Q +10.1 +11/8/2018 +10.59* +Fifth Omnibus Amendment, dated as of May 29, 2019, to (a) the Second Amended and Restated Common Terms Agreement, dated as of June 30, 2015, by and among SPL, as Borrower, Société Générale, as the Common Security Trustee and as the Intercreditor Agent, The Bank of Nova Scotia, as the Secured Debt Holder Group Representative for the Working Capital Debt and other Secured Debt Holder Group Representatives party thereto from time to time, the Secured Hedge Representatives and the Secured Gas Hedge Representatives party thereto from time to time and (b) the Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated as of September 4, 2015, by and among SPL, as Borrower, Société Générale as the Swing Line Lender and as the Common Security Trustee, The Bank of Nova Scotia as the Senior Issuing Bank and Senior Facility Agent and the other agents and lenders from time to time party thereto +10.60 +Amended and Restated Subscription Agreement, dated as of November 26, 2014, by and among the Company, RRJ Capital II Ltd, Baytree Investments (Mauritius) Pte Ltd and Seatown Lionfish Pte. Ltd. relating to convertible PIK notes of the Company +Cheniere +8-K +10.1 +12/2/2014 +10.61 +Amended and Restated Term Loan Facility Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the lenders party thereto from time to time and Société Générale as the Term Loan Facility Agent +Cheniere +8-K +10.1 +5/24/2018 +10.62 +Amended and Restated Common Terms Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, Société Générale, as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, and Société Générale as Intercreditor Agent, and any other facility lenders party thereto from time to time +Cheniere +8-K +10.2 +5/24/2018 +10.63 +First Amendment to the Amended and Restated Common Terms Agreement, dated as of November 28, 2018, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as Intercreditor Agent +Cheniere +10-K +10.60 +2/26/2019 +10.64 +Second Amendment to the Amended and Restated Common Terms Agreement, dated as of August 30, 2019, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as the Intercreditor Agent +Cheniere +10-Q +10.4 +11/1/2019 +126 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.65 +Amended and Restated Common Security and Account Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the Senior Creditor Group Representatives, Société Générale as the Intercreditor Agent, Société Générale as Security Trustee and Mizuho Bank, Ltd as the Account Bank +Cheniere +8-K +10.3 +5/24/2018 +10.66 +First Amendment to the Amended and Restated Common Security and Account Agreement, dated as of November 28, 2018, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, the Senior Creditor Group Representatives, Société Générale as Intercreditor Agent for the Facility Lenders and any Hedging Banks, Société Générale as Security Trustee, and Mizuho Bank, Ltd. as Account Bank +Cheniere +10-K +10.62 +2/26/2019 +10.67 +Second Amendment to Common Security and Account Agreement, dated as of August 30, 2019, by and among the Company, CCL, CCP, Corpus Christi Pipeline GP, LLC, the Senior Creditor Group Representatives, Société Générale as Intercreditor Agent for the Facility Lenders and any Hedging Banks, Société Générale as Security Trustee, and Mizuho Bank, Ltd; as Account Bank +Cheniere +10-Q +10.5 +11/1/2019 +10.68 +Amended and Restated Pledge Agreement, dated May 22, 2018, among CCH HoldCo I and Société Générale as Security Trustee +Cheniere +8-K +10.4 +5/24/2018 +10.69 +Amended and Restated Equity Contribution Agreement, dated May 22, 2018, among CCH and the Company +Cheniere +8-K +10.5 +5/24/2018 +10.70 +Amended and Restated Note Purchase Agreement, dated as of March 1, 2015, by and among CCH HoldCo II, as Issuer, the Company (solely for purposes of acknowledging and agreeing to Section 9 thereof), EIG Management Company, LLC, as administrative agent, The Bank of New York Mellon, as collateral agent, and the note purchasers named therein +Cheniere +8-K +10.1 +3/2/2015 +10.71 +Amendment to Amended and Restated Note Purchase Agreement, dated as of March 16, 2015, by and among CCH HoldCo II, as Issuer, EIG Management Company, LLC, as administrative agent, and the note purchasers named therein +Cheniere +8-K +4.2 +5/13/2015 +10.72 +Amendment 2 to Amended and Restated Note Purchase Agreement, dated as of May 8, 2015, with effect as of May 1, 2015, by and among CCH Hold Co II, as Issuer, the Company, EIG Management Company, LLC, as administrative agent, and the required note holders named therein +Cheniere +8-K +4.3 +5/13/2015 +10.73 +Amendment 3 to Amended and Restated Note Purchase Agreement, dated May 22, 2018, among CCH Holdco II, the Company, EIG Management Company and the noteholders identified therein +Cheniere +8-K +10.6 +5/24/2018 +10.74 +Form of 11.0% Senior Secured Note due 2025 +Cheniere +8-K +4.4 +5/13/2015 +10.75 +Registration Rights Agreement for 11.0% Senior Secured Notes due 2025, dated May 13, 2015, among the Company, CCH HoldCo II and EIG Management Company, LLC as Agent on behalf of the Note Holders +Cheniere +8-K +10.6 +5/13/2015 +10.76 +Pledge Agreement, dated May 13, 2015, among the Company, EIG Management Company, LLC, as Administrative Agent for the Note Holders, and The Bank of New York Mellon as the Collateral Agent for the Note Holders +Cheniere +8-K +10.7 +5/13/2015 +10.77 +Pledge Agreement, dated May 13, 2015, among CCH HoldCo II, EIG Management Company, LLC, as Administrative Agent for the Note Holders, and The Bank of New York Mellon as the Collateral Agent for the Note Holders +Cheniere +8-K +10.8 +5/13/2015 +127 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.78 +Amended and Restated Working Capital Facility Agreement, dated June 29, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the lenders party thereto from time to time, the issuing banks party thereto from time to time, the Bank of Nova Scotia as Working Capital Facility Agent, and Société Générale as Security Trustee +Cheniere +8-K +10.1 +7/2/2018 +10.79 +The Amended and Restated Revolving Credit Agreement, dated as of December 13, 2018, among the Company, the Lenders and Issuing Banks party thereto, Goldman Sachs Bank USA, Morgan Stanley Senior Funding, Inc. and SG Americas Securities, LLC, as Coordinating Lead Arrangers, and Société Générale, as Administrative Agent +Cheniere +8-K +10.1 +12/17/2018 +10.80 +Amendment to Amended and Restated Revolving Credit Agreement, dated as of September 27, 2019, among the Company, Société Générale as administrative agent, and the Requisite Lenders party thereto +Cheniere +10-Q +10.7 +11/1/2019 +10.81 +Credit and Guaranty Agreement, dated as of May 29, 2019, among the Cheniere Partners, as Borrower, certain subsidiaries of the Cheniere Partners, as Subsidiary Guarantors, the lenders from time to time party thereto, MUFG Bank, Ltd., as Administrative Agent and Sole Coordinating Lead Arranger, and certain arrangers and other participants +Cheniere +8-K +10.1 +6/3/2019 +10.82 +Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated September 4, 2015, as amended by (a) Third Omnibus Amendment, dated as of May 23, 2018; (b) Fourth Omnibus Amendment, dated as of September 17, 2018; and (c) Fifth Omnibus Amendment, Consent and Waiver, dated as of May 29, 2019, among SPL, as Borrower, The Bank of Nova Scotia, as Senior Issuing Bank and Senior Facility Agent, ABN Amro Capital USA LLC, HSBC Bank USA, National Association and ING Capital LLC, as Senior Issuing Banks, Société Générale, as Swing Line Lender and Common Security Trustee, and the senior lenders party thereto from time to time +Cheniere +10-Q +10.2 +8/8/2019 +10.83 +Registration Rights Agreement, dated as of September 12, 2019, among Cheniere Partners, the guarantors party thereto and RBC Capital Markets, LLC +Cheniere Partners +8-K +10.1 +9/12/2019 +10.84 +Registration Rights Agreement, dated as of November 13, 2019, among CCH and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and BofA Securities, Inc., for itself and as representative of the purchasers +CCH +8-K +10.1 +11/13/2019 +10.85 +Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the Securities and Exchange Commission pursuant to a request for confidential treatment.) +Cheniere +8-K +10.1 +11/9/2018 +10.86 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: the Change Order CO-00001 Modifications to Insurance Language Change Order, dated June 3, 2019 +Cheniere +10-Q +10.6 +8/8/2019 +128 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.87 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00002 Fuel Provisional Sum Closure, dated July 8, 2019, (ii) the Change Order CO-00003 Currency Provisional Sum Closure, dated July 8, 2019, (iii) the Change Order CO-00004 Foreign Trade Zone, dated July 2, 2019, (iv) the Change Order CO-00005 NGPL Gate Access Security Coordination Provisional Sum, dated July 17, 2019, (v) the Change Order CO-00006 Alternate to Adams Valves, dated August 14, 2019, (vi) the Change Order CO-00007 E-1503 to HRU Permanent Drain Piping, dated August 14, 2019, (vii) the Change Order CO-00008 Differing Subsurface Soil Conditions - Train 6 ISBL, dated August 27, 2019, (viii) the Change Order CO-00009 LNG Berth 3, dated September 25, 2019 and (iv) the Change Order CO-00010 Cold Box Redesign and Addition of Inspection Boxes on Methane Cold Box, dated September 16, 2019 +Cheniere +10-Q +10.10 +11/1/2019 +10.88* +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between the Company and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00011 Insurance Provisional Sum Interim Adjustment, dated October 1, 2019 and (ii) the Change Order CO-00012 Replacement of Timber Piles with Pre-Stressed Concrete Piles, dated October 30, 2019 +10.89 +Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated December 12, 2017, by and between CCL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +Cheniere +10-K/A +10.23 +4/27/2018 +10.90 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00001 Stage 2 EPC Agreement Revised Table A-2, dated May 18, 2018, (ii) the Change Order CO-00002 Stage 2 EPC Agreement Amended and Restated Attachment C, dated May 18, 2018, (iii) the Change Order CO-00003 Fuel Provisional Sum Adjustment, dated May 24, 2018, (iv) the Change Order CO-00004 Currency Provisional Sum Adjustment, dated May 29, 2018, (v) the Change Order CO-00005 JT Valve Modifications, dated July 10, 2018 and (vi) the Change Order CO-00006 Tank B Soil Conditions, International Building Code, and East Jetty Marine Facility Schedule Acceleration, dated September 5, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +Cheniere +10-Q +10.3 +11/8/2018 +10.91 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00007 Tell-Tale Signs, Additional Tie-Ins, and System Inspection Isometrics, dated October 15, 2018, (ii) the Change Order CO-00008 Insurance Provisional Sum Interim Adjustment, dated November 19, 2018 and (iii) the Change Order CO-00009 Traffic and Logistics Impacts Due to Enforcement of Electronic Logging Devices, dated November 28, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +Cheniere +10-K +10.117 +2/26/2019 +129 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.92 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-000010 OSHA Handrail Requirement Changes Impact, dated January 25, 2019, (ii) the Change Order CO-00011 Differing Soil Conditions - Train 3, dated March 7, 2019 and (iii) the Change Order CO-00012 Tank B Logo Deletion, dated March 25, 2019 (Portions of this exhibit have been omitted.) +Cheniere +10-Q +10.2 +5/9/2019 +10.93 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-000013 Section 232 Steel and Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD), dated May 2, 2019, (ii) the Change Order CO-00014 Tank B Jump-over Tie-In Interface - Long Lead Items, dated May 2, 2019 and (iii) the Change Order CO-00015 Section 232 Steel and Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD) Q1_2019, dated June 4, 2019 (Portions of this exhibit have been omitted.) +Cheniere +10-Q +10.4 +8/8/2019 +10.94 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-000016 Tank B Jump-over Tie-In (Part 1) and Deletion of East Jetty Shroud, dated August 5, 2019, (ii) the Change Order CO-00017 H2S Removal Skid PSVs Modifications and Revision to Chemical Cleaning Milestones, dated August 5, 2019 and (iii) the Change Order CO-00018 Cold Box Redesign Major Permanent Plant Materials and Ethylene Cold Box’s E-1504 Partial Mockup, dated September 6, 2019 (Portions of this exhibit have been omitted.) +Cheniere +10-Q +10.9 +11/1/2019 +10.95* +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00019 Aircraft Warning Lights, dated September 23, 2019, (ii) the Change Order CO-00020 Section 232 Steel and Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD) Q2_2019, dated October 8, 2019, (iii) the Change Order CO-00021 Spare Transition Joints for Potential Future Cold Box Modifications, dated October 8, 2019, (iv) the Change Order CO-00022 Modification of the Train 3 Methane Cold Box, dated December 6, 2019 and (v) the Change Order Co-00023 Section 232 Steel & Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD) Q3_2019, dated December 10, 2019 (Portions of this exhibit have been omitted.) +10.96 +LNG Sale and Purchase Agreement (FOB), dated November 21, 2011, between SPL (Seller) and Gas Natural Aprovisionamientos SDG S.A. (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) +Cheniere Partners +8-K +10.1 +11/21/2011 +10.97 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated April 3, 2013, between SPL (Seller) and Gas Natural Aprovisionamientos SDG S.A. (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) +Cheniere Partners +10-Q +10.1 +5/3/2013 +10.98 +Amendment of LNG Sale and Purchase Agreement (FOB), dated January 12, 2017, between SPL (Seller) and Gas Natural Fenosa LNG GOM, Limited (assignee of Gas Natural Aprovisionamientos SDG S.A.) (Buyer) +SPL +(SEC File No. 333-215882) +S-4 +10.3 +2/3/2017 +130 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.99 +LNG Sale and Purchase Agreement (FOB), dated December 11, 2011, between SPL (Seller) and GAIL (India) Limited (Buyer) +Cheniere Partners +8-K +10.1 +12/12/2011 +10.100 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 18, 2013, between SPL (Seller) and GAIL (India) Limited (Buyer) +Cheniere Partners +10-K +10.18 +2/22/2013 +10.101 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated January 25, 2012, between SPL (Seller) and BG Gulf Coast LNG, LLC (Buyer) +Cheniere Partners +8-K +10.1 +1/26/2012 +10.102 +Letter agreement, dated May 12, 2016, amending the Amended and Restated LNG Sale and Purchase Agreement (FOB) between SPL and BG Gulf Coast LNG, LLC dated January 25, 2012 +SPL +(SEC File No. 333-215882) +S-4 +10.7 +2/3/2017 +10.103 +LNG Sale and Purchase Agreement (FOB), dated January 30, 2012, between SPL (Seller) and Korea Gas Corporation (Buyer) +Cheniere Partners +8-K +10.1 +1/30/2012 +10.104 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 18, 2013, between SPL (Seller) and Korea Gas Corporation (Buyer) +Cheniere Partners +10-K +10.19 +2/22/2013 +10.105 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated August 5, 2014, between SPL (Seller) and Cheniere Marketing, LLC (Buyer) +SPL +8-K +10.1 +8/11/2014 +10.106 +Letter agreement, dated December 8, 2016, amending the Amended and Restated LNG Sale and Purchase Agreement (FOB), dated August 5, 2014, between SPL and Cheniere Marketing International LLP (as assignee of Cheniere Marketing, LLC) +SPL +10-K +10.14 +2/24/2017 +10.107 +LNG Sale and Purchase Agreement (FOB), dated April 1, 2014, between CCL (Seller) and Endesa Generación, S.A. (Buyer) +Cheniere +8-K +10.1 +4/2/2014 +10.108 +LNG Sale and Purchase Agreement (FOB), dated April 7, 2014, between CCL (Seller) and Endesa S.A. (Buyer) +Cheniere +8-K +10.1 +4/8/2014 +10.109 +Assignment and Amendment Agreement, dated April 7, 2014, among Endesa Generación S.A., Endesa S.A. and CCL +Cheniere +10-Q +10.3 +5/1/2014 +10.110 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated July 23, 2015, between Endesa S.A. (Buyer) and CCL (Seller) +Cheniere +10-Q +10.9 +10/30/2015 +10.111 +Amendment No. 2 of LNG Sale and Purchase Agreement (FOB), dated July 23, 2015, between Endesa S.A. (Buyer) and CCL (Seller) +Cheniere +10-Q +10.10 +10/30/2015 +10.112 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated March 20, 2015, between CCL (Seller) and PT Pertamina (Persero) (Buyer) +Cheniere +10-Q +10.5 +4/30/2015 +10.113 +Amendment No. 1, dated February 4, 2016, to Amended and Restated LNG Sale and Purchase Agreement (FOB) between CCL and PT Pertamina (Persero), dated March 20, 2015 +CCH +S-4 +10.22 +1/5/2017 +10.114 +Amendment No. 2 of Amended and Restated LNG Sale and Purchase Agreement, dated June 27, 2019, between CCL and PT Pertamina (Persero) +CCH +10-Q +10.1 +11/1/2019 +10.115 +LNG Sale and Purchase Agreement (FOB), dated June 2, 2014, between CCL (Seller) and Gas Natural Fenosa LNG SL (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) +Cheniere +8-K +10.1 +6/2/2014 +10.116 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 27, 2018, between CCL (Seller) and Gas Natural Fenosa LNG GOM, Limited (Buyer) +Cheniere +10-Q +10.6 +5/4/2018 +10.117 +Amended and Restated Base LNG Sale and Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP +CCH +S-4 +10.32 +1/5/2017 +131 +Exhibit No. +Incorporated by Reference (1) +Description +Entity +Form +Exhibit +Filing Date +10.118 +Amendment No. 1, dated June 26, 2015, to Amended and Restated Base LNG Sale and Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP +CCH +S-4 +10.33 +1/5/2017 +10.119 +Amendment No. 2, dated December 27, 2016, to Amended and Restated Base LNG Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP +CCH +S-4 +10.34 +1/5/2017 +10.120 +Cooperative Endeavor Agreement & Payment in Lieu of Tax Agreement with eleven Cameron Parish taxing authorities, dated October 23, 2007, by and between Cheniere Marketing, Inc. and SPLNG +Cheniere +10-Q +10.7 +11/6/2007 +10.121 +Investors’ and Registration Rights Agreement, dated as of July 31, 2012, by and among the Company, Cheniere Energy Partners GP, LLC, Cheniere Partners, Cheniere Class B Units Holdings, LLC, Blackstone CQP Holdco LP and the other investors party thereto from time to time +Cheniere Partners +8-K +10.1 +8/6/2012 +10.122 +Fourth Amended and Restated Agreement of Limited Partnership of Cheniere Partners, dated February 14, 2017 +Cheniere Partners +8-K +3.1 +2/21/2017 +10.123 +Amended and Restated Limited Liability Company Agreement of Cheniere GP Holding Company, LLC, dated December 13, 2013 +Cheniere Holdings +8-K +10.3 +12/18/2013 +10.123 +Nomination and Standstill Agreement, dated August 21, 2015, by and between the Company, Icahn Partners Master Fund LP, Icahn Partners LP, Icahn Onshore LP, Icahn Offshore LP, Icahn Capital LP, IPH GP LLC, Icahn Enterprises Holdings LP, Icahn Enterprises G.P. Inc., Beckton Corp., High River Limited Partnership, Hopper Investments LLC, Barberry Corp., Carl C. Icahn, Jonathan Christodoro and Samuel Merksamer +Cheniere +8-K +99.1 +8/24/2015 +21.1* +Subsidiaries of the Company +23.1* +Consent of KPMG LLP +31.1* +Certification by Chief Executive Officer required by Rule 13a-14(a) and 15d-14(a) under the Exchange Act +31.2* +Certification by Chief Financial Officer required by Rule 13a-14(a) and 15d-14(a) under the Exchange Act +32.1** +Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +32.2** +Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +101.INS* +XBRL Instance Document +101.SCH* +XBRL Taxonomy Extension Schema Document +101.CAL* +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF* +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB* +XBRL Taxonomy Extension Labels Linkbase Document +101.PRE* +XBRL Taxonomy Extension Presentation Linkbase Document +104* +Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) +(1) +Exhibits are incorporated by reference to reports of Cheniere (SEC File No. 001-16383), Cheniere Partners (SEC File No. 001-33366), Cheniere Holdings (SEC File No. 001-36234), SPL (SEC File No. 333-192373), CCH (SEC File No. 333-215435) and SPLNG (SEC File No. 333-138916), as applicable, unless otherwise indicated. +* +Filed herewith. +** +Furnished herewith. +† +Management contract or compensatory plan or arrangement. +132 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED BALANCE SHEETS +(in millions) +December 31, +2019 +2018 +ASSETS +Current assets +Cash and cash equivalents +$ +55 +$ +— +Other current assets +1 +1 +Total current assets +56 +1 +Property, plant and equipment, net +17 +14 +Operating lease assets, net +24 +— +Debt issuance and deferred financing costs, net +16 +21 +Investments in subsidiaries +1,139 +883 +Deferred tax assets, net +315 +— +Total assets +$ +1,567 +$ +919 +LIABILITIES AND STOCKHOLDERS’ DEFICIT +Current liabilities +Current operating lease liabilities +$ +5 +$ +— +Other current liabilities +9 +9 +Total current liabilities +14 +9 +Long-term debt, net +1,534 +1,436 +Non-current operating lease liabilities +33 +— +Stockholders’ deficit +( 14 +) +( 526 +) +Total liabilities and stockholders’ deficit +$ +1,567 +$ +919 +The accompanying notes are an integral part of these condensed financial statements. +133 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF OPERATIONS +(in millions) +Year Ended December 31, +2019 +2018 +2017 +General and administrative expense +$ +17 +$ +8 +$ +7 +Other income (expense) +Interest expense, net +( 141 +) +( 128 +) +( 118 +) +Interest income +1 +— +— +Equity in income (loss) of subsidiaries +490 +607 +( 268 +) +Total other income (expense) +350 +479 +( 386 +) +Income (loss) before income taxes +333 +471 +( 393 +) +Income tax benefit +315 +— +— +Net income (loss) attributable to common stockholders +$ +648 +$ +471 +$ +( 393 +) +The accompanying notes are an integral part of these condensed financial statements. +134 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF STOCKHOLDERS’ DEFICIT +(in millions) +Common Stock +Treasury Stock +Additional Paid-in Capital +Accumulated Deficit +Total Member’s Deficit +Balance at December 31, 2016 +$ +1 +$ +( 374 +) +$ +3,211 +$ +( 4,234 +) +$ +( 1,396 +) +Issuance of stock to acquire additional interest in Cheniere Holdings +— +— +2 +— +2 +Share-based compensation +— +— +34 +— +34 +Shares withheld from employees related to share-based compensation, at cost +— +( 12 +) +— +— +( 12 +) +Equity portion of convertible notes, net +— +— +1 +— +1 +Net loss +— +— +— +( 393 +) +( 393 +) +Balance at December 31, 2017 +1 +( 386 +) +3,248 +( 4,627 +) +( 1,764 +) +Issuance of stock to acquire additional interest in Cheniere Holdings and other merger related adjustments +— +— +694 +— +694 +Share-based compensation +— +— +90 +— +90 +Shares withheld from employees related to share-based compensation, at cost +— +( 20 +) +— +— +( 20 +) +Equity portion of convertible notes, net +— +— +3 +— +3 +Net income +— +— +— +471 +471 +Balance at December 31, 2018 +1 +( 406 +) +4,035 +( 4,156 +) +( 526 +) +Share-based compensation +— +— +131 +— +131 +Shares withheld from employees related to share-based compensation, at cost +— +( 19 +) +— +— +( 19 +) +Shares repurchased, at cost +— +( 249 +) +— +— +( 249 +) +Equity portion of convertible notes, net +— +— +1 +— +1 +Net income +— +— +— +648 +648 +Balance at December 31, 2019 +$ +1 +$ +( 674 +) +$ +4,167 +$ +( 3,508 +) +$ +( 14 +) +The accompanying notes are an integral part of these condensed financial statements. +135 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF CASH FLOWS +(in millions) +Year Ended December 31, +2019 +2018 +2017 +Net cash provided by (used in) operating activities +$ +74 +$ +48 +$ +( 4 +) +Cash flows from investing activities +Property, plant and equipment, net +( 2 +) +— +— +Investments in subsidiaries +842 +568 +209 +Net cash provided by investing activities +840 +568 +209 +Cash flows from financing activities +Debt issuance and deferred financing costs +— +( 13 +) +( 15 +) +Distribution and dividends to non-controlling interest +( 591 +) +( 576 +) +( 185 +) +Payments related to tax withholdings for share-based compensation +( 19 +) +( 20 +) +( 12 +) +Repurchase of common stock +( 249 +) +— +— +Other +— +( 7 +) +— +Net cash used in financing activities +( 859 +) +( 616 +) +( 212 +) +Net increase (decrease) in cash and cash equivalents +55 +— +( 7 +) +Cash and cash equivalents—beginning of period +— +— +7 +Cash and cash equivalents—end of period +$ +55 +$ +— +$ +— +The accompanying notes are an integral part of these condensed financial statements. +136 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS +NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +The Condensed Financial Statements represent the financial information required by Securities and Exchange Commission Regulation S-X 5-04 for Cheniere. +In the Condensed Financial Statements, Cheniere’s investments in affiliates are presented under the equity method of accounting. Under this method, the assets and liabilities of affiliates are not consolidated. The investments in net assets of the affiliates are recorded on the Condensed Balance Sheets. The loss from operations of the affiliates is reported on a net basis as investment in affiliates (investment in and equity in net income (loss) of affiliates). +A substantial amount of Cheniere’s operating, investing and financing activities are conducted by its affiliates. The Condensed Financial Statements should be read in conjunction with Cheniere’s Consolidated Financial Statements. +Recent Accounting Standards +We adopted ASU 2016-02, Leases (Topic 842) , and subsequent amendments thereto (“ASC 842”) on January 1, 2019 using the optional transition approach to apply the standard at the beginning of the first quarter of 2019 with no retrospective adjustments to prior periods. The adoption of the standard resulted in the recognition of right-of-use assets and lease liabilities for operating leases of approximately $ 3 million on our Condensed Balance Sheets, with no material impact on our Condensed Statements of Operations or Condensed Statements of Cash Flows. We have elected the practical expedients to (1) carryforward prior conclusions related to lease identification and classification for existing leases, (2) combine lease and non-lease components of an arrangement for all classes of leased assets and (3) omit short-term leases with a term of 12 months or less from recognition on the balance sheet. See Note 4—Leases for additional information on our leases following the adoption of this standard. +NOTE 2—DEBT +As of December 31, 2019 and 2018 , our debt consisted of the following (in millions): +December 31, +2019 +2018 +Long-term debt: +4.875% Convertible Unsecured Notes due 2021 +$ +1,278 +$ +1,218 +4.25% Convertible Senior Notes due 2045 +625 +625 +$1.25 billion Cheniere Revolving Credit Facility +— +— +Unamortized premium, discount and debt issuance costs, net +( 369 +) +( 407 +) +Total long-term debt, net +$ +1,534 +$ +1,436 +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $ 750 million to $ 1.25 billion . We have posted $ 585 million of letters of credit on behalf of CCH under the Cheniere Revolving Credit Facility , which is available to us to back-stop our obligations under the Equity Contribution Agreement with CCH and, provided that certain conditions are met, for general corporate purposes. +Below is a schedule of future principal payments that we are obligated to make on our outstanding debt at December 31, 2019 (in millions): +Years Ending December 31, +Principal Payments +2020 +$ +— +2021 +1,278 +2022 +— +2023 +— +2024 +— +Thereafter +625 +Total +$ +1,903 +137 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +NOTE 3—GUARANTEES +Cheniere has various financial and performance guarantees and indemnifications which are issued in the normal course of business. These contracts include performance guarantees and stand-by letters of credit. Cheniere enters into these arrangements to facilitate commercial transactions with third parties by enhancing the value of the transaction to the third party. As of December 31, 2019 , outstanding guarantees and other assurances aggregated approximately $ 542 million of varying duration, consisting of parental guarantees. No liabilities were recognized under these guarantee arrangements as of December 31, 2019 . +NOTE 4—LEASES +Our leased assets consist primarily of office space and facilities, which are classified as operating leases. +The following table shows the classification and location of our right-of-use asset s and lease liabilities on our Condensed Balance Sheets (in millions): +Condensed Balance Sheet Location +December 31, 2019 +Right-of-use assets—Operating +Operating lease assets, net +$ +24 +Total right-of-use assets +$ +24 +Current operating lease liabilities +Current operating lease liabilities +$ +5 +Non-current operating lease liabilities +Non-current operating lease liabilities +33 +Total lease liabilities +$ +38 +The following table shows the classification and location of our lease cost on our Condensed Statements of Operations (in millions): +Condensed Statement of Operations Location +Year Ended December 31, 2019 +Operating lease cost (1) +General and administrative expense +$ +9 +(1) +Includes $ 3 million of variable lease costs paid to the lessor. +Future annual minimum lease payments for operating leases as of December 31, 2019 are as follows (in millions): +Years Ending December 31, +Operating Leases (1) +2020 +$ +7 +2021 +7 +2022 +7 +2023 +7 +2024 +7 +Thereafter +12 +Total lease payments +47 +Less: Interest +( 9 +) +Present value of lease liabilities +$ +38 +(1) +Does not include $ 1 million of legally binding minimum lease payments for an office space lease which was executed as of December 31, 2019 but will commence in 2020 and has a fixed minimum lease terms of up to two years . +138 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +Future annual minimum lease payments for operating leases as of December 31, 2018, prepared in accordance with accounting standards prior to the adoption of ASC 842, were as follows (in millions): +Years Ending December 31, +Operating Leases (1) +2019 +$ +8 +2020 +6 +2021 +6 +2022 +6 +2023 +7 +Thereafter +18 +Total lease payments +$ +51 +(1) +Includes payments for certain non-lease components . +The following table shows the weighted-average remaining lease term (in years) and the weighted-average discount rate for our operating leases: +December 31, 2019 +Weighted-average remaining lease term (in years) +6.6 +Weighted-average discount rate +5.5 % +The following table includes other quantitative information for our operating leases (in millions): +Year Ended December 31, 2019 +Cash paid for amounts included in the measurement of lease liabilities: +Operating cash flows from operating leases +$ +7 +Right-of-use assets obtained in exchange for new operating lease liabilities +1 +NOTE 5—SHARE REPURCHASE PROGRAM +On June 3, 2019, we announced that our Board authorized a 3 -year, $ 1.0 billion share repurchase program. During the year ended December 31, 2019 , we repurchased an aggregate of 4.0 million shares of our common stock for $ 249 million , for a weighted average price per share of $ 62.27 . +As of December 31, 2019 , we had up to $ 751 million of the share repurchase program available. Under the share repurchase program, repurchases can be made from time to time using a variety of methods, which may include open market purchases, privately negotiated transactions or otherwise, all in accordance with the rules of the SEC and other applicable legal requirements. The timing and amount of any shares of our common stock that are repurchased under the share repurchase program will be determined by our management based on market conditions and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and may be modified, suspended or discontinued at any time or from time to time at our discretion. +139 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +NOTE 6 —SUPPLEMENTAL CASH FLOW INFORMATION +The following table provides supplemental disclosure of cash flow information (in millions): +Year Ended December 31, +2019 +2018 +2017 +Cash paid during the period for interest, net of amounts capitalized +$ +36 +$ +32 +$ +31 +Non-cash investing and financing activities: +Non-cash capital distribution (contributions) (1) +490 +607 +( 268 +) +Additional interest in Cheniere Holdings acquired +— +702 +2 +(1) +Amounts represent equity income (losses) of affiliates. +140 +ITEM 16. +FORM 10-K SUMMARY +None. +141 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +CHENIERE ENERGY, INC. +(Registrant) +By: +/s/ Jack A. Fusco +Jack A. Fusco +President and Chief Executive Officer +(Principal Executive Officer) +Date: +February 24, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Jack A. Fusco +President and Chief Executive Officer and Director +(Principal Executive Officer) +February 24, 2020 +Jack A. Fusco +/s/ Michael J. Wortley +Executive Vice President and Chief Financial Officer +(Principal Financial Officer) +February 24, 2020 +Michael J. Wortley +/s/ Leonard E. Travis +Vice President and Chief Accounting Officer +(Principal Accounting Officer) +February 24, 2020 +Leonard E. Travis +/s/ G. Andrea Botta +Chairman of the Board +February 24, 2020 +G. Andrea Botta +/s/ Vicky A. Bailey +Director +February 24, 2020 +Vicky A. Bailey +/s/ Nuno Brandolini +Director +February 24, 2020 +Nuno Brandolini +/s/ Michele A. Evans +Director +February 24, 2020 +Michele A. Evans +/s/ David I. Foley +Director +February 24, 2020 +David I. Foley +/s/ David B. Kilpatrick +Director +February 24, 2020 +David B. Kilpatrick +/s/ Andrew Langham +Director +February 24, 2020 +Andrew Langham +/s/ Courtney R. Mather +Director +February 24, 2020 +Courtney R. Mather +/s/ Donald F. Robillard, Jr. +Director +February 24, 2020 +Donald F. Robillard, Jr. +/s/ Neal A. Shear +Director +February 24, 2020 +Neal A. 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0000003570 us-gaap:AllowanceForCreditLossMember 2018-12-31 0000003570 us-gaap:AllowanceForCreditLossMember 2019-01-01 2019-12-31 0000003570 us-gaap:ValuationAllowanceOfDeferredTaxAssetsMember 2018-12-31 0000003570 us-gaap:ValuationAllowanceOfDeferredTaxAssetsMember 2019-01-01 2019-12-31 0000003570 us-gaap:AllowanceForCreditLossMember 2017-12-31 0000003570 us-gaap:AllowanceForCreditLossMember 2018-01-01 2018-12-31 0000003570 us-gaap:ValuationAllowanceOfDeferredTaxAssetsMember 2017-12-31 0000003570 us-gaap:ValuationAllowanceOfDeferredTaxAssetsMember 2018-01-01 2018-12-31 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2020 +or +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-16383 +CHENIERE ENERGY, INC. +(Exact name of registrant as specified in its charter) +Delaware 95-4352386 +(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) +700 Milam Street , Suite 1900 +Houston , Texas 77002 +(Address of principal executive offices) (Zip Code) +( 713 ) 375-5000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol Name of each exchange on which registered +Common Stock, $ 0.003 par value LNG NYSE American +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ☒ Accelerated filer ☐ +Non-accelerated filer ☐ Smaller reporting company ☐ +Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ +The aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant was approximately $ 12.1 billion as of June 30, 2020. +As of February 19, 2021, the issuer had 253,529,085 shares of Common Stock outstanding. +Documents incorporated by reference: The definitive proxy statement for the registrant’s Annual Meeting of Stockholders (to be filed within 120 days of the close of the registrant’s fiscal year) is incorporated by reference into Part III. +CHENIERE ENERGY, INC. +TABLE OF CONTENTS +PART I +Items 1. and 2. Business and Properties +5 +Item 1A. Risk Factors +21 +Item 1B. Unresolved Staff Comments +37 +Item 3. Legal Proceedings +37 +Item 4. Mine Safety Disclosure +38 +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +39 +Item 6. Selected Financial Data +42 +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations +43 +Item 7A. Quantitative and Qualitative Disclosures about Market Risk +68 +Item 8. Financial Statements and Supplementary Data +70 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +118 +Item 9A. Controls and Procedures +118 +Item 9B. Other Information +118 +PART III +PART IV +Item 15. Exhibits and Financial Statement Schedules +119 +Item 16. Form 10-K Summary +142 +Signatures +143 +i +DEFINITIONS +As used in this annual report, the terms listed below have the following meanings: +Common Industry and Other Terms +Bcf billion cubic feet +Bcf/d billion cubic feet per day +Bcf/yr billion cubic feet per year +Bcfe billion cubic feet equivalent +DOE U.S. Department of Energy +EPC engineering, procurement and construction +FERC Federal Energy Regulatory Commission +FTA countries countries with which the United States has a free trade agreement providing for national treatment for trade in natural gas +GAAP generally accepted accounting principles in the United States +Henry Hub the final settlement price (in USD per MMBtu) for the New York Mercantile Exchange’s Henry Hub natural gas futures contract for the month in which a relevant cargo’s delivery window is scheduled to begin +LIBOR London Interbank Offered Rate +LNG liquefied natural gas, a product of natural gas that, through a refrigeration process, has been cooled to a liquid state, which occupies a volume that is approximately 1/600th of its gaseous state +MMBtu million British thermal units, an energy unit +mtpa million tonnes per annum +non-FTA countries countries with which the United States does not have a free trade agreement providing for national treatment for trade in natural gas and with which trade is permitted +SEC U.S. Securities and Exchange Commission +SPA LNG sale and purchase agreement +TBtu trillion British thermal units, an energy unit +Train an industrial facility comprised of a series of refrigerant compressor loops used to cool natural gas into LNG +TUA terminal use agreement +1 +Abbreviated Legal Entity Structure +The following diagram depicts our abbreviated legal entity structure as of December 31, 2020, including our ownership of certain subsidiaries, and the references to these entities used in this annual report: +Unless the context requires otherwise, references to “Cheniere,” the “Company,” “we,” “us” and “our” refer to Cheniere Energy, Inc. and its consolidated subsidiaries, including our publicly traded subsidiary, Cheniere Partners. +Unless the context requires otherwise, references to the “CCH Group” refer to CCH HoldCo II, CCH HoldCo I, CCH, CCL and CCP, collectively. +2 +CAUTIONARY STATEMENT +REGARDING FORWARD-LOOKING STATEMENTS +This annual report contains certain statements that are, or may be deemed to be, “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements, other than statements of historical or present facts or conditions, included herein or incorporated herein by reference are “forward-looking statements.” Included among “forward-looking statements” are, among other things: +• statements that we expect to commence or complete construction of our proposed LNG terminals, liquefaction facilities, pipeline facilities or other projects, or any expansions or portions thereof, by certain dates, or at all; +• statements regarding future levels of domestic and international natural gas production, supply or consumption or future levels of LNG imports into or exports from North America and other countries worldwide or purchases of natural gas, regardless of the source of such information, or the transportation or other infrastructure or demand for and prices related to natural gas, LNG or other hydrocarbon products; +• statements regarding any financing transactions or arrangements, or our ability to enter into such transactions; +• statements regarding the amount and timing of share repurchases; +• statements relating to the construction of our Trains and pipelines, including statements concerning the engagement of any EPC contractor or other contractor and the anticipated terms and provisions of any agreement with any EPC or other contractor, and anticipated costs related thereto; +• statements regarding any SPA or other agreement to be entered into or performed substantially in the future, including any revenues anticipated to be received and the anticipated timing thereof, and statements regarding the amounts of total LNG regasification, natural gas liquefaction or storage capacities that are, or may become, subject to contracts; +• statements regarding counterparties to our commercial contracts, construction contracts and other contracts; +• statements regarding our planned development and construction of additional Trains or pipelines, including the financing of such Trains or pipelines; +• statements that our Trains, when completed, will have certain characteristics, including amounts of liquefaction capacities; +• statements regarding our business strategy, our strengths, our business and operation plans or any other plans, forecasts, projections, or objectives, including anticipated revenues, capital expenditures, maintenance and operating costs and cash flows, any or all of which are subject to change; +• statements regarding legislative, governmental, regulatory, administrative or other public body actions, approvals, requirements, permits, applications, filings, investigations, proceedings or decisions; +• statements regarding our anticipated LNG and natural gas marketing activities; +• statements regarding the outbreak of COVID-19 and its impact on our business and operating results, including any customers not taking delivery of LNG cargoes, the ongoing credit worthiness of our contractual counterparties, any disruptions in our operations or construction of our Trains and the health and safety of our employees, and on our customers, the global economy and the demand for LNG; +• any other statements that relate to non-historica l or future information; and +• other factors described in Item 1A. Risk Factors in this Annual Report on Form 10-K. +All of these types of statements, other than statements of historical or present facts or conditions, are forward-looking statements. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “could,” “should,” “achieve,” “anticipate,” “believe,” “contemplate,” “continue,” “estimate,” “expect,” “intend,” “plan,” “potential,” “predict,” “project,” “pursue,” “target,” the negative of such terms or other comparable terminology. The forward-looking statements contained in this annual report are largely based on our expectations, which reflect estimates and assumptions made by our management. These estimates and assumptions reflect our best judgment based on currently known market conditions and other factors. Although we believe that such estimates are reasonable, they are inherently uncertain and involve a number of risks and uncertainties beyond our control. In addition, assumptions may prove to be inaccurate. We caution that the forward-looking statements contained in this annual report are not guarantees of future performance and that such statements may not be realized or the forward-looking statements or events may not occur. Actual results may differ materially from those anticipated or implied in forward-looking statements as a result of a variety of factors described in this annual report and in the +3 +CAUTIONARY STATEMENT +REGARDING FORWARD-LOOKING STATEMENTS +other reports and other information that we file with the SEC. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these risk factors. These forward-looking statements speak only as of the date made, and other than as required by law, we undertake no obligation to update or revise any forward-looking statement or provide reasons why actual results may differ, whether as a result of new information, future events or otherwise. +4 +PART I +ITEMS 1. AND 2. BUSINESS AND PROPERTIES +General +Cheniere Energy, Inc. (“Cheniere”), a Delaware corporation, is a Houston-based energy infrastructure company primarily engaged in LNG-related businesses. We provide clean, secure and affordable LNG to integrated energy companies, utilities and energy trading companies around the world. We aspire to conduct our business in a safe and responsible manner, delivering a reliable, competitive and integrated source of LNG to our customers. +LNG is natural gas (methane) in liquid form. The LNG we produce is shipped all over the world, turned back into natural gas (called “regasification”) and then transported via pipeline to homes and businesses and used as an energy source that is essential for heating, cooking and other industrial uses. Natural gas is a cleaner-burning, abundant and affordable source of energy. When LNG is converted back to natural gas, it can be used instead of coal, which reduces the amount of pollution traditionally produced from burning fossil fuels, like sulfur dioxide and particulate matter that enters the air we breathe. Additionally, compared to coal, it produces significantly fewer carbon emissions. By liquefying natural gas, we are able to reduce its volume by 600 times so that we can load it onto special LNG carriers designed to keep the LNG cold and in liquid form for efficient transport overseas. +We own and operate the Sabine Pass LNG terminal in Louisiana, one of the largest LNG production facilities in the world, through our ownership interest in and management agreements with Cheniere Energy Partners, L.P. (“Cheniere Partners”), which is a publicly traded limited partnership that we created in 2007. As of December 31, 2020, we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We also own and operate the Corpus Christi LNG terminal in Texas, which is wholly owned by us. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners, through its subsidiary Sabine Pass Liquefaction, LLC (“SPL”), is currently operating five natural gas liquefaction Trains and is constructing one additional Train that is expected to be substantially completed in the second half of 2022, for a total production capacity of approximately 30 mtpa of LNG (the “SPL Project”) at the Sabine Pass LNG terminal. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ subsidiary, Sabine Pass LNG, L.P. (“SPLNG”), that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 17 Bcfe, two existing marine berths and one under construction that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4 Bcf/d. Cheniere Partners also owns a 94-mile pipeline through its subsidiary, Cheniere Creole Trail Pipeline, L.P. (“CTPL”), that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”). +We also own the Corpus Christi LNG terminal near Corpus Christi, Texas, and are currently operating two Trains and one additional Train is undergoing commissioning for a total production capacity of approximately 15 mtpa of LNG. Additionally, we are operating a 23-mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the Trains, the “CCL Project”) through our subsidiaries Corpus Christi Liquefaction, LLC (“CCL”) and Cheniere Corpus Christi Pipeline, L.P. (“CCP”), respectively. The CCL Project, once fully constructed, will contain three LNG storage tanks with aggregate capacity of approximately 10 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. +We have contracted approximately 85% of the total production capacity from the SPL Project and the CCL Project (collectively, the “Liquefaction Projects”) on a term basis, with approximately 18 years of average remaining life as of December 31, 2020. This includes volumes contracted under SPAs in which the customers are required to pay a fixed fee with respect to the contracted volumes irrespective of their election to cancel or suspend deliveries of LNG cargoes, as well as volumes contracted under integrated production marketing (“IPM”) gas supply agreements. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) through our subsidiary Cheniere Corpus Christi Liquefaction Stage III, +5 +LLC (“CCL Stage III”) for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. We received approval from FERC in November 2019 to site, construct and operate the expansion project. +We remain focused on operational excellence and customer satisfaction. Increasing demand of LNG has allowed us to expand our liquefaction infrastructure in a financially disciplined manner. We have increased available liquefaction capacity at our Liquefaction Projects as a result of debottlenecking and other optimization projects. We hold significant land positions at both the Sabine Pass LNG terminal and the Corpus Christi LNG terminal which provide opportunity for further liquefaction capacity expansion. The development of these sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we can make a final investment decision (“FID”). +Although results are consolidated for financial reporting, Cheniere, Cheniere Partners, SPL and the CCH Group operate with independent capital structures. The following diagram depicts our abbreviated capital structure as of December 31, 2020: +Our Business Strategy +Our primary business strategy is to be a full service LNG provider to worldwide end-use customers. We accomplish this objective by owning, constructing and operating LNG and natural gas infrastructure facilities to meet our long-term customers’ energy demands and: +• safely, efficiently and reliably operating and maintaining our assets; +• procuring natural gas and pipeline transport capacity to our facilities; +• providing value to our customers through destination flexibility, options not to lift cargoes and diversity of price and geography; +• commencing commercial delivery for our long-term SPA and IPM customers, of which we have initiated for 17 of 20 long-term SPA and IPM customers as of December 31, 2020; +• safely, on-time and on-budget completing our expansion construction projects; +6 +• maximizing the production of LNG to serve our customers and generating steady and stable revenues and operating cash flows; +• maintaining a flexible capital structure to finance the acquisition, development, construction and operation of the energy assets needed to supply our customers; and +• strategically identifying actionable environmental solutions. +LNG Terminals and Marketing +We shipped our first LNG cargo in February 2016 and we shipped our 1,000th cargo in January 2020. Cheniere’s LNG has been shipped to 35 countries and regions around the world. +Sabine Pass LNG Terminal +Liquefaction Facilities +The SPL Project is one of the largest LNG production facilities in the world. Through Cheniere Partners, we are currently operating five Trains and two marine berths at the SPL Project, and are constructing one additional Train that is expected to be substantially completed in the second half of 2022, and a third marine berth. We have received authorization from the FERC to site, construct and operate Trains 1 through 6, as well as for the construction of the third marine berth. We have achieved substantial completion of the first five Trains of the SPL Project and commenced commercial operating activities for each Train at various times starting in May 2016. The following table summarizes the project completion and construction status of Train 6 of the SPL Project as of December 31, 2020: +SPL Train 6 +Overall project completion percentage 77.6% +Completion percentage of: +Engineering 99.0% +Procurement 99.9% +Subcontract work 54.9% +Construction 49.2% +Date of expected substantial completion 2H 2022 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal: +• Trains 1 through 4—FTA countries and non-FTA countries through December 31, 2050, in an amount up to a combined total of the equivalent of 16 mtpa (approximately 803 Bcf/yr of natural gas). +• Trains 1 through 4—FTA countries and non-FTA countries through December 31, 2050, in an amount up to a combined total of the equivalent of approximately 203 Bcf/yr of natural gas (approximately 4 mtpa). +• Trains 5 and 6—FTA countries and non-FTA countries through December 31, 2050 in an amount up to a combined total of 503.3 Bcf/yr of natural gas (approximately 10 mtpa). +In December 2020, the DOE announced a new policy in which it would no longer issue short-term export authorizations separately from long-term authorizations. Accordingly, the DOE amended each of SPL’s long-term authorizations to include short-term export authority, and vacated the short-term orders. +An application was filed in September 2019 seeking authorization to make additional exports from the SPL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 153 Bcf/yr of natural gas, for a total SPL Project export capacity of approximately 1,662 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the SPL Project of the volumes contemplated in the application. In April 2020, the DOE issued an order authorizing SPL to export to FTA countries related to this application, for which the term was subsequently extended through December 31, 2050, but has not yet issued an order authorizing SPL to export to non-FTA countries for the corresponding LNG volume. A corresponding application for authorization to increase the total LNG production capacity of the SPL Project from the currently authorized level to approximately 1,662 Bcf/yr was also submitted to the FERC and is currently pending. +7 +Customers +SPL has entered into fixed price long-term SPAs generally with terms of 20 years (plus extension rights) and with a weighted average remaining contract length of approximately 17 years (plus extension rights) with eight third parties for Trains 1 through 6 of the SPL Project. Under these SPAs, the customers will purchase LNG from SPL for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG generally equal to approximately 115% of Henry Hub. The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under SPL’s SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under SPL’s SPAs. The variable fees under SPL’s SPAs were generally sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +In aggregate, the annual fixed fee portion to be paid by the third-party SPA customers is approximately $2.9 billion for Trains 1 through 5. After giving effect to an SPA that Cheniere has committed to provide to SPL, the annual fixed fee portion to be paid by the third-party SPA customers would increase to at least $3.3 billion, which is expected to occur upon the date of first commercial delivery of Train 6. +In addition, Cheniere Marketing has an agreement with SPL to purchase at Cheniere Marketing’s option, any LNG produced by SPL in excess of that required for other customers. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +The annual contracted cash flows from fixed fees of each buyer of LNG under SPL’s third-party SPAs that constitute more than 10% of SPL’s aggregate fixed fees under all its SPAs are: +• approximately $720 million from BG Gulf Coast LNG, LLC (“BG”), which is guaranteed by BG Energy Holdings Limited; +• approximately $550 million from Korea Gas Corporation (“KOGAS”); +• approximately $550 million from GAIL; +• approximately $450 million from Naturgy LNG GOM, Limited (formerly known as Gas Natural Fenosa LNG GOM, Limited) (“Naturgy”), which is guaranteed by Naturgy Energy Group, S.A. (formerly known as Gas Natural SDG S.A.); and +• approximately $310 million from Total Gas & Power North America, Inc. (“Total”), which is guaranteed by Total S.A. +The annual aggregate fixed fees for all of SPL’s other SPAs with third-parties is approximately $490 million, prior to giving effect to an SPA that Cheniere has committed to provide to SPL. +Natural Gas Transportation, Storage and Supply +To ensure SPL is able to transport adequate natural gas feedstock to the Sabine Pass LNG terminal, it has entered into transportation precedent and other agreements to secure firm pipeline transportation capacity with CTPL and third-party pipeline companies. SPL has entered into firm storage services agreements with third parties to assist in managing variability in natural gas needs for the SPL Project. SPL has also entered into enabling agreements and long-term natural gas supply contracts with third parties in order to secure natural gas feedstock for the SPL Project. As of December 31, 2020, SPL had secured up to approximately 4,950 TBtu of natural gas feedstock through long-term and short-term natural gas supply contracts with remaining terms that range up to 10 years, a portion of which is subject to conditions precedent. +Construction +SPL entered into lump sum turnkey contracts with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Trains 1 through 6 of the SPL Project, under which Bechtel charges a lump sum for all work +8 +performed and generally bears project cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause SPL to enter into a change order, or SPL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 6 of the SPL Project is approximately $2.5 billion, including estimated costs for the third marine berth that is currently under construction. As of December 31, 2020, we have incurred $1.9 billion under this contract. +Regasification Facilities +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4 Bcf/d and aggregate LNG storage capacity of approximately 17 Bcfe. Approximately 2 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term third-party TUAs, under which SPLNG’s customers are required to pay fixed monthly fees, whether or not they use the LNG terminal. Each of Total and Chevron U.S.A. Inc. (“Chevron”) has reserved approximately 1 Bcf/d of regasification capacity and is obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually, prior to inflation adjustments, for 20 years that commenced in 2009. Total S.A. has guaranteed Total’s obligations under its TUA up to $2.5 billion, subject to certain exceptions, and Chevron Corporation has guaranteed Chevron’s obligations under its TUA up to 80% of the fees payable by Chevron. +The remaining approximately 2 Bcf/d of capacity has been reserved under a TUA by SPL. SPL is obligated to make monthly capacity payments to SPLNG aggregating approximately $250 million annually, prior to inflation adjustments, continuing until at least May 2036. SPL entered into a partial TUA assignment agreement with Total, whereby upon substantial completion of Train 5 of the SPL Project, SPL gained access to substantially all of Total’s capacity and other services provided under Total’s TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Train 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA. During the years ended December 31, 2020, 2019 and 2018, SPL recorded $129 million, $104 million and $30 million, respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Under each of these TUAs, SPLNG is entitled to retain 2% of the LNG delivered to the Sabine Pass LNG terminal. +Corpus Christi LNG Terminal +Liquefaction Facilities +We are currently operating two Trains and two marine berths at the CCL Project and commissioning one additional Train that is expected to be substantially completed in the first quarter of 2021. We have received authorization from the FERC to site, construct and operate Trains 1 through 3 of the CCL Project. We completed construction of Trains 1 and 2 of the CCL Project and commenced commercial operating activities in February 2019 and August 2019, respectively. The following table summarizes the project completion and construction status of Train 3 of the CCL Project, including the related infrastructure, as of December 31, 2020: +CCL Train 3 +Overall project completion percentage 99.6% +Completion percentage of: +Engineering 100.0% +Procurement 100.0% +Subcontract work 99.9% +Construction 99.0% +Expected date of substantial completion 1Q 2021 +Separate from the CCH Group, we are also developing Corpus Christi Stage 3 through our subsidiary CCL Stage III, adjacent to the CCL Project. We received approval from FERC in November 2019 to site, construct and operate seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. +9 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Corpus Christi LNG terminal: +• CCL Project—FTA countries and non-FTA countries through December 31, 2050, up to a combined total of the equivalent of 767 Bcf/yr (approximately 15 mtpa) of natural gas. +• Corpus Christi Stage 3—FTA countries and non-FTA countries through December 31, 2050 in an amount equivalent to 582.14 Bcf/yr (approximately 11 mtpa) of natural gas. +In December 2020, the DOE announced a new policy in which it would no longer issue short-term export authorizations separately from long-term authorizations. Accordingly, the DOE amended each of CCL’s long-term authorizations to include short-term export authority, and vacated the short-term orders. +An application was filed in September 2019 to authorize additional exports from the CCL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 108 Bcf/yr of natural gas, for a total CCL Project export of 875.16 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the CCL Project of the volumes contemplated in the application. In April 2020, the DOE issued an order authorizing CCL to export to FTA countries related to this application, for which the term was subsequently extended through December 31, 2050, but has not yet issued an order authorizing CCL to export to non-FTA countries for the corresponding LNG volume. A corresponding application for authorization to increase the total LNG production capacity of the CCL Project from the currently authorized level to approximately 875.16 Bcf/yr was also submitted to the FERC and is currently pending. +Customers +CCL has entered into fixed price long-term SPAs generally with terms of 20 years (plus extension rights) and with a weighted average remaining contract length of approximately 19 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project. Under these SPAs, the customers will purchase LNG from CCL on a free on board (“FOB”) basis for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under our SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under our SPAs. The variable fee under CCL’s SPAs entered into in connection with the development of the CCL Project was sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery for the applicable Train, as specified in each SPA. +In aggregate, the minimum annual fixed fee portion to be paid by the third-party SPA customers is approximately $1.4 billion for Trains 1 and 2 and increasing to approximately $1.8 billion following the substantial completion of Train 3 of the CCL Project. +The annual contracted cash flows from fixed fees of each buyer of LNG under CCL’s third-party SPAs that constitute more than 10% of CCL’s aggregate fixed fees under all its SPAs for Trains 1 through 3 of the CCL Project are: +• approximately $410 million from Endesa S.A.; +• approximately $280 million from PT Pertamina (Persero); and +• approximately $270 million from Naturgy, which is guaranteed by Naturgy Energy Group, S.A. +The annual aggregate contracted cash flow from fixed fees for all of CCL’s other SPAs with third-parties is approximately $790 million. +10 +In addition, Cheniere Marketing has agreements with CCL to purchase: (1) approximately 15 TBtu per annum of LNG with an approximate term of 23 years, (2) any LNG produced by CCL in excess of that required for other customers at Cheniere Marketing’s option and (3) approximately 44 TBtu of LNG with a term of up to seven years associated with the IPM gas supply agreement between CCL and EOG Resources, Inc. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +Natural Gas Transportation, Storage and Supply +To ensure CCL is able to transport adequate natural gas feedstock to the Corpus Christi LNG terminal, it has entered into transportation precedent agreements to secure firm pipeline transportation capacity with CCP and certain third-party pipeline companies. CCL has entered into a firm storage services agreement with a third party to assist in managing variability in natural gas needs for the CCL Project. CCL has also entered into enabling agreements and long-term natural gas supply contracts with third parties, and will continue to enter into such agreements, in order to secure natural gas feedstock for the CCL Project. As of December 31, 2020, CCL had secured up to approximately 2,938 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to 10 years, a portion of which is subject to the achievement of certain project milestones and other conditions precedent. +CCL Stage III has also entered into long-term natural gas supply contracts with third parties, and anticipates continuing to enter into such agreements, in order to secure natural gas feedstock for Corpus Christi Stage 3. As of December 31, 2020, CCL Stage III had secured up to approximately 2,361 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to approximately 15 years, which is subject to the achievement of certain project milestones and other conditions precedent. +A portion of the natural gas feedstock transactions for CCL and CCL Stage III are IPM transactions, in which the natural gas producers are paid based on a global gas market price less a fixed liquefaction fee and certain costs incurred by us. +Construction +CCL entered into separate lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Trains 1 through 3 of the CCL Project under which Bechtel charges a lump sum for all work performed and generally bears project cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause CCL to enter into a change order, or CCL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 3, which is currently undergoing commissioning, is approximately $2.4 billion, reflecting amounts incurred under change orders through December 31, 2020. As of December 31, 2020, we have incurred $2.4 billion under this contract. +Final Investment Decision for Corpus Christi Stage 3 +FID for Corpus Christi Stage 3 will be subject to, among other things, entering into an EPC contract, obtaining additional commercial support for the project and securing the necessary financing arrangements. +Pipeline Facilities +In November 2019, the FERC authorized CCP to construct and operate the pipeline for Corpus Christi Stage 3. The pipeline will be designed to transport 1.5 Bcf/d of natural gas feedstock required by Corpus Christi Stage 3 from the existing regional natural gas pipeline grid. +Marketing +We market and sell LNG produced by the Liquefaction Projects that is not required for other customers through our integrated marketing function. We have, and continue to develop, a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide. These volumes are expected to be primarily sourced by LNG produced by the Liquefaction Projects but supplemented by volumes procured from other locations worldwide, as needed. As of December 31, 2020, we have sold or have options to sell approximately 4,995 TBtu of LNG to be delivered to customers between 2021 and 2045, including volume from an SPA Cheniere Marketing has committed to provide to SPL. The cargoes +11 +have been sold either on a FOB basis (delivered to the customer at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, as applicable) or a delivered at terminal (“DAT”) basis (delivered to the customer at their specified LNG receiving terminal). We have chartered LNG vessels to be utilized for cargoes sold on a DAT basis. +Significant Customers +The following table shows customers with revenues of 10% or greater of total revenues from external customers: +Percentage of Total Revenues from External Customers +Year Ended December 31, +2020 2019 2018 +BG and its affiliates 14% 16% 18% +Naturgy 12% 10% 14% +KOGAS 10% 11% 19% +GAIL 10% 11% 13% +Competition +If and when SPL, CCL or our integrated marketing function need to replace any existing SPA or enter into new SPAs, they will compete on the basis of price per contracted volume of LNG with each other and other natural gas liquefaction projects throughout the world. Revenues associated with any incremental volumes, including those sold by our integrated marketing function discussed above, will also be subject to market-based price competition. Many of the companies with which we compete are major energy corporations with longer operating histories, more development experience, greater name recognition, greater financial, technical and marketing resources and greater access to markets than us. We have proximity to our customers, with offices located in Houston, London, Singapore, Beijing and Tokyo. +SPLNG currently does not experience competition for its terminal capacity because the entire approximately 4 Bcf/d of regasification capacity that is available at the Sabine Pass LNG terminal has been fully contracted. If and when SPLNG has to replace any TUAs, it will compete with other then-existing LNG terminals for customers. +Governmental Regulation +Our LNG terminals and pipelines are subject to extensive regulation under federal, state and local statutes, rules, regulations and laws. These laws require that we engage in consultations with appropriate federal and state agencies and that we obtain and maintain applicable permits and other authorizations. These regulatory requirements increase the cost of construction and operation, and failure to comply with such laws could result in substantial penalties and/or loss of necessary authorizations. +Federal Energy Regulatory Commission +The design, construction, operation, maintenance and expansion of our liquefaction facilities, the import or export of LNG and the purchase and transportation of natural gas in interstate commerce through our pipelines (including our Creole Trail Pipeline and Corpus Christi Pipeline) are highly regulated activities subject to the jurisdiction of the FERC pursuant to the Natural Gas Act of 1938, as amended (the “NGA”). Under the NGA, the FERC’s jurisdiction generally extends to the transportation of natural gas in interstate commerce, to the sale for resale of natural gas in interstate commerce, to natural gas companies engaged in such transportation or sale and to the construction, operation, maintenance and expansion of LNG terminals and interstate natural gas pipelines. +The FERC’s authority to regulate interstate natural gas pipelines and the services that they provide generally includes regulation of: +• rates and charges, and terms and conditions for natural gas transportation, storage and related services; +• the certification and construction of new facilities and modification of existing facilities; +• the extension and abandonment of services and facilities; +12 +• the administration of accounting and financial reporting regulations, including the maintenance of accounts and records; +• the acquisition and disposition of facilities; +• the initiation and discontinuation of services; and +• various other matters. +Under the NGA, our pipelines are not permitted to unduly discriminate or grant undue preference as to rates or the terms and conditions of service to any shipper, including its own marketing affiliate. Those rates, terms and conditions must be public, and on file with the FERC. In contrast to pipeline regulation, the FERC does not require LNG terminal owners to provide open-access services at cost-based or regulated rates. Although the provisions that codified FERC’s policy in this area expired on January 1, 2015, we see no indication that the FERC intends to change its policy in this area. +We are permitted to make sales of natural gas for resale in interstate commerce pursuant to a blanket marketing certificate automatically granted by the FERC to our marketing affiliates. Our sales of natural gas will be affected by the availability, terms and cost of pipeline transportation. As noted above, the price and terms of access to pipeline transportation are subject to extensive federal and state regulation. +In order to site, construct and operate our LNG terminals, we received and are required to maintain authorizations from the FERC under Section 3 of the NGA as well as other material governmental and regulatory approvals and permits. The Energy Policy Act of 2005 (the “EPAct”) amended Section 3 of the NGA to establish or clarify the FERC’s exclusive authority to approve or deny an application for the siting, construction, expansion or operation of LNG terminals, unless specifically provided otherwise in the EPAct, amendments to the NGA. For example, nothing in the EPAct amendments to the NGA were intended to affect otherwise applicable law related to any other federal agency’s authorities or responsibilities related to LNG terminals or those of a state acting under federal law. +The FERC issued final orders in April and July 2012 approving our application for an order under Section 3 of the NGA authorizing the siting, construction and operation of Trains 1 through 4 of the SPL Project (and related facilities). Subsequently, the FERC issued written approval to commence site preparation work for Trains 1 through 4. In October 2012, we applied to amend the FERC approval to reflect certain modifications to the SPL Project, and in August 2013, the FERC issued an order approving the modifications. In October 2013, we applied to further amend the FERC approval, requesting authorization to increase the total permitted LNG production capacity of Trains 1 through 4 from the then authorized 803 Bcf/yr to 1,006 Bcf/yr so as to more accurately reflect the estimated maximum LNG production capacity of Trains 1 through 4. In February 2014, the FERC issued an order approving the October 2013 application (the “February 2014 Order”). A party to the proceeding requested a rehearing of the February 2014 Order, and in September 2014, the FERC issued an order denying the rehearing request (the “FERC Order Denying Rehearing”). The party petitioned the U.S. Court of Appeals for the District of Columbia Circuit (the “Court of Appeals”) to review the February 2014 Order and the FERC Order Denying Rehearing. The court denied the petition in June 2016. In September 2013, we filed an application with the FERC for authorization to add Trains 5 and 6 to the SPL Project, which was granted by the FERC in an order issued in April 2015 and an order denying rehearing issued in June 2015. These orders are not subject to appellate court review. In October of 2018, SPL applied to the FERC for authorization to add a third marine berth to the Sabine Pass LNG terminal facilities, which FERC approved in February of 2020. +The Creole Trail Pipeline, which interconnects with the Sabine Pass LNG terminal, holds a certificate of public convenience and necessity from the FERC under Section 7 of the NGA. The FERC’s approval under Section 7 of the NGA, as well as several other material governmental and regulatory approvals and permits, may be required prior to making any modifications to the Creole Trail Pipeline as it is a regulated, interstate natural gas pipeline. In 2013, the FERC approved CTPL’s application for authorization to construct, own, operate and maintain certain new facilities in order to enable bi-directional natural gas flow on the Creole Trail Pipeline system to allow for the delivery of up to 1,530,000 Dekatherms per day of feed gas to the Sabine Pass LNG terminal. In November 2013, CTPL received approval from the Louisiana Department of Environmental Quality (“LDEQ”) for the proposed modifications and, with subsequent final FERC clearance, construction was completed in 2015. In September 2013, we filed an application with the FERC for authorization to construct and operate an extension and expansion of Creole Trail Pipeline and related facilities in order to deliver additional domestic natural gas supplies to the Sabine Pass LNG terminal, which was granted by the FERC in an order issued in April 2015 and an order denying rehearing issued in June 2015. These orders are not subject to appellate court review. +13 +In December 2014, the FERC issued an order granting CCL authorization under Section 3 of the NGA to site, construct and operate Trains 1 through 3 of the CCL Project and issued a certificate of public convenience and necessity under Section 7(c) of the NGA authorizing construction and operation of the Corpus Christi Pipeline (the “December 2014 Order”). A party to the proceeding requested a rehearing of the December 2014 Order, and in May 2015, the FERC denied rehearing (the “Order Denying Rehearing”). The party petitioned the relevant Court of Appeals to review the December 2014 Order and the Order Denying Rehearing; that petition was denied on November 4, 2016. In June of 2018, CCL Stage III, CCL and Corpus Christi Pipeline filed an application with the FERC for authorization under Section 3 of the NGA to site, construct and operate additional facilities for the liquefaction and export of domestically-produced natural gas (“Corpus Christi Stage 3”) at the existing CCL Project and pipeline locations. In November 2019, the FERC authorized Corpus Christi Stage 3. Corpus Christi Stage 3 consists of the addition of seven midscale Trains and related facilities. The order is not subject to appellate court review. In 2020, FERC authorized Corpus Christi Pipeline to construct and operate a portion of Corpus Christi Stage 3 (Sinton Compressor Station Unit No. 1) on an interim basis independently from the remaining Corpus Christi Stage 3 facilities, which received FERC approval for in-service in December 2020. +On September 27, 2019, CCL and SPL filed a request with the FERC pursuant to Section 3 of the NGA, requesting authorization to increase the total LNG production capacity of each terminal from currently authorized levels to an amount which reflects more accurately the capacity of each facility based on enhancements during the engineering, design and construction process, as well as operational experience to date. The requested authorizations do not involve construction of new facilities. Corresponding applications for authorization to export the incremental volumes were also submitted to the DOE. +The FERC’s Standards of Conduct apply to interstate pipelines that conduct transmission transactions with an affiliate that engages in natural gas marketing functions. The general principles of the FERC Standards of Conduct are: (1) independent functioning, which requires transmission function employees to function independently of marketing function employees; (2) no-conduit rule, which prohibits passing transmission function information to marketing function employees; and (3) transparency, which imposes posting requirements to detect undue preference due to the improper disclosure of non-public transmission function information. We have established the required policies, procedures and training to comply with the FERC’s Standards of Conduct. +All of our FERC construction, operation, reporting, accounting and other regulated activities are subject to audit by the FERC, which may conduct routine or special inspections and issue data requests designed to ensure compliance with FERC rules, regulations, policies and procedures. The FERC’s jurisdiction under the NGA allows it to impose civil and criminal penalties for any violations of the NGA and any rules, regulations or orders of the FERC up to approximately $1.3 million per day per violation, including any conduct that violates the NGA’s prohibition against market manipulation. +Several other material governmental and regulatory approvals and permits will be required throughout the life of our LNG terminals and our pipelines. In addition, our FERC orders require us to comply with certain ongoing conditions, reporting obligations and maintain other regulatory agency approvals throughout the life of our facilities. For example, throughout the life of our LNG terminals and our pipelines, we are subject to regular reporting requirements to the FERC, the Department of Transportation’s (“DOT”) Pipeline and Hazardous Materials Safety Administration (“PHMSA”) and applicable federal and state regulatory agencies regarding the operation and maintenance of our facilities. To date, we have been able to obtain and maintain required approvals as needed, and the need for these approvals and reporting obligations have not materially affected our construction or operations. +DOE Export Licenses +The DOE has authorized the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal as discussed in Sabine Pass LNG Terminal — Liquefaction Facilities and the Corpus Christi LNG terminal as discussed in Corpus Christi LNG Terminal — Liquefaction Facilities. Although it is not expected to occur, the loss of an export authorization could be a force majeure event under our SPAs. +Under Section 3 of the NGA applications for exports of natural gas to FTA countries, which allow for national treatment for trade in natural gas, are “deemed to be consistent with the public interest” and shall be granted by the DOE without “modification or delay.” FTA countries currently recognized by the DOE for exports of LNG include Australia, Bahrain, Canada, Chile, Colombia, Dominican Republic, El Salvador, Guatemala, Honduras, Jordan, Mexico, Morocco, Nicaragua, Oman, Panama, Peru, Republic of Korea and Singapore. FTAs with Israel and Costa Rica do not require national treatment for trade in natural gas. Applications for export of LNG to non-FTA countries are considered by the DOE in a notice and comment +14 +proceeding whereby the public and other interveners are provided the opportunity to comment and may assert that such authorization would not be consistent with the public interest. +Pipeline and Hazardous Materials Safety Administration +Our LNG terminals as well as the Creole Trail Pipeline and the Corpus Christi Pipeline are subject to regulation by PHMSA. PHMSA is authorized by the applicable pipeline safety laws to establish minimum safety standards for certain pipelines and LNG facilities. The regulatory standards PHMSA has established are applicable to the design, installation, testing, construction, operation, maintenance and management of natural gas and hazardous liquid pipeline facilities and LNG facilities that affect interstate or foreign commerce. PHMSA has also established training, worker qualification and reporting requirements. +In October 2019, PHMSA published final rules revising its regulations governing the safety of certain gas transmission pipelines (effective July 1, 2020) and established new enforcement procedures for the issuance of temporary emergency orders (effective December 2, 2019). +PHMSA performs inspections of pipeline and LNG facilities and has authority to undertake enforcement actions, including issuance of civil penalties up to approximately $218,000 per day per violation, with a maximum administrative civil penalty of approximately $2 million for any related series of violations. +Other Governmental Permits, Approvals and Authorizations +Construction and operation of the Sabine Pass LNG terminal and the CCL Project require additional permits, orders, approvals and consultations to be issued by various federal and state agencies, including the DOT, U.S. Army Corps of Engineers (“USACE”), U.S. Department of Commerce, National Marine Fisheries Service, U.S. Department of the Interior, U.S. Fish and Wildlife Service (“FWS”), the U.S. Environmental Protection Agency (the “EPA”), U.S. Department of Homeland Security, the LDEQ, the Texas Commission on Environmental Quality (“TCEQ”) and the Railroad Commission of Texas (“RRC”). +The USACE issues its permits under the authority of the Clean Water Act (“CWA”) (Section 404) and the Rivers and Harbors Act (Section 10) (the “Section 10/404 Permit”). The EPA administers the Clean Air Act, and has delegated authority to the TCEQ and LDEQ to issue the Title V Operating Permit (the “Title V Permit”) and the Prevention of Significant Deterioration Permit (the “PSD Permit”). These two permits are issued by the LDEQ for the Sabine Pass LNG terminal and CTPL and by the TCEQ for the CCL Project. +Commodity Futures Trading Commission (“CFTC”) +The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amended the Commodity Exchange Act to provide for federal regulation of the over-the-counter derivatives market and entities, such as us, that participate in those markets. Most of the regulations are already in effect, while other rules and regulations, including the new rules on speculative position limits that were finalized by the CFTC on October 15, 2020, are in the process of being phased in. The full impact of the CFTC’s position limits rules is not yet known and these rules could have significant impact on our business. +As required by provisions of the Dodd-Frank Act, the CFTC and federal banking regulators have adopted rules to require Swap Dealers (as defined in the Dodd-Frank Act), including those that are regulated financial institutions, to collect initial and/or variation margin with respect to uncleared swaps from their counterparties that are financial end users, registered swap dealers or major swap participants. These rules do not require collection of margin from non-financial-entity end users who qualify for the end user exception from the mandatory clearing requirement or from non-financial end users or certain other counterparties in certain instances. We qualify as a non-financial-entity end user with respect to the swaps that we enter into to hedge our commercial risks. +Pursuant to the Dodd-Frank Act, the CFTC has adopted additional anti-manipulation and anti-disruptive trading practices regulations that prohibit, among other things, manipulative, deceptive or fraudulent schemes or material misrepresentation in the futures, options, swaps and cash markets. In addition, separate from the Dodd-Frank Act, our use of futures and options on commodities is subject to the Commodity Exchange Act and CFTC regulations, as well as the rules of futures exchanges on +15 +which any of these instruments are executed. Should we violate any of these laws and regulations, we could be subject to a CFTC or an exchange enforcement action and material penalties, possibly resulting in changes in the rates we can charge. +United Kingdom /European Regulations +Our European Union (“EU”) trading activities, which are primarily established in the United Kingdom (“UK”), are subject to a number of EU-wide and UK specific laws and regulations, including but not limited to the European Market Infrastructure Regulation (“EMIR”), the Regulation on Wholesale Energy Market Integrity and Transparency (“REMIT”), the Markets in Financial Instruments Directive and Regulation (“MiFID II”), the Market Abuse Regulation (“MAR”), the UK’s Financial Services and Markets Act 2000 (“FSMA”) and Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”). Each of these laws and regulations are and will be subject to changes arising as a result of Brexit. Further details of these are set out in the Brexit section below. +EMIR is an EU regulation (with text that is relevant across the European Economic Area (“EEA”)) designed to increase the transparency and stability of the EEA derivatives markets. REMIT is an EU regulation (with EEA relevance) that prohibits market manipulation and insider trading in European wholesale energy markets and imposes various transparency and other obligations on participants active in these markets. MiFID II consists of an EU directive, a regulation and a number of delegated acts, rules and guidance, that replaced the original 2004 Markets in Financial Instruments Directive. MiFID II (with relevance throughout the EEA), sets forth an EEA-wide financial services framework, including rules for firms engaging in investment services and activities in connection with certain financial instruments in the EEA. Firms engaging in such activities must be authorized unless an exemption applies. +We are eligible to trade on our own account in commodity derivatives as a result of the “ancillary activity” exemption under MiFID II. MAR was implemented to create an enhanced EU market abuse framework and applies to all financial instruments listed or traded on EU trading venues as well as other over-the-counter (“OTC”) financial instruments priced on, or impacting, the trading venue contract. FSMA governs the regulation of financial services and markets in the UK, and the RAO contains a definitive list of the specified kinds of activities and investments and products that are regulated. We currently qualify for exclusions/exemptions under both FSMA/RAO. +Any violation of the foregoing laws and regulations could result in investigations, possible fines and penalties, and in some scenarios, criminal offenses, as well as reputational damage. +Brexit +The UK withdrew from the EU (“Brexit”) on January 31, 2020, with the transition period ending as of January 1, 2021. A trade deal (the “Deal”) was agreed and ratified by both sides, avoiding a “no deal” Brexit. One area notably absent from the Deal was financial services. The UK and EU will work towards agreeing a memorandum of understanding (the “MoU”) on access to financial services by March 2021, although such an MoU would be less far-reaching than a legal text like an international treaty. +The issue of whether the UK's financial system will be granted “equivalence” by the EU (the scenario that would result in the least disruption and would treat compliance with UK rules as being equivalent to compliance with the corresponding EU rules) remains to be resolved. It should be noted that the UK will also have the right to declare whether EU financial services rules are “equivalent” to its own rules, and each sides' equivalence decision will be made unilaterally, and could be withdrawn unilaterally as well. In contrast, the EU has taken a more limited approach. This includes, in the context of EMIR, granting a finite equivalence decision for the UK's legal regime for central counterparties (“CCPs”) established in the UK until June 30, 2022. Furthermore, the EU has recognized the CCPs ICE Clear Europe Limited, LCH Limited and LME Clear Limited as third country CCPs, with the effect that they may continue to offer their services in the EU. +Additionally, there is no guarantee that any equivalence decision, if granted, will be comprehensive across all financial services. In the meantime, UK firms must comply with the UK's “onshored” versions of the core EU financial services rules, including MiFID II and EMIR. +16 +Environmental Regulation +Our LNG terminals are subject to various federal, state and local laws and regulations relating to the protection of the environment and natural resources. These environmental laws and regulations require significant expenditures for compliance, can affect the cost and output of operations and may impose substantial penalties for non-compliance and substantial liabilities for pollution. Many of these laws and regulations, such as those noted below, restrict or prohibit impacts to the environment or the types, quantities and concentration of substances that can be released into the environment and can lead to substantial administrative, civil and criminal fines and penalties for non-compliance. +Clean Air Act (“CAA”) +Our LNG terminals are subject to the federal CAA and comparable state and local laws. We may be required to incur certain capital expenditures over the next several years for air pollution control equipment in connection with maintaining or obtaining permits and approvals addressing air emission-related issues. We do not believe, however, that our operations, or the construction and operations of our liquefaction facilities, will be materially and adversely affected by any such requirements. +In 2009, the EPA promulgated and finalized the Mandatory Greenhouse Gas Reporting Rule requiring annual reporting of greenhouse gas (“GHG”) emissions from stationary sources in a variety of industries. In 2010, the EPA expanded the rule to include reporting obligations for LNG terminals. In addition, the EPA has defined GHG emissions thresholds that would subject GHG emissions from new and modified industrial sources to regulation if the source is subject to PSD Permit requirements due to its emissions of non-GHG criteria pollutants. While the EPA subsequently took a number of additional actions primarily relating to GHG emissions from the electric power generation and the oil and gas exploration and production industries, those rules were largely stayed or repealed during the Trump Administration including by amendments adopted by the EPA on February 23, 2018 and additional amendments to new source performance standards for the oil and gas industry on September 14 and 15, 2020. On January 20, 2021, President Biden issued an executive order directing the EPA to consider publishing for notice and comment a proposed rule suspending, revising, or rescinding the September 2020 rule, which could result in more stringent GHG emissions rulemaking. We are supportive of regulations reducing GHG emissions over time. +From time to time, Congress has considered proposed legislation directed at reducing GHG emissions. In addition, many states have already taken regulatory action to monitor and/or reduce emissions of GHGs, primarily through the development of GHG emission inventories or regional GHG cap and trade programs. It is not possible at this time to predict how future regulations or legislation may address GHG emissions and impact our business. However, future regulations and laws could result in increased compliance costs or additional operating restrictions and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Coastal Zone Management Act (“CZMA”) +The siting and construction of our LNG terminals within the coastal zone is subject to the requirements of the CZMA. The CZMA is administered by the states (in Louisiana, by the Department of Natural Resources, and in Texas, by the General Land Office). This program is implemented to ensure that impacts to coastal areas are consistent with the intent of the CZMA to manage the coastal areas. +Clean Water Act +Our LNG terminals are subject to the federal CWA and analogous state and local laws. The CWA imposes strict controls on the discharge of pollutants into the navigable waters of the United States, including discharges of wastewater and storm water runoff and fill/discharges into waters of the United States. Permits must be obtained prior to discharging pollutants into state and federal waters. The CWA is administered by the EPA, the USACE and by the states (in Louisiana, by the LDEQ, and in Texas, by the TCEQ). +Resource Conservation and Recovery Act (“RCRA”) +The federal RCRA and comparable state statutes govern the generation, handling and disposal of solid and hazardous wastes and require corrective action for releases into the environment. When such wastes are generated in connection with the operations of our facilities, we are subject to regulatory requirements affecting the handling, transportation, treatment, storage and disposal of such wastes. +17 +Protection of Species, Habitats and Wetlands +Various federal and state statutes, such as the Endangered Species Act (the “ESA”), the Migratory Bird Treaty Act (“MBTA”), the CWA and the Oil Pollution Act, prohibit certain activities that may adversely affect endangered or threatened animal, fish and plant species and/or their designated habitats, wetlands, or other natural resources. If one of our LNG terminals or pipelines adversely affects a protected species or its habitat, we may be required to develop and follow a plan to avoid those impacts. In that case, siting, construction or operation may be delayed or restricted and cause us to incur increased costs. +In August 2019, the FWS announced a series of changes to the rules implementing the ESA, including revisions to the regulations governing interagency cooperation, listing species and delisting critical habitat, and prohibitions related to threatened wildlife and plants, and in August and September 2020, the FWS proposed additional changes to its regulations for designating critical habitat. The revisions are intended to streamline these processes and create more flexibility for the FWS when making ESA-related decisions. +In addition, in January 2021, the FWS issued a final rule defining the scope of the MBTA to cover only actions intentionally directed at migratory birds, their nests or their eggs. +On January 20, 2021, President Biden issued an executive order directing the heads of all agencies to immediately review all regulatory actions taken between January 20, 2017 and January 20, 2021, including FWS regulations implementing the ESA and the MBTA and EPA regulations implementing the CWA and the Oil Pollution Act, which could result in stricter requirements with respect to endangered or threatened animal, fish and plant species and/or their designated habitats, migratory birds, wetlands or other natural resources. +It is not possible at this time to predict how future regulations or legislation may address protection of species, habitats and wetlands and impact our business. However, we do not believe that our operations, or the construction and operations of our liquefaction facilities, will be materially and adversely affected by such regulatory actions. +Market Factors +Our ability to enter into additional long-term SPAs to underpin the development of additional Trains, sale of LNG by Cheniere Marketing, or development of new projects is subject to market factors. These factors include changes in worldwide supply and demand for natural gas, LNG and substitute products, the relative prices for natural gas, crude oil and substitute products in North America and international markets, the rate of fuel switching for power generation from coal, nuclear or oil to natural gas and economic growth in developing countries. In addition, our ability to obtain additional funding to execute our business strategy is subject to the investment community’s appetite for investment in LNG and natural gas infrastructure and our ability to access capital markets. +We expect that global demand for natural gas and LNG will continue to increase as nations seek more abundant, reliable and environmentally cleaner fuel alternatives to oil and coal. Players around the globe have shown commitments to environmental goals consistent with many policy initiatives that we believe are constructive for LNG demand and infrastructure growth. Currently, hundreds of billions of dollars are being invested across Europe and Asia in natural gas projects under construction, and if we included planned commitments, the total would exceed $1 trillion. Some examples include India’s commitment to invest over $60 billion to drive its gas-based economy, Europe’s commitment of well over $100 billion in gas-fired power, import terminals and pipelines, and China’s hundreds of billions all along the natural gas value chain. We highlight regasification capacity, which will not only expand existing import capacities in rapidly growing markets like China and India, but also add new import markets all over the globe, raising the total to approximately 60 by 2030 from 43 today and just 15 markets as recently as 2005. +As a result of these dynamics, global demand for natural gas is projected by the International Energy Agency to grow by approximately 21 trillion cubic feet (“Tcf”) between 2019 and 2030 and 42 Tcf between 2019 and 2040. LNG’s share is seen growing from about 12% in 2019 to about 16% of the global gas market in 2030 and 19% in 2040. Wood Mackenzie Limited (“WoodMac”) forecasts that global demand for LNG will increase by approximately 56%, from approximately 347 mtpa, or 16.6 Tcf, in 2019, to approximately 541 mtpa, or 26.0 Tcf, in 2030 and to 723 mtpa or 34.7 Tcf in 2040. WoodMac also forecasts LNG production from existing operational facilities and new facilities already under construction will be able to supply the market with approximately 476 mtpa in 2030, declining to 381 mtpa in 2040. This will result in a market need for +18 +construction of an additional approximately 65 mtpa of LNG production by 2030 and about 343 mtpa by 2040. As a cleaner burning fuel with far lower emissions than coal or liquid fuels in power generation, we expect gas and LNG to play a central role in balancing grids and contributing to a low carbon energy system globally. We believe the capital and operating costs of the uncommitted capacity of our Liquefaction Projects and Corpus Christi Stage 3 are competitive with new proposed projects globally and we are well-positioned to capture a portion of this incremental market need. +We have limited exposure to the decline in oil prices as we have contracted a significant portion of our LNG production capacity under long-term sale and purchase agreements. These agreements contain fixed fees that are required to be paid even if the customers elect to cancel or suspend delivery of LNG cargoes. We have contracted approximately 85% of the total production capacity from the Liquefaction Projects on a term basis, with approximately 18 years of average remaining life as of December 31, 2020, which includes volumes contracted under SPAs in which the customers are required to pay a fixed fee with respect to the contracted volumes irrespective of their election to cancel or suspend deliveries of LNG cargoes, as well as volumes contracted under IPM gas supply agreements. As of January 31, 2021, U.S. natural gas prices indicate that LNG exported from the U.S. continues to be competitively priced, supporting the opportunity for U.S. LNG to fill uncontracted future demand through the execution of long-term and medium-term contracting of LNG from our terminals. +Subsidiaries +Our assets are generally held by our subsidiaries. We conduct most of our business through these subsidiaries, including the development, construction and operation of our LNG terminal business and the development and operation of our LNG and natural gas marketing business. +Human Capital Resources +We are in a unique position as the first U.S. LNG company in the lower 48. As the first mover, ensuring that we have an adequate supply of skilled employees has been a crucial part of our ability to grow and succeed. As a result, attracting, developing and retaining talent is key, especially as new competitors enter the industry in the coming years in need of the same talent we have recruited and developed. +Our strength lies within the collective expertise of our diverse workforce, living our core values of teamwork, respect, accountability, integrity, nimble and safety. Our employees help drive our success, build our reputation, establish our legacy and deliver on our commitments to our customers. Attracting the best and most diverse talent is a priority. To engage them, we offer fulfilling career opportunities. To keep them engaged, we continually listen to, train, develop and reward them. Our voluntary turnover was less than 4% for 2020. +As of January 31, 2021, we had 1,519 full-time employees with approximately 1,439 located in the U.S. and 80 located outside of the U.S (primarily in the UK). +Our Chief Human Resources Officer, along with senior leadership, are tasked with managing employment-related matters and initiatives including talent attraction and retention, rewards and remuneration, employee relations, employee engagement, diversity and inclusion, and training and development. We communicate progress on our human capital programs to our Board quarterly. +Talent Attraction, Engagement and Retention +Talent Attraction +Through our recruitment efforts, we seek top diverse talent who will continue to drive our strong performance. We have a competitive offering that provides us with a solid pipeline of candidates. Internally and externally, we post openings to attract individuals with a range of backgrounds, skills and experience, offering employee bonuses for referring highly qualified candidates. In addition, we actively recruit at colleges and conduct information sessions at select universities including Historically Black Colleges and Universities (HBCUs) and Hispanic-Serving Institutions (HSIs). +We manage and measure organizational health with a view to gaining insight into employees’ experiences, levels of workplace satisfaction and feelings of engagement and inclusion with the company through biannual engagement surveys. +19 +Insights from the biannual survey are used to develop both company-wide and business unit level organizational and talent development plans and training programs. +We provide robust compensation and benefits programs to our employees. In addition to salaries, these programs (which vary by country) include annual bonuses, stock awards, a 401(k) Plan, healthcare and insurance benefits, health savings and flexible spending accounts, paid time off, family leave, family care resources, employee assistance programs and tuition assistance. +Diversity and Inclusion +We are committed to providing a diverse culture where all employees can thrive and feel welcomed and valued. To create this environment, we are committed to equal employment opportunity and to compliance with all federal, state and local laws that prohibit workplace discrimination, harassment and unlawful retaliation. Both our discrimination and harassment and equal employment opportunity policies demonstrate our commitment to building an inclusive workplace, regardless of race, beliefs, nationality, gender and sexual orientation or any other status protected by our policy. Through our targeted recruitment efforts, we attract a variety of candidates with a diversity of backgrounds, skills, experience and expertise. +We encourage our employees to leverage their unique backgrounds through involvement in various employee resource groups. Groups such as WILS (Women Inspiring Leadership Success), EPN (Emerging Professional Network) and Cultural Champions Teams (CCTs) help build a culture of inclusion. +Development and Training +As the first exporter of LNG in the lower 48 of the US, we faced the unique challenge of developing our own LNG talent. Our apprenticeship program prepares local students for careers in LNG. This program combines classroom education with training and on-site learning experiences at our facilities. +We strive to provide our people with all of the tools and support necessary for them to succeed. We actively encourage our employees to take ownership of their careers and offer a number of resources to do so. Employees undergo annual performance reviews to ensure the ongoing development of their skills and expertise. To ensure safe, reliable and efficient operations in a highly regulated environment, we offer online and site-specific learning opportunities. +Employee Safety, Health and Wellness +The safety of our employees, contractors and communities is one of our core values. Our Cheniere Integrated Management System defines our required safety programs and details safety and health related procedures. Safety efforts are led by our Executive Safety Committee, which includes the CEO, senior leaders from across the company, and representatives from each of our operating assets. We focus our efforts on continuously improving our performance. For the year ended December 31, 2020, we achieved zero employee recordable injuries, and our total recordable incident rate (employees and contractors combined) was 0.17. +To support the well-being of our employees, we provide a wellness program that offers employees incentives to maintain an active lifestyle and set personal wellness goals. Incentives include online education related to health and nutrition as well as subsidies for fitness devices and gym memberships. We also offer mammography screenings, rooms for nursing mothers and biometric screenings on site. +In response to the COVID-19 pandemic, we implemented significant changes that we determined were in the best interest of our employees, as well as the communities in which we operate, and which comply with government regulations. This includes having employees work from home where possible, while implementing additional safety measures for employees continuing essential on-site work. We kept employees informed and connected through weekly messaging, mental health recorded seminars, manager toolkits and the launch of an internal campaign to ensure we are all listening and taking care of each other. We also provided the same level of resources, aid and support for weather-related disasters. +Available Information +Our common stock has been publicly traded since March 24, 2003 and is traded on the NYSE American under the symbol “LNG.” Our principal executive offices are located at 700 Milam Street, Suite 1900, Houston, Texas 77002, and our +20 +telephone number is (713) 375-5000. Our internet address is www.cheniere.com. We provide public access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after we electronically file those materials with, or furnish those materials to, the SEC under the Exchange Act. These reports may be accessed free of charge through our internet website. We make our website content available for informational purposes only. The website should not be relied upon for investment purposes and is not incorporated by reference into this Form 10-K. +We will also make available to any stockholder, without charge, copies of our annual report on Form 10-K as filed with the SEC. For copies of this, or any other filing, please contact: Cheniere Energy, Inc., Investor Relations Department, 700 Milam Street Suite 1900, Houston, Texas 77002 or call (713) 375-5000. The SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers. +Additionally, we encourage you to review our Corporate Responsibility Report (located on our internet site at www.cheniere.com ), for more detailed information regarding our Human Capital programs and initiatives, as well as our response to environmental, social and governance (ESG) issues. Nothing on our website, including our Corporate Responsibility Report or sections thereof, shall be deemed incorporated by reference into this Annual Report. +ITEM 1A. RISK FACTORS +The following are some of the important factors that could affect our financial performance or could cause actual results to differ materially from estimates or expectations contained in our forward-looking statements. We may encounter risks in addition to those described below. Additional risks and uncertainties not currently known to us, or that we currently deem to be immaterial, may also impair or adversely affect our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Risk Factor Summary +Each of the risk factors outlined below are discussed more fully following this summary: +Risks Relating to Our Financial Matters +Our operating results, cash flows and/or liquidity could be adversely affected by the following factors: +• Our existing level of cash resources and significant debt +• History of net losses and negative operating cash flow +• Dilution of our proportionate indirect interests in our assets, business operations and proposed projects from sale of equity or equity-related securities +• Stockholder dilution upon the conversion of our convertible notes +• Failure to perform by our customers under their long-term contracts with us +• Termination of our customer contracts under certain circumstances +• Restrictions in distributions under certain circumstances by our subsidiaries +• Restrictions in agreements governing us and our subsidiaries’ indebtedness +• Use of hedging arrangements +• Certain rules and regulations could adversely affect our ability to hedge risks +Risks Relating to Our LNG Terminal Operations and Commercialization +The operations of our LNG terminals, construction of the remaining or additional Trains and the commercialization of the LNG produced could be adversely affected by the following factors: +• Cost overruns and delays in construction, as well as difficulties in obtaining sufficient financing to pay for such costs and delays +• Our ability to obtain additional funding for additional Trains +• Hurricanes or other disasters +• Failure to obtain and maintain approvals and permits from governmental and regulatory agencies +• Delays in construction leading to reduced revenues or termination of one or more of the SPAs by our customers +• Dependency on Bechtel and other contractors +• Unavailability of third-party pipelines and other facilities interconnected to our pipelines and facilities to transport natural gas +21 +• Inability to purchase or receive physical delivery of sufficient natural gas to satisfy our delivery obligations under the SPAs +• Subjectivity to FERC regulation +• Pipeline safety integrity programs and repairs +• Reduction in the capacity of, or the allocations to, interconnecting third-party pipelines +• Loss of our right to situate our pipelines on property owned by third parties +• Inaccurate estimates for the future capacity ratings and performance capabilities of the Liquefaction Projects +• Failure by any significant customer to perform under agreements +• Inability to contract with customers to sell LNG produced in excess of quantities committed under third-party SPAs +Risks Relating to Our LNG Business in General +The operation or growth of our LNG business, including our customers, could be adversely affected by the following factors: +• Not constructing or operating all of our proposed or additional LNG facilities or Trains beyond those currently planned +• Cyclical or other changes in the demand for and price of LNG and natural gas +• Failure of imported or exported LNG to be a competitive source of energy for the United States or international markets +• Various economic and political factors +• Impediments to the transport of LNG, such as shortages of LNG vessels, or operational impacts on LNG shipping +• Security of firm pipeline transportation capacity on economic terms that is sufficient to meet our feed gas transportation requirements +• Competition based upon the international market price for LNG +• Terrorist attacks, cyber incidents or military campaigns +Risks Relating to Our Business in General +Our operations and business results could also be adversely affected by the following factors: +• COVID-19 global pandemic and volatility in the energy markets +• Outbreaks of infectious diseases, such as the outbreak of COVID-19, at one or more of our facilities +• Significant construction and operating hazards and uninsured risks +• Existing and future environmental and similar laws and governmental regulations +• Major health and safety incident relating to our business +• Increased labor costs, and the unavailability of skilled workers or our failure to attract and retain qualified personnel, including changes in our senior management or other key personnel +• Lack of diversification +• Impairments to goodwill or long-lived assets +• Success of our share repurchase program +• Fluctuation in the market price of our common stock +Risks Relating to Our Financial Matters +Our existing level of cash resources and significant debt could cause us to have inadequate liquidity and could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +As of December 31, 2020, we had $1.6 billion of cash and cash equivalents, $449 million of current restricted cash, $1,126 million of available commitments under the $1.25 billion Cheniere Revolving Credit Facility (“Cheniere Revolving Credit Facility”), $372 million of available commitments under the $2.62 billion delayed draw term loan credit agreement (the “Cheniere Term Loan Facility”), $767 million of available commitments under the $1.2 billion CCH Working Capital Facility (“CCH Working Capital Facility”), $750 million of available commitments under Cheniere Partners’ credit facilities, $787 million of available commitments under the $1.2 billion Amended and Restated SPL Working Capital Facility (“2015 SPL Working Capital Facility”), and $31.5 billion of total debt outstanding on a consolidated basis (before unamortized premium, discount and debt issuance costs), excluding $0.8 billion aggregate outstanding letters of credit and noting that borrowings under certain of our credit facilities may be restricted. We incur, and will incur, significant interest expense relating to the assets at the Sabine Pass and Corpus Christi LNG terminals, and we anticipate needing to incur additional debt to finance the construction of Corpus Christi Stage 3. Our ability to fund our capital expenditures and refinance our indebtedness will depend on our ability to access additional project financing as well as the debt and equity capital markets. A variety of factors beyond our control could impact the availability or cost of capital, including domestic or international economic conditions, increases in +22 +key benchmark interest rates and/or credit spreads, the adoption of new or amended banking or capital market laws or regulations and the repricing of market risks and volatility in capital and financial markets. Our financing costs could increase or future borrowings or equity offerings may be unavailable to us or unsuccessful, which could cause us to be unable to pay or refinance our indebtedness or to fund our other liquidity needs. We also rely on borrowings under our credit facilities to fund our capital expenditures. If any of the lenders in the syndicates backing these facilities was unable to perform on its commitments, we may need to seek replacement financing, which may not be available as needed, or may be available in more limited amounts or on more expensive or otherwise unfavorable terms. +We have not always been profitable historically. We may not be able to achieve sustained profitability or generate positive operating cash flow in the future. +We had a net loss attributable to common stockholders of $85 million for the year ended December 31, 2020, as well as net losses attributable to common stockholders in prior years. In the future, we may incur operating losses and experience negative operating cash flow. We may not be able to reduce costs, increase revenues or reduce our debt service obligations sufficiently to maintain our cash resources, which could cause us to have inadequate liquidity to continue our business. +We will continue to incur significant capital and operating expenditures while we develop and construct the Liquefaction Projects, Corpus Christi Stage 3 and other projects. Any delays beyond the expected development period for these projects could cause operating losses and negative operating cash flows. Our future liquidity may also be affected by the timing of construction financing availability in relation to the incurrence of construction costs and other outflows and by the timing of receipt of cash flows under third-party agreements in relation to the incurrence of project and operating expenses. Moreover, many factors (including factors beyond our control) could result in a disparity between liquidity sources and cash needs, including factors such as construction delays and breaches of agreements. Our ability to generate any significant positive operating cash flow and achieve profitability in the future is dependent on our ability to successfully and timely complete and operate the applicable project. +We may sell equity or equity-related securities or assets, including equity interests in Cheniere Partners. Such sales could dilute our proportionate interests in our assets, business operations and proposed projects of Cheniere Partners or other subsidiaries, and could adversely affect the market price of our common stock. +We have historically pursued a number of alternatives in order to finance the construction of our Trains, including potential issuances and sales of additional equity or equity-related securities by our subsidiaries. Such sales, in one or more transactions, could dilute our proportionate indirect interests in our assets, business operations and proposed projects of Cheniere Partners, including the SPL Project, or in other subsidiaries or projects, including the CCL Project. In addition, such sales, or the anticipation of such sales, could adversely affect the market price of our common stock. +Our stockholders may experience dilution upon the conversion of our convertible notes. +In March 2015, we issued $625 million aggregate principal amount of 4.25% Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”) to certain investors through a registered direct offering. We have the option to satisfy the 2045 Cheniere Convertible Senior Notes conversion obligation with cash, common stock or a combination thereof. Prior to December 15, 2044, the 2045 Cheniere Convertible Senior Notes will be convertible upon the occurrence of certain conditions, and on and after such date they will become freely convertible. The 2045 Cheniere Convertible Senior Notes will become convertible into the common stock of Cheniere at an initial conversion price of $138.38 per share. +The conversion of some or all of the 2045 Cheniere Convertible Senior Notes into shares of our common stock will dilute the ownership percentages and voting power of our existing stockholders. Based on the initial conversion price, if we elect to satisfy the entire conversion obligation of the 2045 Cheniere Convertible Senior Notes with common stock, approximately 4.5 million shares of our common stock would be issued upon the conversion, assuming the notes are converted at maturity. Any sales in the public market of the shares issuable upon conversion of the 2045 Cheniere Convertible Senior Notes could adversely affect the prevailing market prices of our common stock. In addition, the existence of the 2045 Cheniere Convertible Senior Notes may encourage short selling by market participants because the conversion of the 2045 Cheniere Convertible Senior Notes could be used to satisfy short positions, or the anticipated conversion of the 2045 Cheniere Convertible Senior Notes into shares of our common stock could depress the price of our common stock. +23 +Our ability to generate cash is substantially dependent upon the performance by customers under long-term contracts that we have entered into, and we could be materially and adversely affected if any significant customer fails to perform its contractual obligations for any reason. +Our future results and liquidity are substantially dependent upon performance by our customers to make payments under long-term contracts. As of December 31, 2020, SPL had SPAs with eight third-party customers, CCL had SPAs with nine third-party customers and our integrated marketing function had a limited number of SPAs with third-party customers. In addition, SPLNG had TUAs with two third-party customers. We are dependent on each customer’s continued willingness and ability to perform its obligations under its SPA or TUA. We are exposed to the credit risk of any guarantor of these customers’ obligations under their respective agreements in the event that we must seek recourse under a guaranty. As a result of the disruptions caused by the COVID-19 pandemic and the volatility in the energy markets, we believe we are exposed to heightened credit and performance risk of our customers. Additionally, some customers have indicated to us that COVID-19 has impacted their operations and/or may impact their operations in the future. Some of our SPA customers’ primary countries of business have experienced a significant number of COVID-19 cases and/or have been subject to government imposed lockdown or quarantine measures. Although we believe that impacts of the COVID-19 pandemic on LNG regasification facilities, downstream markets and broader energy demand do not constitute valid force majeure claims under our FOB LNG SPAs, if any significant customer fails to perform its obligations under its SPA or TUA, our business, contracts, financial condition, operating results, cash flow, liquidity and prospects could be materially and adversely affected, even if we were ultimately successful in seeking damages from that customer or its guarantor, if any, for a breach of the agreement. +Each of our customer contracts is subject to termination under certain circumstances. +Each of the SPAs contains various termination rights allowing our customers to terminate their SPAs, including, without limitation: (1) upon the occurrence of certain events of force majeure; (2) if we fail to make available specified scheduled cargo quantities; and (3) delays in the commencement of commercial operations. We may not be able to replace these SPAs on desirable terms, or at all, if they are terminated. +Each of SPLNG’s long-term TUAs contains various termination rights. For example, each customer may terminate its TUA if the Sabine Pass LNG terminal experiences a force majeure delay for longer than 18 months, fails to redeliver a specified amount of natural gas in accordance with the customer’s redelivery nominations or fails to accept and unload a specified number of the customer’s proposed LNG cargoes. SPLNG may not be able to replace these TUAs on desirable terms, or at all, if they are terminated. +Our subsidiaries may be restricted under the terms of their indebtedness from making distributions under certain circumstances, which may limit Cheniere Partners’ ability to pay or increase distributions to us or inhibit our access to cash flows from the CCL Project and could materially and adversely affect us. +The agreements governing our subsidiaries’ indebtedness restrict payments that our subsidiaries can make to Cheniere Partners or us in certain events and limit the indebtedness that our subsidiaries can incur. For example, SPL is restricted from making distributions under agreements governing its indebtedness generally until, among other requirements, deposits are made into debt service reserve accounts and a debt service coverage ratio of 1.25:1.00 is satisfied. +CCH is generally restricted from making distributions under agreements governing its indebtedness until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project, funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25:1.00. +Our subsidiaries’ inability to pay distributions to Cheniere Partners or us or to incur additional indebtedness as a result of the foregoing restrictions in the agreements governing their indebtedness may inhibit Cheniere Partners’ ability to pay or increase distributions to us and its other unitholders or inhibit our access to cash flows from the CCL Project, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +24 +Restrictions in agreements governing us and our subsidiaries’ indebtedness may prevent us and our subsidiaries from engaging in certain beneficial transactions. +In addition to restrictions on the ability of us, Cheniere Partners, SPL and CCH to make distributions or incur additional indebtedness, the agreements governing our indebtedness also contain various other covenants that may prevent us from engaging in beneficial transactions, including limitations on our ability to: +• make certain investments; +• purchase, redeem or retire equity interests; +• issue preferred stock; +• sell or transfer assets; +• incur liens; +• enter into transactions with affiliates; +• consolidate, merge, sell or lease all or substantially all of our assets; and +• enter into sale and leaseback transactions. +Our use of hedging arrangements may adversely affect our future operating results or liquidity. +To reduce our exposure to fluctuations in (1) changing interest rates, (2) commodity-related marketing and price risks and (3) foreign exchange volatility, we enter into derivative financial instruments, including futures, swaps and option contracts. To the extent we hedge our exposure to commodity price, interest rate or foreign currency exchange rate exposures, we forego the benefits we would otherwise experience if commodity prices, interest rates or foreign currency exchange rates were to change favorably to our hedged position. Hedging arrangements could also expose us to risk of financial loss in some circumstances, including when: +• expected supply is less than the amount hedged or is otherwise imperfect; +• the counterparty to the hedging contract defaults on its contractual obligations; or +• there is a change in the expected differential between the underlying price in the hedging agreement and actual prices received. +Our use of derivative financial instruments are recorded at fair value on our Consolidated Balance Sheets with changes in the fair value resulting from fluctuations in the underlying commodity prices or hedged item recognized in earnings, unless they satisfy criteria for, and we elect, the normal purchases and sales exception or hedge accounting treatment. All of our derivative financial instruments do not qualify for these exceptions from fair value reporting through earnings. As a result, our quarterly and annual results are subject to significant fluctuations caused by changes in fair value, including circumstances in which there is no underlying economic impact yet realized. +The use of derivatives also may require the posting of cash collateral with counterparties, which can impact working capital when commodity prices, interest rates or foreign currency exchange rates change. +The regulatory and other provisions of the Dodd-Frank Act and the rules adopted thereunder and other regulations, including EMIR and REMIT, could adversely affect our ability to hedge risks associated with our business and our operating results and cash flows. +The provisions of the Dodd-Frank Act and the rules adopted by the CFTC, the SEC and other federal regulators establishing federal regulation of the OTC derivatives market and entities like us that participate in that market may adversely affect our ability to manage certain of our risks on a cost effective basis. Such laws and regulations may also adversely affect our ability to execute our strategies with respect to hedging our exposure to variability in expected future cash flows attributable to the future sale of our LNG inventory and to price risk attributable to future purchases of natural gas to be utilized as fuel to operate our LNG terminals and to secure natural gas feedstock for our liquefaction facilities. +As required by the Dodd-Frank Act, the CFTC and federal banking regulators have adopted rules to require certain market participants to collect and post initial and/or variation margin with respect to uncleared swaps from their counterparties +25 +that are financial end users and certain registered swap dealers and major swap participants. Although we believe we will not be required to post margin with respect to any uncleared swaps we enter into in the future, were we required to post margin as to our uncleared swaps in the future, our cost of entering into and maintaining swaps would be increased. Our counterparties that are subject to the regulations imposing the Basel III capital requirements on them may increase the cost to us of entering into swaps with them or, although not required to collect margin from us under the margin rules, contractually require us to post collateral with them in connection with such swaps in order to offset their increased capital costs or to reduce their capital costs to maintain those swaps on their balance sheets. +European and UK-specific regulations, including but not limited to EMIR, MiFID II, REMIT, MAR, FSMA and RAO, govern our trading activities and our compliance with such laws may result in increased costs and risks to the business similar to the impacts stated above with respect to the Dodd-Frank Act. The increased costs may also have an adverse impact on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Further, any violation of the foregoing laws and regulations could result in investigations, and possible fines and penalties, and in some scenarios, criminal offenses. +Further, although a trade deal (the "Deal") has been reached between the UK and EU following Brexit, with the terms of this deal applying as on January 1, 2021, uncertainties remain. While the UK has implemented its own versions of many key EU rules mentioned above (known as 'onshoring'), the Deal was largely focused on goods, not services. Financial services will be negotiated separately, with an initial deadline for agreement set for March 2021. Depending on the terms of this agreement, and the extent to which the UK chooses to diverge from existing EU rules, mutual equivalence decisions could be granted by each side with the effect that compliance with either financial services regime is equivalent to compliance with the corresponding regime in the eyes of each jurisdictions' regulators. Until these issues are clarified, both sides have implemented temporary measures to avoid major disruption in areas like derivatives trading and clearing. +Risks Relating to Our LNG Terminal Operations and Commercialization +Cost overruns and delays in the completion of one or more Trains, as well as difficulties in obtaining sufficient financing to pay for such costs and delays, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +The actual construction costs of the Trains may be significantly higher than our current estimates as a result of many factors, including change orders under existing or future EPC contracts resulting from the occurrence of certain specified events that may give our EPC contractor the right to cause us to enter into change orders or resulting from changes with which we otherwise agree. We have already experienced increased costs due to change orders. As construction progresses, we may decide or be forced to submit change orders to our contractor that could result in longer construction periods, higher construction costs or both, including change orders to comply with existing or future environmental or other regulations. +The COVID-19 pandemic and the resulting actions taken by governmental and regulatory authorities to prevent the spread of COVID-19 may cause a slow-down in the construction of one or more Trains. Our EPC contractor has advised us of voluntary proactive measures it is taking to protect employees and to mitigate risks associated with COVID-19, however, it has not indicated that there will be any changes to the project cost or schedule and is still performing its obligations under its EPC contracts. While the construction of Trains is continuing, if there were a major outbreak of COVID-19 at any construction site or the implementation of restrictions by the government that prevented construction for an extended period, we could experience significant delays in the construction of one or more Trains. +Delays in the construction of one or more Trains beyond the estimated development periods, as well as change orders to our existing EPC contracts or any future EPC contract related to additional Trains, could increase the cost of completion beyond the amounts that we estimate, which could require us to obtain additional sources of financing to fund our operations until the applicable liquefaction project is fully constructed (which could cause further delays). Our ability to obtain financing that may be needed to provide additional funding to cover increased costs will depend, in part, on factors beyond our control. Accordingly, we may not be able to obtain financing on terms that are acceptable to us, or at all. Even if we are able to obtain financing, we may have to accept terms that are disadvantageous to us or that may have a material adverse effect on our current or future business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +26 +Our ability to complete development of additional Trains will be contingent on our ability to obtain additional funding. If we are unable to obtain sufficient funding, we may be unable to fully execute our business strategy. +We will require significant additional funding to be able to commence construction of additional Trains, which we may not be able to obtain at a cost that results in positive economics, or at all. The inability to achieve acceptable funding may cause a delay in the development of additional Trains, and we may not be able to complete our business plan. Even if we are able to obtain funding, the funding may be inadequate to cover any increases in costs or delays in completion of additional Trains, which may cause a delay in the receipt of revenues projected therefrom or cause a loss of one or more future customers in the event of significant delays. As a result, any significant construction delay, whatever the cause, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Hurricanes or other disasters could result in an interruption of our operations, a delay in the completion of our Liquefaction Projects, damage to our Liquefaction Projects and increased insurance costs, all of which could adversely affect us. +Hurricanes Katrina and Rita in 2005, Hurricane Ike in 2008, Hurricane Harvey in 2017 and Hurricanes Laura and Delta in 2020 caused temporary suspension in construction or operation of our Liquefaction Projects or caused minor damage to our Liquefaction Projects. In August 2020, SPL and CCL entered into an arrangement to provide the ability, in limited circumstances, to potentially fulfill commitments to LNG buyers from the other facility in the event operational conditions impact operations at either the Sabine Pass LNG terminal or the Corpus Christi terminal. During the year ended December 31, 2020, 17 TBtu was loaded at affiliate facilities pursuant to this agreement. Future storms and related storm activity and collateral effects, or other disasters such as explosions, fires, floods or accidents, could result in damage to, or interruption of operations at, the Sabine Pass LNG terminal, the Corpus Christi terminal or related infrastructure, as well as delays or cost increases in the construction and the development of the Liquefaction Projects, Corpus Christi Stage 3 or our other facilities and increase our insurance premiums. The U.S. Global Change Research Program has reported that the U.S.’s energy and transportation systems are expected to be increasingly disrupted by climate change and extreme weather events. An increase in frequency and severity of extreme weather events such as storms, floods, fires and rising sea levels could have an adverse effect on our operations. +Failure to obtain and maintain approvals and permits from governmental and regulatory agencies with respect to the design, construction and operation of our facilities, the development and operation of our pipelines and the export of LNG could impede operations and construction and could have a material adverse effect on us. +The design, construction and operation of interstate natural gas pipelines, LNG terminals, including the Liquefaction Projects, Corpus Christi Stage 3 and other facilities, and the import and export of LNG and the purchase and transportation of natural gas, are highly regulated activities. Approvals of the FERC and DOE under Section 3 and Section 7 of the NGA, as well as several other material governmental and regulatory approvals and permits, including several under the CAA and the CWA, are required in order to construct and operate an LNG facility and an interstate natural gas pipeline and export LNG. Although the FERC has issued orders under Section 3 of the NGA authorizing the siting, construction and operation of the six Trains and related facilities of the SPL Project, the three Trains and related facilities of the CCL Project and the seven midscale Trains and related facilities for Corpus Christi Stage 3, as well as orders under Section 7 of the NGA authorizing the construction and operation of the Creole Trail Pipeline, the Corpus Christi Pipeline and the pipeline for Corpus Christi Stage 3, the FERC orders require us to comply with certain ongoing conditions and obtain certain additional approvals in conjunction with ongoing construction and operations of our liquefaction and pipeline facilities. We will be required to obtain similar approvals and permits with respect to any expansion or modification of our liquefaction and pipeline facilities. We cannot control the outcome of the regulatory review and approval processes. Certain of these governmental permits, approvals and authorizations are or may be subject to rehearing requests, appeals and other challenges. +Authorizations obtained from the FERC, DOE and other federal and state regulatory agencies also contain ongoing conditions, and additional approval and permit requirements may be imposed. We do not know whether or when any such approvals or permits can be obtained, or whether any existing or potential interventions or other actions by third parties will interfere with our ability to obtain and maintain such permits or approvals. If we are unable to obtain and maintain the necessary approvals and permits, including as a result of untimely notices or filings, we may not be able to recover our investment in our projects. Additionally, government disruptions, such as a U.S. government shutdown, may delay or halt our ability to obtain and maintain necessary approvals and permits. There is no assurance that we will obtain and maintain these governmental permits, approvals and authorizations, or that we will be able to obtain them on a timely basis, and failure to +27 +obtain and maintain any of these permits, approvals or authorizations could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Delays in the completion of one or more Trains could lead to reduced revenues or termination of one or more of the SPAs by our customers. +Any delay in completion of a Train could cause a delay in the receipt of revenues projected therefrom or cause a loss of one or more customers in the event of significant delays. In particular, each of our SPAs provides that the customer may terminate that SPA if the relevant Train does not timely commence commercial operations. As a result, any significant construction delay, whatever the cause, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We are dependent on Bechtel and other contractors for the successful completion of the Liquefaction Projects. +Timely and cost-effective completion of the Liquefaction Projects in compliance with agreed specifications is central to our business strategy and is highly dependent on the performance of Bechtel and our other contractors under their agreements. The ability of Bechtel and our other contractors to perform successfully under their agreements is dependent on a number of factors, including their ability to: +• design and engineer each Train to operate in accordance with specifications; +• engage and retain third-party subcontractors and procure equipment and supplies; +• respond to difficulties such as equipment failure, delivery delays, schedule changes and failure to perform by subcontractors, some of which are beyond their control; +• attract, develop and retain skilled personnel, including engineers; +• post required construction bonds and comply with the terms thereof; +• manage the construction process generally, including coordinating with other contractors and regulatory agencies; and +• maintain their own financial condition, including adequate working capital. +Although some agreements may provide for liquidated damages if the contractor fails to perform in the manner required with respect to certain of its obligations, the events that trigger a requirement to pay liquidated damages may delay or impair the operation of the Liquefaction Projects, and any liquidated damages that we receive may not be sufficient to cover the damages that we suffer as a result of any such delay or impairment. The obligations of Bechtel and our other contractors to pay liquidated damages under their agreements are subject to caps on liability, as set forth therein. +Furthermore, we may have disagreements with our contractors about different elements of the construction process, which could lead to the assertion of rights and remedies under their contracts and increase the cost of the Liquefaction Projects or result in a contractor’s unwillingness to perform further work on the Liquefaction Projects. If any contractor is unable or unwilling to perform according to the negotiated terms and timetable of its respective agreement for any reason or terminates its agreement, we would be required to engage a substitute contractor. This would likely result in significant project delays and increased costs, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +If third-party pipelines and other facilities interconnected to our pipelines and facilities are or become unavailable to transport natural gas, this could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We depend upon third-party pipelines and other facilities that provide gas delivery options to our liquefaction facilities and pipelines. If the construction of new or modified pipeline connections is not completed on schedule or any pipeline connection were to become unavailable for current or future volumes of natural gas due to repairs, damage to the facility, lack of capacity or any other reason, our ability to meet our SPA obligations and continue shipping natural gas from producing regions or to end markets could be restricted, thereby reducing our revenues which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +28 +We may not be able to purchase or receive physical delivery of sufficient natural gas to satisfy our delivery obligations under the SPAs, which could have a material adverse effect on us. +Under the SPAs with our customers, we are required to make available to them a specified amount of LNG at specified times. However, we may not be able to purchase or receive physical delivery of sufficient quantities of natural gas to satisfy those obligations, which may provide affected SPA customers with the right to terminate their SPAs. Our failure to purchase or receive physical delivery of sufficient quantities of natural gas could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Our interstate natural gas pipelines and their FERC gas tariffs are subject to FERC regulation. +Our interstate natural gas pipelines are subject to regulation by the FERC under the NGA and the Natural Gas Policy Act of 1978 (the “NGPA”). The FERC regulates the purchase and transportation of natural gas in interstate commerce, including the construction and operation of pipelines, the rates, terms and conditions of service and abandonment of facilities. Under the NGA, the rates charged by our interstate natural gas pipelines must be just and reasonable, and we are prohibited from unduly preferring or unreasonably discriminating against any person with respect to pipeline rates or terms and conditions of service. If we fail to comply with all applicable statutes, rules, regulations and orders, our interstate pipelines could be subject to substantial penalties and fines. +In addition, as a natural gas market participant, should we fail to comply with all applicable FERC-administered statutes, rules, regulations and orders, we could be subject to substantial penalties and fines. Under the EPAct, the FERC has civil penalty authority under the NGA and the NGPA to impose penalties for current violations of up to $1.3 million per day for each violation. +Pipeline safety integrity programs and repairs may impose significant costs and liabilities on us. +The PHMSA requires pipeline operators to develop integrity management programs to comprehensively evaluate certain areas along their pipelines and to take additional measures to protect pipeline segments located in “high consequence areas” where a leak or rupture could potentially do the most harm. As an operator, we are required to: +• perform ongoing assessments of pipeline integrity; +• identify and characterize applicable threats to pipeline segments that could impact a “high consequence area”; +• improve data collection, integration and analysis; +• repair and remediate the pipeline as necessary; and +• implement preventative and mitigating actions. +We are required to maintain pipeline integrity testing programs that are intended to assess pipeline integrity. Any repair, remediation, preventative or mitigating actions may require significant capital and operating expenditures. Should we fail to comply with applicable statutes and the Office of Pipeline Safety’s rules and related regulations and orders, we could be subject to significant penalties and fines. +Any reduction in the capacity of, or the allocations to, interconnecting, third-party pipelines could cause a reduction of volumes transported in our pipelines, which would adversely affect our revenues and cash flow. +We are dependent upon third-party pipelines and other facilities to provide delivery options to and from our pipelines. If any pipeline connection were to become unavailable for volumes of natural gas due to repairs, damage to the facility, lack of capacity or any other reason, our ability to continue shipping natural gas to end markets could be restricted, thereby reducing our revenues. Any permanent interruption at any key pipeline interconnect which causes a material reduction in volumes transported on our pipelines could have a material adverse effect on our business, financial condition, operating results, cash flow, liquidity and prospects. +29 +Our business could be materially and adversely affected if we lose the right to situate our pipelines on property owned by third parties. +We do not own the land on which our pipelines are situated, and we are subject to the possibility of increased costs to retain necessary land use rights. If we were to lose these rights or be required to relocate our pipelines, our business could be materially and adversely affected. +We are relying on estimates for the future capacity ratings and performance capabilities of the Liquefaction Projects, and these estimates may prove to be inaccurate. +We are relying on third parties, principally Bechtel, for the design and engineering services underlying our estimates of the future capacity ratings and performance capabilities of the Liquefaction Projects. If any Train, when actually constructed, fails to have the capacity ratings and performance capabilities that we intend, our estimates may not be accurate. Failure of any of our Trains to achieve our intended capacity ratings and performance capabilities could prevent us from achieving the commercial start dates under our SPAs and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Any failure to perform by our counterparties under agreements may adversely affect our operating results, liquidity and access to financing. +Our integrated marketing function involves our entering into various purchase and sale, hedging and other transactions with numerous third parties (commonly referred to as “counterparties”). In such arrangements, we are exposed to the performance and credit risks of our counterparties, including the risk that one or more counterparties fails to perform its obligation to make deliveries of commodities and/or to make payments. These risks may increase during periods of commodity price volatility. Defaults by suppliers and other counterparties may adversely affect our operating results, liquidity and access to financing. +We may not be able to contract with customers to sell LNG produced in excess of the aggregate annual contract quantities committed to SPL’s and CCL’s third-party SPAs. +We expect to sell any LNG produced in excess of the aggregate annual contract quantity committed to SPL’s and CCL’s third-party SPAs through our integrated marketing function. We have, and continue to develop, a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide, which is primarily sourced by LNG produced by the Liquefaction Projects in excess of the contract quantities committed to SPL’s and CCL’s third party SPAs, supplemented by volume procured from other locations worldwide, as needed. Excess LNG from the Liquefaction Projects competes with other sources of LNG that are priced to indices other than Henry Hub, and any collapse in the spread between global LNG prices and the Henry Hub index could impact the ability of our integrated marketing function to profitably sell any such excess LNG. Failure to secure buyers for a sufficient amount of LNG could materially and adversely affect our operating results, cash flows and liquidity. +Risks Relating to Our LNG Business in General +We may not construct or operate all of our proposed LNG facilities or Trains or any additional LNG facilities or Trains beyond those currently planned, which could limit our growth prospects. +We may not construct some of our proposed LNG facilities or Trains, whether due to lack of commercial interest or inability to obtain financing or otherwise. Our ability to develop additional liquefaction facilities will also depend on the availability and pricing of LNG and natural gas in North America and other places around the world. Competitors may have longer operating histories, more development experience, greater name recognition, larger staffs and substantially greater financial, technical and marketing resources and access to sources of natural gas and LNG than we do. If we are unable or unwilling to construct and operate additional LNG facilities, our prospects for growth will be limited. +Our cost estimates for Trains are subject to change as a result of cost overruns, change orders under existing or future construction contracts, changes in commodity prices (particularly nickel and steel), escalating labor costs and the potential need for additional funds to be expended to maintain construction schedules. In the event we experience cost overruns, delays or +30 +both, the amount of funding needed to complete a Train could exceed our available funds and result in our failure to complete such Train and thereby negatively impact our business and limit our growth prospects. +Cyclical or other changes in the demand for and price of LNG and natural gas may adversely affect our LNG business and the performance of our customers and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Our LNG business and the development of domestic LNG facilities and projects generally is based on assumptions about the future availability and price of natural gas and LNG, and the prospects for international natural gas and LNG markets. Natural gas and LNG prices have been, and are likely to continue to be, volatile and subject to wide fluctuations in response to one or more of the following factors: +• additions to competitive regasification capacity in North America, Europe, Asia and other markets, which could divert LNG from the Sabine Pass LNG terminal and the Corpus Christi LNG terminal; +• competitive liquefaction capacity in North America; +• insufficient or oversupply of natural gas liquefaction or receiving capacity worldwide; +• insufficient LNG tanker capacity; +• weather conditions, including extreme weather events and temperature volatility resulting from climate change; +• reduced demand and lower prices for natural gas; +• increased natural gas production deliverable by pipelines, which could suppress demand for LNG; +• decreased oil and natural gas exploration activities which may decrease the production of natural gas, including as a result of any potential ban on production of natural gas through hydraulic fracturing; +• cost improvements that allow competitors to offer LNG regasification services or provide natural gas liquefaction capabilities at reduced prices; +• changes in supplies of, and prices for, alternative energy sources such as coal, oil, nuclear, hydroelectric, wind and solar energy, which may reduce the demand for natural gas; +• changes in regulatory, tax or other governmental policies regarding imported or exported LNG, natural gas or alternative energy sources, which may reduce the demand for imported or exported LNG and/or natural gas; +• political conditions in natural gas producing regions; +• sudden decreases in demand for LNG as a result of natural disasters or public health crises, including the occurrence of a pandemic, and other catastrophic events; +• adverse relative demand for LNG compared to other markets, which may decrease LNG imports into or exports from North America; and +• cyclical trends in general business and economic conditions that cause changes in the demand for natural gas. +Adverse trends or developments affecting any of these factors could result in decreases in the price of LNG and/or natural gas, which could materially and adversely affect the performance of our customers, and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flows, liquidity and prospects. +Failure of imported or exported LNG to be a competitive source of energy for the United States or international markets could adversely affect our customers and could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Operations of the Liquefaction Projects are dependent upon the ability of our SPA customers to deliver LNG supplies from the United States, which is primarily dependent upon LNG being a competitive source of energy internationally. The success of our business plan is dependent, in part, on the extent to which LNG can, for significant periods and in significant volumes, be supplied from North America and delivered to international markets at a lower cost than the cost of alternative energy sources. Through the use of improved exploration technologies, additional sources of natural gas may be discovered +31 +outside the United States, which could increase the available supply of natural gas outside the United States and could result in natural gas in those markets being available at a lower cost than LNG exported to those markets. +Although SPL has entered into arrangements to utilize up to approximately three-quarters of the regasification capacity at the Sabine Pass LNG terminal in connection with operations of the SPL Project, operations at the Sabine Pass LNG terminal are dependent, in part, upon the ability of our TUA customers to import LNG supplies into the United States, which is primarily dependent upon LNG being a competitive source of energy in North America. In North America, due mainly to a historically abundant supply of natural gas and discoveries of substantial quantities of unconventional, or shale, natural gas, imported LNG has not developed into a significant energy source. The success of the regasification services component of our business plan is dependent, in part, on the extent to which LNG can, for significant periods and in significant volumes, be produced internationally and delivered to North America at a lower cost than the cost to produce some domestic supplies of natural gas, or other alternative energy sources. Through the use of improved exploration technologies, additional sources of natural gas have recently been and may continue to be discovered in North America, which could further increase the available supply of natural gas and could result in natural gas being available at a lower cost than imported LNG. +Political instability in foreign countries that import or export natural gas, or strained relations between such countries and the United States, may also impede the willingness or ability of LNG purchasers or suppliers and merchants in such countries to import or export LNG from or to the United States. Furthermore, some foreign purchasers or suppliers of LNG may have economic or other reasons to obtain their LNG from, or direct their LNG to, non-U.S. markets or from or to our competitors’ liquefaction or regasification facilities in the United States. +In addition to natural gas, LNG also competes with other sources of energy, including coal, oil, nuclear, hydroelectric, wind and solar energy. LNG from the Liquefaction Projects also competes with other sources of LNG, including LNG that is priced to indices other than Henry Hub. Some of these sources of energy may be available at a lower cost than LNG from the Liquefaction Projects in certain markets. The cost of LNG supplies from the United States, including the Liquefaction Projects, may also be impacted by an increase in natural gas prices in the United States. +As a result of these and other factors, LNG may not be a competitive source of energy in the United States or internationally. The failure of LNG to be a competitive supply alternative to local natural gas, oil and other alternative energy sources in markets accessible to our customers could adversely affect the ability of our customers to deliver LNG from the United States or to the United States on a commercial basis. Any significant impediment to the ability to deliver LNG to or from the United States generally, or to the Sabine Pass LNG terminal or the Corpus Christi LNG terminal or from the Liquefaction Projects specifically, could have a material adverse effect on our customers and on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Various economic and political factors could negatively affect the development, construction and operation of LNG facilities, including the Liquefaction Projects and expansion projects, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Commercial development of an LNG facility takes a number of years, requires a substantial capital investment and may be delayed by factors such as: +• increased construction costs; +• economic downturns, increases in interest rates or other events that may affect the availability of sufficient financing for LNG projects on commercially reasonable terms; +• decreases in the price of LNG, which might decrease the expected returns relating to investments in LNG projects; +• the inability of project owners or operators to obtain governmental approvals to construct or operate LNG facilities; +• political unrest or local community resistance to the siting of LNG facilities due to safety, environmental or security concerns; and +• any significant explosion, spill or similar incident involving an LNG facility or LNG vessel. +32 +There may be impediments to the transport of LNG, such as shortages of LNG vessels worldwide or operational impacts on LNG shipping, including maritime transportation routes, which could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +The construction and delivery of LNG vessels require significant capital and long construction lead times. Additionally, the availability of LNG vessels and transportation costs could be impacted to the detriment of our business and our customers because of: +• an inadequate number of shipyards constructing LNG vessels and a backlog of orders at these shipyards; +• shortages of or delays in the receipt of necessary construction materials; +• political or economic disturbances; +• changes in governmental regulations or maritime self-regulatory organizations; +• work stoppages or other labor disturbances; +• bankruptcy or other financial crisis of shipbuilders or shipowners; +• quality or engineering problems; +• disruptions to maritime transportation routes; and +• weather interference or a catastrophic event, such as a major earthquake, tsunami or fire. +We may not be able to secure firm pipeline transportation capacity on economic terms that is sufficient to meet our feed gas transportation requirements, which could have a material adverse effect on us. +We have contracted for firm capacity for our natural gas feedstock transportation requirements for the Liquefaction Projects and for Corpus Christi Stage 3. If and when we need to replace one or more of our existing agreements with these interconnecting pipelines, we may not be able to do so on commercially reasonable terms or at all, which could impair our ability to fulfill our obligations under certain of our SPAs and could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We face competition based upon the international market price for LNG. +Our Liquefaction Projects are subject to the risk of LNG price competition at times when we need to replace any existing SPA, whether due to natural expiration, default or otherwise, or enter into new SPAs. Factors relating to competition may prevent us from entering into a new or replacement SPA on economically comparable terms as existing SPAs, or at all. Such an event could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Factors which may negatively affect potential demand for LNG from our Liquefaction Projects are diverse and include, among others: +• increases in worldwide LNG production capacity and availability of LNG for market supply; +• increases in demand for LNG but at levels below those required to maintain current price equilibrium with respect to supply; +• increases in the cost to supply natural gas feedstock to our Liquefaction Projects; +• decreases in the cost of competing sources of natural gas or alternate fuels such as coal, heavy fuel oil and diesel; +• decreases in the price of non-U.S. LNG, including decreases in price as a result of contracts indexed to lower oil prices; +• increases in capacity and utilization of nuclear power and related facilities; and +• displacement of LNG by pipeline natural gas or alternate fuels in locations where access to these energy sources is not currently available. +33 +Terrorist attacks, cyber incidents or military campaigns may adversely impact our business. +A terrorist attack, cyber incident or military incident involving an LNG facility, our infrastructure or an LNG vessel may result in delays in, or cancellation of, construction of new LNG facilities, including one or more of the Trains, which would increase our costs and decrease our cash flows. A terrorist incident or cyber incident may also result in temporary or permanent closure of our existing facilities, which could increase our costs and decrease our cash flows, depending on the duration and timing of the closure. Our operations could also become subject to increased governmental scrutiny that may result in additional security measures at a significant incremental cost to us. In addition, the threat of terrorism and the impact of military campaigns may lead to continued volatility in prices for natural gas that could adversely affect our business and our customers, including their ability to satisfy their obligations to us under our commercial agreements. Instability in the financial markets as a result of terrorism, cyber incidents or war could also materially adversely affect our ability to raise capital. The continuation of these developments may subject our construction and our operations to increased risks, as well as increased costs, and, depending on their ultimate magnitude, could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Risks Relating to Our Business in General +The COVID-19 global pandemic and volatility in the energy markets may materially and adversely affect our business, financial condition, operating results, cash flow, liquidity and prospects. +The COVID-19 global pandemic has resulted in significant disruption globally. Actions taken by various governmental authorities, individuals and companies around the world to prevent the spread of COVID-19 have restricted travel, business operations, and the overall level of individual movement and in-person interaction across the globe. Additionally, recent disputes over production levels between members of the Organization of Petroleum Exporting Countries and other oil producing countries have resulted in increased volatility in oil and natural gas prices. +The extent, duration and magnitude of the COVID-19 pandemic’s effects will depend on future developments, all of which are highly uncertain and difficult to predict, including the impact of the pandemic on global and regional economies, travel, and economic activity, as well as actions taken by governments, businesses and individuals in response to the pandemic or any future resurgence. These developments include the impact of the COVID-19 pandemic on unemployment rates, the demand for oil and natural gas, levels of consumer confidence and the post-pandemic pace of recovery. +Many uncertainties remain with respect to the COVID-19 pandemic, and we continue to monitor the rapidly evolving situation. The COVID-19 pandemic alone or coupled with continued volatility in the energy markets may materially and adversely affect our business, financial condition, operating results, cash flow, liquidity and prospects or have the effect of heightening many of the other risks described herein. The extent to which our business, contracts, financial condition, operating results, cash flow, liquidity and prospects are affected by the COVID-19 global pandemic or volatility in the energy markets will depend on various factors beyond our control and are highly uncertain, including the duration and scope of the outbreak, decreased demand for LNG and the resulting economic effects of the COVID-19 global pandemic. +Outbreaks of infectious diseases, such as the outbreak of COVID-19, at one or more of our facilities could adversely affect our operations. +Federal, state and local governments have enacted various measures to try to contain the outbreak of COVID-19, such as travel bans and restrictions, quarantines, shelter-in-place orders and business shutdowns. Our facilities at the Sabine Pass LNG terminal and Corpus Christi LNG terminal are critical infrastructure and have continued to operate during the outbreak, which means that we must keep our employees who operate our facilities safe and minimize unnecessary risk of exposure to the virus. In response, we have taken extra precautionary measures to protect the continued safety and welfare of our employees who continue to work at our facilities and have modified certain business and workforce practices, such as implementing work from home policies where appropriate, but there can be no assurances that these measures will prevent any outbreak. Furthermore, the measures taken to prevent an outbreak at our facilities have resulted in increased costs and it is unclear how long such increased costs will continue to be incurred. If a large number of our employees in those critical facilities were to contract COVID-19 at the same time, our operations could be adversely affected. +34 +We are subject to significant construction and operating hazards and uninsured risks, one or more of which may create significant liabilities and losses for us. +The construction and operation of our LNG terminals and our pipelines are, and will be, subject to the inherent risks associated with these types of operations, including explosions, breakdowns or failures of equipment, operational errors by vessel or tug operators, pollution, release of toxic substances, fires, hurricanes and adverse weather conditions and other hazards, each of which could result in significant delays in commencement or interruptions of operations and/or in damage to or destruction of our facilities or damage to persons and property. In addition, our operations and the facilities and vessels of third parties on which our operations are dependent face possible risks associated with acts of aggression or terrorism. +We do not, nor do we intend to, maintain insurance against all of these risks and losses. We may not be able to maintain desired or required insurance in the future at rates that we consider reasonable. The occurrence of a significant event not fully insured or indemnified against could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Existing and future environmental and similar laws and governmental regulations could result in increased compliance costs or additional operating costs or construction costs and restrictions. +Our business is and will be subject to extensive federal, state and local laws, rules and regulations applicable to our construction and operation activities relating to, among other things, air quality, water quality, waste management, natural resources and health and safety. Many of these laws and regulations, such as the CAA, the Oil Pollution Act, the CWA and the RCRA, and analogous state laws and regulations, restrict or prohibit the types, quantities and concentration of substances that can be released into the environment in connection with the construction and operation of our facilities, and require us to maintain permits and provide governmental authorities with access to our facilities for inspection and reports related to our compliance. In addition, certain laws and regulations authorize regulators having jurisdiction over the construction and operation of our LNG terminals and pipelines, including FERC and PHMSA, to issue compliance orders, which may restrict or limit operations or increase compliance or operating costs. Violation of these laws and regulations could lead to substantial liabilities, compliance orders, fines and penalties or to capital expenditures that could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. Federal and state laws impose liability, without regard to fault or the lawfulness of the original conduct, for the release of certain types or quantities of hazardous substances into the environment. As the owner and operator of our facilities, we could be liable for the costs of cleaning up hazardous substances released into the environment at or from our facilities and for resulting damage to natural resources. +In 2009, the EPA promulgated and finalized the Mandatory Greenhouse Gas Reporting Rule requiring annual reporting of GHG emissions from stationary sources in a variety of industries. In 2010, the EPA expanded the rule to include reporting obligations for LNG terminals. In addition, the EPA has defined GHG emissions thresholds that would subject GHG emissions from new and modified industrial sources to regulation if the source is subject to PSD Permit requirements due to its emissions of non-GHG criteria pollutants. While the EPA subsequently took a number of additional actions primarily relating to GHG emissions from the electric power generation and the oil and gas exploration and production industries, those rules were largely stayed or repealed during the Trump Administration including by amendments adopted by the EPA on February 23, 2018 and additional amendments to new source performance standards for the oil and gas industry on September 14 and 15, 2020. On January 20, 2021, President Biden issued an executive order directing the EPA to consider publishing for notice and comment a proposed rule suspending, revising, or rescinding the September 2020 rule, which could result in more stringent GHG emissions rulemaking. In addition, other federal and state initiatives may be considered in the future to address GHG emissions through, for example, United States treaty commitments, direct regulation, market-based regulations such as a carbon emissions tax or cap-and-trade programs or clean energy standards. Such initiatives could affect the demand for or cost of natural gas, which we consume at our terminals, or could increase compliance costs for our operations. We are supportive of regulations reducing GHG emissions over time. +Other future legislation and regulations, such as those relating to the transportation and security of LNG imported to or exported from our terminals or climate policies of destination countries in relation to their obligations under the Paris Agreement or other national climate change-related policies, could cause additional expenditures, restrictions and delays in our business and to our proposed construction activities, the extent of which cannot be predicted and which may require us to limit substantially, delay or cease operations in some circumstances. Revised, reinterpreted or additional laws and regulations that +35 +result in increased compliance costs or additional operating or construction costs and restrictions could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +A major health and safety incident relating to our business could be costly in terms of potential liabilities and reputational damages. +Health and safety performance is critical to the success of all areas of our business. Any failure in health and safety performance may result in personal harm or injury, penalties for non-compliance with relevant regulatory requirements or litigation, and a failure that results in a significant health and safety incident is likely to be costly in terms of potential liabilities. Such a failure could generate public concern and have a corresponding impact on our reputation and our relationships with relevant regulatory agencies and local communities, which in turn could have a material adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We may experience increased labor costs, and the unavailability of skilled workers or our failure to attract and retain qualified personnel could adversely affect us. In addition, changes in our senior management or other key personnel could affect our business results. +We are dependent upon the available labor pool of skilled employees. We compete with other energy companies and other employers to attract and retain qualified personnel with the technical skills and experience required to construct and operate our facilities and pipelines and to provide our customers with the highest quality service. Our affiliates who hire personnel on our behalf are also subject to the Fair Labor Standards Act, which governs such matters as minimum wage, overtime and other working conditions. A shortage in the labor pool of skilled workers or other general inflationary pressures, changes in applicable laws and regulations or labor disputes could make it more difficult for us to attract and retain qualified personnel and could require an increase in the wage and benefits packages that we offer, thereby increasing our operating costs. Any increase in our operating costs could materially and adversely affect our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +We depend on our executive officers for various activities. We do not maintain key person life insurance policies on any of our personnel. Although we have arrangements relating to compensation and benefits with certain of our executive officers, we do not have any employment contracts or other agreements with key personnel other than our employment agreement with our President and Chief Executive Officer binding them to provide services for any particular term. The loss of the services of any of these individuals could have a material adverse effect on our business. +Our lack of diversification could have an adverse effect on our business, contracts, financial condition, operating results, cash flow, liquidity and prospects. +Substantially all of our anticipated revenue in 2021 will be dependent upon our two facilities, the Sabine Pass LNG terminal located in southern Louisiana and the Corpus Christi LNG terminal in Texas. Due to our lack of asset and geographic diversification, an adverse development at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, including the related pipelines, or in the LNG industry, would have a significantly greater impact on our financial condition and operating results than if we maintained more diverse assets and operating areas. +We may incur impairments to goodwill or long-lived assets. +We test our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. We test goodwill for impairment annually during the fourth quarter, or more frequently as circumstances dictate. Significant negative industry or economic trends, including a significant decline in the market price of our common stock, reduced estimates of future cash flows for our business or disruptions to our business could lead to an impairment charge of our long-lived assets, including goodwill. Our valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and to rely heavily on projections of future operating performance. Projections of future operating results and cash flows may vary significantly from results. In addition, if our analysis results in an impairment to our goodwill or long-lived assets, we may be required to record a charge to earnings in our Consolidated Financial Statements during a period in which such impairment is determined to exist, which may negatively impact our operating results. +36 +We cannot guarantee that our share repurchase program will be fully consummated or that it will enhance long-term stockholder value. +In June 2019, our Board authorized a three-year, $1 billion share repurchase program and as of December 31, 2020, up to $596 million remains available for repurchase. Our share repurchase program does not obligate us to acquire any particular amount of common stock. Our share repurchase program may be modified, suspended or terminated at any time, which may result in a decrease in the trading price of our common stock. +The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future. Our stockholders could lose all or part of their investment. +The market price of our common stock has historically experienced and may continue to experience volatility. For example, during the three-year period ended December 31, 2020, the market price of our common stock ranged between $27.06 and $71.03. Such fluctuations may continue as a result of a variety of factors, some of which are beyond our control, including: +• domestic and worldwide supply of and demand for natural gas and corresponding fluctuations in the price of natural gas; +• fluctuations in our quarterly or annual financial results or those of other companies in our industry; +• issuance of additional equity securities which causes further dilution to stockholders; +• sales of a high volume of shares of our common stock by our stockholders; +• operating and stock price performance of companies that investors deem comparable to us; +• events affecting other companies that the market deems comparable to us; +• changes in government regulation or proposals applicable to us; +• actual or potential non-performance by any customer or a counterparty under any agreement; +• announcements made by us or our competitors of significant contracts; +• changes in accounting standards, policies, guidance, interpretations or principles; +• general conditions in the industries in which we operate; +• general economic conditions; +• the failure of securities analysts to cover our common stock or changes in financial or other estimates by analysts; +• changes in investor sentiment regarding the energy industry and fossil fuels; and +• other factors described in these “Risk Factors.” +In addition, the United States securities markets have experienced significant price and volume fluctuations. These fluctuations have often been unrelated to the operating performance of companies in these markets. Market fluctuations and broad market, economic and industry factors may negatively affect the price of our common stock, regardless of our operating performance. If we were to be the object of securities class litigation as a result of volatility in our common stock price or for other reasons, it could result in substantial diversion of our management’s attention and resources, which could negatively affect our financial results. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 3. LEGAL PROCEEDINGS +We may in the future be involved as a party to various legal proceedings, which are incidental to the ordinary course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities on the eventual disposition of these matters. +37 +LDEQ Matter +Certain of our subsidiaries are in discussions with the LDEQ to resolve self-reported deviations arising from operation of the Sabine Pass LNG terminal and the commissioning of the SPL Project, and relating to certain requirements under its Title V Permit. The matter involves deviations self-reported to LDEQ pursuant to the Title V Permit and covering the time period from January 1, 2012 through March 25, 2016. On April 11, 2016, certain of our subsidiaries received a Consolidated Compliance Order and Notice of Potential Penalty (the “Compliance Order”) from LDEQ covering deviations self-reported during that time period. Certain of our subsidiaries continue to work with LDEQ to resolve the matters identified in the Compliance Order. We do not expect that any ultimate sanction will have a material adverse impact on our financial results. +PHMSA Matter +In February 2018, the PHMSA issued a Corrective Action Order (the “CAO”) to SPL in connection with a minor LNG leak from one tank and minor vapor release from a second tank at the Sabine Pass LNG terminal. These two tanks have been taken out of operational service while we conduct analysis, repair and remediation. On April 20, 2018, SPL and PHMSA executed a Consent Agreement and Order (the “Consent Order”) that replaces and supersedes the CAO. On July 9, 2019, PHMSA and FERC issued a joint letter setting out operating conditions required to be met prior to SPL returning the tanks to service. We continue to coordinate with PHMSA and FERC to address the matters relating to the February 2018 leak, including repair approach and related analysis. We do not expect that the Consent Order and related analysis, repair and remediation will have a material adverse impact on our financial results or operations. +ITEM 4. MINE SAFETY DISCLOSURE +Not applicable. +38 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Market Information, Holders and Dividends +Our common stock has traded on the NYSE American under the symbol “LNG” since March 24, 2003. As of February 19, 2021, we had 254 million shares of common stock outstanding held by 91 record owners. +We have never paid a cash dividend on our common stock. Any future change in our dividend policy will be made at the discretion of our Board of Directors (our “Board”) in light of our financial condition, capital requirements, earnings, prospects and any restrictions under any financing agreements, as well as other factors our Board deems relevant. +Purchase of Equity Securities by the Issuer and Affiliated Purchasers +The following table summarizes stock repurchases for the three months ended December 31, 2020: +Period Total Number of Shares Purchased (1) Average Price Paid Per Share (2) Total Number of Shares Purchased as a Part of Publicly Announced Plans Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans (3) +October 1 - 31, 2020 4,726 $48.20 — $595,952,809 +November 1 - 30, 2020 1,925 $49.16 — $595,952,809 +December 1 - 31, 2020 1,891 $56.74 — $595,952,809 +Total +8,542 $50.31 — +(1) Includes issued shares surrendered to us by participants in our share-based compensation plans for payment of applicable tax withholdings on the vesting of share-based compensation awards. Associated shares surrendered by participants are repurchased pursuant to terms of the plan and award agreements and not as part of the publicly announced share repurchase plan. +(2) The price paid per share was based on the average trading price of our common stock on the dates on which we repurchased the shares. +(3) On June 3, 2019, we announced that our Board authorized a 3-year, $1 billion share repurchase program. For additional information, see Note 19—Share Repurchase Program . +39 +Total Stockholder Return +The following is a customized peer group consisting of 17 companies (the “New Peer Group”) that were selected because they are publicly traded companies that have: (1) comparable Global Industries Classification Standards, (2) similar market capitalization, (3) similar enterprise values and (4) similar operating characteristics and capital intensity: +New Peer Group +Air Products and Chemicals, Inc. (APD) +Marathon Petroleum Corporation (MPC) +Baker Hughes Company (BKR) +Occidental Petroleum Corporation (OXY) +ConocoPhillips (COP) +ONEOK, Inc. (OKE) +Enterprise Products Partners L.P. (EPD) +Phillips 66 (PSX) +EOG Resources, Inc. (EOG) Suncor Energy Inc. (SU) +Halliburton Company (HAL) Targa Resources Corp. (TRGP) +Hess Corporation (HES) Valero Energy Corporation (VLO) +Kinder Morgan, Inc. (KMI) +The Williams Companies, Inc. (WMB) +LyondellBasell Industries N.V. (LYB) +The New Peer Group companies were revised during 2020 to (1) focus on companies of more comparable size based on relative enterprise value and assets, (2) distribute more evenly the sub-industry representation across oil and gas sectors (i.e., fewer upstream companies) and (3) remove companies that were acquired, left the industry or that did not offer adequate business comparisons for us. Our previous peer group consisted of 27 companies (the “Old Peer Group”), which included, in addition to the 17 companies in the New Peer Group, the following companies: Apache Corporation (APA), Concho Resources Inc. (CXO), Continental Resources, Inc. (CLR), Devon Energy Corporation (DVN), Diamondback Energy, Inc. (FANG), Freeport-McMoRan Inc. (FCX), Marathon Oil Corporation (MRO), Noble Energy, Inc. (NBL), Pioneer Natural Resources Company (PXD) and Schlumberger Limited (SLB). +The following graph compares the five-year total return on our common stock, the S&P 500 Index, the New Peer Group and the Old Peer Group. The graph was constructed on the assumption that $100 was invested in our common stock, the S&P 500 Index, the New Peer Group and the Old Peer Group on December 31, 2015 and that any dividends were fully reinvested. +Company / Index 2015 2016 2017 2018 2019 2020 +Cheniere Energy, Inc. $ 100.00 $ 111.22 $ 144.54 $ 158.90 $ 163.95 $ 161.15 +S&P 500 Index 100.00 111.95 136.38 130.39 171.44 202.96 +New Peer Group 100.00 137.20 146.83 126.67 154.65 114.12 +Old Peer Group 100.00 142.95 149.23 118.31 138.48 102.62 +40 +41 +ITEM 6. SELECTED FINANCIAL DATA +Selected financial data set forth below are derived from our audited Consolidated Financial Statements for the periods indicated (in millions, except per share data). The financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and the accompanying notes thereto included elsewhere in this report. +Year Ended December 31, +2020 2019 2018 2017 2016 +Consolidated Statement of Operations Data: +Revenues $ 9,358 $ 9,730 $ 7,987 $ 5,601 $ 1,283 +Income (loss) from operations 2,631 2,361 2,024 1,388 (30) +Interest expense, net of capitalized interest (1,525) (1,432) (875) (747) (488) +Net income (loss) 501 1,232 1,200 563 (665) +Net income (loss) attributable to common stockholders (85) 648 471 (393) (610) +Common Stock Data: +Net income (loss) per share attributable to common stockholders—basic $ (0.34) $ 2.53 $ 1.92 $ (1.68) $ (2.67) +Net income (loss) per share attributable to common stockholders—diluted $ (0.34) $ 2.51 $ 1.90 $ (1.68) $ (2.67) +Weighted average number of common shares outstanding—basic 252.4 256.2 245.6 233.1 228.8 +Weighted average number of common shares outstanding—diluted 252.4 258.1 248.0 233.1 228.8 +December 31, +2020 2019 2018 2017 2016 +Consolidated Balance Sheet Data: +Property, plant and equipment, net $ 30,421 $ 29,673 $ 27,245 $ 23,978 $ 20,635 +Total assets 35,697 35,492 31,987 27,906 23,703 +Current debt, net 372 — 239 — 247 +Long-term debt, net 30,471 30,774 28,179 25,336 21,688 +42 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +Introduction +The following discussion and analysis presents management’s view of our business, financial condition and overall performance and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes. This information is intended to provide investors with an understanding of our past performance, current financial condition and outlook for the future. Our discussion and analysis includes the following subjects: +• Overview of Business +• Overview of Significant Events +• Impact of COVID-19 and Market Environment +• Results of Operations +• Liquidity and Capital Resources +• Contractual Obli gations +• Off-Balance Sheet Arrangements +• Summary of Critical Accounting Estimates +• Recent Accounting Standards +Overview of Business +Cheniere, a Delaware corporation, is a Houston-based energy infrastructure company primarily engaged in LNG-related businesses. We provide clean, secure and affordable LNG to integrated energy companies, utilities and energy trading companies around the world. We aspire to conduct our business in a safe and responsible manner, delivering a reliable, competitive and integrated source of LNG to our customers. We own and operate the Sabine Pass LNG terminal in Louisiana, one of the largest LNG production facilities in the world, through our ownership interest in and management agreements with Cheniere Partners, which is a publicly traded limited partnership that we created in 2007. As of December 31, 2020, we owned 100% of the general partner interest and 48.6% of the limited partner interest in Cheniere Partners. We also own and operate the Corpus Christi LNG terminal in Texas, which is wholly owned by us. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners, through its subsidiary SPL, is currently operating five natural gas liquefaction Trains and is constructing one additional Train that is expected to be substantially completed in the second half of 2022, for a total production capacity of approximately 30 mtpa of LNG (the “SPL Project”) at the Sabine Pass LNG terminal. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks with aggregate capacity of approximately 17 Bcfe, two existing marine berths and one under construction that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters and vaporizers with regasification capacity of approximately 4 Bcf/d. Cheniere Partners also owns a 94-mile pipeline through its subsidiary, CTPL, that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines. +We also own the Corpus Christi LNG terminal near Corpus Christi, Texas, and are currently operating two Trains and one additional Train is undergoing commissioning for a total production capacity of approximately 15 mtpa of LNG. Additionally, we are operating a 23-mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the Trains, the “CCL Project”) through our subsidiaries CCL and CCP, respectively. The CCL Project, once fully constructed, will contain three LNG storage tanks with aggregate capacity of approximately 10 Bcfe and two marine berths that can each accommodate vessels with nominal capacity of up to 266,000 cubic meters. +We have contracted approximately 85% of the total production capacity from the SPL Project and the CCL Project (collectively, the “Liquefaction Projects”) on a term basis, with approximately 18 years of average remaining life as of December 31, 2020. This includes volumes contracted under SPAs in which the customers are required to pay a fixed fee with +43 +respect to the contracted volumes irrespective of their election to cancel or suspend deliveries of LNG cargoes, as well as volumes contracted under integrated production marketing (“IPM”) gas supply agreements. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) through our subsidiary CCL Stage III for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. We received approval from FERC in November 2019 to site, construct and operate the expansion project. +We remain focused on operational excellence and customer satisfaction. Increasing demand of LNG has allowed us to expand our liquefaction infrastructure in a financially disciplined manner. We have increased available liquefaction capacity at our Liquefaction Projects as a result of debottlenecking and other optimization projects. We hold significant land positions at both the Sabine Pass LNG terminal and the Corpus Christi LNG terminal which provide opportunity for further liquefaction capacity expansion. The development of these sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we can make a final investment decision (“FID”). +Overview of Significant Events +Our significant events since January 1, 2020 and through the filing date of this Form 10-K include the following: +Operational +• As of February 19, 2021, approximately 1,425 cumulative LNG cargoes totaling over 95 million tonnes of LNG have been produced, loaded and exported from the Liquefaction Projects. +• In December 2020, CCL commenced shipment of LNG commissioning cargoes from Train 3 of the CCL Project. +Financial +• We completed the following financing transactions: +◦ In February 2021, SPL entered into a note purchase agreement for the sale of approximately $147 million aggregate principal amount of 2.95% Senior Secured Notes due 2037 (the “2.95% SPL 2037 Senior Secured Notes”) on a private placement basis. The 2.95% SPL 2037 Senior Secured Notes are expected to be issued in December 2021, and the net proceeds are expected to be used to refinance a portion of SPL’s outstanding Senior Secured Notes due 2022. The 2.95% SPL 2037 Senior Secured Notes will be fully amortizing, with a weighted average life of over 10 years. +◦ In September 2020, we issued an aggregate principal amount of $2.0 billion of 4.625% Senior Secured Notes due 2028 (the “2028 Cheniere Senior Secured Notes”). The net proceeds were used to prepay approximately $2.0 billion of outstanding indebtedness of the Cheniere Term Loan Facility. +◦ In August 2020, CCH issued an aggregate principal amount of approximately $769 million of 3.52% Senior Secured Notes due 2039 (the “3.52% CCH Senior Secured Notes”). The net proceeds of these notes were used to repay a portion of the outstanding borrowings under CCH’s amended and restated credit facility (“CCH Credit Facility”), pay costs associated with certain interest rate derivative instruments that were settled and pay certain fees, costs and expenses incurred in connection with these transactions. +◦ In June 2020, we entered into the Cheniere Term Loan Facility with original commitments of $2.62 billion, which in July 2020 was subsequently increased to $2.695 billion. In July 2020, borrowings under the Cheniere Term Loan Facility were used to (1) redeem the remaining outstanding principal amount of the 11% Convertible Senior Secured Notes due 2025 (the “2025 CCH HoldCo II Convertible Senior Notes”), subsequent to the $300 million redemption in March 2020, pursuant to the amended and restated note purchase agreement for the 2025 CCH HoldCo II Convertible Senior Notes which allowed CCH HoldCo II to redeem the outstanding notes with cash at a price of $1,080 per $1,000 principal amount, (2) repurchase $844 million in aggregate principal amount of outstanding 4.875% Convertible Unsecured Notes due 2021 (the “2021 Cheniere Convertible Unsecured Notes”) at individually negotiated prices from a small number of investors and (3) pay the related fees and expenses. The remaining available commitments under the Cheniere Term Loan Facility of $372 million are expected to be used to repay and/or repurchase a portion of +44 +the remaining outstanding principal amount of the 2021 Cheniere Convertible Unsecured Notes and for the payment of related fees and expenses. +◦ In May 2020, SPL issued an aggregate principal amount of $2.0 billion of 4.500% Senior Secured Notes due 2030 (the “2030 SPL Senior Notes”). Net proceeds of the offering, along with available cash, were used to redeem all of SPL’s outstanding 5.625% Senior Secured Notes due 2021 (the “2021 SPL Senior Notes”). +◦ In March 2020, SPL entered into a $1.2 billion Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement (the “2020 SPL Working Capital Facility”), which refinanced its previous working capital facility, reduced the interest rate and extended the maturity date to March 2025. +• During the year ended December 31, 2020, in line with our previously announced capital allocation priorities, with available cash, we: (1) prepaid $200 million of the borrowings made during the year under the $2.695 billion delayed draw term loan credit agreement (the “Cheniere Term Loan Facility”) and (2) redeemed $300 million of the 2025 CCH HoldCo II Convertible Senior Notes. +• In December 2020, we loaded and shipped the first two LNG cargoes under the 25-year SPA with CPC Corporation, Taiwan, which were delivered in January 2021. +• In May 2020, the date of first commercial delivery was reached under the 20-year SPAs with PT Pertamina (Persero), Naturgy LNG GOM, Limited, Woodside Energy Trading Singapore Pte Ltd, Iberdrola Generación España, S.A.U. (assigned by Iberdrola, S.A.) and Électricité de France, S.A. relating to Train 2 of the CCL Project. +• In February 2021, Fitch Ratings upgraded the outlook of SPL’s senior secured notes rating to positive from stable. +Impact of COVID-19 and Market Environment +The LNG business environment in 2020 was impacted by the coronavirus pandemic and its economic ramifications. Lockdown measures across the globe reduced economic activity and resulted in lower energy needs throughout most of the year. However, LNG demand proved relatively resilient as compared to other hydrocarbons, showing an annual gain of approximately 1.4%, or 5 MT, to 364 MT in 2020. While the economic recovery in Asia, and particularly in China, lifted LNG demand in the second half of the year, uncertainty about the pandemic’s track remains the primary near-term risk to LNG trade. A slow return towards normal is expected to occur in the coming months, depending on the speed of vaccine rollout within regions, vaccine effectiveness against mutations and the speed and shape of economic recovery across the LNG importing nations. The continued improvements in global economic indicators seen in the fourth quarter is encouraging especially in China, which represents one of the key countries for LNG demand growth. +In the fourth quarter of 2020, natural gas and LNG spot prices significantly increased in line with the increase in economic activity and with seasonal norms. After falling to all-time lows in the second quarter, global LNG price benchmarks have made an impressive climb and exited the year at the highest levels since March 2019. As an example, the Dutch Title Transfer Facility (“TTF”), a virtual trading point for natural gas in the Netherlands, settled December at $5.08/MMBtu, $3.94/MMBtu higher than its June 2020 settlement. Similarly, the Japan Korea Marker (“JKM”), an LNG benchmark price assessment for spot physical cargoes delivered ex-ship into certain key markets in Asia, settled December at $6.90/MMBtu, which is $4.84/MMBtu higher than its all-time low July 2020 settlement. Record-low winter temperatures, supply outages and transportation bottlenecks contributed to drive JKM prices up to all-time highs by mid-January 2021. In a projection published in July 2020, IHS Markit estimated LNG demand to reach 383 MT in 2021, implying a return to higher growth in 2021. +We have limited exposure to the fluctuations in oil and LNG spot prices as we have contracted a significant portion of our LNG production capacity under long-term sale and purchase agreements linked to a Henry Hub price. For this reason, we do not expect price fluctuations to have a material impact on our forecasted financial results for 2021. +The number of LNG cargoes for which customers notified us that they would not take delivery has reduced from this summer, a sign that the market is continuing to adjust and rebalance toward equilibrium. We do not expect these events to have a material adverse impact on our forecasted financial results for 2021, due to the highly contracted nature of our business and the fact that customers continue to be obligated to pay fixed fees for cargoes with respect to which they have exercised their contractual right to cancel. As such, during the year ended December 31, 2020, we recognized $969 million in LNG revenues associated with LNG cargoes for which customers notified us that they would not take delivery, of which $38 million would have been recognized subsequent to December 31, 2020, if the cargoes were lifted pursuant to the delivery schedules with the +45 +customers. We experienced decreased revenues during the year ended December 31, 2020 associated with LNG cargoes that were scheduled for delivery for which customers notified us that they would not take delivery of such cargoes. +In addition, in response to the COVID-19 pandemic, we have modified certain business and workforce practices to protect the safety and welfare of our employees who continue to work at our facilities and offices worldwide, as well as implemented certain mitigation efforts to ensure business continuity. In March 2020, we began consulting with a medical advisor, and implemented social distancing through revised shift schedules, work from home policies and designated remote work locations where appropriate, restricted non-essential business travel and began requiring self-screening for employees and contractors. In April 2020, we began providing temporary housing for our workforce for our facilities, implemented temperature testing, incorporated medical and social workers to support employees, implemented prior self-isolation and screening for temporary housing and implemented marine operations with zero contact during loading activities. These measures have resulted in increased costs. While response measures continue to evolve and in most cases have moderated or ceased, we expect to incur incremental operating costs associated with business continuity and protection of our workforce until the risks associated with the pandemic diminish. We have incurred approximately $69 million of such costs during the year ended December 31, 2020. +46 +Results of Operations +The following charts summarize the number of Trains that were in operation during the years ended December 31, 2020, 2019 and 2018 and total revenues and total LNG volumes loaded from our Liquefaction Projects (including both operational and commissioning volumes) for the respective periods: +The following table summarizes the volumes of operational and commissioning LNG cargoes that were loaded from the Liquefaction Projects, which were recognized on our Consolidated Financial Statements during the year ended December 31, 2020: +Year Ended December 31, 2020 +(in TBtu) Operational Commissioning +Volumes loaded during the current period 1,378 6 +Volumes loaded during the prior period but recognized during the current period 33 — +Less: volumes loaded during the current period and in transit at the end of the period (26) (3) +Total volumes recognized in the current period 1,385 3 +Our consolidated net loss attributable to common stockholders was $85 million, or $0.34 per share (basic and diluted), for the year ended December 31, 2020, compared to net income attributable to common stockholders of $648 million, or $2.53 per share—basic and $2.51 per share—diluted, in the year ended December 31, 2019. This $733 million decrease in net income attributable to common stockholders in 2020 was primarily attributable to increases in: (1) losses from commodity derivatives +47 +to secure natural gas feedstock for the Liquefaction Projects, (2) income tax provision, (3) losses on modification or extinguishment of debt, (4) operating and maintenance expense, (5) depreciation and amortization expense, (6) interest rate derivative losses and (7) interest expense, net of capitalized interest. This loss was partially offset by increased gross margins primarily due to additional LNG volume available to be sold from additional Trains that have reached substantial completion between the periods, a portion of which the customers elected not to take delivery but were required to pay a fixed fee with respect to the contracted volumes. +Our consolidated net income attributable to common stockholders was $471 million, or $1.92 per share—basic and $1.90 per share—diluted, in the year ended December 31, 2018. This $177 million increase in net income in 2019 compared to 2018 was primarily attributable to (1) increased gross margins due to increased volume of LNG sold partially offset by decreased pricing on LNG, (2) increased tax benefit from the release of a significant portion of the valuation allowance previously recorded against our deferred tax assets, (3) increased LNG revenues as a result of derivative gains on commodity derivatives and (4) decreased net income attributable to non-controlling interest, which were partially offset by an increase in (1) interest expense, net of amounts capitalized, (2) operating and maintenance expense, (3) derivative losses, net, associated with our interest rate derivatives, (4) depreciation and amortization expense and (5) losses on equity method investments. +We enter into derivative instruments to manage our exposure to (1) changing interest rates, (2) commodity-related marketing and price risks and (3) foreign exchange volatility. Derivative instruments are reported at fair value on our Consolidated Financial Statements. In some cases, the underlying transactions economically hedged receive accrual accounting treatment, whereby revenues and expenses are recognized only upon delivery, receipt or realization of the underlying transaction. Because the recognition of derivative instruments at fair value has the effect of recognizing gains or losses relating to future period exposure, use of derivative instruments may increase the volatility of our results of operations based on changes in market pricing, counterparty credit risk and other relevant factors. +Revenues +Year Ended December 31, +(in millions) 2020 2019 Change 2018 Change +LNG revenues $ 8,924 $ 9,246 $ (322) $ 7,572 $ 1,674 +Regasification revenues 269 266 3 261 5 +Other revenues 165 218 (53) 154 64 +Total revenues $ 9,358 $ 9,730 $ (372) $ 7,987 $ 1,743 +2020 vs. 2019 and 2019 vs. 2018 +Total revenues decreased during the year ended December 31, 2020 from the comparable period in 2019, primarily as a result of decreased revenues recognized by our integrated marketing function due to the recent downturn in the energy market and the absence of variable fees for cargoes in which customers notified us they would not take delivery. During the year ended December 31, 2020, we recognized $969 million in revenues associated with LNG cargoes for which customers notified us that they would not take delivery, of which $38 million would have been recognized subsequent to December 31, 2020, if the cargoes were lifted pursuant to the delivery schedules with the customers. The increase in revenue attributable to LNG volume sold during the year ended December 31, 2019 from the comparable period in 2018 was due to increased volume of LNG sold following the achievement of substantial completion of Trains between the years, partially offset by decreased LNG revenues per MMBtu, which was primarily affected by market prices realized for volumes sold by our integrated marketing function. We expect our LNG revenues to increase in the future upon Train 3 of the CCL Project and Train 6 of the SPL Project becoming operational. +Prior to substantial completion of a Train, amounts received from the sale of commissioning cargoes from that Train are offset against LNG terminal construction-in-process, because these amounts are earned or loaded during the testing phase for the construction of that Train. During the years ended years ended December 31, 2020, 2019 and 2018, we realized offsets to LNG terminal costs of $19 million, $301 million and $140 million, corresponding to 3 TBtu, 51 TBtu and 17 TBtu, respectively, that were related to the sale of commissioning cargoes from the Liquefaction Projects. +Also included in LNG revenues are sale of unutilized natural gas procured for the liquefaction process, gains and losses from derivative instruments, which include the realized value associated with a portion of derivative instruments that settle through physical delivery, and revenues from arrangements in which we financially settled previously-scheduled LNG cargo +48 +sales without physical delivery. We recognized revenues of $436 million, $693 million and $163 million during the years ended December 31, 2020, 2019 and 2018, respectively, related to these transactions. +The following table presents the components of LNG revenues and the corresponding LNG volumes sold: +Year Ended December 31, +2020 2019 2018 +LNG revenues (in millions) : +LNG from the Liquefaction Projects sold under third party long-term agreements (1) $ 6,303 $ 6,342 $ 4,762 +LNG from the Liquefaction Projects sold by our integrated marketing function under short-term agreements 802 1,943 1,902 +LNG procured from third parties 414 268 745 +LNG revenues associated with cargoes not delivered per customer notification (2) 969 — — +Other revenues and derivative gains 436 693 163 +Total LNG revenues $ 8,924 $ 9,246 $ 7,572 +Volumes delivered as LNG revenues (in TBtu) : +LNG from the Liquefaction Projects sold under third party long-term agreements (1) 1,158 1,090 761 +LNG from the Liquefaction Projects sold by our integrated marketing function under short-term agreements 227 368 212 +LNG procured from third parties 103 40 84 +Total volumes delivered as LNG revenues 1,488 1,498 1,057 +(1) Long-term agreements include agreements with an initial tenure of 12 months or more. +(2) LNG revenues include revenues with no corresponding volumes due to revenues attributable to LNG cargoes for which customers notified us that they would not take delivery. +Operating costs and expenses +Year Ended December 31, +(in millions) 2020 2019 Change 2018 Change +Cost of sales $ 4,161 $ 5,079 $ (918) $ 4,597 $ 482 +Operating and maintenance expense 1,320 1,154 166 613 541 +Development expense 6 9 (3) 7 2 +Selling, general and administrative expense 302 310 (8) 289 21 +Depreciation and amortization expense 932 794 138 449 345 +Impairment expense and loss on disposal of assets 6 23 (17) 8 15 +Total operating costs and expenses $ 6,727 $ 7,369 $ (642) $ 5,963 $ 1,406 +2020 vs. 2019 and 2019 vs. 2018 +Our total operating costs and expenses decreased during the year ended December 31, 2020 from the year ended December 31, 2019, primarily as a result of decreased cost of sales, partially offset by increased operating and maintenance expense and depreciation and amortization expense from additional operating Trains between the periods. Our total operating costs and expenses increased during the year ended December 31, 2019 from the year ended December 31, 2018 primarily as a result of the increase in operating Trains between each of the periods, and further due to increased third-party service and maintenance costs from turnaround and related activities at the SPL Project. +Cost of sales includes costs incurred directly for the production and delivery of LNG from the Liquefaction Projects, to the extent those costs are not utilized for the commissioning process. Cost of sales decreased during the year ended December 31, 2020 from the comparable 2019 period, primarily due to decreased pricing of natural gas feedstock between the periods and decreased vessel charter costs. Partially offsetting this decrease was decreased fair value of commodity derivatives to secure natural gas feedstock for the Liquefaction Projects due to unfavorable shifts in long-term forward prices relative to our hedged position and increases in costs associated with sale of unutilized natural gas procured for the liquefaction process and a portion of derivative instruments that settle through physical delivery. Cost of sales increased during the year ended December 31, 2019 from the year ended December 31, 2018 due to increased volume of natural gas feedstock partially offset by decreased +49 +pricing and increased vessel charter costs. Partially offsetting this increase was increased derivative gains from an increase in fair value of the derivatives associated with economic hedges to secure natural gas feedstock for the Liquefaction Projects, primarily due to a favorable shift in long-term forward prices. Cost of sales also includes port and canal fees, variable transportation and storage costs and the sale of natural gas procured for the liquefaction process and other costs to convert natural gas into LNG. +Operating and maintenance expense primarily includes costs associated with operating and maintaining the Liquefaction Projects. During the year ended December 31, 2020, operating and maintenance expense also included costs incurred in response to the COVID-19 pandemic, as further described above in Impact of COVID-19 and Market Environment . Excluding the costs incurred in response to the COVID-19 pandemic, operating and maintenance expense (including affiliates) increased during the year ended December 31, 2020 from the comparable period in 2019, primarily due to increased natural gas transportation and storage capacity demand charges, increased TUA reservation charges due to Total Gas & Power North America, Inc. (“Total”) under the partial TUA assignment agreement and increased payroll and benefit costs from increased headcount from additional Trains operating at the Liquefaction Projects between the periods. The increase during the year ended December 31, 2019 from the comparable period in 2018 was primarily related to: (1) increased natural gas transportation and storage capacity demand charges from operating Train 5 of the SPL Project and Trains 1 and 2 of the CCL Project following the respective substantial completions, (2) increased cost of turnaround and related activities at the SPL Project, (3) increased TUA reservation charges paid to Total from payments under the partial TUA assignment agreement and (4) increased payroll and benefit costs from increased headcount to operate Train 5 of the SPL Project and Trains 1 and 2 of the CCL Project. Operating and maintenance expense also includes insurance and regulatory and other operating costs. +Depreciation and amortization expense increased during each of the years ended December 31, 2020 and 2019 as a result of an increased number of operational Trains, as the related assets began depreciating upon reaching substantial completion. +Impairment expense and loss on disposal of assets decreased during the year ended December 31, 2020 compared to the year ended December 31, 2019 and increased during the year ended December 31, 2019 compared to the year ended December 31, 2018. The higher impairment expense and loss on disposal of assets recognized during the year ended December 31, 2019 was primarily related to the write down of assets used in non-core operations outside of our liquefaction activities, including losses from uncollectible notes receivable. +We expect our operating costs and expenses to generally increase in the future upon Train 3 of the CCL Project and Train 6 of the SPL Project achieving substantial completion, although we expect certain costs will not proportionally increase with the number of operational Trains as cost efficiencies will be realized. +Other income (expense) +Year Ended December 31, +(in millions) 2020 2019 Change 2018 Change +Interest expense, net of capitalized interest $ 1,525 $ 1,432 $ 93 $ 875 $ 557 +Loss on modification or extinguishment of debt 217 55 162 27 28 +Interest rate derivative loss (gain), net 233 134 99 (57) 191 +Other expense (income), net 112 25 87 (48) 73 +Total other expense $ 2,087 $ 1,646 $ 441 $ 797 $ 849 +2020 vs. 2019 and 2019 vs. 2018 +Interest expense, net of capitalized interest, increased during the year ended December 31, 2020 from the comparable 2019 and 2018 periods as a result of a decrease in the portion of total interest costs that is eligible for capitalization as additional Trains of the Liquefaction Projects completed construction between the periods. During the years ended December 31, 2020, 2019 and 2018, we incurred $1.8 billion, $1.8 billion and $1.7 billion of total interest cost, respectively, of which we capitalized $248 million, $414 million and $803 million, respectively, which was primarily related to interest costs incurred for the construction of the Liquefaction Projects. +Loss on modification or extinguishment of debt increased during the year ended December 31, 2020 from the comparable periods in 2019 and 2018. The loss on modification or extinguishment of debt in each of the years included the incurrence of fees paid to lenders, third party fees and write off of unamortized debt issuance costs recognized upon the redemption and repurchase of convertible senior notes, refinancing our credit facilities with senior notes, refinancing of senior +50 +notes, prepayment of the outstanding indebtedness of our term loan facility and paydown of our credit facilities as part of the capital allocation framework. +Interest rate derivative loss, net increased during the year ended December 31, 2020 compared to the comparable 2019 and 2018 periods, primarily due to an unfavorable shift in the long-term forward LIBOR curve between the periods. +Other expense, net increased during the year ended December 31, 2020 from the comparable periods in 2019 and 2018, due to an impairment loss recognized related to our equity method investments. During the year ended December 31, 2020, we recognized other-than-temporary impairment losses of $129 million related to our investment in Midship Holdings, LLC (“Midship Holdings”) which was precipitated primarily due to declining market conditions in the energy industry and customer credit risk, resulting in a reduction in the fair value of our equity interests. We recognized losses of $87 million during the year ended December 31, 2019 related to our investments in certain equity method investees, including Midship Holdings. Impairments were primarily the result of cost overruns and extended construction timelines for operating infrastructure of our investees’ projects, resulting in a reduction of the expected fair value of our equity interests. In each of the years, these impairment losses were partially offset by interest income earned on our cash and cash equivalents. +Income tax benefit (provision) +Year Ended December 31, +(in millions) 2020 2019 Change 2018 Change +Income before income taxes and non-controlling interest $ 544 $ 715 $ (171) $ 1,227 $ (512) +Income tax benefit (provision) (43) 517 (560) (27) 544 +Effective tax rate 7.9 % (72.3) % 2.2 % +2020 vs. 2019 and 2019 vs. 2018 +The effective tax rate of 7.9% for the year ended December 31, 2020 was lower than the 21% federal statutory tax rate primarily due to income allocated to non-controlling interest that is not taxable to Cheniere. The effective tax rate of (72.3)% for the year ended December 31, 2019 was primarily attributable to a one-time tax benefit resulting from the release of a significant portion of our deferred tax asset valuation allowance. The effective tax rate of 2.2% for the year ended December 31, 2018 was lower than the 21% statutory rate primarily as a result of maintaining a valuation allowance against our federal and state net deferred tax assets. Our effective tax rate may continue to experience volatility prospectively due to variability in our pre-tax and taxable earnings and the proportion of such earnings attributable to non-controlling interests. +Net income attributable to non-controlling interest +Year Ended December 31, +(in millions) 2020 2019 Change 2018 Change +Net income attributable to non-controlling interest $ 586 $ 584 $ 2 $ 729 $ (145) +2020 vs. 2019 +Net income attributable to non-controlling interest slightly increased during the year ended December 31, 2020 from the year ended December 31, 2019 primarily due to an increase in consolidated net income recognized by Cheniere Partners, primarily a result of increased margins due to lower pricing of natural gas feedstock, partially offset by increases in (1) loss on modification or extinguishment of debt incurred in conjunction with the refinancing of the 2021 SPL Senior Notes, (2) interest expense, net of capitalized interest and (3) depreciation and amortization expense. +2019 vs. 2018 +Net income attributable to non-controlling interest decreased during the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to the annualized decrease of non-controlling interest as a result of our merger with Cheniere Holdings in September 2018, in which all publicly-held shares of Cheniere Holdings were canceled and the non-controlling interest in Cheniere Holdings was reduced to zero. The consolidated net income recognized by Cheniere Partners decreased from $1.3 billion in the year ended December 31, 2018 to $1.2 billion in the year ended December 31, 2019 primarily +51 +due a decrease in income from operations from higher operating and maintenance expense and an increase in interest expense, net of capitalized interest and increased depreciation and amortization expense, partially offset by increased margins due to higher volumes of LNG sold but decreased pricing on LNG. +Liquidity and Capital Resources +Although results are consolidated for financial reporting, SPL, Cheniere Partners, CCH Group and Cheniere operate with independent capital structures. Our capital requirements include capital and investment expenditures, repayment of long-term debt and repurchase of our shares. We expect the cash needs for at least the next twelve months will be met for each of these independent capital structures as follows: +• SPL through project debt and borrowings, operating cash flows and equity contributions from Cheniere Partners; +• Cheniere Partners through operating cash flows from SPLNG, SPL and CTPL and debt or equity offerings; +• CCH Group through operating cash flows from CCL and CCP, project debt and borrowings and equity contributions from Cheniere; and +• Cheniere through existing unrestricted cash, debt and equity offerings by us or our subsidiaries, operating cash flows, borrowings, services fees from our subsidiaries and distributions from our investment in Cheniere Partners. +The following table provides a summary of our liquidity position at December 31, 2020 and 2019 (in millions): +December 31, +2020 2019 +Cash and cash equivalents (1) $ 1,628 $ 2,474 +Restricted cash designated for the following purposes: +SPL Project 97 181 +CCL Project 70 80 +Other 282 259 +Available commitments under the following credit facilities: +$1.2 billion Amended and Restated SPL Working Capital Facility (“2015 SPL Working Capital Facility”) — 786 +2020 SPL Working Capital Facility 787 — +CQP Credit Facilities executed in 2019 (“2019 CQP Credit Facilities”) 750 750 +CCH Credit Facility — — +$1.2 billion CCH Working Capital Facility (“CCH Working Capital Facility”) 767 729 +$1.25 billion Cheniere Revolving Credit Facility (“Cheniere Revolving Credit Facility”) +1,126 665 +Cheniere Term Loan Facility 372 — +(1) Amounts presented include balances held by our consolidated variable interest entity (“VIE”), Cheniere Partners, as discussed in Note 9—Non-controlling Interest and Variable Interest Entity of our Notes to Consolidated Financial Statements. As of December 31, 2020 and 2019, assets of Cheniere Partners, which are included in our Consolidated Balance Sheets, included $1.2 billion and $1.8 billion, respectively, of cash and cash equivalents. +52 +Sabine Pass LNG Terminal +Liquefaction Facilities +The SPL Project is one of the largest LNG production facilities in the world. Through Cheniere Partners, we are currently operating five Trains and two marine berths at the SPL Project, and are constructing one additional Train that is expected to be substantially completed in the second half of 2022, and a third marine berth. We have received authorization from the FERC to site, construct and operate Trains 1 through 6, as well as for the construction of the third marine berth. We have achieved substantial completion of the first five Trains of the SPL Project and commenced commercial operating activities for each Train at various times starting in May 2016. The following table summarizes the project completion and construction status of Train 6 of the SPL Project as of December 31, 2020: +SPL Train 6 +Overall project completion percentage 77.6% +Completion percentage of: +Engineering 99.0% +Procurement 99.9% +Subcontract work 54.9% +Construction 49.2% +Date of expected substantial completion 2H 2022 +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Sabine Pass LNG terminal: +• Trains 1 through 4—FTA countries and non-FTA countries through December 31, 2050, in an amount up to a combined total of the equivalent of 16 mtpa (approximately 803 Bcf/yr of natural gas). +• Trains 1 through 4—FTA countries and non-FTA countries through December 31, 2050, in an amount up to a combined total of the equivalent of approximately 203 Bcf/yr of natural gas (approximately 4 mtpa). +• Trains 5 and 6—FTA countries and non-FTA countries through December 31, 2050, in an amount up to a combined total of 503.3 Bcf/yr of natural gas (approximately 10 mtpa). +In December 2020, the DOE announced a new policy in which it would no longer issue short-term export authorizations separately from long-term authorizations. Accordingly, the DOE amended each of SPL’s long-term authorizations to include short-term export authority, and vacated the short-term orders. +An application was filed in September 2019 seeking authorization to make additional exports from the SPL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 153 Bcf/yr of natural gas, for a total SPL Project export capacity of approximately 1,662 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the SPL Project of the volumes contemplated in the application. In April 2020, the DOE issued an order authorizing SPL to export to FTA countries related to this application, for which the term was subsequently extended through December 31, 2050, but has not yet issued an order authorizing SPL to export to non-FTA countries for the corresponding LNG volume. A corresponding application for authorization to increase the total LNG production capacity of the SPL Project from the currently authorized level to approximately 1,662 Bcf/yr was also submitted to the FERC and is currently pending. +Customers +SPL has entered into fixed price long-term SPAs generally with terms of 20 years (plus extension rights) and with a weighted average remaining contract length of approximately 17 years (plus extension rights) with eight third parties for Trains 1 through 6 of the SPL Project. Under these SPAs, the customers will purchase LNG from SPL for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG generally equal to approximately 115% of Henry Hub. The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG cargo deliveries under the SPAs as the fixed fee component of the price under SPL’s SPAs. We refer to the fee component that is applicable only in connection +53 +with LNG cargo deliveries as the variable fee component of the price under SPL’s SPAs. The variable fees under SPL’s SPAs were generally sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +In aggregate, the annual fixed fee portion to be paid by the third-party SPA customers is approximately $2.9 billion for Trains 1 through 5. After giving effect to an SPA that Cheniere has committed to provide to SPL, the annual fixed fee portion to be paid by the third-party SPA customers would increase to at least $3.3 billion, which is expected to occur upon the date of first commercial delivery of Train 6. +In addition, Cheniere Marketing has an agreement with SPL to purchase at Cheniere Marketing’s option, any LNG produced by SPL in excess of that required for other customers. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +Natural Gas Transportation, Storage and Supply +To ensure SPL is able to transport adequate natural gas feedstock to the Sabine Pass LNG terminal, it has entered into transportation precedent and other agreements to secure firm pipeline transportation capacity with CTPL and third-party pipeline companies. SPL has entered into firm storage services agreements with third parties to assist in managing variability in natural gas needs for the SPL Project. SPL has also entered into enabling agreements and long-term natural gas supply contracts with third parties in order to secure natural gas feedstock for the SPL Project. As of December 31, 2020, SPL had secured up to approximately 4,950 TBtu of natural gas feedstock through long-term and short-term natural gas supply contracts with remaining terms that range up to 10 years, a portion of which is subject to conditions precedent. +Construction +SPL entered into lump sum turnkey contracts with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Trains 1 through 6 of the SPL Project, under which Bechtel charges a lump sum for all work performed and generally bears project cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause SPL to enter into a change order, or SPL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 6 of the SPL Project is approximately $2.5 billion, including estimated costs for the third marine berth that is currently under construction. As of December 31, 2020, we have incurred $1.9 billion under this contract. +Regasification Facilities +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4 Bcf/d and aggregate LNG storage capacity of approximately 17 Bcfe. Approximately 2 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term third-party TUAs, under which SPLNG’s customers are required to pay fixed monthly fees, whether or not they use the LNG terminal. Each of Total and Chevron U.S.A. Inc. (“Chevron”) has reserved approximately 1 Bcf/d of regasification capacity and is obligated to make monthly capacity payments to SPLNG aggregating approximately $125 million annually, prior to inflation adjustments, for 20 years that commenced in 2009. Total S.A. has guaranteed Total’s obligations under its TUA up to $2.5 billion, subject to certain exceptions, and Chevron Corporation has guaranteed Chevron’s obligations under its TUA up to 80% of the fees payable by Chevron. +The remaining approximately 2 Bcf/d of capacity has been reserved under a TUA by SPL. SPL is obligated to make monthly capacity payments to SPLNG aggregating approximately $250 million annually, prior to inflation adjustments, continuing until at least May 2036. SPL entered into a partial TUA assignment agreement with Total, whereby upon substantial completion of Train 5 of the SPL Project, SPL gained access to substantially all of Total’s capacity and other services provided under Total’s TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Train 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA. During the years ended December 31, 2020, 2019 and 2018, SPL recorded $129 +54 +million, $104 million and $30 million, respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Under each of these TUAs, SPLNG is entitled to retain 2% of the LNG delivered to the Sabine Pass LNG terminal. +Capital Resources +We currently expect that SPL’s capital resources requirements with respect to the SPL Project will be financed through project debt and borrowings, cash flows under the SPAs and equity contributions from Cheniere Partners. We believe that with the net proceeds of borrowings, available commitments under the 2020 SPL Working Capital Facility, 2019 CQP Credit Facilities, cash flows from operations and equity contributions from Cheniere Partners , SPL will have adequate financial resources available to meet its currently anticipated capital, operating and debt service requirements with respect to Trains 1 through 6 of the SPL Project. Additionally, SPLNG generates cash flows from the TUAs, as discussed above. +The following table provides a summary of our capital resources from borrowings and available commitments for the Sabine Pass LNG Terminal, excluding equity contributions to our subsidiaries and cash flows from operations (as described in Sources and Uses of Cash ), at December 31, 2020 and 2019 (in millions): +December 31, +2020 2019 +Senior notes (1) $ 17,750 $ 17,750 +Credit facilities outstanding balance (2) — — +Letters of credit issued (3) 413 414 +Available commitments under credit facilities (3) 1,537 1,536 +Total capital resources from borrowings and available commitments (4) $ 19,700 $ 19,700 +(1) Includes SPL’s 2021 SPL Senior Notes, 6.25% Senior Secured Notes due 2022, 5.625% Senior Secured Notes due 2023, 5.75% Senior Secured Notes due 2024, 5.625% Senior Secured Notes due 2025, 5.875% Senior Secured Notes due 2026 (the “2026 SPL Senior Notes”), 5.00% Senior Secured Notes due 2027 (the “2027 SPL Senior Notes”), 4.200% Senior Secured Notes due 2028 (the “2028 SPL Senior Notes”), 2030 SPL Senior Notes and 5.00% Senior Secured Notes due 2037 (the “2037 SPL Senior Notes”) (collectively, the “SPL Senior Notes”), as well as Cheniere Partners’ $1.5 billion of 5.250% Senior Notes due 2025 (the “2025 CQP Senior Notes”), $1.1 billion of 5.625% Senior Notes due 2026 (the “2026 CQP Senior Notes”) and the 4.500% Senior Notes due 2029 (the “2029 CQP Senior Notes”) (collectively, the “CQP Senior Notes”). +(2) Includes outstanding balances under the 2015 SPL Working Capital Facility, 2020 SPL Working Capital Facility and 2019 CQP Credit Facilities, inclusive of any portion of the 2020 SPL Working Capital Facility and 2019 CQP Credit Facilities that may be used for general corporate purposes. +(3) Consists of 2015 SPL Working Capital Facility, 2020 SPL Working Capital Facility and 2019 CQP Credit Facilities. +(4) Does not include equity contributions that may be available from Cheniere’s borrowings and available cash and cash equivalents. +SPL Senior Notes +The SPL Senior Notes are governed by a common indenture (the “SPL Indenture”) and the terms of the 2037 SPL Senior Notes are governed by a separate indenture (the “2037 SPL Senior Notes Indenture”). Both the SPL Indenture and the 2037 SPL Senior Notes Indenture contain terms and events of default and certain covenants that, among other things, limit SPL’s ability and the ability of SPL’s restricted subsidiaries to incur additional indebtedness or issue preferred stock, make certain investments or pay dividends or distributions on capital stock or subordinated indebtedness or purchase, redeem or retire capital stock, sell or transfer assets, including capital stock of SPL’s restricted subsidiaries, restrict dividends or other payments by restricted subsidiaries, incur liens, enter into transactions with affiliates, dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of SPL’s assets and enter into certain LNG sales contracts. Subject to permitted liens, the SPL Senior Notes are secured on a pari passu first-priority basis by a security interest in all of the membership interests in SPL and substantially all of SPL’s assets. SPL may not make any distributions until, among other requirements, deposits are made into debt service reserve accounts as required and a debt service coverage ratio test of 1.25:1.00 is satisfied. +55 +At any time prior to three months before the respective dates of maturity for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes, 2027 SPL Senior Notes, 2028 SPL Senior Notes, 2030 SPL Senior Notes and 2037 SPL Senior Notes, in which case the time period is six months before the respective dates of maturity), SPL may redeem all or part of such series of the SPL Senior Notes at a redemption price equal to the ‘make-whole’ price (except for the 2037 SPL Senior Notes, in which case the redemption price is equal to the “optional redemption” price) set forth in the respective indentures governing the SPL Senior Notes, plus accrued and unpaid interest, if any, to the date of redemption. SPL may also, at any time within three months of the respective maturity dates for each series of the SPL Senior Notes (except for the 2026 SPL Senior Notes, 2027 SPL Senior Notes, 2028 SPL Senior Notes, 2030 SPL Senior Notes and 2037 SPL Senior Notes, in which case the time period is within six months of the respective dates of maturity), redeem all or part of such series of the SPL Senior Notes at a redemption price equal to 100% of the principal amount of such series of the SPL Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +Both the 2037 SPL Senior Notes Indenture and the SPL Indenture include restrictive covenants. SPL may incur additional indebtedness in the future, including by issuing additional notes, and such indebtedness could be at higher interest rates and have different maturity dates and more restrictive covenants than the current outstanding indebtedness of SPL, including the SPL Senior Notes and the 2020 SPL Working Capital Facility. Semi-annual principal payments for the 2037 SPL Senior Notes are due on March 15 and September 15 of each year beginning September 15, 2025 and are fully amortizing according to a fixed sculpted amortization schedule. +2015 SPL Working Capital Facility +In March 2020, SPL terminated the remaining commitments under the 2015 SPL Working Capital Facility. As of December 31, 2019, SPL had $786 million of available commitments, $414 million aggregate amount of issued letters of credit and no outstanding borrowings under the 2015 SPL Working Capital Facility. +2020 SPL Working Capital Facility +In March 2020, SPL entered into the 2020 SPL Working Capital Facility with aggregate commitments of $1.2 billion, which replaced the 2015 SPL Working Capital Facility. The 2020 SPL Working Capital Facility is intended to be used for loans to SPL, swing line loans to SPL and the issuance of letters of credit on behalf of SPL, primarily for (1) the refinancing of the 2015 SPL Working Capital Facility, (2) fees and expenses related to the 2020 SPL Working Capital Facility, (3) SPL and its future subsidiaries’ gas purchase obligations and (4) SPL and certain of its future subsidiaries’ general corporate purposes. SPL may, from time to time, request increases in the commitments under the 2020 SPL Working Capital Facility of up to $800 million. As of December 31, 2020, SPL had $787 million of available commitments, $413 million aggregate amount of issued letters of credit and no outstanding borrowings under the 2020 SPL Working Capital Facility. +The 2020 SPL Working Capital Facility matures on March 19, 2025, but may be extended with consent of the lenders. The 2020 SPL Working Capital Facility provides for mandatory prepayments under customary circumstances. +The 2020 SPL Working Capital Facility contains customary conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. SPL is restricted from making certain distributions under agreements governing its indebtedness generally until, among other requirements, satisfaction of a 12-month forward-looking and backward-looking 1.25:1.00 debt service reserve ratio test. The obligations of SPL under the 2020 SPL Working Capital Facility are secured by substantially all of the assets of SPL as well as a pledge of all of the membership interests in SPL and certain future subsidiaries of SPL on a pari passu basis by a first priority lien with the SPL Senior Notes. +Cheniere Partners +CQP Senior Notes +The CQP Senior Notes are jointly and severally guaranteed by each of Cheniere Partners’ subsidiaries other than SPL and, subject to certain conditions governing its guarantee, Sabine Pass LP (each a “Guarantor” and collectively, the “CQP Guarantors”). The CQP Senior Notes are governed by the same base indenture (the “CQP Base Indenture”). The 2025 CQP Senior Notes are further governed by the First Supplemental Indenture, the 2026 CQP Senior Notes are further governed by the Second Supplemental Indenture and the 2029 CQP Senior Notes are further governed by the Third Supplemental Indenture. The indentures governing the CQP Senior Notes contain terms and events of default and certain covenants that, among other +56 +things, limit the ability of Cheniere Partners and the CQP Guarantors to incur liens and sell assets, enter into transactions with affiliates, enter into sale-leaseback transactions and consolidate, merge or sell, lease or otherwise dispose of all or substantially all of the applicable entity’s properties or assets. +At any time prior to October 1, 2021 for the 2026 CQP Senior Notes and October 1, 2024 for the 2029 CQP Senior Notes, Cheniere Partners may redeem all or a part of the applicable CQP Senior Notes at a redemption price equal to 100% of the aggregate principal amount of the CQP Senior Notes redeemed, plus the “applicable premium” set forth in the respective indentures governing the CQP Senior Notes, plus accrued and unpaid interest, if any, to the date of redemption. In addition, at any time prior to October 1, 2021 for the 2026 CQP Senior Notes and October 1, 2024 for the 2029 CQP Senior Notes, Cheniere Partners may redeem up to 35% of the aggregate principal amount of the CQP Senior Notes with an amount of cash not greater than the net cash proceeds from certain equity offerings at a redemption price equal to 105.625% of the aggregate principal amount of the 2026 CQP Senior Notes and 104.5% of the aggregate principal amount of the 2029 CQP Senior Notes redeemed, plus accrued and unpaid interest, if any, to the date of redemption. Cheniere Partners also may at any time through the maturity date of October 1, 2025 for the 2025 CQP Senior Notes, October 1, 2021 through the maturity date of October 1, 2026 for the 2026 CQP Senior Notes and October 1, 2024 through the maturity date of October 1, 2029 for the 2029 CQP Senior Notes, redeem the CQP Senior Notes, in whole or in part, at the redemption prices set forth in the respective indentures governing the CQP Senior Notes. +The CQP Senior Notes are Cheniere Partners’ senior obligations, ranking equally in right of payment with Cheniere Partners’ other existing and future unsubordinated debt and senior to any of its future subordinated debt. In the event that the aggregate amount of Cheniere Partners’ secured indebtedness and the secured indebtedness of the CQP Guarantors (other than the CQP Senior Notes or any other series of notes issued under the CQP Base Indenture) outstanding at any one time exceeds the greater of (1) $1.5 billion and (2) 10% of net tangible assets, the CQP Senior Notes will be secured to the same extent as such obligations under the 2019 CQP Credit Facilities. The obligations under the 2019 CQP Credit Facilities are secured on a first-priority basis (subject to permitted encumbrances) with liens on substantially all the existing and future tangible and intangible assets and rights of Cheniere Partners and the CQP Guarantors and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the 2019 CQP Credit Facilities). The liens securing the CQP Senior Notes, if applicable, will be shared equally and ratably (subject to permitted liens) with the holders of other senior secured obligations, which include the 2019 CQP Credit Facilities obligations and any future additional senior secured debt obligations. +2019 CQP Credit Facilities +In May 2019, Cheniere Partners entered into the 2019 CQP Credit Facilities, which consisted of the $750 million term loan (“CQP Term Facility”), which was prepaid and terminated upon issuance of the 2029 CQP Senior Notes in September 2019, and the $750 million revolving credit facility (“CQP Revolving Facility”). Borrowings under the 2019 CQP Credit Facilities will be used to fund the development and construction of Train 6 of the SPL Project and for general corporate purposes, subject to a sublimit, and the 2019 CQP Credit Facilities are also available for the issuance of letters of credit. As of both December 31, 2020 and 2019, Cheniere Partners had $750 million of available commitments and no letters of credit issued or loans outstanding under the 2019 CQP Credit Facilities. +The 2019 CQP Credit Facilities mature on May 29, 2024. Any outstanding balance may be repaid, in whole or in part, at any time without premium or penalty, except for interest rate breakage costs. The 2019 CQP Credit Facilities contain conditions precedent for extensions of credit, as well as customary affirmative and negative covenants, and limit Cheniere Partners’ ability to make restricted payments, including distributions, to once per fiscal quarter and one true-up per fiscal quarter as long as certain conditions are satisfied. +The 2019 CQP Credit Facilities are unconditionally guaranteed and secured by a first priority lien (subject to permitted encumbrances) on substantially all of Cheniere Partners’ and the CQP Guarantors’ existing and future tangible and intangible assets and rights and equity interests in the CQP Guarantors (except, in each case, for certain excluded properties set forth in the 2019 CQP Credit Facilities). +57 +Corpus Christi LNG Terminal +Liquefaction Facilities +We are currently operating two Trains and two marine berths at the CCL Project and commissioning one additional Train that is expected to be substantially completed in the first quarter of 2021. We have received authorization from the FERC to site, construct and operate Trains 1 through 3 of the CCL Project. We completed construction of Trains 1 and 2 of the CCL Project and commenced commercial operating activities in February 2019 and August 2019, respectively. The following table summarizes the project completion and construction status of Train 3 of the CCL Project, including the related infrastructure, as of December 31, 2020: +CCL Train 3 +Overall project completion percentage 99.6% +Completion percentage of: +Engineering 100.0% +Procurement 100.0% +Subcontract work 99.9% +Construction 99.0% +Expected date of substantial completion 1Q 2021 +Separate from the CCH Group, we are also developing Corpus Christi Stage 3 through our subsidiary CCL Stage III, adjacent to the CCL Project. We received approval from FERC in November 2019 to site, construct and operate seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. +The following orders have been issued by the DOE authorizing the export of domestically produced LNG by vessel from the Corpus Christi LNG terminal: +• CCL Project—FTA countries and non-FTA countries through December 31, 2050, up to a combined total of the equivalent of 767 Bcf/yr (approximately 15 mtpa) of natural gas. +• Corpus Christi Stage 3—FTA countries and non-FTA countries through December 31, 2050 in an amount equivalent to 582.14 Bcf/yr (approximately 11 mtpa) of natural gas. +In December 2020, the DOE announced a new policy in which it would no longer issue short-term export authorizations separately from long-term authorizations. Accordingly, the DOE amended each of CCL’s long-term authorizations to include short-term export authority, and vacated the short-term orders. +An application was filed in September 2019 to authorize additional exports from the CCL Project to FTA countries for a 25-year term and to non-FTA countries for a 20-year term in an amount up to the equivalent of approximately 108 Bcf/yr of natural gas, for a total CCL Project export of 875.16 Bcf/yr. The terms of the authorizations are requested to commence on the date of first commercial export from the CCL Project of the volumes contemplated in the application. In April 2020, the DOE issued an order authorizing CCL to export to FTA countries related to this application, for which the term was subsequently extended through December 31, 2050, but has not yet issued an order authorizing CCL to export to non-FTA countries for the corresponding LNG volume. A corresponding application for authorization to increase the total LNG production capacity of the CCL Project from the currently authorized level to approximately 875.16 Bcf/yr was also submitted to the FERC and is currently pending. +Customers +CCL has entered into fixed price long-term SPAs generally with terms of 20 years (plus extension rights) and with a weighted average remaining contract length of approximately 19 years (plus extension rights) with nine third parties for Trains 1 through 3 of the CCL Project. Under these SPAs, the customers will purchase LNG from CCL on a free on board (“FOB”) basis for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115% of Henry Hub. The customers may elect to cancel or suspend deliveries of LNG cargoes, with advance notice as governed by each respective SPA, in which case the customers would still be required to pay the fixed fee with respect to the contracted volumes that are not delivered as a result of such cancellation or suspension. We refer to the fee component that is applicable regardless of a cancellation or suspension of LNG +58 +cargo deliveries under the SPAs as the fixed fee component of the price under our SPAs. We refer to the fee component that is applicable only in connection with LNG cargo deliveries as the variable fee component of the price under our SPAs. The variable fee under CCL’s SPAs entered into in connection with the development of the CCL Project was sized at the time of entry into each SPA with the intent to cover the costs of gas purchases and transportation and liquefaction fuel to produce the LNG to be sold under each such SPA. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery for the applicable Train, as specified in each SPA. +In aggregate, the minimum annual fixed fee portion to be paid by the third-party SPA customers is approximately $1.4 billion for Trains 1 and 2 and increasing to approximately $1.8 billion following the substantial completion of Train 3 of the CCL Project. +In addition, Cheniere Marketing has agreements with CCL to purchase: (1) approximately 15 TBtu per annum of LNG with an approximate term of 23 years, (2) any LNG produced by CCL in excess of that required for other customers at Cheniere Marketing’s option and (3) approximately 44 TBtu of LNG with a term of up to seven years associated with the IPM gas supply agreement between CCL and EOG Resources, Inc. See Marketing section for additional information regarding agreements entered into by Cheniere Marketing. +Natural Gas Transportation, Storage and Supply +To ensure CCL is able to transport adequate natural gas feedstock to the Corpus Christi LNG terminal, it has entered into transportation precedent agreements to secure firm pipeline transportation capacity with CCP and certain third-party pipeline companies. CCL has entered into a firm storage services agreement with a third party to assist in managing variability in natural gas needs for the CCL Project. CCL has also entered into enabling agreements and long-term natural gas supply contracts with third parties, and will continue to enter into such agreements, in order to secure natural gas feedstock for the CCL Project. As of December 31, 2020, CCL had secured up to approximately 2,938 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to 10 years, a portion of which is subject to the achievement of certain project milestones and other conditions precedent. +CCL Stage III has also entered into long-term natural gas supply contracts with third parties, and anticipates continuing to enter into such agreements, in order to secure natural gas feedstock for Corpus Christi Stage 3. As of December 31, 2020, CCL Stage III had secured up to approximately 2,361 TBtu of natural gas feedstock through long-term natural gas supply contracts with remaining terms that range up to approximately 15 years, which is subject to the achievement of certain project milestones and other conditions precedent. +A portion of the natural gas feedstock transactions for CCL and CCL Stage III are IPM transactions, in which the natural gas producers are paid based on a global gas market price less a fixed liquefaction fee and certain costs incurred by us. +Construction +CCL entered into separate lump sum turnkey contracts with Bechtel for the engineering, procurement and construction of Trains 1 through 3 of the CCL Project under which Bechtel charges a lump sum for all work performed and generally bears project cost, schedule and performance risks unless certain specified events occur, in which case Bechtel may cause CCL to enter into a change order, or CCL agrees with Bechtel to a change order. +The total contract price of the EPC contract for Train 3, which is currently undergoing commissioning, is approximately $2.4 billion, reflecting amounts incurred under change orders through December 31, 2020. As of December 31, 2020, we have incurred $2.4 billion under this contract. +Final Investment Decision for Corpus Christi Stage 3 +FID for Corpus Christi Stage 3 will be subject to, among other things, entering into an EPC contract, obtaining additional commercial support for the project and securing the necessary financing arrangements. +59 +Pipeline Facilities +In November 2019, the FERC authorized CCP to construct and operate the pipeline for Corpus Christi Stage 3. The pipeline will be designed to transport 1.5 Bcf/d of natural gas feedstock required by Corpus Christi Stage 3 from the existing regional natural gas pipeline grid. +Capital Resources +The CCH Group expects to finance the construction costs of the CCL Project from one or more of the following: operating cash flows from CCL and CCP, project debt and equity contributions from Cheniere. The following table provides a summary of the capital resources of the CCH Group from borrowings and available commitments for the CCL Project, excluding equity contributions from Cheniere, at December 31, 2020 and December 31, 2019 (in millions): +December 31, +2020 2019 +Senior notes (1) $ 7,721 $ 6,952 +2025 CCH HoldCo II Convertible Senior Notes (2) +— 1,000 +Credit facilities outstanding balance (3) 2,767 3,283 +Letters of credit issued (3) 293 471 +Available commitments under credit facilities (3) 767 729 +Total capital resources from borrowings and available commitments (4) $ 11,548 $ 12,435 +(1) Includes CCH’s 7.000% Senior Secured Notes due 2024, 5.875% Senior Secured Notes due 2025, 5.125% Senior Secured Notes due 2027, 3.700% Senior Secured Notes due 2029, 4.80% Senior Secured Notes due 2039, 3.925% Senior Secured Notes due 2039 and 3.52% CCH Senior Secured Notes (collectively, the “CCH Senior Notes”). +(2) Aggregate original principal amount before debt discount and debt issuance costs and interest paid-in-kind. +(3) Includes the CCH Credit Facility and CCH Working Capital Facility. +(4) Does not include equity contributions that may be available from Cheniere’s borrowings and available cash and cash equivalents. +2025 CCH HoldCo II Convertible Senior Notes +In May 2015, CCH HoldCo II issued $1.0 billion aggregate principal amount of the 2025 CCH HoldCo II Convertible Senior Notes in a private placement. In May 2018, the amended and restated note purchase agreement under which the 2025 CCH HoldCo II Convertible Senior Notes were issued was subsequently amended in connection with commercialization and financing of Train 3 of the CCL Project and to provide the note holders with certain prepayment rights related thereto consistent with those under the CCH Credit Facility. In February 2020, the amended and restated note purchase agreement for the 2025 CCH HoldCo II Convertible Senior Notes was further amended to allow CCH HoldCo II the option to redeem all or a portion of the outstanding notes with cash at a price of $1,080 per $1,000 principal amount, at the time of any CCH HoldCo II or noteholder-initiated conversion through September 2, 2020. In March 2020, CCH HoldCo II redeemed an aggregate outstanding principal amount of $300 million and in July 2020, redeemed the remaining outstanding principal amount with borrowings under the Cheniere Term Loan Facility. +CCH Senior Notes +The CCH Senior Notes are jointly and severally guaranteed by CCH’s subsidiaries, CCL, CCP and Corpus Christi Pipeline GP, LLC (each a “CCH Guarantor” and collectively, the “CCH Guarantors”). The indentures governing the CCH Senior Notes contain customary terms and events of default and certain covenants that, among other things, limit CCH’s ability and the ability of CCH’s restricted subsidiaries to: incur additional indebtedness or issue preferred stock; make certain investments or pay dividends or distributions on membership interests or subordinated indebtedness or purchase, redeem or retire membership interests; sell or transfer assets, including membership or partnership interests of CCH’s restricted subsidiaries; restrict dividends or other payments by restricted subsidiaries to CCH or any of CCH’s restricted subsidiaries; incur liens; enter into transactions with affiliates; dissolve, liquidate, consolidate, merge, sell or lease all or substantially all of the properties or assets of CCH and its restricted subsidiaries taken as a whole; or permit any CCH Guarantor to dissolve, +60 +liquidate, consolidate, merge, sell or lease all or substantially all of its properties and assets. The covenants included in the respective indentures that govern the CCH Senior Notes are subject to a number of important limitations and exceptions. +The CCH Senior Notes are CCH’s senior secured obligations, ranking senior in right of payment to any and all of CCH’s future indebtedness that is subordinated to the CCH Senior Notes and equal in right of payment with CCH’s other existing and future indebtedness that is senior and secured by the same collateral securing the CCH Senior Notes. The CCH Senior Notes are secured by a first-priority security interest in substantially all of CCH’s and the CCH Guarantors’ assets. +At any time prior to six months before the respective dates of maturity for each of the CCH Senior Notes, CCH may redeem all or part of such series of the CCH Senior Notes at a redemption price equal to the “make-whole” price set forth in the appropriate indenture, plus accrued and unpaid interest, if any, to the date of redemption. At any time within six months of the respective dates of maturity for each of the CCH Senior Notes, CCH may redeem all or part of such series of the CCH Senior Notes, in whole or in part, at a redemption price equal to 100% of the principal amount of the CCH Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to the date of redemption. +CCH Credit Facility +In May 2018, CCH amended and restated the CCH Credit Facility to increase total commitments under the CCH Credit Facility from $4.6 billion to $6.1 billion. The obligations of CCH under the CCH Credit Facility are secured by a first priority lien on substantially all of the assets of CCH and its subsidiaries and by a pledge by CCH HoldCo I of its limited liability company interests in CCH. There were no available commitments under the CCH Credit Facility as of both December 31, 2020 and 2019. CCH had $2.6 billion and $3.3 billion of loans outstanding under the CCH Credit Facility as of December 31, 2020 and 2019, respectively. +The CCH Credit Facility matures on June 30, 2024, with principal payments due quarterly commencing on the earlier of (1) the first quarterly payment date occurring more than three calendar months following the completion of the CCL Project as defined in the common terms agreement and (2) a set date determined by reference to the date under which a certain LNG buyer linked to the last Train of the CCL Project to become operational is entitled to terminate its SPA for failure to achieve the date of first commercial delivery for that agreement. Scheduled repayments will be based upon a 19-year tailored amortization, commencing the first full quarter after the completion of Trains 1 through 3 and designed to achieve a minimum projected fixed debt service coverage ratio of 1.50:1. +Under the CCH Credit Facility, CCH is required to hedge not less than 65% of the variable interest rate exposure of its senior secured debt. CCH is restricted from making certain distributions under agreements governing its indebtedness generally until, among other requirements, the completion of the construction of Trains 1 through 3 of the CCL Project, funding of a debt service reserve account equal to six months of debt service and achieving a historical debt service coverage ratio and fixed projected debt service coverage ratio of at least 1.25:1.00. +CCH Working Capital Facility +In June 2018, CCH amended and restated the CCH Working Capital Facility to increase total commitments under the CCH Working Capital Facility from $350 million to $1.2 billion. The CCH Working Capital Facility is intended to be used for loans to CCH (“CCH Working Capital Loans”) and the issuance of letters of credit on behalf of CCH for certain working capital requirements related to developing and operating the CCL Project and for related business purposes. Loans under the CCH Working Capital Facility are guaranteed by the CCH Guarantors. CCH may, from time to time, request increases in the commitments under the CCH Working Capital Facility of up to the maximum allowed for working capital under the Common Terms Agreement that was entered into concurrently with the CCH Credit Facility. As of December 31, 2020 and 2019, CCH had $767 million and $729 million of available commitments, $293 million and $471 million aggregate amount of issued letters of credit and $140 million and zero of loans outstanding under the CCH Working Capital Facility, respectively. +The CCH Working Capital Facility matures on June 29, 2023, and CCH may prepay the CCH Working Capital Loans and loans made in connection with a draw upon any letter of credit (“CCH LC Loans”) at any time without premium or penalty upon three business days’ notice and may re-borrow at any time. CCH LC Loans have a term of up to one year. CCH is required to reduce the aggregate outstanding principal amount of all CCH Working Capital Loans to zero for a period of five consecutive business days at least once each year. +61 +The CCH Working Capital Facility contains conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. The obligations of CCH under the CCH Working Capital Facility are secured by substantially all of the assets of CCH and the CCH Guarantors as well as all of the membership interests in CCH and each of the CCH Guarantors on a pari passu basis with the CCH Senior Notes and the CCH Credit Facility. +Cheniere +Senior Notes +In September 2020, we issued an aggregate principal amount of $2.0 billion of 2028 Cheniere Senior Secured Notes, the proceeds of which were used to prepay a portion of the outstanding indebtedness under the Cheniere Term Loan Facility and to pay related fees and expenses. The associated indentures (“Cheniere Indenture”) contain customary terms and events of default and certain covenants that, among other things, limit our ability to create liens or other encumbrances, enter into sale-leaseback transactions and merge or consolidate with other entities or sell all or substantially all of our assets. The Cheniere Indenture covenants are subject to a number of important limitations and exceptions. +At any time prior to October 15, 2023, we may redeem all or a part of the 2028 Cheniere Senior Secured Notes at a redemption price equal to 100% of the aggregate principal amount thereof, plus the “applicable premium” and accrued and unpaid interest, if any, to but not including the date of redemption. We also may, at any time prior to October 15, 2023, redeem up to 40% of the aggregate principal amount of the 2028 Cheniere Senior Secured Notes with an amount of cash not greater than the net cash proceeds from certain equity offerings at a redemption price equal to 104.625% of the aggregate principal amount of the notes being redeemed, plus accrued and unpaid interest, if any, to but not including, the date of redemption. At any time on or after October 15, 2023 through the maturity date of October 15, 2028, we may redeem all or part of the 2028 Cheniere Senior Secured Notes at the redemption prices described in the Cheniere Indenture. +The 2028 Cheniere Senior Secured Notes are our general senior obligations and rank senior in right of payment to all of our future obligations that are, by their terms, expressly subordinated in right of payment to the 2028 Cheniere Senior Secured Notes and equally in right of payment with all of our other existing and future unsubordinated indebtedness. The 2028 Cheniere Senior Secured Notes will initially be secured on a first-priority basis by a lien on substantially all of our assets and equity interests in our direct subsidiaries (other than certain excluded subsidiaries) (the “Collateral”), which liens will rank pari passu with the liens securing the Cheniere Revolving Credit Facility and Cheniere Term Loan Facility. The 2028 Cheniere Senior Secured Notes will remain secured as long as (1) there are any obligations or undrawn commitments outstanding under the Cheniere Term Loan Facility that are secured by liens on the Collateral or (2) the outstanding aggregate principal amount of our secured indebtedness exceeds $1.25 billion. As of December 31, 2020, the 2028 Cheniere Senior Secured Notes are not guaranteed by any of our subsidiaries. In the future, the 2028 Cheniere Senior Secured Notes will be guaranteed by our subsidiaries who guarantee our other material indebtedness. +Convertible Notes +In November 2014, we issued an aggregate principal amount of $1.0 billion of the 2021 Cheniere Convertible Unsecured Notes. The 2021 Cheniere Convertible Unsecured Notes are convertible at the option of the holder into our common stock at the then applicable conversion rate, provided that the closing price of our common stock is greater than or equal to the conversion price on the date of conversion. In July 2020, we repurchased $844 million in aggregate principal amount of the outstanding 2021 Cheniere Convertible Unsecured Notes at individually negotiated prices from a small number of investors. +In March 2015, we issued $625 million aggregate principal amount of 4.25% Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”). We have the right, at our option, at any time after March 15, 2020, to redeem all or any part of the 2045 Cheniere Convertible Senior Notes at a redemption price equal to the accreted amount of the 2045 Cheniere Convertible Senior Notes to be redeemed, plus accrued and unpaid interest, if any, to such redemption date. +We have the option to satisfy the conversion obligation for the 2021 Cheniere Convertible Unsecured Notes and the 2045 Cheniere Convertible Senior Notes with cash, common stock or a combination thereof. +62 +Cheniere Revolving Credit Facility +In December 2018, we amended and restated the Cheniere Revolving Credit Facility to increase total commitments under the Cheniere Revolving Credit Facility from $750 million to $1.25 billion. The Cheniere Revolving Credit Facility is intended to fund, through loans and letters of credit, equity capital contributions to CCH HoldCo II and its subsidiaries for the development of the CCL Project and, provided that certain conditions are met, for general corporate purposes. As of December 31, 2020 and 2019, we had $1.1 billion and $665 million of available commitments, $124 million and $585 million aggregate amount of issued letters of credit and no loans outstanding under the Cheniere Revolving Credit Facility, respectively. +The Cheniere Revolving Credit Facility matures on December 13, 2022 and contains representations, warranties and affirmative and negative covenants customary for companies like us with lenders of the type participating in the Cheniere Revolving Credit Facility that limit our ability to make restricted payments, including distributions, unless certain conditions are satisfied, as well as limitations on indebtedness, guarantees, hedging, liens, investments and affiliate transactions. Under the Cheniere Revolving Credit Facility, we are required to ensure that the sum of our unrestricted cash and the amount of undrawn commitments under the Cheniere Revolving Credit Facility is at least equal to the lesser of (1) 20% of the commitments under the Cheniere Revolving Credit Facility and (2) $200 million (the “Liquidity Covenant”). However, at any time that the aggregate principal amount of outstanding loans plus drawn and unreimbursed letters of credit under the Cheniere Revolving Credit Facility is greater than 30% of aggregate commitments under the Cheniere Revolving Credit Facility, the Liquidity Covenant will not apply and we will instead be governed by a quarterly non-consolidated leverage ratio covenant not to exceed 5.75:1.00 (the “Springing Leverage Covenant”). +The Cheniere Revolving Credit Facility is secured by a first priority security interest (subject to permitted liens and other customary exceptions) in substantially all of our assets, including our interests in our direct subsidiaries (excluding CCH HoldCo II and certain other subsidiaries). +Cheniere Term Loan Facility +In June 2020, we entered into the Cheniere Term Loan Facility, which was subsequently increased to $2.695 billion in July 2020. In July 2020, borrowings under the Cheniere Term Loan Facility were used to (1) redeem the outstanding principal amount of the 2025 CCH HoldCo II Convertible Senior Notes, (2) repurchase $844 million in aggregate principal amount of outstanding 2021 Cheniere Convertible Unsecured Notes at individually negotiated prices from a small number of investors and (3) pay the related fees and expenses. The remaining commitments under the Cheniere Term Loan Facility are expected to be used to repay and/or repurchase a portion of the remaining principal amount of the 2021 Cheniere Convertible Unsecured Notes and for the payment of related fees and expenses. In September 2020, we prepaid approximately $2.1 billion of the outstanding indebtedness of the Cheniere Term Loan Facility with net proceeds from the 2028 Cheniere Senior Secured Notes and available cash. As of December 31, 2020, we had $372 million of available commitments and $148 million of loans outstanding under the Cheniere Term Loan Facility. +The Cheniere Term Loan Facility matures on June 18, 2023. Loans under the Cheniere Term Loan Facility may be voluntarily prepaid, in whole or in part, at any time, without premium or penalty. Borrowings under the Cheniere Term Loan Facility are subject to customary conditions precedent. The Cheniere Term Loan Facility includes representations, warranties, affirmative and negative covenants and events of default customary for companies like us with lenders of the type participating in the Cheniere Term Loan Facility and consistent with the equivalent provisions contained in the Cheniere Revolving Credit Facility. +The Cheniere Term Loan Facility is secured by a first priority security interest (subject to permitted liens and other customary exceptions) on a pari passu basis with the Cheniere Revolving Credit Facility in substantially all of our assets and equity interests in direct subsidiaries (other than certain excluded subsidiaries). Upon redemption of the 2025 CCH HoldCo II Convertible Senior Notes in July 2020, the equity interests in CCH HoldCo II were pledged as collateral to secure the obligations under the Cheniere Revolving Credit Facility and the Cheniere Term Loan Facility. +Cash Receipts from Subsidiaries +Our ownership interest in the Sabine Pass LNG terminal is held through Cheniere Partners. As of December 31, 2020, we owned a 48.6% limited partner interest in Cheniere Partners in the form of 239.9 million common units. In July 2020, the financial tests required for conversion of Cheniere Partners’ subordinated units, all of which were held by us, were met under +63 +the terms of Cheniere Partners’ partnership agreement and effective August 17, 2020, the first business day following the payment of the quarterly distribution with respect to the quarter ended June 30, 2020, all of Cheniere Partners’ subordinated units were automatically converted into common units on a one-for-one basis and the subordination period was terminated. We also own 100% of the general partner interest and the incentive distribution rights in Cheniere Partners. We are eligible to receive quarterly equity distributions from Cheniere Partners related to our ownership interests and our incentive distribution rights. +We also receive fees for providing management services to some of our subsidiaries. We received $120 million, $119 million and $85 million in total service fees from these subsidiaries during the each of the years ended December 31, 2020, 2019 and 2018, respectively. +Share Repurchase Program +On June 3, 2019, we announced that our Board of Directors (“Board”) authorized a 3-year, $1.0 billion share repurchase program. The following table presents information with respect to repurchases of common stock during the years ended December 31, 2020 and 2019: +Year Ended December 31, +2020 2019 +Aggregate common stock repurchased 2,875,376 4,000,424 +Weighted average price paid per share $ 53.88 $ 62.27 +Total amount paid (in millions) $ 155 $ 249 +As of December 31, 2020, we had up to $596 million of the share repurchase program available. Under the share repurchase program, repurchases can be made from time to time using a variety of methods, which may include open market purchases, privately negotiated transactions or otherwise, all in accordance with the rules of the SEC and other applicable legal requirements. The timing and amount of any shares of our common stock that are repurchased under the share repurchase program will be determined by our management based on market conditions and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and may be modified, suspended or discontinued at any time or from time to time at our discretion. +Marketing +We market and sell LNG produced by the Liquefaction Projects that is not required for other customers through our integrated marketing function. We have, and continue to develop, a portfolio of long-, medium- and short-term SPAs to transport and unload commercial LNG cargoes to locations worldwide. These volumes are expected to be primarily sourced by LNG produced by the Liquefaction Projects but supplemented by volumes procured from other locations worldwide, as needed. As of December 31, 2020, we have sold or have options to sell approximately 4,995 TBtu of LNG to be delivered to customers between 2021 and 2045, including volume from an SPA Cheniere Marketing has committed to provide to SPL. The cargoes have been sold either on a FOB basis (delivered to the customer at the Sabine Pass LNG terminal or the Corpus Christi LNG terminal, as applicable) or a delivered at terminal (“DAT”) basis (delivered to the customer at their specified LNG receiving terminal). We have chartered LNG vessels to be utilized for cargoes sold on a DAT basis. +Cheniere Marketing entered into uncommitted trade finance facilities with available credit of $241 million as of December 31, 2020, primarily to be used for the purchase and sale of LNG for ultimate resale in the course of its operations. The finance facilities are intended to be used for advances, guarantees or the issuance of letters of credit or standby letters of credit on behalf of Cheniere Marketing. As of December 31, 2020 and 2019, Cheniere Marketing had $34 million and $41 million, respectively, in standby letters of credit and guarantees outstanding under the finance facilities. As of December 31, 2020 and 2019, there were no loans outstanding under the finance facilities. Cheniere Marketing pays interest or fees on utilized commitments. +Corporate and Other Activities +We are required to maintain corporate and general and administrative functions to serve our business activities described above. The development of our sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we make an FID. +64 +We have made an equity investment in Midship Holdings, which manages the business and affairs of Midship Pipeline. Midship Pipeline operates the Midship Project with current capacity of up to 1.1 million Dekatherms per day that connects new gas production in the Anadarko Basin to Gulf Coast markets, including markets serving the Liquefaction Projects. The Midship Project was placed in service in April 2020. +Restrictive Debt Covenants +As of December 31, 2020, each of our issuers was in compliance with all covenants related to their respective debt agreements. +LIBOR +The use of LIBOR is expected to be phased out by the end of 2021. It is currently unclear whether LIBOR will be utilized beyond that date or whether it will be replaced by a particular rate. We intend to continue working with our lenders and counterparties to pursue any amendments to our debt and derivative agreements that are currently subject to LIBOR and will continue to monitor, assess and plan for the phase out of LIBOR. +Sources and Uses of Cash +The following table summarizes the sources and uses of our cash, cash equivalents and restricted cash for the years ended December 31, 2020, 2019 and 2018 (in millions). The table presents capital expenditures on a cash basis; therefore, these amounts differ from the amounts of capital expenditures, including accruals, which are referred to elsewhere in this report. Additional discussion of these items follows the table. +Year Ended December 31, +2020 2019 2018 +Sources of cash, cash equivalents and restricted cash: +Net cash provided by operating activities $ 1,265 $ 1,833 $ 1,990 +Proceeds from issuances of debt 7,823 6,434 4,285 +Other 3 4 14 +$ 9,091 $ 8,271 $ 6,289 +Uses of cash, cash equivalents and restricted cash: +Property, plant and equipment, net $ (1,839) $ (3,056) $ (3,643) +Investment in equity method investment (100) (105) (25) +Repayments of debt (6,940) (4,346) (1,391) +Debt issuance and other financing costs (125) (51) (66) +Debt modification or extinguishment costs (172) (15) (17) +Distributions and dividends to non-controlling interest (626) (590) (576) +Payments related to tax withholdings for share-based compensation (43) (19) (20) +Repurchase of common stock (155) (249) — +Other (8) (2) (8) +(10,008) (8,433) (5,746) +Net increase (decrease) in cash, cash equivalents and restricted cash $ (917) $ (162) $ 543 +Operating Cash Flows +Our operating cash net inflows during the years ended December 31, 2020, 2019 and 2018 were $1,265 million, $1,833 million and $1,990 million, respectively. The $568 million decrease in operating cash inflows in 2020 compared to 2019 was primarily related to repayment of paid-in-kind interest related to the redemption of the 2025 CCH HoldCo II Convertible Senior Notes, repurchase of a portion of the 2021 Cheniere Convertible Unsecured Notes and an increase in cash paid for interest, partially offset by the increased cash receipts from the sale of LNG cargoes due to additional LNG volume available to be sold from additional Trains that have reached substantial completion between the periods, a portion of which the customers elected not to take delivery but were required to pay a fixed fee with respect to the contracted volumes. The $157 million decrease in operating cash inflows in 2019 compared to 2018 was primarily related to increased operating costs and expenses, which were partially offset by increased cash receipts from the sale of LNG cargoes, as a result of the additional Trains that were operating at the Liquefaction Projects in 2019. +65 +Proceeds from Issuance of Debt, Repayments of Debt, Debt Issuance and Other Financing Costs and Debt Modification or Extinguishment Costs +During the year ended December 31, 2020, we issued an aggregate principal amount of $4.8 billion in senior secured notes to refinance our near-term debt and repay or prepay the outstanding indebtedness under our credit facilities and convertible notes. Borrowings of $3.1 billion under our credit facilities were used to redeem or repurchase our convertible notes, to fund our working capital requirements or for general corporate purposes. We incurred $125 million of debt issuance costs primarily related to up-front fees paid and $172 million of debt modification or extinguishment costs upon the closing of these transactions. +During the year ended December 31, 2019, we issued an aggregate principal amount of $4.2 billion in senior notes to prepay the outstanding indebtedness under our credit facilities. Borrowings of $2.2 billion under our credit facilities were used for funding future capital expenditures in connection with the construction costs for the Liquefaction Projects, to fund our working capital requirements or for general corporate purposes. We incurred $51 million of debt issuance costs primarily related to up-front fees paid and $15 million of debt modification or extinguishment costs upon the closing of these transactions. +During the year ended December 31, 2018, we issued an aggregate principal amount of $1.1 billion in senior notes to prepay the outstanding indebtedness under our credit facilities. Borrowings of $3.2 billion under our credit facilities during the year were used for funding future capital expenditures in connection with the construction costs for the Liquefaction Projects, to fund our working capital requirements or for general corporate purposes. We incurred $66 million of debt issuance costs primarily related to up-front fees paid and $17 million of debt modification or extinguishment costs upon the closing of these transactions. +Property, Plant and Equipment, net +Cash outflows for property, plant and equipment were primarily for the construction costs for the Liquefaction Projects. These costs are capitalized as construction-in-process until achievement of substantial completion. +Distributions and Dividends to Non-controlling Interest +We own a 48.6% limited partner interest in Cheniere Partners, with the remaining non-controlling interest held by The Blackstone Group Inc., Brookfield Asset Management Inc. and the public, to whom we paid distributions and dividends during the years ended December 31, 2020, 2019 and 2018. +Investment in Equity Method Investment +We invested $100 million, $105 million and $25 million in Midship Holdings, our equity method investment, during the years ended December 31, 2020, 2019 and 2018, respectively. +Repurchase of Common Stock +During the years ended December 31, 2020 and 2019, we paid $155 million and $249 million, respectively, to repurchase approximately 3 million shares and 4 million shares, respectively, of our common stock under the share repurchase program. +66 +Contractual Obligations +We are committed to make cash payments in the future pursuant to certain of our contracts. The following table summarizes certain contractual obligations in place as of December 31, 2020 (in millions): +Payments Due By Period (1) +Total 2021 2022 - 2023 2024 - 2025 Thereafter +Debt (2) $ 30,986 $ 566 $ 2,838 $ 10,579 $ 17,003 +Interest payments (2) 10,213 1,700 2,868 2,187 3,458 +Operating lease obligations (3) 941 197 277 215 252 +Finance lease obligations (4) 177 10 20 20 127 +Purchase obligations: (5) +Construction obligations (6) 662 399 263 — — +Natural gas supply, transportation and storage service agreements (7) 15,417 4,477 4,428 2,507 4,005 +Other purchase obligations (8) 1,544 222 305 303 714 +Total $ 59,940 $ 7,571 $ 10,999 $ 15,811 $ 25,559 +(1) Agreements in force as of December 31, 2020 that have terms dependent on project milestone dates are based on the estimated dates as of December 31, 2020. +(2) Based on the total debt balance, scheduled maturities and fixed or estimated forward interest rates in effect at December 31, 2020. Debt balance is presented net of $501 million in debt discount for outstanding convertible notes with significant spread between the coupon rate and the effective interest rate. The debt discount and the repayment of paid in kind interest are included in interest payments, which is consistent with the presentation in our Consolidated Statements of Cash Flows. Interest payment obligations exclude adjustments for interest rate swap agreements. A discussion of our debt obligations can be found in Note 11—Debt of our Notes to Consolidated Financial Statements. +(3) Operating lease obligations primarily relate to LNG vessel time charters, land sites related to the Liquefaction Projects and corporate office leases. Operating lease obligations do not include $1.6 billion of legally binding minimum lease payments for vessel charters which were executed as of December 31, 2020 but will commence between 2021 and 2022 and have fixed minimum lease terms of up to seven years. A discussion of our lease obligations can be found in Note 12—Leases of our Notes to Consolidated Financial Statements. +(4) Finance lease obligations consist of tug leases supporting the CCL Project, as further discussed in Note 12—Leases of our Notes to Consolidated Financial Statements. +(5) Purchase obligations consist of agreements to purchase goods or services that are enforceable and legally binding that specify fixed or minimum quantities to be purchased. We include only contracts for which conditions precedent have been met. As project milestones and other conditions precedent are achieved, our obligations are expected to increase accordingly. We include contracts for which we have an early termination option if the option is not expected to be exercised. +(6) Construction obligations primarily consist of the estimated remaining cost pursuant to our EPC contracts as of December 31, 2020 for projects with respect to which we have made an FID to commence construction. A discussion of these obligations can be found at Note 20—Commitments and Contingencies of our Notes to Consolidated Financial Statements. +(7) Pricing of natural gas supply agreements is based on estimated forward prices and basis spreads as of December 31, 2020. Natural gas supply, transportation and storage service agreements includes $1.5 billion in payments under agreements with related parties as discussed in Note 14—Related Party Transacti ons of our Notes to Consolidated Financial Statements. +(8) Other purchase obligations primarily relate to payments under SPL’s partial TUA assignment agreement with Total as discussed in Note 13—Revenues from Contracts with Customers of our Notes to Consolidated Financial Statements. +In addition, as of December 31, 2020, we had $830 million aggregate amount of issued letters of credit under our credit facilities. We also had tax agreements with certain local taxing jurisdictions for an aggregate amount of $196 million to be paid through 2033, based on estimated tax obligations as of December 31, 2020. +67 +Off-Balance Sheet Arrangements +As of December 31, 2020, we had no transactions that met the definition of off-balance sheet arrangements that may have a current or future material effect on our consolidated financial position or operating results. +Summary of Critical Accounting Estimates +The preparation of Consolidated Financial Statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Management evaluates its estimates and related assumptions regularly, including those related to the valuation of derivative instruments. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. Management considers the following to be its most critical accounting estimates that involve significant judgment. +Fair Value of Derivative Instruments +All derivative instruments, other than those that satisfy specific exceptions, are recorded at fair value. We record changes in the fair value of our derivative positions based on the value for which the derivative instrument could be exchanged between willing parties. If market quotes are not available to estimate fair value, management’s best estimate of fair value is based on the quoted market price of derivatives with similar characteristics or determined through industry-standard valuation approaches. Such evaluations may involve significant judgment and the results are based on expected future events or conditions, particularly for those valuations using inputs unobservable in the market. +Our derivative instruments consist of interest rate swaps, financial commodity derivative contracts transacted in an over-the-counter market, physical commodity contracts and foreign currency exchange (“FX”) contracts. We value our interest rate swaps using observable inputs including interest rate curves, risk adjusted discount rates, credit spreads and other relevant data. Valuation of our financial commodity derivative contracts is determined using observable commodity price curves and other relevant data. We estimate the fair values of our FX derivative instruments using observable FX rates and other relevant data. +Valuation of our physical commodity contracts is predominantly driven by observable and unobservable market commodity prices and, as applicable to our natural gas supply contracts, our assessment of the associated events deriving fair value, including evaluating whether the respective market is available as pipeline infrastructure is developed. The fair value of our physical commodity contracts incorporates risk premiums related to the satisfaction of conditions precedent, such as completion and placement into service of relevant pipeline infrastructure to accommodate marketable physical gas flow. A portion of our physical commodity contracts require us to make critical accounting estimates that involve significant judgment, as the fair value is developed through the use of internal models which incorporate significant unobservable inputs. In instances where observable data is unavailable, consideration is given to the assumptions that market participants would use in valuing the asset or liability. This includes assumptions about market risks, such as future prices of energy units for unobservable periods, liquidity, volatility and contract duration. +Gains and losses on derivative instruments are recognized in earnings. The ultimate fair value of our derivative instruments is uncertain, and we believe that it is reasonably possible that a change in the estimated fair value could occur in the near future as interest rates, commodity prices and FX rates change. +Recent Accounting Standards +For descriptions of recently issued accounting standards, see Note 2—Summary of Significant Accounting Policies of our Notes to Consolidated Financial Statements. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Marketing and Trading Commodity Price Risk +We have entered into commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the SPL Project, the CCL Project and potential future development of Corpus Christi Stage 3 (“Liquefaction Supply Derivatives”). We have also entered into financial derivatives to hedge the exposure to the commodity markets in +68 +which we have contractual arrangements to purchase or sell physical LNG (“LNG Trading Derivatives”). In order to test the sensitivity of the fair value of the Liquefaction Supply Derivatives and the LNG Trading Derivatives to changes in underlying commodity prices, management modeled a 10% change in the commodity price for natural gas for each delivery location and a 10% change in the commodity price for LNG, respectively, as follows (in millions): +December 31, 2020 December 31, 2019 +Fair Value Change in Fair Value Fair Value Change in Fair Value +Liquefaction Supply Derivatives $ 240 $ 204 $ 149 $ 179 +LNG Trading Derivatives (134) 44 165 22 +Interest Rate Risk +We are exposed to interest rate risk primarily when we incur debt related to project financing. Interest rate risk is managed in part by replacing outstanding floating-rate debt with fixed-rate debt with varying maturities. CCH has entered into interest rate swaps to hedge the exposure to volatility in a portion of the floating-rate interest payments under the CCH Credit Facility (“CCH Interest Rate Derivatives”) and to hedge against changes in interest rates that could impact anticipated future issuance of debt by CCH (“CCH Interest Rate Forward Start Derivatives”). In order to test the sensitivity of the fair value of the CCH Interest Rate Derivatives to changes in interest rates, management modeled a 10% change in the forward one-month LIBOR curve across the remaining terms of the CCH Interest Rate Derivatives and CCH Interest Rate Forward Start Derivatives as follows (in millions): +December 31, 2020 December 31, 2019 +Fair Value Change in Fair Value Fair Value Change in Fair Value +CCH Interest Rate Derivatives $ (140) $ 1 $ (81) $ 19 +CCH Interest Rate Forward Start Derivatives — — (8) 15 +Foreign Currency Exchange Risk +We have entered into foreign currency exchange (“FX”) contracts to hedge exposure to currency risk associated with operations in countries outside of the United States (“FX Derivatives”). In order to test the sensitivity of the fair value of the FX Derivatives to changes in FX rates, management modeled a 10% change in FX rate between the U.S. dollar and the applicable foreign currencies as follows (in millions): +December 31, 2020 December 31, 2019 +Fair Value Change in Fair Value Fair Value Change in Fair Value +FX Derivatives $ (22) $ 2 $ 4 $ — +See Note 7—Derivative Instruments for additional details about our derivative instruments. +69 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +CHENIERE ENERGY, INC. AND SUBSIDIARIES +Management’s Report to the Stockholders of Cheniere Energy, Inc. +71 +Reports of Independent Registered Public Accounting Firm +72 +Consolidated Statements of Operations +75 +Consolidated Balance Sheets +76 +Consolidated Statements of Stockholders’ Equity +77 +Consolidated Statements of Cash Flows +78 +Notes to Consolidated Financial Statements +79 +Note 1—Organization and Nature of Operations +79 +Note 2—Summary of Significant Accounting Policies +79 +Note 3—Restricted Cash +86 +Note 4—Accounts and Other Receivables +87 +Note 5—Inventory +87 +Note 6—Property, Plant and Equipment +87 +Note 7—Derivative Instruments +88 +Note 8—Other Non-current Assets +93 +Note 9—Non-controlling Interest and Variable Interest Entities +94 +Note 10—Accrued Liabilities +95 +Note 11—Debt +96 +Note 12—Leases +100 +Note 13—Revenues from Contracts with Customers +103 +Note 14—Related Party Transactions +106 +Note 15—Income Taxes +107 +Note 16—Share-based Compensation +109 +Note 17—Employee Benefit Plan +111 +Note 18—Net Income (Loss) per Share Attributable to Common Stockholders +112 +Note 19—Share Repurchase Program +112 +Note 20—Commitments and Contingencies +113 +Note 21—Customer Concentration +115 +Note 22—Supplemental Cash Flow Information +115 +Note 23—Subsequent Events +116 +Supplemental Information to Consolidated Financial Statements—Quarterly Financial Data +117 +70 +MANAGEMENT’S REPORT TO THE STOCKHOLDERS OF CHENIERE ENERGY, INC. +Management’s Report on Internal Control Over Financial Reporting +As management, we are responsible for establishing and maintaining adequate internal control over financial reporting for Cheniere Energy, Inc. and its subsidiaries (“Cheniere”). In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we have conducted an assessment, including testing using the criteria in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Cheniere’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and, even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. +Based on our assessment, we have concluded that Cheniere maintained effective internal control over financial reporting as of December 31, 2020, based on criteria in Internal Control—Integrated Framework (2013) issued by the COSO. +Cheniere’s independent registered public accounting firm, KPMG LLP, has issued an audit report on Cheniere’s internal control over financial reporting as of December 31, 2020, which is contained in this Form 10-K. +Management’s Certifications +The certifications of Cheniere’s Chief Executive Officer and Chief Financial Officer required by the Sarbanes-Oxley Act of 2002 have been included as Exhibits 31 and 32 in Cheniere’s Form 10-K. +CHENIERE ENERGY, INC. +By: /s/ Jack A. Fusco By: /s/ Zach Davis +Jack A. Fusco Zach Davis +President and Chief Executive Officer +(Principal Executive Officer) Senior Vice President and Chief Financial Officer +(Principal Financial Officer) +71 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and Board of Directors +Cheniere Energy, Inc.: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of Cheniere Energy, Inc. and subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes and financial statement schedules I to II (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 23, 2021 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Change in Accounting Principle +As discussed in Note 2 to the consolidated financial statements, the Company has changed its method of accounting for leases as of January 1, 2019 due to the adoption of ASU 2016-02, Leases (Topic 842), and subsequent amendments thereto. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Fair value of the level 3 physical liquefaction supply derivatives +As discussed in Notes 2 and 7 to the consolidated financial statements, the Company recorded fair value of level 3 physical liquefaction supply derivatives of $241 million, as of December 31, 2020. The physical liquefaction supply derivatives consist of natural gas supply contracts for the operation of the liquefied natural gas facilities. The fair value of the level 3 physical liquefaction supply derivatives is developed through the use of internal models which incorporate significant unobservable inputs. +We identified the evaluation of the fair value of the level 3 physical liquefaction supply derivatives as a critical audit matter. Specifically, there is subjectivity in certain assumptions used to estimate the fair value, including assumptions for +72 +future prices of energy units for unobservable periods and liquidity. Additionally, the fair value for certain of the liquefaction supply derivatives is derived through the use of complex models, which also include assumptions for volatility. +The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls over the valuation of the level 3 physical liquefaction supply derivatives. This included controls related to the assumptions for significant unobservable inputs and the fair value models. For the level 3 liquefaction supply derivatives selected, we involved valuation professionals with specialized skills who assisted in: +• assessing the models and volatility used by the Company in its valuation by developing independent fair value estimates and comparing the independently developed estimates to the Company’s fair value estimates +• testing the future prices of energy units for unobservable periods and liquidity assumptions by comparing to market data, including quoted or published forward prices for similar commodities. +In addition, we evaluated the Company’s assumptions for future prices of energy units for unobservable periods and liquidity by comparing to market or third-party data, including adjustments for third party quoted transportation prices. +/s/ KPMG LLP +KPMG LLP +We have served as the Company’s auditor since 2014. +Houston, Texas +February 23, 2021 +73 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Stockholders and Board of Directors +Cheniere Energy, Inc.: +Opinion on Internal Control Over Financial Reporting +We have audited Cheniere Energy, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2020 and 2019, the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes and financial statement schedules I to II (collectively, the consolidated financial statements), and our report dated February 23, 2021 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +KPMG LLP +Houston, Texas +February 23, 2021 +74 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +(in millions, except per share data) +Year Ended December 31, +2020 2019 2018 +Revenues +LNG revenues $ 8,924 $ 9,246 $ 7,572 +Regasification revenues 269 266 261 +Other revenues 165 218 154 +Total revenues 9,358 9,730 7,987 +Operating costs and expenses +Cost of sales (excluding items shown separately below) 4,161 5,079 4,597 +Operating and maintenance expense 1,320 1,154 613 +Development expense 6 9 7 +Selling, general and administrative expense 302 310 289 +Depreciation and amortization expense 932 794 449 +Impairment expense and loss on disposal of assets 6 23 8 +Total operating costs and expenses 6,727 7,369 5,963 +Income from operations 2,631 2,361 2,024 +Other income (expense) +Interest expense, net of capitalized interest ( 1,525 ) ( 1,432 ) ( 875 ) +Loss on modification or extinguishment of debt ( 217 ) ( 55 ) ( 27 ) +Interest rate derivative gain (loss), net ( 233 ) ( 134 ) 57 +Other income (expense), net ( 112 ) ( 25 ) 48 +Total other expense ( 2,087 ) ( 1,646 ) ( 797 ) +Income before income taxes and non-controlling interest 544 715 1,227 +Income tax benefit (provision) ( 43 ) 517 ( 27 ) +Net income 501 1,232 1,200 +Less: net income attributable to non-controlling interest 586 584 729 +Net income (loss) attributable to common stockholders $ ( 85 ) $ 648 $ 471 +Net income (loss) per share attributable to common stockholders—basic $ ( 0.34 ) $ 2.53 $ 1.92 +Net income (loss) per share attributable to common stockholders—diluted $ ( 0.34 ) $ 2.51 $ 1.90 +Weighted average number of common shares outstanding—basic 252.4 256.2 245.6 +Weighted average number of common shares outstanding—diluted 252.4 258.1 248.0 +The accompanying notes are an integral part of these consolidated financial statements. +75 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS (1) +(in millions, except share data) +December 31, +2020 2019 +ASSETS +Current assets +Cash and cash equivalents $ 1,628 $ 2,474 +Restricted cash 449 520 +Accounts and other receivables, net 647 491 +Inventory 292 312 +Derivative assets 32 323 +Other current assets 121 92 +Total current assets 3,169 4,212 +Property, plant and equipment, net 30,421 29,673 +Operating lease assets, net 759 439 +Non-current derivative assets 376 174 +Goodwill 77 77 +Deferred tax assets 489 529 +Other non-current assets, net 406 388 +Total assets $ 35,697 $ 35,492 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities +Accounts payable $ 35 $ 66 +Accrued liabilities 1,175 1,281 +Current debt 372 — +Deferred revenue 138 161 +Current operating lease liabilities 161 236 +Derivative liabilities 313 117 +Other current liabilities 2 13 +Total current liabilities 2,196 1,874 +Long-term debt, net 30,471 30,774 +Non-current operating lease liabilities 597 189 +Non-current finance lease liabilities 57 58 +Non-current derivative liabilities 151 151 +Other non-current liabilities 7 11 +Commitments and contingencies (see Note 20) +Stockholders’ equity +Preferred stock, $ 0.0001 par value, 5.0 million shares authorized, none issued +— — +Common stock, $ 0.003 par value, 480.0 million shares authorized +Issued: 273.1 million shares and 270.7 million shares at December 31, 2020 and 2019, respectively +Outstanding: 252.3 million shares and 253.6 million shares at December 31, 2020 and 2019, respectively +1 1 +Treasury stock: 20.8 million shares and 17.1 million shares at December 31, 2020 and 2019, respectively, at cost +( 872 ) ( 674 ) +Additional paid-in-capital 4,273 4,167 +Accumulated deficit ( 3,593 ) ( 3,508 ) +Total stockholders' deficit ( 191 ) ( 14 ) +Non-controlling interest 2,409 2,449 +Total equity 2,218 2,435 +Total liabilities and stockholders’ equity $ 35,697 $ 35,492 +(1) Amounts presented include balances held by our consolidated variable interest entity (“VIE”), Cheniere Partners, as further discussed in Note 9 — Non-controlling Interest and Variable Interest Entity. As of December 31, 2020, total assets and liabilities of Cheniere Partners, which are included in our Consolidated Balance Sheets, were $ 18.8 billion and $ 18.5 billion, respectively, including $ 1.2 billion of cash and cash equivalents and $ 0.1 billion of restricted cash. +The accompanying notes are an integral part of these consolidated financial statements. +76 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(in millions) +Total Stockholders’ Equity +Common Stock Treasury Stock Additional Paid-in Capital Accumulated Deficit Non-controlling Interest Total +Equity +Shares Par Value Amount Shares Amount +Balance at December 31, 2017 237.6 $ 1 12.5 $ ( 386 ) $ 3,248 $ ( 4,627 ) $ 3,004 $ 1,240 +Vesting of restricted stock units 0.5 — — — — — — — +Issuance of stock to acquire additional interest in Cheniere Holdings and other merger related adjustments 19.2 — — — 694 — ( 702 ) ( 8 ) +Share-based compensation — — — — 90 — — 90 +Shares withheld from employees related to share-based compensation, at cost ( 0.3 ) — 0.3 ( 20 ) — — — ( 20 ) +Net income attributable to non-controlling interest — — — — — — 729 729 +Equity portion of convertible notes, net — — — — 3 — — 3 +Distributions and dividends to non-controlling interest — — — — — — ( 576 ) ( 576 ) +Net income — — — — — 471 — 471 +Balance at December 31, 2018 257.0 1 12.8 ( 406 ) 4,035 ( 4,156 ) 2,455 1,929 +Vesting of restricted stock units 0.9 — — — — — — — +Share-based compensation — — — — 131 — — 131 +Shares withheld from employees related to share-based compensation, at cost ( 0.3 ) — 0.3 ( 19 ) — — — ( 19 ) +Shares repurchased, at cost ( 4.0 ) — 4.0 ( 249 ) — — — ( 249 ) +Net income attributable to non-controlling interest — — — — — — 584 584 +Equity portion of convertible notes, net — — — — 1 — — 1 +Distributions and dividends to non-controlling interest — — — — — — ( 590 ) ( 590 ) +Net income — — — — — 648 — 648 +Balance at December 31, 2019 253.6 1 17.1 ( 674 ) 4,167 ( 3,508 ) 2,449 2,435 +Vesting of restricted stock units and performance stock units 2.4 — — — — — — — +Share-based compensation — — — — 114 — — 114 +Issued shares withheld from employees related to share-based compensation, at cost ( 0.8 ) — 0.8 ( 43 ) — — — ( 43 ) +Shares repurchased, at cost ( 2.9 ) — 2.9 ( 155 ) — — — ( 155 ) +Net loss attributable to non-controlling interest — — — — — — 586 586 +Reacquisition of equity component of convertible notes, net of tax — — — — ( 8 ) — — ( 8 ) +Distributions and dividends to non-controlling interest — — — — — — ( 626 ) ( 626 ) +Net loss — — — — — ( 85 ) — ( 85 ) +Balance at December 31, 2020 252.3 $ 1 20.8 $ ( 872 ) $ 4,273 $ ( 3,593 ) $ 2,409 $ 2,218 +The accompanying notes are an integral part of these consolidated financial statements. +77 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in millions) +Year Ended December 31, +2020 2019 2018 +Cash flows from operating activities +Net income $ 501 $ 1,232 $ 1,200 +Adjustments to reconcile net income to net cash provided by operating activities: +Depreciation and amortization expense 932 794 449 +Share-based compensation expense 110 131 113 +Non-cash interest expense 51 143 74 +Amortization of debt issuance costs, premium and discount 114 103 69 +Non-cash operating lease costs 291 350 — +Loss on modification or extinguishment of debt 217 55 27 +Total losses (gains) on derivatives, net 211 ( 400 ) 51 +Net cash provided by settlement of derivative instruments 74 138 17 +Impairment expense and loss on disposal of assets 6 23 8 +Impairment or loss on equity method investments 126 88 — +Deferred taxes 40 ( 521 ) ( 5 ) +Repayment of paid-in-kind interest related to repurchase of convertible notes ( 911 ) — — +Other 2 — ( 5 ) +Changes in operating assets and liabilities: +Accounts and other receivables, net ( 154 ) 1 ( 133 ) +Inventory 21 11 ( 73 ) +Other current assets ( 27 ) ( 18 ) ( 15 ) +Accounts payable and accrued liabilities 54 52 188 +Deferred revenue ( 23 ) 22 26 +Operating lease liabilities ( 277 ) ( 366 ) — +Finance lease liabilities — 1 — +Other, net ( 93 ) ( 6 ) ( 1 ) +Net cash provided by operating activities 1,265 1,833 1,990 +Cash flows from investing activities +Property, plant and equipment, net ( 1,839 ) ( 3,056 ) ( 3,643 ) +Investment in equity method investment ( 100 ) ( 105 ) ( 25 ) +Other ( 8 ) ( 2 ) 14 +Net cash used in investing activities ( 1,947 ) ( 3,163 ) ( 3,654 ) +Cash flows from financing activities +Proceeds from issuances of debt 7,823 6,434 4,285 +Repayments of debt ( 6,940 ) ( 4,346 ) ( 1,391 ) +Debt issuance and other financing costs ( 125 ) ( 51 ) ( 66 ) +Debt modification or extinguishment costs ( 172 ) ( 15 ) ( 17 ) +Distributions and dividends to non-controlling interest ( 626 ) ( 590 ) ( 576 ) +Payments related to tax withholdings for share-based compensation ( 43 ) ( 19 ) ( 20 ) +Repurchase of common stock ( 155 ) ( 249 ) — +Other 3 4 ( 8 ) +Net cash provided by (used in) financing activities ( 235 ) 1,168 2,207 +Net decrease in cash, cash equivalents and restricted cash ( 917 ) ( 162 ) 543 +Cash, cash equivalents and restricted cash—beginning of period 2,994 3,156 2,613 +Cash, cash equivalents and restricted cash—end of period $ 2,077 $ 2,994 $ 3,156 +Balances per Consolidated Balance Sheets: +December 31, +2020 2019 +Cash and cash equivalents $ 1,628 $ 2,474 +Restricted cash 449 520 +Total cash, cash equivalents and restricted cash $ 2,077 $ 2,994 +The accompanying notes are an integral part of these consolidated financial statements. +78 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +NOTE 1— ORGANIZATION AND NATURE OF OPERATIONS +Cheniere, a Delaware corporation, is a Houston-based energy infrastructure company primarily engaged in LNG-related businesses. We are operating and constructing two natural gas liquefaction and export facilities at Sabine Pass and Corpus Christi. +The Sabine Pass LNG terminal is located in Cameron Parish, Louisiana, on the Sabine-Neches Waterway less than four miles from the Gulf Coast. Cheniere Partners, through its subsidiary SPL, is currently operating five natural gas liquefaction Trains and is constructing one additional Train that is expected to be substantially completed in the second half of 2022, for a total production capacity of approximately 30 mtpa of LNG (the “SPL Project”) at the Sabine Pass LNG terminal. The Sabine Pass LNG terminal has operational regasification facilities owned by Cheniere Partners’ subsidiary, SPLNG, that include pre-existing infrastructure of five LNG storage tanks, two marine berths and vaporizers and an additional marine berth that is under construction. Cheniere Partners also owns a 94 -mile pipeline that interconnects the Sabine Pass LNG terminal with a number of large interstate pipelines (the “Creole Trail Pipeline”) through its subsidiary, CTPL. As of December 31, 2020, we owned 100 % of the general partner interest and 48.6 % of the limited partner interest in Cheniere Partners. +The Corpus Christi LNG terminal is located near Corpus Christi, Texas and is operated and constructed by our subsidiary, CCL. We are currently operating two Trains and one additional Train is undergoing commissioning for a total production capacity of approximately 15 mtpa of LNG. We also operate a 23 -mile natural gas supply pipeline that interconnects the Corpus Christi LNG terminal with several interstate and intrastate natural gas pipelines (the “Corpus Christi Pipeline” and together with the Trains, the “CCL Project”) through our subsidiary, CCP. The CCL Project, once fully constructed, will contain three LNG storage tanks and two marine berths. +Additionally, separate from the CCH Group, we are developing an expansion of the Corpus Christi LNG terminal adjacent to the CCL Project (“Corpus Christi Stage 3”) through our subsidiary CCL Stage III, for up to seven midscale Trains with an expected total production capacity of approximately 10 mtpa of LNG. We received approval from FERC in November 2019 to site, construct and operate the expansion project. +We remain focused on operational excellence and customer satisfaction. Increasing demand of LNG has allowed us to expand our liquefaction infrastructure in a financially disciplined manner. We have increased available liquefaction capacity at our Liquefaction Projects as a result of debottlenecking and other optimization projects. We hold significant land positions at both the Sabine Pass LNG terminal and the Corpus Christi LNG terminal which provide opportunity for further liquefaction capacity expansion. The development of these sites or other projects, including infrastructure projects in support of natural gas supply and LNG demand, will require, among other things, acceptable commercial and financing arrangements before we make a final investment decision (“FID”). +NOTE 2— SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +Our Consolidated Financial Statements have been prepared in accordance with GAAP. The Consolidated Financial Statements include the accounts of Cheniere, its majority owned subsidiaries and entities in which it holds a controlling interest, including the accounts of Cheniere Partners and its wholly owned subsidiaries. For those consolidated subsidiaries in which our ownership is less than 100%, the portion of the net income or loss attributable to the non-controlling interest is reported as net income (loss) attributable to non-controlling interest on our Consolidated Statement of Operations. All intercompany accounts and transactions have been eliminated in consolidation. Investments in non-controlled entities, over which Cheniere has the ability to exercise significant influence over operating and financial policies, are accounted for using the equity method of accounting, with our share of earnings or losses reported in other income (expense) on our Consolidated Statement of Operations. In applying the equity method of accounting, the investments are initially recognized at cost, and subsequently adjusted for our proportionate share of earnings, losses and distributions. Investments accounted for using the equity method of accounting are reported as a component of other noncurrent assets. +We make a determination at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a variable interest entity (“VIE”). Generally, a VIE is an entity that +79 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +does not have sufficient equity at risk to finance its activities without additional subordinated financial support from other parties, whose equity investors lack any characteristics of a controlling financial interest or which was established with non-substantive voting. We consolidate VIEs when we are deemed to be the primary beneficiary. The primary beneficiary of a VIE is generally the party that both: (1) has the power to make decisions that most significantly affect the economic performance of the VIE and (2) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. If we are not deemed to be the primary beneficiary of a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. +Recent Accounting Standards +In August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity . This guidance simplifies the accounting for convertible instruments primarily by eliminating the existing cash conversion and beneficial conversion models within Subtopic 470-20, which will result in fewer embedded conversion options being accounted for separately from the debt host. The guidance also amends and simplifies the calculation of earnings per share relating to convertible instruments. This guidance is effective for annual periods beginning after December 15, 2021, including interim periods within that reporting period, with earlier adoption permitted for fiscal years beginning after December 15, 2020, including interim periods within that reporting period, using either a full or modified retrospective approach. We plan to adopt this guidance on January 1, 2022 and are currently evaluating the impact of the provisions of this guidance on our Consolidated Financial Statements and related disclosures. +In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting . This guidance primarily provides temporary optional expedients which simplify the accounting for contract modifications to existing debt agreements expected to arise from the market transition from LIBOR to alternative reference rates. The optional expedients were available to be used upon issuance of this guidance but we have not yet applied the guidance because we have not yet modified any of our existing contracts for reference rate reform. Once we apply an optional expedient to a modified contract and adopt this standard, the guidance will be applied to all subsequent applicable contract modifications until December 31, 2022, at which time the optional expedients are no longer available. +Use of Estimates +The preparation of Consolidated Financial Statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the accompanying notes. Management evaluates its estimates and related assumptions regularly, including those related to fair value measurements, revenue recognition, property, plant and equipment, derivative instruments, leases, goodwill, asset retirement obligations (“AROs”), share-based compensation and income taxes including valuation allowances for deferred tax assets, as further discussed under the respective sections within this note. Changes in facts and circumstances or additional information may result in revised estimates, and actual results may differ from these estimates. +Fair Value Measurements +Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Hierarchy Levels 1, 2 and 3 are terms for the priority of inputs to valuation approaches used to measure fair value. Hierarchy Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Hierarchy Level 2 inputs are inputs that are directly or indirectly observable for the asset or liability, other than quoted prices included within Level 1. Hierarchy Level 3 inputs are inputs that are not observable in the market. +In determining fair value, we use observable market data when available, or models that incorporate observable market data. In addition to market information, we incorporate transaction-specific details that, in management’s judgment, market participants would take into account in measuring fair value. We maximize the use of observable inputs and minimize our use of unobservable inputs in arriving at fair value estimates. +80 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Recurring fair-value measurements are performed for derivative instruments as disclosed in Note 7—Derivative Instruments . The carrying amount of cash and cash equivalents, restricted cash, accounts receivable and accounts payable reported on the Consolidated Balance Sheets approximates fair value. The fair value of debt is the estimated amount we would have to pay to repurchase our debt in the open market, including any premium or discount attributable to the difference between the stated interest rate and market interest rate at each balance sheet date. Debt fair values, as disclosed in Note 11—Debt , are based on quoted market prices for identical instruments, if available, or based on valuations of similar debt instruments using observable or unobservable inputs. Non-financial assets and liabilities initially measured at fair value include intangible assets, goodwill and AROs. +Revenue Recognition +We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. Revenues from the sale of LNG are recognized as LNG revenues, including LNG revenues generated by our integrated marketing function that are reported on a gross or net basis based on an assessment of whether it is acting as the principal or the agent in the transaction. LNG regasification capacity payments are recognized as regasification revenues. See Note 13—Revenues from Contracts with Customers for further discussion of revenues. +Cash and Cash Equivalents +We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. +Restricted Cash +Restricted cash consists of funds that are contractually or legally restricted as to usage or withdrawal and have been presented separately from cash and cash equivalents on our Consolidated Balance Sheets. +Accounts and Notes Receivable +Accounts and notes receivable are reported net of any current expected credit losses. Notes receivable that are not classified as trade receivables are recorded within other current assets in our Consolidated Balance Sheets. Current expected credit losses consider the risk of loss based on past events, current conditions and reasonable and supportable forecasts. A counterparty’s ability to pay is assessed through a credit review process that considers payment terms, the counterparty’s established credit rating or our assessment of the counterparty’s credit worthiness, contract terms, payment status, and other risks or available financial assurances. Adjustments to current expected credit losses are recorded in selling, general and administrative expense in our Consolidated Statements of Operations. As of December 31, 2020 and 2019, we had current expected credit losses on our accounts and notes receivable of $ 5 million and zero , respectively. +Inventory +LNG and natural gas inventory are recorded at the lower of weighted average cost and net realizable value. Materials and other inventory are recorded at the lower of cost and net realizable value and subsequently charged to expense when issued. +Accounting for LNG Activities +Generally, we begin capitalizing the costs of our LNG terminals once the individual project meets the following criteria: (1) regulatory approval has been received, (2) financing for the project is available and (3) management has committed to commence construction. Prior to meeting these criteria, most of the costs associated with a project are expensed as incurred. These costs primarily include professional fees associated with preliminary front-end engineering and design work, costs of securing necessary regulatory approvals and other preliminary investigation and development activities related to our LNG terminals. +Generally, costs that are capitalized prior to a project meeting the criteria otherwise necessary for capitalization include: land acquisition costs, detailed engineering design work and certain permits that are capitalized as other non-current assets. The +81 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +costs of lease options are amortized over the life of the lease once obtained. If no land or lease is obtained, the costs are expensed. +Property, Plant and Equipment +Property, plant and equipment are recorded at cost. Expenditures for construction and commissioning activities, major renewals and betterments that extend the useful life of an asset are capitalized, while expenditures for maintenance and repairs (including those for planned major maintenance projects) to maintain property, plant and equipment in operating condition are generally expensed as incurred. We realize offsets to LNG terminal costs for sales of commissioning cargoes that were earned or loaded prior to the start of commercial operations of the respective Train during the testing phase for its construction. We depreciate our property, plant and equipment using the straight-line depreciation method. Upon retirement or other disposition of property, plant and equipment, the cost and related accumulated depreciation are removed from the account, and the resulting gains or losses are recorded in impairment expense and loss (gain) on disposal of assets. +Management tests property, plant and equipment for impairment whenever events or changes in circumstances have indicated that the carrying amount of property, plant and equipment might not be recoverable. Assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets for purposes of assessing recoverability. Recoverability generally is determined by comparing the carrying value of the asset to the expected undiscounted future cash flows of the asset. If the carrying value of the asset is not recoverable, the amount of impairment loss is measured as the excess, if any, of the carrying value of the asset over its estimated fair value. +We did no t record any impairments related to property, plant and equipment during the years ended December 31, 2020, 2019 and 2018. +Interest Capitalization +We capitalize interest costs during the construction period of our LNG terminals and related assets as construction-in-process. Upon commencement of operations, these costs are transferred out of construction-in-process into terminal and interconnecting pipeline facilities assets and are amortized over the estimated useful life of the asset. +Regulated Natural Gas Pipelines +The Creole Trail Pipeline and Corpus Christi Pipeline are subject to the jurisdiction of the FERC in accordance with the Natural Gas Act of 1938 and the Natural Gas Policy Act of 1978. The economic effects of regulation can result in a regulated company recording as assets those costs that have been or are expected to be approved for recovery from customers, or recording as liabilities those amounts that are expected to be required to be returned to customers, in a rate-setting process in a period different from the period in which the amounts would be recorded by an unregulated enterprise. Accordingly, we record assets and liabilities that result from the regulated rate-making process that may not be recorded under GAAP for non-regulated entities. We continually assess whether regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes and recent rate orders applicable to other regulated entities. Based on this continual assessment, we believe the existing regulatory assets are probable of recovery. These regulatory assets and liabilities are primarily classified in our Consolidated Balance Sheets as other assets and other liabilities. We periodically evaluate their applicability under GAAP and consider factors such as regulatory changes and the effect of competition. If cost-based regulation ends or competition increases, we may have to reduce our asset balances to reflect a market basis less than cost and write off the associated regulatory assets and liabilities. +Items that may influence our assessment are: +• inability to recover cost increases due to rate caps and rate case moratoriums; +• inability to recover capitalized costs, including an adequate return on those costs through the rate-making process and the FERC proceedings; +• excess capacity; +• increased competition and discounting in the markets we serve; and +• impacts of ongoing regulatory initiatives in the natural gas industry. +82 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Natural gas pipeline costs include amounts capitalized as an Allowance for Funds Used During Construction (“AFUDC”). The rates used in the calculation of AFUDC are determined in accordance with guidelines established by the FERC. AFUDC represents the cost of debt and equity funds used to finance our natural gas pipeline additions during construction. AFUDC is capitalized as a part of the cost of our natural gas pipelines. Under regulatory rate practices, we generally are permitted to recover AFUDC, and a fair return thereon, through our rate base after our natural gas pipelines are placed in service. +Derivative Instruments +We use derivative instruments to hedge our exposure to cash flow variability from interest rate, commodity price and foreign currency exchange (“FX”) rate risk. Derivative instruments are recorded at fair value and included in our Consolidated Balance Sheets as assets or liabilities depending on the derivative position and the expected timing of settlement, unless they satisfy criteria for, and we elect, the normal purchases and sales exception. When we have the contractual right and intend to net settle, derivative assets and liabilities are reported on a net basis. +Changes in the fair value of our derivative instruments are recorded in earnings, unless we elect to apply hedge accounting and meet specified criteria. We did no t have any derivative instruments designated as cash flow or fair value hedges during the years ended December 31, 2020, 2019 and 2018. See Note 7—Derivative Instruments for additional details about our derivative instruments. +Leases +We adopted Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842) , and subsequent amendments thereto (“ASC 842”) on January 1, 2019 using the optional transition approach to apply the standard at the beginning of the first quarter of 2019 with no retrospective adjustments to prior periods. The adoption of the standard resulted in the recognition of right-of-use assets and lease liabilities for operating leases of approximately $ 550 million on our Consolidated Balance Sheets, with no material impact on our Consolidated Statements of Operations or Consolidated Statements of Cash Flows. +We determine if an arrangement is, or contains, a lease at inception of the arrangement. When we determine the arrangement is, or contains, a lease, we classify the lease as either an operating lease or a finance lease. Operating and finance leases are recognized on our Consolidated Balance Sheets by recording a lease liability representing the obligation to make future lease payments and a right-of-use asset representing the right to use the underlying asset for the lease term. Operating and finance lease right-of-use assets and liabilities are generally recognized based on the present value of lease payments over the lease term. In determining the present value of lease payments, we use the implicit interest rate in the lease if readily determinable. In the absence of a readily determinable implicitly interest rate, we discount our expected future lease payments using our relevant subsidiary’s incremental borrowing rate. The incremental borrowing rate is an estimate of the interest rate that a given subsidiary would have to pay to borrow on a collateralized basis over a similar term to that of the lease term. Options to renew a lease are included in the lease term and recognized as part of the right-of-use asset and lease liability, only to the extent they are reasonably certain to be exercised. We have elected practical expedients to (1) omit leases with an initial term of 12 months or less from recognition on our balance sheet and (2) to combine both the lease and non-lease components of an arrangement in calculating the right-of-use asset and lease liability for all classes of leased assets. +Lease expense for operating lease payments is recognized on a straight-line basis over the lease term. Lease expense for finance leases is recognized as the sum of the amortization of the right-of-use assets on a straight-line basis and the interest on lease liabilities using the effective interest method over the lease term. +Operating leases are included in operating lease assets, net, current operating lease liabilities and non-current operating lease liabilities on our Consolidated Balance Sheets. Finance leases are included in property, plant and equipment, net, other current liabilities and non-current finance lease liabilities on our Consolidated Balance Sheets. See Note 12—Leases for additional details about our leases. +83 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Concentration of Credit Risk +Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents, restricted cash, derivative instruments and accounts receivable. We maintain cash balances at financial institutions, which may at times be in excess of federally insured levels. We have not incurred losses related to these balances to date. +The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. Certain of our commodity derivative transactions are executed through over-the-counter contracts which are subject to nominal credit risk as these transactions are settled on a daily margin basis with investment grade financial institutions. Collateral deposited for such contracts is recorded within other current assets. Our interest rate and FX derivative instruments are placed with investment grade financial institutions whom we believe are acceptable credit risks. We monitor counterparty creditworthiness on an ongoing basis; however, we cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, we may be limited in our ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, we may not realize the benefit of some of our derivative instruments. +SPL has entered into fixed price long-term SPAs generally with terms of 20 years with eight third parties, CCL has entered into fixed price long-term SPAs generally with terms of 20 years with nine third parties and our integrated marketing function has entered into a limited number of long-term SPAs with third parties. We are dependent on the respective customers’ creditworthiness and their willingness to perform under their respective SPAs. See Note 2 1 —Customer Concentration for additional details about our customer concentration. +SPLNG has entered into two long-term TUAs with third parties for regasification capacity at the Sabine Pass LNG terminal. SPLNG is dependent on the respective customers’ creditworthiness and their willingness to perform under their respective TUAs. SPLNG has mitigated this credit risk by securing TUAs for a significant portion of its regasification capacity with creditworthy third-party customers with a minimum Standard & Poor’s rating of A. +Goodwill +Goodwill is the excess of acquisition cost of a business over the estimated fair value of net assets acquired. Goodwill is not amortized but is tested for impairment at least annually or more frequently if events or circumstances indicate goodwill is more likely than not impaired. Goodwill impairment evaluation requires a comparison of the estimated fair value of a reporting unit to its carrying value. We test goodwill for impairment by either performing a qualitative assessment or a quantitative test. The qualitative assessment is an assessment of historical information and relevant events and circumstances to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. We may elect not to perform the qualitative assessment and instead perform a quantitative impairment test. Significant judgment is required in estimating the fair value of the reporting unit and performing quantitative goodwill impairment tests. +We completed our annual assessment of goodwill impairment as of October 1st by performing a qualitative assessment; the tests indicated it is more likely than not that there was no impairment. Our last quantitative assessment indicated that the reporting unit’s fair value substantially exceeded its carrying value. As discussed above regarding our use of estimates, our judgments and assumptions are inherent in our estimate of future cash flows used to determine the estimate of the reporting unit’s fair value. The use of alternate judgments and/or assumptions could result in the recognition of impairment charges in the Consolidated Financial Statements. A lower fair value estimate in the future for our reporting unit could result in an impairment of goodwill. Factors that could trigger a lower fair value estimate include significant negative industry or economic trends, cost increases, disruptions to our business, regulatory or political environment changes or other unanticipated events. +Debt +Our debt consists of current and long-term secured and unsecured debt securities, convertible debt securities and credit facilities with banks and other lenders. Debt issuances are placed directly by us or through securities dealers or underwriters and are held by institutional and retail investors. +Debt is recorded on our Consolidated Balance Sheets at par value adjusted for unamortized discount or premium and net of unamortized debt issuance costs related to term notes. Debt issuance costs consist primarily of arrangement fees, professional fees, legal fees and printing costs. If debt issuance costs are incurred in connection with a line of credit +84 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +arrangement or on undrawn funds, they are presented as an asset on our Consolidated Balance Sheets. Discounts, premiums and debt issuance costs directly related to the issuance of debt are amortized over the life of the debt and are recorded in interest expense, net of capitalized interest using the effective interest method. Gains and losses on the extinguishment or modification of debt are recorded in gain (loss) on modification or extinguishment of debt on our Consolidated Statements of Operations. +Asset Retirement Obligations +We recognize AROs for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset and for conditional AROs in which the timing or method of settlement are conditional on a future event that may or may not be within our control. The fair value of a liability for an ARO is recognized in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is depreciated over the estimated useful life of the asset. +We have no t recorded an ARO associated with the Sabine Pass LNG terminal. Based on the real property lease agreements at the Sabine Pass LNG terminal, at the expiration of the term of the leases we are required to surrender the LNG terminal in good working order and repair, with normal wear and tear and casualty expected. Our property lease agreements at the Sabine Pass LNG terminal have terms of up to 90 years including renewal options. We have determined that the cost to surrender the Sabine Pass LNG terminal in good order and repair, with normal wear and tear and casualty expected, is immaterial. +We have no t recorded an ARO associated with the Creole Trail Pipeline or the Corpus Christi Pipeline. We believe that it is not feasible to predict when the natural gas transportation services provided by the Creole Trail Pipeline or the Corpus Christi Pipeline will no longer be utilized. In addition, our right-of-way agreements associated with the Creole Trail Pipeline and the Corpus Christi Pipeline have no stipulated termination dates. We intend to operate the Creole Trail Pipeline and the Corpus Christi Pipeline as long as supply and demand for natural gas exists in the United States and intend to maintain it regularly. +Share-based Compensation +We have awarded share-based compensation in the form of stock, restricted stock, restricted stock units, performance stock units and phantom units that are more fully described in Note 16—Share-based Compensation . We recognize share-based compensation based upon the estimated fair value of awards. The recognition period for these costs begins at either the applicable service inception date or grant date and continues throughout the requisite service period. For equity-classified share-based compensation awards (which include stock, restricted stock, restricted stock units and performance stock units to employees and non-employee directors), compensation cost is recognized based on the grant-date fair value and not subsequently remeasured unless modified. The fair value is recognized as expense (net of any capitalization) using the straight-line basis for awards that vest based solely on service conditions and using the accelerated recognition method for awards that vest based on performance conditions. For awards with both time and performance-based conditions, we recognize compensation cost based on the probable outcome of the performance condition at each reporting period. For liability-classified share-based compensation awards (which include phantom units), compensation costs are remeasured at fair value through settlement or maturity. We account for forfeitures as they occur. +Non-controlling Interests +When we consolidate a subsidiary, we include 100% of the assets, liabilities, revenues and expenses of the subsidiary in our Consolidated Financial Statements, even if we own less than 100% of the subsidiary. Non-controlling interests represent third-party ownership in the net assets of our consolidated subsidiaries and are presented as a component of equity. Changes in our ownership interests in subsidiaries that do not result in deconsolidation are generally recognized within equity. See Note 9—Non-controlling Interest and Variable Interest Entities for additional details about our non-controlling interest. +Income Taxes +Provisions for income taxes are based on taxes payable or refundable for the current year and deferred taxes on temporary differences between the tax basis of assets and liabilities and their reported amounts in our Consolidated Financial +85 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Statements. Deferred tax assets and liabilities are included in our Consolidated Financial Statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the current period’s provision for income taxes. +A valuation allowance is recorded to reduce the carrying value of our deferred tax assets when it is more likely than not that a portion or all of the deferred tax assets will expire before realization of the benefit or future deductibility is not probable. +We recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. +Net Income (Loss) Per Share +Basic net income (loss) per share attributable to common stockholders (“EPS”) excludes dilution and is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS reflects potential dilution and is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period increased by the number of additional common shares that would have been outstanding if the potential common shares had been issued. The dilutive effect of unvested stock is calculated using the treasury-stock method and the dilutive effect of convertible securities is calculated using the treasury or if-converted method. +Business Segment +We have determined that we operate as a single operating and reportable segment. Our chief operating decision maker makes resource allocation decisions and assesses performance based on financial information presented on a consolidated basis in the delivery of an integrated source of LNG to our customers. +NOTE 3— RESTRICTED CASH +Restricted cash consists of funds that are contractually or legally restricted as to usage or withdrawal and have been presented separately from cash and cash equivalents on our Consolidated Balance Sheets. As of December 31, 2020 and 2019, restricted cash consisted of the following (in millions): +December 31, +2020 2019 +Current restricted cash +SPL Project $ 97 $ 181 +CCL Project 70 80 +Cash held by our subsidiaries that is restricted to Cheniere 282 259 +Total current restricted cash $ 449 $ 520 +Pursuant to the accounts agreements entered into with the collateral trustees for the benefit of SPL’s debt holders and CCH’s debt holders, SPL and CCH are required to deposit all cash received into reserve accounts controlled by the collateral trustees. The usage or withdrawal of such cash is restricted to the payment of liabilities related to the SPL Project and the CCL Project (collectively, the “Liquefaction Projects”) and other restricted payments. The majority of the cash held by our subsidiaries that is restricted to Cheniere relates to advance funding for operation and construction needs of the Liquefaction Projects. +86 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 4— ACCOUNTS AND OTHER RECEIVABLES +As of December 31, 2020 and 2019, accounts and other receivables, net consisted of the following (in millions): +December 31, +2020 2019 +Trade receivables +SPL and CCL $ 482 $ 328 +Cheniere Marketing 113 113 +Other accounts receivable 52 50 +Total accounts and other receivables, net $ 647 $ 491 +NOTE 5— INVENTORY +As of December 31, 2020 and 2019, inventory consisted of the following (in millions): +December 31, +2020 2019 +Natural gas $ 26 $ 16 +LNG 27 67 +LNG in-transit 88 93 +Materials and other 151 136 +Total inventory $ 292 $ 312 +NOTE 6— PROPERTY, PLANT AND EQUIPMENT +As of December 31, 2020 and 2019, property, plant and equipment, net consisted of the following (in millions): +December 31, +2020 2019 +LNG terminal costs +LNG terminal and interconnecting pipeline facilities $ 27,475 $ 27,305 +LNG site and related costs 324 322 +LNG terminal construction-in-process 5,378 3,903 +Accumulated depreciation ( 2,935 ) ( 2,049 ) +Total LNG terminal costs, net 30,242 29,481 +Fixed assets and other +Computer and office equipment 25 23 +Furniture and fixtures 19 22 +Computer software 117 110 +Leasehold improvements 45 42 +Land 59 59 +Other 25 21 +Accumulated depreciation ( 164 ) ( 141 ) +Total fixed assets and other, net 126 136 +Assets under finance lease +Tug vessels 60 60 +Accumulated depreciation ( 7 ) ( 4 ) +Total assets under finance lease, net 53 56 +Property, plant and equipment, net $ 30,421 $ 29,673 +87 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table shows depreciation expense and offsets to LNG terminal costs during the years ended December 31, 2020 and 2019 (in millions): +Year Ended December 31, +2020 2019 2018 +Depreciation expense $ 926 $ 788 $ 445 +Offsets to LNG terminal costs (1) 19 301 140 +(1) We realize offsets to LNG terminal costs related to the sale of commissioning cargoes because these amounts were earned or loaded prior to the start of commercial operations of the respective Trains of the Liquefaction Projects during the testing phase for its construction. +LNG Terminal Costs +Our LNG terminals are depreciated using the straight-line depreciation method applied to groups of LNG terminal assets with varying useful lives. The identifiable components of our LNG terminals have depreciable lives between 7 and 50 years, as follows: +Components Useful life (yrs) +LNG storage tanks 50 +Natural gas pipeline facilities 40 +Marine berth, electrical, facility and roads 35 +Water pipelines 30 +Regasification processing equipment 30 +Sendout pumps 20 +Liquefaction processing equipment +7 - 50 +Other +10 - 30 +Fixed Assets and Other +Our fixed assets and other are recorded at cost and are depreciated on a straight-line method based on estimated lives of the individual assets or groups of assets. +NOTE 7— DERIVATIVE INSTRUMENTS +We have entered into the following derivative instruments that are reported at fair value: +• interest rate swaps (“CCH Interest Rate Derivatives”) to hedge the exposure to volatility in a portion of the floating-rate interest payments on CCH’s amended and restated credit facility (the “CCH Credit Facility”) and previously, to hedge against changes in interest rates that could impact anticipated future issuance of debt by CCH (“CCH Interest Rate Forward Start Derivatives” and, collectively with the CCH Interest Rate Derivatives, the “Interest Rate Derivatives”); +• commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the Liquefaction Projects and potential future development of Corpus Christi Stage 3 (“Physical Liquefaction Supply Derivatives”) and associated economic hedges (collectively, the “Liquefaction Supply Derivatives”); +• financial derivatives to hedge the exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG (“LNG Trading Derivatives”); and +• foreign currency exchange (“FX”) contracts to hedge exposure to currency risk associated with both LNG Trading Derivatives and operations in countries outside of the United States (“FX Derivatives”). +We recognize our derivative instruments as either assets or liabilities and measure those instruments at fair value. None of our derivative instruments are designated as cash flow or fair value hedging instruments, and changes in fair value are recorded within our Consolidated Statements of Operations to the extent not utilized for the commissioning process. +88 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table shows the fair value of our derivative instruments that are required to be measured at fair value on a recurring basis as of December 31, 2020 and 2019, which are classified as derivative assets, non-current derivative assets, derivative liabilities or non-current derivative liabilities in our Consolidated Balance Sheets (in millions): +Fair Value Measurements as of +December 31, 2020 December 31, 2019 +Quoted Prices in Active Markets +(Level 1) Significant Other Observable Inputs +(Level 2) Significant Unobservable Inputs +(Level 3) Total Quoted Prices in Active Markets +(Level 1) Significant Other Observable Inputs +(Level 2) Significant Unobservable Inputs +(Level 3) Total +CCH Interest Rate Derivatives liability $ — $ ( 140 ) $ — $ ( 140 ) $ — $ ( 81 ) $ — $ ( 81 ) +CCH Interest Rate Forward Start Derivatives liability — — — — — ( 8 ) — ( 8 ) +Liquefaction Supply Derivatives asset (liability) 5 ( 6 ) 241 240 5 6 138 149 +LNG Trading Derivatives asset (liability) ( 3 ) ( 131 ) — ( 134 ) — 165 — 165 +FX Derivatives asset (liability) — ( 22 ) — ( 22 ) — 4 — 4 +We value our Interest Rate Derivatives using an income-based approach utilizing observable inputs to the valuation model including interest rate curves, risk adjusted discount rates, credit spreads and other relevant data. We value our LNG Trading Derivatives and our Liquefaction Supply Derivatives using a market or option-based approach incorporating present value techniques, as needed, using observable commodity price curves, when available, and other relevant data. We value our FX Derivatives with a market approach using observable FX rates and other relevant data. +The fair value of our Physical Liquefaction Supply Derivatives is predominantly driven by observable and unobservable market commodity prices and, as applicable to our natural gas supply contracts, our assessment of the associated events deriving fair value, including evaluating whether the respective market is available as pipeline infrastructure is developed. The fair value of our Physical Liquefaction Supply Derivatives incorporates risk premiums related to the satisfaction of conditions precedent, such as completion and placement into service of relevant pipeline infrastructure to accommodate marketable physical gas flow. As of December 31, 2020 and 2019, some of our Physical Liquefaction Supply Derivatives existed within markets for which the pipeline infrastructure was under development to accommodate marketable physical gas flow. +We include a portion of our Physical Liquefaction Supply Derivatives as Level 3 within the valuation hierarchy as the fair value is developed through the use of internal models which incorporate significant unobservable inputs. In instances where observable data is unavailable, consideration is given to the assumptions that market participants would use in valuing the asset or liability. This includes assumptions about market risks, such as future prices of energy units for unobservable periods, liquidity, volatility and contract duration. +The Level 3 fair value measurements of natural gas positions within our Physical Liquefaction Supply Derivatives could be materially impacted by a significant change in certain natural gas and international LNG prices. The following table includes quantitative information for the unobservable inputs for our Level 3 Physical Liquefaction Supply Derivatives as of December 31, 2020: +Net Fair Value Asset +(in millions) Valuation Approach Significant Unobservable Input Range of Significant Unobservable Inputs / Weighted Average (1) +Physical Liquefaction Supply Derivatives $ 241 Market approach incorporating present value techniques Henry Hub basis spread +$( 0.532 ) - $ 0.092 / $( 0.030 ) +Option pricing model International LNG pricing spread, relative to Henry Hub (2) +117 % - 480 % / 155 % +(1) Unobservable inputs were weighted by the relative fair value of the instruments. +(2) Spread contemplates U.S. dollar-denominated pricing. +89 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Increases or decreases in basis or pricing spreads, in isolation, would decrease or increase, respectively, the fair value of our Physical Liquefaction Supply Derivatives. +The following table shows the changes in the fair value of our Level 3 Physical Liquefaction Supply Derivatives during the years ended December 31, 2020, 2019 and 2018 (in millions): +Year Ended December 31, +2020 2019 2018 +Balance, beginning of period $ 138 $ ( 29 ) $ 43 +Realized and mark-to-market gains (losses): +Included in cost of sales 156 ( 77 ) ( 13 ) +Purchases and settlements: +Purchases 5 199 ( 31 ) +Settlements ( 65 ) 44 ( 29 ) +Transfers into Level 3, net (1) 7 1 1 +Balance, end of period $ 241 $ 138 $ ( 29 ) +Change in unrealized gain (loss) relating to instruments still held at end of period $ 156 $ ( 77 ) $ ( 13 ) +(1) Transferred into Level 3 as a result of unobservable market for the underlying natural gas purchase agreements. +Derivative assets and liabilities arising from our derivative contracts with the same counterparty are reported on a net basis, as all counterparty derivative contracts provide for the unconditional right of set-off in the event of default. The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments in instances when our derivative instruments are in an asset position. Additionally, counterparties are at risk that we will be unable to meet our commitments in instances where our derivative instruments are in a liability position. We incorporate both our own nonperformance risk and the respective counterparty’s nonperformance risk in fair value measurements. In adjusting the fair value of our derivative contracts for the effect of nonperformance risk, we have considered the impact of any applicable credit enhancements, such as collateral postings, set-off rights and guarantees. +Interest Rate Derivatives +CCH has entered into interest rate swaps to protect against volatility of future cash flows and hedge a portion of the variable interest payments on the CCH Credit Facility. CCH previously also had interest rate swaps to hedge against changes in interest rates that could impact anticipated future issuance of debt. In August 2020, we settled the outstanding CCH Interest Rate Forward Start Derivatives. +Cheniere Partners previously had interest rate swaps (“CQP Interest Rate Derivatives”) to hedge a portion of the variable interest payments on its credit facilities. In October 2018, Cheniere Partners terminated the CQP Interest Rate Derivatives related to the 2016 CQP Credit Facilities. +As of December 31, 2020, we had the following Interest Rate Derivatives outstanding: +Notional Amounts +December 31, 2020 December 31, 2019 Maturity Date Weighted Average Fixed Interest Rate Paid Variable Interest Rate Received +CCH Interest Rate Derivatives $ 4.6 billion $ 4.5 billion May 31, 2022 2.30 % One-month LIBOR +90 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table shows the changes in the fair value and settlements of our Interest Rate Derivatives recorded in interest rate derivative gain (loss), net on our Consolidated Statements of Operations during the years ended December 31, 2020, 2019 and 2018 (in millions): +Year Ended December 31, +2020 2019 2018 +CCH Interest Rate Derivatives gain (loss) $ ( 138 ) $ ( 101 ) $ 43 +CCH Interest Rate Forward Start Derivatives loss ( 95 ) ( 33 ) — +CQP Interest Rate Derivatives gain — — 14 +Commodity Derivatives +SPL, CCL and CCL Stage III have entered into physical natural gas supply contracts and associated economic hedges to purchase natural gas for the commissioning and operation of the Liquefaction Projects and potential future development of Corpus Christi Stage 3, respectively, which are primarily indexed to the natural gas market and international LNG indices. The remaining terms of the index-based physical natural gas supply contracts range up to approximately 15 years, some of which commence upon the satisfaction of certain events or states of affairs. +We have entered into, and may from time to time enter into, financial LNG Trading Derivatives in the form of swaps, forwards, options or futures to economically hedge exposure to the commodity markets in which we have contractual arrangements to purchase or sell physical LNG. We have entered into LNG Trading Derivatives to secure a fixed price position to minimize future cash flow variability associated with LNG purchase and sale transactions. +The following table shows the notional amounts of our Liquefaction Supply Derivatives and LNG Trading Derivatives (collectively, “Commodity Derivatives”): +December 31, 2020 December 31, 2019 +Liquefaction Supply Derivatives LNG Trading Derivatives Liquefaction Supply Derivatives LNG Trading Derivatives +Notional amount, net (in TBtu) (1) 10,483 20 9,177 4 +(1) Includes notional amounts for natural gas supply contracts that SPL and CCL have with related parties. See Note 14—Related Party Transactions . +The following table shows the changes in the fair value, settlements and location of our Commodity Derivatives recorded on our Consolidated Statements of Operations during the years ended December 31, 2020, 2019 and 2018 (in millions): +Consolidated Statements of Operations Location (1) Year Ended December 31, +2020 2019 2018 +LNG Trading Derivatives gain (loss) LNG revenues $ ( 26 ) $ 402 $ ( 25 ) +LNG Trading Derivatives loss Cost of sales ( 42 ) ( 89 ) — +Liquefaction Supply Derivatives gain (loss) (2) LNG revenues ( 1 ) 2 ( 1 ) +Liquefaction Supply Derivatives gain (loss) (2) Cost of sales 94 194 ( 100 ) +(1) Fair value fluctuations associated with commodity derivative activities are classified and presented consistently with the item economically hedged and the nature and intent of the derivative instrument. +(2) Does not include the realized value associated with derivative instruments that settle through physical delivery. +FX Derivatives +Cheniere Marketing has entered into FX Derivatives to protect against the volatility in future cash flows attributable to changes in international currency exchange rates. The FX Derivatives economically hedge the foreign currency exposure arising from cash flows expended for both physical and financial LNG transactions. +The total notional amount of our FX Derivatives was $ 786 million and $ 827 million as of December 31, 2020 and 2019, respectively. +91 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table shows the changes in the fair value, settlements and location of our FX Derivatives recorded on our Consolidated Statements of Operations during the years ended December 31, 2020, 2019 and 2018 (in millions): +Year Ended December 31, +Consolidated Statements of Operations Location 2020 2019 2018 +FX Derivatives gain (loss) LNG revenues $ ( 3 ) $ 25 $ 18 +Fair Value and Location of Derivative Assets and Liabilities on the Consolidated Balance Sheets +The following table shows the fair value and location of our derivative instruments on our Consolidated Balance Sheets (in millions): +December 31, 2020 +CCH Interest Rate Derivatives +CCH Interest Rate Forward Start Derivatives +Liquefaction Supply Derivatives (1) +LNG Trading Derivatives (2) +FX Derivatives +Total +Consolidated Balance Sheets Location +Derivative assets $ — $ — $ 27 $ — $ 5 $ 32 +Non-current derivative assets — — 376 — — 376 +Total derivative assets — — 403 — 5 408 +Derivative liabilities ( 100 ) — ( 54 ) ( 134 ) ( 25 ) ( 313 ) +Non-current derivative liabilities ( 40 ) — ( 109 ) — ( 2 ) ( 151 ) +Total derivative liabilities ( 140 ) — ( 163 ) ( 134 ) ( 27 ) ( 464 ) +Derivative asset (liability), net $ ( 140 ) $ — $ 240 $ ( 134 ) $ ( 22 ) $ ( 56 ) +December 31, 2019 +CCH Interest Rate Derivatives +CCH Interest Rate Forward Start Derivatives +Liquefaction Supply Derivatives (1) +LNG Trading Derivatives (2) +FX Derivatives +Total +Consolidated Balance Sheets Location +Derivative assets $ — $ — $ 93 $ 225 $ 5 $ 323 +Non-current derivative assets — — 174 — — 174 +Total derivative assets — — 267 225 5 497 +Derivative liabilities ( 32 ) ( 8 ) ( 16 ) ( 60 ) ( 1 ) ( 117 ) +Non-current derivative liabilities ( 49 ) — ( 102 ) — — ( 151 ) +Total derivative liabilities ( 81 ) ( 8 ) ( 118 ) ( 60 ) ( 1 ) ( 268 ) +Derivative asset (liability), net $ ( 81 ) $ ( 8 ) $ 149 $ 165 $ 4 $ 229 +(1) Does not include collateral posted with counterparties by us of $ 9 million and $ 7 million for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of December 31, 2020 and 2019, respectively. Includes derivative assets for natural gas supply contracts that SPL and CCL have with related parties. See Note 14—Related Party Transactions . +(2) Does not include collateral posted with counterparties by us of $ 7 million and $ 5 million deposited for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of December 31, 2020 and 2019, respectively. +92 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Consolidated Balance Sheets Presentation +Our derivative instruments are presented on a net basis on our Consolidated Balance Sheets as described above. The following table shows the fair value of our derivatives outstanding on a gross and net basis (in millions): +CCH Interest Rate Derivatives +CCH Interest Rate Forward Start Derivatives +Liquefaction Supply Derivatives +LNG Trading Derivatives +FX Derivatives +As of December 31, 2020 +Gross assets $ — $ — $ 452 $ — $ 6 +Offsetting amounts — — ( 49 ) — ( 1 ) +Net assets $ — $ — $ 403 $ — $ 5 +Gross liabilities $ ( 140 ) $ — $ ( 184 ) $ ( 163 ) $ ( 62 ) +Offsetting amounts — — 21 29 35 +Net liabilities $ ( 140 ) $ — $ ( 163 ) $ ( 134 ) $ ( 27 ) +As of December 31, 2019 +Gross assets $ — $ — $ 281 $ 229 $ 9 +Offsetting amounts — — ( 14 ) ( 4 ) ( 4 ) +Net assets $ — $ — $ 267 $ 225 $ 5 +Gross liabilities $ ( 81 ) $ ( 8 ) $ ( 126 ) $ ( 60 ) $ ( 6 ) +Offsetting amounts — — 8 — 5 +Net liabilities $ ( 81 ) $ ( 8 ) $ ( 118 ) $ ( 60 ) $ ( 1 ) +NOTE 8— OTHER NON-CURRENT ASSETS +As of December 31, 2020 and 2019, other non-current assets, net consisted of the following (in millions): +December 31, +2020 2019 +Advances made to municipalities for water system enhancements $ 84 $ 87 +Advances and other asset conveyances to third parties to support LNG terminals 60 55 +Advances made under EPC and non-EPC contracts 9 29 +Equity method investments 81 108 +Debt issuance costs and debt discount, net 42 45 +Tax-related payments and receivables 20 20 +Contract assets, net 80 18 +Other 30 26 +Total other non-current assets, net $ 406 $ 388 +Equity Method Investments +Our equity method investments consist of interests in privately-held companies. In 2017, we acquired an equity interest in Midship Holdings, LLC (“Midship Holdings”), which manages the business and affairs of Midship Pipeline Company, LLC (“Midship Pipeline”). Midship Pipeline is currently operating an approximately 200-mile natural gas pipeline project (the “Midship Project”) that connects production in the Anadarko Basin to Gulf Coast markets. The Midship Project commenced operations in April 2020. +During the year ended December 31, 2020, we recognized other-than-temporary impairment losses of $ 129 million related to our investment in Midship Holdings. Impairment was precipitated primarily due to declining market conditions in the energy industry and customer credit risk, resulting in a reduction in the fair value of our equity interests. During the year ended December 31, 2019, we recognized losses of $ 87 million related to our investments in certain equity method investees, including Midship Holdings. Impairments were primarily the result of cost overruns and extended construction timelines for +93 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +operating infrastructure of our investees’ projects, resulting in a reduction of the fair value of our equity interests. The fair values of our equity interests were measured using an income approach, which utilized level 3 fair value inputs such as projected earnings and discount rates, and/or market approach. Impairment losses associated with our equity method investments are presented in other expense, net. +Our investment in Midship Holdings, net of impairment losses, was $ 80 million and $ 105 million at December 31, 2020 and 2019, respectively. +NOTE 9— NON-CONTROLLING INTEREST AND VARIABLE INTEREST ENTITY +We own a 48.6 % limited partner interest in Cheniere Partners in the form of 239.9 million common units, with the remaining non-controlling interest held by The Blackstone Group Inc., Brookfield Asset Management Inc. and the public. In July 2020, the board of directors of Cheniere Partners’ general partner confirmed and approved that, following the distribution with respect to the three months ended June 30, 2020, the financial tests required for conversion of Cheniere Partners’ subordinated units, all of which were held by us, were met under the terms of Cheniere Partners’ partnership agreement. Accordingly, effective August 17, 2020, the first business day following the payment of the distribution, all of Cheniere Partners’ subordinated units were automatically converted into common units on a one-for-one basis and the subordination period was terminated. We also own 100 % of the general partner interest and the incentive distribution rights in Cheniere Partners. Cheniere Partners is accounted for as a consolidated VIE. +Cheniere Partners is a limited partnership formed by us in 2006 to own and operate the Sabine Pass LNG terminal and related assets. Our subsidiary, Cheniere Partners GP, is the general partner of Cheniere Partners. In 2012, Cheniere Partners, Cheniere and Blackstone CQP Holdco entered into a unit purchase agreement whereby Cheniere Partners sold 100.0 million Class B units to Blackstone CQP Holdco in a private placement. The board of directors of Cheniere Partners GP was modified to include three directors appointed by Blackstone CQP Holdco, four directors appointed by us and four independent directors mutually agreed upon by Blackstone CQP Holdco and us and appointed by us. In addition, we provided Blackstone CQP Holdco with a right to maintain one board seat on our Board of Directors (our “Board”). A quorum of Cheniere Partners GP directors consists of a majority of all directors, including at least two directors appointed by Blackstone CQP Holdco, two directors appointed by us and two independent directors. Blackstone CQP Holdco will no longer be entitled to appoint Cheniere Partners GP directors in the event that Blackstone CQP Holdco’s ownership in Cheniere Partners is less than 20 % of outstanding common units and subordinated units. +We have determined that Cheniere Partners GP is a VIE and that we, as the holder of the equity at risk, do not have a controlling financial interest due to the rights held by Blackstone CQP Holdco. However, we continue to consolidate Cheniere Partners as a result of Blackstone CQP Holdco’s right to maintain one board seat on our Board which creates a de facto agency relationship between Blackstone CQP Holdco and us. GAAP requires that when a de facto agency relationship exists, one of the members of the de facto agency relationship must consolidate the VIE based on certain criteria. As a result, we consolidate Cheniere Partners in our Consolidated Financial Statements. +94 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table presents the summarized assets and liabilities (in millions) of Cheniere Partners, our consolidated VIE, which are included in our Consolidated Balance Sheets. The assets in the table below may only be used to settle obligations of Cheniere Partners. In addition, there is no recourse to us for the consolidated VIE’s liabilities. The assets and liabilities in the table below include third-party assets and liabilities of Cheniere Partners only and exclude intercompany balances that eliminate in consolidation. +December 31, +2020 2019 +ASSETS +Current assets +Cash and cash equivalents $ 1,210 $ 1,781 +Restricted cash 97 181 +Accounts and other receivables, net 318 297 +Other current assets 182 184 +Total current assets 1,807 2,443 +Property, plant and equipment, net 16,723 16,368 +Other non-current assets, net 287 309 +Total assets $ 18,817 $ 19,120 +LIABILITIES +Current liabilities +Accrued liabilities $ 658 $ 709 +Other current liabilities 171 210 +Total current liabilities 829 919 +Long-term debt, net 17,580 17,579 +Other non-current liabilities 126 104 +Total liabilities $ 18,535 $ 18,602 +NOTE 10— ACCRUED LIABILITIES +As of December 31, 2020 and 2019, accrued liabilities consisted of the following (in millions): +December 31, +2020 2019 +Interest costs and related debt fees $ 245 $ 293 +Accrued natural gas purchases 576 460 +LNG terminals and related pipeline costs 147 327 +Compensation and benefits 123 115 +Accrued LNG inventory 4 6 +Other accrued liabilities 80 80 +Total accrued liabilities $ 1,175 $ 1,281 +95 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 11— DEBT +As of December 31, 2020 and 2019, our debt consisted of the following (in millions): +December 31, +2020 2019 +Long-term debt: +SPL — 4.200 % to 6.25 % senior secured notes due between 2022 and 2037 and working capital facility (“2020 SPL Working Capital Facility”) +$ 13,650 $ 13,650 +Cheniere Partners — 4.500 % to 5.625 % senior notes due between 2025 and 2029 and credit facilities (“2019 CQP Credit Facilities”) +4,100 4,100 +CCH — 3.52 % to 7.000 % senior secured notes due between 2024 and 2039 and CCH Credit Facility +10,217 10,235 +CCH HoldCo II — 11.0 % Convertible Senior Secured Notes due 2025 (“2025 CCH HoldCo II Convertible Senior Notes”) +— 1,578 +Cheniere — 4.625 % Senior Secured Notes due 2028 (the “2028 Cheniere Senior Secured Notes”), convertible notes, revolving credit facility (“Cheniere Revolving Credit Facility”) and term loan facility (“Cheniere Term Loan Facility”) +3,145 1,903 +Unamortized premium, discount and debt issuance costs, net ( 641 ) ( 692 ) +Total long-term debt, net 30,471 30,774 +Current debt: +SPL — $ 1.2 billion Amended and Restated SPL Working Capital Facility (“2015 SPL Working Capital Facility”) +— — +CCH — $ 1.2 billion CCH Working Capital Facility (“CCH Working Capital Facility”) and current portion of CCH Credit Facility +271 — +Cheniere Marketing — trade finance facilities +— — +Cheniere — current portion of 4.875 % Convertible Unsecured Notes due 2021 (“2021 Cheniere Convertible Unsecured Notes”) +104 — +Unamortized premium, discount and debt issuance costs, net ( 3 ) — +Total current debt 372 — +Total debt, net $ 30,843 $ 30,774 +Below is a schedule of future principal payments that we are obligated to make, based on current construction schedules, on our outstanding debt at December 31, 2020 (in millions): +Years Ending December 31, Principal Payments +2021 $ 747 +2022 1,089 +2023 1,749 +2024 5,556 +2025 5,023 +Thereafter 17,323 +Total $ 31,487 +96 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Issuances and Repayments +The following table shows the issuances and repayments of long-term debt during the year ended December 31, 2020 (in millions): +Issuances and Long-Term Borrowings Principal Amount Issued +SPL — 4.500 % Senior Secured Notes due 2030 (the “2030 SPL Senior Notes”) (1) +$ 2,000 +CCH — 3.52 % Senior Secured Notes due 2039 (the “3.52% CCH Senior Secured Notes”) (2) +769 +Cheniere — 2028 Cheniere Senior Secured Notes (3) +2,000 +Cheniere — Cheniere Term Loan Facility +2,323 +Cheniere — Cheniere Revolving Credit Facility +455 +Year Ended December 31, 2020 total +$ 7,547 +Repayments, Redemptions and Repurchases Amount Repaid/Redeemed/Repurchased +SPL — 5.625 % Senior Secured Notes due 2021 (the “2021 SPL Senior Notes”) (1) +$ ( 2,000 ) +CCH HoldCo II — 2025 CCH HoldCo II Convertible Senior Notes (3) +( 1,578 ) +CCH — CCH Credit Facility (2) +( 656 ) +Cheniere — 2021 Cheniere Convertible Unsecured Notes (3) +( 844 ) +Cheniere — Cheniere Term Loan Facility (3) +( 2,175 ) +Cheniere — Cheniere Revolving Credit Facility +( 455 ) +Year Ended December 31, 2020 total $ ( 7,708 ) +(1) Proceeds of the 2030 SPL Senior Notes, along with available cash, were used to redeem all of SPL’s outstanding 2021 SPL Senior Notes, resulting in the recognition of debt extinguishment costs of $ 43 million for the year ended December 31, 2020 relating to the payment of early redemption fees and write off of unamortized debt premium and issuance costs. +(2) Proceeds of the 3.52% CCH Senior Secured Notes were used to repay a portion of the outstanding borrowings under the CCH Credit Facility, pay costs associated with certain interest rate derivative instruments that were settled and pay certain fees, costs and expenses incurred in connection with these transactions. The repayment of the CCH Credit Facility resulted in the recognition of debt extinguishment costs of $ 9 million for the year ended December 31, 2020 relating to the write off of unamortized debt discounts and issuance costs. +(3) Proceeds of the 2028 Cheniere Senior Secured Notes, along with $ 200 million in available cash, were used to prepay approximately $ 2.1 billion of the outstanding indebtedness of the Cheniere Term Loan Facility, resulting in the recognition of debt extinguishment costs of $ 16 million for the year ended December 31, 2020. The borrowings under the Cheniere Term Loan Facility, which was entered into in June 2020 with available commitments of $ 2.62 billion and subsequently increased to $ 2.695 billion in July 2020, were used to (1) redeem the outstanding principal amount of the 2025 CCH HoldCo II Convertible Senior Notes remaining after the redemption of an aggregate outstanding principal amount of $ 300 million with available cash in March 2020, including paid-in-kind interest, with cash at a price of $ 1,080 per $1,000 principal amount, (2) repurchase $ 844 million in aggregate principal amount of outstanding 2021 Cheniere Convertible Unsecured Notes, including paid-in-kind interest, at individually negotiated prices from a small number of investors and (3) pay the related fees and expenses. The redemption of the 2025 CCH HoldCo II Convertible Senior Notes and the repurchase of the 2021 Cheniere Convertible Unsecured Notes resulted in the recognition of debt extinguishment costs of $ 149 million and a reduction in equity associated with reacquisition of the embedded conversion option of $ 10 million. +97 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Credit Facilities and Delayed Draw Term Loan +Below is a summary of our credit facilities and delayed draw term loan outstanding as of December 31, 2020 (in millions): +2020 SPL Working Capital Facility (1) 2019 CQP Credit Facilities CCH Credit Facility (2) CCH Working Capital Facility Cheniere Revolving Credit Facility Cheniere Term Loan Facility (3) +Original facility size $ 1,200 $ 1,500 $ 8,404 $ 350 $ 750 $ 2,620 +Incremental commitments — — 1,566 850 500 75 +Less: +Outstanding balance — — 2,627 140 — 148 +Commitments prepaid or terminated — 750 7,343 — — 2,175 +Letters of credit issued 413 — — 293 124 — +Available commitment $ 787 $ 750 $ — $ 767 $ 1,126 $ 372 +Priority ranking Senior secured Senior secured Senior secured Senior secured Senior secured Senior secured +Interest rate on available balance +LIBOR plus 1.125 % - 1.750 % or base rate plus 0.125 % - 0.750 % +LIBOR plus 1.25 % - 2.125 % or base rate plus 0.25 % - 1.125 % +LIBOR plus 1.75 % or base rate plus 0.75 % +LIBOR plus 1.25 % - 1.75 % or base rate plus 0.25 % - 0.75 % +LIBOR plus 1.75 % - 2.50 % or base rate plus 0.75 % - 1.50 % +(4) +Weighted average interest rate of outstanding balance n/a n/a 1.90 % 1.40 % n/a 2.15 % +Maturity date March 19, 2025 May 29, 2024 June 30, 2024 June 29, 2023 December 13, 2022 June 18, 2023 +(1) The 2020 SPL Working Capital Facility contains customary conditions precedent for extensions of credit, as well as customary affirmative and negative covenants. SPL pays a commitment fee equal to an annual rate of 0.1 % to 0.3 % (depending on the then-current rating of SPL), which accrues on the daily amount of the total commitment less the sum of (1) the outstanding principal amount of loans, (2) letters of credit issued and (3) the outstanding principal amount of swing line loans. +(2) We prepaid $ 656 million of outstanding borrowings under the CCH Credit Facility during the year ended December 31, 2020 using proceeds from the issuance of the 3.52% CCH Senior Secured Notes. +(3) Borrowings under the Cheniere Term Loan Facility are subject to customary conditions precedent. The remaining commitments under the Cheniere Term Loan Facility are expected to be used to repay and/or repurchase a portion of the remaining principal amount of the 2021 Cheniere Convertible Unsecured Notes and for the payment of related fees and expenses. We pay a commitment fee equal to 30 % of the margin for LIBOR loans multiplied by the average daily amount of undrawn commitments. If the Cheniere Term Loan Facility is still outstanding on the first anniversary of the Closing Date, as defined by the credit agreement, we will pay duration fees in an amount equal to 0.25 % of the aggregate amount of commitments as of July 10, 2020, which was the date the loans were first borrowed under the Cheniere Term Loan Facility (the “Payment Date”). Furthermore, if the Cheniere Term Loan Facility is still outstanding on the second anniversary of the Closing Date, as defined by the credit agreement, we will pay 0.50 % of the aggregate amount of commitments as of the Payment Date. Annual administrative fees must also be paid to the administrative agent for the Cheniere Term Loan Facility. Subject to customary exceptions, we are required to make mandatory prepayments with respect to the Cheniere Term Loan Facility using the net proceeds of certain events on a pro rata basis and on terms consistent with required prepayments under the Cheniere Revolving Credit Facility . +(4) LIBOR plus (1) 2.00 % to 2.75 % per annum in the first year, (2) 2.50 % to 3.25 % per annum in the second year and (3) 3.00 % to 3.75 % per annum in the third year until maturity, or base rate plus (1) 1.00 % to 1.75 % per annum in the first year, (2) 1.50 % to 2.25 % per annum in the second year and (3) 2.00 % to 2.75 % per annum in the third year until maturity. +98 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Convertible Notes +Below is a summary of our convertible notes outstanding as of December 31, 2020 (in millions): +2021 Cheniere Convertible Unsecured Notes (1) 2045 Cheniere Convertible Senior Notes +Aggregate original principal $ 1,000 $ 625 +Add: interest paid-in-kind 320 — +Less: aggregate principal redeemed ( 844 ) — +Aggregate remaining principal $ 476 $ 625 +Debt component, net of discount and debt issuance costs $ 470 $ 317 +Equity component $ 201 $ 194 +Interest payment method Paid-in-kind Cash +Conversion by us (2) — (3) +Conversion by holders (2) (4) (5) +Conversion basis Cash and/or stock Cash and/or stock +Conversion value in excess of principal $ — $ — +Maturity date May 28, 2021 March 15, 2045 +Contractual interest rate 4.875 % 4.25 % +Effective interest rate (6) 8.1 % 9.4 % +Remaining debt discount and debt issuance costs amortization period (7) 0.4 years 24.2 years +(1) $ 372 million of the 2021 Cheniere Convertible Unsecured Notes is categorized as long-term debt because the remaining available commitments under the Cheniere Term Loan Facility are expected to be used to repay and/or repurchase a portion of the remaining outstanding principal amount of the 2021 Cheniere Convertible Unsecured Notes. +(2) Conversion is subject to various limitations and conditions. +(3) Redeemable at any time at a redemption price payable in cash equal to the accreted amount of the $ 625 million aggregate principal amount of 4.25 % Convertible Senior Notes due 2045 (the “2045 Cheniere Convertible Senior Notes”) to be redeemed, plus accrued and unpaid interest, if any, to such redemption date. +(4) Initially convertible at $ 93.64 (subject to adjustment upon the occurrence of certain specified events), provided that the closing price of our common stock is greater than or equal to the conversion price on the conversion date. +(5) Prior to December 15, 2044, convertible only under certain circumstances as specified in the indenture; thereafter, holders may convert their notes regardless of these circumstances. The conversion rate will initially equal 7.2265 shares of our common stock per $1,000 principal amount of the 2045 Cheniere Convertible Senior Notes, which corresponds to an initial conversion price of approximately $ 138.38 per share of our common stock (subject to adjustment upon the occurrence of certain specified events). +(6) Rate to accrete the discounted carrying value of the convertible notes to the face value over the remaining amortization period. +(7) We amortize any debt discount and debt issuance costs using the effective interest over the period through contractual maturity. +Restrictive Debt Covenants +The indentures governing our senior notes and other agreements underlying our debt contain customary terms and events of default and certain covenants that, among other things, may limit us, our subsidiaries’ and its restricted subsidiaries’ ability to make certain investments or pay dividends or distributions. +As of December 31, 2020, each of our issuers was in compliance with all covenants related to their respective debt agreements. +99 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Interest Expense +Total interest expense, net of capitalized interest, including interest expense related to our convertible notes, consisted of the following (in millions): +Year Ended December 31, +2020 2019 2018 +Interest cost on convertible notes: +Interest per contractual rate $ 152 $ 256 $ 237 +Amortization of debt discount 45 40 35 +Amortization of debt issuance costs 8 12 9 +Total interest cost related to convertible notes 205 308 281 +Interest cost on debt and finance leases excluding convertible notes 1,568 1,538 1,397 +Total interest cost 1,773 1,846 1,678 +Capitalized interest ( 248 ) ( 414 ) ( 803 ) +Total interest expense, net of capitalized interest $ 1,525 $ 1,432 $ 875 +Fair Value Disclosures +The following table shows the carrying amount and estimated fair value of our debt (in millions): +December 31, 2020 December 31, 2019 +Carrying +Amount Estimated +Fair Value Carrying +Amount Estimated +Fair Value +Senior notes — Level 2 (1) +$ 24,700 $ 27,897 $ 22,700 $ 24,650 +Senior notes — Level 3 (2) +2,771 3,423 2,002 2,259 +Credit facilities (3) 2,915 2,915 3,283 3,283 +2021 Cheniere Convertible Unsecured Notes (2) 476 480 1,278 1,312 +2025 CCH HoldCo II Convertible Senior Notes (2) — — 1,578 1,807 +2045 Cheniere Convertible Senior Notes (4) 625 496 625 498 +(1) The Level 2 estimated fair value was based on quotes obtained from broker-dealers or market makers of these senior notes and other similar instruments. +(2) The Level 3 estimated fair value was calculated based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including our stock price and interest rates based on debt issued by parties with comparable credit ratings to us and inputs that are not observable in the market. +(3) The Level 3 estimated fair value approximates the principal amount because the interest rates are variable and reflective of market rates and the debt may be repaid, in full or in part, at any time without penalty. +(4) The Level 1 estimated fair value was based on unadjusted quoted prices in active markets for identical liabilities that we had the ability to access at the measurement date. +NOTE 12— LEASES +Our leased assets consist primarily of (1) LNG vessel time charters (“vessel charters”), (2) tug vessels, (3) office space and facilities and (4) land sites, all of which are classified as operating leases except for our tug vessels at the Corpus Christi LNG terminal, which are classified as finance leases. +Our policy is to recognize leases on our balance sheet by recording a lease liability representing the obligation to make future lease payments and a right-of-use asset representing the right to use the underlying asset for the lease term. As our leases generally do not provide an implicit rate, in order to calculate the lease liability, we discounted our expected future lease payments using our relevant subsidiary’s incremental borrowing rate at the later of January 1, 2019 or the commencement date of the lease. The incremental borrowing rate is an estimate of the rate of interest that a given subsidiary would have to pay to borrow on a collateralized basis over a similar term to that of the lease term. +100 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Many of our leases contain renewal options exercisable at our sole discretion. Options to renew a lease are included in the lease term and recognized as part of the right-of-use asset and lease liability only to the extent they are reasonably certain to be exercised, such as when necessary to satisfy obligations that existed at the execution of the lease or when the non-renewal would otherwise result in a significant economic penalty. +We have elected the practical expedient to omit leases with an initial term of 12 months or less (“short-term lease”) from recognition on the balance sheet. We recognize short-term lease payments on a straight-line basis over the lease term and variable payments under short-term leases in the period in which the obligation is incurred. +Certain of our leases contain non-lease components which are not separated from the lease components when calculating the right-of-use asset and lease liability per our use of the practical expedient to combine both components of an arrangement for all classes of leased assets. +Certain of our leases also contain variable payments, such as inflation, that are not included when calculating the right-of-use asset and lease liability unless the payments are in-substance fixed. +We recognize lease expense for operating leases on a straight-line basis over the lease term. We recognize lease expense for finance leases as the sum of the amortization of the right-of-use assets on a straight-line basis and the interest on lease liabilities using the effective interest method over the lease term. +The following table shows the classification and location of our right-of-use assets and lease liabilities on our Consolidated Balance Sheets (in millions): +December 31, +Consolidated Balance Sheets Location 2020 2019 +Right-of-use assets—Operating Operating lease assets, net $ 759 $ 439 +Right-of-use assets—Financing Property, plant and equipment, net 53 56 +Total right-of-use assets $ 812 $ 495 +Current operating lease liabilities Current operating lease liabilities $ 161 $ 236 +Current finance lease liabilities Other current liabilities 2 1 +Non-current operating lease liabilities Non-current operating lease liabilities 597 189 +Non-current finance lease liabilities Non-current finance lease liabilities 57 58 +Total lease liabilities $ 817 $ 484 +The following table shows the classification and location of our lease costs on our Consolidated Statements of Operations (in millions): +Consolidated Statements of Operations Location Year Ended December 31, +2020 2019 +Operating lease cost (a) Operating costs and expenses (1) $ 432 $ 612 +Finance lease cost: +Amortization of right-of-use assets Depreciation and amortization expense 2 3 +Interest on lease liabilities Interest expense, net of capitalized interest 7 10 +Total lease cost $ 441 $ 625 +(a) Included in operating lease cost: +Short-term lease costs $ 93 $ 230 +Variable lease costs paid to the lessor 16 7 +(1) Presented in cost of sales, operating and maintenance expense or selling, general and administrative expense consistent with the nature of the asset under lease. +During the year ended December 31, 2018, we recognized lease expense for all operating leases of $ 335 million. +101 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Future annual minimum lease payments for operating and finance leases as of December 31, 2020 are as follows (in millions): +Years Ending December 31, Operating Leases (1) Finance Leases +2021 $ 197 $ 10 +2022 156 10 +2023 121 10 +2024 119 10 +2025 96 10 +Thereafter 252 127 +Total lease payments 941 177 +Less: Interest ( 183 ) ( 118 ) +Present value of lease liabilities $ 758 $ 59 +(1) Does not include $ 1.6 billion of legally binding minimum lease payments primarily for vessel charters which were executed as of December 31, 2020 but will commence in future period primarily in the next two years and have fixed minimum lease terms of up to seven years . +The following table shows the weighted-average remaining lease term and the weighted-average discount rate for our operating leases and finance leases: +December 31, 2020 December 31, 2019 +Operating Leases Finance Leases Operating Leases Finance Leases +Weighted-average remaining lease term (in years) 8.2 17.7 8.4 18.7 +Weighted-average discount rate (1) 5.4 % 16.2 % 5.2 % 16.2 % +(1) The finance leases commenced prior to the adoption of the current leasing standard under GAAP. In accordance with previous accounting guidance, the implied rate is based on the fair value of the underlying assets. +The following table includes other quantitative information for our operating and finance leases (in millions): +Year Ended December 31, +2020 2019 +Cash paid for amounts included in the measurement of lease liabilities: +Operating cash flows from operating leases $ 309 $ 389 +Operating cash flows from finance leases 10 9 +Right-of-use assets obtained in exchange for new operating lease liabilities 615 235 +LNG Vessel Subcharters +From time to time, we sublease certain LNG vessels under charter to third parties while retaining our existing obligation to the original lessor. As of December 31, 2020 and 2019, we had zero and $ 9 million in future minimum sublease payments to be received from LNG vessel subcharters, respectively. The following table shows the sublease income recognized in other revenues on our Consolidated Statements of Operations (in millions): +Year Ended December 31, +2020 2019 +Fixed Income $ 68 $ 122 +Variable Income 27 22 +Total sublease income $ 95 $ 144 +102 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 13— REVENUES FROM CONTRACTS WITH CUSTOMERS +The following table represents a disaggregation of revenue earned from contracts with customers during the years ended December 31, 2020, 2019 and 2018 (in millions): +Year Ended December 31, +2020 2019 2018 +LNG revenues (1) $ 8,954 $ 8,817 $ 7,581 +Regasification revenues 269 266 261 +Other revenues 70 74 54 +Total revenues from customers 9,293 9,157 7,896 +Net derivative gain (loss) (2) ( 30 ) 429 ( 9 ) +Other (3) 95 144 100 +Total revenues $ 9,358 $ 9,730 $ 7,987 +(1) LNG revenues include revenues for LNG cargoes in which our customers exercised their contractual right to not take delivery but remained obligated to pay fixed fees irrespective of such election. During the year ended December 31, 2020, we recognized $ 969 million in LNG revenues associated with LNG cargoes for which customers notified us that they would not take delivery, of which $ 38 million would have been recognized subsequent to December 31, 2020, if the cargoes were lifted pursuant to the delivery schedules with the customers. Revenue is generally recognized upon receipt of irrevocable notice that a customer will not take delivery because our customers have no contractual right to take delivery of such LNG cargo in future periods and our performance obligations with respect to such LNG cargo have been satisfied. +(2) See Note 7 —Derivative Instruments for additional information about our derivatives. +(3) Includes revenues from LNG vessel subcharters. See Note 1 2 —Leases for additional information about our subleases. +LNG Revenues +We have entered into numerous SPAs with third party customers for the sale of LNG on a free on board (“FOB”) (delivered to the customer at either the Sabine Pass or Corpus Christi LNG terminal) or delivered at terminal (“DAT”) (delivered to the customer at their LNG receiving terminal) basis. Our customers generally purchase LNG for a price consisting of a fixed fee per MMBtu of LNG (a portion of which is subject to annual adjustment for inflation) plus a variable fee per MMBtu of LNG equal to approximately 115 % of Henry Hub. The fixed fee component is the amount payable to us regardless of a cancellation or suspension of LNG cargo deliveries by the customers. The variable fee component is the amount generally payable to us only upon delivery of LNG plus all future adjustments to the fixed fee for inflation. The SPAs and contracted volumes to be made available under the SPAs are not tied to a specific Train; however, the term of each SPA generally commences upon the date of first commercial delivery of a specified Train. +We intend to primarily use LNG sourced from our Sabine Pass or Corpus Christi terminals to provide contracted volumes to our customers. However, we supplement this LNG with volumes procured from third parties. LNG revenues recognized from LNG that was procured from third parties was $ 414 million, $ 268 million and $ 745 million for the years ended December 31, 2020, 2019 and 2018, respectively. +Revenues from the sale of LNG are recognized at a point in time when the LNG is delivered to the customer, either at the Sabine Pass or Corpus Christi LNG terminal or at the customer’s LNG receiving terminal, based on the terms of the contract, which is the point legal title, physical possession and the risks and rewards of ownership transfer to the customer. Each individual molecule of LNG is viewed as a separate performance obligation. The stated contract price (including both fixed and variable fees) per MMBtu in each LNG sales arrangement is representative of the stand-alone selling price for LNG at the time the contract was negotiated. We have concluded that the variable fees meet the exception for allocating variable consideration to specific parts of the contract. As such, the variable consideration for these contracts is allocated to each distinct molecule of LNG and recognized when that distinct molecule of LNG is delivered to the customer. Because of the use of the exception, variable consideration related to the sale of LNG is also not included in the transaction price. +When we sell LNG on a DAT basis, we consider all transportation costs, including vessel chartering, loading/unloading and canal fees, as fulfillment costs and not as separate services provided to the customer within the arrangement, regardless of +103 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +whether or not such activities occur prior to or after the customer obtains control of the LNG. We expense fulfillment costs as incurred unless otherwise dictated by GAAP. +Fees received pursuant to SPAs are recognized as LNG revenues only after substantial completion of the respective Train. Prior to substantial completion, sales generated during the commissioning phase are offset against the cost of construction for the respective Train, as the production and removal of LNG from storage is necessary to test the facility and bring the asset to the condition necessary for its intended use. +Regasification Revenues +The Sabine Pass LNG terminal has operational regasification capacity of approximately 4 Bcf/d. Approximately 2 Bcf/d of the regasification capacity at the Sabine Pass LNG terminal has been reserved under two long-term TUAs with unaffiliated third-party customers, under which they are required to pay fixed monthly fees regardless of their use of the LNG terminal. Each of the customers has reserved approximately 1 Bcf/d of regasification capacity. The customers are each obligated to make monthly capacity payments to SPLNG aggregating approximately $ 125 million annually for 20 years that commenced in 2009, which is representative of fixed consideration in the contract. A portion of this fee is adjusted annually for inflation which is considered variable consideration. The remaining capacity of the Sabine Pass LNG terminal has been reserved by SPL, for which the associated revenues are eliminated in consolidation. +Because SPLNG is continuously available to provide regasification service on a daily basis with the same pattern of transfer, we have concluded that SPLNG provides a single performance obligation to its customers on a continuous basis over time. We have determined that an output method of recognition based on elapsed time best reflects the benefits of this service to the customer and accordingly, LNG regasification capacity reservation fees are recognized as regasification revenues on a straight-line basis over the term of the respective TUAs. +In 2012, SPL entered into a partial TUA assignment agreement with Total Gas & Power North America, Inc. (“Total”), whereby upon substantial completion of Train 5 of the SPL Project, SPL gained access to substantially all of Total’s capacity and other services provided under Total’s TUA with SPLNG. This agreement provides SPL with additional berthing and storage capacity at the Sabine Pass LNG terminal that may be used to provide increased flexibility in managing LNG cargo loading and unloading activity, permit SPL to more flexibly manage its LNG storage capacity and accommodate the development of Train 6. Notwithstanding any arrangements between Total and SPL, payments required to be made by Total to SPLNG will continue to be made by Total to SPLNG in accordance with its TUA and we continue to recognize the payments received from Total as revenue. During the years ended December 31, 2020, 2019 and 2018, SPL recorded $ 129 million, $ 104 million and $ 30 million, respectively, as operating and maintenance expense under this partial TUA assignment agreement. +Contract Assets and Liabilities +The following table shows our contract assets, net, which are classified as other non-current assets, net on our Consolidated Balance Sheets (in millions): +December 31, +2020 2019 +Contract assets, net $ 80 $ 18 +Contract assets represent our right to consideration for transferring goods or services to the customer under the terms of a sales contract when the associated consideration is not yet due. Changes in contract assets during the year ended December 31, 2020 were primarily attributable to revenue recognized due to the delivery of LNG under certain SPAs for which the associated consideration was not yet due. +104 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +The following table reflects the changes in our contract liabilities, which we classify as deferred revenue on our Consolidated Balance Sheets (in millions): +Year Ended December 31, 2020 +Deferred revenues, beginning of period $ 161 +Cash received but not yet recognized 138 +Revenue recognized from prior period deferral ( 161 ) +Deferred revenues, end of period $ 138 +We record deferred revenue when we receive consideration, or such consideration is unconditionally due from a customer, prior to transferring goods or services to the customer under the terms of a sales contract. Changes in deferred revenue during the years ended December 31, 2020 and 2019 are primarily attributable to differences between the timing of revenue recognition and the receipt of advance payments related to delivery of LNG under certain SPAs. +Transaction Price Allocated to Future Performance Obligations +Because many of our sales contracts have long-term durations, we are contractually entitled to significant future consideration which we have not yet recognized as revenue. The following table discloses the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of December 31, 2020 and 2019: +December 31, 2020 December 31, 2019 +Unsatisfied Transaction Price (in billions) Weighted Average Recognition Timing (years) (1) Unsatisfied Transaction Price (in billions) Weighted Average Recognition Timing (years) (1) +LNG revenues $ 102.3 10 $ 106.4 11 +Regasification revenues 2.1 5 2.4 5 +Total revenues $ 104.4 $ 108.8 +(1) The weighted average recognition timing represents an estimate of the number of years during which we shall have recognized half of the unsatisfied transaction price. +We have elected the following exemptions which omit certain potential future sources of revenue from the table above: +(1) We omit from the table above all performance obligations that are part of a contract that has an original expected duration of one year or less. +(2) The table above excludes substantially all variable consideration under our SPAs and TUAs. We omit from the table above all variable consideration that is allocated entirely to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise to transfer a distinct good or service that forms part of a single performance obligation when that performance obligation qualifies as a series. The amount of revenue from variable fees that is not included in the transaction price will vary based on the future prices of Henry Hub throughout the contract terms, to the extent customers elect to take delivery of their LNG, and adjustments to the consumer price index. Certain of our contracts contain additional variable consideration based on the outcome of contingent events and the movement of various indexes. We have not included such variable consideration in the transaction price to the extent the consideration is considered constrained due to the uncertainty of ultimate pricing and receipt. Approximately 40 % and 52 % of our LNG revenues from contracts included in the table above during the years ended December 31, 2020 and 2019, respectively, were related to variable consideration received from customers. During each of the years ended December 31, 2020 and 2019, approximately 3 % of our regasification revenues were related to variable consideration received from customers. +We may enter into contracts to sell LNG that are conditioned upon one or both of the parties achieving certain milestones such as reaching FID on a certain liquefaction Train, obtaining financing or achieving substantial completion of a Train and any related facilities. These contracts are considered completed contracts for revenue recognition purposes and are included in the transaction price above when the conditions are considered probable of being met. +105 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 14— RELATED PARTY TRANSACTIONS +Natural Gas Supply Agreements +SPL and CCL are party to natural gas supply agreements with related parties in the ordinary course of business, to obtain feed gas for the operation of the Liquefaction Projects. +SPL Natural Gas Supply Agreement +The term of the SPL agreement is for five years , which can commence no earlier than November 1, 2021 and no later than November 1, 2022, following the achievement of contractually-defined conditions precedent. As of December 31, 2020, the notional amount for this agreement was 91 TBtu and had a fair value of zero . +CCL Natural Gas Supply Agreement +The term of the CCL agreement extends through March 2022. Under this agreement, CCL recorded $ 13 million and $ 3 million in accrued liabilities, as of December 31, 2020 and 2019, respectively. +The Liquefaction Supply Derivatives related to this agreement are recorded on our Consolidated Balance Sheets as follows (in millions, except notional amount): +December 31, +2020 2019 +Derivative assets $ 3 $ 3 +Non-current derivative assets 1 2 +Notional amount, net (in TBtu) 60 120 +We recorded the following amounts on our Consolidated Statements of Operations during the years ended December 31, 2020, 2019 and 2018 related to this agreement (in millions): +Year Ended December 31, +2020 2019 2018 +Cost of sales (a) $ 114 $ 85 $ — +(a) Included in costs of sales: +Liquefaction Supply Derivative loss +$ ( 1 ) $ ( 1 ) $ — +Natural Gas Transportation and Storage Agreements +SPL is party to various natural gas transportation and storage agreements and CTPL is party to an operational balancing agreement with a related party in the ordinary course of business for the operation of the SPL Project, with initial primary terms of up to 10 years with extension rights. We recorded operating and maintenance expense of $ 13 million in the year ended December 31, 2020 and accrued liabilities of $ 4 million as of December 31, 2020 with this related party. +Operation and Maintenance Service Agreements +Cheniere LNG O&M Services, LLC (“O&M Services”), our wholly owned subsidiary, provides the development, construction, operation and maintenance services to Midship Pipeline pursuant to agreements in which O&M Services receives an agreed upon fee and reimbursement of costs incurred. O&M Services recorded $ 9 million, $ 12 million and $ 12 million in the years ended December 31, 2020, 2019 and 2018, respectively, of other revenues and $ 2 million and $ 3 million of accounts receivable as of December 31, 2020 and 2019, respectively, for services provided to Midship Pipeline under these agreements. +106 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 15— INCOME TAXES +The jurisdictional components of income before income taxes and non-controlling interest on our Consolidated Statements of Operations for the years ended December 31, 2020, 2019 and 2018 are as follows (in millions): +Year Ended December 31, +2020 2019 2018 +U.S. $ 720 $ 289 $ 997 +International ( 176 ) 426 230 +Total income before income taxes and non-controlling interest $ 544 $ 715 $ 1,227 +Income tax provision (benefit) included in our reported net income consisted of the following (in millions): +Year Ended December 31, +2020 2019 2018 +Current: +Federal $ — $ — $ — +State — — 2 +Foreign — 4 30 +Total current — 4 32 +Deferred: +Federal 41 ( 475 ) — +State 2 ( 46 ) — +Foreign — — ( 5 ) +Total deferred 43 ( 521 ) ( 5 ) +Total income tax provision (benefit) $ 43 $ ( 517 ) $ 27 +Our income tax rates do not bear a customary relationship to statutory income tax rates. A reconciliation of the federal statutory income tax rate of 21% to our effective income tax rate is as follows: +Year Ended December 31, +2020 2019 2018 +U.S. federal statutory tax rate 21.0 % 21.0 % 21.0 % +Non-controlling interest ( 22.6 ) % ( 17.2 ) % ( 11.4 ) % +State tax rate — % ( 5.4 ) % ( 0.4 ) % +Executive compensation 1.4 % 1.3 % 0.5 % +Nondeductible interest expense 8.0 % 5.0 % 2.6 % +Foreign earnings taxed in the U.S. 1.2 % 6.7 % 1.4 % +Foreign rate differential ( 3.7 ) % ( 11.4 ) % ( 1.1 ) % +Tax credits ( 4.5 ) % ( 5.2 ) % ( 0.6 ) % +Internal restructuring 7.0 % — % — % +Other 1.0 % 1.4 % — % +Valuation allowance ( 0.9 ) % ( 68.5 ) % ( 9.8 ) % +Effective tax rate 7.9 % ( 72.3 ) % 2.2 % +107 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Significant components of our deferred tax assets and liabilities at December 31, 2020 and 2019 are as follows (in millions): +December 31, +2020 2019 +Deferred tax assets +Net operating loss carryforwards and credits +Federal $ 3,084 $ 2,860 +Foreign 3 5 +State 257 249 +Federal and state tax credits 95 64 +Disallowed business interest expense carryforward — 154 +Other 290 143 +Less: valuation allowance ( 190 ) ( 196 ) +Total deferred tax assets 3,539 3,279 +Deferred tax liabilities +Investment in partnerships ( 765 ) ( 554 ) +Property, plant and equipment ( 2,089 ) ( 2,110 ) +Other ( 196 ) ( 86 ) +Total deferred tax liabilities ( 3,050 ) ( 2,750 ) +Net deferred tax assets $ 489 $ 529 +Business interest expense carryforward +On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act (“the CARES Act”) was signed into law which provided numerous tax changes in response to the COVID-19 pandemic. In general, the CARES Act was favorable to us because it increased the interest deductibility limit from 30 % to 50 % of adjusted taxable income in 2019 and 2020. +On September 14, 2020, the U.S Department of Treasury issued final and proposed regulations providing guidance on the business interest expense limitation under Section 163(j) of the Internal Revenue Code. In general, the regulations were favorable to us because they allow depreciation capitalized to inventory to be added back to adjusted taxable income from 2018 through 2021, for purposes of computing the allowable interest expense deduction. As permitted under the regulations, we intend to adopt them retroactively beginning with the tax year ended December 31, 2018. +The favorable changes brought about by the CARES Act and the final and proposed interest expense regulations allow us to fully deduct our current year business interest expense and all of our previously disallowed business interest expense carryforward. +Internal Restructuring +On March 31, 2020 we executed an internal restructuring which simplified our legal entity structure, causing foreign income to flow directly to our U.S. tax return. As a result of the internal restructuring, a one-time $ 38 million deferred tax expense was recorded discretely during the first quarter of 2020. +Valuation Allowance +For the period ended December 31, 2020, we have provided a valuation allowance of approximately $ 190 million on certain state NOLs and federal capital loss carryforwards, for which we believe are more likely than not to expire before realization of the benefit. Our valuation allowance decreased by $ 6 million for the year ended December 31, 2020. +For the period ended December 31, 2019, we weighed all of the positive and negative evidence, and determined that sufficient positive evidence existed to support releasing the valuation allowance against substantially all of our federal deferred tax assets and a portion of our state deferred tax assets. The positive evidence supporting such conclusion included successful completion and subsequent operations of Trains 1 and 2 of the CCL Project and Train 5 of the SPL Project, transitioning from a +108 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +three -year cumulative loss position in 2018 to a three -year cumulative income position in 2019, commencing commercial delivery on 13 of our long-term customer SPAs and forecasts of sustained future profitability. +NOL and tax credit carryforwards +At December 31, 2020, we had federal and state NOL carryforwards of approximately $ 15.0 billion and $ 3.2 billion, respectively. Approximately $ 10.6 billion of these NOLs have an indefinite carryforward period. All other NOLs will expire between 2026 and 2040. +At December 31, 2020, we had federal and state tax credit carryforwards of $ 93 million and $ 2 million, respectively. The federal tax credit carryforwards include investment tax credit carryforwards of $ 52 million related to capital equipment placed in service at our Liquefaction Projects. We account for our federal investment tax credits under the flow-through method. The federal tax credit carryforwards also include $ 37 million of foreign tax credits related to tax years 2014 through 2020. The federal and state tax credit carryforwards will expire between 2024 and 2039. +We experienced an ownership change within the provisions of U.S. IRC Section 382 in 2008, 2010 and 2012. An analysis of the annual limitation on the utilization of our NOLs was performed in accordance with IRC Section 382. It was determined that IRC Section 382 will not limit the use of our NOLs over the carryover period. We continue to monitor trading activity in our shares which may cause an additional ownership change which could ultimately affect our ability to fully utilize our existing NOL carryforwards. +Income Tax Audits +We are subject to tax in the U.S. and various state and foreign jurisdictions and we remain subject to periodic audits and reviews by taxing authorities. Federal and state tax returns for the years after 2016 remain open for examination. Tax authorities may have the ability to review and adjust carryover attributes that were generated prior to these periods if utilized in an open tax year. +Unrecognized Tax Benefits +At December 31, 2020, we had unrecognized tax benefits of $ 62 million. If recognized, $ 53 million of unrecognized tax benefits would affect our effective tax rate in future periods. Currently, we do not recognize any accrued liabilities, interest and penalties associated with the unrecognized tax benefits provided in our Consolidated Statements of Operations or our Consolidated Balance Sheets because any settlement of uncertain tax positions would result in an adjustment to our NOL carryforward. We recognize interest and penalties related to income tax matters as part of income tax expense. +A reconciliation of the beginning and ending amounts of our unrecognized tax benefits for the years ended December 31, 2020 and 2019, is as follows (in millions): +Year Ended December 31, +2020 2019 +Balance at beginning of the year $ 61 $ 61 +Additions based on tax positions related to current year 1 — +Additions for tax positions of prior years — — +Reductions for tax positions of prior years — — +Settlements — — +U.S. tax reform rate change — — +Balance at end of the year $ 62 $ 61 +NOTE 16— SHARE-BASED COMPENSATION +We have granted restricted stock shares, restricted stock units, performance stock units and phantom units to employees and non-employee directors under the 2011 Incentive Plan, as amended (the “2011 Plan”) and the 2020 Incentive Plan, which was approved by our shareholders in May 2020. The 2011 Plan and the 2020 Incentive Plan provide for the issuance of +109 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +35.0 million shares and 8.0 million shares, respectively, of our common stock that may be in the form of various share-based performance awards deemed by the Compensation Committee of our Board (the “Compensation Committee”). +Total share-based compensation consisted of the following (in millions): +Year Ended December 31, +2020 2019 2018 +Share-based compensation costs, pre-tax: +Equity awards $ 114 $ 131 $ 89 +Liability awards 2 9 48 +Total share-based compensation 116 140 137 +Capitalized share-based compensation ( 6 ) ( 9 ) ( 24 ) +Total share-based compensation expense $ 110 $ 131 $ 113 +Tax benefit associated with share-based compensation expense $ 23 $ 14 $ 6 +The total unrecognized compensation cost at December 31, 2020 relating to non-vested share-based compensation arrangements consisted of the following: +Unrecognized Compensation Cost +(in millions) Recognized over a weighted average period +(years) +Restricted Stock Share Awards $ 1 0.3 +Restricted Stock Unit and Performance Stock Unit Awards $ 111 1.3 +Phantom Units Awards $ — 0.2 +Restricted Stock Share Awards +Restricted stock share awards are awards of common stock that are subject to restrictions on transfer and to a risk of forfeiture if the recipient terminates employment with us prior to the lapse of the restrictions. These awards vest based on service conditions ( one , two , three or four -year service periods) and performance conditions. All performance conditions of the awards have been achieved as of December 31, 2020. +The table below provides a summary of our restricted stock outstanding (in millions, except for per share information): +Shares Weighted Average Grant Date Fair Value Per Share +Non-vested at January 1, 2020 +0.0 $ 67.79 +Granted 0.1 41.78 +Vested 0.0 — +Forfeited 0.0 — +Non-vested at December 31, 2020 +0.1 $ 41.78 +The fair value of restricted stock share awards vested for the years ended December 31, 2020, 2019 and 2018 were $ 3 million, $ 3 million and $ 53 million, respectively. +Restricted Stock Unit and Performance Stock Unit Awards +Restricted stock units are stock awards that vest over a service period of three years and entitle the holder to receive shares of our common stock upon vesting, subject to restrictions on transfer and to a risk of forfeiture if the recipient terminates employment with us prior to the lapse of the restrictions. Performance stock units provide for cliff vesting after a period of three years with payouts based on metrics dependent upon market and performance achieved over the defined performance period compared to pre-established performance targets. The settlement amounts of the awards are based on market and performance metrics which include cumulative distributable cash flow per share, and in certain circumstances, absolute total shareholder return (“ATSR”) of our common stock. Where applicable, the compensation for performance stock units is based on fair value assigned to the market metric of ATSR using a Monte Carlo model upon grant, which remains constant through the vesting period, and a performance metric, which will vary due to changing estimates regarding the expected achievement of the performance metric of cumulative distributable cash flow per share. The number of shares that may be earned at the end of +110 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +the vesting period ranges from 0 % up to 300 % of the target award amount. Both restricted stock units and performance stock units will be settled in Cheniere common stock (on a one-for-one basis) and are classified as equity awards. +The table below provides a summary of our restricted share unit and performance stock unit awards outstanding assuming payout at target for awards containing performance conditions (in millions, except for per unit information): +Units Weighted Average Grant Date Fair Value Per Unit +Non-vested at January 1, 2020 +4.4 $ 61.68 +Granted (1) 1.8 53.88 +Vested ( 2.3 ) 58.49 +Forfeited ( 0.2 ) 58.83 +Non-vested at December 31, 2020 (2) +3.7 $ 60.00 +(1) This number includes 0.2 million incremental shares of our common stock that were issued based on performance results from previously-granted performance stock unit awards. +(2) This number excludes 1.0 million performance stock units, which represent the incremental number of common units that would be issued if the maximum level of performance under the target awards amount is achieved. +The table below provides a summary of restricted share unit and performance stock unit awards issued and fair value of units vested: +Year Ended December 31, +2020 2019 2018 +Units issued (in millions) 1.8 1.9 2.6 +Weighted average grant date fair value per unit $ 53.88 $ 67.47 $ 59.50 +Fair value of units vested (in millions) $ 137 $ 45 $ 22 +Phantom Units Awards +Phantom units are share-based awards granted to employees over a vesting period that entitle the grantee to receive the cash equivalent to the value of a share of our common stock upon each vesting. We did no t issue any phantom units to our employees and non-employee directors during the years ended December 31, 2020, 2019 and 2018. Phantom units are not eligible to receive quarterly distributions. These awards vest based on service conditions ( two , three or four -year service periods). +The table below provides a summary of our phantom units outstanding (in millions): +Units +Non-vested at January 1, 2020 +0.1 +Granted — +Vested ( 0.1 ) +Forfeited 0.0 +Non-vested at December 31, 2020 +0.0 +The value of phantom units vested during the years ended December 31, 2020, 2019 and 2018 was $ 4 million, $ 11 million and $ 91 million, respectively. +NOTE 17— EMPLOYEE BENEFIT PLAN +We have a defined contribution plan (“401(k) Plan”) which allows eligible employees to contribute up to 75 % of their compensation up to the IRS maximum. We match each employee’s deferrals (contributions) up to 6 % of compensation and may make additional contributions at our discretion. Employees are immediately vested in the contributions made by us. Our contributions to the 401(k) Plan were $ 15 million for each of the years ended December 31, 2020 and 2019 and $ 9 million for the year ended December 31, 2018. We have made no discretionary contributions to the 401(k) Plan to date. +111 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 18— NET INCOME (LOSS) PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS +The following table reconciles basic and diluted weighted average common shares outstanding for the years ended December 31, 2020, 2019 and 2018 (in millions, except per share data): +Year Ended December 31, +2020 2019 2018 +Weighted average common shares outstanding: +Basic 252.4 256.2 245.6 +Dilutive unvested stock — 1.9 2.4 +Diluted 252.4 258.1 248.0 +Basic net income (loss) per share attributable to common stockholders $ ( 0.34 ) $ 2.53 $ 1.92 +Diluted net income (loss) per share attributable to common stockholders $ ( 0.34 ) $ 2.51 $ 1.90 +Potentially dilutive securities that were not included in the diluted net income (loss) per share computations because their effects would have been anti-dilutive were as follows (in millions): +Year Ended December 31, +2020 2019 2018 +Unvested stock (1) 3.4 2.3 0.8 +Convertible notes +2021 Cheniere Convertible Unsecured Notes (2) — 13.7 13.0 +2025 CCH HoldCo II Convertible Senior Notes (3) — 25.5 — +2045 Cheniere Convertible Senior Notes 4.5 4.5 4.5 +Total potentially dilutive common shares 7.9 46.0 18.3 +(1) Does not include 0.5 million shares, 0.5 million shares and 0.4 million shares for the years ended December 31, 2020, 2019 and 2018, respectively, of unvested stock because the performance conditions had not yet been satisfied as of the respective dates. +(2) Since we have the intent and ability to settle the remaining outstanding principal amount of the 2021 Cheniere Convertible Unsecured Notes in cash and the excess conversion premium (the “conversion spread”) in either cash or shares, the treasury stock method was applied for calculating any potential dilutive effect of the conversion spread on net income per share for the year ended December 31, 2020. However, since the average market price of our common stock did not exceed the conversion price of our 2021 Cheniere Convertible Unsecured Notes, the conversion spread was excluded from the computation of diluted net income per share for the year ended December 31, 2020. +(3) Since we redeemed the remaining principal amount of the 2025 CCH HoldCo II Convertible Senior Notes and the related premium in cash, as described in Note 1 1 —Debt , the 2025 CCH HoldCo II Convertible Senior Notes were not included in the computation of net income per share for the year ended December 31, 2020. There were no shares related to the conversion of the 2025 CCH HoldCo II Convertible Senior Notes included in the computation of diluted net income per share for the year ended December 31, 2018, because the substantive non-market based contingencies underlying the eligible conversion date were not met as of December 31, 2018 . +NOTE 19— SHARE REPURCHASE PROGRAM +On June 3, 2019, we announced that our Board of Directors (“Board”) authorized a 3 -year, $ 1.0 billion share repurchase program. The following table presents information with respect to repurchases of common stock during the years ended December 31, 2020 and 2019: +Year Ended December 31, +2020 2019 +Aggregate common stock repurchased 2,875,376 4,000,424 +Weighted average price paid per share $ 53.88 $ 62.27 +Total amount paid (in millions) $ 155 $ 249 +112 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +As of December 31, 2020, we had up to $ 596 million of the share repurchase program available. Under the share repurchase program, repurchases can be made from time to time using a variety of methods, which may include open market purchases, privately negotiated transactions or otherwise, all in accordance with the rules of the SEC and other applicable legal requirements. The timing and amount of any shares of our common stock that are repurchased under the share repurchase program will be determined by our management based on market conditions and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and may be modified, suspended or discontinued at any time or from time to time at our discretion. +NOTE 20— COMMITMENTS AND CONTINGENCIES +We have various contractual obligations which are recorded as liabilities in our Consolidated Financial Statements. Other items, such as certain purchase commitments and other executed contracts which do not meet the definition of a liability as of December 31, 2020, are not recognized as liabilities but require disclosures in our Consolidated Financial Statements. +LNG Terminal Commitments and Contingencies +Obligations under EPC Contracts +SPL has a lump sum turnkey contract with Bechtel Oil, Gas and Chemicals, Inc. (“Bechtel”) for the engineering, procurement and construction of Train 6 of the SPL Project. The EPC contract price for Train 6 of the SPL Project is approximately $ 2.5 billion, reflecting amounts incurred under change orders through December 31, 2020, and including estimated costs for the third marine berth that is currently under construction. As of December 31, 2020, we have incurred $ 1.9 billion under this contract. +CCL has a lump sum turnkey contract with Bechtel for the engineering, procurement and construction of Train 3 of the CCL Project. The EPC contract price for Train 3 of the CCL Project is approximately $ 2.4 billion, reflecting amounts incurred under change orders through December 31, 2020. As of December 31, 2020, we have incurred $ 2.4 billion under this contract. +SPL and CCL have the right to terminate its respective EPC contracts for its convenience, in which case Bechtel will be paid (1) the portion of the contract price for the work performed, (2) costs reasonably incurred by Bechtel on account of such termination and demobilization and (3) a lump sum of up to $ 30 million depending on the termination date. +Obligations under SPAs +SPL and CCL have third-party SPAs which obligate SPL and CCL, respectively, to purchase and liquefy sufficient quantities of natural gas to deliver contracted volumes of LNG to the customers’ vessels, subject to completion of construction of applicable specified Trains of the SPL Project or the CCL Project. In addition, our integrated marketing function has third-party SPAs which obligate us to deliver contracted volumes of LNG to the customers’ vessels or to the customers at their LNG receiving terminals. +Obligations under LNG TUAs +SPLNG has third-party TUAs with Total and Chevron U.S.A. Inc. to provide berthing for LNG vessels and for the unloading, storage and regasification of LNG at the Sabine Pass LNG terminal. +Obligations under Natural Gas Supply, Transportation and Storage Service Agreements +SPL, CCL and CCL Stage III have physical natural gas supply contracts to secure natural gas feedstock for the SPL Project, the CCL Project and potential future development of Corpus Christi Stage 3, respectively. The remaining terms of these contracts range up to 15 years, some of which commence upon the satisfaction of certain events or states of affairs. As of December 31, 2020, SPL, CCL and CCL Stage III have secured up to approximately 4,950 TBtu, 2,938 TBtu and 2,361 TBtu, respectively, of natural gas feedstock through natural gas supply contracts, a portion of which are considered purchase obligations if the certain events or states of affairs are satisfied. +113 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +Additionally, SPL and CCL have natural gas transportation and storage service agreements for the SPL Project and the CCL Project, respectively. The initial terms of the natural gas transportation agreements range up to 20 years for the SPL Project and the CCL Project, with renewal options for certain contracts, and commence upon the occurrence of conditions precedent. The initial term of the natural gas storage service agreements for the SPL Project ranges up to 10 years and the initial term of the natural gas storage service agreements for the CCL Project ranges up to 5 years. +As of December 31, 2020, the obligations of SPL, CCL and CCL Stage III under natural gas supply, transportation and storage service agreements for contracts in which conditions precedent were met were as follows (in millions): +Years Ending December 31, Payments Due (1) +2021 $ 4,477 +2022 2,567 +2023 1,861 +2024 1,367 +2025 1,140 +Thereafter 4,005 +Total $ 15,417 +(1) Pricing of natural gas supply contracts are variable based on market commodity basis prices adjusted for basis spread . Amounts included are based on estimated forward prices and basis spreads as of December 31, 2020. Some of our contracts may not have been negotiated as part of arranging financing for the underlying assets providing the natural gas supply, transportation and storage services. +Restricted Net Assets +At December 31, 2020, our restricted net assets of consolidated subsidiaries were approximately $ 3.0 billion. +Other Commitments +In the ordinary course of business, we have entered into certain multi-year licensing and service agreements, none of which are considered material to our financial position. +Environmental and Regulatory Matters +Our LNG terminals and pipelines are subject to extensive regulation under federal, state and local statutes, rules, regulations and laws. These laws require that we engage in consultations with appropriate federal and state agencies and that we obtain and maintain applicable permits and other authorizations. Failure to comply with such laws could result in legal proceedings, which may include substantial penalties. We believe that, based on currently known information, compliance with these laws and regulations will not have a material adverse effect on our results of operations, financial condition or cash flows. +Legal Proceedings +We are, and may in the future be, involved as a party to various legal proceedings, which are incidental to the ordinary course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities on the eventual disposition of these matters. While the results of these litigation matters and claims cannot be predicted with certainty, we believe the reasonably possible losses from such matters, individually and in the aggregate, are not material. Additionally, we believe the probable final outcome of such matters will not have a material adverse effect on our consolidated results of operations, financial position or cash flows. +114 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 21— CUSTOMER CONCENTRATION +The following table shows customers with revenues of 10% or greater of total revenues from external customers and customers with accounts receivable, net and contract assets, net balances of 10% or greater of total accounts receivable, net and contract assets, net from external customers: +Percentage of Total Revenues from External Customers Percentage of Accounts Receivable, Net and Contract Assets, Net from External Customers +Year Ended December 31, December 31, +2020 2019 2018 2020 2019 +Customer A 14 % 16 % 18 % 14 % 13 % +Customer B 12 % 10 % 14 % 12 % * +Customer C 10 % 11 % 19 % * 13 % +Customer D 10 % 11 % 13 % * * +* Less than 10% +The following table shows revenues from external customers attributable to the country in which the revenues were derived (in millions). We attribute revenues from external customers to the country in which the party to the applicable agreement has its principal place of business. Substantially all of our long-lived assets are located in the United States. +Revenues from External Customers +Year Ended December 31, +2020 2019 2018 +Ireland $ 1,130 $ 989 $ 1,098 +Spain 1,034 598 — +India 1,021 1,160 1,048 +South Korea 942 1,207 1,517 +United States 687 2,807 1,911 +United Kingdom 678 559 155 +Singapore 646 533 417 +Other countries 3,220 1,877 1,841 +Total $ 9,358 $ 9,730 $ 7,987 +NOTE 22— SUPPLEMENTAL CASH FLOW INFORMATION +The following table provides supplemental disclosure of cash flow information (in millions): +Year Ended December 31, +2020 2019 2018 +Cash paid during the period for interest on debt, net of amounts capitalized $ 1,395 $ 1,126 $ 707 +Cash paid for income taxes 2 24 14 +Non-cash investing and financing activities: +Acquisition of non-controlling interest in Cheniere Holdings — — 702 +Acquisition of assets under capital lease (1) — — 60 +(1) See Note 12— Leases for our supplemental cash flow information related to our leases in 2019 following the adoption of ASC 842. +The balance in property, plant and equipment, net funded with accounts payable and accrued liabilities was $ 282 million, $ 473 million and $ 420 million as of December 31, 2020, 2019 and 2018, respectively. +115 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED +NOTE 23— SUBSEQUENT EVENTS +In February 2021, SPL entered into a note purchase agreement for the sale of approximately $ 147 million aggregate principal amount of 2.95 % Senior Secured Notes due 2037 (the “2.95% SPL 2037 Senior Secured Notes”) on a private placement basis. The 2.95% SPL 2037 Senior Secured Notes are expected to be issued in December 2021, and the net proceeds are expected to be used to refinance a portion of SPL’s outstanding Senior Secured Notes due 2022. The 2.95% SPL 2037 Senior Secured Notes will be fully amortizing, with a weighted average life of over 10 years. +116 +CHENIERE ENERGY, INC. AND SUBSIDIARIES +SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS +SUMMARIZED QUARTERLY FINANCIAL DATA +(unaudited) +Summarized Quarterly Financial Data—(in millions, except per share amounts) +First +Quarter Second +Quarter Third +Quarter Fourth +Quarter +Year Ended December 31, 2020: +Revenues $ 2,709 $ 2,402 $ 1,460 $ 2,787 +Income from operations 1,346 937 72 276 +Net income (loss) 603 404 ( 508 ) 2 +Net income (loss) attributable to common stockholders 375 197 ( 463 ) ( 194 ) +Net income (loss) per share attributable to common stockholders—basic (1) 1.48 0.78 ( 1.84 ) ( 0.77 ) +Net income (loss) per share attributable to common stockholders—diluted (1) 1.43 0.78 ( 1.84 ) ( 0.77 ) +Year Ended December 31, 2019: +Revenues $ 2,261 $ 2,292 $ 2,170 $ 3,007 +Income from operations 606 432 307 1,016 +Net income (loss) 337 2 ( 260 ) 1,153 +Net income (loss) attributable to common stockholders 141 ( 114 ) ( 318 ) 939 +Net income (loss) per share attributable to common stockholders—basic (1) 0.55 ( 0.44 ) ( 1.25 ) 3.70 +Net income (loss) per share attributable to common stockholders—diluted (1) 0.54 ( 0.44 ) ( 1.25 ) 3.34 +(1) The sum of the quarterly net income (loss) per share—basic and diluted may not equal the full year amount as the computations of the weighted average common shares outstanding for basic and diluted shares outstanding for each quarter and the full year are performed independently. +117 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +Evaluation of Disclosure Controls and Procedures +Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. +Based on their evaluation as of the end of the fiscal year ended December 31, 2020, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are (1) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and (2) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. +During the most recent fiscal quarter, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +Management’s Report on Internal Control Over Financial Reporting +Our Management’s Report on Internal Control Over Financial Reporting is included in our Consolidated Financial Statements and is incorporated herein by reference. +ITEM 9B. OTHER INFORMATION +None. +PART III +Pursuant to paragraph 3 of General Instruction G to Form 10-K, the information required by Items 10 through 14 of Part III of this Report is incorporated by reference from Cheniere’s definitive proxy statement, which is to be filed pursuant to Regulation 14A within 120 days after the end of Cheniere’s fiscal year ended December 31, 2020. +118 +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +(a) Financial Statements, Schedules and Exhibits +(1) Financial Statements—Cheniere Energy, Inc. and Subsidiaries: +Management’s Report to the Stockholders of Cheniere Energy, Inc. +71 +Reports of Independent Registered Public Accounting Firm +72 +Consolidated Statements of Operations +75 +Consolidated Balance Sheets +76 +Consolidated Statements of Stockholders’ Equity +77 +Consolidated Statements of Cash Flows +78 +Notes to Consolidated Financial Statements +79 +Supplemental Information to Consolidated Financial Statements—Quarterly Financial Data +117 +(2) Financial Statement Schedules: +Schedule I—Condensed Financial Information of Registrant for the years ended December 31, 2020, 2019 and 2018 +133 +Schedule II—Valuation and Qualifying Accounts +141 +(3) Exhibits: +Certain of the agreements filed as exhibits to this Form 10-K contain representations, warranties, covenants and conditions by the parties to the agreements that have been made solely for the benefit of the parties to the agreement. These representations, warranties, covenants and conditions: +• should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate; +• may have been qualified by disclosures that were made to the other parties in connection with the negotiation of the agreements, which disclosures are not necessarily reflected in the agreements; +• may apply standards of materiality that differ from those of a reasonable investor; and +• were made only as of specified dates contained in the agreements and are subject to subsequent developments and changed circumstances. +Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. These agreements are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Investors should not rely on them as statements of fact. +Exhibit No. Incorporated by Reference (1) +Description Entity Form Exhibit Filing Date +2.1 +Amended and Restated Purchase and Sale Agreement, dated as of August 9, 2012, by and among Cheniere Partners, Cheniere Pipeline Company, Grand Cheniere Pipeline, LLC and the Company +Cheniere Partners 8-K 10.2 8/9/2012 +3.1 +Restated Certificate of Incorporation of the Company +Cheniere 10-Q 3.1 8/10/2004 +3.2 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere 8-K 3.1 2/8/2005 +3.3 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere +(SEC File No. 333-160017) +S-8 4.3 6/16/2009 +119 +3.4 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere 8-K 3.1 6/7/2012 +3.5 +Certificate of Amendment of Restated Certificate of Incorporation of the Company +Cheniere 8-K 3.1 2/5/2013 +3.6 +Bylaws of the Company, as amended and restated December 9, 2015 +Cheniere 8-K 3.1 12/15/2015 +3.7 +Amendment No. 1 to the Amended and Restated Bylaws of the Company, dated September 15, 2016 +Cheniere 8-K 3.1 9/19/2016 +4.1 +Specimen Common Stock Certificate of the Company +Cheniere +(SEC File No. 333-10905) +S-1 4.1 8/27/1996 +4.2 +Indenture, dated as of February 1, 2013, by and among SPL, the guarantors that may become party thereto from time to time and The Bank of New York Mellon, as trustee +Cheniere Partners 8-K 4.1 2/4/2013 +4.3 +First Supplemental Indenture, dated as of April 16, 2013, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners 8-K 4.1.1 4/16/2013 +4.4 +Second Supplemental Indenture, dated as of April 16, 2013, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners 8-K 4.1.2 4/16/2013 +4.5 +Form of 5.625% Senior Secured Note due 2023 (Included as Exhibit A-1 to Exhibit 4. 4 above) +Cheniere Partners 8-K 4.1.2 4/16/2013 +4.6 +Third Supplemental Indenture, dated as of November 25, 2013, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners 8-K 4.1 11/25/2013 +4.7 +Form of 6.25% Senior Secured Note due 2022 (Included as Exhibit A-1 to Exhibit 4. 6 above) +Cheniere Partners 8-K 4.1 11/25/2013 +4.8 +Fourth Supplemental Indenture, dated as of May 20, 2014, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners 8-K 4.1 5/22/2014 +4.9 +Form of 5.750% Senior Secured Note due 2024 (Included as Exhibit A-1 to Exhibit 4. 8 above) +Cheniere Partners 8-K 4.1 5/22/2014 +4.10 +Fifth Supplemental Indenture, dated as of May 20, 2014, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners 8-K 4.2 5/22/2014 +4.11 +Form of 5.625% Senior Secured Note due 2023 (Included as Exhibit A-1 to Exhibit 4.1 0 above) +Cheniere Partners 8-K 4.2 5/22/2014 +4.12 +Sixth Supplemental Indenture, dated as of March 3, 2015, between SPL and The Bank of New York Mellon, as Trustee +Cheniere Partners 8-K 4.1 3/3/2015 +4.13 +Form of 5.625% Senior Secured Note due 2025 (Included as Exhibit A-1 to Exhibit 4.1 2 above) +Cheniere Partners 8-K 4.1 3/3/2015 +4.14 +Seventh Supplemental Indenture, dated as of June 14, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 6/14/2016 +4.15 +Form of 5.875% Senior Secured Note due 2026 (Included as Exhibit A-1 to Exhibit 4.1 4 above) +Cheniere Partners 8-K 4.1 6/14/2016 +4.16 +Eighth Supplemental Indenture, dated as of September 19, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 9/23/2016 +4.17 +Ninth Supplemental Indenture, dated as of September 23, 2016, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.2 9/23/2016 +4.18 +Form of 5.00% Senior Secured Note due 2027 (Included as Exhibit A-1 to Exhibit 4.1 7 above) +Cheniere Partners 8-K 4.2 9/23/2016 +4.19 +Tenth Supplemental Indenture, dated as of March 6, 2017, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 3/6/2017 +4.20 +Form of 4.200% Senior Secured Note due 2028 (Included as Exhibit A-1 to Exhibit 4. 19 above) +Cheniere Partners 8-K 4.1 3/6/2017 +4.21 +Eleventh Supplemental Indenture, dated as of May 8, 2020, between SPL and The Bank of New York Mellon, as Trustee under the Indenture +SPL 8-K 4.1 5/8/2020 +4.22 +Form of 4.500% Senior Secured Note due 2030 (Included as Exhibit A-1 to Exhibit 4.2 1 above) +SPL 8-K 4.1 5/8/2020 +120 +4.23 +Indenture, dated as of February 24, 2017, between SPL, the guarantors that may become party thereto from time to time and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 2/27/2017 +4.24 +Form of 5.00% Senior Secured Note due 2037 (Included as Exhibit A-1 to Exhibit 4.2 3 above) +Cheniere Partners 8-K 4.1 2/27/2017 +4.25 +Indenture, dated as of November 28, 2014, by and between the Company, as Issuer, and The Bank of New York Mellon, as Trustee +Cheniere 8-K 4.1 12/2/2014 +4.26 +Form of 4.875% Unsecured PIK Convertible Note due 2021 (Included as Exhibit A to Exhibit 4.2 5 above) +Cheniere 8-K 4.1 12/2/2014 +4.27 +Indenture, dated as of March 9, 2015, between the Company, the Guarantors and The Bank of New York Mellon, as Trustee +Cheniere 8-K 4.1 3/13/2015 +4.28 +First Supplemental Indenture, dated as of March 9, 2015, between the Company, as Issuer, and The Bank of New York Mellon, as Trustee +Cheniere 8-K 4.2 3/13/2015 +4.29 +Form of 4.25% Convertible Senior Note due 2045 (Included as Exhibit A to Exhibit 4.2 8 above) +Cheniere 8-K 4.2 3/13/2015 +4.30 +Indenture, dated as of September 22, 2020, between the Company as issuer, and the Bank of New York Mellon, as trustee +Cheniere 8-K 4.1 9/22/2020 +4.31 +First Supplemental Indenture, dated as of September 22, 2020, between the Company , as issuer, and the Bank of New York Mellon, as trustee +Cheniere 8-K 4.2 9/22/2020 +4.32 +Indenture, dated as of May 18, 2016, among CCH, as Issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee +Cheniere 8-K 4.1 5/18/2016 +4.33 +Form of 7.000% Senior Secured Note due 2024 (Included as Exhibit A-1 to Exhibit 4.3 2 above) +Cheniere 8-K 4.1 5/18/2016 +4.34 +First Supplemental Indenture, dated as of December 9, 2016, among CCH, as Issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee +Cheniere 8-K 4.1 12/9/2016 +4.35 +Form of 5.875% Senior Secured Note due 2025 (Included as Exhibit A-1 to Exhibit 4.3 4 above) +Cheniere 8-K 4.1 12/9/2016 +4.36 +Second Supplemental Indenture, dated as of May 19, 2017, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as trustee +CCH 8-K 4.1 5/19/2017 +4.37 +Form of 5.125% Senior Secured Note due 2027 (Included as Exhibit A-1 to Exhibit 4.3 6 above) +CCH 8-K 4.1 5/19/2017 +4.38 +Third Supplemental Indenture, dated as of September 6, 2019, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as Guarantors, and The Bank of New York Mellon, as Trustee +CCH 8-K 4.1 9/12/2019 +4.39 +Fourth Supplemental Indenture, dated as of November 13, 2019, among CCH, as issuer, CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH 8-K 4.1 11/13/2019 +4.40 +Indenture, dated as of August 20, 2020, among CCH, as issuer, and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH 8-K 4.1 8/21/2020 +4.41 +Indenture, dated as of September 18, 2017, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 9/18/2017 +4.42 +First Supplemental Indenture, dated as of September 18, 2017, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.2 9/18/2017 +4.43 +Form of 5.250% Senior Note due 2025 (Included as Exhibit A-1 to Exhibit 4.4 2 above) +Cheniere Partners 8-K 4.2 9/18/2017 +121 +4.44 +Second Supplemental Indenture, dated as of September 11, 2018, among Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 9/12/2018 +4.45 +Form of 5.625% Senior Note due 2026 (Included as Exhibit A-1 to Exhibit 4.4 4 above) +Cheniere Partners 8-K 4.1 9/12/2018 +4.46 +Third Supplemental Indenture, dated as of September 12, 2019, among Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere Partners 8-K 4.1 9/12/2019 +4.47 +Fourth Supplemental Indenture, dated as of November 5, 2020, between Cheniere Partners, the guarantors party thereto and The Bank of New York Mellon, as Trustee under the Indenture +Cheniere 10-Q 4.4 11/6/2020 +4.48 +Indenture, dated as of September 27, 2019, among CCH, as issuer, and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH 8-K 4.1 9/30/2019 +4.49 +Indenture, dated as of October 17, 2019, among CCH, as issuer, and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and The Bank of New York Mellon, as trustee +CCH 8-K 4.1 10/18/2019 +4.50 +Description of the Registrant’s Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934 +Cheniere 10-K 4.45 2/25/2020 +10.1 +LNG Terminal Use Agreement, dated September 2, 2004, by and between Total LNG USA, Inc. and SPLNG +Cheniere 10-Q 10.1 11/15/2004 +10.2 +Amendment of LNG Terminal Use Agreement, dated January 24, 2005, by and between Total LNG USA, Inc. and SPLNG +Cheniere 10-K 10.40 3/10/2005 +10.3 +Amendment of LNG Terminal Use Agreement, dated June 15, 2010, by and between Total Gas & Power North America, Inc. and SPLNG +Cheniere 10-Q 10.2 8/6/2010 +10.4 +Omnibus Agreement, dated September 2, 2004, by and between Total LNG USA, Inc. and SPLNG +Cheniere 10-Q 10.2 11/15/2004 +10.5 +Parent Guarantee, dated as of November 5, 2004, by Total S.A. in favor of SPLNG +Cheniere 10-Q 10.3 11/15/2004 +10.6 +Letter Agreement, dated September 11, 2012, between Total Gas & Power North America, Inc. and SPLNG +Cheniere Partners 10-Q 10.1 11/2/2012 +10.7 +LNG Terminal Use Agreement, dated November 8, 2004, between Chevron U.S.A. Inc. and SPLNG +Cheniere 10-Q 10.4 11/15/2004 +10.8 +Amendment to LNG Terminal Use Agreement, dated December 1, 2005, by and between Chevron U.S.A. Inc. and SPLNG +SPLNG S-4 10.28 11/22/2006 +10.9 +Amendment of LNG Terminal Use Agreement, dated June 16, 2010, by and between Chevron U.S.A. Inc. and SPLNG +Cheniere 10-Q 10.3 8/6/2010 +10.10 +Omnibus Agreement, dated November 8, 2004, between Chevron U.S.A. Inc. and SPLNG +Cheniere 10-Q 10.5 11/15/2004 +10.11 +Guaranty Agreement, dated as of December 15, 2004, from ChevronTexaco Corporation to SPLNG +SPLNG S-4 10.12 11/22/2006 +10.12 +Second Amended and Restated LNG Terminal Use Agreement, dated as of July 31, 2012, between SPL and SPLNG +SPLNG 8-K 10.1 8/6/2012 +10.13 +Letter Agreement, dated May 28, 2013, by and between SPL and SPLNG +SPLNG 10-Q 10.1 8/2/2013 +10.14 +Guarantee Agreement, dated as of July 31, 2012, by Cheniere Partners in favor of SPLNG +SPLNG 8-K 10.2 8/6/2012 +10.15† +Cheniere Energy, Inc. 2011 Incentive Plan (as amended through April 13, 2017) +Cheniere 10-Q 10.1 8/8/2017 +10.16† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (US - New Hire) +Cheniere 8-K 10.13 8/10/2012 +10.17† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2011 Incentive Plan (UK - New Hire) +Cheniere 8-K 10.14 8/10/2012 +10.18† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grades 18-20) +Cheniere 10-K 10.37 2/24/2017 +10.19† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grades 18-20) +Cheniere 10-Q 10.2 5/4/2017 +122 +10.20† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 17) +Cheniere 10-K 10.38 2/24/2017 +10.21† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 17) +Cheniere 10-Q 10.3 5/4/2017 +10.22† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Key Executive Severance Plan) +Cheniere 10-K 10.39 2/24/2017 +10.23† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Severance Pay Plan) +Cheniere 10-K 10.40 2/24/2017 +10.24† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 16 and Below) +Cheniere 10-Q 10.4 5/4/2017 +10.25† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Singapore) (Grade 16 and Below) +Cheniere 10-Q 10.5 5/4/2017 +10.26† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grades 18-20) +Cheniere 10-K 10.41 2/24/2017 +10.27† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grades 18-20) +Cheniere 10-Q 10.7 5/4/2017 +10.28† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 17) +Cheniere 10-K 10.42 2/24/2017 +10.29† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 17) +Cheniere 10-Q 10.8 5/4/2017 +10.30† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Key Executive Severance Plan) +Cheniere 10-K 10.43 2/24/2017 +10.31† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (Grade 16 and Below — Severance Pay Plan) +Cheniere 10-K 10.44 2/24/2017 +10.32† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (UK) (Grade 16 and Below) +Cheniere 10-Q 10.9 5/4/2017 +10.33† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2011 Incentive Plan (2019 Grades 18-20) +Cheniere 10-K 10.35 2/26/2019 +10.34† +Cheniere Energy, Inc. 2014-2018 Long-Term Cash Incentive Program +Cheniere 10-Q 10.9 4/30/2015 +10.35† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Executive) +Cheniere 10-Q 10.10 4/30/2015 +10.36† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Non-Executive) +Cheniere 10-Q 10.11 4/30/2015 +10.37† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Executive) +Cheniere 10-Q 10.12 4/30/2015 +10.38† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Non-Executive) +Cheniere 10-Q 10.13 4/30/2015 +10.39† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (US - Consultant) +Cheniere 10-Q 10.14 4/30/2015 +10.40† +Form of Phantom Unit Award Agreement under the Cheniere Energy, Inc. 2015 Long-Term Cash Incentive Plan (UK - Consultant) +Cheniere 10-Q 10.15 4/30/2015 +10.41† +Cheniere Energy, Inc. 2020 Incentive Plan +Cheniere (SEC No. 333-238261) +S-8 4.9 5/14/2020 +123 +10.42† +Form of Restricted Stock Grant under the Cheniere Energy, Inc. 2020 Incentive Plan (Director) +Cheniere 8-K 10.4 5/20/2020 +10.43† +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2020 Incentive Plan (Grades 18-20 Executive Officer) +Cheniere 8-K 10.5 5/20/2020 +10.44† +Form of Restricted Stock Unit Award Agreement under the Cheniere Energy, Inc. 2020 Incentive Plan (Grades 18-20) +Cheniere 8-K 10.6 5/20/2020 +10.45†* +Form of Performance Stock Unit Award Agreement under the Cheniere Energy, Inc. 2020 Incentive Plan +10.46†* +Amended and Restated Cheniere Energy, Inc. Key Executive Severance Pay Plan (Effective November 4, 2020) and Summary Plan Description +10.47† +Employment Agreement between the Company and Jack A. Fusco, dated May 12, 2016 +Cheniere 8-K 10.1 5/12/2016 +10.48† +Employment Agreement Amendment between the Company and Jack Fusco, dated August 15, 2019 +Cheniere 8-K 10.1 8/15/2019 +10.49† +Cheniere Energy, Inc. Amended and Restated Retirement Policy, dated effective August 15, 2019 +Cheniere 10-K 10.49 2/25/2020 +10.50† +Form of Indemnification Agreement for officers of the Company +Cheniere 8-K 10.2 5/20/2020 +10.51† +Form of Indemnification Agreement for directors of the Company +Cheniere 8-K 10.1 5/20/2020 +10.52† +Letter Agreement between the Company and Douglas Shanda, dated November 1, 2019 +Cheniere 8-K 10.1 11/1/2019 +10.53† +Letter Agreement, dated August 5, 2020, between Cheniere Energy, Inc. and Michael J. Wortley +Cheniere 8-K 10.1 8/6/2020 +10.54 +Third Amended and Restated Common Terms Agreement, among SPL, as borrower, the Secured Debt Holder Group Representatives party thereto, the Secured Hedge Representatives party thereto, the Secured Gas Hedge Representatives party thereto and Société Générale, as the Common Security Trustee and the Intercreditor Agent +Cheniere 8-K 10.2 3/23/2020 +10.55 +Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, among SPL, as borrower, certain subsidiaries of SPL, The Bank of Nova Scotia, as Senior Facility Agent, Société Générale, as the Common Security Trustee, the issuing banks and lenders from time to time party thereto and other participants +SPL 8-K 10.1 3/23/2020 +10.56 +Third Amended and Restated Accounts Agreement, among SPL, certain subsidiaries of SPL, Société Générale, as the Common Security Trustee, and Citibank, N.A. as the Accounts Bank +SPL 8-K 10.3 3/23/2020 +10.57 +Amended and Restated Subscription Agreement, dated as of November 26, 2014, by and among the Company, RRJ Capital II Ltd, Baytree Investments (Mauritius) Pte Ltd and Seatown Lionfish Pte. Ltd. relating to convertible PIK notes of the Company +Cheniere 8-K 10.1 12/2/2014 +10.58 +Amended and Restated Term Loan Facility Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the lenders party thereto from time to time and Société Générale as the Term Loan Facility Agent +Cheniere 8-K 10.1 5/24/2018 +10.59 +Amended and Restated Common Terms Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, Société Générale, as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, and Société Générale as Intercreditor Agent, and any other facility lenders party thereto from time to time +Cheniere 8-K 10.2 5/24/2018 +124 +10.60 +First Amendment to the Amended and Restated Common Terms Agreement, dated as of November 28, 2018, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as Intercreditor Agent +Cheniere 10-K 10.6 2/26/2019 +10.61 +Second Amendment to the Amended and Restated Common Terms Agreement, dated as of August 30, 2019, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as the Intercreditor Agent +Cheniere 10-Q 10.4 11/1/2019 +10.62* +Third Amendment to the Amended and Restated Common Terms Agreement, dated as of November 8, 2019, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC , Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as the Intercreditor Agent +10.63* +Fourth Amendment to the Amended and Restated Common Terms Agreement, dated as of November 26, 2019, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC , Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as the Intercreditor Agent +10.64* +Fifth Amendment to the Amended and Restated Common Terms Agreement, dated as of November 16, 2020, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC , Société Générale as Term Loan Facility Agent, The Bank of Nova Scotia as Working Capital Facility Agent, each other Facility Agent on behalf of its respective Facility Lenders, and Société Générale as the Intercreditor Agent +10.65 +Amended and Restated Common Security and Account Agreement, dated May 22, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the Senior Creditor Group Representatives, Société Générale as the Intercreditor Agent, Société Générale as Security Trustee and Mizuho Bank, Ltd as the Account Bank +Cheniere 8-K 10.3 5/24/2018 +10.66 +First Amendment to the Amended and Restated Common Security and Account Agreement, dated as of November 28, 2018, by and among CCH, CCL, CCP and Corpus Christi Pipeline GP, LLC, the Senior Creditor Group Representatives, Société Générale as Intercreditor Agent for the Facility Lenders and any Hedging Banks, Société Générale as Security Trustee, and Mizuho Bank, Ltd. as Account Bank +Cheniere 10-K 10.62 2/26/2019 +10.67 +Second Amendment to Common Security and Account Agreement, dated as of August 30, 2019, by and among the Company, CCL, CCP, Corpus Christi Pipeline GP, LLC, the Senior Creditor Group Representatives, Société Générale as Intercreditor Agent for the Facility Lenders and any Hedging Banks, Société Générale as Security Trustee, and Mizuho Bank, Ltd; as Account Bank +Cheniere 10-Q 10.5 11/1/2019 +10.68* +Third Amendment to Common Security and Account Agreement, dated as of November 16, 2020, by and among CCH, CCL, CCP, Corpus Christi Pipeline GP, LLC , the Senior Creditor Group Representatives, Société Générale as Intercreditor Agent for the Facility Lenders and any Hedging Banks, Société Générale as Security Trustee, and Mizuho Bank, Ltd; as Account Bank +10.69 +Amended and Restated Pledge Agreement, dated May 22, 2018, among CCH HoldCo I and Société Générale as Security Trustee +Cheniere 8-K 10.4 5/24/2018 +125 +10.70 +Amended and Restated Equity Contribution Agreement, dated May 22, 2018, among CCH and the Company +Cheniere 8-K 10.5 5/24/2018 +10.71 +Amended and Restated Working Capital Facility Agreement, dated June 29, 2018, among CCH, CCP, Corpus Christi Pipeline GP, LLC, CCL, the lenders party thereto from time to time, the issuing banks party thereto from time to time, the Bank of Nova Scotia as Working Capital Facility Agent, and Société Générale as Security Trustee +Cheniere 8-K 10.1 7/2/2018 +10.72 +The Amended and Restated Revolving Credit Agreement, dated as of December 13, 2018, among the Company, the Lenders and Issuing Banks party thereto, Goldman Sachs Bank USA, Morgan Stanley Senior Funding, Inc. and SG Americas Securities, LLC, as Coordinating Lead Arrangers, and Société Générale, as Administrative Agent +Cheniere 8-K 10.1 12/17/2018 +10.73 +Amendment to Amended and Restated Revolving Credit Agreement, dated as of September 27, 2019, among the Company, Société Générale as administrative agent, and the Requisite Lenders party thereto +Cheniere 10-Q 10.7 11/1/2019 +10.74 +Credit Agreement, dated June 18, 2020, among the Company, the Lenders party thereto, Société Générale, as Administrative Agent, and the other agents and arrangers party thereto from time to time +Cheniere 8-K 10.1 6/19/2020 +10.75 +Amendment No. 2 to the Amended and Restated Revolving Credit Agreement, dated as of June 18, 2020, among the Company, Société Générale as administrative agent, and the Requisite Lenders party thereto +Cheniere 10-Q 10.11 8/6/2020 +10.76 +Credit and Guaranty Agreement, dated as of May 29, 2019, among the Cheniere Partners, as Borrower, certain subsidiaries of the Cheniere Partners, as Subsidiary Guarantors, the lenders from time to time party thereto, MUFG Bank, Ltd., as Administrative Agent and Sole Coordinating Lead Arranger, and certain arrangers and other participants +Cheniere 8-K 10.1 6/3/2019 +10.77 +Amended and Restated Senior Working Capital Revolving Credit and Letter of Credit Reimbursement Agreement, dated September 4, 2015, as amended by (a) Third Omnibus Amendment, dated as of May 23, 2018; (b) Fourth Omnibus Amendment, dated as of September 17, 2018; and (c) Fifth Omnibus Amendment, Consent and Waiver, dated as of May 29, 2019, among SPL, as Borrower, The Bank of Nova Scotia, as Senior Issuing Bank and Senior Facility Agent, ABN Amro Capital USA LLC, HSBC Bank USA, National Association and ING Capital LLC, as Senior Issuing Banks, Société Générale, as Swing Line Lender and Common Security Trustee, and the senior lenders party thereto from time to time +Cheniere 10-Q 10.2 8/8/2019 +10.78 +Registration Rights Agreement, dated as of September 22, 2020, between the Company , as issuer, and Credit Suisse Securities (USA) LLC, for itself and as representative of the purchasers +Cheniere 8-K 10.1 9/22/2020 +10.79 +Registration Rights Agreement, dated as of May 8, 2020, between SPL and Morgan Stanley & Co. LLC +SPL 8-K 10.1 5/8/2020 +10.80 +Registration Rights Agreement, dated as of November 13, 2019, among CCH and CCL, CCP and Corpus Christi Pipeline GP, LLC, as guarantors, and BofA Securities, Inc., for itself and as representative of the purchasers +CCH 8-K 10.1 11/13/2019 +10.81 +Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the Securities and Exchange Commission pursuant to a request for confidential treatment.) +Cheniere 8-K 10.1 11/9/2018 +126 +10.82 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: the Change Order CO-00001 Modifications to Insurance Language Change Order, dated June 3, 2019 +Cheniere 10-Q 10.6 8/8/2019 +10.83 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00002 Fuel Provisional Sum Closure, dated July 8, 2019, (ii) the Change Order CO-00003 Currency Provisional Sum Closure, dated July 8, 2019, (iii) the Change Order CO-00004 Foreign Trade Zone, dated July 2, 2019, (iv) the Change Order CO-00005 NGPL Gate Access Security Coordination Provisional Sum, dated July 17, 2019, (v) the Change Order CO-00006 Alternate to Adams Valves, dated August 14, 2019, (vi) the Change Order CO-00007 E-1503 to HRU Permanent Drain Piping, dated August 14, 2019, (vii) the Change Order CO-00008 Differing Subsurface Soil Conditions - Train 6 ISBL, dated August 27, 2019, (viii) the Change Order CO-00009 LNG Berth 3, dated September 25, 2019 and (iv) the Change Order CO-00010 Cold Box Redesign and Addition of Inspection Boxes on Methane Cold Box, dated September 16, 2019 +Cheniere 10-Q 10.10 11/1/2019 +10.84 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between the Company and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00011 Insurance Provisional Sum Interim Adjustment, dated October 1, 2019 and (ii) the Change Order CO-00012 Replacement of Timber Piles with Pre-Stressed Concrete Piles, dated October 30, 2019 +Cheniere 10-K 10.88 2/25/2020 +10.85 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00013 Cost to Comply with SPL FTZ (FTZ entries, bonded transports and receipts for AG Pipe Spools Only), dated February 10, 2020, (ii) the Change Order CO-00014 Permanent Access Road to Third Berth, dated February 10, 2020, (iii) the Change Order CO-00015 Modifications to Schedule Bonus Language, dated February 10, 2020, (iv) the Change Order CO-00016 LNG Berth 3 LNTP No 3, dated January 31, 2020 and (v) the Change Order CO-00017 Construction Doc Fender Guards and LP Fuel Gas Overpressure Interlock, dated March 18, 2020 +Cheniere 10-Q 10.6 4/30/2020 +10.86 +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00018 Electrical Studies for GTG Grid Modification, dated April 2, 2020, (ii) the Change Order CO-00019 Third Berth - Change in 5kV Electrical Tie-In, dated April 30, 2020, (iii) the Change Order CO-00020 LNG Berth 3 LNTP No. 4, dated May 4, 2020, (iv) the Change Order CO-00021 Train 6 P1601 A/B/ Flange Changes, dated May 27, 2020 and (v) the Change Order CO-00022 Train 6 H2S Skid Modifications to Level Transmitters & GTG Pressure Range Change on PT-573 A/B, dated June 4, 2020 +Cheniere 10-Q 10.9 8/6/2020 +127 +10.87 +Change orders to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between SPL and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00023 Third Berth Vapor Fence Provisional Sum Scope Removal and Closeout, dated June 22, 2020, (ii) the Change Order CO-00024 Train 6 Thermowell Upgrades, dated June 22, 2020, (iii) the Change Order CO-00025 Third Berth Bubble Curtain, dated June 22, 2020, (iv) the Change Order CO-00026 Third Berth Fuel Provisional Sum Closure Change Order, dated July 14, 2020, (v) the Change Order CO-00027 Third Berth Currency Provisional Sum Closure Change Order, dated July 20, 2020, (vi) the Change Order CO-00028 Train 6 Hot Oil WHRU PSV Bypass, dated August 11, 2020 and (vii) the Change Order CO-00029 Change in Law IMO 2020 Regulatory Change – Low Sulphur Emissions on Marine Vessels, dated August 25, 2020 +Cheniere 10-Q 10.2 11/6/2020 +10.88* +Change order to the Lump Sum Turnkey Agreement for the Engineering, Procurement and Construction of the Sabine Pass LNG Stage 4 Liquefaction Facility, dated November 7, 2018, by and between the SPL and Bechtel Oil Gas and Chemicals, Inc.: (i) the Change Order CO-00030 Third Berth Soil Preparation Provisional Sum Interim Adjustment Change Order, dated September 16, 2020, (ii) the Change Order CO-00031 Provisional Sum Consolidation (PAB, Taxes & Insurance), dated October 2, 2020, (iii) the Change Order CO-00032 COVID-19 Impacts, dated October 2, 2020, (iv) the Change Order CO-00033 Third Berth - Jetty Building (00A-4041) - Clean Agent System, dated November 2, 2020 and (v) the Change Order CO-00034 Vanessa Spare Valves, dated November 18, 2020 +10.89 +Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated December 12, 2017, by and between CCL and Bechtel Oil, Gas and Chemicals, Inc. (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +Cheniere 10-K/A 10.23 4/27/2018 +10.90 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00001 Stage 2 EPC Agreement Revised Table A-2, dated May 18, 2018, (ii) the Change Order CO-00002 Stage 2 EPC Agreement Amended and Restated Attachment C, dated May 18, 2018, (iii) the Change Order CO-00003 Fuel Provisional Sum Adjustment, dated May 24, 2018, (iv) the Change Order CO-00004 Currency Provisional Sum Adjustment, dated May 29, 2018, (v) the Change Order CO-00005 JT Valve Modifications, dated July 10, 2018 and (vi) the Change Order CO-00006 Tank B Soil Conditions, International Building Code, and East Jetty Marine Facility Schedule Acceleration, dated September 5, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +Cheniere 10-Q 10.3 11/8/2018 +10.91 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00007 Tell-Tale Signs, Additional Tie-Ins, and System Inspection Isometrics, dated October 15, 2018, (ii) the Change Order CO-00008 Insurance Provisional Sum Interim Adjustment, dated November 19, 2018 and (iii) the Change Order CO-00009 Traffic and Logistics Impacts Due to Enforcement of Electronic Logging Devices, dated November 28, 2018 (Portions of this exhibit have been omitted and filed separately with the SEC pursuant to a request for confidential treatment.) +Cheniere 10-K 10.117 2/26/2019 +128 +10.92 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-000010 OSHA Handrail Requirement Changes Impact, dated January 25, 2019, (ii) the Change Order CO-00011 Differing Soil Conditions - Train 3, dated March 7, 2019 and (iii) the Change Order CO-00012 Tank B Logo Deletion, dated March 25, 2019 (Portions of this exhibit have been omitted.) +Cheniere 10-Q 10.2 5/9/2019 +10.93 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-000013 Section 232 Steel and Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD), dated May 2, 2019, (ii) the Change Order CO-00014 Tank B Jump-over Tie-In Interface - Long Lead Items, dated May 2, 2019 and (iii) the Change Order CO-00015 Section 232 Steel and Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD) Q1_2019, dated June 4, 2019 (Portions of this exhibit have been omitted.) +Cheniere 10-Q 10.4 8/8/2019 +10.94 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-000016 Tank B Jump-over Tie-In (Part 1) and Deletion of East Jetty Shroud, dated August 5, 2019, (ii) the Change Order CO-00017 H2S Removal Skid PSVs Modifications and Revision to Chemical Cleaning Milestones, dated August 5, 2019 and (iii) the Change Order CO-00018 Cold Box Redesign Major Permanent Plant Materials and Ethylene Cold Box’s E-1504 Partial Mockup, dated September 6, 2019 (Portions of this exhibit have been omitted.) +Cheniere 10-Q 10.9 11/1/2019 +10.95 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00019 Aircraft Warning Lights, dated September 23, 2019, (ii) the Change Order CO-00020 Section 232 Steel and Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD) Q2_2019, dated October 8, 2019, (iii) the Change Order CO-00021 Spare Transition Joints for Potential Future Cold Box Modifications, dated October 8, 2019, (iv) the Change Order CO-00022 Modification of the Train 3 Methane Cold Box, dated December 6, 2019 and (v) the Change Order Co-00023 Section 232 Steel & Aluminum Tariffs & Anti-dumping (ADA) and Countervailing Duties (CVD) Q3_2019, dated December 10, 2019 (Portions of this exhibit have been omitted.) +Cheniere 10-K 10.95 2/25/2020 +129 +10.96 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00024 East Jetty Cooldown Line & Simultaneous Ship Loading, dated January 6, 2020, (ii) the Change Order CO-00025 East Jetty Manual Gas Sampler, dated January 7, 2020, (iii) the Change Order CO-00026 Study for Adding Valve Actuator for E-W Jetty Flow Segregation, dated January 8, 2020, (iv) the Change Order CO-00027 Tank B Isolation of Proposed Fourth In-Tank LNG Pump - Long Lead Items, dated January 8, 2020, (v) the Change Order CO-00028 Tank B Rundown Line (Part I), dated January 31, 2020, (vi) the Change Order CO-00029 9% Nickel and Cryogenic Rebar Provisional Sum Closeout, dated February 18, 2020 and (vii) the Change Order CO-00030 Additional Valve for Isolation in CCL Stage 2 to CCL Stage 3 from Tank B, dated February 18, 2020 (Portions of this exhibit have been omitted) +Cheniere 10-Q 10.7 4/30/2020 +10.97 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00031 Tank B Isolation of Proposed 4th In-Tank LNG Pump (Post Start-Up of Tank B) - EPC, dated April 1, 2020, (ii) the Change Order CO-00032 Train 3 Thermowell Upgrades, dated April 3, 2020, (iii) the Change Order CO-00033 Tank B Rundown Line (Part 2) Development Costs, dated April 29, 2020 and (iv) the Change Order CO-00034 Train 3 UPS Modification of MV Motors, dated May 21, 2020 (Portions of this exhibit have been omitted) +Cheniere 10-Q 10.10 8/6/2020 +10.98 +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00035 Spill Conveyance from Flare KO Drum Area, dated July 6, 2020, (ii) the Change Order CO-00036 Tie-Ins for Heavy Hydrocarbon Removal Modifications (E&P) Rev 1, dated August 5, 2020, (iii) the Change Order CO-00037 Train 3 PV-16002 Valve Trim Change - Rev 1, dated August 14, 2020, (iv) the Change Order CO-00038 Hot Oil Overpressure Relief, dated August 14, 2020, (v) the Change Order CO-00039 Supply of Nitrogen for Commissioning Units 16, 17 and Feed Gas, dated August 20, 2020 and (vi) the Change Order CO-00040 COVID-19 Impacts, dated September 15, 2020 (Portions of this exhibit have been omitted) +Cheniere 10-Q 10.3 11/6/2020 +10.99* +Change orders to the Amended and Restated Fixed Price Separated Turnkey Agreement for the Engineering, Procurement and Construction of the Corpus Christi Stage 2 Liquefaction Facility, dated as of December 12, 2017, between CCL and Bechtel Oil, Gas and Chemicals, Inc.: (i) the Change Order CO-00041 Additional O&M Support (COVID-19), dated October 2, 2020 and (ii) the Change Order CO-00042 Replacement of Owner Spare Parts, dated December 31, 2020 (Portions of this exhibit have been omitted) +10.100 +LNG Sale and Purchase Agreement (FOB), dated November 21, 2011, between SPL (Seller) and Gas Natural Aprovisionamientos SDG S.A. (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) +Cheniere Partners 8-K 10.1 11/21/2011 +10.101 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated April 3, 2013, between SPL (Seller) and Gas Natural Aprovisionamientos SDG S.A. (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) +Cheniere Partners 10-Q 10.1 5/3/2013 +130 +10.102 +Amendment of LNG Sale and Purchase Agreement (FOB), dated January 12, 2017, between SPL (Seller) and Gas Natural Fenosa LNG GOM, Limited (assignee of Gas Natural Aprovisionamientos SDG S.A.) (Buyer) +SPL +(SEC File No. 333-215882) +S-4 10.3 2/3/2017 +10.103 +LNG Sale and Purchase Agreement (FOB), dated December 11, 2011, between SPL (Seller) and GAIL (India) Limited (Buyer) +Cheniere Partners 8-K 10.1 12/12/2011 +10.104 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 18, 2013, between SPL (Seller) and GAIL (India) Limited (Buyer) +Cheniere Partners 10-K 10.18 2/22/2013 +10.105 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated January 25, 2012, between SPL (Seller) and BG Gulf Coast LNG, LLC (Buyer) +Cheniere Partners 8-K 10.1 1/26/2012 +10.106 +LNG Sale and Purchase Agreement (FOB), dated January 30, 2012, between SPL (Seller) and Korea Gas Corporation (Buyer) +Cheniere Partners 8-K 10.1 1/30/2012 +10.107 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 18, 2013, between SPL (Seller) and Korea Gas Corporation (Buyer) +Cheniere Partners 10-K 10.19 2/22/2013 +10.108 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated August 5, 2014, between SPL (Seller) and Cheniere Marketing, LLC (Buyer) +SPL 8-K 10.1 8/11/2014 +10.109 +Letter agreement, dated December 8, 2016, amending the Amended and Restated LNG Sale and Purchase Agreement (FOB), dated August 5, 2014, between SPL and Cheniere Marketing International LLP (as assignee of Cheniere Marketing, LLC) +SPL 10-K 10.14 2/24/2017 +10.110 +LNG Sale and Purchase Agreement (FOB), dated April 1, 2014, between CCL (Seller) and Endesa Generación, S.A. (Buyer) +Cheniere 8-K 10.1 4/2/2014 +10.111 +LNG Sale and Purchase Agreement (FOB), dated April 7, 2014, between CCL (Seller) and Endesa S.A. (Buyer) +Cheniere 8-K 10.1 4/8/2014 +10.112 +Assignment and Amendment Agreement, dated April 7, 2014, among Endesa Generación S.A., Endesa S.A. and CCL +Cheniere 10-Q 10.3 5/1/2014 +10.113 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated July 23, 2015, between Endesa S.A. (Buyer) and CCL (Seller) +Cheniere 10-Q 10.9 10/30/2015 +10.114 +Amendment No. 2 of LNG Sale and Purchase Agreement (FOB), dated July 23, 2015, between Endesa S.A. (Buyer) and CCL (Seller) +Cheniere 10-Q 10.10 10/30/2015 +10.115 +Amended and Restated LNG Sale and Purchase Agreement (FOB), dated March 20, 2015, between CCL (Seller) and PT Pertamina (Persero) (Buyer) +Cheniere 10-Q 10.5 4/30/2015 +10.116 +Amendment No. 1, dated February 4, 2016, to Amended and Restated LNG Sale and Purchase Agreement (FOB) between CCL and PT Pertamina (Persero), dated March 20, 2015 +CCH S-4 10.22 1/5/2017 +10.117 +Amendment No. 2 of Amended and Restated LNG Sale and Purchase Agreement, dated June 27, 2019, between CCL and PT Pertamina (Persero) +CCH 10-Q 10.1 11/1/2019 +10.118 +LNG Sale and Purchase Agreement (FOB), dated June 2, 2014, between CCL (Seller) and Gas Natural Fenosa LNG SL (subsequently assigned to Gas Natural Fenosa LNG GOM, Limited) (Buyer) +Cheniere 8-K 10.1 6/2/2014 +10.119 +Amendment No. 1 of LNG Sale and Purchase Agreement (FOB), dated February 27, 2018, between CCL (Seller) and Gas Natural Fenosa LNG GOM, Limited (Buyer) +Cheniere 10-Q 10.6 5/4/2018 +10.120 +Amended and Restated Base LNG Sale and Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP +CCH S-4 10.32 1/5/2017 +10.121 +Amendment No. 1, dated June 26, 2015, to Amended and Restated Base LNG Sale and Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP +CCH S-4 10.33 1/5/2017 +131 +10.122 +Amendment No. 2, dated December 27, 2016, to Amended and Restated Base LNG Purchase Agreement (FOB), dated as of November 28, 2014, between CCL and Cheniere Marketing International LLP +CCH S-4 10.34 1/5/2017 +10.123 +Cooperative Endeavor Agreement & Payment in Lieu of Tax Agreement with eleven Cameron Parish taxing authorities, dated October 23, 2007, by and between Cheniere Marketing, Inc. and SPLNG +Cheniere 10-Q 10.7 11/6/2007 +10.124 +Investors’ and Registration Rights Agreement, dated as of July 31, 2012, by and among the Company, Cheniere Energy Partners GP, LLC, Cheniere Partners, Cheniere Class B Units Holdings, LLC, Blackstone CQP Holdco LP and the other investors party thereto from time to time +Cheniere Partners 8-K 10.1 8/6/2012 +10.125 +Fourth Amended and Restated Agreement of Limited Partnership of Cheniere Partners, dated February 14, 2017 +Cheniere Partners 8-K 3.1 2/21/2017 +10.126 +Amended and Restated Limited Liability Company Agreement of Cheniere GP Holding Company, LLC, dated December 13, 2013 +Cheniere Holdings 8-K 10.3 12/18/2013 +10.127 +Nomination and Standstill Agreement, dated August 21, 2015, by and between the Company, Icahn Partners Master Fund LP, Icahn Partners LP, Icahn Onshore LP, Icahn Offshore LP, Icahn Capital LP, IPH GP LLC, Icahn Enterprises Holdings LP, Icahn Enterprises G.P. Inc., Beckton Corp., High River Limited Partnership, Hopper Investments LLC, Barberry Corp., Carl C. Icahn, Jonathan Christodoro and Samuel Merksamer +Cheniere 8-K 99.1 8/24/2015 +21.1* +Subsidiaries of the Company +23.1* +Consent of KPMG LLP +31.1* +Certification by Chief Executive Officer required by Rule 13a-14(a) and 15d-14(a) under the Exchange Act +31.2* +Certification by Chief Financial Officer required by Rule 13a-14(a) and 15d-14(a) under the Exchange Act +32.1** +Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +32.2** +Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +101.INS* XBRL Instance Document +101.SCH* XBRL Taxonomy Extension Schema Document +101.CAL* XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF* XBRL Taxonomy Extension Definition Linkbase Document +101.LAB* XBRL Taxonomy Extension Labels Linkbase Document +101.PRE* XBRL Taxonomy Extension Presentation Linkbase Document +104* Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) +(1) Exhibits are incorporated by reference to reports of Cheniere (SEC File No. 001-16383), Cheniere Partners (SEC File No. 001-33366), Cheniere Holdings (SEC File No. 001-36234), SPL (SEC File No. 333-192373), CCH (SEC File No. 333-215435) and SPLNG (SEC File No. 333-138916), as applicable, unless otherwise indicated. +* Filed herewith. +** Furnished herewith. +† Management contract or compensatory plan or arrangement. +132 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF OPERATIONS +(in millions) +Year Ended December 31, +2020 2019 2018 +General and administrative expense $ 20 $ 17 $ 8 +Other income (expense) +Interest expense, net of capitalized interest ( 155 ) ( 141 ) ( 128 ) +Interest income — 1 — +Loss on modification or extinguishment of debt ( 50 ) — — +Equity in income of subsidiaries 77 490 607 +Total other income (expense) ( 128 ) 350 479 +Income (loss) before income taxes ( 148 ) 333 471 +Income tax benefit 63 315 — +Net income (loss) attributable to common stockholders $ ( 85 ) $ 648 $ 471 +The accompanying notes are an integral part of these condensed financial statements. +133 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED BALANCE SHEETS +(in millions) +December 31, +2020 2019 +ASSETS +Current assets +Cash and cash equivalents $ — $ 55 +Restricted cash 1 — +Other current assets 1 1 +Total current assets 2 56 +Property, plant and equipment, net 30 17 +Operating lease assets, net 22 24 +Debt issuance and deferred financing costs, net 15 16 +Investments in subsidiaries 2,324 1,139 +Deferred tax assets, net 381 315 +Total assets $ 2,774 $ 1,567 +LIABILITIES AND STOCKHOLDERS’ DEFICIT +Current liabilities +Current operating lease liabilities $ 5 $ 5 +Current debt 103 — +Other current liabilities 37 9 +Total current liabilities 145 14 +Long-term debt, net 2,790 1,534 +Non-current operating lease liabilities 30 33 +Stockholders’ deficit ( 191 ) ( 14 ) +Total liabilities and stockholders’ deficit $ 2,774 $ 1,567 +The accompanying notes are an integral part of these condensed financial statements. +134 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +CONDENSED STATEMENTS OF CASH FLOWS +(in millions) +Year Ended December 31, +2020 2019 2018 +Net cash provided by operating activities $ ( 285 ) $ 74 $ 48 +Cash flows from investing activities +Property, plant and equipment, net ( 13 ) ( 2 ) — +Distribution from (investment in) subsidiaries ( 481 ) 842 568 +Net cash provided by investing activities ( 494 ) 840 568 +Cash flows from financing activities +Proceeds from issuance of debt 4,778 — — +Repayments of debt ( 3,143 ) — — +Debt issuance and deferred financing costs ( 57 ) — ( 13 ) +Debt modification or extinguishment costs ( 29 ) — — +Distribution and dividends to non-controlling interest ( 626 ) ( 591 ) ( 576 ) +Payments related to tax withholdings for share-based compensation ( 43 ) ( 19 ) ( 20 ) +Repurchase of common stock ( 155 ) ( 249 ) — +Other — — ( 7 ) +Net cash used in financing activities 725 ( 859 ) ( 616 ) +Net increase in cash, cash equivalents and restricted cash ( 54 ) 55 — +Cash, cash equivalents and restricted cash—beginning of period 55 — — +Cash, cash equivalents and restricted cash—end of period $ 1 $ 55 $ — +Balances per Condensed Balance Sheets: +December 31, +2020 2019 +Cash and cash equivalents $ — $ 55 +Restricted cash 1 — +Total cash, cash equivalents and restricted cash $ 1 $ 55 +The accompanying notes are an integral part of these condensed financial statements. +135 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS +NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +The Condensed Financial Statements represent the financial information required by Securities and Exchange Commission Regulation S-X 5-04 for Cheniere. +In the Condensed Financial Statements, Cheniere’s investments in affiliates are presented at the net amount attributable to Cheniere. Under this method, the assets and liabilities of affiliates are not consolidated. The investments in net assets of the affiliates are recorded on the Condensed Balance Sheets. The income from operations of the affiliates is reported on a net basis as investment in affiliates (equity in income of subsidiaries). +A substantial amount of Cheniere’s operating, investing and financing activities are conducted by its affiliates. The Condensed Financial Statements should be read in conjunction with Cheniere’s Consolidated Financial Statements. +Recent Accounting Standards +In August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity . This guidance simplifies the accounting for convertible instruments primarily by eliminating the existing cash conversion and beneficial conversion models within Subtopic 470-20, which will result in fewer embedded conversion options being accounted for separately from the debt host. The guidance also amends and simplifies the calculation of earnings per share relating to convertible instruments. This guidance is effective for annual periods beginning after December 15, 2021, including interim periods within that reporting period, with earlier adoption permitted for fiscal years beginning after December 15, 2020, including interim periods within that reporting period, using either a full or modified retrospective approach. We are currently evaluating the impact of the provisions of this guidance on our Consolidated Financial Statements and related disclosures. +In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting . This guidance primarily provides temporary optional expedients which simplify the accounting for contract modifications to existing debt agreements expected to arise from the market transition from LIBOR to alternative reference rates. The optional expedients were available to be used upon issuance of this guidance but we have not yet applied the guidance because we have not yet modified any of our existing contracts for reference rate reform. Once we apply an optional expedient to a modified contract and adopt this standard, the guidance will be applied to all subsequent applicable contract modifications until December 31, 2022, at which time the optional expedients are no longer available. +136 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +NOTE 2—DEBT +As of December 31, 2020 and 2019, our debt consisted of the following (in millions): +December 31, +2020 2019 +Long-term debt: +4.625 % Senior Secured Notes due 2028 (the “2028 Cheniere Senior Secured Notes”), convertible notes, revolving credit facility (“Cheniere Revolving Credit Facility”) and term loan facility (“Cheniere Term Loan Facility”) +$ 3,145 $ 1,903 +Unamortized premium, discount and debt issuance costs, net ( 355 ) ( 369 ) +Total long-term debt, net 2,790 1,534 +Current debt: +Current portion of 4.875 % Convertible Unsecured Notes due 2021 (“2021 Cheniere Convertible Unsecured Notes”) +104 $ — +Unamortized premium, discount and debt issuance costs, net ( 1 ) $ — +Total current debt 103 — +Total debt, net $ 2,893 $ 1,534 +Below is a schedule of future principal payments that we are obligated to make on our outstanding debt at December 31, 2020 (in millions): +Years Ending December 31, Principal Payments +2021 $ 476 +2022 — +2023 148 +2024 — +2025 — +Thereafter 2,625 +Total $ 3,249 +137 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +Issuances and Repayments +The following table shows the issuances and repayments of debt during the year ended December 31, 2020 (in millions): +Issuances and Long-Term Borrowings Principal Amount Issued +2028 Cheniere Senior Secured Notes (1) +$ 2,000 +Cheniere Term Loan Facility +2,323 +Cheniere Revolving Credit Facility +455 +Year Ended December 31, 2020 total +$ 4,778 +Repayments, Redemptions and Repurchases Amount Repaid/Redeemed/Repurchased +2021 Cheniere Convertible Unsecured Notes (1) +$ ( 844 ) +Cheniere Term Loan Facility (1) +( 2,175 ) +Cheniere Revolving Credit Facility +( 455 ) +Year Ended December 31, 2020 total $ ( 3,474 ) +(1) Proceeds of the 2028 Cheniere Senior Secured Notes, along with $ 200 million in available cash, were used to prepay approximately $ 2.1 billion of the outstanding indebtedness of the Cheniere Term Loan Facility, resulting in the recognition of debt extinguishment costs of $ 16 million for the year ended December 31, 2020. The borrowings under the Cheniere Term Loan Facility, which was entered in June 2020 with available commitments of $ 2.62 billion and subsequently increased to $ 2.695 billion in July 2020, were used to (1) redeem the remaining outstanding principal amount of the 2025 CCH HoldCo II Convertible Senior Notes with cash at a price of $ 1,080 per $1,000 principal amount, (2) repurchase $ 844 million in aggregate principal amount of outstanding 2021 Cheniere Convertible Unsecured Notes at individually negotiated prices from a small number of investors and (3) pay the related fees and expenses. The redemption of the 2025 CCH HoldCo II Convertible Senior Notes and the repurchase of the 2021 Cheniere Convertible Unsecured Notes resulted in the recognition of debt extinguishment costs of $ 149 million and a reduction in equity associated with reacquisition of the embedded conversion option of $ 10 million. +NOTE 3—GUARANTEES +Cheniere has various financial and performance guarantees and indemnifications which are issued in the normal course of business. These contracts include performance guarantees and stand-by letters of credit. Cheniere enters into these arrangements to facilitate commercial transactions with third parties by enhancing the value of the transaction to the third party. As of December 31, 2020, outstanding guarantees and other assurances aggregated approximately $ 542 million of varying duration, consisting of parental guarantees. No liabilities were recognized under these guarantee arrangements as of December 31, 2020. +NOTE 4—LEASES +Our leased assets consist primarily of office space and facilities, which are classified as operating leases. +The following table shows the classification and location of our right-of-use assets and lease liabilities on our Condensed Balance Sheets (in millions): +December 31, +Condensed Balance Sheet Location 2020 2019 +Right-of-use assets—Operating Operating lease assets, net $ 22 $ 24 +Total right-of-use assets $ 22 $ 24 +Current operating lease liabilities Current operating lease liabilities $ 5 $ 5 +Non-current operating lease liabilities Non-current operating lease liabilities 30 33 +Total lease liabilities $ 35 $ 38 +138 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +The following table shows the classification and location of our lease cost on our Condensed Statements of Operations (in millions): +Year Ended December 31, +Condensed Statements of Operations Location 2020 2019 +Operating lease cost (1) General and administrative expense $ 10 $ 9 +(1) Includes $ 4 million and $ 3 million of variable lease costs paid to the lessor during the years ended December 31, 2020 and 2019, respectively. +Future annual minimum lease payments for operating leases as of December 31, 2020 are as follows (in millions): +Years Ending December 31, Operating Leases (1) +2021 $ 7 +2022 8 +2023 8 +2024 7 +2025 6 +Thereafter 7 +Total lease payments 43 +Less: Interest ( 8 ) +Present value of lease liabilities $ 35 +The following table shows the weighted-average remaining lease term (in years) and the weighted-average discount rate for our operating leases: +December 31, +2020 2019 +Weighted-average remaining lease term (in years) 5.7 6.6 +Weighted-average discount rate 6.6 % 5.5 % +The following table includes other quantitative information for our operating leases (in millions): +Year Ended December 31, +2020 2019 +Cash paid for amounts included in the measurement of lease liabilities: +Operating cash flows from operating leases $ 7 $ 7 +Right-of-use assets obtained in exchange for new operating lease liabilities 5 1 +NOTE 5—SHARE REPURCHASE PROGRAM +On June 3, 2019, we announced that our Board authorized a 3 -year, $ 1.0 billion share repurchase program. The following table presents information with respect to repurchases of common stock during the years ended December 31, 2020 and 2019: +Year Ended December 31, +2020 2019 +Aggregate common stock repurchased 2,875,376 4,000,424 +Weighted average price paid per share $ 53.88 $ 62.27 +Total amount paid (in millions) $ 155 $ 249 +As of December 31, 2020, we had up to $ 596 million of the share repurchase program available. Under the share repurchase program, repurchases can be made from time to time using a variety of methods, which may include open market purchases, privately negotiated transactions or otherwise, all in accordance with the rules of the SEC and other applicable legal requirements. The timing and amount of any shares of our common stock that are repurchased under the share repurchase program will be determined by our management based on market conditions and other factors. The share repurchase program +139 +SCHEDULE I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT +CHENIERE ENERGY, INC. +NOTES TO CONDENSED FINANCIAL STATEMENTS—CONTINUED +does not obligate us to acquire any particular amount of common stock, and may be modified, suspended or discontinued at any time or from time to time at our discretion. +NOTE 6 —SUPPLEMENTAL CASH FLOW INFORMATION +The following table provides supplemental disclosure of cash flow information (in millions): +Year Ended December 31, +2020 2019 2018 +Cash paid during the period for interest, net of amounts capitalized $ 45 $ 36 $ 32 +Non-cash investing and financing activities: +Non-cash capital distribution (1) 79 490 607 +Additional interest in Cheniere Holdings acquired — — 702 +(1) Amounts represent equity income of affiliates. +140 +SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS +(in millions) +Balance at beginning of period Charged to costs and expenses Charged to other accounts Deductions Balance at end of period +Year Ended December 31, 2020 +Allowance for credit losses or doubtful accounts on receivables and contract assets $ — $ 7 $ — $ — $ 7 +Deferred tax asset valuation allowance 196 ( 6 ) — — 190 +Year Ended December 31, 2019 +Allowance for credit losses or doubtful accounts on receivables and contract assets $ 30 $ 16 $ — $ ( 46 ) $ — +Deferred tax asset valuation allowance 686 ( 490 ) — — 196 +Year Ended December 31, 2018 +Allowance for credit losses or doubtful accounts on receivables and contract assets $ 30 $ — $ — $ — $ 30 +Deferred tax asset valuation allowance 806 ( 120 ) — — 686 +141 +ITEM 16. FORM 10-K SUMMARY +None. +142 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +CHENIERE ENERGY, INC. +(Registrant) +By: /s/ Jack A. Fusco +Jack A. Fusco +President and Chief Executive Officer +(Principal Executive Officer) +Date: February 23, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature Title Date +/s/ Jack A. Fusco President and Chief Executive Officer and Director (Principal Executive Officer) February 23, 2021 +Jack A. Fusco +/s/ Zach Davis Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 23, 2021 +Zach Davis +/s/ Leonard E. Travis Senior Vice President and Chief Accounting Officer +(Principal Accounting Officer) February 23, 2021 +Leonard E. Travis +/s/ G. Andrea Botta Chairman of the Board February 23, 2021 +G. Andrea Botta +/s/ Vicky A. Bailey Director February 23, 2021 +Vicky A. Bailey +/s/ Nuno Brandolini Director February 23, 2021 +Nuno Brandolini +/s/ David B. Kilpatrick Director February 23, 2021 +David B. Kilpatrick +/s/ Sean Klimczak Director February 23, 2021 +Sean Klimczak +/s/ Andrew Langham Director February 23, 2021 +Andrew Langham +/s/ Donald F. Robillard, Jr. Director February 23, 2021 +Donald F. Robillard, Jr. +/s/ Neal A. Shear Director February 23, 2021 +Neal A. Shear +/s/ Andrew Teno Director February 23, 2021 +Andrew Teno +143 \ No newline at end of file diff --git a/raw/filings/0000003570/2020/0000003570-21-000039/filing_metadata.csv b/raw/filings/0000003570/2020/0000003570-21-000039/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..f8804ec297c8d94e9f488ae9897cd8f7eb1fb7dc --- /dev/null +++ b/raw/filings/0000003570/2020/0000003570-21-000039/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000003570,LNG,"Cheniere Energy, Inc.",2020,10-K,2021-02-24,2020-12-31,2021-02-24T00:37:46.000Z,0000003570-21-000039,lng-20201231.htm,10-K,22765689,1,1,https://www.sec.gov/Archives/edgar/data/3570/000000357021000039/lng-20201231.htm,https://www.sec.gov/Archives/edgar/data/3570/000000357021000039/ diff --git a/raw/filings/0000003570/2020/0000003570-21-000039/item1.txt b/raw/filings/0000003570/2020/0000003570-21-000039/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000003570/2020/0000003570-21-000039/item13.txt b/raw/filings/0000003570/2020/0000003570-21-000039/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000004127/2018/0000004127-18-000046/filing.txt b/raw/filings/0000004127/2018/0000004127-18-000046/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..73987fafd56e82081d951d1fe18bb43ac71e4732 --- /dev/null +++ b/raw/filings/0000004127/2018/0000004127-18-000046/filing.txt @@ -0,0 +1,4019 @@ +10-K +1 +fy1810k92818.htm +10-K +Document +UNITED STATES SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +þ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended September 28, 2018 +OR +o +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from __________to__________ +Commission file number 001-05560 +SKYWORKS SOLUTIONS, INC. +(Exact name of registrant as specified in its charter) +Delaware +04-2302115 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +20 Sylvan Road, Woburn, Massachusetts +01801 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: (781) 376-3000 +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock, par value $0.25 per share +Nasdaq Global Select Market +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes o No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. o Yes þ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). þ Yes o No +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company,” in Rule 12b-2 of the Exchange Act. +Large Accelerated filer þ +Accelerated filer o +Non-accelerated filer o +Smaller reporting company o +Emerging growth company o +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No +The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant (based on the closing price of the registrant’s common stock as reported on the Nasdaq Global Select Market on the last business day of the registrant’s most recently completed second fiscal quarter March 30, 2018 ) was approximately $18.2 billion . The number of outstanding shares of the registrant’s common stock, par value $0.25 per share, as of November 7, 2018 , was 177,531,995 . +DOCUMENTS INCORPORATED BY REFERENCE +Part of Form 10-K +Documents from which portions are incorporated by reference +Part III +Portions of the Registrant’s Proxy Statement relating to the Registrant’s 2018 Annual Meeting of Stockholders (to be filed) are incorporated by reference into Items 10, 11, 12, 13 and 14 of this Annual Report on Form 10-K. +SKYWORKS SOLUTIONS, INC. +ANNUAL REPORT ON FORM 10-K +FOR THE YEAR ENDED SEPTEMBER 28, 2018 +TABLE OF CONTENTS +PAGE NO. +PART I +ITEM 1: BUSINESS. +5 +ITEM 1A: RISK FACTORS. +10 +ITEM 1B: UNRESOLVED STAFF COMMENTS. +21 +ITEM 2: PROPERTIES. +21 +ITEM 3: LEGAL PROCEEDINGS. +22 +ITEM 4: MINE SAFETY DISCLOSURES . +22 +PART II +ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. +23 +ITEM 6: SELECTED FINANCIAL DATA. +24 +ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +25 +ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. +32 +ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +33 +ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +64 +ITEM 9A: CONTROLS AND PROCEDURES. +64 +ITEM 9B: OTHER INFORMATION. +65 +PART III +ITEM 10: DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. +65 +ITEM 11: EXECUTIVE COMPENSATION. +65 +ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +65 +ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +65 +ITEM 14: PRINCIPAL ACCOUNTING FEES AND SERVICES. +65 +PART IV +ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES. +66 +ITEM 16: FORM 10-K SUMMARY +66 +SIGNATURES +70 +2 +Table of Contents +CAUTIONARY STATEMENT +This Annual Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the “safe harbor” created by those sections. Any statements that are not statements of historical fact should be considered to be forward-looking statements. Words such as “anticipates”, “believes”, “continue”, “could”, “estimates”, “expects”, “intends”, “may”, “plans”, “potential”, “predicts”, “projects”, “seek”, “should”, “targets”, “will”, “would”, and similar expressions or variations or negatives of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, forward-looking statements include, but are not limited to: +• +our plans to develop and market new products, enhancements or technologies and the timing of these development and marketing plans; +• +our estimates regarding our capital requirements and our needs for additional financing; +• +our estimates of our expenses, future revenues and profitability; +• +our estimates of the size of the markets for our products and services; +• +our expectations related to the rate and degree of market acceptance of our products; and +• +our estimates of the success of other competing technologies that may become available. +Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known and understood by us. Consequently, forward-looking statements involve inherent risks and uncertainties and actual financial results and outcomes may differ materially and adversely from the results and outcomes discussed in or anticipated by the forward-looking statements. A number of important factors could cause actual financial results to differ materially and adversely from those in the forward-looking statements. We urge you to consider the risks and uncertainties discussed elsewhere in this report and in the other documents filed by us with the Securities and Exchange Commission (“SEC”) in evaluating our forward-looking statements. We have no plans, and undertake no obligation, to revise or update our forward-looking statements to reflect any event or circumstance that may arise after the date of this report. We caution readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. +This Annual Report also contains estimates made by independent parties and by us relating to market size and growth and other industry data. These estimates involve a number of assumptions and limitations and you are cautioned not to give undue weight to such estimates. In addition, projections, assumptions and estimates of our future performance and the future performance of the industries in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of important factors, including those described in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. These and other factors could cause results to differ materially and adversely from those expressed in the estimates made by the independent parties and by us. +In this document, the words “we”, “our”, “ours”, “us”, “Skyworks”, and “the Company” refer only to Skyworks Solutions, Inc., and its consolidated subsidiaries and not any other person or entity. In addition, the following is a list of industry standards that may be referenced throughout the document: +• +BiFET (Bipolar Field Effect Transistor): integrates indium gallium phosphide based heterojunction bipolar transistors with field effect transistors on the same gallium arsenide substrate +• +DC (Direct Current): unidirectional flow of an electrical charge +• +CMOS (Complementary Metal Oxide Semiconductor): a technology of constructing integrated circuits +• +GaAs (Gallium Arsenide): a compound of the elements gallium and arsenic that is used in the production of semiconductors +• +HBT (Heterojunction Bipolar Transistor): a type of bipolar junction transistor which uses differing semiconductor materials for the emitter and base regions, creating a heterojunction +• +IoT (Internet of Things): is the interconnection of uniquely identifiable embedded computing devices within the existing internet infrastructure +• +LED (Light Emitting Diode): a two-lead semiconductor light source +• +LTE (Long Term Evolution): 4th generation (“4G”) radio technologies designed to increase the capacity and speed of mobile telephone networks +3 +Table of Contents +• +pHEMT (Pseudomorphic High Electron Mobility Transistor): a type of field effect transistor incorporating a junction between two materials with different band gaps +• +RF (Radio Frequency): electromagnetic wave frequencies that lie in the range extending from around 3 kHz to 300 GHz +• +SAW (Surface Acoustic Wave): electrical input signal is converted to an acoustic wave for filtering and converted back into an electrical signal by interdigitated transducers on a piezoelectric substrate. +• +SOI (Silicon On Insulator): technology refers to the use of layered silicon-insulator-silicon substrate in place of conventional silicon substrates in semiconductor manufacturing +• +TC-SAW (Temperature Compensated Surface Acoustic Wave): SAW filters that have been designed to reduce shift in frequency over temperature. +Skyworks and the Skyworks symbol are trademarks or registered trademarks of Skyworks Solutions, Inc. or its subsidiaries in the United States and other countries. Third-party brands and names are for identification purposes only, and are the property of their respective owners. +4 +Table of Contents +PART l +ITEM 1. BUSINESS. +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. +Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto, General Electric, Google, Honeywell, HTC, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi and ZTE. Our competitors include Analog Devices, Broadcom, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, QUALCOMM and Qorvo. +We are a Delaware corporation that was formed in 1962. We changed our corporate name from Alpha Industries, Inc. to Skyworks Solutions, Inc. on June 25, 2002, following a business combination. We operate worldwide with engineering, manufacturing, sales and service facilities throughout Asia, Europe and North America. Our Internet address is www.skyworksinc.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we electronically submit such material to the SEC. The information contained on our website is not incorporated by reference in this Annual Report. Our SEC filings are also available to the public at www.sec.gov. +In August 2018, we acquired Avnera Corporation (“Avnera”) and expanded our leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors and integrated software. We expect the acquisition of Avnera to enable us to capitalize on the rapid proliferation of audio functionality and its convergence with our advanced connectivity solutions. With our global sales channels, strong customer relationships and operational scale, we plan to leverage Avnera’s innovative product portfolio and systems expertise to increase our footprint in automotive, industrial, home automation, enterprise and high-end consumer markets. +In August 2016, we acquired the remaining 34 percent interest in a joint venture that was initially created in August 2014 with Panasonic Corporation, through its Automotive & Industrial Systems Company (“Panasonic”) for the design, manufacture and sale of Panasonic’s SAW and TC-SAW filter products. The joint venture was dissolved and is now a wholly-owned subsidiary of the Company. With the overall demand for SAW and TC-SAW filters increasing and as technology and product architectures become more complex and the number of required bands grows, this investment assists us in securing a consistent supply of SAW and TC-SAW filters, in addition to allowing us to integrate filters into the design and production of our own products. +INDUSTRY BACKGROUND +Mobile connectivity is exploding on a global basis. With wireless platforms serving as virtual hubs for e-commerce, enterprise to the cloud, social media, gaming and entertainment, these devices are enabling a new, multi-trillion dollar economy. Popular apps including Amazon, Facebook, Netflix, Spotify, Uber, Waze and YouTube all require ultra-fast, highly secure, low-latency, always-on connectivity plus GPS location-based services. As a result, semiconductor solutions are becoming increasingly relevant, resolving the daunting analog and RF complexities that are challenging the capabilities of existing hardware and the supporting network infrastructure. Semiconductor devices continue becoming smaller, more powerful, and easier to integrate across multiple communication protocols, which in turn is enabling mobile and IoT ecosystems. +Skyworks facilitates ubiquitous data creation, delivery and storage as smartphones transmit and receive immense amounts of content supporting multimedia streaming, social networking, virtual reality and emerging frictionless commerce. To enable these applications, we deliver highly integrated solutions leveraging our amplification, filtering, tuning, power management, audio processing and packaging capabilities to continuously push the performance envelope. +Demand for connectivity across emerging markets around the world also continues to grow as the industry drives toward connecting the billions of people who remain unconnected. According to The GSMA Foundation, there will be 5.9 billion mobile subscribers by 2025, representing almost three-quarters of the world’s population. Subscriber growth over this period is forecast to be driven primarily by large markets in Asia, such as India, which alone is expected to add 310 million new unique subscribers by 2020. +5 +Table of Contents +At the same time, connectivity is proliferating into an adjacent set of IoT markets. From smart homes to the smart grid and from industrial to wearables, the number of connected devices is rapidly proliferating. In fact, IHS Markit Ltd. projects the IoT market to grow from an installed base of 15 billion units in 2015 to more than 75 billion units by 2025. Skyworks is enabling these opportunities with highly customized system solutions supporting a broad set of wireless protocols including cellular LTE, Wi-Fi, Bluetooth®, LoRa®, Thread and Zigbee®. +Looking ahead to 5G, we see a market that presents a massive growth opportunity for our industry and certainly for Skyworks. 5G data rates will approach ten to 100 times the fastest 4G speeds of today with near zero latency. To put this in perspective, downloading a full-length HD movie in 3G took one day; in 4G, the same file took minutes. On a 5G network, this content will be downloaded in mere seconds. By 2020 a single autonomous car is expected to consume 4,000 gigabytes of data per day in real-time diagnostics, positioning and vehicle-to-vehicle communications—that is equivalent to the daily data consumed by more than 2,000 smartphone users today. +We expect the key catalysts for Skyworks to be the insatiable demand for data and the profitable usage model for both Mobile and IoT applications, as each connection becomes more valuable and vital particularly as the world embraces 5G. +Solving Connectivity Challenges +The transition to ubiquitous connectivity creates challenges to existing architectures. RF solutions in ultra-thin, high performance consumer products must increase data rates, solve signal interference problems, and occupy minimal board space while at the same time increasing battery life. Meeting these design challenges requires broad competencies including signal transmission and conditioning, the ability to ensure seamless hand-offs between multiple standards, power management, voltage regulation, battery charging, filtering and tuning, among others. This complexity plays directly to our strengths. We have a strong heritage in analog systems design and have spent the last decade investing in key technologies and resources. We are at the forefront of advanced multi-chip module integration and offer unmatched technology breadth, providing deep expertise in CMOS, SOI, GaAs and filters, and maintain strategic partnerships with outside independent wafer fabrication facilities. +SKYWORKS’ STRATEGY +Our ambitious vision is to connect everyone and everything, all the time. To this end, key elements of our strategy include: +Industry-Leading Technology +As the industry migrates to more complex LTE and 5G architectures across a multitude of wireless broadband applications, we are uniquely positioned to help mobile device manufacturers handle growing levels of system complexity in the transmit and receive chain. The trend towards increasing front-end and analog design challenges in smartphones and other mobile devices plays directly into our core strengths and positions us to address these challenges. We believe that we offer the broadest portfolio of radio and analog solutions from the transceiver to the antenna as well as all required manufacturing process technologies. We also hold strong technology leadership positions in passive devices, advanced integration including proprietary shielding and 3-D die stacking as well as SAW and TC-SAW filters. Our product portfolio is reinforced by a library of approximately 3,000 worldwide patents and other intellectual property that we own and control. Together, our industry-leading technology enables us to deliver the highest levels of product performance and integration. +Customer Relationships +Given our scale and technology leadership, we are engaged with key original equipment manufacturers (“OEMs”), smartphone providers and baseband reference design partners. Our customers value our supply chain strength, our innovative technology and our system engineering expertise, resulting in deep customer loyalty. We partner with our customers to support their long-term product road maps and are valued as a system solutions provider rather than just a point product vendor. +Diversification +We are diversifying our business in three areas: our addressed markets, our customer base and our product offerings. By leveraging core analog and mixed signal technologies, we are expanding our family of solutions to a set of increasingly diverse end markets and customers. We are steadily growing our business beyond just mobile devices (where we support all top-tier manufacturers, including the leading smartphone suppliers and key baseband vendors) into additional high-performance analog markets, including automotive, home and factory automation, infrastructure, medical, smart energy and wireless networking. In these markets we leverage our scale, intellectual property and worldwide distribution network, which spans over 2,500 customers and over 2,500 analog components. +6 +Table of Contents +Delivering Operational Excellence +We vertically integrate our supply chain where we can differentiate with highly specialized internal manufacturing capabilities, or enter into alliances and strategic relationships for leading-edge technologies. This hybrid manufacturing model allows us to better balance our manufacturing capacity with the demand of the marketplace. Our internal capacity utilization remains high, resulting in an increase of our gross margin and the return on invested capital on a broader range of revenue. +Additionally, we continue to drive reductions in product design and manufacturing cycle times and further improve product yields. The combination of agile, flexible capacity and world-class module manufacturing and scale advantage allows us to achieve low product costs while integrating multiple technologies into highly sophisticated multi-chip modules. +Maintaining a Performance Driven Culture +We consider our people and corporate culture to be a major competitive advantage and a key driver of our overall strategy. We create key performance indicators that align employee efforts with corporate strategy and link responsibilities with performance measurement. Accountability is paramount and we compensate our employees through a pay-for-performance methodology. We strive to be an employer-of-choice among peer companies and have created a work environment in which turnover is below geographic and industry averages. +Generating Superior Operating Results and Shareholder Returns +We seek to generate financial returns that are comparable to a highly diversified analog semiconductor company. Given our product volume and overall utilization we strive to achieve a best-in-class return on investment and operating income to reward shareholders. +OUR PRODUCT PORTFOLIO +Our product portfolio consists of various solutions, including: +• +Amplifiers: the modules that strengthen the signal so that it has sufficient energy to reach a base station +• +Antenna Tuners: aperture and impedance tuning products that improve antenna performance across frequencies +• +Attenuators: circuits that allow a known source of power to be reduced by a predetermined factor (usually expressed as decibels) +• +Circulators/Isolators: ferrite-based components commonly found on the output of high-power amplifiers used to protect receivers in wireless transmission systems +• +DC/DC Converters: an electronic circuit which converts a source of direct current from one voltage level to another +• +Demodulators: a device or an RF block used in receivers to extract the information that has been modulated onto a carrier or from the carrier itself +• +Detectors: devices used to measure and control RF power in wireless systems +• +Diodes: semiconductor devices that pass current in one direction only +• +Directional Couplers: transmission coupling devices for separately sampling the forward or backward wave in a transmission line +• +Diversity Receive Modules: devices used to improve receiver sensitivity in high data rate applications +• +Filters: devices for recovering and separating mixed and modulated data in RF stages +• +Front-end Modules: two or more functions co-packaged to optimize the performance, cost and application suitability in products, including intermediate or radio frequency signal paths +• +Hybrid: a type of directional coupler used in radio and telecommunications +• +LED Drivers: devices which regulate the current through a light emitting diode or string of diodes for the purpose of creating light +• +Low Noise Amplifiers: devices used to reduce system noise figure in the receive chain +• +Mixers: devices that enable signals to be converted to a higher or lower frequency signal and thereby allowing the signals to be processed more effectively +• +Modulators: devices that take a baseband input signal and output a radio frequency modulated signal +• +Optocouplers/Optoisolators: semiconductor devices that allow signals to be transferred between circuits or systems while ensuring that the circuits or systems are electrically isolated from each other +• +Phase Locked Loops: closed-loop feedback control system that maintains a generated signal in a fixed phase relationship to a reference signal +• +Phase Shifters: designed for use in power amplifier distortion compensation circuits in base station applications +• +Power Dividers/Combiners: utilized to equally split signals into in-phase signals as often found in balanced signal chains and local oscillator distribution networks +• +Receivers: electronic devices that change a radio signal from a transmitter into useful information +7 +Table of Contents +• +Switches: components that perform the change between the transmit and receive function, as well as the band function for cellular handsets +• +Synthesizers: devices that provide ultra-fine frequency resolution, fast switching speed, and low phase-noise performance +• +Technical Ceramics: polycrystalline oxide materials used for a wide variety of electrical, mechanical, thermal and magnetic applications +• +Voltage Controlled Oscillators/Synthesizers: fully integrated, high performance signal source for high dynamic range transceivers +• +Voltage Regulators: generate a fixed level which ideally remains constant over varying input voltage or load conditions +We believe we possess broad technology capabilities and one of the most complete wireless communications product portfolios in the industry. +MARKETING AND DISTRIBUTION +Our products are sold globally through a direct sales force, electronic component distributors and independent sales representatives. Certain distributors have agreements with us which allow for certain sales returns, stock rotations and price protection on certain inventory if we lower the price of those products (see “ Critical Accounting Estimates ” in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to Item 8 of this Annual Report on Form 10-K for further detail on revenue reserves). As is customary in the semiconductor industry, our distributors may also market other products that compete with ours. +Our sales engagement begins at the earliest stages of the design of an existing or potential customer’s product. We collaborate technically with our customers and reference design partners at the inception of new programs. These relationships allow our team to facilitate customer-driven solutions, which leverage the unique strength of our intellectual property and product portfolio while providing high value and greatly reducing time-to-market. +We believe the technical and complex nature of our products and markets demand an extraordinary commitment to maintain close ongoing relationships with our customers. As such, we strive to expand the scope of our customer relationship to include design, engineering, manufacturing, procurement, logistics and project management. We also employ a collaborative approach in developing these relationships by combining the support of our design teams, applications engineers, manufacturing personnel, sales and marketing staff and senior management. Lastly, we leverage our customer relationships with cross-selling opportunities across product lines in order to maximize revenue. +We believe that maintaining frequent and interactive contact with our customers is paramount to our continuous efforts to provide world-class sales and service support. By listening and responding to feedback, we are able to mobilize resources to raise our level of customer satisfaction, improve our ability to anticipate future product needs, and enhance our understanding of key market dynamics. We are confident that diligently following this path positions us to participate in numerous opportunities for growth in the future. +CUSTOMER CONCENTRATION +A small number of OEMs historically has accounted for a significant portion of our net revenue. In the fiscal year ended September 28, 2018 (“fiscal 2018”), Apple Inc. (“Apple”), through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches, and other devices) constituted more than ten percent of our net revenue. In the fiscal year ended September 29, 2017 (“fiscal 2017”), three customers—Apple, Samsung Electronics (“Samsung”), and Huawei Technology Co., Ltd. (“Huawei”)—each constituted ten percent or more of our net revenue. In the fiscal year ended September 30, 2016 (“fiscal 2016”), two customers—Apple and Samsung—each constituted more than ten percent of our net revenue. For further information regarding customer concentrations see Note 17 to Item 8 of this Annual Report on Form 10-K. +INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS +We own or have a license to use numerous United States and foreign patents and patent applications related to our products and our manufacturing operations and processes. In addition, we own a number of trademarks and service marks applicable to certain of our products and services. We believe that our intellectual property, including patents, patent applications, trade secrets and trademarks, is of material importance to our business. We rely on patent, copyright, trademark, trade secret and other intellectual property laws, as well as non-disclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, designs, devices, algorithms, processes and other intellectual property. Our efforts may not meaningfully protect our intellectual +8 +Table of Contents +property, or others may independently develop substantially equivalent or superior proprietary technologies, designs, devices, algorithms, processes or other intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and effective copyright, patent, trademark and trade secret protection may not be available in those jurisdictions. In addition to protecting our intellectual property, we strive to strengthen our intellectual property portfolio to enhance our ability to obtain cross-licenses of intellectual property from others, to obtain access to intellectual property we do not possess and to more favorably resolve potential intellectual property claims against us. Due to rapid technological changes in the industry, we believe establishing and maintaining a technological leadership position depends primarily on our ability to develop new, innovative products through the technical competence of our engineering personnel. +COMPETITIVE CONDITIONS +The competitive environment in the semiconductor industry is in a constant state of flux, with new products continually emerging and existing products approaching technological obsolescence. We compete on the basis of time-to-market, new product innovation, quality, performance, price, compliance with industry standards, strategic relationships with customers and baseband vendors, personnel and protection of our intellectual property. We participate in highly competitive markets against numerous competitors that may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements, or may be able to devote greater resources to the development, promotion and sale of their products than we can. +Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. We mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs and lower manufacturing costs of existing products and by introducing new and higher value-added products. +RESEARCH AND DEVELOPMENT +Our products and markets demand rapid technological advancements requiring a continuous effort to enhance existing products and develop new products and technologies. Accordingly, we maintain a high level of research and development activity. We invested $404.5 million , $355.2 million and $312.4 million in research and development during fiscal 2018, fiscal 2017 and fiscal 2016, respectively. The growth in research and development expenses were the result of increases in our internal product designs and product development activity for our target markets in each of these fiscal years. Our research and development expenses include new product development and innovations in integrated circuit design, investment in advanced semiconductor manufacturing processes, development of new packaging and test capabilities and research on next generation technologies and product opportunities. We maintain close collaborative relationships with many of our customers to help identify market demands and target our development efforts to meet those demands. +RAW MATERIALS +Raw materials for our products and manufacturing processes are generally available from several sources. It is our intent not to depend on a sole source of supply unless market or other conditions dictate otherwise. However, there are limited situations where we procure certain components and services for our products from single or limited sources, and we are currently dependent on a limited number of sole source suppliers. We purchase materials and services primarily pursuant to individual purchase orders. However, we have entered into certain supply agreements for the purchase of raw materials or other manufacturing related services that specify minimum prices and purchase quantity based on our anticipated future requirements. Such amounts are reviewed and included in our contractual obligations and commitments as required. Certain of our suppliers consign raw materials to us at our manufacturing facilities to which we take title as needed in our manufacturing process. We believe we have adequate sources for the supply of raw materials and components for our manufacturing needs with suppliers located around the world. +BACKLOG AND INVENTORY +Our sales are made pursuant to standard purchase orders and specified customer contracts for delivery of products, with such purchase orders officially acknowledged by us according to our own terms and conditions. We also maintain Skyworks-owned finished goods inventory at certain customer “hub” locations. We do not recognize revenue until these customers consume the Skyworks-owned inventory from these hub locations. Due to industry practice, which allows customers to cancel orders with limited advance notice to us prior to shipment, and with little or no penalty, we believe that backlog as of any particular date may not be a reliable indicator of our future revenue levels. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volume could result in a reduction in revenue and us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. +ENVIRONMENTAL REGULATIONS +9 +Table of Contents +Federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes, and other activities affecting the environment have had, and will continue to have, an impact on our manufacturing operations. Most of our customers have mandated that our products comply with various local, regional and national “green” initiatives initiated by such customers or the locations in which they operate. We believe that our current expenditures for environmental capital investment and remediation necessary to comply with present regulations governing environmental protection, and other expenditures for the resolution of environmental claims, will not have a material adverse effect on our liquidity and capital resources, competitive position or financial condition. Environmental regulations are subject to change in the future, and accordingly we are unable to assess the possible effect of compliance with future requirements. +SEASONALITY +Sales of our products are subject to seasonal fluctuation and periods of increased demand in end-user consumer applications, such as smartphones and tablet computing devices. The highest demand for our products generally occurs in our first fiscal quarter ending in December and the fourth fiscal quarter ending in September. The lowest demand for our handset products generally occurs in our second fiscal quarter ending in March and the third fiscal quarter ending in June. +EMPLOYEES +As of September 28, 2018 , we employed approximately 9,400 employees world-wide. Approximately 1,150 of our employees in Mexico, 260 employees in Singapore, and 240 employees in Japan are covered by collective bargaining and other union agreements. +ITEM 1A. RISK FACTORS. +You should carefully consider the risks described below in addition to the other information contained in this report before making an investment decision with respect to any of our securities. Our business, financial condition or results of operations could be materially impacted by any of these risks. The risks and uncertainties described below are not the only ones we face. Additional risks not currently known to us or other factors not perceived by us to present significant risks to our business at this time may impair our business operations, financial condition or results of operations. +We operate in the highly cyclical semiconductor industry, which is subject to significant downturns. +We operate in the semiconductor industry, which is cyclical and subject to rapid declines in demand for end-user products in both the consumer and enterprise markets. Uncertain worldwide economic and political conditions, together with other factors such as the volatility of the financial markets, continue to make it difficult for our customers and for us to accurately forecast and plan future business activities. Uncertainty and economic weakness could result in a market contraction and, as a result, our business, financial condition and results of operations would likely be materially and adversely affected. Such periods of industry downturn are characterized by diminished product demand and revenue, manufacturing overcapacity, excess inventory levels, accelerated erosion of average selling prices, bad debt, inventory charges, restructuring charges, and asset impairment charges. Furthermore, downturns in the semiconductor industry may be prolonged, and any extended delay or failure of the market to recover from an economic downturn would materially and adversely affect our business, financial condition and results of operations beyond our current fiscal year. +Our operating results may be adversely affected by quarterly and annual fluctuations and market downturns. +Our revenues, earnings and other operating results may fluctuate significantly on a quarterly and annual basis. These fluctuations are typically the result of a number of factors, many of which are beyond our control. +These factors include, among others: +• +changes in end-user demand for the products manufactured and sold by our customers, +• +the effects of competitive pricing pressures, including decreases in average selling prices of our products, +• +production capacity levels and fluctuations in manufacturing yields, +• +availability and cost of materials and services from our suppliers, +• +the gain or loss of significant customers, +• +our ability to develop, introduce and market new products and technologies on a timely basis, +• +new product and technology introductions by competitors, +• +increasing industry consolidation among our competitors, +• +changes in the mix of products produced and sold, +• +market acceptance of our products and our customer’s products, and +• +intellectual property disputes, including those concerning payments associated with the licensing and/or sale of intellectual property, and related remedies (e.g., monetary damages, injunctions, or exclusion orders affecting our or our customers’ products). +10 +Table of Contents +We employ certain methods, assumptions, estimates, and other subjective judgments in order to apply our accounting policies and to project future performance, projections which may be publicly disclosed from time to time. Changes to such methods, assumptions, estimates, and judgments, combined with other factors that are difficult to forecast, including the factors listed above, could materially and adversely affect our quarterly or annual operating results and could produce actual operating results that differ significantly from previous estimates and projections. If our operating results fail to meet the expectations of analysts or investors, it could materially and adversely affect the price of our common stock. +Our reliance on a small number of customers for a large portion of our sales could have a material adverse effect on the results of our operations. +Significant portions of our sales are concentrated among a limited number of customers. If we lost one or more of these major customers, or if one or more major customers significantly decreased its orders for our products, our business could be materially and adversely affected. In fiscal 2018, one customer accounted for greater than ten percent of our net revenue. In fiscal 2017, three customers each accounted for ten percent or greater of our net revenue. In fiscal 2016, two customers each accounted for ten percent or greater of our net revenue. For further discussion see Note 17 to Item 8 of this Annual Report on Form 10-K. +Our stock price has been volatile and may fluctuate in the future. +The trading price of our common stock has and may continue to fluctuate significantly. Such fluctuations may be influenced by many factors, including: +• +the volatility of the financial markets, +• +uncertainty regarding the prospects of the domestic and foreign economies, +• +instability in global credit and financial markets, +• +our performance and prospects, +• +the performance and prospects of our major customers and competitors, +• +our revenue concentrations with relatively few customers, +• +the depth and liquidity of the market for our common stock, +• +investor perception of us and the industry in which we operate, +• +changes in earnings estimates, price targets or buy/sell recommendations by analysts, +• +domestic and international political conditions, +• +domestic and international tax, fiscal, and trade policy decisions, and +• +our ability to successfully identify, acquire and integrate acquisition candidates. +Public stock markets have experienced price and trading volume volatility. This volatility has affected, and could significantly and negatively affect, the market prices of securities of many technology companies, particularly the market price of our common stock. Such volatility could materially and adversely affect the market price of our common stock in future periods. +In addition, fluctuations in our stock price, volume of shares traded, and changes in our trading multiples may make our stock attractive to momentum, hedge or day-trading investors who often shift funds into and out of stocks rapidly, exacerbating price fluctuations in either direction. Our company has been, and in the future may be, the subject of commentary by financial news media. Such commentary may contribute to volatility in our stock price. If our operating results do not meet the expectations of securities analysts, the financial news media or investors, our stock price may decline, possibly substantially over a short period of time. +The wireless communications and analog semiconductor markets are characterized by significant competition which may cause pricing pressures, decreased gross margins and rapid loss of market share and may materially and adversely affect our business, financial condition and results of operations. +The wireless communications semiconductor industry, in general, and the other analog markets in which we compete are very competitive. We compete with international and United States semiconductor manufacturers of all sizes in terms of resources and market share, including, but not limited to, Analog Devices, Broadcom, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, QUALCOMM, and Qorvo. +We currently face significant competition in our markets and expect that intense price and product competition will continue. This competition has resulted in, and is expected to continue to result in, declining average selling prices for our products and increased challenges in maintaining or increasing revenue, gross margin and market share. Furthermore, additional competitors may enter our markets as a result of growth opportunities in communications electronics, the trend toward global expansion by foreign and domestic competitors and technological and public policy changes (including national or regional policies intended to develop and support localized competitors). We believe that the principal competitive factors for semiconductor suppliers in our markets include, among others: +11 +Table of Contents +• +rapid time-to-market and product ramps, +• +timely new product innovation, +• +product quality, reliability and performance, +• +product cost and selling price, +• +features available in products, +• +alignment with customer performance specifications, +• +compliance with industry standards, +• +strategic relationships with customers, +• +access to, and the protection and enforcement of, intellectual property, +• +ability to partner with or participate in reference designs of baseband vendors, and +• +maintaining access to manufacturing capacity, raw materials, supplies and services at a competitive cost. +We might not be able to successfully address these factors. Many of our competitors benefit from: +• +long presence in key markets, +• +brand recognition, +• +high levels of customer satisfaction, +• +vertical integration, +• +strong baseband partnership/participation in reference designs, +• +a broad product portfolio allowing them to bundle product offerings, +• +ownership or control of key technology or intellectual property, and +• +strong financial, sales and marketing, manufacturing, distribution, technical or other resources. +As a result, certain competitors may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements or may be able to devote greater resources to the development, promotion and sale of their products than we can. As a result of industry consolidation, certain competitors may be able to further exploit such benefits to strengthen their competitive position. +Our baseband reference design partners may leverage their market position by integrating additional functionality into their product offerings that compete with our solutions. If such a product offering were competitive with our solution as to performance, price and quality, our business could be adversely impacted. +Current and potential competitors have established, or may in the future establish, financial or strategic relationships among themselves or with customers, resellers or other third parties. These relationships may affect customers’ purchasing decisions. Accordingly, it is possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We may not be able to compete successfully against current and potential competitors. Increased competition could result in pricing pressures, decreased gross margins and loss of revenue and market share and may materially and adversely affect our business, financial condition and results of operations. +If Original Equipment Manufacturers, or OEMs, and Original Design Manufacturers, or ODMs, of communications electronics products do not design our products into their equipment, we will have difficulty selling those products. Moreover, a “design win” from a customer does not guarantee future sales to that customer. +Our products are not sold directly to the end-user, but are components or subsystems of other products. As a result, we rely on OEMs and ODMs of wireless communications electronics products to select our products from among alternative offerings to be designed into their equipment. Without these “design wins,” we would have difficulty selling our products. If a manufacturer designs another supplier’s product into one of its product platforms, it is more difficult for us to achieve future design wins with that platform because changing suppliers involves significant cost, time, effort and risk on the part of that manufacturer. Also, achieving a design win with a customer does not ensure that we will receive revenue from that customer. Even after a design win, the customer is not obligated to purchase our products and can choose at any time to reduce or cease use of our products, for example, if its own products are not commercially successful, or for any other reason. We may not continue to achieve design wins or to convert design wins into actual sales, and failure to do so could materially and adversely affect our operating results. Furthermore, as a result of our lengthy product development and sales cycle, we may incur significant research and development expenses, and selling, general and administrative expenses, without generating the anticipated revenue associated with these products. +We are subject to the risks of doing business internationally. +A substantial majority of our net revenue is derived from shipments to customers located outside the United States, primarily in countries located in the Asia-Pacific region and Europe. In addition, we have suppliers located outside the United States, and third-party packaging, assembly and test facilities and foundries located in the Asia-Pacific region. Finally, we maintain wafer fabrication facilities in Kadoma, Japan, and Osaka, Japan, as well as packaging, assembly and test facilities in Mexicali, Mexico, and in Singapore. +12 +Table of Contents +Our international sales and operations are subject to a number of risks inherent in selling and operating abroad. These include, but are not limited to, risks regarding: +• +currency exchange rate fluctuations, including increases or decreases in commodities prices related to such fluctuations, +• +local economic and political conditions, including, but not limited to, social, economic and political instability related to the uncertainty regarding the relationships between the United States and China, Russia, Mexico, North Korea, Middle Eastern countries, other foreign countries, and the international community at large, and related to the United Kingdom’s pending withdrawal from the European Union, +• +labor market conditions and workers’ rights, +• +disruptions of capital and trading markets, +• +inability to collect accounts receivable, +• +restrictive governmental actions (such as restrictions on transfer of funds and trade protection measures, including export duties, quotas, customs duties, border taxes, increased import or export controls and tariffs) that could negatively impact trade between, or increase the cost of operating in, the countries in which we do business, +• +changes in, or non-compliance with, legal or regulatory import/export requirements, including restrictions on selling to certain customers or into certain jurisdictions, +• +natural disasters, acts of terrorism, widespread illness and war, +• +unauthorized transfers of our electronic information and breaches of our information systems, as well as the potential lack of adequate remedies in certain jurisdictions, +• +difficulty in obtaining distribution and support, +• +cultural differences in the conduct of business, +• +direct or indirect government actions, subsidies or policies aimed at supporting local industry, +• +the laws and policies of the United States and other countries affecting trade, foreign investment and loans, foreign travel, and import or export licensing requirements, +• +withdrawal from, or renegotiation of, existing trade agreements by the United States (or other jurisdictions) potentially affecting Mexico, China, and other countries in which we do business, +• +changes in current or future tax law or regulations or new interpretations thereof, by federal or state agencies or foreign governments (including changes in certain countries in Europe and elsewhere regarding corporate taxes, transfer pricing, and tax treaty provisions), +• +changes in the effective tax rate as a result of our overall profitability and mix of earnings in countries with differing statutory tax rates, +• +results of audits and examination of previously filed tax returns, +• +the possibility of being exposed to legal proceedings and potential penalties in a foreign jurisdiction, and/or increased compliance expense, as a result of the numerous, and sometimes conflicting, legal regimes on matters as diverse as anti-corruption, anti-bribery, import/export controls, content requirements, trade restrictions, tariffs, taxation, sanctions, immigration, internal and disclosure control obligations, securities regulation, anti-competition, data privacy and protection (including, but not limited to, the European Union’s General Data Protection Regulation), employment and labor relations, +• +limitations on our ability under local laws to protect or enforce our intellectual property rights in a particular foreign jurisdiction, and +• +restrictions on our ability to repatriate foreign earnings and/or funds and the unfavorable tax impactions related to the same. +Additionally, we are subject to risks in certain global markets in which wireless operators provide subsidies on handset sales to their customers. Increases in cellular handset prices that negatively impact handset sales can result from changes in regulatory policies or other factors, which could impact the demand for our products. Limitations or changes in policy on phone subsidies in the United States, South Korea, Japan, China, and other countries may have additional negative impacts on our revenues. +Some of the countries in which we operate and seek to expand are in emerging markets where legal systems may be less developed or familiar to us. Other jurisdictions in which we conduct business may establish legal and regulatory regimes that differ materially from United States laws and regulations. Compliance with diverse legal requirements is costly and time-consuming and requires significant resources. Violations of one or more of these regulations in the conduct of our business could result in significant fines or monetary damages, criminal sanctions against us or our officers, prohibitions on doing business, unfavorable publicity and other reputation damage, restrictions on our ability to process information and allegations by our clients that we have not performed our contractual obligations. +We are particularly exposed to risks of doing business in China. We expect to continue to expand our business and operations in China. Our success in the Chinese markets may be adversely affected by China’s continuously evolving laws and regulations, including +13 +Table of Contents +those relating to taxation, import and export tariffs, currency controls, anti-corruption, environmental regulations, indigenous innovation, and intellectual property rights and enforcement of those rights. Enforcement of existing laws or agreements may be inconsistent. In addition, changes in the political environment, governmental policies or United States-China relations could result in revisions to laws or regulations or their interpretation and enforcement, exposure of our proprietary intellectual property, increased taxation, restrictions on imports, import duties or currency revaluations, which could have an adverse effect on our business plans and operating results. In particular, the imposition by the United States of tariffs on goods imported from China or deemed to be of Chinese origin and other government actions that restrict our ability to sell our products to Chinese customers or to manufacture or source components in China, and countermeasures imposed by China in response, could directly or indirectly adversely impact our manufacturing costs and the sales of our products in China and elsewhere. Further, the evolving labor market and increasing labor unrest in China may have a negative impact on our customers, which would result in a negative impact on our business and results of operations. Finally, China’s stated policy of reducing its dependence on foreign semiconductor manufacturers and other technology companies could result in reduced demand for our products in China and other key markets as well as reduced supply of critical materials for our products. +Our manufacturing processes are extremely complex and specialized, and disruptions could have a material adverse effect on our business, financial condition and results of operations. +Our manufacturing operations are complex and subject to disruption, including due to causes beyond our control. The fabrication of integrated circuits is an extremely complex and precise process consisting of hundreds of separate steps. It requires production in a highly controlled, clean environment. Minor impurities, contamination of the clean room environment in which our products are produced, errors in any step of the fabrication process, defects in the masks used to print circuits on a wafer, defects in equipment or materials, human error, or a number of other factors can cause a substantial percentage of our products to be rejected or to malfunction. Because our operating results are highly dependent upon our ability to produce integrated circuits at acceptable manufacturing yields, these factors could have a material and adverse effect on our business. +Additionally, our operations may be affected by lengthy or recurring disruptions of operations at any of our production facilities, as well as disruptions at facilities operated by our subcontractors or customers. These disruptions may result from electrical power outages, fire, earthquake, flooding, war, acts of terrorism, health advisories or risks, or other natural or man-made disasters, as well as equipment maintenance, repairs and/or upgrades. Disruptions of our manufacturing operations, or those of our subcontractors and customers, could cause significant delays in shipments until we are able to shift production of the impacted products from an affected facility or subcontractor to another facility or subcontractor, or until the affected customer resumes operations and accepts shipments from us. In the event of such delays, the required alternative capacity, particularly wafer production capacity, may not be available on a timely basis or at all. Even if alternative production capacity is available, we may not be able to obtain it on favorable terms, which could result in higher costs and/or a loss of customers and revenue. Likewise, lower-than-expected demand could lead to underutilized manufacturing facilities, which could negatively impact our financial results. +Due to the highly specialized nature of the gallium arsenide integrated circuit manufacturing process, in the event of a disruption in production at our Newbury Park, California, or Woburn, Massachusetts, semiconductor wafer fabrication facilities as well as our assembly and test facility in Mexicali, Mexico, for any reason, alternative gallium arsenide production capacity would not be immediately available from third-party sources. These disruptions could have a material adverse effect on our business, financial condition and results of operations. +Our SAW and TC-SAW filter manufacturing process is also specialized in nature and in the event of a disruption in production at our filter wafer fabrication facilities in Kadoma, Japan and Osaka, Japan or in our filter assembly and test facility in Singapore, for any reason, alternative filter production capacity would not be immediately available from third-party sources. These disruptions could have a material adverse effect on our business, financial condition and results of operations. +We may not be able to maintain and improve manufacturing yields that contribute positively to our gross margin and profitability. +Minor deviations or disturbances in the manufacturing process can cause substantial manufacturing yield loss, and in some cases, cause production to be suspended and impact our ability to meet customer demand on a timely basis. Manufacturing yields for new products initially tend to be lower as we complete product development and commence volume manufacturing, and typically increase as we bring the product to full production. Our forward product pricing includes this assumption of improving manufacturing yields and, as a result, material variances between projected and actual manufacturing yields will have a direct effect on our gross margin and profitability. The difficulty of accurately forecasting manufacturing yields and maintaining cost competitiveness through improving manufacturing yields will continue to be magnified by the increasing process complexity of manufacturing semiconductor products. Our manufacturing operations may also face pressures arising from the compression of product life cycles, which may require us to manufacture new products faster and for shorter periods while maintaining acceptable manufacturing yields and quality without, in many cases, reaching the longer-term, high-volume manufacturing conducive to higher manufacturing yields and declining costs. +14 +Table of Contents +Remaining competitive in the semiconductor industry depends upon our ability to develop new products, reduce costs in a timely manner, transition to smaller geometry process technologies, and achieve higher levels of design integration. +The semiconductor industry generally and, in particular, many of the markets into which we sell our products, are highly cyclical and characterized by constant and rapid technological change, continuous product evolution, price erosion, evolving technical standards, short product life cycles (including annual product refreshes in some cases), increasing demand for higher levels of integration, increased miniaturization, reduced power consumption and wide fluctuations in product supply and demand. Our operating results depend largely on our ability to continue to cost-effectively introduce new and enhanced products on a timely basis. The successful development and commercialization of semiconductor devices and modules is highly complex and depends on numerous factors, including the ability: +• +to anticipate customer and market requirements and changes in technology and industry standards, +• +to obtain sufficient manufacturing capacity to meet customer demand, +• +to define new products that meet customer and market requirements, +• +to complete development of new products and bring products to market on a timely basis, +• +to differentiate our products from offerings of our competitors, +• +to achieve overall market acceptance of our products, +• +to lengthen the time that a particular product is in demand, and +• +to obtain adequate intellectual property protection for our new products. +Our ability to manufacture current products, and to develop new products, depends on, among other factors, the viability and flexibility of our own internal information technology systems. +We continually evaluate expenditures for planned product development and choose among alternatives based on our understanding of customer technical requirements, new industry standards and expectations of future market growth. We may not be able to develop and introduce new or enhanced wireless communications and analog semiconductor products in a timely and cost-effective manner, and our products may not satisfy customer requirements or achieve market acceptance or we may not be able to anticipate new industry standards and technological changes. We also may not be able to respond successfully to new product announcements and introductions by competitors or to changes in the design or specifications of complementary products of third parties with which our products interface. If we fail to rapidly and cost-effectively introduce new and enhanced products in sufficient quantities that meet our customers’ requirements, our business and results of operations would be materially and adversely harmed. +In addition, prices of many of our products decline, sometimes significantly, over time. Our products may become obsolete earlier than planned or may not have life cycles long enough to allow us to recoup the cost of our investment in designing such products. Accordingly, we believe that to remain competitive, we must continue to reduce the cost of producing and delivering existing products at the same time that we develop and introduce new or enhanced products. We may not be able to continue to reduce the cost of producing and delivering our products and thereby remain competitive. +In order to remain competitive, we expect to continue to transition our products to increasingly smaller geometries. This transition requires us to modify the manufacturing processes for our products, design new products to more stringent standards, and to redesign some existing products. In the past, we have experienced some difficulties migrating to smaller geometry process technologies or new manufacturing processes, which resulted in sub-optimal manufacturing yields, delays in product deliveries and increased expenses. We may face similar difficulties, delays and expenses as we continue to transition our products to smaller geometry processes in the future. In some instances, we depend on our relationships with our third-party foundries to transition to smaller geometry processes successfully. Our foundries may not be able to effectively manage the transition or we may not be able to maintain our relationships with certain foundries. If our foundries or we experience significant delays in this transition or fail to efficiently implement this transition, our business, financial condition and results of operations could be materially and adversely affected. As smaller geometry processes become more prevalent, we expect to continue to integrate greater levels of functionality, as well as customer and third-party intellectual property, into our products. However, we may not be able to achieve higher levels of design integration or deliver new integrated products on a timely basis, or at all. +We may be subject to warranty claims, product recalls, and liability claims. +Although we invest significant resources in the testing of our products, we may discover from time to time defects in our products after they have been shipped, and we may be required to incur additional development and remediation costs, or cash payments to settle claims pursuant to warranty and indemnification provisions in our customer contracts and purchase orders. The potential liabilities associated with these, and similar, provisions in certain of our customer contracts are in some cases capped at significant amounts, and in other cases are uncapped. Depending on the nature of the product defects, we may not be able to recoup our losses from our third-party suppliers. These problems may divert our technical and other resources from other product development efforts and could result in claims against us by our customers or third parties, including liability for costs associated with product recalls, +15 +Table of Contents +indemnification claims, or other obligations under customer contracts. If any of our products contain defects, or have reliability, quality or compatibility problems, our reputation may be damaged and we could be subject to liability claims, which could make it more difficult for us to sell our products to existing and prospective customers and could adversely affect our operating results. Furthermore, such losses would not be covered under our existing corporate insurance programs. +We are dependent upon third parties for the manufacture, assembly and testing of our products. +We rely on foundries to provide silicon-based products and to supplement our gallium arsenide wafer manufacturing capacity. There are significant risks associated with reliance on third-party foundries, including: +• +the lack of wafer supply, potential wafer shortages and higher wafer prices, +• +limited ability to respond to unanticipated changes in customer demand, +• +limited control over delivery schedules, manufacturing yields, production costs and quality assurance, and +• +the inaccessibility of, or delays in obtaining access to, key process technologies and IP blocks. +Although we have long-term supply arrangements to obtain additional external manufacturing capacity, the third-party foundries we use for our standby manufacturing capacity may allocate their limited capacity to the production requirements of other customers and we have no contractual right to prevent them from making such allocations. If we choose to use a new foundry to replace either existing or backup capacity, it will typically take an extended period of time for us to complete our qualification process for that foundry, which will result in a significant passage of time before we can begin shipping products from that new foundry. +Further, the third-party foundries may experience financial difficulties, be unable to deliver products to us in a timely manner or suffer damage or destruction to their facilities, particularly since some of them are located in areas prone to natural disasters. If any disruption of manufacturing capacity occurs, we may not have alternative manufacturing sources immediately available. We may therefore experience difficulties or delays in securing an adequate supply of our products, which could impair our ability to meet our customers’ needs and have a material adverse effect on our operating results. +Although we own and operate assembly and test facilities, we still depend on subcontractors to package, assemble and test certain of our products at cost-competitive rates. We do not have long-term agreements with any of our assembly or test subcontractors and typically procure services from these suppliers on a per order basis. If any of these subcontractors experiences capacity constraints or financial difficulties, suffers any damage to its facilities, experiences power outages or any other disruption of assembly or testing capacity, we may not be able to obtain alternative assembly and testing services in a timely manner and/or at cost-competitive rates. Due to the amount of time that it usually takes us to qualify assemblers and testers, we could experience significant delays in product shipments if we are required to find alternative assemblers or testers for our components. Any problems that we may encounter with the delivery, quality or cost of our products could damage our customer relationships and materially and adversely affect our results of operations. +If we are unable to attract and retain qualified personnel to contribute to the design, development, manufacture and sale of our products, we may not be able to effectively operate our business. +As the source of our technological and product innovations, our key technical personnel represent a significant asset. Our success depends on our ability to continue to attract, retain and motivate qualified personnel, including executive officers and other key management and technical personnel. The competition for management and technical personnel is intense in the semiconductor industry, and therefore we may not be able to continue to attract and retain the qualified management and other personnel necessary for the design, development, manufacture and sale of our products. We may have particular difficulty attracting and retaining key personnel during periods of poor operating performance and/or declines in the price of our common stock, given among other factors, the use of equity-based compensation by us and our competitors. Further, existing immigration laws, together with any changes to immigration policies or regulations in the United States, could make it more difficult for us to recruit and retain highly skilled foreign national graduates of universities in the United States, limiting the pool of available talent. Travel bans, difficulties obtaining visas and other restrictions on international travel could make it more difficult to effectively manage our international operations, collaborate as a global company or service our international customer base. We continue to anticipate increases in human resource needs, particularly in engineering. The loss of the services of one or more of our key employees or our inability to attract, retain and motivate qualified personnel, could have a material adverse effect on our ability to operate our business. +Our business would be adversely affected by the departure of existing members of our senior management team or if our senior management team is unable to effectively implement our strategy. +Our success depends, in large part, on the continued contributions of our senior management team, none of whom is bound by a written employment contract to remain with us for a specified period. The loss of any of our senior management could harm our ability to implement our business strategy and respond to the rapidly changing market conditions in which we operate. +Uncertainties involving the ordering and shipment of, and payment for, our products, could adversely affect our business. +16 +Table of Contents +Our sales are made pursuant to standard purchase orders and/or specified customer contracts for delivery of products and not under long-term supply arrangements with our customers. Our customers may cancel orders before shipment. Additionally, we sell a portion of our products through third-party distributors, some of whom have rights to return products if the product is defective. We may purchase and manufacture inventory based on estimates of customer demand for our products, which is difficult to predict. This difficulty may be compounded when we sell to OEMs indirectly through distributors or contract manufacturers, or both, as our forecasts of demand will then be based on estimates provided by multiple parties. In addition, our customers and/or distributors may change their inventory practices on short notice for any reason. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volumes could result in us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. Some of our customers have implemented vendor-managed inventory, consignment or similar inventory programs which may result in an increase in the time between manufacture of, and payment for, our products. +In addition, if a customer or distributor encounters financial difficulties of its own as a result of a change in demand or for any other reason, the customer’s or distributor’s ability to make timely payments against our accounts receivable could be impaired. +We are dependent upon third parties for the supply of raw materials and components. +Our manufacturing operations depend on obtaining adequate supplies of raw materials and components used in our manufacturing processes at a competitive cost. Although we maintain relationships with suppliers located around the world with the objective of ensuring that we have adequate sources for the supply of raw materials and components for our manufacturing needs, increases in demand from the semiconductor industry for such raw materials and components, as well as increased demand for commodities in general, can result in tighter supplies and higher costs. Our suppliers may not be able to meet our delivery schedules, we may lose a significant or sole supplier, a supplier may not be able to meet performance and quality specifications and we may not be able to purchase such supplies or material at a competitive cost. If a supplier were unable to meet our delivery schedules or if we lost a supplier or a supplier were unable to meet performance or quality specifications, our ability to satisfy customer obligations would be materially and adversely affected. In addition, we review our relationships with suppliers of raw materials and components for our manufacturing needs on an ongoing basis. In connection with our ongoing review, we may modify or terminate our relationship with one or more suppliers. We may also enter into sole supplier arrangements to meet certain of our raw material or component needs. While we do not typically rely on a single source of supply for our raw materials, we are currently dependent on a limited number of sole-source suppliers. If we were to lose these sole sources of supply, for any reason, a material adverse effect on our business could result until an alternate source is obtained. To the extent we enter into additional sole supplier arrangements for any of our raw materials or components, the risks associated with our supply arrangements would be exacerbated. +Our business and operations could suffer in the event of information technology security breaches. +Security breaches, phishing, spoofing, attempts by others to gain unauthorized access to our information technology systems, and other cyberattacks are becoming more sophisticated and are sometimes successful. These incidents, which might be related to industrial or other espionage, include covertly introducing malware to our computers and networks (or to an electronic system operated by a third party for our benefit) and impersonating authorized users, among others. We seek to detect and investigate all security incidents and to prevent their recurrence, but in some cases, we might be unaware of an incident or its magnitude and effects. The theft, unauthorized use, transfer, or publication of our intellectual property, our confidential business information, or the personal data of our employees by third parties or by our employees could harm our competitive position, reduce the value of our investment in research and development and other strategic initiatives or otherwise adversely affect our business. To the extent that any security breach or other cybersecurity incident results in inappropriate disclosure of our customers’, suppliers’, licensees’ or employees’ confidential information, we may incur liability as a result. We expect to continue devoting significant resources to the security of our information technology systems and the training of our employees. However, we cannot ensure that our efforts will be sufficient to prevent or mitigate the damage caused by a cyberattack, cybersecurity incident or network disruption. +If we are not successful in protecting our intellectual property rights, our ability to compete successfully may be materially and adversely affected. +We rely on patent, copyright, trademark, trade secret and other intellectual property laws, as well as nondisclosure and confidentiality agreements and other methods, to protect our proprietary technologies, inventions, information, data, devices, algorithms, processes and other intellectual property. In addition, we often incorporate the intellectual property of our customers, suppliers or other third parties into our designs, and we have obligations with respect to the non-use and non-disclosure of such third-party intellectual property. In the future, it may be necessary to engage in litigation or like activities to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of proprietary rights of others, including our customers. This could require us to expend significant resources and to divert the efforts and attention of our management and technical personnel from our business operations. Regardless of our actions: +17 +Table of Contents +• +the steps we take to prevent misappropriation, infringement, dilution or other violation of our intellectual property or the intellectual property of our customers, suppliers or other third parties may not be successful, and +• +any of our existing or future patents, copyrights, trademarks, trade secrets or other intellectual property rights may be challenged, invalidated or circumvented. +Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization, develop similar technology independently or design around or invalidate our patents. If any of our intellectual property protection mechanisms fails to protect our technology, it would make it easier for our competitors to offer similar competitive products, potentially resulting in loss of market share and price erosion. Even if we receive a patent, the patent claims may not be broad enough to adequately cover and protect our technology. Furthermore, even if we receive patent protection in the United States, we may not seek, or may not be granted, patent protection in other relevant foreign countries. In addition, effective patent, copyright, trademark and trade secret protection and enforcement may be unavailable or limited for certain technologies and in certain foreign countries. +We attempt to control access to, and distribution of, our proprietary information through operational, technological and legal safeguards. Despite our efforts, parties, including former or current employees, may attempt to copy, disclose, transfer or obtain access to our information without our authorization. Furthermore, attempts by computer hackers to gain unauthorized access to our systems or information could result in our confidential and/or proprietary information being compromised or our operations being interrupted. While we attempt to prevent such unauthorized access or misappropriation we may be unable to anticipate the methods used, or be unable to prevent the release of our confidential and/or proprietary information. +We may be subject to claims of infringement of third-party intellectual property rights, or demands that we license third-party technology, which could result in significant expense and prevent us from using our technology. +The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark and other intellectual property rights against technologies that are important to our business and have demanded and may in the future demand that we license their technology or refrain from using it. +Any litigation to determine the validity of any allegations that our products infringe or may infringe intellectual property rights of another party, including indemnification claims arising from our contractual obligations of our customers, regardless of their merit or resolution, could be costly and divert the efforts and attention of our management and technical personnel. Regardless of the merits of any specific claim, we may not prevail in litigation because of the complex technical issues and inherent uncertainties in intellectual property litigation. If litigation were to result in an adverse ruling, we could be required to: +• +pay substantial damages, +• +cease the manufacture, import, use, sale or offer for sale of infringing products or processes, +• +discontinue the use of infringing technology, +• +expend significant resources to develop non-infringing technology, and +• +license technology from the third party claiming infringement, which license may not be available on commercially reasonable terms. +Our operating results or financial condition may be materially adversely affected if we, or one of our customers, were required to take any one or more of the foregoing actions. +In addition, if another supplier to one of our customers, or a customer of ours itself, were found to be infringing upon the intellectual property rights of a third party, the supplier or customer could be ordered to cease the manufacture, import, use, sale or offer for sale of its infringing product(s) or process(es), either of which could result, indirectly, in a decrease in demand from our customers for our products. If such a decrease in demand for our products were to occur, it could have an adverse impact on our operating results. +Many of our products currently incorporate technology licensed or acquired from third parties and we expect our products in the future to also require technology from third parties. If the licenses to such technology that we currently hold become unavailable or the terms on which they are available become commercially unreasonable, or if we are unable to acquire or license necessary technology for our products in the future, our business could be adversely affected. +We sell products in markets that are characterized by rapid technological changes, evolving industry standards, frequent new product introductions, short product life cycles and increasing levels of integration. Our ability to keep pace with this market depends on our ability to obtain technology from third parties on commercially reasonable terms to allow our products to remain competitive. If licenses to such technology are not available on commercially reasonable terms and conditions or at all, and we cannot otherwise acquire or integrate such technology, our products or our customers’ products could become unmarketable or obsolete, and we could lose market share. In such instances, we could also incur substantial unanticipated costs or scheduling delays to develop substitute technology to deliver competitive products. +18 +Table of Contents +There can be no assurance that we will continue to declare cash dividends or repurchase our stock. +We intend to pay quarterly cash dividends subject to capital availability and periodic determinations by our Board of Directors that cash dividends are in the best interest of our stockholders. In addition, from time to time the Board of Directors approves stock repurchase programs, pursuant to which we are authorized to repurchase shares of common stock on the open market or in privately negotiated transactions. +Future cash dividends and the amount and timing of our stock repurchases may be affected by, among other factors: +• +our views on potential future capital requirements, including those related to acquisitions as well as research and development, +• +our ability to generate sufficient earnings and cash flows, +• +use of cash to consummate various acquisition transactions, +• +capital requirements related to cash dividends and stock repurchase programs, +• +changes in federal and state income tax laws or corporate laws, and +• +changes to our business model. +Our cash dividend payments may change from time to time, and we cannot provide assurance that we will increase our cash dividend payment or declare cash dividends in any particular amounts or at all. A reduction in our cash dividend payments or a reduction in the level of our stock repurchases could have a negative effect on our stock price. +Changes in tax laws and regulations worldwide could have an adverse impact on our operating results. +We are subject to taxation in many different countries and localities worldwide. To the extent the tax laws and regulations in these various countries and localities could change, including the Base Erosion and Profit Shifting project being conducted by the Organization for Economic Co-operation and Development, our tax liability in general could increase. For example, our subsidiary in Singapore receives a tax holiday that is expected to be effective through September 2020. Changes in the status of this tax holiday could have a negative effect on our net income in future years. +The new tax legislation (the “Tax Reform Act”), enacted by the United States in December 2017, included several changes to U.S. tax laws that will have a significant impact on our operations, including a reduction in the U.S. corporate tax rate, base-erosion prevention measures on earnings of our non-U.S. subsidiaries, and a one-time mandatory deemed repatriation tax on earnings of certain foreign jurisdictions. Because these changes require a number of complex calculations that previously were not required, our actual tax liability may differ materially from our income tax provisions, estimates, and accruals. Changes in our interpretations and assumptions, as well as additional guidance issued, could increase income tax liabilities and/or reduce certain tax benefits. +We face a risk that capital needed for our business will not be available when we need it. +To the extent that our existing cash and cash equivalents and cash generated from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. If unfavorable capital market conditions exist in the event we were to seek additional financing, we may not be able to raise sufficient capital on favorable terms and on a timely basis, if at all. Failure to obtain capital when required by our business circumstances would have a material adverse effect on us. +In addition, any strategic investments and acquisitions that we may make to help us grow our business may require additional capital resources. The capital required to fund these investments and acquisitions may not be available in the future. +To be successful we may need to make certain investments and acquisitions, integrate companies we acquire, and/or enter into strategic alliances. +Although we have invested in the past, and intend to continue to invest, significant resources in internal research and development activities, the complexity and rapidity of technological changes and the significant expense of internal research and development make it impractical for us to pursue development of all technological solutions on our own. On an ongoing basis, we review investment, alliance and acquisition prospects that would complement our product offerings, augment our market coverage or enhance our technological capabilities. We may not be able to identify and consummate suitable investment, alliance or acquisition transactions in the future. Moreover, if such transactions are consummated, they could result in: +• +issuances of equity securities dilutive to our stockholders, +• +large, transactions, restructuring or other impairment write-offs, +• +the incurrence of substantial debt and assumption of unknown liabilities, +• +the potential loss of key employees from the acquired company, +• +recognition of additional liabilities known or unknown at the time of acquisition, +19 +Table of Contents +• +amortization expenses related to intangible assets, and +• +the diversion of management’s attention from other business concerns. +Moreover, integrating acquired organizations and their products and services may be difficult, expensive, time-consuming and a strain on our resources and our relationship with employees and customers and ultimately may not be successful. Additionally, in periods following an acquisition, we will be required to evaluate goodwill and acquisition-related intangible assets for impairment. If such assets are found to be impaired, they will be written down to estimated fair value, with a charge against earnings. +Increasingly stringent environmental laws, rules and regulations may require us to redesign our existing products and processes, and could adversely affect our ability to cost-effectively produce our products. +The semiconductor industry has been subject to increasing environmental regulations, particularly those environmental requirements that control and restrict the use, transportation, emission, discharge, storage and disposal of certain chemicals, elements and materials used or produced in the semiconductor manufacturing process. Heightened public focus on climate change, sustainability and environmental issues has also led to increased government regulation and caused certain of our customers to impose environmental standards on us as a part of doing business with them. We expect that the trend of increasing environmental awareness will continue for the foreseeable future which will result in higher costs of operations. In addition, our commitment to environmentally sustainable practices, while undertaken in a manner designed to be as efficient and cost effective as possible, may result in increases in costs of operations for us relative to our competitors until technologies and methods are developed that will help reduce those costs or such practices become industry best practice. +A number of domestic and foreign jurisdictions restrict or may seek to restrict the use of various substances, a number of which have been or are currently used in our products or processes. For example, the European Union Restriction of Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) Directive requires that certain substances, which may be found in certain products we have manufactured in the past, be removed from all electronics components. Eliminating such substances from our manufacturing processes requires the expenditure of additional research and development funds to seek alternative substances for our products, as well as increased testing by third parties to ensure the quality of our products and compliance with the RoHS Directive. While we have implemented a compliance program to ensure our product offering meets these regulations, there may be instances where alternative substances will not be available or commercially feasible, or may only be available from a single source, or may be significantly more expensive than their restricted counterparts. Additionally, if we were found to be non-compliant with any such rule or regulation, we could be subject to fines, penalties and/or restrictions imposed by government agencies that could adversely affect our operating results. +Regulations in the United States require that we determine whether certain materials used in our products, referred to as conflict minerals, originated in the Democratic Republic of the Congo or adjoining countries, or were from recycled or scrap sources. The verification and reporting requirements, in addition to customer demands for conflict-free sourcing, impose additional costs on us and on our suppliers, and may limit the sources or increase the prices of materials used in our products. Further, if we are unable to certify that our products are conflict free, we may face challenges with our customers, which could place us at a competitive disadvantage, and our reputation may be harmed. +New climate change laws and regulations could require us to change our manufacturing processes or obtain substitute materials that may cost more or be less available for our manufacturing operations. In addition, new restrictions on emissions of carbon dioxide or other greenhouse gases could result in significant costs for us. The Commonwealth of Massachusetts has adopted greenhouse gas regulations, and the United States Congress may pass federal greenhouse gas legislation in the future. The United States Environmental Protection Agency has issued greenhouse gas reporting regulations that may apply to certain of our operations. Various jurisdictions are developing other climate change-based regulations, that also may increase our expenses and adversely affect our operating results. We expect increased worldwide regulatory activity relating to climate change in the future. Compliance with these laws and regulations has not had a material impact on our capital expenditures, earnings, financial condition or competitive position. +Furthermore, environmental regulations often require parties to fund remedial action for violations of such regulations regardless of fault. Consequently, it is often difficult to estimate the future impact of environmental matters, including potential liabilities. In addition, our customers increasingly require warranties or indemnity relating to compliance with environmental regulations. The amount of expense and capital expenditures that might be required to satisfy environmental liabilities, to complete remedial actions and to continue to comply with applicable environmental laws may have a material adverse effect on our business, financial condition and results of operations. +Certain provisions in our organizational documents and Delaware law may make it difficult for someone to acquire control of us. +20 +Table of Contents +We have certain anti-takeover measures that may affect our common stock. Our certificate of incorporation, our by-laws and the Delaware General Corporation Law contain several provisions that would make more difficult an acquisition of control of us in a transaction not approved by our Board of Directors. Our certificate of incorporation and by-laws include provisions such as: +• +the ability of our Board of Directors to issue shares of preferred stock in one or more series without further authorization of stockholders, +• +a prohibition on stockholder action by written consent, +• +a requirement that stockholders provide advance notice of any stockholder nominations of directors or any proposal of new business to be considered at any meeting of stockholders, +• +a requirement that the affirmative vote of at least 80% of our shares be obtained to amend or repeal the provisions of our certificate of incorporation relating to the election and removal of directors or the right to act by written consent, +• +a requirement that the affirmative vote of at least 80% of our shares be obtained for business combinations unless approved by a majority of the members of the Board of Directors and, in the event that the other party to the business combination is the beneficial owner of 5% or more of our shares, a majority of the members of the Board of Directors in office prior to the time such other party became the beneficial owner of 5% or more of our shares, +• +a fair price provision, and +• +a requirement that the affirmative vote of at least 90% of our shares be obtained to amend or repeal the fair price provision. +In addition to the provisions in our certificate of incorporation and by-laws, Section 203 of the Delaware General Corporation Law generally provides that a corporation may not engage in any business combination with any interested stockholder during the three-year period following the time that such stockholder becomes an interested stockholder, unless a majority of the directors then in office approves either the business combination or the transaction that results in the stockholder becoming an interested stockholder or specified stockholder approval requirements are met. +ITEM 1B. UNRESOLVED STAFF COMMENTS. +None. +ITEM 2. PROPERTIES. +We have executive offices in Irvine, California, and Woburn, Massachusetts. For information regarding property, plant and equipment by geographic region for each of the last three fiscal years, see Note 17 to Item 8 of this Annual Report on Form 10-K. The following table sets forth our principal facilities: +Location +Owned/Leased +Square Footage +Primary Function +Mexicali, Mexico +Owned +380,000 +Manufacturing and office space +Woburn, Massachusetts +Owned +158,000 +Manufacturing and office space +Adamstown, Maryland +Owned +121,200 +Manufacturing and office space +Newbury Park, California +Owned +111,600 +Manufacturing and office space +Osaka, Japan +Leased +405,300 +Filter manufacturing +Mexicali, Mexico +Leased +179,000 +Manufacturing and office space +Singapore, Singapore +Leased +176,800 +Filter manufacturing +Irvine, California +Leased +126,900 +Design center and office space +Newbury Park, California +Leased +115,700 +Design center +Kadoma, Japan +Leased +97,300 +Filter manufacturing and office space +San Jose, California +Leased +51,900 +Design center and office space +Cedar Rapids, Iowa +Leased +42,900 +Design center +Ottawa, Ontario +Leased +33,200 +Design center +Andover, Massachusetts +Leased +22,900 +Design center +Seoul, Korea +Leased +22,900 +Design center +Basking Ridge, New Jersey +Leased +21,800 +Design center +Hillsboro, Oregon +Leased +21,200 +Design center and office space +21 +Table of Contents +ITEM 3. LEGAL PROCEEDINGS. +The information set forth under Note 13 of Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES. +Not Applicable. +22 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. +MARKET INFORMATION AND DIVIDENDS +Our common stock is traded on the Nasdaq Global Select Market under the symbol “SWKS”. +The number of stockholders of record of our common stock as of November 7, 2018, was 12,404. On November 8, 2018, the Company announced that the Board of Directors had declared a cash dividend of $0.38 per share of common stock, payable on December 18, 2018, to stockholders of record as of November 27, 2018. We intend to continue to pay quarterly dividends subject to capital availability and our view that cash dividends are in the best interests of our stockholders. Future cash dividends may be affected by, among other items, our views on potential future capital requirements, including those relating to research and development, creation and expansion of sales distribution channels and investments and acquisitions, legal risks, stock repurchase programs, debt issuance, changes in federal and state income tax law and changes to our business model. +ISSUER PURCHASES OF EQUITY SECURITIES +The following table provides information regarding repurchases of common stock made during the fiscal quarter ended September 28, 2018 : +Period +Total Number of Shares Purchased +Average Price Paid per Share +Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1) +Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs (1) +6/30/18-7/27/18 +829,906 (2) +$97.56 +828,483 +$567.1 million +7/28/18-8/24/18 +718,516(3) +$93.61 +715,597 +$500.1 million +8/25/18-9/28/18 +1,002,162(4) +$87.13 +1,000,000 +$413.0 million +Total +2,550,584 +2,544,080 +_________________________ +(1) The stock repurchase program approved by the Board of Directors on January 31, 2018, authorizes the repurchase of up to $1.0 billion of our common stock from time to time on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. The January 31, 2018, stock repurchase program replaces in its entirety the January 17, 2017, plan and is scheduled to expire on January 31, 2020. +(2) 828,483 shares were repurchased at an average price of $97.56 per share as part of our stock repurchase program, and 1,423 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $96.91 per share. +(3) 715,597 shares were repurchased at an average price of $93.62 per share as part of our stock repurchase program, and 2,919 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $91.52 per share. +(4) 1,000,000 shares were repurchased at an average price of $87.12 per share as part of our stock repurchase program, and 2,162 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $93.02 per share. +On November 15, 2017, we agreed to potentially issue not more than 1% of our common stock to an unaffiliated third party as contingent consideration for its role under a multi-year collaboration agreement. The shares are issuable for no cash payment but only upon the achievement of certain product sale milestones, certain terminations of the agreement or if the Company engages in certain competition with the third party. Though the timing is not certain, the Company does not expect achievement of the product sale milestones to occur any time prior to mid-2020. The transaction was made in reliance on the exemption from registration in Section 4(a)(2) of the Securities Act. The Company has agreed to file a registration statement with the Securities and Exchange Commission registering the resale of any issued shares. +23 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA. +The information set forth below for the five years ended September 28, 2018 , is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , and our consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K to fully understand factors that may affect the comparability of the information presented below. Our fiscal year ends on the Friday closest to September 30. Fiscal 2018, 2017, 2016, and 2015 each consisted of 52 weeks and ended on September 28, 2018, September 29, 2017, September 30, 2016, and October 2, 2015, respectively. Fiscal 2014 consisted of 53 weeks and ended on October 3, 2014. +The following table represents the selected financial data (in millions, except per share data): +Fiscal Years Ended +Statement of Operations Data: +September 28, 2018 (2) +September 29, 2017 +September 30, 2016 (1) +October 2, +2015 +October 3, +2014 +Net revenue +$ +3,868.0 +$ +3,651.4 +$ +3,289.0 +$ +3,258.4 +$ +2,291.5 +Operating income +$ +1,319.3 +$ +1,253.8 +$ +1,118.7 +$ +1,023.1 +$ +565.2 +Operating margin +34.1 +% +34.3 +% +34.0 +% +31.4 +% +24.7 +% +Net income +$ +918.4 +$ +1,010.2 +$ +995.2 +$ +798.3 +$ +457.7 +Earnings per share: +Basic +$ +5.06 +$ +5.48 +$ +5.27 +$ +4.21 +$ +2.44 +Diluted +$ +5.01 +$ +5.41 +$ +5.18 +$ +4.10 +$ +2.38 +Cash dividends declared per share +$ +1.34 +$ +1.16 +$ +1.06 +$ +0.65 +$ +0.22 +As of +Balance Sheet Data: +September 28, 2018 (2) +September 29, 2017 +September 30, 2016 (1) +October 2, +2015 +October 3, +2014 +Working capital +$ +1,872.5 +$ +2,245.8 +$ +1,791.9 +$ +1,450.8 +$ +1,131.6 +Property, plant and equipment, net +$ +1,140.9 +$ +882.3 +$ +806.3 +$ +826.4 +$ +555.9 +Total assets +$ +4,828.9 +$ +4,573.6 +$ +3,855.4 +$ +3,719.4 +$ +2,973.8 +Stockholders’ equity +$ +4,097.0 +$ +4,065.7 +$ +3,541.4 +$ +3,159.2 +$ +2,532.4 +____________ +(1) Fiscal 2016 net income and earnings per share include other income of $88.5 million related to the receipt of the PMC-Sierra merger termination fee. +(2) Fiscal 2018 net income and earnings per share include a one-time charge of $224.6 million related to the mandatory deemed repatriation tax on foreign earnings and a one-time charge of $18.3 million related to the revaluation of deferred tax assets and liabilities at the new corporate tax rate, as a result of the Tax Reform Act. +24 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Annual Report on Form 10-K. In addition to historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially and adversely from those referred to herein due to a number of factors, including, but not limited to, those described below and in Item 1A “ Risk Factors ” and elsewhere in this Annual Report on Form 10-K. +OVERVIEW +We, together with our consolidated subsidiaries, are empowering the wireless networking revolution. Our highly innovative analog semiconductors are connecting people, places, and things spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto, General Electric, Google, Honeywell, HTC, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi and ZTE. +RESULTS OF OPERATIONS +FISCAL YEARS ENDED SEPTEMBER 28, 2018 , SEPTEMBER 29, 2017 , AND SEPTEMBER 30, 2016 . +The following table sets forth the results of our operations expressed as a percentage of net revenue: +September 28, +2018 +September 29, +2017 +September 30, +2016 +Net revenue +100.0 +% +100.0 +% +100.0 +% +Cost of goods sold +49.6 +49.6 +49.4 +Gross profit +50.4 +50.4 +50.6 +Operating expenses: +Research and development +10.4 +9.7 +9.5 +Selling, general and administrative +5.4 +5.6 +6.0 +Amortization of intangibles +0.5 +0.8 +1.0 +Restructuring and other charges +— +— +0.1 +Total operating expenses +16.3 +16.1 +16.6 +Operating income +34.1 +34.3 +34.0 +Other income (expense), net +0.3 +0.1 +(0.2 +) +Merger termination fee +— +— +2.7 +Income before income taxes +34.4 +34.4 +36.5 +Provision for income taxes +10.7 +6.7 +6.2 +Net income +23.7 +% +27.7 +% +30.3 +% +GENERAL +During the fiscal year ended September 28, 2018 , the following key factors contributed to our overall results of operations, financial position and cash flows: +• +Net revenue increased to approximately $3,868.0 million , an increase of 6% as compared to the prior fiscal year. This increase in revenue was primarily driven by our success in capturing a higher share of the increasing radio frequency and analog content per device as smartphone models continue to evolve, increases in applications for the IoT, and the expanding analog product portfolio supporting new vertical markets including aerospace, automotive, industrial, medical and military. +25 +Table of Contents +• +Our ending cash, cash equivalents and marketable securities balance decreased 35.0% to $1,050.2 million in fiscal 2018 from $1,616.8 million in fiscal 2017. This was the result of a 13% decrease in cash from operations to $1,260.6 million in fiscal 2018 from $1,456.3 million in fiscal 2017 due to a $221.9 million increase in cash used for working capital. In addition, we returned $1,002.7 million to shareholders through repurchasing 7.7 million shares of our common stock for $759.5 million together with payments of $243.2 million in cash dividends. Lastly, we invested approximately $422.3 million in capital expenditures and $404.0 million in payments for acquisitions. +NET REVENUE +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Net revenue +$ +3,868.0 +5.9% +$ +3,651.4 +11.0% +$ +3,289.0 +We market and sell our products directly to OEMs of communications and electronics products, third-party original design manufacturers and contract manufacturers, and indirectly through electronic components distributors. We generally experience seasonal peaks during the second half of the calendar year, primarily as a result of increased worldwide production of consumer electronics in anticipation of increased holiday sales, whereas our second and third fiscal quarter is typically lower and in line with seasonal industry trends. +The $216.6 million increase in revenue in fiscal 2018 as compared to fiscal 2017 and the $362.4 million increase in revenue in fiscal 2017 as compared to fiscal 2016 were primarily driven by our success in capturing a higher share of the increasing radio frequency and analog content per device as smartphones models continue to evolve, the increasing number of applications for the IoT, and our expanding analog product portfolio supporting new vertical markets including automotive, industrial, medical and military. +For information regarding net revenue by geographic region and customer concentration, see Note 17 to Item 8 of this Annual Report on Form 10-K. +GROSS PROFIT +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Gross profit +$ +1,950.7 +5.9% +$ +1,841.8 +10.6% +$ +1,665.2 +% of net revenue +50.4 +% +50.4 +% +50.6 +% +Gross profit represents net revenue less cost of goods sold. Our cost of goods sold consists primarily of purchased materials, labor and overhead (including depreciation and share-based compensation expense) associated with product manufacturing. Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. As part of our normal course of business, we mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs, improve manufacturing efficiencies, lower manufacturing costs of existing products and by introducing new and higher value-added products. +Gross profit was $108.9 million higher in fiscal 2018 as compared to fiscal 2017. The increase in gross profit was primarily the result of higher unit volumes, lower overall per-unit material and manufacturing costs, and favorable product mix, with an aggregate gross profit benefit of $267.1 million. These benefits were partially offset by the erosion of average selling price that negatively impacted gross profit by $158.2 million. Gross profit margin remained consistent at 50.4% of net revenue for fiscal 2018. +Gross profit was $176.6 million greater in fiscal 2017 as compared to fiscal 2016. The increase in gross profit was primarily the result of higher unit volumes and lower overall per-unit material and manufacturing costs, with an aggregate gross profit benefit of $306.6 million. These benefits were partially offset by the erosion of average selling price and changes in product mix that combined to negatively impact gross profit by $130.0 million. As a result of these impacts, gross profit margin decreased to 50.4% of net revenue for fiscal 2017. +26 +Table of Contents +RESEARCH AND DEVELOPMENT +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Research and development +$ +404.5 +13.9% +$ +355.2 +13.7% +$ +312.4 +% of net revenue +10.4 +% +9.7 +% +9.5 +% +Research and development expenses consist primarily of direct personnel costs including share-based compensation expense, costs for pre-production evaluation and testing of new devices, masks, engineering prototypes and design tool costs. +The increase in research and development expense in fiscal 2018 as compared to fiscal 2017 is primarily related to increased headcount, overall employee-related compensation expense, and expenses associated with product development activity. Research and development expense increased as a percentage of net revenue due to increased development complexity and our efforts to increase the value of our future products. +The increase in research and development expense in fiscal 2017 as compared to fiscal 2016 is primarily related to increased headcount, overall employee-related compensation expense, and expenses associated with product development activity. Research and development expense increased slightly as a percentage of net revenue due to the aforementioned factors. +SELLING, GENERAL AND ADMINISTRATIVE +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Selling, general and administrative +$ +207.8 +1.6% +$ +204.6 +4.4% +$ +195.9 +% of net revenue +5.4 +% +5.6 +% +6.0 +% +Selling, general and administrative expenses include legal and related costs, accounting, treasury, human resources, information systems, customer service, bad debt expense, sales commissions, share-based compensation expense, advertising, marketing, costs associated with business combinations completed or contemplated during the period and other costs. +The increase in selling, general and administrative expenses in fiscal 2018 as compared to fiscal 2017 was primarily related to increases in employee-related compensation expenses, including share-based compensation, partially offset by an increase in the net gain related to the fair value adjustment of contingent consideration of $11.9 million. Selling, general and administrative expenses decreased as a percentage of net revenue primarily due to the increase in net revenue. +The increase in selling, general and administrative expenses in fiscal 2017 as compared to fiscal 2016 was primarily related to increases in employee-related compensation expenses, including share-based compensation, partially offset by lower legal expenses and the net gain related to the fair value adjustment of contingent consideration of $1.3 million. Selling, general and administrative expenses decreased as a percentage of net revenue due to the aforementioned factors and the increase in net revenue. +AMORTIZATION OF INTANGIBLES +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Amortization of purchased intangibles +$ +20.7 +(25.0)% +$ +27.6 +(17.4)% +$ +33.4 +Amortization of capitalized software +6.0 +100.0% +— +—% +— +Total amortization of intangibles +26.7 +27.6 +33.4 +% of net revenue +0.7 +% +0.8 +% +1.0 +% +27 +Table of Contents +During fiscal 2018, $8.4 million and $18.3 million in amortization of intangibles were included in cost of goods sold and selling, general and administrative expense, respectively. During fiscal 2017, $27.6 million in amortization of intangibles was included in selling, general and administrative expense. +The decrease in amortization for fiscal 2018 and fiscal 2017, as compared to fiscal 2017 and fiscal 2016, respectively, primarily relates to fully amortized intangible assets that were acquired in prior years partially offset by additional intangible assets acquired during the fiscal year. +RESTRUCTURING AND OTHER CHARGES +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Restructuring and other charges +$ +0.8 +33.3% +$ +0.6 +(87.5)% +$ +4.8 +% of net revenue +— +% +— +% +0.1 +% +Restructuring and other charges incurred in fiscal 2018 are related to charges on a leased facility. We do not anticipate any further significant charges associated with these restructuring activities and substantially all of the cash payments related to these restructuring plans have occurred. +Restructuring and other charges incurred in fiscal 2017 are primarily related to restructuring plans initiated during the period. +MERGER TERMINATION FEE +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Merger termination fee +$ +— +—% +$ +— +(100.0)% +$ +88.5 +% of net revenue +— +% +— +% +2.7 +% +On October 29, 2015, we entered into an Amended and Restated Agreement and Plan of Merger (the “Merger Agreement”) with PMC-Sierra, Inc. (“PMC”), providing for, subject to the terms and conditions of the Merger Agreement, our cash acquisition of PMC. On November 23, 2015, PMC notified us that it had terminated the Merger Agreement. As a result, on November 24, 2015, PMC paid us a termination fee of $88.5 million pursuant to the Merger Agreement. +PROVISION FOR INCOME TAXES +Fiscal Years Ended +September 28, +2018 +Change +September 29, +2017 +Change +September 30, +2016 +(dollars in millions) +Provision for income taxes +$ +413.7 +67.6% +$ +246.8 +20.2% +$ +205.4 +% of net revenue +10.7 +% +6.7 +% +6.2 +% +The annual effective tax rate for fiscal 2018 of 31.1% was greater than the United States federal statutory rate of 24.6% primarily due to increases in tax from a one-time charge related to the mandatory deemed repatriation tax on foreign earnings of 16.9%, a one-time charge related to the revaluation of our deferred tax assets and liabilities of 1.4%, and income tax rate expense impact of 0.5% related to a change in our tax reserves, partially offset by benefits of 8.4% related to foreign earnings taxed at a rate less than the United States federal rate, 1.0% related to a domestic production activities deduction, 1.9% related to stock windfall deductions, and 1.5% related to the recognition of federal research and development tax credits. +We operate under a tax holiday in Singapore, which is effective through September 30, 2020. This tax holiday is conditioned upon our compliance with certain employment and investment thresholds in Singapore. The impact of the tax holiday decreased the taxes we owe in Singapore by $38.4 million and $37.4 million for fiscal 2018 and fiscal 2017, respectively. This resulted in tax benefits of $0.21 and $0.20 of diluted earnings per share for fiscal 2018 and fiscal 2017, respectively. +28 +Table of Contents +The annual effective tax rate for fiscal 2017 of 19.6% was less than the United States federal statutory rate of 35.0% primarily due to benefits of 14.3% related to foreign earnings taxed at a rate less than the United States federal rate, 1.6% related to a domestic production activities deduction, and 1.3% related to the recognition of federal research and development tax credits, partially offset by income tax rate expense impact of 1.0% related to a change in our tax reserves. +See Note 9 to Item 8 of this Annual Report on Form 10-K for a detailed discussion of the impact of the Tax Reform Act. +LIQUIDITY AND CAPITAL RESOURCES +Fiscal Years Ended +(in millions) +September 28, +2018 +September 29, +2017 +September 30, +2016 +Cash and cash equivalents at beginning of period +$ +1,616.8 +$ +1,083.8 +$ +1,043.6 +Net cash provided by operating activities +1,260.6 +1,456.3 +1,077.7 +Net cash used in investing activities +(1,150.4 +) +(325.9 +) +(250.9 +) +Net cash used in financing activities +(993.7 +) +(597.4 +) +(786.6 +) +Cash and cash equivalents at end of period +$ +733.3 +$ +1,616.8 +$ +1,083.8 +Cash provided by operating activities: +Cash provided by operating activities consists of net income for the period adjusted for certain non-cash items and changes in certain operating assets and liabilities. For fiscal 2018, we generated $1,260.6 million in cash from operations, a decrease of $195.7 million when compared to $1,456.3 million generated in fiscal 2017. The decrease in cash from operating activities during fiscal 2018 was primarily related to a $221.9 million increase in cash used for working capital. Specifically, the increase in uses of cash were: $156.7 million in accounts receivable due to the timing of customer collections and $273.8 million related to accounts payable, due to the timing of capital expenditures and vendor payments. These increases in uses of cash were offset by increases in sources of cash of: $143.0 million related to changes in other current and long-term liabilities primarily related to the unpaid portion of the mandatory deemed repatriation tax on foreign earnings. +Cash used in investing activities: +Cash used in investing activities consists primarily of cash paid for acquisitions net of cash acquired, capital expenditures, purchased intangibles, cash received from the sale of capital assets, and cash related to the sale or maturity of investments. Cash used in investing activities was $1,150.4 million during fiscal 2018, compared to $325.9 million during fiscal 2017. The cash used for capital expenditures in fiscal 2018 was $422.3 million , primarily related to the purchase of manufacturing equipment to support the expansion of our assembly and test operations, filter production operations, and wafer fabrication facilities. During fiscal 2018, we paid $404.0 million , net of cash acquired, to complete an acquisition and $315.5 million in net purchases of marketable securities. +Cash used in financing activities: +Cash used in financing activities consists primarily of cash transactions related to equity. During fiscal 2018, we had net cash outflows of $993.7 million , compared to $597.4 million in fiscal 2017. The increase in cash used in financing activities primarily related to the increase in share repurchase activity and dividend payments during fiscal 2018. During fiscal 2018 we had the following significant uses of cash: +• +$759.5 million related to our repurchase of 7.7 million shares of our common stock pursuant to the share repurchase programs approved by our Board of Directors on January 31, 2018 , and January 17, 2017 ; +• +$243.2 million related to the payment of cash dividends on our common stock; and +• +$48.0 million related to the minimum statutory payroll tax withholdings upon vesting of employee performance and restricted stock awards. +These uses of cash were partially offset by the net proceeds from employee stock option exercises of $38.8 million and the proceeds from employee stock purchase plans of $18.2 million during fiscal 2018. +Liquidity: +Cash and cash equivalent balances were $733.3 million at September 28, 2018 , representing a decrease of $883.5 million from September 29, 2017 . The decrease resulted from $759.5 million used to repurchase 7.7 million shares of stock, $422.3 million in capital expenditures, $404.0 million related to business acquisition activity, $315.5 million in net purchases of marketable securities and $243.2 million in cash dividend payments during fiscal 2018, which was partially offset by $1,260.6 million in cash generated from operations. Based on our historical results of operations, we expect that our cash, cash equivalents and marketable securities +29 +Table of Contents +on hand and the cash we expect to generate from operations will be sufficient to fund our research and development, capital expenditures, potential acquisitions, working capital, quarterly cash dividend payments (if such dividends are declared by the Board of Directors), outstanding commitments and other liquidity requirements associated with existing operations for at least the next 12 months. However, we cannot be certain that our cash on hand and cash generated from operations will be available in the future to fund all of our capital and operating requirements. In addition, any future strategic investments and acquisitions may require additional cash and capital resources. If we are unable to obtain sufficient cash or capital to meet our needs on a timely basis and on favorable terms, our business and operations could be materially and adversely affected. +Our invested cash balances primarily consist of highly liquid marketable securities that are available to meet near-term cash requirements including: term deposits, certificate of deposits, money market funds, U.S. Treasury securities, agency securities, other government securities, corporate debt securities and commercial paper. +We had $300.6 million of cash and cash equivalents located in foreign jurisdictions at September 28, 2018 . +OFF-BALANCE SHEET ARRANGEMENTS +All significant contractual obligations are recorded on our consolidated balance sheet or fully disclosed in the notes to our consolidated financial statements. We have no material off-balance sheet arrangements as defined in SEC Regulation S-K-303(a)(4)(ii). +CONTRACTUAL CASH FLOWS +Set forth below is a summary of our contractual payment obligations related to our operating leases, other commitments and long-term liabilities at September 28, 2018 (in millions): +Payments Due By Period +Obligation +Total +Less Than 1 Year +1-3 Years +3-5 Years +Thereafter +Other long-term liabilities (1) +$ +308.6 +$ +5.5 +$ +36.9 +$ +36.9 +$ +229.3 +Operating lease obligations +86.8 +21.6 +32.5 +17.5 +15.2 +Contingent consideration for business combinations (2) +3.1 +3.1 +— +— +— +Other commitments (3) +15.0 +12.5 +2.5 +— +— +Total +$ +413.5 +$ +42.7 +$ +71.9 +$ +54.4 +$ +244.5 +_________________________ +(1) +Other long-term liabilities primarily include our gross unrecognized tax benefits, as well as executive deferred compensation, which are both classified as beyond five years due to the uncertain nature of the liabilities. +(2) +Contingent consideration related to business combinations is recorded at fair value and actual results could differ. See Note 3 and Note 5 to Item 8 of this Annual Report on Form 10-K for further detail. +(3) +Other commitments consist of contractual license and royalty payments and other purchase obligations. See Note 12 to Item 8 of this Annual Report on Form 10-K. +CRITICAL ACCOUNTING ESTIMATES +The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments in applying our most critical accounting policies that can have a significant impact on the results we report in our financial statements. The SEC has defined critical accounting policies as those that are both most important to the portrayal of our financial condition and results and which require our most difficult, complex or subjective judgments or estimates. Based on this definition, our most critical accounting policies include revenue recognition, which impacts the recording of net revenue; inventory valuation, which impacts the cost of goods sold and gross margin; assessment of goodwill and long-lived assets, which impacts the impairment of the respective assets; business combinations, which impacts the fair value of acquired assets and assumed liabilities; share-based compensation, which impacts cost of goods sold and operating expenses; loss contingencies, which impacts operating expenses; and income taxes, which impacts the income tax provision. These policies and significant judgments involved are discussed further below. We have other significant accounting policies that do not generally require subjective estimates or judgments or would not have a material impact on our results of operations. Our significant accounting policies are described in Note 2 to Item 8 on this Annual Report on Form 10-K. +Revenue Recognition. We recognize revenue in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 605 Revenue Recognition net of estimated reserves. Our revenue reserves contain uncertainties +30 +Table of Contents +because they require management to make assumptions and to apply judgment to estimate the value of future credits to customers for product returns, price protection and stock rotation for products sold to certain electronic component distributors. Our estimates of the amount and timing of the reserves is based primarily on historical experience and specific contractual arrangements. Refer to Note 2 to Item 8 on this Annual Report on Form 10-K for information about the expected impact of our adoption of ASU 2014-09, Revenue from Contracts with Customers (“Topic 606”). +Inventory Valuation. We value our inventory at the lower of cost or net realizable value. Reserves for excess and obsolete inventory are established on a quarterly basis and are based on a detailed analysis of aged material, forecasted demand in relation to on-hand inventory, salability of our inventory, general market conditions, and product life cycles. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. Our reserves contain uncertainties because the calculation requires management to make assumptions and to apply judgment regarding historical experience, forecasted demand and technological obsolescence. Changes in actual demand or market conditions could adversely impact our reserve calculations. +Goodwill and Long-Lived Assets. We evaluate goodwill and long-lived assets for impairment annually on the first day of the fourth fiscal quarter and whenever events or circumstances arise that may indicate that the carrying value of the goodwill or other intangibles may not be recoverable. +Our impairment analysis contains uncertainties because it requires management to make assumptions and to apply judgment to items such as: determination of the reporting unit and asset groupings, estimated control premiums, discount rates, future cash flows, the profitability of future business strategies and useful lives. +Business Combinations. We apply significant estimates and judgments in order to determine the fair value of the identified tangible and intangible assets acquired, liabilities assumed and goodwill recognized in business combinations. The value of all assets and liabilities are recognized at fair value as of the acquisition date using a market participant approach. +In measuring the fair value, we utilize a number of valuation techniques consistent with the market approach, income approach and/or cost approach. The valuation of the identifiable assets and liabilities includes assumptions such as projected revenue, royalty rates, weighted average cost of capital, discount rates and estimated useful lives. These assessments can be significantly affected by our judgments. +Share-Based Compensation . We have share-based compensation plans which include non-qualified stock options, restricted and performance share awards and units, as well as an employee stock purchase plan and other special share-based awards. Note 10 of Item 8 of this Annual Report on Form 10-K details our current share-based compensation programs. +We determine the fair value of our share-based compensation items with pricing models as of the date of grant using a number of highly complex and subjective variables and assumptions including, but not limited to: our expected stock price volatility over the term of the award, correlation coefficients, risk-free rate, the expected life of the award, dividend yield, and estimated performance against metrics. Compensation expense is recognized over the requisite service period of the underlying awards. Management periodically evaluates these assumptions and updates share-based compensation expense accordingly. +Loss Contingencies. We record an estimate for loss contingencies such as a legal proceeding or claims if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss or range of loss can be reasonably estimated. We disclose material loss contingencies if there is at least a reasonable possibility that a loss has been incurred. +Our loss contingency analysis contains uncertainties because it requires management to assess the degree of probability of an unfavorable outcome and to make a reasonable estimate of the amount of potential loss. +Income Taxes. We account for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between tax and financial reporting. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets. +The application of tax laws and regulations to calculate our tax liabilities is subject to legal and factual interpretation, judgment, and uncertainty in a multitude of jurisdictions. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations, and court rulings. We recognize potential liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and interest will be due. We record an amount as an estimate of probable additional income tax liability at the largest amount +31 +Table of Contents +that we feel is more likely than not, based upon the technical merits of the position, to be sustained upon audit by the relevant tax authority. +OTHER MATTERS +Inflation did not have a material impact on our results of operations during the three-year period ended September 28, 2018 . +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. +We are subject to overall financial market risks, such as changes in market liquidity, credit quality, investment risk, interest rate risk and foreign exchange rate risk as described below. +Investment and Interest Rate Risk +Our exposure to interest rate and general market risks relates principally to our investment portfolio, which consists of cash and cash equivalents (money market funds and marketable securities purchased with less than ninety days until maturity) that total approximately $733.3 million and marketable securities (U.S. Treasury and government securities, corporate bonds and notes, municipal bonds, other government securities) that total approximately $294.1 million and $22.8 million within short-term and long-term marketable securities, respectively, as of September 28, 2018. +The main objectives of our investment activities are liquidity and preservation of capital. Our cash equivalent investments have short-term maturity periods that dampen the impact of market or interest rate risk. Our marketable securities consist of short-term and long-term maturity periods between 90 days and two years. Credit risk associated with our investments is not material because our investments are diversified across several types of securities with high credit ratings, which reduces the amount of credit exposure to any one investment. +Based on our results of operations for the fiscal year ended September 28, 2018, a hypothetical reduction in the interest rates on our cash, cash equivalents, and other investments to zero would result in an immaterial reduction of interest income with a de minimis impact on income before taxes. +Given the low interest rate environment, the objectives of our investment activities, and the relatively low interest income generated from our cash, cash equivalents, and other investments, we do not believe that investment or interest rate risks pose material exposures to our current business or results of operations. +Foreign Exchange Rate Risk +Substantially all sales to customers and arrangements with third-party manufacturers provide for pricing and payment in United States dollars, thereby reducing the impact of foreign exchange rate fluctuations on our results. A percentage of our international operational expenses are denominated in foreign currencies and exchange rate volatility could positively or negatively impact those operating costs. For the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , we had foreign exchange losses of $5.5 million, $3.1 million and $5.6 million, respectively. Increases in the value of the United States dollar relative to other currencies could make our products more expensive, which could negatively impact our ability to compete. Conversely, decreases in the value of the United States dollar relative to other currencies could result in our suppliers raising their prices to continue doing business with us. Given the relatively small number of customers and arrangements with third-party manufacturers denominated in foreign currencies, we do not believe that foreign exchange volatility has a material impact on our current business or results of operations. However, fluctuations in currency exchange rates could have a greater effect on our business or results of operations in the future to the extent our expenses increasingly become denominated in foreign currencies. +We may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. However, we may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. For the fiscal year ended September 28, 2018 , we had no outstanding foreign currency forward or option contracts with financial institutions. +32 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +The following consolidated financial statements of the Company are included herewith: +(1) +Report of Independent Registered Public Accounting Firm +Page 34 +(2) +Consolidated Statements of Operations for the three years ended September 28, 2018 +Page 36 +(3) +Consolidated Statements of Comprehensive Income for the three years ended September 28, 2018 +Page 37 +(4) +Consolidated Balance Sheets at September 28, 2018, and September 29, 2017 +Page 38 +(5) +Consolidated Statements of Cash Flows for the three years ended September 28, 2018 +Page 39 +(6) +Consolidated Statements of Stockholders’ Equity for the three years ended September 28, 2018 +Page 40 +(7) +Notes to Consolidated Financial Statements +Page 41 through 62 +33 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Stockholders and Board of Directors +Skyworks Solutions, Inc.: +Opinions on the Consolidated Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Skyworks Solutions, Inc. and subsidiaries (the Company) as of September 28, 2018 and September 29, 2017, the related consolidated statements of operations, comprehensive income, cash flows, and stockholders' equity for each of the years in the three-year period ended September 28, 2018, and the related notes (collectively, the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of September 28, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 28, 2018 and September 29, 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended September 28, 2018, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 28, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +34 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +We have served as the Company’s auditor since 2002. +Irvine, California +November 14, 2018 +35 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF OPERATIONS +(In millions, except per share amounts) +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Net revenue +$ +3,868.0 +$ +3,651.4 +$ +3,289.0 +Cost of goods sold +1,917.3 +1,809.6 +1,623.8 +Gross profit +1,950.7 +1,841.8 +1,665.2 +Operating expenses: +Research and development +404.5 +355.2 +312.4 +Selling, general and administrative +207.8 +204.6 +195.9 +Amortization of intangibles +18.3 +27.6 +33.4 +Restructuring and other charges +0.8 +0.6 +4.8 +Total operating expenses +631.4 +588.0 +546.5 +Operating income +1,319.3 +1,253.8 +1,118.7 +Other income (expense), net +12.8 +3.2 +(6.6 +) +Merger termination fee +— +— +88.5 +Income before income taxes +1,332.1 +1,257.0 +1,200.6 +Provision for income taxes +413.7 +246.8 +205.4 +Net income +$ +918.4 +$ +1,010.2 +$ +995.2 +Earnings per share: +Basic +$ +5.06 +$ +5.48 +$ +5.27 +Diluted +$ +5.01 +$ +5.41 +$ +5.18 +Weighted average shares: +Basic +181.3 +184.3 +188.7 +Diluted +183.2 +186.7 +192.1 +Cash dividends declared and paid per share +$ +1.34 +$ +1.16 +$ +1.06 +See accompanying Notes to Consolidated Financial Statements. +36 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +(In millions) +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Net income +$ +918.4 +$ +1,010.2 +$ +995.2 +Other comprehensive income +Fair value of investments +(0.1 +) +0.9 +— +Pension adjustments +— +0.7 +(1.8 +) +Foreign currency translation adjustment +(0.2 +) +0.8 +(0.9 +) +Comprehensive income +$ +918.1 +$ +1,012.6 +$ +992.5 +See accompanying Notes to Consolidated Financial Statements. +37 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED BALANCE SHEETS +(In millions, except per share amounts) +As of +September 28, +2018 +September 29, +2017 +ASSETS +Current assets: +Cash and cash equivalents +$ +733.3 +$ +1,616.8 +Marketable securities +294.1 +— +Receivables, net of allowance for doubtful accounts of $0.6 and $0.5, respectively +655.8 +454.7 +Inventory +490.2 +493.5 +Other current assets +88.8 +68.7 +Total current assets +2,262.2 +2,633.7 +Property, plant and equipment, net +1,140.9 +882.3 +Goodwill +1,189.8 +883.0 +Intangible assets, net +143.7 +67.8 +Deferred tax assets, net +36.5 +66.5 +Marketable securities +22.8 +— +Other assets +33.0 +40.3 +Total assets +$ +4,828.9 +$ +4,573.6 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable +$ +229.9 +$ +258.4 +Accrued compensation and benefits +85.2 +68.1 +Other current liabilities +74.6 +61.4 +Total current liabilities +389.7 +387.9 +Long-term tax liabilities +310.5 +92.9 +Other long-term liabilities +31.7 +27.1 +Total liabilities +731.9 +507.9 +Commitments and contingencies ( Note 12 and Note 13 ) +Stockholders’ equity: +Preferred stock, no par value: 25.0 shares authorized, no shares issued +— +— +Common stock, $0.25 par value: 525.0 shares authorized; 228.4 shares issued and 177.4 shares outstanding at September 28, 2018, and 226.0 shares issued and 183.1 shares outstanding at September 29, 2017 +44.4 +45.8 +Additional paid-in capital +3,061.0 +2,893.8 +Treasury stock, at cost +(2,732.5 +) +(1,925.0 +) +Retained earnings +3,732.9 +3,059.6 +Accumulated other comprehensive loss +(8.8 +) +(8.5 +) +Total stockholders’ equity +4,097.0 +4,065.7 +Total liabilities and stockholders’ equity +$ +4,828.9 +$ +4,573.6 +See accompanying Notes to Consolidated Financial Statements. +38 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In millions) +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Cash flows from operating activities: +Net income +$ +918.4 +$ +1,010.2 +$ +995.2 +Adjustments to reconcile net income to net cash provided by operating activities: +Share-based compensation +107.8 +88.5 +78.0 +Depreciation +272.5 +227.2 +214.4 +Amortization of intangible assets +26.7 +27.6 +33.4 +Deferred income taxes +27.3 +2.2 +— +Excess tax benefit from share-based compensation +— +(40.8 +) +(43.7 +) +Changes in fair value of contingent consideration +(11.9 +) +(1.3 +) +— +Other +(0.7 +) +0.3 +0.3 +Changes in assets and liabilities net of acquired balances: +Receivables, net +(193.8 +) +(37.1 +) +121.4 +Inventory +11.9 +(69.2 +) +(147.3 +) +Other current and long-term assets +(12.2 +) +3.3 +(20.4 +) +Accounts payable +(126.0 +) +147.8 +(181.5 +) +Other current and long-term liabilities +240.6 +97.6 +27.9 +Net cash provided by operating activities +1,260.6 +1,456.3 +1,077.7 +Cash flows from investing activities: +Capital expenditures +(422.3 +) +(303.3 +) +(189.3 +) +Payments for acquisitions, net of cash acquired +(404.0 +) +(13.7 +) +(55.6 +) +Purchased intangibles +(8.6 +) +(12.1 +) +(6.0 +) +Purchases of marketable securities +(683.7 +) +— +— +Sales and maturities of investments +368.2 +3.2 +— +Net cash used in investing activities +(1,150.4 +) +(325.9 +) +(250.9 +) +Cash flows from financing activities: +Payments for obligations recorded for business combinations +— +— +(76.5 +) +Excess tax benefit from share-based compensation +— +40.8 +43.7 +Repurchase of common stock - payroll tax withholdings on equity awards +(48.0 +) +(49.2 +) +(73.3 +) +Repurchase of common stock - share repurchase program +(759.5 +) +(432.3 +) +(525.6 +) +Dividends paid +(243.2 +) +(214.6 +) +(201.0 +) +Net proceeds from exercise of stock options +38.8 +53.8 +28.1 +Proceeds from employee stock purchase plan +18.2 +15.0 +18.0 +Deferred payments for intangible assets +— +(5.5 +) +— +Payments of contingent consideration +— +(5.4 +) +— +Net cash used in financing activities +(993.7 +) +(597.4 +) +(786.6 +) +Net increase in cash and cash equivalents +(883.5 +) +533.0 +40.2 +Cash and cash equivalents at beginning of period +1,616.8 +1,083.8 +1,043.6 +Cash and cash equivalents at end of period +$ +733.3 +$ +1,616.8 +$ +1,083.8 +Supplemental cash flow disclosures: +Income taxes paid +$ +135.9 +$ +163.2 +$ +165.9 +See accompanying Notes to Consolidated Financial Statements. +39 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In millions) +Shares of common stock +Par value of common stock +Shares of treasury stock +Value of treasury stock +Additional paid-in capital +Retained earnings +Accumulated other comprehensive loss +Total stockholders ’ equity +Balance at October 2, 2015 +190.3 +$ +47.6 +28.7 +$ +(844.6 +) +$ +2,495.2 +$ +1,469.2 +$ +(8.2 +) +$ +3,159.2 +Net income +— +— +— +— +— +995.2 +— +995.2 +Exercise and settlement of share based awards and related tax benefit, net of shares withheld for taxes +2.6 +0.6 +0.9 +(73.3 +) +109.1 +— +— +36.4 +Share-based compensation expense +— +— +— +— +79.7 +— +— +79.7 +Share repurchase program +(8.0 +) +(2.0 +) +8.0 +(525.6 +) +2.0 +— +— +(525.6 +) +Dividends declared +— +— +— +— +— +(200.8 +) +— +(200.8 +) +Other comprehensive loss +— +— +— +— +— +— +(2.7 +) +(2.7 +) +Balance at September 30, 2016 +184.9 +$ +46.2 +37.6 +$ +(1,443.5 +) +$ +2,686.0 +$ +2,263.6 +$ +(10.9 +) +$ +3,541.4 +Net income +— +— +— +— +— +1,010.2 +— +1,010.2 +Exercise and settlement of share based awards and related tax benefit, net of shares withheld for taxes +2.9 +0.7 +0.6 +(49.2 +) +118.2 +— +— +69.7 +Share-based compensation expense +— +— +— +— +88.5 +— +— +88.5 +Share repurchase program +(4.7 +) +(1.1 +) +4.7 +(432.3 +) +1.1 +— +— +(432.3 +) +Dividends declared +— +— +— +— +— +(214.2 +) +— +(214.2 +) +Other comprehensive income +— +— +— +— +— +— +2.4 +2.4 +Balance at September 29, 2017 +183.1 +$ +45.8 +42.9 +$ +(1,925.0 +) +$ +2,893.8 +$ +3,059.6 +$ +(8.5 +) +$ +4,065.7 +Net income +— +— +— +— +— +918.4 +— +918.4 +Exercise and settlement of share based awards, net of shares withheld for taxes +2.0 +0.5 +0.4 +(48.0 +) +57.8 +— +— +10.3 +Share-based compensation expense +— +— +— +— +107.3 +(1.9 +) +— +105.4 +Share repurchase program +(7.7 +) +(1.9 +) +7.7 +(759.5 +) +1.9 +— +— +(759.5 +) +Dividends declared +— +— +— +— +— +(243.2 +) +— +(243.2 +) +Pre-combination service on replacement awards +— +— +— +— +0.2 +— +— +0.2 +Other comprehensive loss +— +— +— +— +— +— +(0.3 +) +(0.3 +) +Balance at September 28, 2018 +177.4 +$ +44.4 +51.0 +$ +(2,732.5 +) +$ +3,061.0 +$ +3,732.9 +$ +(8.8 +) +$ +4,097.0 +See accompanying Notes to Consolidated Financial Statements. +40 +Table of Contents +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s analog semiconductors are connecting people, places, and things, spanning a number of new applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +PRINCIPLES OF CONSOLIDATION +All Skyworks subsidiaries are included in the Company’s consolidated financial statements and all intercompany balances are eliminated in consolidation. +FISCAL YEAR +The Company’s fiscal year ends on the Friday closest to September 30. Fiscal 2018, 2017, and 2016 each consisted of 52 weeks and ended on September 28, 2018, September 29, 2017, and September 30, 2016, respectively. +USE OF ESTIMATES +The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts of assets, liabilities, revenue, expenses, comprehensive income and accumulated other comprehensive loss during the reporting period. The Company evaluates its estimates on an ongoing basis using historical experience and other factors, including the current economic environment. Significant judgment is required in determining the reserves for and fair value of items such as overall fair value assessments of assets and liabilities, inventory, intangible assets associated with business combinations, share-based compensation, loss contingencies, and income taxes. In addition, significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment testing. Actual results could differ significantly from these estimates. +CASH AND CASH EQUIVALENTS +The Company invests excess cash in time deposits, certificate of deposits, money market funds, U.S. Treasury securities, agency securities, other government securities, corporate debt securities and commercial paper. The Company considers highly liquid investments with maturities of 90 days or less when purchased as cash equivalents. +ALLOWANCE FOR DOUBTFUL ACCOUNTS +The Company maintains general allowances for doubtful accounts related to potential losses that could arise due to customers’ inability to make required payments. These reserves require management to apply judgment in deriving these estimates. In addition, the Company performs ongoing credit evaluations of its customers’ financial condition and if it becomes aware of any specific receivables which may be uncollectable, it performs additional analysis including, but not limited to, factors such as a customer’s credit worthiness, intent and ability to pay and overall financial position, and reserves are recorded if deemed necessary. If the data the Company uses to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and results of operations could be materially affected. +INVESTMENTS +The Company classifies its investment in marketable securities as “available-for-sale.” Available-for-sale securities are carried at fair value with unrealized holding gains or losses recorded in other comprehensive income. Gains or losses are included in earnings in the period in which they are realized. +FAIR VALUE +Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principle or most advantageous market in an orderly transaction between market participants at the measurement date. Applicable accounting guidance provides a hierarchy for inputs used in measuring fair value that prioritize the use of observable inputs over the use of unobservable inputs, when such observable inputs are available. The three levels of inputs that may be used to measure fair value are as follows: +41 +Table of Contents +• +Level 1 - Quoted prices in active markets for identical assets or liabilities. +• +Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-driven valuations in which all significant inputs are observable or can be derived principally from, or corroborated with, observable market data. +• +Level 3 - Fair value is derived from valuation techniques in which one or more significant inputs are unobservable, including assumptions and judgments made by the Company. +It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, the Company uses quoted market prices to measure fair value. If market prices are not available, the Company is required to make judgments about assumptions market participants would use to estimate the fair value of a financial instrument. +The Company measures certain assets and liabilities at fair value on a recurring basis in three levels, based on the market in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. It recognizes transfers within the fair value hierarchy at the end of the fiscal quarter in which the change in circumstances that caused the transfer occurred. +The carrying value of cash and cash equivalents, accounts receivable, other current assets, accounts payable and accrued liabilities approximates fair value due to the short-term maturities of these assets and liabilities. +INVENTORY +Inventory is stated at the lower of cost or net realizable value on a first-in, first-out basis. Reserves for excess and obsolete inventory are established on a quarterly basis and are based on a detailed analysis of aged material, forecasted demand in relation to on-hand inventory, salability of our inventory, general market conditions, and product life cycles. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are carried at cost less accumulated depreciation, with significant renewals and betterments being capitalized and retired equipment written off in the respective periods. Maintenance and repairs are expensed as incurred. +Depreciation is calculated using the straight-line method over the estimated useful lives, which range from five to thirty years for buildings and improvements and three to ten years for machinery and equipment. Leasehold improvements are depreciated over the lesser of the economic life or the life of the associated lease. +VALUATION OF LONG-LIVED ASSETS +Definite lived intangible assets are carried at cost less accumulated amortization. Amortization is calculated based on the pattern of benefit to be recognized from the underlying asset over its estimated useful life. Carrying values for long-lived assets and definite lived intangible assets are reviewed for possible impairment as circumstances warrant. Factors considered important that could result in an impairment review include significant underperformance relative to expected, historical or projected future operating results, significant changes in the manner of use of assets or the Company’s business strategy, or significant negative industry or economic trends. In addition, impairment reviews are conducted at the judgment of management whenever asset values are deemed to be unrecoverable relative to future undiscounted cash flows expected to be generated by that particular asset group. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of an asset group and its eventual disposition. Such estimates require management to exercise judgment and make assumptions regarding factors such as future revenue streams, operating expenditures, cost allocation and asset utilization levels, all of which collectively impact future operating performance. The Company’s estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, technological changes, economic conditions, changes to its business model or changes in its operating performance. If the sum of the undiscounted cash flows is less than the carrying value of an asset group, the Company would recognize an impairment loss, measured as the amount by which the carrying value exceeds the fair value of the asset group. +GOODWILL AND INDEFINITE-LIVED INTANGIBLE ASSETS +Goodwill and indefinite-lived intangible assets are not amortized but are tested at least annually as of the first day of the fourth fiscal quarter for impairment or more frequently if indicators of impairment exist during the fiscal year. The Company assesses its conclusion regarding segments and reporting units in conjunction with its annual goodwill impairment test, and has determined that it has one reporting unit for the purposes of allocating and testing goodwill. +42 +Table of Contents +The Company’s impairment analysis compares its fair value to its net book value to determine if there is an indicator of impairment. In the Company’s calculation of fair value, it considers the closing price of its common stock on the selected testing date, the number of shares of its common stock outstanding and other marketplace activity such as a related control premium. If the calculated fair value is determined to be less than the book value of the reporting unit, an impairment loss is recognized equal to that excess; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +BUSINESS COMBINATIONS +The Company uses the acquisition method of accounting for business combinations and recognizes assets acquired and liabilities assumed at their fair values on the date acquired. Goodwill represents the excess of the purchase price over the fair value of the net assets. The fair values of the assets and liabilities acquired are determined based upon the Company’s valuation using a combination of market, income or cost approaches. The valuation involves making significant estimates and assumptions, which are based on detailed financial models including the projection of future cash flows, the weighted average cost of capital and any cost savings that are expected to be derived in the future from the viewpoint of a market participant. +EMPLOYEE RETIREMENT BENEFIT PLANS +The funded status of benefit pension plans, or the balance of plan assets and benefit obligations, is recognized on the consolidated balance sheet and pension liability adjustments, net of tax, are recorded in Accumulated Other Comprehensive Income. The Company determines discount rates considering the rates of return on high-quality fixed income investments, and the expected long-term rate of return on pension plan assets by considering the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. Decreases in discount rates lead to increases in benefit obligations that, in turn, could lead to an increase in amortization cost through amortization of actuarial gain or loss. A decline in the market values of plan assets will generally result in a lower expected rate of return, which would result in an increase of future retirement benefit costs. +REVENUE RECOGNITION +Revenue from product sales is recognized when there is persuasive evidence of an arrangement, the price to the buyer is fixed and determinable, delivery and transfer of title have occurred in accordance with the shipping terms specified in the arrangement with the customer and collectability is reasonably assured. Revenue from license fees and intellectual property is recognized when due and payable, and all other criteria previously noted have been met. The Company ships product on consignment to certain customers and only recognizes revenue when the customer notifies the Company that the inventory has been consumed. Revenue recognition is deferred in all instances where the earnings process is incomplete. Certain product sales are made to electronic component distributors under agreements allowing for price protection and stock rotation on unsold products. Reserves for sales returns and allowances are recorded based on historical experience or pursuant to contractual arrangements necessitating revenue reserves. Reserves for sales returns and allowances of $32.2 million and $14.7 million were recorded as of September 28, 2018 and September 29, 2017 , respectively. +SHARE-BASED COMPENSATION +The Company recognizes compensation expense for all share-based payment awards made to employees and directors including non-qualified employee stock options, share awards and units, employee stock purchase plan and other special share-based awards based on estimated fair values. +The fair value of share-based payment awards is amortized over the requisite service period, which is defined as the period during which an employee is required to provide service in exchange for an award. The Company uses a straight-line attribution method for all grants that include only a service condition. Awards with both performance and service conditions are expensed over the service period for each separately vesting tranche. +Share-based compensation expense recognized during the period includes actual expense on vested awards and expense associated with unvested awards. Forfeitures are recorded as incurred. +The Company determines the fair value of share-based option awards based on the Company’s closing stock price on the date of grant using a Black-Scholes options pricing model. Under the Black-Scholes model, a number of variables are used including, but not limited to: the expected stock price volatility over the term of the award, the risk-free rate, the expected life of the award and dividend yield. The determination of fair value of restricted and certain performance share awards and units is based on the value of the Company’s stock on the date of grant with performance awards and units adjusted for the actual outcome of the underlying performance condition. +43 +Table of Contents +For more complex performance awards including units with market-based performance conditions the Company employs a Monte Carlo simulation valuation method to calculate the fair value of the awards based on the most likely outcome. Under the Monte Carlo simulation, a number of highly complex and subjective variables are used including, but not limited to: the expected stock price volatility over the term of the award, a correlation coefficient, the risk-free rate, the expected life of the award, and dividend yield. +RESEARCH AND DEVELOPMENT COSTS +Research and development costs are expensed as incurred. +LOSS CONTINGENCIES +The Company records its best estimates of a loss contingency when it is considered probable and the amount can be reasonably estimated. When a range of loss can be reasonably estimated with no best estimate in the range, the minimum estimated liability related to the claim is recorded. As additional information becomes available, the Company assesses the potential liability related to the potential pending loss contingency and revises its estimates. Loss contingencies are disclosed if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and include estimated legal costs. +RESTRUCTURING +A liability for post-employment benefits is recorded when payment is probable, the amount is reasonably estimable, and the obligation relates to rights that have vested or accumulated. Contract exit costs include contract termination fees and future contractual commitments for lease payments. A liability for contract exit costs is recognized in the period in which the Company terminates the contract or on the cease-use date for leased facilities. +FOREIGN CURRENCIES +The Company’s primary functional currency is the United States dollar. Gains and losses related to foreign currency transactions, conversion of foreign denominated cash balances and translation of foreign currency financial statements are included in current results. For certain foreign entities that utilize local currencies as their functional currency, the resulting unrealized translation gains and losses are reported as currency translation adjustment through other comprehensive income (loss) for each period. +INCOME TAXES +The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. This method also requires the recognition of future tax benefits such as net operating loss carry forwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. +The carrying value of the Company’s net deferred tax assets assumes the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to record additional valuation allowances against its deferred tax assets resulting in additional income tax expense in its Consolidated Statement of Operations. Management evaluates the realizability of the deferred tax assets and assesses the adequacy of the valuation allowance quarterly. Likewise, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, an adjustment to the deferred tax assets would increase income or decrease the carrying value of goodwill in the period such determination was made. +The determination of recording or releasing tax valuation allowances is made, in part, pursuant to an assessment performed by management regarding the likelihood that the Company will generate future taxable income against which benefits of its deferred tax assets may or may not be realized. This assessment requires management to exercise significant judgment and make estimates with respect to its ability to generate revenues, gross profits, operating income and taxable income in future periods. Amongst other factors, management must make assumptions regarding overall business and semiconductor industry conditions, operating efficiencies, the Company’s ability to develop products to its customers’ specifications, technological change, the competitive environment and changes in regulatory requirements which may impact its ability to generate taxable income and, in turn, realize the value of its deferred tax assets. +The calculation of the Company’s tax liabilities includes addressing uncertainties in the application of complex tax regulations and is based on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. +44 +Table of Contents +The Company recognizes liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on its recognition threshold and measurement attribute of whether it is more likely than not that the positions the Company has taken in tax filings will be sustained upon tax audit, and the extent to which, additional taxes would be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period in which it is determined the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. The Company recognizes any interest or penalties, if incurred, on any unrecognized tax liabilities or benefits as a component of income tax expense. +EARNINGS PER SHARE +Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporate the potentially dilutive incremental shares issuable upon the assumed exercise of stock options, the assumed vesting of outstanding restricted stock units, and the assumed issuance of common stock under the stock purchase plan using the treasury share method. +RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS +In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”) , which is intended to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The Company adopted ASU 2016-09 at the beginning of the first quarter of fiscal 2018. As a result of adoption, the Company recognized a discrete income tax benefit of $25.6 million to the income tax provision for excess tax benefits generated by the settlement of share-based awards during fiscal 2018. The adoption also resulted in an increase in cash flow from operations and a decrease of cash flow from financing of $25.6 million during fiscal 2018. Prior periods have not been adjusted. The Company has elected to account for forfeitures as they occur and will no longer estimate future forfeitures. The change in accounting for forfeitures was applied using a modified retrospective transition method and resulted in a cumulative-effect adjustment to retained earnings as of the beginning of the first quarter of fiscal 2018 in the amount of $1.9 million . Forfeitures in the future will now be recorded as a benefit in the period they are realized. +In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). This ASU simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. The annual or interim goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount, and an impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The Company early adopted ASU 2017-04 during the second quarter of fiscal 2018 and applied it prospectively, as permitted by the standard. The adoption of this standard did not impact the Company’s consolidated financial statements. +RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS +In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and will supersede most current revenue recognition guidance. The new guidance is required to be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying it recognized at the date of initial application. The Company will adopt this guidance during the first quarter of fiscal 2019 and will apply the modified retrospective approach, with the cumulative effect of applying the new guidance recognized as an adjustment to the opening retained earnings balance. The Company has established a cross-functional team to assess the potential impact of the new revenue standard. The assessment process consists of reviewing the Company’s current accounting policies and practices to identify potential differences that would result from applying the requirements of the new standard to its revenue contracts and identifying appropriate changes to the business processes, systems and controls to support revenue recognition and disclosure requirements under the new standard. The Company has determined the impact of the new revenue standard on its business processes, systems, controls and consolidated financial statements is not material. +In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”). This ASU requires lessees to reflect most leases on their balance sheet as assets and obligations. The effective date for the standard is for fiscal years beginning after December 15, 2018, with early adoption permitted. The standard is to be applied under the modified retrospective method, with elective reliefs, which requires application of the new guidance for all periods presented. The Company is currently evaluating the effect that ASU 2016-02 will have on the consolidated financial statements and related disclosures. +45 +Table of Contents +In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230), (“ASU 2016-15”). This ASU provides guidance on the presentation and classification of specific cash flow items to improve consistency within the statement of cash flows. The effective date for the standard is for fiscal years beginning after December 15, 2017, with early adoption permitted. The Company will early adopt ASU 2016-15 during the first quarter of fiscal 2019 and does not expect it to have a material impact on the consolidated financial statements. +In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740), Intra-entity Transfers of an Asset Other than Inventory (“ASU 2016-16”). This ASU provides guidance that changes the accounting for income tax effects of intra-entity transfers of assets other than inventory. Under the new guidance, the selling (transferring) entity is required to recognize a current tax expense or benefit upon transfer of the asset. Similarly, the purchasing (receiving) entity is required to recognize a deferred tax asset or deferred tax liability, as well as the related deferred tax benefit or expense, upon receipt of the asset. The effective date for the standard is for fiscal years beginning after December, 15, 2017, on a modified retrospective basis, and early adoption is permitted. The Company will early adopt ASU 2016-16 during the first quarter of fiscal 2019 and does not expect it to have a material impact on the consolidated financial statements. +In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718), Scope of Modification Accounting (“ASU 2017-09”). This ASU provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. The effective date for the standard is for interim periods in fiscal years beginning after December 15, 2017, with early adoption permitted, including adoption in any interim period for which financial statements have not yet been issued. The Company will early adopt ASU 2017-09 during the first quarter of fiscal 2019 and does not expect it to have a material impact on the consolidated financial statements. +In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 320), (“ASU 2016-13”). This ASU requires a financial asset (or a group of financial assets) measured on the basis of amortized cost to be presented at the net amount expected to be collected. This ASU requires that the income statement reflect the measurement of credit losses for newly recognized financial assets as well as the expected increases or decreases of expected credit losses that have taken place during the period. This ASU requires that credit losses of debt securities designated as available-for-sale be recorded through an allowance for credit losses. The ASU also limits the credit loss to the amount by which fair value is below amortized cost. This ASU will be effective for the Company in the first quarter of 2021, with early adoption permitted. This ASU requires modified retrospective adoption, with prospective adoption for debt securities for which an other-than-temporary impairment had been recognized before the effective date. The Company is currently evaluating the effect ASU 2016-13 will have on the consolidated financial statements. +In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Topic 320), (“ASU 2016-01”). This ASU provides guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. This ASU will be effective for the Company in the first quarter of fiscal 2019 and requires modified retrospective adoption, with prospective adoption for amendments related to equity securities without readily determinable fair values. The Company is evaluating the effect ASU 2016-01 will have on the consolidated financial statements. +In June 2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718), Improvements to Nonemployee Share-based Payments (“ASU 2018-07”). This ASU expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. The effective date for the standard is for interim periods in fiscal years beginning after December 15, 2018, with early adoption permitted, but no earlier than the Company's adoption date of Topic 606. The new guidance is required to be applied retrospectively with the cumulative effect recognized at the date of initial application. The Company will early adopt ASU 2018-07 during the first quarter of fiscal 2019 and does not expect it to have a material impact on the consolidated financial statements. +In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement - Disclosure Framework (Topic 820), (“ASU 2018-13”) . The updated guidance improves the disclosure requirements on fair value measurements. The updated guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted for any removed or modified disclosures. The Company early adopted the removed or modified disclosures in the fourth quarter of fiscal 2018 and is currently assessing the timing and impact of adopting the updated provisions. +There have been no other recent accounting pronouncements or changes in accounting pronouncements that are of significance, or potential significance, to the Company. +46 +Table of Contents +Supplemental Cash Flow Information +As of September 28, 2018 , the Company had $13.9 million accrued to other long-term liabilities for capital equipment, and $94.1 million accrued to accounts payable for capital equipment. These amounts accrued for capital equipment purchases have been excluded from the consolidated statements of cash flows for fiscal 2018 and are expected to be paid in subsequent periods. The prior period amount under the description “Proceeds from employee stock purchase plan” has been reclassified from net cash provided by operating activities to net cash used in financing activities. +3. BUSINESS COMBINATIONS +On August 17, 2018 , the Company completed its acquisition of Avnera Corporation (“Avnera”). Avnera designs and develops analog system-on-chip (“SoC”) technology products for audio, speech, sensor and artificial intelligence (“AI”) applications. The Company acquired Avnera to expand its leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors and integrated software. The acquisition of Avnera is expected to enable the Company to capitalize on the rapid proliferation of audio functionality and its convergence with its advanced connectivity solutions. +The Company acquired the business for total cash consideration, net of cash acquired, of $404.0 million together with future contingent payments for a total aggregated fair value of $407.1 million . The future contingent consideration payments range from zero to $20.0 million and are based upon the achievement of specified revenue objectives that are payable up to one fiscal year from the anniversary of the acquisition, which at closing had a total estimated fair value of $3.1 million . +Net revenue and net income from this acquisition has been included in the Consolidated Statements of Operations from the acquisition date through the end of the fiscal year on September 28, 2018, and the impact of the acquisition to the ongoing operations on the Company’s net revenue and net income was not material. The Company incurred immaterial transaction-related costs during the fiscal year ended September 28, 2018, which were included within the selling, administrative and general expense. +The allocation of the purchase price to the assets and liabilities recognized in the Company’s acquisition of Avnera was considered final at the time of filing this Annual Report on Form 10-K. The allocation of the purchase price is based on the estimated fair values of the assets acquired and liabilities assumed by major class related to the Avnera acquisition and are reflected, as of the acquisition date, in the accompanying financial statements as follows (in millions): +As of +Estimated fair value of assets acquired, net of cash +August 17, +2018 +Accounts receivable +$ +7.3 +Inventory, including step up +9.8 +Property, plant and equipment +1.5 +Other assets +11.7 +Intangible assets +94.0 +Goodwill +306.8 +Liabilities assumed +(24.0 +) +Estimated fair value of net assets acquired +$ +407.1 +Goodwill is primarily attributable to the assembled workforce and Company specific revenue synergies expected from the integration of the Avnera business. This goodwill will not be deductible for tax purposes. +47 +Table of Contents +As of +Intangible Assets +August 17, +2018 +Developed technology +$ +37.3 +Customer relationships and backlog +10.4 +Tradename +0.3 +Total identified finite-lived intangible assets +48.0 +In process research and development +46.0 +Total identified intangible assets +$ +94.0 +Developed technology relates to SoC-based wireless audio solutions and sound processors. Developed technology was valued using the multi-period excess earnings method under the income approach. This method reflects the present value of the projected cash flows that are expected to be generated by the developed technology less charges representing the contribution of other assets to those cash flows. The economic useful life of two years was determined based on the technology cycle related to each developed technology, as well as the cash flows over the forecast period. +Customer relationships and backlog represent the fair value of future projected revenue that will be derived from sales of products to existing customers of Avnera. Customer relationships and backlog were valued using the with-and-without method under the income approach. In the with-and-without method, the fair value was measured by the difference between the present values of the cash flows with and without the existing customers in place over the period of time necessary to reacquire the customers. The economic useful life of one year was determined based on historical customer acquisition rates. +Tradename relates to the “Avnera” trade name. The fair value was determined by applying the relief-from-royalty method under the income approach. This method is based on the application of a market royalty rate to forecasted revenue under the trade name. +The fair value of in-process research and development, or IPR&D, was determined using the multi-period excess earnings method under the income approach. This method reflects the present value of the projected cash flows that are expected to be generated by the IPR&D, less charges representing the contribution of other assets to those cash flows. +The unaudited pro forma financial results for the fiscal years ended September 28, 2018, and September 29, 2017, combine the unaudited historical results of Skyworks with the unaudited historical results of Avnera for the fiscal years ended September 28, 2018, and September 29, 2017, respectively. The results include the effects of unaudited pro forma adjustments as if Avnera was acquired at the beginning of the prior fiscal year. The unaudited pro forma results presented include amortization charges for acquired intangible assets, adjustments for increases in the fair value of acquired inventory, other charges and related tax effects. The pro forma financial results presented below do not include any anticipated synergies or other expected benefits of the acquisition. These unaudited results are presented for informational purposes only and are not necessarily indicative of future operations (in millions, except per share amounts): +Fiscal Years-Ended +September 28, +2018 +September 29, +2017 +Revenue +$ +3,914.3 +$ +3,693.9 +Net income +926.0 +977.8 +Diluted earnings per common share +$ +5.05 +$ +5.24 +4. MARKETABLE SECURITIES +The Company's portfolio of available-for-sale marketable securities consists of the following (in millions): +48 +Table of Contents +Current +Noncurrent +Available for sale: +September 28, +2018 +September 29, +2017 +September 28, +2018 +September 29, +2017 +U.S. Treasury and government +$ +65.0 +$ +— +$ +— +$ +— +Corporate bonds and notes +204.1 +— +12.0 +— +Municipal bonds +2.0 +— +0.8 +— +Other government +23.0 +— +10.0 +— +Total +$ +294.1 +$ +— +$ +22.8 +$ +— +The contractual maturities of noncurrent available-for-sale marketable securities were due within two years or less . +The Company recorded unrealized gains and losses on sales of available-for-sale marketable securities as follows (in millions): +September 28, 2018 +Amortized Cost +Gross Unrealized Gains +Gross Unrealized Losses +Estimated Fair Value +U.S. Treasury and government +$ +65.0 +$ +— +$ +— +$ +65.0 +Corporate bonds and notes +216.1 +— +(0.1 +) +216.0 +Municipal bonds +2.8 +— +— +2.8 +Other government +33.1 +— +— +33.1 +Total +$ +317.0 +$ +— +$ +(0.1 +) +$ +316.9 +The Company concluded that the unrealized losses were temporary at September 28, 2018. Further, for bonds and other debt securities held by the Company with unrealized losses, the Company did not have the intent to sell, nor was it more likely than not that the Company would be required to sell, such securities before recovery or maturity. +5. FAIR VALUE +Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis +The Company measures certain assets and liabilities at fair value on a recurring basis such as its financial instruments. There have been no transfers between Level 1, 2 or 3 assets or liabilities during the fiscal year ended September 28, 2018 . +Contingent consideration related to business combinations is recorded as a Level 3 liability because management uses significant judgments and unobservable inputs to determine the fair value. The Company reassesses the fair value of its contingent consideration liabilities on a quarterly basis and records any fair value adjustments to earnings in the period that they are determined. The decrease in Level 3 liabilities during fiscal 2018, relates to net adjustments to the fair value of contingent consideration liabilities, which were included in selling, general and administrative expenses, partially offset by the fair value of the contingent consideration associated with a business combination completed during the period, as detailed in Note 3 of these Notes to Consolidated Financial Statements. The fair value of the contingent consideration was determined using a probabilistic Black-Scholes pricing model calibrated to the expected revenue forecast to be generated from the acquired business over a one-year period. +Assets and liabilities recorded at fair value on a recurring basis consisted of the following (in millions): +49 +Table of Contents +As of September 28, 2018 +As of September 29, 2017 +Fair Value Measurements +Fair Value Measurements +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +Assets +Cash equivalents* +$ +79.3 +$ +29.7 +$ +49.6 +$ +— +$ +592.6 +$ +592.6 +$ +— +$ +— +U.S. Treasury and government securities +65.0 +15.0 +50.0 +— +— +— +— +— +Corporate bonds and notes +216.0 +— +216.0 +— +— +— +— +— +Municipal bonds +2.8 +— +2.8 +— +— +— +— +— +Other government securities +33.1 +— +33.1 +— +— +— +— +— +Total +$ +396.2 +$ +44.7 +$ +351.5 +$ +— +$ +592.6 +$ +592.6 +$ +— +$ +— +Liabilities +Contingent consideration +$ +3.1 +$ +— +$ +— +$ +3.1 +$ +11.9 +$ +— +$ +— +$ +11.9 +Total +$ +3.1 +$ +— +$ +— +$ +3.1 +$ +11.9 +$ +— +$ +— +$ +11.9 +* Cash equivalents included in Levels 1 and 2 consist of money market funds and corporate bonds and notes, foreign government bonds, commercial paper, and agency securities purchased with less than ninety days until maturity. +The following table summarizes changes to the fair value of the Level 3 liabilities (in millions): +Contingent Consideration +Balance as of September 29, 2017 +$ +11.9 +Increases to Level 3 liabilities +3.1 +Changes in fair value included in earnings +(11.9 +) +Balance as of September 28, 2018 +$ +3.1 +Assets Measured and Recorded at Fair Value on a Nonrecurring Basis +The Company’s non-financial assets and liabilities, such as goodwill, intangible assets, and other long-lived assets resulting from business combinations, are measured at fair value using income approach valuation methodologies at the date of acquisition and are subsequently re-measured if there are indicators of impairment. +6. INVENTORY +Inventory consists of the following (in millions): +As of +September 28, +2018 +September 29, +2017 +Raw materials +$ +20.2 +$ +24.6 +Work-in-process +340.7 +330.6 +Finished goods +124.8 +123.0 +Finished goods held on consignment by customers +4.5 +15.3 +Total inventory +$ +490.2 +$ +493.5 +7. PROPERTY, PLANT AND EQUIPMENT, NET +Property, plant and equipment, net consists of the following (in millions): +50 +Table of Contents +As of +September 28, +2018 +September 29, +2017 +Land and improvements +$ +11.6 +$ +11.6 +Buildings and improvements +238.0 +137.8 +Furniture and fixtures +31.5 +29.5 +Machinery and equipment +2,089.6 +1,715.3 +Construction in progress +179.0 +164.8 +Total property, plant and equipment, gross +2,549.7 +2,059.0 +Accumulated depreciation +(1,408.8 +) +(1,176.7 +) +Total property, plant and equipment, net +$ +1,140.9 +$ +882.3 +8. GOODWILL AND INTANGIBLE ASSETS +The changes to the carrying amount of goodwill are as follows (in millions): +As of +September 28, +2018 +September 29, +2017 +Goodwill at beginning of the period +$ +883.0 +$ +873.3 +Goodwill recognized through business combinations ( Note 3 ) +306.8 +9.7 +Goodwill impairment +— +— +Goodwill at the end of the period +$ +1,189.8 +$ +883.0 +The Company performed an impairment test of its goodwill as of the first day of the fourth fiscal quarter in accordance with its regularly scheduled testing. The results of this test indicated that the Company’s goodwill was not impaired. There were no other indicators of impairment noted during the fiscal year ended September 28, 2018 . +Intangible assets consist of the following (in millions): +As of +As of +Weighted +average +amortization +period (years) +September 28, 2018 +September 29, 2017 +Gross +carrying +amount +Accumulated +amortization +Net +carrying +amount +Gross +carrying +amount +Accumulated +amortization +Net +carrying +amount +Customer relationships +3.4 +$ +31.7 +$ +(13.2 +) +$ +18.5 +$ +29.7 +$ +(14.6 +) +$ +15.1 +Developed technology and other +5.3 +89.9 +(23.5 +) +66.4 +59.9 +(20.6 +) +39.3 +Trademarks +3.0 +1.6 +(0.8 +) +0.8 +1.6 +(0.3 +) +1.3 +Capitalized software +3.0 +18.0 +(6.0 +) +12.0 +12.1 +— +12.1 +IPR&D +46.0 +— +46.0 +$ +— +— +— +Total intangible assets +$ +187.2 +$ +(43.5 +) +$ +143.7 +$ +103.3 +$ +(35.5 +) +$ +67.8 +Fully amortized intangible assets have been eliminated from both the gross and accumulated amortization amounts. The increase in the gross amount of intangible assets is primarily related to the business combination that closed during the fourth quarter of fiscal 2018. For further information regarding the acquired intangibles see Note 3 , Business Combinations, in these Notes to the Consolidated Financial Statements. +Annual amortization expense for the next five fiscal years related to intangible assets is expected to be as follows (in millions): +51 +Table of Contents +2019 +2020 +2021 +2022 +2023 +Thereafter +Amortization expense, cost of goods sold +$ +24.8 +$ +22.5 +$ +0.1 +$ +0.1 +$ +0.1 +$ +1.9 +Amortization expense, operating expense +22.6 +11.8 +9.0 +1.0 +1.0 +2.8 +Total amortization expense +$ +47.4 +$ +34.3 +$ +9.1 +$ +1.1 +$ +1.1 +$ +4.7 +9. INCOME TAXES +Income before income taxes consists of the following components (in millions): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +United States +$ +712.2 +$ +681.2 +$ +697.5 +Foreign +619.9 +575.8 +503.1 +Income before income taxes +$ +1,332.1 +$ +1,257.0 +$ +1,200.6 +The provision for income taxes consists of the following (in millions): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Current tax expense (benefit): +Federal +$ +347.7 +$ +215.7 +$ +181.8 +State +0.3 +0.3 +0.1 +Foreign +31.2 +24.4 +25.8 +379.2 +240.4 +207.7 +Deferred tax expense (benefit): +Federal +20.3 +5.0 +(0.8 +) +Foreign +14.2 +1.4 +(1.5 +) +34.5 +6.4 +(2.3 +) +Provision for income taxes +$ +413.7 +$ +246.8 +$ +205.4 +The actual income tax expense is different than that which would have been computed by applying the federal statutory tax rate to income before income taxes. A reconciliation of income tax expense as computed at the United States federal statutory income tax rate to the provision for income tax expense is as follows (in millions): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Tax expense at United States statutory rate +$ +327.4 +$ +439.9 +$ +420.2 +Foreign tax rate difference +(111.9 +) +(174.6 +) +(160.8 +) +Tax on deemed repatriation +224.6 +— +— +Effect of stock compensation +(25.6 +) +— +— +Change of tax rate on deferred taxes +18.3 +— +— +Research and development credits +(19.9 +) +(16.3 +) +(33.7 +) +Change in tax reserve +6.7 +12.6 +(2.5 +) +Domestic production activities deduction +(13.9 +) +(19.8 +) +(19.1 +) +Other, net +8.0 +5.0 +1.3 +Provision for income taxes +$ +413.7 +$ +246.8 +$ +205.4 +52 +Table of Contents +The Company operates in foreign jurisdictions with income tax rates lower than the United States tax rate for the fiscal years ended September 28, 2018, and September 29, 2017, which were 24.6% and 35.0% , respectively. The Company’s tax benefits related to foreign earnings taxed at a rate less than the United States federal rate were $111.9 million and $174.6 million for the fiscal years ended September 28, 2018 , and September 29, 2017 , respectively. +The Tax Reform Act includes, among other things, a reduction of the United States corporate tax rate from 35% to 21% , a mandatory deemed repatriation tax on foreign earnings, repeal of the corporate alternative minimum tax and the domestic production activities deduction, and expensing of certain capital investments. The new law makes fundamental changes to the taxation of multinational entities, including a shift from worldwide taxation with deferral to a hybrid territorial system, featuring a participation exemption regime, a minimum tax on low-taxed foreign earnings, and new measures to deter base erosion and promote export from the United States. As a result of this legislation, the Company recognized a one-time transition tax related to the deemed repatriation of foreign earnings of $224.6 million , and a charge related to the revaluation of its deferred tax assets at the new corporate tax rate of $18.3 million . The $224.6 million deemed repatriation tax is payable over the next eight years, $18.0 million per year for each of the next five years, followed by payments of $33.6 million , $44.9 million , and $56.1 million in years six through eight, respectively. The Company has accrued $206.6 million of the deemed repatriation tax in long-term liabilities within the consolidated balance sheet as of September 28, 2018. +Staff Accounting Bulletin 118 (“SAB 118”) provides a measurement period during which companies may analyze the impacts of newly enacted legislation when the company does not have the necessary information available, prepared, or analyzed in reasonable detail to complete the accounting for certain income tax effects of the new legislation, not to exceed one year. The Company does not expect to record any further adjustments within the measurement period as of September 28, 2018, but will continue to monitor the estimate if new guidance becomes available. +In addition to the introduction of a modified territorial tax system, the Tax Reform Act includes two new sets of provisions aimed at preventing or decreasing U.S. tax base erosion—the global intangible low-taxed income (“GILTI”) provisions and the base erosion and anti-abuse tax (“BEAT”) provisions. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company expects to make an accounting policy election to account for GILTI as a component of tax expense in the period in which the Company is subject to the rules and therefore will not provide any deferred tax impacts of GILTI in its consolidated financial statements for the year ended September 28, 2018. The BEAT provisions eliminate the deduction of certain base-erosion payments made to related foreign corporations, and impose a minimum tax if greater than regular tax. The Company does not presently expect that it will be subject to the minimum tax imposed by the BEAT provisions. +The Company’s federal income tax returns for fiscal 2015 and fiscal 2016 are currently under IRS examination. As a result, the Company increased the reserve for uncertain tax positions by $18.9 million , including interest. +On October 2, 2010, the Company expanded its presence in Asia by launching operations in Singapore. The Company operates under a tax holiday in Singapore, which is effective through September 30, 2020 , and is conditional upon the Company’s compliance with certain employment and investment thresholds in Singapore. The impact of the tax holiday decreased Singapore’s taxes by $38.4 million and $37.4 million for the fiscal years ended September 28, 2018 , and September 29, 2017 , respectively, which resulted in tax benefits of $0.21 and $0.20 of diluted earnings per share, respectively. +Deferred income tax assets and liabilities consist of the tax effects of temporary differences related to the following (in millions): +53 +Table of Contents +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +Deferred tax assets: +Inventory +$ +5.7 +$ +7.4 +Bad debts +1.2 +0.1 +Accrued compensation and benefits +4.9 +7.1 +Product returns, allowances and warranty +4.6 +5.2 +Restructuring +— +0.1 +Intangible assets +— +10.6 +Share-based and other deferred compensation +26.1 +40.2 +Net operating loss carry forwards +15.5 +7.7 +Non-United States tax credits +20.3 +20.1 +State tax credits +97.0 +71.0 +Property, plant and equipment +9.1 +7.9 +Other, net +3.3 +2.7 +Deferred tax assets +187.7 +180.1 +Less valuation allowance +(118.6 +) +(90.9 +) +Net deferred tax assets +69.1 +89.2 +Deferred tax liabilities: +Prepaid insurance +(0.6 +) +(0.9 +) +Property, plant and equipment +(25.6 +) +(24.8 +) +Intangible assets +(19.3 +) +(6.2 +) +Other, net +(2.0 +) +— +Net deferred tax liabilities +(47.5 +) +(31.9 +) +Total net deferred tax assets +$ +21.6 +$ +57.3 +In accordance with GAAP, management has determined that it is more likely than not that a portion of its historic and current year income tax benefits will not be realized. As of September 28, 2018 , the Company has a valuation allowance of $118.6 million . This valuation allowance is comprised of $100.5 million related to United States state tax credits, of which $1.5 million are state tax credits acquired from Avnera in fiscal 2018, and $18.1 million are related to foreign deferred tax assets. The Company does not anticipate sufficient taxable income or tax liability to utilize these state and foreign credits. If these benefits are recognized in a future period the valuation allowance on deferred tax assets will be reversed and up to a $118.6 million income tax benefit may be recognized. The Company will need to generate $88.5 million of future United States federal taxable income to utilize its United States deferred tax assets as of September 28, 2018 . The Company believes that future reversals of taxable temporary differences, and its forecast of continued earnings in its domestic and foreign jurisdictions, support its decision to not record a valuation allowance on other deferred tax assets. +Deferred tax assets are recognized for foreign operations when management believes it is more likely than not that the deferred tax assets will be recovered during the carry forward period. The Company will continue to assess its valuation allowance in future periods. +As of September 28, 2018 , the Company has United States federal net operating loss carry forwards of approximately $41.0 million , including $32.7 million related to the acquisition of Avnera. The utilization of these net operating losses is subject to certain annual limitations as required under Internal Revenue Code section 382 and similar state income tax provisions. The United States federal net operating loss carry forwards expire at various dates through 2035 . The Company also has state income tax credit carry forwards of $97.0 million , net of federal benefits, for which the Company has provided a valuation allowance. The state tax credits relate primarily to California research tax credits that can be carried forward indefinitely. +The Company has continued to expand its operations and increase its investments in numerous international jurisdictions. These activities will increase the Company’s earnings attributable to foreign jurisdictions. Due to the enactment of the Tax Reform Act, +54 +Table of Contents +all of the Company’s previously undistributed earnings were deemed repatriated during the year ended September 28, 2018, resulting in a one-time transition tax of $224.6 million . +A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in millions): +Unrecognized tax benefits +Balance at September 29, 2017 +$ +90.4 +Increases based on positions related to prior years +13.5 +Decreases based on positions related to prior years +(0.5 +) +Increases based on positions related to current year +0.5 +Decreases relating to settlements with taxing authorities +— +Decreases relating to lapses of applicable statutes of limitations +(10.5 +) +Balance at September 28, 2018 +$ +93.4 +Of the total unrecognized tax benefits at September 28, 2018 , $77.7 million would impact the effective tax rate, if recognized. The remaining unrecognized tax benefits would not impact the effective tax rate, if recognized, due to the Company’s valuation allowance and certain positions that were required to be capitalized. +The Company anticipates reversals within the next 12 months related to items such as the lapse of the statute of limitations, audit closures, and other items that occur in the normal course of business. Due to open examinations, an estimate of anticipated reversals within the next 12 months cannot be made. During the fiscal year ended September 28, 2018 , the Company recognized $10.5 million of previously unrecognized tax benefits related to the expiration of the statute of limitations and $4.1 million of accrued interest or penalties related to unrecognized tax benefits. As of September 28, 2018, accrued interest and penalties of $7.5 million related to uncertain tax positions have been included in long-term tax liabilities within the consolidated balance sheet. +The Company’s major tax jurisdictions as of September 28, 2018 , are the United States, California, Canada, Luxembourg, Mexico, Japan, and Singapore. For the United States, the Company has open tax years dating back to fiscal 2000 due to the carry forward of tax attributes. For California, the Company has open tax years dating back to fiscal 1999 due to the carry forward of tax attributes. For Canada, the Company has open tax years dating back to fiscal 2012 . For Luxembourg, the Company has open tax years back to fiscal 2012 . For Mexico, the Company has open tax years back to fiscal 2012 . For Singapore, the Company has open tax years dating back to fiscal 2012 . The Company is subject to audit examinations by the respective taxing authorities on a periodic basis, of which the results could impact its financial position, results of operations or cash flows. +10. STOCKHOLDERS’ EQUITY +COMMON STOCK +At September 28, 2018 , the Company is authorized to issue 525.0 million shares of common stock, par value $0.25 per share, of which 228.4 million shares are issued and 177.4 million shares are outstanding. +Holders of the Company’s common stock are entitled to dividends in the event declared by the Company’s Board of Directors out of funds legally available for such purpose. Dividends may not be paid on common stock unless all accrued dividends on preferred stock, if any, have been paid or declared and set aside. In the event of the Company’s liquidation, dissolution or winding up, the holders of common stock will be entitled to share pro rata in the assets remaining after payment to creditors and after payment of the liquidation preference plus any unpaid dividends to holders of any outstanding preferred stock. +Each holder of the Company’s common stock is entitled to one vote for each such share outstanding in the holder’s name. No holder of common stock is entitled to cumulate votes in voting for directors. The Company’s restated certificate of incorporation as amended to date (the “Certificate of Incorporation”) provides that, unless otherwise determined by the Company’s Board of Directors, no holder of stock has any preemptive right to purchase or subscribe for any stock of any class which the Company may issue or sell. +PREFERRED STOCK +The Company’s Certificate of Incorporation has authorized and permits the Company to issue up to 25.0 million shares of preferred stock without par value in one or more series and with rights and preferences that may be fixed or designated by the Company’s Board of Directors without any further action by the Company’s stockholders. The designation, powers, preferences, rights and +55 +Table of Contents +qualifications, limitations and restrictions of the preferred stock of each series will be fixed by the certificate of designation relating to such series, which will specify the terms of the preferred stock. At September 28, 2018 , the Company had no shares of preferred stock issued or outstanding. +SHARE REPURCHASE +On January 31, 2018 , the Board of Directors approved a stock repurchase program, pursuant to which the Company is authorized to repurchase up to $1.0 billion of its common stock from time to time prior to January 31, 2020 , on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. This authorized stock repurchase program replaced in its entirety the January 17, 2017, stock repurchase program. During the fiscal year ended September 28, 2018 , the Company paid approximately $759.5 million (including commissions) in connection with the repurchase of 7.7 million shares of its common stock (paying an average price of $98.84 per share) under the January 31, 2018 , stock repurchase plan and the January 17, 2017, stock repurchase plan. As of September 28, 2018 , $413.0 million remained available under the January 31, 2018 , share repurchase plan. +During the fiscal year ended September 29, 2017 , the Company paid approximately $432.3 million (including commissions) in connection with the repurchase of 4.7 million shares of its common stock (paying an average price of $92.97 per share). +DIVIDENDS +On November 8, 2018 , the Company announced that the Board of Directors had declared a cash dividend on the Company’s common stock of $0.38 per share. This dividend is payable on December 18, 2018 , to the Company’s stockholders of record as of the close of business on November 27, 2018 . Future dividends are subject to declaration by the Board of Directors. The dividends charged to retained earnings in fiscal 2018 and 2017 were as follows (in millions except per share amounts): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +Per Share +Total +Per Share +Total +First quarter +$ +0.32 +$ +58.8 +$ +0.28 +$ +51.8 +Second quarter +0.32 +58.5 +0.28 +51.8 +Third quarter +0.32 +57.8 +0.28 +51.7 +Fourth quarter +0.38 +68.1 +0.32 +58.9 +$ +1.34 +$ +243.2 +$ +1.16 +$ +214.2 +EMPLOYEE STOCK BENEFIT PLANS +As of September 28, 2018 , the Company has the following equity compensation plans under which its equity securities were authorized for issuance to its employees and/or directors: +• +the 1999 Employee Long-Term Incentive Plan +• +the 2002 Employee Stock Purchase Plan +• +the Non-Qualified Employee Stock Purchase Plan +• +the 2005 Long-Term Incentive Plan +• +the AATI 2005 Equity Incentive Plan +• +the 2008 Director Long-Term Incentive Plan +• +the 2015 Long-Term Incentive Plan +Except for the 1999 Employee Long-Term Incentive Plan and the Non-Qualified Employee Stock Purchase Plan, each of the foregoing equity compensation plans was approved by the Company’s stockholders. +As of September 28, 2018 , a total of 85.3 million shares are authorized for grant under the Company’s share-based compensation plans, with 1.9 million options outstanding. The number of common shares reserved for future awards to employees and directors under these plans was 13.8 million at September 28, 2018 . The Company currently grants new equity awards to employees under the 2015 Long-Term Incentive Plan and to non-employee directors under the 2008 Director Long-Term Incentive Plan. +56 +Table of Contents +2015 Long-Term Incentive Plan. Under this plan, officers, employees, non-employee directors and certain consultants may be granted stock options, restricted stock awards and units, performance stock awards and units and other share-based awards. The plan has been approved by the stockholders. Under the plan, up to 19.4 million shares have been authorized for grant. A total of 13.1 million shares are available for new grants as of September 28, 2018 . The maximum contractual term of options under the plan is seven years from the date of grant. Options granted under the plan are exercisable at the determination of the compensation committee and generally vest ratably over four years. Restricted stock awards and units granted under the plan at the determination of the compensation committee generally vest over four or more years. With respect to restricted stock awards, dividends are accumulated and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are also forfeited. No dividends or dividend equivalents are paid or accrued with respect to restricted stock unit awards or other awards until the shares underlying such awards become vested and are issued to the award holder. Performance stock awards and units are contingently granted depending on the achievement of certain predetermined performance goals and generally vest over two or more years. +2008 Director Long-Term Incentive Plan. Under this plan, non-employee directors may be granted stock options, restricted stock awards and other share-based awards. The plan has been approved by the stockholders. Under the plan a total of 1.5 million shares have been authorized for grant. A total of 0.7 million shares are available for new grants as of September 28, 2018 . The maximum contractual term of options granted under the plan is ten years from the date of grant. Options granted under the plan are generally exercisable over four years. Restricted stock awards and units granted under the plan generally vest over one or more years. With respect to restricted stock awards, dividends are accumulated and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are also forfeited. +Employee Stock Purchase Plans. The Company maintains a domestic and an international employee stock purchase plan. Under these plans, eligible employees may purchase common stock through payroll deductions of up to 10% of their compensation. The price per share is the lower of 85% of the fair market value of the common stock at the beginning or end of each offering period (generally six months). The plans provide for purchases by employees of up to an aggregate of 9.7 million shares. Shares of common stock purchased under these plans in the fiscal years ended September 28, 2018, September 29, 2017, and September 30, 2016, were 0.2 million , 0.2 million , and 0.3 million , respectively. At September 28, 2018 , there are 0.5 million shares available for purchase. The Company recognized compensation expense of $5.2 million , $4.5 million and $4.6 million for the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , respectively, related to the employee stock purchase plan. The unrecognized compensation expense on the employee stock purchase plan at September 28, 2018 , was $1.9 million . The weighted average period over which the cost is expected to be recognized is approximately four months. +Stock Options +The following table represents a summary of the Company’s stock options: +Shares (in millions) +Weighted average exercise price +Weighted average remaining contractual life (in years) +Aggregate intrinsic value (in millions) +Balance outstanding at September 29, 2017 +3.0 +$ +50.36 +Granted +0.1 +$ +26.66 +Exercised +(1.1 +) +$ +35.92 +Canceled/forfeited +(0.1 +) +$ +72.42 +Balance outstanding at September 28, 2018 +1.9 +$ +57.12 +3.0 +$ +64.3 +Exercisable at September 28, 2018 +1.2 +$ +50.15 +2.3 +$ +50.8 +The weighted-average grant date fair value per share of employee stock options granted during the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , was $68.32 , $23.25 , and $26.30 , respectively. The increase in the weighted-average grant date fair value per share of employee stock options granted during fiscal 2018 was due to replacement awards granted as a result of the Avnera acquisition completed during the period. The total grant date fair value of the options vested during the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , was $22.6 million , $19.3 million and $21.9 million , respectively. +Restricted and Performance Awards and Units +The following table represents a summary of the Company’s restricted and performance awards and units: +57 +Table of Contents +Shares (In millions) +Weighted average +grant date fair value +Non-vested awards outstanding at September 29, 2017 +2.9 +$ +75.49 +Granted (1) +1.3 +$ +108.86 +Vested +(1.2 +) +$ +69.55 +Canceled/forfeited +(0.3 +) +$ +86.64 +Non-vested awards outstanding at September 28, 2018 +2.7 +$ +92.37 +(1) includes performance shares granted and earned based on maximum performance under the underlying performance metrics +The weighted average grant date fair value per share for awards granted during the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , was $108.86 , $72.84 , and $62.02 , respectively. The total grant date fair value of the awards vested during the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , was $81.1 million , $57.9 million and $71.2 million , respectively. +The following table summarizes the total intrinsic value for stock options exercised and awards vested (in millions): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Awards +$ +134.4 +$ +137.8 +$ +197.6 +Options +$ +75.0 +$ +116.1 +$ +68.9 +Valuation and Expense Information +The following table summarizes pre-tax share-based compensation expense by financial statement line and related tax benefit (in millions): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Cost of goods sold +$ +14.4 +$ +13.6 +$ +11.3 +Research and development +42.6 +35.3 +32.2 +Selling, general and administrative +50.8 +39.6 +34.5 +Total share-based compensation expense +$ +107.8 +$ +88.5 +$ +78.0 +Share-based compensation tax benefit +$ +25.6 +$ +25.1 +$ +22.5 +Capitalized share-based compensation expense at period end +$ +2.9 +$ +4.0 +$ +3.7 +The following table summarizes total compensation costs related to unvested share based awards not yet recognized and the weighted average period over which it is expected to be recognized at September 28, 2018 : +Unrecognized compensation cost for unvested awards +(in millions) +Weighted average remaining recognition period +(in years) +Awards +$ +106.1 +1.5 +Options +$ +11.1 +1.1 +The fair value of the restricted stock awards and units is equal to the closing market price of the Company’s common stock on the date of grant. +The Company issued performance share units during fiscal 2018, fiscal 2017 and fiscal 2016 that contained market-based conditions. The fair value of these performance share units was estimated on the date of the grant using a Monte Carlo simulation with the following weighted average assumptions: +58 +Table of Contents +Fiscal Year Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Volatility of common stock +35.54 +% +39.60 +% +38.24 +% +Average volatility of peer companies +36.78 +% +39.78 +% +34.76 +% +Average correlation coefficient of peer companies +0.47 +0.42 +0.49 +Risk-free interest rate +1.74 +% +0.68 +% +0.44 +% +Dividend yield +1.15 +% +1.44 +% +1.23 +% +The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions: +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Expected volatility +35.86 +% +40.31 +% +42.93 +% +Risk-free interest rate +2.00 +% +1.60 +% +0.98 +% +Dividend yield +1.15 +% +1.44 +% +1.23 +% +Expected option life (in years) +4.0 +4.0 +4.0 +The Company used a historical volatility calculated by the mean reversion of the weekly-adjusted closing stock price over the expected life of the options. The risk-free interest rate assumption is based upon observed treasury bill interest rates appropriate for the expected life of the Company’s employee stock options. The dividend yield was calculated based on the annualized dividend and the stock price on the date of grant. +The expected life of employee stock options represents a calculation based upon the historical exercise, cancellation and forfeiture experience for the Company across its demographic population. The Company believes that this historical data is the best estimate of the expected life of a new option and that generally all groups of the Company’s employees exhibit similar behavior. +On November 15, 2017, the Company agreed to potentially issue not more than 1% of its common stock to an unaffiliated third party as a contingent consideration for its role under a multi-year collaboration agreement, upon the achievement of certain product sales milestones. The shares have been valued utilizing a probability weighted series of Black-Scholes pricing models and could be issued after mid-2020. The shares will be marked to estimated fair value each reporting period through earnings. The amount recorded in the statement of operations within selling, general and administrative expense for the fiscal year ended 2018, is not material. +11. EMPLOYEE BENEFIT PLAN, PENSIONS AND OTHER RETIREE BENEFITS +The Company maintains a 401(k) plan covering substantially all of its employees based in the United States under which all employees at least twenty-one years old are eligible to receive discretionary Company contributions. Discretionary Company contributions in the form of cash are determined by the Board of Directors. The Company has generally contributed a match of up to 4% of an employee’s contributed annual eligible compensation. The Company no longer provides shares of its common stock as contributions to the 401(k) plan. +Defined Benefit Pension: +The Company has a defined benefit pension plan for certain employees in Japan. This plan has been frozen and new employees are not eligible. However, the Company is obligated to make future contributions to fund benefits to the participants with the benefits under the plan being based primarily on a combination of years of service and compensation. +The net amount of the unfunded obligation recognized in other long-term liabilities on the balance sheet consists of (in millions): +59 +Table of Contents +Fiscal Year Ended +September 28, +2018 +September 29, +2017 +Pension benefit obligations at the end of the fiscal year +$ +16.1 +$ +17.0 +Fair value of plan assets at the end of the fiscal year +11.3 +11.5 +Unfunded status, net +$ +(4.8 +) +$ +(5.5 +) +The pension obligation and the net periodic benefit costs associated with the pension have an immaterial impact to the Company’s results of operations and financial position and accordingly, the disclosures required have been excluded from this Annual Report on Form 10-K. +12. COMMITMENTS +The Company has various operating leases primarily for buildings, computers and equipment. Rent expense amounted to $20.5 million , $20.6 million , and $19.5 million in the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , respectively. Future minimum payments under these non-cancelable leases for the next five fiscal years are as follows (in millions): +2019 +2020 +2021 +2022 +2023 +Thereafter +Total +Future minimum payments +$ +21.6 +18.3 +14.2 +12.2 +5.3 +15.2 +$ +86.8 +13. CONTINGENCIES +Legal Matters +From time to time, various lawsuits, claims and proceedings have been, and may in the future be, instituted or asserted against the Company, including those pertaining to patent infringement, intellectual property, environmental hazards, product liability and warranty, safety and health, employment and contractual matters. +The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company’s business and have demanded and may in the future demand that the Company license their technology. The outcome of any such litigation cannot be predicted with certainty and some such lawsuits, claims or proceedings may be disposed of unfavorably to the Company. Generally speaking, intellectual property disputes often have a risk of injunctive relief, which, if imposed against the Company, could materially and adversely affect the Company’s financial condition, or results of operations. From time to time the Company may also be involved in legal proceedings in the ordinary course of business. +The Company monitors the status of legal proceedings and other contingencies on an ongoing basis to ensure loss contingencies are recognized and/or disclosed in its financial statements and footnotes. The Company does not believe there are any pending legal proceedings that are reasonably possible to result in a material loss. The Company is engaged in various legal actions in the normal course of business and, while there can be no assurances, the Company believes the outcome of all pending litigation involving the Company will not have, individually or in the aggregate, a material adverse effect on its business or financial statements. +14. GUARANTEES AND INDEMNITIES +The Company has made no significant contractual guarantees for the benefit of third parties. However, the Company generally indemnifies its customers from third-party intellectual property infringement litigation claims related to its products, and, on occasion, also provides other indemnities related to product sales. In connection with certain facility leases, the Company has indemnified its lessors for certain claims arising from the facility or the lease. +The Company indemnifies its directors and officers to the maximum extent permitted under the laws of the state of Delaware. The duration of the indemnities varies, and in many cases is indefinite. The indemnities to customers in connection with product sales generally are subject to limits based upon the amount of the related product sales and in many cases are subject to geographic and other restrictions. In certain instances, the Company’s indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities in the accompanying consolidated balance sheets and does not expect that such obligations will have a material adverse impact on its financial statements. +60 +Table of Contents +15. RESTRUCTURING AND OTHER CHARGES +During fiscal 2018, the Company recorded restructuring and other charges of approximately $0.8 million related to a leased facility. The Company does not anticipate any material charges in future periods related to these plans. Charges associated with the restructuring plan are categorized in the "Other restructuring programs" in the table below. +During fiscal 2017, the Company implemented immaterial restructuring plans and recorded $0.6 million related to employee severance and other costs. +During fiscal 2016, the Company recorded restructuring and other charges of approximately $4.8 million primarily related to restructuring plans to reduce redundancies associated with acquisitions during the year. +16. EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted earnings per share (in millions, except per share amounts): +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +Net income +$ +918.4 +$ +1,010.2 +$ +995.2 +Weighted average shares outstanding – basic +181.3 +184.3 +188.7 +Dilutive effect of equity based awards +1.9 +2.4 +3.4 +Weighted average shares outstanding – diluted +183.2 +186.7 +192.1 +Net income per share – basic +$ +5.06 +$ +5.48 +$ +5.27 +Net income per share – diluted +$ +5.01 +$ +5.41 +$ +5.18 +Anti-dilutive common stock equivalents +0.2 +0.6 +1.5 +Basic earnings per share are calculated by dividing net income by the weighted average number of shares of the Company’s common stock outstanding during the period. The calculation of diluted earnings per share includes the dilutive effect of equity based awards that were outstanding during the fiscal years ended September 28, 2018 , September 29, 2017 , and September 30, 2016 , using the treasury stock method. Certain of the Company’s outstanding share-based awards, noted in the table above, were excluded because they were anti-dilutive, but they could become dilutive in the future. +17. SEGMENT INFORMATION AND CONCENTRATIONS +The Company considers itself to be a single reportable operating segment which designs, develops, manufactures and markets similar proprietary semiconductor products, including intellectual property. In reaching this conclusion, management considers the definition of the chief operating decision maker (“ CODM ”), how the business is defined by the CODM, the nature of the information provided to the CODM and how that information is used to make operating decisions, allocate resources and assess performance. The Company’s CODM is the president and chief executive officer. The results of operations provided to and analyzed by the CODM are at the consolidated level and accordingly, key resource decisions and assessment of performance is performed at the consolidated level. The Company assesses its determination of operating segments at least annually. +GEOGRAPHIC INFORMATION +Net revenue by geographic area presented based upon the location of the OEMs' headquarters are as follows (in millions): +61 +Table of Contents +Fiscal Years Ended +September 28, +2018 +September 29, +2017 +September 30, +2016 +United States +$ +1,946.2 +$ +1,615.4 +$ +1,455.0 +China +982.8 +1,018.8 +971.2 +South Korea +432.7 +531.8 +393.0 +Taiwan +339.1 +335.4 +323.6 +Europe, Middle East and Africa +144.6 +117.4 +102.1 +Other Asia-Pacific +22.6 +32.6 +44.1 +Total +$ +3,868.0 +$ +3,651.4 +$ +3,289.0 +During fiscal 2018, the Company updated the table above from prior period presentation of net revenue based on the country of destination to current period presentation of net revenue based on the location of the OEMs' headquarters. Prior periods have been reclassified to match the current period presentation. +The Company’s revenue to external customers is generated principally from the sale of semiconductor products that facilitate various wireless communication applications. Accordingly, the Company considers its product offerings to be similar in nature and therefore not segregated for reporting purposes. +Net property, plant and equipment balances, based on the physical locations within the indicated geographic areas are as follows (in millions): +As of +September 28, +2018 +September 29, +2017 +Mexico +$ +449.4 +$ +465.9 +Japan +328.4 +166.4 +United States +123.5 +126.9 +Singapore +222.7 +112.1 +Rest of world +16.9 +11.0 +$ +1,140.9 +$ +882.3 +CONCENTRATIONS +Financial instruments that potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable. Trade accounts receivable are primarily derived from sales to manufacturers of communications and consumer products and electronic component distributors. Ongoing credit evaluations of customers’ financial condition are performed and collateral, such as letters of credit and bank guarantees, are required whenever deemed necessary. +In fiscal 2018, 2017, and 2016, Apple, through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches and other devices, in the aggregate accounted for 47% , 39% and 40% of the Company’s net revenue, respectively. In fiscal 2017 and 2016, Samsung in the aggregate accounted for 12% and 10% of the Company’s net revenue, respectively. In fiscal 2017, Huawei in the aggregate accounted for 10% of the Company’s net revenue. +At September 28, 2018 , the Company’s three largest accounts receivable balances comprised 66% of aggregate gross accounts receivable. This concentration was 53% and 54% at September 29, 2017 , and September 30, 2016 , respectively. +18. QUARTERLY FINANCIAL DATA (UNAUDITED) +The following table summarizes the quarterly and annual results (in millions, except per share data): +62 +Table of Contents +First quarter +Second quarter +Third quarter +Fourth quarter +Fiscal year +Fiscal 2018 +Net revenue +$ +1,051.9 +$ +913.4 +$ +894.3 +$ +1,008.4 +$ +3,868.0 +Gross profit +536.8 +458.7 +451.6 +503.6 +1,950.7 +Net income +70.4 +276.0 +286.5 +285.5 +918.4 +Per share data (1) +Net income, basic +$ +0.38 +$ +1.51 +$ +1.58 +$ +1.60 +$ +5.06 +Net income, diluted +$ +0.38 +$ +1.50 +$ +1.57 +$ +1.58 +$ +5.01 +Fiscal 2017 +Net revenue +$ +914.3 +$ +851.7 +$ +900.8 +$ +984.6 +$ +3,651.4 +Gross profit +463.9 +425.4 +453.6 +498.9 +1,841.8 +Net income +257.8 +224.9 +246.2 +281.3 +1,010.2 +Per share data (1) +Net income, basic +$ +1.39 +$ +1.22 +$ +1.34 +$ +1.53 +$ +5.48 +Net income, diluted +$ +1.38 +$ +1.20 +$ +1.32 +$ +1.51 +$ +5.41 +____________ +(1) +Earnings per share calculations for each of the quarters are based on the weighted average number of shares outstanding and included common stock equivalents in each period. Therefore, the sums of the quarters do not necessarily equal the full year earnings per share. +63 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +None. +ITEM 9A. CONTROLS AND PROCEDURES. +Evaluation of disclosure controls and procedures. +Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 28, 2018 . The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on management’s evaluation of our disclosure controls and procedures as of September 28, 2018 , our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level. +Management’s Annual Report on Internal Control over Financial Reporting +The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: +• +Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; +• +Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +• +Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of September 28, 2018 . In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 Internal Control-Integrated Framework. +Based on their assessment, management concluded that, as of September 28, 2018 , the Company’s internal control over financial reporting is effective based on those criteria. +The Company’s independent registered public accounting firm has issued an audit report on the effectiveness of the Company’s internal control over financial reporting as stated within their report which appears herein. +Changes in internal control over financial reporting. +64 +Table of Contents +There are no changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the period covered by this report that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting. +ITEM 9B. OTHER INFORMATION. +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. +The information under the captions “Directors and Executive Officers”, “Corporate Governance─Committees of the Board of Directors” and “Other Matters─Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive proxy statement for the 2019 Annual Meeting of Stockholders is incorporated herein by reference. +We have adopted a written code of business conduct and ethics that applies to our directors, officers and employees, including our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. We make available our code of business conduct and ethics free of charge through our website, which is located at www.skyworksinc.com. We intend to disclose any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to rules of the SEC and the Nasdaq Global Select Market by posting any such amendment or waivers on our website and disclosing any such waivers in a Form 8-K filed with the SEC. +ITEM 11. EXECUTIVE COMPENSATION. +The information to be included under the caption “Information about Executive and Director Compensation” in our definitive proxy statement for the 2019 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +The information to be included under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in our definitive proxy statement for the 2019 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +The information to be included under the captions “Certain Relationships and Related Transactions” and “Corporate Governance─Director Independence” in our definitive proxy statement for the 2019 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES. +The information to be included under the caption “Ratification of Independent Registered Public Accounting Firm—Audit Fees” in our definitive proxy statement for the 2019 Annual Meeting of Stockholders is incorporated herein by reference. +65 +Table of Contents +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES. +(a) +The following are filed as part of this Annual Report on Form 10-K: +1. +Index to Financial Statements +Page number in this report +Report of Independent Registered Public Accounting Firm +Page 34 +Consolidated Statements of Operations for the three years ended September 28, 2018 +Page 36 +Consolidated Statements of Comprehensive Income for the three years ended September 28, 2018 +Page 38 +Consolidated Balance Sheets at September 28, 2018, and September 29, 2017 +Page 38 +Consolidated Statements of Cash Flows for the three years ended September 28, 2018 +Page 39 +Consolidated Statements of Stockholders’ Equity for the three years ended September 28, 2018 +Page 40 +Notes to Consolidated Financial Statements +Pages 41 through 62 +2. +The schedule listed below is filed as part of this Annual Report on Form 10-K: +All required schedule information is included in the Notes to Consolidated Financial Statements or is omitted because it is either not required or not applicable. +3. +The Exhibits listed in the Exhibit Index immediately following Item 16 are filed as a part of this Annual Report on Form 10-K. +(b) +Exhibits +The exhibits required by Item 601 of Regulation S-K are filed herewith and incorporated by reference herein. The response to this portion of Item 15 is submitted under Item 15 (a) (3). +ITEM 16. FORM 10-K SUMMARY. +None +66 +Table of Contents +EXHIBIT INDEX +Exhibit +Number +Exhibit Description +Form +Incorporated by Reference +Filed Herewith +File No. +Exhibit +Filing Date +2.1 +Memorandum of Understanding dated as of April 28, 2014, by and between the Company and Panasonic Corporation, acting through Automotive & Industrial Systems Company +10-Q +001-05560 +2.1 +7/30/2014 +2.2 +Stock Purchase Agreement dated as of July 2, 2014, by and among the Company, Skyworks Luxembourg S.A.R.L., Panasonic Corporation, acting through Automotive & Industrial Systems Company, Panasonic Asia Pacific Pte., Ltd. Skyworks Panasonic Filter Solutions Japan Co., Ltd. and Skyworks Panasonic Filter Solutions Singapore Pte. Ltd. +10-K +001-05560 +2.5 +11/25/2014 +2.3 +Agreement and Plan of Merger dated as of August 3, 2018, by and among the Company, Avnera Corporation, AI Acquisition Corp., and Shareholder Representative Services LLC, solely in its capacity as the representative and agent of the Equityholders +X +3.1 +Restated Certificate of Incorporation, as Amended +10-Q +001-05560 +3.1 +8/3/2016 +3.2 +Third Amended and Restated By-laws, as Amended +10-Q +001-05560 +3.1 +2/5/2018 +4.1 +Specimen Certificate of Common Stock +S-3 +333-92394 +4 +7/15/2002 +10.1* +Alpha Industries Executive Compensation Plan dated January 1, 1995, and Trust for the Alpha Industries Executive Compensation Plan dated January 3, 1995 +10-K +001-05560 +10.D +12/14/2005 +10.2* +Skyworks Solutions, Inc. 1999 Employee Long-Term Incentive Plan +10-K +001-05560 +10.L +12/23/2002 +10.3* +Skyworks Solutions, Inc. 2002 Employee Stock Purchase Plan +10-Q +001-05560 +10.D +1/31/2013 +10.4* +Skyworks Solutions, Inc. Non-Qualified Employee Stock Purchase Plan +10-Q +001-05560 +10.E +1/31/2013 +10.5* +Skyworks Solutions, Inc. Amended and Restated 2005 Long-Term Incentive Plan +8-K +001-05560 +10.1 +5/13/2013 +10.6* +Form of Nonstatutory Stock Option Agreement under the Company’s 2005 Long-Term Incentive Plan +10-Q +001-05560 +10.B +1/31/2013 +10.7* +Form of Performance Share Agreement under the Company’s 2005 Long-Term Incentive Plan +10-Q +001-05560 +10.C +1/31/2013 +10.8* +Form of Restricted Stock Unit Agreement under the Company’s 2005 Long-Term Incentive Plan +8-K +001-05560 +10.1 +5/9/2014 +10.9* +Skyworks Solutions, Inc. Amended and Restated 2008 Director Long-Term Incentive Plan, as Amended +10-Q +001-05560 +10.1 +5/4/2018 +10.10* +Form of Restricted Stock Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q +001-05560 +10.NN +5/7/2008 +10.11* +Form of Nonstatutory Stock Option Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q +001-05560 +10.OO +5/7/2008 +67 +Table of Contents +Exhibit +Number +Exhibit Description +Form +Incorporated by Reference +Filed Herewith +File No. +Exhibit +Filing Date +10.12* +Form of Restricted Stock Unit Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q +001-05560 +10.2 +5/4/2016 +10.13* +Skyworks Solutions, Inc. 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.1 +8/5/2015 +10.14* +Form of Nonstatutory Stock Option Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.2 +8/5/2015 +10.15* +Form of Performance Share Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.3 +8/5/2015 +10.16* +Form of Restricted Stock Unit Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.4 +8/5/2015 +10.17* +Advanced Analogic Technologies Incorporated 2005 Equity Incentive Plan +10-K +001-05560 +10.DD +11/21/2012 +10.18* +Fiscal Year 2018 Executive Incentive Plan, as Amended +10-Q +001-05560 +10.2 +2/5/2018 +10.19* +Skyworks Solutions, Inc. Cash Compensation Plan for Directors +10-Q +001-05560 +10.1 +7/20/2018 +10.20* +Second Amended and Restated Change of Control / Severance Agreement, dated May 11, 2016, between the Company and David Aldrich +10-Q +001-05560 +10.1 +8/3/2016 +10.21* +Amended and Restated Change in Control / Severance Agreement, dated May 11, 2016, between the Company and Liam Griffin +10-Q +001-05560 +10.2 +8/3/2016 +10.22* +Change in Control / Severance Agreement, dated December 16, 2014, between the Company and Peter Gammel +10-K +001-05560 +10.31 +11/24/2015 +10.23* +Change in Control / Severance Agreement, dated August 29, 2016, between the Company and Kris Sennesael +10-K +001-05560 +10.32 +11/22/2016 +10.24* +Change in Control / Severance Agreement, dated November 10, 2016, between the Company and Robert J. Terry +10-Q +001-05560 +10.2 +2/7/2017 +10.25* +Change in Control / Severance Agreement, dated November 9, 2016, between the Company and Carlos S. Bori +10-K +001-05560 +10.27 +11/13/2017 +10.26* +International Assignment Agreement, dated September 13, 2017, between the Company and Peter L. Gammel +10-K +001-05560 +10.28 +11/13/2017 +21 +Subsidiaries of the Company +X +23.1 +Consent of KPMG LLP +X +31.1 +Certification of the Company’s Chief Executive Officer pursuant to Securities and Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +X +31.2 +Certification of the Company’s Chief Financial Officer pursuant to Securities and Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +X +32.1 +Certification of the Company’s Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +X +Table of Contents +Exhibit +Number +Exhibit Description +Form +Incorporated by Reference +Filed Herewith +File No. +Exhibit +Filing Date +32.2 +Certification of the Company’s Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +X +101.INS +XBRL Instance Document +X +101.SCH +XBRL Taxonomy Extension Schema Document +X +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +X +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +X +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +X +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +X +* Indicates a management contract or compensatory plan or arrangement. +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. +Date: November 14, 2018 +SKYWORKS SOLUTIONS, INC. +Registrant +By: +/s/ Liam K. Griffin +Liam K. Griffin +President and Chief Executive Officer +Director +Table of Contents +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on November 14, 2018 . +Signature and Title +Signature and Title +/s/ Liam K. Griffin +/s/ David J. Aldrich +Liam K. Griffin +David J. Aldrich +Chief Executive Officer +Chairman of the Board +President and Director +(principal executive officer) +/s/ Kevin L. Beebe +Kevin L. Beebe +/s/ Kris Sennesael +Director +Kris Sennesael +Senior Vice President and Chief Financial Officer +/s/Timothy R. Furey +(principal accounting and financial officer) +Timothy R. Furey +Director +/s/ Balakrishnan S. Iyer +Balakrishnan S. Iyer +Director +/s/ Christine King +Christine King +Director +/s/ David P. McGlade +David P. McGlade +Director +/s/ David J. McLachlan +David J. McLachlan +Director +/s/ Robert A. Schriesheim +Robert A. Schriesheim +Director +/s/ Kimberly S. Stevenson +Kimberly S. Stevenson +Director +71 \ No newline at end of file diff --git a/raw/filings/0000004127/2018/0000004127-18-000046/filing_metadata.csv b/raw/filings/0000004127/2018/0000004127-18-000046/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..76d2a312b65b92c8b93b05d85cfc1e16fef63263 --- /dev/null +++ b/raw/filings/0000004127/2018/0000004127-18-000046/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004127,SWKS,"SKYWORKS SOLUTIONS, INC.",2018,10-K,2018-11-15,2018-09-28,2018-11-14T23:44:35.000Z,0000004127-18-000046,fy1810k92818.htm,10-K,10007203,1,0,https://www.sec.gov/Archives/edgar/data/4127/000000412718000046/fy1810k92818.htm,https://www.sec.gov/Archives/edgar/data/4127/000000412718000046/ diff --git a/raw/filings/0000004127/2018/0000004127-18-000046/item1.txt b/raw/filings/0000004127/2018/0000004127-18-000046/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..3522dbee319e89e0de8cca993c981e7f81a9bded --- /dev/null +++ b/raw/filings/0000004127/2018/0000004127-18-000046/item1.txt @@ -0,0 +1,122 @@ +ITEM 1. BUSINESS. +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. +Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto, General Electric, Google, Honeywell, HTC, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi and ZTE. Our competitors include Analog Devices, Broadcom, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, QUALCOMM and Qorvo. +We are a Delaware corporation that was formed in 1962. We changed our corporate name from Alpha Industries, Inc. to Skyworks Solutions, Inc. on June 25, 2002, following a business combination. We operate worldwide with engineering, manufacturing, sales and service facilities throughout Asia, Europe and North America. Our Internet address is www.skyworksinc.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we electronically submit such material to the SEC. The information contained on our website is not incorporated by reference in this Annual Report. Our SEC filings are also available to the public at www.sec.gov. +In August 2018, we acquired Avnera Corporation (“Avnera”) and expanded our leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors and integrated software. We expect the acquisition of Avnera to enable us to capitalize on the rapid proliferation of audio functionality and its convergence with our advanced connectivity solutions. With our global sales channels, strong customer relationships and operational scale, we plan to leverage Avnera’s innovative product portfolio and systems expertise to increase our footprint in automotive, industrial, home automation, enterprise and high-end consumer markets. +In August 2016, we acquired the remaining 34 percent interest in a joint venture that was initially created in August 2014 with Panasonic Corporation, through its Automotive & Industrial Systems Company (“Panasonic”) for the design, manufacture and sale of Panasonic’s SAW and TC-SAW filter products. The joint venture was dissolved and is now a wholly-owned subsidiary of the Company. With the overall demand for SAW and TC-SAW filters increasing and as technology and product architectures become more complex and the number of required bands grows, this investment assists us in securing a consistent supply of SAW and TC-SAW filters, in addition to allowing us to integrate filters into the design and production of our own products. +INDUSTRY BACKGROUND +Mobile connectivity is exploding on a global basis. With wireless platforms serving as virtual hubs for e-commerce, enterprise to the cloud, social media, gaming and entertainment, these devices are enabling a new, multi-trillion dollar economy. Popular apps including Amazon, Facebook, Netflix, Spotify, Uber, Waze and YouTube all require ultra-fast, highly secure, low-latency, always-on connectivity plus GPS location-based services. As a result, semiconductor solutions are becoming increasingly relevant, resolving the daunting analog and RF complexities that are challenging the capabilities of existing hardware and the supporting network infrastructure. Semiconductor devices continue becoming smaller, more powerful, and easier to integrate across multiple communication protocols, which in turn is enabling mobile and IoT ecosystems. +Skyworks facilitates ubiquitous data creation, delivery and storage as smartphones transmit and receive immense amounts of content supporting multimedia streaming, social networking, virtual reality and emerging frictionless commerce. To enable these applications, we deliver highly integrated solutions leveraging our amplification, filtering, tuning, power management, audio processing and packaging capabilities to continuously push the performance envelope. +Demand for connectivity across emerging markets around the world also continues to grow as the industry drives toward connecting the billions of people who remain unconnected. According to The GSMA Foundation, there will be 5.9 billion mobile subscribers by 2025, representing almost three-quarters of the world’s population. Subscriber growth over this period is forecast to be driven primarily by large markets in Asia, such as India, which alone is expected to add 310 million new unique subscribers by 2020. +5 +Table of Contents +At the same time, connectivity is proliferating into an adjacent set of IoT markets. From smart homes to the smart grid and from industrial to wearables, the number of connected devices is rapidly proliferating. In fact, IHS Markit Ltd. projects the IoT market to grow from an installed base of 15 billion units in 2015 to more than 75 billion units by 2025. Skyworks is enabling these opportunities with highly customized system solutions supporting a broad set of wireless protocols including cellular LTE, Wi-Fi, Bluetooth®, LoRa®, Thread and Zigbee®. +Looking ahead to 5G, we see a market that presents a massive growth opportunity for our industry and certainly for Skyworks. 5G data rates will approach ten to 100 times the fastest 4G speeds of today with near zero latency. To put this in perspective, downloading a full-length HD movie in 3G took one day; in 4G, the same file took minutes. On a 5G network, this content will be downloaded in mere seconds. By 2020 a single autonomous car is expected to consume 4,000 gigabytes of data per day in real-time diagnostics, positioning and vehicle-to-vehicle communications—that is equivalent to the daily data consumed by more than 2,000 smartphone users today. +We expect the key catalysts for Skyworks to be the insatiable demand for data and the profitable usage model for both Mobile and IoT applications, as each connection becomes more valuable and vital particularly as the world embraces 5G. +Solving Connectivity Challenges +The transition to ubiquitous connectivity creates challenges to existing architectures. RF solutions in ultra-thin, high performance consumer products must increase data rates, solve signal interference problems, and occupy minimal board space while at the same time increasing battery life. Meeting these design challenges requires broad competencies including signal transmission and conditioning, the ability to ensure seamless hand-offs between multiple standards, power management, voltage regulation, battery charging, filtering and tuning, among others. This complexity plays directly to our strengths. We have a strong heritage in analog systems design and have spent the last decade investing in key technologies and resources. We are at the forefront of advanced multi-chip module integration and offer unmatched technology breadth, providing deep expertise in CMOS, SOI, GaAs and filters, and maintain strategic partnerships with outside independent wafer fabrication facilities. +SKYWORKS’ STRATEGY +Our ambitious vision is to connect everyone and everything, all the time. To this end, key elements of our strategy include: +Industry-Leading Technology +As the industry migrates to more complex LTE and 5G architectures across a multitude of wireless broadband applications, we are uniquely positioned to help mobile device manufacturers handle growing levels of system complexity in the transmit and receive chain. The trend towards increasing front-end and analog design challenges in smartphones and other mobile devices plays directly into our core strengths and positions us to address these challenges. We believe that we offer the broadest portfolio of radio and analog solutions from the transceiver to the antenna as well as all required manufacturing process technologies. We also hold strong technology leadership positions in passive devices, advanced integration including proprietary shielding and 3-D die stacking as well as SAW and TC-SAW filters. Our product portfolio is reinforced by a library of approximately 3,000 worldwide patents and other intellectual property that we own and control. Together, our industry-leading technology enables us to deliver the highest levels of product performance and integration. +Customer Relationships +Given our scale and technology leadership, we are engaged with key original equipment manufacturers (“OEMs”), smartphone providers and baseband reference design partners. Our customers value our supply chain strength, our innovative technology and our system engineering expertise, resulting in deep customer loyalty. We partner with our customers to support their long-term product road maps and are valued as a system solutions provider rather than just a point product vendor. +Diversification +We are diversifying our business in three areas: our addressed markets, our customer base and our product offerings. By leveraging core analog and mixed signal technologies, we are expanding our family of solutions to a set of increasingly diverse end markets and customers. We are steadily growing our business beyond just mobile devices (where we support all top-tier manufacturers, including the leading smartphone suppliers and key baseband vendors) into additional high-performance analog markets, including automotive, home and factory automation, infrastructure, medical, smart energy and wireless networking. In these markets we leverage our scale, intellectual property and worldwide distribution network, which spans over 2,500 customers and over 2,500 analog components. +6 +Table of Contents +Delivering Operational Excellence +We vertically integrate our supply chain where we can differentiate with highly specialized internal manufacturing capabilities, or enter into alliances and strategic relationships for leading-edge technologies. This hybrid manufacturing model allows us to better balance our manufacturing capacity with the demand of the marketplace. Our internal capacity utilization remains high, resulting in an increase of our gross margin and the return on invested capital on a broader range of revenue. +Additionally, we continue to drive reductions in product design and manufacturing cycle times and further improve product yields. The combination of agile, flexible capacity and world-class module manufacturing and scale advantage allows us to achieve low product costs while integrating multiple technologies into highly sophisticated multi-chip modules. +Maintaining a Performance Driven Culture +We consider our people and corporate culture to be a major competitive advantage and a key driver of our overall strategy. We create key performance indicators that align employee efforts with corporate strategy and link responsibilities with performance measurement. Accountability is paramount and we compensate our employees through a pay-for-performance methodology. We strive to be an employer-of-choice among peer companies and have created a work environment in which turnover is below geographic and industry averages. +Generating Superior Operating Results and Shareholder Returns +We seek to generate financial returns that are comparable to a highly diversified analog semiconductor company. Given our product volume and overall utilization we strive to achieve a best-in-class return on investment and operating income to reward shareholders. +OUR PRODUCT PORTFOLIO +Our product portfolio consists of various solutions, including: +• +Amplifiers: the modules that strengthen the signal so that it has sufficient energy to reach a base station +• +Antenna Tuners: aperture and impedance tuning products that improve antenna performance across frequencies +• +Attenuators: circuits that allow a known source of power to be reduced by a predetermined factor (usually expressed as decibels) +• +Circulators/Isolators: ferrite-based components commonly found on the output of high-power amplifiers used to protect receivers in wireless transmission systems +• +DC/DC Converters: an electronic circuit which converts a source of direct current from one voltage level to another +• +Demodulators: a device or an RF block used in receivers to extract the information that has been modulated onto a carrier or from the carrier itself +• +Detectors: devices used to measure and control RF power in wireless systems +• +Diodes: semiconductor devices that pass current in one direction only +• +Directional Couplers: transmission coupling devices for separately sampling the forward or backward wave in a transmission line +• +Diversity Receive Modules: devices used to improve receiver sensitivity in high data rate applications +• +Filters: devices for recovering and separating mixed and modulated data in RF stages +• +Front-end Modules: two or more functions co-packaged to optimize the performance, cost and application suitability in products, including intermediate or radio frequency signal paths +• +Hybrid: a type of directional coupler used in radio and telecommunications +• +LED Drivers: devices which regulate the current through a light emitting diode or string of diodes for the purpose of creating light +• +Low Noise Amplifiers: devices used to reduce system noise figure in the receive chain +• +Mixers: devices that enable signals to be converted to a higher or lower frequency signal and thereby allowing the signals to be processed more effectively +• +Modulators: devices that take a baseband input signal and output a radio frequency modulated signal +• +Optocouplers/Optoisolators: semiconductor devices that allow signals to be transferred between circuits or systems while ensuring that the circuits or systems are electrically isolated from each other +• +Phase Locked Loops: closed-loop feedback control system that maintains a generated signal in a fixed phase relationship to a reference signal +• +Phase Shifters: designed for use in power amplifier distortion compensation circuits in base station applications +• +Power Dividers/Combiners: utilized to equally split signals into in-phase signals as often found in balanced signal chains and local oscillator distribution networks +• +Receivers: electronic devices that change a radio signal from a transmitter into useful information +7 +Table of Contents +• +Switches: components that perform the change between the transmit and receive function, as well as the band function for cellular handsets +• +Synthesizers: devices that provide ultra-fine frequency resolution, fast switching speed, and low phase-noise performance +• +Technical Ceramics: polycrystalline oxide materials used for a wide variety of electrical, mechanical, thermal and magnetic applications +• +Voltage Controlled Oscillators/Synthesizers: fully integrated, high performance signal source for high dynamic range transceivers +• +Voltage Regulators: generate a fixed level which ideally remains constant over varying input voltage or load conditions +We believe we possess broad technology capabilities and one of the most complete wireless communications product portfolios in the industry. +MARKETING AND DISTRIBUTION +Our products are sold globally through a direct sales force, electronic component distributors and independent sales representatives. Certain distributors have agreements with us which allow for certain sales returns, stock rotations and price protection on certain inventory if we lower the price of those products (see “ Critical Accounting Estimates ” in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to Item 8 of this Annual Report on Form 10-K for further detail on revenue reserves). As is customary in the semiconductor industry, our distributors may also market other products that compete with ours. +Our sales engagement begins at the earliest stages of the design of an existing or potential customer’s product. We collaborate technically with our customers and reference design partners at the inception of new programs. These relationships allow our team to facilitate customer-driven solutions, which leverage the unique strength of our intellectual property and product portfolio while providing high value and greatly reducing time-to-market. +We believe the technical and complex nature of our products and markets demand an extraordinary commitment to maintain close ongoing relationships with our customers. As such, we strive to expand the scope of our customer relationship to include design, engineering, manufacturing, procurement, logistics and project management. We also employ a collaborative approach in developing these relationships by combining the support of our design teams, applications engineers, manufacturing personnel, sales and marketing staff and senior management. Lastly, we leverage our customer relationships with cross-selling opportunities across product lines in order to maximize revenue. +We believe that maintaining frequent and interactive contact with our customers is paramount to our continuous efforts to provide world-class sales and service support. By listening and responding to feedback, we are able to mobilize resources to raise our level of customer satisfaction, improve our ability to anticipate future product needs, and enhance our understanding of key market dynamics. We are confident that diligently following this path positions us to participate in numerous opportunities for growth in the future. +CUSTOMER CONCENTRATION +A small number of OEMs historically has accounted for a significant portion of our net revenue. In the fiscal year ended September 28, 2018 (“fiscal 2018”), Apple Inc. (“Apple”), through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches, and other devices) constituted more than ten percent of our net revenue. In the fiscal year ended September 29, 2017 (“fiscal 2017”), three customers—Apple, Samsung Electronics (“Samsung”), and Huawei Technology Co., Ltd. (“Huawei”)—each constituted ten percent or more of our net revenue. In the fiscal year ended September 30, 2016 (“fiscal 2016”), two customers—Apple and Samsung—each constituted more than ten percent of our net revenue. For further information regarding customer concentrations see Note 17 to Item 8 of this Annual Report on Form 10-K. +INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS +We own or have a license to use numerous United States and foreign patents and patent applications related to our products and our manufacturing operations and processes. In addition, we own a number of trademarks and service marks applicable to certain of our products and services. We believe that our intellectual property, including patents, patent applications, trade secrets and trademarks, is of material importance to our business. We rely on patent, copyright, trademark, trade secret and other intellectual property laws, as well as non-disclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, designs, devices, algorithms, processes and other intellectual property. Our efforts may not meaningfully protect our intellectual +8 +Table of Contents +property, or others may independently develop substantially equivalent or superior proprietary technologies, designs, devices, algorithms, processes or other intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and effective copyright, patent, trademark and trade secret protection may not be available in those jurisdictions. In addition to protecting our intellectual property, we strive to strengthen our intellectual property portfolio to enhance our ability to obtain cross-licenses of intellectual property from others, to obtain access to intellectual property we do not possess and to more favorably resolve potential intellectual property claims against us. Due to rapid technological changes in the industry, we believe establishing and maintaining a technological leadership position depends primarily on our ability to develop new, innovative products through the technical competence of our engineering personnel. +COMPETITIVE CONDITIONS +The competitive environment in the semiconductor industry is in a constant state of flux, with new products continually emerging and existing products approaching technological obsolescence. We compete on the basis of time-to-market, new product innovation, quality, performance, price, compliance with industry standards, strategic relationships with customers and baseband vendors, personnel and protection of our intellectual property. We participate in highly competitive markets against numerous competitors that may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements, or may be able to devote greater resources to the development, promotion and sale of their products than we can. +Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. We mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs and lower manufacturing costs of existing products and by introducing new and higher value-added products. +RESEARCH AND DEVELOPMENT +Our products and markets demand rapid technological advancements requiring a continuous effort to enhance existing products and develop new products and technologies. Accordingly, we maintain a high level of research and development activity. We invested $404.5 million , $355.2 million and $312.4 million in research and development during fiscal 2018, fiscal 2017 and fiscal 2016, respectively. The growth in research and development expenses were the result of increases in our internal product designs and product development activity for our target markets in each of these fiscal years. Our research and development expenses include new product development and innovations in integrated circuit design, investment in advanced semiconductor manufacturing processes, development of new packaging and test capabilities and research on next generation technologies and product opportunities. We maintain close collaborative relationships with many of our customers to help identify market demands and target our development efforts to meet those demands. +RAW MATERIALS +Raw materials for our products and manufacturing processes are generally available from several sources. It is our intent not to depend on a sole source of supply unless market or other conditions dictate otherwise. However, there are limited situations where we procure certain components and services for our products from single or limited sources, and we are currently dependent on a limited number of sole source suppliers. We purchase materials and services primarily pursuant to individual purchase orders. However, we have entered into certain supply agreements for the purchase of raw materials or other manufacturing related services that specify minimum prices and purchase quantity based on our anticipated future requirements. Such amounts are reviewed and included in our contractual obligations and commitments as required. Certain of our suppliers consign raw materials to us at our manufacturing facilities to which we take title as needed in our manufacturing process. We believe we have adequate sources for the supply of raw materials and components for our manufacturing needs with suppliers located around the world. +BACKLOG AND INVENTORY +Our sales are made pursuant to standard purchase orders and specified customer contracts for delivery of products, with such purchase orders officially acknowledged by us according to our own terms and conditions. We also maintain Skyworks-owned finished goods inventory at certain customer “hub” locations. We do not recognize revenue until these customers consume the Skyworks-owned inventory from these hub locations. Due to industry practice, which allows customers to cancel orders with limited advance notice to us prior to shipment, and with little or no penalty, we believe that backlog as of any particular date may not be a reliable indicator of our future revenue levels. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volume could result in a reduction in revenue and us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. +ENVIRONMENTAL REGULATIONS +9 +Table of Contents +Federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes, and other activities affecting the environment have had, and will continue to have, an impact on our manufacturing operations. Most of our customers have mandated that our products comply with various local, regional and national “green” initiatives initiated by such customers or the locations in which they operate. We believe that our current expenditures for environmental capital investment and remediation necessary to comply with present regulations governing environmental protection, and other expenditures for the resolution of environmental claims, will not have a material adverse effect on our liquidity and capital resources, competitive position or financial condition. Environmental regulations are subject to change in the future, and accordingly we are unable to assess the possible effect of compliance with future requirements. +SEASONALITY +Sales of our products are subject to seasonal fluctuation and periods of increased demand in end-user consumer applications, such as smartphones and tablet computing devices. The highest demand for our products generally occurs in our first fiscal quarter ending in December and the fourth fiscal quarter ending in September. The lowest demand for our handset products generally occurs in our second fiscal quarter ending in March and the third fiscal quarter ending in June. +EMPLOYEES +As of September 28, 2018 , we employed approximately 9,400 employees world-wide. Approximately 1,150 of our employees in Mexico, 260 employees in Singapore, and 240 employees in Japan are covered by collective bargaining and other union agreements. \ No newline at end of file diff --git a/raw/filings/0000004127/2018/0000004127-18-000046/item13.txt b/raw/filings/0000004127/2018/0000004127-18-000046/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..4cfe688811fd825f93c0775ec9cad0053e20f7e7 --- /dev/null +++ b/raw/filings/0000004127/2018/0000004127-18-000046/item13.txt @@ -0,0 +1,2 @@ +ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +65 \ No newline at end of file diff --git a/raw/filings/0000004127/2019/0000004127-19-000049/filing.txt b/raw/filings/0000004127/2019/0000004127-19-000049/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..ae91a18e7a0247f30d00c36d607264b34e8c9a84 --- /dev/null +++ b/raw/filings/0000004127/2019/0000004127-19-000049/filing.txt @@ -0,0 +1,4592 @@ 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OF 1934 +For the transition period from __________to__________ +Commission file number 001-05560 +Skyworks Solutions, Inc. +(Exact name of registrant as specified in its charter) +Delaware +04-2302115 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +20 Sylvan Road, +Woburn +Massachusetts +01801 +(Address of principal executive offices) +(Zip Code) +(781) +376-3000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +Common Stock, par value $0.25 per share +SWKS +Nasdaq Global Select Market +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes o No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. o Yes þ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). þ Yes o No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company,” in Rule 12b-2 of the Exchange Act. +Large accelerated filer +þ +Accelerated filer ☐ +Non-accelerated filer ☐ +Smaller reporting company +☐ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes þ No +The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant (based on the closing price of the registrant’s common stock as reported on the Nasdaq Global Select Market on the last business day of the registrant’s most recently completed second fiscal quarter March 29, 2019 ) was approximately $ 14.2 billion . The number of outstanding shares of the registrant’s common stock, par value $0.25 per share, as of November 12, 2019 , was 170,375,324 . +DOCUMENTS INCORPORATED BY REFERENCE +Part of Form 10-K +Documents from which portions are incorporated by reference +Part III +Portions of the Registrant’s Proxy Statement relating to the Registrant’s 2020 Annual Meeting of Stockholders (to be filed) are incorporated by reference into Items 10, 11, 12, 13 and 14 of this Annual Report on Form 10-K. +SKYWORKS SOLUTIONS, INC. +ANNUAL REPORT ON FORM 10-K +FOR THE YEAR ENDED SEPTEMBER 27, 2019 +TABLE OF CONTENTS +PAGE NO. +PART I +ITEM 1: BUSINESS. +5 +ITEM 1A: RISK FACTORS. +10 +ITEM 1B: UNRESOLVED STAFF COMMENTS. +21 +ITEM 2: PROPERTIES. +21 +ITEM 3: LEGAL PROCEEDINGS. +22 +ITEM 4: MINE SAFETY DISCLOSURES . +22 +PART II +ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. +23 +ITEM 6: SELECTED FINANCIAL DATA. +24 +ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +25 +ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. +30 +ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +32 +ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +59 +ITEM 9A: CONTROLS AND PROCEDURES. +59 +ITEM 9B: OTHER INFORMATION. +60 +PART III +ITEM 10: DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. +60 +ITEM 11: EXECUTIVE COMPENSATION. +60 +ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +60 +ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +60 +ITEM 14: PRINCIPAL ACCOUNTING FEES AND SERVICES. +60 +PART IV +ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES. +61 +ITEM 16: FORM 10-K SUMMARY +61 +SIGNATURES +64 +2 +Table of Contents +CAUTIONARY STATEMENT +This Annual Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the “safe harbor” created by those sections. Any statements that are not statements of historical fact should be considered to be forward-looking statements. Words such as “anticipates”, “believes”, “continue”, “could”, “estimates”, “expects”, “intends”, “may”, “plans”, “potential”, “predicts”, “projects”, “seek”, “should”, “targets”, “will”, “would”, and similar expressions or variations or negatives of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, forward-looking statements include, but are not limited to: +• +our plans to develop and market new products, enhancements or technologies and the timing of these development and marketing plans; +• +our estimates regarding our capital requirements and our needs for additional financing; +• +our estimates of our expenses, future revenues and profitability; +• +our estimates of the size of the markets for our products and services; +• +our expectations related to the rate and degree of market acceptance of our products; and +• +our estimates of the success of other competing technologies that may become available. +Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known and understood by us. Consequently, forward-looking statements involve inherent risks and uncertainties and actual financial results and outcomes may differ materially and adversely from the results and outcomes discussed in or anticipated by the forward-looking statements. A number of important factors could cause actual financial results to differ materially and adversely from those in the forward-looking statements. We urge you to consider the risks and uncertainties discussed elsewhere in this report and in the other documents filed by us with the Securities and Exchange Commission (“SEC”) in evaluating our forward-looking statements. We have no plans, and undertake no obligation, to revise or update our forward-looking statements to reflect any event or circumstance that may arise after the date of this report. We caution readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. +This Annual Report also contains estimates made by independent parties and by us relating to market size and growth and other industry data. These estimates involve a number of assumptions and limitations and you are cautioned not to give undue weight to such estimates. In addition, projections, assumptions and estimates of our future performance and the future performance of the industries in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of important factors, including those described in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. These and other factors could cause results to differ materially and adversely from those expressed in the estimates made by the independent parties and by us. +In this document, the words “we”, “our”, “ours”, “us”, “Skyworks”, and “the Company” refer only to Skyworks Solutions, Inc., and its consolidated subsidiaries and not any other person or entity. In addition, the following is a list of industry standards that may be referenced throughout the document: +• +5G (Fifth Generation): next-generation cellular network technology +• +ASoC (Analog System on Chip): combines the required electronic circuits of various computer components into a single, integrated chip. +• +BAW (Bulk Acoustic Wave): electrical input signal is converted to an acoustic wave for filtering and converted back into an electrical signal by a metal-piezo-metal vertical structure +• +BiFET (Bipolar Field Effect Transistor): integrates indium gallium phosphide based heterojunction bipolar transistors with field effect transistors on the same gallium arsenide substrate +• +DC (Direct Current): unidirectional flow of an electrical charge +• +CMOS (Complementary Metal Oxide Semiconductor): a technology of constructing integrated circuits +• +GaAs (Gallium Arsenide): a compound of the elements gallium and arsenic that is used in the production of semiconductors +• +HBT (Heterojunction Bipolar Transistor): a type of bipolar junction transistor which uses differing semiconductor materials for the emitter and base regions, creating a heterojunction +3 +Table of Contents +• +IoT (Internet of Things): is the interconnection of uniquely identifiable embedded computing devices within the existing internet infrastructure +• +LED (Light Emitting Diode): a two-lead semiconductor light source +• +LTE (Long Term Evolution): 4th generation (“4G”) radio technologies designed to increase the capacity and speed of mobile telephone networks +• +MIMO (Multiple In, Multiple Out): a method for multiplying the capacity of a radio link using multiple transmission and receiving antennas to exploit multipath propagation; more commonly, it refers to LTE, 5G, and Wi-Fi techniques to send more than one data signal (also known as data layers) with encoded information to increase capacity in modern telecommunications systems +• +pHEMT (Pseudomorphic High Electron Mobility Transistor): a type of field effect transistor incorporating a junction between two materials with different band gaps +• +RF (Radio Frequency): electromagnetic wave frequencies that lie in the range extending from around 3 kHz to 300 GHz +• +SAW (Surface Acoustic Wave): electrical input signal is converted to an acoustic wave for filtering and converted back into an electrical signal by interdigitated transducers on a piezoelectric substrate. +• +SOI (Silicon On Insulator): technology refers to the use of layered silicon-insulator-silicon substrate in place of conventional silicon substrates in semiconductor manufacturing +• +TC-SAW (Temperature Compensated Surface Acoustic Wave): SAW filters that have been designed to reduce shift in frequency over temperature. +Skyworks and the Skyworks symbol are trademarks or registered trademarks of Skyworks Solutions, Inc. or its subsidiaries in the United States and other countries. Third-party brands and names are for identification purposes only, and are the property of their respective owners. +4 +Table of Contents +PART l +ITEM 1. BUSINESS. +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. +Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto (a Thales company), General Electric, Google, Honeywell, HTC, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi and ZTE. Our competitors include Analog Devices, Broadcom, Cirrus Logic, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, Qorvo and Qualcomm. +We are a Delaware corporation that was formed in 1962. We changed our corporate name from Alpha Industries, Inc. to Skyworks Solutions, Inc. on June 25, 2002, following a business combination. We operate worldwide with engineering, manufacturing, sales, and service facilities throughout Asia, Europe, and North America. Our Internet address is www.skyworksinc.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we electronically submit such material to the SEC. The information contained on our website is not incorporated by reference in this Annual Report. Our SEC filings are also available to the public at www.sec.gov. +In August 2018, we acquired Avnera Corporation (“Avnera”) and expanded our leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors, and integrated software. The acquisition of Avnera enables us to capitalize on the rapid proliferation of audio functionality and its convergence with our advanced connectivity solutions. With our global sales channels, strong customer relationships and operational scale, we are leveraging Avnera’s innovative product portfolio and systems expertise to increase our footprint in automotive, industrial, home automation, enterprise and high-end consumer markets. +INDUSTRY BACKGROUND +Wireless connectivity is exploding on a global basis. 5G is dramatically altering the world, creating an ecosystem where everyone is connected to everything, all the time—changing how individuals live, work, play, and learn. More importantly, 5G goes well beyond simply making the mobile communications experience better by increasing reliability, adding new features, and enhancing data rates. It is creating a market for diverse and transformative applications driven by the ability to deliver greater speeds, bandwidth and capacity, significantly lower latency, and more secure connectivity. +In fact, 5G connections will approach ten to 100 times faster than 4G speeds. To put this in perspective, downloading a full-length HD movie in 3G took one day; in 4G, the same file took minutes. On a 5G network, this content can be downloaded in mere seconds. 5G will also enable increasingly efficient and safe vehicle communication, paving the way for autonomous vehicles as well as networks that could make wireless healthcare a reality. +At the same time, connectivity is expanding into an adjacent set of IoT markets. From smart homes to the smart grid and from industrial to wearables, the number of connected devices is rapidly proliferating. IHS Markit Ltd. projects the IoT market to grow from an installed base of 15 billion units in 2015 to more than 75 billion units by 2025. Skyworks is enabling these opportunities with highly customized system solutions supporting a broad set of wireless protocols including cellular LTE, Wi-Fi, Bluetooth®, LoRa®, Thread, and Zigbee®. +Looking forward, we see a market that presents a significant growth opportunity for our industry and for Skyworks. The key catalysts for Skyworks will continue to be the insatiable demand for data and the profitable usage model, as each connection becomes more valuable and the world embraces 5G. According to a June 2019 Ericsson “Mobility Report,” there are expected to be 1.9 billion mobile 5G subscriptions globally by the end of 2024 driven by “rapid early momentum and enthusiasm” in the global market. 5G technology will also support the tens of billions of connected devices, smart objects, and embedded sensors expected to come online as the IoT becomes mainstream. +Solving Connectivity Challenges +5 +Table of Contents +We expect that highly integrated semiconductor solutions will play an increasingly pivotal role in the deployment of this next generation standard by resolving the daunting analog and RF complexities that are challenging the capabilities of existing hardware and the supporting network infrastructure. Meeting these design challenges requires broad competencies including signal transmission and conditioning, the ability to ensure seamless hand-offs between multiple standards, power management, voltage regulation, battery charging, advanced filtering, and tuning. +Skyworks is at the forefront of this sea change in connectivity, delivering the solutions that will enable the true potential of 5G and the IoT. We have a rich heritage in analog systems design and have spent the last decade investing in key technologies and resources. Our strength is underpinned by world-class performance and scale across a broad array of capabilities that include advanced TC-SAW and BAW filters, an expanded family of MIMO, ultra-high band, and diversity receive modules and expanding into emerging technologies including millimeter wave. From our breakthrough SKY5® unifying platform to our 5G small cell solutions, Skyworks’ approach across both infrastructure and user equipment facilitates powerful, high-speed end-to-end 5G connectivity. +SKYWORKS’ STRATEGY +Our ambitious vision is to connect everyone and everything, all the time. To this end, key elements of our strategy include: +Industry-Leading Technology +As the industry migrates to more complex 5G architectures across a multitude of wireless applications, we are well positioned to help mobile device manufacturers handle growing levels of system complexity in the transmit and receive chain. The trend towards increasing front-end and analog design challenges in smartphones and other platforms plays directly into our core strengths and positions us to address these challenges. We believe that we offer the broadest portfolio of radio and analog solutions from the transceiver to the antenna as well as all required manufacturing process technologies. We also hold strong technology leadership positions in passive devices, advanced integration including proprietary shielding and 3-D die stacking as well as SAW, TC-SAW and BAW filters. Our product portfolio is reinforced by a library of approximately 3,500 worldwide patents and other intellectual property that we own and control. Together, our industry-leading technology enables us to deliver the highest levels of product performance and integration. +Customer Relationships +Given our scale and technology leadership, we are engaged with key original equipment manufacturers (“OEMs”), smartphone providers and baseband reference design partners. Our customers value our supply chain strength, our innovative technology and our system engineering expertise, resulting in deep customer loyalty. We partner with our customers to support their long-term product road maps and are valued as a system solutions provider rather than just a point product vendor. +Diversification +We are diversifying our business in three areas: our addressed markets, our customer base and our product offerings. By leveraging core analog and mixed signal technologies, we are expanding our family of solutions to a set of increasingly diverse end markets and customers. With the adoption of 5G and the opportunity to enable more applications, we are steadily growing our business beyond just mobile devices (where we support all top-tier manufacturers, including the leading smartphone suppliers and key baseband vendors) into additional high-performance analog markets, including automotive, home and factory automation, infrastructure, medical, smart energy and wireless networking. In these markets we leverage our scale, intellectual property and worldwide distribution network, which spans over 3,200 customers and over 2,500 analog components. +Delivering Operational Excellence +We vertically integrate our supply chain where we can differentiate with highly specialized internal manufacturing capabilities, or enter into alliances and strategic relationships for leading-edge technologies. This hybrid manufacturing model allows us to better balance our manufacturing capacity with the demand of the marketplace. Our internal capacity utilization remains high, resulting in an increase of our gross margin and the return on invested capital on a broader range of revenue. +Additionally, we continue to drive reductions in product design and manufacturing cycle times and further improve product yields. The combination of agile, flexible capacity and world-class module manufacturing and scale advantage allows us to achieve low product costs while integrating multiple technologies into highly sophisticated multi-chip modules. +Maintaining a Performance-Driven Culture +We consider our people and corporate culture to be a major competitive advantage and a key driver of our overall strategy. We create key performance indicators that align employee efforts with corporate strategy and link responsibilities with performance +6 +Table of Contents +measurement. Accountability is paramount and we compensate our employees through a pay-for-performance methodology. We strive to be an employer-of-choice among peer companies and have created a work environment in which turnover is below geographic and industry averages. +Generating Superior Operating Results and Shareholder Returns +We seek to generate financial returns that are comparable to a highly diversified analog semiconductor company. Given our product volume and overall utilization we strive to achieve a best-in-class return on investment and operating income to reward shareholders. +OUR PRODUCT PORTFOLIO +Our product portfolio consists of various solutions, including: +• +Amplifiers: the modules that strengthen the signal so that it has sufficient energy to reach a base station +• +Antenna Tuners: aperture and impedance tuning products that improve antenna performance across frequencies +• +Attenuators: circuits that allow a known source of power to be reduced by a predetermined factor (usually expressed as decibels) +• +Circulators/Isolators: ferrite-based components commonly found on the output of high-power amplifiers used to protect receivers in wireless transmission systems +• +Wireless ASoC: an intelligent 2.4 GHz and 5GHz wireless radio integrated circuit that includes all the analog and digital functions optimized for building wireless audio headsets, headphones, and wireless speaker systems +• +DC/DC Converters: an electronic circuit which converts a source of direct current from one voltage level to another +• +Demodulators: a device or an RF block used in receivers to extract the information that has been modulated onto a carrier or from the carrier itself +• +Detectors: devices used to measure and control RF power in wireless systems +• +Diodes: semiconductor devices that pass current in one direction only +• +Directional Couplers: transmission coupling devices for separately sampling the forward or backward wave in a transmission line +• +Diversity Receive Modules: devices used to improve receiver sensitivity in high data rate applications +• +Filters: devices for recovering and separating mixed and modulated data in RF stages +• +Front-end Modules: two or more functions co-packaged to optimize the performance, cost and application suitability in products, including intermediate or radio frequency signal paths +• +Hybrid: a type of directional coupler used in radio and telecommunications +• +LED Drivers: devices which regulate the current through a light emitting diode or string of diodes for the purpose of creating light +• +Low Noise Amplifiers: devices used to reduce system noise figure in the receive chain +• +Mixers: devices that enable signals to be converted to a higher or lower frequency signal and thereby allowing the signals to be processed more effectively +• +Modulators: devices that take a baseband input signal and output a radio frequency modulated signal +• +Optocouplers/Optoisolators: semiconductor devices that allow signals to be transferred between circuits or systems while ensuring that the circuits or systems are electrically isolated from each other +• +Phase Locked Loops: closed-loop feedback control system that maintains a generated signal in a fixed phase relationship to a reference signal +• +Phase Shifters: designed for use in power amplifier distortion compensation circuits in base station applications +• +Power Dividers/Combiners: utilized to equally split signals into in-phase signals as often found in balanced signal chains and local oscillator distribution networks +• +Receivers: electronic devices that change a radio signal from a transmitter into useful information +• +Switches: components that perform the change between the transmit and receive function, as well as the band function for cellular handsets +• +Synthesizers: devices that provide ultra-fine frequency resolution, fast switching speed, and low phase-noise performance +• +Technical Ceramics: polycrystalline oxide materials used for a wide variety of electrical, mechanical, thermal and magnetic applications +• +Voltage Controlled Oscillators/Synthesizers: fully integrated, high performance signal source for high dynamic range transceivers +• +Voltage Regulators: generate a fixed level which ideally remains constant over varying input voltage or load conditions +We believe we possess broad technology capabilities and one of the most complete wireless communications product portfolios in the industry. +7 +Table of Contents +MARKETING AND DISTRIBUTION +Our products are sold globally through a direct sales force, electronic component distributors and independent sales representatives. Certain distributors have agreements with us which allow for certain sales returns, stock rotations and price protection on certain inventory if we lower the price of those products (see “ Critical Accounting Estimates ” in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to Item 8 of this Annual Report on Form 10-K for further detail on revenue reserves). As is customary in the semiconductor industry, our distributors may also market other products that compete with ours. +Our sales engagement begins at the earliest stages of the design of an existing or potential customer’s product. We collaborate technically with our customers and reference design partners at the inception of new programs. These relationships allow our team to facilitate customer-driven solutions, which leverage the unique strength of our intellectual property and product portfolio while providing high value and greatly reducing time-to-market. +We believe the technical and complex nature of our products and markets demand an extraordinary commitment to maintain close ongoing relationships with our customers. As such, we strive to expand the scope of our customer relationship to include design, engineering, manufacturing, procurement, logistics and project management. We also employ a collaborative approach in developing these relationships by combining the support of our design teams, applications engineers, manufacturing personnel, sales and marketing staff and senior management. Lastly, we leverage our customer relationships with cross-selling opportunities across product lines in order to maximize revenue. +We believe that maintaining frequent and interactive contact with our customers is paramount to our continuous efforts to provide world-class sales and service support. By listening and responding to feedback, we are able to mobilize resources to raise our level of customer satisfaction, improve our ability to anticipate future product needs, and enhance our understanding of key market dynamics. We are confident that diligently following this path positions us to participate in numerous opportunities for growth in the future. +CUSTOMER CONCENTRATION +A small number of OEMs historically has accounted for a significant portion of our net revenue. In the fiscal years ended September 27, 2019 (“fiscal 2019”), and September 28, 2018 (“fiscal 2018”), Apple Inc. (“Apple”), through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches, and other devices) constituted more than ten percent of our net revenue. In the fiscal year ended September 29, 2017 (“fiscal 2017”), three customers—Apple, Samsung Electronics (“Samsung”), and Huawei Technology Co., Ltd. (“Huawei”)—each constituted ten percent or more of our net revenue. For further information regarding customer concentrations see Note 15 to Item 8 of this Annual Report on Form 10-K. +INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS +We own or have a license to use numerous United States and foreign patents and patent applications related to our products and our manufacturing operations and processes. In addition, we own a number of trademarks and service marks applicable to certain of our products and services. We believe that our intellectual property, including patents, patent applications, trade secrets and trademarks, is of material importance to our business. We rely on patent, copyright, trademark, trade secret and other intellectual property laws, as well as non-disclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, designs, devices, algorithms, processes and other intellectual property. Our efforts may not meaningfully protect our intellectual property, or others may independently develop substantially equivalent or superior proprietary technologies, designs, devices, algorithms, processes or other intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and effective copyright, patent, trademark and trade secret protection may not be available in those jurisdictions. In addition to protecting our intellectual property, we strive to strengthen our intellectual property portfolio to enhance our ability to obtain cross-licenses of intellectual property from others, to obtain access to intellectual property we do not possess and to more favorably resolve potential intellectual property claims against us. Due to rapid technological changes in the industry, we believe establishing and maintaining a technological leadership position depends primarily on our ability to develop new, innovative products through the technical competence of our engineering personnel. +COMPETITIVE CONDITIONS +The competitive environment in the semiconductor industry is in a constant state of flux, with new products continually emerging and existing products approaching technological obsolescence. We compete on the basis of time-to-market, new product innovation, quality, performance, price, compliance with industry standards, strategic relationships with customers and baseband vendors, +8 +Table of Contents +personnel and protection of our intellectual property. We participate in highly competitive markets against numerous competitors that may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements, or may be able to devote greater resources to the development, promotion and sale of their products than we can. +Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. We mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs and lower manufacturing costs of existing products and by introducing new and higher value-added products. +RESEARCH AND DEVELOPMENT +Our products and markets demand rapid technological advancements requiring a continuous effort to enhance existing products and develop new products and technologies. Accordingly, we maintain a high level of research and development activity. We invested $424.1 million , $404.5 million and $355.2 million in research and development during fiscal 2019, fiscal 2018 and fiscal 2017, respectively. The growth in research and development expenses were the result of increases in our internal product designs and product development activity for our target markets in each of these fiscal years. Our research and development expenses include new product development and innovations in integrated circuit design, investment in advanced semiconductor manufacturing processes, development of new packaging and test capabilities and research on next generation technologies and product opportunities. We maintain close collaborative relationships with many of our customers to help identify market demands and target our development efforts to meet those demands. +RAW MATERIALS +Raw materials for our products and manufacturing processes are generally available from several sources. It is our intent not to depend on a sole source of supply unless market or other conditions dictate otherwise. However, there are limited situations where we procure certain components and services for our products from single or limited sources, and we are currently dependent on a limited number of sole source suppliers. We purchase materials and services primarily pursuant to individual purchase orders. However, we have entered into certain supply agreements for the purchase of raw materials or other manufacturing related services that specify minimum prices and purchase quantity based on our anticipated future requirements. Such amounts are reviewed and included in our contractual obligations and commitments as required. Certain of our suppliers consign raw materials to us at our manufacturing facilities to which we take title as needed in our manufacturing process. We believe we have adequate sources for the supply of raw materials and components for our manufacturing needs with suppliers located around the world. +BACKLOG AND INVENTORY +Our sales are primarily from the sale of semiconductor products under individual customer purchase orders, some of which have underlying master sales agreements that specify terms governing the product sales. In the absence of a sales agreement, the Company’s standard terms and conditions apply. We also maintain Skyworks-owned finished goods inventory at certain customer “hub” locations. We do not recognize revenue until these customers consume the Skyworks-owned inventory from these hub locations. Due to industry practice, which allows customers to cancel orders with limited advance notice to us prior to shipment, and with little or no penalty, we believe that backlog as of any particular date may not be a reliable indicator of our future revenue levels. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volume could result in a reduction in revenue and us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. +ENVIRONMENTAL REGULATIONS +Federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes, and other activities affecting the environment have had, and will continue to have, an impact on our manufacturing operations. Most of our customers have mandated that our products comply with various local, regional and national “green” initiatives initiated by such customers or the locations in which they operate. We believe that our current expenditures for environmental capital investment and remediation necessary to comply with present regulations governing environmental protection, and other expenditures for the resolution of environmental claims, will not have a material adverse effect on our liquidity and capital resources, competitive position or financial condition. Environmental regulations are subject to change in the future, and accordingly we are unable to assess the possible effect of compliance with future requirements. +SEASONALITY +Sales of our products are subject to seasonal fluctuation and periods of increased demand in end-user consumer applications, such as smartphones and tablet computing devices. The highest demand for our products generally occurs in our first fiscal quarter ending +9 +Table of Contents +in December and the fourth fiscal quarter ending in September. The lowest demand for our handset products generally occurs in our second fiscal quarter ending in March and the third fiscal quarter ending in June. +EMPLOYEES +As of September 27, 2019 , we employed approximately 9,000 employees world-wide. Approximately 2,850 of our employees in Mexico, 315 employees in Singapore, and 320 employees in Japan are covered by collective bargaining and other union agreements. +ITEM 1A. RISK FACTORS. +You should carefully consider the risks described below in addition to the other information contained in this report before making an investment decision with respect to any of our securities. Our business, financial condition or results of operations could be materially impacted by any of these risks. The risks and uncertainties described below are not the only ones we face. Additional risks not currently known to us or other factors not perceived by us to present significant risks to our business at this time may impair our business operations, financial condition, or results of operations. +We operate in the highly cyclical semiconductor industry, which is subject to significant downturns. +We operate in the semiconductor industry, which is cyclical and subject to rapid declines in demand for end-user products in both the consumer and enterprise markets. Uncertain worldwide economic and political conditions, together with other factors such as the volatility of the financial markets, continue to make it difficult for our customers and for us to accurately forecast and plan future business activities. Uncertainty and economic weakness could result in a market contraction and, as a result, our business, financial condition and results of operations would likely be materially and adversely affected. Such periods of industry downturn are characterized by diminished product demand and revenue, manufacturing overcapacity, excess inventory levels, accelerated erosion of average selling prices, bad debt, inventory charges, restructuring charges, and asset impairment charges. Furthermore, downturns in the semiconductor industry may be prolonged, and any extended delay or failure of the market to recover from an economic downturn would materially and adversely affect our business, financial condition, and results of operations beyond our current fiscal year. +Our operating results may be adversely affected by quarterly and annual fluctuations and market downturns. +Our revenues, earnings, and other operating results may fluctuate significantly on a quarterly and annual basis. These fluctuations are typically the result of a number of factors, many of which are beyond our control. +These factors include, among others: +• +changes in end-user demand for the products manufactured and sold by our customers, +• +the effects of competitive pricing pressures, including decreases in average selling prices of our products, +• +production capacity levels and fluctuations in manufacturing yields, +• +availability and cost of materials and services from our suppliers, +• +the gain or loss of significant customers, +• +our ability to develop, introduce and market new products and technologies on a timely basis, +• +new product and technology introductions by competitors, +• +delays in the adoption of standards by standard-setting bodies and delays in the commercial deployment of certain technologies (including, but not limited to, 5G), +• +actions by government regulators to restrict or delay the availability of sufficient spectrum for wireless technologies, including technologies that utilize unlicensed spectrum and/or shared spectrum, +• +changes in consumers’ rates of replacement of smartphones and other devices that utilize our products, +• +increasing industry consolidation among our competitors, +• +changes in the mix of products produced and sold, +• +market acceptance of our products and our customer’s products (including, but not limited to, market acceptance of 5G products), and +• +intellectual property disputes, including those concerning payments associated with the licensing and/or sale of intellectual property, and related remedies (e.g., monetary damages, injunctions, or exclusion orders affecting our or our customers’ products). +We employ certain methods, assumptions, estimates, and other subjective judgments in order to apply our accounting policies and to project future performance, projections which may be publicly disclosed from time to time. Changes to such methods, assumptions, estimates, and judgments, combined with other factors that are difficult to forecast, including the factors listed above, could materially and adversely affect our quarterly or annual operating results and could produce actual operating results that differ significantly from +10 +Table of Contents +previous estimates and projections. If our operating results fail to meet the expectations of analysts or investors, it could materially and adversely affect the price of our common stock. +Our reliance on a small number of customers for a large portion of our sales could have a material adverse effect on the results of our operations. +Significant portions of our sales are concentrated among a limited number of customers. If we lost one or more of these major customers, or if one or more major customers significantly decreased its orders for our products, our business could be materially and adversely affected. In each of fiscal 2019 and fiscal 2018, one customer accounted for greater than ten percent of our net revenue. In fiscal 2017, three customers each accounted for ten percent or greater of our net revenue. For further discussion see Note 15 to Item 8 of this Annual Report on Form 10-K. +Our stock price has been volatile and may fluctuate in the future. +The trading price of our common stock has and may continue to fluctuate significantly. Such fluctuations may be influenced by many factors, including: +• +the volatility of the financial markets, +• +uncertainty regarding the prospects of the domestic and foreign economies, +• +instability in global credit and financial markets, +• +our performance and prospects, +• +the performance and prospects of our major customers and competitors, +• +our revenue concentrations with relatively few customers, +• +the depth and liquidity of the market for our common stock, +• +investor perception of us and the industry in which we operate, +• +changes in earnings estimates, price targets, or buy/sell recommendations by analysts, +• +domestic and international political conditions, +• +domestic and international tax, fiscal, and trade policy decisions, and +• +our ability to successfully identify, acquire, and integrate acquisition candidates. +Public stock markets have experienced price and trading volume volatility. This volatility has affected, and could significantly and negatively affect, the market prices of securities of many technology companies, particularly the market price of our common stock. Such volatility could materially and adversely affect the market price of our common stock in future periods. +In addition, fluctuations in our stock price, volume of shares traded, and changes in our trading multiples may make our stock attractive to momentum, hedge, day-trading, or activist investors who often shift funds into and out of stocks rapidly, exacerbating price fluctuations in either direction. Our company has been, and in the future may be, the subject of commentary by financial news media. Such commentary may contribute to volatility in our stock price. If our operating results do not meet the expectations of securities analysts, the financial news media, or investors, our stock price may decline, possibly substantially over a short period of time. +The wireless communications and analog semiconductor markets are characterized by significant competition which may cause pricing pressures, decreased gross margins and rapid loss of market share and may materially and adversely affect our business, financial condition, and results of operations. +The wireless communications semiconductor industry, in general, and the other analog markets in which we compete are very competitive. We compete with international and United States semiconductor manufacturers of all sizes in terms of resources and market share, including, but not limited to, Analog Devices, Broadcom, Cirrus Logic, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, Qorvo, and Qualcomm. +We currently face significant competition in our markets and expect that intense price and product competition will continue. This competition has resulted in, and is expected to continue to result in, declining average selling prices for many of our products and increased challenges in maintaining or increasing revenue, gross margin, and market share. Furthermore, additional competitors may enter our markets as a result of growth opportunities in communications electronics, the trend toward global expansion by foreign and domestic competitors and technological and public policy changes (including national or regional policies intended to develop and support localized competitors). We believe that the principal competitive factors for semiconductor suppliers in our markets include, among others: +• +rapid time-to-market and product ramps (including, but not limited to, high-volume product ramps), +• +timely new product innovation, +• +ability to capture design wins in new growth markets, such as 5G, +• +product quality, reliability, and performance, +11 +Table of Contents +• +ability of certain products, including “high reliability” solutions, to perform under stringent operating conditions, +• +product cost and selling price, +• +features available in products, +• +alignment with customer performance specifications, +• +compliance with industry standards, +• +strategic relationships with customers, +• +access to, and the protection and enforcement of, intellectual property, +• +ability to partner with or participate in reference designs of baseband vendors, and +• +maintaining access to manufacturing capacity, raw materials, supplies, and services at a competitive cost. +We might not be able to successfully address these factors. Many of our competitors benefit from: +• +long presence in key markets, +• +brand recognition, +• +high levels of customer satisfaction, +• +vertical integration, +• +strong baseband partnership/participation in reference designs, +• +a broad product portfolio allowing them to bundle product offerings, +• +ownership or control of key technology or intellectual property, and +• +strong financial, sales and marketing, manufacturing, distribution, technical, or other resources. +As a result, certain competitors may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements or may be able to devote greater resources to the development, promotion, and sale of their products than we can. As a result of industry consolidation, certain competitors may be able to further exploit such benefits to strengthen their competitive position. +Our baseband reference design partners may leverage their market position by integrating additional functionality into their product offerings that compete with our solutions. If such a product offering were competitive with our solution as to performance, price, and quality, or if the interoperability of our solution with the partner’s baseband products were to be restricted, our business could be adversely impacted. +Current and potential competitors have established, or may in the future establish, financial, or strategic relationships among themselves or with customers, resellers, or other third parties. These relationships may affect customers’ purchasing decisions. Accordingly, it is possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We may not be able to compete successfully against current and potential competitors. Increased competition could result in pricing pressures, decreased gross margins and loss of revenue and market share and may materially and adversely affect our business, financial condition, and results of operations. +If Original Equipment Manufacturers, or OEMs, and Original Design Manufacturers, or ODMs, of communications electronics products do not design our products into their equipment, we will have difficulty selling those products. Moreover, a “design win” from a customer does not guarantee future sales to that customer. +Our products are not sold directly to the end-user, but are components or subsystems of other products. As a result, we rely on OEMs and ODMs of wireless communications electronics products to select our products from among alternative offerings to be designed into their equipment. Without these “design wins,” we would have difficulty selling our products. If a manufacturer designs another supplier’s product into one of its product platforms, it is more difficult for us to achieve future design wins with that platform because changing suppliers involves significant cost, time, effort, and risk on the part of that manufacturer. Also, achieving a design win with a customer does not ensure that we will receive revenue from that customer. Even after a design win, the customer is not obligated to purchase our products and can choose at any time to reduce or cease use of our products, for example, if its own products are not commercially successful, or for any other reason. We may not continue to achieve design wins or to convert design wins into actual sales, and failure to do so could materially and adversely affect our operating results. Furthermore, as a result of our lengthy product development and sales cycle, we may incur significant research and development expenses, and selling, general, and administrative expenses, without generating the anticipated revenue associated with these products. +We are subject to the risks of doing business internationally. +A substantial majority of our net revenue is derived from shipments to customers located outside the United States, primarily in countries located in the Asia-Pacific region and Europe. We have suppliers located outside the United States, and third-party packaging, assembly, and test facilities and foundries located in the Asia-Pacific region. We maintain wafer fabrication facilities in Kadoma, Japan, and Osaka, Japan, as well as packaging, assembly, and test facilities in Mexicali, Mexico, and in Singapore. Our international +12 +Table of Contents +sales and operations are subject to a number of risks inherent in selling and operating abroad. These include, but are not limited to, risks regarding: +• +currency exchange rate fluctuations, including increases or decreases in commodities prices related to such fluctuations, +• +local economic and political conditions, including, but not limited to, social, economic, and political instability related to the uncertainty regarding the relationships between the United States and China, Russia, Mexico, North Korea, Middle Eastern countries, other foreign countries, and the international community at large, and related to the United Kingdom’s pending withdrawal from the European Union, +• +restrictive governmental actions (such as restrictions on transfer of funds and trade protection measures, including export duties, quotas, customs duties, border taxes, border closures, increased import or export controls, and tariffs), or actions by non-governmental individuals and groups (such as protests, insurgencies, and organized crime), that could negatively impact trade between, or increase the cost of operating in, the countries in which we do business, +• +labor market conditions and workers’ rights, +• +disruptions of capital and trading markets, +• +inability to collect accounts receivable, +• +changes in, or non-compliance with, legal or regulatory import/export requirements, including restrictions on selling to certain customers or into certain jurisdictions, +• +natural disasters, acts of terrorism, widespread illness, and war, +• +misappropriation or other unauthorized transfers of our electronic information and breaches of our information systems, as well as the potential lack of adequate remedies in certain jurisdictions, +• +difficulty in obtaining distribution and support, +• +cultural differences in the conduct of business, +• +direct or indirect government actions, subsidies or policies aimed at supporting local industry, +• +the laws and policies of the United States and other countries affecting trade, foreign investment and loans, foreign travel, and import or export licensing requirements, +• +withdrawal from, or renegotiation of, existing trade agreements by the United States (or other jurisdictions) potentially affecting Mexico, China, and other countries in which we do business, +• +changes in current or future tax law or regulations or new interpretations thereof, by federal or state agencies or foreign governments (including changes in certain countries in Europe and elsewhere regarding corporate taxes, transfer pricing, and tax treaty provisions), +• +changes in the effective tax rate as a result of our overall profitability and mix of earnings in countries with differing statutory tax rates, +• +results of audits and examination of previously filed tax returns, +• +the possibility of being exposed to legal proceedings and potential penalties in a foreign jurisdiction, and/or increased compliance expense, as a result of the numerous, and sometimes conflicting, legal regimes on matters as diverse as anti-corruption, anti-bribery, import/export controls, content requirements, trade restrictions, tariffs, taxation, sanctions, immigration, internal and disclosure control obligations, securities regulation, anti-competition, data privacy and protection (including, but not limited to, the European Union’s General Data Protection Regulation), employment, and labor relations, +• +limitations on our ability under local laws to protect or enforce our intellectual property rights in a particular foreign jurisdiction, and +• +restrictions on our ability to repatriate foreign earnings and/or funds and the unfavorable tax impactions related to the same. +Additionally, we are subject to risks in certain global markets in which wireless operators provide subsidies on handset sales to their customers. Increases in cellular handset prices that negatively impact handset sales can result from changes in regulatory policies or other factors, which could impact the demand for our products. Limitations or changes in policy on phone subsidies in the United States, South Korea, Japan, China, and other countries may have additional negative impacts on our revenues. +Some of the countries in which we operate and seek to expand are in emerging markets where legal systems may be less developed or familiar to us, potentially impacting our ability to obtain appropriate recourse in the event of a dispute. Other jurisdictions in which we conduct business may establish legal and regulatory regimes that differ materially from United States laws and regulations. Compliance with diverse legal requirements is costly and time-consuming and requires significant resources. Violations of one or more of these regulations in the conduct of our business could result in significant fines or monetary damages, criminal sanctions against us or our officers, prohibitions on doing business, unfavorable publicity and other reputation damage, restrictions on our ability to process information, and allegations by our clients that we have not performed our contractual obligations. +13 +Table of Contents +We are particularly exposed to risks of doing business in China. Although we intend to expand our business and operations in China, our success in the Chinese markets may be adversely affected by China’s continuously evolving laws and regulations, including those relating to taxation, import and export tariffs, currency controls, anti-corruption, environmental regulations, indigenous innovation, and intellectual property rights and enforcement of those rights. Enforcement of existing laws or agreements may be inconsistent. In addition, changes in the political environment, governmental policies or United States-China relations could result in revisions to laws or regulations or their interpretation and enforcement, exposure of our proprietary intellectual property, increased taxation, restrictions on imports, import duties, or currency revaluations, which could have an adverse effect on our business plans and operating results. In particular, the imposition by the United States of tariffs on goods imported from China or deemed to be of Chinese origin and other government actions that restrict our ability to sell our products to Chinese customers or to manufacture or source components in China, and countermeasures imposed by China in response, could directly or indirectly adversely impact our manufacturing costs and the sales of our products in China and elsewhere. For example, in May 2019, the U.S. Bureau of Industry and Security of the U.S. Department of Commerce placed Huawei and certain of its affiliates on the Bureau’s Entity List, which resulted in our temporarily suspending shipments to Huawei, and which is expected to adversely affect future demand for our products from this customer. Further, the evolving labor market and increasing labor unrest in China may have a negative impact on our customers, which would result in a negative impact on our business and results of operations. Finally, China’s stated policy of reducing its dependence on foreign semiconductor manufacturers and other technology companies could result in reduced demand for our products in China and other key markets as well as reduced supply of critical materials for our products. +Our manufacturing processes are extremely complex and specialized, and disruptions could have a material adverse effect on our business, financial condition, and results of operations. +Our manufacturing operations are complex and subject to disruption, including due to causes beyond our control. The fabrication of integrated circuits is an extremely complex and precise process consisting of hundreds of separate steps. It requires production in a highly controlled, clean environment. Minor impurities, contamination of the clean room environment in which our products are produced, errors in any step of the fabrication process, defects in the masks used to print circuits on a wafer, defects in equipment or materials, human error, or a number of other factors can cause a substantial percentage of our products to be rejected or to malfunction. Because our operating results are highly dependent upon our ability to produce integrated circuits at acceptable manufacturing yields, these factors could have a material and adverse effect on our business. +Additionally, our operations may be affected by lengthy or recurring disruptions of operations at any of our production facilities, as well as disruptions at facilities operated by our subcontractors or customers. These disruptions may result from electrical power outages, fire, earthquake, flooding, war, acts of terrorism, health advisories or risks, or other natural or man-made disasters, as well as equipment maintenance, repairs, and/or upgrades. Disruptions of our manufacturing operations, or those of our subcontractors and customers, could cause significant delays in shipments until we are able to shift production of the impacted products from an affected facility or subcontractor to another facility or subcontractor, or until the affected customer resumes operations and accepts shipments from us. In the event of such delays, the required alternative capacity, particularly wafer production capacity, may not be available on a timely basis or at all. Even if alternative production capacity is available, we may not be able to obtain it on favorable terms, which could result in higher costs and/or a loss of customers and revenue. Likewise, lower-than-expected demand could lead to underutilized manufacturing facilities, which could negatively impact our financial results. +Due to the highly specialized nature of our manufacturing processes, in the event of a disruption in production at one or more of our facilities for any reason, alternative production capacity would not be immediately available from third-party sources. These disruptions could have a material adverse effect on our business, financial condition, and results of operations. Our key facilities include, but are not limited to, our semiconductor wafer fabrication facilities in Newbury Park, California, and Woburn, Massachusetts, our SAW, TC-SAW, and BAW filter wafer fabrication facilities in Kadoma, Japan, and Osaka, Japan, and our assembly and test facilities in Mexicali, Mexico, and in Singapore. +We may not be able to maintain and improve manufacturing yields that contribute positively to our gross margin and profitability. +Minor deviations or disturbances in the manufacturing process can cause substantial manufacturing yield loss, and in some cases, cause production to be suspended and impact our ability to meet customer demand on a timely basis. Manufacturing yields for new products initially tend to be lower as we complete product development and commence volume manufacturing, and typically increase as we bring the product to full production. Our forward product pricing includes this assumption of improving manufacturing yields and, as a result, material variances between projected and actual manufacturing yields will have a direct effect on our gross margin and profitability. The difficulty of accurately forecasting manufacturing yields and maintaining cost competitiveness through improving manufacturing yields will continue to be magnified by the increasing process complexity of manufacturing semiconductor products. Our manufacturing operations may also face pressures arising from the compression of product life cycles, which may require us to manufacture new products faster and for shorter periods while maintaining acceptable manufacturing yields and quality without, in many cases, reaching the longer-term, high-volume manufacturing conducive to higher manufacturing yields and declining costs. +14 +Table of Contents +Remaining competitive in the semiconductor industry depends upon our ability to develop new products, reduce costs in a timely manner, transition to smaller geometry process technologies, and achieve higher levels of design integration. +The semiconductor industry generally and, in particular, many of the markets into which we sell our products, are highly cyclical and characterized by constant and rapid technological change, continuous product evolution, price erosion, evolving technical standards, short product life cycles (including annual product refreshes in some cases), increasing demand for higher levels of integration, increased miniaturization, reduced power consumption, and wide fluctuations in product supply and demand. Our operating results depend largely on our ability to continue to cost-effectively introduce new and enhanced products on a timely basis. The successful development and commercialization of semiconductor devices and modules is highly complex and depends on numerous factors, including the ability: +• +to anticipate customer and market requirements and changes in technology and industry standards, +• +to obtain sufficient manufacturing capacity to meet customer demand, +• +to define new products that meet customer and market requirements, +• +to complete development of new products and bring products to market on a timely basis, +• +to differentiate our products from offerings of our competitors, +• +to achieve overall market acceptance of our products, +• +to lengthen the time that a particular product is in demand, and +• +to obtain adequate intellectual property protection for our new products. +Our ability to manufacture current products, and to develop new products, depends on, among other factors, the viability and flexibility of our own internal information technology systems. +We continually evaluate expenditures for planned product development and choose among alternatives based on our understanding of customer technical requirements, new industry standards, and expectations of future market growth. We may not be able to develop and introduce new or enhanced wireless communications and analog semiconductor products in a timely and cost-effective manner, and our products may not satisfy customer requirements or achieve market acceptance or we may not be able to anticipate new industry standards and technological changes. We also may not be able to respond successfully to new product announcements and introductions by competitors or to changes in the design or specifications of complementary products of third parties with which our products interface. If we fail to rapidly and cost-effectively introduce new and enhanced products in sufficient quantities that meet our customers’ requirements, our business and results of operations would be materially and adversely harmed. +In addition, prices of many of our products decline, sometimes significantly, over time. Our products may become obsolete earlier than planned or may not have life cycles long enough to allow us to recoup the cost of our investment in designing such products. Accordingly, we believe that to remain competitive, we must continue to reduce the cost of producing and delivering existing products at the same time that we develop and introduce new or enhanced products. We may not be able to continue to reduce the cost of producing and delivering our products and thereby remain competitive. +In order to remain competitive, we expect to continue to transition many of our products to increasingly smaller geometries. This transition often requires us to upgrade our capital equipment, modify the manufacturing processes for our products, design new products to more stringent standards, and redesign some existing products. In the past, we have experienced some difficulties migrating to smaller geometry process technologies or new manufacturing processes, which resulted in sub-optimal manufacturing yields, delays in product deliveries, and increased expenses. We may face similar difficulties, delays, and expenses as we continue to transition our products to smaller geometry processes in the future. In some instances, we depend on our relationships with our third-party foundries to transition to smaller geometry processes successfully. Our foundries may not be able to effectively manage the transition or we may not be able to maintain our relationships with certain foundries. If our foundries or we experience significant delays in this transition or fail to efficiently implement this transition, our business, financial condition, and results of operations could be materially and adversely affected. As smaller geometry processes become more prevalent, we expect to continue to integrate greater levels of functionality, as well as customer and third-party intellectual property, into our products. However, we may not be able to achieve higher levels of design integration or deliver new integrated products on a timely basis, or at all. +We may be subject to warranty claims, product recalls, and liability claims. +Although we invest significant resources in the testing of our products, we may discover from time to time defects in our products after they have been shipped, and we may be required to incur additional development and remediation costs, or cash payments to settle claims pursuant to warranty and indemnification provisions in our customer contracts and purchase orders. Certain of our products, including “high reliability” solutions, may not be able to perform under stringent operating conditions. Examples of our “high reliability” solutions include applications intended for the aerospace, automotive, medical, and military markets. The potential liabilities associated with these, and similar, provisions in certain of our customer contracts are in some cases capped at significant amounts, and in other cases are uncapped. Depending on the nature of the product defects, we may not be able to recoup our losses +15 +Table of Contents +from our third-party suppliers. These problems may divert our technical and other resources from other product development efforts and could result in claims against us by our customers or third parties, including liability for costs associated with product recalls, indemnification claims, or other obligations under customer contracts. If any of our products contain defects, or have reliability, quality, or compatibility problems, our reputation may be damaged and we could be subject to liability claims, which could make it more difficult for us to sell our products to existing and prospective customers and could adversely affect our operating results. Furthermore, such losses would not be covered under our existing corporate insurance programs. +We are dependent upon third parties for the manufacture, assembly, and testing of our products. +We rely on foundries to provide silicon-based products and to supplement our gallium arsenide wafer manufacturing capacity. There are significant risks associated with reliance on third-party foundries, including: +• +the lack of wafer supply, potential wafer shortages, and higher wafer prices, +• +limited ability to respond to unanticipated changes in customer demand, +• +limited control over delivery schedules, manufacturing yields, production costs, and quality assurance, and +• +the inaccessibility of, or delays in obtaining access to, key process technologies, materials, and IP blocks. +Even in cases where we have long-term supply arrangements to obtain additional external manufacturing capacity, the third-party foundries we use for our standby manufacturing capacity may allocate their limited capacity to the production requirements of other customers and in general we have no contractual right to prevent them from making such allocations. If we choose to use a new foundry to replace either existing or backup capacity, it will typically take an extended period of time for us to complete our qualification process for that foundry, which will result in a significant passage of time before we can begin shipping products from that new foundry. +Further, the third-party foundries may experience financial difficulties or changes in control, be unable to deliver products to us in a timely manner, or suffer damage or destruction to their facilities, particularly since some of them are located in areas prone to natural disasters. If any disruption of manufacturing capacity occurs, we may not have alternative manufacturing sources immediately available. We may therefore experience difficulties or delays in securing an adequate supply of our products, which could impair our ability to meet our customers’ needs and have a material adverse effect on our operating results. +Although we own and operate assembly and test facilities, we still depend on subcontractors to package, assemble, and test certain of our products at cost-competitive rates. For those assembly and test subcontractors with whom we do not have long-term agreements, we typically procure services from these suppliers on a per-order basis. If any of our subcontractors experiences capacity constraints or financial difficulties, suffers any damage to its facilities, experiences power outages or any other disruption of assembly or testing capacity, we may not be able to obtain alternative assembly and testing services in a timely manner and/or at cost-competitive rates. Due to the amount of time that it usually takes us to qualify assembly and test subcontractors, we could experience significant delays in product shipments if we are required to find alternative assembly and test subcontractors for our components. Any problems that we may encounter with the delivery, quality, or cost of our products could damage our customer relationships and materially and adversely affect our results of operations. +If we are unable to attract and retain qualified personnel to contribute to the design, development, manufacture and sale of our products, we may not be able to effectively operate our business. +As the source of our technological and product innovations, our key technical personnel represent a significant asset. Our success depends on our ability to continue to attract, retain, and motivate qualified personnel, including executive officers and other key management and technical personnel. The competition for management and technical personnel is intense in the semiconductor industry, and therefore we may not be able to continue to attract and retain the qualified management and other personnel necessary for the design, development, manufacture, and sale of our products. Our employees are highly sought after by our competitors and other companies. We may have particular difficulty attracting and retaining key personnel during periods of poor operating performance and/or declines in the price of our common stock, given among other factors, the use of equity-based compensation by us and our competitors. Further, existing immigration laws, together with any changes to immigration policies or regulations in the United States, make it more difficult for us to recruit and retain highly skilled foreign national graduates of universities in the United States, limiting the pool of available talent. Travel bans, difficulties obtaining visas and other restrictions on international travel make it more difficult to effectively manage our international operations, collaborate as a global company, or service our international customer base. We continue to anticipate increases in human resource needs, particularly in engineering. The loss of the services of one or more of our key employees or our inability to attract, retain, and motivate qualified personnel, could have a material adverse effect on our ability to operate our business. +Our business would be adversely affected by the departure of existing members of our senior management team or if our senior management team is unable to effectively implement our strategy. +16 +Table of Contents +Our success depends, in large part, on the continued contributions of our senior management team, none of whom is bound by a written employment contract to remain with us for a specified period. The loss of any of our senior management could harm our ability to implement our business strategy and respond to the rapidly changing market conditions in which we operate. +Uncertainties involving the ordering and shipment of, and payment for, our products, could adversely affect our business. +Our sales are typically made pursuant to standard purchase orders and/or specified customer contracts for delivery of products and not under long-term supply arrangements with our customers. Our customers may cancel orders before shipment. Additionally, we sell a portion of our products through third-party distributors, some of whom have rights to return products if the product is nonconforming. We may purchase and manufacture inventory based on estimates of customer demand for our products, which is difficult to predict. This difficulty may be compounded when we sell to OEMs indirectly through distributors or contract manufacturers, or both, as our forecasts of demand will then be based on estimates provided by multiple parties. In addition, our customers and/or distributors may change their inventory practices on short notice for any reason. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volumes could result in us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. Some of our customers have implemented vendor-managed inventory, consignment, or similar inventory programs which may result in an increase in the time between manufacture of, and payment for, our products. +In addition, if a customer or distributor encounters financial difficulties of its own as a result of a change in demand or for any other reason, the customer’s or distributor’s ability to make timely payments against our accounts receivable could be impaired. +We are dependent upon third parties for the supply of raw materials and components. +Our manufacturing operations depend on obtaining adequate supplies of raw materials and components used in our manufacturing processes at a competitive cost. Although we maintain relationships with suppliers located around the world with the objective of ensuring that we have adequate sources for the supply of raw materials and components for our manufacturing needs, increases in demand from the semiconductor industry for such raw materials and components (including, but not limited to, precious and rare earth metals), as well as increased demand for commodities in general, can result in tighter supplies and higher costs. Our suppliers may not be able to meet our delivery schedules, we may lose a significant or sole supplier, a supplier may not be able to meet performance and quality specifications and we may not be able to purchase such supplies or material at a competitive cost. If a supplier were unable to meet our delivery schedules or if we lost a supplier or a supplier were unable to meet performance or quality specifications, our ability to satisfy customer obligations would be materially and adversely affected. In addition, we review our relationships with suppliers of raw materials and components for our manufacturing needs on an ongoing basis. In connection with our ongoing review, we may modify or terminate our relationship with one or more suppliers. We may also enter into sole supplier arrangements to meet certain of our raw material or component needs. While we do not typically rely on a single source of supply for our raw materials, we are currently dependent on a limited number of sole-source suppliers. If we were to lose these sole sources of supply, for any reason, a material adverse effect on our business could result until an alternate source is obtained. To the extent we enter into additional sole supplier arrangements for any of our raw materials or components, the risks associated with our supply arrangements would be exacerbated. +Our business and operations could suffer in the event of information technology security breaches. +Security breaches, phishing, spoofing, attempts by others to gain unauthorized access to our information technology systems, and other cyberattacks are becoming more sophisticated and persistent and are sometimes successful. These incidents, which might be related to industrial or other espionage, include covertly introducing malware and spyware to our computers and networks (or to an electronic system operated by a third party for our benefit) and impersonating authorized users, among others. We seek to detect and investigate all security incidents and to prevent their recurrence, but in some cases, we might be unaware of an incident or its magnitude and effects. The theft, unauthorized use, transfer, or publication of our intellectual property, our confidential business information, or the personal data of our employees by third parties or by our employees could harm our competitive position, reduce the value of our investment in research and development and other strategic initiatives or otherwise adversely affect our business. To the extent that any security breach or other cybersecurity incident results in inappropriate disclosure of our customers’, suppliers’, licensees’ or employees’ confidential information, we may incur liability as a result. We expect to continue devoting significant resources to the security of our information technology systems and the training of our employees. However, we cannot ensure that our efforts will be sufficient to prevent or mitigate the damage caused by a cyberattack, cybersecurity incident, or network disruption. +If we are not successful in protecting our intellectual property rights, our ability to compete successfully may be materially and adversely affected. +We rely on patent, copyright, trademark, trade secret, and other intellectual property rights and laws, as well as nondisclosure and confidentiality agreements and other methods, to protect our proprietary technologies, inventions, information, data, devices, algorithms, processes, and other intellectual property. In addition, we often incorporate the intellectual property of our customers, suppliers, or other third parties into our designs, and we have obligations with respect to the non-use and non-disclosure of such +17 +Table of Contents +third-party intellectual property. From time to time, it may be necessary to engage in litigation or like activities to enforce our intellectual property rights, to protect our trade secrets, or to determine the validity and scope of proprietary rights of others, including our customers. This could require us to expend significant resources and to divert the efforts and attention of our management and technical personnel from our business operations. Regardless of our actions: +• +the steps we take to prevent misappropriation, infringement, dilution, or other violation of our intellectual property or the intellectual property of our customers, suppliers, or other third parties may not be successful, and +• +any of our existing or future patents, copyrights, trademarks, trade secrets, or other intellectual property rights may be challenged, invalidated, deemed unenforceable, or circumvented. +A third party could copy, misappropriate, or otherwise obtain and use our technology without authorization, develop similar technology independently, or design around or invalidate our patents. If any of our intellectual property protection mechanisms fails to protect our technology, it would make it easier for our competitors to offer similar competitive products, potentially resulting in loss of market share and price erosion. Even if we receive a patent, the patent claims may not be broad enough to adequately cover and protect our technology. Furthermore, even if we receive patent protection in the United States, we may not seek, or may not be granted, patent protection in other relevant foreign countries. In addition, effective patent, copyright, trademark, and trade secret protection, and enforcement may be unavailable, impractical, or limited for certain technologies and in certain foreign countries. +We attempt to control access to, and distribution of, our proprietary and confidential information through operational, technological, and legal safeguards. Despite our efforts, parties, including former or current employees, may attempt to copy, disclose, transfer, or obtain access to our information without our authorization. Furthermore, attempts by computer hackers to gain unauthorized access to our systems or information could result in our confidential and/or proprietary information being compromised or our operations being interrupted. While we attempt to prevent such unauthorized access or misappropriation we may be unable to anticipate the methods used, or be unable to prevent the release of our confidential and/or proprietary information or that of a third party. +We may be subject to claims of infringement of third-party intellectual property rights, or demands that we license third-party technology, which could result in significant expense and prevent us from using our technology. +The semiconductor industry is characterized by vigorous protection, enforcement, and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark, and other intellectual property rights against technologies that are important to our business and have demanded and may in the future demand that we license their technology or refrain from using it. +Any litigation to determine the validity of any allegations that our products infringe or may infringe intellectual property rights of another party, including indemnification claims arising from our contractual obligations of our customers, regardless of their merit or resolution, could be costly and divert the efforts and attention of our management and technical personnel. Regardless of the merits of any specific claim, we may not prevail in litigation because of the complex technical issues and inherent uncertainties in intellectual property litigation. If litigation were to result in an adverse ruling, we could be required to: +• +pay substantial damages, +• +cease the manufacture, import, use, sale, or offer for sale of infringing products or processes, +• +discontinue the use of infringing technology, +• +expend significant resources to develop non-infringing technology, and +• +license technology from the third party claiming infringement, which license may not be available on commercially reasonable terms. +Our operating results or financial condition may be materially adversely affected if we, or one of our customers, were required to take any one or more of the foregoing actions. +In addition, if another supplier to one of our customers, or a customer of ours itself, were found to be infringing upon the intellectual property rights of a third party, the supplier or customer could be ordered to cease the manufacture, import, use, sale, or offer for sale of its infringing product(s) or process(es), either of which could result, indirectly, in a decrease in demand from our customers for our products. If such a decrease in demand for our products were to occur, it could have an adverse impact on our operating results. +Many of our products currently incorporate technology licensed or acquired from third parties and we expect our products in the future to also require technology from third parties. If the licenses to such technology that we currently hold become unavailable or the terms on which they are available become commercially unreasonable, or if we are unable to acquire or license necessary technology for our products in the future, our business could be adversely affected. +18 +Table of Contents +We sell products in markets that are characterized by rapid technological changes, evolving industry standards, frequent new product introductions, short product life cycles, and increasing levels of integration. Our ability to keep pace with this market depends on our ability to obtain technology from third parties on commercially reasonable terms to allow our products to remain competitive. If licenses to such technology are not available on commercially reasonable terms and conditions or at all, and we cannot otherwise acquire or integrate such technology, our products or our customers’ products could become unmarketable or obsolete, and we could lose market share. In such instances, we could also incur substantial unanticipated costs or scheduling delays to develop substitute technology to deliver competitive products. +There can be no assurance that we will continue to declare cash dividends or repurchase our stock. +We intend to pay quarterly cash dividends subject to capital availability and periodic determinations by our Board of Directors that cash dividends are in the best interest of our stockholders. In addition, from time to time the Board of Directors approves stock repurchase programs, pursuant to which we are authorized to repurchase shares of common stock on the open market or in privately negotiated transactions. +Future cash dividends and the amount and timing of our stock repurchases may be affected by, among other factors: +• +our views on potential future capital requirements, including those related to acquisitions as well as research and development, +• +our ability to generate sufficient earnings and cash flows, +• +use of cash to consummate various acquisition transactions, +• +capital requirements related to cash dividends and stock repurchase programs, +• +changes in federal and state income tax laws or corporate laws, and +• +changes to our business model. +Our cash dividend payments may change from time to time, and we cannot provide assurance that we will increase our cash dividend payment or declare cash dividends in any particular amounts or at all. A reduction in our cash dividend payments or a reduction in the level of our stock repurchases could have a negative effect on our stock price. +Changes in tax laws and regulations worldwide could have an adverse impact on our operating results. +We are subject to taxation in many different countries and localities worldwide. To the extent the tax laws and regulations in these various countries and localities could change, including the Base Erosion and Profit Shifting project being conducted by the Organization for Economic Co-operation and Development, our tax liability in general could increase. +The tax legislation (the “Tax Reform Act”), enacted by the United States in December 2017, included several changes to U.S. tax laws that have had, and will continue to have, a significant impact on our operations, including a reduction in the U.S. corporate tax rate, base-erosion prevention measures on earnings of our non-U.S. subsidiaries, and a one-time mandatory deemed repatriation tax on earnings of certain foreign jurisdictions. Because these changes require a number of complex calculations that previously were not required, our actual tax liability may differ materially from our income tax provisions, estimates, and accruals. Changes in our interpretations and assumptions, as well as additional guidance issued, could increase income tax liabilities and/or reduce certain tax benefits. +We face a risk that capital needed for our business will not be available when we need it. +To the extent that our existing cash and cash equivalents and cash generated from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. If unfavorable capital market conditions exist in the event we were to seek additional financing, we may not be able to raise sufficient capital on favorable terms and on a timely basis, if at all. Failure to obtain capital when required by our business circumstances would have a material adverse effect on us. +In addition, any strategic investments and acquisitions that we may make to help us grow our business may require additional capital resources. The capital required to fund these investments and acquisitions may not be available in the future. +To be successful we may need to make certain investments and acquisitions, integrate companies we acquire, and/or enter into strategic alliances. +Although we have invested in the past, and intend to continue to invest, significant resources in internal research and development activities, the complexity and rapidity of technological changes and the significant expense of internal research and development make it impractical for us to pursue development of all technological solutions on our own. On an ongoing basis, we review investment, alliance, and acquisition prospects that would complement our product offerings, augment our market coverage or enhance our technological capabilities. We may not be able to identify and consummate suitable investment, alliance, or acquisition transactions in the future. Moreover, if such transactions are consummated, they could result in: +19 +Table of Contents +• +issuances of equity securities dilutive to our stockholders, +• +restructuring or other impairment write-offs, +• +the incurrence of substantial debt and assumption of unknown liabilities, +• +the potential loss of key employees from the acquired company, +• +recognition of additional liabilities known or unknown at the time of acquisition, +• +amortization expenses related to intangible assets, and +• +the diversion of management’s attention from other business concerns. +Moreover, integrating acquired organizations and their products and services may be difficult, expensive, time-consuming, and a strain on our resources and our relationship with employees and customers and ultimately may not be successful. Additionally, in periods following an acquisition, we will be required to evaluate goodwill and acquisition-related intangible assets for impairment. If such assets are found to be impaired, they will be written down to estimated fair value, with a charge against earnings. +Increasingly stringent environmental laws, rules, and regulations may require us to redesign our existing products and processes, and could adversely affect our ability to cost-effectively produce our products. +The semiconductor industry has been subject to increasing environmental regulations, particularly those environmental requirements that control and restrict the use, transportation, emission, discharge, storage, and disposal of certain chemicals, elements, and materials used or produced in the semiconductor manufacturing process. Heightened public focus on climate change, sustainability, and environmental issues has also led to increased government regulation and caused certain of our customers to impose environmental standards on us as a part of doing business with them. We expect that the trend of increasing environmental awareness will continue which will result in higher costs of operations. In addition, our commitment to environmentally sustainable practices, while undertaken in a manner designed to be as efficient and cost effective as possible, may result in increases in costs of operations for us relative to our competitors until technologies and methods are developed that will help reduce those costs or such practices become industry best practice. +A number of domestic and foreign jurisdictions restrict or may seek to restrict the use of various substances, a number of which have been or are currently used in our products or processes. For example, the European Union Restriction of Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) Directive requires that certain substances, which may be found in certain products we have manufactured in the past, be removed from all electronics components. Eliminating such substances from our manufacturing processes requires the expenditure of additional research and development funds to seek alternative substances for our products, as well as increased testing by third parties to ensure the quality of our products and compliance with the RoHS Directive. While we have implemented a compliance program to ensure our product offering meets these regulations, there may be instances where alternative substances will not be available or commercially feasible, or may only be available from a single source, or may be significantly more expensive than their restricted counterparts. Additionally, if we were found to be non-compliant with any such rule or regulation, we could be subject to fines, penalties and/or restrictions imposed by government agencies that could adversely affect our operating results. +Regulations in the United States require that we determine whether certain materials used in our products, referred to as conflict minerals, originated in the Democratic Republic of the Congo or adjoining countries, or were from recycled or scrap sources. The verification and reporting requirements, in addition to customer demands for conflict-free sourcing, impose additional costs on us and on our suppliers, and may limit the sources or increase the prices of materials used in our products. Further, if we are unable to certify that our products are conflict free, we may face challenges with our customers, which could place us at a competitive disadvantage, and our reputation may be harmed. +New climate change laws and regulations could require us to change our manufacturing processes or obtain substitute materials that may cost more or be less available for our manufacturing operations. Various jurisdictions in which we do business have implemented, or in the future could implement or amend, restrictions on emissions of carbon dioxide or other greenhouse gases and other climate change-based rules and regulations, which may increase our expenses and adversely affect our operating results. We expect increased worldwide regulatory activity relating to climate change in the future. Compliance with these laws and regulations has not had a material impact on our capital expenditures, earnings, financial condition or competitive position. +Furthermore, environmental regulations often require parties to fund remedial action for violations of such regulations regardless of fault. Consequently, it is often difficult to estimate the future impact of environmental matters, including potential liabilities. In addition, our customers increasingly require warranties or indemnity relating to compliance with environmental regulations. The amount of expense and capital expenditures that might be required to satisfy environmental liabilities, to complete remedial actions, and to continue to comply with applicable environmental laws may have a material adverse effect on our business, financial condition, and results of operations. +20 +Table of Contents +Certain provisions in our organizational documents and Delaware law may make it difficult for someone to acquire control of us. +We have certain anti-takeover measures that may affect our common stock. Our certificate of incorporation, our by-laws, and the Delaware General Corporation Law contain several provisions that would make more difficult an acquisition of control of us in a transaction not approved by our Board of Directors. Our certificate of incorporation and by-laws include provisions such as: +• +the ability of our Board of Directors to issue shares of preferred stock in one or more series without further authorization of stockholders, +• +a prohibition on stockholder action by written consent, +• +a requirement that stockholders provide advance notice of any stockholder nominations of directors or any proposal of new business to be considered at any meeting of stockholders, +• +a requirement that the affirmative vote of at least 80% of our shares be obtained to amend or repeal the provisions of our certificate of incorporation relating to the election and removal of directors or the right to act by written consent, +• +a requirement that the affirmative vote of at least 80% of our shares be obtained for business combinations unless approved by a majority of the members of the Board of Directors and, in the event that the other party to the business combination is the beneficial owner of 5% or more of our shares, a majority of the members of the Board of Directors in office prior to the time such other party became the beneficial owner of 5% or more of our shares, +• +a fair price provision, and +• +a requirement that the affirmative vote of at least 90% of our shares be obtained to amend or repeal the fair price provision. +In addition to the provisions in our certificate of incorporation and by-laws, Section 203 of the Delaware General Corporation Law generally provides that a corporation may not engage in any business combination with any interested stockholder during the three-year period following the time that such stockholder becomes an interested stockholder, unless a majority of the directors then in office approves either the business combination or the transaction that results in the stockholder becoming an interested stockholder or specified stockholder approval requirements are met. +ITEM 1B. UNRESOLVED STAFF COMMENTS. +None. +ITEM 2. PROPERTIES. +We have executive offices in Irvine, California, and Woburn, Massachusetts. For information regarding property, plant and equipment by geographic region for each of the last three fiscal years, see Note 15 to Item 8 of this Annual Report on Form 10-K. The following table sets forth our principal facilities: +21 +Table of Contents +Location +Owned/Leased +Square Footage +Primary Function +Mexicali, Mexico +Owned +380,000 +Manufacturing and office space +Woburn, Massachusetts +Owned +158,000 +Manufacturing and office space +Adamstown, Maryland +Owned +121,200 +Manufacturing and office space +Newbury Park, California +Owned +111,600 +Manufacturing and office space +Osaka, Japan +Leased +405,300 +Filter manufacturing +Singapore, Singapore +Leased +298,800 +Filter manufacturing +Irvine, California +Leased +218,500 +Design center and office space +Mexicali, Mexico +Leased +179,000 +Manufacturing and office space +Newbury Park, California +Leased +115,700 +Design center +Kadoma, Japan +Leased +97,300 +Filter manufacturing and office space +Ottawa, Ontario +Leased +82,200 +Design center +Hillsboro, Oregon +Leased +59,500 +Design center and office space +San Jose, California +Leased +51,900 +Design center and office space +Cedar Rapids, Iowa +Leased +42,900 +Design center +Andover, Massachusetts +Leased +22,900 +Design center +Seoul, Korea +Leased +22,900 +Design center +Basking Ridge, New Jersey +Leased +21,800 +Design center +ITEM 3. LEGAL PROCEEDINGS. +The information set forth under Note 11 of Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES. +Not Applicable. +22 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. +MARKET INFORMATION AND DIVIDENDS +Our common stock is traded on the Nasdaq Global Select Market under the symbol “SWKS”. +The number of stockholders of record of our common stock as of November 12, 2019 , was 11,174 . On November 12, 2019 , the Company announced that the Board of Directors had declared a cash dividend of $0.44 per share of common stock, payable on December 24, 2019 , to stockholders of record as of December 3, 2019 . We intend to continue to pay quarterly dividends subject to capital availability and our view that cash dividends are in the best interests of our stockholders. Future cash dividends may be affected by, among other items, our views on potential future capital requirements, including those relating to research and development, creation and expansion of sales distribution channels and investments and acquisitions, legal risks, stock repurchase programs, debt issuance, changes in federal and state income tax law and changes to our business model. +ISSUER PURCHASES OF EQUITY SECURITIES +The following table provides information regarding repurchases of common stock made during the fiscal quarter ended September 27, 2019 : +Period +Total Number of Shares Purchased +Average Price Paid per Share +Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1) +Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs (1) +6/29/19-7/26/19 +1,277(2) +$81.69 +— +$1.77 billion +7/27/19-8/23/19 +780,814(3) +$76.72 +772,437 +$1.71 billion +8/24/19-9/27/19 +1,163,658(4) +$75.00 +1,160,559 +$1.63 billion +Total +1,945,749 +1,932,996 +_________________________ +(1) The stock repurchase program approved by the Board of Directors on January 30, 2019 , authorizes the repurchase of up to $ 2.0 billion of our common stock from time to time on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. The January 30, 2019 , stock repurchase program replaced in its entirety the January 31, 2018, plan and is scheduled to expire on January 30, 2021 . +(2) Represents shares repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements. +(3) 772,437 shares were repurchased at an average price of $76.73 per share as part of our stock repurchase program, and 8,377 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $76.33 per share. +(4) 1,160,559 shares were repurchased at an average price of $75.01 per share as part of our stock repurchase program, and 3,099 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $74.95 per share. +23 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA. +The information set forth below for the five years ended September 27, 2019 , is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , and our consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K to fully understand factors that may affect the comparability of the information presented below. Our fiscal year ends on the Friday closest to September 30. Fiscal 2019, 2018, 2017, 2016, and 2015 each consisted of 52 weeks and ended on September 27, 2019, September 28, 2018, September 29, 2017, September 30, 2016, and October 2, 2015, respectively. +The following table represents the selected financial data (in millions, except per share data): +Fiscal Years Ended +Statement of Operations Data: +September 27, 2019 (1) +September 28, 2018 (2) +September 29, 2017 +September 30, 2016 (3) +October 2, +2015 +Net revenue +$ +3,376.8 +$ +3,868.0 +$ +3,651.4 +$ +3,289.0 +$ +3,258.4 +Operating income +$ +952.0 +$ +1,319.3 +$ +1,253.8 +$ +1,118.7 +$ +1,023.1 +Operating margin +28.2 +% +34.1 +% +34.3 +% +34.0 +% +31.4 +% +Net income +$ +853.6 +$ +918.4 +$ +1,010.2 +$ +995.2 +$ +798.3 +Earnings per share: +Basic +$ +4.92 +$ +5.06 +$ +5.48 +$ +5.27 +$ +4.21 +Diluted +$ +4.89 +$ +5.01 +$ +5.41 +$ +5.18 +$ +4.10 +Cash dividends declared per share +$ +1.58 +$ +1.34 +$ +1.16 +$ +1.06 +$ +0.65 +As of +Balance Sheet Data: +September 27, 2019 +September 28, 2018 +September 29, 2017 +September 30, +2016 +October 2, +2015 +Working capital +$ +1,860.6 +$ +1,872.5 +$ +2,245.8 +$ +1,791.9 +$ +1,450.8 +Property, plant and equipment, net +$ +1,205.6 +$ +1,140.9 +$ +882.3 +$ +806.3 +$ +826.4 +Total assets +$ +4,839.6 +$ +4,828.9 +$ +4,573.6 +$ +3,855.4 +$ +3,719.4 +Stockholders’ equity +$ +4,122.3 +$ +4,097.0 +$ +4,065.7 +$ +3,541.4 +$ +3,159.2 +____________ +(1) Fiscal 2019 net revenue, net income, and earnings per share were adversely impacted as a result of the U.S. Bureau of Industry and Security of the U.S. Department of Commerce placing Huawei and certain of its affiliates on the Bureau’s Entity List (the “Entity List”) in May 2019. +(2) Fiscal 2018 net income and earnings per share include a one-time charge of $224.6 million related to the mandatory deemed repatriation tax on foreign earnings and a one-time charge of $18.3 million related to the revaluation of deferred tax assets and liabilities at the new corporate tax rate, as a result of the Tax Reform Act. +(3) Fiscal 2016 net income and earnings per share include other income of $88.5 million related to the receipt of a merger termination fee in November 2015 in connection with the termination by PMC-Sierra, Inc. (“PMC”), of the Amended and Restated Agreement and Plan of Merger that we had entered into with PMC in October 2015. +24 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Annual Report on Form 10-K. In addition to historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially and adversely from those referred to herein due to a number of factors, including, but not limited to, those described below and in Item 1A “ Risk Factors ” and elsewhere in this Annual Report on Form 10-K. +OVERVIEW +We, together with our consolidated subsidiaries, are empowering the wireless networking revolution. Our highly innovative analog semiconductors are connecting people, places, and things spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto (a Thales company), General Electric, Google, Honeywell, HTC, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi and ZTE. +RESULTS OF OPERATIONS +FISCAL YEARS ENDED SEPTEMBER 27, 2019 , SEPTEMBER 28, 2018 , AND SEPTEMBER 29, 2017 . +The table below sets forth the results of our operations expressed as a percentage of net revenue. See Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended September 28, 2018, filed with the SEC on November 15, 2018, as amended by Amendment No. 1 to such Annual Report on Form 10-K, filed with the SEC on January 25, 2019 (the “2018 10-K”), for Management’s Discussions and Analysis of Financial Condition and Results of Operations for the fiscal year ended September 29, 2017. +September 27, +2019 +September 28, +2018 +September 29, +2017 +Net revenue +100.0 +% +100.0 +% +100.0 +% +Cost of goods sold +52.5 +49.6 +49.6 +Gross profit +47.5 +50.4 +50.4 +Operating expenses: +Research and development +12.5 +10.4 +9.7 +Selling, general and administrative +5.9 +5.4 +5.6 +Amortization of intangibles +0.7 +0.5 +0.8 +Restructuring and other charges +0.2 +— +— +Total operating expenses +19.3 +16.3 +16.1 +Operating income +28.2 +34.1 +34.3 +Other income (expense), net +0.3 +0.3 +0.1 +Income before income taxes +28.5 +34.4 +34.4 +Provision for income taxes +3.2 +10.7 +6.7 +Net income +25.3 +% +23.7 +% +27.7 +% +GENERAL +During the fiscal year ended September 27, 2019 , the following key factors contributed to our overall results of operations, financial position and cash flows: +• +Net revenue decreased 12.7% to $3,376.8 million , as compared to fiscal 2018. This decrease in revenue was primarily driven by weakness in smartphone demand and Huawei being added to the Entity List, partially offset by the increasing number of IoT applications, our expanding analog product portfolio supporting new vertical markets including automotive, consumer, industrial, infrastructure, medical, and military, and our success in capturing a higher share of the increasing radio frequency and analog content per device as smartphone models continue to evolve. +25 +Table of Contents +• +Our ending cash, cash equivalents and marketable securities balance increased 3.1% to $1,082.2 million in fiscal 2019 from $1,050.2 million in fiscal 2018 . This increase was primarily the result of a 8.5% increase in cash from operations to $1,367.4 million in fiscal 2019 from $1,260.6 million in fiscal 2018 , partially offset by the repurchase of 8.9 million shares of our common stock for $657.6 million , capital expenditures of $398.4 million , and cash dividends of $273.9 million . +NET REVENUE +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Net revenue +$ +3,376.8 +(12.7)% +$ +3,868.0 +5.9% +$ +3,651.4 +We market and sell our products directly to OEMs of communications and electronics products, third-party original design manufacturers and contract manufacturers, and indirectly through electronic components distributors. We generally experience seasonal peaks during our fourth and first fiscal quarters (which correspond to the second half of the calendar year), primarily as a result of increased worldwide production of consumer electronics in anticipation of increased holiday sales, whereas our second and third fiscal quarters are typically lower and in line with seasonal industry trends. +The $491.2 million decrease in net revenue in fiscal 2019 , as compared to fiscal 2018 , is primarily related to weakness in smartphone demand and Huawei being added to the Entity List, partially offset by the increasing number of IoT applications, our expanding analog product portfolio supporting new vertical markets including automotive, consumer, industrial, infrastructure, medical, and military, and our success in capturing a higher share of the increasing radio frequency and analog content per device as smartphone models continue to evolve. +For information regarding net revenue by geographic region and customer concentration, see Note 15 to Item 8 of this Annual Report on Form 10-K. +GROSS PROFIT +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Gross profit +$ +1,603.8 +(17.8)% +$ +1,950.7 +5.9% +$ +1,841.8 +% of net revenue +47.5 +% +50.4 +% +50.4 +% +Gross profit represents net revenue less cost of goods sold. Our cost of goods sold consists primarily of purchased materials, labor and overhead (including depreciation and share-based compensation expense) associated with product manufacturing. Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. As part of our normal course of business, we mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs, improve manufacturing efficiencies, lower manufacturing costs of existing products and by introducing new and higher value-added products. +The $346.9 million decrease in gross profit in fiscal 2019 , as compared to fiscal 2018 , was primarily the result of lower unit volumes and lower average selling prices with a gross profit impact of $546.5 million. In addition, we incurred a $66.1 million inventory-related charge due to lower expected demand as a result of Huawei being added to the Entity List. These negative impacts were partially offset by favorable product mix that positively impacted gross profit by $265.7 million. As a result of these impacts, gross profit margin decreased to 47.5% of net revenue for fiscal 2019 as compared to 50.4% in fiscal 2018 . +RESEARCH AND DEVELOPMENT +26 +Table of Contents +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Research and development +$ +424.1 +4.8% +$ +404.5 +13.9% +$ +355.2 +% of net revenue +12.5 +% +10.4 +% +9.7 +% +Research and development expenses consist primarily of direct personnel costs including share-based compensation expense, costs for pre-production evaluation and testing of new devices, masks, engineering prototypes and design tool costs. +The increase in research and development expense in fiscal 2019 , as compared to fiscal 2018 , was primarily related to an increase in employee-related compensation expense and product development-related expenses. Research and development expense increased as a percentage of net revenue as a result of our increased investment in developing new technologies and products, as well as the decrease in net revenue. +SELLING, GENERAL AND ADMINISTRATIVE +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Selling, general and administrative +$ +198.3 +(4.6)% +$ +207.8 +1.6% +$ +204.6 +% of net revenue +5.9 +% +5.4 +% +5.6 +% +Selling, general and administrative expenses include legal and related costs, accounting, treasury, human resources, information systems, customer service, bad debt expense, sales commissions, share-based compensation expense, advertising, marketing, costs associated with business combinations completed or contemplated during the period and other costs. +The decrease in selling, general and administrative expenses in fiscal 2019 , as compared to fiscal 2018 , was primarily related to a decrease in share-based compensation expense. Selling, general and administrative expenses increased as a percentage of net revenue primarily due to the decrease in net revenue. +AMORTIZATION OF INTANGIBLES +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Amortization of intangibles, cost of goods sold +$ +34.1 +305.4% +$ +8.4 +100.0% +$ +— +Amortization of intangibles, operating expense +22.6 +23.5% +18.3 +(33.7)% +27.6 +Total amortization of intangibles, including inventory step-up +56.7 +26.7 +27.6 +% of net revenue +1.7 +% +0.7 +% +0.8 +% +The increase in amortization for fiscal 2019 , as compared to fiscal 2018 , was primarily due to amortization attributable to the Avnera acquisition completed in the fourth quarter of fiscal 2018 . +RESTRUCTURING AND OTHER CHARGES +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Restructuring and other charges +$ +6.8 +750.0% +$ +0.8 +33.3% +$ +0.6 +% of net revenue +0.2 +% +— +% +— +% +27 +Table of Contents +Restructuring and other charges incurred in fiscal 2019 were primarily related to employee severance and other termination benefits as well as charges on a leased facility resulting from restructuring plans initiated during the period. We do not anticipate any further significant charges associated with these restructuring activities and the remaining cash payments related to these restructuring plans are not material. +Restructuring and other charges incurred in fiscal 2018 are related to charges on a leased facility. +PROVISION FOR INCOME TAXES +Fiscal Years Ended +September 27, +2019 +Change +September 28, +2018 +Change +September 29, +2017 +(dollars in millions) +Provision for income taxes +$ +107.4 +(74.0)% +$ +413.7 +67.6% +$ +246.8 +% of net revenue +3.2 +% +10.7 +% +6.7 +% +The annual effective tax rate for fiscal 2019 of 11.2% was less than the United States federal statutory rate of 21.0% primarily due to benefits of 12.0% related to foreign earnings taxed at a rate less than the United States federal rate, 4.3% related to benefits from the foreign derived intangible income (“FDII”) deduction, 0.2% related to stock windfall deductions, and 2.7% related to the recognition of federal research and development tax credits, partially offset by increases in income tax rate expense impact of 5.7% related to global intangible low-taxed income (“GILTI”) expense, 1.5% related to a change in our tax reserves, and 0.5% from the partial settlement of the Internal Revenue Service (“IRS”) audit of our fiscal 2015 and 2016 income tax returns. +The decrease in the effective tax rate for fiscal 2019, as compared to the 31.1% effective rate for fiscal 2018 , was primarily due to the enactment of the 2017 Tax Reform Act including a one-time charge related to the mandatory deemed repatriation tax on foreign earnings and a one-time charge related to the revaluation of our deferred tax assets and liabilities. +See Note 8 to Item 8 of this Annual Report on Form 10-K for additional information regarding income taxes. +LIQUIDITY AND CAPITAL RESOURCES +Fiscal Years Ended +(in millions) +September 27, +2019 +September 28, +2018 +September 29, +2017 +Cash and cash equivalents at beginning of period +$ +733.3 +$ +1,616.8 +$ +1,083.8 +Net cash provided by operating activities +1,367.4 +1,260.6 +1,456.3 +Net cash used in investing activities +(336.9 +) +(1,150.4 +) +(325.9 +) +Net cash used in financing activities +(912.5 +) +(993.7 +) +(597.4 +) +Cash and cash equivalents at end of period +$ +851.3 +$ +733.3 +$ +1,616.8 +Cash provided by operating activities: +Cash provided by operating activities consists of net income for the period adjusted for certain non-cash items and changes in certain operating assets and liabilities. The $106.8 million increase in cash provided by operating activities for fiscal 2019, as compared to fiscal 2018, was primarily related to favorable changes in working capital driven by higher cash collections and the timing of capital expenditures and vendor payments. +Cash used in investing activities: +Cash used in investing activities consists primarily of cash paid for acquisitions net of cash acquired, capital expenditures, purchased intangibles, cash received from the sale of capital assets, and cash related to the sale or maturity of investments. The $813.5 million decrease in cash used in investing activities for fiscal 2019, as compared to fiscal 2018, was primarily related to $404.0 million paid for the Avnera acquisition in fiscal 2018 and a $401.9 million difference in the net purchase and sale of marketable securities. +Cash used in financing activities: +Cash used in financing activities consists primarily of cash transactions related to equity. The $81.2 million decrease in cash used in financing activities for fiscal 2019, as compared to fiscal 2018, was primarily related to $101.9 million decrease in stock repurchase activity, partially offset by an increase in dividend payments. +28 +Table of Contents +Liquidity: +Cash, cash equivalents and marketable securities totaled $1,082.2 million as of September 27, 2019 , representing an increase of $32.0 million from September 28, 2018 . The increase resulted from $1,367.4 million in cash generated from operations, which was partially offset by $657.6 million used to repurchase 8.9 million shares of stock, $398.4 million in capital expenditures, and $273.9 million in cash dividend payments during fiscal 2019 . Based on our historical results of operations, we expect that our cash, cash equivalents and marketable securities on hand and the cash we expect to generate from operations will be sufficient to fund our research and development, capital expenditures, potential acquisitions, working capital, quarterly cash dividend payments (if such dividends are declared by the Board of Directors), outstanding commitments and other liquidity requirements associated with existing operations for at least the next 12 months. However, we cannot be certain that our cash on hand and cash generated from operations will be available in the future to fund all of our capital and operating requirements. In addition, any future strategic investments and acquisitions may require additional cash and capital resources. If we are unable to obtain sufficient cash or capital to meet our needs on a timely basis and on favorable terms, our business and operations could be materially and adversely affected. +Our invested cash balances primarily consist of highly liquid marketable securities that are available to meet near-term cash requirements including: term deposits, certificate of deposits, money market funds, U.S. Treasury securities, agency securities, other government securities, corporate debt securities and commercial paper. +OFF-BALANCE SHEET ARRANGEMENTS +All significant contractual obligations are recorded on our consolidated balance sheet or fully disclosed in the notes to our consolidated financial statements. We have no material off-balance sheet arrangements as defined in SEC Regulation S-K Item 303(a)(4)(ii). +CONTRACTUAL CASH FLOWS +Set forth below is a summary of our contractual payment obligations related to our operating leases, other commitments and long-term liabilities at September 27, 2019 (in millions): +Payments Due By Period +Obligation +Total +Less Than 1 Year +1-3 Years +3-5 Years +Thereafter +Other long-term liabilities (1) +$ +315.5 +$ +— +$ +38.2 +$ +38.2 +$ +239.1 +Operating lease obligations +219.9 +26.7 +50.7 +44.8 +97.7 +Other commitments (2) +19.3 +8.6 +10.7 +— +— +Total +$ +554.7 +$ +35.3 +$ +99.6 +$ +83.0 +$ +336.8 +_________________________ +(1) +Other long-term liabilities primarily include our gross unrecognized tax benefits, repatriation tax payable, and executive deferred compensation. Gross unrecognized tax benefits and executive deferred compensation are both classified as beyond five years due to the uncertain nature of the liabilities. +(2) +Other commitments consist of contractual license and royalty payments and other purchase obligations. See Note 10 to Item 8 of this Annual Report on Form 10-K. +CRITICAL ACCOUNTING ESTIMATES +The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments in applying our most critical accounting policies that can have a significant impact on the results we report in our financial statements. The SEC has defined critical accounting policies as those that are both most important to the portrayal of our financial condition and results and which require our most difficult, complex or subjective judgments or estimates. Based on this definition, our most critical accounting policies include revenue recognition, which impacts the recording of net revenue; inventory valuation, which impacts the cost of goods sold and gross margin; assessment of goodwill and long-lived assets, which impacts the impairment of the respective assets; share-based compensation, which impacts cost of goods sold and operating expenses; loss contingencies, which impacts operating expenses; and income taxes, which impacts the income tax provision. These policies and significant judgments involved are discussed further below. We have other significant accounting policies that do not generally require subjective estimates or judgments or would not have a material impact on our results of operations. Our significant accounting policies are described in Note 2 to Item 8 of this Annual Report on Form 10-K. +Revenue Recognition. We recognize revenue in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 606 Revenue from Contracts with Customers net of estimated reserves . Our revenue reserves contain +29 +Table of Contents +uncertainties because they require management to make assumptions and to apply judgment to estimate the value of future credits to customers for product returns, price protection and stock rotation for products sold to certain electronic component distributors. We base these estimates on the expected value method considering all reasonably available information, including our historical experience and current expectations, and is reflected in the transaction price when sales are recorded. +Inventory Valuation. We value our inventory at the lower of cost or net realizable value. Reserves for excess and obsolete inventory are established on a quarterly basis and are based on a detailed analysis of aged material, salability of our inventory, market conditions, and product life cycles. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. Our reserves contain uncertainties because the calculation requires management to make assumptions and to apply judgment regarding historical experience, market conditions and technological obsolescence. Changes in actual demand or market conditions could adversely impact our reserve calculations. +Goodwill and Long-Lived Assets. We evaluate goodwill and long-lived assets for impairment annually on the first day of the fourth fiscal quarter and whenever events or circumstances arise that may indicate that the carrying value of the goodwill or other intangibles may not be recoverable. +Our impairment analysis contains uncertainties because it requires management to make assumptions and to apply judgment to items such as: determination of the reporting unit and asset groupings, estimated control premiums, discount rates, future cash flows, the profitability of future business strategies and useful lives. +Share-Based Compensation . We have share-based compensation plans which include non-qualified stock options, restricted and performance share awards and units, as well as an employee stock purchase plan and other special share-based awards. Note 9 of Item 8 of this Annual Report on Form 10-K details our current share-based compensation programs. +We determine the fair value of our share-based compensation items with pricing models as of the date of grant using a number of subjective variables and assumptions including, but not limited to: our expected stock price volatility over the term of the award, correlation coefficients, risk-free rate, the expected life of the award, dividend yield, and estimated performance against metrics. Compensation expense is recognized over the requisite service period of the underlying awards. Management periodically evaluates these assumptions and updates share-based compensation expense accordingly. +Loss Contingencies. We record an estimate for loss contingencies such as a legal proceeding or claims if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss or range of loss can be reasonably estimated. We disclose material loss contingencies if there is at least a reasonable possibility that a loss has been incurred. +Our loss contingency analysis contains uncertainties because it requires management to assess the degree of probability of an unfavorable outcome and to make a reasonable estimate of the amount of potential loss. +Income Taxes. We account for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between tax and financial reporting. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets. +The application of tax laws and regulations to calculate our tax liabilities is subject to legal and factual interpretation, judgment, and uncertainty in a multitude of jurisdictions. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations, and court rulings. We recognize potential liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and interest will be due. We record an amount as an estimate of probable additional income tax liability at the largest amount that we feel is more likely than not, based upon the technical merits of the position, to be sustained upon audit by the relevant tax authority. +OTHER MATTERS +Inflation did not have a material impact on our results of operations during the three-year period ended September 27, 2019 . +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. +30 +Table of Contents +We are subject to overall financial market risks, such as changes in market liquidity, credit quality, investment risk, interest rate risk and foreign exchange rate risk as described below. +Investment and Interest Rate Risk +Our exposure to interest rate and general market risks relates principally to our investment portfolio, which consists of cash and cash equivalents (money market funds and marketable securities purchased with less than ninety days until maturity) that total approximately $851.3 million and marketable securities (U.S. Treasury and government securities, corporate bonds and notes, municipal bonds, other government securities) that total approximately $203.3 million and $27.6 million within short-term and long-term marketable securities, respectively, as of September 27, 2019 . +The main objectives of our investment activities are liquidity and preservation of capital. Our cash equivalent investments have short-term maturity periods that dampen the impact of market or interest rate risk. Our marketable securities consist of short-term and long-term maturity periods between 90 days and two years. Credit risk associated with our investments is not material because our investments are diversified across several types of securities with high credit ratings, which reduces the amount of credit exposure to any one investment. +Based on our results of operations for the fiscal year ended September 27, 2019 , a hypothetical reduction in the interest rates on our cash, cash equivalents, and other investments to zero would result in an immaterial reduction of interest income with a de minimis impact on income before taxes. +Given the low interest rate environment, the objectives of our investment activities, and the relatively low interest income generated from our cash, cash equivalents, and other investments, we do not believe that investment or interest rate risks pose material exposures to our current business or results of operations. +Foreign Exchange Rate Risk +Substantially all sales to customers and arrangements with third-party manufacturers provide for pricing and payment in United States dollars, thereby reducing the impact of foreign exchange rate fluctuations on our results. A percentage of our international operational expenses are denominated in foreign currencies and exchange rate volatility could positively or negatively impact those operating costs. For the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , we had foreign exchange losses of $6.2 million, $5.5 million and $3.1 million, respectively. Increases in the value of the United States dollar relative to other currencies could make our products more expensive, which could negatively impact our ability to compete. Conversely, decreases in the value of the United States dollar relative to other currencies could result in our suppliers raising their prices to continue doing business with us. Given the relatively small number of customers and arrangements with third-party manufacturers denominated in foreign currencies, we do not believe that foreign exchange volatility has a material impact on our current business or results of operations. However, fluctuations in currency exchange rates could have a greater effect on our business or results of operations in the future to the extent our expenses increasingly become denominated in foreign currencies. +We may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. However, we may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. For the fiscal year ended September 27, 2019 , we had no outstanding foreign currency forward or option contracts with financial institutions. +31 +Table of Contents +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +The following consolidated financial statements of the Company are included herewith: +(1) +Report of Independent Registered Public Accounting Firm +Page 33 +(2) +Consolidated Statements of Operations for the three years ended September 27, 2019 +Page 35 +(3) +Consolidated Statements of Comprehensive Income for the three years ended September 27, 2019 +Page 36 +(4) +Consolidated Balance Sheets at September 27, 2019, and September 28, 2018 +Page 37 +(5) +Consolidated Statements of Cash Flows for the three years ended September 27, 2019 +Page 38 +(6) +Consolidated Statements of Stockholders’ Equity for the three years ended September 27, 2019 +Page 39 +(7) +Notes to Consolidated Financial Statements +Page 40 through 57 +32 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Stockholders and Board of Directors +Skyworks Solutions, Inc.: +Opinions on the Consolidated Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Skyworks Solutions, Inc. and subsidiaries (the Company) as of September 27, 2019 and September 28, 2018, the related consolidated statements of operations, comprehensive income, cash flows and stockholders’ equity for each of the years in the three-year period ended September 27, 2019 and the related notes (collectively, the consolidated financial statements). We also have audited the Company’s internal control over financial reporting as of September 27, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of September 27, 2019 and September 28, 2018, and the results of its operations and its cash flows for each of the years in the three-year period ended September 27, 2019, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 27, 2019 based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting . Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally +33 +Table of Contents +accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgment. The communication of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +As discussed in Notes 2 and 8 to the consolidated financial statements, the Company has recorded gross unrecognized tax benefits of $103.3 million in domestic and foreign jurisdictions as of September 27, 2019. The Company records unrecognized tax benefits when there is more than a 50% likelihood that its tax positions will not be sustained upon examination by the taxing authorities. This determination requires the Company’s judgement in the interpretation of domestic and international tax laws and regulations. +We identified the assessment of the gross unrecognized tax benefits as a critical audit matter because of the high degree of auditor judgement involved in evaluating the Company’s interpretation of domestic and international tax laws and regulations. +The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s unrecognized tax benefit process, including controls over the interpretation of domestic and international tax laws and regulations. We involved domestic and international tax professionals with specialized skills and knowledge, who assisted in: +• +assessing the Company’s ongoing compliance with applicable domestic and international tax laws and regulations, +• +reading the Company’s documentation that provided the basis for its tax positions and evaluating the impact of changes in the Company’s tax structure, changes in domestic and international tax laws and regulations, and similar settlements with applicable taxing authorities, and +• +evaluating the Company’s interpretation of domestic and international tax laws and regulations by developing an independent assessment based on our understanding and interpretation of the domestic and international tax laws and regulations. +/s/ KPMG LLP +We have served as the Company’s auditor since 2002. +Irvine, California +November 14, 2019 +34 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF OPERATIONS +(In millions, except per share amounts) +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Net revenue +$ +3,376.8 +$ +3,868.0 +$ +3,651.4 +Cost of goods sold +1,773.0 +1,917.3 +1,809.6 +Gross profit +1,603.8 +1,950.7 +1,841.8 +Operating expenses: +Research and development +424.1 +404.5 +355.2 +Selling, general and administrative +198.3 +207.8 +204.6 +Amortization of intangibles +22.6 +18.3 +27.6 +Restructuring and other charges +6.8 +0.8 +0.6 +Total operating expenses +651.8 +631.4 +588.0 +Operating income +952.0 +1,319.3 +1,253.8 +Other income, net +9.0 +12.8 +3.2 +Income before income taxes +961.0 +1,332.1 +1,257.0 +Provision for income taxes +107.4 +413.7 +246.8 +Net income +$ +853.6 +$ +918.4 +$ +1,010.2 +Earnings per share: +Basic +$ +4.92 +$ +5.06 +$ +5.48 +Diluted +$ +4.89 +$ +5.01 +$ +5.41 +Weighted average shares: +Basic +173.5 +181.3 +184.3 +Diluted +174.5 +183.2 +186.7 +Cash dividends declared and paid per share +$ +1.58 +$ +1.34 +$ +1.16 +See accompanying Notes to Consolidated Financial Statements. +35 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +(In millions) +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Net income +$ +853.6 +$ +918.4 +$ +1,010.2 +Other comprehensive income (loss), net of tax +Fair value of investments +0.3 +( 0.1 +) +0.9 +Pension adjustments +0.5 +— +0.7 +Foreign currency translation adjustment +— +( 0.2 +) +0.8 +Comprehensive income +$ +854.4 +$ +918.1 +$ +1,012.6 +See accompanying Notes to Consolidated Financial Statements. +36 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED BALANCE SHEETS +(In millions, except per share amounts) +As of +September 27, +2019 +September 28, +2018 +ASSETS +Current assets: +Cash and cash equivalents +$ +851.3 +$ +733.3 +Marketable securities +203.3 +294.1 +Receivables, net of allowance for doubtful accounts of $0.8 and $0.6, respectively +465.3 +655.8 +Inventory +609.7 +490.2 +Other current assets +105.0 +88.8 +Total current assets +2,234.6 +2,262.2 +Property, plant and equipment, net +1,205.6 +1,140.9 +Goodwill +1,189.8 +1,189.8 +Intangible assets, net +107.9 +143.7 +Deferred tax assets, net +40.8 +36.5 +Marketable securities +27.6 +22.8 +Other assets +33.3 +33.0 +Total assets +$ +4,839.6 +$ +4,828.9 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable +190.5 +229.9 +Accrued compensation and benefits +76.0 +85.2 +Other current liabilities +107.5 +74.6 +Total current liabilities +374.0 +389.7 +Long-term tax liabilities +312.4 +310.5 +Other long-term liabilities +30.9 +31.7 +Total liabilities +717.3 +731.9 +Commitments and contingencies ( Note 10 and Note 11 ) +Stockholders’ equity: +Preferred stock, no par value: 25.0 shares authorized, no shares issued +— +— +Common stock, $0.25 par value: 525.0 shares authorized; 230.2 shares issued and 170.1 shares outstanding at September 27, 2019, and 228.4 shares issued and 177.4 shares outstanding at September 28, 2018 +42.5 +44.4 +Additional paid-in capital +3,188.0 +3,061.0 +Treasury stock, at cost +( 3,412.9 +) +( 2,732.5 +) +Retained earnings +4,312.6 +3,732.9 +Accumulated other comprehensive loss +( 7.9 +) +( 8.8 +) +Total stockholders’ equity +4,122.3 +4,097.0 +Total liabilities and stockholders’ equity +$ +4,839.6 +$ +4,828.9 +See accompanying Notes to Consolidated Financial Statements. +37 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In millions) +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Cash flows from operating activities: +Net income +$ +853.6 +$ +918.4 +$ +1,010.2 +Adjustments to reconcile net income to net cash provided by operating activities: +Share-based compensation +80.1 +107.8 +88.5 +Depreciation +314.9 +272.5 +227.2 +Amortization of intangible assets, including inventory step-up +56.7 +26.7 +27.6 +Deferred income taxes +( 6.1 +) +27.3 +2.2 +Changes in fair value of contingent consideration +( 3.1 +) +( 11.9 +) +( 1.3 +) +Other, net +16.8 +( 0.7 +) +0.3 +Excess tax benefit from share-based compensation +— +— +( 40.8 +) +Changes in assets and liabilities: +Receivables, net +190.5 +( 193.8 +) +( 37.1 +) +Inventory +( 119.6 +) +11.9 +( 69.2 +) +Other current and long-term assets +( 16.7 +) +( 12.2 +) +3.3 +Accounts payable +( 33.0 +) +( 126.0 +) +147.8 +Other current and long-term liabilities +33.3 +240.6 +97.6 +Net cash provided by operating activities +1,367.4 +1,260.6 +1,456.3 +Cash flows from investing activities: +Capital expenditures +( 398.4 +) +( 422.3 +) +( 303.3 +) +Purchased intangibles +( 25.0 +) +( 8.6 +) +( 12.1 +) +Purchases of marketable securities +( 360.5 +) +( 683.7 +) +— +Sales and maturities of marketable securities +447.0 +368.2 +3.2 +Payments for acquisitions, net of cash +— +( 404.0 +) +( 13.7 +) +Net cash used in investing activities +( 336.9 +) +( 1,150.4 +) +( 325.9 +) +Cash flows from financing activities: +Repurchase of common stock - payroll tax withholdings on equity awards +( 22.8 +) +( 48.0 +) +( 49.2 +) +Repurchase of common stock - stock repurchase program +( 657.6 +) +( 759.5 +) +( 432.3 +) +Dividends paid +( 273.9 +) +( 243.2 +) +( 214.6 +) +Net proceeds from exercise of stock options +22.1 +38.8 +53.8 +Proceeds from employee stock purchase plan +19.7 +18.2 +15.0 +Deferred payments for intangibles +— +— +( 5.5 +) +Payments of contingent consideration +— +— +( 5.4 +) +Excess tax benefit from share-based compensation +— +— +40.8 +Net cash used in financing activities +( 912.5 +) +( 993.7 +) +( 597.4 +) +Net increase (decrease) in cash and cash equivalents +118.0 +( 883.5 +) +533.0 +Cash and cash equivalents at beginning of period +733.3 +1,616.8 +1,083.8 +Cash and cash equivalents at end of period +$ +851.3 +$ +733.3 +$ +1,616.8 +Supplemental cash flow disclosures: +Income taxes paid +$ +124.4 +$ +135.9 +$ +163.2 +See accompanying Notes to Consolidated Financial Statements. +38 +Table of Contents +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In millions) +Shares of common stock +Par value of common stock +Shares of treasury stock +Value of treasury stock +Additional paid-in capital +Retained earnings +Accumulated other comprehensive income (loss) +Total stockholders ’ equity +Balance at September 30, 2016 +184.9 +$ +46.2 +37.6 +$ +( 1,443.5 +) +$ +2,686.0 +$ +2,263.6 +$ +( 10.9 +) +$ +3,541.4 +Net income +— +— +— +— +— +1,010.2 +— +1,010.2 +Exercise and settlement of share-based awards and related tax benefit, net of shares withheld for taxes +2.9 +0.7 +0.6 +( 49.2 +) +118.2 +— +— +69.7 +Share-based compensation expense +— +— +— +— +88.5 +— +— +88.5 +Stock repurchase program +( 4.7 +) +( 1.1 +) +4.7 +( 432.3 +) +1.1 +— +— +( 432.3 +) +Dividends declared +— +— +— +— +— +( 214.2 +) +— +( 214.2 +) +Other comprehensive income +— +— +— +— +— +— +2.4 +2.4 +Balance at September 29, 2017 +183.1 +$ +45.8 +42.9 +$ +( 1,925.0 +) +$ +2,893.8 +$ +3,059.6 +$ +( 8.5 +) +$ +4,065.7 +Net income +— +— +— +— +— +918.4 +— +918.4 +Exercise and settlement of share-based awards, net of shares withheld for taxes +2.0 +0.5 +0.4 +( 48.0 +) +57.8 +— +— +10.3 +Share-based compensation expense +— +— +— +— +107.3 +( 1.9 +) +— +105.4 +Stock repurchase program +( 7.7 +) +( 1.9 +) +7.7 +( 759.5 +) +1.9 +— +— +( 759.5 +) +Dividends declared +— +— +— +— +— +( 243.2 +) +— +( 243.2 +) +Pre-combination service on replacement awards +— +— +— +— +0.2 +— +— +0.2 +Other comprehensive loss +— +— +— +— +— +— +( 0.3 +) +( 0.3 +) +Balance at September 28, 2018 +177.4 +$ +44.4 +51.0 +$ +( 2,732.5 +) +$ +3,061.0 +$ +3,732.9 +$ +( 8.8 +) +$ +4,097.0 +Net income +— +— +— +— +— +853.6 +— +853.6 +Exercise and settlement of share-based awards, net of shares withheld for taxes +1.6 +0.3 +0.3 +( 22.8 +) +42.2 +— +— +19.8 +Share-based compensation expense +— +— +— +— +82.5 +— +— +82.5 +Stock repurchase program +( 8.9 +) +( 2.2 +) +8.9 +( 657.6 +) +2.2 +— +— +( 657.6 +) +Dividends declared +— +— +— +— +— +( 273.9 +) +— +( 273.9 +) +Other comprehensive income +— +— +— +— +— +— +0.8 +0.8 +Balance at September 27, 2019 +170.1 +$ +42.5 +60.1 +$ +( 3,412.9 +) +$ +3,188.0 +$ +4,312.6 +$ +( 7.9 +) +$ +4,122.3 +See accompanying Notes to Consolidated Financial Statements. +39 +Table of Contents +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s analog semiconductors are connecting people, places, and things, spanning a number of new applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +PRINCIPLES OF CONSOLIDATION +All Skyworks subsidiaries are included in the Company’s consolidated financial statements and all intercompany balances are eliminated in consolidation. +FISCAL YEAR +The Company’s fiscal year ends on the Friday closest to September 30. Fiscal 2019, 2018, and 2017 each consisted of 52 weeks and ended on September 27, 2019, September 28, 2018, and September 29, 2017, respectively. +USE OF ESTIMATES +The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts of assets, liabilities, revenue, expenses, comprehensive income and accumulated other comprehensive loss during the reporting period. The Company evaluates its estimates on an ongoing basis using historical experience and other factors, including the current economic environment. Significant judgment is required in determining the reserves for and fair value of items such as overall fair value assessments of assets and liabilities, inventory, intangible assets associated with business combinations, share-based compensation, loss contingencies, and income taxes. In addition, significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment testing. Actual results could differ significantly from these estimates. +CASH AND CASH EQUIVALENTS +The Company invests excess cash in time deposits, certificate of deposits, money market funds, U.S. Treasury securities, agency securities, other government securities, corporate debt securities and commercial paper. The Company considers highly liquid investments as cash equivalents including money market funds and investments with maturities of 90 days or less when purchased. +ALLOWANCE FOR DOUBTFUL ACCOUNTS +The Company maintains general allowances for doubtful accounts related to potential losses that could arise due to customers’ inability to make required payments. These reserves require management to apply judgment in deriving these estimates. In addition, the Company performs ongoing credit evaluations of its customers’ financial condition and if it becomes aware of any specific receivables which may be uncollectable, it performs additional analysis including, but not limited to, factors such as a customer’s credit worthiness, intent and ability to pay and overall financial position, and reserves are recorded if deemed necessary. If the data the Company uses to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and results of operations could be materially affected. +INVESTMENTS +The Company classifies its investment in marketable debt securities as “available-for-sale.” Available-for-sale securities are carried at fair value with unrealized holding gains or losses recorded in other comprehensive income, net of tax. Gains or losses are included in earnings in the period in which they are realized. The cost of securities sold is determined based on the specific identification method. +FAIR VALUE +Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principle or most advantageous market in an orderly transaction between market participants at the measurement date. Applicable accounting guidance provides a hierarchy for inputs used in measuring fair value that prioritize the use of observable inputs over the use of unobservable inputs, when such observable inputs are available. The three levels of inputs that may be used to measure fair value are as follows: +40 +Table of Contents +• +Level 1 - Quoted prices in active markets for identical assets or liabilities. +• +Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-driven valuations in which all significant inputs are observable or can be derived principally from, or corroborated with, observable market data. +• +Level 3 - Fair value is derived from valuation techniques in which one or more significant inputs are unobservable, including assumptions and judgments made by the Company. +It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, the Company uses quoted market prices to measure fair value. If market prices are not available, the Company is required to make judgments about assumptions market participants would use to estimate the fair value of a financial instrument. +The Company measures certain assets and liabilities at fair value on a recurring basis in three levels, based on the market in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. It recognizes transfers within the fair value hierarchy at the end of the fiscal quarter in which the change in circumstances that caused the transfer occurred. +The carrying value of cash and cash equivalents, accounts receivable, other current assets, accounts payable and accrued liabilities approximates fair value due to the short-term maturities of these assets and liabilities. +INVENTORY +Inventory is stated at the lower of cost or net realizable value on a first-in, first-out basis. Reserves for excess and obsolete inventory are established on a quarterly basis and are based on a detailed analysis of aged material, salability of our inventory, market conditions, and product life cycles. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. +PROPERTY, PLANT AND EQUIPMENT +Property, plant and equipment are carried at cost less accumulated depreciation, with significant renewals and betterments being capitalized and retired equipment written off in the respective periods. Maintenance and repairs are expensed as incurred. +Depreciation is calculated using the straight-line method over the estimated useful lives, which range from five to thirty years for buildings and improvements and three to ten years for machinery and equipment. Leasehold improvements are depreciated over the lesser of the economic life or the life of the associated lease. +VALUATION OF LONG-LIVED ASSETS +Definite lived intangible assets are carried at cost less accumulated amortization. Amortization is calculated based on the pattern of benefit to be recognized from the underlying asset over its estimated useful life. Carrying values for long-lived assets and definite lived intangible assets are reviewed for possible impairment as circumstances warrant. Factors considered important that could result in an impairment review include significant underperformance relative to expected, historical or projected future operating results, significant changes in the manner of use of assets or the Company’s business strategy, or significant negative industry or economic trends. In addition, impairment reviews are conducted at the judgment of management whenever asset values are deemed to be unrecoverable relative to future undiscounted cash flows expected to be generated by that particular asset group. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of an asset group and its eventual disposition. Such estimates require management to exercise judgment and make assumptions regarding factors such as future revenue streams, operating expenditures, cost allocation and asset utilization levels, all of which collectively impact future operating performance. The Company’s estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, technological changes, economic conditions, changes to its business model or changes in its operating performance. If the sum of the undiscounted cash flows is less than the carrying value of an asset group, the Company would recognize an impairment loss, measured as the amount by which the carrying value exceeds the fair value of the asset group. +GOODWILL AND INDEFINITE-LIVED INTANGIBLE ASSETS +Goodwill and indefinite-lived intangible assets are not amortized but are tested at least annually as of the first day of the fourth fiscal quarter for impairment or more frequently if indicators of impairment exist during the fiscal year. The Company assesses its conclusion regarding segments and reporting units in conjunction with its annual goodwill impairment test, and has determined that it has one reporting unit for the purposes of allocating and testing goodwill. +41 +Table of Contents +The Company’s impairment analysis compares its fair value to its net book value to determine if there is an indicator of impairment. In the Company’s calculation of fair value, it considers the closing price of its common stock on the selected testing date, the number of shares of its common stock outstanding and other marketplace activity such as a related control premium. If the calculated fair value is determined to be less than the book value of the reporting unit, an impairment loss is recognized equal to that excess; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +REVENUE RECOGNITION +The Company derives its revenue primarily from the sale of semiconductor products under individual customer purchase orders, some of which have underlying master sales agreements that specify terms governing the product sales. In the absence of a sales agreement, the Company’s standard terms and conditions apply. Revenue is recognized when control of the promised goods or services is transferred to the Company’s customers, in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The Company applies a five-step approach as defined in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers (Topic 606), in determining the amount and timing of revenue to be recognized: (1) identifying the contract with a customer; (2) identifying the performance obligations in the contract; (3) determining the transaction price; (4) allocating the transaction price to the performance obligations in the contract; and (5) recognizing revenue when the corresponding performance obligation is satisfied. +Each distinct promise to transfer products is considered to be an identified performance obligation for which revenue is recognized at a point in time upon transfer of control of the products to the customer. Transfer of control occurs upon shipment to the distributor or direct customer or when products are pulled from consignment inventory by the customer. Point in time recognition is determined as products manufactured under non-cancellable orders create an asset with an alternative use to the Company. Returns under the Company’s general assurance warranty of products have not been material, and warranty-related services are not considered a separate performance obligation. As of September 27, 2019 , the amount of remaining performance obligation that has not been recognized as revenue is not material. +Pricing adjustments and estimates of returns are treated as variable consideration for purposes of determining the transaction price. Sales returns are generally accepted at the Company’s discretion or from distributors with stock rotation rights. Stock rotation allows distributors limited levels of returns and is based on the distributor’s prior purchases. Price protection represents price discounts granted to certain distributors and is based on negotiations on sales to end customers. Variable consideration is estimated using the expected value method considering all reasonably available information, including the Company’s historical experience and its current expectations, and is reflected in the transaction price when sales are recorded. The Company records net revenue excluding taxes collected on its sales to trade customers. +Accounts receivable represents the Company’s unconditional right to receive consideration from its customer. Substantially all payments are collected within the Company’s standard terms, which do not include a significant financing component. To date, there have been no material impairment losses on accounts receivable. There were no material contract assets or contract liabilities recorded on the consolidated balance sheet in any of the periods presented. All incremental customer contract acquisition costs are expensed as they are incurred as the amortization period of the asset that the Company otherwise would have recognized is one year or less in duration. +SHARE-BASED COMPENSATION +The Company recognizes compensation expense for all share-based payment awards made to employees and directors including non-qualified employee stock options, share awards and units, employee stock purchase plan and other special share-based awards based on estimated fair values. +The fair value of share-based payment awards is amortized over the requisite service period, which is defined as the period during which an employee is required to provide service in exchange for an award. The Company uses a straight-line attribution method for all grants that include only a service condition. Awards with both performance and service conditions are expensed over the service period for each separately vesting tranche. +Share-based compensation expense recognized during the period includes actual expense on vested awards and expense associated with unvested awards. Forfeitures are recorded as incurred. +The Company determines the fair value of share-based option awards based on the Company’s closing stock price on the date of grant using a Black-Scholes options pricing model. Under the Black-Scholes model, a number of variables are used including, but not limited to: the expected stock price volatility over the term of the award, the risk-free rate, the expected life of the award and +42 +Table of Contents +dividend yield. The determination of fair value of restricted and certain performance share awards and units is based on the value of the Company’s stock on the date of grant with performance awards and units adjusted for the actual outcome of the underlying performance condition. +For more complex performance awards including units with market-based performance conditions the Company employs a Monte Carlo simulation valuation method to calculate the fair value of the awards based on the most likely outcome. Under the Monte Carlo simulation, a number of subjective variables and assumptions are used including, but not limited to: the expected stock price volatility over the term of the award, a correlation coefficient, the risk-free rate, and dividend yield. +RESEARCH AND DEVELOPMENT COSTS +Research and development costs are expensed as incurred. +LOSS CONTINGENCIES +The Company records its best estimates of a loss contingency when it is considered probable and the amount can be reasonably estimated. When a range of loss can be reasonably estimated with no best estimate in the range, the minimum estimated liability related to the claim is recorded. As additional information becomes available, the Company assesses the potential liability related to the potential pending loss contingency and revises its estimates. Loss contingencies are disclosed if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and include estimated legal costs. +RESTRUCTURING +A liability for post-employment benefits is recorded when payment is probable and the amount is reasonably estimable. Contract exit costs include contract termination fees and future contractual commitments for lease payments. A liability for contract exit costs is recognized in the period in which the Company terminates the contract or on the cease-use date for leased facilities. +FOREIGN CURRENCIES +The Company’s functional currency is the United States dollar. Gains and losses related to foreign currency transactions and conversion of foreign denominated cash balances are included in current results. +INCOME TAXES +The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. This method also requires the recognition of future tax benefits such as net operating loss carry forwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. +The carrying value of the Company’s net deferred tax assets assumes the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to record additional valuation allowances against its deferred tax assets resulting in additional income tax expense in its Consolidated Statement of Operations. Management evaluates the realizability of the deferred tax assets and assesses the adequacy of the valuation allowance quarterly. Likewise, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made. +The determination of recording or releasing tax valuation allowances is made, in part, pursuant to an assessment performed by management regarding the likelihood that the Company will generate future taxable income against which benefits of its deferred tax assets may or may not be realized. This assessment requires management to exercise significant judgment and make estimates with respect to its ability to generate revenues, gross profits, operating income and taxable income in future periods. Amongst other factors, management must make assumptions regarding overall business and semiconductor industry conditions, operating efficiencies, the Company’s ability to develop products to its customers’ specifications, technological change, the competitive environment and changes in regulatory requirements which may impact its ability to generate taxable income and, in turn, realize the value of its deferred tax assets. +The calculation of the Company’s tax liabilities includes addressing uncertainties in the application of complex tax regulations and is based on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. +43 +Table of Contents +The Company recognizes liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on its recognition threshold and measurement attribute of whether it is more likely than not that the positions the Company has taken in tax filings will be sustained upon tax audit, and the extent to which, additional taxes would be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period in which it is determined the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. The Company recognizes any interest or penalties, if incurred, on any unrecognized tax liabilities or benefits as a component of income tax expense. +EARNINGS PER SHARE +Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporate the potentially dilutive incremental shares issuable upon the assumed exercise of stock options, the assumed vesting of outstanding restricted stock units, and the assumed issuance of common stock under the stock purchase plan using the treasury share method. +RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS +In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606), (“ASU 2014-09”), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The Company adopted ASU 2014-09 at the beginning of the first quarter of fiscal 2019 using the modified retrospective approach, with the cumulative effect of applying the new guidance recognized as an adjustment to the opening retained earnings balance. The Company determined the impact of adopting the new revenue standard on its business processes, systems, controls and consolidated financial statements during fiscal 2019 was not material, except for an increase in accounts receivable and other current liabilities in the amount of $ 29.1 million to reflect customer credits as a liability. +In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740), Intra-entity Transfers of an Asset Other than Inventory (“ASU 2016-16”). This ASU provides guidance that changes the accounting for income tax effects of intra-entity transfers of assets other than inventory. Under the new guidance, the selling (transferring) entity is required to recognize a current tax expense or benefit upon transfer of the asset. Similarly, the purchasing (receiving) entity is required to recognize a deferred tax asset or deferred tax liability, as well as the related deferred tax benefit or expense, upon receipt of the asset. The Company adopted ASU 2016-16 during the first quarter of fiscal 2019. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. +In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 320), (“ASU 2016-13”). This ASU requires a financial asset (or a group of financial assets) measured on the basis of amortized cost to be presented at the net amount expected to be collected. This ASU requires that the income statement reflect the measurement of credit losses for newly recognized financial assets as well as the expected increases or decreases of expected credit losses that have taken place during the period. This ASU requires that credit losses of debt securities designated as available-for-sale be recorded through an allowance for credit losses. The ASU also limits the credit loss to the amount by which fair value is below amortized cost. The Company adopted ASU 2016-13 during the first quarter of fiscal 2019. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. +In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Topic 320), (“ASU 2016-01”). This ASU provides guidance for the recognition, measurement, presentation, and disclosure of financial assets and liabilities. The Company adopted ASU 2016-01 during the first quarter of fiscal 2019. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. +In June 2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718), Improvements to Nonemployee Share-based Payments (“ASU 2018-07”). This ASU expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. The Company adopted ASU 2018-07 during the second quarter of fiscal 2019. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. +In August 2018, the FASB issued ASU 2018-15, Intangibles-Goodwill and Other-Internal-Use Software (Topic 350), Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU 2018-15”). The new guidance clarifies the accounting for implementation costs in cloud computing arrangements. The Company adopted ASU 2018-15, on a prospective basis, during the second quarter of fiscal 2019. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. +RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS +44 +Table of Contents +In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”). This ASU requires lessees to reflect leases with a term greater than one year on their balance sheet as assets and obligations. The Company plans to adopt the new guidance in the first quarter of fiscal 2020. The Company will utilize the modified retrospective method and will recognize any cumulative effect adjustment in retained earnings at the beginning of the period of adoption. The Company plans to elect the package of three practical expedients that permits the Company to maintain its historical conclusions about lease identification, lease classification and initial direct costs for leases that exist at the date of adoption. Further, upon implementation of the new guidance, the Company intends to elect the practical expedient to not separate lease and non-lease components. The Company has performed an assessment of the impact that the adoption of ASU 2016-02 will have on the consolidated financial statements and related disclosures. Based on that assessment, the Company has estimated that the adoption of ASU 2016-02 will result in the recognition of approximately $160 million to $180 million of right-of-use assets and lease liabilities based on the present value of future minimum lease payments for currently executed leases. The Company does not expect the adoption of this new guidance to have a significant impact on its Consolidated Statements of Operations or its Consolidated Statements of Cash Flows. +There have been no other recent accounting pronouncements or changes in accounting pronouncements that are of significance, or potential significance, to the Company. +3. MARKETABLE SECURITIES +The Company's portfolio of available-for-sale marketable securities consists of the following (in millions): +Current +Noncurrent +Available for sale: +September 27, +2019 +September 28, +2018 +September 27, +2019 +September 28, +2018 +U.S. Treasury and government +$ +34.3 +$ +65.0 +$ +20.0 +$ +— +Corporate bonds and notes +66.2 +204.1 +5.9 +12.0 +Municipal bonds +102.9 +2.0 +1.7 +0.8 +Other government +— +23.0 +— +10.0 +Total +$ +203.3 +$ +294.1 +$ +27.6 +$ +22.8 +The contractual maturities of noncurrent available-for-sale marketable securities were due within two years or less. There were gross unrealized gains of $ 0.1 million on U.S. Treasury securities, $ 0.1 million on corporate bonds and notes, and $ 0.1 million on municipal bonds at September 27, 2019 , and $ 0.1 million in gross unrealized losses on corporate bonds and notes at September 28, 2018 . +4. FAIR VALUE +Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis +The Company measures certain assets and liabilities at fair value on a recurring basis such as its financial instruments. There have been no transfers between Level 1, 2 or 3 assets or liabilities during the fiscal year ended September 27, 2019 . The decrease of $ 3.1 million in Level 3 liabilities included in earnings during fiscal 2019 relates to a reversal of the fair value of the contingent consideration liability, which was included in selling, general and administrative expenses. +Assets and liabilities recorded at fair value on a recurring basis consisted of the following (in millions): +45 +Table of Contents +As of September 27, 2019 +As of September 28, 2018 +Fair Value Measurements +Fair Value Measurements +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +Assets +Cash and cash equivalents* +$ +851.3 +$ +809.5 +$ +41.8 +$ +— +$ +733.3 +$ +683.7 +$ +49.6 +$ +— +U.S. Treasury and government securities +54.2 +28.4 +25.8 +— +65.0 +15.0 +50.0 +— +Corporate bonds and notes +72.1 +— +72.1 +— +216.0 +— +216.0 +— +Municipal bonds +104.6 +— +104.6 +— +2.8 +— +2.8 +— +Other government securities +— +— +— +— +33.1 +— +33.1 +— +Total +$ +1,082.2 +$ +837.9 +$ +244.3 +$ +— +$ +1,050.2 +$ +698.7 +$ +351.5 +$ +— +Liabilities +Contingent consideration +$ +— +$ +— +$ +— +$ +— +$ +3.1 +$ +— +$ +— +$ +3.1 +Total +$ +— +$ +— +$ +— +$ +— +$ +3.1 +$ +— +$ +— +$ +3.1 +* Cash equivalents included in Levels 1 and 2 consist of money market funds and corporate bonds and notes, foreign government bonds, commercial paper, and agency securities purchased with less than ninety days until maturity. +Assets Measured and Recorded at Fair Value on a Nonrecurring Basis +The Company’s non-financial assets and liabilities, such as goodwill, intangible assets, and other long-lived assets resulting from business combinations, are measured at fair value using income approach valuation methodologies at the date of acquisition and are subsequently re-measured if there are indicators of impairment. +5. INVENTORY +Inventory consists of the following (in millions): +As of +September 27, +2019 +September 28, +2018 +Raw materials +$ +24.4 +$ +20.2 +Work-in-process +336.2 +340.7 +Finished goods +245.7 +124.8 +Finished goods held on consignment by customers +3.4 +4.5 +Total inventory +$ +609.7 +$ +490.2 +6. PROPERTY, PLANT AND EQUIPMENT, NET +Property, plant and equipment, net consists of the following (in millions): +As of +September 27, +2019 +September 28, +2018 +Land and improvements +$ +11.7 +$ +11.6 +Buildings and improvements +354.4 +238.0 +Furniture and fixtures +33.8 +31.5 +Machinery and equipment +2,311.5 +2,089.6 +Construction in progress +172.5 +179.0 +Total property, plant and equipment, gross +2,883.9 +2,549.7 +Accumulated depreciation +( 1,678.3 +) +( 1,408.8 +) +Total property, plant and equipment, net +$ +1,205.6 +$ +1,140.9 +7. GOODWILL AND INTANGIBLE ASSETS +46 +Table of Contents +The Company’s goodwill balance was $ 1,189.8 million as of September 27, 2019 , and September 28, 2018 . The Company performed an impairment test of its goodwill as of the first day of the fourth fiscal quarter in accordance with its regularly scheduled testing. The results of this test indicated that the Company’s goodwill was not impaired. There were no other indicators of impairment noted during the fiscal year ended September 27, 2019 . +Intangible assets consist of the following (in millions): +As of +As of +Weighted +average +amortization +period (years) +September 27, 2019 +September 28, 2018 +Gross +carrying +amount +Accumulated +amortization +Net +carrying +amount +Gross +carrying +amount +Accumulated +amortization +Net +carrying +amount +Customer relationships +3.8 +$ +25.6 +$ +( 19.5 +) +$ +6.1 +$ +31.7 +$ +( 13.2 +) +$ +18.5 +Developed technology and other +4.2 +94.4 +( 48.9 +) +45.5 +89.9 +( 23.5 +) +66.4 +Trademarks +3.0 +1.6 +( 1.3 +) +0.3 +1.6 +( 0.8 +) +0.8 +Capitalized software +3.0 +— +— +— +18.0 +( 6.0 +) +12.0 +Technology licenses +2.4 +24.9 +( 4.8 +) +20.1 +$ +— +— +— +IPR&D +35.9 +— +35.9 +$ +46.0 +— +46.0 +Total intangible assets +$ +182.4 +$ +( 74.5 +) +$ +107.9 +$ +187.2 +$ +( 43.5 +) +$ +143.7 +The decrease in the gross amount of intangible assets is primarily related to fully amortized intangible assets have been eliminated from both the gross and accumulated amortization amounts, partially offset by current period additions to technology licenses. +Annual amortization expense for the next five fiscal years related to intangible assets, excluding IPR&D, is expected to be as follows (in millions): +2020 +2021 +2022 +2023 +2024 +Thereafter +Total amortization expense +$ +42.2 +$ +18.8 +$ +5.1 +$ +1.1 +$ +1.1 +$ +3.7 +8. INCOME TAXES +Income before income taxes consists of the following components (in millions): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +United States +$ +427.2 +$ +712.2 +$ +681.2 +Foreign +533.8 +619.9 +575.8 +Income before income taxes +$ +961.0 +$ +1,332.1 +$ +1,257.0 +The provision for income taxes consists of the following (in millions): +47 +Table of Contents +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Current tax expense (benefit): +Federal +$ +85.3 +$ +347.7 +$ +215.7 +State +( 0.1 +) +0.3 +0.3 +Foreign +23.5 +31.2 +24.4 +108.7 +379.2 +240.4 +Deferred tax expense (benefit): +Federal +( 0.4 +) +20.3 +5.0 +Foreign +( 0.9 +) +14.2 +1.4 +( 1.3 +) +34.5 +6.4 +Provision for income taxes +$ +107.4 +$ +413.7 +$ +246.8 +The actual income tax expense is different than that which would have been computed by applying the federal statutory tax rate to income before income taxes. A reconciliation of income tax expense as computed at the United States federal statutory income tax rate to the provision for income tax expense is as follows (in millions): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Tax expense at United States statutory rate +$ +201.8 +$ +327.4 +$ +439.9 +Foreign tax rate difference +( 115.3 +) +( 111.9 +) +( 174.6 +) +Tax on deemed repatriation +8.1 +224.6 +— +Effect of stock compensation +( 1.6 +) +( 25.6 +) +— +Change of tax rate on deferred taxes +— +18.3 +— +Research and development credits +( 25.7 +) +( 19.9 +) +( 16.3 +) +Change in tax reserve +14.0 +6.7 +12.6 +Domestic production activities deduction +— +( 13.9 +) +( 19.8 +) +Global Intangible Low-Taxed Income +54.3 +— +— +Foreign Derived Intangible Income +( 41.5 +) +— +— +Settlements with Tax Authorities +4.3 +— +— +Other, net +9.0 +8.0 +5.0 +Provision for income taxes +$ +107.4 +$ +413.7 +$ +246.8 +The Company operates in foreign jurisdictions with income tax rates lower than the United States tax rate for the fiscal years ended September 27, 2019 , and September 28, 2018 , which were 21.0 % and 24.6 % , respectively. The Company’s tax benefits related to foreign earnings taxed at a rate less than the United States federal rate were $ 115.3 million and $ 111.9 million for the fiscal years ended September 27, 2019 , and September 28, 2018 , respectively. +The Tax Reform Act includes, among other things, a reduction of the United States corporate tax rate from 35.0% to 21.0 % , a mandatory deemed repatriation tax on foreign earnings, repeal of the corporate alternative minimum tax and the domestic production activities deduction, and expensing of certain capital investments. The law makes fundamental changes to the taxation of multinational entities, including a shift from worldwide taxation with deferral to a hybrid territorial system, featuring a participation exemption regime, a minimum tax on low-taxed foreign earnings, and new measures to deter base erosion and promote export from the United States. As a result of this legislation, during fiscal 2018 the Company recognized a one-time transition tax related to the deemed repatriation of foreign earnings of $ 224.6 million and a charge related to the revaluation of its deferred tax assets at the new corporate tax rate of $ 18.3 million . During fiscal 2019, the Company completed its analysis of the impact of the Tax Reform Act and recorded a discrete income tax expense adjustment of $ 8.1 million to the prior year provisional estimates. The $ 232.7 million deemed repatriation tax is payable over the next eight years. The Company had accrued $ 195.9 million and $ 206.6 million of the deemed repatriation tax in long-term liabilities within the consolidated balance sheet as of September 27, 2019 , and September 28, 2018 , respectively. +48 +Table of Contents +In addition to the introduction of a modified territorial tax system, the Tax Reform Act includes new sets of provisions aimed at preventing or decreasing U.S. tax base erosion: the global intangible low-taxed income (“GILTI”) provisions, the base erosion and anti-abuse tax (“BEAT”) provisions, and the foreign derived intangible income (“FDII”) provisions. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company has made an accounting policy election to account for taxes due on GILTI inclusions as a component of current-period tax expense. The BEAT provisions eliminate the deduction of certain base-erosion payments made to related foreign corporations and impose a minimum tax if greater than regular tax. The FDII provisions allow a U.S. corporation an immediate deduction for a portion of its FDII. The amount of the deduction will depend in part on the Company’s U.S. taxable income. The GILTI and FDII provisions became effective for the Company in fiscal 2019 and resulted in a $ 54.3 million tax expense and a $ 41.5 million tax benefit, respectively. The Company has analyzed the BEAT provisions for the year ended September 27, 2019 , and has determined that it is not subject to the minimum tax imposed by the BEAT provisions. +The Company’s federal income tax returns for fiscal 2015 and fiscal 2016 are currently under IRS examination. During the year ended September 27, 2019 , the Company effectively settled a portion of this IRS examination. As a result, the Company accrued a tax payable of $4.3 million , including interest. +On October 2, 2010, the Company expanded its presence in Asia by launching operations in Singapore. The Company operates under a tax holiday in Singapore, which was originally effective through September 30, 2020 . The Company has obtained an extension of this tax holiday through September 30, 2030. The original tax holiday and the extension are both conditioned upon the Company’s compliance with certain employment and investment thresholds in Singapore. The impact of the tax holiday decreased Singapore’s taxes by $ 32.8 million , $ 38.4 million , and $ 37.4 million for the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , respectively, which resulted in tax benefits of $ 0.19 , $ 0.21 , and $0.20 of diluted earnings per share, respectively. +Deferred income tax assets and liabilities consist of the tax effects of temporary differences related to the following (in millions): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +Deferred tax assets: +Inventory +$ +10.1 +$ +5.7 +Bad debts +0.2 +1.2 +Accrued compensation and benefits +5.9 +4.9 +Product returns, allowances and warranty +0.3 +4.6 +Restructuring +0.6 +— +Share-based and other deferred compensation +21.2 +26.1 +Net operating loss carry forwards +11.3 +15.5 +Non-United States tax credits +20.7 +20.3 +State tax credits +106.4 +97.0 +Property, plant and equipment +17.7 +9.1 +Other, net +5.9 +3.3 +Deferred tax assets +200.3 +187.7 +Less valuation allowance +( 129.1 +) +( 118.6 +) +Net deferred tax assets +71.2 +69.1 +Deferred tax liabilities: +Prepaid insurance +( 0.5 +) +( 0.6 +) +Property, plant and equipment +( 19.3 +) +( 25.6 +) +Intangible assets +( 17.4 +) +( 19.3 +) +Other, net +( 6.3 +) +( 2.0 +) +Net deferred tax liabilities +( 43.5 +) +( 47.5 +) +Total net deferred tax assets +$ +27.7 +$ +21.6 +In accordance with GAAP, management has determined that it is more likely than not that a portion of its historic and current year income tax benefits will not be realized. As of September 27, 2019 , the Company has a valuation allowance of $ 129.1 million . This +49 +Table of Contents +valuation allowance is comprised of $ 109.8 million related to United States state tax credits and $ 19.3 million are related to foreign deferred tax assets. The Company does not anticipate sufficient taxable income or tax liability to utilize these state and foreign credits. If these benefits are recognized in a future period the valuation allowance on deferred tax assets will be reversed and up to a $ 129.1 million income tax benefit may be recognized. The Company will need to generate $ 106.4 million of future United States federal taxable income to utilize its United States deferred tax assets as of September 27, 2019 . The Company believes that future reversals of taxable temporary differences, and its forecast of continued earnings in its domestic and foreign jurisdictions, support its decision to not record a valuation allowance on other deferred tax assets. The Company will continue to assess its valuation allowance in future periods. The net valuation allowance increased by $ 10.5 million and $ 27.7 million in fiscal 2019 and fiscal 2018, respectively, primarily related to increases for foreign and state net operating loss and tax credit carryovers. +As of September 27, 2019 , the Company has United States federal net operating loss carry forwards of approximately $ 18.2 million , including $ 10.3 million related to the acquisition of Avnera. The utilization of these net operating losses is subject to certain annual limitations as required under Internal Revenue Code section 382 and similar state income tax provisions. The United States federal net operating loss carry forwards expire at various dates through 2035 . The Company also has state income tax credit carry forwards of $ 106.4 million , net of federal benefits, for which the Company has provided a valuation allowance. The state tax credits relate primarily to California research tax credits that can be carried forward indefinitely. +A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in millions): +Unrecognized tax benefits +Balance at September 28, 2018 +$ +93.4 +Increases based on positions related to prior years +7.1 +Decreases based on positions related to prior years +( 0.3 +) +Increases based on positions related to current year +9.6 +Decreases relating to settlements with taxing authorities +( 6.3 +) +Decreases relating to lapses of applicable statutes of limitations +( 0.2 +) +Balance at September 27, 2019 +$ +103.3 +Of the total unrecognized tax benefits at September 27, 2019 , $ 87.6 million would impact the effective tax rate, if recognized. The remaining unrecognized tax benefits would not impact the effective tax rate, if recognized, due to the Company’s valuation allowance and certain positions that were required to be capitalized. +The Company anticipates reversals within the next 12 months related to items such as the lapse of the statute of limitations, audit closures, and other items that occur in the normal course of business. Due to open examinations, an estimate of anticipated reversals within the next 12 months cannot be made. During the fiscal years 2019, 2018, and 2017, the Company recognized $ 6.0 million , $ 4.1 million and $ 2.6 million , respectively, of interest or penalties related to unrecognized tax benefits. Accrued interest and penalties of $ 12.7 million and $ 7.5 million related to uncertain tax positions have been included in long-term tax liabilities within the consolidated balance sheet as of September 27, 2019 , and September 28, 2018 , respectively. +The Company’s major tax jurisdictions as of September 27, 2019 , are the United States, California, Canada, Luxembourg, Mexico, Japan, and Singapore. For the United States, the Company has open tax years dating back to fiscal 2000 due to the carry forward of tax attributes. For California, the Company has open tax years dating back to fiscal 1999 due to the carry forward of tax attributes. For Canada, the Company has open tax years dating back to fiscal 2013 . For Luxembourg, the Company has open tax years back to fiscal 2013 . For Mexico, the Company has open tax years back to fiscal 2013 . For Japan, the Company has open tax years back to fiscal 2014 . For Singapore, the Company has open tax years dating back to fiscal 2013 . The Company is subject to audit examinations by the respective taxing authorities on a periodic basis, of which the results could impact its financial position, results of operations or cash flows. +9. STOCKHOLDERS’ EQUITY +COMMON STOCK +At September 27, 2019 , the Company is authorized to issue 525.0 million shares of common stock, par value $ 0.25 per share, of which 230.2 million shares are issued and 170.1 million shares are outstanding. +50 +Table of Contents +Holders of the Company’s common stock are entitled to dividends in the event declared by the Company’s Board of Directors out of funds legally available for such purpose. Dividends may not be paid on common stock unless all accrued dividends on preferred stock, if any, have been paid or declared and set aside. In the event of the Company’s liquidation, dissolution or winding up, the holders of common stock will be entitled to share pro rata in the assets remaining after payment to creditors and after payment of the liquidation preference plus any unpaid dividends to holders of any outstanding preferred stock. +Each holder of the Company’s common stock is entitled to one vote for each such share outstanding in the holder’s name. No holder of common stock is entitled to cumulate votes in voting for directors. The Company’s restated certificate of incorporation as amended to date (the “Certificate of Incorporation”) provides that, unless otherwise determined by the Company’s Board of Directors, no holder of stock has any preemptive right to purchase or subscribe for any stock of any class which the Company may issue or sell. +PREFERRED STOCK +The Company’s Certificate of Incorporation has authorized and permits the Company to issue up to 25.0 million shares of preferred stock without par value in one or more series and with rights and preferences that may be fixed or designated by the Company’s Board of Directors without any further action by the Company’s stockholders. The designation, powers, preferences, rights and qualifications, limitations and restrictions of the preferred stock of each series will be fixed by the certificate of designation relating to such series, which will specify the terms of the preferred stock. At September 27, 2019 , the Company had no shares of preferred stock issued or outstanding. +STOCK REPURCHASE +On January 30, 2019 , the Board of Directors approved a stock repurchase program, pursuant to which the Company is authorized to repurchase up to $ 2.0 billion of its common stock from time to time prior to January 30, 2021 , on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. This authorized stock repurchase program replaced in its entirety the January 31, 2018 , stock repurchase program. During the fiscal year ended September 27, 2019 , the Company paid approximately $ 657.6 million (including commissions) in connection with the repurchase of 8.9 million shares of its common stock (paying an average price of $ 74.26 per share) under the January 30, 2019 , stock repurchase plan and the January 31, 2018 , stock repurchase plan. As of September 27, 2019 , $ 1,626.4 million remained available under the January 30, 2019 , stock repurchase plan. +During the fiscal year ended September 28, 2018 , the Company paid approximately $ 759.5 million (including commissions) in connection with the repurchase of 7.7 million shares of its common stock (paying an average price of $ 98.84 per share). +DIVIDENDS +On November 12, 2019 , the Company announced that the Board of Directors had declared a cash dividend on the Company’s common stock of $ 0.44 per share. This dividend is payable on December 24, 2019 , to the Company’s stockholders of record as of the close of business on December 3, 2019 . Future dividends are subject to declaration by the Board of Directors. The dividends charged to retained earnings in fiscal 2019 and 2018 were as follows (in millions except per share amounts): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +Per Share +Total +Per Share +Total +First quarter +$ +0.38 +$ +67.1 +$ +0.32 +$ +58.8 +Second quarter +0.38 +66.0 +0.32 +58.5 +Third quarter +0.38 +65.7 +0.32 +57.8 +Fourth quarter +0.44 +75.1 +0.38 +68.1 +$ +1.58 +$ +273.9 +$ +1.34 +$ +243.2 +EMPLOYEE STOCK BENEFIT PLANS +As of September 27, 2019 , the Company has the following equity compensation plans under which its equity securities were authorized for issuance to its employees and/or directors: +• +the 2002 Employee Stock Purchase Plan +51 +Table of Contents +• +the Non-Qualified Employee Stock Purchase Plan +• +the 2005 Long-Term Incentive Plan +• +the AATI 2005 Equity Incentive Plan +• +the 2008 Director Long-Term Incentive Plan +• +the 2015 Long-Term Incentive Plan +Except for the Non-Qualified Employee Stock Purchase Plan, each of the foregoing equity compensation plans was approved by the Company’s stockholders. +As of September 27, 2019 , a total of 85.3 million shares are authorized for grant under the Company’s share-based compensation plans, with 1.3 million options outstanding. The number of common shares reserved for future awards to employees and directors under these plans was 12.4 million at September 27, 2019 . The Company currently grants new equity awards to employees under the 2015 Long-Term Incentive Plan and to non-employee directors under the 2008 Director Long-Term Incentive Plan. +2015 Long-Term Incentive Plan. Under this plan, officers, employees, and certain consultants may be granted stock options, restricted stock awards and units, performance stock awards and units and other share-based awards. The plan has been approved by the stockholders. Under the plan, up to 19.4 million shares have been authorized for grant. A total of 11.7 million shares are available for new grants as of September 27, 2019 . The maximum contractual term of options under the plan is seven years from the date of grant. Options granted under the plan at the determination of the compensation committee generally vest ratably over four years. Restricted stock awards and units granted under the plan at the determination of the compensation committee generally vest over four or more years. With respect to restricted stock awards, dividends are accumulated and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are also forfeited. No dividends or dividend equivalents are paid or accrued with respect to restricted stock unit awards or other awards until the shares underlying such awards become vested and are issued to the award holder. Performance stock awards and units are contingently granted depending on the achievement of certain predetermined performance goals and generally vest over two or more years. +2008 Director Long-Term Incentive Plan. Under this plan, non-employee directors may be granted stock options, restricted stock awards, and other share-based awards. The plan has been approved by the stockholders. Under the plan a total of 1.5 million shares have been authorized for grant. A total of 0.6 million shares are available for new grants as of September 27, 2019 . The maximum contractual term of options granted under the plan is ten years from the date of grant. Options granted under the plan are generally exercisable over four years. Restricted stock awards and units granted under the plan generally vest over one or more years. With respect to restricted stock awards, dividends are accumulated and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are also forfeited. +Employee Stock Purchase Plans. The Company maintains a domestic and an international employee stock purchase plan. Under these plans, eligible employees may purchase common stock through payroll deductions of up to 10 % of their compensation. The price per share is the lower of 85 % of the fair market value of the common stock at the beginning or end of each offering period (six months). The plans provide for purchases by employees of up to an aggregate of 9.7 million shares. Shares of common stock purchased under these plans in the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , were 0.3 million , 0.2 million , and 0.2 million , respectively. At September 27, 2019 , there are 0.2 million shares available for purchase. The Company recognized compensation expense of $ 5.8 million , $ 5.2 million and $ 4.5 million for the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , respectively, related to the employee stock purchase plan. The unrecognized compensation expense on the employee stock purchase plan at September 27, 2019 , was $ 1.9 million . The weighted average period over which the cost is expected to be recognized is approximately four months. +Stock Options +The following table represents a summary of the Company’s stock options: +52 +Table of Contents +Shares (in millions) +Weighted average exercise price +Weighted average remaining contractual life (in years) +Aggregate intrinsic value (in millions) +Balance outstanding at September 28, 2018 +1.9 +$ +57.12 +Granted +— +$ +82.64 +Exercised +( 0.6 +) +$ +37.31 +Canceled/forfeited +— +$ +82.46 +Balance outstanding at September 27, 2019 +1.3 +$ +65.38 +2.6 +$ +19.5 +Exercisable at September 27, 2019 +1.0 +$ +63.46 +2.2 +$ +17.5 +The weighted-average grant date fair value per share of employee stock options granted during the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , was $ 21.74 , $ 68.32 , and $ 23.25 , respectively. The increase in the weighted-average grant date fair value per share of employee stock options granted during fiscal 2018 was due to replacement awards granted as a result of the Avnera acquisition completed during the period. The total grant date fair value of the options vested during the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , was $ 23.7 million , $ 22.6 million and $ 19.3 million , respectively. +Restricted and Performance Awards and Units +The following table represents a summary of the Company’s restricted and performance awards and units: +Shares (In millions) +Weighted average +grant date fair value +Non-vested awards outstanding at September 28, 2018 +2.7 +$ +92.37 +Granted (1) +1.5 +$ +78.41 +Vested +( 0.8 +) +$ +85.95 +Canceled/forfeited +( 0.5 +) +$ +91.24 +Non-vested awards outstanding at September 27, 2019 +2.9 +$ +87.22 +(1) includes performance shares granted and earned assuming maximum performance under the underlying performance metrics +The weighted average grant date fair value per share for awards granted during the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , was $ 78.41 , $ 108.86 , and $ 72.84 , respectively. The total grant date fair value of the awards vested during the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , was $ 74.9 million , $ 81.1 million and $ 57.9 million , respectively. +The following table summarizes the total intrinsic value for stock options exercised and awards vested (in millions): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Awards +$ +67.7 +$ +134.4 +$ +137.8 +Options +$ +26.4 +$ +75.0 +$ +116.1 +Valuation and Expense Information +The following table summarizes pre-tax share-based compensation expense by financial statement line and related tax benefit (in millions): +53 +Table of Contents +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Cost of goods sold +$ +13.0 +$ +14.4 +$ +13.6 +Research and development +41.6 +42.6 +35.3 +Selling, general and administrative +25.5 +50.8 +39.6 +Total share-based compensation expense +$ +80.1 +$ +107.8 +$ +88.5 +Share-based compensation tax benefit +$ +1.6 +$ +25.6 +$ +25.1 +Capitalized share-based compensation expense at period end +$ +4.7 +$ +2.9 +$ +4.0 +The following table summarizes total compensation costs related to unvested share-based awards not yet recognized and the weighted average period over which it is expected to be recognized at September 27, 2019 : +Unrecognized compensation cost for unvested awards +(in millions) +Weighted average remaining recognition period +(in years) +Awards +$ +129.6 +1.7 +Options +$ +2.6 +0.7 +The fair value of the restricted stock awards and units is equal to the closing market price of the Company’s common stock on the date of grant. +The Company issued performance share units during fiscal 2019, fiscal 2018, and fiscal 2017 that contained market-based conditions. The fair value of these performance share units was estimated on the date of the grant using a Monte Carlo simulation with the following weighted average assumptions: +Fiscal Year Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Volatility of common stock +32.65 +% +35.54 +% +39.60 +% +Average volatility of peer companies +37.07 +% +36.78 +% +39.78 +% +Average correlation coefficient of peer companies +0.47 +0.47 +0.42 +Risk-free interest rate +2.98 +% +1.74 +% +0.68 +% +Dividend yield +1.84 +% +1.15 +% +1.44 +% +The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions: +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Expected volatility +34.47 +% +35.86 +% +40.31 +% +Risk-free interest rate +2.76 +% +2.00 +% +1.60 +% +Dividend yield +1.84 +% +1.15 +% +1.44 +% +Expected option life (in years) +4.0 +4.0 +4.0 +The Company used a historical volatility calculated by the mean reversion of the weekly-adjusted closing stock price over the expected life of the options. The risk-free interest rate assumption is based upon observed treasury bill interest rates appropriate for the expected life of the Company’s employee stock options. The dividend yield was calculated based on the annualized dividend and the stock price on the date of grant. +The expected life of employee stock options represents a calculation based upon the historical exercise, cancellation and forfeiture experience for the Company across its demographic population. The Company believes that this historical data is the best estimate of the expected life of a new option and that generally all groups of the Company’s employees exhibit similar behavior. +54 +Table of Contents +10. COMMITMENTS +The Company has various operating leases primarily for buildings, computers and equipment. Rent expense amounted to $ 18.7 million , $ 20.5 million , and $ 20.6 million in the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , respectively. Future minimum payments under these non-cancelable leases for the next five fiscal years are as follows (in millions): +2020 +2021 +2022 +2023 +2024 +Thereafter +Total +Future minimum payments +$ +26.7 +25.9 +24.8 +23.3 +21.5 +97.7 +$ +219.9 +11. CONTINGENCIES +Legal Matters +From time to time, various lawsuits, claims and proceedings have been, and may in the future be, instituted or asserted against the Company, including those pertaining to patent infringement, intellectual property, environmental hazards, product liability and warranty, safety and health, employment and contractual matters. +The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company’s business and have demanded and may in the future demand that the Company license their technology. The outcome of any such litigation cannot be predicted with certainty and some such lawsuits, claims or proceedings may be disposed of unfavorably to the Company. Generally speaking, intellectual property disputes often have a risk of injunctive relief, which, if imposed against the Company, could materially and adversely affect the Company’s financial condition, or results of operations. From time to time the Company may also be involved in legal proceedings in the ordinary course of business. +The Company monitors the status of legal proceedings and other contingencies on an ongoing basis to ensure loss contingencies are recognized and/or disclosed in its financial statements and footnotes. The Company does not believe there are any pending legal proceedings that are reasonably possible to result in a material loss. The Company is engaged in various legal actions in the normal course of business and, while there can be no assurances, the Company believes the outcome of all pending litigation involving the Company will not have, individually or in the aggregate, a material adverse effect on its business or financial statements. +12. GUARANTEES AND INDEMNITIES +The Company has made no significant contractual guarantees for the benefit of third parties. However, the Company generally indemnifies its customers from third-party intellectual property infringement litigation claims related to its products, and, on occasion, also provides other indemnities related to product sales. In connection with certain facility leases, the Company has indemnified its lessors for certain claims arising from the facility or the lease. +The Company indemnifies its directors and officers to the maximum extent permitted under the laws of the state of Delaware. The duration of the indemnities varies, and in many cases is indefinite. The indemnities to customers in connection with product sales generally are subject to limits based upon the amount of the related product sales and in many cases are subject to geographic and other restrictions. In certain instances, the Company’s indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities in the accompanying consolidated balance sheets and does not expect that such obligations will have a material adverse impact on its financial statements. +13. RESTRUCTURING AND OTHER CHARGES +During fiscal 2019, the Company recorded restructuring and other charges of approximately $ 6.8 million primarily related to employee severance and other termination benefits as well as charges on a leased facility resulting from restructuring plans initiated during the period. The Company does not anticipate any further significant charges associated with these restructuring activities and the remaining cash payments related to these restructuring plans are not material. +During fiscal 2018, the Company recorded restructuring and other charges of approximately $ 0.8 million related to a leased facility. +55 +Table of Contents +During fiscal 2017, the Company implemented immaterial restructuring plans and recorded $ 0.6 million related to employee severance and other costs. +14. EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted earnings per share (in millions, except per share amounts): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +Net income +$ +853.6 +$ +918.4 +$ +1,010.2 +Weighted average shares outstanding – basic +173.5 +181.3 +184.3 +Dilutive effect of equity based awards +1.0 +1.9 +2.4 +Weighted average shares outstanding – diluted +174.5 +183.2 +186.7 +Net income per share – basic +$ +4.92 +$ +5.06 +$ +5.48 +Net income per share – diluted +$ +4.89 +$ +5.01 +$ +5.41 +Anti-dilutive common stock equivalents +1.4 +0.2 +0.6 +Basic earnings per share are calculated by dividing net income by the weighted average number of shares of the Company’s common stock outstanding during the period. The calculation of diluted earnings per share includes the dilutive effect of equity based awards that were outstanding during the fiscal years ended September 27, 2019 , September 28, 2018 , and September 29, 2017 , using the treasury stock method. Certain of the Company’s outstanding share-based awards, noted in the table above, were excluded because they were anti-dilutive, but they could become dilutive in the future. +15. SEGMENT INFORMATION AND CONCENTRATIONS +The Company has a single reportable operating segment which designs, develops, manufactures and markets similar proprietary semiconductor products, including intellectual property. In reaching this conclusion, management considers the definition of the chief operating decision maker (“ CODM ”), how the business is defined by the CODM, the nature of the information provided to the CODM and how that information is used to make operating decisions, allocate resources and assess performance. The Company’s CODM is the president and chief executive officer. The results of operations provided to and analyzed by the CODM are at the consolidated level and accordingly, key resource decisions and assessment of performance are performed at the consolidated level. The Company assesses its determination of operating segments at least annually. +GEOGRAPHIC INFORMATION +The Company presents net revenue by geographic area based upon the location of the OEMs’ headquarters as it believes that doing so best depicts how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. Net revenue by geographic area is as follows (in millions): +Fiscal Years Ended +September 27, +2019 +September 28, +2018 +September 29, +2017 +United States +$ +1,860.4 +$ +1,946.2 +$ +1,615.4 +China +718.7 +982.8 +1,018.8 +South Korea +365.5 +432.7 +531.8 +Taiwan +271.1 +339.1 +335.4 +Europe, Middle East and Africa +134.9 +144.6 +117.4 +Other Asia-Pacific +26.2 +22.6 +32.6 +Total +$ +3,376.8 +$ +3,868.0 +$ +3,651.4 +The Company’s revenue from external customers is generated principally from the sale of semiconductor products that facilitate various wireless communication applications. Accordingly, the Company considers its product offerings to be similar in nature and therefore not segregated for reporting purposes. +56 +Table of Contents +Net property, plant and equipment balances, based on the physical locations within the indicated geographic areas are as follows (in millions): +As of +September 27, +2019 +September 28, +2018 +Japan +$ +491.9 +$ +328.4 +Mexico +351.5 +449.4 +Singapore +229.9 +222.7 +United States +117.6 +126.6 +Rest of world +14.7 +13.8 +$ +1,205.6 +$ +1,140.9 +CONCENTRATIONS +Financial instruments that potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable. Trade accounts receivable are primarily derived from sales to manufacturers of communications and consumer products and electronic component distributors. Ongoing credit evaluations of customers’ financial condition are performed and collateral, such as letters of credit and bank guarantees, are required whenever deemed necessary. +In fiscal 2019 , 2018 , and 2017 , Apple, through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches and other devices, in the aggregate accounted for 51 % , 47 % , and 39 % of the Company’s net revenue, respectively. In fiscal 2017 , Samsung and Huawei in the aggregate accounted for 12 % and 10 % of the Company’s net revenue, respectively. +At September 27, 2019 , the Company’s three largest accounts receivable balances comprised 67 % of aggregate gross accounts receivable. This concentration was 66 % and 53 % at September 28, 2018 , and September 29, 2017 , respectively. +16. QUARTERLY FINANCIAL DATA (UNAUDITED) +T he following table summarizes the quarterly and annual results (in millions, except per share data): +First quarter +Second quarter +Third quarter +Fourth quarter +Fiscal year +Fiscal 2019 +Net revenue +$ +972.0 +$ +810.4 +$ +767.0 +$ +827.4 +$ +3,376.8 +Gross profit +485.1 +400.2 +312.5 +406.0 +1,603.8 +Net income +284.9 +214.0 +144.1 +210.6 +853.6 +Per share data (1) +Net income, basic +$ +1.61 +$ +1.23 +$ +0.83 +$ +1.23 +$ +4.92 +Net income, diluted +$ +1.60 +$ +1.23 +$ +0.83 +$ +1.22 +$ +4.89 +Fiscal 2018 +Net revenue +$ +1,051.9 +$ +913.4 +$ +894.3 +$ +1,008.4 +$ +3,868.0 +Gross profit +536.8 +458.7 +451.6 +503.6 +1,950.7 +Net income +70.4 +276.0 +286.5 +285.5 +918.4 +Per share data (1) +Net income, basic +$ +0.38 +$ +1.51 +$ +1.58 +$ +1.60 +$ +5.06 +Net income, diluted +$ +0.38 +$ +1.50 +$ +1.57 +$ +1.58 +$ +5.01 +____________ +(1) +Earnings per share calculations for each of the quarters are based on the weighted average number of shares outstanding and included common stock equivalents in each period. Therefore, the sums of the quarters do not necessarily equal the full year earnings per share. +57 +Table of Contents +58 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +None. +ITEM 9A. CONTROLS AND PROCEDURES. +Evaluation of disclosure controls and procedures. +Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 27, 2019 . The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on management’s evaluation of our disclosure controls and procedures as of September 27, 2019 , our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level. +Management’s Annual Report on Internal Control over Financial Reporting +The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: +• +Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; +• +Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +• +Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of September 27, 2019 . In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 Internal Control-Integrated Framework. +Based on their assessment, management concluded that, as of September 27, 2019 , the Company’s internal control over financial reporting is effective based on those criteria. +The Company’s independent registered public accounting firm has issued an audit report on the effectiveness of the Company’s internal control over financial reporting as stated within their report which appears herein. +Changes in internal control over financial reporting. +59 +Table of Contents +There are no changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the fourth quarter of 2019 that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting. +ITEM 9B. OTHER INFORMATION. +Effective as of November 19, 2019, Peter L. Gammel will retire from his position as Chief Technology Officer of the Company. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. +The information under the captions “Directors and Executive Officers”, “Corporate Governance─Committees of the Board of Directors” and “Other Matters─Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders is incorporated herein by reference. +We have adopted a written code of business conduct and ethics that applies to our directors, officers and employees, including our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. We make available our code of business conduct and ethics free of charge through our website, which is located at www.skyworksinc.com. We intend to disclose any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to rules of the SEC and the Nasdaq Global Select Market by posting any such amendment or waivers on our website and disclosing any such waivers in a Form 8-K filed with the SEC. +ITEM 11. EXECUTIVE COMPENSATION. +The information to be included under the caption “Information about Executive and Director Compensation” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +The information to be included under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +The information to be included under the captions “Certain Relationships and Related Transactions” and “Corporate Governance─Director Independence” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES. +The information to be included under the caption “Ratification of Independent Registered Public Accounting Firm—Audit Fees” in our definitive proxy statement for the 2020 Annual Meeting of Stockholders is incorporated herein by reference. +60 +Table of Contents +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES. +(a) +The following are filed as part of this Annual Report on Form 10-K: +1. +Index to Financial Statements +Page number in this report +Report of Independent Registered Public Accounting Firm +Page 33 +Consolidated Statements of Operations for the three years ended September 27, 2019 +Page 35 +Consolidated Statements of Comprehensive Income for the three years ended September 27, 2019 +Page 38 +Consolidated Balance Sheets at September 27, 2019, and September 28, 2018 +Page 37 +Consolidated Statements of Cash Flows for the three years ended September 27, 2019 +Page 38 +Consolidated Statements of Stockholders’ Equity for the three years ended September 27, 2019 +Page 39 +Notes to Consolidated Financial Statements +Pages 40 through 57 +2. +The schedule listed below is filed as part of this Annual Report on Form 10-K: +All required schedule information is included in the Notes to Consolidated Financial Statements or is omitted because it is either not required or not applicable. +3. +The Exhibits listed in the Exhibit Index immediately following Item 16 are filed as a part of this Annual Report on Form 10-K. +(b) +Exhibits +The exhibits required by Item 601 of Regulation S-K are filed herewith and incorporated by reference herein. The response to this portion of Item 15 is submitted under Item 15 (a) (3). +ITEM 16. FORM 10-K SUMMARY. +None +61 +Table of Contents +EXHIBIT INDEX +Exhibit +Number +Exhibit Description +Form +Incorporated by Reference +Filed Herewith +File No. +Exhibit +Filing Date +2.1 +Agreement and Plan of Merger dated as of August 3, 2018, by and among the Company, Avnera Corporation, AI Acquisition Corp., and Shareholder Representative Services LLC, solely in its capacity as the representative and agent of the Equityholders +10-K +001-05560 +2.3 +11/15/2018 +3.1 +Restated Certificate of Incorporation, as Amended +10-Q +001-05560 +3.1 +8/3/2016 +3.2 +Third Amended and Restated By-laws, as Amended +10-Q +001-05560 +3.1 +2/5/2018 +4.1 +Specimen Certificate of Common Stock +S-3 +333-92394 +4 +7/15/2002 +4.2 +Description of Capital Stock +X +10.1* +Skyworks Solutions, Inc. 2002 Employee Stock Purchase Plan +10-Q +001-05560 +10.D +1/31/2013 +10.2* +Skyworks Solutions, Inc. Non-Qualified Employee Stock Purchase Plan +10-Q +001-05560 +10.E +1/31/2013 +10.3* +Skyworks Solutions, Inc. Amended and Restated 2005 Long-Term Incentive Plan +8-K +001-05560 +10.1 +5/13/2013 +10.4* +Form of Nonstatutory Stock Option Agreement under the Company’s 2005 Long-Term Incentive Plan +10-Q +001-05560 +10.B +1/31/2013 +10.5* +Skyworks Solutions, Inc. Amended and Restated 2008 Director Long-Term Incentive Plan, as Amended +10-Q +001-05560 +10.1 +5/4/2018 +10.6* +Form of Nonstatutory Stock Option Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q +001-05560 +10.OO +5/7/2008 +10.7* +Form of Restricted Stock Unit Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q +001-05560 +10.2 +5/4/2016 +10.8* +Skyworks Solutions, Inc. 2015 Long-Term Incentive Plan, as Amended +10-Q +001-05560 +10.1 +8/7/2019 +10.9* +Form of Nonstatutory Stock Option Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.2 +8/5/2015 +10.10* +Form of Performance Share Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.3 +8/5/2015 +10.11* +Form of Restricted Stock Unit Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q +001-05560 +10.4 +8/5/2015 +10.12* +Fiscal Year 2019 Executive Incentive Plan +10-Q +001-05560 +10.1 +2/6/2019 +10.13* +Skyworks Solutions, Inc. Cash Compensation Plan for Directors +10-Q +001-05560 +10.1 +7/20/2018 +10.14* +Second Amended and Restated Change of Control / Severance Agreement, dated May 11, 2016, between the Company and David Aldrich +10-Q +001-05560 +10.1 +8/3/2016 +10.15* +Amended and Restated Change in Control / Severance Agreement, dated May 11, 2016, between the Company and Liam Griffin +10-Q +001-05560 +10.2 +8/3/2016 +10.16* +Change in Control / Severance Agreement, dated December 16, 2014, between the Company and Peter Gammel +10-K +001-05560 +10.31 +11/24/2015 +62 +Table of Contents +Exhibit +Number +Exhibit Description +Form +Incorporated by Reference +Filed Herewith +File No. +Exhibit +Filing Date +10.17* +Change in Control / Severance Agreement, dated August 29, 2016, between the Company and Kris Sennesael +10-K +001-05560 +10.32 +11/22/2016 +10.18* +Change in Control / Severance Agreement, dated November 10, 2016, between the Company and Robert J. Terry +10-Q +001-05560 +10.2 +2/7/2017 +10.19* +Change in Control / Severance Agreement, dated November 9, 2016, between the Company and Carlos S. Bori +10-K +001-05560 +10.27 +11/13/2017 +10.20* +International Assignment Agreement, dated September 13, 2017, between the Company and Peter L. Gammel +10-K +001-05560 +10.28 +11/13/2017 +21 +Subsidiaries of the Company +X +23.1 +Consent of KPMG LLP +X +31.1 +Certification of the Company’s Chief Executive Officer pursuant to Securities and Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +X +31.2 +Certification of the Company’s Chief Financial Officer pursuant to Securities and Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +X +32.1 +Certification of the Company’s Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +X +32.2 +Certification of the Company’s Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +X +101.INS +Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH +Inline XBRL Taxonomy Extension Schema Document +X +101.CAL +Inline XBRL Taxonomy Extension Calculation Linkbase Document +X +101.DEF +Inline XBRL Taxonomy Extension Definition Linkbase Document +X +101.LAB +Inline XBRL Taxonomy Extension Label Linkbase Document +X +101.PRE +Inline XBRL Taxonomy Extension Presentation Linkbase Document +X +104 +Cover Page Interactive Data File (formatted as inline XBRL with applicable taxonomy extension information contained in Exhibits 101) +* Indicates a management contract or compensatory plan or arrangement. +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. +Date: November 14, 2019 +SKYWORKS SOLUTIONS, INC. +Registrant +By: +/s/ Liam K. Griffin +Liam K. Griffin +President and Chief Executive Officer +Director +Table of Contents +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on November 14, 2019 . +Signature and Title +Signature and Title +/s/ Liam K. Griffin +/s/ David J. Aldrich +Liam K. Griffin +David J. Aldrich +Chief Executive Officer +Chairman of the Board +President and Director +(principal executive officer) +/s/ Alan S. Batey +Alan S. Batey +/s/ Kris Sennesael +Director +Kris Sennesael +Senior Vice President and Chief Financial Officer +/s/ Kevin L. Beebe +(principal accounting and financial officer) +Kevin L. Beebe +Director +/s/ Timothy R. Furey +Timothy R. Furey +Director +/s/ Balakrishnan S. Iyer +Balakrishnan S. Iyer +Director +/s/ Christine King +Christine King +Director +/s/ David P. McGlade +David P. McGlade +Director +/s/ Robert A. Schriesheim +Robert A. Schriesheim +Director +/s/ Kimberly S. Stevenson +Kimberly S. Stevenson +Director +65 \ No newline at end of file diff --git a/raw/filings/0000004127/2019/0000004127-19-000049/filing_metadata.csv b/raw/filings/0000004127/2019/0000004127-19-000049/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..2e359b311e1418913ab2aec2f7416ec1bd5a3c34 --- /dev/null +++ b/raw/filings/0000004127/2019/0000004127-19-000049/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004127,SWKS,"SKYWORKS SOLUTIONS, INC.",2019,10-K,2019-11-14,2019-09-27,2019-11-14T13:21:35.000Z,0000004127-19-000049,fy1910k92719.htm,10-K,9915751,1,1,https://www.sec.gov/Archives/edgar/data/4127/000000412719000049/fy1910k92719.htm,https://www.sec.gov/Archives/edgar/data/4127/000000412719000049/ diff --git a/raw/filings/0000004127/2019/0000004127-19-000049/item1.txt b/raw/filings/0000004127/2019/0000004127-19-000049/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..4f796e404bd4474aa81dcfb88d08f43abd393c2b --- /dev/null +++ b/raw/filings/0000004127/2019/0000004127-19-000049/item1.txt @@ -0,0 +1,124 @@ +ITEM 1. BUSINESS. +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. +Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto (a Thales company), General Electric, Google, Honeywell, HTC, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi and ZTE. Our competitors include Analog Devices, Broadcom, Cirrus Logic, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, Qorvo and Qualcomm. +We are a Delaware corporation that was formed in 1962. We changed our corporate name from Alpha Industries, Inc. to Skyworks Solutions, Inc. on June 25, 2002, following a business combination. We operate worldwide with engineering, manufacturing, sales, and service facilities throughout Asia, Europe, and North America. Our Internet address is www.skyworksinc.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we electronically submit such material to the SEC. The information contained on our website is not incorporated by reference in this Annual Report. Our SEC filings are also available to the public at www.sec.gov. +In August 2018, we acquired Avnera Corporation (“Avnera”) and expanded our leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors, and integrated software. The acquisition of Avnera enables us to capitalize on the rapid proliferation of audio functionality and its convergence with our advanced connectivity solutions. With our global sales channels, strong customer relationships and operational scale, we are leveraging Avnera’s innovative product portfolio and systems expertise to increase our footprint in automotive, industrial, home automation, enterprise and high-end consumer markets. +INDUSTRY BACKGROUND +Wireless connectivity is exploding on a global basis. 5G is dramatically altering the world, creating an ecosystem where everyone is connected to everything, all the time—changing how individuals live, work, play, and learn. More importantly, 5G goes well beyond simply making the mobile communications experience better by increasing reliability, adding new features, and enhancing data rates. It is creating a market for diverse and transformative applications driven by the ability to deliver greater speeds, bandwidth and capacity, significantly lower latency, and more secure connectivity. +In fact, 5G connections will approach ten to 100 times faster than 4G speeds. To put this in perspective, downloading a full-length HD movie in 3G took one day; in 4G, the same file took minutes. On a 5G network, this content can be downloaded in mere seconds. 5G will also enable increasingly efficient and safe vehicle communication, paving the way for autonomous vehicles as well as networks that could make wireless healthcare a reality. +At the same time, connectivity is expanding into an adjacent set of IoT markets. From smart homes to the smart grid and from industrial to wearables, the number of connected devices is rapidly proliferating. IHS Markit Ltd. projects the IoT market to grow from an installed base of 15 billion units in 2015 to more than 75 billion units by 2025. Skyworks is enabling these opportunities with highly customized system solutions supporting a broad set of wireless protocols including cellular LTE, Wi-Fi, Bluetooth®, LoRa®, Thread, and Zigbee®. +Looking forward, we see a market that presents a significant growth opportunity for our industry and for Skyworks. The key catalysts for Skyworks will continue to be the insatiable demand for data and the profitable usage model, as each connection becomes more valuable and the world embraces 5G. According to a June 2019 Ericsson “Mobility Report,” there are expected to be 1.9 billion mobile 5G subscriptions globally by the end of 2024 driven by “rapid early momentum and enthusiasm” in the global market. 5G technology will also support the tens of billions of connected devices, smart objects, and embedded sensors expected to come online as the IoT becomes mainstream. +Solving Connectivity Challenges +5 +Table of Contents +We expect that highly integrated semiconductor solutions will play an increasingly pivotal role in the deployment of this next generation standard by resolving the daunting analog and RF complexities that are challenging the capabilities of existing hardware and the supporting network infrastructure. Meeting these design challenges requires broad competencies including signal transmission and conditioning, the ability to ensure seamless hand-offs between multiple standards, power management, voltage regulation, battery charging, advanced filtering, and tuning. +Skyworks is at the forefront of this sea change in connectivity, delivering the solutions that will enable the true potential of 5G and the IoT. We have a rich heritage in analog systems design and have spent the last decade investing in key technologies and resources. Our strength is underpinned by world-class performance and scale across a broad array of capabilities that include advanced TC-SAW and BAW filters, an expanded family of MIMO, ultra-high band, and diversity receive modules and expanding into emerging technologies including millimeter wave. From our breakthrough SKY5® unifying platform to our 5G small cell solutions, Skyworks’ approach across both infrastructure and user equipment facilitates powerful, high-speed end-to-end 5G connectivity. +SKYWORKS’ STRATEGY +Our ambitious vision is to connect everyone and everything, all the time. To this end, key elements of our strategy include: +Industry-Leading Technology +As the industry migrates to more complex 5G architectures across a multitude of wireless applications, we are well positioned to help mobile device manufacturers handle growing levels of system complexity in the transmit and receive chain. The trend towards increasing front-end and analog design challenges in smartphones and other platforms plays directly into our core strengths and positions us to address these challenges. We believe that we offer the broadest portfolio of radio and analog solutions from the transceiver to the antenna as well as all required manufacturing process technologies. We also hold strong technology leadership positions in passive devices, advanced integration including proprietary shielding and 3-D die stacking as well as SAW, TC-SAW and BAW filters. Our product portfolio is reinforced by a library of approximately 3,500 worldwide patents and other intellectual property that we own and control. Together, our industry-leading technology enables us to deliver the highest levels of product performance and integration. +Customer Relationships +Given our scale and technology leadership, we are engaged with key original equipment manufacturers (“OEMs”), smartphone providers and baseband reference design partners. Our customers value our supply chain strength, our innovative technology and our system engineering expertise, resulting in deep customer loyalty. We partner with our customers to support their long-term product road maps and are valued as a system solutions provider rather than just a point product vendor. +Diversification +We are diversifying our business in three areas: our addressed markets, our customer base and our product offerings. By leveraging core analog and mixed signal technologies, we are expanding our family of solutions to a set of increasingly diverse end markets and customers. With the adoption of 5G and the opportunity to enable more applications, we are steadily growing our business beyond just mobile devices (where we support all top-tier manufacturers, including the leading smartphone suppliers and key baseband vendors) into additional high-performance analog markets, including automotive, home and factory automation, infrastructure, medical, smart energy and wireless networking. In these markets we leverage our scale, intellectual property and worldwide distribution network, which spans over 3,200 customers and over 2,500 analog components. +Delivering Operational Excellence +We vertically integrate our supply chain where we can differentiate with highly specialized internal manufacturing capabilities, or enter into alliances and strategic relationships for leading-edge technologies. This hybrid manufacturing model allows us to better balance our manufacturing capacity with the demand of the marketplace. Our internal capacity utilization remains high, resulting in an increase of our gross margin and the return on invested capital on a broader range of revenue. +Additionally, we continue to drive reductions in product design and manufacturing cycle times and further improve product yields. The combination of agile, flexible capacity and world-class module manufacturing and scale advantage allows us to achieve low product costs while integrating multiple technologies into highly sophisticated multi-chip modules. +Maintaining a Performance-Driven Culture +We consider our people and corporate culture to be a major competitive advantage and a key driver of our overall strategy. We create key performance indicators that align employee efforts with corporate strategy and link responsibilities with performance +6 +Table of Contents +measurement. Accountability is paramount and we compensate our employees through a pay-for-performance methodology. We strive to be an employer-of-choice among peer companies and have created a work environment in which turnover is below geographic and industry averages. +Generating Superior Operating Results and Shareholder Returns +We seek to generate financial returns that are comparable to a highly diversified analog semiconductor company. Given our product volume and overall utilization we strive to achieve a best-in-class return on investment and operating income to reward shareholders. +OUR PRODUCT PORTFOLIO +Our product portfolio consists of various solutions, including: +• +Amplifiers: the modules that strengthen the signal so that it has sufficient energy to reach a base station +• +Antenna Tuners: aperture and impedance tuning products that improve antenna performance across frequencies +• +Attenuators: circuits that allow a known source of power to be reduced by a predetermined factor (usually expressed as decibels) +• +Circulators/Isolators: ferrite-based components commonly found on the output of high-power amplifiers used to protect receivers in wireless transmission systems +• +Wireless ASoC: an intelligent 2.4 GHz and 5GHz wireless radio integrated circuit that includes all the analog and digital functions optimized for building wireless audio headsets, headphones, and wireless speaker systems +• +DC/DC Converters: an electronic circuit which converts a source of direct current from one voltage level to another +• +Demodulators: a device or an RF block used in receivers to extract the information that has been modulated onto a carrier or from the carrier itself +• +Detectors: devices used to measure and control RF power in wireless systems +• +Diodes: semiconductor devices that pass current in one direction only +• +Directional Couplers: transmission coupling devices for separately sampling the forward or backward wave in a transmission line +• +Diversity Receive Modules: devices used to improve receiver sensitivity in high data rate applications +• +Filters: devices for recovering and separating mixed and modulated data in RF stages +• +Front-end Modules: two or more functions co-packaged to optimize the performance, cost and application suitability in products, including intermediate or radio frequency signal paths +• +Hybrid: a type of directional coupler used in radio and telecommunications +• +LED Drivers: devices which regulate the current through a light emitting diode or string of diodes for the purpose of creating light +• +Low Noise Amplifiers: devices used to reduce system noise figure in the receive chain +• +Mixers: devices that enable signals to be converted to a higher or lower frequency signal and thereby allowing the signals to be processed more effectively +• +Modulators: devices that take a baseband input signal and output a radio frequency modulated signal +• +Optocouplers/Optoisolators: semiconductor devices that allow signals to be transferred between circuits or systems while ensuring that the circuits or systems are electrically isolated from each other +• +Phase Locked Loops: closed-loop feedback control system that maintains a generated signal in a fixed phase relationship to a reference signal +• +Phase Shifters: designed for use in power amplifier distortion compensation circuits in base station applications +• +Power Dividers/Combiners: utilized to equally split signals into in-phase signals as often found in balanced signal chains and local oscillator distribution networks +• +Receivers: electronic devices that change a radio signal from a transmitter into useful information +• +Switches: components that perform the change between the transmit and receive function, as well as the band function for cellular handsets +• +Synthesizers: devices that provide ultra-fine frequency resolution, fast switching speed, and low phase-noise performance +• +Technical Ceramics: polycrystalline oxide materials used for a wide variety of electrical, mechanical, thermal and magnetic applications +• +Voltage Controlled Oscillators/Synthesizers: fully integrated, high performance signal source for high dynamic range transceivers +• +Voltage Regulators: generate a fixed level which ideally remains constant over varying input voltage or load conditions +We believe we possess broad technology capabilities and one of the most complete wireless communications product portfolios in the industry. +7 +Table of Contents +MARKETING AND DISTRIBUTION +Our products are sold globally through a direct sales force, electronic component distributors and independent sales representatives. Certain distributors have agreements with us which allow for certain sales returns, stock rotations and price protection on certain inventory if we lower the price of those products (see “ Critical Accounting Estimates ” in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to Item 8 of this Annual Report on Form 10-K for further detail on revenue reserves). As is customary in the semiconductor industry, our distributors may also market other products that compete with ours. +Our sales engagement begins at the earliest stages of the design of an existing or potential customer’s product. We collaborate technically with our customers and reference design partners at the inception of new programs. These relationships allow our team to facilitate customer-driven solutions, which leverage the unique strength of our intellectual property and product portfolio while providing high value and greatly reducing time-to-market. +We believe the technical and complex nature of our products and markets demand an extraordinary commitment to maintain close ongoing relationships with our customers. As such, we strive to expand the scope of our customer relationship to include design, engineering, manufacturing, procurement, logistics and project management. We also employ a collaborative approach in developing these relationships by combining the support of our design teams, applications engineers, manufacturing personnel, sales and marketing staff and senior management. Lastly, we leverage our customer relationships with cross-selling opportunities across product lines in order to maximize revenue. +We believe that maintaining frequent and interactive contact with our customers is paramount to our continuous efforts to provide world-class sales and service support. By listening and responding to feedback, we are able to mobilize resources to raise our level of customer satisfaction, improve our ability to anticipate future product needs, and enhance our understanding of key market dynamics. We are confident that diligently following this path positions us to participate in numerous opportunities for growth in the future. +CUSTOMER CONCENTRATION +A small number of OEMs historically has accounted for a significant portion of our net revenue. In the fiscal years ended September 27, 2019 (“fiscal 2019”), and September 28, 2018 (“fiscal 2018”), Apple Inc. (“Apple”), through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches, and other devices) constituted more than ten percent of our net revenue. In the fiscal year ended September 29, 2017 (“fiscal 2017”), three customers—Apple, Samsung Electronics (“Samsung”), and Huawei Technology Co., Ltd. (“Huawei”)—each constituted ten percent or more of our net revenue. For further information regarding customer concentrations see Note 15 to Item 8 of this Annual Report on Form 10-K. +INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS +We own or have a license to use numerous United States and foreign patents and patent applications related to our products and our manufacturing operations and processes. In addition, we own a number of trademarks and service marks applicable to certain of our products and services. We believe that our intellectual property, including patents, patent applications, trade secrets and trademarks, is of material importance to our business. We rely on patent, copyright, trademark, trade secret and other intellectual property laws, as well as non-disclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, designs, devices, algorithms, processes and other intellectual property. Our efforts may not meaningfully protect our intellectual property, or others may independently develop substantially equivalent or superior proprietary technologies, designs, devices, algorithms, processes or other intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and effective copyright, patent, trademark and trade secret protection may not be available in those jurisdictions. In addition to protecting our intellectual property, we strive to strengthen our intellectual property portfolio to enhance our ability to obtain cross-licenses of intellectual property from others, to obtain access to intellectual property we do not possess and to more favorably resolve potential intellectual property claims against us. Due to rapid technological changes in the industry, we believe establishing and maintaining a technological leadership position depends primarily on our ability to develop new, innovative products through the technical competence of our engineering personnel. +COMPETITIVE CONDITIONS +The competitive environment in the semiconductor industry is in a constant state of flux, with new products continually emerging and existing products approaching technological obsolescence. We compete on the basis of time-to-market, new product innovation, quality, performance, price, compliance with industry standards, strategic relationships with customers and baseband vendors, +8 +Table of Contents +personnel and protection of our intellectual property. We participate in highly competitive markets against numerous competitors that may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements, or may be able to devote greater resources to the development, promotion and sale of their products than we can. +Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. We mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs and lower manufacturing costs of existing products and by introducing new and higher value-added products. +RESEARCH AND DEVELOPMENT +Our products and markets demand rapid technological advancements requiring a continuous effort to enhance existing products and develop new products and technologies. Accordingly, we maintain a high level of research and development activity. We invested $424.1 million , $404.5 million and $355.2 million in research and development during fiscal 2019, fiscal 2018 and fiscal 2017, respectively. The growth in research and development expenses were the result of increases in our internal product designs and product development activity for our target markets in each of these fiscal years. Our research and development expenses include new product development and innovations in integrated circuit design, investment in advanced semiconductor manufacturing processes, development of new packaging and test capabilities and research on next generation technologies and product opportunities. We maintain close collaborative relationships with many of our customers to help identify market demands and target our development efforts to meet those demands. +RAW MATERIALS +Raw materials for our products and manufacturing processes are generally available from several sources. It is our intent not to depend on a sole source of supply unless market or other conditions dictate otherwise. However, there are limited situations where we procure certain components and services for our products from single or limited sources, and we are currently dependent on a limited number of sole source suppliers. We purchase materials and services primarily pursuant to individual purchase orders. However, we have entered into certain supply agreements for the purchase of raw materials or other manufacturing related services that specify minimum prices and purchase quantity based on our anticipated future requirements. Such amounts are reviewed and included in our contractual obligations and commitments as required. Certain of our suppliers consign raw materials to us at our manufacturing facilities to which we take title as needed in our manufacturing process. We believe we have adequate sources for the supply of raw materials and components for our manufacturing needs with suppliers located around the world. +BACKLOG AND INVENTORY +Our sales are primarily from the sale of semiconductor products under individual customer purchase orders, some of which have underlying master sales agreements that specify terms governing the product sales. In the absence of a sales agreement, the Company’s standard terms and conditions apply. We also maintain Skyworks-owned finished goods inventory at certain customer “hub” locations. We do not recognize revenue until these customers consume the Skyworks-owned inventory from these hub locations. Due to industry practice, which allows customers to cancel orders with limited advance notice to us prior to shipment, and with little or no penalty, we believe that backlog as of any particular date may not be a reliable indicator of our future revenue levels. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volume could result in a reduction in revenue and us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. +ENVIRONMENTAL REGULATIONS +Federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes, and other activities affecting the environment have had, and will continue to have, an impact on our manufacturing operations. Most of our customers have mandated that our products comply with various local, regional and national “green” initiatives initiated by such customers or the locations in which they operate. We believe that our current expenditures for environmental capital investment and remediation necessary to comply with present regulations governing environmental protection, and other expenditures for the resolution of environmental claims, will not have a material adverse effect on our liquidity and capital resources, competitive position or financial condition. Environmental regulations are subject to change in the future, and accordingly we are unable to assess the possible effect of compliance with future requirements. +SEASONALITY +Sales of our products are subject to seasonal fluctuation and periods of increased demand in end-user consumer applications, such as smartphones and tablet computing devices. The highest demand for our products generally occurs in our first fiscal quarter ending +9 +Table of Contents +in December and the fourth fiscal quarter ending in September. The lowest demand for our handset products generally occurs in our second fiscal quarter ending in March and the third fiscal quarter ending in June. +EMPLOYEES +As of September 27, 2019 , we employed approximately 9,000 employees world-wide. Approximately 2,850 of our employees in Mexico, 315 employees in Singapore, and 320 employees in Japan are covered by collective bargaining and other union agreements. \ No newline at end of file diff --git a/raw/filings/0000004127/2019/0000004127-19-000049/item13.txt b/raw/filings/0000004127/2019/0000004127-19-000049/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..5feb8f08d405107dd92b3c7211bc02f1b129b7c7 --- /dev/null +++ b/raw/filings/0000004127/2019/0000004127-19-000049/item13.txt @@ -0,0 +1,2 @@ +ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +60 \ No newline at end of file diff --git a/raw/filings/0000004127/2020/0000004127-20-000058/filing.txt b/raw/filings/0000004127/2020/0000004127-20-000058/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..91721822906744d3b2dbc590fec740463198dab6 --- /dev/null +++ b/raw/filings/0000004127/2020/0000004127-20-000058/filing.txt @@ -0,0 +1,1647 @@ 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swks:CompanyMember 2019-09-28 2020-10-02 0000004127 swks:CompanyMember 2018-09-29 2019-09-27 0000004127 swks:CompanyMember 2017-09-30 2018-09-28 0000004127 us-gaap:CreditConcentrationRiskMember 2019-09-28 2020-10-02 0000004127 us-gaap:CreditConcentrationRiskMember 2018-09-29 2019-09-27 0000004127 us-gaap:CreditConcentrationRiskMember 2017-09-30 2018-09-28 +UNITED STATES SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +☑ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended October 2, 2020 +OR +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from __________to__________ +Commission file number 001-05560 +Skyworks Solutions, Inc. +(Exact name of registrant as specified in its charter) +Delaware 04-2302115 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +5260 California Avenue +Irvine +California 92617 +(Address of principal executive offices) (Zip Code) +(949) +231-3000 +(Registrant’s telephone number, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol(s) Name of each exchange on which registered +Common Stock, par value $0.25 per share SWKS Nasdaq Global Select Market +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes o No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. o Yes þ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). þ Yes o No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company,” in Rule 12b-2 of the Exchange Act. +Large accelerated filer þ +Accelerated filer ☐ +Non-accelerated filer ☐ +Smaller reporting company ☐ Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepares or issued its audit report. þ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes þ No +The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant (based on the closing price of the registrant’s common stock as reported on the Nasdaq Global Select Market on the last business day of the registrant’s most recently completed second fiscal quarter March 27, 2020) was approximately $ 14.5 billion. The number of outstanding shares of the registrant’s common stock, par value $0.25 per share, as of November 11, 2020, was 166,081,720 . +DOCUMENTS INCORPORATED BY REFERENCE +Part of Form 10-K Documents from which portions are incorporated by reference +Part III Portions of the Registrant’s Proxy Statement relating to the Registrant’s 2021 Annual Meeting of Stockholders (to be filed) are incorporated by reference into Items 10, 11, 12, 13, and 14 of this Annual Report on Form 10-K. +SKYWORKS SOLUTIONS, INC. +ANNUAL REPORT ON FORM 10-K +FOR THE YEAR ENDED OCTOBER 2, 2020 +TABLE OF CONTENTS +PAGE NO. +PART I +ITEM 1: BUSINESS. +5 +ITEM 1A: RISK FACTORS. +11 +ITEM 1B: UNRESOLVED STAFF COMMENTS. +25 +ITEM 2: PROPERTIES. +25 +ITEM 3: LEGAL PROCEEDINGS. +25 +ITEM 4: MINE SAFETY DISCLOSURES . +25 +PART II +ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. +25 +ITEM 6: SELECTED FINANCIAL DATA. +27 +ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +28 +ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. +33 +ITEM 8: FINANCIAL ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. AND SUPPLEMENTARY DATA. +35 +ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +62 +ITEM 9A: CONTROLS AND PROCEDURES. +62 +ITEM 9B: OTHER INFORMATION. +63 +PART III +ITEM 10: DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. +63 +ITEM 11: EXECUTIVE COMPENSATION. +63 +ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +63 +ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +63 +ITEM 14: PRINCIPAL ACCOUNTING FEES AND SERVICES. +63 +PART IV +ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES. +64 +ITEM 16: FORM 10-K SUMMARY +64 +SIGNATURES +67 +CAUTIONARY STATEMENT +This Annual Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the “safe harbor” created by those sections. Any statements that are not statements of historical fact should be considered to be forward-looking statements. Words such as “anticipates”, “believes”, “continue”, “could”, “estimates”, “expects”, “intends”, “may”, “plans”, “potential”, “predicts”, “projects”, “seek”, “should”, “targets”, “will”, “would”, and similar expressions or variations or negatives of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, forward-looking statements include, but are not limited to: +• our plans to develop and market new products, enhancements or technologies and the timing of these development and marketing plans; +• our estimates regarding our capital requirements and our needs for additional financing; +• our estimates of our expenses, future revenues, and profitability; +• our estimates of the possible impacts of the COVID-19 pandemic; +• our estimates of the size of the markets for our products and services; +• our expectations related to the rate and degree of market acceptance of our products; and +• our estimates of the success of other competing technologies that may become available. +Although forward-looking statements in this Annual Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known and understood by us. Consequently, forward-looking statements involve inherent risks and uncertainties and actual financial results and outcomes may differ materially and adversely from the results and outcomes discussed in or anticipated by the forward-looking statements. A number of important factors could cause actual financial results to differ materially and adversely from those in the forward-looking statements. We urge you to consider the risks and uncertainties discussed elsewhere in this report (including in Item 1A, Risk Factors) and in the other documents filed by us with the Securities and Exchange Commission (“SEC”) in evaluating our forward-looking statements. We have no plans, and undertake no obligation, to revise or update our forward-looking statements to reflect any event or circumstance that may arise after the date of this report. We caution readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. +This Annual Report also contains estimates made by independent parties and by us relating to market size and growth and other industry data. These estimates involve a number of assumptions and limitations and you are cautioned not to give undue weight to such estimates. In addition, projections, assumptions and estimates of our future performance and the future performance of the industries in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of important factors, including those described in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. These and other factors could cause results to differ materially and adversely from those expressed in the estimates made by the independent parties and by us. +In this document, the words “we”, “our”, “ours”, “us”, “Skyworks”, and “the Company” refer only to Skyworks Solutions, Inc., and its consolidated subsidiaries and not any other person or entity. In addition, the following is a list of industry standards that may be referenced throughout the document: +• 5G (Fifth Generation): next-generation cellular network technology +• ASoC (Analog System on Chip): combines the required electronic circuits of various computer components into a single, integrated chip +• BAW (Bulk Acoustic Wave): electrical input signal is converted to an acoustic wave for filtering and converted back into an electrical signal by a metal-piezo-metal vertical structure +• BiFET (Bipolar Field Effect Transistor): integrates indium gallium phosphide–based heterojunction bipolar transistors with field effect transistors on the same gallium arsenide substrate +• DC (Direct Current): unidirectional flow of an electrical charge +• CMOS (Complementary Metal Oxide Semiconductor): a technology of constructing integrated circuits +• GaAs (Gallium Arsenide): a compound of the elements gallium and arsenic that is used in the production of semiconductors +• HBT (Heterojunction Bipolar Transistor): a type of bipolar junction transistor which uses differing semiconductor materials for the emitter and base regions, creating a heterojunction +• IoT (Internet of Things): the interconnection of uniquely identifiable embedded computing devices within the existing internet infrastructure +• LED (Light Emitting Diode): a two-lead semiconductor light source +• LTE (Long Term Evolution): 4th generation (“4G”) radio technologies designed to increase the capacity and speed of mobile telephone networks +• MIMO (Multiple In, Multiple Out): a method for multiplying the capacity of a radio link using multiple transmission and receiving antennas to exploit multipath propagation; more commonly, it refers to LTE, 5G, and Wi-Fi techniques to send more than one data signal (also known as data layers) with encoded information to increase capacity in modern telecommunications systems +• pHEMT (Pseudomorphic High Electron Mobility Transistor): a type of field effect transistor incorporating a junction between two materials with different band gaps +• RF (Radio Frequency): electromagnetic wave frequencies that lie in the range extending from around 3 kHz to 300 GHz +• SAW (Surface Acoustic Wave): electrical input signal is converted to an acoustic wave for filtering and converted back into an electrical signal by interdigitated transducers on a piezoelectric substrate +• SOI (Silicon On Insulator): technology refers to the use of layered silicon-insulator-silicon substrate in place of conventional silicon substrates in semiconductor manufacturing +• TC-SAW (Temperature Compensated Surface Acoustic Wave): SAW filters that have been designed to reduce shift in frequency over temperature +Skyworks and the Skyworks symbol are trademarks or registered trademarks of Skyworks Solutions, Inc. or its subsidiaries in the United States and other countries. Third-party brands and names are for identification purposes only and are the property of their respective owners. +PART l +ITEM 1. BUSINESS. +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, entertainment and gaming, industrial, medical, military, smartphone, tablet, and wearable markets. +Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto (a Thales company), General Electric, Fibocom, Google, Honeywell, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi, and ZTE. Our competitors include Analog Devices, Broadcom, Cirrus Logic, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, Qorvo, and Qualcomm. +We operate worldwide with engineering, manufacturing, sales, and service facilities throughout Asia, Europe, and North America. Our Internet address is www.skyworksinc.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we electronically submit such material to the SEC. The information contained on our website is not incorporated by reference in this Annual Report. Our SEC filings are also available to the public at www.sec.gov. +In August 2018, we acquired Avnera Corporation (“Avnera”) and expanded our leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors, and integrated software. The acquisition of Avnera enables us to capitalize on the rapid proliferation of audio functionality and its convergence with our advanced connectivity solutions. With our global sales channels, strong customer relationships and operational scale, we are leveraging Avnera’s innovative product portfolio and systems expertise to increase our footprint in automotive, industrial, home automation, enterprise, and high-end consumer markets. +Industry Background +Wireless connectivity is exploding on a global basis. The COVID-19 pandemic has underscored the importance of our mission of connecting everyone and everything, all the time. Work-from-home, remote healthcare, virtual education, and other social distancing trends, driven in part by the pandemic, have propelled an extraordinary need for faster speeds, increased bandwidth and capacity, significantly lower latency, and more reliable and secure wireless connectivity. +5G is dramatically altering the world, creating a market for diverse and transformative applications, and changing how individuals live, work, play, and learn. Most of the world’s largest economies now have functioning commercial 5G networks, and the world’s leading smartphone manufacturers have released 5G-enabled devices. The transition from 4G to 5G has just started, and according to a June 2020 Ericsson “Mobility Report,” there are expected to be 2.8 billion mobile 5G subscriptions globally by the end of 2025. +At the same time, connectivity is expanding into an adjacent set of IoT markets. From smart homes to the smart grid and from industrial to wearables, the number of connected devices is rapidly proliferating. ABI Research IoT Market Tracker forecasts 117 billion IoT connections by 2026. Skyworks is enabling these opportunities with highly customized system solutions supporting a broad set of wireless protocols including cellular LTE, Wi-Fi, Bluetooth®, LoRa®, Thread and Zigbee®. In addition, next-generation Wi-Fi 6 products are emerging as the standard offering across enterprise, carrier, and retail segments and are expected to accelerate the deployment of IoT devices. ABI Research anticipates relatively swift adoption with 1.4 billion Wi-Fi 6E chipset shipments by 2025. +Looking forward, we see significant growth opportunity for our industry and for Skyworks. The key catalysts for Skyworks will continue to be the insatiable demand for data and the profitable usage model, as each connection becomes more valuable and the world embraces 5G. +Solving Connectivity Challenges +We expect that highly integrated semiconductor solutions will play an increasingly pivotal role in the deployment of this next generation standard by resolving the daunting analog and RF complexities that are challenging the capabilities of existing hardware and the supporting network infrastructure. Meeting these design challenges requires broad competencies including +signal transmission and conditioning, the ability to ensure seamless hand-offs between multiple standards, power management, voltage regulation, battery charging, advanced filtering, and tuning. +Skyworks is at the forefront of this sea change in connectivity, delivering the solutions that will enable the true potential of 5G and the IoT. We have a rich heritage in analog systems design and have spent years investing in key technologies and resources. Our strength is underpinned by world-class performance and scale across a broad array of capabilities that include advanced TC-SAW and BAW filters, an expanded family of MIMO, ultra-high band, and diversity receive modules and expanding into emerging technologies. From our breakthrough Sky5® unifying platform to our 5G small cell solutions, Skyworks’ approach across both infrastructure and user equipment facilitates powerful, high-speed end-to-end 5G connectivity. +Skyworks' Strategy +Our ambitious vision is to connect everyone and everything, all the time. To this end, key elements of our strategy include: +Industry-Leading Technology +As the industry migrates to more complex 5G architectures across a multitude of wireless applications, we are well positioned to help mobile device manufacturers handle growing levels of system complexity in the transmit and receive chain. The trend towards increasing front-end and analog design challenges in smartphones and other platforms plays directly into our core strengths and positions us to address these challenges. We believe that we offer the broadest portfolio of radio and analog solutions from the transceiver to the antenna as well as all required manufacturing process technologies. We also hold strong technology leadership positions in passive devices, advanced integration including proprietary shielding and 3-D die stacking as well as SAW, TC-SAW and BAW filters. Our product portfolio is reinforced by a library of approximately 3,950 worldwide patents and other intellectual property that we own and control. Together, our industry-leading technology enables us to deliver the highest levels of product performance and integration. +Customer Relationships +Given our scale and technology leadership, we are engaged with key original equipment manufacturers (“OEMs”), smartphone providers and baseband reference design partners. Our customers value our global supply chain, our innovative technology and our system engineering expertise, resulting in deep customer loyalty. We partner with our customers to support their long-term product road maps and are valued as a system solutions provider rather than just a point product vendor. +Diversification +We are diversifying our business in three areas: our addressed markets, our customer base, and our product offerings. By leveraging core analog and mixed signal technologies, we are expanding our family of solutions to a set of increasingly diverse end markets and customers. With the adoption of 5G and the opportunity to enable more applications, we are steadily growing our business beyond just mobile devices (where we support all top-tier manufacturers, including the leading smartphone suppliers and key baseband vendors) into additional high-performance analog markets, including automotive, home and factory automation, infrastructure, aerospace and defense, medical, smart energy, and wireless networking. In these markets we leverage our scale, intellectual property, and worldwide distribution network, which spans over 3,200 customers and over 2,500 analog components. +Delivering Operational Excellence +We vertically integrate our supply chain where we can differentiate with highly specialized internal manufacturing capabilities or enter into alliances and strategic relationships for leading-edge technologies. This hybrid manufacturing model allows us to better balance our manufacturing capacity with the demand of the marketplace. Our internal capacity utilization remains high, resulting in stable gross margins and strong return on invested capital on a broader range of revenue. +Additionally, we continue to drive reductions in product design and manufacturing cycle times and further improve product yields. The combination of agile, flexible capacity and world-class module manufacturing and scale advantage allows us to achieve low product costs while integrating multiple technologies into highly sophisticated multi-chip modules. +Maintaining a Performance-Driven Culture +We consider our people and corporate culture to be a major competitive advantage and a key driver of our overall strategy. We create key performance indicators that align employee efforts with corporate strategy and link responsibilities with performance measurement. Accountability is paramount, and we compensate our employees through a pay-for-performance methodology. We strive to be an employer-of-choice among peer companies and have created a work environment in which turnover is below geographic and industry averages. +Generating Superior Operating Results and Shareholder Returns +We seek to generate financial returns that are comparable to a highly diversified analog semiconductor company. Given our product volume and overall utilization we strive to achieve a best-in-class return on investment and operating income to reward shareholders. +Our Product Portfolio +Our product portfolio consists of various solutions, including: +• Amplifiers: the modules that strengthen the signal so that it has sufficient energy to reach a base station +• Antenna Tuners: aperture and impedance tuning products that improve antenna performance across frequencies +• Attenuators: circuits that allow a known source of power to be reduced by a predetermined factor (usually expressed as decibels) +• Circulators/Isolators: ferrite-based components commonly found on the output of high-power amplifiers used to protect receivers in wireless transmission systems +• Wireless ASoC: an intelligent 2.4 GHz and 5GHz wireless radio integrated circuit that includes all the analog and digital functions optimized for building cognitive wireless audio headsets, headphones, and wireless speaker systems +• DC/DC Converters: an electronic circuit which converts a source of direct current from one voltage level to another +• Demodulators: a device or an RF block used in receivers to extract the information that has been modulated onto a carrier or from the carrier itself +• Detectors: devices used to measure and control RF power in wireless systems +• Diodes: semiconductor devices that pass current in one direction only +• Directional Couplers: transmission coupling devices for separately sampling the forward or backward wave in a transmission line +• Diversity Receive Modules: devices used to improve receiver sensitivity in high data rate applications +• Filters: devices for recovering and separating mixed and modulated data in RF stages, including SAW, TC-SAW, and BAW filters +• Front-end Modules: two or more functions co-packaged to optimize the performance, cost, and application suitability in products, including intermediate or radio frequency signal paths +• Hybrid: a type of directional coupler used in radio and telecommunications +• LED Drivers: devices which regulate the current through a light emitting diode or string of diodes for the purpose of creating light +• Low Noise Amplifiers: devices used to reduce system noise figure in the receive chain +• Mixers: devices that enable signals to be converted to a higher or lower frequency signal and thereby allowing the signals to be processed more effectively +• Modulators: devices that take a baseband input signal and output a radio frequency modulated signal +• Optocouplers/Optoisolators: semiconductor devices that allow signals to be transferred between circuits or systems while ensuring that the circuits or systems are electrically isolated from each other +• Phase Locked Loops: closed-loop feedback control system that maintains a generated signal in a fixed phase relationship to a reference signal +• Phase Shifters: designed for use in power amplifier distortion compensation circuits in base station applications +• Power Dividers/Combiners: utilized to equally split signals into in-phase signals as often found in balanced signal chains and local oscillator distribution networks +• Receivers: electronic devices that change a radio signal from a transmitter into useful information +• Switches: components that perform the change between the transmit and receive function, as well as the band function for cellular handsets +• Synthesizers: devices that provide ultra-fine frequency resolution, fast switching speed, and low phase-noise performance +• Technical Ceramics: polycrystalline oxide materials used for a wide variety of electrical, mechanical, thermal, and magnetic applications +• Voltage Controlled Oscillators/Synthesizers: fully integrated, high performance signal source for high dynamic range transceivers +• Voltage Regulators: generate a fixed level which ideally remains constant over varying input voltage or load conditions +We believe we possess broad technology capabilities and one of the most complete wireless communications product portfolios in the industry. +Marketing and Distribution +Our products are sold globally through a direct sales force, electronic component distributors and independent sales representatives. Certain distributors have agreements with us which allow for certain sales returns, stock rotations and price protection on certain inventory if we lower the price of those products (see “Critical Accounting Estimates” in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to Item 8 of this Annual Report on Form 10-K for further detail on revenue reserves). As is customary in the semiconductor industry, our distributors may also market other products that compete with ours. +Our sales engagement begins at the earliest stages of the design of an existing or potential customer’s product. We collaborate technically with our customers and reference design partners at the inception of new programs. These relationships allow our team to facilitate customer-driven solutions, which leverage the unique strength of our intellectual property and product portfolio while providing high value and greatly reducing time-to-market. +We believe the technical and complex nature of our products and markets demand an extraordinary commitment to maintain close ongoing relationships with our customers. As such, we strive to expand the scope of our customer relationship to include design, engineering, manufacturing, procurement, logistics, and project management. We also employ a collaborative approach in developing these relationships by combining the support of our design teams, applications engineers, manufacturing personnel, sales and marketing staff and senior management. Lastly, we leverage our customer relationships with cross-selling opportunities across product lines in order to maximize revenue. +We believe that maintaining frequent and interactive contact with our customers is paramount to our continuous efforts to provide world-class sales and service support. By listening and responding to feedback, we are able to mobilize resources to raise our level of customer satisfaction, improve our ability to anticipate future product needs, and enhance our understanding of key market dynamics. We are confident that diligently following this path positions us to participate in numerous opportunities for growth in the future. +Customer Concentration +A small number of OEMs historically has accounted for a significant portion of our net revenue. In the fiscal years ended October 2, 2020 (“fiscal 2020”), September 27, 2019 (“fiscal 2019”), and September 28, 2018 (“fiscal 2018”), Apple Inc. (“Apple”), through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches, and other devices, constituted more than ten percent of our net revenue. For further information regarding customer concentrations see Note 14 to Item 8 of this Annual Report on Form 10-K. +Intellectual Property and Proprietary Rights +We own or have a license to use numerous United States and foreign patents and patent applications related to our products and our manufacturing operations and processes. In addition, we own a number of trademarks and service marks applicable to certain of our products and services. We believe that our intellectual property, including patents, patent applications, trade secrets and trademarks, is of material importance to our business. We rely on patent, copyright, trademark, trade secret, and other intellectual property laws, as well as non-disclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, designs, devices, algorithms, processes, and other intellectual property. Our efforts may not meaningfully protect our intellectual property, or others may independently develop substantially equivalent or superior proprietary technologies, designs, devices, algorithms, processes, or other intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and effective copyright, patent, trademark, and trade secret protection may not be available in those jurisdictions. In addition to protecting our intellectual property, we strive to strengthen our intellectual property portfolio to enhance our ability to obtain cross-licenses of intellectual property from others, to obtain access to intellectual property we do not possess and to more favorably resolve potential intellectual property claims against us. Due to rapid technological changes in the industry, we believe establishing and maintaining a technological leadership position depends primarily on our ability to develop new, innovative products through the technical competence of our engineering personnel. +Competitive Conditions +The competitive environment in the semiconductor industry is in a constant state of flux, with new products continually emerging and existing products approaching technological obsolescence. We compete on the basis of time-to-market, new product innovation, quality, performance, price, compliance with industry standards, strategic relationships with customers and baseband vendors, personnel, and protection of our intellectual property. We participate in highly competitive markets against numerous competitors that may be able to adapt more quickly than we can to new or emerging technologies and changes in +customer requirements, or may be able to devote greater resources to the development, promotion, and sale of their products than we can. +Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. We mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs and lower manufacturing costs of existing products and by introducing new and higher value-added products. +Research and Development +Our products and markets demand rapid technological advancements requiring a continuous effort to enhance existing products and develop new products and technologies. Accordingly, we maintain a high level of research and development activity. We invested $464.1 million, $424.1 million, and $404.5 million in research and development during fiscal 2020, fiscal 2019, and fiscal 2018, respectively. The growth in research and development expenses were the result of increases in our internal product designs and product development activity for our target markets in each of these fiscal years. Our research and development expenses include new product development and innovations in integrated circuit design, investment in advanced semiconductor manufacturing processes, development of new packaging and test capabilities and research on next generation technologies and product opportunities. We maintain close collaborative relationships with many of our customers to help identify market demands and target our development efforts to meet those demands. +Raw Materials +Raw materials for our products and manufacturing processes are generally available from several sources. It is our intent not to depend on a sole source of supply unless market or other conditions dictate otherwise. However, there are limited situations where we procure certain components and services for our products from single or limited sources, and we are currently dependent on a limited number of sole source suppliers. We purchase materials and services primarily pursuant to individual purchase orders. However, we have entered into certain supply agreements for the purchase of raw materials or other manufacturing related services that specify minimum prices and purchase quantity based on our anticipated future requirements. Such amounts are reviewed and included in our contractual obligations and commitments as required. Certain of our suppliers consign raw materials to us at our manufacturing facilities to which we take title as needed in our manufacturing process. We believe we have adequate sources for the supply of raw materials and components for our manufacturing needs with suppliers located around the world. +Backlog and Inventory +Our sales are primarily from the sale of semiconductor products under individual customer purchase orders, some of which have underlying master sales agreements that specify terms governing the product sales. In the absence of a sales agreement, the Company’s standard terms and conditions apply. We also maintain Skyworks-owned finished goods inventory at certain customer “hub” locations. We do not recognize revenue until these customers consume the Skyworks-owned inventory from these hub locations. Due to industry practice, which allows customers to cancel orders with limited advance notice to us prior to shipment, and with little or no penalty, we believe that backlog as of any particular date may not be a reliable indicator of our future revenue levels. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volume could result in a reduction in revenue and us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. +Government Regulations +We are subject to international, federal, state, and local legislation, regulations, and other requirements relating to the discharge of substances into the environment; the treatment, transport, and disposal of hazardous wastes; recycling and product packaging; worker health and safety; and other activities affecting the environment, our workforce, and the management of our manufacturing operations. In addition, most of our customers have mandated that our operations and our products comply with various “green” initiatives and workers’ rights initiatives initiated by such customers, industry groups in which such customers participate, or the jurisdictions in which such customers operate. We believe that our operations and facilities comply in all material respects with applicable environmental laws and worker health and safety laws. Our efforts to comply with environmental laws and worker health and safety laws (including laws or regulations promulgated in response to the ongoing COVID-19 pandemic, as discussed below in Item 1A, Risk Factors) could have material impacts on our capital expenditures, competitive position, or financial condition, though the magnitude and duration of such impacts are uncertain and difficult to quantify. +We are also subject to import/export controls, tariffs, and other trade-related regulations and restrictions in the countries in which we have operations or otherwise do business. These controls, tariffs, regulations, and restrictions (including those related +to, or affected by, United States-China relations, as discussed below in Item 1A, Risk Factors) have had, and we believe may continue to have, a material impact on our business, including our ability to sell products and to manufacture or source components. +Government regulations are subject to change in the future, and accordingly we are unable to assess the possible effect of compliance with future requirements or whether our compliance with such regulations will materially impact our business, results of operations, or financial condition. +Seasonality +Sales of our products are subject to seasonal fluctuation and periods of increased demand in end-user consumer applications, such as smartphones and tablet computing devices. The highest demand for our products generally occurs in our first fiscal quarter ending in December and the fourth fiscal quarter ending in September. The lowest demand for our handset products generally occurs in our second fiscal quarter ending in March and the third fiscal quarter ending in June. +Employees +Skyworks’ workforce consists of approximately 10,000 employees located around the world, more than 99% of whom are full-time employees. As of October 2, 2020: +• Our workforce was distributed geographically approximately as follows: 61% in Mexico, 21% in the United States, 17% in Asia, 1% in Canada, and less than 1% in Europe. +• Our workforce was distributed by function approximately as follows: 51% in individual contributor manufacturing roles, 29% in engineering or technician roles, 10% in managerial roles, and 10% in professional or other administrative roles. +• Approximately 3,550 of our employees in Mexico, 670 of our employees in Singapore, and 350 of our employees in Japan were covered by collective bargaining and other union agreements. +In managing our business, we focus on attracting and retaining employees by providing compensation and benefits packages that are competitive within the applicable market, taking into account the job position’s location and responsibilities. Nearly all full-time employees across the globe are eligible to participate in one of the Company’s incentive plans, under which payments are tied to pre-established performance goals. In addition, we believe that developing our employees’ skillsets and decision-making abilities—through challenging project assignments, formal training, mentorship, and recognition—is key not only to our employees’ job satisfaction and our retention efforts, but also to maintaining a strong leadership pipeline. +ITEM 1A. RISK FACTORS. +You should carefully consider the risks described below, some of which have manifested and any of which may occur in the future, in addition to the other information contained in this report before making an investment decision with respect to any of our securities. Our business, results of operations, and financial condition could be materially and adversely impacted by any of these risks, which could in turn adversely affect our stock price. Additional risks not currently known to us or other factors not perceived by us as material risks could also present significant risks to our business. +Risks associated with operating a global business in many international jurisdictions +The effects of the global COVID-19 pandemic are adversely affecting our business operations. +The ongoing global COVID-19 pandemic—including both the resulting public health crisis as well as the measures being taken by governments, businesses, and individuals in an effort to limit COVID-19’s spread—has adversely affected, and continues to adversely affect, our business operations. The impacts of the COVID-19 pandemic on our business operations and workforce, and the duration of such impacts, are uncertain, constantly evolving, and difficult to quantify, but have thus far included, or in the future may include, the following: +• We have experienced large fluctuations in the demand for our products, including a significant decrease in overall demand in the initial stages of the pandemic followed more recently by substantial increases in demand for certain of our products. We may experience continued large fluctuations in demand or a reduction in the pricing of our products, either of which could be exacerbated by a continued or deepening global economic downturn or recession caused by the ongoing COVID-19 pandemic. +• In April 2020, we suspended our operations in Mexicali, Mexico, for approximately two weeks pursuant to an order by the government of the state of Baja California, Mexico, resulting in the temporary reduction in our production levels. In the event that our manufacturing operations in Mexicali become subject to significant restrictions or are suspended again, or in the event that one or more of our other facilities is forced to suspend or limit its activities, including, but not limited to, as a result of such operations or activities not being considered to be an “essential” business under applicable laws, regulations, or orders (including “shelter at home” orders or other quarantine-related orders), we may experience further reductions in production levels, which would limit our ability to meet customer demand and impact our operating results. +• We have implemented certain measures at our facilities worldwide in an effort to protect our employees’ health and well-being (including social distancing, allowing many employees to work remotely, limiting the number of employees attending meetings, screening employees and visitors when entering facilities, educating employees about the virus and preventative measures, enhancing cleaning protocols, and suspending employee travel), some of which have reduced the overall efficiency of our operations and increased manufacturing costs. The expected duration of such protective measures remains uncertain, and we may be required to implement additional measures in the future, further impacting our business operations. +• We have experienced, and may continue to experience, reduced production capacity as a result of employee quarantines, absenteeism, and attrition, as well as restrictions on certain of our employees’ ability to work. Additionally, we may experience negative impacts to our sales, marketing, research and development, and other critical business functions for similar reasons. +• Given the difficulty of forecasting demand and supply needs, and given that our suppliers are facing similar challenges as a result of the pandemic, we have experienced, and may continue to experience, disruptions to our supply chain in connection with the sourcing of materials, components, equipment, assembly and test services, engineering support, and other services. +• We have experienced, and may continue to experience, disruptions to global transportation networks, limiting or delaying our ability, and/or increasing our cost, to send or receive products and materials at one or more of our facilities, including as a result of trade restrictions, border closures, or disruptions in the operations of third-party carriers. +• Significant portions of our sales are concentrated among a limited number of customers. We may experience negative impacts to our business operations if one or more of these major customers were to significantly decrease its orders for our products due to disruptions to its business operations or other pandemic-related issues. +• Our business operations, as well as the business operations of our customers, suppliers, and other third-party service providers, are subject to frequent and unpredictable changes in the political, regulatory, legal, or economic conditions in the jurisdictions in which they operate. +• The deterioration of worldwide credit and financial markets could limit the ability of our customers to pay for product purchases in a timely manner, or at all. +• In the event we are unable to fulfill our contractual obligations, lawsuits may be threatened or filed against us by customers or other third parties. In addition, force majeure clauses in our contracts could limit our ability to pursue remedies for certain third-party disruptions and delays. +11 +These effects, alone or taken together, could have a material adverse effect on our business, results of operations, customer and supplier relations, employee relations, cash flows, and financial condition. The resumption of normal business operations after any such interruptions may be delayed or constrained by lingering effects of COVID-19 on our customers, suppliers, and other third-party service providers. There can be no assurance that any decrease in sales resulting from COVID-19 will be offset by increased sales in subsequent periods. +The degree to which COVID-19 impacts us will depend on future developments that are highly uncertain and cannot be predicted, including, but not limited to, the duration and spread of the pandemic, its severity, the actions to contain COVID-19 or treat its impact, the timing and magnitude of the U.S. government’s economic stimulus efforts, and how quickly and to what extent normal economic and operating conditions resume. Even after the COVID-19 pandemic has subsided as a public health matter, we may experience material adverse impacts to our business as a result of its adverse impact on the global economy. +The risks of doing business internationally apply to all aspects of our operations. +We derive significant revenues from customers located outside the United States, primarily in countries located in the Asia-Pacific region and Europe. We have suppliers located outside the United States, and third-party packaging, assembly, and test facilities and foundries located in the Asia-Pacific region. We also operate our own wafer fabrication facilities in Kadoma, Japan, and Osaka, Japan, as well as packaging, assembly, and test facilities in Mexicali, Mexico, and in Singapore (with a substantial majority of our finished products being assembled and tested in our Mexicali facility). Our international sales and operations are subject to a number of risks inherent in selling and operating abroad. These include, but are not limited to, risks regarding: +• currency exchange rate fluctuations, including increases or decreases in commodities prices related to such fluctuations, +• local economic and political conditions, including, but not limited to, social, economic, and political instability related to the uncertainty regarding the relationships between the United States and China, Russia, Mexico, North Korea, Middle Eastern countries, other foreign countries, and the international community at large, and related to the United Kingdom’s withdrawal from the European Union, +• restrictive governmental actions (such as restrictions on transfer of funds, restrictions on individuals’ movement, including travel restrictions, quarantines, lockdowns, and curfews, and trade protection measures, including export duties, quotas, customs duties, border taxes, border closures, increased import or export controls, and tariffs), or actions by non-governmental individuals and groups (such as protests, insurgencies, and organized crime), that could negatively impact trade between, or increase the cost of operating in, the countries in which we do business, +• labor market conditions and laws, +• disruptions of capital and trading markets, +• inability to collect accounts receivable, +• changes in, or non-compliance with, legal or regulatory import/export requirements, including restrictions on selling to certain customers or into certain jurisdictions, +• natural disasters, acts of terrorism, widespread illness or other deterioration of public health conditions, and war, +• misappropriation or other unauthorized transfers of our electronic information and breaches of our information systems, as well as the potential lack of adequate remedies in certain jurisdictions, +• difficulty in engaging distribution partners or obtaining sales or other business support in certain jurisdictions, +• cultural differences in the conduct of business, +• direct or indirect government actions, subsidies, or policies aimed at supporting local industry, +• the laws and policies of the United States and other countries affecting trade, foreign investment and loans, foreign travel, and import or export licensing requirements, +• withdrawal from, or renegotiation of, existing trade agreements by the United States (or other jurisdictions) potentially affecting Mexico, China, and other countries in which we do business, +• changes in current or future tax law or regulations or new interpretations thereof, by federal or state agencies or foreign governments (including changes in certain countries in Europe and elsewhere regarding corporate taxes, transfer pricing, and tax treaty provisions), +• changes in the effective tax rate as a result of our overall profitability and mix of earnings in countries with differing statutory tax rates, +• results of audits and examination of previously filed tax returns, +• the possibility of being exposed to legal proceedings and potential penalties in a foreign jurisdiction, and/or increased compliance expense, as a result of the numerous, and sometimes conflicting, legal regimes on matters as diverse as anti-corruption, anti-bribery, import/export controls, content requirements, trade restrictions, tariffs, taxation, sanctions, immigration, internal and disclosure control obligations, securities regulation, anti-competition, data privacy and protection (including, but not limited to, the European Union’s General Data Protection Regulation), employment, and labor relations, and +12 +• limitations on our ability under local laws to protect or enforce our intellectual property rights in a particular foreign jurisdiction. +Additionally, we are subject to risks in certain global markets in which wireless operators provide subsidies on handset sales to their customers. Increases in cellular handset prices that negatively impact handset sales can result from changes in regulatory policies or other factors, which could impact the demand for our products. Limitations or changes in policy on phone subsidies in the United States, South Korea, Japan, China, and other countries may have additional negative impacts on our revenues. +Some of the countries in which we operate and seek to expand are in emerging markets where legal systems may be less developed or familiar to us, potentially impacting our ability to obtain appropriate recourse in the event of a dispute. Other jurisdictions in which we conduct business may establish legal and regulatory regimes that differ materially from United States laws and regulations. Compliance with diverse legal requirements is costly and time-consuming and requires significant resources. Violations of one or more of these regulations in the conduct of our business could result in significant fines or monetary damages, criminal sanctions against us or our officers, prohibitions on doing business, unfavorable publicity and other reputation damage, restrictions on our ability to process information, and allegations by our clients that we have not performed our contractual obligations. +We are subject to the risks of doing business in China. +Although we intend to expand our business and operations in China, our success in the Chinese markets may be adversely affected by China’s continuously evolving laws and regulations, including those relating to taxation, import and export tariffs and restrictions, currency controls, environmental regulations, indigenous innovation, and intellectual property rights and enforcement of those rights. Enforcement of existing laws or agreements may be inconsistent, and the potential issuance of new laws and regulations creates uncertainty. In addition, changes in the political environment, governmental policies or United States-China relations could result in revisions to laws or regulations or their interpretation and enforcement, exposure of our proprietary intellectual property, increased taxation, restrictions on imports, import duties, or currency revaluations, which could have an adverse effect on our business plans and operating results. In particular, the imposition by the United States of tariffs on goods imported from China or deemed to be of Chinese origin and other government actions that restrict our ability to sell our products to Chinese customers or to manufacture or source components in China, and countermeasures imposed by China in response, could directly or indirectly adversely impact our manufacturing costs and the sales of our products in China and elsewhere. For example, during fiscal 2019, the U.S. Bureau of Industry and Security of the U.S. Department of Commerce placed Huawei Technology Co., Ltd., and certain of its affiliates (collectively, “Huawei”) on the Bureau’s Entity List (the “Entity List”), which resulted in our temporarily suspending shipments to Huawei. During fiscal 2020, the addition of other entities to the Entity List (with the prospect of more entities to be added in the future), together with changes to rules regarding the shipment of foreign direct products, again resulted in the suspension of shipments to Huawei. In the absence of further changes to applicable export laws and regulations, we will only be able to sell our products to Huawei and potentially other companies named on the Entity List pursuant to limited export licenses from the U.S. Department of Commerce. Further, the evolving labor market and increasing labor unrest in China may have a negative impact on our customers, which would result in a negative impact on our business, results of operations, and financial condition. Finally, China’s stated policy of reducing its dependence on foreign semiconductor manufacturers and other technology companies could result in reduced demand for our products in China and other key markets as well as reduced supply of critical materials for our products. +Changes in tax laws and regulations could have an adverse impact on our operating results. +We are subject to taxation in many different countries and localities worldwide. To the extent the tax laws and regulations in these various countries and localities could change, our tax liability in general could increase. +On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act (the “Tax Reform Act”), which significantly reformed the U.S. Internal Revenue Code of 1986, as amended, and has had, and may continue to have, a significant impact on our operations. +Because the changes in U.S. tax law require a number of complex calculations that previously were not required, our actual tax liability may differ materially from our income tax provisions, estimates, and accruals. Changes in our interpretations and assumptions, as well as additional guidance issued under these laws, could increase income tax liabilities and/or reduce certain tax benefits. It is also possible that Congress will enact legislation in connection with the COVID-19 pandemic in addition to the Families First Coronavirus Response Act and the Coronavirus Aid, Relief, and Economic Security Act enacted in March 2020, some of which could have an impact on our operations. In addition, it is uncertain if and to what extent various states will conform to the Tax Reform Act or other changes to tax law. +13 +Future changes in tax laws, regulations, and treaties, or the interpretation thereof, in addition to initiatives related to the Base Erosion and Profit Shifting Project of the Organisation for Economic Co-Operation and Development; the European Commission’s “state aid” investigations; and other developments could have an adverse effect on the taxation of international businesses, including our own. Furthermore, countries where we are subject to taxes, including the United States, evaluate their tax policies and rules on a regular basis, and we may see significant changes in legislation and regulations concerning taxation (including as a result of any changes proposed during the next U.S. presidential administration). +We are unable to predict what tax changes may be enacted in the future or what effect such changes would have on our business, but such changes could affect our effective tax rates in countries where we have operations and could have an adverse effect on our overall tax position in the future, along with increasing the complexity, burden, and cost of tax compliance. +Risks associated with the development, manufacturing, and sale of our products +Our operating results may be adversely affected by quarterly and annual fluctuations and market downturns. +Our revenues, earnings, and other operating results may fluctuate significantly on a quarterly and annual basis. These fluctuations are typically the result of a number of factors, many of which are beyond our control. +These factors include, among others: +• delays in the widespread deployment of commercial 5G networks or in consumer adoption of 5G-enabled devices, +• changes in end-user demand for the products manufactured and sold by our customers, +• the effects of competitive pricing pressures, including decreases in average selling prices of our products, +• production capacity levels and fluctuations in manufacturing yields, +• availability and cost of materials and services from our suppliers, +• the gain or loss of significant customers, +• our ability to develop, introduce, and market new products and technologies on a timely basis, +• market acceptance of our products and our customer’s products (including, but not limited to, market acceptance of new, emerging technologies), +• new product and technology introductions by competitors, +• delays in the adoption of standards by standard-setting bodies and delays in the commercial deployment or consumer adoption of certain technologies, +• actions by government regulators to restrict or delay the availability of sufficient spectrum for wireless technologies, including technologies that utilize unlicensed spectrum and/or shared spectrum, +• changes in consumers’ rates of replacement of smartphones and other devices that utilize our products, +• increasing industry consolidation among our competitors, +• changes in the mix of products produced and sold, and +• intellectual property disputes, including those concerning payments associated with the licensing and/or sale of intellectual property, and related remedies (e.g., monetary damages, injunctions, or exclusion orders affecting our or our customers’ products). +We employ certain methods, assumptions, estimates, and other subjective judgments in order to apply our accounting policies and to project future performance, and such projections may be publicly disclosed from time to time. Changes to such methods, assumptions, estimates, and judgments, combined with other factors that are difficult to forecast, including the factors listed above, could materially and adversely affect our quarterly or annual operating results and could produce actual operating results that differ significantly from previous estimates and projections. If our operating results fail to meet the expectations of analysts or investors, it could materially and adversely affect the price of our common stock. +We rely on a small number of customers for a large portion of our sales. +Significant portions of our sales are concentrated among a limited number of customers. If we lost one or more of these major customers, or if one or more major customers significantly decreased its orders for our products, our business, results of operations, and financial condition could be materially and adversely impacted, which could adversely affect our stock price. In each of fiscal 2020, fiscal 2019, and fiscal 2018, one customer accounted for greater than ten percent of our net revenue. For further discussion see Note 14 to Item 8 of this Annual Report on Form 10-K. +We rely on Original Equipment Manufacturers (“OEMs”) and Original Design Manufacturers (“ODMs”) to design our products into their end products. +Our products are not sold directly to the end user but are components or subsystems of other products. As a result, we rely on OEMs and ODMs of wireless communications electronics products to select our products from among alternative offerings to be designed into their equipment. Without these “design wins,” we would have difficulty selling our products. If a manufacturer designs another supplier’s product into one of its product platforms, it is more difficult for us to achieve future design wins with that platform because changing suppliers involves significant cost, time, effort, and risk on the part of that manufacturer. Also, +14 +achieving a design win with a customer does not ensure that we will receive revenue from that customer. Even after a design win, the customer is not obligated to purchase our products and can choose at any time to reduce or cease use of our products, for example, if its own products are not commercially successful, or for any other reason. We may not continue to achieve design wins or to convert design wins into actual sales, and failure to do so could materially and adversely affect our operating results. Furthermore, as a result of our lengthy product development and sales cycle, we may incur significant research and development expenses, and selling, general, and administrative expenses, without generating the anticipated revenue associated with these products. +Our manufacturing processes are extremely complex, specialized, and subject to disruption. +Our manufacturing operations are complex and subject to disruption, including due to causes beyond our control. The fabrication of integrated circuits is an extremely complex and precise process consisting of hundreds of separate steps. It requires production in a highly controlled, clean environment. Minor impurities, contamination of the clean room environment in which our products are produced, errors in any step of the fabrication process, defects in the masks used to print circuits on a wafer, defects in equipment or materials, human error, or a number of other factors can cause a substantial percentage of our products to be rejected or to malfunction. Because our operating results are highly dependent upon our ability to produce integrated circuits at acceptable manufacturing yields, these factors could have a material and adverse effect on our business. +Additionally, our operations may be affected by lengthy or recurring disruptions of operations at any of our production facilities, as well as disruptions at facilities operated by our subcontractors or customers. These disruptions may result from electrical power outages, fire, earthquake, flooding, war, acts of terrorism, health advisories or risks, or other natural or man-made disasters, as well as equipment maintenance, repairs, and/or upgrades. Disruptions of our manufacturing operations, or those of our subcontractors and customers, could cause significant delays in shipments until we are able to shift production of the impacted products from an affected facility or subcontractor to another facility or subcontractor, or until the affected customer resumes operations and accepts shipments from us. In the event of such delays, the required alternative capacity, particularly wafer production capacity, may not be available on a timely basis or at all. Even if alternative production capacity is available, we may not be able to obtain it on favorable terms, which could result in higher costs and/or a loss of customers and revenue. Likewise, lower-than-expected demand could lead to underutilized manufacturing facilities, which could negatively impact our financial results. +Due to the highly specialized nature of our manufacturing processes, in the event of a disruption in production at one or more of our facilities for any reason, alternative production capacity would not be immediately available from third-party sources. These disruptions could have a material adverse effect on our business, results of operations, and financial condition. Our key facilities include, but are not limited to, our semiconductor wafer fabrication facilities in Newbury Park, California, and Woburn, Massachusetts, our SAW, TC-SAW, and BAW filter wafer fabrication facilities in Kadoma, Japan, and Osaka, Japan, and our assembly and test facilities in Mexicali, Mexico, and in Singapore. +We may not be able to maintain and improve manufacturing yields that contribute positively to our gross margin and profitability. +Minor deviations or disturbances in the manufacturing process can cause substantial manufacturing yield loss, and in some cases, cause production to be suspended and impact our ability to meet customer demand on a timely basis. Manufacturing yields for new products initially tend to be lower as we complete product development and commence volume manufacturing, and typically increase as we bring the product to full production. Our forward product pricing includes this assumption of improving manufacturing yields and, as a result, material variances between projected and actual manufacturing yields will have a direct effect on our gross margin and profitability. The difficulty of accurately forecasting manufacturing yields and maintaining cost competitiveness through improving manufacturing yields will continue to be magnified by the increasing process complexity of manufacturing semiconductor products. Our manufacturing operations may also face pressures arising from the compression of product life cycles, which may require us to manufacture new products faster and for shorter periods while maintaining acceptable manufacturing yields and quality without, in many cases, reaching the longer-term, high-volume manufacturing conducive to higher manufacturing yields and declining costs. +We are dependent upon third parties for the manufacture, assembly, and testing of our products. +We rely on foundries to provide silicon-based products and to supplement our gallium arsenide wafer manufacturing capacity. There are significant risks associated with reliance on third-party foundries, including: +• the lack of wafer supply, potential wafer shortages, and higher wafer prices, +• limited ability to respond to unanticipated changes in customer demand, +• limited control over delivery schedules, manufacturing yields, production costs, process technologies, and quality assurance, and +• the inaccessibility of, or delays in obtaining access to, key process technologies, materials, and IP blocks. +15 +Even in cases where we have long-term supply arrangements to obtain additional external manufacturing capacity, the third-party foundries we use for our standby manufacturing capacity may allocate their limited capacity to the production requirements of other customers and in general we have no contractual right to prevent them from making such allocations. If we choose to use a new foundry to replace either existing or backup capacity, it will typically take an extended period of time for us to complete our qualification process for that foundry, which will result in a significant passage of time before we can begin shipping products from that new foundry. +Further, the third-party foundries may experience financial difficulties or changes in control, be unable to deliver products to us in a timely manner, be unwilling to invest in processes that meet our needs, or suffer damage or destruction to their facilities, particularly since some of them are located in areas prone to natural disasters. If any disruption of manufacturing capacity occurs, we may not have alternative manufacturing sources immediately available. We may therefore experience difficulties, delays, or additional costs in securing an adequate supply of our products, which could impair our ability to meet our customers’ needs and have a material adverse effect on our operating results. +Although we own and operate assembly and test facilities, we still depend on subcontractors to package, assemble, and test certain of our products at cost-competitive rates. For those assembly and test subcontractors with whom we do not have long-term agreements, we typically procure services from these suppliers on a per-order basis. If any of our subcontractors experiences capacity constraints or financial difficulties, suffers any damage to its facilities, experiences power outages or any other disruption of assembly or testing capacity, we may not be able to obtain alternative assembly and testing services in a timely manner and/or at cost-competitive rates. Due to the amount of time that it usually takes us to qualify assembly and test subcontractors, we could experience significant delays and/or costs in product shipments if we are required to find alternative assembly and test subcontractors for our components. Any problems that we may encounter with the delivery, quality, or cost of our products could damage our customer relationships and materially and adversely affect our business, results of operations, and financial condition. +We are dependent upon third parties for the supply of raw materials and components. +Our manufacturing operations depend on obtaining adequate supplies of raw materials and components used in our manufacturing processes at a competitive cost. Although we maintain relationships with suppliers located around the world with the objective of ensuring that we have adequate sources for the supply of raw materials and components for our manufacturing needs, increases in demand from the semiconductor industry for such raw materials and components (including, but not limited to, precious and rare earth metals), as well as increased demand for commodities in general, can result in tighter supplies and higher costs. Our suppliers may not be able to meet our delivery schedules, we may lose a significant or sole supplier, a supplier may not be able to meet performance and quality specifications and we may not be able to purchase such supplies or material at a competitive cost. If a supplier were unable to meet our delivery schedules or if we lost a supplier or a supplier were unable to meet performance or quality specifications, our ability to satisfy customer obligations would be materially and adversely affected. In addition, we review our relationships with suppliers of raw materials and components for our manufacturing needs on an ongoing basis. In connection with our ongoing review, we may modify or terminate our relationship with one or more suppliers. We may also enter into sole supplier arrangements to meet certain of our raw material or component needs. While we do not typically rely on a single source of supply for our raw materials, we are currently dependent on a limited number of sole-source suppliers. If we were to lose these sole sources of supply, for any reason, a material adverse effect on our business could result until an alternate source is obtained. To the extent we enter into additional sole supplier arrangements for any of our raw materials or components, the risks associated with our supply arrangements would be exacerbated. +We may not be able to effectively operate our business if we are unable to attract and retain qualified personnel. +As the source of our technological and product innovations, our key technical personnel represent a significant asset. Our success depends on our ability to continue to attract, retain, and motivate qualified personnel, including executive officers and other key management and technical personnel. The competition for management and technical personnel is intense in the semiconductor industry, and therefore we may not be able to continue to attract and retain the qualified management and other personnel necessary for the design, development, manufacture, and sale of our products. Our employees are highly sought after by our competitors and other companies, which in some cases may be able to offer compensation opportunities in excess of what we offer. We may have particular difficulty attracting and retaining key personnel during periods of poor operating performance and/or declines in the price of our common stock, given, among other factors, the use of equity-based compensation by us and our competitors. If we are unable to obtain required stockholder approval for future increases in the number of shares available under our long-term incentive plans, we may be limited in granting equity-based incentive awards, which may impair our efforts to attract and retain necessary personnel. Further, existing immigration laws, together with any changes to immigration policies or regulations in the United States, make it more difficult for us to recruit and retain highly skilled foreign national graduates of universities in the United States, limiting the pool of available talent. Travel bans, difficulties obtaining visas and other restrictions on international travel make it more difficult to effectively manage our international operations, collaborate as a global company, and service our international customer base. The increased ability for employees in our industry to work from home or in other remote work arrangements could increase employee mobility and turnover, potentially making it more difficult for us to +16 +compete in the job market. We continue to anticipate increases in human resource needs, particularly in engineering. The loss of the services of one or more of our key employees or our inability to attract, retain, and motivate qualified personnel, could have a material adverse effect on our ability to operate our business. +Our business would be adversely affected by the departure of existing members of our senior management team or if our senior management team is unable to effectively implement our strategy. +Our success depends, in large part, on the continued contributions of our senior management team, none of whom is bound by a written employment contract to remain with us for a specified period. The loss of any member of our senior management team could harm our ability to implement our business strategy and respond to the rapidly changing market conditions in which we operate. In addition, the loss of certain members of our senior management team could harm our relationships with key customers, which could negatively impact our future revenue, results of operations, and financial condition. +We are subject to uncertainties involving the ordering and shipment of, and payment for, our products. +Our sales are typically made pursuant to standard purchase orders and/or specified customer contracts for delivery of products and not under long-term supply arrangements with our customers. Our customers may seek to cancel or defer orders before shipment. Additionally, we sell a portion of our products through third-party distributors, some of whom have rights to return products if the product is nonconforming. We may purchase and manufacture inventory based on estimates of customer demand for our products, which is difficult to predict. This difficulty may be compounded when we sell to OEMs indirectly through distributors or contract manufacturers, or both, as our forecasts of demand will then be based on estimates provided by multiple parties. In addition, our customers and/or distributors may change their inventory practices on short notice for any reason. Many of our products are customized to the needs or specifications of a specific customer or have a limited number of potential buyers. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volumes could result in us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. On the other hand, customers may require rapid increases in production on short notice, which could result in damaged customer relationships, increased liabilities, or harm to our reputation if we are unable to meet such increases in demand. Some of our customers have implemented vendor-managed inventory, consignment, or similar inventory programs that may result in an increase in the time between manufacture of, and payment for, our products. +In addition, if a customer or distributor encounters financial difficulties of its own as a result of a change in demand or for any other reason, the customer’s or distributor’s ability to make timely payments against our accounts receivable could be impaired. +We face a risk that capital needed for our business will not be available when we need it. +To the extent that our existing cash and cash equivalents and cash generated from operations are insufficient to fund our future activities (including, but not limited to, capital expenditures), we may need to raise additional funds through public or private equity or debt financing. If unfavorable capital market conditions exist in the event we were to seek additional financing, we may not be able to raise sufficient capital on favorable terms and on a timely basis, if at all. Failure to obtain capital when required by our business circumstances would have a material adverse effect on us. +In addition, the future growth of our business is likely to require the expansion of our manufacturing facilities, the upgrade of our manufacturing equipment, strategic investments, and/or corporate acquisitions. The capital required to fund these investments may not be available in the future. +Risks associated with our industry +The semiconductor industry is highly cyclical and subject to significant downturns. +We operate in the semiconductor industry, which is cyclical and subject to rapid declines in demand for end-user products in both the consumer and enterprise markets. Uncertain worldwide economic and political conditions, together with other factors such as the volatility of the financial markets, continue to make it difficult for our customers and for us to accurately forecast and plan future business activities. For example, it is difficult to predict what impact the outcomes of the U.S. presidential and congressional elections in November 2020 may have on economic conditions, consumer confidence, geopolitical turmoil, civil unrest, and future legislation and regulation. In addition, the rapid increase in consumer demand for certain devices and technologies that enable remote work, education, and entertainment as a result of the COVID-19 pandemic could limit future consumer demand for such products. Uncertainty and economic weakness could result in a market contraction and, as a result, our business, results of operations, and financial condition would likely be materially and adversely affected. Such periods of industry downturn are characterized by diminished product demand and revenue, manufacturing overcapacity, excess inventory levels, accelerated erosion of average selling prices, bad debt, inventory charges, restructuring charges, and asset impairment charges. Furthermore, downturns in the semiconductor industry may be prolonged, and any extended delay or failure of the market to recover from an economic downturn would materially and adversely impact our business, results of operations, and financial condition, which could adversely affect our stock price. +17 +The wireless communications and analog semiconductor markets are characterized by significant competition. +The wireless communications semiconductor industry, in general, and the other analog markets in which we compete are very competitive, which may cause pricing pressures, decreased gross margins, and rapid loss of market share. We compete with international and United States semiconductor manufacturers of all sizes in terms of resources and market share, including, but not limited to, Analog Devices, Broadcom, Cirrus Logic, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, Qorvo, and Qualcomm. +We currently face significant competition in our markets and expect that intense price and product competition will continue. This competition has resulted in, and is expected to continue to result in, declining average selling prices for many of our products and increased challenges in maintaining or increasing revenue, gross margin, and market share. Furthermore, additional competitors may enter our markets as a result of growth opportunities in communications electronics, the trend toward global expansion by foreign and domestic competitors and technological and public policy changes (including national or regional policies intended to develop and support localized competitors). We believe that the principal competitive factors for semiconductor suppliers in our markets include, among others: +• rapid time-to-market and product ramps (including, but not limited to, high-volume product ramps), +• timely new product innovation, +• ability to capture design wins in new growth markets, such as 5G, +• product quality, reliability, and performance, +• ability of certain products, including “high reliability” solutions, to perform under stringent operating conditions, +• product cost and selling price, +• features available in products, +• alignment with customer performance specifications, +• compliance with industry standards, +• strategic relationships with customers, +• access to, and the protection and enforcement of, intellectual property, +• ability to partner with or participate in reference designs of baseband vendors, and +• maintaining access to manufacturing capacity, raw materials, supplies, and services at a competitive cost. +We might not be able to successfully address these factors. Many of our competitors benefit from: +• long presence in key markets, +• brand recognition, +• high levels of customer satisfaction, +• vertical integration, +• strong baseband partnership/participation in reference designs, +• a broad product portfolio allowing them to bundle product offerings, +• ownership or control of key technology or intellectual property, and +• strong financial, sales and marketing, manufacturing, distribution, technical, or other resources. +As a result, certain competitors may be able to adapt more quickly than we can to new or emerging technologies and changes in customer requirements or may be able to devote greater resources to the development, promotion, and sale of their products than we can. As a result of industry consolidation, certain competitors may be able to further exploit such benefits to strengthen their competitive position. +Our baseband reference design partners may leverage their market position by integrating additional functionality into their product offerings that compete with our solutions. If such a product offering were competitive with our solution as to performance, price, and quality, or if the interoperability of our solution with the partner’s baseband products were to be restricted, our business could be adversely impacted. +Current and potential competitors have established, or may in the future establish, financial or strategic relationships among themselves or with customers, resellers, or other third parties. These relationships may affect customers’ purchasing decisions. Accordingly, it is possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We may not be able to compete successfully against current and potential competitors. Increased competition could result in pricing pressures, decreased gross margins, and loss of revenue and market share and may materially and adversely affect our business, results of operations, and financial condition. +Remaining competitive in the semiconductor industry depends upon our ability to constantly innovate. +The semiconductor industry generally and, in particular, many of the markets into which we sell our products, are highly cyclical and characterized by constant and rapid technological change, continuous product evolution, price erosion, evolving technical standards, short product life cycles (including annual product refreshes in some cases), increasing demand for higher levels of +18 +integration, increased miniaturization, reduced power consumption, and wide fluctuations in product supply and demand. Our operating results depend largely on our ability to continue to cost-effectively introduce new and enhanced products on a timely basis. The successful development and commercialization of semiconductor devices and modules is highly complex and depends on numerous factors, including the ability: +• to anticipate customer and market requirements and changes in technology and industry standards, +• to obtain sufficient manufacturing capacity within an international supply chain to meet customer demand, +• to define new products that meet customer and market requirements, +• to complete development of new products and bring products to market on a timely basis, +• to differentiate our products from offerings of our competitors, +• to achieve overall market acceptance of our products, +• to lengthen the time that a particular product is in demand, +• to source and maintain manufacturing materials, and +• to obtain adequate multi-jurisdictional intellectual property protection for our new products. +Our ability to manufacture current products, and to develop new products, depends on, among other factors, the viability and flexibility of our own internal information technology systems. +We continually evaluate expenditures for planned product development and choose among alternatives based on our understanding of customer technical requirements, new industry standards, and expectations of future market growth and technologies. We may not be able to develop and introduce new or enhanced wireless communications and analog semiconductor products in a timely and cost-effective manner, and our products may not satisfy customer requirements or achieve market acceptance, or we may not be able to anticipate new industry standards and technological changes. We also may not be able to respond successfully to new product announcements and introductions by competitors or to changes in the design or specifications of complementary products of third parties with which our products interface. If we fail to rapidly and cost-effectively introduce new and enhanced products in sufficient quantities that meet our customers’ requirements, our business, results of operations, and financial condition could be materially and adversely affected. +In addition, prices of many of our products decline, sometimes significantly, over time. Our products may become obsolete earlier than planned or may not have life cycles long enough to allow us to recoup the cost of our investment in designing such products. Accordingly, we believe that to remain competitive, we must continue to reduce the cost of producing and delivering existing products at the same time that we develop and introduce new or enhanced products. We may not be able to continue to reduce the cost of producing and delivering our products in a timely manner and thereby remain competitive. +In order to remain competitive, we expect to continue to transition many of our products to increasingly smaller geometries and form factors. This transition often requires us to upgrade our capital equipment, modify the manufacturing processes for our products, design new products to more stringent standards, and redesign some existing products. We have experienced some difficulties migrating to smaller geometry process technologies or new manufacturing processes, which resulted in sub-optimal manufacturing yields, delays in product deliveries, and increased expenses. We may face similar difficulties, delays, and expenses as we continue to transition our products to smaller geometry processes in the future. In some instances, we depend on our relationships with our third-party foundries and packaging sub-contractors to transition to smaller geometry processes successfully. Our manufacturing partners may not be able to effectively manage the transition, or we may not be able to maintain our relationships with certain manufacturing partners. If our manufacturing partners or we experience significant delays in this transition or fail to efficiently implement this transition, our business, results of operations, and financial condition could be materially and adversely affected. As smaller geometry processes become more prevalent, we expect to continue to integrate greater levels of functionality, as well as customer and third-party intellectual property, into our products. However, we may not be able to achieve higher levels of design integration or deliver new integrated products on a timely basis, or at all. +Increasingly stringent environmental laws, rules, regulations, and customer expectations may require us to redesign our existing products and processes and could adversely affect our ability to cost-effectively produce our products. +The semiconductor industry has been subject to increasing environmental regulations, particularly those environmental requirements that control and restrict the use, transportation, emission, discharge, storage, and disposal of certain chemicals, elements, and materials used or produced in the semiconductor manufacturing process. Heightened public focus on climate change, sustainability, and environmental issues has also led to increased government regulation and caused certain of our customers to impose environmental standards on us as a part of doing business with them. We expect that the trend of increasing environmental awareness will continue, which will result in higher costs of operations. In addition, our commitment to environmentally sustainable practices, while undertaken in a manner designed to be as efficient and cost effective as possible, may result in increases in costs of operations for us relative to our competitors until technologies and methods are developed that will help reduce those costs or such practices become industry best practice. +19 +A number of domestic and foreign jurisdictions restrict or may seek to restrict the use of various substances, a number of which have been or are currently used in our products or processes. For example, the European Union Restriction of Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) Directive requires that certain substances, which may be found in certain products we have manufactured in the past, be removed from all electronics components. Eliminating such substances from our manufacturing processes requires the expenditure of additional research and development funds to seek alternative substances for our products, as well as increased testing by third parties to ensure the quality of our products and compliance with the RoHS Directive. While we have implemented a compliance program to ensure our product offering meets these regulations, there may be instances where alternative substances will not be available or commercially feasible, or may only be available from a single source, or may be significantly more expensive than their restricted counterparts. Additionally, if we were found to be non-compliant with any such rule or regulation, we could be subject to fines, penalties and/or restrictions imposed by government agencies that could adversely affect our operating results. +Regulations in the United States require that we determine whether certain materials used in our products, referred to as conflict minerals, originated in the Democratic Republic of the Congo or adjoining countries, or were from recycled or scrap sources. The verification and reporting requirements, in addition to customer demands for conflict-free sourcing, impose additional costs on us and on our suppliers, and may limit the sources or increase the prices of materials used in our products. Further, if we are unable to certify that our products are conflict free, we may face challenges with our customers, which could place us at a competitive disadvantage, and our reputation may be harmed. In addition, our customers may begin to require reports on our sourcing of other minerals or substances, which may impact our ongoing operations and increase our operating costs. +New climate change laws and regulations could require us to change our manufacturing processes or obtain substitute materials that may cost more or be less available for our manufacturing operations. Various jurisdictions in which we do business have implemented, or in the future could implement or amend, restrictions on emissions of carbon dioxide or other greenhouse gases, limitations or restrictions on water use, regulations on energy management and waste management, and other climate change-based rules and regulations, which may increase our expenses and adversely affect our operating results. We expect increased worldwide regulatory activity relating to climate change in the future. Compliance with these laws and regulations has not had a material impact on our capital expenditures, earnings, financial condition, or competitive position. +Furthermore, environmental regulations often require parties to fund remedial action for violations of such regulations regardless of fault. Consequently, it is often difficult to estimate the future impact of environmental matters, including potential liabilities. In addition, our customers increasingly require warranties or indemnity relating to compliance with environmental regulations. The amount of expense and capital expenditures that might be required to satisfy environmental liabilities, to complete remedial actions, and to continue to comply with applicable environmental laws may have a material adverse effect on our business, results of operations, and financial condition. +To be successful we may need to make investments and acquisitions, integrate companies we acquire, and/or enter into strategic alliances. +Although we have invested in the past, and intend to continue to invest, significant resources in internal research and development activities, the complexity and rapidity of technological changes and the significant expense of internal research and development make it impractical for us to pursue development of all technological solutions on our own. On an ongoing basis, we review investment, alliance, and acquisition prospects that would complement our product offerings, augment our market coverage, or enhance our technological capabilities. We may not be able to identify and consummate suitable investment, alliance, or acquisition transactions in the future. Moreover, if such transactions are consummated, they could result in: +• issuances of equity securities dilutive to our stockholders, +• restructuring or other impairment write-offs, +• the incurrence of substantial debt and assumption of unknown liabilities, +• the potential loss of key employees from the acquired company, +• recognition of additional liabilities known or unknown at the time of acquisition, +• amortization expenses related to intangible assets, and +• the diversion of management’s attention from other business concerns. +Moreover, integrating acquired organizations and their products and services may be difficult, expensive, time-consuming, and a strain on our resources and our relationship with employees and customers and ultimately may not be successful. Additionally, in periods following an acquisition, we will be required to evaluate goodwill and acquisition-related intangible assets for impairment. If such assets are found to be impaired, they will be written down to estimated fair value, with a charge against earnings. +Risks associated with cybersecurity and intellectual property protection +We may not be able to prevent, or timely detect, information technology security breaches. +20 +Security breaches, phishing, spoofing, attempts by others to gain unauthorized access to our information technology systems, networks, and databases and other cyberattacks continue to become more sophisticated and persistent and are sometimes successful. These incidents, which might be related to industrial, state-sponsored, and/or economic espionage, or financial cyber extortion or fraud, include covertly introducing malware and spyware to our computers and networks (or to an electronic system operated by a third party for our benefit) and impersonating authorized users, among others. We seek to detect and investigate all security incidents and to prevent their recurrence, but in some cases, we might be unaware of an incident or its magnitude, duration, and effects. The theft, unauthorized use, transfer, or publication of our intellectual property, our confidential business and/or technical information, or the personal data of our employees and customers by third parties or by our employees could harm our competitive position, reduce the value of our investment in research and development and other strategic initiatives or otherwise adversely affect our business and technology development. To the extent that any security breach or other cybersecurity incident results in inappropriate disclosure of our customers’, suppliers’, licensees’, or employees’ confidential information, we may incur liability, face contractual and regulatory fines and penalties, and sustain significant financial resources to remediate such breach. Such an incident could, among other things, also damage our reputation, impair our ability to attract and retain our customers, impact our stock price, and materially damage supplier relationships. If such incident impedes our inability to use or access our information systems for an extended period of time, this could adversely affect our business operations and financial results. In addition, certain suppliers and other third parties with whom we conduct business, including foundries, assembly and test contractors, and distributors, have been, and are likely to continue to be, subject to cybersecurity incidents or network disruptions that could jeopardize our proprietary or sensitive data, impact such third parties’ ability to meet their obligations to us, or otherwise negatively impact our ongoing business operations. We expect to continue devoting significant resources to the security of our information technology systems, networks, and databases, including through the training of our employees and monitoring the security posture of critical third parties who have access to our systems or sensitive data. However, we cannot ensure that these security measures and monitoring efforts will be sufficient to prevent or mitigate the damage caused by a cybersecurity incident or network disruption, and our systems may be vulnerable to hacking, insider threats, employee error or manipulation, system malfunctions or other adverse events. While we maintain insurance coverage to mitigate some of these risks, such coverage may be insufficient to cover all losses or all types of claims that may arise. +In order to remain competitive, we must be able to successfully protect our intellectual property rights. +We rely on patent, copyright, trademark, trade secret, and other intellectual property rights and laws, as well as nondisclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, inventions, information, data, devices, algorithms, processes, and other intellectual property. In addition, we often incorporate the intellectual property of our customers, suppliers, or other third parties into our designs, and we have obligations with respect to the non-use and non-disclosure of such third-party intellectual property. From time to time, it may be necessary to engage in litigation or like activities to enforce our intellectual property rights, to protect our trade secrets, or to determine the validity, enforceability, and scope of proprietary rights of others, including our customers. This could require us to expend significant resources and to divert the efforts and attention of our management and technical personnel from our business operations. Regardless of our actions: +• the steps we take to prevent misappropriation, infringement, dilution, or other violation of our intellectual property or the intellectual property of our customers, suppliers, or other third parties may not be successful, +• any of our existing or future patents, copyrights, trademarks, trade secrets, or other intellectual property rights may be challenged, invalidated, deemed unenforceable, or circumvented, and +• we may be contractually prohibited, or otherwise discouraged, by certain customers from pursuing remedies for third parties’ violations of our intellectual property. +A third party could copy, misappropriate, or otherwise obtain and use our technology without authorization, develop similar technology independently, or design around or invalidate our patents. If any of our intellectual property protection mechanisms fails to protect our technology, it would make it easier for our competitors to offer similar competitive products, potentially resulting in loss of market share and price erosion. Even if we receive a patent, the patent claims may not be broad enough to adequately cover and protect our technology or could be rendered invalid or unenforceable. Furthermore, even if we receive patent protection in the United States, we may not seek, or may not be granted, patent protection in other relevant foreign countries. In addition, effective patent, copyright, trademark, and trade secret protection and enforcement may be unavailable, impractical, or limited for certain technologies and in certain foreign countries. +We attempt to control access to, and distribution of, our proprietary and confidential information through operational, technological, and legal safeguards. Despite our efforts, parties, including current and former employees, consultants, customers, licensees, suppliers, vendors, and other third-party affiliates may attempt to copy, disclose, transfer, or obtain access to our information without our authorization. Furthermore, attempts by computer hackers to gain unauthorized access to our systems or information could result in our confidential and/or proprietary information being compromised or our manufacturing and other business operations being interrupted. While we make reasonable attempts to prevent such unauthorized access or misappropriation, we may be unable to anticipate or detect the methods used, or we may be unable to prevent the release of our confidential and/or proprietary information or that of a third party. +21 +We are subject to the risks of licensing third-party intellectual property. +We sell products in markets that are characterized by rapid technological changes, evolving industry standards, frequent new product introductions, short product life cycles, and increasing levels of integration. Many of our products currently use or incorporate technology licensed or acquired from third parties and we expect our products in the future to also require technology from third parties. Our ability to keep pace with this market depends on our ability to obtain technology from third parties on commercially reasonable terms to allow our products to remain competitive. If licenses to such technology for our current or future products become unavailable or the terms on which they are available become commercially unreasonable, and we cannot otherwise acquire or integrate such technology, our products or our customers’ products could become unmarketable or obsolete, we could lose market share, and our business could be adversely affected. In such instances, we could also incur substantial unanticipated costs or scheduling delays to develop substitute technology to deliver competitive products. +Risks associated with claims, litigation, and legal compliance +We may be subject to warranty claims, product recalls, and liability claims. +Although we invest significant resources in the testing of our products, from time to time we become aware of alleged defects in our products after they have been shipped, and we may be required to incur additional development and remediation costs, or cash payments to settle claims pursuant to warranty and indemnification provisions in our customer contracts and purchase orders. Certain of our products, including “high reliability” solutions, may not be able to perform under stringent operating conditions. Examples of our “high reliability” solutions include applications intended for the aerospace, automotive, medical, and military markets. The potential liabilities associated with these, and similar, provisions in certain of our customer contracts are in some cases capped at significant amounts, and in other cases are uncapped. In addition, because we do not always have a direct relationship with the end customers of our products, our products may be used in applications for which they were not necessarily designed or tested, and they may not perform as anticipated in such applications. Depending on the nature of any product defect claims, we may not be able to recoup our losses from our third-party suppliers. Investigating, analyzing, and/or remediating alleged product defects may divert our technical and other resources from other product development efforts and could result in claims against us by our customers or third parties, including liability for costs associated with product recalls, indemnification claims, product redesigns, or obligations under customer contracts. If any of our products contain defects, or have reliability, quality, or compatibility problems, our reputation may be damaged, and we could be subject to liability claims, which could make it more difficult for us to sell our products to existing and prospective customers and could adversely affect our operating results. Furthermore, such losses would not be covered under our existing corporate insurance programs. +We may be subject to claims of infringement of third-party intellectual property rights or demands that we license third-party technology. +The semiconductor industry is characterized by vigorous protection, enforcement, and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark, and other intellectual property rights against technologies that are important to our business and manufacturing operations and have demanded and may in the future demand that we license their technology or refrain from using it. +Any litigation to determine the validity of any allegations that our products infringe or may infringe or misappropriate the intellectual property rights of another party, including indemnification claims arising from our contractual obligations of our customers, regardless of their merit or resolution, could be costly and divert the efforts and attention of our management and technical personnel. Regardless of the merits of any specific claim, we may not prevail in litigation because of the complex technical issues and inherent uncertainties in intellectual property litigation. If litigation were to result in an adverse ruling, we could be required to: +• pay substantial damages, +• cease the manufacture, import, use, sale, or offer for sale of infringing products or processes, +• discontinue the use of infringing technology, +• expend significant resources to develop an alternate non-infringing technology, and +• license technology from the third party claiming infringement, which license may not be available on commercially reasonable terms. +Our operating results or financial condition may be materially adversely affected if we, or one of our customers, were required to take any one or more of the foregoing actions. +In addition, if another supplier to one of our customers, or a customer of ours itself, were found to be infringing upon the intellectual property rights of a third party, the supplier or customer could be ordered to cease the manufacture, import, use, sale, or offer for sale of its infringing product(s) or process(es), either of which could result, indirectly, in a decrease in demand from our customers for our products. If such a decrease in demand for our products were to occur, it could have an adverse impact on our operating results. +22 +Risks associated with owning our common stock +Our stock price has been volatile and may fluctuate in the future. +The trading price of our common stock has fluctuated and may continue to fluctuate significantly. Such fluctuations may be influenced by many factors, including: +• the volatility of the financial markets, +• uncertainty regarding the prospects of the domestic and foreign economies, +• instability in global credit and financial markets, +• our performance and prospects, +• the performance and prospects of our major customers and competitors, +• our revenue concentrations with relatively few customers, +• the depth and liquidity of the market for our common stock, +• the inclusion, exclusion, or removal of our stock from market indices, such as the S&P 500 Index, +• our stock repurchase and dividend activities, +• investor perception of us and the industry in which we operate, +• changes in earnings estimates, price targets, or buy/sell recommendations by analysts, +• domestic and international political conditions, +• domestic and international tax, fiscal, and trade policy decisions, and +• our ability to successfully identify, acquire, and integrate acquisition candidates. +Public stock markets have experienced price and trading volume volatility. This volatility has affected, and could significantly and negatively affect in the future, the market prices of securities of many technology companies, particularly the market price of our common stock. +In addition, fluctuations in our stock price, volume of shares traded, and changes in our trading multiples may make our stock attractive to momentum, hedge, day-trading, or activist investors who often shift funds into and out of stocks rapidly, exacerbating price fluctuations in either direction. We have been, and in the future may be, the subject of commentary by financial news media. Such commentary may contribute to volatility in our stock price. If our operating results do not meet the expectations of securities analysts, the financial news media, or investors, our stock price may decline, possibly substantially over a short period of time. +There can be no assurance that we will continue to declare cash dividends or repurchase our stock. +We intend to pay quarterly cash dividends subject to capital availability and periodic determinations by our Board of Directors that cash dividends are in the best interest of our stockholders. In addition, from time to time the Board of Directors approves stock repurchase programs, pursuant to which we are authorized to repurchase shares of common stock on the open market or in privately negotiated transactions. +Future cash dividends and the amount and timing of our stock repurchases may be affected by, among other factors: +• our views on potential future capital requirements, including those related to acquisitions as well as research and development, +• our ability to generate sufficient earnings and cash flows, +• use of cash to consummate various acquisition transactions, +• capital requirements related to cash dividends and stock repurchase programs, +• changes in federal and state income tax laws or corporate laws, and +• changes to our business model. +Our cash dividend payments may change from time to time, and we cannot provide assurance that we will increase our cash dividend payment or declare cash dividends in any particular amounts or at all. A reduction in our cash dividend payments or a reduction in the level of our stock repurchases could have a negative effect on our stock price. +Certain provisions in our organizational documents and Delaware law may make it difficult for someone to acquire control of us. +We have certain anti-takeover measures that may affect our common stock. Our certificate of incorporation, our by-laws, and the Delaware General Corporation Law contain several provisions that would make more difficult an acquisition of control of us in a transaction not approved by our Board of Directors. Our certificate of incorporation and by-laws include provisions such as: +• the ability of our Board of Directors to issue shares of preferred stock in one or more series without further authorization of stockholders, +• a prohibition on stockholder action by written consent, +• a requirement that stockholders provide advance notice of any stockholder nominations of directors or any proposal of new business to be considered at any meeting of stockholders, +23 +• a requirement that the affirmative vote of at least 80% of our shares be obtained to amend or repeal the provisions of our certificate of incorporation relating to the election and removal of directors or the right to act by written consent, +• a requirement that the affirmative vote of at least 80% of our shares be obtained for business combinations unless approved by a majority of the members of the Board of Directors and, in the event that the other party to the business combination is the beneficial owner of 5% or more of our shares, a majority of the members of the Board of Directors in office prior to the time such other party became the beneficial owner of 5% or more of our shares, +• a fair price provision, and +• a requirement that the affirmative vote of at least 90% of our shares be obtained to amend or repeal the fair price provision. +In addition to the provisions in our certificate of incorporation and by-laws, Section 203 of the Delaware General Corporation Law generally provides that a corporation may not engage in any business combination with any interested stockholder during the three-year period following the time that such stockholder becomes an interested stockholder, unless a majority of the directors then in office approves either the business combination or the transaction that results in the stockholder becoming an interested stockholder or specified stockholder approval requirements are met. +24 +ITEM 1B. UNRESOLVED STAFF COMMENTS. +None. +ITEM 2. PROPERTIES. +We have executive offices in Irvine, California, and Woburn, Massachusetts. For information regarding property, plant, and equipment by geographic region for each of the last three fiscal years, see Note 14 to Item 8 of this Annual Report on Form 10-K. The following table sets forth our principal facilities: +Location +Owned/Leased +Square Footage +Primary Function +Mexicali, Mexico Owned 380,000 Manufacturing and office space +Woburn, Massachusetts Owned 158,000 Manufacturing and office space +Adamstown, Maryland Owned 121,200 Manufacturing and office space +Newbury Park, California Owned 111,600 Manufacturing and office space +Osaka, Japan Leased 405,300 Filter manufacturing +Singapore, Singapore Leased 282,200 Filter manufacturing +Irvine, California Leased 218,500 Design center and office space +Mexicali, Mexico Leased 179,000 Manufacturing and office space +Newbury Park, California Leased 115,700 Design center +Kadoma, Japan Leased 97,300 Filter manufacturing and office space +ITEM 3. LEGAL PROCEEDINGS. +The information set forth under Note 11 of Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES. +Not Applicable. +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. +Market Information and Dividends +Our common stock is traded on the Nasdaq Global Select Market under the symbol “SWKS”. +The number of stockholders of record of our common stock as of November 2, 2020, was 10,419. On November 2, 2020, the Company announced that the Board of Directors had declared a cash dividend of $0.50 per share of common stock, payable on December 10, 2020, to stockholders of record as of November 19, 2020. We intend to continue to pay quarterly dividends subject to capital availability and our view that cash dividends are in the best interests of our stockholders. Future cash dividends may be affected by, among other items, our views on potential future capital requirements, including those relating to research and development, creation and expansion of sales distribution channels and investments and acquisitions, legal risks, stock repurchase programs, debt issuance, changes in federal and state income tax law and changes to our business model. +Issuer Purchases of Equity Securities +The following table provides information regarding repurchases of common stock made during the fiscal quarter ended October 2, 2020: +25 +Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (1) +6/27/20-7/24/20 490 (2) $125.85 — $1.21 billion +7/25/20-8/28/20 636,181 (3) $142.17 627,437 $1.12 billion +8/29/20-10/2/20 1,031,417 (4) $138.45 1,025,231 $0.98 billion +1,668,088 1,652,668 +_________________________ +(1) The stock repurchase program approved by the Board of Directors on January 30, 2019, authorizes the repurchase of up to $2.0 billion of our common stock from time to time on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. The January 30, 2019, stock repurchase program replaced in its entirety the January 31, 2018, plan and is scheduled to expire on January 30, 2021. +(2) Represents shares repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements. +(3) 627,437 shares were repurchased at an average price of $142.12 per share as part of our stock repurchase program, and 8,744 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $146.09 per share. +(4) 1,025,231 shares were repurchased at an average price of $138.42 per share as part of our stock repurchase program, and 6,186 shares were repurchased by us at the fair market value of the common stock as of the applicable purchase date, in connection with the satisfaction of tax withholding obligations under equity award agreements with an average price of $142.76 per share. +26 +ITEM 6. SELECTED FINANCIAL DATA. +The information set forth below for the five years ended October 2, 2020, is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , and our consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K to fully understand factors that may affect the comparability of the information presented below. Our fiscal year ends on the Friday closest to September 30. Fiscal 2020 consisted of 53 weeks and ended on October 2, 2020. Fiscal 2019, 2018, 2017, and 2016 each consisted of 52 weeks and ended on September 27, 2019, September 28, 2018, September 29, 2017, and September 30, 2016, respectively. +The following table represents the selected financial data (in millions, except per share data): +Fiscal Years Ended +Statement of Operations Data: October 2, 2020 (1) September 27, 2019 (1) September 28, 2018 (2) September 29, 2017 September 30, 2016 (3) +Net revenue $ 3,355.7 $ 3,376.8 $ 3,868.0 $ 3,651.4 $ 3,289.0 +Operating income $ 891.8 $ 952.0 $ 1,319.3 $ 1,253.8 $ 1,118.7 +Operating margin 26.6 % 28.2 % 34.1 % 34.3 % 34.0 % +Net income $ 814.8 $ 853.6 $ 918.4 $ 1,010.2 $ 995.2 +Earnings per share: +Basic $ 4.84 $ 4.92 $ 5.06 $ 5.48 $ 5.27 +Diluted $ 4.80 $ 4.89 $ 5.01 $ 5.41 $ 5.18 +Cash dividends declared per share $ 1.82 $ 1.58 $ 1.34 $ 1.16 $ 1.06 +As of +Balance Sheet Data: October 2, 2020 September 27, 2019 September 28, 2018 September 29, +2017 September 30, +2016 +Working capital $ 1,869.2 $ 1,860.6 $ 1,872.5 $ 2,245.8 $ 1,791.9 +Property, plant, and equipment, net $ 1,249.5 $ 1,205.6 $ 1,140.9 $ 882.3 $ 806.3 +Total assets $ 5,106.7 $ 4,839.6 $ 4,828.9 $ 4,573.6 $ 3,855.4 +Stockholders’ equity $ 4,164.2 $ 4,122.3 $ 4,097.0 $ 4,065.7 $ 3,541.4 +____________ +(1) Fiscal 2020 and fiscal 2019 net revenue, net income, and earnings per share were adversely impacted as a result of the U.S. Bureau of Industry and Security of the U.S. Department of Commerce placing Huawei on the Entity List in May 2019. +(2) Fiscal 2018 net income and earnings per share include a one-time charge of $224.6 million related to the mandatory deemed repatriation tax on foreign earnings and a one-time charge of $18.3 million related to the revaluation of deferred tax assets and liabilities at the new corporate tax rate, as a result of the Tax Reform Act. +(3) Fiscal 2016 net income and earnings per share include other income of $88.5 million related to the receipt of a merger termination fee in November 2015 in connection with the termination by PMC-Sierra, Inc. (“PMC”), of the Amended and Restated Agreement and Plan of Merger that we had entered into with PMC in October 2015. +27 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Annual Report on Form 10-K. In addition to historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially and adversely from those referred to herein due to a number of factors, including, but not limited to, those described below and in Item 1A “Risk Factors” and elsewhere in this Annual Report on Form 10-K. +OVERVIEW +We, together with our consolidated subsidiaries, are empowering the wireless networking revolution. Our highly innovative analog semiconductors are connecting people, places, and things spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, entertainment and gaming, industrial, medical, military, smartphone, tablet, and wearable markets. Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto (a Thales company), General Electric, Fibocom, Google, Honeywell, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi, and ZTE. +Impact of COVID-19 +The COVID-19 pandemic and the resulting economic downturn are affecting business conditions in our industry. Overall demand for our products has decreased as a result of the pandemic, which impacted our operating results for fiscal 2020. The duration, severity, and future impact of the pandemic continue to be highly uncertain and could still result in significant disruptions to our business operations, including our supply chain, as well as negative impacts to our financial condition. As a result of the temporary suspension of our operations in Mexicali, Mexico, for approximately two weeks in April 2020, we incurred a $23.4 million production utilization charge, as described below. A renewed suspension of our operations in Mexicali, or a continued reduction in our production capacity due to employee quarantines, employee absenteeism, and restrictions on certain of our employees’ ability to work, would negatively impact our future operating results. +RESULTS OF OPERATIONS +Fiscal Years Ended October 2, 2020, September 27, 2019, and September 28, 2018. +The following table sets forth the results of our operations expressed as a percentage of net revenue. See Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended September 27, 2019, filed with the SEC on November 14, 2019, as amended by Amendment No. 1 to such Annual Report on Form 10-K, filed with the SEC on January 27, 2020 (the “2019 10-K”), for Management’s Discussions and Analysis of Financial Condition and Results of Operations for the fiscal year ended September 28, 2018. +28 +October 2, +2020 September 27, +2019 September 28, +2018 +Net revenue 100.0 % 100.0 % 100.0 % +Cost of goods sold 51.9 52.5 49.6 +Gross profit 48.1 47.5 50.4 +Operating expenses: +Research and development 13.7 12.5 10.4 +Selling, general, and administrative 6.9 5.9 5.4 +Amortization of intangibles 0.4 0.7 0.5 +Restructuring, impairment, and other charges 0.4 0.2 — +Total operating expenses 21.5 19.3 16.3 +Operating income 26.6 28.2 34.1 +Other income (expense), net — 0.3 0.3 +Income before income taxes 26.6 28.5 34.4 +Provision for income taxes 2.3 3.2 10.7 +Net income 24.3 % 25.3 % 23.7 % +General +During the fiscal year ended October 2, 2020, the following key factors contributed to our overall results of operations, financial position, and cash flows: +• Net revenue decreased 0.6% to $3,355.7 million, as compared to fiscal 2019. This decrease in revenue was driven primarily by reduced demand resulting from Huawei continuing to remain on the Entity List. Additionally, demand for our products was negatively impacted by the ongoing COVID-19 pandemic. These decreases in revenue were partially offset by an increase in demand for our new 5G solutions being deployed across a growing set of customers. +• Our ending cash, cash equivalents and marketable securities balance decreased 9.5% to $980.0 million in fiscal 2020 from $1,082.2 million in fiscal 2019. This decrease in cash, cash equivalents and marketable securities during fiscal 2020, was primarily the result of the repurchase of 6.3 million shares of common stock for $647.5 million, capital expenditures of $389.4 million, and dividend payments of $307.0 million, partially offset by cash generated from operations of $1,204.5 million. +Net Revenue +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Net revenue $ 3,355.7 (0.6)% $ 3,376.8 (12.7)% $ 3,868.0 +We market and sell our products directly to OEMs of communications and electronics products, third-party original design manufacturers and contract manufacturers, and indirectly through electronic components distributors. We generally experience seasonal peaks during our fourth and first fiscal quarters (which correspond to the second half of the calendar year), primarily as a result of increased worldwide production of consumer electronics in anticipation of increased holiday sales, whereas our second and third fiscal quarters are typically lower and in line with seasonal industry trends. +The decrease in net revenue in fiscal 2020, as compared to fiscal 2019, was driven by reduced demand resulting from Huawei continuing to remain on the Entity List as well as the ongoing COVID-19 pandemic, partially offset by an increase in demand for our new 5G solutions being deployed across a growing set of customers. +For information regarding net revenue by geographic region and customer concentration, see Note 14 to Item 8 of this Annual Report on Form 10-K. +Gross Profit +29 +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Gross profit $ 1,612.9 0.6% $ 1,603.8 (17.8)% $ 1,950.7 +% of net revenue 48.1 % 47.5 % 50.4 % +Gross profit represents net revenue less cost of goods sold. Our cost of goods sold consists primarily of purchased materials, labor and overhead (including depreciation and share-based compensation expense) associated with product manufacturing. Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. As part of our normal course of business, we mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs, improve manufacturing efficiencies, lower manufacturing costs of existing products and by introducing new and higher value-added products. +The increase in gross profit in fiscal 2020, as compared to fiscal 2019, was primarily the result of a favorable product mix, partially offset by lower unit volumes and lower average selling prices. In addition, there was a $23.4 million production utilization charge in fiscal 2020, due to the temporary suspension of our operations in Mexicali in the government's effort to contain the COVID-19 pandemic. This one-time charge was less than the $66.1 million inventory-related one-time charge incurred in fiscal 2019, due to lower expected demand as a result of Huawei being added to the Entity List. As a result of these impacts, gross profit margin increased to 48.1% of net revenue for fiscal 2020, as compared to 47.5% in fiscal 2019. +Research and Development +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Research and development $ 464.1 9.4% $ 424.1 4.8% $ 404.5 +% of net revenue 13.8 % 12.5 % 10.4 % +Research and development expenses consist primarily of direct personnel costs including share-based compensation expense, costs for pre-production evaluation and testing of new devices, masks, engineering prototypes and design tool costs. +The increase in research and development expense in fiscal 2020, as compared to fiscal 2019, was primarily related to an increase in employee-related share-based compensation expense due to higher performance achievement with respect to performance stock awards. +Selling, General, and Administrative +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Selling, general, and administrative $ 231.4 16.7% $ 198.3 (4.6)% $ 207.8 +% of net revenue 6.9 % 5.9 % 5.4 % +Selling, general, and administrative expenses include legal and related costs, accounting, treasury, human resources, information systems, customer service, bad debt expense, sales commissions, share-based compensation expense, advertising, marketing, costs associated with business combinations completed or contemplated during the period, and other costs. +The increase in selling, general, and administrative expenses in fiscal 2020, as compared to fiscal 2019, was primarily related to increases in employee-related share-based compensation expense due to higher performance achievement with respect to performance stock awards. +Amortization of Intangibles +30 +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Total amortization of intangibles, including inventory step-up 46.0 (18.9)% 56.7 112.4% 26.7 +% of net revenue 1.5 % 1.7 % 0.7 % +The decrease in total amortization expense for fiscal 2020, as compared to fiscal 2019, was primarily related to fully amortized intangible assets that were acquired in prior years. +Restructuring, Impairment, and Other Charges +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Restructuring, impairment, and other charges $ 13.8 102.9% $ 6.8 750.0% $ 0.8 +% of net revenue 0.4 % 0.2 % — % +Restructuring, impairment, and other charges incurred in fiscal 2020 were primarily related to the abandonment of a previously capitalized in-process research and development (“IPR&D”) project. +Restructuring, impairment, and other charges incurred in fiscal 2019 were primarily related to employee severance and other termination benefits as well as charges on a leased facility resulting from restructuring plans initiated during the period. +Provision for Income Taxes +Fiscal Years Ended +October 2, +2020 Change September 27, +2019 Change September 28, +2018 +(dollars in millions) +Provision for income taxes $ 76.9 (28.4)% $ 107.4 (74.0)% $ 413.7 +% of net revenue 2.3 % 3.2 % 10.7 % +The annual effective tax rate for fiscal 2020 of 8.6% was less than the United States federal statutory rate of 21.0% primarily due to benefits of 9.7% related to foreign earnings taxed at a rate less than the United States federal rate, 4.6% related to benefits from the foreign derived intangible income (“FDII”) deduction, 1.2% related to stock windfall deductions, and 2.6% related to the recognition of federal research and development tax credits, partially offset by increases in income tax rate expense impact of 4.0% related to global intangible low-taxed income (“GILTI”) expense, and 1.1% related to a change in our tax reserves. +The decrease in the effective tax rate for fiscal 2020, as compared to the 11.2% effective rate for fiscal 2019, was primarily due to benefits related to favorable changes to GILTI and increased windfall tax deductions. +See Note 8 to Item 8 of this Annual Report on Form 10-K for additional information regarding income taxes. +LIQUIDITY AND CAPITAL RESOURCES +Fiscal Years Ended +(in millions) October 2, +2020 September 27, +2019 September 28, +2018 +Cash and cash equivalents at beginning of period $ 851.3 $ 733.3 $ 1,616.8 +Net cash provided by operating activities 1,204.5 1,367.4 1,260.6 +Net cash used in investing activities (581.4) (336.9) (1,150.4) +Net cash used in financing activities (907.7) (912.5) (993.7) +Cash and cash equivalents at end of period $ 566.7 $ 851.3 $ 733.3 +31 +Cash provided by operating activities: +Cash provided by operating activities consists of net income for the period adjusted for certain non-cash items and changes in certain operating assets and liabilities. The $162.9 million decrease in cash provided by operating activities for fiscal 2020, as compared to fiscal 2019, was primarily related to unfavorable changes in working capital. +Cash used in investing activities: +Cash used in investing activities consists primarily of cash paid for acquisitions net of cash acquired, capital expenditures, purchased intangibles, and cash related to the sale or maturity of marketable securities. The $244.5 million increase in cash used in investing activities for fiscal 2020, as compared to fiscal 2019, was primarily related to a $269.3 million difference in the net purchase and sale of marketable securities, partially offset by a $9.0 million decrease in cash used for capital expenditures. +Cash used in financing activities: +Cash used in financing activities consists primarily of cash transactions related to equity. The $4.8 million decrease in cash used in financing activities for fiscal 2020, as compared to fiscal 2019, was primarily related to an increase of $35.0 million in net proceeds from employee stock option exercises and a decrease of $10.1 million in stock repurchase activity. These decreases in cash used in financing activities were partially offset by an increase of $33.1 million in dividend payments and an increase of $10.3 million related to the minimum statutory payroll tax withholdings upon vesting of employee performance and restricted stock awards. +Liquidity: +Cash, cash equivalents and marketable securities totaled $980.0 million as of October 2, 2020, representing a decrease of $102.3 million from September 27, 2019. The decrease resulted from $647.5 million used to repurchase 6.3 million shares of stock, $389.4 million in capital expenditures, and $307.0 million in cash dividend payments, which was partially offset by $1,204.5 million in cash generated from operations during fiscal 2020. Based on our historical results of operations, we expect that our cash, cash equivalents and marketable securities on hand and the cash we expect to generate from operations will be sufficient to fund our research and development, capital expenditures, potential acquisitions, working capital, quarterly cash dividend payments (if such dividends are declared by the Board of Directors), outstanding commitments and other liquidity requirements associated with existing operations for at least the next 12 months. However, we cannot be certain that our cash on hand and cash generated from operations will be available in the future to fund all of our capital and operating requirements. In addition, any future strategic investments and acquisitions may require additional cash and capital resources. If we are unable to obtain sufficient cash or capital to meet our needs on a timely basis and on favorable terms, our business and operations could be materially and adversely affected. +Our invested cash balances primarily consist of highly liquid marketable securities that are available to meet near-term cash requirements including: term deposits, certificate of deposits, money market funds, U.S. Treasury securities, agency securities, corporate debt securities and commercial paper. +OFF-BALANCE SHEET ARRANGEMENTS +All significant contractual obligations are recorded on our consolidated balance sheet or fully disclosed in the notes to our consolidated financial statements. We have no material off-balance sheet arrangements as defined in SEC Regulation S-K Item 303(a)(4)(ii). +CONTRACTUAL CASH FLOWS +Set forth below is a summary of our contractual payment obligations related to our operating leases, other commitments, and long-term liabilities at October 2, 2020 (in millions): +Payments Due By Period +Obligation +Total +Less Than 1 Year +1-3 Years +3-5 Years +Thereafter +Other long-term liabilities (1) $ 310.1 $ 19.1 $ 38.2 $ 38.2 $ 214.6 +Operating lease obligations 203.4 25.7 53.8 42.3 81.6 +Other commitments (2) 11.5 8.0 3.5 — — +Total $ 525.0 $ 52.8 $ 95.5 $ 80.5 $ 296.2 +_________________________ +32 +(1) Other long-term liabilities primarily include our gross unrecognized tax benefits, repatriation tax payable, and executive deferred compensation. Gross unrecognized tax benefits and executive deferred compensation are both classified as beyond five years due to the uncertain nature of the liabilities. +(2) Other commitments consist of contractual license and royalty payments and other purchase obligations. +CRITICAL ACCOUNTING ESTIMATES +The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments in applying our most critical accounting policies that can have a significant impact on the results we report in our financial statements. The SEC has defined critical accounting policies as those that are both most important to the portrayal of our financial condition and results and which require our most difficult, complex, or subjective judgments or estimates. Based on this definition, our most critical accounting policies include revenue recognition, which impacts the recording of net revenue; inventory valuation, which impacts the cost of goods sold and gross margin; assessment of goodwill and long-lived assets, which impacts the impairment of the respective assets; share-based compensation, which impacts cost of goods sold and operating expenses; loss contingencies, which impacts operating expenses; and income taxes, which impacts the income tax provision. These policies and significant judgments involved are discussed further below. We have other significant accounting policies that do not generally require subjective estimates or judgments or would not have a material impact on our results of operations. Our significant accounting policies are described in Note 2 to Item 8 of this Annual Report on Form 10-K. +Revenue Recognition. We recognize revenue in accordance with the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 606 Revenue from Contracts with Customers net of estimated reserves . Our revenue reserves contain uncertainties because they require management to make assumptions and to apply judgment to estimate the value of future credits to customers for product returns, price protection and stock rotation for products sold to certain electronic component distributors. We base these estimates on the expected value method considering all reasonably available information, including our historical experience and current expectations, and is reflected in the transaction price when sales are recorded. +Inventory Valuation . We value our inventory at the lower of cost or net realizable value. Reserves for excess and obsolete inventory are established on a quarterly basis and are based on a detailed analysis of aged material, salability of our inventory, market conditions, and product life cycles. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. Our reserves contain uncertainties because the calculation requires management to make assumptions and to apply judgment regarding historical experience, market conditions and technological obsolescence. Changes in actual demand or market conditions could adversely impact our reserve calculations. +Income Taxes. The application of tax laws and regulations to calculate our tax liabilities is subject to legal and factual interpretation, judgment, and uncertainty in a multitude of jurisdictions. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations, and court rulings. We recognize potential liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and interest will be due. We record an amount as an estimate of probable additional income tax liability at the largest amount that we feel is more likely than not, based upon the technical merits of the position, to be sustained upon audit by the relevant tax authority. +OTHER MATTERS +Inflation did not have a material impact on our results of operations during the three-year period ended October 2, 2020. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. +We are subject to overall financial market risks, such as changes in market liquidity, credit quality, investment risk, interest rate risk and foreign exchange rate risk as described below. +Investment and Interest Rate Risk +Our exposure to interest rate and general market risks relates principally to our investment portfolio, which consists of cash and cash equivalents (money market funds and marketable securities purchased with less than ninety days until maturity) that total approximately $566.7 million and marketable securities (U.S. Treasury and government securities, corporate bonds and notes, +33 +municipal bonds) that total approximately $408.1 million and $5.2 million within short-term and long-term marketable securities, respectively, as of October 2, 2020. +The main objectives of our investment activities are liquidity and preservation of capital. Our cash equivalent investments have short-term maturity periods that dampen the impact of market or interest rate risk. Our marketable securities consist of short-term and long-term maturity periods between 90 days and two years. Credit risk associated with our investments is not material because our investments are diversified across several types of securities with high credit ratings, which reduces the amount of credit exposure to any one investment. +Based on our results of operations for the fiscal year ended October 2, 2020, a hypothetical reduction in the interest rates on our cash, cash equivalents, and other investments to zero would result in an immaterial reduction of interest income with a de minimis impact on income before taxes. +Given the low interest rate environment, the objectives of our investment activities, and the relatively low interest income generated from our cash, cash equivalents, and other investments, we do not believe that investment or interest rate risks currently pose material exposures to our business or results of operations. +Foreign Exchange Rate Risk +Substantially all sales to customers and arrangements with third-party manufacturers provide for pricing and payment in United States dollars, thereby reducing the impact of foreign exchange rate fluctuations on our results. A percentage of our international operational expenses are denominated in foreign currencies and exchange rate volatility could positively or negatively impact those operating costs. For the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, we had foreign exchange losses of $5.9 million, $6.2 million, and $5.5 million, respectively. Increases in the value of the United States dollar relative to other currencies could make our products more expensive, which could negatively impact our ability to compete. Conversely, decreases in the value of the United States dollar relative to other currencies could result in our suppliers raising their prices to continue doing business with us. Given the relatively small number of customers and arrangements with third-party manufacturers denominated in foreign currencies, we do not believe that foreign exchange volatility has a material impact on our current business or results of operations. However, fluctuations in currency exchange rates could have a greater effect on our business or results of operations in the future to the extent our expenses increasingly become denominated in foreign currencies. +We may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. However, we may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. For the fiscal year ended October 2, 2020, we had no outstanding foreign currency forward or option contracts with financial institutions. +34 +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +The following consolidated financial statements of the Company are included herewith: +(1) +Report of Independent Registered Public Accounting Firm +Page 36 +(2) +Consolidated Statements of Operations for the three years ended October 2, 2020 +Page 38 +(3) +Consolidated Statements of Comprehensive Income for the three years ended October 2, 2020 +Page 39 +(4) +Consolidated Balance Sheets at October 2, 2020, and September 27, 2019 +Page 40 +(5) +Consolidated Statements of Cash Flows for the three years ended October 2, 2020 +Page 41 +(6) +Consolidated Statements of Stockholders’ Equity for the three years ended October 2, 2020 +Page 42 +(7) +Notes to Consolidated Financial Statements +Page 43 through 60 +35 +Report of Independent Registered Public Accounting Firm +To the Stockholders and Board of Directors +Skyworks Solutions, Inc.: +Opinions on the Consolidated Financial Statements and Internal Control Over Financial Reporting +We have audited the accompanying consolidated balance sheets of Skyworks Solutions, Inc. and subsidiaries (the Company) as of October 2, 2020 and September 27, 2019, the related consolidated statements of operations, comprehensive income, cash flows, and stockholders’ equity for each of the years in the three-year period ended October 2, 2020, and the related notes (collectively, the consolidated financial statements). We also have audited the Company’s internal control over financial reporting as of October 2, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of October 2, 2020 and September 27, 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended October 2, 2020, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of October 2, 2020 based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +Change in Accounting Principle +As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for leases in fiscal 2020 due to the adoption of the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 842, Leases . +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting . Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting +36 +includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matter +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Assessment of the Gross Unrecognized Tax Benefits +As discussed in Notes 2 and 8 to the consolidated financial statements, the Company has recorded gross unrecognized tax benefits of $117.6 million in domestic and foreign jurisdictions as of October 2, 2020. The Company records unrecognized tax benefits when there is more than a 50% likelihood that its tax positions will not be sustained upon examination by the taxing authorities. This determination requires management of the Company to apply judgment in the interpretation of domestic and international tax laws and regulations. +We identified the assessment of the gross unrecognized tax benefits as a critical audit matter because of the high degree of auditor judgment involved in evaluating the Company’s interpretation of domestic and international tax laws and regulations, including the need to involve professionals with specialized skills and knowledge. +The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls over the Company’s unrecognized tax benefit process, including controls over the interpretation of domestic and international tax laws and regulations. We involved domestic and international tax professionals with specialized skills and knowledge, who assisted in: +– assessing the Company’s ongoing compliance with applicable domestic and international tax laws and regulations, +– reading the Company’s documentation that provided the basis for its tax positions, +– evaluating the impact of changes in the Company’s tax structure, changes in domestic and international tax laws and regulations, and similar settlements with applicable taxing authorities, and +– evaluating the Company’s interpretation of domestic and international tax laws and regulations based on our understanding and interpretation of the domestic and international tax laws and regulations. +/s/ KPMG LLP +We have served as the Company’s auditor since 2002. +Irvine, California +November 16, 2020 +37 +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF OPERATIONS +(In millions, except per share amounts) +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Net revenue $ 3,355.7 $ 3,376.8 $ 3,868.0 +Cost of goods sold 1,742.8 1,773.0 1,917.3 +Gross profit 1,612.9 1,603.8 1,950.7 +Operating expenses: +Research and development 464.1 424.1 404.5 +Selling, general, and administrative 231.4 198.3 207.8 +Amortization of intangibles 11.8 22.6 18.3 +Restructuring, impairment, and other charges 13.8 6.8 0.8 +Total operating expenses 721.1 651.8 631.4 +Operating income 891.8 952.0 1,319.3 +Other income (expense), net ( 0.1 ) 9.0 12.8 +Income before income taxes 891.7 961.0 1,332.1 +Provision for income taxes 76.9 107.4 413.7 +Net income $ 814.8 $ 853.6 $ 918.4 +Earnings per share: +Basic $ 4.84 $ 4.92 $ 5.06 +Diluted $ 4.80 $ 4.89 $ 5.01 +Weighted average shares: +Basic 168.5 173.5 181.3 +Diluted 169.9 174.5 183.2 +Cash dividends declared and paid per share $ 1.82 $ 1.58 $ 1.34 +See accompanying Notes to Consolidated Financial Statements. +38 +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +(In millions) +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Net income $ 814.8 $ 853.6 $ 918.4 +Other comprehensive income (loss), net of tax +Fair value of investments 0.1 0.3 ( 0.1 ) +Pension adjustments — 0.5 — +Foreign currency translation adjustment — — ( 0.2 ) +Comprehensive income $ 814.9 $ 854.4 $ 918.1 +See accompanying Notes to Consolidated Financial Statements. +39 +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED BALANCE SHEETS +(In millions, except per share amounts) +As of +October 2, +2020 September 27, +2019 +ASSETS +Current assets: +Cash and cash equivalents $ 566.7 $ 851.3 +Marketable securities 408.1 203.3 +Receivables, net of allowance of $0.6 and $0.8, respectively 393.6 465.3 +Inventory 806.0 609.7 +Other current assets 143.2 105.0 +Total current assets 2,317.6 2,234.6 +Property, plant, and equipment, net 1,249.5 1,205.6 +Operating lease right-of-use assets 167.9 — +Goodwill 1,189.8 1,189.8 +Intangible assets, net 53.5 107.9 +Deferred tax assets, net 55.3 40.8 +Marketable securities 5.2 27.6 +Other long-term assets 67.9 33.3 +Total assets $ 5,106.7 $ 4,839.6 +LIABILITIES AND STOCKHOLDERS’ EQUITY +Current liabilities: +Accounts payable 226.9 190.5 +Accrued compensation and benefits 113.5 76.0 +Other current liabilities 108.0 107.5 +Total current liabilities 448.4 374.0 +Long-term tax liabilities 311.3 312.4 +Long-term operating lease liabilities 150.7 — +Other long-term liabilities 32.1 30.9 +Total liabilities 942.5 717.3 +Commitments and contingencies (Note 11) +Stockholders’ equity: +Preferred stock, no par value: 25.0 shares authorized, no shares issued +— — +Common stock, $0.25 par value: 525.0 shares authorized; 232.3 shares issued and 165.6 shares outstanding at October 2, 2020, and 230.2 shares issued and 170.1 shares outstanding at September 27, 2019 +41.4 42.5 +Additional paid-in capital 3,403.7 3,188.0 +Treasury stock, at cost ( 4,093.5 ) ( 3,412.9 ) +Retained earnings 4,820.4 4,312.6 +Accumulated other comprehensive loss ( 7.8 ) ( 7.9 ) +Total stockholders’ equity 4,164.2 4,122.3 +Total liabilities and stockholders’ equity $ 5,106.7 $ 4,839.6 +See accompanying Notes to Consolidated Financial Statements. +40 +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF CASH FLOWS +(In millions) +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Cash flows from operating activities: +Net income $ 814.8 $ 853.6 $ 918.4 +Adjustments to reconcile net income to net cash provided by operating activities: +Share-based compensation 156.6 80.1 107.8 +Depreciation 318.3 314.9 272.5 +Amortization of intangible assets, including inventory step-up 46.0 56.7 26.7 +Deferred income taxes ( 13.4 ) ( 6.1 ) 27.3 +Asset impairment charges 11.8 — — +Changes in fair value of contingent consideration — ( 3.1 ) ( 11.9 ) +Other, net 3.8 16.8 ( 0.7 ) +Changes in assets and liabilities: +Receivables, net 71.7 190.5 ( 193.8 ) +Inventory ( 190.4 ) ( 119.6 ) 11.9 +Accounts payable 61.1 ( 33.0 ) ( 126.0 ) +Other current and long-term assets and liabilities ( 75.8 ) 16.6 228.4 +Net cash provided by operating activities 1,204.5 1,367.4 1,260.6 +Cash flows from investing activities: +Capital expenditures ( 389.4 ) ( 398.4 ) ( 422.3 ) +Purchased intangibles ( 9.1 ) ( 25.0 ) ( 8.6 ) +Purchases of marketable securities ( 790.5 ) ( 360.5 ) ( 683.7 ) +Sales and maturities of marketable securities 607.6 447.0 368.2 +Payments for acquisitions, net of cash — — ( 404.0 ) +Net cash used in investing activities ( 581.4 ) ( 336.9 ) ( 1,150.4 ) +Cash flows from financing activities: +Repurchase of common stock - payroll tax withholdings on equity awards ( 33.1 ) ( 22.8 ) ( 48.0 ) +Repurchase of common stock - stock repurchase program ( 647.5 ) ( 657.6 ) ( 759.5 ) +Dividends paid ( 307.0 ) ( 273.9 ) ( 243.2 ) +Net proceeds from exercise of stock options 57.1 22.1 38.8 +Proceeds from employee stock purchase plan 22.8 19.7 18.2 +Net cash used in financing activities ( 907.7 ) ( 912.5 ) ( 993.7 ) +Net increase (decrease) in cash and cash equivalents ( 284.6 ) 118.0 ( 883.5 ) +Cash and cash equivalents at beginning of period 851.3 733.3 1,616.8 +Cash and cash equivalents at end of period $ 566.7 $ 851.3 $ 733.3 +Supplemental cash flow disclosures: +Income taxes paid $ 110.8 $ 124.4 $ 135.9 +Non-cash investing in capital expenditures, accrued but not paid $ 78.7 $ 101.5 $ 108.0 +See accompanying Notes to Consolidated Financial Statements. +41 +SKYWORKS SOLUTIONS, INC. +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +(In millions) +Shares of common stock Par value of common stock Shares of treasury stock Value of treasury stock Additional paid-in capital Retained earnings Accumulated other comprehensive income (loss) +Total stockholders ’ equity +Balance at September 29, 2017 183.1 $ 45.8 42.9 $ ( 1,925.0 ) $ 2,893.8 $ 3,059.6 $ ( 8.5 ) $ 4,065.7 +Net income — — — — — 918.4 — 918.4 +Exercise and settlement of share-based awards, net of shares withheld for taxes 2.0 0.5 0.4 ( 48.0 ) 57.8 — — 10.3 +Share-based compensation expense — — — — 107.3 ( 1.9 ) — 105.4 +Stock repurchase program ( 7.7 ) ( 1.9 ) 7.7 ( 759.5 ) 1.9 — — ( 759.5 ) +Dividends declared — — — — — ( 243.2 ) — ( 243.2 ) +Pre-combination service on replacement awards — — — — 0.2 — — 0.2 +Other comprehensive loss — — — — — — ( 0.3 ) ( 0.3 ) +Balance at September 28, 2018 177.4 $ 44.4 51.0 $ ( 2,732.5 ) $ 3,061.0 $ 3,732.9 $ ( 8.8 ) $ 4,097.0 +Net income — — — — — 853.6 — 853.6 +Exercise and settlement of share-based awards, net of shares withheld for taxes 1.6 0.3 0.3 ( 22.8 ) 42.2 — — 19.8 +Share-based compensation expense — — — — 82.5 — — 82.5 +Stock repurchase program ( 8.9 ) ( 2.2 ) 8.9 ( 657.6 ) 2.2 — — ( 657.6 ) +Dividends declared — — — — — ( 273.9 ) — ( 273.9 ) +Other comprehensive income — — — — — — 0.8 0.8 +Balance at September 27, 2019 170.1 $ 42.5 60.1 $ ( 3,412.9 ) $ 3,188.0 $ 4,312.6 $ ( 7.9 ) $ 4,122.3 +Net income — — — — — 814.8 — 814.8 +Exercise and settlement of share-based awards, net of shares withheld for taxes 1.8 0.5 0.3 ( 33.1 ) 79.4 — — 46.8 +Share-based compensation expense — — — — 134.7 — — 134.7 +Stock repurchase program ( 6.3 ) ( 1.6 ) 6.3 ( 647.5 ) 1.6 — — ( 647.5 ) +Dividends declared — — — — — ( 307.0 ) — ( 307.0 ) +Other comprehensive income — — — — — — 0.1 0.1 +Balance at October 2, 2020 165.6 $ 41.4 66.7 $ ( 4,093.5 ) $ 3,403.7 $ 4,820.4 $ ( 7.8 ) $ 4,164.2 +See accompanying Notes to Consolidated Financial Statements. +42 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s analog semiconductors are connecting people, places, and things, spanning a number of new applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, entertainment and gaming, industrial, medical, military, smartphone, tablet, and wearable markets. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Principles of Consolidation +All Skyworks subsidiaries are included in the Company’s consolidated financial statements and all intercompany balances are eliminated in consolidation. Certain items in the fiscal years 2019 and 2018 financial statements have been reclassified to conform to the fiscal 2020 presentation. +Fiscal Year +The Company’s fiscal year ends on the Friday closest to September 30. Fiscal 2020 consisted of 53 weeks and ended on October 2, 2020. Fiscal 2019 and 2018 each consisted of 52 weeks and ended on September 27, 2019 and September 28, 2018, respectively. +Use of Estimates +The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts of assets, liabilities, revenue, expenses, comprehensive income and accumulated other comprehensive loss during the reporting period. The Company evaluates its estimates on an ongoing basis using historical experience and other factors, including the current economic environment. Judgment is required in determining the reserves for and fair value of items such as overall fair value assessments of assets and liabilities, particularly those classified as Level 2 or Level 3 in the fair value hierarchy, marketable securities, inventory, intangible assets associated with business combinations, share-based compensation, loss contingencies, and income taxes. In addition, judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment testing. Actual results could differ significantly from these estimates. +Cash and Cash Equivalents +The Company invests excess cash in time deposits, certificate of deposits, money market funds, U.S. Treasury securities, agency securities, other government securities, corporate debt securities and commercial paper. The Company considers highly liquid investments as cash equivalents including money market funds and investments with maturities of 90 days or less when purchased. +Investments +The Company classifies its investment in marketable debt securities as “available-for-sale.” Available-for-sale securities are carried at fair value with unrealized holding gains or losses recorded in other comprehensive income, net of tax. Gains or losses are included in earnings in the period in which they are realized. The cost of securities sold is determined based on the specific identification method. The cost of available-for-sale debt securities is adjusted for premiums and discounts, with the amortization or accretion of such amounts included as a portion of interest. Available-for-sale debt securities with an original maturity date greater than three months and less than one year are classified as current investments. Available-for-sale debt securities with an original maturity date exceeding one year are classified as long-term. +Fair Value +Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principle or most advantageous market in an orderly transaction between market participants at the measurement date. Applicable accounting guidance provides a hierarchy for inputs used in measuring fair value that prioritize the use of observable inputs over the use of unobservable inputs, when such observable inputs are available. The three levels of inputs that may be used to measure fair value are as follows: +• Level 1 - Quoted prices in active markets for identical assets or liabilities. +43 +• Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-driven valuations in which all significant inputs are observable or can be derived principally from, or corroborated with, observable market data. +• Level 3 - Fair value is derived from valuation techniques in which one or more significant inputs are unobservable, including assumptions and judgments made by the Company. +It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, the Company uses quoted market prices to measure fair value. If market prices are not available, the Company is required to make judgments about assumptions market participants would use to estimate the fair value of a financial instrument. +The Company measures certain assets and liabilities at fair value on a recurring basis in three levels, based on the market in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. It recognizes transfers within the fair value hierarchy at the end of the fiscal quarter in which the change in circumstances that caused the transfer occurred. +The carrying value of cash and cash equivalents, accounts receivable, other current assets, accounts payable and accrued liabilities approximates fair value due to the short-term maturities of these assets and liabilities. +Inventory +Inventory is stated at the lower of cost or net realizable value on a first-in, first-out basis. Reserves for excess and obsolete inventory are established on a quarterly basis and are based on a detailed analysis of aged material, salability of our inventory, market conditions, and product life cycles. Once reserves are established, write-downs of inventory are considered permanent adjustments to the cost basis of inventory. +Property, Plant, and Equipment +Property, plant, and equipment are carried at cost less accumulated depreciation, with significant renewals and betterments being capitalized and retired equipment written off in the respective periods. Maintenance and repairs are expensed as incurred. +Depreciation is calculated using the straight-line method over the estimated useful lives, which range from five to thirty years for buildings and improvements and three to ten years for machinery and equipment. Leasehold improvements are depreciated over the lesser of the economic life or the life of the associated lease. +Leases +The Company determines if an arrangement is a lease at its inception. Right-of-use (“ROU”) assets and liabilities are recognized at the lease commencement date based on the present value of lease payments over the lease term. The Company uses its estimated incremental borrowing rate in determining the present value of lease payments considering the term of the lease, which is derived from information available at the lease commencement date. The lease term includes renewal options when it is reasonably certain that the option will be exercised and excludes termination options. To the extent that the Company’s agreements have variable lease payments, the Company includes variable lease payments that depend on an index or a rate and excludes those that depend on facts or circumstances occurring after the commencement date, other than the passage of time. +Lease expense for these leases is recognized on a straight-line basis over the lease term. The Company has elected not to recognize ROU assets and lease liabilities that arise from short-term (12 months or less) leases for any class of underlying asset. Operating leases are included in operating lease ROU assets, other current liabilities, and long-term operating lease liabilities in the Company's condensed consolidated balance sheet. +Valuation of Long-Lived Assets +Definite lived intangible assets are carried at cost less accumulated amortization. Amortization is calculated based on the pattern of benefit to be recognized from the underlying asset over its estimated useful life. Carrying values for long-lived assets and definite lived intangible assets are reviewed for possible impairment as circumstances warrant. Factors considered important that could result in an impairment review include significant underperformance relative to expected, historical or projected future operating results, significant changes in the manner of use of assets or the Company’s business strategy, or significant negative industry or economic trends. In addition, impairment reviews are conducted at the judgment of +44 +management whenever asset values are deemed to be unrecoverable relative to future undiscounted cash flows expected to be generated by that particular asset group. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of an asset group and its eventual disposition. Such estimates require management to exercise judgment and make assumptions regarding factors such as future revenue streams, operating expenditures, cost allocation and asset utilization levels, all of which collectively impact future operating performance. The Company’s estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, technological changes, economic conditions, changes to its business model or changes in its operating performance. If the sum of the undiscounted cash flows is less than the carrying value of an asset group, the Company would recognize an impairment loss, measured as the amount by which the carrying value exceeds the fair value of the asset group. +Goodwill and Indefinite-Lived Intangible Assets +Goodwill and indefinite-lived intangible assets are not amortized but are tested at least annually as of the first day of the fourth fiscal quarter for impairment or more frequently if indicators of impairment exist during the fiscal year. The Company assesses its conclusion regarding segments and reporting units in conjunction with its annual goodwill impairment test and has determined that it has one reporting unit for the purposes of allocating and testing goodwill. +The Company’s impairment analysis compares its fair value to its net book value to determine if there is an indicator of impairment. In the Company’s calculation of fair value, it considers the closing price of its common stock on the selected testing date, the number of shares of its common stock outstanding and other marketplace activity such as a related control premium. If the calculated fair value is determined to be less than the book value of the reporting unit, an impairment loss is recognized equal to that excess; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. +Revenue Recognition +The Company derives its revenue primarily from the sale of semiconductor products under individual customer purchase orders, some of which have underlying master sales agreements that specify terms governing the product sales. In the absence of a sales agreement, the Company’s standard terms and conditions apply. Revenue is recognized when control of the promised goods or services is transferred to the Company’s customers, in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The Company applies a five-step approach as defined in FASB ASC 606, Revenue from Contracts with Customers (Topic 606), in determining the amount and timing of revenue to be recognized: (1) identifying the contract with a customer; (2) identifying the performance obligations in the contract; (3) determining the transaction price; (4) allocating the transaction price to the performance obligations in the contract; and (5) recognizing revenue when the corresponding performance obligation is satisfied. +Each distinct promise to transfer products is considered to be an identified performance obligation for which revenue is recognized at a point in time upon transfer of control of the products to the customer. Transfer of control occurs upon shipment to the distributor or direct customer or when products are pulled from consignment inventory by the customer. Point in time recognition is determined as products manufactured under non-cancellable orders create an asset with an alternative use to the Company. Returns under the Company’s general assurance warranty of products have not been material, and warranty-related services are not considered a separate performance obligation. +Pricing adjustments and estimates of returns are treated as variable consideration for purposes of determining the transaction price. Sales returns are generally accepted at the Company’s discretion or from distributors with stock rotation rights. Stock rotation allows distributors limited levels of returns and is based on the distributor’s prior purchases. Price protection represents price discounts granted to certain distributors and is based on negotiations on sales to end customers. Variable consideration is estimated using the expected value method considering all reasonably available information, including the Company’s historical experience and its current expectations, and is reflected in the transaction price when sales are recorded. The Company records net revenue excluding taxes collected on its sales to trade customers. +Accounts receivable represents the Company’s unconditional right to receive consideration from its customer. Substantially all payments are collected within the Company’s standard terms, which do not include a significant financing component. To date, there have been no material impairment losses on accounts receivable. There were no material contract assets or contract liabilities recorded on the consolidated balance sheet in any of the periods presented. All incremental customer contract acquisition costs are expensed as they are incurred as the amortization period of the asset that the Company otherwise would have recognized is one year or less in duration. +Share-Based Compensation +45 +The Company recognizes compensation expense for all share-based payment awards made to employees and directors including non-qualified employee stock options, share awards and units, employee stock purchase plan and other special share-based awards based on estimated fair values. +The fair value of share-based payment awards is amortized over the requisite service period, which is defined as the period during which an employee is required to provide service in exchange for an award. The Company uses a straight-line attribution method for all grants that include only a service condition. Awards with both performance and service conditions are expensed over the service period for each separately vesting tranche. +Share-based compensation expense recognized during the period includes actual expense on vested awards and expense associated with unvested awards. Forfeitures are recorded as incurred. +The Company determines the fair value of share-based option awards based on the Company’s closing stock price on the date of grant using a Black-Scholes options pricing model. Under the Black-Scholes model, a number of variables are used including, but not limited to: the expected stock price volatility over the term of the award, the risk-free rate, the expected life of the award and dividend yield. The determination of fair value of restricted and certain performance stock awards and units is based on the value of the Company’s stock on the date of grant with performance awards and units adjusted for the actual outcome of the underlying performance condition. +For more complex performance awards including units with market-based performance conditions the Company employs a Monte Carlo simulation valuation method to calculate the fair value of the awards based on the most likely outcome. Under the Monte Carlo simulation, a number of variables and assumptions are used including, but not limited to: the expected stock price volatility over the term of the award, a correlation coefficient, the risk-free rate, and dividend yield. +Research and Development Costs +Research and development costs are expensed as incurred. +Loss Contingencies +The Company records its best estimates of a loss contingency when it is considered probable and the amount can be reasonably estimated. When a range of loss can be reasonably estimated with no best estimate in the range, the minimum estimated liability related to the claim is recorded. As additional information becomes available, the Company assesses the potential liability related to the potential pending loss contingency and revises its estimates. Material loss contingencies are disclosed if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and include estimated legal costs. +Restructuring +A liability for post-employment benefits is recorded when payment is probable and the amount is reasonably estimable. Contract exit costs include contract termination fees and future contractual commitments for lease payments. A liability for contract exit costs is recognized in the period in which the Company terminates the contract or on the cease-use date for leased facilities. +Foreign Currencies +The Company’s functional currency is the United States dollar. Gains and losses related to foreign currency transactions and conversion of foreign denominated cash balances are included in current results. +Income Taxes +The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. This method also requires the recognition of future tax benefits such as net operating loss carry forwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. +The carrying value of the Company’s net deferred tax assets assumes the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to record additional valuation allowances against its deferred tax assets +46 +resulting in additional income tax expense in its Consolidated Statement of Operations. Management evaluates the realizability of the deferred tax assets and assesses the adequacy of the valuation allowance quarterly. Likewise, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made. +The determination of recording or releasing tax valuation allowances is made, in part, pursuant to an assessment performed by management regarding the likelihood that the Company will generate future taxable income against which benefits of its deferred tax assets may or may not be realized. This assessment requires management to exercise judgment and make estimates with respect to its ability to generate revenues, gross profits, operating income, and taxable income in future periods. Amongst other factors, management must make assumptions regarding overall business and semiconductor industry conditions, operating efficiencies, the Company’s ability to develop products to its customers’ specifications, technological change, the competitive environment, and changes in regulatory requirements which may impact its ability to generate taxable income and, in turn, realize the value of its deferred tax assets. +The calculation of the Company’s tax liabilities includes addressing uncertainties in the application of complex tax regulations and is based on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. +The Company recognizes liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on its recognition threshold and measurement attribute of whether it is more likely than not that the positions the Company has taken in tax filings will be sustained upon tax audit, and the extent to which, additional taxes would be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period in which it is determined the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. The Company recognizes any interest or penalties, if incurred, on any unrecognized tax liabilities or benefits as a component of income tax expense. +Earnings Per Share +Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporate the potentially dilutive incremental shares issuable upon the assumed exercise of stock options, the assumed vesting of outstanding restricted stock units, and the assumed issuance of common stock under the stock purchase plan using the treasury share method. Shares issuable upon the vesting of performance stock awards are likewise included in the calculation of diluted earnings per share as of the date the condition(s) have been satisfied. +Recently Adopted Accounting Pronouncements +In February 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842) (“ASU 2016-02”). This ASU requires lessees to reflect leases with a term greater than one year on their balance sheet as assets and obligations. The Company adopted the standard in the first quarter of fiscal 2020, using the modified retrospective approach, whereby the Company was not required to adjust comparative period financial statements for the new standard. Upon adoption, the Company recorded an ROU asset of $ 141.4 million and a lease liability of $ 143.1 million. This standard did not have a material impact on the Consolidated Statement of Operations or Consolidated Statement of Cash Flows. +Upon adoption, the Company elected the package of three practical expedients that permits the Company to maintain its historical conclusions about lease identification, lease classification and initial direct costs for leases that exist at the date of adoption. Further, the Company elected the practical expedient to not separate lease and non-lease components. +3. MARKETABLE SECURITIES +The Company's portfolio of available-for-sale marketable securities consists of the following (in millions): +Current Noncurrent +Available-for-sale: October 2, +2020 September 27, +2019 October 2, +2020 September 27, +2019 +U.S. Treasury and government $ 129.4 $ 34.2 $ 5.0 $ 20.0 +Corporate bonds and notes 276.8 66.2 — 5.9 +Municipal bonds 1.9 102.9 0.2 1.7 +Total $ 408.1 $ 203.3 $ 5.2 $ 27.6 +47 +The contractual maturities of noncurrent available-for-sale marketable securities were due within two years or less. There were gross unrealized gains of $ 0.3 million on U.S. Treasury securities and $ 0.2 million on corporate bonds and notes as of October 2, 2020, and $ 0.1 million in gross unrealized losses on municipal bonds as of September 27, 2019. +4. FAIR VALUE +Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis +The Company measures certain assets and liabilities at fair value on a recurring basis such as its financial instruments. There have been no transfers between Level 1, 2 or 3 assets or liabilities during the fiscal year ended October 2, 2020. +Assets and liabilities recorded at fair value on a recurring basis consisted of the following (in millions): +As of October 2, 2020 As of September 27, 2019 +Fair Value Measurements Fair Value Measurements +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +Assets +Cash and cash equivalents* $ 566.7 $ 561.2 $ 5.5 $ — $ 851.3 $ 809.5 $ 41.8 $ — +U.S. Treasury and government securities 134.4 43.2 91.2 — 54.2 28.4 25.8 — +Corporate bonds and notes 276.8 — 276.8 — 72.1 — 72.1 — +Municipal bonds 2.1 — 2.1 — 104.6 — 104.6 — +Total $ 980.0 $ 604.4 $ 375.6 $ — $ 1,082.2 $ 837.9 $ 244.3 $ — +* Cash equivalents included in Levels 1 and 2 consist of money market funds and corporate bonds and notes, commercial paper, and agency securities purchased with less than ninety days until maturity. +Assets Measured and Recorded at Fair Value on a Nonrecurring Basis +The Company’s non-financial assets and liabilities, such as goodwill, intangible assets, and other long-lived assets resulting from business combinations, are measured at fair value using income approach valuation methodologies at the date of acquisition and are subsequently re-measured if there are indicators of impairment. During fiscal 2020, the Company abandoned a previously capitalized IPR&D project and recorded an impairment charge of $ 9.8 million. +5. INVENTORY +Inventory consists of the following (in millions): +As of +October 2, +2020 September 27, +2019 +Raw materials $ 37.8 $ 24.4 +Work-in-process 566.4 336.2 +Finished goods 198.9 245.7 +Finished goods held on consignment by customers 2.9 3.4 +Total inventory $ 806.0 $ 609.7 +6. PROPERTY, PLANT, AND EQUIPMENT, NET +Property, plant, and equipment, net consists of the following (in millions): +48 +As of +October 2, +2020 September 27, +2019 +Land and improvements $ 11.8 $ 11.7 +Buildings and improvements 424.8 354.4 +Furniture and fixtures 46.5 33.8 +Machinery and equipment 2,556.1 2,311.5 +Construction in progress 140.7 172.5 +Total property, plant, and equipment, gross 3,179.9 2,883.9 +Accumulated depreciation ( 1,930.4 ) ( 1,678.3 ) +Total property, plant, and equipment, net $ 1,249.5 $ 1,205.6 +7. GOODWILL AND INTANGIBLE ASSETS +The Company’s goodwill balance was $ 1,189.8 million as of October 2, 2020, and September 27, 2019. The Company performed an impairment test of its goodwill as of the first day of the fourth fiscal quarter in accordance with its regularly scheduled testing. The results of this test indicated that the Company’s goodwill was not impaired. There were no other indicators of impairment noted during the fiscal year ended October 2, 2020. +Intangible assets consist of the following (in millions): +As of As of +Weighted +average +amortization +period (years) +October 2, 2020 September 27, 2019 +Gross +carrying +amount +Accumulated +amortization +Net +carrying +amount +Gross +carrying +amount +Accumulated +amortization +Net +carrying +amount +Customer relationships 5.0 $ 18.2 $ ( 15.8 ) $ 2.4 $ 25.6 $ ( 19.5 ) $ 6.1 +Developed technology and other 3.8 101.0 ( 81.6 ) 19.4 94.4 ( 48.9 ) 45.5 +Trademarks 3.0 1.6 ( 1.5 ) 0.1 1.6 ( 1.3 ) 0.3 +Technology licenses 3.0 26.3 ( 14.2 ) 12.1 $ 24.9 ( 4.8 ) 20.1 +IPR&D 19.5 — 19.5 $ 35.9 — 35.9 +Total intangible assets $ 166.6 $ ( 113.1 ) $ 53.5 $ 182.4 $ ( 74.5 ) $ 107.9 +Fully amortized intangible assets are eliminated from both the gross and accumulated amortization amounts in the first quarter of each fiscal year. Accrued technology licenses payable of $ 11.5 million and $ 20.1 million have been included in other current liabilities within the consolidated balance sheets as of October 2, 2020, and September 27, 2019, respectively. +Annual amortization expense for the next five fiscal years related to definite-lived intangible assets, excluding IPR&D, is expected to be as follows (in millions): +2021 2022 2023 2024 2025 Thereafter +Amortization expense, cost of goods sold $ 6.0 $ 0.1 $ 0.1 $ 0.1 $ 0.1 $ 1.7 +Amortization expense, operating expense $ 17.0 $ 5.0 $ 1.0 $ 1.0 $ 1.0 $ 0.9 +Total amortization expense $ 23.0 $ 5.1 $ 1.1 $ 1.1 $ 1.1 $ 2.6 +8. INCOME TAXES +Income before income taxes consists of the following components (in millions): +49 +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +United States $ 435.9 $ 427.2 $ 712.2 +Foreign 455.8 533.8 619.9 +Income before income taxes $ 891.7 $ 961.0 $ 1,332.1 +The provision for income taxes consists of the following components(in millions): +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Current tax expense (benefit): +Federal $ 44.4 $ 85.3 $ 347.7 +State — ( 0.1 ) 0.3 +Foreign 49.5 23.5 31.2 +93.9 108.7 379.2 +Deferred tax expense (benefit): +Federal ( 6.8 ) ( 0.4 ) 20.3 +Foreign ( 10.2 ) ( 0.9 ) 14.2 +( 17.0 ) ( 1.3 ) 34.5 +Provision for income taxes $ 76.9 $ 107.4 $ 413.7 +The actual income tax expense is different than that which would have been computed by applying the federal statutory tax rate to income before income taxes. A reconciliation of income tax expense as computed at the United States federal statutory income tax rate to the provision for income tax expense is as follows (in millions): +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Tax expense at United States statutory rate $ 187.3 $ 201.8 $ 327.4 +Foreign tax rate difference ( 86.6 ) ( 115.3 ) ( 111.9 ) +Tax on deemed repatriation 0.2 8.1 224.6 +Effect of stock compensation ( 10.3 ) ( 1.6 ) ( 25.6 ) +Change of tax rate on deferred taxes — — 18.3 +Research and development credits ( 23.0 ) ( 25.7 ) ( 19.9 ) +Change in tax reserve 10.1 14.0 6.7 +Domestic production activities deduction — — ( 13.9 ) +Global Intangible Low-Taxed Income 35.9 54.3 — +Foreign Derived Intangible Income ( 41.2 ) ( 41.5 ) — +Settlements with Tax Authorities ( 0.5 ) 4.3 — +Other, net 5.0 9.0 8.0 +Provision for income taxes $ 76.9 $ 107.4 $ 413.7 +The Company operates in foreign jurisdictions with income tax rates lower than the United States tax rate of 21.0 % for the fiscal years ended October 2, 2020, and September 27, 2019. The Company’s tax benefits related to foreign earnings taxed at a rate less than the United States federal rate were $ 86.6 million and $ 115.3 million for the fiscal years ended October 2, 2020, and September 27, 2019, respectively. +The Tax Reform Act includes, among other things, a reduction of the United States corporate tax rate from 35.0% to 21.0%, a mandatory deemed repatriation tax on foreign earnings, repeal of the corporate alternative minimum tax and the domestic production activities deduction, and expensing of certain capital investments. The law makes fundamental changes to the +50 +taxation of multinational entities, including a shift from worldwide taxation with deferral to a hybrid territorial system, featuring a participation exemption regime, a minimum tax on low-taxed foreign earnings, and new measures to deter base erosion and promote export from the United States. As a result of this legislation, during fiscal 2018 the Company recognized a one-time transition tax related to the deemed repatriation of foreign earnings of $ 224.6 million and a charge related to the revaluation of its deferred tax assets at the new corporate tax rate of $ 18.3 million. During fiscal 2020 and fiscal 2019, the Company recorded discrete income tax expense adjustments of $ 0.2 million and $ 8.1 million, respectively, to the prior year provisional estimates. The Company had accrued $ 18.6 million and $ 177.0 million of the deemed repatriation tax in short-term and long-term liabilities within the consolidated balance sheet, respectively, as of October 2, 2020. The Company had accrued $ 18.8 million and $ 195.9 million of the deemed repatriation tax in short-term and long-term liabilities within the consolidated balance sheet, respectively, as of September 27, 2019. +In addition to the introduction of a modified territorial tax system, the Tax Reform Act includes new sets of provisions aimed at preventing or decreasing U.S. tax base erosion: the GILTI provisions, the base erosion and anti-abuse tax (“BEAT”) provisions, and the FDII provisions. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company has made an accounting policy election to account for taxes due on GILTI inclusions as a component of current-period tax expense. The BEAT provisions eliminate the deduction of certain base-erosion payments made to related foreign corporations and impose a minimum tax if greater than regular tax. The FDII provisions allow a U.S. corporation an immediate deduction for a portion of its FDII. The amount of the deduction will depend in part on the Company’s U.S. taxable income. The GILTI and FDII provisions became effective for the Company in fiscal 2019 and resulted in a $ 54.3 million tax expense and a $ 41.5 million tax benefit, respectively. In fiscal 2020, the GILTI and FDII provisions resulted in $ 35.9 million tax expense and $ 41.2 million tax benefit, respectively. The Company has analyzed the BEAT provisions for fiscal 2020, 2019, and 2018, and has determined that it is not subject to the minimum tax imposed by the BEAT provisions. +The Company’s federal income tax returns for fiscal 2015, fiscal 2016, fiscal 2018, and fiscal 2019 are currently under IRS examination. During the year ended September 27, 2019, the Company effectively settled a portion of this IRS examination. As a result, the Company accrued a tax payable of $ 3.8 million, including interest. +On October 2, 2010, the Company expanded its presence in Asia by launching operations in Singapore. The Company operates under a tax holiday in Singapore, which is effective through September 30, 2030 . The current tax holiday is conditioned upon the Company’s compliance with certain employment and investment thresholds in Singapore. The impact of the tax holiday decreased Singapore’s taxes by $ 63.1 million, $ 32.8 million, and $ 38.4 million for the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, respectively, which resulted in tax benefits of $ 0.37 , $ 0.19 , and $ 0.21 of diluted earnings per share, respectively. +Deferred income tax assets and liabilities consist of the tax effects of temporary differences related to the following (in millions): +51 +Fiscal Years Ended +October 2, +2020 September 27, +2019 +Deferred tax assets: +Inventory $ 12.1 $ 10.1 +Bad debts 0.1 0.2 +Accrued compensation and benefits 10.1 5.9 +Product returns, allowances, and warranty 0.4 0.3 +Restructuring — 0.6 +Share-based and other deferred compensation 25.9 21.2 +Net operating loss carry forwards 7.4 11.3 +Non-United States tax credits 16.5 20.7 +State tax credits 115.5 106.4 +Leases 43.4 — +Property, plant, and equipment 24.3 17.7 +Other, net 5.8 5.9 +Deferred tax assets 261.5 200.3 +Less valuation allowance ( 137.4 ) ( 129.1 ) +Net deferred tax assets 124.1 71.2 +Deferred tax liabilities: +Prepaid insurance ( 0.9 ) ( 0.5 ) +Property, plant, and equipment ( 26.4 ) ( 19.3 ) +Intangible assets ( 7.6 ) ( 17.4 ) +Leases ( 41.5 ) — +Other, net ( 6.6 ) ( 6.3 ) +Net deferred tax liabilities ( 83.0 ) ( 43.5 ) +Total net deferred tax assets $ 41.1 $ 27.7 +In accordance with GAAP, management has determined that it is more likely than not that a portion of the Company's historic and current year income tax benefits will not be realized. As of October 2, 2020, the Company has a valuation allowance of $ 137.4 million. This valuation allowance is comprised of $ 118.8 million related to United States state tax credits and $ 18.6 million related to foreign deferred tax assets. The Company does not anticipate sufficient taxable income or tax liability to utilize these state and foreign credits. If these benefits are recognized in a future period, the valuation allowance on deferred tax assets will be reversed and up to a $ 137.4 million income tax benefit may be recognized. The Company will need to generate $ 124.1 million of future United States federal taxable income to utilize its United States deferred tax assets as of October 2, 2020. The Company believes that future reversals of taxable temporary differences, and its forecast of continued earnings in its domestic and foreign jurisdictions, support its decision to not record a valuation allowance on other deferred tax assets. The Company will continue to assess its valuation allowance in future periods. The net valuation allowance increased by $ 8.3 million and $ 10.5 million in fiscal 2020 and fiscal 2019, respectively, primarily related to increases for foreign and state net operating loss and tax credit carryovers. +As of October 2, 2020, the Company has United States federal net operating loss carry forwards of approximately $ 8.1 million. The utilization of these net operating losses is subject to certain annual limitations as required under Internal Revenue Code section 382 and similar state income tax provisions. The United States federal net operating loss carry forwards expire at various dates through 2035. The Company also has state income tax credit carry forwards of $ 115.4 million, net of federal benefits, for which the Company has provided a valuation allowance. The state tax credits relate primarily to California research tax credits that can be carried forward indefinitely. +A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in millions): +52 +Unrecognized tax benefits +Balance at September 27, 2019 $ 103.3 +Increases based on positions related to prior years 2.8 +Decreases based on positions related to prior years ( 3.9 ) +Increases based on positions related to current year 15.5 +Decreases relating to settlements with taxing authorities — +Decreases relating to lapses of applicable statutes of limitations ( 0.1 ) +Balance at October 2, 2020 $ 117.6 +Of the total unrecognized tax benefits at October 2, 2020, $ 95.3 million would impact the effective tax rate, if recognized. The remaining unrecognized tax benefits would not impact the effective tax rate, if recognized, due to the Company’s valuation allowance and certain positions that were required to be capitalized. +The Company anticipates reversals within the next 12 months related to items such as the lapse of the statute of limitations, audit closures, and other items that occur in the normal course of business. Due to open examinations, an estimate of anticipated reversals within the next 12 months cannot be made. During the fiscal years 2020, 2019, and 2018, the Company recognized $ 4.6 million, $ 6.0 million, and $ 4.1 million, respectively, of interest or penalties related to unrecognized tax benefits. Accrued interest and penalties of $ 16.1 million and $ 12.7 million related to uncertain tax positions have been included in long-term tax liabilities within the consolidated balance sheet as of October 2, 2020, and September 27, 2019, respectively. +The Company’s major tax jurisdictions as of October 2, 2020, are the United States, California, Canada, Mexico, Japan, and Singapore. For the United States, the Company has open tax years dating back to fiscal 2001 due to the carry forward of tax attributes. For California, the Company has open tax years dating back to fiscal 1999 due to the carry forward of tax attributes. For Canada, the Company has open tax years dating back to fiscal 2013 . For Mexico, the Company has open tax years back to fiscal 2014 . For Japan, the Company has open tax years back to fiscal 2014 . For Singapore, the Company has open tax years dating back to fiscal 2014 . The Company is subject to audit examinations by the respective taxing authorities on a periodic basis, of which the results could impact its financial position, results of operations or cash flows. +9. STOCKHOLDERS’ EQUITY +Common Stock +At October 2, 2020, the Company is authorized to issue 525.0 million shares of common stock, par value $ 0.25 per share, of which 232.3 million shares are issued and 165.6 million shares are outstanding. +Holders of the Company’s common stock are entitled to dividends in the event declared by the Company’s Board of Directors out of funds legally available for such purpose. Dividends may not be paid on common stock unless all accrued dividends on preferred stock, if any, have been paid or declared and set aside. In the event of the Company’s liquidation, dissolution or winding up, the holders of common stock will be entitled to share pro rata in the assets remaining after payment to creditors and after payment of the liquidation preference plus any unpaid dividends to holders of any outstanding preferred stock. +Each holder of the Company’s common stock is entitled to one vote for each such share outstanding in the holder’s name. No holder of common stock is entitled to cumulate votes in voting for directors. The Company’s restated certificate of incorporation as amended to date (the “Certificate of Incorporation”) provides that, unless otherwise determined by the Company’s Board of Directors, no holder of stock has any preemptive right to purchase or subscribe for any stock of any class which the Company may issue or sell. +Preferred Stock +The Company’s Certificate of Incorporation has authorized and permits the Company to issue up to 25.0 million shares of preferred stock without par value in one or more series and with rights and preferences that may be fixed or designated by the Company’s Board of Directors without any further action by the Company’s stockholders. The designation, powers, preferences, rights and qualifications, limitations, and restrictions of the preferred stock of each series will be fixed by the certificate of designation relating to such series, which will specify the terms of the preferred stock. At October 2, 2020, the Company had no shares of preferred stock issued or outstanding. +53 +Stock Repurchase +On January 30, 2019, the Board of Directors approved a stock repurchase program, pursuant to which the Company is authorized to repurchase up to $ 2.0 billion of its common stock from time to time prior to January 30, 2021, on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. This authorized stock repurchase program replaced in its entirety the January 31, 2018, stock repurchase program. The timing and amount of any shares of the Company’s common stock that are repurchased under the repurchase program are determined by the Company’s management based on its evaluation of market conditions and other factors. +During the fiscal year ended October 2, 2020, the Company paid approximately $ 647.5 million (including commissions) in connection with the repurchase of 6.3 million shares of its common stock (paying an average price of $ 102.74 per share) under the January 30, 2019, stock repurchase plan. As of October 2, 2020, $ 978.8 million remained available under the January 30, 2019, stock repurchase plan. +During the fiscal year ended September 27, 2019, the Company paid approximately $ 657.6 million (including commissions) in connection with the repurchase of 8.9 million shares of its common stock (paying an average price of $ 74.26 per share). During the fiscal year ended September 28, 2018, the Company paid approximately $ 759.5 million (including commissions) in connection with the repurchase of 7.7 million shares of its common stock (paying an average price of $ 98.84 per share). +Dividends +On November 2, 2020 , the Company announced that the Board of Directors had declared a cash dividend on the Company’s common stock of $ 0.50 per share. This dividend is payable on December 10, 2020 , to the Company’s stockholders of record as of the close of business on November 19, 2020 . Future dividends are subject to declaration by the Board of Directors. The dividends charged to retained earnings in fiscal 2020 and 2019 were as follows (in millions except per share data): +Fiscal Years Ended +October 2, +2020 September 27, +2019 +Per Share Total Per Share Total +First quarter $ 0.44 $ 75.1 $ 0.38 $ 67.1 +Second quarter 0.44 74.9 0.38 66.0 +Third quarter 0.44 73.5 0.38 65.7 +Fourth quarter 0.50 83.5 0.44 75.1 +$ 1.82 $ 307.0 $ 1.58 $ 273.9 +Employee Stock Benefit Plans +As of October 2, 2020, the Company has the following equity compensation plans under which its equity securities were authorized for issuance to its employees and/or directors: +◦ the 2002 Employee Stock Purchase Plan +◦ the Non-Qualified Employee Stock Purchase Plan +◦ the 2005 Long-Term Incentive Plan +◦ the 2008 Director Long-Term Incentive Plan +◦ the 2015 Long-Term Incentive Plan +Except for the Non-Qualified Employee Stock Purchase Plan, each of the foregoing equity compensation plans was approved by the Company’s stockholders. +As of October 2, 2020, a total of 65.2 million shares are authorized for grant under the Company’s share-based compensation plans, with 0.4 million options outstanding. The number of common shares reserved for future awards to employees and directors under these plans was 11.0 million at October 2, 2020. The Company currently grants new equity awards to employees under the 2015 Long-Term Incentive Plan and to non-employee directors under the 2008 Director Long-Term Incentive Plan. +54 +2015 Long-Term Incentive Plan. Under this plan, officers, employees, and certain consultants may be granted stock options, restricted stock awards and units, performance stock awards and units and other share-based awards. The plan has been approved by the stockholders. Under the plan, up to 19.4 million shares have been authorized for grant. A total of 10.4 million shares are available for new grants as of October 2, 2020. The maximum contractual term of options under the plan is seven years from the date of grant. Options granted under the plan at the determination of the compensation committee generally vest ratably over four years. Restricted stock awards and units granted under the plan at the determination of the compensation committee generally vest over three or more years. With respect to restricted stock awards, dividends are accumulated from the grant date and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are forfeited. No dividends or dividend equivalents are accumulated or paid with respect to restricted stock unit awards or other awards until the shares underlying such awards vest and are issued to the award holder. Performance stock awards and units are contingently granted depending on the achievement of certain predetermined performance goals and generally vest over two or more years. +2008 Director Long-Term Incentive Plan. Under this plan, non-employee directors may be granted stock options, restricted stock awards, and other share-based awards. The plan has been approved by the stockholders. Under the plan a total of 1.5 million shares have been authorized for grant. A total of 0.6 million shares are available for new grants as of October 2, 2020. The maximum contractual term of options granted under the plan is ten years from the date of grant. Options granted under the plan are generally exercisable over four years. Restricted stock awards and units granted under the plan generally vest over one or more years. With respect to restricted stock awards, dividends are accumulated from the grant date and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are forfeited. +Employee Stock Purchase Plans. The Company maintains a domestic and an international employee stock purchase plan. Under these plans, eligible employees may purchase common stock through payroll deductions of up to 10 % of their compensation. The price per share is the lower of 85 % of the fair market value of the common stock at the beginning or end of each offering period (six months). The plans provide for purchases by employees of up to an aggregate of 11.6 million shares. Shares of common stock purchased under these plans in the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, were 0.3 million, 0.3 million, and 0.2 million, respectively. At October 2, 2020, there are 1.8 million shares available for purchase. The Company recognized compensation expense of $ 6.6 million, $ 5.8 million, and $ 5.2 million for the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, respectively, related to the employee stock purchase plan. The unrecognized compensation expense on the employee stock purchase plan at October 2, 2020, was $ 3.1 million. The weighted average period over which the cost is expected to be recognized is approximately four months. +Stock Options +The following table represents a summary of the Company’s stock options: +Shares +(in millions) +Weighted average exercise price +Weighted average remaining +contractual life (in years) Aggregate intrinsic value (in millions) +Balance outstanding at September 27, 2019 +1.3 $ 65.38 +Granted — $ 98.72 +Exercised ( 0.9 ) $ 63.69 +Canceled/forfeited — $ 50.23 +Balance outstanding at October 2, 2020 +0.4 $ 70.28 2.2 $ 27.8 +Exercisable at October 2, 2020 +0.3 $ 70.10 1.9 $ 24.6 +The weighted-average grant date fair value per share of employee stock options granted during the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, was $ 24.49 , $ 21.74 , and $ 68.32 , respectively. +Restricted and Performance Awards and Units +The following table represents a summary of the Company’s restricted and performance awards and units: +55 +Shares +(in millions) +Weighted average +grant date fair value +Non-vested awards outstanding at September 27, 2019 2.9 $ 89.14 +Granted (1) 1.4 $ 99.68 +Vested ( 1.0 ) $ 85.35 +Canceled/forfeited ( 0.4 ) $ 93.44 +Non-vested awards outstanding at October 2, 2020 2.9 $ 94.77 +(1) includes performance stock awards granted and earned assuming target performance under the underlying performance metrics +The weighted average grant date fair value per share for awards granted during the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, was $ 99.68 , $ 78.41 , and $ 108.86 , respectively. +The following table summarizes the total intrinsic value for stock options exercised and awards vested (in millions): +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Awards $ 100.9 $ 67.7 $ 134.4 +Options $ 44.2 $ 26.4 $ 75.0 +Valuation and Expense Information +The following table summarizes pre-tax share-based compensation expense by financial statement line and related tax benefit (in millions): +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Cost of goods sold $ 23.2 $ 13.0 $ 14.4 +Research and development 68.7 41.6 42.6 +Selling, general and administrative 64.7 25.5 50.8 +Total share-based compensation expense $ 156.6 $ 80.1 $ 107.8 +Share-based compensation tax benefit $ 10.3 $ 1.6 $ 25.6 +Capitalized share-based compensation expense at period end $ 10.6 $ 4.7 $ 2.9 +The following table summarizes total compensation costs related to unvested share-based awards not yet recognized and the weighted average period over which it is expected to be recognized at October 2, 2020: +Unrecognized compensation cost for unvested awards +(in millions) Weighted average remaining recognition period +(in years) +Awards $ 170.7 1.6 +Options $ 0.3 0.5 +The fair value of the restricted stock awards and units is equal to the closing market price of the Company’s common stock on the date of grant. +The Company issued performance stock unit awards during fiscal 2020, fiscal 2019, and fiscal 2018 that contained market-based conditions. T he fair value of these performance stock unit awards was estimated on the date of the grant using a Monte Carlo simulation with the following weighted average assumptions: +56 +Fiscal Year Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Volatility of common stock 32.22 % 32.65 % 35.54 % +Average volatility of peer companies 33.96 % 37.07 % 36.78 % +Average correlation coefficient of peer companies 0.61 0.47 0.47 +Risk-free interest rate 1.62 % 2.98 % 1.74 % +Dividend yield 1.78 % 1.84 % 1.15 % +The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions: +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Expected volatility 34.26 % 34.47 % 35.86 % +Risk-free interest rate 1.65 % 2.76 % 2.00 % +Dividend yield 1.78 % 1.84 % 1.15 % +Expected option life (in years) 4.0 4.0 4.0 +The Company used a historical volatility calculated by the mean reversion of the weekly-adjusted closing stock price over the expected life of the options. The risk-free interest rate assumption is based upon observed treasury bill interest rates appropriate for the expected life of the Company’s employee stock options. The dividend yield was calculated based on the annualized dividend and the stock price on the date of grant. +The expected life of employee stock options represents a calculation based upon the historical exercise, cancellation, and forfeiture experience for the Company across its demographic population. The Company believes that this historical data is the best estimate of the expected life of a new option and that generally all groups of the Company’s employees exhibit similar behavior. +10. LEASES +The Company’s lease arrangements consist primarily of corporate, manufacturing, and other facility agreements as well as various machinery and office equipment agreements. The leases expire at various dates through 2033, some of which include options to extend the lease term. The options with the longest potential total lease term consist of options for extension of up to three five-year periods following expiration of the original lease term. +During the fiscal year ended October 2, 2020, the Company recorded $ 28.1 million of operating lease expense and $ 7.6 million of variable lease expense. During the fiscal years ended September 27, 2019, and September 28, 2018, the Company recorded $ 18.7 million and $ 20.5 million of rent expense, respectively. The Company’s finance leases and short-term leases are immaterial. +Supplemental cash information and non-cash activities related to operating leases are as follows (in millions): +Fiscal Year Ended +October 2, +2020 +Operating cash outflows from operating leases $ 25.4 +Operating lease assets obtained in exchange for new lease liabilities $ 31.0 +Maturities of lease liabilities under operating leases by fiscal year are as follows (in millions): +57 +As of +October 2, +2020 +2021 $ 25.7 +2022 28.7 +2023 25.1 +2024 21.7 +2025 20.6 +Thereafter 81.6 +Total lease payments 203.4 +Less: imputed interest ( 24.5 ) +Present value of lease liabilities 178.9 +Less: current portion (included in other current liabilities) (28.2) +Total $ 150.7 +Future minimum lease liabilities under non-cancelable operating leases are as follows (in millions): +As of +September 27, +2019 +2020 $ 26.7 +2021 25.9 +2022 24.8 +2023 23.3 +2024 21.5 +Thereafter 97.7 +Total $ 219.9 +Weighted-average remaining lease term and discount rate related to operating leases are as follows: +As of +October 2, +2020 +Weighted-average remaining lease term (years) 8.2 +Weighted-average discount rate 3.3 % +11. COMMITMENTS AND CONTINGENCIES +Legal Matters +From time to time, various lawsuits, claims and proceedings have been, and may in the future be, instituted or asserted against the Company, including those pertaining to patent infringement, intellectual property, environmental hazards, product liability and warranty, safety and health, employment, and contractual matters. +The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark, and other intellectual property rights to technologies that are important to the Company’s business and have demanded and may in the future demand that the Company license their technology. The outcome of any such litigation cannot be predicted with certainty and some such lawsuits, claims or proceedings may be disposed of unfavorably to the Company. Generally speaking, intellectual property disputes often have a risk of injunctive relief, which, if imposed against the Company, could materially and adversely affect the Company’s financial condition, or results of operations. From time to time the Company may also be involved in legal proceedings in the ordinary course of business. +58 +The Company monitors the status of legal proceedings and other contingencies on an ongoing basis to ensure loss contingencies are recognized and/or disclosed in its financial statements and footnotes. The Company does not believe there are any pending legal proceedings that are reasonably possible to result in a material loss. The Company is engaged in various legal actions in the normal course of business and, while there can be no assurances, the Company believes the outcome of all pending litigation involving the Company will not have, individually or in the aggregate, a material adverse effect on its business or financial statements. +12. GUARANTEES AND INDEMNITIES +The Company has made no significant contractual guarantees for the benefit of third parties. However, the Company generally indemnifies its customers from third-party intellectual property infringement litigation claims related to its products, and, on occasion, also provides other indemnities related to product sales. In connection with certain facility leases, the Company has indemnified its lessors for certain claims arising from the facility or the lease. +The Company indemnifies its directors and officers to the maximum extent permitted under the laws of the state of Delaware. The duration of the indemnities varies, and in many cases is indefinite. The indemnities to customers in connection with product sales generally are subject to limits based upon the amount of the related product sales and in many cases are subject to geographic and other restrictions. In certain instances, the Company’s indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities in the accompanying consolidated balance sheets and does not expect that such obligations will have a material adverse impact on its financial statements. +13. EARNINGS PER SHARE +The following table sets forth the computation of basic and diluted earnings per share (in millions, except per share amounts): +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +Net income $ 814.8 $ 853.6 $ 918.4 +Weighted average shares outstanding – basic 168.5 173.5 181.3 +Dilutive effect of equity-based awards 1.4 1.0 1.9 +Weighted average shares outstanding – diluted 169.9 174.5 183.2 +Net income per share – basic $ 4.84 $ 4.92 $ 5.06 +Net income per share – diluted $ 4.80 $ 4.89 $ 5.01 +Anti-dilutive common stock equivalents 0.1 1.4 0.2 +Basic earnings per share are calculated by dividing net income by the weighted average number of shares of the Company’s common stock outstanding during the period. The calculation of diluted earnings per share includes the dilutive effect of equity-based awards that were outstanding during the fiscal years ended October 2, 2020, September 27, 2019, and September 28, 2018, using the treasury stock method. Shares issuable upon the vesting of performance stock awards are likewise included in the calculation of diluted earnings per share as of the date the condition(s) have been satisfied. Certain of the Company’s outstanding share-based awards, noted in the table above, were excluded because they were anti-dilutive, but they could become dilutive in the future. +14. SEGMENT INFORMATION AND CONCENTRATIONS +The Company has a single reportable operating segment which designs, develops, manufactures, and markets similar proprietary semiconductor products, including intellectual property. In reaching this conclusion, management considers the definition of the chief operating decision maker (“ CODM ”), how the business is defined by the CODM, the nature of the information provided to the CODM and how that information is used to make operating decisions, allocate resources, and assess performance. The Company’s CODM is the president and chief executive officer. The results of operations provided to and analyzed by the CODM are at the consolidated level and accordingly, key resource decisions and assessment of performance are performed at the consolidated level. The Company assesses its determination of operating segments at least annually. +59 +Geographic Information +The Company presents net revenue by geographic area based upon the location of the OEMs’ headquarters as it believes that doing so best depicts how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. Net revenue by geographic area is as follows (in millions): +Fiscal Years Ended +October 2, +2020 September 27, +2019 September 28, +2018 +United States $ 2,012.8 $ 1,860.4 $ 1,946.2 +China 700.7 718.7 982.8 +South Korea 254.6 365.5 432.7 +Taiwan 240.4 271.1 339.1 +Europe, Middle East, and Africa 122.9 134.9 144.6 +Other Asia-Pacific 24.3 26.2 22.6 +Total $ 3,355.7 $ 3,376.8 $ 3,868.0 +The Company’s revenue from external customers is generated principally from the sale of semiconductor products that facilitate various wireless communication applications. Accordingly, the Company considers its product offerings to be similar in nature and therefore not segregated for reporting purposes. Accrued customer liabilities of $ 20.3 million and $ 38.5 million have been included in other current liabilities within the consolidated balance sheets as of October 2, 2020 and September 27, 2019, respectively. +Net property, plant, and equipment balances, based on the physical locations within the indicated geographic areas are as follows (in millions): +As of +October 2, +2020 September 27, +2019 +Japan $ 507.0 $ 491.9 +Mexico 364.9 351.5 +Singapore 237.4 229.9 +United States 124.8 117.6 +Rest of world 15.4 14.7 +$ 1,249.5 $ 1,205.6 +Concentrations +Financial instruments that potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable. Trade accounts receivable are primarily derived from sales to manufacturers of communications and consumer products and electronic component distributors. The Company performs ongoing credit evaluations of customers. +In fiscal 2020, 2019, and 2018, Apple, through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop, and notebook computers, watches and other devices, in the aggregate accounted for 56 %, 51 %, and 47 % of the Company’s net revenue, respectively. +At October 2, 2020, the Company’s three largest accounts receivable balances comprised 70 % of aggregate gross accounts receivable. This concentration was 67 % and 66 % at September 27, 2019, and September 28, 2018, respectively. +15. QUARTERLY FINANCIAL DATA (UNAUDITED) +The following table summarizes the quarterly and annual results (in millions, except per share data). Amounts may not total for the fiscal year due to rounding: +60 +First quarter +Second quarter +Third quarter +Fourth quarter +Fiscal year +Fiscal 2020 +Net revenue $ 896.1 $ 766.1 $ 736.8 $ 956.8 $ 3,355.7 +Gross profit 444.3 375.6 334.1 458.9 1,612.9 +Net income 257.1 181.1 129.7 246.9 814.8 +Per share data (1) +Net income, basic $ 1.51 $ 1.07 $ 0.78 $ 1.48 $ 4.84 +Net income, diluted $ 1.50 $ 1.06 $ 0.77 $ 1.46 $ 4.80 +Fiscal 2019 +Net revenue $ 972.0 $ 810.4 $ 767.0 $ 827.4 $ 3,376.8 +Gross profit 485.1 400.2 312.5 406.0 1,603.8 +Net income 284.9 214.0 144.1 210.6 853.6 +Per share data (1) +Net income, basic $ 1.61 $ 1.23 $ 0.83 $ 1.23 $ 4.92 +Net income, diluted $ 1.60 $ 1.23 $ 0.83 $ 1.22 $ 4.89 +____________ +(1) Earnings per share calculations for each of the quarters are based on the weighted average number of shares outstanding and included common stock equivalents in each period. Therefore, the sums of the quarters do not necessarily equal the full year earnings per share. +61 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +None. +ITEM 9A. CONTROLS AND PROCEDURES. +Evaluation of Disclosure Controls and Procedures +Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of October 2, 2020. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on management’s evaluation of our disclosure controls and procedures as of October 2, 2020, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level. +Management’s Annual Report on Internal Control Over Financial Reporting +The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: +• Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; +• Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and +• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of October 2, 2020. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 Internal Control-Integrated Framework. +Based on their assessment, management concluded that, as of October 2, 2020, the Company’s internal control over financial reporting is effective based on those criteria. +The Company’s independent registered public accounting firm has issued an audit report on the effectiveness of the Company’s internal control over financial reporting as stated within their report which appears herein. +Changes in Internal Control Over Financial Reporting. +62 +There are no changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the fourth quarter of fiscal 2020 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. +Due to the ongoing COVID-19 pandemic, a significant number of our employees are now working from home. The design of our processes, systems, and controls allows for remote execution with accessibility to secure data. +ITEM 9B. OTHER INFORMATION. +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. +The information under the captions “Directors and Executive Officers,” “Corporate Governance─Committees of the Board of Directors,” and “Other Matters—Delinquent Section 16(a) Reports,” if applicable, in our definitive proxy statement for the 2021 Annual Meeting of Stockholders is incorporated herein by reference. +We have adopted a written code of business conduct and ethics that applies to our directors, officers, and employees, including our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. We make available our code of business conduct and ethics free of charge through our website at www.skyworksinc.com. We intend to disclose any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed by posting any such amendment or waivers on our website pursuant to SEC requirements and rules of the Nasdaq Global Select Market. +ITEM 11. EXECUTIVE COMPENSATION. +The information to be included under the caption “Information about Executive and Director Compensation” in our definitive proxy statement for the 2021 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +The information to be included under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in our definitive proxy statement for the 2021 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +The information to be included under the captions “Certain Relationships and Related Transactions” and “Corporate Governance─Director Independence” in our definitive proxy statement for the 2021 Annual Meeting of Stockholders is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES. +The information to be included under the caption “Ratification of Independent Registered Public Accounting Firm—Audit Fees” in our definitive proxy statement for the 2021 Annual Meeting of Stockholders is incorporated herein by reference. +63 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES. +(a) The following are filed as part of this Annual Report on Form 10-K: +1. Index to Financial Statements Page number in this report +Report of Independent Registered Public Accounting Firm +Page 36 +Consolidated Statements of Operations for the three years ended October 2, 2020 +Page 38 +Consolidated Statements of Comprehensive Income for the three years ended October 2, 2020 +Page 39 +Consolidated Balance Sheets at October 2, 2020, and September 27, 2019 +Page 40 +Consolidated Statements of Cash Flows for the three years ended October 2, 2020 +Page 41 +Consolidated Statements of Stockholders’ Equity for the three years ended October 2, 2020 +Page 42 +Notes to Consolidated Financial Statements +Pages 43 through 60 +2. The schedule listed below is filed as part of this Annual Report on Form 10-K: +All required schedule information is included in the Notes to Consolidated Financial Statements or is omitted because it is either not required or not applicable. +3. +The Exhibits listed in the Exhibit Index immediately following Item 16 are filed as a part of this Annual Report on Form 10-K. +(b) Exhibits +The exhibits required by Item 601 of Regulation S-K are filed herewith and incorporated by reference herein. The response to this portion of Item 15 is submitted under Item 15 (a) (3). +ITEM 16. FORM 10-K SUMMARY. +None +64 +Table of Contents +EXHIBIT INDEX +Exhibit +Number +Exhibit Description Form Incorporated by Reference +Filed Herewith +File No. Exhibit Filing Date +2.1 +Agreement and Plan of Merger dated as of August 3, 2018, by and among the Company, Avnera Corporation, AI Acquisition Corp., and Shareholder Representative Services LLC, solely in its capacity as the representative and agent of the Equityholders +10-K 001-05560 2.3 11/15/2018 +3.1 +Restated Certificate of Incorporation, as Amended +10-Q 001-05560 3.1 8/3/2016 +3.2 +Third Amended and Restated By-laws, as Amended +10-Q 001-05560 3.1 2/5/2018 +4.1 +Specimen Certificate of Common Stock +S-3 333-92394 4 7/15/2002 +4.2 +Description of Capital Stock +10-K 001-05560 4.2 11/14/2019 +10.1* +Skyworks Solutions, Inc. 2002 Employee Stock Purchase Plan, as Amended +10-Q 001-05560 10.1 7/24/2020 +10.2* +Skyworks Solutions, Inc. Non-Qualified Employee Stock Purchase Plan, as Amended +10-Q 001-05560 10.2 7/24/2020 +10.3* +Skyworks Solutions, Inc. Amended and Restated 2005 Long-Term Incentive Plan +8-K 001-05560 10.1 5/13/2013 +10.4* +Form of Nonstatutory Stock Option Agreement under the Company’s 2005 Long-Term Incentive Plan +10-Q 001-05560 10.B 1/31/2013 +10.5* +Skyworks Solutions, Inc. Amended and Restated 2008 Director Long-Term Incentive Plan, as Amended +10-Q 001-05560 10.1 5/4/2018 +10.6* +Form of Nonstatutory Stock Option Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q 001-05560 10.OO 5/7/2008 +10.7* +Form of Restricted Stock Unit Agreement under the Company’s 2008 Director Long-Term Incentive Plan +10-Q 001-05560 10.2 5/4/2016 +10.8* +Skyworks Solutions, Inc. 2015 Long-Term Incentive Plan, as Amended +10-Q 001-05560 10.1 8/7/2019 +10.9* +Form of Nonstatutory Stock Option Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q 001-05560 10.2 8/5/2015 +10.10* +Form of Performance Share Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q 001-05560 10.3 8/5/2015 +10.11* +Form of Restricted Stock Unit Agreement under the Company’s 2015 Long-Term Incentive Plan +10-Q 001-05560 10.4 8/5/2015 +10.12* +Fiscal Year 2020 Executive Incentive Plan +10-Q 001-05560 10.1 1/24/2020 +10.13* +Skyworks Solutions, Inc. Cash Compensation Plan for Directors +10-Q 001-05560 10.1 5/5/2020 +10.14* +Amended and Restated Change in Control / Severance Agreement, dated May 11, 2016, between the Company and Liam Griffin +10-Q 001-05560 10.2 8/3/2016 +10.15* +Change in Control / Severance Agreement, dated August 29, 2016, between the Company and Kris Sennesael +10-K 001-05560 10.32 11/22/2016 +10.16* +Change in Control / Severance Agreement, dated November 10, 2016, between the Company and Robert J. Terry +10-Q 001-05560 10.2 2/7/2017 +Table of Contents +Exhibit +Number +Exhibit Description Form Incorporated by Reference +Filed Herewith +File No. Exhibit Filing Date +10.17* +Change in Control / Severance Agreement, dated November 9, 2016, between the Company and Carlos S. Bori +10-K 001-05560 10.27 11/13/2017 +10.18* +Change in Control / Severance Agreement, dated April 13, 2018, between the Company and Kari A. Durham +10-Q 001-05560 10.2 1/24/2020 +21 +Subsidiaries of the Company +X +23.1 +Consent of KPMG LLP +X +31.1 +Certification of the Company’s Chief Executive Officer pursuant to Securities and Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +X +31.2 +Certification of the Company’s Chief Financial Officer pursuant to Securities and Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +X +32.1 +Certification of the Company’s Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +X +32.2 +Certification of the Company’s Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +X +101.INS Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH Inline XBRL Taxonomy Extension Schema Document X +101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase Document X +101.DEF Inline XBRL Taxonomy Extension Definition Linkbase Document X +101.LAB Inline XBRL Taxonomy Extension Label Linkbase Document X +101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase Document X +104 Cover Page Interactive Data File (formatted as inline XBRL with applicable taxonomy extension information contained in Exhibits 101) +* Indicates a management contract or compensatory plan or arrangement. +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. +Date: November 16, 2020 +SKYWORKS SOLUTIONS, INC. +Registrant +By: /s/ Liam K. Griffin +Liam K. Griffin +President and Chief Executive Officer +Director +Table of Contents +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on November 16, 2020. +Signature and Title Signature and Title +/s/ Liam K. Griffin +/s/ David J. Aldrich +Liam K. Griffin David J. Aldrich +Chief Executive Officer Chairman of the Board +President and Director +(principal executive officer) /s/ Alan S. Batey +Alan S. Batey +/s/ Kris Sennesael Director +Kris Sennesael +Senior Vice President and Chief Financial Officer /s/ Kevin L. Beebe +(principal accounting and financial officer) Kevin L. Beebe +Director +/s/ Timothy R. Furey +Timothy R. Furey +Director +/s/ Christine King +Christine King +Director +/s/ David P. McGlade +David P. McGlade +Director +/s/ Robert A. Schriesheim +Robert A. Schriesheim +Director +/s/ Kimberly S. Stevenson +Kimberly S. Stevenson +Director +68 \ No newline at end of file diff --git a/raw/filings/0000004127/2020/0000004127-20-000058/filing_metadata.csv b/raw/filings/0000004127/2020/0000004127-20-000058/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..eecfbc7a6df871f63ebf75fac2bc892f1aa6a1bc --- /dev/null +++ b/raw/filings/0000004127/2020/0000004127-20-000058/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004127,SWKS,"SKYWORKS SOLUTIONS, INC.",2020,10-K,2020-11-17,2020-10-02,2020-11-17T01:05:07.000Z,0000004127-20-000058,swks-20201002.htm,10-K,9244981,1,1,https://www.sec.gov/Archives/edgar/data/4127/000000412720000058/swks-20201002.htm,https://www.sec.gov/Archives/edgar/data/4127/000000412720000058/ diff --git a/raw/filings/0000004127/2020/0000004127-20-000058/item1.txt b/raw/filings/0000004127/2020/0000004127-20-000058/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..665877485a417896ea6d854617cc206445d1657b --- /dev/null +++ b/raw/filings/0000004127/2020/0000004127-20-000058/item1.txt @@ -0,0 +1,92 @@ +ITEM 1. BUSINESS. +Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the aerospace, automotive, broadband, cellular infrastructure, connected home, entertainment and gaming, industrial, medical, military, smartphone, tablet, and wearable markets. +Our key customers include Amazon, Apple, Arris, Bose, Cisco, DJI, Ericsson, Foxconn, Garmin, Gemalto (a Thales company), General Electric, Fibocom, Google, Honeywell, Huawei, Itron, Lenovo, LG Electronics, Microsoft, Motorola, Netgear, Northrop Grumman, OPPO, Rockwell Collins, Samsung, Sierra Wireless, Sonos, Technicolor, VIVO, Xiaomi, and ZTE. Our competitors include Analog Devices, Broadcom, Cirrus Logic, Maxim Integrated Products, Murata Manufacturing, NXP Semiconductors, Qorvo, and Qualcomm. +We operate worldwide with engineering, manufacturing, sales, and service facilities throughout Asia, Europe, and North America. Our Internet address is www.skyworksinc.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we electronically submit such material to the SEC. The information contained on our website is not incorporated by reference in this Annual Report. Our SEC filings are also available to the public at www.sec.gov. +In August 2018, we acquired Avnera Corporation (“Avnera”) and expanded our leadership in wireless connectivity by adding ultra-low power analog circuits to enable smart interfaces via acoustic signal processing, sensors, and integrated software. The acquisition of Avnera enables us to capitalize on the rapid proliferation of audio functionality and its convergence with our advanced connectivity solutions. With our global sales channels, strong customer relationships and operational scale, we are leveraging Avnera’s innovative product portfolio and systems expertise to increase our footprint in automotive, industrial, home automation, enterprise, and high-end consumer markets. +Industry Background +Wireless connectivity is exploding on a global basis. The COVID-19 pandemic has underscored the importance of our mission of connecting everyone and everything, all the time. Work-from-home, remote healthcare, virtual education, and other social distancing trends, driven in part by the pandemic, have propelled an extraordinary need for faster speeds, increased bandwidth and capacity, significantly lower latency, and more reliable and secure wireless connectivity. +5G is dramatically altering the world, creating a market for diverse and transformative applications, and changing how individuals live, work, play, and learn. Most of the world’s largest economies now have functioning commercial 5G networks, and the world’s leading smartphone manufacturers have released 5G-enabled devices. The transition from 4G to 5G has just started, and according to a June 2020 Ericsson “Mobility Report,” there are expected to be 2.8 billion mobile 5G subscriptions globally by the end of 2025. +At the same time, connectivity is expanding into an adjacent set of IoT markets. From smart homes to the smart grid and from industrial to wearables, the number of connected devices is rapidly proliferating. ABI Research IoT Market Tracker forecasts 117 billion IoT connections by 2026. Skyworks is enabling these opportunities with highly customized system solutions supporting a broad set of wireless protocols including cellular LTE, Wi-Fi, Bluetooth®, LoRa®, Thread and Zigbee®. In addition, next-generation Wi-Fi 6 products are emerging as the standard offering across enterprise, carrier, and retail segments and are expected to accelerate the deployment of IoT devices. ABI Research anticipates relatively swift adoption with 1.4 billion Wi-Fi 6E chipset shipments by 2025. +Looking forward, we see significant growth opportunity for our industry and for Skyworks. The key catalysts for Skyworks will continue to be the insatiable demand for data and the profitable usage model, as each connection becomes more valuable and the world embraces 5G. +Solving Connectivity Challenges +We expect that highly integrated semiconductor solutions will play an increasingly pivotal role in the deployment of this next generation standard by resolving the daunting analog and RF complexities that are challenging the capabilities of existing hardware and the supporting network infrastructure. Meeting these design challenges requires broad competencies including +signal transmission and conditioning, the ability to ensure seamless hand-offs between multiple standards, power management, voltage regulation, battery charging, advanced filtering, and tuning. +Skyworks is at the forefront of this sea change in connectivity, delivering the solutions that will enable the true potential of 5G and the IoT. We have a rich heritage in analog systems design and have spent years investing in key technologies and resources. Our strength is underpinned by world-class performance and scale across a broad array of capabilities that include advanced TC-SAW and BAW filters, an expanded family of MIMO, ultra-high band, and diversity receive modules and expanding into emerging technologies. From our breakthrough Sky5® unifying platform to our 5G small cell solutions, Skyworks’ approach across both infrastructure and user equipment facilitates powerful, high-speed end-to-end 5G connectivity. +Skyworks' Strategy +Our ambitious vision is to connect everyone and everything, all the time. To this end, key elements of our strategy include: +Industry-Leading Technology +As the industry migrates to more complex 5G architectures across a multitude of wireless applications, we are well positioned to help mobile device manufacturers handle growing levels of system complexity in the transmit and receive chain. The trend towards increasing front-end and analog design challenges in smartphones and other platforms plays directly into our core strengths and positions us to address these challenges. We believe that we offer the broadest portfolio of radio and analog solutions from the transceiver to the antenna as well as all required manufacturing process technologies. We also hold strong technology leadership positions in passive devices, advanced integration including proprietary shielding and 3-D die stacking as well as SAW, TC-SAW and BAW filters. Our product portfolio is reinforced by a library of approximately 3,950 worldwide patents and other intellectual property that we own and control. Together, our industry-leading technology enables us to deliver the highest levels of product performance and integration. +Customer Relationships +Given our scale and technology leadership, we are engaged with key original equipment manufacturers (“OEMs”), smartphone providers and baseband reference design partners. Our customers value our global supply chain, our innovative technology and our system engineering expertise, resulting in deep customer loyalty. We partner with our customers to support their long-term product road maps and are valued as a system solutions provider rather than just a point product vendor. +Diversification +We are diversifying our business in three areas: our addressed markets, our customer base, and our product offerings. By leveraging core analog and mixed signal technologies, we are expanding our family of solutions to a set of increasingly diverse end markets and customers. With the adoption of 5G and the opportunity to enable more applications, we are steadily growing our business beyond just mobile devices (where we support all top-tier manufacturers, including the leading smartphone suppliers and key baseband vendors) into additional high-performance analog markets, including automotive, home and factory automation, infrastructure, aerospace and defense, medical, smart energy, and wireless networking. In these markets we leverage our scale, intellectual property, and worldwide distribution network, which spans over 3,200 customers and over 2,500 analog components. +Delivering Operational Excellence +We vertically integrate our supply chain where we can differentiate with highly specialized internal manufacturing capabilities or enter into alliances and strategic relationships for leading-edge technologies. This hybrid manufacturing model allows us to better balance our manufacturing capacity with the demand of the marketplace. Our internal capacity utilization remains high, resulting in stable gross margins and strong return on invested capital on a broader range of revenue. +Additionally, we continue to drive reductions in product design and manufacturing cycle times and further improve product yields. The combination of agile, flexible capacity and world-class module manufacturing and scale advantage allows us to achieve low product costs while integrating multiple technologies into highly sophisticated multi-chip modules. +Maintaining a Performance-Driven Culture +We consider our people and corporate culture to be a major competitive advantage and a key driver of our overall strategy. We create key performance indicators that align employee efforts with corporate strategy and link responsibilities with performance measurement. Accountability is paramount, and we compensate our employees through a pay-for-performance methodology. We strive to be an employer-of-choice among peer companies and have created a work environment in which turnover is below geographic and industry averages. +Generating Superior Operating Results and Shareholder Returns +We seek to generate financial returns that are comparable to a highly diversified analog semiconductor company. Given our product volume and overall utilization we strive to achieve a best-in-class return on investment and operating income to reward shareholders. +Our Product Portfolio +Our product portfolio consists of various solutions, including: +• Amplifiers: the modules that strengthen the signal so that it has sufficient energy to reach a base station +• Antenna Tuners: aperture and impedance tuning products that improve antenna performance across frequencies +• Attenuators: circuits that allow a known source of power to be reduced by a predetermined factor (usually expressed as decibels) +• Circulators/Isolators: ferrite-based components commonly found on the output of high-power amplifiers used to protect receivers in wireless transmission systems +• Wireless ASoC: an intelligent 2.4 GHz and 5GHz wireless radio integrated circuit that includes all the analog and digital functions optimized for building cognitive wireless audio headsets, headphones, and wireless speaker systems +• DC/DC Converters: an electronic circuit which converts a source of direct current from one voltage level to another +• Demodulators: a device or an RF block used in receivers to extract the information that has been modulated onto a carrier or from the carrier itself +• Detectors: devices used to measure and control RF power in wireless systems +• Diodes: semiconductor devices that pass current in one direction only +• Directional Couplers: transmission coupling devices for separately sampling the forward or backward wave in a transmission line +• Diversity Receive Modules: devices used to improve receiver sensitivity in high data rate applications +• Filters: devices for recovering and separating mixed and modulated data in RF stages, including SAW, TC-SAW, and BAW filters +• Front-end Modules: two or more functions co-packaged to optimize the performance, cost, and application suitability in products, including intermediate or radio frequency signal paths +• Hybrid: a type of directional coupler used in radio and telecommunications +• LED Drivers: devices which regulate the current through a light emitting diode or string of diodes for the purpose of creating light +• Low Noise Amplifiers: devices used to reduce system noise figure in the receive chain +• Mixers: devices that enable signals to be converted to a higher or lower frequency signal and thereby allowing the signals to be processed more effectively +• Modulators: devices that take a baseband input signal and output a radio frequency modulated signal +• Optocouplers/Optoisolators: semiconductor devices that allow signals to be transferred between circuits or systems while ensuring that the circuits or systems are electrically isolated from each other +• Phase Locked Loops: closed-loop feedback control system that maintains a generated signal in a fixed phase relationship to a reference signal +• Phase Shifters: designed for use in power amplifier distortion compensation circuits in base station applications +• Power Dividers/Combiners: utilized to equally split signals into in-phase signals as often found in balanced signal chains and local oscillator distribution networks +• Receivers: electronic devices that change a radio signal from a transmitter into useful information +• Switches: components that perform the change between the transmit and receive function, as well as the band function for cellular handsets +• Synthesizers: devices that provide ultra-fine frequency resolution, fast switching speed, and low phase-noise performance +• Technical Ceramics: polycrystalline oxide materials used for a wide variety of electrical, mechanical, thermal, and magnetic applications +• Voltage Controlled Oscillators/Synthesizers: fully integrated, high performance signal source for high dynamic range transceivers +• Voltage Regulators: generate a fixed level which ideally remains constant over varying input voltage or load conditions +We believe we possess broad technology capabilities and one of the most complete wireless communications product portfolios in the industry. +Marketing and Distribution +Our products are sold globally through a direct sales force, electronic component distributors and independent sales representatives. Certain distributors have agreements with us which allow for certain sales returns, stock rotations and price protection on certain inventory if we lower the price of those products (see “Critical Accounting Estimates” in Part II, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to Item 8 of this Annual Report on Form 10-K for further detail on revenue reserves). As is customary in the semiconductor industry, our distributors may also market other products that compete with ours. +Our sales engagement begins at the earliest stages of the design of an existing or potential customer’s product. We collaborate technically with our customers and reference design partners at the inception of new programs. These relationships allow our team to facilitate customer-driven solutions, which leverage the unique strength of our intellectual property and product portfolio while providing high value and greatly reducing time-to-market. +We believe the technical and complex nature of our products and markets demand an extraordinary commitment to maintain close ongoing relationships with our customers. As such, we strive to expand the scope of our customer relationship to include design, engineering, manufacturing, procurement, logistics, and project management. We also employ a collaborative approach in developing these relationships by combining the support of our design teams, applications engineers, manufacturing personnel, sales and marketing staff and senior management. Lastly, we leverage our customer relationships with cross-selling opportunities across product lines in order to maximize revenue. +We believe that maintaining frequent and interactive contact with our customers is paramount to our continuous efforts to provide world-class sales and service support. By listening and responding to feedback, we are able to mobilize resources to raise our level of customer satisfaction, improve our ability to anticipate future product needs, and enhance our understanding of key market dynamics. We are confident that diligently following this path positions us to participate in numerous opportunities for growth in the future. +Customer Concentration +A small number of OEMs historically has accounted for a significant portion of our net revenue. In the fiscal years ended October 2, 2020 (“fiscal 2020”), September 27, 2019 (“fiscal 2019”), and September 28, 2018 (“fiscal 2018”), Apple Inc. (“Apple”), through sales to multiple distributors, contract manufacturers and direct sales for multiple applications including smartphones, tablets, desktop and notebook computers, watches, and other devices, constituted more than ten percent of our net revenue. For further information regarding customer concentrations see Note 14 to Item 8 of this Annual Report on Form 10-K. +Intellectual Property and Proprietary Rights +We own or have a license to use numerous United States and foreign patents and patent applications related to our products and our manufacturing operations and processes. In addition, we own a number of trademarks and service marks applicable to certain of our products and services. We believe that our intellectual property, including patents, patent applications, trade secrets and trademarks, is of material importance to our business. We rely on patent, copyright, trademark, trade secret, and other intellectual property laws, as well as non-disclosure and confidentiality agreements and other methods, to protect our confidential and proprietary technologies, designs, devices, algorithms, processes, and other intellectual property. Our efforts may not meaningfully protect our intellectual property, or others may independently develop substantially equivalent or superior proprietary technologies, designs, devices, algorithms, processes, or other intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and effective copyright, patent, trademark, and trade secret protection may not be available in those jurisdictions. In addition to protecting our intellectual property, we strive to strengthen our intellectual property portfolio to enhance our ability to obtain cross-licenses of intellectual property from others, to obtain access to intellectual property we do not possess and to more favorably resolve potential intellectual property claims against us. Due to rapid technological changes in the industry, we believe establishing and maintaining a technological leadership position depends primarily on our ability to develop new, innovative products through the technical competence of our engineering personnel. +Competitive Conditions +The competitive environment in the semiconductor industry is in a constant state of flux, with new products continually emerging and existing products approaching technological obsolescence. We compete on the basis of time-to-market, new product innovation, quality, performance, price, compliance with industry standards, strategic relationships with customers and baseband vendors, personnel, and protection of our intellectual property. We participate in highly competitive markets against numerous competitors that may be able to adapt more quickly than we can to new or emerging technologies and changes in +customer requirements, or may be able to devote greater resources to the development, promotion, and sale of their products than we can. +Erosion of average selling prices of established products is typical of the semiconductor industry. Consistent with trends in the industry, we anticipate that average selling prices for our established products will continue to decline over time. We mitigate the gross margin impact of declining average selling prices with efforts to increase unit volumes, reduce material costs and lower manufacturing costs of existing products and by introducing new and higher value-added products. +Research and Development +Our products and markets demand rapid technological advancements requiring a continuous effort to enhance existing products and develop new products and technologies. Accordingly, we maintain a high level of research and development activity. We invested $464.1 million, $424.1 million, and $404.5 million in research and development during fiscal 2020, fiscal 2019, and fiscal 2018, respectively. The growth in research and development expenses were the result of increases in our internal product designs and product development activity for our target markets in each of these fiscal years. Our research and development expenses include new product development and innovations in integrated circuit design, investment in advanced semiconductor manufacturing processes, development of new packaging and test capabilities and research on next generation technologies and product opportunities. We maintain close collaborative relationships with many of our customers to help identify market demands and target our development efforts to meet those demands. +Raw Materials +Raw materials for our products and manufacturing processes are generally available from several sources. It is our intent not to depend on a sole source of supply unless market or other conditions dictate otherwise. However, there are limited situations where we procure certain components and services for our products from single or limited sources, and we are currently dependent on a limited number of sole source suppliers. We purchase materials and services primarily pursuant to individual purchase orders. However, we have entered into certain supply agreements for the purchase of raw materials or other manufacturing related services that specify minimum prices and purchase quantity based on our anticipated future requirements. Such amounts are reviewed and included in our contractual obligations and commitments as required. Certain of our suppliers consign raw materials to us at our manufacturing facilities to which we take title as needed in our manufacturing process. We believe we have adequate sources for the supply of raw materials and components for our manufacturing needs with suppliers located around the world. +Backlog and Inventory +Our sales are primarily from the sale of semiconductor products under individual customer purchase orders, some of which have underlying master sales agreements that specify terms governing the product sales. In the absence of a sales agreement, the Company’s standard terms and conditions apply. We also maintain Skyworks-owned finished goods inventory at certain customer “hub” locations. We do not recognize revenue until these customers consume the Skyworks-owned inventory from these hub locations. Due to industry practice, which allows customers to cancel orders with limited advance notice to us prior to shipment, and with little or no penalty, we believe that backlog as of any particular date may not be a reliable indicator of our future revenue levels. The cancellation or deferral of product orders, the return of previously sold products, or overproduction due to a change in anticipated order volume could result in a reduction in revenue and us holding excess or obsolete inventory, which could result in inventory write-downs and, in turn, could have a material adverse effect on our financial condition. +Government Regulations +We are subject to international, federal, state, and local legislation, regulations, and other requirements relating to the discharge of substances into the environment; the treatment, transport, and disposal of hazardous wastes; recycling and product packaging; worker health and safety; and other activities affecting the environment, our workforce, and the management of our manufacturing operations. In addition, most of our customers have mandated that our operations and our products comply with various “green” initiatives and workers’ rights initiatives initiated by such customers, industry groups in which such customers participate, or the jurisdictions in which such customers operate. We believe that our operations and facilities comply in all material respects with applicable environmental laws and worker health and safety laws. Our efforts to comply with environmental laws and worker health and safety laws (including laws or regulations promulgated in response to the ongoing COVID-19 pandemic, as discussed below in Item 1A, Risk Factors) could have material impacts on our capital expenditures, competitive position, or financial condition, though the magnitude and duration of such impacts are uncertain and difficult to quantify. +We are also subject to import/export controls, tariffs, and other trade-related regulations and restrictions in the countries in which we have operations or otherwise do business. These controls, tariffs, regulations, and restrictions (including those related +to, or affected by, United States-China relations, as discussed below in Item 1A, Risk Factors) have had, and we believe may continue to have, a material impact on our business, including our ability to sell products and to manufacture or source components. +Government regulations are subject to change in the future, and accordingly we are unable to assess the possible effect of compliance with future requirements or whether our compliance with such regulations will materially impact our business, results of operations, or financial condition. +Seasonality +Sales of our products are subject to seasonal fluctuation and periods of increased demand in end-user consumer applications, such as smartphones and tablet computing devices. The highest demand for our products generally occurs in our first fiscal quarter ending in December and the fourth fiscal quarter ending in September. The lowest demand for our handset products generally occurs in our second fiscal quarter ending in March and the third fiscal quarter ending in June. +Employees +Skyworks’ workforce consists of approximately 10,000 employees located around the world, more than 99% of whom are full-time employees. As of October 2, 2020: +• Our workforce was distributed geographically approximately as follows: 61% in Mexico, 21% in the United States, 17% in Asia, 1% in Canada, and less than 1% in Europe. +• Our workforce was distributed by function approximately as follows: 51% in individual contributor manufacturing roles, 29% in engineering or technician roles, 10% in managerial roles, and 10% in professional or other administrative roles. +• Approximately 3,550 of our employees in Mexico, 670 of our employees in Singapore, and 350 of our employees in Japan were covered by collective bargaining and other union agreements. +In managing our business, we focus on attracting and retaining employees by providing compensation and benefits packages that are competitive within the applicable market, taking into account the job position’s location and responsibilities. Nearly all full-time employees across the globe are eligible to participate in one of the Company’s incentive plans, under which payments are tied to pre-established performance goals. In addition, we believe that developing our employees’ skillsets and decision-making abilities—through challenging project assignments, formal training, mentorship, and recognition—is key not only to our employees’ job satisfaction and our retention efforts, but also to maintaining a strong leadership pipeline. \ No newline at end of file diff --git a/raw/filings/0000004127/2020/0000004127-20-000058/item13.txt b/raw/filings/0000004127/2020/0000004127-20-000058/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..a0b4593838a5c1e486681d6e8c9ec195e9541740 --- /dev/null +++ b/raw/filings/0000004127/2020/0000004127-20-000058/item13.txt @@ -0,0 +1,2 @@ +ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. +63 \ No newline at end of file diff --git a/raw/filings/0000004281/2018/0000004281-19-000031/filing.txt b/raw/filings/0000004281/2018/0000004281-19-000031/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..79283e85249a3f1ac28cbd8e1241163fe063a974 --- /dev/null +++ b/raw/filings/0000004281/2018/0000004281-19-000031/filing.txt @@ -0,0 +1,6663 @@ +10-K +1 +form10k_4q18.htm +10-K +Document +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +[ x ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +For The Fiscal Year Ended December 31, 2018 +OR +[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) +OF THE SECURITIES EXCHANGE ACT OF 1934 +Commission File Number 1-3610 +ARCONIC INC. +(Exact name of registrant as specified in its charter) +Delaware +25-0317820 +(State of incorporation) +(I.R.S. Employer Identification No.) +390 Park Avenue, New York, New York 10022-4608 +(Address of principal executive offices) (Zip code) +Registrant’s telephone numbers: +Investor Relations----------------(212) 836-2758 +Office of the Secretary-----------(212) 836-2732 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, par value $1.00 per share +New York Stock Exchange +$3.75 Cumulative Preferred Stock, par value $100.00 per share +NYSE American +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ✓ No . +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes No ✓ . +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes ✓ No . +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ✓ No . +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [] +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer [ ✓ ] Accelerated filer [] Non-accelerated filer [] +Smaller reporting company [] Emerging growth company [] +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No ✓ . +The aggregate market value of the outstanding common stock, other than shares held by persons who may be deemed affiliates of the registrant, as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $8 billion. As of February 15, 2019 , there were 484,940,842 shares of common stock, par value $1.00 per share, of the registrant outstanding. +Documents incorporated by reference. +Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement for its 2019 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A (Proxy Statement). +Table of Contents +TABLE OF CONTENTS +Page(s) +Part I +Item 1. +Business +1 +Item 1A. +Risk Factors +14 +Item 1B. +Unresolved Staff Comments +28 +Item 2. +Properties +29 +Item 3. +Legal Proceedings +30 +Item 4. +Mine Safety Disclosures +32 +Part II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +32 +Item 6. +Selected Financial Data +34 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +35 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +51 +Item 8. +Financial Statements and Supplementary Data +52 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +103 +Item 9A. +Controls and Procedures +103 +Item 9B. +Other Information +104 +Part III +Item 10. +Directors, Executive Officers and Corporate Governance +104 +Item 11. +Executive Compensation +104 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +104 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +104 +Item 14. +Principal Accounting Fees and Services +104 +Part IV +Item 15. +Exhibits, Financial Statement Schedules +105 +Item 16. +Form 10-K Summary +114 +Signatures +115 +Note on Incorporation by Reference +In this Form 10-K, selected items of information and data are incorporated by reference to portions of the Proxy Statement. Unless otherwise provided herein, any reference in this report to disclosures in the Proxy Statement shall constitute incorporation by reference of only that specific disclosure into this Form 10-K. +Table of Contents +PART I +Item 1. Business. +General +Arconic Inc. is a Delaware corporation with its principal office in New York, New York and the successor to Arconic Pennsylvania (as defined below) which was formed in 1888 and formerly known as Alcoa Inc. In this report, unless the context otherwise requires, “Arconic” or the “Company” means Arconic Inc., a Delaware corporation, and all subsidiaries consolidated for the purposes of its financial statements. +The Company’s Internet address is http://www.arconic.com . Arconic makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC). The information on the Company’s Internet site is not a part of, or incorporated by reference in, this annual report on Form 10-K. The SEC maintains an Internet site that contains these reports at http://www.sec.gov . +Forward-Looking Statements +This report contains (and oral communications made by Arconic may contain) statements that relate to future events and expectations and, as such, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those containing such words as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “guidance,” “intends,” “may,” “outlook,” “plans,” “projects,” “seeks,” “sees,” “should,” “targets,” “will,” “would,” or other words of similar meaning. All statements that reflect Arconic’s expectations, assumptions or projections about the future, other than statements of historical fact, are forward-looking statements, including, without limitation, forecasts relating to the growth of the aerospace, automotive, commercial transportation and other end markets; statements and guidance regarding future financial results or operating performance; statements about Arconic’s strategies, outlook, business and financial prospects; and statements regarding potential share gains. Forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and changes in circumstances that are difficult to predict. Although Arconic believes that the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that these expectations will be attained and it is possible that actual results may differ materially from those indicated by these forward-looking statements due to a variety of risks and uncertainties. +For a discussion of some of the specific factors that may cause Arconic’s actual results to differ materially from those projected in any forward-looking statements, see the following sections of this report: Part I, Item 1A. (Risk Factors), Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations), including the disclosures under Segment Information and Critical Accounting Policies and Estimates, and Note U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). Market projections are subject to the risks discussed in this report and other risks in the market. Arconic disclaims any intention or obligation to update publicly any forward-looking statements, whether in response to new information, future events or otherwise, except as required by applicable law. +Overview +Arconic (“Arconic” or the “Company”) is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging. +Arconic is a global company operating in 18 countries. Based upon the country where the point of sale occurred, the United States and Europe generated 65% and 24%, respectively, of Arconic’s sales in 2018. In addition, Arconic has operating activities in Brazil, Canada, China, Japan, and Russia, among others. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in these countries . +Arconic’s operations consist of three worldwide reportable segments: Engineered Products and Solutions, Global Rolled Products and Transportation and Construction Solutions. +Background +Arconic Inc. Reincorporation +On December 31, 2017 (the “Effective Date”), Arconic Inc., a Pennsylvania corporation (“Arconic Pennsylvania” or, prior to the Reincorporation (as defined below), the “Company”), effected the change of the Company’s jurisdiction of incorporation from Pennsylvania to Delaware (the “Reincorporation”) by merging (the “Reincorporation Merger”) with a direct wholly owned Delaware subsidiary, Arconic (in this section, “Arconic Delaware” or, following the Reincorporation, the “Company”), pursuant to an Agreement and Plan of Merger (the “Reincorporation Merger Agreement”), dated as of October 12, 2017, by and +1 +Table of Contents +between Arconic Pennsylvania and Arconic Delaware. Arconic Pennsylvania shareholders approved the Reincorporation Merger to effect the Reincorporation at a Special Meeting of Shareholders held on November 30, 2017. As a result of the Reincorporation, (i) Arconic Pennsylvania has ceased to exist, (ii) Arconic Delaware automatically inherited the reporting obligations of Arconic Pennsylvania under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and (iii) Arconic Delaware is deemed to be the successor issuer to Arconic Pennsylvania. +The common stock, par value $1.00 per share, of Arconic Pennsylvania (the “Arconic Pennsylvania Common Stock”) was listed for trading on the New York Stock Exchange and traded under the symbol “ARNC.” As of the Effective Date, this symbol, without interruption, represents shares of common stock, par value $1.00 per share, of Arconic Delaware (the “Arconic Delaware Common Stock”). There was no change in the Exchange Act File Number assigned by the SEC as a result of the Reincorporation. +As of the Effective Date, the rights of the Company’s stockholders began to be governed by the General Corporation Law of the State of Delaware, the Certificate of Incorporation of Arconic Delaware (the “Delaware Certificate”) and the Bylaws of Arconic Delaware (the “Delaware Bylaws”). +Other than the change in corporate domicile, the Reincorporation did not result in any change in the business, physical location, management, financial condition or number of authorized shares of the Company, nor did it result in any change in location of its current employees, including management. On the Effective Date, (i) the directors and officers of Arconic Pennsylvania prior to the Reincorporation continued as the directors and officers of Arconic Delaware after the Reincorporation, (ii) each outstanding share of Arconic Pennsylvania Common Stock was automatically converted into one share of Arconic Delaware Common Stock, (iii) each outstanding share of Serial Preferred Stock, par value $100 per share, of Arconic Pennsylvania (the “Arconic Pennsylvania Preferred Stock”) was automatically converted into one share of Serial Preferred Stock, par value $100 per share, of Arconic Delaware (the “Arconic Delaware Preferred Stock”) and (iv) all of Arconic Pennsylvania’s employee benefit and compensation plans immediately prior to the Reincorporation were continued by Arconic Delaware, and each outstanding equity award and notional share unit relating to shares of Arconic Pennsylvania Common Stock was converted into an equity award or notional share unit, as applicable, relating to an equivalent number of shares of Arconic Delaware Common Stock on the same terms and subject to the same conditions. Beginning at the effective time of the Reincorporation, each certificate representing Arconic Pennsylvania Common Stock or Arconic Pennsylvania Preferred Stock was deemed for all corporate purposes to evidence ownership of Arconic Delaware Common Stock or Arconic Delaware Preferred Stock, as applicable. The Company’s stockholders may, but are not required to, exchange their stock certificates as a result of the Reincorporation. +The foregoing descriptions of the Arconic Delaware Common Stock, the Arconic Delaware Preferred Stock, the Delaware Certificate and the Delaware Bylaws are qualified in their entirety by the full text of the Delaware Certificate and the Delaware Bylaws, which are filed as Exhibits 3(a) and 3(b), respectively, to this report. +Alcoa Corporation Separation Transaction +On November 1, 2016, Alcoa Inc. completed the separation of its business into two independent, publicly traded companies (the “Separation”) – Alcoa Corporation and Arconic Inc. (the new name for Alcoa Inc.). Following the Separation, Alcoa Corporation holds the Alumina and Primary Metals segments, the rolling mill at the Warrick, Indiana operations and the 25.1% stake in the Ma’aden Rolling Company in Saudi Arabia previously held by the Company. The Company retained the Global Rolled Products (other than the rolling mill at the Warrick, Indiana operations and the 25.1% ownership stake in the Ma’aden Rolling Company), Engineered Products and Solutions and Transportation and Construction Solutions segments. +The Separation was effected by a pro rata distribution of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders (the “Distribution”). The Company’s shareholders of record as of the close of business on October 20, 2016 (the “Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the Record Date. The Company did not issue fractional shares of Alcoa Corporation common stock in the Distribution. Instead, each shareholder otherwise entitled to receive a fractional share of Alcoa Corporation common stock received cash in lieu of fractional shares. +The Company distributed 146,159,428 shares of common stock of Alcoa Corporation in the Distribution and retained 36,311,767 shares, or approximately 19.9%, of the common stock of Alcoa Corporation immediately following the Distribution. As a result of the Distribution, Alcoa Corporation became an independent public company trading under the symbol “AA” on the New York Stock Exchange, and the Company trades under the symbol “ARNC” on the New York Stock Exchange. +During 2017, the Company disposed of its retained interest in Alcoa Corporation. In February 2017, the Company sold 23,353,000 shares of Alcoa Corporation stock at $38.03 per share, which resulted in cash proceeds of $888 million and a gain of $351 million. In April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 shares (valued at $35.91 per share) in +2 +Table of Contents +Alcoa Corporation stock (the “Debt-for-Equity Exchange”) and recorded a gain of $167 million. The gains of $351 million and $167 million associated with the disposition of the Alcoa Corporation shares were recorded in Other Income, Net in the accompanying Statement of Consolidated Operations in Part II, Item 8 (Financial Statements and Supplementary Data). +On October 31, 2016, in connection with the Separation and the Distribution, Arconic entered into several agreements with Alcoa Corporation or its subsidiaries that govern the relationship of the parties following the Distribution, including the following: Separation and Distribution Agreement, Transition Services Agreement, Tax Matters Agreement, Employee Matters Agreement, certain Patent, Know-How, Trade Secret License and Trademark License Agreements, Toll Processing and Services Agreement, Master Agreement for the Supply of Primary Aluminum, Massena Lease and Operations Agreement, Fusina Lease and Operations Agreement, and Stockholder and Registration Rights Agreement. The Toll Processing and Services Agreement expired by its terms at the end of 2018. +Recent Developments +On January 22, 2019, the Company announced that its Board of Directors (the Board) had determined to no longer pursue a potential sale of Arconic as part of its strategy and portfolio review. Management and the Board have been conducting a rigorous and comprehensive strategy and portfolio review over the past year and as part of that process had considered a sale of the Company, among other matters. However, the Company did not receive a proposal for a full-Company transaction that management and the Board believed would be in the best interest of Arconic’s shareholders and other stakeholders. Management and the Board remain confident in Arconic’s significant potential and are strongly focused on enhancing value for shareholders, through continued operational improvements and through other potential initiatives which have been previously identified in the strategy and portfolio review. The Company has announced the following key initiatives as part of its ongoing strategy and portfolio review: +• +Commenced plans to reduce operating costs by approximately $200 million on an annual run-rate basis, designed to maximize the impact in 2019; +• +Announced the planned separation of its portfolio into Engineered Products and Forgings and Global Rolled Products, with a spin-off of one of the businesses; +• +Considering the potential sale of businesses that do not best fit into one of the two segments above; +• +Intends to execute its previously authorized $500 million share repurchase program in the first half of 2019; +• +The Board also authorized an additional $500 million of share repurchases, effective through the end of 2020; and +• +Expects to reduce its quarterly common stock dividend from $0.06 to $0.02 per share. +On February 6, 2019, the Company announced that the Board appointed John C. Plant, current Chairman of the Board, as Chairman and Chief Executive Officer of the Company, effective February 6, 2019, to succeed Chip Blankenship, who ceased to serve as Chief Executive Officer of the Company and resigned as a member of the Board, in each case as of that date. In addition, the Company announced that the Board appointed Elmer L. Doty, current member of the Board, as President and Chief Operating Officer, a newly created position, effective February 6, 2019. Mr. Doty will remain a member of the Board. The Company also announced that Arthur D. Collins, Jr., current member of the Board, has been appointed interim Lead Independent Director of the Company, effective February 6, 2019. +On February 19, 2019, the Company entered into an accelerated share repurchase (“ASR”) agreement with JPMorgan Chase Bank to repurchase $700 million of its common stock, pursuant to the share repurchase program previously authorized by the Board. Under the ASR agreement, Arconic will receive initial delivery of approximately 32 million shares on February 21, 2019. The final number of shares to be repurchased will be based on the volume-weighted average price of Arconic’s common stock during the term of the transaction, less a discount. The ASR agreement is expected to be completed during the first half of 2019. +The Company will evaluate its organizational structure in conjunction with the planned separation of its portfolio and changes to its reportable segments are expected in the first half of 2019. +3 +Table of Contents +Description of the Business +Information describing Arconic’s businesses can be found on the indicated pages of this report: +Item +Page(s) +Discussion of Recent Business Developments: +Management’s Discussion and Analysis of Financial Condition and Results of Operations: +Overview and Results of Operations +35 +Notes to Consolidated Financial Statements: +Note D. Restructuring and Other Charges +70 +Note G. Pension and Other Postretirement Benefits +73 +Note H. Income Taxes +80 +Note T. Acquisitions and Divestitures +96 +Note U. Contingencies and Commitments +97 +Segment Information: +Business Descriptions, Principal Products, Principal Markets, Methods of Distribution, Seasonality and Dependence Upon Customers: +Engineered Products and Solutions +40 +Global Rolled Products +41 +Transportation and Construction Solutions +42 +Financial Information about Segments and Geographic Areas: +Note C. Segment and Geographic Area Information +66 +Major Product Revenues +Products that contributed 10% or more to consolidated revenues for the years ended December 31, 2018 , 2017 and 2016 , were: +For the Year Ended +December 31, +2018 +2017 +2016 +Innovative flat-rolled products +40 +% +39 +% +39 +% +Engines +21 +% +21 +% +21 +% +Engineered structures +13 +% +13 +% +14 +% +Fastening systems +11 +% +11 +% +12 +% +Arconic has no customer that accounts for 10% or more of its consolidated revenues. However, certain of the Company’s businesses are dependent upon a few significant customers. The loss of any such significant customer could have a material adverse effect on such businesses. +Engineered Products and Solutions +Arconic’s Engineered Products and Solutions segment (“EP&S”) develops and manufactures high performance products mainly for the aerospace (commercial and defense), commercial transportation, and power generation end markets. Such products include fastening systems (titanium, steel, and nickel superalloys); seamless rolled rings (nickel superalloys, steel and titanium); investment castings (nickel superalloys, titanium, and aluminum), including airfoils and structural components; forged airframe and jet engine components (nickel superalloys, titanium, aluminum), including bulkheads, disks and shafts; extruded airframe components (aluminum); and various other forged and extruded metallic components for the oil and gas, industrial products, automotive, and land and sea defense end markets. +In January 2018, EP&S announced a change in the organizational structure of the segment, from four business units to three business units, with a focus on aligning its internal structure to core markets and customers and reducing costs. The three business units are Arconic Engines; Arconic Fastening Systems; and Arconic Engineered Structures. +Arconic Engines (AEN). AEN produces investment cast airfoils, seamless rolled rings and closed-die (including isothermal) forged turbine disks for aero engine and industrial gas turbines, as well as other structural aero engine components. AEN also provides additive manufacturing technologies, superalloy ingots, open-die forging, machining, performance coatings, and hot isostatic pressing for high performance parts. +Arconic Fastening Systems (AFS). AFS produces aerospace fastening systems, as well as commercial transportation fasteners. The business’s high-tech, multi-material fastening systems are found nose to tail on aircraft and aero engines. The +4 +Table of Contents +business’s products are also critical components of industrial gas turbines, automobiles, commercial transportation vehicles, and construction and industrial equipment. +Arconic Engineered Structures (AES). AES produces titanium and aluminum ingots and mill products for aerospace and defense applications and is vertically integrated to produce structural investment castings, forgings and extrusions, for airframe, wing, aero-engine, and landing gear components, as well as lightweight drive shafts for the commercial transportation industries. AES also provides multi-material airframe subassemblies and solutions related to advanced technologies and materials, such as 3D printing and titanium aluminides. +For additional discussion of the EP&S segment's business, see “Results of Operations—Segment Information” in Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note C to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +In July 2018, Arconic announced a two-year Joint Development Agreement with Lockheed Martin to develop customized lightweight material systems and advanced manufacturing processes, such as metal 3D printing, to advance current and next-generation aerospace and defense solutions - including new structures and systems. +In December 2018, as part of the Company’s ongoing strategy and portfolio review, Arconic completed the sale of its Eger, Hungary forgings business that manufactured high volume steel forgings for drivetrain components in the European heavy-duty truck and automotive market to Angstrom Automotive Group LLC. +5 +Table of Contents +Engineered Products and Solutions Principal Facilities 1 +Country +Facility +Products +Australia +Oakleigh +Fasteners +Canada +Georgetown, Ontario 2 +Aerospace Castings +Laval, Québec +Aerospace Castings and Machining +China +Suzhou 2 +Fasteners and Rings +France +Dives-sur-Mer +Aerospace and Industrial Gas Turbine Castings +Evron +Aerospace and Specialty Castings +Gennevilliers +Aerospace and Industrial Gas Turbine Castings +Montbrison +Fasteners +St. Cosme-en-Vairais 2 +Fasteners +Toulouse +Fasteners +Us-par-Vigny +Fasteners +Germany +Bestwig +Aerospace Castings +Erwitte +Aerospace Castings +Hannover 2 +Extrusions +Hildesheim-Bavenstedt 2 +Fasteners +Kelkheim 2 +Fasteners +Hungary +Nemesvámos +Fasteners +Székesfehérvár +Aerospace and Industrial Gas Turbine Castings and Forgings +Japan +Nomi +Aerospace and Industrial Gas Turbine Castings +Mexico +Ciudad Acuña 2 +Aerospace Castings/Fasteners and Rings +Morocco +Casablanca 2 +Fasteners +South Korea +Kyoungnam +Extrusions +United Kingdom +Darley Dale +Forgings +Ecclesfield +Ingot Castings +Exeter 2 +Aerospace and Industrial Gas Turbine Castings and Alloy +Glossop +Ingot Castings +Ickles +Ingot Castings +Leicester 2 +Fasteners +Low Moor +Extrusions +Meadowhall +Forgings +Provincial Park +Forgings +Redditch 2 +Fasteners +River Don +Forgings +Telford +Fasteners +Welwyn Garden City +Aerospace Formed Parts +6 +Table of Contents +Country +Facility +Products +United States +Chandler, AZ +Extrusions +Tucson, AZ 2 +Fasteners +Carson, CA 2 +Fasteners +City of Industry, CA 2 +Fasteners +Fontana, CA +Rings +Fullerton, CA 2 +Fasteners +Rancho Cucamonga, CA +Rings +Sylmar, CA +Fasteners +Torrance, CA +Fasteners +Branford, CT +Aerospace Coatings +Winsted, CT +Aerospace Machining +Savannah, GA +Forgings +Lafayette, IN +Extrusions +La Porte, IN +Aerospace and Industrial Gas Turbine Castings +Baltimore, MD 2 +Extrusions +Whitehall, MI +Aerospace and Industrial Gas Turbine Castings and Coatings, Titanium Alloy and Specialty Products +Washington, MO +Aerospace Formed Parts, Titanium Mill Products +Big Lake, MN +Aerospace Machining +New Brighton, MN +Aerospace Machining +Dover, NJ +Aerospace and Industrial Gas Turbine Castings and Alloy +Verdi, NV +Rings +Kingston, NY 2 +Fasteners +Massena, NY +Extrusions +Rochester, NY +Rings +Canton, OH 2 +Ferro-Titanium Alloys and Titanium Mill Products +Cleveland, OH +Investment Casting Equipment, Aerospace Components, Castings, Forgings and Oil & Gas Drilling Products +Niles, OH +Titanium Mill Products +Morristown, TN 2 +Aerospace and Industrial Gas Turbine Ceramic Products +Austin, TX 2 +Additively Manufactured Parts +Houston, TX 2 +Extrusions +Spring, TX +Deep Water Drilling Machining +Waco, TX 2 +Fasteners +Wichita Falls, TX +Aerospace and Industrial Gas Turbine Castings +Hampton, VA 2 +Aerospace and Industrial Gas Turbine Castings +Martinsville, VA +Titanium Mill Products +1 +Principal facilities are listed, and do not include 14 locations that serve as sales and administrative offices, distribution centers or warehouses. +2 +Leased property or partially leased property. +Global Rolled Products +Arconic’s Global Rolled Products segment (“GRP”) has a single group organization structure and produces a range of aluminum sheet and plate products for the following markets: +Aerospace and Automotive - GRP provides a wide range of products, including many highly-differentiated sheet and plate products, for the worldwide aerospace and regional automotive markets. +Brazing, Commercial Transportation and Industrial - GRP provides specialty aluminum sheet and plate products for automotive, commercial transportation and industrial applications including proprietary heat exchanger products like multilayer brazing sheet. +7 +Table of Contents +Packaging - GRP serves the packaging market in Russia, Asia and Latin America through regional facilities. +For additional discussion of the Global Rolled Products segment’s business, see “Results of Operations—Segment Information” in Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note C to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +In July 2018, the Company announced it had signed a new long-term contract with Boeing to supply aluminum sheet and plate for all models produced by Boeing Commercial Airplanes. The multiyear contract, which extends and adds to the Companies’ 2014 contract, is the largest to date and captures growth in the build rate increases of the Boeing 737 program. +On October 31, 2018, the Company sold its Texarkana, Texas rolling mill and cast house to Ta Chen International, Inc. for $302 million in cash, subject to post-closing adjustments, plus additional contingent consideration of up to $50 million. The contingent consideration relates to the achievement of various milestones within 36 months of the transaction closing date associated with operationalizing the rolling mill equipment. The Texarkana rolling mill facility had previously been idle since late 2009. In early 2016, the Company restarted the Texarkana cast house to meet demand for aluminum slab. As part of the agreement, the Company will continue to produce aluminum slab at the facility for a period of 18 months through a lease back of the cast house building and equipment, after which time, Ta Chen will perform toll processing of metal for the Company for a period of six months. The Company will supply Ta Chen with cold-rolled aluminum coil during this 24-month period. +In February 2019, the Company announced an investment of approximately $100 million to expand its hot mill capability and add downstream equipment capabilities to manufacture industrial and automotive aluminum products in its Tennessee Operations facility near Knoxville, Tennessee. The project, which is expected to create 70 new jobs, is already underway and is expected to be complete by the fourth quarter of 2020. +Global Rolled Products Principal Facilities +Country +Location +Products +Brazil +Itapissuma +Specialty Foil +China +Kunshan +Sheet and Plate +Qinhuangdao 1 +Sheet and Plate +Hungary +Székesfehérvár +Sheet and Plate/Slabs and Billets +Russia +Samara +Sheet and Plate/Extrusions and Forgings +United Kingdom +Birmingham +Plate +United States +Davenport, IA +Sheet and Plate +Danville, IL 2 +Sheet and Plate +Hutchinson, KS 2 +Sheet and Plate +Lancaster, PA +Sheet and Plate +Alcoa, TN +Sheet +Texarkana, TX 1, 3 +Slabs +San Antonio, TX 4 +Micromill™ +1 +Leased property or partially leased property. +2 +Properties are satellite locations of the Davenport, Iowa facility. +3 +The aluminum slab that is cast at Texarkana is turned into aluminum sheets at Arconic’s expanded automotive facility in Davenport, Iowa and its rolling mill in Lancaster, Pennsylvania. See discussion above concerning the sale of this facility. +4 +Micromill™ production facility produces sheet for automotive and industrial applications using Arconic innovative production process. +Transportation and Construction Solutions +Arconic’s Transportation and Construction Solutions segment ("TCS") produces products that are used mostly in the commercial transportation and nonresidential building and construction end markets. Such products include integrated aluminum structural systems, architectural extrusions and forged aluminum commercial vehicle wheels. +The Transportation and Construction Solutions segment is comprised of two business units: Arconic Wheel and Transportation Products; and Building and Construction Systems. +Arconic Wheel and Transportation Products (AWTP). AWTP provides forged aluminum wheels and related products for heavy-duty trucks and the commercial transportation markets. +8 +Table of Contents +Building and Construction Systems (BCS). BCS provides building and construction architectural framing products and aluminum curtain wall and front entry systems. +For additional discussion of the Transportation and Construction Solutions segment’s business, see “Results of Operations—Segment Information” in Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note C to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +In April 2018, the Company completed the sale of its Latin America Extrusions business to a subsidiary of Hydro Extruded Solutions AS. The sale is part of Arconic’s continued drive to streamline its business portfolio, reduce complexity and further focus on its higher-margin products and profitable growth. +On July 31, 2018, the Company announced that it had initiated a sale process of its BCS business, as part of the Company’s ongoing strategy and portfolio review that commenced in January 2018. +Transportation and Construction Solutions Principal Facilities 1 +Country +Facility +Products +Canada +Lethbridge, Alberta +Architectural Products +China +Suzhou 2 +Forgings +France +Merxheim 2 +Architectural Products +Hungary +Székesfehérvár +Forgings +Japan +Jôetsu City 2 +Forgings +Mexico +Monterrey +Forgings +United Kingdom +Runcorn +Architectural Products +United States +Springdale, AR +Architectural Products +Visalia, CA +Architectural Products +Eastman, GA +Architectural Products +Barberton, OH +Forgings +Cleveland, OH +Forgings +Bloomsburg, PA +Architectural Products +Cranberry, PA +Architectural Products +1 +Principal facilities are listed, and do not include 8 locations that serve as sales and administrative offices, distribution centers or warehouses. In addition to the facilities listed above, TCS has 20 service centers. These centers perform light manufacturing, such as assembly and fabrication of certain products. +2 +Leased property or partially leased property. +9 +Table of Contents +Sources and Availability of Raw Materials +Important raw materials purchased in 2018 for each of the Company’s reportable segments are listed below. +Engineered Products and Solutions +Global Rolled Products +Alloying materials +Alloying materials +Cobalt +Aluminum scrap +Electricity +Coatings +Natural gas +Electricity +Nickel alloys +Lube oil +Primary aluminum (ingot, billet, P1020, high purity) +Natural gas +Stainless steel +Packaging materials +Steel +Primary aluminum (ingot, slab, billet, P1020, high purity) +Titanium alloys +Steam +Titanium sponge +Transportation and Construction Solutions +Aluminum coil +Aluminum scrap +Electricity +Natural gas +Paint/Coating +Primary aluminum (billet) +Resin +Generally, other materials are purchased from third-party suppliers under competitively priced supply contracts or bidding arrangements. The Company believes that the raw materials necessary to its business are and will continue to be available. +Patents, Trade Secrets and Trademarks +The Company believes that its domestic and international patent, trade secret and trademark assets provide it with a significant competitive advantage. The Company’s rights under its patents, as well as the products made and sold under them, are important to the Company as a whole and, to varying degrees, important to each business segment. The patents owned by Arconic generally concern metal alloys, particular products, manufacturing equipment or techniques. Arconic’s business as a whole is not, however, materially dependent on any single patent, trade secret or trademark. As a result of product development and technological advancement, the Company continues to pursue patent protection in jurisdictions throughout the world. As of the end of 2018, the Company’s worldwide patent portfolio consists of approximately 1,863 granted patents and 824 pending patent applications. +The Company also has a significant number of trade secrets, mostly regarding manufacturing processes and material compositions that give many of its businesses important advantages in their markets. The Company continues to strive to improve those processes and generate new material compositions that provide additional benefits. +With respect to domestic and international registered trademarks, the Company has many that have significant recognition within the markets that are served. Examples include the name “Arconic” and the Arconic symbol for aluminum, nickel, and titanium products, Howmet ® metal castings, Huck ® fasteners, Kawneer ® building panels and Dura-Bright ® wheels with easy-clean surface treatments. A significant trademark filing campaign for the name “Arconic” was completed in 2016, in support of the corporate launch of Arconic Inc. As of the end of 2018, the Company’s worldwide trademark portfolio consists of approximately 1,967 registered trademarks and 465 pending trademark applications. The Company’s rights under its trademarks are important to the Company as a whole and, to varying degrees, important to each business segment. +Competitive Conditions +Engineered Products and Solutions (EP&S) +EP & S’s business units - AFS, AEN and AES -are subject to substantial and intense competition in the markets they serve. Although Arconic believes its advanced technology, manufacturing processes and experience provide advantages to Arconic’s customers, such as high quality and superior mechanical properties that meet the Company’s customers’ most stringent requirements, many of the products Arconic makes can be produced by competitors using similar types of manufacturing +10 +Table of Contents +processes as well as alternative forms of manufacturing. Despite intense competition, Arconic continues as a market leader in most of its principal markets. Several factors, including Arconic’s legacy of technical innovation, state-of-the-art capabilities, engaged employees and long-standing customer relationships, enable the Company to maintain its competitive position. +Principal competitors in the EP&S segment include Berkshire Hathaway Inc., through its acquisition of Precision Castparts Corporation and subsidiaries, for titanium and titanium-based alloys, precision forgings, seamless rolled rings, investment castings and aerospace fasteners; VSMPO (Russia) for titanium and titanium-based alloys and precision forgings; the High-Performance Materials & Components segment of Allegheny Technologies, Inc. (ATI) for titanium and titanium-based alloys, precision forgings, and investment castings; Lisi Aerospace (France) for aerospace fasteners; and Aubert & Duval (part of Eramet Group in France) for precision forgings. +Other competitors include: +• +Kaiser Aluminum - for extruded products +• +Universal Alloy Corp., part of Montana Tech Components - for extruded products +• +Doncasters Group Ltd. (UK) - for investment castings +• +Consolidated Precision Products Corp., part of Warburg Pincus - for investment castings +• +Weber Metals, part of Otto Fuchs - for precision forgings +• +Forgital - for seamless rings +• +Frisa (Mexico) - for seamless rings +Several of Arconic’s largest customers have captive superalloy furnaces for producing airfoil investment castings for their own use. Many other companies around the world also produce superalloy investment castings, and some of these companies currently compete with Arconic in the aerospace and other markets, while others are capable of competing with the Company should they choose to do so. +International competition in the investment castings , fasteners, rings and forgings markets may also increase in the future as a result of strategic alliances among engine original equipment manufacturers (OEMs), aero-structure prime contractors, and overseas companies, especially in developing markets, particularly where “offset” or “local content” requirements create purchase obligations with respect to products manufactured in or directed to a particular country. +Global Rolled Products (GRP) +GRP is one of the leaders in many of the aluminum flat rolled products markets in which it participates, including aerospace, automotive, commercial transportation, industrial markets (including brazing sheet) and packaging. However, much like other Arconic businesses, GRP is subject to substantial and intense competition in all of its markets. +While GRP participates in markets where Arconic believes the Company has a significant competitive advantage due to customer intimacy, advanced manufacturing capability, unique technology and/or differentiated products, in certain cases, the Company’s competitors are capable of making products similar to Arconic’s. The Company continuously works to maintain and enhance its competitive advantage through innovation: new alloys such as aerospace alloys, differentiated products such as the Company’s 5-layer brazing products and break-through processes such as Arconic Micromill® technology. +Some of GRP’s markets are worldwide and some are more regionally focused. Participation in these segments by GRP’s competitors varies. For example, Novelis is the largest flat rolled products producer competing in automotive, but it does not participate in the aerospace market. On the other hand, Constellium participates in all major market segments including aerospace, brazing, industrial, commercial transportation and packaging. Granges participates only in the brazing sheet market. Other GRP competitors include Aleris, AMAG, Hydro, Kaiser, Kobe, Nanshan, and UACJ. The competitive landscape is changing - in this past year, Novelis announced the acquisition of aluminum rolled products producer Aleris and Braidy Industries announced its intention to build a new aluminum mill near Ashland, Kentucky for automotive production. +Additionally, there are a number of new competitors emerging, particularly in China and other developing economies. Arconic expects that this competitive pressure will continue and increase in the future as customers seek to globalize their supply bases in order to reduce costs. The Company continually monitors and plans for these new emerging players. +Summary of Major Competitors for GRP: +• +Constellium (The Netherlands) +• +Novelis +• +Kaiser Aluminum +• +AMAG (Austria) +• +UACJ (Japan) +11 +Table of Contents +• +Aleris +• +Hydro (Norway) +• +Nanshan (China) +• +Granges (Sweden) +• +Kobe (Japan) +Transportation and Construction Solutions (TCS) +In the forged aluminum wheels business, AWTP competes in commercial transportation, under the product brand name Alcoa ® Wheels, for the major regions that it serves (Americas, Europe, Japan, China, and Australia). AWTP competes against steel wheels, as well as aluminum. Its larger competitors are Accuride Corporation, Nippon Steel & Sumitomo Metal Corporation, Zhejiang Dicastal Hongxin Technology Co. Ltd, Wheels India Limited and Speedline (member of the Ronal Group). AWTP has continued to see aluminum wheel suppliers (both forged and cast aluminum wheels) from China, Taiwan, India and South Korea attempting to penetrate the commercial transportation market. +BCS is a manufacturer of aluminum architectural systems and products in North America and Europe. In North America, BCS primarily competes in the nonresidential building segment. In Europe, it competes in both the residential and the nonresidential building segments. BCS competes with regional and local players in the architectural systems and more global companies in the products markets. BCS’s competitive advantage is the cornerstone to its strong brand, innovative products, customer intimacy and technical services. Over the past decade, the regional competitors, primarily in North America, have narrowed the product portfolio and technical services advantages. However, BCS has maintained its competitive advantage through innovative products like highly energy-efficient high-thermal products and differentiated services. BCS sales are derived mainly from the retail, office, education and healthcare building segments. +BCS is organized into two business segments: architectural systems and architectural products. The primary product categories in architectural systems are storefront, framing and entrances (SEF), curtain walls, and windows. In the SEF and curtain wall businesses, BCS competes with competitors like Apogee, YKK, Oldcastle, Schüco, Hydro/SAPA and Reynaers in their aluminum framing systems business. The architectural products business is more global and is primarily served by subsidiaries of larger companies like Alpolic (Mitsubishi Corporation), Alucobond (Schweiter Technologies) and Novelis (Aditya Birla Group). The primary product categories are aluminum composite material and coil coated sheet. The competitive landscape in the architectural systems market has been relatively stable since the mid-2000s, with the major competitors in North America and Europe still operating in their markets, despite some industry consolidation in North America during the late 2000s. +Summary of Major Competitors: +AWTP: +• +Accuride Corporation +• +Nippon Steel & Sumitomo Metal Corporation (Japan) +• +Zhejiang Dicastal Hongxin Technology Co. Ltd (China) +• +Wheels India Limited (India) +• +Speedline (member of the Ronal Group in Switzerland) +BCS: +• +Apogee, Oldcastle and YKK +• +Alpolic, Alucobond and Alucoil +• +Schüco (Germany), Hydro/SAPA (Norway), Reynaers (Belgium) and Corialis (Belgium) +• +Alucobond, Alucoil, Euramax and Novelis +Research and Development +Arconic, at its light metals research center, engages in research and development (R&D) programs that include process and product development, and basic and applied research. +Throughout 2018, the Company continued working on new developments in all business segments and leveraging new technologies. The Company has continued investing in additive manufacturing, with a focus on producing metal powder materials tailored for a range of additive process technologies, and furthering its development of advanced 3D printing design and manufacturing techniques-such as Arconic’s Ampliforge ™ process-to improve production speeds, reduce costs, and achieve material properties not possible through other additive flowpaths. The Company’s powder production facility was completed at the Arconic Technology Center (ATC) in 2016. This facility will continue its focus on material development in aluminum, nickel and titanium alloys. +12 +Table of Contents +The Company is also producing and qualifying additively manufactured aerospace, automotive and defense components via laser powder bed printing technology. It also is developing more formable titanium plate based wrought products for customers. +Arconic’s Micromill® technology, which enables aluminum sheet to be produced in a matter of minutes rather than weeks and with enhanced structural properties, continues to grow. Specifically, the Arconic Micromill® technology located in San Antonio continues to transition to commercial production. In addition, the Company has invested in further developing Micromill™ technology, including installation of a pilot line at the ATC. +The Company continues to develop differentiated pretreatment technology, for example, by continuing to improve on its A951 technology, which enables aluminum to be joined with steel (e.g., in automotive applications). In addition, the Company continues to advance its joining methods/fasteners (like RSR™) and highly formable and high strength automotive sheet products for automotive original equipment manufacturer applications in both cosmetic hang on parts and structural body-in-white applications. A pilot coating line was installed at ATC in 2018. +The Company continued its differentiation in the commercial transportation market with Dura-Bright ® EVO, UltraOne™ and European UltraOne™ wheel products. +The Company also continues to develop and deploy proprietary processing technologies in the manufacture of aerospace components, as well as a continued commitment and commercialization of a portfolio of proprietary aerospace fasteners. One such example is Ergo-Tech ® blind fasteners which enable automated assembly operations. +Environmental Matters +Information relating to environmental matters is included in Note U to the Consolidated Financial Statements under the caption “Environmental Matters”. Approved capital expenditures for new or expanded facilities for environmental control are $28 million for 2019 and estimated expenditures for such purposes are $8 million for 2020. +Employees +Total worldwide employment at the end of 2018 was approximately 43,000 employees in 29 countries. About 18,600 of these employees are represented by labor unions. The Company believes that relations with its employees and any applicable union representatives generally are good. +In the United States, approximately 7,900 employees are represented by various labor unions. The largest collective bargaining agreement is the master collective bargaining agreement between Arconic and the United Steelworkers (USW). The USW master agreement covers approximately 3,400 employees at four U.S. locations; the current labor agreement expires on May 15, 2019. There are 17 other collective bargaining agreements in the United States with varying expiration dates. +On a regional basis, collective bargaining agreements with varying expiration dates cover approximately 8,900 employees in Europe and Russia, 8,100 employees in North America, 600 employees in South America, and 1,000 employees in Asia. +Executive Officers of the Registrant +The names, ages, positions and areas of responsibility of the executive officers of the Company as of February 21, 2019 are listed below. +Elmer L. Doty , 64, Director, President and Chief Operating Officer. Mr. Doty was appointed President and Chief Operating Officer of Arconic effective February 6, 2019, and has served on the Arconic Board of Directors since May 2017. From March 2016 until February 2019, Mr. Doty was an Operating Executive at The Carlyle Group LP, multinational private equity, alternative asset management and financial services corporation, where he held a similar position from March 2012 to December 2012. From December 2012 to February 2016, Mr. Doty was President and Chief Executive Officer of Accudyne Industries LLC, a provider of precision-engineered flow control systems and industrial compressors. Mr. Doty also was the President and Chief Executive Officer of Vought Aircraft Industries, Inc. from 2006 until its acquisition in 2010 by Triumph Group, a leader in manufacturing and overhauling aerospace structures, systems and components. Prior to Vought, Mr. Doty was Executive Vice President and General Manager of the Land Systems Division of United Defense Industries, Inc. (now BAE Systems). Earlier in his career, Mr. Doty held executive positions at General Electric Company and FMC Corporation. +Ken Giacobbe , 53, Executive Vice President and Chief Financial Officer. Mr. Giacobbe was elected Executive Vice President and Chief Financial Officer of Arconic effective November 1, 2016. Mr. Giacobbe joined Arconic in 2004 as Vice President of Finance for Global Extruded Products, part of Alcoa Forgings and Extrusions. He then served as Vice President of Finance for the Company’s Building and Construction Systems business from 2008 until 2011. In 2011, he assumed the role of Group Controller for the Engineered Products and Solutions segment. From January 2013 until October 2016, Mr. Giacobbe served as Chief Financial Officer of the Engineered Products and Solutions segment. Before joining Arconic, Mr. Giacobbe held senior finance roles at Avaya and Lucent Technologies. +13 +Table of Contents +Timothy D. Myers , 53, Executive Vice President and Group President, Global Rolled Products and Transportation and Construction Solutions. Mr. Myers was appointed Executive Vice President and Group President, Global Rolled Products and Transportation and Construction Solutions in October 2017. Prior to being appointed to his current role, he was Executive Vice President and Group President, Transportation and Construction Solutions from May 2016 to October 2017. Prior to that assignment, he was President of Alcoa Wheel and Transportation Products, from June 2009 to May 2016. Mr. Myers was Vice President and General Manager, Commercial Vehicle Wheels for the Alcoa Wheel Products business from January 2006 to June 2009. Mr. Myers joined Arconic in 1991 as an automotive applications engineer in the Commercial Rolled Products Division, and held a series of engineering, marketing, sales and management positions with the Company since that time. +Paul Myron , 52, Vice President and Controller. Mr. Myron was elected Vice President and Controller of Arconic effective November 1, 2016. Mr. Myron joined Arconic as a systems analyst in Pittsburgh and in 1992 relocated to the Company’s Davenport, Iowa facility as a product accountant. He served in numerous financial management positions from 1995 until 2000 when he was named Commercial Manager and Controller for the Atlantic division of the Alcoa World Alumina and Chemicals business. In 2002, Mr. Myron was appointed Vice President of Finance, Alcoa Primary Metals and later became Vice President of Finance, Alcoa World Alumina and Chemicals. In 2005 Mr. Myron was named Director of Financial Planning and Analysis, accountable for Arconic’s financial planning, analysis, and reporting worldwide. In February 2012, he became Director of Finance Initiatives for the Engineered Products and Solutions segment, overseeing specific financial initiatives and projects within the group. From July 2012 until his most recent appointment, Mr. Myron served as Vice President, Finance and Business Excellence for the Arconic Power and Propulsion business. +John C. Plant , 65, Chairman and Chief Executive Officer. Mr. Plant was appointed Chief Executive Officer of Arconic effective February 6, 2019. He has served as Arconic's Chairman since October 2017 and as a member of the Board since February 2016. Mr. Plant previously served as Chairman of the Board, President and Chief Executive Officer of TRW Automotive from 2011 to 2015, and as its President and Chief Executive Officer from 2003 to 2011. TRW Automotive was acquired by ZF Friedrichshafen AG in May 2015. Mr. Plant was a co-member of the Chief Executive Office of TRW Inc. from 2001 to 2003 and an Executive Vice President of TRW from the company's 1999 acquisition of Lucas Varity to 2003. Prior to TRW, Mr. Plant was President of Lucas Varity Automotive and managing director of the Electrical and Electronics division from 1991 through 1997. +Katherine H. Ramundo , 51, Executive Vice President, Chief Legal Officer and Secretary. Ms. Ramundo was elected to her current position effective November 1, 2016. Prior to joining Arconic, from January 2013 through August 2015, she was Executive Vice President, General Counsel and Secretary of ANN INC., the parent company of ANN TAYLOR and LOFT brands, based in New York. Prior to ANN INC., she served as Vice President, Deputy General Counsel and Assistant Secretary at Colgate-Palmolive, where she held various legal roles from November 1997 to January 2013. She began her career as a litigator in New York, practicing at major law firms, including Cravath, Swaine & Moore and Sidley & Austin. +The Company’s executive officers are elected or appointed to serve until the next annual meeting of the Board of Directors (held in conjunction with the annual meeting of shareholders) except in the case of earlier death, retirement, resignation or removal. +Item 1A. Risk Factors. +Arconic’s business, financial condition and results of operations may be impacted by a number of factors. In addition to the factors discussed elsewhere in this report, the following risks and uncertainties could materially harm its business, financial condition or results of operations, including causing Arconic’s actual results to differ materially from those projected in any forward-looking statements. The following list of significant risk factors is not all-inclusive or necessarily in order of importance. Additional risks and uncertainties not presently known to Arconic or that Arconic currently deems immaterial also may materially adversely affect the Company in future periods. +The markets for Arconic’s products are highly cyclical and are influenced by a number of factors, including global economic conditions. +Arconic is subject to cyclical fluctuations in global economic conditions and lightweight metals end-use markets. Arconic sells many products to industries that are cyclical, such as the aerospace, automotive, and commercial transportation and construction industries, and the demand for its products is sensitive to, and quickly impacted by, demand for the finished goods manufactured by its customers in these industries, which may change as a result of changes in regional or worldwide economies, currency exchange rates, energy prices or other factors beyond its control. +In particular, Arconic derives a significant portion of its revenue from products sold to the aerospace industry, which can be highly cyclical and reflective of changes in the general economy. The commercial aerospace industry is historically driven by the demand from commercial airlines for new aircraft. The U.S. and international commercial aviation industries may face challenges arising from competitive pressures and fuel costs. Demand for commercial aircraft is influenced by airline industry profitability, trends in airline passenger traffic, the state of U.S., regional and world economies, the ability of +14 +Table of Contents +aircraft purchasers to obtain required financing and numerous other factors including the effects of terrorism, health and safety concerns, environmental constraints imposed upon aircraft operators, the retirement of older aircraft, and technological improvements to new engines. The military aerospace cycle is highly dependent on U.S. and foreign government funding; however, it is also driven by the effects of terrorism, a changing global political environment, U.S. foreign policy, the retirement of older aircraft, and technological improvements to new engines. +Further, the demand for Arconic’s automotive and ground transportation products is driven by the number of vehicles produced by automotive manufacturers and Arconic content per vehicle. The automotive industry is sensitive to general economic conditions, including credit markets and interest rates, and consumer spending and preferences regarding vehicle ownership and usage, vehicle size, configuration and features. Automotive sales and production can also be affected by other factors including the age of the vehicle fleet and related scrappage rates, labor relations issues, fuel prices, regulatory requirements, government initiatives, trade agreements and levels of competition. +While Arconic believes that the long-term prospects for its products are positive, the Company is unable to predict the future course of industry variables, the strength of the U.S., regional or global economies, or the effects of government intervention. Negative economic conditions, such as a major economic downturn, a prolonged recovery period, or disruptions in the financial markets, could have a material adverse effect on Arconic’s business, financial condition or results of operations. +Arconic faces significant competition, which may have an adverse effect on profitability. +As discussed in Part I, Item 1. (Business-Competitive Conditions) of this report, the markets for Arconic’s products are highly competitive. Arconic’s competitors include a variety of both U.S. and non-U.S. companies in all major markets. New product offerings, new technologies in the marketplace or new facilities may compete with or replace Arconic products. The willingness of customers to accept substitutes for the products sold by Arconic, the ability of large customers to exert leverage in the marketplace to affect the pricing for Arconic’s products, and technological advancements or other developments by or affecting Arconic’s competitors or customers could adversely affect Arconic’s business, financial condition or results of operations. +In addition, Arconic may face increased competition due to industry consolidation. As companies attempt to strengthen or hold their market positions in an evolving industry, companies could be acquired or may be unable to continue operations. Companies that are strategic alliance partners in some areas of Arconic’s business may acquire or form alliances with Arconic’s competitors, thereby reducing their business with Arconic. Industry consolidation may result in stronger competitors who are better able to compete as sole-source vendors for customers. If there is consolidation among Arconic’s customer base, those customers may be able to command increased leverage in negotiating prices and other terms of sale, which could adversely affect Arconic’s profitability. Moreover, if, as a result of increased leverage, customer pressures require Arconic to reduce its pricing such that its gross margins are diminished, the Company could decide not to sell certain products under such less favorable terms, which would decrease Arconic’s revenue. Consolidation among the Company’s customer base may also lead to reduced demand for Arconic’s solutions, replacement of Arconic products by the combined entity with those of Arconic’s competitors and cancellations of orders, each of which could have a material adverse effect on Arconic’s business, operating results and financial condition. +Arconic may be unable to develop innovative new products or implement technology initiatives successfully. +Arconic’s competitive position and future performance depends, in part, on the Company’s ability to: +• +identify and evolve with emerging technological and broader industry trends in Arconic’s target end-markets; +• +identify and successfully execute on a strategy to remain an essential and sustainable element of its customer’s supply chain; +• +fund, develop, manufacture and bring innovative new products and services to market quickly and cost-effectively; +• +monitor disruptive technologies and understand customers’ and competitors’ abilities to deploy those disruptive technologies; and +• +achieve sufficient return on investment for new products based on capital expenditures and research and development spending. +Arconic is working on new developments for a number of strategic projects in all business segments, including additive manufacturing, alloy development, engineered finishes and product design, high speed continuous casting and rolling technology, and other advanced manufacturing technologies. For more information on Arconic’s research and development programs, see “Research and Development” in Part I, Item 1 . (Business-Research and Development) of this report. +15 +Table of Contents +While Arconic intends to continue committing substantial financial resources and effort to the development of innovative new products and services, it may not be able to successfully differentiate its products or services from those of its competitors or match the level of research and development spending of its competitors, including those developing technology to displace Arconic’s current products. In addition, Arconic may not be able to adapt to evolving markets and technologies or achieve and maintain technological advantages. There can be no assurance that any of Arconic’s new products or services, development programs or technologies will be commercially adopted or beneficial to Arconic. +Arconic could be adversely affected by changes in the business or financial condition or the loss of a significant customer or customers. +A significant downturn or deterioration in the business or financial condition or loss of a key customer or customers supplied by Arconic could affect Arconic’s financial results in a particular period. Arconic’s customers may experience delays in the launch of new products, labor strikes, diminished liquidity or credit unavailability, weak demand for their products, or other difficulties in their businesses. Arconic’s customers may also change their business strategies or modify their business relationships with Arconic, including to reduce the amount of Arconic’s products they purchase or to switch to alternative suppliers. If Arconic is unsuccessful in replacing business lost from such customers, profitability may be adversely affected. +Arconic could encounter manufacturing difficulties or other issues that impact product performance, quality or safety, which could affect Arconic’s reputation, business and financial statements. +The manufacture of many of Arconic’s products is a highly exacting and complex process. Problems may arise during manufacturing for a variety of reasons, including equipment malfunction, failure to follow specific protocols, specifications and procedures, including those related to quality or safety, problems with raw materials, supply chain interruptions, natural disasters, labor unrest and environmental factors. Such problems could have an adverse impact on the Company’s ability to fulfill orders or on product quality or performance. Product manufacturing or performance issues could result in recalls, customer penalties, contract cancellation and product liability exposure, including if any of our products are non-compliant or are used in an unintended and/or unapproved manner that results in injuries or other damages. Because of approval and license requirements applicable to manufacturers and/or their suppliers, alternatives to mitigate manufacturing disruptions may not be readily available to the Company or its customers. Accordingly, manufacturing problems, product defects or other risks associated with our products, including their use or application, could result in significant costs to and liability for Arconic that could have a material adverse effect on its business, financial condition or results of operations, including the payment of potentially substantial monetary damages, fines or penalties, as well as negative publicity and damage to the Company’s reputation, which could adversely impact product demand and customer relationships. +Arconic’s business depends, in part, on its ability to meet increased program demand successfully and to mitigate the impact of program cancellations, reductions and delays. +Arconic is currently under contract to supply components for a number of new and existing commercial, general aviation, military aircraft and aircraft engine programs and is the sole supplier of aluminum sheet for a number of aluminum-intensive automotive vehicle programs. Many of these programs are scheduled for production increases over the next several years. If Arconic fails to meet production levels or encounters difficulty or unexpected costs in meeting such levels, it could have a material adverse effect on the Company’s business, financial condition or results of operations. Similarly, program cancellations, reductions or delays could also have a material adverse effect on Arconic’s business. +Arconic could be adversely affected by reductions in defense spending. +Arconic’s products are used in a variety of military applications, including military aircraft and armored vehicles. Although many of the programs in which Arconic participates extend several years, they are subject to annual funding through congressional appropriations. Changes in military strategy and priorities, or reductions in defense spending, may affect current and future funding of these programs and could reduce the demand for Arconic’s products, which could adversely affect Arconic’s business, financial condition or results of operations. +Arconic’s global operations and status as a public company expose the Company to risks that could adversely affect Arconic’s business, financial condition, results of operations, cash flows or the market price of its securities. +Arconic has operations or activities in numerous countries and regions outside the United States, including Europe, Brazil, Canada, China, Japan, and Russia. As a result, the Company’s global operations are affected by economic, political and other conditions in the foreign countries in which Arconic does business as well as U.S. laws regulating international trade, including: +• +economic and commercial instability risks, including those caused by sovereign and private debt default, corruption, and changes in local government laws, regulations and policies, such as those related to tariffs, sanctions and trade barriers, taxation, exchange controls, employment regulations and repatriation of earnings; +16 +Table of Contents +• +geopolitical risks such as political instability, civil unrest, expropriation, nationalization of properties by a government, imposition of sanctions, and renegotiation or nullification of existing agreements; +• +war or terrorist activities; +• +kidnapping of personnel; +• +major public health issues such as an outbreak of a pandemic or epidemic (such as Sudden Acute Respiratory Syndrome, Avian Influenza, H7N9 virus, or the Ebola virus), which could cause disruptions in Arconic’s operations or workforce; +• +difficulties enforcing intellectual property and contractual rights in certain jurisdictions; +• +changes in trade and tax laws that may result in our customers being subjected to increased taxes, duties and tariffs and reduce their willingness to use our services in countries in which we are currently manufacturing their products; +• +rising labor costs; +• +labor unrest, including strikes; +• +compliance with antitrust and competition regulations; +• +compliance with foreign labor laws, which generally provide for increased notice, severance and consultation requirements compared to U.S. laws; +• +aggressive, selective or lax enforcement of laws and regulations by national governmental authorities; +• +compliance with the Foreign Corrupt Practices Act (“FCPA”) and other anti-bribery and corruption laws; +• +compliance with U.S. laws concerning trade, including the International Traffic in Arms Regulations (“ITAR”), the Export Administration Regulations (“EAR”), and the sanctions, regulations and embargoes administered by the U.S. Department of Treasury’s Office of Foreign Asset Controls (“OFAC”); +• +imposition of currency controls; +• +adverse tax audit rulings; and +• +unexpected events, including fires or explosions at facilities, and natural disasters. +Although the effect of any of the foregoing factors is difficult to predict, any one or more of them could adversely affect Arconic’s business, financial condition, or results of operations. While Arconic believes it has adopted appropriate risk management, compliance programs and insurance arrangements to address and reduce the risks associated with these factors, such measures may provide inadequate protection against costs or liabilities that may arise from such events. +As a public company, Arconic is subject to, among other things, the reporting requirements of the Securities Exchange Act of 1934, as amended, the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act and the regulations of the New York Stock Exchange. Arconic’s failure to comply with applicable law could subject it to penalties under federal securities laws, expose it to lawsuits and restrict its ability to access financing. Under the Sarbanes-Oxley Act, Arconic must maintain effective disclosure controls and procedures and internal control over financial reporting. There can be no assurance that Arconic’s internal control over financial reporting will be effective in the future or that a material weakness will not be discovered with respect to a prior period for which the Company had previously believed that internal controls were effective. Any failure to maintain effective disclosure controls and procedures or internal control over financial reporting could result in adverse regulatory consequences and/or a loss of investor confidence, which could limit the Company’s ability to access the global capital markets and could have a material adverse effect on the Company’s business, financial condition or the market price of Arconic securities. +A material disruption of Arconic’s operations, particularly at one or more of the Company’s manufacturing facilities, could adversely affect Arconic’s business. +If Arconic’s operations, particularly one of the Company’s manufacturing facilities, were to be disrupted as a result of significant equipment failures, natural disasters, power outages, fires, explosions, terrorism, theft, sabotage, adverse weather conditions, public health crises, labor disputes or other reasons, the Company may be unable to effectively meet its obligations to or demand from its customers, which could adversely affect Arconic’s financial performance. +Interruptions in production could increase the Company’s costs and reduce its sales. Any interruption in production capability could require the Company to make substantial capital expenditures or purchase alternative material at higher costs to fill customer orders, which could negatively affect Arconic’s profitability and financial condition. Arconic maintains property damage insurance that the Company believes to be adequate to provide for reconstruction of facilities and equipment, as well as business interruption insurance to mitigate losses resulting from significant production interruption or shutdown caused by an insured loss. However, any recovery under Arconic’s insurance policies may not offset the lost profits or increased costs that may be experienced during the disruption of operations, which could adversely affect Arconic’s business, results of operations, financial condition and cash flow. +17 +Table of Contents +Arconic may face challenges to its intellectual property rights which could adversely affect the Company’s reputation, business and competitive position. +Arconic owns important intellectual property, including patents, trademarks, copyrights and trade secrets. The Company’s intellectual property plays an important role in maintaining Arconic’s competitive position in a number of the markets that the Company serves. Arconic’s competitors may develop technologies that are similar or superior to Arconic’s proprietary technologies or design around the patents Arconic owns or licenses. The pursuit of remedies for any misappropriation of Arconic intellectual property is expensive and the ultimate remedies may be deemed insufficient. Further, as the Company expands its operations in jurisdictions where the enforcement of intellectual property rights is less robust, the risk of misappropriation of Arconic intellectual property increases, despite efforts the Company undertakes to protect it. Developments or assertions by or against Arconic relating to intellectual property rights, and any inability to protect or enforce Arconic’s rights sufficiently, could adversely affect Arconic’s business and competitive position. +Arconic may be unable to realize the expected benefits from acquisitions, divestitures, joint ventures and strategic alliances. +Arconic has made, and may continue to plan and execute, acquisitions and divestitures and take other actions to grow its business or streamline its portfolio. Although management believes that its strategic actions are beneficial to Arconic, there is no assurance that anticipated benefits will be realized. Acquisitions present significant challenges and risks, including the effective integration of the business into the Company, unanticipated costs and liabilities, and the ability to realize anticipated benefits, such as growth in market share, revenue or margins, at the levels or in the timeframe expected. The Company may be unable to manage acquisitions successfully. Additionally, adverse factors may prevent Arconic from realizing the benefits of its growth projects, including unfavorable global economic conditions, currency fluctuations, or unexpected delays in target timelines. +With respect to portfolio optimization actions such as divestitures, curtailments and closures, Arconic may face barriers to exit from unprofitable businesses or operations, including high exit costs or objections from customers, suppliers, unions, local or national governments, or other stakeholders. In addition, Arconic may retain unforeseen liabilities for divested entities if a buyer fails to honor all commitments. Arconic’s business operations are capital intensive, and curtailment or closure of operations or facilities may include significant charges, including employee separation costs, asset impairment charges and other measures. +In addition, Arconic has participated in, and may continue to participate in, joint ventures, strategic alliances and other similar arrangements from time to time. Although the Company has, in connection with past and existing joint ventures, sought to protect its interests, joint ventures and strategic alliances inherently involve special risks. Whether or not Arconic holds majority interests or maintains operational control in such arrangements, its partners may: +• +have economic or business interests or goals that are inconsistent with or opposed to those of the Company; +• +exercise veto rights to block actions that Arconic believes to be in its or the joint venture’s or strategic alliance’s best interests; +• +take action contrary to Arconic’s policies or objectives with respect to investments; or +• +as a result of financial or other difficulties, be unable or unwilling to fulfill their obligations under the joint venture, strategic alliance or other agreements, such as contributing capital to expansion or maintenance projects. +There can be no assurance that acquisitions, growth investments, divestitures, closures, joint ventures, strategic alliances or similar arrangements will be undertaken or completed in their entirety as planned or that they will be beneficial to Arconic, whether due to the above-described risks, unfavorable global economic conditions, increases in construction costs, currency fluctuations, political risks, or other factors. +Arconic may be unable to realize future targets or goals established for its business segments, or complete projects, at the levels, projected costs or by the dates targeted. +From time to time, Arconic may announce future targets or goals for its business, which are based on the Company’s then current expectations, estimates, forecasts and projections about the operating environment, economies and markets in which Arconic operates. Future targets and goals reflect the Company’s beliefs and assumptions and its perception of historical trends, then current conditions and expected future developments, as well as other factors management believes are appropriate in the circumstances. As such, targets and goals are inherently subject to significant business, economic, competitive and other uncertainties and contingencies regarding future events, including the risks discussed in this report. The actual outcome may be materially different. There can be no assurance that any targets or goals established by the Company will be accomplished at the levels or by the dates targeted, if at all. Failure to achieve the targets or goals by the Company may have a material adverse effect on its business, financial condition, results of operations or the market price of its securities. +18 +Table of Contents +In addition, the implementation of Arconic’s business strategy periodically involves the entry into and the execution of complex projects, which place significant demands on the Company’s management and personnel, and may depend on numerous factors beyond the Company’s control. There can be no assurance that such projects will be completed within budgeted costs, on a timely basis, or at all, whether due to the risks described in this report, or other factors. The failure to complete a material project as planned, or a significant delay in a material project, whatever the cause, could have an adverse effect on Arconic’s business, financial condition, or results of operations. +Arconic’s plans to restructure the Company, including separating into two companies and the possible sales of businesses, will involve significant time and expense, which could disrupt or adversely affect Arconic’s business, may not achieve some or all of the anticipated benefits, are subject to various risks and uncertainties and may not be completed in accordance with the expected plans or anticipated timelines, or at all. +On February 8, 2019, Arconic announced plans to separate into Engineered Products & Forgings and Global Rolled Products, with a spin-off of one of the businesses, and to consider the possible sales of certain businesses. +Arconic expects that the process of completing the proposed separation and possible sales of businesses will be time-consuming and involve significant costs and expenses, which may be significantly higher than what it currently anticipates and may not yield a benefit if the separation and/or sales are not completed. Executing these transactions will also require significant time and attention from Arconic’s senior management and employees, which could disrupt the Company’s ongoing business and adversely affect financial results and results of operations. Arconic may also experience increased difficulties in attracting, retaining and motivating employees or maintaining or initiating relationships with lead suppliers, customers and other parties with which Arconic currently does business, or may do business in the future, during the pendency of the separation and/or possible sales of businesses and following their completion, which could have a material and adverse effect on Arconic’s businesses, financial condition, results of operations and prospects, or the businesses, financial condition, results of operations and prospects of the independent companies resulting from the separation. +Arconic may not realize some or all of the anticipated strategic, financial, operational or other benefits from the separation and/or possible sales of businesses. For example, as independent companies, the Engineered Products & Forgings and Global Rolled Products businesses will be smaller, less diversified companies with a narrower business focus and may be more vulnerable to changing market conditions, such as changes in industry conditions, which could result in increased volatility in their cash flows, working capital and financing requirements and could materially and adversely affect the respective business, financial condition and results of operations. Moreover, following the separation, there can be no assurance that either company will be able to obtain an investment grade rating from nationally recognized credit rating agencies, which could, among other things, increase the non-investment grade rated company’s cost of capital. Further, there can be no assurance that the combined value of the common stock of the two companies will be equal to or greater than what the value of Arconic’s common stock would have been had the proposed separation not occurred. In addition, if Arconic pursues the possible sales of businesses, it may face barriers to exit or objections from various stakeholders, and/or may retain liabilities for divested entities. There can be no assurance that any such sales will be undertaken or completed or that they will be beneficial to Arconic, whether due to the above-described risks, unfavorable global economic conditions, currency fluctuations, political risks, or other factors. +Additionally, the separation is subject to approval by Arconic’s Board of Directors and market, regulatory and certain other conditions. Unanticipated developments, including, among others, failure of the separation to qualify for the expected tax treatment, the possibility that any third-party consents required in connection with the separation will not be received, material adverse changes in business or industry conditions, changes in global economic and financial market conditions generally, and the ability to complete the possible sales of businesses, could delay or prevent the completion of the proposed separation, or cause the proposed separation to occur on terms or conditions that are different or less favorable than expected. +Information technology system failures, cyber attacks and security breaches may threaten the integrity of Arconic’s intellectual property and other sensitive information, disrupt its business operations, and result in reputational harm and other negative consequences that could have a material adverse effect on its financial condition and results of operations. +Arconic relies on its information technology systems to manage and operate its business, process transactions, and summarize its operating results. Arconic’s information technology systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, and catastrophic events, such as fires, floods, earthquakes, tornadoes, hurricanes, acts of war or terrorism, and usage errors by employees. If Arconic’s information technology systems are damaged or cease to function properly, the Company may have to make a significant investment to fix or replace them, and Arconic may suffer loss of critical data and interruptions or delays in its operations. Any material disruption in the Company’s information technology systems, or delays or difficulties in implementing or integrating new +19 +Table of Contents +systems or enhancing current systems, could have an adverse effect on Arconic’s business, financial condition or results of operations. +Arconic also faces global cybersecurity threats, which may range from uncoordinated individual attempts to sophisticated and targeted measures, known as advanced persistent threats, directed at the Company. Cyber attacks and security breaches may include, but are not limited to, attempts to access information, computer viruses, denial of service and other electronic security breaches. +The Company believes that it faces a heightened threat of cyber attacks due to the industries it serves, the locations of its operations and its technological innovations. The Company has experienced cybersecurity attacks in the past, including breaches of its information technology systems in which information was taken, and may experience them in the future, potentially with more frequency or sophistication. Based on information known to date, past attacks have not had a material impact on Arconic’s financial condition or results of operations. However, due to the evolving nature of cybersecurity threats, the scope and impact of any future incident cannot be predicted. +Arconic employs a number of measures to protect and defend against cyber attacks, including technical security controls, data encryption, firewalls, intrusion prevention systems, anti-virus software and frequent backups. Additionally, the Company conducts regular periodic training of its employees regarding the protection of sensitive information which includes training intended to prevent the success of “phishing” attacks. While the Company continually works to safeguard its systems and mitigate potential risks, there is no assurance that such actions will be sufficient to prevent cyber attacks or security breaches that manipulate or improperly use its systems or networks, compromise confidential or otherwise protected information, destroy or corrupt data, or otherwise disrupt its operations. The occurrence of such events could negatively impact Arconic’s reputation and its competitive position and could result in litigation with third parties, regulatory action, loss of business, potential liability and increased remediation costs, any of which could have a material adverse effect on its financial condition and results of operations. In addition, such attacks or breaches could require significant management attention and resources, and result in the diminution of the value of the Company’s investment in research and development. +Arconic’s enterprise risk management program and disclosure controls and procedures address cybersecurity and include elements intended to ensure that there is an analysis of potential disclosure obligations arising from cyber attacks and security breaches. Arconic also maintains compliance programs to address the potential applicability of restrictions against trading while in possession of material, nonpublic information generally and in connection with a cyber attack or security breach. However, a breakdown in existing controls and procedures around the Company’s cybersecurity environment may prevent Arconic from detecting, reporting or responding to cyber incidents in a timely manner and could have a material adverse effect on the Company’s financial condition or the market price of its securities. +A decline in Arconic’s financial performance or outlook could negatively impact the Company’s access to the global capital markets, reduce the Company’s liquidity and increase its borrowing costs. +Arconic has significant capital requirements and depends, in part, upon the issuance of debt to fund its operations and contractual commitments and pursue strategic acquisitions. A decline in the Company’s financial performance or outlook due to internal or external factors could affect the Company’s access to, and the availability or cost of, financing on acceptable terms and conditions. There can be no assurance that Arconic will have access to the global capital market on terms the Company finds acceptable. Limitations on Arconic’s ability to access the global capital markets, a reduction in the Company’s liquidity or an increase in borrowing costs could materially and adversely affect Arconic’s ability to maintain or grow its business, which in turn may adversely affect its financial condition and results of operations. +A downgrade of Arconic’s credit ratings could limit Arconic’s ability to obtain future financing, increase its borrowing costs, increase the pricing of its credit facilities, adversely affect the market price of its securities, trigger letter of credit or other collateral postings, or otherwise impair its business, financial condition, and results of operations. +Arconic’s credit ratings are important to the Company’s cost of capital. The major rating agencies routinely evaluate Arconic’s credit profile and assign debt ratings to the Company. This evaluation is based on a number of factors, which include financial strength, business and financial risk, as well as transparency with rating agencies and timeliness of financial reporting. On May 1, 2017, Standard and Poor’s Ratings Services (S&P) affirmed Arconic’s long-term debt at BBB-, an investment grade rating, with a stable outlook, and its short-term debt at A-3. On February 7, 2019, S&P changed the outlook from stable to negative credit watch. On October 8, 2018, Moody’s Investor Service (Moody’s) affirmed Arconic’s long-term debt rating at Ba2, a non-investment grade, with a stable outlook, and its short-term debt rating at Speculative Grade Liquidity-2. On September 27, 2018, Fitch affirmed Arconic’s long-term debt rating at BB+, a non-investment grade, and short-term debt at B. Additionally, Fitch changed the outlook from stable to positive. +There can be no assurance that one or more of these or other rating agencies will not take negative actions with respect to Arconic’s ratings. Increased debt levels, macroeconomic conditions, a deterioration in the Company’s debt protection metrics, +20 +Table of Contents +a contraction in the Company’s liquidity, or other factors could potentially trigger such actions. A rating agency may lower, suspend or withdraw entirely a rating or place it on negative outlook or watch if, in that rating agency’s judgment, circumstances so warrant. +A downgrade of Arconic’s credit ratings by one or more rating agencies could adversely impact the market price of Arconic’s securities; adversely affect existing financing (for example, a downgrade by S&P or Moody’s would subject Arconic to higher costs under Arconic’s Five-Year Revolving Credit Agreement and certain of its other revolving credit facilities); limit access to the capital (including commercial paper) or credit markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all; result in more restrictive covenants in agreements governing the terms of any future indebtedness that the Company incurs; increase the cost of borrowing or fees on undrawn credit facilities; result in vendors or counterparties seeking collateral or letters of credit from Arconic; or otherwise impair Arconic’s business, financial condition, liquidity and results of operations. +Arconic’s business and growth prospects may be negatively impacted by limits in its capital expenditures. +Arconic requires substantial capital to invest in growth opportunities and to maintain and prolong the life and capacity of its existing facilities. Insufficient cash generation or capital project overruns may negatively impact Arconic’s ability to fund as planned its sustaining and return-seeking capital projects. Over the long term, Arconic’s ability to take advantage of improved market conditions or growth opportunities in its businesses may be constrained by earlier capital expenditure restrictions, which could adversely affect the long-term value of its business and the Company’s position in relation to its competitors. +An adverse decline in the liability discount rate, lower-than-expected investment return on pension assets and other factors could affect Arconic’s results of operations or amount of pension funding contributions in future periods. +Arconic’s results of operations may be negatively affected by the amount of expense Arconic records for its pension and other postretirement benefit plans, reductions in the fair value of plan assets and other factors. Arconic calculates income or expense for its plans using actuarial valuations in accordance with accounting principles generally accepted in the United States of America (GAAP). +These valuations reflect assumptions about financial market and other economic conditions, which may change based on changes in key economic indicators. The most significant year-end assumptions used by Arconic to estimate pension or other postretirement benefit income or expense for the following year are the discount rate applied to plan liabilities and the expected long-term rate of return on plan assets. In addition, Arconic is required to make an annual measurement of plan assets and liabilities, which may result in a significant charge to shareholders’ equity. For a discussion regarding how Arconic’s financial statements can be affected by pension and other postretirement benefits accounting policies, see “Critical Accounting Policies and Estimates-Pension and Other Postretirement Benefits” in Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note G to the Consolidated Financial Statements-Pension and Other Postretirement Benefits in Part II, Item 8. (Financial Statements and Supplementary Data). Although GAAP expense and pension funding contributions are impacted by different regulations and requirements, the key economic factors that affect GAAP expense would also likely affect the amount of cash or securities Arconic would contribute to the pension plans. +Potential pension contributions include both mandatory amounts required under federal law and discretionary contributions to improve the plans’ funded status. The Moving Ahead for Progress in the 21st Century Act (“MAP-21”), enacted in 2012, provided temporary relief for employers like Arconic who sponsor defined benefit pension plans related to funding contributions under the Employee Retirement Income Security Act of 1974 by allowing the use of a 25-year average discount rate within an upper and lower range for purposes of determining minimum funding obligations. In 2014, the Highway and Transportation Funding Act (HATFA) was signed into law. HATFA extended the relief provided by MAP-21 and modified the interest rates that had been set by MAP-21. In 2015, the Bipartisan Budget Act of 2015 (BBA 2015) was signed into law. BBA 2015 extends the relief period provided by HAFTA. Arconic believes that the relief provided by BBA 2015 will moderately reduce the cash flow sensitivity of the Company’s U.S. pension plans’ funded status to potential declines in discount rates over the next several years. However, higher than expected pension contributions due to a decline in the plans’ funded status as a result of declines in the discount rate or lower-than-expected investment returns on plan assets could have a material negative effect on the Company’s cash flows. Adverse capital market conditions could result in reductions in the fair value of plan assets and increase the Company’s liabilities related to such plans, which could adversely affect Arconic’s liquidity and results of operations. +Unanticipated changes in Arconic’s tax provisions or exposure to additional tax liabilities could affect Arconic’s future profitability. +Arconic is subject to income taxes in both the United States and various non-U.S. jurisdictions. Its domestic and international tax liabilities are dependent upon the distribution of income among these different jurisdictions. Changes in applicable domestic or foreign tax laws and regulations, or their interpretation and application, including the possibility of retroactive +21 +Table of Contents +effect, could affect the Company’s tax expense and profitability. Arconic’s tax expense includes estimates of additional tax that may be incurred for tax exposures and reflects various estimates and assumptions. The assumptions include assessments of future earnings of the Company that could impact the valuation of its deferred tax assets. The Company’s future results of operations could be adversely affected by changes in the effective tax rate as a result of a change in the mix of earnings in countries with differing statutory tax rates, changes in the overall profitability of the Company, changes in tax legislation and rates, changes in generally accepted accounting principles, changes in the valuation of deferred tax assets and liabilities, the results of tax audits and examinations of previously filed tax returns or related litigation and continuing assessments of its tax exposures. +Corporate tax law changes continue to be analyzed in the United States and in many other jurisdictions. In particular, on December 22, 2017, the Tax Cuts and Jobs Act (the “2017 Act”) was signed into law, significantly reforming the United States Internal Revenue Code of 1986, as amended. During 2018, the Internal Revenue Service began a number of guidance projects which serve to both interpret and implement the 2017 Act. Those guidance projects, which include both Proposed and Final Treasury Regulations, will continue into 2019. The Company continues to review the components of the 2017 Act, as well as the ongoing interpretive guidance, and evaluate its consequences. As such, the ultimate impact of the 2017 Act may differ from reported amounts due to, among other things, changes in interpretations and assumptions the Company has made to date; and actions the Company may take as a result of the 2017 Act and related guidance. These changes to the U.S. corporate tax system could have a substantial impact, positive or negative, on Arconic’s future effective tax rate, cash tax expenditures, and deferred tax assets and liabilities. +Arconic’s business could be adversely affected by increases in the cost of aluminum. +Arconic derives a significant portion of its revenue from aluminum-based products. The price of primary aluminum has historically been subject to significant cyclical price fluctuations and the timing of changes in the market price of aluminum is largely unpredictable. Although the Company’s pricing of products is generally intended to pass the risk of metal price fluctuations on to the Company’s customers or is otherwise hedged, there are situations where Arconic is unable to pass on the entire cost of increases to its customers and there is a potential time lag on certain products between increases in costs for aluminum and the point when the Company can implement a corresponding increase in price to its customers and/or there are other timing factors that may result in Arconic's exposure to certain price fluctuations which could have a material adverse effect on Arconic’s business, financial condition or results of operations. +Arconic is exposed to fluctuations in foreign currency exchange rates and interest rates, as well as inflation, economic factors, and currency controls in the countries in which it operates. +Economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, competitive factors in the countries in which Arconic operates, and continued volatility or deterioration in the global economic and financial environment could affect Arconic’s revenues, expenses and results of operations. Changes in the valuation of the U.S. dollar against other currencies, including the Euro, British pound, Chinese yuan (renminbi) and Russian ruble, may affect Arconic’s profitability as some important inputs are purchased in other currencies, while the Company’s products are generally sold in U.S. dollars. +In addition, a portion of Arconic’s indebtedness, including certain borrowings under the Company’s Five-Year Credit Facility, bears interest at rates equal to the London Interbank Offering Rate (LIBOR) plus an applicable margin based on the credit ratings of Arconic’s outstanding senior unsecured long-term debt. Accordingly, the Company is subject to risk from changes in interest rates on the variable component of the rate. Further, LIBOR is the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms and other pressures may cause LIBOR to disappear entirely or to perform differently than in the past. The consequences of these developments cannot be entirely predicted, but could include changes in the cost of Arconic’s variable rate indebtedness. +Arconic also faces risks arising from the imposition of cash repatriation restrictions and exchange controls. Cash repatriation restrictions and exchange controls may limit the Company’s ability to convert foreign currencies into U.S. dollars or to remit dividends and other payments by Arconic’s foreign subsidiaries or businesses located in or conducted within a country imposing restrictions or controls. While Arconic currently has no need, and does not intend, to repatriate or convert cash held in countries that have significant restrictions or controls in place, should the Company need to do so to fund its operations, it may be unable to repatriate or convert such cash, or be unable to do so without incurring substantial costs. Arconic currently has substantial operations in countries that have cash repatriation restrictions or exchange controls in place, including China, and, if the Company were to need to repatriate or convert such cash, these controls and restrictions may have an adverse effect on Arconic’s operating results and financial condition. +Arconic may not realize expected benefits from its productivity and cost-reduction initiatives. +Arconic has undertaken, and may continue to undertake, productivity and cost-reduction initiatives to improve performance and conserve cash, including deployment of company-wide business process models, such as Arconic’s degrees of +22 +Table of Contents +implementation process in which ideas are executed in a disciplined manner to generate savings, and operating cost reductions, including, among others, those announced on February 8, 2019, in connection with the Company’s ongoing strategic and portfolio review. There is no assurance that these initiatives will be successful or beneficial to Arconic or that estimated cost savings from such activities will be realized. If Arconic fails to achieve net cost savings at anticipated levels, its business, financial condition or results of operations could be adversely affected. +Arconic’s customers may reduce their demand for aluminum products in favor of alternative materials. +Certain applications of Arconic’s aluminum-based products compete with products made from other materials, such as steel, titanium and composites. The willingness of customers to pursue materials other than aluminum depends upon the desire to achieve specific attributes. For example, the commercial aerospace industry has used and continues to evaluate the further use of alternative materials to aluminum, such as titanium and composites, in order to reduce the weight and increase the fuel efficiency of aircraft. Additionally, the automotive industry, while motivated to reduce vehicle weight through the use of aluminum, may revert to steel or other materials for certain applications. Further, the decision to use aluminum may be impacted by aluminum prices. The willingness of customers to accept other materials in lieu of aluminum could adversely affect the demand for certain of Arconic’s products, and thus adversely affect Arconic’s business, financial condition or results of operations. +Arconic’s profitability could be adversely affected by volatility in the availability or cost of raw materials. +Arconic’s results of operations may be affected by changes in the availability or cost of raw materials (including, but not limited to, aluminum, cobalt, nickel, titanium sponge and vanadium), as well as freight costs associated with transportation of raw materials. The availability and costs of certain raw materials necessary for the production of Arconic’s products may be influenced by private or government entities including mergers and acquisitions, changes in world politics or regulatory requirements, labor relations between the producers and their work forces, unstable governments in exporting nations, export quotas, sanctions, new or increased import duties, countervailing or anti-dumping duties, market forces of supply and demand, and inflation. In addition, from time to time, commodity prices may fall rapidly. When this happens, suppliers may withdraw capacity from the market until prices improve, which may cause periodic supply interruptions. Arconic may be unable to offset fully the effects of raw material shortages or higher costs through customer price increases, productivity improvements or cost reduction programs. Shortages or price fluctuations in raw materials could have a material adverse effect on Arconic’s operating results. +Union disputes and other employee relations issues could adversely affect Arconic’s business, financial condition or results of operations. +A significant portion of Arconic’s employees are represented by labor unions in a number of countries under various collective bargaining agreements with varying durations and expiration dates. For more information, see “Employees” in Part I, Item 1. (Business) of this report. While Arconic previously has been successful in renegotiating its collective bargaining agreements with various unions, Arconic may not be able to satisfactorily renegotiate all collective bargaining agreements in the United States and other countries when they expire. In addition, existing collective bargaining agreements may not prevent a strike or work stoppage at Arconic’s facilities in the future. Arconic may also be subject to general country strikes or work stoppages unrelated to its business or collective bargaining agreements. Any such work stoppages (or potential work stoppages) could have a material adverse effect on Arconic’s business, financial condition or results of operations. +A failure to attract, retain or provide adequate succession plans for key personnel could adversely affect Arconic’s operations and competitiveness. +Arconic’s existing operations and development projects require highly skilled executives and staff with relevant industry and technical experience. The inability of the Company to attract and retain such people may adversely impact Arconic’s ability to meet project demands adequately and fill roles in existing operations. Skills shortages in engineering, manufacturing, technology, construction and maintenance contractors and other labor market inadequacies may also impact activities. These shortages may adversely impact the cost and schedule of development projects and the cost and efficiency of existing operations. +In addition, the continuity of key personnel and the preservation of institutional knowledge are vital to the success of the Company’s growth and business strategy. The loss of key members of management and other personnel could significantly harm Arconic’s business, and any unplanned turnover, or failure to develop adequate succession plans for key positions, could deplete the Company’s institutional knowledge base, delay or impede the execution of the Company’s business plans and erode Arconic’s competitiveness. +Arconic may be exposed to significant legal proceedings, investigations or changes in U.S. federal, state or foreign law, regulation or policy. +Arconic’s results of operations or liquidity in a particular period could be affected by new or increasingly stringent laws, +23 +Table of Contents +regulatory requirements or interpretations, or outcomes of significant legal proceedings or investigations adverse to Arconic. The Company may experience a change in effective tax rates or become subject to unexpected or rising costs associated with business operations or provision of health or welfare benefits to employees due to changes in laws, regulations or policies. The Company may be a party to litigation in a foreign jurisdiction where geopolitical risks might influence the ultimate outcome of such litigation. The Company is also subject to a variety of legal and regulatory compliance risks associated with its business and products. These risks include, among other things, potential claims relating to product liability, product testing, health and safety, environmental matters, required record keeping and record retention, intellectual property rights, government contracts and taxes, as well as compliance with U.S. and foreign laws and regulations governing import and export, anti-bribery, antitrust and competition, sales and trading practices, human rights and modern slavery, sourcing of raw materials, third-party relationships, supply chain operations and the manufacture and sale of products. Arconic could be subject to fines, penalties, damages (in certain cases, treble damages), or suspension or debarment from government contracts. +For example, in the event that an Arconic product fails to perform as expected, regardless of fault, or is used in an unexpected manner, and such failure or use results in, or is alleged to result in, bodily injury and/or property damage or other losses, Arconic may be subject to product liability lawsuits and other claims or may be required or requested by its customers to participate in a recall or other corrective action involving such product. In addition, if an Arconic product is perceived to be defective or unsafe, sales of the Company’s products could be diminished, and the Company could be subject to further liability claims. Even if Arconic successfully defends against these types of claims, the Company could still be required to spend a substantial amount of money in connection with legal proceedings or investigations with respect to such claims; the Company’s management could be required to devote significant time, attention and operational resources responding to and defending against these claims; and Arconic’s reputation could suffer, any of which could have a material adverse effect on its financial condition and results of operations. +While Arconic believes it has adopted appropriate risk management and compliance programs to address and reduce these risks, including insurance arrangements with respect to these risks, such measures may provide inadequate protection against liabilities that may arise. The global and diverse nature of Arconic’s operations means that these risks will continue to exist, and additional legal proceedings and contingencies may arise from time to time. In addition, various factors or developments can lead the Company to change current estimates of liabilities or make such estimates for matters previously unsusceptible to reasonable estimates, such as a significant judicial ruling or judgment, a significant settlement, significant regulatory developments or changes in applicable law. A future adverse ruling or settlement or unfavorable changes in laws, regulations or policies, or other contingencies that the Company cannot predict with certainty could have a material adverse effect on the Company’s financial condition, results of operations or cash flows in a particular period. For additional information regarding the legal proceedings involving the Company, see the discussion in Part I, Item 3. (Legal Proceedings) of this report and in Note U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +Arconic is subject to a broad range of health, safety and environmental laws and regulations in the jurisdictions in which it operates and may be exposed to substantial costs and liabilities associated with such laws and regulations. +Arconic’s operations worldwide are subject to numerous complex and increasingly stringent health, safety and environmental laws and regulations. The costs of complying with such laws and regulations, including participation in assessments and cleanups of sites, as well as internal voluntary programs, are significant and will continue to be so for the foreseeable future. Environmental laws may impose cleanup liability on owners and occupiers of contaminated property, including past or divested properties, regardless of whether the owners and occupiers caused the contamination or whether the activity that caused the contamination was lawful at the time it was conducted. Environmental matters for which Arconic may be liable may arise in the future at its present sites, where no problem is currently known, at previously owned sites, sites previously operated by the Company, sites owned by its predecessors or sites that it may acquire in the future. Compliance with health, safety and environmental laws and regulations, including remediation obligations, may prove to be more challenging and costly than the Company anticipates. For example, new data and information, including information about the ways in which the Company’s products are used, may lead the Company, regulatory authorities, government agencies or other entities or organizations to publish guidelines or recommendations, or impose restrictions, related to the manufacturing or use of the Company’s products. This could lead to reduced sales or market acceptance of the Company’s products. Arconic’s results of operations or liquidity in a particular period could be affected by certain health, safety or environmental matters, including remediation costs and damages related to certain sites as well as other health and safety risks relating to its operations and products. Additionally, evolving regulatory standards and expectations can result in increased litigation and/or increased costs, all of which can have a material and adverse effect on the Company’s financial condition, results of operations and cash flows. +24 +Table of Contents +Arconic is subject to privacy and data security/protection laws in the jurisdictions in which it operates and may be exposed to substantial costs and liabilities associated with such laws and regulations. +The regulatory environment surrounding information security and privacy is increasingly demanding, with frequent imposition of new and changing requirements. For example, the European Union's General Data Protection Regulation (“GDPR”), which became effective in May 2018, imposed significant new requirements on how companies process and transfer personal data, as well as significant fines for non-compliance. Compliance with changes in privacy and information security laws and standards may result in significant expense due to increased investment in technology and the development of new operational processes, which could have a material adverse effect on Arconic’s financial condition and results of operations. In addition, the payment of potentially significant fines or penalties in the event of a breach of the GDRP or other privacy and information security laws, as well as the negative publicity associated with such a breach, could damage the Company’s reputation and adversely impact product demand and customer relationships. +Arconic may be subject to securities litigation, which could cause the Company to incur substantial costs and divert management’s attention and resources. +Arconic currently is, and may in the future become, subject to claims and litigation alleging violations of the securities laws. Arconic is generally obliged, to the extent permitted by law, to indemnify its current and former directors and officers who are named as defendants in these types of lawsuits. Regardless of the outcome, securities litigation may require substantial attention from management and could result in significant legal expenses, settlement costs or damage awards that could have a material impact on the Company’s financial position, results of operations and cash flows. +Failure to comply with domestic or international employment and related laws could result in penalties or costs that could have a material adverse effect on Arconic’s business results. +Arconic is subject to a variety of domestic and foreign employment laws, such as the Fair Labor Standards Act (which governs such matters as minimum wages, overtime and other working conditions), state and local wage laws, the Employee Retirement Income Security Act (“ERISA”), and regulations related to safety, discrimination, organizing, whistle-blowing, classification of employees, privacy and severance payments, citizenship requirements, and healthcare insurance mandates. Allegations that Arconic has violated such laws or regulations could damage the Company’s reputation and lead to fines from or settlements with federal, state or foreign regulatory authorities or damages payable to employees, which could have a material adverse impact on Arconic’s operations and financial condition. +Arconic may be affected by global climate change or by legal, regulatory, or market responses to such change. +Increased concern over climate change has led to new and proposed legislative and regulatory initiatives, such as cap-and-trade systems, additional limits on emissions of greenhouse gases or Corporate Average Fuel Economy (CAFE) standards in the United States. New or revised laws and regulations in this area could directly and indirectly affect Arconic’s customers and suppliers (through an increase in the cost of production or their ability to produce satisfactory products) or business (through an impact on Arconic’s inventory availability, cost of sales, operations or demand for Arconic products), which could result in an adverse effect on our financial condition, results of operations and cash flows. Compliance with any new or more stringent laws or regulations, or stricter interpretations of existing laws, could require additional expenditures by the Company or its customers or suppliers. Also, Arconic relies on natural gas, electricity, fuel oil and transport fuel to operate its facilities. Any increased costs of these energy sources because of new laws could be passed along to the Company and its customers and suppliers, which could also have a negative impact on Arconic’s profitability. +Anti-takeover provisions could prevent or delay a change in control of Arconic, including a takeover attempt by a third party and limit the power of Arconic’s shareholders. +Arconic’s Certificate of Incorporation and Bylaws contain, and Delaware law contains, provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the bidder and to encourage prospective acquirers to negotiate with Arconic’s Board of Directors rather than to attempt a hostile takeover. For example, Arconic is subject to Section 203 of the Delaware General Corporation Law, which imposes certain restrictions on mergers and other business combinations between the Company and any holder of 15% or more of the Company’s outstanding common stock, which could make it more difficult for another party to acquire Arconic. Additionally, the Company’s Certificate of Incorporation authorizes Arconic’s Board of Directors to issue preferred stock or adopt other anti-takeover measures without shareholder approval. These provisions may apply even if an offer may be considered beneficial by some shareholders and could delay or prevent an acquisition that Arconic’s Board of Directors determines is not in the best interests of Arconic’s shareholders. These provisions may also limit the price that investors might be willing to pay in the future for shares of Arconic common stock or prevent or discourage attempts to remove and replace incumbent directors. +25 +Table of Contents +Dividends on Arconic common stock could be reduced or eliminated in the event of material future deterioration in business conditions or in other circumstances. +Arconic has historically paid dividends on its common stock; however, it has no obligation to do so. The existence, timing, declaration, amount and payment of future dividends to Arconic’s shareholders falls within the discretion of Arconic’s Board of Directors, and the Company’s dividend policy may change at any time without advance notice to Arconic’s shareholders. For example, on February 8, 2019, in connection with the Company’s ongoing strategic and portfolio review, Arconic announced that it expected to reduce its quarterly common stock dividend from $0.06 to $0.02 per share. The Arconic Board of Directors’ decisions regarding the payment of dividends will depend on many factors, such as Arconic’s financial condition, earnings, capital requirements, debt service obligations, covenants associated with certain of the Company’s debt service obligations, industry practice, legal requirements, regulatory constraints and other factors that Arconic’s Board of Directors deems relevant. Arconic’s Board of Directors may determine to further reduce or eliminate Arconic’s common stock dividend in the event of material future deteriorations in business conditions or in other circumstances. +Changes in the United Kingdom’s economic and other relationships with the European Union could adversely affect Arconic. +In March 2017, the United Kingdom formally triggered the process to withdraw from the European Union (also referred to as "Brexit") following the results of a national referendum that took place in June 2016. The ultimate effects of Brexit on Arconic are difficult to predict, but because the Company currently operates and conducts business in the United Kingdom and in Europe, Brexit could cause disruptions and create uncertainty to Arconic’s businesses, including affecting the business of and/or our relationships with Arconic’s customers and suppliers, as well as altering the relationship among tariffs and currencies, including the value of the British pound and the Euro relative to the U.S. dollar. Such disruptions and uncertainties could adversely affect Arconic’s financial condition, operating results and cash flows. In addition, Brexit could result in legal uncertainty and potentially divergent national laws and regulations as new legal relationships between the United Kingdom and the European Union are established. The ultimate effects of Brexit on Arconic will also depend on the terms of any agreements the United Kingdom and the European Union make to retain access to each other’s respective markets either during a transitional period or more permanently. +Arconic may not achieve some or all of the expected benefits of the Separation from Alcoa Corporation, and failure to realize such benefits in a timely manner may materially adversely affect Arconic’s business. +Arconic may be unable to achieve the full strategic and financial benefits expected to result from the Separation, or such benefits may be delayed or not occur at all. The Separation is expected to provide the following benefits, among others: (i) enabling the management of each company to pursue more effectively its own distinct operating priorities and strategies, to focus on strengthening its core business and its unique needs, and to pursue distinct and targeted opportunities for long-term growth and profitability; (ii) permitting each company to allocate its financial resources to meet the unique needs of its own business, allowing each company to intensify its focus on its distinct strategic priorities and to pursue more effectively its own distinct capital structures and capital allocation strategies; (iii) allowing each company to articulate more effectively a clear investment thesis to attract a long-term investor base suited to its business and providing investors with two distinct and targeted investment opportunities; (iv) creating an independent equity currency tracking each company's underlying business, affording Arconic and Alcoa Corporation direct access to the capital markets and facilitating each company’s ability to consummate future acquisitions or other restructuring transactions utilizing its common stock; (v) allowing each company more consistent application of incentive structures and targets, due to the common nature of the underlying businesses; and (vi) separating and simplifying the structures required to manage two distinct and differing underlying businesses. +Arconic may not achieve these and other anticipated benefits for a variety of reasons, including, among others: (i) Arconic may be more susceptible to market fluctuations and other adverse events than if Alcoa Corporation were still a part of the Company because Arconic’s business is less diversified than it was prior to the completion of the Separation; and (ii) as a smaller, independent company, Arconic may be unable to obtain certain goods, services and technologies at prices or on terms as favorable as those it obtained prior to completion of the Separation. If Arconic fails to achieve some or all of the benefits expected to result from the Separation, or if such benefits are delayed, it could have a material adverse effect on Arconic’s competitive position, business, financial condition, results of operations and cash flows. +Alcoa Corporation may fail to perform under various transaction agreements that were executed as part of the Separation. +In connection with the Separation, Arconic and Alcoa Corporation entered into a Separation and Distribution Agreement and also entered into various other agreements, of which the following were still in effect during 2018: a Tax Matters Agreement, an Employee Matters Agreement, intellectual property license agreements, a metal supply agreement, real estate and office leases and a spare parts loan agreement. The Separation and Distribution Agreement, the Tax Matters Agreement and the Employee Matters Agreement, together with the documents and agreements by which the internal reorganization of the +26 +Table of Contents +Company prior to the Separation was effected, determined the allocation of assets and liabilities between the companies following the Separation for those respective areas and included any necessary indemnifications related to liabilities and obligations. Arconic will rely on Alcoa Corporation to satisfy its performance and payment obligations under these agreements. If Alcoa Corporation is unable or unwilling to satisfy its obligations under these agreements, including its indemnification obligations, we could incur operational difficulties and/or losses. +In connection with the Separation from Alcoa Corporation, Alcoa Corporation has agreed to indemnify Arconic for certain liabilities and Arconic has agreed to indemnify Alcoa Corporation for certain liabilities. If Arconic is required to pay under these indemnities to Alcoa Corporation, Arconic’s financial results could be negatively impacted. The Alcoa Corporation indemnity may be insufficient to hold Arconic harmless from the full amount of liabilities for which Alcoa Corporation will be allocated responsibility, and Alcoa Corporation may be unable to satisfy its indemnification obligations in the future. +Pursuant to the Separation and Distribution Agreement and certain other agreements with Alcoa Corporation, Alcoa Corporation has agreed to indemnify Arconic for certain liabilities, and Arconic has agreed to indemnify Alcoa Corporation for certain liabilities, in each case for uncapped amounts. Indemnities that Arconic may be required to provide Alcoa Corporation are not subject to any cap, may be significant and could negatively impact Arconic’s business. Third parties could also seek to hold Arconic responsible for any of the liabilities that Alcoa Corporation has agreed to retain. Any amounts Arconic is required to pay pursuant to these indemnification obligations and other liabilities could require Arconic to divert cash that would otherwise have been used in furtherance of the Company’s operating business. Further, the indemnity from Alcoa Corporation may be insufficient to protect Arconic against the full amount of such liabilities, and Alcoa Corporation may be unable to satisfy its indemnification obligations fully. Moreover, even if Arconic ultimately succeeds in recovering from Alcoa Corporation any amounts for which Arconic is held liable, Arconic may be temporarily required to bear such losses. Each of these risks could negatively affect Arconic’s business, results of operations and financial condition. +The Separation could result in substantial tax liability. +It was a condition to the Distribution that (i) the private letter ruling from the Internal Revenue Service (the “IRS”) regarding certain U.S. federal income tax matters relating to the Separation and the Distribution received by Arconic remain valid and be satisfactory to Arconic’s Board of Directors and (ii) Arconic receive an opinion of its outside counsel, satisfactory to the Board of Directors, regarding the qualification of the Distribution, together with certain related transactions, as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) of the Internal Revenue Code of 1986, as amended (the “Code”). Both of these conditions were satisfied prior to the Distribution. However, the IRS private letter ruling and the opinion of counsel were based upon and relied on, among other things, various facts and assumptions, as well as certain representations, statements and undertakings of Arconic and Alcoa Corporation, including those relating to the past and future conduct of Arconic and Alcoa Corporation. If any of these representations, statements or undertakings is, or becomes, inaccurate or incomplete, or if Arconic or Alcoa Corporation breaches any of its representations or covenants contained in any of the Separation- related agreements and documents or in any documents relating to the IRS private letter ruling and/or the opinion of counsel, the IRS private letter ruling and/or the opinion of counsel may be invalid and the conclusions reached therein could be jeopardized. +Notwithstanding Arconic’s receipt of the IRS private letter ruling and the opinion of counsel, the IRS could determine that the Distribution and/or certain related transactions should be treated as taxable transactions for U.S. federal income tax purposes if it determines that any of the representations, assumptions or undertakings upon which the IRS private letter ruling or the opinion of counsel was based are false or have been violated. In addition, the IRS private letter ruling does not address all of the issues that are relevant to determining whether the Distribution, together with certain related transactions, qualifies as a transaction that is generally tax-free for U.S. federal income tax purposes, and the opinion of counsel represents the judgment of such counsel and is not binding on the IRS or any court and the IRS or a court may disagree with the conclusions in the opinion of counsel. Accordingly, notwithstanding receipt by Arconic of the IRS private letter ruling and the opinion of counsel, there can be no assurance that the IRS will not assert that the Distribution and/or certain related transactions do not qualify for tax-free treatment for U.S. federal income tax purposes or that a court would not sustain such a challenge. In the event the IRS were to prevail with such challenge, Arconic, Alcoa Corporation and Arconic shareholders could be subject to significant U.S. federal income tax liability. +If the Distribution, together with certain related transactions, fails to qualify as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) of the Code, in general, for U.S. federal income tax purposes, Arconic would recognize taxable gain as if it had sold the Alcoa Corporation common stock in a taxable sale for its fair market value and Arconic shareholders who received Alcoa Corporation shares in the distribution would be subject to tax as if they had received a taxable distribution equal to the fair market value of such shares. +Under current U.S. federal income tax law, even if the Distribution, together with certain related transactions, otherwise qualifies for tax-free treatment under Sections 355 and 368(a)(1)(D) of the Code, the Distribution may nevertheless be +27 +Table of Contents +rendered taxable to Arconic and its shareholders as a result of certain post-Distribution transactions, including certain acquisitions of shares or assets of Arconic or Alcoa Corporation. The possibility of rendering the Distribution taxable as a result of such transactions may limit Arconic’s ability to pursue certain equity issuances, strategic transactions or other transactions that would otherwise maximize the value of Arconic’s business. Under the Tax Matters Agreement that Arconic entered into with Alcoa Corporation, Alcoa Corporation may be required to indemnify Arconic against any additional taxes and related amounts resulting from (i) an acquisition of all or a portion of the equity securities or assets of Alcoa Corporation, whether by merger or otherwise (and regardless of whether Alcoa Corporation participated in or otherwise facilitated the acquisition), (ii) issuing equity securities beyond certain thresholds, (iii) repurchasing shares of Alcoa Corporation stock other than in certain open-market transactions, (iv) ceasing actively to conduct certain of its businesses, (v) other actions or failures to act by Alcoa Corporation or (vi) any of Alcoa Corporation’s representations, covenants or undertakings contained in any of the Separation-related agreements and documents or in any documents relating to the IRS private letter ruling and/or the opinion of counsel being incorrect or violated. However, the indemnity from Alcoa Corporation may be insufficient to protect Arconic against the full amount of such additional taxes or related liabilities, and Alcoa Corporation may be unable to satisfy its indemnification obligations fully. Moreover, even if Arconic ultimately succeeds in recovering from Alcoa Corporation any amounts for which Arconic is held liable, Arconic may be temporarily required to bear such losses. In addition, Arconic and Arconic’s subsidiaries may incur certain tax costs in connection with the Separation, including tax costs resulting from separations in non-U.S. jurisdictions, which may be material. Each of these risks could negatively affect Arconic’s business, results of operations and financial condition. +Item 1B. Unresolved Staff Comments. +None. +28 +Table of Contents +Item 2. Properties. +Arconic’s principal office is located at 390 Park Avenue, New York, New York 10022-4608. Arconic’s corporate center is located at 201 Isabella Street, Pittsburgh, Pennsylvania 15212-5858. The Arconic Technology Center for research and development is located at 100 Technical Drive, New Kensington, Pennsylvania 15069-0001. +Arconic leases some of its facilities; however, it is the opinion of management that the leases do not materially affect the continued use of the properties or the properties’ values. +Arconic believes that its facilities are suitable and adequate for its operations. Although no title examination of properties owned by Arconic has been made for the purpose of this report, the Company knows of no material defects in title to any such properties. See Notes A and N to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Arconic has active plants and holdings under the following segments and in the following geographic areas: +ENGINEERED PRODUCTS AND SOLUTIONS +See the table and related text in the Engineered Products and Solutions Facilities section on page 6 of this report. +GLOBAL ROLLED PRODUCTS +See the table and related text in the Global Rolled Products Facilities section on page 8 of this report. +TRANSPORTATION AND CONSTRUCTION SOLUTIONS +See the table and related text in the Transportation and Construction Solutions section on page 9 of this report. +29 +Table of Contents +Item 3. Legal Proceedings. +In the ordinary course of its business, Arconic is involved in a number of lawsuits and claims, both actual and potential. +Environmental Matters +Arconic is involved in proceedings under the Comprehensive Environmental Response, Compensation and Liability Act, also known as Superfund (CERCLA) or analogous state provisions regarding the usage, disposal, storage or treatment of hazardous substances at a number of sites in the U.S. The Company has committed to participate, or is engaged in negotiations with federal or state authorities relative to its alleged liability for participation, in clean-up efforts at several such sites. The most significant of these matters, the remediation of the Grasse River in Massena, NY, is discussed in the Environmental Matters section of Note U to the Consolidated Financial Statements under the caption “Environmental Matters”. +Reynobond PE +As previously reported, on June 13, 2017, the Grenfell Tower in London, UK caught fire resulting in fatalities, injuries and damage. A French subsidiary of Arconic, Arconic Architectural Products SAS (AAP SAS), supplied a product, Reynobond PE, to its customer, a cladding system fabricator, which used the product as one component of the overall cladding system on Grenfell Tower. The fabricator supplied its portion of the cladding system to the façade installer, who then completed and installed the system under the direction of the general contractor. Neither Arconic nor AAP SAS was involved in the design or installation of the system used at the Grenfell Tower, nor did it have a role in any other aspect of the building’s refurbishment or original design. Regulatory investigations into the overall Grenfell Tower matter are being conducted, including a criminal investigation by the London Metro Police, a Public Inquiry by the British government and a consumer protection inquiry by a French public authority. AAP SAS has sought and received core participant status in the Public Inquiry. The Company will no longer sell the PE product for architectural use on buildings. +Howard v. Arconic Inc. et al. As previously reported, a purported class action complaint related to the Grenfell Tower fire was filed on August 11, 2017 in the United States District Court for the Western District of Pennsylvania against Arconic Inc. and Klaus Kleinfeld. A related purported class action complaint was filed in the United States District Court for the Western District of Pennsylvania on August 25, 2017, under the caption Sullivan v. Arconic Inc. et al. , against Arconic Inc., two former Arconic executives, several current and former Arconic directors, and banks that acted as underwriters for Arconic’s September 18, 2014 preferred stock offering (the “Preferred Offering”). The plaintiff in Sullivan had previously filed a purported class action against the same defendants on July 18, 2017 in the Southern District of New York and, on August 25, 2017, voluntarily dismissed that action without prejudice. On February 7, 2018, on motion from certain putative class members, the court consolidated Howard and Sullivan , closed Sullivan , and appointed lead plaintiffs in the consolidated case. On April 9, 2018, the lead plaintiffs in the consolidated purported class action filed a consolidated amended complaint. The consolidated amended complaint alleges that the registration statement for the Preferred Offering contained false and misleading statements and omitted to state material information, including by allegedly failing to disclose material uncertainties and trends resulting from sales of Reynobond PE for unsafe uses and by allegedly expressing a belief that appropriate risk management and compliance programs had been adopted while concealing the risks posed by Reynobond PE sales. The consolidated amended complaint also alleges that between November 4, 2013 and June 23, 2017 Arconic and Kleinfeld made false and misleading statements and failed to disclose material information about the Company’s commitment to safety, business and financial prospects, and the risks of the Reynobond PE product, including in Arconic’s Form 10-Ks for the fiscal years ended December 31, 2013, 2014, 2015 and 2016, its Form 10-Qs and quarterly financial press releases from the fourth quarter of 2013 through the first quarter of 2017, its 2013, 2014, 2015 and 2016 Annual Reports, and its 2016 Annual Highlights Report. The consolidated amended complaint seeks, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. On June 8, 2018, all defendants moved to dismiss the consolidated amended complaint for failure to state a claim. Briefing on that motion is now closed and the parties await a ruling. +Raul v. Albaugh, et al. As previously reported, on June 22, 2018, a derivative complaint was filed nominally on behalf of Arconic by a purported Arconic shareholder against all current members of Arconic’s Board of Directors, Klaus Kleinfeld and Ken Giacobbe, naming Arconic as a nominal defendant, in the United States District Court for the District of Delaware. The complaint raises similar allegations as the consolidated amended complaint in Howard , as well as allegations that the defendants improperly authorized the sale of Reynobond PE for unsafe uses, and asserts claims under Section 14(a) of the Securities Exchange Act of 1934 and Delaware state law. On July 13, 2018, the parties filed a stipulation agreeing to stay this case until the final resolution of the Howard case, the Grenfell Tower public inquiry in London, and the investigation by the London Metropolitan Police Service and on June 23, 2018, the Court approved the stay. +While the Company believes that these cases are without merit and intends to challenge them vigorously, there can be no assurances regarding the ultimate resolution of these matters. Given the preliminary nature of these matters and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. The Board of Directors has also received letters, purportedly sent on behalf of shareholders, reciting allegations similar to those made in the federal court lawsuits and demanding that the Board +30 +Table of Contents +authorize the Company to initiate litigation against members of management, the Board and others. The Board of Directors has appointed a Special Litigation Committee of the Board to review and make recommendations to the Board regarding the appropriate course of action with respect to these shareholder demand letters. The Special Litigation Committee and the Board are continuing to consider the appropriate responses to the shareholder demand letters in view of developments in proceedings concerning the Grenfell Tower fire. +Other Matters +As previously reported, Arconic Inc. and its subsidiaries and former subsidiaries are defendants in lawsuits filed on behalf of persons alleging injury as a result of occupational or other exposure to asbestos. Arconic, its subsidiaries and former subsidiaries have numerous insurance policies over many years that provide coverage for asbestos related claims. Arconic has significant insurance coverage and believes that Arconic’s reserves are adequate for its known asbestos exposure related liabilities. The costs of defense and settlement have not been and are not expected to be material to the results of operations, cash flows, and financial position of the Company. +Tax +Pursuant to the Tax Matters Agreement, dated as of October 31, 2016, entered into between the Company and Alcoa Corporation in connection with the Separation, the Company shares responsibility with Alcoa Corporation for, and Alcoa Corporation has agreed to partially indemnify the Company with respect to, the following matter. +As previously reported, in July 2013, following a Spanish corporate income tax audit covering the 2006 through 2009 tax years, an assessment was received mainly disallowing certain interest deductions claimed by a Spanish consolidated tax group owned by the Company. In August 2013, the Company filed an appeal of this assessment in Spain’s Central Tax Administrative Court, which was denied in January 2015. Arconic filed another appeal in Spain’s National Court in March 2015 which was denied in July 2018. The National Court’s decision requires the assessment for the 2006 through 2009 tax years to be reissued to take into account the outcome of the 2003 to 2005 audit which was closed in 2017. The Company estimates the revised assessment to be $174 million (€152 million), including interest. +The Company has petitioned to the Supreme Court of Spain to review the National Court’s decision. If the petition is accepted, the Supreme Court will review the assessment on its merits and render a final decision. In the event the Company is unsuccessful in appealing the assessment to the Supreme Court of Spain, a portion of the assessment may be offset with existing net operating losses and tax credits available to the Spanish consolidated tax group, which would be shared between the Company and Alcoa Corporation as provided for in the Tax Matters Agreement. As a result of the National Court decision, an income tax reserve, including interest, of $60 million (€52 million) was established in 2018. Concurrent with the establishment of the reserve, an indemnification receivable of $29 million (€25 million), representing Alcoa Corporation’s 49% share of the liability, was also recorded in 2018. +Additionally, while the tax years 2010 through 2013 are closed to audit, it is possible that the Company may receive assessments for tax years subsequent to 2013. Any potential assessment for an individual tax year is not expected to be material to the Company’s consolidated operations. At this time, the Company is unable to reasonably predict an ultimate outcome for this matter. +Matters Previously Reported – Alcoa Corporation +We have included the matters discussed below in which the Company remains party to proceedings relating to Alcoa Corporation in accordance with SEC regulations. The Separation and Distribution Agreement, dated October 31, 2016, entered into between the Company and Alcoa Corporation in connection with the Separation, provides for cross-indemnities between the Company and Alcoa Corporation for claims subject to indemnification. The Company does not expect any of such matters to result in a net claim against it. +St. Croix Proceedings +Red Dust Docket Cases, (St. Croix) f/k/a Abednego, Laurie L.A., et al. v. St. Croix Alumina, L.L.C., et al . As previously reported, on January 14, 2010, Arconic was served with a multi-plaintiff action complaint involving several thousand individual persons claiming to be residents of St. Croix who are alleged to have suffered personal injury or property damage from Hurricane Georges or winds blowing material from the St. Croix Alumina, L.L.C. (“SCA”) facility on the island of St. Croix (U.S. Virgin Islands) since the time of the hurricane. This complaint, Abednego, et al. v. Alcoa, et al. was filed in the Superior Court of the Virgin Islands, St. Croix Division. Following an unsuccessful attempt by Arconic and SCA to remove the case to federal court, the case has been lodged in the Superior Court. The complaint names as defendants the same entities that were sued in a February 1999 action arising out of the impact of Hurricane Georges on the island and added as a defendant the current owner of the alumina facility property. +Also as previously reported, on March 1, 2012, Arconic was served with a separate multi-plaintiff action complaint involving +31 +Table of Contents +approximately 200 individual persons alleging claims essentially identical to those set forth in the Abednego v. Alcoa complaint. This complaint, Abraham, et al. v. Alcoa, et al., was filed on behalf of plaintiffs previously dismissed in the federal court proceeding involving the original litigation over Hurricane Georges impacts. The matter was originally filed in the Superior Court of the Virgin Islands, St. Croix Division, on March 30, 2011. +Arconic and other defendants in the Abraham and Abednego cases filed or renewed motions to dismiss each case in March 2012 and August 2012 following service of the Abraham complaint on Arconic and remand of the Abednego complaint to Superior Court, respectively. By order dated August 10, 2015, the Superior Court dismissed plaintiffs’ complaints without prejudice to re-file the complaints individually, rather than as a multi-plaintiff filing. The order also preserves the defendants’ grounds for dismissal if new, individual complaints are filed. On July 7, 2017, the Court issued an order and associated memoranda on plaintiff’s multiple motions for extension of time to file the individual Complaints. Following the court’s July 7, 2017 order, a total of 429 complaints were filed and accepted by the court by the deadline of July 30, 2017 (and consolidated into the Red Dust Claims docket (Master Case No.: SX-15-CV-620)). These complaints include claims of about 1,260 individual plaintiffs. On December 11, 2017, the court issued a new scheduling order and further set a scheduling conference for January 18, 2018. At that conference, the court set the next status conference for late July 2018. +The July 2018 status conference was canceled. On November 5, 2018, notice of an order of reassignment was entered, transferring the claims to the newly created Complex Litigation Division of the Superior Court of the Virgin Islands, Division of St. Croix. Following the transfer, the Court scheduled a status conference to discuss the most efficient manner in which to proceed with discovery. The conference took place on January 24, 2019. The Court has not issued a discovery schedule. On January 28, 2019, the plaintiffs filed a motion asking for a determination that expert testimony will not be required on the issue of causation, which defendants opposed. The Court has not ruled on that motion. +Other Contingencies +In addition to the matters discussed above, various other lawsuits, claims, and proceedings have been or may be instituted or asserted against Arconic, including those pertaining to environmental, product liability, safety and health, employment, tax and antitrust matters. While the amounts claimed in these other matters may be substantial, the ultimate liability cannot currently be determined because of the considerable uncertainties that exist. Therefore, it is possible that the Company’s liquidity or results of operations in a period could be materially affected by one or more of these other matters. However, based on facts currently available, management believes that the disposition of these other matters that are pending or asserted will not have a material adverse effect, individually or in the aggregate, on the results of operations, financial position, or cash flows of the Company. +Item 4. Mine Safety Disclosures. +Not applicable. +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company’s common stock is listed on the New York Stock Exchange. Prior to the Separation of Alcoa Corporation from the Company, the Company’s common stock traded under the symbol “AA.” In connection with the separation, on November 1, 2016, the Company changed its stock symbol and its common stock began trading under the symbol “ARNC.” +On October 5, 2016, the Company’s common shareholders approved a 1-for-3 reverse stock split of the Company’s outstanding and authorized shares of common stock (the “Reverse Stock Split”). As a result of the Reverse Stock Split, every three shares of issued and outstanding common stock were combined into one issued and outstanding share of common stock, without any change in the par value per share. The Reverse Stock Split reduced the number of shares of common stock outstanding from approximately 1.3 billion shares to approximately 0.4 billion shares, and proportionately decreased the number of authorized shares of common stock from 1.8 billion to 0.6 billion shares. The Company’s common stock began trading on a Reverse Stock Split-adjusted basis on October 6, 2016. +On November 1, 2016, the Company completed the Separation of its business into two independent, publicly traded companies: the Company and Alcoa Corporation. The Separation was effected by means of a pro rata distribution by the Company of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders. The Company’s shareholders of record as of the close of business on October 20, 2016 (the “Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the Record Date. The Company retained 19.9% of the outstanding common stock of Alcoa Corporation immediately following the Separation. See disposition of retained shares in Note V to the Consolidated Financial Statements in Part II Item 8 of this Form 10-K. +The number of holders of record of common stock was approximately 11,668 as of February 15, 2019 . +32 +Table of Contents +Stock Performance Graph +The following graph compares the most recent five-year performance of the Company’s common stock with (1) the Standard & Poor’s (S&P) 500 ® Index, (2) the S&P 500 ® Materials Index, a group of 25 companies categorized by Standard & Poor’s as active in the “materials” market sector, (3) the S&P Aerospace & Defense Select Industry Index, a group of 33 companies categorized by Standard & Poor’s as active in the “aerospace & defense” industry and (4) the S&P 500 ® Industrials Index, a group of 69 companies categorized by Standard & Poor’s as active in the “industrials” market sector. The graph assumes, in each case, an initial investment of $100 on December 31, 2013, and the reinvestment of dividends. Historical prices prior to the separation of Alcoa Corporation from the Company on November 1, 2016, have been adjusted to reflect the value of the Separation transaction. The graph, table and related information shall not be deemed to be “filed” with the SEC, nor shall such information be incorporated by reference into future filings under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing. +Please note that the Company intends to replace the S&P 500® Materials Index with the S&P Aerospace & Defense Select Industry Index and the S&P 500® Industrials Index in subsequent stock performance graphs. We believe that the companies and industries represented in the S&P Aerospace & Defense Select Industry Index and the S&P 500® Industrials Index better reflect the markets in which the Company currently participates. All three indices are represented in the graph below. +Copyright© 2019 Standard & Poor's, a division of S&P Global. All rights reserved. +As of December 31, +2013 +2014 +2015 +2016 +2017 +2018 +Arconic Inc. +$ +100 +$ +149.83 +$ +94.62 +$ +80.22 +$ +119.02 +$ +74.47 +S&P 500 ® Index +100 +113.69 +115.26 +129.05 +157.22 +150.33 +S&P 500 ® Materials Index +100 +106.91 +97.95 +114.30 +141.55 +120.74 +S&P Aerospace & Defense Select Industry Index +100 +111.43 +117.49 +139.70 +197.50 +181.56 +S&P 500 ® Industrials Index +100 +109.83 +107.04 +127.23 +153.99 +133.53 +33 +Table of Contents +Item 6. Selected Financial Data. +The separation of Alcoa Inc. into two standalone, publicly-traded companies, Arconic Inc. (the new name for Alcoa Inc.) and Alcoa Corporation, became effective on November 1, 2016 (the “Separation Transaction”). The financial results of Alcoa Corporation for all periods prior to the Separation Transaction have been retrospectively reflected in the Statement of Consolidated Operations as discontinued operations and, as such, have been excluded from continuing operations and segment results for 2016 and all prior periods presented prior to the Separation Transaction. The cash flows related to Alcoa Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows for 2016 and all prior periods presented. +(dollars in millions, except per-share amounts) +For the year ended December 31, +2018 +2017 +2016 +2015 +2014 +Sales +$ +14,014 +$ +12,960 +$ +12,394 +$ +12,413 +$ +12,542 +Amounts attributable to Arconic: +Income (loss) from continuing operations (1) +$ +642 +$ +(74 +) +$ +(1,062 +) +$ +(157 +) +$ +(61 +) +Income (loss) from discontinued operations (2) +— +— +121 +(165 +) +329 +Net income (loss) +$ +642 +$ +(74 +) +$ +(941 +) +$ +(322 +) +$ +268 +Earnings (loss) per share attributable to Arconic common shareholders: (3) +Basic: +Income (loss) from continuing operations +$ +1.33 +$ +(0.28 +) +$ +(2.58 +) +$ +(0.54 +) +$ +(0.21 +) +Income (loss) from discontinued operations +— +— +0.27 +(0.39 +) +0.85 +Net income (loss) +$ +1.33 +$ +(0.28 +) +$ +(2.31 +) +$ +(0.93 +) +$ +0.64 +Diluted: +Income (loss) from continuing operations +$ +1.30 +$ +(0.28 +) +$ +(2.58 +) +$ +(0.54 +) +$ +(0.21 +) +Income (loss) from discontinued operations +— +— +0.27 +(0.39 +) +0.84 +Net income (loss) +$ +1.30 +$ +(0.28 +) +$ +(2.31 +) +$ +(0.93 +) +$ +0.63 +Cash dividends declared per common share (1) +$ +0.24 +$ +0.24 +$ +0.36 +$ +0.36 +$ +0.36 +Total assets +18,693 +18,718 +20,038 +36,477 +37,298 +Total debt +6,330 +6,844 +8,084 +8,827 +8,445 +Cash provided from (used for) operations (4) +217 +(39 +) +95 +764 +1,674 +Capital expenditures: +Capital expenditures—continuing operations +768 +596 +827 +789 +775 +Capital expenditures—discontinued operations +— +— +298 +391 +444 +Total capital expenditures +$ +768 +$ +596 +$ +1,125 +$ +1,180 +$ +1,219 +(1) +Calculated from the accompanying Statement of Consolidated Operations as Income (loss) from continuing operations after income taxes less Net income from continuing operations attributable to noncontrolling interests. +(2) +Calculated from the accompanying Statement of Consolidated Operations as Income from discontinued operations after income taxes less Net income from discontinued operations attributable to noncontrolling interests. +(3) +Per share data has been retroactively restated to reflect the 1-for-3 reverse stock split which became effective on October 6, 2016 (see Note I to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). +(4) +Cash provided from (used for) operations has not been restated for discontinued operations presentation for 2016 and all prior periods presented (see Basis of Presentation section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). Cash provided from (used for) operations in 2014 has not been recast for the impact of the new accounting pronouncements that were adopted in the first quarter of 2018 (see Recently Adopted Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). +The data presented in the Selected Financial Data table should be read in conjunction with the information provided in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7. and the Consolidated Financial Statements and Notes in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +34 +Table of Contents +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. +(dollars in millions, except per-share amounts; shipments in thousands of metric tons [kmt]) +Overview +Our Business +Arconic (“Arconic” or the “Company”) is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging. +Arconic is a global company operating in 18 countries. Based upon the country where the point of sale occurred, the United States and Europe generated 65% and 24%, respectively, of Arconic’s sales in 2018. In addition, Arconic has operating activities in Brazil, Canada, China, Japan, and Russia, among others. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in these countries . +Management Review of 2018 and Outlook for the Future +In 2018 , Arconic’s revenues increase d 8% over 2017 as a result of higher volumes across all segments including strong volume growth in aerospace engines and defense, automotive, commercial transportation, industrial, and building and construction end markets; higher aluminum pricing and favorable product mix primarily impacting the Global Rolled Products segment; and favorable foreign currency movements; partially offset by a decline in volumes in the industrial gas turbine end market; lower sales of $90 from the divestiture of the Latin America extrusions business (divested in April 2018), $54 from the divestiture of the rolling mill in Fusina, Italy (divested in March 2017), and $46 from the ramp down of Arconic's North American packaging operations (completed in December 2018); and costs of $38 in 2018 related to settlements of certain customer claims primarily related to product introductions. In the segments, Segment operating profit decreased 6% from 2017 as volume growth was more than offset by performance shortfalls in the disks operations, manufacturing inefficiencies in the Engineered Structures business, unfavorable product mix, and higher aluminum prices. +Net income was $642 in 2018 compared to a Net loss of $74 in 2017. There were several significant items that impacted the fourth quarter of 2018. The Company recognized proceeds of approximately $300 in cash and recorded a gain of $119 ($154 pre-tax) on the sale of the Texarkana rolling mill. The Company recorded a loss of $39 ($43 pre-tax) on the sale of the Eger, Hungary forgings business. The Company also recorded a charge of $72 ($92 pre-tax) for pension plan settlement charges associated with significant lump sum payments made to participants. Additionally, the Company recorded several discrete tax items, including benefits related to the reversal of a foreign deferred tax liability of $74 as well as the release of valuation allowances and revaluation of deferred taxes. +Management continued its focus on liquidity and cash flows as well as improving its operating performance through cost reductions, streamlined organizational structures, margin enhancement, and profitable revenue generation. Management has continued its intensified focus on capital efficiency. This focus and the related results enabled Arconic to end 2018 with a solid financial position. +The following financial information reflects certain key measures of Arconic’s 2018 results: +• +Sales of $14,014 , up 8% from 2017, with growth from all segments as key end markets remained healthy, and Net income of $642 , or $1.30 per diluted share; +• +Total segment operating profit of $1,581 , a decrease of $97 , or 6% , from 2017 1 ; +• +Cash provided from operations of $217 , cash used for financing activities of $649, and cash provided from investing activities of $565, reflecting improvements in working capital; +• +Cash on hand at the end of the year of $2,277 ; and +• +Total debt of $6,330 , a decrease in total debt of $514 from 2017 . +(1) For the reconciliation of Total segment operating profit to Consolidated income before income taxes and related information, see page 43. +On January 22, 2019, the Company announced that its Board of Directors (the Board) had determined to no longer pursue a potential sale of Arconic as part of its strategy and portfolio review. Management and the Board have been conducting a rigorous and comprehensive strategy and portfolio review over the past year and as part of that process had considered a sale of the Company, among other matters. However, the Company did not receive a proposal for a full-Company transaction that management and the Board believed would be in the best interest of Arconic’s shareholders and other stakeholders. Management and the Board remain confident in Arconic’s significant potential and are strongly focused on enhancing value for shareholders, through continued operational improvements and through other potential initiatives which have been previously identified in the strategy and portfolio review. The Company has announced the following key initiatives as part of its ongoing +35 +Table of Contents +strategy and portfolio review: +• +Commenced plans to reduce operating costs by approximately $200 on an annual run-rate basis, designed to maximize the impact in 2019; +• +Announced the planned separation of its portfolio into Engineered Products and Forgings and Global Rolled Products, with a spin-off of one of the businesses; +• +Considering the potential sale of businesses that do not best fit into one of the two segments above; +• +Intends to execute its previously authorized $500 share repurchase program in the first half of 2019; +• +The Board also authorized an additional $500 of share repurchases, effective through the end of 2020; and +• +Expects to reduce its quarterly common stock dividend from $0.06 to $0.02 per share. +On February 6, 2019, the Company announced that the Board appointed John C. Plant, current Chairman of the Board, as Chairman and Chief Executive Officer of the Company, effective February 6, 2019, to succeed Chip Blankenship, who ceased to serve as Chief Executive Officer of the Company and resigned as a member of the Board, in each case as of that date. In addition, the Company announced that the Board appointed Elmer L. Doty, current member of the Board, as President and Chief Operating Officer, a newly created position, effective February 6, 2019. Mr. Doty will remain a member of the Board. The Company also announced that Arthur D. Collins, Jr., current member of the Board, has been appointed interim Lead Independent Director of the Company, effective February 6, 2019. +On February 19, 2019, the Company entered into an accelerated share repurchase (“ASR”) agreement with JPMorgan Chase Bank to repurchase $700 of its common stock, pursuant to the share repurchase program previously authorized by the Board. Under the ASR agreement, Arconic will receive initial delivery of approximately 32 million shares on February 21, 2019. The final number of shares to be repurchased will be based on the volume-weighted average price of Arconic’s common stock during the term of the transaction, less a discount. The ASR agreement is expected to be completed during the first half of 2019. +The Company will evaluate its organizational structure in conjunction with the planned separation of its portfolio and changes to its reportable segments are expected in the first half of 2019. +In 2019, management projects that sales will be up approximately 2% to 4% supported by increases in most of the Company’s key end markets, as robust growth and the Company’s unique position in those markets is expected to continue. These increases will be partly offset by the expected decline in aluminum prices in 2019 compared with 2018. Earnings per share is expected to grow as management continues to focus on operational performance and driving further cost reductions. The Company expects favorable impacts from volume, net cost savings, aerospace pricing, and lower aluminum pricing, which will be pressured by the continuation of new product introductions in aerospace as well as higher transportation costs and aluminum scrap spreads. Cash flows are expected to keep pace for the full year in 2019 compared with 2018, resulting from improved operating performance and the focus on capital efficiency that is expected to drive lower capital expenditures. Cash flows in the first quarter of 2019 are expected to reflect the typical use of cash based on anticipated timing of working capital increases and interest payments. +2016 Separation Transaction. On November 1, 2016, the Company completed the separation of its business into two standalone, publicly-traded companies, Arconic Inc. and Alcoa Corporation. Following the Separation Transaction, Arconic comprises the Global Rolled Products (other than the rolling mill in Warrick, Indiana, and the 25.1% equity ownership stake in the Ma’aden Rolling Company), the Engineered Products and Solutions, and the Transportation and Construction Solutions segments. Alcoa Corporation comprises the Alumina and Primary Metals segments, the rolling mill in Warrick, Indiana, and the 25.1% equity ownership stake in the Ma’aden Rolling Company in Saudi Arabia. +The Separation Transaction was effected by the distribution of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders (the “Distribution”). The Company’s shareholders of record as of the close of business on October 20, 2016 (the “Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the Record Date. The Company distributed 146,159,428 shares of common stock of Alcoa Corporation in the Distribution and retained 36,311,767 shares, or approximately 19.9% (see disposition of retained shares under Results of Operations below), of the common stock of Alcoa Corporation immediately following the Distribution. As a result of the Distribution, Alcoa Corporation is now an independent public company trading under the symbol “AA” on the New York Stock Exchange, and the Company trades under the symbol “ARNC” on the New York Stock Exchange. +On October 31, 2016, Arconic entered into several agreements with Alcoa Corporation that govern the relationship of the parties following the completion of the Separation Transaction. These agreements include the following: Separation and Distribution Agreement, Transition Services Agreement, Tax Matters Agreement, Employee Matters Agreement, Alcoa Corporation to Arconic Inc. Patent, Know-How, and Trade Secret License Agreement, Arconic Inc. to Alcoa Corporation Patent, Know-How, and Trade Secret License Agreement, Alcoa Corporation to Arconic Inc. Trademark License Agreement, Toll Processing and Services Agreement, Master Agreement for the Supply of Primary Aluminum, Massena Lease and +36 +Table of Contents +Operations Agreement, Fusina Lease and Operations Agreement, and Stockholder and Registration Rights Agreement. The Toll Processing and Services Agreement expired by its terms at the end of 2018. +Results of Operations +Earnings Summary +Sales. Sales for 2018 were $14,014 compared with $12,960 in 2017 , an increase of $1,054 , or 8% . The increase was the result of strong volume growth across all segments, primarily in the aerospace engines and defense, automotive, commercial transportation, industrial, and building and construction end markets; higher aluminum prices and favorable product mix primarily in the Global Rolled Products segment; and favorable foreign currency movements; partially offset by a decline in volumes in the industrial gas turbine end market; lower sales of $190 from the divestitures of the Latin America extrusions business (divested in April 2018), the rolling mill in Fusina, Italy (divested in March 2017), and the ramp down of Arconic's North American packaging operations (completed in December 2018); and costs of $38 in 2018 related to settlements of certain customer claims primarily related to product introductions. +Sales for 2017 were $12,960 compared with $12,394 in 2016 , an increase of $566 , or 5% . The increase was the result of strong volume growth in all segments and higher aluminum pricing, partially offset by the planned ramp down and Toll Processing Agreement relating to the Company’s North America packaging business in Tennessee in the Global Rolled Products segment, as well as unfavorable product pricing in both the Engineered Products and Solutions and Global Rolled Products segments. Pursuant to the Toll Processing Agreement that Arconic entered into with Alcoa Corporation on October 31, 2016 in connection with the Separation Transaction, Arconic provides can body stock to Alcoa Corporation using aluminum supplied by Alcoa Corporation, resulting in the absence of metal sales in 2017 compared to 2016. +Cost of Goods Sold (COGS). COGS as a percentage of Sales was 81.3% in 2018 compared with 78.9% in 2017 . The increase was the result of higher aluminum prices; unfavorable aerospace product mix; higher transportation costs; manufacturing inefficiencies in the Engineered Structures business; performance shortfalls in the disks operations; costs related to settlements of certain customer claims noted above; and the impact of a $23 charge related to a physical inventory adjustment at one plant in the Engineered Products and Solutions segment that was recorded in the second quarter of 2018. While a portion of this charge for the physical inventory adjustment related to prior years, the majority related to the first half of 2018. The out-of-period amounts were not material to any interim or annual periods. +COGS as a percentage of Sales was 78.9% in 2017 compared with 78.2% in 2016 . The increase was primarily attributable to cost increases, including net higher aluminum prices of $84 and ramp-up costs related to new commercial aerospace engines, and a lower margin product mix, partially offset by net cost savings. +Selling, General Administrative, and Other Expenses (SG&A). SG&A expenses were $604 , or 4.3% of Sales, in 2018 compared with $715 , or 5.5% of Sales, in 2017 . The decrease in SG&A was the result of proxy, advisory and governance-related costs of $58, costs related to the separation of Alcoa Inc. of $18, and costs associated with the Company’s Delaware reincorporation of $3 in 2017, none of which recurred in 2018. Additionally, lower expenses driven by lower annual incentive compensation accruals and overhead cost reductions were somewhat offset by an increase in legal and other advisory costs related to Grenfell Tower of $4 as well as strategy and portfolio review costs of $7 in 2018. +SG&A expenses were $715 , or 5.5% of Sales, in 2017 compared with $924 , or 7.5% of Sales, in 2016 . The decrease in SG&A was the result of expenses related to the Separation Transaction of $193 in 2016 compared to $18 in 2017, as well as ongoing overhead cost reduction efforts, partially offset by proxy, advisory and governance-related costs of $58, external legal and other advisory costs related to Grenfell Tower of $14, and costs associated with the Company’s Delaware reincorporation of $3 in 2017. +Research and Development Expenses (R&D). R&D expenses were $103 in 2018 compared with $109 in 2017 and $130 in 2016 . The decrease in both periods was the result of lower spending. +Provision for Depreciation and Amortization (D&A). The provision for D&A was $576 in 2018 compared with $551 in 2017 and $535 in 2016 . The increase in both periods was primarily due to capital projects placed into service. +Impairment of Goodwill. In 2017, the Company recognized an impairment of goodwill of $719 related to the annual impairment review of the Arconic Forgings and Extrusions business (see Goodwill under Critical Accounting Policies and Estimates below). +Restructuring and Other Charges. Restructuring and other charges were $9 in 2018 compared with $165 in 2017 . The decrease of $156 was primarily due to the gain on the sale of the Texarkana rolling mill of $154, lower layoff costs, and a postretirement curtailment benefit of $28, partially offset by pension plan settlement charges of $96 associated with significant lump sum payments made to participants, a loss on the sale of the Eger, Hungary forgings business of $43, and pension curtailment charges of $23. In 2017, the Company recorded a loss on the sale of the Fusina, Italy rolling mill of $60 and a charge for the impairment of assets associated with the sale of the Latin America extrusions business of $41. See Note T to the +37 +Table of Contents +to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Restructuring and other charges were $165 in 2017 compared with $155 in 2016 . The increase of $10 was primarily due to a loss of $60 on the sale of the Fusina, Italy rolling mill and a charge of $41 for the impairment of assets associated with the sale of the Latin America extrusions business (divested in 2018) in 2017, partially offset by $57 for costs related to the exit of certain legacy Firth Rixson operations in the U.K. and $37 for exit costs related to the decision in 2016 to permanently shut down a can sheet facility. See Note T to the to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Interest Expense. Interest expense was $378 in 2018 compared with $496 in 2017 . The decrease of $118 , or 24% , was the result of higher costs incurred in 2017 related to the early redemption of the Company’s outstanding debt than were incurred during 2018, as well as lower debt outstanding. +Interest expense was $496 in 2017 compared with $499 in 2016 . The decrease of $3 , or 1% , was primarily due to lower interest expense resulting from lower outstanding debt, mostly offset by $73 primarily in higher premiums paid in 2017 related to the early redemption of $1,250 in debt. In the second quarter of 2017, Arconic redeemed all of the Company’s 6.50% Bonds due 2018 and 6.75% Notes due 2018, and a portion of the Company’s 5.72% Notes due 2019 in advance of the respective maturity dates. +Other Expense (Income), Net. Other expense, net was $79 in 2018 compared with Other income, net of $486 in 2017 . The decrease in other income, net of $565 was the result of gains recorded during 2017 related to the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $351, the Debt-for-Equity Exchange (in April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 shares (valued at $35.91 per share) in Alcoa Corporation stock and recorded a gain of $167), income of $81 associated with an adjustment to the contingent earn-out liability related to the Firth Rixson acquisition (see Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), and income of $25 due to the reversal of a liability associated with a separation-related guarantee, none of which recurred in 2018, and unfavorable foreign currency movements, somewhat offset by lower non-service related net periodic benefit cost and the benefit of $29 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve (see Note U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). +Other income, net was $486 in 2017 compared with Other expense, net of $41 in 2016 . The increase in other income, net of $527 was primarily due to the gain on the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $351 (in February 2017, the Company sold 23,353,000 shares of Alcoa Corporation stock at $38.03 per share, which resulted in cash proceeds of $888 and a gain of $351) and the gain of $167 on the Debt-for-Equity Exchange, income of $25 associated with a higher reversal of a contingent earn-out liability related to the Firth Rixson acquisition (see Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), and income of $25 due to the reversal of a liability associated with a separation-related guarantee. The Company was required to provide a guarantee for an Alcoa Corporation electricity contract in the event of an Alcoa Corporation payment default. In the fourth quarter of 2017, Alcoa Corporation announced that it had terminated the electricity contract at its Rockdale Operations and, as a result, Arconic reversed its associated guarantee liability. +Income Taxes. Arconic’s effective tax rate was 26.0% in 2018 compared with the U.S. federal statutory rate of 21%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $60 charge to establish a tax reserve in Spain, a $59 net charge resulting from the Company’s finalized analysis of the U.S. Tax Cuts and Jobs Acts of 2017 ("the 2017 Act"), a $13 charge for U.S. state taxes, foreign income taxed in higher rate jurisdictions, and foreign losses with no tax benefit, partially offset by a $74 benefit related to the reversal of a foreign recapture obligation, a $38 benefit to reverse a foreign tax reserve that is effectively settled, and a $10 benefit for the release of U.S. valuation allowances. +Arconic’s effective tax rate was 115.7% in 2017 compared with the U.S. federal statutory rate of 35%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $719 impairment of goodwill, a $41 impairment of assets in the Latin America extrusions business, and a $60 charge related to the sale of a rolling mill in Italy that are nondeductible for income tax purposes, a $272 tax charge as a provisional impact of the 2017 Act, and a $23 tax charge for an increase in an uncertain tax position in Germany, partially offset by a $73 tax benefit related to the sale and Debt-for-Equity Exchange of the Alcoa Corporation stock, a $69 tax benefit for the release of U.S. state valuation allowances net of the federal tax benefit, a $27 favorable tax impact associated with a non-taxable earn-out liability adjustment in connection with the Firth Rixson acquisition, and by foreign income taxed in lower rate jurisdictions. +Arconic’s effective tax rate was 356.5% in 2016 compared with the U.S. federal statutory rate of 35%. The effective tax rate differs from the U.S. federal statutory rate primarily due to a $1,267 discrete income tax charge for valuation allowances related to the Separation Transaction (see Note H to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), a $95 tax charge associated with the redemption of company-owned life insurance +38 +Table of Contents +policies whose tax basis was less than the redemption amount resulting in a taxable gain, a $51 net charge for the remeasurement of certain deferred tax assets and liabilities due to tax rate and tax law changes, and a $34 unfavorable tax impact related to certain separation costs which are nondeductible for income tax purposes, somewhat offset by a $39 discrete income tax benefit for the release of valuation allowances in Canada and Russia, a $38 tax benefit related to currency impacts of a distribution of previously taxed income, and a $26 favorable tax impact associated with non-taxable settlement proceeds and earn-out liability adjustments in connection with the Firth Rixson acquisition. +Management anticipates that the effective tax rate in 2019 will be between 26.5% and 28.5%. However, business portfolio actions, changes in the current economic environment, tax legislation or rate changes, currency fluctuations, ability to realize deferred tax assets, movements in stock price impacting tax benefits or deficiencies on stock-based payment awards, and the results of operations in certain taxing jurisdictions may cause this estimated rate to fluctuate. +Income (Loss) From Continuing Operations After Income Taxes. Income from continuing operations after income taxes was $642 for 2018 , or $1.30 per diluted share, compared to a loss from continuing operations after income taxes of $74 for 2017 , or $0.28 per share. The increase in results of $716 was due in part to the following items that occurred in 2017 but did not recur in 2018: a charge for goodwill impairment of $719 ($719 pre-tax); gains related to the sale of a portion of Arconic’s investment in Alcoa Corporation common stock and the Debt-for-Equity Exchange of $405 ($518 pre-tax); and favorable adjustments of $97 ($106 pre-tax) to contingent earn-out and guarantee liabilities as noted below. Additional favorable impacts in 2018 included: volume growth across all segments; lower SG&A expenses due to proxy and separation costs incurred in 2017 and not recurring in 2018, as well as lower incentive compensation accruals; lower Restructuring and other charges driven primarily by the gain on sale of the Texarkana rolling mill, offset by pension settlement charges and the loss on sale of the Eger, Hungary forgings business; lower Interest expense due to lower debt levels; lower pension expenses; and lower Income taxes. These favorable impacts were partially offset by unfavorable aerospace product mix, higher aluminum prices, manufacturing inefficiencies in the Engineered Structures business, performance shortfalls in the disks operations, settlements of certain customer claims, and an unfavorable physical inventory adjustment at one plant. +Loss from continuing operations after income taxes was $74 for 2017 , or $0.28 per diluted share, compared with $1,062 for 2016, or $2.58 per share. The increase in results of $988 was primarily attributable to charges for tax valuation allowances and costs related to the Separation Transaction in 2016; a gain of $238 ($351 pre-tax) on the sale of a portion of Arconic’s investment in Alcoa Corporation common stock and a gain of $167 ($167 pre-tax) on the Debt-for-Equity Exchange in 2017; income of $25 ($25 pre-tax) associated with a higher reversal of a contingent earn-out liability related to the Firth Rixson acquisition and income of $16 ($25 pre-tax) due to the reversal of a liability associated with a separation-related guarantee; net cost savings; and higher sales volumes across all segments; partially offset by a charge for goodwill impairment of $719 ($719 pre-tax); a charge related to the 2017 Act of $272; $47 ($73 pre-tax) of higher premiums paid for the early redemption of debt in 2017; higher LIFO inventory expense associated with higher aluminum prices; charges for asset impairments of the Fusina, Italy rolling mill of $60 ($60 pre-tax) and Latin America extrusions business of $41 ($41 pre-tax) based on the sale of these businesses; unfavorable product pricing, primarily in aerospace; and lower-margin product mix. +Segment Information +Arconic’s operations consist of three worldwide reportable segments: Engineered Products and Solutions, Global Rolled Products and Transportation and Construction Solutions (see below). In the first quarter of 2018, the Company changed its primary measure of segment performance from Adjusted earnings before interest, tax, depreciation, and amortization (“Adjusted EBITDA”) to Segment operating profit, which more closely aligns segment performance with Operating income as presented in the Statement of Consolidated Operations. Segment performance under Arconic’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Arconic’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and other charges and Impairment of goodwill. Segment operating profit also includes certain items that, under the previous segment performance measure, were recorded in Corporate, such as the impact of LIFO inventory accounting, metal price lag, intersegment profit eliminations, and derivative activities. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Arconic are in Corporate. Prior period financial information has been recast to conform to current year presentation. +Segment operating profit for all reportable segments totaled $1,581 in 2018 , $1,678 in 2017 , and $1,622 in 2016 . The following information provides Sales and Segment operating profit for each reportable segment, as well as certain shipment data for Global Rolled Products, for each of the three years in the period ended December 31, 2018 . See Note C to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +39 +Table of Contents +Engineered Products and Solutions +2018 +2017 +2016 +Third-party sales +$ +6,316 +$ +5,943 +$ +5,728 +Segment operating profit +$ +891 +$ +964 +$ +955 +The Engineered Products and Solutions segment produces products that are used primarily in the aerospace (commercial and defense), industrial, commercial transportation, and power generation end markets. Such products include fastening systems (titanium, steel, and nickel superalloys); seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils and forged jet engine components (e.g., jet engine disks), and extruded, machined and formed aircraft parts (titanium and aluminum), all of which are sold directly to customers and through distributors. More than 75% of the third-party sales in this segment are from the aerospace end market. A small part of this segment also produces various forged, extruded, and machined metal products (titanium, aluminum and steel) for the oil and gas, automotive, and land and sea defense end markets. Seasonal decreases in sales are generally experienced in the third quarter of the year due to the European summer slowdown across all end markets. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, British pound and the euro. +On December 31, 2018, as part of the Company’s ongoing strategy and portfolio review, Arconic completed the sale of its Eger, Hungary forgings business that manufactured high volume steel forgings for drivetrain components in the European heavy-duty truck and automotive market. This business generated third-party sales of $32 , $38 , and $29 in 2018, 2017, and 2016, respectively, and had 180 employees at the time of the divestiture. See Restructuring and other charges under Results of Operations above. +In April 2016, Arconic completed the sale of the Remmele Medical business (that was part of the RTI International Metals Inc. (RTI) acquisition) that manufactured precision-machined metal products for customers in the minimally invasive surgical device and implantable device markets. Remmele Medical generated third-party sales of $23 from January 1, 2016 through the divestiture date, and, at the time of the divestiture, had approximately 330 employees. +Third-party sales for the Engineered Products and Solutions segment increased $373 , or 6% , in 2018 compared with 2017 , primarily attributable to higher volumes in the aerospace engines and defense end markets and favorable foreign currency movements, partially offset by a decline in volumes in the industrial gas turbine market and lower aerospace pricing principally in the fasteners business. +Third-party sales for this segment increased $215 , or 4% , in 2017 compared with 2016 , primarily attributable to volume growth in both aerospace engines and airframes, partially offset by lower product pricing, primarily in the aerospace end market, and the absence of sales of $23 related to the Remmele Medical business, which was sold in April 2016. +Segment operating profit for the Engineered Products and Solutions segment decreased $73 , or 8% , in 2018 compared with 2017 , primarily attributable to performance shortfalls in the disks operations; manufacturing inefficiencies in the Engineered Structures business, including the now resolved forging press outage at the Cleveland facility that impacted the fourth quarter of 2018 with higher costs of $10; unfavorable aerospace engine mix and new product introductions; a physical inventory adjustment of $23; and lower aerospace pricing principally in the fasteners business; partly offset by the strength in aerospace engine and defense volumes. +Segment operating profit for this segment increased $9 , or 1% , in 2017 compared with 2016 , primarily on higher volumes and net cost savings, partially offset by product pricing pressures, ramp up costs associated with increasing production volumes of new aerospace engine parts, and a lower margin product mix. +In 2019, demand in the commercial aerospace end market is expected to remain strong, driven by the ramp-up of new aerospace engine platforms. Demand in the defense end market is expected to grow due to the continuing ramp-up of certain aerospace programs, while declines in the industrial gas turbine market are expected to continue, albeit at lower levels than in 2018. Net cost savings and favorable pricing are expected. +40 +Table of Contents +Global Rolled Products (1) +2018 +2017 +2016 +Third-party sales +$ +5,604 +$ +5,000 +$ +4,865 +Intersegment sales +160 +148 +118 +Total sales +$ +5,764 +$ +5,148 +$ +4,983 +Segment operating profit +$ +386 +$ +424 +$ +421 +Third-party aluminum shipments (kmt) +1,249 +1,197 +1,339 +(1) +Excludes the Warrick, IN rolling operations and the equity interest in the rolling mill at the joint venture in Saudi Arabia, both of which were previously part of the Global Rolled Products segment but became part of Alcoa Corporation effective November 1, 2016. +The Global Rolled Products segment produces aluminum sheet and plate for a variety of end markets. Sheet and plate is sold directly to customers and through distributors related to the aerospace, automotive, commercial transportation, packaging, building and construction, and industrial products (mainly used in the production of machinery and equipment and consumer durables) end markets. A small portion of this segment also produces aseptic foil for the packaging end market. While the customer base for flat-rolled products is large, a significant amount of sales of sheet and plate is to a relatively small number of customers. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, Chinese yuan, the euro, the Russian ruble, the Brazilian real, and the British pound. +On April 6, 2018, the U.S. Treasury Department’s Office of Foreign Asset Control (“OFAC”) announced new sanctions against Russian “oligarchs” and extended those sanctions to companies that are majority-owned or substantively controlled by those oligarchs. These sanctions block U.S. persons - both individuals and companies - from engaging in transactions with listed oligarchs and their companies. These sanctions originally extended to UC Rusal PLC (“Rusal”), which supplies primary aluminum to Arconic in Europe, the United States, and to the Company’s Samara plant in Russia. The Company operated under a series of temporary licenses issued by OFAC until January 27, 2019 when OFAC removed Rusal from the list of sanctioned parties. The Company complies with and expects to continue to comply with all other aspects of these sanctions and we do not anticipate any interruption in Samara’s ability to operate normally. +In March 2017, Arconic completed the sale of its Fusina, Italy rolling mill. The rolling mill generated third-party sales of $54 and $165 for 2017 and 2016, respectively. At the time of the divestiture, the rolling mill had approximately 312 employees. See Restructuring and other charges under Results of Operations above. +On November 1, 2016, Arconic entered into a Toll Processing Agreement with Alcoa Corporation for the tolling of metal for the Warrick, IN rolling mill which became a part of Alcoa Corporation upon the completion of the Separation Transaction. As part of this arrangement, Arconic provided a toll processing service to Alcoa Corporation to produce can sheet products at its facility in Tennessee through the end date of the contract, December 31, 2018. Alcoa Corporation supplied all required raw materials to Arconic and Arconic processed the raw materials into finished can sheet coils ready for shipment to the end customer. Tolling revenue for 2018, 2017, and the two months ended December 31, 2016 was $144, $190 and $37, respectively. +Third-party sales for the Global Rolled Products segment increased $604 , or 12% , in 2018 compared with 2017 , primarily attributable to higher aluminum prices; higher volumes in the automotive, commercial transportation, and industrial end markets; and favorable product mix; partially offset by the absence of sales of $54 from the rolling mill in Fusina, Italy (divested in March 2017) and the planned ramp down of Arconic's North American packaging operations (completed in December 2018). +Third-party sales for this segment increased $135 , or 3% , in 2017 compared with 2016 , primarily attributable to volume growth in the automotive end market and higher aluminum pricing, partially offset by the impact of $362 associated with the ramp-down and Toll Processing Agreement with Alcoa Corporation at the Company’s North America packaging business in Tennessee, the absence of sales of $111 from the rolling mill in Fusina, Italy, aerospace customer inventory destocking and reduced build rates, and pricing pressures in the global packaging market. +Segment operating profit for the Global Rolled Products segment decreased $38 , or 9% , in 2018 compared with 2017 , primarily driven by unfavorable aerospace wide-body production mix, higher aluminum prices, and higher transportation costs and scrap spreads, partially offset by higher automotive, commercial transportation and industrial volumes. The higher aluminum prices negatively impacted segment operating profit margin by $30, or 100 basis points, in 2018 compared with 2017. +Segment operating profit for this segment increased $3 , or 1% , in 2017 compared with 2016 , primarily driven by net cost savings and increased automotive volumes, partially offset by lower aerospace volume from customer destocking and reduced build rates, continued pricing pressure on global packaging products and higher aluminum prices. The higher aluminum prices +41 +Table of Contents +negatively impacted segment operating profit margin by $37, or 150 basis points, in 2017 compared with 2016. +In 2019, demand in the North America commercial transportation, brazing, and industrial end markets is expected to grow as a result of the International Trade Commission initiated common alloy trade case. Demand in the automotive end market is expected to continue to grow due to the growing demand for innovative products and aluminum-intensive vehicles. Demand from the commercial airframe end market is expected to be flat as the ramp-up of new programs is offset by lower build rates for aluminum intensive wide-body programs. Net productivity improvements are anticipated to continue. +Transportation and Construction Solutions +2018 +2017 +2016 +Third-party sales +$ +2,126 +$ +2,011 +$ +1,802 +Segment operating profit +$ +304 +$ +290 +$ +246 +The Transportation and Construction Solutions segment produces products that are used mostly in the commercial transportation and nonresidential building and construction end markets. Such products include integrated aluminum structural systems, architectural extrusions, and forged aluminum commercial vehicle wheels, which are sold both directly to customers and through distributors. A small part of this segment also produces aluminum products for the industrial products end market. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are primarily the U.S. dollar, the euro, and the Brazilian real. +On July 31, 2018, the Company announced that it had initiated a sale process of its Building and Construction Systems (BCS) business, as part of the Company’s ongoing strategy and portfolio review that commenced in January 2018. BCS generated third-party sales of approximately $1,140 , $1,070 , and $1,010 for 2018, 2017, and 2016, respectively. The sale process continues to progress. The Company’s decision regarding whether to sell the business will not be finalized until final binding offers are evaluated. Until the Company makes that final decision, the BCS business will remain classified as held and in-use in the Consolidated Financial Statements. +On April 2, 2018, Arconic completed the sale of its Latin America extrusions business as part of its continued drive to streamline its business portfolio, reduce complexity and further focus on its higher-margin products and profitable growth. This business generated sales of $25 , $115 , and $103 in 2018, 2017, and 2016 respectively, and had 612 employees at the time of the divestiture. See Restructuring and Other Charges under Results of Operations above. +Third-party sales for the Transportation and Construction Solutions segment increased $115 , or 6% , in 2018 compared with 2017 , primarily driven by higher volumes in the commercial transportation and building and construction end markets, favorable foreign currency movements and higher aluminum prices, partially offset by the absence of sales of $90 resulting from the divestiture of the Latin America extrusions business in April 2018. +Third-party sales for this segment increased $209 , or 12% , in 2017 compared with 2016 , primarily driven by increased volumes in the commercial transportation and building and construction end markets, higher aluminum pricing, and favorable foreign currency movements, partially offset by lower product pricing. +Segment operating profit for the Transportation and Construction Solutions segment increased $14 , or 5% , in 2018 compared with 2017 , principally driven by higher volumes in the commercial transportation and building and construction end markets and net cost savings, which more than offset higher aluminum prices. The higher aluminum prices negatively impacted segment operating margin by $57, or 270 basis points, in 2018 compared with 2017. +Segment operating profit for this segment increased $44 , or 18% , in 2017 compared with 2016 , principally driven by net cost savings and higher volumes, partially offset by lower product pricing in the heavy-duty truck market, unfavorable product mix, and higher aluminum prices. The higher aluminum prices negatively impacted segment operating margin by $8, or 90 basis points, in 2017 compared with 2016. +In 2019, we expect continued growth in the North American and European commercial transportation and building and construction markets and continued demand for innovative products. Net productivity improvements are anticipated to continue. +42 +Table of Contents +Reconciliation of Total segment operating profit to Consolidated income from continuing operations before income taxes +2018 +2017 +2016 +Total segment operating profit +$ +1,581 +$ +1,678 +$ +1,622 +Unallocated amounts: +Impairment of goodwill +— +(719 +) +— +Restructuring and other charges +(9 +) +(165 +) +(155 +) +Corporate expense +(247 +) +(314 +) +(513 +) +Consolidated operating income +$ +1,325 +$ +480 +$ +954 +Interest expense +(378 +) +(496 +) +(499 +) +Other (expense) income, net +(79 +) +486 +(41 +) +Consolidated income from continuing operations before income taxes +$ +868 +$ +470 +$ +414 +See Restructuring and Other Charges, Impairment of Goodwill, Interest Expense, and Other Expense (Income), Net discussions above under Results of Operations for reference. +Corporate expense decreased in 2018 compared with 2017 primarily due to proxy, advisory and governance-related costs of $58 and costs related to the separation of Alcoa Inc. of $18 in 2017, neither of which recurred in 2018. Also, lower expenses driven by lower annual incentive compensation accruals and overhead cost reductions were partially offset by costs incurred in the second quarter of 2018 related to the settlements of certain customer claims primarily related to product introductions of $38, an increase in legal and other advisory costs related to Grenfell Tower of $4, and strategy and portfolio review costs of $7 in 2018. +Corporate expense decreased in 2017 compared with 2016 primarily attributable to costs incurred in 2016 related to the Separation Transaction, partially offset by proxy, advisory and governance-related costs and legal and other advisory costs related to Grenfell Tower incurred in 2017. +Environmental Matters +See the Environmental Matters section of Note U to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. +Liquidity and Capital Resources +Arconic maintains a disciplined approach to cash management and strengthening of its balance sheet. Management continued to focus on actions to improve Arconic’s cost structure and liquidity, providing the Company with the ability to operate effectively. Such actions included procurement efficiencies and overhead rationalization to reduce costs, working capital initiatives, and maintaining a sustainable level of capital expenditures. +Cash provided from operations and financing activities is expected to be adequate to cover Arconic’s operational and business needs over the next 12 months. For an analysis of long-term liquidity, see Contractual Obligations and Off-Balance Sheet Arrangements below. +At December 31, 2018 , cash and cash equivalents of Arconic were $2,277 , of which $541 was held by Arconic's non-U.S. subsidiaries. If the cash held by non-U.S. subsidiaries were to be repatriated to the U.S., the company does not expect there to be additional material income tax consequences. +The Statement of Consolidated Cash Flows has not been restated for discontinued operations, therefore the discussion below concerning Operating Activities, Financing Activities, and Investing Activities for the year ended December 31, 2016 includes the results of both Arconic and Alcoa Corporation up through the completion of the Separation Transaction on November 1, 2016. +Operating Activities +Cash provided from operations in 2018 was $217 compared with cash used for operations of $39 in 2017 . The increase of $256 was primarily due to lower working capital of $209 and a favorable change in noncurrent liabilities of $169 due primarily to reversals in 2017 related to the Firth Rixson earn-out liability of $81 and separation-related guarantee liability of $25, partially offset by lower operating results. The components of the change in working capital included favorable changes of $277 in accounts payable, $127 in taxes, including income taxes, and $118 in inventories, partially offset by unfavorable changes of $227 in receivables, $74 in accrued expenses, and $12 in prepaid expenses and other current assets. +Cash used for operations in 2017 was $39 compared with Cash provided from operations $95 in 2016 . The decrease of $134 was primarily due to lower operating results and higher pension contributions of $20, partially offset by a favorable change in +43 +Table of Contents +noncurrent assets of $111 due to the prepayment of $200 made in April 2016 related to a gas supply agreement for the Australia alumina refineries (Alcoa Corporation), a favorable change in noncurrent liabilities of $55, and lower cash used for working capital of $17. The components of the change in working capital included favorable changes of $101 in receivables; $87 in prepaid expenses and other current assets; and $278 in accrued expenses; mostly offset by unfavorable changes in working capital, including $163 in inventories; $170 in accounts payable, trade; and $116 in taxes, including income taxes. +Financing Activities +Cash used for financing activities was $649 in 2018 compared with $1,015 in 2017 and $757 in 2016 . +The use of cash in 2018 was principally the result of $1,103 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the remaining outstanding 5.72% Notes due in 2019 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K) and $119 in dividends to shareholders. These items were partially offset by $600 in additions to debt, primarily from borrowings under certain revolving credit facilities. +The use of cash in 2017 was principally the result of $1,634 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the Company’s 6.50% Bonds due 2018, 6.75% Notes due 2018, and a portion of the 5.72% Notes due 2019 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K); $162 in dividends to shareholders; and $52 in premiums paid on early redemption of debt. These items were partially offset by $816 in additions to debt, primarily from borrowings under certain revolving credit facilities, and $50 of proceeds from the exercise of stock options. +The use of cash in 2016 was principally the result of $2,734 in payments on debt, mostly related to the repayment of borrowings under certain revolving credit facilitates (see below) and the repayment in December 2016 of $750 of outstanding principal of 5.55% Notes due February 2017; $228 in dividends to shareholders; and $175 in net cash paid to noncontrolling interests (Alcoa Corporation). These items were mostly offset by $1,962 in additions to debt, virtually all of which was the result of borrowing under certain revolving credit facilities, and $421 in net cash transferred from Alcoa Corporation at the completion of the Separation Transaction. +In July 2015, through the acquisition of RTI, Arconic assumed the obligation to repay two tranches of convertible debt; one tranche was due and settled in cash on December 1, 2015 (principal amount of $115) and the other tranche is due on October 15, 2019 (principal amount of $403), unless earlier converted or purchased by Arconic at the holder’s option under specific conditions. Upon conversion of the 2019 convertible notes, holders will receive, at Arconic’s election, cash, shares of common stock (approximately 14,453,000 shares using the December 31, 2018 conversion rate of 35.9125 shares per $1,000 (not in millions) bond or per-share conversion price of $27.8455), or a combination of cash and shares. On the maturity date, each holder of outstanding notes will be entitled to receive $1,000 (not in millions) in cash for each $1,000 (not in millions) bond, together with accrued and unpaid interest. +In September 2014, Arconic completed two public securities offerings under its shelf registration statement for (i) $1,250 of 25 million depositary shares, each representing a 1/10th interest in a share of Arconic’s 5.375% Class B Mandatory Convertible Preferred Stock, Series 1, par value $1 per share, liquidation preference $500 per share, and (ii) $1,250 of 5.125% Notes due 2024. The net proceeds of the offerings were used to finance the cash portion of the acquisition of Firth Rixson. On October 2, 2017, all outstanding 24,975,978 depositary shares were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this noncash equity transaction. +Arconic maintains a Five-Year Revolving Credit Agreement (the “Credit Agreement”) with a syndicate of lenders and issuers named therein that expires on June 29, 2023 and provides for a senior unsecured revolving credit facility of $3,000. In addition to the Credit Agreement, Arconic has a number of other credit agreements that provide a combined borrowing capacity of $715 as of December 31, 2018. See Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Arconic’s costs of borrowing and ability to access the capital markets are affected not only by market conditions but also by the short- and long-term debt ratings assigned to Arconic by the major credit rating agencies. +On May 1, 2017, Standard and Poor’s Ratings Services (S&P) affirmed Arconic’s long-term debt at BBB-, an investment grade rating, with a stable outlook, and its short-term debt at A-3. On February 7, 2019, S&P changed the outlook from stable to negative credit watch. On November 1, 2016, Moody’s Investor Service (Moody’s) downgraded Arconic’s long-term debt rating from Ba1, a non-investment grade, to Ba2 and its short-term debt rating from Speculative Grade Liquidity-1 to Speculative Grade Liquidity-2. Additionally, Moody’s changed the outlook from negative to stable (ratings and outlook were affirmed on November 2, 2017 and October 8, 2018). On April 21, 2016, Fitch affirmed Arconic’s long-term debt rating at BB+, a non-investment grade, and short-term debt at B. Additionally, Fitch changed the outlook from positive to evolving. On July 7, 2016, Fitch changed the outlook from evolving to stable (ratings and outlook were affirmed on July 3, 2017). On September +44 +Table of Contents +27, 2018, Fitch changed the outlook from stable to positive (ratings and outlook were affirmed on September 27, 2018). +Investing Activities +Cash provided from investing activities was $565 in 2018 compared with $1,320 in 2017 and $591 in 2016 . +The source of cash in 2018 included cash receipts from sold receivables of $1,016 and proceeds from the sale of the Texarkana, Texas rolling mill and cast house of $302, partially offset by capital expenditures of $768, including the horizontal heat treat furnace at the Davenport, Iowa plant and an expansion of a wheels plant in Szekesfehervar, Hungary. +The source of cash in 2017 included proceeds of $888 from the sale of a portion of Arconic’s investment in Alcoa Corporation common stock, cash receipts from sold receivables of $792, and the receipt of proceeds from the sale of the Yadkin Hydroelectric Project of $243, somewhat offset by cash used for capital expenditures of $596, including the aerospace expansion (very thick plate stretcher and horizontal heat treat furnace) at the Davenport, Iowa plant and a titanium aluminide furnace at the Niles, Ohio facility, and the injection of $10 into the Fusina rolling business prior to its sale. +The source of cash in 2016 was mainly due to $778 of cash receipts from sold receivables, $692 in proceeds from the sale of assets and businesses, including $457 from the redemption of company-owned life insurance policies, $120 in proceeds related to the sale of the Intalco smelter wharf property (Alcoa Corporation), and $102 in proceeds ($99 net of transaction costs) from the sale of the Remmele Medical business, which was part of Arconic’s acquisition of RTI in July 2015; and $280 in sales of investments, composed primarily of $145 for an equity interest in a natural gas pipeline in Australia (Alcoa Corporation) and $130 for securities held by Arconic’s captive insurance company. These sources of cash were partially offset by $1,125 in capital expenditures ($298 Alcoa Corporation), 29% of which related to growth projects, including the aerospace expansion (very thick plate stretcher) at the Davenport, Iowa plant and a titanium aluminide furnace at the Niles, Ohio facility. +Noncash Financing and Investing Activities +On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction. See Note I to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +In the second quarter of 2017, the Company completed a Debt-for-Equity Exchange with the Investment Banks for the remaining portion of Arconic’s retained interest in Alcoa Corporation common stock for a portion of the Company’s outstanding notes held by the Investment Banks for $465 including accrued and unpaid interest. See Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +On October 5, 2016, Arconic completed a 1-for-3 reverse stock split of its outstanding and authorized shares of common stock, pursuant to the authorization provided at a special meeting of Arconic common shareholders (the “Reverse Stock Split”). The Reverse Stock Split reduced the number of shares of common stock outstanding from approximately 1.3 billion shares to approximately 0.4 billion shares. The par value of the common stock remained at $1.00 per share. Accordingly, Common stock and Additional capital in the Company’s Statement of Changes in Consolidated Equity at December 31, 2016 reflect a decrease and increase of $877 , respectively. +In August 2016, Arconic retired its outstanding treasury stock consisting of approximately 76 million shares. As a result, Common stock and Additional capital were decreased by $76 and $2,563 , respectively, in the Company’s Statement of Changes in Consolidated Equity at December 31, 2016, to reflect the retirement of the treasury shares. +45 +Table of Contents +Contractual Obligations and Off-Balance Sheet Arrangements +Contractual Obligations. Arconic is required to make future payments under various contracts, including long-term purchase obligations, financing arrangements, and lease agreements. Arconic also has commitments to fund its pension plans, provide payments for other postretirement benefit plans, and fund capital projects. As of December 31, 2018 , a summary of Arconic’s outstanding contractual obligations is as follows (these contractual obligations are grouped in the same manner as they are classified in the Statement of Consolidated Cash Flows in order to provide a better understanding of the nature of the obligations and to provide a basis for comparison to historical information): +Total +2019 +2020-2021 +2022-2023 +Thereafter +Operating activities: +Energy-related purchase obligations +$ +72 +$ +37 +$ +28 +$ +7 +$ +— +Raw material purchase obligations +829 +652 +155 +19 +3 +Other purchase obligations +102 +81 +13 +6 +2 +Operating leases +379 +94 +128 +70 +87 +Interest related to total debt +2,326 +351 +592 +370 +1,013 +Estimated minimum required pension funding +1,860 +255 +840 +765 +— +Other postretirement benefit payments +730 +90 +170 +170 +300 +Layoff and other restructuring payments +25 +19 +4 +1 +1 +Deferred revenue arrangements +18 +12 +6 +— +— +Uncertain tax positions +187 +— +— +— +187 +Financing activities: +Total debt +6,330 +421 +2,243 +623 +3,043 +Dividends to shareholders +— +— +— +— +— +Investing activities: +Capital projects +665 +532 +133 +— +— +Totals +$ +13,523 +$ +2,544 +$ +4,312 +$ +2,031 +$ +4,636 +Obligations for Operating Activities +Energy-related purchase obligations consist primarily of electricity and natural gas contracts with expiration dates ranging from one year to five years. Raw material purchase obligations consist mostly of aluminum, titanium sponge, and various other metals with expiration dates ranging from less than one year to six years. Many of these purchase obligations contain variable pricing components, and, as a result, actual cash payments may differ from the estimates provided in the preceding table. Operating leases represent multi-year obligations for certain land and buildings, plant equipment, vehicles, and computer equipment. +Interest related to total debt is based on interest rates in effect as of December 31, 2018 and is calculated on debt with maturities that extend to 2042. +Estimated minimum required pension funding and postretirement benefit payments are based on actuarial estimates using current assumptions for discount rates, long-term rate of return on plan assets, rate of compensation increases, and health care cost trend rates, among others. It is Arconic’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Arconic contributes additional amounts as deemed appropriate. In 2018, the Company funded $298, of which $72 was contributed to its U.S. plans in excess of the minimum required under the Employee Retirement Income Security Act (ERISA). The estimates reported in the preceding table include amounts sufficient to meet the minimum required, along with a $34 contribution in 2019 related to an agreement with the Pension Benefit Guaranty Corporation (PBGC) (see Note G to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). Arconic has determined that it is not practicable to present pension funding and other postretirement benefit payments beyond 2023 and 2028, respectively. +Layoff and other restructuring payments to be paid within one year primarily relate to severance costs, special layoff benefit payments, and lease termination costs, while payments expected to be paid over the next several years relate to lease termination costs. +Deferred revenue arrangements require Arconic to deliver product to a customer over the specified contract period through 2020 for a sheet and plate contract. While these obligations are not expected to result in cash payments, they represent contractual obligations for which the Company would be obligated if the specified product deliveries could not be made. +46 +Table of Contents +Uncertain tax positions taken or expected to be taken on an income tax return may result in additional payments to tax authorities. The amount in the preceding table includes interest and penalties accrued related to such positions as of December 31, 2018 . The total amount of uncertain tax positions is included in the “Thereafter” column as the Company is not able to reasonably estimate the timing of potential future payments. If a tax authority agrees with the tax position taken or expected to be taken or the applicable statute of limitations expires, then additional payments will not be necessary. +Obligations for Financing Activities +Arconic has historically paid quarterly dividends on its preferred and common stock. Including dividends on preferred stock, Arconic paid $119 in dividends to shareholders during 2018 . Because all dividends are subject to approval by Arconic’s Board of Directors, amounts are not included in the preceding table unless such authorization has occurred. As of December 31, 2018 , there were 483,270,717 shares of outstanding common stock and 546,024 shares of outstanding Class A preferred stock. In 2018, the annual preferred stock dividend was $3.75 per share and the annual common stock dividend was $0.24 per share. +Obligations for Investing Activities +Capital projects in the preceding table only include amounts approved by management as of December 31, 2018 . Funding levels may vary in future years based on anticipated construction schedules of the projects. It is expected that significant expansion projects will be funded through various sources, including cash provided from operations. Total capital expenditures are anticipated to be approximately $700 in 2019 . +Off-Balance Sheet Arrangements +At December 31, 2018 , Arconic has outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2019 and 2026 was $37 at December 31, 2018 . +Pursuant to the Separation and Distribution Agreement between Arconic and Alcoa Corporation, Arconic was required to provide certain guarantees for Alcoa Corporation, which had a combined fair value of $6 and $8 at December 31, 2018 and 2017 , respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. Arconic was required to provide payment guarantees for Alcoa Corporation issued on behalf of a third party related to project financing for Alcoa Corporation’s aluminum complex in Saudi Arabia. During the third quarter of 2018, Arconic was released from this guarantee. Furthermore, Arconic was required to provide guarantees related to two long-term supply agreements for energy for Alcoa Corporation facilities in the event of an Alcoa Corporation payment default. In October 2017, Alcoa Corporation announced that it had terminated one of the two agreements, the electricity contract with Luminant Generation Company LLC that was tied to its Rockdale Operations, effective as of October 1, 2017. As a result of the termination of the Rockdale electricity contract, Arconic recorded income of $25 in the fourth quarter of 2017 associated with reversing the fair value of the electricity contract guarantee. For the remaining long-term supply agreement, Arconic is required to provide a guarantee up to an estimated present value amount of approximately $1,087 and $1,297 at December 31, 2018 and December 31, 2017 , respectively, in the event of an Alcoa Corporation payment default. This guarantee expires in 2047 . For this guarantee, subject to its provisions, Arconic is secondarily liable in the event of a payment default by Alcoa Corporation. Arconic currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote. +In December 2016, Arconic entered into a one -year claims purchase agreement with a bank covering claims up to $245 related to the Saudi Arabian joint venture and two long-term energy supply agreements. The majority of the premium was paid by Alcoa Corporation. The agreement matured in December 2017 and was not renewed in 2018 due to the decline in exposure to guarantee claims including a substantial reduction in the guarantees related to the Saudi Arabian joint venture and also the elimination of the guarantee related to the Rockdale energy contract. In December 2018, Arconic entered into a one-year insurance policy with a limit of $80 relating to the remaining long-term energy supply agreement. The premium is expected to be paid by Alcoa Corporation. The decision to enter into a claims purchase agreement or insurance policy will be made on an annual basis going forward. +Arconic has outstanding letters of credit primarily related to workers’ compensation, environmental obligations, and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2019 , was $136 at December 31, 2018 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to retain letters of credit of $54 that had previously been provided related to both Arconic and Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016. Alcoa Corporation workers’ compensation claims and letter of credit fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation. +Arconic has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire at various dates, primarily in 2019 , was $50 at December 31, 2018 . +47 +Table of Contents +Pursuant to the Separation and Distribution Agreement, Arconic was required to provide surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016 and, as a result, Arconic has $25 in outstanding surety bonds relating to these liabilities. Alcoa Corporation workers’ compensation claims and surety bond fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation. +Critical Accounting Policies and Estimates +The preparation of the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America requires management to make certain judgments, estimates, and assumptions regarding uncertainties that affect the amounts reported in the Consolidated Financial Statements and disclosed in the accompanying Notes. Areas that require significant judgments, estimates, and assumptions include accounting for environmental and litigation matters; the testing of goodwill, other intangible assets, and properties, plants, and equipment for impairment; estimating fair value of businesses acquired or divested; pension plans and other postretirement benefits obligations; stock-based compensation; and income taxes. +Management uses historical experience and all available information to make these judgments, estimates, and assumptions, and actual results may differ from those used to prepare the Company’s Consolidated Financial Statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and accompanying Notes provide a meaningful and fair perspective of the Company. +A summary of the Company’s significant accounting policies is included in Note A to the Consolidated Financial Statements. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the Consolidated Financial Statements with useful and reliable information about the Company’s operating results and financial condition. +Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future revenues, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery. Claims for recovery are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Arconic has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations. +Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss. +Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. +Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Arconic had six reporting units for 2018, of which three were included in the Engineered Products and Solutions segment (Arconic Fastening Systems, Arconic Engines, Arconic Engineered Structures), two were included in the Transportation and Construction Solutions segment (Arconic Wheel and Transportation Products and Building and Construction Systems), and the remaining reporting unit was the Global Rolled Products segment. +In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the +48 +Table of Contents +existence of events or circumstances leads to a determination that it is more likely than not (greater than 50% ) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. +Arconic determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Arconic’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three -year period. +During the 2018 annual review of goodwill, management proceeded directly to the quantitative impairment test for all six of its reporting units. The estimated fair values for each of the six reporting units exceeded their respective carrying values by more than 25%, thus, there was no goodwill impairment. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Arconic uses a discounted cash flow model (DCF) to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. Arconic would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit. +Goodwill impairment tests in 2017 and 2016 indicated that goodwill was not impaired for any of the Company’s reporting units, except for the Arconic Forgings and Extrusions (AFE) business whose estimated fair value was lower than its carrying value. As such, Arconic recorded an impairment for the full amount of goodwill in the AFE reporting unit of $719 . The decrease in the AFE fair value was primarily due to unfavorable performance that was impacting operating margins and a higher discount rate due to an increase in the risk-free rate of return, while the carrying value increased compared to prior year. +Properties, Plants, and Equipment and Other Intangible Assets. Properties, plants, and equipment and Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is calculated as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a DCF model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of assets also require significant judgments. +In the second quarter of 2018, the Company updated its three-year strategic plan and determined that there was a decline in the forecasted financial performance for the disks operations, an asset group within the AEN business unit. As such, the Company evaluated the recoverability of the long-lived assets by comparing their carrying value of approximately $515 to the estimated undiscounted net cash flows of the disks operations, resulting in an estimated fair value in excess of their carrying value of approximately 13% ; thus, there was no impairment. If the disks operations do not achieve the revised forecasted financial performance or if there are changes in any significant assumptions, a material non-cash impairment of long-lived assets may occur in future periods. These significant assumptions include sales growth, cost of raw materials, ramp up of additional production capacity, and working capital. A 1% decrease in the forecasted net cash flows would reduce the undiscounted cash flows by approximately $6 . There were no indicators of impairment identified for the disks operations during the third or fourth quarters of 2018 and, as such, the Company did not evaluate the recoverability of its long-lived assets. +Discontinued Operations and Assets Held for Sale. The fair values of all businesses to be divested are estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements. +49 +Table of Contents +Pension and Other Postretirement Benefits. Liabilities and expenses for pension and other postretirement benefits are determined using actuarial methodologies and incorporate significant assumptions, including the interest rate used to discount the future estimated liability, the expected long-term rate of return on plan assets, and several assumptions relating to the employee workforce (salary increases, health care cost trend rates, retirement age, and mortality). +The interest rate used to discount future estimated liabilities is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have an average duration of 10 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. In 2018 , 2017 , and 2016 , the discount rate used to determine benefit obligations for U.S. pension and other postretirement benefit plans was 4.35% , 3.75% , and 4.20% , respectively. The impact on the liabilities of a change in the discount rate of 1/4 of 1% would be approximately $170 and either a charge or credit of approximately $2 to after-tax earnings in the following year. +In conjunction with the annual measurement of the funded status of Arconic’s pension and other postretirement benefit plans at December 31, 2015, management elected to change the manner in which the interest cost component of net periodic benefit cost will be determined in 2016 and beyond. Previously, the interest cost component was determined by multiplying the single equivalent rate described above and the aggregate discounted cash flows of the plans’ projected benefit obligations. Under the new methodology, the interest cost component will be determined by aggregating the product of the discounted cash flows of the plans’ projected benefit obligations for each year and an individual spot rate (referred to as the “spot rate” approach). This change resulted in a lower interest cost component of net periodic benefit cost under the new methodology compared to the previous methodology in 2018, 2017, and 2016 of $24, $34, and $84, respectively, for pension plans and $4, $6, and $14, respectively, for other postretirement benefit plans. Management believes this new methodology, which represents a change in an accounting estimate, is a better measure of the interest cost as each year’s cash flows are specifically linked to the interest rates of bond payments in the same respective year. +The expected long-term rate of return on plan assets is generally applied to a five-year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment. +For 2018 , 2017 , and 2016 , management used 7.00% , 7.75% , and 7.75% , respectively, as its expected long-term rate of return, which was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. These rates fell within the respective range of the 20-year moving average of actual performance and the expected future return developed by asset class. For 2019 , management anticipates that 7.00% will be the expected long-term rate of return. The decrease of 75 basis points in the 2018 expected long-term rate of return was due to a decrease in the expected return by asset class and the 20-year moving average. A change in the assumption for the expected long-term rate of return on plan assets of 1/4 of 1% would impact after-tax earnings by approximately $10 for 2019 . +In 2018, a net loss of $114 (after-tax) was recorded in other comprehensive loss, primarily due to the impact of the adoption of new accounting guidance that permits a reclassification to Accumulated deficit for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017, as well as the plan asset performance that was less than expected, which were partially offset by the increase in the discount rate of 60 basis points and the amortization of actuarial losses. In 2017, a net loss of $220 (after-tax) was recorded in other comprehensive loss, primarily due to the decrease in the discount rate of 45 basis points and plan asset performance less than expected, which were partially offset by the amortization of actuarial losses. In 2016, a net benefit of $1,601 (after-tax and noncontrolling interest) was recorded in other comprehensive loss, primarily due to the transfer of $2,080 to Alcoa Corporation which was partially offset by a net charge of $479. The charge was due to the unfavorable performance of the plan assets and a 9 basis point decrease in the discount rate, which were partially offset by the amortization of actuarial losses. +Stock-Based Compensation. Arconic recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. +50 +Table of Contents +Compensation expense recorded in 2018 , 2017 , and 2016 was $50 ( $39 after-tax), $54 ( $36 after-tax), and $76 ( $51 after-tax), respectively. +Income Taxes. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Arconic’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. +The 2017 Act created a new requirement that certain income earned by foreign subsidiaries, Global Intangible Low Taxed Income (GILTI), must be included in the gross income of the U.S. shareholder. The 2017 Act also established the Base Erosion and Anti-Abuse Tax (BEAT). Until regulations are finalized, judgement will be required to apply preliminary guidance, including proposed regulations, to Arconic’s facts and circumstances. +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that supports the realizability of deferred tax assets. +Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. +Recently Adopted Accounting Guidance. See the Recently Adopted Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Recently Issued Accounting Guidance. See the Recently Issued Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +Not material. +51 +Table of Contents +Item 8. Financial Statements and Supplementary Data. +Management’s Reports to Arconic Shareholders +Management’s Report on Financial Statements and Practices +The accompanying Consolidated Financial Statements of Arconic Inc. and its subsidiaries (the “Company”) were prepared by management, which is responsible for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s best judgments and estimates. The other financial information included in the annual report is consistent with that in the financial statements. +Management also recognizes its responsibility for conducting the Company’s affairs according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in key policy statements issued from time to time regarding, among other things, conduct of its business activities within the laws of the host countries in which the Company operates and potentially conflicting outside business interests of its employees. The Company maintains a systematic program to assess compliance with these policies. +Management’s Report on Internal Control over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control—Integrated Framework (2013) , issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Based on the assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2018 , based on criteria in Internal Control—Integrated Framework (2013) issued by the COSO. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2018 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein. +/s/ John C. Plant +John C. Plant +Chairman and Chief Executive Officer +/s/ Ken Giacobbe +Ken Giacobbe +Executive Vice President and +Chief Financial Officer +52 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors of Arconic Inc. +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of Arconic Inc. and its subsidiaries (the "Company") as of December 31, 2018 and 2017, and the related consolidated statements of operations, comprehensive (loss) income, changes in equity, and cash flows for each of the three years in the period ended December 31, 2018, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017 , and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. +Basis for Opinions +The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ PricewaterhouseCoopers LLP +Pittsburgh, Pennsylvania +February 21, 2019 +We have served as the Company’s auditor since 1950. +53 +Table of Contents +Arconic and subsidiaries +Statement of Consolidated Operations +(in millions, except per-share amounts) +For the year ended December 31, +2018 +2017 +2016 +Sales ( B and C ) +$ +14,014 +$ +12,960 +$ +12,394 +Cost of goods sold (exclusive of expenses below) +11,397 +10,221 +9,696 +Selling, general administrative, and other expenses +604 +715 +924 +Research and development expenses +103 +109 +130 +Provision for depreciation and amortization +576 +551 +535 +Impairment of goodwill ( A and O ) +— +719 +— +Restructuring and other charges ( D ) +9 +165 +155 +Operating income +1,325 +480 +954 +Interest expense ( E ) +378 +496 +499 +Other expense (income), net ( F ) +79 +(486 +) +41 +Income from continuing operations before income taxes +868 +470 +414 +Provision for income taxes ( H ) +226 +544 +1,476 +Income (loss) from continuing operations after income taxes +642 +(74 +) +(1,062 +) +Income from discontinued operations after income taxes ( V ) +— +— +184 +Net income (loss) +642 +(74 +) +(878 +) +Less: Net income from discontinued operations attributable to noncontrolling interests ( V ) +— +— +63 +Net income (loss) Attributable to Arconic +$ +642 +$ +(74 +) +$ +(941 +) +Amounts Attributable to Arconic Common Shareholders ( J ): +Net income (loss) +$ +651 +$ +(127 +) +$ +(1,010 +) +Earnings (loss) per share—basic: +Continuing operations +$ +1.33 +$ +(0.28 +) +$ +(2.58 +) +Discontinued operations +— +— +0.27 +Net earnings (loss) per share-basic +$ +1.33 +$ +(0.28 +) +$ +(2.31 +) +Earnings (loss) per share—diluted +Continuing operations +$ +1.30 +$ +(0.28 +) +$ +(2.58 +) +Discontinued operations +— +— +0.27 +Net earnings (loss) per share-diluted +$ +1.30 +$ +(0.28 +) +$ +(2.31 +) +The accompanying notes are an integral part of the consolidated financial statements. +54 +Table of Contents +Arconic and subsidiaries +Statement of Consolidated Comprehensive Income (Loss) +(in millions) +Arconic +Noncontrolling +Interests +Total +For the year ended December 31, +2018 +2017 +2016 +2018 +2017 +2016 +2018 +2017 +2016 +Net income (loss) +$ +642 +$ +(74 +) +$ +(941 +) +$ +— +$ +— +$ +63 +$ +642 +$ +(74 +) +$ +(878 +) +Other comprehensive income (loss), net of tax ( K ): +Change in unrecognized net actuarial loss and prior service cost/benefit related to pension and other postretirement benefits +255 +(220 +) +(479 +) +— +— +(3 +) +255 +(220 +) +(482 +) +Foreign currency translation adjustments +(146 +) +252 +268 +— +2 +182 +(146 +) +254 +450 +Net change in unrealized gains on available-for-sale securities +(1 +) +(134 +) +137 +— +— +— +(1 +) +(134 +) +137 +Net change in unrecognized gains/losses on cash flow hedges +(23 +) +26 +(617 +) +— +— +5 +(23 +) +26 +(612 +) +Total Other comprehensive income (loss), net of tax +85 +(76 +) +(691 +) +— +2 +184 +85 +(74 +) +(507 +) +Comprehensive income (loss) +$ +727 +$ +(150 +) +$ +(1,632 +) +$ +— +$ +2 +$ +247 +$ +727 +$ +(148 +) +$ +(1,385 +) +The accompanying notes are an integral part of the consolidated financial statements. +55 +Table of Contents +Arconic and subsidiaries +Consolidated Balance Sheet +(in millions) +December 31, +2018 +2017 +Assets +Current assets: +Cash and cash equivalents +2,277 +$ +2,150 +Receivables from customers, less allowances of $4 in 2018 and $8 in 2017 ( L ) +1,047 +1,035 +Other receivables ( L ) +451 +339 +Inventories ( M ) +2,492 +2,480 +Prepaid expenses and other current assets +314 +374 +Total current assets +6,581 +6,378 +Properties, plants, and equipment, net ( N ) +5,704 +5,594 +Goodwill ( A and O ) +4,500 +4,535 +Deferred income taxes ( H ) +573 +743 +Intangibles, net ( O ) +919 +987 +Other noncurrent assets +416 +481 +Total assets +$ +18,693 +$ +18,718 +Liabilities +Current liabilities: +Accounts payable, trade +2,129 +$ +1,839 +Accrued compensation and retirement costs +370 +399 +Taxes, including income taxes +118 +75 +Accrued interest payable +113 +124 +Other current liabilities +356 +349 +Short-term debt ( P and R ) +434 +38 +Total current liabilities +3,520 +2,824 +Long-term debt, less amount due within one year ( P and R ) +5,896 +6,806 +Accrued pension benefits ( G ) +2,230 +2,564 +Accrued other postretirement benefits ( G ) +723 +841 +Other noncurrent liabilities and deferred credits ( Q ) +739 +759 +Total liabilities +13,108 +13,794 +Contingencies and commitments ( U ) +Equity +Arconic shareholders’ equity: +Preferred stock ( I ) +55 +55 +Common stock ( I ) +483 +481 +Additional capital +8,319 +8,266 +Accumulated deficit ( A ) +(358 +) +(1,248 +) +Accumulated other comprehensive loss ( A and K ) +(2,926 +) +(2,644 +) +Total Arconic shareholders’ equity +5,573 +4,910 +Noncontrolling interests +12 +14 +Total equity +5,585 +4,924 +Total liabilities and equity +$ +18,693 +$ +18,718 +The accompanying notes are an integral part of the consolidated financial statements. +56 +Table of Contents +Arconic and subsidiaries +Statement of Consolidated Cash Flows +(in millions) +For the year ended December 31, +2018 +2017 +2016 +Operating activities +Net income (loss) +$ +642 +$ +(74 +) +$ +(878 +) +Adjustments to reconcile net income (loss) to cash provided from (used for) operations: +Depreciation and amortization +576 +551 +1,132 +Deferred income taxes +31 +434 +1,125 +Equity income, net of dividends +— +— +42 +Impairment of goodwill ( A and O ) +— +719 +— +Restructuring and other charges +9 +165 +257 +Net loss (gain) from investing activities - asset sales +10 +(513 +) +(156 +) +Net periodic pension benefit cost ( G ) +130 +217 +304 +Stock-based compensation +50 +67 +86 +Other +75 +112 +63 +Changes in assets and liabilities, excluding effects of acquisitions, divestitures, and foreign currency translation adjustments: +(Increase) in receivables ( A ) +(1,142 +) +(915 +) +(1,016 +) +(Increase) in inventories +(74 +) +(192 +) +(29 +) +(Increase) decrease in prepaid expenses and other current assets +(1 +) +11 +(76 +) +Increase in accounts payable, trade +339 +62 +232 +(Decrease) in accrued expenses +(190 +) +(116 +) +(394 +) +Increase (decrease) in taxes, including income taxes +104 +(23 +) +93 +Pension contributions +(298 +) +(310 +) +(290 +) +(Increase) in noncurrent assets +(20 +) +(41 +) +(152 +) +(Decrease) in noncurrent liabilities +(24 +) +(193 +) +(248 +) +Cash provided from (used for) operations +217 +(39 +) +95 +Financing Activities +Net change in short-term borrowings (original maturities of three months or less) +(7 +) +(2 +) +(3 +) +Additions to debt (original maturities greater than three months) ( P ) +600 +816 +1,962 +Payments on debt (original maturities greater than three months) ( P ) +(1,103 +) +(1,634 +) +(2,734 +) +Premiums paid on early redemption of debt ( A and P ) +(17 +) +(52 +) +(3 +) +Proceeds from exercise of employee stock options +16 +50 +4 +Dividends paid to shareholders +(119 +) +(162 +) +(228 +) +Distributions to noncontrolling interests +— +(14 +) +(226 +) +Contributions from noncontrolling interests +— +— +51 +Net cash transferred from Alcoa Corporation at separation +— +— +421 +Other +(19 +) +(17 +) +(1 +) +Cash used for financing activities +(649 +) +(1,015 +) +(757 +) +Investing Activities +Capital expenditures +(768 +) +(596 +) +(1,125 +) +Acquisitions, net of cash acquired ( S ) +— +— +10 +Proceeds from the sale of assets and businesses ( S ) +309 +(9 +) +692 +Sales of investments ( S and V ) +9 +890 +280 +Cash receipts from sold receivables ( A and L ) +1,016 +792 +778 +Other ( V ) +(1 +) +243 +(44 +) +Cash provided from investing activities +565 +1,320 +591 +Effect of exchange rate changes on cash, cash equivalents and restricted cash +(4 +) +9 +(8 +) +Net change in cash, cash equivalents and restricted cash ( A ) +129 +275 +(79 +) +Cash, cash equivalents and restricted cash at beginning of year ( A ) +2,153 +1,878 +1,957 +Cash, cash equivalents and restricted cash at end of year ( A ) +$ +2,282 +$ +2,153 +$ +1,878 +The accompanying notes are an integral part of the consolidated financial statements. +57 +Table of Contents +Arconic and subsidiaries +Statement of Changes in Consolidated Equity +(in millions, except per-share amounts) +Arconic Shareholders +Preferred +stock +Mandatory +convertible +preferred +stock +Common +stock +Additional +capital +Retained earnings (deficit) +Treasury +stock +Accumulated +Other +Comprehensive +Loss +Noncontrolling +interests +Total +equity +Balance at December 31, 2015 +$ +55 +$ +3 +$ +1,391 +$ +10,019 +$ +8,834 +$ +(2,825 +) +$ +(5,431 +) +$ +2,085 +$ +14,131 +Net (loss) income +— +— +— +— +(941 +) +— +— +63 +(878 +) +Other comprehensive (loss) income ( K ) +— +— +— +— +— +— +(691 +) +184 +(507 +) +Cash dividends declared: +Preferred–Class A @ $3.75 per share +— +— +— +— +(2 +) +— +— +— +(2 +) +Preferred–Class B @ $26.8750 per share +— +— +— +— +(67 +) +— +— +— +(67 +) +Common @ $0.36 per share +— +— +— +— +(159 +) +— +— +— +(159 +) +Stock-based compensation ( I ) +— +— +— +86 +— +— +— +— +86 +Common stock issued: compensation plans ( I ) +— +— +— +(205 +) +— +186 +— +— +(19 +) +Retirement of Treasury stock ( I ) +(76 +) +(2,563 +) +2,639 +— +Reverse stock split ( I ) +(877 +) +877 +— +Distribution of Alcoa Corporation +(8,692 +) +3,554 +(2,133 +) +(7,271 +) +Distributions +— +— +— +— +— +— +— +(226 +) +(226 +) +Contributions +— +— +— +— +— +— +— +51 +51 +Other +— +— +— +— +— +— +— +2 +2 +Balance at December 31, 2016 +$ +55 +$ +3 +$ +438 +$ +8,214 +$ +(1,027 +) +$ +— +$ +(2,568 +) +$ +26 +$ +5,141 +Net loss +— +— +— +— +(74 +) +— +— +— +(74 +) +Other comprehensive loss ( K ) +— +— +— +— +— +— +(76 +) +2 +(74 +) +Cash dividends declared: +Preferred–Class A @ $3.75 per share +— +— +— +— +(2 +) +— +— +— +(2 +) +Preferred–Class B @ $20.1563 per share +— +— +— +— +(51 +) +— +— +— +(51 +) +Common @ $0.24 per share +— +— +— +— +(109 +) +— +— +— +(109 +) +Stock-based compensation ( I ) +— +— +— +67 +— +— +— +— +67 +Common stock issued: compensation plans ( I ) +— +— +— +21 +— +— +— +— +21 +Conversion of mandatory convertible preferred stock ( I ) +— +(3 +) +39 +(36 +) +— +— +— +— +— +Issuance of common stock ( I ) +— +— +4 +— +— +— +— +— +4 +Distributions +— +— +— +— +— +— +— +(14 +) +(14 +) +Other +— +— +— +— +15 +— +— +— +15 +Balance at December 31, 2017 +$ +55 +$ +— +$ +481 +$ +8,266 +$ +(1,248 +) +$ +— +$ +(2,644 +) +$ +14 +$ +4,924 +Adoption of accounting standard ( A ) +— +— +— +— +367 +— +(367 +) +— +— +Net income +— +— +— +— +642 +— +— +— +642 +Other comprehensive income ( K ) +— +— +— +— +— +— +85 +— +85 +Cash dividends declared: +Preferred–Class A @ $3.75 per share +— +— +— +— +(2 +) +— +— +— +(2 +) +Common @ $0.24 per share +— +— +— +— +(117 +) +— +— +— +(117 +) +Stock-based compensation ( I ) +— +— +— +50 +— +— +— +— +50 +Common stock issued: compensation plans ( I ) +— +— +2 +3 +— +— +— +— +5 +Other +— +— +— +— +— +— +— +(2 +) +(2 +) +Balance at December 31, 2018 +$ +55 +$ +— +$ +483 +$ +8,319 +$ +(358 +) +$ +— +$ +(2,926 +) +$ +12 +$ +5,585 +The accompanying notes are an integral part of the consolidated financial statements. +58 +Table of Contents +Arconic and subsidiaries +Notes to the Consolidated Financial Statements +(dollars in millions, except per-share amounts) +A. Summary of Significant Accounting Policies +Basis of Presentation. The Consolidated Financial Statements of Arconic Inc. and subsidiaries (“Arconic” or the “Company”) are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) and require management to make certain judgments, estimates, and assumptions. These may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. They also may affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates upon subsequent resolution of identified matters. Certain amounts in previously issued financial statements were reclassified to conform to the current period presentation (see below and Note C ) +On January 1, 2018, Arconic adopted new guidance issued by the Financial Accounting Standards Board (FASB) related to the following: presentation of net periodic pension cost and net periodic postretirement benefit cost that required a reclassification of costs within the Statement of Consolidated Operations; presentation of certain cash receipts and cash payments within the Statement of Consolidated Cash Flows that required a reclassification of amounts between operating and either financing or investing activities; the classification of restricted cash within the Statement of Consolidated Cash Flows; and the reclassification from Accumulated other comprehensive loss to Accumulated deficit in the Consolidated Balance Sheet of stranded tax effects resulting from the Tax Cuts and Jobs Act enacted on December 22, 2017. See Recently Adopted Accounting Guidance below for further details. +Also on January 1, 2018, the Company changed its primary measure of segment performance from Adjusted earnings before interest, tax, depreciation and amortization (“Adjusted EBITDA”) to Segment operating profit, which more closely aligns segment performance with Operating income as presented in the Statement of Consolidated Operations. See Note C for further details. +The separation of Alcoa Inc. into two standalone, publicly-traded companies, Arconic Inc. (the new name for Alcoa Inc.) and Alcoa Corporation, became effective on November 1, 2016 (the “Separation Transaction”). The financial results of Alcoa Corporation for 2016 have been retrospectively reflected in the Statement of Consolidated Operations as discontinued operations and, as such, have been excluded from continuing operations and segment results for 2016. The cash flows and comprehensive income related to Alcoa Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows and Statement of Consolidated Comprehensive Income (Loss), respectively, for 2016. See Note V for additional information related to the Separation Transaction and discontinued operations. +Principles of Consolidation. The Consolidated Financial Statements include the accounts of Arconic and companies in which Arconic has a controlling interest. Intercompany transactions have been eliminated. Investments in affiliates in which Arconic cannot exercise significant influence are accounted for on the cost method. +Management also evaluates whether an Arconic entity or interest is a variable interest entity and whether Arconic is the primary beneficiary. Consolidation is required if both of these criteria are met. Arconic does not have any variable interest entities requiring consolidation. +Cash Equivalents. Cash equivalents are highly liquid investments purchased with an original maturity of three months or less. +Inventory Valuation. Inventories are carried at the lower of cost and net realizable value, with cost for approximately half of U.S. inventories determined under the last-in, first-out (LIFO) method. The cost of other inventories is determined under a combination of the first-in, first-out (FIFO) and average-cost methods. +Properties, Plants, and Equipment. Properties, plants, and equipment are recorded at cost. Depreciation is recorded principally on the straight-line method at rates based on the estimated useful lives of the assets. The following table details the weighted-average useful lives of structures and machinery and equipment by reporting segment (numbers in years): +Structures +Machinery and equipment +Engineered Products and Solutions +29 +17 +Global Rolled Products +31 +21 +Transportation and Construction Solutions +27 +18 +Gains or losses from the sale of asset groups are generally recorded in Restructuring and other charges while the sale of individual assets are recorded in Other expense (income), net (see policy below for assets classified as held for sale and discontinued operations). Repairs and maintenance are charged to expense as incurred. Interest related to the construction of qualifying assets is capitalized as part of the construction costs. +59 +Table of Contents +Properties, plants, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is calculated as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a discounted cash flow (DCF) model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of the assets also require significant judgments. See Note N for further information. +Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. +Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Arconic had eight reporting units for 2017 and 2016, of which four were included in the Engineered Products and Solutions segment (Arconic Fastening Systems and Rings, Arconic Power and Propulsion, Arconic Forgings and Extrusions, and Arconic Titanium and Engineered Products), three were included in the Transportation and Construction Solutions segment (Arconic Wheel and Transportation Products, Building and Construction Systems, and Latin America Extrusions), and the remaining reporting unit was the Global Rolled Products segment. +In January 2018, management changed the organizational structure of the businesses in the Engineered Products and Solutions segment from four business units to three business units with a focus on aligning its internal structure to core markets and customers and reducing cost. As a result, management assessed and concluded that each of the three new business units (Arconic Fastening Systems (AFS), Arconic Engines (AEN), and Arconic Engineered Structures (AES)) represent reporting units for goodwill impairment evaluation purposes. Goodwill was reallocated to the three new reporting units and both the historical and new Engineered Products and Solutions reporting units were evaluated for impairment during the first quarter of 2018. The estimated fair value of each reporting unit substantially exceeded its carrying value; thus, there was no goodwill impairment. In April 2018, Arconic completed the sale of its Latin America extrusions business and, therefore, it is no longer a reporting unit for the Company. More than 90% of Arconic’s total goodwill at December 31, 2018 was allocated to the three Engineered Products and Solutions reporting units: AEN ( $2,065 ), AFS ( $1,607 ), and AES ( $507 ). +In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (greater than 50% ) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. +Arconic determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Arconic’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three -year period. +Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent quantitative impairment test completed for a reporting unit and compares the weighted average cost of capital (WACC) between the current and prior years for each reporting unit. +During the 2018 annual review of goodwill, management proceeded directly to the quantitative impairment test for all six of its reporting units. The estimated fair values for each of the six reporting units exceeded their respective carrying values by more than 25%, thus, there was no goodwill impairment. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Arconic uses a +60 +Table of Contents +discounted cash flow model (DCF) to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. Arconic would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit. +In connection with the interim impairment evaluation of long-lived assets for the disks operations (an asset group within the AEN business unit) in the second quarter of 2018, which resulted from a decline in forecasted financial performance for the business in connection with its updated three-year strategic plan, the Company also performed an interim impairment evaluation of goodwill for the AEN reporting unit. The estimated fair value of the reporting unit was substantially in excess of the carrying value; thus, there was no impairment of goodwill. +Goodwill impairment tests in 2017 and 2016 indicated that goodwill was not impaired for any of the Company’s reporting units, except for the Arconic Forgings and Extrusions (AFE) business whose estimated fair value was lower than its carrying value. As such, Arconic recorded an impairment for the full amount of goodwill in the AFE reporting unit of $719 . The decrease in the AFE fair value was primarily due to unfavorable performance that was impacting operating margins and a higher discount rate due to an increase in the risk-free rate of return, while the carrying value increased compared to prior year. +Other Intangible Assets. Intangible assets with indefinite useful lives are not amortized while intangible assets with finite useful lives are amortized generally on a straight-line basis over the periods benefited. The following table details the weighted-average useful lives of software and other intangible assets by reporting segment (numbers in years): +Software +Other intangible assets +Engineered Products and Solutions +5 +33 +Global Rolled Products +5 +9 +Transportation and Construction Solutions +5 +16 +Revenue Recognition. The Company's contracts with customers are comprised of acknowledged purchase orders incorporating the Company’s standard terms and conditions, or for larger customers, may also generally include terms under negotiated multi-year agreements. These contracts with customers typically consist of the manufacture of products which represent single performance obligations that are satisfied upon transfer of control of the product to the customer. The Company produces fastening systems; seamless rolled rings; investment castings, including airfoils and forged jet engine components; extruded, machined and formed aircraft parts; aluminum sheet and plate; integrated aluminum structural systems; architectural extrusions; and forged aluminum commercial vehicle wheels. Transfer of control is assessed based on alternative use of the products we produce and our enforceable right to payment for performance to date under the contract terms. Transfer of control and revenue recognition generally occur upon shipment or delivery of the product, which is when title, ownership and risk of loss pass to the customer and is based on the applicable shipping terms. The shipping terms vary across all businesses and depend on the product, the country of origin, and the type of transportation (truck, train, or vessel). An invoice for payment is issued at time of shipment. The Company’s objective is to have net 30 -day terms. Our business units set commercial terms on which Arconic sells products to its customers. These terms are influenced by industry custom, market conditions, product line (specialty versus commodity products), and other considerations. +In certain circumstances, Arconic receives advanced payments from its customers for product to be delivered in future periods. These advanced payments are recorded as deferred revenue until the product is delivered and title and risk of loss have passed to the customer in accordance with the terms of the contract. Deferred revenue is included in Other current liabilities and Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. +Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future revenues, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery. Claims for recovery are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Arconic has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations. +Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is +61 +Table of Contents +deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss. +Income Taxes. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Arconic’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset Global Intangible Low Taxed Income (GILTI) income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. +Stock-Based Compensation. Arconic recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. +Foreign Currency. The local currency is the functional currency for Arconic’s significant operations outside the United States, except for certain operations in Canada and Russia, where the U.S. dollar is used as the functional currency. The determination of the functional currency for Arconic’s operations is made based on the appropriate economic and management indicators. +Acquisitions. Arconic’s business acquisitions are accounted for using the acquisition method. The purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. Any excess purchase price over the fair value of the net assets acquired is recorded as goodwill. For all acquisitions, operating results are included in the Statement of Consolidated Operations from the date of the acquisition. +62 +Table of Contents +Discontinued Operations and Assets Held for Sale. For those businesses where management has committed to a plan to divest, each business is valued at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, an impairment loss is recognized. Fair value is estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements. Depreciation and amortization expense is not recorded on assets of a business to be divested once they are classified as held for sale. Businesses to be divested are generally classified in the Consolidated Financial Statements as either discontinued operations or held for sale. +For businesses classified as discontinued operations, the balance sheet amounts and results of operations are reclassified from their historical presentation to assets and liabilities of discontinued operations on the Consolidated Balance Sheet and to discontinued operations on the Statement of Consolidated Operations, respectively, for all periods presented. The gains or losses associated with these divested businesses are recorded in discontinued operations on the Statement of Consolidated Operations. The Statement of Consolidated Cash Flows is not required to be reclassified for discontinued operations for any period. Segment information does not include the assets or operating results of businesses classified as discontinued operations for all periods presented. These businesses are expected to be disposed of within one year . +For businesses classified as held for sale that do not qualify for discontinued operations treatment, the balance sheet and cash flow amounts are reclassified from their historical presentation to assets and liabilities of operations held for sale for all periods presented. The results of operations continue to be reported in continuing operations. The gains or losses associated with these divested businesses are recorded in Restructuring and other charges on the Statement of Consolidated Operations. The segment information includes the assets and operating results of businesses classified as held for sale for all periods presented. +Recently Adopted Accounting Guidance. In May 2014, the FASB issued changes to the recognition of revenue from contracts with customers. These changes created a comprehensive framework for all entities in all industries to apply in the determination of when to recognize revenue and, therefore, supersede virtually all existing revenue recognition requirements and guidance. This framework is expected to result in less complex guidance in application while providing a consistent and comparable methodology for revenue recognition. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve this principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract(s), (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract(s), and (v) recognize revenue when, or as, the entity satisfies a performance obligation. These changes became effective for Arconic on January 1, 2018. Arconic adopted this new guidance using the modified retrospective transition approach applied to those contracts that were not completed as of January 1, 2018. There was no cumulative effect adjustment to the opening balance of retained earnings in the Consolidated Balance Sheet in 2018, as the adoption did not result in a change to our timing of revenue recognition, which continues to be at a point in time. See the Revenue Recognition policy above. +In January 2016, the FASB issued changes to equity investments. These changes require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values using the measurement alternative of cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer. Also, the impairment assessment of equity investments without readily determinable fair values has been simplified by requiring a qualitative assessment to identify impairment. Also, the new guidance required changes in fair value of equity securities to be recognized immediately as a component of net income instead of being reported in accumulated other comprehensive loss until the gain (loss) is realized. These changes became effective for Arconic on January 1, 2018 and have been applied on a prospective basis. Arconic elected the measurement alternative for its equity investments that do not have readily determinable fair values. The adoption of this guidance did not have a material impact on the Consolidated Financial Statements. +In August 2016, the FASB issued changes to the classification of certain cash receipts and cash payments within the statement of cash flows. The guidance identifies eight specific cash flow items and the sections where they must be presented within the statement of cash flows. These changes became effective for Arconic on January 1, 2018 and have been be applied retrospectively. As a result of the adoption, Arconic reclassified cash received related to beneficial interest in previously transferred trade accounts receivable from operating activities to investing activities in the Statement of Consolidated Cash Flows. This new accounting standard does not reflect a change in our underlying business or activities. The reclassification of cash received related to beneficial interest in previously transferred trade accounts receivable was $792 and $778 for 2017 and +63 +Table of Contents +2016 , respectively. In addition, Arconic reclassified $52 and $3 of cash paid for debt prepayments including extinguishment costs from operating activities to financing activities for 2017 and 2016 , respectively. +In November 2016, the FASB issued changes to the classification of cash and cash equivalents within the statement of cash flow. Restricted cash and cash equivalents will be included within the cash and cash equivalents line on the cash flow statement and a reconciliation must be prepared to the statement of financial position. Transfers between restricted cash and cash equivalents and cash and cash equivalents will no longer be presented as cash flow activities in the Statement of Consolidated Cash Flows and for material balances of restricted cash and cash equivalents, Arconic will disclose information regarding the nature of the restrictions. These changes became effective for Arconic on January 1, 2018 and have been applied retrospectively. Management has determined that the adoption of this guidance did not have a material impact on the Statement of Consolidated Cash Flows. Restricted cash was $6 , $4 , and $15 in 2018 , 2017 , and 2016 , respectively. +In March 2017, the FASB issued changes to the presentation of net periodic pension cost and net periodic postretirement benefit cost. The new guidance requires registrants to present the service cost component of net periodic benefit cost in the same income statement line item or items as other employee compensation costs arising from services rendered during the period. Also, only the service cost component will be eligible for asset capitalization. Registrants will present the other components of net periodic benefit cost separately from the service cost component; and, the line item or items used in the income statement to present the other components of net periodic benefit cost must be disclosed. These changes became effective for Arconic on January 1, 2018 and were adopted retrospectively for the presentation of the service cost component and the other components of net periodic benefit cost in the Statement of Consolidated Operations, and prospectively for the asset capitalization of the service cost component of net periodic benefit cost. The Company recorded the service related net periodic benefit cost within Cost of goods sold, Selling, general administrative, and other expenses and Research and development expenses and recorded the non-service related net periodic benefit cost (except for the curtailment cost which was recorded in Restructuring and other charges ) separately from service cost in Other expense (income), net within the Statement of Consolidated Operations. The impact of the retrospective adoption of this guidance was an increase to consolidated Operating income of $154 and $135 , while there was no impact to consolidated Net income, for 2017 and 2016 , respectively. +In May 2017, the FASB issued clarification to guidance on the modification accounting criteria for share-based payment awards. The new guidance requires registrants to apply modification accounting unless three specific criteria are met. The three criteria are 1) the fair value of the award is the same before and after the modification, 2) the vesting conditions are the same before and after the modification and 3) the classification as a debt or equity award is the same before and after the modification. These changes became effective for Arconic on January 1, 2018 and were applied prospectively to new awards modified after adoption. The adoption of this guidance did not have a material impact on the Consolidated Financial Statements. +In February 2018, the FASB issued guidance that allows an optional reclassification from Accumulated other comprehensive loss to Accumulated deficit for stranded tax effects resulting from the Tax Cuts and Jobs Act enacted on December 22, 2017. Stranded tax effects were created when deferred taxes, originally established in Other comprehensive income at 35%, were revalued to 21% as a component of income tax expense from continuing operations. The Company elected to early adopt this provision in the fourth quarter of 2018 and reclassified $367 of beneficial stranded tax effects in Accumulated other comprehensive loss to Accumulated deficit in its Consolidated Balance Sheet and Statement of Changes in Consolidated Equity. +In August 2018, the FASB issued guidance which requires cloud computing arrangement implementation costs to be accounted for in accordance with the software stage model, regardless of whether or not the cloud computing arrangement contains a license. Arconic adopted this guidance in the third quarter of 2018. The adoption of this guidance did not have a material impact on the Consolidated Financial Statements. +Also, in August 2018, the Securities and Exchange Commission (SEC) issued guidance to eliminate or modify certain disclosure requirements that have become redundant, overlapping, outdated or superseded in light of other SEC rules, GAAP or changes in the information environment. This guidance became effective on November 5, 2018 and will be applied to filings thereafter. The adoption of this guidance did not have a material impact on the Consolidated Financial Statements. +Recently Issued Accounting Guidance. In February 2016, the FASB issued changes to the accounting and presentation of leases. These changes require lessees to recognize a right of use asset and lease liability on the balance sheet for all leases with terms longer than 12 months. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize a right of use asset and lease liability. Also, when measuring assets and liabilities arising from a lease, optional payments should be included only if the lessee is reasonably certain to exercise an option to extend the lease, exercise a purchase option, or not exercise an option to terminate the lease. As originally released, the standards update required application at the beginning of the earliest comparative period presented at the time of adoption. However, in July 2018, the FASB provided entities the option to instead apply the provisions of the new leases guidance at the effective date, without adjusting the comparative periods presented. The Company expects to apply the provisions of the new +64 +Table of Contents +leases guidance at the effective date, without adjusting the comparative periods presented. These changes became effective for Arconic on January 1, 2019. +Arconic’s current operating lease portfolio is primarily comprised of land and buildings, plant equipment, vehicles, and computer equipment. A cross-functional implementation team has determined the scope of arrangements that will be subject to this standard and continues to assess the impact to the Company’s systems, processes and internal controls. Arconic has contracted with a third-party vendor to implement a software solution. Concurrently, Arconic has been compiling and uploading lease data into the software solution to account for leases under the new standard. Management continues to evaluate the impact of these changes on the Consolidated Balance Sheet, which will require right of use assets and lease liabilities be recorded for operating leases. Arconic anticipates the impact of adoption on January 1, 2019 will result in a right of use asset and total lease liability related to operating leases in the range of $300 to $340 , while the accounting for capital leases will remain unchanged. The adoption is not expected to have a material impact on the Statement of Consolidated Operations or Statement of Consolidated Cash Flows. +In June 2016, the FASB added a new impairment model (known as the current expected credit loss (CECL) model) that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses. The CECL model applies to most debt instruments, trade receivables, lease receivables, financial guarantee contracts, and other loan commitments. The CECL model does not have a minimum threshold for recognition of impairment losses and entities will need to measure expected credit losses on assets that have a low risk of loss. These changes become effective for Arconic on January 1, 2020. Management is currently evaluating the potential impact of these changes on the Consolidated Financial Statements. +In August 2017, the FASB issued guidance that will make more financial and nonfinancial hedging strategies eligible for hedge accounting. It also amends the presentation and disclosure requirements and changes how companies assess effectiveness. It is intended to more closely align hedge accounting with companies’ risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. These changes became effective for Arconic on January 1, 2019. For cash flow and net investment hedges existing at the date of adoption, Arconic will apply a cumulative-effect adjustment related to eliminating the separate measurement of ineffectiveness to Accumulated other comprehensive loss with a corresponding adjustment to the opening balance of Accumulated deficit as of the beginning of the fiscal year in which the amendment is adopted. The amended presentation and disclosure guidance is required only prospectively. Arconic has engaged a third-party consultant to assist with a review of the Company’s risk management and hedging strategies, with any changes to be implemented in conjunction with the adoption of the new guidance. Under the new guidance, Management expects to utilize cash flow hedge accounting of its variable priced purchases and sales. Management determined that the adoption of this guidance will not have a material impact on the Consolidated Financial Statements. +In August 2018, the FASB issued guidance that impacts disclosures for defined benefit pension plans and other postretirement benefit plans. These changes become effective for Arconic's annual report for the year ending December 31, 2020, with early adoption permitted. Management has determined that the adoption of this guidance will not have a material impact on the Consolidated Financial Statements. 20. +65 +Table of Contents +B. Revenue from Contracts with Customers +The following table disaggregates revenue by major end market served. Differences between segment totals and consolidated Arconic are in Corporate. In 2018, Corporate included $38 of costs related to settlements of certain customer claims primarily related to product introductions. +For the year ended December 31, +Engineered +Products and +Solutions +Global Rolled +Products +Transportation +and Construction +Solutions +Total +Segment +2018 +Aerospace +$ +4,947 +$ +891 +$ +— +$ +5,838 +Transportation +440 +2,443 +969 +3,852 +Building and construction +— +217 +1,150 +1,367 +Industrial and Other +929 +2,053 +7 +2,989 +Total end-market revenue +$ +6,316 +$ +5,604 +$ +2,126 +$ +14,046 +2017 +Aerospace +$ +4,572 +$ +883 +$ +— +$ +5,455 +Transportation +383 +1,981 +805 +3,169 +Building and construction +— +204 +1,113 +1,317 +Industrial and Other +988 +1,932 +93 +3,013 +Total end-market revenue +$ +5,943 +$ +5,000 +$ +2,011 +$ +12,954 +2016 +Aerospace +$ +4,358 +$ +942 +$ +— +$ +5,300 +Transportation +347 +1,577 +708 +2,632 +Building and construction +— +200 +1,060 +1,260 +Industrial and Other +1,023 +2,146 +34 +3,203 +Total end-market revenue +$ +5,728 +$ +4,865 +$ +1,802 +$ +12,395 +C. Segment and Geographic Area Information +Arconic is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging. Arconic’s segments are organized by product on a worldwide basis. In the first quarter of 2018, the Company changed its primary measure of segment performance from Adjusted earnings before interest, tax, depreciation, and amortization (“Adjusted EBITDA”) to Segment operating profit, which more closely aligns segment performance with Operating income as presented in the Statement of Consolidated Operations. Segment performance under Arconic’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Arconic’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and other charges and Impairment of goodwill. Segment operating profit also includes certain items that, under the previous segment performance measure, were recorded in Corporate, such as the impact of LIFO inventory accounting, metal price lag, intersegment profit eliminations, and derivative activities. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Arconic are in Corporate. Prior period financial information has been recast to conform to current year presentation. +The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies (see Note A ). Transactions among segments are established based on negotiation among the parties. Differences between segment totals and Arconic’s consolidated totals for line items not reconciled are in Corporate. +Arconic’s operations consist of three worldwide reportable segments as follows: +Engineered Products and Solutions. This segment produces products that are used primarily in the aerospace (commercial and defense), industrial, commercial transportation, and power generation end markets. Such products include fastening systems (titanium, steel, and nickel superalloys); seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils and forged jet engine components (e.g., jet engine disks); and extruded, +66 +Table of Contents +machined and formed aircraft parts (titanium and aluminum), all of which are sold directly to customers and through distributors. More than 75% of the third-party sales in this segment are from the aerospace end market. A small part of this segment also produces various forged, extruded, and machined metal products (titanium, aluminum and steel) for the oil and gas, automotive, and land and sea defense end markets. Seasonal decreases in sales are generally experienced in the third quarter of the year due to the European summer slowdown across all end markets. +Global Rolled Products. This segment produces aluminum sheet and plate for a variety of end markets. Sheet and plate is sold directly to customers and through distributors related to the aerospace, automotive, commercial transportation, packaging, building and construction, and industrial products (mainly used in the production of machinery and equipment and consumer durables) end markets. A small portion of this segment also produces aseptic foil for the packaging end market. While the customer base for flat-rolled products is large, a significant amount of sales of sheet and plate is to a relatively small number of customers. +Transportation and Construction Solutions. This segment produces products that are used mostly in the commercial transportation and nonresidential building and construction end markets. Such products include integrated aluminum structural systems, architectural extrusions, and forged aluminum commercial vehicle wheels, which are sold both directly to customers and through distributors. A small part of this segment also produces aluminum products for the industrial products end market. +67 +Table of Contents +The operating results and assets of Arconic’s reportable segments were as follows: +Engineered Products and Solutions +Global Rolled Products +Transportation and Construction Solutions +Total +2018 +Sales: +Third-party sales +$ +6,316 +$ +5,604 +$ +2,126 +$ +14,046 +Intersegment sales +— +160 +— +160 +Total sales +$ +6,316 +$ +5,764 +$ +2,126 +$ +14,206 +Profit and loss: +Segment operating profit +$ +891 +$ +386 +$ +304 +$ +1,581 +Restructuring and other charges +71 +(156 +) +1 +(84 +) +Provision for depreciation and amortization +282 +212 +50 +544 +2017 +Sales: +Third-party sales +$ +5,943 +$ +5,000 +$ +2,011 +$ +12,954 +Intersegment sales +— +148 +— +148 +Total sales +$ +5,943 +$ +5,148 +$ +2,011 +$ +13,102 +Profit and loss: +Segment operating profit +$ +964 +$ +424 +$ +290 +$ +1,678 +Restructuring and other charges +30 +72 +52 +154 +Provision for depreciation and amortization +268 +205 +50 +523 +2016 +Sales: +Third-party sales +$ +5,728 +$ +4,865 +$ +1,802 +$ +12,395 +Intersegment sales +— +118 +— +118 +Total sales +$ +5,728 +$ +4,983 +$ +1,802 +$ +12,513 +Profit and loss: +Segment operating profit +$ +955 +$ +421 +$ +246 +$ +1,622 +Restructuring and other charges +78 +40 +14 +132 +Provision for depreciation and amortization +255 +201 +48 +504 +2018 +Assets: +Capital expenditures +$ +349 +$ +255 +$ +111 +$ +715 +Goodwill +4,179 +245 +76 +4,500 +Total assets +10,346 +3,934 +1,089 +15,369 +2017 +Assets: +Capital expenditures +$ +308 +$ +178 +$ +57 +$ +543 +Goodwill +4,205 +252 +78 +4,535 +Total assets +10,325 +3,955 +1,041 +15,321 +The following tables reconcile certain segment information to consolidated totals: +For the year ended December 31, +2018 +2017 +2016 +Sales: +Total segment sales +$ +14,206 +$ +13,102 +$ +12,513 +Elimination of intersegment sales +(160 +) +(148 +) +(118 +) +Corporate +(32 +) +6 +(1 +) +Consolidated sales +$ +14,014 +$ +12,960 +$ +12,394 +68 +Table of Contents +For the year ended December 31, +2018 +2017 +2016 +Total segment operating profit +$ +1,581 +$ +1,678 +$ +1,622 +Unallocated amounts: +Impairment of goodwill +— +(719 +) +— +Restructuring and other charges +(9 +) +(165 +) +(155 +) +Corporate expense +(247 +) +(314 +) +(513 +) +Consolidated operating income +$ +1,325 +$ +480 +$ +954 +Interest expense +(378 +) +(496 +) +(499 +) +Other (expense) income, net +(79 +) +486 +(41 +) +Consolidated income before income taxes +$ +868 +$ +470 +$ +414 +December 31, +2018 +2017 +Assets: +Total segment assets +$ +15,369 +$ +15,321 +Unallocated amounts: +Cash and cash equivalents +2,277 +2,150 +Deferred income taxes +573 +743 +Corporate fixed assets, net +305 +310 +Fair value of derivative contracts +37 +91 +Other +132 +103 +Consolidated assets +$ +18,693 +$ +18,718 +Sales by major product grouping were as follows: +For the year ended December 31, +2018 +2017 +2016 +Sales: +Innovative flat-rolled products +$ +5,588 +$ +4,992 +$ +4,864 +Engines +2,940 +2,708 +2,560 +Engineered structures +1,839 +1,743 +1,683 +Fastening systems +1,531 +1,484 +1,463 +Architectural aluminum systems +1,140 +1,065 +1,010 +Aluminum wheels +969 +805 +689 +Other +7 +163 +125 +$ +14,014 +$ +12,960 +$ +12,394 +Geographic information for sales was as follows (based upon the country where the point of sale occurred): +For the year ended December 31, +2018 +2017 +2016 +Sales: +United States +$ +9,137 +$ +8,167 +$ +7,823 +France +936 +965 +930 +Hungary +823 +739 +619 +United Kingdom +737 +721 +711 +China +632 +615 +582 +Russia +553 +500 +433 +Germany +302 +309 +284 +Canada +285 +261 +262 +Brazil +214 +285 +250 +Japan +170 +141 +145 +Other +225 +257 +355 +$ +14,014 +$ +12,960 +$ +12,394 +69 +Table of Contents +Geographic information for long-lived assets was as follows (based upon the physical location of the assets): +December 31, +2018 +2017 +Long-lived assets: +United States +$ +4,148 +$ +4,005 +China +326 +347 +Hungary +257 +227 +Russia +253 +276 +United Kingdom +253 +259 +France +163 +159 +Germany +84 +88 +Canada +61 +63 +Brazil +54 +62 +Other +105 +108 +$ +5,704 +$ +5,594 +D. Restructuring and Other Charges +Restructuring and other charges for each year in the three-year period ended December 31, 2018 were comprised of the following: +2018 +2017 +2016 +Asset impairments +$ +13 +$ +58 +$ +80 +Layoff costs +20 +64 +68 +Pension and Other postretirement benefits - net settlement and curtailment charges +91 +— +2 +Net (gain) loss on divestitures of assets and businesses ( T ) +(109 +) +57 +3 +Other +13 +(3 +) +27 +Reversals of previously recorded layoff costs +(19 +) +(11 +) +(25 +) +Restructuring and other charges +$ +9 +$ +165 +$ +155 +Layoff costs were recorded based on approved detailed action plans submitted by the operating locations that specified positions to be eliminated, benefits to be paid under existing severance plans, union contracts or statutory requirements, and the expected timetable for completion of the plans. +2018 Actions . In 2018, Arconic recorded Restructuring and other charges of $9 ( $9 after-tax), which included a net gain on the sale of several assets and businesses of $109 ( $81 after-tax), primarily made up of a gain on the asset sale of Texarkana of $154 ( $119 after-tax) and loss on the sale of the Eger, Hungary forgings business of $43 ( $39 after-tax) (see note T ); charges of $96 ( $75 after-tax) for pension settlement and $23 ( $18 after-tax) for pension curtailment; a postretirement curtailment benefit of $28 ( $22 after-tax) (see note G ); and a charge of $20 ( $17 after-tax) for layoff costs, including the separation of approximately 125 employees ( 89 in the Engineered Products and Solutions segment and 36 in Corporate); a charge of $12 ( $9 after-tax) for contract termination costs and asset impairments associated with the shutdown of a facility in Acuna, Mexico; a charge of $6 ( $4 after-tax) for contract termination costs related to the New York office; a charge of $8 ( $4 after-tax) for other miscellaneous items including accelerated depreciation and asset impairments; and a benefit of $19 ( $15 after-tax) for the reversal of a number of layoff reserves related to prior periods. +As of December 31, 2018 , approximately 110 of the 125 employees were separated. The remaining separations for 2018 restructuring programs are expected to be completed by the end of 2019. In 2018 , cash payments of $9 were made against layoff reserves related to the 2018 restructuring programs. +2017 Actions . In 2017, Arconic recorded Restructuring and other charges of $165 ( $143 after-tax), which were comprised of the following components: $69 ( $47 after-tax) for layoff costs related to cost reduction initiatives including the separation of approximately 880 employees ( 400 in the Engineered Products and Solutions segment, 245 in the Global Rolled Products segment, 135 in the Transportation and Construction Solutions segment, and 100 in Corporate), a charge of $60 ( $60 after-tax) related to the sale of the Fusina, Italy rolling mill; a charge of $41 ( $41 after-tax) for the impairment of assets associated with the sale of the Latin America extrusions business (see Note T ); a net benefit of $6 ( $4 after-tax) for the reversal of forfeited executive stock compensation of $13 , partially offset by a charge of $7 for the related severance; a net charge of $12 ( $7 after- +70 +Table of Contents +tax) for other miscellaneous items; and a favorable benefit of $11 ( $8 after-tax) for the reversal of a number of small layoff reserves related to prior periods. +As of December 31, 2018 , approximately 570 of the 660 employees (previously 760 ) were separated. The total number of employees associated with 2017 restructuring programs was updated to reflect employees, who were initially identified for separation, accepting other positions within Arconic and natural attrition. The remaining separations for 2017 restructuring programs are expected to be completed by the end of 2019. In 2018 and 2017 , cash payments of $34 and $28 , respectively, were made against layoff reserves related to 2017 restructuring programs. +2016 Actions. In 2016, Arconic recorded Restructuring and other charges of $155 ( $114 after-tax), which were comprised of the following components: $57 ( $46 after-tax) for costs related to the exit of certain legacy Firth Rixson operations in the U.K.; $37 ( $24 after-tax) for exit costs related to the decision to permanently shut down a can sheet facility; $20 ( $14 after-tax) for costs related to the closures of five facilities, primarily in the Transportation and Construction Solutions segment and Engineered Products and Solutions segment, including the separation of approximately 280 employees; $53 ( $33 after-tax) for other layoff costs, including the separation of approximately 1,315 employees ( 1,045 in the Engineered Products and Solutions segment, 210 in Corporate, 30 in the Global Rolled Products segment, and 30 in the Transportation and Construction Solutions segment); $11 ( $8 after-tax) for other miscellaneous items, including $3 ( $2 after-tax) for the sale of Remmele Medical, an RTI subsidiary; $2 ( $1 after-tax) for a pension settlement; and $25 ( $12 after-tax) for the reversal of a number of small layoff reserves related to prior periods. +In 2016, management made the decision to exit certain legacy Firth Rixson facilities in the U.K. Costs related to these actions included asset impairments and accelerated depreciation of $51 ; other exit costs of $4 ; and $2 for the separation of 60 employees. +Also in 2016, management approved the shutdown and demolition of the can sheet facility in Tennessee upon completion of the Toll Processing and Services Agreement with Alcoa Corporation. Costs related to this action included $21 in asset impairments; $9 in other exit costs; and $7 for the separation of 145 employees. The other exit costs of $9 represent $4 in asset retirement obligations and $3 in environmental remediation, both of which were triggered by the decision to permanently shut down and demolish the can sheet facility in Tennessee, and $2 in other exit costs. +As of December 31, 2018 , the separations associated with the 2016 restructuring programs were essentially complete. In 2018 , 2017 , and 2016 , cash payments of $4 , $26 , and $16 , respectively, were made against layoff reserves related to 2016 restructuring programs. +Activity and reserve balances for restructuring charges were as follows: +Layoff +costs +Other +exit costs +Total +Reserve balances at December 31, 2015 +$ +84 +$ +9 +$ +93 +2016 +Cash payments +(73 +) +(13 +) +(86 +) +Restructuring charges +70 +27 +97 +Other (1) +(31 +) +(14 +) +(45 +) +Reserve balances at December 31, 2016 +$ +50 +$ +9 +$ +59 +2017 +Cash payments +$ +(59 +) +$ +(6 +) +$ +(65 +) +Restructuring charges +64 +1 +65 +Other (2) +1 +(2 +) +(1 +) +Reserve balances at December 31, 2017 +$ +56 +$ +2 +$ +58 +2018 +Cash payments +$ +(47 +) +$ +(2 +) +$ +(49 +) +Restructuring charges +111 +13 +124 +Other (3) +(110 +) +2 +(108 +) +Reserve balances at December 31, 2018 +$ +10 +$ +15 +$ +25 +(1) +In 2016, Other for layoff costs included reversals of previously recorded restructuring charges of $25 , effects of foreign currency translation and other of $4 , and a reclassification of $2 in pension costs, as the impact was reflected in Arconic’s separate liability for Accrued pension benefits. Other for other exit costs included reclassifications of $8 in asset retirement and $2 in environmental obligations, as the impacts were reflected in Arconic’s separate liabilities +71 +Table of Contents +for asset retirement obligations and environmental remediation, and a reclassification of $4 in legal obligations, as the impact was included in Arconic’s separate liability for legal costs. +(2) +In 2017, Other for layoff costs included a reclassification of a stock awards reversal of $13 , offset by reversals of previously recorded restructuring charges of $11 and foreign currency translation of $1 . +(3) +In 2018, Other for layoff costs included reclassifications of $119 in pension costs and a $28 credit in postretirement benefits, as the impacts were reflected in Arconic's separate liabilities for Accrued pension benefits and Accrued postretirement benefits, and reversals of previously recorded restructuring charges of $19 . +The remaining reserves are expected to be paid in cash during 2019, with the exception of approximately $5 to $7 , which is expected to be paid over the next several years for lease termination costs. +E. Interest Cost Components +For the year ended December 31, +2018 +2017 +2016 +Amount charged to expense +$ +378 +$ +496 +$ +499 +Amount capitalized +23 +22 +32 +$ +401 +$ +518 +$ +531 +F. Other Expense (Income), Net +For the year ended December 31, +2018 +2017 +2016 +Non-service related net periodic benefit cost +$ +112 +$ +154 +$ +135 +Interest income +(23 +) +(19 +) +(16 +) +Foreign currency losses (gains), net +26 +(5 +) +(4 +) +Net loss (gain) from asset sales +10 +(513 +) +11 +Other, net +(46 +) +(103 +) +(85 +) +$ +79 +$ +(486 +) +$ +41 +In 2018, Non-service related net periodic benefit cost included lower net actuarial losses as a result of pension actions taken during 2018 (see Note G ) and Other, net included a benefit from establishing a tax indemnification receivable of $29 reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve (see Note U ). In 2017, Net loss (gain) from asset sales included a gain on the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $351 (see Note V ) and a gain of $167 on the Debt-for-Equity Exchange (see Note V ). In 2017, Other, net included an adjustment of $81 to the contingent earn-out liability related to the 2014 acquisition of Firth Rixson (see Note T ) and an adjustment of $25 associated with a separation-related guarantee liability (see Note U ). In 2016, Non-service related net periodic benefit cost included a reduction of the recognition of actuarial losses and a methodology change in the calculation of interest cost, which were partially offset by the reduction in the expected return on plan assets. In 2016, Other, net included an adjustment of $56 to the contingent earn-out liability and a post-closing adjustment of $20 , both related to the acquisition of Firth Rixson. +72 +Table of Contents +G. Pension and Other Postretirement Benefits +Arconic maintains pension plans covering most U.S. employees and certain employees in foreign locations. Pension benefits generally depend on length of service, job grade, and remuneration. Substantially all benefits are paid through pension trusts that are sufficiently funded to ensure that all plans can pay benefits to retirees as they become due. Most salaried and non-bargaining hourly U.S. employees hired after March 1, 2006 participate in a defined contribution plan instead of a defined benefit plan. +Arconic also maintains health care and life insurance postretirement benefit plans covering eligible U.S. retired employees and certain retirees from foreign locations. Generally, the medical plans are unfunded and pay a percentage of medical expenses, reduced by deductibles and other coverage. Life benefits are generally provided by insurance contracts. Arconic retains the right, subject to existing agreements, to change or eliminate these benefits. All salaried and certain non-bargaining hourly U.S. employees hired after January 1, 2002 and certain bargaining hourly U.S. employees hired after July 1, 2010 are not eligible for postretirement health care benefits. All salaried and certain hourly U.S. employees that retire on or after April 1, 2008 are not eligible for postretirement life insurance benefits. +Effective January 1, 2015, Arconic no longer offers postretirement health care benefits to Medicare-eligible, primarily non-bargaining, U.S. retirees through Company-sponsored plans. Qualifying retirees (hired prior to January 1, 2002), both current and future, may access these benefits in the marketplace by purchasing coverage directly from insurance carriers. +In the first quarter of 2018, the Company announced that, effective April 1, 2018, benefit accruals for future service and compensation under all of the Company's qualified and non-qualified defined benefit pension plans for U.S. salaried and non-bargaining hourly employees ceased. As a result of this change, in the first quarter of 2018, the Company recorded a decrease to the Accrued pension benefits liability of $136 related to the reduction of future benefits, $141 offset in Accumulated other comprehensive loss, and curtailment charges of $5 in Restructuring and other charges. +On April 13, 2018, the United Auto Workers ratified a new five -year labor agreement, covering approximately 1,300 U.S. employees of Arconic, which expires on March 31, 2023. A provision within the agreement includes a retirement benefit increase for future retirees that participate in a defined benefit pension plan, which impacts approximately 300 of those employees. In addition, effective January 1, 2019, benefit accruals for future service will cease. As result of these changes, a curtailment charge of $9 was recorded in Restructuring and other charges in the second quarter of 2018. +In the third quarter of 2018, the Company announced that effective December 31, 2018, it will end all pre-Medicare medical, prescription drug and vision coverage for current and future salaried and non-bargained hourly employees and retirees of the Company and its subsidiaries. As a result of this change, in the third quarter of 2018, the Company recorded a decrease to the Accrued other postretirement benefits liability of $32 related to the reduction of future benefits, $4 offset in Accumulated other comprehensive loss, and a curtailment benefit of $28 in Restructuring and other charges. +In the fourth quarter, the company communicated to plan participants that effective in the first quarter of 2019, benefit accruals for future service and compensation for employees in the United Kingdom defined benefit pension plans will cease. The plan curtailment resulted in a $13 decrease in the Accrued pension benefits liability which was offset in Accumulated other comprehensive loss. Additionally, on October 29, 2018, the United Kingdom High Court ruled that defined benefit pension plans offering Guaranteed Minimum Pensions must review benefits accrued between May 1990 to April 1997 to ensure gender pay equality. The review resulted in an increase to the Accrued pension benefits liability of $9 and a corresponding curtailment charge that was recorded in Restructuring and other charges. +In the third and fourth quarters of 2018, settlement accounting applied to certain U.S. pension plans due to lump sum payments to participants, resulting in settlement charges of $96 that were recorded in Restructuring and other charges. +73 +Table of Contents +The funded status of all of Arconic’s pension and other postretirement benefit plans are measured as of December 31 each calendar year. +Obligations and Funded Status +Pension benefits +Other +postretirement benefits +December 31, +2018 +2017 +2018 +2017 +Change in benefit obligation +Benefit obligation at beginning of year +$ +7,359 +$ +7,026 +$ +927 +$ +980 +Service cost +46 +90 +7 +7 +Interest cost +219 +234 +28 +30 +Amendments +18 +1 +(25 +) +— +Actuarial (gains) losses +(372 +) +311 +(51 +) +1 +Settlements +(146 +) +— +— +— +Curtailments +(154 +) +— +— +— +Benefits paid +(422 +) +(425 +) +(86 +) +(98 +) +Medicare Part D subsidy receipts +— +— +6 +7 +Foreign currency translation impact +(72 +) +122 +— +— +Benefit obligation at end of year (1) +$ +6,476 +$ +7,359 +$ +806 +$ +927 +Change in plan assets (1) +Fair value of plan assets at beginning of year +$ +4,862 +$ +4,666 +$ +— +$ +— +Actual return on plan assets +(144 +) +212 +— +— +Employer contributions +298 +310 +— +— +Benefits paid +(397 +) +(404 +) +— +— +Administrative expenses +(33 +) +(33 +) +— +— +Settlements +(178 +) +— +— +— +Foreign currency translation impact +(74 +) +111 +— +— +Fair value of plan assets at end of year (1) +$ +4,334 +$ +4,862 +$ +— +$ +— +Net funded status +$ +(2,142 +) +$ +(2,497 +) +$ +(806 +) +$ +(927 +) +Amounts recognized in the Consolidated Balance Sheet consist of: +Noncurrent assets +$ +111 +$ +89 +$ +— +$ +— +Current liabilities +(23 +) +(22 +) +(83 +) +(86 +) +Noncurrent liabilities +(2,230 +) +(2,564 +) +(723 +) +(841 +) +Net amount recognized +$ +(2,142 +) +$ +(2,497 +) +$ +(806 +) +$ +(927 +) +Amounts recognized in Accumulated Other Comprehensive Loss consist of: +Net actuarial loss +$ +2,957 +$ +3,240 +$ +87 +$ +146 +Prior service cost (benefit) +3 +10 +(27 +) +(37 +) +Net amount recognized, before tax effect +$ +2,960 +$ +3,250 +$ +60 +$ +109 +Other changes in plan assets and benefit obligations recognized in Other Comprehensive Loss consist of: +Net actuarial (gain) loss +$ +(19 +) +$ +481 +$ +(52 +) +$ +1 +Amortization of accumulated net actuarial loss +(264 +) +(220 +) +(7 +) +(5 +) +Prior service cost (benefit) +19 +— +(25 +) +— +Amortization of prior service (cost) benefit +(26 +) +(5 +) +35 +8 +Net amount recognized, before tax effect +$ +(290 +) +$ +256 +$ +(49 +) +$ +4 +(1) +At December 31, 2018 , the benefit obligation, fair value of plan assets, and funded status for U.S. pension plans were $5,282 , $3,123 , and $(2,159) , respectively. At December 31, 2017 , the benefit obligation, fair value of plan assets, and funded status for U.S. pension plans were $6,018 , $3,544 , and $(2,474) respectively. +74 +Table of Contents +Pension Plan Benefit Obligations +Pension benefits +2018 +2017 +The projected benefit obligation and accumulated benefit obligation for all defined benefit pension plans was as follows: +Projected benefit obligation +$ +6,476 +$ +7,359 +Accumulated benefit obligation +6,444 +7,169 +The aggregate projected benefit obligation and fair value of plan assets for pension plans with projected benefit obligations in excess of plan assets was as follows: +Projected benefit obligation +5,435 +6,600 +Fair value of plan assets +3,182 +4,016 +The aggregate accumulated benefit obligation and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets was as follows: +Accumulated benefit obligation +5,415 +6,422 +Fair value of plan assets +3,179 +3,998 +Components of Net Periodic Benefit Cost +Pension benefits (1) +Other postretirement benefits (2) +For the year ended December 31, +2018 +2017 +2016 +2018 +2017 +2016 +Service cost +$ +46 +$ +90 +$ +155 +$ +7 +$ +7 +$ +13 +Interest cost +219 +234 +431 +28 +30 +63 +Expected return on plan assets +(306 +) +(332 +) +(677 +) +— +— +— +Recognized net actuarial loss +168 +220 +380 +7 +5 +24 +Amortization of prior service cost (benefit) +3 +5 +13 +(7 +) +(8 +) +(24 +) +Settlements (3) +96 +— +19 +— +— +— +Curtailments (4) +23 +— +— +(28 +) +— +— +Special termination benefits (5) +— +— +2 +— +— +— +Net periodic benefit cost (6) +$ +249 +$ +217 +$ +323 +$ +7 +$ +34 +$ +76 +Discontinued operations +— +— +122 +— +— +41 +Net amount recognized in Statement of Consolidated Operations +$ +249 +$ +217 +$ +201 +$ +7 +$ +34 +$ +35 +Note: +the footnotes below include components of Net Periodic Benefit Cost related to Alcoa Corporation through the completion of the Separation Transaction in 2016. +(1) +In 2018 , 2017 and 2016 , net periodic benefit cost for U.S. pension plans was $239 , $206 , and $261 , respectively. +(2) +In 2018 , 2017 and 2016 , net periodic benefit cost for other postretirement benefits reflects a reduction of $10 , $11 , and $22 , respectively, related to the recognition of the federal subsidy awarded under Medicare Part D. +(3) +In 2018 and 2016, settlements were due to workforce reductions (see Note D ) and the payment of lump sum benefits and/or purchases of annuity contracts. +(4) +In 2018, curtailments were due to a reduction of future benefits, resulting in the recognition of favorable and unfavorable plan amendments. +(5) +In 2016, special termination benefits were due to workforce reductions (see Note D ). +(6) +Amounts attributed to joint venture partners are not included. Service cost was included within Cost of goods sold, Selling, general administrative, and other expenses , and Research and development expenses ; curtailments and settlements were included in Restructuring and other charges; and all other cost components were recorded in Other expense (income), net in the Statement of Consolidated Operations. +75 +Table of Contents +Amounts Expected to be Recognized in Net Periodic Benefit Cost +Pension benefits +Other postretirement benefits +December 31, +2019 +2019 +Net actuarial loss recognition +$ +139 +$ +3 +Prior service cost (benefit) recognition +2 +(4 +) +Assumptions +Weighted average assumptions used to determine benefit obligations for U.S. pension and other postretirement benefit plans were as follows (assumptions for non-U.S. plans did not differ materially): +December 31, +2018 +2017 +Discount rate +4.35 +% +3.75 +% +Rate of compensation increase +3.50 +3.50 +Cash balance plan interest crediting rate +3.00 +3.00 +The discount rate is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have an average duration of 10 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. +The rate of compensation increase is based upon actual experience. For 2019 , the rate of compensation increase will be 3.5% , which approximates the five -year average. +Weighted average assumptions used to determine net periodic benefit cost for U.S. pension and other postretirement benefit plans were as follows (assumptions for non-U.S. plans did not differ materially): +2018 +2017 +2016 +Discount rate to calculate service cost (1) +3.75 +% +4.20 +% +4.29 +% +Discount rate to calculate interest cost (1) +3.30 +3.60 +3.15 +Expected long-term rate of return on plan assets +7.00 +7.75 +7.75 +Rate of compensation increase +3.50 +3.50 +3.50 +Cash balance plan interest crediting rate +3.00 +3.00 +3.00 +(1) +In all periods presented, the respective discount rates were used to determine net periodic benefit cost for most U.S. pension plans for the full annual period. However, the discount rates for a limited number of plans were updated during 2018 , 2017 , and 2016 to reflect the remeasurement of these plans due to new union labor agreements, settlements, and/or curtailments. The updated discount rates used were not significantly different from the discount rates presented. +In conjunction with the annual measurement of the funded status of Arconic’s pension and other postretirement benefit plans at December 31, 2015, management elected to change the manner in which the interest cost component of net periodic benefit costs is determined in 2016 and beyond. Previously, the interest component was determined by multiplying the single equivalent rate and the aggregate discounted cash flows of the plans’ projected benefit obligations. Under the new methodology, the interest cost component is determined by aggregating the product of the discounted cash flows of the plans’ projected benefit obligations for each year and an individual spot rate (referred to as the “spot rate” approach). This change resulted in a lower interest cost component of net periodic benefit cost under the new methodology compared to the previous methodology in 2018, 2017, and 2016 of $24 , $34 , and $84 , respectively, for pension plans and $ 4 , $6 , and $14 , respectively, for other postretirement benefit plans. Management believes this new methodology, which represents a change in an accounting estimate, is a better measure of the interest cost as each year’s cash flows are specifically linked to the interest rates of bond payments in the same respective year. +The expected long-term rate of return on plan assets is generally applied to a five -year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing +76 +Table of Contents +this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment. +For 2018 , 2017 , and 2016 , the expected long-term rate of return used by management was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. These rates fell within the respective range of the 20 -year moving average of actual performance and the expected future return developed by asset class. In 2018, management reduced the expected long-term rate of return by 75 basis points due to a decrease in the expected return by asset class and the 20-year moving average. For 2019 , management anticipates that 7.00% will be the expected long-term rate of return. +Assumed health care cost trend rates for U.S. other postretirement benefit plans were as follows (assumptions for non-U.S. plans did not differ materially): +2018 +2017 +2016 +Health care cost trend rate assumed for next year +5.50 +% +5.50 +% +5.50 +% +Rate to which the cost trend rate gradually declines +4.50 +4.50 +4.50 +Year that the rate reaches the rate at which it is assumed to remain +2022 +2021 +2020 +The assumed health care cost trend rate is used to measure the expected cost of gross eligible charges covered by Arconic’s other postretirement benefit plans. For 2019 , a 5.5% trend rate will be used, reflecting management’s best estimate of the change in future health care costs covered by the plans. The plans’ actual annual health care cost trend experience over the past three years has ranged from (3.3)% to (0.5)% . Management does not believe this three-year range is indicative of expected increases for future health care costs over the long-term. +Assumed health care cost trend rates have an effect on the amounts reported for the health care plan. A one-percentage point change in these assumed rates would have the following effects: +1% increase +1% decrease +Effect on other postretirement benefit obligations +$ +22 +$ +(22 +) +Effect on total of service and interest cost components +1 +(1 +) +Plan Assets +Arconic’s pension plans’ investment policy and weighted average asset allocations at December 31, 2018 and 2017 , by asset class, were as follows: +Plan assets +at +December 31, +Asset class +Policy range +2018 +2017 +Equities +20–55% +29 +% +28 +% +Fixed income +25–55% +48 +47 +Other investments +15–35% +23 +25 +Total +100 +% +100 +% +The principal objectives underlying the investment of the pension plans’ assets are to ensure that Arconic can properly fund benefit obligations as they become due under a broad range of potential economic and financial scenarios, maximize the long-term investment return with an acceptable level of risk based on such obligations, and broadly diversify investments across and within various asset classes to protect asset values against adverse movements. Specific objectives for long-term investment strategy include reducing the volatility of pension assets relative to pension liabilities and achieving diversification across the balance of the asset portfolio. The use of derivative instruments is permitted where appropriate and necessary for achieving overall investment policy objectives. The investment strategy has used long duration cash bonds and derivative instruments to offset a portion of the interest rate sensitivity of U.S. pension liabilities. Exposure to broad equity risk has been decreased and diversified through investments in discretionary and systematic macro hedge funds, long/short equity hedge funds, high yield bonds, emerging market debt and global and emerging market equities. Investments are further diversified by strategy, asset class, geography, and sector to enhance returns and mitigate downside risk. A large number of external investment managers are used to gain broad exposure to the financial markets and to mitigate manager-concentration risk. +Investment practices comply with the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and other applicable laws and regulations. +77 +Table of Contents +The following section describes the valuation methodologies used by the trustees to measure the fair value of pension plan assets, including an indication of the level in the fair value hierarchy in which each type of asset is generally classified (see Note R for the definition of fair value and a description of the fair value hierarchy). +Equities. These securities consist of: (i) direct investments in the stock of publicly traded U.S. and non-U.S. companies, and equity derivatives, that are valued based on the closing price reported in an active market on which the individual securities are traded (generally classified in Level 1); (ii) the plans’ share of commingled funds that are invested in the stock of publicly traded companies and are valued at the net asset value of shares held at December 31 (included in Level 1); and (iii) direct investments in long/short equity hedge funds and private equity (limited partnerships and venture capital partnerships) that are valued at net asset value. +Fixed income. These securities consist of: (i) U.S. government debt that are generally valued using quoted prices (included in Level 1); (ii) cash and cash equivalents invested in publicly-traded funds and are valued based on the closing price reported in an active market on which the individual securities are traded (generally classified in Level 1); (iii) publicly traded U.S. and non-U.S. fixed interest obligations (principally corporate bonds and debentures) and are valued through consultation and evaluation with brokers in the institutional market using quoted prices and other observable market data (included in Level 2); (iv) fixed income derivatives that are generally valued using industry standard models with market-based observable inputs (included in Level 2); and (v) cash and cash equivalents invested in institutional funds and are valued at net asset value. +Other investments. These investments include, among others: (i) exchange traded funds, such as gold, and real estate investment trusts and are valued based on the closing price reported in an active market on which the investments are traded (included in Level 1) and (ii) direct investments of discretionary and systematic macro hedge funds and private real estate (includes limited partnerships) and are valued at net asset value. +The fair value methods described above may not be indicative of net realizable value or reflective of future fair values. Additionally, while Arconic believes the valuation methods used by the plans’ trustees are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. +78 +Table of Contents +The following table presents the fair value of pension plan assets classified under the appropriate level of the fair value hierarchy or net asset cost: +December 31, 2018 +Level 1 +Level 2 +Net asset value +Total +Equities: +Equity securities +$ +318 +$ +— +$ +578 +$ +896 +Long/short equity hedge funds +— +— +232 +232 +Private equity +— +— +147 +147 +$ +318 +$ +— +$ +957 +$ +1,275 +Fixed income: +Intermediate and long duration government/credit +$ +200 +$ +934 +$ +770 +$ +1,904 +Other +9 +9 +152 +170 +$ +209 +$ +943 +$ +922 +$ +2,074 +Other investments: +Real estate +$ +81 +$ +— +$ +164 +$ +245 +Discretionary and systematic macro hedge funds +— +— +471 +471 +Other +56 +— +212 +268 +$ +137 +$ +— +$ +847 +$ +984 +Net plan assets (1) +$ +664 +$ +943 +$ +2,726 +$ +4,333 +December 31, 2017 +Level 1 +Level 2 +Net Asset Value +Total +Equities +Equity securities +$ +379 +$ +— +$ +593 +$ +972 +Long/short equity hedge funds +— +— +230 +230 +Private equity +— +— +155 +155 +$ +379 +$ +— +$ +978 +$ +1,357 +Fixed income: +Intermediate and long duration government/credit +$ +201 +$ +981 +$ +779 +$ +1,961 +Other +164 +8 +145 +317 +$ +365 +$ +989 +$ +924 +$ +2,278 +Other investments: +Real estate +$ +85 +$ +— +$ +172 +$ +257 +Discretionary and systematic macro hedge funds +— +— +583 +583 +Other +77 +7 +275 +359 +$ +162 +$ +7 +$ +1,030 +$ +1,199 +Net plan assets (2) +$ +906 +$ +996 +$ +2,932 +$ +4,834 +(1) +As of December 31, 2018 , the total fair value of pension plans’ assets excludes a net receivable of $1 , which represents securities purchased and sold but not yet settled plus interest and dividends earned on various investments. +(2) +As of December 31, 2017 , the total fair value of pension plans’ assets excludes a net receivable of $28 , which represents assets due from Alcoa Corporation as a result of plan separations and securities sold not yet settled plus interest and dividends earned on various investments. +79 +Table of Contents +Funding and Cash Flows +It is Arconic’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Arconic contributes additional amounts as deemed appropriate. In 2018 and 2017 , cash contributions to Arconic’s pension plans were $298 and $310 , respectively. The $298 includes $72 contributed to the Company’s U.S. plans that was in excess of the minimum required under ERISA. +The minimum required contribution to pension plans in 2019 is estimated to be $255 (of which $230 is for U.S. plans) and includes $34 related to an agreement reached with the Pension Benefit Guaranty Corporation (PBGC), as discussed in the following paragraph. +During the third quarter of 2016, the PBGC approved management’s plan to separate the Alcoa Inc. pension plans between Arconic Inc. and Alcoa Corporation. The plan stipulates that Arconic will make cash contributions over a period of 30 months (from November 1, 2016) to its two largest pension plans. Payments are expected to be made in three increments of no less than $50 each ( $150 total) over this 30 -month period. The Company made payments of $50 in March 2018 and $50 in April 2017. In the third quarter of 2018, the 2018 U.S. pension plan valuations were completed and additional pension contributions of $16 that were made in the first quarter of 2018 were able to be used to partially satisfy the third $50 requirement. The remaining $34 payment is expected to be made in 2019. Through the end of 2018, $116 of pension contributions have been made toward the $150 requirement. +Benefit payments expected to be paid to pension and other postretirement benefit plans’ participants and expected Medicare Part D subsidy receipts are as follows utilizing the current assumptions outlined above: +For the year ended December 31, +Pension +benefits paid +Gross Other post- +retirement +benefits +Medicare Part D +subsidy receipts +Net Other post- +retirement +benefits +2019 +$ +460 +$ +90 +$ +5 +$ +85 +2020 +460 +85 +5 +80 +2021 +455 +85 +5 +80 +2022 +455 +85 +5 +80 +2023 +450 +85 +5 +80 +Thereafter +2,170 +300 +25 +275 +$ +4,450 +$ +730 +$ +50 +$ +680 +Defined Contribution Plans +Arconic sponsors savings and investment plans in various countries, primarily in the United States. Arconic’s contributions and expenses related to these plans were $123 in 2018 , $89 in 2017 , and $71 in 2016 . In the United States, employees may contribute a portion of their compensation to the plans, and Arconic matches a portion of these contributions in equivalent form of the investments elected by the employee. +H. Income Taxes +The components of income from continuing operations before income taxes were as follows: +For the year ended December 31, +2018 +2017 +2016 +United States +$ +518 +$ +500 +$ +84 +Foreign +350 +(30 +) +330 +$ +868 +$ +470 +$ +414 +80 +Table of Contents +The provision for income taxes consisted of the following: +For the year ended December 31, +2018 +2017 +2016 +Current: +Federal (1) +$ +45 +$ +— +$ +— +Foreign +138 +98 +133 +State and local +4 +(2 +) +1 +187 +96 +134 +Deferred: +Federal +146 +489 +1,208 +Foreign +(94 +) +37 +136 +State and local +(13 +) +(78 +) +(2 +) +39 +448 +1,342 +Total +$ +226 +$ +544 +$ +1,476 +(1) +Includes U.S. taxes related to foreign income +Arconic has unamortized tax-deductible goodwill of $26 resulting from intercompany stock sales and reorganizations. Arconic recognizes the tax benefits (at a 25% rate) associated with this tax-deductible goodwill when it is amortized for local income tax purposes rather than in the period in which the transaction is consummated. +A reconciliation of the U.S. federal statutory rate to Arconic’s effective tax rate was as follows (the effective tax rate for all periods was a provision on income): +For the year ended December 31, +2018 +2017 +2016 +U.S. federal statutory rate +21.0 +% +35.0 +% +35.0 +% +Taxes on foreign operations +4.0 +(8.8 +) +(11.5 +) +U.S. State and local taxes +1.5 +0.7 +(0.4 +) +Federal benefit of state tax +(0.3 +) +3.7 +0.4 +Permanent differences on restructuring and other charges and asset disposals (1) +(16.9 +) +(167.4 +) +(107.8 +) +Non-deductible acquisition costs +— +0.3 +8.4 +Statutory tax rate and law changes (2) +6.5 +52.5 +(15.7 +) +Tax holidays +(1.6 +) +(3.0 +) +(0.8 +) +Changes in valuation allowances +0.9 +137.9 +426.8 +Impairment of goodwill +— +53.5 +— +Company-owned life insurance/split-dollar net premiums +— +— +23.0 +Changes in uncertain tax positions +12.8 +10.1 +2.1 +Prior year tax adjustments +(2.6 +) +(0.9 +) +(1.7 +) +Other +0.7 +2.1 +(1.3 +) +Effective tax rate +26.0 +% +115.7 +% +356.5 +% +(1) +Additional losses were reported in Spain's 2017 tax return related to the Separation Transaction which are offset by an increased valuation allowance. +(2) +In 2018, the Company finalized its accounting for the Tax Cuts and Jobs Act of 2017 ("the 2017 Act”) and recorded an additional $59 charge. In December 2017, an estimated $272 tax charge was recorded with respect to the enactment of the 2017 Act. In December 2016, Spain and the United States enacted tax law changes which resulted in the remeasurement of certain deferred tax liabilities recorded by Arconic. +On December 22, 2017, the 2017 Act was signed into law, making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the non-previously taxed post-1986 foreign earnings and profits of certain U.S.-owned foreign corporations as of December 31, 2017. Also on December 22, 2017, Staff Accounting Bulletin No. 118 ("SAB 118"), Income Tax Accounting Implications of the Tax Cuts and Jobs Act, was issued by the SEC to address the application of U.S. GAAP for financial reporting. SAB 118 permitted the use of provisional amounts based on reasonable estimates in the financial statements. SAB +81 +Table of Contents +118 also provided that the tax impact may be considered incomplete in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the 2017 Act. +The Company calculated a reasonable estimate of the impact of the 2017 Act’s tax rate reduction and one-time transition tax in its 2017 year end income tax provision in accordance with its understanding of the 2017 Act and guidance available and, as a result, recorded a $272 tax charge in the fourth quarter of 2017, the period in which the legislation was enacted. +In 2018, the Company included a $59 tax charge in income from continuing operations as a result of finalizing its accounting for the 2017 Tax Act in accordance with SAB 118. This charge primarily related to a $16 charge for the one-time transition tax and a $43 charge to update deferred tax balances. +The components of net deferred tax assets and liabilities were as follows: +2018 +2017 +December 31, +Deferred +tax +assets +Deferred +tax +liabilities +Deferred +tax +assets +Deferred +tax +liabilities +Depreciation +$ +38 +$ +694 +$ +31 +$ +693 +Employee benefits +836 +27 +936 +23 +Loss provisions +94 +— +134 +14 +Deferred income/expense +22 +1,102 +19 +1,144 +Tax loss carryforwards +3,159 +— +3,305 +— +Tax credit carryforwards +579 +— +638 +— +Other +94 +20 +24 +33 +$ +4,822 +$ +1,843 +$ +5,087 +$ +1,907 +Valuation allowance +(2,486 +) +— +(2,584 +) +— +$ +2,336 +$ +1,843 +$ +2,503 +$ +1,907 +The following table details the expiration periods of the deferred tax assets presented above: +December 31, 2018 +Expires +within +10 years +Expires +within +11-20 years +No +expiration (1) +Other (2) +Total +Tax loss carryforwards +$ +300 +$ +461 +$ +2,398 +$ +— +$ +3,159 +Tax credit carryforwards +497 +70 +12 +— +579 +Other +— +— +64 +1,020 +1,084 +Valuation allowance +(752 +) +(287 +) +(1,390 +) +(57 +) +(2,486 +) +$ +45 +$ +244 +$ +1,084 +$ +963 +$ +2,336 +(1) +Deferred tax assets with no expiration may still have annual limitations on utilization. +(2) +Other represents deferred tax assets whose expiration is dependent upon the reversal of the underlying temporary difference. A substantial amount of Other relates to employee benefits that will become deductible for tax purposes over an extended period of time as contributions are made to employee benefit plans and payments are made to retirees. +The total deferred tax asset (net of valuation allowance) is supported by projections of future taxable income exclusive of reversing temporary differences ( 24% ) and taxable temporary differences that reverse within the carryforward period ( 76% ). +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not (greater than 50% ) that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation +82 +Table of Contents +allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Arconic’s foreign tax credits in the United States have a 10-year carryforward period with expirations ranging from 2019 to 2027 (as of December 31, 2018). Valuation allowances were initially established in prior years on a portion of the foreign tax credit carryforwards, primarily due to insufficient foreign source income to allow for full utilization of the credits within the expiration period. After consideration of all available evidence including potential tax planning strategies, incremental valuation allowances of $46 , $9 and $302 were recognized in 2018, 2017 and 2016, respectively. Foreign tax credits of $8 , $57 , and $128 expired at the end of 2018, 2017, and 2016, respectively, resulting in a corresponding decrease to the valuation allowance. At December 31, 2018, the cumulative amount of the valuation allowance was $417 . The need for this valuation allowance will be reassessed on a continuous basis in future periods and, as a result, the allowance may increase or decrease based on changes in facts and circumstances. +Arconic released $10 and $98 of certain U.S. state valuation allowances in 2018 and 2017, respectively. After weighing all available positive and negative evidence, management determined that the underlying net deferred tax assets were more likely than not realizable based on projected taxable income estimates taking into account expected post-separation apportionment data. Valuation allowances of $ 675 remain against other net state deferred tax assets expected to expire before utilization. The need for valuation allowances against net state deferred tax assets will be reassessed on a continuous basis in future periods and, as a result, the allowance may increase or decrease based on changes in facts and circumstances. +In 2018, Arconic reduced a valuation allowance by $92 as a result of increasing a tax reserve for unrecognized tax benefits in Spain. The valuation allowance reduction was partially offset by a $20 charge with respect to losses no longer supported by reversing temporary differences. Arconic also recorded an additional valuation allowance of $61 and $675 in 2018 and 2017, respectively, which offsets a deferred tax asset recorded for additional losses reported on the Spanish tax return related to the Separation Transaction that are not more likely than not to be realized. +In 2016, Arconic recognized a $1,267 discrete income tax charge for valuation allowances related to the Separation Transaction, including $925 with respect to Alcoa Corporation’s net deferred tax assets in the United States, $302 with respect to Arconic’s foreign tax credits in the United States, and $42 with respect to certain deferred tax assets in Luxembourg, partially offset by $2 related to the net impact of other smaller items. After weighing all positive and negative evidence, as described above, management determined that the net deferred tax assets of Alcoa Corporation were not more likely than not to be realized due to lack of historical and projected domestic source taxable income. As such, a valuation allowance was recorded immediately prior to separation. +In 2016, Arconic also recorded additional valuation allowances in Australia of $93 related to the Separation Transaction, in Spain of $163 related to a tax law change and in Luxembourg of $280 related to the Separation Transaction as well as a tax law change. These valuation allowances fully offset current year changes in deferred tax asset balances of each respective jurisdiction, resulting in no net impact to tax expense. The need for a valuation allowance will be reassessed on a continuous basis in future periods by each jurisdiction and, as a result, the allowances may increase or decrease based on changes in facts and circumstances. +Arconic also recognized discrete income tax benefits in 2016 related to the release of valuation allowances on certain net deferred tax assets in Russia and Canada of $19 and $20 , respectively. After weighing all available evidence, management determined that it was more likely than not that the net income tax benefits associated with the underlying deferred tax assets would be realizable based on historic cumulative income and projected taxable income. +83 +Table of Contents +The following table details the changes in the valuation allowance: +December 31, +2018 +2017 +2016 +Balance at beginning of year +$ +2,584 +$ +1,940 +$ +1,291 +Increase to allowance +136 +831 +772 +Release of allowance +(154 +) +(246 +) +(209 +) +Acquisitions and divestitures +— +(1 +) +(1 +) +Tax apportionment, tax rate and tax law changes +(14 +) +(24 +) +106 +Foreign currency translation +(66 +) +84 +(19 +) +Balance at end of year +$ +2,486 +$ +2,584 +$ +1,940 +As a result of the 2017 Act, the non-previously taxed post-1986 foreign earnings and profits (calculated based on U.S. tax principles) of certain U.S.-owned foreign corporations has been subject to U.S. tax under the one-time transition tax provisions. The 2017 Act also created a new requirement that certain income earned by foreign subsidiaries, GILTI, must be included in the gross income of the U.S. shareholder. The 2017 Act also established the Base Erosion and Anti-Abuse Tax (BEAT). In the first quarter of 2018, Arconic made a final accounting policy election to treat taxes due from future inclusions in U.S. taxable income related to GILTI as a current period expense when incurred. Arconic has estimated a GILTI inclusion for 2018 and recorded tax expense accordingly. Arconic does not anticipate being subject to BEAT for 2018. +Foreign U.S. GAAP earnings that have not otherwise been subject to U.S. tax, will generally be exempt from future U.S. tax under the 2017 Act when distributed. Such distributions, as well as distributions of previously taxed foreign earnings, could potentially be subject to U.S. state tax in certain states, and foreign withholding taxes. Foreign currency gains/losses related to the translation of previously taxed earnings from functional currency to U.S. dollars could also be subject to U.S. tax when distributed. At this time, Arconic has no plans to distribute such earnings in the foreseeable future. If such earnings were to be distributed, Arconic would expect the potential U.S. state tax and withholding tax impacts to be immaterial and the potential deferred tax liability associated with future foreign currency gains to be impracticable to determine. +Arconic and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. With a few minor exceptions, Arconic is no longer subject to income tax examinations by tax authorities for years prior to 2006. All U.S. tax years prior to 2018 have been audited by the Internal Revenue Service. Various state and foreign jurisdiction tax authorities are in the process of examining Arconic’s income tax returns for various tax years through 2017. +A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest and penalties) was as follows: +December 31, +2018 +2017 +2016 +Balance at beginning of year +$ +73 +$ +28 +$ +18 +Additions for tax positions of the current year +— +23 +12 +Additions for tax positions of prior years +143 +27 +— +Reductions for tax positions of prior years +(42 +) +— +— +Settlements with tax authorities +— +— +(1 +) +Expiration of the statute of limitations +(6 +) +(5 +) +(1 +) +Foreign currency translation +(2 +) +— +— +Balance at end of year +$ +166 +$ +73 +$ +28 +For all periods presented, a portion of the balance pertains to state tax liabilities, which are presented before any offset for federal tax benefits. The effect of unrecognized tax benefits, if recorded, that would impact the annual effective tax rate for 2018, 2017, and 2016 would be approximately 5% , 15% , and 6% , respectively, of pre-tax book income. Arconic does not anticipate that changes in its unrecognized tax benefits will have a material impact on the Statement of Consolidated Operations during 2019. +It is Arconic’s policy to recognize interest and penalties related to income taxes as a component of the Provision for income taxes on the accompanying Statement of Consolidated Operations. Arconic recognized interest of $ 22 and $1 for 2018 and 2017, respectively, but did not recognize any interest or penalties in 2016. Due to the expiration of the statute of limitations, settlements with tax authorities, and refunded overpayments, Arconic recognized interest income of $1 and $2 in 2018 and 2017, respectively, but did not recognize any interest income in 2016. As of December 31, 2018 , and 2017 , the amount accrued for the payment of interest and penalties was $21 and $2 , respectively. +84 +Table of Contents +I. Preferred and Common Stock +Preferred Stock. Arconic has two classes of preferred stock: Class A Preferred Stock and Class B Serial Preferred Stock. Class A Preferred Stock has 660,000 shares authorized at a par value of $100 per share with an annual $3.75 cumulative dividend preference per share. There were 546,024 shares of Class A Preferred Stock outstanding at December 31, 2018 and 2017 . Class B Serial Preferred Stock has 10,000,000 shares authorized at a par value of $1 per share. There were no shares of Class B Serial Preferred Stock outstanding at December 31, 2018 and 2017 (see below). +In September 2014, Arconic completed a public offering under its shelf registration statement for $1,250 of 25 million depositary shares, each of which represents a 1/10th interest in a share of Arconic’s 5.375% Class B Mandatory Convertible Preferred Stock, Series 1, par value $1 per share, liquidation preference $500 per share (the “Mandatory Convertible Preferred Stock”). The 25 million depositary shares are equivalent to 2.5 million shares of Mandatory Convertible Preferred Stock. Each depositary share entitled the holder, through the depositary, to a proportional fractional interest in the rights and preferences of a share of Mandatory Convertible Preferred Stock, including conversion, dividend, liquidation, and voting rights, subject to terms of the deposit agreement. Arconic received $1,213 in net proceeds from the public offering reflecting an underwriting discount. The net proceeds were used, together with the net proceeds of issued debt, to finance the cash portion of the acquisition of Firth Rixson. The underwriting discount was recorded as a decrease to Additional capital. The Mandatory Convertible Preferred Stock constituted a series of Arconic’s Class B Serial Preferred Stock, which ranks senior to Arconic’s common stock and junior to Arconic’s Class A Preferred Stock and existing and future indebtedness. Holders of the Mandatory Convertible Preferred Stock generally had no voting rights. +Dividends on the Mandatory Convertible Preferred Stock were cumulative in nature and paid at the rate of $26.8750 per annum per share in 2016 and 2015, which commenced January 1, 2015 (paid on December 30, 2014). +On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction. Dividends on the Mandatory Convertible Preferred Stock were paid at the rate of $20.1563 per share in 2017. +Common Stock. Pursuant to the authorization provided at a special meeting of Arconic common shareholders held on October 5, 2016, shareholders approved a 1-for-3 reverse stock split of Arconic’s outstanding and authorized shares of common stock (the “Reverse Stock Split”). As a result of the Reverse Stock Split, every three shares of issued and outstanding common stock were combined into one issued and outstanding share of common stock. The Reverse Stock Split reduced the number of shares of common stock outstanding from approximately 1.3 billion shares to approximately 0.4 billion shares. The par value of the common stock remained at $1 per share. Accordingly, Common stock and Additional capital in the accompanying Consolidated Balance Sheet at December 31, 2016 reflected a decrease and increase of $877 , respectively. The number of authorized shares of common stock was also decreased from 1.8 billion shares to 0.6 billion shares. The Company’s common stock began trading on a reverse stock split-adjusted basis on the NYSE on October 6, 2016. +In August 2016, Arconic retired its outstanding treasury stock consisting of approximately 25 million shares ( 76 million shares pre-Reverse Stock Split). As a result, Common stock and Additional capital in the accompanying 2016 Consolidated Balance Sheet were decreased by $76 and $2,563 , respectively, to reflect the retirement of the treasury shares. As of December 31, 2018 , and 2017 , there was no outstanding treasury stock. +In July 2015, through the acquisition of RTI International Metals Inc. (RTI), Arconic assumed the obligation to repay two tranches of convertible debt; one tranche was due and settled in cash on December 1, 2015 (principal amount of $115 ) and the other tranche is due on October 15, 2019 (principal amount of $403 ), unless earlier converted or purchased by Arconic at the holder’s option under specific conditions. Upon conversion of the 2019 convertible notes, holders will receive, at Arconic’s election, cash, shares of common stock (approximately 14,453,000 shares using the December 31, 2018 conversion rate of 35.9125 shares per $1,000 (not in millions) bond or per-share conversion price of $27.8455 ), or a combination of cash and shares. On the maturity date, each holder of outstanding notes will be entitled to receive $1,000 (not in millions) in cash for each $1,000 (not in millions) bond, together with accrued and unpaid interest. +At December 31, 2018 , 483,270,717 shares were issued and outstanding. Dividends paid in 2018 and 2017 were $0.24 per annum or $0.06 per quarter and $0.36 per annum or $0.09 per quarter in 2016 . +As of December 31, 2018 , 47 million shares of common stock were reserved for issuance under Arconic’s stock-based compensation plans. As of December 31, 2018 , 41 million shares remain available for issuance. Arconic issues new shares to satisfy the exercise of stock options and the conversion of stock awards. +See Note W for further information on common stock repurchases. +85 +Table of Contents +Share Activity (number of shares) +Common stock +Treasury +Outstanding +Balance at end of 2015 +81,051,103 +1,310,160,141 +Issued for stock-based compensation plans +(5,219,660 +) +5,302,128 +Treasury stock retirement +(75,831,443 +) +— +Reverse Stock Split +— +(876,942,489 +) +Balance at end of 2016 +— +438,519,780 +Conversion of convertible notes +— +39,242,706 +Issued for stock-based compensation plans +— +3,654,051 +Balance at end of 2017 +— +481,416,537 +Issued for stock-based compensation plans +— +1,854,180 +Balance at end of 2018 +— +483,270,717 +Stock-Based Compensation +Arconic has a stock-based compensation plan under which stock options and restricted stock unit awards are granted in January each year to eligible employees. Stock options are granted at the closing market price of Arconic’s common stock on the date of grant and typically vest over a three -year service period (1/3 each year) with a ten -year contractual term. In 2018, there were stock options granted that vest over a four -year cliff service period. Restricted stock unit awards typically vest over a three -year service period from the date of grant. As part of Arconic’s stock-based compensation plan design, individuals who are retirement-eligible have a six-month requisite service period in the year of grant. Certain of these awards also include performance and market conditions. For the majority of performance stock awards issued in 2018 , 2017 , and 2016 , the final number of shares earned will be based on Arconic’s achievement of sales and profitability targets over the respective three -year performance periods. For awards issued in 2018 and 2017, the award will be earned at the end of the three -year performance period. For awards issued in 2016, one-third of the award will be earned each year based on the performance against the pre-established targets for that year. The performance stock awards earned over the three-year period vest at the end of the third year. Additionally, the 2018 and 2017 awards will be scaled by a total shareholder return (“TSR”) multiplier, which depends upon relative three -year performance against the TSRs of a group of peer companies. +In 2018 , 2017 and 2016 , Arconic recognized stock-based compensation expense of $50 ( $39 after-tax), $54 ( $36 after-tax), and $76 ( $51 after-tax), respectively. The expense related to restricted stock unit awards in 2018 , 2017 and 2016 was approximately 85% , 85% and 80% , respectively. No stock-based compensation expense was capitalized in any of those years. 2017 stock-based compensation expense was reduced by $13 for certain executive pre-vest cancellations which were recorded in Restructuring and other charges within the Statement of Consolidated Operations. At December 31, 2018 , there was $52 (pre-tax) of unrecognized compensation expense related to non-vested stock option grants and non-vested restricted stock unit award grants. This expense is expected to be recognized over a weighted average period of 1.8 years. +Stock-based compensation expense is based on the grant date fair value of the applicable equity grant. For restricted stock unit awards, the fair value was equivalent to the closing market price of Arconic’s common stock on the date of grant. The grant date fair value of the 2018 and 2017 performance awards containing a market condition was $20.25 and $21.99 , respectively, and was valued using a Monte Carlo model. A Monte Carlo simulation uses assumptions of stock price behavior to estimate the probability of satisfying market conditions and the resulting fair value of the award. The risk-free interest rate ( 2.7% in 2018 and 1.5% in 2017 ) was based on a yield curve of interest rates at the time of the grant based on the remaining performance period. Because of limited historical information due to the Separation Transaction, volatility ( 32.0% in 2018 and 38.0% in 2017 ) was estimated using implied volatility and the representative price return approach, which uses price returns of comparable companies, was used to develop a correlation assumption. For stock options, the fair value was estimated on the date of grant using a lattice-pricing model, which generated a result of $9.79 ( $10.99 for four -year cliff options), $6.26 , and $4.78 per option in 2018 , 2017 , and 2016 , respectively. The lattice-pricing model uses a number of assumptions to estimate the fair value of a stock option, including a risk-free interest rate, dividend yield, volatility, exercise behavior, and contractual life. The following paragraph describes in detail the assumptions used to estimate the fair value of stock options granted in 2018 (the assumptions used to estimate the fair value of stock options granted in 2017 and 2016 were not materially different, except as noted below). +The risk-free interest rate ( 2.5% ) was based on a yield curve of interest rates at the time of the grant based on the contractual life of the option. The dividend yield ( 0.9% ) was based on a one-year average. Volatility ( 34.0% for 2018 , 38.1% for 2017 , and 44.5% in 2016 ) was based on comparable companies in 2018 and 2017 (except 2016 historical volatilities were used) and implied volatilities over the term of the option. Arconic utilized historical option forfeiture data to estimate annual pre- and +86 +Table of Contents +post-vesting forfeitures ( 6% ). Exercise behavior ( 61% ) was based on a weighted average exercise ratio (exercise patterns for grants issued over the number of years in the contractual option term) of an option’s intrinsic value resulting from historical employee exercise behavior. Based upon the other assumptions used in the determination of the fair value, the life of an option ( 6.0 years ( 7.3 years for four -year cliff options)) was an output of the lattice-pricing model. The activity for stock options and stock awards during 2018 was as follows (options and awards in millions): +Stock options +Stock awards +Number of +options +Weighted +average +exercise price +Number of +awards +Weighted +average FMV +per award +Outstanding, January 1, 2018 +11 +$ +23.94 +7 +$ +21.49 +Granted +1 +29.97 +2 +26.48 +Exercised +(1 +) +18.95 +— +— +Converted +— +— +(1 +) +32.75 +Expired or forfeited +(1 +) +26.96 +(1 +) +21.10 +Performance share adjustment +— +— +— +18.47 +Outstanding, December 31, 2018 +10 +$ +24.95 +7 +$ +21.13 +As of December 31, 2018 , the number of stock options outstanding had a weighted average remaining contractual life of 4.8 years and a total intrinsic value of $3 . Additionally, 7.8 million of the stock options outstanding were fully vested and exercisable and had a weighted average remaining contractual life of 3.7 years, a weighted average exercise price of $25.49 , and a total intrinsic value of $2 as of December 31, 2018 . In 2018 , 2017 , and 2016 , the cash received from stock option exercises was $16 , $50 , and $4 and the total tax benefit realized from these exercises was $2 , $4 , and $0 , respectively. The total intrinsic value of stock options exercised during 2018 , 2017 and 2016 was $7 , $13 , and $1 , respectively. +J. Earnings Per Share +Basic earnings per share (EPS) amounts are computed by dividing earnings (loss), after the deduction of preferred stock dividends declared, by the average number of common shares outstanding. Diluted EPS amounts assume the issuance of common stock for all potentially dilutive share equivalents outstanding. +The information used to compute basic and diluted EPS attributable to Arconic common shareholders was as follows (shares in millions): +For the year ended December 31, +2018 +2017 +2016 +Net income (loss) from continuing operations attributable to Arconic +$ +642 +$ +(74 +) +$ +(1,062 +) +Less: preferred stock dividends declared +(2 +) +(53 +) +(69 +) +Income (loss) from continuing operations available to Arconic common shareholders +640 +(127 +) +(1,131 +) +Income from discontinued operations after income taxes and noncontrolling interests (1) +— +— +121 +Net income (loss) available to Arconic common shareholders—basic +640 +(127 +) +(1,010 +) +Add: interest expense related to convertible notes +11 +— +— +Net income (loss) available to Arconic common shareholders - diluted +$ +651 +$ +(127 +) +$ +(1,010 +) +Average shares outstanding - basic +483 +451 +438 +Effect of dilutive securities: +Stock options +1 +— +— +Stock and performance awards +5 +— +— +Convertible notes +14 +— +— +Average shares outstanding - diluted +503 +451 +438 +(1) +Calculated from the Statement of Consolidated Operations as Income from discontinued operations after income taxes less Net income from discontinued operations attributable to noncontrolling interests. +87 +Table of Contents +The following shares were excluded from the calculation of average shares outstanding – diluted as their effect was anti-dilutive (shares in millions). +2018 +2017 +2016 +Mandatory convertible preferred stock +n/a +39 +39 +Convertible notes +— +14 +14 +Stock options (1) +9 +11 +13 +Stock awards +— +7 +8 +(1) +The average exercise price of options per share was $26.79 , $33.32 , and $26.93 for 2018 , 2017 , and 2016 , respectively. +In 2017, had Arconic generated sufficient net income, 30 million , 14 million , 5 million , and 1 million potential shares of common stock related to the mandatory convertible preferred stock, convertible notes, stock awards, and stock options, respectively, would have been included in diluted average shares outstanding. The mandatory convertible preferred stock converted on October 2, 2017 (see Note I ). +In 2016, had Arconic generated sufficient net income, 28 million , 10 million , 4 million , and 1 million potential shares of common stock related to the mandatory convertible preferred stock, convertible notes, stock awards, and stock options, respectively, would have been included in diluted average shares outstanding. +88 +Table of Contents +K. Accumulated Other Comprehensive Loss +The following table details the activity of the four components that comprise Accumulated other comprehensive loss for both Arconic’s shareholders and noncontrolling interests: +Arconic +Noncontrolling Interests +2018 +2017 +2016 +2018 +2017 +2016 +Pension and other postretirement benefits ( G ) +Balance at beginning of period +$ +(2,230 +) +$ +(2,010 +) +$ +(3,611 +) +$ +— +$ +— +$ +(56 +) +Adoption of accounting standard (A) +(369 +) +— +— +— +— +— +Other comprehensive income (loss): +Unrecognized net actuarial loss and prior service cost/benefit +70 +(466 +) +(1,112 +) +— +— +(9 +) +Tax (expense) benefit +(19 +) +102 +380 +— +— +3 +Total Other comprehensive income (loss) before reclassifications, net of tax +51 +(364 +) +(732 +) +— +— +(6 +) +Amortization of net actuarial loss and prior service cost (1) +262 +222 +389 +— +— +4 +Tax expense (2) +(58 +) +(78 +) +(136 +) +— +— +(1 +) +Total amount reclassified from Accumulated other comprehensive loss, net of tax (8) +204 +144 +253 +— +— +3 +Total Other comprehensive income (loss) +255 +(220 +) +(479 +) +— +— +(3 +) +Transfer to Alcoa Corporation +— +— +2,080 +— +— +59 +Balance at end of period +$ +(2,344 +) +$ +(2,230 +) +$ +(2,010 +) +$ +— +$ +— +$ +— +Foreign currency translation +Balance at beginning of period +$ +(437 +) +$ +(689 +) +$ +(2,412 +) +$ +— +$ +(2 +) +$ +(780 +) +Other comprehensive (loss) income (3) +(146 +) +252 +268 +— +2 +182 +Transfer to Alcoa Corporation +— +— +1,455 +— +— +596 +Balance at end of period +$ +(583 +) +$ +(437 +) +$ +(689 +) +$ +— +$ +— +$ +(2 +) +Available-for-sale securities +Balance at beginning of period +$ +(2 +) +$ +132 +$ +(5 +) +$ +— +$ +— +$ +— +Other comprehensive (loss) income (4) +(1 +) +(134 +) +137 +— +— +— +Balance at end of period +$ +(3 +) +$ +(2 +) +$ +132 +$ +— +$ +— +$ +— +Cash flow hedges +Balance at beginning of period +$ +25 +$ +(1 +) +$ +597 +— +$ +— +$ +(3 +) +Adoption of accounting standard ( A ) +2 +— +— +— +— +— +Other comprehensive (loss) income: +Net change from periodic revaluations +(15 +) +37 +(843 +) +— +— +36 +Tax benefit (expense) +3 +(9 +) +252 +— +— +(10 +) +Total Other comprehensive (loss) income before reclassifications, net of tax +(12 +) +28 +(591 +) +— +— +26 +Net amount reclassified to earnings +Aluminum contracts (5) +(8 +) +(2 +) +1 +— +— +— +Energy contracts (6) +— +— +(49 +) +— +— +(34 +) +Interest rate contracts (7) +(2 +) +— +9 +— +— +5 +Nickel contracts (6) +(4 +) +(1 +) +1 +— +— +— +Sub-total +(14 +) +(3 +) +(38 +) +— +— +(29 +) +Tax benefit (2) +3 +1 +12 +— +— +8 +Total amount reclassified from Accumulated other comprehensive loss, net of tax (8) +(11 +) +(2 +) +(26 +) +— +— +(21 +) +Total Other comprehensive (loss) income +(23 +) +26 +(617 +) +— +— +5 +Transfer to Alcoa Corporation +— +— +19 +— +— +(2 +) +Balance at end of period +$ +4 +$ +25 +$ +(1 +) +$ +— +$ +— +$ +— +Total balance at end of period +$ +(2,926 +) +$ +(2,644 +) +$ +(2,568 +) +$ +— +$ +— +$ +(2 +) +89 +Table of Contents +(1) +These amounts were included in the computation of net periodic benefit cost for pension and other postretirement benefits (see Note G ). +(2) +These amounts were included in Provision for income taxes on the accompanying Statement of Consolidated Operations. +(3) +In all periods presented, there were no tax impacts related to rate changes and no amounts were reclassified to earnings. +(4) +Realized gains and losses were included in Other expense (income), net , net on the accompanying Statement of Consolidated Operations. +(5) +These amounts were included in Sales on the accompanying Statement of Consolidated Operations. +(6) +These amounts were included in Cost of goods sold on the accompanying Statement of Consolidated Operations. +(7) +These amounts were included in Interest expense on the accompanying Statement of Consolidated Operations. +(8) +A positive amount indicates a corresponding charge to earnings and a negative amount indicates a corresponding benefit to earnings. These amounts were reflected on the accompanying Statement of Consolidated Operations in the line items indicated in footnotes 1 through 7. +L. Receivables +Sale of Receivables Program +Arconic has an arrangement with three financial institutions to sell certain customer receivables without recourse on a revolving basis. The sale of such receivables is completed using a bankruptcy remote special purpose entity, which is a consolidated subsidiary of Arconic. This arrangement provides up to a maximum funding of $400 for receivables sold. Arconic maintains a beneficial interest, or a right to collect cash, on the sold receivables that have not been funded (deferred purchase program). On March 30, 2012, Arconic initially sold $304 of customer receivables in exchange for $50 in cash and $254 of deferred purchase program under the arrangement. Arconic has received additional net cash funding of $300 ( $2,958 in draws and $2,658 in repayments) since the program’s inception, including net cash draws totaling $0 ( $600 in draws and $600 in repayments) in 2018 and net cash draws totaling $0 ( $600 in draws and $600 in repayments) in 2017 . +As of December 31, 2018 , and 2017 , the deferred purchase program receivable was $234 and $187 , respectively, which was included in Other receivables on the accompanying Consolidated Balance Sheet. The deferred purchase program receivable is reduced as collections of the underlying receivables occur; however, as this is a revolving program, the sale of new receivables will result in an increase in the deferred purchase program receivable. The gross amount of receivables sold and total cash collected under this program since its inception was $41,784 and $41,200 respectively. Arconic services the customer receivables for the financial institutions at market rates; therefore, no servicing asset or liability was recorded. +In 2018 and 2017 , the gross cash outflows and inflows associated with the deferred purchase program receivable were $6,375 and $6,328 respectively, and $5,471 and $5,367 , respectively. +Cash receipts from customer payments on sold receivables (which are cash receipts on the underlying trade receivables that have been previously sold in this program) as well as cash receipts and cash disbursements from draws and repayments under the program are presented as cash receipts from sold receivables within investing activities in the Statement of Consolidated Cash Flows. See Note A for additional information on new accounting guidance that impacts the Company. +Allowance for Doubtful Accounts +The following table details the changes in the allowance for doubtful accounts related to customer receivables and other receivables: +Customer receivables +Other receivables +2018 +2017 +2016 +2018 +2017 +2016 +Balance at beginning of year +$ +8 +$ +13 +$ +8 +$ +34 +$ +32 +$ +34 +Provision for doubtful accounts +2 +1 +7 +7 +9 +6 +Write off of uncollectible accounts +(2 +) +(5 +) +(3 +) +(2 +) +(1 +) +(1 +) +Recoveries of prior write-offs +— +— +(1 +) +(3 +) +(3 +) +1 +Other +(4 +) +(1 +) +2 +(5 +) +(3 +) +(8 +) +Balance at end of year +$ +4 +$ +8 +$ +13 +$ +31 +$ +34 +$ +32 +90 +Table of Contents +M. Inventories +December 31, +2018 +2017 +Finished goods +$ +668 +$ +669 +Work-in-process +1,371 +1,349 +Purchased raw materials +366 +381 +Operating supplies +87 +81 +Total inventories +$ +2,492 +$ +2,480 +At December 31, 2018 and 2017 , the portion of inventories valued on a LIFO basis was $1,292 and $1,208 , respectively. If valued on an average-cost basis, total inventories would have been $530 and $481 higher at December 31, 2018 and 2017 , respectively. During 2018 and 2017 , reductions in LIFO inventory quantities caused partial liquidations of the lower cost LIFO inventory base. These liquidations resulted in the recognition of immaterial income amounts in 2018 , 2017 , and 2016 . +In the second quarter of 2018, a charge of $23 was recorded in Cost of goods sold and Inventories to reflect a physical inventory adjustment at one plant in the Engineered Products and Solutions segment. While a portion of this charge relates to prior years, the majority relates to 2018. The out-of-period amounts were not material to any interim or annual periods. +N. Properties, Plants, and Equipment, Net +December 31, +2018 +2017 +Land and land rights +$ +136 +$ +140 +Structures: +Engineered Products and Solutions +796 +784 +Global Rolled Products +1,068 +1,090 +Transportation and Construction Solutions +248 +268 +Other +252 +253 +2,364 +2,395 +Machinery and equipment: +Engineered Products and Solutions +3,437 +3,054 +Global Rolled Products +4,629 +4,641 +Transportation and Construction Solutions +748 +777 +Other +420 +358 +9,234 +8,830 +11,734 +11,365 +Less: accumulated depreciation and amortization +6,769 +6,392 +4,965 +4,973 +Construction work-in-progress +739 +621 +$ +5,704 +$ +5,594 +During the second quarter of 2018, the Company updated its three-year strategic plan and determined that there was a decline in the forecasted financial performance for the disks operations, an asset group within the Arconic Engines business unit. As such, the Company evaluated the recoverability of the long-lived assets by comparing their carrying value of approximately $515 to the estimated undiscounted net cash flows of the disks operations, resulting in an estimated fair value in excess of their carrying value of approximately 13% ; thus, there was no impairment. If the disks operations do not achieve the revised forecasted financial performance or if there are changes in any significant assumptions, a material non-cash impairment of long-lived assets may occur in future periods. These significant assumptions include sales growth, cost of raw materials, ramp up of additional production capacity, and working capital. A 1% decrease in the forecasted net cash flows would reduce the undiscounted cash flows by approximately $6 . There were no indicators of impairment identified for the disks operations during the third or fourth quarters of 2018 and, as such, the Company did not evaluate the recoverability of its long-lived assets. +91 +Table of Contents +O. Goodwill and Other Intangible Assets +The following table details the changes in the carrying amount of goodwill: +Engineered +Products +and +Solutions +Global +Rolled +Products +Transportation +and +Construction +Solutions +Total +Balances at December 31, 2016 +Goodwill +$ +4,832 +$ +241 +$ +128 +$ +5,201 +Accumulated impairment losses +— +— +(53 +) +(53 +) +Goodwill, net +4,832 +241 +75 +5,148 +Impairment ( A ) +(719 +) +— +— +(719 +) +Translation and other +92 +11 +3 +106 +Balances at December 31, 2017 +Goodwill +4,924 +252 +131 +5,307 +Accumulated impairment losses +(719 +) +— +(53 +) +(772 +) +Goodwill, net +4,205 +252 +78 +4,535 +Divestitures ( T ) +(1 +) +— +— +(1 +) +Translation and other +(25 +) +(7 +) +(2 +) +(34 +) +Balances at December 31, 2018 +Goodwill +4,898 +245 +129 +5,272 +Accumulated impairment losses +(719 +) +— +(53 +) +(772 +) +Goodwill, net +$ +4,179 +$ +245 +$ +76 +$ +4,500 +In 2017, Arconic recognized an impairment of goodwill in the amount of $719 related to the annual impairment review of the Arconic Forgings and Extrusions business. See Goodwill policy in Note A . +Other intangible assets were as follows: +December 31, 2018 +Gross +carrying +amount +Accumulated +amortization +Intangibles, net +Computer software +$ +768 +$ +(657 +) +$ +111 +Patents and licenses +110 +(107 +) +3 +Other intangibles +922 +(149 +) +773 +Total amortizable intangible assets +1,800 +(913 +) +887 +Indefinite-lived trade names and trademarks +32 +— +32 +Total other intangible assets +$ +1,832 +$ +(913 +) +$ +919 +December 31, 2017 +Gross +carrying +amount +Accumulated +amortization +Intangibles, net +Computer software +$ +789 +$ +(674 +) +$ +115 +Patents and licenses +110 +(107 +) +3 +Other intangibles +953 +(116 +) +837 +Total amortizable intangible assets +1,852 +(897 +) +955 +Indefinite-lived trade names and trademarks +32 +— +32 +Total other intangible assets +$ +1,884 +$ +(897 +) +$ +987 +Computer software consists primarily of software costs associated with an enterprise business solution within Arconic to drive common systems among all businesses. +Amortization expense related to the intangible assets in the tables above for the years ended December 31, 2018 , 2017 , and 2016 was $81 , $71 , and $65 , respectively, and is expected to be in the range of approximately $63 to $70 annually from 2019 to 2023 . +92 +Table of Contents +P. Debt +Long-Term Debt. +December 31, +2018 +2017 +5.72% Notes, due 2019 +$ +— +$ +500 +1.63% Convertible Notes, due 2019 +403 +403 +6.150% Notes, due 2020 +1,000 +1,000 +5.40% Notes, due 2021 +1,250 +1,250 +5.87% Notes, due 2022 +627 +627 +5.125% Notes, due 2024 +1,250 +1,250 +5.90% Notes, due 2027 +625 +625 +6.75% Bonds, due 2028 +300 +300 +5.95% Notes due 2037 +625 +625 +Iowa Finance Authority Loan, due 2042 (4.75%) +250 +250 +Other (1) +(29 +) +(23 +) +6,301 +6,807 +Less: amount due within one year +405 +1 +$ +5,896 +$ +6,806 +(1) +Includes various financing arrangements related to subsidiaries, unamortized debt discounts related to outstanding notes and bonds listed in the table above, an equity option related to the convertible notes due in 2019, and unamortized debt issuance costs. +The principal amount of long-term debt maturing in each of the next five years is $405 in 2019 , $1,000 in 2020 , $1,250 in 2021 , $627 in 2022 , and $0 in 2023 . +Public Debt – During the first quarter of 2018, the Company completed the early redemption of its remaining outstanding 5.72% Notes due in 2019, with aggregate principal amount of $500 , for $518 in cash including accrued and unpaid interest. As a result, the Company recorded a charge of $19 in Interest expense in the accompanying Statement of Consolidated Operations for 2018 primarily for the premium paid on the early redemption of these notes in excess of their carrying value. +During the second quarter of 2017, the Company announced three separate cash tender offers by the Investment Banks for the purchase of the Company’s 6.50% Bonds due 2018 (the “ 6.50% Bonds”), 6.75% Notes due 2018 (the “ 6.75% Notes”), and 5.72% Notes due 2019 (the “ 5.72% Notes”), up to a maximum purchase amount of $1,000 aggregate principal amount of notes, subject to certain conditions. The Investment Banks purchased notes totaling $805 aggregate principal amount, including $150 aggregate principal amount of 6.50% Bonds, $405 aggregate principal amount of 6.75% Notes, and $250 aggregate principal amount of 5.72% Notes. +Also, during the second quarter of 2017, the Company agreed to acquire the notes from the Investment Banks for $409 in cash plus its remaining investment in Alcoa Corporation common stock ( 12,958,767 shares valued at $35.91 per share) for total consideration of $874 including accrued and unpaid interest. The Company recorded a charge of $58 ( $27 in cash) primarily for the premium for the early redemption of the notes, a benefit of $8 for the proceeds of a related interest rate swap agreement, and a charge of $2 for legal fees associated with the transaction in Interest expense, and recorded a gain of $167 in Other income, net in the accompanying Statement of Consolidated Operations for the Debt-for-Equity Exchange. +Finally, during the second quarter of 2017, the Company completed the early redemption of its remaining outstanding 6.50% Bonds, with aggregate principal amount of $100 , and its remaining outstanding 6.75% Notes, with aggregate principal amount of $345 , for $479 in cash including accrued and unpaid interest. As a result of the early redemption of the 6.50% Bonds and 6.75% Notes, the Company recorded a charge of $24 in Interest expense in the accompanying Statement of Consolidated Operations for the premium paid for the early redemption of these notes in excess of their carrying value. +The Company has the option to redeem certain of its Notes and Bonds in whole or part, at any time at a redemption price equal to the greater of principal amount or the sum of the present values of the remaining scheduled payments, discounted using a defined treasury rate plus a spread, plus in either case accrued and unpaid interest to the redemption date. +Credit Facilities. On July 25, 2014, Arconic entered into a Five -Year Revolving Credit Agreement with a syndicate of lenders and issuers named therein, which provides for a senior unsecured revolving credit facility (the “Credit Facility”). By an Extension Request and Amendment Letter dated as of June 5, 2015, the maturity date of the Credit Facility was extended to July 25, 2020. On September 16, 2016, Arconic entered into Amendment No. 1 to the Five -Year Revolving Credit Agreement to permit the Separation Transaction and to amend certain terms of the Credit Agreement, including the replacement of the +93 +Table of Contents +existing financial covenant with a leverage ratio and reduction of total commitments available from $4,000 to $3,000 . On June 29, 2018, Arconic entered into Amendment No. 2 (“Amendment No. 2”) to amend and restate the Five-Year Revolving Credit Agreement. The Five-Year Revolving Credit Agreement, as so amended and restated, is herein referred to as the “Credit Agreement.” +The Credit Agreement provides a $3,000 Credit Facility, the proceeds of which are to be used to provide working capital or for other general corporate purposes of Arconic. Subject to the terms and conditions of the Credit Agreement, Arconic may from time to time request increases in lender commitments under the Credit Facility, not to exceed $500 in aggregate principal amount, and may also request the issuance of letters of credit, subject to a letter of credit sublimit of $1,000 of the Credit Facility. Pursuant to the Credit Agreement, Arconic shall not permit the ratio of Consolidated Net Debt to Consolidated EBITDA (each as defined in the Credit Agreement) as of the end of each fiscal quarter for the period of the four fiscal quarters most recently ended, to be greater than 4.50 to 1.00, which maximum level will step down successively to 4.00 to 1.00 on December 31, 2018, and to 3.50 to 1.00 on December 31, 2019 and thereafter. +The Credit Agreement includes additional covenants, including, among others, (a) limitations on Arconic’s ability to incur liens securing indebtedness for borrowed money, (b) limitations on Arconic’s ability to consummate a merger, consolidation or sale of all or substantially all of its assets, and (c) limitations on Arconic’s ability to change the nature of its business. As of December 31, 2018 , Arconic was in compliance with all such covenants. +The Credit Facility matures on June 29, 2023, unless extended or earlier terminated in accordance with the provisions of the Credit Agreement. Arconic may make two one -year extension requests during the term of the Credit Facility, subject to the lender consent requirements set forth in the Credit Agreement. Under the provisions of the Credit Agreement, Arconic will pay a fee of 0.25% per annum (based on Arconic’s current long-term debt ratings) of the total commitment to maintain the Credit Facility. +The Credit Facility is unsecured and amounts payable under it will rank pari passu with all other unsecured, unsubordinated indebtedness of Arconic. Borrowings under the Credit Facility may be denominated in U.S. dollars or euros. Loans will bear interest at a base rate or a rate equal to LIBOR, plus, in each case, an applicable margin based on the credit ratings of Arconic’s outstanding senior unsecured long-term debt. The applicable margin on base rate loans and LIBOR loans will be 0.50% and 1.50% per annum, respectively, based on Arconic’s current long-term debt ratings. Loans may be prepaid without premium or penalty, subject to customary breakage costs. +The obligation of Arconic to pay amounts outstanding under the Credit Facility may be accelerated upon the occurrence of an “Event of Default” as defined in the Credit Agreement. Such Events of Default include, among others, (a) non-payment of obligations; (b) breach of any representation or warranty in any material respect; (c) non-performance of covenants and obligations; (d) with respect to other indebtedness in a principal amount in excess of $100 million , a default thereunder that causes such indebtedness to become due prior to its stated maturity or a default in the payment at maturity of any principal of such indebtedness; (e) the bankruptcy or insolvency of Arconic; and (f) a change in control of Arconic. +There were no amounts outstanding at December 31, 2018 and 2017 and no amounts were borrowed during 2018 , 2017 , or 2016 under the Credit Facility. +In addition to the Credit Agreement above, Arconic has a number of other credit agreements that provide a combined borrowing capacity of $715 as of December 31, 2018 , of which $465 is due to expire in 2019 and $250 is due to expire in 2020 . The purpose of any borrowings under these credit arrangements is to provide for working capital requirements and for other general corporate purposes. The covenants contained in all these arrangements are the same as the Credit Agreement. In 2018 , 2017 , and 2016 , Arconic borrowed and repaid $600 , $810 , and $1,950 , respectively, under the respective credit arrangements. The weighted-average interest rate and weighted-average days outstanding of the respective borrowings during 2018 , 2017 , and 2016 were 3.3% , 2.6% , and 1.9% , respectively, and 46 days, 46 days, and 49 days, respectively. +Short-Term Debt. At December 31, 2018 and 2017 , short-term debt was $29 and $38 , respectively. These amounts included $29 and $33 at December 31, 2018 and 2017 , respectively, related to accounts payable settlement arrangements with certain vendors and third-party intermediaries. These arrangements provide that, at the vendor’s request, the third-party intermediary advances the amount of the scheduled payment to the vendor, less an appropriate discount, before the scheduled payment date and Arconic makes payment to the third-party intermediary on the date stipulated in accordance with the commercial terms negotiated with its vendors. Arconic records imputed interest related to these arrangements in Interest expense on the accompanying Statement of Consolidated Operations. +Commercial Paper. Arconic had no outstanding commercial paper at December 31, 2018 and 2017 . In 2018 and 2017 , the average outstanding commercial paper was $49 and $67 , respectively. Commercial paper matures at various times within one year and had an annual weighted average interest rate of 2.5% , 1.6% , and 1.1% during 2018 , 2017 , and 2016 , respectively. +94 +Table of Contents +Q. Other Noncurrent Liabilities and Deferred Credits +December 31, +2018 +2017 +Environmental remediation ( U ) +$ +185 +$ +253 +Income taxes ( H ) +146 +162 +Accrued compensation and retirement costs +195 +218 +Sale-leaseback financing obligation +119 +— +Other +94 +126 +$ +739 +$ +759 +The sale-leaseback financing obligation represents the cash received from the sale of the Texarkana, Texas cast house. The transaction has been accounted for as a deferred gain due to continuing involvement. See Note T . +R. Other Financial Instruments +Fair Value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (i) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (ii) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below: +• +Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. +• +Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means. +• +Level 3 - Inputs that are both significant to the fair value measurement and unobservable. +The carrying values of Cash and cash equivalents, Restricted cash, Derivatives, Noncurrent receivables and Short-term debt included in the Consolidated Balance Sheet approximate their fair values. The Company holds exchange-traded fixed income securities which are considered available-for-sale securities that are carried at fair value which is based on quoted market prices which are classified in Level 1 of the fair value hierarchy. The fair value of Long-term debt, less amount due within one year was based on quoted market prices for public debt and on interest rates that are currently available to Arconic for issuance of debt with similar terms and maturities for non-public debt. The fair value amounts for all Long-term debt were classified in Level 2 of the fair value hierarchy. +2018 +2017 +December 31, +Carrying +value +Fair +value +Carrying +value +Fair +value +Long-term debt, less amount due within one year +5,896 +5,873 +6,806 +7,443 +S. Cash Flow Information +Cash paid for interest and income taxes was as follows: +2018 +2017 +2016 +Interest, net of amount capitalized +$ +391 +$ +508 +$ +524 +Income taxes, net of amount refunded +$ +74 +$ +118 +$ +324 +As it relates to cash paid for acquisitions, during 2016, Arconic made a $10 cash payment for a working capital adjustment from a prior period acquisition. +During 2016, Arconic sold various securities held by its captive insurance company for $130 , and an equity interest in a natural gas pipeline of $145 (Alcoa Corporation), both of which were included in Sales of investments on the accompanying Statement of Consolidated Cash Flows. +95 +Table of Contents +In 2016, Arconic received $457 in proceeds from the redemption of certain company-owned life insurance policies, sold its Intalco smelter wharf property (Alcoa Corporation) for $120 , and sold the Remmele Medical business (see Note T ) for $102 . These amounts were included in Proceeds from the sale of assets and businesses on the accompanying Statement of Consolidated Cash Flows. +Noncash Financing and Investing Activities. On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction (see Note I ). +In the second quarter of 2017, the Company completed a Debt-for-Equity Exchange with the Investment Banks for the remaining portion of Arconic’s retained interest in Alcoa Corporation common stock for a portion of the Company’s outstanding notes held by the Investment Banks for $465 including accrued and unpaid interest (see Note P ). +On October 5, 2016, Arconic completed a 1-for- 3 Reverse Stock Split (see Note I ). The Reverse Stock Split reduced the number of shares of common stock outstanding from approximately 1.3 billion shares to approximately 0.4 billion shares. The par value of the common stock remained at $1.00 per share. Accordingly, Common stock and Additional capital in the Company’s Statement of Changes in Consolidated Equity at December 31, 2016 reflect a decrease and increase of $877 , respectively. +In August 2016, Arconic retired its outstanding treasury stock consisting of approximately 76 million shares (see Note I ). As a result, Common stock and Additional capital were decreased by $76 and $2,563 , respectively, in the Company’s Statement of Changes in Consolidated Equity at December 31, 2016, to reflect the retirement of the treasury shares. +T. Acquisitions and Divestitures +2018 Divestitures . On April 2, 2018, Arconic completed the sale of its Latin America extrusions business to a subsidiary of Hydro Extruded Solutions AS for $2 , following the settlement of post-closing and other adjustments in December 2018. As a result of entering into the agreement to sell the Latin America extrusions business in December 2017, a charge of $41 was recognized in the fourth quarter of 2017 in Restructuring and other charges in the Statement of Consolidated Operations related to the non-cash impairment of the net book value of the business and an additional charge of $2 related to a post-closing adjustment was recognized in the fourth quarter of 2018. The operating results and assets and liabilities of the business were included in the Transportation and Construction Solutions segment. This business generated sales of $25 , $115 , and $103 in 2018, 2017, and 2016 respectively, and had 612 employees at the time of the divestiture. +On July 31, 2018, the Company announced that it had initiated a sale process of its Building and Construction Systems (BCS) business, as part of the Company’s ongoing strategy and portfolio review that commenced in January 2018. BCS is part of the Transportation and Construction Solutions segment and generated third-party sales of approximately $1,140 , $1,070 , and $1,010 for 2018, 2017, and 2016, respectively. The sale process continues to progress. The Company’s decision regarding whether to sell the business will not be finalized until final binding offers are evaluated at a later stage in the sale process. Until the Company makes that final decision, the BCS business will remain classified as held and in-use in the Consolidated Financial Statements. +On October 31, 2018, the Company sold its Texarkana, Texas rolling mill and cast house, which had a combined net book value of $63 , to Ta Chen International, Inc. for $302 in cash, subject to post-closing adjustments, plus additional contingent consideration of up to $50 . The contingent consideration relates to the achievement of various milestones within 36 months of the transaction closing date associated with operationalizing the rolling mill equipment. The operating results and assets and liabilities of the business were included in the Global Rolled Products segment. The Texarkana rolling mill facility had previously been idle since late 2009. In early 2016, the Company restarted the Texarkana cast house to meet demand for aluminum slab. As part of the agreement, the Company will continue to produce aluminum slab at the facility for a period of 18 months through a lease back of the cast house building and equipment, after which time, Ta Chen will perform toll processing of metal for the Company for a period of six months. The Company will supply Ta Chen with cold-rolled aluminum coil during this 24 -month period. +The sale of the rolling mill and cast house has been accounted for separately. The gain on the sale of the rolling mill of $154 , including the fair value of contingent consideration of $5 , was recorded in Restructuring and other charges in the Statement of Consolidated Operations in the fourth quarter of 2018. The Company will reevaluate its estimate of the amount of contingent consideration to which it will be entitled at the end of each reporting period and recognize any changes thereto in the Statement of Consolidated Operations. The Company has continuing involvement related to the lease back of the cast house, and, therefore has deferred the gain associated with the cast house in 2018. As a result, the Company continues to treat the cast house building and equipment that it sold to Ta Chen as owned and therefore reflected these assets in its Consolidated Balance Sheet and has been depreciating them over their remaining useful life. Additionally, the Company recorded the cash proceeds associated with the sale of the cast house assets as a noncurrent liability in its Consolidated Balance Sheet which included a deferred gain of $95 . The Company will adopt the new lease accounting standard in the first quarter of 2019, under which the +96 +Table of Contents +Company's continuing involvement no longer requires deferral of the cast house gain. As such, the deferred gain on the sale of the cast house will be treated as a cumulative effect of an accounting change within retained earnings on January 1, 2019. +On December 31, 2018, as part of the Company’s ongoing strategy and portfolio review, Arconic completed the sale of its Eger, Hungary forgings business to Angstrom Automotive Group LLC for $2 , which resulted in a loss of $43 recorded in Restructuring and other charges in the Statement of Consolidated Operations. The operating results and assets and liabilities of the business were included in the Engineered Products and Solutions segment. This business generated sales of $32 , $38 , and $29 in 2018, 2017, and 2016 respectively, and had 180 employees at the time of the divestiture. +2017 Divestitures . In March 2017, Arconic completed the sale of its Fusina, Italy rolling mill to Slim Aluminium. While owned by Arconic, the operating results and assets and liabilities of the Fusina, Italy rolling mill were included in the Global Rolled Products segment. As part of the transaction, Arconic injected $10 of cash into the business and provided a third-party guarantee with a fair value of $5 related to Slim Aluminium’s environmental remediation. The Company recorded a loss on the sale of $60 , which was recorded in Restructuring and other charges on the Statement of Consolidated Operations for 2017. The rolling mill generated sales of approximately $54 and $165 for 2017 and 2016, respectively. At the time of the divestiture, the rolling mill had approximately 312 employees. +2016 Divestitures . In April 2016, Arconic completed the sale of the Remmele Medical business to LISI MEDICAL for $102 in cash ( $99 net of transaction costs), which was included in Proceeds from the sale of assets and businesses on the accompanying Statement of Consolidated Cash Flows. This business, which was part of the RTI acquisition in 2015, manufactured precision-machined metal products for customers in the minimally invasive surgical device and implantable device markets. Since this transaction occurred within a year of the completion of the RTI acquisition, no gain was recorded on this transaction as the excess of the proceeds over the carrying value of the net assets of this business was reflected as a purchase price adjustment (decrease to goodwill of $44 ) to the final allocation of the purchase price related to Arconic’s acquisition of RTI. While owned by Arconic, the operating results and assets and liabilities of this business were included in the Engineered Products and Solutions segment. This business generated sales of approximately $20 from January 1, 2016 through the divestiture date, April 29, 2016, and, at the time of the divestiture, had approximately 330 employees. +2014 Acquisitions. In November 2014, Arconic acquired Firth Rixson. The purchase price included an earn-out agreement that required Arconic to make earn-out payments up to an aggregate maximum amount of $150 through December 31, 2020 upon certain conditions. This earn-out was contingent on the Firth Rixson forging business in Savannah, Georgia achieving certain identified financial targets through December 31, 2020. During the fourth quarter of 2016, management determined that payment of the maximum amount was not probable based on the forecasted financial performance of this location. Therefore, the fair value of this liability was reduced by $56 with a corresponding credit to Other income, net on the accompanying Statement of Consolidated Operations. During the fourth quarter of 2017, management determined that payment of the remaining amount of the contingent liability was not probable based on the forecasted financial performance of this location. Therefore, the fair value of this liability was reduced by $81 to zero at December 31, 2017 with a corresponding credit to Other income, net on the accompanying Statement of Consolidated Operations. The fair value of this liability remains at zero at December 31, 2018 based on the forecasted financial performance of this location. +U. Contingencies and Commitments +Contingencies +Environmental Matters. Arconic participates in environmental assessments and cleanups at more than 100 locations. These include owned or operating facilities and adjoining properties, previously owned or operating facilities and adjoining properties, and waste sites, including Superfund (Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)) sites. +A liability is recorded for environmental remediation when a cleanup program becomes probable and the costs can be reasonably estimated. As assessments and cleanups proceed, the liability is adjusted based on progress made in determining the extent of remedial actions and related costs. The liability can change substantially due to factors such as the nature and extent of contamination, changes in remedial requirements, and technological changes, among others. +Arconic’s remediation reserve balance was $266 at December 31, 2018 and $294 at December 31, 2017 (of which $81 and $41 , respectively, was classified as a current liability), and reflects the most probable costs to remediate identified environmental conditions for which costs can be reasonably estimated. In 2018, the Company has seen higher expenditures with the start of construction related to the Grasse River project. Arconic expects that trend to continue for 2019 as reflected by the increase in the portion of the reserve that is considered a current liability. Payments related to remediation expenses applied against the reserve were $32 in 2018 and $26 in 2017 and includes expenditures currently mandated, as well as those not required by any regulatory authority or third party. +Included in annual operating expenses are the recurring costs of managing hazardous substances and environmental programs. +97 +Table of Contents +These costs are estimated to be approximately 1% or less of cost of goods sold. +The following discussion provides details regarding the current status of the most significant remediation reserves related to a current Arconic site. +Massena West, NY— Arconic has an ongoing remediation project related to the Grasse River, which is adjacent to Arconic’s Massena plant site. Many years ago, it was determined that sediments and fish in the river contain varying levels of polychlorinated biphenyls (PCBs). The project, which was selected by the U.S. Environmental Protection Agency (EPA) in a Record of Decision issued in April 2013, is aimed at capping PCB contaminated sediments with concentration in excess of one part per million in the main channel of the river and dredging PCB contaminated sediments in the near-shore areas where total PCBs exceed one part per million. At December 31, 2018 and December 31, 2017 , the reserve balance associated with this matter was $198 and $215 , respectively. Arconic is in the planning and design phase of the project, which is expected to be completed early in 2019. Following EPA’s approval of the final design, the actual remediation fieldwork is expected to commence and take approximately four years . The majority of the expenditures related to the project are expected to be incurred between 2019 and 2022 . +Tax. Pursuant to the Tax Matters Agreement entered into between Arconic and Alcoa Corporation in connection with the separation transaction with Alcoa Corporation, Arconic shares responsibility with Alcoa Corporation, and Alcoa Corporation has agreed to partially indemnify Arconic for 49% of the ultimate liability, with respect to the following matter. +As previously reported, in July 2013, following a Spanish corporate income tax audit covering the 2006 through 2009 tax years, an assessment was received mainly disallowing certain interest deductions claimed by a Spanish consolidated tax group owned by the Company. In August 2013, the Company filed an appeal of this assessment in Spain’s Central Tax Administrative Court, which was denied in January 2015. Arconic filed another appeal in Spain’s National Court in March 2015 which was denied in July 2018. The National Court’s decision requires the assessment for the 2006 through 2009 tax years to be reissued to take into account the outcome of the 2003 to 2005 audit which was closed in 2017. The Company estimates the revised assessment to be $174 ( €152 ), including interest. +The Company has petitioned to the Supreme Court of Spain to review the National Court’s decision. If the petition is accepted, the Supreme Court will review the assessment on its merits and render a final decision. In the event the Company is unsuccessful in appealing the assessment to the Supreme Court of Spain, a portion of the assessment may be offset with existing net operating losses and tax credits available to the Spanish consolidated tax group, which would be shared between the Company and Alcoa Corporation as provided for in the Tax Matters Agreement. As a result of the National Court decision, an income tax reserve, including interest, of $60 ( €52 ) was established in 2018. Concurrent with the establishment of the reserve, an indemnification receivable of $29 ( €25 ), representing Alcoa Corporation’s 49% share of the liability, was also recorded in 2018. +Additionally, while the tax years 2010 through 2013 are closed to audit, it is possible that the Company may receive assessments for tax years subsequent to 2013. Any potential assessment for an individual tax year is not expected to be material to the Company’s consolidated operations. +Reynobond PE. As previously reported, on June 13, 2017, the Grenfell Tower in London, UK caught fire resulting in fatalities, injuries and damage. A French subsidiary of Arconic, Arconic Architectural Products SAS (AAP SAS), supplied a product, Reynobond PE, to its customer, a cladding system fabricator, which used the product as one component of the overall cladding system on Grenfell Tower. The fabricator supplied its portion of the cladding system to the façade installer, who then completed and installed the system under the direction of the general contractor. Neither Arconic nor AAP SAS was involved in the design or installation of the system used at the Grenfell Tower, nor did it have a role in any other aspect of the building’s refurbishment or original design. Regulatory investigations into the overall Grenfell Tower matter are being conducted, including a criminal investigation by the London Metro Police, a Public Inquiry by the British government and a consumer protection inquiry by a French public authority. AAP SAS has sought and received core participant status in the Public Inquiry. The Company will no longer sell the PE product for architectural use on buildings. +Howard v. Arconic Inc. et al. As previously reported, a purported class action complaint related to the Grenfell Tower fire was filed on August 11, 2017 in the United States District Court for the Western District of Pennsylvania against Arconic Inc. and Klaus Kleinfeld. A related purported class action complaint was filed in the United States District Court for the Western District of Pennsylvania on August 25, 2017, under the caption Sullivan v. Arconic Inc. et al. , against Arconic Inc., two former Arconic executives, several current and former Arconic directors, and banks that acted as underwriters for Arconic’s September 18, 2014 preferred stock offering (the “Preferred Offering”). The plaintiff in Sullivan had previously filed a purported class action against the same defendants on July 18, 2017 in the Southern District of New York and, on August 25, 2017, voluntarily dismissed that action without prejudice. On February 7, 2018, on motion from certain putative class members, the court consolidated Howard and Sullivan , closed Sullivan , and appointed lead plaintiffs in the consolidated case. On April 9, 2018, the lead plaintiffs in the consolidated purported class action filed a consolidated amended complaint. The consolidated amended complaint alleges that the registration statement for the Preferred Offering contained false and misleading statements and +98 +Table of Contents +omitted to state material information, including by allegedly failing to disclose material uncertainties and trends resulting from sales of Reynobond PE for unsafe uses and by allegedly expressing a belief that appropriate risk management and compliance programs had been adopted while concealing the risks posed by Reynobond PE sales. The consolidated amended complaint also alleges that between November 4, 2013 and June 23, 2017 Arconic and Kleinfeld made false and misleading statements and failed to disclose material information about the Company’s commitment to safety, business and financial prospects, and the risks of the Reynobond PE product, including in Arconic’s Form 10-Ks for the fiscal years ended December 31, 2013, 2014, 2015 and 2016, its Form 10-Qs and quarterly financial press releases from the fourth quarter of 2013 through the first quarter of 2017, its 2013, 2014, 2015 and 2016 Annual Reports, and its 2016 Annual Highlights Report. The consolidated amended complaint seeks, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. On June 8, 2018, all defendants moved to dismiss the consolidated amended complaint for failure to state a claim. Briefing on that motion is now closed and the parties await a ruling. +Raul v. Albaugh, et al. As previously reported, on June 22, 2018, a derivative complaint was filed nominally on behalf of Arconic by a purported Arconic shareholder against all current members of Arconic’s Board of Directors, Klaus Kleinfeld and Ken Giacobbe, naming Arconic as a nominal defendant, in the United States District Court for the District of Delaware. The complaint raises similar allegations as the consolidated amended complaint in Howard , as well as allegations that the defendants improperly authorized the sale of Reynobond PE for unsafe uses, and asserts claims under Section 14(a) of the Securities Exchange Act of 1934 and Delaware state law. On July 13, 2018, the parties filed a stipulation agreeing to stay this case until the final resolution of the Howard case, the Grenfell Tower public inquiry in London, and the investigation by the London Metropolitan Police Service and on June 23, 2018, the Court approved the stay. +While the Company believes that these cases are without merit and intends to challenge them vigorously, there can be no assurances regarding the ultimate resolution of these matters. Given the preliminary nature of these matters and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. The Board of Directors has also received letters, purportedly sent on behalf of shareholders, reciting allegations similar to those made in the federal court lawsuits and demanding that the Board authorize the Company to initiate litigation against members of management, the Board and others. The Board of Directors has appointed a Special Litigation Committee of the Board to review and make recommendations to the Board regarding the appropriate course of action with respect to these shareholder demand letters. The Special Litigation Committee and the Board are continuing to consider the appropriate responses to the shareholder demand letters in view of developments in proceedings concerning the Grenfell Tower fire. +Other. In addition to the matters discussed above, various other lawsuits, claims, and proceedings have been or may be instituted or asserted against Arconic, including those pertaining to environmental, product liability, safety and health, employment, tax and antitrust matters. While the amounts claimed in these other matters may be substantial, the ultimate liability cannot currently be determined because of the considerable uncertainties that exist. Therefore, it is possible that the Company’s liquidity or results of operations in a period could be materially affected by one or more of these other matters. However, based on facts currently available, management believes that the disposition of these other matters that are pending or asserted will not have a material adverse effect, individually or in the aggregate, on the results of operations, financial position or cash flows of the Company. +Commitments +Purchase Obligations. Arconic has entered into purchase commitments for raw materials, energy and other goods and services, which total $770 in 2019 , $169 in 2020 , $27 in 2021 , $24 in 2022 , $8 in 2023 , and $5 thereafter. +Operating Leases. Certain land and buildings, plant equipment, vehicles, and computer equipment are under operating lease agreements. Total expense for all leases was $144 in 2018 , $113 in 2017 , and $110 in 2016 . Under long-term operating leases, minimum annual rentals are $94 in 2019 , $74 in 2020 , $54 in 2021 , $40 in 2022 , $30 in 2023 , and $87 thereafter. +Guarantees. At December 31, 2018 , Arconic had outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2019 and 2026 was $37 at December 31, 2018 . +Pursuant to the Separation and Distribution Agreement between Arconic and Alcoa Corporation, Arconic was required to provide certain guarantees for Alcoa Corporation, which had a combined fair value of $6 and $8 at December 31, 2018 and 2017 , respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. Arconic was required to provide payment guarantees for Alcoa Corporation issued on behalf of a third party related to project financing for Alcoa Corporation’s aluminum complex in Saudi Arabia. During the third quarter of 2018, Arconic was released from this guarantee. Furthermore, Arconic was required to provide guarantees related to two long-term supply agreements for energy for Alcoa Corporation facilities in the event of an Alcoa Corporation payment default. In October 2017, Alcoa Corporation announced that it had terminated one of the two agreements, the electricity contract with Luminant +99 +Table of Contents +Generation Company LLC that was tied to its Rockdale Operations, effective as of October 1, 2017. As a result of the termination of the Rockdale electricity contract, Arconic recorded income of $25 in the fourth quarter of 2017 associated with reversing the fair value of the electricity contract guarantee. For the remaining long-term supply agreement, Arconic is required to provide a guarantee up to an estimated present value amount of approximately $1,087 and $1,297 at December 31, 2018 and December 31, 2017 , respectively, in the event of an Alcoa Corporation payment default. This guarantee expires in 2047 . For this guarantee, subject to its provisions, Arconic is secondarily liable in the event of a payment default by Alcoa Corporation. Arconic currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote. +In December 2016, Arconic entered into a one -year claims purchase agreement with a bank covering claims up to $245 related to the Saudi Arabian joint venture and two long-term energy supply agreements. The majority of the premium was paid by Alcoa Corporation. The agreement matured in December 2017 and was not renewed in 2018 due to the decline in exposure to guarantee claims including a substantial reduction in the guarantees related to the Saudi Arabian joint venture and also the elimination of the guarantee related to the Rockdale energy contract. In December 2018, Arconic entered into a one -year insurance policy with a limit of $80 relating to the remaining long-term energy supply agreement. The premium is expected to be paid by Alcoa Corporation. The decision to enter into a claims purchase agreement or insurance policy will be made on an annual basis going forward. +Letters of Credit. Arconic has outstanding letters of credit, primarily related to workers’ compensation, environmental obligations and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2019 , was $136 at December 31, 2018 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to retain letters of credit of $54 that had previously been provided related to both Arconic and Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016. Alcoa Corporation workers’ compensation claims and letter of credit fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation. +Surety Bonds. Arconic has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire at various dates, primarily in 2019 , was $50 at December 31, 2018 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to provide surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016 and, as a result, Arconic has $25 in outstanding surety bonds relating to these liabilities. Alcoa Corporation workers’ compensation claims and surety bond fees paid by Arconic are being proportionately billed to and are being fully reimbursed by Alcoa Corporation. +V. Separation Transaction and Discontinued Operations +On November 1, 2016, Arconic completed the Separation Transaction. Alcoa Inc., which was re-named Arconic Inc., continues to own the Global Rolled Products (except for the Warrick, IN rolling operations and the equity interest in the rolling mill at the joint venture in Saudi Arabia), Engineered Products and Solutions, and Transportation and Construction Solutions segments. Alcoa Corporation includes the Alumina and Primary Metals segments and the aforementioned Warrick, IN rolling operations and equity interest in the rolling mill at the joint venture in Saudi Arabia, both of which were formally part of the Global Rolled Products segment. +Arconic completed the Separation Transaction by distribution on November 1, 2016 of 80.1% of the outstanding common stock of Alcoa Corporation to the Company’s shareholders of record (the “Distribution”) as of the close of business on October 20, 2016 (the “Record Date”). Arconic retained 19.9% of the Alcoa Corporation common stock ( 36,311,767 shares). In the Distribution, each Company shareholder received one share of Alcoa Corporation common stock for every three shares of Arconic common stock held as of the close of business on the Record Date. Shareholders received cash in lieu of fractional shares of Alcoa Corporation common stock. The Company had recorded the retained interest as a cost method investment in Investment in common stock of Alcoa Corporation in the December 2016 Consolidated Balance Sheet. The fair value of Arconic’s retained interest in Alcoa Corporation was $1,020 at December 31, 2016 and was based on the closing stock price of Alcoa Corporation as of December 31, 2016 multiplied by the number of shares of Alcoa Corporation common stock owned by the Company at that date. +In February 2017, Arconic sold 23,353,000 of its shares of Alcoa Corporation common stock at $38.03 per share, which resulted in cash proceeds of $888 which were recorded in Sales of investments within Investing Activities in the accompanying Statement of Consolidated Cash Flows, and a gain of $351 which was recorded in Other expense (income), net in the accompanying Statement of Consolidated Operations. In April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 Alcoa Corporation shares (valued at $35.91 per share) (the “Debt-for-Equity Exchange”) (See Note P ). A gain of $167 on the Debt-for-Equity Exchange was recorded in Other expense (income), net in the accompanying Statement of Consolidated Operations. As of May 4, 2017, the Company no longer maintained a retained interest in Alcoa Corporation +100 +Table of Contents +common stock. +On October 31, 2016, Arconic entered into several agreements with Alcoa Corporation that govern the relationship of the parties following the completion of the Separation Transaction. These agreements include the following: Separation and Distribution Agreement, Transition Services Agreement, Tax Matters Agreement, Employee Matters Agreement, Alcoa Corporation to Arconic Inc. Patent, Know-How, and Trade Secret License Agreement, Arconic Inc. to Alcoa Corporation Patent, Know-How, and Trade Secret License Agreement, Alcoa Corporation to Arconic Inc. Trademark License Agreement, Toll Processing and Services Agreement (the “Toll Processing Agreement”), Master Agreement for the Supply of Primary Aluminum, Massena Lease and Operations Agreement, Fusina Lease and Operations Agreement, and Stockholder and Registration Rights Agreement. +Effective November 1, 2016, Arconic entered into a Toll Processing Agreement with Alcoa Corporation for the tolling of metal for the Warrick, IN rolling mill which became a part of Alcoa Corporation upon completion of the Separation Transaction. As part of this arrangement, Arconic provided a toll processing service to Alcoa Corporation to produce can sheet products at its facility in Tennessee through the end date of the contract, December 31, 2018. Alcoa Corporation supplied all required raw materials to Arconic and Arconic processed the raw materials into finished can sheet coils ready for shipment to the end customer. Tolling revenues for 2018, 2017, and the two-month period ended December 31, 2016 and accounts receivable at December 31, 2018, December 31, 2017, and December 31, 2016 were not material to the consolidated results of operations and financial position for the years ended December 31, 2018, December 31, 2017, and December 31, 2016. +As part of the Separation Transaction, Arconic was required to provide maximum potential future payment guarantees for Alcoa Corporation issued on behalf of a third party, guarantees related to two long-term Alcoa Corporation energy supply agreements, guarantees related to certain Alcoa Corporation environmental liabilities and energy supply contracts, letters of credit and surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016, and letters of credit for certain Alcoa Corporation equipment leases and energy contracts (see Note U ). +As part of the Separation Transaction, Arconic had recorded a receivable in the December 2016 Consolidated Balance Sheet for the net after-tax proceeds from Alcoa Corporation’s sale of the Yadkin Hydroelectric Project. The transaction closed and the Company received proceeds of $238 in the first quarter of 2017 and the remaining $5 in the second quarter of 2017. The $243 proceeds were included in Other within Investing Activities in the Statement of Consolidated Cash Flows. +The results of operations of Alcoa Corporation were presented as discontinued operations in the Statement of Consolidated Operations as summarized below (the amounts presented in the table below have not been recast to reflect the adoption of new guidance issued by the FASB related to the presentation of net periodic pension cost and net periodic postretirement benefit cost as detailed in Note A ): +Ten months +ended October 31, +2016 +Sales +$ +6,752 +Cost of goods sold (exclusive of expenses below) +5,655 +Selling, general administrative, and other expenses +164 +Research and development +28 +Provision for depreciation, depletion and amortization +593 +Restructuring and other charges +102 +Interest expense +28 +Other (income) expenses, net +(75 +) +Income from discontinued operations before income taxes +257 +Provision for income taxes +73 +Income from discontinued operations after income taxes +184 +Less: Net income from discontinued operations attributable to noncontrolling interests +63 +Net income from discontinued operations +$ +121 +During 2017 and 2016, Arconic recognized $18 ( $12 after-tax) and $193 ( $158 after-tax), respectively, in Selling, general administrative, and other expenses on the accompanying Statement of Consolidated Operations for costs related to the Separation Transaction. In addition, Arconic also incurred capital expenditures and debt issuance costs of $110 during 2016 related to the Separation Transaction. None of the aforementioned costs and expenses related to the Separation Transaction were reclassified into discontinued operations. +101 +Table of Contents +On November 1, 2016, management evaluated the net assets of Alcoa Corporation for potential impairment and determined that no impairment charge was required. +The cash flows related to Alcoa Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows for 2016. The following table presents depreciation, depletion and amortization, restructuring and other charges, and purchases of property, plant and equipment of the discontinued operations related to Alcoa Corporation: +For the year ended December 31, +2016 +Depreciation, depletion and amortization +$ +593 +Restructuring and other charges +$ +102 +Capital expenditures +$ +298 +W. Subsequent Events +Management evaluated all activity of Arconic and concluded that no subsequent events have occurred that would require recognition in the Consolidated Financial Statements or disclosure in the Notes to the Consolidated Financial Statements, except as noted below: +On January 22, 2019, the Company announced that its Board of Directors (the Board) had determined to no longer pursue a potential sale of Arconic as part of its strategy and portfolio review. +On February 6, 2019, the Company announced that the Board appointed John C. Plant, current Chairman of the Board, as Chairman and Chief Executive Officer of the Company, effective February 6, 2019, to succeed Chip Blankenship, who ceased to serve as Chief Executive Officer of the Company and resigned as a member of the Board, in each case as of that date. In addition, the Company announced that the Board appointed Elmer L. Doty, current member of the Board, as President and Chief Operating Officer, a newly created position, effective February 6, 2019. Mr. Doty will remain a member of the Board. The Company also announced that Arthur D. Collins, Jr., current member of the Board, has been appointed interim Lead Independent Director of the Company, effective February 6, 2019. +On February 8, 2019, the Company announced the following key initiatives as part of its ongoing strategy and portfolio review: plans to reduce operating costs, designed to maximize the impact in 2019; the planned separation of its portfolio into Engineered Products and Forgings (EP&F) and Global Rolled Products (GRP), with a spin-off of one of the businesses; the potential sale of businesses that do not best fit into EP&F or GRP; execute its previously authorized $500 share repurchase program in the first half of 2019; the Board authorized an additional $500 of share repurchases, effective through the end of 2020; and plans to reduce its quarterly common stock dividend from $0.06 to $0.02 per share. +On February 19, 2019, the Company entered into an accelerated share repurchase (“ASR”) agreement with JPMorgan Chase Bank to repurchase $700 of its common stock, pursuant to the share repurchase program previously authorized by the Board. Under the ASR agreement, Arconic will receive initial delivery of approximately 32 million shares on February 21, 2019. The final number of shares to be repurchased will be based on the volume-weighted average price of Arconic’s common stock during the term of the transaction, less a discount. The ASR agreement is expected to be completed during the first half of 2019. +The Company will evaluate its organizational structure in conjunction with the planned separation of its portfolio and changes to its reportable segments are expected in the first half of 2019. +102 +Table of Contents +Supplemental Financial Information (unaudited) +Quarterly Data +(in millions, except per-share amounts) +First +Second +Third +Fourth (2) +Year +2018 +Sales +$ +3,445 +$ +3,573 +$ +3,524 +$ +3,472 +$ +14,014 +Net income +$ +143 +$ +120 +$ +161 +$ +218 +$ +642 +Earnings per share attributable to Arconic common shareholders (1) : +Basic +Net income per share—basic +$ +0.30 +$ +0.25 +$ +0.33 +$ +0.45 +$ +1.33 +Diluted +Net income per share—diluted +$ +0.29 +$ +0.24 +$ +0.32 +$ +0.44 +$ +1.30 +2017 +Sales +$ +3,192 +$ +3,261 +$ +3,236 +$ +3,271 +$ +12,960 +Net income (loss) +$ +322 +$ +212 +$ +119 +$ +(727 +) +$ +(74 +) +Earnings (loss) per share attributable to Arconic common shareholders (1) : +Basic +Net income (loss) per share—basic +$ +0.69 +$ +0.44 +$ +0.23 +$ +(1.51 +) +$ +(0.28 +) +Diluted +Net income (loss) per share—basic +$ +0.65 +$ +0.43 +$ +0.22 +$ +(1.51 +) +$ +(0.28 +) +(1) +Per share amounts are calculated independently for each period presented; therefore, the sum of the quarterly per share amounts may not equal the per share amounts for the year. +(2) +In the fourth quarter of 2018, Arconic recorded a gain of $119 ( $154 pre-tax) on the sale of the Texarkana rolling mill, offset by pension plan settlement charges of $72 ($ 92 pre-tax) associated with significant lump sum payments made to participants and a loss of $39 ($ 43 pre-tax) on the sale of the Eger, Hungary forgings business. Additionally, Arconic recorded discrete tax items primarily comprised of a benefit related to certain prior year foreign investment losses no longer recapturable. In the fourth quarter of 2017, Arconic recorded an impairment of goodwill related to the forgings and extrusions business of $719 ( $719 pre-tax); a provisional charge of $272 associated with the revaluation of U.S. net deferred tax assets due to a decrease in the U.S. corporate tax rate from 35% to 21% , as well as a one-time transition tax on the non-previously taxed earnings and profits of certain U.S.-owned foreign corporations as of December 31, 2017; a favorable adjustment to the Firth Rixson earn-out liability of $81 ( $81 pre-tax); and a favorable adjustment to a separation-related guarantee liability of $16 ( $25 pre-tax). +Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. +None. +Item 9A. Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures +Arconic’s Chief Executive Officer and Chief Financial Officer have evaluated the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as of the end of the period covered by this report, and they have concluded that these controls and procedures are effective. +(b) Management’s Annual Report on Internal Control over Financial Reporting +Management’s Report on Internal Control over Financial Reporting is included in Part II, Item 8 of this Form 10-K beginning on page 51 . +(c) Attestation Report of the Registered Public Accounting Firm +The effectiveness of Arconic’s internal control over financial reporting as of December 31, 2018 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included in Part II, Item 8 of this Form 10-K on page 52 . +103 +Table of Contents +(d) Changes in Internal Control over Financial Reporting +There have been no changes in internal control over financial reporting during the fourth quarter of 2018 , that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +Item 9B. Other Information. +None. +PART III +Item 10. Directors, Executive Officers and Corporate Governance. +The information required by Item 401 of Regulation S-K regarding directors is contained under the caption “Item 1 Election of Directors” of the Proxy Statement and is incorporated by reference. The information required by Item 401 of Regulation S-K regarding executive officers is set forth in Part I, Item 1 of this report under “Executive Officers of the Registrant.” +The information required by Item 405 of Regulation S-K is contained under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement and is incorporated by reference. +The Company’s Code of Ethics for the CEO, CFO and Other Financial Professionals is publicly available on the Company’s Internet website at http://www.arconic.com under the section “Investors—Corporate Governance.” The remaining information required by Item 406 of Regulation S-K is contained under the captions “Corporate Governance” and “Corporate Governance—Business Conduct Policies and Code of Ethics” of the Proxy Statement and is incorporated by reference. +The information required by Items 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is included under the captions “Item 1 Election of Directors—Nominating Board Candidates—Procedures and Director Qualifications” and “Corporate Governance—Committees of the Board—Audit Committee” of the Proxy Statement and is incorporated by reference. +Item 11. Executive Compensation. +The information required by Item 402 of Regulation S-K is contained under the captions “Director Compensation”, “Executive Compensation” and “Corporate Governance—Recovery of Incentive Compensation” of the Proxy Statement. Such information is incorporated by reference. +The information required by Items 407(e)(4) and (e)(5) of Regulation S-K is contained under the captions “Corporate Governance—Compensation Committee Interlocks and Insider Participation” and “Item 3 Advisory Approval of Executive Compensation—Compensation Committee Report” of the Proxy Statement. Such information (other than the Compensation Committee Report, which shall not be deemed to be “filed”) is incorporated by reference. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by Item 201(d) of Regulation S-K relating to securities authorized for issuance under equity compensation plans is contained under the caption “Equity Compensation Plan Information” of the Proxy Statement and is incorporated by reference. +The information required by Item 403 of Regulation S-K is contained under the captions “Arconic Stock Ownership— Stock Ownership of Certain Beneficial Owners” and “— Stock Ownership of Directors and Executive Officers” of the Proxy Statement and is incorporated by reference. +Item 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by Item 404 of Regulation S-K is contained under the captions “Executive Compensation” (excluding the information under the caption “Compensation Committee Report”) and “Corporate Governance— Related Person Transactions” of the Proxy Statement and is incorporated by reference. +The information required by Item 407(a) of Regulation S-K regarding director independence is contained under the captions “Item 1 Election of Directors” and “Corporate Governance” of the Proxy Statement and is incorporated by reference. +Item 14. Principal Accounting Fees and Services. +The information required by Item 9(e) of Schedule 14A is contained under the captions “Item 2 Ratification of Appointment of Independent Registered Public Accounting Firm—Report of the Audit Committee” and “— Audit and Non-Audit Fees” of the Proxy Statement and in Attachment A (Pre-Approval Policies and Procedures for Audit and Non-Audit Services) thereto and is incorporated by reference. +104 +Table of Contents +PART IV +Item 15. Exhibits, Financial Statement Schedules. +(a) The consolidated financial statements and exhibits listed below are filed as part of this report. +(1) The Company’s consolidated financial statements, the notes thereto and the report of the Independent Registered Public Accounting Firm are on pages 53 through 102 of this report. +(2) Financial statement schedules have been omitted because they are not applicable, not required, or the required information is included in the consolidated financial statements or notes thereto. +(3) Exhibits. +Exhibit +Number +Description* +2(a) +Share Purchase Agreement, dated as of June 25, 2014, by and among Alcoa Inc., Alcoa IH Limited, FR Acquisition Corporation (US), Inc., FR Acquisitions Corporation (Europe) Limited, FR Acquisition Finance Subco (Luxembourg), S.à.r.l. and Oak Hill Capital Partners III, L.P. and Oak Hill Capital Management Partners III, L.P., collectively in their capacity as the Seller Representative, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated June 27, 2014. +2(b) +Separation and Distribution Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(c) +Tax Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(d) +Employee Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(d)(1) +Amendment No. 1, dated December 13, 2016, to Employee Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2(e)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +2(e) +Alcoa Corporation to Arconic Inc. Patent, Know-How, and Trade Secret License Agreement, dated as of October 31, 2016, by and between Alcoa USA Corp. and Arconic Inc., incorporated by reference to exhibit 2.5 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(f) +Arconic Inc. to Alcoa Corporation Patent, Know-How, and Trade Secret License Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa USA Corp., incorporated by reference to exhibit 2.6 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(g) +Amended and Restated Alcoa Corporation to Arconic Inc. Trademark License Agreement, dated as of June 25, 2017, by and between Alcoa USA Corp. and Arconic Inc., incorporated by reference to exhibit 2 to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2017. +2(h) +Master Agreement for the Supply of Primary Aluminum, dated as of October 31, 2016, by and between Alcoa Corporation and its affiliates and Arconic Inc., incorporated by reference to exhibit 2.9 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +105 +Table of Contents +2(i) +Massena Lease and Operations Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.10 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(j) +Agreement and Plan of Merger, dated October 12, 2017, by and between Arconic Inc., a Pennsylvania corporation, and Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +3(a) +Certificate of Incorporation of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 3.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +3(b) +Bylaws of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 3.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(a) +Form of Certificate for Shares of Common Stock of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 4.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(b) +Bylaws. See exhibit 3(b) above. +4(c) +Form of Indenture, dated as of September 30, 1993, between Alcoa Inc. and The Bank of New York Trust Company, N.A., as successor to J. P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association), as successor Trustee to PNC Bank, National Association, as Trustee (undated form of Indenture incorporated by reference to exhibit 4(a) to Registration Statement No. 33-49997 on Form S-3). +4(c)(1) +First Supplemental Indenture, dated as of January 25, 2007, between Alcoa Inc. and The Bank of New York Trust Company, N.A., as successor to J.P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association), as successor Trustee to PNC Bank, National Association, as Trustee, incorporated by reference to exhibit 99.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2007. +4(c)(2) +Second Supplemental Indenture, dated as of July 15, 2008, between Alcoa Inc. and The Bank of New York Mellon Trust Company, N.A., as successor in interest to J. P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association, as successor to PNC Bank, National Association), as Trustee, incorporated by reference to exhibit 4(c) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 15, 2008. +4(c)(3) +Fourth Supplemental Indenture, dated as of December 31, 2017, between Arconic Inc., a Pennsylvania corporation, Arconic Inc., a Delaware corporation, and The Bank of New York Mellon Trust Company, N.A., as trustee, incorporated by reference to exhibit 4.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(d) +Form of 6.75% Bonds Due 2028, incorporated by reference to exhibit 4(d) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +4(e) +Form of 5.90% Notes Due 2027, incorporated by reference to exhibit 4(e) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +4(f) +Form of 5.95% Notes Due 2037, incorporated by reference to exhibit 4(f) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +4(g) +Form of 5.87% Notes Due 2022, incorporated by reference to exhibit 4.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 21, 2007. +106 +Table of Contents +4(h) +Form of 6.150% Notes Due 2020, incorporated by reference to exhibit 4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated August 3, 2010. +4(i) +Form of 5.40% Notes Due 2021, incorporated by reference to exhibit 4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated April 21, 2011. +4(j) +Form of 5.125% Notes Due 2024, incorporated by reference to exhibit 4.5 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 22, 2014. +4(k) +Indenture, dated as of December 14, 2010, between RTI International Metals, Inc. and The Bank of New York Trust Company, N.A., as Trustee, incorporated by reference to exhibit 4(m) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(k)(1) +Third Supplemental Indenture, dated as of April 17, 2013, between RTI International Metals, Inc. and The Bank of New York Trust Company, N.A., as Trustee, incorporated by reference to exhibit 4(n) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(k)(2) +Fourth Supplemental Indenture, dated as of July 23, 2015, between RTI International Metals, Inc. and The Bank of New York Trust Company, N.A., as Trustee, incorporated by reference to exhibit 4.1 on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +4(k)(3) +Fifth Supplemental Indenture, dated as of November 30, 2017, between RTI International Metals, Inc. and The Bank of New York Trust Company, N.A., as Trustee, incorporated by reference to exhibit 4.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 4, 2017. +4(k)(4) +Sixth Supplemental Indenture, dated as of December 31, 2017, between Arconic Inc., a Pennsylvania corporation, Arconic Inc., a Delaware corporation, and The Bank of New York Mellon Trust Company, N.A., as Trustee, incorporated by reference to exhibit 4.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(k)(5) +Form of 1.625% Convertible Senior Notes Due 2019. See exhibit 4(k)(1) above. +4(l) +Arconic Bargaining Retirement Savings Plan (formerly known as the Alcoa Retirement Savings Plan for Bargaining Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(m) +Arconic Hourly Non-Bargaining Retirement Savings Plan (formerly known as the Alcoa Retirement Savings Plan for Hourly Non-Bargaining Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(q) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(n) +Arconic Fastener Systems and Rings Retirement Savings Plan (formerly known as the Alcoa Retirement Savings Plan for Fastener Systems Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(r) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(o) +Arconic Salaried Retirement Savings Plan (formerly known as the Alcoa Retirement Savings Plan for Salaried Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(s) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(p) +Arconic Retirement Savings Plan for ATEP Bargaining Employees, effective January 1, 2017, incorporated by reference to exhibit 4 to Post-Effective Amendment, dated December 30, 2016, to Registration Statement No. 333-32516 on Form S-8. +107 +Table of Contents +10(a) +Earnout Agreement, dated as of June 25, 2014, by and among Alcoa Inc., FR Acquisition Finance Subco (Luxembourg), S.à.r.l. and Oak Hill Capital Partners III, L.P. and Oak Hill Capital Management Partners III, L.P., collectively in their capacity as the Seller Representative, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated June 27, 2014. +10(b) +Five-Year Revolving Credit Agreement, dated as of July 25, 2014, among Alcoa Inc., the Lenders and Issuers named therein, Citibank, N.A., as Administrative Agent for the Lenders and Issuers, and JPMorgan Chase Bank, N.A., as Syndication Agent, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 31, 2014. +10(b)(1) +Extension Request and Amendment Letter, dated as of June 5, 2015, among Alcoa Inc., each lender and issuer party thereto, and Citibank, N.A., as Administrative Agent, effective July 7, 2015, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 13, 2015. +10(b)(2) +Amendment No. 1, dated September 16, 2016, to the Five-Year Revolving Credit Agreement dated as of July 25, 2014, among Arconic Inc., the lenders and issuers named therein, Citibank, N.A., as administrative agent, and JPMorgan Chase Bank, N.A. as syndication agent, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 19, 2016. +10(b)(3) +Assumption Agreement, dated as of December 31, 2017, by Arconic Inc., a Delaware corporation, in favor of and for the benefit of the Lenders and Citibank, N.A., as administrative agent, incorporated by reference to exhibit 4.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +10(b)(4) +Amendment No. 2, dated as of June 29, 2018, to the Company’s Five-Year Revolving Credit Agreement dated as of July 25, 2014, by and among the Company, a syndicate of lenders and issuers named therein, Citibank, N.A., as administrative agent for the lenders and issuers, and JPMorgan Chase Bank, N.A., as syndication agent, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated July 2, 2018. +10(c) +Plea Agreement dated January 8, 2014, between the United States of America and Alcoa World Alumina LLC, incorporated by reference to exhibit 10(l) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2013. +10(d) +Agreement, dated February 1, 2016, by and between Elliott Associates, L.P., Elliott International, L.P., Elliott International Capital Advisors Inc. and Alcoa Inc., incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 1, 2016. +10(e) +Settlement Agreement, dated as of May 22, 2017, by and among Elliott Associates, L.P., Elliott International, L.P., Elliott International Capital Advisors Inc. and Arconic Inc., incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 22, 2017 (reporting an event on May 21, 2017). +10(f) +Letter Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of December 19, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 19, 2017. +10(g) +Registration Rights Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of December 19, 2017, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 19, 2017. +108 +Table of Contents +10(g)(1) +Amendment to Registration Rights Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of February 2, 2018, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 6, 2018. +10(h) +Alcoa Internal Revenue Code Section 162(m) Compliant Annual Cash Incentive Compensation Plan, as Amended and Restated, incorporated by reference to Exhibit 10(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 11, 2016. +10(i) +2004 Summary Description of the Alcoa Incentive Compensation Plan, incorporated by reference to exhibit 10(g) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2004. +10(i)(1) +Incentive Compensation Plan of Alcoa Inc., as revised and restated effective November 8, 2007, incorporated by reference to exhibit 10(k)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2007. +10(i)(2) +Amendment to Incentive Compensation Plan of Alcoa Inc., effective December 18, 2009, incorporated by reference to exhibit 10(n)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2009. +10(j) +Arconic Employees’ Excess Benefits Plan C (formerly referred to as the Alcoa Inc. Employees’ Excess Benefits Plan, Plan C), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(j) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(j)(1) +First Amendment to Arconic Employees’ Excess Benefits Plan C (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(l)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(j)(2) +Second Amendment to Arconic Employees’ Excess Benefits Plan C (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(l)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(j)(3) +Third Amendment to Arconic Employees’ Excess Benefits Plan C (as amended and restated effective August 1, 2016), incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 8, 2018. +10(k) +Deferred Fee Plan for Directors, as amended effective July 9, 1999, incorporated by reference to exhibit 10(g)(1) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 1999. +10(l) +Amended and Restated Deferred Fee Plan for Directors, effective November 1, 2016, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2016. +10(m) +Non-Employee Director Compensation Policy, effective February 6, 2019. +10(n) +Fee Continuation Plan for Non-Employee Directors, incorporated by reference to exhibit 10(k) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1989. +10(n)(1) +Amendment to Fee Continuation Plan for Non-Employee Directors, effective November 10, 1995, incorporated by reference to exhibit 10(i)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1995. +109 +Table of Contents +10(n)(2) +Second Amendment to the Fee Continuation Plan for Non-Employee Directors, effective September 15, 2006, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 20, 2006. +10(o) +Arconic Deferred Compensation Plan, as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(o)(1) +First Amendment to the Arconic Deferred Compensation Plan (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(r)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(p) +Summary of the Executive Split Dollar Life Insurance Plan, dated November 1990, incorporated by reference to exhibit 10(m) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1990. +10(q) +Amended and Restated Dividend Equivalent Compensation Plan, effective January 1, 1997, incorporated by reference to exhibit 10(h) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2004. +10(r) +Form of Indemnity Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10(j) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1987.) +10(s) +Form of Indemnification Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2018. +10(t) +Amended and Restated 2009 Alcoa Stock Incentive Plan, dated February 15, 2011, incorporated by reference to exhibit 10(z)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2010. +10(u) +Arconic Supplemental Pension Plan for Senior Executives (formerly referred to as the Alcoa Supplemental Pension Plan for Senior Executives), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(v) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(u)(1) +First Amendment to Arconic Supplemental Pension Plan for Senior Executives (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(x)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(u)(2) +Second Amendment to Arconic Supplemental Pension Plan for Senior Executives (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(x)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(v) +Deferred Fee Estate Enhancement Plan for Directors, effective July 10, 1998, incorporated by reference to exhibit 10(r) to the Company’s Annual Report on Form 10-K (Commission file number 1- 3610) for the year ended December 31, 1998. +10(w) +Arconic Inc. Change in Control Severance Plan, as amended and restated effective February 1, 2018, incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 6, 2018. +110 +Table of Contents +10(x) +Letter Agreement, dated August 14, 2007, between Alcoa Inc. and Klaus Kleinfeld, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2007. +10(y) +Executive Severance Agreement, as amended and restated effective December 8, 2008, between Alcoa Inc. and Klaus Kleinfeld, incorporated by reference to exhibit 10(gg) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +10(y)(1) +Letter Agreement between Arconic Inc. and Klaus Kleinfeld, dated February 27, 2017, incorporated by reference to exhibit 10(y)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(z) +Separation Agreement between Arconic Inc. and Klaus Kleinfeld, dated July 31, 2017, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2017. +10(aa) +Form of Executive Severance Agreement between the Company and new officers entered into after July 22, 2010, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2010. +10(bb) +Arconic Inc. Executive Severance Plan, as effective February 27, 2017, incorporated by reference to exhibit 10(aa) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(cc) +Letter Agreement, by and between Alcoa Inc. and Katherine H. Ramundo, dated as of July 28, 2016, incorporated by reference to exhibit 10(ff) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(dd) +Letter Agreement, from Arconic Inc. to Katherine H. Ramundo, dated as of May 31, 2018, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(ee) +Letter Agreement between Arconic Inc. and David P. Hess, dated May 17, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 22, 2017 (reporting an event on May 17, 2017). +10(ff) +Letter Agreement, by and between Arconic Inc. and Charles P. Blankenship, dated as of October 19, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated October 23, 2017 +10(gg) +Letter Agreement, by and between Arconic Inc. and Mark J. Krakowiak, dated as of January 20, 2018, incorporated by reference to exhibit 10(ii) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(hh) +Letter Agreement, from Arconic Inc. to Ken Giacobbe, dated as of February 14, 2019. +10(ii) +Arconic Global Pension Plan, as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(bb) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(jj) +Global Expatriate Employee Policy (pre-January 1, 2003), incorporated by reference to exhibit 10(uu) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2005. +111 +Table of Contents +10(kk) +Arconic Inc. Legal Fee Reimbursement Plan, effective as of April 30, 2018, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2018. +10(ll) +Summary Description of Equity Choice Program for Performance Equity Award Participants, dated November 2005, incorporated by reference to exhibit 10.6 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 16, 2005. +10(mm) +2013 Arconic Stock Incentive Plan, as Amended and Restated, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 22, 2018. +10(mm)(1) +Terms and Conditions (Australian Addendum) to the 2013 Arconic Stock Incentive Plan, effective May 3, 2013, incorporated by reference to exhibit 10(d) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 8, 2013. +10(nn) +RTI International Metals, Inc. 2004 Stock Plan, incorporated by reference to exhibit 4(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +10(oo) +RTI International Metals, Inc. 2014 Stock and Incentive Plan, incorporated by reference to exhibit 4(a) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +10(oo)(1) +First Amendment to the RTI International Metals, Inc. 2014 Stock and Incentive Plan, as amended and assumed by Arconic Inc., dated February 1, 2018, incorporated by reference to exhibit 10(oo)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(pp) +Form of Award Agreement for Stock Options, effective May 8, 2009, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 13, 2009. +10(qq) +Form of Award Agreement for Stock Options, effective January 1, 2010, incorporated by reference to exhibit 10(ddd) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2009. +10(rr) +Terms and Conditions for Stock Options, effective January 1, 2011, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2011. +10(ss) +Terms and Conditions for Stock Option Awards, effective May 3, 2013, incorporated by reference to exhibit 10(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 8, 2013. +10(tt) +Terms and Conditions for Stock Option Awards under the 2013 Arconic Stock Incentive Plan, effective July 22, 2016, incorporated by reference to Exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10(uu) +Global Stock Option Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(uu) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(vv) +Form of Stock Option Award Agreement, incorporated by reference to exhibit 10(f) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(ww) +Terms and Conditions for Restricted Share Units, effective May 3, 2013, incorporated by reference to exhibit 10(c) to the Company’s Current Report on Form 8-K (Commission file number 1- 3610) dated May 8, 2013. +112 +Table of Contents +10(xx) +Terms and Conditions for Restricted Share Units under the 2013 Arconic Stock Incentive Plan, effective July 22, 2016, incorporated by reference to Exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10(yy) +Terms and Conditions for Restricted Share Units for Annual Director Awards under the 2013 Arconic Stock Incentive Plan, effective November 30, 2016, incorporated by reference to exhibit 10(vv) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(zz) +Terms and Conditions for Restricted Share Units for Annual Director Awards under the 2013 Arconic Stock Incentive Plan, as Amended and Restated, effective December 5, 2017, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2018. +10(aaa) +Terms and Conditions for Deferred Fee Restricted Share Units for Director Awards under the 2013 Arconic Stock Incentive Plan, effective November 30, 2016, incorporated by reference to exhibit 10(ww) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(bbb) +Terms and Conditions for Restricted Share Units issued on or after January 13, 2017, under the 2013 Arconic Stock Incentive Plan, effective January 13, 2017, incorporated by reference to exhibit 10(xx) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(ccc) +Terms and Conditions for Restricted Share Units - Interim CEO (David P. Hess) Award, effective October 23, 2017, incorporated by reference to exhibit 10(ccc) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(ddd) +Terms and Conditions for Restricted Share Units - Non-Executive Chairman (John C. Plant) Director Award, effective October 23, 2017, incorporated by reference to exhibit 10(ddd) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(eee) +Terms and Conditions for Restricted Share Units - Non-Executive Chairman (John C. Plant) Director Award, effective October 23, 2018, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2018. +10(fff) +Global Restricted Share Unit Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(eee) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(ggg) +Terms and Conditions for Restricted Share Units issued on or after January 19, 2018, under the 2013 Arconic Stock Incentive Plan, effective January 19, 2018, incorporated by reference to exhibit 10(fff) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(hhh) +Form of Restricted Share Unit Award Agreement, incorporated by reference to exhibit 10(g) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(iii) +Terms and Conditions for Special Retention Awards under the 2013 Arconic Stock Incentive Plan, effective January 1, 2015, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2015. +10(jjj) +Terms and Conditions for Special Retention Awards under the 2013 Arconic Stock Incentive Plan, effective July 22, 2016, incorporated by reference to exhibit 10(e) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +113 +Table of Contents +10(kkk) +Global Special Retention Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(kkk) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(lll) +Special Retention Award Agreement - Katherine H. Ramundo, effective May 16, 2018, incorporated by reference to exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(mmm) +Special Retention Award Agreement - Paul Myron, effective May 16, 2018, incorporated by reference to exhibit 10(e) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(nnn) +Special Retention Award Agreement - Ken Giacobbe, effective February 12, 2019. +21 +Subsidiaries of the Registrant. +23 +Consent of Independent Registered Public Accounting Firm. +24 +Power of Attorney for certain directors. +31 +Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101. INS +XBRL Instance Document. +101. SCH +XBRL Taxonomy Extension Schema Document. +101. CAL +XBRL Taxonomy Extension Calculation Linkbase Document. +101. DEF +XBRL Taxonomy Extension Definition Linkbase Document. +101. LAB +XBRL Taxonomy Extension Label Linkbase Document. +101. PRE +XBRL Taxonomy Extension Presentation Linkbase Document. +* Exhibit Nos. 10(h) through 10(nnn) are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K. +Amendments and modifications to other Exhibits previously filed have been omitted when in the opinion of the registrant such Exhibits as amended or modified are no longer material or, in certain instances, are no longer required to be filed as Exhibits. +No other instruments defining the rights of holders of long-term debt of the registrant or its subsidiaries have been filed as Exhibits because no such instruments met the threshold materiality requirements under Regulation S-K. The registrant agrees, however, to furnish a copy of any such instruments to the Commission upon request. +Item 16. Form 10-K Summary. +None. +114 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ARCONIC INC. +February 21, 2019 +By +/s/ Paul Myron +Paul Myron +Vice President and Controller (Also signing as Principal Accounting Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ John C. Plant +Chairman and Chief Executive Officer +February 21, 2019 +John C. Plant +(Principal Executive Officer and Director) +/s/ Ken Giacobbe +February 21, 2019 +Ken Giacobbe +Executive Vice President and Chief Financial Officer (Principal Financial Officer) +James F. Albaugh, Amy E. Alving, Christopher L. Ayers, Arthur D. Collins, Jr., Elmer L. Doty, Rajiv L. Gupta, David P. Hess, Sean O. Mahoney, David J. Miller, E. Stanley O’Neal, and Ulrich R. Schmidt, each as a Director, on February 21, 2019 , by Paul Myron, their Attorney-in-Fact.* +*By +/s/ Paul Myron +Paul Myron +Attorney-in-Fact +115 \ No newline at end of file diff --git a/raw/filings/0000004281/2018/0000004281-19-000031/filing_metadata.csv b/raw/filings/0000004281/2018/0000004281-19-000031/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..6c964c0e709ef365dc77a99d9ef9df307e72e3ff --- /dev/null +++ b/raw/filings/0000004281/2018/0000004281-19-000031/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004281,HWM,Howmet Aerospace Inc.,2018,10-K,2019-02-21,2018-12-31,2019-02-21T22:24:56.000Z,0000004281-19-000031,form10k_4q18.htm,10-K,21550633,1,0,https://www.sec.gov/Archives/edgar/data/4281/000000428119000031/form10k_4q18.htm,https://www.sec.gov/Archives/edgar/data/4281/000000428119000031/ diff --git a/raw/filings/0000004281/2018/0000004281-19-000031/item1.txt b/raw/filings/0000004281/2018/0000004281-19-000031/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..2a864fb8d8ecea060e9df9d1b07d172bb7570ed7 --- /dev/null +++ b/raw/filings/0000004281/2018/0000004281-19-000031/item1.txt @@ -0,0 +1,7 @@ +Item 1. Business. +General +Arconic Inc. is a Delaware corporation with its principal office in New York, New York and the successor to Arconic Pennsylvania (as defined below) which was formed in 1888 and formerly known as Alcoa Inc. In this report, unless the context otherwise requires, “Arconic” or the “Company” means Arconic Inc., a Delaware corporation, and all subsidiaries consolidated for the purposes of its financial statements. +The Company’s Internet address is http://www.arconic.com . Arconic makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC). The information on the Company’s Internet site is not a part of, or incorporated by reference in, this annual report on Form 10-K. The SEC maintains an Internet site that contains these reports at http://www.sec.gov . +Forward-Looking Statements +This report contains (and oral communications made by Arconic may contain) statements that relate to future events and expectations and, as such, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those containing such words as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “guidance,” “intends,” “may,” “outlook,” “plans,” “projects,” “seeks,” “sees,” “should,” “targets,” “will,” “would,” or other words of similar meaning. All statements that reflect Arconic’s expectations, assumptions or projections about the future, other than statements of historical fact, are forward-looking statements, including, without limitation, forecasts relating to the growth of the aerospace, automotive, commercial transportation and other end markets; statements and guidance regarding future financial results or operating performance; statements about Arconic’s strategies, outlook, business and financial prospects; and statements regarding potential share gains. Forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and changes in circumstances that are difficult to predict. Although Arconic believes that the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that these expectations will be attained and it is possible that actual results may differ materially from those indicated by these forward-looking statements due to a variety of risks and uncertainties. +For a discussion of some of the specific factors that may cause Arconic’s actual results to differ materially from those projected in any forward-looking statements, see the following sections of this report: Part I, \ No newline at end of file diff --git a/raw/filings/0000004281/2018/0000004281-19-000031/item13.txt b/raw/filings/0000004281/2018/0000004281-19-000031/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..678e8c5391a573f1b629a06bea4da035a03cd44c --- /dev/null +++ b/raw/filings/0000004281/2018/0000004281-19-000031/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related 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COMMISSION +WASHINGTON, D.C. 20549 +FORM 10-K +☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF +THE SECURITIES EXCHANGE ACT OF 1934 +For The Fiscal Year Ended December 31, 2019 +OR +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) +OF THE SECURITIES EXCHANGE ACT OF 1934 +Commission File Number 1-3610 +ARCONIC INC. +(Exact name of registrant as specified in its charter) +Delaware +25-0317820 +(State of incorporation) +(I.R.S. Employer Identification No.) +201 Isabella Street, Suite 200 , Pittsburgh , Pennsylvania 15212-5872 +(Address of principal executive offices) (Zip code) +Investor Relations----------------(412) 553-1950 +Office of the Secretary-----------( 412 ) 553-1940 +(Registrant’s telephone numbers, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +Common Stock, par value $1.00 per share +ARNC +New York Stock Exchange +$3.75 Cumulative Preferred Stock, +par value $100.00 per share +ARNC PR +NYSE American +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ✓ No . +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. +Yes No ✓ . +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes ✓ No . +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ✓ No . +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer [ ✓ ] Accelerated filer [] Non-accelerated filer [] +Smaller reporting company ☐ Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ✓ . +The aggregate market value of the outstanding common stock, other than shares held by persons who may be deemed affiliates of the registrant, as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $ 11 billion . As of February 21, 2020 , there were 435,918,568 shares of common stock, par value $1.00 per share, of the registrant outstanding. +Documents incorporated by reference. +Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement for its 2020 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A (Proxy Statement). +Table of Contents +TABLE OF CONTENTS +Page(s) +Part I +Item 1. +Business +1 +Item 1A. +Risk Factors +15 +Item 1B. +Unresolved Staff Comments +29 +Item 2. +Properties +29 +Item 3. +Legal Proceedings +29 +Item 4. +Mine Safety Disclosures +32 +Part II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +33 +Item 6. +Selected Financial Data +36 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +37 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +52 +Item 8. +Financial Statements and Supplementary Data +53 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +107 +Item 9A. +Controls and Procedures +107 +Item 9B. +Other Information +107 +Part III +Item 10. +Directors, Executive Officers and Corporate Governance +107 +Item 11. +Executive Compensation +107 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +107 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +108 +Item 14. +Principal Accounting Fees and Services +108 +Part IV +Item 15. +Exhibits, Financial Statement Schedules +108 +Item 16. +Form 10-K Summary +117 +Signatures +118 +Note on Incorporation by Reference +In this Form 10-K, selected items of information and data are incorporated by reference to portions of the Proxy Statement. Unless otherwise provided herein, any reference in this report to disclosures in the Proxy Statement shall constitute incorporation by reference of only that specific disclosure into this Form 10-K. +Table of Contents +PART I +Item 1. Business. +General +Arconic Inc. is a Delaware corporation with its principal office in Pittsburgh, Pennsylvania and the successor to Arconic Pennsylvania (as defined below) which was formed in 1888 and formerly known as Alcoa Inc. In this report, unless the context otherwise requires, “Arconic” or the “Company” means Arconic Inc., a Delaware corporation, and all subsidiaries consolidated for the purposes of its financial statements. +The Company’s Internet address is http://www.arconic.com . Arconic makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC). The information on the Company’s Internet site is not a part of, or incorporated by reference in, this annual report on Form 10-K. The SEC maintains an Internet site that contains these reports at http://www.sec.gov . +Forward-Looking Statements +This report contains (and oral communications made by Arconic may contain) statements that relate to future events and expectations and, as such, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those containing such words as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “guidance,” “intends,” “may,” “outlook,” “plans,” “projects,” “seeks,” “sees,” “should,” “targets,” “will,” “would,” or other words of similar meaning. All statements that reflect Arconic’s expectations, assumptions or projections about the future, other than statements of historical fact, are forward-looking statements, including, without limitation, forecasts relating to the growth of the aerospace, automotive, commercial transportation and other end markets; statements and guidance regarding future financial results or operating performance; statements about Arconic’s strategies, outlook, business and financial prospects; and statements regarding potential share gains. Forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and changes in circumstances that are difficult to predict. Although Arconic believes that the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that these expectations will be attained and it is possible that actual results may differ materially from those indicated by these forward-looking statements due to a variety of risks and uncertainties. +For a discussion of some of the specific factors that may cause Arconic’s actual results to differ materially from those projected in any forward-looking statements, see the following sections of this report: Part I, Item 1A. (Risk Factors), Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations), including the disclosures under Segment Information and Critical Accounting Policies and Estimates, and Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). Market projections are subject to the risks discussed in this report and other risks in the market. Arconic disclaims any intention or obligation to update publicly any forward-looking statements, whether in response to new information, future events or otherwise, except as required by applicable law. +Overview +Arconic Inc. (“Arconic” or the “Company”) is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging. +Arconic is a global company operating in 18 countries. Based upon the country where the point of sale occurred, the United States and Europe generated 67% and 23%, respectively, of Arconic’s sales in 2019. In addition, Arconic has operating activities in numerous countries and regions outside the United States, including Europe, Canada, China, Japan, and Russia. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in countries with such operating activities . +Arconic has two reportable segments, which are organized by product on a worldwide basis: Engineered Products and Forgings (EP&F) and Global Rolled Products (GRP). +Background +Arconic Inc. Reincorporation +On December 31, 2017 (the “Effective Date”), Arconic Inc., a Pennsylvania corporation (“Arconic Pennsylvania” or, prior to the Reincorporation (as defined below), the “Company”), effected the change of the Company’s jurisdiction of incorporation from Pennsylvania to Delaware (the “Reincorporation”) by merging (the “Reincorporation Merger”) with a direct wholly owned Delaware subsidiary, Arconic (in this section, “Arconic Delaware” or, following the Reincorporation, the “Company”), pursuant to an Agreement and Plan of Merger (the “Reincorporation Merger Agreement”), dated as of October 12, 2017, by and +1 +Table of Contents +between Arconic Pennsylvania and Arconic Delaware. Arconic Pennsylvania shareholders approved the Reincorporation Merger to effect the Reincorporation at a Special Meeting of Shareholders held on November 30, 2017. As a result of the Reincorporation, (i) Arconic Pennsylvania has ceased to exist, (ii) Arconic Delaware automatically inherited the reporting obligations of Arconic Pennsylvania under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and (iii) Arconic Delaware is deemed to be the successor issuer to Arconic Pennsylvania. +The common stock, par value $1.00 per share, of Arconic Pennsylvania (the “Arconic Pennsylvania Common Stock”) was listed for trading on the New York Stock Exchange and traded under the symbol “ARNC.” As of the Effective Date, this symbol, without interruption, represents shares of common stock, par value $1.00 per share, of Arconic Delaware (the “Arconic Delaware Common Stock”). There was no change in the Exchange Act File Number assigned by the SEC as a result of the Reincorporation. +As of the Effective Date, the rights of the Company’s stockholders began to be governed by the General Corporation Law of the State of Delaware, the Certificate of Incorporation of Arconic Delaware (the “Delaware Certificate”) and the Bylaws of Arconic Delaware (the “Delaware Bylaws”). +Other than the change in corporate domicile, the Reincorporation did not result in any change in the business, physical location, management, financial condition or number of authorized shares of the Company, nor did it result in any change in location of its current employees, including management. On the Effective Date, (i) the directors and officers of Arconic Pennsylvania prior to the Reincorporation continued as the directors and officers of Arconic Delaware after the Reincorporation, (ii) each outstanding share of Arconic Pennsylvania Common Stock was automatically converted into one share of Arconic Delaware Common Stock, (iii) each outstanding share of Serial Preferred Stock, par value $100 per share, of Arconic Pennsylvania (the “Arconic Pennsylvania Preferred Stock”) was automatically converted into one share of Serial Preferred Stock, par value $100 per share, of Arconic Delaware (the “Arconic Delaware Preferred Stock”) and (iv) all of Arconic Pennsylvania’s employee benefit and compensation plans immediately prior to the Reincorporation were continued by Arconic Delaware, and each outstanding equity award and notional share unit relating to shares of Arconic Pennsylvania Common Stock was converted into an equity award or notional share unit, as applicable, relating to an equivalent number of shares of Arconic Delaware Common Stock on the same terms and subject to the same conditions. Beginning at the effective time of the Reincorporation, each certificate representing Arconic Pennsylvania Common Stock or Arconic Pennsylvania Preferred Stock was deemed for all corporate purposes to evidence ownership of Arconic Delaware Common Stock or Arconic Delaware Preferred Stock, as applicable. The Company’s stockholders may, but are not required to, exchange their stock certificates as a result of the Reincorporation. +The foregoing descriptions of the Arconic Delaware Common Stock, the Arconic Delaware Preferred Stock, the Delaware Certificate and the Delaware Bylaws are qualified in their entirety by the full text of the Delaware Certificate and the Delaware Bylaws, which are filed as Exhibits 3(a) and 3(b), respectively, to this report. +Alcoa Corporation Separation Transaction +On November 1, 2016, Alcoa Inc. completed the separation of its business into two independent, publicly traded companies (the “Separation of Alcoa”) – Alcoa Corporation and Arconic Inc. (the new name for Alcoa Inc.). Following the Separation of Alcoa, Alcoa Corporation holds the Alumina and Primary Metals segments, the rolling mill at the Warrick, Indiana operations and the 25.1% stake in the Ma’aden Rolling Company in Saudi Arabia previously held by the Company. The Company retained the Global Rolled Products (other than the rolling mill at the Warrick, Indiana operations and the 25.1% ownership stake in the Ma’aden Rolling Company), Engineered Products and Solutions and Transportation and Construction Solutions segments. +The Separation of Alcoa was effected by a pro rata distribution of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders (the “Distribution of Alcoa”). The Company’s shareholders of record as of the close of business on October 20, 2016 (the “Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the Record Date. The Company did not issue fractional shares of Alcoa Corporation common stock in the Distribution of Alcoa. Instead, each shareholder otherwise entitled to receive a fractional share of Alcoa Corporation common stock received cash in lieu of fractional shares. +The Company distributed 146,159,428 shares of common stock of Alcoa Corporation in the Distribution of Alcoa and retained 36,311,767 shares, or approximately 19.9%, of the common stock of Alcoa Corporation immediately following the Distribution of Alcoa. As a result of the Distribution of Alcoa, Alcoa Corporation became an independent public company trading under the symbol “AA” on the New York Stock Exchange, and the Company trades under the symbol “ARNC” on the New York Stock Exchange. +During 2017, the Company disposed of its retained interest in Alcoa Corporation. In February 2017, the Company sold 23,353,000 shares of Alcoa Corporation stock at $38.03 per share, which resulted in cash proceeds of $888 million and a gain of $351 million. In April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 shares (valued at $35.91 per share) in +2 +Table of Contents +Alcoa Corporation stock (the “Debt-for-Equity Exchange”) and recorded a gain of $167 million. The gains of $351 million and $167 million associated with the disposition of the Alcoa Corporation shares were recorded in Other expense (income), net in the accompanying Statement of Consolidated Operations in Part II, Item 8 (Financial Statements and Supplementary Data). +On October 31, 2016, in connection with the Separation of Alcoa and the Distribution of Alcoa, Arconic entered into several agreements with Alcoa Corporation or its subsidiaries that govern the relationship of the parties following the Distribution of Alcoa, including the following: Separation and Distribution Agreement, Transition Services Agreement, Tax Matters Agreement, Employee Matters Agreement, certain Patent, Know-How, Trade Secret License and Trademark License Agreements, Toll Processing and Services Agreement, Master Agreement for the Supply of Primary Aluminum, Massena Lease and Operations Agreement, Fusina Lease and Operations Agreement, and Stockholder and Registration Rights Agreement. The Toll Processing and Services Agreement expired by its terms at the end of 2018. +Recent Developments +On January 22, 2019, the Company announced that its Board of Directors (the Board) had determined to no longer pursue a potential sale of Arconic as part of its strategy and portfolio review. Management and the Board had been conducting a rigorous and comprehensive strategy and portfolio review over the past year and as part of that process had considered a sale of the Company, among other matters. However, the Company did not receive a proposal for a full-Company transaction that management and the Board believed would be in the best interest of Arconic’s shareholders and other stakeholders. Management and the Board remain confident in Arconic’s significant potential and are strongly focused on enhancing value for shareholders, through continued operational improvements and through other potential initiatives which had been previously identified in the strategy and portfolio review. +On February 8, 2019, Arconic announced, as part of its strategy and portfolio review, a separation of its portfolio into two independent, publicly-traded companies (the “Separation of Arconic”). The Engineered Products and Forgings (EP&F) businesses (engine products, fastening systems, engineered structures and forged wheels) will remain in the existing company, which will be renamed Howmet Aerospace Inc. and change its stock ticker from “ARNC” to “HWM” in connection with the separation. The Global Rolled Products (GRP) businesses (global rolled products, aluminum extrusions and building and construction systems) will be held by a new company that will be named Arconic Corporation at separation and that intends to list its common stock on the New York Stock Exchange under the symbol “ARNC.” +On February 6, 2020, the Company announced that its Board of Directors has approved the completion of the Separation of Arconic. +Timothy D. Myers will serve as Arconic Corporation Chief Executive Officer. The Arconic Inc. Board has also named new directors to the Arconic Corporation and Howmet Aerospace Boards: +• +Joining the Arconic Corporation Board of Directors will be: Timothy Myers; William Austen; Christopher Ayers*; Margaret Billson; Austin Camporin; Jacques Croisetiere; Elmer Doty*; Carol Eicher; Fritz Henderson; E. Stanley O’Neal*; and Jeffrey Stafeil. +* Will resign from the Arconic Inc. Board +• +Joining the Howmet Aerospace Board will be: Joseph Cantie; Robert Leduc; Jody Miller; and Nicole Piasecki. +The Separation of Arconic will occur by means of a pro rata distribution by Arconic Inc. (which will be renamed Howmet Aerospace Inc.) of all of the outstanding common stock of Arconic Corporation (the “ Distribution of Arconic ” ). The Distribution of Arconic is intended to qualify as a tax-free transaction to Arconic Inc. stockholders for U.S. federal income tax purposes. +Distribution of Arconic Information +At the time of separation, Arconic Inc. stockholders are expected to receive one share of Arconic Corporation common stock for every four shares of Arconic Inc. common stock held as of the record date. The record date will be March 19, 2020 and the time of the distribution will be 12:01 A.M. on April 1, 2020. +At the time of separation, stockholders of Arconic Inc. will retain their shares of Arconic Inc. Due to the name change of Arconic Inc. to Howmet Aerospace Inc. upon separation, these shares will become Howmet Aerospace Inc. shares. +No fractional shares of Arconic Corporation common stock will be issued in the distribution, and stockholders will receive cash in lieu of fractional shares. The separation distribution is expected to be paid on April 1, 2020 to Arconic Inc. stockholders of record as of the close of business on the record date. +The distribution remains subject to the satisfaction or waiver of the conditions described in Arconic Rolled Products Corporation’s Registration Statement on Form 10, as amended. The Form 10 has been filed by Arconic Rolled Products Corporation with the SEC and is available at www.arconic.com . +3 +Table of Contents +No action is required by Arconic Inc. stockholders to receive shares of Arconic Corporation common stock in the distribution. Arconic Inc. expects to make available an information statement to all stockholders entitled to receive the distribution of shares of Arconic Corporation common stock. The information statement is filed as an exhibit to Arconic Rolled Products Corporation’s Registration Statement on Form 10 and describes Arconic Corporation and certain risks of owning Arconic Corporation common stock and provides other information regarding the separation and distribution. +Trading Common Stock +Arconic Inc. stockholders who hold shares of common stock on the record date of March 19, 2020, and decide to sell any of those shares before the distribution date, should consult their stockbroker, bank or other nominee to understand whether the shares of Arconic Inc. common stock will be sold with or without entitlement to Arconic Corporation common stock pursuant to the distribution. +Beginning on or about March 18, 2020, and continuing up to and through the distribution date, two markets are expected for Arconic Inc. common stock: the “regular-way” market and the “ex-distribution” market. Shares that trade in the “regular-way” market will be entitled to shares of Arconic Corporation common stock distributed pursuant to the distribution; shares that trade in the “ex-distribution” market will trade under the symbol HWM WI and without an entitlement to shares of Arconic Corporation common stock distributed pursuant to the distribution. +Arconic Corporation anticipates “when-issued” trading of its common stock will begin on or about March 18, 2020, under the symbol ARNC WI, and will continue up to and through the distribution date. “Regular-way” trading in Arconic Corporation’s common stock is expected to begin on April 1, 2020. +The separation date may change if certain conditions are not satisfied by that date, as described in Arconic Rolled Products Corporation’s information statement filed with the Form 10. +Note Offering +On February 7, 2020, the Company announced that Arconic Rolled Products Corporation (the “Issuer”), which is currently a wholly-owned subsidiary of Arconic, closed its offering of $600,000,000 aggregate principal amount of 6.125% second-lien notes due 2028 (the “Notes”). +The Issuer intends to use the proceeds from the offering to make a payment to Arconic to fund the transfer of certain assets from Arconic to the Issuer in connection with the Separation of Arconic and for general corporate purposes. The net proceeds from the offering will be held in escrow until the completion of the Separation of Arconic and the satisfaction of certain other escrow release conditions. Prior to the separation, the Notes will not be guaranteed. Following the separation, the Notes will be guaranteed by certain of the Issuer’s wholly-owned domestic subsidiaries. Each of the Notes and the related guarantees will be secured on a second-priority basis by liens on certain assets of the Issuer and the guarantors. +The Notes and related guarantees were sold in a private placement to qualified institutional buyers in accordance with Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”), and to certain non-United States persons in offshore transactions in accordance with Regulation S under the Securities Act. +The Notes and related guarantees have not been and will not be registered under the Securities Act or the securities laws of any other jurisdiction and may not be offered or sold in the United States or to, or for the benefit of, U.S. persons absent registration under, or an applicable exemption from, the registration requirements of the Securities Act. +4 +Table of Contents +Description of the Business +Information describing Arconic’s businesses can be found on the indicated pages of this report: +Item +Page(s) +Discussion of Recent Business Developments: +Management’s Discussion and Analysis of Financial Condition and Results of Operations: +Overview and Results of Operations +37 +Notes to Consolidated Financial Statements: +Note C. Restructuring and Other Charges +72 +Note F. Pension and Other Postretirement Benefits +75 +Note G. Income Taxes +82 +Note S. Acquisitions and Divestitures +98 +Note T. Contingencies and Commitments +100 +Segment Information: +Business Descriptions, Principal Products, Principal Markets, Methods of Distribution, Seasonality and Dependence Upon Customers: +Engineered Products and Forgings +41 +Global Rolled Products +42 +Financial Information about Segments and Geographic Areas: +Note B. Segment and Geographic Area Information +67 +Major Product Sales +Products that contributed 10% or more to consolidated sales for the years ended December 31, 2019 , 2018 , and 2017 , were: +For the Year Ended +December 31, +2019 +2018 +2017 +Innovative flat-rolled products +39 +% +40 +% +39 +% +Engine products +24 +% +21 +% +21 +% +Fastening systems +11 +% +11 +% +11 +% +Engineered structures +8 +% +13 +% +13 +% +Arconic has no customer that accounts for 10% or more of its consolidated sales. However, certain of the Company’s businesses are dependent upon a few significant customers. The loss of any such significant customer could have a material adverse effect on such businesses. +Engineered Products and Forgings +Arconic’s Engineered Products and Forgings segment (“EP&F”) produces products that are used primarily in the aerospace (commercial and defense), industrial, commercial transportation, and power generation end markets. Such products include fastening systems (titanium, steel, and nickel superalloys) and seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils; forged jet engine components (e.g., jet engine disks); extruded, machined and forged aircraft parts (titanium and aluminum); and forged aluminum commercial vehicle wheels, all of which are sold directly to customers and through distributors. A small part of this segment also produces various forged and machined metal products (titanium and aluminum) for various end markets. +In the third quarter of 2019, the Company realigned its operations by eliminating its Transportation and Construction Solutions (TCS) segment and transferring the Forged Wheels business to its EP&F segment and the Building and Construction Systems business to its GRP segment, consistent with how the Chief Executive Officer is assessing operating performance and allocating capital in conjunction with the planned Separation of Arconic. The Latin American extrusions business, which was formerly part of the Company's TCS segment until its sale in April of 2018, was moved to Corporate. In the first quarter of 2019, the Company transferred its aluminum extrusions operations (Aluminum Extrusions) from its Engineered Structures business unit within the EP&F segment to the GRP segment, based on synergies with GRP including similar customer base, technologies, and manufacturing capabilities. +5 +Table of Contents +Engine Products. Engine Products produces investment cast airfoils, seamless rolled rings and closed-die (including isothermal) forged turbine disks for aero engine and industrial gas turbines, as well as other structural aero engine components. Engine Products also provides additive manufacturing technologies, superalloy ingots, open-die forging, machining, performance coatings, and hot isostatic pressing for high performance parts. +Fastening Systems. Fastening Systems produces aerospace fastening systems, as well as commercial transportation fasteners. The business’s high-tech, multi-material fastening systems are found nose to tail on aircraft and aero engines. The business’s products are also critical components of industrial gas turbines, automobiles, commercial transportation vehicles, and construction and industrial equipment. +Engineered Structures. Engineered Structures produces titanium and aluminum ingots and mill products for aerospace and defense applications and is vertically integrated to produce structural investment castings, forgings and extrusions, for airframe, wing, aero-engine, and landing gear components. Engineered Structures also provides multi-material airframe subassemblies and solutions related to advanced technologies and materials, such as 3D printing and titanium aluminides. +Forged Wheels. Forged Wheels provides forged aluminum wheels and related products for heavy-duty trucks and the commercial transportation markets. +For additional discussion of the EP&F segment's business, see “Results of Operations—Segment Information” in Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note B to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +On May 31, 2019, Arco nic sold a small additive manufacturing facility outside of Austin, TX within the EP&F segment. The sale is subject to certain post-closing adjustments. +On August 15, 2019, Arconic sold inventories and properties, plants, and equipment related to a small energy business (RTI Energy) within the EP&F segment. +In December 2019, Arconic c losed the sale of its forgings business in the United Kingdom subject to working capital and other adjustments. The forgings business primarily produced steel, titanium, and nickel based forged components for aerospace, mining, and off-highway markets and its operating results and assets and liabilities were included in the EP&F segment. +6 +Table of Contents +Engineered Products and Forgings Principal Facilities 1 +Country +Facility +Products +Australia +Oakleigh +Fasteners +Canada +Georgetown, Ontario 2 +Aerospace Castings +Laval, Québec +Aerospace Castings and Machining +China +Suzhou 2 +Fasteners, Rings and Forgings +France +Dives-sur-Mer +Aerospace and Industrial Gas Turbine Castings +Evron +Aerospace and Specialty Castings +Gennevilliers +Aerospace and Industrial Gas Turbine Castings +Montbrison +Fasteners +St. Cosme-en-Vairais 2 +Fasteners +Toulouse +Fasteners +Us-par-Vigny +Fasteners +Germany +Bestwig +Aerospace Castings +Erwitte +Aerospace Castings +Hildesheim-Bavenstedt 2 +Fasteners +Kelkheim 2 +Fasteners +Hungary +Nemesvámos +Fasteners +Székesfehérvár +Aerospace and Industrial Gas Turbine Castings and Forgings +Japan +J Ô etsu City 2 +Forgings +Nomi +Aerospace and Industrial Gas Turbine Castings +Mexico +Ciudad Acuña 2 +Aerospace Castings/Fasteners and Rings +Monterrey +Forgings +Morocco +Casablanca 2 +Fasteners +United Kingdom +Ecclesfield +Ingot Castings +Exeter 2 +Aerospace and Industrial Gas Turbine Castings and Alloy +Glossop +Ingot Castings +Ickles +Ingot Castings +Leicester 2 +Fasteners +Low Moor +Extrusions +Redditch 2 +Fasteners +Telford +Fasteners +Welwyn Garden City +Aerospace Formed Parts +7 +Table of Contents +Country +Facility +Products +United States +Tucson, AZ 2 +Fasteners +Carson, CA 2 +Fasteners +City of Industry, CA 2 +Fasteners +Fontana, CA +Rings +Fullerton, CA 2 +Fasteners +Rancho Cucamonga, CA +Rings +Sylmar, CA +Fasteners +Torrance, CA +Fasteners +Branford, CT +Aerospace Coatings +Winsted, CT +Aerospace Machining +Savannah, GA +Forgings +La Porte, IN +Aerospace and Industrial Gas Turbine Castings +Whitehall, MI +Aerospace and Industrial Gas Turbine Castings and Coatings, Titanium Alloy and Specialty Products +Washington, MO +Aerospace Formed Parts, Titanium Mill Products +Big Lake, MN +Aerospace Machining +New Brighton, MN +Aerospace Machining +Dover, NJ +Aerospace and Industrial Gas Turbine Castings and Alloy +Verdi, NV +Rings +Kingston, NY 2 +Fasteners +Rochester, NY +Rings +Barberton, OH +Forgings +Canton, OH 2 +Ferro-Titanium Alloys and Titanium Mill Products +Cleveland, OH +Investment Casting Equipment, Aerospace Components, Castings, Forgings and Oil & Gas Drilling Products +Niles, OH +Titanium Mill Products +Morristown, TN 2 +Aerospace and Industrial Gas Turbine Ceramic Products +Houston, TX 2 +Extrusions +Waco, TX 2 +Fasteners +Wichita Falls, TX +Aerospace and Industrial Gas Turbine Castings +Hampton, VA 2 +Aerospace and Industrial Gas Turbine Castings +Martinsville, VA +Titanium Mill Products +1 +Principal facilities are listed, and do not include 22 locations that serve as sales and administrative offices, distribution centers or warehouses. +2 +Leased property or partially leased property. +Global Rolled Products +Arconic’s Global Rolled Products segment (“GRP”) produces aluminum sheet and plate, aluminum extruded and machined parts, integrated aluminum structural systems, and architectural extrusions used in the automotive, aerospace, building and construction, industrial, packaging, and commercial transportation end markets. The following represent the business units within the Company’s GRP segment: +Rolled Products . Rolled products are used in the production of finished goods ranging from airframes and automotive body panels to industrial plate and brazing sheet. Sheet and plate are used extensively in the transportation industries as well as in building and construction. They are also used for industrial applications such as tooling plate for the production of plastic products. +Aluminum Extrusions . Aluminum Extrusions produces a range of extruded products, including aerospace shapes (wing stringer, floor beams, fuselage, cargo), automotive shapes (driveshafts, anti-lock brake housings, turbo charger), seamless tube, hollows, mortar fins and high strength rod and bar. With process and product technologies that include large and small +8 +Table of Contents +extrusion presses, integrated cast houses, horizontal heat treat furnaces, vertical heat treat furnaces, annealing furnaces, induction billet heating and ultrasonic inspection capabilities, the Extrusions unit serves a broad range of customers in several of core market segments. +Building and Construction Systems . Building and Construction Systems (BCS) manufactures differentiated products and building envelope solutions, including entrances, curtain walls, windows, composite panel and coil coated sheet. The business operates in two market segments: architectural systems, which carry the Kawneer ® brand, and architectural products, which carry the Reynobond ® and Reynolux ® brands. The BCS business has competitive positions in both market segments, attributable to its strong brand recognition, high quality products and strong relationships through the building and construction value chain. +As noted above, in the third quarter of 2019, the Company realigned its operations by eliminating its TCS segment and transferring the Forged Wheels business to its EP&F segment and the Building and Construction Systems (BCS) business to its GRP segment, consistent with how the Chief Executive Officer is assessing operating performance and allocating capital in conjunction with the planned Separation of Arconic. In the first quarter of 2019, the Company transferred its aluminum extrusions operations (Aluminum Extrusions) from its Engineered Structures business unit within the EP&F segment to the GRP segment, based on synergies with GRP including similar customer base, technologies, and manufacturing capabilities. +For additional discussion of the Global Rolled Products segment’s business, see “Results of Operations—Segment Information” in Part II, Item 7. (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note B to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +In February 2019, the Company announced an investment of approximately $100 million to expand its hot mill capability and add downstream equipment capabilities to manufacture industrial and automotive aluminum products in its Tennessee Operations facility near Knoxville, Tennessee. The project, which is expected to create 70 new jobs, is already underway and is expected to be complete by the fourth quarter of 2020. +In Aug ust 2019, Arconic reached an agreement to sell its aluminum rolling mill in Itapissuma, Brazil for $50 million in cash, subject to working capital and other adjustments. The rolling mill produces specialty foil and sheet products and its operating results and assets and liabilities are included in the GRP segment. The sale transaction closed February 1, 2020. +On October 30, 2019, Arconic reached an agreement to sell its hard alloy extrusions plant in South Korea for $61 million in cash, subject to working capital and other adjustments. The operating results and assets and liabilities of this plant are included in the GRP segment. The sale transaction is expected to close in the first quarter of 2020, subject to regulatory approvals and customary closing conditions. +9 +Table of Contents +Global Rolled Products Principal Facilities 1 +Country +Location +Products +Canada +Lethbridge, Alberta +Architectural Products +China +Kunshan +Sheet and Plate +Qinhuangdao 2 +Sheet and Plate +France +Merxheim 2 +Architectural Products +Germany +Hannover 2 +Extrusions +Hungary +Székesfehérvár +Sheet and Plate/Slabs and Billets +South Korea +Kyoungnam +Extrusions +Russia +Samara +Sheet and Plate/Extrusions and Forgings +United Kingdom +Birmingham +Plate +Runcorn +Architectural Products +United States +Chandler, AZ 2 +Extrusions +Springdale, AR +Architectural Products +Visalia, CA +Architectural Products +Eastman, GA +Architectural Products +Danville, IL 2 +Sheet and Plate +Lafayette, IN +Extrusions +Davenport, IA +Sheet and Plate +Hutchinson, KS 3 +Sheet and Plate +Baltimore, MD 2 +Extrusions +Massena, NY +Extrusions +Bloomsburg, PA +Architectural Products +Cranberry, PA +Architectural Products +Lancaster, PA +Sheet and Plate +Alcoa, TN +Sheet +Texarkana, TX 2, 4 +Slabs +San Antonio, TX 5 +Micromill™ +1 +Principal facilities are listed, and do not include 20 locations that serve as service centers or administrative offices. These service centers perform light manufacturing, such as assembly and fabrication of certain products. +2 +Leased property or partially leased property. +3 +Properties are satellite locations of the Davenport, Iowa facility. +4 +The aluminum slab that is cast at Texarkana is turned into aluminum sheets at Arconic’s expanded automotive facility in Davenport, Iowa and its rolling mill in Lancaster, Pennsylvania. In October 2018, the Company sold the rolling mill and cast house to Ta Chen International, Inc. and leased the cast house building and equipment for a term of 18 months. The Company’s lease expires April 30, 2020. +5 +Micromill™ production facility produces sheet for automotive and industrial applications using Arconic innovative production process. The Company curtailed operations in San Antonio in late December 2019. +10 +Table of Contents +Sources and Availability of Raw Materials +Important raw materials purchased in 2019 for each of the Company’s reportable segments are listed below. +Engineered Products and Forgings +Global Rolled Products +Alloying materials +Alloying materials +Cobalt +Aluminum coil +Electricity +Aluminum scrap +Natural gas +Coatings +Nickel alloys +Electricity +Primary aluminum (ingot, billet, P1020, high purity) +Lube oil +Stainless steel +Natural gas +Steel +Packaging materials +Titanium alloys +Paint/Coating +Titanium sponge +Primary aluminum (ingot, slab, billet, P1020, high purity) +Resin +Steam +Generally, other materials are purchased from third-party suppliers under competitively priced supply contracts or bidding arrangements. The Company believes that the raw materials necessary to its business are and will continue to be available. +Patents, Trade Secrets and Trademarks +The Company believes that its domestic and international patent, trade secret and trademark assets provide it with a significant competitive advantage. The Company’s rights under its patents, as well as the products made and sold under them, are important to the Company as a whole and, to varying degrees, important to each business segment. The patents owned by Arconic generally concern metal alloys, particular products, manufacturing equipment or techniques. Arconic’s business as a whole is not, however, materially dependent on any single patent, trade secret or trademark. As a result of product development and technological advancement, the Company continues to pursue patent protection in jurisdictions throughout the world. As of the end of 2019, the Company’s worldwide patent portfolio consists of approximately 1,635 granted patents (1,004 EP&F patents and 631 GRP patents) and 538 pending patent applications (284 EP&F patent applications and 254 GRP patent applications). +The Company also has a significant number of trade secrets, mostly regarding manufacturing processes and material compositions that give many of its businesses important advantages in their markets. The Company continues to strive to improve those processes and generate new material compositions that provide additional benefits. With respect to domestic and international registered trademarks, the Company has many that have significant recognition within the markets that are served. Examples include the name “Arconic” and the Arconic symbol for aluminum, nickel, and titanium products, Howmet ® metal castings, Huck ® fasteners, Kawneer ® building panels and Dura-Bright ® wheels with easy-clean surface treatments. A significant trademark filing campaign for the names “Howmet” and “Howmet Aerospace” along with its “H” logo was initiated in 2019, in support of the corporate launch of Howmet Aerospace Inc. As of the end of 2019, the Company’s worldwide trademark portfolio consists of approximately 2,066 registered trademarks (1,450 EP&F trademarks and 616 GRP trademarks) and 818 pending trademark applications (361 EP&F trademark applications and 457 GRP trademark applications). The Company’s rights under its trademarks are important to the Company as a whole and, to varying degrees, important to each business segment. +Competitive Conditions +Engineered Products and Forgings (EP&F) +EP&F’s business units - Fastening Systems, Engine Products, Engineered Structures and Forged Wheels - are subject to substantial and intense competition in the markets they serve. Although Arconic believes its advanced technology, manufacturing processes and experience provide advantages to Arconic’s customers, such as high quality and superior mechanical properties that meet the Company’s customers’ most stringent requirements, many of the products Arconic makes can be produced by competitors using similar types of manufacturing processes as well as alternative forms of manufacturing. Despite intense competition, Arconic continues as a market leader in most of its principal markets. Several factors, including Arconic’s legacy of technical innovation, state-of-the-art capabilities, engaged employees and long-standing customer relationships, enable the Company to maintain its competitive position. +Principal competitors in the EP&F segment include Berkshire Hathaway Inc., through its 2016 acquisition of Precision Castparts Corporation and subsidiaries, for titanium and titanium-based alloys, precision forgings, seamless rolled rings, +11 +Table of Contents +investment castings and aerospace fasteners; VSMPO (Russia) for titanium and titanium-based alloys and precision forgings; the High-Performance Materials & Components segment of Allegheny Technologies, Inc. (ATI) for titanium and titanium-based alloys, precision forgings, and investment castings; Lisi Aerospace (France) for aerospace fasteners; and Aubert & Duval (part of Eramet Group in France) for precision forgings. +In the forged aluminum wheels business, Forged Wheels competes against steel and aluminum wheel suppliers in the commercial transportation industry under the product brand name Alcoa ® Wheels for the major regions that it serves (Americas, Europe, Japan, China, and Australia). Its larger aluminum wheel competitors are Accuride Corporation, Speedline (member of the Ronal Group), Nippon Steel Corporation, Dicastal, Alux, and Wheels India Limited. In recent years, Forged Wheels has seen an increase in the number of aluminum wheel suppliers (both forged and cast aluminum wheels) from China, Taiwan, India and South Korea attempting to penetrate the global commercial transportation market. +Other competitors for EP&F include: +• +Doncasters Group Ltd. (UK) - investment castings +• +Consolidated Precision Products Corp., owned by Warburg Pincus - investment castings +• +Weber Metals, part of Otto Fuchs - precision forgings +• +Forgital - seamless rings +• +Frisa (Mexico) - seamless rings +Several of Arconic’s largest customers have captive superalloy furnaces for producing airfoil investment castings for their own use. Many other companies around the world also produce superalloy investment castings, and some of these companies currently compete with Arconic in the aerospace and other markets, while others are capable of competing with the Company should they choose to do so. +International competition in the investment castings , fasteners, rings and forgings markets may also increase in the future as a result of strategic alliances among engine original equipment manufacturers (OEMs), aero-structure prime contractors, and overseas companies, especially in developing markets, particularly where “offset” or “local content” requirements create purchase obligations with respect to products manufactured in or directed to a particular country. +Global Rolled Products (GRP) +Rolled Products +Arconic’s Rolled Products business unit is one of the leaders in many of the aluminum flat rolled markets in which it participates, including ground transportation (including brazing sheet), aerospace, industrial and packaging markets. While Rolled Products participates in markets where Arconic believes it has a significant competitive advantage due to customer intimacy, advanced manufacturing capability, unique technology and/or differentiated products, in certain cases, our competitors are capable of making products similar to Arconic’s products. We continuously work to maintain and enhance our competitive position through innovation: new alloys such as aluminum lithium aerospace alloys, differentiated products such as our 5-layer brazing products and break-through processes such as A951™ bonding technology. +Some of Arconic’s Rolled Products markets are global and some are more regionally focused. Participation in these segments by competitors varies. For example, Novelis is the largest flat rolled products producer competing in automotive, but it does not participate in the aerospace market. On the other hand, Kaiser participates in aerospace, but does not participate in the automotive sheet market. Other competitors include Aleris, AMAG, Constellium, Hydro, Kobe, Nanshan, and UACJ. +Additionally, there are a number of new competitors emerging, particularly in China and other developing economies. Arconic expects that this competitive pressure will continue and increase in the future as customers seek to globalize their supply bases in order to reduce costs. +12 +Table of Contents +List of Major Competitors for Rolled Products: +• +Aleris +• +AMAG (Austria) +• +Constellium (Netherlands) +• +Granges (Sweden) +• +Hydro (Norway) +• +Kaiser Aluminum +• +Kobe (Japan) +• +Nanshan (China) +• +Novelis +• +UACJ (Japan) +Aluminum Extrusions +The Aluminum Extrusions business unit is a leader in many of the markets in which it participates, including aerospace, automotive (including driveshafts) and industrial markets. While Aluminum Extrusions participates in markets where Arconic believes we have a significant competitive position due to customer intimacy, advanced manufacturing capability, unique technology and/or differentiated products, in certain cases, our competitors are capable of making products similar to Arconic’s products. We continuously work to maintain and enhance our competitive position through innovation: new alloys such as aluminum lithium aerospace alloys and differentiated products. +Some of Arconic’s Aluminum Extrusions markets are worldwide and some are more regionally focused. Participation in these segments by competitors varies. For example, UAC is the largest competitor in aerospace extrusions, but it does not participate in the drawn tubing market. On the other hand, Unna participates in drawn tubing, but they do not compete in extrusions. Other competitors include Kaiser, Constellium, Otto Fuchs, Taber, Ye Fong, and Impol. +Additionally, there are a number of other competitors emerging, particularly in China and other developing economies. We expect that this competitive pressure will continue and increase in the future as customers seek to globalize their supply bases in order to reduce costs. +List of Major Competitors for Aluminum Extrusions: +• +Constellium (France)​ +• +Impol (Poland)​ +• +Kaiser​ +• +Otto Fuchs (Germany)​ +• +Taber​ +• +UAC (USA/Romania)​ +• +Unna (Germany)​ +• +Ye Fong (Taiwan) +BCS +In North America, Arconic’s BCS business unit primarily competes in the nonresidential building segment. In Europe, it competes in both the residential and the nonresidential building segments. Arconic’s competitive advantage is based on strong brands, innovative products, customer intimacy and technical services. +In the architectural systems market, Arconic competes with regional competitors like Apogee, YKK, and Oldcastle in North America and Schüco, Hydro/SAPA and Reynaers in Europe. The competitive landscape in the architectural systems market has been relatively stable since the mid-2000s, with the major competitors in North America and Europe remaining constant, despite some industry consolidation in North America during the late 2000s. +The primary product categories in architectural products are aluminum composite material and coil coated sheet. The architectural products business is a more global market and is primarily served by subsidiaries of larger companies like Alpolic (Mitsubishi Corporation), Alucobond (Schweiter Technologies) and Novelis (Aditya Birla Group). +13 +Table of Contents +List of Major Competitors for Architectural Systems: +• +North America - Apogee, Oldcastle and YKK +• +Europe - Schüco (Germany), Hydro/SAPA (Norway), Reynaers (Belgium) and Corialis (Belgium) +​ +List of Major Competitors for Architectural Products: +• +Composite Material - Alucobond (Switzerland), Alucoil (Spain) and Alpolic (Japan)​ +• +Coil Coated Sheet - Euramax, Novelis and Hydro (Norway) +Environmental Matters +Information relating to environmental matters is included in Note T to the Consolidated Financial Statements under the caption “Environmental Matters.” Approved capital expenditures for new or expanded facilities for environmental control are $14 million for 2020 and estimated expenditures for such purposes are $15 million for 2021. +Employees +Total worldwide employment at the end of 2019 was approximately 41,700 employees in 28 countries. Many, but less than 50%, of these employees are represented by labor unions. The Company believes that relations with its employees and any applicable union representatives generally are good. +In the United States, the largest collective bargaining agreement is the master collective bargaining agreement between Arconic and the United Steelworkers (USW). The USW master agreement covers approximately 3,000 employees at four U.S. locations; the current labor agreement expires on May 15, 2022. There are 17 other collective bargaining agreements in the United States with varying expiration dates, including those in the master agreement. +On a regional basis, collective bargaining agreements with varying expiration dates cover employees in Europe and Russia, North America, South America and Asia. +Executive Officers of the Registrant +The names, ages, positions and areas of responsibility of the executive officers of the Company as of February 26, 2020 are listed below. +Ken Giacobbe , 54, Executive Vice President and Chief Financial Officer. Mr. Giacobbe was elected Executive Vice President and Chief Financial Officer of Arconic effective November 1, 2016. Mr. Giacobbe joined Arconic in 2004 as Vice President of Finance for Global Extruded Products, part of Alcoa Forgings and Extrusions. He then served as Vice President of Finance for the Company’s Building and Construction Systems business from 2008 until 2011. In 2011, he assumed the role of Group Controller for the Engineered Products and Forgings segment. From January 2013 until October 2016, Mr. Giacobbe served as Chief Financial Officer of the Engineered Products and Forgings segment. Before joining Arconic, Mr. Giacobbe held senior finance roles at Avaya and Lucent Technologies. +Neil E. Marchuk , 62, Executive Vice President, Human Resources. Mr. Marchuk was elected to his current position effective March 1, 2019. Prior to joining Arconic, from January 2016 to February 2019, he was Executive Vice President and Chief Human Resources Officer at Adient, an automotive manufacturer. From July 2006 to May 2015, Mr. Marchuk was Executive Vice President of Human Resource at TRW Automotive, and served as TRW’s Vice President, Human Resources from September 2004 to July 2006 . Prior to joining TRW, from December 2001 to August 2004, Mr. Marchuk was Director Corporate Human Resources for E.I. Du Pont De Nemours and Company (“E.I. Du Pont”). From September 1999 to November 2001, Mr. Marchuk was Director Global HR Delivery for E.I. Du Pont. From February 1999 to August 1999, Mr. Marchuk served E.I. Du Pont as its Global HR Director Global Services Division. +Timothy D. Myers , 54, Executive Vice President and Group President, Global Rolled Products. Mr. Myers has served as Executive Vice President and Group President, Global Rolled Products, which now includes Arconic's Extrusions and Building and Construction Systems businesses, since October 2017. From May 2016 to June 2019, he served as Executive Vice President and Group President of Arconic's Transportation and Construction Solutions segment, which then comprised Arconic Wheel and Transportation Products and Building and Construction Systems and which segment was eliminated in the third quarter of 2019, with the Building and Construction Systems business then moved to the Global Rolled Products segment. Prior to that assignment, he was President of Alcoa Wheel and Transportation Products, from June 2009 to May 2016. Mr. Myers was Vice President and General Manager, Commercial Vehicle Wheels for the Alcoa Wheel Products business from January 2006 to June 2009. Mr. Myers joined Arconic in 1991 as an automotive applications engineer in the Commercial Rolled Products Division, and held a series of engineering, marketing, sales and management positions with the Company since that time. +Paul Myron , 53, Vice President and Controller. Mr. Myron was elected Vice President and Controller of Arconic effective November 1, 2016. Mr. Myron joined Arconic as a systems analyst in Pittsburgh and in 1992 relocated to the Company’s +14 +Table of Contents +Davenport, Iowa facility as a product accountant. He served in numerous financial management positions from 1995 until 2000 when he was named Commercial Manager and Controller for the Atlantic division of the Alcoa World Alumina and Chemicals business. In 2002, Mr. Myron was appointed Vice President of Finance, Alcoa Primary Metals and later became Vice President of Finance, Alcoa World Alumina and Chemicals. In 2005 Mr. Myron was named Director of Financial Planning and Analysis, accountable for Arconic’s financial planning, analysis, and reporting worldwide. In February 2012, he became Director of Finance Initiatives for the Engineered Products and Forgings segment, overseeing specific financial initiatives and projects within the group. From July 2012 until his most recent appointment, Mr. Myron served as Vice President, Finance and Business Excellence for the Arconic Power and Propulsion business. +John C. Plant , 66, Chairman and Chief Executive Officer. Mr. Plant was appointed Chief Executive Officer of Arconic effective February 6, 2019. He has served as Arconic's Chairman since October 2017 and as a member of the Board since February 2016. Mr. Plant previously served as Chairman of the Board, President and Chief Executive Officer of TRW Automotive from 2011 to 2015, and as its President and Chief Executive Officer from 2003 to 2011. TRW Automotive was acquired by ZF Friedrichshafen AG in May 2015. Mr. Plant was a co-member of the Chief Executive Office of TRW Inc. from 2001 to 2003 and an Executive Vice President of TRW from the company's 1999 acquisition of Lucas Varity to 2003. Prior to TRW, Mr. Plant was President of Lucas Varity Automotive and managing director of the Electrical and Electronics division from 1991 through 1997. +Katherine H. Ramundo , 52, Executive Vice President, Chief Legal Officer and Secretary. Ms. Ramundo was elected to her current position effective November 1, 2016. Prior to joining Arconic, from January 2013 through August 2015, she was Executive Vice President, General Counsel and Secretary of ANN INC., the parent company of ANN TAYLOR and LOFT brands, based in New York. Prior to ANN INC., she served as Vice President, Deputy General Counsel and Assistant Secretary at Colgate-Palmolive, where she held various legal roles from November 1997 to January 2013. She began her career as a litigator in New York, practicing at major law firms, including Cravath, Swaine & Moore and Sidley & Austin. +The Company’s executive officers are elected or appointed to serve until the next annual meeting of the Board of Directors (held in conjunction with the annual meeting of shareholders) except in the case of earlier death, retirement, resignation or removal. +Item 1A. Risk Factors. +Arconic’s business, financial condition and results of operations may be impacted by a number of factors. In addition to the factors discussed elsewhere in this report, the following risks and uncertainties could materially harm its business, financial condition or results of operations, including causing Arconic’s actual results to differ materially from those projected in any forward-looking statements. The following list of significant risk factors is not all-inclusive or necessarily in order of importance. Additional risks and uncertainties not presently known to Arconic or that Arconic currently deems immaterial also may materially adversely affect the Company in future periods. +Risks Related to Our Business +The markets for Arconic’s products are highly cyclical and are influenced by a number of factors, including global economic conditions. +Arconic is subject to cyclical fluctuations in global economic conditions and lightweight metals end-use markets. Arconic sells many products to industries that are cyclical, such as the aerospace, automotive, commercial transportation and building and construction industries, and the demand for its products is sensitive to, and quickly impacted by, demand for the finished goods manufactured by its customers in these industries, which may change as a result of changes in regional or worldwide economies, currency exchange rates, energy prices or other factors beyond its control. +In particular, Arconic derives a significant portion of its revenue from products sold to the aerospace industry, which can be highly cyclical and reflective of changes in the general economy. The commercial aerospace industry is historically driven by the demand from commercial airlines for new aircraft. The U.S. and international commercial aviation industries may face challenges arising from competitive pressures and fuel costs. Demand for commercial aircraft is influenced by airline industry profitability, trends in airline passenger traffic, the state of U.S., regional and world economies, the ability of aircraft purchasers to obtain required financing and numerous other factors including the effects of terrorism, health and safety concerns, environmental constraints imposed upon aircraft operators, the retirement of older aircraft, the performance and cost of alternative materials, and technological improvements to aircraft. The military aerospace cycle is highly dependent on U.S. and foreign government funding; however, it is also driven by the effects of terrorism, a changing global political environment, U.S. foreign policy, the retirement of older military aircraft, and technological improvements to new engines. +Further, the demand for Arconic’s automotive and ground transportation products is driven by the number of vehicles produced by automotive and commercial transportation manufacturers and volume of aluminum content per vehicle. The automotive industry is sensitive to general economic conditions, including credit markets and interest rates, and consumer spending and +15 +Table of Contents +preferences regarding vehicle ownership and usage, vehicle size, configuration and features. Automotive and commercial transportation sales and production can also be affected by other factors, including the age of the vehicle fleet and related scrappage rates, labor relations issues, fuel prices, regulatory requirements, government initiatives, trade agreements and levels of competition both within and outside of the aluminum industry. +Arconic is unable to predict the future course of industry variables, the strength of the U.S., regional or global economies, or the effects of government actions. Negative economic conditions, such as a major economic downturn, a prolonged recovery period, or disruptions in the financial markets, could have a material adverse effect on Arconic’s business, financial condition or results of operations. +Arconic faces significant competition, which may have an adverse effect on profitability. +As discussed in Part I, Item 1. (Business-Competitive Conditions) of this report, the markets for Arconic’s products are highly competitive. Arconic’s competitors include a variety of both U.S. and non-U.S. companies in all major markets. New product offerings, new technologies in the marketplace or new facilities may compete with or replace Arconic products. The willingness of customers to accept substitutes for the products sold by Arconic, the ability of large customers to exert leverage in the marketplace to affect the pricing for Arconic’s products, and technological advancements or other developments by or affecting Arconic’s competitors or customers could adversely affect Arconic’s business, financial condition or results of operations. +In addition, Arconic may face increased competition due to industry consolidation. As companies attempt to strengthen or maintain their market positions in an evolving industry, companies could be acquired or merged. Companies that are strategic alliance partners in some areas of Arconic’s business may acquire or form alliances with Arconic’s competitors, thereby reducing their business with Arconic. Industry consolidation may result in stronger competitors who are better able to obtain favorable terms from suppliers or who are better able to compete as sole-source vendors for customers. Consolidation within Arconic’s customer base may result in customers who are better able to command increased leverage in negotiating prices and other terms of sale, which could adversely affect Arconic’s profitability. Moreover, if, as a result of increased leverage, customers require Arconic to reduce its pricing such that its gross margins are diminished, Arconic could decide not to sell certain products to a particular customer, or not to sell certain products at all, which would decrease Arconic’s revenue. Consolidation within Arconic’s customer base may also lead to reduced demand for Arconic’s products, a combined entity replacing Arconic’s products with those of Arconic’s competitors and cancellations of orders. The result of these developments could have a material adverse effect on Arconic’s business, operating results and financial condition. +Arconic could be adversely affected by changes in the business or financial condition or the loss of a significant customer or customers. +Arconic has long-term contracts with a significant number of its customers, some of which are subject to renewal, renegotiation or re-pricing at periodic intervals or upon changes in competitive supply conditions. Arconic’s failure to successfully renew, renegotiate or favorably re-price such agreements, or a material deterioration in or termination of these customer relationships, could result in a reduction or loss in customer purchase volume or revenue. +Additionally, a significant downturn or deterioration in the business or financial condition or loss of a key customer supplied by Arconic could affect Arconic’s financial results. Arconic’s customers may experience delays in the launch of new products, labor strikes, diminished liquidity or credit unavailability, weak demand for their products, or other difficulties in their businesses. For example, in 2019, Boeing announced a temporary reduction in the production rate of, and subsequently announced a temporary suspension of production of, the Boeing 737 MAX aircraft, which has resulted in, and is expected to continue to result in, a reduction in sales of aluminum sheet and plate and other products that Arconic produces for Boeing airplanes. As no firm timeline has been established for either the adjustment of Boeing’s manufacturing plans, or for returning the aircraft into service, we are currently unable to definitively quantify any such potential impact. +Arconic’s customers may also change their business strategies or modify their business relationships with Arconic, including to reduce the amount of Arconic’s products they purchase or to switch to alternative suppliers. If Arconic’s customers reduce, terminate or delay purchases from Arconic due to the foregoing factors or otherwise and Arconic is unsuccessful in enforcing its contract rights or replacing such business in whole or in part or replaces it with less profitable business, our financial condition and results of operations may be adversely affected. +Arconic could encounter manufacturing difficulties or other issues that impact product performance, quality or safety, which could affect Arconic’s reputation, business and financial statements. +The manufacture of many of Arconic’s products is a highly exacting and complex process. Problems may arise during manufacturing for a variety of reasons, including equipment malfunction, failure to follow specific protocols, specifications and procedures, including those related to quality or safety, problems with raw materials, supply chain interruptions, natural disasters, labor unrest and environmental factors. Such problems could have an adverse impact on the Company’s ability to fulfill orders or on product quality or on performance. Product manufacturing or performance issues could result in recalls, customer penalties, contract cancellation and product liability exposure. Because of approval, license and qualification +16 +Table of Contents +requirements applicable to manufacturers and/or their suppliers, alternatives to mitigate manufacturing disruptions may not be readily available to Arconic or its customers. Accordingly, manufacturing problems, product defects or other risks associated with our products, could result in significant costs to and liability for us that could have a material adverse effect on our business, financial condition or results of operations, including the payment of potentially substantial monetary damages, fines or penalties, as well as negative publicity and damage to our reputation, which could adversely impact product demand and customer relationships. +Arconic’s business depends, in part, on its ability to meet increased program demand successfully and to mitigate the impact of program cancellations, reductions and delays. +Arconic is currently under contract to supply components for a number of new and existing commercial, general aviation, military aircraft and aircraft engine programs as well as aluminum sheet and extrusions for a number of aluminum-intensive automotive vehicle programs. Many of these programs are scheduled for production increases over the next several years. If Arconic fails to meet production levels or encounters difficulty or unexpected costs in meeting such levels, it could have a material adverse effect on the Company’s business, financial condition or results of operations. Similarly, program cancellations, reductions or delays could also have a material adverse effect on Arconic’s business. +Product liability, product safety, personal injury, property damage, and recall claims and investigations may materially affect Arconic’s financial condition and damage Arconic’s reputation. +The manufacture and sale of our products exposes Arconic to potential product liability, personal injury, property damage and related claims. These claims may arise from failure to meet product specifications, design flaws in our products, malfunction of our products, misuse of our products, use of our products in an unintended, unapproved or unrecommended manner, or use of our products with systems not manufactured or sold by us. New data and information, including information about the ways in which Arconic’s products are used, may lead Arconic, regulatory authorities, government agencies or other entities or organizations to publish guidelines or recommendations, or impose restrictions, related to the manufacturing or use of Arconic’s products. +In the event that an Arconic product fails to perform as expected, regardless of fault, or is used in an unexpected manner, and such failure or use results in, or is alleged to result in, bodily injury and/or property damage or other losses, Arconic may be subject to product liability lawsuits and other claims, or may be required or requested by its customers to participate in a recall or other corrective action involving such product. In addition, if an Arconic product is perceived to be defective or unsafe, sales of Arconic’s products could be diminished, Arconic’s reputation could be adversely impacted and Arconic could be subject to further liability claims. Moreover, events that give rise to actual, potential or perceived product safety concerns could expose Arconic to government investigations or regulatory enforcement actions. +There can be no assurance that Arconic will be successful in defending any such proceedings or that insurance available to Arconic will be sufficient to cover any losses associated with such proceedings. An adverse outcome in one or more of these proceedings or investigations could: (i) have a material adverse effect on Arconic’s business, financial condition or profitability; (ii) impose substantial monetary damages and/or non-monetary penalties; (iii) result in additional litigation, regulatory investigations or other proceedings involving Arconic; result in loss of customers; (iv) require changes to our products or business operations; or (v) damage Arconic’s reputation and/or negatively impact the market price of Arconic’s common stock. Even if Arconic successfully defends against these types of claims, Arconic could still be required to spend a substantial amount of money in connection with legal proceedings or investigations with respect to such claims; Arconic’s management could be required to devote significant time, attention and operational resources responding to and defending against these claims and responding to these investigations; and Arconic’s reputation could suffer. Product liability claims and related lawsuits and investigations, product recalls, and allegations of product safety or quality issues, regardless of their validity or ultimate outcome, may have a material adverse effect on Arconic’s business, financial condition and reputation and on our ability to attract and retain customers. +For further discussion of potential liability associated with some of our products, including proceedings and investigations relating to the June 13, 2017 fire at the Grenfell Tower in London, U.K., see Part I, Item 3 . (Legal Proceedings) of this report. +Arconic’s global operations expose Arconic to risks that could adversely affect Arconic’s business, financial condition, results of operations, cash flows or the market price of its securities. +Arconic has operations or activities in numerous countries and regions outside the United States, including Europe, Canada, China, Japan and Russia. As a result, Arconic’s global operations are affected by economic, political and other conditions in the foreign countries in which Arconic does business as well as U.S. laws regulating international trade, including: +• +economic and commercial instability risks, including those caused by sovereign and private debt default, corruption, and changes in local government laws, regulations and policies, such as those related to tariffs, sanctions and trade barriers (including tariffs imposed by the United States as well as retaliatory tariffs imposed by China or other foreign entities), taxation, exchange controls, employment regulations and repatriation of assets or earnings; +17 +Table of Contents +• +geopolitical risks such as political instability, civil unrest, expropriation, nationalization of properties by a government, imposition of sanctions, and renegotiation or nullification of existing agreements; +• +war or terrorist activities; +• +kidnapping of personnel; +• +major public health issues such as an outbreak of a pandemic or epidemic (such as Sudden Acute Respiratory Syndrome, Avian Influenza, H7N9 virus, coronavirus (including the novel strain that surfaced in Wuhan, China in December 2019, which has resulted in travel restrictions and shutdown of certain businesses in the region), or the Ebola virus), which could cause disruptions in Arconic’s operations, workforce or supply chain; +• +difficulties enforcing contractual rights and intellectual property, including a lack of remedies for misappropriation in certain jurisdictions; +• +changes in trade and tax laws that may result in our customers being subjected to increased taxes, duties and tariffs and reduce their willingness to use our services in countries in which we are currently manufacturing their products; +• +rising labor costs; +• +labor unrest, including strikes; +• +compliance with antitrust and competition regulations; +• +compliance with foreign labor laws, which generally provide for increased notice, severance and consultation requirements compared to U.S. laws; +• +aggressive, selective or lax enforcement of laws and regulations by national governmental authorities; +• +compliance with the Foreign Corrupt Practices Act and other anti-bribery and corruption laws; +• +compliance with U.S. laws concerning trade, including the International Traffic in Arms Regulations, the Export Administration Regulations, and the sanctions, regulations and embargoes administered by the U.S. Department of Treasury’s Office of Foreign Assets Control; +• +imposition of currency controls; and +• +adverse tax audit rulings, +Although the effect of any of the foregoing factors is difficult to predict, any one or more of them could adversely affect Arconic’s business, financial condition, or results of operations. The Company’s international operations subject Arconic to complex and dynamic laws and regulations that, in some cases, could result in conflict or inconsistency between applicable laws and/or legal obligations. While Arconic believes it has adopted appropriate risk management, compliance programs and insurance arrangements to address and reduce the associated risks, such measures may provide inadequate protection against costs, penalties, liabilities or other potential risks such as loss of export privileges or repatriation of assets that may arise from such events. +A material disruption of Arconic’s operations, particularly at one or more of the Company’s manufacturing facilities, could adversely affect Arconic’s business. +If Arconic’s operations, particularly one of the Company’s manufacturing facilities, were to be disrupted as a result of significant equipment failures, natural disasters, power outages, fires, explosions, terrorism, theft, sabotage, adverse weather conditions, public health crises, labor disputes or other reasons, Arconic may be unable to effectively meet its obligations to or demand from its customers, which could adversely affect Arconic’s financial performance. +Interruptions in production could increase Arconic’s costs and reduce its sales. Any interruption in production capability could require the Company to incur costs for premium freight, make substantial capital expenditures or purchase alternative material at higher costs to fill customer orders, which could negatively affect Arconic’s profitability and financial condition. Furthermore, because customers may be dependent on planned deliveries from us, customers that have to reschedule their own production due to our delivery delays may be able to pursue financial claims against us, and we may incur costs to correct such problems in addition to any liability resulting from such claims. Arconic maintains property damage insurance that the Company believes to be adequate to provide for reconstruction of facilities and equipment, as well as business interruption insurance to mitigate losses resulting from significant production interruption or shutdown caused by an insured loss. However, any recovery under Arconic’s insurance policies may not offset the lost profits or increased costs that may be experienced during the disruption of operations, which could adversely affect Arconic’s business, results of operations, financial condition and cash flow. +18 +Table of Contents +Arconic may be unable to realize future targets or goals established for its business segments, or complete projects, at the levels, projected costs or by the dates targeted. +From time to time, Arconic may announce future targets or goals for its business, which are based on the Company’s then current expectations, estimates, forecasts and projections about the operating environment, economies and markets in which Arconic operates. Future targets and goals reflect the Company’s beliefs and assumptions and its perception of historical trends, then current conditions and expected future developments, as well as other factors appropriate in the circumstances. As such, targets and goals are inherently subject to significant business, economic, competitive and other uncertainties and contingencies regarding future events, including the risks discussed in this report. The actual outcome may be materially different. There can be no assurance that any targets or goals established by the Company will be accomplished at the levels or by the dates targeted, if at all. Failure to achieve the targets or goals by the Company may have a material adverse effect on its business, financial condition, results of operations or the market price of its securities. +In addition, the implementation of Arconic’s business strategy periodically involves the entry into and the execution of complex projects, which place significant demands on the Company’s management and personnel, and may depend on numerous factors beyond the Company’s control. There can be no assurance that such projects will be completed within budgeted costs, on a timely basis, or at all, whether due to the risks described in this report, or other factors. The failure to complete a material project as planned, or a significant delay in a material project, whatever the cause, could have an adverse effect on Arconic’s business, financial condition, or results of operations. +Information technology system failures, cyber attacks and security breaches may threaten the integrity of Arconic’s intellectual property and other sensitive information, disrupt its business operations, and result in reputational harm and other negative consequences that could have a material adverse effect on its financial condition and results of operations. +Arconic relies on its information technology systems to manage and operate its business, process transactions, and summarize its operating results. Arconic’s information technology systems are subject to damage or interruption from power outages, computer, network and telecommunications failures, computer viruses, and catastrophic events, such as fires, floods, earthquakes, tornadoes, hurricanes, acts of war or terrorism, and usage errors by employees. If Arconic’s information technology systems are damaged or cease to function properly, the Company may have to make a significant investment to fix or replace them, and Arconic may suffer loss of critical data and interruptions or delays in its operations. Any material disruption in the Company’s information technology systems, or delays or difficulties in implementing or integrating new systems or enhancing current systems, could have an adverse effect on Arconic’s business, financial condition or results of operations. +Arconic also faces global cybersecurity threats, which may range from uncoordinated individual attempts to sophisticated and targeted measures, known as advanced persistent threats, directed at the Company. Cyber attacks and security breaches may include, but are not limited to, attempts to access information, computer viruses, denial of service and other electronic security breaches. +The Company believes that it faces a heightened threat of cyber attacks due to the industries it serves, the locations of its operations and its technological innovations. The Company has experienced cybersecurity attacks in the past, including breaches of its information technology systems in which information was taken, and may experience them in the future, potentially with more frequency or sophistication. Based on information known to date, past attacks have not had a material impact on Arconic’s financial condition or results of operations. However, due to the evolving nature of cybersecurity threats, the scope and impact of any future incident cannot be predicted. +Arconic employs a number of measures to protect and defend against cyber attacks, including technical security controls, data encryption, firewalls, intrusion prevention systems, anti-virus software and frequent backups. Additionally, the Company conducts regular periodic training of its employees regarding the protection of sensitive information which includes training intended to prevent the success of “phishing” attacks. While the Company continually works to safeguard its systems and mitigate potential risks, there is no assurance that such actions will be sufficient to prevent cyber attacks or security breaches that manipulate or improperly use its systems or networks, compromise confidential or otherwise protected information, destroy or corrupt data, or otherwise disrupt its operations. The occurrence of such events could negatively impact Arconic’s reputation and its competitive position and could result in litigation with third parties, regulatory action, loss of business, potential liability and increased remediation costs, any of which could have a material adverse effect on its financial condition and results of operations. In addition, such attacks or breaches could require significant management attention and resources, and could result in the diminution of the value of the Company’s investment in research and development. +Arconic’s enterprise risk management program and disclosure controls and procedures address cybersecurity and include elements intended to ensure that there is an analysis of potential disclosure obligations arising from cyber attacks and security breaches. Arconic also maintains compliance programs to address the potential applicability of restrictions against trading while in possession of material, nonpublic information generally and in connection with a cyber attack or security breach. +19 +Table of Contents +However, a breakdown in existing controls and procedures around the Company’s cybersecurity environment may prevent Arconic from detecting, reporting or responding to cyber incidents in a timely manner and could have a material adverse effect on the Company’s financial condition or the market price of its securities. +Arconic may be unable to develop innovative new products or implement technology initiatives successfully. +Arconic’s competitive position and future performance depends, in part, on the Company’s ability to: +• +identify and evolve with emerging technological and broader industry trends in Arconic’s target end-markets; +• +identify and successfully execute on a strategy to remain an essential and sustainable element of its customers’ supply chains; +• +fund, develop, manufacture and bring innovative new products and services to market quickly and cost-effectively; +• +monitor disruptive technologies and understand customers’ and competitors’ abilities to deploy those disruptive technologies; and +• +achieve sufficient return on investment for new products based on capital expenditures and research and development spending. +Arconic is working on new developments for a number of strategic projects, including advanced alloy development, engineered finishes and product design, rolling technology, and other advanced manufacturing technologies. +While Arconic intends to continue to develop innovative new products and services, it may not be able to successfully differentiate its products or services from those of its competitors or match the level of research and development spending of its competitors, including those developing technology to displace Arconic’s current products. In addition, Arconic may not be able to adapt to evolving markets and technologies or achieve and maintain technological advantages. There can be no assurance that any of Arconic’s new products or services, development programs or technologies will be commercially adopted or beneficial to Arconic. +Arconic could be adversely affected by reductions in defense spending. +Arconic’s products are used in a variety of military applications, including military aircraft and armored vehicles. Although many of the programs in which Arconic participates extend several years, they are subject to annual funding through congressional appropriations. Changes in military strategy and priorities, or reductions in defense spending, may affect current and future funding of these programs and could reduce the demand for Arconic’s products, which could adversely affect Arconic’s business, financial condition or results of operations. +Arconic may face challenges to its intellectual property rights which could adversely affect the Company’s reputation, business and competitive position. +Arconic owns important intellectual property, including patents, trademarks, copyrights and trade secrets. The Company’s intellectual property plays an important role in maintaining Arconic’s competitive position in a number of the markets that the Company serves. Arconic’s competitors may develop technologies that are similar or superior to Arconic’s proprietary technologies or design around the patents Arconic owns or licenses. Despite its controls and safeguards, Arconic’s technology may be misappropriated by its employees, its competitors or other third parties. The pursuit of remedies for any misappropriation of Arconic intellectual property is expensive and the ultimate remedies may be deemed insufficient. Further, in jurisdictions where the enforcement of intellectual property rights is less robust, the risk of misappropriation of Arconic intellectual property increases, despite efforts the Company undertakes to protect it. Developments or assertions by or against Arconic relating to intellectual property rights, and any inability to protect or enforce Arconic’s rights sufficiently, could adversely affect Arconic’s business and competitive position. +A decline in Arconic’s financial performance or outlook or a deterioration in its credit profile could negatively impact the Company’s access to capital markets, reduce its liquidity and increase its borrowing costs. +Arconic has significant capital requirements and depends, in part, upon the issuance of debt to fund its operations and contractual commitments and pursue strategic acquisitions. A decline in the Company’s financial performance or outlook due to internal or external factors could affect the Company’s access to, and the availability or cost of, financing on acceptable terms and conditions. There can be no assurance that Arconic will have access to the global capital market on terms the Company finds acceptable. Limitations on Arconic’s ability to access the global capital markets, a reduction in the Company’s liquidity or an increase in borrowing costs could materially and adversely affect Arconic’s ability to maintain or grow its business, which in turn may adversely affect its financial condition and results of operations. +A downgrade of Arconic’s credit ratings could limit Arconic’s ability to obtain future financing, increase its borrowing costs, increase the pricing of its credit facilities, adversely affect the market price of its securities, +20 +Table of Contents +trigger letter of credit or other collateral postings, or otherwise impair its business, financial condition, and results of operations. +Arconic’s credit ratings are important to the Company’s cost of capital. The major credit rating agencies evaluate our creditworthiness and give us specified credit ratings. These ratings are based on a number of factors, including our financial strength and financial policies as well as our strategies, operations, execution and timeliness of financial reporting. These credit ratings are limited in scope, and do not address all material risks related to investment in us, but rather reflect only the view of each rating agency at the time the rating is issued. Nonetheless, the credit ratings Arconic receives impact our borrowing costs as well as the terms upon which we will have access to capital. Failure to maintain sufficiently high credit ratings could adversely affect the interest rate in future financings, our liquidity or our competitive position, and could also restrict our access to capital markets. +On May 1, 2017, Standard and Poor’s Ratings Services (S&P) affirmed Arconic’s long-term debt at BBB-, an investment grade rating, with a stable outlook, and its short-term debt at A-3. On February 7, 2019, S&P placed the rating on negative credit watch and, subsequently, on April 26, S&P affirmed the long-term debt rating at BBB- but changed the outlook to negative. On January 28, 2020, S&P affirmed the long-term debt rating at BBB- but changed the outlook to stable in expectation of the Separation impact. On November 1, 2016, Moody’s Investor Service (Moody’s) downgraded Arconic’s long-term debt rating from Ba1, a non-investment grade, to Ba2 with a stable outlook and its short-term debt rating from Speculative Grade Liquidity-1 to Speculative Grade Liquidity-2. Moody’s ratings and outlooks were affirmed on November 2, 2017, October 8, 2018, and October 9, 2019. On January 24, 2020, Moody’s affirmed the long-term debt rating at Ba2 but changed the outlook to negative. On April 21, 2016, Fitch affirmed Arconic’s long-term debt rating at BB+, a non-investment grade, and short-term debt at B. Additionally, Fitch changed the outlook from positive to evolving. On July 7, 2016, Fitch changed the outlook from evolving to stable (ratings and outlook were affirmed on July 3, 2017). On September 27, 2018, Fitch changed the outlook from stable to positive (ratings and outlook were affirmed on October 8, 2019). +There can be no assurance that one or more of these or other rating agencies will not take negative actions with respect to Arconic’s ratings in the future. Increased debt levels, macroeconomic conditions, a deterioration in the Company’s debt protection metrics, a contraction in the Company’s liquidity, or other factors could potentially trigger such actions. A rating agency may lower, suspend or withdraw entirely a rating or place it on negative outlook or watch if, in that rating agency’s judgment, circumstances so warrant. +A downgrade of Arconic’s credit ratings by one or more rating agencies could: (i) result in adverse consequences, including: adversely impact the market price of Arconic’s securities; (ii) adversely affect existing financing (for example, a downgrade by S&P or Moody’s would subject Arconic to higher costs under Arconic’s Five-Year Revolving Credit Agreement and certain of its other revolving credit facilities); (iii) limit access to the capital (including commercial paper) or credit markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all; (iv) result in more restrictive covenants in agreements governing the terms of any future indebtedness that the Company incurs; (v) increase the cost of borrowing or fees on undrawn credit facilities; or (vi) result in vendors or counterparties seeking collateral or letters of credit from Arconic. +Limitations on Arconic’s ability to access the global capital markets, a reduction in Arconic’s liquidity or an increase in borrowing costs could materially and adversely affect Arconic’s ability to maintain or grow its business, which in turn may adversely affect its financial condition, liquidity and results of operations. +Arconic’s business and growth prospects may be negatively impacted by limits in its capital expenditures. +Arconic requires substantial capital to invest in growth opportunities and to maintain and prolong the life and capacity of its existing facilities. Insufficient cash generation or capital project overruns may negatively impact Arconic’s ability to fund as planned its sustaining and return-seeking capital projects. Over the long term, Arconic’s ability to take advantage of improved market conditions or growth opportunities in its businesses may be constrained by earlier capital expenditure restrictions, which could adversely affect the long-term value of its business and the Company’s position in relation to its competitors. +An adverse decline in the liability discount rate, lower-than-expected investment return on pension assets and other factors could affect Arconic’s results of operations or amount of pension funding contributions in future periods. +Arconic’s results of operations may be negatively affected by the amount of expense Arconic records for its pension and other postretirement benefit plans, reductions in the fair value of plan assets and other factors. Arconic calculates income or expense for its plans using actuarial valuations in accordance with accounting principles generally accepted in the United States of America (GAAP). +These valuations reflect assumptions about financial market and other economic conditions, which may change based on changes in key economic indicators. The most significant year-end assumptions used by Arconic to estimate pension or other postretirement benefit income or expense for the following year are the discount rate applied to plan liabilities and the expected long-term rate of return on plan assets. In addition, Arconic is required to make an annual measurement of plan assets and +21 +Table of Contents +liabilities, which may result in a significant charge to shareholders’ equity. For a discussion regarding how Arconic’s financial statements can be affected by pension and other postretirement benefits accounting policies, see “Critical Accounting Policies and Estimates-Pension and Other Postretirement Benefits” in Part II, Item 7 . (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note F to the Consolidated Financial Statements-Pension and Other Postretirement Benefits in Part II, Item 8 . (Financial Statements and Supplementary Data). Although GAAP expense and pension funding contributions are impacted by different regulations and requirements, the key economic factors that affect GAAP expense would also likely affect the amount of cash or securities Arconic would contribute to the pension plans. +Potential pension contributions include both mandatory amounts required under federal law and discretionary contributions to improve the plans’ funded status. The Moving Ahead for Progress in the 21st Century Act (“MAP-21”), enacted in 2012, provided temporary relief for employers like Arconic who sponsor defined benefit pension plans related to funding contributions under the Employee Retirement Income Security Act of 1974 by allowing the use of a 25-year average discount rate within an upper and lower range for purposes of determining minimum funding obligations. In 2014, the Highway and Transportation Funding Act (HATFA) was signed into law. HATFA extended the relief provided by MAP-21 and modified the interest rates that had been set by MAP-21. In 2015, the Bipartisan Budget Act of 2015 (BBA 2015) was signed into law. BBA 2015 extends the relief period provided by HATFA. Arconic believes that the relief provided by BBA 2015 will moderately reduce the cash flow sensitivity of the Company’s U.S. pension plans’ funded status over the next several years due to recent and potential future declines in discount rates. However, higher than expected pension contributions due to a decline in the plans’ funded status as a result of unpredictable future declines in the discount rate or lower-than-expected investment returns on plan assets could have a material negative effect on the Company’s cash flows. Adverse capital market conditions could result in reductions in the fair value of plan assets and increase the Company’s liabilities related to such plans, which could adversely affect Arconic’s liquidity and results of operations. +Unanticipated changes in Arconic’s tax provisions or exposure to additional tax liabilities could affect Arconic’s future profitability. +Arconic is subject to income taxes in both the United States and various non-U.S. jurisdictions. Its domestic and international tax liabilities are dependent upon the distribution of income among these different jurisdictions. Changes in applicable domestic or foreign tax laws and regulations, or their interpretation and application, including the possibility of retroactive effect, could affect the Company’s tax expense and profitability. Arconic’s tax expense includes estimates of additional tax that may be incurred for tax exposures and reflects various estimates and assumptions. The assumptions include assessments of future earnings of the Company that could impact the valuation of its deferred tax assets. The Company’s future results of operations could be adversely affected by changes in the effective tax rate as a result of a change in the mix of earnings in countries with differing statutory tax rates, changes in the overall profitability of the Company, changes in tax legislation and rates, changes in generally accepted accounting principles, changes in the valuation of deferred tax assets and liabilities, the results of tax audits and examinations of previously filed tax returns or related litigation and continuing assessments of its tax exposures. +Corporate tax law changes continue to be analyzed in the United States and in many other jurisdictions. In particular, on December 22, 2017, the Tax Cuts and Jobs Act (the “2017 Act”) was signed into law, significantly reforming the United States Internal Revenue Code of 1986, as amended. During 2018, the Internal Revenue Service (the “IRS”) began a number of guidance projects which serve to both interpret and implement the 2017 Act. Those guidance projects, which include both Proposed and Final Treasury Regulations, continued in 2019 and may continue in 2020. Arconic continues to review the components of the 2017 Act, as well as the ongoing interpretive guidance, and evaluate its consequences. As such, the ultimate impact of the 2017 Act may differ from reported amounts due to, among other things, changes in interpretations and assumptions the Company has made to date; and actions the Company may take as a result of the 2017 Act and related guidance. These changes to the U.S. corporate tax system could have a substantial impact, positive or negative, on Arconic’s future effective tax rate, cash tax expenditures, and deferred tax assets and liabilities. +Arconic may be unable to realize the expected benefits from acquisitions, divestitures, joint ventures and strategic alliances. +Arconic has made, and may continue to plan and execute, acquisitions and divestitures and take other actions to grow its business or streamline its portfolio. There is no assurance that anticipated benefits will be realized. Acquisitions present significant challenges and risks, including the effective integration of the business into the Company, unanticipated costs and liabilities, and the ability to realize anticipated benefits, such as growth in market share, revenue or margins, at the levels or in the timeframe expected. The Company may be unable to manage acquisitions successfully. Additionally, adverse factors may prevent Arconic from realizing the benefits of its growth projects, including unfavorable global economic conditions, currency fluctuations, or unexpected delays in target timelines. +With respect to portfolio optimization actions such as divestitures, curtailments and closures, Arconic may face barriers to exit from unprofitable businesses or operations, including high exit costs or objections from customers, suppliers, unions, local or +22 +Table of Contents +national governments, or other stakeholders. In addition, Arconic may retain unforeseen liabilities for divested entities or businesses, including, but not limited to, if a buyer fails to honor all commitments. Arconic’s business operations are capital intensive, and curtailment or closure of operations or facilities may include significant charges, including employee separation costs, asset impairment charges and other measures. +In addition, Arconic has participated in, and may continue to participate in, joint ventures, strategic alliances and other similar arrangements from time to time. Although the Company has, in connection with past and existing joint ventures, sought to protect its interests, joint ventures and strategic alliances inherently involve special risks. Whether or not Arconic holds majority interests or maintains operational control in such arrangements, its partners may: +• +have economic or business interests or goals that are inconsistent with or opposed to those of the Company; +• +exercise veto rights to block actions that Arconic believes to be in our or the joint venture’s or strategic alliance’s best interests; +• +take action contrary to Arconic’s policies or objectives with respect to investments; or +• +as a result of financial or other difficulties, be unable or unwilling to fulfill their obligations under the joint venture, strategic alliance or other agreements, such as contributing capital to expansion or maintenance projects. +There can be no assurance that acquisitions, growth investments, divestitures, closures, joint ventures, strategic alliances or similar arrangements will be undertaken or completed in their entirety as planned or that they will be beneficial to Arconic, whether due to the above-described risks, unfavorable global economic conditions, increases in construction costs, currency fluctuations, political risks, or other factors. +Arconic’s business could be adversely affected by increases in the cost of aluminum. +Arconic derives a significant portion of its revenue from aluminum-based products. The price of primary aluminum has historically been subject to significant cyclical price fluctuations and the timing of changes in the market price of aluminum is largely unpredictable. Although the Company’s pricing of products is generally intended to pass substantially all the risk of metal price fluctuations on to the Company’s customers or is otherwise hedged, there are situations where Arconic is unable to pass on the entire cost of increases to its customers and there is a potential time lag on certain products between increases in costs for aluminum and the point when the Company can implement a corresponding increase in price to its customers and/or there are other timing factors that may result in Arconic's exposure to certain price fluctuations which could have a material adverse effect on Arconic’s business, financial condition or results of operations. Further, since metal prices fluctuate among the various exchanges, Arconic competitors may enjoy a metal price advantage from time to time. +Arconic may be adversely affected by changes in the availability or cost of other raw materials (including, but not limited to, cobalt, nickel, titanium sponge, vanadium, copper, magnesium and zinc), as well as freight costs associated with transportation of raw materials. The availability and costs of certain raw materials necessary for the production of Arconic’s products may be influenced by private or government entities including mergers and acquisitions, changes in world politics or regulatory requirements (such as human rights regulations or environmental regulations), labor relations between the producers and their work forces, unstable governments in exporting nations, export quotas, sanctions, new or increased import duties, countervailing or anti-dumping duties, market forces of supply and demand, and inflation. In addition, from time to time, commodity prices may fall rapidly. When this happens, suppliers may withdraw capacity from the market until prices improve, which may cause periodic supply interruptions. Arconic may be unable to offset fully the effects of raw material shortages or higher costs through customer price increases, productivity improvements or cost reduction programs. Shortages or price fluctuations in raw materials could have a material adverse effect on Arconic’s operating results. +Arconic is dependent on a limited number of suppliers for a substantial portion of our aluminum and certain other raw materials essential to our operations. +Arconic has supply arrangements with a limited number of suppliers for aluminum and other raw materials. We maintain annual or long-term contracts for a majority of our supply requirements, and for the remainder we depend on spot purchases. From time to time, increasing demand levels have caused regional supply constraints in the industry and further increases in demand levels could exacerbate these issues. Such constraints could impact our production or force us to purchase primary metal and other supplies from alternative sources, which may not be available in sufficient quantities or may only be available on terms that are less favorable to us. Further, there can be no assurance that we will be able to renew, or obtain replacements for, any of our long-term contracts when they expire on terms that are as favorable as our existing agreements or at all. Additionally, Arconic could have exposure if a key supplier in a particular region is unable to deliver sufficient quantities of a necessary material on a timely basis. In addition, a significant downturn in the business or financial condition of our significant suppliers exposes us to the risk of default by the supplier on our contractual agreements, and this risk is increased by weak and deteriorating economic conditions on a global, regional or industry sector level. +23 +Table of Contents +Arconic is exposed to fluctuations in foreign currency exchange rates and interest rates, as well as inflation, economic factors, and currency controls in the countries in which it operates. +Economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, competitive factors in the countries in which Arconic operates, and continued volatility or deterioration in the global economic and financial environment could affect Arconic’s revenues, expenses and results of operations. Changes in the valuation of the U.S. dollar against other currencies, including the Euro, British pound, Canadian dollar, Chinese yuan (renminbi), Japanese yen and Russian ruble, may affect Arconic’s profitability as some important inputs are purchased in other currencies, while the Company’s products are generally sold in U.S. dollars. +In addition, a portion of Arconic’s indebtedness, including certain borrowings under the Company’s Five-Year Credit Facility, bears interest at rates equal to the London Interbank Offering Rate (“LIBOR”) plus an applicable margin based on the credit ratings of Arconic’s outstanding senior unsecured long-term debt. Accordingly, the Company is subject to risk from changes in interest rates on the variable component of the rate. Further, LIBOR is the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms and other pressures may cause LIBOR to disappear entirely or to perform differently than in the past. The consequences of these developments cannot be entirely predicted, but could include changes in the cost of Arconic’s variable rate indebtedness. +Arconic also faces risks arising from the imposition of cash repatriation restrictions and exchange controls. Cash repatriation restrictions and exchange controls may limit the Company’s ability to convert foreign currencies into U.S. dollars or to remit dividends and other payments by Arconic’s foreign subsidiaries or businesses located in or conducted within a country imposing restrictions or controls. While Arconic currently has no need, and does not intend, to repatriate or convert cash held in countries that have significant restrictions or controls in place, should the Company need to do so to fund its operations, it may be unable to repatriate or convert such cash, or be unable to do so without incurring substantial costs. Arconic currently has substantial operations in countries that have cash repatriation restrictions or exchange controls in place, including China, and, if the Company were to need to repatriate or convert such cash, these controls and restrictions may have an adverse effect on Arconic’s operating results and financial condition. +Arconic may not realize expected benefits from its productivity and cost-reduction initiatives. +Arconic has undertaken, and may continue to undertake, productivity and cost-reduction initiatives to improve performance and conserve cash, including deployment of company-wide business process models, such as Arconic’s degrees of implementation process in which ideas are executed in a disciplined manner to generate savings, and operating cost reductions. There is no assurance that these initiatives will be successful or beneficial to Arconic or that estimated cost savings from such activities will be realized. If Arconic fails to achieve net cost savings at anticipated levels, its business, financial condition or results of operations could be adversely affected. +Arconic’s customers may reduce their demand for aluminum products in favor of alternative materials. +Certain applications of Arconic’s aluminum-based products compete with products made from other materials, such as steel, titanium and composites. The willingness of customers to pursue materials other than aluminum often depends upon the desire to achieve specific attributes. For example, the commercial aerospace industry has used and continues to evaluate the further use of alternative materials to aluminum, such as titanium and composites, in order to reduce the weight and increase the fuel efficiency of aircraft. Additionally, the automotive industry, while motivated to reduce vehicle weight through the use of aluminum, may revert to steel or other materials for certain applications. Further, the decision to use aluminum may be impacted by aluminum prices or compatibility of aluminum with other materials used by a customer in a given application. The willingness of customers to accept other materials in lieu of aluminum could adversely affect the demand for certain of Arconic’s products, and thus adversely affect Arconic’s business, financial condition or results of operations. +Labor disputes and other employee relations issues could adversely affect Arconic’s business, financial condition or results of operations. +A significant portion of Arconic’s employees are represented by labor unions in a number of countries under various collective bargaining agreements with varying durations and expiration dates. For more information, see “Employees” in Part I, Item 1 . (Business) of this report. While Arconic previously has been successful in renegotiating its collective bargaining agreements with various unions, Arconic may not be able to satisfactorily renegotiate all collective bargaining agreements in the United States and other countries when they expire. In addition, existing collective bargaining agreements may not prevent a strike or work stoppage at Arconic’s facilities in the future. Arconic may also be subject to general country strikes or work stoppages unrelated to its business or collective bargaining agreements. Any such work stoppages (or potential work stoppages) could have a material adverse effect on Arconic’s business, financial condition or results of operations. +24 +Table of Contents +A failure to attract, retain or provide adequate succession plans for key personnel could adversely affect Arconic’s operations and competitiveness. +Arconic’s existing operations and development projects require highly skilled executives and staff with relevant industry and technical experience. The inability of the Company to attract and retain such people may adversely impact Arconic’s ability to meet project demands adequately and fill roles in existing operations. Skills shortages in engineering, manufacturing, technology, construction and maintenance contractors and other labor market inadequacies may also impact activities. These shortages may adversely impact the cost and schedule of development projects and the cost and efficiency of existing operations. +In addition, the continuity of key personnel and the preservation of institutional knowledge are vital to the success of the Company’s growth and business strategy. The loss of key members of management and other personnel could significantly harm Arconic’s business, and any unplanned turnover, or failure to develop adequate succession plans for key positions, could deplete the Company’s institutional knowledge base, result in loss of technical or other expertise, delay or impede the execution of the Company’s business plans and erode Arconic’s competitiveness. +Arconic may be exposed to significant legal proceedings, investigations or changes in U.S. federal, state or foreign law, regulation or policy. +Arconic’s results of operations or liquidity in a particular period could be affected by new or increasingly stringent laws, regulatory requirements or interpretations, or outcomes of significant legal proceedings or investigations adverse to Arconic. The Company may experience an unfavorable change in effective tax rates or become subject to unexpected or rising costs associated with business operations or provision of health or welfare benefits to employees due to changes in laws, regulations or policies. +Arconic is also subject to a variety of legal and regulatory compliance risks in the United States and abroad in connection with its business and products. These risks include, among other things, potential claims relating to product liability, product testing, health and safety, environmental matters, employment matters, required record keeping and record retention, compliance with securities laws, intellectual property rights, government contracts and taxes, insurance or commercial matters, as well as compliance with U.S. and foreign laws and regulations, including those governing import and export, anti-bribery, antitrust and competition, sales and trading practices, human rights and modern slavery, sourcing of raw materials, third-party relationships, supply chain operations and the manufacture and sale of products. Arconic may be a party to litigation in a foreign jurisdiction where geopolitical risks might influence the ultimate outcome of such litigation. Arconic could be subject to fines, penalties, damages (in certain cases, treble damages), or suspension or debarment from government contracts. +The global and diverse nature of Arconic’s operations means that these risks will continue to exist, and additional legal proceedings and contingencies may arise from time to time. While Arconic believes it has adopted appropriate risk management and compliance programs to address and reduce these risks, including insurance arrangements with respect to these risks, such measures may provide inadequate protection against liabilities that may arise. In addition, various factors or developments can lead the Company to change current estimates of liabilities or make such estimates for matters previously unsusceptible to reasonable estimates, such as a significant judicial ruling or judgment, a significant settlement, significant regulatory developments or changes in applicable law. A future adverse ruling or settlement or unfavorable changes in laws, regulations or policies, or other contingencies that the Company cannot predict with certainty could have a material adverse effect on the Company’s financial condition, results of operations or cash flows in a particular period. Litigation and compliance efforts may require substantial attention from management and could result in significant legal expenses, settlement costs or damage awards that could have a material impact on the Company’s financial position, results of operations and cash flows. For additional information regarding the legal proceedings involving the Company, including proceedings and investigations relating to the June 13, 2017 fire at the Grenfell Tower in London, U.K., see the discussion in Part I, Item 3 . (Legal Proceedings) of this report and in Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data). +Arconic is exposed to environmental and safety risks and is subject to a broad range of health, safety and environmental laws and regulations which may result in substantial costs and liabilities. +Arconic’s operations worldwide are subject to numerous complex and increasingly stringent health, safety and environmental laws and regulations. The costs of complying with such laws and regulations, including participation in assessments and cleanups of sites, as well as internal voluntary programs, are significant and will continue to be so for the foreseeable future. Environmental laws may impose cleanup liability on owners and occupiers of contaminated property, including present, past or divested properties, regardless of whether the owners and occupiers caused the contamination or whether the activity that caused the contamination was lawful at the time it was conducted. Environmental matters for which Arconic may be liable may arise in the future at its present sites, at sites owned or operated by its predecessors or affiliates, at sites that it may acquire in the future, or at third-party sites used by Arconic, its predecessors or affiliates for material and waste handling and disposal. Compliance with health, safety and environmental laws and regulations, including remediation obligations, may prove to be +25 +Table of Contents +more challenging and costly than the Company anticipates. Arconic’s results of operations or liquidity in a particular period could be affected by certain health, safety or environmental matters, including remediation costs and damages related to certain sites as well as other health and safety risks relating to its operations and products. Additionally, evolving regulatory standards and expectations can result in increased litigation and/or increased costs, including increased remediation costs, all of which can have a material and adverse effect on the Company’s financial condition, results of operations and cash flows. +In addition, the industrial activities conducted at Arconic’s facilities present a significant risk of injury or death to our employees, customers or third parties that may be on site. We have experienced serious injuries in the past, notwithstanding the safety protocols, practices and precautions we take. Our operations are subject to regulation by various federal, state and local agencies in the United States and regulation by foreign government entities abroad responsible for employee health and safety, including the Occupational Safety and Health Administration. From time to time, we have incurred fines for violations of various health and safety standards. While we maintain insurance and have in place policies to minimize such risks, we may nevertheless be unable to avoid material liabilities for any injury or death that may occur in the future. These types of incidents may not be covered by or may exceed our insurance coverage and could have a material adverse effect on our results of operations and financial condition or result in negative publicity and/or significant reputational harm. +Arconic is subject to privacy and data security/protection laws in the jurisdictions in which it operates and may be exposed to substantial costs and liabilities associated with such laws and regulations. +The regulatory environment surrounding information security and privacy is increasingly demanding, with frequent imposition of new and changing requirements. For example, the European Union’s General Data Protection Regulation (“GDPR”), which became effective in May 2018, imposed significant new requirements on how companies process and transfer personal data, as well as significant fines for non-compliance. Compliance with changes in privacy and information security laws and standards may result in significant expense due to increased investment in technology and the development of new operational processes, which could have a material adverse effect on Arconic’s financial condition and results of operations. In addition, the payment of potentially significant fines or penalties in the event of a breach of the GDPR or other privacy and information security laws, as well as the negative publicity associated with such a breach, could damage the Company’s reputation and adversely impact product demand and customer relationships. +Failure to comply with domestic or international employment and related laws could result in penalties or costs that could have a material adverse effect on Arconic’s business results. +Arconic is subject to a variety of domestic and foreign employment laws, such as the Fair Labor Standards Act (which governs such matters as minimum wages, overtime and other working conditions), state and local wage laws, the Employee Retirement Income Security Act, and regulations related to safety, discrimination, organizing, whistle-blowing, classification of employees, privacy and severance payments, citizenship requirements, and healthcare insurance mandates. Allegations that Arconic has violated such laws or regulations could damage the Company’s reputation and lead to fines from or settlements with federal, state or foreign regulatory authorities or damages payable to employees, which could have a material adverse impact on Arconic’s operations and financial condition. +Arconic may be affected by global climate change or by legal, regulatory, or market responses to such change. +Increased concern over climate change has led to new and proposed legislative and regulatory initiatives, such as cap-and-trade systems, additional limits on emissions of greenhouse gases or Corporate Average Fuel Economy (CAFE) standards in the United States. New or revised laws and regulations in this area could directly and indirectly affect Arconic and its customers and suppliers, including by increasing the costs of production or impacting demand for certain products, which could result in an adverse effect on our financial condition, results of operations and cash flows. Compliance with any new or more stringent laws or regulations, or stricter interpretations of existing laws, could require additional expenditures by the Company or its customers or suppliers. Also, Arconic relies on natural gas, electricity, fuel oil and transport fuel to operate its facilities. Any increased costs of these energy sources because of new laws could be passed along to the Company and its customers and suppliers, which could also have a negative impact on Arconic’s profitability. +Changes in the United Kingdom’s economic and other relationships with the European Union could adversely affect Arconic. +In March 2017, the United Kingdom formally triggered the process to withdraw from the European Union (also referred to as "Brexit") following the results of a national referendum that took place in June 2016. The United Kingdom formally left the European Union on January 31, 2020. A transition period through December 31, 2020 has been established to allow the United Kingdom and the European Union to negotiate the terms of the United Kingdom’s withdrawal. However, there is continued uncertainty surrounding the future relationship between the United Kingdom and the European Union, including trade agreements between the United Kingdom and the European Union. +The ultimate effects of Brexit on Arconic are difficult to predict, but because the Company currently operates and conducts business in the United Kingdom and in Europe, Brexit could cause disruptions and create uncertainty to Arconic’s businesses, +26 +Table of Contents +including affecting the business of and/or our relationships with Arconic’s customers and suppliers, as well as altering the relationship among tariffs and currencies, including the value of the British pound and the Euro relative to the U.S. dollar. Such disruptions and uncertainties could adversely affect Arconic’s financial condition, operating results and cash flows. In addition, Brexit could result in legal uncertainty and potentially divergent national laws and regulations as new legal relationships between the United Kingdom and the European Union are established. The ultimate effects of Brexit on Arconic will also depend on the terms of any agreements the United Kingdom and the European Union make to retain access to each other’s respective markets either during the transition period or more permanently. +Dividends on Arconic common stock could be reduced or eliminated in the event of material future deterioration in business conditions or in other circumstances. +Arconic has historically paid dividends on its common stock; however, it has no obligation to do so. The existence, timing, declaration, amount and payment of future dividends to Arconic’s stockholders falls within the discretion of Arconic’s Board of Directors, and the Company’s dividend policy may change at any time without advance notice to Arconic’s stockholders. For example, on February 8, 2019, in connection with the Company’s ongoing strategic and portfolio review, Arconic announced that it expected to reduce its quarterly common stock dividend from $0.06 to $0.02 per share. The Arconic Board of Directors’ decisions regarding the payment of dividends will depend on many factors, such as Arconic’s financial condition, earnings, capital requirements, debt service obligations, covenants associated with certain of the Company’s debt service obligations, industry practice, legal requirements, regulatory constraints and other factors that Arconic’s Board of Directors deems relevant. Arconic’s Board of Directors may determine to further reduce or eliminate Arconic’s common stock dividend in the event of material future deteriorations in business conditions or in other circumstances. +Anti-takeover provisions could prevent or delay a change in control of Arconic, including a takeover attempt by a third party and limit the power of Arconic’s shareholders. +Arconic’s Certificate of Incorporation and Bylaws contain, and Delaware law contains, provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the bidder and to encourage prospective acquirers to negotiate with Arconic’s Board of Directors rather than to attempt a hostile takeover. For example, Arconic is subject to Section 203 of the Delaware General Corporation Law, which imposes certain restrictions on mergers and other business combinations between the Company and any holder of 15% or more of the Company’s outstanding common stock, which could make it more difficult for another party to acquire Arconic. Additionally, the Company’s Certificate of Incorporation authorizes Arconic’s Board of Directors to issue preferred stock or adopt other anti-takeover measures without shareholder approval. These provisions may apply even if an offer may be considered beneficial by some shareholders and could delay or prevent an acquisition that Arconic’s Board of Directors determines is not in the best interests of Arconic’s shareholders. These provisions may also limit the price that investors might be willing to pay in the future for shares of Arconic common stock or prevent or discourage attempts to remove and replace incumbent directors. +Risks Related to the Separation of Alcoa +The Separation of Alcoa could result in substantial tax liability. +It was a condition to the Distribution of Alcoa that (i) the private letter ruling from the Internal Revenue Service (the “IRS”) regarding certain U.S. federal income tax matters relating to the Separation of Alcoa and the Distribution of Alcoa received by Arconic remain valid and be satisfactory to Arconic’s Board of Directors and (ii) Arconic receive an opinion of its outside counsel, satisfactory to the Board of Directors, regarding the qualification of the Distribution of Alcoa, together with certain related transactions, as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) of the Internal Revenue Code of 1986, as amended (the “Code”). Both of these conditions were satisfied prior to the Distribution of Alcoa. However, the IRS private letter ruling and the opinion of counsel were based upon and relied on, among other things, various facts and assumptions, as well as certain representations, statements and undertakings of Arconic and Alcoa Corporation, including those relating to the past and future conduct of Arconic and Alcoa Corporation. If any of these representations, statements or undertakings is, or becomes, inaccurate or incomplete, or if Arconic or Alcoa Corporation breaches any of its representations or covenants contained in any of the Separation of Alcoa-related agreements and documents or in any documents relating to the IRS private letter ruling and/or the opinion of counsel, the IRS private letter ruling and/or the opinion of counsel may be invalid and the conclusions reached therein could be jeopardized. +Notwithstanding Arconic’s receipt of the IRS private letter ruling and the opinion of counsel, the IRS could determine that the Distribution of Alcoa and/or certain related transactions should be treated as taxable transactions for U.S. federal income tax purposes if it determines that any of the representations, assumptions or undertakings upon which the IRS private letter ruling or the opinion of counsel was based are false or have been violated. In addition, the IRS private letter ruling does not address all of the issues that are relevant to determining whether the Distribution of Alcoa, together with certain related transactions, qualifies as a transaction that is generally tax-free for U.S. federal income tax purposes, and the opinion of counsel represents the judgment of such counsel and is not binding on the IRS or any court and the IRS or a court may disagree with the +27 +Table of Contents +conclusions in the opinion of counsel. Accordingly, notwithstanding receipt by Arconic of the IRS private letter ruling and the opinion of counsel, there can be no assurance that the IRS will not assert that the Distribution of Alcoa and/or certain related transactions do not qualify for tax-free treatment for U.S. federal income tax purposes or that a court would not sustain such a challenge. In the event the IRS were to prevail with such challenge, Arconic, Alcoa Corporation and Arconic shareholders could be subject to significant U.S. federal income tax liability. +If the Distribution of Alcoa, together with certain related transactions, fails to qualify as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) of the Code, in general, for U.S. federal income tax purposes, Arconic would recognize taxable gain as if it had sold the Alcoa Corporation common stock in a taxable sale for its fair market value and Arconic shareholders who received Alcoa Corporation shares in the distribution would be subject to tax as if they had received a taxable distribution equal to the fair market value of such shares. +Under current U.S. federal income tax law, even if the Distribution of Alcoa, together with certain related transactions, otherwise qualifies for tax-free treatment under Sections 355 and 368(a)(1)(D) of the Code, the Distribution of Alcoa may nevertheless be rendered taxable to Arconic and its shareholders as a result of certain post-Distribution of Alcoa transactions, including certain acquisitions of shares or assets of Arconic or Alcoa Corporation. The possibility of rendering the Distribution of Alcoa taxable as a result of such transactions may limit Arconic’s ability to pursue certain equity issuances, strategic transactions or other transactions that would otherwise maximize the value of Arconic’s business. Under the Tax Matters Agreement that Arconic entered into with Alcoa Corporation, Alcoa Corporation may be required to indemnify Arconic against any additional taxes and related amounts resulting from (i) an acquisition of all or a portion of the equity securities or assets of Alcoa Corporation, whether by merger or otherwise (and regardless of whether Alcoa Corporation participated in or otherwise facilitated the acquisition), (ii) issuing equity securities beyond certain thresholds, (iii) repurchasing shares of Alcoa Corporation stock other than in certain open-market transactions, (iv) ceasing actively to conduct certain of its businesses, (v) other actions or failures to act by Alcoa Corporation or (vi) any of Alcoa Corporation’s representations, covenants or undertakings contained in any of the Separation of Alcoa-related agreements and documents or in any documents relating to the IRS private letter ruling and/or the opinion of counsel being incorrect or violated. However, the indemnity from Alcoa Corporation may be insufficient to protect Arconic against the full amount of such additional taxes or related liabilities, and Alcoa Corporation may be unable to satisfy its indemnification obligations fully. Moreover, even if Arconic ultimately succeeds in recovering from Alcoa Corporation any amounts for which Arconic is held liable, Arconic may be temporarily required to bear such losses. In addition, Arconic and Arconic’s subsidiaries may incur certain tax costs in connection with the Separation of Alcoa, including tax costs resulting from separations in non-U.S. jurisdictions, which may be material. Each of these risks could negatively affect Arconic’s business, results of operations and financial condition. +Risks Related to the Separation of Arconic +The Separation of Arconic involves significant time and expense, which could disrupt or adversely affect Arconic’s business, may not achieve some or all of the anticipated benefits, is subject to various risks and uncertainties and may not be completed in accordance with the expected plans or anticipated timelines, or at all. +On February 8, 2019, Arconic announced plans to separate into two independent, publicly-traded companies, composed of the Engineered Products and Forgings businesses, on the one hand, and the Global Rolled Products businesses, on the other hand . The Separation of Arconic will be subject to the satisfaction of a number of customary conditions, including, among others, receipt of a tax opinion from external counsel. +Arconic expects that the process of completing the Separation of Arconic will be time-consuming and involve significant costs and expenses, which may be significantly higher than what it currently anticipates and may not yield a benefit if the Separation of Arconic is not completed. Executing the Separation of Arconic will also require significant time and attention from Arconic’s senior management and employees, which could disrupt the Company’s ongoing business and adversely affect financial results and results of operations. Arconic may also experience increased difficulties in attracting, retaining and motivating employees or maintaining or initiating relationships with lead suppliers, customers and other parties with which Arconic currently does business, or may do business in the future, during the pendency of the Separation of Arconic and following its completion, which could have a material and adverse effect on Arconic’s businesses, financial condition, results of operations and prospects, or the businesses, financial condition, results of operations and prospects of the independent companies resulting from the Separation of Arconic. And, although we intend for the separation transactions to be tax-free to the Company’s shareholders for U.S. federal income tax purposes, there can be no assurance that Separation of Arconic will so qualify. If the Separation of Arconic were ultimately determined to be taxable, we, the Company’s shareholders and/or the new independent company would incur income tax liabilities that could be significant. +Arconic may not realize some or all of the anticipated strategic, financial, operational or other benefits from the Separation of Arconic. For example, as independent companies, the Engineered Products & Forgings and Global Rolled Products businesses will be smaller, less diversified companies with a narrower business focus and may be more vulnerable to changing market conditions, such as changes in industry conditions, which could result in increased volatility in their cash flows, working capital +28 +Table of Contents +and financing requirements and could materially and adversely affect the respective business, financial condition and results of operations. Moreover, following the Separation of Arconic, there can be no assurance that either company will be able to obtain an investment grade rating from nationally recognized credit rating agencies, which could, among other things, increase the non-investment grade rated company’s cost of capital. Further, there can be no assurance that the combined value of the common stock of the two companies will be equal to or greater than what the value of Arconic’s common stock would have been had the proposed Separation of Arconic not occurred. +Additionally, the separation is subject to market, regulatory and certain other conditions. Unanticipated developments, including, among others, failure of the Separation of Arconic to qualify for the expected tax treatment, the possibility that any third-party consents required in connection with the Separation of Arconic will not be received, material adverse changes in business or industry conditions and changes in global economic and financial market conditions generally, could delay or prevent the completion of the Separation of Arconic, or cause the Separation of Arconic to occur on terms or conditions that are different or less favorable than expected. +Item 1B. Unresolved Staff Comments. +None. +Item 2. Properties. +Arconic’s principal office and corporate center is located at 201 Isabella Street, Suite 200, Pittsburgh, Pennsylvania 15212-5858. The Arconic Technology Center for research and development is located at 100 Technical Drive, New Kensington, Pennsylvania 15069-0001. +Arconic leases some of its facilities; however, it is the opinion of management that the leases do not materially affect the continued use of the properties or the properties’ values. +Arconic believes that its facilities are suitable and adequate for its operations. Although no title examination of properties owned by Arconic has been made for the purpose of this report, the Company knows of no material defects in title to any such properties. See Notes A and M to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Arconic has active plants and holdings under the following segments and in the following geographic areas: +ENGINEERED PRODUCTS AND FORGINGS +See the table and related text in the Engineered Products and Forgings Facilities section on page 7 of this report. +GLOBAL ROLLED PRODUCTS +See the table and related text in the Global Rolled Products Facilities section on page 10 of this report. +Item 3. Legal Proceedings. +In the ordinary course of its business, Arconic is involved in a number of lawsuits and claims, both actual and potential. +Environmental Matters +Arconic is involved in proceedings under the Comprehensive Environmental Response, Compensation and Liability Act, also known as Superfund (CERCLA) or analogous state provisions regarding the usage, disposal, storage or treatment of hazardous substances at a number of sites in the U.S. The Company has committed to participate, or is engaged in negotiations with federal or state authorities relative to its alleged liability for participation, in clean-up efforts at several such sites. The most significant of these matters, the remediation of the Grasse River in Massena, NY, is discussed in the Environmental Matters section of Note T to the Consolidated Financial Statements under the caption “Environmental Matters”. +Reynobond PE +As previously reported, on June 13, 2017, the Grenfell Tower in London, U.K. caught fire resulting in fatalities, injuries and damage. A French subsidiary of Arconic, Arconic Architectural Products SAS (AAP SAS), supplied a product, Reynobond PE, to its customer, a cladding system fabricator, which used the product as one component of the overall cladding system on Grenfell Tower. The fabricator supplied its portion of the cladding system to the façade installer, who then completed and installed the system under the direction of the general contractor. Neither Arconic nor AAP SAS was involved in the design or installation of the system used at the Grenfell Tower, nor did it have a role in any other aspect of the building’s refurbishment or original design. Regulatory investigations into the overall Grenfell Tower matter are being conducted, including a criminal investigation by the London Metropolitan Police Service (the “Police”), a Public Inquiry by the British government and a +29 +Table of Contents +consumer protection inquiry by a French public authority. The Public Inquiry was announced by the U.K. Prime Minister on June 15, 2017 and subsequently was authorized to examine the circumstances leading up to and surrounding the Grenfell Tower fire in order to make findings of fact and recommendations to the U.K. Government on matters such as the design, construction, and modification of the building, the role of relevant public authorities and contractors, the implications of the fire for the adequacy and enforcement of relevant regulations, arrangements in place for handling emergencies, and the handling of concerns from residents, among other things. Hearings for Phase 1 of the Public Inquiry began on May 21, 2018 and concluded on December 12, 2018. Phase 2 hearings of the Public Inquiry began in early 2020, following which a final report will be written and subsequently published. AAP SAS is participating as a Core Participant in the Public Inquiry and is also cooperating with the ongoing parallel investigation by the Police. The Company no longer sells the PE product for architectural use on buildings. Given the preliminary nature of these investigations and the uncertainty of potential future litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Behrens et al. v. Arconic Inc. et al. As previously reported, on June 6, 2019, 247 plaintiffs comprised of survivors and estates of decedents of the Grenfell Tower fire filed a complaint against “Arconic Inc., Alcoa Inc., and Arconic Architectural Products, LLC” (collectively, for purposes of the description of such proceeding, the “Arconic Defendants”), as well as Saint-Gobain Corporation, d/b/a Celotex and Whirlpool Corporation, in the Court of Common Pleas of Philadelphia County. The complaint alleges claims under Pennsylvania state law for products liability and wrongful death related to the fire. In particular, the plaintiffs allege that the Arconic Defendants knowingly supplied a dangerous product (Reynobond PE) for installation on the Grenfell Tower despite knowing that Reynobond PE was unfit for use above a certain height. The Arconic Defendants removed the case to the United States District Court for the Eastern District of Pennsylvania on June 19, 2019. On August 29, 2019, the Arconic Defendants moved to dismiss the complaint on the bases, among other things, that: (i) the case should be heard in the United Kingdom, not the United States; (ii) there is no jurisdiction over necessary parties; and (iii) Pennsylvania products liability law does not apply to manufacture and sale of product overseas. On December 23, 2019, the Court issued an order denying the motion to dismiss the complaint on bases (ii) and (iii) and suggesting a procedure for limited discovery followed by further briefing on those subjects. Discovery is ongoing on defendants’ motion to have the case dismissed in favor of a UK forum (forum non conveniens). On January 23, 2020, the Court ordered that the parties complete discovery relating to forum non conveniens by March 16, 2020, and that briefing conclude on April 13, 2020. The Court will hold oral argument on this motion on May 7, 2020. Given the preliminary nature of this matter and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Howard v. Arconic Inc. et al. As previously reported, a purported class action complaint related to the Grenfell Tower fire was filed on August 11, 2017, in the United States District Court for the Western District of Pennsylvania against Arconic Inc. and Klaus Kleinfeld. A related purported class action complaint was filed in the United States District Court for the Western District of Pennsylvania on September 15, 2017, under the caption Sullivan v. Arconic Inc. et al. , against Arconic Inc. three former Arconic executives, several current and former Arconic directors, and banks that acted as underwriters for Arconic’s September 18, 2014 preferred stock offering (the “Preferred Offering”). The plaintiff in Sullivan had previously filed a purported class action against the same defendants on July 18, 2017 in the Southern District of New York and, on August 25, 2017, voluntarily dismissed that action without prejudice. On February 7, 2018, on motion from certain putative class members, the court consolidated Howard and Sullivan , closed Sullivan , and appointed lead plaintiffs in the consolidated case. On April 9, 2018, the lead plaintiffs in the consolidated purported class action filed a consolidated amended complaint. The consolidated amended complaint alleged that the registration statement for the Preferred Offering contained false and misleading statements and omitted to state material information, including by allegedly failing to disclose material uncertainties and trends resulting from sales of Reynobond PE for unsafe uses and by allegedly expressing a belief that appropriate risk management and compliance programs had been adopted while concealing the risks posed by Reynobond PE sales. The consolidated amended complaint also alleged that between November 4, 2013 and June 23, 2017 Arconic and Kleinfeld made false and misleading statements and failed to disclose material information about the Company’s commitment to safety, business and financial prospects, and the risks of the Reynobond PE product, including in Arconic’s Form 10-Ks for the fiscal years ended December 31, 2013, 2014, 2015, and 2016, its Form 10-Qs and quarterly financial press releases from the fourth quarter of 2013 through the first quarter of 2017, its 2013, 2014, 2015, and 2016 Annual Reports, its 2016 Annual Highlights Report, and on its official website. The consolidated amended complaint sought, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. On June 8, 2018, all defendants moved to dismiss the consolidated amended complaint for failure to state a claim. On June 21, 2019, the Court granted the defendants’ motion to dismiss in full, dismissing the consolidated amended complaint in its entirety without prejudice. On July 23, 2019, the lead plaintiffs filed a second amended complaint. The second amended complaint alleges generally the same claims as the consolidated amended complaint with certain additional allegations, as well as claims that the risk factors set forth in the registration statement for the Preferred Offering were inadequate and that certain additional statements in the sources identified above were misleading. The second amended complaint seeks, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. On September 11, 2019, all defendants moved to dismiss the second amended +30 +Table of Contents +complaint. Plaintiffs’ opposition to that motion was filed on November 1, 2019 and all defendants filed a reply brief on November 26, 2019. Given the preliminary nature of this matter and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Raul v. Albaugh, et al. As previously reported, on June 22, 2018, a derivative complaint was filed nominally on behalf of Arconic by a purported Arconic stockholder against the then members of Arconic’s Board of Directors and Klaus Kleinfeld and Ken Giacobbe, naming Arconic as a nominal defendant, in the United States District Court for the District of Delaware. The complaint raises similar allegations as the consolidated amended complaint and second amended complaint in Howard , as well as allegations that the defendants improperly authorized the sale of Reynobond PE for unsafe uses, and asserts claims under Section 14(a) of the Exchange Act and Delaware state law. On July 13, 2018, the parties filed a stipulation agreeing to stay this case until the final resolution of the Howard case, the Grenfell Tower Public Inquiry in London, and the investigation by the Police and on July 23, 2018, the Court approved the stay. Given the preliminary nature of this matter and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +While the Company believes that these cases are without merit and intends to challenge them vigorously, there can be no assurances regarding the ultimate resolution of these matters. +Stockholder Demands. As previously reported, the Board of Directors also received letters, purportedly sent on behalf of stockholders, reciting allegations similar to those made in the federal court lawsuits and demanding that the Board authorize the Company to initiate litigation against members of management, the Board, and others. The Board of Directors appointed a Special Litigation Committee of the Board to review, investigate, and make recommendations to the Board regarding the appropriate course of action with respect to these stockholder demand letters. On May 22, 2019, the Special Litigation Committee, following completion of its investigation into the claims demanded in the demand letters, recommended to the Board that it reject the demands to authorize commencement of litigation. On May 28, 2019, the Board adopted the Special Litigation Committee’s findings and recommendations and rejected the demands that it authorize commencement of actions to assert the claims set forth in the demand letters. +Other Matters +As previously reported, Arconic Inc. and its subsidiaries and former subsidiaries are defendants in lawsuits filed on behalf of persons alleging injury as a result of occupational or other exposure to asbestos. Arconic, its subsidiaries and former subsidiaries have numerous insurance policies over many years that provide coverage for asbestos related claims. Arconic has significant insurance coverage and believes that Arconic’s reserves are adequate for its known asbestos exposure related liabilities. The costs of defense and settlement have not been and are not expected to be material to the results of operations, cash flows, and financial position of the Company. +Tax +Pursuant to the Tax Matters Agreement, dated as of October 31, 2016, entered into between the Company and Alcoa Corporation in connection with the Separation of Alcoa, the Company shares responsibility with Alcoa Corporation for, and Alcoa Corporation has agreed to partially indemnify the Company with respect to, the following matter. +As previously reported, in July 2013, following a Spanish corporate income tax audit covering the 2006 through 2009 tax years, an assessment was received mainly disallowing certain interest deductions claimed by a Spanish consolidated tax group owned by the Company. In August 2013, the Company filed an appeal of this assessment in Spain’s Central Tax Administrative Court, which was denied in January 2015. Arconic filed another appeal in Spain’s National Court in March 2015 which was denied in July 2018. The National Court’s decision requires the assessment for the 2006 through 2009 tax years to be reissued to take into account the outcome of the 2003 to 2005 audit which was closed in 2017. The Company estimates the revised assessment to be $172 million (€154 million), including interest. +In March 2019, the Supreme Court of Spain accepted the Company’s petition to review the National Court’s decision, and the Company has filed a formal appeal of the assessment. The Supreme Court is reviewing the assessment on its merits and will render a final decision. In the event the Company receives an unfavorable ruling from the Supreme Court of Spain, a portion of the assessment may be offset with existing net operating losses and tax credits available to the Spanish consolidated tax group, which would be shared between the Company and Alcoa Corporation as provided for in the Tax Matters Agreement. +In the third quarter of 2018, Arconic established an income tax reserve, and an indemnification receivable representing Alcoa Corporation’s 49% share of the liability. As of the end of 2019, the balances of the reserve, including interest, and the receivable are $59 million (€53 million) and $29 million (€26 million), respectively. +Additionally, while the tax years 2010 through 2013 are closed to audit, it is possible that the Company may receive assessments for tax years subsequent to 2013. Any potential assessment for an individual tax year is not expected to be material +31 +Table of Contents +to the Company’s consolidated operations. At this time, the Company is unable to reasonably predict an ultimate outcome for this matter. +Matters Previously Reported – Alcoa Corporation +We have included the matters discussed below in which the Company remains party to proceedings relating to Alcoa Corporation in accordance with SEC regulations. The Separation and Distribution Agreement, dated October 31, 2016, entered into between the Company and Alcoa Corporation in connection with the Separation of Alcoa, provides for cross-indemnities between the Company and Alcoa Corporation for claims subject to indemnification. The Company does not expect any of such matters to result in a net claim against it. +St. Croix Proceedings +Red Dust Docket Cases, (St. Croix) f/k/a Abednego, Laurie L.A., et al. v. St. Croix Alumina, L.L.C., et al . As previously reported, on January 14, 2010, Arconic was served with a multi-plaintiff action complaint involving several thousand individual persons claiming to be residents of St. Croix who are alleged to have suffered personal injury or property damage from Hurricane Georges or winds blowing material from the St. Croix Alumina, L.L.C. (“SCA”) facility on the island of St. Croix (U.S. Virgin Islands) since the time of the hurricane. This complaint, Abednego, et al. v. Alcoa, et al. was filed in the Superior Court of the Virgin Islands, St. Croix Division. Following an unsuccessful attempt by Arconic and SCA to remove the case to federal court, the case has been lodged in the Superior Court. The complaint names as defendants the same entities that were sued in a February 1999 action arising out of the impact of Hurricane Georges on the island and added as a defendant the current owner of the alumina facility property. +Also as previously reported, on March 1, 2012, Arconic was served with a separate multi-plaintiff action complaint involving approximately 200 individual persons alleging claims essentially identical to those set forth in the Abednego v. Alcoa complaint. This complaint, Abraham, et al. v. Alcoa, et al., was filed on behalf of plaintiffs previously dismissed in the federal court proceeding involving the original litigation over Hurricane Georges impacts. The matter was originally filed in the Superior Court of the Virgin Islands, St. Croix Division, on March 30, 2011. +Arconic and other defendants in the Abraham and Abednego cases filed or renewed motions to dismiss each case in March 2012 and August 2012 following service of the Abraham complaint on Arconic and remand of the Abednego complaint to Superior Court, respectively. By order dated August 10, 2015, the Superior Court dismissed plaintiffs’ complaints without prejudice to re-file the complaints individually, rather than as a multi-plaintiff filing. The order also preserves the defendants’ grounds for dismissal if new, individual complaints are filed. On July 7, 2017, the Court issued an order and associated memoranda on plaintiff’s multiple motions for extension of time to file the individual Complaints. Following the court’s July 7, 2017 order, a total of 429 complaints were filed and accepted by the court by the deadline of July 30, 2017 (and consolidated into the Red Dust Claims docket (Master Case No.: SX-15-CV-620)). These complaints include claims of about 1,260 individual plaintiffs. +On November 5, 2018, notice of an order of reassignment was entered, transferring the claims to the newly created Complex Litigation Division of the Superior Court of the Virgin Islands, Division of St. Croix. On January 28, 2019, the plaintiffs filed a motion asking for a determination that expert testimony will not be required on the issue of causation, which defendants opposed. The Court has not ruled on that motion. +Other Contingencies +In addition to the matters discussed above, various other lawsuits, claims, and proceedings have been or may be instituted or asserted against Arconic, including those pertaining to environmental, product liability, safety and health, employment, tax and antitrust matters. While the amounts claimed in these other matters may be substantial, the ultimate liability cannot currently be determined because of the considerable uncertainties that exist. Therefore, it is possible that the Company’s liquidity or results of operations in a period could be materially affected by one or more of these other matters. However, based on facts currently available, management believes that the disposition of these other matters that are pending or asserted will not have a material adverse effect, individually or in the aggregate, on the results of operations, financial position, or cash flows of the Company. +Item 4. Mine Safety Disclosures. +Not applicable. +32 +Table of Contents +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company’s common stock is listed on the New York Stock Exchange. Prior to the Separation of Alcoa Corporation from the Company, the Company’s common stock traded under the symbol “AA.” In connection with the Separation of Alcoa, on November 1, 2016, the Company changed its stock symbol and its common stock began trading under the symbol “ARNC.” +On October 5, 2016, the Company’s common shareholders approved a 1-for-3 reverse stock split of the Company’s outstanding and authorized shares of common stock (the “Reverse Stock Split”). As a result of the Reverse Stock Split, every three shares of issued and outstanding common stock were combined into one issued and outstanding share of common stock, without any change in the par value per share. The Reverse Stock Split reduced the number of shares of common stock outstanding from approximately 1.3 billion shares to approximately 0.4 billion shares, and proportionately decreased the number of authorized shares of common stock from 1.8 billion to 0.6 billion shares. The Company’s common stock began trading on a Reverse Stock Split-adjusted basis on October 6, 2016. +On November 1, 2016, the Company completed the Separation of Alcoa. The Separation of Alcoa was effected by means of a pro rata distribution by the Company of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders. The Company’s shareholders of record as of the close of business on October 20, 2016 (the “Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the Record Date. The Company retained 19.9% of the outstanding common stock of Alcoa Corporation immediately following the Separation of Alcoa. See disposition of retained shares in Note U to the Consolidated Financial Statements in Part II Item 8 of this Form 10-K. +In conjunction with the Separation of Arconic, the Company will remain publicly traded and will change its name to “Howmet Aerospace Inc.” (“Howmet Aerospace”) and its stock symbol from “ARNC” to “HWM”, and “Arconic Rolled Products Corporation” will change its name to “Arconic Corporation” and its common stock will be listed on the New York Stock Exchange under the symbol “ARNC.” +The number of holders of record of common stock was approximately 10,874 as of February 21, 2020 . +Stock Performance Graph +The following graph compares the most recent five-year performance of the Company’s common stock with (1) the Standard & Poor’s (S&P) 500 ® Index, (2) the S&P 500 ® Industrials Index, a group of 70 companies categorized by Standard & Poor’s as active in the “industrials” market sector, and (3) the S&P Aerospace & Defense Select Industry Index, a group of 32 companies categorized by Standard & Poor’s as active in the “aerospace & defense” industry. The graph assumes, in each case, an initial investment of $100 on December 31, 2014, and the reinvestment of dividends. Historical prices prior to the Separation of Alcoa on November 1, 2016, have been adjusted to reflect the value of the Separation transaction. The graph, table and related information shall not be deemed to be “filed” with the SEC, nor shall such information be incorporated by reference into future filings under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing. +33 +Table of Contents +Copyright© 2020 Standard & Poor's, a division of S&P Global. All rights reserved. +As of December 31, +2014 +2015 +2016 +2017 +2018 +2019 +Arconic Inc. +$ +100 +$ +63.15 +$ +53.54 +$ +79.44 +$ +49.70 +$ +91.24 +S&P 500 ® Index +100 +101.38 +113.51 +138.29 +132.23 +173.86 +S&P 500 ® Industrials Index +100 +97.47 +115.85 +140.22 +121.58 +157.29 +S&P Aerospace & Defense Select Industry Index +100 +105.43 +125.36 +177.24 +162.93 +212.35 +34 +Table of Contents +Issuer Purchases of Equity Securities +Period +Total Number +of Shares Purchased +Average +Price Paid +Per Share +Total Number +of Shares +Purchased as +Part of Publicly +Announced +Repurchase +Plans or +Programs (1) +Approximate +Dollar Value +of Shares that +May Yet Be +Purchased Under +the Plans or +Programs +October 1 - October 31, 2019 +— +$ +— +— +$ +400,000,000 +November 1 - November 30, 2019 (2) +1,626,681 +$ +30.74 +1,626,681 +$ +350,000,000 +December 1 - December 31, 2019 +— +$ +— +— +$ +350,000,000 +Total for quarter ended +December 31, 2019 +1,626,681 +(1) On February 5, 2018, the Company announced that its Board of Directors (the Board) had authorized the repurchase of up to $500 million of the Company's outstanding common stock (the "February 2018 Share Repurchase Program"). There was no stated expiration for the February 2018 Share Repurchase Program, and no shares were repurchased during 2018. On February 8, 2019, the Company announced that the Board had authorized the repurchase of an additional $500 million of the Company's outstanding common stock, effective through the end of 2020. On May 20, 2019, the Company announced that the Board had authorized the repurchase of a further $500 million of the Company's outstanding common stock (the "May 2019 Share Repurchase Program"). There was no stated expiration for the May 2019 Share Repurchase Program. +(2) On November 14, 2019, the Company entered into an agreement with Citigroup Global Markets Inc. to repurchase $50 million of its common stock (the “November 2019 share repurchase program”), pursuant to the share repurchase programs previously authorized by its Board. All of the shares repurchased were immediately retired. After giving effect to the November 2019 share repurchase program, $350 million remains available under the prior authorizations by the Board for share repurchases through the end of 2020. +35 +Table of Contents +Item 6. Selected Financial Data. +(dollars in millions, except per-share amounts) +For the year ended December 31, +2019 +2018 +2017 +2016 +2015 +Sales +$ +14,192 +$ +14,014 +$ +12,960 +$ +12,394 +$ +12,413 +Amounts attributable to Arconic: +Income (loss) from continuing operations +$ +470 +$ +642 +$ +(74 +) +$ +(1,062 +) +$ +(157 +) +Income (loss) from discontinued operations +— +— +— +121 +(165 +) +Net income (loss) +$ +470 +$ +642 +$ +(74 +) +$ +(941 +) +$ +(322 +) +Earnings (loss) per share attributable to Arconic common shareholders: +Basic: +Income (loss) from continuing operations +$ +1.05 +$ +1.33 +$ +(0.28 +) +$ +(2.58 +) +$ +(0.54 +) +Income (loss) from discontinued operations +— +— +— +0.27 +(0.39 +) +Net income (loss) +$ +1.05 +$ +1.33 +$ +(0.28 +) +$ +(2.31 +) +$ +(0.93 +) +Diluted: +Income (loss) from continuing operations +$ +1.03 +$ +1.30 +$ +(0.28 +) +$ +(2.58 +) +$ +(0.54 +) +Income (loss) from discontinued operations +— +— +— +0.27 +(0.39 +) +Net income (loss) +$ +1.03 +$ +1.30 +$ +(0.28 +) +$ +(2.31 +) +$ +(0.93 +) +Cash dividends declared per common share +$ +0.12 +$ +0.24 +$ +0.24 +$ +0.36 +$ +0.36 +Total assets +17,578 +18,693 +18,718 +20,038 +36,477 +Total debt +5,940 +6,330 +6,844 +8,084 +8,827 +Cash provided from (used for) operations +406 +217 +(39 +) +95 +764 +Capital expenditures: +Capital expenditures—continuing operations +586 +768 +596 +827 +789 +Capital expenditures—discontinued operations +— +— +— +298 +391 +Total capital expenditures +$ +586 +$ +768 +$ +596 +$ +1,125 +$ +1,180 +Effective November 1, 2016, Alcoa Inc. separated into two standalone, publicly-traded companies, Arconic Inc. (the new name for Alcoa Inc.) and Alcoa Corporation (the “Separation of Alcoa”). The results of operations of Alcoa Corporation for all periods prior to the Separation of Alcoa were retrospectively reflected in the table above as discontinued operations and, as such, were excluded from continuing operations for all prior periods presented prior to the Separation of Alcoa. The cash flow information presented in the table above included the cash flows related to Alcoa Corporation for the first ten months of 2016 and full year 2015. +The data presented in the Selected Financial Data table should be read in conjunction with the information provided in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 . and the Consolidated Financial Statements and Notes in Part II, Item 8 . (Financial Statements and Supplementary Data) of this Form 10-K. +36 +Table of Contents +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. +(dollars in millions, except per-share amounts; shipments in thousands of metric tons [kmt]) +Overview +Our Business +Arconic Inc. (“Arconic” or the “Company”) is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging. +Arconic is a global company operating in 18 countries. Based upon the country where the point of sale occurred, the United States and Europe generated 67% and 23%, respectively, of Arconic’s sales in 2019. In addition, Arconic has operating activities in numerous countries and regions outside the United States, including Europe, Canada, China, Japan, and Russia. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in countries with such operating activities . +Management Review of 2019 and Outlook for the Future +In 2019 , Sales increase d 1% over 2018 as a result of volume growth in the aerospace, packaging, commercial transportation, and industrial end markets; and favorable product pricing in the Global Rolled Products (GRP) and Engineered Products and Forgings (EP&F) segments; partially offset by lower aluminum prices; and lower sales of $216 from divestitures of forgings businesses in the United Kingdom (divested in December 2019) and Eger, Hungary (divested in December 2018), Latin America extrusions (divested in April 2018), and the completed ramp down of Arconic's North American packaging operations (in December 2018). In the segments, Segment operating profit increased 27% from 2018 due to favorable product pricing, net cost savings, lower raw material costs including aluminum price, and higher volumes, partially offset by the impact of the Tennessee plant transition to industrial production, operational challenges at one aluminum extrusions plant, and higher variable compensation costs. +Management continued its focus on liquidity and cash flows as well as improving its operating performance through cost reductions, streamlined organizational structures, margin enhancement, and profitable revenue generation. Management has continued its intensified focus on capital efficiency. This focus and the related results enabled Arconic to end 2019 with a solid financial position. +The following financial information reflects certain key highlights of Arconic’s 2019 results: +• +Sales of $14,192 , up 1% from 2018 , with growth in key end markets, and Net income of $470 , or $1.03 per diluted share; +• +Total segment operating profit of $2,015 , an increase of $429 , or 27% , from 2018 1 ; +• +Cash provided from operations of $406 ; cash used for financing activities of $1,568 , reflecting the Company’s repurchase of $1,150 of its common stock and the repayment of convertible notes in 2019; and cash provided from investing activities of $583 ; +• +Cash on hand at the end of the year of $1,648 ; and +• +Total debt of $5,940 , a decrease of $390 from 2018 , reflecting repayment of $403 of convertible notes in October 2019. +(1) For the reconciliation of Total segment operating profit to Consolidated income before income taxes and related information, see page 43. +The Company rapidly executed on the separation plan that was announced in February 2019 and is targeting completion of the separation on April 1, 2020. The company will separate into two independent, publicly-traded companies, to be named Howmet Aerospace Inc. (Remain Co.) and Arconic Corporation (Spin Co.) (the “Separation of Arconic”). Remain Co. will be comprised of the Company’s Engineered Products and Forgings businesses (engine products, fastening systems, engineered structures and forged wheels) and will be renamed Howmet Aerospace Inc. at separation and change its stock ticker from “ARNC” to “HWM.” Spin Co. will be comprised of the Company’s Global Rolled Products businesses (global rolled products, aluminum extrusions and building and construction systems) and will be held by a new company that will be named Arconic Corporation at separation and that intends to list its common stock on the New York Stock Exchange under the symbol “ARNC.” +On February 5, 2020, Arconic’s Board of Directors approved the completion of the Separation of Arconic by means of a pro rata distribution by the Company of all of the outstanding common stock of Arconic Corporation, with each Arconic Inc. stockholder of record as of the close of business on March 19, 2020 receiving one share of Arconic Corporation common stock for every four shares of the Company’s common stock held as of the record date. On February 7, 2020, the Company announced that Arconic Rolled Products Corporation (the “Issuer”), which is currently a wholly-owned subsidiary of Arconic, +37 +Table of Contents +closed its offering of $600 aggregate principal amount of 6.125% second-lien notes due 2028. The proceeds will be used to make a payment to Arconic to fund the transfer of certain assets to the Issuer in connection with the separation and for general corporate purposes. On February 13, 2020, the Registration Statement on Form 10 for Arconic Rolled Products Corporation was declared effective by the Securities and Exchange Commission. +In conjunction with the Separation of Arconic, the Company realigned its reporting segments in the third quarter of 2019 by eliminating its Transportation and Construction Solutions segment and transferring the forged wheels business to the EP&F segment and transferring the building and construction systems business to the GRP segment. The Company also executed on its plan to sell businesses that do not best fit into one of its two segments, having signed or closed on divestitures in 2019 resulting in proceeds of approximately $190. +Results of Operations +Earnings Summary +Sales. Sales for 2019 were $14,192 compared with $14,014 in 2018 , an increase of $178 , or 1% . The increase was primarily due to volume growth in the aerospace, packaging, commercial transportation, and industrial end markets; favorable product pricing and mix in the GRP segment; and favorable product pricing in the EP&F segment when fulfilling volume above contractual share, renewing contracts, and selling non-contractual spot business; partially offset by lower aluminum prices; lower sales of $216 from the completed ramp down of Arconic's North American packaging operations (in December 2018) and the divestitures of forgings businesses in the United Kingdom (divested in December 2019) and Hungary (divested in December 2018), and the Latin America extrusions business (divested in April 2018); and unfavorable foreign currency movements. +Sales for 2018 were $14,014 compared with $12,960 in 2017 , an increase of $1,054 , or 8% . The increase was the result of strong volume growth across both segments, primarily in the aerospace engines and defense, automotive, commercial transportation, industrial, and building and construction end markets; higher aluminum prices and favorable product mix primarily in the GRP segment; and favorable foreign currency movements; partially offset by a decline in volumes in the industrial gas turbine end market; lower sales of $190 from the divestitures of the Latin America extrusions business, the rolling mill in Fusina, Italy (divested in March 2017), and the ramp down of Arconic's North American packaging operations; and costs of $38 in 2018 related to settlements of certain customer claims primarily related to product introductions. +Cost of Goods Sold (COGS). COGS as a percentage of Sales was 79.1% in 2019 compared with 81.3% in 2018 . The decrease was primarily due to lower raw material costs including aluminum prices; net cost savings; favorable product pricing; and costs incurred in 2018 that did not recur in 2019 related to settlements of certain customer claims of $38 noted above and a charge related to a physical inventory adjustment at one plant in the GRP segment of $23. These positive impacts were partially offset by unfavorable product mix; a charge for environmental remediation at Grasse River of $25; the impairment of energy business assets of $10; and a charge primarily for a one-time signing bonus for employees associated with the collective bargaining agreement negotiation of $9. In June of 2019 the Company and the United Steelworkers reached a tentative three-year labor agreement covering approximately 3,400 employees at four U.S. locations; the previous labor agreement expired on May 15, 2019. The tentative agreement was ratified on July 11, 2019. Additionally, in 2019, the Company sustained a fire at a fasteners plant in France and recorded charges of $26 for higher operating costs, equipment and inventory damage, and repairs and cleanup costs. The Company submitted an insurance claim and received a partial settlement of $25, which was in excess of its $10 insurance deductible. The insurance claim included $8 of margin not recognized from lost revenue due to the fire. The Company anticipates a charge of approximately $10 to $15 in the first quarter of 2020, with additional impacts in subsequent quarters as the business continues to recover from the fire, which are also expected to be covered by insurance proceeds. +COGS as a percentage of Sales was 81.3% in 2018 compared with 78.9% in 2017 . The increase was the result of higher aluminum prices; unfavorable aerospace product mix; higher transportation costs; manufacturing inefficiencies in Engineered Structures; performance shortfalls in the Disks asset group; costs related to settlements of certain customer claims noted above; and the impact of a charge related to a physical inventory adjustment at one plant in the GRP segment of $23 that was recorded in the second quarter of 2018. While a portion of this charge for the physical inventory adjustment related to prior years, the majority related to the first half of 2018. The out-of-period amounts were not material to any interim or annual periods. +Selling, General Administrative, and Other Expenses (SG&A). SG&A expenses were $704 , or 5.0% of Sales, in 2019 compared with $604 , or 4.3% of Sales, in 2018 . The increase in SG&A of $100 , or 17% , was primarily due to costs associated with the planned Separation of Arconic of $78 and higher annual incentive compensation accruals and executive compensation costs, partially offset by lower costs driven by overhead cost reductions and lower net legal and other advisory costs related to Grenfell Tower of $10, primarily due to insurance reimbursements. +SG&A expenses were $604 , or 4.3% of Sales, in 2018 compared with $715 , or 5.5% of Sales, in 2017 . The decrease in SG&A of $111 , or 16% , was the result of proxy, advisory and governance-related costs of $58, costs related to the Separation of Alcoa Inc. of $18, and costs associated with the Company’s Delaware reincorporation of $3 in 2017, none of which recurred in 2018. +38 +Table of Contents +Additionally, lower expenses driven by lower annual incentive compensation accruals and overhead cost reductions were somewhat offset by an increase in legal and other advisory costs related to Grenfell Tower of $4 as well as strategy and portfolio review costs of $7 in 2018. +Research and Development Expenses (R&D). R&D expenses were $70 in 2019 compared with $103 in 2018 . The decrease of $33 , or 32% , was primarily due to the consolidation of the Company's primary R&D facility in conjunction with ongoing cost reduction efforts. +R&D expenses were $103 in 2018 compared with $109 in 2017 . The decrease of $6 , or 6% , was the result of lower spending. +Provision for Depreciation and Amortization (D&A). The provision for D&A was $536 in 2019 compared with $576 in 2018 . The decrease of $40 , or 7% , was primarily due to the impact of divestitures, as well as asset impairments in the EP&F segment during the second quarter of 2019 (see Note M to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). +The provision for D&A was $576 in 2018 compared with $551 in 2017 . The increase of $25 , or 5% , was primarily due to capital projects placed into service. +Impairment of Goodwill. In 2017, the Company recognized an impairment of goodwill of $719 related to the annual impairment review of its Arconic Forgings and Extrusions (AFE) business (see Goodwill under Critical Accounting Policies and Estimates below). +Restructuring and Other Charges. Restructuring and other charges were $620 in 2019 compared with $9 in 2018 and $165 in 2017 . +Restructuring and other charges in 2019 primarily included asset impairments of $556, related to the Disks asset group of $428, agreements to sell the Company’s Brazilian rolling mill operations, the U.K. forgings business, and a small additive business of $112, and a trade name intangible asset and properties, plant, and equipment related to the Company’s primary research and development facility of $25; and a charge for layoff costs of $103, including the separation of approximately 1,310 employees; partially offset by a benefit from the elimination of the life insurance benefit for the U.S. salaried and non-bargaining hourly retirees of the Company and its subsidiaries of $58; and a gain for contingent consideration received from the sale of the Texarkana rolling mill of $20. +Restructuring and other charges in 2018 primarily included a charge for pension and other postretirement benefits net settlements and curtailments of $91; a loss on the sale of the Hungary forgings business of $43; and a charge for layoff costs of $20, including the separation of approximately 125 employees; partially offset by a gain on the asset sale of the Texarkana rolling mill of $154. +Restructuring and other charges in 2017 primarily included a charge for layoff costs of $69, including the separation of approximately 880 employees; a charge related to the sale of the Italy rolling mill of $60; and a charge for the impairment of assets associated with the sale of the Latin America extrusions business of $41. +See Note C to the to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Interest Expense. Interest expense was $338 in 2019 compared with $378 in 2018 . The decrease of $40 , or 11% , was primarily due to lower debt outstanding, driven by the repayment of the aggregate outstanding principal amount of the 1.63% Convertible Notes of approximately $403 on October 15, 2019, as well as costs incurred of $19 in 2018 related to the premium paid on the early redemption of the Company’s then outstanding 5.72% Senior Notes due 2019 that did not recur in 2019. +Interest expense was $378 in 2018 compared with $496 in 2017 . The decrease of $118 , or 24% , was the result of higher costs incurred in 2017 related to the early redemption of the Company’s outstanding debt than were incurred during 2018, as well as lower debt outstanding. +Other Expense (Income), Net. Other expense, net was $122 in 2019 compared with $79 in 2018 . The increase of $43 was primarily due to an increase in deferred compensation arrangements and related investment performance and the benefit recognized in 2018 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve of $29 that did not recur in 2019, partially offset by favorable foreign currency movements. +Other expense, net was $79 in 2018 compared with Other income, net of $486 in 2017 . The decrease in Other income, net of $565 was the result of gains recorded during 2017 related to the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $351, the Debt-for-Equity Exchange (in April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 shares (valued at $35.91 per share) in Alcoa Corporation stock and recorded a gain of $167), income associated with an adjustment to the contingent earn-out liability related to the Firth Rixson acquisition of $81 (see Note S to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), and +39 +Table of Contents +income due to the reversal of a liability associated with a separation-related guarantee of $25, none of which recurred in 2018, and unfavorable foreign currency movements, somewhat offset by lower non-service related net periodic benefit cost and the benefit of $29 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve (see Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). +Income Taxes. Arconic’s effective tax rate was 18.3% in 2019 compared with the U.S. federal statutory rate of 21%. The effective rate differs from the U.S. federal statutory rate primarily as a result of a $94 net benefit related to a U.S. tax election which caused the deemed liquidation of a foreign subsidiary’s assets into its U.S. tax parent, a $24 net benefit associated with the deduction of foreign taxes that were previously claimed as a U.S. foreign tax credit, and a $12 net benefit for foreign tax rate changes, partially offset by the tax impact of $89 of non-deductible executive compensation and transaction costs, $53 of impairment charges related to the Company’s Brazilian rolling mill operations and other foreign losses with no tax benefit, a $14 charge for U.S. state taxes, and by foreign income subject to U.S. taxes. +Arconic’s effective tax rate was 26.0% in 2018 compared with the U.S. federal statutory rate of 21%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $60 charge to establish a tax reserve in Spain, a $59 net charge resulting from the Company’s finalized analysis of the U.S. Tax Cuts and Jobs Acts of 2017 ("the 2017 Act"), a $13 charge for U.S. state taxes, foreign income taxed in higher rate jurisdictions, and foreign losses with no tax benefit, partially offset by a $74 benefit related to the reversal of a foreign recapture obligation, a $38 benefit to reverse a foreign tax reserve that is effectively settled, and a $10 benefit for the release of U.S. valuation allowances. +Arconic’s effective tax rate was 115.7% in 2017 compared with the U.S. federal statutory rate of 35%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $719 impairment of goodwill, a $41 impairment of assets in the Latin America extrusions business, and a $60 charge related to the sale of a rolling mill in Italy that are nondeductible for income tax purposes, a $272 tax charge as a provisional impact of the 2017 Act, and a $23 tax charge for an increase in an uncertain tax position in Germany, partially offset by a $73 tax benefit related to the sale and Debt-for-Equity Exchange of the Alcoa Corporation stock, a $69 tax benefit for the release of U.S. state valuation allowances net of the federal tax benefit, a $27 favorable tax impact associated with a non-taxable earn-out liability adjustment in connection with the Firth Rixson acquisition, and by foreign income taxed in lower rate jurisdictions. Arconic’s effective tax rate was 356.5% in 2016 compared with the U.S. fed +Arconic anticipates that the effective tax rate in 2020 will be between 26.5% and 28.5%. However, the planned Separation of Arconic, other business portfolio actions, changes in the current economic environment, tax legislation or rate changes, currency fluctuations, ability to realize deferred tax assets, movements in stock price impacting tax benefits or deficiencies on stock-based payment awards, and the results of operations in certain taxing jurisdictions may cause this estimated rate to fluctuate. +Net Income. Net income was $470 for 2019 , or $1.03 per diluted share, compared to Net income of $642 for 2018 , or $1.33 per share. The decrease in results of $172 was primarily due to higher Restructuring and other charges; higher SG&A expenses due to costs associated with the planned Separation of Arconic of $70 ($78 before-tax) and higher annual incentive compensation accruals and executive compensation costs; and higher Other expense, net due to an increase in deferred compensation arrangements and related investment performance and the benefit recognized in 2018 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve of $28 ($29 before-tax) that did not recur in 2019; partially offset by volume growth; favorable product pricing; net cost savings; lower D&A due to the impact of divestitures as well as asset impairments in the EP&F segment; lower Interest expense due to lower debt outstanding and costs incurred of $15 ($19 before-tax) in 2018 related to the premium paid on the early redemption of debt that did not recur in 2019; lower R&D expenses due to the consolidation of the Company's primary R&D facility in conjunction with ongoing cost reduction efforts; and lower Income taxes primarily as a result of a benefit related to a U.S. tax election which caused the deemed liquidation of a foreign subsidiary’s assets into its U.S. tax parent. +Net income was $642 for 2018, or $1.30 per diluted share, compared to a Net loss of $74 for 2017, or $0.28 per share. The increase in results of $716 was due in part to the following items that occurred in 2017 but did not recur in 2018: a charge for goodwill impairment of $719 ($719 pre-tax); gains related to the sale of a portion of Arconic’s investment in Alcoa Corporation common stock and the Debt-for-Equity Exchange of $405 ($518 pre-tax); and favorable adjustments to contingent earn-out and guarantee liabilities of $97 ($106 pre-tax). Additional favorable impacts in 2018 included: volume growth across both segments; lower SG&A expenses due to proxy and separation costs incurred in 2017 and not recurring in 2018, as well as lower incentive compensation accruals; lower Restructuring and other charges driven primarily by the gain on sale of the Texarkana rolling mill, offset by pension settlement charges and the loss on sale of the forgings business in Hungary; lower Interest expense due to lower debt levels; lower pension expenses; and lower Income taxes. These favorable impacts were partially offset by unfavorable aerospace product mix, higher aluminum prices, manufacturing inefficiencies in Engineered Structures, performance shortfalls in the Disks asset group, settlements of certain customer claims, and an unfavorable physical inventory adjustment at one plant. +40 +Table of Contents +Segment Information +Arconic’s operations consist of two worldwide reportable segments: Engineered Products and Forgings (EP&F) and Global Rolled Products (GRP). Segment performance under Arconic’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Arconic’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and other charges and Impairment of goodwill. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Arconic are in Corporate. +In the third quarter of 2019, the Company realigned its operations by eliminating its Transportation and Construction Solutions (TCS) segment and transferring the Forged Wheels business to its EP&F segment and the Building and Solutions Systems (BCS) business to its GRP segment, consistent with how the Chief Executive Officer is assessing operating performance and allocating capital in conjunction with the planned Separation of Arconic (see Note U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). The Latin America extrusions business, which was formerly part of the Company's TCS segment until its sale in April of 2018 (see Note S to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), was moved to Corporate. In the first quarter of 2019, management transferred its aluminum extrusions operations from its Engineered Structures business unit within the EP&F segment to the GRP segment, based on synergies with the GRP segment including similar customer base, technologies, and manufacturing capabilities. Prior period financial information has been recast to conform to current year presentation. +Arconic produces aerospace engine parts and components, aerospace fastening systems, and aluminum sheet and plate products for Boeing 737 MAX airplanes. The temporary reduction in the production rate of the 737 MAX airplanes that was announced by Boeing in April 2019 did not have a significant impact on the Company's sales or segment operating profit in 2019. In late December 2019, Boeing announced a temporary suspension of production of the 737 MAX airplanes. In 2020, the Company expects a reduction in production rate to have a negative impact on sales of approximately $400 along with a corresponding impact on segment operating profit in the EP&F and GRP segments. +Segment operating profit for all reportable segments totaled $2,015 in 2019 , $1,586 in 2018 , and $1,689 in 2017 . The following information provides Sales and Segment operating profit for each reportable segment, as well as certain shipment data for GRP, for each of the three years in the period ended December 31, 2019 . See Note B to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Engineered Products and Forgings +2019 +2018 +2017 +Third-party sales +$ +7,105 +$ +6,798 +$ +6,300 +Segment operating profit +$ +1,390 +$ +1,105 +$ +1,119 +The Engineered Products and Forgings segment produces products that are used primarily in the aerospace (commercial and defense), industrial, commercial transportation, and power generation end markets. Such products include fastening systems (aluminum, titanium, steel, and nickel superalloys) and seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils; forged jet engine components (e.g., jet engine disks); extruded, machined and forged aircraft parts (titanium and aluminum); and forged aluminum commercial vehicle wheels, all of which are sold directly to customers and through distributors. Approximately 70% of the third-party sales in this segment are from the aerospace end market. A small part of this segment also produces various forged and machined metal products (titanium and aluminum) for various end markets. Seasonal decreases in sales are experienced for certain products in the third quarter of the year due to the European summer slowdown. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, British pound and the euro. +On December 1, 2019, Arconic completed the divestiture of its forgings business in the United Kingdom. The forgings business primarily produces steel, titanium, and nickel based forged components for aerospace, mining, and off-highway markets. This business generated third-party sales of $116, $131, and $127 in 2019, 2018, and 2017, respectively, and had 540 employees at the time of the divestiture. +On December 31, 2018, as part of the Company’s then ongoing strategy and portfolio review, Arconic completed the sale of its forgings business in Hungary that manufactured high volume steel forgings for drivetrain components in the European heavy-duty truck and automotive market. This business generated third-party sales of $32 and $38 in 2018 and 2017, respectively, and had 180 employees at the time of the divestiture. +Third-party sales for the Engineered Products and Forgings segment increased $307 , or 5% , in 2019 compared with 2018 , primarily as a result of higher aerospace and commercial transportation volumes and favorable product pricing, partially offset by unfavorable foreign currency movements and lower sales of $47 from divestitures of forgings businesses in the United Kingdom (divested in December 2019) and Hungary (divested in December 2018). +41 +Table of Contents +Third-party sales for this segment increased $498 , or 8% , in 2018 compared with 2017 , primarily attributable to higher volumes in the aerospace engines, defense, and commercial transportation end markets and favorable foreign currency movements, partially offset by a decline in volumes in the industrial gas turbine market and lower aerospace pricing principally in the fasteners business. +Segment operating profit for the Engineered Products and Forgings segment increased $285 , or 26% , in 2019 compared with 2018 , due to net cost savings, higher volumes as noted previously, favorable product pricing, and lower raw material costs, partially offset by the unfavorable impact of new product introductions in aerospace engines and unfavorable product mix. +Segment operating profit for this segment decreased $14 , or 1% , in 2018 compared with 2017 , primarily attributable to performance shortfalls in the Disks asset group; manufacturing inefficiencies in the Engineered Structures business, associated with the now resolved forging press outage at the Cleveland facility that impacted the fourth quarter of 2018 with higher costs of $10; unfavorable aerospace engine mix and new product introductions; and lower aerospace pricing principally in the fasteners business; partly offset by the strength in aerospace engine, defense, and commercial transportation volumes and net cost savings. +In 2020 compared to 2019, demand in the commercial aerospace end market, excluding the impact of Boeing 737 MAX, is expected to remain strong, driven by the ramp-up of new aerospace engine platforms. Demand in the defense end market is expected to continue to grow due to the ramp-up of certain aerospace programs, while the commercial transportation end market is expected to be down. Net cost savings and favorable pricing are expected to continue. +In mid-February 2020, a fire occurred at the Company’s forged wheels plant located in Barberton, Ohio. While some equipment has safely been returned to service at reduced production levels, the extent of the damage and the financial impact are not yet known as the investigation into the cause of the fire and its full impact continues. The Company has insurance with a deductible of $10. +Global Rolled Products +2019 +2018 +2017 +Third-party sales +$ +7,082 +$ +7,223 +$ +6,540 +Intersegment sales +183 +205 +183 +Total sales +$ +7,265 +$ +7,428 +$ +6,723 +Segment operating profit +$ +625 +$ +481 +$ +570 +Third-party aluminum shipments (kmt) +1,379 +1,301 +1,249 +The Global Rolled Products segment produces aluminum sheet and plate, aluminum extruded and machined parts, integrated aluminum structural systems, and architectural extrusions used in the automotive, aerospace, building and construction, industrial, packaging, and commercial transportation end markets. Products are sold directly to customers and through distributors. While the customer base for flat-rolled products is large, a significant amount of sales of sheet and plate is to a relatively small number of customers. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, Chinese yuan, the euro, the Russian ruble, the Brazilian real, and the British pound. +In March 2017, Arconic completed the sale of its Fusina, Italy rolling mill. The rolling mill generated third-party sales of $54 in 2017 and had approximately 312 employees. +Third-party sales for the Global Rolled Products segment decreased $141 , or 2% , in 2019 compared with 2018 , primarily as a result of lower aluminum prices, the absence of sales of $144 from the completed ramp down of Arconic's North American packaging operations (completed in December 2018), and unfavorable foreign currency movements, partially offset by favorable product pricing and mix and higher volumes in the packaging, aerospace, and industrial end markets. +Third-party sales for this segment increased $683 , or 10% , in 2018 compared with 2017 , primarily attributable to higher aluminum prices; higher volumes in the automotive, commercial transportation, and industrial end markets; and favorable product mix; partially offset by the absence of sales of $54 from the rolling mill in Fusina, Italy and the planned ramp down of Arconic's North American packaging operations. +Segment operating profit for the Global Rolled Products segment increased $144 , or 30% , in 2019 compared with 2018 , due to favorable pricing adjustments on industrial and commercial transportation products; favorable aluminum price impacts; net cost savings; favorable product mix; and the impact of a charge incurred in 2018 related to a physical inventory adjustment at one plant that did not recur in 2019; partially offset by operational challenges at one aluminum extrusions plant and the impact of the Tennessee plant transition to industrial production. +42 +Table of Contents +Segment operating profit for this segment decreased $89 , or 16% , in 2018 compared with 2017 , primarily driven by operational challenges at one plant, higher aluminum prices, unfavorable aerospace wide-body production mix, higher transportation costs and scrap spreads, and a physical inventory adjustment of $23; partially offset by higher automotive, commercial transportation and industrial volumes. +On February 1, 2020, Arconic sold its aluminum rolling mill in Itapissuma, Brazil. This rolling mill generated sales of $143 in 2019 and had 513 employees at the time of divestiture. +In 2020 compared to 2019, demand from the automotive end market is expected to be up, while headwinds will continue in the commercial transportation end market. The aerospace airframe end market will be heavily influenced by the 737 MAX situation. Growth is expected with the Tennessee industrial products ramp-up. The BCS business expects continued growth and margin expansion. Net productivity improvements are also anticipated to continue. +Reconciliation of Total segment operating profit to Consolidated income from continuing operations before income taxes +2019 +2018 +2017 +Total segment operating profit +$ +2,015 +$ +1,586 +$ +1,689 +Unallocated amounts: +Impairment of goodwill +— +— +(719 +) +Restructuring and other charges +(620 +) +(9 +) +(165 +) +Corporate expense +(360 +) +(252 +) +(325 +) +Consolidated operating income +$ +1,035 +$ +1,325 +$ +480 +Interest expense +(338 +) +(378 +) +(496 +) +Other (expense) income, net +(122 +) +(79 +) +486 +Consolidated income from continuing operations before income taxes +$ +575 +$ +868 +$ +470 +See Impairment of Goodwill, Restructuring and Other Charges, Interest Expense, and Other Expense (Income), Net, discussions above under Results of Operations for reference. +Corporate expense increased $108 , or 43% , in 2019 compared with 2018 primarily due to costs associated with the planned Separation of Arconic of $78 ; higher annual incentive compensation accruals and executive compensation costs; environmental remediation costs for Grasse River of $25; impairment of energy business assets of $10; net impacts associated with a fire at a fasteners plant of $9 (net of insurance reimbursements); and collective bargaining agreement negotiation costs of $9; partially offset by costs incurred in 2018 that did not recur in 2019 related to settlements of certain customer claims of $38; lower costs driven by overhead cost reductions; lower research and development expenses; and lower net legal and other advisory costs related to Grenfell Tower of $10 primarily due to insurance reimbursements. +Corporate expense decreased $73 , or 22% , in 2018 compared with 2017 primarily due to proxy, advisory and governance-related costs of $58 and costs related to the Separation of Alcoa Inc. of $18 in 2017, neither of which recurred in 2018. Also, lower expenses driven by lower annual incentive compensation accruals and overhead cost reductions were partially offset by costs incurred in the second quarter of 2018 related to the settlements of certain customer claims primarily related to product introductions of $38, an increase in legal and other advisory costs related to Grenfell Tower of $4, and strategy and portfolio review costs of $7 in 2018. +Environmental Matters +See the Environmental Matters section of Note T to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. +Liquidity and Capital Resources +Arconic maintains a disciplined approach to cash management and strengthening of its balance sheet. Management continued to focus on actions to improve Arconic’s cost structure and liquidity, providing the Company with the ability to operate effectively. Such actions included procurement efficiencies and overhead rationalization to reduce costs, working capital initiatives, and maintaining a sustainable level of capital expenditures. +Cash provided from operations and financing activities is expected to be adequate to cover Arconic’s operational and business needs over the next 12 months. For an analysis of long-term liquidity, see Contractual Obligations and Off-Balance Sheet Arrangements below. +43 +Table of Contents +At December 31, 2019 , cash and cash equivalents of Arconic were $1,648 , of which $414 was held by Arconic's non-U.S. subsidiaries. If the cash held by non-U.S. subsidiaries were to be repatriated to the U.S., the company does not expect there to be additional material income tax consequences. +Operating Activities +Cash provided from operations in 2019 was $406 compared with $217 in 2018 . The increase of $189 , or 87% , was primarily due to higher operating results and lower pension contributions of $30 , partially offset by higher working capital of $112 . The components of the change in working capital included unfavorable changes in accounts payable of $395 and taxes, including income taxes of $106 , partially offset by favorable changes in receivables of $165 and accrued expenses of $148 . +Cash provided from operations in 2018 was $217 compared with Cash used for operations $39 in 2017 . The increase of $256 was primarily due to lower working capital of $209 and a favorable change in noncurrent liabilities of $169 due primarily to reversals in 2017 related to the Firth Rixson earn-out liability of $81 and separation-related guarantee liability of $25, partially offset by lower operating results. The components of the change in working capital included favorable changes in accounts payable of $277, taxes, including income taxes of $127, and inventories of $118, partially offset by unfavorable changes in receivables of $227, accrued expenses of $74, and prepaid expenses and other current assets of $12. +Financing Activities +Cash used for financing activities was $1,568 in 2019 compared with $649 in 2018 and $1,015 in 2017 . +The use of cash in 2019 was primarily related to the repurchase of $1,150 of common stock (see Note H to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data); repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily the aggregate outstanding principal amount of the 1.63% Convertible Notes of approximately $403 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data); and dividends paid to shareholders of $57 . These items were partially offset by additions to debt for borrowings under certain revolving credit facilities of $400 and proceeds from the exercise of employee stock options of $56 . +The use of cash in 2018 was principally the result of $1,103 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the then remaining outstanding 5.72% Notes due in 2019 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K) and $119 in dividends to shareholders. These items were partially offset by $600 in additions to debt, primarily from borrowings under certain revolving credit facilities. +The use of cash in 2017 was principally the result of $1,634 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the Company’s 6.50% Bonds due 2018, 6.75% Notes due 2018, and a portion of the 5.72% Notes due 2019 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K); $162 in dividends to shareholders; and $52 in premiums paid on early redemption of debt. These items were partially offset by $816 in additions to debt, primarily from borrowings under certain revolving credit facilities, and $50 of proceeds from the exercise of stock options. +In September 2014, Arconic completed two public securities offerings under its shelf registration statement for (i) $1,250 of 25 million depositary shares, each representing a 1/10th interest in a share of Arconic’s 5.375% Class B Mandatory Convertible Preferred Stock, Series 1, par value $1 per share, liquidation preference $500 per share, and (ii) $1,250 of 5.125% Notes due 2024. The net proceeds of the offerings were used to finance the cash portion of the acquisition of Firth Rixson. On October 2, 2017, all outstanding 24,975,978 depositary shares were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this noncash equity transaction. +Arconic maintains a Five-Year Revolving Credit Agreement (the “Credit Agreement”) with a syndicate of lenders and issuers named therein that expires on June 29, 2023 and provides for a senior unsecured revolving credit facility of $3,000. In addition to the Credit Agreement, Arconic has a number of other credit agreements that provide a combined borrowing capacity of $640 as of December 31, 2019. See Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Arconic’s costs of borrowing and ability to access the capital markets are affected not only by market conditions but also by the short- and long-term debt ratings assigned to Arconic by the major credit rating agencies. +On May 1, 2017, Standard and Poor’s Ratings Services (S&P) affirmed Arconic’s long-term debt at BBB-, an investment grade rating, with a stable outlook, and its short-term debt at A-3. On February 7, 2019, S&P placed the rating on negative credit watch and, subsequently, on April 26, S&P affirmed the long-term debt rating at BBB- but changed the outlook to negative. On January 28, 2020, S&P affirmed the long-term debt rating at BBB- but changed the outlook to stable in expectation of the separation impact. On November 1, 2016, Moody’s Investor Service (Moody’s) downgraded Arconic’s long-term debt rating +44 +Table of Contents +from Ba1, a non-investment grade, to Ba2 with a stable outlook and its short-term debt rating from Speculative Grade Liquidity-1 to Speculative Grade Liquidity-2. Moody’s ratings and outlooks were affirmed on November 2, 2017, October 8, 2018, and October 9, 2019. On January 24, 2020, Moody’s affirmed the long-term debt rating at Ba2 but changed the outlook to negative. On April 21, 2016, Fitch affirmed Arconic’s long-term debt rating at BB+, a non-investment grade, and short-term debt at B. Additionally, Fitch changed the outlook from positive to evolving. On July 7, 2016, Fitch changed the outlook from evolving to stable (ratings and outlook were affirmed on July 3, 2017). On September 27, 2018, Fitch changed the outlook from stable to positive (ratings and outlook were affirmed on October 8, 2019). +Investing Activities +Cash provided from investing activities was $583 in 2019 compared with $565 in 2018 and $1,320 in 2017 . +The source of cash in 2019 was primarily due to cash receipts from sold receivables of $995 , proceeds from the sale of assets and businesses of $103 (see Note S to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data), and the sale of fixed income securities of $73 , partially offset by capital expenditures of $586 , including expansion of a wheels plant in Hungary, expansion of aerospace airfoils capacity in the United States, and transition of the Tennessee plant to industrial production. +The source of cash in 2018 included cash receipts from sold receivables of $1,016 and proceeds from the sale of the Texarkana, Texas rolling mill and cast house of $302, partially offset by capital expenditures of $768, including the horizontal heat treat furnace at the Davenport, Iowa plant and an expansion of a wheels plant in Szekesfehervar, Hungary. +The source of cash in 2017 included proceeds of $888 from the sale of a portion of Arconic’s investment in Alcoa Corporation common stock, cash receipts from sold receivables of $792, and the receipt of proceeds from the sale of the Yadkin Hydroelectric Project of $243 (see Note U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), somewhat offset by cash used for capital expenditures of $596, including the aerospace expansion (very thick plate stretcher and horizontal heat treat furnace) at the Davenport, Iowa plant and a titanium aluminide furnace at the Niles, Ohio facility, and the injection of $10 into the rolling business in Italy prior to its sale. +Noncash Financing and Investing Activities +On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction. See Note H to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +In the second quarter of 2017, the Company completed a Debt-for-Equity Exchange with the Investment Banks for the remaining portion of Arconic’s retained interest in Alcoa Corporation common stock for a portion of the Company’s outstanding notes held by the Investment Banks for $465 including accrued and unpaid interest. See Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +45 +Table of Contents +Contractual Obligations and Off-Balance Sheet Arrangements +Contractual Obligations. Arconic is required to make future payments under various contracts, including long-term purchase obligations, financing arrangements, and lease agreements. Arconic also has commitments to fund its pension plans, provide payments for other postretirement benefit plans, and fund capital projects. As of December 31, 2019 , a summary of Arconic’s outstanding contractual obligations is as follows (these contractual obligations are grouped in the same manner as they are classified in the Statement of Consolidated Cash Flows in order to provide a better understanding of the nature of the obligations and to provide a basis for comparison to historical information): +Total +2020 +2021-2022 +2023-2024 +Thereafter +Operating activities: +Energy-related purchase obligations +$ +57 +$ +29 +$ +25 +$ +3 +$ +— +Raw material purchase obligations +569 +495 +64 +8 +2 +Other purchase obligations +134 +80 +49 +5 +— +Operating leases +317 +81 +108 +58 +70 +Interest related to total debt +1,975 +344 +444 +344 +843 +Estimated minimum required pension funding +1,705 +475 +655 +575 +— +Other postretirement benefit payments +655 +80 +160 +155 +260 +Layoff and other restructuring payments +34 +34 +— +— +— +Deferred revenue arrangements +36 +6 +30 +— +— +Uncertain tax positions +220 +— +— +— +220 +Financing activities: +Total debt +5,940 +1,028 +1,871 +1,246 +1,795 +Dividends to shareholders +— +— +— +— +— +Investing activities: +Capital projects +401 +247 +121 +33 +— +Totals +$ +12,043 +$ +2,899 +$ +3,527 +$ +2,427 +$ +3,190 +Obligations for Operating Activities +Energy-related purchase obligations consist primarily of electricity and natural gas contracts with expiration dates ranging from one year to five years. Raw material purchase obligations consist mostly of aluminum, titanium sponge, and various other metals with expiration dates ranging from less than one year to six years. Many of these purchase obligations contain variable pricing components, and, as a result, actual cash payments may differ from the estimates provided in the preceding table. +Operating leases represent multi-year obligations for certain land and buildings, plant equipment, vehicles, and computer equipment. +Interest related to total debt is based on interest rates in effect as of December 31, 2019 and is calculated on debt with maturities that extend to 2042. +Estimated minimum required pension funding and postretirement benefit payments are based on actuarial estimates using current assumptions for discount rates, long-term rate of return on plan assets, and health care cost trend rates, among others. It is Arconic’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Arconic contributes additional amounts as deemed appropriate. The estimates reported in the preceding table include amounts sufficient to meet the minimum required, along with approximately $60 of contributions in 2020 related to actions designed to reduce future obligations. Arconic has determined that it is not practicable to present pension funding and other postretirement benefit payments beyond 2024 and 2029, respectively. +Layoff and other restructuring payments to be paid within one year primarily relate to severance costs, special layoff benefit payments, and lease termination costs. +Deferred revenue arrangements require Arconic to deliver product to certain customers over the specified contract period (through 2020 for a sheet and plate contract and 2021 for certain aerospace parts contracts). While these obligations are not expected to result in cash payments, they represent contractual obligations for which the Company would be obligated if the specified product deliveries could not be made. +46 +Table of Contents +Uncertain tax positions taken or expected to be taken on an income tax return may result in additional payments to tax authorities. The amount in the preceding table includes interest and penalties accrued related to such positions as of December 31, 2019 . The total amount of uncertain tax positions is included in the “Thereafter” column as the Company is not able to reasonably estimate the timing of potential future payments. If a tax authority agrees with the tax position taken or expected to be taken or the applicable statute of limitations expires, then additional payments will not be necessary. +Obligations for Financing Activities +Arconic has historically paid quarterly dividends on its preferred and common stock. Including dividends on preferred stock, Arconic paid $57 in dividends to shareholders during 2019 . Because all dividends are subject to approval by Arconic’s Board of Directors, amounts are not included in the preceding table unless such authorization has occurred. As of December 31, 2019 , there were 432,855,183 shares of outstanding common stock and 546,024 shares of outstanding Class A preferred stock. In 2019 , the preferred stock dividend was $3.75 per share and the common stock dividend was $0.12 per share. +Obligations for Investing Activities +Capital projects in the preceding table only include amounts approved by management as of December 31, 2019 . Funding levels may vary in future years based on anticipated construction schedules of the projects. It is expected that significant expansion projects will be funded through various sources, including cash provided from operations. Total capital expenditures are anticipated to be less than four percent of sales in 2020 . +Off-Balance Sheet Arrangements +At December 31, 2019 , Arconic had outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2020 and 2040 was $31 at December 31, 2019 . +Pursuant to the Separation and Distribution Agreement between Arconic and Alcoa Corporation, Arconic was required to provide certain guarantees for Alcoa Corporation, which had a combined fair value of $9 and $6 at December 31, 2019 and 2018 , respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. Arconic was required to provide guarantees related to two long-term supply agreements for energy for Alcoa Corporation facilities in the event of an Alcoa Corporation payment default. In October 2017, Alcoa Corporation announced that it had terminated one of the two agreements, the electricity contract with Luminant Generation Company LLC that was tied to its Rockdale Operations, effective as of October 1, 2017. As a result of the termination of the Rockdale electricity contract, Arconic recorded income of $25 in the fourth quarter of 2017 associated with reversing the fair value of the electricity contract guarantee. For the remaining long-term supply agreement, Arconic is required to provide a guarantee up to an estimated present value amount of approximately $1,353 and $1,087 at December 31, 2019 and December 31, 2018 , respectively, in the event of an Alcoa Corporation payment default. This guarantee expires in 2047 . For this guarantee, subject to its provisions, Arconic is secondarily liable in the event of a payment default by Alcoa Corporation. Arconic currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote. In December 2019, Arconic entered into a one-year insurance policy with a limit of $80 relating to the remaining long-term energy supply agreement. The premium is expected to be paid by Alcoa Corporation. The decision to enter into a claims purchase agreement or insurance policy will be made on an annual basis going forward. +Arconic has outstanding letters of credit primarily related to workers’ compensation, environmental obligations, and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2020 , was $142 at December 31, 2019 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to retain letters of credit of $52 that had previously been provided related to both Arconic and Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016. Alcoa Corporation workers’ compensation claims and letter of credit fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation. +Arconic has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire at various dates, primarily in 2020 , was $50 at December 31, 2019 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to provide surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016 and, as a result, Arconic has $24 in outstanding surety bonds relating to these liabilities. Alcoa Corporation workers’ compensation claims and surety bond fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation. +47 +Table of Contents +Critical Accounting Policies and Estimates +The preparation of the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America requires management to make certain judgments, estimates, and assumptions regarding uncertainties that affect the amounts reported in the Consolidated Financial Statements and disclosed in the accompanying Notes. Areas that require significant judgments, estimates, and assumptions include accounting for environmental and litigation matters; the testing of goodwill, other intangible assets, and properties, plants, and equipment for impairment; estimating fair value of businesses acquired or divested; pension plans and other postretirement benefits obligations; stock-based compensation; and income taxes. +Management uses historical experience and all available information to make these judgments, estimates, and assumptions, and actual results may differ from those used to prepare the Company’s Consolidated Financial Statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and accompanying Notes provide a meaningful and fair perspective of the Company. +A summary of the Company’s significant accounting policies is included in Note A to the Consolidated Financial Statements. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the Consolidated Financial Statements with useful and reliable information about the Company’s operating results and financial condition. +Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future sales, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery. Claims for recovery are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Arconic has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations. +Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss. +Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. +Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. For 2019, Arconic had seven reporting units, of which four were included in the EP&F segment (Fastening Systems, Engineered Structures, Engine Products, and Forged Wheels), and three were included in the GRP segment (Global Rolled Products, Aluminum Extrusions, and BCS.) +In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (greater than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment +48 +Table of Contents +review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. +Arconic determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Arconic’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three-year period. +Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent quantitative impairment test completed for a reporting unit and compares the weighted average cost of capital (WACC) between the current and prior years for each reporting unit. +During the 2019 annual review of goodwill, management proceeded directly to the quantitative impairment test for all seven of its reporting units. The estimated fair values for each of the seven reporting units exceeded their respective carrying values by more than 50%, thus, there was no goodwill impairment. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Arconic uses a discounted cash flow (DCF) model to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. Arconic would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit. +In the first quarter of 2019, management transferred its aluminum extrusions business (Aluminum Extrusions) from Engineered Structures within the EP&F segment to the GRP segment, based on synergies with the GRP segment including similar customer base, technologies, and manufacturing capabilities. Management assessed and concluded that the remaining Engineered Structures business unit and the Aluminum Extrusions business unit represent reporting units. As a result of the reorganization, goodwill of $110 was reallocated from Engineered Structures to Aluminum Extrusions and these reporting units were evaluated for impairment during the first quarter of 2019. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no goodwill impairment. In the second quarter of 2019, management transferred its castings operations from Engineered Structures to Engine Products within the EP&F segment based on process expertise for investment castings that existed within Engine Products. As a result, goodwill of $105 was reallocated from Engineered Structures to Engine Products and these reporting units were evaluated for impairment during the second quarter of 2019. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no impairment. As a result of the elimination of the TCS segment in the third quarter of 2019 (see Segment Information above), the Company transferred $7 of Forged Wheels goodwill and $68 of BCS goodwill from the TCS segment to the EP&F and GRP segments, respectively. Both Forged Wheels and BCS are considered reporting units. +In the second quarter of 2019, as a result of the decline in the forecasted financial performance and related impairment of long-lived assets of the Disks asset group within Engine Products, the Company also performed an interim impairment evaluation of goodwill for Engine Products. The estimated fair value of the reporting unit was substantially in excess of its carrying value; thus, there was no impairment of goodwill. +In connection with the interim impairment evaluation of long-lived assets for the Disks asset group within Engine Products in the second quarter of 2018, which resulted from a decline in forecasted financial performance for the business in connection with its updated three-year strategic plan, the Company also performed an interim impairment evaluation of goodwill for Engine Products. The estimated fair value of the reporting unit was substantially in excess of the carrying value; thus, there was no impairment of goodwill. +Goodwill impairment tests in 2018 and 2017 indicated that goodwill was not impaired for any of the Company’s reporting units, except for the AFE business (the AFE operations were realigned and transferred to Aluminum Extrusions and Engine Products) whose estimated fair value was lower than its carrying value. As such, Arconic recorded an impairment for the full amount of goodwill in the AFE reporting unit of $719 in 2017. The decrease in fair value of AFE was primarily due to unfavorable performance that was impacting operating margins and a higher discount rate due to an increase in the risk-free rate of return, while the carrying value increased compared to prior year. +49 +Table of Contents +Properties, Plants, and Equipment and Other Intangible Assets. Properties, plants, and equipment and Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is measured as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a DCF model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of the assets also require significant judgments. +During the second quarter of 2019, the Company updated its five-year strategic plan and determined that there was a decline in the forecasted financial performance for the Disks asset group within the EP&F segment. As such, the Company evaluated the recoverability of the Disks asset group long-lived assets by comparing the carrying value to the undiscounted cash flows of the Disks asset group. The carrying value exceeded the undiscounted cash flows and therefore the Disks asset group long-lived assets were deemed to be impaired. The impairment charge was measured as the amount of carrying value in excess of fair value of the long-lived assets, with fair value determined using a DCF model and a combination of sales comparison and cost approach valuation methods including an estimate for economic obsolescence. The impairment charge of $ 428 recorded in the second quarter of 2019 impacted properties, plants, and equipment; intangible assets; and certain other noncurrent assets by $ 198 , $ 197 , and $ 33 , respectively. The impairment charge was recorded in Restructuring and other charges in the Statement of Consolidated Operations. +During the second quarter of 2018, the Company updated its three-year strategic plan and determined that there was a decline in the forecasted financial performance for the Disks asset group within the EP&F segment. As such, the Company evaluated the recoverability of the long-lived assets by comparing their carrying value of approximately $515 to the estimated undiscounted net cash flows of the Disks asset group, resulting in an estimated fair value in excess of their carrying value of approximately 13% ; thus, there was no impairment. +Discontinued Operations and Assets Held for Sale. The fair values of all businesses to be divested are estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements. +Pension and Other Postretirement Benefits. Liabilities and expenses for pension and other postretirement benefits are determined using actuarial methodologies and incorporate significant assumptions, including the interest rate used to discount the future estimated liability, the expected long-term rate of return on plan assets, and several assumptions relating to the employee workforce (health care cost trend rates, retirement age, and mortality). +The interest rate used to discount future estimated liabilities is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have an average duration of 10 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. In 2019 , 2018 , and 2017 , the discount rate used to determine benefit obligations for U.S. pension and other postretirement benefit plans was 3.30% , 4.35% , and 3.75% , respectively. The impact on the liabilities of a change in the discount rate of 1/4 of 1% would be approximately $220 and either a charge or credit of approximately $1 to after-tax earnings in the following year. +The expected long-term rate of return on plan assets is generally applied to a five-year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment. +For 2019 , 2018 , and 2017 , management used 7.00% , 7.00% , and 7.75% , respectively, as its expected long-term rate of return, which was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. These rates fell within the respective range of the 20-year moving average of actual performance and the expected future +50 +Table of Contents +return developed by asset class. For 2020 , management anticipates that 7.00% will be the expected long-term rate of return. The decrease of 75 basis points in the 2018 expected long-term rate of return was due to a decrease in the expected return by asset class and the 20-year moving average. A change in the assumption for the expected long-term rate of return on plan assets of 1/4 of 1% would impact after-tax earnings by approximately $9 for 2020 . +In 2019, a net loss of $388 (after-tax) was recorded in other comprehensive loss, primarily due to the decrease in the discount rate of 105 basis points, which was partially offset by the plan asset performance that was greater than expected, and by the amortization of actuarial losses. In 2018, a net loss of $114 (after-tax) was recorded in other comprehensive loss, primarily due to the impact of the adoption of new accounting guidance that permits a reclassification to Retained earnings (accumulated deficit) for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017, as well as the plan asset performance that was less than expected, which were partially offset by the increase in the discount rate of 60 basis points and the amortization of actuarial losses. In 2017, a net loss of $220 (after-tax) was recorded in other comprehensive loss, primarily due to the decrease in the discount rate of 45 basis points and plan asset performance less than expected, which were partially offset by the amortization of actuarial losses. +Stock-Based Compensation. Arconic recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. +Compensation expense recorded in 2019 , 2018 , and 2017 was $78 ( $70 after-tax), $50 ( $39 after-tax), and $54 ( $36 after-tax), respectively. +Income Taxes. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Arconic’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. +The 2017 Act created a new requirement that certain income earned by foreign subsidiaries, Global Intangible Low Taxed Income (GILTI), must be included in the gross income of the U.S. shareholder. The 2017 Act also established the Base Erosion and Anti-Abuse Tax (BEAT). Until regulations are finalized, judgement will be required to apply preliminary guidance, including proposed regulations, to Arconic’s facts and circumstances. +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are +51 +Table of Contents +recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. +Recently Adopted Accounting Guidance. See the Recently Adopted Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Recently Issued Accounting Guidance. See the Recently Issued Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +Not material. +52 +Table of Contents +Item 8. Financial Statements and Supplementary Data. +Management’s Reports to Arconic Shareholders +Management’s Report on Financial Statements and Practices +The accompanying Consolidated Financial Statements of Arconic Inc. and its subsidiaries (the “Company”) were prepared by management, which is responsible for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s best judgments and estimates. The other financial information included in the annual report is consistent with that in the financial statements. +Management also recognizes its responsibility for conducting the Company’s affairs according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in key policy statements issued from time to time regarding, among other things, conduct of its business activities within the laws of the host countries in which the Company operates and potentially conflicting outside business interests of its employees. The Company maintains a systematic program to assess compliance with these policies. +Management’s Report on Internal Control over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control—Integrated Framework (2013) , issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Based on the assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2019 , based on criteria in Internal Control—Integrated Framework (2013) issued by the COSO. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2019 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein. +/s/ John C. Plant +John C. Plant +Chairman and Chief Executive Officer +/s/ Ken Giacobbe +Ken Giacobbe +Executive Vice President and +Chief Financial Officer +53 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Board of Directors and Shareholders of Arconic Inc. +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheet of Arconic Inc. and its subsidiaries (the “Company”) as of December 31, 2019 and 2018, and the related consolidated statements of operations, of comprehensive income (loss), of changes in equity and of cash flows for each of the three years in the period ended December 31, 2019, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. +Change in Accounting Principle +As discussed in Note A to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinions +The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +54 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +Goodwill Impairment Assessment - Engine Products and Engineered Structures Reporting Units +As described in Notes A and N to the consolidated financial statements, the Company’s consolidated goodwill balance was $4,493 million as of December 31, 2019, and the amount of the goodwill associated with the Engine Products and Engineered Structures reporting units was $2,164 million and $289 million, respectively. Goodwill is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist. The evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Fair value is estimated using a discounted cash flow model. The determination of fair value using this technique requires management to use significant estimates and assumptions related to forecasting operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. +The principal considerations for our determination that performing procedures relating to the goodwill impairment assessment of the Engine Products and Engineered Structures reporting units is a critical audit matter are there was significant judgment by management when developing the fair value measurements of the reporting units. This in turn led to a high degree of auditor judgment, effort and subjectivity in performing procedures and evaluating audit evidence related to management’s cash flow projections and significant assumptions, including sales growth (volumes and pricing), production costs, and discount rates. In addition, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s annual goodwill impairment assessment, including controls over the valuation of the Company’s reporting units. These procedures also included, among others, testing management’s process for developing the fair value estimates; evaluating the appropriateness of the discounted cash flow model and performing sensitivity analyses over the assumptions in the model; testing the completeness, accuracy, and relevance of underlying data used in the model; and evaluating the significant assumptions used by management, including sales growth (volumes and pricing), production costs, and discount rates. Evaluating management’s assumptions related to sales growth (volumes and pricing) and production costs involved evaluating whether the assumptions used by management were reasonable by considering the current and past performance of the reporting units, obtaining evidence to support the reasonableness of the assumptions, and considering whether the assumptions were consistent with evidence obtained in other areas of the audit. Professionals with specialized skill and knowledge were used to assist in the evaluation of the discounted cash flow models and certain significant assumptions, including the discount rates. +Properties, Plants, and Equipment Impairment Assessment - Disks Asset Group +As described in Notes A and M to the consolidated financial statements, the Company’s consolidated properties, plants and equipment balance was $5,463 million as of December 31, 2019. During the second quarter of 2019, management recorded an impairment charge of $428 million to reduce the carrying value of the long-lived assets in the Disks asset group to their fair value, which included impairment charges to properties, plants and equipment of $198 million. Long-lived assets are reviewed for impairment whenever events indicate that the carrying amount of the asset group may not be recoverable. The impairment charge was measured as the amount of carrying value in excess of fair value of the long-lived assets, with fair value determined using a discounted cash flow model and a combination of sales comparison and cost approach valuation methods, including an estimate for economic obsolescence. +The principal considerations for our determination that performing procedures relating to the properties, plants, and equipment impairment assessment of the Disks asset group is a critical audit matter are there was significant judgment by management when developing the fair value of the properties, plants and equipment in the Disks asset group. This in turn led to a high +55 +Table of Contents +degree of auditor judgment, effort and subjectivity in performing procedures and evaluating audit evidence related to management’s valuation methods and significant assumptions, including economic obsolescence. In addition, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s asset group impairment assessment, including controls over the valuation of the asset group. These procedures also included, among others, evaluating (i) the appropriateness of management’s valuation methodologies and (ii) the reasonableness of the estimated economic obsolescence utilized in determining the fair value of properties, plants and equipment in the Disks asset group. Professionals with specialized skill and knowledge were utilized to assist in the evaluation of the valuation methods and certain significant assumptions, including economic obsolescence. +/s/ PricewaterhouseCoopers LLP +Pittsburgh, Pennsylvania +February 26, 2020 +We have served as the Company’s auditor since 1950. +56 +Table of Contents +Arconic and subsidiaries +Statement of Consolidated Operations +(in millions, except per-share amounts) +For the year ended December 31, +2019 +2018 +2017 +Sales ( B ) +$ +14,192 +$ +14,014 +$ +12,960 +Cost of goods sold (exclusive of expenses below) +11,227 +11,397 +10,221 +Selling, general administrative, and other expenses +704 +604 +715 +Research and development expenses +70 +103 +109 +Provision for depreciation and amortization +536 +576 +551 +Impairment of goodwill ( A and N ) +— +— +719 +Restructuring and other charges ( C ) +620 +9 +165 +Operating income +1,035 +1,325 +480 +Interest expense ( D ) +338 +378 +496 +Other expense (income), net ( E ) +122 +79 +( 486 +) +Income before income taxes +575 +868 +470 +Provision for income taxes ( G ) +105 +226 +544 +Net income (loss) +$ +470 +$ +642 +$ +( 74 +) +Amounts Attributable to Arconic Common Shareholders ( I ): +Net income (loss) +$ +477 +$ +651 +$ +( 127 +) +Earnings (loss) per share - basic +$ +1.05 +$ +1.33 +$ +( 0.28 +) +Earnings (loss) per share - diluted +$ +1.03 +$ +1.30 +$ +(0.28 +) +Average Shares Outstanding ( I ): +Average shares outstanding - basic +446 +483 +451 +Average shares outstanding - diluted +463 +503 +451 +The accompanying notes are an integral part of the consolidated financial statements. +57 +Table of Contents +Arconic and subsidiaries +Statement of Consolidated Comprehensive Income (Loss) +(in millions) +Arconic +Noncontrolling Interests +Total +For the year ended December 31, +2019 +2018 +2017 +2019 +2018 +2017 +2019 +2018 +2017 +Net income (loss) +$ +470 +$ +642 +$ +( 74 +) +$ +— +$ +— +$ +— +$ +470 +$ +642 +$ +( 74 +) +Other comprehensive income (loss), net of tax ( J ): +Change in unrecognized net actuarial loss and prior service cost/benefit related to pension and other postretirement benefits +( 388 +) +255 +( 220 +) +— +— +— +( 388 +) +255 +( 220 +) +Foreign currency translation adjustments +( 13 +) +( 146 +) +252 +— +— +2 +( 13 +) +( 146 +) +254 +Net change in unrealized gains on debt securities +3 +( 1 +) +( 134 +) +— +— +— +3 +( 1 +) +( 134 +) +Net change in unrecognized gains/losses on cash flow hedges +( 3 +) +( 23 +) +26 +— +— +— +( 3 +) +( 23 +) +26 +Total Other comprehensive (loss) income, net of tax +( 401 +) +85 +( 76 +) +— +— +2 +( 401 +) +85 +( 74 +) +Comprehensive income (loss) +$ +69 +$ +727 +$ +( 150 +) +$ +— +$ +— +$ +2 +$ +69 +$ +727 +$ +( 148 +) +The accompanying notes are an integral part of the consolidated financial statements. +58 +Table of Contents +Arconic and subsidiaries +Consolidated Balance Sheet +(in millions) +December 31, +2019 +2018 +Assets +Current assets: +Cash and cash equivalents +$ +1,648 +$ +2,277 +Receivables from customers, less allowances of $3 in 2019 and $4 in 2018 ( K ) +967 +1,047 +Other receivables ( K ) +484 +451 +Inventories ( L ) +2,429 +2,492 +Prepaid expenses and other current assets +314 +314 +Total current assets +5,842 +6,581 +Properties, plants, and equipment, net ( M ) +5,463 +5,704 +Goodwill ( A and N ) +4,493 +4,500 +Deferred income taxes ( G ) +608 +573 +Intangibles, net ( N ) +658 +919 +Other noncurrent assets ( A and O ) +514 +416 +Total assets +$ +17,578 +$ +18,693 +Liabilities +Current liabilities: +Accounts payable, trade +$ +2,043 +$ +2,129 +Accrued compensation and retirement costs +432 +370 +Taxes, including income taxes +87 +118 +Accrued interest payable +112 +113 +Other current liabilities ( A and O ) +418 +356 +Short-term debt ( P and Q ) +1,034 +434 +Total current liabilities +4,126 +3,520 +Long-term debt, less amount due within one year ( P and Q ) +4,906 +5,896 +Accrued pension benefits ( F ) +2,460 +2,230 +Accrued other postretirement benefits ( F ) +714 +723 +Other noncurrent liabilities and deferred credits ( A and O ) +751 +739 +Total liabilities +12,957 +13,108 +Contingencies and commitments ( T ) +Equity +Arconic shareholders’ equity: +Preferred stock ( H ) +55 +55 +Common stock ( H ) +433 +483 +Additional capital ( H ) +7,319 +8,319 +Retained earnings (accumulated deficit) ( A ) +129 +( 358 +) +Accumulated other comprehensive loss ( A and J ) +( 3,329 +) +( 2,926 +) +Total Arconic shareholders’ equity +4,607 +5,573 +Noncontrolling interests +14 +12 +Total equity +4,621 +5,585 +Total liabilities and equity +$ +17,578 +$ +18,693 +The accompanying notes are an integral part of the consolidated financial statements. +59 +Table of Contents +Arconic and subsidiaries +Statement of Consolidated Cash Flows +(in millions) +For the year ended December 31, +2019 +2018 +2017 +Operating activities +Net income (loss) +$ +470 +$ +642 +$ +( 74 +) +Adjustments to reconcile net income (loss) to cash provided from (used for) operations: +Depreciation and amortization +536 +576 +551 +Deferred income taxes +( 19 +) +31 +434 +Impairment of goodwill ( A and N ) +— +— +719 +Restructuring and other charges +620 +9 +165 +Net loss (gain) from investing activities - asset sales +7 +10 +( 513 +) +Net periodic pension benefit cost ( F ) +115 +130 +217 +Stock-based compensation +60 +50 +67 +Other +13 +75 +112 +Changes in assets and liabilities, excluding effects of acquisitions, divestitures, and foreign currency translation adjustments: +(Increase) in receivables +( 977 +) +( 1,142 +) +( 915 +) +(Increase) in inventories +( 3 +) +( 74 +) +( 192 +) +Decrease (increase) in prepaid expenses and other current assets +4 +( 1 +) +11 +(Decrease) increase in accounts payable, trade +( 56 +) +339 +62 +(Decrease) in accrued expenses +( 42 +) +( 190 +) +( 116 +) +(Decrease) increase in taxes, including income taxes +( 2 +) +104 +( 23 +) +Pension contributions +( 268 +) +( 298 +) +( 310 +) +(Increase) in noncurrent assets +( 7 +) +( 20 +) +( 41 +) +(Decrease) in noncurrent liabilities +( 45 +) +( 24 +) +( 193 +) +Cash provided from (used for) operations +406 +217 +( 39 +) +Financing Activities +Net change in short-term borrowings (original maturities of three months or less) +2 +( 7 +) +( 2 +) +Additions to debt (original maturities greater than three months) ( P ) +400 +600 +816 +Payments on debt (original maturities greater than three months) ( P ) +( 806 +) +( 1,103 +) +( 1,634 +) +Premiums paid on early redemption of debt ( P ) +— +( 17 +) +( 52 +) +Proceeds from exercise of employee stock options +56 +16 +50 +Dividends paid to shareholders +( 57 +) +( 119 +) +( 162 +) +Distributions to noncontrolling interests +— +— +( 14 +) +Repurchase of common stock ( H ) +( 1,150 +) +— +— +Other +( 13 +) +( 19 +) +( 17 +) +Cash used for financing activities +( 1,568 +) +( 649 +) +( 1,015 +) +Investing Activities +Capital expenditures +( 586 +) +( 768 +) +( 596 +) +Proceeds from the sale of assets and businesses ( S ) +103 +309 +( 9 +) +Sales of investments ( U ) +73 +9 +890 +Cash receipts from sold receivables ( K ) +995 +1,016 +792 +Other ( U ) +( 2 +) +( 1 +) +243 +Cash provided from investing activities +583 +565 +1,320 +Effect of exchange rate changes on cash, cash equivalents and restricted cash +— +( 4 +) +9 +Net change in cash, cash equivalents and restricted cash +( 579 +) +129 +275 +Cash, cash equivalents and restricted cash at beginning of year +2,282 +2,153 +1,878 +Cash, cash equivalents and restricted cash at end of year +$ +1,703 +$ +2,282 +$ +2,153 +The accompanying notes are an integral part of the consolidated financial statements. +60 +Table of Contents +Arconic and subsidiaries +Statement of Changes in Consolidated Equity +(in millions, except per-share amounts) +Arconic Shareholders +Preferred +stock +Mandatory +convertible +preferred +stock +Common +stock +Additional +capital +Retained earnings (accumulated deficit) +Accumulated +Other +Comprehensive +Loss +Noncontrolling +interests +Total +equity +Balance at December 31, 2016 +$ +55 +$ +3 +$ +438 +$ +8,214 +$ +( 1,027 +) +$ +( 2,568 +) +$ +26 +$ +5,141 +Net loss +— +— +— +— +( 74 +) +— +— +( 74 +) +Other comprehensive (loss) income ( J ) +— +— +— +— +— +( 76 +) +2 +( 74 +) +Cash dividends declared: +Preferred–Class A @ $3.75 per share +— +— +— +— +( 2 +) +— +— +( 2 +) +Preferred–Class B @ $20.1563 per share +— +— +— +— +( 51 +) +— +— +( 51 +) +Common @ $0.24 per share +— +— +— +— +( 109 +) +— +— +( 109 +) +Stock-based compensation ( H ) +— +— +— +67 +— +— +— +67 +Common stock issued: compensation plans ( H ) +— +— +— +21 +— +— +— +21 +Conversion of mandatory convertible preferred stock ( H ) +— +( 3 +) +39 +( 36 +) +— +— +— +— +Issuance of common stock ( H ) +— +— +4 +— +— +— +— +4 +Distributions +— +— +— +— +— +— +( 14 +) +( 14 +) +Other +— +— +— +— +15 +— +— +15 +Balance at December 31, 2017 +$ +55 +$ +— +$ +481 +$ +8,266 +$ +( 1,248 +) +$ +( 2,644 +) +$ +14 +$ +4,924 +Adoption of accounting standard ( A ) +— +— +— +— +367 +( 367 +) +— +— +Net income +— +— +— +— +642 +— +— +642 +Other comprehensive income ( J ) +— +— +— +— +— +85 +— +85 +Cash dividends declared: +Preferred–Class A @ $3.75 per share +— +— +— +— +( 2 +) +— +— +( 2 +) +Common @ $0.24 per share +— +— +— +— +( 117 +) +— +— +( 117 +) +Stock-based compensation ( H ) +— +— +— +50 +— +— +— +50 +Common stock issued: compensation plans ( H ) +— +— +2 +3 +— +— +— +5 +Other +— +— +— +— +— +— +( 2 +) +( 2 +) +Balance at December 31, 2018 +$ +55 +$ +— +$ +483 +$ +8,319 +$ +( 358 +) +$ +( 2,926 +) +$ +12 +$ +5,585 +Adoption of accounting standard ( A ) +— +— +— +— +75 +( 2 +) +— +73 +Net income +— +— +— +— +470 +— +— +470 +Other comprehensive loss ( J ) +— +— +— +— +— +( 401 +) +— +( 401 +) +Cash dividends declared: +Preferred–Class A @ $3.75 per share +— +— +— +— +( 2 +) +— +— +( 2 +) +Common @ $0.12 per share +— +— +— +— +( 56 +) +— +— +( 56 +) +Repurchase and retirement of common stock ( H ) +— +— +( 55 +) +( 1,095 +) +— +— +— +( 1,150 +) +Stock-based compensation ( H ) +— +— +— +57 +— +— +— +57 +Common stock issued: compensation plans ( H ) +— +— +5 +36 +— +— +— +41 +Other +— +— +— +2 +— +— +2 +4 +Balance at December 31, 2019 +$ +55 +$ +— +$ +433 +$ +7,319 +$ +129 +$ +( 3,329 +) +$ +14 +$ +4,621 +The accompanying notes are an integral part of the consolidated financial statements. +61 +Table of Contents +Arconic and subsidiaries +Notes to the Consolidated Financial Statements +(dollars in millions, except per-share amounts) +A. Summary of Significant Accounting Policies +Basis of Presentation. The Consolidated Financial Statements of Arconic Inc. and subsidiaries (“Arconic” or the “Company”) are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) and require management to make certain judgments, estimates, and assumptions. These may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. They also may affect the reported amounts of sales and expenses during the reporting period. Actual results could differ from those estimates upon subsequent resolution of identified matters. Certain amounts in previously issued financial statements were reclassified to conform to the current period presentation (see Note B ). +In the third quarter of 2019, the Company realigned its operations by eliminating its Transportation and Construction Solutions (TCS) segment and transferring the Forged Wheels business to the Engineered Products and Forgings (EP&F) segment and the Building and Construction Systems (BCS) business to the Global Rolled Products (GRP) segment. See Note B for further details. +On February 8, 2019, the Company announced the separation of its portfolio into two independent, publicly-traded companies (the "Separation of Arconic"). The EP&F segment will remain in the existing company (Remain Co.) which will be renamed Howmet Aerospace Inc. at separation. The GRP segment will comprise Spin Co. and will be named Arconic Corporation at separation. The Company is targeting to complete the Separation of Arconic on April 1, 2020. See Note U for further details. +Principles of Consolidation. The Consolidated Financial Statements include the accounts of Arconic and companies in which Arconic has a controlling interest. Intercompany transactions have been eliminated. Investments in affiliates in which Arconic cannot exercise significant influence that do not have readily determinable fair values are accounted for at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. +Management also evaluates whether an Arconic entity or interest is a variable interest entity and whether Arconic is the primary beneficiary. Consolidation is required if both of these criteria are met. Arconic does not have any variable interest entities requiring consolidation. +Cash Equivalents. Cash equivalents are highly liquid investments purchased with an original maturity of three months or less. +Inventory Valuation. Inventories are carried at the lower of cost and net realizable value, with cost for approximately half of U.S. inventories determined under the last-in, first-out (LIFO) method. The cost of other inventories is determined under a combination of the first-in, first-out (FIFO) and average-cost methods. +Properties, Plants, and Equipment. Properties, plants, and equipment are recorded at cost. Depreciation is recorded principally on the straight-line method at rates based on the estimated useful lives of the assets. The following table details the weighted-average useful lives of structures and machinery and equipment by reporting segment (numbers in years): +Structures +Machinery and equipment +Engineered Products and Forgings +29 +17 +Global Rolled Products +31 +21 +Gains or losses from the sale of asset groups are generally recorded in Restructuring and other charges while the sale of individual assets are recorded in Other expense (income), net (see policy below for assets classified as held for sale and discontinued operations). Repairs and maintenance are charged to expense as incurred. Interest related to the construction of qualifying assets is capitalized as part of the construction costs. +Properties, plants, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is measured as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a discounted cash flow (DCF) model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of the assets also require significant judgments. See Note M for further information. +62 +Table of Contents +Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. +Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. For 2019, Arconic had seven reporting units, of which four were included in the Engineered Products and Forgings (EP&F) segment (Fastening Systems, Engineered Structures, Engine Products, and Forged Wheels), and three were included in the Global Rolled Products (GRP) segment (Global Rolled Products, Aluminum Extrusions, and BCS). More than 90 % of Arconic’s total goodwill at December 31, 2019 was allocated to the four EP&F reporting units: Engine Products ( $ 2,164 ), Fastening Systems ( $ 1,607 ), Engineered Structures ( $ 289 ), and Forged Wheels ( $ 7 ). +In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (greater than 50 % ) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. +Arconic determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Arconic’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three -year period. +Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent quantitative impairment test completed for a reporting unit and compares the weighted average cost of capital (WACC) between the current and prior years for each reporting unit. +During the 2019 annual review of goodwill, management proceeded directly to the quantitative impairment test for all seven of its reporting units. The estimated fair values for each of the seven reporting units exceeded their respective carrying values by more than 50 % , thus, there was no goodwill impairment. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Arconic uses a DCF model to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. Arconic would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit. +In the first quarter of 2019, management transferred its aluminum extrusions business (Aluminum Extrusions) from Engineered Structures within the EP&F segment to the GRP segment, based on synergies with the GRP segment including similar customer base, technologies, and manufacturing capabilities. Management assessed and concluded that the remaining Engineered Structures business unit and the Aluminum Extrusions business unit represent reporting units. As a result of the reorganization, goodwill of $ 110 was reallocated from Engineered Structures to Aluminum Extrusions and these reporting units were evaluated for impairment during the first quarter of 2019. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no goodwill impairment. In the second quarter of 2019, management transferred its castings operations from Engineered Structures to Engine Products within the EP&F segment based on process expertise for investment castings that existed within Engine Products. As a result, goodwill of $ 105 was reallocated from Engineered Structures to Engine Products and these reporting units were evaluated for impairment during the second quarter of 2019. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no impairment. As a result of the elimination of the TCS segment in the third quarter of 2019 (see Note B ), the Company transferred $ 7 of +63 +Table of Contents +Forged Wheels goodwill and $ 68 of BCS goodwill from the TCS segment to the EP&F and GRP segments, respectively. Both Forged Wheels and BCS are considered reporting units. +In the second quarter of 2019, as a result of the decline in the forecasted financial performance and related impairment of long-lived assets of the Disks asset group within Engine Products (see Note M ), the Company also performed an interim impairment evaluation of goodwill for Engine Products. The estimated fair value of the reporting unit was substantially in excess of its carrying value; thus, there was no impairment of goodwill. +In connection with the interim impairment evaluation of long-lived assets for the Disks asset group within Engine Products in the second quarter of 2018 (see Note M ), which resulted from a decline in forecasted financial performance for the business in connection with its updated three-year strategic plan, the Company also performed an interim impairment evaluation of goodwill for Engine Products. The estimated fair value of the reporting unit was substantially in excess of the carrying value; thus, there was no impairment of goodwill. +Goodwill impairment tests in 2018 and 2017 indicated that goodwill was not impaired for any of the Company’s reporting units, except for the Arconic Forgings and Extrusions business (AFE) (the AFE operations were realigned and transferred to Aluminum Extrusions and Engine Products) whose estimated fair value was lower than its carrying value. As such, Arconic recorded an impairment for the full amount of goodwill in the AFE reporting unit of $ 719 in 2017. The decrease in fair value of AFE was primarily due to unfavorable performance that was impacting operating margins and a higher discount rate due to an increase in the risk-free rate of return, while the carrying value increased compared to prior year. +Other Intangible Assets. Intangible assets with indefinite useful lives are not amortized while intangible assets with finite useful lives are amortized generally on a straight-line basis over the periods benefited. The following table details the weighted-average useful lives of software and other intangible assets by reporting segment (numbers in years): +Software +Other intangible assets +Engineered Products and Forgings +5 +32 +Global Rolled Products +5 +13 +Leases. The Company determines whether a contract contains a lease at inception. The Company leases land and buildings, plant equipment, vehicles, and computer equipment which have been classified as operating leases. Certain real estate leases include one or more options to renew; the exercise of lease renewal options is at the Company’s discretion. The Company includes renewal option periods in the lease term when it is determined that the options are reasonably certain to be exercised. Certain of Arconic's real estate lease agreements include rental payments that either have fixed contractual increases over time or adjust periodically for inflation. Certain of the Company's lease agreements include variable lease payments. The variable portion of payments is not included in the initial measurement of the right-of-use asset or lease liability due to the uncertainty of the payment amount and is recorded as lease cost in the period incurred. The Company also rents or subleases certain real estate to third parties, which is not material to the consolidated financial statements. +Operating lease right-of-use assets and lease liabilities with an initial term greater than 12 months are recorded on the balance sheet at the present value of the future minimum lease payments over the lease term at the lease commencement date and are recognized as lease expense on a straight-line basis over the lease term. The Company uses an incremental collateralized borrowing rate based on the information available at the lease commencement date in determining the present value of future payments, as most of its leases do not provide an implicit rate. The operating lease right-of-use assets also include any lease prepayments made and were reduced by lease incentives and accrued exit costs. +Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future sales, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery. Claims for recovery are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Arconic has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations. +Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar +64 +Table of Contents +historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss. +Revenue Recognition. The Company's contracts with customers are comprised of acknowledged purchase orders incorporating the Company’s standard terms and conditions, or for larger customers, may also generally include terms under negotiated multi-year agreements. These contracts with customers typically consist of the manufacture of products which represent single performance obligations that are satisfied upon transfer of control of the product to the customer. The Company produces fastening systems; seamless rolled rings; investment castings, including airfoils and forged jet engine components; extruded, machined and formed aircraft parts; aluminum sheet and plate; integrated aluminum structural systems; architectural extrusions; and forged aluminum commercial vehicle wheels. Transfer of control is assessed based on alternative use of the products we produce and our enforceable right to payment for performance to date under the contract terms. Transfer of control and revenue recognition generally occur upon shipment or delivery of the product, which is when title, ownership and risk of loss pass to the customer and is based on the applicable shipping terms. The shipping terms vary across all businesses and depend on the product, the country of origin, and the type of transportation (truck, train, or vessel). An invoice for payment is issued at time of shipment. Our business units set commercial terms on which Arconic sells products to its customers. These terms are influenced by industry custom, market conditions, product line (specialty versus commodity products), and other considerations. +In certain circumstances, Arconic receives advanced payments from its customers for product to be delivered in future periods. These advanced payments are recorded as deferred revenue until the product is delivered and title and risk of loss have passed to the customer in accordance with the terms of the contract. Deferred revenue is included in Other current liabilities and Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. +Income Taxes. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Arconic’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset Global Intangible Low Taxed Income (GILTI) income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. +65 +Table of Contents +Stock-Based Compensation. Arconic recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. +Foreign Currency. The local currency is the functional currency for Arconic’s significant operations outside the United States, except for certain operations in Canada and Russia, where the U.S. dollar is used as the functional currency. The determination of the functional currency for Arconic’s operations is made based on the appropriate economic and management indicators. +Acquisitions. Arconic’s business acquisitions are accounted for using the acquisition method. The purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. Any excess purchase price over the fair value of the net assets acquired is recorded as goodwill. For all acquisitions, operating results are included in the Statement of Consolidated Operations from the date of the acquisition. +Discontinued Operations and Assets Held for Sale. For those businesses where management has committed to a plan to divest, each business is valued at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, an impairment loss is recognized. Fair value is estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements. Depreciation and amortization expense is not recorded on assets of a business to be divested once they are classified as held for sale. Businesses to be divested are generally classified in the Consolidated Financial Statements as either discontinued operations or held for sale. +For businesses classified as discontinued operations, the balance sheet amounts and results of operations should be reclassified from their historical presentation to assets and liabilities of discontinued operations on the Consolidated Balance Sheet and to discontinued operations on the Statement of Consolidated Operations, respectively, for all periods presented. The gains or losses associated with these divested businesses are recorded in discontinued operations on the Statement of Consolidated Operations. The Statement of Consolidated Cash Flows is not required to be reclassified for discontinued operations for any period. Segment information does not include the assets or operating results of businesses classified as discontinued operations for all periods presented. These businesses are expected to be disposed of within one year . +For businesses classified as held for sale that do not qualify for discontinued operations treatment, the balance sheet and cash flow amounts should be reclassified from their historical presentation to assets and liabilities of operations held for sale for all periods presented. The results of operations continue to be reported in continuing operations. The gains or losses associated with these divested businesses are recorded in Restructuring and other charges on the Statement of Consolidated Operations. The segment information includes the assets and operating results of businesses classified as held for sale for all periods presented. +Recently Adopted Accounting Guidance. In February 2016, the Financial Accounting Standards Board (FASB) issued changes to the accounting and presentation of leases. These changes require lessees to recognize a right-of-use asset and lease liability on the balance sheet, initially measured at the present value of the future lease payments for all operating leases with a term greater than 12 months. +These changes became effective for Arconic on January 1, 2019 and have been applied using the modified retrospective approach as of the date of adoption, under which leases existing at, or entered into after, January 1, 2019 were required to be recognized and measured. Prior period amounts have not been adjusted and continue to be reflected in accordance with the Company’s historical accounting. The Company elected the package of practical expedients permitted under the transition guidance within the new standard, which among other things, allowed the Company to carry forward the historical lease classification. The Company also elected to separate lease components from non-lease components for all classes of assets. +The adoption of this new lease standard resulted in the Company recording operating lease right-of-use assets and lease liabilities of approximately $ 320 on the Consolidated Balance Sheet as of January 1, 2019. Also, the Company reclassified cash proceeds of $ 119 from Other noncurrent liabilities and deferred credits, assets of $ 24 from Properties, plants, and equipment, net, and deferred tax assets of $ 22 from Other noncurrent assets to Retained earnings (accumulated deficit) reflecting the cumulative effect of an accounting change related to the sale-leaseback of the Texarkana, Texas cast house (see Note S ). The adoption of the standard had no impact on the Statement of Consolidated Operations or Statement of Consolidated Cash Flows. +66 +Table of Contents +In August 2017, the FASB issued guidance that made more financial and nonfinancial hedging strategies eligible for hedge accounting. It also amended the presentation and disclosure requirements and changed how companies assess effectiveness. It is intended to more closely align hedge accounting with companies’ risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. These changes became effective for Arconic on January 1, 2019. For cash flow hedges, Arconic recorded a cumulative effect adjustment of $ 2 related to eliminating the separate measurement of ineffectiveness by decreasing Accumulated other comprehensive loss and increasing Retained earnings (accumulated deficit) on the accompanying Consolidated Balance Sheet. The amendments to presentation and disclosure are required prospectively. Arconic has determined that under the new accounting guidance it is able to more broadly use cash flow hedge accounting for its variable priced inventory purchases and customer sales. +In February 2018, the FASB issued guidance that allows an optional reclassification from Accumulated other comprehensive loss to Accumulated deficit for stranded tax effects resulting from the Tax Cuts and Jobs Act enacted on December 22, 2017. Stranded tax effects were created when deferred taxes, originally established in Other comprehensive income at 35%, were revalued to 21% as a component of income tax expense from continuing operations. The Company elected to early adopt this provision in the fourth quarter of 2018 and reclassified $ 367 of beneficial stranded tax effects in Accumulated other comprehensive loss to Retained earnings (accumulated deficit) in its Consolidated Balance Sheet and Statement of Changes in Consolidated Equity. +In March 2019, the Securities and Exchange Commission (SEC) issued guidance to modernize and simplify certain disclosure requirements in a manner that reduces the costs and burdens on preparers while continuing to provide all material information to investors. This guidance became effective on May 2, 2019 and has been applied to filings thereafter. The adoption of this guidance did not have a material impact on the Notes to the Consolidated Financial Statements. +Recently Issued Accounting Guidance. In June 2016, the FASB added a new impairment model (known as the current expected credit loss (CECL) model) that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses. The CECL model applies to most debt instruments, trade receivables, lease receivables, financial guarantee contracts, and other loan commitments. The CECL model does not have a minimum threshold for recognition of impairment losses and entities will need to measure expected credit losses on assets that have a low risk of loss. These changes became effective for Arconic on January 1, 2020. Management has determined that the adoption of this guidance did not have a material impact on the Consolidated Financial Statements. +In August 2018, the FASB issued guidance that impacts disclosures for defined benefit pension plans and other postretirement benefit plans. These changes become effective for Arconic's annual report for the year ending December 31, 2020, with early adoption permitted. Management has determined that the adoption of this guidance will not have a material impact on the Consolidated Financial Statements. +In December 2019, the FASB issued guidance that is intended to simplify various aspects related to the accounting for income taxes. These changes become effective on January 1, 2021, with early adoption permitted. Management is currently evaluating the potential impact of these changes on the Consolidated Financial Statements. +B. Segment and Geographic Area Information +Arconic is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging. Arconic’s operations consist of two worldwide reportable segments: EP&F and GRP. Segment performance under Arconic’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Arconic’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and other charges and Impairment of goodwill. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Arconic are in Corporate. +In the third quarter of 2019, the Company realigned its operations by eliminating its TCS segment and transferring the Forged Wheels business to its EP&F segment and BCS to its GRP segment, consistent with how the Chief Executive Officer is assessing operating performance and allocating capital in conjunction with the planned Separation of Arconic (see Note U ). The Latin America extrusions business, which was formerly part of the Company's TCS segment until its sale in April of 2018 (see Note S ), was moved to Corporate. In the first quarter of 2019, management transferred its aluminum extrusions operations from its Engineered Structures business unit within the EP&F segment to the GRP segment, based on synergies with the GRP segment including similar customer base, technologies, and manufacturing capabilities. Prior period financial information has been recast to conform to current year presentation. +The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies (see Note A ). Transactions among segments are established based on negotiation among the parties. Differences between segment totals and Arconic’s consolidated totals for line items not reconciled are in Corporate. +67 +Table of Contents +Engineered Products and Forgings . This segment produces products that are used primarily in the aerospace (commercial and defense), industrial, commercial transportation, and power generation end markets. Such products include fastening systems (aluminum, titanium, steel, and nickel superalloys) and seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils; forged jet engine components (e.g., jet engine disks); extruded, machined and forged aircraft parts (titanium and aluminum); and forged aluminum commercial vehicle wheels, all of which are sold directly to customers and through distributors. Approximately 70 % of the third-party sales in this segment are from the aerospace end market. A small part of this segment also produces various forged and machined metal products (titanium and aluminum) for various end markets. Seasonal decreases in sales are experienced for certain products in the third quarter of the year due to the European summer slowdown. +Global Rolled Products. This segment produces aluminum sheet and plate, aluminum extruded and machined parts, integrated aluminum structural systems, and architectural extrusions used in the automotive, aerospace, building and construction, industrial, packaging, and commercial transportation end markets. Products are sold directly to customers and through distributors. While the customer base for flat-rolled products is large, a significant amount of sales of sheet and plate are to a relatively small number of customers. +68 +Table of Contents +The operating results and assets of Arconic’s reportable segments were as follows: +Engineered Products and Forgings +Global Rolled Products +Total +2019 +Sales: +Third-party sales +$ +7,105 +$ +7,082 +$ +14,187 +Intersegment sales +— +183 +183 +Total segment sales +$ +7,105 +$ +7,265 +$ +14,370 +Profit and loss: +Segment operating profit +$ +1,390 +$ +625 +$ +2,015 +Restructuring and other charges +509 +81 +590 +Provision for depreciation and amortization +269 +233 +502 +2018 +Sales: +Third-party sales +$ +6,798 +$ +7,223 +$ +14,021 +Intersegment sales +— +205 +205 +Total segment sales +$ +6,798 +$ +7,428 +$ +14,226 +Profit and loss: +Segment operating profit +$ +1,105 +$ +481 +$ +1,586 +Restructuring and other charges +70 +( 157 +) +( 87 +) +Provision for depreciation and amortization +289 +253 +542 +2017 +Sales: +Third-party sales +$ +6,300 +$ +6,540 +$ +12,840 +Intersegment sales +— +183 +183 +Total segment sales +$ +6,300 +$ +6,723 +$ +13,023 +Profit and loss: +Segment operating profit +$ +1,119 +$ +570 +$ +1,689 +Restructuring and other charges +30 +83 +113 +Provision for depreciation and amortization +275 +243 +518 +2019 +Assets: +Capital expenditures +$ +344 +$ +189 +$ +533 +Goodwill +4,067 +426 +4,493 +Total assets (1) +10,034 +4,907 +14,941 +2018 +Assets: +Capital expenditures +$ +407 +$ +308 +$ +715 +Goodwill +4,186 +314 +4,500 +Total assets +10,494 +4,845 +15,339 +(1) Segment assets at December 31, 2019 included operating lease right-of-use assets (see Notes A and O ). Segment assets for the EP&F segment at December 31, 2019 were impacted by a long-lived asset impairment charge of $ 428 recorded in the second quarter of 2019 (see Note M ). +69 +Table of Contents +The following tables reconcile certain segment information to consolidated totals: +For the year ended December 31, +2019 +2018 +2017 +Sales: +Total segment sales +$ +14,370 +$ +14,226 +$ +13,023 +Elimination of intersegment sales +( 183 +) +( 205 +) +( 183 +) +Corporate +5 +( 7 +) +120 +Consolidated sales +$ +14,192 +$ +14,014 +$ +12,960 +For the year ended December 31, +2019 +2018 +2017 +Total segment operating profit +$ +2,015 +$ +1,586 +$ +1,689 +Unallocated amounts: +Impairment of goodwill +— +— +( 719 +) +Restructuring and other charges +( 620 +) +( 9 +) +( 165 +) +Corporate expense +( 360 +) +( 252 +) +( 325 +) +Consolidated operating income +$ +1,035 +$ +1,325 +$ +480 +Interest expense +( 338 +) +( 378 +) +( 496 +) +Other (expense) income, net +( 122 +) +( 79 +) +486 +Consolidated income before income taxes +$ +575 +$ +868 +$ +470 +December 31, +2019 +2018 +Assets: +Total segment assets +$ +14,941 +$ +15,339 +Unallocated amounts: +Cash and cash equivalents +1,648 +2,277 +Deferred income taxes +608 +573 +Corporate fixed assets, net +326 +334 +Fair value of derivative contracts +6 +37 +Other +49 +133 +Consolidated assets +$ +17,578 +$ +18,693 +Sales by major product grouping were as follows: +For the year ended December 31, +2019 +2018 +2017 +Sales: +Innovative flat-rolled products +$ +5,471 +$ +5,604 +$ +5,000 +Engine products +3,452 +3,220 +2,965 +Fastening systems +1,561 +1,531 +1,484 +Engineered structures +1,123 +1,081 +1,023 +Architectural aluminum systems +1,118 +1,135 +1,069 +Forged wheels +969 +966 +828 +Aluminum extrusions +493 +484 +471 +Other +5 +( 7 +) +120 +$ +14,192 +$ +14,014 +$ +12,960 +70 +Table of Contents +Geographic information for sales was as follows (based upon the country where the point of sale occurred): +For the year ended December 31, +2019 +2018 +2017 +Sales: +United States +$ +9,548 +$ +9,137 +$ +8,167 +France +864 +936 +965 +United Kingdom +732 +737 +721 +Hungary +719 +823 +739 +China +630 +632 +615 +Russia +511 +553 +500 +Germany +322 +302 +309 +Canada +313 +285 +261 +Japan +190 +170 +141 +Brazil +159 +214 +285 +Other +204 +225 +257 +$ +14,192 +$ +14,014 +$ +12,960 +Geographic information for long-lived assets was as follows (based upon the physical location of the assets): +December 31, +2019 +2018 +Long-lived assets: +United States +$ +4,193 +$ +4,148 +China +338 +326 +Hungary +302 +257 +Russia +233 +253 +United Kingdom +189 +253 +France +185 +163 +Germany +86 +84 +Canada +57 +61 +Mexico +57 +45 +Brazil +5 +54 +Other +69 +60 +$ +5,714 +$ +5,704 +71 +Table of Contents +The following table disaggregates revenue by major end market served. Differences between segment totals and consolidated Arconic are in Corporate. In 2018, Corporate included $ 38 of costs related to settlements of certain customer claims primarily related to product introductions. +For the year ended December 31, +Engineered +Products and +Forgings +Global Rolled +Products +Total +Segment +2019 +Aerospace +$ +5,075 +$ +1,251 +$ +6,326 +Transportation +1,289 +2,418 +3,707 +Building and construction +— +1,300 +1,300 +Industrial and Other +741 +2,113 +2,854 +Total end-market revenue +$ +7,105 +$ +7,082 +$ +14,187 +2018 +Aerospace +$ +4,722 +$ +1,116 +$ +5,838 +Transportation +1,302 +2,550 +3,852 +Building and construction +— +1,357 +1,357 +Industrial and Other +774 +2,200 +2,974 +Total end-market revenue +$ +6,798 +$ +7,223 +$ +14,021 +2017 +Aerospace +$ +4,347 +$ +1,109 +$ +5,456 +Transportation +1,098 +2,072 +3,170 +Building and construction +— +1,269 +1,269 +Industrial and Other +855 +2,090 +2,945 +Total end-market revenue +$ +6,300 +$ +6,540 +$ +12,840 +C. Restructuring and Other Charges +Restructuring and other charges for each year in the three-year period ended December 31, 2019 were comprised of the following: +2019 +2018 +2017 +Non-cash asset impairments +$ +570 +$ +13 +$ +58 +Layoff costs +103 +20 +64 +Pension and Other postretirement benefits - net settlement and curtailment charges +( 49 +) +91 +— +Net (gain) loss on divestitures of assets and businesses ( S ) +( 20 +) +( 109 +) +57 +Other +26 +13 +( 3 +) +Reversals of previously recorded layoff costs +( 10 +) +( 19 +) +( 11 +) +Restructuring and other charges +$ +620 +$ +9 +$ +165 +Layoff costs were recorded based on approved detailed action plans submitted by the operating locations that specified positions to be eliminated, benefits to be paid under existing severance plans, union contracts or statutory requirements, and the expected timetable for completion of the plans. +2019 Actions . In 2019, Arconic recorded Restructuring and other charges of $ 620 ( $ 512 after-tax), this included a non-cash charge for asset impairments of $ 570 ( $ 477 after-tax), primarily comprised of $ 428 ( $ 345 after-tax) for impairment of the Disks long-lived asset group, a charge of $ 112 ( $ 109 after-tax) for impairment of assets associated with agreements to sell the Company’s Brazilian rolling mill operations ( $ 53 ), the U.K. forgings business ( $ 46 ), and a small additive business ( $ 13 ), a charge of $ 25 ( $ 19 after-tax) for impairment of a trade name intangible asset and properties, plant, and equipment related to the Company’s primary research and development facility, and a charge of $ 5 ( $ 4 after-tax) for an impairment of a cost method investment of the GRP segment; a charge of $ 103 ( $ 78 after-tax) for layoff costs, including the separation of approximately +72 +Table of Contents +1,310 employees ( 484 in the GRP segment, 460 in Corporate, and 366 in the EP&F segment); a charge of $ 26 ( $ 21 after-tax) for other miscellaneous items including lease terminations of $ 12 primarily related to a corporate aircraft, accelerated depreciation of $ 9 , a net charge of $ 2 for executive severance net of the benefit of forfeited executive stock compensation, and a charge for various other exit costs of $ 4 ; and a charge of $ 9 ( $ 7 after-tax) for pension settlement accounting. These charges were partially offset by a benefit of $ 58 ( $ 45 after-tax) from the elimination of the life insurance benefit for the U.S. salaried and non-bargaining hourly retirees of the Company and its subsidiaries; a benefit of $ 10 ( $ 9 after-tax) from the reversal of a number of current year layoff reserves; and a gain of $ 20 ( $ 17 after-tax) for contingent consideration received from the Texarkana sale. +As of December 31, 2019, approximately 947 of the 1,310 employees were separated. The remaining separations for the 2019 restructuring programs are expected to be completed in 2020. In 2019 , cash payments of $ 65 were made against layoff reserves related to 2019 restructuring programs. +2018 Actions . In 2018, Arconic recorded Restructuring and other charges of $ 9 ( $ 9 after-tax), which included a net gain on the sale of several assets and businesses of $ 109 ( $ 81 after-tax), primarily made up of a gain on the asset sale of Texarkana of $ 154 ( $ 119 after-tax) and loss on the sale of the Hungary forgings business of $ 43 ( $ 39 after-tax) (see note S ); charges of $ 96 ( $ 75 after-tax) for pension settlement and $ 23 ( $ 18 after-tax) for pension curtailment; a postretirement curtailment benefit of $ 28 ( $ 22 after-tax) (see note F ); and a charge of $ 20 ( $ 17 after-tax) for layoff costs, including the separation of approximately 125 employees ( 89 in the EP&F segment and 36 in Corporate); a charge of $ 12 ( $ 9 after-tax) for contract termination costs and asset impairments associated with the shutdown of a facility in Acuna, Mexico; a charge of $ 6 ( $ 4 after-tax) for contract termination costs related to the New York office; a charge of $ 8 ( $ 4 after-tax) for other miscellaneous items including accelerated depreciation and asset impairments; and a benefit of $ 19 ( $ 15 after-tax) for the reversal of a number of layoff reserves related to prior periods. +As of December 31, 2019, the separations associated with the 2018 restructuring programs were essentially complete. In 2019 and 2018, cash payments of $ 4 and $ 9 , respectively, were made against layoff reserves related to the 2018 restructuring programs. +2017 Actions . In 2017, Arconic recorded Restructuring and other charges of $ 165 ( $ 143 after-tax), which were comprised of the following components: a charge of $ 69 ( $ 47 after-tax) for layoff costs related to cost reduction initiatives including the separation of approximately 880 employees ( 403 in the EP&F segment, 336 in the GRP segment, and 141 in Corporate), a charge of $ 60 ( $ 60 after-tax) related to the sale of the Italy rolling mill; a charge of $ 41 ( $ 41 after-tax) for the impairment of assets associated with the sale of the Latin America extrusions business (see Note S ); a net benefit of $ 6 ( $ 4 after-tax) for the reversal of forfeited executive stock compensation of $ 13 , partially offset by a charge of $ 7 for the related severance; a net charge of $ 12 ( $ 7 after-tax) for other miscellaneous items; and a benefit of $ 11 ( $ 8 after-tax) for the reversal of a number of small layoff reserves related to prior periods. +As of December 31, 2019, the separations associated with the 2017 restructuring programs were essentially complete. In 2019, 2018, and 2017, cash payments of $ 5 , $ 34 , and $ 28 , respectively, were made against layoff reserves related to the 2017 restructuring programs. +73 +Table of Contents +Activity and reserve balances for restructuring charges were as follows: +Layoff +costs +Other +exit costs +Total +Reserve balances at December 31, 2016 +$ +50 +$ +9 +$ +59 +2017 +Cash payments +( 59 +) +( 6 +) +( 65 +) +Restructuring charges +64 +1 +65 +Other (1) +1 +( 2 +) +( 1 +) +Reserve balances at December 31, 2017 +$ +56 +$ +2 +$ +58 +2018 +Cash payments +$ +( 47 +) +$ +( 2 +) +$ +( 49 +) +Restructuring charges +111 +13 +124 +Other (2) +( 110 +) +2 +( 108 +) +Reserve balances at December 31, 2018 +$ +10 +$ +15 +$ +25 +2019 +Cash payments +$ +( 74 +) +$ +( 5 +) +$ +( 79 +) +Restructuring charges +56 +574 +630 +Other (3) +39 +( 581 +) +( 542 +) +Reserve balances at December 31, 2019 +$ +31 +$ +3 +$ +34 +(1) +In 2017, Other for layoff costs included a reclassification of a stock awards reversal of $ 13 , offset by reversals of previously recorded restructuring charges of $ 11 and foreign currency translation of $ 1 . +(2) +In 2018, Other for layoff costs included reclassifications of $ 119 in pension costs and a $ 28 credit in postretirement benefits, as the impacts were reflected in Arconic's separate liabilities for Accrued pension benefits and Accrued postretirement benefits, and reversals of previously recorded restructuring charges of $ 19 . +(3) +In 2019, Other for layoff costs included reclassifications of a $ 58 credit for elimination of life insurance benefits for U.S. salaried and non-bargaining hourly retirees, a charge of $ 9 for pension plan settlement accounting, as the impacts were reflected in Arconic's separate liabilities for Accrued pension benefits and Accrued postretirement benefits, and reversals of previously recorded restructuring charges of $ 10 . +In 2019, Other for other exit costs included a charge of $ 428 for impairment of the Disks long-lived asset group; a charge of $ 112 for impairment of assets associated with agreement to sell the Company’s Brazilian rolling mill operations, the U.K. forgings business, and a small additive business; a charge of $ 25 for impairment of properties, plants, and equipment related to the Company’s primary research and development facility and a trade name intangible asset; a charge of $ 12 for lease terminations; a charge of $ 9 for accelerated depreciation as the impacts were primarily reflected in various noncurrent asset accounts; a charge of $ 5 related to the impairment of a cost method investment of GRP, and a charge of $ 1 related to other miscellaneous items; partially offset by a gain of $ 20 related to contingent consideration from the Texarkana sale. Additionally, Other included the reclassification of $ 9 in lease exit costs to reduce right-of-use assets within Other noncurrent assets in accordance with the new lease accounting standard. +The remaining reserves are expected to be paid in cash during 2020. +74 +Table of Contents +D. Interest Cost Components +For the year ended December 31, +2019 +2018 +2017 +Amount charged to expense +$ +338 +$ +378 +$ +496 +Amount capitalized +33 +23 +22 +$ +371 +$ +401 +$ +518 +E. Other Expense (Income), Net +For the year ended December 31, +2019 +2018 +2017 +Non-service related net periodic benefit cost +$ +116 +$ +112 +$ +154 +Interest income +( 25 +) +( 23 +) +( 19 +) +Foreign currency (gains) losses, net +( 1 +) +26 +( 5 +) +Net loss (gain) from asset sales +7 +10 +( 513 +) +Other, net +25 +( 46 +) +( 103 +) +$ +122 +$ +79 +$ +( 486 +) +In 2019, Other, net included an increase in deferred compensation arrangements and related investment performance. In 2018, Non-service related net periodic benefit cost included lower net actuarial losses as a result of pension actions taken during 2018 (see Note F ) and Other, net included a benefit from establishing a tax indemnification receivable of $ 29 reflecting Alcoa Corporation’s 49 % share of a Spanish tax reserve (see Note T ). In 2017, Net loss (gain) from asset sales included a gain on the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $ 351 (see Note U ) and a gain of $ 167 on the Debt-for-Equity Exchange (see Note U ). In 2017, Other, net included an adjustment of $ 81 to the contingent earn-out liability related to the 2014 acquisition of Firth Rixson (see Note S ) and an adjustment of $ 25 associated with a separation-related guarantee liability (see Note T ). +F. Pension and Other Postretirement Benefits +Arconic maintains pension plans covering most U.S. employees and certain employees in foreign locations. Pension benefits generally depend on length of service and job grade. Substantially all benefits are paid through pension trusts that are sufficiently funded to ensure that all plans can pay benefits to retirees as they become due. Most salaried and non-bargaining hourly U.S. employees hired after March 1, 2006, participate in a defined contribution plan instead of a defined benefit plan. +Arconic also maintains health care and life insurance postretirement benefit plans covering eligible U.S. retired employees and certain retirees from foreign locations. Generally, the medical plans are unfunded and pay a percentage of medical expenses, reduced by deductibles and other coverage. Life benefits are generally provided by insurance contracts. Arconic retains the right, subject to existing agreements, to change or eliminate these benefits. All salaried and certain non-bargaining hourly U.S. employees hired after January 1, 2002 and certain bargaining hourly U.S. employees hired after July 1, 2010, are not eligible for postretirement health care benefits. All salaried and certain hourly U.S. employees that retire on or after April 1, 2008 are not eligible for postretirement life insurance benefits. +Effective January 1, 2015, Arconic no longer offers postretirement health care benefits to Medicare-eligible, primarily non-bargaining, U.S. retirees through Company-sponsored plans. Qualifying retirees (hired prior to January 1, 2002), both current and future, may access these benefits in the marketplace by purchasing coverage directly from insurance carriers. +On April 1, 2018, benefit accruals for future service and compensation under all of the Company's qualified and non-qualified defined benefit pension plans for U.S. salaried and non-bargaining hourly employees ceased. As a result of this change, in 2018, the Company recorded a decrease to the Accrued pension benefit liability of $ 136 related to the reduction of future benefits ( $ 141 offset in Accumulated other comprehensive loss) and curtailment charges of $ 5 in Restructuring and other charges. +On April 13, 2018, the United Auto Workers ratified a new five-year labor agreement, covering approximately 1,300 U.S. employees of Arconic, which expires on March 31, 2023. A provision within the agreement includes a retirement benefit increase for future retirees that participate in a defined benefit pension plan, which impacts approximately 300 of those employees. In addition, effective January 1, 2019, benefit accruals for future service ceased. As result of these changes, in 2018, a curtailment charge of $ 9 was recorded in Restructuring and other charges. +In 2018, the Company announced that effective December 31, 2018, it would end all pre-Medicare medical, prescription drug and vision coverage for current and future salaried and non-bargained hourly employees and retirees of the Company and its +75 +Table of Contents +subsidiaries. As a result of this change, in 2018, the Company recorded a decrease to the Accrued other postretirement benefits liability of $ 32 related to the reduction of future benefits, $ 4 offset in Accumulated other comprehensive loss, and a curtailment benefit of $ 28 in Restructuring and other charges. +In 2018, the company communicated to plan participants that effective in the first quarter of 2019, benefit accruals for future service and compensation for employees in the United Kingdom defined benefit pension plans will cease. The plan curtailment resulted in a $ 13 decrease in the Accrued pension benefits liability which was offset in Accumulated other comprehensive loss. Additionally, on October 29, 2018, the United Kingdom High Court ruled that defined benefit pension plans offering Guaranteed Minimum Pensions must review benefits accrued between May 1990 to April 1997 to ensure gender pay equality. The review resulted in an increase to the Accrued pension benefits liability of $ 9 and a corresponding curtailment charge that was recorded in Restructuring and other charges. +In 2019, the Company communicated to plan participants that for its U.S. salaried and non-bargained hourly retirees of the Company and its subsidiaries, it would eliminate the life insurance benefit effective May 1, 2019, and certain health care subsidies effective December 31, 2019. As a result of these changes, in 2019, the Company recorded a decrease to the Accrued other postretirement benefits liability of $ 75 , which was offset by a curtailment benefit of $ 58 in Restructuring and other charges and $ 17 in Accumulated other comprehensive loss. +In June 2019, the Company and the United Steelworkers (USW) reached a tentative three-year labor agreement that was ratified on July 11, 2019 covering approximately 3,400 employees at four U.S. locations; the previous labor agreement expired on May 15, 2019. In 2019, the Company recognized $ 9 in Cost of goods sold on the accompanying Statement of Consolidated Operations primarily for a one-time signing bonus for employees. Additionally, on July 25, 2019, the USW ratified a new four-year labor agreement covering approximately 560 employees at the Company’s Niles, Ohio facility. The prior labor agreement expired on June 30, 2018. +In 2019 and 2018, the Company applied settlement accounting to U.S. pension plans due to lump sum payments to participants which resulted in settlement charges of $ 9 and $ 96 that were recorded in Restructuring and other charges. +76 +Table of Contents +The funded status of all of Arconic’s pension and other postretirement benefit plans are measured as of December 31 each calendar year. +Obligations and Funded Status +Pension benefits +Other +postretirement benefits +December 31, +2019 +2018 +2019 +2018 +Change in benefit obligation +Benefit obligation at beginning of year +$ +6,476 +$ +7,359 +$ +806 +$ +927 +Service cost +25 +46 +7 +7 +Interest cost +235 +219 +28 +28 +Amendments +— +18 +( 78 +) +( 25 +) +Actuarial losses (gains) +974 +( 372 +) +100 +( 51 +) +Settlements +( 23 +) +( 146 +) +— +— +Curtailments +— +( 154 +) +— +— +Benefits paid +( 477 +) +( 422 +) +( 82 +) +( 86 +) +Medicare Part D subsidy receipts +— +— +5 +6 +Foreign currency translation impact +39 +( 72 +) +— +— +Benefit obligation at end of year (1) +$ +7,249 +$ +6,476 +$ +786 +$ +806 +Change in plan assets (1) +Fair value of plan assets at beginning of year +$ +4,334 +$ +4,862 +$ +— +$ +— +Actual return on plan assets +731 +( 144 +) +— +— +Employer contributions +268 +298 +— +— +Benefits paid +( 453 +) +( 397 +) +— +— +Administrative expenses +( 34 +) +( 33 +) +— +— +Settlements +( 22 +) +( 178 +) +— +— +Foreign currency translation impact +44 +( 74 +) +— +— +Fair value of plan assets at end of year (1) +$ +4,868 +$ +4,334 +$ +— +$ +— +Net funded status +$ +( 2,381 +) +$ +( 2,142 +) +$ +( 786 +) +$ +( 806 +) +Amounts recognized in the Consolidated Balance Sheet consist of: +Noncurrent assets +$ +104 +$ +111 +$ +— +$ +— +Current liabilities +( 25 +) +( 23 +) +( 72 +) +( 83 +) +Noncurrent liabilities +( 2,460 +) +( 2,230 +) +( 714 +) +( 723 +) +Net amount recognized +$ +( 2,381 +) +$ +( 2,142 +) +$ +( 786 +) +$ +( 806 +) +Amounts recognized in Accumulated Other Comprehensive Loss consist of: +Net actuarial loss +$ +3,375 +$ +2,957 +$ +179 +$ +87 +Prior service cost (benefit) +1 +3 +( 37 +) +( 27 +) +Net amount recognized, before tax effect +$ +3,376 +$ +2,960 +$ +142 +$ +60 +Other changes in plan assets and benefit obligations recognized in Other Comprehensive Loss consist of: +Net actuarial loss (gain) +$ +566 +$ +( 19 +) +$ +100 +$ +( 52 +) +Amortization of accumulated net actuarial loss +( 148 +) +( 264 +) +( 8 +) +( 7 +) +Prior service cost (benefit) +— +19 +( 78 +) +( 25 +) +Amortization of prior service (cost) benefit +( 2 +) +( 26 +) +68 +35 +Net amount recognized, before tax effect +$ +416 +$ +( 290 +) +$ +82 +$ +( 49 +) +77 +Table of Contents +(1) +At December 31, 2019 , the benefit obligation, fair value of plan assets, and funded status for U.S. pension plans were $ 5,884 , $ 3,513 , and $( 2,371 ) , respectively. At December 31, 2018 , the benefit obligation, fair value of plan assets, and funded status for U.S. pension plans were $ 5,282 , $ 3,123 , and $( 2,159 ) respectively. +Pension Plan Benefit Obligations +Pension benefits +2019 +2018 +The projected benefit obligation and accumulated benefit obligation for all defined benefit pension plans were as follows: +Projected benefit obligation +$ +7,249 +$ +6,476 +Accumulated benefit obligation +7,219 +6,444 +The aggregate projected benefit obligation and fair value of plan assets for pension plans with projected benefit obligations in excess of plan assets was as follows: +Projected benefit obligation +6,064 +5,435 +Fair value of plan assets +3,579 +3,182 +The aggregate accumulated benefit obligation and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets was as follows: +Accumulated benefit obligation +6,045 +5,415 +Fair value of plan assets +3,579 +3,179 +Components of Net Periodic Benefit Cost +Pension benefits (1) +Other postretirement benefits (2) +For the year ended December 31, +2019 +2018 +2017 +2019 +2018 +2017 +Service cost +$ +25 +$ +46 +$ +90 +$ +7 +$ +7 +$ +7 +Interest cost +235 +219 +234 +28 +28 +30 +Expected return on plan assets +( 286 +) +( 306 +) +( 332 +) +— +— +— +Recognized net actuarial loss +139 +168 +220 +4 +7 +5 +Amortization of prior service cost (benefit) +2 +3 +5 +( 6 +) +( 7 +) +( 8 +) +Settlements (3) +9 +96 +— +— +— +— +Curtailments (4) +— +23 +— +( 58 +) +( 28 +) +— +Net periodic benefit cost (5) +$ +124 +$ +249 +$ +217 +$ +( 25 +) +$ +7 +$ +34 +(1) +In 2019 , 2018 and 2017 , net periodic benefit cost for U.S. pension plans was $ 127 , $ 239 , and $ 206 , respectively. +(2) +In 2019 , 2018 and 2017 , net periodic benefit cost for other postretirement benefits reflects a reduction of $ 11 , $ 10 , and $ 11 , respectively, related to the recognition of the federal subsidy awarded under Medicare Part D. +(3) +In 2019 and 2018, settlements were due to workforce reductions (see Note C ) and the payment of lump sum benefits. +(4) +In 2019 and 2018, curtailments were due to a reduction of future benefits, resulting in the recognition of favorable and unfavorable plan amendments. +(5) +Service cost was included within Cost of goods sold, Selling, general administrative, and other expenses, and Research and development expenses; curtailments and settlements were included in Restructuring and other charges; and all other cost components were recorded in Other expense (income), net in the Statement of Consolidated Operations. +Amounts Expected to be Recognized in Net Periodic Benefit Cost +Pension benefits +Other postretirement benefits +December 31, +2020 +2020 +Net actuarial loss recognition +$ +176 +$ +8 +Prior service cost (benefit) recognition +— +( 7 +) +78 +Table of Contents +Assumptions +Weighted average assumptions used to determine benefit obligations for U.S. pension and other postretirement benefit plans were as follows (assumptions for non-U.S. plans did not differ materially): +December 31, +2019 +2018 +Discount rate +3.30 +% +4.35 +% +Rate of compensation increase +— +3.50 +Cash balance plan interest crediting rate +3.00 +3.00 +The discount rate is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have an average duration of 10 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. +Benefit accruals for future compensation under the Company’s major salaried and non-bargained hourly defined benefit pension plans have ceased. The rate of compensation increase no longer impacts the determination of the benefit obligation and is not reported in the preceding table effective December 31, 2019. +Weighted average assumptions used to determine net periodic benefit cost for U.S. pension and other postretirement benefit plans were as follows (assumptions for non-U.S. plans did not differ materially): +2019 +2018 +2017 +Discount rate to calculate service cost (1) +4.35 +% +3.75 +% +4.20 +% +Discount rate to calculate interest cost (1) +4.00 +3.30 +3.60 +Expected long-term rate of return on plan assets +7.00 +7.00 +7.75 +Rate of compensation increase +3.50 +3.50 +3.50 +Cash balance plan interest crediting rate +3.00 +3.00 +3.00 +(1) +In all periods presented, the respective discount rates were used to determine net periodic benefit cost for most U.S. pension plans for the full annual period. However, the discount rates for a limited number of plans were updated during 2019 , 2018 , and 2017 to reflect the remeasurement of these plans due to new union labor agreements, settlements, and/or curtailments. The updated discount rates used were not significantly different from the discount rates presented. +The expected long-term rate of return on plan assets is generally applied to a five -year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment. +For 2019 , 2018 , and 2017 , the expected long-term rate of return used by management was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. These rates fell within the respective range of the 20 -year moving average of actual performance and the expected future return developed by asset class. In 2018, management reduced the expected long-term rate of return by 75 basis points due to a decrease in the expected return by asset class and the 20-year moving average. For 2020 , management anticipates that 7.00 % will be the expected long-term rate of return. +Assumed health care cost trend rates for U.S. other postretirement benefit plans were as follows (assumptions for non-U.S. plans did not differ materially): +2019 +2018 +2017 +Health care cost trend rate assumed for next year +5.50 +% +5.50 +% +5.50 +% +Rate to which the cost trend rate gradually declines +4.50 +4.50 +4.50 +Year that the rate reaches the rate at which it is assumed to remain +2023 +2022 +2021 +79 +Table of Contents +The assumed health care cost trend rate is used to measure the expected cost of gross eligible charges covered by Arconic’s other postretirement benefit plans. For 2020 , a 5.5 % trend rate will be used, reflecting management’s best estimate of the change in future health care costs covered by the plans. The plans’ actual annual health care cost trend experience over the past three years has ranged from ( 3.8 )% to 0.7 % . Management does not believe this three-year range is indicative of expected increases for future health care costs over the long-term. +Assumed health care cost trend rates have an effect on the amounts reported for the health care plan. A one-percentage point change in these assumed rates would have the following effects: +1% increase +1% decrease +Effect on other postretirement benefit obligations +$ +23 +$ +( 22 +) +Effect on total of service and interest cost components +1 +( 1 +) +Plan Assets +Arconic’s pension plans’ investment policy and weighted average asset allocations at December 31, 2019 and 2018 , by asset class, were as follows: +Plan assets +at +December 31, +Asset class +Policy range +2019 +2018 +Equities +20–55% +31 +% +29 +% +Fixed income +25–55% +50 +48 +Other investments +15–35% +19 +23 +Total +100 +% +100 +% +The principal objectives underlying the investment of the pension plans’ assets are to ensure that Arconic can properly fund benefit obligations as they become due under a broad range of potential economic and financial scenarios, maximize the long-term investment return with an acceptable level of risk based on such obligations, and broadly diversify investments across and within various asset classes to protect asset values against adverse movements. Specific objectives for long-term investment strategy include reducing the volatility of pension assets relative to pension liabilities and achieving diversification across the balance of the asset portfolio. The use of derivative instruments is permitted where appropriate and necessary for achieving overall investment policy objectives. The investment strategy uses long duration cash bonds and derivative instruments to offset a portion of the interest rate sensitivity of U.S. pension liabilities. Exposure to broad equity risk is decreased and diversified through investments in discretionary and systematic macro hedge funds, long/short equity hedge funds, high yield bonds, emerging market debt and global and emerging market equities. Investments are further diversified by strategy, asset class, geography, and sector to enhance returns and mitigate downside risk. A large number of external investment managers are used to gain broad exposure to the financial markets and to mitigate manager-concentration risk. +Investment practices comply with the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and other applicable laws and regulations. +The following section describes the valuation methodologies used to measure the fair value of pension plan assets, including an indication of the level in the fair value hierarchy in which each type of asset is generally classified (see Note Q for the definition of fair value and a description of the fair value hierarchy). +Equities. These securities consist of: (i) direct investments in the stock of publicly traded U.S. and non-U.S. companies, and equity derivatives, that are valued based on the closing price reported in an active market on which the individual securities are traded (generally classified in Level 1); (ii) the plans’ share of commingled funds that are invested in the stock of publicly traded companies and are valued at the net asset value of shares held at December 31 (included in Level 1); and (iii) direct investments in long/short equity hedge funds and private equity (limited partnerships and venture capital partnerships) that are valued at net asset value. +Fixed income. These securities consist of: (i) U.S. government debt that are generally valued using quoted prices (included in Level 1); (ii) cash and cash equivalents invested in publicly-traded funds and are valued based on the closing price reported in an active market on which the individual securities are traded (generally classified in Level 1); (iii) publicly traded U.S. and non-U.S. fixed interest obligations (principally corporate bonds and debentures) and are valued through consultation and evaluation with brokers in the institutional market using quoted prices and other observable market data (included in Level 2); +80 +Table of Contents +(iv) fixed income derivatives that are generally valued using industry standard models with market-based observable inputs (included in Level 2); and (v) cash and cash equivalents invested in institutional funds and are valued at net asset value. +Other investments. These investments include, among others: (i) exchange traded funds, such as gold, and real estate investment trusts and are valued based on the closing price reported in an active market on which the investments are traded (included in Level 1) and (ii) direct investments of discretionary and systematic macro hedge funds and private real estate (includes limited partnerships) and are valued at net asset value. +The fair value methods described above may not be indicative of net realizable value or reflective of future fair values. Additionally, while Arconic believes the valuation methods used by the plans’ trustees are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. +The following table presents the fair value of pension plan assets classified under the appropriate level of the fair value hierarchy or net asset cost: +December 31, 2019 +Level 1 +Level 2 +Net asset value +Total +Equities: +Equity securities +$ +590 +$ +— +$ +508 +$ +1,098 +Long/short equity hedge funds +— +— +260 +260 +Private equity +— +— +155 +155 +$ +590 +$ +— +$ +923 +$ +1,513 +Fixed income: +Intermediate and long duration government/credit +$ +121 +$ +1,047 +$ +1,003 +$ +2,171 +Other +126 +7 +144 +277 +$ +247 +$ +1,054 +$ +1,147 +$ +2,448 +Other investments: +Real estate +$ +104 +$ +— +$ +165 +$ +269 +Discretionary and systematic macro hedge funds +— +— +405 +405 +Other +— +— +240 +240 +$ +104 +$ +— +$ +810 +$ +914 +Net plan assets (1) +$ +941 +$ +1,054 +$ +2,880 +$ +4,875 +December 31, 2018 +Level 1 +Level 2 +Net Asset Value +Total +Equities +Equity securities +$ +318 +$ +— +$ +578 +$ +896 +Long/short equity hedge funds +— +— +232 +232 +Private equity +— +— +147 +147 +$ +318 +$ +— +$ +957 +$ +1,275 +Fixed income: +Intermediate and long duration government/credit +$ +200 +$ +934 +$ +770 +$ +1,904 +Other +9 +9 +152 +170 +$ +209 +$ +943 +$ +922 +$ +2,074 +Other investments: +Real estate +$ +81 +$ +— +$ +164 +$ +245 +Discretionary and systematic macro hedge funds +— +— +471 +471 +Other +56 +— +212 +268 +$ +137 +$ +— +$ +847 +$ +984 +Net plan assets (2) +$ +664 +$ +943 +$ +2,726 +$ +4,333 +(1) +As of December 31, 2019 , the total fair value of pension plans’ assets excludes a net payable of $ 7 , which represents securities purchased and sold but not yet settled plus interest and dividends earned on various investments. +(2) +As of December 31, 2018 , the total fair value of pension plans’ assets excludes a net receivable of $ 1 , which represents securities purchased and sold but not yet settled plus interest and dividends earned on various investments. +81 +Table of Contents +Funding and Cash Flows +It is Arconic’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Arconic contributes additional amounts as deemed appropriate. In 2019 and 2018 , cash contributions to Arconic’s pension plans were $ 268 and $ 298 , respectively. The $ 268 includes $ 53 contributed to the Company’s U.S. plans that was in excess of the minimum required under ERISA. +The contribution to the Company’s pension plans in 2020 is estimated to be $ 475 (of which $ 403 is for U.S. plans). The minimum required is $ 415 , along with approximately $ 60 of contributions related to actions designed to reduce future obligations. +During the third quarter of 2016, the Pension Benefit Guaranty Corporation approved management’s plan to separate the Alcoa Inc. pension plans between Arconic Inc. and Alcoa Corporation. The plan stipulated that Arconic make cash contributions of $ 150 over a period of 30 months (from November 1, 2016) to its two largest pension plans. The Company satisfied the requirements of the plan by making payments of $ 34 , $ 66 , and $ 50 in April 2019, March 2018, and April 2017, respectively. +Benefit payments expected to be paid to pension and other postretirement benefit plans’ participants and expected Medicare Part D subsidy receipts are as follows utilizing the current assumptions outlined above: +For the year ended December 31, +Pension +benefits paid +Gross Other post- +retirement +benefits +Medicare Part D +subsidy receipts +Net Other post- +retirement +benefits +2020 +$ +470 +$ +80 +$ +5 +$ +75 +2021 +465 +80 +5 +75 +2022 +460 +80 +5 +75 +2023 +455 +80 +5 +75 +2024 +450 +75 +5 +70 +Thereafter +2,120 +260 +25 +235 +$ +4,420 +$ +655 +$ +50 +$ +605 +Defined Contribution Plans +Arconic sponsors savings and investment plans in various countries, primarily in the United States. Arconic’s contributions and expenses related to these plans were $ 125 , $ 123 , and $ 89 in 2019 , 2018 , and 2017 , respectively. In the United States, employees may contribute a portion of their compensation to the plans, and Arconic matches a portion of these contributions in equivalent form of the investments elected by the employee. +G. Income Taxes +The components of income from continuing operations before income taxes were as follows: +For the year ended December 31, +2019 +2018 +2017 +United States +$ +275 +$ +518 +$ +500 +Foreign +300 +350 +( 30 +) +$ +575 +$ +868 +$ +470 +82 +Table of Contents +The provision for income taxes consisted of the following: +For the year ended December 31, +2019 +2018 +2017 +Current: +Federal (1) +$ +4 +$ +45 +$ +— +Foreign +108 +138 +98 +State and local +5 +4 +( 2 +) +117 +187 +96 +Deferred: +Federal +65 +146 +489 +Foreign +( 53 +) +( 94 +) +37 +State and local +( 24 +) +( 13 +) +( 78 +) +( 12 +) +39 +448 +Total +$ +105 +$ +226 +$ +544 +(1) +Includes U.S. taxes related to foreign income +A reconciliation of the U.S. federal statutory rate to Arconic’s effective tax rate was as follows (the effective tax rate for all periods was a provision on income): +For the year ended December 31, +2019 +2018 +2017 +U.S. federal statutory rate +21.0 +% +21.0 +% +35.0 +% +Foreign tax rate differential +2.6 +2.4 +( 8.7 +) +U.S. and residual tax on foreign earnings +6.0 +1.6 +( 0.1 +) +U.S. State and local taxes +2.5 +1.5 +0.7 +Federal benefit of state tax +0.4 +( 0.3 +) +3.7 +Permanent differences related to asset disposals and items included in restructuring and other charges (1) +( 22.9 +) +( 16.9 +) +( 167.4 +) +Non-deductible transaction costs +1.6 +— +0.3 +Non-deductible officer compensation +1.8 +0.1 +— +Statutory tax rate and law changes (2) +( 0.2 +) +6.5 +52.5 +Tax holidays +( 3.2 +) +( 1.6 +) +( 3.0 +) +Changes in valuation allowances (3) +( 14.2 +) +0.9 +137.9 +Impairment of goodwill +— +— +53.5 +Changes in uncertain tax positions +6.1 +12.8 +10.1 +Prior year tax adjustments (4) +15.2 +( 2.6 +) +( 0.9 +) +Other +1.6 +0.6 +2.1 +Effective tax rate +18.3 +% +26.0 +% +115.7 +% +(1) +In 2019, a net tax benefit was recognized related to a U.S. tax election which caused the deemed liquidation of a foreign subsidiary's assets into its U.S. tax parent. The benefit is partially offset by an increase in uncertain tax positions. Losses reported in Spain's 2017 tax return related to the Separation of Alcoa are offset by an increased valuation allowance. +(2) +In 2018, the Company finalized its accounting for the Tax Cuts and Jobs Act of 2017 ("the 2017 Act”) and recorded an additional $ 59 charge. In December 2017, an estimated $ 272 tax charge was recorded with respect to the enactment of the 2017 Act. +(3) +In 2019, the Company released a valuation allowance related to 2015 and 2016 foreign tax credits, subsequent to filing U.S. amended tax returns to deduct, rather than credit, foreign taxes. +(4) +In 2019, the Company filed U.S. amended tax returns to deduct, rather than credit, 2015 and 2016 foreign taxes resulting in a tax cost associated with the write-off of the deferred tax asset for the credit, partially offset by a tax benefit for the deduction. +83 +Table of Contents +On December 22, 2017, the 2017 Act was signed into law, making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the non-previously taxed post-1986 foreign earnings and profits of certain U.S.-owned foreign corporations as of December 31, 2017. Also on December 22, 2017, Staff Accounting Bulletin No. 118 ("SAB 118"), Income Tax Accounting Implications of the Tax Cuts and Jobs Act, was issued by the SEC to address the application of U.S. GAAP for financial reporting. SAB 118 permitted the use of provisional amounts based on reasonable estimates in the financial statements. SAB 118 also provided that the tax impact may be considered incomplete in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the 2017 Act. +The Company calculated a reasonable estimate of the impact of the 2017 Act’s tax rate reduction and one-time transition tax in its 2017 year end income tax provision in accordance with its understanding of the 2017 Act and guidance available and, as a result, recorded a $ 272 tax charge in the fourth quarter of 2017, the period in which the legislation was enacted. +In 2018, the Company included a $ 59 tax charge in income from continuing operations as a result of finalizing its accounting for the 2017 Tax Act in accordance with SAB 118. This charge primarily related to a $ 16 charge for the one-time transition tax and a $ 43 charge to update deferred tax balances. +The components of net deferred tax assets and liabilities were as follows: +2019 +2018 +December 31, +Deferred +tax +assets +Deferred +tax +liabilities +Deferred +tax +assets +Deferred +tax +liabilities +Depreciation +$ +25 +$ +729 +$ +38 +$ +694 +Employee benefits +887 +16 +836 +27 +Loss provisions +92 +— +94 +— +Deferred income/expense +96 +943 +22 +1,102 +Interest +56 +— +— +— +Tax loss carryforwards +2,932 +— +3,159 +— +Tax credit carryforwards +379 +— +579 +— +Other +52 +16 +94 +20 +$ +4,519 +$ +1,704 +$ +4,822 +$ +1,843 +Valuation allowance +( 2,256 +) +— +( 2,486 +) +— +$ +2,263 +$ +1,704 +$ +2,336 +$ +1,843 +The following table details the expiration periods of the deferred tax assets presented above: +December 31, 2019 +Expires +within +10 years +Expires +within +11-20 years +No +expiration (1) +Other (2) +Total +Tax loss carryforwards +$ +452 +$ +235 +$ +2,245 +$ +— +$ +2,932 +Tax credit carryforwards +300 +69 +10 +— +379 +Other +— +— +120 +1,088 +1,208 +Valuation allowance +( 711 +) +( 176 +) +( 1,306 +) +( 63 +) +( 2,256 +) +$ +41 +$ +128 +$ +1,069 +$ +1,025 +$ +2,263 +(1) +Deferred tax assets with no expiration may still have annual limitations on utilization. +(2) +Other represents deferred tax assets whose expiration is dependent upon the reversal of the underlying temporary difference. A substantial amount of Other relates to employee benefits that will become deductible for tax purposes over an extended period of time as contributions are made to employee benefit plans and payments are made to retirees. +The total deferred tax asset (net of valuation allowance) is supported by projections of future taxable income exclusive of reversing temporary differences ( 27 % ) and taxable temporary differences that reverse within the carryforward period ( 73 % ). +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not (greater than 50% ) that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of +84 +Table of Contents +taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Arconic’s foreign tax credits in the United States have a 10-year carryforward period with expirations ranging from 2020 to 2028 (as of December 31, 2019). Valuation allowances were initially established in prior years on a portion of the foreign tax credit carryforwards, primarily due to insufficient foreign source income to allow for full utilization of the credits within the expiration period. After consideration of all available evidence including potential tax planning strategies, incremental valuation allowances of $ 46 and $ 9 were recognized in 2018 and 2017, respectively. No additional valuation allowance was recorded in 2019 as the Company intends to deduct, rather than credit, foreign taxes. Foreign tax credits of $ 88 , $ 8 , and $ 57 expired at the end of 2019, 2018, and 2017, respectively, resulting in a corresponding decrease to the valuation allowance. The valuation allowance was also reduced by $ 113 as a result of Arconic deducting foreign taxes that were previously claimed as a U.S. foreign tax credit. At December 31, 2019, the cumulative amount of the valuation allowance was $ 216 . The need for this valuation allowance will be reassessed on a continuous basis in future periods and, as a result, the allowance may increase or decrease based on changes in facts and circumstances. +Arconic also recorded a valuation allowance of $ 10 related to capital losses and capital investments in 2019. Capital losses can only offset capital gain income. Arconic does not have sufficient sources of capital gain income to support the utilization of these losses and investments. The need for valuation allowances against capital losses and investments will be reassessed on a continuing basis. +Arconic released $ 13 and $ 10 of certain U.S. state valuation allowances in 2019 and 2018, respectively. After weighing all available positive and negative evidence, the Company determined that the underlying net deferred tax assets were more likely than not realizable based on projected taxable income estimates. Valuation allowances of $ 672 remain against other net state deferred tax assets expected to expire before utilization. The need for valuation allowances against net state deferred tax assets will be reassessed on a continuous basis in future periods and, as a result, the allowance may increase or decrease based on changes in facts and circumstances. +In 2018, Arconic reduced a valuation allowance by $ 92 as a result of increasing a tax reserve for unrecognized tax benefits in Spain. The valuation allowance reduction was partially offset by a $ 20 charge with respect to losses no longer supported by reversing temporary differences. Arconic also recorded an additional valuation allowance of $ 61 and $ 675 in 2018 and 2017, respectively, which offsets a deferred tax asset recorded for additional losses reported on the Spanish tax return related to the Separation of Alcoa that are not more likely than not to be realized. +85 +Table of Contents +The following table details the changes in the valuation allowance: +December 31, +2019 +2018 +2017 +Balance at beginning of year +$ +2,486 +$ +2,584 +$ +1,940 +Increase to allowance +37 +136 +831 +Release of allowance +( 222 +) +( 154 +) +( 246 +) +Acquisitions and divestitures +( 2 +) +— +( 1 +) +Tax apportionment, tax rate and tax law changes +( 13 +) +( 14 +) +( 24 +) +Foreign currency translation +( 30 +) +( 66 +) +84 +Balance at end of year +$ +2,256 +$ +2,486 +$ +2,584 +As a result of the 2017 Act, the non-previously taxed post-1986 foreign earnings and profits (calculated based on U.S. tax principles) of certain U.S.-owned foreign corporations has been subject to U.S. tax under the one-time transition tax provisions. The 2017 Act also created a new requirement that certain income earned by foreign subsidiaries, GILTI, must be included in the gross income of the U.S. shareholder. The 2017 Act also established the Base Erosion and Anti-Abuse Tax (BEAT). In the first quarter of 2018, Arconic made a final accounting policy election to treat taxes due from future inclusions in U.S. taxable income related to GILTI as a current period expense when incurred. Arconic has estimated a GILTI inclusion for 2019 and 2018 and recorded tax expense accordingly. Arconic does not anticipate being subject to BEAT for 2019 and 2018. +Foreign U.S. GAAP earnings that have not otherwise been subject to U.S. tax, will generally be exempt from future U.S. tax under the 2017 Act when distributed. Such distributions, as well as distributions of previously taxed foreign earnings, could potentially be subject to U.S. state tax in certain states, and foreign withholding taxes. Foreign currency gains/losses related to the translation of previously taxed earnings from functional currency to U.S. dollars could also be subject to U.S. tax when distributed. At this time, Arconic has no plans to distribute such earnings in the foreseeable future. If such earnings were to be distributed, Arconic would expect the potential U.S. state tax and withholding tax impacts to be immaterial and the potential deferred tax liability associated with future foreign currency gains to be impracticable to determine. +Arconic and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. With a few minor exceptions, Arconic is no longer subject to income tax examinations by tax authorities for years prior to 2006. All U.S. tax years prior to 2019 have been audited by the Internal Revenue Service. Various state and foreign jurisdiction tax authorities are in the process of examining Arconic’s income tax returns for various tax years through 2018. +A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest and penalties) was as follows: +December 31, +2019 +2018 +2017 +Balance at beginning of year +$ +166 +$ +73 +$ +28 +Additions for tax positions of the current year +34 +— +23 +Additions for tax positions of prior years +3 +143 +27 +Reductions for tax positions of prior years +— +( 42 +) +— +Settlements with tax authorities +— +— +— +Expiration of the statute of limitations +( 2 +) +( 6 +) +( 5 +) +Foreign currency translation +( 4 +) +( 2 +) +— +Balance at end of year +$ +197 +$ +166 +$ +73 +For all periods presented, a portion of the balance pertains to state tax liabilities, which are presented before any offset for federal tax benefits. The effect of unrecognized tax benefits, if recorded, that would impact the annual effective tax rate for 2019, 2018, and 2017 would be approximately 13 % , 5 % , and 15 % , respectively, of pre-tax book income. Arconic does not anticipate that changes in its unrecognized tax benefits will have a material impact on the Statement of Consolidated Operations during 2020. +It is Arconic’s policy to recognize interest and penalties related to income taxes as a component of the Provision for income taxes on the accompanying Statement of Consolidated Operations. Arconic recognized interest of $ 6 , $ 22 and $ 1 for 2019, 2018, and 2017, respectively. Due to the expiration of the statute of limitations, settlements with tax authorities, and refunded overpayments, Arconic recognized interest income of $ 0 , $ 1 , and $ 2 in 2019, 2018, and 2017, respectively. As of December 31, 2019 , 2018 , and 2017, the amount accrued for the payment of interest and penalties was $ 23 , $ 21 , and $ 2 , respectively. +86 +Table of Contents +H. Preferred and Common Stock +Preferred Stock. Arconic has two classes of preferred stock: Class A Preferred Stock and Class B Serial Preferred Stock. Class A Preferred Stock has 660,000 shares authorized at a par value of $ 100 per share with an annual $ 3.75 cumulative dividend preference per share. There were 546,024 shares of Class A Preferred Stock outstanding at December 31, 2019 and 2018 . Class B Serial Preferred Stock has 10,000,000 shares authorized at a par value of $ 1 per share. There were no shares of Class B Serial Preferred Stock outstanding at December 31, 2019 and 2018 (see below). +In September 2014, Arconic completed a public offering under its shelf registration statement for $ 1,250 of 25 million depositary shares, each of which represented a 1/10th interest in a share of Arconic’s 5.375 % Class B Mandatory Convertible Preferred Stock, Series 1, par value $ 1 per share, liquidation preference $ 500 per share (the “Mandatory Convertible Preferred Stock”). The 25 million depositary shares were equivalent to 2.5 million shares of Mandatory Convertible Preferred Stock. Each depositary share entitled the holder, through the depositary, to a proportional fractional interest in the rights and preferences of a share of Mandatory Convertible Preferred Stock, including conversion, dividend, liquidation, and voting rights, subject to terms of the deposit agreement. Arconic received $ 1,213 in net proceeds from the public offering reflecting an underwriting discount. The net proceeds were used, together with the net proceeds of issued debt, to finance the cash portion of the acquisition of Firth Rixson. The underwriting discount was recorded as a decrease to Additional capital. The Mandatory Convertible Preferred Stock constituted a series of Arconic’s Class B Serial Preferred Stock, which ranks senior to Arconic’s common stock and junior to Arconic’s Class A Preferred Stock and existing and future indebtedness. Holders of the Mandatory Convertible Preferred Stock generally had no voting rights. +Dividends on the Mandatory Convertible Preferred Stock were cumulative in nature and paid at the rate of $ 26.8750 per annum per share in 2016 and 2015, which commenced January 1, 2015 (paid on December 30, 2014). +On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction. Dividends on the Mandatory Convertible Preferred Stock were paid at the rate of $ 20.1563 per share in 2017. +Common Stock. At December 31, 2019 , there were 600,000,000 shares authorized and 432,855,183 shares issued and outstanding. Dividends paid of $ 0.12 per annum ( $ 0.06 dividend in the first quarter of 2019 and $ 0.02 per quarter for the remainder of the year) in 2019 and $ 0.24 per annum or $ 0.06 per quarter in 2018 and 2017 . +As of December 31, 2019 , 47 million shares of common stock were reserved for issuance under Arconic’s stock-based compensation plans. As of December 31, 2019 , 37 million shares remain available for issuance. Arconic issues new shares to satisfy the exercise of stock options and the conversion of stock awards. +In July 2015, through the acquisition of RTI International Metals Inc. (RTI), Arconic assumed the obligation to repay two tranches of convertible debt; one tranche was due and settled in cash on December 1, 2015 (principal amount of $ 115 ) and the other tranche was due on October 15, 2019 (principal amount of $ 403 ), unless earlier converted or purchased by Arconic at the holder’s option under specific conditions. No shares of the Company’s common stock were issued in connection with the maturity or final conversion of this convertible debt. See Note P for additional details. +Share Activity (number of shares) +Common stock +Treasury +Outstanding +Balance at end of 2016 +— +438,519,780 +Conversion of convertible notes +— +39,242,706 +Issued for stock-based compensation plans +— +3,654,051 +Balance at end of 2017 +— +481,416,537 +Issued for stock-based compensation plans +— +1,854,180 +Balance at end of 2018 +— +483,270,717 +Issued for stock-based compensation plans +— +4,436,830 +Repurchase and retirement of common stock +— +( 54,852,364 +) +Balance at end of 2019 +— +432,855,183 +On February 19, 2019, the Company entered into an accelerated share repurchase (ASR) agreement with JPMorgan Chase Bank to repurchase $ 700 of its common stock (the “February 2019 ASR”), pursuant to the share repurchase programs +87 +Table of Contents +previously authorized by its Board of Directors (the Board). Under the February 2019 ASR, Arconic received an initial delivery of shares on February 21, 2019 and additional shares on April 29, 2019. On May 2, 2019, the Company entered into an ASR agreement with JPMorgan Chase Bank to repurchase $ 200 of its common stock (the “May 2019 ASR”), pursuant to the share repurchase programs previously authorized by its Board. Under the May 2019 ASR, Arconic received an initial delivery of shares on May 6, 2019 and additional shares on June 12, 2019. On May 14, 2019, the Board authorized an additional share repurchase program of up to $ 500 of its outstanding common stock. On August 6, 2019, the Company entered into an ASR agreement with Goldman Sachs & Co. LLC to repurchase $ 200 of its common stock (the “August 2019 ASR”), pursuant to the share repurchase programs previously authorized by its Board. Under the August 2019 ASR, Arconic received an initial delivery of shares on August 8, 2019 and additional shares on October 3, 2019. On November 14, 2019, the Company entered into an agreement with Citigroup Global Markets Inc. to repurchase $ 50 of its common stock (the “November 2019 share repurchase program”), pursuant to the share repurchase programs previously authorized by its Board. All of the shares repurchased during 2019 were immediately retired. After giving effect to the February 2019 ASR, May 2019 ASR, August 2019 ASR, and November 2019 share repurchase program, $ 350 remains available under the prior authorizations by the Board for share repurchases through the end of 2020. +The following table provides details for the share repurchases during 2019. +Share delivery date +Number of shares +Average price +Total +February 21, 2019 +31,908,831 +April 29, 2019 +4,525,592 +February 2019 ASR total +36,434,423 +$ 19.21 +$ 700 +May 6, 2019 +7,455,732 +June 12, 2019 +1,561,249 +May 2019 ASR total +9,016,981 +$ 22.18 +$ 200 +August 8, 2019 +6,791,172 +October 3, 2019 +983,107 +August 2019 ASR total +7,774,279 +$ 25.73 +$ 200 +November 18, 2019 +428,000 +November 19, 2019 +428,000 +November 20, 2019 +370,000 +November 21, 2019 +400,681 +November 2019 share repurchase program +1,626,681 +$ 30.74 +$ 50 +2019 Share repurchase total +54,852,364 +$ 20.97 +$ 1,150 +Stock-Based Compensation +Arconic has a stock-based compensation plan under which stock options and/or restricted stock unit awards are granted in the first quarter of each year to eligible employees. Stock options are granted at the closing market price of Arconic’s common stock on the date of grant and typically vest over a three -year service period (1/3 each year) with a ten -year contractual term. Restricted stock unit awards typically vest over a three -year service period from the date of grant. As part of Arconic’s stock-based compensation plan design, individuals who are retirement-eligible have a six-month requisite service period in the year of grant. Certain of the restricted stock unit awards include performance and market conditions and are granted to a limited number of eligible employees. In 2019, performance stock awards were granted to the CEO that vest either based on achievement of the planned Separation of Arconic (see Note U for further details) or the achievement of certain stock price thresholds. Performance stock awards granted in the first quarter of 2019 were converted to restricted stock unit awards (at target), in order to address the planned Separation of Arconic. For performance stock awards issued in 2018 and 2017 , the final number of shares earned will be based on Arconic’s achievement of sales and profitability targets over the respective performance periods and will be earned at the end of the third year. Additionally, the 2018 and 2017 performance stock awards will be scaled by a total shareholder return (“TSR”) multiplier, which depends upon relative performance against the TSRs of a group of peer companies. +In conjunction with their employment agreements, certain current and former executives were granted cash bonus awards based on the achievement of certain stock price thresholds. These awards are liability classified and were marked-to-market each +88 +Table of Contents +quarter using a Monte Carlo simulation. At the end of the year, the stock price thresholds have been fully reached. The cash payment of $ 23 will occur in 2021 in accordance with the terms of the agreements. +In 2019 , 2018 , and 2017 , Arconic recognized stock-based compensation expense of $ 78 ( $ 70 after-tax), $ 50 ( $ 39 after-tax), and $ 54 ( $ 36 after-tax), respectively. Cash bonus awards of $ 21 were recorded in 2019. Of the remaining stock-based compensation expense in 2019, more than 95 % relates to restricted stock unit awards. The expense related to restricted stock unit awards in 2018 and 2017 was approximately 85 % . No stock-based compensation expense was capitalized in any of those years. Stock-based compensation expense was reduced by $ 3 and $ 13 in 2019 and 2017, respectively, for certain executive pre-vest cancellations which were recorded in Restructuring and other charges within the Statement of Consolidated Operations. At December 31, 2019 , there was $ 50 (pre-tax) of unrecognized compensation expense related to non-vested stock option grants and non-vested restricted stock unit award grants. This expense is expected to be recognized over a weighted average period of 1.3 years. +Stock-based compensation expense is based on the grant date fair value of the applicable equity grant. For restricted stock unit awards, the fair value was equivalent to the closing market price of Arconic’s common stock on the date of grant. The weighted average grant date fair value of the 2019 performance stock awards with a market condition (achievement of certain stock price thresholds) was $ 11.93 . The grant date fair value of the 2018 performance stock awards containing a market condition (scaled by TSR multiplier) was $ 20.25 . The 2019 and 2018 performance awards were valued using a Monte Carlo model. A Monte Carlo simulation uses assumptions of stock price behavior to estimate the probability of satisfying market conditions and the resulting fair value of the award. The risk-free interest rate ( 1.6 % in 2019 and 2.7 % in 2018 ) was based on a yield curve of interest rates at the time of the grant based on the remaining performance period. In 2019 volatility was estimated using implied and historical volatility ( 33.4 % ). Because of limited historical information due to the Separation of Alcoa, 2018 volatility ( 32.0 % ) was estimated using implied volatility, and the representative price return approach, which uses price returns of comparable companies, was used to develop a correlation assumption. For stock options, the fair value was estimated on the date of grant using a lattice-pricing model, which generated a result of $ 9.79 and $ 6.26 per option in 2018 and 2017 , respectively. There were no stock options issued in 2019. The lattice-pricing model uses a number of assumptions to estimate the fair value of a stock option, including a risk-free interest rate, dividend yield, volatility, exercise behavior, and contractual life. The following paragraph describes in detail the assumptions used to estimate the fair value of stock options granted in 2018 (the assumptions used to estimate the fair value of stock options granted in 2017 were not materially different, except as noted below). +The risk-free interest rate ( 2.5 % ) was based on a yield curve of interest rates at the time of the grant based on the contractual life of the option. The dividend yield ( 0.9 % ) was based on a one-year average. Volatility ( 34.0 % for 2018 and 38.1 % in 2017 ) was based on comparable companies and implied volatilities over the term of the option. Arconic utilized historical option forfeiture data to estimate annual post-vesting forfeitures ( 6 % ). Exercise behavior ( 61 % ) was based on a weighted average exercise ratio (exercise patterns for grants issued over the number of years in the contractual option term) of an option’s intrinsic value resulting from historical employee exercise behavior. Based upon the other assumptions used in the determination of the fair value, the life of an option ( 6.0 years ) was an output of the lattice-pricing model. The activity for stock options and stock awards during 2019 was as follows (options and awards in millions): +Stock options +Stock awards +Number of +options +Weighted +average +exercise price +Number of +awards +Weighted +average FMV +per award +Outstanding, December 31, 2018 +10 +$ +24.95 +7 +$ +21.13 +Granted +— +— +4 +19.80 +Exercised +( 2 +) +21.34 +— +— +Converted +— +— +( 3 +) +15.78 +Expired or forfeited +( 1 +) +28.37 +( 1 +) +22.10 +Performance share adjustment +— +— +— +19.96 +Outstanding, December 31, 2019 +7 +$ +25.75 +7 +$ +22.05 +As of December 31, 2019 , the number of stock options outstanding had a weighted average remaining contractual life of 3.4 years and a total intrinsic value of $ 40 . Additionally, 5.9 million of the stock options outstanding were fully vested and exercisable and had a weighted average remaining contractual life of 3.0 years, a weighted average exercise price of $ 25.80 , and a total intrinsic value of $ 36 as of December 31, 2019 . In 2019 , 2018 , and 2017 , the cash received from stock option exercises was $ 56 , $ 16 , and $ 50 and the total tax benefit realized from these exercises was $ 4 , $ 2 , and $ 4 , respectively. The total intrinsic value of stock options exercised during 2019 , 2018 , and 2017 was $ 17 , $ 7 , and $ 13 , respectively. +89 +Table of Contents +I. Earnings Per Share +Basic earnings per share (EPS) amounts are computed by dividing earnings (loss), after the deduction of preferred stock dividends declared, by the average number of common shares outstanding. Diluted EPS amounts assume the issuance of common stock for all potentially dilutive share equivalents outstanding. +The information used to compute basic and diluted EPS attributable to Arconic common shareholders was as follows (shares in millions): +For the year ended December 31, +2019 +2018 +2017 +Net income (loss) +$ +470 +$ +642 +$ +( 74 +) +Less: preferred stock dividends declared +( 2 +) +( 2 +) +( 53 +) +Net income (loss) available to Arconic common shareholders - basic +468 +640 +( 127 +) +Add: interest expense related to convertible notes +9 +11 +— +Net income (loss) available to Arconic common shareholders - diluted +$ +477 +$ +651 +$ +( 127 +) +Average shares outstanding - basic +446 +483 +451 +Effect of dilutive securities: +Stock options +1 +1 +— +Stock and performance awards +5 +5 +— +Convertible notes (1) +11 +14 +— +Average shares outstanding - diluted +463 +503 +451 +(1) +The convertible notes matured on October 15, 2019 (see Note P ). No shares of the Company’s common stock were issued in connection with the maturity or the final conversion of the convertible notes. As of October 15, 2019, the calculation of average diluted shares outstanding ceased to include the approximately 15 million shares of common stock and the corresponding interest expense previously attributable to the convertible notes. +Common stock outstanding at December 31, 2019 and 2018 was 433 million and 483 million , respectively. The decrease in common stock outstanding at December 31, 2019 was primarily due to the impact of share repurchases of approximately 55 million in 2019 (see Note H ). As average shares outstanding are used in the calculation for both basic and diluted EPS, the full impact of share repurchases was not realized in EPS in 2019 as the share repurchases occurred at varying points during 2019. +The following shares were excluded from the calculation of average shares outstanding – diluted as their effect was anti-dilutive (shares in millions). +2019 +2018 +2017 +Mandatory convertible preferred stock +n/a +n/a +39 +Convertible notes +— +— +14 +Stock options (1) +1 +9 +11 +Stock awards +— +— +7 +(1) +The average exercise price of options per share was $ 35.75 , $ 26.79 , and $ 33.32 for 2019 , 2018 , and 2017 , respectively. +In 2017, had Arconic generated sufficient net income, 30 million , 14 million , 5 million , and 1 million potential shares of common stock related to the mandatory convertible preferred stock, convertible notes, stock awards, and stock options, respectively, would have been included in diluted average shares outstanding. The mandatory convertible preferred stock converted on October 2, 2017 (see Note H ). +90 +Table of Contents +J. Accumulated Other Comprehensive Loss +The following table details the activity of the four components that comprise Accumulated other comprehensive loss for both Arconic’s shareholders and noncontrolling interests: +Arconic +Noncontrolling Interests +2019 +2018 +2017 +2019 +2018 +2017 +Pension and other postretirement benefits ( F ) +Balance at beginning of period +$ +( 2,344 +) +$ +( 2,230 +) +$ +( 2,010 +) +$ +— +$ +— +$ +— +Adoption of accounting standard (A) +— +( 369 +) +— +— +— +— +Other comprehensive (loss) income: +— +Unrecognized net actuarial gain and prior service cost/benefit +( 587 +) +70 +( 466 +) +— +— +— +Tax benefit (expense) +129 +( 19 +) +102 +— +— +— +Total Other comprehensive (loss) income before reclassifications, net of tax +( 458 +) +51 +( 364 +) +— +— +— +Amortization of net actuarial loss and prior service cost (1) +90 +262 +222 +— +— +— +Tax expense (2) +( 20 +) +( 58 +) +( 78 +) +— +— +— +Total amount reclassified from Accumulated other comprehensive loss, net of tax (3) +70 +204 +144 +— +— +— +Total Other comprehensive (loss) income +( 388 +) +255 +( 220 +) +— +— +— +Balance at end of period +$ +( 2,732 +) +$ +( 2,344 +) +$ +( 2,230 +) +$ +— +$ +— +$ +— +Foreign currency translation +Balance at beginning of period +$ +( 583 +) +$ +( 437 +) +$ +( 689 +) +$ +— +$ +— +$ +( 2 +) +Other comprehensive (loss) income (4) +( 13 +) +( 146 +) +252 +— +— +2 +Balance at end of period +$ +( 596 +) +$ +( 583 +) +$ +( 437 +) +$ +— +$ +— +$ +— +Debt securities +Balance at beginning of period +$ +( 3 +) +$ +( 2 +) +$ +132 +$ +— +$ +— +$ +— +Other comprehensive income (loss) (5) +3 +( 1 +) +( 134 +) +— +— +— +Balance at end of period +$ +— +$ +( 3 +) +$ +( 2 +) +$ +— +$ +— +$ +— +Cash flow hedges +Balance at beginning of period +$ +4 +$ +25 +$ +( 1 +) +$ +— +$ +— +$ +— +Adoption of accounting standard ( A ) +( 2 +) +2 +— +— +— +— +Other comprehensive (loss) income: +Net change from periodic revaluations +( 9 +) +( 15 +) +37 +— +— +— +Tax benefit (expense) +3 +3 +( 9 +) +— +— +— +Total Other comprehensive (loss) income before reclassifications, net of tax +( 6 +) +( 12 +) +28 +— +— +— +Net amount reclassified to earnings +Aluminum contracts (6) +5 +( 8 +) +( 2 +) +— +— +— +Interest rate contracts (8) +— +( 2 +) +— +— +— +— +Nickel contracts (7) +( 1 +) +( 4 +) +( 1 +) +— +— +— +Sub-total +4 +( 14 +) +( 3 +) +— +— +— +Tax (expense) benefit (2) +( 1 +) +3 +1 +— +— +— +Total amount reclassified from Accumulated other comprehensive loss, net of tax (3) +3 +( 11 +) +( 2 +) +— +— +— +Total Other comprehensive (loss) income +( 3 +) +( 23 +) +26 +— +— +— +Balance at end of period +$ +( 1 +) +$ +4 +$ +25 +$ +— +$ +— +$ +— +Accumulated other comprehensive loss +$ +( 3,329 +) +$ +( 2,926 +) +$ +( 2,644 +) +$ +— +$ +— +$ +— +(1) +These amounts were recorded in Other expense (income), net (see Note E ). +91 +Table of Contents +(2) +These amounts were included in Provision for income taxes on the accompanying Statement of Consolidated Operations. +(3) +A positive amount indicates a corresponding charge to earnings and a negative amount indicates a corresponding benefit to earnings. +(4) +In all periods presented, no amounts were reclassified to earnings. +(5) +Realized gains and losses were included in Other expense (income), net , on the accompanying Statement of Consolidated Operations. +(6) +These amounts were included in Sales on the accompanying Statement of Consolidated Operations. +(7) +These amounts were included in Cost of goods sold on the accompanying Statement of Consolidated Operations. +(8) +These amounts were included in Interest expense on the accompanying Statement of Consolidated Operations. +K. Receivables +Sale of Receivables Program +Arconic has an arrangement with three financial institutions to sell certain customer receivables without recourse on a revolving basis. The sale of such receivables is completed using a bankruptcy remote special purpose entity, which is a consolidated subsidiary of Arconic. This arrangement provides up to a maximum funding of $ 400 for receivables sold. Arconic maintains a beneficial interest, or a right to collect cash, on the sold receivables that have not been funded (deferred purchase program). On March 30, 2012, Arconic initially sold $ 304 of customer receivables in exchange for $ 50 in cash and $ 254 of deferred purchase program under the arrangement. Arconic has received additional net cash funding of $ 300 ( $ 3,558 in draws and $ 3,258 in repayments) since the program’s inception, including net cash draws totaling $ 0 ( $ 600 in draws and $ 600 in repayments) in 2019 and net cash draws totaling $ 0 ( $ 600 in draws and $ 600 in repayments) in 2018 . +As of December 31, 2019 , and 2018 , the deferred purchase program receivable was $ 246 and $ 234 , respectively, which was included in Other receivables on the accompanying Consolidated Balance Sheet. The deferred purchase program receivable is reduced as collections of the underlying receivables occur; however, as this is a revolving program, the sale of new receivables will result in an increase in the deferred purchase program receivable. The gross amount of receivables sold and total cash collected under this program since its inception was $ 48,383 and $ 47,787 respectively. Arconic services the customer receivables for the financial institutions at market rates; therefore, no servicing asset or liability was recorded. +In 2019 and 2018 , the gross cash outflows and inflows associated with the deferred purchase program receivable were $ 6,599 and $ 6,586 respectively, and $ 6,375 and $ 6,328 , respectively. +Cash receipts from customer payments on sold receivables (which are cash receipts on the underlying trade receivables that have been previously sold in this program) as well as cash receipts and cash disbursements from draws and repayments under the program are presented as cash receipts from sold receivables within investing activities in the Statement of Consolidated Cash Flows. +On January 2, 2020, the Company entered into an amendment to remove subsidiaries of the GRP business from the sale of receivables program in preparation for the planned Separation of Arconic and repurchased the remaining $ 282 unpaid receivables of GRP customers in a non-cash transaction by reducing the amount of the deferred purchase program receivable. +Allowance for Doubtful Accounts +The following table details the changes in the allowance for doubtful accounts related to customer receivables and other receivables: +Customer receivables +Other receivables +2019 +2018 +2017 +2019 +2018 +2017 +Balance at beginning of year +$ +4 +$ +8 +$ +13 +$ +31 +$ +34 +$ +32 +Provision for doubtful accounts +3 +2 +1 +13 +7 +9 +Write off of uncollectible accounts +( 2 +) +( 2 +) +( 5 +) +( 2 +) +( 2 +) +( 1 +) +Recoveries of prior write-offs +— +— +— +( 5 +) +( 3 +) +( 3 +) +Other +( 2 +) +( 4 +) +( 1 +) +( 4 +) +( 5 +) +( 3 +) +Balance at end of year +$ +3 +$ +4 +$ +8 +$ +33 +$ +31 +$ +34 +92 +Table of Contents +L. Inventories +December 31, +2019 +2018 +Finished goods +$ +671 +$ +668 +Work-in-process +1,316 +1,371 +Purchased raw materials +343 +366 +Operating supplies +99 +87 +Total inventories +$ +2,429 +$ +2,492 +At December 31, 2019 and 2018 , the portion of inventories valued on a LIFO basis was $ 1,257 and $ 1,292 , respectively. If valued on an average-cost basis, total inventories would have been $ 445 and $ 530 higher at December 31, 2019 and 2018 , respectively. During 2019 and 2018 , reductions in LIFO inventory quantities caused partial liquidations of the lower cost LIFO inventory base. These liquidations resulted in the recognition of immaterial income amounts in 2019 , 2018 , and 2017 . +In the second quarter of 2018, a charge of $ 23 was recorded in Cost of goods sold and Inventories to reflect a physical inventory adjustment at one plant in the GRP segment (this plant was previously included in the EP&F segment prior to the transfer of the aluminum extrusions operations from the EP&F segment to the GRP segment in the first quarter of 2019 - see Note C). While a portion of this charge relates to prior years, the majority relates to 2018. The out-of-period amounts were not material to any interim or annual periods. +M. Properties, Plants, and Equipment, Net +December 31, +2019 +2018 +Land and land rights +$ +128 +$ +136 +Structures: +Engineered Products and Forgings +812 +769 +Global Rolled Products +1,304 +1,317 +Other +269 +278 +2,385 +2,364 +Machinery and equipment: +Engineered Products and Forgings +3,514 +3,433 +Global Rolled Products +5,401 +5,356 +Other +378 +445 +9,293 +9,234 +11,806 +11,734 +Less: accumulated depreciation and amortization +7,074 +6,769 +4,732 +4,965 +Construction work-in-progress +731 +739 +$ +5,463 +$ +5,704 +During the second quarter of 2019, the Company updated its five-year strategic plan and determined that there was a decline in the forecasted financial performance for the Disks asset group within the EP&F segment. As such, the Company evaluated the recoverability of the Disks asset group long-lived assets by comparing the carrying value to the undiscounted cash flows of the Disks asset group. The carrying value exceeded the undiscounted cash flows and therefore the Disks asset group long-lived assets were deemed to be impaired. The impairment charge was measured as the amount of carrying value in excess of fair value of the long-lived assets, with fair value determined using a DCF model and a combination of sales comparison and cost approach valuation methods including an estimate for economic obsolescence. The impairment charge of $ 428 recorded in the second quarter of 2019 impacted properties, plants, and equipment; intangible assets; and certain other noncurrent assets by $ 198 , $ 197 , and $ 33 , respectively. The impairment charge was recorded in Restructuring and other charges in the Statement of Consolidated Operations in 2019. +During the second quarter of 2018, the Company updated its three-year strategic plan and determined that there was a decline in the forecasted financial performance for the Disks asset group within the EP&F segment. As such, the Company evaluated the recoverability of the long-lived assets by comparing their carrying value of approximately $ 515 to the estimated undiscounted net cash flows of the Disks asset group, resulting in an estimated fair value in excess of their carrying value of +93 +Table of Contents +approximately 13 % ; thus, there was no impairment. There were no indicators of impairment identified for the Disks asset group during the third or fourth quarters of 2018 and, as such, the Company did not evaluate the recoverability of its long-lived assets. +N. Goodwill and Other Intangible Assets +The following table details the changes in the carrying amount of goodwill: +Engineered Products and Forgings +Global Rolled Products +Total +Balances at December 31, 2017 +Goodwill +$ +4,931 +$ +351 +$ +5,282 +Accumulated impairment losses (1) +( 719 +) +( 28 +) +( 747 +) +Goodwill, net +4,212 +323 +4,535 +Acquisitions and Divestitures (F) +( 1 +) +— +( 1 +) +Translation and other +( 25 +) +( 9 +) +( 34 +) +Balances at December 31, 2018 +Goodwill +4,905 +342 +5,247 +Accumulated impairment losses +( 719 +) +( 28 +) +( 747 +) +Goodwill, net +4,186 +314 +4,500 +Divestitures ( T ) +( 13 +) +— +( 13 +) +Translation and other +4 +2 +6 +Transfer from Engineered Structures to Aluminum Extrusions +( 110 +) +110 +— +Balances at December 31, 2019 +Goodwill +4,786 +454 +5,240 +Accumulated impairment losses +( 719 +) +( 28 +) +( 747 +) +Goodwill, net +$ +4,067 +$ +426 +$ +4,493 +(1) +$ 25 of fully impaired goodwill related to Latin America Extrusions has been moved to Corporate. See Note B . +In 2017, Arconic recognized an impairment of goodwill in the amount of $ 719 related to the annual impairment review of the Arconic Forgings and Extrusions business. See Goodwill policy in Note A . +Other intangible assets were as follows: +December 31, 2019 +Gross +carrying +amount +Accumulated +amortization +Intangibles, net +Computer software +$ +744 +$ +( 659 +) +$ +85 +Patents and licenses +95 +( 93 +) +2 +Other intangibles +714 +( 175 +) +539 +Total amortizable intangible assets +1,553 +( 927 +) +626 +Indefinite-lived trade names and trademarks +32 +— +32 +Total other intangible assets +$ +1,585 +$ +( 927 +) +$ +658 +December 31, 2018 +Gross +carrying +amount +Accumulated +amortization +Intangibles, net +Computer software +$ +768 +$ +( 657 +) +$ +111 +Patents and licenses +110 +( 107 +) +3 +Other intangibles +922 +( 149 +) +773 +Total amortizable intangible assets +1,800 +( 913 +) +887 +Indefinite-lived trade names and trademarks +32 +— +32 +Total other intangible assets +$ +1,832 +$ +( 913 +) +$ +919 +94 +Table of Contents +During the second quarter of 2019, the Company recorded a charge of $ 197 for intangible asset impairments associated with the Disks long-lived asset group. See Note M for additional details. +Computer software consists primarily of software costs associated with an enterprise business solution within Arconic to drive common systems among all businesses. +Amortization expense related to the intangible assets in the tables above for the years ended December 31, 2019 , 2018 , and 2017 was $ 70 , $ 81 , and $ 71 , respectively, and is expected to be in the range of approximately $ 50 to $ 60 annually from 2020 to 2024 . +O. Leases +Operating lease cost, which includes short-term leases and variable lease payments and approximates cash paid, was $ 145 , $ 144 , and $ 113 in 2019 , 2018 , and 2017 , respectively. +Operating lease right-of-use assets and lease liabilities in the Consolidated Balance Sheet were as follows: +December 31, 2019 +Right-of-use assets classified in Other noncurrent assets +$ +252 +Current portion of lease liabilities classified in Other current liabilities +71 +Long-term portion of lease liabilities classified in Other noncurrent liabilities and deferred credits +194 +Total lease liabilities +$ +265 +Future minimum contractual operating lease obligations were as follows: +December 31, 2019 +December 31, 2018 +2019 +$ +— +$ +94 +2020 +81 +74 +2021 +62 +54 +2022 +46 +40 +2023 +34 +30 +2024 +24 +— +Thereafter +70 +87 +Total lease payments +$ +317 +$ +379 +Less: Imputed interest +( 52 +) +Present value of lease liabilities +$ +265 +Right-of-use assets obtained in exchange for operating lease obligations in 2019 were $ 41 . The weighted-average remaining lease term and weighted-average discount rate at December 31, 2019 was 6 years and 6.0 % , respectively. +95 +Table of Contents +P. Debt +Long-Term Debt. +December 31, +2019 +2018 +1.63% Convertible Notes, due 2019 +$ +— +$ +403 +6.150% Notes, due 2020 +1,000 +1,000 +5.40% Notes, due 2021 +1,250 +1,250 +5.87% Notes, due 2022 +627 +627 +5.125% Notes, due 2024 +1,250 +1,250 +5.90% Notes, due 2027 +625 +625 +6.75% Bonds, due 2028 +300 +300 +5.95% Notes due 2037 +625 +625 +Iowa Finance Authority Loan, due 2042 (4.75%) +250 +250 +Other (1) +( 18 +) +( 29 +) +5,909 +6,301 +Less: amount due within one year +1,003 +405 +$ +4,906 +$ +5,896 +(1) +Includes various financing arrangements related to subsidiaries, unamortized debt discounts related to outstanding notes and bonds listed in the table above, an equity option related to the convertible notes due in 2019, and unamortized debt issuance costs. +The principal amount of long-term debt maturing in each of the next five years is $ 1,000 in 2020 , $ 1,250 in 2021 , $ 627 in 2022 , $ 0 in 2023 , and $ 1,250 in 2024 . +Public Debt. On October 15, 2019, the 1.63 % Convertible Notes ("the Notes") matured in accordance with their terms and the Company repaid in cash on the maturity date the aggregate outstanding principal amount of the Notes of approximately $ 403 together with accrued and unpaid interest, pursuant to the terms of the Notes. +During the first quarter of 2018, the Company completed the early redemption of its remaining outstanding 5.72 % Notes due in 2019, with aggregate principal amount of $ 500 , for $ 518 in cash including accrued and unpaid interest. As a result, the Company recorded a charge of $ 19 in Interest expense in the accompanying Statement of Consolidated Operations for 2018 primarily for the premium paid on the early redemption of these notes in excess of their carrying value. +During the second quarter of 2017, the Company announced three separate cash tender offers by the Investment Banks for the purchase of the Company’s 6.50 % Bonds due 2018 (the “ 6.50 % Bonds”), 6.75 % Notes due 2018 (the “ 6.75 % Notes”), and 5.72 % Notes due 2019 (the “ 5.72 % Notes”), up to a maximum purchase amount of $ 1,000 aggregate principal amount of notes, subject to certain conditions. The Investment Banks purchased notes totaling $ 805 aggregate principal amount, including $ 150 aggregate principal amount of 6.50 % Bonds, $ 405 aggregate principal amount of 6.75 % Notes, and $ 250 aggregate principal amount of 5.72 % Notes. +Also, during the second quarter of 2017, the Company agreed to acquire the notes from the Investment Banks for $ 409 in cash plus its remaining investment in Alcoa Corporation common stock ( 12,958,767 shares valued at $ 35.91 per share) for total consideration of $ 874 including accrued and unpaid interest. The Company recorded a charge of $ 58 ( $ 27 in cash) primarily for the premium for the early redemption of the notes, a benefit of $ 8 for the proceeds of a related interest rate swap agreement, and a charge of $ 2 for legal fees associated with the transaction in Interest expense, and recorded a gain of $ 167 in Other expense (income), net in the accompanying Statement of Consolidated Operations for the Debt-for-Equity Exchange. +Finally, during the second quarter of 2017, the Company completed the early redemption of its remaining outstanding 6.50 % Bonds, with aggregate principal amount of $ 100 , and its remaining outstanding 6.75 % Notes, with aggregate principal amount of $ 345 , for $ 479 in cash including accrued and unpaid interest. As a result of the early redemption of the 6.50 % Bonds and 6.75 % Notes, the Company recorded a charge of $ 24 in Interest expense in the accompanying Statement of Consolidated Operations for the premium paid for the early redemption of these notes in excess of their carrying value. +The Company has the option to redeem certain of its Notes and Bonds in whole or part, at any time at a redemption price equal to the greater of principal amount or the sum of the present values of the remaining scheduled payments, discounted using a defined treasury rate plus a spread, plus in either case accrued and unpaid interest to the redemption date. +96 +Table of Contents +Credit Facilities. On July 25, 2014, Arconic entered into a Five -Year Revolving Credit Agreement with a syndicate of lenders and issuers named therein, which provides for a senior unsecured revolving credit facility (the “Credit Facility”). By an Extension Request and Amendment Letter dated as of June 5, 2015, the maturity date of the Credit Facility was extended to July 25, 2020. On September 16, 2016, Arconic entered into Amendment No. 1 to the Five -Year Revolving Credit Agreement to permit the Separation of Alcoa and to amend certain terms of the Credit Agreement, including the replacement of the existing financial covenant with a leverage ratio and reduction of total commitments available from $ 4,000 to $ 3,000 . On June 29, 2018, Arconic entered into Amendment No. 2 (“Amendment No. 2”) to amend and restate the Five-Year Revolving Credit Agreement. The Five-Year Revolving Credit Agreement, as so amended and restated, is herein referred to as the “Credit Agreement.” +The Credit Agreement provides a $ 3,000 Credit Facility, the proceeds of which are to be used to provide working capital or for other general corporate purposes of Arconic. Subject to the terms and conditions of the Credit Agreement, Arconic may from time to time request increases in lender commitments under the Credit Facility, not to exceed $ 500 in aggregate principal amount, and may also request the issuance of letters of credit, subject to a letter of credit sublimit of $ 1,000 of the Credit Facility. Pursuant to the Credit Agreement, Arconic shall not permit the ratio of Consolidated Net Debt to Consolidated EBITDA (each as defined in the Credit Agreement) as of the end of each fiscal quarter for the period of the four fiscal quarters most recently ended, to be greater than 4.50 to 1.00, which maximum level will step down successively to 4.00 to 1.00 on December 31, 2018, and to 3.50 to 1.00 on December 31, 2019 and thereafter. +The Credit Agreement includes additional covenants, including, among others, (a) limitations on Arconic’s ability to incur liens securing indebtedness for borrowed money, (b) limitations on Arconic’s ability to consummate a merger, consolidation or sale of all or substantially all of its assets, and (c) limitations on Arconic’s ability to change the nature of its business. As of December 31, 2019 , Arconic was in compliance with all such covenants. +The Credit Facility matures on June 29, 2023, unless extended or earlier terminated in accordance with the provisions of the Credit Agreement. Arconic may make two one -year extension requests during the term of the Credit Facility, subject to the lender consent requirements set forth in the Credit Agreement. Under the provisions of the Credit Agreement, Arconic will pay a fee of 0.25 % per annum (based on Arconic’s current long-term debt ratings) of the total commitment to maintain the Credit Facility. +The Credit Facility is unsecured and amounts payable under it will rank pari passu with all other unsecured, unsubordinated indebtedness of Arconic. Borrowings under the Credit Facility may be denominated in U.S. dollars or euros. Loans will bear interest at a base rate or a rate equal to LIBOR, plus, in each case, an applicable margin based on the credit ratings of Arconic’s outstanding senior unsecured long-term debt. The applicable margin on base rate loans and LIBOR loans will be 0.50 % and 1.50 % per annum, respectively, based on Arconic’s current long-term debt ratings. Loans may be prepaid without premium or penalty, subject to customary breakage costs. +The obligation of Arconic to pay amounts outstanding under the Credit Facility may be accelerated upon the occurrence of an “Event of Default” as defined in the Credit Agreement. Such Events of Default include, among others, (a) non-payment of obligations; (b) breach of any representation or warranty in any material respect; (c) non-performance of covenants and obligations; (d) with respect to other indebtedness in a principal amount in excess of $ 100 million , a default thereunder that causes such indebtedness to become due prior to its stated maturity or a default in the payment at maturity of any principal of such indebtedness; (e) the bankruptcy or insolvency of Arconic; and (f) a change in control of Arconic. +There were no amounts outstanding at December 31, 2019 and 2018 and no amounts were borrowed during 2019 , 2018 , or 2017 under the Credit Facility. +In addition to the Credit Agreement above, Arconic has a number of other credit agreements that provide a combined borrowing capacity of $ 640 as of December 31, 2019 , all of which is due to expire in 2020 . The purpose of any borrowings under these credit arrangements is to provide for working capital requirements and for other general corporate purposes. The covenants contained in all these arrangements are the same as the Credit Agreement. In 2019 , 2018 , and 2017 , Arconic borrowed and repaid $ 400 , $ 600 , and $ 810 , respectively, under the respective credit arrangements. The weighted-average interest rate and weighted-average days outstanding of the respective borrowings during 2019 , 2018 , and 2017 were 3.7 % , 3.3 % , and 2.6 % , respectively, and 49 days, 46 days, and 46 days, respectively. +Short-Term Debt. At December 31, 2019 and 2018 , short-term debt was $ 31 and $ 29 , respectively. These amounts included $ 29 and $ 29 at December 31, 2019 and 2018 , respectively, related to accounts payable settlement arrangements with certain vendors and third-party intermediaries. These arrangements provide that, at the vendor’s request, the third-party intermediary advances the amount of the scheduled payment to the vendor, less an appropriate discount, before the scheduled payment date and Arconic makes payment to the third-party intermediary on the date stipulated in accordance with the commercial terms negotiated with its vendors. Arconic records imputed interest related to these arrangements in Interest expense on the accompanying Statement of Consolidated Operations. +97 +Table of Contents +Commercial Paper. Arconic had no outstanding commercial paper at December 31, 2019 and 2018 . In 2019 , Arconic did not issue commercial paper. In 2018 , the average outstanding commercial paper was $ 49 . Commercial paper matures at various times within one year and had an annual weighted average interest rate of 2.5 % during 2018 . +Q. Other Financial Instruments +Fair Value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (i) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (ii) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below: +• +Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. +• +Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means. +• +Level 3 - Inputs that are both significant to the fair value measurement and unobservable. +The carrying values of Cash and cash equivalents, Restricted cash, Derivatives, Noncurrent receivables, and Short-term debt included in the Consolidated Balance Sheet approximate their fair value. The Company holds exchange-traded fixed income securities which are considered available-for-sale securities that are carried at fair value which is based on quoted market prices which are classified in Level 1 of the fair value hierarchy. The fair value of Long-term debt, less amount due within one year was based on quoted market prices for public debt and on interest rates that are currently available to Arconic for issuance of debt with similar terms and maturities for non-public debt. The fair value amounts for all Long-term debt were classified in Level 2 of the fair value hierarchy. +2019 +2018 +December 31, +Carrying +value +Fair +value +Carrying +value +Fair +value +Long-term debt, less amount due within one year +$ +4,906 +$ +5,337 +$ +5,896 +$ +5,873 +Restricted cash was $ 55 (see Note S ), $ 6 , and $ 4 in 2019 , 2018 , and 2017 , respectively, and was recorded in Prepaid expenses and other current assets on the Consolidated Balance Sheet. +R. Cash Flow Information +Cash paid for interest and income taxes was as follows: +2019 +2018 +2017 +Interest, net of amount capitalized +$ +340 +$ +391 +$ +508 +Income taxes, net of amount refunded +$ +122 +$ +74 +$ +118 +Noncash Financing and Investing Activities. On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction (see Note H ). +In the second quarter of 2017, the Company completed a Debt-for-Equity Exchange with the Investment Banks for the remaining portion of Arconic’s retained interest in Alcoa Corporation common stock for a portion of the Company’s outstanding notes held by the Investment Banks for $ 465 including accrued and unpaid interest (see Note P ). +S. Acquisitions and Divestitures +2019 Divestitures. On May 31, 2019, Arconic sold a small additive manufacturing facility within the EP&F segment for $ 1 in cash, which resulted in a loss of $ 13 recorded in Restructuring and other charges in the Statement of Consolidated Operations. The sale is subject to certain post-closing adjustments. +98 +Table of Contents +On August 15, 2019, Arconic sold inventories and properties, plants, and equipment related to a small energy business within the EP&F segment for $ 13 in cash. Arconic recognized a charge of $ 10 related to inventory impairment and recorded the charge in Cost of goods sold in the Statement of Consolidated Operations. +On October 30, 2019, Arconic reached an agreement to sell its hard alloy extrusions plant in South Korea for $ 61 in cash, subject to working capital and other adjustments. The operating results and assets and liabilities of this plant are included in the GRP segment. The sale transaction is expected to close in the first quarter of 2020, subject to regulatory approvals and customary closing conditions. Arconic expects to recognize a gain of $ 25 to $ 30 upon the sale, which will be recorded in Restructuring and other charges in the Statement of Consolidated Operations. +On December 1, 2019, Arconic completed the sale of its forgings business in the United Kingdom for $ 64 in cash, which resulted in a loss on sale of $ 46 which was recorded in Restructuring and other charges in the Statement of Consolidated Operations. Of the cash proceeds received, $ 53 was recorded as Restricted cash within Prepaid expenses and other current assets on the Consolidated Balance Sheet at December 31, 2019 as its use is subject to restriction by the U.K. pension authority until certain U.K. pension plan changes have been made and approved. The forgings business primarily produces steel, titanium, and nickel based forged components for aerospace, mining, and off-highway markets and its operating results and assets and liabilities are included in the EP&F segment. The sale remains subject to certain post-closing adjustments. This business generated sales of $ 116 , $ 131 , and $ 127 in 2019, 2018, and 2017, and had 540 employees at the time of divestiture. +On February 1, 2020, Arconic sold its aluminum rolling mill in Itapissuma, Brazil for $ 50 in cash, subject to working capital and other adjustments. The rolling mill produces specialty foil and sheet products and its operating results and assets and liabilities were included in the GRP segment. As a result of entering into the agreement to sell in August 2019, Arconic recognized a charge of $ 53 in 2019 related to a non-cash impairment of the net book value of the business, primarily properties, plants, and equipment. This charge was recorded in Restructuring and other charges in the Statement of Consolidated Operations. This business generated sales of $ 143 , $ 179 , and $ 162 in 2019, 2018, and 2017 respectively, and had 513 employees at the time of divestiture. +2018 Divestitures . On April 2, 2018, Arconic completed the sale of the Latin America extrusions business to a subsidiary of Hydro Extruded Solutions AS for $ 2 , following the settlement of post-closing and other adjustments in December 2018. As a result of entering into the agreement to sell the Latin America extrusions business in December 2017, a charge of $ 41 was recognized in Restructuring and other charges in the Statement of Consolidated Operations related to the non-cash impairment of the net book value of the business and an additional charge of $ 2 related to a post-closing adjustment was recorded in 2018. The operating results and assets and liabilities of the business were included in the TCS segment at the time of divestiture, but were transferred to Corporate in connection with a segment change (see Note B ). This business generated sales of $ 25 and $ 115 in 2018 and 2017 and had 612 employees at the time of divestiture. +On July 31, 2018, the Company announced that it had initiated a sale process of BCS, as part of the Company’s then ongoing strategy and portfolio review. In the first quarter of 2019, the Company decided to no longer pursue the sale of BCS. +On October 31, 2018, the Company sold its Texarkana, Texas rolling mill and cast house, which had a combined net book value of $ 63 , to Ta Chen International, Inc. for $ 302 in cash, including the settlement of post-closing adjustments, plus additional contingent consideration of up to $ 50 . The contingent consideration relates to the achievement of various milestones within 36 months of the transaction closing date associated with operationalizing the rolling mill equipment. The operating results and assets and liabilities of the business were included in the GRP segment. The Texarkana rolling mill facility had previously been idle since late 2009. In early 2016, the Company restarted the Texarkana cast house to meet demand for aluminum slab. As part of the agreement, the Company will continue to produce aluminum slab at the facility for a period of 18 months through a lease back of the cast house building and equipment, after which time, Ta Chen may perform toll processing of metal for the Company for a period of six months. The Company will supply Ta Chen with cold-rolled aluminum coil during this 24 -month period. +The sale of the rolling mill and cast house had been accounted for separately. The gain on the sale of the rolling mill of $ 154 , including the fair value of contingent consideration of $ 5 was recorded in the fourth quarter of 2018. In the fourth quarter of 2019, the Company received additional contingent consideration of $ 20 and recorded a gain. These amounts were recorded in Restructuring and other charges in the Statement of Consolidated Operations. The Company continues to reevaluate its estimate of the remaining $ 25 of contingent consideration to which it will be entitled at the end of each reporting period and will recognize any changes thereto in the Statement of Consolidated Operations. +The Company had continuing involvement related to the lease back of the cast house. As a result, in 2018, the Company continued to treat the cast house building and equipment that it sold to Ta Chen as owned and therefore reflected the following balances in its Consolidated Balance Sheet at December 31, 2018: assets of $ 24 in Properties, plants, and equipment, net; cash proceeds of $ 119 in Other noncurrent liabilities and deferred credits (which included a deferred gain of $ 95 ); and a deferred tax asset of $ 22 in Other noncurrent assets. In conjunction with the adoption of the new lease accounting standard (see Note A ), the Company's continuing involvement no longer requires deferral of the recognition of the cast house sale. As such, the cash +99 +Table of Contents +proceeds, fixed assets, and deferred tax asset related to the cast house were reclassified to Retained earnings (accumulated deficit) as a cumulative effect of an accounting change. +On December 31, 2018, as part of the Company’s then ongoing strategy and portfolio review, Arconic completed the sale of its forgings business in Hungary to Angstrom Automotive Group LLC for $ 2 , which resulted in a loss of $ 43 recorded in Restructuring and other charges in the Statement of Consolidated Operations. While owned by Arconic, the operating results and assets and liabilities of the business were included in the EP&F segment. This business generated sales of $ 32 and $ 38 in 2018 and 2017, respectively, and had 180 employees at the time of the divestiture. +2017 Divestitures . In March 2017, Arconic completed the sale of its rolling mill in Italy to Slim Aluminium. While owned by Arconic, the operating results and assets and liabilities of the Fusina, Italy rolling mill were included in the GRP segment. As part of the transaction, Arconic injected $ 10 of cash into the business and provided a third-party guarantee with a fair value of $ 5 related to Slim Aluminium’s environmental remediation. The Company recorded a loss on the sale of $ 60 , which was recorded in Restructuring and other charges on the Statement of Consolidated Operations in 2017. The rolling mill generated sales of approximately $ 54 in 2017 and had approximately 312 employees. +2014 Acquisitions. In November 2014, Arconic acquired Firth Rixson. The purchase price included an earn-out agreement that required Arconic to make earn-out payments up to an aggregate maximum amount of $ 150 through December 31, 2020 upon certain conditions. This earn-out was contingent on the Firth Rixson forgings business in Savannah, Georgia achieving certain identified financial targets through December 31, 2020. During 2016, management determined that payment of the maximum amount was not probable based on the forecasted financial performance of this location. Therefore, the fair value of this liability was reduced by $ 56 with a corresponding credit to Other expense (income), net on the accompanying Statement of Consolidated Operations. During 2017, management determined that payment of the remaining amount of the contingent liability was not probable based on the forecasted financial performance of this location. Therefore, the fair value of this liability was reduced by $ 81 to zero at December 31, 2017 with a corresponding credit to Other expense (income), net on the accompanying Statement of Consolidated Operations. The fair value of this liability has remained at zero at December 31, 2019 and December 31, 2018 based on the forecasted financial performance of this location. +T. Contingencies and Commitments +Contingencies +Environmental Matters. Arconic participates in environmental assessments and cleanups at more than 100 locations. These include owned or operating facilities and adjoining properties, previously owned or operating facilities and adjoining properties, and waste sites, including Superfund (Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)) sites. +A liability is recorded for environmental remediation when a cleanup program becomes probable and the costs can be reasonably estimated. As assessments and cleanups proceed, the liability is adjusted based on progress made in determining the extent of remedial actions and related costs. The liability can change substantially due to factors such as the nature and extent of contamination, changes in remedial requirements, and technological changes, among others. +Arconic’s remediation reserve balance was $ 230 at December 31, 2019 and $ 266 at December 31, 2018 recorded in Other noncurrent liabilities and deferred credits in the Consolidated Balance Sheet (of which $ 94 and $ 81 , respectively, were classified as a current liability), and reflects the most probable costs to remediate identified environmental conditions for which costs can be reasonably estimated. Payments related to remediation expenses applied against the reserve were $ 65 in 2019 and $ 32 in 2018 and included expenditures currently mandated, as well as those not required by any regulatory authority or third party. The higher payments in 2019 compared with 2018 reflect the start of construction related to the Grasse River project. Arconic expects that trend to continue for 2020 as reflected by the increase in the portion of the reserve that is considered a current liability. +Included in annual operating expenses are the recurring costs of managing hazardous substances and environmental programs. These costs are estimated to be approximately 1 % or less of Cost of goods sold. +The following discussion provides details regarding the current status of the most significant remediation reserves related to a current Arconic site. +Massena West, NY— Arconic has an ongoing remediation project related to the Grasse River, which is adjacent to Arconic’s Massena plant site. Many years ago, it was determined that sediments and fish in the river contain varying levels of polychlorinated biphenyls (PCBs). The project, which was selected by the U.S. Environmental Protection Agency (EPA) in a Record of Decision issued in April 2013, is aimed at capping PCB contaminated sediments with concentration in excess of one part per million in the main channel of the river and dredging PCB contaminated sediments in the near-shore areas where total PCBs exceed one part per million. At December 31, 2019 and 2018 , the reserve balances associated with this matter were $ 171 and $ 198 , respectively. In the first quarter of 2019, Arconic received approval from the EPA of its final remedial design which +100 +Table of Contents +is now under construction and is expected to be completed in 2022. During the second quarter of 2019, Arconic recorded a charge of $ 25 due to changes required in the remedial design and post-construction monitoring. As the project proceeds, the liability may be updated due to factors such as changes in remedial requirements, site restoration costs, and ongoing operation and maintenance costs, among others. +Tax. Pursuant to the Tax Matters Agreement, dated as of October 31, 2016, entered into between the Company and Alcoa Corporation in connection with the Separation of Alcoa, the Company shares responsibility with Alcoa Corporation for, and Alcoa Corporation has agreed to partially indemnify the Company with respect to the following matter. +As previously reported, in July 2013, following a Spanish corporate income tax audit covering the 2006 through 2009 tax years, an assessment was received mainly disallowing certain interest deductions claimed by a Spanish consolidated tax group owned by the Company. In August 2013, the Company filed an appeal of this assessment in Spain’s Central Tax Administrative Court, which was denied in January 2015. Arconic filed another appeal in Spain’s National Court in March 2015 which was denied in July 2018. The National Court’s decision requires the assessment for the 2006 through 2009 tax years to be reissued to take into account the outcome of the 2003 to 2005 audit which was closed in 2017. The Company estimates the revised assessment to be $ 172 ( € 154 ), including interest. +In March 2019, the Supreme Court of Spain accepted the Company's petition to review the National Court’s decision, and the Company has filed a formal appeal of the assessment. The Supreme Court is reviewing the assessment on its merits and will render a final decision. In the event the Company receives an unfavorable ruling from the Supreme Court of Spain, a portion of the assessment may be offset with existing net operating losses and tax credits available to the Spanish consolidated tax group, which would be shared between the Company and Alcoa Corporation as provided for in the Tax Matters Agreement. +In the third quarter of 2018, Arconic established an income tax reserve and an indemnification receivable representing Alcoa Corporation’s 49 % share of the liability. As of the end of 2019, the balances of the reserve, including interest, and the receivable are $ 59 million ( € 53 million) and $ 29 million ( € 26 million), respectively. +Additionally, while the tax years 2010 through 2013 are closed to audit, it is possible that the Company may receive assessments for tax years subsequent to 2013. Any potential assessment for an individual tax year is not expected to be material to the Company’s consolidated operations. +Reynobond PE. As previously reported, on June 13, 2017, the Grenfell Tower in London, U.K. caught fire resulting in fatalities, injuries and damage. A French subsidiary of Arconic, Arconic Architectural Products SAS (AAP SAS), supplied a product, Reynobond PE, to its customer, a cladding system fabricator, which used the product as one component of the overall cladding system on Grenfell Tower. The fabricator supplied its portion of the cladding system to the façade installer, who then completed and installed the system under the direction of the general contractor. Neither Arconic nor AAP SAS was involved in the design or installation of the system used at the Grenfell Tower, nor did it have a role in any other aspect of the building’s refurbishment or original design. Regulatory investigations into the overall Grenfell Tower matter are being conducted, including a criminal investigation by the London Metropolitan Police Service (the “Police”), a Public Inquiry by the British government and a consumer protection inquiry by a French public authority. The Public Inquiry was announced by the U.K. Prime Minister on June 15, 2017 and subsequently was authorized to examine the circumstances leading up to and surrounding the Grenfell Tower fire in order to make findings of fact and recommendations to the U.K. Government on matters such as the design, construction and modification of the building, the role of relevant public authorities and contractors, the implications of the fire for the adequacy and enforcement of relevant regulations, arrangements in place for handling emergencies and the handling of concerns from residents, among other things. Hearings for Phase 1 of the Public Inquiry began on May 21, 2018 and concluded on December 12, 2018. Phase 2 hearings of the Public Inquiry began in early 2020, following which a final report will be written and subsequently published. AAP SAS is participating as a Core Participant in the Public Inquiry and is also cooperating with the ongoing parallel investigation by the Police. The Company no longer sells the PE product for architectural use on buildings. Given the preliminary nature of these investigations and the uncertainty of potential future litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Behrens et al. v. Arconic Inc. et al. As previously reported, on June 6, 2019, 247 plaintiffs comprised of survivors and estates of decedents of the Grenfell Tower fire filed a complaint against “Arconic Inc., Alcoa Inc. and Arconic Architectural Products, LLC” (collectively, for purposes of the description of such proceeding, the “Arconic Defendants”), as well as Saint-Gobain Corporation, d/b/a Celotex and Whirlpool Corporation, in the Court of Common Pleas of Philadelphia County. The complaint alleges claims under Pennsylvania state law for products liability and wrongful death related to the fire. In particular, the plaintiffs allege that the Arconic Defendants knowingly supplied a dangerous product (Reynobond PE) for installation on the Grenfell Tower despite knowing that Reynobond PE was unfit for use above a certain height. The Arconic Defendants removed the case to the United States District Court for the Eastern District of Pennsylvania on June 19, 2019. On August 29, 2019, the Arconic Defendants moved to dismiss the complaint on the bases, among other things, that: (i) the case should be heard in the United Kingdom, not the United States; (ii) there is no jurisdiction over necessary parties; and (iii) Pennsylvania products +101 +Table of Contents +liability law does not apply to manufacture and sale of product overseas. On December 23, 2019, the Court issued an order denying the motion to dismiss the complaint on bases (ii) and (iii) and suggesting a procedure for limited discovery followed by further briefing on those subjects. Discovery is ongoing on defendants’ motion to have the case dismissed in favor of a UK forum (forum non conveniens). On January 23, 2020, the Court ordered that the parties complete discovery relating to forum non conveniens by March 16, 2020, and that briefing conclude on April 13, 2020. The Court will hold oral argument on this motion on May 7, 2020. Given the preliminary nature of this matter and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Howard v. Arconic Inc. et al. As previously reported, a purported class action complaint related to the Grenfell Tower fire was filed on August 11, 2017 in the United States District Court for the Western District of Pennsylvania against Arconic Inc. and Klaus Kleinfeld. A related purported class action complaint was filed in the United States District Court for the Western District of Pennsylvania on September 15, 2017, under the caption Sullivan v. Arconic Inc. et al. , against Arconic Inc., three former Arconic executives, several current and former Arconic directors, and banks that acted as underwriters for Arconic’s September 18, 2014 preferred stock offering (the “Preferred Offering”). The plaintiff in Sullivan had previously filed a purported class action against the same defendants on July 18, 2017 in the Southern District of New York and, on August 25, 2017, voluntarily dismissed that action without prejudice. On February 7, 2018, on motion from certain putative class members, the court consolidated Howard and Sullivan , closed Sullivan , and appointed lead plaintiffs in the consolidated case. On April 9, 2018, the lead plaintiffs in the consolidated purported class action filed a consolidated amended complaint. The consolidated amended complaint alleged that the registration statement for the Preferred Offering contained false and misleading statements and omitted to state material information, including by allegedly failing to disclose material uncertainties and trends resulting from sales of Reynobond PE for unsafe uses and by allegedly expressing a belief that appropriate risk management and compliance programs had been adopted while concealing the risks posed by Reynobond PE sales. The consolidated amended complaint also alleged that between November 4, 2013 and June 23, 2017 Arconic and Kleinfeld made false and misleading statements and failed to disclose material information about the Company’s commitment to safety, business and financial prospects, and the risks of the Reynobond PE product, including in Arconic’s Form 10-Ks for the fiscal years ended December 31, 2013, 2014, 2015, and 2016, its Form 10-Qs and quarterly financial press releases from the fourth quarter of 2013 through the first quarter of 2017, its 2013, 2014, 2015, and 2016 Annual Reports, its 2016 Annual Highlights Report, and on its official website. The consolidated amended complaint sought, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. On June 8, 2018, all defendants moved to dismiss the consolidated amended complaint for failure to state a claim. On June 21, 2019, the Court granted the defendants’ motion to dismiss in full, dismissing the consolidated amended complaint in its entirety without prejudice. On July 23, 2019, the lead plaintiffs filed a second amended complaint. The second amended complaint alleges generally the same claims as the consolidated amended complaint with certain additional allegations, as well as claims that the risk factors set forth in the registration statement for the Preferred Offering were inadequate and that certain additional statements in the sources identified above were misleading. The second amended complaint seeks, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. On September 11, 2019, all defendants moved to dismiss the second amended complaint. Plaintiffs’ opposition to that motion was filed by November 1, 2019 and all defendants filed a reply brief on November 26, 2019. Given the preliminary nature of this matter and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Raul v. Albaugh, et al. As previously reported, on June 22, 2018, a derivative complaint was filed nominally on behalf of Arconic by a purported Arconic stockholder against the then members of Arconic’s Board of Directors and Klaus Kleinfeld and Ken Giacobbe, naming Arconic as a nominal defendant, in the United States District Court for the District of Delaware. The complaint raises similar allegations as the consolidated amended complaint and second amended complaint in Howard , as well as allegations that the defendants improperly authorized the sale of Reynobond PE for unsafe uses, and asserts claims under Section 14(a) of the Exchange Act and Delaware state law. On July 13, 2018, the parties filed a stipulation agreeing to stay this case until the final resolution of the Howard case, the Grenfell Tower Public Inquiry in London, and the investigation by the Police and on July 23, 2018, the Court approved the stay. Given the preliminary nature of this matter and the uncertainty of litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +While the Company believes that these cases are without merit and intends to challenge them vigorously, there can be no assurances regarding the ultimate resolution of these matters. +Stockholder Demands. As previously noted, the Board of Directors also received letters, purportedly sent on behalf of stockholders, reciting allegations similar to those made in the federal court lawsuits and demanding that the Board authorize the Company to initiate litigation against members of management, the Board and others. The Board of Directors appointed a Special Litigation Committee of the Board to review, investigate, and make recommendations to the Board regarding the appropriate course of action with respect to these stockholder demand letters. On May 22, 2019, the Special Litigation +102 +Table of Contents +Committee, following completion of its investigation into the claims demanded in the demand letters, recommended to the Board that it reject the demands to authorize commencement of litigation. On May 28, 2019, the Board adopted the Special Litigation Committee’s findings and recommendations and rejected the demands that it authorize commencement of actions to assert the claims set forth in the demand letters. +Other. In addition to the matters discussed above, various other lawsuits, claims, and proceedings have been or may be instituted or asserted against Arconic, including those pertaining to environmental, product liability, safety and health, employment, tax and antitrust matters. While the amounts claimed in these other matters may be substantial, the ultimate liability cannot currently be determined because of the considerable uncertainties that exist. Therefore, it is possible that the Company’s liquidity or results of operations in a period could be materially affected by one or more of these other matters. However, based on facts currently available, management believes that the disposition of these other matters that are pending or asserted will not have a material adverse effect, individually or in the aggregate, on the results of operations, financial position or cash flows of the Company. +Commitments +Purchase Obligations. Arconic has entered into purchase commitments for raw materials, energy and other goods and services, which total $ 604 in 2020 , $ 93 in 2021 , $ 45 in 2022 , $ 12 in 2023 , $ 4 in 2024 , and $ 2 thereafter. +Operating Leases. See Note O for the operating lease future minimum contractual obligations. +Guarantees. At December 31, 2019 , Arconic had outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2020 and 2040 was $ 31 at December 31, 2019 . +Pursuant to the Separation and Distribution Agreement between Arconic and Alcoa Corporation, Arconic was required to provide certain guarantees for Alcoa Corporation, which had a combined fair value of $ 9 and $ 6 at December 31, 2019 and 2018 , respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. Furthermore, Arconic was required to provide guarantees related to two long-term supply agreements for energy for Alcoa Corporation facilities in the event of an Alcoa Corporation payment default. In October 2017, Alcoa Corporation announced that it had terminated one of the two agreements, the electricity contract with Luminant Generation Company LLC that was tied to its Rockdale Operations, effective as of October 1, 2017. As a result of the termination of the Rockdale electricity contract, Arconic recorded income of $ 25 in the fourth quarter of 2017 associated with reversing the fair value of the electricity contract guarantee. For the remaining long-term supply agreement, Arconic is required to provide a guarantee up to an estimated present value amount of approximately $ 1,353 and $ 1,087 at December 31, 2019 and December 31, 2018 , respectively, in the event of an Alcoa Corporation payment default. This guarantee expires in 2047 . For this guarantee, subject to its provisions, Arconic is secondarily liable in the event of a payment default by Alcoa Corporation. Arconic currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote. In December 2019, Arconic entered into a one-year insurance policy with a limit of $ 80 relating to the remaining long-term energy supply agreement. The premium is expected to be paid by Alcoa Corporation. The decision to enter into a claims purchase agreement or insurance policy will be made on an annual basis going forward. +Letters of Credit. Arconic has outstanding letters of credit, primarily related to workers’ compensation, environmental obligations and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2020 , was $ 142 at December 31, 2019 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to retain letters of credit of $ 52 that had previously been provided related to both Arconic and Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016. Alcoa Corporation workers’ compensation claims and letter of credit fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation. +Surety Bonds. Arconic has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire at various dates, primarily in 2020 , was $ 50 at December 31, 2019 . +Pursuant to the Separation and Distribution Agreement, Arconic was required to provide surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016 and, as a result, Arconic has $ 24 in outstanding surety bonds relating to these liabilities. Alcoa Corporation workers’ compensation claims and surety bond fees paid by Arconic are being proportionately billed to and that portion billed is being fully reimbursed by Alcoa Corporation. +103 +Table of Contents +U. Separation Transactions +2019 Proposed Separation Transaction. On February 8, 2019, Arconic announced, as part of its strategy and portfolio review, a separation of its portfolio into two independent, publicly-traded companies (the "Separation of Arconic"). The EP&F segment will remain in the existing company (Remain Co.) which will be renamed Howmet Aerospace Inc. at separation. The GRP segment will comprise Spin Co. and will be named Arconic Corporation at separation. The Company has also executed on the sale of businesses that do not best fit into the EP&F and GRP segments. The Company is targeting to complete the Separation of Arconic on April 1, 2020. The Separation of Arconic remains subject to the satisfaction of certain conditions and may change if certain conditions are not satisfied by that date, as described in Arconic Rolled Products Corporation’s (“Arconic Corporation”) information statement filed with the Form 10. +On February 5, 2020, Arconic’s Board of Directors approved the completion of the separation by means of a pro rata distribution (the “Distribution”) by the Company of all of the outstanding common stock of Arconic Corporation. To consummate the separation and the Distribution, the Board declared a pro rata distribution of Arconic Corporation common stock, which is expected to be effective at 12:01 a.m. Eastern Time on April 1, 2020, to Company stockholders of record as of the close of business on March 19, 2020 (the “Record Date”). In the Distribution, each Company stockholder will receive one share of Arconic Corporation common stock for every four shares of the Company’s common stock held as of the close of business on the Record Date. Stockholders will receive cash in lieu of fractional shares of Arconic Corporation common stock. +Timothy D. Myers will serve as Arconic Corporation Chief Executive Officer. Arconic’s Board of Directors has also named new directors to the Arconic Corporation and Howmet Aerospace Boards. Joining the Arconic Corporation Board of Directors will be: Timothy Myers; William Austen; Christopher Ayers; Margaret Billson; Austin Camporin; Jacques Croisetiere; Elmer Doty; Carol Eicher; Fritz Henderson; E. Stanley O’Neal; and Jeffrey Stafeil. Christopher Ayers, Elmer Doty and Stanley O’Neal will resign from the Arconic Inc. Board of Directors. Joining the Howmet Aerospace Board of Directors will be: Joseph Cantie; Robert Leduc; Jody Miller; and Nicole Piasecki. +On February 7, 2020, the Company announced that Arconic Rolled Products Corporation (the “Issuer”), which is currently a wholly-owned subsidiary of Arconic, closed its offering of $ 600 aggregate principal amount of 6.125 % second-lien notes due 2028 (the “Notes”). The Issuer intends to use the proceeds from the offering to make a payment to Arconic to fund the transfer of certain assets from Arconic to the Issuer in connection with the Separation of Arconic and for general corporate purposes. The net proceeds from the offering will be held in escrow until the completion of the separation and the satisfaction of certain other escrow release conditions. Prior to the separation, the Notes will not be guaranteed. Following the separation, the Notes will be guaranteed by certain of the Issuer’s wholly-owned domestic subsidiaries. Each of the Notes and the related guarantees will be secured on a second-priority basis by liens on certain assets of the Issuer and the guarantors. +On February 13, 2020, the Form 10 for Arconic Rolled Products Corporation was declared effective by the SEC. +In 2019 , Arconic recognized $ 78 in Selling, general administrative, and other expenses on the accompanying Statement of Consolidated Operations for costs related to the Separation of Arconic. +2016 Separation Transaction. The separation of Alcoa Inc. into two standalone, publicly-traded companies, Arconic Inc. (the new name for Alcoa Inc.) and Alcoa Corporation, became effective on November 1, 2016 (the “Separation of Alcoa”). As part of the Separation of Alcoa, Arconic retained 19.9 % of the Alcoa Corporation common stock ( 36,311,767 shares). In February 2017, Arconic sold 23,353,000 of its shares of Alcoa Corporation common stock at $ 38.03 per share, which resulted in cash proceeds of $ 888 which were recorded in Sales of investments within Investing Activities in the accompanying Statement of Consolidated Cash Flows, and a gain of $ 351 which was recorded in Other expense (income), net in the accompanying Statement of Consolidated Operations. In April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 Alcoa Corporation shares (valued at $ 35.91 per share) (the “Debt-for-Equity Exchange”) (See Note P ). A gain of $ 167 on the Debt-for-Equity Exchange was recorded in Other expense (income), net in the accompanying Statement of Consolidated Operations. As of May 4, 2017, the Company no longer maintained a retained interest in Alcoa Corporation common stock. +As part of the Separation of Alcoa, Arconic was required to provide maximum potential future payment guarantees for Alcoa Corporation issued on behalf of a third party, guarantees related to two long-term Alcoa Corporation energy supply agreements, guarantees related to certain Alcoa Corporation environmental liabilities and energy supply contracts, letters of credit and surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016, and letters of credit for certain Alcoa Corporation equipment leases and energy contracts (see Note T ). +As part of the Separation of Alcoa, Arconic received proceeds of $ 243 in 2017 related to Alcoa Corporation’s sale of its Yadkin Hydroelectric Project, which were included in Other within Investing Activities in the Statement of Consolidated Cash Flows. +During 2017, Arconic recognized $ 18 ( $ 12 after-tax) in Selling, general administrative, and other expenses on the accompanying Statement of Consolidated Operations for costs related to the Separation of Alcoa. +104 +Table of Contents +V. Subsequent Events +Management evaluated all activity of Arconic and concluded that no subsequent events have occurred that would require recognition in the Consolidated Financial Statements or disclosure in the Notes to the Consolidated Financial Statements, except as noted below: +See Note K for details of an amendment to remove GRP from the sale of receivables program. +See Note S for details of the divestiture of the Company's aluminum rolling mill in Itapissuma, Brazil. +See Note U for updates on the planned Separation of Arconic. +On February 25, 2020, the Company announced that its current Chief Executive Officer, John C. Plant, and Tolga Oal, who currently serves as President of the Company’s Engineered Structures business unit, will serve as Co-Chief Executive Officers of the Company following the Separation of Arconic. Until the Separation of Arconic, Mr. Plant will continue to serve as sole Chief Executive Officer of the Company and Mr. Oal will hold the title of Co-Chief Executive Officer Designate. Mr. Plant will serve as Executive Chairman of the Board of Directors of Howmet Aerospace following the Separation of Arconic. +105 +Table of Contents +Supplemental Financial Information (unaudited) +Quarterly Data +(in millions, except per-share amounts) +First +Second (2) +Third +Fourth (3) +Year +2019 +Sales +$ +3,541 +$ +3,691 +$ +3,559 +$ +3,401 +$ +14,192 +Net income (loss) +$ +187 +$ +( 121 +) +$ +95 +$ +309 +$ +470 +Earnings (loss) per share attributable to Arconic common shareholders (1) : +Basic +Net income (loss) per share—basic +$ +0.40 +$ +( 0.27 +) +$ +0.22 +$ +0.71 +$ +1.05 +Diluted +Net income (loss) per share—diluted +$ +0.39 +$ +( 0.27 +) +$ +0.21 +$ +0.70 +$ +1.03 +2018 +Sales +$ +3,445 +$ +3,573 +$ +3,524 +$ +3,472 +$ +14,014 +Net income +$ +143 +$ +120 +$ +161 +$ +218 +$ +642 +Earnings per share attributable to Arconic common shareholders (1) : +Basic +Net income per share—basic +$ +0.30 +$ +0.25 +$ +0.33 +$ +0.45 +$ +1.33 +Diluted +Net income per share—basic +$ +0.29 +$ +0.24 +$ +0.32 +$ +0.44 +$ +1.30 +(1) +Per share amounts are calculated independently for each period presented; therefore, the sum of the quarterly per share amounts may not equal the per share amounts for the year. +(2) +In the second quarter of 2019, the Company recorded an impairment charge of $ 428 related to its disks business (see Note M ). +(3) +In the fourth quarter of 2019, the Company incurred costs associated with the planned Separation of Arconic of $ 28 ( $ 34 pre-tax), recorded a gain for contingent consideration received related to the 2018 sale of the Texarkana rolling mill of $ 15 ( $ 20 pre-tax), and recorded several discrete tax items principally related to a benefit for a U.S. tax election which caused the deemed liquidation of a foreign subsidiary’s assets into its U.S. tax parent. In the fourth quarter of 2018, Arconic recorded a gain of $ 119 ( $ 154 pre-tax) on the sale of the Texarkana rolling mill, offset by pension plan settlement charges of $ 72 ($ 92 pre-tax) associated with significant lump sum payments made to participants and a loss of $ 39 ($ 43 pre-tax) on the sale of the forging business in Hungary. Additionally, Arconic recorded discrete tax items primarily comprised of a benefit related to certain prior year foreign investment losses no longer recapturable. +106 +Table of Contents +Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. +None. +Item 9A. Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures +Arconic’s Chief Executive Officer and Chief Financial Officer have evaluated the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as of the end of the period covered by this report, and they have concluded that these controls and procedures are effective. +(b) Management’s Annual Report on Internal Control over Financial Reporting +Management’s Report on Internal Control over Financial Reporting is included in Part II, Item 8 of this Form 10-K beginning on page 53 . +(c) Attestation Report of the Registered Public Accounting Firm +The effectiveness of Arconic’s internal control over financial reporting as of December 31, 2019 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included in Part II, Item 8 of this Form 10-K on page 54 . +(d) Changes in Internal Control over Financial Reporting +There have been no changes in internal control over financial reporting during the fourth quarter of 2019 , that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +Item 9B. Other Information. +None. +PART III +Item 10. Directors, Executive Officers and Corporate Governance. +The information required by Item 401 of Regulation S-K regarding directors is contained under the caption “Item 1 Election of Directors” of the Proxy Statement and is incorporated by reference. The information required by Item 401 of Regulation S-K regarding executive officers is set forth in Part I, Item 1 of this report under “Executive Officers of the Registrant.” +The information required by Item 405 of Regulation S-K is contained under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement and is incorporated by reference. +The Company’s Code of Ethics for the CEO, CFO and Other Financial Professionals is publicly available on the Company’s Internet website at http://www.arconic.com under the section “Investors—Corporate Governance.” The remaining information required by Item 406 of Regulation S-K is contained under the captions “Corporate Governance” and “Corporate Governance—Business Conduct Policies and Code of Ethics” of the Proxy Statement and is incorporated by reference. +The information required by Items 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is included under the captions “Item 1 Election of Directors—Nominating Board Candidates—Procedures and Director Qualifications” and “Corporate Governance—Committees of the Board—Audit Committee” of the Proxy Statement and is incorporated by reference. +Item 11. Executive Compensation. +The information required by Item 402 of Regulation S-K is contained under the captions “Director Compensation”, “Executive Compensation” and “Corporate Governance—Recovery of Incentive Compensation” of the Proxy Statement. Such information is incorporated by reference. +The information required by Items 407(e)(4) and (e)(5) of Regulation S-K is contained under the captions “Corporate Governance—Compensation Committee Interlocks and Insider Participation” and “Item 3 Advisory Approval of Executive Compensation—Compensation Committee Report” of the Proxy Statement. Such information (other than the Compensation Committee Report, which shall not be deemed to be “filed”) is incorporated by reference. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by Item 201(d) of Regulation S-K relating to securities authorized for issuance under equity compensation plans is contained under the caption “Equity Compensation Plan Information” of the Proxy Statement and is +107 +Table of Contents +incorporated by reference. +The information required by Item 403 of Regulation S-K is contained under the captions “Arconic Stock Ownership— Stock Ownership of Certain Beneficial Owners” and “— Stock Ownership of Directors and Executive Officers” of the Proxy Statement and is incorporated by reference. +Item 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by Item 404 of Regulation S-K is contained under the captions “Executive Compensation” (excluding the information under the caption “Compensation Committee Report”) and “Corporate Governance— Related Person Transactions” of the Proxy Statement and is incorporated by reference. +The information required by Item 407(a) of Regulation S-K regarding director independence is contained under the captions “Item 1 Election of Directors” and “Corporate Governance” of the Proxy Statement and is incorporated by reference. +Item 14. Principal Accounting Fees and Services. +The information required by Item 9(e) of Schedule 14A is contained under the captions “Item 2 Ratification of Appointment of Independent Registered Public Accounting Firm—Report of the Audit Committee” and “— Audit and Non-Audit Fees” of the Proxy Statement and in Attachment A (Pre-Approval Policies and Procedures for Audit and Non-Audit Services) thereto and is incorporated by reference. +PART IV +Item 15. Exhibits, Financial Statement Schedules. +(a) The consolidated financial statements and exhibits listed below are filed as part of this report. +(1) The Company’s consolidated financial statements, the notes thereto and the report of the Independent Registered Public Accounting Firm are on pages 54 through 106 of this report. +(2) Financial statement schedules have been omitted because they are not applicable, not required, or the required information is included in the consolidated financial statements or notes thereto. +(3) Exhibits. +Exhibit +Number +Description* +2(a) +Share Purchase Agreement, dated as of June 25, 2014, by and among Alcoa Inc., Alcoa IH Limited, FR Acquisition Corporation (US), Inc., FR Acquisitions Corporation (Europe) Limited, FR Acquisition Finance Subco (Luxembourg), S.à.r.l. and Oak Hill Capital Partners III, L.P. and Oak Hill Capital Management Partners III, L.P., collectively in their capacity as the Seller Representative, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated June 27, 2014. +2(b) +Separation and Distribution Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(c) +Tax Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(d) +Employee Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(d)(1) +Amendment No. 1, dated December 13, 2016, to Employee Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2(e)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +108 +Table of Contents +2(e) +Alcoa Corporation to Arconic Inc. Patent, Know-How, and Trade Secret License Agreement, dated as of October 31, 2016, by and between Alcoa USA Corp. and Arconic Inc., incorporated by reference to exhibit 2.5 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(f) +Arconic Inc. to Alcoa Corporation Patent, Know-How, and Trade Secret License Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa USA Corp., incorporated by reference to exhibit 2.6 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(g) +Amended and Restated Alcoa Corporation to Arconic Inc. Trademark License Agreement, dated as of June 25, 2017, by and between Alcoa USA Corp. and Arconic Inc., incorporated by reference to exhibit 2 to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2017. +2(h) +Master Agreement for the Supply of Primary Aluminum, dated as of October 31, 2016, by and between Alcoa Corporation and its affiliates and Arconic Inc., incorporated by reference to exhibit 2.9 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(i) +Massena Lease and Operations Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.10 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(j) +Agreement and Plan of Merger, dated October 12, 2017, by and between Arconic Inc., a Pennsylvania corporation, and Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +3(a) +Certificate of Incorporation of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 3.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +3(a)(1) +Amendment to Arconic Inc. Certificate of Incorporation, effective as of the Separation of Arconic, incorporated by reference to exhibit 3.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 6, 2020. +3(b) +Bylaws of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 3.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +3(b)(1) +Amendment to Arconic Inc. Bylaws, effective as of the Separation of Arconic, incorporated by reference to exhibit 3.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 6, 2020. +4(a) +Form of Certificate for Shares of Common Stock of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 4.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(b) +Bylaws. See exhibits 3(b) and 3(b)(1) above. +4(c) +Form of Indenture, dated as of September 30, 1993, between Alcoa Inc. and The Bank of New York Trust Company, N.A., as successor to J. P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association), as successor Trustee to PNC Bank, National Association, as Trustee (undated form of Indenture incorporated by reference to exhibit 4(a) to Registration Statement No. 33-49997 on Form S-3). +4(c)(1) +First Supplemental Indenture, dated as of January 25, 2007, between Alcoa Inc. and The Bank of New York Trust Company, N.A., as successor to J.P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association), as successor Trustee to PNC Bank, National Association, as Trustee, incorporated by reference to exhibit 99.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2007. +4(c)(2) +Second Supplemental Indenture, dated as of July 15, 2008, between Alcoa Inc. and The Bank of New York Mellon Trust Company, N.A., as successor in interest to J. P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association, as successor to PNC Bank, National Association), as Trustee, incorporated by reference to exhibit 4(c) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 15, 2008. +109 +Table of Contents +4(c)(3) +Fourth Supplemental Indenture, dated as of December 31, 2017, between Arconic Inc., a Pennsylvania corporation, Arconic Inc., a Delaware corporation, and The Bank of New York Mellon Trust Company, N.A., as trustee, incorporated by reference to exhibit 4.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(d) +Form of 6.75% Bonds Due 2028, incorporated by reference to exhibit 4(d) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +4(e) +Form of 5.90% Notes Due 2027, incorporated by reference to exhibit 4(e) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +4(f) +Form of 5.95% Notes Due 2037, incorporated by reference to exhibit 4(f) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +4(g) +Form of 5.87% Notes Due 2022, incorporated by reference to exhibit 4.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 21, 2007. +4(h) +Form of 6.150% Notes Due 2020, incorporated by reference to exhibit 4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated August 3, 2010. +4(i) +Form of 5.40% Notes Due 2021, incorporated by reference to exhibit 4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated April 21, 2011. +4(j) +Form of 5.125% Notes Due 2024, incorporated by reference to exhibit 4.5 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 22, 2014. +4(k) +Arconic Bargaining Retirement Savings Plan (formerly known as the Alcoa Retirement Savings Plan for Bargaining Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(l) +Arconic Salaried Retirement Savings Plan (formerly known as the Alcoa Retirement Savings Plan for Salaried Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(s) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(m) +Arconic Retirement Savings Plan for ATEP Bargaining Employees, effective January 1, 2017, incorporated by reference to exhibit 4 to Post-Effective Amendment, dated December 30, 2016, to Registration Statement No. 333-32516 on Form S-8. +4(n) +Arconic Corp. Hourly 401(k) Plan, effective as of February 1, 2020, incorporated by reference to exhibit 4(a) to Post-Effective Amendment dated February 3, 2020, to Registration Statement No. 333-32516 on Form S-8. +4(o) +Arconic Corp. Salaried 401(k) Plan, effective as of February 1, 2020, incorporated by reference to exhibit 4(b) to Post-Effective Amendment dated February 3, 2020, to Registration Statement No. 333-32516 on Form S-8. +4(p) +Description of Arconic Inc.'s Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934. +4(q) +Indenture, dated February 7, 2020, among Arconic Rolled Products Corporation, the guarantors from time to time party thereto, U.S. Bank National Association, as trustee, U.S. Bank National Association, as collateral agent, and U.S. Bank National Association, as registrar, paying agent and authenticating agent, incorporated by reference to exhibit 99.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 7, 2020. +10(a) +Earnout Agreement, dated as of June 25, 2014, by and among Alcoa Inc., FR Acquisition Finance Subco (Luxembourg), S.à.r.l. and Oak Hill Capital Partners III, L.P. and Oak Hill Capital Management Partners III, L.P., collectively in their capacity as the Seller Representative, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated June 27, 2014. +10(b) +Five-Year Revolving Credit Agreement, dated as of July 25, 2014, among Alcoa Inc., the Lenders and Issuers named therein, Citibank, N.A., as Administrative Agent for the Lenders and Issuers, and JPMorgan Chase Bank, N.A., as Syndication Agent, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 31, 2014. +110 +Table of Contents +10(b)(1) +Extension Request and Amendment Letter, dated as of June 5, 2015, among Alcoa Inc., each lender and issuer party thereto, and Citibank, N.A., as Administrative Agent, effective July 7, 2015, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 13, 2015. +10(b)(2) +Amendment No. 1, dated September 16, 2016, to the Five-Year Revolving Credit Agreement dated as of July 25, 2014, among Arconic Inc., the lenders and issuers named therein, Citibank, N.A., as administrative agent, and JPMorgan Chase Bank, N.A. as syndication agent, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 19, 2016. +10(b)(3) +Assumption Agreement, dated as of December 31, 2017, by Arconic Inc., a Delaware corporation, in favor of and for the benefit of the Lenders and Citibank, N.A., as administrative agent, incorporated by reference to exhibit 4.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +10(b)(4) +Amendment No. 2, dated as of June 29, 2018, to the Company’s Five-Year Revolving Credit Agreement dated as of July 25, 2014, by and among the Company, a syndicate of lenders and issuers named therein, Citibank, N.A., as administrative agent for the lenders and issuers, and JPMorgan Chase Bank, N.A., as syndication agent, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated July 2, 2018. +10(c) +Plea Agreement dated January 8, 2014, between the United States of America and Alcoa World Alumina LLC, incorporated by reference to exhibit 10(l) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2013. +10(d) +Agreement, dated February 1, 2016, by and between Elliott Associates, L.P., Elliott International, L.P., Elliott International Capital Advisors Inc. and Alcoa Inc., incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 1, 2016. +10(e) +Settlement Agreement, dated as of May 22, 2017, by and among Elliott Associates, L.P., Elliott International, L.P., Elliott International Capital Advisors Inc. and Arconic Inc., incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 22, 2017 (reporting an event on May 21, 2017). +10(f) +Letter Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of December 19, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 19, 2017. +10(g) +Registration Rights Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of December 19, 2017, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 19, 2017. +10(g)(1) +Amendment to Registration Rights Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of February 2, 2018, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 6, 2018. +10(h) +Arconic Inc. 2020 Annual Cash Incentive Plan, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 10, 2019 . +10(i) +Arconic Employees’ Excess Benefits Plan C (formerly referred to as the Alcoa Inc. Employees’ Excess Benefits Plan, Plan C), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(j) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(i)(1) +First Amendment to Arconic Employees’ Excess Benefits Plan C (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(l)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(i)(2) +Second Amendment to Arconic Employees’ Excess Benefits Plan C (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(l)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +111 +Table of Contents +10(i)(3) +Third Amendment to Arconic Employees’ Excess Benefits Plan C (as amended and restated effective August 1, 2016), incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 8, 2018. +10(j) +Deferred Fee Plan for Directors, as amended effective July 9, 1999, incorporated by reference to exhibit 10(g)(1) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 1999. +10(k) +Amended and Restated Deferred Fee Plan for Directors, effective November 1, 2016, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2016. +10(l) +Non-Employee Director Compensation Policy, effective February 6, 2019, incorporated by reference to exhibit 10(m) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2018. +10(m) +Fee Continuation Plan for Non-Employee Directors, incorporated by reference to exhibit 10(k) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1989. +10(m)(1) +Amendment to Fee Continuation Plan for Non-Employee Directors, effective November 10, 1995, incorporated by reference to exhibit 10(i)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1995. +10(m)(2) +Second Amendment to the Fee Continuation Plan for Non-Employee Directors, effective September 15, 2006, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 20, 2006. +10(n) +Arconic Deferred Compensation Plan, as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(n)(1) +First Amendment to the Arconic Deferred Compensation Plan (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(r)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(o) +Summary of the Executive Split Dollar Life Insurance Plan, dated November 1990, incorporated by reference to exhibit 10(m) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1990. +10(p) +Amended and Restated Dividend Equivalent Compensation Plan, effective January 1, 1997, incorporated by reference to exhibit 10(h) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2004. +10(q) +Form of Indemnity Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10(j) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1987.) +10(r) +Form of Indemnification Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2018. +10(s) +Amended and Restated 2009 Alcoa Stock Incentive Plan, dated February 15, 2011, incorporated by reference to exhibit 10(z)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2010. +10(t) +Arconic Supplemental Pension Plan for Senior Executives (formerly referred to as the Alcoa Supplemental Pension Plan for Senior Executives), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(v) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(t)(1) +First Amendment to Arconic Supplemental Pension Plan for Senior Executives (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(x)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +112 +Table of Contents +10(t)(2) +Second Amendment to Arconic Supplemental Pension Plan for Senior Executives (as amended and restated effective August 1, 2016), effective January 1, 2018, incorporated by reference to exhibit 10(x)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(u) +Deferred Fee Estate Enhancement Plan for Directors, effective July 10, 1998, incorporated by reference to exhibit 10(r) to the Company’s Annual Report on Form 10-K (Commission file number 1- 3610) for the year ended December 31, 1998. +10(v) +Arconic Inc. Change in Control Severance Plan, as amended and restated, effective May 14, 2019, incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K dated May 17, 2019 . +10(w) +Letter Agreement, dated August 14, 2007, between Alcoa Inc. and Klaus Kleinfeld, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2007. +10(x) +Executive Severance Agreement, as amended and restated effective December 8, 2008, between Alcoa Inc. and Klaus Kleinfeld, incorporated by reference to exhibit 10(gg) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +10(x)(1) +Letter Agreement between Arconic Inc. and Klaus Kleinfeld, dated February 27, 2017, incorporated by reference to exhibit 10(y)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(y) +Separation Agreement between Arconic Inc. and Klaus Kleinfeld, dated July 31, 2017, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2017. +10(z) +Form of Executive Severance Agreement between the Company and new officers entered into after July 22, 2010, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2010. +10(aa) +Arconic Inc. Executive Severance Plan, as amended and restated, effective May 14, 2019, incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K dated May 17, 2019. +10(bb) +Letter Agreement, by and between Alcoa Inc. and Katherine H. Ramundo, dated as of July 28, 2016, incorporated by reference to exhibit 10(ff) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(cc) +Letter Agreement, from Arconic Inc. to Katherine H. Ramundo, dated as of May 31, 2018, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(dd) +Letter Agreement between Arconic Inc. and David P. Hess, dated May 17, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 22, 2017 (reporting an event on May 17, 2017). +10(ee) +Letter Agreement, by and between Arconic Inc. and Charles P. Blankenship, dated as of October 19, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated October 23, 2017 +10(ff) +Separation Agreement between Arconic Inc. and Charles P. Blankenship, dated as of March 14, 2019, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated March 18, 2019. +10(gg) +Letter Agreement, by and between Arconic Inc. and Mark J. Krakowiak, dated as of January 20, 2018, incorporated by reference to exhibit 10(ii) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(hh) +Letter Agreement, from Arconic Inc. to Ken Giacobbe, dated as of February 14, 2019, incorporated by reference to exhibit 10(hh) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2018. +113 +Table of Contents +10(ii) +Letter Agreement, by and between Arconic Inc. and John C. Plant, dated as of February 6, 2019, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10(jj) +Letter Agreement, by and between Arconic Inc. and John C. Plant, dated as of August 1, 2019, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated August 2, 2019. +10(kk) +Letter Agreement, by and between Arconic Inc. and John C. Plant, dated as of February 24, 2020, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 25, 2020. +10(ll) +Letter Agreement, by and between Arconic Inc. and Elmer L. Doty, dated as of February 6, 2019, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10(mm) +Letter Agreement, by and between Arconic Inc. and Neil E. Marchuk, dated as of February 13, 2019, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10(nn) +Letter Agreement between Arconic Inc. and Timothy D. Myers, dated as of January 13, 2020, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 17, 2020. +10(oo) +Letter Agreement between Arconic Inc. and Tolga Oal, dated as of January 24, 2020, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2020. +10(pp) +Arconic Global Pension Plan, as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(bb) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(qq) +Global Expatriate Employee Policy (pre-January 1, 2003), incorporated by reference to exhibit 10(uu) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2005. +10(rr) +Arconic Inc. Legal Fee Reimbursement Plan, effective as of April 30, 2018, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2018. +10(ss) +Summary Description of Equity Choice Program for Performance Equity Award Participants, dated November 2005, incorporated by reference to exhibit 10.6 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 16, 2005. +10(tt) +2013 Arconic Stock Incentive Plan, as Amended and Restated, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated May 17, 2019 . +10(tt)(1) +Terms and Conditions (Australian Addendum) to the 2013 Arconic Stock Incentive Plan, effective May 3, 2013, incorporated by reference to exhibit 10(d) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 8, 2013. +10(uu) +RTI International Metals, Inc. 2004 Stock Plan, incorporated by reference to exhibit 4(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +10(vv) +RTI International Metals, Inc. 2014 Stock and Incentive Plan, incorporated by reference to exhibit 4(a) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +10(vv)(1) +First Amendment to the RTI International Metals, Inc. 2014 Stock and Incentive Plan, as amended and assumed by Arconic Inc., dated February 1, 2018, incorporated by reference to exhibit 10(oo)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(ww) +Form of Award Agreement for Stock Options, effective January 1, 2010, incorporated by reference to exhibit 10(ddd) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2009. +114 +Table of Contents +10(xx) +Terms and Conditions for Stock Options, effective January 1, 2011, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2011. +10(yy) +Terms and Conditions for Stock Option Awards, effective May 3, 2013, incorporated by reference to exhibit 10(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 8, 2013. +10(zz) +Terms and Conditions for Stock Option Awards under the 2013 Arconic Stock Incentive Plan, effective July 22, 2016, incorporated by reference to Exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10(aaa) +Global Stock Option Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(uu) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(bbb) +Form of Stock Option Award Agreement, incorporated by reference to exhibit 10(f) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(ccc) +Terms and Conditions for Restricted Share Units, effective May 3, 2013, incorporated by reference to exhibit 10(c) to the Company’s Current Report on Form 8-K (Commission file number 1- 3610) dated May 8, 2013. +10(ddd) +Terms and Conditions for Restricted Share Units under the 2013 Arconic Stock Incentive Plan, effective July 22, 2016, incorporated by reference to Exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10(eee) +Terms and Conditions for Restricted Share Units for Annual Director Awards under the 2013 Arconic Stock Incentive Plan, effective November 30, 2016, incorporated by reference to exhibit 10(vv) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(fff) +Terms and Conditions for Restricted Share Units for Annual Director Awards under the 2013 Arconic Stock Incentive Plan, as Amended and Restated, effective December 5, 2017, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2018. +10(ggg) +Terms and Conditions for Deferred Fee Restricted Share Units for Director Awards under the 2013 Arconic Stock Incentive Plan, effective November 30, 2016, incorporated by reference to exhibit 10(ww) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(hhh) +Terms and Conditions for Restricted Share Units issued on or after January 13, 2017, under the 2013 Arconic Stock Incentive Plan, effective January 13, 2017, incorporated by reference to exhibit 10(xx) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10(iii) +Terms and Conditions for Restricted Share Units - Interim CEO (David P. Hess) Award, effective October 23, 2017, incorporated by reference to exhibit 10(ccc) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(jjj) +Terms and Conditions for Restricted Share Units - Non-Executive Chairman (John C. Plant) Director Award, effective October 23, 2017, incorporated by reference to exhibit 10(ddd) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(kkk) +Terms and Conditions for Restricted Share Units - Non-Executive Chairman (John C. Plant) Director Award, effective October 23, 2018, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2018. +10(lll) +Global Restricted Share Unit Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(eee) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(mmm) +Terms and Conditions for Restricted Share Units issued on or after January 19, 2018, under the 2013 Arconic Stock Incentive Plan, effective January 19, 2018, incorporated by reference to exhibit 10(fff) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +115 +Table of Contents +10(nnn) +Form of Restricted Share Unit Award Agreement, incorporated by reference to exhibit 10(g) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(ooo) +Restricted Share Unit Award Agreement - Executive Vice President, Human Resources (Neil E. Marchuk) Annual Equity Award, effective March 15, 2019, incorporated by reference to exhibit 10(f) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10(ppp) +Restricted Share Unit Award Agreement - Executive Vice President, Human Resources (Neil E. Marchuk) Sign-on Equity Award, effective March 15, 2019, incorporated by reference to exhibit 10(g) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10(qqq) +Terms and Conditions for Special Retention Awards under the 2013 Arconic Stock Incentive Plan, effective January 1, 2015, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2015. +10(rrr) +Terms and Conditions for Special Retention Awards under the 2013 Arconic Stock Incentive Plan, effective July 22, 2016, incorporated by reference to exhibit 10(e) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10(sss) +Global Special Retention Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(kkk) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(ttt) +Special Retention Award Agreement - Katherine H. Ramundo, effective May 16, 2018, incorporated by reference to exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(uuu) +Special Retention Award Agreement - Paul Myron, effective May 16, 2018, incorporated by reference to exhibit 10(e) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(vvv) +Special Retention Award Agreement - Ken Giacobbe, effective February 12, 2019, incorporated by reference to exhibit 10(nnn) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2018. +10(www) +Special Retention Award Agreement - Paul Myron, effective February 28, 2019, incorporated by reference to exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10(xxx) +Special Retention Award Agreement - Neil E. Marchuk, effective May 14, 2019, incorporated by reference to exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2019. +21 +Subsidiaries of the Registrant. +23 +Consent of Independent Registered Public Accounting Firm. +24 +Power of Attorney for certain directors. +31 +Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101. INS +XBRL Instance Document. +101. SCH +XBRL Taxonomy Extension Schema Document. +101. CAL +XBRL Taxonomy Extension Calculation Linkbase Document. +101. DEF +XBRL Taxonomy Extension Definition Linkbase Document. +101. LAB +XBRL Taxonomy Extension Label Linkbase Document. +116 +Table of Contents +101. PRE +XBRL Taxonomy Extension Presentation Linkbase Document. +104 +The cover page of this Annual Report on Form 10-K for the year ended December 31, 2019, formatted in Inline XBRL and contained in Exhibit 101). +* Exhibit Nos. 10(h) through 10(xxx) are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K. +Amendments and modifications to other Exhibits previously filed have been omitted when in the opinion of the registrant such Exhibits as amended or modified are no longer material or, in certain instances, are no longer required to be filed as Exhibits. +No other instruments defining the rights of holders of long-term debt of the registrant or its subsidiaries have been filed as Exhibits because no such instruments met the threshold materiality requirements under Regulation S-K. The registrant agrees, however, to furnish a copy of any such instruments to the Commission upon request. +Item 16. Form 10-K Summary. +None. +117 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +ARCONIC INC. +February 26, 2020 +By +/s/ Paul Myron +Paul Myron +Vice President and Controller (Also signing as Principal Accounting Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ John C. Plant +February 26, 2020 +John C. Plant +Chairman and Chief Executive Officer +(Principal Executive Officer and Director) +/s/ Ken Giacobbe +February 26, 2020 +Ken Giacobbe +Executive Vice President and Chief Financial Officer (Principal Financial Officer) +James F. Albaugh, Amy E. Alving, Christopher L. Ayers, Elmer L. Doty, Rajiv L. Gupta, Sean O. Mahoney, David J. Miller, E. Stanley O’Neal, and Ulrich R. Schmidt, each as a Director, on February 26, 2020 , by Paul Myron, their Attorney-in-Fact.* +*By +/s/ Paul Myron +Paul Myron +Attorney-in-Fact +118 \ No newline at end of file diff --git a/raw/filings/0000004281/2019/0000004281-20-000038/filing_metadata.csv b/raw/filings/0000004281/2019/0000004281-20-000038/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..27deac7b74a53a51a3f4190679a2bd1faae02c74 --- /dev/null +++ b/raw/filings/0000004281/2019/0000004281-20-000038/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004281,HWM,Howmet Aerospace Inc.,2019,10-K,2020-02-27,2019-12-31,2020-02-26T22:48:56.000Z,0000004281-20-000038,form10k4q19.htm,10-K,23792350,1,1,https://www.sec.gov/Archives/edgar/data/4281/000000428120000038/form10k4q19.htm,https://www.sec.gov/Archives/edgar/data/4281/000000428120000038/ diff --git a/raw/filings/0000004281/2019/0000004281-20-000038/item1.txt b/raw/filings/0000004281/2019/0000004281-20-000038/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..c2c18b390efc8f68b150073752a5632ddeb9a7c0 --- /dev/null +++ b/raw/filings/0000004281/2019/0000004281-20-000038/item1.txt @@ -0,0 +1,7 @@ +Item 1. Business. +General +Arconic Inc. is a Delaware corporation with its principal office in Pittsburgh, Pennsylvania and the successor to Arconic Pennsylvania (as defined below) which was formed in 1888 and formerly known as Alcoa Inc. In this report, unless the context otherwise requires, “Arconic” or the “Company” means Arconic Inc., a Delaware corporation, and all subsidiaries consolidated for the purposes of its financial statements. +The Company’s Internet address is http://www.arconic.com . Arconic makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC). The information on the Company’s Internet site is not a part of, or incorporated by reference in, this annual report on Form 10-K. The SEC maintains an Internet site that contains these reports at http://www.sec.gov . +Forward-Looking Statements +This report contains (and oral communications made by Arconic may contain) statements that relate to future events and expectations and, as such, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those containing such words as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “guidance,” “intends,” “may,” “outlook,” “plans,” “projects,” “seeks,” “sees,” “should,” “targets,” “will,” “would,” or other words of similar meaning. All statements that reflect Arconic’s expectations, assumptions or projections about the future, other than statements of historical fact, are forward-looking statements, including, without limitation, forecasts relating to the growth of the aerospace, automotive, commercial transportation and other end markets; statements and guidance regarding future financial results or operating performance; statements about Arconic’s strategies, outlook, business and financial prospects; and statements regarding potential share gains. Forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and changes in circumstances that are difficult to predict. Although Arconic believes that the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that these expectations will be attained and it is possible that actual results may differ materially from those indicated by these forward-looking statements due to a variety of risks and uncertainties. +For a discussion of some of the specific factors that may cause Arconic’s actual results to differ materially from those projected in any forward-looking statements, see the following sections of this report: Part I, \ No newline at end of file diff --git a/raw/filings/0000004281/2019/0000004281-20-000038/item13.txt b/raw/filings/0000004281/2019/0000004281-20-000038/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..3e1cfb89afad721f529aa314ff3800bd62345f40 --- /dev/null +++ b/raw/filings/0000004281/2019/0000004281-20-000038/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related 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1-3610 +HOWMET AEROSPACE INC. +(Exact name of registrant as specified in its charter) +Delaware 25-0317820 +(State of incorporation) (I.R.S. Employer Identification No.) +201 Isabella Street, Suite 200 , Pittsburgh , Pennsylvania 15212-5872 +(Address of principal executive offices) (Zip code) +Investor Relations----------------(412) 553-1950 +Office of the Secretary-----------( 412 ) 553-1940 +(Registrant’s telephone numbers, including area code) +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol Name of each exchange on which registered +Common Stock, par value $1.00 per share HWM New York Stock Exchange +$3.75 Cumulative Preferred Stock, +par value $100.00 per share HWM PR NYSE American +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ✓ No . +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. +Yes No ✓ . +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes ✓ No . +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ✓ No . +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ☑ Accelerated filer ☐ Non-accelerated filer ☐ +Smaller reporting company ☐ Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ✓ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ✓ . +The aggregate market value of the outstanding common stock, other than shares held by persons who may be deemed affiliates of the registrant, as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $ 7 billion. As of February 12, 2021, there were 433,614,667 shares of common stock, par value $1.00 per share, of the registrant outstanding. +Documents incorporated by reference. +Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement for its 2021 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A (Proxy Statement). +Table of Contents +Explanatory Note +On April 1, 2020, Arconic Inc. completed the separation of its business into two independent, publicly-traded companies: Howmet Aerospace Inc. (the new name for Arconic Inc.) and Arconic Corporation. The financial results of Arconic Corporation for all periods prior to April 1, 2020, have been retrospectively reflected in the Statement of Consolidated Operations as discontinued operations and, as such, have been excluded from continuing operations and segment results for all periods prior to April 1, 2020. Additionally, the related assets and liabilities associated with Arconic Corporation in the December 31, 2019 Consolidated Balance Sheet are classified as assets and liabilities of discontinued operations. The cash flows, comprehensive income, and equity related to Arconic Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows, Statement of Consolidated Comprehensive Income, and Statement of Changes in Consolidated Equity, respectively, for all periods prior to April 1, 2020. +Table of Contents +TABLE OF CONTENTS +Page(s) +Part I +Item 1. +Business +1 +Item 1A. +Risk Factors +11 +Item 1B. +Unresolved Staff Comments +25 +Item 2. +Properties +26 +Item 3. +Legal Proceedings +26 +Item 4. +Mine Safety Disclosures +27 +Part II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +28 +Item 6. +Selected Financial Data Financial Data +30 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +31 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +45 +Item 8. +Financial Statements and Supplementary Data +46 +Item 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +101 +Item 9A. +Controls and Procedures +101 +Item 9B. +Other Information +101 +Part III +Item 10. +Directors, Executive Officers and Corporate Governance +101 +Item 11. +Executive Compensation +101 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +102 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +102 +Item 14. +Principal Accounting Fees and Services +102 +Part IV +Item 15. +Exhibits, Financial Statement Schedules +103 +Item 16. +Form 10-K Summary +111 +Signatures +112 +Note on Incorporation by Reference +In this Form 10-K, selected items of information and data are incorporated by reference to portions of the Proxy Statement. Unless otherwise provided herein, any reference in this report to disclosures in the Proxy Statement shall constitute incorporation by reference of only that specific disclosure into this Form 10-K. +Table of Contents +PART I +Item 1. Business. +General +Howmet Aerospace Inc. (formerly known as Arconic Inc.) is a Delaware corporation with its principal office in Pittsburgh, Pennsylvania and the successor to Arconic Pennsylvania (as defined below) which was formed in 1888 and formerly known as Alcoa Inc. In this report, unless the context otherwise requires, “Howmet”, the “Company”, “we”, “us” and “our” refer to Howmet Aerospace Inc., a Delaware corporation, and its consolidated subsidiaries. +The Company’s Internet address is http://www.howmet.com. Howmet makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission ("SEC"). The Company's website is included in this annual report on Form 10-K as an inactive textual reference only. The information on, or accessible through, the Company’s website is not a part of, or incorporated by reference in, this annual report on Form 10-K. The SEC maintains an Internet site that contains these reports at http://www.sec.gov. +Forward-Looking Statements +This report contains (and oral communications made by Howmet may contain) statements that relate to future events and expectations and, as such, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those containing such words as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “guidance,” “intends,” “may,” “outlook,” “plans,” “projects,” “seeks,” “sees,” “should,” “targets,” “will,” “would,” or other words of similar meaning. All statements that reflect Howmet’s expectations, assumptions or projections about the future, other than statements of historical fact, are forward-looking statements, including, without limitation, statements, forecasts and outlook relating to the condition of end markets; future financial results, operating performance, or estimated or expected future capital expenditures; future strategic actions; and Howmet's strategies, outlook, and business and financial prospects. These statements reflect beliefs and assumptions that are based on Howmet’s perception of historical trends, current conditions and expected future developments, as well as other factors Howmet believes are appropriate in the circumstances. Forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and changes in circumstances that are difficult to predict. Although Howmet believes that the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that these expectations will be attained and it is possible that actual results may differ materially from those indicated by these forward-looking statements due to a variety of risks and uncertainties. +For a discussion of some of the specific factors that may cause Howmet’s actual results to differ materially from those projected in any forward-looking statements, see the following sections of this report: Part I, Item 1A (Risk Factors), Part II, Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations), including the disclosures under Segment Information and Critical Accounting Policies and Estimates, and Note V to the Consolidated Financial Statements in Part II, Item 8. Market projections are subject to the risks discussed in this report and other risks in the market. Howmet disclaims any intention or obligation to update publicly any forward-looking statements, whether in response to new information, future events or otherwise, except as required by applicable law. +Overview +Howmet is a leading global provider of advanced engineered solutions for the aerospace and transportation industries. The Company’s primary businesses focus on jet engine components, aerospace fastening systems, and titanium structural parts necessary for mission-critical performance and efficiency in aerospace and defense applications, as well as forged wheels for commercial transportation. +Howmet is a global company operating in 20 countries. Based upon the country where the point of shipment occurred, the United States and Europe generated 68% and 21%, respectively, of Howmet’s sales in 2020. In addition, Howmet has operating activities in numerous countries and regions outside the United States and Europe, including Canada, Mexico, China and Japan. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in countries with such operating activities. +Background +The Arconic Inc. Separation Transaction +Howmet Aerospace Inc. is the new name for Arconic Inc., following Arconic Inc.’s separation of its businesses on April 1, 2020 (the “Arconic Inc. Separation Transaction”) into two independent, publicly traded companies – Howmet Aerospace Inc. and Arconic Corporation. Following this separation, Howmet retains the Engine Products, Fastening Systems, Engineered +1 +Table of Contents +Structures, and Forged Wheels businesses; and Arconic Corporation holds the Rolled Products, Aluminum Extrusions, and Building and Construction Systems businesses. The Company trades under the symbol “HWM” on the New York Stock Exchange, and Arconic Corporation trades under the symbol “ARNC” on the New York Stock Exchange. +The Arconic Inc. Separation Transaction was effected by a distribution of all outstanding shares of Arconic Corporation common stock to the Company’s stockholders (the “Distribution of Arconic”). The Company’s stockholders of record as of the close of business on March 19, 2020 (the “2020 Record Date”) received one share of Arconic Corporation common stock for every four shares of the Company’s common stock held as of the 2020 Record Date. The Company did not issue fractional shares of Arconic Corporation common stock in the Distribution of Arconic. Instead, each stockholder otherwise entitled to receive a fractional share of Arconic Corporation common stock received cash in lieu of fractional shares. +In connection with the Arconic Inc. Separation Transaction, Howmet and Arconic Corporation entered into several agreements that govern the relationship of the parties following the separation, including the following: Separation and Distribution Agreement, Tax Matters Agreement, Employee Matters Agreement, certain Patent, Know-How and Trade Secret License Agreements, certain Trademark License Agreements, Raw Material Supply Agreements, Second Supplemental Tax and Project Certificate and Agreement, and Lease and Property Management Agreement. +The 2017 Reincorporation of Howmet (then known as Arconic Inc.) +On December 31, 2017 (the “Effective Date”), Arconic Inc., a Pennsylvania corporation (“Arconic Pennsylvania”), effected the change of Arconic Pennsylvania’s jurisdiction of incorporation from Pennsylvania to Delaware (the “Reincorporation”) by merging (the “Reincorporation Merger”) with a direct wholly owned Delaware subsidiary, Arconic Inc. (in this section, “Arconic Delaware” or, following the Reincorporation, the “Company”), pursuant to an Agreement and Plan of Merger, dated as of October 12, 2017, by and between Arconic Pennsylvania and Arconic Delaware. Arconic Pennsylvania shareholders approved the Reincorporation Merger to effect the Reincorporation at a Special Meeting of Shareholders held on November 30, 2017. As a result of the Reincorporation, (i) Arconic Pennsylvania ceased to exist, (ii) Arconic Delaware automatically inherited the reporting obligations of Arconic Pennsylvania under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and (iii) Arconic Delaware is deemed to be the successor issuer to Arconic Pennsylvania. +The common stock, par value $1.00 per share, of Arconic Pennsylvania (the “Arconic Pennsylvania Common Stock”) was listed for trading on the New York Stock Exchange and traded under the symbol “ARNC.” As of the Effective Date, this symbol, without interruption, represented shares of common stock, par value $1.00 per share, of Arconic Delaware (the “Arconic Delaware Common Stock”). There was no change in the Exchange Act File Number assigned by the SEC as a result of the Reincorporation. +As of the Effective Date, the rights of the Company’s stockholders began to be governed by the General Corporation Law of the State of Delaware, the Certificate of Incorporation of Arconic Delaware and the Bylaws of Arconic Delaware. +Other than the change in corporate domicile, the Reincorporation did not result in any change in the business, physical location, management, financial condition or number of authorized shares of the Company, nor did it result in any change in location of its current employees, including management. On the Effective Date, (i) the directors and officers of Arconic Pennsylvania prior to the Reincorporation continued as the directors and officers of Arconic Delaware after the Reincorporation, (ii) each outstanding share of Arconic Pennsylvania Common Stock was automatically converted into one share of Arconic Delaware Common Stock, (iii) each outstanding share of Serial Preferred Stock, par value $100 per share, of Arconic Pennsylvania was automatically converted into one share of Serial Preferred Stock, par value $100 per share, of Arconic Delaware and (iv) all of Arconic Pennsylvania’s employee benefit and compensation plans immediately prior to the Reincorporation were continued by Arconic Delaware, and each outstanding equity award and notional share unit relating to shares of Arconic Pennsylvania Common Stock was converted into an equity award or notional share unit, as applicable, relating to an equivalent number of shares of Arconic Delaware Common Stock on the same terms and subject to the same conditions. Beginning on the Effective Date, each certificate representing Arconic Pennsylvania Common Stock or Arconic Pennsylvania Preferred Stock was deemed for all corporate purposes to evidence ownership of Arconic Delaware Common Stock or Arconic Delaware Preferred Stock, as applicable. The Company’s stockholders may, but are not required to, exchange their stock certificates as a result of the Reincorporation. +The Alcoa Inc. Separation Transaction +On November 1, 2016, Alcoa Inc. completed the separation of its business into two independent, publicly traded companies (the “Alcoa Inc. Separation Transaction”) – Arconic Inc. (the new name for Alcoa Inc. and which, through the transactions described above, later became Howmet Aerospace Inc.) and Alcoa Corporation. Following the Alcoa Inc. Separation Transaction, the Company retained the Global Rolled Products (other than the rolling mill at the Warrick, Indiana operations and the 25.1% ownership stake in the Ma’aden Rolling Company), the Engineered Products and Solutions and the Transportation and Construction Solutions segments. Alcoa Corporation comprised the Alumina and Primary Metals segments, +2 +Table of Contents +the rolling mill at the Warrick, Indiana operations, and the 25.1% stake in the Ma’aden Rolling Company in Saudi Arabia previously held by the Company. +The Alcoa Inc. Separation Transaction was effected by a pro rata distribution of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders (the “Distribution of Alcoa”). The Company’s shareholders of record as of the close of business on October 20, 2016 (the “2016 Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the 2016 Record Date. The Company did not issue fractional shares of Alcoa Corporation common stock in the Distribution of Alcoa. Instead, each shareholder otherwise entitled to receive a fractional share of Alcoa Corporation common stock received cash in lieu of fractional shares. +The Company distributed 146,159,428 shares of common stock of Alcoa Corporation in the Distribution of Alcoa and retained 36,311,767 shares, or approximately 19.9%, of the common stock of Alcoa Corporation immediately following the Distribution of Alcoa. During 2017, the Company disposed all of its retained interest in Alcoa Corporation. +As a result of the Distribution of Alcoa, Alcoa Corporation became an independent public company trading under the symbol “AA” on the New York Stock Exchange, and the Company traded under the symbol “ARNC” on the New York Stock Exchange. +On October 31, 2016, in connection with the Alcoa Inc. Separation Transaction, Arconic Inc. entered into several agreements with Alcoa Corporation or its subsidiaries that govern the relationship of the parties following the Distribution of Alcoa, including the following: Separation and Distribution Agreement, Tax Matters Agreement, Employee Matters Agreement, and certain Patent, Know-How, Trade Secret License and Trademark License Agreements. +Description of the Business +The Company produces products that are used primarily in the aerospace (commercial and defense), commercial transportation, and industrial and other end markets. Such products include fastening systems (titanium, steel, and nickel superalloys), seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils and structural parts; forged jet engine components (e.g., jet engine disks); machined and forged aircraft parts (titanium and aluminum); and forged aluminum commercial vehicle wheels, all of which are sold directly to customers and/or through distributors. +Aerospace (Commercial and Defense) End Market. Howmet’s largest end market is aerospace, which represented approximately 69% of the Company’s revenue in 2020. The Company produces a range of high performance multi-materials, highly engineered products, and vertically integrated machined solutions for aero engines and airframe structures, ranging from investment castings, advanced coatings, seamless rings, forgings, titanium extrusions, and titanium mill products, to fasteners that hold aircraft together. Wingtip to wingtip, nose to tail, Howmet can produce more than 90% of all structural and rotating aero engine components. Modernization of the commercial and defense platforms is driven by an array of challenging performance requirements. With its precision engineering, materials science expertise and advanced manufacturing processes, Howmet aims to help its customers achieve greater fuel economies, reduced emissions, passenger comfort and maintenance efficiencies. +Commercial Transportation End Market . The commercial transportation end market represented approximately 16% of the Company’s revenue in 2020. The Company invented the forged aluminum wheel in 1948, and continues to advance technology to deliver breakthrough solutions that make trucks and buses lighter, more fuel efficient and sharper-looking. Howmet’s forged aluminum wheels are a leading choice for commercial trucks and mass transportation vehicles because they can reduce weight and save fuel. The strength of the Company’s rivets, bolts and fasteners offers another light-weighting solution that delivers performance. +Industrial and Other End Markets. Industrial and other end markets include industrial gas turbines, oil and gas, and other industrials, which represented approximately 15% of the Company’s revenue in 2020. +Howmet has four reportable segments, which are organized by product on a worldwide basis: Engine Products, Fastening Systems, Engineered Structures and Forged Wheels. +Engine Products +Engine Products produces investment castings, including airfoils, and seamless rolled rings primarily for aircraft engines and industrial gas turbines. Engine Products produces rotating parts as well as structural parts. Engine Products principally serves the commercial and defense aerospace as well as industrial gas turbine end markets. +Fastening Systems +Fastening Systems produces aerospace and industrial fasteners, latches, bearings, fluid fittings and installation tools . A leading producer of highly engineered aerospace fasteners with a broad range of fastening systems, the segment also supplies the commercial transportation, renewable, and material handling industries. The business’s high-tech, multi-material fastening +3 +Table of Contents +systems are found nose to tail on commercial and military aircraft, as well as on jet engines, industrial gas turbines, automobiles, commercial transportation vehicles, wind turbines, solar power systems, and construction and industrial equipment . +Engineered Structures +Engineered Structures produces titanium ingots and mill products for aerospace and defense applications and is vertically integrated to produce titanium forgings, extrusions forming and machining services for airframe, wing, aero-engine, and landing gear components. Engineered Structures also produces aluminum forgings, nickel forgings, and aluminum machined components and assemblies for aerospace and defense applications. The principal end markets served by Engineered Structures are commercial aerospace, defense aerospace, and land and sea defense. +Forged Wheels +Forged Wheels manufactures forged aluminum truck, bus, and trailer wheels and related products for the commercial transportation end market globally. The Company’s portfolio of wheels is sold under the product brand name Alcoa® Wheels. Its Ultra ONE® Wheel with MagnaForce® alloy is the lightest portfolio of wheels on the market. The Company’s proprietary Dura-Bright® surface treatment is unmatched in appearance and corrosion protection. +For additional discussion of each segment's business, see “Results of Operations—Segment Information” in Part II, Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note D to the Consolidated Financial Statements in Part II, Item 8. +Sales by End Market and Significant Customer Revenue +Sales by end markets for the years ended December 31, 2020, 2019, and 2018, were: +For the Year Ended +December 31, +2020 2019 2018 +Aerospace - Commercial 50 % 59 % 59 % +Aerospace - Defense 19 % 13 % 11 % +Commercial Transportation 16 % 17 % 18 % +Industrial and Other 15 % 11 % 12 % +In 2020, General Electric Company, Raytheon Technologies Corporation and The Boeing Company represented approximately 11% , 9 % and 8%, respectively, of the Company’s third-party sales. The loss of any such significant customer could have a material adverse effect on such businesses. See Part I, Item 1A (Risk Factors). +4 +Table of Contents +The Company's Principal Facilities 1 +Country Facility Location Segment Products +Australia Oakleigh Fastening Systems Fasteners +Canada +Georgetown, Ontario 2 +Engine Products Aerospace Castings +Laval, Québec Engine Products; Engineered Structures Aerospace Castings and Machining +China +Suzhou 2 +Engine Products; Fastening Systems; Forged Wheels Fasteners, Rings and Forgings +France Dives-sur-Mer Engine Products Aerospace and Industrial Gas Turbine Castings +Evron Engine Products Aerospace and Specialty Castings +Gennevilliers Engine Products Aerospace and Industrial Gas Turbine Castings +Montbrison Fastening Systems Fasteners +St. Cosme-en-Vairais 2 +Fastening Systems Fasteners +Toulouse Fastening Systems Fasteners +Us-par-Vigny Fastening Systems Fasteners +Germany Bestwig Engine Products Aerospace Castings +Erwitte Engine Products +Machining of Aerospace Castings +Hildesheim-Bavenstedt 2 +Fastening Systems Fasteners +Kelkheim 2 +Fastening Systems Fasteners +Hungary Nemesvámos Fastening Systems Fasteners +Székesfehérvár Engine Products; Forged Wheels Aerospace and Industrial Gas Turbine Castings and Forgings +Japan +J Ô etsu City 2 +Forged Wheels Forgings +Nomi Engine Products Aerospace and Industrial Gas Turbine Castings +Mexico +Ciudad Acuña 2 +Engine Products; Fastening Systems Aerospace Castings/Rings and Fasteners +Monterrey Forged Wheels Forgings +Morocco +Casablanca 2 +Fastening Systems Fasteners +United Kingdom Ecclesfield Engine Products +Metal, Billets +Exeter 2 +Engine Products Aerospace and Industrial Gas Turbine Castings and Alloy +Glossop Engine Products +Metal, Billets +Ickles Engine Products +Metal, Billets +Leicester 2 +Fastening Systems Fasteners +Low Moor Engineered Structures Extrusions +Redditch 2 +Fastening Systems Fasteners +Telford Fastening Systems Fasteners +Welwyn Garden City Engineered Structures Aerospace Formed Parts +5 +Table of Contents +Country Facility Location Segment Products +United States +Tucson, AZ 2 +Fastening Systems Fasteners +Carson, CA 2 +Fastening Systems Fasteners +City of Industry, CA 2 +Fastening Systems Fasteners +Fontana, CA Engine Products Rings +Fullerton, CA 2 +Fastening Systems Fasteners +Rancho Cucamonga, CA Engine Products Rings +Sylmar, CA Fastening Systems Fasteners +Torrance, CA Fastening Systems Fasteners +Branford, CT Engine Products Aerospace Coatings +Winsted, CT Engine Products Aerospace Machining +Savannah, GA Engineered Structures +Forgings, Disks +La Porte, IN Engine Products Aerospace and Industrial Gas Turbine Castings +Whitehall, MI Engine Products Aerospace and Industrial Gas Turbine Castings and Coatings, Titanium Alloy and Specialty Products +Washington, MO Engineered Structures Aerospace Formed Parts, Titanium Mill Products +Big Lake, MN Engineered Structures Aerospace Machining +New Brighton, MN Engineered Structures Aerospace Machining +Dover, NJ Engine Products Aerospace and Industrial Gas Turbine Castings and Alloy +Verdi, NV Engine Products Rings +Kingston, NY 2 +Fastening Systems Fasteners +Rochester, NY Engine Products Rings +Barberton, OH Forged Wheels Machining of Forgings +Canton, OH 2,3 +Engineered Structures Ferro-Titanium Alloys and Titanium Mill Products +Cleveland, OH Engine Products; Engineered Structures; Forged Wheels Forgings, Investment Casting Equipment, and Aerospace Components +Niles, OH Engineered Structures Titanium Mill Products +Morristown, TN 2 +Engine Products Aerospace and Industrial Gas Turbine Ceramic Products +Houston, TX 2 +Engineered Structures Extrusions +Waco, TX 2 +Fastening Systems Fasteners +Wichita Falls, TX Engine Products Aerospace and Industrial Gas Turbine Castings +Hampton, VA 2 +Engine Products Aerospace and Industrial Gas Turbine Castings +Martinsville, VA Engineered Structures Titanium Mill Products +1 Principal facilities are listed by location, with certain locations having more than one facility. The list in the above table does not include 20 locations that serve as sales and administrative offices, distribution centers or warehouses. +2 Leased property or partially leased property. +3 Canton Ferro-Titanium Alloys was sold on February 1, 2021. +6 +Table of Contents +Sources and Availability of Raw Materials +Important raw materials purchased in 2020 for each of the Company’s reportable segments are listed below. +Engine Products +Fastening Systems +Engineered Structures +Forged Wheels +Ceramics +Aluminum Alloys +Energy +Energy +Cobalt +Energy +Nickel Alloys +Primary and Scrap Aluminum +Energy +Nickel Alloys and Stainless Steels +Primary Aluminum +Nickel +Steels +Titanium Scrap +Platinum +Titanium Alloys +Titanium Sponge +Titanium +Vanadium Alloys +Generally, raw materials are purchased from third-party suppliers under competitively priced supply contracts or bidding arrangements. The Company believes that the raw materials necessary to its business are and will continue to be available. +Patents, Trade Secrets and Trademarks +The Company believes that its domestic and international patent, trade secret and trademark assets provide it with a significant competitive advantage. The Company’s rights under its patents, as well as the products made and sold under them, are important to the Company as a whole and, to varying degrees, important to each business segment. The patents owned by Howmet generally concern particular products, manufacturing equipment or techniques. Howmet’s business as a whole is not, however, materially dependent on any single patent, trade secret or trademark. As a result of product development and technological advancement, the Company continues to pursue patent protection in jurisdictions throughout the world. As of the end of 2020, the Company’s worldwide patent portfolio consists of approximately 959 granted patents and 183 pending patent applications. +The Company also has a significant number of trade secrets, mostly regarding manufacturing processes and material compositions that give many of its businesses important advantages in their markets. The Company continues to strive to improve those processes and generate new material compositions that provide additional benefits. With respect to domestic and international registered trademarks, the Company has many that have significant recognition within the markets that are served. Examples include the name Howmet ® metal castings, Huck ® fasteners, and Dura-Bright ® wheels with easy-clean surface treatments. A significant trademark filing campaign for the names “Howmet” and “Howmet Aerospace” along with its “H” logo was initiated in 2019, in support of the corporate launch of Howmet Aerospace Inc. As of the end of 2020, the Company’s worldwide trademark portfolio consists of approximately 1,372 registered trademarks and 329 pending trademark applications. The Company’s rights under its trademarks are important to the Company as a whole and, to varying degrees, important to each business segment. +Competitive Conditions +The Company’s segments - Engine Products, Fastening Systems, Engineered Structures and Forged Wheels - are subject to substantial and intense competition in the markets they serve. Although Howmet believes its advanced technology, manufacturing processes and experience provide advantages to Howmet’s customers, such as high quality and superior mechanical properties that meet the Company’s customers’ most stringent requirements, many of the products Howmet makes can be produced by competitors using similar types of manufacturing processes as well as alternative forms of manufacturing. Despite intense competition, Howmet continues as a market leader in most of its principal markets. Several factors, including Howmet’s technological expertise, state-of-the-art capabilities, engaged employees and long-standing customer relationships, enable the Company to maintain its competitive position. +Principal competitors include Berkshire Hathaway Inc., through its 2016 acquisition of Precision Castparts Corporation and subsidiaries, for titanium and titanium-based alloys, precision forgings, seamless rolled rings, investment castings and aerospace fasteners; VSMPO (Russia) for titanium and titanium-based alloys and precision forgings; the High-Performance Materials & Components segment of Allegheny Technologies, Inc. for titanium and titanium-based alloys, precision forgings, and investment castings; Lisi Aerospace (France) for aerospace fasteners; and Aubert & Duval (part of Eramet Group in France) for precision forgings. Other competitors include Doncasters Group Ltd. (UK) and Consolidated Precision Products Corp. (owned by Warburg Pincus and Berkshire Partners) for investment castings; Weber Metals (part of Otto Fuchs) for precision forgings; and Forgital and Frisa (Mexico) for seamless rings. +Forged Wheels competes against aluminum and steel wheel suppliers in the commercial transportation industry under the product brand name Alcoa ® Wheels for the major regions that it serves (Americas, Europe, Japan, China, and Australia). Its larger aluminum wheel competitors are Accuride Corporation, Speedline (member of the Ronal Group), Nippon Steel Corporation, Dicastal, Alux, and Wheels India Limited. In recent years, Forged Wheels has seen an increase in the number of +7 +Table of Contents +aluminum wheel suppliers (both forged and cast aluminum wheels) from China, Taiwan, India and South Korea attempting to penetrate the global commercial transportation market. +Several of Howmet’s largest customers have captive superalloy furnaces for producing airfoil investment castings for their own use. Many other companies around the world also produce superalloy investment castings, and some of these companies currently compete with Howmet in the aerospace and other markets, while others are capable of competing with the Company should they choose to do so. +International competition in the investment castings , fasteners, rings and forgings markets may also increase in the future as a result of strategic alliances among engine original equipment manufacturers (“OEMs”), aero-structure prime contractors, and overseas companies, especially in developing markets, particularly where “offset” or “local content” requirements create purchase obligations with respect to products manufactured in or directed to a particular country. +Environmental Matters +Information relating to environmental matters is included in Note V to the Consolidated Financial Statements under the caption “Environmental Matters.” Capital expenditures for new or expanded facilities for environmental control for 2021 and 2022 are estimated to be less than $5 million per year. +Human Capital +To recruit, attract, develop and retain world-class talent, the Company has created a culture that embraces diversity, drives inclusion, and empowers and engages our employees. +Training and Development +The Company offers an integrated approach, enabling our employees to own their development and create rewarding careers that draw on their aptitudes and support their ambitions. We provide learning and development opportunities and equip our managers to provide ongoing coaching and feedback, so employees maximize their performance and potential, delivering success for Howmet. +Diversity, Equity and Inclusion +Events in 2020, particularly in the United States, underscored the importance and power of diversity, equity and inclusion ("DEI"). Howmet’s inclusive, respectful and values-based company culture fosters inclusive work environments that leverage the diversity of backgrounds, experience and thought within our organization. The Company partners with key external organizations that focus on DEI, including the Human Rights Campaign, the National Hispanic Corporate Council and Diversity Best Practices, to review and continuously improve our DEI initiatives. We continue to seek additional partners to further eliminate discrimination and implicit bias from the Company’s policies and processes. +During 2020, we renewed our commitment to supporting our six employee resource groups ("ERGs") – Howmet African Heritage Network, Howmet Hispanic Network, Howmet Next Generation Network, Howmet Pride Network, Howmet Veterans Network and Howmet Women’s Network. The ERGs provide workplace networks for employees who have shared characteristics, special interests or life experiences. They offer a conduit to professional development, strengthen business impact internally and externally, and promote commitments to a diverse workplace. During 2020, the ERGs provided a positive way for the Company to direct dedicated company resources toward employee education, community building and social impact initiatives. +The Company also provided diversity awareness training on implicit bias and added inclusion to our leadership competency development in 2020. +Health and Safety +Howmet’s strong health and safety culture empowers our employees and contractors to take personal responsibility for their actions and the safety of their coworkers. This culture is supported by internal policies, standards, rules and procedures that clearly articulate our stringent requirements for working safely in all of our facilities worldwide. The Company embeds annual health and safety goals and objectives into its operating plans to progress against our ultimate goal of zero incidents. We prioritize our risk management processes toward the prevention of fatality and serious injury potential to focus on the hazards that have the potential for life-altering outcomes. +COVID-19 represented the biggest health challenge in the history of our Company, impacting our employees, suppliers and customers. This adverse situation became a unifying moment, as our employees worked tirelessly to establish internal and external programs and protocols to protect our people and processes, which were deemed essential for the aerospace, defense and transportation industries. Through our pandemic deployment system, the Company readied our plants around the world with a comprehensive toolbox based on risk. We structured our location pandemic programs around entry screening, self- assessment of symptoms, hygiene, masks, social distancing and robust implementation of tracing and quarantine protocols. +8 +Table of Contents +Special pandemic-related policies for leave and alternative schedules were put in place to incentivize staying at home when sick. In addition, for employees who could meet their work commitments remotely, we provided resources and equipment to enable them to work from home. Access to mental health and resilience support was communicated and made available through our employee assistance partners. +Employees +Total worldwide employment at the end of 2020 was approximately 19,700 employees in 24 countries. Many, but less than 50%, of these employees are represented by labor unions. The Company believes that relations with its employees and any applicable union representatives generally are good. +There are nine collective bargaining agreements in the United States with varying expiration dates. In the United States, the largest collective bargaining agreement is the agreement between Howmet and the United Autoworkers ("UAW") at our Whitehall, Michigan location. The Whitehall UAW agreement covers approximately 1,000 employees; the current agreement expires on March 31, 2023. In addition to the employees covered by the Whitehall UAW agreement, approximately 1,600 other employees in the United States are also represented by labor unions. +On a regional basis, collective bargaining agreements with varying expiration dates cover employees in Europe, North America, South America, and Asia. +Executive Officers of the Registrant +The names, ages, positions and areas of responsibility of the executive officers of the Company as of February 16, 2021 are listed below. The Company’s executive officers are elected or appointed to serve until the next annual meeting of the Board of Directors (held in conjunction with the annual meeting of shareholders), except in the case of earlier death, retirement, resignation or removal. +Ken Giacobbe , 55, Executive Vice President and Chief Financial Officer. Mr. Giacobbe was elected Executive Vice President and Chief Financial Officer of Howmet effective November 1, 2016. Mr. Giacobbe joined Howmet in 2004 as Vice President of Finance for Global Extruded Products, part of Alcoa Forgings and Extrusions. He then served as Vice President of Finance for the Company’s Building and Construction Systems business from 2008 until 2011. In 2011, he assumed the role of Group Controller for the Engineered Products and Solutions segment. From January 2013 until October 2016, Mr. Giacobbe served as Chief Financial Officer of the Engineered Products and Solutions segment. Before joining Howmet, Mr. Giacobbe held senior finance roles at Avaya and Lucent Technologies. +Neil E. Marchuk , 63, Executive Vice President and Chief Human Resources Officer. Mr. Marchuk was elected Executive Vice President and Chief Human Resources Officer of Howmet effective March 1, 2019. Prior to joining Howmet, from January 2016 to February 2019, he was Executive Vice President and Chief Human Resources Officer at Adient, an automotive manufacturer. From July 2006 to May 2015, Mr. Marchuk was Executive Vice President of Human Resource at TRW Automotive, and served as TRW’s Vice President, Human Resources from September 2004 to July 2006 . Prior to joining TRW, from December 2001 to August 2004, Mr. Marchuk was Director Corporate Human Resources for E.I. Du Pont De Nemours and Company (“E.I. Du Pont”). From September 1999 to November 2001, Mr. Marchuk was Director Global HR Delivery for E.I. Du Pont. From February 1999 to August 1999, Mr. Marchuk served E.I. Du Pont as its Global HR Director Global Services Division. +Paul Myron , 54, Vice President and Controller. Mr. Myron was elected Vice President and Controller of Howmet effective November 1, 2016. Mr. Myron joined Howmet as a systems analyst in Pittsburgh and in 1992 relocated to the Company’s Davenport, Iowa facility as a product accountant. He served in numerous financial management positions from 1995 until 2000 when he was named Commercial Manager and Controller for the Atlantic division of the Alcoa World Alumina and Chemicals business. In 2002, Mr. Myron was appointed Vice President of Finance, Alcoa Primary Metals and later became Vice President of Finance, Alcoa World Alumina and Chemicals. In 2005 Mr. Myron was named Director of Financial Planning and Analysis, accountable for the Company’s financial planning, analysis, and reporting worldwide. In February 2012, he became Director of Finance Initiatives for the Engineered Products and Solutions segment, overseeing specific financial initiatives and projects within the group. From July 2012 until his most recent appointment, Mr. Myron served as Vice President, Finance and Business Excellence for the Arconic Power and Propulsion business. +Tolga I. Oal , 49, Co-Chief Executive Officer. Mr. Oal was appointed Co-Chief Executive Officer of Howmet effective April 1, 2020. He served as President of Arconic Engineered Structures from May 2019 to April 2020. Prior to joining Howmet, Mr. Oal held leadership roles as President Driveline, President Americas and Senior Vice President Purchasing for American Axle & Manufacturing in Detroit, Michigan from September 2015 to April 2019. From June 2008 to September 2015, Mr. Oal held several leadership positions at TRW Automotive, including Vice President and General Manager of the Global Electronics Business Unit. Prior to his experience at TRW, Mr. Oal spent several years at Siemens VDO Automotive in Europe and the United States. +9 +Table of Contents +John C. Plant , 67, Chairman and Co-Chief Executive Officer. Mr. Plant was appointed Co-Chief Executive Officer of Howmet effective April 1, 2020. He was the Company’s Chief Executive Officer from February 6, 2019 to April 1, 2020. He has served as Howmet's Chairman since October 2017 and as a member of the Board since February 2016. Mr. Plant previously served as Chairman of the Board, President and Chief Executive Officer of TRW Automotive from 2011 to 2015, and as its President and Chief Executive Officer from 2003 to 2011. TRW Automotive was acquired by ZF Friedrichshafen AG in May 2015. Mr. Plant was a co-member of the Chief Executive Office of TRW Inc. from 2001 to 2003 and an Executive Vice President of TRW from the company's 1999 acquisition of Lucas Varity to 2003. Prior to TRW, Mr. Plant was President of Lucas Varity Automotive and managing director of the Electrical and Electronics division from 1991 through 1997. +Katherine H. Ramundo , 53, Executive Vice President, Chief Legal Officer and Secretary. Ms. Ramundo was elected Executive Vice President, Chief Legal Officer and Secretary of Howmet effective November 1, 2016. Prior to joining Howmet, from January 2013 through August 2015, she was Executive Vice President, General Counsel and Secretary of ANN INC., the parent company of ANN TAYLOR and LOFT brands, based in New York. Prior to ANN INC., she served as Vice President, Deputy General Counsel and Assistant Secretary at Colgate-Palmolive, where she held various legal roles from November 1997 to January 2013. She began her career as a litigator in New York, practicing at major law firms, including Cravath, Swaine & Moore and Sidley & Austin. +On January 13, 2021, Ms. Ramundo notified the Company of her intention to resign from the Company, effective as of February 19, 2021, to pursue another professional opportunity. +10 +Table of Contents +Item 1A. Risk Factors. +Howmet’s business, financial condition and results of operations may be impacted by a number of factors. In addition to the factors discussed elsewhere in this report, the following risks and uncertainties could materially harm the Company’s business, financial condition or results of operations, including causing its actual results to differ materially from those projected in any forward-looking statements. The following list of risk factors is not all-inclusive or necessarily in order of importance. Additional risks and uncertainties not presently known to Howmet or that Howmet currently deems immaterial also may materially adversely affect the Company in future periods. +Risks Related to Our Business and Operations +Our business, results of operations, financial condition and/or cash flows have been and could continue to be materially adversely affected by the effects of the COVID-19 pandemic. +Any outbreaks of contagious diseases, public health epidemics or pandemics and other adverse public health developments in countries where we, our employees, customers and suppliers operate could have a material and adverse effect on our business, results of operations, financial condition and/or cash flows. Specifically, the COVID-19 pandemic affecting the global community, including the United States, Europe and South America, is adversely impacting our operations, and the nature and extent of the impact over time is highly uncertain and beyond our control. The extent to which COVID-19 further affects our operations over time will depend on future developments, which are highly uncertain, including the duration of the pandemic, the continued severity of the virus, resurgences and emergence of variants of the virus, the efficacy and availability of vaccines, and the extent of actions that may be taken to contain its impact. These actions include, but are not limited to, declarations of states of emergency, business closures, manufacturing restrictions and a prolonged period of travel, commercial and/or other similar restrictions and limitations, many of which have been implemented across much of the globe and all of which have negatively affected our business. The longer the duration, the greater the impact on our business and the more heightened the risk of a continuing material adverse effect on our business, results of operations, financial conditions and/or cash flows, as well as on our business strategies and initiatives. We continue to monitor guidelines proposed by federal, state and local, as well as foreign, governments with respect to measures for continued operation, which may change over time depending on public health, safety and other considerations. We are continuing to focus on the safety and protection of our workforce by continuing to implement additional safety protocols in light of COVID-19. +As a result of COVID-19 and the measures designed to contain its spread, our global sales, including to customers in the aerospace and commercial transportation industries that are impacted by COVID-19, have been and are expected to continue to be negatively impacted due to the disruption in demand, which has had and over time could continue to have a material adverse effect on our business, results of operations, financial condition and/or cash flows. The COVID-19 pandemic has subjected our operations, financial performance and financial condition to a number of risks, including, but not limited to, those discussed below: +• Business and operations risks: We continue to monitor the evolving situation relating to COVID-19 to determine whether we will need to significantly modify our business practices or take actions as may be required by government authorities or that we determine are in the best interests of our employees, customers, partners, suppliers and shareholders. We have had a number of smaller manufacturing locations that have experienced periods of shutdowns. Future shutdowns will be dependent on facts and circumstances as they unfold, including based on the restrictions and limitations noted above. Additional shutdowns, while not required by governmental authorities, may be necessary to match our production to the reduced demand of our customers. In addition, due to the foregoing factors and potential further disruptions, we may be unable to perform fully on our contracts and our costs may increase. We may also face challenges in restoring our production levels if and when COVID-19 abates, including as a result of government-imposed or other limitations that prevent the return of all or a portion of our workforce, continue to disrupt demand and/or limit the capabilities of our suppliers. As a result of COVID-19 and its potential impact on the aerospace industry, the possibility exists that a sustained impact to our operations, financial results and market capitalization may require material impairments of our assets, including, but not limited to, goodwill, intangible assets, long-lived assets, and right-of-use assets. While we have already implemented plans to reduce costs, including certain headcount reductions, reductions in certain cash outflows, suspension of our common stock dividend and reductions in the levels of our capital expenditures, the longer-term impact of the COVID-19 pandemic is uncertain, but could continue to have a material adverse effect on our business, results of operations, financial condition and/or cash flows. +• Customer and supplier risks : We have limited visibility into future demand due to the disruptions resulting from COVID-19. The sharp decrease in air travel resulting from the COVID-19 pandemic and the measures that governments and private organizations worldwide have implemented in an attempt to contain its spread is adversely affecting, and will likely continue to adversely affect, airlines and airframers and their respective demand for our customers’ products and services. Aircraft manufacturers are reducing production rates due to fewer expected aircraft deliveries and, as a result, demand for products in the OEM market has significantly decreased. Several of our aerospace and commercial transportation customers temporarily suspended operations at certain production sites, +11 +Table of Contents +reduced operations and production rates, and/or took cost-cutting actions, including, but not limited to, General Electric Company, Raytheon Technologies Corporation and The Boeing Company, which represented approximately 11%, 9% and 8%, respectively, of our third-party sales in 2020. Due to the foregoing factors and other cost-cutting measures, we are experiencing, and expect to continue experiencing, lower demand and volume for our products, customer requests for potential payment deferrals, pricing concessions or other contract modifications, and delays in deliveries and the achievement of other billing milestones. COVID-19 may also limit the ability of our counterparties generally to perform their obligations to us, including, but not limited to, our customers’ ability to make timely payments to us. These trends may lead to charges, impairments and other adverse financial impacts over time, as noted above, as we have historically depended upon the strength of these industries, particularly the commercial aerospace industry. In addition, the ongoing COVID-19 pandemic may negatively impact customer contract negotiations, including the ability to negotiate acceptable terms in contract renewal negotiations and our ability to obtain new customers. Similarly, our suppliers may not have the materials, capacity, or capability to manufacture our products according to our schedule and specifications. To date, we have not experienced significant disruption to our supply chain. If our suppliers’ operations were to be impacted, we may need to seek alternate suppliers, which may be more expensive, may not be available or may result in delays in shipments to us and subsequently to our customers, each of which would adversely affect our business, results of operations, financial condition and/or cash flows. The duration of the current disruptions to our customers and to our supply chain, and related financial impact to us, cannot be estimated at this time. Should such disruption continue for an extended period of time, the impact will have a material adverse effect on our business, results of operations, financial condition and/or cash flows. Ultimately, the demand for our products is, in turn, driven by demand for transportation and for people to travel within and between various countries. Should the COVID-19 pandemic cause a long-term deterioration in demand for transportation or travel due to fear or anxiety related to health concerns, governmental restriction, economic hardships, or increased use of electronic communication technologies embraced during the COVID-19 related shutdowns, the effects on our business may extend well beyond the current COVID-19 health crisis and immediate related governmental actions. +• Market risks : The current financial market dynamics and volatility pose heightened risks to our liquidity. For example, dramatically lower interest rates and lower expected asset valuations and returns can materially impact the calculation of long-term liabilities such as our pension. In addition, extreme volatility in financial markets has had and may continue to have adverse impacts on other asset valuations such as the value of the investment portfolios supporting our pension. Our long-term liabilities are sensitive to numerous factors and assumptions that can move in offsetting directions and should be considered as of the time of a relevant measurement event. +• Liquidity and credit risks : We currently have the ability to borrow up to $1.0 billion under our Five-Year Revolving Credit Agreement (the “Credit Agreement”), which was amended in June 2020. A prolonged period of generating lower financial results and cash from operations could adversely affect our financial condition, including in respect of satisfying both required and voluntary pension funding requirements, could result in potential increases in net debt or reductions in EBITDA, and could otherwise negatively affect our ability to achieve our strategic objectives. If the foregoing or other factors negatively impact our ability to comply with the financial covenant in the Credit Agreement, our ability to draw under the Credit Agreement would be adversely affected. There can also be no assurance that we will not face credit rating downgrades as a result of weaker than anticipated performance of our business or other factors, including overall market conditions. Rating downgrades could further adversely affect our cost of funds and related margins, liquidity, competitive position and access to capital markets, and a significant downgrade could have an adverse commercial impact on our business. Conditions in the financial and credit markets may also limit the availability of funding or increase the cost of funding (including for receivables securitization or supply chain finance programs used to finance working capital) or our ability to refinance certain of our indebtedness, which could adversely affect our business, financial position, results of operations and/or cash flows. Although the U.S. federal and other governments have announced a number of funding programs to support businesses, our ability or willingness to access funding under such programs may be limited by regulations or other guidance, including eligibility criteria, or by further change or uncertainty related to the terms of these programs. +The COVID-19 pandemic may also exacerbate other risks disclosed herein, including, but not limited to, risks related to global economic conditions, competition, loss of customers, costs of supplies, manufacturing difficulties and disruptions, investment returns, our credit profile, our credit ratings and interest rates. We expect that the longer the period of disruption from COVID-19 continues, the more material the adverse impact will be on our business operations, financial performance, results of operations and/or cash flows. In addition, the COVID-19 pandemic may also affect our operating and financial results in a manner that is not presently known to us or that we currently do not expect to present significant risks to our business, results of operations, financial conditions and/or cash flows. +The markets for Howmet’s products are highly cyclical and are influenced by a number of factors, including global economic conditions. +12 +Table of Contents +Howmet is subject to cyclical fluctuations in global economic conditions and lightweight metals end-use markets. Howmet sells many products to industries that are cyclical, such as the aerospace and commercial transportation industries, and the demand for its products is sensitive to, and quickly impacted by, demand for the finished goods manufactured by its customers in these industries, which may change as a result of changes in regional or worldwide economies, currency exchange rates, energy prices or other factors beyond its control. +In particular, Howmet derives a significant portion of its revenue from products sold to the aerospace industry, which can be highly cyclical and reflective of changes in the general economy. The commercial aerospace industry is historically driven by the demand from commercial airlines for new aircraft and spare parts. The U.S. and international commercial aviation industries may face challenges arising from competitive pressures and fuel costs. Demand for commercial aircraft and spare parts is influenced by airline industry profitability, trends in airline passenger traffic, the state of U.S., regional and world economies, the ability of aircraft purchasers to obtain required financing and numerous other factors including the effects of terrorism, health and safety concerns (including as a result of the COVID-19 pandemic), environmental constraints imposed upon aircraft operators, the retirement of older aircraft, the performance and cost of alternative materials, and technological improvements to aircraft. The military aerospace cycle is highly dependent on U.S. and foreign government funding; however, it is also driven by the effects of terrorism, a changing global geopolitical environment, U.S. foreign policy, the retirement of older military aircraft, and technological improvements to new engines. +Further, the demand for Howmet’s commercial transportation products is driven by the number of vehicles produced by commercial transportation and automotive manufacturers. Commercial transportation and automotive sales and production are affected by many factors, including the age of the vehicle fleet and related scrappage rates, labor relations issues, fuel prices, regulatory requirements, government initiatives, trade agreements and levels of competition. The automotive industry is also sensitive to general economic conditions, including credit markets and interest rates, and consumer spending and preferences regarding vehicle ownership and usage, vehicle size, configuration and features. +Howmet is unable to predict the future course of industry variables, the strength of the U.S., regional or global economies, or the effects of government actions. Negative economic conditions, such as a major economic downturn, a prolonged recovery period, or disruptions in the financial markets, could have a material adverse effect on Howmet’s business, financial condition or results of operations. +Howmet could encounter manufacturing difficulties or other issues that impact product performance, quality or safety, which could adversely affect Howmet’s reputation, business and financial statements. +The manufacture of many of Howmet’s products is a highly exacting and complex process. Problems may arise during manufacturing for a variety of reasons, including equipment malfunction, failure to follow specific protocols, specifications and procedures, including those related to quality or safety, problems with raw materials, supply chain interruptions, natural disasters, labor unrest and environmental factors. Such problems could have an adverse impact on the Company’s ability to fulfill orders or meet product quality or performance. Product manufacturing or performance issues could result in recalls, customer penalties, contract cancellation and product liability exposure. Because of approval, license and qualification requirements applicable to manufacturers and/or their suppliers, alternatives to mitigate manufacturing disruptions may not be readily available to Howmet or its customers. Accordingly, manufacturing problems, product defects or other risks associated with our products, could result in significant costs to and liability for us that could have a material adverse effect on our business, financial condition or results of operations, including the payment of potentially substantial monetary damages, fines or penalties, as well as negative publicity and damage to our reputation, which could adversely impact product demand and customer relationships. +A material disruption of Howmet’s operations, particularly at one or more of its manufacturing facilities, could adversely affect Howmet’s business. +If Howmet’s operations, particularly one of its key manufacturing facilities, were to be disrupted as a result of significant equipment failures, natural disasters, power outages, fires, explosions, terrorism, theft, sabotage, adverse weather conditions, public health crises, labor disputes or other reasons, Howmet may be unable to effectively meet its obligations to or demand from its customers, which could adversely affect Howmet’s financial performance. +Interruptions in production could increase Howmet’s costs and reduce its sales. Any interruption in production capability could require the Company to incur costs for premium freight, make substantial capital expenditures, or purchase alternative material at higher costs to fill customer orders, which could negatively affect Howmet’s profitability and financial condition. Furthermore, a delivery delay by us due to production interruptions could subject us to liability from customer claims that such delay resulted in losses to the customer. Howmet maintains property damage insurance that the Company believes to be adequate to provide for reconstruction of facilities and equipment, as well as business interruption insurance to mitigate losses resulting from significant production interruption or shutdown caused by an insured loss. However, any recovery under Howmet’s insurance policies may not offset the lost profits or increased costs that may be experienced during the disruption of operations, which could adversely affect Howmet’s business, results of operations, financial condition and cash flow. +13 +Table of Contents +Information technology system failures, cyber attacks and security breaches may threaten the integrity of Howmet’s intellectual property and other sensitive information, disrupt its business operations, and result in reputational harm and other negative consequences that could have a material adverse effect on its financial condition and results of operations. +Howmet relies on its information technology systems to manage and operate its business, process transactions, and summarize its operating results. Howmet’s information technology systems could be subject to damage or interruption from power outages; computer, network and telecommunications failures; computer viruses; catastrophic events, such as fires, floods, earthquakes, tornadoes, hurricanes, acts of war or terrorism; and usage errors by employees. If Howmet’s information technology systems are damaged or cease to function properly, the Company may have to make a significant investment to fix or replace them, and Howmet may suffer loss of critical data and interruptions or delays in its operations. Any material disruption in the Company’s information technology systems, or delays or difficulties in implementing or integrating new systems or enhancing current systems, could have an adverse effect on Howmet’s business, financial condition or results of operations. +Howmet also faces global cybersecurity threats, which may range from uncoordinated individual attempts to sophisticated and targeted measures, known as advanced persistent threats, directed at the Company. Cyber attacks and security breaches may include, but are not limited to, attempts to access information, computer viruses, denial of service and other electronic security breaches. +The Company believes that it faces a heightened threat of cyber attacks due to the industries it serves, the locations of its operations and its technological innovations. The Company has experienced cybersecurity attacks in the past, including breaches of its information technology systems in which information was taken, and may experience them in the future, potentially with more frequency or sophistication. Based on information known to date, past attacks have not had a material impact on Howmet’s financial condition or results of operations. However, due to the evolving nature of cybersecurity threats, the scope and impact of any future incident cannot be predicted. +Howmet employs a number of measures to protect and defend against cyber attacks, including technical security controls, data encryption, firewalls, intrusion prevention systems, anti-virus software and frequent backups. Additionally, the Company conducts regular periodic training of its employees regarding the protection of sensitive information, which includes training intended to prevent the success of “phishing” attacks. While the Company continually works to safeguard its systems and mitigate potential risks, there is no assurance that such actions will be sufficient to prevent cyber attacks or security breaches that manipulate or improperly use the Company’s systems or networks, compromise confidential or otherwise protected information, destroy or corrupt data, or otherwise disrupt its operations. The occurrence of such events could negatively impact Howmet’s reputation and its competitive position and could result in litigation with third parties, regulatory action, loss of business, potential liability and increased remediation costs, any of which could have a material adverse effect on its financial condition and results of operations. In addition, such attacks or breaches could require significant management attention and resources, and could result in the diminution of the value of the Company’s investment in research and development. +Howmet’s enterprise risk management program and disclosure controls and procedures address cybersecurity and include elements intended to ensure that there is an analysis of potential disclosure obligations arising from cyber attacks and security breaches. Howmet also maintains compliance programs to address the potential applicability of restrictions against trading while in possession of material, nonpublic information generally and in connection with a cyber attack or security breach. +However, a breakdown in existing controls and procedures around the Company’s cybersecurity environment may prevent Howmet from detecting, reporting or responding to cyber incidents in a timely manner and could have a material adverse effect on the Company’s financial condition or the market price of its securities. +Howmet is dependent on a limited number of suppliers for a substantial portion of raw materials essential to our operations, and supply chain disruptions could have a material adverse effect on our business. +Howmet has supply arrangements with a limited number of suppliers for raw materials. We maintain annual or long-term contracts for a majority of our supply requirements, and for the remainder we depend on spot purchases. There can be no assurance that we will be able to renew, or obtain replacements for, any of our long-term contracts when they expire on terms that are as favorable as our existing agreements, or at all. +From time to time, increasing demand levels have caused regional supply constraints in the industry and further increases in demand levels could exacerbate these issues. Such constraints could impact our production or force us to purchase primary metal and other supplies from alternative sources, which may not be available in sufficient quantities or on terms that are favorable to us. Howmet could also have exposure if a key supplier is unable to deliver sufficient quantities of a necessary material on a timely basis. In addition, a significant downturn in the business or financial condition of a key supplier exposes us to the risk of default by the supplier on its contractual agreement, and this risk is increased by weak and deteriorating economic conditions on a global, regional or industry sector level. Any of the foregoing supply chain disruptions or those due to capacity constraints, trade barriers, labor shortages, business continuity, quality, cyber attacks, delivery issues or disruptions due to weather-related, natural disaster, or pandemic events could adversely affect Howmet’s operations and profitability. +14 +Table of Contents +Howmet’s business could be adversely affected by increases in the cost or volatility in the availability of raw materials. +Howmet may be adversely affected by changes in the availability or cost of raw materials (including, but not limited to, nickel, titanium, aluminum, cobalt, vanadium and platinum), as well as freight costs associated with transportation of raw materials. The availability and costs of certain raw materials necessary for the production of Howmet’s products may be influenced by private or government entities including mergers and acquisitions, changes in geopolitical conditions or regulatory requirements (such as human rights regulations or environmental regulations), labor relations between the producers and their work forces, unstable governments in exporting nations, export quotas, sanctions, new or increased import duties, countervailing or anti-dumping duties, market forces of supply and demand, and inflation. In addition, from time to time, commodity prices may fall rapidly. When this happens, suppliers may withdraw capacity from the market until prices improve, which may cause periodic supply interruptions. Howmet may be unable to offset fully the effects of raw material shortages or higher costs through customer price increases, productivity improvements or cost reduction programs. Shortages or price fluctuations in raw materials could have a material adverse effect on Howmet’s operating results. +Howmet could be adversely affected by the loss of key customers or significant changes in the business or financial condition of its customers. +Howmet has long-term contracts with a significant number of its customers, some of which are subject to renewal, renegotiation or re-pricing at periodic intervals or upon changes in competitive supply conditions. Howmet’s failure to successfully renew, renegotiate or favorably re-price such agreements, or a material deterioration in or termination of these customer relationships, could result in a reduction or loss in customer purchase volume or revenue. +Additionally, a significant downturn or deterioration in the business or financial condition or loss of a key customer supplied by Howmet could affect Howmet’s financial results. Howmet’s customers may experience delays in the launch of new products, labor strikes, diminished liquidity or credit unavailability, weak demand for their products, or other difficulties in their businesses. For example, due to the grounding of the 737 MAX aircraft by regulatory authorities in March 2019, Boeing suspended production of the aircraft in January 2020 and resumed low-rate production in May 2020, which has resulted in a reduction in the Company’s sales. While regulatory authorities in the United States and certain other jurisdictions lifted grounding orders beginning in late 2020, our sales could continue to be negatively affected from the residual impacts of the 737 MAX grounding. +Howmet’s customers may also change their business strategies or modify their business relationships with Howmet, including to reduce the amount of Howmet’s products they purchase or to switch to alternative suppliers. If Howmet’s customers reduce, terminate or delay purchases from Howmet due to the foregoing factors or otherwise and Howmet is unsuccessful in enforcing its contract rights or replacing such business in whole or in part or replaces it with less profitable business, our financial condition and results of operations may be adversely affected. +Howmet could be adversely affected by reductions in defense spending. +Howmet’s products are used in a variety of military applications, including military aircraft. Although many of the programs in which Howmet participates extend several years, they are subject to annual funding through congressional appropriations. Changes in military strategy, policy and priorities, or reductions in defense spending, may affect current and future funding of these programs and could reduce the demand for Howmet’s products, which could adversely affect Howmet’s business, financial condition or results of operations. +Howmet may be unable to realize future targets or goals established for its business, or complete projects, at the levels, projected costs or by the dates targeted. +From time to time, Howmet may announce future targets or goals for its business, including revenue growth, cash generation, cost savings, restructuring plans, cost reductions and improvements in profitability. Future targets and goals reflect the Company’s beliefs and assumptions and are based on the Company’s then current expectations, its perception of historical trends, and estimates and projections about the environment, economies and markets in which Howmet operates, as well as other applicable factors. As such, they are inherently subject to significant business, economic, competitive and other uncertainties regarding future events, including the risks discussed in this report. The actual outcome may be materially different. Failure by the Company to achieve the targets or goals at the levels or by the dates targeted, if at all, may have a material adverse effect on its business, financial condition, results of operations or the market price of its securities. +In addition, the implementation of Howmet’s business strategy may involve the entry into and the execution of complex projects, which place significant demands on the Company’s management and personnel, and may depend on numerous factors beyond the Company’s control. There can be no assurance that such projects will be completed within budgeted costs, on a timely basis, or at all, whether due to the risks described in this report, or other factors. The failure to complete a material project as planned, or a significant delay in its execution, could have an adverse effect on Howmet’s business, financial condition or results of operations. +Howmet faces significant competition, which may have an adverse effect on profitability. +15 +Table of Contents +As discussed in Part I, I tem 1 (Business-Competitive Conditions) of this report, the markets for Howmet’s products are highly competitive. Howmet’s competitors include a variety of both U.S. and non-U.S. companies in our product markets. New product offerings, new technologies in the marketplace or new facilities may compete with or replace Howmet products. The willingness of customers to accept substitutes for the products sold by Howmet, the ability of large customers to exert leverage in the marketplace to affect the pricing for Howmet’s products, and technological advancements or other developments by or affecting Howmet’s competitors or customers could adversely affect Howmet’s business, financial condition or results of operations. +In addition, Howmet may face increased competition due to industry consolidation. As companies attempt to strengthen or maintain their market positions in an evolving industry, companies could be acquired or merged. Companies that are strategic alliance partners in some areas of Howmet’s business may acquire or form alliances with Howmet’s competitors, thereby reducing their business with Howmet. Industry consolidation may result in stronger competitors who are better able to obtain favorable terms from suppliers or who are better able to compete as sole-source vendors for customers. Consolidation within Howmet’s customer base may result in customers who are better able to command increased leverage in negotiating prices and other terms of sale, which could adversely affect Howmet’s profitability. Moreover, if, as a result of increased leverage, customers require Howmet to reduce its pricing such that its gross margins are diminished, Howmet could decide not to sell certain products to a particular customer, or not to sell certain products at all, which would decrease Howmet’s revenue and could benefit its competitors. Consolidation within Howmet’s customer base may also lead to reduced demand for Howmet’s products if a combined entity replaces Howmet’s products with those of Howmet’s competitors with which it has prior relationships. The result of these developments could have a material adverse effect on Howmet’s business, operating results and financial condition. +Howmet may be unable to develop innovative new products or implement technology initiatives successfully. +Howmet’s competitive position and future performance depends, in part, on the Company’s ability to: +• identify and evolve with emerging technological and broader industry trends in Howmet’s end markets; +• identify and successfully execute on a strategy to remain an essential and sustainable element of our customers’ supply chains; +• fund, develop, manufacture and bring innovative new products to market quickly and cost-effectively; +• monitor disruptive technologies and understand customers’ and competitors’ abilities to deploy such technologies; and +• achieve sufficient return on investment for new products based on capital expenditures and research and development spending. +Howmet is working on new developments for a number of strategic projects, including advanced alloy development, engineered product design, and other advanced manufacturing technologies. While Howmet intends to continue to develop innovative new products and services, it may not be able to successfully differentiate its products or services from those of its competitors or match the level of research and development spending of its competitors, including those developing technology to displace Howmet’s current products. In addition, Howmet may not be able to adapt to evolving markets and technologies or achieve and maintain technological advantages. There can be no assurance that any of Howmet’s new products, development programs or technologies will be commercially adopted or be beneficial to Howmet. +Howmet’s business depends, in part, on its ability to meet increased program demand successfully and to mitigate the impact of program cancellations, reductions and delays. +Howmet is currently under contract to supply components for a number of new and existing commercial, general aviation, military aircraft and aircraft engine programs. Many of these contracts contemplate production increases over the next several years. If Howmet fails to meet production levels or encounters difficulty or unexpected costs in meeting such levels, it could have a material adverse effect on the Company’s business, financial condition or results of operations. Similarly, program cancellations, reductions or delays could also have a material adverse effect on Howmet’s business. +Risks Related to Legal and Regulatory Matters +Product liability, product safety, personal injury, property damage, and recall claims and investigations may materially affect Howmet’s financial condition and damage its reputation. +The manufacture and sale of our products expose Howmet to potential product liability, personal injury, property damage and related claims. These claims may arise from allegations of failure to meet product specifications, product design flaws and malfunction of products, as well as from misuse of our products, use of our products in an unintended, unapproved or unrecommended manner, or use of our products with systems not manufactured or sold by us. New data and information, including information about the ways in which Howmet’s products are used, may lead Howmet, regulatory authorities, government agencies or other entities or organizations to publish guidelines or recommendations, or impose restrictions, related to the manufacturing or use of Howmet’s products. +16 +Table of Contents +In the event that a Howmet product fails to perform as expected, regardless of fault, or is used in an unexpected manner, and such failure or use results in, or is alleged to result in, bodily injury and/or property damage or other losses, Howmet may be subject to product liability lawsuits and other claims, or may be required or requested by its customers to participate in a recall or other corrective action involving such product. In addition, if a Howmet product is perceived to be defective or unsafe, Howmet’s sales could decrease, its reputation could be adversely impacted and it could be subject to further liability claims. Moreover, events that give rise to actual, potential or perceived product safety concerns could expose Howmet to government investigations or regulatory enforcement actions. +There can be no assurance that Howmet will be successful in defending any such proceedings or that insurance available to Howmet will be sufficient to cover any losses associated with such proceedings. An adverse outcome in one or more of these proceedings or investigations could: (i) have a material adverse effect on Howmet’s business, financial condition or profitability; (ii) impose substantial monetary damages and/or non-monetary penalties; (iii) result in additional litigation, regulatory investigations or other proceedings involving Howmet; (iv) result in loss of customers; (v) require changes to our products or business operations; or (vi) damage Howmet’s reputation and/or negatively impact the market price of Howmet’s common stock. Even if Howmet successfully defends against these types of claims, Howmet could still be required to spend a substantial amount of money in connection with legal proceedings or investigations with respect to such claims; Howmet’s management could be required to devote significant time, attention and operational resources responding to and defending against these claims and responding to these investigations; and Howmet’s reputation could suffer. Product liability claims and related lawsuits and investigations, product recalls, and allegations of product safety or quality issues, regardless of their validity or ultimate outcome, may have a material adverse effect on Howmet’s business, financial condition and reputation and on our ability to attract and retain customers. +Our business may be adversely affected if we fail to comply with government contracting regulations. +We derive a portion of our revenue from sales to U.S. and foreign governments and their respective agencies, as a subcontractor of their prime contractors. Such contracts are subject to various procurement laws and regulations and contract provisions relating to their formation, administration and performance. Failure to comply with these laws, regulations or provisions in our government contracts could result in the imposition of various civil and criminal penalties, termination of contracts, forfeiture of profits, suspension of payments, increased pricing pressure or suspension from future government contracting. If our government contracts are terminated, if we are suspended from government work, or if our ability to compete for new contracts is adversely affected, our financial condition and results of operation could be adversely affected. +Howmet’s global operations expose Howmet to risks that could adversely affect its business, financial condition, results of operations, cash flows or the market price of its securities. +Howmet has operations or activities in numerous countries and regions outside the United States, including Europe, Canada, Mexico, China, and Japan. As a result, Howmet’s global operations are affected by economic, political and other conditions in the foreign countries in which Howmet does business, as well as U.S. laws regulating international trade, including: +• economic and commercial instability risks, including those caused by sovereign and private debt default, corruption, and changes in local government laws, regulations and policies, such as those related to tariffs, sanctions and trade barriers (including tariffs imposed by the United States as well as retaliatory tariffs imposed by China or other foreign entities), taxation, data privacy, exchange controls, employment regulations and repatriation of assets or earnings; +• geopolitical risks such as political instability, civil unrest, expropriation, nationalization of properties by a government, imposition of sanctions, and renegotiation or nullification of existing agreements; +• war, terrorist activities, kidnapping of personnel or other dangerous conditions; +• major public health issues, such as an outbreak of a pandemic or epidemic (such as Sudden Acute Respiratory Syndrome, Avian Influenza, H7N9 virus, coronavirus (including COVID-19), and the Ebola virus), which could cause disruptions in Howmet’s operations, workforce, supply chain or end markets; +• difficulties enforcing contractual rights and intellectual property, including a lack of remedies for misappropriation in certain jurisdictions; +• changes in trade and tax laws that may result in our customers being subjected to increased taxes, duties and tariffs and reduce their willingness to use our services in countries in which we are currently manufacturing their products; +• compliance with antitrust and competition regulations; +• rising labor costs or labor unrest, including strikes; +• compliance with foreign labor laws, which generally provide for increased notice, severance and consultation requirements as compared to U.S. laws; +• aggressive, selective or lax enforcement of laws and regulations by foreign governmental authorities; +• compliance with the Foreign Corrupt Practices Act and other anti-bribery and corruption laws; +17 +Table of Contents +• compliance with U.S. laws concerning trade, including the International Traffic in Arms Regulations, the Export Administration Regulations, and the sanctions, regulations and embargoes administered by the U.S. Department of Treasury’s Office of Foreign Assets Control; +• imposition of currency controls; and +• adverse tax audit rulings. +Although the effect of any of the foregoing factors is difficult to predict, any one or more of them could adversely affect Howmet’s business, financial condition, or results of operations. The Company’s international operations subject Howmet to complex and dynamic laws and regulations that, in some cases, could result in conflict or inconsistency between applicable laws of different jurisdictions and/or legal obligations. While Howmet believes it has adopted appropriate risk management, compliance programs and insurance arrangements to address and reduce the associated risks, such measures may provide inadequate protection against costs, penalties, liabilities or other potential risks such as loss of export privileges or repatriation of assets that may arise from such events. +Howmet may face challenges to its intellectual property rights which could adversely affect the Company’s reputation, business and competitive position. +Howmet owns important intellectual property, including patents, trademarks, copyrights and trade secrets. The Company’s intellectual property plays an important role in maintaining Howmet’s competitive position in a number of the markets that the Company serves. Howmet’s competitors may develop technologies that are similar or superior to Howmet’s proprietary technologies or design around the patents Howmet owns or licenses. Despite its controls and safeguards, Howmet’s technology may be misappropriated by its employees, its competitors or other third parties. The pursuit of remedies for any misappropriation of Howmet intellectual property is expensive and the ultimate remedies may be deemed insufficient. Further, in jurisdictions where the enforcement of intellectual property rights is less robust, the risk of misappropriation of Howmet intellectual property increases, despite efforts the Company undertakes to protect it. Developments or assertions by or against Howmet relating to intellectual property rights, and any inability to protect or enforce Howmet’s rights sufficiently, could adversely affect Howmet’s business and competitive position. +Howmet may be exposed to significant legal proceedings, investigations or changes in U.S. federal, state or foreign law, regulation or policy. +Howmet’s results of operations or liquidity in a particular period could be affected by new or increasingly stringent laws, regulatory requirements or interpretations, or outcomes of significant legal proceedings or investigations adverse to Howmet. The Company may experience an unfavorable change in effective tax rates or become subject to unexpected or rising costs associated with business operations or provision of health or welfare benefits to employees due to changes in laws, regulations or policies. +Howmet is also subject to a variety of legal and regulatory compliance risks in the United States and abroad in connection with its business and products. These risks include, among other things, potential claims relating to product liability, product testing, health and safety, environmental matters, employment matters, required record keeping and record retention, compliance with securities laws, intellectual property rights, government contracts and taxes, insurance or commercial matters, as well as compliance with U.S. and foreign laws and regulations, including those governing import and export, anti-bribery, antitrust and competition, sales and trading practices, human rights and modern slavery, sourcing of raw materials, third-party relationships, supply chain operations and the manufacture and sale of products. Howmet may be a party to litigation in a foreign jurisdiction where geopolitical risks might influence the ultimate outcome of such litigation. Howmet could be subject to fines, penalties, damages (in certain cases, treble damages), or suspension or debarment from government contracts. +The global and diverse nature of Howmet’s operations means that these risks will continue to exist, and additional legal proceedings and contingencies may arise from time to time. While Howmet believes it has adopted appropriate risk management and compliance programs to address and reduce these risks, including insurance arrangements with respect to these risks, such measures may provide inadequate protection against liabilities that may arise. In addition, various factors or developments can lead the Company to change current estimates of liabilities or make such estimates for matters previously unsusceptible to reasonable estimates, such as a significant judicial ruling or judgment, a significant settlement, significant regulatory developments or changes in applicable law. A future adverse ruling or settlement or unfavorable changes in laws, regulations or policies, or other contingencies that the Company cannot predict with certainty could have a material adverse effect on the Company’s financial condition, results of operations or cash flows in a particular period. Litigation and compliance efforts may require substantial attention from management and could result in significant legal expenses, settlement costs or damage awards that could have a material impact on the Company’s financial position, results of operations and cash flows. For additional information regarding the legal proceedings involving the Company, see Part I, Item 3 (Legal Proceedings) of this report and in Note V to the Consolidated Financial Statements in Part II, Item 8. +Unanticipated changes in Howmet’s tax provisions or exposure to additional tax liabilities could affect Howmet’s future profitability. +18 +Table of Contents +Howmet is subject to income taxes in both the United States and various non-U.S. jurisdictions. Its domestic and international tax liabilities are dependent upon the distribution of income among these different jurisdictions. Changes in applicable domestic or foreign tax laws and regulations, or their interpretation and application, including the possibility of retroactive effect, could affect the Company’s tax expense and profitability. Howmet’s tax expense includes estimates of additional tax that may be incurred for tax exposures and reflects various estimates and assumptions. The assumptions include assessments of future earnings of the Company that could impact the valuation of its deferred tax assets. The Company’s future results of operations could be adversely affected by changes in the effective tax rate as a result of a change in the mix of earnings in countries with differing statutory tax rates, changes in the overall profitability of the Company, changes in tax legislation and rates, changes in generally accepted accounting principles, changes in the valuation of deferred tax assets and liabilities, the results of tax audits and examinations of previously filed tax returns or related litigation and continuing assessments of its tax exposures. +Corporate tax law changes continue to be analyzed in the United States and in many other jurisdictions. In particular, on December 22, 2017, the Tax Cuts and Jobs Act (the “2017 Act”) was signed into law, significantly reforming the U.S. Internal Revenue Code of 1986, as amended. During 2018, the Internal Revenue Service (the “IRS”) began a number of guidance projects which serve to both interpret and implement the 2017 Act. Those guidance projects, which include both Proposed and Final Treasury Regulations, continued into 2020. Howmet continues to review the ongoing interpretive guidance and evaluate its consequences. The ultimate impact of the 2017 Act may differ from reported amounts due to, among other things, changes resulting from such ongoing guidance. Further, we cannot predict the impact of any efforts to change or repeal the 2017 Act or enact alternative legislation by the new presidential administration or Congress. +Labor disputes and other employee relations issues could adversely affect Howmet’s business, financial condition or results of operations. +A significant portion of Howmet’s employees are represented by labor unions in a number of countries under various collective bargaining agreements with varying durations and expiration dates. For more information, see “Employees” in Part I, Item 1 (Business) of this report. While Howmet previously has been successful in renegotiating its collective bargaining agreements with various unions, Howmet may not be able to satisfactorily renegotiate all collective bargaining agreements in the United States and other countries when they expire. In addition, existing collective bargaining agreements may not prevent a strike or work stoppage at Howmet’s facilities in the future. Howmet may also be subject to general country strikes or work stoppages unrelated to its business or collective bargaining agreements. Any such work stoppages (or potential work stoppages) could have a material adverse effect on Howmet’s business, financial condition or results of operations. +Howmet is subject to privacy and data security/protection laws in the jurisdictions in which it operates and may be exposed to substantial costs and liabilities associated with such laws and regulations. +The regulatory environment surrounding information security and privacy is increasingly demanding, with frequent imposition of new and changing requirements. For example, the European Union’s General Data Protection Regulation (“GDPR”), which became effective in May 2018, imposed significant new requirements on how companies process and transfer personal data, as well as significant fines for non-compliance. Compliance with changes in privacy and information security laws and standards may result in significant expense due to increased investment in technology and the development of new operational processes, which could have a material adverse effect on Howmet’s financial condition and results of operations. In addition, the payment of potentially significant fines or penalties in the event of a breach of the GDPR or other privacy and information security laws, as well as the negative publicity associated with such a breach, could damage the Company’s reputation and adversely impact product demand and customer relationships. +Failure to comply with domestic or international employment and related laws could result in penalties or costs that could have a material adverse effect on Howmet’s business results. +Howmet is subject to a variety of domestic and foreign employment laws, such as the Fair Labor Standards Act (which governs such matters as minimum wages, overtime and other working conditions), state and local wage laws, the Employee Retirement Income Security Act, and regulations related to safety, discrimination, organizing, whistle-blowing, classification of employees, privacy and severance payments, citizenship requirements, and healthcare insurance mandates. Allegations that Howmet has violated such laws or regulations could damage the Company’s reputation and lead to fines from or settlements with federal, state or foreign regulatory authorities or damages payable to employees, which could have a material adverse impact on Howmet’s operations and financial condition. +Howmet is exposed to environmental, health and safety risks and is subject to a broad range of health, safety and environmental laws and regulations which may result in substantial costs and liabilities. +Howmet’s operations worldwide are subject to numerous complex and increasingly stringent health, safety and environmental laws and regulations. The costs of complying with such laws and regulations, including participation in assessments and cleanups of sites, as well as internal voluntary programs, are significant and will continue to be so for the foreseeable future. Environmental laws may impose cleanup liability on owners and occupiers of contaminated property, including present, past or divested properties, regardless of whether the owners and occupiers caused the contamination or whether the activity that +19 +Table of Contents +caused the contamination was lawful at the time it was conducted. Environmental matters for which Howmet may be liable may arise in the future at its present sites, at sites owned or operated by its predecessors or affiliates, at sites that it may acquire in the future, or at third-party sites used by Howmet, its predecessors or affiliates for material and waste handling and disposal. Compliance with health, safety and environmental laws and regulations, including remediation obligations, may prove to be more challenging and costly than the Company anticipates. Howmet’s results of operations or liquidity in a particular period could be affected by certain health, safety or environmental matters, including remediation costs and damages related to certain sites as well as other health and safety risks relating to its operations and products. Additionally, evolving regulatory standards and expectations can result in increased litigation and/or increased costs, including increased remediation costs, all of which can have a material and adverse effect on the Company’s financial condition, results of operations and cash flows. +In addition, the industrial activities conducted at Howmet’s facilities present a significant risk of injury or death to our employees, customers or third parties that may be on site. We have experienced serious injuries in the past, notwithstanding the safety protocols, practices and precautions we take. Our operations are subject to regulation by various federal, state and local agencies in the United States and regulation by foreign government entities abroad responsible for employee health and safety, including the Occupational Safety and Health Administration. From time to time, we have incurred fines for violations of various health and safety standards. In addition to industrial activities, the global COVID-19 pandemic will continue to significantly impact the health of our employees and increase the cost of health and safety measures within our operations. Significant community transmission in the vicinity of our operations is likely to impact the workforce availability due to quarantine and isolation practices. Social distancing, mask use, testing and other measures increase costs of operation. While we maintain insurance and have in place policies to minimize risks associated with industrial activities and COVID-19, we may nevertheless be unable to avoid material liabilities relating to any injury, death or other workers compensation claims. These types of incidents may not be covered by or may exceed our insurance coverage and could have a material adverse effect on our results of operations and financial condition or result in negative publicity and/or significant reputational harm. +Howmet may be affected by global climate change or by legal, regulatory, or market responses to such change. +Increased concern over climate change has led to new and proposed legislative and regulatory initiatives, such as cap-and-trade systems, additional limits on emissions of greenhouse gases or Corporate Average Fuel Economy (“CAFE”) standards in the United States. New or revised laws and regulations in this area could directly and indirectly affect Howmet and its customers and suppliers, including by increasing the costs of production or impacting demand for certain products, which could result in an adverse effect on our financial condition, results of operations and cash flows. Compliance with any new or more stringent laws or regulations, or stricter interpretations of existing laws, could require additional expenditures by the Company or its customers or suppliers. Also, Howmet relies on natural gas, electricity, fuel oil and transport fuel to operate its facilities. Any increased costs of these energy sources because of new laws could be passed along to the Company and its customers and suppliers, which could also have a negative impact on Howmet’s profitability. +Physical risk associated with climate change may result in an increase of the exposure and impact of events with damage due to flooding, extreme winds and extreme precipitation for Howmet locations, suppliers or customers. Prolonged periods of drought may result in wildfires, which may have an adverse effect on production capacity of Howmet sites, suppliers and customers. While we maintain insurance coverage, these types of incidents may not be covered by or may exceed our insurance coverage and could have a material adverse effect on our results of operations and financial condition. +Risks Related to Liquidity and Capital Resources +A decline in Howmet’s financial performance or outlook or a deterioration in its credit profile could negatively impact the Company’s access to capital markets, its liquidity and its borrowing costs. +Howmet has significant capital requirements and depends, in part, upon the issuance of debt to fund its operations and contractual commitments and pursue strategic actions. A decline in the Company’s financial performance or outlook due to internal or external factors could affect the Company’s access to, and the availability or cost of, financing on acceptable terms and conditions. There can be no assurance that Howmet will have access to the global capital market on terms the Company finds acceptable. Limitations on Howmet’s ability to access the global capital markets, a reduction in the Company’s liquidity or an increase in borrowing costs could materially and adversely affect Howmet’s ability to maintain or grow its business, which in turn may adversely affect its financial condition and results of operations. +A downgrade of Howmet’s credit ratings could limit its ability to obtain future financing, increase borrowing costs and costs relating to credit facilities, adversely affect the market price of Howmet securities, trigger collateral postings, or otherwise impair its business, financial condition, and results of operations. +Howmet’s credit ratings are important to the Company’s cost of capital. The major credit rating agencies evaluate our creditworthiness and give us specified credit ratings. These ratings are based on a number of factors, including our financial strength and financial policies as well as our strategies, operations, execution and timeliness of financial reporting. These credit ratings are limited in scope, and do not address all material risks related to investment in us, but rather reflect only the view of each rating agency at the time the rating is issued. Nonetheless, the credit ratings Howmet receives impact our borrowing costs +20 +Table of Contents +as well as the terms upon which we will have access to capital. Failure to maintain sufficiently high credit ratings could adversely affect the interest rate in future financings, our liquidity or our competitive position, and could also restrict our access to capital markets. For information on our credit ratings, see "Liquidity and Capital Resources" in Part II, Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations). +There can be no assurance that one or more of the credit rating agencies will not take negative actions with respect to Howmet’s ratings in the future. Increased debt levels, macroeconomic conditions, a deterioration in the Company’s debt protection metrics, a contraction in the Company’s liquidity, or other factors could potentially trigger such actions. A rating agency may lower, suspend or withdraw entirely a rating or place it on negative outlook or watch if, in that rating agency’s judgment, circumstances so warrant. A downgrade of Howmet’s credit ratings by one or more rating agencies could result in adverse consequences, including: (i) adversely impact the market price of Howmet securities; (ii) adversely affect existing financing (for example, a downgrade by S&P or Moody’s would subject Howmet to higher costs under the Credit Agreement); (iii) limit access to the capital (including commercial paper) or credit markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all; (iv) result in more restrictive covenants in agreements governing the terms of any future indebtedness that the Company incurs; (v) increase the cost of borrowing or fees on undrawn credit facilities; or (vi) result in vendors or counterparties seeking collateral or letters of credit from Howmet. +Limitations on Howmet’s ability to access the global capital markets, a reduction in Howmet’s liquidity or an increase in borrowing costs could materially and adversely affect Howmet’s ability to maintain or grow its business, which in turn may adversely affect its financial condition, liquidity and results of operations. +Howmet’s business and growth prospects may be negatively impacted by limits in its capital expenditures. +Howmet requires substantial capital to invest in growth opportunities and to maintain and prolong the life and capacity of its existing facilities. Insufficient cash generation or capital project overruns may negatively impact Howmet’s ability to fund as planned its sustaining and return-seeking capital projects. Over the long term, Howmet’s ability to take advantage of improved market conditions or growth opportunities in its businesses may be constrained by earlier capital expenditure restrictions, which could adversely affect the long-term value of its business and the Company’s position in relation to its competitors. +An adverse decline in the liability discount rate, lower-than-expected investment return on pension assets and other factors could adversely affect Howmet’s results of operations or amount of pension funding contributions in future periods. +Howmet’s results of operations may be negatively affected by the amount of expense Howmet records for its pension and other postretirement benefit plans, reductions in the fair value of plan assets and other factors. Howmet calculates income or expense for its plans using actuarial valuations in accordance with accounting principles generally accepted in the United States of America ("GAAP"). +These valuations reflect assumptions about financial market and other economic conditions, which may change based on changes in key economic indicators. The most significant year-end assumptions used by Howmet to estimate pension or other postretirement benefit income or expense for the following year are the discount rate applied to plan liabilities and the expected long-term rate of return on plan assets. In addition, Howmet is required to make an annual measurement of plan assets and liabilities, which may result in a significant charge to shareholders’ equity. For a discussion regarding how Howmet’s financial statements can be affected by pension and other postretirement benefits accounting policies, see “Critical Accounting Policies and Estimates—Pension and Other Postretirement Benefits” in Part II, Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and Note H to the Consolidated Financial Statements in Part II, Item 8. Although GAAP expense and pension funding contributions are impacted by different regulations and requirements, the key economic factors that affect GAAP expense would also likely affect the amount of cash or securities Howmet would contribute to the pension plans. +Potential pension contributions include both mandatory amounts required under federal law and discretionary contributions to improve the plans’ funded status. The Moving Ahead for Progress in the 21st Century Act (“MAP-21”), enacted in 2012, provided temporary relief for employers like Howmet who sponsor defined benefit pension plans related to funding contributions under the Employee Retirement Income Security Act of 1974 by allowing the use of a 25-year average discount rate within an upper and lower range for purposes of determining minimum funding obligations. In 2014, the Highway and Transportation Funding Act ("HATFA") extended the relief provided by MAP-21 and modified the interest rates that had been set by MAP-21. In 2015, the Bipartisan Budget Act of 2015 ("BBA 2015") extended the relief period provided by HATFA. Howmet believes that the relief provided by BBA 2015 will moderately reduce the cash flow sensitivity of the Company’s U.S. pension plans’ funded status over the next several years due to recent and potential future declines in discount rates. However, higher than expected pension contributions due to a decline in the plans’ funded status as a result of unpredictable future declines in the discount rate or lower-than-expected investment returns on plan assets could have a material negative effect on the Company’s cash flows. Adverse capital market conditions could result in reductions in the fair value of plan assets and increase the Company’s liabilities related to such plans, which could adversely affect our liquidity and results of operations. +21 +Table of Contents +Howmet is exposed to fluctuations in foreign currency exchange rates and interest rates, as well as inflation, economic factors, and currency controls in the countries in which it operates. +Economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, competitive factors in the countries in which Howmet operates, and volatility or deterioration in the global economic and financial environment could affect Howmet’s revenue, expenses and results of operations. Changes in the valuation of the U.S. dollar against other currencies, including the Euro, British pound, Canadian dollar, Chinese yuan (renminbi), and Japanese yen, may affect Howmet’s profitability. +In addition, a portion of Howmet’s indebtedness, including borrowings, if any, under the Company’s Five-Year Credit Facility, bears interest at rates equal to the London Interbank Offering Rate (“LIBOR”) plus an applicable margin based on the credit ratings of Howmet’s outstanding senior unsecured long-term debt. Accordingly, the Company is subject to risk from changes in interest rates on the variable component of the rate. Further, LIBOR is the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms and other pressures may cause LIBOR to disappear entirely or to perform differently than in the past. The consequences of these developments cannot be entirely predicted, but could include changes in the cost of Howmet’s variable rate indebtedness. +Howmet also faces risks arising from the imposition of cash repatriation restrictions and exchange controls. Cash repatriation restrictions and exchange controls may limit the Company’s ability to convert foreign currencies into U.S. dollars or to remit dividends and other payments by Howmet’s foreign subsidiaries or businesses located in or conducted within a country imposing restrictions or controls. While Howmet currently has no need, and does not intend, to repatriate or convert cash held in countries that have significant restrictions or controls in place, should the Company need to do so to fund its operations, it may be unable to repatriate or convert such cash, or be unable to do so without incurring substantial costs. Howmet currently has operations in countries that have cash repatriation restrictions or exchange controls in place, including China, and, if the Company were to need to repatriate or convert such cash, these controls and restrictions may have an adverse effect on Howmet’s operating results and financial condition. +Dividends and share repurchases fall within the discretion of our Board of Directors, depend on a number of factors, and are subject to limits under the Company’s Credit Agreement. +Share repurchases and the declaration of dividends fall within the discretion of Howmet’s Board of Directors, and the Board’s decision regarding such matters depends on many factors, including Howmet’s financial condition, earnings, capital requirements, debt service obligations, covenants associated with certain of the Company’s debt obligations, industry practice, legal requirements, regulatory constraints and other factors that the Board deems relevant. In addition, under the Company’s amendment to the Credit Agreement, during the period from June 30, 2020 through December 31, 2021 (unless the Company ends this period earlier in accordance with the amendment or otherwise), common stock dividends and share repurchases are permitted only if no borrowings are outstanding under the Credit Agreement and are limited to an aggregate amount of $100 million through June 30, 2021, with such limit increasing to an aggregate amount of $250 million after June 30, 2021 if the Consolidated Net Debt to Consolidated EBITDA ratio is no greater than 3.75 to 1.00. The Company suspended dividends in April 2020 to preserve cash and provide flexibility in light of the impact of the COVID-19 pandemic. Since June 30, 2020, the Company has repurchased approximately $ 73 million of its common stock. There can be no assurance that the Company will declare dividends or repurchase stock in the future in any particular amounts, or at all. +General Risks +Failure to attract and retain a highly skilled and diverse global workforce, or provide adequate succession plans for key personnel could adversely affect Howmet’s operations and competitiveness. +Howmet’s global operations require highly skilled personnel with relevant industry and technical experience. Shortages in certain skills, in areas such as engineering, manufacturing and technology and other labor market inadequacies have created more competition for talent among us and other companies both within and outside of our industry. If the Company fails to attract, develop and retain a diverse global workforce with the skills and in the locations we need to operate and grow our business, our operations could be adversely impacted. +In addition, the continuity of key personnel and the preservation of institutional knowledge are vital to the success of the Company’s growth and business strategy. The loss of key members of management and other personnel could significantly harm Howmet’s business, and any unplanned turnover, or failure to develop adequate succession plans for key positions, could deplete the Company’s institutional knowledge base, result in loss of technical or other expertise, delay or impede the execution of the Company’s business plans and erode Howmet’s competitiveness. +Howmet may be unable to realize the expected benefits from acquisitions, divestitures and strategic alliances. +Howmet has made, and may continue to plan and execute, acquisitions and divestitures and take other actions to grow its business or streamline its portfolio. There is no assurance that anticipated benefits will be realized. Acquisitions present significant challenges and risks, including the effective integration of the business into the Company, unanticipated costs and +22 +Table of Contents +liabilities, and the ability to realize anticipated benefits, such as growth in market share, revenue or margins, at the levels or in the timeframe expected. The Company may be unable to manage acquisitions successfully. Additionally, adverse factors may prevent Howmet from realizing the benefits of its growth projects, including unfavorable global economic conditions, currency fluctuations, or unexpected delays in target timelines. +With respect to portfolio optimization actions such as divestitures, curtailments and closures, Howmet may face barriers to exit from unprofitable businesses or operations, including high exit costs or objections from customers, suppliers, unions, local or national governments, or other stakeholders. In addition, Howmet may retain unforeseen liabilities for divested entities or businesses, including, but not limited to, if a buyer fails to honor all commitments. Howmet’s business operations are capital intensive, and curtailment or closure of operations or facilities may include significant charges, including employee separation costs, asset impairment charges and other measures. +In addition, Howmet has participated in, and may continue to participate in, strategic alliances, joint ventures and other similar arrangements from time to time. Strategic alliances and joint ventures inherently involve special risks. Even if Howmet holds majority interests or maintains operational control in such arrangements, its partners may have opposing economic or business interests, exercise veto rights to block Howmet actions, take action contrary to Howmet’s policies or objectives, or, as a result of financial or other difficulties, be unable to fulfill their obligations. +There can be no assurance that acquisitions, growth investments, divestitures, closures, strategic alliances, joint ventures or similar arrangements will be undertaken or completed in their entirety as planned or that they will be beneficial to Howmet, whether due to the above-described risks, unfavorable global economic conditions, increases in costs, currency fluctuations, geopolitical risks, or other factors. +Anti-takeover provisions could prevent or delay a change in control of Howmet, including a takeover attempt by a third party and limit the power of Howmet’s shareholders. +Howmet’s Certificate of Incorporation and Bylaws contain, and Delaware law contains, provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the bidder and to encourage prospective acquirers to negotiate with Howmet’s Board of Directors rather than to attempt a hostile takeover. For example, Howmet is subject to Section 203 of the Delaware General Corporation Law, which imposes certain restrictions on mergers and other business combinations between the Company and any holder of 15% or more of the Company’s outstanding common stock, which could make it more difficult for another party to acquire Howmet. Additionally, the Company’s Certificate of Incorporation authorizes Howmet’s Board of Directors to issue preferred stock or adopt other anti-takeover measures without stockholder approval. These provisions may apply even if an offer may be considered beneficial by some stockholders and could delay or prevent an acquisition that Howmet’s Board of Directors determines is not in the best interests of Howmet’s shareholders. These provisions may also limit the price that investors might be willing to pay in the future for shares of Howmet common stock or prevent or discourage attempts to remove and replace incumbent directors. +Arconic Corporation may fail to perform under various transaction agreements that were executed as part of the Arconic Inc. Separation Transaction. +In connection with the Arconic Inc. Separation Transaction, we entered into a separation and distribution agreement with Arconic Corporation and also entered into various other agreements, including a tax matters agreement, an agreement related to the Davenport plant, an employee matters agreement, intellectual property license agreements, metal supply agreements and real estate and office leases. The separation and distribution agreement, the tax matters agreement and the employee matters agreement, together with the documents and agreements by which the internal reorganization of the Company prior to the separation was effected, determined the allocation of assets and liabilities between us and Arconic Corporation following the Arconic Inc. Separation Transaction for those respective areas and included any necessary indemnifications related to liabilities and obligations. We will rely on Arconic Corporation to satisfy its performance and payment obligations under these agreements. If Arconic Corporation is unable or unwilling to satisfy its obligations under these agreements, including its indemnification obligations, we could incur operational difficulties and/or losses. +In connection with the Arconic Inc. Separation Transaction, Arconic Corporation agreed to indemnify us for certain liabilities and we agreed to indemnify Arconic Corporation for certain liabilities. If we are required to pay under these indemnities to Arconic Corporation, our financial results could be negatively impacted. The Arconic Corporation indemnity may not be sufficient to hold us harmless from the full amount of liabilities for which Arconic Corporation is allocated responsibility, and Arconic Corporation may not be able to satisfy its indemnification obligations in the future. +Pursuant to the separation and distribution agreement and certain other agreements with Arconic Corporation, Arconic Corporation has agreed to indemnify us for certain liabilities, and we have agreed to indemnify Arconic Corporation for certain liabilities, in each case for uncapped amounts. Indemnities that we may be required to provide Arconic Corporation are not subject to any cap, may be significant and could negatively impact our business. Third parties could also seek to hold us responsible for any of the liabilities that Arconic Corporation has agreed to retain. Any amounts we are required to pay pursuant to these indemnification obligations and other liabilities could require us to divert cash that would otherwise have been used in +23 +Table of Contents +furtherance of the Company’s operations. Further, the indemnity from Arconic Corporation may not be sufficient to protect us against the full amount of such liabilities, and Arconic Corporation may not be able to fully satisfy its indemnification obligations. Moreover, even if we ultimately succeed in recovering from Arconic Corporation any amounts for which we are held liable, we may be temporarily required to bear such losses. Each of these risks could negatively affect our business, results of operations and financial condition. +The Arconic Inc. Separation Transaction could result in substantial tax liability. +It was a condition to the Distribution of Arconic that we receive an opinion of our outside counsel, satisfactory to our Board of Directors, regarding the qualification of the distribution, together with certain related transactions, as a “reorganization” within the meaning of Sections 355 and 368(a)(1)(D) of the Internal Revenue Code of 1986, as amended (the “Code”). This condition was satisfied prior to the Distribution of Arconic. However, the opinion of counsel was based upon and relied on, among other things, various facts and assumptions, as well as certain representations, statements and undertakings by us and Arconic Corporation, including those relating to the past and future conduct by us and Arconic Corporation. If any of these facts, assumptions, representations, statements or undertakings is, or becomes, inaccurate or incomplete, or if we or Arconic Corporation breach any of our representations or covenants contained in the separation agreement and certain other agreements and documents or in any documents relating to the opinion of counsel, the opinion of counsel may be invalid and the conclusions reached therein could be jeopardized. +Notwithstanding our receipt of the opinion of counsel, the Internal Revenue Service (the “IRS”) could determine that the Distribution of Arconic and/or certain related transactions should be treated as taxable transactions for U.S. federal income tax purposes if it determines that any of the representations, assumptions or undertakings upon which the opinion of counsel was based are false or have been violated. In addition, the opinion of counsel represents the judgment of such counsel and is not binding on the IRS or any court, and the IRS or a court may disagree with the conclusions in the opinion of counsel. Accordingly, notwithstanding receipt of the opinion of counsel, there can be no assurance that: (i) the IRS will not assert that the Distribution of Arconic and/or certain related transactions do not qualify for tax-free treatment for U.S. federal income tax purposes; or (ii) a court would not sustain such a challenge. In the event the IRS were to prevail with such challenge, we, our stockholders and Arconic Corporation, could be subject to significant U.S. federal income tax liability. +If the Distribution of Arconic fails to qualify as a transaction that is generally tax-free for U.S. federal income tax purposes under Sections 355 and 368(a)(1)(D) of the Code, in general, for U.S. federal income tax purposes, we would recognize taxable gain as if we had sold the Arconic Corporation common stock in a taxable sale for its fair market value, and our stockholders who received such Arconic Corporation shares in the Distribution of Arconic would be subject to tax as if they had received a taxable distribution equal to the fair market value of such shares. +Under current U.S. federal income tax law, even if the Distribution of Arconic, together with certain related transactions, otherwise qualifies for tax-free treatment under Sections 355 and 368(a)(1)(D) of the Code, the Distribution of Arconic may nevertheless be rendered taxable to us as a result of certain post-distribution transactions, including certain acquisitions of shares or assets of ours or Arconic Corporation. Under the tax matters agreement entered into between us and Arconic Corporation in connection with the Arconic Inc. Separation Transaction, Arconic Corporation may be required to indemnify us for any taxes resulting from the Arconic Inc. Separation Transaction (and any related costs and other damages) to the extent such amounts resulted from (i) an acquisition of all or a portion of the equity securities or assets of Arconic Corporation, whether by merger or otherwise (and regardless of whether we participated in or otherwise facilitated the acquisition), (ii) other actions or failures to act by Arconic Corporation, or (iii) any of Arconic Corporation’s representations, covenants or undertakings contained in the separation agreement and certain other agreements and documents or in any documents relating to the opinion of counsel being incorrect or violated. However, the indemnity from Arconic Corporation may not be sufficient to protect us against the full amount of such additional taxes or related liabilities, and Arconic Corporation may not be able to fully satisfy its indemnification obligations. Moreover, even if we ultimately succeed in recovering from Arconic Corporation any amounts for which we are held liable, we may be temporarily required to bear such losses. In addition, we and our subsidiaries may incur certain tax costs in connection with the Arconic Inc. Separation Transaction, including non-U.S. tax costs resulting from transactions (including the internal reorganization) in non-U.S. jurisdictions, which may be material. Each of these risks could negatively affect our business, results of operations and financial condition. +The Alcoa Inc. Separation Transaction could result in substantial tax liability. +It was a condition to the Distribution of Alcoa that (i) the private letter ruling from the Internal Revenue Service (the “IRS”) regarding certain U.S. federal income tax matters relating to the Alcoa Inc. Separation Transaction and the Distribution of Alcoa received by Howmet remain valid and be satisfactory to Howmet’s Board of Directors and (ii) Howmet receive an opinion of its outside counsel, satisfactory to the Board of Directors, regarding the qualification of the Distribution of Alcoa, together with certain related transactions, as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) of the Internal Revenue Code of 1986, as amended (the “Code”). Both of these conditions were satisfied prior to the Distribution of Alcoa. However, the IRS private letter ruling and the opinion of counsel were based upon and relied on, among other things, various facts and assumptions, as well as certain representations, statements and +24 +Table of Contents +undertakings of Howmet and Alcoa Corporation, including those relating to the past and future conduct of Howmet and Alcoa Corporation. If any of these representations, statements or undertakings is, or becomes, inaccurate or incomplete, or if Howmet or Alcoa Corporation breaches any of its representations or covenants contained in any of the Alcoa Inc. Separation Transaction-related agreements and documents or in any documents relating to the IRS private letter ruling and/or the opinion of counsel, the IRS private letter ruling and/or the opinion of counsel may be invalid and the conclusions reached therein could be jeopardized. +Notwithstanding Howmet’s receipt of the IRS private letter ruling and the opinion of counsel, the IRS could determine that the Distribution of Alcoa and/or certain related transactions should be treated as taxable transactions for U.S. federal income tax purposes if it determines that any of the representations, assumptions or undertakings upon which the IRS private letter ruling or the opinion of counsel was based are false or have been violated. In addition, the IRS private letter ruling does not address all of the issues that are relevant to determining whether the Distribution of Alcoa, together with certain related transactions, qualifies as a transaction that is generally tax-free for U.S. federal income tax purposes, and the opinion of counsel represents the judgment of such counsel and is not binding on the IRS or any court and the IRS or a court may disagree with the conclusions in the opinion of counsel. Accordingly, notwithstanding receipt by Howmet of the IRS private letter ruling and the opinion of counsel, there can be no assurance that (i) the IRS will not assert that the Distribution of Alcoa and/or certain related transactions do not qualify for tax-free treatment for U.S. federal income tax purposes; or (ii) a court would not sustain such a challenge. In the event the IRS were to prevail with such challenge, Howmet, Alcoa Corporation and Howmet shareholders could be subject to significant U.S. federal income tax liability. +If the Distribution of Alcoa, together with certain related transactions, fails to qualify as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) of the Code, in general, for U.S. federal income tax purposes, Howmet would recognize taxable gain as if it had sold the Alcoa Corporation common stock in a taxable sale for its fair market value and Howmet shareholders who received Alcoa Corporation shares in the distribution would be subject to tax as if they had received a taxable distribution equal to the fair market value of such shares. +Under current U.S. federal income tax law, even if the Distribution of Alcoa, together with certain related transactions, otherwise qualifies for tax-free treatment under Sections 355 and 368(a)(1)(D) of the Code, the Distribution of Alcoa may nevertheless be rendered taxable to Howmet and its shareholders as a result of certain post-Distribution of Alcoa transactions, including certain acquisitions of shares or assets of Howmet or Alcoa Corporation. The possibility of rendering the Distribution of Alcoa taxable as a result of such transactions may limit Howmet’s ability to pursue certain equity issuances, strategic transactions or other transactions that would otherwise maximize the value of Howmet’s business. Under the Tax Matters Agreement that Howmet entered into with Alcoa Corporation, Alcoa Corporation may be required to indemnify Howmet against any additional taxes and related amounts resulting from (i) an acquisition of all or a portion of the equity securities or assets of Alcoa Corporation, whether by merger or otherwise (and regardless of whether Alcoa Corporation participated in or otherwise facilitated the acquisition), (ii) other actions or failures to act by Alcoa Corporation or (iii) any of Alcoa Corporation’s representations, covenants or undertakings contained in any of the Alcoa Inc. Separation Transaction-related agreements and documents or in any documents relating to the IRS private letter ruling and/or the opinion of counsel being incorrect or violated. However, the indemnity from Alcoa Corporation may be insufficient to protect Howmet against the full amount of such additional taxes or related liabilities, and Alcoa Corporation may be unable to satisfy its indemnification obligations fully. Moreover, even if Howmet ultimately succeeds in recovering from Alcoa Corporation any amounts for which Howmet is held liable, Howmet may be temporarily required to bear such losses. In addition, Howmet and Howmet’s subsidiaries may incur certain tax costs in connection with the Alcoa Inc. Separation Transaction, including tax costs resulting from separations in non-U.S. jurisdictions, which may be material. Each of these risks could negatively affect Howmet’s business, results of operations and financial condition. +Item 1B. Unresolved Staff Comments. +None. +25 +Table of Contents +Item 2. Properties. +Howmet’s principal office and corporate center is located at 201 Isabella Street, Suite 200, Pittsburgh, Pennsylvania 15212-5858. +Howmet leases some of its facilities; however, it is the opinion of management that the leases do not materially affect the continued use of the properties or the properties’ values. +Howmet believes that its facilities are suitable and adequate for its operations. Although no title examination of properties owned by Howmet has been made for the purpose of this report, the Company knows of no material defects in title to any such properties. See Notes A and O to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. +Howmet has active plants and holdings in various geographic areas. See the table regarding the Company's principal facilities in Part I, Item 1. (Business). +Item 3. Legal Proceedings. +In the ordinary course of its business, Howmet is involved in a number of lawsuits and claims, both actual and potential. For a discussion of legal proceedings, see Note V to the Consolidated Financial Statements in Part II, Item 8, in addition to the matters set forth below. +Environmental Matters +Howmet is involved in proceedings under the Comprehensive Environmental Response, Compensation and Liability Act, also known as Superfund (“CERCLA”) or analogous state provisions regarding the usage, disposal, storage or treatment of hazardous substances at a number of sites in the U.S. The Company has committed to participate, or is engaged in negotiations with federal or state authorities relative to its alleged liability for participation, in clean-up efforts at several such sites. See the Environmental Matters section of Note V to the Consolidated Financial Statements for more information. +Other Matters +As previously reported, Howmet, its subsidiaries and former subsidiaries are defendants in lawsuits filed on behalf of persons alleging injury as a result of occupational or other exposure to asbestos. Howmet, its subsidiaries and former subsidiaries have numerous insurance policies over many years that provide coverage for asbestos related claims. The Company has significant insurance coverage and believes that Howmet’s reserves are adequate for its known asbestos exposure related liabilities. The costs of defense and settlement have not been and are not expected to be material to the results of operations, cash flows, and financial position of the Company. +Matters Related to Alcoa Corporation +Prior to the Alcoa Inc. Separation Transaction on November 1, 2016, the Company was known as Alcoa Inc. We have included the matters discussed below in which the Company remains party to proceedings relating to Alcoa Corporation. The Separation and Distribution Agreement, dated October 31, 2016, entered into between the Company and Alcoa Corporation in connection with the Alcoa Inc. Separation Transaction, provides for cross-indemnities between the Company and Alcoa Corporation for claims subject to indemnification. The Company does not expect any of such matters to result in a net claim against it. +St. Croix Proceedings +Red Dust Docket Cases, (St. Croix) f/k/a Abednego, Laurie L.A., et al. v. St. Croix Alumina, L.L.C., et al . On January 14, 2010, Alcoa Inc. was served with a multi-plaintiff action complaint involving several thousand individual persons claiming to be residents of St. Croix who are alleged to have suffered personal injury or property damage from Hurricane Georges or winds blowing material from the St. Croix Alumina, L.L.C. (“SCA”) facility on the island of St. Croix (U.S. Virgin Islands) since the time of the hurricane. This complaint, Abednego, et al. v. Alcoa , et al., was filed in the Superior Court of the Virgin Islands, St. Croix Division. Following an unsuccessful attempt by Alcoa Inc. and SCA to remove the case to federal court, the case has been lodged in the Superior Court. The complaint names as defendants the same entities that were sued in a February 1999 action arising out of the impact of Hurricane Georges on the island and added as a defendant the current owner of the alumina facility property. +On March 1, 2012, Alcoa Inc. was served with a separate multi-plaintiff action complaint involving approximately 200 individual persons alleging claims essentially identical to those set forth in the Abednego v. Alcoa complaint. This complaint, Abraham, et al. v. Alcoa, et al. , was filed on behalf of plaintiffs previously dismissed in the federal court proceeding involving the original litigation over Hurricane Georges impacts. The matter was originally filed in the Superior Court of the Virgin Islands, St. Croix Division, on March 30, 2011. +Alcoa Inc. and other defendants in the Abraham and Abednego cases filed or renewed motions to dismiss each case in March 2012 and August 2012 following service of the Abraham complaint on Alcoa Inc. and remand of the Abednego complaint to +26 +Table of Contents +Superior Court, respectively. By order dated August 10, 2015, the Superior Court dismissed plaintiffs’ complaints without prejudice to re-file the complaints individually, rather than as a multi-plaintiff filing. The order also preserves the defendants’ grounds for dismissal if new, individual complaints are filed. On July 7, 2017, the Court issued an order and associated memoranda on plaintiff’s multiple motions for extension of time to file the individual complaints. Following the court’s July 7, 2017 order, a total of 429 complaints were filed and accepted by the court by the deadline of July 30, 2017 (and consolidated into the Red Dust Claims docket (Master Case No.: SX-15-CV-620)). These complaints include claims of about 1,260 individual plaintiffs. +On November 5, 2018, notice of an order of reassignment was entered, transferring the claims to the newly created Complex Litigation Division of the Superior Court of the Virgin Islands, Division of St. Croix. On January 28, 2019, the plaintiffs filed a motion asking for a determination that expert testimony will not be required on the issue of causation, which defendants opposed. The Court has not ruled on that motion. +Item 4. Mine Safety Disclosures. +Not applicable. +27 +Table of Contents +PART II +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +The Company’s common stock is listed on the New York Stock Exchange under the symbol “HWM.” +Prior to the Arconic Inc. Separation Transaction on April 1, 2020, the Company was known as Arconic Inc. and was listed under the stock symbol “ARNC.” +On October 5, 2016, the Company’s common shareholders approved a 1-for-3 reverse stock split of the Company’s outstanding and authorized shares of common stock (the “Reverse Stock Split”). The Company’s common stock began trading on a Reverse Stock Split-adjusted basis on October 6, 2016, in which every three shares of issued and outstanding common stock were combined into one issued and outstanding share of common stock, without any change in the par value per share. +Prior to the Alcoa Inc. Separation Transaction on November 1, 2016, the Company was known as Alcoa Inc. and was listed under the stock symbol “AA.” +The number of holders of record of common stock was approximately 10,920 as of February 12, 2021. +Stock Performance Graph +The following graph compares the most recent five-year performance of the Company’s common stock with (1) the Standard & Poor’s (S&P) 500 ® Index, (2) the S&P 500 ® Industrials Index, a group of 73 companies categorized by Standard & Poor’s as active in the “industrials” market sector, and (3) the S&P Aerospace & Defense Index, which comprises General Dynamics Corporation, Howmet Aerospace Inc., Huntington Ingalls Industries, L3Harris Technologies, Inc., Lockheed Martin Corporation, Northrop Grumman Corporation, Raytheon Technologies Corporation, Teledyne Technologies Incorporated, Textron Inc., The Boeing Company, and Transdigm Group Inc. +The graph assumes, in each case, an initial investment of $100 on December 31, 2015, and the reinvestment of dividends. The historical prices of the Company presented in the graph and table have been adjusted to reflect the impact of the Arconic Inc. Separation Transaction, the Reverse Stock Split, and the Alcoa Inc. Separation Transaction. The graph, table and related information shall not be deemed to be “filed” with the SEC, nor shall such information be incorporated by reference into future filings under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing. +28 +Table of Contents +As of December 31, 2015 2016 2017 2018 2019 2020 +Howmet Aerospace, Inc. $ 100.00 $ 84.78 $ 125.78 $ 78.70 $ 144.47 $ 151.66 +S&P 500 ® Index +100.00 111.96 136.40 130.42 171.49 203.04 +S&P 500 ® Industrials Index +100.00 118.86 143.86 124.74 161.38 179.23 +S&P Aerospace & Defense Index 100.00 118.90 168.11 154.54 201.41 169.05 +29 +Table of Contents +Issuer Purchases of Equity Securities +The following table presents information with respect to the Company’s open-market repurchases of its common stock during the quarter ended December 31, 2020: +(in millions except share and per share amounts) +Period Total Number +of Shares Purchased +Average +Price Paid +Per Share (1) +Total Number +of Shares +Purchased as +Part of Publicly +Announced +Repurchase +Plans or +Programs +Approximate +Dollar Value +of Shares that +May Yet Be +Purchased Under +the Plans or +Programs (1)(2) +October 1 - October 31, 2020 — $ — — $ 299.5 +November 1 - November 30, 2020 937,831 $ 23.99 937,831 $ 277.0 +December 1 - December 31, 2020 — $ — — $ 277.0 +Total for quarter ended December 31, 2020 937,831 $ 23.99 937,831 +(1) Excludes commissions cost +(2) On May 20, 2019, the Company announced that its Board of Directors authorized the repurchase of $500 million of the Company's outstanding common stock (the "Share Repurchase Program") by means of trading plans established from time to time in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, block trades, private transactions, open market repurchases and/or accelerated share repurchase agreements or other derivative transactions. There was no stated expiration for the Share Repurchase Program under which the Company may repurchase shares from time to time and pursuant to such terms, as and if it deems appropriate. The Share Repurchase Program may be suspended, modified or terminated at any time without prior notice. After giving effect to the share repurchases made through December 31, 2020, approximately $277 million remains available under the prior authorization by the Board for the Share Repurchase Program. The amount of share repurchases by the Company may be limited under the terms of the Five-Year Revolving Credit Agreement (See Note R to the Consolidated Financial Statements for additional detail). +Item 6. Selected Financial Data. +The Company has elected to comply with the Regulation S-K amendment to eliminate Item 301. +30 +Table of Contents +Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. +(dollars in millions, except per-share amounts) +Overview +Our Business +Howmet is a global leader in lightweight metals engineering and manufacturing. Howmet’s innovative, multi-material products, which include nickel, titanium, aluminum, and cobalt, are used worldwide in the aerospace (commercial and defense), commercial transportation, and industrial and other end markets. +Howmet is a global company operating in 20 countries. Based upon the country where the point of shipment occurred, the United States and Europe generated 68% and 21%, respectively, of Howmet’s sales in 2020. In addition, Howmet has operating activities in numerous countries and regions outside the United States and Europe, including Canada, Mexico, China and Japan. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in countries with such operating activities. +Management Review of 2020 and Outlook for the Future +In 2020, Sales decreased 26% over 2019 primarily as a result of lower volumes in the commercial aerospace and commercial transportation markets driven by the impacts of COVID-19 and 737 MAX and 787 production declines along with a decrease in sales of $116 due to the divestiture of the forgings business in the United Kingdom in December 2019, all partially offset by 14% and 28% sales growth in the defense aerospace and industrial gas turbine markets, respectively, as well as favorable product pricing. +In the segments, Segment operating profit decreased 36% from 2019 due to lower volumes in the commercial aerospace and commercial transportation markets driven by the impacts of COVID-19 and 737 MAX and 787 production declines and unfavorable product mix, partially offset by favorable product pricing, net cost savings and 14% and 28% sales growth in the defense aerospace and industrial gas turbine markets, respectively. +Management continued its focus on liquidity and cash flows as well as improving its operating performance through cost reductions, streamlined organizational structures, margin enhancement, and profitable revenue generation. Management has continued its intensified focus on capital efficiency. This focus and the related results enabled Howmet to end 2020 with a solid financial position. +The following financial information reflects certain key highlights of Howmet’s 2020 results: +• Sales of $5,259 down 26% from 2019, with significant reductions in sales in commercial aerospace and commercial transportation markets, driven by COVID-19 and 737 MAX and 787 production declines; +• Net income from continuing operations of $211, or $0.48 per diluted share; +• Income from continuing operations before income taxes of $171, a decrease of $39, or 19%, from 2019; +• Total segment operating profit of $890, a decrease of $500, or 36%, from 2019 (1) ; +• Cash provided from operations of $9; cash used for financing activities of $369; and cash provided from investing activities of $271; +• Cash on hand at the end of the year of $1,610; and +• Total debt of $5,075, primarily due to a decrease of $865 from 2019, reflecting repayments of $2,040 along with $20 of other debt, partially offset by issuance of debt during the second quarter of 2020 of $1,200 notes due 2025. +(1) See below in Results of Operations for the reconciliation of Total segment operating profit to Income from continuing operations before income taxes. +The Company rapidly executed on the separation plan that was announced during February 2019 with completion of the separation on April 1, 2020. The Company separated into two independent, publicly-traded companies, Howmet Aerospace Inc. and Arconic Corporation (the “Arconic Inc. Separation Transaction”). Howmet Aerospace is comprised of the Engineered Products and Forgings businesses (engine products, fastening systems, engineered structures, and forged wheels) and is listed under the stock ticker of “HWM.” Arconic Corporation is comprised of the former Global Rolled Products segment (global rolled products, aluminum extrusions, and building and construction systems) and is under the new company name Arconic Corporation, listed on the New York Stock Exchange under the symbol “ARNC.” +Results of Operations +Earnings Summary +Sales. Sales for 2020 were $5,259 compared with $7,098 in 2019, a decrease of $1,839, or 26%. The decrease was primarily a result of lower volumes in the commercial aerospace and commercial transportation markets driven by the impacts of +31 +Table of Contents +COVID-19 and 737 MAX and 787 production declines along with a decrease in sales of $116 due to the divestiture of the forgings business in the U.K. in December 2019, all partially offset by growth in the defense aerospace and industrial gas turbine markets and favorable product pricing. +Sales for 2019 were $7,098 compared with $6,778 in 2018, an increase of $320, or 5%. The increase was primarily due to volume growth in aerospace, commercial transportation, and industrial end markets; and favorable pricing when fulfilling volume above contractual share and renewing contracts; partially offset by lower sales from the divestitures of forgings businesses in the United Kingdom (divested in December 2019) and Hungary (divested in December 2018); and unfavorable foreign currency movements. +Cost of Goods Sold (COGS). COGS as a percentage of Sales was 73.7% in 2020 compared with 73.5% in 2019. The increase was primarily due to the impact of COVID-19 and lower volumes, partially offset by net cost savings, favorable product pricing, intentional product exits, and the impairment of energy business assets of $10 in the second quarter of 2019. In 2019, the Company sustained a fire at a fasteners plant in France. Additionally, in mid-February 2020, a fire occurred at the Company's forged wheels plant located in Barberton, Ohio. The Company submitted insurance claims related to these plant fires and received partial settlements of $39 in 2020 compared to $25 in 2019, which were in excess of the insurance deductible. In 2020, the Company recorded charges of $41 related to plant fires compared to $26 in 2019. The downtime reduced production levels and affected productivity at the plants. +COGS as a percentage of Sales was 73.5% in 2019 compared with 75.4% in 2018. The decrease was primarily due to lower raw material costs; net costs savings; favorable product pricing; and costs incurred in 2018 that did not recur in 2019 related to settlements of certain customer claims, partially offset by an unfavorable product mix and the impairment of energy business assets of $10. Additionally, in 2019, the Company sustained a fire at a fasteners plant in France and recorded charges of $26 for higher operating costs, equipment and inventory damage, and repairs and cleanup costs. The Company submitted an insurance claim and received partial settlement of $25, which was in excess of its $10 insurance deductible. The insurance claim included $8 of margin not recognized from lost revenue due to the fire. +Selling, General Administrative, and Other Expenses (SG&A). SG&A expenses were $277, or 5.3% of Sales, in 2020 compared with $400, or 5.6% of Sales, in 2019. The decrease in SG&A of $123, or 31%, was primarily due to overhead cost reductions and lower net legal and other advisory costs related to Grenfell Tower of $20, partially offset by higher costs associated with the Arconic Inc. Separation Transaction through June 30, 2020 of $2. +SG&A expenses were $400, or 5.6% of Sales, in 2019 compared with $371, or 5.5% of Sales, in 2018. The increase in SG&A of $29, or 8%, was primarily due to costs associated with the Arconic Inc. Separation Transaction of $5 and higher annual incentive compensation accruals and executive compensation costs, partially offset by lower costs driven by overhead cost reductions and lower net legal and other advisory costs related to Grenfell Tower of $10, primarily due to insurance reimbursements. +Research and Development Expenses (R&D). R&D expenses were $17 in 2020 compared with $28 in 2019. The decrease of $11, or 39%, was primarily due to the continued consolidation of the Company's primary R&D facility in conjunction with ongoing cost reduction efforts. +R&D expenses were $28 in 2019 compared with $41 in 2018. The decrease of $13, or 32%, was primarily due to the consolidation of the Company's primary R&D facility in conjunction with ongoing cost reduction efforts. +Provision for Depreciation and Amortization (D&A). The provision for D&A was $279 in 2020 compared with $295 in 2019. The decrease of $16, or 5%, was primarily driven by asset impairments of the Disks long-lived assets group during the second quarter of 2019 (see Notes O and P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K) and the impact of divestitures as well as lower corporate software amortization and research center depreciation, which were partially offset by increased Forged Wheels D&A due to the capacity expansion in Hungary, capacity expansions at two U.S. facilities and an additional $6 D&A related to the Barberton fire. +The provision for D&A was $295 in 2019 compared with $314 in 2018. The decrease of $19, or 6% was primarily due to the impact of divestitures, as well as asset impairments of the Disks long-lived asset group during the second quarter of 2019 (see Note O and P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). +32 +Table of Contents +Restructuring and Other Charges. Restructuring and other charges were $182 in 2020 compared with $582 in 2019 and $163 in 2018. +Restructuring and other charges in 2020 consisted primarily of a $113 charge for layoff costs, a $74 charge for U.K. and U.S. pension plans' settlement accounting; a $5 post-closing adjustment related to the sale of the Company’s U.K. forgings business; a $5 charge for impairment of assets associated with an agreement to sell an aerospace components business in the U.K that did not occur and the business was returned to held for use; $5 charge related to the impairment of a cost method investment, which were partially offset by a benefit of $21 related to the reversal of a number of prior period programs; +Restructuring and other charges in 2019 consisted primarily of a $428 charge for impairment of the Disks long-lived asset group; a $69 charge for layoff costs ; a $46 charge for impairment of assets associated with an agreement to sell the U.K. forgings business; a $14 charge for impairment of properties, plants, and equipment related to the Company’s primary research and development facility; a $13 loss on sale of assets primarily related to a small additive business; a $12 charge for other exit costs from lease terminations primarily related to the exit of the corporate aircraft; a $9 settlement accounting charge for U.S. pension plans; a $5 charge for impairment of a cost method investment; and a $7 charge for other exit costs; which were partially offset by a benefit of $16 related to the elimination of the life insurance benefit for the U.S. salaried and non-bargaining hourly retirees of the Company and its subsidiaries. +Restructuring and other charges in 2018 consisted primarily of a $96 charge for pension plan settlement accounting; a $23 charge for pension curtailment; a $43 loss on sale of a Hungary forgings business; a $18 charge for layoff costs; a $12 charge for contract termination costs and asset impairments associated with the shutdown of a facility in Acuna, Mexico; which were offset partially by a $28 postretirement curtailment benefit. +See Note E to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Interest Expense. Interest expense was $381 in 2020 compared with $338 in 2019. The increase of $43, or 13%, was primarily due to premiums paid on the early redemption of debt of $59 which was offset by lower debt outstanding in 2020 driven by the early redemption of $1,000, $889 and $151 of the principal amount of the 6.150% Notes, 5.400% Notes due in 2021 and 5.870% Notes due in 2022, respectively, in April and May 2020, which was offset by the issuance on April 24, 2020 of the 6.875% Notes due 2025 in the aggregate principal amount of $1,200. +Interest expense was $338 in 2019 compared with $377 in 2018. The decrease of $39, or 10%, was primarily due to lower debt outstanding, driven by the repayment of the aggregate outstanding principal amount of the 1.63% Convertible Notes of approximately $403 on October 15, 2019, as well as costs incurred of $19 in 2018 related to the premium paid on the early redemption of the Company’s then outstanding 5.72% Senior Notes due in 2019 that did not recur in 2019. +On January 15, 2021, the Company completed the early redemption of all of the remaining $361 aggregate principal amount of the 5.400% Notes due in April 2021 (the "5.400% Notes") as well as $5 in accrued interest. The redemption of these 5.400% Notes will save approximately $5 in Interest expense, net in the first quarter of 2021 and $19 annually. +Other Expense (Income), Net. Other expense (income), net was $74 in 2020 compared with $31 in 2019. The increase in expense of $43 was primarily driven by the write-off of an indemnification receivable related to a Spanish tax reserve reflecting Alcoa Corporation's 49% share and Arconic Corporation's 33.66% share of a Spanish tax reserve of $53 and lower interest income of $19, which were partially offset by lower deferred compensation expense of $14 and favorable foreign currency movements of $16. +Other expense (income), net was $31 in 2019 compared with Other expense (income), net of $(30) in 2018. The increase in Other expense, net of $61 was primarily due to an increase in deferred compensation expense of $32 and the benefit recognized in 2018 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve of $29. +Income Taxes. Howmet’s effective tax rate was 23.4% (benefit on pre-tax income) in 2020 compared with the U.S. federal statutory rate of 21%. The effective rate differs from the U.S. federal statutory rate primarily as a result of a $64 benefit related to the release of an income tax reserve following a favorable Spanish tax case decision, a $30 benefit related to the recognition of a previously uncertain U.S. tax position, and a $30 benefit for a U.S. tax law change related to the issuance of final regulations that provide for an exclusion of certain high-taxed foreign earnings from the calculation of Global Intangible Low-Taxed Income ("GILTI"), partially offset by U.S. tax on foreign earnings, $8 of charges related to the remeasurement of deferred tax balances as a result of the Arconic Inc. Separation Transaction, the tax impact of $49 of nondeductible loss related to the reversal of indemnification receivables associated with the favorable Spanish tax case decision, and the tax impact of other nondeductible expenses. +Howmet’s effective tax rate was 40.0% (provision on pre-tax income) in 2019 compared with the U.S. federal statutory rate of 21%. The effective rate differs from the U.S. federal statutory rate primarily as a result of foreign income taxed in higher rate +33 +Table of Contents +jurisdictions and subject to U.S. taxes including GILTI, foreign losses with no tax benefit, and other nondeductible expenses, partially offset by a $24 benefit associated with the deduction of foreign taxes that were previously claimed as a U.S. foreign tax credit, and a $12 benefit for a foreign tax rate change. +Howmet’s effective tax rate was 27.8% (provision on pre-tax income) in 2018 compared with the U.S. federal statutory rate of 21%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $60 charge to establish a tax reserve in Spain, a $59 net charge resulting from the Company's finalized analysis of the U.S. Tax Cuts and Jobs Act of 2017 (the "2017 Act"), and foreign income taxed in higher rate jurisdictions and subject to U.S. taxes including GILTI, partially offset by a $74 benefit related to the reversal of a foreign recapture obligation, a $38 benefit to reverse a foreign tax reserve that was effectively settled, and a $10 benefit for the release of U.S. valuation allowances. +Howmet anticipates that the effective tax rate in 2021 will be between 26.5% and 28.5%. However, changes in the current economic environment, tax legislation or rate changes, currency fluctuations, ability to realize deferred tax assets, movements in stock price impacting tax benefits or deficiencies on stock-based payment awards, and the results of operations in certain taxing jurisdictions may cause this estimated rate to fluctuate. +Net Income from Continuing Operations. Net income from continuing operations was $211, or $0.48 per diluted share, for 2020 compared to $126, or $0.27 per diluted share, in 2019. The increase in results of $85, or 67%, was primarily due to the non-recurring 2019 impact of the $428 charge for impairment of the Disks long-lived asset group included in Restructuring and other charges, a decrease of $123 due to lower SG&A costs, favorable product pricing, and a net $10 related to the settlement of the Spanish corporate income tax audit, partially offset by a decrease in volumes in the commercial aerospace and commercial transportation markets, the impact of COVID-19, and an increase in premiums paid on the early redemption of debt of $59. +Net income from continuing operations was $126, or $0.27 per diluted share, for 2019 compared to $309, or $0.63 per diluted share, for 2018. The decrease in results of $183, or 59%, was primarily due to higher Restructuring charges primarily due to the non-recurring 2019 impact of the $428 charge for impairment of the Disks long-lived asset group, higher SG&A costs related primarily to annual incentive compensation accruals and executive compensation costs, higher Other expense, net due to an increase in deferred compensation expense, and the benefit recognized in 2018 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve of $29 that did not recur in 2019, partially offset by volume growth, favorable product pricing, net cost savings, lower D&A due to the impact of divestitures as well as asset impairments related to the Disks long-lived asset group, lower Interest expense due to lower debt outstanding and costs incurred of $19 in 2018 related to the premium paid on the early redemption of debt that did not recur in 2019, and lower Income taxes primarily as a result of a benefit related to a U.S. tax election which caused the deemed liquidation of a foreign subsidiary’s assets into its U.S. tax parent. +Net Income. Net income was $261 for 2020 composed of $211 of income from continuing operations and $50 from discontinued operations, or $0.48 and $0.11 per diluted share, respectively. +Net income was $470 for 2019 composed of $126 of income from continuing operations and $344 from discontinued operations, or $0.27 and $0.76 per diluted share, respectively. +Net income was $642 for 2018 composed of $309 of income from continuing operations and $333 from discontinued operations, or $0.63 and $0.67 per diluted share, respectively. +See details of discontinued operations in Note C to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Segment Information +The Company’s operations consist of four worldwide reportable segments: Engine Products, Fastening Systems, Engineered Structures and Forged Wheels. Segment performance under Howmet’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Howmet’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and Other charges and Impairment of Goodwill. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Howmet are in Corporate. +In the second quarter of 2020, the Company realigned its operations consistent with how the Co-Chief Executive Officers assess operating performance and allocating capital in conjunction with the Arconic Inc. Separation Transaction (see Note C to the Consolidated Financial Statements in Part II Item 8 of this Form 10-K). Prior period financial information has been recast to conform to current year presentation. +The Company produces aerospace engine parts and components and aerospace fastening systems for Boeing 737 MAX airplanes. In late December 2019, Boeing announced a temporary suspension of production of the 737 MAX airplanes. This decline in production had a negative impact on sales and segment operating profit in the Engine Products, Fastening Systems and Engineered Structures segments for the full year ended December 31, 2020. While regulatory authorities in the United +34 +Table of Contents +States and certain other jurisdictions lifted grounding orders beginning in late 2020, our sales could continue to be negatively affected from the residual impacts of the 737 MAX grounding. +Income from continuing operations before income taxes totaled $171 in 2020, $210 in 2019, and $428 in 2018. Segment operating profit for all reportable segments totaled $890 in 2020, $1,390 in 2019, and $1,105 in 2018. The following information provides Sales and Segment operating profit for each reportable segment for each of the three years in the period ended December 31, 2020. See below for the reconciliation of Income from continuing operations before income taxes to Total segment operating profit. +Engine Products +2020 2019 2018 +Third-party sales $ 2,406 $ 3,320 $ 3,092 +Segment operating profit $ 417 $ 621 $ 464 +Engine Products produces investment castings, including airfoils, and seamless rolled rings primarily for aircraft engines (aerospace commercial and defense) and industrial gas turbines. Engine Products produces rotating parts as well as structural parts, which are sold directly to customers. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, British pound and Euro. +Third-party sales for the Engine Products segment decreased $914 or 28% in 2020 compared with 2019, primarily due to lower volumes in the commercial aerospace end market driven by the impact of COVID-19 and the suspension of 737 MAX production, along with a decrease in sales of $116 from the divestiture of the forgings business in the U.K. (December 2019) (see Note U to the Consolidated Financial Statements in Part II Item 8 of this Form 10-K), partially offset by higher volumes in the defense aerospace and industrial gas turbines end markets as well as favorable product pricing. +Third-party sales for the Engine Products segment increased $228 or 7% in 2019 compared with 2018, primarily as a result of higher commercial and defense aerospace volumes and favorable product pricing, partially offset by unfavorable foreign currency movements and lower sales of $47 from divestitures of forgings businesses in the United Kingdom (divested in December 2019) and Hungary (divested in December 2018). +Operating profit for the Engine Products segment decreased $204, or 33%, in 2020 compared with 2019, primarily due to lower commercial aerospace sales volumes from the suspension of 737 MAX production, and COVID-19 productivity impacts, partially offset by cost reductions, favorable product pricing, and favorable sales volumes in the defense aerospace and industrial gas turbines end markets. +Operating profit for the Engine Products segment increased $157 or 34% in 2019 compared with 2018, due to net cost savings, higher sales volumes as noted previously, favorable product pricing, and lower raw material costs, partially offset by the unfavorable impact of new product introductions in aerospace engines and unfavorable product mix. +On December 1, 2019, the Company completed the divestiture of its forgings business in the United Kingdom. The forgings business primarily produces steel, titanium, and nickel based forged components for aerospace, mining, and off-highway markets. This business generated third-party sales of $116 and $131 in 2019 and 2018, respectively, and had 540 employees at the time of the divestiture. +On December 31, 2018, as part of the Company’s then ongoing strategy and portfolio review, the Company completed the sale of its forgings business in Hungary that manufactured high volume steel forgings for drivetrain components in the European heavy-duty truck and automotive market. This business generated third-party sales of $32 in 2018, and had 180 employees at the time of the divestiture. +In 2021 compared to 2020, demand in industrial gas turbines and defense aerospace end markets is expected to increase while the commercial aerospace end market is expected to be down driven by the impact of COVID-19. Favorable product pricing and cost reductions are expected to continue. +35 +Table of Contents +Fastening Systems +2020 2019 2018 +Third-party sales $ 1,245 $ 1,561 $ 1,531 +Segment operating profit $ 247 $ 396 $ 357 +Fastening Systems produces aerospace fastening systems, as well as commercial transportation fasteners. The business’s high-tech, multi-material fastening systems are found nose to tail on aircraft and aero engines. The business’s products are also critical components of automobiles, commercial transportation vehicles, and construction and industrial equipment. Fastening Systems are sold directly to customers and through distributors. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, British pound and euro. +Third-party sales for the Fastening Systems segment decreased $316 or 20% in 2020 compared with 2019, primarily due to lower sales volumes in the commercial aerospace end market driven by the impact of COVID-19 and the suspension of 737 MAX production, along with lower volumes in the commercial transportation end market also impacted by the effects of COVID-19, only slightly offset by volume growth in the Industrial end market and favorable product pricing. +Third-party sales for this segment increased $30, or 2%, in 2019 compared with 2018, primarily attributable to higher volumes in the aerospace and commercial transportation end markets, partially offset by unfavorable foreign currency movements. +Operating profit for the Fastening Systems segment decreased $149, or 38%, in 2020 compared with 2019, primarily due to lower commercial aerospace and commercial transportation sales volumes and COVID-19 productivity impacts, partially offset by cost reductions and favorable product pricing. +Operating profit for the Fastening Systems segment increased $39, or 11%, in 2019 compared with 2018, due to net cost savings and higher volumes as noted previously, partially offset by an unfavorable product mix. +In 2021 compared to 2020, demand in the commercial aerospace end market is expected to be down driven by the impact of COVID-19. Favorable cost reductions are expected to continue. +Engineered Structures +2020 2019 2018 +Third-party sales $ 927 $ 1,255 $ 1,209 +Segment operating profit $ 73 $ 120 $ 64 +Engineered Structures produces titanium ingots and mill products for aerospace and defense applications and is vertically integrated to produce titanium forgings, extrusions forming and machining services for airframe, wing, aero-engine, and landing gear components. Engineered Structures also produces aluminum forgings, nickel forgings, and aluminum machined components and assemblies for aerospace and defense applications. The segments products are sold directly to customers and through distributors and sales, costs, and expenses of this segment are generally transacted in the local currency of the respective operations, which are mostly the U.S. dollar, British pound and the euro. +Third-party sales for the Engineered Structures segment decreased $328, or 26%, in 2020 compared with 2019, primarily due to lower sales volumes in the commercial aerospace end market driven by COVID-19, Boeing 787 production declines and 737 MAX production suspension, partially offset by an increase in the defense aerospace sales volume and favorable product pricing. +Third-party sales for the Engineered Structures segment increased $46, or 4%, in 2019 compared with 2018, primarily the result of higher aerospace end market sales volumes and favorable product pricing, partially offset by unfavorable foreign currency movements. +Operating profit for the Engineered Structures segment decreased $47, or 39%, in 2020 compared with 2019, primarily due to lower commercial aerospace sales volumes and COVID-19 productivity impacts, partially offset by cost reductions, and favorable product pricing. +Operating profit for the Engineered Structures segment increased $56 or 88%, in 2019 compared with 2018, primarily due to net cost savings, favorable product pricing, lower raw material costs, and higher aerospace end market sales volumes, partially offset by unfavorable product mix. +In 2021 compared to 2020, demand in the commercial aerospace end market is expected to be down driven by the impact of COVID-19. Favorable cost reductions are expected to continue. +36 +Table of Contents +Forged Wheels +2020 2019 2018 +Third-party sales $ 679 $ 969 $ 966 +Segment operating profit $ 153 $ 253 $ 220 +Forged Wheels provides forged aluminum wheels and related products for heavy-duty trucks, trailers, and buses globally. Forged Wheels' products are sold directly to OEMs and through distributors with the sales and costs and expenses of this segment transacted in local currency. +Third-party sales for the Forged Wheels segment decreased $290, or 30%, in 2020 compared with 2019, primarily due to lower volumes in the commercial transportation end market driven by COVID-19 and production downtime related to the Barberton plant fire (discussed below). +Third-party sales for the Forged Wheels segment increased $3, effectively flat in 2019 compared with 2018, primarily the result of stable volumes in the commercial transportation end market. +Operating profit for the Forged Wheels segment decreased $100, or 40%, in 2020 compared with 2019, primarily due to lower commercial transportation sales volumes and COVID-19 productivity impacts, partially offset by cost reductions. +Operating profit for the Forged Wheels segment increased $33 or 15%, in 2019 compared with 2018, primarily due to net cost savings and lower raw material costs. +In mid-February 2020, a fire occurred at the Company’s forged wheels plant located in Barberton, Ohio. The downtime reduced production levels and affected productivity at the plant. The Company has insurance with a deductible of $10. +In 2021 compared to 2020, demand in the commercial transportation markets served by Forged Wheels is expected to increase in most regions. Commercial transportation OEMs are expected to increase output as global economies recover from 2020 COVID-19 lows. +Reconciliation of Total segment operating profit to Income from continuing operations before income taxes +2020 2019 2018 +Income from continuing operations before income taxes $ 171 $ 210 $ 428 +Interest expense 381 338 377 +Other expense (income), net 74 31 (30) +Consolidated operating income $ 626 $ 579 $ 775 +Unallocated amounts: +Restructuring and other charges 182 582 163 +Corporate expense 82 229 167 +Total segment operating profit +$ 890 $ 1,390 $ 1,105 +Total segment operating profit is a non-GAAP financial measure. Management believes that this measure is meaningful to investors because management reviews the operating results of the segments of the Company excluding Corporate results. +See Restructuring and Other Charges, Interest Expense, and Other Expense (Income), Net, discussions above under Results of Operations for reference. +Corporate expense decreased $147, or 64%, in 2020 compared with 2019 primarily due to lower annual incentive compensation accruals and executive compensation costs, lower costs driven by overhead cost reductions, lower contract services and outsourcing costs; lower research and development expenses; and lower net legal and other advisory costs along with costs incurred in 2019 that did not recur in 2020, including the impacts of facility fires, net of insurance of $6 and collective bargaining agreement negotiation costs of $9. Costs associated with the Arconic Inc. Separation Transaction of $7, were an increase of $2 compared to 2019. +Corporate expense increased $62, or 37%, in 2019 compared with 2018 primarily due to costs associated with the Arconic Inc. Separation Transaction of $5; higher annual incentive compensation accruals and executive compensation costs; net impacts associated with a fire at a fasteners plant of $9 (net of insurance reimbursements); and collective bargaining agreement negotiation costs of $9; partially offset by costs incurred in 2018 that did not recur in 2019 related to settlements of certain customer claims of $38; lower costs driven by overhead cost reductions; lower research and development expenses; and lower net legal and other advisory costs related to Grenfell Tower of $10. +37 +Table of Contents +Environmental Matters +See the Environmental Matters section of Note V to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. +Liquidity and Capital Resources +Howmet maintains a disciplined approach to cash management and strengthening of its balance sheet. Management continued to focus on actions to improve Howmet’s cost structure and liquidity, providing the Company with the ability to operate effectively. Such actions included procurement efficiencies and overhead rationalization to reduce costs, working capital initiatives, and maintaining a sustainable level of capital expenditures. +Cash provided from operations and financing activities is expected to be adequate to cover Howmet's operational and business needs over the next 12 months. For an analysis of long-term liquidity, see Contractual Obligations and Off-Balance Sheet Arrangements below. +At December 31, 2020, cash and cash equivalents of Howmet were $1,610, of which $253 was held by Howmet's non-U.S. subsidiaries. If the cash held by non-U.S. subsidiaries were to be repatriated to the U.S., the company does not expect there to be additional material income tax consequences. +The cash flows related to Arconic Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows for all periods prior to the Arconic Inc. Separation Transaction. +During 2020 the Company identified a misclassification in the presentation of changes in accounts payable and capital expenditures in its previously issued Statement of Consolidated Cash Flows, and has revised its Statement of Consolidated Cash Flows for 2019. See Note A to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for additional detail. +Operating Activities +Cash provided from operations in 2020 was $9 compared with $461 in 2019 and $217 in 2018. +The decrease in cash used for operations of $452, or 98%, between 2020 and 2019 was primarily due to lower operating results of $874, partially offset by lower working capital of $355 and lower noncurrent assets of $46, noncurrent liabilities of $10 and pension contributions of $11. The components of the change in working capital included favorable changes in receivables of $739, inventories of $77, and taxes, including income taxes of $100, offset by accounts payable of $380, accrued expenses of $175 and prepaid expenses and other current assets of $6. +The increase of $244, or 112%, between 2019 and 2018 was primarily due to higher operating results of $279 and lower pension contributions of $30 and noncurrent assets of $13, partially offset by higher working capital of $57 and noncurrent liabilities of $21. The components of the change in working capital included unfavorable changes in accounts payable of $340 and taxes, including income taxes of $106, partially offset by favorable changes in receivables of $165 accrued expenses of $148, inventories of $71 and prepaid expenses and other current assets of $5. +Financing Activities +Cash used for financing activities was $369 in 2020 compared with $1,568 in 2019 and $649 in 2018. +The use of cash in 2020 was primarily related to the repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily the aggregate outstanding principal amount of the 6.15% Notes due 2020 of approximately $2,040 (see Note R to the Consolidated Financial Statements in Part II, Item 8. Financial Statements and Supplementary Data), cash distributed to Arconic Corporation at the Arconic Inc. Separation Transaction of $500, repurchase of common stock of $73 (see Note J to the Consolidated Financial Statements in Part II, Item 8. Financial Statements and Supplementary Data), debt issuance costs of $61, premiums paid on the redemption of debt of $59, and dividends paid to shareholders of $11. These items were partially offset by long-term debt issuance of $2,400 (of which $1,200 went with Arconic Corporation at the Arconic Inc. Separation Transaction) and proceeds from the exercise of employee stock options of $33. +The use of cash in 2019 was primarily related to the repurchase of $1,150 of common stock (see Note J to the Consolidated Financial Statements in Part II, Item 8. Financial Statements and Supplementary Data); repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily the aggregate outstanding principal amount of the 1.63% Convertible Notes of approximately $403 (see Note R to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data)); and dividends paid to shareholders of $57. These items were partially offset by proceeds from the exercise of employee stock options of $56. +The use of cash in 2018 was principally the result of $1,103 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the then remaining outstanding 5.72% Notes due in 2019 (see Note R to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and +38 +Table of Contents +Supplementary Data of this Form 10-K)) and $119 in dividends to shareholders. These items were partially offset by $600 in additions to debt, primarily from borrowings under certain revolving credit facilities. +The Company maintains a Five-Year Revolving Credit Agreement (the “Credit Agreement”) with a syndicate of lenders and issuers named therein. On June 26, 2020, the Company entered into an amendment to its Credit Agreement to modify certain terms which provided relief from its existing financial covenant through December 31, 2021 and reduced total commitment available from $1,500 to $1,000. See Note R to the Consolidated Financial Statements in Part II, Item 8. Financial Statements and Supplementary Data of this Form 10-K. In addition to the Credit Agreement, the Company has other credit facilities from time to time. +The Company may in the future repurchase additional portions of its debt or equity securities from time to time, in either the open market or through privately negotiated transactions, in accordance with applicable SEC and other legal requirements. The timing, prices, and sizes of purchases depend upon prevailing trading prices, general economic and market conditions, and other factors, including applicable securities laws. +The Company’s costs of borrowing and ability to access the capital markets are affected not only by market conditions but also by the short- and long-term debt ratings assigned to the Company by the major credit rating agencies. +The Company's credit ratings from the three major credit rating agencies are as follows: +Long-Term Debt Short-Term Debt Outlook Date of Last Update +Standard and Poor’s BB+ B Negative September 9, 2020 +Moody’s Ba3 Speculative Grade Liquidity-2 Negative April 23, 2020 +Fitch BBB- B Stable April 22, 2020 +Investing Activities +Cash provided from investing activities was $271 in 2020 compared with $528 in 2019 and $565 in 2018. +The source of cash in 2020 was primarily cash receipts from sold receivables of $422 and proceeds from the sale a rolling mill business in Itapissuma, Brazil for $50 and a hard alloy extrusions plant in South Korea for $62 which were related to Arconic Corporation (see Notes C and U to the Consolidated Financial Statements in Part II, Item 8 (Financial Statements and Supplementary Data)), partially offset by capital expenditures of $267. +The source of cash in 2019 was primarily cash receipts from sold receivables of $995, proceeds from the sale of assets and businesses of $103 primarily from the sale of a forgings business in the U.K. for $64 and the sale of inventories and properties, plants, and equipment related to a small energy business for $13 as well as contingent consideration of $20 related to the sale of the Texarkana, Texas rolling mill (which was part of Arconic Corporation at the Arconic Inc. Separation Transaction) (see Notes C and U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data)), and the sale of fixed income securities of $73, partially offset by capital expenditures of $641, including expansion of a wheels plant in Hungary, expansion of aerospace airfoils capacity in the United States, and transition of the Tennessee plant to industrial production (which was part of Arconic Corporation at the Arconic Inc. Separation Transaction). +The source of cash in 2018 was primarily cash receipts from sold receivables of $1,016 and proceeds from the sale of the Texarkana, Texas rolling mill and cast house of $302 which was related to Arconic Corporation, partially offset by capital expenditures of $768, including the horizontal heat treat furnace at the Davenport, Iowa plant (which was part of Arconic Corporation at the Arconic Inc. Separation Transaction) and an expansion of a wheels plant in Székesfehérvár, Hungary. +39 +Table of Contents +Contractual Obligations and Off-Balance Sheet Arrangements +Contractual Obligations +Howmet is required to make future payments under various contracts, including long-term purchase obligations, financing arrangements, and lease agreements. Howmet also has commitments to fund its pension plans, provide payments for other postretirement benefit plans, and fund capital projects. +As of December 31, 2020, a summary of Howmet’s outstanding contractual obligations is as follows (these contractual obligations are grouped in the same manner as they are classified in the Statement of Consolidated Cash Flows in order to provide a better understanding of the nature of the obligations and to provide a basis for comparison to historical information): +Total 2021 2022-2023 2024-2025 Thereafter +Operating activities: +Raw material purchase obligations $ 205 $ 159 $ 38 $ 8 $ — +Other purchase obligations 54 51 3 — — +Operating leases 163 44 59 28 32 +Interest related to total debt 1,941 286 519 400 736 +Estimated minimum required pension funding 514 140 229 145 — +Other postretirement benefit payments 146 17 32 30 67 +Layoff and other restructuring payments 54 54 — — — +Uncertain tax positions 2 — — — 2 +Financing activities: +Total debt 5,102 376 476 2,450 1,800 +Investing activities: +Capital projects 169 123 46 — — +Totals $ 8,350 $ 1,250 $ 1,402 $ 3,061 $ 2,637 +Obligations for Operating Activities +Raw material purchase obligations consist mostly of aluminum, cobalt, nickel, and various other metals with expiration dates ranging from less than one year to five years. Many of these purchase obligations contain variable pricing components, and, as a result, actual cash payments may differ from the estimates provided in the preceding table. The Company generally passes through metal costs in customer contracts with limited exceptions. In connection with the Arconic Inc. Separation Transaction , the Company entered into several agreements with Arconic Corporation that govern the relationship between the Company and Arconic Corporation following the separation, including Raw Material Supply Agreements. +Operating leases represent multi-year obligations for certain land and buildings, plant equipment, vehicles, and computer equipment. +Interest related to total debt is based on interest rates in effect as of December 31, 2020 and is calculated on debt with maturities that extend to 2042. +Estimated minimum required pension funding and postretirement benefit payments are based on actuarial estimates using current assumptions for discount rates, long-term rate of return on plan assets, and health care cost trend rates, among others. It is Howmet’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Howmet contributes additional amounts as deemed appropriate. The estimates reported in the preceding table include amounts sufficient to meet the minimum required. Howmet has determined that it is not practicable to present pension funding and other postretirement benefit payments beyond 2024 and 2029, respectively. +Layoff and other restructuring payments to be paid within one year primarily relate to severance costs, special layoff benefit payments, and lease termination costs. +Uncertain tax positions taken or expected to be taken on an income tax return may result in additional payments to tax authorities. The amount in the preceding table includes interest and penalties accrued related to such positions as of December 31, 2020. The total amount of uncertain tax positions is included in the “Thereafter” column as the Company is not able to reasonably estimate the timing of potential future payments. If a tax authority agrees with the tax position taken or expected to be taken or the applicable statute of limitations expires, then additional payments will not be necessary. +40 +Table of Contents +Obligations for Financing Activities +Howmet has historically paid quarterly dividends on its preferred and common stock. Including dividends on preferred stock, the Company paid $11 in dividends to shareholders during 2020. Because all dividends are subject to approval by Howmet’s Board of Directors, amounts are not included in the preceding table unless such authorization has occurred. As of December 31, 2020, there were 432,906,377 shares of outstanding common stock and 546,024 shares of outstanding Class A preferred stock. In 2020, the preferred stock dividend was $3.75 per share. Dividend of $0.02 per share on the Company's common stock was paid in the first quarter of 2020. As the duration of the COVID-19 pandemic is uncertain, the Company is taking a series of actions to address the financial impact, including the suspension of dividends on common stock in April 2020. See Part I, Item 1A (Risk Factors). +Obligations for Investing Activities +Capital projects in the preceding table only include amounts approved by management as of December 31, 2020. Funding levels may vary in future years based on anticipated construction schedules of the projects. It is expected that significant expansion projects will be funded through various sources, including cash provided from operations. Total capital expenditures are anticipated to be approximately 4% of sales in 2021. +Off-Balance Sheet Arrangements +At December 31, 2020, the Company had outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2021 and 2040 was $44 at December 31, 2020. +Pursuant to the Separation and Distribution Agreement between the Company and Alcoa Corporation, the Company is required to provide certain guarantees for Alcoa Corporation, which had a combined fair value of $12 and $9 at December 31, 2020 and 2019, respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. For a long-term supply agreement, the Company is required to provide a guarantee up to an estimated present value amount of approximately $1,398 and $1,353 at December 31, 2020 and December 31, 2019, respectively, in the event of an Alcoa Corporation payment default. This guarantee expires in 2047. For this guarantee, subject to its provisions, the Company is secondarily liable in the event of a payment default by Alcoa Corporation. The Company currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote. In December 2019, Arconic Inc. entered into a one-year insurance policy with a limit of $80 relating to the long-term energy supply agreement. The premium is expected to be paid by Alcoa Corporation. In December 2020, a surety bond with a limit of $80 relating to the long-term energy supply agreement was obtained by Alcoa Corporation to protect Howmet's obligation. This surety bond will be renewed on an annual basis. +Howmet has outstanding letters of credit primarily related to workers’ compensation, environmental obligations, and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2021, was $105 at December 31, 2020. +Pursuant to the Separation and Distribution Agreements between the Company and Arconic Corporation and between the Company and Alcoa Corporation, the Company is required to retain letters of credit of $53 that had previously been provided related to the Company, Arconic Corporation, and Alcoa Corporation workers’ compensation claims which occurred prior to the respective separation transactions of April 1, 2020 and November 1, 2016. Arconic Corporation and Alcoa Corporation workers’ compensation claims and letter of credit fees paid by the Company are being proportionally billed to and are being reimbursed by Arconic Corporation and Alcoa Corporation. Also, the Company was required to provide letters of credit for certain Arconic Corporation environmental obligations and, as a result, the Company has $29 of outstanding letters of credit relating to liabilities (which are included in the $105 in the above paragraph). $13 of these outstanding letters of credit are pending cancellation and will be deemed cancelled once returned by the beneficiary. Arconic Corporation has issued surety bonds to cover these environmental obligations. Arconic Corporation is being billed for these letter of credit fees paid by the Company and will reimburse the Company for any payments made under these letters of credit. +Howmet has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire at various dates, primarily in 2021, was $43 at December 31, 2020. +Pursuant to the Separation and Distribution Agreements between the Company and Arconic Corporation and between the Company and Alcoa Corporation, the Company was required to provide surety bonds of $26 (which are included in the $43 in the above paragraph) that had previously been provided, related to the Company, Arconic Corporation and Alcoa Corporation workers’ compensation claims which occurred prior to the respective separation transactions of April 1, 2020 and November 1, 2016. Arconic Corporation and Alcoa Corporation workers’ compensation letters of credit and surety bond fees paid by the Company are being proportionally billed to and are being reimbursed by Arconic Corporation and Alcoa Corporation. +41 +Table of Contents +Critical Accounting Policies and Estimates +The preparation of the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America requires management to make certain judgments, estimates, and assumptions regarding uncertainties that affect the amounts reported in the Consolidated Financial Statements and disclosed in the accompanying Notes. These estimates are based on historical experience and, in some cases, assumptions based on current and future market experience, including considerations relating to the impact of COVID-19. The impact of COVID-19 is rapidly changing and of unknown duration and macroeconomic impact and as a result, these considerations remain highly uncertain. Areas that require significant judgments, estimates, and assumptions include the testing of goodwill, other intangible assets, and properties, plants, and equipment for impairment; estimating fair value of businesses acquired or divested; pension plans and other postretirement benefits obligations; stock-based compensation; and income taxes. +Management uses historical experience and all available information to make these judgments, estimates, and assumptions, and actual results may differ from those used to prepare the Company’s Consolidated Financial Statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and accompanying Notes provide a meaningful and fair perspective of the Company. +A summary of the Company’s significant accounting policies is included in Note A to the Consolidated Financial Statements. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the Consolidated Financial Statements with useful and reliable information about the Company’s operating results and financial condition. +Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. +Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Howmet had four reporting units (Engine Products, Fastening Systems, Engineered Structures, and Forged Wheels) for 2020. +In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (greater than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. +The Company determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Howmet’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three-year period. +Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent quantitative impairment test completed for a reporting unit and compares the weighted average cost of capital ("WACC") between the current and prior years for each reporting unit. +During the first quarter of 2020, Howmet's market capitalization declined significantly compared to the fourth quarter of 2019. Over the same period, the equity value of our peer group companies, and the overall U.S. stock market also declined significantly amid market volatility. In addition, as a result of the COVID-19 pandemic and measures designed to contain the spread, sales globally to customers in the aerospace and commercial transportation industries impacted by COVID-19 have been and are expected to be negatively impacted as a result of disruption in demand. As a result of these macroeconomic factors, we performed a qualitative impairment test to evaluate whether it is more likely than not that the fair value of any of our +42 +Table of Contents +reporting units is less than its carrying value. As a result of this assessment, the Company performed a quantitative impairment test in the first quarter for the Engineered Structures reporting unit and concluded that though the margin between the fair value of the reporting unit and carrying value had declined from approximately 60% to approximately 15%, it was not impaired. Consistent with prior practice, a discounted cash flow model was used to estimate the current fair value of the reporting unit. The significant assumptions and estimates utilized to determine fair value were developed utilizing current market and forecast information reflecting the disruption in demand that has had and is expected to have a negative impact on the Company’s global sales in the aerospace industry. During the second and third quarters of 2020, there were no indicators of impairment identified for the Engineered Structures reporting unit. +During the 2020 annual review of goodwill in the fourth quarter, management proceeded directly to the quantitative impairment test for all four of its reporting units. The estimated fair values for each of the four reporting units exceeded their respective carrying values by 50% or greater; thus, there was no goodwill impairment. The annual goodwill impairment tests performed in the fourth quarter of 2019 and 2018 also indicated that goodwill was not impaired for any of the Company’s reporting units. +Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Howmet uses a discounted cash flow ("DCF") model to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth, production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. Howmet would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit. +Properties, Plants, and Equipment and Other Intangible Assets. Properties, plants, and equipment and Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is measured as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a DCF model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of the assets also require significant judgments. +During the second quarter of 2019, the Company updated its five-year strategic plan and determined that there was a decline in the forecasted financial performance for the Disks asset group within the Engine Products and Forgings segment at that time. As such, the Company evaluated the recoverability of the Disks asset group long-lived assets by comparing the carrying value to the undiscounted cash flows of the Disks asset group. The carrying value exceeded the undiscounted cash flows and therefore the Disks asset group long-lived assets were deemed to be impaired. The impairment charge was measured as the amount of carrying value in excess of fair value of the long-lived assets, with fair value determined using a DCF model and a combination of sales comparison and cost approach valuation methods including an estimate for economic obsolescence. The impairment charge of $428, of which $247 and $181 related to the Engine Products and Engineered Structures segments, respectively, which was recorded in the second quarter of 2019, impacted properties, plants, and equipment; intangible assets; and certain other noncurrent assets by $198, $197, and $33, respectively. The impairment charge was recorded in Restructuring and other charges in the Statement of Consolidated Operations. +Discontinued Operations and Assets Held for Sale. The fair values of all businesses to be divested are estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements. +Pension and Other Postretirement Benefits. Liabilities and expenses for pension and other postretirement benefits are determined using actuarial methodologies and incorporate significant assumptions, including the interest rate used to discount the future estimated liability, the expected long-term rate of return on plan assets, and several assumptions relating to the employee workforce (health care cost trend rates, retirement age, and mortality). +The interest rate used to discount future estimated liabilities for the U.S. is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary, while both the U.K. and Canada utilize models +43 +Table of Contents +developed by the respective actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have a global average duration of 12 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. In 2020, 2019, and 2018, the discount rate used to determine benefit obligations for pension and other postretirement benefit plans was 2.40%, 3.00%, and 4.00%, respectively. The impact on the liabilities of a change in the discount rate of 1/4 of 1% would be approximately $90 and either a charge or credit of approximately $1 to earnings in the following year. +The expected long-term rate of return on plan assets is generally applied to a five-year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment. +For 2020, 2019, and 2018, management used 6.00%, 5.60%, and 5.90%, respectively, as its expected long-term rate of return on plan assets, which was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. T hese rates fell within the respective range of the 20-year moving average of actual performance and the expected future return developed by asset class. For 2021, management anticipates that 6.00% will be the expected long-term rate of return for the plan assets. A change in the assumption for the expected long-term rate of return on plan assets of 1/4 of 1% would impact earnings by approximately $4 for 2021. +In 2020, a net loss of $46 (after-tax) was recorded in other comprehensive loss, primarily due to the decrease in the discount rate, partially offset by the plan asset performance that was greater than expected, and by amortization of actuarial losses. After adjusting for the impact of Arconic Corporation's obligation, the net pension and other postretirement benefit obligation decreased less than 2% during 2020. In 2019, a net loss of $388 (after-tax) was recorded in other comprehensive loss, primarily due to the decrease in the discount rate, which was partially offset by the plan asset performance that was greater than expected, and by the amortization of actuarial losses. In 2018, a net loss of $114 (after-tax) was recorded in other comprehensive loss, primarily due to the impact of the adoption of new accounting guidance that permits a reclassification to Retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017, as well as the plan asset performance that was less than expected, which were partially offset by the increase in the discount rate and the amortization of actuarial losses. +Stock-Based Compensation. Howmet recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. +Compensation expense recorded in 2020, 2019, and 2018 was $46 ($42 after-tax), $69 ($63 after-tax), and $40 ($31 after-tax), respectively. +Income Taxes. The provision (benefit) for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision (benefit) for income taxes represents income taxes paid or payable (or received or receivable) based on current year pre-tax income plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Howmet’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carry-back periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Howmet’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. +44 +Table of Contents +Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +The 2017 Act created a new requirement that certain income earned by foreign subsidiaries, Global Intangible Low Taxed Income ("GILTI"), must be included in the gross income of the U.S. shareholder. In 2018, Howmet made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. +Recently Adopted Accounting Guidance. See the Recently Adopted Accounting Guidance section of Note B to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Recently Issued Accounting Guidance. See the Recently Issued Accounting Guidance section of Note B to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K. +Item 7A. Quantitative and Qualitative Disclosures About Market Risk. +Not material. +45 +Table of Contents +Item 8. Financial Statements and Supplementary Data. +Management’s Reports to Howmet Shareholders +Management’s Report on Financial Statements and Practices +The accompanying Consolidated Financial Statements of Howmet Aerospace Inc. and its subsidiaries (the “Company”) were prepared by management, which is responsible for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s best judgments and estimates. The other financial information included in the annual report is consistent with that in the financial statements. +Management also recognizes its responsibility for conducting the Company’s affairs according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in key policy statements issued from time to time regarding, among other things, conduct of its business activities within the laws of the host countries in which the Company operates and potentially conflicting outside business interests of its employees. The Company maintains a systematic program to assess compliance with these policies. +Management’s Report on Internal Control over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control—Integrated Framework (2013) , issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). The Company’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Based on the assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2020, based on criteria in Internal Control—Integrated Framework (2013) issued by the COSO. +The effectiveness of the Company’s internal control over financial reporting as of December 31, 2020 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein. +/s/ John C. Plant +John C. Plant +Executive Chairman and Co-Chief Executive Officer +/s/ Tolga Oal +Tolga Oal +Co-Chief Executive Officer +/s/ Ken Giacobbe +Ken Giacobbe +Executive Vice President and Chief Financial Officer +46 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Board of Directors and Shareholders of Howmet Aerospace Inc. +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheet of Howmet Aerospace Inc. and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of operations, of comprehensive income, of changes in equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. +Change in Accounting Principle +As discussed in Note B to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinions +The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +47 +Table of Contents +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +Goodwill Impairment Assessments – Engineered Structures Reporting Unit +As described in Notes A and P to the consolidated financial statements, the Company’s consolidated goodwill balance was $4,102 million as of December 31, 2020, and the amount of the goodwill associated with the Engineered Structures reporting unit was $304 million. Goodwill is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist. During the first quarter of 2020, management performed a quantitative impairment test for the Engineered Structures reporting unit and concluded that it was not impaired. The evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Fair value is estimated using a discounted cash flow model. The determination of fair value using this technique requires management to use significant estimates and assumptions related to forecasting operating cash flows, including sales growth, production costs, capital spending, and discount rate. +The principal considerations for our determination that performing procedures relating to the goodwill impairment assessments of the Engineered Structures reporting unit is a critical audit matter are the significant judgment by management when developing the fair value measurements of the reporting unit. This in turn led to a high degree of auditor judgment, effort and subjectivity in performing procedures and evaluating audit evidence related to management’s cash flow projections and significant assumptions related to sales growth, production costs, and discount rate for the first quarter assessment, and sales growth and production costs for the annual impairment assessment. In addition, the audit effort involved the use of professionals with specialized skill and knowledge. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s goodwill impairment assessments, including controls over the valuation of the Company’s Engineered Structures reporting unit. These procedures also included, among others, testing management’s process for developing the fair value estimates; evaluating the appropriateness of the discounted cash flow models and performing sensitivity analyses over the assumptions; testing the completeness and accuracy of underlying data used in the models; and evaluating the reasonableness of the significant assumptions used by management related to sales growth, production costs, and discount rate for the first quarter assessment and sales growth and production costs for the annual impairment assessment. Evaluating management’s assumptions related to sales growth and production costs involved evaluating whether the assumptions used by management were reasonable by considering (i) the current and past performance of the reporting unit, (ii) the consistency with relevant industry data, and (iii) considering whether the assumptions were consistent with evidence obtained in other areas of the audit. Professionals with specialized skill and knowledge were used to assist in the evaluation of the discounted cash flow models and, for the first quarter assessment, the discount rate assumption. +/s/ PricewaterhouseCoopers LLP +Pittsburgh, Pennsylvania +February 16, 2021 +We have served as the Company’s auditor since 1950. +48 +Table of Contents +Howmet Aerospace Inc. and subsidiaries +Statement of Consolidated Operations +(in millions, except per-share amounts) +For the year ended December 31, 2020 2019 2018 +Sales ( D ) +$ 5,259 $ 7,098 $ 6,778 +Cost of goods sold (exclusive of expenses below) 3,878 5,214 5,114 +Selling, general administrative, and other expenses 277 400 371 +Research and development expenses 17 28 41 +Provision for depreciation and amortization 279 295 314 +Restructuring and other charges ( E ) +182 582 163 +Operating income 626 579 775 +Interest expense ( F ) +381 338 377 +Other expense (income), net ( G ) +74 31 ( 30 ) +Income before income taxes 171 210 428 +(Benefit) provision for income taxes ( I ) +( 40 ) 84 119 +Income from continuing operations after income taxes $ 211 $ 126 $ 309 +Income from discontinued operations after income taxes ( C ) +50 344 333 +Net income $ 261 $ 470 $ 642 +Amounts Attributable to Howmet Aerospace Common Shareholders ( K ): +Net income $ 259 $ 477 $ 651 +Earnings per share - basic +Continuing operations $ 0.48 $ 0.28 $ 0.64 +Discontinued operations $ 0.11 $ 0.77 $ 0.69 +Earnings per share - diluted +Continuing operations $ 0.48 $ 0.27 $ 0.63 +Discontinued operations $ 0.11 $ 0.76 $ 0.67 +Average Shares Outstanding ( J ): +Average shares outstanding - basic 435 446 483 +Average shares outstanding - diluted 439 463 503 +The accompanying notes are an integral part of the consolidated financial statements. +49 +Table of Contents +Howmet Aerospace Inc. and subsidiaries +Statement of Consolidated Comprehensive Income +(in millions) +For the year ended December 31, 2020 2019 2018 +Net income $ 261 $ 470 $ 642 +Other comprehensive (loss) income, net of tax ( L ) : +Change in unrecognized net actuarial loss and prior service cost/benefit related to pension and other postretirement benefits ( 46 ) ( 388 ) 255 +Foreign currency translation adjustments 58 ( 13 ) ( 146 ) +Net change in unrealized gains on debt securities — 3 ( 1 ) +Net change in unrecognized gains/losses on cash flow hedges 4 ( 3 ) ( 23 ) +Total Other comprehensive income (loss), net of tax 16 ( 401 ) 85 +Comprehensive income $ 277 $ 69 $ 727 +The accompanying notes are an integral part of the consolidated financial statements. +50 +Table of Contents +Howmet Aerospace Inc and subsidiaries +Consolidated Balance Sheet +(in millions) +December 31, 2020 2019 +Assets +Current assets: +Cash and cash equivalents $ 1,610 $ 1,577 +Receivables from customers, less allowances of $ 1 in 2020 and $ 1 in 2019 ( M ) +328 583 +Other receivables ( M ) +29 349 +Inventories ( N ) +1,488 1,607 +Prepaid expenses and other current assets 217 285 +Current assets of discontinued operations ( C ) +— 1,442 +Total current assets 3,672 5,843 +Properties, plants, and equipment, net ( O ) +2,592 2,629 +Goodwill ( A and P ) +4,102 4,067 +Deferred income taxes ( I ) +272 209 +Intangibles, net ( P ) +571 599 +Other noncurrent assets ( A and Q ) +234 316 +Noncurrent assets of discontinued operations ( C ) +— 3,899 +Total assets $ 11,443 $ 17,562 +Liabilities +Current liabilities: +Accounts payable, trade $ 599 $ 976 +Accrued compensation and retirement costs 205 285 +Taxes, including income taxes 102 65 +Accrued interest payable 89 112 +Other current liabilities ( A and Q ) +289 229 +Short-term debt ( R and S ) +376 1,034 +Current liabilities of discontinued operations ( C ) +— 1,424 +Total current liabilities 1,660 4,125 +Long-term debt, less amount due within one year ( R and S ) +4,699 4,906 +Accrued pension benefits ( H ) +985 1,030 +Accrued other postretirement benefits ( H ) +198 200 +Other noncurrent liabilities and deferred credits ( A and Q ) +324 438 +Noncurrent liabilities of discontinued operations ( C ) +— 2,258 +Total liabilities 7,866 12,957 +Contingencies and commitments ( V ) +Equity +Howmet Aerospace shareholders’ equity: +Preferred stock ( J ) +55 55 +Common stock ( J ) +433 433 +Additional capital ( J ) +4,668 7,319 +Retained earnings ( A ) +364 113 +Accumulated other comprehensive loss ( A and L ) +( 1,943 ) ( 3,329 ) +Total Howmet Aerospace shareholders’ equity 3,577 4,591 +Noncontrolling interests — 14 +Total equity 3,577 4,605 +Total liabilities and equity $ 11,443 $ 17,562 +The accompanying notes are an integral part of the consolidated financial statements. +51 +Table of Contents +Howmet Aerospace Inc and subsidiaries +Statement of Consolidated Cash Flows +(in millions) +For the year ended December 31, 2020 2019 2018 +Operating activities +Net income $ 261 $ 470 $ 642 +Adjustments to reconcile net income to cash used for operations: +Depreciation and amortization 338 536 576 +Deferred income taxes 2 ( 19 ) 31 +Restructuring and other charges 164 620 9 +Net loss from investing activities - asset sales 8 7 10 +Net periodic pension benefit cost ( H ) +51 115 130 +Stock-based compensation 45 60 50 +Other 59 13 75 +Changes in assets and liabilities, excluding effects of acquisitions, divestitures, and foreign currency translation adjustments: +(Increase) in receivables ( 238 ) ( 977 ) ( 1,142 ) +Decrease (increase) in inventories 74 ( 3 ) ( 74 ) +(Increase) decrease in prepaid expenses and other current assets ( 2 ) 4 ( 1 ) +(Decrease) increase in accounts payable, trade ( 381 ) ( 1 ) 339 +(Decrease) in accrued expenses ( 217 ) ( 42 ) ( 190 ) +Decrease (increase) in taxes, including income taxes 98 ( 2 ) 104 +Pension contributions ( 257 ) ( 268 ) ( 298 ) +Decrease (increase) in noncurrent assets 39 ( 7 ) ( 20 ) +(Decrease) in noncurrent liabilities ( 35 ) ( 45 ) ( 24 ) +Cash provided from operations 9 461 217 +Financing Activities +Net change in short-term borrowings (original maturities of three months or less) ( 15 ) 2 ( 7 ) +Additions to debt (original maturities greater than three months) ( R ) +2,400 400 600 +Payments on debt (original maturities greater than three months) ( R ) +( 2,043 ) ( 806 ) ( 1,103 ) +Debt issuance costs ( C and R ) +( 61 ) — — +Premiums paid on early redemption of debt ( R ) +( 59 ) — ( 17 ) +Proceeds from exercise of employee stock options 33 56 16 +Dividends paid to shareholders ( 11 ) ( 57 ) ( 119 ) +Repurchase of common stock ( J ) +( 73 ) ( 1,150 ) — +Net cash transferred to Arconic Corporation at separation ( 500 ) — — +Other ( 40 ) ( 13 ) ( 19 ) +Cash used for financing activities ( 369 ) ( 1,568 ) ( 649 ) +Investing Activities +Capital expenditures ( A and D ) +( 267 ) ( 641 ) ( 768 ) +Proceeds from the sale of assets and businesses ( U ) +114 103 309 +Sales of investments — 73 9 +Cash receipts from sold receivables ( M ) +422 995 1,016 +Other 2 ( 2 ) ( 1 ) +Cash provided from Investing Activities 271 528 565 +Effect of exchange rates on cash, cash equivalents and restricted cash ( 3 ) — ( 4 ) +Net change in cash, cash equivalents and restricted cash ( 92 ) ( 579 ) 129 +Cash, cash equivalents and restricted cash at beginning of year 1,703 2,282 2,153 +Cash, cash equivalents and restricted cash at end of year $ 1,611 $ 1,703 $ 2,282 +The accompanying notes are an integral part of the consolidated financial statements. +52 +Table of Contents +Howmet and subsidiaries +Statement of Changes in Consolidated Equity +(in millions, except per-share amounts) +Howmet Shareholders +Preferred +stock Common +stock Additional +capital Retained earnings (accumulated deficit) Accumulated +Other +Comprehensive +Loss Noncontrolling +interests Total +equity +Balance at December 31, 2017 $ 55 $ 481 $ 8,266 $ ( 1,264 ) $ ( 2,644 ) $ 14 $ 4,908 +Adoption of accounting standard ( B ) +— — — $ 367 ( 367 ) — — +Net income — — — 642 — — 642 +Other comprehensive income ( L ) +— — — — 85 — 85 +Cash dividends declared: +Preferred–Class A @ $ 3.75 per share +— — — ( 2 ) — — ( 2 ) +Common @ $ 0.24 per share +— — — ( 117 ) — — ( 117 ) +Stock-based compensation ( J ) +— — 50 — — — 50 +Common stock issued: compensation plans ( J ) +— 2 3 — — — 5 +Other — — — — — ( 2 ) ( 2 ) +Balance at December 31, 2018 $ 55 $ 483 $ 8,319 $ ( 374 ) $ ( 2,926 ) $ 12 $ 5,569 +Adoption of accounting standard ( B ) +— — — 75 ( 2 ) — 73 +Net income — — — 470 — — 470 +Other comprehensive loss ( L ) +— — — — ( 401 ) — ( 401 ) +Cash dividends declared: +Preferred–Class A @ $ 3.75 per share +— — — ( 2 ) — — ( 2 ) +Common @ $ 0.12 per share +— — — ( 56 ) — — ( 56 ) +Repurchase and retirement of common stock ( J ) +— ( 55 ) ( 1,095 ) — — — ( 1,150 ) +Stock-based compensation ( J ) +— — 57 — — — 57 +Common stock issued: compensation plans ( J ) +— 5 36 — — — 41 +Other — — 2 — — 2 4 +Balance at December 31, 2019 $ 55 $ 433 $ 7,319 $ 113 $ ( 3,329 ) $ 14 $ 4,605 +Net income — — — 261 — — 261 +Other comprehensive income ( L ) +— — — — 16 — 16 +Cash dividends declared: +Preferred–Class A @ $ 3.75 per share +— — — ( 2 ) — — ( 2 ) +Common @ $ 0.02 per share +— — — ( 8 ) — — ( 8 ) +Repurchase and retirement of common stock ( J ) +— ( 3 ) ( 70 ) — — — ( 73 ) +Stock-based compensation ( J ) +— — 45 — — — 45 +Common stock issued: compensation plans ( J ) +— 3 ( 9 ) — — — ( 6 ) +Distribution to Arconic Corporation ( C ) +— — ( 2,617 ) — 1,370 ( 14 ) ( 1,261 ) +Balance at December 31, 2020 $ 55 $ 433 $ 4,668 $ 364 $ ( 1,943 ) $ — $ 3,577 +The accompanying notes are an integral part of the consolidated financial statements. +53 +Table of Contents +Howmet Aerospace and subsidiaries +Notes to the Consolidated Financial Statements +(dollars in millions, except per-share amounts) +A. Summary of Significant Accounting Policies +Basis of Presentation. The Consolidated Financial Statements of Howmet Aerospace Inc. (formerly known as Arconic Inc.) and subsidiaries (“Howmet” or the “Company”) are prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP") and require management to make certain judgments, estimates, and assumptions. These estimates are based on historical experience and, in some cases, assumptions based on current and future market experience, including considerations relating to the impact of the global pandemic coronavirus (“COVID-19”). The impact of COVID-19 is rapidly changing and of unknown duration and macroeconomic impact and as a result, these considerations remain highly uncertain. We have made our best estimates using all relevant information available at the time, but it is possible that our estimates will differ from our actual results and affect the Consolidated Financial Statements in future periods and potentially require adverse adjustments to the recoverability of goodwill, intangible and long-lived assets, the realizability of deferred tax assets and other judgments and estimations and assumptions. These may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. They also may affect the reported amounts of sales and expenses during the reporting period. Actual results could differ from those estimates upon subsequent resolution of identified matters. +The separation of Arconic Inc. into two standalone, publicly-traded companies, Howmet Aerospace Inc. and Arconic Corporation, (the “Arconic Inc. Separation Transaction”) occurred on April 1, 2020. The Engineered Products and Forgings ("EP&F") segment remained in the existing company which was renamed Howmet Aerospace Inc. The Global Rolled Products ("GRP") segment was the Spin Co. and was named Arconic Corporation. In the second quarter of 2020, in conjunction with the Arconic Inc. Separation Transaction, the Company realigned its operations by separating the former EP&F segment into four new segments: Engine Products, Fastening Systems, Engineered Structures and Forged Wheels. See Note D for further details. +The financial results of Arconic Corporation for all periods prior to the Arconic Inc. Separation Transaction have been retrospectively reflected in the Statement of Consolidated Operations as discontinued operations and, as such, have been excluded from continuing operations and segment results for all periods presented. In addition, the related assets and liabilities associated with Arconic Corporation in the December 2019 Consolidated Balance Sheet are classified as assets and liabilities of discontinued operations. The cash flows, comprehensive income, and equity related to Arconic Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows, Statement of Consolidated Comprehensive Income, and Statement of Changes in Consolidated Equity, respectively, for all periods prior to the Arconic Inc. Separation Transaction. See Note C for additional information related to the Arconic Inc. Separation Transaction and discontinued operations. +The Company derived approximately 69 %, 71 % and 70 % of its revenue from products sold to the aerospace end-market for the years ended December 31, 2020, 2019 and 2018. As a result of COVID-19 and its impact on the aerospace industry to-date, the possibility exists that there could be a sustained impact to our operations and financial results. Since the start of the pandemic, certain original equipment manufacturer (“OEM”) customers have reduced production or suspended manufacturing operations in North America and Europe on a temporary basis. While the pandemic has resulted in the temporary closure of a small number of the Company's manufacturing facilities, all of our manufacturing facilities are currently operating. Since the duration of the pandemic is uncertain, the Company is taking a series of actions to address the financial impact, including announcing certain headcount reductions and reducing certain cash outflows by suspending dividends on common stock and reducing the level of its capital expenditures to preserve cash and maintain liquidity. +The Company identified a misclassification in the presentation of changes in accounts payable and capital expenditures in its previously issued Statement of Consolidated Cash Flows during 2020. Although management has determined that such misclassification did not materially misstate the Statement of Consolidated Cash Flows for the year ended December 31, 2019, the Company has revised it resulting in a $ 55 increase to previously reported capital expenditures and decrease to cash provided from investing activities with a corresponding reduction (decrease) in accounts payable, trade and increase in cash provided by operations. +A $ 16 deferred tax error was identified related to periods prior to 2018 during 2020. Although management has determined it was not material to any periods, the Company has revised its Statement of Changes in Consolidated Equity for the years ended December 31, 2019 and 2018 to present the correction as a reduction to Retained Earnings as of December 31, 2017. The accompanying Consolidated Balance Sheet at December 31, 2019 also reflects the revision for such tax item. +Principles of Consolidation. The Consolidated Financial Statements include the accounts of Howmet Aerospace Inc. and companies in which Howmet Aerospace Inc. has a controlling interest. Intercompany transactions have been eliminated. Investments in affiliates in which Howmet Aerospace Inc. cannot exercise significant influence that do not have readily +54 +Table of Contents +determinable fair values are accounted for at cost less impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. +Management also evaluates whether a Howmet Aerospace Inc. entity or interest is a variable interest entity and whether Howmet Aerospace Inc. is the primary beneficiary. Consolidation is required if both of these criteria are met. Howmet Aerospace Inc. does not have any variable interest entities requiring consolidation. +Cash Equivalents. Cash equivalents are highly liquid investments purchased with an original maturity of three months or less. +Inventory Valuation. Inventories are carried at the lower of cost and net realizable value with the cost of inventories determined under a combination of the first-in, first-out ("FIFO"), last-in, first-out ("LIFO") and average-cost methods. See Note N for further details. +Properties, Plants, and Equipment. Properties, plants, and equipment are recorded at cost. Depreciation is recorded principally on the straight-line method at rates based on the estimated useful lives of the assets. +The following table details the weighted-average useful lives of structures and machinery and equipment by reporting segment (numbers in years): +Structures Machinery and equipment +Engine Products 30 16 +Fastening Systems 28 17 +Engineered Structures 28 18 +Forged Wheels 29 18 +Gains or losses from the sale of asset groups are generally recorded in Restructuring and other charges while the sale of individual assets are recorded in Other expense (income), net (see policy below for assets classified as held for sale and discontinued operations). Repairs and maintenance are charged to expense as incurred. Interest related to the construction of qualifying assets is capitalized as part of the construction costs. +Properties, plants, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is measured as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a discounted cash flow ("DCF") model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of the assets also require significant judgments. See Note O for further details. +Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. +Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Howmet had four reporting units composed of the Engine Products, Fastening Systems, Engineered Structures and Forged Wheels segments. +In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (greater than 50 %) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test. +Howmet determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that +55 +Table of Contents +an impairment is more likely than not, a quantitative impairment test will be performed. Howmet's policy is that a quantitative impairment test be performed for each reporting unit at least once during every three-year period. +Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent quantitative impairment test completed for a reporting unit and compares the weighted average cost of capital ("WACC") between the current and prior years for each reporting unit. +During the first quarter of 2020, Howmet's market capitalization declined significantly compared to the fourth quarter of 2019. Over the same period, the equity value of our peer group companies, and the overall U.S. stock market also declined significantly amid market volatility. In addition, as a result of the COVID-19 pandemic and measures designed to contain the spread, sales globally to customers in the aerospace and commercial transportation industries impacted by COVID-19 have been and are expected to continue to be negatively impacted as a result of disruption in demand. As a result of these macroeconomic factors, we performed a qualitative impairment test to evaluate whether it is more likely than not that the fair value of any of our reporting units is less than its carrying value. As a result of this assessment, the Company performed a quantitative impairment test in the first quarter for the Engineered Structures reporting unit and concluded that though the margin between the fair value of the reporting unit and carrying value had declined from approximately 60 % to approximately 15 %, it was not impaired. Consistent with prior practice, a discounted cash flow model was used to estimate the current fair value of the reporting unit. The significant assumptions and estimates utilized to determine fair value were developed utilizing current market and forecast information reflecting the disruption in demand that has and is expected to negatively impact the Company’s sales globally in the aerospace industry. During the second and third quarters of 2020, there were no indicators of impairment identified for the Engineered Structures reporting unit. +During the 2020 annual review of goodwill in the fourth quarter, management proceeded directly to the quantitative impairment test for all four of its reporting units. The estimated fair values for each of the four reporting units exceeded their respective carrying values by more than 50 %, thus, there was no goodwill impairment. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Howmet uses a DCF model to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth, production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. The annual goodwill impairment tests in the fourth quarter of 2020, 2019 and 2018 indicated that goodwill was not impaired for any of the Company’s reporting units. If actual results or external market factors decline significantly from management’s estimates, future goodwill impairment charges (or the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit) may be necessary and could be material. +In the first quarter of 2020, management transferred its Savannah, Georgia business from the Engine Products reporting unit to the Engineered Structures reporting unit. As a result of the reorganization, these reporting units were evaluated for impairment during the first quarter of 2020. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no goodwill impairment. In the second quarter of 2019, the Company transferred its castings operations from Engineered Structures to Engine Products. As a result, these reporting units were evaluated for impairment during the second quarter of 2019. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no impairment. +In the second quarter of 2019, as a result of the decline in the forecasted financial performance and related impairment of long-lived assets of the Disks asset group which composed business currently in the Engine Products and Engineered Structures segments (see Note O ), the Company also performed an interim impairment evaluation of goodwill for Engine Products. The estimated fair value of the Engine Products reporting unit was substantially in excess of its carrying value; thus, there was no impairment of goodwill. +In connection with the interim impairment evaluation of long-lived assets for the Disks asset group in the second quarter of 2018, which resulted from a decline in forecasted financial performance for the business in connection with its updated three-year strategic plan, the Company also performed an interim impairment evaluation of goodwill for Engine Products. The estimated fair value of the reporting unit was substantially in excess of the carrying value; thus, there was no impairment of goodwill. +56 +Table of Contents +Other Intangible Assets. Intangible assets with indefinite useful lives are not amortized while intangible assets with finite useful lives are amortized generally on a straight-line basis over the periods benefited. +The following table details the weighted-average useful lives of software and other intangible assets by reporting segment (numbers in years): +Software Other intangible assets +Engine Products 7 33 +Fastening Systems 6 23 +Engineered Structures 4 10 +Forged Wheels 4 23 +Leases. The Company determines whether a contract contains a lease at inception. The Company leases land and buildings, plant equipment, vehicles, and computer equipment which have been classified as operating leases. Certain real estate leases include one or more options to renew; the exercise of lease renewal options is at the Company’s discretion. The Company includes renewal option periods in the lease term when it is determined that the options are reasonably certain to be exercised. Certain of Howmet's real estate lease agreements include rental payments that either have fixed contractual increases over time or adjust periodically for inflation. Certain of the Company's lease agreements include variable lease payments. The variable portion of payments is not included in the initial measurement of the right-of-use asset or lease liability due to the uncertainty of the payment amount and is recorded as lease cost in the period incurred. The Company also rents or subleases certain real estate to third parties, which is not material to the consolidated financial statements. +Operating lease right-of-use assets and lease liabilities with an initial term greater than 12 months are recorded on the balance sheet at the present value of the future minimum lease payments over the lease term at the lease commencement date and are recognized as lease expense on a straight-line basis over the lease term. The Company uses an incremental collateralized borrowing rate based on the information available at the lease commencement date in determining the present value of future payments, as most of its leases do not provide an implicit rate. The operating lease right-of-use assets also include any lease prepayments made and were reduced by lease incentives and accrued exit costs. +Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future sales, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery. Claims for recovery are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Howmet has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations. +Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss. +Revenue Recognition. The Company's contracts with customers are comprised of acknowledged purchase orders incorporating the Company’s standard terms and conditions, or for larger customers, may also generally include terms under negotiated multi-year agreements. These contracts with customers typically consist of the manufacture of products which represent single performance obligations that are satisfied upon transfer of control of the product to the customer. The Company produces fastening systems; seamless rolled rings; investment castings, including airfoils; extruded, machined and formed aircraft parts; and forged aluminum commercial vehicle wheels. Transfer of control is assessed based on alternative use of the products we produce and our enforceable right to payment for performance to date under the contract terms. Transfer of control and revenue recognition generally occur upon shipment or delivery of the product, which is when title, ownership and risk of loss pass to the customer and is based on the applicable shipping terms. The shipping terms vary across all businesses and depend on the +57 +Table of Contents +product, the country of origin, and the type of transportation (truck, train, or vessel). An invoice for payment is issued at time of shipment. Our segments set commercial terms on which Howmet sells products to its customers. These terms are influenced by industry custom, market conditions, product line (specialty versus commodity products), and other considerations. +In certain circumstances, Howmet receives advanced payments from its customers for product to be delivered in future periods. These advanced payments are recorded as deferred revenue until the product is delivered and title and risk of loss have passed to the customer in accordance with the terms of the contract. Deferred revenue is included in Other current liabilities and Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. Advanced payments were $ 97 and $ 85 at December 31, 2020 and December 31, 2019, respectively. +Income Taxes. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Howmet’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted. +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Howmet’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also remeasured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, the Company made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset Global Intangible Low-Taxed Income ("GILTI") inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. +Stock-Based Compensation. Howmet recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time. +Foreign Currency. The local currency is the functional currency for Howmet’s significant operations outside the United States ("U.S."), except for certain operations in Canada, United Kingdom and France, where the U.S. dollar is used as the functional currency. The determination of the functional currency for Howmet’s operations is made based on the appropriate economic and management indicators. +Acquisitions. Howmet’s business acquisitions are accounted for using the acquisition method. The purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. Any excess purchase price over the fair value of the net assets acquired is recorded as goodwill. For all acquisitions, operating results are included in the Statement of Consolidated Operations from the date of the acquisition. +58 +Table of Contents +Discontinued Operations and Assets Held for Sale. For those businesses where management has committed to a plan to divest, each business is valued at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, an impairment loss is recognized. Fair value is estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements. Depreciation and amortization expense is not recorded on assets of a business to be divested once they are classified as held for sale. Businesses to be divested are generally classified in the Consolidated Financial Statements as either discontinued operations or held for sale. +For businesses classified as discontinued operations, the balance sheet amounts and results of operations should be reclassified from their historical presentation to assets and liabilities of discontinued operations on the Consolidated Balance Sheet and to discontinued operations on the Statement of Consolidated Operations, respectively, for all periods presented. The gains or losses associated with these divested businesses are recorded in discontinued operations on the Statement of Consolidated Operations. The Statement of Consolidated Cash Flows is not required to be reclassified for discontinued operations for any period. Segment information does not include the assets or operating results of businesses classified as discontinued operations for all periods presented. These businesses are expected to be disposed of within one year . +For businesses classified as held for sale that do not qualify for discontinued operations treatment, the balance sheet and cash flow amounts should be reclassified from their historical presentation to assets and liabilities of operations held for sale for all periods presented. The results of operations continue to be reported in continuing operations. The gains or losses associated with these divested businesses are recorded in Restructuring and other charges on the Statement of Consolidated Operations. The segment information includes the assets and operating results of businesses classified as held for sale for all periods presented. +B. Recently Adopted and Recently Issued Accounting Guidance +Recently Adopted Accounting Guidance. +On January 1, 2020, the Company adopted changes issued by the Financial Accounting Standards Board ("FASB") related to the impairment model for expected credit losses. The new impairment model (known as the current expected credit loss ("CECL") model) is based on expected losses rather than incurred losses. The Company recognizes as an allowance its estimate of expected credit losses. The CECL model applies to most debt instruments, trade receivables, lease receivables, financial guarantee contracts, and other loan commitments and requires the measurement of expected credit losses on assets including those that have a low risk of loss. The adoption of this new guidance did not have a material impact on the Consolidated Financial Statements. +In August 2018, the FASB issued guidance that impacts disclosures for defined benefit pension plans and other postretirement benefit plans. These changes became effective for Howmet's annual report for the year ended December 31, 2020 which did not have a material impact on its Consolidated Financial Statements. +In February 2016, the FASB issued changes to the accounting and presentation of leases. These changes required lessees to recognize a right-of-use asset and lease liability on the balance sheet, initially measured at the present value of lease payments for all operating leases with a term greater than 12 months. These changes became effective for the Company on January 1, 2019 and have been applied using the modified retrospective approach as of the date of adoption, under which leases existing at, or entered into after, January 1, 2019 were required to be recognized and measured. Prior period amounts have not been adjusted and continue to be reflected in accordance with the Company’s historical accounting. The Company elected the package of practical expedients permitted under the transition guidance within the new standard, which among other things, allowed the Company to carry forward the historical lease classification. The Company also elected to separate lease components from non-lease components for all classes of assets. +The adoption of this new lease standard resulted in the Company recording operating lease right-of-use assets and lease liabilities of approximately $ 320 on the Consolidated Balance Sheet as of January 1, 2019. The adoption of the new lease standard had no impact on the Statement of Consolidated Operations or Statement of Consolidated Cash Flows. The Company entered into a sale leaseback arrangement in October 2018 for a cast house that is now part of Arconic Corporation, and due to continuing involvement, the gain on sale was deferred. In connection with the adoption of the new lease accounting standard on January 1, 2019, the arrangement no longer required that the gain be deferred. As such, the associated $ 73 deferred gain, net of tax was recognized as a cumulative effect of an accounting change within Accumulated deficit in its Consolidated Balance Sheet and Statement of Changes in Consolidated Equity. +In August 2017, the FASB issued guidance that made more financial and nonfinancial hedging strategies eligible for hedge accounting. It also amended the presentation and disclosure requirements and changed how companies assess effectiveness. It is +59 +Table of Contents +intended to more closely align hedge accounting with companies’ risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. These changes became effective for the Company on January 1, 2019. For cash flow hedges, Howmet recorded a cumulative effect adjustment of $ 2 related to eliminating the separate measurement of ineffectiveness by decreasing Accumulated other comprehensive loss and increasing Retained earnings on its Consolidated Balance Sheet and Statement of Changes in Consolidated Equity. The amendments to presentation and disclosure are required prospectively. Howmet has determined that under the new accounting guidance it is able to more broadly use cash flow hedge accounting for its variable priced inventory purchases and customer sales. +In February 2018, the FASB issued guidance that allows an optional reclassification from Accumulated other comprehensive loss to Accumulated deficit for stranded tax effects resulting from the Tax Cuts and Jobs Act enacted on December 22, 2017. Stranded tax effects were created when deferred taxes, originally established in Other comprehensive income at 35%, were revalued to 21% as a component of income tax expense from continuing operations. The Company elected to early adopt this provision in the fourth quarter of 2018 and reclassified $ 367 of beneficial stranded tax effects in Accumulated other comprehensive loss to Retained earnings in its Consolidated Balance Sheet and Statement of Changes in Consolidated Equity. +Recently Issued Accounting Guidance. +In December 2019, the FASB issued guidance that is intended to simplify various aspects related to the accounting for income taxes. These changes became effective for Howmet on January 1, 2021. The adoption of this new guidance will not have a material impact on its Consolidated Financial Statements. +In March 2020, the FASB issued amendments that provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform, if certain criteria are met. The amendments apply only to contracts and hedging relationships that reference London Inter-bank Offered Rate ("LIBOR") or another reference rate expected to be discontinued due to reference rate reform. These amendments are effective immediately and may be applied prospectively to contract modifications made and hedging relationships entered into or evaluated on or before December 31, 2022. Management is currently evaluating the potential impact of these changes on the Consolidated Financial Statements. +C. Arconic Inc. Separation Transaction and Discontinued Operations +On April 1, 2020, the Company completed the previously announced separation of its business into two independent, publicly-traded companies. Following the Arconic Inc. Separation Transaction, Arconic Corporation held the Global Rolled Products businesses (global rolled products, aluminum extrusions, and building and construction systems) previously held by the Company. The Company retained the Engineered Products and Forgings businesses (engine products, fastening systems, engineered structures, and forged wheels). +The Company's Board of Directors approved the completion of the separation on February 5, 2020, which was effected by the distribution (the "Distribution") by the Company of all of the outstanding common stock of Arconic Corporation on April 1, 2020 to the Company’s stockholders who held shares as of the close of business on March 19, 2020 (the "Record Date"). In the Distribution, each Company stockholder of record as of the Record Date received one share of Arconic Corporation common stock for every four shares of the Company’s common stock held as of the Record Date. The Company did not issue fractional shares of Arconic Corporation common stock in the Distribution. Instead, each stockholder otherwise entitled to a fractional share of Arconic Corporation common stock received cash in lieu of fractional shares. +In connection with the Arconic Inc. Separation Transaction , the Company entered into several agreements with Arconic Corporation that govern the relationship between the Company and Arconic Corporation following the Distribution, including the following: a Separation and Distribution Agreement, Tax Matters Agreement, Employee Matters Agreement, certain Patent, Know-How, Trade Secret License and Trademark License Agreements, and Raw Material Supply Agreements. +On February 7, 2020, Arconic Corporation completed an offering of $ 600 aggregate principal amount of 6.125 % senior secured second-lien notes due 2028. On March 25, 2020, Arconic Corporation entered into a credit agreement which provided for a $ 600 aggregate principal amount seven-year senior secured first-lien loan B facility and a revolving credit facility which is guaranteed by certain of Arconic Corporation's wholly-owned domestic subsidiaries and secured on a first-priority basis by liens on substantially all assets of Arconic Corporation and subsidiary guarantors. Arconic Corporation used the proceeds to make payment to the Company to fund the transfer of certain assets to Arconic Corporation relating to the Arconic Inc. Separation Transaction and for general corporate purposes. The Company incurred debt issuance costs of $ 45 associated with these issuances for the first quarter of 2020 and year ended December 31, 2020. +On February 1, 2020, the Company completed the sale of its rolling mill in Itapissuma, Brazil for $ 50 in cash which resulted in a loss of $ 59 , of which $ 53 was recognized in discontinued operations in the second half of 2019 and $ 6 in the first quarter of 2020 and year ended December 31, 2020. On March 1, 2020, the Company sold its hard alloy extrusions plant in South Korea +60 +Table of Contents +for $ 62 in cash, which resulted in a gain that was recognized in discontinued operations in the first quarter of 2020 and year ended December 31, 2020. +On October 31, 2018, the Company sold its Texarkana, Texas rolling mill and cast house, which had a combined net book value of $ 63 , to Ta Chen International, Inc. for $ 302 in cash, including the settlement of post-closing adjustments, plus additional contingent consideration of up to $ 50 . The contingent consideration related to the achievement of various milestones within 36 months of the transaction closing date associated with operationalizing the rolling mill equipment. As part of the agreement, the Company produced aluminum slab at the facility for a period of 18 months through a lease back of the cast house building and equipment. The sale of the rolling mill and cast house had been accounted for separately. The gain on the sale of the rolling mill of $ 154 , including the fair value of contingent consideration of $ 5 , was recorded in 2018. In 2019, the Company received additional contingent consideration of $ 20 and recorded a gain. These amounts were recorded in discontinued operations in the Statement of Consolidated Operations. The Company had continuing involvement related to the lease back of the cast house. As a result, in 2018, the Company continued to treat the cast house building and equipment that it sold to Ta Chen as owned. In conjunction with the adoption of the new lease accounting standard on January 1, 2019 (see Note B ), the Company's continuing involvement no longer required deferral of the recognition of the cast house sale. As such, the cash proceeds, properties, plant and equipment and deferred tax assets related to the cast house were reclassified to Retained earnings as a cumulative effect of an accounting change of $ 73 in 2018. +Discontinued Operations +The results of operations of Arconic Corporation are presented as discontinued operations in the Statement of Consolidated Operations as summarized below: +Year ended December 31, +2020 2019 2018 +Sales $ 1,576 $ 7,094 $ 7,236 +Cost of goods sold 1,292 6,013 6,283 +Selling, general administrative, research and development and other expenses 106 346 295 +Provision for depreciation and amortization 59 241 262 +Restructuring and other charges (credits) ( 18 ) 38 ( 154 ) +Interest expense 7 — 1 +Other expense, net 42 91 109 +Income from discontinued operations 88 365 440 +Provision for income taxes 38 21 107 +Income from discontinued operations after income taxes $ 50 $ 344 $ 333 +The following table presents purchases of properties, plant and equipment (capital expenditures), proceeds from the sale of businesses and provision for depreciation and amortization of discontinued operations related to Arconic Corporation: +Year ended December 31, +2020 2019 2018 +Capital expenditures $ 72 $ 210 $ 308 +Proceeds from the sales of businesses $ 112 $ 20 $ 309 +Provision for depreciation and amortization $ 59 $ 241 $ 262 +On April 1, 2020, management evaluated the net assets of Arconic Corporation for potential impairment and determined that no impairment charge was required. +The cash flows and equity related to Arconic Corporation have not been segregated and are included in the Statement of Consolidated Cash Flows or Statement of Comprehensive Income for all periods presented prior to the Arconic Inc. Separation Transaction. +61 +Table of Contents +The carrying amount of the major classes of assets and liabilities related to Arconic Corporation classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheet consisted of the following: +December 31, 2019 +Total Assets of Discontinued Operations +Cash and cash equivalents $ 71 +Receivables from customers 385 +Other receivables 135 +Inventories 822 +Prepaid expenses and other current assets 29 +Current assets of discontinued operations 1,442 +Properties, plants, and equipment, net 2,834 +Goodwill 426 +Intangibles, net 60 +Deferred income taxes 383 +Other noncurrent assets 196 +Noncurrent assets of discontinued operations 3,899 +Total assets of discontinued operations $ 5,341 +Total Liabilities of Discontinued Operations: +Accounts payable, trade $ 1,067 +Accrued compensation and retirement costs 147 +Taxes, including income taxes 22 +Other current liabilities 188 +Current liabilities of discontinued operations 1,424 +Accrued pension benefits 1,429 +Accrued other postretirement benefits 514 +Other noncurrent liabilities and deferred credits 315 +Noncurrent liabilities of discontinued operations 2,258 +Total liabilities of discontinued operations $ 3,682 +D. Segment and Geographic Area Information +Howmet is a global leader in lightweight metals engineering and manufacturing. Howmet’s innovative, multi-material products, which include nickel, titanium, aluminum, and cobalt, are used worldwide in the aerospace (commercial and defense), commercial transportation, and industrial and other end markets. Segment performance under Howmet’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Howmet’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and Other charges and Impairment of Goodwill. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Howmet are in Corporate. +Following the Arconic Inc. Separation Transaction, Howmet’s operations consist of four worldwide reportable segments as follows: +Engine Products +Engine Products produces investment castings, including airfoils, and seamless rolled rings primarily for aircraft engines and industrial gas turbines. Engine Products produces rotating parts as well as structural parts. +Fastening Systems +Fastening Systems produces aerospace fastening systems, as well as commercial transportation fasteners. The business’s high-tech, multi-material fastening systems are found nose to tail on aircraft and aero engines. The business’s products are also critical components of automobiles, commercial transportation vehicles, and construction and industrial equipment. +62 +Table of Contents +Engineered Structures +Engineered Structures produces titanium ingots and mill products for aerospace and defense applications and is vertically integrated to produce titanium forgings, extrusions forming and machining services for airframe, wing, aero-engine, and landing gear components. Engineered Structures also produces aluminum forgings, nickel forgings, and aluminum machined components and assemblies for aerospace and defense applications. +Forged Wheels +Forged Wheels provides forged aluminum wheels and related products for heavy-duty trucks and the commercial transportation markets. +Goodwill +The Company had $ 4,102 of Goodwill at December 31, 2020, and the Company reviews it for impairment annually in the fourth quarter, or more frequently, if indicators exist or if a decision is made to sell or realign a business. +On January 1, 2020, management transferred the Savannah business from the Engine Products segment to the Engineered Structures segment, based on synergies with forgings technologies and manufacturing capabilities. As a result of the reorganization, goodwill of $ 17 was reallocated from Engine Products to Engineered Structures, and these reporting units were evaluated for impairment during the first quarter of 2020. The estimated fair value of each of these reporting units substantially exceeded their carrying value; thus, there was no goodwill impairment at the date the business was transferred. +During the first quarter of 2020, Howmet's market capitalization declined significantly compared to the fourth quarter of 2019. Over the same period, the equity value of our peer group companies, and the overall U.S. stock market also declined significantly amid market volatility. In addition, as a result of the COVID-19 pandemic and measures designed to contain the spread, global sales to customers in the aerospace and commercial transportation industries impacted by COVID-19 have been and are expected to be negatively impacted as a result of disruption in demand. As a result of these macroeconomic factors, we performed a qualitative impairment test to evaluate whether it is more likely than not that the fair value of any of our reporting units is less than its carrying value. As a result of this assessment, the Company performed a quantitative impairment test in the first quarter for the Engineered Structures reporting unit and concluded that though the margin between the fair value of the reporting unit and carrying value had declined from approximately 60 % to approximately 15 %, it was not impaired. Consistent with prior practice, a discounted cash flow model was used to estimate the current fair value of the reporting unit. The significant assumptions and estimates utilized to determine fair value were developed utilizing current market and forecast information reflecting the disruption in demand that has and is expected to negatively impact the Company’s sales globally in the aerospace industry. If our actual results or external market factors decline significantly from management’s estimates, future goodwill impairment charges may be necessary and could be material. During the second and third quarters of 2020, there were no indicators of impairment identified for the Engineered Structures reporting unit. +The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies (see Note A ). Transactions among segments are established based on negotiation among the parties. Differences between segment totals and Howmet’s consolidated totals for line items not reconciled are in Corporate. +63 +Table of Contents +The operating results and assets of the Company's reportable segments were as follows: +Year ended Engine Products Fastening Systems Engineered Structures Forged Wheels Total +Segment +2020 +Sales: +Third-party sales $ 2,406 $ 1,245 $ 927 $ 679 $ 5,257 +Inter-segment sales 5 — 7 — 12 +Total sales $ 2,411 $ 1,245 $ 934 $ 679 $ 5,269 +Profit and loss: +Segment operating profit $ 417 $ 247 $ 73 $ 153 $ 890 +Restructuring and other charges 36 39 28 3 106 +Provision for depreciation and amortization 123 48 52 39 262 +Other: +Capital expenditures $ 77 $ 39 $ 19 $ 23 $ 158 +Total Assets $ 4,756 $ 2,707 $ 1,444 $ 628 $ 9,535 +2019 +Sales: +Third-party sales $ 3,320 $ 1,561 $ 1,255 $ 969 $ 7,105 +Inter-segment sales 11 — 13 — 24 +Total sales $ 3,331 $ 1,561 $ 1,268 $ 969 $ 7,129 +Profit and loss: +Segment operating profit $ 621 $ 396 $ 120 $ 253 $ 1,390 +Restructuring and other charges 297 6 199 4 506 +Provision for depreciation and amortization 131 48 58 32 269 +Other: +Capital expenditures $ 211 $ 36 $ 27 $ 70 $ 344 +Total Assets $ 5,445 $ 2,810 $ 1,151 $ 629 $ 10,035 +2018 +Sales: +Third-party sales $ 3,092 $ 1,531 $ 1,209 $ 966 $ 6,798 +Inter-segment sales 16 — 19 — 35 +Total sales $ 3,108 $ 1,531 $ 1,228 $ 966 $ 6,833 +Profit and loss: +Segment operating profit $ 464 $ 357 $ 64 $ 220 $ 1,105 +Restructuring and other charges 47 17 ( 5 ) — 59 +Provision for depreciation and amortization 141 48 69 31 289 +Other: +Capital expenditures $ 217 $ 47 $ 53 $ 90 $ 407 +64 +Table of Contents +The following table reconciles Total segment capital expenditures, which are presented on an accrual basis, with Capital expenditures as presented on the statement of cash flows. Differences between segment and consolidated totals are in Corporate and discontinued operations, including the impact of changes in accrued capital expenditures during the period. +For the year ended December 31, 2020 2019 2018 +Total segment capital expenditures $ 158 $ 344 $ 407 +Corporate and discontinued operations 109 297 361 +Capital expenditures $ 267 $ 641 $ 768 +The following tables reconcile certain segment information to consolidated totals: +For the year ended December 31, 2020 2019 2018 +Sales: +Total segment sales $ 5,269 $ 7,129 $ 6,833 +Elimination of inter-segment sales ( 12 ) ( 24 ) ( 35 ) +Corporate 2 ( 7 ) ( 20 ) +Consolidated sales $ 5,259 $ 7,098 $ 6,778 +For the year ended December 31, 2020 2019 2018 +Total segment operating profit $ 890 $ 1,390 $ 1,105 +Unallocated amounts: +Restructuring and other charges ( 182 ) ( 582 ) ( 163 ) +Corporate expense ( 82 ) ( 229 ) ( 167 ) +Consolidated operating income $ 626 $ 579 $ 775 +Interest expense ( 381 ) ( 338 ) ( 377 ) +Other (expense) income, net ( 74 ) ( 31 ) 30 +Income from continuing operations before income taxes $ 171 $ 210 $ 428 +December 31, 2020 2019 +Assets: +Total segment assets $ 9,535 $ 10,035 +Unallocated amounts: +Cash and cash equivalents 1,610 1,577 +Deferred income taxes 272 209 +Corporate fixed assets, net 140 135 +Fair value of derivative contracts 5 6 +Discontinued operations — 5,341 +Accounts receivable securitization ( 241 ) ( 61 ) +Other 122 320 +Consolidated assets $ 11,443 $ 17,562 +Segment assets include third party receivables while the accounts receivable securitization item includes the impact of sold receivables under the Company's Accounts Receivable securitization programs. (See Note M ) +65 +Table of Contents +Geographic information for sales was as follows (based upon the destination of the sale): +For the year ended December 31, 2020 2019 2018 +Sales: +United States $ 2,782 $ 3,534 $ 3,265 +Japan 388 480 462 +France 327 546 523 +Germany 309 385 385 +United Kingdom 231 420 438 +Mexico 185 277 252 +Italy 181 195 196 +Canada 119 179 155 +Poland 76 131 112 +China 75 168 165 +Other 586 783 825 +$ 5,259 $ 7,098 $ 6,778 +Geographic information for long-lived tangible assets was as follows (based upon the physical location of the assets): +December 31, 2020 2019 +Long-lived assets: +United States $ 1,967 $ 2,025 +Hungary 213 202 +France 150 141 +United Kingdom 109 101 +Germany 78 82 +Mexico 62 57 +China 59 61 +Canada 44 43 +Japan 25 25 +Other 16 17 +$ 2,723 $ 2,754 +66 +Table of Contents +The following table disaggregates segment revenue by major end market served. Differences between total segment and consolidated totals are in Corporate. +Engine Products Fastening Systems Engineered Structures Forged Wheels Total +Segment +Year ended December 31, 2020 +Aerospace - Commercial $ 1,247 $ 808 $ 542 $ — $ 2,597 +Aerospace - Defense 557 156 303 — 1,016 +Commercial Transportation — 155 — 679 834 +Industrial and Other 602 126 82 — 810 +Total end-market revenue $ 2,406 $ 1,245 $ 927 $ 679 $ 5,257 +Year ended December 31, 2019 +Aerospace - Commercial $ 2,229 $ 1,060 $ 897 $ — $ 4,186 +Aerospace - Defense 475 158 256 — 889 +Commercial Transportation 20 227 — 970 1,217 +Industrial and Other 596 116 102 ( 1 ) 813 +Total end-market revenue $ 3,320 $ 1,561 $ 1,255 $ 969 $ 7,105 +Year ended December 31, 2018 +Aerospace - Commercial $ 2,056 $ 1,069 $ 871 $ — $ 3,996 +Aerospace - Defense 373 120 233 — 726 +Commercial Transportation 48 229 — 969 1,246 +Industrial and Other 615 113 105 ( 3 ) 830 +Total end-market revenue $ 3,092 $ 1,531 $ 1,209 $ 966 $ 6,798 +The Company derived 69 %, 71 % and 70 % of its revenue for the year ended December 31, 2020, 2019 and 2018, respectively, from aerospace end markets. +General Electric Company represented approximately 11 % of the Company’s third-party sales for the year ended December 31, 2020, primarily from the Engine Products Segment. +E. Restructuring and Other Charges +Restructuring and other charges were comprised of the following: +For the year ended December 31, 2020 2019 2018 +Layoff costs $ 113 $ 69 $ 18 +Reversals of and adjustments to previously recorded layoff reserves ( 21 ) ( 6 ) ( 8 ) +Pension, Other post-retirement benefits (costs) and deferred compensation - net settlement and curtailments 69 ( 7 ) 91 +Non-cash asset impairments ( O ) +5 442 9 +Net loss on divestitures of assets and businesses ( U ) +8 63 43 +Other 8 21 10 +Restructuring and other charges $ 182 $ 582 $ 163 +Layoff costs were recorded based on approved detailed action plans submitted by the operating locations that specified positions to be eliminated, benefits to be paid under existing severance plans, union contracts or statutory requirements and the expected timetable for completion of the plans. +2020 Actions. In 2020, Howmet recorded Restructuring and other charges of $ 182 , which included a $ 113 charge for layoff costs, including the separation of 4,301 employees ( 1,706 in Engine Products, 1,675 in Fastening Systems, 805 in Engineered Structures, 92 in Forged Wheels and 23 in Corporate); a $ 69 net charge for Pension, Other postretirement benefits and deferred compensation - net settlement and curtailments composed of a $ 74 charge for U.K. and U.S. pension plans' settlement accounting offset by a $ 3 benefit from the termination of a deferred compensation plan and a $ 2 curtailment benefit related to a +67 +Table of Contents +postretirement plan; a $ 5 post-closing adjustment related to the sale of the Company’s U.K. forgings business (which was formerly part of the Engine Products segment); a $ 5 charge for impairment of assets associated with an agreement to sell an aerospace components business in the U.K. (within the Engineered Structures segment) that did not occur and the business was returned to held for use; $ 5 charge related to the impairment of a cost method investment; a $ 2 charge for accelerated depreciation; a $ 1 charge for impairment of assets due to a facility sale and a $ 6 charge for various other exit costs. These charges were partially offset by a benefit of $ 21 related to the reversal of a number of prior period programs and a gain of $ 3 on the sale of assets. +As of December 31, 2020, 3,519 of the 4,301 employees were separated. The remaining separations for the 2020 restructuring programs are expected to be completed in 2021. +2019 Actions . In 2019, Howmet recorded Restructuring and other charges of $ 582 which included a $ 428 charge for impairment of the Disks long-lived asset group; a $ 69 charge for layoff costs, including the separation of 917 employees ( 103 in Engine Products, 128 in Engineered Structures, 132 in Fastening Systems, 60 in Forged Wheels and 494 in Corporate); a $ 46 charge for impairment of assets associated with an agreement to sell the UK forging business; a $ 14 charge for impairment of properties, plants, and equipment related to the Company’s primary research and development facility; a $ 13 loss on sale of assets primarily related to a small additive business; a $ 12 charge for other exit costs from lease terminations primarily related to the exit of the corporate aircraft; a $ 9 settlement accounting charge for U.S. pension plans; a $ 5 charge for impairment of a cost method investment; a $ 2 net charge for executive severance net of the benefit of forfeited executive s tock compensation and a $ 7 charge for other exit costs; partially offset by a benefit of $ 16 related to the elimination of the life insurance benefit for the U.S. salaried and non-bargaining hourly retirees of the Company and its subsidiaries; a benefit of $ 6 for the reversal of a number of layoff reserves related to prior periods and a net gain of $ 1 on the sales of assets. +In 2019 the Company recorded an impairment charge of $ 428 related to the Disks long-lived asset group, of which $ 247 and $ 181 was related to the Engine Products and Engineered Structures segments, respectively, as the carrying value exceeded the forecasted undiscounted cash flows composed of a write-down of properties, plants and equipment, intangible assets and certain other noncurrent assets. See Note O for additional details. +As of December 31, 2020, the separations associated with the 2019 restructuring programs were essentially complete. +2018 Actions . In 2018, Howmet recorded Restructuring and other charges of $ 163 , which included a $ 96 charge for pension plan settlement accounting; a $ 23 charge for pension curtailment; a postretirement curtailment benefit of $ 28 ; a $ 43 loss on sale of the Hungary forgings business; a $ 18 charge for layoff costs, including the separation of approximately 125 employees ( 34 in Engine Products, 55 in Fastening Systems and 36 in Corporate); a $ 12 charge for contract termination costs and asset impairments associated with the shutdown of a facility in Acuna, Mexico; a $ 6 charge for contract termination costs related to the New York office; a $ 4 charge for other miscellaneous items including accelerated depreciation and asset impairments; a $ 3 benefit for other exit costs and a $ 8 benefit for the reversal of a number of layoff reserves related to prior periods. +As of December 31, 2020, the separations associated with the 2018 restructuring programs were complete. +68 +Table of Contents +Activity and reserve balances for restructuring charges were as follows: +Layoff +costs Other +exit costs Total +Reserve balances at December 31, 2017 $ 33 $ — $ 33 +2018 Activity +Cash payments ( 30 ) — ( 30 ) +Restructuring and other charges 101 62 163 +Other (1) +( 91 ) ( 53 ) ( 144 ) +Reserve balances at December 31, 2018 $ 13 $ 9 $ 22 +2019 Activity +Cash payments $ ( 63 ) $ — $ ( 63 ) +Restructuring and other charges 58 524 582 +Other (2) +5 ( 533 ) ( 528 ) +Reserve balances at December 31, 2019 $ 13 $ — $ 13 +2020 Activity +Cash payments $ ( 51 ) $ — $ ( 51 ) +Restructuring and other charges 161 21 182 +Other (3) +( 69 ) ( 21 ) ( 90 ) +Reserve balances at December 31, 2020 $ 54 $ — $ 54 +(1) In 2018, Other for layoff costs included reclassifications of $ 119 in settlement and curtailment pension costs and a $ 28 benefit in postretirement benefits, as the impacts were reflected in the Company's separate liabilities for Accrued pension benefits and Accrued postretirement benefits. In 2018, Other exit costs included a $ 43 loss on sale of the Hungary forgings business; a $ 9 charge for contract termination costs associated with the shutdown of a facility in Acuna, Mexico and the New York office; a $ 4 charge for other miscellaneous items including accelerated depreciation and asset impairments; a $ 3 benefit for other exit costs. +(2) In 2019, Other for layoff costs included reclassifications of a $ 16 credit for elimination of life insurance benefits for U.S. salaried and non-bargaining hourly retirees, a charge of $ 9 for pension plan settlement accounting, as the impacts were reflected in the Company's separate liabilities for Accrued pension benefits and Accrued postretirement benefits; a charge of $ 2 net charge for executive severance net of the benefit of forfeited executive stock compensation. In 2019, Other exit costs included a charge of $ 428 for impairment of the Disks long-lived asset group; a charge of $ 59 for impairment of assets associated with agreement to sell the U.K. forgings business, and a small additive business; a charge of $ 14 for impairment of properties, plants, and equipment related to the Company’s primary research and development facility; a charge of $ 12 for lease terminations; $ 5 charge for impairment of a cost method investment, a charge of $ 7 related to other miscellaneous items and $ 9 reclassification of lease exit costs to reduce right of use assets in Other Noncurrent assets in accordance with the adoption of the new lease accounting standard; partially offset by a gain of $ 1 on the sales of assets. +(3) In 2020, Other for layoff costs included $ 74 in settlement accounting charges related to U.K. and U.S. pension plans, offset by a $ 3 benefit from the termination of a deferred compensation plan and a $ 2 curtailment benefit related to a postretirement plan; while Other exit costs included a charge of $ 5 for impairment of assets; a $ 5 post-closing adjustment related to the sale of a business; a $ 5 charge related to the impairment of a cost method investment; a $ 2 charge for accelerated depreciation; a $ 1 charge for impairment of assets due to a facility closure and a $ 6 charge for various other exit costs, which were offset by a gain of $ 3 on the sale of assets. +The remaining reserves at December 31, 2020 are expected to be paid in cash during 2021. +69 +Table of Contents +F. Interest Cost Components +For the year ended December 31, 2020 2019 2018 +Amount charged to expense $ 381 $ 338 $ 377 +Amount capitalized 11 33 23 +$ 392 $ 371 $ 400 +G. Other Expense (Income), Net +For the year ended December 31, 2020 2019 2018 +Non-service related net periodic benefit cost $ 26 $ 17 $ 19 +Interest income ( 5 ) ( 24 ) ( 22 ) +Foreign currency (gains) losses, net ( 11 ) 5 9 +Net loss from asset sales 8 10 10 +Deferred Compensation 10 24 ( 8 ) +Other, net 46 ( 1 ) ( 38 ) +Total $ 74 $ 31 $ ( 30 ) +In 2020, Other, net included a charge from the write-off of a tax indemnification receivable of $ 53 reflecting the aggregate of Alcoa Corporation’s 49 % share and Arconic Corporation's 33.66 % share of a Spanish tax reserve (see Note V ). In 2018, Non-service related net periodic benefit cost included lower net actuarial losses as a result of pension actions taken during 2018 (see Note H ) and Other, net included a benefit from establishing a tax indemnification receivable of $ 29 reflecting Alcoa Corporation’s 49 % share of a Spanish tax reserve (see Note V ). +H. Pension and Other Postretirement Benefits +Howmet maintains pension plans covering most U.S. employees and certain employees in foreign locations. Pension benefits generally depend on length of service and job grade. Substantially all benefits are paid through pension trusts that are sufficiently funded to ensure that all plans can pay benefits to retirees as they become due. Most salaried and non-bargaining hourly U.S. employees hired after March 1, 2006, participate in a defined contribution plan instead of a defined benefit plan. +Howmet also maintains health care and life insurance postretirement benefit plans covering eligible U.S. retired employees and certain retirees from foreign locations. Generally, the medical plans are unfunded and pay a percentage of medical expenses, reduced by deductibles and other coverage. Life benefits are generally provided by insurance contracts. Howmet retains the right, subject to existing agreements, to change or eliminate these benefits. All salaried and certain non-bargaining hourly U.S. employees hired after January 1, 2002 and certain bargaining hourly U.S. employees hired after July 1, 2010, are not eligible for postretirement health care benefits. All salaried and certain hourly U.S. employees that retire on or after April 1, 2008 are not eligible for postretirement life insurance benefits. Effective May 1, 2019, salaried employees and retirees are not eligible for postretirement life insurance benefits. +Effective January 1, 2015, Howmet no longer offers postretirement health care benefits to Medicare-eligible, primarily non-bargaining, U.S. retirees through Company-sponsored plans. Qualifying retirees (hired prior to January 1, 2002), both current and future, may access these benefits in the marketplace by purchasing coverage directly from insurance carriers. +On April 1, 2018, benefit accruals for future service and compensation under all of the Company's qualified and non-qualified defined benefit pension plans for U.S. salaried and non-bargaining hourly employees ceased. As a result of this change, in 2018, the Company recorded a decrease to the Accrued pension benefit liability of $ 136 related to the reduction of future benefits ($ 141 offset in Accumulated other comprehensive loss) and curtailment charges of $ 5 in Restructuring and other charges. +On April 13, 2018, the United Auto Workers ratified a new five-year labor agreement, covering approximately 1,300 U.S. employees, which expires on March 31, 2023. A provision within the agreement includes a retirement benefit increase for future retirees that participate in a defined benefit pension plan, which impacts approximately 300 of those employees. In addition, effective January 1, 2019, benefit accruals for future service of this group ceased. As result of these changes, in 2018, a curtailment charge of $ 9 was recorded in Restructuring and other charges. +In 2018, the Company announced that effective December 31, 2018, it would end all pre-Medicare medical, prescription drug and vision coverage for current and future salaried and non-bargained hourly employees and retirees of the Company and its subsidiaries. As a result of this change, in 2018, the Company recorded a decrease to the Accrued other postretirement benefits +70 +Table of Contents +liability of $ 32 related to the reduction of future benefits, $ 4 offset in Accumulated other comprehensive loss, and a curtailment benefit of $ 28 in Restructuring and other charges. +In 2018, the company communicated to plan participants that effective in the first quarter of 2019, benefit accruals for future service and compensation for employees in the United Kingdom defined benefit pension plans will cease. The plan curtailment resulted in a $ 13 decrease in the Accrued pension benefits liability which was offset in Accumulated other comprehensive loss. Additionally, on October 29, 2018, the United Kingdom High Court ruled that defined benefit pension plans offering Guaranteed Minimum Pensions must review benefits accrued between May 1990 to April 1997 to ensure gender pay equality. The review resulted in an increase to the Accrued pension benefits liability of $ 9 and a corresponding curtailment charge that was recorded in Restructuring and other charges. +In 2019, the Company communicated to plan participants that for its U.S. salaried and non-bargained hourly retirees of the Company and its subsidiaries, it would eliminate the life insurance benefit effective May 1, 2019, and certain health care subsidies effective December 31, 2019. As a result of these changes, in 2019, the Company recorded a decrease to the Accrued other postretirement benefits liability of $ 75 , which was offset by a curtailment benefit of $ 58 (of which $ 16 was recorded in Restructuring and other charges and $ 42 related to Arconic Corporation in Discontinued Operations) and $ 17 in Accumulated other comprehensive loss. +In June 2019, the Company and the United Steelworkers ("USW") reached a tentative three-year labor agreement that was ratified on July 11, 2019 covering approximately 3,400 employees at four U.S. locations of Arconic Corporation; the previous labor agreement expired on May 15, 2019. In 2019, the Company recognized $ 9 in Discontinued operations on the accompanying Statement of Consolidated Operations primarily for a one-time signing bonus for employees. Additionally, on July 25, 2019, the USW ratified a new four-year labor agreement covering approximately 560 employees at the Company’s Niles, Ohio facility. The prior labor agreement expired on June 30, 2018. +In 2020 and 2019, the Company applied settlement accounting to U.S. pension plans due to lump sum payments to participants which resulted in settlement charges of $ 8 and $ 9 , respectively, that were recorded in Restructuring and other charges. +In 2020 the Company undertook a number of actions to reduce pension obligations in the U.K. by offering lump sum payments to certain plan participants and entering into group annuity contracts with a third-party carrier to pay and administer future annuity payments which resulted in settlement charges of $ 66 th at were recorded in Restructuring and other charges in the Statement of Consolidated Operations. These actions reduced the number of pension plan participants in the U.K. by approximately half. +In 2020, the Company communicated to plan participants that for its U.S. salaried and non-bargained hourly retirees of the Company and its subsidiaries, it would eliminate certain health care subsidies effective December 31, 2021, and that for certain bargained retirees of the Company, it would eliminate certain health care subsidies effective December 31, 2021 and the life insurance benefit effective August 1, 2020. As a result of these amendments, the Company recorded a decrease to the Accrued other postretirement benefits liability of $ 6 in 2020, which was offset in Accumulated other comprehensive loss. +71 +Table of Contents +The funded status of all of Howmet’s pension and other postretirement benefit plans are measured as of December 31 each calendar year. +Obligations and Funded Status +Pension benefits Other +postretirement benefits +December 31, 2020 2019 2020 2019 +Change in benefit obligation +Benefit obligation at beginning of year $ 7,249 $ 6,476 $ 786 $ 806 +Transfer to Arconic Corporation ( 4,355 ) — ( 569 ) — +Service cost 6 25 2 7 +Interest cost 71 235 7 28 +Amendments 6 — ( 11 ) ( 78 ) +Actuarial losses (1) +313 974 14 100 +Settlements ( 398 ) ( 23 ) — — +Benefits paid ( 153 ) ( 477 ) ( 17 ) ( 82 ) +Medicare Part D subsidy receipts — — 3 5 +Foreign currency translation impact ( 26 ) 39 — — +Benefit obligation at end of year (2) +$ 2,713 $ 7,249 $ 215 $ 786 +Change in plan assets (2) +Fair value of plan assets at beginning of year $ 4,868 $ 4,334 $ — $ — +Transfer to Arconic Corporation ( 2,982 ) — — — +Actual return on plan assets 203 731 — — +Employer contributions 227 268 — — +Benefits paid ( 136 ) ( 453 ) — — +Administrative expenses ( 12 ) ( 34 ) — — +Settlement payments ( 413 ) ( 22 ) — — +Foreign currency translation impact ( 31 ) 44 — — +Fair value of plan assets at end of year (2) +$ 1,724 $ 4,868 $ — $ — +Funded status $ ( 989 ) $ ( 2,381 ) $ ( 215 ) $ ( 786 ) +Amounts recognized in the Consolidated Balance Sheet consist of: +Noncurrent assets $ 12 $ 41 $ — $ — +Noncurrent assets of discontinued operations — 63 — — +Current liabilities ( 16 ) ( 19 ) ( 17 ) ( 17 ) +Current liabilities of discontinued operations — ( 7 ) — ( 55 ) +Noncurrent liabilities ( 985 ) ( 1,030 ) ( 198 ) ( 200 ) +Noncurrent liabilities of discontinued operations — ( 1,429 ) — ( 514 ) +Net amount recognized $ ( 989 ) $ ( 2,381 ) $ ( 215 ) $ ( 786 ) +Amounts recognized in Accumulated Other Comprehensive Loss consist of: +Net actuarial loss $ 1,274 $ 3,375 $ 22 $ 179 +Prior service cost (benefit) 6 1 ( 28 ) ( 37 ) +Net amount recognized, before tax effect $ 1,280 $ 3,376 $ ( 6 ) $ 142 +Other changes in plan assets and benefit obligations recognized in Other Comprehensive Loss consist of: +Net actuarial loss $ 166 $ 566 $ 14 $ 100 +Amortization of accumulated net actuarial (loss) gain ( 123 ) ( 148 ) 1 ( 8 ) +Loss transferred to Arconic Corporation ( 2,144 ) — ( 170 ) — +72 +Table of Contents +Prior service cost (benefit) 5 — ( 11 ) ( 78 ) +Amortization of prior service (cost) benefit — ( 2 ) 5 68 +Prior service credit transferred to Arconic Corporation — — 13 — +Net amount recognized, before tax effect $ ( 2,096 ) $ 416 $ ( 148 ) $ 82 +(1) At December 31, 2020, the actuarial losses impacting the benefit obligation were due to changes in discount rate, alternative interest cost method and other changes including census data, partially offset by actual asset returns in excess of expected returns. +(2) At December 31, 2020, the benefit obligation, fair value of plan assets, and funded status for U.S. pension plans were $ 2,327 , $ 1,361 , and $( 966 ), respectively. At December 31, 2019, the benefit obligation, fair value of plan assets, and funded status for U.S. pension plans were $ 5,884 , $ 3,513 , and $( 2,371 ) respectively. +Pension Plan Benefit Obligations +Pension benefits +2020 2019 +The projected benefit obligation and accumulated benefit obligation for all defined benefit pension plans were as follows: +Projected benefit obligation $ 2,713 $ 7,249 +Accumulated benefit obligation 2,707 7,219 +The aggregate projected benefit obligation and fair value of plan assets for pension plans with projected benefit obligations in excess of plan assets was as follows: +Projected benefit obligation 2,364 6,064 +Fair value of plan assets 1,364 3,579 +The aggregate accumulated benefit obligation and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets was as follows: +Accumulated benefit obligation 2,359 6,045 +Fair value of plan assets 1,364 3,579 +Components of Net Periodic Benefit Cost +Pension benefits (1) +Other postretirement benefits (2) +For the year ended December 31, 2020 2019 2018 2020 2019 2018 +Service cost $ 12 $ 25 $ 46 $ 3 $ 7 $ 7 +Interest cost 97 235 219 10 28 28 +Expected return on plan assets ( 136 ) ( 286 ) ( 306 ) — — — +Recognized net actuarial loss 78 139 168 3 4 7 +Amortization of prior service cost (benefit) — 2 3 ( 6 ) ( 6 ) ( 7 ) +Settlements (3) +76 9 96 — — — +Curtailments (4) +— — 23 ( 2 ) ( 58 ) ( 28 ) +Net periodic benefit cost (5) +$ 127 $ 124 $ 249 $ 8 $ ( 25 ) $ 7 +Discontinued operations 20 95 100 6 ( 15 ) 12 +Net amount recognized in Statement of Consolidated Operations $ 107 $ 29 $ 149 $ 2 $ ( 10 ) $ ( 5 ) +(1) In 2020, 2019 and 2018, net periodic benefit cost for U.S. pension plans was $ 58 , $ 127 , and $ 239 , respectively. +(2) In 2020, 2019 and 2018, net periodic benefit cost for other postretirement benefits reflects a reduction of $ 1 , $ 11 , and $ 10 , respectively, related to the recognition of the federal subsidy awarded under Medicare Part D. +(3) In 2020, settlements were related to U.K. actions including lump sum benefits and the purchase of group annuity contracts as well as U.S. lump sum benefit payments. In 2019 and 2018, settlements were due to workforce reductions and the payment of lump sum benefits. (See Note E ) +73 +Table of Contents +(4) In 2020, the curtailment was due to workforce reductions. In 2019 and 2018, curtailments were due to a reduction of future benefits, resulting in the recognition of favorable and unfavorable plan amendments. +(5) Service cost was included within Cost of goods sold, Selling, general administrative, and other expenses, and Research and development expenses; curtailments and settlements were included in Restructuring and other charges; and all other cost components were recorded in Other expense (income), net in the Statement of Consolidated Operations. +Assumptions +Weighted average assumptions used to determine benefit obligations for pension and other postretirement benefit plans were as follows: +December 31, 2020 2019 +Discount rate 2.40 % 3.00 % +Cash balance plan interest crediting rate 3.00 % 3.00 % +The U.S. discount rate is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary while both the U.K. and Canada utilize models developed internally by their respective actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have a global average duration o f 12 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. +Benefit accruals for future compensation under the Company’s major salaried and non-bargained hourly defined benefit pension plans have ceased. The rate of compensation increase no longer impacts the determination of the benefit obligation. +Weighted average assumptions used to determine net periodic benefit cost for pension and other postretirement benefit plans were as follows: +2020 2019 2018 +Discount rate to calculate service cost (1) +3.30 % 4.30 % 3.60 % +Discount rate to calculate interest cost (1) +2.70 % 3.90 % 3.30 % +Expected long-term rate of return on plan assets 6.00 % 5.60 % 5.90 % +Rate of compensation increase (2) +— % 3.50 % 3.50 % +Cash balance plan interest crediting rate 3.00 % 3.00 % 3.00 % +(1) In all periods presented, the respective global discount rates were used to determine net periodic benefit cost for most pension plans for the full annual period. However, the discount rates for a limited number of plans were updated during 2020, 2019, and 2018 to reflect the remeasurement of these plans due to new union labor agreements, settlements, and/or curtailments. The updated discount rates used were not significantly different from the discount rates presented. +(2) Benefit accruals for future compensation under the Company’s major salaried and non-bargained hourly defined benefit pension plans have ceased. The rate of compensation increase no longer impacts the determination of the benefit obligation. +The expected long-term rate of return on plan assets (“EROA”) is generally applied to a five-year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment. +For 2020, 2019, and 2018, the U.S. expected long-term rate of return used by management was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. These rates fell within the respective range of the 20-year moving average of actual performance and the expected future return developed by asset class. In 2018, management reduced the expected long-term rate of return by 75 basis points to 7.00 % for the U.S. Pension plans due to a decrease in the expected return by asset class and the 20-year moving average. For 2021, management anticipates that 7.00 % will continue to be the expected long-term rate of return for the U.S. Pension plans. EROA assumptions are developed by country. Annual changes in the weighted average EROA are impacted by the relative size of the assets by country. +74 +Table of Contents +Assumed health care cost trend rates for U.S. other postretirement benefit plans were as follows: +2020 2019 2018 +Health care cost trend rate assumed for next year 5.50 % 5.50 % 5.50 % +Rate to which the cost trend rate gradually declines 4.50 4.50 4.50 +Year that the rate reaches the rate at which it is assumed to remain 2023 2023 2022 +The assumed health care cost trend rate is used to measure the expected cost of gross eligible charges covered by Howmet’s other postretirement benefit plans. For 2021, a 5.5 % trend rate will be used, reflecting management’s best estimate of the change in future health care costs covered by the plans. The plans’ actual annual health care cost trend experience over the past three years has ranged from ( 3.8 )% to 4.0 %. Management does not believe this three-year range is indicative of expected increases for future health care costs over the long-term. +Plan Assets +Howmet’s pension plans’ investment policy at December 31, 2020 by asset class, were as follows: +Asset class +Policy range (1) +Equities 20–55% +Fixed income 25–55% +Other investments 15–35% +Total +(1) Policy range is for U.S. plan assets only, as both the U.K. and Canadian asset investment allocations are controlled by a third-party trustee with input from Howmet. +The principal objectives underlying the investment of the pension plans’ assets are to ensure that Howmet can properly fund benefit obligations as they become due under a broad range of potential economic and financial scenarios, maximize the long-term investment return with an acceptable level of risk based on such obligations, and broadly diversify investments across and within various asset classes to protect asset values against adverse movements. Specific objectives for long-term investment strategy include reducing the volatility of pension assets relative to pension liabilities and achieving diversification across the balance of the asset portfolio. The use of derivative instruments is permitted where appropriate and necessary for achieving overall investment policy objectives. The investment strategy uses long duration cash bonds and derivative instruments to offset a portion of the interest rate sensitivity of U.S. pension liabilities. Exposure to broad equity risk is decreased and diversified through investments in discretionary and systematic macro hedge funds, long/short equity hedge funds, high yield bonds, emerging market debt and global and emerging market equities. Investments are further diversified by strategy, asset class, geography, and sector to enhance returns and mitigate downside risk. A large number of external investment managers are used to gain broad exposure to the financial markets and to mitigate manager-concentration risk. +Investment practices comply with the requirements of the Employee Retirement Income Security Act of 1974 ("ERISA") and other applicable laws and regulations. +The following section describes the valuation methodologies used to measure the fair value of pension plan assets, including an indication of the level in the fair value hierarchy in which each type of asset is generally classified (see Note S for the definition of fair value and a description of the fair value hierarchy). +Equities. These securities consist of: (i) direct investments in the stock of publicly traded U.S. and non-U.S. companies, and equity derivatives, that are valued based on the closing price reported in an active market on which the individual securities are traded (generally classified in Level 1); (ii) the plans’ share of commingled funds that are invested in the stock of publicly traded companies and are valued at the net asset value of shares held at December 31 (included in Level 1 and Level 2); and (iii) direct investments in long/short equity hedge funds and private equity (limited partnerships and venture capital partnerships) that are valued at net asset value. +Fixed income. These securities consist of: (i) U.S. government debt that are generally valued using quoted prices (included in Level 1); (ii) cash and cash equivalents invested in publicly-traded funds and are valued based on the closing price reported in an active market on which the individual securities are traded (generally classified in Level 1); (iii) publicly traded U.S. and non-U.S. fixed interest obligations (principally corporate bonds and debentures) and are valued through consultation and evaluation with brokers in the institutional market using quoted prices and other observable market data (included in Level 2); (iv) fixed income derivatives that are generally valued using industry standard models with market-based observable inputs (included in Level 2); and (v) cash and cash equivalents invested in institutional funds and are valued at net asset value. +75 +Table of Contents +Other investments. These investments include, among others: (i) exchange traded funds, such as gold, and real estate investment trusts and are valued based on the closing price reported in an active market on which the investments are traded (included in Level 1) and (ii) direct investments of discretionary and systematic macro hedge funds and private real estate (includes limited partnerships) and are valued at net asset value. +The fair value methods described above may not be indicative of net realizable value or reflective of future fair values. Additionally, while Howmet believes the valuation methods used by the plans’ trustees are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. +The following table presents the fair value of pension plan assets classified under the appropriate level of the fair value hierarchy or net asset value: +December 31, 2020 Level 1 Level 2 Net Asset Value Total +Equities: +Equity securities $ 274 $ 89 $ 68 $ 431 +Long/short equity hedge funds — — 77 77 +Private equity — — 87 87 +$ 274 $ 89 $ 232 $ 595 +Fixed income: +Intermediate and long duration government/credit $ 78 $ 579 $ 31 $ 688 +Other 63 254 — 317 +$ 141 $ 833 $ 31 $ 1,005 +Other investments: +Real estate $ 31 $ — $ 52 $ 83 +Discretionary and systematic macro hedge funds — — 94 94 +Other — — 23 23 +$ 31 $ — $ 169 $ 200 +Net plan assets (1) +$ 446 $ 922 $ 432 $ 1,800 +December 31, 2019 Level 1 Level 2 Net Asset Value Total +Equities +Equity securities $ 590 $ — $ 508 $ 1,098 +Long/short equity hedge funds — — 260 260 +Private equity — — 155 155 +$ 590 $ — $ 923 $ 1,513 +Fixed income: +Intermediate and long duration government/credit $ 121 $ 1,047 $ 1,003 $ 2,171 +Other 126 7 144 277 +$ 247 $ 1,054 $ 1,147 $ 2,448 +Other investments: +Real estate $ 104 $ — $ 165 $ 269 +Discretionary and systematic macro hedge funds — — 405 405 +Other — — 240 240 +$ 104 $ — $ 810 $ 914 +Net plan assets (2) +$ 941 $ 1,054 $ 2,880 $ 4,875 +(1) As of December 31, 2020, the total fair value of pension plans’ assets excludes a net payable of $ 76 , which represents securities purchased and sold but not yet settled plus interest and dividends earned on various investments. +(2) As of December 31, 2019, the total fair value of pension plans’ assets excludes a net receivable of $ 7 , which represents securities purchased and sold but not yet settled plus interest and dividends earned on various investments. +76 +Table of Contents +Funding and Cash Flows +It is Howmet’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Howmet contributes additional amounts as deemed appropriate. In 2020 and 2019, cash contributions to Howmet’s pension plans were $ 227 and $ 268 , respectively, which includes $ 25 and $ 53 , respectively, contributed to the Company’s U.S. plans that was in excess of the minimum required under ERISA. +The contributions to the Company’s pension plans in 2021 are estimated to be $ 140 (of w hich $ 130 is for U.S. plans), all of which are minimum required contributions. +During the third quarter of 2016, the Pension Benefit Guaranty Corporation approved management’s plan to separate the Alcoa Inc. pension plans between the Company and Alcoa Corporation. The plan stipulated that the Company make cash contributions of $ 150 over a period of 30 months (from November 1, 2016) to its two largest pension plans. The Company satisfied the requirements of the plan by making payments of $ 34 , $ 66 , and $ 50 in April 2019, March 2018, and April 2017, respectively. +Benefit payments expected to be paid to pension and other postretirement benefit plans’ participants and expected Medicare Part D subsidy receipts are as follows utilizing the current assumptions outlined above: +For the year ended December 31, Pension +benefits paid Gross Other post- +retirement +benefits Less Medicare Part D +subsidy receipts Net Other post- +retirement +benefits +2021 $ 168 $ 17 $ 1 $ 16 +2022 169 16 1 15 +2023 164 16 1 15 +2024 160 15 1 14 +2025 158 15 1 14 +2026 - 2030 728 67 6 61 +$ 1,547 $ 146 $ 11 $ 135 +Defined Contribution Plans +Howmet sponsors savings and investment plans in various countries, primarily in the U.S. Howmet’s contributions and expenses related to these plans were $ 73 , $ 87 , and $ 85 in 2020, 2019, and 2018, respectively. U.S. employees may contribute a portion of their compensation to the plans, and Howmet matches a portion of these contributions in equivalent form of the investments elected by the employee. +I. Income Taxes +The components of income from continuing operations before income taxes were as follows: +For the year ended December 31, 2020 2019 2018 +United States $ 84 $ 128 $ 166 +Foreign 87 82 262 +$ 171 $ 210 $ 428 +77 +Table of Contents +The provision for income taxes consisted of the following: +For the year ended December 31, 2020 2019 2018 +Current: +Federal (1) +$ ( 2 ) $ — $ — +Foreign 2 86 68 +State and local ( 2 ) — — +( 2 ) 86 68 +Deferred: +Federal ( 67 ) 33 100 +Foreign 11 ( 41 ) ( 53 ) +State and local 18 6 4 +( 38 ) ( 2 ) 51 +Total $ ( 40 ) $ 84 $ 119 +(1) Includes U.S. taxes related to foreign income +A reconciliation of the U.S. federal statutory rate to Howmet’s effective tax rate was as follows (the effective tax rate for 2020 was a benefit on income and for 2019 and 2018 was a provision on income): +For the year ended December 31, 2020 2019 2018 +U.S. federal statutory rate 21.0 % 21.0 % 21.0 % +Foreign tax rate differential ( 1.4 ) 10.6 3.2 +U.S. and residual tax on foreign earnings 5.6 15.3 5.5 +U.S. State and local taxes 2.2 0.8 ( 0.4 ) +Federal (cost) benefit of state tax ( 2.0 ) 1.2 0.4 +Permanent differences related to asset disposals and items included in restructuring and other charges (1) +6.8 ( 1.3 ) ( 34.3 ) +Non-deductible officer compensation 3.5 4.9 0.3 +Statutory tax rate and law changes (2) +( 15.9 ) ( 0.6 ) 13.2 +Tax holidays ( 0.4 ) ( 8.2 ) ( 3.0 ) +Changes in valuation allowances (3) +74.8 ( 52.2 ) ( 1.3 ) +Changes in uncertain tax positions (4) +( 116.9 ) 0.3 26.2 +Prior year tax adjustments (5) +( 1.7 ) 44.3 ( 4.2 ) +Other 1.0 3.9 1.2 +Effective tax rate ( 23.4 ) % 40.0 % 27.8 % +(1) In 2018, a $ 74 benefit was recorded related to the reversal of a foreign recapture obligation. +(2) In 2020, final regulations were issued that provided an election to exclude from GILTI any foreign earnings subject to a local country tax rate of at least 90% of the U.S. tax rate. The Company recorded a $ 30 benefit related to this tax law change. In 2018, the Company finalized its accounting for the Tax Cuts and Jobs Act of 2017 ("the 2017 Act”) and recorded an additional $ 59 charge. +(3) In 2020, a $ 104 valuation allowance was recorded related to deferred tax assets that were previously subject to a reserve that was otherwise released in 2020 as a result of a favorable Spanish tax case decision. In 2019, the Company released a $ 112 valuation allowance related to 2015 and 2016 foreign tax credits, subsequent to filing U.S. amended tax returns to deduct, rather than credit, foreign taxes. +(4) In 2020, the Company released a $ 64 reserve liability and a $ 104 reserve recorded as a contra balance against deferred tax assets as a result of a favorable Spanish tax case decision. A $ 30 benefit related to a previously uncertain U.S. tax position was also recognized in 2020. In 2018, the tax charge to establish the reserves related to the Spanish tax matter was partially offset by a $ 38 benefit related to a foreign reserve that was effectively settled. +(5) In 2019, the Company filed U.S. amended tax returns to deduct, rather than credit, 2015 and 2016 foreign taxes resulting in a $ 112 tax cost associated with the write-off of the deferred tax asset for the credit, partially offset by a $ 24 tax benefit for the deduction. +78 +Table of Contents +On December 22, 2017, the 2017 Act was signed into law, making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the non-previously taxed post-1986 foreign earnings and profits of certain U.S.-owned foreign corporations as of December 31, 2017. Also on December 22, 2017, Staff Accounting Bulletin No. 118 ("SAB 118"), Income Tax Accounting Implications of the Tax Cuts and Jobs Act, was issued by the SEC to address the application of U.S. GAAP for financial reporting. SAB 118 permitted the use of provisional amounts based on reasonable estimates in the financial statements. SAB 118 also provided that the tax impact may be considered incomplete in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the 2017 Act. +The Company calculated a reasonable estimate of the impact of the 2017 Act’s tax rate reduction and one-time transition tax in its 2017 year end income tax provision in accordance with its understanding of the 2017 Act and guidance available and, as a result, recorded a $ 272 tax charge in the fourth quarter of 2017, the period in which the legislation was enacted. +In 2018, the Company included a $ 59 tax charge in income from continuing operations as a result of finalizing its accounting for the 2017 Tax Act in accordance with SAB 118. This charge primarily related to a $ 16 charge for the one-time transition tax and a $ 43 charge to update deferred tax balances. +The components of net deferred tax assets and liabilities were as follows: +2020 2019 +December 31, Deferred +tax +assets Deferred +tax +liabilities Deferred +tax +assets Deferred +tax +liabilities +Depreciation $ 21 $ 506 $ 10 $ 480 +Employee benefits 364 — 368 6 +Loss provisions 24 1 36 — +Deferred income/expense 41 1,033 48 939 +Interest 3 — 56 — +Tax loss carryforwards 3,267 — 2,819 — +Tax credit carryforwards 378 — 379 — +Other 7 13 23 — +$ 4,105 $ 1,553 $ 3,739 $ 1,425 +Valuation allowance ( 2,307 ) — ( 2,121 ) — +$ 1,798 $ 1,553 $ 1,618 $ 1,425 +The following table details the expiration periods of the deferred tax assets presented above: +December 31, 2020 Expires +within +10 years Expires +within +11-20 years +No +Expiration (1) +Other (2) +Total +Tax loss carryforwards $ 378 $ 262 $ 2,627 $ — $ 3,267 +Tax credit carryforwards 299 66 13 — 378 +Other (3) +— — 389 71 460 +Valuation allowance ( 644 ) ( 161 ) ( 1,479 ) ( 23 ) ( 2,307 ) +$ 33 $ 167 $ 1,550 $ 48 $ 1,798 +(1) Deferred tax assets with no expiration may still have annual limitations on utilization. +(2) Other represents deferred tax assets whose expiration is dependent upon the reversal of the underlying temporary difference. +(3) A substantial amount of Other deferred tax assets relates to employee benefits that will become deductible for tax purposes in jurisdictions with unlimited expiration over an extended period of time as contributions are made to employee benefit plans and payments are made to retirees. +The total deferred tax asset (net of valuation allowance) is supported by projections of future taxable income exclusive of reversing temporary differences ( 15 %) and taxable temporary differences that reverse within the carryforward period ( 85 %). +79 +Table of Contents +Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not (greater than 50%) that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Howmet’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also remeasured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays. +In 2018, the Company made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that support the realizability of deferred tax assets. +Howmet’s foreign tax credits in the United States have a 10-year carryforward period with expirations ranging from 2021 to 2029 (as of December 31, 2020). Valuation allowances were initially established in prior years on a portion of the foreign tax credit carryforwards, primarily due to insufficient foreign source income to allow for full utilization of the credits within the expiration period. After consideration of all available evidence including potential tax planning strategies, an incremental valuation allowance of $ 46 was recognized in 2018. No additional valuation allowance was recorded in 2020 and 2019 as the Company intends to deduct, rather than credit, foreign taxes. Foreign tax credits of $ 88 and $ 8 expired at the end of 2019 and 2018, respectively, resulting in a corresponding decrease to the valuation allowance. The valuation allowance was also reduced by $ 113 in 2019 as a result of the Company filing amended tax returns to deduct foreign taxes that were previously claimed as a U.S. foreign tax credit. At December 31, 2020, the cumulative amount of the valuation allowance was $ 216 . The need for this valuation allowance will be reassessed on a continuous basis in future periods and, as a result, the allowance may increase or decrease based on changes in facts and circumstances. +In 2020, the Company reversed $ 1 of valuation allowance recorded in 2019 related to capital losses utilized in the 2019 tax return. The Company also recorded a valuation allowance of $ 9 related to capital investments in 2019. Capital losses can only offset capital gain income. Howmet does not anticipate sufficient future sources of capital gain income to support the utilization future capital losses on these investments. The need for valuation allowances against capital investments will be reassessed on a continuing basis. +The Company recorded a $ 20 increase and $ 11 decrease to U.S. state valuation allowances in 2020 and 2019, respectively. After weighing all available positive and negative evidence, the Company determined the adjustments based on the underlying net deferred tax assets that were more likely than not realizable based on projected taxable income. Changes in fully reserved U.S. state tax losses, credits and other deferred tax assets resulting from expirations, audit adjustments, tax rate, and tax law changes also resulted in a corresponding $ 58 decrease and $ 5 increase in the valuation allowance in 2020 and 2019, respectively. Valuation allowances of $ 609 remain against state deferred tax assets expected to expire before utilization. The need for valuation allowances against state deferred tax assets will be reassessed on a continuous basis in future periods and, as a result, the allowance may increase or decrease based on changes in facts and circumstances. +In 2020, the Company increased a valuation allowance by $ 104 as a result of releasing a tax reserve following a favorable Spanish tax case decision. In 2018, the Company had reduced a valuation allowance by $ 92 as a result of increasing a tax reserve for unrecognized tax benefits related to the same Spanish tax case. The valuation allowance reduction was partially offset by a $ 20 charge with respect to losses no longer supported by reversing temporary differences. The Company also recorded an additional valuation allowance of $ 61 in 2018, which offset a deferred tax asset recorded for additional losses reported on the Spanish tax return related to the Alcoa Inc. Separation Transaction that are not more likely than not to be realized. +80 +Table of Contents +The following table details the changes in the valuation allowance: +December 31, 2020 2019 2018 +Balance at beginning of year $ 2,121 $ 2,357 $ 2,459 +Increase to allowance 136 19 119 +Release of allowance ( 50 ) ( 211 ) ( 144 ) +Acquisitions and divestitures — ( 2 ) — +Tax apportionment, tax rate and tax law changes ( 23 ) ( 13 ) ( 14 ) +Foreign currency translation 123 ( 29 ) ( 63 ) +Balance at end of year $ 2,307 $ 2,121 $ 2,357 +As a result of the 2017 Act, the non-previously taxed post-1986 foreign earnings and profits (calculated based on U.S. tax principles) of certain U.S.-owned foreign corporations has been subject to U.S. tax under the one-time transition tax provisions. The 2017 Act also created a new requirement that certain income earned by foreign subsidiaries, GILTI, must be included in the gross income of the U.S. shareholder. The 2017 Act also established the Base Erosion and Anti-Abuse Tax ("BEAT"). In the first quarter of 2018, the Company made a final accounting policy election to treat taxes due from future inclusions in U.S. taxable income related to GILTI as a current period expense when incurred. Howmet has estimated a GILTI inclusion for 2020, 2019, and 2018 and recorded tax expense accordingly. Howmet does not anticipate being subject to BEAT for these years. +Foreign U.S. GAAP earnings that have not otherwise been subject to U.S. tax, will generally be exempt from future U.S. tax under the 2017 Act when distributed. Such distributions, as well as distributions of previously taxed foreign earnings, could potentially be subject to U.S. state tax in certain states, and foreign withholding taxes. Foreign currency gains/losses related to the translation of previously taxed earnings from functional currency to U.S. dollars could also be subject to U.S. tax when distributed. At this time, Howmet has no plans to distribute such earnings in the foreseeable future. If such earnings were to be distributed, Howmet would expect the potential U.S. state tax and withholding tax impacts to be immaterial and the potential deferred tax liability associated with future foreign currency gains to be impracticable to determine. +Howmet and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. With a few minor exceptions, Howmet is no longer subject to income tax examinations by tax authorities for years prior to 2011. All U.S. tax years prior to 2020 have been audited by the Internal Revenue Service. Various state and foreign jurisdiction tax authorities are in the process of examining the Company’s income tax returns for various tax years through 2019. +A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest and penalties) was as follows: +December 31, 2020 2019 2018 +Balance at beginning of year $ 176 $ 148 $ 50 +Additions for tax positions of the current year — 34 — +Additions for tax positions of prior years — — 143 +Reductions for tax positions of prior years ( 182 ) ( 1 ) ( 38 ) +Settlements with tax authorities ( 1 ) — — +Expiration of the statute of limitations — ( 2 ) ( 6 ) +Foreign currency translation 9 ( 3 ) ( 1 ) +Balance at end of year $ 2 $ 176 $ 148 +For all periods presented, a portion of the balance pertains to state tax liabilities, which are presented before any offset for federal tax benefits. The effect of unrecognized tax benefits, if recorded, that would impact the annual effective tax rate for 2020, 2019, and 2018 would be approximately 1 %, 36 %, and 11 %, respectively, of pre-tax book income. Howmet does not anticipate that changes in its unrecognized tax benefits will have a material impact on the Statement of Consolidated Operations during 2021. +It is Howmet’s policy to recognize interest and penalties related to income taxes as a component of the Provision for income taxes on the accompanying Statement of Consolidated Operations. Howmet recognized interest of $ 2 , $ 6 , and $ 22 in 2020, 2019, and 2018, respectively. Due to the expiration of the statute of limitations, settlements with tax authorities, reductions in prior accruals and refunded overpayments, Howmet recognized interest income of $ 25 , $ 0 , and $ 1 in 2020, 2019, and 2018, respectively. As of December 31, 2020, 2019, and 2018, the amount accrued for the payment of interest and penalties was $ 2 , $ 23 , and $ 21 , respectively. +81 +Table of Contents +J. Preferred and Common Stock +Preferred Stock. Howmet has two classes of preferred stock: $ 3.75 Cumulative Preferred Stock ("Class A Preferred Stock") and Class B Serial Preferred Stock. Class A Preferred Stock has 660,000 shares authorized at a par value of $ 100 per share with an annual $ 3.75 cumulative dividend preference per share. There were 546,024 shares of Class A Preferred Stock outstanding at December 31, 2020 and 2019. Class B Serial Preferred Stock has 10,000,000 shares authorized as a par value of $ 1 per share. There were no shares of Class B Serial Preferred Stock outstanding at December 31, 2020 and 2019. +Common Stock. At December 31, 2020, there were 600,000,000 shares authorized and 432,906,377 shares issued and outstanding. Dividends paid were $ 0.02 per share in 2020 (all in the first quarter of 2020) and $ 0.12 per share in 2019 ($ 0.06 dividend in the first quarter of 2019 and $ 0.02 per quarter for the remainder of the year) and $ 0.24 per share in 2018, or $ 0.06 per quarter in 2018. +As of December 31, 2020, 47 million shares of common stock were reserved for issuance under Howmet’s stock-based compensation plans. As of December 31, 2020, 33 million shares remain available for issuance. Howmet issues new shares to satisfy the exercise of stock options and the conversion of stock awards. +In July 2015, through the acquisition of RTI International Metals Inc. ("RTI"), the Company assumed the obligation to repay two tranches of convertible debt; one tranche was due and settled in cash on December 1, 2015 (principal amount of $ 115 ) and the other tranche was due and settled in cash on October 15, 2019 (principal amount of $ 403 ). No shares of the Company’s common stock were issued in connection with the maturity or final conversion of this convertible debt. +Common Stock Outstanding and Share Activity (number of shares) +Balance at December 31, 2017 481,416,537 +Issued for stock-based compensation plans 1,854,180 +Balance at December 31, 2018 483,270,717 +Issued for stock-based compensation plans 4,436,830 +Repurchase and retirement of common stock ( 54,852,364 ) +Balance at December 31, 2019 432,855,183 +Issued for stock-based compensation plans 3,896,119 +Repurchase and retirement of common stock ( 3,844,925 ) +Balance at December 31, 2020 432,906,377 +On February 19, 2019, the Company entered into an accelerated share repurchase ("ASR") agreement with JPMorgan Chase Bank to repurchase $ 700 of its common stock (the “February 2019 ASR”), pursuant to the share repurchase programs previously authorized by its Board of Directors (the "Board"). On May 2, 2019, the Company entered into an ASR agreement with JPMorgan Chase Bank to repurchase $ 200 of its common stock (the "May 2019 ASR"), pursuant to the share repurchase programs previously authorized by its Board. +On May 14, 2019, the Board authorized the repurchase of an additional $ 500 of its outstanding common stock. Pursuant to the share repurchase programs previously authorized by the Board, the Company entered into an ASR agreement on August 6, 2019 with Goldman Sachs & Co. LLC to repurchase $ 200 of its common stock (the "August 2019 ASR"). In November 2019, the Company repurchased $ 50 of its common stock on the open market. +In August/September 2020 and in November 2020, the Company repurchased $ 51 and $ 22 , respectively, of its common stock on the open market. +Shares repurchased during 2020 and 2019 were $ 73 and $ 1,150 , respectively. All of the shares repurchased during 2020 and 2019 were immediately retired. After giving effect to the share repurchases made through December 31, 2020, approximately $ 277 remains available under the prior authorizations by the Board for share repurchases. The amount of share repurchases by the Company may be limited under the terms of the Five-Year Revolving Credit Agreement. (See Note R ) +82 +Table of Contents +The following table provides details for the share repurchases during 2020 and 2019. +Number of shares Average price Total +August/September 2020 open market repurchase 2,907,094 $ 17.36 $ 51 +November 2020 open market repurchase 937,831 $ 23.99 $ 22 +2020 Share repurchase total 3,844,925 $ 18.98 $ 73 +February 2019 ASR total 36,434,423 $ 19.21 $ 700 +May 2019 ASR total 9,016,981 $ 22.18 $ 200 +August 2019 ASR total 7,774,279 $ 25.73 $ 200 +November 2019 open market repurchase 1,626,681 $ 30.74 $ 50 +2019 Share repurchase total 54,852,364 $ 20.97 $ 1,150 +Stock-Based Compensation +Howmet has a stock-based compensation plan under which stock options and/or restricted stock unit awards are granted in the first half of each year to eligible employees. Stock options are granted at the closing market price of Howmet’s common stock on the date of grant and typically vest over a three-year service period (1/3 each year) with a ten-year contractual term. Restricted stock unit awards typically vest over a three-year service period from the date of grant. As part of Howmet’s stock-based compensation plan design, individuals who are retirement-eligible have a six-month requisite service period in the year of grant. Certain of the restricted stock unit awards include performance and market conditions and are granted to certain eligible employees. In 2020 and 2019, performance stock awards were granted to a senior executive that vest either based on achievement of the Arconic Inc. Separation Transaction (see Note C for further details) or the achievement of certain stock price thresholds. For performance stock awards granted to other employees in 2020, the final number of shares earned will be based on Howmet’s achievement of profitability targets over the respective performance periods and will be earned at the end of the third year. Performance stock awards granted in the first quarter of 2019 were converted to restricted stock unit awards (at target), in order to address the pending Arconic Inc. Separation Transaction. For performance stock awards granted in 2018, in order to address the pending Arconic Inc. Separation Transaction, the final number of shares earned will be based on Howmet’s achievement of sales and profitability targets over performance periods in 2018 and 2019. Additionally, the 2020 and 2018 performance stock awards will be scaled by a total shareholder return ("TSR") multiplier, which depends upon relative performance against the TSRs of a group of peer companies. +In conjunction with their employment agreements, certain current and former executives were granted cash bonus awards based on the achievement of certain stock price thresholds. These awards are liability classified and were marked-to-market each quarter using a Monte Carlo simulation. The stock price thresholds have been fully reached. The cash payment of $ 23 will occur in 2021 in accordance with the terms of the agreements. +In 2020, 2019, and 2018, Howmet recognized stock-based compensation expense of $ 46 ($ 42 after-tax), $ 69 ($ 63 after-tax), and $ 40 ($ 31 after-tax), respectively. Senior executive performance awards granted in April 2020 were modified in June 2020, resulting in incremental compensation expense of $ 12 , which will be amortized over the remaining service period ending April 1, 2023. Additionally, the effect of the Arconic Inc. Separation Transaction was a modification of the original stock options and restricted stock award units. The modifications were designed with the intention that the intrinsic value of the stock option or stock award were the same both previous to and after the adjustments. An immaterial charge was recorded to Restructuring and other charges related to the modification. +Over 95 % of compensation expense recorded in 2020 relates to restricted stock unit awards. Cash bonus awards of $ 2 and $ 21 were recorded in 2020 and 2019, respectively. Of the remaining stock-based compensation expense in 2019, more than 95 % relates to restricted stock unit awards. The expense related to restricted stock unit awards in 2018 was approximately 80 %. No stock-based compensation expense was capitalized in any of those years. Stock-based compensation expense was reduced by $ 3 in 2019 for certain executive pre-vest cancellations which were recorded in Restructuring and other charges within the Statement of Consolidated Operations. At December 31, 2020, there was $ 51 (pre-tax) of unrecognized compensation expense related to non-vested stock option grants and non-vested restricted stock unit award grants. This expense is expected to be recognized over a weighted average period of 1.8 years. +83 +Table of Contents +Stock-based compensation expense is based on the grant date fair value of the applicable equity grant. For restricted stock unit awards, the fair value was equivalent to the closing market price of Howmet’s common stock on the date of grant. The weighted average grant date fair value of the 2020 performance stock awards with a market condition scaled by a TSR multiplier was $ 21.33 , and the weighted average grant date fair value of the April 2020 senior executive performance stock awards with a market condition (achievement of certain stock price thresholds) was $ 2.57 . The weighted average grant date fair value of the 2019 performance stock awards with a market condition (achievement of certain stock price thresholds) was $ 11.93 . The grant date fair value of the 2018 performance stock awards containing a market condition (scaled by TSR multiplier) was $ 20.25 . The 2020, 2019 and 2018 performance awards were valued using a Monte Carlo model. A Monte Carlo simulation uses assumptions of stock price behavior to estimate the probability of satisfying market conditions and the resulting fair value of the award. The risk-free interest rate ( 0.3 % in 2020, 1.6 % in 2019 and in 2.7 % 2018) was based on a yield curve of interest rates at the time of the grant based on the remaining performance period. In 2020 volatility was estimated using a blended rate of Howmet's historical volatility and a peer-based volatility ( 48.3 %) due to the Arconic Inc. Separation Transaction and the related changes in the nature of the business. In 2019 volatility was estimated using implied and historical volatility ( 33.4 %). Because of limited historical information due to the Alcoa Inc. Separation Transaction, 2018 volatility ( 32.0 %) was estimated using implied volatility, and the representative price return approach, which uses price returns of comparable companies, was used to develop a correlation assumption. For stock options, the fair value was estimated on the date of grant using a lattice-pricing model, which generated a result of $ 9.79 per option in 2018. There were no stock options issued in 2020 or 2019. The lattice-pricing model uses a number of assumptions to estimate the fair value of a stock option, including a risk-free interest rate, dividend yield, volatility, exercise behavior, and contractual life. The following paragraph describes in detail the assumptions used to estimate the fair value of stock options granted in 2018. +The risk-free interest rate ( 2.5 %) was based on a yield curve of interest rates at the time of the grant based on the contractual life of the option. The dividend yield ( 0.9 %) was based on a one-year average. Volatility ( 34.0 %) was based on comparable companies and implied volatilities over the term of the option. Howmet utilized historical option forfeiture data to estimate annual post-vesting forfeitures ( 6 %). Exercise behavior ( 61 %) was based on a weighted average exercise ratio (exercise patterns for grants issued over the number of years in the contractual option term) of an option’s intrinsic value resulting from historical employee exercise behavior. Based upon the other assumptions used in the determination of the fair value, the life of an option ( 6.0 ) was an output of the lattice-pricing mod. The activity for stock options and stock awards during 2020 was as follows (options and awards in millions): +Stock options Stock awards +Number of +options Weighted +average +exercise price Number of +awards Weighted +average FMV +per award +Outstanding, December 31, 2019 7 $ 25.75 7 $ 22.05 +Granted — — 6 10.89 +Exercised ( 2 ) 21.65 — — +Converted — — ( 4 ) 19.54 +Expired or forfeited ( 1 ) 30.12 — 19.57 +Canceled due to Arconic Inc. Separation Transaction (1) +( 1 ) 27.85 ( 1 ) 23.84 +Adjustment due to Arconic Inc. Separation Transaction (2) +— 24.35 1 19.10 +Performance share adjustment — — — 21.20 +Outstanding, December 31, 2020 3 $ 24.47 9 $ 13.68 +(1) As a result of the Arconic Inc. Separation Transaction, all stock options and stock awards relating to Arconic Corporation employees were cancelled. +(2) As a result of the Arconic Inc. Separation Transaction, all stock options and stock awards relating to Howmet employees were adjusted to reflect the Arconic Inc. Separation Transaction. +As of December 31, 2020, the number of stock options outstanding had a weighted average remaining contractual life of 2.9 years and a total intrinsic value of $ 18 . Additionally, 3.1 million of the stock options outstanding were fully vested and exercisable and had a weighted average remaining contractual life of 2.8 years, a weighted average exercise price of $ 24.32 , and a total intrinsic value of $ 18 as of December 31, 2020. In 2020, 2019, and 2018, the cash received from stock option exercises was $ 33 , $ 56 , and $ 16 and the total tax benefit realized from these exercises was $ 3 , $ 4 , and $ 2 , respectively. The total intrinsic value of stock options exercised during 2020, 2019, and 2018 was $ 14 , $ 17 , and $ 7 , respectively. +84 +Table of Contents +K. Earnings Per Share +Basic earnings per share ("EPS") amounts are computed by dividing earnings (loss), after the deduction of preferred stock dividends declared, by the average number of common shares outstanding. Diluted EPS amounts assume the issuance of common stock for all potentially dilutive share equivalents outstanding. +The information used to compute basic and diluted EPS attributable to Howmet common shareholders was as follows (shares in millions): +For the year ended December 31, 2020 2019 2018 +Net income from continuing operations attributable to common shareholders $ 211 126 309 +Less: preferred stock dividends declared 2 2 2 +Net income from continuing operations attributable to common shareholders: 209 124 307 +Income from discontinued operations 50 344 333 +Net income available to Howmet Aerospace common shareholders - basic 259 468 640 +Add: interest expense related to convertible notes — 9 11 +Net income available to Howmet common shareholders - diluted $ 259 $ 477 $ 651 +Average shares outstanding - basic 435 446 483 +Effect of dilutive securities: +Stock options — 1 1 +Stock and performance awards 4 5 5 +Convertible notes (1) +— 11 14 +Average shares outstanding - diluted 439 463 503 +(1) The convertible notes matured on October 15, 2019 (see Note R ). No shares of the Company’s common stock were issued in connection with the maturity or the final conversion of the convertible notes. As of October 15, 2019, the calculation of average diluted shares outstanding ceased to include the approximately 15 million shares of common stock and the corresponding interest expense previously attributable to the convertible notes. +Common stock outstanding was 433 million shares at both at December 31, 2020 and 2019. +The following shares were excluded from the calculation of average shares outstanding – diluted as their effect was anti-dilutive (shares in millions). +For the year ended December 31, 2020 2019 2018 +Convertible notes — — — +Stock options 1 1 9 +Stock awards — — — +(1) +85 +Table of Contents +L. Accumulated Other Comprehensive Loss +The following table details the activity of the four components that comprise Accumulated other comprehensive loss for Howmet's shareholders: +2020 2019 2018 +Pension and other postretirement benefits ( H ) +Balance at beginning of period $ ( 2,732 ) $ ( 2,344 ) $ ( 2,230 ) +Adoption of accounting standard (1) +— — ( 369 ) +Other comprehensive (loss) income: +Unrecognized net actuarial (loss) gain and prior service cost/benefit ( 211 ) ( 587 ) 70 +Tax benefit (expense) 48 129 ( 19 ) +Total Other comprehensive (loss) income before reclassifications, net of tax ( 163 ) ( 458 ) 51 +Amortization of net actuarial loss and prior service cost (2) +149 90 262 +Tax expense (3) +( 32 ) ( 20 ) ( 58 ) +Total amount reclassified from Accumulated other comprehensive loss, net of tax (4) +117 70 204 +Total Other comprehensive (loss) income ( 46 ) ( 388 ) 255 +Transfer to Arconic Corporation 1,798 — — +Balance at end of period $ ( 980 ) $ ( 2,732 ) $ ( 2,344 ) +Foreign currency translation +Balance at beginning of period $ ( 596 ) $ ( 583 ) $ ( 437 ) +Other comprehensive (loss) (5) +58 ( 13 ) ( 146 ) +Transfer to Arconic Corporation ( 428 ) — — +Balance at end of period $ ( 966 ) $ ( 596 ) $ ( 583 ) +Debt securities +Balance at beginning of period $ — $ ( 3 ) $ ( 2 ) +Other comprehensive income (loss) (6) +— 3 ( 1 ) +Balance at end of period $ — $ — $ ( 3 ) +Cash flow hedges +Balance at beginning of period $ ( 1 ) $ 4 $ 25 +Adoption of accounting standard (7) +— ( 2 ) 2 +Other comprehensive (loss): +Net change from periodic revaluations — ( 9 ) ( 15 ) +Tax benefit — 3 3 +Total Other comprehensive (loss) income before reclassifications, net of tax — ( 6 ) ( 12 ) +Net amount reclassified to earnings 6 4 ( 14 ) +Tax (expense) benefit (3) +( 2 ) ( 1 ) 3 +Total amount reclassified from Accumulated other comprehensive loss, net of tax (4) +4 3 ( 11 ) +Total Other comprehensive (loss) 4 ( 3 ) ( 23 ) +Balance at end of period $ 3 $ ( 1 ) $ 4 +Accumulated other comprehensive loss balance at end of period $ ( 1,943 ) $ ( 3,329 ) $ ( 2,926 ) +(1) Adjustment related to eliminating stranded tax effects resulting from a change in income tax rates resulting from the enactment of the Tax Cuts and Jobs Act +(2) These amounts were recorded in Other expense (income), net (see Note G ). +(3) These amounts were included in Provision for income taxes on the accompanying Statement of Consolidated Operations. +(4) A positive amount indicates a corresponding charge to earnings and a negative amount indicates a corresponding benefit to earnings. +86 +Table of Contents +(5) In all periods presented, no amounts were reclassified to earnings. +(6) Realized gains and losses were included in Other expense (income), net, on the accompanying Statement of Consolidated Operations. +(7) Adjustment was related to eliminating the separate measurement of hedge ineffectiveness as part of the adoption of new hedge accounting guidance . +M. Receivables +Sale of Receivables Program +The Company has two accounts receivables securitization arrangements. +The first is an arrangement with financial institutions to sell certain customer receivables without recourse on a revolving basis ("Receivables Sale Program"). The sale of such receivables is completed using a bankruptcy remote special purpose entity, which is a consolidated subsidiary of the Company. This arrangement historically provided up to a maximum funding of $ 400 for receivables sold. The Company maintains a beneficial interest, or a right to collect cash, on the sold receivables that have not been funded (deferred purchase program receivable). In the first quarter of 2020, the Company entered into an amendment to remove subsidiaries of the GRP business from the sale of receivables program in preparation for the Arconic Inc. Separation Transaction and repurchased the remaining $ 282 unpaid receivables of GRP customers in a non-cash transaction by reducing the amount of the deferred purchase program receivable. This amendment also reduced the maximum funding for receivables sold to $ 300 . Effective September 30, 2020, the concentration limit of one customer may be reduced at the discretion of the financial institutions or automatically upon the downgrade of its debt rating as defined in the Receivables Sale Program agreement. A reduction in the customer's concentration limit would reduce the eligible receivable funding base thereby reducing the amount of future draws available and may also require repayment of a portion of existing draws. +The Company had net cash repayments totaling $ 146 ($ 207 in draws and $ 353 in repayments) in 2020 and net cash repayments totaling $ 0 ($ 600 in draws and $ 600 in repayments) in 2019. +As of December 31, 2020, and 2019, the deferred purchase program receivable was $ 12 and $ 246 , respectively, which was included in Other receivables on the accompanying Consolidated Balance Sheet. The deferred purchase program receivable is reduced as collections of the underlying receivables occur; however, as this is a revolving program, the sale of new receivables will result in an increase in the deferred purchase program receivable. The Company services the customer receivables for the financial institutions at market rates; therefore, no servicing asset or liability was recorded. +On April 14, 2020, the Company’s credit rating was downgraded by Moody’s Investors Service, Inc., which resulted in a termination event under the provisions of the Receivables Sale Program agreement for which a waiver was obtained. This termination event under the Receivables Sale Program is not an event of default under the Company’s other financing and commercial agreements, including the Credit Agreement. On May 5, 2020, an amendment to the Receivables Sale Program was executed that cured the termination event. +Cash receipts from customer payments on sold receivables (which are cash receipts on the underlying trade receivables that have been previously sold in this program) as well as cash receipts and cash disbursements from draws and repayments under the program are presented as cash receipts from sold receivables within investing activities in the Statement of Consolidated Cash Flows. +The second arrangement is one in which the Company, through a wholly-owned special purpose entity (“SPE”), entered into an receivables purchase agreement (the “Receivables Purchase Agreement”) on June 30, 2020 such that the SPE may sell certain receivables to financial institutions until the earlier of June 30, 2021 or a termination event. The Receivables Purchase Agreement also contains customary representations and warranties, as well as affirmative and negative covenants. Pursuant to the Receivables Purchase Agreement, the Company does not maintain effective control over the transferred receivables, and therefore accounts for these transfers as sales of receivables. +The SPE sold $ 165 of its receivables without recourse and received cash funding under this program in 2020, resulting in derecognition of the receivables from the Company’s consolidated balance sheets (of which $ 46 remained outstanding from the customer at December 31, 2020 and $ 0 was in the program at December 31, 2019). Cash received from collections of sold receivables is used by the SPE to fund additional purchases of receivables on a revolving basis, not to exceed $ 125 , which is the aggregate maximum limit. As collateral against the sold receivables, the SPE maintains a certain level of unsold receivables, which was $ 33 at December 31, 2020. Costs associated with the sales of receivables are reflected in the Company’s Consolidated statements of operations for the periods in which the sales occur. Cash receipts from sold receivables under the Receivables Purchase Agreement are presented within operating activities in the Statement of Consolidated Cash Flows. +87 +Table of Contents +The Company had accounts receivable securitization arrangements totaling $ 425 at December 31, 2020, of which $ 250 was drawn. The Company had accounts receivable securitization arrangements totaling $ 400 at December 31, 2019, of which $ 350 was drawn. The $ 100 reduction in the amount drawn resulted in a corresponding reduction in Cash and cash equivalents. +Other Customer Receivable Sales +In 2020, the Company sold $ 32 of a certain customer’s receivables in exchange for cash (of which $ 0 remained outstanding from the customer at December 31, 2020), the proceeds from which are presented in changes in receivables within operating activities in the Statement of Consolidated Cash Flows. The sale of these customer receivables partially offset the maximum funding reduction resulting from the Arconic Inc. Separation Transaction as well as customer concentration limits within the first accounts receivable securitization arrangement. +In 2020, the Company sold another customer’s receivables of $ 149 in exchange for cash (of which $ 50 remained outstanding from the customer at December 31, 2020), the proceeds from which are presented in changes in receivables within operating activities in the Statement of Consolidated Cash Flows. The sale of these customer receivables was undertaken to offset a change in the customer’s payment patterns (customer had been taking a discount for paying early). +Allowance for Doubtful Accounts +The following table details the changes in the allowance for doubtful accounts related to customer receivables and other receivables: +Customer receivables Other receivables +2020 2019 2018 2020 2019 2018 +Balance at beginning of year $ 1 $ 1 $ 3 $ 15 $ 15 $ 15 +Provision for doubtful accounts 1 2 — 3 7 2 +Write off of uncollectible accounts — ( 1 ) ( 2 ) ( 1 ) ( 2 ) ( 1 ) +Recoveries of prior write-offs — — — ( 1 ) ( 3 ) ( 3 ) +Other ( 1 ) ( 1 ) — 3 ( 2 ) 2 +Balance at end of year $ 1 $ 1 $ 1 $ 19 $ 15 $ 15 +N. Inventories +December 31, 2020 2019 +Finished goods $ 528 $ 524 +Work-in-process 629 741 +Purchased raw materials 292 299 +Operating supplies 39 43 +Total inventories $ 1,488 $ 1,607 +At December 31, 2020 and 2019, the portion of inventories valued on a LIFO basis was $ 458 and $ 503 , respectively. If valued on an average-cost basis, total inventories would have been $ 131 and $ 133 higher at December 31, 2020 and 2019, respectively. +O. Properties, Plants, and Equipment, Net +December 31, 2020 December 31, 2019 +Land and land rights $ 98 $ 99 +Structures 1,033 938 +Machinery and equipment 3,879 3,626 +5,010 4,663 +Less: accumulated depreciation and amortization 2,626 2,449 +2,384 2,214 +Construction work-in-progress 208 415 +Properties, plants, and equipment, net $ 2,592 $ 2,629 +88 +Table of Contents +During the second quarter of 2019, the Company updated its five-year strategic plan and determined that there was a decline in the forecasted financial performance for the Disks asset group within the Engineered Products and Forgings segment at that time. As such, the Company evaluated the recoverability of the Disks asset group long-lived assets by comparing the carrying value to the undiscounted cash flows of the Disks asset group. The carrying value exceeded the undiscounted cash flows and therefore the Disks asset group long-lived assets were deemed to be impaired. The impairment charge was measured as the amount of carrying value in excess of fair value of the long-lived assets, with fair value determined using a DCF model and a combination of sales comparison and cost approach valuation methods including an estimate for economic obsolescence. The impairment charge of $ 428 , of which $ 247 and $ 181 related to the Engine Products and Engineered Structures segments, respectively, recorded in the second quarter of 2019 impacted properties, plants, and equipment; intangible assets; and certain other noncurrent assets by $ 198 , $ 197 , and $ 33 , respectively. The impairment charge was recorded in Restructuring and other charges in the Statement of Consolidated Operations in 2019. +Depreciation expense related to Properties, plants and equipment recorded in Provision for depreciation and amortization in the accompanying Statement of Consolidated Operations was $ 236 , $ 234 , and $ 253 for the years ended December 31, 2020, 2019 and 2018, respectively . +89 +Table of Contents +P. Goodwill and Other Intangible Assets +The following table details the changes in the carrying amount of goodwill: +Engine Products Fastening Systems Engineered Structures Forged Wheels Total +Balances at December 31, 2018 +Goodwill $ 2,785 $ 1,607 $ 506 $ 7 $ 4,905 +Accumulated impairment losses ( 719 ) — — — ( 719 ) +Goodwill, net 2,066 1,607 506 7 4,186 +Acquisitions and Divestitures (See Note U ) +( 13 ) — — — ( 13 ) +Translation and other 6 — ( 2 ) — 4 +Transfer from Engineered Structures to Discontinued Operations (Arconic Corporation) — — ( 110 ) — ( 110 ) +Transfer from Engineered Structures to Engine Products 105 — ( 105 ) — — +Balances at December 31, 2019 +Goodwill 2,883 1,607 289 7 4,786 +Accumulated impairment losses ( 719 ) — — — ( 719 ) +Goodwill, net 2,164 1,607 289 7 4,067 +Impairment (See Note U ) +— — ( 2 ) — ( 2 ) +Translation and other 24 13 — — 37 +Transfer from Engine Products to Engineered Structures ( 17 ) — 17 — — +Balances at December 31, 2020 +Goodwill 2,890 1,620 306 7 4,823 +Accumulated impairment losses ( 719 ) — ( 2 ) — ( 721 ) +Goodwill, net $ 2,171 $ 1,620 $ 304 $ 7 $ 4,102 +In the first quarter of 2020, the Savannah operations was transferred from the Engine Products segment to the Engineered Structures segment, and as a result goodwill of $ 17 was reallocated. +In the second quarter of 2019, the Company's casting operations were transferred from the Engineered Structures segment to the Engine Products segment, and as a result goodwill of $ 105 was reallocated. In the second quarter of 2018, the aluminum extrusion operations was also transferred from the Engineered Structures segment to Discontinued operations, and as a result goodwill of $ 110 was reallocated. +Other intangible assets were as follows: +December 31, 2020 Gross +carrying +amount Accumulated +amortization Intangibles, net +Computer software $ 194 $ ( 169 ) $ 25 +Patents and licenses 67 ( 65 ) 2 +Other intangibles 700 ( 188 ) 512 +Total amortizable intangible assets 961 ( 422 ) 539 +Indefinite-lived trade names and trademarks 32 — 32 +Total intangible assets, net $ 993 $ ( 422 ) $ 571 +90 +Table of Contents +December 31, 2019 Gross +carrying +amount Accumulated +amortization Intangibles, net +Computer software $ 199 $ ( 165 ) $ 34 +Patents and licenses 67 ( 65 ) 2 +Other intangibles 693 ( 162 ) 531 +Total amortizable intangible assets 959 ( 392 ) 567 +Indefinite-lived trade names and trademarks 32 — 32 +Total intangible assets, net $ 991 $ ( 392 ) $ 599 +During the second quarter of 2019, the Company recorded a charge of $ 197 for intangible asset impairments associated with the Disks long-lived asset group which was recorded in Restructuring and other charges in the accompanying Statement of Consolidated Operations. See Note O for additional details. +Computer software consists primarily of software costs associated with enterprise business solutions across Howmet's businesses. +Amortization expense related to the intangible assets recorded in Provision for depreciation and amortization in the accompanying Statement of Consolidated Operations was $ 40 , $ 58 , and $ 58 for the years ended December 31, 2020, 2019, and 2018 respectively, and is expected to be in the range of approximately $ 37 to $ 43 annually from 2021 to 2025. +Q. Leases +Operating lease cost, which included short-term leases and variable lease payments and approximated cash paid, was $ 67 , $ 84 , and $ 87 in 2020, 2019, and 2018, respectively. +Operating lease right-of-use assets and lease liabilities in the Consolidated Balance Sheet were as follows: +December 31, 2020 2019 +Right-of-use assets classified in Other noncurrent assets $ 131 $ 125 +Current portion of lease liabilities classified in Other current liabilities +38 38 +Long-term portion of lease liabilities classified in Other noncurrent liabilities and deferred credits 100 98 +Total lease liabilities $ 138 $ 136 +Future minimum contractual operating lease obligations were as follows at December 31, 2020: +2021 $ 44 +2022 34 +2023 25 +2024 17 +2025 11 +Thereafter 32 +Total lease payments $ 163 +Less: Imputed interest ( 25 ) +Present value of lease liabilities $ 138 +December 31, 2020 2019 +Right-of-use assets obtained in exchange for operating lease obligations $ 35 $ 26 +Weighted-average remaining lease term in years 6 6 +Weighted-average discount rate 5.6 % 5.9 % +91 +Table of Contents +R. Debt +Debt. +December 31, 2020 2019 +6.150% Notes, due 2020 $ — $ 1,000 +5.400% Notes, due 2021 (1) +361 1,250 +5.870% Notes, due 2022 476 627 +5.125% Notes, due 2024 1,250 1,250 +6.875% Notes, due 2025 1,200 — +5.900% Notes, due 2027 625 625 +6.750% Bonds, due 2028 300 300 +5.950% Notes, due 2037 625 625 +4.750% Iowa Finance Authority Loan, due 2042 250 250 +Other (2) +( 12 ) 13 +5,075 5,940 +Less: amount due within one year 376 1,034 +Total long-term debt $ 4,699 $ 4,906 +(1) Redeemed on January 15, 2021. +(2) Includes various financing arrangements related to subsidiaries, unamortized debt discounts and unamortized debt issuance costs related to outstanding notes and bonds listed in the table above. +The principal amount of long-term debt maturing in each of the next five years is $ 361 in 2021, $ 476 in 2022, $ 0 in 2023, $ 1,250 in 2024, and $ 1,200 in 2025. +Public Debt. On January 15, 2021 the Company completed the early redemption of all the remaining $ 361 of its 5.400 % Notes due in April 2021 (the “ 5.400 % Notes ” ) at par and paid $ 5 in accrued interest. On an annual basis, the redemption of these Notes will decrease Interest expense, net by approximately $ 19 . +On May 21, 2020, the Company completed a cash tender offer and redeemed $ 589 and $ 151 of principa l amount of the 5.400 % Notes and its 5.870 % Notes due 2022, respectively. The amount of early tender premium and accrued interest and associated with the notes accepted for early settlement were $ 24 and $ 4 , respectively, which was recorded in Interest expense, net during the second quarter ended June 30, 2020 and nine months ended September 30, 2020 in the Statement of Consolidated Operations. +On April 24, 2020, the Company completed an offering of $ 1,200 aggregate principal amount of 6.875 % Notes due 2025, the proceeds of which have been used to fund the cash tender offers noted above and to pay related transaction fees, including applicable premiums and expenses, with the remaining amount to be used for general corporate purposes. The Company incurred deferred financing costs of $ 14 associated with the issuance in the second quarter of 2020. +On April 16, 2020, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission, which became effective automatically (the “Shelf Registration Statement”). The Shelf Registration Statement allows for offerings of debt securities from time to time. +On April 6, 2020, the Company completed the early redemption of all $ 1,000 of its 6.150 % Notes due 2020 (the " 6.150 % Notes") and the early partial redemption of $ 300 of its 5.400 % Notes. Holders of the 6.150 % Notes were paid an aggregate of $ 1,020 and holders of the 5.400 % Notes were paid an aggregate of $ 315 , plus accrued and unpaid interest up to, but not including, the redemption date. The Company incurred early termination premium and accrued interest of $ 35 and $ 17 , respectively, which has been recorded in Interest expense, net during the second quarter ended June 30, 2020 and nine months ended September 30, 2020 in the Statement of Consolidated Operations. +On October 15, 2019, the 1.63 % Convertible Notes matured in accordance with their terms and the Company repaid in cash the aggregate outstanding principal amount of $ 403 together with accrued and unpaid interest. +During the first quarter of 2018, the Company completed the early redemption of its remaining outstanding 5.72 % Notes due in 2019, with aggregate principal amount of $ 500 , for $ 518 in cash including accrued and unpaid interest. As a result, the Company recorded a charge of $ 19 in Interest expense in the accompanying Statement of Consolidated Operations for 2018 primarily for the premium paid on the early redemption of these notes in excess of their carrying value. +92 +Table of Contents +The Company has the option to redeem certain of its Notes and Bonds in whole or part, at any time at a redemption price equal to the greater of principal amount or the sum of the present values of the remaining scheduled payments, discounted using a defined treasury rate plus a spread, plus in either case accrued and unpaid interest to the redemption date. +Credit Facilities. On July 25, 2014, Howmet entered into a Five-Year Revolving Credit Agreement with a syndicate of lenders and issuers named therein, which provides for a senior unsecured revolving credit facility (the “Credit Facility”). By an Extension Request and Amendment Letter dated as of June 5, 2015, the maturity date of the Credit Facility was extended to July 25, 2020. On September 16, 2016, Howmet entered into Amendment No. 1 to the Five-Year Revolving Credit Agreement to permit the Alcoa Inc. Separation Transaction and to amend certain terms of the Credit Agreement, including the replacement of the existing financial covenant with a leverage ratio and reduction of total commitments available from $ 4,000 to $ 3,000 . On June 29, 2018, the Company entered into Amendment No. 2 (“Amendment No. 2”) to amend and restate the Five-Year Revolving Credit Agreement. The Five-Year Revolving Credit Agreement, as so amended and restated, is herein referred to as the “Credit Agreement.” +On March 4, 2020, the Company entered into Amendment No. 3 to the Credit Agreement. The amendment was entered into to permit the Arconic Inc. Separation Transaction and to amend certain terms of the Credit Agreement, including a change to the existing financial covenant and reduction of total commitments available from $ 3,000 to $ 1,500 , effective April 1, 2020 and extended the maturity date from June 29, 2023 to April 1, 2025. The Company was required to maintain a ratio of Consolidated Net Debt (as defined in the Credit Agreement) to Consolidated EBITDA (as defined in the Credit Agreement) to be no greater than 3.50 to 1.00. +On June 26, 2020, the Company entered into Amendment No. 4 to the Credit Agreement to provide relief from its existing financial covenant through December 31, 2021 and reduce total commitment available from $ 1,500 to $ 1,000 . The Company is required to maintain a ratio of Consolidated Net Debt to Consolidated EBITDA (as defined in the Credit Agreement) as of the end of each fiscal quarter for the period of the four fiscal quarters of the Company most recently ended, to be no greater than (i) 5.00 to 1.00 for any quarter ending on or prior to December 31, 2020, (ii) 5.25 to 1.00 for the quarter ending March 31, 2021, (iii) 5.00 to 1.00 for the quarter ending June 30, 2021, (iv) 4.50 to 1.00 for the quarter ending September 30, 2021, and (v) 4.00 to 1.00 for the quarter ending December 31, 2021. The ratio returns to 3.50 to 1.00 for all periods thereafter. +Under Amendment No. 4 to the Credit Agreement, during the covenant relief period from June 30, 2020 through December 31, 2021 (unless the Company ends the covenant relief period earlier in accordance with the amendment), common stock dividends and share repurchases are permitted only if no borrowings under the Credit Agreement are outstanding at the time and are limited to an aggregate amount of $ 100 through June 30, 2021, with such limit increasing by $ 150 to an aggregate amount of $ 250 after June 30, 2021 if the Consolidated Net Debt to Consolidated EBITDA ratio is no greater than 3.75 to 1.00. At December 31, 2020, the Company was in compliance with all covenants under the Credit Agreement. Availability under the Credit Agreement could be reduced in future periods if the Company fails to maintain the required ratios referenced above. +The Credit Agreement includes additional covenants, including, among others, (a) limitations on Howmet’s ability to incur liens securing indebtedness for borrowed money, (b) limitations on Howmet’s ability to consummate a merger, consolidation or sale of all or substantially all of its assets, and (c) limitations on Howmet’s ability to change the nature of its business. +The Credit Facility matures on April 1, 2025, unless extended or earlier terminated in accordance with the provisions of the Credit Agreement. Howmet may make two one-year extension requests during the term of the Credit Facility, subject to the lender consent requirements set forth in the Credit Agreement. Under the provisions of the Credit Agreement, Howmet will pay a fee of 0.30 % per annum (based on Howmet’s current long-term debt ratings) of the total commitment to maintain the Credit Facility. +The Credit Facility is unsecured and amounts payable under it will rank pari passu with all other unsecured, unsubordinated indebtedness of Howmet. Borrowings under the Credit Facility may be denominated in U.S. dollars or euros. Loans will bear interest at a base rate or a rate equal to LIBOR, plus, in each case, an applicable margin based on the credit ratings of Howmet’s outstanding senior unsecured long-term debt. The applicable margin during the covenant relief period on base rate loans and LIBOR loans will be 1.20 % and 2.20 % per annum, respectively, through June 30, 2021; and 0.95 % and 1.95 % per annum, respectively, for the period from June 30, 2021 through December 31,2021, based on Howmet’s current long-term debt ratings. The applicable margin in 2022 and thereafter on base rate loans and LIBOR loans will be 0.70 % and 1.70 % per annum, respectively, based on Howmet’s current long-term debt ratings. The applicable margin during and after the covenant relief period is subject to change based on the Company’s long-term debt ratings. Loans may be prepaid without premium or penalty, subject to customary breakage costs. +The obligation of Howmet to pay amounts outstanding under the Credit Facility may be accelerated upon the occurrence of an “Event of Default” as defined in the Credit Agreement. Such Events of Default include, among others, (a) non-payment of obligations; (b) breach of any representation or warranty in any material respect; (c) non-performance of covenants and obligations; (d) with respect to other indebtedness in a principal amount in excess of $ 100 , a default thereunder that causes such +93 +Table of Contents +indebtedness to become due prior to its stated maturity or a default in the payment at maturity of any principal of such indebtedness; (e) the bankruptcy or insolvency of Howmet; and (f) a change in control of Howmet. +There were no amounts outstanding at December 31, 2020 and 2019, and no amounts were borrowed during 2020, 2019, or 2018 under the Credit Agreement. +In addition to the Credit Agreement, the Company had several other credit agreements that provided a borrowing capacity of $ 640 as of December 31, 2019, and all of which expired in 2020. The purpose of any borrowings under these credit arrangements was to provide for working capital requirements and for other general corporate purposes. The covenants contained in these arrangements were the same as the Credit Agreement. In 2020, nothing was borrowed or repaid under these arrangements. In 2019 and 2018, Howmet borrowed and repaid $ 400 and $ 600 , respectively, under the respective credit arrangements. The weighted-average interest rate and weighted-average days outstanding of the respective borrowings during 2019 and 2018 were 3.7 %, and 3.3 %, respectively, and 49 days and 46 days, respectively. +Short-Term Debt. At December 31, 2020 and 2019, short-term debt was $ 14 and $ 31 , respectively, substantially all of which related to accounts payable settlement arrangements with certain vendors and third-party intermediaries. These arrangements provide that, at the vendor’s request, the third-party intermediary advances the amount of the scheduled payment to the vendor, less an appropriate discount, before the scheduled payment date, and Howmet makes payment to the third-party intermediary on the date stipulated in accordance with the commercial terms negotiated with its vendors. Howmet records imputed interest related to these arrangements in Interest expense on the accompanying Statement of Consolidated Operations. +Commercial Paper. Howmet had no outstanding commercial paper at December 31, 2020 and 2019. In 2020 and 2019, Howmet did not issue commercial paper. In 2018, the average outstanding commercial paper was $ 49 . Commercial paper matured at various times in 2018 and had an annual weighted average interest rate of 2.5 % during 2018. +S. Other Financial Instruments +Fair Value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (i) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (ii) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below: +• Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. +• Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means. +• Level 3 - Inputs that are both significant to the fair value measurement and unobservable. +The carrying values of Cash and cash equivalents, Restricted cash, Derivatives, Noncurrent receivables, and Short-term debt included in the Consolidated Balance Sheet approximate their fair value. The Company holds exchange-traded fixed income securities which are considered available-for-sale securities that are carried at fair value which is based on quoted market prices which are classified in Level 1 of the fair value hierarchy. The fair value of Long-term debt, less amounts due within one year was based on quoted market prices for public debt and on interest rates that are currently available to Howmet for issuance of debt with similar terms and maturities for non-public debt. The fair value amounts for all Long-term debt were classified in Level 2 of the fair value hierarchy. +2020 2019 +December 31, Carrying +value Fair +value Carrying +value Fair +value +Long-term debt, less amounts due within one year $ 4,699 $ 5,426 $ 4,906 $ 5,337 +Restricted cash was $ 1 , $ 55 (see Note U ), and $ 6 in 2020, 2019, and 2018, respectively, and was recorded in Prepaid expenses and other current assets on the Consolidated Balance Sheet. +94 +Table of Contents +T. Cash Flow Information +Cash paid for interest and income taxes for both continuing and discontinued operations was as follows: +2020 2019 2018 +Interest, net of amounts capitalized $ 401 $ 340 $ 391 +Income taxes, net of amounts refunded $ ( 33 ) $ 122 $ 74 +The Company incurred capital expenditures which remain unpaid at December 31, 2020, 2019 and 2018 of $ 50 , $ 133 and $ 188 respectively, which result in cash outflows for investing activities in subsequent periods. +U. Acquisitions and Divestitures +2020 Divestitures +On January 31, 2020, the Company reached an agreement to sell a small manufacturing plant within the Engineered Structures segment for $ 12 in cash and therefore was classified as held for sale. However, as the sale did not close, the Company changed the classification of the assets from held for sale to held for use and recorded these assets at their lower of carrying value (assuming no initial reclassification for held for sale was made) or fair value. The result was a $ 5 non-cash impairment in 2020 which was recorded in Restructuring and other charges in the Statement of Consolidated Operations. +2019 Divestitures +On May 31, 2019, the Company sold a small additive manufacturing facility within the Engineered Structures segment for $ 1 in cash, which resulted in a loss of $ 13 recorded in Restructuring and other charges in the Statement of Consolidated Operations in 2019. +On August 15, 2019, the Company sold inventories and properties, plants, and equipment related to a small energy business within the Engineered Structures segment for $ 13 in cash. The Company recognized a charge of $ 10 related to inventory impairment and recorded the charge in Cost of goods sold in the Statement of Consolidated Operations in 2019. +On December 1, 2019, the Company completed the sale of its forgings business in the United Kingdom (U.K.) for $ 64 in cash, which resulted in a loss on sale of $ 46 which was recorded in Restructuring and other charges in the Statement of Consolidated Operations in 2019. The Company settled certain post-closing adjustments which resulted in a $ 5 reduction in the purchase price and an additional loss of sale which was recorded in Restructuring and other charges in the Statement of Consolidated Operations in 2020. The sale remains subject to certain tax post-closing adjustments. Of the cash proceeds received, $ 53 was recorded as Restricted cash within Prepaid expenses and other current assets on the Consolidated Balance Sheet at December 31, 2019 as its use is subject to restriction by the U.K. pension authority until certain U.K. pension plan changes have been made and approved. The restriction on these proceeds was removed in the second quarter of 2020. The forgings business primarily produces steel, titanium, and nickel based forged components for aerospace, mining, and off-highway markets and its operating results and assets and liabilities were included in the Engine Products segment. This business generated third party sales of $ 116 , and $ 126 in 2019 and 2018, and had 540 employees at the time of divestiture. +2018 Divestitures +On December 31, 2018, as part of the Company’s then ongoing strategy and portfolio review, Howmet completed the sale of its forgings business in Hungary to Angstrom Automotive Group LLC for $ 2 , which resulted in a loss of $ 43 recorded in Restructuring and other charges in the Statement of Consolidated Operations in 2018. While owned by Howmet, the operating results and assets and liabilities of the business were included in the Engine Products segment. This business generated sales of $ 32 in 2018 and had 180 employees at the time of the divestiture. +V. Contingencies and Commitments +Contingencies +Environmental Matters. Howmet participates in environmental assessments and cleanups at more than 30 locations. These include owned or operating facilities and adjoining properties, previously owned or operating facilities and adjoining properties, and waste sites, including Superfund (Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA")) sites. +A liability is recorded for environmental remediation when a cleanup program becomes probable and the costs can be reasonably estimated. As assessments and cleanups proceed, the liability is adjusted based on progress made in determining the extent of remedial actions and related costs. The liability can change substantially due to factors such as the nature and extent of contamination, changes in remedial requirements, and technological changes, among others. +95 +Table of Contents +The Company's remediation reserve balance was $ 10 at December 31, 2020 and $ 8 at December 31, 2019 recorded in Other noncurrent liabilities and deferred credits in the Consolidated Balance Sheet (of which $ 5 and $ 3 , respectively, were classified as a current liability), and reflects the most probable costs to remediate identified environmental conditions for which costs can be reasonably estimated. Payments related to remediation expenses applied against the reserve were $ 2 in 2020 and $ 3 in 2019 and included expenditures currently mandated, as well as those not required by any regulatory authority or third party. +Included in annual operating expenses are the recurring costs of managing hazardous substances and environmental programs. These costs are estimated to be less than 1 % of Cost of goods sold. +The Company previously reported on a remediation project related to the Grasse River, which is adjacent to the Massena West, New York plant site that is now part of Arconic Corporation. Pursuant to the Separation and Distribution Agreement between the Company and Arconic Corporation, dated as of March 31, 2020, Arconic Corporation agreed to assume and indemnify the Company against potential liabilities associated with the Grasse River remediation project. Therefore, the Company will no longer report on the Grasse River matter unless and until some event in the future causes it to become material and reportable. +Tax. As pre viously reported, in July 2013, following a Spanish corporate income tax audit covering the 2006 through 2009 tax years, an assessment was received mainly disallowing certain interest deductions claimed by a Spanish consolidated tax group owned by the Company. The Company appealed this assessment to Spain's Central Tax Administrative Court, and subsequently to Spain's National Court, each of which was denied. +The Company then appealed the decision to the Supreme Court of Spain. In November 2020, the Supreme Court of Spain rendered a decision in favor of the taxpayer, removing the assessment in its entirety. The decision is final and cannot be further appealed. +As a result of the favorable decision, in the fourth quarter of 2020, the Company released an income tax reserve, including interest, of $ 64 (€ 54 ), which was recorded in Provision (benefit) for income taxes in the Consolidated Statement of Operations, that was previously established in the third quarter of 2018. In addition, the Company reversed a combined indemnification receivable of $ 53 (€ 45 ) for Alcoa Corporation's 49 % share and Arconic Corporation's 33.66 % share of the total reserve, which was recorded in Other expense (income), net in the Consolidated Statement of Operations, that were previously established pursuant to the October 31, 2016 and March 31, 2020 Tax Matters Agreements, respectively. As of the end of 2020, the Company no longer has a balance recorded for this matter. +Reynobond PE. Prior to the Arconic Inc. Separation Transaction on April 1, 2020, the Company was known as Arconic Inc. References to “Arconic Inc.” in this “Reynobond PE” section refer to Arconic Inc. only and do not include its subsidiaries, except as otherwise stated. +On June 13, 2017, the Grenfell Tower in London, U.K. caught fire resulting in fatalities, injuries and damage. A French subsidiary of Arconic Inc., Arconic Architectural Products SAS ("AAP SAS") (now a subsidiary of Arconic Corporation as a result of the Arconic Inc. Separation Transaction), supplied a product, Reynobond PE, to its customer, a cladding system fabricator, which used the product as one component of the overall cladding system on Grenfell Tower. The fabricator supplied its portion of the cladding system to the façade installer, who then completed and installed the system under the direction of the general contractor. Neither Arconic Inc. nor AAP SAS was involved in the design or installation of the system used at the Grenfell Tower, nor did it have a role in any other aspect of the building’s refurbishment or original design. Regulatory investigations into the overall Grenfell Tower matter are being conducted, including a criminal investigation by the London Metropolitan Police Service (the “Police”), a Public Inquiry by the British government and a consumer protection inquiry by a French public authority. The Public Inquiry was announced by the U.K. Prime Minister on June 15, 2017 and subsequently was authorized to examine the circumstances leading up to and surrounding the Grenfell Tower fire in order to make findings of fact and recommendations to the U.K. Government on matters such as the design, construction and modification of the building, the role of relevant public authorities and contractors, the implications of the fire for the adequacy and enforcement of relevant regulations, arrangements in place for handling emergencies and the handling of concerns from residents, among other things. Hearings for Phase 1 of the Public Inquiry began on May 21, 2018 and concluded on December 12, 2018. Phase 2 hearings of the Public Inquiry began in early 2020, following which a final report will be written and subsequently published. AAP SAS is participating as a Core Participant in the Public Inquiry and is also cooperating with the ongoing parallel investigation by the Police. Arconic Corporation does not sell and Arconic Inc. previously stopped selling the PE product for architectural use on buildings. Given the preliminary nature of these investigations and the uncertainty of potential future litigation, the Company cannot reasonably estimate at this time the likelihood of an unfavorable outcome or the possible loss or range of losses in the event of an unfavorable outcome. +Pursuant to the Separation and Distribution Agreement, dated as of March 31, 2020, Arconic Corporation agreed to indemnify the Company for certain liabilities and the Company agreed to indemnify Arconic Corporation for certain liabilities. As a result of the Arconic Inc. Separation Transaction, Arconic Corporation holds the building and construction systems businesses previously held by the Company and AAP SAS is a subsidiary of Arconic Corporation; accordingly, Arconic Corporation has +96 +Table of Contents +agreed to assume and indemnify the Company against potential liabilities associated with the June 13, 2017 fire at the Grenfell Tower in London, U.K., including the following legal proceedings in which Arconic Inc. and/or its then directors were named as parties: +United Kingdom Litigation. On December 23, 2020, claimant groups comprised of survivors and estates of decedents of the Grenfell Tower fire filed claims in the U.K. arising from that fire, against 23 defendants, including Howmet Aerospace Inc., AAP SAS, Arconic Corporation, the Royal Borough of Kensington and Chelsea, the Royal Borough of Kensington and Chelsea Tenant Management Organisation Ltd, the London Fire Commissioner, the UK Home Office, The Ministry of Housing, Communities and Local Government, Rydon Maintenance Ltd, Celotex Ltd, Saint-Gobain Construction Products UK Limited, Kingspan Insulation Limited, Kingspan Group PLC, Studio E Architects Ltd (in liquidation), Harley Facades Ltd, Harley Curtain Wall Limited (in liquidation), CEP Architectural Facades Ltd, Exova (U.K.) Ltd, CS Stokes & Associates Ltd, Artelia Projects UK Limited, Whirlpool UK Appliances Limited, Whirlpool Company Polska Sp.z.o.o. and Whirlpool Corporation. The Company has not yet been served with the claims and, therefore, currently does not have information regarding claimants’ substantive allegations or the relief that claimants seek. +Behrens et al. v. Arconic Inc. et al. On June 6, 2019, 247 plaintiffs comprised of survivors and estates of decedents of the Grenfell Tower fire filed a complaint against “Arconic Inc., Alcoa Inc. and Arconic Architectural Products, LLC” (collectively, for purposes of the description of such proceeding, the “Arconic Defendants”), as well as Saint-Gobain Corporation, d/b/a Celotex, and Whirlpool Corporation alleging claims under Pennsylvania state law for products liability and wrongful death related to the fire. In particular, the plaintiffs allege that the Arconic Defendants knowingly supplied a dangerous product ("Reynobond PE") for installation on the Grenfell Tower despite knowing that Reynobond PE was unfit for use above a certain height. Plaintiffs seek monetary damages exceeding $ 75,000 for each plaintiff. The case was removed to the United States District Court for the Eastern District of Pennsylvania. Defendants moved to dismiss the case on numerous grounds, including forum non conveniens. Defendant Saint-Gobain Corporation was subsequently voluntarily dismissed from the case. On September 16, 2020, the court issued an order granting the remaining defendants’ motion to dismiss on forum non conveniens grounds, subject to certain conditions, determining that the United Kingdom, and not the United States, is the appropriate place for plaintiffs to bring their case. Plaintiffs subsequently filed a motion for reconsideration, which the court denied on November 23, 2020. Plaintiffs are appealing the judgment; the Arconic Defendants are cross-appealing one of the conditions. +Howard v. Arconic Inc. et al. A purported class action complaint related to the Grenfell Tower fire was filed on August 11, 2017 in the United States District Court for the Western District of Pennsylvania against Arconic Inc. and Klaus Kleinfeld. A related purported class action complaint was filed in the United States District Court for the Western District of Pennsylvania on September 15, 2017, under the caption Sullivan v. Arconic Inc. et al ., against Arconic Inc., three former Arconic Inc. executives, several current and former directors, and certain banks. Howard and Sullivan were subsequently consolidated and the lead plaintiffs in the consolidated purported class action filed a consolidated amended complaint alleging violations of the federal securities laws and seeking, among other things, unspecified compensatory damages and an award of attorney and expert fees and expenses. After the court granted the defendants’ motion to dismiss in full, the lead plaintiffs filed a second amended complaint, and all defendants have moved to dismiss the second amended complaint. +Raul v. Albaugh, et al. On June 22, 2018, a derivative complaint was filed nominally on behalf of Arconic Inc. by a purported Arconic Inc. stockholder against the then members of Arconic Inc.’s Board of Directors and Klaus Kleinfeld and Ken Giacobbe, naming Arconic Inc. as a nominal defendant, in the United States District Court for the District of Delaware. The complaint raises similar allegations as the consolidated amended complaint and second amended complaint in Howard , as well as allegations that the defendants improperly authorized the sale of Reynobond PE for unsafe uses, and asserts claims under federal securities laws and Delaware state law. The case has been stayed until the final resolution of the Howard case, the Grenfell Tower Public Inquiry in London, and the investigation by the Police. +While there can be no assurances regarding the ultimate resolution of these matters, Arconic Corporation has agreed to assume and indemnify the Company against potential liabilities associated with them. +Stockholder Demands. Prior to the Arconic Inc. Separation Transaction, the Board of Directors also received letters, purportedly sent on behalf of stockholders, reciting allegations similar to those made in the federal court lawsuits and demanding that the Board authorize the Company to initiate litigation against members of management, the Board and others. The Board of Directors appointed a Special Litigation Committee of the Board to review, investigate, and make recommendations to the Board regarding the appropriate course of action with respect to these stockholder demand letters. On May 22, 2019, the Special Litigation Committee, following completion of its investigation into the claims demanded in the demand letters, recommended to the Board that it reject the demands to authorize commencement of litigation. On May 28, 2019, the Board adopted the Special Litigation Committee’s findings and recommendations and rejected the demands that it authorize commencement of actions to assert the claims set forth in the demand letters. +97 +Table of Contents +Lehman Brothers International (Europe) ("LBIE") Claim. On June 26, 2020, LBIE filed formal proceedings against two Firth Rixson entities ("Firth") in the High Court of Justice, Business and Property Courts of England and Wales. The proceedings relate to interest rate swap transactions that Firth entered into with LBIE in 2007 to 2008. In 2008, LBIE commenced insolvency proceedings, an event of default under the agreements, rendering LBIE unable to meet its obligations under the swaps and suspending Firth’s payment obligations. In the Court proceedings, LBIE seeks a declaration that Firth has a contractual obligation to pay the amounts owing to LBIE under the agreements. The parties filed position papers on July 24, 2020 and October 19, 2020 (LBIE) and September 21, 2020 (Firth). A virtual hearing in this matter occurred on January 13 and 14, 2021 in London. A decision is expected in three to six months. The resolution of this matter is not probable as of December 31, 2020. +Other. In addition to the matters discussed above, various other lawsuits, claims, and proceedings have been or may be instituted or asserted against the Company, including those pertaining to environmental, product liability, safety and health, employment, tax and antitrust matters. While the amounts claimed in these other matters may be substantial, the ultimate liability cannot currently be determined because of the considerable uncertainties that exist. Therefore, it is possible that the Company’s liquidity or results of operations in a period could be materially affected by one or more of these other matters. However, based on facts currently available, management believes that the disposition of these other matters that are pending or asserted will not have a material adverse effect, individually or in the aggregate, on the results of operations, financial position or cash flows of the Company. +Commitments +Purchase Obligations. Howmet has entered into purchase commitments for raw materials, energy and other goods and services, which total $ 210 in 2021, $ 31 in 2022, $ 10 in 2023, $ 8 in 2024, $ 0 in 2025, and $ 0 thereafter. +Operating Leases. See Note Q for the operating lease future minimum contractual obligations. +Guarantees. At December 31, 2020, Howmet had outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2021 and 2040 was $ 44 at December 31, 2020. +Pursuant to the Separation and Distribution Agreement between Howmet and Alcoa Corporation, Howmet was required to provide certain guarantees for Alcoa Corporation, which had a fair value of $ 12 and $ 9 at December 31, 2020 and 2019, respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. The Company was required to provide a guarantee up to an estimated present value amount of approximately $ 1,398 and $ 1,353 at December 31, 2020 and December 31, 2019, respectively. For this guarantee, subject to its provisions, the Company is secondarily liable in the event of a payment default by Alcoa Corporation. The Company currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote. +Letters of Credit. The Company has outstanding letters of credit, primarily related to workers’ compensation, environmental obligations and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2021, was $ 105 at December 31, 2020. +Pursuant to the Separation and Distribution Agreements between the Company and Arconic Corporation and between the Company and Alcoa Corporation, the Company is required to retain letters of credit of $ 53 that had previously been provided related to the Company, Arconic Corporation, and Alcoa Corporation workers’ compensation claims which occurred prior to the respective separation transactions of April 1, 2020 and November 1, 2016. Arconic Corporation and Alcoa Corporation workers’ compensation and letters of credit fees paid by the Company are being proportionally billed to and are being reimbursed by Arconic Corporation and Alcoa Corporation, respectively. Also, the Company was required to provide letters of credit for certain Arconic Corporation environmental obligations and, as a result, the Company has $ 29 of outstanding letters of credit relating to liabilities (which are included in the $ 105 in the above paragraph). $ 13 of these outstanding letters of credit are pending cancellation and will be deemed cancelled once returned by the beneficiary. Arconic Corporation has issued surety bonds to cover these environmental obligations. Arconic Corporation is being billed for these letter of credit fees paid by the Company and will reimburse the Company for any payments made under these letters of credit. +Surety Bonds. The Company has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire and automatically renew at various dates, primarily in 2021, was $ 43 at December 31, 2020. +Pursuant to the Separation and Distribution Agreements between the Company and Arconic Corporation and between the Company and Alcoa Corporation, the Company is required to provide surety bonds of $ 26 (which are included in the $ 43 in the above paragraph) that had previously been provided related to the Company, Arconic Corporation, and Alcoa Corporation workers’ compensation claims which occurred prior to the respective separation transactions of April 1, 2020 and November 1, +98 +Table of Contents +2016. Arconic Corporation and Alcoa Corporation workers’ compensation claims paid and surety bond fees paid by the Company are being proportionately billed to and are being reimbursed by Arconic Corporation and Alcoa Corporation. +W. Subsequent Events +Management evaluated all activity of Howmet and concluded that no subsequent events have occurred that would require recognition in the Consolidated Financial Statements or disclosure in the Notes to the Consolidated Financial Statements, except as noted below: +See Note R for the early redemption of debt. +99 +Table of Contents +Supplemental Financial Information (unaudited) +Quarterly Data +(in millions, except per-share amounts) +First +Second (2) +Third Fourth Year +2020 +Sales $ 1,634 $ 1,253 $ 1,134 $ 1,238 $ 5,259 +Income (loss) from continuing operations after income taxes $ 153 $ ( 84 ) $ 36 $ 106 $ 211 +Net income (loss) per share from continuing operations attributable to Howmet common shareholders (1) : +Net income (loss) from continuing operations - basic $ 0.35 $ ( 0.19 ) $ 0.08 $ 0.24 $ 0.48 +Net income (loss) from continuing operations - diluted $ 0.34 $ ( 0.19 ) $ 0.08 $ 0.24 $ 0.48 +2019 +Sales $ 1,752 $ 1,818 $ 1,794 $ 1,734 $ 7,098 +Income (loss) from continuing operations after income taxes $ 86 $ ( 136 ) $ 58 $ 118 $ 126 +Earnings (loss) per share attributable to Howmet common shareholders (1) : +Net income (loss) from continuing operations - basic $ 0.18 $ ( 0.31 ) $ 0.13 $ 0.27 $ 0.28 +Net income (loss) from continuing operations - diluted $ 0.18 $ ( 0.31 ) $ 0.13 $ 0.27 $ 0.27 +(1) Per share amounts are calculated independently for each period presented; therefore, the sum of the quarterly per share amounts may not equal the per share amounts for the year. +(2) In the second quarter of 2020, the Company recorded settlement accounting charges of $ 62 associated with its U.K. pension plan related to the Arconic Inc. Separation Transaction and premium paid on early redemption of debt of $ 59 . In the second quarter of 2019, the Company recorded an impairment charge of $ 428 related to its Disks business (see Note O ). +100 +Table of Contents +Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. +None. +Item 9A. Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures +Howmet’s co-Chief Executive Officers and Chief Financial Officer have evaluated the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as of the end of the period covered by this report, and they have concluded that these controls and procedures are effective. +(b) Management’s Annual Report on Internal Control over Financial Reporting +Management’s Report on Internal Control over Financial Reporting is included in Part II, Item 8 of this Form 10-K beginning on page 46 . +(c) Attestation Report of the Registered Public Accounting Firm +The effectiveness of Howmet’s internal control over financial reporting as of December 31, 2020 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included in Part II, Item 8 of this Form 10-K on page 47 . +(d) Changes in Internal Control over Financial Reporting +There have been no changes in internal control over financial reporting during the fourth quarter of 2020, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +Item 9B. Other Information. +None. +PART III +Item 10. Directors, Executive Officers and Corporate Governance. +The information required by Item 401 of Regulation S-K regarding directors is contained under the caption “Item 1 Election of Directors” of the Proxy Statement and is incorporated by reference. The information required by Item 401 of Regulation S-K regarding executive officers is set forth in Part I, Item 1 of this report under “Executive Officers of the Registrant.” +The information required by Item 405 of Regulation S-K is contained under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement and is incorporated by reference. +The Company’s Code of Ethics for the CEO, CFO and Other Financial Professionals is publicly available on the Company’s Internet website at www.howmet.com under the section “Investors—Corporate Governance—Governance and Policies.” The remaining information required by Item 406 of Regulation S-K is contained under the captions “Corporate Governance” and “Corporate Governance—Business Conduct Policies and Code of Ethics” of the Proxy Statement and is incorporated by reference. +The information required by Items 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is included under the captions “Item 1 Election of Directors—Nominating Board Candidates—Procedures and Director Qualifications” and “Corporate Governance—Committees of the Board—Audit Committee” of the Proxy Statement and is incorporated by reference. +Item 11. Executive Compensation. +The information required by Item 402 of Regulation S-K is contained under the captions “Director Compensation”, “Executive Compensation” and “Corporate Governance—Recovery of Incentive Compensation” of the Proxy Statement. Such information is incorporated by reference. +The information required by Items 407(e)(4) and (e)(5) of Regulation S-K is contained under the captions “Corporate Governance—Compensation Committee Interlocks and Insider Participation” and “Item 3 Advisory Approval of Executive Compensation—Compensation Committee Report” of the Proxy Statement. Such information (other than the Compensation Committee Report, which shall not be deemed to be “filed”) is incorporated by reference. +101 +Table of Contents +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The following table gives information about Howmet’s common stock that could be issued under the Company’s equity compensation plans as of December 31, 2020. +Equity Compensation Plan Information +Plan Category +Number of securities to +be issued upon exercise of +outstanding options, warrants and rights +Weighted-average +exercise price of +outstanding options, warrants and rights +Number of securities remaining available for future issuance under +equity compensation +plans (excluding +securities reflected in column (a)) +(a) +(b) +(c) +Equity compensation plans approved by security holders (1) +11,706,858 (1) +$24.47 +26,517,097 (2) +Equity compensation plans not approved by security holders +— — — +Total +11,706,858 +$24.47 +26,517,097 (2) +(1) Includes the 2013 Howmet Aerospace Stock Incentive Plan, as Amended and Restated (approved by shareholders in May 2019, May 2018, May 2016 and May 2013) (the “2013 Plan”) and 2009 Alcoa Stock Incentive Plan (approved by shareholders in May 2009). Also includes 5,273 stock options resulting from the merger conversion of RTI Metals employee equity. Table amounts are comprised of the following: +• 3,191,692 stock options +• 5,173,704 restricted share units +• 3,341,462 performance share awards (2,887,515 granted in 2020 at target) +(2) The 2013 Plan authorizes, in addition to stock options, other types of stock-based awards in the form of stock appreciation rights, restricted shares, restricted share units, performance awards and other awards. The shares that remain available for issuance under the 2013 Plan may be issued in connection with any one of these awards. Up to 66,666,667 shares may be issued under the plan. Any award other than an option or a stock appreciation right shall count as 2.33 shares. Options and stock appreciation rights shall be counted as one share for each option or stock appreciation right. In addition, the 2013 Plan provides the following are available to grant under the 2013 Plan: (i) shares that are issued under the 2013 Plan, which are subsequently forfeited, cancelled or expire in accordance with the terms of the award and (ii) shares that had previously been issued under prior plans that are outstanding as of the date of the 2013 Plan which are subsequently forfeited, cancelled or expire in accordance with the terms of the award. +The information required by Item 403 of Regulation S-K is contained under the captions “Howmet Aerospace Stock Ownership—Stock Ownership of Certain Beneficial Owners” and “Howmet Aerospace Stock Ownership—Stock Ownership of Directors and Executive Officers” of the Proxy Statement and is incorporated by reference. +Item 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by Item 404 of Regulation S-K is contained under the captions “Executive Compensation” (excluding the information under the caption “Compensation Committee Report”) and “Corporate Governance— Related Person Transactions” of the Proxy Statement and is incorporated by reference. +The information required by Item 407(a) of Regulation S-K regarding director independence is contained under the captions “Item 1 Election of Directors” and “Corporate Governance” of the Proxy Statement and is incorporated by reference. +Item 14. Principal Accounting Fees and Services. +The information required by Item 9(e) of Schedule 14A is contained under the captions “Item 2 Ratification of Appointment of Independent Registered Public Accounting Firm—Report of the Audit Committee” and “Item 2 Ratification of Appointment of Independent Registered Public Accounting Firm— Audit and Non-Audit Fees” of the Proxy Statement and in its Attachment A (Pre-Approval Policies and Procedures for Audit and Non-Audit Services) thereto and is incorporated by reference. +102 +Table of Contents +PART IV +Item 15. Exhibits, Financial Statement Schedules. +(a) The consolidated financial statements and exhibits listed below are filed as part of this report. +(1) The Company’s consolidated financial statements, the notes thereto and the report of the Independent Registered Public Accounting Firm are on pages 47 through 100 of this report. +(2) Financial statement schedules have been omitted because they are not applicable, not required, or the required information is included in the consolidated financial statements or notes thereto. +(3) Exhibits. +Exhibit +Number +Description* +2(a) +Separation and Distribution Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(b) +Tax Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(c) +Employee Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(c)(1) +Amendment No. 1, dated December 13, 2016, to Employee Matters Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2(e)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +2(d) +Alcoa Corporation to Arconic Inc. Patent, Know-How, and Trade Secret License Agreement, dated as of October 31, 2016, by and between Alcoa USA Corp. and Arconic Inc., incorporated by reference to exhibit 2.5 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(e) +Arconic Inc. to Alcoa Corporation Patent, Know-How, and Trade Secret License Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa USA Corp., incorporated by reference to exhibit 2.6 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(f) +Amended and Restated Alcoa Corporation to Arconic Inc. Trademark License Agreement, dated as of June 25, 2017, by and between Alcoa USA Corp. and Arconic Inc., incorporated by reference to exhibit 2 to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2017. +2(g) Reserved. +2(h) +Massena Lease and Operations Agreement, dated as of October 31, 2016, by and between Arconic Inc. and Alcoa Corporation, incorporated by reference to exhibit 2.10 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated November 4, 2016. +2(i) +Agreement and Plan of Merger, dated October 12, 2017, by and between Arconic Inc., a Pennsylvania corporation, and Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 2.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +2(j) +Separation and Distribution Agreement, dated as of March 31, 2020, by and between Arconic Inc. and Arconic Rolled Products Corporation, incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(k) +Tax Matters Agreement, dated as of March 31, 2020, by and between Arconic Inc. and Arconic Rolled Products Corporation, incorporated by reference to Exhibit 2.2 to the Company's Current Report on Form 8-K filed on April 6, 2020. +103 +Table of Contents +2(l) +Employee Matters Agreement, dated as of March 31, 2020, by and between Arconic Inc. and Arconic Rolled Products Corporation, incorporated by reference to Exhibit 2.3 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(l)(1) +First Amendment to Employee Matters Agreement, dated as of April 10, 2020, by and between Howmet Aerospace Inc. and Arconic Corporation, incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on April 13, 2020. +2(m) +Patent, Know-How, and Trade Secret License Agreement, dated as of March 31, 2020, by and between Arconic Inc. and Arconic Rolled Products Corporation, incorporated by reference to Exhibit 2.4 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(n) +Patent, Know-How, and Trade Secret License Agreement, dated as of March 31, 2020, by and between Arconic Rolled Products Corporation and Arconic Inc. , incorporated by reference to Exhibit 2.5 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(o) +Trademark License Agreement, dated as of March 31, 2020, by and between Arconic Rolled Products Corporation and Arconic Inc. , incorporated by reference to Exhibit 2.6 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(p) +Trademark License Agreement, dated as of March 31, 2020, by and between Arconic Inc. and Arconic Rolled Products Corporation, incorporated by reference to Exhibit 2.7 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(q) +Master Agreement for Product Supply, dated as of March 31, 2020, by and between Arconic Massena LLC, Arconic Lafayette LLC, Arconic Davenport LLC and Arconic Inc., incorporated by reference to Exhibit 2.8 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(r) +Second Supplemental Tax and Project Certificate and Agreement, dated as of March 31, 2020, by and among Arconic Inc., Arconic Davenport LLC and Arconic Rolled Products Corporation, incorporated by reference to Exhibit 2.9 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(s) +Lease and Property Management Agreement, dated as of March 31, 2020, by and between Arconic Inc. and Arconic Massena LLC, incorporated by reference to Exhibit 2.10 to the Company's Current Report on Form 8-K filed on April 6, 2020. +2(t) +Metal Supply & Tolling Agreement by and between Arconic-Köfém Mill Products Hungary Kft and Arconic-Köfém Kft, dated January 1, 2020. +3(a) +Certificate of Incorporation of Howmet Aerospace Inc., a Delaware corporation. +3(b) +Bylaws of Howmet Aerospace Inc., a Delaware corporation. +4(a) +Form of Certificate for Shares of Common Stock of Arconic Inc., a Delaware corporation, incorporated by reference to exhibit 4.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(b) Bylaws. See exhibit 3(b) above. +4(c) Form of Indenture, dated as of September 30, 1993, between Alcoa Inc. and The Bank of New York Trust Company, N.A., as successor to J. P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association), as successor Trustee to PNC Bank, National Association, as Trustee (undated form of Indenture incorporated by reference to exhibit 4(a) to Registration Statement No. 33-49997 on Form S-3). +4(c)(1) +First Supplemental Indenture, dated as of January 25, 2007, between Alcoa Inc. and The Bank of New York Trust Company, N.A., as successor to J.P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association), as successor Trustee to PNC Bank, National Association, as Trustee, incorporated by reference to exhibit 99.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2007. +104 +Table of Contents +4(c)(2) +Second Supplemental Indenture, dated as of July 15, 2008, between Alcoa Inc. and The Bank of New York Mellon Trust Company, N.A., as successor in interest to J. P. Morgan Trust Company, National Association (formerly Chase Manhattan Trust Company, National Association, as successor to PNC Bank, National Association), as Trustee, incorporated by reference to exhibit 4(c) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 15, 2008. +4(c)(3) +Fourth Supplemental Indenture, dated as of December 31, 2017, between Arconic Inc., a Pennsylvania corporation, Arconic Inc., a Delaware corporation, and The Bank of New York Mellon Trust Company, N.A., as trustee, incorporated by reference to exhibit 4.3 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +4(c)(4) +Fifth Supplemental Indenture, dated as of April 16, 2020, between Howmet Aerospace Inc., a Delaware corporation, and The Bank of New York Mellon Trust Company, N.A., as trustee, incorporated by reference to exhibit 4(e) to the Company’s Registration Statement on Form S-3 (Registration Statement No. 333-237705) dated April 16, 2020. +4(c)(5) +Sixth Supplemental Indenture, dated as of May 6, 2020 between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee, incorporated by reference to exhibit 4.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 6, 2020. +4(d) +Form of 6.75% Bonds Due 2028, incorporated by reference to exhibit 4(d) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +4(e) +Form of 5.90% Notes Due 2027, incorporated by reference to exhibit 4(e) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +4(f) +Form of 5.95% Notes Due 2037, incorporated by reference to exhibit 4(f) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2008. +4(g) +Form of 5.87% Notes Due 2022, incorporated by reference to exhibit 4.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 21, 2007. +4(h) +Form of 5.40% Notes Due 2021, incorporated by reference to exhibit 4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated April 21, 2011. +4(i) +Form of 5.125% Notes Due 2024, incorporated by reference to exhibit 4.5 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 22, 2014. +4(j) +Form of 6.875% Notes due 2025, incorporated by reference to exhibit 4.6 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated April 24, 2020. +4(k) +Howmet Aerospace Hourly Retirement Savings Plan (formerly known as the Arconic Bargaining Retirement Savings Plan and, prior to that, the Alcoa Retirement Savings Plan for Bargaining Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(l) +Howmet Aerospace Salaried Retirement Savings Plan (formerly known as the Arconic Salaried Retirement Savings Plan and, prior to that, the Alcoa Retirement Savings Plan for Salaried Employees), as Amended and Restated effective January 1, 2015, incorporated by reference to exhibit 4(s) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2015. +4(m) +Howmet Aerospace Niles Bargaining Retirement Savings Plan (formerly known as the Arconic Retirement Savings Plan for ATEP Bargaining Employees), effective January 1, 2017, incorporated by reference to exhibit 4 to Post-Effective Amendment, dated December 30, 2016, to Registration Statement No. 333-32516 on Form S-8. +4(p) +Description of Arconic Inc.'s Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934, incorporated by reference to exhibit 4(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2019. +10(a) +Five-Year Revolving Credit Agreement, dated as of July 25, 2014, among Alcoa Inc., the Lenders and Issuers named therein, Citibank, N.A., as Administrative Agent for the Lenders and Issuers, and JPMorgan Chase Bank, N.A., as Syndication Agent, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 31, 2014. +105 +Table of Contents +10(a)(1) +Extension Request and Amendment Letter, dated as of June 5, 2015, among Alcoa Inc., each lender and issuer party thereto, and Citibank, N.A., as Administrative Agent, effective July 7, 2015, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 13, 2015. +10(a)(2) +Amendment No. 1, dated September 16, 2016, to the Five-Year Revolving Credit Agreement dated as of July 25, 2014, among Arconic Inc., the lenders and issuers named therein, Citibank, N.A., as administrative agent, and JPMorgan Chase Bank, N.A. as syndication agent, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 19, 2016. +10(a)(3) +Assumption Agreement, dated as of December 31, 2017, by Arconic Inc., a Delaware corporation, in favor of and for the benefit of the Lenders and Citibank, N.A., as administrative agent, incorporated by reference to exhibit 4.4 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 4, 2018. +10(a)(4) +Amendment No. 2, dated as of June 29, 2018, to the Company’s Five-Year Revolving Credit Agreement dated as of July 25, 2014, by and among the Company, a syndicate of lenders and issuers named therein, Citibank, N.A., as administrative agent for the lenders and issuers, and JPMorgan Chase Bank, N.A., as syndication agent, incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated July 2, 2018. +10(a)( 5) +Amendment No. 3, dated as of March 4, 2020, to the Company’s Five-Year Revolving Credit Agreement dated as of July 25, 2014, among the Company, the lenders and issuers named therein, Citibank, N.A., as administrative agent, JPMorgan Chase Bank, N.A., as syndication agent, and Goldman Sachs Bank USA, as documentation agent, incorporated by reference to Exhibit 10.1 to Amendment No. 1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated March 5, 2020. +10(a)(6) +Amendment No. 4, dated as of June 26, 2020, to the Company’s Five-Year Revolving Credit Agreement dated as of July 25, 2014, among the Company, the lenders and issuers named therein, Citibank, N.A., as administrative agent, and JPMorgan Chase Bank, N.A., as syndication agent. +10(b) +Plea Agreement dated January 8, 2014, between the United States of America and Alcoa World Alumina LLC, incorporated by reference to exhibit 10(l) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2013. +10( c ) +Agreement, dated February 1, 2016, by and between Elliott Associates, L.P., Elliott International, L.P., Elliott International Capital Advisors Inc. and Alcoa Inc., incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 1, 2016. +10( d ) +Settlement Agreement, dated as of May 22, 2017, by and among Elliott Associates, L.P., Elliott International, L.P., Elliott International Capital Advisors Inc. and Arconic Inc., incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 22, 2017 (reporting an event on May 21, 2017). +10( e ) +Letter Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of December 19, 2017, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 19, 2017. +10( f ) +Registration Rights Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of December 19, 2017, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 19, 2017. +10( f )(1) +Amendment to Registration Rights Agreement, by and among Arconic Inc. and Elliott Associates, L.P., Elliott International, L.P. and Elliott International Capital Advisors Inc., dated as of February 2, 2018, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 6, 2018. +10( g ) +Howmet Aerospace Inc. 2020 Annual Cash Incentive Plan (formerly known as the Arconic Inc. 2020 Annual Cash Incentive Plan), incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated December 10, 2019 . +10( h ) +Howmet Aerospace Excess Benefits Plan C (formerly known as the Arconic Employees’ Excess Benefits Plan C), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(j) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +106 +Table of Contents +10( h )(1) +First Amendment to Howmet Aerospace Excess Benefits Plan C (formerly known as the Arconic Employees’ Excess Benefits Plan C), effective January 1, 2018, incorporated by reference to exhibit 10(l)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( h )(2) +Second Amendment to Howmet Aerospace Excess Benefits Plan C (formerly known as the Arconic Employees’ Excess Benefits Plan C), effective January 1, 2018, incorporated by reference to exhibit 10(l)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( h )(3) +Third Amendment to Howmet Aerospace Excess Benefits Plan C (formerly known as the Arconic Employees’ Excess Benefits Plan C), effective March 31, 2018. incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 8, 2018. +10( i ) +Deferred Fee Plan for Directors, as amended effective July 9, 1999, incorporated by reference to exhibit 10(g)(1) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 1999. +10(j) +Amended and Restated Deferred Fee Plan for Directors, effective April 1, 2020, incorporated by reference to exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2020. +10(k) +Non-Employee Director Compensation Policy, effective April 1, 2020, incorporated by reference to exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2020. +10(l) Fee Continuation Plan for Non-Employee Directors, incorporated by reference to exhibit 10(k) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1989. +10( l )(1) +Amendment to Fee Continuation Plan for Non-Employee Directors, effective November 10, 1995, incorporated by reference to exhibit 10(i)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1995. +10( l )(2) +Second Amendment to the Fee Continuation Plan for Non-Employee Directors, effective September 15, 2006, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated September 20, 2006. +10( m ) +Howmet Aerospace Deferred Compensation Plan (formerly known as the Arconic Deferred Compensation Plan), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(p) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10( m )(1) +First Amendment to the Howmet Aerospace Deferred Compensation Plan (formerly known as the Arconic Deferred Compensation Plan), effective January 1, 2018, incorporated by reference to exhibit 10(r)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10(n) Summary of the Executive Split Dollar Life Insurance Plan, dated November 1990, incorporated by reference to exhibit 10(m) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1990. +10( o ) +Amended and Restated Dividend Equivalent Compensation Plan, effective January 1, 1997, incorporated by reference to exhibit 10(h) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2004. +10(p) Form of Indemnity Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10(j) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 1987.) +10( q ) +Form of Indemnification Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10.1 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated January 25, 2018. +107 +Table of Contents +10( r ) +Amended and Restated 2009 Alcoa Stock Incentive Plan, dated February 15, 2011, incorporated by reference to exhibit 10(z)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2010. +10( s ) +Howmet Aerospace Supplemental Pension Plan for Senior Executives (formerly known as the Arconic Supplemental Pension Plan for Senior Executives), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(v) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10( s )(1) +First Amendment to Howmet Aerospace Supplemental Pension Plan for Senior Executives (formerly known as the Arconic Supplemental Pension Plan for Senior Executives), effective January 1, 2018, incorporated by reference to exhibit 10(x)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( s )(2) +Second Amendment to Howmet Aerospace Supplemental Pension Plan for Senior Executives (formerly known as the Arconic Supplemental Pension Plan for Senior Executives), effective January 1, 2018, incorporated by reference to exhibit 10(x)(2) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( t ) +Deferred Fee Estate Enhancement Plan for Directors, effective July 10, 1998, incorporated by reference to exhibit 10(r) to the Company’s Annual Report on Form 10-K (Commission file number 1- 3610) for the year ended December 31, 1998. +10 (u) +Howmet Aerospace Inc. Change in Control Severance Plan, as Amended and Restated, effective September 30, 2020, incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +10(v) +Howmet Aerospace Inc. Executive Severance Plan, as Amended and Restated, effective September 30, 2020 incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +10( w ) +Letter Agreement, by and between Alcoa Inc. and Katherine H. Ramundo, dated as of July 28, 2016, incorporated by reference to exhibit 10(ff) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( x ) +Letter Agreement, from Arconic Inc. to Ken Giacobbe, dated as of February 14, 2019, incorporated by reference to exhibit 10(hh) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2018. +10( y ) +Letter Agreement, by and between Arconic Inc. and John C. Plant, dated as of February 6, 2019, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10 ( z ) +Letter Agreement, by and between Arconic Inc. and John C. Plant, dated as of August 1, 2019, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated August 2, 2019. +10( aa ) +Letter Agreement, by and between Arconic Inc. and John C. Plant, dated as of February 24, 2020, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated February 25, 2020. +10(bb) +Letter Agreement between Howmet Aerospace Inc. and John C. Plant, dated as of June 9, 2020, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on June 12, 2020. +10( cc ) +Letter Agreement, by and between Arconic Inc. and Elmer L. Doty, dated as of February 6, 2019, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10( dd ) +Letter Agreement, by and between Arconic Inc. and Neil E. Marchuk, dated as of February 13, 2019, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10( ee ) +Letter Agreement between Arconic Inc. and Tolga Oal, dated as of February 24, 2020, incorporated by reference to exhibit 10.2 to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated February 25, 2020. +108 +Table of Contents +10( ff ) +Howmet Aerospace Global Pension Plan (formerly known as the Arconic Global Pension Plan), as amended and restated effective August 1, 2016, incorporated by reference to exhibit 10(bb) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10( gg ) +Global Expatriate Employee Policy (pre-January 1, 2003), incorporated by reference to exhibit 10(uu) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2005. +10( hh ) +Howmet Aerospace Inc. Legal Fee Reimbursement Plan (formerly known as the Arconic Inc. Legal Fee Reimbursement Plan), effective as of April 30, 2018, incorporated by reference to exhibit 10(b) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2018. +10(ii) +2013 Howmet Aerospace Stock Incentive Plan, as Amended and Restated, effective September 30, 2020, incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +10( jj ) +Terms and Conditions (Australian Addendum) to the 2013 Howmet Aerospace Stock Incentive Plan, effective May 3, 2013, incorporated by reference to exhibit 10(d) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 8, 2013. +10( kk ) +RTI International Metals, Inc. 2004 Stock Plan, incorporated by reference to exhibit 4(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +10( ll ) +RTI International Metals, Inc. 2014 Stock and Incentive Plan, incorporated by reference to exhibit 4(a) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated July 23, 2015. +10( ll )(1) +First Amendment to the RTI International Metals, Inc. 2014 Stock and Incentive Plan, as amended and assumed by Arconic Inc., dated January 19, 2018, incorporated by reference to exhibit 10(oo)(1) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( mm ) +Terms and Conditions for Stock Options, effective January 1, 2011, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2011. +10( nn ) +Terms and Conditions for Stock Option Awards, effective May 3, 2013, incorporated by reference to exhibit 10(b) to the Company’s Current Report on Form 8-K (Commission file number 1-3610) dated May 8, 2013. +10( oo ) +Terms and Conditions for Stock Option Awards under the 2013 Howmet Aerospace Stock Incentive Plan, effective July 22, 2016, incorporated by reference to Exhibit 10(d) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10( pp ) +Global Stock Option Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(uu) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( qq ) +Form of Stock Option Award Agreement, incorporated by reference to exhibit 10(f) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10( rr ) +Terms and Conditions for Restricted Share Units, effective May 3, 2013, incorporated by reference to exhibit 10(c) to the Company’s Current Report on Form 8-K (Commission file number 1- 3610) dated May 8, 2013. +10( ss ) +Terms and Conditions for Restricted Share Units under the under the 2013 Howmet Aerospace Stock Incentive Plan, effective July 22, 2016, incorporated by reference to exhibit 10(c) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10( tt ) +Terms and Conditions for Restricted Share Units for Annual Director Awards under the 2013 Howmet Aerospace Stock Incentive Plan, effective November 30, 2016, incorporated by reference to exhibit 10(vv) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +109 +Table of Contents +10( uu ) +Terms and Conditions for Restricted Share Units for Annual Director Awards under the 2013 Howmet Aerospace Stock Incentive Plan, as Amended and Restated, effective December 5, 2017, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2018. +10( vv ) +Terms and Conditions for Deferred Fee Restricted Share Units for Director Awards under the 2013 Howmet Aerospace Stock Incentive Plan, effective November 30, 2016, incorporated by reference to exhibit 10(ww) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10( ww ) +Terms and Conditions for Restricted Share Units issued on or after January 13, 2017, under the 2013 Howmet Aerospace Stock Incentive Plan, effective January 13, 2017, incorporated by reference to exhibit 10(xx) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2016. +10( xx ) +Global Restricted Share Unit Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(eee) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( yy ) +Terms and Conditions for Restricted Share Units issued on or after January 19, 2018, under the 2013 Howmet Aerospace Stock Incentive Plan, effective January 19, 2018, incorporated by reference to exhibit 10(fff) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( zz ) +Form of Restricted Share Unit Award Agreement, incorporated by reference to exhibit 10(g) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10( aaa ) +Restricted Share Unit Award Agreement - Executive Vice President, Human Resources (Neil E. Marchuk) Annual Equity Award, effective March 15, 2019, incorporated by reference to exhibit 10(f) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10( bbb ) +Restricted Share Unit Award Agreement - Executive Vice President, Human Resources (Neil E. Marchuk) Sign-on Equity Award, effective March 15, 2019, incorporated by reference to exhibit 10(g) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended March 31, 2019. +10( ccc ) +Terms and Conditions for Special Retention Awards under the 2013 Howmet Aerospace Stock Incentive Plan, effective January 1, 2015, incorporated by reference to exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2015. +10( ddd ) +Terms and Conditions for Special Retention Awards under the 2013 Howmet Aerospace Stock Incentive Plan, effective July 22, 2016, incorporated by reference to exhibit 10(e) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2016. +10( eee ) +Global Special Retention Award Agreement, effective January 19, 2018, incorporated by reference to exhibit 10(kkk) to the Company’s Annual Report on Form 10-K (Commission file number 1-3610) for the year ended December 31, 2017. +10( fff ) +Special Retention Award Agreement - Paul Myron, effective May 16, 2018, incorporated by reference to exhibit 10(e) to the Company’s Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended June 30, 2018. +10(ggg) +Global Restricted Share Unit Award Agreement, effective September 30, 2020, incorporated by reference to Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +1 0(hhh) +Global Stock Option Award Agreement, effective September 30, 2020, incorporated by reference to Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +110 +Table of Contents +1 0(iii) +Global Special Retention Award Agreement, effective September 30, 2020, incorporated by reference to Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +1 0(jjj) +Terms and Conditions for Restricted Share Units, effective September 30, 2020, , incorporated by reference to Exhibit 10.7 to the Company's Quarterly Report on Form 10-Q (Commission file number 1-3610) for the quarter ended September 30, 2020. +21 +Subsidiaries of the Registrant. +23 +Consent of Independent Registered Public Accounting Firm. +24 +Power of Attorney for directors. +31 +Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +32 +Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101. INS Inline XBRL Instance Document. +101. SCH Inline XBRL Taxonomy Extension Schema Document. +101. CAL Inline XBRL Taxonomy Extension Calculation Linkbase Document. +101. DEF Inline XBRL Taxonomy Extension Definition Linkbase Document. +101. LAB Inline XBRL Taxonomy Extension Label Linkbase Document. +101. PRE Inline XBRL Taxonomy Extension Presentation Linkbase Document. +104 The cover page of this Annual Report on Form 10-K for the year ended December 31, 2020 (formatted in Inline XBRL and contained in Exhibit 101). +* Exhibit Nos. 10(g) through 10(jjj) are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K. +Amendments and modifications to other Exhibits previously filed have been omitted when in the opinion of the registrant such Exhibits as amended or modified are no longer material or, in certain instances, are no longer required to be filed as Exhibits. +No other instruments defining the rights of holders of long-term debt of the registrant or its subsidiaries have been filed as Exhibits because no such instruments met the threshold materiality requirements under Regulation S-K. The registrant agrees, however, to furnish a copy of any such instruments to the Commission upon request. +Item 16. Form 10-K Summary. +None. +111 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +HOWMET AEROSPACE INC. +February 16, 2021 By /s/ Paul Myron +Paul Myron +Vice President and Controller (Also signing as Principal Accounting Officer) +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature Title Date +/s/ John C. Plant February 16, 2021 +John C. Plant +Executive Chairman and Co-Chief Executive Officer (Co-Principal Executive Officer and Director) +/s/ Tolga Oal February 16, 2021 +Tolga Oal Co-Chief Executive Officer (Co-Principal Executive Officer and Director) +/s/ Ken Giacobbe February 16, 2021 +Ken Giacobbe Executive Vice President and Chief Financial Officer (Principal Financial Officer) +James F. Albaugh, Amy E. Alving, Joseph S. Cantie, Robert F. Leduc, David J. Miller, Jody G. Miller, Nicole W. Piasecki and Ulrich R. Schmidt, each as a Director, on February 16, 2021, by Paul Myron, their Attorney-in-Fact.* +*By /s/ Paul Myron +Paul Myron +Attorney-in-Fact +112 \ No newline at end of file diff --git a/raw/filings/0000004281/2020/0000004281-21-000049/filing_metadata.csv b/raw/filings/0000004281/2020/0000004281-21-000049/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..937bdcc23fcc19e3f4da2637abe7dbbc47f6502f --- /dev/null +++ b/raw/filings/0000004281/2020/0000004281-21-000049/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004281,HWM,Howmet Aerospace Inc.,2020,10-K,2021-02-16,2020-12-31,2021-02-16T21:44:06.000Z,0000004281-21-000049,arnc-20201231.htm,10-K,23165012,1,1,https://www.sec.gov/Archives/edgar/data/4281/000000428121000049/arnc-20201231.htm,https://www.sec.gov/Archives/edgar/data/4281/000000428121000049/ diff --git a/raw/filings/0000004281/2020/0000004281-21-000049/item1.txt b/raw/filings/0000004281/2020/0000004281-21-000049/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..cc7e350066628ebf61835269f218cee1de677d56 --- /dev/null +++ b/raw/filings/0000004281/2020/0000004281-21-000049/item1.txt @@ -0,0 +1,7 @@ +Item 1. Business. +General +Howmet Aerospace Inc. (formerly known as Arconic Inc.) is a Delaware corporation with its principal office in Pittsburgh, Pennsylvania and the successor to Arconic Pennsylvania (as defined below) which was formed in 1888 and formerly known as Alcoa Inc. In this report, unless the context otherwise requires, “Howmet”, the “Company”, “we”, “us” and “our” refer to Howmet Aerospace Inc., a Delaware corporation, and its consolidated subsidiaries. +The Company’s Internet address is http://www.howmet.com. Howmet makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission ("SEC"). The Company's website is included in this annual report on Form 10-K as an inactive textual reference only. The information on, or accessible through, the Company’s website is not a part of, or incorporated by reference in, this annual report on Form 10-K. The SEC maintains an Internet site that contains these reports at http://www.sec.gov. +Forward-Looking Statements +This report contains (and oral communications made by Howmet may contain) statements that relate to future events and expectations and, as such, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those containing such words as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “guidance,” “intends,” “may,” “outlook,” “plans,” “projects,” “seeks,” “sees,” “should,” “targets,” “will,” “would,” or other words of similar meaning. All statements that reflect Howmet’s expectations, assumptions or projections about the future, other than statements of historical fact, are forward-looking statements, including, without limitation, statements, forecasts and outlook relating to the condition of end markets; future financial results, operating performance, or estimated or expected future capital expenditures; future strategic actions; and Howmet's strategies, outlook, and business and financial prospects. These statements reflect beliefs and assumptions that are based on Howmet’s perception of historical trends, current conditions and expected future developments, as well as other factors Howmet believes are appropriate in the circumstances. Forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and changes in circumstances that are difficult to predict. Although Howmet believes that the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that these expectations will be attained and it is possible that actual results may differ materially from those indicated by these forward-looking statements due to a variety of risks and uncertainties. +For a discussion of some of the specific factors that may cause Howmet’s actual results to differ materially from those projected in any forward-looking statements, see the following sections of this report: Part I, \ No newline at end of file diff --git a/raw/filings/0000004281/2020/0000004281-21-000049/item13.txt b/raw/filings/0000004281/2020/0000004281-21-000049/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..dd08031812115920ca82219cb9101040ac6b044e --- /dev/null +++ b/raw/filings/0000004281/2020/0000004281-21-000049/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +102 \ No newline at end of file diff --git a/raw/filings/0000004457/2018/0000004457-18-000016/filing.txt b/raw/filings/0000004457/2018/0000004457-18-000016/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..bf584e0b5ebccf18e5e527029831e92df10b8446 --- /dev/null +++ b/raw/filings/0000004457/2018/0000004457-18-000016/filing.txt @@ -0,0 +1,7828 @@ +10-K +1 +March201810K.htm +MARCH 2018 10-K +United States Securities and exchange commission +Washington, D.C. 20549 +Form 10-K +(Mark One) +[X]Annual Report Pursuant to Section 13 or 15( d ) of the securities exchange act of 1934. +For the fiscal year ended March 31, 2018 +or +[ ]Transition report pursuant to section 13 or 15( d ) OF THE SECURITIES EXCHANGE ACT OF 1934. +For the transition period from __________________ to _________________ +Commission +File Number +Registrant, State of Incorporation Address and Telephone Number +I.R.S. Employer Identification No. +1-11255 +AMERCO +88-0106815 +(A Nevada Corporation) +5555 Kietzke Lane, Ste. 100 +Reno, Nevada 89511 +Telephone (775) 688-6300 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common stock, $0.25 par value +NASDAQ Global Select Market +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] No [ ] +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act. Yes [ ] No [X] +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] +Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ] +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer [X] Accelerated filer [ ] +Non-accelerated filer [ ] (Do not check if a smaller reporting company) Smaller reporting company [ ] +Emerging growth company [ ] +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] +The aggregate market value of AMERCO common stock held by non-affiliates on September 29, 2017 was $2,624,776,498. The aggregate market value was computed using the closing price for the common stock trading on NASDAQ on such date. Shares held by executive officers, directors and persons owning directly or indirectly more than 5% of the outstanding common stock have been excluded from the preceding number because such persons may be deemed to be affiliates of the registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +19,607,788 shares of AMERCO Common Stock, $0.25 par value, were outstanding at May 25, 2018. +Documents incorporated by reference: portions of AMERCO’s definitive proxy statement for the 2018 annual meeting of stockholders, to be filed within 120 days after AMERCO’s fiscal year ended March 31, 2018, are incorporated by reference into Part III of this report. +TABLE OF CONTENTS +Page +PART I +Item 1. +Business +1 +Item 1A. +Risk Factors +7 +Item 1B. +Unresolved Staff Comments +12 +Item 2. +Properties +12 +Item 3. +Legal Proceedings +12 +Item 4. +Mine Safety Disclosures +13 +PART II +Item 5. +Ma rket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +13 +Item 6. +Selected Financial Data +16 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +17 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +38 +Item 8. +F inancial Statements and Supplementary Data +39 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +39 +Item 9A. +Controls and Procedures +39 +Item 9B. +Other Information +42 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +42 +Item 11. +Executive Compensation +42 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +42 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +42 +Item 14. +Principal Accounting Fees and Services +42 +PART IV +Item 15. +Exhibits and Financial Statement Schedules +42 +Item 16. +Form 10-K Summary +49 +Part i +Item 1. Business +Company Overview +We are North America’s largest “do-it-yourself” moving and storage operator through our subsidiary U-Haul International, Inc. (“U-Haul”). U-Haul is synonymous with “do-it-yourself” moving and storage and is a leader in supplying products and services to help people move and store their household and commercial goods. Our primary service objective is to provide a better and better product or service to more and more people at a lower and lower cost. Unless the context otherwise requires, the terms “AMERCO,” “Company,” “we,” “us,” or “our” refer to AMERCO, a Nevada corporation, and all of its legal subsidiaries, on a consolidated basis. +We were founded in 1945 as a sole proprietorship under the name "U-Haul Trailer Rental Company" and have rented trailers ever since. Starting in 1959, we rented trucks on a one-way and in-town basis exclusively through independent U-Haul ® dealers. In 1974, we began developing our network of U-Haul ® managed retail stores, through which we rent our trucks and trailers, self-storage rooms and portable moving and storage units and sell moving and self-storage products and services to complement our independent dealer network. +We rent our distinctive orange and white U-Haul ® trucks and trailers as well as offer self-storage rooms through a network of 1,790 Company operated retail moving stores and approximately 20,000 independent U-Haul ® dealers. We also sell U-Haul ® brand boxes, tape and other moving and self-storage products and services to “do-it-yourself” moving and storage customers at all of our distribution outlets and through our uhaul.com ® and eMove ® websites. +We believe U-Haul ® is the most convenient supplier of products and services addressing the needs of the United States and Canada’s “do-it-yourself” moving and storage markets. Our broad geographic coverage throughout the United States and Canada and our extensive selection of U-Haul ® brand moving equipment rentals, self-storage rooms, portable moving and storage units and related moving and storage products and services provide our customers with convenient “one-stop” shopping. +Since 1945, U-Haul ® has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Through Repwest Insurance Company (“Repwest”) and ARCOA Risk Retention Group ("ARCOA"), our property and casualty insurance subsidiaries, we manage the property, liability and related insurance claims processing for U-Haul ® . Oxford Life Insurance Company (“Oxford”), our life insurance subsidiary, sells life insurance, Medicare supplement insurance, annuities and other related products to the senior market. +Available Information +AMERCO ® and U-Haul ® are each incorporated in Nevada. U-Haul’s internet address is uhaul.com. On AMERCO’s investor relations website, amerco.com, we post the following filings as soon as practicable after they are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”): our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, proxy statements related to meetings of our stockholders, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We also use our investor relations website as a means of disclosing material information and for complying with our disclosure obligations under Regulation FD. All such filings on our website are available free of charge. Additionally, you will find these materials on the SEC’s website at sec.gov. +1 +Products and Rental Equipment +Our customers are primarily “do-it-yourself” household movers. U-Haul ® moving equipment is specifically designed, engineered and manufactured for the “do-it-yourself” household mover. These “do-it-yourself” movers include individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and “do-it-yourself” home remodeling and gardening enthusiasts who need to transport materials. +As of March 31, 2018, our rental fleet consisted of approximately 161,000 trucks, 118,000 trailers and 42,000 towing devices. This equipment and our U-Haul brand of self-moving products and services are available through our network of managed retail moving stores and independent U-Haul dealers. Independent U-Haul dealers receive rental equipment from the Company, act as rental agents and are paid a commission based on gross revenues generated from their U-Haul ® rentals. +Our rental truck chassis are engineered by domestic truck manufacturers. These chassis are joined with the U-Haul ® designed and manufactured van boxes primarily at U-Haul ® operated manufacturing and assembly facilities strategically located throughout the United States. U-Haul ® rental trucks feature our proprietary Lowest Deck SM , which provides our customers with extra ease of loading. The loading ramps on our trucks are the widest in the industry, which reduce the effort needed to move belongings. Our trucks are fitted with convenient, padded rub rails with tie downs on every interior wall. Our Gentle Ride Suspension SM helps our customers safely move delicate and prized possessions. Also, the engineers at our U-Haul Technical Center determined that the softest ride in our trucks was at the front of the van box. Consequently, we designed the part of the van box that hangs over the front cab of the truck to be the location for our customers to place their most fragile items during their move. We call this area Mom’s Attic ® . +Our distinctive trailers are also manufactured at these same U-Haul ® operated manufacturing and assembly facilities. These trailers are well suited to the low profile of many of today’s newly manufactured automobiles. Our engineering staff is committed to making our trailers easy to tow, safe, aerodynamic and fuel efficient. +To provide our self-move customers with added value, our rental trucks and trailers are designed with fuel efficiency in mind. Many of our trucks are fitted with fuel economy gauges, another tool that assists our customers in conserving fuel. To help make our rental equipment more reliable, we routinely perform extensive preventive maintenance and repairs. +We also provide customers with equipment to transport their vehicles. We provide two towing options; auto transport, in which all four wheels are off the ground, and a tow dolly, in which the front wheels of the towed vehicle are off the ground. +To help our customers load their boxes and larger household appliances and furniture, we offer several accessory rental items. Our utility dolly has a lightweight design and is easy to maneuver. Another rental accessory is our four wheel dolly, which provides a large, flat surface for moving dressers, wall units, pianos and other large household items. U-Haul ® appliance dollies provide the leverage needed to move refrigerators, freezers, washers and dryers easily and safely. These utility, furniture and appliance dollies, along with the low decks and the wide loading ramps on U-Haul ® trucks and trailers, are designed for easy loading and unloading of our customers’ belongings. +The total package U-Haul ® offers to the “do-it-yourself” household mover doesn’t end with trucks, trailers and accessory rental items. Our moving supplies include a wide array of affordably priced U-Haul ® brand boxes, tape and packing materials. We also provide specialty boxes for dishes, computers and sensitive electronic equipment, as well as tape, security locks, and packing supplies. U-Haul ® brand boxes are specifically sized to make loading easier. +We estimate that U-Haul ® is North America’s largest seller and installer of hitches and towing systems. In addition to towing U-Haul ® equipment, these hitching and towing systems can tow jet skis, motorcycles, boats, campers and horse trailers. Each year, more than one million customers visit our locations for expertise on complete towing systems, trailer rentals and the latest in towing accessories. +2 +U-Haul ® has one of North America’s largest propane refilling networks, with over 1,100 locations providing this convenient service. We employ trained, certified personnel to refill propane cylinders and alternative fuel vehicles. Our network of propane dispensing locations is one of the largest automobile alternative refueling networks in North America. +Our self-storage business was a natural outgrowth of our self-moving operations. Conveniently located U-Haul ® self-storage rental facilities provide clean, dry and secure space for storage of household and commercial goods. Storage units range in size from 6 square feet to over 1,000 square feet. As of March 31, 2018, we operate 1,519 self-storage locations in the United States and Canada, with nearly 632,000 rentable storage rooms comprising 55.2 million square feet of rentable storage space. Our self-storage centers feature a wide array of security measures, ranging from electronic property access control gates to individually alarmed storage units. At many centers, we offer climate controlled storage rooms to protect temperature sensitive goods such as video tapes, albums, photographs and precious wood furniture. +Another extension of our strategy to make “do-it-yourself” moving and storage easier is our U-Box ® program. A U-Box ® portable moving and storage unit is delivered to a location of our customer’s choosing either by the customers themselves through the use of a U-Box ® trailer, with the assistance of a Moving Helper or by Company personnel. Once the U-Box ® portable moving and storage unit is filled, it can be stored at the customer’s location, or taken to one of our Company operated locations, a participating independent dealer, or moved to a location of the customer’s choice. +Additionally, we offer moving and storage protection packages such as Safemove ® and Safetow ® . These programs provide moving and towing customers with a damage waiver, cargo protection and medical and life insurance coverage. Safestor ® provides protection for storage customers from loss on their goods in storage. Safestor Mobile ® provides protection for customers stored belongings when using our U-Box ® portable moving and storage units. For our customers who desire additional coverage over and above the standard Safemove ® protection, we also offer our Safemove Plus ® product. This package provides the rental customer with a layer of primary liability protection. +We believe that through our website, uhaul.com, we have aggregated the largest network of customers and independent businesses in the self-moving and self-storage industry. In particular, our Moving Helper program connects “do-it-yourself” movers with thousands of independent service providers in the United States and Canada to assist our customers in packing, loading, unloading, cleaning and performing other services. +Through the U-Haul Storage Affiliates ® program, independent storage businesses can join one of the world’s largest self-storage reservation systems. Self-storage customers making a reservation through uhaul.com ® can access all of the U-Haul self-storage centers and all of our independent storage affiliate partners for even greater convenience to meet their self-storage needs. For the independent storage operator, our network gives them access to products and services allowing them to compete with larger operators more cost effectively. +We own numerous trademarks and service marks that contribute to the identity and recognition of our Company and its products and services. Certain of these marks are integral to the conduct of our business, a loss of any of which could have a material adverse affect on our business. We consider the trademark “U-Haul ® ” to be of material importance to our business in addition, but not limited to, the U.S. trademarks and service marks “AMERCO ® ”, “eMove ® ”, “Gentle Ride Suspension SM ”, “In-Town ® ”, “Lowest Decks SM ”, “Moving made Easier ® ”, “Make Moving Easier ® ”, “Mom’s Attic ® ”, “Moving Help ® ”, “Moving Helper ® ”, “Safemove ® ”, “Safemove Plus ® ”, “Safestor ® ”, “Safestor Mobile ® ”, “Safetow ® ”, “U-Box ® ”, “uhaul.com ® ”, “U-Haul Investors Club ® ”, “U-Haul Truck Share ® ”, “U-Haul Truck Share 24/7 ® “ “U-Note ® ”, “WebSelfStorage ® ”, among others, for use in connection with the moving and storage business. Additionally, applications to register the U-Haul Smart Mobility Center SM trademarks are pending in the U.S. Patent and Trademark Office. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO ® , U-Haul ® , and Amerco Real Estate Company +(“Real Estate”), and the subsidiaries of U-Haul ® and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +3 +Life Insurance, comprised of Oxford and its subsidiaries. +Financial information for each of our operating segments is included in the Notes to Consolidated Financial Statements as part of Item 8: Financial Statements and Supplementary Data of this Annual Report on Form 10-K. +Moving and Storage Operating Segment +Moving and Storage operating segment (“Moving and Storage”) consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +Net revenue from Moving and Storage was approximately 91.3%, 90.8% and 91.0% of consolidated net revenue in fiscal 2018, 2017 and 2016, respectively. +During fiscal 2018, we placed over 34,000 new trucks in service. These additions and replacements to the fleet were a combination of U-Haul ® manufactured vehicles and purchases. As new trucks are added to the fleet, we typically remove older trucks from the fleet. The total number of rental trucks in the fleet increased during fiscal 2018 as the pace of new additions was greater than those trucks removed for retirement and sale. +Within our truck and trailer rental operation, we are focused on expanding our independent dealer network to provide added convenience for our customers. U-Haul ® maximizes vehicle utilization by managing distribution of the truck and trailer fleets among the 1,790 Company operated stores and approximately 20,000 independent dealers. Utilizing its proprietary reservations management system, our centers and dealers electronically report their inventory in real-time, which facilitates matching equipment to customer demand. Approximately 55% of all U-Move ® rental revenue originates from our operated centers. +At our owned and operated retail stores we are implementing new initiatives to improve customer service. These initiatives include improving management of our rental equipment to provide our retail centers with the right type of rental equipment, at the right time and at the most convenient location for our customers, effectively marketing our broad line of self-moving related products and services, expanding accessibility to provide more convenience to our customers, and enhancing our ability to properly staff locations during our peak hours of operations by attracting and retaining “moonlighters” (part-time U-Haul ® employees with full-time jobs elsewhere) during our peak hours of operation. As of April 2017, U-Haul expanded it’s offering of U-Haul Truck Share 24/7 ® to our entire network in the United States and Canada. In May 2018, U-Haul received intellectual property protection of such system from the U.S. Trademark Office. +Our self-moving related products and services, such as boxes, pads and insurance, help our customers have a better moving experience and help them to protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +Our self-storage business operations consist of the rental of self-storage rooms, portable moving and storage units, sales of self-storage related products, the facilitation of sales of services, and the management of self-storage facilities owned by others. +U-Haul ® is one of the largest North American operators of self-storage and has been a leader in the self-storage industry since 1974. U-Haul ® operates nearly 632,000 rentable storage rooms, comprising 55.2 million square feet of rentable storage space with locations in 49 states and 10 Canadian provinces. U-Haul’s owned and managed self-storage facility locations range in size up to 309,000 square feet of storage space, with individual storage units in sizes ranging from 6 square feet to over 1,000 square feet. +The primary market for storage rooms is the storage of household goods. We believe that our self-storage services provide a competitive advantage through such things as Max Security, an electronic system that monitors the storage facility 24 hours a day, climate control in select units, individually alarmed rooms, extended hours access, and an internet-based customer reservation and account management system. +4 +Moving Help ® and U-Haul Storage Affiliates ® on uhaul.com are online marketplaces that connect consumers to independent Moving Help ® service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated Moving Help ® and affiliates provide pack and load help, cleaning help, self-storage and similar services all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Environmental laws and regulations are complex, change frequently and could become more stringent in the future. +Moving and Storage business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally our weakest. +Property and Casualty Insurance Operating Segment +Our Property and Casualty Insurance operating segment (“Property and Casualty Insurance”) provides loss adjusting and claims handling for U-Haul through regional offices across the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestore Mobile ® and Safestor ® protection packages to U-Haul customers. We attempt to price our products to be a good value to our customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. +Net revenue from Property and Casualty Insurance was approximately 2.0%, 2.0% and 2.0% of consolidated net revenue in fiscal 2018, 2017 and 2016, respectively. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Net revenue from Life Insurance was approximately 6.7%, 7.2% and 7.0% of consolidated net revenue in fiscal 2018, 2017 and 2016, respectively. +Employees +As of March 31, 2018, we employed over 29,000 people throughout the United States and Canada with approximately 98% of these employees working within Moving and Storage and approximately 55% of these employees working on a part-time basis. +Sales and Marketing +We promote U-Haul ® brand awareness through direct and co-marketing arrangements. Our direct marketing activities consist of web-based initiatives, print and social media as well as trade events, movie cameos of our rental fleet and boxes, and industry and consumer communications. We believe that our rental equipment is our best form of advertisement. We support our independent U-Haul ® dealers through marketing U-Haul ® moving and self-storage rentals, products and services. +Our marketing plan focuses on maintaining our leadership position in the “do-it-yourself” moving and storage industry by continually improving the ease of use and economy of our rental equipment, by providing added convenience to our retail centers, through independent U-Haul dealers, and by expanding the capabilities of our U-Haul websites. +A significant driver of U-Haul’s rental transaction volume is our utilization of an online reservation and sales system, through uhaul.com and our 24-hour 1-800-GO-U-HAUL telephone reservations system. These points of contact are prominently featured and are a major driver of customer lead sources. +5 +Competition +Moving and Storage Operating Segment +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. Generally speaking, we consider there to be two distinct users of rental trucks: commercial and “do-it-yourself” residential users. We primarily focus on the “do-it-yourself” residential user. Within this segment, we believe the principal competitive factors are convenience of rental locations, availability of quality rental moving equipment, breadth of essential products and services, and total cost to the user. Our major national competitors in both the in-town and one-way moving equipment rental market include Avis Budget Group, Inc. and Penske Truck Leasing. We have numerous competitors throughout the United States and Canada who compete with us in the in-town market. +The self-storage market is large and very fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Our largest competitors in the self-storage market are Public Storage Inc., Extra Space Storage, Inc., Cubesmart and Life Storage, Inc. +Insurance Operating Segments +The insurance industry is highly competitive. In addition, the marketplace includes financial services firms offering both insurance and financial products. Some of the insurance companies are owned by stockholders and others are owned by policyholders. Many competitors have been in business for a longer period of time or possess substantially greater financial resources and broader product portfolios than our insurance companies. We compete in the insurance business based upon price, product design, and services rendered to agents and policyholders. +Financial Data of Segment and Geographic Areas +For financial data of our segments and geographic areas please see Note 21, Financial Information by Geographic Area, and Note 21A, Consolidating Financial Information by Consolidating Industry Segment, of our Notes to Consolidated Financial Statements. +Cautionary Statement Regarding Forward-Looking Statements +This Annual Report on Form 10-K (“Annual Report”), contains “forward-looking statements” regarding future events and our future results of operations. We may make additional written or oral forward-looking statements from time to time in filings with the SEC or otherwise. We believe such forward-looking statements are within the meaning of the safe-harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Such statements may include, but are not limited to, estimates of capital expenditures, plans for future operations, products or services, financing needs and plans, our perceptions of our legal positions and anticipated outcomes of government investigations and pending litigation against us, liquidity, goals and strategies, plans for new business, storage occupancy, growth rate assumptions, pricing, costs, and access to capital and leasing markets the impact of our compliance with environmental laws and cleanup costs, our used vehicle disposition strategy, the sources and availability of funds for our rental equipment and self-storage expansion and replacement strategies and plans, our plan to expand our U-Haul storage affiliate program, that additional leverage can be supported by our operations and business, the availability of alternative vehicle manufacturers, our estimates of the residual values of our equipment fleet, our plans with respect to off-balance sheet arrangements, our plans to continue to invest in the U-Box ® program, the impact of interest rate and foreign currency exchange rate changes on our operations, the sufficiency of our capital resources and the sufficiency of capital of our insurance subsidiaries as well as assumptions relating to the foregoing. The words “believe,” “expect,” “anticipate,” “plan,” “may,” “will,” “could,” “estimate,” “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. +6 +Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Factors that could significantly affect results include, without limitation, the risk factors enumerated below under the heading “Risk Factors” and other factors described in this Annual Report or the other documents we file with the SEC. These factors, the following disclosures, as well as other statements in this Annual Report and in the Notes to Consolidated Financial Statements, could contribute to or cause such risks or uncertainties, or could cause our stock price to fluctuate dramatically. Consequently, the forward-looking statements should not be regarded as representations or warranties by us that such matters will be realized. We assume no obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by law. +Item 1A. Risk Factors +The following discussion of risk factors should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) and the Consolidated Financial Statements and related notes. These risk factors may be important in understanding this Annual Report or elsewhere. +We operate in a highly competitive industry. +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. We believe the principal competitive factors in this industry are convenience of rental locations, availability of quality rental moving equipment, breadth of essential services and products and total cost. Financial results for the Company can be adversely impacted by aggressive pricing from our competitors. Some of our competitors may have greater financial resources than we have. We cannot assure you that we will be able to maintain existing rental prices or implement price increases. Moreover, if our competitors reduce prices and we are not able or willing to do so as well, we may lose rental volume, which would likely have a materially adverse affect on our results of operations. Numerous potential competitors are working to establish paradigm shifting technologies from self driving vehicles to Uber-like offerings. +The self-storage industry is large and highly fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Competition in the market areas in which we operate is significant and affects the occupancy levels, rental rates and operating expenses of our facilities. Competition might cause us to experience a decrease in occupancy levels, limit our ability to raise rental rates or require us to offer discounted rates that would have a material affect on results of operations and financial condition. Entry into the self-storage business may be accomplished through the acquisition of existing facilities by persons or institutions with the required initial capital. Development of new self-storage facilities is more difficult however, due to land use, zoning, environmental and other regulatory requirements. The self-storage industry has in the past experienced overbuilding in response to perceived increases in demand. We cannot assure you that we will be able to successfully compete in existing markets or expand into new markets. +We are highly leveraged. +As of March 31, 2018, we had total debt outstanding of $3,538.7 million and total undiscounted operating and ground lease commitments of $165.9 million. Although we believe, based on existing information, that additional leverage can be supported by our operations and revenues, our existing debt could impact us in the following ways among other considerations: +require us to allocate a considerable portion of cash flows from operations to debt service and lease payments; +limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; +limit our ability to obtain additional financing; and +place us at a disadvantage compared to our competitors who may have less debt. +7 +Our ability to make payments on our debt and leases depends upon our ability to maintain and improve our operating performance and generate cash flow. To some extent, this is subject to prevailing economic and competitive conditions and to certain financial, business and other factors, some of which are beyond our control. If we are unable to generate sufficient cash flow from operations to service our debt and meet our other cash needs, including our leases, we may be forced to reduce or delay capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness and leases. If we must sell our assets, it may negatively affect our ability to generate revenue. In addition, we may incur additional debt or leases that would exacerbate the risks associated with our indebtedness. +Economic conditions, including those related to the credit markets, may adversely affect our industry, business and results of operations. +Consumer and commercial spending is generally affected by the health of the economy, which places some of the factors affecting the success of our business beyond our control. Our businesses, although not as traditionally cyclical as some, could experience significant downturns in connection with or in anticipation of, declines in general economic conditions. In times of declining consumer spending we may be driven, along with our competitors, to reduce pricing which would have a negative impact on gross profit. We cannot predict if another downturn in the economy will occur, which could result in reduced revenues and working capital. +Should credit markets in the United States tighten or if interest rates increase significantly, we may not be able to refinance existing debt or find additional financing on favorable terms, if at all. If one or more of the financial institutions that support our existing credit facilities fails, we may not be able to find a replacement, which would negatively impact our ability to borrow under credit facilities. If our operating results were to worsen significantly and our cash flows or capital resources prove inadequate, or if interest rates increase significantly, we could face liquidity problems that could materially and adversely affect our results of operations and financial condition. +Our fleet rotation program can be adversely affected by financial market conditions. +To meet the needs of our customers, U-Haul maintains a large fleet of rental equipment. Our rental truck fleet rotation program is funded internally through operations and externally from debt and lease financing. Our ability to fund our routine fleet rotation program could be adversely affected if financial market conditions limit the general availability of external financing. This could lead us to operate trucks longer than initially planned and/or reduce the size of the fleet, either of which could materially and negatively affect our results of operations. +Another important aspect of our fleet rotation program is the sale of used rental equipment. The sale of used equipment provides us with funds that can be used to purchase new equipment. Conditions may arise that could lead to the decrease in demand and/or resale values for our used equipment. This could have a material adverse effect on our financial results, which could result in substantial losses on the sale of equipment and decreases in cash flows from the sales of equipment. +We obtain our rental trucks from a limited number of manufacturers. +Over the last twenty years, we purchased the majority of our rental trucks from Ford Motor Company and General Motors Corporation. Our fleet can be negatively affected by issues our manufacturers may face within their own supply chain. Also, it is possible that our suppliers may face financial difficulties or organizational changes which could negatively impact their ability to accept future orders or fulfill existing orders. The cost of acquiring new rental trucks could increase materially and negatively affect our ability to rotate new equipment into the fleet. Although we believe that we could contract with alternative manufacturers for our rental trucks, we cannot guarantee or predict how long that would take. In addition, termination of our existing relationship with these suppliers could have a material adverse effect on our business, financial condition or results of operations for an indefinite period of time. +8 +We may not be able to effectively hedge against interest rate changes in our variable debt. +In certain instances, the Company seeks to manage its exposure to interest rate risk through the use of hedging instruments including interest rate swap agreements and forward swaps. We enter into these arrangements with counterparties that are significant financial institutions with whom we generally have other financial arrangements. We are exposed to credit risk should these counterparties not be able to perform on their obligations. Additionally, a failure on our part to effectively hedge against interest rate changes may adversely affect our financial condition and results of operations. We are required to record these financial instruments at their fair value. Changes in interest rates can significantly impact the valuation of the instruments resulting in non-cash changes to our financial position. +A substantial amount of our shares is owned by a small contingent of stockholders. +Willow Grove Holdings LP, directly and through controlled entities (“WGHLP”), owns 8,309,584 shares of AMERCO common stock, and together with Edward J. Shoen and Mark V. Shoen, owns 8,361,643 shares (approximately 42.6%) of AMERCO common stock. The general partner of WGHLP controls the voting and disposition decisions with respect to the common stock of AMERCO owned by WGHLP, and is managed by Edward J. Shoen (the Chairman of the Board of Directors and Chief Executive Officer of AMERCO) and his brother, Mark V. Shoen. Accordingly, Edward J. Shoen and Mark V. Shoen are in a position to significantly influence our business and policies, including the approval of certain significant transactions, the election of the members of our Board of Directors (the “Board”) and other matters submitted to our stockholders. There can be no assurance that their interests will not conflict with the interests of our other stockholders. +In addition, 1,143,609 shares (approximately 5.8%) of AMERCO common stock are owned under our Employee Stock Ownership Plan (“ESOP”). Each ESOP participant is entitled to vote the shares allocated to himself or herself in their discretion. In the event an ESOP participant does not vote his or her shares, such shares shall be voted by the ESOP trustee, in the ESOP trustee’s discretion. +Our quarterly results of operations fluctuate due to seasonality and other factors associated with our industry. +Our business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally weakest, due to a greater potential for adverse weather conditions and other factors that are not necessarily seasonal. As a result, our operating results for any given quarterly period are not necessarily indicative of operating results for an entire year. +Our operations subject us to numerous environmental regulations and the possibility that environmental liability in the future could adversely affect our operations. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Under environmental laws or common law principles, we can be held liable for hazardous substances that are found on real property we have owned or operated. We are aware of issues regarding hazardous substances on some of our real estate and we have put in place a remediation plan at each site where we believe such a plan is necessary. See Note 18, Contingencies, of the Notes to Consolidated Financial Statements. We regularly make capital and operating expenditures to stay in compliance with environmental laws. In particular, we have managed a testing and removal program since 1988 for our underground storage tanks. Despite these compliance efforts, the risk of environmental liability is part of the nature of our business. +Environmental laws and regulations are complex, change frequently and could become more stringent in the future. We cannot assure you that future compliance with these regulations, future environmental liabilities, the cost of defending environmental claims, conducting any environmental remediation or generally resolving liabilities caused by us or related third parties will not have a material adverse effect on our business, financial condition or results of operations. +9 +We operate in a highly regulated industry and changes in existing regulations or violations of existing or future regulations could have a material adverse effect on our operations and profitability. +Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. The failure to comply with these laws and regulations may adversely affect our ability to sell or rent such property or to use the property as collateral for future borrowings. Compliance with changing regulations could substantially impair real property and equipment productivity and increase our costs. In addition, the Federal government may institute some regulation that limits carbon emissions by setting a maximum amount of carbon individual entities can emit without penalty. This would likely affect everyone who uses fossil fuels and would disproportionately affect users in the highway transportation industries. While there are too many variables at this time to assess the impact of the various proposed federal and state regulations that could affect carbon emissions, many experts believe these proposed rules could significantly affect the way companies operate in their businesses. +Our operations can be limited by land-use regulations. Zoning choices enacted by individual municipalities in the United States and Canada may limit our ability to serve certain markets with our products and services. +Our insurance companies are heavily regulated by state insurance departments and the National Association of Insurance Commissioners (“NAIC”). These insurance regulations are primarily in place to protect the interests of our policyholders and not our investors. Changes in these laws and regulations could increase our costs, inhibit new sales, or limit our ability to implement rate increases. +A significant portion of our revenues are generated through third-parties. +Our business plan relies upon a network of independent dealers strategically located throughout the United States and Canada. As of March 31, 2018 we had approximately 20,000 independent equipment rental dealers. In fiscal 2018, approximately 45% of our equipment rental revenues were generated through this network. +We manage 482 U-Haul branded locations on behalf of subsidiaries of WGHLP and Mercury Partners, L.P. (“Mercury”). These locations generated $29.6 million of management fees in fiscal 2018. Additionally, these locations served as U-Haul equipment dealers and accounted for approximately 12% of our equipment rental revenues in fiscal 2018. +Our inability to maintain this network or its current cost structure could inhibit our ability to adequately serve our customers and may negatively affect our results of operations and financial position. +We face liability risks associated with the operation of our rental fleet, sales of our products and operation of our locations. +The business of renting moving and storage equipment to customers exposes us to liability claims including property damage, personal injury and even death. Likewise, the operation of our moving and storage centers along with the sale of our related moving supplies, towing accessories and installation, and refilling of propane tanks may subject us to liability claims. We seek to limit the occurrence of such events through the design of our equipment, communication of its proper use, exhaustive repair and maintenance schedules, extensive training of our personnel, proactive risk management assessments and by providing our customers with online resources for the proper use of products and services. Regardless, accidents still occur and we manage the financial risk of these events through third party insurance carriers. While these excess loss insurance policies are available today at reasonable costs, this could change and could negatively affect our results of operations and financial position. +10 +Terrorist attacks could negatively impact our operations and profitability and may expose us to liability and reputational damage. +Terrorist attacks may negatively affect our operations and profitability. Such attacks may damage our facilities and it is also possible that our rental equipment could be involved in a terrorist attack. Although we carry excess of loss insurance coverage, it may prove to be insufficient to cover us for acts of terror using our rental equipment. Moreover, we may suffer reputational damage that could arise from a terrorist attack which utilizes our rental equipment. The consequences of any terrorist attacks or hostilities are unpredictable and difficult to quantify. We seek to minimize these risks through our operational processes and procedures; however, we may not be able to foresee events that could have an adverse effect on our operations. +Our ability to attract and retain qualified employees, and changes in laws or other labor issues could adversely affect our business and our results of operations. +The success of our business is predicated upon our workforce providing excellent customer service. Our ability to attract and retain this employee base may be inhibited due to prevailing wage rates, benefit costs and the adoption of new or revised employment and labor laws and regulations. Should this occur we may be unable to provide service in certain areas or we may experience significantly increased costs of labor that could adversely affect our results of operations and financial condition. +We are highly dependent upon our automated systems and the Internet for managing our business. +Our information systems are largely Internet-based, including our point-of-sale reservation system, payment processing and telephone systems. While our reliance on this technology lowers our cost of providing service and expands our abilities to better serve customers, it exposes us to various risks including natural and man-made disasters, terrorist attacks and cyber-attacks. We have put into place extensive security protocols, backup systems and alternative procedures to mitigate these risks. However, disruptions or breaches, detected or undetected by us, for any period of time in any portion of these systems could adversely affect our results of operations and financial condition and inflict reputational damage. +In addition, the provision of service to our customers and the operation of our networks and systems involve the storage and transmission of proprietary information and sensitive or confidential data, including personal information of customers, employees and others. Our information technology systems may be susceptible to computer viruses, attacks by computer hackers, malicious insiders, or catastrophic events. Hackers, acting individually or in coordinated groups, may also launch distributed denial of service attacks or ransom or other coordinated attacks that may cause service outages or other interruptions in our business and access to our data. In addition, breaches in security could expose us, our customers, or the individuals affected, to a risk of loss or misuse of proprietary information and sensitive or confidential data. The techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently, may be difficult to detect for a long time and often are not recognized until launched against a target. As a result, we may be unable to anticipate these techniques or to implement adequate preventative measures. +Any of these occurrences could result in disruptions in our operations, the loss of existing or potential customers, damage to our brand and reputation, and litigation and potential liability for the Company. In addition, the cost and operational consequences of implementing further data or system protection measures could be significant and our efforts to deter, identify, mitigate and/or eliminate any security breaches may not be successful. +A.M. Best financial strength ratings are crucial to our life insurance business. +In June 2017, A.M. Best affirmed the financial strength rating for Oxford and Christian Fidelity Life Insurance Company (“CFLIC”) of A- with a stable outlook and affirmed the financial strength rating for North American Insurance Company (“NAI”) of B++ with a stable outlook. Financial strength ratings are important external factors that can affect the success of Oxford’s business plans. Accordingly, if Oxford’s ratings, relative to its competitors, are not maintained or do not continue to improve, Oxford may not be able to retain and attract business as currently planned, which could adversely affect our results of operations and financial condition. +11 +We may incur losses due to our reinsurers’ or counterparties’ failure to perform under existing contracts or we may be unable to secure sufficient reinsurance or hedging protection in the future. +We use reinsurance and derivative contracts to mitigate our risk of loss in various circumstances; primarily at Repwest and for Moving and Storage. These agreements do not release us from our primary obligations and therefore we remain ultimately responsible for these potential costs. We cannot provide assurance that these reinsurers or counterparties will fulfill their obligations. Their inability or unwillingness to make payments to us under the terms of the contracts may have a material adverse effect on our financial condition and results of operations. +At December 31, 2017, Repwest reported $1.1 million of reinsurance recoverables, net of allowances and $94.5 million of reserves and liabilities ceded to reinsurers. Of this, Repwest’s largest exposure to a single reinsurer was $57.5 million. +Recent changes to U.S. tax laws may adversely affect our financial condition or results of operations and create the risk that we may need to adjust our accounting for these changes. +The Tax Reform Act makes significant changes to U.S. tax laws and includes numerous provisions that affect businesses, including ours. For instance, as a result of lower corporate tax rates, the Tax Reform Act tends to reduce both the value of deferred tax assets and the amount of deferred tax liabilities. It also limits interest rate deductions and the amount of net operating losses that can be used each year and alters the expensing of capital expenditures. Other provisions have international tax consequences for businesses like ours that operate internationally. The Tax Reform Act is unclear in certain respects and will require interpretations and implementing regulations by the IRS, as well as state tax authorities, and the Tax Reform Act could be subject to amendments and technical corrections, any of which could lessen or increase the adverse (and positive) impacts of the Tax Reform Act. The accounting treatment of these tax law changes is complex, and some of the changes may affect both current and future periods. Others will primarily affect future periods. As discussed elsewhere in this Annual Report on Form 10-K, we believe our analysis and computations of the tax effects of the Tax Reform Act on us is substantially, but not entirely, complete. Consistent with guidance from the Securities and Exchange Commission, our financial statements reflect our estimates of the tax effects of the Tax Reform Act on us. +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +The Company, through its legal subsidiaries, owns property, plant and equipment that are utilized in the manufacturing, repair and rental of U-Haul ® equipment and storage space, as well as providing office space for us. Such facilities exist throughout the United States and Canada. We also manage storage facilities owned by others. We operate 1,790 U-Haul ® retail centers of which 482 U-Haul branded locations are managed for subsidiaries of WGHLP and Mercury, and 11 manufacturing and assembly facilities. We also operate over 130 fixed-site repair facilities located throughout the United States and Canada. These facilities are used primarily for the benefit of Moving and Storage. +Item 3. Legal Proceedings +Litigation +On July 1, 2014, a 100-pound propane cylinder allegedly filled at a Philadelphia-area U-Haul Co. of Pennsylvania (“UHPA”) center exploded while in use on a food truck. The explosion killed two people and injured eleven. Following the incident, the injured parties and their estates filed a number of lawsuits against U-Haul and its subsidiary, UHPA, both of which denied the allegations. One plaintiff sued AMERCO, which also denied the allegations. All suits were filed in the Philadelphia Court of Common Pleas. The plaintiffs alleged, among other things, that UHPA should not have refilled the propane cylinder at issue because it was out-of-date and improperly fitted with an incorrect valve, which allegedly caused the explosion. The plaintiffs sought compensatory and punitive damages. +12 +After several settlements with the less-injured plaintiffs, in April 2018, the parties reached an agreement, in principle, to settle the remaining cases. We will pay our self-insured retention and attorney’s fees. Together, these amounts are currently estimated to be $26.4 million, of which $15.3 million has already been paid. The balance of the settlement amount is accrued on our balance sheet in Policy benefits and losses, claims and loss expenses payable with offsetting insurance recoveries from our insurance carriers in Other assets. The U.S. Department of Justice is investigating the cause of the incident. Following the resolution in principle of the civil claims in April 2018, the U.S. Attorney’s Office for the Eastern District of Pennsylvania advised the Company for the first time that UHPA is a target of the investigation, but has not advised UHPA as to what specific violations are being investigated. UHPA will vigorously defend itself against any criminal allegations or charges. +Environmental +Compliance with environmental requirements of federal, state and local governments may significantly affect Real Estate’s business operations. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Real Estate is aware of issues regarding hazardous substances on some of its properties. Real Estate regularly makes capital and operating expenditures to stay in compliance with environmental laws and has put in place a remedial plan at each site where it believes such a plan is necessary. Since 1988, Real Estate has managed a testing and removal program for underground storage tanks. +Based upon the information currently available to Real Estate, compliance with the environmental laws and its share of the costs of investigation and cleanup of known hazardous waste sites are not expected to result in a material adverse effect on AMERCO’s financial position or results of operations. +Other +We are named as a defendant in various other litigation and claims arising out of the normal course of business. In management’s opinion, none of these other matters will have a material effect on our financial position and results of operations. +Item 4. Mine Safety Disclosure +Not applicable. +Part ii +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +As of May 9, 2018, there were approximately 2,800 holders of record of our common stock. We derived the number of our stockholders using internal stock ledgers and utilizing Mellon Investor Services Stockholder listings. AMERCO’s common stock is listed on the NASDAQ Global Select Market under the trading symbol “UHAL”. +The following table sets forth the high and the low sales price of the common stock of AMERCO for the periods indicated: +Years Ended March 31, +2018 +2017 +High +Low +High +Low +First quarter +$ +394.50 +$ +338.30 +$ +382.44 +$ +333.35 +Second quarter +398.94 +349.71 +399.16 +319.20 +Third quarter +400.99 +348.58 +375.26 +307.80 +Fourth quarter +386.00 +326.30 +391.22 +355.50 +13 +Dividends +AMERCO ® does not have a formal dividend policy. The Board periodically considers the advisability of declaring and paying dividends to common stockholders in light of existing circumstances. +Common Stock Dividends +Declared Date +Per Share Amount +Record Date +Dividend Date +March 8, 2018 +$ +0.50 +March 23, 2018 +April 6, 2018 +December 6, 2017 +0.50 +December 21, 2017 +January 5, 2018 +July 5, 2017 +1.00 +July 20, 2017 +August 3, 2017 +February 8, 2017 +1.00 +February 23, 2017 +March 9, 2017 +October 5, 2016 +1.00 +October 20, 2016 +November 3, 2016 +See Note 20, Statutory Financial Information of Insurance Subsidiaries, of the Notes to Consolidated Financial Statements for a discussion of certain statutory restrictions on the ability of the insurance subsidiaries to pay dividends to AMERCO. +14 +Performance Graph +The following graph compares the cumulative total stockholder return on the Company’s common stock for the period March 31, 2013 through March 31, 2018 with the cumulative total return on the Dow Jones US Total Market and the Dow Jones US Transportation Average. The comparison assumes that $100 was invested on March 31, 2013 in the Company’s common stock and in each of the comparison indices. The graph reflects the value of the investment based on the closing price of the common stock trading on NASDAQ on March 31, 2014, 2015, 2016, 2017 and 2018. +Fiscal years ended March 31: +2013 +2014 +2015 +2016 +2017 +2018 +AMERCO +$ +100 +$ +137 +$ +196 +$ +214 +$ +230 +$ +209 +Dow Jones US Total Market +100 +113 +122 +121 +142 +165 +Dow Jones US Transportation Average +100 +123 +142 +129 +148 +169 +15 +Item 6.Selected Financial Data +The following selected financial data should be read in conjunction with the MD&A, and the Consolidated Financial Statements and related notes in this Annual Report. +Listed below is selected financial data for AMERCO and consolidated subsidiaries for each of the last five years: +Years Ended March 31, +2018 +2017 +2016 +2015 +2014 +(In thousands, except share and per share data) +Summary of Operations: +Self-moving equipment rentals +$ +2,479,742 +$ +2,362,833 +$ +2,297,980 +$ +2,146,391 +$ +1,955,423 +Self-storage revenues +323,903 +286,886 +247,944 +211,136 +181,794 +Self-moving and self-storage products and service sales +261,557 +253,073 +251,541 +244,177 +234,187 +Property management fees +29,602 +29,075 +26,533 +25,341 +24,493 +Life insurance premiums +154,703 +163,579 +162,662 +156,103 +157,919 +Property and casualty insurance premiums +57,100 +52,334 +50,020 +46,456 +41,052 +Net investment and interest income +110,473 +102,276 +86,617 +84,728 +79,591 +Other revenue +184,034 +171,711 +152,171 +160,199 +160,793 +Total revenues +3,601,114 +3,421,767 +3,275,468 +3,074,531 +2,835,252 +Operating expenses +1,807,983 +1,568,083 +1,470,047 +1,479,409 +1,313,674 +Commission expenses +276,705 +267,230 +262,627 +249,642 +227,332 +Cost of sales +160,489 +152,485 +144,990 +146,072 +127,270 +Benefits and losses +185,311 +182,710 +167,436 +158,760 +156,702 +Amortization of deferred policy acquisition costs +24,514 +26,218 +23,272 +19,661 +19,982 +Lease expense +33,960 +37,343 +49,780 +79,798 +100,466 +Depreciation, net gains on disposals (a) +543,247 +449,025 +291,235 +279,107 +261,306 +Net gains on disposal of real estate +(195,414) +(3,590) +(545) +(942) +(1,694) +Total costs and expenses +2,836,795 +2,679,504 +2,408,842 +2,411,507 +2,205,038 +Earnings from operations +764,319 +742,263 +866,626 +663,024 +630,214 +Interest expense +(126,706) +(113,406) +(97,715) +(97,525) +(92,692) +Fees and amortization on early extinguishment of debt +– +(499) +– +(4,081) +– +Pretax earnings +637,613 +628,358 +768,911 +561,418 +537,522 +Income tax benefit (expense) +152,970 +(229,934) +(279,910) +(204,677) +(195,131) +Earnings available to common shareholders +$ +790,583 +$ +398,424 +$ +489,001 +$ +356,741 +$ +342,391 +Basic and diluted earnings per common share +$ +40.36 +$ +20.34 +$ +24.95 +$ +18.21 +$ +17.51 +Weighted average common shares outstanding: Basic and diluted +19,588,889 +19,586,606 +19,596,110 +19,586,633 +19,558,758 +Cash dividends declared and accrued Common stock +39,175 +39,171 +97,960 +19,594 +19,568 +Balance Sheet Data: +Property, plant and equipment, net +$ +6,816,741 +$ +5,957,735 +$ +5,017,511 +$ +4,107,637 +$ +3,409,211 +Total assets +10,746,985 +9,405,840 +8,109,288 +6,855,600 +5,989,930 +Notes, loans and leases payable, net +3,513,076 +3,262,880 +2,647,396 +2,174,294 +1,933,311 +Stockholders' equity +3,408,708 +2,619,744 +2,251,406 +1,884,359 +1,527,368 +(a) Net gains were ($11.8) million, ($32.5) million, ($98.2) million, ($73.7) million and ($31.9) million for fiscal 2018, 2017, 2016, 2015 and 2014, respectively. +16 +Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations +We begin this MD&A with the overall strategy of AMERCO, followed by a description of, and strategy related to, our operating segments to give the reader an overview of the goals of our businesses and the direction in which our businesses and products are moving. We then discuss our critical accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Next, we discuss our results of operations for fiscal 2018 compared with fiscal 2017, and for fiscal 2017 compared with fiscal 2016 which are followed by an analysis of liquidity changes in our balance sheets and cash flows, and a discussion of our financial commitments in the sections entitled Liquidity and Capital Resources and Disclosures about Contractual Obligations and Commercial Commitments. We conclude this MD&A by discussing our outlook for fiscal 2019. +This MD&A should be read in conjunction with the other sections of this Annual Report, including Item 1: Business, Item 6: Selected Financial Data and Item 8: Financial Statements and Supplementary Data. The various sections of this MD&A contain a number of forward-looking statements, as discussed under the caption, Cautionary Statements Regarding Forward-Looking Statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this Annual Report and particularly under the section Item 1A: Risk Factors. Our actual results may differ materially from these forward-looking statements. +AMERCO has a fiscal year that ends on the 31 st of March for each year that is referenced. Our insurance company subsidiaries have fiscal years that end on the 31 st of December for each year that is referenced. They have been consolidated on that basis. Our insurance companies’ financial reporting processes conform to calendar year reporting as required by state insurance departments. Management believes that consolidating their calendar year into our fiscal year financial statements does not materially affect the presentation of financial position or results of operations. We disclose all material events, if any, occurring during the intervening period. Consequently, all references to our insurance subsidiaries’ years 2017, 2016 and 2015 correspond to fiscal 2018, 2017 and 2016 for AMERCO. +Overall Strategy +Our overall strategy is to maintain our leadership position in the North American “do-it-yourself” moving and storage industry. We accomplish this by providing a seamless and integrated supply chain to the “do-it-yourself” moving and storage market. As part of executing this strategy, we leverage the brand recognition of U-Haul with our full line of moving and self-storage related products and services and the convenience of our broad geographic presence. +Our primary focus is to provide our customers with a wide selection of moving rental equipment, convenient self-storage rental facilities and portable moving and storage units and related moving and self-storage products and services. We are able to expand our distribution and improve customer service by increasing the amount of moving equipment and storage rooms and portable moving and storage units available for rent, expanding the number of independent dealers in our network and expanding and taking advantage of our eMove capabilities. +Property and Casualty Insurance is focused on providing and administering property and casualty insurance to U-Haul and its customers, its independent dealers and affiliates. +Life Insurance is focused on long-term capital growth through direct writing and reinsuring of life, Medicare supplement and annuity products in the senior marketplace. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO, U-Haul, and Real Estate and the subsidiaries of U-Haul and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +Life Insurance, comprised of Oxford and its subsidiaries. +See Note 1, Basis of Presentation, Note 21, Financial Information by Geographic Area, and Note 21A, Consolidating Financial Information by Industry Segment, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. +17 +Moving and Storage Operating Segment +Moving and Storage consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +With respect to our truck, trailer, specialty rental items and self-storage rental business, we are focused on expanding our dealer network, which provides added convenience for our customers and expanding the selection and availability of rental equipment to satisfy the needs of our customers. +U-Haul ® brand self-moving related products and services, such as boxes, pads and tape allow our customers to, among other things; protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +uhaul.com ® is an online marketplace that connects consumers to our operations as well as independent Moving Help ® service providers and thousands of independent Self-Storage Affiliates. Our network of customer rated affiliates and service providers furnish pack and load help, cleaning help, self-storage and similar services, all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Since 1945, U-Haul has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Property and Casualty Insurance Operating Segment +Property and Casualty Insurance provides loss adjusting and claims handling for U-Haul through regional offices in the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestor ® and Safestor Mobile ® protection packages to U-Haul ® customers. We continue to focus on increasing the penetration of these products into the moving and storage market. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul ® related programs. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Critical Accounting Policies and Estimates +Our financial statements have been prepared in accordance with the generally accepted accounting principles (“GAAP”) in the United States. The methods, estimates and judgments we use in applying our accounting policies can have a significant impact on the results we report in our financial statements. Note 3, Accounting Policies, of the Notes to Consolidated Financial Statements in Item 8: Financial Statements and Supplementary Data, in this Annual Report summarizes the significant accounting policies and methods used in the preparation of our consolidated financial statements and related disclosures. Certain accounting policies require us to make difficult and subjective judgments and assumptions, often as a result of the need to estimate matters that are inherently uncertain. +Following is a detailed description of the accounting policies that we deem most critical to us and that require management’s most difficult and subjective judgments. These estimates are based on historical experience, observance of trends in particular areas, information and valuations available from outside sources and on various other assumptions that are believed to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates under different assumptions and conditions; such differences may be material. +18 +We also have other policies that we consider key accounting policies, such as revenue recognition; however, these policies do not meet the definition of critical accounting estimates, because they do not generally require us to make estimates or judgments that are difficult or subjective. The accounting policies that we deem most critical to us, and involve the most difficult, subjective or complex judgments include the following: +Principles of Consolidation +We apply Accounting Standards Codification (“ASC”) 810 - Consolidation (“ASC 810”) in our principles of consolidation. ASC 810 addresses arrangements where a company does not hold a majority of the voting or similar interests of a variable interest entity (“VIE”). A company is required to consolidate a VIE if it has determined it is the primary beneficiary. ASC 810 also addresses the policy when a company owns a majority of the voting or similar rights and exercises effective control. +As promulgated by ASC 810, a VIE is not self-supportive due to having one or both of the following conditions: (i) it has an insufficient amount of equity for it to finance its activities without receiving additional subordinated financial support or (ii) its owners do not hold the typical risks and rights of equity owners. This determination is made upon the creation of a variable interest and is re-assessed on an on-going basis should certain changes in the operations of a VIE, or its relationship with the primary beneficiary trigger a reconsideration under the provisions of ASC 810. After a triggering event occurs the facts and circumstances are utilized in determining whether or not a company is a VIE, which other company(ies) have a variable interest in the entity, and whether or not the company’s interest is such that it is the primary beneficiary. +We will continue to monitor our relationships with the other entities regarding who is the primary beneficiary, which could change based on facts and circumstances of any reconsideration events. +Recoverability of Property, Plant and Equipment +Our property, plant and equipment is stated at cost. Interest expense incurred during the initial construction of buildings is considered part of cost. Depreciation is computed for financial reporting purposes using the straight-line or an accelerated method based on a declining balance formula over the following estimated useful lives: rental equipment 2-20 years and buildings and non-rental equipment 3-55 years. Routine maintenance costs are charged to operating expense as they are incurred. Gains and losses on dispositions of property, plant and equipment are netted against depreciation expense when realized. Equipment depreciation is recognized in amounts expected to result in the recovery of estimated residual values upon disposal, i.e., minimize gains or losses. In determining the depreciation rate, historical disposal experience, holding periods and trends in the market for vehicles are reviewed. As a result of changes in IRS regulations regarding the capitalization of assets, beginning in the first quarter of fiscal 2017, we raised the value threshold before certain assets are capitalized within our depreciation policy. This change in threshold, results in the immediate recognition of reported operating costs with a lagging decrease in depreciation expense over the term that these assets would have been depreciated. This change in threshold is expected to benefit us through the immediate recognition of tax deductible costs. +We regularly perform reviews to determine whether facts and circumstances exist which indicate that the carrying amount of assets, including estimates of residual value, may not be recoverable or that the useful life of assets are shorter or longer than originally estimated. Reductions in residual values (i.e., the price at which we ultimately expect to dispose of revenue earning equipment) or useful lives will result in an increase in depreciation expense over the remaining life of the equipment. Reviews are performed based on vehicle class, generally subcategories of trucks and trailers. We assess the recoverability of our assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their estimated remaining lives against their respective carrying amounts. We consider factors such as current and expected future market price trends on used vehicles and the expected life of vehicles included in the fleet. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If asset residual values are determined to be recoverable, but the useful lives are shorter or longer than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives. +19 +For our box truck fleet we utilize an accelerated method of depreciation based upon a declining formula. Under the declining balances method (2.4 times declining balance), the book value of a rental truck is reduced by approximately 16%, 13%, 11%, 9%, 8%, 7%, and 6% of cost during years one through seven, respectively, and then reduced on a straight line basis to a salvage value of 15% by the end of year fifteen. Comparatively, a standard straight line approach would reduce the book value by approximately 5.7% per year over the life of the truck. +Although we intend to sell our used vehicles for prices approximating book value, the extent to which we realize a gain or loss on the sale of used vehicles is dependent upon various factors including but not limited to, the general state of the used vehicle market, the age and condition of the vehicle at the time of its disposal and the depreciation rates with respect to the vehicle . We typically sell our used vehicles at our sales centers throughout the United States and Canada, on our website at uhaul.com/trucksales or by phone at 1-866-404-0355. Additionally, we sell a large portion of our pickup and cargo van fleet at automobile dealer auctions. +Insurance Reserves +Liabilities for life insurance and certain annuity and health policies are established to meet the estimated future obligations of policies in force, and are based on mortality, morbidity and withdrawal assumptions from recognized actuarial tables which contain margins for adverse deviation. In addition, liabilities for health, disability and other policies include estimates of payments to be made on insurance claims for reported losses and estimates of losses incurred, but not yet reported (“IBNR”). Liabilities for annuity contracts consist of contract account balances that accrue to the benefit of the policyholders. +Insurance reserves for Property and Casualty Insurance and U-Haul take into account losses incurred based upon actuarial estimates and are management’s best approximation of future payments. These estimates are based upon past claims experience and current claim trends as well as social and economic conditions such as changes in legal theories and inflation. These reserves consist of case reserves for reported losses and a provision for IBNR losses, both reduced by applicable reinsurance recoverables, resulting in a net liability. +Due to the nature of the underlying risks and high degree of uncertainty associated with the determination of the liability for future policy benefits and claims, the amounts to be ultimately paid to settle these liabilities cannot be precisely determined and may vary significantly from the estimated liability, especially for long-tailed casualty lines of business such as excess workers’ compensation. As a result of the long-tailed nature of the excess workers’ compensation policies written by Repwest during 1983 through 2001, it may take a number of years for claims to be fully reported and finally settled. +On a regular basis insurance reserve adequacy is reviewed by management to determine if existing assumptions need to be updated. In determining the assumptions for calculating workers’ compensation reserves, management considers multiple factors including the following: +Claimant longevity +Cost trends associated with claimant treatments +Changes in ceding entity and third party administrator reporting practices +Changes in environmental factors including legal and regulatory +Current conditions affecting claim settlements +Future economic conditions including inflation +We have reserved each claim based upon the accumulation of current claim costs projected through each claimant’s life expectancy, and then adjusted for applicable reinsurance arrangements. Management reviews each claim bi-annually or more frequently, if there are changes in facts or circumstances to determine if the estimated life-time claim costs have increased and then adjusts the reserve estimate accordingly at that time. We have factored in an estimate of what the potential cost increases could be in our IBNR liability. We have not assumed settlement of the existing claims in calculating the reserve amount, unless it is in the final stages of completion. +20 +Continued increases in claim costs, including medical inflation and new treatments and medications could lead to future adverse development resulting in additional reserve strengthening. Conversely, settlement of existing claims or if injured workers return to work or expire prematurely, could lead to future positive development. +Impairment of Investments +Investments are evaluated pursuant to guidance contained in ASC 320 - Investments - Debt and Equity Securities to determine if and when a decline in market value below amortized cost is other-than-temporary. Management makes certain assumptions or judgments in its assessment including but not limited to: our ability and intent to hold the security, quoted market prices, dealer quotes or discounted cash flows, industry factors, financial factors, and issuer specific information such as credit strength. Other-than-temporary impairment in value is recognized in the current period operating results. There were no write downs in fiscal 2018, 2017 and 2016, respectively. +Income Taxes +We file a consolidated tax return with all of our legal subsidiaries. +Our tax returns are periodically reviewed by various taxing authorities. The final outcome of these audits may cause changes that could materially impact our financial results. Please see Note 13, Provision for Taxes, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information. +Fair Values +Fair values of cash equivalents approximate carrying value due to the short period of time to maturity. Fair values of short-term investments, investments available-for-sale, long-term investments, mortgage loans and notes on real estate, and interest rate swap contracts are based on quoted market prices, dealer quotes or discounted cash flows. Fair values of trade receivables approximate their recorded value. +Our financial instruments that are exposed to concentrations of credit risk consist primarily of temporary cash investments, trade receivables, reinsurance recoverables and notes receivable. Limited credit risk exists on trade receivables due to the diversity of our customer base and their dispersion across broad geographic markets. We place our temporary cash investments with financial institutions and limit the amount of credit exposure to any one financial institution. +We have mortgage receivables, which potentially expose us to credit risk. The portfolio of notes is principally collateralized by self-storage facilities and commercial properties. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. The estimated fair values were determined using the discounted cash flow method and using interest rates currently offered for similar loans to borrowers with similar credit ratings. +The carrying amount of long-term debt and short-term borrowings are estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for debt of similar term and remaining maturity. +Other investments including short-term investments are substantially current or bear reasonable interest rates. As a result, the carrying values of these financial instruments approximate fair value. +Subsequent Events +Please see Note 22, Subsequent Events, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +Recent Accounting Pronouncements +Please see Note 3, Accounting Policies, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +21 +AMERCO and Consolidated Subsidiaries +Fiscal 2018 Compared with Fiscal 2017 +Listed below, on a consolidated basis, are revenues for our major product lines for fiscal 2018 and fiscal 2017: +Year Ended March 31, +2018 +2017 +(In thousands) +Self-moving equipment rentals +$ +2,479,742 +$ +2,362,833 +Self-storage revenues +323,903 +286,886 +Self-moving and self-storage products and service sales +261,557 +253,073 +Property management fees +29,602 +29,075 +Life insurance premiums +154,703 +163,579 +Property and casualty insurance premiums +57,100 +52,334 +Net investment and interest income +110,473 +102,276 +Other revenue +184,034 +171,711 +Consolidated revenue +$ +3,601,114 +$ +3,421,767 +Self-moving equipment rental revenues increased $116.9 million during fiscal 2018, compared with fiscal 2017 largely due to growth in both one-way and In-Town ® transactions. Over the course of fiscal 2018 we added new Company owned locations to our retail network and increased the number of trucks, trailers, and towing devices in our rental fleet. +Self-storage revenues increased $37.0 million during fiscal 2018, compared with fiscal 2017. The average monthly amount of occupied square feet increased by 8.9% during fiscal 2018, compared with the same period last year. The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. Over the last twelve months, we added approximately 3.7 million net rentable square feet, or a 13.4% increase, with approximately 1.2 million of that coming on during the fourth quarter of fiscal 2018. +Sales of self-moving and self-storage products and services increased $8.5 million during fiscal 2018, compared with fiscal 2017. Increases were recognized in the sales of moving supplies, propane and towing accessories and related installations. +Life insurance premiums decreased $8.9 million during fiscal 2018, compared with fiscal 2017 primarily due to decreased Medicare supplement premiums. +Property and casualty insurance premiums increased $4.8 million during fiscal 2018, compared with fiscal 2017 due to an increase in Safetow ® and Safestor ® sales, which is a reflection of the increased equipment and storage rental transactions. +Net investment and interest income increased $8.2 million during fiscal 2018, compared with fiscal 2017 due to a larger invested asset base at our insurance companies. +Other revenue increased $12.3 million during fiscal 2018, compared with fiscal 2017, primarily coming from growth in our U-Box ® program. +As a result of the items mentioned above, revenues for AMERCO and its consolidated entities were $3,601.1 million for fiscal 2018 as compared with $3,421.8 million for fiscal 2017. +22 +Listed below are revenues and earnings from operations at each of our operating segments for fiscal 2018 and 2017. The insurance companies’ years ended December 31, 2017 and 2016. +Year Ended March 31, +2018 +2017 +(In thousands) +Moving and storage +Revenues +$ +3,290,667 +$ +3,113,000 +Earnings from operations before equity in earnings of subsidiaries +711,773 +688,913 +Property and casualty insurance +Revenues +74,571 +68,986 +Earnings from operations +25,878 +27,161 +Life insurance +Revenues +243,862 +245,599 +Earnings from operations +27,959 +27,646 +Eliminations +Revenues +(7,986) +(5,818) +Earnings from operations before equity in earnings of subsidiaries +(1,291) +(1,457) +Consolidated Results +Revenues +3,601,114 +3,421,767 +Earnings from operations +764,319 +742,263 +Total costs and expenses increased $157.3 million during fiscal 2018, compared with fiscal 2017. Our insurance segments accounted for $4.8 million of the increase. +Excluding net gains on the disposal of real estate, total costs and expenses increased $349.1 million during fiscal 2018, compared with fiscal 2017. Operating expenses at Moving and Storage increased $238.2 million. In the second quarter of fiscal 2017, we recognized the difference between the accrued amount and actual settlement amount of the PODS Enterprises, Inc. (“PEI”) case as a $24.6 million reduction of operating expenses. Excluding this effect in the prior year, operating expenses for Moving and Storage increased $213.6 million. This was primarily due to increased personnel costs, equipment maintenance, payment processing fees, new facility related costs and property tax. Repair costs, primarily associated with the portion of the fleet nearing resale, accounted for $72.9 million of the increase for fiscal 2018. Personnel bonuses associated with tax reform for the entire workforce combined with bonuses for our field management team accounted for $31.1 million of the increase. Lease expense decreased $3.4 million as a result of our shift in financing new equipment on the balance sheet versus through operating leases. Net gains from the disposal of rental equipment decreased $20.7 million. Compared with fiscal 2017, we have sold more used trucks, however on average the trucks sold in fiscal 2018 had a higher average cost than in fiscal 2017 and average sales proceeds per truck were lower in fiscal 2018. Depreciation expense associated with our rental fleet increased $56.5 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $17.0 million. Net gains on disposal of real estate increased $191.8 million. The increase resulted from the sale of a portion of our Chelsea, NY property which resulted in a pre-tax gain of $190.7 million. +As a result of the above mentioned changes in revenues and expenses, earnings from operations increased to $764.3 million for fiscal 2018, compared with $742.3 million for fiscal 2017. +Interest expense for fiscal 2018 was $126.7 million, compared with $113.4 million for fiscal 2017 due to an increase in borrowings in fiscal 2018 partially offset by lower borrowing costs. In addition, we incurred costs associated with the early extinguishment of debt during the third quarter of fiscal 2017 of $0.5 million for the write-off of unamortized transaction costs related to defeased debt. +23 +Income tax benefit (expense) was $153.0 million for fiscal 2018, compared with ($229.9) million for fiscal 2017 due to the effects of the Tax Reform Act as enacted on December 22, 2017. Our effective tax rate was (24.0%) of net income before taxes for fiscal 2018, compared to 36.6% in the prior-year period. The decrease in our deferred tax liability resulting from the application of the new Federal income tax rate accounted for a $371.5 million decrease, partially offset by a $11.7 million one-time increase resulting from the deemed repatriation of foreign earnings and a $4.0 million one-time increase resulting from Phase Three tax on our Life Insurance subsidiary. Excluding the one-time benefits and charges mentioned above, our effective tax rate for all of fiscal 2018, post Tax Reform Act, was 31.8%, compared with 36.6% for fiscal 2017. We project that our effective tax rate for the fiscal year ending March 31, 2019 will be approximately 24.3%. See Note 13, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information on income taxes. +As a result of the above mentioned items, earnings available to common shareholders were $790.6 million for fiscal 2018, compared with $398.4 million for fiscal 2017. +Basic and diluted earnings per common share for fiscal 2018 were $40.36, compared with $20.34 for fiscal 2017. +The weighted average common shares outstanding basic and diluted were 19,588,889 for fiscal 2018, compared with 19,586,606 for fiscal 2017. +AMERCO and Consolidated Subsidiaries +Fiscal 2017 Compared with Fiscal 2016 +Listed below, on a consolidated basis, are revenues for our major product lines for fiscal 2017 and fiscal 2016: +Year Ended March 31, +2017 +2016 +(In thousands) +Self-moving equipment rentals +$ +2,362,833 +$ +2,297,980 +Self-storage revenues +286,886 +247,944 +Self-moving and self-storage products and service sales +253,073 +251,541 +Property management fees +29,075 +26,533 +Life insurance premiums +163,579 +162,662 +Property and casualty insurance premiums +52,334 +50,020 +Net investment and interest income +102,276 +86,617 +Other revenue +171,711 +152,171 +Consolidated revenue +$ +3,421,767 +$ +3,275,468 +Self-moving equipment rental revenues increased $64.9 million during fiscal 2017, compared with fiscal 2016. During fiscal 2017, we continued to grow our rental system through the expansion of our distribution network and by increasing the number of trucks, trailers and towing devices available to our customers. Both In-Town ® and one-way transactions increased compared with fiscal 2016, which resulted in improved revenue results. +Self-storage revenues increased $38.9 million during fiscal 2017, compared with fiscal 2016. The average monthly amount of occupied square feet increased by 11.8% during fiscal 2017 compared with fiscal 2016. The growth in revenues and square feet rented came from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to our real estate portfolio. During the twelve months ended March 31, 2017, we added approximately 3.4 million net rentable square feet, or a 14.0% increase, with approximately 1.0 million net rental square feet added during the fourth quarter of fiscal 2017. +Sales of self-moving and self-storage products and services increased $1.5 million during fiscal 2017, compared with fiscal 2016, primarily from the sale of moving supplies. +Life insurance premiums increased $0.9 million during fiscal 2017, compared with fiscal 2016 primarily due to increased life and Medicare supplement premiums. +24 +Property and casualty insurance premiums increased $2.3 million during fiscal 2017, compared with fiscal 2016 due to an increase in Safetow ® and Safestor ® sales, which was a reflection of the increased equipment and storage rental transactions. +Net investment and interest income increased $15.7 million during fiscal 2017, compared with fiscal 2016 due to a larger invested asset base at our insurance companies and gains generated from our mortgage loan portfolio. +Other revenue increased $19.5 million during fiscal 2017, compared with fiscal 2016, primarily coming from growth in our U-Box ® program. +As a result of the items mentioned above, revenues for AMERCO and its consolidated entities were $3,421.8 million for fiscal 2017 as compared with $3,275.5 million for fiscal 2016. +Listed below are revenues and earnings from operations at each of our operating segments for fiscal 2017 and 2016. The insurance companies’ years ended December 31, 2016 and 2015. +Year Ended March 31, +2017 +2016 +(In thousands) +Moving and storage +Revenues +$ +3,113,000 +$ +2,984,504 +Earnings from operations before equity in earnings of subsidiaries +688,913 +813,124 +Property and casualty insurance +Revenues +68,986 +64,803 +Earnings from operations +27,161 +24,547 +Life insurance +Revenues +245,599 +231,220 +Earnings from operations +27,646 +29,773 +Eliminations +Revenues +(5,818) +(5,059) +Earnings from operations before equity in earnings of subsidiaries +(1,457) +(818) +Consolidated Results +Revenues +3,421,767 +3,275,468 +Earnings from operations +742,263 +866,626 +Total costs and expenses increased $270.7 million during fiscal 2017, compared with fiscal 2016. Our insurance segments accounted for $18.1 million of the increase primarily due to increased benefit costs. +Moving and Storage total costs and expenses increased $252.7 million. In October 2016, we settled the litigation with PEI. As part of this settlement, we paid $41.4 million to PEI. In fiscal 2015 and fiscal 2016, we recorded $66.0 million as accrued contingencies and interest related to this lawsuit. During the second quarter of fiscal 2017, we recognized the difference between our contingency accrual and the actual settlement as a $24.6 million reduction of operating expenses. Excluding the effect of the reversal of this accrual during fiscal 2017, operating expenses increased $122.9 million for Moving and Storage, primarily due to increased personnel costs, equipment maintenance and property tax, as well as a change in the accounting threshold for the expensing of smaller capital items that led to the additional costs being recognized immediately versus over time through depreciation expense. Net gains from the disposal of rental equipment decreased $65.7 million. Compared with fiscal 2016, we have sold fewer used trucks, however on average the trucks sold had a higher average cost and we experienced a decrease in the average sales proceeds per unit. Depreciation expense associated with our rental fleet increased $66.9 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $25.2 million. Net gains on disposal of real estate increased $3.0 million. Lease expense decreased $12.4 million as a result of our shift in financing new equipment on the balance sheet versus through operating leases. +As a result of the above mentioned changes in revenues and expenses, earnings from operations decreased to $742.3 million for fiscal 2017, compared with $866.6 million for fiscal 2016. +25 +Interest expense for fiscal 2017 was $113.4 million, compared with $97.7 million for fiscal 2016 due to an increase in borrowings in fiscal 2017 partially offset by lower borrowing costs. In addition, we incurred costs associated with the early extinguishment of debt during the third quarter of fiscal 2017 of $0.5 million for the write-off of unamortized transaction costs related to defeased debt. +Income tax expense was $229.9 million for fiscal 2017, compared with $279.9 million for fiscal 2016. The decrease was due to lower pretax earnings for fiscal 2017. The effective tax rate was 36.6% and 36.4% for fiscal 2017 and 2016, respectively. +As a result of the above mentioned items, earnings available to common shareholders were $398.4 million for fiscal 2017, compared with $489.0 million for fiscal 2016. +Basic and diluted earnings per common share for fiscal 2017 were $20.34, compared with $24.95 for fiscal 2016. +The weighted average common shares outstanding basic and diluted were 19,586,606 for fiscal 2017, compared with 19,596,110 for fiscal 2016. +Moving and Storage +Fiscal 2018 Compared with Fiscal 2017 +Listed below are revenues for the major product lines at Moving and Storage for fiscal 2018 and fiscal 2017: +Year Ended March 31, +2018 +2017 +(In thousands) +Self-moving equipment rentals +$ +2,483,956 +$ +2,366,526 +Self-storage revenues +323,903 +286,886 +Self-moving and self-storage products and service sales +261,557 +253,073 +Property management fees +29,602 +29,075 +Net investment and interest income +12,232 +9,688 +Other revenue +179,417 +167,752 +Moving and Storage revenue +$ +3,290,667 +$ +3,113,000 +Self-moving equipment rental revenues increased $117.4 million during fiscal 2018, compared with fiscal 2017 largely due to growth in both one-way and In-Town ® transactions. Over the course of fiscal 2018 we added new Company owned locations to our retail network and increased the number of trucks, trailers, and towing devices in our rental fleet. +Self-storage revenues increased $37.0 million during fiscal 2018, compared with fiscal 2017. The average monthly amount of occupied square feet increased by 8.9% during fiscal 2018, compared with the same period last year. The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. Over the last twelve months, we added approximately 3.7 million net rentable square feet, or a 13.4% increase, with approximately 1.2 million of that coming on during the fourth quarter of fiscal 2018. +Sales of self-moving and self-storage products and services increased $8.5 million during fiscal 2018, compared with fiscal 2017. Increases were recognized in the sales of moving supplies, propane and towing accessories and related installations. +Net investment and interest income increased $2.5 million during fiscal 2018, compared with fiscal 2017. +Other revenue increased $11.7 million during fiscal 2018, compared with fiscal 2017, primarily coming from growth in our U-Box ® program. +26 +The Company owns and manages self-storage facilities. Self-storage revenues reported in the consolidated financial statements represent Company-owned locations only. Self-storage data for our owned storage locations follows: +Year Ended March 31, +2018 +2017 +(In thousands, except occupancy rate) +Room count as of March 31 +366 +318 +Square footage as of March 31 +30,974 +27,305 +Average monthly number of rooms occupied +246 +226 +Average monthly occupancy rate based on room count +71.6% +75.8% +Average monthly square footage occupied +22,203 +20,386 +The approximately 3.7 million net rentable square feet that we’ve added during fiscal 2018 was a mix of existing storage locations we acquired and new development. On average, the occupancy rate of this new capacity on the date it was added was approximately 5%. +Excluding net gains on the disposal of real estate, total costs and expenses increased $346.6 million during fiscal 2018, compared with fiscal 2017. Operating expenses at Moving and Storage increased $238.2 million. In the second quarter of fiscal 2017, we recognized the difference between the accrued amount and actual settlement amount of the PEI case as a $24.6 million reduction of operating expenses. Excluding this effect in the prior year, operating expenses for Moving and Storage increased $213.6 million. This was primarily due to increased personnel costs, equipment maintenance, payment processing fees, new facility related costs and property tax. Repair costs, primarily associated with the portion of the fleet nearing resale, accounted for $72.9 million of the increase for fiscal 2018. Personnel bonuses associated with tax reform for the entire workforce combined with bonuses for our field management team accounted for $31.1 million of the increase. Lease expense decreased $3.3 million as a result of our shift in financing new equipment on the balance sheet versus through operating leases. Net gains from the disposal of rental equipment decreased $20.7 million. Compared with fiscal 2017, we have sold more used trucks, however on average the trucks sold in fiscal 2018 had a higher average cost than in fiscal 2017 and the average sales proceeds per truck were lower in fiscal 2018. Depreciation expense associated with our rental fleet increased $56.5 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $17.0 million. Net gains on disposal of real estate increased $191.8 million. The increase was caused by the sale of a portion of our Chelsea, NY property which resulted in a pre-tax gain of $190.7 million. +As a result of the above mentioned changes in revenues and expenses, earnings from operations for Moving and Storage before consolidation of the equity in the earnings of the insurance subsidiaries increased to $711.8 million for fiscal 2018 as compared with $688.9 million for fiscal 2017. +Equity in the earnings of AMERCO’s insurance subsidiaries increased $11.2 million for fiscal 2018, compared with fiscal 2017. +As a result of the above mentioned changes in revenues and expenses, earnings from operations increased to $758.8 million for fiscal 2018, compared with $724.7 million for fiscal 2017. +27 +Moving and Storage +Fiscal 2017 Compared with Fiscal 2016 +Listed below are revenues for the major product lines at Moving and Storage for fiscal 2017 and fiscal 2016: +Year Ended March 31, +2017 +2016 +(In thousands) +Self-moving equipment rentals +$ +2,366,526 +$ +2,301,586 +Self-storage revenues +286,886 +247,944 +Self-moving and self-storage products and service sales +253,073 +251,541 +Property management fees +29,075 +26,533 +Net investment and interest income +9,688 +8,801 +Other revenue +167,752 +148,099 +Moving and Storage revenue +$ +3,113,000 +$ +2,984,504 +Self-moving equipment rental revenues increased $64.9 million during fiscal 2017, compared with fiscal 2016. During fiscal 2017, we continued to grow our rental system through the expansion of our distribution network and by increasing the number of trucks, trailers and towing devices available to our customers. Both In-Town ® and one-way transactions increased compared with fiscal 2016, this resulted in our improved revenue results. +Self-storage revenues increased $38.9 million during fiscal 2017, compared with fiscal 2016. The average monthly amount of occupied square feet increased by 11.8% during fiscal 2017 compared with fiscal 2016. The growth in revenues and square feet rented camesfrom a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. During the twelve months ended March 31, 2017, we added approximately 3.4 million net rentable square feet, or a 14.0% increase, with approximately 1.0 million net rental square feet added during the fourth quarter of fiscal 2017. +Sales of self-moving and self-storage products and services increased $1.5 million during fiscal 2017, compared with fiscal 2016. Increases were recognized in the sales of moving supplies. +Net investment and interest income increased $0.9 million during fiscal 2017, compared with fiscal 2016. +Other revenue increased $19.7 million during fiscal 2017, compared with fiscal 2016 primarily coming from growth in our U-Box ® program rentals. +The Company owns and manages self-storage facilities. Self-storage revenues reported in the consolidated financial statements represent Company-owned locations only. Self-storage data for our owned storage locations follows: +Year Ended March 31, +2017 +2016 +(In thousands, except occupancy rate) +Room count as of March 31 +318 +275 +Square footage as of March 31 +27,305 +23,951 +Average monthly number of rooms occupied +226 +203 +Average monthly occupancy rate based on room count +75.8% +80.1% +Average monthly square footage occupied +20,386 +18,231 +The approximately 3.4 million net rentable square feet that we’ve added during fiscal 2017 was a mix of existing storage locations we acquired and new development. On average, the occupancy rate of this new capacity on the date it was added was approximately 11%. +28 +Total costs and expenses increased $252.7 million during fiscal 2017, compared with fiscal 2016. In October 2016, we settled the litigation with PEI. As part of this settlement, we paid $41.4 million to PEI. In fiscal 2015 and fiscal 2016, we recorded $66.0 million as accrued contingencies and interest related to this lawsuit. During the second quarter of fiscal 2017, we recognized the difference between our contingency accrual and the actual settlement as a $24.6 million reduction of operating expenses. Excluding the effect of the reversal of this accrual in fiscal 2017, operating expenses for Moving and Storage increased $122.9 million, primarily due to personnel costs, equipment maintenance and property tax, as well as a change in the accounting threshold for the expensing of smaller capital items that led to the additional costs being recognized immediately versus over time though depreciation expense. Net gains from the disposal of rental equipment decreased $65.7 million. Compared with fiscal 2016, we have sold fewer used trucks, however on average the trucks sold had a higher average cost and we experienced a decrease in the average sales proceeds per unit. Depreciation expense associated with our rental fleet increased $66.9 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $25.2 million. Net gains on disposal of real estate increased $3.0 million. Lease expense decreased $12.4 million as a result of our shift in financing new equipment on the balance sheet versus through operating leases. +As a result of the above mentioned changes in revenues and expenses, earnings from operations for Moving and Storage before consolidation of the equity in the earnings of the insurance subsidiaries decreased to $688.9 million for fiscal 2017 as compared with $813.1 million for fiscal 2016. +Equity in the earnings of AMERCO’s insurance subsidiaries increased $0.3 million for fiscal 2017, compared with fiscal 2016. +As a result of the above mentioned changes in revenues and expenses, earnings from operations decreased to $724.7 million for fiscal 2017, compared with $848.6 million for fiscal 2016. +Property and Casualty Insurance +2017 Compared with 2016 +Net premiums were $58.8 million and $52.3 million for the years ended December 31, 2017 and 2016, respectively. A significant portion of Repwest’s premiums are from policies sold in conjunction with U-Haul rental transactions. The premium growth corresponded with the increased moving and storage transactions at U-Haul. +Net investment income was $15.8 million and $16.7 million for the years ended December 31, 2017 and 2016, respectively. The change was primarily due to a decrease in realized capital gains of $0.9 million. The December 31, 2016 results were impacted by above average early pay-offs within the mortgage loan portfolio. +Net operating expenses were $32.7 million and $28.4 million for the years ended December 31, 2017 and 2016, respectively. This was due to an increase in commissions and loss adjusting fees. +Benefits and losses incurred were $16.0 million and $13.4 million for the years ended December 31, 2017 and 2016, respectively. The increase was due to an increase in policies sold and related claims activity. +As a result of the above mentioned changes in revenues and expenses, pretax earnings from operations were $25.9 million and $27.2 million for the years ended December 31, 2017 and 2016, respectively. +Property and Casualty Insurance +2016 Compared with 2015 +Net premiums were $52.3 million and $50.0 million for the years ended December 31, 2016 and 2015, respectively. A significant portion of Repwest’s premiums are from policies sold in conjunction with U-Haul rental transactions. The premium growth corresponded with the increased moving and storage transactions at U-Haul. +Net investment income was $16.7 million and $14.8 million for the years ended December 31, 2016 and 2015, respectively. The change was primarily due to an increase in realized capital gains of $1.3 million and a $1.1 million increase in fixed maturity income due to a larger invested asset base. +29 +Net operating expenses were $28.4 million and $28.0 million for the years ended December 31, 2016 and 2015, respectively. +Benefits and losses incurred were $13.4 million and $12.3 million for the years ended December 31, 2016 and 2015, respectively. The increase was due to an increase in policies sold and related claims activity. +As a result of the above mentioned changes in revenues and expenses, pretax earnings from operations were $27.2 million and $24.5 million for the years ended December 31, 2016 and 2015, respectively. +Life Insurance +2017 Compared with 2016 +Net premiums were $154.7 million and $163.6 million for the years ended December 31, 2017 and 2016, respectively. Medicare Supplement premiums decreased by $9.3 million due to the reduction in new sales and declined premiums on the existing business offset by rate increases on renewal premiums. The remaining lines of business had a net increase of $0.4 million. Deferred annuity deposits were $296.8 million or $93.7 million above the prior year and are accounted for on the balance sheet as deposits rather than premiums. +Net investment income was $84.2 million and $77.5 million for the years ended December 31, 2017 and 2016, respectively. Investment income and realized gains from fixed maturities increased $10.9 million from a larger invested asset base, partially offset by a $4.3 million decrease in gains from our mortgage loan portfolio. +Net operating expenses were $22.1 million and $22.4 million for the years ended December 31, 2017 and 2016, respectively. The decrease was primarily due to a reduction in commission expense from decreased Medicare Supplement premiums. +Benefits and losses incurred were flat at $169.3 million for both the years ended December 31, 2017 and 2016. A decrease of $9.2 million in Medicare supplement benefits from an improved benefit to premium ratio was offset by an increase in the remaining lines of business. Life insurance benefits increased $1.6 million with increased mortality while interest credited to policyholders increased by $7.3 million from a larger annuity base. Other benefits increased $0.3 million. +Amortization of deferred acquisition costs (“DAC”), sales inducement asset (“SIA”) and the value of business acquired (“VOBA”) was $24.5 million and $26.2 million for the years December 31, 2017 and 2016, respectively. The decrease was primarily due to additional DAC amortization in the prior year generated by added gains on discounted mortgage loan investments partially offset by the increased amortization from a larger DAC asset in the current year. +As a result of the above mentioned changes in revenues and expenses, pretax earnings from operations were $28.0 million and $27.6 million for the years ended December 31, 2017 and 2016, respectively. +Life Insurance +2016 Compared with 2015 +Net premiums were $163.6 million and $162.7 million for the years ended December 31, 2016 and 2015, respectively. Life premiums increased $0.4 million primarily from the increase in renewal premiums offset by a reduction in new sales and reinsurance premiums. An additional increase of $0.7 million was from supplemental contract considerations. Medicare supplement and other health premiums decreased $0.2 million. Deferred annuity deposits were $203.1 million or $65.1 million below the prior year and are accounted for on the balance sheet as deposits rather than premiums. +Net investment income was $77.5 million and $64.0 million for the years ended December 31, 2016 and 2015, respectively. An increase of $14.6 million in net investment income was attributable to a larger asset base and the gains from our mortgage loans portfolio, which was partially offset by a $1.1 million decrease in capital gains. +Net operating expenses were $22.4 million and $23.0 million for the years ended December 31, 2016 and 2015, respectively. The decrease was primarily due to a reduction in acquisition expenses from the decrease in annuity sales. +30 +Benefits and losses incurred were $169.3 million and $155.1 million for the years ended December 31, 2016 and 2015, respectively. Medicare Supplement benefits increased by $8.8 million as a result of the increase in total policies in force from prior and new sales and the increased benefit to premium ratio. Life, annuities and other health benefits decreased $0.2 million. Interest credited to policyholders increased $5.6 million as a result of the increased deferred annuity deposit base and lower interest credited on policyholder accounts indexed to an S&P index in the third quarter of 2015. +Amortization of DAC, SIA and VOBA was $26.2 million and $23.3 million for the years ended December 31, 2016 and 2015, respectively. The increase was due to an additional Annuity DAC amortization generated by the investment gains along with increased amortization associated with a larger DAC asset. This was partially offset by a decrease in Medicare supplement amortization. +As a result of the above mentioned changes in revenues and expenses, pretax earnings from operations were $27.6 million and $29.8 million for the years ended December 31, 2016 and 2015, respectively. +Liquidity and Capital Resources +We believe our current capital structure is a positive factor that will enable us to pursue our operational plans and goals and provide us with sufficient liquidity for the foreseeable future. There are many factors which could affect our liquidity, including some which are beyond our control, and there is no assurance that future cash flows and liquidity resources will be sufficient to meet our outstanding debt obligations and our other future capital needs. +At March 31, 2018, cash and cash equivalents totaled $759.4 million, compared with $697.8 million at March 31, 2017. The assets of our insurance subsidiaries are generally unavailable to fulfill the obligations of non-insurance operations (AMERCO, U-Haul and Real Estate). As of March 31, 2018 (or as otherwise indicated), cash and cash equivalents, other financial assets (receivables, short-term investments, other investments, fixed maturities, and related party assets) and debt obligations of each operating segment were: +Moving & Storage +Property and Casualty Insurance (a) +Life Insurance (a) +(In thousands) +Cash and cash equivalents +$ +702,036 +$ +6,639 +$ +50,713 +Other financial assets +127,793 +458,040 +1,991,925 +Debt obligations +3,513,076 +– +– +(a) As of December 31, 2017 +At March 31, 2018, Moving and Storage had available borrowing capacity under existing credit facilities of $180.0 million. +A summary of our consolidated cash flows for fiscal 2018, 2017 and 2016 is shown in the table below: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Net cash provided by operating activities +$ +936,328 +$ +1,058,119 +$ +1,045,346 +Net cash used by investing activities +(896,948) +(1,182,572) +(1,259,682) +Net cash provided by financing activities +16,604 +223,753 +388,872 +Effects of exchange rate on cash +5,598 +(2,140) +(15,740) +Net cash flow +61,582 +97,160 +158,796 +Cash at the beginning of the period +697,806 +600,646 +441,850 +Cash at the end of the period +$ +759,388 +$ +697,806 +$ +600,646 +Net cash provided by operating activities decreased $121.8 million in fiscal 2018, compared with fiscal 2017. Reduced profitability at the Moving and Storage segment combined with a $31.8 million increase in income tax payment accounted for the majority of the decline in fiscal 2018. +31 +Net cash used by investing activities decreased $285.6 million in fiscal 2018, compared with fiscal 2017. Purchases of property, plant and equipment, which are reported net of cash from sales and lease-back transactions, decreased $53.1 million, while cash from the sales of property, plant and equipment increased $212.3 million largely due to the sale of a portion of our Chelsea location in New York. For our insurance subsidiaries, net cash used in investing activities increased $66.4 million compared with the prior year. Net cash deposited in real estate acquisition escrow accounts decreased $31.4 million in fiscal 2018, compared with a net increase of $38.1 million in fiscal 2017. +Net cash provided by financing activities decreased $207.1 million in fiscal 2018, as compared with fiscal 2017 due to a decrease in borrowings of $244.2 million, net increase in repayments of debt and capital leases of $72.4 million, an increase in annuity deposits, net of withdrawals, by Life Insurance of $83.3 million and a decrease in dividends paid of $28.9 million. +Liquidity and Capital Resources and Requirements of Our Operating Segments +Moving and Storage +To meet the needs of our customers, U-Haul maintains a large fleet of rental equipment. Capital expenditures have primarily consisted of new rental equipment acquisitions and the buyouts of existing fleet from leases. The capital to fund these expenditures has historically been obtained internally from operations and the sale of used equipment and externally from debt and lease financing. In the future, we anticipate that our internally generated funds will be used to service the existing debt and fund operations. U-Haul estimates that during fiscal 2019 the Company will reinvest in its truck and trailer rental fleet approximately $450 million, net of equipment sales and excluding any lease buyouts. For fiscal 2018, the Company invested, net of sales, approximately $515 million before any lease buyouts in its truck and trailer fleet. Fleet investments in fiscal 2019 and beyond will be dependent upon several factors including availability of capital, the truck rental environment and the used-truck sales market. We anticipate that the fiscal 2019 investments will be funded largely through debt financing, external lease financing and cash from operations. Management considers several factors including cost and tax consequences when selecting a method to fund capital expenditures. Our allocation between debt and lease financing can change from year to year based upon financial market conditions which may alter the cost or availability of financing options. +Real Estate has traditionally financed the acquisition of self-storage properties to support U-Haul's growth through debt financing and funds from operations. The Company’s plan for the expansion of owned storage properties includes the acquisition of existing self-storage locations from third parties, the acquisition and development of bare land, and the acquisition and redevelopment of existing buildings not currently used for self-storage. The Company expects to fund these development projects through a combination of internally generated funds along with borrowings against existing properties as they operationally mature. For fiscal 2018, the Company invested $609.7 million in real estate acquisitions, new construction and renovation and repair. For fiscal 2019, the timing of new projects will be dependent upon several factors, including the entitlement process, availability of capital, weather, and the identification and successful acquisition of target properties. U-Haul's growth plan in self-storage also includes the expansion of the U-Haul Storage Affiliate program, which does not require significant capital. +32 +Net capital expenditures (purchases of property, plant and equipment less proceeds from the sale of property, plant and equipment and lease proceeds) were $666.6 million, $932.0 million and $969.9 million for fiscal 2018, 2017 and 2016, respectively. The components of our net capital expenditures are provided in the following table: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Purchases of rental equipment +$ +1,006,503 +$ +1,178,908 +$ +881,331 +Equipment lease buyouts +6,594 +63,505 +81,718 +Purchases of real estate, construction and renovations +606,990 +484,487 +592,363 +Other capital expenditures +140,627 +139,448 +90,788 +Gross capital expenditures +1,760,714 +1,866,348 +1,646,200 +Less: Lease proceeds +(396,969) +(446,843) +(137,046) +Less: Sales of property, plant and equipment +(699,803) +(487,475) +(539,256) +Net capital expenditures +663,942 +932,030 +969,898 +Moving and Storage continues to hold significant cash and we believe has access to additional liquidity. Management may invest these funds in our existing operations, expand our product lines or pursue external opportunities in the self-moving and storage marketplace, pay dividends or reduce existing indebtedness where possible. +Property and Casualty Insurance +State insurance regulations restrict the amount of dividends that can be paid to stockholders of insurance companies. As a result, Property and Casualty Insurance's assets are generally not available to satisfy the claims of AMERCO, or its legal subsidiaries. +We believe that stockholders equity at the Property and Casualty operating segment remains sufficient and we do not believe that its ability to pay ordinary dividends to AMERCO will be restricted per state regulations. +Our Property and Casualty operating segment stockholder’s equity was $211.2 million, $180.9 million, and $160.6 million at December 31, 2017, 2016, and 2015, respectively. The increase in 2017 compared with 2016 resulted from net earnings of $22.9 million, an increase in accumulated other comprehensive income of $10.4 million offset by a $2.9 million one-time reclassification to move the effect of the rate reduction from other comprehensive income to retained earnings. Property and Casualty Insurance does not use debt or equity issues to increase capital and therefore has no direct exposure to capital market conditions other than through its investment portfolio. +Life Insurance +Life Insurance manages its financial assets to meet policyholder and other obligations including investment contract withdrawals and deposits. Life Insurance's net deposit increase for the year ended December 31, 2017 was $219.3 million. State insurance regulations restrict the amount of dividends that can be paid to stockholders of insurance companies. As a result, Life Insurance's funds are generally not available to satisfy the claims of AMERCO ® or its legal subsidiaries. +Our Life Insurance operating segment stockholder’s equity was $332.9 million, $296.1 million, and $271.7 million at December 31, 2017, 2016 and 2015, respectively. The increase in 2017 compared with 2016 resulted from earnings of $24.1 million and an increase in accumulated other comprehensive income of $19.0 million primarily due to the effect of interest rate changes on the fixed maturity portion of the investment portfolio and a decrease in deferred income tax from a reduced corporate tax rate under the Tax Cut and Jobs Act. This was offset by a $6.3 million one-time reclassification to move the effect of the rate reduction from other comprehensive income to retained earnings. Life Insurance has not historically used debt or equity issues to increase capital and therefore has not had any significant direct exposure to capital market conditions other than through its investment portfolio. However, as of December 31, 2017, Oxford had outstanding deposits of $60.0 million through its membership in the Federal Home Loan Bank (“FHLB”). For a more detailed discussion of this deposit, please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements. +33 +Cash Provided from Operating Activities by Operating Segments +Moving and Storage +Net cash provided by operating activities was $858.6 million, $983.6 million and $994.0 million in fiscal 2018, 2017 and 2016. Reduced profitability at the Moving and Storage segment combined with a $31.8 million increase in income tax payment accounted for the majority of the decline in fiscal 2018. +Property and Casualty Insurance +Net cash provided by operating activities was $20.6 million, $18.2 million, and $19.0 million for the years ended December 31, 2017, 2016, and 2015, respectively. The variation in cash activity was consistent with typical claims activity. +Property and Casualty Insurance’s cash and cash equivalents and short-term investment portfolios amounted to $17.0 million, $20.7 million, and $24.3 million at December 31, 2017, 2016, and 2015, respectively. These balances reflect funds in transition from maturity proceeds to long-term investments. Management believes this level of liquid assets, combined with budgeted cash flow, is adequate to meet foreseeable cash needs. Capital and operating budgets allow Property and Casualty Insurance to schedule cash needs in accordance with investment and underwriting proceeds. +Life Insurance +Net cash provided by operating activities was $57.2 million, $56.3 million and $32.4 million for the years ended December 31, 2017, 2016 and 2015, respectively. The increase in operating cash flows was due to the increase in investment income and lower benefit payments offset by a decrease in collected premiums. +In addition to cash flows from operating activities and financing activities, a substantial amount of liquid funds are available through Life Insurance's short-term portfolio and its membership in the FHLB. At December 31, 2017, 2016 and 2015, cash and cash equivalents and short-term investments amounted to $50.7 million, $20.6 million and $25.5 million, respectively. Management believes that the overall sources of liquidity are adequate to meet foreseeable cash needs. +Liquidity and Capital Resources - Summary +We believe we have the financial resources needed to meet our business plans including our working capital needs. We continue to hold significant cash and have access to existing credit facilities and additional liquidity to meet our anticipated capital expenditure requirements for investment in our rental fleet, rental equipment and storage acquisitions and build outs. +Our borrowing strategy is primarily focused on asset-backed financing and rental equipment leases. As part of this strategy, we seek to ladder maturities and focus on fixing our interest rates. While each of these loans typically contains provisions governing the amount that can be borrowed in relation to specific assets, the overall structure is flexible with no limits on overall Company borrowings. Management believes it has adequate liquidity between cash and cash equivalents and unused borrowing capacity in existing credit facilities to meet the current and expected needs of the Company over the next several years. At March 31, 2018, we had available borrowing capacity under existing credit facilities of $180.0 million. It is possible that circumstances beyond our control could alter the ability of the financial institutions to lend us the unused lines of credit. We believe that there are additional opportunities for leverage in our existing capital structure. For a more detailed discussion of our long-term debt and borrowing capacity, please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. +Fair Value of Financial Instruments +Certain assets and liabilities are recorded at fair value on the consolidated balance sheets and are measured and classified based upon a three tiered approach to valuation. ASC 820 requires that financial assets and liabilities recorded at fair value be classified and disclosed in a Level 1, Level 2 or Level 3 category. For more information, please see Note 15, Fair Value Measurements, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +34 +The available-for-sale securities held by the Company are recorded at fair value. These values are determined primarily from actively traded markets where prices are based either on direct market quotes or observed transactions. Liquidity is a factor considered during the determination of the fair value of these securities. Market price quotes may not be readily available for certain securities or the market for them has slowed or ceased. In situations where the market is determined to be illiquid, fair value is determined based upon limited available information and other factors including expected cash flows. At March 31, 2018, we had $0.3 million of available-for-sale assets classified in Level 3. +The interest rate swaps held by us as hedges against interest rate risk for our variable rate debt are recorded at fair value. These values are determined using pricing valuation models which include broker quotes for which significant inputs are observable. They include adjustments for counterparty credit quality and other deal-specific factors, where appropriate and are classified as Level 2. +Disclosures about Contractual Obligations and Commercial Commitments +The following table provides contractual commitments and contingencies as of March 31, 2018: +Payment due by Period (as of March 31, 2018) +Contractual Obligations +Total +04/01/18 - 03/31/19 +04/01/19 - 03/31/21 +04/01/21 - 03/31/23 +Thereafter +(In thousands) +Notes and loans payable - Principal +$ +2,039,482 +$ +199,396 +274,618 +$ +309,365 +$ +1,256,103 +Notes and loans payable - Interest +642,675 +84,006 +149,090 +127,140 +282,439 +Revolving credit agreements - Principal +515,000 +55,000 +203,334 +256,666 +– +Revolving credit agreements - Interest +39,833 +14,006 +23,315 +2,512 +– +Capital leases - Principal +984,217 +244,740 +412,454 +210,880 +116,143 +Capital leases - Interest +76,094 +26,150 +31,822 +14,287 +3,835 +Operating leases +126,847 +36,494 +40,430 +29,760 +20,163 +Ground leases +54,748 +991 +2,049 +2,060 +49,648 +Property and casualty obligations (a) +139,064 +11,700 +14,306 +9,136 +103,922 +Life, health and annuity obligations (b) +2,950,456 +390,996 +503,803 +469,945 +1,585,712 +Self insurance accruals (c) +407,263 +115,246 +158,154 +72,094 +61,769 +Post retirement benefit liability +16,311 +802 +2,067 +2,848 +10,594 +Total contractual obligations +$ +7,991,990 +$ +1,179,527 +$ +1,815,442 +$ +1,506,693 +$ +3,490,328 +(a) These estimated obligations for unpaid losses and loss adjustment expenses include case reserves for reported claims and IBNR claims estimates and are net of expected reinsurance recoveries. The ultimate amount to settle both the case reserves and IBNR is an estimate based upon historical experience and current trends and such estimates could materially differ from actual results. The assumptions do not include future premiums. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +(b) These estimated obligations are based on mortality, morbidity, withdrawal and lapse assumptions drawn from our historical experience and adjusted for any known trends. These obligations include expected interest crediting but no amounts for future annuity deposits or premiums for life and Medicare supplement policies. The cash flows shown above are undiscounted for interest and as a result total outflows for all years shown significantly exceed the corresponding liabilities of $1,808.9 million included in our consolidated balance sheet as of March 31, 2018. Life Insurance expects to fully fund these obligations from their invested asset portfolio. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +(c) These estimated obligations are primarily the Company’s self insurance accruals for portions of the liability coverage for our rental equipment. The estimates for future settlement are based upon historical experience and current trends. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +As presented above, contractual obligations on debt and guarantees represent principal payments while contractual obligations for operating leases represent the notional payments under the lease arrangements. +ASC 740 - Income Taxes liabilities and interest of $44.2 million is not included above due to uncertainty surrounding ultimate settlements, if any. +35 +Off Balance Sheet Arrangements +The Company uses off-balance sheet arrangements in situations where management believes that the economics and sound business principles warrant their use. +AMERCO utilizes operating leases for certain rental equipment and facilities with terms expiring substantially through 2024. In the event of a shortfall in proceeds from the sales of the underlying rental equipment assets, AMERCO has guaranteed $15.7 million of residual values at March 31, 2018 for these assets at the end of their respective lease terms. AMERCO has been leasing rental equipment since 1987. To date, we have not experienced residual value shortfalls related to these leasing arrangements. Using the average cost of fleet related debt as the discount rate, the present value of AMERCO’s minimum lease payments and residual value guarantees was $26.0 million at March 31, 2018. +Historically, we have used off-balance sheet arrangements in connection with the expansion of our self-storage business. For more information please see Note 19, Related Party Transactions, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. These arrangements were primarily used when our overall borrowing structure was more limited. We do not face similar limitations currently and off-balance sheet arrangements have not been utilized in our self-storage expansion in recent years. In the future, we will continue to identify and consider off-balance sheet opportunities to the extent such arrangements would be economically advantageous to us and our stockholders. SAC Holdings, Four SAC Self-Storage Corporation (“4 SAC”), Five SAC Self-Storage Corporation (“5 SAC”), Galaxy Investments, L.P. (“Galaxy”) and Private Mini are substantially controlled by Blackwater. Blackwater is wholly-owned by WGHLP, which is owned by Mark V. Shoen (a significant shareholder) and various trusts associated with Edward J. Shoen (our Chairman of the Board, President and a significant shareholder) and Mark V. Shoen. +We currently manage the self-storage properties owned or leased by Blackwater and Mercury pursuant to a standard form of management agreement, under which we receive a management fee of between 4% and 10% of the gross receipts plus reimbursement for certain expenses. We received management fees, exclusive of reimbursed expenses, of $29.5 million, $27.8 million and $27.1 million from the above mentioned entities during fiscal 2018, 2017 and 2016, respectively. This management fee is consistent with the fee received for other properties we previously managed for third parties. Mark V. Shoen controls the general partner of Mercury. The limited partner interests of Mercury are indirectly owned by Mark V. Shoen, James P. Shoen (a significant shareholder), and a trust benefitting the children and grandchildren of Edward J. Shoen (our Chairman of the Board, President and a significant shareholder). +We lease space for marketing company offices, vehicle repair shops and hitch installation centers from subsidiaries of Blackwater. Total lease payments pursuant to such leases were $2.7 million, $2.7 million and $2.6 million for fiscal years 2018, 2017 and 2016, respectively. The terms of the leases are similar to the terms of leases for other properties owned by unrelated parties that are leased by us. +At March 31, 2018, subsidiaries of Blackwater acted as U-Haul independent dealers. The financial and other terms of the dealership contracts with the aforementioned companies and their subsidiaries are substantially identical to the terms of those with our other independent dealers whereby commissions are paid by us based on equipment rental revenues. We paid the above mentioned entities $58.6 million, $57.1 million and $54.7 million in commissions pursuant to such dealership contracts during fiscal 2018, 2017 and 2016, respectively. +During fiscal 2018, a subsidiary of ours held a junior unsecured note of SAC Holdings. Substantially all of the equity interest of SAC Holdings is controlled by Blackwater. We do not have an equity ownership interest in SAC Holdings. We recorded interest income of $3.3 million, $4.9 million and $5.0 million and received cash interest payments of $8.7 million, $4.5 million and $4.6 million from SAC Holdings during fiscal 2018, 2017 and 2016, respectively. The largest aggregate amount of notes receivable outstanding during fiscal 2018 was $48.1 million. In December 2017, this note and interest receivable was repaid in full as we received payments of $53.0 million. +These agreements along with a note with subsidiaries of Blackwater, excluding Dealer Agreements, provided revenues of $26.9 million, expenses of $2.7 million and cash flows of $77.6 million during fiscal 2018. Revenues and commission expenses related to the Dealer Agreements were $273.6 million and $58.6 million, respectively during fiscal 2018. +Fiscal 2019 Outlook +36 +We will continue to focus our attention on increasing transaction volume and improving pricing, product and utilization for self-moving equipment rentals. Maintaining an adequate level of new investment in our truck fleet is an important component of our plan to meet our operational goals. Revenue in the U-Move ® program could be adversely impacted should we fail to execute in any of these areas. Even if we execute our plans, we could see declines in revenues primarily due to unforeseen events including adverse economic conditions or heightened competition that is beyond our control. +With respect to our storage business, we have added new locations and expanded at existing locations. In fiscal 2019, we are actively looking to acquire new locations, complete current projects and increase occupancy in our existing portfolio of locations. New projects and acquisitions will be considered and pursued if they fit our long-term plans and meet our financial objectives. We will continue to invest capital and resources in the U-Box ® program throughout fiscal 2019. +Property and Casualty Insurance will continue to provide loss adjusting and claims handling for +U-Haul and underwrite components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestor ® , and Safestor Mobile ® protection packages to U-Haul customers. +Life Insurance is pursuing its goal of expanding its presence in the senior market through the sales of its Medicare supplement, life and annuity policies. This strategy includes growing its agency force, expanding its new product offerings, and pursuing business acquisition opportunities. +Quarterly Results (unaudited) +The quarterly results shown below are derived from unaudited financial statements for the eight quarters beginning April 1, 2016 and ending March 31, 2018. We believe that all necessary adjustments have been included in the amounts stated below to present fairly, and in accordance with GAAP, such results. Moving and Storage operations are seasonal and proportionally more of the Company’s revenues and net earnings from its Moving and Storage operations are generated in the first and second quarters of each fiscal year (April through September). The operating results for the periods presented are not necessarily indicative of results for any future period. +Quarter Ended +March 31, 2018 +December 31, 2017 +September 30, 2017 +June 30, 2017 +(In thousands, except for share and per share data) +Total revenues +$ +757,621 +$ +842,882 +$ +1,042,686 +$ +957,925 +Earnings from operations +2,770 +303,137 +229,381 +229,031 +Earnings available to common +shareholders +10,843 +528,894 +124,639 +126,207 +Basic and diluted earnings +per common share +$ +0.56 +$ +27.00 +$ +6.36 +$ +6.44 +Weighted average common shares +outstanding: basic and diluted +19,589,871 +19,589,218 +19,588,571 +19,587,891 +Quarter Ended +March 31, 2017 +December 31, 2016 +September 30, 2016 +June 30, 2016 +(In thousands, except for share and per share data) +Total revenues +$ +709,436 +$ +790,455 +$ +998,685 +$ +923,191 +Earnings from operations +43,745 +131,981 +306,980 +259,557 +Earnings available to common +shareholders +9,548 +65,228 +176,475 +147,173 +Basic and diluted earnings +per common share +$ +0.49 +$ +3.33 +$ +9.01 +$ +7.51 +Weighted average common shares +outstanding: basic and diluted +19,587,204 +19,586,694 +19,586,411 +19,586,069 +37 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +We are exposed to financial market risks, including changes in interest rates and currency exchange rates. To mitigate these risks, we may utilize derivative financial instruments, among other strategies. We do not use derivative financial instruments for speculative purposes. +Interest Rate Risk +The exposure to market risk for changes in interest rates relates primarily to our variable rate debt obligations and one variable rate operating lease. We have used interest rate swap agreements and forward swaps to reduce our exposure to changes in interest rates. We enter into these arrangements with counterparties that are significant financial institutions with whom we generally have other financial arrangements. We are exposed to credit risk should these counterparties not be able to perform on their obligations. Following is a summary of our interest rate swaps agreements at March 31, 2018: +Notional Amount +Fair Value +Effective Date +Expiration Date +Fixed Rate +Floating Rate +(In thousands) +$ +61,388 +$ +(891) +8/18/2006 +8/10/2018 +5.43% +1 Month LIBOR +7,813 +(a) +(6) +6/1/2011 +6/1/2018 +2.38% +1 Month LIBOR +16,042 +(a) +4 +8/15/2011 +8/15/2018 +1.86% +1 Month LIBOR +6,400 +(a) +6 +9/12/2011 +9/10/2018 +1.75% +1 Month LIBOR +6,182 +(b) +39 +3/28/2012 +3/28/2019 +1.42% +1 Month LIBOR +8,854 +70 +4/16/2012 +4/1/2019 +1.28% +1 Month LIBOR +17,100 +318 +1/15/2013 +12/15/2019 +1.07% +1 Month LIBOR +(a) forward swap +(b) operating lease +As of March 31, 2018, we had $705.1 million of variable rate debt obligations and $6.2 million of a variable rate operating lease. If the London Inter-Bank Offer Rate were to increase 100 basis points, the increase in interest expense on the variable rate debt and a variable rate operating lease would decrease future earnings and cash flows by $5.9 million annually (after consideration of the effect of the above derivative contracts). Certain senior mortgages have an anticipated repayment date and a maturity date. If these senior mortgages are not repaid by the anticipated repayment date the interest rate on these mortgages would increase from the current fixed rate. We are using the anticipated repayment date for our maturity schedule. +Additionally, our insurance subsidiaries’ fixed income investment portfolios expose us to interest rate risk. This interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. As part of our insurance companies’ asset and liability management, actuaries estimate the cash flow patterns of our existing liabilities to determine their duration. These outcomes are compared to the characteristics of the assets that are currently supporting these liabilities assisting management in determining an asset allocation strategy for future investments that management believes will mitigate the overall effect of interest rates. +Foreign Currency Exchange Rate Risk +The exposure to market risk for changes in foreign currency exchange rates relates primarily to our Canadian business. Approximately 4.6%, 4.4% and 4.4% of our revenue was generated in Canada in fiscal 2018, 2017 and 2016, respectively. The result of a 10% change in the value of the U.S. dollar relative to the Canadian dollar would not be material to net income. We typically do not hedge any foreign currency risk since the exposure is not considered material. +38 +Item 8. Financial Statements and Supplementary Data +The Report of Independent Registered Public Accounting Firm and Consolidated Financial Statements of AMERCO and its consolidated subsidiaries including the notes to such statements and the related schedules are set forth on the “F” pages hereto and are incorporated by reference herein. +Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +Not applicable. +Item 9A. Controls and Procedures +Attached as exhibits to this Annual Report are certifications of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), which are required in accordance with Rule 13a-14 of the Exchange Act. This "Controls and Procedures" section includes information concerning the controls and procedures evaluation referred to in the certifications and it should be read in conjunction with the certifications for a more complete understanding of the topics presented in the section Evaluation of Disclosure Controls and Procedures. +Following this discussion is the report of BDO USA, LLP, our independent registered public accounting firm, regarding its audit of AMERCO’s internal control over financial reporting as set forth below in this section. This section should be read in conjunction with the certifications of our CEO and CFO and the BDO USA, LLP report for a more complete understanding of the topics presented. +Evaluation of Disclosure Controls and Procedures +The Company’s management, with the participation of the CEO and CFO, conducted an evaluation of the effectiveness of the design and operation of the Company’s "disclosure controls and procedures" (as such term is defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) (“Disclosure Controls”) as of the end of the period covered by this Annual Report. Our Disclosure Controls are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Our Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Based upon the controls evaluation, our CEO and CFO have concluded that as of the end of the period covered by this Annual Report, our Disclosure Controls were effective at a reasonable assurance level related to the above stated design purposes. +Inherent Limitations on Effectiveness of Controls +The Company's management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. +39 +Changes in Internal Control over Financial Reporting +There has not been any change in the Company’s internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f) during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements. +Management assessed our internal control over financial reporting as of March 31, 2018, the end of our fiscal year. Management based its assessment on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management's assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment. This assessment is supported by testing and monitoring performed both by our Internal Audit function and our Finance function. +Based on our assessment, management has concluded that our internal control over financial reporting was effective as of the end of the fiscal year 2018. We reviewed the results of management's assessment with the Audit Committee of our Board. +Our independent registered public accounting firm, BDO USA, LLP, has audited the Company's internal control over financial reporting and has issued their report, which is included on the following page. +40 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +AMERCO +Reno, Nevada +Opinion on Internal Control over Financial Reporting +We have audited AMERCO and consolidated subsidiaries’ (the “Company”) internal control over financial reporting as of March 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”) In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of March 31, 2018, based on the COSO criteria . +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of March 31, 2018 and 2017, the related consolidated statements of operations, changes in stockholders’ equity, comprehensive income (loss) and cash flows for each of the three years in the period ended March 31, 2018, and the related notes and schedules and our report dated May 30, 2018 expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ BDO USA, LLP +Phoenix, Arizona +May 30, 2018 +41 +Item 9B. Other Information +Not applicable. +PART III +Item 10. Directors, Executive Officers and Corporate Governance +The information required to be disclosed under this Item 10 is incorporated herein by reference to AMERCO’s definitive proxy statement, in connection with its 2018 annual meeting of stockholders (the “Proxy Statement”), which will be filed with the SEC within 120 days after the close of the Company’s 2018 fiscal year. +The Company has a Code of Ethics that applies to all directors, officers and employees of the Company, including the Company’s principal executive officer and principal financial officer. A copy of our Code of Ethics is posted on AMERCO’s website at amerco.com/governance.aspx. We intend to satisfy the disclosure requirements of Current Report on Form 8-K regarding any amendment to, or waiver from, a provision of our Code of Ethics by posting such information on the Company’s website, at the web address and location specified above, unless otherwise required to file a Current Report on Form 8-K by NASDAQ rules and regulations. +Item 11. Executive Compensation +The information required to be disclosed under this Item 11 is incorporated herein by reference to the Proxy Statement. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +The information required to be disclosed under this Item 12 is incorporated herein by reference to the Proxy Statement. +Item 13. Certain Relationships and Related Transactions, and Director Independence +The information required to be disclosed under this Item 13 is incorporated herein by reference to the Proxy Statement. +Item 14. Principal Accounting Fees and Services +The information required to be disclosed under this Item 14 is incorporated herein by reference to the Proxy Statement. +PART IV +Item 15. Exhibits and Financial Statement Schedules +The following documents are filed as part of this Report: +Page +1 +Financial Statements: +Report of Independent Registered Public Accounting Firm +F-1 +Consolidated Balance Sheets - March 31, 2018 and 2017 +F-2 +Consolidated Statements of Operations - Years Ended March 31, 2018, 2017, and 2016 +F-3 +Consolidated Statements of Comprehensive Income (Loss) - Years Ended March 31, 2018, 2017, and 2016 +F-4 +Consolidated Statements of Changes in Stockholders' Equity - Years Ended March 31, 2018, 2017, and 2016 +F-5 +Consolidated Statements of Cash Flows - Years Ended March 31, 2018, 2017, and 2016 +F-6 +Notes to Consolidated Financial Statements +F-7 +2 +Financial Statement Schedules required to be filed by Item 8: +Schedule I - Condensed Financial Information of AMERCO +F-54 +Schedule II - AMERCO and Consolidated Subsidiaries Valuation and Qualifying Accounts +F-58 +Schedule V - AMERCO and Consolidated Subsidiaries Supplemental Information (For Property-Casualty Insurance Operations) +F-59 +42 +All other schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. +Exhibits: +Exhibit Number +Description +Page or Method of Filing +3.1 +Amended and Re s tated Articles of Incorporation of AMERCO +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed on June 9, 2016, file no. 1-11255 +3.2 +Restated Bylaws of AM E RCO +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed on September 5, 2013, file no. 1-11255 +4.1 +U-Haul Investors Club Base Indenture, dated February 14, 2011 by and between AMERCO and U. S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on February 22, 2011, file no. 1-11255 +4.2 +Second Supp l emental Indenture, dated February 17, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on February 22, 2011, file no. 1-11255 +4.3 +Fourth Supplemental Indenture, dated March 15, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on March 22, 2011, file no. 1-11255 +4.4 +Seven t h Supplemental Indenture, dated March 29, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on April 1, 2011, file no. 1-11255 +4.5 +Tenth Supplemental Indenture, dated June 7, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 23, 2011, file no. 1-11255 +4.6 +Eleventh Supplemental Indenture dated June 7, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 31, 2011, file no. 1-11255 +4.7 +Twelfth Supplemental Indenture dated June 14, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 23, 2011, file no. 1-11255 +4.8 +Fourteenth Supplemental Indenture dated July 20, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on August 17, 2011, file no. 1-11255 +4.9 +Sixteenth Supplemental Indenture dated August 31, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 28, 2011, file no. 1-11255 +4.10 +Seventeenth Supplemental Indenture dated November 8, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on January 18, 2012, file no. 1-11255 +4.11 +Eighteenth Supplemental Indenture dated January 7, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on March 26, 2012, file no. 1-11255 +4.12 +Nineteenth Supplemental Indenture dated May 14, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on May 15, 2012, file no. 1-11255 +43 +4.13 +Eighth Supplemental Indenture, dated April 12, 2011, by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year end March 31, 2012, file no. 1-11255 +4.14 +Twentieth Supplemental Indenture dated September 4, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 4, 2012, file no. 1-11255 +4.15 +Twenty-first Supplemental Indenture dated January 15, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on January 15, 2013, file no. 1-11255 +4.16 +Twenty-second Supplemental Indenture, dated May 28, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 30, 2013, file no. 1-11255 +4.17 +Twenty-third Supplemental Indenture, dated November 26, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on November 26, 2013, file no. 1-11255 +4.18 +Twenty-fourth Supplemental Indenture, dated April 22, 2014 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on April 22, 2014, file no. 1-11255 +4.19 +Twenty-fifth Supplemental Indenture, dated July 7, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on July 7, 2015, file no. 1-11255 +4.20 +Twenty-sixth Supplemental Indenture, dated September 29, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on September 29, 2015, file no. 1-11255 +4.21 +Twenty-seventh Supplemental Indenture, dated December 15, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on December 15, 2015, file no. 1-11255 +4.22 +Twenty-eighth Supplemental Indenture, dated September 13, 2016 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on September 13, 2016, file no. 1-11255 +4.23 +Twenty-ninth Supplemental Indenture, dated January 24, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on January 24, 2017, file no. 1-11255 +4.24 +Thirtieth Supplemental Indenture, dated June 27, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on June 27, 2017, file no. 1-11255 +4.25 +Thirty-first Supplemental Indenture, dated October 24, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on October 25, 2017, file no. 1-11255 +4.26 +Thirty-second Supplem e ntal Indenture, dated March 6, 2018 by a nd between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on March 6, 2018, file no. 1-11255 +10.1 +Management Agreement between Four SAC Self-Storage Corp o ration and subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 1997, file no. 1-11255 +44 +10.2 +Management Agreement between Five SAC Self-Storage Corpo r ation and subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 1999, file no. 1-11255 +10.3 +Property Management Agreement +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2004, file no. 1-11255 +10.4 +U-Haul Dealership Contract between U-Haul Leasing & Sales Co., and U-Haul Moving Partners, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, file no. 1-11255 +10.5 +Property Management Agreement between Mercury Partners, LP, Mercury 99, LLC and U-Haul Self-Storage Management (WPC), Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, file no. 1-11255 +10.6 +Amended and Restated Credit Agreement, dated June 8, 2005, among Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.7 +Security Agreement dated June 8, 2005, by Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and the Marketing Grantors named therein in favor of Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.8 +Guarantee, dated June 8, 2005, by U-Haul International, Inc. in favor of Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.9 +Promissory Note, dated June 8, 2005 by Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc. and U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.10 +Amendment No. 1 to the Amended and Restated Credit Agreement and Security Agreement, dated as of August 18, 2006, to the Amended and Restated Credit Agreement, dated as of June 8, 2005, among Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and the Marketing Grantors named therein in favor of Merrill Lynch Commercial Financial Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed August 23, 2006, file no. 1-11255 +45 +10.11 +Amended and Restated Property Management Agreement among Eight SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.12 +Amended and Restated Property Management Agreement among Nine SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.13 +Amended and Restated Property Management Agreement among Ten SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.14 +Amended and Restated Property Management Agreement among Eleven SAC Self-Storage Corporation and Eleven SAC Self-Storage Odenton, Inc. and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.15 +Amended and Restated Property Management Agreement among Twelve SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.16 +Amended and Restated Property Management Agreement among Thirteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.17 +Amended and Restated Property Management Agreement among Fourteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.18 +Amended and Restated Property Management Agreement among Fifteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.19 +Amended and Restated Property Management Agreement among Sixteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.20 +Amended and Restated Property Management Agreement among Seventeen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.21 +Amended and Restated Property Management Agreement among Eighteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.22 +Amended and Restated Property Management Agreement among Twenty SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +46 +10.23 +Amended and Restated Property Management Agreement among Twenty-One SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.24 +Amended and Restated Property Management Agreement among Twenty-Two SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.25 +Amended and Restated Property Management Agreement among Twenty-Three SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.26 +Amended and Restated Property Management Agreement among Twenty-Four SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.27 +Amended and Restated Property Management Agreement among Twenty-Five SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.28 +Amended and Restated Property Management Agreement among Twenty-Six SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.29 +Amended and Restated Property Management Agreement among Twenty-Seven SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.30 +Amended and Restated Property Management Agreement among Three-A SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.31 +Amended and Restated Property Management Agreement among Three-B SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.32 +Amended and Restated Property Management Agreement among Three-C SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.33 +Amended and Restated Property Management Agreement among Three-D SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.34 +Amended and Restated Property Management Agreement among Galaxy Storage One, LP and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.35 +U-Haul Dealership Contract Addendum +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +47 +10.36 +Loan Agreement, dated as of August 12, 2015 among U-Haul Co of Florida 8, LLC, U-Haul Co. of Florida 9, LLC, U-Haul Co. of Florida 10, UHIL 8, LLC, UHIL 9, LLC, UHIL 10, LLC, UHIL 13, LLC, AREC 8, LLC, AREC 9, LLC, AREC 10, LLC and AREC 13, LLC, each a Delaware limited liability company, collectively as Borrower, and Morgan Stanley Bank, N.A. and JP Morgan Chase Bank, National Association, collectively as Lender +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on August 14, 2015, file no. 1-11255 +10.37 +Property Management Agreement dated December 11, 2014 between Three SAC Self-Storage Corporation and U-Haul Co. (Canada), Ltd +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.38 +Property Management Agreement dated December 16, 2014 among Galaxy Storage Two, L.P. and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.39 +Property Management Agreement dated June 25, 2015 among 2015 SAC Self-Storage, LLC and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.40 +Property Management Agreement dated March 21, 2016 among Five SAC RW, LLC and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.41 +Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.42 +Amended and Restated AMERCO Employee Stock Ownership Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.43 +Property Management Agreement among Six-SAC Self-Storage Corporation and certain subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 27, 2016, file no. 1-11255 +10.44 +Stockholder Agreement dated September 12, 2016, between Edward J. Shoen, Mark V. Shoen, Foster Road LLC, Willow Grove Holdings LP, Blackwater Investments, Inc. and SAC Holdings Corporation +Incorporated by reference to Exhibit 99.1, filed with the Schedule 13-D/A, filed on September 12, 2016, file number 5-39669 +10.45 +2016 Stock Option Plan (Shelf Stock Option Plan)* +Incorporated by reference to Exhibit C to Definitive Proxy for the Special Meeting of Stockholders filed on April 20, 2016 +10.46 +Credit Agreement, dated as of September 1, 2017 by and among AMERCO, as the Borrower, Bank of America, N.A., as Agent for all Lenders, and the fina n cial institutions party thereto from to time as, Lenders. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 7, 2017, file no. 1-11255 +10.47 +Template Dealership Contract +Filed herewith +48 +10.48 +Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Filed herewith +10.49 +Amendment to the Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Filed herewith +10.50 +Amended and Restated AMERCO Employee Stock Ownership Plan* +Filed herewith +10.51 +Amendment to the Amended and Restated AMERCO Employee Stock Ownership Plan +Filed herewith +14 +Code of Ethics +Incorporated by reference to AMERCO’s Quarterly Report on Form 8-K, filed on April 15, 2014, file no. 1-11255 +21 +Subsidiaries of AMERCO +Filed herewith +23.1 +Consent of BDO USA, LLP +Filed herewith +24 +Power of Attorney +Refer to signature page +31.1 +Rule 13a-14(a)/15d-14(a) Certificate of Edward J. Shoen, President and Chairman of the Board of AMERCO +Filed herewith +31.2 +Rule 13a-14(a)/15d-14(a) Certificate of Jason A. Berg, Chief Financial Officer of AMERCO +Filed herewith +32.1 +Certificate of Edward J. Shoen, President and Chairman of the Board of AMERCO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Furnished herewith +32.2 +Certificate of Jason A. Berg, Chief Financial Officer of AMERCO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Furnished herewith +101.INS +XBRL Instance Document +Furnished herewith +101.SCH +XBRL Taxonomy Extension Schema +Furnished herewith +101.CAL +XBRL Taxonomy Extension Calculation Linkbase +Furnished herewith +101.LAB +XBRL Taxonomy Extension Label Linkbase +Furnished herewith +101.PRE +XBRL Taxonomy Extension Presentation Linkbase +Furnished herewith +101.DEF +XBRL Taxonomy Extension Definition Linkbase +Furnished herewith +* Indicates management plan or compensatory arrangement. +Item 16. Form 10-K Summary +None. +49 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +AMERCO +Reno, Nevada +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of AMERCO and consolidated subsidiaries (the “Company”) as of March 31, 2018 and 2017, the related consolidated statements of operations, changes in stockholders’ equity, comprehensive income (loss), and cash flows for each of the three years in the period ended March 31, 2018, and the related notes and schedules (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at March 31, 2018 and 2017, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2018 , in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of March 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated May 30, 2018 expressed an unqualified opinion thereon. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/BDO USA, LLP +We have served as the Company's auditor since 2003. +Phoenix, Arizona +May 30, 2018 +F- 1 +Amerco and consolidated subsidiaries +Consolidated balance sheets +March 31, +2018 +2017 +(In thousands, except share data) +ASSETS +Cash and cash equivalents +$ +759,388 +$ +697,806 +Reinsurance recoverables and trade receivables, net +193,538 +178,081 +Inventories and parts, net +89,877 +82,439 +Prepaid expenses +165,692 +124,728 +Investments, fixed maturities and marketable equities +1,919,860 +1,663,768 +Investments, other +399,064 +367,830 +Deferred policy acquisition costs, net +124,767 +130,213 +Other assets +244,782 +97,525 +Related party assets +33,276 +86,168 +3,930,244 +3,428,558 +Property, plant and equipment, at cost: +Land +827,649 +648,757 +Buildings and improvements +3,140,713 +2,618,265 +Furniture and equipment +632,803 +510,415 +Rental trailers and other rental equipment +545,968 +492,280 +Rental trucks +4,390,750 +4,091,598 +9,537,883 +8,361,315 +Less: Accumulated depreciation +(2,721,142) +(2,384,033) +Total property, plant and equipment +6,816,741 +5,977,282 +Total assets +$ +10,746,985 +$ +9,405,840 +LIABILITIES AND STOCKHOLDERS' EQUITY +Liabilities: +Accounts payable and accrued expenses +$ +510,678 +$ +450,541 +Notes, loans and leases payable, net +3,513,076 +3,262,880 +Policy benefits and losses, claims and loss expenses payable +1,248,033 +1,086,322 +Liabilities from investment contracts +1,364,066 +1,112,498 +Other policyholders' funds and liabilities +10,040 +10,150 +Deferred income +34,276 +28,696 +Deferred income taxes, net +658,108 +835,009 +Total liabilities +7,338,277 +6,786,096 +Commitments and contingencies (notes 9, 16, 17, and 18) +Stockholders' equity: +Series preferred stock, with or without par value, 50,000,000 shares authorized: +Series A preferred stock, with no par value, 6,100,000 shares authorized; +6,100,000 shares issued and none outstanding as of March 31, 2018 and 2017 +– +– +Series B preferred stock, with no par value, 100,000 shares authorized; none +issued and outstanding as of March 31, 2018 and 2017 +– +– +Serial common stock, with or without par value, 250,000,000 shares authorized: +Serial common stock of $0.25 par value, 10,000,000 shares authorized; +none issued and outstanding as of March 31, 2018 and 2017 +– +– +Common stock, with $0.25 par value, 250,000,000 shares authorized: +Common stock of $0.25 par value, 250,000,000 shares authorized; 41,985,700 +issued and 19,607,788 outstanding as of March 31, 2018 and 2017 +10,497 +10,497 +Additional paid-in capital +452,746 +452,172 +Accumulated other comprehensive loss +(4,623) +(51,236) +Retained earnings +3,635,561 +2,892,893 +Cost of common shares in treasury, net (22,377,912 shares as of March 31, 2018 and 2017) +(525,653) +(525,653) +Cost of preferred shares in treasury, net (6,100,000 shares as of March 31, 2018 and 2017) +(151,997) +(151,997) +Unearned employee stock ownership plan shares +(7,823) +(6,932) +Total stockholders' equity +3,408,708 +2,619,744 +Total liabilities and stockholders' equity +$ +10,746,985 +$ +9,405,840 +The accompanying notes are an integral part of these consolidated financial statements. +F- 2 +amerco and consolidated subsidiaries +Consolidated statements of operations +Years Ended March 31, +2018 +2017 +2016 +(In thousands, except share and per share data) +Revenues: +Self-moving equipment rentals +$ +2,479,742 +$ +2,362,833 +$ +2,297,980 +Self-storage revenues +323,903 +286,886 +247,944 +Self-moving and self-storage products and service sales +261,557 +253,073 +251,541 +Property management fees +29,602 +29,075 +26,533 +Life insurance premiums +154,703 +163,579 +162,662 +Property and casualty insurance premiums +57,100 +52,334 +50,020 +Net investment and interest income +110,473 +102,276 +86,617 +Other revenue +184,034 +171,711 +152,171 +Total revenues +3,601,114 +3,421,767 +3,275,468 +Costs and expenses: +Operating expenses +1,807,983 +1,568,083 +1,470,047 +Commission expenses +276,705 +267,230 +262,627 +Cost of sales +160,489 +152,485 +144,990 +Benefits and losses +185,311 +182,710 +167,436 +Amortization of deferred policy acquisition costs +24,514 +26,218 +23,272 +Lease expense +33,960 +37,343 +49,780 +Depreciation, net gains on disposals of ($11,822, $32,495 and $98,158, respectively) +543,247 +449,025 +291,235 +Net gains on disposal of real estate +(195,414) +(3,590) +(545) +Total costs and expenses +2,836,795 +2,679,504 +2,408,842 +Earnings from operations +764,319 +742,263 +866,626 +Interest expense +(126,706) +(113,406) +(97,715) +Fees and amortization on early extinguishment of debt +– +(499) +– +Pretax earnings +637,613 +628,358 +768,911 +Income tax benefit (expense) +152,970 +(229,934) +(279,910) +Earnings available to common stockholders +$ +790,583 +$ +398,424 +$ +489,001 +Basic and diluted earnings per common share +$ +40.36 +$ +20.34 +$ +24.95 +Weighted average common shares outstanding: Basic and diluted +19,588,889 +19,586,606 +19,596,110 +Related party revenues for fiscal 2018, 2017 and 2016, net of eliminations, were $32.9 million, $34.0 million and $32.6 million, respectively. +Related party costs and expenses for fiscal 2018, 2017, and 2016, net of eliminations, were $61.3 million, $59.9 million and $57.4 million, respectively. +The accompanying notes are an integral part of these consolidated financial statements. +F- 3 +Amerco and Consolidated Subsidiaries +Consolidated statements of comprehensive income (loss) +Fiscal Year Ended March 31, 2018 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +637,613 +$ +152,970 +$ +790,583 +Other comprehensive income: +Foreign currency translation +14,652 +– +14,652 +Unrealized net gain on investments +30,929 +(10,825) +20,104 +Change in fair value of cash flow hedges +4,445 +(1,363) +3,082 +Change in postretirement benefit obligations +288 +(253) +35 +Total comprehensive income +$ +687,927 +$ +140,529 +$ +828,456 +Fiscal Year Ended March 31, 2017 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +628,358 +$ +(229,934) +$ +398,424 +Other comprehensive income: +Foreign currency translation +(5,862) +– +(5,862) +Unrealized net gain on investments +13,822 +(4,838) +8,984 +Change in fair value of cash flow hedges +9,916 +(3,767) +6,149 +Change in postretirement benefit obligations +28 +(10) +18 +Total comprehensive income +$ +646,262 +$ +(238,549) +$ +407,713 +Fiscal Year Ended March 31, 2016 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +768,911 +$ +(279,910) +$ +489,001 +Other comprehensive income: +Foreign currency translation +(4,473) +– +(4,473) +Unrealized net loss on investments +(41,639) +14,573 +(27,066) +Change in fair value of cash flow hedges +9,721 +(3,694) +6,027 +Change in postretirement benefit obligations +(1,029) +381 +(648) +Total comprehensive income +$ +731,491 +$ +(268,650) +$ +462,841 +The accompanying notes are an integral part of these consolidated financial statements . +F- 4 +Amerco and consolidated subsidiaries +consolidated statements of changes in stockholders’ equity +Description +Common Stock +Additional Paid-In Capital +Accumulated Other Comprehensive +Income (Loss) +Retained Earnings +Less: Treasury Common Stock +Less: Treasury Preferred Stock +Less: Unearned Employee Stock Ownership Plan Shares +Total Stockholders' Equity +(In thousands) +Balance as of March 31, 2015 +$ +10,497 +$ +449,668 +$ +(34,365) +$ +2,142,600 +$ +(525,653) +$ +(151,997) +$ +(6,391) +$ +1,884,359 +Increase in market value of released ESOP shares +– +1,961 +– +– +– +– +– +1,961 +Release of unearned ESOP shares +– +– +– +– +– +– +9,507 +9,507 +Purchase of ESOP shares +– +– +– +– +– +– +(9,302) +(9,302) +Foreign currency translation +– +– +(4,473) +– +– +– +– +(4,473) +Unrealized net loss on investments, net of tax +– +– +(27,066) +– +– +– +– +(27,066) +Change in fair value of cash flow hedges, net of tax +– +– +6,027 +– +– +– +– +6,027 +Change in postretirement benefit obligations +– +– +(648) +– +– +– +– +(648) +Net earnings +– +– +– +489,001 +– +– +– +489,001 +Common stock dividends: ($5.00 per share for fiscal 2016) +– +– +– +(97,960) +– +– +– +(97,960) +Net activity +– +1,961 +(26,160) +391,041 +– +– +205 +367,047 +Balance as of March 31, 2016 +$ +10,497 +$ +451,629 +$ +(60,525) +$ +2,533,641 +$ +(525,653) +(151,997) +$ +(6,186) +$ +2,251,406 +Increase in market value of released ESOP shares +– +543 +– +– +– +– +– +543 +Release of unearned ESOP shares +– +– +– +– +– +– +10,360 +10,360 +Purchase of ESOP shares +– +– +– +– +– +– +(11,106) +(11,106) +Foreign currency translation +– +– +(5,862) +– +– +– +– +(5,862) +Unrealized net gain on investments, net of tax +– +– +8,984 +– +– +– +– +8,984 +Change in fair value of cash flow hedges, net of tax +– +– +6,149 +– +– +– +– +6,149 +Change in postretirement benefit obligations +– +– +18 +– +– +– +– +18 +Net earnings +– +– +– +398,424 +– +– +– +398,424 +Common stock dividends: ($2.00 per share for fiscal 2017) +– +– +– +(39,172) +– +– +– +(39,172) +Net activity +– +543 +9,289 +359,252 +– +– +(746) +368,338 +Balance as of March 31, 2017 +$ +10,497 +$ +452,172 +$ +(51,236) +$ +2,892,893 +$ +(525,653) +$ +(151,997) +$ +(6,932) +$ +2,619,744 +Adjustment for adoption of ASU 2018 - 02 +– +– +8,740 +(8,740) +– +– +– +– +Increase in market value of released ESOP shares +– +574 +– +– +– +– +– +574 +Release of unearned ESOP shares +– +– +– +– +– +– +10,749 +10,749 +Purchase of ESOP shares +– +– +– +– +– +– +(11,640) +(11,640) +Foreign currency translation +– +– +14,652 +– +– +– +– +14,652 +Unrealized net gain on investments, net of tax +– +– +20,104 +– +– +– +– +20,104 +Change in fair value of cash flow hedges, net of tax +– +– +3,082 +– +– +– +– +3,082 +Change in postretirement benefit obligations +– +– +35 +– +– +– +– +35 +Net earnings +– +– +– +790,583 +– +– +– +790,583 +Common stock dividends: ($2.00 per share for fiscal 2018) +– +– +– +(39,175) +– +– +– +(39,175) +Net activity +– +574 +46,613 +742,668 +– +– +(891) +788,964 +Balance as of March 31, 2018 +$ +10,497 +$ +452,746 +$ +(4,623) +$ +3,635,561 +$ +(525,653) +$ +(151,997) +$ +(7,823) +$ +3,408,708 +The accompanying notes are an integral part of these consolidated financial statements. +F- 5 +amerco and consolidated subsidiaries +consolidated statements of cash flows +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Cash flows from operating activities: +Net earnings +$ +790,583 +$ +398,424 +$ +489,001 +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +555,069 +481,520 +389,393 +Amortization of deferred policy acquisition costs +24,514 +26,218 +23,272 +Amortization of debt issuance costs +3,868 +4,062 +3,419 +Interest credited to policyholders +32,302 +25,020 +20,465 +Change in allowance for losses on trade receivables +(120) +(46) +(205) +Change in allowance for inventories and parts reserves +5,065 +1,330 +(1,343) +Net gains on disposal of personal property +(11,822) +(32,495) +(98,158) +Net gains on disposal of real estate +(195,414) +(3,590) +(545) +Net gains on sales of investments +(6,269) +(5,284) +(4,491) +Deferred income taxes +(193,434) +173,112 +138,075 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(15,329) +(2,890) +14,765 +Inventories and parts +(12,384) +(4,072) +(9,009) +Prepaid expenses +(40,765) +9,386 +(10,338) +Capitalization of deferred policy acquisition costs +(27,350) +(27,111) +(32,590) +Other assets +(165,968) +(2,488) +16,261 +Related party assets +53,408 +343 +56,644 +Accounts payable and accrued expenses +(25,546) +(5,056) +37,312 +Policy benefits and losses, claims and loss expenses payable +161,121 +15,378 +9,626 +Other policyholders' funds and liabilities +(109) +1,499 +(349) +Deferred income +5,524 +5,921 +4,757 +Related party liabilities +(616) +(1,062) +(616) +Net cash provided by operating activities +936,328 +1,058,119 +1,045,346 +Cash flow from investing activities: +Escrow deposits +31,362 +(38,058) +(4,358) +Purchase of: +Property, plant and equipment +(1,363,745) +(1,419,505) +(1,509,154) +Short term investments +(63,556) +(635,847) +(515,899) +Fixed maturity investments +(390,900) +(355,101) +(398,987) +Equity securities +(662) +(489) +(1,315) +Preferred stock +(1,000) +– +(1,005) +Real estate +(1,939) +(32,807) +(15,459) +Mortgage loans +(83,507) +(154,310) +(87,204) +Proceeds from sales and paydowns of: +Property, plant and equipment +699,803 +487,475 +539,256 +Short term investments +67,790 +655,726 +528,180 +Fixed maturity investments +164,825 +190,578 +154,536 +Equity securities +– +– +2,044 +Preferred stock +4,208 +4,181 +1,126 +Real estate +2,783 +8,753 +21,589 +Mortgage loans +37,590 +106,832 +26,968 +Net cash used by investing activities +(896,948) +(1,182,572) +(1,259,682) +Cash flow from financing activities: +Borrowings from credit facilities +498,464 +742,625 +837,972 +Principal repayments on credit facilities +(356,451) +(367,844) +(428,403) +Payment of debt issuance costs +(5,111) +(5,055) +(10,184) +Capital lease payments +(296,363) +(212,545) +(168,661) +Employee Stock Ownership Plan Shares +(11,640) +(11,106) +(9,302) +Securitization deposits +(2,180) +446 +544 +Common stock dividends paid +(29,380) +(58,757) +(78,374) +Investment contract deposits +401,814 +285,148 +358,237 +Investment contract withdrawals +(182,549) +(149,159) +(112,957) +Net cash provided by financing activities +16,604 +223,753 +388,872 +Effects of exchange rate on cash +5,598 +(2,140) +(15,740) +Increase in cash and cash equivalents +61,582 +97,160 +158,796 +Cash and cash equivalents at the beginning of period +697,806 +600,646 +441,850 +Cash and cash equivalents at the end of period +$ +759,388 +$ +697,806 +$ +600,646 +The accompanying notes are an integral part of these consolidated financial statements. +F- 6 +amerco and consolidated subsidiaries +notes to consolidated financial statements +Note 1. Basis of Presentation +AMERCO, a Nevada Corporation (“AMERCO”), has a fiscal year that ends on the 31 st of March for each year that is referenced. Our insurance company subsidiaries have fiscal years that end on the 31 st of December for each year that is referenced. They have been consolidated on that basis. Our insurance companies’ financial reporting processes conform to calendar year reporting as required by state insurance departments. Management believes that consolidating their calendar year into our fiscal year financial statements does not materially affect the financial position or results of operations. We disclose any material events occurring during the intervening period. Consequently, all references to our insurance subsidiaries’ years 2017, 2016 and 2015 correspond to fiscal 2018, 2017 and 2016 for AMERCO. +Accounts denominated in non-U.S. currencies have been translated into U.S. dollars. Certain amounts reported in previous years have been reclassified to conform to the current presentation. +Note 2. Principles of Consolidation +We apply Accounting Standards Codification (“ASC”) 810 - Consolidation (“ASC 810”) in our principles of consolidation. ASC 810 addresses arrangements where a company does not hold a majority of the voting or similar interests of a variable interest entity (“VIE”). A company is required to consolidate a VIE if it has determined it is the primary beneficiary. ASC 810 also addresses the policy when a company owns a majority of the voting or similar rights and exercises effective control. +As promulgated by ASC 810, a VIE is not self-supportive due to having one or both of the following conditions: (i) it has an insufficient amount of equity for it to finance its activities without receiving additional subordinated financial support or (ii) its owners do not hold the typical risks and rights of equity owners. This determination is made upon the creation of a variable interest and is re-assessed on an on-going basis should certain changes in the operations of a VIE, or its relationship with the primary beneficiary trigger a reconsideration under the provisions of ASC 810. After a triggering event occurs the most recent facts and circumstances are utilized in determining whether or not a company is a VIE, which other company(ies) have a variable interest in the entity, and whether or not the company’s interest is such that it is the primary beneficiary. +We will continue to monitor our relationships with the other entities regarding who is the primary beneficiary, which could change based on facts and circumstances of any reconsideration events. +Intercompany accounts and transactions have been eliminated. +Description of Legal Entities +AMERCO is the holding company for: +U-Haul International, Inc. (“U-Haul”), +Amerco Real Estate Company (“Real Estate”), +Repwest Insurance Company (“Repwest”), and +Oxford Life Insurance Company (“Oxford”). +Unless the context otherwise requires, the terms “Company,” “we,” “us” or “our” refer to AMERCO and all of its legal subsidiaries. +Description of Operating Segments +AMERCO has three reportable segments. They are Moving and Storage, Property and Casualty Insurance and Life Insurance. +Moving and Storage includes AMERCO, U-Haul, and Real Estate and the wholly-owned subsidiaries of U-Haul and Real Estate. Operations consist of the rental of trucks and trailers, sales of moving supplies, sales of towing accessories, sales of propane, and the rental of fixed and portable moving and storage units to the “do-it-yourself” mover and management of self-storage properties owned by others. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +F- 7 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Property and Casualty Insurance includes Repwest and its wholly-owned subsidiaries and ARCOA Risk Retention Group (“ARCOA”). Property and Casualty Insurance provides loss adjusting and claims handling for U-Haul through regional offices in the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestor ® and Safestor Mobile ® protection packages to U-Haul customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. ARCOA is a group captive insurer owned by us and our wholly-owned subsidiaries whose purpose is to provide insurance products related to our moving and storage business. +Life Insurance includes Oxford and its wholly-owned subsidiaries. Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Note 3. Accounting Policies +Use of Estimates +The preparation of financial statements in conformity with the generally accepted accounting principles (“GAAP”) in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. The accounting policies that we deem most critical to us and that require management’s most difficult and subjective judgments include the principles of consolidation, the recoverability of property, plant and equipment, the adequacy of insurance reserves, the recognition and measurement of impairments for investments accounted for under ASC 320 - Investments - Debt and Equity Securities and the recognition and measurement of income tax assets and liabilities. The actual results experienced by us may materially differ from management’s estimates. +Cash and Cash Equivalents +We consider cash equivalents to be highly liquid debt securities with insignificant interest rate risk with original maturities from the date of purchase of three months or less. +Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash deposits. Accounts at each United States financial institution are insured by the Federal Deposit Insurance Corporation up to $250,000. Accounts at each Canadian financial institution are insured by the Canada Deposit Insurance Corporation up to $100,000 CAD per account. At March 31, 2018 and March 31, 2017, we held cash equivalents in excess of these insured limits. To mitigate this risk, we select financial institutions based on their credit ratings and financial strength. +Investments +Fixed Maturities and Marketable Equities. Fixed maturity investments consist of either marketable debt, equity or redeemable preferred stocks. As of the balance sheet dates, all of our investments in these securities were classified as available-for-sale. Available-for-sale investments are reported at fair value, with unrealized gains or losses recorded net of taxes and applicable adjustments to deferred policy acquisition costs in stockholders’ equity. Fair value for these investments is based on quoted market prices, dealer quotes or discounted cash flows. The cost of investments sold is based on the specific identification method. +In determining if and when a decline in market value below carrying value is an other-than-temporary impairment, management makes certain assumptions or judgments in its assessment including but not limited to: our ability to hold the security, quoted market prices, dealer quotes, discounted cash flows, industry factors, financial factors, and issuer specific information. Other-than-temporary impairments, to the extent of the decline, as well as realized gains or losses on the sale or exchange of investments are recognized in the current period operating results. +Mortgage Loans and Notes on Real Estate. Mortgage loans and notes on real estate are reported at their unpaid balance, net of any allowance for possible losses and any unamortized premium or discount. +F- 8 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Recognition of Investment Income. Interest income from bonds and mortgage notes is recognized when earned. Dividends on common and preferred stocks are recognized on the ex-dividend dates. Realized gains and losses on the sale or exchange of investments are recognized at the trade date. +Derivative Financial Instruments +Our objective for holding derivative financial instruments is to manage interest rate risk exposure primarily through entering interest rate swap agreements. An interest rate swap is a contractual exchange of interest payments between two parties. A standard interest rate swap involves the payment of a fixed rate times a notional amount by one party in exchange for a receiving floating rate times the same notional amount from another party. As interest rates change, the difference to be paid or received is accrued and recognized as interest expense or income over the life of the agreement. We do not enter into these instruments for trading purposes. Counterparties to the interest rate swap agreements are major financial institutions. In accordance with ASC 815 - Derivatives and Hedging , we recognize interest rate swap agreements on the balance sheet at fair value, which are classified as prepaid expenses (asset) or accrued expenses (liability). Derivatives that are not designated as cash flow hedges for accounting purposes must be adjusted to fair value through income. If the derivative qualifies and is designated as a cash flow hedge, changes in its fair value will either be offset against the change in fair value of the hedged item through earnings or recorded in accumulated other comprehensive income (loss) until the hedged item is recognized in earnings. See Note 11, Derivatives, of the Notes to Consolidated Financial Statements. +Inventories and parts, net +Inventories and parts, net were as follows: +March 31, +2018 +2017 +(In thousands) +Truck and trailer parts and accessories (a) +$ +83,335 +$ +71,918 +Hitches and towing components (b) +18,627 +17,799 +Moving supplies and propane (b) +9,370 +9,112 +Subtotal +111,332 +98,829 +Less: LIFO reserves +(16,126) +(14,340) +Less: excess and obsolete reserves +(5,329) +(2,050) +Total +$ +89,877 +$ +82,439 +(a) Primarily held for internal usage, including equipment manufacturing and repair +(b) Primarily held for retail sales +Inventories consist primarily of truck and trailer parts and accessories used to manufacture and repair rental equipment as well as products and accessories available for retail sale. Inventory is held at our owned locations; our independent dealers do not hold any of our inventory. Inventories are stated at the lower cost or net realizable value. +Inventory cost is primarily determined using the last-in first-out method (“LIFO”). Inventories valued using LIFO consisted of approximately 96% and 94% of the total inventories for March 31, 2018 and 2017, respectively. Had we utilized the first-in first-out method (“FIFO”), stated inventory balances would have been $16.1 million and $14.3 million higher at March 31, 2018 and 2017, respectively. In fiscal 2017, the negative effect on income due to liquidation of a portion of the LIFO inventory was $0.1 million. +F- 9 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Property, Plant and Equipment +Our Property, plant and equipment is stated at cost. Interest expense incurred during the initial construction of buildings is considered part of cost. Depreciation is computed for financial reporting purposes using the straight line or an accelerated method based on a declining balance formula over the following estimated useful lives: rental equipment 2-20 years and buildings and non-rental equipment 3-55 years. Routine maintenance costs are charged to operating expense as they are incurred. Gains and losses on dispositions of property, plant and equipment, other than real estate, are netted against depreciation expense when realized. The net amount of gains, netted against depreciation expense, were $11.8 million, $32.5 million and $98.2 million during fiscal 2018, 2017 and 2016, respectively. Equipment depreciation is recognized in amounts expected to result in the recovery of estimated residual values upon disposal, i.e., minimize gains or losses. In determining the depreciation rate, historical disposal experience, holding periods and trends in the market for vehicles are reviewed. As a result of changes in IRS regulations regarding the capitalization of assets, beginning in the first quarter of fiscal 2017, we raised the value threshold before certain assets are capitalized within our depreciation policy. This change in threshold, results in the immediate recognition of reported operating costs with a lagging decrease in depreciation expense over the term that these assets would have been depreciated. Due to this change, we had additional operating expenses of $23.1 million and $23.9 million in fiscal 2018 and 2017, respectively. This change in threshold is expected to benefit us through the immediate recognition of tax deductible costs. +We regularly perform reviews to determine whether facts and circumstances exist which indicate that the carrying amount of assets, including estimates of residual value, may not be recoverable or that the useful life of assets are shorter or longer than originally estimated. Reductions in residual values (i.e., the price at which we ultimately expect to dispose of revenue earning equipment) or useful lives will result in an increase in depreciation expense over the remaining life of the equipment. Reviews are performed based on vehicle class, generally subcategories of trucks and trailers. We assess the recoverability of our assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their estimated remaining lives against their respective carrying amounts. We consider factors such as current and expected future market price trends on used vehicles and the expected life of vehicles included in the fleet. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If asset residual values are determined to be recoverable, but the useful lives are shorter or longer than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives. +For our box truck fleet we utilize an accelerated method of depreciation based upon a declining formula. Under the declining balances method (2.4 times declining balance), the book value of a rental truck is reduced approximately 16%, 13%, 11%, 9%, 8%, 7%, and 6% during years one through seven, respectively and then reduced on a straight line basis to a salvage value of 15% by the end of year fifteen. Comparatively, a standard straight line approach would reduce the book value by approximately 5.7% per year over the life of the truck. +Although we intend to sell our used vehicles for prices approximating book value, the extent to which we realize a gain or loss on the sale of used vehicles is dependent upon various factors including, but not limited to, the general state of the used vehicle market, the age and condition of the vehicle at the time of its disposal and the depreciation rates with respect to the vehicle . We typically sell our used vehicles at our sales centers throughout the United States and Canada, on our website at uhaul.com/trucksales or by phone at 1-866-404-0355. Additionally, we sell a large portion of our pickup and cargo van fleet at automobile dealer auctions. +In addition to our property, plant and equipment, we had real estate held for investment of $53.8 million and $66.2 million for fiscal 2018 and 2017, respectively and is included in Investments, other. +Receivables +Trade receivables include trade accounts from moving and self-storage customers and dealers, insurance premiums and amounts due from re-insurers, less management’s estimate of uncollectible accounts. +F- 10 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Insurance premiums receivable for policies that are billed through contracted agents are recorded net of commissions payable. A commission payable is recorded as a separate liability for those premiums that are billed direct. +Reinsurance recoverables include case reserves and actuarial estimates of claims incurred but not reported ("IBNR"). These receivables are not expected to be collected until after the associated claim has been adjudicated and billed to the re-insurer. The reinsurance recoverables may have little or no allowance for doubtful accounts due to the fact that reinsurance is typically procured from carriers with strong credit ratings. Furthermore, we do not cede losses to a re-insurer if the carrier is deemed financially unable to perform on the contract. Reinsurance recoverables also include insurance ceded to other insurance companies. +Notes and mortgage receivables include accrued interest and are reduced by discounts and amounts considered by management to be uncollectible. +Policy Benefits and Losses, Claims and Loss Expenses Payable +Life Insurance’s liabilities for life insurance and certain annuity and health policies are established to meet the estimated future obligations of policies in force, and are based on mortality, morbidity and withdrawal assumptions from recognized actuarial tables which contain margins for adverse deviation. Liabilities for health, disability and other policies include estimates of payments to be made on insurance claims for reported losses and estimates of IBNR losses. Oxford’s liabilities for deferred annuity contracts consist of contract account balances that accrue to the benefit of the policyholders. +Property and Casualty Insurance’s liability for reported and unreported losses is based on Repwest’s historical data along with industry averages. The liability for unpaid loss adjustment expenses is based on historical ratios of loss adjustment expenses paid to losses paid. Amounts recoverable from re-insurers on unpaid losses are estimated in a manner consistent with the claim liability associated with the re-insured policy. Adjustments to the liability for unpaid losses and loss expenses as well as amounts recoverable from re-insurers on unpaid losses are charged or credited to expense in the periods in which they are made. +Due to the nature of the underlying risks and high degree of uncertainty associated with the determination of the liability for future policy benefits and claims, the amounts to be ultimately paid to settle these liabilities cannot be precisely determined and may vary significantly from the estimated liability, especially for long-tailed casualty lines of business such as excess workers’ compensation. As a result of the long-tailed nature of the excess workers’ compensation policies written by Repwest during 1983 through 2001, it may take a number of years for claims to be fully reported and finally settled. +On a regular basis insurance reserve adequacy is reviewed by management to determine if existing assumptions need to be updated. In determining the assumptions for calculating workers’ compensation reserves, management considers multiple factors including the following: +Claimant longevity +Cost trends associated with claimant treatments +Changes in ceding entity and third party administrator reporting practices +Changes in environmental factors including legal and regulatory +Current conditions affecting claim settlements +Future economic conditions including inflation +We have reserved each claim based upon the accumulation of current claim costs projected through each claimant’s life expectancy and then adjusted for applicable reinsurance arrangements. Management reviews each claim bi-annually or more frequently, if there are changes in facts or circumstances to determine if the estimated life-time claim costs have increased and then adjusts the reserve estimate accordingly at that time. We have factored in an estimate of what the potential cost increases could be in our IBNR liability. We have not assumed settlement of the existing claims in calculating the reserve amount, unless it is in the final stages of completion. +F- 11 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continued increases in claim costs, including medical inflation and new treatments and medications could lead to future adverse development resulting in additional reserve strengthening. Conversely, settlement of existing claims or if injured workers return to work or expire prematurely, could lead to future positive development. +Self-Insurance Reserves +U-Haul retains the risk for certain public liability and property damage programs related to our rental equipment. The consolidated balance sheets include $408.5 million and $399.2 million of liabilities related to these programs as of March 31, 2018 and 2017, respectively. These liabilities are recorded in Policy benefits and losses, claims and loss expenses payable. Management takes into account losses incurred based upon actuarial estimates, past experience, current claim trends, as well as social and economic conditions. This liability is subject to change in the future based upon changes in the underlying assumptions including claims experience, frequency of incidents, and severity of incidents. +Additionally, as of March 31, 2018 and 2017, the consolidated balance sheets include liabilities of $15.2 million and $13.7 million, respectively, related to medical plan benefits we provide for eligible employees. We estimate this liability based on actual claims outstanding as of the balance sheet date as well as an actuarial estimate of IBNR claims. This liability is reported net of estimated recoveries from excess loss reinsurance policies with unaffiliated insurers of $22 thousand and $0.1 million as of March 31, 2018 and 2017, respectively. These amounts are recorded in Accounts payable and accrued expenses on the consolidated balance sheets. +Revenue Recognition +Self-moving rentals are recognized for the period that trucks and moving equipment are rented. Self-storage revenues, based upon the number of paid storage contract days, are recognized as earned during the period. Sales of self-moving and self-storage related products are recognized at the time that title passes and the customer accepts delivery. Property and casualty insurance premiums are recognized as revenue over the policy periods. Traditional life and Medicare supplement insurance premiums are recognized as revenue over the premium-paying periods of the contracts when due from the policyholders. For products where premiums are due over a significantly shorter duration than the period over which benefits are provided, such as our single premium whole life product, premiums are recognized when received and excess profits are deferred and recognized in relation to the insurance in force. Interest and investment income are recognized as earned. +Amounts collected from customers for sales tax are recorded on a net basis. +Advertising +All advertising costs are expensed as incurred. Advertising expense was $8.1 million, $8.7 million and $9.6 million in fiscal 2018, 2017 and 2016, respectively. +Deferred Policy Acquisition Costs +Commissions and other costs that fluctuate with and are primarily related to the acquisition or renewal of certain insurance premiums are deferred. For our Life Insurance’s life and health insurance products, these costs are amortized, with interest, in relation to revenue such that costs are realized as a constant percentage of revenue. For its annuity insurance products the costs are amortized, with interest, in relation to the present value of actual and expected gross profits. +Starting in fiscal 2014, new annuity contract holders were provided with a sales inducement in the form of a premium bonus (the “Sales Inducement Asset”). Sales inducements are recognized as an asset with a corresponding increase to the policyholder liability and are amortized in a similar manner to Deferred Policy Acquisition Costs. As of December 31, 2017 and 2016, the Sales Inducement Asset included with Deferred Policy Acquisition Costs amounted to $21.2 million and $23.0 million, respectively on the consolidated balance sheet and amortization expense totaled $3.7 million $3.3 million and $3.0 million for the periods ended December 31, 2017, 2016 and 2015, respectively. +F- 12 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Environmental Costs +Liabilities are recorded when environmental assessments and remedial efforts, if applicable, are probable and the costs can be reasonably estimated. The amount of the liability is based on management’s best estimate of undiscounted future costs. Certain recoverable environmental costs related to the removal of underground storage tanks or related contamination are capitalized and amortized over the estimated useful lives of the properties. These costs are capitalized if they improve the safety or efficiency of the property or are incurred in preparing the property for sale. +Income Taxes +AMERCO files a consolidated tax return with all of its legal subsidiaries. In accordance with ASC 740 - Income Taxes (“ASC 740”), the provision for income taxes reflects deferred income taxes resulting from changes in temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. +Comprehensive Income (Loss) +Comprehensive income (loss) consists of net earnings, foreign currency translation adjustments, unrealized gains and losses on investments, the change in fair value of cash flow hedges and the change in postretirement benefit obligations. +Debt Issuance Costs +We defer costs directly associated with acquiring third-party financing. Debt issuance costs are deferred and amortized. Debt issuance costs related to our long-term debt are reflected as a direct deduction from the carrying amount of the debt in accordance with our adoption of Accounting Standards Update (“ASU”) 2015-03, Simplifying the Presentation of Debt Issuance Costs . Please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements. +Adoption of New Accounting Pronouncements +In October 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-17, Interests Held through Related Parties That Are Under Common Control , which modifies existing guidance with respect to how a decision maker that holds an indirect interest in a VIE through a common control party determines whether it is the primary beneficiary of the VIE as part of the analysis of whether the VIE would need to be consolidated. Under ASU 2016-17, a decision maker would need to consider only its proportionate indirect interest in the VIE held through a common control party. Previous guidance had required the decision maker to treat the common control party’s interest in the VIE as if the decision maker held the interest itself. As a result of ASU 2016-17, in certain cases, previous consolidation conclusions may change. We adopted this standard in the first quarter of fiscal 2018. The adoption of this standard did not have a material impact on our consolidated financial statements. +In February 2018, the FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220) (“ASU 2018-02”), this amendment requires a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects associated with the change in the federal corporate income tax rate in the 2017 Tax Reform Act (the “Tax Reform Act”) . The amount of the reclassification is equal to the impact of the change in deferred taxes related to amounts recorded in accumulated other comprehensive income resulting from the change in the statutory corporate tax rate from 35% to 21%. ASU 2018-02 is effective for all entities in fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted and retrospective application is required. We chose to adopt the amendment in ASU 2018-02 during the fourth quarter of fiscal 2018 and recorded a decrease of approximately $8.7 million to retained earnings with a corresponding increase to accumulated other comprehensive income to reclassify the stranded tax effects from the Tax Reform Act. +F- 13 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Recent Accounting Pronouncements +In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) , an updated standard on revenue recognition. The standard outlines a five-step model for entities to use in accounting for revenue arising from contracts with customers. The standard applies to all contracts with customers except for leases, insurance contracts, financial instruments, certain nonmonetary exchanges and certain guarantees. The standard also requires expanded disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09 became effective for the Company on April 1, 2018 and will be adopted on a modified retrospective basis, but we do not expect it to have a material effect on our consolidated financial statements. While we are still finalizing the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures, we have performed an impact assessment by analyzing certain existing material revenue transactions and arrangements that are representative of our business segments and their revenue streams. Additionally, we have assessed any potential impacts on our internal controls and processes related to both the implementation and ongoing compliance of the new guidance. Based on the assessment performed to date, we do not expect material changes to our current policies related to the timing of revenue recognition and the accounting for costs; however, we will be finalizing our assessment in advance of the filing of our first quarter June 30, 2018 Form 10-Q. The standard will impact our disclosures including disclosures presenting further disaggregation of revenue. We are in the process of developing our new footnote disclosures required under the new standard. +In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Among other provisions, the new guidance requires the fair value measurement of investments in certain equity securities. For investments without readily determinable fair values, entities have the option to either measure these investments at fair value or at cost adjusted for changes in observable prices minus impairment. All changes in measurement will be recognized in net income. The guidance is effective for interim periods and annual period beginning after December 15, 2017. Early adoption is not permitted, except for certain provisions relating to financial liabilities. We do not expect adoption of ASU 2016-01 to have a material effect on our consolidated financial statements. +In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) . This update will require lessees to recognize all leases with terms greater than 12 months on their balance sheet as lease liabilities with a corresponding right-of-use asset. This update maintains the dual model for lease accounting, requiring leases to be classified as either operating or finance, with lease classification determined in a manner similar to existing lease guidance. The basic principle is that leases of all types convey the right to direct the use and obtain substantially all the economic benefits of an identified asset, meaning they create an asset and liability for lessees. Lessees will classify leases as either finance leases (comparable to current capital leases) or operating leases (comparable to current operating leases). Costs for a finance lease will be split between amortization and interest expense, with operating leases reporting a single lease expense. This update will also require both qualitative and quantitative disclosures to help financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years; however, early adoption is permitted. We have determined that the provisions of ASU 2016-02 may result in an increase in assets to recognize the present value of the lease obligations with a corresponding increase in liabilities. We are still in the process of determining the impact on our consolidated financial statements. For the last ten years, we have reported a discounted estimate of the off-balance sheet lease obligations in our MD&A. +F- 14 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326) . This update will require that financial assets measured at amortized cost be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis. The income statement reflects the measurement of credit losses for newly recognized financial assets, as well as the expected credit losses during the period. The measurement of expected credit losses is based upon historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. Credit losses relating to available-for-sale debt securities will be recorded through an allowance for credit losses rather than as a direct write-down to the security. This update will become effective for the Company for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are currently evaluating the impact of this standard on our consolidated financial statements. +In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments . This update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The effective date of ASU 2016-15 is for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted. We are currently evaluating the impact of this standard on our consolidated financial statements. +In October 2016, the FASB issued ASU 2016-16, Income Taxes - Intra-Entity Transfers of Assets Other Than Inventory , which will require an entity to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. This update will become effective for the Company for fiscal years beginning after December 31, 2017, and interim periods within those fiscal years with early adoption permitted. We are currently evaluating the impact of this standard on our consolidated financial statements. +In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230) Restricted Cash . The new guidance requires that the reconciliation of the beginning-of-period and end-of-period amounts shown in the statements of cash flows include restricted cash and restricted cash equivalents. If restricted cash is presented separately from cash and cash equivalents on the balance sheet, companies will be required to reconcile the amounts presented on the statement of cash flows to the amounts on the balance sheet. Companies will also need to disclose information about the nature of the restrictions. This update will become effective for the Company for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted. We do not expect adoption of ASU 2016-18 to have a material effect on our consolidated financial statements. +In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805) Clarifying the Definition of a Business . This update is to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. This update will become effective for the Company for fiscal years beginning after December 15, 2017, including interim periods within those years. We do not expect adoption of ASU 2017-01 to have a material effect on our consolidated financial statements. +In March 2017, the FASB issued ASU 2017-07, Compensation - Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost , which changes how companies that sponsor defined benefit pension plans present the related net periodic benefit cost in the income statement. The service cost component of the net periodic benefit cost will continue to be presented in the same income statement line items, however other components of the net periodic benefit cost will be presented as a component of other income and excluded from operating profit. ASU 2017-07 will become effective for public companies during interim and annual reporting periods beginning after December 15, 2017 with early adoption permitted. We do not expect adoption of ASU 2017-07 to have a material effect on our consolidated financial statements. +F- 15 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In March 2017, the FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Cost (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. These amendments shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes the interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. We are currently evaluating the impact of this standard on our consolidated financial statements. +From time to time, new accounting pronouncements are issued by the FASB or the SEC that are adopted by us as of the specified effective date. Unless otherwise discussed, these ASUs entail technical corrections to existing guidance or affect guidance related to specialized industries or entities and therefore will have minimal, if any, impact on our financial position or results of operations upon adoption. +Note 4. Earnings Per Share +Our earnings per share is calculated by dividing our earnings available to common stockholders by the weighted average common shares outstanding, basic and diluted. +The weighted average common shares outstanding exclude post-1992 shares of the employee stock ownership plan that have not been committed to be released. The unreleased shares, net of shares committed to be released, were 17,581; 20,226; and 21,883 as of March 31, 2018, 2017, and 2016, respectively. +Note 5. Reinsurance Recoverables and Trade Receivables, Net +Reinsurance recoverables and trade receivables, net were as follows: +March 31, +2018 +2017 +(In thousands) +Reinsurance recoverable +$ +100,335 +$ +111,433 +Trade accounts receivable +65,001 +41,062 +Paid losses recoverable +1,078 +544 +Accrued investment income +21,549 +20,145 +Premiums and agents' balances +1,702 +1,294 +Independent dealer receivable +85 +493 +Other receivables +4,284 +3,649 +194,034 +178,620 +Less: Allowance for doubtful accounts +(496) +(539) +$ +193,538 +$ +178,081 +F- 16 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 6. Investments +Expected maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. +We deposit bonds with insurance regulatory authorities to meet statutory requirements. The adjusted cost of bonds on deposit with insurance regulatory authorities was $32.4 million and $16.8 million at December 31, 2017 and 2016, respectively. +Available-for-Sale Investments +Available-for-sale investments at March 31, 2018 were as follows: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses More than 12 Months +Gross +Unrealized +Losses Less than 12 Months +Estimated +Market +Value +(In thousands) +U.S. treasury securities and government obligations +$ +123,557 +$ +3,595 +$ +(1,036) +$ +(203) +$ +125,913 +U.S. government agency mortgage-backed securities +36,416 +951 +(1) +(93) +37,273 +Obligations of states and political subdivisions +178,702 +9,938 +(217) +(18) +188,405 +Corporate securities +1,388,300 +50,056 +(3,009) +(1,826) +1,433,521 +Mortgage-backed securities +94,106 +2,072 +– +(153) +96,025 +Redeemable preferred stocks +10,609 +321 +(29) +(40) +10,861 +Common stocks +15,732 +12,329 +(10) +(189) +27,862 +$ +1,847,422 +$ +79,262 +$ +(4,302) +$ +(2,522) +$ +1,919,860 +Available-for-sale investments at March 31, 2017 were as follows: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses More than 12 Months +Gross +Unrealized +Losses Less than 12 Months +Estimated +Market +Value +(In thousands) +U.S. treasury securities and government obligations +$ +123,474 +$ +2,892 +$ +– +$ +(1,675) +$ +124,691 +U.S. government agency mortgage-backed securities +27,908 +1,070 +(6) +(377) +28,595 +Obligations of states and political subdivisions +159,417 +9,466 +(23) +(424) +168,436 +Corporate securities +1,263,703 +32,901 +(5,731) +(13,837) +1,277,036 +Mortgage-backed securities +26,577 +515 +– +(5) +27,087 +Redeemable preferred stocks +13,789 +168 +– +(468) +13,489 +Common stocks +15,732 +8,728 +(10) +(16) +24,434 +$ +1,630,600 +$ +55,740 +$ +(5,770) +$ +(16,802) +$ +1,663,768 +The available-for-sale tables include gross unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. +We sold available-for-sale securities with a fair value of $163.7 million, $190.2 million and $150.7 million in fiscal 2018, 2017 and 2016, respectively. The gross realized gains on these sales totaled $5.4 million, $5.1 million and $4.2 million in fiscal 2018, 2017 and 2016, respectively. We realized gross losses on these sales of $0.3 million, $2.2 million and $0.6 million in fiscal 2018, 2017 and 2016, respectively. +F- 17 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The unrealized losses of more than twelve months in the available-for-sale tables are considered temporary declines. We track each investment with an unrealized loss and evaluate them on an individual basis for other-than-temporary impairments including obtaining corroborating opinions from third party sources, performing trend analysis and reviewing management’s future plans. Certain of these investments may have declines determined by management to be other-than-temporary and we recognized these write-downs through earnings. There were no write downs in fiscal 2018, 2017 and 2016. +The investment portfolio primarily consists of corporate securities and U.S. government securities. We believe we monitor our investments as appropriate. Our methodology of assessing other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors, including the length of time to maturity, the extent to which the fair value has been less than the cost, the financial condition and the near-term prospects of the issuer, and whether the debtor is current on its contractually obligated interest and principal payments. Nothing has come to management’s attention that would lead to the belief that each issuer would not have the ability to meet the remaining contractual obligations of the security, including payment at maturity. We have the ability and intent not to sell our fixed maturity and common stock investments for a period of time sufficient to allow us to recover our costs. +The portion of other-than-temporary impairment related to a credit loss is recognized in earnings. The significant inputs utilized in the evaluation of mortgage backed securities credit losses include ratings, delinquency rates, and prepayment activity. The significant inputs utilized in the evaluation of asset backed securities credit losses include the time frame for principal recovery and the subordination and value of the underlying collateral. +There were no credit losses recognized in earnings for which a portion of an other-than-temporary impairment was recognized in accumulated other comprehensive loss for fiscal 2018, 2017 or 2016. +The adjusted cost and estimated market value of available-for-sale investments by contractual maturity, were as follows: +March 31, 2018 +March 31, 2017 +Amortized +Cost +Estimated +Market +Value +Amortized +Cost +Estimated +Market +Value +(In thousands) +Due in one year or less +$ +36,446 +$ +36,674 +$ +35,399 +$ +35,795 +Due after one year through five years +441,223 +450,816 +324,286 +333,016 +Due after five years through ten years +607,895 +626,174 +598,232 +607,184 +Due after ten years +641,411 +671,448 +616,585 +622,763 +1,726,975 +1,785,112 +1,574,502 +1,598,758 +Mortgage backed securities +94,106 +96,025 +26,577 +27,087 +Redeemable preferred stocks +10,609 +10,861 +13,789 +13,489 +Equity securities +15,732 +27,862 +15,732 +24,434 +$ +1,847,422 +$ +1,919,860 +$ +1,630,600 +$ +1,663,768 +F- 18 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Investments, other +The carrying value of other investments was as follows: +March 31, +2018 +2017 +(In thousands) +Mortgage loans, net +$ +309,952 +$ +262,875 +Short-term investments +10,350 +15,149 +Real estate +53,776 +66,174 +Policy loans +17,677 +17,112 +Other equity investments +7,309 +6,520 +$ +399,064 +$ +367,830 +Mortgage loans are carried at the unpaid balance, less an allowance for probable losses net of any unamortized premium or discount. The portfolio of mortgage loans is principally collateralized by self-storage facilities and commercial properties. The interest rate range on the mortgage loans is 4.3% to 6.9% with maturities between 2018 and 2036. The allowance for probable losses was $0.5 million and $0.5 million as of March 31, 2018 and 2017, respectively. The estimated fair value of these loans as of March 31, 2018 and 2017 approximated the carrying value. These loans represent first lien mortgages held by us. +Short-term investments consist primarily of investments in money market funds, mutual funds and any other investments with short-term characteristics that have original maturities of less than one year at acquisition. These investments are recorded at cost, which approximates fair value. +Real estate obtained through foreclosure and held for sale is carried at the lower of fair value at time of foreclosure or current estimated fair value less cost to sell. Other equity investments are carried at cost and assessed for impairment. +Insurance policy loans are carried at their unpaid balance. +Note 7. Other Assets +Other assets were as follows: +March 31, +2018 +2017 +(In thousands) +Deposits (debt-related) +$ +33,546 +$ +32,182 +Cash surrender value of life insurance policies +31,904 +32,070 +Deposits (real estate related) +19,332 +27,755 +Insurance recoveries +160,000 +– +Other +– +5,518 +$ +244,782 +$ +97,525 +F- 19 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 8. Net Investment and Interest Income +Net investment and interest income, were as follows: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Fixed maturities +$ +84,476 +$ +73,041 +$ +63,453 +Real estate +5,344 +5,189 +3,775 +Insurance policy loans +1,212 +1,212 +1,188 +Mortgage loans +17,783 +20,617 +14,631 +Short-term, amounts held by ceding reinsurers, net and other investments +3,098 +1,157 +208 +Investment income +111,913 +101,216 +83,255 +Less: investment expenses +(4,766) +(3,820) +(2,724) +Investment income - related party, net eliminations +3,326 +4,880 +6,086 +Net investment and interest income +$ +110,473 +$ +102,276 +$ +86,617 +Note 9. Borrowings +Long-Term Debt +Long-term debt was as follows: +March 31, +2018 Rate (a) +Maturities +2018 +2017 +(In thousands) +Real estate loan (amortizing term) +3.24% - 6.93% +2023 +$ +135,287 +$ +169,289 +Senior mortgages +3.72% - 6.62% +2021 - 2038 +1,487,645 +1,292,160 +Working capital loan (revolving credit) +3.15% +2018 +55,000 +85,000 +Fleet loans (amortizing term) +1.95% - 4.76% +2018 - 2025 +342,971 +324,977 +Fleet loan (securitization) +4.90% +– +– +52,112 +Fleet loans (revolving credit) +2.80% - 2.81% +2020 - 2021 +460,000 +417,000 +Capital leases (rental equipment) +1.92% - 4.80% +2018 - 2025 +984,217 +876,828 +Other obligations +2.75% - 8.00% +2018 - 2047 +73,579 +69,867 +Notes, loans and leases payable +$ +3,538,699 +$ +3,287,233 +Less: Debt issuance costs +(25,623) +(24,353) +Total notes, loans and leases payable, net +$ +3,513,076 +$ +3,262,880 +(a) Interest rate as of March 31, 2018, taking into account the effect of applicable hedging instruments +Real Estate Backed Loans +Real Estate Loan +Amerco Real Estate Company and certain of its subsidiaries and U-Haul Company of Florida are borrowers under a Real Estate Loan. As of March 31, 2018, the outstanding balance on the Real Estate Loan was $135.3 million. The Real Estate Loan requires monthly principal and interest payments, with the unpaid loan balance and accrued and unpaid interest due at maturity. The Real Estate Loan is secured by various properties owned by the borrowers. The final maturity of the term loan is April 2023. +The interest rate, per the provisions of the amended loan agreement, is the applicable London Inter-Bank Offer Rate (“LIBOR”) plus the applicable margin. At March 31, 2018, the applicable LIBOR was 1.74% and the applicable margin was 1.50%, the sum of which was 3.24%, which was applied to $73.9 million of the Real Estate Loan. The rate of the remaining balance of $61.4 million of the Real Estate Loan is hedged with an interest rate swap fixing the rate at 6.93% based on current margin. The interest rate swap expires in August 2018, after which date the remaining balance will incur interest at a rate of LIBOR plus a margin of 1.50%. The default provisions of the Real Estate Loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. There are limited restrictions regarding our use of the funds. +F- 20 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Senior Mortgages +Various subsidiaries of Amerco Real Estate Company and U-Haul International, Inc. are borrowers under certain senior mortgages. These senior mortgage loan balances as of March 31, 2018 were in the aggregate amount of $1,487.6 million and mature between 2021 and 2038. The senior mortgages require monthly principal and interest payments. The senior mortgages are secured by certain properties owned by the borrowers. The fixed interest rates, per the provisions of the senior mortgages, range between 3.72% and 6.62%. Certain senior mortgages have an anticipated repayment date and a maturity date. If these senior mortgages are not repaid by the anticipated repayment date, the interest rate on these mortgages would increase from the current fixed rate. We are using the anticipated repayment date for our maturity schedule. Amerco Real Estate Company and U-Haul International, Inc. have provided limited guarantees of the senior mortgages. The default provisions of the senior mortgages include non-payment of principal or interest and other standard reporting and change-in-control covenants. There are limited restrictions regarding our use of the funds. +Working Capital Loans +Various subsidiaries of Amerco Real Estate Company and U-Haul International, Inc. are borrowers under an asset backed working capital loan. The maximum amount that can be drawn at any one time is $55.0 million. At March 31, 2018, the outstanding balance was $55.0 million. This loan is secured by certain properties owned by the borrowers. This loan agreement provides for term loans, subject to the terms of the loan agreement. The final maturity of the loan is November 2018. This loan requires monthly interest payments with the unpaid loan balance and accrued and unpaid interest due at maturity. The interest rate, per the provision of the loan agreement, is the applicable LIBOR plus the applicable margin. At March 31, 2018, the applicable LIBOR was 1.65% and the margin was 1.50%, the sum of which was 3.15%. AMERCO is the guarantor of this loan. The default provisions of the loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. +AMERCO is a borrower under a working capital loan. The current maximum credit commitment is $150.0 million, which can be increased to $300.0 million by bringing in other lenders. At March 31, 2018, the full $150.0 million was available to be drawn. This loan agreement provides for revolving loans, subject to the terms of the loan agreement. The final maturity of this loan is September 2020. This loan requires monthly interest payments with the unpaid loan balance and accrued and unpaid interest due at maturity. The interest rate is the applicable LIBOR plus a margin between 1.38% and 1.50% depending on the amount outstanding. The default provisions of the loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. There is a 0.30% fee charged for unused capacity. +Fleet Loans +Rental Truck Amortizing Loans +U-Haul International, Inc. and several of its subsidiaries are borrowers under amortizing term loans. The aggregate balance of the loans as of March 31, 2018 was $343.0 million with the final maturities between June 2018 and March 2025. +The amortizing loans require monthly principal and interest payments, with the unpaid loan balance and accrued and unpaid interest due at maturity. These loans were used to purchase new trucks. The interest rates, per the provision of the loan agreements, are the applicable LIBOR plus the applicable margins. At March 31, 2018, the applicable LIBOR was between 1.66% and 1.78% and applicable margins were between 1.72% and 2.38%. The interest rates are hedged with interest rate swaps fixing the rates between 2.82% and 4.76% based on current margins. Additionally, $288.2 million of these loans are carried at fixed rates ranging between 1.95% and 3.94%. +AMERCO and, in some cases, U-Haul International, Inc. are guarantors of these loans. The default provisions of these loans include non-payment of principal or interest and other standard reporting and change-in-control covenants. +F- 21 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Rental Truck Securitizations +2010 U-Haul S Fleet and its subsidiaries (collectively, “2010 USF”) issued a $155.0 million asset-backed note (“2010 Box Truck Note”). 2010 USF is a bankruptcy-remote special purpose entity wholly-owned by U-Haul International, Inc. The net proceeds from the securitized transaction were used to finance new box truck purchases. U.S. Bank, NA acted as the trustee for this securitization. The 2010 Box Truck Note had a fixed interest rate of 4.90% and in October 2017 the note was repaid in full. +Rental Truck Revolvers +Various subsidiaries of U-Haul International, Inc. entered into three revolving fleet loans in aggregate for $490.0 million, which can be increased to a maximum of $565.0 million. These loans mature between March 2020 and November 2021. The interest rate, per the provision of the loan agreements, is the applicable LIBOR plus the applicable margin. At March 31, 2018, the applicable LIBOR was between 1.65% and 1.66% and the margin was 1.15%, the sum of which was between 2.80% and 2.81%. Only interest is paid on the loans until the last nine months when principal is due monthly. As of March 31, 2018, the aggregate outstanding balance of the loans was $460.0 million. +Capital Leases +We regularly enter into capital leases for new equipment with the terms of the leases between five and seven years. During fiscal 2018, we entered into $397.0 million of new capital leases. At March 31, 2018 and March 31, 2017, the balance of our capital leases was $984.2 million and $876.8 million, respectively. The net book value of the corresponding capitalized assets was $1,407.6 million and $1,233.3 million at March 31, 2018 and March 31, 2017, respectively. +Other Obligations +In February 2011, AMERCO and U.S. Bank, NA (the “Trustee”) entered into the U-Haul Investors Club ® Indenture. AMERCO and the Trustee entered into this indenture to provide for the issuance of notes by us directly to investors over our proprietary website, uhaulinvestorsclub.com (“U-Notes ® ”). The U-Notes ® are secured by various types of collateral including, but not limited to, rental equipment and real estate. U-Notes ® are issued in smaller series that vary as to principal amount, interest rate and maturity. U-Notes ® are obligations of the Company and secured by the associated collateral; they are not guaranteed by any of the Company’s affiliates or subsidiaries. +At March 31, 2018, the aggregate outstanding principal balance of the U-Notes ® issued was $77.3 million, of which $3.8 million is held by our insurance subsidiaries and eliminated in consolidation. Interest rates range between 2.75% and 8.00% and maturity dates range between 2018 and 2047. +Oxford is a member of the Federal Home Loan Bank (“FHLB”) and, as such, the FHLB has made deposits with Oxford. As of December 31, 2017, the deposits had an aggregate balance of $60.0 million, for which Oxford pays fixed interest rates between 1.33% and 1.75% with maturities between March 29, 2018 and March 30, 2020. As of December 31, 2017, available-for-sale investments held with the FHLB totaled $129.2 million, of which $73.1 million were pledged as collateral to secure the outstanding deposits. The balances of these deposits are included within Liabilities from investment contracts on the consolidated balance sheet. +Annual Maturities of Notes, Loans and Leases Payable +The annual maturities of long-term debt as of March 31, 2018 for the next five years and thereafter are as follows: +Years Ended March 31, +2019 +2020 +2021 +2022 +2023 +Thereafter +Total +(In thousands) +Notes, loans and leases payable, secured +$ +499,136 +$ +398,626 +$ +491,780 +$ +507,929 +$ +268,982 +$ +1,372,246 +$ +3,538,699 +F- 22 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 10. Interest on Borrowings +Interest Expense +Components of interest expense include the following: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Interest expense +$ +125,412 +$ +106,221 +$ +85,404 +Capitalized interest +(6,466) +(4,863) +(3,623) +Amortization of transaction costs +3,867 +3,445 +3,235 +Interest expense resulting from derivatives +3,893 +8,603 +12,699 +Total interest expense +126,706 +113,406 +97,715 +Amortization on early extinguishment of debt +– +499 +– +Total +$ +126,706 +$ +113,905 +$ +97,715 +Interest paid in cash, including payments related to derivative contracts, amounted to $129.3 million, $113.7 million and $95.1 million for fiscal 2018, 2017 and 2016, respectively. +Interest Rates +Interest rates and our revolving credit borrowings were as follows: +Revolving Credit Activity +Years Ended March 31, +2018 +2017 +2016 +(In thousands, except interest rates) +Weighted average interest rate during the year +2.48% +1.83% +1.67% +Interest rate at year end +2.84% +2.06% +1.82% +Maximum amount outstanding during the year +$ +538,000 +$ +597,000 +$ +347,000 +Average amount outstanding during the year +$ +517,997 +$ +477,888 +$ +237,372 +Facility fees +$ +410 +$ +158 +$ +201 +F- 23 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 11. Derivatives +We manage exposure to changes in market interest rates. Our use of derivative instruments is limited to highly effective interest rate swaps to hedge the risk of changes in cash flows (future interest payments) attributable to changes in LIBOR swap rates, the designated benchmark interest rate being hedged on certain of our LIBOR indexed variable rate debt and a variable rate operating lease. The interest rate swaps effectively fix our interest payments on certain LIBOR indexed variable rate debt. We monitor our positions and the credit ratings of its counterparties and do not currently anticipate non-performance by the counterparties. Interest rate swap agreements are not entered into for trading purposes. +Original variable rate debt and lease amount +Agreement Date +Effective Date +Expiration Date +Designated cash flow hedge date +(In millions) +$ +300.0 +8/16/2006 +8/18/2006 +8/10/2018 +8/4/2006 +25.0 +(a) +4/26/2011 +6/1/2011 +6/1/2018 +6/1/2011 +50.0 +(a) +7/29/2011 +8/15/2011 +8/15/2018 +7/29/2011 +20.0 +(a) +8/3/2011 +9/12/2011 +9/10/2018 +8/3/2011 +15.1 +(b) +3/27/2012 +3/28/2012 +3/28/2019 +3/26/2012 +25.0 +4/13/2012 +4/16/2012 +4/1/2019 +4/12/2012 +44.3 +1/11/2013 +1/15/2013 +12/15/2019 +1/11/2013 +(a) forward swap +(b) operating lease +As of March 31, 2018, the total notional amount of our variable interest rate swaps on debt and an operating lease was $117.6 million and $6.2 million, respectively. +The net derivative fair values reflected in accounts payable and accrued expenses in the balance sheets were as follows: +Liability Derivative Fair Value as of +March 31, 2018 +March 31, 2017 +(In thousands) +Interest rate contracts designated as hedging instruments +$ +460 +$ +4,903 +The Effect of Interest Rate +Contracts on the Statements of Operations +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Loss recognized in income on interest rate contracts +$ +3,893 +$ +8,603 +$ +12,699 +Gain recognized in AOCI on interest rate contracts (effective portion) +$ +(4,445) +$ +(9,916) +$ +(9,721) +Loss reclassified from AOCI into income (effective portion) +$ +3,893 +$ +8,628 +$ +12,616 +(Gain) loss recognized in income on interest rate contracts (ineffective portion and amount excluded from effectiveness testing) +$ +– +$ +(25) +$ +83 +Gains or losses recognized in income on derivatives are recorded as interest expense in the statements of operations. During fiscal 2018, we recognized an increase in the fair value of our cash flows hedges of $2.7 million, net of taxes. Embedded in this change was $3.9 million of losses reclassified from accumulated other comprehensive income (loss) to interest expense during the year. At March 31, 2018, we expect to reclassify $0.7 million of net losses on interest rate contracts from accumulated other comprehensive income (loss) to earnings as interest expense over the next twelve months. Please see Note 3, Accounting Policies, in the Notes to Consolidated Financial Statements. +F- 24 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 12. Stockholders’ Equity +Common Stock Dividends +Declared Date +Per Share Amount +Record Date +Dividend Date +March 8, 2018 +$ +0.50 +March 23, 2018 +April 6, 2018 +December 6, 2017 +0.50 +December 21, 2017 +January 5, 2018 +July 5, 2017 +1.00 +July 20, 2017 +August 3, 2017 +February 8, 2017 +1.00 +February 23, 2017 +March 9, 2017 +October 5, 2016 +1.00 +October 20, 2016 +November 3, 2016 +On June 8, 2016, the stockholder’s approved the 2016 AMERCO Stock Option Plan (Shelf Stock Option Plan). As of March 31, 2018, no awards had been issued under this plan. +Note 13. Provision for Taxes +Earnings before taxes and the provision for taxes consisted of the following: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Pretax earnings: +U.S. +$ +628,901 +$ +609,589 +$ +745,194 +Non-U.S. +8,712 +18,769 +23,717 +Total pretax earnings +$ +637,613 +$ +628,358 +$ +768,911 +Current provision +Federal +$ +21,780 +$ +38,723 +$ +118,974 +State +6,471 +10,818 +15,988 +Non-U.S. +1,412 +3,334 +3,303 +29,663 +52,875 +138,265 +Deferred provision (benefit) +Federal +(199,415) +160,527 +125,950 +State +15,479 +15,210 +12,561 +Non-U.S. +1,303 +1,322 +3,134 +(182,633) +177,059 +141,645 +Provision for income tax expense (benefit) +$ +(152,970) +$ +229,934 +$ +279,910 +Income taxes paid (net of income tax refunds received) +$ +68,671 +$ +36,880 +$ +141,901 +F- 25 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The difference between the tax provision at the statutory federal income tax rate and the tax provision attributable to income before taxes was as follows: +Years Ended March 31, +2018 +2017 +2016 +Statutory federal income tax rate +31.55% +35.00% +35.00% +Increase (reduction) in rate resulting from: +Deferred tax liability revaluation +(58.25%) +0.00% +0.00% +State taxes, net of federal benefit +2.33% +2.66% +2.34% +Foreign rate differential +0.00% +(0.31%) +(0.24%) +Federal tax credits +(0.32%) +(0.41%) +(0.19%) +Transition tax +1.83% +0.00% +0.00% +Dividend received deduction +(0.03%) +(0.03%) +(0.02%) +Phase III tax +0.63% +0.00% +0.00% +Other +(1.73%) +(0.32%) +(0.49%) +Actual tax expense (benefit) of operations +(23.99%) +36.59% +36.40% +Significant components of our deferred tax assets and liabilities were as follows: +March 31, +2018 +2017 +(In thousands) +Deferred tax assets: +Net operating loss and credit carry forwards +$ +3,136 +$ +1,948 +Accrued expenses +104,309 +168,331 +Policy benefit and losses, claims and loss expenses payable, net +11,148 +21,287 +Total deferred tax assets +$ +118,593 +$ +191,566 +Deferred tax liabilities: +Property, plant and equipment +$ +741,607 +$ +986,334 +Deferred policy acquisition costs +12,995 +20,901 +Unrealized gains +18,863 +19,140 +Other +3,236 +200 +Total deferred tax liabilities +776,701 +1,026,575 +Net deferred tax liability +$ +658,108 +$ +835,009 +The net operating loss and credit carry-forwards in the above table are primarily attributable to $45.3 million of state net operating losses that will begin to expire March 31, 2019 if not utilized. +The Tax Reform Act was enacted on December 22, 2017. The Tax Reform Act reduces the U.S. federal corporate income tax rate from 35% to 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and repeals the deferral of the phase three tax for life insurance companies. The blended statutory Federal Tax Rate for our full fiscal year ended March 31, 2018 is 31.55%. At March 31, 2018, we have not completed our accounting for the tax effects of enactment of the Tax Reform Act; however, we have made a reasonable estimate of the effects of all items affected by the Tax Reform Act. For these items, we recognized a provisional benefit amount of $355.7 million which is included as a component of tax expense (benefit) from continuing operations. +We re-measured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. However, we are still analyzing certain aspects of the Tax Reform Act and refining our calculations, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The provisional amount recorded related to the re-measurement of our deferred tax balance was a benefit of $371.5 million for the fiscal year ended March 31, 2018. +F- 26 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +For fiscal 2018, we elected to reclassify the income tax effects of the Tax Reform Act in the amount of $8.7 million from accumulated other comprehensive income to retained earnings under ASU 2018-02. In addition, we have adopted the “investment by investment” approach with regard to releasing disproportionate income tax effects from accumulated other comprehensive income. +We calculated and recorded a provisional one-time transition tax on earnings from foreign subsidiaries based on the post-1986 earnings and profits (“E&P”) of our Canadian subsidiaries that were previously deferred from U.S. income taxes. The provisional amount of this one-time transition tax liability for our foreign subsidiaries resulted in an increase in income tax expense of $11.7 million for the fiscal year ended March 31, 2018. We have not yet completed our calculation of the total post-1986 E&P for these foreign subsidiaries. Further, the transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when we finalize the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation and finalize the amounts held in cash or other specified assets. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the transition tax, or any additional outside basis difference inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in these entities (i.e., basis difference in excess of that subject to the one-time transition tax) is not practicable. +The Tax Reform Act repeals the special rules with regard to distribution to shareholders from pre-1984 policyholders surplus account of our Life Insurance segment. This one-time tax was based on the balance of our pre-1984 policyholder surplus account. We estimated a provisional amount for our one-time tax liability for Phase Three Tax, resulting in an increase in income tax expense of $4.0 million for the fiscal year ended March 31, 2018. +ASC 740 prescribes a minimum recognition and measurement methodology that a tax position is required to meet before being recognized in the financial statements. The total amount of unrecognized tax benefits at March 31, 2017 was $26.7 million. The change in after tax benefit as a result of the change in Federal tax rate from 35% to 21% is $5.8 million. This entire amount of unrecognized tax benefits if resolved in our favor, would favorably impact our effective tax rate. During the current year, we recorded tax expense (net of settlements), resulting from uncertain tax positions in the amount of $3.2 million. At March 31, 2018, the amount of unrecognized tax benefits and the amount that would favorably affect our effective tax rate was $35.7 million. +A reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period are as follows: +Unrecognized Tax Benefits +March 31, +2018 +2017 +(In thousands) +Unrecognized tax benefits beginning balance +$ +26,720 +$ +23,912 +Revaluation based on change in after tax benefit +5,755 +– +Additions based on tax positions related to the current year +4,139 +2,964 +Reductions for tax positions of prior years +(96) +(156) +Settlements +(779) +– +Unrecognized tax benefits ending balance +$ +35,739 +$ +26,720 +We recognize interest related to unrecognized tax benefits as interest expense, and penalties as operating expenses. At March 31, 2017, the amount of interest and penalties accrued on unrecognized tax benefits was $6.7 million, net of tax. The change in after tax benefit as a result of the change in Federal tax rate from 35% to 21% is $1.4 million. During the current year we recorded expense from interest and penalties in the amount of $0.4 million, net of tax. At March 31, 2018, the amount of interest and penalties accrued on unrecognized tax benefits was $8.5 million, net of tax. +We file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With some exceptions, we are no longer subject to audit for years prior to the fiscal year ended March 31, +F- 27 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +2015. +Note 14. Employee Benefit Plans +Profit Sharing Plans +We provide tax-qualified profit sharing retirement plans for the benefit of eligible employees, former employees and retirees in the United States and Canada. The plans are designed to provide employees with an accumulation of funds for retirement on a tax-deferred basis and provide for annual discretionary employer contributions. Amounts to be contributed are determined by the President and Chairman of the Board of Directors (the “Board”) of the Company under the delegation of authority from the Board, pursuant to the terms of the Profit Sharing Plan. No contributions were made to the profit sharing plan during fiscal 2018, 2017 or 2016. +We also provide an employee savings plan which allows participants to defer income under Section 401(k) of the Internal Revenue Code of 1986. +ESOP Plan +We sponsor a leveraged ESOP that generally covers all employees with one year or more of service. The ESOP shares initially were pledged as collateral for its debt which was originally funded by U-Haul. We make annual contributions to the ESOP equal to the ESOP’s debt service. As the debt is repaid, shares are released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. ESOP shares are committed to be released monthly and ESOP compensation expense is recorded based on the current market price at the end of the month. These shares then become outstanding for the earnings per share computations. ESOP compensation expense was $11.4 million, $10.7 million and $11.6 million for fiscal 2018, 2017 and 2016, respectively. Listed below is a summary of these financing arrangements as of fiscal year-end: +Outstanding as of +Interest Payments +Financing Date +March 31, 2018 +2018 +2017 +2016 +(In thousands) +June, 1991 +$ +16 +$ +1 +$ +2 +$ +10 +July, 2009 +466 +26 +36 +33 +February, 2016 +5,122 +242 +– +– +Leveraged contributions to the Plan Trust during fiscal 2018, 2017 and 2016 were $1.0 million, $0.2 million and $0.4 million, respectively. In fiscal 2018, 2017 and 2016, the Company made non-leveraged contributions of $11.0 million, $11.0 and $4.0 million, respectively to the Plan Trust. In both fiscal 2018 and 2017, $0.1 million of dividends from unallocated shares were applied to debt. +Shares held by the Plan were as follows: +Years Ended March 31, +2018 +2017 +(In thousands) +Allocated shares +1,112 +1,160 +Unreleased shares - leveraged +19 +21 +Fair value of unreleased shares - leveraged +$ +6,448 +$ +8,127 +Unreleased shares - non-leveraged +13 +9 +Fair value of unreleased shares - non-leveraged +$ +4,557 +$ +3,539 +The fair value of unreleased shares issued prior to 1992 is defined as the historical cost of such shares. The fair value of unreleased shares issued subsequent to December 31, 1992 is defined as the trading value of such shares as of March 31, 2018 and March 31, 2017, respectively. During fiscal 2018, we released for allocation 3,571 leveraged shares and 26, 659 non-leveraged shares. As of December 31, 2018, there are 3,660 shares committed to be released. +F- 28 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Post Retirement and Post Employment Benefits +We provide medical and life insurance benefits to our eligible employees and their dependents upon retirement from the Company. The retirees must have attained age sixty-five and earned twenty years of full-time service upon retirement for coverage under the medical plan. The medical benefits are capped at a $20,000 lifetime maximum per covered person. The benefits are coordinated with Medicare and any other medical policies in force. Retirees who have attained age sixty-five and earned at least ten years of full-time service upon retirement from the Company are entitled to group term life insurance benefits. The life insurance benefit is $2,000 plus $100 for each year of employment over ten years. The plan is not funded and claims are paid as they are incurred. We use a March 31 measurement date for our post retirement benefit disclosures. +The components of net periodic post retirement benefit cost were as follows: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Service cost for benefits earned during the period +$ +1,073 +$ +1,026 +$ +961 +Interest cost on accumulated postretirement benefit +869 +814 +752 +Other components +58 +88 +35 +Net periodic postretirement benefit cost +$ +2,000 +$ +1,928 +$ +1,748 +The fiscal 2018 and fiscal 2017 post retirement benefit liability included the following components: +Years Ended March 31, +2018 +2017 +(In thousands) +Beginning of year +$ +22,247 +$ +20,791 +Service cost for benefits earned during the period +1,073 +1,026 +Interest cost on accumulated post retirement benefit +869 +814 +Net benefit payments and expense +(644) +(443) +Actuarial loss +(229) +59 +Accumulated postretirement benefit obligation +23,316 +22,247 +Current liabilities +802 +737 +Non-current liabilities +22,514 +21,510 +Total post retirement benefit liability recognized in statement of financial position +23,316 +22,247 +Components included in accumulated other comprehensive income (loss): +Unrecognized net loss +(2,530) +(2,817) +Cumulative net periodic benefit cost (in excess of employer contribution) +$ +20,786 +$ +19,430 +The discount rate assumptions in computing the information above were as follows: +Years Ended March 31, +2018 +2017 +2016 +(In percentages) +Accumulated postretirement benefit obligation +3.98% +3.94% +3.89% +F- 29 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 became law. Net periodic post retirement benefit cost above includes the effect of the subsidy. The discount rate represents the expected yield on a portfolio of high grade (AA to AAA rated or equivalent) fixed income investments with cash flow streams sufficient to satisfy benefit obligations under the plan when due. Fluctuations in the discount rate assumptions primarily reflect changes in U.S. interest rates. The assumed health care cost trend rate used to measure the accumulated postretirement benefit obligation as of the end of fiscal 2018 was 6.9% in the initial year and was projected to decline annually to an ultimate rate of 4.5% in fiscal 2038. The assumed health care cost trend rate used to measure the accumulated post retirement benefit obligation as of the end of fiscal 2017 (and used to measure the fiscal 2018 net periodic benefit cost) was 7.1% in the initial year and was projected to decline annually to an ultimate rate of 4.5% in fiscal 2038. +If the estimated health care cost trend rate assumptions were increased by one percent, the accumulated post retirement benefit obligation as of fiscal year-end would increase by $287 thousand and the total of the service cost and interest cost components would increase by $25 thousand. A decrease in the estimated health care cost trend rate assumption of one percent would decrease the accumulated post retirement benefit obligation as of fiscal year-end by $323 thousand and the total of the service cost and interest cost components would decrease by $29 thousand. +Post employment benefits provided by us, other than upon retirement, are not material. +Future net benefit payments are expected as follows: +Future Net Benefit Payments +(In thousands) +Year-ended: +2019 +$ +802 +2020 +946 +2021 +1,121 +2022 +1,317 +2023 +1,531 +2024 through 2028 +10,594 +Total +$ +16,311 +Note 15. Fair Value Measurements +Fair values of cash equivalents approximate carrying value due to the short period of time to maturity. Fair values of short-term investments, investments available-for-sale, long-term investments, mortgage loans and notes on real estate, and interest rate swap contracts are based on quoted market prices, dealer quotes or discounted cash flows. Fair values of trade receivables approximate their recorded value. +Our financial instruments that are exposed to concentrations of credit risk consist primarily of temporary cash investments, trade receivables, reinsurance recoverables and notes receivable. Limited credit risk exists on trade receivables due to the diversity of our customer base and their dispersion across broad geographic markets. We place our temporary cash investments with financial institutions and limit the amount of credit exposure to any one financial institution. +We have mortgage receivables, which potentially expose us to credit risk. The portfolio of notes is principally collateralized by self-storage facilities and commercial properties. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. The estimated fair values were determined using the discounted cash flow method and using interest rates currently offered for similar loans to borrowers with similar credit ratings. +The carrying amount of long-term debt and short-term borrowings are estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for debt of similar term and remaining maturity. +Other investments including short-term investments are substantially current or bear reasonable interest rates. As a result, the carrying values of these financial instruments approximate fair value. +F- 30 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Assets and liabilities are recorded at fair value on the consolidated balance sheets and are measured and classified based upon a three tiered approach to valuation. ASC 820, Fair Value Measurements and Disclosures, (“ASC 820”) requires that financial assets and liabilities recorded at fair value be classified and disclosed in one of the following three categories: +Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2 – Quoted prices for identical or similar financial instruments in markets that are not considered to be active, or similar financial instruments for which all significant inputs are observable, either directly or indirectly, or inputs other than quoted prices that are observable, or inputs that are derived principally from or corroborated by observable market data through correlation or other means; and +Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and are unobservable. These reflect management’s assumptions about the assumptions a market participant would use in pricing the asset or liability. +A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. The following tables represent the financial assets and liabilities on the condensed consolidated balance sheet at March 31, 2018 and 2017, that are subject to ASC 820 and the valuation approach applied to each of these items. +Year Ended March 31, 2018 +Total +Level 1 +Level 2 +Level 3 +(In thousands) +Assets +Short-term investments +$ +475,320 +$ +475,320 +$ +– +$ +– +Fixed maturities - available for sale +1,881,137 +7,567 +1,873,293 +277 +Preferred stock +10,861 +10,861 +– +– +Common stock +27,862 +27,862 +– +– +Derivatives +4,388 +4,388 +– +– +Total +$ +2,399,568 +$ +525,998 +$ +1,873,293 +$ +277 +Liabilities +Derivatives +460 +– +460 +– +Total +$ +460 +$ +– +$ +460 +$ +– +Year Ended March 31, 2017 +Total +Level 1 +Level 2 +Level 3 +(In thousands) +Assets +Short-term investments +$ +521,911 +$ +521,710 +$ +201 +$ +– +Fixed maturities - available for sale +1,625,845 +6,491 +1,619,024 +330 +Preferred stock +13,489 +13,489 +– +– +Common stock +24,434 +24,434 +– +– +Derivatives +4,260 +4,260 +– +– +Total +$ +2,189,939 +$ +570,384 +$ +1,619,225 +$ +330 +Liabilities +Derivatives +4,903 +– +4,903 +– +Total +$ +4,903 +$ +– +$ +4,903 +$ +– +Short term investments in the tables above also include cash equivalents. In light of our definition of an active market, we reclassified $86.3 million of fixed maturities – available for sale from Level 1 to Level 2 due to a review of their trading activity for fiscal 2017. +F- 31 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The following tables represent the fair value measurements for our assets at March 31, 2018 using significant unobservable inputs (Level 3). +Fixed Maturities - Asset Backed Securities +(In thousands) +Balance at March 31, 2016 +$ +338 +Fixed Maturities - Asset Backed Securities - redeemed +(12) +Fixed Maturities - Asset Backed Securities - net gain (unrealized) +4 +Balance at March 31, 2017 +$ +330 +Fixed Maturities - Asset Backed Securities - redeemed +(91) +Fixed Maturities - Asset Backed Securities - net gain (unrealized) +38 +Balance at March 31, 2018 +$ +277 +Note 16. Reinsurance and Policy Benefits and Losses, Claims and Loss Expenses Payable +During their normal course of business, our insurance subsidiaries assume and cede reinsurance on both a coinsurance and a risk premium basis. They also obtain reinsurance for that portion of risks exceeding their retention limits. The maximum amount of life insurance retained on any one life is $125,000. +Direct +Amount (a) +Ceded to +Other +Companies +Assumed +from Other +Companies +Net +Amount (a) +Percentage of +Amount +Assumed to Net +(In thousands) +Year ended December 31, 2017 +Life insurance in force +$ +947,720 +$ +248 +$ +876,865 +$ +1,824,337 +48% +Premiums earned: +Life +$ +51,227 +$ +4 +$ +9,880 +$ +61,103 +16% +Accident and health +90,396 +295 +1,977 +92,078 +2% +Annuity +728 +– +794 +1,522 +52% +Property and casualty +57,161 +69 +8 +57,100 +0% +Total +$ +199,512 +$ +368 +$ +12,659 +$ +211,803 +Year ended December 31, 2016 +Life insurance in force +$ +937,779 +$ +249 +$ +915,769 +$ +1,853,299 +49% +Premiums earned: +Life +$ +50,251 +$ +– +$ +10,626 +$ +60,877 +17% +Accident and health +99,450 +310 +2,263 +101,403 +2% +Annuity +505 +– +794 +1,299 +61% +Property and casualty +52,329 +– +5 +52,334 +0% +Total +$ +202,535 +$ +310 +$ +13,688 +$ +215,913 +Year ended December 31, 2015 +Life insurance in force +$ +927,647 +$ +397 +$ +949,413 +$ +1,876,663 +51% +Premiums earned: +Life +$ +49,126 +$ +8 +$ +11,310 +$ +60,428 +19% +Accident and health +99,354 +312 +2,545 +101,587 +3% +Annuity +392 +– +255 +647 +39% +Property and casualty +50,012 +– +8 +50,020 +0% +Total +$ +198,884 +$ +320 +$ +14,118 +$ +212,682 +(a) Balances are reported net of inter-segment transactions. +F- 32 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +To the extent that a reinsurer is unable to meet its obligation under the related reinsurance agreements, Repwest would remain liable for the unpaid losses and loss expenses. Pursuant to certain of these agreements, Repwest holds letters of credit as of December 31, 2017 in the amount of $0.1 million from re-insurers and has issued letters of credit in the amount of $1.9 million in favor of certain ceding companies. +Policy benefits and losses, claims and loss expenses payable for Property and Casualty Insurance were as follows: +December 31, +2017 +2016 +(In thousands) +Unpaid losses and loss adjustment expense +$ +233,554 +$ +244,400 +Reinsurance losses payable +805 +580 +Total +$ +234,359 +$ +244,980 +Activity in the liability for unpaid losses and loss adjustment expenses for Property and Casualty Insurance is summarized as follows: +December 31, +2017 +2016 +2015 +(In thousands) +Balance at January 1 +$ +244,400 +$ +251,964 +$ +271,609 +Less: reinsurance recoverable +103,952 +107,311 +120,894 +Net balance at January 1 +140,448 +144,653 +150,715 +Incurred related to: +Current year +15,749 +13,297 +11,713 +Prior years +233 +107 +585 +Total incurred +15,982 +13,404 +12,298 +Paid related to: +Current year +8,969 +7,777 +7,007 +Prior years +8,397 +9,832 +11,353 +Total paid +17,366 +17,609 +18,360 +Net balance at December 31 +139,064 +140,448 +144,653 +Plus: reinsurance recoverable +94,490 +103,952 +107,311 +Balance at December 31 +$ +233,554 +$ +244,400 +$ +251,964 +The liability for incurred losses and loss adjustment expenses (net of reinsurance recoverable of $94.5 million) decreased by $1.4 million as of December 31, 2017. +F- 33 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The information about property and casualty incurred and paid loss and loss adjustment expense development for the years end December 31, 2012 through 2017, and the average annual percentage payout of incurred claims by age as of December 31, 2017, is presented as supplementary information. Claims data for 2012 through 2017 is unaudited. +As of +December 31, 2017 +Total of +Incurred-but- +Not-Reported +Liabilities Plus +Expected +Cumulative +Development +Number of +Accident +on Reported +Reported +Year +2012 +2013 +2014 +2015 +2016 +2017 +Claims +Claims +(In thousands, except claim counts) +2012 +$ +8,971 +$ +8,903 +$ +8,831 +$ +8,788 +$ +8,753 +$ +8,735 +$ +– +6,889 +2013 +9,861 +9,853 +9,914 +9,741 +9,576 +– +7,663 +2014 +11,691 +10,907 +10,720 +10,759 +374 +9,648 +2015 +12,214 +12,459 +12,460 +1,649 +10,718 +2016 +13,297 +13,011 +1,366 +11,134 +2017 +15,749 +4,823 +11,424 +Total +8,212 +The following table presents paid claims development as of December 31, 2017, net of reinsurance. Claims data for 2012 through 2017 are unaudited. +Cumulative Paid Claims and Allocated Claim Adjustment Expenses, Net of Reinsurance +(In thousands) +Accident +Year +2012 +2013 +2014 +2015 +2016 +2017 +2012 +$ +4,415 +$ +6,345 +$ +8,179 +$ +8,410 +$ +8,734 +$ +8,735 +2013 +5,227 +7,608 +8,718 +9,462 +9,576 +2014 +6,154 +8,087 +9,270 +9,293 +2015 +7,509 +9,601 +9,730 +2016 +7,777 +10,665 +2017 +8,969 +Total +56,968 +All outstanding liabilities before 2012, net of reinsurance +125,740 +Liabilities for claims and claim adjustment expenses, net of reinsurance +139,064 +The reconciliation of the net incurred and paid claims development tables for the liability for claims and claims adjustment expenses is as follows: +December 31, 2017 +(In thousands) +Liabilities for unpaid Property and Casualty claims +and claim adjustment expenses, net of reinsurance +$ +139,064 +Total reinsurance recoverable on unpaid +Property and Casualty claims +$ +94,490 +Total gross liability for unpaid Property and Casualty +claims and claim adjustment expense +$ +233,554 +F- 34 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The following is supplementary information about average historical claims duration as of December 31, 2017. +Average Annual Percentage Payout of Incurred Claims by Age, net of Reinsurance +Years +1 +2 +3 +4 +5 +6 +Property and Casualty Insurance +56.6% +20.8% +11.2% +3.5% +2.4% +0.0% +Note 17. Commitments +We lease a portion of our rental equipment and certain of our facilities under operating leases with terms that expire at various dates substantially through 2024. As of March 31, 2018, we have guaranteed $15.7 million of residual values for these rental equipment assets at the end of the respective lease terms. Certain leases contain renewal and fair market value purchase options as well as mileage and other restrictions. At the expiration of the lease, we have the option to renew the lease, purchase the asset for fair market value, or sell the asset to a third party on behalf of the lessor. We have been leasing equipment since 1987 and have experienced no material losses relating to these types of residual value guarantees. +Lease expenses were as follows: +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Lease expense +$ +33,960 +$ +37,343 +$ +49,780 +Operating and ground lease commitments for leases having terms of more than one year were as follows: +Property, Plant and Equipment +Rental +Equipment +Ground +Operating +Operating +Total +(In thousands) +Year-ended March 31: +2019 +$ +991 +$ +17,014 +$ +9,010 +$ +27,015 +2020 +1,024 +17,217 +1,300 +19,541 +2021 +1,024 +16,699 +– +17,723 +2022 +1,030 +15,066 +– +16,096 +2023 +1,030 +14,693 +– +15,723 +Thereafter +49,649 +20,163 +– +69,812 +Total +$ +54,748 +$ +100,852 +$ +10,310 +$ +165,910 +Note 18. Contingencies +Litigation +On July 1, 2014, a 100-pound propane cylinder allegedly filled at a Philadelphia-area U-Haul Co. of Pennsylvania (“UHPA”) center exploded while in use on a food truck. The explosion killed two people and injured eleven. Following the incident, the injured parties and their estates filed a number of lawsuits against U-Haul and its subsidiary, UHPA, both of which denied the allegations. One plaintiff sued AMERCO, which also denied the allegations. All suits were filed in the Philadelphia Court of Common Pleas. The plaintiffs alleged, among other things, that UHPA should not have refilled the propane cylinder at issue because it was out-of-date and improperly fitted with an incorrect valve, which allegedly caused the explosion. The plaintiffs sought compensatory and punitive damages. +F- 35 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +After several settlements with the less-injured plaintiffs, in April 2018, the parties reached an agreement, in principle, to settle the remaining cases. We will pay our self-insured retention and attorney’s fees. Together, these amounts are currently estimated to be $26.4 million, of which $15.3 million has already been paid. The balance of the settlement amount is accrued on our balance sheet in Policy benefits and losses, claims and loss expenses payable with offsetting insurance recoveries from our insurance carriers in Other assets. The U.S. Department of Justice is investigating the cause of the incident. Following the resolution in principle of the civil claims in April 2018, the U.S. Attorney’s Office for the Eastern District of Pennsylvania advised the Company for the first time that UHPA is a target of the investigation, but has not advised UHPA as to what specific violations are being investigated. UHPA will vigorously defend itself against any criminal allegations or charges. +Environmental +Compliance with environmental requirements of federal, state and local governments may significantly affect Real Estate’s business operations. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Real Estate is aware of issues regarding hazardous substances on some of its properties. Real Estate regularly makes capital and operating expenditures to stay in compliance with environmental laws and has put in place a remedial plan at each site where it believes such a plan is necessary. Since 1988, Real Estate has managed a testing and removal program for underground storage tanks. +Based upon the information currently available to Real Estate, compliance with the environmental laws and its share of the costs of investigation and cleanup of known hazardous waste sites are not expected to result in a material adverse effect on AMERCO’s financial position or results of operations. +Other +We are named as a defendant in various other litigation and claims arising out of the normal course of business. In management’s opinion, none of these other matters will have a material effect on our financial position and results of operations. +Note 19. Related Party Transactions +As set forth in the Company’s Audit Committee Charter and consistent with NASDAQ Listing Rules, our Audit Committee (the “Audit Committee”) reviews and maintains oversight over related party transactions which are required to be disclosed under the Securities and Exchange Commission (“SEC”) rules and regulations and in accordance with GAAP. Accordingly, all such related party transactions are submitted to the Audit Committee for ongoing review and oversight. Our internal processes are designed to ensure that our legal and finance departments identify and monitor potential related party transactions that may require disclosure and Audit Committee oversight. +AMERCO has engaged in related party transactions and has continuing related party interests with certain major stockholders, directors and officers of the consolidated group as disclosed below. Management believes that the transactions described below and in the related notes were completed on terms substantially equivalent to those that would prevail in arm’s-length transactions. +SAC Holding Corporation and SAC Holding II Corporation (collectively “SAC Holdings”) were established in order to acquire and develop self-storage properties. These properties are being managed by us pursuant to management agreements. In the past, we sold real estate and various self-storage properties to SAC Holdings, and such sales provided significant cash flows to us. SAC Holdings, Four SAC Self-Storage Corporation (“4 SAC”), Five SAC Self-Storage Corporation (“5 SAC”), Galaxy Investments, L.P. (“Galaxy”) and Private Mini Storage Realty, L.P. (“Private Mini”) are substantially controlled by Blackwater Investments, Inc. (“Blackwater”). Blackwater is wholly-owned by Willow Grove Holdings LP (“WGHLP”), which is owned by Mark V. Shoen (a significant shareholder), and various trusts associated with Edward J. Shoen (our Chairman of the Board, President and a significant shareholder) and Mark V. Shoen. +F- 36 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Related Party Revenues +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +U-Haul interest income revenue from Blackwater +$ +3,326 +$ +4,880 +$ +6,086 +U-Haul management fee revenue from Blackwater +23,577 +23,130 +21,987 +U-Haul management fee revenue from Mercury +6,025 +5,945 +4,546 +$ +32,928 +$ +33,955 +$ +32,619 +During fiscal 2018, a subsidiary of ours held a junior unsecured note of SAC Holdings. We do not have an equity ownership interest in SAC Holdings. We received cash interest payments of $8.7 million, $4.5 million and $4.6 million, from SAC Holdings during fiscal 2018, 2017 and 2016, respectively. The largest aggregate amount of notes receivable outstanding during fiscal 2018 was $48.1 million. In December 2017, this note and interest receivables were repaid in full as we received payments of $53.0 million. +We currently manage the self-storage properties owned or leased by Blackwater and Mercury Partners, L.P. (“Mercury”), pursuant to a standard form of management agreement, under which we receive a management fee of between 4% and 10% of the gross receipts plus reimbursement for certain expenses. We received management fees, exclusive of reimbursed expenses, of $29.5 million, $27.8 million and $27.1 million from the above mentioned entities during fiscal 2018, 2017 and 2016, respectively. This management fee is consistent with the fee received for other properties we previously managed for third parties. Mark V. Shoen controls the general partner of Mercury. The limited partner interests of Mercury are indirectly owned by Mark V. Shoen, James P. Shoen (a significant shareholder), and a trust benefitting the children and a grandchild of Edward J. Shoen. +Related Party Costs and Expenses +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +U-Haul lease expenses to Blackwater +$ +2,684 +$ +2,740 +$ +2,648 +U-Haul commission expenses to Blackwater +58,595 +57,113 +54,720 +$ +61,279 +$ +59,853 +$ +57,368 +We lease space for marketing company offices, vehicle repair shops and hitch installation centers from subsidiaries of Blackwater. The terms of the leases are similar to the terms of leases for other properties owned by unrelated parties that are leased to us. +At March 31, 2018, subsidiaries of Blackwater acted as U-Haul independent dealers. The financial and other terms of the dealership contracts with the aforementioned companies and their subsidiaries are substantially identical to the terms of those with our other independent dealers whereby commissions are paid by us based upon equipment rental revenues. +These agreements and notes with subsidiaries of Blackwater, excluding Dealer Agreements, provided revenues of $26.9 million, expenses of $2.7 million and cash flows of $77.6 million during fiscal 2018. Revenues and commission expenses related to the Dealer Agreements were $273.6 million and $58.6 million, respectively for fiscal 2018. +Pursuant to the variable interest entity (“VIE”) model under ASC 810 – Consolidation (“ASC 810”), management determined that the management agreements with subsidiaries of Blackwater represent potential variable interests for us. Management evaluated whether it should be identified as the primary beneficiary of one or more of these VIEs using a two-step approach in which management (i) identified all other parties that hold interests in the VIEs, and (ii) determined if any variable interest holder has the power to direct the activities of the VIEs that most significantly impact their economic performance. +Management determined that we do not have a variable interest in the holding entities of Blackwater based upon management agreements which are with the individual operating entities; therefore, we are precluded from consolidating these entities. +F- 37 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +We do not have the power to direct the activities that most significantly impact the economic performance of the individual operating entities which have management agreements with U-Haul. There are no fees or penalties disclosed in the management agreement for termination of the agreement. Through control of the holding entities' assets, and its ability and history of making key decisions relating to the entity and its assets, Blackwater, and its owner, are the variable interest holder with the power to direct the activities that most significantly impact each of the individual holding entities and the individual operating entities’ performance. As a result, we have no basis under ASC 810 to consolidate these entities. +We have not provided financial or other support explicitly or implicitly during the fiscal years ended March 31, 2018 and 2017, respectively to any of these entities that it was not previously contractually required to provide. In addition, we currently have no plan to provide any financial support to any of these entities in the future. The carrying amount and classification of the assets and liabilities in our balance sheets that relate to our variable interests in the aforementioned entities are as follows, which approximate the maximum exposure to loss as a result of our involvement with these entities: +Related Party Assets +March 31, +2018 +2017 +(In thousands) +U-Haul note receivable from Blackwater +$ +– +$ +48,098 +U-Haul interest receivable from Blackwater +– +5,397 +U-Haul receivable from Blackwater +24,034 +23,202 +U-Haul receivable from Mercury +10,357 +9,195 +Other (a) +(1,115) +276 +$ +33,276 +$ +86,168 +(a) Timing differences for intercompany balances with insurance subsidiaries resulting from the three month difference in reporting periods. +F- 38 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 20. Statutory Financial Information of Insurance Subsidiaries +Applicable laws and regulations of the States of Arizona and Nevada require Property and Casualty Insurance and Life Insurance to maintain minimum capital and surplus determined in accordance with statutory accounting principles. Audited statutory net income and statutory capital and surplus for the years ended are listed below: +Years Ended December 31, +2017 +2016 +2015 +(In thousands) +Repwest: +Audited statutory net income +$ +16,328 +$ +19,580 +$ +22,308 +Audited statutory capital and surplus +197,375 +176,009 +158,376 +ARCOA: +Audited statutory net income +1,190 +1,451 +1,391 +Audited statutory capital and surplus +7,991 +6,798 +5,386 +Oxford: +Audited statutory net income +10,350 +17,473 +12,150 +Audited statutory capital and surplus +195,931 +189,279 +172,282 +CFLIC: +Audited statutory net income +8,062 +8,139 +9,217 +Audited statutory capital and surplus +26,653 +28,011 +28,892 +NAI: +Audited statutory net income +1,594 +1,039 +1,161 +Audited statutory capital and surplus +12,674 +12,691 +12,685 +The amount of dividends that can be paid to shareholders by insurance companies domiciled in the State of Arizona is limited. Any dividend in excess of the limit requires prior regulatory approval. The statutory surplus for Repwest at December 31, 2017 that could be distributed as ordinary dividends was $16.3 million. The statutory surplus for Oxford at December 31, 2017 that could be distributed as ordinary dividends was $10.4 million. Oxford did not pay a dividend to AMERCO in fiscal 2018, 2017 or 2016. After receiving approval from the Arizona Department of Insurance, Repwest paid a $19.6 million non-cash dividend to AMERCO in fiscal 2016, but did not pay a dividend in fiscal 2018 or 2017. +F- 39 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 21. Financial Information by Geographic Area +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2018 +Total revenues +$ +3,435,821 +$ +165,293 +$ +3,601,114 +Depreciation and amortization, net of gains on disposal +363,826 +8,521 +372,347 +Interest expense +123,777 +2,929 +126,706 +Pretax earnings +628,901 +8,712 +637,613 +Income tax expense (benefit) +(155,685) +2,715 +(152,970) +Identifiable assets +10,424,862 +322,123 +10,746,985 +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2017 +Total revenues +$ +3,271,563 +$ +150,204 +$ +3,421,767 +Depreciation and amortization, net of gains on disposal +466,378 +5,275 +471,653 +Interest expense +112,834 +572 +113,406 +Pretax earnings +609,589 +18,769 +628,358 +Income tax expense +225,278 +4,656 +229,934 +Identifiable assets +9,030,528 +375,312 +9,405,840 +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2016 +Total revenues +$ +3,129,909 +$ +145,559 +$ +3,275,468 +Depreciation and amortization, net of gains on disposal +313,099 +863 +313,962 +Interest expense +97,551 +164 +97,715 +Pretax earnings +745,194 +23,717 +768,911 +Income tax expense +273,473 +6,437 +279,910 +Identifiable assets +7,859,928 +249,360 +8,109,288 +Note 21A. Consolidating Financial Information by Industry Segment +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO, U-Haul, and Real Estate and the subsidiaries of U-Haul and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +Life Insurance, comprised of Oxford and its subsidiaries. +Management tracks revenues separately, but does not report any separate measure of the profitability for rental vehicles, rentals of self-storage spaces and sales of products that are required to be classified as a separate operating segment and accordingly does not present these as separate reportable segments. Deferred income taxes are shown as liabilities on the consolidating statements. +The information includes elimination entries necessary to consolidate AMERCO, the parent, with its subsidiaries. +Investments in subsidiaries are accounted for by the parent using the equity method of accounting. +F- 40 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 21A. Financial Information by Consolidating Industry Segment: +Consolidating balance sheets by industry segment as of March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Assets: +Cash and cash equivalents +$ +702,036 +$ +6,639 +$ +50,713 +$ +– +$ +759,388 +Reinsurance recoverables and trade receivables, net +64,798 +99,682 +29,058 +– +193,538 +Inventories and parts, net +89,877 +– +– +– +89,877 +Prepaid expenses +165,692 +– +– +– +165,692 +Investments, fixed maturities and marketable equities +– +285,846 +1,634,014 +– +1,919,860 +Investments, other +22,992 +65,553 +310,519 +– +399,064 +Deferred policy acquisition costs, net +– +– +124,767 +– +124,767 +Other assets +241,493 +685 +2,604 +– +244,782 +Related party assets +40,003 +6,959 +18,334 +(32,020) +(c) +33,276 +1,326,891 +465,364 +2,170,009 +(32,020) +3,930,244 +Investment in subsidiaries +544,151 +– +– +(544,151) +(b) +– +Property, plant and equipment, at cost: +Land +827,649 +– +– +– +827,649 +Buildings and improvements +3,140,713 +– +– +– +3,140,713 +Furniture and equipment +632,803 +– +– +– +632,803 +Rental trailers and other rental equipment +545,968 +– +– +– +545,968 +Rental trucks +4,390,750 +– +– +– +4,390,750 +9,537,883 +– +– +– +9,537,883 +Less: Accumulated depreciation +(2,721,142) +– +– +– +(2,721,142) +Total property, plant and equipment +6,816,741 +– +– +– +6,816,741 +Total assets +$ +8,687,783 +$ +465,364 +$ +2,170,009 +$ +(576,171) +$ +10,746,985 +(a) Balances as of December 31, 2017 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 41 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Liabilities: +Accounts payable and accrued expenses +$ +505,721 +$ +2,582 +$ +2,375 +$ +– +$ +510,678 +Notes, loans and leases payable, net +3,513,076 +– +– +– +3,513,076 +Policy benefits and losses, claims and loss expenses payable +568,456 +234,359 +445,218 +– +1,248,033 +Liabilities from investment contracts +– +– +1,364,066 +– +1,364,066 +Other policyholders' funds and liabilities +– +5,377 +4,663 +– +10,040 +Deferred income +34,276 +– +– +– +34,276 +Deferred income taxes +629,389 +8,927 +19,792 +– +658,108 +Related party liabilities +28,157 +2,870 +993 +(32,020) +(c) +– +Total liabilities +5,279,075 +254,115 +1,837,107 +(32,020) +7,338,277 +Stockholders' equity : +Series preferred stock: +Series A preferred stock +– +– +– +– +– +Series B preferred stock +– +– +– +– +– +Series A common stock +– +– +– +– +– +Common stock +10,497 +3,301 +2,500 +(5,801) +(b) +10,497 +Additional paid-in capital +452,956 +91,120 +26,271 +(117,601) +(b) +452,746 +Accumulated other comprehensive income (loss) +(4,623) +16,526 +35,982 +(52,508) +(b) +(4,623) +Retained earnings +3,635,351 +100,302 +268,149 +(368,241) +(b) +3,635,561 +Cost of common shares in treasury, net +(525,653) +– +– +– +(525,653) +Cost of preferred shares in treasury, net +(151,997) +– +– +– +(151,997) +Unearned employee stock ownership plan shares +(7,823) +– +– +– +(7,823) +Total stockholders' equity +3,408,708 +211,249 +332,902 +(544,151) +3,408,708 +Total liabilities and stockholders' equity +$ +8,687,783 +$ +465,364 +$ +2,170,009 +$ +(576,171) +$ +10,746,985 +(a) Balances as of December 31, 2017 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 42 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2017 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Assets: +Cash and cash equivalents +$ +671,665 +$ +12,725 +$ +13,416 +$ +– +$ +697,806 +Reinsurance recoverables and trade receivables, net +41,234 +107,757 +29,090 +– +178,081 +Inventories and parts, net +82,439 +– +– +– +82,439 +Prepaid expenses +124,728 +– +– +– +124,728 +Investments, fixed maturities and marketable equities +– +248,816 +1,414,952 +– +1,663,768 +Investments, other +35,342 +63,086 +269,402 +– +367,830 +Deferred policy acquisition costs, net +– +– +130,213 +– +130,213 +Other assets +93,197 +1,922 +2,406 +– +97,525 +Related party assets +88,829 +11,496 +18,465 +(32,622) +(c) +86,168 +1,137,434 +445,802 +1,877,944 +(32,622) +3,428,558 +Investment in subsidiaries +477,058 +– +– +(477,058) +(b) +– +Property, plant and equipment, at cost: +Land +648,757 +– +– +– +648,757 +Buildings and improvements +2,618,265 +– +– +– +2,618,265 +Furniture and equipment +510,415 +– +– +– +510,415 +Rental trailers and other rental equipment +492,280 +– +– +– +492,280 +Rental trucks +4,091,598 +– +– +– +4,091,598 +8,361,315 +– +– +– +8,361,315 +Less: Accumulated depreciation +(2,384,033) +– +– +– +(2,384,033) +Total property, plant and equipment +5,977,282 +– +– +– +5,977,282 +Total assets +$ +7,591,774 +$ +445,802 +$ +1,877,944 +$ +(509,680) +$ +9,405,840 +(a) Balances as of December 31, 2016 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 43 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2017 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Liabilities: +Accounts payable and accrued expenses +$ +441,667 +$ +1,926 +$ +6,948 +$ +– +$ +450,541 +Notes, loans and leases payable, net +3,262,880 +– +– +– +3,262,880 +Policy benefits and losses, claims and loss expenses payable +399,181 +244,980 +442,161 +– +1,086,322 +Liabilities from investment contracts +– +– +1,112,498 +– +1,112,498 +Other policyholders' funds and liabilities +– +4,184 +5,966 +– +10,150 +Deferred income +28,696 +– +– +– +28,696 +Deferred income taxes +809,566 +11,243 +14,200 +– +835,009 +Related party liabilities +30,040 +2,539 +43 +(32,622) +(c) +– +Total liabilities +4,972,030 +264,872 +1,581,816 +(32,622) +6,786,096 +Stockholders' equity : +Series preferred stock: +Series A preferred stock +– +– +– +– +– +Series B preferred stock +– +– +– +– +– +Series A common stock +– +– +– +– +– +Common stock +10,497 +3,301 +2,500 +(5,801) +(b) +10,497 +Additional paid-in capital +452,382 +91,120 +26,271 +(117,601) +(b) +452,172 +Accumulated other comprehensive income (loss) +(51,236) +6,166 +16,933 +(23,099) +(b) +(51,236) +Retained earnings +2,892,683 +80,343 +250,424 +(330,557) +(b) +2,892,893 +Cost of common shares in treasury, net +(525,653) +– +– +– +(525,653) +Cost of preferred shares in treasury, net +(151,997) +– +– +– +(151,997) +Unearned employee stock ownership plan shares +(6,932) +– +– +– +(6,932) +Total stockholders' equity +$ +2,619,744 +180,930 +296,128 +(477,058) +2,619,744 +Total liabilities and stockholders' equity +7,591,774 +$ +445,802 +$ +1,877,944 +$ +(509,680) +$ +9,405,840 +(a) Balances as of December 31, 2016 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 44 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,483,956 +$ +– +$ +– +$ +(4,214) +(c) +$ +2,479,742 +Self-storage revenues +323,903 +– +– +– +323,903 +Self-moving & self-storage products & service sales +261,557 +– +– +– +261,557 +Property management fees +29,602 +– +– +– +29,602 +Life insurance premiums +– +– +154,703 +– +154,703 +Property and casualty insurance premiums +– +58,800 +– +(1,700) +(c) +57,100 +Net investment and interest income +12,232 +15,771 +84,158 +(1,688) +(b) +110,473 +Other revenue +179,417 +– +5,001 +(384) +(b) +184,034 +Total revenues +3,290,667 +74,571 +243,862 +(7,986) +3,601,114 +Costs and expenses: +Operating expenses +1,759,624 +32,710 +22,061 +(6,412) +(b,c) +1,807,983 +Commission expenses +276,705 +– +– +– +276,705 +Cost of sales +160,489 +– +– +– +160,489 +Benefits and losses +– +15,983 +169,328 +– +185,311 +Amortization of deferred policy acquisition costs +– +– +24,514 +– +24,514 +Lease expense +34,243 +– +– +(283) +(b) +33,960 +Depreciation, net gains on disposals +543,247 +– +– +– +543,247 +Net gains on disposal of real estate +(195,414) +– +– +– +(195,414) +Total costs and expenses +2,578,894 +48,693 +215,903 +(6,695) +2,836,795 +Earnings from operations before equity in earnings of subsidiaries +711,773 +25,878 +27,959 +(1,291) +764,319 +Equity in earnings of subsidiaries +46,990 +– +– +(46,990) +(d) +– +Earnings from operations +758,763 +25,878 +27,959 +(48,281) +764,319 +Interest expense +(127,997) +– +– +1,291 +(b) +(126,706) +Pretax earnings +630,766 +25,878 +27,959 +(46,990) +637,613 +Income tax benefit (expense) +159,817 +(2,989) +(3,858) +– +152,970 +Earnings available to common shareholders +$ +790,583 +$ +22,889 +$ +24,101 +$ +(46,990) +$ +790,583 +(a) Balances for the year ended December 31, 2017 +(b) Eliminate intercompany lease / interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- 45 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2017 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,366,526 +$ +– +$ +– +$ +(3,693) +(c) +$ +2,362,833 +Self-storage revenues +286,886 +– +– +– +286,886 +Self-moving & self-storage products & service sales +253,073 +– +– +– +253,073 +Property management fees +29,075 +– +– +– +29,075 +Life insurance premiums +– +– +163,579 +– +163,579 +Property and casualty insurance premiums +– +52,334 +– +– +52,334 +Net investment and interest income +9,688 +16,652 +77,540 +(1,604) +(b) +102,276 +Other revenue +167,752 +– +4,480 +(521) +(b) +171,711 +Total revenues +3,113,000 +68,986 +245,599 +(5,818) +3,421,767 +Costs and expenses: +Operating expenses +1,521,408 +28,421 +22,429 +(4,175) +(b,c) +1,568,083 +Commission expenses +267,230 +– +– +– +267,230 +Cost of sales +152,485 +– +– +– +152,485 +Benefits and losses +– +13,404 +169,306 +– +182,710 +Amortization of deferred policy acquisition costs +– +– +26,218 +– +26,218 +Lease expense +37,529 +– +– +(186) +(b) +37,343 +Depreciation, net gains on disposals +449,025 +– +– +– +449,025 +Net gains on disposal of real estate +(3,590) +– +– +– +(3,590) +Total costs and expenses +2,424,087 +41,825 +217,953 +(4,361) +2,679,504 +Earnings from operations before equity in earnings of subsidiaries +688,913 +27,161 +27,646 +(1,457) +742,263 +Equity in earnings of subsidiaries +35,797 +– +– +(35,797) +(d) +– +Earnings from operations +724,710 +27,161 +27,646 +(37,254) +742,263 +Interest expense +(114,863) +– +– +1,457 +(b) +(113,406) +Amortization on early extinguished of debt +(499) +– +– +– +(499) +Pretax earnings +609,348 +27,161 +27,646 +(35,797) +628,358 +Income tax expense +(210,924) +(9,346) +(9,664) +– +(229,934) +Earnings available to common shareholders +$ +398,424 +$ +17,815 +$ +17,982 +$ +(35,797) +$ +398,424 +(a) Balances for the year ended December 31, 2016 +(b) Eliminate intercompany lease/interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- 46 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2016 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,301,586 +$ +– +$ +– +$ +(3,606) +(c) +$ +2,297,980 +Self-storage revenues +247,944 +– +– +– +247,944 +Self-moving & self-storage products & service sales +251,541 +– +– +– +251,541 +Property management fees +26,533 +– +– +– +26,533 +Life insurance premiums +– +– +162,662 +– +162,662 +Property and casualty insurance premiums +– +50,020 +– +– +50,020 +Net investment and interest income +8,801 +14,783 +63,999 +(966) +(b) +86,617 +Other revenue +148,099 +– +4,559 +(487) +(b) +152,171 +Total revenues +2,984,504 +64,803 +231,220 +(5,059) +3,275,468 +Costs and expenses: +Operating expenses +1,423,107 +27,958 +23,037 +(4,055) +(b,c) +1,470,047 +Commission expenses +262,627 +– +– +– +262,627 +Cost of sales +144,990 +– +– +– +144,990 +Benefits and losses +– +12,298 +155,138 +– +167,436 +Amortization of deferred policy acquisition costs +– +– +23,272 +– +23,272 +Lease expense +49,966 +– +– +(186) +(b) +49,780 +Depreciation, net gains on disposals +291,235 +– +– +– +291,235 +Net (gains) losses on disposal of real estate +(545) +– +– +– +(545) +Total costs and expenses +2,171,380 +40,256 +201,447 +(4,241) +2,408,842 +Earnings from operations before equity in earnings of subsidiaries +813,124 +24,547 +29,773 +(818) +866,626 +Equity in earnings of subsidiaries +35,522 +– +– +(35,522) +(d) +– +Earnings from operations +848,646 +24,547 +29,773 +(36,340) +866,626 +Interest expense +(98,533) +– +– +818 +(b) +(97,715) +Pretax earnings +750,113 +24,547 +29,773 +(35,522) +768,911 +Income tax expense +(261,112) +(8,379) +(10,419) +– +(279,910) +Earnings available to common shareholders +$ +489,001 +$ +16,168 +$ +19,354 +$ +(35,522) +$ +489,001 +(a) Balances for the year ended December 31, 2015 +(b) Eliminate intercompany lease/interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- 47 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2018, are as follows: +Moving & Storage +Consolidated +Property & +Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +790,583 +$ +22,889 +$ +24,101 +$ +(46,990) +$ +790,583 +Earnings from consolidated subsidiaries +(46,990) +– +– +46,990 +– +Adjustments to reconcile net earnings to the cash provided by operations: +Depreciation +555,069 +– +– +– +555,069 +Amortization of deferred policy acquisition costs +– +– +24,514 +– +24,514 +Amortization of debt issuance costs +3,868 +– +– +– +3,868 +Interest credited to policyholders +– +– +32,302 +– +32,302 +Change in allowance for losses on trade receivables +(31) +– +(89) +– +(120) +Change in allowance for inventories and parts reserve +5,065 +– +– +– +5,065 +Net gains on disposal of personal property +(11,822) +– +– +– +(11,822) +Net gains on disposal of real estate +(195,414) +– +– +– +(195,414) +Net gains on sales of investments +– +(1,703) +(4,566) +– +(6,269) +Deferred income taxes +(182,358) +(6,596) +(4,480) +– +(193,434) +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(23,444) +8,075 +40 +– +(15,329) +Inventories and parts +(12,384) +– +– +– +(12,384) +Prepaid expenses +(40,765) +– +– +– +(40,765) +Capitalization of deferred policy acquisition costs +– +– +(27,350) +– +(27,350) +Other assets +(167,579) +1,810 +(199) +– +(165,968) +Related party assets +48,855 +4,553 +– +– +53,408 +Accounts payable and accrued expenses +(36,384) +648 +10,190 +– +(25,546) +Policy benefits and losses, claims and loss expenses payable +168,687 +(10,623) +3,057 +– +161,121 +Other policyholders' funds and liabilities +– +1,194 +(1,303) +– +(109) +Deferred income +5,524 +– +– +– +5,524 +Related party liabilities +(1,884) +318 +950 +– +(616) +Net cash provided by operating activities +858,596 +20,565 +57,167 +– +936,328 +Cash flows from investing activities: +Escrow deposits +31,362 +– +– +– +31,362 +Purchases of: +Property, plant and equipment +(1,363,745) +– +– +– +(1,363,745) +Short term investments +– +(63,556) +– +– +(63,556) +Fixed maturities investments +– +(51,273) +(339,627) +– +(390,900) +Equity securities +– +– +(662) +– +(662) +Preferred stock +– +(1,000) +– +– +(1,000) +Real estate +(1,365) +(440) +(134) +– +(1,939) +Mortgage loans +– +(14,409) +(69,098) +– +(83,507) +Proceeds from sales and paydowns of: +Property, plant and equipment +699,803 +– +– +– +699,803 +Short term investments +– +61,133 +6,657 +– +67,790 +Fixed maturities investments +– +23,026 +141,799 +– +164,825 +Preferred stock +– +4,208 +– +– +4,208 +Real estate +2,783 +– +– +– +2,783 +Mortgage loans +– +15,660 +21,930 +– +37,590 +Net cash used by investing activities +(631,162) +(26,651) +(239,135) +– +(896,948) +(page 1 of 2) +(a) Balance for the period ended December 31, 2017 +F- 48 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continuation of consolidating cash flow statements by industry segment for the year ended March 31, 2018, are as follows: +Moving & Storage +Consolidated +Property & +Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +498,464 +– +– +– +498,464 +Principal repayments on credit facilities +(356,451) +– +– +– +(356,451) +Payment of debt issuance costs +(5,111) +– +– +– +(5,111) +Capital lease payments +(296,363) +– +– +– +(296,363) +Employee Stock Ownership Plan Shares +(11,640) +– +– +– +(11,640) +Securitization deposits +(2,180) +– +– +– +(2,180) +Common stock dividends paid +(29,380) +– +– +– +(29,380) +Investment contract deposits +– +– +401,814 +– +401,814 +Investment contract withdrawals +– +– +(182,549) +– +(182,549) +Net cash provided (used) by financing activities +(202,661) +– +219,265 +– +16,604 +Effects of exchange rate on cash +5,598 +– +– +– +5,598 +Increase (decrease) in cash and cash equivalents +30,371 +(6,086) +37,297 +– +61,582 +Cash and cash equivalents at beginning of period +671,665 +12,725 +13,416 +– +697,806 +Cash and cash equivalents at end of period +$ +702,036 +$ +6,639 +$ +50,713 +$ +– +$ +759,388 +(page 2 of 2) +(a) Balance for the period ended December 31, 2017 +F- 49 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2017, are as follows: +Moving & Storage +Consolidated +Property & +Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +398,424 +$ +17,815 +$ +17,982 +$ +(35,797) +$ +398,424 +Earnings from consolidated subsidiaries +(35,797) +– +– +35,797 +– +Adjustments to reconcile net earnings to the cash provided by operations: +Depreciation +481,520 +– +– +– +481,520 +Amortization of deferred policy acquisition costs +– +– +26,218 +– +26,218 +Amortization of debt issuance costs +4,062 +– +– +– +4,062 +Interest credited to policyholders +– +– +25,020 +– +25,020 +Change in allowance for losses on trade receivables +31 +– +(77) +– +(46) +Change in allowance for inventories and parts reserve +1,330 +– +– +– +1,330 +Net gains on disposal of personal property +(32,495) +– +– +– +(32,495) +Net gains on disposal of real estate +(3,590) +– +– +– +(3,590) +Net gains on sales of investments +– +(2,636) +(2,648) +– +(5,284) +Deferred income taxes +173,059 +2,340 +(2,287) +– +173,112 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(6,806) +4,221 +(305) +– +(2,890) +Inventories and parts +(4,072) +– +– +– +(4,072) +Prepaid expenses +9,386 +– +– +– +9,386 +Capitalization of deferred policy acquisition costs +– +– +(27,111) +– +(27,111) +Other assets +(3,827) +1,341 +(2) +– +(2,488) +Related party assets +(872) +1,215 +– +– +343 +Accounts payable and accrued expenses +(14,793) +392 +9,345 +– +(5,056) +Policy benefits and losses, claims and loss expenses payable +13,283 +(7,838) +9,933 +– +15,378 +Other policyholders' funds and liabilities +– +1,167 +332 +– +1,499 +Deferred income +5,921 +– +– +– +5,921 +Related party liabilities +(1,170) +226 +(118) +– +(1,062) +Net cash provided by operating activities +983,594 +18,243 +56,282 +– +1,058,119 +Cash flows from investing activities: +Escrow deposits +(38,058) +– +– +– +(38,058) +Purchases of: +Property, plant and equipment +(1,419,505) +– +– +– +(1,419,505) +Short term investments +– +(77,693) +(558,154) +– +(635,847) +Fixed maturities investments +– +(42,628) +(312,473) +– +(355,101) +Equity securities +– +– +(489) +– +(489) +Real estate +(19,406) +(4,648) +(8,753) +– +(32,807) +Mortgage loans +– +(21,021) +(133,289) +– +(154,310) +Proceeds from sales and paydowns of: +Property, plant and equipment +487,475 +– +– +– +487,475 +Short term investments +– +80,225 +575,501 +– +655,726 +Fixed maturities investments +– +32,127 +158,451 +– +190,578 +Preferred stock +– +4,181 +– +– +4,181 +Real estate +6,275 +– +2,478 +– +8,753 +Mortgage loans +– +9,890 +96,942 +– +106,832 +Net cash used by investing activities +(983,219) +(19,567) +(179,786) +– +(1,182,572) +(page 1 of 2) +(a) Balance for the period ended December 31, 2016 +(b) Eliminate intercompany investments +F- 50 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continuation of consolidating cash flow statements by industry segment for the year ended March 31, 2017, are as follows: +Moving & Storage +Consolidated +Property & +Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +715,625 +– +27,000 +– +742,625 +Principal repayments on credit facilities +(340,844) +– +(27,000) +– +(367,844) +Payment of debt issuance costs +(5,055) +– +– +– +(5,055) +Capital lease payments +(212,545) +– +– +– +(212,545) +Employee Stock Ownership Plan Shares +(11,106) +– +– +– +(11,106) +Securitization deposits +446 +– +– +– +446 +Common stock dividends paid +(58,757) +– +– +– +(58,757) +Investment contract deposits +– +– +285,148 +– +285,148 +Investment contract withdrawals +– +– +(149,159) +– +(149,159) +Net cash provided by financing activities +87,764 +– +135,989 +– +223,753 +Effects of exchange rate on cash +(2,140) +– +– +– +(2,140) +Increase (decrease) in cash and cash equivalents +85,999 +(1,324) +12,485 +– +97,160 +Cash and cash equivalents at beginning of period +585,666 +14,049 +931 +– +600,646 +Cash and cash equivalents at end of period +$ +671,665 +$ +12,725 +$ +13,416 +$ +– +$ +697,806 +(page 2 of 2) +(a) Balance for the period ended December 31, 2016 +F- 51 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2016 are as follows: +Moving & Storage +Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +489,001 +$ +16,168 +$ +19,354 +$ +(35,522) +$ +489,001 +Earnings from consolidated subsidiaries +(35,522) +– +– +35,522 +– +Adjustments to reconcile net earnings to the cash provided by operations: +Depreciation +389,393 +– +– +– +389,393 +Amortization of deferred policy acquisition costs +– +– +23,272 +– +23,272 +Amortization of debt issuance costs +3,419 +– +– +– +3,419 +Interest credited to policyholders +– +– +20,465 +– +20,465 +Change in allowance for losses on trade receivables +7 +– +(212) +– +(205) +Change in allowance for inventories and parts reserve +(1,343) +– +– +– +(1,343) +Net gains on disposal of personal property +(98,158) +– +– +– +(98,158) +Net gains on disposal of real estate +(545) +– +– +– +(545) +Net gains on sales of investments +– +(1,317) +(3,174) +– +(4,491) +Deferred income taxes +124,838 +9,311 +3,926 +– +138,075 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(2,169) +13,528 +3,406 +– +14,765 +Inventories and parts +(9,009) +– +– +– +(9,009) +Prepaid expenses +(10,338) +– +– +– +(10,338) +Capitalization of deferred policy acquisition costs +– +– +(32,590) +– +(32,590) +Other assets +17,170 +(1,050) +141 +– +16,261 +Related party assets +55,962 +682 +(18,075) +18,075 +(b) +56,644 +Accounts payable and accrued expenses +26,018 +1,533 +9,761 +– +37,312 +Policy benefits and losses, claims and loss expenses payable +23,215 +(18,925) +5,336 +– +9,626 +Other policyholders' funds and liabilities +– +(1,056) +707 +– +(349) +Deferred income +4,757 +– +– +– +4,757 +Related party liabilities +17,296 +115 +48 +(18,075) +(b) +(616) +Net cash provided by operating activities +993,992 +18,989 +32,365 +– +1,045,346 +Cash flows from investing activities: +Escrow deposits +(4,358) +– +– +– +(4,358) +Purchases of: +Property, plant and equipment +(1,509,154) +– +– +– +(1,509,154) +Short term investments +– +(44,735) +(471,164) +– +(515,899) +Fixed maturities investments +– +(45,048) +(353,939) +– +(398,987) +Equity securities +– +– +(1,315) +– +(1,315) +Preferred stock +– +(1,005) +– +– +(1,005) +Real estate +(15,384) +(36) +(39) +– +(15,459) +Mortgage loans +– +(1,800) +(85,404) +– +(87,204) +Proceeds from sales and paydowns of: +Property, plant and equipment +539,256 +– +– +– +539,256 +Short term investments +– +44,756 +483,424 +– +528,180 +Fixed maturities investments +– +26,193 +128,343 +– +154,536 +Equity securities +– +1,236 +808 +– +2,044 +Preferred stock +– +1,126 +– +– +1,126 +Real estate +21,589 +– +– +– +21,589 +Mortgage loans +– +5,878 +21,090 +– +26,968 +Net cash used by investing activities +(968,051) +(13,435) +(278,196) +– +(1,259,682) +(page 1 of 2) +(a) Balance for the period ended December 31, 2015 +(b) Eliminate intercompany investments +F- 52 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continuation of consolidating cash flow statements by industry segment for the year ended March 31, 2016 are as follows: +Moving & Storage +Consolidated +Property & +Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +790,972 +– +47,000 +– +837,972 +Principal repayments on credit facilities +(381,403) +– +(47,000) +– +(428,403) +Payment of debt issuance costs +(10,184) +– +– +– +(10,184) +Capital lease payments +(168,661) +– +– +– +(168,661) +Employee Stock Ownership Plan Shares +(9,302) +– +– +– +(9,302) +Securitization deposits +544 +– +– +– +544 +Common stock dividends paid +(78,374) +– +– +– +(78,374) +Investment contract deposits +– +– +358,237 +– +358,237 +Investment contract withdrawals +– +– +(112,957) +– +(112,957) +Net cash provided by financing activities +143,592 +– +245,280 +– +388,872 +Effects of exchange rate on cash +(15,740) +– +– +– +(15,740) +Increase (decrease) in cash and cash equivalents +153,793 +5,554 +(551) +– +158,796 +Cash and cash equivalents at beginning of period +431,873 +8,495 +1,482 +– +441,850 +Cash and cash equivalents at end of period +$ +585,666 +$ +14,049 +$ +931 +$ +– +$ +600,646 +(page 2 of 2) +(a) Balance for the period ended December 31, 2015 +F- 53 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 22. Subsequent Events +Our management has evaluated subsequent events occurring after March 31, 2018. We do not believe any other subsequent events have occurred that would require further disclosure or adjustment to our financial statements other than as stated below. +On March 8, 2018, we declared a cash dividend on our Common Stock of $0.50 per share to holders of record on March 23, 2018. The dividend was paid on April 6, 2018. +SCHEDULE I +CONDENSED FINANCIAL INFORMATION OF AMERCO +BALANCE SHEETS +March 31, +2018 +2017 +(In thousands) +ASSETS +Cash and cash equivalents +$ +469,209 +$ +361,231 +Investment in subsidiaries +2,244,867 +1,522,083 +Related party assets +1,227,491 +1,474,948 +Other assets +114,568 +78,119 +Total assets +$ +4,056,135 +$ +3,436,381 +LIABILITIES AND STOCKHOLDERS' EQUITY +Liabilities: +Other liabilities +$ +639,604 +$ +809,705 +639,604 +809,705 +Stockholders' equity: +Preferred stock +– +– +Common stock +10,497 +10,497 +Additional paid-in capital +452,956 +452,382 +Accumulated other comprehensive loss +(4,623) +(51,236) +Retained earnings: +Beginning of period +2,883,943 +2,533,431 +Net earnings +790,583 +398,424 +Dividends +(39,175) +(39,172) +End of period +3,635,351 +2,892,683 +Cost of common shares in treasury +(525,653) +(525,653) +Cost of preferred shares in treasury +(151,997) +(151,997) +Total stockholders' equity +3,416,531 +2,626,676 +Total liabilities and stockholders' equity +$ +4,056,135 +$ +3,436,381 +The accompanying notes are an integral part of these condensed financial statements. +F- 54 +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF OPERATIONS +Years Ended March 31, +2018 +2017 +2016 +(In thousands, except share and per share data) +Revenues: +Net interest income and other revenues +$ +4,606 +$ +1,912 +$ +2,420 +Expenses: +Operating expenses +7,003 +7,115 +7,525 +Other expenses +91 +109 +111 +Total expenses +7,094 +7,224 +7,636 +Equity in earnings of subsidiaries +681,786 +327,773 +417,087 +Interest income +120,549 +103,211 +93,873 +Pretax earnings +799,847 +425,672 +505,744 +Income tax expense +(9,264) +(27,248) +(16,743) +Earnings available to common shareholders +$ +790,583 +$ +398,424 +$ +489,001 +Basic and diluted earnings per common share +$ +40.36 +$ +20.34 +$ +24.95 +Weighted average common shares outstanding: Basic and diluted +19,588,889 +19,586,606 +19,596,110 +The accompanying notes are an integral part of these condensed financial statements. +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF comprehensive income +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Net earnings +$ +790,583 +$ +398,424 +$ +489,001 +Other comprehensive income (loss) +37,873 +9,289 +(26,160) +Total comprehensive income +$ +828,456 +$ +407,713 +$ +462,841 +The accompanying notes are an integral part of these condensed financial statements. +F- 55 +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF CASH FLOW +Years Ended March 31, +2018 +2017 +2016 +(In thousands) +Cash flows from operating activities: +Net earnings +$ +790,583 +$ +398,424 +$ +489,001 +Change in investments in subsidiaries +(681,786) +(327,773) +(417,087) +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +3 +10 +6 +Net loss on sale of real and personal property +– +13 +– +Deferred income taxes +(182,358) +173,059 +124,838 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +– +– +– +Prepaid expenses +(36,516) +16,021 +(8,723) +Other assets +65 +(20) +6 +Related party assets +– +1 +56,849 +Accounts payable and accrued expenses +278 +(297) +(14) +Net cash provided (used) by operating activities +(109,731) +259,438 +244,876 +Cash flows from investing activities: +Purchases of property, plant and equipment +(1) +(55) +(8) +Proceeds of property, plant and equipment +– +39 +– +Net cash used by investing activities +(1) +(16) +(8) +Cash flows from financing activities: +Proceeds from (repayments) of intercompany loans +250,214 +(221,124) +(76,354) +Common stock dividends paid +(29,380) +(58,757) +(78,374) +Net cash provided (used) by financing activities +220,834 +(279,881) +(154,728) +Effects of exchange rate on cash +(3,124) +– +– +Increase (decrease) in cash and cash equivalents +107,978 +(20,459) +90,140 +Cash and cash equivalents at beginning of period +361,231 +381,690 +291,550 +Cash and cash equivalents at end of period +$ +469,209 +$ +361,231 +$ +381,690 +Income taxes paid, net of income taxes refunds received, amounted to $68.7 million, $36.9 million and $141.9 million for fiscal 2018, 2017 and 2016, respectively. +The accompanying notes are an integral part of these condensed financial statements. +F- 56 +CONDENSED FINANCIAL INFORMATION OF AMERCO +NOTES TO CONDENSED FINANCIAL INFORMATION +March 31, 2018, 2017, and 2016 +1. Summary of Significant Accounting Policies +AMERCO, a Nevada corporation, was incorporated in April, 1969, and is the holding Company for U-Haul International, Inc., Amerco Real Estate Company, Repwest Insurance Company and Oxford Life Insurance Company. The financial statements of the Registrant should be read in conjunction with the Consolidated Financial Statements and notes thereto included in this Annual Report. +AMERCO is included in a consolidated Federal income tax return with all of its U.S. subsidiaries. Accordingly, the provision for income taxes has been calculated for Federal income taxes of AMERCO and subsidiaries included in the consolidated return of AMERCO. State taxes for all subsidiaries are allocated to the respective subsidiaries. +The financial statements include only the accounts of AMERCO, which include certain of the corporate operations of AMERCO. The interest in AMERCO’s majority owned subsidiaries is accounted for on the equity method. The intercompany interest income and expenses are eliminated in the Consolidated Financial Statements. +2. Guarantees +AMERCO has guaranteed performance of certain long-term leases and other obligations. See Note 17, Contingent Liabilities and Commitments, and Note 19, Related Party Transactions, of the Notes to Consolidated Financial Statements. +F- 57 +SCHEDULE II +AMERCO AND CONSOLIDATED SUBSIDIARIES +VALUATION AND QUALIFYING ACCOUNTS +Balance at Beginning of Year +Additions Charged to Costs and Expenses +Additions Charged to Other Accounts +Deductions +Balance at Year End +Year ended March 31, 2018 +(In thousands) +Allowance for doubtful accounts +(deducted from trade receivable) +$ +539 +$ +886 +$ +– +$ +(929) +$ +496 +Allowance for obsolescence +(deducted from inventory) +$ +2,050 +$ +3,279 +$ +– +$ +– +$ +5,329 +Allowance for LIFO +(deducted from inventory) +$ +14,340 +$ +1,786 +$ +– +$ +– +$ +16,126 +Allowance for probable losses +(deducted from mortgage loans) +$ +493 +$ +125 +$ +– +$ +– +$ +618 +Year ended March 31, 2017 +Allowance for doubtful accounts +(deducted from trade receivable) +$ +585 +$ +913 +$ +– +$ +(959) +$ +539 +Allowance for obsolescence +(deducted from inventory) +$ +1,597 +$ +1,218 +$ +– +$ +(765) +$ +2,050 +Allowance for LIFO +(deducted from inventory) +$ +13,463 +$ +877 +$ +– +$ +– +$ +14,340 +Allowance for probable losses +(deducted from mortgage loans) +$ +368 +$ +125 +$ +– +$ +– +$ +493 +Year ended March 31, 2016 +Allowance for doubtful accounts +(deducted from trade receivable) +$ +790 +$ +967 +$ +– +$ +(1,172) +$ +585 +Allowance for obsolescence +(deducted from inventory) +$ +1,384 +$ +213 +$ +– +$ +– +$ +1,597 +Allowance for LIFO +(deducted from inventory) +$ +15,019 +$ +– +$ +– +$ +(1,556) +$ +13,463 +Allowance for probable losses +(deducted from mortgage loans) +$ +370 +$ +– +$ +– +$ +(2) +$ +368 +F- 58 +SCHEDULE V +AMERCO AND CONSOLIDATED SUBSIDIARIES +SUPPLEMENTAL INFORMATION (FOR PROPERTY-CASUALTY INSURANCE Operations) +Years Ended December 31, 2017, 2016, AND 2015 +Fiscal Year +Affiliation with Registrant +Deferred Policy Acquisition Cost +Reserves for Unpaid Claims and Adjustment Expenses +Discount if any, Deducted +Unearned Premiums +Net Earned Premiums (1) +Net Investment Income (2) +Claim and Claim Adjustment Expenses Incurred Related to Current Year +Claim and Claim Adjustment Expenses Incurred Related to Prior Year +Amortization of Deferred Policy Acquisition Costs +Paid Claims and Claim Adjustment Expense +Net Premiums Written (1) +(In thousands) +2018 +Consolidated property +casualty entity +$ +– +$ +233,554 +$ +N/A +$ +70 +$ +57,100 +$ +14,079 +$ +15,749 +$ +233 +$ +– +$ +17,366 +$ +57,123 +2017 +Consolidated property +casualty entity +– +244,400 +N/A +49 +52,334 +14,015 +13,297 +107 +– +17,609 +52,324 +2016 +Consolidated property +casualty entity +– +251,964 +N/A +59 +50,020 +13,491 +11,713 +585 +– +18,360 +50,034 +(1) The earned and written premiums are reported net of intersegment transactions. There were $2.3 million in written premiums and $1.7 million in earned premiums eliminated for the year ended December 31, 2017 and no written or earned premiums eliminated for the years ended December 31, 2016 and 2015, respectively. +(2) Net Investment Income excludes net realized (gains) losses on investments of ($1.7) million, ($2.6) million and ($1.3) million for the years ended December 31, 2017, 2016 and 2015, respectively . +F- 59 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +AMERCO +Date: May 30, 2018 +/s/ Edward J. Shoen +Edward J. Shoen +President and Chairman of the Board +(Duly Authorized Officer) +Date: May 30, 2018 +/s/ Jason A. Berg +Jason A. Berg +Chief Financial Officer +(Principal Financial Officer) +Date: May 30, 2018 +/s/ Mary K. Thompson +Mary K. Thompson +Chief Accounting Officer +POWER OF ATTORNEY +KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Edward J. Shoen his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act or things requisite and necessary to be done in and about the premises, as fully and to all intents and purposes as he might or could do in person hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Jason A. Berg +Chief Financial Officer +May 30, 2018 +Jason A. Berg +/s/ James E. Acridge +Director +May 30, 2018 +James E. Acridge +/s/ John P. Brogan +Director +May 30, 2018 +John P. Brogan +/s/ John M. Dodds +Director +May 30, 2018 +John M. Dodds +/s/ James J. Grogan +Director +May 30, 2018 +James J. Grogan +/s/ Richard J. Herrera +Director +May 30, 2018 +Richard J. Herrera +/s/ Karl A. Schmidt +Director +May 30, 2018 +Karl A. Schmidt +/s/ Samuel J. Shoen +Director +May 30, 2018 +Samuel J. Shoen \ No newline at end of file diff --git a/raw/filings/0000004457/2018/0000004457-18-000016/filing_metadata.csv b/raw/filings/0000004457/2018/0000004457-18-000016/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..b153d78a009b1bf2efbd5688d2012592a16e786d --- /dev/null +++ b/raw/filings/0000004457/2018/0000004457-18-000016/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004457,UHAL-B,U-Haul Holding Co /NV/,2018,10-K,2018-05-30,2018-03-31,2018-05-30T20:08:44.000Z,0000004457-18-000016,March201810K.htm,MARCH 2018 10-K,25848830,1,0,https://www.sec.gov/Archives/edgar/data/4457/000000445718000016/March201810K.htm,https://www.sec.gov/Archives/edgar/data/4457/000000445718000016/ diff --git a/raw/filings/0000004457/2018/0000004457-18-000016/item1.txt b/raw/filings/0000004457/2018/0000004457-18-000016/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..c8b095847505b3dd705b23d5f8ee4f6cf50be418 --- /dev/null +++ b/raw/filings/0000004457/2018/0000004457-18-000016/item1.txt @@ -0,0 +1,76 @@ +Item 1. Business +Company Overview +We are North America’s largest “do-it-yourself” moving and storage operator through our subsidiary U-Haul International, Inc. (“U-Haul”). U-Haul is synonymous with “do-it-yourself” moving and storage and is a leader in supplying products and services to help people move and store their household and commercial goods. Our primary service objective is to provide a better and better product or service to more and more people at a lower and lower cost. Unless the context otherwise requires, the terms “AMERCO,” “Company,” “we,” “us,” or “our” refer to AMERCO, a Nevada corporation, and all of its legal subsidiaries, on a consolidated basis. +We were founded in 1945 as a sole proprietorship under the name "U-Haul Trailer Rental Company" and have rented trailers ever since. Starting in 1959, we rented trucks on a one-way and in-town basis exclusively through independent U-Haul ® dealers. In 1974, we began developing our network of U-Haul ® managed retail stores, through which we rent our trucks and trailers, self-storage rooms and portable moving and storage units and sell moving and self-storage products and services to complement our independent dealer network. +We rent our distinctive orange and white U-Haul ® trucks and trailers as well as offer self-storage rooms through a network of 1,790 Company operated retail moving stores and approximately 20,000 independent U-Haul ® dealers. We also sell U-Haul ® brand boxes, tape and other moving and self-storage products and services to “do-it-yourself” moving and storage customers at all of our distribution outlets and through our uhaul.com ® and eMove ® websites. +We believe U-Haul ® is the most convenient supplier of products and services addressing the needs of the United States and Canada’s “do-it-yourself” moving and storage markets. Our broad geographic coverage throughout the United States and Canada and our extensive selection of U-Haul ® brand moving equipment rentals, self-storage rooms, portable moving and storage units and related moving and storage products and services provide our customers with convenient “one-stop” shopping. +Since 1945, U-Haul ® has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Through Repwest Insurance Company (“Repwest”) and ARCOA Risk Retention Group ("ARCOA"), our property and casualty insurance subsidiaries, we manage the property, liability and related insurance claims processing for U-Haul ® . Oxford Life Insurance Company (“Oxford”), our life insurance subsidiary, sells life insurance, Medicare supplement insurance, annuities and other related products to the senior market. +Available Information +AMERCO ® and U-Haul ® are each incorporated in Nevada. U-Haul’s internet address is uhaul.com. On AMERCO’s investor relations website, amerco.com, we post the following filings as soon as practicable after they are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”): our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, proxy statements related to meetings of our stockholders, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We also use our investor relations website as a means of disclosing material information and for complying with our disclosure obligations under Regulation FD. All such filings on our website are available free of charge. Additionally, you will find these materials on the SEC’s website at sec.gov. +1 +Products and Rental Equipment +Our customers are primarily “do-it-yourself” household movers. U-Haul ® moving equipment is specifically designed, engineered and manufactured for the “do-it-yourself” household mover. These “do-it-yourself” movers include individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and “do-it-yourself” home remodeling and gardening enthusiasts who need to transport materials. +As of March 31, 2018, our rental fleet consisted of approximately 161,000 trucks, 118,000 trailers and 42,000 towing devices. This equipment and our U-Haul brand of self-moving products and services are available through our network of managed retail moving stores and independent U-Haul dealers. Independent U-Haul dealers receive rental equipment from the Company, act as rental agents and are paid a commission based on gross revenues generated from their U-Haul ® rentals. +Our rental truck chassis are engineered by domestic truck manufacturers. These chassis are joined with the U-Haul ® designed and manufactured van boxes primarily at U-Haul ® operated manufacturing and assembly facilities strategically located throughout the United States. U-Haul ® rental trucks feature our proprietary Lowest Deck SM , which provides our customers with extra ease of loading. The loading ramps on our trucks are the widest in the industry, which reduce the effort needed to move belongings. Our trucks are fitted with convenient, padded rub rails with tie downs on every interior wall. Our Gentle Ride Suspension SM helps our customers safely move delicate and prized possessions. Also, the engineers at our U-Haul Technical Center determined that the softest ride in our trucks was at the front of the van box. Consequently, we designed the part of the van box that hangs over the front cab of the truck to be the location for our customers to place their most fragile items during their move. We call this area Mom’s Attic ® . +Our distinctive trailers are also manufactured at these same U-Haul ® operated manufacturing and assembly facilities. These trailers are well suited to the low profile of many of today’s newly manufactured automobiles. Our engineering staff is committed to making our trailers easy to tow, safe, aerodynamic and fuel efficient. +To provide our self-move customers with added value, our rental trucks and trailers are designed with fuel efficiency in mind. Many of our trucks are fitted with fuel economy gauges, another tool that assists our customers in conserving fuel. To help make our rental equipment more reliable, we routinely perform extensive preventive maintenance and repairs. +We also provide customers with equipment to transport their vehicles. We provide two towing options; auto transport, in which all four wheels are off the ground, and a tow dolly, in which the front wheels of the towed vehicle are off the ground. +To help our customers load their boxes and larger household appliances and furniture, we offer several accessory rental items. Our utility dolly has a lightweight design and is easy to maneuver. Another rental accessory is our four wheel dolly, which provides a large, flat surface for moving dressers, wall units, pianos and other large household items. U-Haul ® appliance dollies provide the leverage needed to move refrigerators, freezers, washers and dryers easily and safely. These utility, furniture and appliance dollies, along with the low decks and the wide loading ramps on U-Haul ® trucks and trailers, are designed for easy loading and unloading of our customers’ belongings. +The total package U-Haul ® offers to the “do-it-yourself” household mover doesn’t end with trucks, trailers and accessory rental items. Our moving supplies include a wide array of affordably priced U-Haul ® brand boxes, tape and packing materials. We also provide specialty boxes for dishes, computers and sensitive electronic equipment, as well as tape, security locks, and packing supplies. U-Haul ® brand boxes are specifically sized to make loading easier. +We estimate that U-Haul ® is North America’s largest seller and installer of hitches and towing systems. In addition to towing U-Haul ® equipment, these hitching and towing systems can tow jet skis, motorcycles, boats, campers and horse trailers. Each year, more than one million customers visit our locations for expertise on complete towing systems, trailer rentals and the latest in towing accessories. +2 +U-Haul ® has one of North America’s largest propane refilling networks, with over 1,100 locations providing this convenient service. We employ trained, certified personnel to refill propane cylinders and alternative fuel vehicles. Our network of propane dispensing locations is one of the largest automobile alternative refueling networks in North America. +Our self-storage business was a natural outgrowth of our self-moving operations. Conveniently located U-Haul ® self-storage rental facilities provide clean, dry and secure space for storage of household and commercial goods. Storage units range in size from 6 square feet to over 1,000 square feet. As of March 31, 2018, we operate 1,519 self-storage locations in the United States and Canada, with nearly 632,000 rentable storage rooms comprising 55.2 million square feet of rentable storage space. Our self-storage centers feature a wide array of security measures, ranging from electronic property access control gates to individually alarmed storage units. At many centers, we offer climate controlled storage rooms to protect temperature sensitive goods such as video tapes, albums, photographs and precious wood furniture. +Another extension of our strategy to make “do-it-yourself” moving and storage easier is our U-Box ® program. A U-Box ® portable moving and storage unit is delivered to a location of our customer’s choosing either by the customers themselves through the use of a U-Box ® trailer, with the assistance of a Moving Helper or by Company personnel. Once the U-Box ® portable moving and storage unit is filled, it can be stored at the customer’s location, or taken to one of our Company operated locations, a participating independent dealer, or moved to a location of the customer’s choice. +Additionally, we offer moving and storage protection packages such as Safemove ® and Safetow ® . These programs provide moving and towing customers with a damage waiver, cargo protection and medical and life insurance coverage. Safestor ® provides protection for storage customers from loss on their goods in storage. Safestor Mobile ® provides protection for customers stored belongings when using our U-Box ® portable moving and storage units. For our customers who desire additional coverage over and above the standard Safemove ® protection, we also offer our Safemove Plus ® product. This package provides the rental customer with a layer of primary liability protection. +We believe that through our website, uhaul.com, we have aggregated the largest network of customers and independent businesses in the self-moving and self-storage industry. In particular, our Moving Helper program connects “do-it-yourself” movers with thousands of independent service providers in the United States and Canada to assist our customers in packing, loading, unloading, cleaning and performing other services. +Through the U-Haul Storage Affiliates ® program, independent storage businesses can join one of the world’s largest self-storage reservation systems. Self-storage customers making a reservation through uhaul.com ® can access all of the U-Haul self-storage centers and all of our independent storage affiliate partners for even greater convenience to meet their self-storage needs. For the independent storage operator, our network gives them access to products and services allowing them to compete with larger operators more cost effectively. +We own numerous trademarks and service marks that contribute to the identity and recognition of our Company and its products and services. Certain of these marks are integral to the conduct of our business, a loss of any of which could have a material adverse affect on our business. We consider the trademark “U-Haul ® ” to be of material importance to our business in addition, but not limited to, the U.S. trademarks and service marks “AMERCO ® ”, “eMove ® ”, “Gentle Ride Suspension SM ”, “In-Town ® ”, “Lowest Decks SM ”, “Moving made Easier ® ”, “Make Moving Easier ® ”, “Mom’s Attic ® ”, “Moving Help ® ”, “Moving Helper ® ”, “Safemove ® ”, “Safemove Plus ® ”, “Safestor ® ”, “Safestor Mobile ® ”, “Safetow ® ”, “U-Box ® ”, “uhaul.com ® ”, “U-Haul Investors Club ® ”, “U-Haul Truck Share ® ”, “U-Haul Truck Share 24/7 ® “ “U-Note ® ”, “WebSelfStorage ® ”, among others, for use in connection with the moving and storage business. Additionally, applications to register the U-Haul Smart Mobility Center SM trademarks are pending in the U.S. Patent and Trademark Office. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO ® , U-Haul ® , and Amerco Real Estate Company +(“Real Estate”), and the subsidiaries of U-Haul ® and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +3 +Life Insurance, comprised of Oxford and its subsidiaries. +Financial information for each of our operating segments is included in the Notes to Consolidated Financial Statements as part of Item 8: Financial Statements and Supplementary Data of this Annual Report on Form 10-K. +Moving and Storage Operating Segment +Moving and Storage operating segment (“Moving and Storage”) consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +Net revenue from Moving and Storage was approximately 91.3%, 90.8% and 91.0% of consolidated net revenue in fiscal 2018, 2017 and 2016, respectively. +During fiscal 2018, we placed over 34,000 new trucks in service. These additions and replacements to the fleet were a combination of U-Haul ® manufactured vehicles and purchases. As new trucks are added to the fleet, we typically remove older trucks from the fleet. The total number of rental trucks in the fleet increased during fiscal 2018 as the pace of new additions was greater than those trucks removed for retirement and sale. +Within our truck and trailer rental operation, we are focused on expanding our independent dealer network to provide added convenience for our customers. U-Haul ® maximizes vehicle utilization by managing distribution of the truck and trailer fleets among the 1,790 Company operated stores and approximately 20,000 independent dealers. Utilizing its proprietary reservations management system, our centers and dealers electronically report their inventory in real-time, which facilitates matching equipment to customer demand. Approximately 55% of all U-Move ® rental revenue originates from our operated centers. +At our owned and operated retail stores we are implementing new initiatives to improve customer service. These initiatives include improving management of our rental equipment to provide our retail centers with the right type of rental equipment, at the right time and at the most convenient location for our customers, effectively marketing our broad line of self-moving related products and services, expanding accessibility to provide more convenience to our customers, and enhancing our ability to properly staff locations during our peak hours of operations by attracting and retaining “moonlighters” (part-time U-Haul ® employees with full-time jobs elsewhere) during our peak hours of operation. As of April 2017, U-Haul expanded it’s offering of U-Haul Truck Share 24/7 ® to our entire network in the United States and Canada. In May 2018, U-Haul received intellectual property protection of such system from the U.S. Trademark Office. +Our self-moving related products and services, such as boxes, pads and insurance, help our customers have a better moving experience and help them to protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +Our self-storage business operations consist of the rental of self-storage rooms, portable moving and storage units, sales of self-storage related products, the facilitation of sales of services, and the management of self-storage facilities owned by others. +U-Haul ® is one of the largest North American operators of self-storage and has been a leader in the self-storage industry since 1974. U-Haul ® operates nearly 632,000 rentable storage rooms, comprising 55.2 million square feet of rentable storage space with locations in 49 states and 10 Canadian provinces. U-Haul’s owned and managed self-storage facility locations range in size up to 309,000 square feet of storage space, with individual storage units in sizes ranging from 6 square feet to over 1,000 square feet. +The primary market for storage rooms is the storage of household goods. We believe that our self-storage services provide a competitive advantage through such things as Max Security, an electronic system that monitors the storage facility 24 hours a day, climate control in select units, individually alarmed rooms, extended hours access, and an internet-based customer reservation and account management system. +4 +Moving Help ® and U-Haul Storage Affiliates ® on uhaul.com are online marketplaces that connect consumers to independent Moving Help ® service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated Moving Help ® and affiliates provide pack and load help, cleaning help, self-storage and similar services all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Environmental laws and regulations are complex, change frequently and could become more stringent in the future. +Moving and Storage business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally our weakest. +Property and Casualty Insurance Operating Segment +Our Property and Casualty Insurance operating segment (“Property and Casualty Insurance”) provides loss adjusting and claims handling for U-Haul through regional offices across the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestore Mobile ® and Safestor ® protection packages to U-Haul customers. We attempt to price our products to be a good value to our customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. +Net revenue from Property and Casualty Insurance was approximately 2.0%, 2.0% and 2.0% of consolidated net revenue in fiscal 2018, 2017 and 2016, respectively. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Net revenue from Life Insurance was approximately 6.7%, 7.2% and 7.0% of consolidated net revenue in fiscal 2018, 2017 and 2016, respectively. +Employees +As of March 31, 2018, we employed over 29,000 people throughout the United States and Canada with approximately 98% of these employees working within Moving and Storage and approximately 55% of these employees working on a part-time basis. +Sales and Marketing +We promote U-Haul ® brand awareness through direct and co-marketing arrangements. Our direct marketing activities consist of web-based initiatives, print and social media as well as trade events, movie cameos of our rental fleet and boxes, and industry and consumer communications. We believe that our rental equipment is our best form of advertisement. We support our independent U-Haul ® dealers through marketing U-Haul ® moving and self-storage rentals, products and services. +Our marketing plan focuses on maintaining our leadership position in the “do-it-yourself” moving and storage industry by continually improving the ease of use and economy of our rental equipment, by providing added convenience to our retail centers, through independent U-Haul dealers, and by expanding the capabilities of our U-Haul websites. +A significant driver of U-Haul’s rental transaction volume is our utilization of an online reservation and sales system, through uhaul.com and our 24-hour 1-800-GO-U-HAUL telephone reservations system. These points of contact are prominently featured and are a major driver of customer lead sources. +5 +Competition +Moving and Storage Operating Segment +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. Generally speaking, we consider there to be two distinct users of rental trucks: commercial and “do-it-yourself” residential users. We primarily focus on the “do-it-yourself” residential user. Within this segment, we believe the principal competitive factors are convenience of rental locations, availability of quality rental moving equipment, breadth of essential products and services, and total cost to the user. Our major national competitors in both the in-town and one-way moving equipment rental market include Avis Budget Group, Inc. and Penske Truck Leasing. We have numerous competitors throughout the United States and Canada who compete with us in the in-town market. +The self-storage market is large and very fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Our largest competitors in the self-storage market are Public Storage Inc., Extra Space Storage, Inc., Cubesmart and Life Storage, Inc. +Insurance Operating Segments +The insurance industry is highly competitive. In addition, the marketplace includes financial services firms offering both insurance and financial products. Some of the insurance companies are owned by stockholders and others are owned by policyholders. Many competitors have been in business for a longer period of time or possess substantially greater financial resources and broader product portfolios than our insurance companies. We compete in the insurance business based upon price, product design, and services rendered to agents and policyholders. +Financial Data of Segment and Geographic Areas +For financial data of our segments and geographic areas please see Note 21, Financial Information by Geographic Area, and Note 21A, Consolidating Financial Information by Consolidating Industry Segment, of our Notes to Consolidated Financial Statements. +Cautionary Statement Regarding Forward-Looking Statements +This Annual Report on Form 10-K (“Annual Report”), contains “forward-looking statements” regarding future events and our future results of operations. We may make additional written or oral forward-looking statements from time to time in filings with the SEC or otherwise. We believe such forward-looking statements are within the meaning of the safe-harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Such statements may include, but are not limited to, estimates of capital expenditures, plans for future operations, products or services, financing needs and plans, our perceptions of our legal positions and anticipated outcomes of government investigations and pending litigation against us, liquidity, goals and strategies, plans for new business, storage occupancy, growth rate assumptions, pricing, costs, and access to capital and leasing markets the impact of our compliance with environmental laws and cleanup costs, our used vehicle disposition strategy, the sources and availability of funds for our rental equipment and self-storage expansion and replacement strategies and plans, our plan to expand our U-Haul storage affiliate program, that additional leverage can be supported by our operations and business, the availability of alternative vehicle manufacturers, our estimates of the residual values of our equipment fleet, our plans with respect to off-balance sheet arrangements, our plans to continue to invest in the U-Box ® program, the impact of interest rate and foreign currency exchange rate changes on our operations, the sufficiency of our capital resources and the sufficiency of capital of our insurance subsidiaries as well as assumptions relating to the foregoing. The words “believe,” “expect,” “anticipate,” “plan,” “may,” “will,” “could,” “estimate,” “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. +6 +Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Factors that could significantly affect results include, without limitation, the risk factors enumerated below under the heading “Risk Factors” and other factors described in this Annual Report or the other documents we file with the SEC. These factors, the following disclosures, as well as other statements in this Annual Report and in the Notes to Consolidated Financial Statements, could contribute to or cause such risks or uncertainties, or could cause our stock price to fluctuate dramatically. Consequently, the forward-looking statements should not be regarded as representations or warranties by us that such matters will be realized. We assume no obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by law. \ No newline at end of file diff --git a/raw/filings/0000004457/2018/0000004457-18-000016/item13.txt b/raw/filings/0000004457/2018/0000004457-18-000016/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..3fcf0bfb98e1da4f283fb5e658707b99c4f89eae --- /dev/null +++ b/raw/filings/0000004457/2018/0000004457-18-000016/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +42 \ No newline at end of file diff --git a/raw/filings/0000004457/2019/0000004457-19-000024/filing.txt b/raw/filings/0000004457/2019/0000004457-19-000024/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..73e8f14e245c87cd59eff2682680a3abc678eb81 --- /dev/null +++ b/raw/filings/0000004457/2019/0000004457-19-000024/filing.txt @@ -0,0 +1,8056 @@ +10-K +1 +march201910k.htm +MARCH 31, 2019 10-K +United States Securities and exchange commission +Washington, D.C. 20549 +Form 10-K +(Mark One) +[X]Annual Report Pursuant to Section 13 or 15( d ) of the securities exchange act of 1934. +For the fiscal year ended March 31, 2019 +or +[ ]Transition report pursuant to section 13 or 15( d ) OF THE SECURITIES EXCHANGE ACT OF 1934. +For the transition period from __________________ to _________________ +Commission +File Number +Registrant, State of Incorporation Address and Telephone Number +I.R.S. Employer Identification No. +1-11255 +AMERCO +88-0106815 +(A Nevada Corporation) +5555 Kietzke Lane, Ste. 100 +Reno, Nevada 89511 +Telephone (775) 688-6300 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common stock, $0.25 par value +NASDAQ Global Select Market +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] No [ ] +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act. Yes [ ] No [X] +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes [X] No [ ] +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer [X] Accelerated filer [ ] +Non-accelerated filer [ ] Smaller reporting company [ ] +Emerging growth company [ ] +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] +The aggregate market value of AMERCO common stock held by non-affiliates on September 28, 2018 was $3,167,360,502. The aggregate market value was computed using the closing price for the common stock trading on NASDAQ on such date. Shares held by executive officers, directors and persons owning directly or indirectly more than 5% of the outstanding common stock have been excluded from the preceding number because such persons may be deemed to be affiliates of the registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +19,607,788 shares of AMERCO Common Stock, $0.25 par value, were outstanding at May 24, 2019. +Documents incorporated by reference: portions of AMERCO’s definitive proxy statement for the 2019 annual meeting of stockholders, to be filed within 120 days after AMERCO’s fiscal year ended March 31, 2019, are incorporated by reference into Part III of this report. +TABLE OF CONTENTS +Page +PART I +Item 1. +Business +1 +Item 1A. +Risk Factors +7 +Item 1B. +Unresolved Staff Comments +12 +Item 2. +Properties +12 +Item 3. +Legal Proceedings +12 +Item 4. +Mine Safety Disclosures +13 +PART II +Item 5. +Ma rket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +13 +Item 6. +Selected Financial Data +15 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +16 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +37 +Item 8. +F inancial Statements and Supplementary Data +38 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +38 +Item 9A. +Controls and Procedures +38 +Item 9B. +Other Information +41 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +41 +Item 11. +Executive Compensation +41 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +41 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +41 +Item 14. +Principal Accounting Fees and Services +41 +PART IV +Item 15. +Exhibits; Financial Statement Schedules +41 +Item 16. +Form 10-K Summary +49 +Part i +Item 1. Business +Company Overview +We are North America’s largest “do-it-yourself” moving and storage operator through our subsidiary U-Haul International, Inc. (“U-Haul”). U-Haul is synonymous with “do-it-yourself” moving and storage and is a leader in supplying products and services to help people move and store their household and commercial goods. Our primary service objective is to “provide a better and better product and service to more and more people at a lower and lower cost.” Unless the context otherwise requires, the terms “AMERCO,” “Company,” “we,” “us,” or “our” refer to AMERCO, a Nevada corporation, and all of its legal subsidiaries, on a consolidated basis. +We were founded in 1945 as a sole proprietorship under the name "U-Haul Trailer Rental Company" and have rented trailers ever since. Starting in 1959, we rented trucks on a one-way and in-town basis exclusively through independent U-Haul ® dealers. In 1973, we began developing our network of U-Haul ® managed retail stores, through which we rent our trucks and trailers, self-storage units and portable moving and storage units and sell moving and self-storage products and services to complement our independent dealer network. +We rent our distinctive orange and white U-Haul ® trucks and trailers as well as offer self-storage units through a network of 1,981 Company-operated retail moving stores and over 20,000 independent U-Haul ® dealers. We also sell U-Haul ® brand boxes, tape and other moving and self-storage products and services to “do-it-yourself” moving and storage customers at all of our distribution outlets and through our uhaul.com ® and eMove ® websites. +We believe U-Haul ® is the most convenient supplier of products and services addressing the needs of the United States and Canada’s “do-it-yourself” moving and storage markets. Our broad geographic coverage throughout the United States and Canada and our extensive selection of U-Haul ® brand moving equipment rentals, self-storage units, portable moving and storage units and related moving and storage products and services provide our customers with convenient “one-stop” shopping. +Since 1945, U-Haul ® has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Through Repwest Insurance Company (“Repwest”) and ARCOA Risk Retention Group ("ARCOA"), our property and casualty insurance subsidiaries, we manage the property, liability and related insurance claims processing for U-Haul ® . Oxford Life Insurance Company (“Oxford”), our life insurance subsidiary, sells life insurance, Medicare supplement insurance, annuities and other related products to the senior market. +Available Information +AMERCO ® and U-Haul ® are each incorporated in Nevada. The internet address for U-Haul is uhaul.com. On AMERCO’s investor relations website, amerco.com, we post the following filings as soon as practicable after they are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”): our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, proxy statements related to meetings of our stockholders, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We also use our investor relations website as a means of disclosing material information and for complying with our disclosure obligations under Regulation FD. All such filings on our website are available free of charge. Additionally, you will find these materials on the SEC’s website at sec.gov. +1 +Products and Rental Equipment +Our customers are primarily “do-it-yourself” household movers. U-Haul ® moving equipment is specifically designed, engineered and manufactured for the “do-it-yourself” household mover. These “do-it-yourself” movers include individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and “do-it-yourself” home remodeling and gardening enthusiasts who need to transport materials. +As of March 31, 2019, our rental fleet consisted of approximately 167,000 trucks, 120,000 trailers and 43,000 towing devices. This equipment and our U-Haul brand of self-moving products and services are available through our network of managed retail moving stores and independent U-Haul dealers. Independent U-Haul dealers receive rental equipment from the Company, act as rental agents and are paid a commission based on gross revenues generated from their U-Haul ® rentals. +Our rental truck chassis are engineered by domestic truck manufacturers. These chassis are joined with the U-Haul ® designed and manufactured van boxes primarily at U-Haul ® operated manufacturing and assembly facilities strategically located throughout the United States. U-Haul ® rental trucks feature our proprietary Lowest Deck SM , which provides our customers with extra ease of loading. The loading ramps on our trucks are the widest in the industry, which reduce the effort needed to move belongings. Our trucks are fitted with convenient, padded rub rails with tie downs on every interior wall. Our Gentle Ride Suspension SM helps our customers safely move delicate and prized possessions. Also, the engineers at our U-Haul Technical Center determined that the softest ride in our trucks was at the front of the van box. Consequently, we designed the part of the van box that hangs over the front cab of the truck to be the location for our customers to place their most fragile items during their move. We call this area Mom’s Attic ® . +Our distinctive trailers are also manufactured at these same U-Haul ® operated manufacturing and assembly facilities. These trailers are well suited to the low profile of many of today’s newly manufactured automobiles. Our engineering staff is committed to making our trailers easy to tow, safe, aerodynamic and fuel efficient. +To provide our self-move customers with added value, our rental trucks and trailers are designed with fuel efficiency in mind. Many of our trucks are fitted with fuel economy gauges, another tool that assists our customers in conserving fuel. To help make our rental equipment more reliable, we routinely perform extensive preventive maintenance and repairs. +We also provide customers with equipment to transport their vehicles. We provide two towing options: auto transport, in which all four wheels are off the ground, and a tow dolly, in which the front wheels of the towed vehicle are off the ground. +To help our customers load their boxes and larger household appliances and furniture, we offer several accessory rental items. Our utility dolly has a lightweight design and is easy to maneuver. Another rental accessory is our four wheel dolly, which provides a large, flat surface for moving dressers, wall units, pianos and other large household items. U-Haul ® appliance dollies provide the leverage needed to move refrigerators, freezers, washers and dryers easily and safely. These utility, furniture and appliance dollies, along with the low decks and the wide loading ramps on U-Haul ® trucks and trailers, are designed for easy loading and unloading of our customers’ belongings. +The total package U-Haul ® offers to the “do-it-yourself” household mover doesn’t end with trucks, trailers and accessory rental items. Our moving supplies include a wide array of affordably priced U-Haul ® brand boxes, tape and packing materials. We also provide specialty boxes for dishes, computers and sensitive electronic equipment, as well as tape, security locks, and packing supplies. U-Haul ® brand boxes are specifically sized to make loading easier. +We estimate that U-Haul ® is North America’s largest seller and installer of hitches and towing systems. In addition to towing U-Haul ® equipment, these hitching and towing systems can tow jet skis, motorcycles, boats, campers and horse trailers. Each year, more than one million customers visit our locations for expertise on complete towing systems, trailer rentals and the latest in towing accessories. +2 +U-Haul ® has one of North America’s largest propane refilling networks, with over 1,100 locations providing this convenient service. We employ trained, certified personnel to refill propane cylinders and alternative fuel vehicles. Our network of propane dispensing locations is one of the largest automobile alternative refueling networks in North America. +Our self-storage business was a natural outgrowth of our self-moving operations. Conveniently located U-Haul ® self-storage rental facilities provide clean, dry and secure space for storage of household and commercial goods. Storage units range in size from 6 square feet to over 1,000 square feet. As of March 31, 2019, we operate 1,631 self-storage locations in the United States and Canada, with nearly 697,000 rentable storage units comprising 60.7 million square feet of rentable storage space. Our self-storage centers feature a wide array of security measures, ranging from electronic property access control gates to individually alarmed storage units. At many centers, we offer climate-controlled storage units to protect temperature sensitive goods such as video tapes, albums, photographs and precious wood furniture. +Another extension of our strategy to make “do-it-yourself” moving and storage easier is our U-Box ® program. A U-Box ® portable moving and storage unit is delivered to a location of our customer’s choosing either by the customers themselves through the use of a U-Box ® trailer, with the assistance of a Moving Helper or by Company personnel. Once the U-Box ® portable moving and storage unit is filled, it can be stored at the customer’s location, or taken to one of our Company operated locations, a participating independent dealer, or moved to a location of the customer’s choice. +Additionally, we offer moving and storage protection packages such as Safemove ® and Safetow ® . These programs provide moving and towing customers with a damage waiver, cargo protection and medical and life insurance coverage. Safestor ® provides protection for storage customers from loss on their goods in storage. Safestor Mobile ® provides protection for customers stored belongings when using our U-Box ® portable moving and storage units. For our customers who desire additional coverage over and above the standard Safemove ® protection, we also offer our Safemove Plus ® product. This package provides the rental customer with a layer of primary liability protection. +We believe that through our website, uhaul.com, we have aggregated the largest network of customers and independent businesses in the self-moving and self-storage industry. In particular, our Moving Helper program connects “do-it-yourself” movers with thousands of independent service providers in the United States and Canada to assist our customers in packing, loading, unloading, cleaning and performing other services. +Through the U-Haul Storage Affiliates ® program, independent storage businesses can join one of the world’s largest self-storage reservation systems. Self-storage customers making a reservation through uhaul.com ® can access all of the U-Haul self-storage centers and all of our independent storage affiliate partners for even greater convenience to meet their self-storage needs. For the independent storage operator, our network gives them access to products and services allowing them to compete with larger operators more cost effectively. +We own numerous trademarks and service marks that contribute to the identity and recognition of our Company and its products and services. Certain of these marks are integral to the conduct of our business, a loss of any of which could have a material adverse affect on our business. We consider the trademark “U-Haul ® ” to be of material importance to our business in addition, but not limited to, the U.S. trademarks and service marks “AMERCO ® ”, “eMove ® ”, “Gentle Ride Suspension SM ”, “In-Town ® ”, “Lowest Decks SM ”, “Moving made Easier ® ”, “Make Moving Easier ® ”, “Mom’s Attic ® ”, “Moving Help ® ”, “Moving Helper ® ”, “Safemove ® ”, “Safemove Plus ® ”, “Safestor ® ”, “Safestor Mobile ® ”, “Safetow ® ”, “U-Box ® ”, “uhaul.com ® ”, “U-Haul Investors Club ® ”, “U-Haul Truck Share ® ”, “U-Haul Truck Share 24/7 ® “ “U-Note ® ”, “WebSelfStorage ® ”, and “U-Haul Smart Mobility Center ®” , among others, for use in connection with the moving and storage business. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO ® , U-Haul ® , and Amerco Real Estate Company +(“Real Estate”), and the subsidiaries of U-Haul ® and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +Life Insurance, comprised of Oxford and its subsidiaries. +3 +Financial information for each of our operating segments is included in the Notes to Consolidated Financial Statements as part of Item 8: Financial Statements and Supplementary Data of this Annual Report on Form 10-K. +Moving and Storage Operating Segment +Moving and Storage operating segment (“Moving and Storage”) consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +Net revenue from Moving and Storage was approximately 94.0%, 91.3% and 90.8% of consolidated net revenue in fiscal 2019, 2018 and 2017, respectively. +The total number of rental trucks in the fleet increased during fiscal 2019 as the pace of new additions was greater than those trucks removed for retirement and sale. These additions and replacements to the fleet were a combination of U-Haul ® manufactured vehicles and purchases. As new trucks are added to the fleet, we typically remove older trucks from the fleet. +Within our truck and trailer rental operation, we are focused on expanding our independent dealer network to provide added convenience for our customers. U-Haul ® maximizes vehicle utilization by managing distribution of the truck and trailer fleets among the 1,981 Company-operated stores and 20,000 independent dealers. Utilizing its proprietary reservations management system, our centers and dealers electronically report their inventory in real-time, which facilitates matching equipment to customer demand. Over half of all U-Move ® rental revenue originated from our operated centers. +At our owned and operated retail stores we are implementing new initiatives to improve customer service. These initiatives include improving management of our rental equipment to provide our retail centers with the right type of rental equipment, at the right time and at the most convenient location for our customers, effectively marketing our broad line of self-moving related products and services, expanding accessibility to provide more convenience to our customers, and enhancing our ability to properly staff locations during our peak hours of operations by attracting and retaining “moonlighters” (part-time U-Haul ® employees with full-time jobs elsewhere) during our peak hours of operation. As of April 2017, U-Haul expanded it’s offering of U-Haul Truck Share 24/7 ® to our entire network in the United States and Canada. U-Haul currently has several U.S. Patents pending on its U-Haul Truck Share 24/7 ® system. +Our self-moving related products and services, such as boxes, pads and insurance, help our customers have a better moving experience and help them to protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +Our self-storage business operations consist of the rental of self-storage units, portable moving and storage units, sales of self-storage related products, the facilitation of sales of services, and the management of self-storage facilities owned by others. +U-Haul ® is one of the largest North American operators of self-storage and has been a leader in the self-storage industry since 1974. U-Haul ® operates nearly 697,000 rentable storage units, comprising 60.7 million square feet of rentable storage space with locations in 50 states and 10 Canadian provinces. Our owned and managed self-storage facility locations range in size up to 309,000 square feet of storage space, with individual storage units in sizes ranging from 6 square feet to over 1,000 square feet. +The primary market for storage units is the storage of household goods. We believe that our self-storage services provide a competitive advantage through such things as Max Security, an electronic system that monitors the storage facility 24 hours a day, climate control in select units, individually alarmed units, extended hours access, and an internet-based customer reservation and account management system. +4 +Moving Help ® and U-Haul Storage Affiliates ® on uhaul.com are online marketplaces that connect consumers to independent Moving Help ® service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated Moving Help ® and affiliates provide pack and load help, cleaning help, self-storage and similar services all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Environmental laws and regulations are complex, change frequently and could become more stringent in the future. +Moving and Storage business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally our weakest. +Property and Casualty Insurance Operating Segment +Our Property and Casualty Insurance operating segment (“Property and Casualty Insurance”) provides loss adjusting and claims handling for U-Haul through regional offices across the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestore Mobile ® and Safestor ® protection packages to U-Haul customers. We attempt to price our products to be a good value to our customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. +Net revenue from Property and Casualty Insurance was approximately 1.9%, 2.0% and 2.0% of consolidated net revenue in fiscal 2019, 2018 and 2017, respectively. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Net revenue from Life Insurance was approximately 4.1%, 6.7% and 7.2% of consolidated net revenue in fiscal 2019, 2018 and 2017, respectively. +Employees +As of March 31, 2019, we employed over 30,000 people throughout the United States and Canada with approximately 99% of these employees working within Moving and Storage and approximately 54% of these employees working on a part-time basis. +Sales and Marketing +We promote U-Haul ® brand awareness through direct and co-marketing arrangements. Our direct marketing activities consist of web-based initiatives, print and social media as well as trade events, movie and television cameos of our rental fleet and boxes, and industry and consumer communications. We believe that our rental equipment is our best form of advertisement. We support our independent U-Haul ® dealers through marketing U-Haul ® moving and self-storage rentals, products and services. +Our marketing plan focuses on maintaining our leadership position in the “do-it-yourself” moving and storage industry by continually improving the ease of use and economy of our rental equipment, by providing added convenience to our retail centers, through independent U-Haul dealers, and by expanding the capabilities of our U-Haul websites. +A significant driver of rental transaction volume is our utilization of an online reservation and sales system, through uhaul.com and our 24-hour 1-800-GO-U-HAUL telephone reservations system. These points of contact are prominently featured and are a major driver of customer lead sources. +5 +Competition +Moving and Storage Operating Segment +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. Generally speaking, we consider there to be two distinct users of rental trucks: commercial and “do-it-yourself” residential users. We primarily focus on the “do-it-yourself” residential user. Within this segment, we believe the principal competitive factors are convenience of rental locations, availability of quality rental moving equipment, breadth of essential products and services, and total cost to the user. Our major national competitors in both the in-town and one-way moving equipment rental market include Avis Budget Group, Inc. and Penske Truck Leasing. We have numerous competitors throughout the United States and Canada who compete with us in the in-town market. +The self-storage market is large and very fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Our largest competitors in the self-storage market are Public Storage Inc., Extra Space Storage, Inc., CubeSmart and Life Storage, Inc. +Insurance Operating Segments +The insurance industry is highly competitive. In addition, the marketplace includes financial services firms offering both insurance and financial products. Some of the insurance companies are owned by stockholders and others are owned by policyholders. Many competitors have been in business for a longer period of time or possess substantially greater financial resources and broader product portfolios than our insurance companies. We compete in the insurance business based upon price, product design, and services rendered to agents and policyholders. +Financial Data of Segment and Geographic Areas +For financial data of our segments and geographic areas please see Note 21, Financial Information by Geographic Area, and Note 21A, Consolidating Financial Information by Consolidating Industry Segment, of our Notes to Consolidated Financial Statements. +Cautionary Statement Regarding Forward-Looking Statements +This Annual Report on Form 10-K (“Annual Report”), contains “forward-looking statements” regarding future events and our future results of operations. We may make additional written or oral forward-looking statements from time to time in filings with the SEC or otherwise. We believe such forward-looking statements are within the meaning of the safe-harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Such statements may include, but are not limited to, estimates of capital expenditures, plans for future operations, products or services, financing needs and plans, our perceptions of our legal positions and anticipated outcomes of government investigations and pending litigation against us, liquidity and the availability of financial resources to meet our needs, goals and strategies, plans for new business, storage occupancy, growth rate assumptions, pricing, costs, and access to capital and leasing markets the impact of our compliance with environmental laws and cleanup costs, our used vehicle disposition strategy, the sources and availability of funds for our rental equipment and self-storage expansion and replacement strategies and plans, our plan to expand our U-Haul storage affiliate program, that additional leverage can be supported by our operations and business, the availability of alternative vehicle manufacturers, our estimates of the residual values of our equipment fleet, our plans with respect to off-balance sheet arrangements, our plans to continue to invest in the U-Box ® program, the impact of interest rate and foreign currency exchange rate changes on our operations, the sufficiency of our capital resources and the sufficiency of capital of our insurance subsidiaries as well as assumptions relating to the foregoing. The words “believe,” “expect,” “anticipate,” “plan,” “may,” “will,” “could,” “estimate,” “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. +6 +Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Factors that could significantly affect results include, without limitation, the risk factors enumerated below under the heading “Risk Factors” and other factors described in this Annual Report or the other documents we file with the SEC. These factors, the following disclosures, as well as other statements in this Annual Report and in the Notes to Consolidated Financial Statements, could contribute to or cause such risks or uncertainties, or could cause our stock price to fluctuate dramatically. Consequently, the forward-looking statements should not be regarded as representations or warranties by us that such matters will be realized. We assume no obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by law. +Item 1A. Risk Factors +The following discussion of risk factors should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) and the Consolidated Financial Statements and related notes. These risk factors may be important in understanding this Annual Report or elsewhere. +We operate in a highly competitive industry. +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. We believe the principal competitive factors in this industry are convenience of rental locations, availability of quality rental moving equipment, breadth of essential services and products and total cost. Financial results for the Company can be adversely impacted by aggressive pricing from our competitors. Some of our competitors may have greater financial resources than we have. We cannot assure you that we will be able to maintain existing rental prices or implement price increases. Moreover, if our competitors reduce prices and we are not able or willing to do so as well, we may lose rental volume, which would likely have a materially adverse effect on our results of operations. Numerous potential competitors are working to establish paradigm shifting technologies from self-driving vehicles to ride-hailing services and other technologies that connect riders with vehicles. +The self-storage industry is large and highly fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Competition in the market areas in which we operate is significant and affects the occupancy levels, rental rates and operating expenses of our facilities. Competition might cause us to experience a decrease in occupancy levels, limit our ability to raise rental rates or require us to offer discounted rates that would have a material effect on results of operations and financial condition. Entry into the self-storage business may be accomplished through the acquisition of existing facilities by persons or institutions with the required initial capital. Development of new self-storage facilities is more difficult however, due to land use, zoning, environmental and other regulatory requirements. The self-storage industry has in the past experienced overbuilding in response to perceived increases in demand. We cannot assure you that we will be able to successfully compete in existing markets or expand into new markets. +We are highly leveraged. +As of March 31, 2019, we had total debt outstanding of $4,210.2 million and total undiscounted operating and ground lease commitments of $148.0 million. Although we believe, based on existing information, that additional leverage can be supported by our operations and revenues, our existing debt could impact us in the following ways among other considerations: +require us to allocate a considerable portion of cash flows from operations to debt service and lease payments; +limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; +limit our ability to obtain additional financing; and +place us at a disadvantage compared to our competitors who may have less debt. +7 +Our ability to make payments on our debt and leases depends upon our ability to maintain and improve our operating performance and generate cash flow. To some extent, this is subject to prevailing economic and competitive conditions and to certain financial, business and other factors, some of which are beyond our control. If we are unable to generate sufficient cash flow from operations to service our debt and meet our other cash needs, including our leases, we may be forced to reduce or delay capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness and leases. If we must sell our assets, it may negatively affect our ability to generate revenue. In addition, we may incur additional debt or leases that would exacerbate the risks associated with our indebtedness. +Uncertainty regarding LIBOR may adversely impact our indebtedness under our credit and loan facilities. +On July 27, 2017, the United Kingdom’s Financial Conduct Authority, which regulates LIBOR, announced that it intends to phase out LIBOR by the end of 2021. It is unclear if at that time whether or not LIBOR will cease to exist or if new methods of calculating LIBOR will be established such that it continues to exist after 2021. In addition, in April 2018, the Federal Reserve System, in conjunction with the Alternative Reference Rates Committee, announced the replacement of LIBOR with a new index, calculated by short-term repurchase agreements collateralized by U.S. Treasury securities, called the Secured Overnight Financing Rate (“SOFR”). At this time, it is not possible to predict whether SOFR will attain market traction as a LIBOR replacement. Additionally, the future of LIBOR at this time is uncertain. Potential changes, or uncertainty related to such potential changes, may adversely affect the market for LIBOR-based securities, including our portfolio of LIBOR-indexed, floating-rate debt securities, or the cost of our borrowings. In addition, changes or reforms to the determination or supervision of LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR, which could have an adverse impact on the market for LIBOR-based securities, including the value of the LIBOR-indexed, floating-rate debt securities in our portfolio, or the cost of our borrowings. Additionally, if LIBOR ceases to exist, we may need to renegotiate our credit and loan facilities extending beyond 2021 that utilize LIBOR as a factor in determining the interest rate and certain of our existing credit facilities to replace LIBOR with the new standard that is established. The potential effect of the phase-out or replacement of LIBOR on our cost of capital and net investment income cannot yet be determined. +Economic conditions, including those related to the credit markets, may adversely affect our industry, business and results of operations. +Consumer and commercial spending is generally affected by the health of the economy, which places some of the factors affecting the success of our business beyond our control. Our businesses, although not as traditionally cyclical as some, could experience significant downturns in connection with or in anticipation of, declines in general economic conditions. In times of declining consumer spending we may be driven, along with our competitors, to reduce pricing which would have a negative impact on gross profit. We cannot predict if another downturn in the economy will occur, which could result in reduced revenues and working capital. +Should credit markets in the United States tighten or if interest rates increase significantly, we may not be able to refinance existing debt or find additional financing on favorable terms, if at all. If one or more of the financial institutions that support our existing credit facilities fails or opts not to continue to lend to us, we may not be able to find a replacement, which would negatively impact our ability to borrow under credit facilities. If our operating results were to worsen significantly and our cash flows or capital resources prove inadequate, or if interest rates increase significantly, we could face liquidity problems that could materially and adversely affect our results of operations and financial condition. +Our fleet rotation program can be adversely affected by financial market conditions. +To meet the needs of our customers, U-Haul maintains a large fleet of rental equipment. Our rental truck fleet rotation program is funded internally through operations and externally from debt and lease financing. Our ability to fund our routine fleet rotation program could be adversely affected if financial market conditions limit the general availability of external financing. This could lead us to operate trucks longer than initially planned and/or reduce the size of the fleet, either of which could materially and negatively affect our results of operations. +8 +Another important aspect of our fleet rotation program is the sale of used rental equipment. The sale of used equipment provides us with funds that can be used to purchase new equipment. Conditions may arise that could lead to the decrease in demand and/or resale values for our used equipment. This could have a material adverse effect on our financial results, which could result in substantial losses on the sale of equipment and decreases in cash flows from the sales of equipment. +We obtain our rental trucks from a limited number of manufacturers. +Over the last twenty years, we purchased the majority of our rental trucks from Ford Motor Company and General Motors Corporation. Our fleet can be negatively affected by issues our manufacturers may face within their own supply chain. Also, it is possible that our suppliers may face financial difficulties or organizational changes which could negatively impact their ability to accept future orders or fulfill existing orders. The cost of acquiring new rental trucks could increase materially and negatively affect our ability to rotate new equipment into the fleet. Although we believe that we could contract with alternative manufacturers for our rental trucks, we cannot guarantee or predict how long that would take. In addition, termination of our existing relationship with these suppliers could have a material adverse effect on our business, financial condition or results of operations for an indefinite period of time. +A substantial amount of our shares is owned by a small contingent of stockholders. +Willow Grove Holdings LP, directly and through controlled entities (“WGHLP”), owns 8,309,584 shares of AMERCO common stock, and together with Edward J. Shoen and Mark V. Shoen, owns 8,361,731 shares (approximately 42.6%) of AMERCO common stock. The general partner of WGHLP controls the voting and disposition decisions with respect to the common stock of AMERCO owned by WGHLP, and is managed by Edward J. Shoen (the Chairman of the Board of Directors and Chief Executive Officer of AMERCO) and his brother, Mark V. Shoen. Accordingly, Edward J. Shoen and Mark V. Shoen are in a position to significantly influence our business and policies, including the approval of certain significant transactions, the election of the members of our Board of Directors (the “Board”) and other matters submitted to our stockholders. There can be no assurance that their interests will not conflict with the interests of our other stockholders. +In addition, 1,084,571 shares (approximately 5.5%) of AMERCO common stock are owned under our Employee Stock Ownership Plan (“ESOP”). Each ESOP participant is entitled to vote the shares allocated to himself or herself in their discretion. In the event an ESOP participant does not vote his or her shares, such shares shall be voted by the ESOP trustee, in the ESOP trustee’s discretion. +Our operations subject us to numerous environmental regulations and the possibility that environmental liability in the future could adversely affect our operations. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Under environmental laws or common law principles, we can be held liable for hazardous substances that are found on real property we have owned or operated. We are aware of issues regarding hazardous substances on some of our real estate and we have put in place a remediation plan at each site where we believe such a plan is necessary. See Note 18, Contingencies, of the Notes to Consolidated Financial Statements. We regularly make capital and operating expenditures to stay in compliance with environmental laws. In particular, we have managed a testing and removal program since 1988 for our underground storage tanks. Despite these compliance efforts, the risk of environmental liability is part of the nature of our business. +Environmental laws and regulations are complex, change frequently and could become more stringent in the future. We cannot assure you that future compliance with these regulations, future environmental liabilities, the cost of defending environmental claims, conducting any environmental remediation or generally resolving liabilities caused by us or related third parties will not have a material adverse effect on our business, financial condition or results of operations. +9 +We operate in a highly regulated industry and changes in existing regulations or violations of existing or future regulations could have a material adverse effect on our operations and profitability. +Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. The failure to comply with these laws and regulations may adversely affect our ability to sell or rent such property or to use the property as collateral for future borrowings. Compliance with changing regulations could substantially impair real property and equipment productivity and increase our costs. In addition, the Federal government may institute some regulation that limits carbon emissions by setting a maximum amount of carbon individual entities can emit without penalty. This would likely affect everyone who uses fossil fuels and would disproportionately affect users in the highway transportation industries. While there are too many variables at this time to assess the impact of the various proposed federal and state regulations that could affect carbon emissions, many experts believe these proposed rules could significantly affect the way companies operate in their businesses. +Our operations can be limited by land-use regulations. Zoning choices enacted by individual municipalities in the United States and Canada may limit our ability to serve certain markets with our products and services. +Our insurance companies are heavily regulated by state insurance departments and the National Association of Insurance Commissioners (“NAIC”). These insurance regulations are primarily in place to protect the interests of our policyholders and not our investors. Changes in these laws and regulations could increase our costs, inhibit new sales, or limit our ability to implement rate increases. +A significant portion of our revenues are generated through third-parties. +Our business plan relies upon a network of independent dealers strategically located throughout the United States and Canada. As of March 31, 2019 we had over 20,000 independent equipment rental dealers. In fiscal 2019, less than half of all U-Move ® rental revenue originated through this network. +Our inability to maintain this network or its current cost structure could inhibit our ability to adequately serve our customers and may negatively affect our results of operations and financial position. +We face liability risks associated with the operation of our rental fleet, sales of our products and operation of our locations. +The business of renting moving and storage equipment to customers exposes us to liability claims including property damage, personal injury and even death. Likewise, the operation of our moving and storage centers along with the sale of our related moving supplies, towing accessories and installation, and refilling of propane tanks may subject us to liability claims. We seek to limit the occurrence of such events through the design of our equipment, communication of its proper use, exhaustive repair and maintenance schedules, extensive training of our personnel, proactive risk management assessments and by providing our customers with online resources for the proper use of products and services. Regardless, accidents still occur and we manage the financial risk of these events through third party insurance carriers. While these excess loss insurance policies are available today at reasonable costs, this could change and could negatively affect our results of operations and financial position. +Terrorist attacks could negatively impact our operations and profitability and may expose us to liability and reputational damage. +Terrorist attacks may negatively affect our operations and profitability. Such attacks may damage our facilities and it is also possible that our rental equipment could be involved in a terrorist attack. Although we carry excess of loss insurance coverage, it may prove to be insufficient to cover us for acts of terror using our rental equipment. Moreover, we may suffer reputational damage that could arise from a terrorist attack which utilizes our rental equipment. The consequences of any terrorist attacks or hostilities are unpredictable and difficult to quantify. We seek to minimize these risks through our operational processes and procedures; however, we may not be able to foresee events that could have an adverse effect on our operations. +10 +We are highly dependent upon our automated systems and the Internet for managing our business. +Our information systems are largely Internet-based, including our point-of-sale reservation system, payment processing and telephone systems. While our reliance on this technology lowers our cost of providing service and expands our abilities to better serve customers, it exposes us to various risks including natural and man-made disasters, terrorist attacks and cyber-attacks. We have put into place extensive security protocols, backup systems and alternative procedures to mitigate these risks. However, disruptions or breaches, detected or undetected by us, for any period of time in any portion of these systems could adversely affect our results of operations and financial condition and inflict reputational damage. +In addition, the provision of service to our customers and the operation of our networks and systems involve the storage and transmission of proprietary information and sensitive or confidential data, including personal information of customers, employees and others. Our information technology systems may be susceptible to computer viruses, attacks by computer hackers, malicious insiders, or catastrophic events. Hackers, acting individually or in coordinated groups, may also launch distributed denial of service attacks or ransom or other coordinated attacks that may cause service outages or other interruptions in our business and access to our data. In addition, breaches in security could expose us, our customers, or the individuals affected, to a risk of loss or misuse of proprietary information and sensitive or confidential data. The techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently, may be difficult to detect for a long time and often are not recognized until launched against a target. As a result, we may be unable to anticipate these techniques or to implement adequate preventative measures. +Any of these occurrences could result in disruptions in our operations, the loss of existing or potential customers, damage to our brand and reputation, and litigation and potential liability for the Company. In addition, the cost and operational consequences of implementing further data or system protection measures could be significant and our efforts to deter, identify, mitigate and/or eliminate any security breaches may not be successful. +A.M. Best financial strength ratings are crucial to our life insurance business. +In June 2018, A.M. Best affirmed the financial strength rating for Oxford and Christian Fidelity Life Insurance Company (“CFLIC”) of A- with a stable outlook and affirmed the financial strength rating for North American Insurance Company (“NAI”) of B++ with a stable outlook. Financial strength ratings are important external factors that can affect the success of Oxford’s business plans. Accordingly, if Oxford’s ratings, relative to its competitors, are not maintained or do not continue to improve, Oxford may not be able to retain and attract business as currently planned, which could adversely affect our results of operations and financial condition. +We may incur losses due to our reinsurers’ or counterparties’ failure to perform under existing contracts or we may be unable to secure sufficient reinsurance or hedging protection in the future. +We use reinsurance and derivative contracts to mitigate our risk of loss in various circumstances; primarily at Repwest and for Moving and Storage. These agreements do not release us from our primary obligations and therefore we remain ultimately responsible for these potential costs. We cannot provide assurance that these reinsurers or counterparties will fulfill their obligations. Their inability or unwillingness to make payments to us under the terms of the contracts may have a material adverse effect on our financial condition and results of operations. +At December 31, 2018, Repwest reported $2.3 million of reinsurance recoverables, net of allowances and $94.9 million of reserves and liabilities ceded to reinsurers. Of this, Repwest’s largest exposure to a single reinsurer was $60.6 million. +11 +Recent changes to U.S. tax laws may adversely affect our financial condition or results of operations and create the risk that we may need to adjust our accounting for these changes. +The Tax Cuts and Jobs Act (“Tax Reform Act”) made significant changes to U.S. tax laws and includes numerous provisions that affect businesses, including ours. For instance, as a result of lower corporate tax rates, the Tax Reform Act tends to reduce both the value of deferred tax assets and the amount of deferred tax liabilities. It also limits interest expense deductions and the amount of net operating losses that can be used each year and alters the expensing of capital expenditures. Other provisions have international tax consequences for businesses like ours that operate internationally. The Tax Reform Act is unclear in certain respects and will require interpretations and implementing regulations by the IRS, as well as state tax authorities, and the Tax Reform Act could be subject to amendments and technical corrections, any of which could lessen or increase the adverse (and positive) impacts of the Tax Reform Act. The accounting treatment of these tax law changes was complex, and some of the changes affected both current and future periods. Others primarily affected future periods. As discussed elsewhere in this Annual Report, our analysis and computations of the tax effects of the Tax Reform Act on us was complete as of December 22, 2018. +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +The Company, through its legal subsidiaries, owns property, plant and equipment that are utilized in the manufacturing, repair and rental of U-Haul ® equipment and storage space, as well as providing office space for us. Such facilities exist throughout the United States and Canada. We also manage storage facilities owned by others. We operate 1,981 U-Haul ® retail centers of which 488 U-Haul branded locations are managed for subsidiaries of WGHLP and Mercury, and 11 manufacturing and assembly facilities. We also operate over 141 fixed-site repair facilities located throughout the United States and Canada. These facilities are used primarily for the benefit of Moving and Storage. +Item 3. Legal Proceedings +Litigation +On July 1, 2014, a 100-pound propane cylinder exploded while in use on a food truck in Philadelphia, Pennsylvania. The explosion killed two people and injured eleven. Following the incident, the injured parties and their estates filed a number of lawsuits in the Philadelphia Court of Common Pleas against U-Haul and its subsidiary, U-Haul Co. of Pennsylvania (“UHPA”), alleging that UHPA improperly filled propane cylinders that were overdue for periodic requalification and offered such cylinders for transportation, which allegedly caused the deaths and injuries. One plaintiff also sued AMERCO. All U-Haul defendants denied the allegations. The parties reached agreements to settle the civil cases by April 2018. We have paid a total of $27.9 million, representing our self-insured retention and attorney’s fees for all related civil matters. +In June 2018, following the resolution of the civil claims, the United States Attorney's Office for the Eastern District of Pennsylvania filed an initial 6-count indictment and a superseding 7-count indictment against UHPA. In January 2019, the U.S. Attorney's Office agreed to dismiss Counts 1 through 5 alleging UHPA improperly filled propane cylinders that were overdue for periodic requalification and offering such cylinders for transportation. UHPA entered a guilty plea with respect to Counts 6 and 7 relating to a failure to properly train UHPA employees dispensing propane and documentation thereof. On May 7, 2019, the United States District Court for the Eastern District of Pennsylvania accepted the plea agreement and imposed a $1 million fine and two years of probation on UHPA. UHPA was also ordered to pay $800 in associated court fees. +12 +Environmental +Compliance with environmental requirements of federal, state and local governments may significantly affect Real Estate’s business operations. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Real Estate is aware of issues regarding hazardous substances on some of its properties. Real Estate regularly makes capital and operating expenditures to stay in compliance with environmental laws and has put in place a remedial plan at each site where it believes such a plan is necessary. Since 1988, Real Estate has managed a testing and removal program for underground storage tanks. +Based upon the information currently available to Real Estate, compliance with the environmental laws and its share of the costs of investigation and cleanup of known hazardous waste sites are not expected to result in a material adverse effect on AMERCO’s financial position or results of operations. +Other +We are named as a defendant in various other litigations and claims arising out of the normal course of business. In management’s opinion, none of these other matters will have a material effect on our financial position and results of operations. +Item 4. Mine Safety Disclosure +Not applicable. +Part ii +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +As of May 9, 2019, there were approximately 2,800 holders of record of our common stock. We derived the number of our stockholders using internal stock ledgers and utilizing Mellon Investor Services Stockholder listings. AMERCO’s common stock is listed on the NASDAQ Global Select Market under the trading symbol “UHAL”. +Dividends +AMERCO ® does not have a formal dividend policy. The Board periodically considers the advisability of declaring and paying dividends to common stockholders in light of existing circumstances. +The following table lists the dividends that have been declared and issued since July 2017. +Common Stock Dividends +Declared Date +Per Share Amount +Record Date +Dividend Date +March 6, 2019 +$ +0.50 +March 21, 2019 +April 4, 2019 +December 5, 2018 +0.50 +December 20, 2018 +January 7, 2019 +August 23, 2018 +0.50 +September 10, 2018 +September 24, 2018 +June 6, 2018 +0.50 +June 21, 2018 +July 5, 2018 +March 8, 2018 +0.50 +March 23, 2018 +April 6, 2018 +December 6, 2017 +0.50 +December 21, 2017 +January 5, 2018 +July 5, 2017 +1.00 +July 20, 2017 +August 3, 2017 +See Note 20, Statutory Financial Information of Insurance Subsidiaries, of the Notes to Consolidated Financial Statements for a discussion of certain statutory restrictions on the ability of the insurance subsidiaries to pay dividends to AMERCO. +13 +Performance Graph +The following graph compares the cumulative total stockholder return on the Company’s common stock for the period March 31, 2014 through March 31, 2019 with the cumulative total return on the Dow Jones US Total Market and the Dow Jones US Transportation Average. The comparison assumes that $100 was invested on March 31, 2014 in the Company’s common stock and in each of the comparison indices. The graph reflects the value of the investment based on the closing price of the common stock trading on NASDAQ on March 31, 2015, 2016, 2017, 2018 and 2019. +Fiscal years ended March 31: +2014 +2015 +2016 +2017 +2018 +2019 +AMERCO +$ +100 +$ +141 +$ +154 +$ +165 +$ +151 +$ +163 +Dow Jones US Total Market +100 +108 +107 +125 +146 +157 +Dow Jones US Transportation Average +100 +114 +104 +119 +136 +136 +14 +Item 6.Selected Financial Data +The following selected financial data should be read in conjunction with the MD&A, and the Consolidated Financial Statements and related notes in this Annual Report. +Listed below is selected financial data for AMERCO and consolidated subsidiaries for each of the last five years: +Years Ended March 31, +2019 +2018 +2017 +2016 +2015 +(In thousands, except share and per share data) +Summary of Operations: +Self-moving equipment rentals +$ +2,653,497 +$ +2,479,742 +$ +2,362,833 +$ +2,297,980 +$ +2,146,391 +Self-storage revenues +367,276 +323,903 +286,886 +247,944 +211,136 +Self-moving and self-storage products and service sales +264,146 +261,557 +253,073 +251,541 +244,177 +Property management fees +29,148 +29,602 +29,075 +26,533 +25,341 +Life insurance premiums +63,488 +154,703 +163,579 +162,662 +156,103 +Property and casualty insurance premiums +60,853 +57,100 +52,334 +50,020 +46,456 +Net investment and interest income +110,934 +110,473 +102,276 +86,617 +84,728 +Other revenue +219,365 +184,034 +171,711 +152,171 +160,199 +Total revenues +3,768,707 +3,601,114 +3,421,767 +3,275,468 +3,074,531 +Operating expenses +1,981,180 +1,807,056 +1,567,181 +1,469,260 +1,478,675 +Commission expenses +288,408 +276,705 +267,230 +262,627 +249,642 +Cost of sales +162,142 +160,489 +152,485 +144,990 +146,072 +Benefits and losses +100,277 +185,311 +182,710 +167,436 +158,760 +Amortization of deferred policy acquisition costs +28,556 +24,514 +26,218 +23,272 +19,661 +Lease expense +33,158 +33,960 +37,343 +49,780 +79,798 +Depreciation, net gains on disposals (a) +554,043 +543,247 +449,025 +291,235 +279,107 +Net gains on disposal of real estate +(44) +(195,414) +(3,590) +(545) +(942) +Total costs and expenses +3,147,720 +2,835,868 +2,678,602 +2,408,055 +2,410,773 +Earnings from operations +620,987 +765,246 +743,165 +867,413 +663,758 +Other components of net periodic benefit costs +(1,013) +(927) +(902) +(787) +(734) +Interest expense +(142,445) +(126,706) +(113,406) +(97,715) +(97,525) +Fees and amortization on early extinguishment of debt +– +– +(499) +– +(4,081) +Pretax earnings +477,529 +637,613 +628,358 +768,911 +561,418 +Income tax benefit (expense) +(106,672) +152,970 +(229,934) +(279,910) +(204,677) +Earnings available to common shareholders +$ +370,857 +$ +790,583 +$ +398,424 +$ +489,001 +$ +356,741 +Basic and diluted earnings per common share +$ +18.93 +$ +40.36 +$ +20.34 +$ +24.95 +$ +18.21 +Weighted average common shares outstanding: Basic and diluted +19,592,048 +19,588,889 +19,586,606 +19,596,110 +19,586,633 +Cash dividends declared and accrued Common stock +39,180 +39,175 +39,171 +97,960 +19,594 +Balance Sheet Data: +Property, plant and equipment, net +$ +7,933,971 +$ +6,816,741 +$ +5,957,735 +$ +5,017,511 +$ +4,107,637 +Total assets +11,891,713 +10,747,422 +9,405,840 +8,109,288 +6,855,600 +Notes, loans and leases payable, net +4,163,323 +3,513,076 +3,262,880 +2,647,396 +2,174,294 +Stockholders' equity +3,692,389 +3,408,708 +2,619,744 +2,251,406 +1,884,359 +(a) Net gains were ($27.0) million, ($11.8) million, ($32.5) million, ($98.2) million and ($73.7) million for fiscal 2019, 2018, 2017, 2016 and 2015, respectively. +15 +Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations +We begin this MD&A with the overall strategy of AMERCO, followed by a description of, and strategy related to, our operating segments to give the reader an overview of the goals of our businesses and the direction in which our businesses and products are moving. We then discuss our critical accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Next, we discuss our results of operations for fiscal 2019 compared with fiscal 2018, and for fiscal 2018 compared with fiscal 2017, which are followed by an analysis of liquidity changes in our balance sheets and cash flows, and a discussion of our financial commitments in the sections entitled Liquidity and Capital Resources and Disclosures about Contractual Obligations and Commercial Commitments. We conclude this MD&A by discussing our outlook for fiscal 2020. +This MD&A should be read in conjunction with the other sections of this Annual Report, including Item 1: Business, Item 6: Selected Financial Data and Item 8: Financial Statements and Supplementary Data. The various sections of this MD&A contain a number of forward-looking statements, as discussed under the caption, Cautionary Statements Regarding Forward-Looking Statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this Annual Report and particularly under the section Item 1A: Risk Factors. Our actual results may differ materially from these forward-looking statements. +AMERCO has a fiscal year that ends on the 31 st of March for each year that is referenced. Our insurance company subsidiaries have fiscal years that end on the 31 st of December for each year that is referenced. They have been consolidated on that basis. Our insurance companies’ financial reporting processes conform to calendar year reporting as required by state insurance departments. Management believes that consolidating their calendar year into our fiscal year financial statements does not materially affect the presentation of financial position or results of operations. We disclose all material events, if any, occurring during the intervening period. Consequently, all references to our insurance subsidiaries’ years 2018, 2017 and 2016 correspond to fiscal 2019, 2018 and 2017 for AMERCO. +Overall Strategy +Our overall strategy is to maintain our leadership position in the North American “do-it-yourself” moving and storage industry. We accomplish this by providing a seamless and integrated supply chain to the “do-it-yourself” moving and storage market. As part of executing this strategy, we leverage the brand recognition of U-Haul with our full line of moving and self-storage related products and services and the convenience of our broad geographic presence. +Our primary focus is to provide our customers with a wide selection of moving rental equipment, convenient self-storage rental facilities and portable moving and storage units and related moving and self-storage products and services. We are able to expand our distribution and improve customer service by increasing the amount of moving equipment and storage units and portable moving and storage units available for rent, expanding the number of independent dealers in our network and expanding and taking advantage of our eMove capabilities. +Property and Casualty Insurance is focused on providing and administering property and casualty insurance to U-Haul and its customers, its independent dealers and affiliates. +Life Insurance is focused on long-term capital growth through direct writing and reinsuring of life, Medicare supplement and annuity products in the senior marketplace. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO, U-Haul, and Real Estate and the subsidiaries of U-Haul and Real Estate; +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA; and +Life Insurance, comprised of Oxford and its subsidiaries. +See Note 1, Basis of Presentation, Note 21, Financial Information by Geographic Area, and Note 21A, Consolidating Financial Information by Industry Segment, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. +16 +Moving and Storage Operating Segment +Moving and Storage consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +With respect to our truck, trailer, specialty rental items and self-storage rental business, we are focused on expanding our dealer network, which provides added convenience for our customers and expanding the selection and availability of rental equipment to satisfy the needs of our customers. +U-Haul ® brand self-moving related products and services, such as boxes, pads and tape allow our customers to, among other things, protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +uhaul.com ® is an online marketplace that connects consumers to our operations as well as independent Moving Help ® service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated affiliates and service providers furnish pack and load help, cleaning help, self-storage and similar services throughout the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Since 1945, U-Haul has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Property and Casualty Insurance Operating Segment +Property and Casualty Insurance provides loss adjusting and claims handling for U-Haul through regional offices in the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestor ® and Safestor Mobile ® protection packages to U-Haul ® customers. We continue to focus on increasing the penetration of these products into the moving and storage market. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul ® related programs. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Critical Accounting Policies and Estimates +Our financial statements have been prepared in accordance with the generally accepted accounting principles (“GAAP”) in the United States. The methods, estimates and judgments we use in applying our accounting policies can have a significant impact on the results we report in our financial statements. Note 3, Accounting Policies, of the Notes to Consolidated Financial Statements in Item 8: Financial Statements and Supplementary Data, in this Annual Report summarizes the significant accounting policies and methods used in the preparation of our consolidated financial statements and related disclosures. Certain accounting policies require us to make difficult and subjective judgments and assumptions, often as a result of the need to estimate matters that are inherently uncertain. +Following is a detailed description of the accounting policies that we deem most critical to us and that require management’s most difficult and subjective judgments. These estimates are based on historical experience, observance of trends in particular areas, information and valuations available from outside sources and on various other assumptions that are believed to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates under different assumptions and conditions, and such differences may be material. +17 +We also have other policies that we consider key accounting policies, such as revenue recognition; however, these policies do not meet the definition of critical accounting estimates, because they do not generally require us to make estimates or judgments that are difficult or subjective. The accounting policies that we deem most critical to us, and involve the most difficult, subjective or complex judgments include the following: +Principles of Consolidation +We apply Accounting Standards Codification (“ASC”) 810 - Consolidation (“ASC 810”) in our principles of consolidation. ASC 810 addresses arrangements where a company does not hold a majority of the voting or similar interests of a variable interest entity (“VIE”). A company is required to consolidate a VIE if it has determined it is the primary beneficiary. ASC 810 also addresses the policy when a company owns a majority of the voting or similar rights and exercises effective control. +A VIE is not self-supportive due to having one or both of the following conditions: (i) it has an insufficient amount of equity for it to finance its activities without receiving additional subordinated financial support or (ii) its owners do not hold the typical risks and rights of equity owners. This determination is made upon the creation of a variable interest and is re-assessed on an on-going basis should certain changes in the operations of a VIE, or its relationship with the primary beneficiary trigger a reconsideration. After a reconsideration event occurs the facts and circumstances are utilized in determining whether or not a company is a VIE, which other company(ies) have a variable interest in the entity, and whether or not the company’s interest is such that it is the primary beneficiary. Determination of the primary beneficiary, if any, is based on a) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, and b) the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. +We will continue to monitor our relationships with the other entities regarding who is the primary beneficiary, which could change based on facts and circumstances of any reconsideration events. +Recoverability of Property, Plant and Equipment +Our property, plant and equipment is stated at cost. Interest expense, if any, incurred during the initial construction of buildings is considered part of cost. Depreciation is computed for financial reporting purposes using the straight-line or an accelerated method based on a declining balance formula over the following estimated useful lives: rental equipment 2-20 years and buildings and non-rental equipment 3-55 years. Routine maintenance costs are charged to operating expense as they are incurred. Gains and losses on dispositions of property, plant and equipment, other than real estate (“personal property”), are netted against depreciation expense when realized. Equipment depreciation is recognized in amounts expected to result in the recovery of estimated residual values upon disposal, i.e., minimize gains or losses. In determining the depreciation rate, historical disposal experience, holding periods and trends in the market for vehicles are reviewed. As a result of changes in IRS regulations regarding the capitalization of assets, beginning in the first quarter of fiscal 2017, we raised the value threshold before certain assets are capitalized within our depreciation policy. This change in threshold, results in the immediate recognition of reported operating costs with a lagging decrease in depreciation expense over the term that these assets would have been depreciated. This change in threshold benefited us through the immediate recognition of tax deductible costs. +We regularly perform reviews to determine whether facts and circumstances exist which indicate that the carrying amount of assets, including estimates of residual value, may not be recoverable or that the useful life of assets are shorter or longer than originally estimated. Reductions in residual values (i.e., the price at which we ultimately expect to dispose of revenue earning equipment) or useful lives will result in an increase in depreciation expense over the remaining life of the equipment. Reviews are performed based on vehicle class, generally subcategories of trucks and trailers. We assess the recoverability of our assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their estimated remaining lives against their respective carrying amounts. We consider factors such as current and expected future market price trends on used vehicles and the expected life of vehicles included in the fleet. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If asset residual values are determined to be recoverable, but the useful lives are shorter or longer than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives. +18 +For our box truck fleet we utilize an accelerated method of depreciation based upon a declining formula. Under the declining balances method (2.4 times declining balance), the book value of a rental truck is reduced by approximately 16%, 13%, 11%, 9%, 8%, 7%, and 6% of cost during years one through seven, respectively, and then reduced on a straight line basis to a salvage value of 15% by the end of year fifteen. Comparatively, a standard straight line approach would reduce the book value by approximately 5.7% per year over the life of the truck. +Although we intend to sell our used vehicles for prices approximating book value, the extent to which we realize a gain or loss on the sale of used vehicles is dependent upon various factors including but not limited to, the general state of the used vehicle market, the age and condition of the vehicle at the time of its disposal and the depreciation rates with respect to the vehicle . We typically sell our used vehicles at our sales centers throughout the United States and Canada, on our website at uhaul.com/trucksales or by phone at 1-866-404-0355. Additionally, we sell a large portion of our pickup and cargo van fleet at automobile dealer auctions. +Insurance Reserves +Liabilities for life insurance and certain annuity and health policies are established to meet the estimated future obligations of policies in force, and are based on mortality, morbidity and withdrawal assumptions from recognized actuarial tables which contain margins for adverse deviation. In addition, liabilities for health, disability and other policies include estimates of payments to be made on insurance claims for reported losses and estimates of losses incurred, but not yet reported (“IBNR”). Liabilities for annuity contracts consist of contract account balances that accrue to the benefit of the policyholders. +Insurance reserves for Property and Casualty Insurance and U-Haul take into account losses incurred based upon actuarial estimates and are management’s best approximation of future payments. These estimates are based upon past claims experience and current claim trends as well as social and economic conditions such as changes in legal theories and inflation. These reserves consist of case reserves for reported losses and a provision for IBNR losses, both reduced by applicable reinsurance recoverables, resulting in a net liability. +Due to the nature of the underlying risks and high degree of uncertainty associated with the determination of the liability for future policy benefits and claims, the amounts to be ultimately paid to settle these liabilities cannot be precisely determined and may vary significantly from the estimated liability, especially for long-tailed casualty lines of business such as excess workers’ compensation. As a result of the long-tailed nature of the excess workers’ compensation policies written by Repwest from 1983 through 2001, it may take a number of years for claims to be fully reported and finally settled. +On a regular basis insurance reserve adequacy is reviewed by management to determine if existing assumptions need to be updated. In determining the assumptions for calculating workers’ compensation reserves, management considers multiple factors including the following: +Claimant longevity, +Cost trends associated with claimant treatments, +Changes in ceding entity and third party administrator reporting practices, +Changes in environmental factors including legal and regulatory, +Current conditions affecting claim settlements, and +Future economic conditions including inflation. +We have reserved each claim based upon the accumulation of current claim costs projected through each claimant’s life expectancy, and then adjusted for applicable reinsurance arrangements. Management reviews each claim bi-annually or more frequently, if there are changes in facts or circumstances to determine if the estimated life-time claim costs have increased and then adjusts the reserve estimate accordingly at that time. We have factored in an estimate of what the potential cost increases could be in our IBNR liability. We have not assumed settlement of the existing claims in calculating the reserve amount, unless it is in the final stages of completion. +19 +Continued increases in claim costs, including medical inflation and new treatments and medications could lead to future adverse development resulting in additional reserve strengthening. Conversely, settlement of existing claims or if injured workers return to work or expire prematurely, could lead to future positive development. +Impairment of Investments +Investments are evaluated pursuant to guidance contained in ASC 320 - Investments - Debt and Equity Securities to determine if and when a decline in market value below amortized cost is other-than-temporary. Management makes certain assumptions or judgments in its assessment including but not limited to: our ability and intent to hold the security, quoted market prices, dealer quotes or discounted cash flows, industry factors, financial factors, and issuer specific information such as credit strength. Other-than-temporary impairment in value is recognized in the current period operating results. There were no write downs in fiscal 2019, 2018 and 2017. +Income Taxes +We file a consolidated tax return with all of our legal subsidiaries. +Our tax returns are periodically reviewed by various taxing authorities. The final outcome of these audits may cause changes that could materially impact our financial results. Please see Note 13, Provision for Taxes, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information. +Fair Values +Fair values of cash equivalents approximate carrying value due to the short period of time to maturity. Fair values of short-term investments, investments available-for-sale, long-term investments, mortgage loans and notes on real estate, and interest rate swap contracts are based on quoted market prices, dealer quotes or discounted cash flows. Fair values of trade receivables approximate their recorded value. +Our financial instruments that are exposed to concentrations of credit risk consist primarily of temporary cash investments, trade receivables, reinsurance recoverables and notes receivable. Limited credit risk exists on trade receivables due to the diversity of our customer base and their dispersion across broad geographic markets. We place our temporary cash investments with financial institutions and limit the amount of credit exposure to any one financial institution. +We have mortgage receivables, which potentially expose us to credit risk. The portfolio of notes is principally collateralized by self-storage facilities and commercial properties. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. The estimated fair values were determined using the discounted cash flow method and using interest rates currently offered for similar loans to borrowers with similar credit ratings. +The carrying amount of long-term debt and short-term borrowings are estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for debt of similar term and remaining maturity. +Other investments including short-term investments are substantially current or bear reasonable interest rates. As a result, the carrying values of these financial instruments approximate fair value. +Subsequent Events +Please see Note 22, Subsequent Events, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +Recent Accounting Pronouncements +Please see Note 3, Accounting Policies, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +20 +AMERCO and Consolidated Subsidiaries +Fiscal 2019 Compared with Fiscal 2018 +Listed below, on a consolidated basis, are revenues for our major product lines for fiscal 2019 and fiscal 2018: +Year Ended March 31, +2019 +2018 +(In thousands) +Self-moving equipment rentals +$ +2,653,497 +$ +2,479,742 +Self-storage revenues +367,276 +323,903 +Self-moving and self-storage products and service sales +264,146 +261,557 +Property management fees +29,148 +29,602 +Life insurance premiums +63,488 +154,703 +Property and casualty insurance premiums +60,853 +57,100 +Net investment and interest income +110,934 +110,473 +Other revenue +219,365 +184,034 +Consolidated revenue +$ +3,768,707 +$ +3,601,114 +Self-moving equipment rental revenues increased $173.8 million during fiscal 2019, compared with fiscal 2018. During fiscal 2019 we expanded the number of Company-owned locations along with independent dealers, and increased the number of trucks, trailers and towing devices in our rental fleet. In the third and fourth quarters we saw revenue improvements in our corporate account business. Revenue and transactions for both the One-way and in-town markets improved compared to fiscal 2018. +Self-storage revenues increased $43.4 million during fiscal 2019, compared with fiscal 2018. The average monthly amount of occupied square feet increased by 12.0% during fiscal 2019 compared with the same period last year. The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. Over the last twelve months, we added approximately 5.3 million net rentable square feet, a 17.0% increase, with approximately 1.5 million of that occurring on during the fourth quarter of fiscal 2019. +Sales of self-moving and self-storage products and services increased $2.6 million during fiscal 2019, compared with fiscal 2018, primarily from the sales of moving supplies and propane. +Life insurance premiums decreased $91.2 million during fiscal 2019, compared with fiscal 2018. In the fourth quarter of fiscal 2019, Oxford agreed to terminate a reinsurance contract with one of our reinsurers (“Reinsurance contract termination”). As a result there was a one-time decrease in life insurance premiums of $78.4 million due to the transfer of liabilities to the reinsurer for termination of the contract, along with decreased Medicare supplement premiums. +Property and casualty insurance premiums increased $3.8 million during fiscal 2019, compared with fiscal 2018 due to an increase in Safetow ® and Safestor ® sales which corresponds with increased equipment and storage rental transactions. +Net investment and interest income increased $0.5 million during fiscal 2019, compared with fiscal 2018 due to a larger invested asset base at our life insurance subsidiary. Updated accounting guidance now requires changes in the market value of equity securities held for investment at our insurance subsidiaries to be recognized through income. This accounted for a $5.7 million decrease in fiscal 2019. +Other revenue increased $35.3 million during fiscal 2019, compared with fiscal 2018, caused primarily by growth in our U-Box ® program. +21 +Listed below are revenues and earnings from operations at each of our operating segments for fiscal 2019 and 2018. The insurance companies’ years ended December 31, 2018 and 2017. +Year Ended March 31, +2019 +2018 +(In thousands) +Moving and storage +Revenues +$ +3,545,809 +$ +3,290,667 +Earnings from operations before equity in earnings of subsidiaries +569,241 +712,700 +Property and casualty insurance +Revenues +75,837 +74,571 +Earnings from operations +27,406 +25,878 +Life insurance +Revenues +154,714 +243,862 +Earnings from operations +25,481 +27,959 +Eliminations +Revenues +(7,653) +(7,986) +Earnings from operations before equity in earnings of subsidiaries +(1,141) +(1,291) +Consolidated Results +Revenues +3,768,707 +3,601,114 +Earnings from operations +620,987 +765,246 +Total costs and expenses increased $116.5 million during fiscal 2019, compared with fiscal 2018, excluding changes to net (gains) losses on disposal of real estate. The Moving and Storage segment accounted for a $203.2 million increase and our insurance segments total costs and expenses decreased $86.9 million largely due to a one-time decrease of $76.4 million in life benefits due to the Reinsurance contract termination. Operating expenses for Moving and Storage increased $180.0 million, largely from increased personnel, maintenance repairs, shipping costs associated with U-Box ® , building maintenance and property taxes. Repair costs accounted for $45.6 million of the increase. Net gains from the disposal of rental equipment increased $15.1 million. Compared with fiscal 2018, we sold more used trucks and the average sales proceeds per truck improved. Depreciation expense associated with our rental fleet increased $13.2 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements, increased $17.9 million. Net gains on disposal of real estate decreased $195.4 million. The decrease was caused by the sale of a portion of our Chelsea, New York property in October 2017, which resulted in a pre-tax gain of $190.7 million in fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations decreased to $621.0 million for fiscal 2019, compared with $765.2 million for fiscal 2018. +Interest expense for fiscal 2019 was $142.4 million, compared with $126.7 million for fiscal 2018 due to an increase in borrowings in fiscal 2019. +Income tax benefit (expense) was ($106.7) million for fiscal 2019, compared with $153.0 million for fiscal 2018 due to the effects of the Tax Reform Act as enacted on December 22, 2017. Our effective tax rate was 22.3% of net income before taxes for fiscal 2019, compared to (24.0%) in the prior-year period. The decrease in our deferred tax liability in fiscal 2018 resulting from the application of the new federal income tax rate accounted for a $371.5 million decrease, partially offset by a $10.7 million one-time increase resulting from the deemed repatriation of foreign earnings and a $4.2 million one-time increase resulting from Phase Three tax on our Life Insurance subsidiary. Excluding the one-time benefits and charges mentioned above, our effective tax rate for all of fiscal 2018, post Tax Reform Act, was 31.8%. See Note 13, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information on income taxes. +As a result of the above-mentioned items, earnings available to common shareholders were $370.9 million for fiscal 2019, compared with $790.6 million for fiscal 2018. +Basic and diluted earnings per common share for fiscal 2019 were $18.93, compared with $40.36 for fiscal 2018. +22 +The weighted average common shares outstanding basic and diluted were 19,592,048 for fiscal 2019, compared with 19,588,889 for fiscal 2018. +AMERCO and Consolidated Subsidiaries +Fiscal 2018 Compared with Fiscal 2017 +Listed below, on a consolidated basis, are revenues for our major product lines for fiscal 2018 and fiscal 2017: +Year Ended March 31, +2018 +2017 +(In thousands) +Self-moving equipment rentals +$ +2,479,742 +$ +2,362,833 +Self-storage revenues +323,903 +286,886 +Self-moving and self-storage products and service sales +261,557 +253,073 +Property management fees +29,602 +29,075 +Life insurance premiums +154,703 +163,579 +Property and casualty insurance premiums +57,100 +52,334 +Net investment and interest income +110,473 +102,276 +Other revenue +184,034 +171,711 +Consolidated revenue +$ +3,601,114 +$ +3,421,767 +Self-moving equipment rental revenues increased $116.9 million during fiscal 2018, compared with fiscal 2017 largely due to growth in both one-way and In-Town ® transactions. Over the course of fiscal 2018 we added new Company-owned locations to our retail network and increased the number of trucks, trailers, and towing devices in our rental fleet. +Self-storage revenues increased $37.0 million during fiscal 2018, compared with fiscal 2017. The average monthly amount of occupied square feet increased by 8.9% during fiscal 2018, compared with the same period last year. The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. During fiscal 2018, we added approximately 3.7 million net rentable square feet, or a 13.4% increase, with approximately 1.2 million of that coming on during the fourth quarter of fiscal 2018. +Sales of self-moving and self-storage products and services increased $8.5 million during fiscal 2018, compared with fiscal 2017. Increases were recognized in the sales of moving supplies, propane and towing accessories and related installations. +Life insurance premiums decreased $8.9 million during fiscal 2018, compared with fiscal 2017 primarily due to decreased Medicare supplement premiums. +Property and casualty insurance premiums increased $4.8 million during fiscal 2018, compared with fiscal 2017 due to an increase in Safetow ® and Safestor ® sales, which is a reflection of the increased equipment and storage rental transactions. +Net investment and interest income increased $8.2 million during fiscal 2018, compared with fiscal 2017 due to a larger invested asset base at our insurance companies. +Other revenue increased $12.3 million during fiscal 2018, compared with fiscal 2017, caused primarily by growth in our U-Box ® program. +23 +Listed below are revenues and earnings from operations at each of our operating segments for fiscal 2018 and 2017. The insurance companies’ years ended December 31, 2017 and 2016. +Year Ended March 31, +2018 +2017 +(In thousands) +Moving and storage +Revenues +$ +3,290,667 +$ +3,113,000 +Earnings from operations before equity in earnings of subsidiaries +712,700 +689,815 +Property and casualty insurance +Revenues +74,571 +68,986 +Earnings from operations +25,878 +27,161 +Life insurance +Revenues +243,862 +245,599 +Earnings from operations +27,959 +27,646 +Eliminations +Revenues +(7,986) +(5,818) +Earnings from operations before equity in earnings of subsidiaries +(1,291) +(1,457) +Consolidated Results +Revenues +3,601,114 +3,421,767 +Earnings from operations +765,246 +743,165 +Total costs and expenses increased $157.3 million during fiscal 2018, compared with fiscal 2017. Our insurance segments accounted for $4.8 million of the increase. +Excluding net gains on the disposal of real estate, total costs and expenses increased $349.1 million during fiscal 2018, compared with fiscal 2017. Operating expenses at Moving and Storage increased $238.2 million. In the second quarter of fiscal 2017, we recognized the difference between the accrued amount and actual settlement amount of the PODS Enterprises, Inc. (“PEI”) case as a $24.6 million reduction of operating expenses. Excluding this effect in the prior year, operating expenses for Moving and Storage increased $213.6 million. This was primarily due to increased personnel costs, equipment maintenance, payment processing fees, new facility related costs and property tax. Repair costs, primarily associated with the portion of the fleet nearing resale, accounted for $72.9 million of the increase for fiscal 2018. Personnel bonuses associated with tax reform for the entire workforce combined with bonuses for our field management team accounted for $31.1 million of the increase. Lease expense decreased $3.4 million as a result of our shift in financing new equipment on the balance sheet versus through operating leases. Net gains from the disposal of rental equipment decreased $20.7 million. Compared with fiscal 2017, we sold more used trucks, however on average the trucks sold in fiscal 2018 had a higher average cost than in fiscal 2017 and average sales proceeds per truck were lower in fiscal 2018. Depreciation expense associated with our rental fleet increased $56.5 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $17.0 million. Net gains on disposal of real estate increased $191.8 million. The increase resulted from the sale of a portion of our Chelsea, New York property which resulted in a pre-tax gain of $190.7 million. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations increased to $765.2 million for fiscal 2018, compared with $743.2 million for fiscal 2017. +Interest expense for fiscal 2018 was $126.7 million, compared with $113.4 million for fiscal 2017 due to an increase in borrowings in fiscal 2018 partially offset by lower borrowing costs. In addition, we incurred costs associated with the early extinguishment of debt during the third quarter of fiscal 2017 of $0.5 million for the write-off of unamortized transaction costs related to defeased debt. +24 +Income tax benefit (expense) was $153.0 million for fiscal 2018, compared with ($229.9) million for fiscal 2017 due to the effects of the Tax Reform Act as enacted on December 22, 2017. Our effective tax rate was (24.0%) of net income before taxes for fiscal 2018, compared to 36.6% in the prior-year period. The decrease in our deferred tax liability resulting from the application of the new federal income tax rate accounted for a $371.5 million decrease, partially offset by a $10.7 million one-time increase resulting from the deemed repatriation of foreign earnings and a $4.2 million one-time increase resulting from Phase Three tax on our Life Insurance subsidiary. Excluding the one-time benefits and charges mentioned above, our effective tax rate for all of fiscal 2018, post Tax Reform Act, was 31.8%, compared with 36.6% for fiscal 2017. See Note 13, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information on income taxes. +As a result of the above-mentioned items, earnings available to common shareholders were $790.6 million for fiscal 2018, compared with $398.4 million for fiscal 2017. +Basic and diluted earnings per common share for fiscal 2018 were $40.36, compared with $20.34 for fiscal 2017. +The weighted average common shares outstanding basic and diluted were 19,588,889 for fiscal 2018, compared with 19,586,606 for fiscal 2017. +Moving and Storage +Fiscal 2019 Compared with Fiscal 2018 +Listed below are revenues for the major product lines at Moving and Storage for fiscal 2019 and fiscal 2018: +Year Ended March 31, +2019 +2018 +(In thousands) +Self-moving equipment rentals +$ +2,656,327 +$ +2,483,956 +Self-storage revenues +367,276 +323,903 +Self-moving and self-storage products and service sales +264,146 +261,557 +Property management fees +29,148 +29,602 +Net investment and interest income +13,857 +12,232 +Other revenue +215,055 +179,417 +Moving and Storage revenue +$ +3,545,809 +$ +3,290,667 +Self-moving equipment rental revenues increased $172.4 million during fiscal 2019, compared with fiscal 2018. During fiscal 2019 we expanded the number of Company-owned locations along with independent dealers, and increased the number of trucks, trailers and towing devices in our rental fleet. In the third and fourth quarters we saw revenue improvements in our corporate account business. Revenue and transactions for both the One-way and in-town markets improved compared to fiscal 2018. +Self-storage revenues increased $43.4 million during fiscal 2019, compared with fiscal 2018. The average monthly amount of occupied square feet increased by 12.0% during fiscal 2019 compared with the same period last year. The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. Over the last twelve months, we added approximately 5.3 million net rentable square feet, a 17.0% increase, with approximately 1.5 million of that coming on during the fourth quarter of fiscal 2019. +25 +The Company owns and manages self-storage facilities. Self-storage revenues reported in the consolidated financial statements represent Company-owned locations only. Self-storage data for our owned storage locations follows: +Year Ended March 31, +2019 +2018 +(In thousands, except occupancy rate) +Unit count as of March 31 +428 +366 +Square footage as of March 31 +36,237 +30,974 +Average monthly number of units occupied +275 +246 +Average monthly occupancy rate based on unit count +68.7% +71.6% +Average monthly square footage occupied +24,862 +22,203 +Over the last twelve months we added approximately 5.3 million net rentable square feet of new storage to the system. This was a mix of existing storage locations we acquired and new development. On average, the occupancy rate of this new capacity on the date it was added was 9.5%. +Sales of self-moving and self-storage products and services increased $2.6 million during fiscal 2019, compared with fiscal 2018 primarily from the sales of moving supplies and propane. +Other revenue increased $35.6 million during fiscal 2019, compared with fiscal 2018, caused primarily by growth in our U-Box ® program. +Total costs and expenses increased $203.2 million during fiscal 2019, compared with fiscal 2018, excluding changes to net (gains) losses on disposal of real estate. Operating expenses for Moving and Storage increased $179.6 million, largely from increased personnel, maintenance repairs, shipping costs associated with U-Box ® , building maintenance and property taxes. Repair costs accounted for $45.6 million of the increase. Net gains from the disposal of rental equipment increased $15.1 million. Compared with fiscal 2018, we sold more used trucks and the average sales proceeds per truck improved. Depreciation expense associated with our rental fleet increased $13.2 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $17.9 million. Net gains on disposal of real estate decreased $195.4 million. The decrease was caused by the sale of a portion of our Chelsea, New York property in October 2017 which resulted in a pre-tax gain of $190.7 million in fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations for Moving and Storage before consolidation of the equity in the earnings of the insurance subsidiaries decreased to $569.2 million for fiscal 2019 as compared with $712.7 million for fiscal 2018. +Equity in the earnings of AMERCO’s insurance subsidiaries decreased $5.2 million for fiscal 2019, compared with fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations decreased to $611.1 million for fiscal 2019, compared with $759.7 million for fiscal 2018. +26 +Moving and Storage +Fiscal 2018 Compared with Fiscal 2017 +Listed below are revenues for the major product lines at Moving and Storage for fiscal 2018 and fiscal 2017: +Year Ended March 31, +2018 +2017 +(In thousands) +Self-moving equipment rentals +$ +2,483,956 +$ +2,366,526 +Self-storage revenues +323,903 +286,886 +Self-moving and self-storage products and service sales +261,557 +253,073 +Property management fees +29,602 +29,075 +Net investment and interest income +12,232 +9,688 +Other revenue +179,417 +167,752 +Moving and Storage revenue +$ +3,290,667 +$ +3,113,000 +Self-moving equipment rental revenues increased $117.4 million during fiscal 2018, compared with fiscal 2017, largely due to growth in both one-way and In-Town ® transactions. Over the course of fiscal 2018 we added new Company-owned locations to our retail network and increased the number of trucks, trailers, and towing devices in our rental fleet. +Self-storage revenues increased $37.0 million during fiscal 2018, compared with fiscal 2017. The average monthly amount of occupied square feet increased by 8.9% during fiscal 2018, compared with the same period last year. The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. During fiscal 2018, we added approximately 3.7 million net rentable square feet, or a 13.4% increase, with approximately 1.2 million of that coming on during the fourth quarter of fiscal 2018. +The Company owns and manages self-storage facilities. Self-storage revenues reported in the consolidated financial statements represent Company-owned locations only. Self-storage data for our owned storage locations follows: +Year Ended March 31, +2018 +2017 +(In thousands, except occupancy rate) +Unit count as of March 31 +366 +318 +Square footage as of March 31 +30,974 +27,305 +Average monthly number of units occupied +246 +226 +Average monthly occupancy rate based on unit count +71.6% +75.8% +Average monthly square footage occupied +22,203 +20,386 +The approximately 3.7 million net rentable square feet that we’ve added during fiscal 2018 was a mix of existing storage locations we acquired and new development. On average, the occupancy rate of this new capacity on the date it was added was approximately 5%. +Sales of self-moving and self-storage products and services increased $8.5 million during fiscal 2018, compared with fiscal 2017. Increases were recognized in the sales of moving supplies, propane and towing accessories and related installations. +Other revenue increased $11.7 million during fiscal 2018, compared with fiscal 2017, primarily coming from growth in our U-Box ® program. +27 +Excluding net gains on the disposal of real estate, total costs and expenses increased $346.6 million during fiscal 2018, compared with fiscal 2017. Operating expenses at Moving and Storage increased $238.2 million. In the second quarter of fiscal 2017, we recognized the difference between the accrued amount and actual settlement amount of the PEI case as a $24.6 million reduction of operating expenses. Excluding this effect in fiscal 2017, operating expenses for Moving and Storage increased $213.6 million. This was primarily due to increased personnel costs, equipment maintenance, payment processing fees, new facility related costs and property tax. Repair costs, primarily associated with the portion of the fleet nearing resale, accounted for $72.9 million of the increase for fiscal 2018. Personnel bonuses associated with tax reform for the entire workforce combined with bonuses for our field management team accounted for $31.1 million of the increase. Lease expense decreased $3.3 million as a result of our shift in financing new equipment on the balance sheet versus through operating leases. Net gains from the disposal of rental equipment decreased $20.7 million. Compared with fiscal 2017, we sold more used trucks, however on average the trucks sold in fiscal 2018 had a higher average cost than in fiscal 2017 and the average sales proceeds per truck were lower in fiscal 2018. Depreciation expense associated with our rental fleet increased $56.5 million due to a larger fleet. Depreciation expense on all other assets, largely from buildings and improvements increased $17.0 million. Net gains on disposal of real estate increased $191.8 million. The increase was caused by the sale of a portion of our Chelsea, New York property which resulted in a pre-tax gain of $190.7 million. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations for Moving and Storage before consolidation of the equity in the earnings of the insurance subsidiaries increased to $712.7 million for fiscal 2018 as compared with $689.8 million for fiscal 2017. +Equity in the earnings of AMERCO’s insurance subsidiaries increased $11.2 million for fiscal 2018, compared with fiscal 2017. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations increased to $759.7 million for fiscal 2018, compared with $725.6 million for fiscal 2017. +Property and Casualty Insurance +2018 Compared with 2017 +Net premiums were $63.5 million and $58.8 million for the years ended December 31, 2018 and 2017, respectively. A significant portion of Repwest’s premiums are from policies sold in conjunction with U-Haul rental transactions. The premium growth corresponded with the increased moving and storage transactions at U-Haul. +Net investment and interest income was $12.3 million and $15.8 million for the years ended December 31, 2018 and 2017, respectively. The main driver of the change in net investment income was the increase in realized losses of $5.7 million due to market changes in our equity securities for the twelve months ended December 31, 2018. Updated accounting guidance now requires changes in the market value of equity securities held for investment to be recognized through income. +Net operating expenses were $34.2 million and $32.7 million for the years ended December 31, 2018 and 2017, respectively. The change was due to an increase in commissions, decreased loss adjusting fees and subrogation income. +Benefits and losses expenses were $14.2 million and $16.0 million for the years ended December 31, 2018 and 2017, respectively. The decrease resulted from favorable loss experience. +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $27.4 million and $25.9 million for the years ended December 31, 2018 and 2017, respectively. +Property and Casualty Insurance +2017 Compared with 2016 +Net premiums were $58.8 million and $52.3 million for the years ended December 31, 2017 and 2016, respectively. The premium growth corresponded with the increased moving and storage transactions at U-Haul. +28 +Net investment and interest income was $15.8 million and $16.7 million for the years ended December 31, 2017 and 2016, respectively. The change was primarily due to a decrease in realized capital gains of $0.9 million. The December 31, 2016 results were impacted by above average early pay-offs within the mortgage loan portfolio. +Net operating expenses were $32.7 million and $28.4 million for the years ended December 31, 2017 and 2016, respectively. This was due to an increase in commissions and loss adjusting fees. +Benefits and losses expenses were $16.0 million and $13.4 million for the years ended December 31, 2017 and 2016, respectively. The increase was due to an increase in policies sold and related claims activity. +As a result of the above mentioned changes in revenues and expenses, pretax earnings from operations were $25.9 million and $27.2 million for the years ended December 31, 2017 and 2016, respectively. +Life Insurance +2018 Compared with 2017 +Net premiums were $63.5 million and $154.7 million for the years ended December 31, 2018 and 2017, respectively. There was a one-time decrease in life insurance premiums of $78.4 million due to the transfer of liabilities as a result of the Reinsurance contract termination, effective November 30, 2018. Medicare Supplement premiums decreased by $12.6 million due to the reduction in new sales and policy decrements on the existing business offset by premium rate increases. Premiums on other lines of business increased $0.2 million. Deferred annuity deposits were $370.1 million or $73.8 million above the prior year and are accounted for on the balance sheet as deposits rather than premiums. +Net investment and interest income was $86.4 million and $84.2 million for the years ended December 31, 2018 and 2017, respectively. Investment income from fixed maturities and other invested assets increased $10.1 million from a larger invested asset base, partially offset by a $2.8 million decrease in realized losses and a $5.1 million loss on derivatives. +Net operating expenses were $14.6 million and $22.1 million for the years ended December 31, 2018 and 2017, respectively. The decrease was due to a one-time commission allowance of $6.8 million received on the reinsurance agreement termination which was recorded as a reduction to commission expense and a reduction in commission expense from the decreased Medicare supplement premiums. +Benefits and losses expenses were $86.1 million and $169.3 million for the years ended December 31, 2018 and 2017, respectively. There was a one-time decrease of $76.4 million in Life benefits due to the transfer of liabilities for the Reinsurance contract termination. Medicare supplement and other health benefits decreased $9.8 million from the declined policies in force. Partially offsetting this was a $3.2 million increase in interest credited to policyholders on a larger annuity deposit base. +Amortization of deferred acquisition costs (“DAC”), sales inducement asset (“SIA“) and the value of business acquired (“VOBA”) was $28.6 million and $24.5 million for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to a one-time $3.3 million VOBA write-off as a result of the Reinsurance contract termination. In addition, there was an increase in annuity DAC amortization due to the increased amount of annuity business sold over the last year . Conversely, DAC amortization associated with Medicare Supplement has decreased as a result of the declining business inforce. +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $25.5 million and $28.0 million for the years ended December 31, 2018 and 2017, respectively. +29 +Life Insurance +2017 Compared with 2016 +Net premiums were $154.7 million and $163.6 million for the years ended December 31, 2017 and 2016, respectively. Medicare Supplement premiums decreased by $9.3 million due to the reduction in new sales and declined premiums on the existing business offset by rate increases on renewal premiums. The remaining lines of business had a net increase of $0.4 million. Deferred annuity deposits were $296.8 million or $93.7 million above the prior year and are accounted for on the balance sheet as deposits rather than premiums. +Net investment and interest income was $84.2 million and $77.5 million for the years ended December 31, 2017 and 2016, respectively. Investment income and realized gains from fixed maturities increased $10.9 million from a larger invested asset base, partially offset by a $4.3 million decrease in gains from our mortgage loan portfolio. +Net operating expenses were $22.1 million and $22.4 million for the years ended December 31, 2017 and 2016, respectively. The decrease was primarily due to a reduction in commission expense from decreased Medicare Supplement premiums. +Benefits and losses expenses were flat at $169.3 million for both the years ended December 31, 2017 and 2016. A decrease of $9.2 million in Medicare supplement benefits from an improved benefit to premium ratio was offset by an increase in the remaining lines of business. Life insurance benefits increased $1.6 million with increased mortality while interest credited to policyholders increased by $7.3 million from a larger annuity base. Other benefits increased $0.3 million. +Amortization of DAC, SIA and VOBA was $24.5 million and $26.2 million for the years December 31, 2017 and 2016, respectively. The decrease was primarily due to additional DAC amortization in the prior year generated by added gains on discounted mortgage loan investments partially offset by the increased amortization from a larger DAC asset in fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $28.0 million and $27.6 million for the years ended December 31, 2017 and 2016, respectively. +Liquidity and Capital Resources +We believe our current capital structure is a positive factor that will enable us to pursue our operational plans and goals and provide us with sufficient liquidity for the foreseeable future. There are many factors which could affect our liquidity, including some which are beyond our control, and there is no assurance that future cash flows and liquidity resources will be sufficient to meet our outstanding debt obligations and our other future capital needs. +At March 31, 2019, cash and cash equivalents totaled $673.7 million, compared with $759.4 million at March 31, 2018. The assets of our insurance subsidiaries are generally unavailable to fulfill the obligations of non-insurance operations (AMERCO, U-Haul and Real Estate). As of March 31, 2019 (or as otherwise indicated), cash and cash equivalents, other financial assets (receivables, short-term investments, other investments, fixed maturities, and related party assets) and debt obligations of each operating segment were: +Moving & Storage +Property and Casualty Insurance (a) +Life Insurance (a) +(In thousands) +Cash and cash equivalents +$ +643,918 +$ +5,757 +$ +24,026 +Other financial assets +149,842 +463,079 +2,207,099 +Debt obligations +4,163,323 +– +– +(a) As of December 31, 2018 +30 +At March 31, 2019, Moving and Storage had available borrowing capacity under existing credit facilities of $80.6 million. +A summary of our consolidated cash flows for fiscal 2019, 2018 and 2017 is shown in the table below: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Net cash provided by operating activities +$ +975,583 +$ +937,684 +$ +1,059,455 +Net cash used by investing activities +(1,571,136) +(898,304) +(1,183,908) +Net cash provided by financing activities +514,582 +16,604 +223,753 +Effects of exchange rate on cash +(4,716) +5,598 +(2,140) +Net increase (decrease) in cash flow +(85,687) +61,582 +97,160 +Cash at the beginning of the period +759,388 +697,806 +600,646 +Cash at the end of the period +$ +673,701 +$ +759,388 +$ +697,806 +Net cash provided by operating activities increased $37.9 million in fiscal 2019, compared with fiscal 2018 from reduced federal income tax payments in fiscal 2019 compared with fiscal 2018, a $64.6 million cash transfer as a result of the Reinsurance contract termination in our Life Insurance segment during fiscal 2019 and the repayment of $53.0 million in notes and interest from Blackwater in fiscal 2018. +Net cash used by investing activities increased $672.8 million in fiscal 2019, compared with fiscal 2018. Purchases of property, plant and equipment, which are reported net of cash from sales and lease-back transactions, increased $506.2 million. Cash from the sales of property, plant and equipment decreased $93.5 million largely due to reduced fleet sales. Net cash deposited in real estate acquisitions escrow accounts decreased $27.1 million. For our insurance subsidiaries, net cash used in investing activities increased $45.7 million compared with the same period last year. +Net cash provided by financing activities increased $498.0 million in fiscal 2019, compared with fiscal 2018. This was due to a combination of decreased debt and capital lease repayments of $49.6 million, an increase in cash from borrowings of $398.8 million, an increase in net annuity deposits from Life Insurance of $48.0 million and an increase in common stock dividends paid of $9.8 million. +Liquidity and Capital Resources and Requirements of Our Operating Segments +Moving and Storage +To meet the needs of our customers, U-Haul maintains a large fleet of rental equipment. Capital expenditures have primarily consisted of new rental equipment acquisitions and the buyouts of existing fleet from leases. The capital to fund these expenditures has historically been obtained internally from operations and the sale of used equipment and externally from debt and lease financing. In the future, we anticipate that our internally generated funds will be used to service the existing debt and fund operations. U-Haul estimates that during fiscal 2020 the Company will reinvest in its truck and trailer rental fleet approximately $700 million, net of equipment sales and excluding any lease buyouts. For fiscal 2019, the Company invested, net of sales, approximately $560 million before any lease buyouts in its truck and trailer fleet. Fleet investments in fiscal 2020 and beyond will be dependent upon several factors including the availability of capital, the truck rental environment and the used-truck sales market. We anticipate that the fiscal 2020 investments will be funded largely through debt financing, external lease financing and cash from operations. Management considers several factors including cost and tax consequences when selecting a method to fund capital expenditures. Our allocation between debt and lease financing can change from year to year based upon financial market conditions which may alter the cost or availability of financing options. +Real Estate has traditionally financed the acquisition of self-storage properties to support U-Haul's growth through debt financing and funds from operations. The Company’s plan for the expansion of owned storage properties includes the acquisition of existing self-storage locations from third parties, the acquisition and development of bare land, and the acquisition and redevelopment of existing buildings not currently used for self-storage. The Company expects to fund these development projects through a combination of internally generated funds along with borrowings against existing properties as they operationally mature. For fiscal 2019, the Company invested $1,003 million in real estate acquisitions, new construction and renovation and repair. For fiscal 2020, the timing of new projects will be dependent upon several factors, including the entitlement process, availability of capital, weather, and the +31 +identification and successful acquisition of target properties. U-Haul's growth plan in self-storage also includes the expansion of the U-Haul Storage Affiliate program, which does not require significant capital. +Net capital expenditures (purchases of property, plant and equipment less proceeds from the sale of property, plant and equipment and lease proceeds) were $1,263.7 million, $663.9 million and $932.0 million for fiscal 2019, 2018 and 2017, respectively. The components of our net capital expenditures are provided in the following table: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Purchases of rental equipment +$ +1,162,909 +$ +1,006,503 +$ +1,178,908 +Equipment lease buyouts +30,566 +6,594 +63,505 +Purchases of real estate, construction and renovations +1,003,030 +606,990 +484,487 +Other capital expenditures +21,831 +140,627 +139,448 +Gross capital expenditures +2,218,336 +1,760,714 +1,866,348 +Less: Lease proceeds +(348,368) +(396,969) +(446,843) +Less: Sales of property, plant and equipment +(606,271) +(699,803) +(487,475) +Net capital expenditures +1,263,697 +663,942 +932,030 +Moving and Storage continues to hold significant cash and we believe has access to additional liquidity. Management may invest these funds in our existing operations, expand our product lines or pursue external opportunities in the self-moving and storage marketplace, pay dividends or reduce existing indebtedness where possible. +Property and Casualty Insurance +State insurance regulations restrict the amount of dividends that can be paid to stockholders of insurance companies. As a result, Property and Casualty Insurance's assets are generally not available to satisfy the claims of AMERCO, or its legal subsidiaries. +We believe that stockholders’ equity at the Property and Casualty operating segment remains sufficient and we do not believe that its ability to pay ordinary dividends to AMERCO will be restricted per state regulations. +Our Property and Casualty operating segment stockholders’ equity was $222.4 million, $211.2 million, and $180.9 million as of December 31, 2018, 2017, and 2016, respectively. The increase in 2018 compared with 2017 resulted from net earnings of $21.7 million, a reduction in accumulated other comprehensive income of $20.2 million and an increase due to a one-time reclass of $9.7 million between other comprehensive income and beginning retained earnings due to the implementation of ASU 2016-01. Property and Casualty Insurance does not use debt or equity issues to increase capital and therefore has no direct exposure to capital market conditions other than through its investment portfolio. +Life Insurance +Life Insurance manages its financial assets to meet policyholder and other obligations including investment contract withdrawals and deposits. Life Insurance's net deposit increase for the year ended December 31, 2018 was $267.3 million. State insurance regulations restrict the amount of dividends that can be paid to stockholders of insurance companies. As a result, Life Insurance's assets are generally not available to satisfy the claims of AMERCO ® or its legal subsidiaries. +Our Life Insurance operating segment stockholders’ equity was $311.7 million, $332.9 million, and $296.1 million as of December 31, 2018, 2017 and 2016, respectively. The decrease in 2018 compared with 2017 resulted from earnings of $20.1 million and a reduction in accumulated other comprehensive income of $41.3 million primarily due to the effect of interest rate changes on the fixed maturity portion of the investment portfolio. Life Insurance has not historically used debt or equity issues to increase capital and therefore has not had any significant direct exposure to capital market conditions other than through its investment portfolio. However, as of December 31, 2018, Oxford had outstanding deposits of $60.0 million through its membership in the Federal Home Loan Bank (“FHLB”). For a more detailed discussion of this deposit, please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements. +32 +Cash Provided from Operating Activities by Operating Segments +Moving and Storage +Net cash provided by operating activities was $958.9 million, $858.6 million and $983.6 million in fiscal 2018, 2017 and 2016 from operations, reduced federal income tax payments in fiscal 2019 and the repayment of $53.0 million in notes and interest from Blackwater in fiscal 2018. +Property and Casualty Insurance +Net cash provided by operating activities was $19.8 million, $21.9 million, and $19.6 million for the years ended December 31, 2018, 2017, and 2016, respectively. The decrease was the result of changes in intercompany balances and the timing of payables activity . +Property and Casualty Insurance’s cash and cash equivalents and short-term investment portfolios amounted to $11.2 million, $17.0 million, and $20.7 million as of December 31, 2018, 2017, and 2016, respectively. These balances reflect funds in transition from maturity proceeds to long-term investments. Management believes this level of liquid assets, combined with budgeted cash flow, is adequate to meet foreseeable cash needs. Capital and operating budgets allow Property and Casualty Insurance to schedule cash needs in accordance with investment and underwriting proceeds. +Life Insurance +Net cash provided (used) by operating activities was ($3.2) million, $57.2 million and $56.3 million for the years ended December 31, 2018, 2017 and 2016, respectively. The decrease in operating cash flows was primarily due to a $64.6 million cash transfer as a result of the Reinsurance contract termination, offset by an increase in investment income along with a decrease in benefits and commissions. +In addition to cash flows from operating activities and financing activities, a substantial amount of liquid funds are available through Life Insurance's short-term portfolio and its membership in the FHLB. As of December 31, 2018, 2017 and 2016, cash and cash equivalents and short-term investments amounted to $24.1 million, $50.7 million and $20.6 million, respectively. Management believes that the overall sources of liquidity are adequate to meet foreseeable cash needs. +Liquidity and Capital Resources - Summary +We believe we have the financial resources needed to meet our business plans including our working capital needs. We continue to hold significant cash and have access to existing credit facilities and additional liquidity to meet our anticipated capital expenditure requirements for investment in our rental fleet, rental equipment and storage acquisitions and build outs. +Our borrowing strategy is primarily focused on asset-backed financing and rental equipment leases. As part of this strategy, we seek to ladder maturities and fix interest rates. While each of these loans typically contains provisions governing the amount that can be borrowed in relation to specific assets, the overall structure is flexible with no limits on overall Company borrowings. Management believes it has adequate liquidity between cash and cash equivalents and unused borrowing capacity in existing credit facilities to meet the current and expected needs of the Company over the next several years. As of March 31, 2019, we had available borrowing capacity under existing credit facilities of $80.6 million. It is possible that circumstances beyond our control could alter the ability of the financial institutions to lend us the unused lines of credit. We believe that there are additional opportunities for leverage in our existing capital structure. For a more detailed discussion of our long-term debt and borrowing capacity, please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. +Fair Value of Financial Instruments +Certain assets and liabilities are recorded at fair value on the consolidated balance sheets and are measured and classified based upon a three tiered approach to valuation. ASC 820 requires that financial assets and liabilities recorded at fair value be classified and disclosed in a Level 1, Level 2 or Level 3 category. For more information, please see Note 15, Fair Value Measurements, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +33 +The available-for-sale securities held by the Company are recorded at fair value. These values are determined primarily from actively traded markets where prices are based either on direct market quotes or observed transactions. Liquidity is a factor considered during the determination of the fair value of these securities. Market price quotes may not be readily available for certain securities or the market for them has slowed or ceased. In situations where the market is determined to be illiquid, fair value is determined based upon limited available information and other factors including expected cash flows. As of March 31, 2019, we had $0.2 million of available-for-sale assets classified in Level 3. +The interest rate swaps held by us as hedges against interest rate risk for our variable rate debt are recorded at fair value. These values are determined using pricing valuation models which include broker quotes for which significant inputs are observable. They include adjustments for counterparty credit quality and other deal-specific factors, where appropriate and are classified as Level 2. +Disclosures about Contractual Obligations and Commercial Commitments +The following table provides contractual commitments and contingencies as of March 31, 2019: +Payment due by Period (as of March 31, 2019) +Contractual Obligations +Total +04/01/19 - 03/31/20 +04/01/20 - 03/31/22 +04/01/22 - 03/31/24 +Thereafter +(In thousands) +Notes and loans payable - Principal +$ +2,190,191 +$ +174,812 +277,063 +$ +504,119 +$ +1,234,197 +Notes and loans payable - Interest +698,905 +93,723 +169,906 +138,891 +296,385 +Revolving credit agreements - Principal +959,400 +– +630,556 +328,844 +– +Revolving credit agreements - Interest +101,307 +35,928 +53,696 +11,683 +– +Capital leases - Principal +1,042,652 +301,086 +386,458 +232,703 +122,405 +Capital leases - Interest +93,942 +31,030 +39,138 +18,697 +5,077 +Operating leases +94,288 +25,042 +33,191 +29,991 +6,064 +Ground leases +53,758 +1,024 +2,054 +2,061 +48,619 +Property and casualty obligations (a) +134,050 +12,845 +14,930 +9,317 +96,958 +Life, health and annuity obligations (b) +3,414,305 +400,914 +570,992 +527,739 +1,914,660 +Self insurance accruals (c) +406,640 +116,950 +159,216 +75,059 +55,415 +Post retirement benefit liability +19,143 +1,037 +2,672 +3,571 +11,863 +Total contractual obligations +$ +9,208,581 +$ +1,194,391 +$ +2,339,872 +$ +1,882,675 +$ +3,791,643 +(a) These estimated obligations for unpaid losses and loss adjustment expenses include case reserves for reported claims and IBNR claims estimates and are net of expected reinsurance recoveries. The ultimate amount to settle both the case reserves and IBNR is an estimate based upon historical experience and current trends and such estimates could materially differ from actual results. The assumptions do not include future premiums. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +(b) These estimated obligations are based on mortality, morbidity, withdrawal and lapse assumptions drawn from our historical experience and adjusted for any known trends. These obligations include expected interest crediting but no amounts for future annuity deposits or premiums for life and Medicare supplement policies. The cash flows shown above are undiscounted for interest and as a result total outflows for all years shown significantly exceed the corresponding liabilities of $2,039.4 million included in our consolidated balance sheet as of March 31, 2019. Life Insurance expects to fully fund these obligations from their invested asset portfolio. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +(c) These estimated obligations are primarily the Company’s self insurance accruals for portions of the liability coverage for our rental equipment. The estimates for future settlement are based upon historical experience and current trends. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +As presented above, contractual obligations on debt and guarantees represent principal payments while contractual obligations for operating leases represent the notional payments under the lease arrangements. +ASC 740 - Income Taxes liabilities and interest of $46.7 million is not included above due to uncertainty surrounding ultimate settlements, if any. +34 +Off Balance Sheet Arrangements +The Company uses off-balance sheet arrangements in situations where management believes that the economics and sound business principles warrant their use. +We utilize operating leases for certain rental equipment and facilities with terms expiring substantially through 2024. In the event of a shortfall in proceeds from the sales of the underlying rental equipment assets, AMERCO has guaranteed $5.2 million of residual values as of March 31, 2019 for these assets at the end of their respective lease terms. AMERCO has been leasing rental equipment since 1987. To date, we have not experienced residual value shortfalls related to these leasing arrangements. Using the average cost of fleet related debt as the discount rate, the present value of AMERCO’s minimum lease payments and residual value guarantees was $6.4 million as of March 31, 2019. +During the 1990s, we used certain off-balance sheet arrangements in connection with the expansion of our self-storage business. For more information please see Note 19, Related Party Transactions, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. These arrangements were primarily used when our overall borrowing structure was more limited. We do not face similar limitations currently and off-balance sheet arrangements have not been utilized in our self-storage expansion in recent years. In the future, we will continue to identify and consider off-balance sheet opportunities to the extent such arrangements would be economically advantageous to us and our stockholders. SAC Holdings, Four SAC Self-Storage Corporation (“4 SAC”), Five SAC Self-Storage Corporation (“5 SAC”), Galaxy Investments, L.P. (“Galaxy”) and Private Mini are substantially controlled by Blackwater. Blackwater is wholly-owned by WGHLP, which is owned by Mark V. Shoen (a significant shareholder) and various trusts associated with Edward J. Shoen (our Chairman of the Board, President and a significant shareholder) and Mark V. Shoen. +We currently manage the self-storage properties owned or leased by Blackwater and Mercury pursuant to a standard form of management agreement, under which we receive a management fee of between 4% and 10% of the gross receipts plus reimbursement for certain expenses. We received management fees, exclusive of reimbursed expenses, of $30.0 million, $29.5 million and $27.8 million from the above mentioned entities during fiscal 2019, 2018 and 2017, respectively. This management fee is consistent with the fee received for other properties we previously managed for third parties. Mark V. Shoen controls the general partner of Mercury. The limited partner interests of Mercury are indirectly owned by Mark V. Shoen, James P. Shoen, and a trust benefitting the children and grandchildren of Edward J. Shoen. +We lease space for marketing company offices, vehicle repair shops and hitch installation centers from subsidiaries of Blackwater. Total lease payments pursuant to such leases were $2.7 million for fiscal years 2019, 2018 and 2017. The terms of the leases are similar to the terms of leases for other properties owned by unrelated parties that are leased by us. +As of March 31, 2019, subsidiaries of Blackwater acted as U-Haul independent dealers. The financial and other terms of the dealership contracts with the aforementioned companies and their subsidiaries are substantially identical to the terms of those with our other independent dealers whereby commissions are paid by us based on equipment rental revenues. We paid the above mentioned entities $61.4 million, $58.6 million and $57.1 million in commissions pursuant to such dealership contracts during fiscal 2019, 2018 and 2017, respectively. +These agreements with subsidiaries of Blackwater, excluding Dealer Agreements, provided revenues of $24.0 million, expenses of $2.7 million and cash flows of $21.3 million during fiscal 2019. Revenues and commission expenses related to the Dealer Agreements were $288.2 million and $61.4 million, respectively during fiscal 2019. +Fiscal 2020 Outlook +We will continue to focus our attention on increasing transaction volume and improving pricing, product and utilization for self-moving equipment rentals. Maintaining an adequate level of new investment in our truck fleet is an important component of our plan to meet our operational goals. Revenue in the U-Move ® program could be adversely impacted should we fail to execute in any of these areas. Even if we execute our plans, we could see declines in revenues primarily due to unforeseen events including adverse economic conditions or heightened competition that is beyond our control. +35 +With respect to our storage business, in fiscal 2019 we have added new locations and expanded existing locations. In fiscal 2020, we are actively looking to complete current projects, increase occupancy in our existing portfolio of locations and acquire new locations. New projects and acquisitions will be considered and pursued if they fit our long-term plans and meet our financial objectives. We will continue to invest capital and resources in the U-Box ® program throughout fiscal 2020. +Property and Casualty Insurance will continue to provide loss adjusting and claims handling for U-Haul and underwrite components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestor ® , and Safestor Mobile ® protection packages to U-Haul customers. +Life Insurance is pursuing its goal of expanding its presence in the senior market through the sales of its Medicare supplement, life and annuity policies. This strategy includes growing its agency force, expanding its new product offerings, and pursuing business acquisition opportunities. +Quarterly Results (unaudited) +The quarterly results shown below are derived from unaudited financial statements for the eight quarters beginning April 1, 2017 and ending March 31, 2019. We believe that all necessary adjustments have been included in the amounts stated below to present fairly, and in accordance with GAAP, such results. Moving and Storage operations are seasonal and proportionally more of the Company’s revenues and net earnings from its Moving and Storage operations are generated in the first and second quarters of each fiscal year (April through September). The operating results for the periods presented are not necessarily indicative of results for any future period. +Quarter Ended +March 31, 2019 +December 31, 2018 +September 30, 2018 +June 30, 2018 +(In thousands, except for share and per share data) +Total revenues +$ +725,532 +$ +919,091 +$ +1,104,507 +$ +1,019,577 +Earnings from operations +27,237 +138,102 +250,944 +204,704 +Earnings available to common +shareholders +831 +78,635 +163,542 +127,849 +Basic and diluted earnings +per common share +$ +0.04 +$ +4.01 +$ +8.35 +$ +6.53 +Weighted average common shares +outstanding: basic and diluted +19,594,008 +19,591,963 +19,591,312 +19,590,585 +Quarter Ended +March 31, 2018 +December 31, 2017 +September 30, 2017 +June 30, 2017 +(In thousands, except for share and per share data) +Total revenues +$ +757,621 +$ +842,882 +$ +1,042,686 +$ +957,925 +Earnings from operations +3,002 +303,368 +229,613 +229,263 +Earnings available to common +shareholders +10,843 +528,894 +124,639 +126,207 +Basic and diluted earnings +per common share +$ +0.56 +$ +27.00 +$ +6.36 +$ +6.44 +Weighted average common shares +outstanding: basic and diluted +19,589,871 +19,589,218 +19,588,571 +19,587,891 +36 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +We are exposed to financial market risks, including changes in interest rates and currency exchange rates. To mitigate these risks, we may utilize derivative financial instruments, among other strategies. We do not use derivative financial instruments for speculative purposes. +Interest Rate Risk +The exposure to market risk for changes in interest rates relates primarily to our variable rate debt obligations and one variable rate operating lease. We have used interest rate swap agreements and forward swaps to reduce our exposure to changes in interest rates. We enter into these arrangements with counterparties that are significant financial institutions with whom we generally have other financial arrangements. We are exposed to credit risk should these counterparties not be able to perform on their obligations. Following is a summary of our interest rate swaps agreements at March 31, 2019: +Notional Amount +Fair Value +Effective Date +Expiration Date +Fixed Rate +Floating Rate +(In thousands) +$ +7,604 +– +4/16/2012 +4/1/2019 +1.28% +1 Month LIBOR +15,188 +139 +1/15/2013 +12/15/2019 +1.07% +1 Month LIBOR +As of March 31, 2019, we had $1,084.1 million of variable rate debt obligations. If the London Inter-Bank Offer Rate were to increase 100 basis points, the increase in interest expense on the variable rate debt would decrease future earnings and cash flows by $10.6 million annually (after consideration of the effect of the above derivative contracts). Certain senior mortgages have an anticipated repayment date and a maturity date. If these senior mortgages are not repaid by the anticipated repayment date the interest rate on these mortgages would increase from the current fixed rate. We are using the anticipated repayment date for our maturity schedule. +Additionally, our insurance subsidiaries’ fixed income investment portfolios expose us to interest rate risk. This interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. As part of our insurance companies’ asset and liability management, actuaries estimate the cash flow patterns of our existing liabilities to determine their duration. These outcomes are compared to the characteristics of the assets that are currently supporting these liabilities assisting management in determining an asset allocation strategy for future investments that management believes will mitigate the overall effect of interest rates. +We use derivatives to hedge our equity market exposure to indexed annuity products sold by our Life Insurance company. These contracts earn a return for the contractholder based on the change in the value of the S&P 500 index between annual index point dates. We buy and sell listed equity and index call options and call option spreads. The credit risk is with the party in which the options are written. The net option price is paid up front and there are no additional cash requirements or additional contingent liabilities. These contracts are held at fair market value on our balance sheet. At March 31, 2019 and 2018, these derivative hedges had a net market value of $1.5 million and $4.4 million, with notional amounts of $284.0 million and $227.4 million, respectively. These derivative instruments are included in Investments, other; on the consolidated balance sheets. +Although the call options are employed to be effective hedges against our policyholder obligations from an economic standpoint, they do not meet the requirements for hedge accounting under GAAP. Accordingly, the call options are marked to fair value on each reporting date with the change in fair value, plus or minus, included as a component of net investment and interest income. The change in fair value of the call options includes the gains or losses recognized at the expiration of the option term and the changes in fair value for open contracts. +Foreign Currency Exchange Rate Risk +The exposure to market risk for changes in foreign currency exchange rates relates primarily to our Canadian business. Approximately 4.6%, 4.6% and 4.4% of our revenue was generated in Canada in fiscal 2019, 2018 and 2017, respectively. The result of a 10% change in the value of the U.S. dollar relative to the Canadian dollar would not be material to net income. We typically do not hedge any foreign currency risk since the exposure is not considered material. +37 +Item 8. Financial Statements and Supplementary Data +The Report of Independent Registered Public Accounting Firm and Consolidated Financial Statements of AMERCO and its consolidated subsidiaries including the notes to such statements and the related schedules are set forth on the “F” pages hereto and are incorporated by reference herein. +Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +Not applicable. +Item 9A. Controls and Procedures +Attached as exhibits to this Annual Report are certifications of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), which are required in accordance with Rule 13a-14 of the Exchange Act. This "Controls and Procedures" section includes information concerning the controls and procedures evaluation referred to in the certifications and it should be read in conjunction with the certifications for a more complete understanding of the topics presented in the section Evaluation of Disclosure Controls and Procedures. +Following this discussion is the report of BDO USA, LLP, our independent registered public accounting firm, regarding its audit of AMERCO’s internal control over financial reporting as set forth below in this section. This section should be read in conjunction with the certifications of our CEO and CFO and the BDO USA, LLP report for a more complete understanding of the topics presented. +Evaluation of Disclosure Controls and Procedures +The Company’s management, with the participation of the CEO and CFO, conducted an evaluation of the effectiveness of the design and operation of the Company’s "disclosure controls and procedures" (as such term is defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) (“Disclosure Controls”) as of the end of the period covered by this Annual Report. Our Disclosure Controls are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Our Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Based upon the controls evaluation, our CEO and CFO have concluded that as of the end of the period covered by this Annual Report, our Disclosure Controls were effective at a reasonable assurance level related to the above stated design purposes. +Inherent Limitations on Effectiveness of Controls +The Company's management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of the effectiveness of our controls to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. +Changes in Internal Control over Financial Reporting +There has not been any change in the Company’s internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f) during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +38 +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements. +Management assessed our internal control over financial reporting as of March 31, 2019, the end of our fiscal year. Management based its assessment on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management's assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment. This assessment is supported by testing and monitoring performed both by our Internal Audit function and our Finance function. +Based on our assessment, management has concluded that our internal control over financial reporting was effective as of the end of the fiscal year 2019. We reviewed the results of management's assessment with the Audit Committee of our Board. +Our independent registered public accounting firm, BDO USA, LLP, has audited the Company's internal control over financial reporting and has issued their report, which is included on the following page. +39 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +AMERCO +Reno, Nevada +Opinion on Internal Control over Financial Reporting +We have audited AMERCO and consolidated subsidiaries’ (the “Company”) internal control over financial reporting as of March 31, 2019, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of March 31, 2019, based on the COSO criteria . +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of March 31, 2019 and 2018, the related consolidated statements of operations, changes in stockholders’ equity, comprehensive income (loss), and cash flows for each of the three years in the period ended March 31, 2019, and the related notes and schedules and our report dated May 29, 2019, expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ BDO USA, LLP +Phoenix, Arizona +May 29, 2019 +40 +Item 9B. Other Information +Not applicable. +PART III +Item 10. Directors, Executive Officers and Corporate Governance +The information required to be disclosed under this Item 10 is incorporated herein by reference to AMERCO’s definitive proxy statement, in connection with its 2019 annual meeting of stockholders (the “Proxy Statement”), which will be filed with the SEC within 120 days after the close of the Company’s 2019 fiscal year. +The Company has a Code of Ethics that applies to all directors, officers and employees of the Company, including the Company’s principal executive officer and principal financial officer. A copy of our Code of Ethics is posted on AMERCO’s website at amerco.com/governance.aspx. We intend to satisfy the disclosure requirements of Current Report on Form 8-K regarding any amendment to, or waiver from, a provision of our Code of Ethics by posting such information on the Company’s website, at the web address and location specified above, unless otherwise required to file a Current Report on Form 8-K by NASDAQ rules and regulations. +Item 11. Executive Compensation +The information required to be disclosed under this Item 11 is incorporated herein by reference to the Proxy Statement. +Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +The information required to be disclosed under this Item 12 is incorporated herein by reference to the Proxy Statement. +Item 13. Certain Relationships and Related Transactions, and Director Independence +The information required to be disclosed under this Item 13 is incorporated herein by reference to the Proxy Statement. +Item 14. Principal Accounting Fees and Services +The information required to be disclosed under this Item 14 is incorporated herein by reference to the Proxy Statement. +PART IV +Item 15. Exhibits; Financial Statement Schedules +The following documents are filed as part of this Report: +Page +1 +Financial Statements: +Report of Independent Registered Public Accounting Firm +F-1 +Consolidated Balance Sheets - March 31, 2019 and 2018 +F-2 +Consolidated Statements of Operations - Years Ended March 31, 2019, 2018, and 2017 +F-3 +Consolidated Statements of Comprehensive Income (Loss) - Years Ended March 31, 2019, 2018, and 2017 +F-4 +Consolidated Statements of Changes in Stockholders' Equity - Years Ended March 31, 2019, 2018, and 2017 +F-5 +Consolidated Statements of Cash Flows - Years Ended March 31, 2019, 2018, and 2017 +F-6 +Notes to Consolidated Financial Statements +F-8 +2 +Financial Statement Schedules required to be filed by Item 8: +Schedule I - Condensed Financial Information of AMERCO +F-60 +Schedule II - AMERCO and Consolidated Subsidiaries Valuation and Qualifying Accounts +F-64 +Schedule V - AMERCO and Consolidated Subsidiaries Supplemental Information (For Property-Casualty Insurance Operations) +F-65 +41 +All other schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. +Exhibits: +Exhibit Number +Description +Page or Method of Filing +3.1 +Amended and Re s tated Articles of Incorporation of AMERCO +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed on June 9, 2016, file no. 1-11255 +3.2 +Restated Bylaws of AM E RCO +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed on September 5, 2013, file no. 1-11255 +4.1 +U-Haul Investors Club Base Indenture, dated February 14, 2011 by and between AMERCO and U. S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on February 22, 2011, file no. 1-11255 +4.2 +Second Supp l emental Indenture, dated February 17, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on February 22, 2011, file no. 1-11255 +4.3 +Fourth Supplemental Indenture, dated March 15, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on March 22, 2011, file no. 1-11255 +4.4 +Seven t h Supplemental Indenture, dated March 29, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on April 1, 2011, file no. 1-11255 +4.5 +Tenth Supplemental Indenture, dated June 7, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 23, 2011, file no. 1-11255 +4.6 +Eleventh Supplemental Indenture dated June 7, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 31, 2011, file no. 1-11255 +4.7 +Twelfth Supplemental Indenture dated June 14, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 23, 2011, file no. 1-11255 +4.8 +Fourteenth Supplemental Indenture dated July 20, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on August 17, 2011, file no. 1-11255 +4.9 +Sixteenth Supplemental Indenture dated August 31, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 28, 2011, file no. 1-11255 +4.10 +Seventeenth Supplemental Indenture dated November 8, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on January 18, 2012, file no. 1-11255 +4.11 +Eighteenth Supplemental Indenture dated January 7, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on March 26, 2012, file no. 1-11255 +4.12 +Nineteenth Supplemental Indenture dated May 14, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on May 15, 2012, file no. 1-11255 +42 +4.13 +Eighth Supplemental Indenture, dated April 12, 2011, by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year end March 31, 2012, file no. 1-11255 +4.14 +Twentieth Supplemental Indenture dated September 4, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 4, 2012, file no. 1-11255 +4.15 +Twenty-first Supplemental Indenture dated January 15, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on January 15, 2013, file no. 1-11255 +4.16 +Twenty-second Supplemental Indenture, dated May 28, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 30, 2013, file no. 1-11255 +4.17 +Twenty-third Supplemental Indenture, dated November 26, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on November 26, 2013, file no. 1-11255 +4.18 +Twenty-fourth Supplemental Indenture, dated April 22, 2014 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on April 22, 2014, file no. 1-11255 +4.19 +Twenty-fifth Supplemental Indenture, dated July 7, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on July 7, 2015, file no. 1-11255 +4.20 +Twenty-sixth Supplemental Indenture, dated September 29, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on September 29, 2015, file no. 1-11255 +4.21 +Twenty-seventh Supplemental Indenture, dated December 15, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on December 15, 2015, file no. 1-11255 +4.22 +Twenty-eighth Supplemental Indenture, dated September 13, 2016 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on September 13, 2016, file no. 1-11255 +4.23 +Twenty-ninth Supplemental Indenture, dated January 24, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on January 24, 2017, file no. 1-11255 +4.24 +Thirtieth Supplemental Indenture, dated June 27, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on June 27, 2017, file no. 1-11255 +4.25 +Thirty-first Supplemental Indenture, dated October 24, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on October 25, 2017, file no. 1-11255 +4.26 +Thirty-second Supplem e ntal Indenture, dated March 6, 2018 by a nd between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on March 6, 2018, file no. 1-11255 +4.27 +Amended and Restated Twenty-fifth Supplemental Indenture, dated August 28, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on August 28, 2018, file no. 1-11255 +43 +4.28 +Thirty-third Supplemental Indenture, dated August 28, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on August 28, 2018, file no. 1-11255 +4.29 +Thirty-fourth Supplemental Indenture, dated October 23, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on October 23, 2018, file no. 1-11255 +4.30 +Thirty-fifth Supplemental Indenture, dated March 7, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on March 7, 2019, file no. 1-11255 +4.31 +Amen d ed and Restated Thirty-third Supplemental Indenture, dated May 3, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 3, 2019, file no. 1-11255 +4.32 +Amended and Restated Thirty-fourth Supplem e ntal Indenture, dated May 3, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 3, 2019, file no. 1-11255 +4.33 +Thirty-sixth Supplemental Indenture, dated May 3, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 3, 2019, file no. 1-11255 +10.1 +Management Agreement between Four SAC Self-Storage Corp o ration and subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 1997, file no. 1-11255 +10.2 +Management Agreement between Five SAC Self-Storage Corpo r ation and subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 1999, file no. 1-11255 +10.3 +Property Management Agreement +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2004, file no. 1-11255 +10.4 +U-Haul Dealership Contract between U-Haul Leasing & Sales Co., and U-Haul Moving Partners, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, file no. 1-11255 +10.5 +Property Management Agreement between Mercury Partners, LP, Mercury 99, LLC and U-Haul Self-Storage Management (WPC), Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, file no. 1-11255 +10.6 +Amended and Restated Credit Agreement, dated June 8, 2005, among Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.7 +Security Agreement dated June 8, 2005, by Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and the Marketing Grantors named therein in favor of Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +44 +10.8 +Guarantee, dated June 8, 2005, by U-Haul International, Inc. in favor of Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.9 +Promissory Note, dated June 8, 2005 by Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc. and U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.10 +Amendment No. 1 to the Amended and Restated Credit Agreement and Security Agreement, dated as of August 18, 2006, to the Amended and Restated Credit Agreement, dated as of June 8, 2005, among Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and the Marketing Grantors named therein in favor of Merrill Lynch Commercial Financial Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed August 23, 2006, file no. 1-11255 +10.11 +Amended and Restated Property Management Agreement among Eight SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.12 +Amended and Restated Property Management Agreement among Nine SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.13 +Amended and Restated Property Management Agreement among Ten SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.14 +Amended and Restated Property Management Agreement among Eleven SAC Self-Storage Corporation and Eleven SAC Self-Storage Odenton, Inc. and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.15 +Amended and Restated Property Management Agreement among Twelve SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.16 +Amended and Restated Property Management Agreement among Thirteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.17 +Amended and Restated Property Management Agreement among Fourteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +45 +10.18 +Amended and Restated Property Management Agreement among Fifteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.19 +Amended and Restated Property Management Agreement among Sixteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.20 +Amended and Restated Property Management Agreement among Seventeen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.21 +Amended and Restated Property Management Agreement among Eighteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.22 +Amended and Restated Property Management Agreement among Twenty SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.23 +Amended and Restated Property Management Agreement among Twenty-One SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.24 +Amended and Restated Property Management Agreement among Twenty-Two SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.25 +Amended and Restated Property Management Agreement among Twenty-Three SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.26 +Amended and Restated Property Management Agreement among Twenty-Four SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.27 +Amended and Restated Property Management Agreement among Twenty-Five SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.28 +Amended and Restated Property Management Agreement among Twenty-Six SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.29 +Amended and Restated Property Management Agreement among Twenty-Seven SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.30 +Amended and Restated Property Management Agreement among Three-A SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +46 +10.31 +Amended and Restated Property Management Agreement among Three-B SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.32 +Amended and Restated Property Management Agreement among Three-C SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.33 +Amended and Restated Property Management Agreement among Three-D SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.34 +Amended and Restated Property Management Agreement among Galaxy Storage One, LP and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.35 +U-Haul Dealership Contract Addendum +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.36 +Loan Agreement, dated as of August 12, 2015 among U-Haul Co of Florida 8, LLC, U-Haul Co. of Florida 9, LLC , U-Haul Co. of Florida 10, UHIL 8, LLC, UHIL 9, LLC, UHIL 10, LLC, UHIL 13, LLC, AREC 8, LLC, AREC 9, LLC, AREC 10, LLC and AREC 13, LLC, each a Delaware limited liability company, collectively as Borrower, and Morgan Stanley Bank, N.A. and JP Morgan Chase Bank, National Association, collectively as Lender +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on August 14, 2015, file no. 1-11255 +10.37 +Property Management Agreement dated December 11, 2014 between Three SAC Self-Storage Corporation and U-Haul Co. (Canada), Ltd +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.38 +Property Management Agreement dated December 16, 2014 among Galaxy Storage Two, L.P. and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.39 +Property Management Agreement dated June 25, 2015 among 2015 SAC Self-Storage, LLC and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.40 +Property Management Agreement dated March 21, 2016 among Five SAC RW, LLC and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.41 +Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.42 +Amended and Restated AMERCO Employee Stock Ownership Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +47 +10.43 +Property Management Agreement among Six-SAC Self-Storage Corporation and certain subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 27, 2016, file no. 1-11255 +10.44 +Stockholder Agreement dated September 12, 2016, between Edward J. Shoen, Mark V. Shoen, Foster Road LLC, Willow Grove Holdings LP, Blackwater Investments, Inc. and SAC Holdings Corporation +Incorporated by reference to Exhibit 99.1, filed with the Schedule 13-D/A, filed on September 12, 2016, file number 5-39669 +10.45 +2016 Stock Option Plan (Shelf Stock Option Plan)* +Incorporated by reference to Exhibit C to Definitive Proxy for the Special Meeting of Stockholders filed on April 20, 2016 +10.46 +Credit Agreement, dated as of September 1, 2017 by and among AMERCO, as the Borrower, Bank of America, N.A., as Agent for all Lenders, and the fina n cial institutions party thereto from to time as, Lenders. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 7, 2017, file no. 1-11255 +10.47 +Template Dealership Contract +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.48 +Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.49 +Amendment to the Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.50 +Amended and Restated AMERCO Employee Stock Ownership Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.51 +Amendment to the Amended and Restated AMERCO Employee Stock Ownership Plan +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +14 +Code of Ethics +Incorporated by reference to AMERCO’s Quarterly Report on Form 8-K, filed on April 15, 2014, file no. 1-11255 +21 +Subsidiaries of AMERCO +Filed herewith +23.1 +Consent of BDO USA, LLP +Filed herewith +24 +Power of Attorney +Refer to signature page +31.1 +Rule 13a-14(a)/15d-14(a) Certificate of Edward J. Shoen, President and Chairman of the Board of AMERCO +Filed herewith +31.2 +Rule 13a-14(a)/15d-14(a) Certificate of Jason A. Berg, Chief Financial Officer of AMERCO +Filed herewith +32.1 +Certificate of Edward J. Shoen, President and Chairman of the Board of AMERCO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Furnished herewith +48 +32.2 +Certificate of Jason A. Berg, Chief Financial Officer of AMERCO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Furnished herewith +101.INS +XBRL Instance Document +Furnished herewith +101.SCH +XBRL Taxonomy Extension Schema +Furnished herewith +101.CAL +XBRL Taxonomy Extension Calculation Linkbase +Furnished herewith +101.LAB +XBRL Taxonomy Extension Label Linkbase +Furnished herewith +101.PRE +XBRL Taxonomy Extension Presentation Linkbase +Furnished herewith +101.DEF +XBRL Taxonomy Extension Definition Linkbase +Furnished herewith +* Indicates management plan or compensatory arrangement. +Item 16. Form 10-K Summary +None. +49 +Report of Independent Registered Public Accounting Firm +Shareholders and Board of Directors +AMERCO +Reno, Nevada +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of AMERCO and consolidated subsidiaries’ (the “Company”) as of March 31, 2019 and 2018, the related consolidated statements of operations, changes in stockholders’ equity, comprehensive income (loss) and cash flows for each of the three years in the period ended March 31, 2019, and the related notes and schedules (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at March 31, 2019 and 2018, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2019 , in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of March 31, 2019, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated May 29, 2019, expressed an unqualified opinion thereon. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ BDO USA, LLP +We have served as the Company's auditor since 2003. +Phoenix, Arizona +May 29, 2019 +F- 1 +Amerco and consolidated subsidiaries +Consolidated balance sheets +March 31, +2019 +2018 +(In thousands, except share data) +ASSETS +Cash and cash equivalents +$ +673,701 +$ +759,388 +Reinsurance recoverables and trade receivables, net +224,785 +193,538 +Inventories and parts, net +103,504 +89,877 +Prepaid expenses +174,100 +166,129 +Investments, fixed maturities and marketable equities +2,235,397 +1,919,860 +Investments, other +300,736 +399,064 +Deferred policy acquisition costs, net +136,276 +124,767 +Other assets +78,354 +244,782 +Related party assets +30,889 +33,276 +3,957,742 +3,930,681 +Property, plant and equipment, at cost: +Land +976,454 +827,649 +Buildings and improvements +4,003,726 +3,140,713 +Furniture and equipment +689,780 +632,803 +Rental trailers and other rental equipment +590,039 +545,968 +Rental trucks +4,762,028 +4,390,750 +11,022,027 +9,537,883 +Less: Accumulated depreciation +(3,088,056) +(2,721,142) +Total property, plant and equipment +7,933,971 +6,816,741 +Total assets +$ +11,891,713 +$ +10,747,422 +LIABILITIES AND STOCKHOLDERS' EQUITY +Liabilities: +Accounts payable and accrued expenses +$ +556,873 +$ +511,115 +Notes, loans and leases payable, net +4,163,323 +3,513,076 +Policy benefits and losses, claims and loss expenses payable +1,011,183 +1,248,033 +Liabilities from investment contracts +1,666,742 +1,364,066 +Other policyholders' funds and liabilities +15,047 +10,040 +Deferred income +35,186 +34,276 +Deferred income taxes, net +750,970 +658,108 +Total liabilities +8,199,324 +7,338,714 +Commitments and contingencies (notes 9, 16, 17, and 18) +Stockholders' equity: +Series preferred stock, with or without par value, 50,000,000 shares authorized: +Series A preferred stock, with no par value, 6,100,000 shares authorized; +6,100,000 shares issued and none outstanding as of March 31, 2019 and 2018 +– +– +Series B preferred stock, with no par value, 100,000 shares authorized; none +issued and outstanding as of March 31, 2019 and 2018 +– +– +Serial common stock, with or without par value, 250,000,000 shares authorized: +Serial common stock of $0.25 par value, 10,000,000 shares authorized; +none issued and outstanding as of March 31, 2019 and 2018 +– +– +Common stock, with $0.25 par value, 250,000,000 shares authorized: +Common stock of $0.25 par value, 250,000,000 shares authorized; 41,985,700 +issued and 19,607,788 outstanding as of March 31, 2019 and 2018 +10,497 +10,497 +Additional paid-in capital +453,326 +452,746 +Accumulated other comprehensive loss +(66,698) +(4,623) +Retained earnings +3,976,962 +3,635,561 +Cost of common shares in treasury, net (22,377,912 shares as of March 31, 2019 and 2018) +(525,653) +(525,653) +Cost of preferred shares in treasury, net (6,100,000 shares as of March 31, 2019 and 2018) +(151,997) +(151,997) +Unearned employee stock ownership plan shares +(4,048) +(7,823) +Total stockholders' equity +3,692,389 +3,408,708 +Total liabilities and stockholders' equity +$ +11,891,713 +$ +10,747,422 +The accompanying notes are an integral part of these consolidated financial statements. +F- 2 +amerco and consolidated subsidiaries +Consolidated statements of operations +Years Ended March 31, +2019 +2018 +2017 +(In thousands, except share and per share data) +Revenues: +Self-moving equipment rentals +$ +2,653,497 +$ +2,479,742 +$ +2,362,833 +Self-storage revenues +367,276 +323,903 +286,886 +Self-moving and self-storage products and service sales +264,146 +261,557 +253,073 +Property management fees +29,148 +29,602 +29,075 +Life insurance premiums +63,488 +154,703 +163,579 +Property and casualty insurance premiums +60,853 +57,100 +52,334 +Net investment and interest income +110,934 +110,473 +102,276 +Other revenue +219,365 +184,034 +171,711 +Total revenues +3,768,707 +3,601,114 +3,421,767 +Costs and expenses: +Operating expenses +1,981,180 +1,807,056 +1,567,181 +Commission expenses +288,408 +276,705 +267,230 +Cost of sales +162,142 +160,489 +152,485 +Benefits and losses +100,277 +185,311 +182,710 +Amortization of deferred policy acquisition costs +28,556 +24,514 +26,218 +Lease expense +33,158 +33,960 +37,343 +Depreciation, net gains on disposals of ($26,982, $11,822 and $32,495, respectively) +554,043 +543,247 +449,025 +Net gains on disposal of real estate +(44) +(195,414) +(3,590) +Total costs and expenses +3,147,720 +2,835,868 +2,678,602 +Earnings from operations +620,987 +765,246 +743,165 +Other components of net periodic benefit costs +(1,013) +(927) +(902) +Interest expense +(142,445) +(126,706) +(113,406) +Fees and amortization on early extinguishment of debt +– +– +(499) +Pretax earnings +477,529 +637,613 +628,358 +Income tax benefit (expense) +(106,672) +152,970 +(229,934) +Earnings available to common stockholders +$ +370,857 +$ +790,583 +$ +398,424 +Basic and diluted earnings per common share +$ +18.93 +$ +40.36 +$ +20.34 +Weighted average common shares outstanding: Basic and diluted +19,592,048 +19,588,889 +19,586,606 +Related party revenues for fiscal 2019, 2018 and 2017, net of eliminations, were $29.1 million, $32.9 million and $34.0 million, respectively. +Related party costs and expenses for fiscal 2019, 2018, and 2017, net of eliminations, were $64.1 million, $61.3 million and $59.9 million, respectively. +Please see Note 19, Related Party Transactions, of the Notes to Consolidated Financial Statements for more information on the related party revenues and costs and expenses. +The accompanying notes are an integral part of these consolidated financial statements. +F- 3 +Amerco and Consolidated Subsidiaries +Consolidated statements of comprehensive income (loss) +Fiscal Year Ended March 31, 2019 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +477,529 +$ +(106,672) +$ +370,857 +Other comprehensive income: +Foreign currency translation +(1,759) +– +(1,759) +Unrealized net loss on investments +(76,124) +16,356 +(59,768) +Change in fair value of cash flow hedges +633 +(156) +477 +Change in postretirement benefit obligations +(1,359) +334 +(1,025) +Total comprehensive income +$ +398,920 +$ +(90,138) +$ +308,782 +Fiscal Year Ended March 31, 2018 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +637,613 +$ +152,970 +$ +790,583 +Other comprehensive income: +Foreign currency translation +14,652 +– +14,652 +Unrealized net gain on investments +30,929 +(10,825) +20,104 +Change in fair value of cash flow hedges +4,445 +(1,363) +3,082 +Change in postretirement benefit obligations +288 +(253) +35 +Total comprehensive income +$ +687,927 +$ +140,529 +$ +828,456 +Fiscal Year Ended March 31, 2017 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +628,358 +$ +(229,934) +$ +398,424 +Other comprehensive income: +Foreign currency translation +(5,862) +– +(5,862) +Unrealized net gain on investments +13,822 +(4,838) +8,984 +Change in fair value of cash flow hedges +9,916 +(3,767) +6,149 +Change in postretirement benefit obligations +28 +(10) +18 +Total comprehensive income +$ +646,262 +$ +(238,549) +$ +407,713 +The accompanying notes are an integral part of these consolidated financial statements . +F- 4 +Amerco and consolidated subsidiaries +consolidated statements of changes in stockholders’ equity +Description +Common Stock +Additional Paid-In Capital +Accumulated Other Comprehensive +Income (Loss) +Retained Earnings +Less: Treasury Common Stock +Less: Treasury Preferred Stock +Less: Unearned Employee Stock Ownership Plan Shares +Total Stockholders' Equity +(In thousands) +Balance as of March 31, 2016 +$ +10,497 +$ +451,629 +$ +(60,525) +$ +2,533,641 +$ +(525,653) +$ +(151,997) +$ +(6,186) +$ +2,251,406 +Increase in market value of released ESOP shares +– +543 +– +– +– +– +– +543 +Release of unearned ESOP shares +– +– +– +– +– +– +10,360 +10,360 +Purchase of ESOP shares +– +– +– +– +– +– +(11,106) +(11,106) +Foreign currency translation +– +– +(5,862) +– +– +– +– +(5,862) +Unrealized net gain on investments, net of tax +– +– +8,984 +– +– +– +– +8,984 +Change in fair value of cash flow hedges, net of tax +– +– +6,149 +– +– +– +– +6,149 +Change in postretirement benefit obligations +– +– +18 +– +– +– +– +18 +Net earnings +– +– +– +398,424 +– +– +– +398,424 +Common stock dividends: ($2.00 per share for fiscal 2017) +– +– +– +(39,172) +– +– +– +(39,172) +Net activity +– +543 +9,289 +359,252 +– +– +(746) +368,338 +Balance as of March 31, 2017 +$ +10,497 +$ +452,172 +$ +(51,236) +$ +2,892,893 +$ +(525,653) +(151,997) +$ +(6,932) +$ +2,619,744 +Adjustment for adoption of ASU 2018 - 02 +– +– +8,740 +(8,740) +– +– +– +– +Increase in market value of released ESOP shares +– +574 +– +– +– +– +– +574 +Release of unearned ESOP shares +– +– +– +– +– +– +10,749 +10,749 +Purchase of ESOP shares +– +– +– +– +– +– +(11,640) +(11,640) +Foreign currency translation +– +– +14,652 +– +– +– +– +14,652 +Unrealized net gain on investments, net of tax +– +– +20,104 +– +– +– +– +20,104 +Change in fair value of cash flow hedges, net of tax +– +– +3,082 +– +– +– +– +3,082 +Change in postretirement benefit obligations +– +– +35 +– +– +– +– +35 +Net earnings +– +– +– +790,583 +– +– +– +790,583 +Common stock dividends: ($2.00 per share for fiscal 2018) +– +– +– +(39,175) +– +– +– +(39,175) +Net activity +– +574 +46,613 +742,668 +– +– +(891) +788,964 +Balance as of March 31, 2018 +$ +10,497 +$ +452,746 +$ +(4,623) +$ +3,635,561 +$ +(525,653) +$ +(151,997) +$ +(7,823) +$ +3,408,708 +Adjustment for adoption of ASU 2016 - 01 +– +– +(9,724) +9,724 +– +– +– +– +Increase in market value of released ESOP shares +– +580 +– +– +– +– +– +580 +Release of unearned ESOP shares +– +– +– +– +– +– +9,392 +9,392 +Purchase of ESOP shares +– +– +– +– +– +– +(5,617) +(5,617) +Foreign currency translation +– +– +(1,759) +– +– +– +– +(1,759) +Unrealized net loss on investments, net of tax +– +– +(50,044) +– +– +– +– +(50,044) +Change in fair value of cash flow hedges, net of tax +– +– +477 +– +– +– +– +477 +Change in postretirement benefit obligations +– +– +(1,025) +– +– +– +– +(1,025) +Net earnings +– +– +– +370,857 +– +– +– +370,857 +Common stock dividends: ($2.00 per share for fiscal 2019) +– +– +– +(39,180) +– +– +– +(39,180) +Net activity +– +580 +(62,075) +341,401 +– +– +3,775 +283,681 +Balance as of March 31, 2019 +$ +10,497 +$ +453,326 +$ +(66,698) +$ +3,976,962 +$ +(525,653) +$ +(151,997) +$ +(4,048) +$ +3,692,389 +The accompanying notes are an integral part of these consolidated financial statements. +F- 5 +amerco and consolidated subsidiaries +consolidated statements of cash flows +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Cash flows from operating activities: +Net earnings +$ +370,857 +$ +790,583 +$ +398,424 +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +581,025 +555,069 +481,520 +Amortization of deferred policy acquisition costs +28,556 +24,514 +26,218 +Amortization of premiums and accretion of discounts related to investments, net +13,107 +12,790 +11,828 +Amortization of debt issuance costs +3,923 +3,868 +4,062 +Interest credited to policyholders +35,387 +32,302 +25,020 +Change in allowance for losses on trade receivables +52 +(120) +(46) +Change in allowance for inventories and parts reserves +(146) +5,065 +1,330 +Net gains on disposal of personal property +(26,982) +(11,822) +(32,495) +Net gains on disposal of real estate +(44) +(195,414) +(3,590) +Net gains on sales of investments +(2,663) +(6,269) +(5,284) +Net losses on equity investments +5,739 +– +– +Deferred income taxes +106,811 +(193,434) +173,112 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(31,365) +(15,329) +(2,890) +Inventories and parts +(13,492) +(12,384) +(4,072) +Prepaid expenses +(8,620) +(40,765) +9,386 +Capitalization of deferred policy acquisition costs +(25,957) +(27,350) +(27,111) +Other assets +157,152 +(165,968) +(2,488) +Related party assets +4,194 +53,408 +343 +Accounts payable and accrued expenses +10,263 +(36,980) +(15,548) +Policy benefits and losses, claims and loss expenses payable +(236,120) +161,121 +15,378 +Other policyholders' funds and liabilities +5,007 +(109) +1,499 +Deferred income +966 +5,524 +5,921 +Related party liabilities +(2,067) +(616) +(1,062) +Net cash provided by operating activities +975,583 +937,684 +1,059,455 +Cash flows from investing activities: +Escrow deposits +4,299 +31,362 +(38,058) +Purchase of: +Property, plant and equipment +(1,869,968) +(1,363,745) +(1,419,505) +Short term investments +(54,048) +(63,556) +(635,847) +Fixed maturity investments +(540,045) +(390,900) +(355,101) +Equity securities +(957) +(662) +(489) +Preferred stock +– +(1,000) +– +Real estate +(635) +(1,939) +(32,807) +Mortgage loans +(63,611) +(83,507) +(154,310) +Proceeds from sales and paydowns of: +Property, plant and equipment +606,271 +699,803 +487,475 +Short term investments +66,037 +67,790 +655,726 +Fixed maturity investments +123,551 +163,469 +189,242 +Equity securities +8,608 +– +– +Preferred stock +1,625 +4,208 +4,181 +Real estate +– +2,783 +8,753 +Mortgage loans +147,737 +37,590 +106,832 +Net cash used by investing activities +(1,571,136) +(898,304) +(1,183,908) +Page 1 of 2 +The accompanying notes are an integral part of these consolidated financial statements. +F- 6 +amerco and consolidated subsidiaries +consolidated statements of cash flows (continued) +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +$ +897,311 +$ +498,464 +$ +742,625 +Principal repayments on credit facilities +(299,748) +(356,451) +(367,844) +Payment of debt issuance costs +(7,243) +(5,111) +(5,055) +Capital lease payments +(303,431) +(296,363) +(212,545) +Employee stock ownership plan shares +(418) +(11,640) +(11,106) +Securitization deposits +– +(2,180) +446 +Common stock dividends paid +(39,179) +(29,380) +(58,757) +Investment contract deposits +400,123 +401,814 +285,148 +Investment contract withdrawals +(132,833) +(182,549) +(149,159) +Net cash provided by financing activities +514,582 +16,604 +223,753 +Effects of exchange rate on cash +(4,716) +5,598 +(2,140) +Increase (decrease) in cash and cash equivalents +(85,687) +61,582 +97,160 +Cash and cash equivalents at the beginning of period +759,388 +697,806 +600,646 +Cash and cash equivalents at the end of period +$ +673,701 +$ +759,388 +$ +697,806 +Page 2 of 2 +F- 7 +amerco and consolidated subsidiaries +notes to consolidated financial statements +Note 1. Basis of Presentation +AMERCO, a Nevada Corporation (“AMERCO”), has a fiscal year that ends on the 31 st of March for each year that is referenced. Our insurance company subsidiaries have fiscal years that end on the 31 st of December for each year that is referenced. They have been consolidated on that basis. Our insurance companies’ financial reporting processes conform to calendar year reporting as required by state insurance departments. Management believes that consolidating their calendar year into our fiscal year financial statements does not materially affect the financial position or results of operations. We disclose material events, if any, occurring during the intervening period. Consequently, all references to our insurance subsidiaries’ years 2018, 2017 and 2016 correspond to fiscal 2019, 2018 and 2017 for AMERCO. +Accounts denominated in non-U.S. currencies have been translated into U.S. dollars. Certain amounts reported in previous years have been reclassified to conform to the current presentation. Please see Note 3, Accounting Policies – Adoption of New Accounting Pronouncements , of the Notes to Consolidated Financial Statements. +Note 2. Principles of Consolidation +We apply Accounting Standards Codification (“ASC”) 810 - Consolidation (“ASC 810”) in our principles of consolidation. ASC 810 addresses arrangements where a company does not hold a majority of the voting or similar interests of a variable interest entity (“VIE”). A company is required to consolidate a VIE if it has determined it is the primary beneficiary. ASC 810 also addresses the policy when a company owns a majority of the voting or similar rights and exercises effective control. +A VIE is not self-supportive due to having one or both of the following conditions: (i) it has an insufficient amount of equity for it to finance its activities without receiving additional subordinated financial support or (ii) its owners do not hold the typical risks and rights of equity owners. This determination is made upon the creation of a variable interest and is re-assessed on an on-going basis should certain changes in the operations of a VIE, or its relationship with the primary beneficiary trigger a reconsideration. After a reconsideration event occurs the most recent facts and circumstances are utilized in determining whether or not a company is a VIE, which other company(ies) have a variable interest in the entity, and whether or not the company’s interest is such that it is the primary beneficiary. +We will continue to monitor our relationships with the other entities regarding who is the primary beneficiary, which could change based on facts and circumstances of any reconsideration events. Please see Note 19, Related Party Transactions, of the Notes to Consolidated Financial Statements. +The accompanying Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated. +Description of Legal Entities +AMERCO is the holding company for: +U-Haul International, Inc. (“U-Haul”); +Amerco Real Estate Company (“Real Estate”); +Repwest Insurance Company (“Repwest”); and +Oxford Life Insurance Company (“Oxford”). +Unless the context otherwise requires, the terms “Company,” “we,” “us” or “our” refer to AMERCO and all of its legal subsidiaries. +Description of Operating Segments +AMERCO has three reportable segments. They are Moving and Storage, Property and Casualty Insurance and Life Insurance. +Moving and Storage includes AMERCO, U-Haul, and Real Estate and the wholly-owned subsidiaries of U-Haul and Real Estate. Operations consist of the rental of trucks and trailers, sales of moving supplies, sales of towing accessories, sales of propane, and the rental of fixed and portable moving and storage units to the “do-it-yourself” mover and management of self-storage properties owned by others. +F- 8 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +Property and Casualty Insurance includes Repwest and its wholly-owned subsidiaries and ARCOA Risk Retention Group (“ARCOA”). Property and Casualty Insurance provides loss adjusting and claims handling for U-Haul through regional offices in the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestor ® and Safestor Mobile ® protection packages to U-Haul customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. ARCOA is a group captive insurer owned by us and our wholly owned subsidiaries whose purpose is to provide insurance products related to our moving and storage business. +Life Insurance includes Oxford and its wholly owned subsidiaries. Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Note 3. Accounting Policies +Use of Estimates +The preparation of financial statements in conformity with the generally accepted accounting principles (“GAAP”) in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. The accounting policies that we deem most critical to us and that require management’s most difficult and subjective judgments include the principles of consolidation, the recoverability of property, plant and equipment, the adequacy of insurance reserves, the recognition and measurement of impairments for investments accounted for under ASC 320 - Investments - Debt and Equity Securities and the recognition and measurement of income tax assets and liabilities. The actual results experienced by us may materially differ from management’s estimates. +Cash and Cash Equivalents +We consider cash equivalents to be highly liquid debt securities with insignificant interest rate risk with original maturities from the date of purchase of three months or less. +Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash deposits. Accounts at each United States financial institution are insured by the Federal Deposit Insurance Corporation up to $250,000. Accounts at each Canadian financial institution are insured by the Canada Deposit Insurance Corporation up to $100,000 CAD per account. As of March 31, 2019 and March 31, 2018, we held cash equivalents in excess of these insured limits. To mitigate this risk, we select financial institutions based on their credit ratings and financial strength. +Investments +Fixed Maturities and Marketable Equities. Fixed maturity investments consist of either marketable debt, equity or redeemable preferred stocks. As of the balance sheet dates, all of our investments in these securities were classified as available-for-sale. Available-for-sale investments are reported at fair value, with unrealized gains or losses recorded net of taxes and applicable adjustments to deferred policy acquisition costs in stockholders’ equity. Changes in the market value of common stocks are recognized in earnings. Fair value for these investments is based on quoted market prices, dealer quotes or discounted cash flows. The cost of investments sold is based on the specific identification method. +In determining if and when a decline in market value below carrying value is an other-than-temporary impairment, management makes certain assumptions or judgments in its assessment including but not limited to: our ability to hold the security, quoted market prices, dealer quotes, discounted cash flows, industry factors, financial factors, and issuer specific information. Other-than-temporary impairments, to the extent of the decline, as well as realized gains or losses on the sale or exchange of investments are recognized in the current period operating results. +Mortgage Loans and Notes on Real Estate. Mortgage loans and notes on real estate are reported at their unpaid balance, net of any allowance for possible losses and any unamortized premium or discount. +F- 9 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Recognition of Investment Income. Interest income from bonds and mortgage notes is recognized when earned. Dividends on common and preferred stocks are recognized on the ex-dividend dates. Realized gains and losses on the sale or exchange of investments are recognized at the trade date. +Derivative Financial Instruments +Our objective for holding derivative financial instruments is to manage interest rate risk exposure primarily through entering interest rate swap agreements. An interest rate swap is a contractual exchange of interest payments between two parties. A standard interest rate swap involves the payment of a fixed rate times a notional amount by one party in exchange for a receiving floating rate times the same notional amount from another party. As interest rates change, the difference to be paid or received is accrued and recognized as interest expense or income over the life of the agreement. We do not enter into these instruments for trading purposes. Counterparties to the interest rate swap agreements are major financial institutions. Interest rate swap agreements are recognized at fair value on the balance sheet and are classified as prepaid expenses (asset) or accrued expenses (liability). Derivatives that are not designated as cash flow hedges for accounting purposes must be adjusted to fair value through income. If the derivative qualifies and is designated as a cash flow hedge, changes in its fair value will be recorded in accumulated other comprehensive income (loss) until the hedged item is recognized in earnings. See Note 11, Derivatives, of the Notes to Consolidated Financial Statements. +Inventories and parts, net +Inventories and parts, net were as follows: +March 31, +2019 +2018 +(In thousands) +Truck and trailer parts and accessories (a) +$ +94,344 +$ +83,335 +Hitches and towing components (b) +20,113 +18,627 +Moving supplies and propane (b) +10,356 +9,370 +Subtotal +124,813 +111,332 +Less: LIFO reserves +(18,987) +(16,126) +Less: excess and obsolete reserves +(2,322) +(5,329) +Total +$ +103,504 +$ +89,877 +(a) Primarily held for internal usage, including equipment manufacturing and repair +(b) Primarily held for retail sales +Inventories consist primarily of truck and trailer parts and accessories used to manufacture and repair rental equipment as well as products and accessories available for retail sale. Inventory is held at our owned locations; our independent dealers do not hold any of our inventory. Inventories are stated at the lower cost or net realizable value. +Inventory cost is primarily determined using the last-in first-out method (“LIFO”). Inventories valued using LIFO consisted of approximately 96% of the total inventories for March 31, 2019 and 2018. Had we utilized the first-in first-out method (“FIFO”), stated inventory balances would have been $19.0 million and $16.1 million higher as of March 31, 2019 and 2018, respectively. In fiscal 2018, the negative effect on income due to liquidation of a portion of the LIFO inventory was $0.1 million. +F- 10 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Property, Plant and Equipment +Our Property, plant and equipment is stated at cost. Interest expense, if any, incurred during the initial construction of buildings is considered part of cost. Depreciation is computed for financial reporting purposes using the straight line or an accelerated method based on a declining balance formula over the following estimated useful lives: rental equipment 2-20 years and buildings and non-rental equipment 3-55 years. Routine maintenance costs are charged to operating expense as they are incurred. Gains and losses on dispositions of property, plant and equipment, other than real estate (“personal property”), are netted against depreciation expense when realized. The net amount of gains, netted against depreciation expense, were $27.0 million, $11.8 million and $32.5 million during fiscal 2019, 2018 and 2017, respectively. Equipment depreciation is recognized in amounts expected to result in the recovery of estimated residual values upon disposal, i.e., minimize gains or losses. In determining the depreciation rate, historical disposal experience, holding periods and trends in the market for vehicles are reviewed. As a result of changes in IRS regulations regarding the capitalization of assets, beginning in the first quarter of fiscal 2017, we raised the value threshold before certain assets are capitalized within our depreciation policy. This change in threshold, results in the immediate recognition of reported operating costs with a lagging decrease in depreciation expense over the term that these assets would have been depreciated. Due to this change, we had operating expenses of $21.0 million and $23.1 million in fiscal 2019 and 2018, respectively. This change in threshold benefited us through the immediate recognition of tax deductible costs. +We regularly perform reviews to determine whether facts and circumstances exist which indicate that the carrying amount of assets, including estimates of residual value, may not be recoverable or that the useful life of assets are shorter or longer than originally estimated. Reductions in residual values (i.e., the price at which we ultimately expect to dispose of revenue earning equipment) or useful lives will result in an increase in depreciation expense over the remaining life of the equipment. Reviews are performed based on vehicle class, generally subcategories of trucks and trailers. We assess the recoverability of our assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their estimated remaining lives against their respective carrying amounts. We consider factors such as current and expected future market price trends on used vehicles and the expected life of vehicles included in the fleet. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If asset residual values are determined to be recoverable, but the useful lives are shorter or longer than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives. +For our box truck fleet we utilize an accelerated method of depreciation based upon a declining formula. Under the declining balances method (2.4 times declining balance), the book value of a rental truck is reduced approximately 16%, 13%, 11%, 9%, 8%, 7%, and 6% during years one through seven, respectively and then reduced on a straight line basis to a salvage value of 15% by the end of year fifteen. Comparatively, a standard straight line approach would reduce the book value by approximately 5.7% per year over the life of the truck. +Although we intend to sell our used vehicles for prices approximating book value, the extent to which we realize a gain or loss on the sale of used vehicles is dependent upon various factors including, but not limited to, the general state of the used vehicle market, the age and condition of the vehicle at the time of its disposal and the depreciation rates with respect to the vehicle . We typically sell our used vehicles at our sales centers throughout the United States and Canada, on our website at uhaul.com/trucksales or by phone at 1-866-404-0355. Additionally, we sell a large portion of our pickup and cargo van fleet at automobile dealer auctions. +In addition to our property, plant and equipment, we had real estate held for investment of $53.5 million and $53.8 million for fiscal 2019 and 2018, respectively and is included in Investments, other. +Receivables +Trade receivables include trade accounts from moving and self-storage customers and dealers, insurance premiums and amounts due from re-insurers, less management’s estimate of uncollectible accounts. +F- 11 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Insurance premiums receivable for policies that are billed through contracted agents are recorded net of commissions payable. A commission payable is recorded as a separate liability for those premiums that are billed direct. +Reinsurance recoverables include case reserves and actuarial estimates of claims incurred but not reported ("IBNR"). These receivables are not expected to be collected until after the associated claim has been adjudicated and billed to the re-insurer. The reinsurance recoverables may have little or no allowance for doubtful accounts due to the fact that reinsurance is typically procured from carriers with strong credit ratings. Furthermore, we do not cede losses to a re-insurer if the carrier is deemed financially unable to perform on the contract. Reinsurance recoverables also include insurance ceded to other insurance companies. +Notes and mortgage receivables include accrued interest and are reduced by discounts and amounts considered by management to be uncollectible. +Policy Benefits and Losses, Claims and Loss Expenses Payable +Life Insurance’s liabilities for life insurance and certain annuity and health policies are established to meet the estimated future obligations of policies in force, and are based on mortality, morbidity and withdrawal assumptions from recognized actuarial tables which contain margins for adverse deviation. Liabilities for health, disability and other policies include estimates of payments to be made on insurance claims for reported losses and estimates of IBNR losses. Oxford’s liabilities for deferred annuity contracts consist of contract account balances that accrue to the benefit of the policyholders. +Property and Casualty Insurance’s liability for reported and unreported losses is based on Repwest’s historical data along with industry averages. The liability for unpaid loss adjustment expenses is based on historical ratios of loss adjustment expenses paid to losses paid. Amounts recoverable from re-insurers on unpaid losses are estimated in a manner consistent with the claim liability associated with the re-insured policy. Adjustments to the liability for unpaid losses and loss expenses as well as amounts recoverable from re-insurers on unpaid losses are charged or credited to expense in the periods in which they are made. +Due to the nature of the underlying risks and high degree of uncertainty associated with the determination of the liability for future policy benefits and claims, the amounts to be ultimately paid to settle these liabilities cannot be precisely determined and may vary significantly from the estimated liability, especially for long-tailed casualty lines of business such as excess workers’ compensation. As a result of the long-tailed nature of the excess workers’ compensation policies written by Repwest during 1983 through 2001, it may take a number of years for claims to be fully reported and finally settled. +On a regular basis insurance reserve adequacy is reviewed by management to determine if existing assumptions need to be updated. In determining the assumptions for calculating workers’ compensation reserves, management considers multiple factors including the following: +Claimant longevity +Cost trends associated with claimant treatments +Changes in ceding entity and third party administrator reporting practices +Changes in environmental factors including legal and regulatory +Current conditions affecting claim settlements +Future economic conditions including inflation +We have reserved each claim based upon the accumulation of current claim costs projected through each claimant’s life expectancy and then adjusted for applicable reinsurance arrangements. Management reviews each claim bi-annually or more frequently, if there are changes in facts or circumstances to determine if the estimated life-time claim costs have increased and then adjusts the reserve estimate accordingly at that time. We have factored in an estimate of what the potential cost increases could be in our IBNR liability. We have not assumed settlement of the existing claims in calculating the reserve amount, unless it is in the final stages of completion. +F- 12 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continued increases in claim costs, including medical inflation and new treatments and medications could lead to future adverse development resulting in additional reserve strengthening. Conversely, settlement of existing claims or if injured workers return to work or expire prematurely, could lead to future positive development. +Self-Insurance Reserves +U-Haul retains the risk for certain public liability and property damage programs related to our rental equipment. The consolidated balance sheets include $407.9 million and $408.5 million of liabilities related to these programs as of March 31, 2019 and 2018, respectively. These liabilities are recorded in Policy benefits and losses, claims and loss expenses payable. Management takes into account losses incurred based upon actuarial estimates, past experience, current claim trends, as well as social and economic conditions. This liability is subject to change in the future based upon changes in the underlying assumptions including claims experience, frequency of incidents, and severity of incidents. +Additionally, as of March 31, 2019 and 2018, the consolidated balance sheets include liabilities of $15.6 million and $15.2 million, respectively, related to medical plan benefits we provide for eligible employees. We estimate this liability based on actual claims outstanding as of the balance sheet date as well as an actuarial estimate of IBNR claims. These amounts are recorded in Accounts payable and accrued expenses on the consolidated balance sheets. +Revenue Recognition +Self-moving rentals are recognized for the period that trucks and moving equipment are rented. Self-storage revenues, based upon the number of paid storage contract days, are recognized as earned during the period. Sales of self-moving and self-storage related products are recognized at the time that title passes and the customer accepts delivery. Property and casualty insurance premiums are recognized as revenue over the policy periods. Traditional life and Medicare supplement insurance premiums are recognized as revenue over the premium-paying periods of the contracts when due from the policyholders. For products where premiums are due over a significantly shorter duration than the period over which benefits are provided, such as our single premium whole life product, premiums are recognized when received and excess profits are deferred and recognized in relation to the insurance in force. Interest and investment income are recognized as earned. +Amounts collected from customers for sales tax are recorded on a net basis. Please see Note 22, Revenue Recognition, of the Notes to Consolidated Financial Statements. +Advertising +All advertising costs are expensed as incurred. Advertising expense was $10.6 million, $8.1 million and $8.7 million in fiscal 2019, 2018 and 2017, respectively. +Deferred Policy Acquisition Costs +Commissions and other costs that fluctuate with and are primarily related to the acquisition or renewal of certain insurance premiums are deferred. For our Life Insurance’s life and health insurance products, these costs are amortized, with interest, in relation to revenue such that costs are realized as a constant percentage of revenue. For its annuity insurance products the costs are amortized, with interest, in relation to the present value of actual and expected gross profits. +Starting in fiscal 2014, new annuity contract holders were provided with a sales inducement in the form of a premium bonus (the “Sales Inducement Asset”). Sales inducements are recognized as an asset with a corresponding increase to the policyholder liability and are amortized in a similar manner to Deferred Policy Acquisition Costs. As of December 31, 2018 and 2017, the Sales Inducement Asset included with Deferred Policy Acquisition Costs amounted to $19.1 million and $21.2 million, respectively on the consolidated balance sheet and amortization expense totaled $3.7 million, $3.7 million and $3.3 million for the periods ended December 31, 2018, 2017 and 2016, respectively. +F- 13 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Environmental Costs +Liabilities are recorded when environmental assessments and remedial efforts, if applicable, are probable and the costs can be reasonably estimated. The amount of the liability is based on management’s best estimate of undiscounted future costs. Certain recoverable environmental costs related to the removal of underground storage tanks or related contamination are capitalized and amortized over the estimated useful lives of the properties. These costs are capitalized if they improve the safety or efficiency of the property or are incurred in preparing the property for sale. +Income Taxes +AMERCO files a consolidated tax return with all of its legal subsidiaries. The provision for income taxes reflects deferred income taxes resulting from changes in temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. +Comprehensive Income (Loss) +Comprehensive income (loss) consists of net earnings, foreign currency translation adjustments, unrealized gains and losses on investments, the change in fair value of cash flow hedges and the change in postretirement benefit obligations. +Debt Issuance Costs +We defer costs directly associated with acquiring third-party financing. Debt issuance costs are deferred and amortized. Debt issuance costs related to our long-term debt are reflected as a direct deduction from the carrying amount of the debt. Please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements. +Adoption of New Accounting Pronouncements +In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which provided an updated standard on revenue recognition. The standard outlines a five-step model for entities to use in accounting for revenue arising from contracts with customers. The standard applies to all contracts with customers except for leases, insurance contracts, financial instruments, certain nonmonetary exchanges and certain guarantees. The standard also requires expanded disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09 became effective for us on April 1, 2018 and was adopted on a modified retrospective basis. We performed an impact assessment by analyzing certain existing material revenue transactions and arrangements that are representative of our business segments and their revenue streams. Additionally, we assessed any potential impacts on our internal controls and processes related to both the implementation and ongoing compliance of the new guidance. The adoption of the standard did not have a material impact on our consolidated financial statements. Please see Note 22, Revenue Recognition, of the Notes to Consolidated Financial Statements. +In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which addressed certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Among other provisions, the new guidance requires the fair value measurement of investments in certain equity securities. During fiscal 2019 changes in certain equity securities were recognized in earnings. For investments without readily determinable fair values, entities have the option to either measure these investments at fair value or at cost adjusted for changes in observable prices minus impairment. All changes in measurement will be recognized in net income. The guidance was effective for interim and annual reporting periods beginning after December 15, 2017. We adopted this standard in the first quarter of fiscal 2019 and recorded an increase of approximately $9.7 million to retained earnings with a corresponding decrease to accumulated other comprehensive income (loss). Please see Note 6, Investments, of the Notes to Consolidated Financial Statements. +F- 14 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). This update addressed eight specific cash flow issues with the objective of reducing the existing diversity in practice. The effective date of ASU 2016-15 was for interim and annual reporting periods beginning after December 15, 2017. The adoption of this standard did not have a material impact on our consolidated financial statements. +In October 2016, the FASB issued ASU 2016-16, Income Taxes - Intra-Entity Transfers of Assets Other Than Inventory , which required an entity to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. This update was effective for fiscal years beginning after December 31, 2017, and interim periods within those fiscal years. We adopted this standard in the first quarter of fiscal 2019. The adoption of this standard did not have a material impact on our consolidated financial statements. +In March 2017, the FASB issued ASU 2017-07, Compensation - Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU 2017-07”), which changed how companies that sponsor defined benefit pension plans present the related net periodic benefit cost in the income statement. The service cost component of the net periodic benefit cost continues to be presented in the same income statement line items, however other components of the net periodic benefit cost are presented as a component of other income and excluded from operating profit. ASU 2017-07 became effective for public companies during interim and annual reporting periods beginning after December 15, 2017. We adopted this standard in the first quarter of fiscal 2019. We report the current service cost component of net periodic benefit cost in Operating expenses on our condensed consolidated statements of operations and report the Other components of net periodic benefit cost as a separate item outside of earnings from operations. We have applied these changes in presentation retrospectively, which resulted in a decrease in earnings from operations of $1.0 million, $0.9 million and $0.9 million for fiscal 2019, 2018 and 2017, respectively. These changes in presentation did not result in any changes to earnings available to common stockholders or earnings per common share. Details of the net periodic costs are provided in Note 13, Employee Benefit Plans, of the Notes to Condensed Consolidated Financial Statements. +Recent Accounting Pronouncements +On April 1, 2019, we adopted ASU 2016-02, “Leases (Topic 842)” along with related updates, which require a lessee to recognize all leases with terms greater than 12 months on their balance sheet as a liability for its lease obligation, measured at the present value of lease payments not yet paid, and a corresponding asset representing its right to use the underlying asset over the lease term. The new leasing standard does not significantly change a lessee’s recognition, measurement and presentation of expenses and cash flows. Additionally, Topic 842 aligns key aspects of lessor accounting with the new revenue recognition guidance in Topic 606 (see ASU 2014-09 on the previous page) and expands disclosure of key information about leasing arrangements in an attempt to help financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases . We have determined portions of the vehicle rental contracts that convey the right to control the use of identified assets are within the scope of the accounting guidance contained in the new leasing standard. As we disclosed in our discussion of ASU 2014-09, the Company’s rental related revenues are accounted for under the revenue accounting standard Topic 606. +Topic 842 maintains the dual model for lease accounting, requiring leases to be classified as either operating or finance, with lease classification determined in a manner similar to existing lease guidance. The basic principle is that leases of all types convey the right to direct the use and obtain substantially all the economic benefits of an identified asset, meaning they create an asset and liability for lessees. Lessees classify leases as either finance leases (comparable to current capital leases) or operating leases (comparable to current operating leases). Costs for a finance lease are split between amortization and interest expense, with operating leases reporting a single lease expense. +F- 15 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Topic 842 substantially changed the accounting for sale-leasebacks going forward, where the Company is to assess if the contract qualifies as a sale under ASC 606. We have determined that our equipment sale-leasebacks do not qualify as a sale, as the buyer-lessors do not obtain control of the assets in our ongoing sale-leaseback arrangements. As a result, we expect future sale-leasebacks to be accounted for as a financial liability and the leased assets will be capitalized at cost. As all existing sale-leasebacks have been accounted for as a sale, the Company did not reassess any existing sale-leaseback transactions. +The Company adopted the new leasing standard using the Effective Date Approach, which allows entities to only apply the new lease standard in the year of adoption. The Company elected the available practical expedients for existing or expired contracts of lessees and lessors wherein the Company is not required to reassess whether such contracts contain leases, the lease classification or the initial direct costs. Additionally, the Company elected as accounting policies to not recognize right of use assets or lease liabilities for short-term leases (i.e. those with a term of 12 months or less) and to combine lease and non-lease components in the contract for both lessee and lessor arrangements. Adoption of this standard will result in most of the Company’s operating lease commitments being recognized as operating lease liabilities and right-of-use assets, which will increase total assets by $111.2 million and total liabilities by $109.6 million. +In June 2016, FASB issued ASU 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments . This standard requires the measurement and recognition of expected credit losses held at amortized cost. This new standard requires the use of forward-looking information to estimate credit losses and requires credit losses for available for sale debt securities to be recorded through an allowance for credit losses rather than a reduction in the amortized cost basis. This update is effective for public companies for annual reporting periods beginning after December 15, 2019. We are currently evaluating the impact of this standard on our consolidated financial statements. +In March 2017, the FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Cost (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. These amendments shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes the interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. We are currently evaluating the impact of this standard on our consolidated financial statements. +In August 2018, the FASB adopted ASU 2018-12, Targeted Improvements to the Accounting for Long-Duration Contracts (“ASU 2018-12”). The amendments in this update require insurance companies to annually review and update the assumptions used for measuring the liability under long-duration contracts, such as life insurance, disability income, and annuities. The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 31, 2020. We are currently in the process of evaluating the impact of the adoption of this amendment on our financial statements; however, the adoption of ASU 2018-12 will impact the statements of operations because the effect of any update to the assumptions we used at the inception of the contracts will be recorded in net income. +In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820) - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which modifies the disclosures on fair value measurements by removing the requirement to disclose the amount and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy and the policy for the timing of such transfers. ASU 2018-13 expands the disclosure requirements for Level 3 fair value measurements, primarily focused on changes in unrealized gains and losses included in other comprehensive income. ASU 2018-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. We are currently evaluating the impact of this update on our disclosures in the Notes to Consolidated Financial Statements. +F- 16 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In August 2018, the FASB issued ASU 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General Subtopic 715-20 - Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans (“ASU 2018-14”), which amends ASC 715 to add, remove, and clarify disclosure requirements related to defined benefit pension and other postretirement plans. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. We are currently evaluating the impact of this standard on our consolidated financial statements. +From time to time, new accounting pronouncements are issued by the FASB or the SEC that are adopted by us as of the specified effective date. Unless otherwise discussed, these ASUs entail technical corrections to existing guidance or affect guidance related to specialized industries or entities and therefore will have minimal, if any, impact on our financial position or results of operations upon adoption. +Note 4. Earnings Per Share +Our earnings per share is calculated by dividing our earnings available to common stockholders by the weighted average common shares outstanding, basic and diluted. +The weighted average common shares outstanding exclude post-1992 shares of the employee stock ownership plan that have not been committed to be released. The unreleased shares, net of shares committed to be released, were 11,949; 17,581; and 20,226 as of March 31, 2019, 2018, and 2017, respectively. +Note 5. Reinsurance Recoverables and Trade Receivables, Net +Reinsurance recoverables and trade receivables, net were as follows: +March 31, +2019 +2018 +(In thousands) +Reinsurance recoverable +$ +99,615 +$ +100,335 +Trade accounts receivable +90,786 +65,001 +Paid losses recoverable +2,333 +1,078 +Accrued investment income +25,142 +21,549 +Premiums and agents' balances +1,545 +1,702 +Independent dealer receivable +390 +85 +Other receivables +5,523 +4,284 +225,334 +194,034 +Less: Allowance for doubtful accounts +(549) +(496) +$ +224,785 +$ +193,538 +F- 17 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 6. Investments +Expected maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. +We deposit bonds with insurance regulatory authorities to meet statutory requirements. The adjusted cost of bonds on deposit with insurance regulatory authorities was $30.8 million and $32.4 million as of December 31, 2018 and 2017, respectively. +Available-for-Sale Investments +Available-for-sale investments as of March 31, 2019 were as follows: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses More than 12 Months +Gross +Unrealized +Losses Less than 12 Months +Estimated +Market +Value +(In thousands) +U.S. treasury securities and government obligations +$ +136,010 +$ +2,409 +$ +(2,104) +$ +(447) +$ +135,868 +U.S. government agency mortgage-backed securities +31,101 +433 +(146) +(19) +31,369 +Obligations of states and political subdivisions +298,955 +8,079 +(233) +(905) +305,896 +Corporate securities +1,613,199 +14,777 +(14,257) +(24,986) +1,588,733 +Mortgage-backed securities +148,203 +880 +(285) +(903) +147,895 +Redeemable preferred stocks +1,493 +20 +– +(45) +1,468 +$ +2,228,961 +$ +26,598 +$ +(17,025) +$ +(27,305) +$ +2,211,229 +Available-for-sale investments as of March 31, 2018 were as follows: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses More than 12 Months +Gross +Unrealized +Losses Less than 12 Months +Estimated +Market +Value +(In thousands) +U.S. treasury securities and government obligations +$ +123,557 +$ +3,595 +$ +(1,036) +$ +(203) +$ +125,913 +U.S. government agency mortgage-backed securities +15,941 +572 +– +(93) +16,420 +Obligations of states and political subdivisions +178,702 +9,938 +(217) +(18) +188,405 +Corporate securities +1,388,300 +50,056 +(3,009) +(1,826) +1,433,521 +Mortgage-backed securities +114,581 +2,451 +(1) +(153) +116,878 +Redeemable preferred stocks +2,118 +129 +– +– +2,247 +$ +1,823,199 +$ +66,741 +$ +(4,263) +$ +(2,293) +$ +1,883,384 +The available-for-sale tables include gross unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. +We sold available-for-sale securities with a fair value of $114.8 million, $163.7 million and $190.2 million in fiscal 2019, 2018 and 2017, respectively. The gross realized gains on these sales totaled $2.0 million, $5.4 million and $5.1 million in fiscal 2019, 2018 and 2017, respectively. We realized gross losses on these sales of $0.2 million, $0.3 million and $2.2 million in fiscal 2019, 2018 and 2017, respectively. +The unrealized losses of more than twelve months in the available-for-sale tables are considered temporary declines. We track each investment with an unrealized loss and evaluate them on an individual basis for other-than-temporary impairments, including obtaining corroborating opinions from third party sources, performing trend analysis and reviewing management’s future plans. Certain of these investments may have declines determined by management to be other-than-temporary and we recognized these write-downs through earnings. There were no write downs in fiscal 2019, 2018 and 2017. +F- 18 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The investment portfolio primarily consists of corporate securities and U.S. government securities. We believe we monitor our investments as appropriate. Our methodology of assessing other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors, including the length of time to maturity, the extent to which the fair value has been less than the cost, the financial condition and the near-term prospects of the issuer, and whether the debtor is current on its contractually obligated interest and principal payments. Nothing has come to management’s attention that would lead to the belief that any issuer would not have the ability to meet the remaining contractual obligations of the security, including payment at maturity. We have the ability and intent not to sell our fixed maturity and common stock investments for a period of time sufficient to allow us to recover our costs. +The portion of other-than-temporary impairment related to a credit loss is recognized in earnings. The significant inputs utilized in the evaluation of mortgage backed securities credit losses include ratings, delinquency rates, and prepayment activity. The significant inputs utilized in the evaluation of asset backed securities credit losses include the time frame for principal recovery and the subordination and value of the underlying collateral. +There were no credit losses recognized in earnings for which a portion of an other-than-temporary impairment was recognized in accumulated other comprehensive loss for fiscal 2019, 2018 or 2017. +The adjusted cost and estimated market value of available-for-sale investments by contractual maturity, were as follows: +March 31, 2019 +March 31, 2018 +Amortized +Cost +Estimated +Market +Value +Amortized +Cost +Estimated +Market +Value +(In thousands) +Due in one year or less +$ +71,987 +$ +71,954 +$ +36,446 +$ +36,674 +Due after one year through five years +541,195 +540,658 +441,159 +450,749 +Due after five years through ten years +621,031 +614,485 +607,075 +625,282 +Due after ten years +845,052 +834,769 +621,820 +651,554 +2,079,265 +2,061,866 +1,706,500 +1,764,259 +Mortgage backed securities +148,203 +147,895 +114,581 +116,878 +Redeemable preferred stocks +1,493 +1,468 +2,118 +2,247 +$ +2,228,961 +$ +2,211,229 +$ +1,823,199 +$ +1,883,384 +As of March 31, 2018, equity investments were classified as available-for-sale on our balance sheet. However, upon adoption of ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities , on April 1, 2018, the updated guidance eliminated the available-for-sale balance sheet classification for equity investments. As of March 31, 2019 and 2018, our common stock and non-redeemable preferred stock that are included in Investments, fixed maturities and marketable equities on our balance sheet are stated in the table below. The changes in the fair value of these equity investments are recognized through Net investment and interest income. +Equity investments of common stock and non-redeemable preferred stock were as follows: +March 31, 2019 +March 31, 2018 +Amortized +Cost +Estimated +Market +Value +Amortized +Cost +Estimated +Market +Value +(In thousands) +Common stocks +$ +10,123 +$ +17,379 +$ +15,732 +$ +27,862 +Non-redeemable preferred stocks +7,451 +6,789 +8,491 +8,614 +$ +17,574 +$ +24,168 +$ +24,223 +$ +36,476 +F- 19 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Investments, other +The carrying value of other investments was as follows: +March 31, +2019 +2018 +(In thousands) +Mortgage loans, net +$ +225,829 +$ +309,952 +Short-term investments +5,546 +10,350 +Real estate +53,519 +53,776 +Policy loans +10,491 +17,677 +Other equity investments +5,351 +7,309 +$ +300,736 +$ +399,064 +Mortgage loans are carried at the unpaid balance, less an allowance for probable losses net of any unamortized premium or discount. The portfolio of mortgage loans is principally collateralized by self-storage facilities and commercial properties. The interest rate range on the mortgage loans is 4.1% to 8.2% with maturities between 2019 and 2036. The allowance for probable losses was $0.5 million and $0.5 million as of March 31, 2019 and 2018, respectively. The estimated fair value of these loans as of March 31, 2019 and 2018 approximated the carrying value. These loans represent first lien mortgages held by us. Mortgage loans are reviewed on an ongoing basis and analysis may include market analysis, estimated valuations of the underlying collateral, loan to value ratios, tenant creditworthiness and other factors. For our mortgage loans, no specifically identified loans were impaired as of March 31, 2019. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. +Short-term investments consist primarily of investments in money market funds, mutual funds and any other investments with short-term characteristics that have original maturities of less than one year at acquisition. These investments are recorded at cost, which approximates fair value. +Real estate held for investment is carried at the lower of fair value at time of acquisition or current estimated fair value less cost to sell. Other equity investments are carried at cost and assessed for impairment. +Insurance policy loans are carried at their unpaid balance. +Note 7. Other Assets +Other assets were as follows: +March 31, +2019 +2018 +(In thousands) +Deposits (debt-related) +$ +30,408 +$ +33,546 +Cash surrender value of life insurance policies +30,985 +31,904 +Deposits (real estate related) +16,961 +19,332 +Insurance recoveries +– +160,000 +$ +78,354 +$ +244,782 +F- 20 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 8. Net Investment and Interest Income +Net investment and interest income, were as follows: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Fixed maturities +$ +99,348 +$ +84,476 +$ +73,041 +Real estate +5,538 +5,344 +5,189 +Insurance policy loans +1,305 +1,212 +1,212 +Mortgage loans +16,674 +17,783 +20,617 +Short-term, amounts held by ceding reinsurers, net and other investments +(7,429) +3,098 +1,157 +Investment income +115,436 +111,913 +101,216 +Less: investment expenses +(4,502) +(4,766) +(3,820) +Investment income - related party, net eliminations +– +3,326 +4,880 +Net investment and interest income +$ +110,934 +$ +110,473 +$ +102,276 +Note 9. Borrowings +Long-Term Debt +Long-term debt was as follows: +March 31, +2019 Rate (a) +Maturities +2019 +2018 +(In thousands) +Real estate loan (amortizing term) +3.99% +2023 +$ +102,913 +$ +135,287 +Senior mortgages +3.72% - 6.62% +2021 - 2038 +1,741,652 +1,487,645 +Real estate loans (revolving credit) +3.74% - 3.99% +2021 - 2024 +429,400 +55,000 +Fleet loans (amortizing term) +1.95% - 4.66% +2019 - 2025 +263,209 +342,971 +Fleet loans (revolving credit) +3.64% +2021 - 2023 +530,000 +460,000 +Capital leases (rental equipment) +1.92% - 5.04% +2019 - 2026 +1,042,652 +984,217 +Other obligations +2.75% - 8.00% +2019 - 2048 +82,417 +73,579 +Notes, loans and leases payable +$ +4,192,243 +$ +3,538,699 +Less: Debt issuance costs +(28,920) +(25,623) +Total notes, loans and leases payable, net +$ +4,163,323 +$ +3,513,076 +(a) Interest rate as of March 31, 2019, taking into account the effect of applicable hedging instruments +Real Estate Backed Loans +Real Estate Loan +Real Estate and certain of its subsidiaries and U-Haul Company of Florida are borrowers under a real estate loan (the “Real Estate Loan”). The Real Estate Loan requires monthly principal and interest payments, with the unpaid loan balance and accrued and unpaid interest due at maturity. The Real Estate Loan is secured by various properties owned by the borrowers.. +The interest rate, per the provisions of the amended loan agreement, is the applicable London Inter-Bank Offer Rate (“LIBOR”) plus the applicable margin. As of March 31, 2019, the applicable LIBOR was 2.49% and the applicable margin was 1.50%, the sum of which was 3.99%. The default provisions of the Real Estate Loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. There are limited restrictions regarding our use of the funds. +F- 21 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Senior Mortgages +Various subsidiaries of Real Estate and U-Haul are borrowers under certain senior mortgages. The senior mortgages require monthly principal and interest payments. The senior mortgages are secured by certain properties owned by the borrowers. The fixed interest rates, per the provisions of the senior mortgages, range between 3.72% and 6.62%. Certain senior mortgages have an anticipated repayment date and a maturity date. If these senior mortgages are not repaid by the anticipated repayment date, the interest rate on these mortgages would increase from the current fixed rate. We are using the anticipated repayment date for our maturity schedule. Real Estate and U-Haul have provided limited guarantees of the senior mortgages. The default provisions of the senior mortgages include non-payment of principal or interest and other standard reporting and change-in-control covenants. There are limited restrictions regarding our use of the funds. +Real Estate Loans (Revolving Credit) +Various subsidiaries of Real Estate are borrowers under asset-backed real estate loans with an aggregate borrowing capacity of 335.0 million. As of March 31, 2019, the outstanding balance of these loans in the aggregate was $329.4 million. These loans are secured by certain properties owned by the borrowers. The loan agreements provide for term loans, subject to the terms of the loan agreements. The final maturity of the loans is between June 2021 and February 2024. The loans require monthly interest payments with the unpaid loan balance and accrued and unpaid interest due at maturity. The interest rate, per the provision of the loan agreements, is the applicable LIBOR plus the applicable margin. As of March 31, 2019, the applicable LIBOR was between 2.49% and 2.50% and the margin was between 1.25% and 1.50%, the sum of which was between 3.74% and 3.99%. AMERCO is the guarantor of these loans. The default provisions of the loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. +AMERCO is a borrower under a real estate loan. The current maximum credit commitment is $150.0 million, which can be increased to $300.0 million by bringing in other lenders. As of March 31, 2019, the outstanding balance was $100.0 million. This loan agreement provides for revolving loans, subject to the terms of the loan agreement. The final maturity of this loan is September 2021. This loan requires monthly interest payments with the unpaid loan balance and accrued and unpaid interest due at maturity. As of March 31, 2019, the applicable LIBOR was 2.49% and the margin was 1.38%, the sum of which was 3.87%. The default provisions of the loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. There is a 0.30% fee charged for unused capacity. +Fleet Loans +Rental Truck Amortizing Loans +The amortizing loans require monthly principal and interest payments, with the unpaid loan balance and accrued and unpaid interest due at maturity. These loans were used to purchase new trucks. The interest rates, per the provision of the loan agreements, are the applicable LIBOR plus the applicable margins. As of March 31, 2019, the applicable LIBOR was between 2.48% and 2.49% and applicable margins were between 1.72% and 1.75%. The interest rates are hedged with interest rate swaps fixing the rates between 2.82% and 3.00% based on current margins. Additionally, $241.4 million of these loans are carried at fixed rates ranging between 1.95% and 4.66%. +AMERCO, and in some cases U-Haul, is guarantor of these loans. The default provisions of these loans include non-payment of principal or interest and other standard reporting and change-in-control covenants. +F- 22 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Rental Truck Revolvers +Various subsidiaries of U-Haul entered into three revolving fleet loans with an aggregate borrowing capacity of $555.0 million. The interest rates, per the provision of the loan agreements, are the applicable LIBOR plus the applicable margin. As of March 31, 2019, the applicable LIBOR was 2.49%, and the margin was 1.15%, the sum of which was 3.64%. Only interest is paid on the loans until the last nine months of the respective loan terms when principal becomes due monthly. In April 2019, the rental truck revolving loan that was scheduled to mature in January 2021 was extended to May 2024 and availability increased by $10.0 million. +Capital Leases +We regularly enter into capital leases for new equipment with the terms of the leases between five and seven years. During fiscal 2019, we entered into $348.4 million of new capital leases. As of March 31, 2019 the interest rates were between 1.92% and 5.04%. The net book value of the corresponding capitalized assets was $1,574.0 million and $1,407.6 million as of March 31, 2019 and March 31, 2018, respectively. +Other Obligations +In February 2011, AMERCO and U.S. Bank, NA (the “Trustee”) entered into the U-Haul Investors Club ® Indenture. AMERCO and the Trustee entered into this indenture to provide for the issuance of notes by us directly to investors over our proprietary website, uhaulinvestorsclub.com (“U-Notes ® ”). The U-Notes ® are secured by various types of collateral including, but not limited to, rental equipment and real estate. U-Notes ® are issued in smaller series that vary as to principal amount, interest rate and maturity. U-Notes ® are obligations of the Company and secured by the associated collateral; they are not guaranteed by any of the Company’s affiliates or subsidiaries. +As of March 31, 2019, the aggregate outstanding principal balance of the U-Notes ® issued was $85.6 million, of which $3.2 million is held by our insurance subsidiaries and eliminated in consolidation. Interest rates range between 2.75% and 8.00% and maturity dates range between 2019 and 2048. +Oxford is a member of the Federal Home Loan Bank (“FHLB”) and, as such, the FHLB has made deposits with Oxford. As of December 31, 2018, the deposits had an aggregate balance of $60.0 million, for which Oxford pays fixed interest rates between 1.67% and 2.95% with maturities between September 29, 2019 and March 29, 2021. As of December 31, 2018, available-for-sale investments held with the FHLB totaled $124.4 million, of which $69.8 million were pledged as collateral to secure the outstanding deposits. The balances of these deposits are included within Liabilities from investment contracts on the condensed consolidated balance sheets. +Annual Maturities of Notes, Loans and Leases Payable +The annual maturities of our notes, loans and leases payable as of March 31, 2019 for the next five years and thereafter are as follows: +Years Ended March 31, +2020 +2021 +2022 +2023 +2024 +Thereafter +Total +(In thousands) +Notes, loans and leases payable, secured +$ +475,898 +$ +544,868 +$ +749,209 +$ +540,888 +$ +524,778 +$ +1,356,602 +$ +4,192,243 +F- 23 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 10. Interest on Borrowings +Interest Expense +Components of interest expense include the following: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Interest expense +$ +150,609 +$ +125,412 +$ +106,221 +Capitalized interest +(12,733) +(6,466) +(4,863) +Amortization of transaction costs +3,745 +3,867 +3,445 +Interest expense resulting from cash flow hedges +824 +3,893 +8,603 +Total interest expense +142,445 +126,706 +113,406 +Amortization on early extinguishment of debt +– +– +499 +Total +$ +142,445 +$ +126,706 +$ +113,905 +Interest paid in cash, including payments related to derivative contracts, amounted to $149.8 million, $129.3 million and $113.7 million for fiscal 2019, 2018 and 2017, respectively. +Interest Rates +Interest rates and our revolving credit borrowings were as follows: +Revolving Credit Activity +Years Ended March 31, +2019 +2018 +2017 +(In thousands, except interest rates) +Weighted average interest rate during the year +3.39% +2.48% +1.83% +Interest rate at year end +3.60% +2.84% +2.06% +Maximum amount outstanding during the year +$ +959,400 +$ +538,000 +$ +597,000 +Average amount outstanding during the year +$ +699,415 +$ +517,997 +$ +477,888 +Facility fees +$ +374 +$ +410 +$ +158 +Note 11. Derivatives +We manage exposure to changes in market interest rates. Our use of derivative instruments is limited to highly effective interest rate swaps to hedge the risk of changes in cash flows (future interest payments) attributable to changes in LIBOR swap rates, with the designated benchmark interest rate being hedged on certain of our LIBOR indexed variable rate debt and a variable rate operating lease. The interest rate swaps effectively fix our interest payments on certain LIBOR indexed variable rate debt. We monitor our positions and the credit ratings of its counterparties and do not currently anticipate non-performance by the counterparties. Interest rate swap agreements are not entered into for trading purposes. +F- 24 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The derivative fair values reflected in prepaid expense and accounts payable and accrued expenses in the balance sheets were as follows: +March 31, 2019 +March 31, 2018 +(In thousands) +Interest rate contracts designated as hedging instruments +Assets +$ +139 +$ +437 +Liabilities +– +(897) +Notional amount (debt) +22,792 +123,779 +Notional amount (lease) +– +6,182 +The Effect of Interest Rate +Contracts on the Statements of Operations +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Loss recognized in income on interest rate contracts +$ +824 +$ +3,893 +$ +8,603 +Gain recognized in AOCI on interest rate contracts (effective portion) +$ +(633) +$ +(4,445) +$ +(9,916) +Loss reclassified from AOCI into income (effective portion) +$ +789 +$ +3,893 +$ +8,628 +(Gain) loss recognized in income on interest rate contracts (ineffective portion and amount excluded from effectiveness testing) +$ +35 +$ +– +$ +(25) +Gains or losses recognized in income on derivatives are recorded as interest expense in the statements of operations. During fiscal 2019, we recognized an increase in the fair value of our cash flows hedges of $0.5 million, net of taxes. Embedded in this change was $0.8 million of losses reclassified from accumulated other comprehensive income (loss) to interest expense during the year. As of March 31, 2019, we expect to reclassify $0.2 million of net gains on interest rate contracts from accumulated other comprehensive income (loss) (“AOCI”) to earnings as interest expense over the next twelve months. Please see Note 3, Accounting Policies, in the Notes to Consolidated Financial Statements. +We use derivatives to hedge our equity market exposure to indexed annuity products sold by our Life Insurance company. These contracts earn a return for the contractholder based on the change in the value of the S&P 500 index between annual index point dates. We buy and sell listed equity and index call options and call option spreads. The credit risk is with the party in which the options are written. The net option price is paid up front and there are no additional cash requirements or additional contingent liabilities. These contracts are held at fair market value on our balance sheet. At March 31, 2019 and 2018, these derivative hedges had a net market value of $1.5 million and $4.4 million, with notional amounts of $284.0 million and $227.4 million, respectively. These derivative instruments are included in Investments, other; on the consolidated balance sheets. +Although the call options are employed to be effective hedges against our policyholder obligations from an economic standpoint, they do not meet the requirements for hedge accounting under GAAP. Accordingly, the call options are marked to fair value on each reporting date with the change in fair value, plus or minus, included as a component of net investment and interest income. The change in fair value of the call options includes the gains or losses recognized at the expiration of the option term and the changes in fair value for open contracts. +F- 25 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 12. Stockholders’ Equity +The following table lists the dividends that have been declared and issued since July 2017. +Common Stock Dividends +Declared Date +Per Share Amount +Record Date +Dividend Date +March 6, 2019 +$ +0.50 +March 21, 2019 +April 4, 2019 +December 5, 2018 +0.50 +December 20, 2018 +January 7, 2019 +August 23, 2018 +0.50 +September 10, 2018 +September 24, 2018 +June 6, 2018 +0.50 +June 21, 2018 +July 5, 2018 +March 8, 2018 +0.50 +March 23, 2018 +April 6, 2018 +December 6, 2017 +0.50 +December 21, 2017 +January 5, 2018 +July 5, 2017 +1.00 +July 20, 2017 +August 3, 2017 +On June 8, 2016, our stockholders’ approved the 2016 AMERCO Stock Option Plan (Shelf Stock Option Plan). As of March 31, 2019, no awards had been issued under this plan. +Note 13. Provision for Taxes +Earnings before taxes and the provision for taxes consisted of the following: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Pretax earnings: +U.S. +$ +466,175 +$ +628,901 +$ +609,589 +Non-U.S. +11,354 +8,712 +18,769 +Total pretax earnings +$ +477,529 +$ +637,613 +$ +628,358 +Current provision (benefit) +Federal +$ +(6,114) +$ +21,780 +$ +38,723 +State +3,420 +6,471 +10,818 +Non-U.S. +1,375 +1,412 +3,334 +(1,319) +29,663 +52,875 +Deferred provision (benefit) +Federal +94,961 +(199,415) +160,527 +State +11,311 +15,479 +15,210 +Non-U.S. +1,719 +1,303 +1,322 +107,991 +(182,633) +177,059 +Provision for income tax expense (benefit) +$ +106,672 +$ +(152,970) +$ +229,934 +Income taxes paid (net of income tax refunds received) +$ +4,255 +$ +68,671 +$ +36,880 +F- 26 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The difference between the tax provision at the statutory federal income tax rate and the tax provision attributable to income before taxes was as follows: +Years Ended March 31, +2019 +2018 +2017 +Statutory federal income tax rate +21.00% +31.55% +35.00% +Increase (reduction) in rate resulting from: +Deferred tax liability revaluation +0.00% +(58.25)% +0.00% +State taxes, net of federal benefit +2.41% +2.33% +2.66% +Foreign rate differential +0.15% +0.00% +(0.31)% +Federal tax credits +(0.15)% +(0.32)% +(0.41)% +Transition tax +(0.20)% +1.83% +0.00% +Dividend received deduction +(0.01)% +(0.03)% +(0.03)% +Phase III tax +0.00% +0.63% +0.00% +Other +(0.86)% +(1.73)% +(0.32)% +Actual tax expense (benefit) of operations +22.34% +(23.99)% +36.59% +Significant components of our deferred tax assets and liabilities were as follows: +March 31, +2019 +2018 +(In thousands) +Deferred tax assets: +Net operating loss and credit carry forwards +$ +90,061 +$ +3,136 +Accrued expenses +105,727 +104,309 +Policy benefit and losses, claims and loss expenses payable, net +16,515 +11,148 +Total deferred tax assets +$ +212,303 +$ +118,593 +Deferred tax liabilities: +Property, plant and equipment +$ +940,433 +$ +741,607 +Deferred policy acquisition costs +14,191 +12,995 +Unrealized gains +4,223 +18,863 +Other +4,426 +3,236 +Total deferred tax liabilities +963,273 +776,701 +Net deferred tax liability +$ +750,970 +$ +658,108 +The net operating loss (“NOL”) and credit carry-forwards in the above table are primarily attributable to $358.9 million of federal NOLs and $172.3 million of state NOLs. The federal NOL consists of $266.8 million as of March 31, 2019, and $92.1 million as of March 31, 2018 . The federal NOL as of March 31, 2019 has an indefinite life, but is subject to the single tax year limitation under section 172 (a) equal to the lesser of available NOL carryover or 80% of a taxpayer's pre-NOL deduction taxable income (the "80% limitation"). The federal NOL as of March 31, 2018 is not limited and can be carried forward to offset taxable income for 20 years. As of March 31, 2019 and March 31, 2018, AMERCO had state NOLs of $172.3 million and $45.3 million, respectively, that will begin to expire March 31, 2020, if not utilized. +The Tax Cuts and Jobs Act (the “Tax Reform Act”) was enacted on December 22, 2017. The Tax Reform Act reduced the U.S. federal corporate income tax rate from 35% to 21%, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and repealed the deferral of the phase three tax for life insurance companies. The blended statutory Federal Tax Rate for our full fiscal year ended March 31, 2018 was 31.55%. As of December 22, 2018, we have completed our accounting for the tax effects of enactment of the Tax Reform Act. For the fiscal year ended March 31, 2018, we recognized a benefit amount of $356.6 million which was included as a component of income tax expense from continuing operations. +F- 27 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +For the fiscal year ended March 31, 2018, we re-measured certain tax deferred assets and liabilities based on the rates they are expected to reverse in the future, which is generally 21%. The amount recorded related to the re-measurement of our deferred tax balance was a benefit of $371.5 million for the fiscal year ended March 31, 2018. +As of December 31, 2017, we elected to reclassify the income tax effects of the Tax Reform Act in the amount of $8.7 million from accumulated other comprehensive income to retained earnings under ASU 2018-02. In addition, we have adopted the “investment by investment” approach with regard to releasing disproportionate income tax effects from accumulated other comprehensive income. +For the fiscal year ended March 31, 2018, we calculated and recorded a one-time transition tax on earnings from foreign subsidiaries based on the post 1986 earnings and profits (“E&P”) of our Canadian subsidiaries that were previously deferred from U.S. income taxes. The effect of this one-time transition tax liability for our foreign subsidiaries resulted in an increase in income tax expense of $10.7 million for the fiscal year ended March 31, 2018. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to transition tax, or any additional outside basis difference inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in these entities (i.e., basis difference in excess of that subject to the one-time transition tax) is not practicable. +The Tax Reform Act repeals the special rules with regard to distribution to shareholders from pre-1984 policyholders surplus account. This one-time tax was based on the balance of our pre-1984 policyholder surplus account. We reported the amount of our one-time tax liability for Phase Three Tax, resulting in an increase in income tax expense of $4.2 million for the fiscal year ended March 31, 2018. +ASC 740 prescribes a minimum recognition and measurement methodology that a tax position is required to meet before being recognized in the financial statements. A reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period are as follows: +Unrecognized Tax Benefits +March 31, +2019 +2018 +(In thousands) +Unrecognized tax benefits beginning balance +$ +35,739 +$ +26,720 +Revaluation based on change in after tax benefit +– +5,755 +Additions based on tax positions related to the current year +1,887 +4,139 +Reductions for tax positions of prior years +(46) +(96) +Settlements +(379) +(779) +Unrecognized tax benefits ending balance +$ +37,201 +$ +35,739 +We recognize interest related to unrecognized tax benefits as interest expense, and penalties as operating expenses. At March 31, 2019 and 2018, the amount of interest and penalties accrued on unrecognized tax benefits was $9.5 million and $8.5 million, net of tax. During the current year we recorded expense from interest and penalties in the amount of $1.0 million, net of tax. +We file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With some exceptions, we are no longer subject to audit for years prior to the fiscal year ended March 31, 2016. +F- 28 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 14. Employee Benefit Plans +Profit Sharing Plans +We provide tax-qualified profit sharing retirement plans for the benefit of eligible employees, former employees and retirees in the United States and Canada. The plans are designed to provide employees with an accumulation of funds for retirement on a tax-deferred basis and provide for annual discretionary employer contributions. Amounts to be contributed are determined by the President and Chairman of the Board of Directors (the “Board”) of the Company under the delegation of authority from the Board, pursuant to the terms of the Profit Sharing Plan. No contributions were made to the profit sharing plan during fiscal 2019, 2018 or 2017. +We also provide an employee savings plan which allows participants to defer income under Section 401(k) of the Internal Revenue Code of 1986. +ESOP Plan +We sponsor a leveraged ESOP that generally covers all employees with one year or more of service. The ESOP shares initially were pledged as collateral for its debt which was originally funded by U-Haul. We make annual contributions to the ESOP equal to the ESOP’s debt service. As the debt is repaid, shares are released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. ESOP shares are committed to be released monthly and ESOP compensation expense is recorded based on the current market price at the end of the month. These shares then become outstanding for the earnings per share computations. ESOP compensation expense was $11.3 million, $11.4 million and $10.7 million for fiscal 2019, 2018 and 2017, respectively. +Listed below is a summary of these financing arrangements as of fiscal year-end: +Outstanding as of +Interest Payments +Financing Date +March 31, 2019 +2019 +2018 +2017 +(In thousands) +June, 1991 +$ +– +$ +1 +$ +1 +$ +2 +July, 2009 +233 +17 +26 +36 +February, 2016 +4,966 +190 +242 +– +Leveraged contributions to the Plan Trust during fiscal 2019, 2018 and 2017 were $1.0 million, $1.0 million and $0.2 million, respectively. In fiscal 2019, 2018 and 2017, the Company made non-leveraged contributions of $5.0 million, $11.0 and $11.0 million, respectively to the Plan Trust. In both fiscal 2018 and 2017, $0.1 million of dividends from unallocated shares were applied to debt. +Shares held by the Plan were as follows: +Years Ended March 31, +2019 +2018 +(In thousands) +Allocated shares +1,069 +1,112 +Unreleased shares - leveraged +16 +19 +Fair value of unreleased shares - leveraged +$ +6,019 +$ +6,448 +Unreleased shares - non-leveraged +– +13 +Fair value of unreleased shares - non-leveraged +$ +– +$ +4,557 +The fair value of unreleased shares issued prior to 1992 is defined as the historical cost of such shares. The fair value of unreleased shares issued subsequent to December 31, 1992 is defined as the trading value of such shares as of March 31, 2019 and March 31, 2018, respectively. During fiscal 2019, we released for allocation 3,661 leveraged shares and 27,969 non-leveraged shares. As of December 31, 2019, it is estimated there will be 16,260 shares committed to be released. +F- 29 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Post Retirement and Post Employment Benefits +We provide medical and life insurance benefits to our eligible employees and their dependents upon retirement from the Company. The retirees must have attained age sixty-five and earned twenty years of full-time service upon retirement for coverage under the medical plan. The medical benefits are capped at a $20,000 lifetime maximum per covered person. The benefits are coordinated with Medicare and any other medical policies in force. Retirees who have attained age sixty-five and earned at least ten years of full-time service upon retirement from the Company are entitled to group term life insurance benefits. The life insurance benefit is $2,000 plus $100 for each year of employment over ten years. The plan is not funded and claims are paid as they are incurred. We use a March 31 measurement date for our post retirement benefit disclosures. +The components of net periodic post retirement benefit cost were as follows: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Service cost for benefits earned during the period +$ +1,108 +$ +1,073 +$ +1,026 +Other components of net periodic benefit costs: +Interest cost on accumulated postretirement benefit +943 +869 +814 +Other components +70 +58 +88 +Total other components of net periodic benefit costs +1,013 +927 +902 +Net periodic postretirement benefit cost +$ +2,121 +$ +2,000 +$ +1,928 +The fiscal 2019 and fiscal 2018 post retirement benefit liability included the following components: +Years Ended March 31, +2019 +2018 +(In thousands) +Beginning of year +$ +23,316 +$ +22,247 +Service cost for benefits earned during the period +1,108 +1,073 +Interest cost on accumulated post retirement benefit +943 +869 +Net benefit payments and expense +(979) +(644) +Actuarial (gain) loss +1,429 +(229) +Accumulated postretirement benefit obligation +25,817 +23,316 +Current liabilities +1,037 +802 +Non-current liabilities +24,780 +22,514 +Total post retirement benefit liability recognized in statement of financial position +25,817 +23,316 +Components included in accumulated other comprehensive income (loss): +Unrecognized net loss +(3,890) +(2,530) +Cumulative net periodic benefit cost (in excess of employer contribution) +$ +21,927 +$ +20,786 +The discount rate assumptions in computing the information above were as follows: +Years Ended March 31, +2019 +2018 +2017 +(In percentages) +Accumulated postretirement benefit obligation +3.83% +3.98% +3.94% +F- 30 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 became law. Net periodic post retirement benefit cost above includes the effect of the subsidy. The discount rate represents the expected yield on a portfolio of high grade (AA to AAA rated or equivalent) fixed income investments with cash flow streams sufficient to satisfy benefit obligations under the plan when due. Fluctuations in the discount rate assumptions primarily reflect changes in U.S. interest rates. The assumed health care cost trend rate used to measure the accumulated postretirement benefit obligation as of the end of fiscal 2019 was 6.7% in the initial year and was projected to decline annually to an ultimate rate of 4.5% in fiscal 2038. The assumed health care cost trend rate used to measure the accumulated post retirement benefit obligation as of the end of fiscal 2018 (and used to measure the fiscal 2019 net periodic benefit cost) was 6.9% in the initial year and was projected to decline annually to an ultimate rate of 4.5% in fiscal 2038. +If the estimated health care cost trend rate assumptions were increased by one percent, the accumulated post retirement benefit obligation as of fiscal year-end would increase by $274 thousand and the total of the service cost and interest cost components would increase by $27 thousand. A decrease in the estimated health care cost trend rate assumption of one percent would decrease the accumulated post retirement benefit obligation as of fiscal year-end by $309 thousand and the total of the service cost and interest cost components would decrease by $31 thousand. +Post employment benefits provided by us, other than upon retirement, are not material. +Future net benefit payments are expected as follows: +Future Net Benefit Payments +(In thousands) +Year-ended: +2020 +$ +1,037 +2021 +1,227 +2022 +1,445 +2023 +1,665 +2024 +1,906 +2025 through 2028 +11,863 +Total +$ +19,143 +Note 15. Fair Value Measurements +Assets and liabilities are recorded at fair value on the consolidated balance sheets and are measured and classified based upon a three-tiered approach to valuation. Financial assets and liabilities recorded at fair value and are classified and disclosed in one of the following three categories: +Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2 – Quoted prices for identical or similar financial instruments in markets that are not considered to be active, or similar financial instruments for which all significant inputs are observable, either directly or indirectly, or inputs other than quoted prices that are observable, or inputs that are derived principally from or corroborated by observable market data through correlation or other means; and +Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and are unobservable. These reflect management’s assumptions about the assumptions a market participant would use in pricing the asset or liability. +A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. +Fair values of cash equivalents approximate carrying value due to the short period of time to maturity. Fair values of short-term investments, investments available-for-sale, long-term investments, mortgage loans and notes on real estate, and interest rate swap contracts are based on quoted market prices, dealer quotes or discounted cash flows. Fair values of trade receivables approximate their recorded +F- 31 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +value. +Our financial instruments that are exposed to concentrations of credit risk consist primarily of temporary cash investments, trade receivables, reinsurance recoverables and notes receivable. Limited credit risk exists on trade receivables due to the diversity of our customer base and their dispersion across broad geographic markets. We place our temporary cash investments with financial institutions and limit the amount of credit exposure to any one financial institution. +We have mortgage receivables, which potentially expose us to credit risk. The portfolio of notes is principally collateralized by self-storage facilities and commercial properties. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. The estimated fair values were determined using the discounted cash flow method and using interest rates currently offered for similar loans to borrowers with similar credit ratings. +The carrying amount of long-term debt and short-term borrowings are estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for debt of similar term and remaining maturity. +Other investments including short-term investments are substantially current or bear reasonable interest rates. As a result, the carrying values of these financial instruments approximate fair value. +The carrying values and estimated fair values for the financial instruments stated above and their placement in the fair value hierarchy are as follows: +Fair Value Hierarchy +Carrying +Total Estimated +Year Ended March 31, 2019 +Value +Level 1 +Level 2 +Level 3 +Fair Value +(In thousands) +Assets +Reinsurance recoverables and trade receivables, net +$ +224,785 +$ +– +$ +– +$ +224,785 +$ +224,785 +Mortgage loans, net +225,829 +– +– +225,829 +225,829 +Other investments +74,907 +– +– +74,907 +74,907 +Total +$ +525,521 +$ +– +$ +– +$ +525,521 +$ +525,521 +Liabilities +Notes, loans and leases payable +4,192,243 +– +4,192,243 +– +4,192,243 +Total +$ +4,192,243 +$ +– +$ +4,192,243 +$ +– +$ +4,192,243 +Fair Value Hierarchy +Carrying +Total Estimated +Year Ended March 31, 2018 +Value +Level 1 +Level 2 +Level 3 +Fair Value +(In thousands) +Assets +Reinsurance recoverables and trade receivables, net +$ +193,538 +$ +– +$ +– +$ +193,538 +$ +193,538 +Mortgage loans, net +309,952 +– +– +309,952 +309,952 +Other investments +89,112 +– +– +89,112 +89,112 +Total +$ +592,602 +$ +– +$ +– +$ +592,602 +$ +592,602 +Liabilities +Notes, loans and leases payable +3,538,699 +– +3,538,699 +– +3,538,699 +Total +$ +3,538,699 +$ +– +$ +3,538,699 +$ +– +$ +3,538,699 +F- 32 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The following tables represent the financial assets and liabilities on the condensed consolidated balance sheets as of March 31, 2019 and 2018, that are measured at fair value on a recurring basis and the level within the fair value hierarchy. +Year Ended March 31, 2019 +Total +Level 1 +Level 2 +Level 3 +(In thousands) +Assets +Short-term investments +$ +463,847 +$ +463,599 +$ +248 +$ +– +Fixed maturities - available for sale +2,209,761 +7,327 +2,202,213 +221 +Preferred stock +8,257 +8,257 +– +– +Common stock +17,379 +17,379 +– +– +Derivatives +1,607 +1,468 +139 +– +Total +$ +2,700,851 +$ +498,030 +$ +2,202,600 +$ +221 +Liabilities +Derivatives +– +– +– +– +Total +$ +– +$ +– +$ +– +$ +– +Year Ended March 31, 2018 +Total +Level 1 +Level 2 +Level 3 +(In thousands) +Assets +Short-term investments +$ +475,320 +$ +475,320 +$ +– +$ +– +Fixed maturities - available for sale +1,881,137 +7,567 +1,873,293 +277 +Preferred stock +10,861 +10,861 +– +– +Common stock +27,862 +27,862 +– +– +Derivatives +4,825 +4,388 +437 +– +Total +$ +2,400,005 +$ +525,998 +$ +1,873,730 +$ +277 +Liabilities +Derivatives +897 +– +897 +– +Total +$ +897 +$ +– +$ +897 +$ +– +The following tables represent the fair value measurements for our assets as of March 31, 2019 using significant unobservable inputs (Level 3). +Fixed Maturities - Asset Backed Securities +(In thousands) +Balance at March 31, 2017 +$ +330 +Fixed Maturities - Asset Backed Securities - redeemed +(91) +Fixed Maturities - Asset Backed Securities - net gain (unrealized) +38 +Balance at March 31, 2018 +$ +277 +Fixed Maturities - Asset Backed Securities - redeemed +(96) +Fixed Maturities - Asset Backed Securities - net gain (unrealized) +40 +Balance at March 31, 2019 +$ +221 +F- 33 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 16. Reinsurance and Policy Benefits and Losses, Claims and Loss Expenses Payable +During their normal course of business, our insurance subsidiaries assume and cede reinsurance on both a coinsurance and a risk premium basis. They also obtain reinsurance for that portion of risks exceeding their retention limits. The maximum amount of life insurance retained on any one life is $125,000. +Direct +Amount (a) +Ceded to +Other +Companies +Assumed +from Other +Companies +Net +Amount (a) +Percentage of +Amount +Assumed to Net +(In thousands) +Year ended December 31, 2018 +Life insurance in force +$ +941,822 +$ +207 +$ +548,152 +$ +1,489,767 +37% +Premiums earned: +Life +$ +51,691 +$ +(1) +$ +(69,616) +$ +(17,924) +388% +Accident and health +77,813 +267 +1,851 +79,397 +2% +Annuity +1,221 +– +794 +2,015 +39% +Property and casualty +60,848 +– +– +60,848 +0% +Total +$ +191,573 +$ +266 +$ +(66,971) +$ +124,336 +Year ended December 31, 2017 +Life insurance in force +$ +947,720 +$ +248 +$ +876,865 +$ +1,824,337 +48% +Premiums earned: +Life +$ +51,227 +$ +4 +$ +9,880 +$ +61,103 +16% +Accident and health +90,396 +295 +1,977 +92,078 +2% +Annuity +728 +– +794 +1,522 +52% +Property and casualty +57,161 +69 +8 +57,100 +0% +Total +$ +199,512 +$ +368 +$ +12,659 +$ +211,803 +Year ended December 31, 2016 +Life insurance in force +$ +937,779 +$ +249 +$ +915,769 +$ +1,853,299 +49% +Premiums earned: +Life +$ +50,251 +$ +– +$ +10,626 +$ +60,877 +17% +Accident and health +99,450 +310 +2,263 +101,403 +2% +Annuity +505 +– +794 +1,299 +61% +Property and casualty +52,329 +– +5 +52,334 +0% +Total +$ +202,535 +$ +310 +$ +13,688 +$ +215,913 +(a) Balances are reported net of inter-segment transactions. +To the extent that a reinsurer is unable to meet its obligation under the related reinsurance agreements, Repwest would remain liable for the unpaid losses and loss expenses. Pursuant to certain of these agreements, Repwest holds letters of credit as of December 31, 2017 in the amount of $0.1 million from re-insurers and has issued letters of credit in the amount of $1.9 million in favor of certain ceding companies. +F- 34 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Policy benefits and losses, claims and loss expenses payable for Property and Casualty Insurance were as follows: +December 31, +2018 +2017 +(In thousands) +Unpaid losses and loss adjustment expense +$ +228,970 +$ +233,554 +Reinsurance losses payable +988 +805 +Total +$ +229,958 +$ +234,359 +Activity in the liability for unpaid losses and loss adjustment expenses for Property and Casualty Insurance is summarized as follows: +December 31, +2018 +2017 +2016 +(In thousands) +Balance at January 1 +$ +233,554 +$ +244,400 +$ +251,964 +Less: reinsurance recoverable +94,490 +103,952 +107,311 +Net balance at January 1 +139,064 +140,448 +144,653 +Incurred related to: +Current year +19,579 +15,749 +13,297 +Prior years +(5,365) +233 +107 +Total incurred +14,214 +15,982 +13,404 +Paid related to: +Current year +8,838 +8,969 +7,777 +Prior years +10,390 +8,397 +9,832 +Total paid +19,228 +17,366 +17,609 +Net balance at December 31 +134,050 +139,064 +140,448 +Plus: reinsurance recoverable +94,920 +94,490 +103,952 +Balance at December 31 +$ +228,970 +$ +233,554 +$ +244,400 +Prior year incurred losses were impacted by favorable development on numerous Excess Workers Compensation claims. The liability for incurred losses and loss adjustment expenses (net of reinsurance recoverable of $94.9 million) decreased by $5.1 million as of December 31, 2018. +F- 35 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The information about property and casualty incurred and paid loss and loss adjustment expense development for the years end December 31, 2012 through 2018, and the average annual percentage payout of incurred claims by age as of December 31, 2018, is presented as supplementary information. Claims data for 2012 through 2017 is unaudited. Claims data for 2018 is audited. +As of +December 31, 2018 +Total of +Incurred-but- +Not-Reported +Liabilities Plus +Expected +Cumulative +Development +Number of +Accident +on Reported +Reported +Year +2012 +2013 +2014 +2015 +2016 +2017 +2018 +Claims +Claims +(In thousands, except claim counts) +2012 +$ +8,971 +$ +8,903 +$ +8,831 +$ +8,788 +$ +8,753 +$ +8,735 +$ +8,735 +$ +– +6,889 +2013 +9,861 +9,853 +9,914 +9,741 +9,576 +9,595 +– +7,663 +2014 +11,691 +10,907 +10,720 +10,759 +10,748 +323 +9,648 +2015 +12,214 +12,459 +12,460 +12,464 +1,821 +10,719 +2016 +13,297 +13,011 +13,056 +1,300 +11,146 +2017 +15,749 +16,109 +1,218 +11,496 +2018 +19,580 +7,932 +11,144 +Total +12,594 +The following table presents paid claims development as of December 31, 2018, net of reinsurance. Claims data for 2012 through 2017 are unaudited. Claims data for 2018 is audited. +Cumulative Paid Claims and Allocated Claim Adjustment Expenses, Net of Reinsurance +(In thousands) +Accident +Year +2012 +2013 +2014 +2015 +2016 +2017 +2018 +2012 +$ +4,415 +$ +6,345 +$ +8,179 +$ +8,410 +$ +8,734 +$ +8,734 +$ +8,734 +2013 +5,227 +7,608 +8,718 +9,462 +9,576 +9,595 +2014 +6,154 +8,087 +9,270 +9,293 +10,325 +2015 +7,509 +9,601 +9,730 +10,343 +2016 +7,777 +10,665 +11,643 +2017 +8,969 +11,638 +2018 +8,838 +Total +Total +71,116 +All outstanding liabilities before 2012, net of reinsurance +114,877 +Liabilities for claims and claim adjustment expenses, net of reinsurance +134,050 +F- 36 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The reconciliation of the net incurred and paid claims development tables for the liability for claims and claims adjustment expenses is as follows: +December 31, 2018 +(In thousands) +Liabilities for unpaid Property and Casualty claims +and claim adjustment expenses, net of reinsurance +$ +134,050 +Total reinsurance recoverable on unpaid +Property and Casualty claims +$ +94,920 +Total gross liability for unpaid Property and Casualty +claims and claim adjustment expense +$ +228,970 +The following is supplementary information about average historical claims duration as of December 31, 2018. +Average Annual Percentage Payout of Incurred Claims by Age, net of Reinsurance +Years +1 +2 +3 +4 +5 +6 +7 +Property and Casualty Insurance +54.7% +20.1% +10.4% +3.9% +4.8% +0.1% +0.0% +Note 17. Commitments +We lease a portion of our rental equipment and certain of our facilities under operating leases with terms that expire at various dates substantially through 2024. As of March 31, 2019, we have guaranteed $5.2 million of residual values for these rental equipment assets at the end of the respective lease terms. Certain leases contain renewal and fair market value purchase options as well as mileage and other restrictions. At the expiration of the lease, we have the option to renew the lease, purchase the asset for fair market value, or sell the asset to a third party on behalf of the lessor. We have been leasing equipment since 1987 and have experienced no material losses relating to these types of residual value guarantees. +Lease expenses were as follows: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Lease expense +$ +33,158 +$ +33,960 +$ +37,343 +Operating and ground lease commitments for leases having terms of more than one year were as follows: +Property, Plant and Equipment +Rental +Equipment +Ground +Operating +Operating +Total +(In thousands) +Year-ended March 31: +2020 +$ +1,024 +$ +18,536 +$ +1,292 +$ +20,852 +2021 +1,024 +17,471 +– +18,495 +2022 +1,030 +15,720 +– +16,750 +2023 +1,030 +15,287 +– +16,317 +2024 +1,031 +14,705 +– +15,736 +Thereafter +48,619 +6,064 +– +54,683 +Total +$ +53,758 +$ +87,783 +$ +1,292 +$ +142,833 +F- 37 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 18. Contingencies +Litigation +On July 1, 2014, a 100-pound propane cylinder exploded while in use on a food truck in Philadelphia, Pennsylvania. The explosion killed two people and injured eleven. Following the incident, the injured parties and their estates filed a number of lawsuits in the Philadelphia Court of Common Pleas against U-Haul and its subsidiary, U-Haul Co. of Pennsylvania (“UHPA”), alleging that UHPA improperly filled propane cylinders that were overdue for periodic requalification and offered such cylinders for transportation, which allegedly caused the deaths and injuries. One plaintiff also sued AMERCO. All U-Haul defendants denied the allegations. The parties reached agreements to settle the civil cases by April 2018. We have paid a total of $27.9 million, representing our self-insured retention and attorney’s fees for all related civil matters. +In June 2018, following the resolution of the civil claims, the United States Attorney's Office for the Eastern District of Pennsylvania filed an initial 6-count indictment and a superseding 7-count indictment against UHPA. In January 2019, the U.S. Attorney's Office agreed to dismiss Counts 1 through 5 alleging UHPA improperly filled propane cylinders that were overdue for periodic requalification and offering such cylinders for transportation. UHPA entered a guilty plea with respect to Counts 6 and 7 relating to a failure to properly train UHPA employees dispensing propane and documentation thereof. On May 7, 2019, the United States District Court for the Eastern District of Pennsylvania accepted the plea agreement and imposed a $1 million fine and two years of probation on UHPA. UHPA was also ordered to pay $800 in associated court fees. +Environmental +Compliance with environmental requirements of federal, state and local governments may significantly affect Real Estate’s business operations. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Real Estate is aware of issues regarding hazardous substances on some of its properties. Real Estate regularly makes capital and operating expenditures to stay in compliance with environmental laws and has put in place a remedial plan at each site where it believes such a plan is necessary. Since 1988, Real Estate has managed a testing and removal program for underground storage tanks. +Based upon the information currently available to Real Estate, compliance with the environmental laws and its share of the costs of investigation and cleanup of known hazardous waste sites are not expected to result in a material adverse effect on AMERCO’s financial position or results of operations. +Other +We are named as a defendant in various other litigation and claims arising out of the normal course of business. In management’s opinion, none of these other matters will have a material effect on our financial position and results of operations. +Note 19. Related Party Transactions +As set forth in the Company’s Audit Committee Charter and consistent with NASDAQ Listing Rules, our Audit Committee (the “Audit Committee”) reviews and maintains oversight over related party transactions which are required to be disclosed under the Securities and Exchange Commission (“SEC”) rules and regulations and in accordance with GAAP. Accordingly, all such related party transactions are submitted to the Audit Committee for ongoing review and oversight. Our internal processes are designed to ensure that our legal and finance departments identify and monitor potential related party transactions that may require disclosure and Audit Committee oversight. +AMERCO has engaged in related party transactions and has continuing related party interests with certain major stockholders, directors and officers of the consolidated group as disclosed below. Management believes that the transactions described below and in the related notes were completed on terms substantially equivalent to those that would prevail in arm’s-length transactions. +F- 38 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +SAC Holding Corporation and SAC Holding II Corporation (collectively “SAC Holdings”) were established in order to acquire and develop self-storage properties. These properties are being managed by us pursuant to management agreements. In the past, we sold real estate and various self-storage properties to SAC Holdings, and such sales provided significant cash flows to us. SAC Holdings, Four SAC Self-Storage Corporation (“4 SAC”), Five SAC Self-Storage Corporation (“5 SAC”), Galaxy Investments, L.P. (“Galaxy”) and Private Mini Storage Realty, L.P. (“Private Mini”) are substantially controlled by Blackwater Investments, Inc. (“Blackwater”). Blackwater is wholly-owned by Willow Grove Holdings LP (“WGHLP”), which is owned by Mark V. Shoen, and various trusts associated with Edward J. Shoen and Mark V. Shoen. +Related Party Revenues +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +U-Haul interest income revenue from Blackwater +$ +– +$ +3,326 +$ +4,880 +U-Haul management fee revenue from Blackwater +23,986 +23,577 +23,130 +U-Haul management fee revenue from Mercury +5,162 +6,025 +5,945 +$ +29,148 +$ +32,928 +$ +33,955 +We currently manage the self-storage properties owned or leased by Blackwater and Mercury Partners, L.P. (“Mercury”), pursuant to a standard form of management agreement, under which we receive a management fee of between 4% and 10% of the gross receipts plus reimbursement for certain expenses. We received management fees, exclusive of reimbursed expenses, of $30.0 million, $29.5 million and $27.8 million from the above-mentioned entities during fiscal 2019, 2018 and 2017, respectively. This management fee is consistent with the fee received for other properties we previously managed for third parties. Mark V. Shoen controls the general partner of Mercury. The limited partner interests of Mercury are indirectly owned by Mark V. Shoen, James P. Shoen, and a trust benefitting the children and grandchildren of Edward J. Shoen. +Related Party Costs and Expenses +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +U-Haul lease expenses to Blackwater +$ +2,678 +$ +2,684 +$ +2,740 +U-Haul commission expenses to Blackwater +61,434 +58,595 +57,113 +$ +64,112 +$ +61,279 +$ +59,853 +We lease space for marketing company offices, vehicle repair shops and hitch installation centers from subsidiaries of Blackwater. The terms of the leases are similar to the terms of leases for other properties owned by unrelated parties that are leased to us. +At March 31, 2019, subsidiaries of Blackwater acted as U-Haul independent dealers. The financial and other terms of the dealership contracts with the aforementioned companies and their subsidiaries are substantially identical to the terms of those with our other independent dealers whereby commissions are paid by us based upon equipment rental revenues. +These agreements and notes with subsidiaries of Blackwater, excluding Dealer Agreements, provided revenues of $24.0 million, expenses of $2.7 million and cash flows of $21.3 million during fiscal 2019. Revenues and commission expenses related to the Dealer Agreements were $288.2 million and $61.4 million, respectively for fiscal 2019. +Management determined that management agreements with subsidiaries of Blackwater represent potential variable interests for us. Management evaluated whether it should be identified as the primary beneficiary of one or more of these VIEs using a two-step approach in which management (i) identified all other parties that hold interests in the VIEs, and (ii) determined if any variable interest holder has the power to direct the activities of the VIEs that most significantly impact their economic performance. +F- 39 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Management determined that we do not have a variable interest in the holding entities of Blackwater based upon management agreements which are with the individual operating entities; therefore, we are precluded from consolidating these entities. +We do not have the power to direct the activities that most significantly impact the economic performance of the individual operating entities which have management agreements with U-Haul. There are no fees or penalties disclosed in the management agreement for termination of the agreement. Through control of the holding entities' assets, and its ability and history of making key decisions relating to the entity and its assets, Blackwater, and its owner, are the variable interest holder with the power to direct the activities that most significantly impact each of the individual holding entities and the individual operating entities’ performance. As a result, we have no basis to consolidate these entities. +We have not provided financial or other support explicitly or implicitly during the fiscal years ended March 31, 2019 and 2018, respectively to any of these entities that it was not previously contractually required to provide. In addition, we currently have no plan to provide any financial support to any of these entities in the future. The carrying amount and classification of the assets and liabilities in our balance sheets that relate to our variable interests in the aforementioned entities are as follows, which approximate the maximum exposure to loss as a result of our involvement with these entities: +Related Party Assets +March 31, +2019 +2018 +(In thousands) +U-Haul receivable from Blackwater +25,158 +24,034 +U-Haul receivable from Mercury +7,234 +10,357 +Other (a) +(1,503) +(1,115) +$ +30,889 +$ +33,276 +(a) Timing differences for intercompany balances with insurance subsidiaries resulting from the three month difference in reporting periods. +F- 40 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 20. Statutory Financial Information of Insurance Subsidiaries +Applicable laws and regulations of the States of Arizona and Nevada require Property and Casualty Insurance and Life Insurance to maintain minimum capital and surplus determined in accordance with statutory accounting principles. Audited statutory net income and statutory capital and surplus for the years ended are listed below: +Years Ended December 31, +2018 +2017 +2016 +(In thousands) +Repwest: +Audited statutory net income +$ +23,960 +$ +16,328 +$ +19,580 +Audited statutory capital and surplus +216,763 +197,375 +176,009 +ARCOA: +Audited statutory net income +1,612 +1,190 +1,451 +Audited statutory capital and surplus +9,390 +7,991 +6,798 +Oxford: +Audited statutory net income +11,367 +10,350 +17,473 +Audited statutory capital and surplus +203,723 +195,931 +189,279 +CFLIC: +Audited statutory net income +8,735 +8,062 +8,139 +Audited statutory capital and surplus +27,232 +26,653 +28,011 +NAI: +Audited statutory net income +1,436 +1,594 +1,039 +Audited statutory capital and surplus +12,817 +12,674 +12,691 +The amount of dividends that can be paid to shareholders by insurance companies domiciled in the State of Arizona is limited. Any dividend in excess of the limit requires prior regulatory approval. The statutory surplus for Repwest at December 31, 2018 that could be distributed as ordinary dividends was $21.7 million. The statutory surplus for Oxford at December 31, 2018 that could be distributed as ordinary dividends was $11.4 million. Neither Oxford nor Repwest paid a dividend to AMERCO in fiscal 2019, 2018 or 2017. +For our insurance subsidiaries, statutory accounting principles (“SAP”) differ from GAAP primarily in that: (i) premiums from deferred annuities are recognized as revenue under SAP, while they are accounted for as liabilities from investment contracts under GAAP; (ii) policy acquisition costs are expensed as incurred under SAP, while they are deferred and amortized over the effective period of the related life insurance policies or the present value of actual and expected gross profits from annuity deposits; (iii) policy benefits and losses are established using different actuarial assumptions; and (iv) investments are valued on a different basis and valuation allowances attributable to investments are different. In addition, certain assets are not admitted under SAP and are charged directly to surplus. +F- 41 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 21. Financial Information by Geographic Area +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2019 +Total revenues +$ +3,597,285 +$ +171,422 +$ +3,768,707 +Depreciation and amortization, net of gains on disposal +575,134 +7,421 +582,555 +Interest expense +139,573 +2,872 +142,445 +Pretax earnings +466,175 +11,354 +477,529 +Income tax expense +103,578 +3,094 +106,672 +Identifiable assets +11,526,876 +364,837 +11,891,713 +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2018 +Total revenues +$ +3,435,821 +$ +165,293 +$ +3,601,114 +Depreciation and amortization, net of gains on disposal +363,826 +8,521 +372,347 +Interest expense +123,777 +2,929 +126,706 +Pretax earnings +628,901 +8,712 +637,613 +Income tax expense (benefit) +(155,685) +2,715 +(152,970) +Identifiable assets +10,425,299 +322,123 +10,747,422 +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2017 +Total revenues +$ +3,271,563 +$ +150,204 +$ +3,421,767 +Depreciation and amortization, net of gains on disposal +466,378 +5,275 +471,653 +Interest expense +112,834 +572 +113,406 +Pretax earnings +609,589 +18,769 +628,358 +Income tax expense +225,278 +4,656 +229,934 +Identifiable assets +9,030,528 +375,312 +9,405,840 +Note 21A. Consolidating Financial Information by Industry Segment +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO, U-Haul, and Real Estate and the subsidiaries of U-Haul and Real Estate; +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA; and +Life Insurance, comprised of Oxford and its subsidiaries. +Management tracks revenues separately, but does not report any separate measure of the profitability for rental vehicles, rentals of self-storage spaces and sales of products that are required to be classified as a separate operating segment and accordingly does not present these as separate reportable segments. Deferred income taxes, net are shown as liabilities on the consolidating statements. +The information includes elimination entries necessary to consolidate AMERCO, the parent, with its subsidiaries. +Investments in subsidiaries are accounted for by the parent using the equity method of accounting. +F- 42 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 21A. Financial Information by Consolidating Industry Segment: +Consolidating balance sheets by industry segment as of March 31, 2019 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Assets: +Cash and cash equivalents +$ +643,918 +$ +5,757 +$ +24,026 +$ +– +$ +673,701 +Reinsurance recoverables and trade receivables, net +90,832 +102,120 +31,833 +– +224,785 +Inventories and parts, net +103,504 +– +– +– +103,504 +Prepaid expenses +174,100 +– +– +– +174,100 +Investments, fixed maturities and marketable equities +– +279,641 +1,955,756 +– +2,235,397 +Investments, other +23,013 +74,679 +203,044 +– +300,736 +Deferred policy acquisition costs, net +– +– +136,276 +– +136,276 +Other assets +72,768 +2,456 +3,130 +– +78,354 +Related party assets +35,997 +6,639 +16,466 +(28,213) +(c) +30,889 +1,144,132 +471,292 +2,370,531 +(28,213) +3,957,742 +Investment in subsidiaries +534,157 +– +– +(534,157) +(b) +– +Property, plant and equipment, at cost: +Land +976,454 +– +– +– +976,454 +Buildings and improvements +4,003,726 +– +– +– +4,003,726 +Furniture and equipment +689,780 +– +– +– +689,780 +Rental trailers and other rental equipment +590,039 +– +– +– +590,039 +Rental trucks +4,762,028 +– +– +– +4,762,028 +11,022,027 +– +– +– +11,022,027 +Less: Accumulated depreciation +(3,088,056) +– +– +– +(3,088,056) +Total property, plant and equipment +7,933,971 +– +– +– +7,933,971 +Total assets +$ +9,612,260 +$ +471,292 +$ +2,370,531 +$ +(562,370) +$ +11,891,713 +(a) Balances as of December 31, 2018 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 43 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2019 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Liabilities: +Accounts payable and accrued expenses +$ +548,099 +$ +2,844 +$ +5,930 +$ +– +$ +556,873 +Notes, loans and leases payable, net +4,163,323 +– +– +– +4,163,323 +Policy benefits and losses, claims and loss expenses payable +407,934 +229,958 +373,291 +– +1,011,183 +Liabilities from investment contracts +– +– +1,666,742 +– +1,666,742 +Other policyholders' funds and liabilities +– +5,259 +9,788 +– +15,047 +Deferred income +35,186 +– +– +– +35,186 +Deferred income taxes, net +741,644 +6,961 +2,365 +– +750,970 +Related party liabilities +25,446 +3,836 +692 +(29,974) +(c) +– +Total liabilities +5,921,632 +248,858 +2,058,808 +(29,974) +8,199,324 +Stockholders' equity : +Series preferred stock: +Series A preferred stock +– +– +– +– +– +Series B preferred stock +– +– +– +– +– +Series A common stock +– +– +– +– +– +Common stock +10,497 +3,301 +2,500 +(5,801) +(b) +10,497 +Additional paid-in capital +453,536 +91,120 +26,271 +(117,601) +(b) +453,326 +Accumulated other comprehensive income (loss) +(68,459) +(3,721) +(5,300) +10,782 +(b) +(66,698) +Retained earnings +3,976,752 +131,734 +288,252 +(419,776) +(b) +3,976,962 +Cost of common shares in treasury, net +(525,653) +– +– +– +(525,653) +Cost of preferred shares in treasury, net +(151,997) +– +– +– +(151,997) +Unearned employee stock ownership plan shares +(4,048) +– +– +– +(4,048) +Total stockholders' equity +3,690,628 +222,434 +311,723 +(532,396) +3,692,389 +Total liabilities and stockholders' equity +$ +9,612,260 +$ +471,292 +$ +2,370,531 +$ +(562,370) +$ +11,891,713 +(a) Balances as of December 31, 2018 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 44 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Assets: +Cash and cash equivalents +$ +702,036 +$ +6,639 +$ +50,713 +$ +– +$ +759,388 +Reinsurance recoverables and trade receivables, net +64,798 +99,682 +29,058 +– +193,538 +Inventories and parts, net +89,877 +– +– +– +89,877 +Prepaid expenses +166,129 +– +– +– +166,129 +Investments, fixed maturities and marketable equities +– +285,846 +1,634,014 +– +1,919,860 +Investments, other +22,992 +65,553 +310,519 +– +399,064 +Deferred policy acquisition costs, net +– +– +124,767 +– +124,767 +Other assets +241,493 +685 +2,604 +– +244,782 +Related party assets +40,003 +6,959 +18,334 +(32,020) +(c) +33,276 +1,327,328 +465,364 +2,170,009 +(32,020) +3,930,681 +Investment in subsidiaries +544,151 +– +– +(544,151) +(b) +– +Property, plant and equipment, at cost: +Land +827,649 +– +– +– +827,649 +Buildings and improvements +3,140,713 +– +– +– +3,140,713 +Furniture and equipment +632,803 +– +– +– +632,803 +Rental trailers and other rental equipment +545,968 +– +– +– +545,968 +Rental trucks +4,390,750 +– +– +– +4,390,750 +9,537,883 +– +– +– +9,537,883 +Less: Accumulated depreciation +(2,721,142) +– +– +– +(2,721,142) +Total property, plant and equipment +6,816,741 +– +– +– +6,816,741 +Total assets +$ +8,688,220 +$ +465,364 +$ +2,170,009 +$ +(576,171) +$ +10,747,422 +(a) Balances as of December 31, 2017 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 45 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Liabilities: +Accounts payable and accrued expenses +$ +506,158 +$ +2,582 +$ +2,375 +$ +– +$ +511,115 +Notes, loans and leases payable, net +3,513,076 +– +– +– +3,513,076 +Policy benefits and losses, claims and loss expenses payable +568,456 +234,359 +445,218 +– +1,248,033 +Liabilities from investment contracts +– +– +1,364,066 +– +1,364,066 +Other policyholders' funds and liabilities +– +5,377 +4,663 +– +10,040 +Deferred income +34,276 +– +– +– +34,276 +Deferred income taxes, net +629,389 +8,927 +19,792 +– +658,108 +Related party liabilities +28,157 +2,870 +993 +(32,020) +(c) +– +Total liabilities +5,279,512 +254,115 +1,837,107 +(32,020) +7,338,714 +Stockholders' equity : +Series preferred stock: +Series A preferred stock +– +– +– +– +– +Series B preferred stock +– +– +– +– +– +Series A common stock +– +– +– +– +– +Common stock +10,497 +3,301 +2,500 +(5,801) +(b) +10,497 +Additional paid-in capital +452,956 +91,120 +26,271 +(117,601) +(b) +452,746 +Accumulated other comprehensive income (loss) +(4,623) +16,526 +35,982 +(52,508) +(b) +(4,623) +Retained earnings +3,635,351 +100,302 +268,149 +(368,241) +(b) +3,635,561 +Cost of common shares in treasury, net +(525,653) +– +– +– +(525,653) +Cost of preferred shares in treasury, net +(151,997) +– +– +– +(151,997) +Unearned employee stock ownership plan shares +(7,823) +– +– +– +(7,823) +Total stockholders' equity +$ +3,408,708 +211,249 +332,902 +(544,151) +3,408,708 +Total liabilities and stockholders' equity +8,688,220 +$ +465,364 +$ +2,170,009 +$ +(576,171) +$ +10,747,422 +(a) Balances as of December 31, 2017 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- 46 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2019 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,656,327 +$ +– +$ +– +$ +(2,830) +(c) +$ +2,653,497 +Self-storage revenues +367,276 +– +– +– +367,276 +Self-moving & self-storage products & service sales +264,146 +– +– +– +264,146 +Property management fees +29,148 +– +– +– +29,148 +Life insurance premiums +– +– +63,488 +– +63,488 +Property and casualty insurance premiums +– +63,488 +– +(2,635) +(c) +60,853 +Net investment and interest income +13,857 +12,349 +86,395 +(1,667) +(b) +110,934 +Other revenue +215,055 +– +4,831 +(521) +(b) +219,365 +Total revenues +3,545,809 +75,837 +154,714 +(7,653) +3,768,707 +Costs and expenses: +Operating expenses +1,938,317 +34,218 +14,613 +(5,968) +(b,c) +1,981,180 +Commission expenses +288,408 +– +– +– +288,408 +Cost of sales +162,142 +– +– +– +162,142 +Benefits and losses +– +14,213 +86,064 +– +100,277 +Amortization of deferred policy acquisition costs +– +– +28,556 +– +28,556 +Lease expense +33,702 +– +– +(544) +(b) +33,158 +Depreciation, net gains on disposals +554,043 +– +– +– +554,043 +Net gains on disposal of real estate +(44) +– +– +– +(44) +Total costs and expenses +2,976,568 +48,431 +129,233 +(6,512) +3,147,720 +Earnings from operations before equity in earnings of subsidiaries +569,241 +27,406 +25,481 +(1,141) +620,987 +Equity in earnings of subsidiaries +41,811 +– +– +(41,811) +(d) +– +Earnings from operations +611,052 +27,406 +25,481 +(42,952) +620,987 +Other components of net periodic benefit costs +(1,013) +– +– +– +(1,013) +Interest expense +(143,586) +– +– +1,141 +(b) +(142,445) +Pretax earnings +466,453 +27,406 +25,481 +(41,811) +477,529 +Income tax benefit (expense) +(95,596) +(5,698) +(5,378) +– +(106,672) +Earnings available to common shareholders +$ +370,857 +$ +21,708 +$ +20,103 +$ +(41,811) +$ +370,857 +(a) Balances for the year ended December 31, 2018 +(b) Eliminate intercompany lease / interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- 47 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,483,956 +$ +– +$ +– +$ +(4,214) +(c) +$ +2,479,742 +Self-storage revenues +323,903 +– +– +– +323,903 +Self-moving & self-storage products & service sales +261,557 +– +– +– +261,557 +Property management fees +29,602 +– +– +– +29,602 +Life insurance premiums +– +– +154,703 +– +154,703 +Property and casualty insurance premiums +– +58,800 +– +(1,700) +(c) +57,100 +Net investment and interest income +12,232 +15,771 +84,158 +(1,688) +(b) +110,473 +Other revenue +179,417 +– +5,001 +(384) +(b) +184,034 +Total revenues +3,290,667 +74,571 +243,862 +(7,986) +3,601,114 +Costs and expenses: +Operating expenses +1,758,697 +32,710 +22,061 +(6,412) +(b,c) +1,807,056 +Commission expenses +276,705 +– +– +– +276,705 +Cost of sales +160,489 +– +– +– +160,489 +Benefits and losses +– +15,983 +169,328 +– +185,311 +Amortization of deferred policy acquisition costs +– +– +24,514 +– +24,514 +Lease expense +34,243 +– +– +(283) +(b) +33,960 +Depreciation, net gains on disposals +543,247 +– +– +– +543,247 +Net gains on disposal of real estate +(195,414) +– +– +– +(195,414) +Total costs and expenses +2,577,967 +48,693 +215,903 +(6,695) +2,835,868 +Earnings from operations before equity in earnings of subsidiaries +712,700 +25,878 +27,959 +(1,291) +765,246 +Equity in earnings of subsidiaries +46,990 +– +– +(46,990) +(d) +– +Earnings from operations +759,690 +25,878 +27,959 +(48,281) +765,246 +Other components of net periodic benefit costs +(927) +– +– +– +(927) +Interest expense +(127,997) +– +– +1,291 +(b) +(126,706) +Pretax earnings +630,766 +25,878 +27,959 +(46,990) +637,613 +Income tax expense +159,817 +(2,989) +(3,858) +– +152,970 +Earnings available to common shareholders +$ +790,583 +$ +22,889 +$ +24,101 +$ +(46,990) +$ +790,583 +(a) Balances for the year ended December 31, 2017 +(b) Eliminate intercompany lease/interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- 48 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2017 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,366,526 +$ +– +$ +– +$ +(3,693) +(c) +$ +2,362,833 +Self-storage revenues +286,886 +– +– +– +286,886 +Self-moving & self-storage products & service sales +253,073 +– +– +– +253,073 +Property management fees +29,075 +– +– +– +29,075 +Life insurance premiums +– +– +163,579 +– +163,579 +Property and casualty insurance premiums +– +52,334 +– +– +52,334 +Net investment and interest income +9,688 +16,652 +77,540 +(1,604) +(b) +102,276 +Other revenue +167,752 +– +4,480 +(521) +(b) +171,711 +Total revenues +3,113,000 +68,986 +245,599 +(5,818) +3,421,767 +Costs and expenses: +Operating expenses +1,520,506 +28,421 +22,429 +(4,175) +(b,c) +1,567,181 +Commission expenses +267,230 +– +– +– +267,230 +Cost of sales +152,485 +– +– +– +152,485 +Benefits and losses +– +13,404 +169,306 +– +182,710 +Amortization of deferred policy acquisition costs +– +– +26,218 +– +26,218 +Lease expense +37,529 +– +– +(186) +(b) +37,343 +Depreciation, net gains on disposals +449,025 +– +– +– +449,025 +Net (gains) losses on disposal of real estate +(3,590) +– +– +– +(3,590) +Total costs and expenses +2,423,185 +41,825 +217,953 +(4,361) +2,678,602 +Earnings from operations before equity in earnings of subsidiaries +689,815 +27,161 +27,646 +(1,457) +743,165 +Equity in earnings of subsidiaries +35,797 +– +– +(35,797) +(d) +– +Earnings from operations +725,612 +27,161 +27,646 +(37,254) +743,165 +Other components of net periodic benefit costs +(902) +– +– +– +(902) +Interest expense +(114,863) +– +– +1,457 +(b) +(113,406) +Amortization on early extinguished of debt +(499) +(499) +Pretax earnings +609,348 +27,161 +27,646 +(35,797) +628,358 +Income tax expense +(210,924) +(9,346) +(9,664) +– +(229,934) +Earnings available to common shareholders +$ +398,424 +$ +17,815 +$ +17,982 +$ +(35,797) +$ +398,424 +(a) Balances for the year ended December 31, 2016 +(b) Eliminate intercompany lease/interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- 49 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2019, are as follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +370,857 +$ +21,708 +$ +20,103 +$ +(41,811) +$ +370,857 +Earnings from consolidated subsidiaries +(41,811) +– +– +41,811 +– +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +581,025 +– +– +– +581,025 +Amortization of deferred policy acquisition costs +– +– +28,556 +– +28,556 +Amortization of premiums and accretion of discounts related to investments, net +– +1,361 +11,746 +– +13,107 +Amortization of debt issuance costs +3,923 +– +– +– +3,923 +Interest credited to policyholders +– +– +35,387 +– +35,387 +Change in allowance for losses on trade receivables +57 +– +(5) +– +52 +Change in allowance for inventories and parts reserve +(146) +– +– +– +(146) +Net gains on disposal of personal property +(26,982) +– +– +– +(26,982) +Net gains on disposal of real estate +(44) +– +– +– +(44) +Net (gains) losses on sales of investments +– +(2,971) +308 +– +(2,663) +Net losses on equity securities +– +5,739 +– +– +5,739 +Deferred income taxes +112,434 +830 +(6,453) +– +106,811 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(26,160) +(2,438) +(2,767) +– +(31,365) +Inventories and parts +(13,492) +– +– +– +(13,492) +Prepaid expenses +(8,620) +– +– +– +(8,620) +Capitalization of deferred policy acquisition costs +– +– +(25,957) +– +(25,957) +Other assets +159,126 +(1,449) +(525) +– +157,152 +Related party assets +3,857 +339 +(2) +– +4,194 +Accounts payable and accrued expenses +6,454 +257 +3,552 +– +10,263 +Policy benefits and losses, claims and loss expenses payable +(159,793) +(4,400) +(71,927) +– +(236,120) +Other policyholders' funds and liabilities +– +(117) +5,124 +– +5,007 +Deferred income +966 +– +– +– +966 +Related party liabilities +(2,711) +944 +(300) +– +(2,067) +Net cash provided (used) by operating activities +958,940 +19,803 +(3,160) +– +975,583 +Cash flows from investing activities: +Escrow deposits +4,299 +– +– +– +4,299 +Purchases of: +Property, plant and equipment +(1,869,968) +– +– +– +(1,869,968) +Short term investments +– +(53,878) +(170) +– +(54,048) +Fixed maturities investments +– +(33,775) +(506,270) +– +(540,045) +Equity securities +– +– +(957) +– +(957) +Preferred stock +– +– +– +– +– +Real estate +(236) +(187) +(212) +– +(635) +Mortgage loans +– +(20,031) +(43,580) +– +(63,611) +Proceeds from sales and paydowns of: +Property, plant and equipment +606,271 +– +– +– +606,271 +Short term investments +– +58,767 +7,270 +– +66,037 +Fixed maturities investments +– +12,305 +111,246 +– +123,551 +Equity securities +– +8,608 +– +– +8,608 +Preferred stock +– +1,625 +– +– +1,625 +Real estate +– +– +– +– +– +Mortgage loans +– +5,881 +141,856 +– +147,737 +Net cash used by investing activities +(1,259,634) +(20,685) +(290,817) +– +(1,571,136) +(page 1 of 2) +(a) Balance for the period ended December 31, 2018 +F- 50 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continuation of consolidating cash flow statements by industry segment for the year ended March 31, 2019, are as follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +897,311 +– +– +– +897,311 +Principal repayments on credit facilities +(299,748) +– +– +– +(299,748) +Payment of debt issuance costs +(7,243) +– +– +– +(7,243) +Capital lease payments +(303,431) +– +– +– +(303,431) +Employee stock ownership plan shares +(418) +– +– +– +(418) +Securitization deposits +– +– +– +– +– +Common stock dividends paid +(39,179) +– +– +– +(39,179) +Investment contract deposits +– +– +400,123 +– +400,123 +Investment contract withdrawals +– +– +(132,833) +– +(132,833) +Net cash provided by financing activities +247,292 +– +267,290 +– +514,582 +Effects of exchange rate on cash +(4,716) +– +– +– +(4,716) +Decrease in cash and cash equivalents +(58,118) +(882) +(26,687) +– +(85,687) +Cash and cash equivalents at beginning of period +702,036 +6,639 +50,713 +– +759,388 +Cash and cash equivalents at end of period +$ +643,918 +$ +5,757 +$ +24,026 +$ +– +$ +673,701 +(page 2 of 2) +(a) Balance for the period ended December 31, 2018 +F- 51 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2018, are as follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +790,583 +$ +22,889 +$ +24,101 +$ +(46,990) +$ +790,583 +Earnings from consolidated subsidiaries +(46,990) +– +– +46,990 +– +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +555,069 +– +– +– +555,069 +Amortization of deferred policy acquisition costs +– +– +24,514 +– +24,514 +Amortization of premiums and accretion of discounts related to investments, net +– +1,356 +11,434 +– +12,790 +Amortization of debt issuance costs +3,868 +– +– +– +3,868 +Interest credited to policyholders +– +– +32,302 +– +32,302 +Change in allowance for losses on trade receivables +(31) +– +(89) +– +(120) +Change in allowance for inventories and parts reserve +5,065 +– +– +– +5,065 +Net gains on disposal of personal property +(11,822) +– +– +– +(11,822) +Net gains on disposal of real estate +(195,414) +– +– +– +(195,414) +Net gains on sales of investments +– +(1,703) +(4,566) +– +(6,269) +Net (gains) losses on equity securities +– +– +– +– +– +Deferred income taxes +(182,358) +(6,596) +(4,480) +– +(193,434) +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(23,444) +8,075 +40 +– +(15,329) +Inventories and parts +(12,384) +– +– +– +(12,384) +Prepaid expenses +(40,765) +– +– +– +(40,765) +Capitalization of deferred policy acquisition costs +– +– +(27,350) +– +(27,350) +Other assets +(167,579) +1,810 +(199) +– +(165,968) +Related party assets +48,855 +4,553 +– +– +53,408 +Accounts payable and accrued expenses +(36,384) +648 +(1,244) +– +(36,980) +Policy benefits and losses, claims and loss expenses payable +168,687 +(10,623) +3,057 +– +161,121 +Other policyholders' funds and liabilities +– +1,194 +(1,303) +– +(109) +Deferred income +5,524 +– +– +– +5,524 +Related party liabilities +(1,884) +318 +950 +– +(616) +Net cash provided by operating activities +858,596 +21,921 +57,167 +– +937,684 +Cash flows from investing activities: +Escrow deposits +31,362 +– +– +– +31,362 +Purchases of: +Property, plant and equipment +(1,363,745) +– +– +– +(1,363,745) +Short term investments +– +(63,556) +– +– +(63,556) +Fixed maturities investments +– +(51,273) +(339,627) +– +(390,900) +Equity securities +– +– +(662) +– +(662) +Preferred stock +– +(1,000) +– +– +(1,000) +Real estate +(1,365) +(440) +(134) +– +(1,939) +Mortgage loans +– +(14,409) +(69,098) +– +(83,507) +Proceeds from sales and paydowns of: +Property, plant and equipment +699,803 +– +– +– +699,803 +Short term investments +– +61,133 +6,657 +– +67,790 +Fixed maturities investments +– +21,670 +141,799 +– +163,469 +Preferred stock +– +4,208 +– +– +4,208 +Real estate +2,783 +– +– +– +2,783 +Mortgage loans +– +15,660 +21,930 +– +37,590 +Net cash used by investing activities +(631,162) +(28,007) +(239,135) +– +(898,304) +(page 1 of 2) +(a) Balance for the period ended December 31, 2017 +F- 52 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continuation of consolidating cash flow statements by industry segment for the year ended March 31, 2018, are as follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +498,464 +– +– +– +498,464 +Principal repayments on credit facilities +(356,451) +– +– +– +(356,451) +Payment of debt issuance costs +(5,111) +– +– +– +(5,111) +Capital lease payments +(296,363) +– +– +– +(296,363) +Employee stock ownership plan shares +(11,640) +– +– +– +(11,640) +Securitization deposits +(2,180) +– +– +– +(2,180) +Common stock dividends paid +(29,380) +– +– +– +(29,380) +Investment contract deposits +– +– +401,814 +– +401,814 +Investment contract withdrawals +– +– +(182,549) +– +(182,549) +Net cash provided (used) by financing activities +(202,661) +– +219,265 +– +16,604 +Effects of exchange rate on cash +5,598 +– +– +– +5,598 +Increase (decrease) in cash and cash equivalents +30,371 +(6,086) +37,297 +– +61,582 +Cash and cash equivalents at beginning of period +671,665 +12,725 +13,416 +– +697,806 +Cash and cash equivalents at end of period +$ +702,036 +$ +6,639 +$ +50,713 +$ +– +$ +759,388 +(page 2 of 2) +(a) Balance for the period ended December 31, 2017 +F- 53 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2017 are as follows: +Moving & Storage +Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +398,424 +$ +17,815 +$ +17,982 +$ +(35,797) +$ +398,424 +Earnings from consolidated subsidiaries +(35,797) +– +– +35,797 +– +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +481,520 +– +– +– +481,520 +Amortization of deferred policy acquisition costs +– +– +26,218 +– +26,218 +Amortization of premiums and accretion of discounts related to investments, net +– +1,336 +10,492 +– +11,828 +Amortization of debt issuance costs +4,062 +– +– +– +4,062 +Interest credited to policyholders +– +– +25,020 +– +25,020 +Change in allowance for losses on trade receivables +31 +– +(77) +– +(46) +Change in allowance for inventories and parts reserve +1,330 +– +– +– +1,330 +Net gains on disposal of personal property +(32,495) +– +– +– +(32,495) +Net gains on disposal of real estate +(3,590) +– +– +– +(3,590) +Net gains on sales of investments +– +(2,636) +(2,648) +– +(5,284) +Net (gains) losses on equity securities +– +– +– +– +– +Deferred income taxes +173,059 +2,340 +(2,287) +– +173,112 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +(6,806) +4,221 +(305) +– +(2,890) +Inventories and parts +(4,072) +– +– +– +(4,072) +Prepaid expenses +9,386 +– +– +– +9,386 +Capitalization of deferred policy acquisition costs +– +– +(27,111) +– +(27,111) +Other assets +(3,827) +1,341 +(2) +– +(2,488) +Related party assets +(872) +1,215 +– +– +343 +Accounts payable and accrued expenses +(14,793) +392 +(1,147) +– +(15,548) +Policy benefits and losses, claims and loss expenses payable +13,283 +(7,838) +9,933 +– +15,378 +Other policyholders' funds and liabilities +– +1,167 +332 +– +1,499 +Deferred income +5,921 +– +– +– +5,921 +Related party liabilities +(1,170) +226 +(118) +– +(1,062) +Net cash provided by operating activities +983,594 +19,579 +56,282 +– +1,059,455 +Cash flows from investing activities: +Escrow deposits +(38,058) +– +– +– +(38,058) +Purchases of: +Property, plant and equipment +(1,419,505) +– +– +– +(1,419,505) +Short term investments +– +(77,693) +(558,154) +– +(635,847) +Fixed maturities investments +– +(42,628) +(312,473) +– +(355,101) +Equity securities +– +– +(489) +– +(489) +Real estate +(19,406) +(4,648) +(8,753) +– +(32,807) +Mortgage loans +– +(21,021) +(133,289) +– +(154,310) +Proceeds from sales and paydowns of: +Property, plant and equipment +487,475 +– +– +– +487,475 +Short term investments +– +80,225 +575,501 +– +655,726 +Fixed maturities investments +– +30,791 +158,451 +– +189,242 +Preferred stock +– +4,181 +– +– +4,181 +Real estate +6,275 +– +2,478 +– +8,753 +Mortgage loans +– +9,890 +96,942 +– +106,832 +Net cash used by investing activities +(983,219) +(20,903) +(179,786) +– +(1,183,908) +(page 1 of 2) +(a) Balance for the period ended December 31, 2016 +F- 54 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Continuation of consolidating cash flow statements by industry segment for the year ended March 31, 2017 are as follows: +Moving & Storage +Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +715,625 +– +27,000 +– +742,625 +Principal repayments on credit facilities +(340,844) +– +(27,000) +– +(367,844) +Payment of debt issuance costs +(5,055) +– +– +– +(5,055) +Capital lease payments +(212,545) +– +– +– +(212,545) +Employee stock ownership plan shares +(11,106) +– +– +– +(11,106) +Securitization deposits +446 +– +– +– +446 +Common stock dividends paid +(58,757) +– +– +– +(58,757) +Investment contract deposits +– +– +285,148 +– +285,148 +Investment contract withdrawals +– +– +(149,159) +– +(149,159) +Net cash provided by financing activities +87,764 +– +135,989 +– +223,753 +Effects of exchange rate on cash +(2,140) +– +– +– +(2,140) +Increase (decrease) in cash and cash equivalents +85,999 +(1,324) +12,485 +– +97,160 +Cash and cash equivalents at beginning of period +585,666 +14,049 +931 +– +600,646 +Cash and cash equivalents at end of period +$ +671,665 +$ +12,725 +$ +13,416 +$ +– +$ +697,806 +(page 2 of 2) +(a) Balance for the period ended December 31, 2016 +F- 55 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 22. Revenue Recognition +In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which provided an updated standard on revenue recognition. The standard outlines a five-step model for entities to use in accounting for revenue arising from contracts with customers. The standard applies to all contracts with customers except for leases, insurance contracts, financial instruments, certain nonmonetary exchanges and certain guarantees. The standard also requires expanded disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. ASU 2014-09 became effective for us on April 1, 2018 and was adopted on a modified retrospective basis. Due to insignificant changes in our revenue recognition pattern for applicable revenue streams as a result of the updated guidance, there was no cumulative effect recorded. Additionally, due to the relatively short duration of our equipment contracts, we elected to use the practical expedient for contracts that begin and end within the same reporting period in applying the updated guidance to our applicable revenue streams. We performed an impact assessment by analyzing certain existing material revenue transactions and arrangements that are representative of our business segments and their revenue streams. Additionally, we assessed any potential impacts on our internal controls and processes related to both the implementation and ongoing compliance of the new guidance. The adoption of the standard did not have a material impact on our consolidated financial statements. +We enter into contracts that may include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of amounts collected from customers for taxes, such as sales tax, and remitted to the applicable taxing authorities. We account for a contract under Topic 606 when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. For contracts scoped into this standard, revenue is recognized when (or as) the performance obligations are satisfied by means of transferring goods or services to the customer as applicable to each revenue stream as discussed below. A contract may be partially within the scope of Topic 606 and partially within the scope of other topics. This is applicable to insurance premiums received in conjunction with equipment rentals, for which we allocate the transaction price relating to these distinct performance obligations covered by Topic 944 on a relative standalone selling price basis. There were no material contract assets or liabilities as of March 31, 2019 and March 31, 2018. +Self-moving rentals are recognized over the contract period that trucks and moving equipment are rented. We offer two types of self-moving rental contracts, one-way rentals and in-town rentals, which have varying payment terms. Customer payment is received at the initiation of the contract for one-way rentals which covers an allowable limit for equipment usage. An estimated fee in the form of a deposit is received at the initiation of the contract for in-town rentals, and final payment is received upon the return of the equipment based on actual fees incurred. The contract price is estimated at the initiation of the contract, as there is variable consideration associated with ratable fees incurred based on the number of days the equipment is rented and the number of miles driven. Variable consideration is estimated using the most likely amount method which is based on the intended use of the rental equipment by the customer at the initiation of the contract. Historically, the variability in estimated transaction pricing compared to actual is not significant due to the relatively short duration of rental contracts. Each performance obligation has an observable stand-alone selling price. We concluded that the performance obligations identified are satisfied over time under Topic 606, which is consistent with the timing of our revenue recognition under legacy guidance. The input method of passage of time is appropriate as there is a direct relationship between our inputs and the transfer of benefit to the customer over the life of the contract. Self-moving rental contracts span a relatively short period of time, and the majority of these contracts began and ended within the same fiscal year. +F- 56 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The Company’s self-moving rental revenues do not currently meet the definition of a lease under Topic 840 - Leases due to the existence of substitution rights, and thus are accounted for under Topic 606. However, the contracts are expected to meet the definition of a lease pursuant to the guidance in ASU 2016-02, Leases (Topic 842) (“ASU 2016-02”) because those substitution rights do not provide an economic benefit to the Company that would exceed the cost of exercising the right. Therefore, upon adoption of ASU 2016-02 on April 1, 2019, self-rental contracts will be accounted for as leases. We do not expect this change to result in a change in the timing and pattern of recognition of the related revenues due to the short-term nature of the self-moving rental contracts. +Self-storage revenues are recognized as earned over the contract period based upon the number of paid storage contract days. Self-storage revenues are recognized in accordance with existing guidance in Topic 840 – Leases. +Sales of self-moving and self-storage related products are recognized at the time that title passes and the customer accepts delivery. The performance obligations identified for this portfolio of contracts include moving and storage product sales, installation services and/or propane sales. Each of these performance obligations has an observable stand-alone selling price. We concluded that the performance obligations identified are satisfied at a point in time under Topic 606, which is consistent with the timing of our revenue recognition under legacy guidance. The basis for this conclusion is that the customer does not receive the product/propane or benefit from the installation services until the related performance obligation is satisfied. These products/services being provided have an alternative use as they are not customized and can be sold/provided to any customer. In addition, we only have the right to receive payment once the products have been transferred to the customer or the installation services have been completed. Although product sales have a right of return policy, our estimated obligation for future product returns is not material to the financial statements at this time. +Property management fees are recognized over the period that agreed-upon services are provided. The performance obligation for this portfolio of contracts is property management services, which represents a series of distinct days of service, each of which is comprised of activities that may vary from day to day. However, those tasks are activities to fulfill the property management services and are not separate promises in the contract. We determined that each increment of the promised service is distinct in accordance with paragraph 606-10-25-19 of Topic 606. This is because the customer can benefit from each increment of service on its own and each increment of service is separately identifiable because no day of service significantly modifies or customizes another and no day of service significantly affects either the entity’s ability to fulfill another day of service or the benefit to the customer of another day of service. As such, we concluded that the performance obligation is satisfied over time under Topic 606, which is consistent with the timing of our revenue recognition under legacy guidance for the Management Fee component of the compensation received in exchange for the service. Additionally, in certain contracts the Company has the ability to earn an incentive fee based on operational results. Historically these fees have been recognized once fully determinable. Under Topic 606, we measure and recognize the progress toward completion of the performance obligation on a quarterly basis using the most likely amount method to determine an accrual for the Incentive Fee portion of the compensation received in exchange for the property management service. The variable consideration recognized is subject to constraints due to a range of possible consideration amounts based on actual operational results. The amount accrued in the fourth quarter fiscal 2019 did not have a material effect on our financial statements. +Traditional life and Medicare supplement insurance premiums are recognized as revenue over the premium-paying periods of the contracts when due from the policyholders. For products where premiums are due over a significantly shorter duration than the period over which benefits are provided, such as our single premium whole life product, premiums are recognized when received and excess profits are deferred and recognized in relation to the insurance in force. Life insurance premiums are recognized in accordance with existing guidance in Topic 944 – Financial Services – Insurance. +Property and casualty insurance premiums are recognized as revenue over the policy periods. Interest and investment income are recognized as earned. Property and casualty premiums are recognized in accordance with existing guidance in Topic 944 – Financial Services – Insurance. +F- 57 +AMERCO AND CONSOLIDATED SUBSIDIARIES +NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) +Net investment and interest income has multiple components. Interest income from bonds and mortgage notes are recognized when earned. Dividends on common and preferred stocks are recognized on the ex-dividend dates. Realized gains and losses on the sale or exchange of investments are recognized at the trade date. Net investment and interest income is recognized in accordance with existing guidance in Topic 825 – Financial Instruments. +Other revenue consists of numerous services or rentals, of which U-Box contracts and service fees from Moving Help are the main components. The performance obligations identified for U-Box contracts are fees for rental, storage and shipping of U-Box containers to a specified location, each of which are distinct. A contract may be partially within the scope of Topic 606 and partially within the scope of other topics. The rental and storage obligations in U-Box contracts meet the definition of a lease in Topic 840, while the shipping obligation represents a contract with a customer accounted for under Topic 606. Therefore, we allocate the total transaction price between the performance obligations of storage fees and rental fees and the shipping fees on a standalone selling price basis. U-Box shipping fees are collected once the shipment is in transit. Shipping fees in U-Box contracts are set at the initiation of the contract based on the shipping origin and destination, and the performance obligation is satisfied over time under Topic 606, which is consistent with the timing of our revenue recognition under legacy guidance. U-Box shipping contracts span over a relatively short period of time, and the majority of these contracts begin and end within the same fiscal year. Moving Help services fees are generated as we provide a neutral venue for the connection between the service provider and the customer for agreed upon services. We do not control the specified services provided by the service provider before that service is transferred to the customer. +In the following tables, the revenue is disaggregated by timing of revenue recognition: +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Revenues recognized over time +$ +2,814,732 +$ +2,617,990 +$ +2,494,060 +Revenues recognized at a point in time +305,408 +301,152 +291,886 +Total revenues recognized under ASC 606 +3,120,140 +2,919,142 +2,785,946 +Revenues recognized under ASC 840 +406,070 +353,924 +311,403 +Revenues recognized under ASC 944 +131,563 +217,575 +222,142 +Revenues recognized under ASC 320 +110,934 +110,473 +102,276 +Total revenues +$ +3,768,707 +$ +3,601,114 +$ +3,421,767 +In the above tables, the revenues recognized over time include self-moving equipment rentals, property management fees, the shipping fees associated with U-Box rentals and a portion of other revenues, whereas revenues recognized at a point in time include self-moving and self-storage products and service sales and a portion of other revenues. +We recognize liabilities resulting from contracts with customers for self-moving equipment rentals and self-storage revenues in which the length of the contract goes beyond the reported period end, although rental periods of the contract are generally short-term in nature. The timing of revenue recognition results in contract liabilities that are reflected in deferred income on the balance sheet. The deferred income balances associated with equipment rentals and storage revenues as of March 31, 2018 were recognized as revenue during the fiscal year ended March 31, 2019. +F- 58 +Note 23. Subsequent Events +Our management has evaluated subsequent events occurring after March 31, 2019. We do not believe any other subsequent events have occurred that would require further disclosure or adjustment to our financial statements other than as stated below. +On March 6, 2019, we declared a cash dividend on our Common Stock of $0.50 per share to holders of record on March 21, 2019. The dividend was paid on April 4, 2019. +F- 59 +SCHEDULE I +CONDENSED FINANCIAL INFORMATION OF AMERCO +BALANCE SHEETS +March 31, +2019 +2018 +(In thousands) +ASSETS +Cash and cash equivalents +$ +428,950 +$ +469,209 +Investment in subsidiaries +2,474,671 +2,244,867 +Related party assets +1,424,274 +1,227,491 +Other assets +120,896 +114,568 +Total assets +$ +4,448,791 +$ +4,056,135 +LIABILITIES AND STOCKHOLDERS' EQUITY +Liabilities: +Other liabilities +$ +754,115 +$ +639,604 +754,115 +639,604 +Stockholders' equity: +Preferred stock +– +– +Common stock +10,497 +10,497 +Additional paid-in capital +453,536 +452,956 +Accumulated other comprehensive loss +(68,459) +(4,623) +Retained earnings: +Beginning of period +3,635,351 +2,883,943 +Adjustment for adoption of ASU 2016-01 +9,724 +– +Net earnings +370,857 +790,583 +Dividends +(39,180) +(39,175) +End of period +3,976,752 +3,635,351 +Cost of common shares in treasury +(525,653) +(525,653) +Cost of preferred shares in treasury +(151,997) +(151,997) +Total stockholders' equity +3,694,676 +3,416,531 +Total liabilities and stockholders' equity +$ +4,448,791 +$ +4,056,135 +The accompanying notes are an integral part of these condensed financial statements. +F- 60 +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF OPERATIONS +Years Ended March 31, +2019 +2018 +2017 +(In thousands, except share and per share data) +Revenues: +Net interest income and other revenues +$ +8,601 +$ +4,606 +$ +1,912 +Expenses: +Operating expenses +8,840 +7,003 +7,115 +Other expenses +93 +91 +109 +Total expenses +8,933 +7,094 +7,224 +Equity in earnings of subsidiaries +279,589 +681,786 +327,773 +Interest income +112,649 +120,549 +103,211 +Pretax earnings +391,906 +799,847 +425,672 +Income tax expense +(21,049) +(9,264) +(27,248) +Earnings available to common shareholders +$ +370,857 +$ +790,583 +$ +398,424 +Basic and diluted earnings per common share +$ +18.93 +$ +40.36 +$ +20.34 +Weighted average common shares outstanding: Basic and diluted +19,592,048 +19,588,889 +19,586,606 +The accompanying notes are an integral part of these condensed financial statements. +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF comprehensive income +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Net earnings +$ +370,857 +$ +790,583 +$ +398,424 +Other comprehensive income (loss) +(62,075) +37,873 +9,289 +Total comprehensive income +$ +308,782 +$ +828,456 +$ +407,713 +The accompanying notes are an integral part of these condensed financial statements. +F- 61 +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF CASH FLOW +Years Ended March 31, +2019 +2018 +2017 +(In thousands) +Cash flows from operating activities: +Net earnings +$ +370,857 +$ +790,583 +$ +398,424 +Change in investments in subsidiaries +(279,589) +(681,786) +(327,773) +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +1 +3 +10 +Net loss on sale of real and personal property +– +– +13 +Deferred income taxes +112,434 +(182,358) +173,059 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +– +– +– +Prepaid expenses +(6,289) +(36,516) +16,021 +Other assets +(40) +65 +(20) +Related party assets +– +– +1 +Accounts payable and accrued expenses +2,260 +278 +(297) +Net cash provided (used) by operating activities +199,634 +(109,731) +259,438 +Cash flows from investing activities: +Purchases of property, plant and equipment +(1) +(1) +(55) +Proceeds of property, plant and equipment +– +– +39 +Net cash used by investing activities +(1) +(1) +(16) +Cash flows from financing activities: +Proceeds from (repayments) of intercompany loans +(196,382) +250,214 +(221,124) +Common stock dividends paid +(39,179) +(29,380) +(58,757) +Net cash provided (used) by financing activities +(235,561) +220,834 +(279,881) +Effects of exchange rate on cash +(4,331) +(3,124) +– +Increase (decrease) in cash and cash equivalents +(40,259) +107,978 +(20,459) +Cash and cash equivalents at beginning of period +469,209 +361,231 +381,690 +Cash and cash equivalents at end of period +$ +428,950 +$ +469,209 +$ +361,231 +Income taxes paid, net of income taxes refunds received, amounted to $4.3 million, $68.7 million and $36.9 million for fiscal 2019, 2018 and 2017, respectively. +The accompanying notes are an integral part of these condensed financial statements. +F- 62 +CONDENSED FINANCIAL INFORMATION OF AMERCO +NOTES TO CONDENSED FINANCIAL INFORMATION +March 31, 2019, 2018, and 2017 +1. Summary of Significant Accounting Policies +AMERCO, a Nevada corporation, was incorporated in April, 1969, and is the holding Company for U-Haul International, Inc., Amerco Real Estate Company, Repwest Insurance Company and Oxford Life Insurance Company. The financial statements of the Registrant should be read in conjunction with the Consolidated Financial Statements and notes thereto included in this Annual Report. +AMERCO is included in a consolidated Federal income tax return with all of its U.S. subsidiaries. Accordingly, the provision for income taxes has been calculated for Federal income taxes of AMERCO and subsidiaries included in the consolidated return of AMERCO. State taxes for all subsidiaries are allocated to the respective subsidiaries. +The financial statements include only the accounts of AMERCO, which include certain of the corporate operations of AMERCO. The interest in AMERCO’s majority owned subsidiaries is accounted for on the equity method. The intercompany interest income and expenses are eliminated in the Consolidated Financial Statements. +2. Guarantees +AMERCO has guaranteed performance of certain long-term leases and other obligations. See Note 17, Contingent Liabilities and Commitments, and Note 19, Related Party Transactions, of the Notes to Consolidated Financial Statements. +F- 63 +SCHEDULE II +AMERCO AND CONSOLIDATED SUBSIDIARIES +VALUATION AND QUALIFYING ACCOUNTS +Balance at Beginning of Year +Additions Charged to Costs and Expenses +Additions Charged to Other Accounts +Deductions +Balance at Year End +Year ended March 31, 2019 +(In thousands) +Allowance for doubtful accounts +(deducted from trade receivable) +$ +496 +$ +1,550 +$ +– +$ +(1,497) +$ +549 +Allowance for obsolescence +(deducted from inventory) +$ +5,329 +$ +– +$ +– +$ +(3,007) +$ +2,322 +Allowance for LIFO +(deducted from inventory) +$ +16,126 +$ +2,861 +$ +– +$ +– +$ +18,987 +Allowance for probable losses +(deducted from mortgage loans) +$ +618 +$ +– +$ +– +$ +(125) +$ +493 +Year ended March 31, 2018 +Allowance for doubtful accounts +(deducted from trade receivable) +$ +539 +$ +886 +$ +– +$ +(929) +$ +496 +Allowance for obsolescence +(deducted from inventory) +$ +2,050 +$ +3,279 +$ +– +$ +– +$ +5,329 +Allowance for LIFO +(deducted from inventory) +$ +14,340 +$ +1,786 +$ +– +$ +– +$ +16,126 +Allowance for probable losses +(deducted from mortgage loans) +$ +493 +$ +125 +$ +– +$ +– +$ +618 +Year ended March 31, 2017 +Allowance for doubtful accounts +(deducted from trade receivable) +$ +585 +$ +913 +$ +– +$ +(959) +$ +539 +Allowance for obsolescence +(deducted from inventory) +$ +1,597 +$ +1,218 +$ +– +$ +(765) +$ +2,050 +Allowance for LIFO +(deducted from inventory) +$ +13,463 +$ +877 +$ +– +$ +– +$ +14,340 +Allowance for probable losses +(deducted from mortgage loans) +$ +368 +$ +125 +$ +– +$ +– +$ +493 +F- 64 +SCHEDULE V +AMERCO AND CONSOLIDATED SUBSIDIARIES +SUPPLEMENTAL INFORMATION (FOR PROPERTY-CASUALTY INSURANCE Operations) +Years Ended December 31, 2018, 2017, AND 2016 +Fiscal Year +Affiliation with Registrant +Deferred Policy Acquisition Cost +Reserves for Unpaid Claims and Adjustment Expenses +Discount if any, Deducted +Unearned Premiums +Net Earned Premiums (1) +Net Investment Income (2) +Claim and Claim Adjustment Expenses Incurred Related to Current Year +Claim and Claim Adjustment Expenses Incurred Related to Prior Year +Amortization of Deferred Policy Acquisition Costs +Paid Claims and Claim Adjustment Expense +Net Premiums Written (1) +(In thousands) +2019 +Consolidated property +casualty entity +$ +– +$ +228,970 +$ +N/A +$ +239 +$ +60,853 +$ +9,373 +$ +19,579 +$ +(5,365) +$ +– +$ +19,228 +$ +61,022 +2018 +Consolidated property +casualty entity +– +233,554 +N/A +70 +57,100 +14,079 +15,749 +233 +– +17,366 +57,123 +2017 +Consolidated property +casualty entity +– +244,400 +N/A +49 +52,334 +14,015 +13,297 +107 +– +17,609 +52,324 +(1)The earned and written premiums are reported net of intersegment transactions. There were $2.8 million and $2.3 million in written premiums and $2.6 million and $1.7 million in earned premiums eliminated for the year ended December 31, 2018 and 2017, respectively and no written or earned premiums eliminated for the year ended December 31, 2016. +(2) Net Investment Income excludes net realized (gains) losses on investments of ($3.0) million, ($1.7) million and ($2.6) million for the years ended December 31, 2018, 2017 and 2016, respectively . +F- 65 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +AMERCO +Date: May 29, 2019 +/s/ Edward J. Shoen +Edward J. Shoen +President and Chairman of the Board +(Duly Authorized Officer) +Date: May 29, 2019 +/s/ Jason A. Berg +Jason A. Berg +Chief Financial Officer +(Principal Financial Officer) +POWER OF ATTORNEY +KNOW ALL BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Edward J. Shoen his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act or things requisite and necessary to be done in and about the premises, as fully and to all intents and purposes as he might or could do in person hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Jason A. Berg +Chief Financial Officer +May 29, 2019 +Jason A. Berg +/s/ James E. Acridge +Director +May 29, 2019 +James E. Acridge +/s/ John P. Brogan +Director +May 29, 2019 +John P. Brogan +/s/ John M. Dodds +Director +May 29, 2019 +John M. Dodds +/s/ James J. Grogan +Director +May 29, 2019 +James J. Grogan +/s/ Richard J. Herrera +Director +May 29, 2019 +Richard J. Herrera +/s/ Karl A. Schmidt +Director +May 29, 2019 +Karl A. Schmidt +/s/ Samuel J. Shoen +Director +May 29, 2019 +Samuel J. Shoen \ No newline at end of file diff --git a/raw/filings/0000004457/2019/0000004457-19-000024/filing_metadata.csv b/raw/filings/0000004457/2019/0000004457-19-000024/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..19cbab172c280b9729f4268761032a4a314bc89d --- /dev/null +++ b/raw/filings/0000004457/2019/0000004457-19-000024/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004457,UHAL-B,U-Haul Holding Co /NV/,2019,10-K,2019-05-29,2019-03-31,2019-05-29T21:04:17.000Z,0000004457-19-000024,march201910k.htm,"MARCH 31, 2019 10-K",23181314,1,0,https://www.sec.gov/Archives/edgar/data/4457/000000445719000024/march201910k.htm,https://www.sec.gov/Archives/edgar/data/4457/000000445719000024/ diff --git a/raw/filings/0000004457/2019/0000004457-19-000024/item1.txt b/raw/filings/0000004457/2019/0000004457-19-000024/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..ab371fe8fac691af70548cc236bd15eddf96eb9f --- /dev/null +++ b/raw/filings/0000004457/2019/0000004457-19-000024/item1.txt @@ -0,0 +1,76 @@ +Item 1. Business +Company Overview +We are North America’s largest “do-it-yourself” moving and storage operator through our subsidiary U-Haul International, Inc. (“U-Haul”). U-Haul is synonymous with “do-it-yourself” moving and storage and is a leader in supplying products and services to help people move and store their household and commercial goods. Our primary service objective is to “provide a better and better product and service to more and more people at a lower and lower cost.” Unless the context otherwise requires, the terms “AMERCO,” “Company,” “we,” “us,” or “our” refer to AMERCO, a Nevada corporation, and all of its legal subsidiaries, on a consolidated basis. +We were founded in 1945 as a sole proprietorship under the name "U-Haul Trailer Rental Company" and have rented trailers ever since. Starting in 1959, we rented trucks on a one-way and in-town basis exclusively through independent U-Haul ® dealers. In 1973, we began developing our network of U-Haul ® managed retail stores, through which we rent our trucks and trailers, self-storage units and portable moving and storage units and sell moving and self-storage products and services to complement our independent dealer network. +We rent our distinctive orange and white U-Haul ® trucks and trailers as well as offer self-storage units through a network of 1,981 Company-operated retail moving stores and over 20,000 independent U-Haul ® dealers. We also sell U-Haul ® brand boxes, tape and other moving and self-storage products and services to “do-it-yourself” moving and storage customers at all of our distribution outlets and through our uhaul.com ® and eMove ® websites. +We believe U-Haul ® is the most convenient supplier of products and services addressing the needs of the United States and Canada’s “do-it-yourself” moving and storage markets. Our broad geographic coverage throughout the United States and Canada and our extensive selection of U-Haul ® brand moving equipment rentals, self-storage units, portable moving and storage units and related moving and storage products and services provide our customers with convenient “one-stop” shopping. +Since 1945, U-Haul ® has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Through Repwest Insurance Company (“Repwest”) and ARCOA Risk Retention Group ("ARCOA"), our property and casualty insurance subsidiaries, we manage the property, liability and related insurance claims processing for U-Haul ® . Oxford Life Insurance Company (“Oxford”), our life insurance subsidiary, sells life insurance, Medicare supplement insurance, annuities and other related products to the senior market. +Available Information +AMERCO ® and U-Haul ® are each incorporated in Nevada. The internet address for U-Haul is uhaul.com. On AMERCO’s investor relations website, amerco.com, we post the following filings as soon as practicable after they are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”): our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, proxy statements related to meetings of our stockholders, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We also use our investor relations website as a means of disclosing material information and for complying with our disclosure obligations under Regulation FD. All such filings on our website are available free of charge. Additionally, you will find these materials on the SEC’s website at sec.gov. +1 +Products and Rental Equipment +Our customers are primarily “do-it-yourself” household movers. U-Haul ® moving equipment is specifically designed, engineered and manufactured for the “do-it-yourself” household mover. These “do-it-yourself” movers include individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and “do-it-yourself” home remodeling and gardening enthusiasts who need to transport materials. +As of March 31, 2019, our rental fleet consisted of approximately 167,000 trucks, 120,000 trailers and 43,000 towing devices. This equipment and our U-Haul brand of self-moving products and services are available through our network of managed retail moving stores and independent U-Haul dealers. Independent U-Haul dealers receive rental equipment from the Company, act as rental agents and are paid a commission based on gross revenues generated from their U-Haul ® rentals. +Our rental truck chassis are engineered by domestic truck manufacturers. These chassis are joined with the U-Haul ® designed and manufactured van boxes primarily at U-Haul ® operated manufacturing and assembly facilities strategically located throughout the United States. U-Haul ® rental trucks feature our proprietary Lowest Deck SM , which provides our customers with extra ease of loading. The loading ramps on our trucks are the widest in the industry, which reduce the effort needed to move belongings. Our trucks are fitted with convenient, padded rub rails with tie downs on every interior wall. Our Gentle Ride Suspension SM helps our customers safely move delicate and prized possessions. Also, the engineers at our U-Haul Technical Center determined that the softest ride in our trucks was at the front of the van box. Consequently, we designed the part of the van box that hangs over the front cab of the truck to be the location for our customers to place their most fragile items during their move. We call this area Mom’s Attic ® . +Our distinctive trailers are also manufactured at these same U-Haul ® operated manufacturing and assembly facilities. These trailers are well suited to the low profile of many of today’s newly manufactured automobiles. Our engineering staff is committed to making our trailers easy to tow, safe, aerodynamic and fuel efficient. +To provide our self-move customers with added value, our rental trucks and trailers are designed with fuel efficiency in mind. Many of our trucks are fitted with fuel economy gauges, another tool that assists our customers in conserving fuel. To help make our rental equipment more reliable, we routinely perform extensive preventive maintenance and repairs. +We also provide customers with equipment to transport their vehicles. We provide two towing options: auto transport, in which all four wheels are off the ground, and a tow dolly, in which the front wheels of the towed vehicle are off the ground. +To help our customers load their boxes and larger household appliances and furniture, we offer several accessory rental items. Our utility dolly has a lightweight design and is easy to maneuver. Another rental accessory is our four wheel dolly, which provides a large, flat surface for moving dressers, wall units, pianos and other large household items. U-Haul ® appliance dollies provide the leverage needed to move refrigerators, freezers, washers and dryers easily and safely. These utility, furniture and appliance dollies, along with the low decks and the wide loading ramps on U-Haul ® trucks and trailers, are designed for easy loading and unloading of our customers’ belongings. +The total package U-Haul ® offers to the “do-it-yourself” household mover doesn’t end with trucks, trailers and accessory rental items. Our moving supplies include a wide array of affordably priced U-Haul ® brand boxes, tape and packing materials. We also provide specialty boxes for dishes, computers and sensitive electronic equipment, as well as tape, security locks, and packing supplies. U-Haul ® brand boxes are specifically sized to make loading easier. +We estimate that U-Haul ® is North America’s largest seller and installer of hitches and towing systems. In addition to towing U-Haul ® equipment, these hitching and towing systems can tow jet skis, motorcycles, boats, campers and horse trailers. Each year, more than one million customers visit our locations for expertise on complete towing systems, trailer rentals and the latest in towing accessories. +2 +U-Haul ® has one of North America’s largest propane refilling networks, with over 1,100 locations providing this convenient service. We employ trained, certified personnel to refill propane cylinders and alternative fuel vehicles. Our network of propane dispensing locations is one of the largest automobile alternative refueling networks in North America. +Our self-storage business was a natural outgrowth of our self-moving operations. Conveniently located U-Haul ® self-storage rental facilities provide clean, dry and secure space for storage of household and commercial goods. Storage units range in size from 6 square feet to over 1,000 square feet. As of March 31, 2019, we operate 1,631 self-storage locations in the United States and Canada, with nearly 697,000 rentable storage units comprising 60.7 million square feet of rentable storage space. Our self-storage centers feature a wide array of security measures, ranging from electronic property access control gates to individually alarmed storage units. At many centers, we offer climate-controlled storage units to protect temperature sensitive goods such as video tapes, albums, photographs and precious wood furniture. +Another extension of our strategy to make “do-it-yourself” moving and storage easier is our U-Box ® program. A U-Box ® portable moving and storage unit is delivered to a location of our customer’s choosing either by the customers themselves through the use of a U-Box ® trailer, with the assistance of a Moving Helper or by Company personnel. Once the U-Box ® portable moving and storage unit is filled, it can be stored at the customer’s location, or taken to one of our Company operated locations, a participating independent dealer, or moved to a location of the customer’s choice. +Additionally, we offer moving and storage protection packages such as Safemove ® and Safetow ® . These programs provide moving and towing customers with a damage waiver, cargo protection and medical and life insurance coverage. Safestor ® provides protection for storage customers from loss on their goods in storage. Safestor Mobile ® provides protection for customers stored belongings when using our U-Box ® portable moving and storage units. For our customers who desire additional coverage over and above the standard Safemove ® protection, we also offer our Safemove Plus ® product. This package provides the rental customer with a layer of primary liability protection. +We believe that through our website, uhaul.com, we have aggregated the largest network of customers and independent businesses in the self-moving and self-storage industry. In particular, our Moving Helper program connects “do-it-yourself” movers with thousands of independent service providers in the United States and Canada to assist our customers in packing, loading, unloading, cleaning and performing other services. +Through the U-Haul Storage Affiliates ® program, independent storage businesses can join one of the world’s largest self-storage reservation systems. Self-storage customers making a reservation through uhaul.com ® can access all of the U-Haul self-storage centers and all of our independent storage affiliate partners for even greater convenience to meet their self-storage needs. For the independent storage operator, our network gives them access to products and services allowing them to compete with larger operators more cost effectively. +We own numerous trademarks and service marks that contribute to the identity and recognition of our Company and its products and services. Certain of these marks are integral to the conduct of our business, a loss of any of which could have a material adverse affect on our business. We consider the trademark “U-Haul ® ” to be of material importance to our business in addition, but not limited to, the U.S. trademarks and service marks “AMERCO ® ”, “eMove ® ”, “Gentle Ride Suspension SM ”, “In-Town ® ”, “Lowest Decks SM ”, “Moving made Easier ® ”, “Make Moving Easier ® ”, “Mom’s Attic ® ”, “Moving Help ® ”, “Moving Helper ® ”, “Safemove ® ”, “Safemove Plus ® ”, “Safestor ® ”, “Safestor Mobile ® ”, “Safetow ® ”, “U-Box ® ”, “uhaul.com ® ”, “U-Haul Investors Club ® ”, “U-Haul Truck Share ® ”, “U-Haul Truck Share 24/7 ® “ “U-Note ® ”, “WebSelfStorage ® ”, and “U-Haul Smart Mobility Center ®” , among others, for use in connection with the moving and storage business. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO ® , U-Haul ® , and Amerco Real Estate Company +(“Real Estate”), and the subsidiaries of U-Haul ® and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +Life Insurance, comprised of Oxford and its subsidiaries. +3 +Financial information for each of our operating segments is included in the Notes to Consolidated Financial Statements as part of Item 8: Financial Statements and Supplementary Data of this Annual Report on Form 10-K. +Moving and Storage Operating Segment +Moving and Storage operating segment (“Moving and Storage”) consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul ® throughout the United States and Canada. +Net revenue from Moving and Storage was approximately 94.0%, 91.3% and 90.8% of consolidated net revenue in fiscal 2019, 2018 and 2017, respectively. +The total number of rental trucks in the fleet increased during fiscal 2019 as the pace of new additions was greater than those trucks removed for retirement and sale. These additions and replacements to the fleet were a combination of U-Haul ® manufactured vehicles and purchases. As new trucks are added to the fleet, we typically remove older trucks from the fleet. +Within our truck and trailer rental operation, we are focused on expanding our independent dealer network to provide added convenience for our customers. U-Haul ® maximizes vehicle utilization by managing distribution of the truck and trailer fleets among the 1,981 Company-operated stores and 20,000 independent dealers. Utilizing its proprietary reservations management system, our centers and dealers electronically report their inventory in real-time, which facilitates matching equipment to customer demand. Over half of all U-Move ® rental revenue originated from our operated centers. +At our owned and operated retail stores we are implementing new initiatives to improve customer service. These initiatives include improving management of our rental equipment to provide our retail centers with the right type of rental equipment, at the right time and at the most convenient location for our customers, effectively marketing our broad line of self-moving related products and services, expanding accessibility to provide more convenience to our customers, and enhancing our ability to properly staff locations during our peak hours of operations by attracting and retaining “moonlighters” (part-time U-Haul ® employees with full-time jobs elsewhere) during our peak hours of operation. As of April 2017, U-Haul expanded it’s offering of U-Haul Truck Share 24/7 ® to our entire network in the United States and Canada. U-Haul currently has several U.S. Patents pending on its U-Haul Truck Share 24/7 ® system. +Our self-moving related products and services, such as boxes, pads and insurance, help our customers have a better moving experience and help them to protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +Our self-storage business operations consist of the rental of self-storage units, portable moving and storage units, sales of self-storage related products, the facilitation of sales of services, and the management of self-storage facilities owned by others. +U-Haul ® is one of the largest North American operators of self-storage and has been a leader in the self-storage industry since 1974. U-Haul ® operates nearly 697,000 rentable storage units, comprising 60.7 million square feet of rentable storage space with locations in 50 states and 10 Canadian provinces. Our owned and managed self-storage facility locations range in size up to 309,000 square feet of storage space, with individual storage units in sizes ranging from 6 square feet to over 1,000 square feet. +The primary market for storage units is the storage of household goods. We believe that our self-storage services provide a competitive advantage through such things as Max Security, an electronic system that monitors the storage facility 24 hours a day, climate control in select units, individually alarmed units, extended hours access, and an internet-based customer reservation and account management system. +4 +Moving Help ® and U-Haul Storage Affiliates ® on uhaul.com are online marketplaces that connect consumers to independent Moving Help ® service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated Moving Help ® and affiliates provide pack and load help, cleaning help, self-storage and similar services all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Environmental laws and regulations are complex, change frequently and could become more stringent in the future. +Moving and Storage business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally our weakest. +Property and Casualty Insurance Operating Segment +Our Property and Casualty Insurance operating segment (“Property and Casualty Insurance”) provides loss adjusting and claims handling for U-Haul through regional offices across the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove ® , Safetow ® , Safemove Plus ® , Safestore Mobile ® and Safestor ® protection packages to U-Haul customers. We attempt to price our products to be a good value to our customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. +Net revenue from Property and Casualty Insurance was approximately 1.9%, 2.0% and 2.0% of consolidated net revenue in fiscal 2019, 2018 and 2017, respectively. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Net revenue from Life Insurance was approximately 4.1%, 6.7% and 7.2% of consolidated net revenue in fiscal 2019, 2018 and 2017, respectively. +Employees +As of March 31, 2019, we employed over 30,000 people throughout the United States and Canada with approximately 99% of these employees working within Moving and Storage and approximately 54% of these employees working on a part-time basis. +Sales and Marketing +We promote U-Haul ® brand awareness through direct and co-marketing arrangements. Our direct marketing activities consist of web-based initiatives, print and social media as well as trade events, movie and television cameos of our rental fleet and boxes, and industry and consumer communications. We believe that our rental equipment is our best form of advertisement. We support our independent U-Haul ® dealers through marketing U-Haul ® moving and self-storage rentals, products and services. +Our marketing plan focuses on maintaining our leadership position in the “do-it-yourself” moving and storage industry by continually improving the ease of use and economy of our rental equipment, by providing added convenience to our retail centers, through independent U-Haul dealers, and by expanding the capabilities of our U-Haul websites. +A significant driver of rental transaction volume is our utilization of an online reservation and sales system, through uhaul.com and our 24-hour 1-800-GO-U-HAUL telephone reservations system. These points of contact are prominently featured and are a major driver of customer lead sources. +5 +Competition +Moving and Storage Operating Segment +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. Generally speaking, we consider there to be two distinct users of rental trucks: commercial and “do-it-yourself” residential users. We primarily focus on the “do-it-yourself” residential user. Within this segment, we believe the principal competitive factors are convenience of rental locations, availability of quality rental moving equipment, breadth of essential products and services, and total cost to the user. Our major national competitors in both the in-town and one-way moving equipment rental market include Avis Budget Group, Inc. and Penske Truck Leasing. We have numerous competitors throughout the United States and Canada who compete with us in the in-town market. +The self-storage market is large and very fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Our largest competitors in the self-storage market are Public Storage Inc., Extra Space Storage, Inc., CubeSmart and Life Storage, Inc. +Insurance Operating Segments +The insurance industry is highly competitive. In addition, the marketplace includes financial services firms offering both insurance and financial products. Some of the insurance companies are owned by stockholders and others are owned by policyholders. Many competitors have been in business for a longer period of time or possess substantially greater financial resources and broader product portfolios than our insurance companies. We compete in the insurance business based upon price, product design, and services rendered to agents and policyholders. +Financial Data of Segment and Geographic Areas +For financial data of our segments and geographic areas please see Note 21, Financial Information by Geographic Area, and Note 21A, Consolidating Financial Information by Consolidating Industry Segment, of our Notes to Consolidated Financial Statements. +Cautionary Statement Regarding Forward-Looking Statements +This Annual Report on Form 10-K (“Annual Report”), contains “forward-looking statements” regarding future events and our future results of operations. We may make additional written or oral forward-looking statements from time to time in filings with the SEC or otherwise. We believe such forward-looking statements are within the meaning of the safe-harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Such statements may include, but are not limited to, estimates of capital expenditures, plans for future operations, products or services, financing needs and plans, our perceptions of our legal positions and anticipated outcomes of government investigations and pending litigation against us, liquidity and the availability of financial resources to meet our needs, goals and strategies, plans for new business, storage occupancy, growth rate assumptions, pricing, costs, and access to capital and leasing markets the impact of our compliance with environmental laws and cleanup costs, our used vehicle disposition strategy, the sources and availability of funds for our rental equipment and self-storage expansion and replacement strategies and plans, our plan to expand our U-Haul storage affiliate program, that additional leverage can be supported by our operations and business, the availability of alternative vehicle manufacturers, our estimates of the residual values of our equipment fleet, our plans with respect to off-balance sheet arrangements, our plans to continue to invest in the U-Box ® program, the impact of interest rate and foreign currency exchange rate changes on our operations, the sufficiency of our capital resources and the sufficiency of capital of our insurance subsidiaries as well as assumptions relating to the foregoing. The words “believe,” “expect,” “anticipate,” “plan,” “may,” “will,” “could,” “estimate,” “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. +6 +Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Factors that could significantly affect results include, without limitation, the risk factors enumerated below under the heading “Risk Factors” and other factors described in this Annual Report or the other documents we file with the SEC. These factors, the following disclosures, as well as other statements in this Annual Report and in the Notes to Consolidated Financial Statements, could contribute to or cause such risks or uncertainties, or could cause our stock price to fluctuate dramatically. Consequently, the forward-looking statements should not be regarded as representations or warranties by us that such matters will be realized. We assume no obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by law. \ No newline at end of file diff --git a/raw/filings/0000004457/2019/0000004457-19-000024/item13.txt b/raw/filings/0000004457/2019/0000004457-19-000024/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..7b1e49c464e7612e99132133fcd6b35e171cf679 --- /dev/null +++ b/raw/filings/0000004457/2019/0000004457-19-000024/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +41 \ No newline at end of file diff --git a/raw/filings/0000004457/2020/0000004457-20-000053/filing.txt b/raw/filings/0000004457/2020/0000004457-20-000053/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..7b954444c6ed52ed4c161a3762f25bf2189e44d0 --- /dev/null +++ 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commission +Washington, D.C. 20549 +Form +10-K +(Mark One) +☒ +Annual Report Pursuant to Section 13 or 15( +d +) of the securities exchange act of 1934. +For the fiscal year ended +March 31, 2020 +or +☐ +Transition report pursuant to section 13 or 15( +d +) OF THE SECURITIES EXCHANGE ACT OF 1934. +For the transition period from __________________ to _________________ +Commission File Number +001-11255 +State or other jurisdiction of +incorporation or organization +Registrant, State of Incorporation +Address and Telephone Number +I.R.S. Employer +Identification No. +Nevada +88-0106815 +AMERCO +(A Nevada Corporation) +5555 Kietzke Lane +, +Ste. 100 +Reno +, +Nevada +89511 +Telephone ( +775 +) +688-6300 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbol +Name of each exchange on which registered +Common stock, $0.25 par value +UHAL +NASDAQ +Global Select Market +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes +☒ +No +☐ +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act. +Yes +☐ +No +☒ +Indicate by check mark whether the registrant +(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes +☒ +No +☐ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes +☒ +No +☐ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated Filer +☒ +Accelerated Filer +☐ +Non-accelerated Filer +☐ +Smaller Reporting Company +☐ +Emerging Growth Company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. +☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +Yes +☐ +No +☒ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report +☒ +The aggregate market value of AMERCO common stock held by non-affiliates on September 30, 2019 was $ +3,494,102,743 +. The aggregate market value was computed using the closing price for the common stock trading on NASDAQ on such date. Shares held by executive officers, directors and persons owning directly or indirectly more than 5% of the outstanding common stock have been excluded from the preceding number because such persons may be deemed to be affiliates of the registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +19,607,788 +shares of AMERCO Common Stock, $0.25 par value, were outstanding at May 22, 2020. +Documents incorporated by reference: portions of AMERCO’s definitive proxy statement for the 2020 annual meeting of stockholders, to be filed within 120 days after AMERCO’s fiscal year ended March 31, 2020, are incorporated by reference into Part III of this report. +TABLE OF CONTENTS +Page +PART I +Item 1. +Business +1 +Item 1A. +Risk Factors +7 +Item 1B. +Unresolved Staff Comments +13 +Item 2. +Properties +13 +Item 3. +Legal Proceedings +13 +Item 4. +Mine Safety Disclosures +13 +PART II +Item 5. +Ma +rket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +14 +Item 6. +Selected Financial Data +16 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +17 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +37 +Item 8. +F +inancial Statements and Supplementary Data +38 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +38 +Item 9A. +Controls and Procedures +38 +Item 9B. +Other Information +41 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +41 +Item 11. +Executive Compensation +41 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +41 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +41 +Item 14. +Principal Accountant Fees and Services +41 +PART IV +Item 15. +Exhibits; Financial Statement Schedules +41 +Item 16. +Form 10-K Summary +49 +Part i +Item 1. Business +Company Overview +We are North America’s largest “do-it-yourself” moving and storage operator through our subsidiary U-Haul International, Inc. (“U-Haul”). U-Haul is synonymous with “do-it-yourself” moving and storage and is a leader in supplying products and services to help people move and store their household and commercial goods. Our primary service objective is to “provide a better and better product and service to more and more people at a lower and lower cost.” Unless the context otherwise requires, the terms “AMERCO,” “Company,” “we,” “us,” or “our” refer to AMERCO, a Nevada corporation, and all of its legal subsidiaries, on a consolidated basis. +We were founded in 1945 as a sole proprietorship under the name "U-Haul Trailer Rental Company" and have rented trailers ever since. Starting in 1959, we rented trucks on a one-way and in-town basis exclusively through independent U-Haul +® +dealers. In 1973, we began developing our network of U-Haul +® +managed retail stores, through which we rent our trucks and trailers, self-storage units and portable moving and storage units and sell moving and self-storage products and services to complement our independent dealer network. +We rent our distinctive orange and white U-Haul +® +trucks and trailers as well as offer self-storage units through a network of 2,065 Company-operated retail moving stores and over 20,100 independent U-Haul +® +dealers. We also sell U-Haul +® +brand boxes, tape and other moving and self-storage products and services to “do-it-yourself” moving and storage customers at all of our distribution outlets and through our uhaul.com +® +and eMove +® +websites. +We believe U-Haul +® +is the most convenient supplier of products and services addressing the needs of the United States and Canada’s “do-it-yourself” moving and storage markets. Our broad geographic coverage throughout the United States and Canada and our extensive selection of U-Haul +® +brand moving equipment rentals, self-storage units, portable moving and storage units and related moving and storage products and services provide our customers with convenient “one-stop” shopping. +Since 1945, U-Haul +® +has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Through Repwest Insurance Company (“Repwest”) and ARCOA Risk Retention Group ("ARCOA"), our property and casualty insurance subsidiaries, we manage the property, liability and related insurance claims processing for U-Haul +® +. Oxford Life Insurance Company (“Oxford”), our life insurance subsidiary, sells life insurance, Medicare supplement insurance, annuities and other related products to the senior market. +Available Information +AMERCO +® +and U-Haul +® +are each incorporated in Nevada. The internet address for U-Haul is uhaul.com. On AMERCO’s investor relations website, amerco.com, we post the following filings as soon as practicable after they are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”): our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, proxy statements related to meetings of our stockholders, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We also use our investor relations website as a means of disclosing material information and for complying with our disclosure obligations under Regulation FD. All such filings on our website are available free of charge. Additionally, you will find these materials on the SEC’s website at sec.gov. +1 +Products and Rental Equipment +Our customers are primarily “do-it-yourself” household movers. U-Haul +® +moving equipment is specifically designed, engineered and manufactured for the “do-it-yourself” household mover. These “do-it-yourself” movers include individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and “do-it-yourself” home remodeling and gardening enthusiasts who need to transport materials. +As of March 31, 2020, our rental fleet consisted of approximately 176,000 trucks, 127,000 trailers and 41,000 towing devices. This equipment and our U-Haul brand of self-moving products and services are available through our network of managed retail moving stores and independent U-Haul dealers. Independent U-Haul dealers receive rental equipment from the Company, act as rental agents and are paid a commission based on gross revenues generated from their U-Haul +® +rentals. +Our rental truck chassis are engineered by domestic truck manufacturers. These chassis are joined with the U-Haul +® +designed and manufactured van boxes primarily at U-Haul +® +operated manufacturing and assembly facilities strategically located throughout the United States. U-Haul +® +rental trucks feature our proprietary Lowest Deck +SM +, which provides our customers with extra ease of loading. The loading ramps on our trucks are the widest in the industry, which reduce the effort needed to move belongings. Our trucks are fitted with convenient, padded rub rails with tie downs on every interior wall. Our Gentle Ride Suspension +SM +helps our customers safely move delicate and prized possessions. Also, the engineers at our U-Haul Technical Center determined that the softest ride in our trucks was at the front of the van box. Consequently, we designed the part of the van box that hangs over the front cab of the truck to be the location for our customers to place their most fragile items during their move. We call this area Mom’s Attic +® +. +Our distinctive trailers are also manufactured at these same U-Haul +® +operated manufacturing and assembly facilities. These trailers are well suited to the low profile of many of today’s newly manufactured automobiles. Our engineering staff is committed to making our trailers easy to tow, safe, aerodynamic and fuel efficient. +To provide our self-move customers with added value, our rental trucks and trailers are designed with fuel efficiency in mind. Many of our trucks are fitted with fuel economy gauges, another tool that assists our customers in conserving fuel. To help make our rental equipment more reliable, we routinely perform extensive preventive maintenance and repairs. +We also provide customers with equipment to transport their vehicles. We provide two towing options: auto transport, in which all four wheels are off the ground, and a tow dolly, in which the front wheels of the towed vehicle are off the ground. +To help our customers load their boxes and larger household appliances and furniture, we offer several accessory rental items. Our utility dolly has a lightweight design and is easy to maneuver. Another rental accessory is our four wheel dolly, which provides a large, flat surface for moving dressers, wall units, pianos and other large household items. U-Haul +® +appliance dollies provide the leverage needed to move refrigerators, freezers, washers and dryers easily and safely. These utility, furniture and appliance dollies, along with the low decks and the wide loading ramps on U-Haul +® +trucks and trailers, are designed for easy loading and unloading of our customers’ belongings. +The total package U-Haul +® +offers to the “do-it-yourself” household mover doesn’t end with trucks, trailers and accessory rental items. Our moving supplies include a wide array of affordably priced U-Haul +® +brand boxes, tape and packing materials. We also provide specialty boxes for dishes, computers and sensitive electronic equipment, as well as tape, security locks, and packing supplies. U-Haul +® +brand boxes are specifically sized to make loading easier. +We estimate that U-Haul +® +is North America’s largest seller and installer of hitches and towing systems. In addition to towing U-Haul +® +equipment, these hitching and towing systems can tow jet skis, motorcycles, boats, campers and horse trailers. Each year, millions of customers visit our locations for expertise on complete towing systems, trailer rentals and the latest in towing accessories. +U-Haul +® +has one of North America’s largest propane refilling networks, with nearly 1,200 locations providing this convenient service. We employ trained, certified personnel to refill propane cylinders and alternative fuel vehicles. Our network of propane dispensing locations is one of the largest automobile alternative refueling networks in North America. +2 +Our self-storage business was a natural outgrowth of our self-moving operations. Conveniently located U-Haul +® +self-storage rental facilities provide clean, dry and secure space for storage of household and commercial goods. Storage units range in size from 6 square feet to over 1,000 square feet. As of March 31, 2020, we operate 1,745 self-storage locations in the United States and Canada, with over 774,000 rentable storage units comprising 66.7 million square feet of rentable storage space. Our self-storage centers feature a wide array of security measures, ranging from electronic property access control gates to individually alarmed storage units. At many centers, we offer climate-controlled storage units to protect temperature sensitive goods such as video tapes, albums, photographs and precious wood furniture. +Another extension of our strategy to make “do-it-yourself” moving and storage easier is our U-Box +® +program. +A U-Box +® +portable moving and storage unit is delivered to a location of our customer’s choosing either by the customers themselves through the use of a U-Box +® +trailer, with the assistance of a Moving Helper or by Company personnel. Once the U-Box +® +portable moving and storage unit is filled, it can be stored at the customer’s location, or taken to one of our Company operated locations, a participating independent dealer, or moved to a location of the customer’s choice. +Additionally, we offer moving and storage protection packages such as Safemove +® +and Safetow +® +. These programs provide moving and towing customers with a damage waiver, cargo protection and medical and life insurance coverage. Safestor +® +provides protection for storage customers from loss on their goods in storage. Safestor Mobile +® +provides protection for customers stored belongings when using our U-Box +® +portable moving and storage units. For our customers who desire additional coverage over and above the standard Safemove +® +protection, we also offer our Safemove Plus +® +product. This package provides the rental customer with a layer of primary liability protection. +We believe that through our website, uhaul.com, we have aggregated the largest network of customers and independent businesses in the self-moving and self-storage industry. In particular, our Moving Helper program connects “do-it-yourself” movers with thousands of independent service providers in the United States and Canada to assist our customers in packing, loading, unloading, cleaning and performing other services. +Through the U-Haul Storage Affiliates +® +program, independent storage businesses can join one of the world’s largest self-storage reservation systems. Self-storage customers making a reservation through uhaul.com +® +can access all of the U-Haul self-storage centers and all of our independent storage affiliate partners for even greater convenience to meet their self-storage needs. For the independent storage operator, our network gives them access to products and services allowing them to compete with larger operators more cost effectively. +We own numerous trademarks and service marks that contribute to the identity and recognition of our Company and its products and services. Certain of these marks are integral to the conduct of our business, a loss of any of which could have a material adverse affect on our business. We consider the trademark “U-Haul +® +” to be of material importance to our business in addition, but not limited to, the U.S. trademarks and service marks “AMERCO +® +”, “eMove +® +”, “Gentle Ride Suspension +SM +”, “In-Town +® +”, “Lowest Decks +SM +”, “Moving made Easier +® +”, “Make Moving Easier +® +”, “Mom’s Attic +® +”, “Moving Help +® +”, “Moving Helper +® +”, “Safemove +® +”, “Safemove Plus +® +”, “Safestor +® +”, “Safestor Mobile +® +”, +“Safetow +® +”, +“U-Box +® +”, “uhaul.com +® +”, “U-Haul Investors Club +® +”, “U-Haul Truck Share +® +”, “U-Haul Truck Share 24/7 +® +“ “U-Note +® +”, “WebSelfStorage +® +”, and “U-Haul Smart Mobility Center +®” +, among others, for use in connection with the moving and storage business. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO +® +, U-Haul +® +, and Amerco Real Estate Company +(“Real Estate”), and the subsidiaries of U-Haul +® +and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +Life Insurance, comprised of Oxford and its subsidiaries. +Financial information for each of our operating segments is included in the Notes to Consolidated Financial Statements as part of Item 8: Financial Statements and Supplementary Data of this Annual Report on Form 10-K. +3 +Moving and Storage Operating Segment +Moving and Storage operating segment (“Moving and Storage”) consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul +® +throughout the United States and Canada. +Net revenue from Moving and Storage was approximately 91.8%, 94.0% and 91.3% of consolidated net revenue in fiscal 2020, 2019 and 2018, respectively. +The total number of rental trucks in the fleet increased during fiscal 2020 as the pace of new additions was greater than those trucks removed for retirement and sale. These additions and replacements to the fleet were a combination of U-Haul +® +manufactured vehicles and purchases. As new trucks are added to the fleet, we typically remove older trucks from the fleet. +Within our truck and trailer rental operation, we are focused on expanding our independent dealer network to provide added convenience for our customers. U-Haul +® +maximizes vehicle utilization by managing distribution of the truck and trailer fleets among the 2,065 Company-operated stores and over 20,100 independent dealers. Utilizing its proprietary reservations management system, our centers and dealers electronically report their inventory in real-time, which facilitates matching equipment to customer demand. Over half of all U-Move +® +rental revenue originated from our operated centers. +At our owned and operated retail stores we are implementing new initiatives to improve customer service. These initiatives include improving management of our rental equipment to provide our retail centers with the right type of rental equipment, at the right time and at the most convenient location for our customers, effectively marketing our broad line of self-moving related products and services, expanding accessibility to provide more convenience to our customers, and enhancing our ability to properly staff locations during our peak hours of operations by attracting and retaining “moonlighters” (part-time U-Haul +® +employees with full-time jobs elsewhere) during our peak hours of operation. +As of April 2017, U-Haul expanded it’s offering of U-Haul Truck Share 24/7 +® +to our entire network in the United States and Canada. U-Haul currently has several U.S. Patents pending on its U-Haul Truck Share 24/7 +® +system. +Our self-moving related products and services, such as boxes, pads and insurance, help our customers have a better moving experience and help them to protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +Our self-storage business operations consist of the rental of +self-storage units, portable moving and storage units, sales of self-storage related products, the facilitation of sales of services, and the management of self-storage facilities owned by others. +U-Haul +® +is one of the largest North American operators of self-storage and has been a leader in the self-storage industry since 1974. U-Haul +® +operates nearly 774,000 rentable storage units, comprising 66.7 million square feet of rentable storage space with locations in 50 states and 10 Canadian provinces. Our owned and managed self-storage facility locations range in size up to 309,000 square feet of storage space, with individual storage units in sizes ranging from 6 square feet to over 1,000 square feet. +The primary market for storage units is the storage of household goods. We believe that our self-storage services provide a competitive advantage through such things as Max Security, an electronic system that monitors the storage facility 24 hours a day, climate control in select units, individually alarmed units, extended hours access, and an internet-based customer reservation and account management system. +4 +Moving +Help +® +and U-Haul Storage Affiliates +® +on uhaul.com are online marketplaces that connect consumers to independent Moving Help +® +service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated Moving Help +® +and affiliates provide pack and load help, cleaning help, self-storage and similar services all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Environmental laws and regulations are complex, change frequently and could become more stringent in the future. +Moving and Storage business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally our weakest. +Property and Casualty Insurance Operating Segment +Our Property and Casualty Insurance operating segment (“Property and Casualty Insurance”) provides loss adjusting and claims handling for U-Haul through regional offices across the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove +® +, Safetow +® +, Safemove Plus +® +, Safestore Mobile +® +and Safestor +® +protection packages to U-Haul customers. We attempt to price our products to be a good value to our customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. +Net revenue from Property and Casualty Insurance was approximately 2.2%, 1.9% and 2.0% of consolidated net revenue in fiscal 2020, 2019 and 2018, respectively. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Net revenue from Life Insurance was approximately 6.0%, 4.1% and 6.7% of consolidated net revenue in fiscal 2020, 2019 and 2018, respectively. +Employees +As of March 31, 2020, we employed approximately 30,000 people throughout the United States and Canada with approximately 99% of these employees working within Moving and Storage and approximately 52% of these employees working on a part-time basis. +Sales and Marketing +We promote U-Haul +® +brand awareness through direct and co-marketing arrangements. Our direct marketing activities consist of web-based initiatives, print and social media as well as trade events, movie and television cameos of our rental fleet and boxes, television commercials, and industry and consumer communications. We believe that our rental equipment is our best form of advertisement. We support our independent U-Haul +® +dealers through marketing U-Haul +® +moving and self-storage rentals, products and services. +Our marketing plan focuses on maintaining our leadership position in the “do-it-yourself” moving and storage industry by continually improving the ease of use and economy of our rental equipment, by providing added convenience to our retail centers, through independent U-Haul dealers, and by expanding the capabilities of our U-Haul websites. +A significant driver of rental transaction volume is our utilization of an online reservation and sales system, through uhaul.com and our 24-hour 1-800-GO-U-HAUL telephone reservations system. These points of contact are prominently featured and are a major driver of customer lead sources. +5 +Competition +Moving and Storage Operating Segment +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. Generally speaking, we consider there to be two distinct users of rental trucks: commercial and “do-it-yourself” residential users. We primarily focus on the “do-it-yourself” residential user. Within this segment, we believe the principal competitive factors are convenience of rental locations, availability of quality rental moving equipment, breadth of essential products and services, and total cost to the user. Our major national competitors in both the in-town and one-way moving equipment rental market include Avis Budget Group, Inc. and Penske Truck Leasing. We have numerous competitors throughout the United States and Canada who compete with us in the in-town market. +The self-storage market is large and very fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Our largest competitors in the self-storage market are Public Storage Inc., Extra Space Storage, Inc., CubeSmart and Life Storage, Inc. +Insurance Operating Segments +The insurance industry is highly competitive. In addition, the marketplace includes financial services firms offering both insurance and financial products. Some of the insurance companies are owned by stockholders and others are owned by policyholders. Many competitors have been in business for a longer period of time or possess substantially greater financial resources and broader product portfolios than our insurance companies. We compete in the insurance business based upon price, product design, and services rendered to agents and policyholders. +Financial Data of Segment and Geographic Areas +For financial data of our segments and geographic areas please see Note 22, Financial Information by Geographic Area, and Note 22A, Consolidating Financial Information by Consolidating Industry Segment, of our Notes to Consolidated Financial Statements. +Cautionary Statement Regarding Forward-Looking Statements +This Annual Report on Form 10-K (“Annual Report”), contains “forward-looking statements” regarding future events and our future results of operations. We may make additional written or oral forward-looking statements from time to time in filings with the SEC or otherwise. We believe such forward-looking statements are within the meaning of the safe-harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Such statements may include, but are not limited to, the risk associated with COVID-19 or similar events on employees or customers, impact on the economic environment or demand of our products and the cost and availability of debt and capital estimates of capital expenditures, plans for future operations, products or services, financing needs and plans, our perceptions of our legal positions and anticipated outcomes of government investigations and pending litigation against us, liquidity and the availability of financial resources to meet our needs, goals and strategies, plans for new business, storage occupancy, growth rate assumptions, pricing, costs, and access to capital and leasing markets, the impact of our compliance with environmental laws and cleanup costs, our used vehicle disposition strategy, the sources and availability of funds for our rental equipment and self-storage expansion and replacement strategies and plans, our plan to expand our U-Haul storage affiliate program, that additional leverage can be supported by our operations and business, the availability of alternative vehicle manufacturers, our estimates of the residual values of our equipment fleet, our plans with respect to off-balance sheet arrangements, our plans to continue to invest in the U-Box +® +program, the impact of interest rate and foreign currency exchange rate changes on our operations, the sufficiency of our capital resources, and the sufficiency of capital of our insurance subsidiaries as well as assumptions relating to the foregoing. The words “believe,” “expect,” “anticipate,” “plan,” “may,” “will,” “could,” “estimate,” “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. +6 +Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Factors that could significantly affect results include, without limitation, the risk factors enumerated below under the heading “Risk Factors” and other factors described in this Annual Report or the other documents we file with the SEC. These factors, the following disclosures, as well as other statements in this Annual Report and in the Notes to Consolidated Financial Statements, could contribute to or cause such risks or uncertainties, or could cause our stock price to fluctuate dramatically. Consequently, the forward-looking statements should not be regarded as representations or warranties by us that such matters will be realized. We assume no obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by law. +Item 1A. Risk Factors +The following discussion of risk factors should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) and the Consolidated Financial Statements and related notes. +These risk factors may be important in understanding this Annual Report or elsewhere. +The recent novel coronavirus +(“COVID-19”) +global pandemic has had and is expected to continue to have an adverse effect on our business and results of operations. +Future viral pandemics could have similar or more severe effects on our business. +In late 2019, +COVID-19 +was first detected in Wuhan, China. In March 2020, the World Health Organization declared +COVID-19 +a global pandemic, and governmental authorities around the world have implemented measures to reduce the spread of +COVID-19. +The virus, along with measures have adversely affected workforces, customers, consumer sentiment, economies and financial markets. +The combination of customer-initiated changes in behavior along with state and local jurisdictions imposing shelter-in-place orders, quarantines, executive orders and similar government orders and restrictions to control the spread of COVID-19 have resulted in reduced business activity. +These events have highlighted several risks to our business resulting from COVID-19 or other potential future pandemics. +Our locations are considered essential services and have been open and serving communities throughout the current pandemic. There is a risk this may not always be the case. +Additionally, our workforce may be negatively impacted by such a pandemic that could lead to disruptions in our ability to serve customers. +We are unable to accurately predict the impact that COVID-19 or other such similar outbreaks will have on our operations going forward due to uncertainties which will be dictated by the length of time that such disruptions continue, which will, in turn, depend on the currently unknowable duration of COVID-19 and the impact of governmental regulations that might be imposed in response to the pandemic. +While it is premature to accurately predict the ultimate impact of these developments, we suspect that our results for the quarter ending June 30, 2020 and potentially the remainder of fiscal 2021 may be significantly adversely affected. +To the extent COVID-19 +adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this “Risk Factors” section, such as those relating to our high level of indebtedness, our need to generate sufficient cash flows to service our indebtedness, our ability to comply with the covenants contained in the agreements that govern our indebtedness, our fleet rotation program, the manufacturers and suppliers of our rental equipment, our independent dealers and the operation of our rental fleet, sales of our products and operation of our locations. +7 +We operate in a highly competitive industry. +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. We believe the principal competitive factors in this industry are convenience of rental locations, availability of quality rental moving equipment, breadth of essential services and products and total cost. Financial results for the Company can be adversely impacted by aggressive pricing from our competitors. Some of our competitors may have greater financial resources than we have. We cannot assure you that we will be able to maintain existing rental prices or implement price increases. Moreover, if our competitors reduce prices and we are not able or willing to do so as well, we may lose rental volume, which would likely have a materially adverse effect on our results of operations. Numerous potential competitors are working to establish paradigm shifting technologies from self-driving vehicles to ride-hailing services and other technologies that connect riders with vehicles. +The self-storage industry is large and highly fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Competition in the market areas in which we operate is significant and affects the occupancy levels, rental rates and operating expenses of our facilities. Competition might cause us to experience a decrease in occupancy levels, limit our ability to raise rental rates or require us to offer discounted rates that would have a material effect on results of operations and financial condition. Entry into the self-storage business may be accomplished through the acquisition of existing facilities by persons or institutions with the required initial capital. Development of new self-storage facilities is more difficult however, due to land use, zoning, environmental and other regulatory requirements. The self-storage industry has in the past experienced overbuilding in response to perceived increases in demand. We cannot assure you that we will be able to successfully compete in existing markets or expand into new markets. +We are highly leveraged. +As of March 31, 2020, we had total debt outstanding of $4,651.1 million and operating lease liabilities of $106.4 million. Although we believe, based on existing information, that additional leverage can be supported by our operations and revenues, our existing debt could impact us in the following ways among other considerations: +require us to allocate a considerable portion of cash flows from operations to debt service and lease payments; +limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; +limit our ability to obtain additional financing; and +place us at a disadvantage compared to our competitors who may have less debt. +Our ability to make payments on our debt and leases depends upon our ability to maintain and improve our operating performance and generate cash flow. To some extent, this is subject to prevailing economic and competitive conditions and to certain financial, business and other factors, some of which are beyond our control. If we are unable to generate sufficient cash flow from operations to service our debt and meet our other cash needs, including our leases, we may be forced to reduce or delay capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness and leases. If we must sell our assets, it may negatively affect our ability to generate revenue. In addition, we may incur additional debt or leases that would exacerbate the risks associated with our indebtedness. +8 +Uncertainty regarding LIBOR may adversely impact our indebtedness under our credit and loan facilities. +On July 27, 2017, the United Kingdom’s Financial Conduct Authority, which regulates London Inter-Bank Offer Rate (“LIBOR”), announced that it intends to phase out LIBOR by the end of 2021. It is unclear if at that time whether or not LIBOR will cease to exist or if new methods of calculating LIBOR will be established such that it continues to exist after 2021. In addition, in April 2018, the Federal Reserve System, in conjunction with the Alternative Reference Rates Committee, announced the replacement of LIBOR with a new index, calculated by short-term repurchase agreements collateralized by U.S. Treasury securities, called the Secured Overnight Financing Rate (“SOFR”). At this time, it is not possible to predict whether SOFR will attain market traction as a LIBOR replacement. Additionally, the future of LIBOR at this time is uncertain. Potential changes, or uncertainty related to such potential changes, may adversely affect the market for LIBOR-based securities, including our portfolio of LIBOR-indexed, floating-rate debt securities, or the cost of our borrowings. In addition, changes or reforms to the determination or supervision of LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR, which could have an adverse impact on the market for LIBOR-based securities, including the value of the LIBOR-indexed, floating-rate debt securities in our portfolio, or the cost of our borrowings. Additionally, if LIBOR ceases to exist, we may need to renegotiate our credit and loan facilities extending beyond 2021 that utilize LIBOR as a factor in determining the interest rate and certain of our existing credit facilities to replace LIBOR with the new standard that is established. The potential effect of the phase-out or replacement of LIBOR on our cost of capital and net investment income cannot yet be determined. +Economic conditions, including those related to the credit markets, may adversely affect our industry, business and results of operations. +Consumer and commercial spending is generally affected by the health of the economy, which places some of the factors affecting the success of our business beyond our control. Our businesses, although not as traditionally cyclical as some, could experience significant downturns in connection with or in anticipation of, declines in general economic conditions. In times of declining consumer spending we may be driven, along with our competitors, to reduce pricing which would have a negative impact on gross profit. +We cannot predict if another downturn in the economy will occur, which could result in reduced revenues and working capital. +Should credit markets in the United States tighten or if interest rates increase significantly, we may not be able to refinance existing debt or find additional financing on favorable terms, if at all. +If one or more of the financial institutions that support our existing credit facilities fails or opts not to continue to lend to us, we may not be able to find a replacement, which would negatively impact our ability to borrow under credit facilities. +If our operating results were to worsen significantly and our cash flows or capital resources prove inadequate, or if interest rates increase significantly, we could face liquidity problems that could materially and adversely affect our results of operations and financial condition. +Our fleet rotation program can be adversely affected by financial market conditions. +To meet the needs of our customers, U-Haul maintains a large fleet of rental equipment. Our rental truck fleet rotation program is funded internally through operations and externally from debt and lease financing. Our ability to fund our routine fleet rotation program could be adversely affected if financial market conditions limit the general availability of external financing. This could lead us to operate trucks longer than initially planned and/or reduce the size of the fleet, either of which could materially and negatively affect our results of operations. +Another important aspect of our fleet rotation program is the sale of used rental equipment. The sale of used equipment provides us with funds that can be used to purchase new equipment. Conditions may arise that could lead to the decrease in demand and/or resale values for our used equipment. This could have a material adverse effect on our financial results, which could result in substantial losses on the sale of equipment and decreases in cash flows from the sales of equipment. +9 +We obtain our rental trucks from a limited number of manufacturers. +Over the last twenty years, we purchased the majority of our rental trucks from Ford Motor Company and General Motors Corporation. Our fleet can be negatively affected by issues our manufacturers may face within their own supply chain. Also, it is possible that our suppliers may face financial difficulties or organizational changes which could negatively impact their ability to accept future orders or fulfill existing orders. The cost of acquiring new rental trucks could increase materially and negatively affect our ability to rotate new equipment into the fleet. Although we believe that we could contract with alternative manufacturers for our rental trucks, we cannot guarantee or predict how long that would take. In addition, termination of our existing relationship with these suppliers could have a material adverse effect on our business, financial condition or results of operations for an indefinite period of time. +A substantial amount of our shares is owned by a small contingent of stockholders. +Willow Grove Holdings LP, directly and through controlled entities (“WGHLP”), owns 8,337,804 shares of AMERCO common stock, and together with Edward J. Shoen and Mark V. Shoen, owns 8,390,066 shares (approximately 42.8%) of AMERCO common stock. +The general partner of WGHLP controls the voting and disposition decisions with respect to the common stock of AMERCO owned by WGHLP, and is managed by Edward J. Shoen (the Chairman of the Board of Directors and Chief Executive Officer of AMERCO) and his brother, Mark V. Shoen. +Accordingly, +Edward J. Shoen +and +Mark V. Shoen +are in a position to significantly influence +our business and policies, including the approval of +certain +significant transactions, the election of the members of +our +Board +of Directors (the “Board”) +and other matters submitted to our stockholders. There can be no assurance that their +interests will not conflict with the interests +of our other stockholders. +In addition, 1,003,040 shares (approximately 5.1%) of AMERCO common stock are owned under our Employee Stock Ownership Plan (“ESOP”). +Each ESOP participant is entitled to vote the shares allocated to himself or herself in their discretion. +In the event an ESOP participant does not vote his or her shares, such shares shall be voted by the ESOP trustee, in the ESOP trustee’s discretion. +Our operations subject us to numerous environmental regulations and the possibility that environmental liability in the future could adversely affect our operations. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Under environmental laws or common law principles, we can be held liable for hazardous substances that are found on real property we have owned or operated. We are aware of issues regarding hazardous substances on some of our real estate and we have put in place a remediation plan at each site where we believe such a plan is necessary. See Note 19, Contingencies, of the Notes to Consolidated Financial Statements. We regularly make capital and operating expenditures to stay in compliance with environmental laws. In particular, we have managed a testing and removal program since 1988 for our underground storage tanks. +Despite these compliance efforts, the risk of environmental liability is part of the nature of our business. +Environmental laws and regulations are complex, change frequently and could become more stringent in the future. We cannot assure you that future compliance with these regulations, future environmental liabilities, the cost of defending environmental claims, conducting any environmental remediation or generally resolving liabilities caused by us or related third parties will not have a material adverse effect on our business, financial condition or results of operations. +10 +We operate in a highly regulated industry and changes in existing regulations or violations of existing or future regulations could have a material adverse effect on our operations and profitability. +Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. The failure to comply with these laws and regulations may adversely affect our ability to sell or rent such property or to use the property as collateral for future borrowings. Compliance with changing regulations could substantially impair real property and equipment productivity and increase our costs. In addition, the Federal government may institute some regulation that limits carbon emissions by setting a maximum amount of carbon individual entities can emit without penalty. This would likely affect everyone who uses fossil fuels and would disproportionately affect users in the highway transportation industries. While there are too many variables at this time to assess the impact of the various proposed federal and state regulations that could affect carbon emissions, many experts believe these proposed rules could significantly affect the way companies operate in their businesses. +Our operations can be limited by land-use regulations. Zoning choices enacted by individual municipalities in the United States and Canada may limit our ability to serve certain markets with our products and services. +Our insurance companies are heavily regulated by state insurance departments and the National Association of Insurance Commissioners (“NAIC”). These insurance regulations are primarily in place to protect the interests of our policyholders and not our investors. Changes in these laws and regulations could increase our costs, inhibit new sales, or limit our ability to implement rate increases. +A significant portion of our revenues are generated through third-parties. +Our business plan relies upon a network of independent dealers strategically located throughout the United States and Canada. +As of March 31, 2020 we had over 20,100 independent equipment rental dealers. +In fiscal 2020, less than half of all U-Move +® +rental revenue originated through this network. +Our inability to maintain this network or its current cost structure could inhibit our ability to adequately serve our customers and may negatively affect our results of operations and financial position. +We face liability risks associated with the operation of our rental fleet, sales of our products and operation of our locations. +The business of renting moving and storage equipment to customers exposes us to liability claims including property damage, personal injury and even death. Likewise, the operation of our moving and storage centers along with the sale of our related moving supplies, towing accessories and installation, and refilling of propane tanks may subject us to liability claims. +We seek to limit the occurrence of such events through the design of our equipment, communication of its proper use, exhaustive repair and maintenance schedules, extensive training of our personnel, proactive risk management assessments and by providing our customers with online resources for the proper use of products and services. +Regardless, accidents still occur and we manage the financial risk of these events through third party insurance carriers. While these excess loss and property insurance policies are available today at reasonable costs, this could change and could negatively affect our results of operations and financial position. +Terrorist attacks could negatively impact our operations and profitability and may expose us to liability and reputational damage. +Terrorist attacks may negatively affect our operations and profitability. +Such attacks may damage our facilities and it is also possible that our rental equipment could be involved in a terrorist attack. +Although we carry excess of loss insurance coverage, it may prove to be insufficient to cover us for acts of terror using our rental equipment. +Moreover, we may suffer reputational damage that could arise from a terrorist attack which utilizes our rental equipment. The consequences of any terrorist attacks or hostilities are unpredictable and difficult to quantify. +We seek to minimize these risks through our operational processes and procedures; however, we may not be able to foresee events that could have an adverse effect on our operations. +11 +We are highly dependent upon our automated systems and the Internet for managing our business. +Our information systems are largely Internet-based, including our point-of-sale reservation system, payment processing and telephone systems. +While our reliance on this technology lowers our cost of providing service and expands our abilities to better serve customers, it exposes us to various risks including natural and man-made disasters, terrorist attacks and cyber-attacks. +We have put into place extensive security protocols, backup systems and alternative procedures to mitigate these risks. +However, disruptions or breaches, detected or undetected by us, for any period of time in any portion of these systems could adversely affect our results of operations and financial condition and inflict reputational damage. +In addition, the provision of service to our customers and the operation of our networks and systems involve the storage and transmission of proprietary information and sensitive or confidential data, including personal information of customers, employees and others. Our information technology systems may be susceptible to computer viruses, attacks by computer hackers, malicious insiders, or catastrophic events. Hackers, acting individually or in coordinated groups, may also launch distributed denial of service attacks or ransom or other coordinated attacks that may cause service outages or other interruptions in our business and access to our data. +In addition, breaches in security could expose us, our customers, or the individuals affected, to a risk of loss or misuse of proprietary information and sensitive or confidential data. The techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently, may be difficult to detect for a long time and often are not recognized until launched against a target. As a result, we may be unable to anticipate these techniques or to implement adequate preventative measures. +Any of these occurrences could result in disruptions in our operations, the loss of existing or potential customers, damage to our brand and reputation, and litigation and potential liability for the Company. In addition, the cost and operational consequences of implementing further data or system protection measures could be significant and our efforts to deter, identify, mitigate and/or eliminate any security breaches may not be successful. +A.M. Best financial strength ratings are crucial to our life insurance business. +In June 2019, A.M. Best affirmed the financial strength rating for Oxford and Christian Fidelity Life Insurance Company (“CFLIC”) of A- and revised the outlook from stable to positive and affirmed the financial strength rating for North American Insurance Company (“NAI”) of B++ with a stable outlook. Financial strength ratings are important external factors that can affect the success of Oxford’s business plans. Accordingly, if Oxford’s ratings, relative to its competitors, are not maintained or do not continue to improve, Oxford may not be able to retain and attract business as currently planned, which could adversely affect our results of operations and financial condition. +We may incur losses due to our reinsurers’ or counterparties’ failure to perform under existing contracts or we may be unable to secure sufficient reinsurance or hedging protection in the future. +We use reinsurance and derivative contracts to mitigate our risk of loss in various circumstances; primarily at Repwest and for Moving and Storage. These agreements do not release us from our primary obligations and therefore we remain ultimately responsible for these potential costs. We cannot provide assurance that these reinsurers or counterparties will fulfill their obligations. Their inability or unwillingness to make payments to us under the terms of the contracts may have a material adverse effect on our financial condition and results of operations. +At December 31, 2019, Repwest reported $0.6 million of reinsurance recoverables, net of allowances and $87.1 million of reserves and liabilities ceded to reinsurers. Of this, Repwest’s largest exposure to a single reinsurer was $54.5 million. +12 +Recent changes to U.S. tax laws may adversely affect our financial condition or results of operations and create the risk that we may need to adjust our accounting for these changes. +The Tax Cuts and Jobs Act (“Tax Reform Act”) and the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) made significant changes to U.S. tax laws and includes numerous provisions that affect businesses, including ours. +For instance, as a result of lower corporate tax rates, the Tax Reform Act tends to reduce both the value of deferred tax assets and the amount of deferred tax liabilities. +It also limits interest expense deductions and the amount of net operating losses that can be used each year and alters the expensing of capital expenditures. Other provisions have international tax consequences for businesses like ours that operate internationally. The CARES Act allows for the carryback of certain net operating losses. The Tax Reform Act is unclear in certain respects and will require interpretations and implementing regulations by the IRS, as well as state tax authorities, and the Tax Reform Act and CARES Act could be subject to amendments and technical corrections, any of which could lessen or increase the adverse (and positive) impacts of these acts. The accounting treatment of these tax law changes was complex, and some of the changes affected both current and future periods. +Others primarily affected future periods. +As discussed elsewhere in this Annual Report, our analysis and computations of the tax effects of the Tax Reform Act on us was complete as of December 22, 2018. +Item 1B. Unresolved Staff Comments +None. +Item 2. Properties +The Company, through its legal subsidiaries, owns property, plant and equipment that are utilized in the manufacturing, repair and rental of U-Haul +® +equipment and storage space, as well as providing office space for us. Such facilities exist throughout the United States and Canada. We also manage storage facilities owned by others. We operate 2,065 U-Haul +® +retail centers of which 488 U-Haul branded locations are managed for subsidiaries of WGHLP and Mercury Partners, L.P. (“Mercury”), and 11 manufacturing and assembly facilities. We also operate over 145 fixed-site repair facilities located throughout the United States and Canada. These facilities are used primarily for the benefit of Moving and Storage. +Item 3. Legal Proceedings +Environmental +Compliance with environmental requirements of federal, state and local governments may significantly affect Real Estate’s business operations. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Real Estate is aware of issues regarding hazardous substances on some of its properties. Real Estate regularly makes capital and operating expenditures to stay in compliance with environmental laws and has put in place a remedial plan at each site where it believes such a plan is necessary. Since 1988, Real Estate has managed a testing and removal program for underground storage tanks. +Based upon the information currently available to Real Estate, compliance with the environmental laws and its share of the costs of investigation and cleanup of known hazardous waste sites are not expected to result in a material adverse effect on AMERCO’s financial position or results of operations. +Other +We are named as a defendant in various other litigations and claims arising out of the normal course of business. In management’s opinion, none of these other matters will have a material effect on our financial position and results of operations. +Item 4. Mine Safety Disclosures +Not applicable. +13 +Part ii +Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +As of May 15, 2020, there were approximately 3,000 holders of record of our common stock. We derived the number of our stockholders using internal stock ledgers and utilizing Mellon Investor Services Stockholder listings. AMERCO’s common stock is listed on the NASDAQ Global Select Market under the trading symbol “UHAL”. +Dividends +AMERCO +® +does not have a formal dividend policy. The Board periodically considers the advisability of declaring and paying dividends to common stockholders in light of existing circumstances. +The following table lists the dividends that have been declared and issued for fiscal 2020 and 2019. +Common Stock Dividends +Declared Date +Per Share Amount +Record Date +Dividend Date +December 4, 2019 +$ +0.50 +December 19, 2019 +January 6, 2020 +August 22, 2019 +0.50 +September 9, 2019 +September 23, 2019 +March 6, 2019 +0.50 +March 21, 2019 +April 4, 2019 +December 5, 2018 +0.50 +December 20, 2018 +January 7, 2019 +August 23, 2018 +0.50 +September 10, 2018 +September 24, 2018 +June 6, 2018 +0.50 +June 21, 2018 +July 5, 2018 +See Note 21, Statutory Financial Information of Insurance Subsidiaries, of the Notes to Consolidated Financial Statements for a discussion of certain statutory restrictions on the ability of the insurance subsidiaries to pay dividends to AMERCO. +14 +Performance Graph +The following graph compares the cumulative total stockholder return on the Company’s common stock for the period March 31, 2015 through March 31, 2020 with the cumulative total return on the Dow Jones US Total Market and the Dow Jones US Transportation Average. The comparison assumes that $100 was invested on March 31, 2015 in the Company’s common stock and in each of the comparison indices. The graph reflects the value of the investment based on the closing price of the common stock trading on NASDAQ on March 31, 2016, 2017, 2018, 2019 and 2020. +Fiscal years ended March 31: +2015 +2016 +2017 +2018 +2019 +2020 +AMERCO +$ +100 +$ +108 +$ +116 +$ +105 +$ +114 +$ +89 +Dow Jones US Total Market +100 +100 +117 +136 +147 +124 +Dow Jones US Transportation Average +100 +92 +105 +120 +120 +89 +15 +Item +6.Selected +Financial +Data +The following selected financial data should be read in conjunction with the MD&A, and the Consolidated Financial Statements and related notes in this Annual Report. +Listed below is selected financial data for AMERCO and consolidated subsidiaries for each of the last five years: +Years Ended March 31, +2020 +2019 +2018 +2017 +2016 +(In thousands, except share and per share data) +Summary of Operations: +Self-moving equipment rentals +$ +2,692,413 +$ +2,653,497 +$ +2,479,742 +$ +2,362,833 +$ +2,297,980 +Self-storage revenues +418,741 +367,276 +323,903 +286,886 +247,944 +Self-moving and self-storage products and service sales +265,091 +264,146 +261,557 +253,073 +251,541 +Property management fees +30,406 +29,148 +29,602 +29,075 +26,533 +Life insurance premiums +127,976 +63,488 +154,703 +163,579 +162,662 +Property and casualty insurance premiums +66,053 +60,853 +57,100 +52,334 +50,020 +Net investment and interest income +137,829 +110,934 +110,473 +102,276 +86,617 +Other revenue +240,359 +219,365 +184,034 +171,711 +152,171 +Total revenues +3,978,868 +3,768,707 +3,601,114 +3,421,767 +3,275,468 +Operating expenses +2,117,148 +1,981,180 +1,807,056 +1,567,181 +1,469,260 +Commission expenses +288,332 +288,408 +276,705 +267,230 +262,627 +Cost of sales +164,018 +162,142 +160,489 +152,485 +144,990 +Benefits and losses +174,836 +100,277 +185,311 +182,710 +167,436 +Amortization of deferred policy acquisition costs +31,219 +28,556 +24,514 +26,218 +23,272 +Lease expense +26,882 +33,158 +33,960 +37,343 +49,780 +Depreciation, net gains on disposals (a) +637,063 +554,043 +543,247 +449,025 +291,235 +Net gains on disposal of real estate +(758) +(44) +(195,414) +(3,590) +(545) +Total costs and expenses +3,438,740 +3,147,720 +2,835,868 +2,678,602 +2,408,055 +Earnings from operations +540,128 +620,987 +765,246 +743,165 +867,413 +Other components of net periodic benefit costs +(1,054) +(1,013) +(927) +(902) +(787) +Interest expense +(160,950) +(142,445) +(126,706) +(113,406) +(97,715) +Fees and amortization on early extinguishment of debt +– +– +– +(499) +– +Pretax earnings +378,124 +477,529 +637,613 +628,358 +768,911 +Income tax benefit (expense) +63,924 +(106,672) +152,970 +(229,934) +(279,910) +Earnings available to common shareholders +$ +442,048 +$ +370,857 +$ +790,583 +$ +398,424 +$ +489,001 +Basic and diluted earnings per common share +$ +22.55 +$ +18.93 +$ +40.36 +$ +20.34 +$ +24.95 +Weighted average common shares outstanding: Basic and diluted +19,603,708 +19,592,048 +19,588,889 +19,586,606 +19,596,110 +Cash dividends declared and accrued Common stock +19,608 +39,180 +39,175 +39,171 +97,960 +Balance Sheet Data: +Property, plant and equipment, net +$ +7,843,060 +$ +7,933,971 +$ +6,816,741 +$ +5,957,735 +$ +5,017,511 +Total assets +13,438,024 +11,891,713 +10,747,422 +9,405,840 +8,109,288 +Notes, loans and finance/capital leases payable, net +4,621,291 +4,163,323 +3,513,076 +3,262,880 +2,647,396 +Stockholders' equity +4,220,720 +3,692,389 +3,408,708 +2,619,744 +2,251,406 +(a) Net gains were ($27.1) million, ($27.0) million, ($11.8) million, ($32.5) million and ($98.2) million for fiscal 2020, 2019, 2018, 2017 and 2016, respectively. +16 +Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations +We begin this MD&A with the overall strategy of AMERCO, followed by a description of, and strategy related to, our operating segments to give the reader an overview of the goals of our businesses and the direction in which our businesses and products are moving. We then discuss our critical accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Next, we discuss our results of operations for fiscal 2020 compared with fiscal 2019, and for fiscal 2019 compared with fiscal 2018, which are followed by an analysis of liquidity changes in our balance sheets and cash flows, and a discussion of our financial commitments in the sections entitled Liquidity and Capital Resources and Disclosures about Contractual Obligations and Commercial Commitments. We conclude this MD&A by discussing our outlook for fiscal 2021. +This MD&A should be read in conjunction with the other sections of this Annual Report, including Item 1: Business, Item 6: Selected Financial Data and Item 8: Financial Statements and Supplementary Data. The various sections of this MD&A contain a number of forward-looking statements, as discussed under the caption, Cautionary Statements Regarding Forward-Looking Statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this Annual Report and particularly under the section Item 1A: Risk Factors. Our actual results may differ materially from these forward-looking statements. +AMERCO has a fiscal year that ends on the 31 +st +of March for each year that is referenced. Our insurance company subsidiaries have fiscal years that end on the 31 +st +of December for each year that is referenced. They have been consolidated on that basis. Our insurance companies’ financial reporting processes conform to calendar year reporting as required by state insurance departments. Management believes that consolidating their calendar year into our fiscal year financial statements does not materially affect the presentation of financial position or results of operations. We disclose all material events, if any, occurring during the intervening period. Consequently, all references to our insurance subsidiaries’ years 2019, 2018 and 2017 correspond to fiscal 2020, 2019 and 2018 for AMERCO. +Overall Strategy +Our overall strategy is to maintain our leadership position in the North American “do-it-yourself” moving and storage industry. We accomplish this by providing a seamless and integrated supply chain to the “do-it-yourself” moving and storage market. As part of executing this strategy, we leverage the brand recognition of U-Haul +with our full line of moving and self-storage related products and services and the convenience of our broad geographic presence. +Our primary focus is to provide our customers with a wide selection of moving rental equipment, convenient self-storage rental facilities and portable moving and storage units and related moving and self-storage products and services. We are able to expand our distribution and improve customer service by increasing the amount of moving equipment and storage units and portable moving and storage units available for rent, expanding the number of independent dealers in our network and expanding and taking advantage of our eMove capabilities. +Property and Casualty Insurance is focused on providing and administering property and casualty insurance to U-Haul and its customers, its independent dealers and affiliates. +Life Insurance is focused on long-term capital growth through direct writing and reinsuring of life, Medicare supplement and annuity products in the senior marketplace. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO, U-Haul, and Real Estate and the subsidiaries of +U-Haul and Real Estate; +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA; and +Life Insurance, comprised of Oxford and its subsidiaries. +See Note 1, Basis of Presentation, Note 22, Financial Information by Geographic Area, and Note 22A, Consolidating Financial Information by Industry Segment, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. +17 +Moving and Storage Operating Segment +Moving and Storage consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul +® +throughout the United States and Canada. +With respect to our truck, trailer, specialty rental items and self-storage rental business, we are focused on expanding our dealer network, which provides added convenience for our customers and expanding the selection and availability of rental equipment to satisfy the needs of our customers. +U-Haul +® +brand self-moving related products and services, such as boxes, pads and tape allow our customers to, among other things, protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +uhaul.com +® +is an online marketplace that connects consumers to our operations as well as independent Moving Help +® +service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated affiliates and service providers furnish pack and load help, cleaning help, self-storage and similar services throughout the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +U-Haul’s Truck Share 24/7, Skip-the-Counter Self-Storage rentals and Scan & Go self-checkout for moving supplies provide our customers methods for conducting business with us directly via their mobile devices and also limiting physical exposure. +Since 1945, U-Haul has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Property and Casualty Insurance Operating Segment +Property and Casualty Insurance provides loss adjusting and claims handling for U-Haul through regional offices in the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove +® +, Safetow +® +, Safemove Plus +® +, +Safestor +® +and Safestor Mobile +® +protection packages to U-Haul +® +customers. We continue to focus on increasing the penetration of these products into the moving and storage market. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul +® +related programs. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Critical Accounting Policies and Estimates +Our financial statements have been prepared in accordance with the generally accepted accounting principles (“GAAP”) in the United States. The methods, estimates and judgments we use in applying our accounting policies can have a significant impact on the results we report in our financial statements. Note 3, Accounting Policies, of the Notes to Consolidated Financial Statements in Item 8: Financial Statements and Supplementary Data, in this Annual Report summarizes the significant accounting policies and methods used in the preparation of our consolidated financial statements and related disclosures. Certain accounting policies require us to make difficult and subjective judgments and assumptions, often as a result of the need to estimate matters that are inherently uncertain. +Following is a detailed description of the accounting policies that we deem most critical to us and that require management’s most difficult and subjective judgments. These estimates are based on historical experience, observance of trends in particular areas, information and valuations available from outside sources and on various other assumptions that are believed to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates under different assumptions and conditions, and such differences may be material. +18 +We also have other policies that we consider key accounting policies, such as revenue recognition; however, these policies do not meet the definition of critical accounting estimates, because they do not generally require us to make estimates or judgments that are difficult or subjective. The accounting policies that we deem most critical to us, and involve the most difficult, subjective or complex judgments include the following: +Recoverability of Property, Plant and Equipment +Our property, plant and equipment is stated at cost. Interest expense, if any, incurred during the initial construction of buildings is considered part of cost. Depreciation is computed for financial reporting purposes using the straight-line or an accelerated method based on a declining balance formula over the following estimated useful lives: rental equipment 2-20 years and buildings and non-rental equipment 3-55 years. Routine maintenance costs are charged to operating expense as they are incurred. Gains and losses on dispositions of property, plant and equipment, other than real estate (“personal property”), are netted against depreciation expense when realized. Equipment depreciation is recognized in amounts expected to result in the recovery of estimated residual values upon disposal, i.e., minimize gains or losses. In determining the depreciation rate, historical disposal experience, holding periods and trends in the market for vehicles are reviewed. As a result of changes in IRS regulations regarding the capitalization of assets, beginning in the first quarter of fiscal 2017, we raised the value threshold before certain assets are capitalized within our depreciation policy. This change in threshold, results in the immediate recognition of reported operating costs with a lagging decrease in depreciation expense over the term that these assets would have been depreciated. This change in threshold benefited us through the immediate recognition of tax deductible costs. +We regularly perform reviews to determine whether facts and circumstances exist which indicate that the carrying amount of assets, including estimates of residual value, may not be recoverable or that the useful life of assets are shorter or longer than originally estimated. Reductions in residual values (i.e., the price at which we ultimately expect to dispose of revenue earning equipment) or useful lives will result in an increase in depreciation expense over the remaining life of the equipment. Reviews are performed based on vehicle class, generally subcategories of trucks and trailers. We assess the recoverability of our assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their estimated remaining lives against their respective carrying amounts. We consider factors such as current and expected future market price trends on used vehicles and the expected life of vehicles included in the fleet. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If asset residual values are determined to be recoverable, but the useful lives are shorter or longer than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives. +For our box truck fleet we utilize an accelerated method of depreciation based upon a declining formula. Under the declining balances method (2.4 times declining balance), the book value of a rental truck is reduced by approximately 16%, 13%, 11%, 9%, 8%, 7%, and 6% of cost during years one through seven, respectively, and then reduced on a straight line basis to a salvage value of 15% by the end of year fifteen. Comparatively, a standard straight line approach would reduce the book value by approximately 5.7% per year over the life of the truck. +Although we intend to sell our used vehicles for prices approximating book value, the extent to which we realize a gain or loss on the sale of used vehicles is dependent upon various factors including but not limited to, the general state of the used vehicle market, the age and condition of the vehicle at the time of its disposal and the depreciation rates with respect to the vehicle +. +We typically sell our used vehicles at our sales centers throughout the United States and Canada, on our website at uhaul.com/trucksales or by phone at 1-866-404-0355. Additionally, we sell a large portion of our pickup and cargo van fleet at automobile dealer auctions. +19 +Insurance Reserves +Liabilities for future policy benefits related to life insurance, Medical supplement insurance, and deferred annuities are determined by Management utilizing the net premium valuation methodology and are accrued when premium revenue is recognized. The liability, which represents the present value of future benefits to be paid to policyholders and related expenses less the present value of future net premiums, is estimated using assumptions applicable at the time the insurance contracts are written, with provisions for the risk of adverse deviation, as appropriate. Assumptions include expected mortality and morbidity experience, policy lapses and surrenders, current asset yields and expenses, and expected interest rate yields. The Company periodically performs a gross premium valuation and reviews original assumptions, including capitalized expenses which reduce the gross premium valuation, to evaluate whether the assets and liabilities are adequate and whether a loss reserve should be recognized. +Insurance reserves for Property and Casualty Insurance and U-Haul take into account losses incurred based upon actuarial estimates and are management’s best approximation of future payments. +These estimates are based upon past claims experience and current claim trends as well as social and economic conditions such as changes in legal theories and inflation. +These reserves consist of case reserves for reported losses and a provision for IBNR losses, both reduced by applicable reinsurance recoverables, resulting in a net liability. +Due to the nature of the underlying risks and high degree of uncertainty associated with the determination of the liability for future policy benefits and claims, the amounts to be ultimately paid to settle these liabilities cannot be precisely determined and may vary significantly from the estimated liability, especially for long-tailed casualty lines of business such as excess workers’ compensation. +As a result of the long-tailed nature of the excess workers’ compensation policies written by Repwest from 1983 through 2001, it may take a number of years for claims to be fully reported and finally settled. +On a regular basis insurance reserve adequacy is reviewed by management to determine if existing assumptions need to be updated. In determining the assumptions for calculating workers’ compensation reserves, management considers multiple factors including the following: +Claimant longevity, +Cost trends associated with claimant treatments, +Changes in ceding entity and third party administrator reporting practices, +Changes in environmental factors including legal and regulatory, +Current conditions affecting claim settlements, and +Future economic conditions including inflation. +We have reserved each claim based upon the accumulation of current claim costs projected through each claimant’s life expectancy, and then adjusted for applicable reinsurance arrangements. +Management reviews each claim bi-annually or more frequently, if there are changes in facts or circumstances to determine if the estimated life-time claim costs have increased and then adjusts the reserve estimate accordingly at that time. +We have factored in an estimate of what the potential cost increases could be in our IBNR liability. +We have not assumed settlement of the existing claims in calculating the reserve amount, unless it is in the final stages of completion. +Continued increases in claim costs, including medical inflation and new treatments and medications could lead to future adverse development resulting in additional reserve strengthening. +Conversely, settlement of existing claims or if injured workers return to work or expire prematurely, could lead to future positive development. +Impairment of Investments +Investments are evaluated pursuant to guidance contained in ASC 320 - +Investments - Debt and Equity Securities +to determine if and when a decline in market value of debt securities below amortized cost is other-than-temporary. Management makes certain assumptions or judgments in its assessment including but not limited to: our ability and intent to hold the security, quoted market prices, dealer quotes or discounted cash flows, industry factors, financial factors, and issuer specific information such as credit strength. Other-than-temporary impairment in value is recognized in the current period operating results. There were no write downs in fiscal 2020, 2019 and 2018. +20 +Income Taxes +We file a consolidated tax return with all of our legal subsidiaries. +Our tax returns are periodically reviewed by various taxing authorities. The final outcome of these audits may cause changes that could materially impact our financial results. Please see Note 14, Provision for Taxes, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information. +Fair Values +Fair values of cash equivalents approximate carrying value due to the short period of time to maturity. Fair values of short-term investments, investments available-for-sale, long-term investments, mortgage loans and notes on real estate, and interest rate swap contracts are based on quoted market prices, dealer quotes or discounted cash flows. Fair values of trade receivables approximate their recorded value. +Our financial instruments that are exposed to concentrations of credit risk consist primarily of temporary cash investments, trade receivables, reinsurance recoverables and notes receivable. Limited credit risk exists on trade receivables due to the diversity of our customer base and their dispersion across broad geographic markets. We place our temporary cash investments with financial institutions and limit the amount of credit exposure to any one financial institution. +We have mortgage receivables, which potentially expose us to credit risk. The portfolio of notes is principally collateralized by self-storage facilities and commercial properties. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. The estimated fair values were determined using the discounted cash flow method and using interest rates currently offered for similar loans to borrowers with similar credit ratings. +The carrying amount of long-term debt and short-term borrowings are estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for debt of similar term and remaining maturity. +Other investments including short-term investments are substantially current or bear reasonable interest rates. As a result, the carrying values of these financial instruments approximate fair value. +Recent Accounting Pronouncements +Please see Note 3, Accounting Policies, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information. +21 +AMERCO and Consolidated Subsidiaries +Fiscal 2020 Compared with Fiscal 2019 +Listed below, on a consolidated basis, are revenues for our major product lines for fiscal 2020 and fiscal 2019: +Year Ended March 31, +2020 +2019 +(In thousands) +Self-moving equipment rentals +$ +2,692,413 +$ +2,653,497 +Self-storage revenues +418,741 +367,276 +Self-moving and self-storage products and service sales +265,091 +264,146 +Property management fees +30,406 +29,148 +Life insurance premiums +127,976 +63,488 +Property and casualty insurance premiums +66,053 +60,853 +Net investment and interest income +137,829 +110,934 +Other revenue +240,359 +219,365 +Consolidated revenue +$ +3,978,868 +$ +3,768,707 +Self-moving equipment rental revenues increased $38.9 million during fiscal 2020, compared with fiscal 2019. +Revenue for both our In-town and one-way markets improved for trucks and trailers. +Partially offsetting the improvement was a reduction in the volume of Corporate Account rentals in the third and fourth quarters of fiscal 2020, along with the decline in overall rental activity in the second half of March 2020 due to the COVID-19 related stay-at-home orders. +We increased the number of retail locations, trucks and trailers in the rental fleet compared to the same period last year. +Self-storage revenues increased $51.5 million during fiscal 2020, compared with fiscal 2019. +The average monthly number of occupied units increased by 16%, or 45,000 units during fiscal 2020 compared with the same period last year. +The growth in revenues and units rented comes from a combination of occupancy gains at existing locations and from the addition of new facilities to the portfolio. During fiscal 2020, we added approximately 5.8 million net rentable square feet, a 16% increase, with approximately 1.2 million of that occurring during the fourth quarter of fiscal 2020. +Life insurance premiums increased $64.5 million during fiscal 2020, compared with fiscal 2019 primarily due to a reinsurance agreement termination in the fourth quarter of fiscal 2019, reducing prior year premiums by $76.0 million. +Property and casualty insurance premiums increased $5.2 million during fiscal 2020, compared with fiscal 2019. A significant portion of Repwest’s premiums are from policies sold in conjunction with U-Haul rental transactions. The premium increase corresponded with the increased moving and storage transactions at U-Haul during the same period. +Net investment and interest income increased $26.9 million during fiscal 2020, compared with fiscal 2019 due to a larger invested asset base and realized gains on derivatives at our life insurance subsidiary. +Additionally, recognizing the changes in market value of unaffiliated common stocks at our insurance subsidiary accounted for $9.5 million of the increase. +Other revenue increased $21.0 million during fiscal 2020, compared with fiscal 2019, caused primarily by growth in our U-Box +® +program. +22 +Listed +below +are +revenues +and +earnings +from +operations +at +each +of +our +operating +segments +for +fiscal +2020 +and +2019. +The +insurance +companies’ +years +ended +December +31, +2019 +and +2018. +Year Ended March 31, +2020 +2019 +(In thousands) +Moving and storage +Revenues +$ +3,657,766 +$ +3,545,809 +Earnings from operations before equity in earnings of subsidiaries +471,962 +569,241 +Property and casualty insurance +Revenues +89,064 +75,837 +Earnings from operations +42,884 +27,406 +Life insurance +Revenues +241,464 +154,714 +Earnings from operations +26,394 +25,481 +Eliminations +Revenues +(9,426) +(7,653) +Earnings from operations before equity in earnings of subsidiaries +(1,112) +(1,141) +Consolidated Results +Revenues +3,978,868 +3,768,707 +Earnings from operations +540,128 +620,987 +Total costs and expenses increased $291.0 million during fiscal 2020, compared with fiscal 2019. Our insurance segments’ total costs and expenses increased $83.6 million; this was largely due to a one-time decrease of $76.4 million in life benefits in fiscal 2019 because Oxford agreed to terminate a reinsurance contract with one of our reinsurers (“Reinsurance contract termination”). +Operating expenses for Moving and Storage increased $131.3 million. +The largest contributors to this were personnel, liability costs, utilities, property maintenance projects, property taxes and freight expense. Repair costs associated with the rental fleet increased $19.5 million primarily due to an increase in the number of rental trucks and trailers. +Depreciation expense associated with our rental fleet increased $55.1 million to $510.5 million due to the larger fleet. +Depreciation expense on all other assets, mostly buildings and improvements, increased $28.0 million to $153.6 million. Gains on the disposal of real estate increased $0.7 million due to the condemnation of a property in the first quarter of fiscal 2020. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations decreased to $540.1 million for fiscal 2020, compared with $621.0 million for fiscal 2019. +Interest expense for fiscal 2020 was $161.0 million, compared with $142.4 million for fiscal 2019 due to an increase in borrowings in fiscal 2020. +Income tax benefit (expense) was $63.9 million for fiscal 2020, compared with ($106.7) million for fiscal 2019 due to the effect of the Coronavirus Aid, Relief and Economic Security (the “CARES Act”) as enacted on March 27, 2020. Our effective tax rate was (16.9%) of net income before taxes for fiscal 2020, compared with 22.3% in the prior year period. Federal net operating losses from fiscal years 2018, 2019 and 2020 have been carried back to prior tax years as provided by the CARES Act. The statutory tax rate for the carryback years was 35% as compared with 21% at present. Consequently, we recognized a benefit amount of $146.0 million in fiscal 2020. Excluding the CARES Act benefit mentioned above, our effective tax rate for all of fiscal 2020, post CARES Act, was 21.7% compared with 22.3% for fiscal 2019. See Note 14, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information on income taxes. +As a result of the above-mentioned items, earnings available to common shareholders were $442.0 million for fiscal 2020, compared with $370.9 million for fiscal 2019. +Basic and diluted earnings per common share for fiscal 2020 were $22.55, compared with $18.93 for fiscal 2019. +The weighted average common shares outstanding basic and diluted were 19,603,708 for fiscal 2020, compared with 19,592,048 for fiscal 2019. +23 +AMERCO and Consolidated Subsidiaries +Fiscal 2019 Compared with Fiscal 2018 +Listed below, on a consolidated basis, are revenues for our major product lines for fiscal 2019 and fiscal 2018: +Year Ended March 31, +2019 +2018 +(In thousands) +Self-moving equipment rentals +$ +2,653,497 +$ +2,479,742 +Self-storage revenues +367,276 +323,903 +Self-moving and self-storage products and service sales +264,146 +261,557 +Property management fees +29,148 +29,602 +Life insurance premiums +63,488 +154,703 +Property and casualty insurance premiums +60,853 +57,100 +Net investment and interest income +110,934 +110,473 +Other revenue +219,365 +184,034 +Consolidated revenue +$ +3,768,707 +$ +3,601,114 +Self-moving equipment rental revenues increased $173.8 million during fiscal 2019, compared with fiscal 2018. During fiscal 2019 we expanded the number of Company-owned locations along with independent dealers, and increased the number of trucks, trailers and towing devices in our rental fleet. +In the third and fourth quarters of fiscal 2019, we saw revenue improvements in our corporate account business. +Revenue and transactions for both the One-way and in-town markets improved compared to fiscal 2018. +Self-storage revenues increased $43.4 million during fiscal 2019, compared with fiscal 2018. +The average monthly amount of occupied square feet increased by 12.0% during fiscal 2019 compared with the same period in fiscal 2018. +The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. During fiscal 2019, we added approximately 5.3 million net rentable square feet, a 17.0% increase, with approximately 1.5 million of that occurring on during the fourth quarter of fiscal 2019. +Sales of self-moving and self-storage products and services increased $2.6 million during fiscal 2019, compared with fiscal 2018, primarily from the sales of moving supplies and propane. +Life insurance premiums decreased $91.2 million during fiscal 2019, compared with fiscal 2018. In the fourth quarter of fiscal 2019, due to the Reinsurance contract termination. As a result, there was a one-time decrease in life insurance premiums of $78.4 million due to the transfer of liabilities to the reinsurer for termination of the contract, along with decreased Medicare supplement premiums. +Property and casualty insurance premiums increased $3.8 million during fiscal 2019, compared with fiscal 2018 due to an increase in Safetow +® +and Safestor +® +sales which corresponds with increased equipment and storage rental transactions. +Net investment and interest income increased $0.5 million during fiscal 2019, compared with fiscal 2018 due to a larger invested asset base at our life insurance subsidiary. This accounted for a $5.7 million decrease in fiscal 2019. +Other revenue increased $35.3 million during fiscal 2019, compared with fiscal 2018, caused primarily by growth in our U-Box +® +program. +24 +Listed +below +are +revenues +and +earnings +from +operations +at +each +of +our +operating +segments +for +fiscal +2019 +and +2018. +The +insurance +companies’ +years +ended +December +31, +2018 +and +2017. +Year Ended March 31, +2019 +2018 +(In thousands) +Moving and storage +Revenues +$ +3,545,809 +$ +3,290,667 +Earnings from operations before equity in earnings of subsidiaries +569,241 +712,700 +Property and casualty insurance +Revenues +75,837 +74,571 +Earnings from operations +27,406 +25,878 +Life insurance +Revenues +154,714 +243,862 +Earnings from operations +25,481 +27,959 +Eliminations +Revenues +(7,653) +(7,986) +Earnings from operations before equity in earnings of subsidiaries +(1,141) +(1,291) +Consolidated Results +Revenues +3,768,707 +3,601,114 +Earnings from operations +620,987 +765,246 +Total costs and expenses increased $116.5 million during fiscal 2019, compared with fiscal 2018, excluding changes to net (gains) losses on disposal of real estate. The Moving and Storage segment accounted for a $203.2 million increase and our insurance segments total costs and expenses decreased $86.9 million largely due to a one-time decrease of $76.4 million in life benefits due to the Reinsurance contract termination. Operating expenses for Moving and Storage increased $179.6 million, largely from increased personnel, maintenance repairs, shipping costs associated with U-Box +® +, building maintenance and property taxes. Repair costs accounted for $45.6 million of the increase. Net gains from the disposal of rental equipment increased $15.1 million. +Compared with fiscal 2018, we sold more used trucks and the average sales proceeds per truck improved. +Depreciation expense associated with our rental fleet increased $11.6 million due to a larger fleet. +Depreciation expense on all other assets, largely from buildings and improvements, increased $14.4 million. +Net gains on disposal of real estate decreased $195.4 million. +The decrease was caused by the sale of a portion of our Chelsea, New York property in October 2017, which resulted in a pre-tax gain of $190.7 million in fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations decreased to $621.0 million for fiscal 2019, compared with $765.2 million for fiscal 2018. +Interest expense for fiscal 2019 was $142.4 million, compared with $126.7 million for fiscal 2018 due to an increase in borrowings in fiscal 2019. +Income tax benefit (expense) was ($106.7) million for fiscal 2019, compared with $153.0 million for fiscal 2018 due to the effects of the Tax Reform Act as enacted on December 22, 2017. Our effective tax rate was 22.3% of net income before taxes for fiscal 2019, compared to (24.0%) in the prior-year period. The decrease in our deferred tax liability in fiscal 2018 resulting from the application of the new federal income tax rate accounted for a $371.5 million decrease, partially offset by a $10.7 million one-time increase resulting from the deemed repatriation of foreign earnings and a $4.2 million one-time increase resulting from Phase Three tax on our Life Insurance subsidiary. Excluding the one-time benefits and charges mentioned above, our effective tax rate for all of fiscal 2018, post Tax Reform Act, was 31.8%. See Note 14, Provisions for Taxes, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report for more information on income taxes. +As a result of the above-mentioned items, earnings available to common shareholders were $370.9 million for fiscal 2019, compared with $790.6 million for fiscal 2018. +Basic and diluted earnings per common share for fiscal 2019 were $18.93, compared with $40.36 for fiscal 2018. +25 +The weighted average common shares outstanding basic and diluted were 19,592,048 for fiscal 2019, compared with 19,588,889 for fiscal 2018. +Moving and Storage +Fiscal 2020 Compared with Fiscal 2019 +Listed below are revenues for the major product lines at Moving and Storage for fiscal 2020 and fiscal 2019: +Year Ended March 31, +2020 +2019 +(In thousands) +Self-moving equipment rentals +$ +2,696,516 +$ +2,656,327 +Self-storage revenues +418,741 +367,276 +Self-moving and self-storage products and service sales +265,091 +264,146 +Property management fees +30,406 +29,148 +Net investment and interest income +10,593 +13,857 +Other revenue +236,419 +215,055 +Moving and Storage revenue +$ +3,657,766 +$ +3,545,809 +Self-moving equipment rental revenues increased $40.2 million during fiscal 2020, compared with fiscal 2019. Revenue for both our In-town and one-way markets improved for trucks and trailers. +Partially offsetting the improvement was a reduction in the volume of Corporate Account rentals in the third and fourth quarters of fiscal 2020 along with the decline in overall rental activity in the second half of March 2020 due to the COVID-19 related stay-at-home orders. +We increased the number of retail locations, trucks and trailers in the rental fleet compared to the same period last year. +Self-storage revenues increased $51.5 million during fiscal 2020, compared with fiscal 2019. +The average monthly number of occupied units increased by 16%, or 45,000 units during fiscal 2020 compared with the same period last year. +The growth in revenues and units rented comes from a combination of occupancy gains at existing locations and from the addition of new facilities to the portfolio. During fiscal 2020, we added approximately 5.8 million net rentable square feet, a 16% increase, with approximately 1.2 million of that occurring during the fourth quarter of fiscal 2020. +The Company owns and manages self-storage facilities. Self-storage revenues reported in the consolidated financial statements represent Company-owned locations only. Self-storage data for our owned storage locations follows: +Year Ended March 31, +2020 +2019 +(In thousands, except occupancy rate) +Unit count as of March 31 +503 +428 +Square footage as of March 31 +42,082 +36,237 +Average monthly number of units occupied +319 +275 +Average monthly occupancy rate based on unit count +67.7% +68.7% +Average monthly square footage occupied +28,946 +24,862 +During fiscal 2020, we added approximately 5.8 million net rentable square feet of new storage to the system. This was a mix of existing storage locations we acquired and new development. On average, the occupancy rate of this new capacity on the date it was added was 2%. +Net investment and interest income decreased $3.3 million during fiscal 2020, compared with fiscal 2019 due to decreased invested cash balances and lower yields. +Other revenue increased $21.4 million during fiscal 2020, compared with fiscal 2019, caused primarily by growth in our U-Box +® +program. +26 +Total costs and expenses increased $209.2 million during fiscal 2020, compared with fiscal 2019. Operating expenses for Moving and Storage increased $131.3 million. +The largest contributors to this were personnel, liability costs, utilities, property maintenance projects, property taxes and freight expense. Repair costs associated with the rental fleet increased $19.5 million primarily due to an increase in the number of rental trucks and trailers. +Depreciation expense associated with our rental fleet increased $55.1 million to $510.5 million due to the larger fleet. +Depreciation expense on all other assets, mostly buildings and improvements, increased $28.0 million to $153.6 million. Gains on the disposal of real estate increased $0.7 million due to the condemnation of a property in the first quarter of fiscal 2020. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations for Moving and Storage before consolidation of the equity in the earnings of the insurance subsidiaries decreased to $472.0 million for fiscal 2020 as compared with $569.2 million for fiscal 2019. +Equity in the earnings of AMERCO’s insurance subsidiaries increased $14.0 million for fiscal 2020, compared with fiscal 2019. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations decreased to $527.8 million for fiscal 2020, compared with $611.1 million +for fiscal 2019. +Moving and Storage +Fiscal 2019 Compared with Fiscal 2018 +Listed below are revenues for the major product lines at Moving and Storage for fiscal 2019 and fiscal 2018: +Year Ended March 31, +2019 +2018 +(In thousands) +Self-moving equipment rentals +$ +2,656,327 +$ +2,483,956 +Self-storage revenues +367,276 +323,903 +Self-moving and self-storage products and service sales +264,146 +261,557 +Property management fees +29,148 +29,602 +Net investment and interest income +13,857 +12,232 +Other revenue +215,055 +179,417 +Moving and Storage revenue +$ +3,545,809 +$ +3,290,667 +Self-moving equipment rental revenues increased $172.4 million during fiscal 2019, compared with fiscal 2018. During fiscal 2019 we expanded the number of Company-owned locations along with independent dealers, and increased the number of trucks, trailers and towing devices in our rental fleet. +In the third and fourth quarters we saw revenue improvements in our corporate account business. +Revenue and transactions for both the One-way and in-town markets improved compared to fiscal 2018. +Self-storage revenues increased $43.4 million during fiscal 2019, compared with fiscal 2018. +The average monthly amount of occupied square feet increased by 12.0% during fiscal 2019 compared with the same period in fiscal 2018. +The growth in revenues and square feet rented comes from a combination of improved rates per square foot, occupancy gains at existing locations and from the addition of new facilities to the portfolio. During fiscal 2019, we added approximately 5.3 million net rentable square feet, a 17.0% increase, with approximately 1.5 million of that coming on during the fourth quarter of fiscal 2019. +27 +The Company owns and manages self-storage facilities. Self-storage revenues reported in the consolidated financial statements represent Company-owned locations only. Self-storage data for our owned storage locations follows: +Year Ended March 31, +2019 +2018 +(In thousands, except occupancy rate) +Unit count as of March 31 +428 +366 +Square footage as of March 31 +36,237 +30,974 +Average monthly number of units occupied +275 +246 +Average monthly occupancy rate based on unit count +68.7% +71.6% +Average monthly square footage occupied +24,862 +22,203 +During fiscal 2019, we added approximately 5.3 million net rentable square feet of new storage to the system. This was a mix of existing storage locations we acquired and new development. On average, the occupancy rate of this new capacity on the date it was added was 9.5%. +Sales of self-moving and self-storage products and services increased $2.6 million during fiscal 2019, compared with fiscal 2018 primarily from the sales of moving supplies and propane. +Other revenue increased $35.6 million during fiscal 2019, compared with fiscal 2018, caused primarily by growth in our U-Box +® +program. +Total costs and expenses increased $203.2 million during fiscal 2019, compared with fiscal 2018, excluding changes to net (gains) losses on disposal of real estate. Operating expenses for Moving and Storage increased $179.6 million, largely from increased personnel, maintenance repairs, shipping costs associated with U-Box +® +, building maintenance and property taxes. Repair costs accounted for $45.6 million of the increase. Net gains from the disposal of rental equipment increased $15.1 million. +Compared with fiscal 2018, we sold more used trucks and the average sales proceeds per truck improved. +Depreciation expense associated with our rental fleet increased $11.6 million due to a larger fleet. +Depreciation expense on all other assets, largely from buildings and improvements increased $14.4 million. +Net gains on disposal of real estate decreased $195.4 million. +The decrease was caused by the sale of a portion of our Chelsea, New York property in October 2017 which resulted in a pre-tax gain of $190.7 million in fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations for Moving and Storage before consolidation of the equity in the earnings of the insurance subsidiaries decreased to $569.2 million for fiscal 2019 as compared with $712.7 million for fiscal 2018. +Equity in the earnings of AMERCO’s insurance subsidiaries decreased $5.2 million for fiscal 2019, compared with fiscal 2018. +As a result of the above-mentioned changes in revenues and expenses, earnings from operations decreased to $611.1 million for fiscal 2019, compared with $759.7 million for fiscal 2018. +Property and Casualty Insurance +2019 Compared with 2018 +Net premiums were $69.1 million and $63.5 million for the years ended December 31, 2019 and 2018, respectively. A significant portion of Repwest’s premiums are from policies sold in conjunction with U-Haul rental transactions. The premium growth corresponded with the increased moving and storage transactions at U-Haul. +Net investment and interest income were $19.9 million and $12.3 million for the years ended December 31, 2019 and 2018, respectively. The increase in equity valuations of $9.5 million were offset by a decrease in realized investment gains of $2.6 million. +Net operating expenses were $33.8 million and $34.2 million for the years ended December 31, 2019 and 2018, respectively. The change was due to an increase in commissions, decreased loss adjusting fees and subrogation income. +Benefits and losses expenses were $12.4 million and $14.2 million for the years +ended December 31, 2019 and 2018, respectively. The decrease resulted from favorable loss experience. +28 +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $42.9 million and $27.4 million for the years ended December 31, 2019 and 2018, respectively. +Property and Casualty Insurance +2018 Compared with 2017 +Net premiums were $63.5 million and $58.8 million for the years ended December 31, 2018 and 2017, respectively. A significant portion of Repwest’s premiums are from policies sold in conjunction with U-Haul rental transactions. The premium growth corresponded with the increased moving and storage transactions at U-Haul. +Net investment and interest income was $12.3 million and $15.8 million for the years ended December 31, 2018 and 2017, respectively. The main driver of the change in net investment income was the increase in realized losses of $5.7 million due to market changes in our equity securities for the twelve months ended December 31, 2018. Updated accounting guidance now requires changes in the market value of equity securities held for investment to be recognized through income. +Net operating expenses were $34.2 million and $32.7 million for the years ended December 31, 2018 and 2017, respectively. The change was due to an increase in commissions, decreased loss adjusting fees and subrogation income. +Benefits and losses expenses were $14.2 million and $16.0 million for the years +ended December 31, 2018 and 2017, respectively. The decrease resulted from favorable loss experience. +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $27.4 million and $25.9 million for the years ended December 31, 2018 and 2017, respectively. +Life Insurance +2019 Compared with 2018 +Net premiums were $128.0 million and $63.5 million for the years ended December 31, 2019 and 2018, respectively. Life insurance premiums increased by $76.8 million primarily due to a reinsurance agreement termination in the fourth quarter of fiscal 2019, reducing prior year premiums by $76.0 million. +Medicare Supplement premiums decreased by $11.2 million due to minimal new sales and declined premiums on the existing business offset by rate increases on renewal premiums. In addition, the remaining lines of business premiums decreased by $1.2 million. Deferred annuity deposits were $221.5 million or $148.6 million below prior year and are accounted for on balance sheet as deposits rather than premiums. +Net investment and interest income was $109.0 million and $86.4 million for the years ended December 31, 2019 and 2018, respectively. Net investment income from fixed maturities increased $10.5 million from a larger invested assets base. The increase in realized capital gains and mortgage prepayment gain was $8.0 million, coupled with an $8.0 million increase in realized gains on derivatives used as economic hedges for our fixed indexed annuities. This was partially offset by a $3.9 million decrease in the investment income from other invested assets, primarily from a reduced investment in mortgage loans. +Net operating expenses were $21.4 million and $14.6 million for the years ended December 31, 2019 and 2018, respectively. The variance was primarily due to a $6.5 million increase in life insurance commission expense offset by a $0.3 million reduction in Medicare supplement commission expense. +The increase in life insurance commission expense was primarily due to a prior year commission expense reduction in the fourth quarter of 2018 from a commission allowance on a reinsurance agreement termination. In addition, there was an increase of $0.6 million in general expenses. +Benefits and losses expenses were $162.4 million and $86.1 million for the years ended December 31, 2019 and 2018, respectively. Life insurance benefits increased by a $73.5 million due to the reinsurance agreement termination in the fourth quarter of fiscal 2019, reducing prior year life benefits by $71.6 million. An additional increase of $1.9 million in life benefits was a result of adverse mortality. The interest credited to policyholders increased by $15.1 million on a larger annuity deposit base. This was offset by a $11.0 million decrease in Medicare supplement benefits from the declined policies in force and a $1.3 million in supplementary annuity contract disbursements and the remaining lines. +29 +Amortization of deferred acquisition costs (“DAC”), sales inducement asset (“SIA“) and the value of business acquired (“VOBA”) was $31.2 million and $28.6 million for the years ended December 31, 2019 and 2018, respectively. The increase of $6.2 million was primarily due to a higher DAC amortization on annuities from the increased asset base supported by continued sales. +This was offset by a $ 3.5 million decrease in VOBA amortization, a result of a VOBA write off in the prior year due to a reinsurance agreement termination. +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $26.4 million and $25.5 million for the years ended December 31, 2019 and 2018, respectively. +Life Insurance +2018 Compared with 2017 +Net premiums were $63.5 million and $154.7 million for the years ended December 31, 2018 and 2017, respectively. There was a one-time decrease in life insurance premiums of $78.4 million due to the transfer of liabilities as a result of the Reinsurance contract termination, effective November 30, 2018. Medicare Supplement premiums decreased by $12.6 million due to the reduction in new sales and policy decrements on the existing business offset by premium rate increases. Premiums on other lines of business increased $0.2 million. Deferred annuity deposits were $370.1 million or $73.8 million above the prior year and are accounted for on the balance sheet as deposits rather than premiums. +Net investment and interest income was $86.4 million and $84.2 million for the years ended December 31, 2018 and 2017, respectively. Investment income from fixed maturities and other invested assets increased $10.1 million from a larger invested asset base, partially offset by a $2.8 million decrease in realized losses and a $5.1 million loss on derivatives. +Net operating expenses were $14.6 million and $22.1 million for the years ended December 31, 2018 and 2017, respectively. The decrease was due to a one-time commission allowance of $6.8 million received on the reinsurance agreement termination which was recorded as a reduction to commission expense and a reduction in commission expense from the decreased Medicare supplement premiums. +Benefits and losses expenses were $86.1 million and $169.3 million for the years ended December 31, 2018 and 2017, respectively. There was a one-time decrease of $76.4 million in Life benefits due to the transfer of liabilities for the Reinsurance contract termination. Medicare supplement and other health benefits decreased $9.8 million from the declined policies in force. Partially offsetting this was a $3.2 million increase in interest credited to policyholders on a larger annuity deposit base. +Amortization of DAC, SIA and VOBA was $28.6 million and $24.5 million for the years ended December 31, 2018 and 2017, respectively. +The increase was primarily due to a one-time $3.3 million VOBA write-off as a result of the Reinsurance contract termination. In addition, there was an increase in annuity DAC amortization due to the increased amount of annuity business sold during fiscal 2019 +. Conversely, DAC amortization associated with Medicare Supplement has decreased as a result of the declining business inforce. +As a result of the above-mentioned changes in revenues and expenses, pretax earnings from operations were $25.5 million and $28.0 million for the years ended December 31, 2018 and 2017, respectively. +Liquidity and Capital Resources +We believe our current capital structure is a positive factor that will enable us to pursue our operational plans and goals and provide us with sufficient liquidity for the foreseeable future. There are many factors which could affect our liquidity, including some which are beyond our control, and there is no assurance that future cash flows and liquidity resources will be sufficient to meet our outstanding debt obligations and our other future capital needs. +30 +At March 31, 2020, cash and cash equivalents totaled $494.4 million, compared with $673.7 million at March 31, 2019. The assets of our insurance subsidiaries are generally unavailable to fulfill the obligations of non-insurance operations (AMERCO, U-Haul and Real Estate). As of March 31, 2020 (or as otherwise indicated), cash and cash equivalents, other financial assets (receivables, short-term investments, other investments, fixed maturities, and related party assets) and debt obligations of each operating segment were: +Moving & Storage +Property and Casualty Insurance (a) +Life Insurance (a) +(In thousands) +Cash and cash equivalents +$ +459,078 +$ +4,794 +$ +30,480 +Other financial assets +122,088 +480,275 +2,504,213 +Debt obligations +4,609,844 +– +11,447 +(a) As of December 31, 2019 +At March 31, 2020, Moving and Storage had available borrowing capacity under existing credit facilities of $39.0 million. +Towards the end of March and into April and May 2020, COVID-19 has negatively affected our operating cash flows through lower self-moving equipment rental revenues along with a near total reduction in equipment sales proceeds stemming from the closures of commercial auto auctions. +In March 2020, we drew down $50.0 million from our corporate revolver and in April 2020, we expanded this revolver by an additional $50.0 million and fully borrowed that as well. +We entered into $225 million of additional term loans in April and May to further strengthen our liquidity position. +These loans have not had a material negative effect on our cost of borrowing. +We believe that the Company has adequate liquidity to meet our obligations. +However, there can be no assurance that market conditions resulting from COVID-19 will not worsen and have a material negative effect on our liquidity. +A summary of our consolidated cash flows for fiscal 2020, 2019 and 2018 is shown in the table below: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Net cash provided by operating activities +$ +1,075,513 +$ +975,583 +$ +937,684 +Net cash used by investing activities +(1,766,649) +(1,571,136) +(898,304) +Net cash provided by financing activities +512,320 +514,582 +16,604 +Effects of exchange rate on cash +(533) +(4,716) +5,598 +Net increase (decrease) in cash flow +(179,349) +(85,687) +61,582 +Cash at the beginning of the period +673,701 +759,388 +697,806 +Cash at the end of the period +$ +494,352 +$ +673,701 +$ +759,388 +Net cash provided by operating activities increased $99.9 million in fiscal 2020, compared with fiscal 2019. +The reinsurance transaction at the life insurance segment in fiscal 2019 accounts for $64.6 million of the improvement. +Operating cash from the Moving and Storage segment increased by $21.6 million. +Net cash used by investing activities increased $195.5 million in fiscal 2020, compared with fiscal 2019. Purchases of property, plant and equipment, which are reported net of cash from sales and lease-back transactions (for fiscal 2019 and fiscal 2018), increased $439.4 million. Cash from the sales of property, plant and equipment increased $81.1 million largely due to increased fleet sales. Net cash deposited in real estate acquisitions escrow accounts increased $2.3 million. For our insurance subsidiaries, net cash used in investing activities decreased $159.9 million compared with the same period last year. +Net cash provided by financing activities decreased $2.3 million in fiscal 2020, compared with fiscal 2019. This was due to a combination of increased debt and capital lease repayments of $54.6 million, an increase in cash from borrowings of $224.1 million, a decrease in net annuity deposits from Life Insurance of $183.7 million and a decrease in common stock dividends paid of $9.8 million. +31 +Liquidity and Capital Resources and Requirements of Our Operating Segments +Moving and Storage +To meet the needs of our customers, U-Haul maintains a large fleet of rental equipment. Capital expenditures have primarily consisted of new rental equipment acquisitions and the buyouts of existing fleet from leases. The capital to fund these expenditures has historically been obtained internally from operations and the sale of used equipment and externally from debt and lease financing. In the future, we anticipate that our internally generated funds will be used to service the existing debt and fund operations. U-Haul estimates that during fiscal 2021 the Company will reinvest in its truck and trailer rental fleet approximately $460 million, net of equipment sales and excluding any lease buyouts. For fiscal 2020, the Company invested, net of sales, approximately $700 million before any lease buyouts in its truck and trailer fleet. Fleet investments in fiscal 2021 and beyond will be dependent upon several factors including the availability of capital, the truck rental environment and the used-truck sales market. We anticipate that the fiscal 2021 investments will be funded largely through debt financing, external lease financing and cash from operations. Management considers several factors including cost and tax consequences when selecting a method to fund capital expenditures. Our allocation between debt and lease financing can change from year to year based upon financial market conditions which may alter the cost or availability of financing options. +Based upon interactions with our existing lenders, the Company does not believe that COVID-19 will materially inhibit our ability to obtain financing for the purchases of rental equipment in fiscal 2021. +Should the situation severely worsen this belief could change. +Real Estate has traditionally financed the acquisition of self-storage properties to support U-Haul's growth through debt financing and funds from operations. The Company’s plan for the expansion of owned storage properties includes the acquisition of existing self-storage locations from third parties, the acquisition and development of bare land, and the acquisition and redevelopment of existing buildings not currently used for self-storage. The Company expects to fund these development projects through a combination of internally generated funds along with borrowings against existing properties as they operationally mature. For fiscal 2020, the Company invested $751 million in real estate acquisitions, new construction and renovation and repair compared to $1.0 billion in fiscal 2019. +For fiscal 2021, the timing of new projects will be dependent upon several factors, including the entitlement process, availability of capital, weather, the identification and successful acquisition of target properties and any lingering effects of COVID-19. +In April and May of 2020, the Company has opted to slow the development of new self-storage projects to preserve liquidity. +We will calibrate our capital spending based in part upon the evolving effects of COVID-19. +U-Haul's growth plan in self-storage also includes the expansion of the U-Haul Storage Affiliate program, which does not require significant capital. +Net capital expenditures (purchases of property, plant and equipment less proceeds from the sale of property, plant and equipment and lease proceeds) were $1,622.0 million, $1,263.7 million and $663.9 million for fiscal 2020, 2019 and 2018, respectively. The components of our net capital expenditures are provided in the following table: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Purchases of rental equipment +$ +1,374,141 +$ +1,162,909 +$ +1,006,503 +Equipment lease buyouts +63,973 +30,566 +6,594 +Purchases of real estate, construction and renovations +751,395 +1,003,030 +606,990 +Other capital expenditures +119,897 +21,831 +140,627 +Gross capital expenditures +2,309,406 +2,218,336 +1,760,714 +Less: Lease proceeds +– +(348,368) +(396,969) +Less: Sales of property, plant and equipment +(687,375) +(606,271) +(699,803) +Net capital expenditures +1,622,031 +1,263,697 +663,942 +Moving and Storage continues to hold significant cash and we believe has access to additional liquidity. Management may invest these funds in our existing operations, expand our product lines or pursue external opportunities in the self-moving and storage marketplace, pay dividends or reduce existing indebtedness where possible. +32 +Property and Casualty Insurance +State insurance regulations may restrict the amount of dividends that can be paid to stockholders of insurance companies. +As a result, Property and Casualty Insurance's assets are generally not available to satisfy the claims of AMERCO, or its legal subsidiaries. For calendar year 2020, the ordinary dividend available to be paid to AMERCO is $22.7 million. For more information, please see Note 21, Statutory Financial Information of Insurance Subsidiaries, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +We believe that stockholders’ equity at the Property and Casualty operating segment remains sufficient and we do not believe that its ability to pay ordinary dividends to AMERCO will be restricted per state regulations. +Our Property and Casualty operating segment stockholders’ equity was $251.1 million, $222.4 million, and $211.2 million as of December 31, 2019, 2018, and 2017, respectively. The increase in 2019 compared with 2018 resulted from net earnings of $33.9 million, an increase in accumulated other comprehensive income of $16.4 million and offset by the $21.6 million dividend paid to AMERCO. Property and Casualty Insurance does not use debt or equity issues to increase capital and therefore has no direct exposure to capital market conditions other than through its investment portfolio. +Life Insurance +Life Insurance manages its financial assets to meet policyholder and other obligations including investment contract withdrawals and deposits. Life Insurance's net deposits for the year ended December 31, 2019 was $83.6 million. State insurance regulations may restrict the amount of dividends that can be paid to stockholders of insurance companies. +As a result, Life Insurance's assets are generally not available to satisfy the claims of AMERCO +® +or its legal subsidiaries. For calendar year 2020, the ordinary dividend available to be paid to AMERCO is $18.6 million. For more information, please see Note 21, Statutory Financial Information of Insurance Subsidiaries, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. +Our Life Insurance operating segment stockholders’ equity was $417.4 million, $311.7 million, and $332.9 million as of December 31, 2019, 2018 and 2017, respectively. The increase in 2019 compared with 2018 resulted from earnings of $21.9 million and an increase in accumulated other comprehensive income of $83.8 million primarily due to the effect of interest rate changes on the fixed maturity portion of the investment portfolio. Life Insurance has not historically used debt or equity issues to increase capital and therefore has not had any significant direct exposure to capital market conditions other than through its investment portfolio. However, as of December 31, 2019, Oxford had outstanding advances of $60.0 million through its membership in the Federal Home Loan Bank (“FHLB”). For a more detailed discussion of these advances, please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements. +Cash Provided from Operating Activities by Operating Segments +Moving and Storage +Net cash provided by operating activities was $980.5 million, $958.9 million and $858.6 million in fiscal 2020, 2019 and 2018 from operations. +Property and Casualty Insurance +Net cash provided by operating activities was $22.5 million, $19.8 million, and $21.9 million for the years ended December 31, 2019, 2018, and 2017, respectively. +The increase was the result of an increase in net earnings. +Property and Casualty Insurance’s cash and cash equivalents and short-term investment portfolios amounted to $11.8 million, $11.2 million, and $17.0 million as of December 31, 2019, 2018, and 2017, respectively. These balances reflect funds in transition from maturity proceeds to long-term investments. Management believes this level of liquid assets, combined with budgeted cash flow, is adequate to meet foreseeable cash needs. Capital and operating budgets allow Property and Casualty Insurance to schedule cash needs in accordance with investment and underwriting proceeds. +33 +Life Insurance +Net cash provided (used) by operating activities was $72.5 million, ($3.2) million and $57.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. An increase of $ +64.6 million resulted from a prior year reduction due to a cash transfer to State Mutual Insurance Company under reinsurance agreement termination +. The remaining increase of $11.1 million was primarily due to an increase in investment income on a larger invested asset base and along with timing of settlement of payables, offset by an increase in federal tax expense. +In addition to cash flows from operating activities and financing activities, a substantial amount of liquid funds are available through Life Insurance's short-term portfolio and its membership in the FHLB. As of December 31, 2019, 2018 and 2017, cash and cash equivalents and short-term investments amounted to $30.5 million, $24.1 million and $50.7 million, respectively. Management believes that the overall sources of liquidity are adequate to meet foreseeable cash needs. +Liquidity and Capital Resources - Summary +We believe we have the financial resources needed to meet our business plans including our working capital needs. We continue to hold significant cash and have access to additional liquidity to meet our anticipated capital expenditure requirements for investment in our rental fleet, rental equipment and storage acquisitions and build outs. +As a result of the federal income tax provisions of the CARES Act, we have filed applicable forms with the IRS to carryback net operating losses and requested refunds of previous deposits totaling approximately $235 million. +We believe that upon the filing of our March 31, 2020 federal income tax return additional refunds in excess of $250 million will be due to the Company. +These amounts are expected to provide us additional liquidity in fiscal 2021. +It is possible future legislation could negatively impact our ability to receive these tax refunds. +Our borrowing strategy is primarily focused on asset-backed financing and rental equipment leases. As part of this strategy, we seek to ladder maturities and fix interest rates. While each of these loans typically contains provisions governing the amount that can be borrowed in relation to specific assets, the overall structure is flexible with no limits on overall Company borrowings. Management believes it has adequate liquidity between cash and cash equivalents and unused borrowing capacity in existing credit facilities to meet the current and expected needs of the Company over the next several years. As of March 31, 2020, we had available borrowing capacity under existing credit facilities of $39.0 million. +While it is possible that circumstances beyond our control could alter the ability of the financial institutions to lend us the unused lines of credit, in April the Company did draw down these remaining amounts successfully. +We believe that there are additional opportunities for leverage in our existing capital structure. For a more detailed discussion of our long-term debt and borrowing capacity, please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. +34 +Disclosures about Contractual Obligations and Commercial Commitments +The following table provides contractual commitments and contingencies as of March 31, 2020: +Payment due by Period (as of March 31, 2020) +Contractual Obligations +Total +04/01/20 - 03/31/21 +04/01/21 - 03/31/23 +04/01/23 - 03/31/25 +Thereafter +(In thousands) +Notes and loans payable - Principal +$ +2,431,364 +$ +159,186 +384,015 +$ +521,767 +$ +1,366,396 +Notes and loans payable - Interest +692,069 +100,651 +180,572 +139,460 +271,386 +Revolving credit agreements - Principal +1,086,000 +– +735,111 +350,889 +– +Revolving credit agreements - Interest +88,113 +31,008 +48,003 +9,102 +– +Finance/capital leases - Principal +734,870 +218,424 +288,350 +181,658 +46,438 +Finance/capital leases - Interest +62,376 +22,445 +27,688 +10,991 +1,252 +Finance liability - Principal +398,834 +81,574 +115,145 +94,209 +107,906 +Finance liability - Interest +46,184 +12,760 +18,269 +11,069 +4,086 +Operating lease liabilities +162,144 +23,782 +43,239 +30,317 +64,806 +Property and casualty obligations (a) +122,044 +22,984 +22,574 +15,633 +60,853 +Life, health and annuity obligations (b) +3,352,451 +431,226 +684,228 +534,165 +1,702,832 +Self insurance accruals (c) +410,107 +123,375 +162,637 +70,399 +53,696 +Post retirement benefit liability +19,347 +1,151 +2,897 +3,718 +11,581 +Total contractual obligations +$ +9,605,903 +$ +1,228,566 +$ +2,712,728 +$ +1,973,377 +$ +3,691,232 +(a) These estimated obligations for unpaid losses and loss adjustment expenses include case reserves for reported claims and IBNR claims estimates and are net of expected reinsurance recoveries. The ultimate amount to settle both the case reserves and IBNR is an estimate based upon historical experience and current trends and such estimates could materially differ from actual results. The assumptions do not include future premiums. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +(b) These estimated obligations are based on mortality, morbidity, withdrawal and lapse assumptions drawn from our historical experience and adjusted for any known trends. These obligations include expected interest crediting but no amounts for future annuity deposits or premiums for life and Medicare supplement policies. +The cash flows shown above are undiscounted for interest and as a result total outflows for all years shown significantly exceed the corresponding liabilities of $2,179.4 million included in our consolidated balance sheet as of March 31, 2020. Life Insurance expects to fully fund these obligations from their invested asset portfolio. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +(c) These estimated obligations are primarily the Company’s self insurance accruals for portions of the liability coverage for our rental equipment. The estimates for future settlement are based upon historical experience and current trends. Due to the significant assumptions employed in this model, the amounts shown could materially differ from actual results. +As presented above, contractual obligations on debt and guarantees represent principal payments while contractual obligations for operating leases represent the notional payments under the lease arrangements. +ASC 740 - +Income Taxes +liabilities and interest of $42.4 million is not included above due to uncertainty surrounding ultimate settlements, if any. +Off Balance Sheet Arrangements +The Company uses off-balance sheet arrangements in situations where management believes that the economics and sound business principles warrant their use. +Historically, we used certain off-balance sheet arrangements in connection with the expansion of our self-storage business. For more information please see Note 20, Related Party Transactions, of the Notes to Consolidated Financial Statements included in Item 8: Financial Statements and Supplementary Data, of this Annual Report. These arrangements were primarily used when our overall borrowing structure was more limited. We do not face similar limitations currently and off-balance sheet arrangements have not been utilized in our self-storage expansion in recent years. In the future, we will continue to identify and consider off-balance sheet opportunities to the extent such arrangements would be economically advantageous to us and our stockholders. +35 +Fiscal 2021 Outlook +We will continue to focus our attention on increasing transaction volume and improving pricing, product and utilization for self-moving equipment rentals. +Maintaining an adequate level of new investment in our truck fleet is an important component of our plan to meet our operational goals. Revenue in the U-Move +® +program could be adversely impacted should we fail to execute in any of these areas. Even if we execute our plans, we could see declines in revenues primarily due to unforeseen events including adverse economic conditions or heightened competition that is beyond our control. +With respect to our storage business, in fiscal 2020 we have added new locations and expanded existing locations. In fiscal 2021, we are actively looking to complete current projects, increase occupancy in our existing portfolio of locations and acquire new locations. New projects and acquisitions will be considered and pursued if they fit our long-term plans and meet our financial objectives. We will continue to invest capital and resources in the U-Box +® +program throughout fiscal 2021. +In light of COVID-19 and its lingering effects, we may be challenged in our progress. +Property and Casualty Insurance will continue to provide loss adjusting and claims handling for U-Haul and underwrite components of the Safemove +® +, Safetow +® +, Safemove Plus +® +, Safestor +® +, and Safestor Mobile +® +protection packages to U-Haul customers. +Life Insurance is pursuing its goal of expanding its presence in the senior market through the sales of its Medicare supplement, life and annuity policies. This strategy includes growing its agency force, expanding its new product offerings, and pursuing business acquisition opportunities. +Quarterly Results (unaudited) +The quarterly results shown below are derived from unaudited financial statements for the eight quarters beginning April 1, 2018 and ending March 31, 2020. We believe that all necessary adjustments have been included in the amounts stated below to present fairly, and in accordance with GAAP, such results. Moving and Storage operations are seasonal and proportionally more of the Company’s revenues and net earnings from its Moving and Storage operations are generated in the first and second quarters of each fiscal year (April through September). The operating results for the periods presented are not necessarily indicative of results for any future period. +Quarter Ended +March 31, 2020 +December 31, 2019 +September 30, 2019 +June 30, 2019 +(In thousands, except for share and per share data) +Total revenues +$ +821,525 +$ +927,880 +$ +1,150,214 +$ +1,079,249 +Earnings from operations +958 +80,565 +244,740 +213,865 +Earnings available to common +shareholders +122,368 +30,932 +156,326 +132,422 +Basic and diluted earnings +per common share +$ +6.24 +$ +1.58 +$ +7.97 +$ +6.76 +Weighted average common shares +outstanding: basic and diluted +19,607,788 +19,607,788 +19,602,566 +19,597,697 +Quarter Ended +March 31, 2019 +December 31, 2018 +September 30, 2018 +June 30, 2018 +(In thousands, except for share and per share data) +Total revenues +$ +725,532 +$ +919,091 +$ +1,104,507 +$ +1,019,577 +Earnings from operations +27,237 +138,102 +250,944 +204,704 +Earnings available to common +shareholders +831 +78,635 +163,542 +127,849 +Basic and diluted earnings +per common share +$ +0.04 +$ +4.01 +$ +8.35 +$ +6.53 +Weighted average common shares +outstanding: basic and diluted +19,594,008 +19,591,963 +19,591,312 +19,590,585 +36 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +We are exposed to financial market risks, including changes in interest rates and currency exchange rates. To mitigate these risks, we may utilize derivative financial instruments, among other strategies. We do not use derivative financial instruments for speculative purposes. +Interest Rate Risk +The exposure to market risk for changes in interest rates relates primarily to our variable rate debt obligations and one variable rate operating lease. We have used interest rate swap agreements and forward swaps to reduce our exposure to changes in interest rates. We enter into these arrangements with counterparties that are significant financial institutions with whom we generally have other financial arrangements. We are exposed to credit risk should these counterparties not be able to perform on their obligations. Following is a summary of our interest rate swaps agreements at March 31, 2020: +Notional Amount +Fair Value +Effective Date +Expiration Date +Fixed Rate +Floating Rate +(In thousands) +$ +85,000 +$ +(2,775) +6/28/2019 +6/15/2022 +1.76% +1 Month LIBOR +75,000 +(2,564) +6/28/2019 +6/30/2022 +1.78% +1 Month LIBOR +75,000 +(2,875) +6/28/2019 +10/31/2022 +1.77% +1 Month LIBOR +As of March 31, 2020, we had $1,178.9 million of variable rate debt obligations. If the LIBOR were to increase 100 basis points, the increase in interest expense on the variable rate debt would decrease future earnings and cash flows by $9.4 million annually (after consideration of the effect of the above derivative contracts). Certain senior mortgages have an anticipated repayment date and a maturity date. If these senior mortgages are not repaid by the anticipated repayment date the interest rate on these mortgages would increase from the current fixed rate. We are using the anticipated repayment date for our maturity schedule. +Additionally, our insurance subsidiaries’ fixed income investment portfolios expose us to interest rate risk. This interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. As part of our insurance companies’ asset and liability management, actuaries estimate the cash flow patterns of our existing liabilities to determine their duration. These outcomes are compared to the characteristics of the assets that are currently supporting these liabilities assisting management in determining an asset allocation strategy for future investments that management believes will mitigate the overall effect of interest rates. +We use derivatives to hedge our equity market exposure to indexed annuity products sold by our Life Insurance company. These contracts earn a return for the contractholder based on the change in the value of the S&P 500 index between annual index point dates. We buy and sell listed equity and index call options and call option spreads. The credit risk is with the party in which the options are written. The net option price is paid up front and there are no additional cash requirements or additional contingent liabilities. These contracts are held at fair market value on our balance sheet. At March 31, 2020 and 2019, these derivative hedges had a net market value of $5.9 million and $1.5 million, with notional amounts of $246.8 +million and $284.0 +million, respectively. These derivative instruments are included in Investments, other; on the consolidated balance sheets. +Although the call options are employed to be effective hedges against our policyholder obligations from an economic standpoint, they do not meet the requirements for hedge accounting under GAAP. Accordingly, the call options are marked to fair value on each reporting date with the change in fair value, plus or minus, included as a component of net investment and interest income. The change in fair value of the call options includes the gains or losses recognized at the expiration of the option term and the changes in fair value for open contracts. +Foreign Currency Exchange Rate Risk +The exposure to market risk for changes in foreign currency exchange rates relates primarily to our Canadian business. Approximately 4.6% of our revenue was generated in Canada in fiscal 2020, 2019 and 2018. The result of a 10% change in the value of the U.S. dollar relative to the Canadian dollar would not be material to net income. We typically do not hedge any foreign currency risk since the exposure is not considered material. +37 +Item 8. +Financial Statements and Supplementary Data +The Report of Independent Registered Public Accounting Firm and Consolidated Financial Statements of AMERCO and its consolidated subsidiaries including the notes to such statements and the related schedules are set forth on the “F” pages hereto and are incorporated by reference herein. +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +Not applicable. +Item 9A. +Controls and Procedures +Attached as exhibits to this Annual Report are certifications of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), which are required in accordance with Rule 13a-14 of the Exchange Act. This "Controls and Procedures" section includes information concerning the controls and procedures evaluation referred to in the certifications and it should be read in conjunction with the certifications for a more complete understanding of the topics presented in the section Evaluation of Disclosure Controls and Procedures. +Following this discussion is the report of BDO USA, LLP, our independent registered public accounting firm, regarding its audit of AMERCO’s internal control over financial reporting as set forth below in this section. This section should be read in conjunction with the certifications of our CEO and CFO and the BDO USA, LLP report for a more complete understanding of the topics presented. +Evaluation of Disclosure Controls and Procedures +The Company’s management, with the participation of the CEO and CFO, conducted an evaluation of the effectiveness of the design and operation of the Company’s "disclosure controls and procedures" (as such term is defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) (“Disclosure Controls”) as of the end of the period covered by this Annual Report. Our Disclosure Controls are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Our Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Based upon the controls evaluation, our CEO and CFO have concluded that as of the end of the period covered by this Annual Report, our Disclosure Controls were effective at a reasonable assurance level related to the above stated design purposes. +Inherent Limitations on Effectiveness of Controls +The Company's management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of the effectiveness of our controls to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. +Changes in Internal Control over Financial Reporting +There has not been any change in the Company’s internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f) during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +38 +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements. +Management assessed our internal control over financial reporting as of March 31, 2020, the end of our fiscal year. Management based its assessment on criteria established in +Internal Control-Integrated Framework (2013) +issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management's assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment. This assessment is supported by testing and monitoring performed both by our Internal Audit function and our Finance function. +Based on our assessment, management has concluded that our internal control over financial reporting was effective as of the end of the fiscal year 2020. We reviewed the results of management's assessment with the Audit Committee of our Board. +Our independent registered public accounting firm, BDO USA, LLP, has audited the Company's internal control over financial reporting and has issued their report, which is included on the following page. +39 +Report of Independent Registered Public Accounting Firm +Stockholders and Board of Directors +AMERCO +Reno, Nevada +Opinion on Internal Control over Financial Reporting +We have audited AMERCO and consolidated subsidiaries’ (the “Company”) internal control over financial reporting as of March 31, 2020, based on criteria established in +Internal Control – Integrated Framework (2013) +issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). +In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of March 31, 2020, based on the COSO criteria +. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of March 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the three years in the period ended March 31, 2020, and the related notes and schedules and our report dated May 27, 2020, expressed an unqualified opinion thereon. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ BDO USA, LLP +Phoenix, Arizona +May 27, 2020 +40 +Item 9B. +Other Information +Not applicable. +PART III +Item +10. +Directors, Executive Officers and Corporate Governance +The information required to be disclosed under this Item 10 is incorporated herein by reference to AMERCO’s definitive proxy statement, in connection with its 2020 annual meeting of stockholders (the “Proxy Statement”), which will be filed with the SEC within 120 days after the close of the Company’s 2020 fiscal year. +The Company has a Code of Ethics that applies to all directors, officers and employees of the Company, including the Company’s principal executive officer and principal financial officer. A copy of our Code of Ethics is posted on AMERCO’s website at amerco.com/governance.aspx. +We intend to satisfy the disclosure requirements of Current Report on Form 8-K regarding any amendment to, or waiver from, a provision of our Code of Ethics by posting such information on the Company’s website, at the web address and location specified above, unless otherwise required to file a Current Report on Form 8-K by NASDAQ rules and regulations. +Item +11. +Executive Compensation +The information required to be disclosed under this Item 11 is incorporated herein by reference to the Proxy Statement. +Item +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +The information required to be disclosed under this Item 12 is incorporated herein by reference to the Proxy Statement. +Item 13. +Certain Relationships and Related Transactions, and Director Independence +The information required to be disclosed under this Item 13 is incorporated herein by reference to the Proxy Statement. +Item 14. +Principal Accountant Fees and Services +The information required to be disclosed under this Item 14 is incorporated herein by reference to the Proxy Statement. +PART IV +Item 15. +Exhibits; Financial Statement Schedules +The following documents are filed as part of this Report: +Page +1 +Financial Statements: +Report of Independent Registered Public Accounting Firm +F-1 +Consolidated Balance Sheets - March 31, 2020 and 2019 +F-4 +Consolidated Statements of Operations - Years Ended March 31, 2020, 2019, and 2018 +F-5 +Consolidated Statements of Comprehensive Income (Loss) - Years Ended March 31, 2020, 2019, and 2018 +F-6 +Consolidated Statements of Changes in Stockholders' Equity - Years Ended March 31, 2020, 2019, and 2018 +F-7 +Consolidated Statements of Cash Flows - Years Ended March 31, 2020, 2019, and 2018 +F-8 +Notes to Consolidated Financial Statements +F-10 +2 +Financial Statement Schedules required to be filed by Item 8: +Schedule I - Condensed Financial Information of AMERCO +F-64 +Schedule II - AMERCO and Consolidated Subsidiaries Valuation and Qualifying Accounts +F-68 +Schedule V - AMERCO and Consolidated Subsidiaries Supplemental Information (For Property-Casualty Insurance Operations) +F-69 +41 +All other schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. +Exhibits: +Exhibit Number +Description +Page or Method of Filing +3.1 +Amended and Restated Articles of Incorporation of AMERCO +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed on June 9, 2016, file no. 1-11255 +3.2 +Restated Bylaws of AMERCO +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed on September 5, 2013, file no. 1-11255 +4.1 +U-Haul Investors Club Base Indenture, dated February 14, 2011 by and between AMERCO and U. S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on February 22, 2011, file no. 1-11255 +4.2 +Second Supplemental Indenture, dated February 17, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on February 22, 2011, file no. 1-11255 +4.3 +Fourth Supplemental Indenture, dated March 15, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on March 22, 2011, file no. 1-11255 +4.4 +Seventh Supplemental Indenture, dated March 29, 2011, by and among AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on April 1, 2011, file no. 1-11255 +4.5 +Tenth Supplemental Indenture, dated June 7, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 23, 2011, file no. 1-11255 +4.6 +Eleventh Supplemental Indenture dated June 7, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 31, 2011, file no. 1-11255 +4.7 +Twelfth Supplemental Indenture dated June 14, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 23, 2011, file no. 1-11255 +4.8 +Fourteenth Supplemental Indenture dated July 20, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on August 17, 2011, file no. 1-11255 +4.9 +Sixteenth Supplemental Indenture dated August 31, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 28, 2011, file no. 1-11255 +4.10 +Seventeenth Supplemental Indenture dated November 8, 2011 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on January 18, 2012, file no. 1-11255 +4.11 +Eighteenth Supplemental Indenture dated January 7, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on March 26, 2012, file no. 1-11255 +4.12 +Nineteenth Supplemental Indenture dated May 14, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on May 15, 2012, file no. 1-11255 +4.13 +Eighth Supplemental Indenture, dated April 12, 2011, by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year end March 31, 2012, file no. 1-11255 +42 +4.14 +Twentieth Supplemental Indenture dated September 4, 2012 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 4, 2012, file no. 1-11255 +4.15 +Twenty-first Supplemental Indenture dated January 15, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on January 15, 2013, file no. 1-11255 +4.16 +Twenty-second Supplemental Indenture, dated May 28, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 30, 2013, file no. 1-11255 +4.17 +Twenty-third Supplemental Indenture, dated November 26, 2013 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on November 26, 2013, file no. 1-11255 +4.18 +Twenty-fourth Supplemental Indenture, dated April 22, 2014 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on April 22, 2014, file no. 1-11255 +4.19 +Twenty-fifth Supplemental Indenture, dated July 7, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on July 7, 2015, file no. 1-11255 +4.20 +Twenty-sixth Supplemental Indenture, dated September 29, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on September 29, 2015, file no. 1-11255 +4.21 +Twenty-seventh Supplemental Indenture, dated December 15, 2015 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on December 15, 2015, file no. 1-11255 +4.22 +Twenty-eighth Supplemental Indenture, dated September 13, 2016 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on September 13, 2016, file no. 1-11255 +4.23 +Twenty-ninth Supplemental Indenture, dated January 24, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on January 24, 2017, file no. 1-11255 +4.24 +Thirtieth Supplemental Indenture, dated June 27, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on June 27, 2017, file no. 1-11255 +4.25 +Thirty-first Supplemental Indenture, dated October 24, 2017 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on October 25, 2017, file no. 1-11255 +4.26 +Thirty-second Supplemental Indenture, dated March 6, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on March 6, 2018, file no. 1-11255 +4.27 +Amended and Restated Twenty-fifth Supplemental Indenture, dated August 28, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on August 28, 2018, file no. 1-11255 +4.28 +Thirty-third Supplemental Indenture, dated August 28, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on August 28, 2018, file no. 1-11255 +4.29 +Thirty-fourth Supplemental Indenture, dated October 23, 2018 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on October 23, 2018, file no. 1-11255 +43 +4.30 +Thirty-fifth Supplemental Indenture, dated March 7, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on March 7, 2019, file no. 1-11255 +4.31 +Amended and Restated Thirty-third Supplemental Indenture, dated May 3, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 3, 2019, file no. 1-11255 +4.32 +Amended and Restated Thirty-fourth Supplemental Indenture, dated May 3, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 3, 2019, file no. 1-11255 +4.33 +Thirty-sixth Supplemental Indenture, dated May 3, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on May 3, 2019, file no. 1-11255 +4.34 +Thirty-seventh Supplemental Indenture, dated December 10, 2019 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on December 10, 2019, file no. 1-11255 +4.35 +Thirty-eighth Supplemental Indenture, dated February 18, 2020 by and between AMERCO and U.S. Bank National Association +Incorporated by reference to AMERCO's Current Report on Form 8-K, filed on February 18, 2020, file no. 1-11255 +4.36 +Description of Registered Securities +Filed herewith +10.1 +Management Agreement between Four SAC Self-Storage Corporation and subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 1997, file no. 1-11255 +10.2 +Management Agreement between Five SAC Self-Storage Corporation and subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 1999, file no. 1-11255 +10.3 +Property Management Agreement +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2004, file no. 1-11255 +10.4 +U-Haul Dealership Contract between U-Haul Leasing & Sales Co., and U-Haul Moving Partners, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, file no. 1-11255 +10.5 +Property Management Agreement between Mercury Partners, LP, Mercury 99, LLC and U-Haul Self-Storage Management (WPC), Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, file no. 1-11255 +10.6 +Amended and Restated Credit Agreement, dated June 8, 2005, among Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +44 +10.7 +Security Agreement dated June 8, 2005, by Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and the Marketing Grantors named therein in favor of Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.8 +Guarantee, dated June 8, 2005, by U-Haul International, Inc. in favor of Merrill Lynch Commercial Finance Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.9 +Promissory Note, dated June 8, 2005 by Amerco Real Estate Company, Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc. and U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K/A, filed June 14, 2005, file no. 1-11255 +10.10 +Amendment No. 1 to the Amended and Restated Credit Agreement and Security Agreement, dated as of August 18, 2006, to the Amended and Restated Credit Agreement, dated as of June 8, 2005, among Amerco Real Estate Company of Texas, Inc., Amerco Real Estate Company of Alabama, Inc., U-Haul Co. of Florida, Inc., U-Haul International, Inc. and the Marketing Grantors named therein in favor of Merrill Lynch Commercial Financial Corp. +Incorporated by reference to AMERCO’s Current Report on Form 8-K filed August 23, 2006, file no. 1-11255 +10.11 +Amended and Restated Property Management Agreement among Eight SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.12 +Amended and Restated Property Management Agreement among Nine SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.13 +Amended and Restated Property Management Agreement among Ten SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.14 +Amended and Restated Property Management Agreement among Eleven SAC Self-Storage Corporation and Eleven SAC Self-Storage Odenton, Inc. and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.15 +Amended and Restated Property Management Agreement among Twelve SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +45 +10.16 +Amended and Restated Property Management Agreement among Thirteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.17 +Amended and Restated Property Management Agreement among Fourteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.18 +Amended and Restated Property Management Agreement among Fifteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.19 +Amended and Restated Property Management Agreement among Sixteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.20 +Amended and Restated Property Management Agreement among Seventeen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, file no. 1-11255 +10.21 +Amended and Restated Property Management Agreement among Eighteen SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.22 +Amended and Restated Property Management Agreement among Twenty SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.23 +Amended and Restated Property Management Agreement among Twenty-One SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.24 +Amended and Restated Property Management Agreement among Twenty-Two SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.25 +Amended and Restated Property Management Agreement among Twenty-Three SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.26 +Amended and Restated Property Management Agreement among Twenty-Four SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.27 +Amended and Restated Property Management Agreement among Twenty-Five SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.28 +Amended and Restated Property Management Agreement among Twenty-Six SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +46 +10.29 +Amended and Restated Property Management Agreement among Twenty-Seven SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.30 +Amended and Restated Property Management Agreement among Three-A SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.31 +Amended and Restated Property Management Agreement among Three-B SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.32 +Amended and Restated Property Management Agreement among Three-C SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.33 +Amended and Restated Property Management Agreement among Three-D SAC Self-Storage Corporation and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.34 +Amended and Restated Property Management Agreement among Galaxy Storage One, LP and subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on October 4, 2013, file no. 1-11255 +10.35 +U-Haul Dealership Contract Addendum +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2012, file no. 1-11255 +10.36 +Loan Agreement, dated as of August 12, 2015 among U-Haul Co of Florida 8, LLC, U-Haul Co. of Florida 9, LLC, U-Haul Co. of Florida 10, UHIL 8, LLC, UHIL 9, LLC, UHIL 10, LLC, UHIL 13, LLC, AREC 8, LLC, AREC 9, LLC, AREC 10, LLC and AREC 13, LLC, each a Delaware limited liability company, collectively as Borrower, and Morgan Stanley Bank, N.A. and JP Morgan Chase Bank, National Association, collectively as Lender +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on August 14, 2015, file no. 1-11255 +10.37 +Property Management Agreement dated December 11, 2014 between Three SAC Self-Storage Corporation and U-Haul Co. (Canada), Ltd +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.38 +Property Management Agreement dated December 16, 2014 among Galaxy Storage Two, L.P. and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.39 +Property Management Agreement dated June 25, 2015 among 2015 SAC Self-Storage, LLC and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +10.40 +Property Management Agreement dated March 21, 2016 among Five SAC RW, LLC and certain subsidiaries of AMERCO +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2016, file no. 1-11255 +47 +10.41 +Property Management Agreement among Six-SAC Self-Storage Corporation and certain subsidiaries of U-Haul International, Inc. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on June 27, 2016, file no. 1-11255 +10.42 +Stockholder Agreement dated September 12, 2016, between Edward J. Shoen, Mark V. Shoen, Foster Road LLC, Willow Grove Holdings LP, Blackwater Investments, Inc. and SAC Holdings Corporation +Incorporated by reference to Exhibit 99.1, filed with the Schedule 13-D/A, filed on September 12, 2016, file number 5-39669 +10.43 +2016 Stock Option Plan (Shelf Stock Option Plan)* +Incorporated by reference to Exhibit C to Definitive Proxy for the Special Meeting of Stockholders filed on April 20, 2016 +10.44 +Credit Agreement, dated as of September 1, 2017 by and among AMERCO, as the Borrower, Bank of America, N.A., as Agent for all Lenders, and the financial institutions party thereto from to time as, Lenders. +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on September 7, 2017, file no. 1-11255 +10.45 +Template Dealership Contract +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.46 +Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.47 +Amendment to the Amended and Restated AMERCO Employee Savings and Profit and Sharing Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.48 +Amended and Restated AMERCO Employee Stock Ownership Plan* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.49 +Amendment to the Amended and Restated AMERCO Employee Stock Ownership Plan +* +Incorporated by reference to AMERCO’s Annual Report on Form 10-K for the year ended March 31, 2018, file no. 1-11255 +10.50 +Credit Agreement, dated as of May 22, 2020 by and among AMERCO, as the Borrower, PNC Bank, NA as agent for all Lenders, and the financial institutions party thereto, as Lenders +Incorporated by reference to AMERCO’s Current Report on Form 8-K, filed on May 27, 2020, file no. 1-11255 +14 +Code of Ethics +Incorporated by reference to AMERCO’s Quarterly Report on Form 8-K, filed on April 15, 2014, file no. 1-11255 +21 +Subsidiaries of AMERCO +Filed herewith +23.1 +Consent of BDO USA, LLP +Filed herewith +24 +Power of Attorney +Refer to signature page +31.1 +Rule 13a-14(a)/15d-14(a) Certificate of Edward J. Shoen, President and Chairman of the Board of AMERCO +Filed herewith +31.2 +Rule 13a-14(a)/15d-14(a) Certificate of Jason A. Berg, Chief Financial Officer of AMERCO +Filed herewith +48 +32.1 +Certificate of Edward J. Shoen, President and Chairman of the Board of AMERCO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Furnished herewith +32.2 +Certificate of Jason A. Berg, Chief Financial Officer of AMERCO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Furnished herewith +101.INS +XBRL Instance Document +Furnished herewith +101.SCH +XBRL Taxonomy Extension Schema +Furnished herewith +101.CAL +XBRL Taxonomy Extension Calculation Linkbase +Furnished herewith +101.LAB +XBRL Taxonomy Extension Label Linkbase +Furnished herewith +101.PRE +XBRL Taxonomy Extension Presentation Linkbase +Furnished herewith +101.DEF +XBRL Taxonomy Extension Definition Linkbase +Furnished herewith +104 +Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101) +* Indicates management plan or compensatory arrangement. +Item 16. +Form 10-K Summary +None. +49 +Report of Independent Registered Public Accounting Firm +Stockholders and Board of Directors +AMERCO +Reno, Nevada +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of AMERCO and consolidated subsidiaries’ (the “Company”) as of March 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the three years in the period ended March 31, 2020, and the related notes and schedules (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at March 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended March 31, 2020 +, +in conformity with accounting principles generally accepted in the United States of America. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of March 31, 2020, based on criteria established in +Internal Control – Integrated Framework +(2013) +issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated May 27, 2020, expressed an unqualified opinion thereon. +Change in Accounting Principle +As discussed in Note 3 to the consolidated financial statements, effective April 1, 2019, the Company adopted Accounting Standards Codification Topic 842, +Leases +(Topic 842). +Basis for +Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. +We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +F-1 +Self-Insurance Reserves (U-Haul) +As described in Notes 3 and 22A to the consolidated financial statements, U-Haul retains the risk for certain public liability and property damage programs related to its rental equipment, which is referred to as self-insurance. The estimated U-Haul self-insurance reserve as of March 31, 2020 was $410 million and +was recorded in the consolidated balance sheets within policy benefits and losses, claims and loss expenses payable. +The self-insurance reserve estimate requires significant management judgment and is based upon historical claims experience, current claim trends, and actuarial estimates. +We identified the valuation of self-insurance reserves as a critical audit matter. Significant and complex management judgments and assumptions, including the use of management specialists in actuarial methods, is required to evaluate historical claims experience, current claims trends and actuarial estimates, including (i) estimates of future incurred and paid losses, and (ii) initial expected claim costs. +Auditing these complex judgments and assumptions involved especially challenging auditor judgment due to the nature and extent of audit evidence and effort required to address these matters, including the extent of specialized skills or knowledge needed. +The primary procedures we performed to address this critical audit matter included the following: +Testing the design and operating effectiveness of internal controls surrounding the U-Haul self-insurance reserve process, including controls over: (i) existence and accuracy of historical claims data used by the actuary, and (ii) management’s review of the external actuary’s estimate of the self-insurance reserves. +Testing the completeness and accuracy of claims data utilized by the actuary by selecting a sample of claims and corroborating key attributes of claims detail. +Utilizing personnel with specialized knowledge and skill in actuarial methods to assist in evaluating the appropriateness of the methodology and key assumptions utilized by the external actuary including the future development of incurred and paid losses, initial expected claim cost per exposure and retrospective review of prior year estimates. +Valuation of Future Policy Benefits (Oxford) +As discussed in Notes 3, 17 and 22A of the consolidated financial statements, the Company’s life insurance subsidiary +(“Oxford”), sells life insurance, Medicare supplement insurance, and deferred annuities. Liabilities for future policy benefits are recorded in the consolidated balance sheets within policy benefits and losses, claims and loss expenses payable. Management’s estimate of liabilities for future policy benefits as of December 31, 2019 was $377 million. The liability is determined by Management utilizing the net premium valuation methodology and is accrued when premium revenue is recognized. The liability, which represents the present value of future benefits to be paid to policyholders and related expenses less the present value of future net premiums, is estimated using assumptions applicable at the time the insurance contracts are written, with provisions for the risk of adverse deviation, as appropriate. +The Company periodically performs a gross premium valuation and reviews original assumptions, including capitalized expenses which reduce the gross premium valuation, to evaluate whether assets and the liabilities are adequate and whether a loss should be recognized. +We identified +the valuation of future policy benefits for life and annuity policies as a critical audit matter. Significant and complex management judgments and assumptions included +expected mortality experience, policy lapses and surrenders, asset yields and expenses, and expected interest rate yields. Management specialists in actuarial methods are utilized to evaluate the valuation of future policy benefits to determine whether loss recognition is required. Auditing these complex judgments and assumptions involved especially challenging auditor judgment due to the nature and extent of audit evidence and effort required to address these matters, including the extent of specialized skills or knowledge needed. +F-2 +The primary procedures we performed to address this critical audit matter included:  +Testing +the design and operating effectiveness of internal controls +used to estimate future policy benefits including controls over: (i) the appropriateness and completeness of underlying data and the reasonableness of assumptions used, (ii) the reasonableness of internal actuary’s forecasted cash flows and evaluation of results of the gross premium valuation, and (iii) review of management’s estimation process around capitalized expenses. +Testing the completeness and accuracy of a sample of the data utilized to calculate management’s assumptions as the basis for the gross premium valuation. +Utilizing a specialist with knowledge and skill in actuarial methods to assist in reviewing the methodology and assumptions used in the gross premium valuation, including (i) assessing the reasonableness of assumptions used through independent calculations, (ii) evaluating the reasonableness of the amortization of capitalized expenses, (iii) +e +valuating the applicability of the assumptions and sources of management’s calculation at the time the insurance contracts were written and, (iv) reviewing the reasonableness of the gross premium valuation, including evaluating whether loss recognition is warranted. +Reserve for Property & Casualty Losses and Loss Adjustment Expenses (Repwest) +As described in Notes 3, 17 and 22A to the consolidated financial statements, the Company’s property and casualty insurance subsidiary (“Repwest”) recorded $209 million of reserves for property and casualty (“P&C”) losses and loss adjustment expenses at December 31, 2019. +Reserves for P&C losses and loss adjustment expenses are recorded in the consolidated balance sheets within policy benefits and losses, claims and loss expenses payable. Insurance reserves for P&C +take into account losses incurred based upon actuarial estimates and are management’s best approximation of future payments. These estimates are based upon past claims experience and current claim trends as well as actuarial estimates. Changes in judgments and assumptions could materially impact the valuation of these liabilities, particularly for exposure with a long period of time between the insured period and settlement of all claims, such as, excess workers’ compensation claims. +We identified the reserve for P&C losses and loss adjustment expense as a critical audit matter. Significant and complex management judgments and assumptions, including the use of management specialists in actuarial methods, is required to evaluate past claims experience, current claim trends and actuarial estimates +, including expected length of claims and cost trends associated with claimant treatments. +Auditing +these complex judgments and assumptions +involved especially challenging auditor judgment due to the nature and extent of audit effort required to address these matters, including the extent of specialized skill or knowledge needed. +The primary procedures we performed to address this critical audit matter included: +Testing the design and operating effectiveness of internal controls surrounding the reserve for +P&C losses and loss adjustment expense reserves process +, including controls over (i) existence and accuracy of historical claims data used by the actuary, and (ii) management’s review of the external actuary’s estimate of the P&C losses and loss adjustment expense. +Testing the completeness and accuracy of claims data utilized by the actuary by selecting a sample of claims and corroborating key attributes of claims detail. +Utilizing personnel with specialized knowledge and skill in actuarial methods to assist in +evaluating the appropriateness of the methodology and the assumptions used by management’s actuary including (i) performing a retrospective review of the prior year reserve estimate against actual performance, and (ii) performing independent estimates around certain actuarial assumptions related to +expected and incurred loss development between the financial reporting date and the projected date when all claims ultimately settle +. +/s/ BDO USA, LLP +We have served as the Company's auditor since 2003. +Phoenix, Arizona +May 27, 2020 +F-3 +Amerco and consolidated subsidiaries +Consolidated balance sheets +March 31, +2020 +2019 +(In thousands, except share data) +ASSETS +Cash and cash equivalents +$ +494,352 +$ +673,701 +Reinsurance recoverables and trade receivables, net +186,672 +224,785 +Inventories and parts, net +101,083 +103,504 +Prepaid expenses +562,904 +174,100 +Investments, fixed maturities and marketable equities +2,492,738 +2,235,397 +Investments, other +360,373 +300,736 +Deferred policy acquisition costs, net +103,118 +136,276 +Other assets +71,956 +78,354 +Right of use assets - financing, net +1,080,353 +– +Right of use assets - operating +106,631 +– +Related party assets +34,784 +30,889 +5,594,964 +3,957,742 +Property, plant and equipment, at cost: +Land +1,032,945 +976,454 +Buildings and improvements +4,663,461 +4,003,726 +Furniture and equipment +752,363 +689,780 +Rental trailers and other rental equipment +511,520 +590,039 +Rental trucks +3,595,933 +4,762,028 +10,556,222 +11,022,027 +Less: Accumulated depreciation +( 2,713,162 ) +( 3,088,056 ) +Total property, plant and equipment +7,843,060 +7,933,971 +Total assets +$ +13,438,024 +$ +11,891,713 +LIABILITIES AND STOCKHOLDERS' EQUITY +Liabilities: +Accounts payable and accrued expenses +$ +554,353 +$ +556,873 +Notes, loans and finance/capital leases payable, net +4,621,291 +4,163,323 +Operating lease liabilies +106,443 +– +Policy benefits and losses, claims and loss expenses payable +997,647 +1,011,183 +Liabilities from investment contracts +1,802,217 +1,666,742 +Other policyholders' funds and liabilities +10,190 +15,047 +Deferred income +31,620 +35,186 +Deferred income taxes, net +1,093,543 +750,970 +Total liabilities +9,217,304 +8,199,324 +Commitments and contingencies (notes 9, 17, 18, and 19) +Stockholders' equity: +Series preferred stock, with or without par value, +50,000,000 +shares authorized: +Series A preferred stock, with no par value, +6,100,000 +shares authorized; +6,100,000 +shares issued and none outstanding as of March 31, 2020 and 2019 +– +– +Series B preferred stock, with no par value, +100,000 +shares authorized; none +issued and outstanding as of March 31, 2020 and 2019 +– +– +Serial common stock, with or without par value, +250,000,000 +shares authorized: +Serial common stock of $ +0.25 +par value, +10,000,000 +shares authorized; +none issued and outstanding as of March 31, 2020 and 2019 +– +– +Common stock, with $ +0.25 +par value, +250,000,000 +shares authorized: +Common stock of $ +0.25 +par value, +250,000,000 +shares authorized; +41,985,700 +issued and +19,607,788 +outstanding as of March 31, 2020 and 2019 +10,497 +10,497 +Additional paid-in capital +453,819 +453,326 +Accumulated other comprehensive loss +34,652 +( 66,698 ) +Retained earnings +4,399,402 +3,976,962 +Cost of common shares in treasury, net ( +22,377,912 +shares as of March 31, 2020 and 2019) +( 525,653 ) +( 525,653 ) +Cost of preferred shares in treasury, net ( +6,100,000 +shares as of March 31, 2020 and 2019) +( 151,997 ) +( 151,997 ) +Unearned employee stock ownership plan shares +– +( 4,048 ) +Total stockholders' equity +4,220,720 +3,692,389 +Total liabilities and stockholders' equity +$ +13,438,024 +$ +11,891,713 +The accompanying notes are an integral part of these consolidated financial statements. +F- +4 +amerco and consolidated subsidiaries +Consolidated statements of operations +Years Ended March 31, +2020 +2019 +2018 +(In thousands, except share and per share data) +Revenues: +Self-moving equipment rentals +$ +2,692,413 +$ +2,653,497 +$ +2,479,742 +Self-storage revenues +418,741 +367,276 +323,903 +Self-moving and self-storage products and service sales +265,091 +264,146 +261,557 +Property management fees +30,406 +29,148 +29,602 +Life insurance premiums +127,976 +63,488 +154,703 +Property and casualty insurance premiums +66,053 +60,853 +57,100 +Net investment and interest income +137,829 +110,934 +110,473 +Other revenue +240,359 +219,365 +184,034 +Total revenues +3,978,868 +3,768,707 +3,601,114 +Costs and expenses: +Operating expenses +2,117,148 +1,981,180 +1,807,056 +Commission expenses +288,332 +288,408 +276,705 +Cost of sales +164,018 +162,142 +160,489 +Benefits and losses +174,836 +100,277 +185,311 +Amortization of deferred policy acquisition costs +31,219 +28,556 +24,514 +Lease expense +26,882 +33,158 +33,960 +Depreciation, net gains on disposals of ($ +27,057 +, $ +26,982 +and $ +11,822 +respectively) +637,063 +554,043 +543,247 +Net gains on disposal of real estate +( 758 ) +( 44 ) +( 195,414 ) +Total costs and expenses +3,438,740 +3,147,720 +2,835,868 +Earnings from operations +540,128 +620,987 +765,246 +Other components of net periodic benefit costs +(1,054) +(1,013) +(927) +Interest expense +(160,950) +(142,445) +(126,706) +Pretax earnings +378,124 +477,529 +637,613 +Income tax benefit (expense) +63,924 +(106,672) +152,970 +Earnings available to common stockholders +$ +442,048 +$ +370,857 +$ +790,583 +Basic and diluted earnings per common share +$ +22.55 +$ +18.93 +$ +40.36 +Weighted average common shares outstanding: Basic and diluted +19,603,708 +19,592,048 +19,588,889 +Related party revenues for fiscal 2020, 2019 and 2018, net of eliminations, were $ +30.4 +million, $ +29.1 +million and $ +32.9 +million, respectively. +Related party costs and expenses for fiscal 2020, 2019, and 2018, net of eliminations, were $ +64.7 +million, $ +64.1 +million and $ +61.3 +million, respectively. +Please see Note 20, Related Party Transactions, of the Notes to Consolidated Financial Statements for more information on the related party revenues and costs and expenses. +The accompanying notes are an integral part of these consolidated financial statements. +F- +5 +Amerco +and +Consolidated +Subsidiaries +Consolidated statements of comprehensive income (loss) +Fiscal Year Ended March 31, 2020 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +378,124 +$ +63,924 +$ +442,048 +Other comprehensive income: +Foreign currency translation +9,377 +– +9,377 +Unrealized net gain on investments +124,566 +( 26,623 ) +97,943 +Change in fair value of cash flow hedges +( 8,352 ) +2,051 +(6,301) +Amounts reclassified into earnings on hedging activities +( 3 ) +1 +(2) +Change in postretirement benefit obligations +441 +( 108 ) +333 +Total other comprehensive income +126,029 +(24,679) +101,350 +Total comprehensive income +$ +504,153 +$ +39,245 +$ +543,398 +Fiscal Year Ended March 31, 2019 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +477,529 +$ +(106,672) +$ +370,857 +Other comprehensive income: +Foreign currency translation +( 1,759 ) +– +( 1,759 ) +Unrealized net loss on investments +( 76,124 ) +16,356 +(59,768) +Change in fair value of cash flow hedges +598 +( 147 ) +451 +Amounts reclassified into earnings on hedging activities +35 +(9) +26 +Change in postretirement benefit obligations +( 1,359 ) +334 +( 1,025 ) +Total other comprehensive income +(78,609) +16,534 +( 62,075 ) +Total comprehensive income +$ +398,920 +$ +(90,138) +$ +308,782 +Fiscal Year Ended March 31, 2018 +Pre-tax +Tax +Net +(In thousands) +Comprehensive income: +Net earnings +$ +637,613 +$ +152,970 +$ +790,583 +Other comprehensive income: +Foreign currency translation +14,652 +– +14,652 +Unrealized net gain on investments +30,929 +( 10,825 ) +20,104 +Change in fair value of cash flow hedges +4,445 +( 1,363 ) +3,082 +Amounts reclassified into earnings on hedging activities +– +– +– +Change in postretirement benefit obligations +288 +( 253 ) +35 +Total other comprehensive income +50,314 +(12,441) +37,873 +Total comprehensive income +$ +687,927 +$ +140,529 +$ +828,456 +The accompanying notes are an integral part of these consolidated financial statements. +F- +6 +Amerco and consolidated subsidiaries +consolidated statements of changes in stockholders’ equity +Description +Common Stock +Additional Paid-In Capital +Accumulated Other Comprehensive +Income (Loss) +Retained Earnings +Less: Treasury Common Stock +Less: Treasury Preferred Stock +Less: Unearned Employee Stock Ownership Plan Shares +Total Stockholders' Equity +(In thousands) +Balance as of March 31, 2017 +$ +10,497 +$ +452,172 +$ +( 51,236 ) +$ +2,892,893 +$ +( 525,653 ) +$ +( 151,997 ) +$ +( 6,932 ) +$ +2,619,744 +Adjustment for adoption of ASU 2018 - 02 +– +– +8,740 +( 8,740 ) +– +– +– +– +Increase in market value of released ESOP shares +– +574 +– +– +– +– +– +574 +Release of unearned ESOP shares +– +– +– +– +– +– +10,749 +10,749 +Purchase of ESOP shares +– +– +– +– +– +– +( 11,640 ) +( 11,640 ) +Foreign currency translation +– +– +14,652 +– +– +– +– +14,652 +Unrealized net gain on investments, net of tax +– +– +20,104 +– +– +– +– +20,104 +Change in fair value of cash flow hedges, net of tax +– +– +3,082 +– +– +– +– +3,082 +Change in postretirement benefit obligations +– +– +35 +– +– +– +– +35 +Net earnings +– +– +– +790,583 +– +– +– +790,583 +Common stock dividends: ($ +2.00 +per share for fiscal 2018) +– +– +– +( 39,175 ) +– +– +– +( 39,175 ) +Net activity +– +574 +46,613 +742,668 +– +– +( 891 ) +788,964 +Balance as of March 31, 2018 +$ +10,497 +$ +452,746 +$ +( 4,623 ) +$ +3,635,561 +$ +( 525,653 ) +( 151,997 ) +$ +( 7,823 ) +$ +3,408,708 +Adjustment for adoption of ASU 2016 - 01 +– +– +( 9,724 ) +9,724 +– +– +– +– +Increase in market value of released ESOP shares +– +580 +– +– +– +– +– +580 +Release of unearned ESOP shares +– +– +– +– +– +– +9,392 +9,392 +Purchase of ESOP shares +– +– +– +– +– +– +( 5,617 ) +(5,617) +Foreign currency translation +– +– +( 1,759 ) +– +– +– +– +( 1,759 ) +Unrealized net loss on investments, net of tax +– +– +( 50,044 ) +– +– +– +– +(50,044) +Change in fair value of cash flow hedges, net of tax +– +– +477 +– +– +– +– +477 +Change in postretirement benefit obligations +– +– +( 1,025 ) +– +– +– +– +( 1,025 ) +Net earnings +– +– +– +370,857 +– +– +– +370,857 +Common stock dividends: ($ +2.00 +per share for fiscal 2019) +– +– +– +( 39,180 ) +– +– +– +( 39,180 ) +Net activity +– +580 +( 62,075 ) +341,401 +– +– +3,775 +283,681 +Balance as of March 31, 2019 +$ +10,497 +$ +453,326 +$ +( 66,698 ) +$ +3,976,962 +$ +( 525,653 ) +$ +( 151,997 ) +$ +( 4,048 ) +$ +3,692,389 +Increase in market value of released ESOP shares +– +493 +– +– +– +– +– +493 +Release of unearned ESOP shares +– +– +– +– +– +– +4,253 +4,253 +Purchase of ESOP shares +– +– +– +– +– +– +( 205 ) +(205) +Foreign currency translation +– +– +9,377 +– +– +– +– +9,377 +Unrealized net gain on investments, net of tax +– +– +97,943 +– +– +– +– +97,943 +Change in fair value of cash flow hedges, net of tax +– +– +(6,303) +– +– +– +– +(6,303) +Change in postretirement benefit obligations +– +– +333 +– +– +– +– +333 +Net earnings +– +– +– +442,048 +– +– +– +442,048 +Common stock dividends: ($ +1.00 +per share for fiscal 2020) +– +– +– +( 19,608 ) +– +– +– +( 19,608 ) +Net activity +– +493 +101,350 +422,440 +– +– +4,048 +528,331 +Balance as of March 31, 2020 +$ +10,497 +$ +453,819 +$ +34,652 +$ +4,399,402 +$ +( 525,653 ) +$ +( 151,997 ) +$ +– +$ +4,220,720 +The accompanying notes are an integral part of these consolidated financial statements. +F-7 +amerco and consolidated subsidiaries +consolidated statements of cash flows +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Cash flows from operating activities: +Net earnings +$ +442,048 +$ +370,857 +$ +790,583 +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +664,120 +581,025 +555,069 +Amortization of deferred policy acquisition costs +31,219 +28,556 +24,514 +Amortization of premiums and accretion of discounts related to investments, net +13,317 +13,107 +12,790 +Amortization of debt issuance costs +4,426 +3,923 +3,868 +Interest credited to policyholders +51,857 +35,387 +32,302 +Change in allowance for losses on trade receivables +( 14 ) +52 +( 120 ) +Change in allowance for inventories and parts reserves +640 +( 146 ) +5,065 +Net gains on disposal of personal property +(27,057) +(26,982) +(11,822) +Net gains on disposal of real estate +( 758 ) +( 44 ) +( 195,414 ) +Net gains on sales of investments +( 13,596 ) +( 2,663 ) +( 6,269 ) +Net (gains) losses on equity investments +( 3,783 ) +5,739 +– +Deferred income taxes +317,893 +106,811 +( 193,434 ) +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +38,129 +( 31,365 ) +( 15,329 ) +Inventories and parts +1,776 +( 13,492 ) +( 12,384 ) +Prepaid expenses +( 391,120 ) +( 8,620 ) +( 40,765 ) +Capitalization of deferred policy acquisition costs +( 24,447 ) +( 25,957 ) +( 27,350 ) +Other assets +( 1,295 ) +157,152 +( 165,968 ) +Related party assets +( 5,645 ) +4,194 +53,408 +Accounts payable and accrued expenses +( 4,530 ) +10,263 +( 36,980 ) +Policy benefits and losses, claims and loss expenses payable +( 12,618 ) +( 236,120 ) +161,121 +Other policyholders' funds and liabilities +( 4,857 ) +5,007 +( 109 ) +Deferred income +( 1,818 ) +966 +5,524 +Related party liabilities +1,626 +( 2,067 ) +( 616 ) +Net cash provided by operating activities +1,075,513 +975,583 +937,684 +Cash flows from investing activities: +Escrow deposits +6,617 +4,299 +31,362 +Purchase of: +Property, plant and equipment +( 2,309,406 ) +( 1,869,968 ) +( 1,363,745 ) +Short term investments +( 61,226 ) +( 54,048 ) +( 63,556 ) +Fixed maturity investments +( 379,349 ) +( 540,045 ) +( 390,900 ) +Equity securities +( 83 ) +( 957 ) +( 662 ) +Preferred stock +– +– +( 1,000 ) +Real estate +( 4,286 ) +( 635 ) +( 1,939 ) +Mortgage loans +( 62,016 ) +( 63,611 ) +( 83,507 ) +Proceeds from sales and paydowns of: +Property, plant and equipment +687,375 +606,271 +699,803 +Short term investments +59,056 +66,037 +67,790 +Fixed maturity investments +268,636 +123,551 +163,469 +Equity securities +185 +8,608 +– +Preferred stock +2,375 +1,625 +4,208 +Real estate +311 +– +2,783 +Mortgage loans +25,162 +147,737 +37,590 +Net cash used by investing activities +( 1,766,649 ) +( 1,571,136 ) +( 898,304 ) +Page 1 of 2 +The accompanying notes are an integral part of these consolidated financial statements. +F- +8 +amerco +and +consolidated +subsidiaries +consolidated statements of cash flows (continued) +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +$ +1,121,412 +$ +897,311 +$ +498,464 +Principal repayments on credit facilities +( 349,986 ) +( 299,748 ) +( 356,451 ) +Payment of debt issuance costs +( 5,332 ) +( 7,243 ) +( 5,111 ) +Capital lease payments +( 307,782 ) +( 303,431 ) +( 296,363 ) +Employee stock ownership plan shares +(206) +(418) +( 11,640 ) +Securitization deposits +– +– +( 2,180 ) +Common stock dividends paid +( 29,404 ) +( 39,179 ) +( 29,380 ) +Investment contract deposits +234,640 +400,123 +401,814 +Investment contract withdrawals +( 151,022 ) +( 132,833 ) +( 182,549 ) +Net cash provided by financing activities +512,320 +514,582 +16,604 +Effects of exchange rate on cash +( 533 ) +( 4,716 ) +5,598 +Increase (decrease) in cash and cash equivalents +( 179,349 ) +( 85,687 ) +61,582 +Cash and cash equivalents at the beginning of period +673,701 +759,388 +697,806 +Cash and cash equivalents at the end of period +$ +494,352 +$ +673,701 +$ +759,388 +Page 2 of 2 +The accompanying notes are an integral part of these consolidated financial statements. +F- +9 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 1. Basis of Presentation +AMERCO, a Nevada Corporation (“AMERCO”), has a fiscal year that ends on the 31 +st +of March for each year that is referenced. Our insurance company subsidiaries have fiscal years that end on the 31 +st +of December for each year that is referenced. They have been consolidated on that basis. Our insurance companies’ financial reporting processes conform to calendar year reporting as required by state insurance departments. Management believes that consolidating their calendar year into our fiscal year financial statements does not materially affect the financial position or results of operations. We disclose material events, if any, occurring during the intervening period. Consequently, all references to our insurance subsidiaries’ years 2019, 2018 and 2017 correspond to fiscal 2020, 2019 and 2018 for AMERCO. +Accounts denominated in non-U.S. currencies have been translated into U.S. dollars. Certain amounts reported in previous years have been reclassified to conform to the current presentation. Please see Note 3, Accounting Policies – +Adoption of New Accounting Pronouncements +, of the Notes to Consolidated Financial Statements. +Note 2. Principles of Consolidation +We apply Accounting Standards Codification (“ASC”) 810 - +Consolidation +(“ASC 810”) in our principles of consolidation. ASC 810 addresses arrangements where a company does not hold a majority of the voting or similar interests of a variable interest entity (“VIE”). A company is required to consolidate a VIE if it has determined it is the primary beneficiary. ASC 810 also addresses the policy when a company owns a majority of the voting or similar rights and exercises effective control. +A VIE is not self-supportive due to having one or both of the following conditions: (i) it has an insufficient amount of equity for it to finance its activities without receiving additional subordinated financial support or (ii) its owners do not hold the typical risks and rights of equity owners. This determination is made upon the creation of a variable interest and is re-assessed on an on-going basis should certain changes in the operations of a VIE, or its relationship with the primary beneficiary trigger a reconsideration. After a reconsideration event occurs the most recent facts and circumstances are utilized in determining whether or not a company is a VIE, which other company(ies) have a variable interest in the entity, and whether or not the company’s interest is such that it is the primary beneficiary. +We will continue to monitor our relationships with the other entities regarding who is the primary beneficiary, which could change based on facts and circumstances of any reconsideration events. Please see Note 20, Related Party Transactions, of the Notes to Consolidated Financial Statements. +The accompanying Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries, which are consolidated under the voting interest model. Intercompany accounts and transactions have been eliminated. +Description of Legal Entities +AMERCO is the holding company for: +U-Haul International, Inc. (“U-Haul”); +Amerco Real Estate Company (“Real Estate”); +Repwest Insurance Company (“Repwest”); and +Oxford Life Insurance Company (“Oxford”). +Unless the context otherwise requires, the terms “Company,” “we,” “us” or “our” refer to AMERCO and all of its legal subsidiaries. +Description of Operating Segments +AMERCO has three ( +3 +) reportable segments. They are Moving and Storage, Property and Casualty Insurance and Life Insurance. +F- +10 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Moving and Storage includes AMERCO, U-Haul, and Real Estate and the wholly-owned subsidiaries of U-Haul and Real Estate. Operations consist of the rental of trucks and trailers, sales of moving supplies, sales of towing accessories, sales of propane, and the rental of fixed and portable moving and storage units to the “do-it-yourself” mover and management of self-storage properties owned by others. Operations are conducted under the registered trade name U-Haul +® +throughout the United States and Canada. +Property and Casualty Insurance includes Repwest and its wholly-owned subsidiaries and ARCOA Risk Retention Group (“ARCOA”). Property and Casualty Insurance provides loss adjusting and claims handling for U-Haul through regional offices in the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove +® +, Safetow +® +, Safemove Plus +® +, Safestor +® +and Safestor Mobile +® +protection packages to U-Haul customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. ARCOA is a group captive insurer owned by us and our wholly owned subsidiaries whose purpose is to provide insurance products related to our moving and storage business. +Life Insurance includes Oxford and its wholly owned subsidiaries. Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Note 3. +Accounting Policies +Use of Estimates +The preparation of financial statements in conformity with the generally accepted accounting principles (“GAAP”) in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. The accounting policies that we deem most critical to us and that require management’s most difficult and subjective judgments include the principles of consolidation, the recoverability of property, plant and equipment, the adequacy of insurance reserves, the recognition and measurement of impairments for investments accounted for under ASC 320 - +Investments +- +Debt and Equity Securities +and the recognition and measurement of income tax assets and liabilities. The actual results experienced by us may materially differ from management’s estimates. +Cash and Cash Equivalents +We consider cash equivalents to be highly liquid debt securities with insignificant interest rate risk with original maturities from the date of purchase of three months or less. +Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash deposits. Accounts at each United States financial institution are insured by the Federal Deposit Insurance Corporation up to $ +250,000 +. Accounts at each Canadian financial institution are insured by the Canada Deposit Insurance Corporation up to $ +100,000 +CAD per account. As of March 31, 2020 and March 31, 2019, we held cash equivalents in excess of these insured limits. To mitigate this risk, we select financial institutions based on their credit ratings and financial strength. +Investments +Fixed Maturities and Marketable Equities. +Fixed maturity investments consist of either marketable debt, equity or redeemable preferred stocks. As of the balance sheet dates, all of our investments in these securities were classified as available-for-sale. Available-for-sale investments are reported at fair value, with unrealized gains or losses recorded net of taxes and applicable adjustments to deferred policy acquisition costs in stockholders’ equity. Changes in the market value of common stocks are recognized in earnings. Fair value for these investments is based on quoted market prices, dealer quotes or discounted cash flows. The cost of investments sold is based on the specific identification method. +In determining if and when a decline in market value below carrying value is an other-than-temporary impairment, management makes certain assumptions or judgments in its assessment including but not limited to: our ability to hold the security, quoted market prices, dealer quotes, discounted cash flows, industry factors, financial factors, and issuer specific information. Other-than-temporary impairments, to the extent of the decline, as well as realized gains or losses on the sale or exchange of investments are recognized in the current period operating results. +F- +11 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Mortgage Loans and Notes on Real Estate. +Mortgage loans and notes on real estate are reported at their unpaid balance, net of any allowance for possible losses and any unamortized premium or discount. +Recognition of Investment Income. +Interest income from bonds and mortgage notes is recognized when earned. Dividends on common and preferred stocks are recognized on the ex-dividend dates. Realized gains and losses on the sale or exchange of investments are recognized at the trade date. +Derivative Financial Instruments +Our objective for holding derivative financial instruments is to manage interest rate risk exposure primarily through entering interest rate swap agreements and call options. We do not enter into these instruments for trading purposes. Counterparties to the interest rate swap agreements are major financial institutions. Derivatives are recognized at fair value on the balance sheet and are classified as prepaid expenses (asset) or accrued expenses (liability). Derivatives that are not designated as cash flow hedges for accounting purposes must be adjusted to fair value through income. If the derivative qualifies and is designated as a cash flow hedge, changes in its fair value will be recorded in accumulated other comprehensive income (loss) until the hedged item is recognized in earnings. See Note 11, Derivatives, of the Notes to Consolidated Financial Statements. +Inventories and parts, net +Inventories and parts, net were as follows: +March 31, +2020 +2019 +(In thousands) +Truck and trailer parts and accessories (a) +$ +88,138 +$ +94,344 +Hitches and towing components (b) +23,070 +20,113 +Moving supplies and propane (b) +11,824 +10,356 +Subtotal +123,032 +124,813 +Less: LIFO reserves +( 18,886 ) +( 18,987 ) +Less: excess and obsolete reserves +( 3,063 ) +( 2,322 ) +Total +$ +101,083 +$ +103,504 +(a) Primarily held for internal usage, including equipment manufacturing and repair +(b) Primarily held for retail sales +Inventories consist primarily of truck and trailer parts and accessories used to manufacture and repair rental equipment as well as products and accessories available for retail sale. Inventory is held at our owned locations; our independent dealers do not hold any of our inventory. Inventories are stated at the lower cost or net realizable value. +Inventory cost is primarily determined using the last-in first-out method (“LIFO”). Inventories valued using LIFO consisted of approximately +96 +% of the total inventories for March 31, 2020 and 2019. Had we utilized the first-in first-out method (“FIFO”), stated inventory balances would have been $18.9 million and $19.0 million higher as of March 31, 2020 and 2019, respectively. In fiscal 2020, the negative effect on income due to liquidation of a portion of the LIFO inventory was $ +0.1 +million. +F- +12 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Property, Plant and Equipment +Our Property, plant and equipment is stated at cost. Interest expense, if any, incurred during the initial construction of buildings is considered part of cost. Depreciation is computed for financial reporting purposes using the straight line or an accelerated method based on a declining balance formula over the following estimated useful lives: rental equipment 2-20 years and buildings and non-rental equipment 3-55 years. Routine maintenance costs are charged to operating expense as they are incurred. Gains and losses on dispositions of property, plant and equipment, other than real estate (“personal property”), are netted against depreciation expense when realized. The net amount of gains, netted against depreciation expense, were $ +27.1 +million, $ +27.0 +million and $ +11.8 +million during fiscal 2020, 2019 and 2018, respectively. Equipment depreciation is recognized in amounts expected to result in the recovery of estimated residual values upon disposal, i.e., minimize gains or losses. In determining the depreciation rate, historical disposal experience, holding periods and trends in the market for vehicles are reviewed. As a result of changes in IRS regulations regarding the capitalization of assets, beginning in the first quarter of fiscal 2017, we raised the value threshold before certain assets are capitalized within our depreciation policy. This change in threshold, results in the immediate recognition of reported operating costs with a lagging decrease in depreciation expense over the term that these assets would have been depreciated. Due to this change, we had operating expenses of $ +27.7 +million and $ +21.0 +million in fiscal 2020 and 2019, respectively. This change in threshold benefited us through the immediate recognition of tax deductible costs. +We regularly perform reviews to determine whether facts and circumstances exist which indicate that the carrying amount of assets, including estimates of residual value, may not be recoverable or that the useful life of assets are shorter or longer than originally estimated. Reductions in residual values (i.e., the price at which we ultimately expect to dispose of revenue earning equipment) or useful lives will result in an increase in depreciation expense over the remaining life of the equipment. Reviews are performed based on vehicle class, generally subcategories of trucks and trailers. We assess the recoverability of our assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their estimated remaining lives against their respective carrying amounts. We consider factors such as current and expected future market price trends on used vehicles and the expected life of vehicles included in the fleet. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If asset residual values are determined to be recoverable, but the useful lives are shorter or longer than originally estimated, the net book value of the assets is depreciated over the newly determined remaining useful lives. +For our box truck fleet we utilize an accelerated method of depreciation based upon a declining formula. Under the declining balances method (2.4 times declining balance), the book value of a rental truck is reduced approximately +16 +%, +13 +%, +11 +%, +9 +%, +8 +%, +7 +%, and +6 +% during years one through seven, respectively and then reduced on a straight line basis to a salvage value of +15 +% by the end of year fifteen. Comparatively, a standard straight line approach would reduce the book value by approximately +5.7 +% per year over the life of the truck. +Although we intend to sell our used vehicles for prices approximating book value, the extent to which we realize a gain or loss on the sale of used vehicles is dependent upon various factors including, but not limited to, the general state of the used vehicle market, the age and condition of the vehicle at the time of its disposal and the depreciation rates with respect to the vehicle +. +We typically sell our used vehicles at our sales centers throughout the United States and Canada, on our website at uhaul.com/trucksales or by phone at 1-866-404-0355. Additionally, we sell a large portion of our pickup and cargo van fleet at automobile dealer auctions. +In addition to our property, plant and equipment, we had real estate held for future development or use of $ +69.6 +million and $ +53.5 +million for fiscal 2020 and 2019, respectively and is included in Investments, other. +Receivables +Trade receivables include trade accounts from moving and self-storage customers and dealers, insurance premiums and amounts due from re-insurers, less management’s estimate of uncollectible accounts. +F- +13 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Insurance premiums receivable for policies that are billed through contracted agents are recorded net of commissions payable. A commission payable is recorded as a separate liability for those premiums that are billed direct. +Reinsurance recoverables include case reserves and actuarial estimates of claims incurred but not reported ("IBNR"). These receivables are not expected to be collected until after the associated claim has been adjudicated and billed to the re-insurer. The reinsurance recoverables may have little or no allowance for doubtful accounts due to the fact that reinsurance is typically procured from carriers with strong credit ratings. Furthermore, we do not cede losses to a re-insurer if the carrier is deemed financially unable to perform on the contract. Reinsurance recoverables also include insurance ceded to other insurance companies. +Notes and mortgage receivables include accrued interest and are reduced by discounts and amounts considered by management to be uncollectible. +Policy Benefits and Losses, Claims and Loss Expenses Payable +Liabilities for future policy benefits related to life insurance, Medical supplement insurance, and deferred annuities are determined by management utilizing the net premium valuation methodology and are accrued when premium revenue is recognized. The liability, which represents the present value of future benefits to be paid to policyholders and related expenses less the present value of future net premiums, is estimated using assumptions applicable at the time the insurance contracts are written, with provisions for the risk of adverse deviation, as appropriate. Assumptions include expected mortality and morbidity experience, policy lapses and surrenders, current asset yields and expenses, and expected interest rate yields. The Company periodically performs a gross premium valuation and reviews original assumptions, including capitalized expenses which reduce the gross premium valuation, to evaluate whether the assets and liabilities are adequate and whether a loss reserve should be recognized. Liabilities for health, disability and other policies include estimates of payments to be made on insurance claims for reported losses and estimates of IBNR losses. Oxford’s liabilities for deferred annuity contracts consist of contract account balances that accrue to the benefit of the policyholders. +Property and Casualty Insurance’s liability for reported and unreported losses is based on Repwest’s historical data along with industry averages. The liability for unpaid loss adjustment expenses is based on historical ratios of loss adjustment expenses paid to losses paid. Amounts recoverable from re-insurers on unpaid losses are estimated in a manner consistent with the claim liability associated with the re-insured policy. Adjustments to the liability for unpaid losses and loss expenses as well as amounts recoverable from re-insurers on unpaid losses are charged or credited to expense in the periods in which they are made. +Due to the nature of the underlying risks and high degree of uncertainty associated with the determination of the liability for future policy benefits and claims, the amounts to be ultimately paid to settle these liabilities cannot be precisely determined and may vary significantly from the estimated liability, especially for long-tailed casualty lines of business such as excess workers’ compensation. +As a result of the long-tailed nature of the excess workers’ compensation policies written by Repwest during 1983 through 2001, it may take a number of years for claims to be fully reported and finally settled. +On a regular basis insurance reserve adequacy is reviewed by management to determine if existing assumptions need to be updated. In determining the assumptions for calculating workers’ compensation reserves, management considers multiple factors including the following: +Claimant longevity +Cost trends associated with claimant treatments +Changes in ceding entity and third party administrator reporting practices +Changes in environmental factors including legal and regulatory +Current conditions affecting claim settlements +Future economic conditions including inflation +F- +14 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +We have reserved each claim based upon the accumulation of current claim costs projected through each claimant’s life expectancy and then adjusted for applicable reinsurance arrangements. +Management reviews each claim bi-annually or more frequently, if there are changes in facts or circumstances to determine if the estimated life-time claim costs have increased and then adjusts the reserve estimate accordingly at that time. +We have factored in an estimate of what the potential cost increases could be in our IBNR liability. +We have not assumed settlement of the existing claims in calculating the reserve amount, unless it is in the final stages of completion. +Continued increases in claim costs, including medical inflation and new treatments and medications could lead to future adverse development resulting in additional reserve strengthening. +Conversely, settlement of existing claims or if injured workers return to work or expire prematurely, could lead to future positive development. +Self-Insurance Reserves +U-Haul retains the risk for certain public liability and property damage programs related to our rental equipment. The consolidated balance sheets include $ +410.1 +million and $ +407.9 +million of liabilities related to these programs as of March 31, 2020 and 2019, respectively. These liabilities are recorded in Policy benefits and losses, claims and loss expenses payable. Management takes into account losses incurred based upon actuarial estimates, past experience, current claim trends, as well as social and economic conditions. This liability is subject to change in the future based upon changes in the underlying assumptions including claims experience, frequency of incidents, and severity of incidents. +Additionally, as of March 31, 2020 and 2019, the consolidated balance sheets include liabilities of $ +15.7 +million and $ +15.6 +million, respectively, related to medical plan benefits we provide for eligible employees. We estimate this liability based on actual claims outstanding as of the balance sheet date as well as an actuarial estimate of IBNR claims. These amounts are recorded in Accounts payable and accrued expenses on the consolidated balance sheets. +Revenue Recognition +Self-moving rentals are recognized for the period that trucks and moving equipment are rented. Self-storage revenues, based upon the number of paid storage contract days, are recognized as earned during the period. +Sales of self-moving and self-storage related products are recognized at the time that title passes and the customer accepts delivery. +Property and casualty insurance premiums are recognized as revenue over the policy periods. Traditional life and Medicare supplement insurance premiums are recognized as revenue over the premium-paying periods of the contracts when due from the policyholders. For products where premiums are due over a significantly shorter duration than the period over which benefits are provided, such as our single premium whole life product, premiums are recognized when received and excess profits are deferred and recognized in relation to the insurance in force. +Interest and investment income are recognized as earned. +Amounts collected from customers for sales tax are recorded on a net basis. Please see Note 23, Revenue Recognition, of the Notes to Consolidated Financial Statements. +Advertising +All advertising costs are expensed as incurred. Advertising expense was $ +13.7 +million, $ +10.6 +million and $ +8.1 +million in fiscal 2020, 2019 and 2018, respectively. +Deferred Policy Acquisition Costs +Commissions and other costs that fluctuate with and are primarily related to the successful acquisition or renewal of certain insurance premiums are deferred. For our Life Insurance’s life and health insurance products, these costs are amortized, with interest, in relation to revenue such that costs are realized as a constant percentage of revenue. For its annuity insurance products the costs are amortized, with interest, in relation to the present value of actual and expected gross profits. +F- +15 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Starting in fiscal 2014, new annuity contract holders were provided with a sales inducement in the form of a premium bonus (the “Sales Inducement Asset”). +Sales inducements are recognized as an asset with a corresponding increase to the policyholder liability and are amortized in a similar manner to Deferred Policy Acquisition Costs. +As of December 31, 2019 and 2018, the Sales Inducement Asset included with Deferred Policy Acquisition Costs amounted to $ +16.8 +million and $ +19.1 +million, respectively on the consolidated balance sheet and amortization expense totaled $ +5.5 +million, $ +3.7 +million and $ +3.7 +million for the periods ended December 31, 2019, 2018 and 2017, respectively. +Environmental Costs +Liabilities are recorded when environmental assessments and remedial efforts, if applicable, are probable and the costs can be reasonably estimated. The amount of the liability is based on management’s best estimate of undiscounted future costs. Certain recoverable environmental costs related to the removal of underground storage tanks or related contamination are capitalized and amortized over the estimated useful lives of the properties. These costs are capitalized if they improve the safety or efficiency of the property or are incurred in preparing the property for sale. +Income Taxes +AMERCO files a consolidated tax return with all of its legal subsidiaries. The provision for income taxes reflects deferred income taxes resulting from changes in temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. +Comprehensive Income (Loss) +Comprehensive income (loss) consists of net earnings, foreign currency translation adjustments, unrealized gains and losses on investments, the change in fair value of cash flow hedges and the change in postretirement benefit obligations. +Debt Issuance Costs +We defer costs directly associated with acquiring third-party financing. Debt issuance costs are deferred and amortized to interest expense using the effective interest method. Debt issuance costs related to our long-term debt are reflected as a direct deduction from the carrying amount of the debt. Please see Note 9, Borrowings, of the Notes to Consolidated Financial Statements. +Adoption of New Accounting Pronouncements +On April 1, 2019, we adopted Accounting Standards Codification Topic 842, which require a lessee to recognize all +leases with terms greater than 12 months on their balance sheet as +a liability for its lease obligation, measured at the present value of lease payments not yet paid, and a corresponding asset representing its right to use the underlying asset over the lease term. The new leasing standard does not significantly change a lessee’s recognition, measurement and presentation of expenses and cash flows. Additionally, Topic 842 +aligns key aspects of lessor accounting with the new revenue recognition guidance in Topic 606 (see +Note 23, Revenue Recognition) +and expands disclosure of key information about leasing arrangements +in an attempt to help financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases +. +We have determined portions of the vehicle rental contracts that convey the right to control the use of identified assets are within the scope of the accounting guidance contained in the new leasing standard. As described in Note 23, Revenue Recognition, the Company’s rental related revenues are accounted for under the revenue accounting standard Topic 606. +Topic 842 requires leases to be classified as either operating or finance, with lease classification determined in a manner similar to the former lease guidance. The basic principle is that leases of all types convey the right to direct the use and obtain substantially all the economic benefits of an identified asset, meaning they create an asset and liability for lessees. Lessees classify leases as either finance leases (comparable to former capital leases) or operating leases. Costs for a finance lease are split between amortization and interest expense, with operating leases reporting a single lease expense. +F- +16 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Topic 842 substantially changed the accounting for sale-leasebacks going forward, where we are to assess if the contract qualifies as a sale under ASC 606. We have determined that our equipment sale-leasebacks do not qualify as a sale, as the buyer-lessors do not obtain control of the assets in our ongoing sale-leaseback arrangements. As a result, we expect future sale-leasebacks to be accounted for as a financial liability and the leased assets will be capitalized at cost. As all former sale-leasebacks have been accounted for as a sale, we did not reassess any former sale-leaseback transactions. +We adopted the new leasing standard using the Effective Date Approach, which allows entities to only apply the new lease standard in the year of adoption. We elected the available practical expedients for existing or expired contracts of lessees and lessors wherein the Company is not required to reassess whether such contracts contain leases, the lease classification or the initial direct costs. Additionally, we elected as accounting policies to not recognize right of use assets or lease liabilities for short-term leases (i.e. those with a term of 12 months or less) and to combine lease and non-lease components in the contract for both lessee and lessor arrangements. +Adoption of this standard resulted in most of our operating lease commitments being recognized as operating lease liabilities and right-of-use (“ROU”) assets. Please see Note 18, Leases, of the Notes to Consolidated Financial Statements. +On April 10, 2020, the FASB issued a question-and-answer document that allows entities to elect not evaluate whether a concession provided by a lessor to a lessee in response to COVID-19 is a lease modification. An entity that makes this election may then elect to apply the lease modification guidance to that relief or account for the concession as if it were contemplated in the existing contract. +On April 1, 2019, the Company adopted ASU 2017-08, +Receivables – Nonrefundable Fees and Other Cost (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. +These amendments shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The adoption of the standard did not have a material impact on our consolidated financial statements. +Recent Accounting Pronouncements +In June 2016, FASB issued ASU 2016-13, +Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments +(“ASU 2016-13”). This standard requires the measurement and recognition of expected credit losses held at amortized cost. This new standard requires the use of forward-looking information to estimate credit losses and requires credit losses for available for sale debt securities to be recorded through an allowance for credit losses rather than a reduction in the amortized cost basis. This update is effective for public companies for annual reporting periods beginning after December 15, 2019. In November 2019, the FASB released ASU 2019-11, +Codification Improvements to Topic 326, Financial Instruments—Credit Losses, +which +clarified narrow issues within ASU 2016-13. +Specifically, the four main clarifications include: expected recoveries for purchased financial assets with credit deterioration; transition relief for troubled debt restructurings; disclosures for accrued interest receivables; and financial assets backed by collateral maintenance provisions. +The Company has completed the development of the implementation plan and is in the process of model development. The Company is evaluating whether ASU 2016-13 will have a material impact on the Company’s consolidated financial statements. +In August 2018, the FASB adopted ASU 2018-12, +Targeted Improvements to the Accounting for Long-Duration Contracts +(“ASU 2018-12”). The amendments in this update require insurance companies to annually review and update the assumptions used for measuring the liability under long-duration contracts, such as life insurance, disability income, and annuities. The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 31, 2020. We are currently in the process of evaluating the impact of the adoption of this amendment on our financial statements; however, the adoption of ASU 2018-12 will impact the statements of operations because the effect of any update to the assumptions we used at the inception of the contracts will be recorded in net income. +F- +17 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +In August 2018, the FASB issued ASU 2018-13, +Fair Value Measurement (Topic 820) - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement +(“ASU 2018-13”), which modifies the disclosures on fair value measurements by removing the requirement to disclose the amount and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy and the policy for the timing of such transfers. ASU 2018-13 expands the disclosure requirements for Level 3 fair value measurements, primarily focused on changes in unrealized gains and losses included in other comprehensive income. ASU 2018-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The adoption of the standard is not expected to have a material impact on our consolidated financial statements. +In August 2018, the FASB issued ASU 2018-14, +Compensation - Retirement Benefits - Defined Benefit Plans - General Subtopic 715-20 - Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans +(“ASU 2018-14”), +which amends ASC 715 to add, remove, and clarify disclosure requirements related to defined benefit pension and other postretirement plans. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. We are currently evaluating the impact of this standard on our consolidated financial statements. +In March 2020, FASB issued ASU 2020-04, Reference Rate Reform (Topic 848), +Facilitation of the Effects of Reference Rate Reform on Financial Reporting +(“ASU 2020-04”). This standard provides temporary optional expedients and exceptions to the US GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from the London Interbank Offered Rate (“LIBOR”) and other interbank offered rates to alternative reference rates, such as the Secured Overnight Financing Rate. Entities can elect not to apply certain modification accounting requirements to contracts affected by what the guidance calls reference rate reform, if certain criteria are met. An entity that makes this election would not have to remeasure the contracts at the modification date or reassess a previous accounting determination. The guidance is effective upon issuance and generally can be applied through December 31, 2022. We are currently evaluating the impact of these standards on our consolidated financial statements. +From time to time, new accounting pronouncements are issued by the FASB or the SEC that are adopted by us as of the specified effective date. Unless otherwise discussed, these ASUs entail technical corrections to existing guidance or affect guidance related to specialized industries or entities and therefore will have minimal, if any, impact on our financial position or results of operations upon adoption. +Note 4. +Earnings Per Share +Our earnings per share is calculated by dividing our earnings available to common stockholders by the weighted average common shares outstanding, basic and diluted. +The weighted average common shares outstanding exclude post-1992 shares of the employee stock ownership plan that have not been committed to be released. The unreleased shares, net of shares committed to be released, were +11,949 +; and +17,581 +as of March 31, 2019 and 2018, respectively. As of March 31, 2020, all of these shares have been released. +F- +18 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 5. +Reinsurance Recoverables and Trade Receivables, Net +Reinsurance recoverables and trade receivables, net were as follows: +March 31, +2020 +2019 +(In thousands) +Reinsurance recoverable +$ +89,020 +$ +99,615 +Trade accounts receivable +59,394 +90,786 +Paid losses recoverable +624 +2,333 +Accrued investment income +25,744 +25,142 +Premiums and agents' balances +1,582 +1,545 +Independent dealer receivable +1,015 +390 +Other receivables +9,828 +5,523 +187,207 +225,334 +Less: Allowance for doubtful accounts +( 535 ) +( 549 ) +$ +186,672 +$ +224,785 +Note 6. +Investments +Expected maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. +We deposit bonds with insurance regulatory authorities to meet statutory requirements. The adjusted cost of bonds on deposit with insurance regulatory authorities was $ +30.8 +million for both December 31, 2019 and 2018. +Available-for-Sale Investments +Available-for-sale investments as of March 31, 2020 were as follows: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses More than 12 Months +Gross +Unrealized +Losses Less than 12 Months +Estimated +Market +Value +(In thousands) +U.S. treasury securities and government obligations +$ +112,421 +$ +7,959 +$ +( 1 ) +$ +– +$ +120,379 +U.S. government agency mortgage-backed securities +88,449 +759 +( 1 ) +( 373 ) +88,834 +Obligations of states and political subdivisions +287,643 +20,664 +( 155 ) +– +308,152 +Corporate securities +1,656,425 +100,302 +( 919 ) +( 812 ) +1,754,996 +Mortgage-backed securities +187,784 +6,011 +( 1 ) +( 107 ) +193,687 +Redeemable preferred stocks +1,493 +72 +– +– +1,565 +$ +2,334,215 +$ +135,767 +$ +( 1,077 ) +$ +( 1,292 ) +$ +2,467,613 +F- +19 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Available-for-sale investments as of March 31, 2019 were as follows: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses More than 12 Months +Gross +Unrealized +Losses Less than 12 Months +Estimated +Market +Value +(In thousands) +U.S. treasury securities and government obligations +$ +136,010 +$ +2,409 +$ +( 2,104 ) +$ +( 447 ) +$ +135,868 +U.S. government agency mortgage-backed securities +31,101 +433 +( 146 ) +( 19 ) +31,369 +Obligations of states and political subdivisions +298,955 +8,079 +( 233 ) +( 905 ) +305,896 +Corporate securities +1,613,199 +14,777 +( 14,257 ) +( 24,986 ) +1,588,733 +Mortgage-backed securities +148,203 +880 +( 285 ) +( 903 ) +147,895 +Redeemable preferred stocks +1,493 +20 +– +( 45 ) +1,468 +$ +2,228,961 +$ +26,598 +$ +( 17,025 ) +$ +( 27,305 ) +$ +2,211,229 +The available-for-sale tables include gross unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. +We sold available-for-sale securities with a fair value of $ +264.5 +million, $ +114.8 +million and $ +163.7 +million in fiscal 2020, 2019 and 2018, respectively. The gross realized gains on these sales totaled $ +6.4 +million, $ +2.0 +million and $ +5.4 +million in fiscal 2020, 2019 and 2018, respectively. We realized gross losses on these sales of $ +0.2 +million, $ +0.2 +million and $ +0.3 +million in fiscal 2020, 2019 and 2018, respectively. +The unrealized losses of more than twelve months in the available-for-sale tables are considered temporary declines. We track each investment with an unrealized loss and evaluate them on an individual basis for other-than-temporary impairments, including obtaining corroborating opinions from third party sources, performing trend analysis and reviewing management’s future plans. Certain of these investments may have declines determined by management to be other-than-temporary and we recognized these write-downs through earnings. There were no write downs in fiscal 2020, 2019 and 2018. +We reviewed our available-for-sale investments at the end of the first quarter of fiscal 2021 and noted an increase in the unrealized loss position of $50.2 million (unaudited). We reviewed credit ratings of the issuers of these securities and determined that each issuer was current on its scheduled interest, dividends or principal payments. We further reviewed the fair value of these securities a month later and observed that the unrealized loss had recovered by $23.4 million (unaudited). +The investment portfolio primarily consists of corporate securities and obligations of states and political subdivisions. We believe we monitor our investments as appropriate. Our methodology of assessing other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors, including the length of time to maturity, the extent to which the fair value has been less than the cost, the financial condition and the near-term prospects of the issuer, and whether the debtor is current on its contractually obligated interest and principal payments. Nothing has come to management’s attention that would lead to the belief that any issuer would not have the ability to meet the remaining contractual obligations of the security, including payment at maturity. We have the ability and intent not to sell our fixed maturity and common stock investments for a period of time sufficient to allow us to recover our costs. +The portion of other-than-temporary impairment related to a credit loss is recognized in earnings. The significant inputs utilized in the evaluation of mortgage backed securities credit losses include ratings, delinquency rates, and prepayment activity. The significant inputs utilized in the evaluation of asset backed securities credit losses include the time frame for principal recovery and the subordination and value of the underlying collateral. +F- +20 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +There were no credit losses recognized in earnings for which a portion of an other-than-temporary impairment was recognized in accumulated other comprehensive loss for fiscal 2020, 2019 or 2018. +The adjusted cost and estimated market value of available-for-sale investments by contractual maturity, were as follows: +March 31, 2020 +March 31, 2019 +Amortized +Cost +Estimated +Market +Value +Amortized +Cost +Estimated +Market +Value +(In thousands) +Due in one year or less +$ +128,747 +$ +129,420 +$ +71,987 +$ +71,954 +Due after one year through five years +547,821 +566,934 +541,195 +540,658 +Due after five years through ten years +636,036 +678,636 +621,031 +614,485 +Due after ten years +832,334 +897,371 +845,052 +834,769 +2,144,938 +2,272,361 +2,079,265 +2,061,866 +Mortgage backed securities +187,784 +193,687 +148,203 +147,895 +Redeemable preferred stocks +1,493 +1,565 +1,493 +1,468 +$ +2,334,215 +$ +2,467,613 +$ +2,228,961 +$ +2,211,229 +As of March 31, 2018, equity investments were classified as available-for-sale on our balance sheet. However, upon adoption of ASU 2016-01, +Recognition and Measurement of Financial Assets and Financial Liabilities +, on April 1, 2018, the updated guidance eliminated the available-for-sale balance sheet classification for equity investments. As of March 31, 2020 and 2019, our common stock and non-redeemable preferred stock that are included in Investments, fixed maturities and marketable equities on our balance sheet are stated in the table below. The changes in the fair value of these equity investments are recognized through Net investment and interest income. +Equity investments of common stock and non-redeemable preferred stock were as follows: +March 31, 2020 +March 31, 2019 +Amortized +Cost +Estimated +Market +Value +Amortized +Cost +Estimated +Market +Value +(In thousands) +Common stocks +$ +9,775 +$ +20,015 +$ +10,123 +$ +17,379 +Non-redeemable preferred stocks +5,076 +5,110 +7,451 +6,789 +$ +14,851 +$ +25,125 +$ +17,574 +$ +24,168 +Investments, other +The carrying value of other investments was as follows: +March 31, +2020 +2019 +(In thousands) +Mortgage loans, net +$ +262,688 +$ +225,829 +Short-term investments +6,995 +5,546 +Real estate +69,569 +53,519 +Policy loans +11,212 +10,491 +Other equity investments +9,909 +5,351 +$ +360,373 +$ +300,736 +F- +21 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Mortgage loans are carried at the unpaid balance, less an allowance for probable losses net of any unamortized premium or discount. The portfolio of mortgage loans is principally collateralized by self-storage facilities and commercial properties. The interest rate range on the mortgage loans is +4.1 +% to +8.2 +% with maturities between +2020 +and +2036 +. The allowance for probable losses was $ +0.5 +million for both March 31, 2020 and 2019, respectively. The estimated fair value of these loans as of March 31, 2020 and 2019 were not materially different compared to the carrying value. These loans represent first lien mortgages held by us. Mortgage loans are reviewed on an ongoing basis and analysis may include market analysis, estimated valuations of the underlying collateral, loan to value ratios, tenant creditworthiness and other factors. For our mortgage loans, no specifically identified loans were impaired as of March 31, 2020. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. +Short-term investments consist primarily of investments in money market funds, mutual funds and any other investments with short-term characteristics that have original maturities of less than one year at acquisition. These investments are recorded at cost, which approximates fair value. +Real estate held for future development or use is carried at the lower of fair value at time of acquisition or current estimated fair value less cost to sell. Other equity investments are carried at cost and assessed for impairment. +Insurance policy loans are carried at their unpaid balance. +Note 7. +Other Assets +Other assets were as follows: +March 31, +2020 +2019 +(In thousands) +Deposits (debt-related) +$ +33,020 +$ +30,408 +Cash surrender value of life insurance policies +31,371 +30,985 +Deposits (real estate related) +7,565 +16,961 +$ +71,956 +$ +78,354 +Note 8. +Net Investment and Interest Income +Net investment and interest income, were as follows: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Fixed maturities +$ +107,434 +$ +99,348 +$ +84,476 +Real estate +7,304 +5,538 +5,344 +Insurance policy loans +974 +1,305 +1,212 +Mortgage loans +17,164 +16,674 +17,783 +Short-term, amounts held by ceding reinsurers, net and other investments +9,807 +( 7,429 ) +3,098 +Investment income +142,683 +115,436 +111,913 +Less: investment expenses +( 4,854 ) +( 4,502 ) +( 4,766 ) +Investment income - related party, net eliminations +– +– +3,326 +Net investment and interest income +$ +137,829 +$ +110,934 +$ +110,473 +F- +22 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 9. +Borrowings +Long-Term Debt +Long-term debt was as follows: +March 31, +2020 Rates (a) +Maturities +2020 +2019 +(In thousands) +Real estate loan (amortizing term) +2.36 +% +2023 +$ +92,913 +$ +102,913 +Senior mortgages +3.11 +% +6.62 +% +2021 +- +2038 +2,029,878 +1,741,652 +Real estate loans (revolving credit) +2.98 +% +3.14 +% +2022 +- +2025 +519,000 +429,400 +Fleet loans (amortizing term) +1.95 +% +4.66 +% +2020 +- +2027 +224,089 +263,209 +Fleet loans (revolving credit) +2.73 +% +2.75 +% +2022 +- +2024 +567,000 +530,000 +Finance/capital leases (rental equipment) +1.92 +% +5.04 +% +2020 +- +2026 +734,870 +1,042,652 +Finance liability (rental equipment) +2.63 +% +4.22 +% +2024 +- +2027 +398,834 +– +Other obligations +2.50 +% +8.00 +% +2020 +- +2049 +84,484 +82,417 +Notes, loans and finance/capital leases payable +$ +4,651,068 +$ +4,192,243 +Less: Debt issuance costs +( 29,777 ) +( 28,920 ) +Total notes, loans and finance/capital leases payable, net +$ +4,621,291 +$ +4,163,323 +(a) Interest rate as of March 31, 2020, taking into account the effect of applicable hedging instruments +Real Estate Backed Loans +Real Estate Loan +Real Estate and certain of its subsidiaries and U-Haul Company of Florida are borrowers under a real estate loan (the “Real Estate Loan”). +The Real Estate Loan requires monthly principal and interest payments, with the unpaid loan balance and accrued and unpaid interest due at maturity. The Real Estate Loan is secured by various properties owned by the borrowers. +The interest rate, per the provisions of the amended loan agreement, is the applicable London Inter-Bank Offer Rate (“LIBOR”) plus the applicable margin. As of March 31, 2020, the applicable LIBOR was +0.86 +% and the applicable margin was +1.50 +%, the sum of which was +2.36 +%. The default provisions of the Real Estate Loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. There are limited restrictions regarding our use of the funds. +Senior Mortgages +Various subsidiaries of Real Estate and U-Haul are borrowers under certain senior mortgages. The senior mortgages require monthly principal and interest payments. The senior mortgages are secured by certain properties owned by the borrowers. The fixed interest rates, per the provisions of the senior mortgages, range between +3.11 +% and +6.62 +%. Certain senior mortgages have an anticipated repayment date and a maturity date. If these senior mortgages are not repaid by the anticipated repayment date, the interest rate on these mortgages would increase from the current fixed rate. We are using the anticipated repayment date for our maturity schedule. Real Estate and U-Haul have provided limited guarantees of the senior mortgages. The default provisions of the senior mortgages include non-payment of principal or interest and other standard reporting and change-in-control covenants. There are limited restrictions regarding our use of the funds. +F- +23 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Real Estate Loans (Revolving Credit) +Various subsidiaries of Real Estate are borrowers under asset-backed real estate loans with an aggregate borrowing capacity of $ +385.0 +million. These loans are secured by certain properties owned by the borrowers. The loan agreements provide for term loans, subject to the terms of the loan agreements. The final maturity of the loans is between June +2022 +and March +2025 +. The loans require monthly interest payments with the unpaid loan balance and accrued and unpaid interest due at maturity. The interest rate, per the provision of the loan agreements, is the applicable LIBOR plus the applicable margin. As of March 31, 2020, the applicable LIBOR was between +1.58 +% and +1.60 +% and the margin was between +1.25 +% and +1.40 +%, the sum of which was between 2.85% and 3.10%. AMERCO is the guarantor of these loans. The default provisions of the loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. +AMERCO is a borrower under a real estate loan. The current maximum credit commitment is $ +150.0 +million, which can be increased to $ +300.0 +million by bringing in other lenders. As of March 31, 2020, the outstanding balance was $ +150.0 +million. This loan agreement provides for revolving loans, subject to the terms of the loan agreement. This loan requires monthly interest payments with the unpaid loan balance and accrued and unpaid interest due at maturity. As of March 31, 2020, the applicable LIBOR was +1.60 +% and the margin was +1.38 +%, the sum of which was +2.98 +%. The default provisions of the loan include non-payment of principal or interest and other standard reporting and change-in-control covenants. +There is a +0.30 +% fee charged for unused capacity. In April 2020, the Company expanded the borrowing capacity to $ +200.0 +million, extended the maturity to April 2023 and the margin increased to +2.25 +%. +Fleet Loans +Rental Truck Amortizing Loans +The amortizing loans require monthly principal and interest payments, with the unpaid loan balance and accrued and unpaid interest due at maturity. These loans were used to purchase new trucks. The interest rates, per the provision of the loan agreements, are carried at fixed rates ranging between +1.95 +% and +4.66 +%. +AMERCO, and in some cases U-Haul, is guarantor of these loans. The default provisions of these loans include non-payment of principal or interest and other standard reporting and change-in-control covenants. +Rental Truck Revolvers +Various subsidiaries of U-Haul entered into three revolving fleet loans with an aggregate borrowing capacity of $ +590.0 +million. The interest rates, per the provision of the loan agreements, are the applicable LIBOR plus the applicable margin. As of March 31, 2020, the applicable LIBOR was between +1.58 +% and +1.60 +%, and the margin was +1.15 +%, the sum of which was between 2.73% and 2.75%. Only interest is paid on the loans until the last nine months of the respective loan terms when principal becomes due monthly. +Finance/Capital Leases +The Finance/Capital Lease balance represents our sale-leaseback transactions of rental equipment that were entered into and classified as capital leases prior to the adoption of ASC 842 on April 1, 2019. The historical capital lease balance was reclassified to Right-of-use assets-finance, net. The agreements are generally seven (7) year terms with interest rates ranging from +1.92 +% to +5.04 +%. +All of our finance leases are collateralized by our rental fleet. There were no new financing leases, as assessed under the new leasing guidance, entered into during fiscal 2020. +F- +24 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Finance Liabilities +Finance Liabilities represent our rental equipment financing transactions that have historically been accounted for as capital leases prior to the adoption of ASC 842 on April 1, 2019, which substantially changed the accounting for sale-leasebacks going forward. In accordance with the new leasing guidance, we assess if sale-leaseback transactions qualify as a sale at initiation by determining if a transfer of ownership occurs. +We have determined that our equipment sale-leasebacks do not qualify as a sale, as the buyer-lessors do not obtain control of the assets in our ongoing sale-leaseback arrangements. As a result, we expect future sale-leasebacks to be accounted for as a financial liability and the leased assets will be capitalized at cost. +Our finance liabilities have an average term of seven (7) years and interest rates ranging from +2.63 +% to +4.22 +%. These finance liabilities are collateralized by our rental fleet. +Other Obligations +In February 2011, AMERCO and U.S. Bank, NA (the “Trustee”) entered into the U-Haul Investors Club +® +Indenture. +AMERCO and the Trustee entered into this indenture to provide for the issuance of notes by us directly to investors over our proprietary website, uhaulinvestorsclub.com (“U-Notes +® +”). The U-Notes +® +are secured by various types of collateral including, but not limited to, rental equipment and real estate. +U-Notes +® +are issued in smaller series that vary as to principal amount, interest rate and maturity. +U-Notes +® +are obligations of the Company and secured by the associated collateral; they are not guaranteed by any of the Company’s affiliates or subsidiaries. +As of March 31, 2020, the aggregate outstanding principal balance of the U-Notes +® +issued was $ +87.3 +million, of which $ +2.8 +million is held by our insurance subsidiaries and eliminated in consolidation. Interest rates range between +2.50 +% and +8.00 +% and maturity dates range between +2020 +and +2049 +. +Oxford is a member of the Federal Home Loan Bank (“FHLB”) and, as such, the FHLB has made advances to Oxford. As of December 31, 2019, the advances had an aggregate balance of $ +60.0 +million, for which Oxford pays fixed interest rates between +1.72 +% and +2.95 +% with maturities between March 30, 2020 and September 30, 2022. As of December 31, 2019, available-for-sale investments held with the FHLB totaled $ +117.9 +million, of which $ +67.6 +million were pledged as collateral to secure the outstanding advances. The balances of these advances are included within Liabilities from investment contracts on the condensed consolidated balance sheets. +Annual Maturities of Notes, Loans and Finance/Capital Leases Payable +The annual maturities of our notes, loans and finance/capital leases payable as of March 31, 2020 for the next five years and thereafter are as follows: +Years Ended March 31, +2021 +2022 +2023 +2024 +2025 +Thereafter +Total +(In thousands) +Notes, loans and finance/capital leases payable, secured +$ +459,184 +$ +510,933 +$ +1,011,688 +$ +755,025 +$ +393,498 +$ +1,520,740 +$ +4,651,068 +F- +25 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 10. +Interest on Borrowings +Interest Expense +Components of interest expense include the following: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Interest expense +$ +180,444 +$ +150,609 +$ +125,412 +Capitalized interest +( 23,517 ) +( 12,733 ) +( 6,466 ) +Amortization of transaction costs +4,427 +3,745 +3,867 +Interest expense resulting from cash flow hedges +( 404 ) +824 +3,893 +Total interest expense +160,950 +142,445 +126,706 +Interest paid in cash, including payments related to derivative contracts, amounted to $ +168.1 +million, $ +149.8 +million and $ +129.3 +million for fiscal 2020, 2019 and 2018, respectively. +Interest Rates +Interest rates and our revolving credit borrowings were as follows: +Revolving Credit Activity +Years Ended March 31, +2020 +2019 +2018 +(In thousands, except interest rates) +Weighted average interest rate during the year +3.31 +% +3.39 +% +2.48 +% +Interest rate at year end +2.86 +% +3.60 +% +2.84 +% +Maximum amount outstanding during the year +$ +1,086,000 +$ +959,400 +$ +538,000 +Average amount outstanding during the year +$ +1,002,081 +$ +699,415 +$ +517,997 +Facility fees +$ +193 +$ +374 +$ +410 +Note 11. +Derivatives +We manage exposure to changes in market interest rates. Our use of derivative instruments is limited to highly effective interest rate swaps to hedge the risk of changes in cash flows (future interest payments) attributable to changes in LIBOR swap rates, with the designated benchmark interest rate being hedged on certain of our LIBOR indexed variable rate debt and a variable rate operating lease. The interest rate swaps effectively fix our interest payments on certain LIBOR indexed variable rate debt. We monitor our positions and the credit ratings of its counterparties and do not currently anticipate non-performance by the counterparties. Interest rate swap agreements are not entered into for trading purposes. These fair values are determined using pricing valuation models which include broker quotes for which significant inputs are observable. They include adjustments for counterparty credit quality and other deal-specific factors, where appropriate and are classified as Level 2 in the fair value hierarchy. +The derivative fair values reflected in prepaid expense and accounts payable and accrued expenses in the consolidated balance sheet were as follows: +March 31, 2020 +March 31, 2019 +(In thousands) +Interest rate contracts designated as hedging instruments +Assets +$ +– +$ +139 +Liabilities +8,214 +– +Notional amount (debt) +235,000 +22,792 +F- +26 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The Effect of Interest Rate +Contracts on the Statements of Operations +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +(Gain) loss recognized in AOCI on interest rate contracts +$ +8,356 +$ +( 633 ) +$ +( 4,445 ) +(Gain) loss reclassified from AOCI into income +$ +( 401 ) +$ +789 +$ +3,893 +Gains or losses recognized in income on derivatives are recorded as interest expense in the consolidated statements of operations. +During fiscal year 2020, we recognized a decrease in the fair value of our cash flow hedges of $ +6.3 +million, net of taxes. +During fiscal year 2020, we reclassified $ +0.4 +million from accumulated other comprehensive income (loss) (“AOCI”) to interest expense. +As of March, 31 2020, we expect to reclassify $ +0.4 +million of net gains on interest contracts from AOCI to earnings as interest expense over the next twelve months. +We use derivatives to hedge our equity market exposure to indexed annuity products sold by our Life Insurance company. These contracts earn a return for the contractholder based on the change in the value of the S&P 500 index between annual index point dates. We buy and sell listed equity and index call options and call option spreads. The credit risk is with the party in which the options are written. The net option price is paid up front and there are no additional cash requirements or additional contingent liabilities. These contracts are held at fair market value on our balance sheet. At March 31, 2020 and 2019, these derivative hedges had a net market value of $ +5.9 +million and $ +1.5 +million, with notional amounts of $ +246.8 +million and $ +284.0 +million, respectively. These derivative instruments are included in Investments, other; on the consolidated balance sheets. The fair values of these call options are determined based on quoted market prices from the relevant exchange and are classified as Level 1 in the fair value hierarchy. +Although the call options are employed to be effective hedges against our policyholder obligations from an economic standpoint, they do not meet the requirements for hedge accounting under GAAP. Accordingly, the call options are marked to fair value on each reporting date with the change in fair value, plus or minus, included as a component of net investment and interest income. The change in fair value of the call options include the gains or losses recognized at the expiration of the option term and the changes in fair value for open contracts. +Note 12. +Accumulated Other Comprehensive Income (Loss) +A summary of our AOCI components, net of tax, were as follows: +Foreign Currency Translation +Unrealized Net Gain on Investments +Fair Market Value of Cash Flow Hedges +Postretirement Benefit Obligation Net Loss +Accumulated Other Comprehensive Income (Loss) +(In thousands) +Balance as of March 31, 2019 +$ +( 56,612 ) +$ +( 7,259 ) +$ +107 +$ +( 2,934 ) +$ +( 66,698 ) +Foreign currency translation +9,377 +– +– +– +9,377 +Unrealized net gain on investments +– +97,943 +– +– +97,943 +Change in fair value of cash flow hedges +– +– +( 6,301 ) +– +(6,301) +Amounts reclassified into earnings on hedging activities +– +– +( 2 ) +– +( 2 ) +Change in post retirement benefit obligaiton +– +– +– +333 +333 +Other comprehensive income (loss) +9,377 +97,943 +( 6,303 ) +333 +101,350 +Balance as of March 31, 2020 +$ +( 47,235 ) +$ +90,684 +$ +( 6,196 ) +$ +( 2,601 ) +$ +34,652 +F- +27 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 13. Stockholders’ Equity +The following table lists the dividends that have been declared and issued for fiscal years 2020 and 2019. +Common Stock Dividends +Declared Date +Per Share Amount +Record Date +Dividend Date +December 4, 2019 +$ +0.50 +December 19, 2019 +January 6, 2020 +August 22, 2019 +0.50 +September 9, 2019 +September 23, 2019 +March 6, 2019 +0.50 +March 21, 2019 +April 4, 2019 +December 5, 2018 +0.50 +December 20, 2018 +January 7, 2019 +August 23, 2018 +0.50 +September 10, 2018 +September 24, 2018 +June 6, 2018 +0.50 +June 21, 2018 +July 5, 2018 +On June 8, 2016, our stockholders’ approved the 2016 AMERCO Stock Option Plan (Shelf Stock Option Plan). As of March 31, 2020, no awards had been issued under this plan. +Note 14. +Provision for Taxes +Earnings before taxes and the provision for taxes consisted of the following: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Pretax earnings: +U.S. +$ +372,687 +$ +466,175 +$ +628,901 +Non-U.S. +5,437 +11,354 +8,712 +Total pretax earnings +$ +378,124 +$ +477,529 +$ +637,613 +Current provision (benefit) +Federal +$ +( 373,817 ) +$ +( 6,114 ) +$ +21,780 +State +( 9,600 ) +3,420 +6,471 +Non-U.S. +949 +1,375 +1,412 +( 382,468 ) +( 1,319 ) +29,663 +Deferred provision (benefit) +Federal +307,846 +94,961 +( 199,415 ) +State +9,728 +11,311 +15,479 +Non-U.S. +970 +1,719 +1,303 +318,544 +107,991 +( 182,633 ) +Provision for income tax expense (benefit) +$ +(63,924) +$ +106,672 +$ +(152,970) +Income taxes paid (net of income tax refunds received) +$ +6,859 +$ +4,255 +$ +68,671 +F- +28 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The difference between the tax provision at the statutory federal income tax rate and the tax provision attributable to income before taxes was as follows: +Years Ended March 31, +2020 +2019 +2018 +(in percentages) +Statutory federal income tax rate +21.00 +% +21.00 +% +31.55 +% +Increase (reduction) in rate resulting from: +Deferred tax liability revaluation +– +% +– +% +( 58.25 ) +% +NOL tax rate benefit +( 38.62 ) +% +– +% +– +% +State taxes, net of federal benefit +0.02 +% +2.41 +% +2.33 +% +Foreign rate differential +0.21 +% +0.15 +% +– +% +Federal tax credits +( 0.53 ) +% +( 0.15 ) +% +( 0.32 ) +% +Transition tax +– +% +( 0.20 ) +% +1.83 +% +Tax-exempt income +( 0.17 ) +% +– +% +– +% +Dividend received deduction +( 0.01 ) +% +( 0.01 ) +% +( 0.03 ) +% +Phase III tax +– +% +– +% +0.63 +% +Other +1.19 +% +( 0.86 ) +% +( 1.73 ) +% +Actual tax expense (benefit) of operations +( 16.91 ) +% +22.34 +% +( 23.99 ) +% +Significant components of our deferred tax assets and liabilities were as follows: +March 31, +2020 +2019 +Deferred tax assets: +(In thousands) +Net operating loss and credit carry forwards +$ +25,973 +$ +90,061 +Accrued expenses +105,171 +105,727 +Policy benefit and losses, claims and loss expenses payable, net +20,189 +16,515 +Operating leases +22,353 +– +Total deferred tax assets +$ +173,686 +$ +212,303 +Deferred tax liabilities: +Property, plant and equipment +$ +1,198,198 +$ +940,433 +Operating leases +22,353 +– +Deferred policy acquisition costs +12,795 +14,191 +Unrealized gains +29,873 +4,223 +Other +4,010 +4,426 +Total deferred tax liabilities +1,267,229 +963,273 +Net deferred tax liability +$ +1,093,543 +$ +750,970 +On March 27, 2020, President Trump signed into U.S. federal law the Coronavirus Aid, Relief and Economic Security (the “CARES Act”), which is aimed at providing emergency assistance and health care for individuals, families, and businesses affected by COVID-19 and generally supporting the U.S. economy. +Among other things, the CARES Act includes provisions relating to net operating loss (“NOL”) carryback periods, alternative minimum tax (“AMT”) credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. +In particular, the CARES Act allows for NOLs generated in 2018, 2019, or 2020 to be carried back 5 years. +F- +29 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +As a result, the NOL and credit carry-forwards in the above table are primarily attributable to state NOLs. +Federal NOLs from fiscal years 2018, 2019 and 2020 have been carried back to prior tax years as provided by the CARES Act. +The statutory tax rate for the carryback years was 35% as compared to 21% at present. +Consequently, we recognized a benefit amount of $ +146.0 +million for fiscal year 2020. +It is possible future legislation could reduce or delay our ability to carryback these losses. +As of March 31, 2020 and March 31, 2019, AMERCO had state NOLs of $ +337.3 +million and $ +172.3 +million, respectively, that will begin to expire March 31, 2021, if not utilized. +The 2017 Tax Cuts and Jobs Act (the “Tax Reform Act”) was enacted on December 22, 2017. The Tax Reform Act reduced the U.S. federal corporate income tax rate from 35% to 21%, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, and repealed the deferral of the phase three tax for life insurance companies. The blended statutory Federal Tax Rate for our full fiscal year 2018 was +31.55 +%. As of December 22, 2018, we completed our accounting for the tax effects of enactment of the Tax Reform Act. For fiscal year 2018, we recognized a benefit amount of $ +356.6 +million, which was included as a component of income tax expense from continuing operations. +For fiscal year 2018, we re-measured certain deferred tax assets and liabilities based on the rates they are expected to reverse in the future which is generally 21%. +The amount recorded related to the re-measurement of our deferred tax balance was a benefit of $ +371.5 +million for fiscal year 2018. +As of December 31, 2017, the Company elected to reclassify the income tax effects of the Tax Reform Act in the amount of $ +8.7 +million from AOCI to retained earnings under ASU 2018-02. In addition, the Company has adopted the "investment by investment" approach as our accounting policy with regard to releasing disproportionate income tax effects from AOCI. +For fiscal year 2018, we calculated and recorded a one-time transition tax on earnings from foreign subsidiaries based on the post-1986 earnings and profits of our Canadian subsidiaries that were previously deferred from U.S. income taxes. +The effect of this one-time transition tax liability for our foreign subsidiaries resulted in an increase in income tax expense of $ +10.7 +million for fiscal year 2018. +No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to transition tax, or any additional outside basis difference inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in these entities (i.e., basis difference in excess of that subject to the one-time transition tax) is not practicable. +The Tax Reform Act repeals the special rules with regard to distribution to shareholders from pre-1984 policyholders surplus account. This one-time tax was based on the balance of our pre-1984 policyholder surplus account. We reported the amount of our one-time tax liability for Phase Three Tax, resulting in an increase in income tax expense of $ +4.2 +million for fiscal year 2018. +The Company accounts for uncertainty in income taxes by recognizing the tax benefit or expense from an uncertain tax position only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the position. The Company measures the tax benefits and expenses recognized in the consolidated financial statements from such a position based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. +F- +30 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +A reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period are as follows: +Unrecognized Tax Benefits +March 31, +2020 +2019 +(In thousands) +Unrecognized tax benefits beginning balance +$ +37,201 +$ +35,739 +Revaluation based on change in after tax benefit +– +– +Additions based on tax positions related to the current year +42 +1,887 +Reductions for tax positions of prior years +( 7,606 ) +( 46 ) +Settlements +( 5 ) +( 379 ) +Unrecognized tax benefits ending balance +$ +29,632 +$ +37,201 +We recognize interest related to unrecognized tax benefits as interest expense, and penalties as income tax expenses. At March 31, 2020 and 2019, the amount of interest accrued on unrecognized tax benefits was $ +12.8 +million and $ +9.5 +million, net of tax. During the current year we recorded expense from interest in the amount of $ +3.3 +million, net of tax. +We file income tax returns in the U.S. federal jurisdiction, and various states and Canadian jurisdictions. While the Company has ongoing audits in Canada and various state jurisdictions, there have been no proposed or anticipated adjustments that would materially impact the financial statements. With some exceptions, we are no longer subject to audit for years prior to the fiscal year ended March 31, 2017. +Note 15. +Employee Benefit Plans +Profit Sharing Plans +We provide tax-qualified profit sharing retirement plans for the benefit of eligible employees, former employees and retirees in the United States and Canada. The plans are designed to provide employees with an accumulation of funds for retirement on a tax-deferred basis and provide for annual discretionary employer contributions. Amounts to be contributed are determined by the President and Chairman of the Board of Directors (the “Board”) of the Company under the delegation of authority from the Board, pursuant to the terms of the Profit Sharing Plan. No contributions were made to the profit sharing plan during fiscal 2020, 2019 or 2018. +We also provide an employee savings plan which allows participants to defer income under Section 401(k) of the Internal Revenue Code of 1986. +ESOP Plan +We sponsor an Employee Stock Ownership Plan (“ESOP”) that generally covers all employees with one year or more of service. The ESOP began as a leveraged plan where shares were pledged as collateral for its debt which was originally funded by U-Haul. We made annual contributions to the ESOP equal to the ESOP’s debt service. As the debt was repaid, shares were released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. ESOP shares were committed to be released monthly and ESOP compensation expense was recorded based on the current market price at the end of the month. These shares then become outstanding for the earnings per share computations. +In fiscal 2020 we delivered the plan and now contributions are made at the discretion of management with expense being recognized upon the decision to contribute. +ESOP compensation expense was $ +10.3 +million, $ +11.3 +million and $ +11.4 +million for fiscal 2020, 2019 and 2018, respectively, which are included in operating expenses in the consolidated statements of operations. +F- +31 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Listed below is a summary of these financing arrangements as of fiscal year-end: +Outstanding as of +Interest Payments +Financing Date +March 31, 2020 +2020 +2019 +2018 +(In thousands) +June, 1991 +$ +– +$ +– +$ +1 +$ +1 +July, 2009 +– +9 +17 +26 +February, 2016 +– +229 +190 +242 +Leveraged contributions to the Plan Trust during fiscal 2020, 2019 and 2018 were $ +5.6 +million, $ +1.0 +million and $ +1.0 +million, respectively. In fiscal 2020, 2019 and 2018, the Company made non-leveraged contributions of $ +4.0 +million, $ +5.2 +and $ +11.0 +million, respectively to the Plan Trust. In both fiscal 2020 and 2019, $ +0.0 +million of dividends from unallocated shares were applied to debt. +Shares held by the Plan were as follows: +Years Ended March 31, +2020 +2019 +(In thousands) +Allocated shares +1,003 +1,069 +Unreleased shares - leveraged +– +16 +Fair value of unreleased shares - leveraged +$ +– +$ +6,019 +Unreleased shares - non-leveraged +– +– +Fair value of unreleased shares - non-leveraged +$ +– +$ +– +The fair value of unreleased shares issued prior to 1992 is defined as the historical cost of such shares. The fair value of unreleased shares issued subsequent to December 31, 1992 is defined as the trading value of such shares as of March 31, 2020 and March 31, 2019, respectively. During fiscal 2020, we released for allocation 16,558 leveraged shares and 13,989 non-leveraged shares. As of March 31, 2020, it is estimated there will be no shares committed to be released. +Post Retirement and Post Employment Benefits +We provide a health reimbursement benefit to our eligible U.S. employees and their eligible dependents upon retirement from the Company. The retiree must have attained age sixty-five and earned twenty years of full-time service upon retirement to be awarded the health reimbursement benefit. The health reimbursement benefit is capped at a $ +20,000 +lifetime maximum per covered person. Reimbursements are coordinated with Medicare and any other medical policies in force. +In addition, retirees who have attained age sixty-five and earned at least twenty years of full-time service upon retirement from the Company are entitled to group term life insurance benefits. The life insurance benefit is $ +3,000 +plus $ +100 +for each year of employment over twenty years. The benefits are not funded, and claims are paid as they are incurred. We use a March 31 measurement date for our post retirement benefit disclosures. +The components of net periodic post retirement benefit cost were as follows: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Service cost for benefits earned during the period +$ +1,055 +$ +1,108 +$ +1,073 +Other components of net periodic benefit costs: +Interest cost on accumulated postretirement benefit +964 +943 +869 +Other components +90 +70 +58 +Total other components of net periodic benefit costs +1,054 +1,013 +927 +Net periodic postretirement benefit cost +$ +2,109 +$ +2,121 +$ +2,000 +F- +32 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The fiscal 2020 and fiscal 2019 post retirement benefit liability included the following components: +Years Ended March 31, +2020 +2019 +(In thousands) +Beginning of year +$ +25,817 +$ +23,316 +Service cost for benefits earned during the period +1,055 +1,108 +Interest cost on accumulated post retirement benefit +964 +943 +Net benefit payments and expense +( 93 ) +( 979 ) +Actuarial (gain) loss +( 240 ) +1,429 +Accumulated postretirement benefit obligation +27,503 +25,817 +Current liabilities +1,151 +1,037 +Non-current liabilities +26,352 +24,780 +Total post retirement benefit liability recognized in statement of financial position +27,503 +25,817 +Components included in accumulated other comprehensive income (loss): +Unrecognized net loss +( 3,447 ) +( 3,890 ) +Cumulative net periodic benefit cost (in excess of employer contribution) +$ +24,056 +$ +21,927 +The discount rate assumptions in computing the information above were as follows: +Years Ended March 31, +2020 +2019 +2018 +(In percentages) +Accumulated postretirement benefit obligation +3.37 +% +3.83 +% +3.98 +% +In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 became law. Net periodic post retirement benefit cost above includes the effect of the subsidy. The discount rate represents the expected yield on a portfolio of high grade (AA to AAA rated or equivalent) fixed income investments with cash flow streams sufficient to satisfy benefit obligations under the plan when due. Fluctuations in the discount rate assumptions primarily reflect changes in U.S. interest rates. The assumed health care cost trend rate used to measure the accumulated postretirement benefit obligation as of the end of fiscal 2020 was +6.5 +% in the initial year and was projected to decline annually to an ultimate rate of +4.5 +% in fiscal 2038. The assumed health care cost trend rate used to measure the accumulated post retirement benefit obligation as of the end of fiscal 2019 (and used to measure the fiscal 2020 net periodic benefit cost) was +6.9 +% in the initial year and was projected to decline annually to an ultimate rate of +4.5 +% in fiscal 2038. +If the estimated health care cost trend rate assumptions were increased by one percent, the accumulated post retirement benefit obligation as of fiscal year-end would increase by $ +246 +thousand and the total of the service cost and interest cost components would increase by $ +25 +thousand. A decrease in the estimated health care cost trend rate assumption of one percent would decrease the accumulated post retirement benefit obligation as of fiscal year-end by $ +278 +thousand and the total of the service cost and interest cost components would decrease by $ +29 +thousand. +F- +33 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Post employment benefits provided by us, other than upon retirement, are not material. +Future net benefit payments are expected as follows: +Future Net Benefit Payments +(In thousands) +Year-ended: +2021 +$ +1,151 +2022 +1,350 +2023 +1,547 +2024 +1,753 +2025 +1,965 +2026 through 2029 +11,581 +Total +$ +19,347 +Note 16. +Fair Value Measurements +Certain assets and liabilities are recorded at fair value on the consolidated balance sheets and are measured and classified based upon a three-tiered approach to valuation. Financial assets and liabilities recorded at fair value and are classified and disclosed in one of the following three categories: +Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2 – Quoted prices for identical or similar financial instruments in markets that are not considered to be active, or similar financial instruments for which all significant inputs are observable, either directly or indirectly, or inputs other than quoted prices that are observable, or inputs that are derived principally from or corroborated by observable market data through correlation or other means; and +Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and are unobservable. These reflect management’s assumptions about the assumptions a market participant would use in pricing the asset or liability. +A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. +Fair values of cash equivalents approximate carrying value due to the short period of time to maturity. Fair values of short-term investments, investments available-for-sale, long-term investments, mortgage loans and notes on real estate, and interest rate swap contracts are based on quoted market prices, dealer quotes or discounted cash flows. Fair values of trade receivables approximate their recorded value. +Our financial instruments that are exposed to concentrations of credit risk consist primarily of temporary cash investments, trade receivables, reinsurance recoverables and notes receivable. Limited credit risk exists on trade receivables due to the diversity of our customer base and their dispersion across broad geographic markets. We place our temporary cash investments with financial institutions and limit the amount of credit exposure to any one financial institution. +We have mortgage receivables, which potentially expose us to credit risk. The portfolio of notes is principally collateralized by self-storage facilities and commercial properties. We have not experienced any material losses related to the notes from individual or groups of notes in any particular industry or geographic area. The estimated fair values were determined using the discounted cash flow method and using interest rates currently offered for similar loans to borrowers with similar credit ratings. +The carrying amount of long-term debt and short-term borrowings are estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for debt of similar term and remaining maturity. +F- +34 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Other investments including short-term investments are substantially current or bear reasonable interest rates. As a result, the carrying values of these financial instruments approximate fair value. +The carrying values and estimated fair values for the financial instruments stated above and their placement in the fair value hierarchy are as follows: +Fair Value Hierarchy +Year Ended March 31, 2020 +Carrying Value +Level 1 +Level 2 +Level 3 +Total Estimated Fair Value +(In thousands) +Assets +Reinsurance recoverables and trade receivables, net +$ +186,672 +$ +– +$ +– +$ +186,672 +$ +186,672 +Mortgage loans, net +262,688 +– +– +262,688 +262,688 +Other investments +97,685 +– +– +97,685 +97,685 +Total +$ +547,045 +$ +– +$ +– +$ +547,045 +$ +547,045 +Liabilities +Notes, loans and finance/capital leases payable +$ +4,651,068 +$ +– +$ +4,651,068 +$ +– +$ +4,342,308 +Total +$ +4,651,068 +$ +– +$ +4,651,068 +$ +– +$ +4,342,308 +Fair Value Hierarchy +Year Ended March 31, 2019 +Carrying Value +Level 1 +Level 2 +Level 3 +Total Estimated Fair Value +(In thousands) +Assets +Reinsurance recoverables and trade receivables, net +$ +224,785 +$ +– +$ +– +$ +224,785 +$ +224,785 +Mortgage loans, net +225,829 +– +– +225,829 +225,829 +Other investments +74,907 +– +– +74,907 +74,907 +Total +$ +525,521 +$ +– +$ +– +$ +525,521 +$ +525,521 +Liabilities +Notes, loans and finance/capital leases payable +$ +4,192,243 +– +$ +4,192,243 +$ +– +$ +4,192,243 +Total +$ +4,192,243 +$ +– +$ +4,192,243 +$ +– +$ +4,192,243 +F- +35 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The following tables represent the financial assets and liabilities on the condensed consolidated balance sheets as of March 31, 2020 and 2019, that are measured at fair value on a recurring basis and the level within the fair value hierarchy. +Year Ended March 31, 2020 +Total +Level 1 +Level 2 +Level 3 +(In thousands) +Assets +Short-term investments +$ +369,279 +$ +368,968 +$ +311 +$ +– +Fixed maturities - available for sale +2,466,048 +7,156 +2,458,731 +161 +Preferred stock +6,675 +6,675 +– +– +Common stock +20,015 +20,015 +– +– +Derivatives +5,944 +5,944 +– +– +Total +$ +2,867,961 +$ +408,758 +$ +2,459,042 +$ +161 +Liabilities +Derivatives +$ +8,214 +$ +– +$ +8,214 +$ +– +Total +$ +8,214 +$ +– +$ +8,214 +$ +– +Year Ended March 31, 2019 +Total +Level 1 +Level 2 +Level 3 +(In thousands) +Assets +Short-term investments +$ +463,847 +$ +463,599 +$ +248 +$ +– +Fixed maturities - available for sale +2,209,761 +7,327 +2,202,213 +221 +Preferred stock +8,257 +8,257 +– +– +Common stock +17,379 +17,379 +– +– +Derivatives +1,607 +1,468 +139 +– +Total +$ +2,700,851 +$ +498,030 +$ +2,202,600 +$ +221 +Liabilities +Derivatives +$ +– +$ +– +$ +– +$ +– +Total +$ +– +$ +– +$ +– +$ +– +The fair value measurements of our assets using significant unobservable inputs (Level 3) were $0.2 million and $0.3 million as of March 31, 2020 and 2019, respectively. +F- +36 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Note 17. +Reinsurance and Policy Benefits and Losses, Claims and Loss Expenses Payable +During their normal course of business, our insurance subsidiaries assume and cede reinsurance on both a coinsurance and a risk premium basis. They also obtain reinsurance for that portion of risks exceeding their retention limits. The maximum amount of life insurance retained on any one life is $ +125,000 +. +Direct +Amount (a) +Ceded to +Other +Companies +Assumed +from Other +Companies +Net +Amount (a) +Percentage of +Amount +Assumed to Net +(In thousands) +Year ended December 31, 2019 +Life insurance in force +$ +957,280 +$ +7 +$ +441,563 +$ +1,398,836 +32 +% +Premiums earned: +Life +$ +53,289 +$ +1 +$ +5,629 +$ +58,917 +10 +% +Accident and health +66,863 +226 +1,563 +68,200 +2 +% +Annuity +65 +– +794 +859 +92 +% +Property and casualty +69,126 +– +15 +69,141 +– +% +Total +$ +189,343 +$ +227 +$ +8,001 +$ +197,117 +Year ended December 31, 2018 +Life insurance in force +$ +941,822 +$ +207 +$ +548,152 +$ +1,489,767 +37 +% +Premiums earned: +Life +$ +51,691 +$ +( 1 ) +$ +( 69,616 ) +$ +( 17,924 ) +388 +% +Accident and health +77,813 +267 +1,851 +79,397 +2 +% +Annuity +1,221 +– +794 +2,015 +39 +% +Property and casualty +60,848 +– +– +60,848 +– +% +Total +$ +191,573 +$ +266 +$ +( 66,971 ) +$ +124,336 +Year ended December 31, 2017 +Life insurance in force +$ +947,720 +$ +248 +$ +876,865 +$ +1,824,337 +48 +% +Premiums earned: +Life +$ +51,227 +$ +4 +$ +9,880 +$ +61,103 +16 +% +Accident and health +90,396 +295 +1,977 +92,078 +2 +% +Annuity +728 +– +794 +1,522 +52 +% +Property and casualty +57,161 +69 +8 +57,100 +– +% +Total +$ +199,512 +$ +368 +$ +12,659 +$ +211,803 +(a) +Balances are reported net of inter-segment transactions. +Reserves for recognizing a premium deficiency included in future policy benefits are established, if necessary, when the liability for future policy benefits plus the present value of expected future gross premiums are determined to be materially insufficient to provide for expected future policy benefits and expenses. Additionally, in certain instances the policyholder liability for a particular line of business may not be deficient in the aggregate to trigger loss recognition, but the pattern of earnings may be such that profits are expected to be recognized in earlier years followed by losses in later years. In these situations, accounting standards require that an additional liability be recognized by an amount necessary to sufficiently offset the losses that would be recognized in later years. The Company has not recognized any reserves related to premium deficiencies in the years ended December 31, 2019 and December 31, 2018. +To the extent that a reinsurer is unable to meet its obligation under the related reinsurance agreements, Repwest would remain liable for the unpaid losses and loss expenses. Pursuant to certain of these agreements, Repwest holds letters of credit as of December 31, 2019 in the amount of $ +0.1 +million from re-insurers and has issued letters of credit in the amount of $ +1.9 +million in favor of certain ceding companies. +F- +37 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Policy benefits and losses, claims and loss expenses payable for Property and Casualty Insurance were as follows: +December 31, +2019 +2018 +(In thousands) +Unpaid losses and loss adjustment expense +$ +209,127 +$ +228,970 +Reinsurance losses payable +1,214 +988 +Total +$ +210,341 +$ +229,958 +Activity in the liability for unpaid losses and loss adjustment expenses for Property and Casualty Insurance is summarized as follows: +December 31, +2019 +2018 +2017 +(In thousands) +Balance at January 1 +$ +228,970 +$ +233,554 +$ +244,400 +Less: reinsurance recoverable +94,920 +94,490 +103,952 +Net balance at January 1 +134,050 +139,064 +140,448 +Incurred related to: +Current year +22,137 +19,579 +15,749 +Prior years +( 9,535 ) +( 5,365 ) +233 +Total incurred +12,602 +14,214 +15,982 +Paid related to: +Current year +7,366 +8,838 +8,969 +Prior years +17,242 +10,390 +8,397 +Total paid +24,608 +19,228 +17,366 +Net balance at December 31 +122,044 +134,050 +139,064 +Plus: reinsurance recoverable +87,083 +94,920 +94,490 +Balance at December 31 +$ +209,127 +$ +228,970 +$ +233,554 +Prior year incurred losses were impacted by favorable development on numerous Excess Workers Compensation claims. The liability for incurred losses and loss adjustment expenses (net of reinsurance recoverable of $ +87.1 +million) decreased by $ +19.8 +million as of December 31, 2019. +F- +38 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The information about property and casualty incurred and paid loss and loss adjustment expense development for the years end December 31, 2013 through 2019, and the average annual percentage payout of incurred claims by age as of December 31, 2019, is presented as supplementary information. Claims data for 2013 through 2018 is unaudited. Claims data for 2019 is audited. +Cumulative Incurred Claims and Allocted Claims Adjustment Expenses, Net of Reinsurance +As of +December 31, 2019 +Total of +Incurred-but- +Not-Reported +Liabilities Plus +Expected +Cumulative +Development +Number of +Accident +on Reported +Reported +Year +2013 +2014 +2015 +2016 +2017 +2018 +2019 +Claims +Claims +(In thousands, except claim counts) +2013 +$ +9,861 +$ +9,853 +$ +9,914 +$ +9,741 +$ +9,576 +$ +9,595 +$ +9,594 +$ +– +7,652 +2014 +11,691 +10,907 +10,720 +10,759 +10,748 +10,493 +78 +9,627 +2015 +12,214 +12,459 +12,460 +12,464 +11,087 +– +10,652 +2016 +13,297 +13,011 +13,056 +11,790 +– +10,954 +2017 +15,749 +16,109 +17,078 +1,411 +11,291 +2018 +19,580 +18,386 +4,692 +11,083 +2019 +22,138 +10,743 +10,745 +Total +16,924 +The following table presents paid claims development as of December 31, 2019, net of reinsurance. Claims data for 2013 through 2018 is unaudited. Claims data for 2019 is audited. +Cumulative Paid Claims and Allocated Claim Adjustment Expenses, Net of Reinsurance +(In thousands) +Accident +Year +2013 +2014 +2015 +2016 +2017 +2018 +2019 +2013 +$ +5,227 +$ +7,608 +$ +8,718 +$ +9,462 +$ +9,576 +$ +9,595 +$ +9,594 +2014 +6,154 +8,087 +9,270 +9,293 +10,325 +10,327 +2015 +7,509 +9,601 +9,730 +10,343 +11,087 +2016 +7,777 +10,665 +11,643 +11,746 +2017 +8,969 +11,638 +14,825 +2018 +8,838 +12,689 +2019 +7,366 +Total +Total +77,634 +All outstanding liabilities before 2013, net of reinsurance +99,113 +Liabilities for claims and claim adjustment expenses, net of reinsurance +122,044 +F- +39 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +The reconciliation of the net incurred and paid claims development tables for the liability for claims and claims adjustment expenses is as follows: +December 31, 2019 +(In thousands) +Liabilities for unpaid Property and Casualty claims +and claim adjustment expenses, net of reinsurance +$ +122,044 +Total reinsurance recoverable on unpaid +Property and Casualty claims +$ +87,083 +Total gross liability for unpaid Property and Casualty +claims and claim adjustment expense +$ +209,127 +The following is supplementary information about average historical claims duration as of December 31, 2019. +Average Annual Percentage Payout of Incurred Claims by Age, net of Reinsurance +(In percentages) +Years +1 +2 +3 +4 +5 +6 +7 +Property and Casualty Insurance +54.4 +% +20.5 +% +10.2 +% +3.6 +% +5.9 +% +0.1 +% +– +% +Note 18. Leases +Lessor +We have determined that revenues derived by providing self-moving equipment rentals, self-storage rentals and certain other revenues, including U-Box rentals, are within the scope of the accounting guidance contained in Topic 842. Our self-moving equipment rental related revenues have been accounted for under the revenue accounting standard Topic 606, until the adoption of Topic 842. +For the periods after April 1, 2019, we combined all lease and non-lease components of lease contracts for which the timing and pattern of transfer are the same and the lease component meets the classification of an operating lease, and account for them in accordance with Topic 842. The revenue streams accounted for in accordance with Topic 842 are recognized evenly over the period of rental. Please see Note 23, Revenue Recognition, of the Notes to Consolidated Financial Statements. +Lessee +We determine if an arrangement is a lease at inception. Operating leases, which are comprised primarily of storage rental locations, are included in ROU assets - operating and operating lease liability in our consolidated balance sheet dated March 31, 2020. Finance leases, which are comprised primarily of rental equipment leases, are included in ROU assets - financing, net, and notes, loans and finance/capital leases payable, net in our consolidated balance sheet dated March 31, 2020. +ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the expected remaining lease term. We use our incremental borrowing rate based on information available at commencement date including the rate for a fully collateralized loan that can either be fully amortizing or financed with a residual at the end of the lease term, for a borrower with similar credit quality in order to determine the present value of lease payments. Our lease terms may include options to extend or terminate the lease, which are included in the calculation of ROU assets when it is reasonably certain that we will exercise those options. Lease expense for lease payments is recognized on a straight-line basis over the lease term. +F- +40 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +We have lease agreements with lease and non-lease components, which are generally not accounted for separately. Additionally, for certain leases, we apply a portfolio approach to account for the operating lease ROU assets and liabilities as the leases are similar in nature and have nearly identical contract provisions. +Adoption of this standard resulted in most of our operating lease commitments being recognized as operating lease liabilities and ROU assets, which increased total assets and total liabilities by approximately $ +105.4 +million related to property operating leases, as of April 1, 2019. In addition, we reclassified a net amount of $ +948.2 +million related to vehicle financing leases from property, plant, and equipment, net to ROU assets financing, net. During fiscal 2020, we recognized new operating leases and ROU assets of $ +20.2 +million. +The standard also changed the manner by which we account for our equipment sale/leaseback transactions. +Based on our assessment, the lease transactions are classified as financing leases, and therefore the transactions do not qualify as a sale. +Pursuant to the guidance, new sale leaseback transactions that fail to qualify as a sale will be accounted for as a financial liability. +Please see Note 9, Borrowings, of the Notes to Consolidated Finanical Statements for additional information. +The following table shows the components of our right-of-use assets, net: +As of March 31, 2020 +Finance +Operating +Total +(In thousands) +Buildings and improvements +$ +– +$ +125,547 +$ +125,547 +Furniture and equipment +21,113 +– +21,113 +Rental trailers and other rental equipment +116,072 +– +116,072 +Rental trucks +1,738,081 +– +1,738,081 +Right-of-use assets, gross +1,875,266 +125,547 +2,000,813 +Less: Accumulated depreciation +( 794,913 ) +( 18,916 ) +( 813,829 ) +Right-of-use assets, net +$ +1,080,353 +$ +106,631 +$ +1,186,984 +Finance +Operating +Weighted average remaining lease term (years) +4 Years +14 Years +Weighted average discount rate +3.5 +% +4.6 +% +For the last twelve months ended March 31, 2020, cash paid for leases included in our operating and financing cash flow activities were $ +25.9 +million and $307.8 million, respectively. +The components of lease costs, including leases of less than 12 months, were as follows: +Twelve Months Ended +March 31, 2020 +(In thousands) +Operating lease costs +$ +27,494 +Finance lease cost: +Amortization of right-of-use assets +$ +186,860 +Interest on lease liabilities +30,901 +Total finance lease cost +$ +217,761 +F- +41 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Maturities of lease liabilities were as follows: +Finance leases +Operating leases +Year ending March 31, +(In thousands) +2021 +$ +218,424 +$ +23,782 +2022 +164,190 +22,001 +2023 +124,160 +21,238 +2024 +106,156 +20,616 +2025 +75,502 +9,701 +Thereafter +46,438 +64,806 +Total lease payments +734,870 +162,144 +Less: imputed interest +– +( 55,701 ) +Present value of lease liabilities +$ +734,870 +$ +106,443 +As previously disclosed in our 2019 Annual Report o Form 10-K and under the previous lease accounting standard, our operating and ground lease commitments for leases having terms of more than one year were as follows: +Total +(In thousands) +Year-ended March 31: +2020 +$ +20,852 +2021 +18,495 +2022 +16,750 +2023 +16,317 +2024 +15,736 +Thereafter +54,683 +Total +$ +142,833 +Note 19. +Contingencies +COVID-19 +In late 2019, COVID-19 was first detected in Wuhan, China. In March 2020, the World Health Organization declared COVID-19 a global pandemic, and governmental authorities around the world have implemented measures to reduce the spread of COVID-19. These measures have adversely affected workforces, customers, consumer sentiment, economies and financial markets. +During and subsequent to the fourth quarter of fiscal 2020, the Company has been impacted by the spread of COVID-19. The extent to which COVID-19 impacts the Company’s business, operations and financial results will depend upon numerous evolving factors that the Company is not able to predict at this time, including among others: customer initiated changes in behavior, actions that have been and continue to be taken by governmental entities, our workforce may be negatively impacted disrupting our ability to serve customers, any new information that may emerge concerning the severity and duration of COVID-19 and the reaction of capital markets. +For April the two most significant effects that we have experienced are an approximate +30 +% (unaudited) decline in self-moving equipment rental income along with a decrease of approximately $ +39.5 +million (unaudited) in proceeds from the sales of rental equipment compared to April 2019. +The decline in equipment rental revenue has been improving in May (unaudited). +Although the Company cannot estimate the length or gravity of the impact of COVID-19 at this time, if the pandemic continues, it may have a material adverse effect on the Company’s results of future operations, financial position and liquidity in fiscal 2021. +F- +42 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +CARES Act +The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations, increased limitations on qualified charitable contributions, and technical corrections to tax depreciation methods for qualified improvement property. We continue to examine the impact the CARES Act may have on our business. To date we have availed ourselves of the provisions related to deferring certain payroll taxes, carrybacks of net operating losses, and will utilize the technical corrections to tax deprecation methods. +We estimate that the net operating loss carrybacks combined with the depreciation adjustments for our fiscal 2020 federal income tax return will result in a refund of approximately $ +381 +million, which are reflected in Prepaid expense. As refunds are received, they will reduce this amount. We have estimated and recorded the overall effects of the CARES Act and do not anticipate a material change. It is possible future legislation could reduce or delay our ability to carryback these losses. +Environmental +Compliance with environmental requirements of federal, state and local governments may significantly affect Real Estate’s business operations. Among other things, these requirements regulate the discharge of materials into the air, land and water and govern the use and disposal of hazardous substances. Real Estate is aware of issues regarding hazardous substances on some of its properties. Real Estate regularly makes capital and operating expenditures to stay in compliance with environmental laws and has put in place a remedial plan at each site where it believes such a plan is necessary. Since 1988, Real Estate has managed a testing and removal program for underground storage tanks. +Based upon the information currently available to Real Estate, compliance with the environmental laws and its share of the costs of investigation and cleanup of known hazardous waste sites are not expected to result in a material adverse effect on AMERCO’s financial position or results of operations. +Other +We are named as a defendant in various other litigation and claims arising out of the normal course of business. In management’s opinion, none of these other matters will have a material effect on our financial position and results of operations. +Note 20. +Related Party Transactions +As set forth in the Company’s Audit Committee Charter and consistent with NASDAQ Listing Rules, our Audit Committee (the “Audit Committee”) reviews and maintains oversight over related party transactions which are required to be disclosed under the Securities and Exchange Commission (“SEC”) rules and regulations and in accordance with GAAP. Accordingly, all such related party transactions are submitted to the Audit Committee for ongoing review and oversight. Our internal processes are designed to ensure that our legal and finance departments identify and monitor potential related party transactions that may require disclosure and Audit Committee oversight. +AMERCO has engaged in related party transactions and has continuing related party interests with certain major stockholders, directors and officers of the consolidated group as disclosed below. +SAC Holding Corporation and SAC Holding II Corporation (collectively “SAC Holdings”) were established in order to acquire and develop self-storage properties. These properties are being managed by us pursuant to management agreements. In the past, we sold real estate and various self-storage properties to SAC Holdings, and such sales provided significant cash flows to us. SAC Holdings, Four SAC Self-Storage Corporation, Five SAC Self-Storage Corporation, Galaxy Investments, L.P. and 2015 SAC self-storage are substantially controlled by Blackwater Investments, Inc. (“Blackwater”). Blackwater is wholly owned by Willow Grove Holdings LP, which is owned by Mark V. Shoen (a significant stockholder), and various trusts associated with Edward J. Shoen (our Chairman of the Board, President and a significant stockholder) and Mark V. Shoen. +F- +43 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Related Party Revenues +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +U-Haul interest income revenue from Blackwater +$ +– +$ +– +$ +3,326 +U-Haul management fee revenue from Blackwater +24,014 +23,986 +23,577 +U-Haul management fee revenue from Mercury +6,392 +5,162 +6,025 +$ +30,406 +$ +29,148 +$ +32,928 +We currently manage the self-storage properties owned or leased by Blackwater and Mercury Partners, L.P. (“Mercury”), pursuant to a standard form of management agreement, under which we receive a management fee of between +4 +% and +10 +% of the gross receipts plus reimbursement for certain expenses. We received management fees, exclusive of reimbursed expenses, of $ +29.0 +million, $ +30.0 +million and $ +29.5 +million from the above-mentioned entities during fiscal 2020, 2019 and 2018, respectively. This management fee is consistent with the fee received for other properties we previously managed for third parties. Mark V. Shoen controls the general partner of Mercury. The limited partner interests of Mercury are owned indirectly by James P. Shoen and various trusts benefitting Edward J. Shoen and James P. Shoen or their descendants. +Mercury holds the option to purchase a portfolio of properties currently leased by Mercury and a U-Haul subsidiary, which option is exercisable in 2024. +Related Party Costs and Expenses +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +U-Haul lease expenses to Blackwater +$ +2,631 +$ +2,678 +$ +2,684 +U-Haul commission expenses to Blackwater +62,066 +61,434 +58,595 +$ +64,697 +$ +64,112 +$ +61,279 +We lease space for marketing company offices, vehicle repair shops and hitch installation centers from subsidiaries of Blackwater. The terms of the leases are similar to the terms of leases for other properties owned by unrelated parties that are leased to us. +As of March 31, 2020, subsidiaries of Blackwater acted as U-Haul independent dealers. The financial and other terms of the dealership contracts with the aforementioned companies and their subsidiaries are substantially identical to the terms of those with our other independent dealers whereby commissions are paid by us based upon equipment rental revenues. +These agreements and notes with subsidiaries of Blackwater, excluding Dealer Agreements, provided revenues of $ +24.0 +million, expenses of $ +2.6 +million and cash flows of $ +21.5 +million during fiscal 2020. Revenues and commission expenses related to the Dealer Agreements were $ +293.6 +million and $ +62.1 +million, respectively for fiscal 2020. +In December 2019, Real Estate completed the sale of two office buildings to Oxford at cost for approximately $ +15.0 +million. Oxford assumed the debt securing the property of $ +11.5 +million and paid the balance in cash. There were no gains on this transaction. +Management determined that we do not have a variable interest pursuant to the VIE model under ASC 810 in the holding entities of Blackwater based upon management agreements which are with the individual operating entities; therefore, we are precluded from consolidating these entities. +F- +44 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +Related Party Assets +March 31, +2020 +2019 +(In thousands) +U-Haul receivable from Blackwater +$ +25,293 +$ +25,158 +U-Haul receivable from Mercury +9,893 +7,234 +Other (a) +( 402 ) +( 1,503 ) +$ +34,784 +$ +30,889 +(a) Timing differences for intercompany balances with insurance subsidiaries resulting from the three month difference in reporting periods. +Note 21. +Statutory Financial Information of Insurance Subsidiaries +Applicable laws and regulations of the States of Arizona and Nevada require Property and Casualty Insurance and Life Insurance to maintain minimum capital and surplus determined in accordance with statutory accounting principles. Audited statutory net income and statutory capital and surplus for the years ended are listed below: +Years Ended December 31, +2019 +2018 +2017 +(In thousands) +Repwest: +Audited statutory net income +$ +28,614 +$ +23,960 +$ +16,328 +Audited statutory capital and surplus +226,999 +216,763 +197,375 +ARCOA: +Audited statutory net income +2,906 +1,612 +1,190 +Audited statutory capital and surplus +12,851 +9,390 +7,991 +Oxford: +Audited statutory net income +18,599 +11,367 +10,350 +Audited statutory capital and surplus +223,264 +203,723 +195,931 +CFLIC: +Audited statutory net income +8,043 +8,735 +8,062 +Audited statutory capital and surplus +26,305 +27,232 +26,653 +NAI: +Audited statutory net income +1,942 +1,436 +1,594 +Audited statutory capital and surplus +13,371 +12,817 +12,674 +The amount of dividends that can be paid to shareholders by insurance companies domiciled in the State of Arizona is limited. There are restrictions on the ability of our insurance subsidiaries to transfer funds to us in the form of cash dividends, loans or advances. Their ordinary dividends are limited to the lower of 10% of prior year statutory surplus or prior year net income. Any extraordinary dividend, loans or advances to us from the insurance subsidiaries must be approved by the domiciliary insurance commissioner. Any dividend in excess of the limit requires prior regulatory approval. The statutory surplus for Repwest at December 31, 2019 that could be distributed as ordinary dividends was $ +22.7 +million. The statutory surplus for Oxford at December 31, 2019 that could be distributed as ordinary dividends was $ +18.6 +million. Repwest paid a dividend of $ +21.6 +million to AMERCO during fiscal 2020. Repwest did not pay a dividend to AMERCO in fiscal 2019 or 2018. Oxford did not pay a dividend to AMERCO in fiscal 2020, 2019 or 2018, respectively. Restricted net assets for our insurance subsidiaries were $ +98.5 +million and $ +130.2 +million as of March 31, 2020 and 2019, respectively. +F- +45 +amerco and consolidated subsidiaries +notes to consolidated financial statements – (continued) +For our insurance subsidiaries, statutory accounting principles (“SAP”) differ from GAAP primarily in that: (i) premiums from deferred annuities are recognized as revenue under SAP, while they are accounted for as liabilities from investment contracts under GAAP; (ii) policy acquisition costs are expensed as incurred under SAP, while they are deferred and amortized over the effective period of the related life insurance policies or the present value of actual and expected gross profits from annuity deposits; (iii) policy benefits and losses are established using different actuarial assumptions; and (iv) investments are valued on a different basis and valuation allowances attributable to investments are different. In addition, certain assets are not admitted under SAP and are charged directly to surplus. +Note 22. +Financial Information by Geographic Area +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2020 +Total revenues +$ +3,797,849 +$ +181,019 +$ +3,978,868 +Depreciation and amortization, net of gains on disposal +652,110 +15,414 +667,524 +Interest expense +157,595 +3,355 +160,950 +Pretax earnings +372,687 +5,437 +378,124 +Income tax expense (benefit) +( 65,842 ) +1,918 +(63,924) +Identifiable assets +13,016,942 +421,082 +13,438,024 +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2019 +Total revenues +$ +3,597,285 +$ +171,422 +$ +3,768,707 +Depreciation and amortization, net of gains on disposal +575,134 +7,421 +582,555 +Interest expense +139,573 +2,872 +142,445 +Pretax earnings +466,175 +11,354 +477,529 +Income tax expense +103,578 +3,094 +106,672 +Identifiable assets +11,526,876 +364,837 +11,891,713 +United States +Canada +Consolidated +(All amounts are in thousands U.S. $'s) +Fiscal Year Ended March 31, 2018 +Total revenues +$ +3,435,821 +$ +165,293 +$ +3,601,114 +Depreciation and amortization, net of gains on disposal +363,826 +8,521 +372,347 +Interest expense +123,777 +2,929 +126,706 +Pretax earnings +628,901 +8,712 +637,613 +Income tax expense (benefit) +( 155,685 ) +2,715 +(152,970) +Identifiable assets +10,425,299 +322,123 +10,747,422 +F- +46 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Note 22A. +Consolidating Financial Information by Industry Segment +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO, U-Haul, and Real Estate and the subsidiaries of +U-Haul and Real Estate; +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA; and +Life Insurance, comprised of Oxford and its subsidiaries. +Management tracks revenues separately, but does not report any separate measure of the profitability for rental vehicles, rentals of self-storage spaces and sales of products that are required to be classified as a separate operating segment and accordingly does not present these as separate reportable segments. Deferred income taxes, net are shown as liabilities on the consolidating statements. +The information includes elimination entries necessary to consolidate AMERCO, the parent, with its subsidiaries. +Investments in subsidiaries are accounted for by the parent using the equity method of accounting. +F- +47 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Note 22A. Financial Information by Consolidating Industry Segment: +Consolidating balance sheets by industry segment as of March +31, 2020 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Assets: +Cash and cash equivalents +$ +459,078 +$ +4,794 +$ +30,480 +$ +– +$ +494,352 +Reinsurance recoverables and trade receivables, net +60,073 +93,995 +32,604 +– +186,672 +Inventories and parts, net +101,083 +– +– +– +101,083 +Prepaid expenses +562,904 +– +– +– +562,904 +Investments, fixed maturities and marketable equities +– +288,998 +2,203,740 +– +2,492,738 +Investments, other +20,988 +90,145 +249,240 +– +360,373 +Deferred policy acquisition costs, net +– +– +103,118 +– +103,118 +Other assets +69,128 +680 +2,148 +– +71,956 +Right of use assets - financing, net +1,080,353 +– +– +– +1,080,353 +Right of use assets - operating +106,631 +– +– +– +106,631 +Related party assets +41,027 +7,137 +18,629 +( 32,009 ) +(c) +34,784 +2,501,265 +485,749 +2,639,959 +( 32,009 ) +5,594,964 +Investment in subsidiaries +668,498 +– +– +( 668,498 ) +(b) +– +Property, plant and equipment, at cost: +Land +1,032,945 +– +– +– +1,032,945 +Buildings and improvements +4,663,461 +– +– +– +4,663,461 +Furniture and equipment +752,363 +– +– +– +752,363 +Rental trailers and other rental equipment +511,520 +– +– +– +511,520 +Rental trucks +3,595,933 +– +– +– +3,595,933 +10,556,222 +– +– +– +10,556,222 +Less: +Accumulated depreciation +( 2,713,162 ) +– +– +– +( 2,713,162 ) +Total property, plant and equipment +7,843,060 +– +– +– +7,843,060 +Total assets +$ +11,012,823 +$ +485,749 +$ +2,639,959 +$ +( 700,507 ) +$ +13,438,024 +(a) +Balances as of December 31, 2019 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- +48 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating +balance +sheets +by +industry +segment +as +of +March +31, +2020 +are +as +follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Liabilities: +Accounts payable and accrued expenses +$ +545,685 +$ +5,530 +$ +3,138 +$ +– +$ +554,353 +Notes, loans and finance/capital leases payable, net +4,609,844 +– +11,447 +– +4,621,291 +Operating lease liability +106,443 +– +– +– +106,443 +Policy benefits and losses, claims and loss expenses payable +410,107 +210,341 +377,199 +– +997,647 +Liabilities from investment contracts +– +– +1,802,217 +– +1,802,217 +Other policyholders' funds and liabilities +– +5,751 +4,439 +– +10,190 +Deferred income +31,620 +– +– +– +31,620 +Deferred income taxes, net +1,063,681 +8,447 +21,415 +– +1,093,543 +Related party liabilities +24,275 +4,616 +2,670 +( 31,561 ) +(c) +– +Total liabilities +6,791,655 +234,685 +2,222,525 +( 31,561 ) +9,217,304 +Stockholders' equity : +Series preferred stock: +Series A preferred stock +– +– +– +– +– +Series B preferred stock +– +– +– +– +– +Series A common stock +– +– +– +– +– +Common stock +10,497 +3,301 +2,500 +( 5,801 ) +(b) +10,497 +Additional paid-in capital +454,029 +91,120 +26,271 +( 117,601 ) +(b) +453,819 +Accumulated other comprehensive income (loss) +35,100 +12,581 +78,550 +( 91,579 ) +(b) +34,652 +Retained earnings +4,399,192 +144,062 +310,113 +( 453,965 ) +(b) +4,399,402 +Cost of common shares in treasury, net +( 525,653 ) +– +– +– +( 525,653 ) +Cost of preferred shares in treasury, net +( 151,997 ) +– +– +– +( 151,997 ) +Unearned employee stock ownership plan shares +– +– +– +– +– +Total stockholders' equity +4,221,168 +251,064 +417,434 +( 668,946 ) +4,220,720 +Total liabilities and stockholders' equity +$ +11,012,823 +$ +485,749 +$ +2,639,959 +$ +( 700,507 ) +$ +13,438,024 +(a) +Balances as of December 31, 2019 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- +49 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating balance sheets by industry segment as of March 31, 2019 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Assets: +Cash and cash equivalents +$ +643,918 +$ +5,757 +$ +24,026 +$ +– +$ +673,701 +Reinsurance recoverables and trade receivables, net +90,832 +102,120 +31,833 +– +224,785 +Inventories and parts, net +103,504 +– +– +– +103,504 +Prepaid expenses +174,100 +– +– +– +174,100 +Investments, fixed maturities and marketable equities +– +279,641 +1,955,756 +– +2,235,397 +Investments, other +23,013 +74,679 +203,044 +– +300,736 +Deferred policy acquisition costs, net +– +– +136,276 +– +136,276 +Other assets +72,768 +2,456 +3,130 +– +78,354 +Related party assets +35,997 +6,639 +16,466 +( 28,213 ) +(c) +30,889 +1,144,132 +471,292 +2,370,531 +( 28,213 ) +3,957,742 +Investment in subsidiaries +534,157 +– +– +( 534,157 ) +(b) +– +Property, plant and equipment, at cost: +Land +976,454 +– +– +– +976,454 +Buildings and improvements +4,003,726 +– +– +– +4,003,726 +Furniture and equipment +689,780 +– +– +– +689,780 +Rental trailers and other rental equipment +590,039 +– +– +– +590,039 +Rental trucks +4,762,028 +– +– +– +4,762,028 +11,022,027 +– +– +– +11,022,027 +Less: +Accumulated depreciation +( 3,088,056 ) +– +– +– +( 3,088,056 ) +Total property, plant and equipment +7,933,971 +– +– +– +7,933,971 +Total assets +$ +9,612,260 +$ +471,292 +$ +2,370,531 +$ +( 562,370 ) +$ +11,891,713 +(a) +Balances as of December 31, 2018 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- +50 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating +balance +sheets +by +industry +segment +as +of +March +31, +2019 +are +as +follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Liabilities: +Accounts payable and accrued expenses +$ +548,099 +$ +2,844 +$ +5,930 +$ +– +$ +556,873 +Notes, loans and leases payable, net +4,163,323 +– +– +– +4,163,323 +Policy benefits and losses, claims and loss expenses payable +407,934 +229,958 +373,291 +– +1,011,183 +Liabilities from investment contracts +– +– +1,666,742 +– +1,666,742 +Other policyholders' funds and liabilities +– +5,259 +9,788 +– +15,047 +Deferred income +35,186 +– +– +– +35,186 +Deferred income taxes, net +741,644 +6,961 +2,365 +– +750,970 +Related party liabilities +25,446 +3,836 +692 +( 29,974 ) +(c) +– +Total liabilities +5,921,632 +248,858 +2,058,808 +( 29,974 ) +8,199,324 +Stockholders' equity : +Series preferred stock: +Series A preferred stock +– +– +– +– +– +Series B preferred stock +– +– +– +– +– +Series A common stock +– +– +– +– +– +Common stock +10,497 +3,301 +2,500 +( 5,801 ) +(b) +10,497 +Additional paid-in capital +453,536 +91,120 +26,271 +( 117,601 ) +(b) +453,326 +Accumulated other comprehensive income (loss) +( 68,459 ) +( 3,721 ) +( 5,300 ) +10,782 +(b) +( 66,698 ) +Retained earnings +3,976,752 +131,734 +288,252 +( 419,776 ) +(b) +3,976,962 +Cost of common shares in treasury, net +( 525,653 ) +– +– +– +( 525,653 ) +Cost of preferred shares in treasury, net +( 151,997 ) +– +– +– +( 151,997 ) +Unearned employee stock ownership plan shares +( 4,048 ) +– +– +– +( 4,048 ) +Total stockholders' equity +$ +3,690,628 +222,434 +311,723 +( 532,396 ) +3,692,389 +Total liabilities and stockholders' equity +9,612,260 +$ +471,292 +$ +2,370,531 +$ +( 562,370 ) +$ +11,891,713 +(a) +Balances as of December 31, 2018 +(b) Eliminate investment in subsidiaries +(c) Eliminate intercompany receivables and payables +F- +51 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2020 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,696,516 +$ +– +$ +– +$ +( 4,103 ) +(c) +$ +2,692,413 +Self-storage revenues +418,741 +– +– +– +418,741 +Self-moving & self-storage products & service sales +265,091 +– +– +– +265,091 +Property management fees +30,406 +– +– +– +30,406 +Life insurance premiums +– +– +127,976 +– +127,976 +Property and casualty insurance premiums +– +69,141 +– +( 3,088 ) +(c) +66,053 +Net investment and interest income +10,593 +19,923 +109,018 +( 1,705 ) +(b) +137,829 +Other revenue +236,419 +– +4,470 +( 530 ) +(b) +240,359 +Total revenues +3,657,766 +89,064 +241,464 +( 9,426 ) +3,978,868 +Costs and expenses: +Operating expenses +2,069,655 +33,770 +21,425 +( 7,702 ) +(b,c) +2,117,148 +Commission expenses +288,332 +– +– +– +288,332 +Cost of sales +164,018 +– +– +– +164,018 +Benefits and losses +– +12,410 +162,426 +– +174,836 +Amortization of deferred policy acquisition costs +– +– +31,219 +– +31,219 +Lease expense +27,494 +– +– +( 612 ) +(b) +26,882 +Depreciation, net gains on disposals +637,063 +– +– +– +637,063 +Net gains on disposal of real estate +( 758 ) +– +– +– +( 758 ) +Total costs and expenses +3,185,804 +46,180 +215,070 +( 8,314 ) +3,438,740 +Earnings from operations before equity in earnings of subsidiaries +471,962 +42,884 +26,394 +( 1,112 ) +540,128 +Equity in earnings of subsidiaries +55,789 +– +– +( 55,789 ) +(d) +– +Earnings from operations +527,751 +42,884 +26,394 +( 56,901 ) +540,128 +Other components of net periodic benefit costs +( 1,054 ) +– +– +– +(1,054) +Interest expense +( 162,062 ) +– +– +1,112 +(b) +(160,950) +Pretax earnings +364,635 +42,884 +26,394 +( 55,789 ) +378,124 +Income tax benefit (expense) +77,413 +( 8,956 ) +( 4,533 ) +– +63,924 +Earnings available to common shareholders +$ +442,048 +$ +33,928 +$ +21,861 +$ +( 55,789 ) +$ +442,048 +(a) +Balances for the year ended December 31, 2019 +(b) Eliminate intercompany lease / interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- +52 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2019 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,656,327 +$ +– +$ +– +$ +( 2,830 ) +(c) +$ +2,653,497 +Self-storage revenues +367,276 +– +– +– +367,276 +Self-moving & self-storage products & service sales +264,146 +– +– +– +264,146 +Property management fees +29,148 +– +– +– +29,148 +Life insurance premiums +– +– +63,488 +– +63,488 +Property and casualty insurance premiums +– +63,488 +– +( 2,635 ) +(c) +60,853 +Net investment and interest income +13,857 +12,349 +86,395 +( 1,667 ) +(b) +110,934 +Other revenue +215,055 +– +4,831 +( 521 ) +(b) +219,365 +Total revenues +3,545,809 +75,837 +154,714 +( 7,653 ) +3,768,707 +Costs and expenses: +Operating expenses +1,938,317 +34,218 +14,613 +( 5,968 ) +(b,c) +1,981,180 +Commission expenses +288,408 +– +– +– +288,408 +Cost of sales +162,142 +– +– +– +162,142 +Benefits and losses +– +14,213 +86,064 +– +100,277 +Amortization of deferred policy acquisition costs +– +– +28,556 +– +28,556 +Lease expense +33,702 +– +– +( 544 ) +(b) +33,158 +Depreciation, net gains on disposals +554,043 +– +– +– +554,043 +Net gains on disposal of real estate +( 44 ) +– +– +– +( 44 ) +Total costs and expenses +2,976,568 +48,431 +129,233 +( 6,512 ) +3,147,720 +Earnings from operations before equity in earnings of subsidiaries +569,241 +27,406 +25,481 +( 1,141 ) +620,987 +Equity in earnings of subsidiaries +41,811 +– +– +( 41,811 ) +(d) +– +Earnings from operations +611,052 +27,406 +25,481 +( 42,952 ) +620,987 +Other components of net periodic benefit costs +( 1,013 ) +– +– +– +(1,013) +Interest expense +( 143,586 ) +– +– +1,141 +(b) +(142,445) +Pretax earnings +466,453 +27,406 +25,481 +( 41,811 ) +477,529 +Income tax expense +( 95,596 ) +( 5,698 ) +( 5,378 ) +– +(106,672) +Earnings available to common shareholders +$ +370,857 +$ +21,708 +$ +20,103 +$ +( 41,811 ) +$ +370,857 +(a) +Balances for the year ended December 31, 2018 +(b) Eliminate intercompany lease/interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- +53 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating statements of operations by industry segment for period ending March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty Insurance (a) +Life +Insurance (a) +Eliminations +AMERCO +Consolidated +(In thousands) +Revenues: +Self-moving equipment rentals +$ +2,483,956 +$ +– +$ +– +$ +( 4,214 ) +(c) +$ +2,479,742 +Self-storage revenues +323,903 +– +– +– +323,903 +Self-moving & self-storage products & service sales +261,557 +– +– +– +261,557 +Property management fees +29,602 +– +– +– +29,602 +Life insurance premiums +– +– +154,703 +– +154,703 +Property and casualty insurance premiums +– +58,800 +– +( 1,700 ) +(c) +57,100 +Net investment and interest income +12,232 +15,771 +84,158 +( 1,688 ) +(b) +110,473 +Other revenue +179,417 +– +5,001 +( 384 ) +(b) +184,034 +Total revenues +3,290,667 +74,571 +243,862 +( 7,986 ) +3,601,114 +Costs and expenses: +Operating expenses +1,758,697 +32,710 +22,061 +( 6,412 ) +(b,c) +1,807,056 +Commission expenses +276,705 +– +– +– +276,705 +Cost of sales +160,489 +– +– +– +160,489 +Benefits and losses +– +15,983 +169,328 +– +185,311 +Amortization of deferred policy acquisition costs +– +– +24,514 +– +24,514 +Lease expense +34,243 +– +– +( 283 ) +(b) +33,960 +Depreciation, net gains on disposals +543,247 +– +– +– +543,247 +Net (gains) losses on disposal of real estate +( 195,414 ) +– +– +– +( 195,414 ) +Total costs and expenses +2,577,967 +48,693 +215,903 +( 6,695 ) +2,835,868 +Earnings from operations before equity in earnings of subsidiaries +712,700 +25,878 +27,959 +( 1,291 ) +765,246 +Equity in earnings of subsidiaries +46,990 +– +– +( 46,990 ) +(d) +– +Earnings from operations +759,690 +25,878 +27,959 +( 48,281 ) +765,246 +Other components of net periodic benefit costs +( 927 ) +– +– +– +(927) +Interest expense +( 127,997 ) +– +– +1,291 +(b) +(126,706) +Pretax earnings +630,766 +25,878 +27,959 +( 46,990 ) +637,613 +Income tax benefit (expense) +159,817 +( 2,989 ) +( 3,858 ) +– +152,970 +Earnings available to common shareholders +$ +790,583 +$ +22,889 +$ +24,101 +$ +( 46,990 ) +$ +790,583 +(a) +Balances for the year ended December 31, 2017 +(b) Eliminate intercompany lease/interest income +(c) Eliminate intercompany premiums +(d) Eliminate equity in earnings of subsidiaries +F- +54 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2020, are as follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +442,048 +$ +33,928 +$ +21,861 +$ +( 55,789 ) +$ +442,048 +Earnings from consolidated subsidiaries +( 55,789 ) +– +– +55,789 +– +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +664,120 +– +– +– +664,120 +Amortization of deferred policy acquisition costs +– +– +31,219 +– +31,219 +Amortization of premiums and accretion of discounts related to investments, net +– +1,469 +11,848 +– +13,317 +Amortization of debt issuance costs +4,426 +– +– +– +4,426 +Interest credited to policyholders +– +– +51,857 +– +51,857 +Change in allowance for losses on trade receivables +( 14 ) +– +– +– +( 14 ) +Change in allowance for inventories and parts reserve +640 +– +– +– +640 +Net gains on disposal of personal property +( 27,057 ) +– +– +– +(27,057) +Net gains on disposal of real estate +( 758 ) +– +– +– +( 758 ) +Net gains on sales of investments +– +( 355 ) +( 13,241 ) +– +( 13,596 ) +Net gains on equity securities +– +( 3,783 ) +– +– +( 3,783 ) +Deferred income taxes +323,980 +( 2,847 ) +( 3,240 ) +– +317,893 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +30,771 +8,127 +( 769 ) +– +38,129 +Inventories and parts +1,776 +– +– +– +1,776 +Prepaid expenses +( 391,120 ) +– +– +– +( 391,120 ) +Capitalization of deferred policy acquisition costs +– +– +( 24,447 ) +– +( 24,447 ) +Other assets +( 3,099 ) +2,098 +( 294 ) +– +( 1,295 ) +Related party assets +( 5,106 ) +( 539 ) +– +– +( 5,645 ) +Accounts payable and accrued expenses +( 4,428 ) +2,688 +( 2,790 ) +– +( 4,530 ) +Policy benefits and losses, claims and loss expenses payable +3,092 +( 19,618 ) +3,908 +– +( 12,618 ) +Other policyholders' funds and liabilities +– +491 +( 5,348 ) +– +( 4,857 ) +Deferred income +( 1,818 ) +– +– +– +( 1,818 ) +Related party liabilities +( 1,170 ) +819 +1,977 +– +1,626 +Net cash provided by operating activities +980,494 +22,478 +72,541 +– +1,075,513 +Cash flows from investing activities: +Escrow deposits +6,617 +– +– +– +6,617 +Purchases of: +Property, plant and equipment +( 2,309,406 ) +– +– +– +( 2,309,406 ) +Short term investments +– +( 60,590 ) +( 636 ) +– +( 61,226 ) +Fixed maturities investments +– +( 13,001 ) +( 366,348 ) +– +( 379,349 ) +Equity securities +– +– +( 83 ) +– +( 83 ) +Preferred stock +– +– +– +– +– +Real estate +– +( 328 ) +( 3,958 ) +– +( 4,286 ) +Mortgage loans +– +( 18,050 ) +( 43,966 ) +– +( 62,016 ) +Proceeds from sales and paydowns of: +Property, plant and equipment +687,375 +– +– +– +687,375 +Short term investments +– +59,056 +– +– +59,056 +Fixed maturities investments +– +25,386 +243,250 +– +268,636 +Equity securities +– +185 +– +– +185 +Preferred stock +– +1,375 +1,000 +– +2,375 +Real estate +311 +– +– +– +311 +Mortgage loans +– +4,126 +21,036 +– +25,162 +Net cash used by investing activities +( 1,615,103 ) +( 1,841 ) +( 149,705 ) +– +( 1,766,649 ) +(page 1 of 2) +(a) Balance for the period ended December 31, 2019 +F- +55 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Continuation +of +consolidating +cash +flow +statements +by +industry +segment +for +the +year +ended +March +31, +2020, +are +as +follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +1,118,912 +– +2,500 +– +1,121,412 +Principal repayments on credit facilities +( 347,486 ) +– +( 2,500 ) +– +( 349,986 ) +Payment of debt issuance costs +( 5,332 ) +– +– +– +( 5,332 ) +Capital lease payments +( 307,782 ) +– +– +– +( 307,782 ) +Employee stock ownership plan shares +( 206 ) +– +– +– +(206) +Securitization deposits +– +– +– +– +– +Common stock dividends paid +( 29,404 ) +– +– +– +( 29,404 ) +Net contribution from (to) related party +21,600 +( 21,600 ) +– +– +– +Investment contract deposits +– +– +234,640 +– +234,640 +Investment contract withdrawals +– +– +( 151,022 ) +– +( 151,022 ) +Net cash provided (used) by financing activities +450,302 +( 21,600 ) +83,618 +– +512,320 +Effects of exchange rate on cash +( 533 ) +– +– +– +( 533 ) +Decrease in cash and cash equivalents +( 184,840 ) +( 963 ) +6,454 +– +( 179,349 ) +Cash and cash equivalents at beginning of period +643,918 +5,757 +24,026 +– +673,701 +Cash and cash equivalents at end of period +$ +459,078 +$ +4,794 +$ +30,480 +$ +– +$ +494,352 +(page 2 of 2) +(a) Balance for the period ended December 31, 2019 +F- +56 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2019, are as follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +370,857 +$ +21,708 +$ +20,103 +$ +( 41,811 ) +$ +370,857 +Earnings from consolidated subsidiaries +( 41,811 ) +– +– +41,811 +– +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +581,025 +– +– +– +581,025 +Amortization of deferred policy acquisition costs +– +– +28,556 +– +28,556 +Amortization of premiums and accretion of discounts related to investments, net +– +1,361 +11,746 +– +13,107 +Amortization of debt issuance costs +3,923 +– +– +– +3,923 +Interest credited to policyholders +– +– +35,387 +– +35,387 +Change in allowance for losses on trade receivables +57 +– +( 5 ) +– +52 +Change in allowance for inventories and parts reserve +( 146 ) +– +– +– +( 146 ) +Net gains on disposal of personal property +( 26,982 ) +– +– +– +(26,982) +Net gains on disposal of real estate +( 44 ) +– +– +– +( 44 ) +Net (gains) losses on sales of investments +– +( 2,971 ) +308 +– +( 2,663 ) +Net losses on equity securities +– +5,739 +– +– +5,739 +Deferred income taxes +112,434 +830 +( 6,453 ) +– +106,811 +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +( 26,160 ) +( 2,438 ) +( 2,767 ) +– +( 31,365 ) +Inventories and parts +( 13,492 ) +– +– +– +( 13,492 ) +Prepaid expenses +( 8,620 ) +– +– +– +( 8,620 ) +Capitalization of deferred policy acquisition costs +– +– +( 25,957 ) +– +( 25,957 ) +Other assets +159,126 +( 1,449 ) +( 525 ) +– +157,152 +Related party assets +3,857 +339 +( 2 ) +– +4,194 +Accounts payable and accrued expenses +6,454 +257 +3,552 +– +10,263 +Policy benefits and losses, claims and loss expenses payable +( 159,793 ) +( 4,400 ) +( 71,927 ) +– +( 236,120 ) +Other policyholders' funds and liabilities +– +( 117 ) +5,124 +– +5,007 +Deferred income +966 +– +– +– +966 +Related party liabilities +( 2,711 ) +944 +( 300 ) +– +( 2,067 ) +Net cash provided (used) by operating activities +958,940 +19,803 +( 3,160 ) +– +975,583 +Cash flows from investing activities: +Escrow deposits +4,299 +– +– +– +4,299 +Purchases of: +Property, plant and equipment +( 1,869,968 ) +– +– +– +( 1,869,968 ) +Short term investments +– +( 53,878 ) +( 170 ) +– +( 54,048 ) +Fixed maturities investments +– +( 33,775 ) +( 506,270 ) +– +( 540,045 ) +Equity securities +– +– +( 957 ) +– +( 957 ) +Preferred stock +– +– +– +– +– +Real estate +( 236 ) +( 187 ) +( 212 ) +– +( 635 ) +Mortgage loans +– +( 20,031 ) +( 43,580 ) +– +( 63,611 ) +Proceeds from sales and paydowns of: +Property, plant and equipment +606,271 +– +– +– +606,271 +Short term investments +– +58,767 +7,270 +– +66,037 +Fixed maturities investments +– +12,305 +111,246 +– +123,551 +Equity securities +– +8,608 +– +– +8,608 +Preferred stock +– +1,625 +– +– +1,625 +Real estate +– +– +– +– +– +Mortgage loans +– +5,881 +141,856 +– +147,737 +Net cash used by investing activities +( 1,259,634 ) +( 20,685 ) +( 290,817 ) +– +( 1,571,136 ) +(page 1 of 2) +(a) Balance for the period ended December 31, 2018 +F- +57 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Continuation +of +consolidating +cash +flow +statements +by +industry +segment +for +the +year +ended +March +31, +2019, +are +as +follows: +Moving & Storage Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +897,311 +– +– +– +897,311 +Principal repayments on credit facilities +( 299,748 ) +– +– +– +( 299,748 ) +Payment of debt issuance costs +( 7,243 ) +– +– +– +( 7,243 ) +Capital lease payments +( 303,431 ) +– +– +– +( 303,431 ) +Employee stock ownership plan shares +( 418 ) +– +– +– +(418) +Common stock dividends paid +( 39,179 ) +– +– +– +( 39,179 ) +Investment contract deposits +– +– +400,123 +– +400,123 +Investment contract withdrawals +– +– +( 132,833 ) +– +( 132,833 ) +Net cash provided by financing activities +247,292 +– +267,290 +– +514,582 +Effects of exchange rate on cash +( 4,716 ) +– +– +– +( 4,716 ) +Increase (decrease) in cash and cash equivalents +( 58,118 ) +( 882 ) +( 26,687 ) +– +( 85,687 ) +Cash and cash equivalents at beginning of period +702,036 +6,639 +50,713 +– +759,388 +Cash and cash equivalents at end of period +$ +643,918 +$ +5,757 +$ +24,026 +$ +– +$ +673,701 +(page 2 of 2) +(a) Balance for the period ended December 31, 2018 +F- +58 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Consolidating cash flow statements by industry segment for the year ended March 31, 2018 are as follows: +Moving & Storage +Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from operating activities: +Net earnings +$ +790,583 +$ +22,889 +$ +24,101 +$ +( 46,990 ) +$ +790,583 +Earnings from consolidated subsidiaries +( 46,990 ) +– +– +46,990 +– +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +555,069 +– +– +– +555,069 +Amortization of deferred policy acquisition costs +– +– +24,514 +– +24,514 +Amortization of premiums and accretion of discounts related to investments, net +– +1,356 +11,434 +– +12,790 +Amortization of debt issuance costs +3,868 +– +– +– +3,868 +Interest credited to policyholders +– +– +32,302 +– +32,302 +Change in allowance for losses on trade receivables +( 31 ) +– +( 89 ) +– +( 120 ) +Change in allowance for inventories and parts reserve +5,065 +– +– +– +5,065 +Net gains on disposal of personal property +( 11,822 ) +– +– +– +(11,822) +Net gains on disposal of real estate +( 195,414 ) +– +– +– +( 195,414 ) +Net gains on sales of investments +– +( 1,703 ) +( 4,566 ) +– +( 6,269 ) +Deferred income taxes +( 182,358 ) +( 6,596 ) +( 4,480 ) +– +( 193,434 ) +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +( 23,444 ) +8,075 +40 +– +( 15,329 ) +Inventories and parts +( 12,384 ) +– +– +– +( 12,384 ) +Prepaid expenses +( 40,765 ) +– +– +– +( 40,765 ) +Capitalization of deferred policy acquisition costs +– +– +( 27,350 ) +– +( 27,350 ) +Other assets +( 167,579 ) +1,810 +( 199 ) +– +( 165,968 ) +Related party assets +48,855 +4,553 +– +– +53,408 +Accounts payable and accrued expenses +( 36,384 ) +648 +( 1,244 ) +– +( 36,980 ) +Policy benefits and losses, claims and loss expenses payable +168,687 +( 10,623 ) +3,057 +– +161,121 +Other policyholders' funds and liabilities +– +1,194 +( 1,303 ) +– +( 109 ) +Deferred income +5,524 +– +– +– +5,524 +Related party liabilities +( 1,884 ) +318 +950 +– +( 616 ) +Net cash provided by operating activities +858,596 +21,921 +57,167 +– +937,684 +Cash flows from investing activities: +Escrow deposits +31,362 +– +– +– +31,362 +Purchases of: +Property, plant and equipment +( 1,363,745 ) +– +– +– +( 1,363,745 ) +Short term investments +– +( 63,556 ) +– +– +( 63,556 ) +Fixed maturities investments +– +( 51,273 ) +( 339,627 ) +– +( 390,900 ) +Equity securities +– +– +( 662 ) +– +( 662 ) +Preferred stock +– +( 1,000 ) +– +– +( 1,000 ) +Real estate +( 1,365 ) +( 440 ) +( 134 ) +– +( 1,939 ) +Mortgage loans +– +( 14,409 ) +( 69,098 ) +– +( 83,507 ) +Proceeds from sales and paydowns of: +Property, plant and equipment +699,803 +– +– +– +699,803 +Short term investments +– +61,133 +6,657 +– +67,790 +Fixed maturities investments +– +21,670 +141,799 +– +163,469 +Preferred stock +– +4,208 +– +– +4,208 +Real estate +2,783 +– +– +– +2,783 +Mortgage loans +– +15,660 +21,930 +– +37,590 +Net cash used by investing activities +( 631,162 ) +( 28,007 ) +( 239,135 ) +– +( 898,304 ) +(page 1 of 2) +(a) Balance for the period ended December 31, 2017 +F- +59 +amerco and consolidated subsidiaries +notes to condensed consolidated financial statements – (continued) +Continuation +of +consolidating +cash +flow +statements +by +industry +segment +for +the +year +ended +March +31, +2018 +are +as +follows: +Moving & Storage +Consolidated +Property & Casualty +Insurance (a) +Life +Insurance (a) +Elimination +AMERCO +Consolidated +(In thousands) +Cash flows from financing activities: +Borrowings from credit facilities +498,464 +– +– +– +498,464 +Principal repayments on credit facilities +( 356,451 ) +– +– +– +( 356,451 ) +Payment of debt issuance costs +( 5,111 ) +– +– +– +( 5,111 ) +Capital lease payments +( 296,363 ) +– +– +– +( 296,363 ) +Employee stock ownership plan shares +( 11,640 ) +– +– +– +( 11,640 ) +Securitization deposits +( 2,180 ) +– +– +– +( 2,180 ) +Common stock dividends paid +( 29,380 ) +– +– +– +( 29,380 ) +Investment contract deposits +– +– +401,814 +– +401,814 +Investment contract withdrawals +– +– +( 182,549 ) +– +( 182,549 ) +Net cash provided (used) by financing activities +( 202,661 ) +– +219,265 +– +16,604 +Effects of exchange rate on cash +5,598 +– +– +– +5,598 +Increase (decrease) in cash and cash equivalents +30,371 +( 6,086 ) +37,297 +– +61,582 +Cash and cash equivalents at beginning of period +671,665 +12,725 +13,416 +– +697,806 +Cash and cash equivalents at end of period +$ +702,036 +$ +6,639 +$ +50,713 +$ +– +$ +759,388 +(page 2 of 2) +(a) Balance for the period ended December 31, 2017 +F- +60 +Note 23. +Revenue Recognition +Revenue Recognized in Accordance with Topic 606 +On April 1, 2018, we adopted ASC Topic 606, +Revenue from Contracts with Customers (Topic 606) +, on a modified retrospective basis. The standard outlines a five-step model for entities to use in accounting for revenue arising from contracts with customers. The standard applies to all contracts with customers except for leases, insurance contracts, financial instruments, certain nonmonetary exchanges and certain guarantees. The standard also requires expanded disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments. Due to insignificant changes in our revenue recognition pattern for applicable revenue streams as a result of the updated guidance, there was no cumulative effect recorded. +Additionally, we elected to use the practical expedient for contracts that begin and end within the same reporting period in applying the updated guidance to our applicable revenue streams. The adoption of the standard did not have a material effect on our Consolidated Balance Sheets, Consolidated Statements of Operations, or Consolidated Statements of Cash Flows. +We enter into contracts that may include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of amounts collected from customers for taxes, such as sales tax, and remitted to the applicable taxing authorities. We account for a contract under Topic 606 when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. For contracts scoped into this standard, revenue is recognized when (or as) the performance obligations are satisfied by means of transferring goods or services to the customer as applicable to each revenue stream as discussed below. +There were no material contract assets or liabilities as of March 31, 2020 and March 31, 2019. +Sales of self-moving and self-storage related products are recognized at the time that title passes and the customer accepts delivery. The performance obligations identified for this portfolio of contracts include moving and storage product sales, installation services and/or propane sales. Each of these performance obligations has an observable stand-alone selling price. We concluded that the performance obligations identified are satisfied at a point in time under Topic 606, which is consistent with the timing of our revenue recognition under legacy guidance. The basis for this conclusion is that the customer does not receive the product/propane or benefit from the installation services until the related performance obligation is satisfied. These products/services being provided have an alternative use as they are not customized and can be sold/provided to any customer. In addition, we only have the right to receive payment once the products have been transferred to the customer or the installation services have been completed. Although product sales have a right of return policy, our estimated obligation for future product returns is not material to the financial statements at this time. +Property management fees are recognized over the period that agreed-upon services are provided. The performance obligation for this portfolio of contracts is property management services, which represents a series of distinct days of service, each of which is comprised of activities that may vary from day to day. However, those tasks are activities to fulfill the property management services and are not separate promises in the contract. We determined that each increment of the promised service is distinct in accordance with paragraph 606-10-25-19. This is because the customer can benefit from each increment of service on its own and each increment of service is separately identifiable because no day of service significantly modifies or customizes another and no day of service significantly affects either the entity’s ability to fulfill another day of service or the benefit to the customer of another day of service. As such, we concluded that the performance obligation is satisfied over time under Topic 606, which is consistent with the timing of our revenue recognition under legacy guidance for the Management Fee component of the compensation received in exchange for the service. Additionally, in certain contracts the Company has the ability to earn an incentive fee based on operational results. Historically, these fees have been recognized once fully determinable. Under Topic 606, we measure and recognize the progress toward completion of the performance obligation on a quarterly basis using the most likely amount method to determine an accrual for the incentive fee portion of the compensation received in exchange for the property management service. The variable consideration recognized is subject to constraints due to a range of possible consideration amounts based on actual operational results. The amount accrued in the fourth quarter of fiscal 2020 did not have a material effect on our financial statements. +Other +revenue +consists +of +numerous +services +or +rentals, +of +which +U-Box +contracts +and +service +fees +from +Moving +Help +are +the +main +components. +The +performance +obligations +identified +for +U-Box +contracts +F- +61 +are +fees +for +rental, +storage +and +shipping +of +U-Box +containers +to +a +specified +location, +each +of +which +are +distinct. +A +contract +may +be +partially +within +the +scope +of +Topic +606 +and +partially +within +the +scope +of +other +topics. +The +rental +and +storage +obligations +in +U-Box +contracts +meet +the +definition +of +a +lease +in +Topic +842, +while +the +shipping +obligation +represents +a +contract +with +a +customer +accounted +for +under +Topic +606. +Therefore, +we +allocate +the +total +transaction +price +between +the +performance +obligations +of +storage +fees +and +rental +fees +and +the +shipping +fees +on +a +standalone +selling +price +basis. +U-Box +shipping +fees +are +collected +once +the +shipment +is +in +transit. +Shipping +fees +in +U-Box +contracts +are +set +at +the +initiation +of +the +contract +based +on +the +shipping +origin +and +destination, +and +the +performance +obligation +is +satisfied +over +time +under +Topic +606, +which +is +consistent +with +the +timing +of +our +revenue +recognition +under +legacy +guidance. +U-Box +shipping +contracts +span +over +a +relatively +short +period +of +time, +and +the +majority +of +these +contracts +begin +and +end +within +the +same +fiscal +year. +Moving +Help +services +fees +are +recognized +in +accordance +with +Topic +606. +Moving +Help +services +are +generated +as +we +provide +a +neutral +venue +for +the +connection +between +the +service +provider +and +the +customer +for +agreed +upon +services. +We +do +not +control +the +specified +services +provided +by +the +service +provider +before +that +service +is +transferred +to +the +customer. +Revenue Recognized in Accordance withTopic 842/840 +The Company’s self-moving rental revenues meet the definition of a lease pursuant to the guidance in ASU 2016-02, Leases (Topic 842) because those substitution rights do not provide an economic benefit to the Company that would exceed the cost of exercising the right. +Therefore, upon adoption of Topic 842 on April 1, 2019, self-rental contracts are being accounted for as leases. We combined all lease and non-lease components of lease contracts for which the timing and pattern of transfer are the same and the lease component meets the classification of an operating lease, and account for them in accordance with Topic 842. The revenue streams accounted for in accordance with Topic 842 are recognized evenly over the period of rental. We do not expect this change to result in a change in the timing and pattern of recognition of the related revenues due to the short-term nature of the self-moving rental contracts. Please see Note 18, Leases, of the Notes to Condensed Consolidated Financial Statements. +Self-storage revenues are recognized as earned over the contract period based upon the number of paid storage contract days. +We lease portions of our operating properties to tenants under agreements that are classified as operating leases. We recognize the total minimum lease payments provided for under the leases on a straight-line basis over the lease term. Generally, under the terms of our leases, the majority of our rental expenses, including common area maintenance, real estate taxes and insurance, are recovered from our customers. +The following table summarizes the minimum lease payments due from our customers and operating property tenants on leases for the next five years and thereafter: +Year Ended March 31, +2021 +2022 +2023 +2024 +2025 +Thereafter +(In thousands) +Self-moving equipment rentals +$ +2,139 +$ +– +$ +– +$ +– +$ +– +$ +– +Property lease revenues +20,715 +16,927 +13,250 +9,834 +7,102 +58,379 +Total +$ +22,854 +$ +16,927 +$ +13,250 +$ +9,834 +$ +7,102 +$ +58,379 +Revenue Recognized in Accordance with Other Topics +Traditional life and Medicare supplement insurance premiums are recognized as revenue over the premium-paying periods of the contracts when due from the policyholders. For products where premiums are due over a significantly shorter duration than the period over which benefits are provided, such as our single premium whole life product, premiums are recognized when received and excess profits are deferred and recognized in relation to the insurance in force. Life insurance premiums are recognized in accordance with existing guidance in Topic 944 – Financial Services – Insurance. +Property and casualty insurance premiums are recognized as revenue over the policy periods. Interest and investment income are recognized as earned. Property and casualty premiums are recognized in accordance with existing guidance in Topic 944 – Financial Services – Insurance. +F- +62 +Net investment and interest income has multiple components. Interest income from bonds and mortgage notes are recognized when earned. Dividends on common and preferred stocks are recognized on the ex-dividend dates. Realized gains and losses on the sale or exchange of investments are recognized at the trade date. Net investment and interest income was recognized in accordance with existing guidance in Topic 825 – Financial Instruments. +In the following tables, the revenue is disaggregated by timing of revenue recognition: +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Revenues recognized over time +$ +147,565 +$ +2,814,732 +$ +2,617,990 +Revenues recognized at a point in time +309,804 +305,408 +301,152 +Total revenues recognized under ASC 606 +457,369 +3,120,140 +2,919,142 +Revenues recognized under ASC 842 or 840 +3,182,902 +406,070 +353,924 +Revenues recognized under ASC 944 +200,768 +131,563 +217,575 +Revenues recognized under ASC 320 +137,829 +110,934 +110,473 +Total revenues +$ +3,978,868 +$ +3,768,707 +$ +3,601,114 +In the above tables, the revenues recognized over time include self-moving equipment rentals, property management fees, the shipping fees associated with U-Box rentals and a portion of other revenues for fiscal 2019 and 2018, respectively. Whereas revenues recognized at a point in time include self-moving and self-storage products and service sales and a portion of other revenues. Self-moving equipment rentals are now in revenues recognized under ASC 842/840 as of April 1, 2019. +We recognized liabilities resulting from contracts with customers for self-moving equipment rentals, self-storage revenues, U-Box revenues and tenant revenue, in which the length of the contract goes beyond the reported period end, although rental periods of the equipment, storage and U-Box contract are generally short-term in nature. The timing of revenue recognition results in liabilities that are reflected in deferred income on the balance sheet. +Note 24. +Subsequent Events +Our management has evaluated subsequent events occurring after March 31, 2020. We do not believe any other subsequent events have occurred that would require further disclosure or adjustment to our financial statements other than as stated below. +In April 2020, Oxford paid AMERCO a cash dividend of $ +18.6 +million. +In April 2020, we expanded our corporate revolver by an additional $ +50.0 +million and fully borrowed that as well. In May 2020, we entered into a one-year term loan totaling $ +200.0 +million at a rate of one-month LIBOR plus a +2.00 +% margin. This loan is secured by the Company’s claims for federal income tax refund, to further strengthen our liquidity position. +F- +63 +SCHEDULE +I +CONDENSED FINANCIAL INFORMATION OF AMERCO +BALANCE SHEETS +March 31, +2020 +2019 +(In thousands) +ASSETS +Cash and cash equivalents +$ +294,528 +$ +428,950 +Investment in subsidiaries +2,758,509 +2,474,671 +Related party assets +1,734,358 +1,424,274 +Other assets +502,064 +120,896 +Total assets +$ +5,289,459 +$ +4,448,791 +LIABILITIES AND STOCKHOLDERS' EQUITY +Liabilities: +Other liabilities +$ +1,068,291 +$ +754,115 +1,068,291 +754,115 +Stockholders' equity: +Preferred stock +– +– +Common stock +10,497 +10,497 +Additional paid-in capital +454,029 +453,536 +Accumulated other comprehensive income (loss) +35,100 +( 68,459 ) +Retained earnings: +Beginning of period +3,976,752 +3,635,351 +Adjustment for adoption of ASU 2016-01 +– +9,724 +Net earnings +442,048 +370,857 +Dividends +( 19,608 ) +( 39,180 ) +End of period +4,399,192 +3,976,752 +Cost of common shares in treasury +( 525,653 ) +( 525,653 ) +Cost of preferred shares in treasury +( 151,997 ) +( 151,997 ) +Total stockholders' equity +4,221,168 +3,694,676 +Total liabilities and stockholders' equity +$ +5,289,459 +$ +4,448,791 +The accompanying notes are an integral part of these condensed financial statements. +F- +64 +CONDENSED +FINANCIAL +INFORMATION +OF +AMERCO +STATEMENTS OF OPERATIONS +Years Ended March 31, +2020 +2019 +2018 +(In thousands, except share and per share data) +Revenues: +Net interest income and other revenues +$ +6,586 +$ +8,601 +$ +4,606 +Expenses: +Operating expenses +10,622 +8,840 +7,003 +Other expenses +96 +93 +91 +Total expenses +10,718 +8,933 +7,094 +Equity in earnings of subsidiaries +205,940 +279,589 +681,786 +Interest income +130,670 +112,649 +120,549 +Pretax earnings +332,478 +391,906 +799,847 +Income tax benfefit (expense) +109,570 +( 21,049 ) +( 9,264 ) +Earnings available to common shareholders +$ +442,048 +$ +370,857 +$ +790,583 +Basic and diluted earnings per common share +$ +22.55 +$ +18.93 +$ +40.36 +Weighted average common shares outstanding: Basic and diluted +19,603,708 +19,592,048 +19,588,889 +The accompanying notes are an integral part of these condensed financial statements. +CONDENSED FINANCIAL INFORMATION OF AMERCO +STATEMENTS OF comprehensive income +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Net earnings +$ +442,048 +$ +370,857 +$ +790,583 +Other comprehensive income (loss) +101,350 +( 62,075 ) +37,873 +Total comprehensive income +$ +543,398 +$ +308,782 +$ +828,456 +The accompanying notes are an integral part of these condensed financial statements. +F- +65 +CONDENSED +FINANCIAL +INFORMATION +OF +AMERCO +STATEMENTS OF CASH FLOW +Years Ended March 31, +2020 +2019 +2018 +(In thousands) +Cash flows from operating activities: +Net earnings +$ +442,048 +$ +370,857 +$ +790,583 +Change in investments in subsidiaries +( 205,940 ) +( 279,589 ) +( 681,786 ) +Adjustments to reconcile net earnings to cash provided by operations: +Depreciation +1 +1 +3 +Net loss on sale of real and personal property +– +– +– +Deferred income taxes +323,980 +112,434 +( 182,358 ) +Net change in other operating assets and liabilities: +Reinsurance recoverables and trade receivables +– +– +– +Prepaid expenses +( 381,190 ) +( 6,289 ) +( 36,516 ) +Other assets +22 +( 40 ) +65 +Related party assets +– +– +– +Accounts payable and accrued expenses +1,935 +2,260 +278 +Net cash provided (used) by operating activities +180,856 +199,634 +( 109,731 ) +Cash flows from investing activities: +Purchases of property, plant and equipment +– +( 1 ) +( 1 ) +Proceeds of property, plant and equipment +– +– +– +Net cash used by investing activities +– +( 1 ) +( 1 ) +Cash flows from financing activities: +Proceeds from (repayments) of intercompany loans +( 311,534 ) +( 196,382 ) +250,214 +Common stock dividends paid +( 29,404 ) +( 39,179 ) +( 29,380 ) +Net contribution from related party +21,600 +– +– +Net cash provided (used) by financing activities +( 319,338 ) +( 235,561 ) +220,834 +Effects of exchange rate on cash +4,060 +( 4,331 ) +( 3,124 ) +Increase (decrease) in cash and cash equivalents +( 134,422 ) +( 40,259 ) +107,978 +Cash and cash equivalents at beginning of period +428,950 +469,209 +361,231 +Cash and cash equivalents at end of period +$ +294,528 +$ +428,950 +$ +469,209 +Income taxes paid, net of income taxes refunds received, amounted to $ +6.9 +million, $ +4.3 +million and $ +68.7 +million for fiscal 2020, 2019 and 2018, respectively. +The accompanying notes are an integral part of these condensed financial statements. +F- +66 +CONDENSED FINANCIAL INFORMATION OF AMERCO +NOTES TO CONDENSED FINANCIAL INFORMATION +March 31, 2020, 2019, and 2018 +1. +Summary of Significant Accounting Policies +AMERCO, a Nevada corporation, was incorporated in April, 1969, and is the holding Company for U-Haul International, Inc., Amerco Real Estate Company, Repwest Insurance Company and Oxford Life Insurance Company. The financial statements of the Registrant should be read in conjunction with the Consolidated Financial Statements and notes thereto included in this Annual Report. +AMERCO is included in a consolidated Federal income tax return with all of its U.S. subsidiaries. Accordingly, the provision for income taxes has been calculated for Federal income taxes of AMERCO and subsidiaries included in the consolidated return of AMERCO. State taxes for all subsidiaries are allocated to the respective subsidiaries. +The financial statements include only the accounts of AMERCO, which include certain of the corporate operations of AMERCO. The interest in AMERCO’s majority owned subsidiaries is accounted for on the equity method. The intercompany interest income and expenses are eliminated in the Consolidated Financial Statements. +2. +Guarantees +AMERCO has guaranteed performance of certain long-term leases and other obligations. See Note 18, Leases, and Note 20, Related Party Transactions, of the Notes to Consolidated Financial Statements. +F- +67 +SCHEDULE II +AMERCO AND CONSOLIDATED SUBSIDIARIES +VALUATION AND QUALIFYING ACCOUNTS +Balance at Beginning of Year +Additions Charged to Costs and Expenses +Additions Charged to Other Accounts +Deductions +Balance at Year End +Year ended March 31, 2020 +(In thousands) +Allowance for doubtful accounts +(deducted from trade receivable) +$ +549 +$ +731 +$ +– +$ +( 745 ) +$ +535 +Allowance for obsolescence +(deducted from inventory) +$ +2,322 +$ +741 +$ +– +$ +– +$ +3,063 +Allowance for LIFO +(deducted from inventory) +$ +18,987 +$ +– +$ +– +$ +( 101 ) +$ +18,886 +Allowance for probable losses +(deducted from mortgage loans) +$ +493 +$ +– +$ +– +$ +– +$ +493 +Year ended March 31, 2019 +Allowance for doubtful accounts +(deducted from trade receivable) +$ +496 +$ +1,550 +$ +– +$ +( 1,497 ) +$ +549 +Allowance for obsolescence +(deducted from inventory) +$ +5,329 +$ +– +$ +– +$ +( 3,007 ) +$ +2,322 +Allowance for LIFO +(deducted from inventory) +$ +16,126 +$ +2,861 +$ +– +$ +– +$ +18,987 +Allowance for probable losses +(deducted from mortgage loans) +$ +618 +$ +– +$ +– +$ +( 125 ) +$ +493 +Year ended March 31, 2018 +Allowance for doubtful accounts +(deducted from trade receivable) +$ +585 +$ +886 +$ +– +$ +( 929 ) +$ +496 +Allowance for obsolescence +(deducted from inventory) +$ +2,050 +$ +3,279 +$ +– +$ +– +$ +5,329 +Allowance for LIFO +(deducted from inventory) +$ +14,340 +$ +1,786 +$ +– +$ +– +$ +16,126 +Allowance for probable losses +(deducted from mortgage loans) +$ +493 +$ +125 +$ +– +$ +– +$ +618 +F- +68 +SCHEDULE V +AMERCO AND CONSOLIDATED SUBSIDIARIES +SUPPLEMENTAL INFORMATION (FOR PROPERTY-CASUALTY INSURANCE Operations) +Years Ended December 31, 2019, 2018, AND 2017 +Fiscal Year +Affiliation with Registrant +Deferred Policy Acquisition Cost +Reserves for Unpaid Claims and Adjustment Expenses +Discount if any, Deducted +Unearned Premiums +Net Earned Premiums (1) +Net Investment Income (2) +Claim and Claim Adjustment Expenses Incurred Related to Current Year +Claim and Claim Adjustment Expenses Incurred Related to Prior Year +Amortization of Deferred Policy Acquisition Costs +Paid Claims and Claim Adjustment Expense +Net Premiums Written (1) +(In thousands) +2020 +Consolidated property +casualty entity +$ +– +$ +209,127 +$ +– +$ +233 +$ +69,138 +$ +19,926 +$ +22,137 +$ +( 9,535 ) +$ +– +$ +24,608 +$ +66,277 +2019 +Consolidated property +casualty entity +– +228,970 +– +239 +60,853 +9,373 +19,579 +( 5,365 ) +– +19,228 +61,022 +2018 +Consolidated property +casualty entity +– +233,554 +– +70 +57,100 +14,079 +15,749 +233 +– +17,366 +57,123 +(1)The earned and written premiums are reported net of intersegment transactions. There were $ +3.1 +million, $ +2.8 +million and $ +2.3 +million in written premiums and $ +2.8 +million, $ +2.6 +million and $ +1.7 +million in earned premiums eliminated for the year ended December 31, 2019, 2018 and 2017, respectively. +(2) Net Investment Income excludes net realized (gains) losses +on investments of ($ +0.4 +) million, ($ +3.0 +) million and ($ +1.7 +) million for the years ended December 31, 2019, 2018 and 2017, respectively +. +F- +69 +SIGNATURES +Pursuant to the requirements of Section +13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +AMERCO +Date: +May 27, 2020 +/s/ Edward J. Shoen +Edward J. Shoen +President and Chairman of the Board +(Principal Executive Officer) +Date: +May 27, 2020 +/s/ Jason A. Berg +Jason A. Berg +Chief Financial Officer +(Principal Financial Officer) +Date: +May 27, 2020 +/s/ Maria L. Bell +Maria L. Bell +(Chief Accounting Officer) +F- +70 +POWER OF ATTORNEY +KNOW ALL BY THESE PRESENTS, +that each person whose signature appears below constitutes and appoints Edward J. Shoen his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form +10-K, and to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act or things requisite and necessary to be done in and about the premises, as fully and to all intents and purposes as he might or could do in person hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +/s/ Edward J. Shoen +President and Chairman of the Board +May 27, 2020 +Edward J. Shoen +/s/ Jason A. Berg +Chief Financial Officer +May 27, 2020 +Jason A. Berg +/s/ Maria L. Bell +Chief Accounting Officer +May 27, 2020 +Maria L. Bell +/s/ James E. Acridge +Director +May 27, 2020 +James E. Acridge +/s/ John P. Brogan +Director +May 27, 2020 +John P. Brogan +/s/ James J. Grogan +Director +May 27, 2020 +James J. Grogan +/s/ Richard J. Herrera +Director +May 27, 2020 +Richard J. Herrera +/s/ Karl A. Schmidt +Director +May 27, 2020 +Karl A. Schmidt +/s/ Roberta R. Shank +Director +May 27, 2020 +Roberta R. Shank +/s/ Samuel J. Shoen +Director +May 27, 2020 +Samuel J. Shoen +F- +71 \ No newline at end of file diff --git a/raw/filings/0000004457/2020/0000004457-20-000053/filing_metadata.csv b/raw/filings/0000004457/2020/0000004457-20-000053/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..0cff05c0d71529168fac8ff741d280fde08c3e1f --- /dev/null +++ b/raw/filings/0000004457/2020/0000004457-20-000053/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004457,UHAL-B,U-Haul Holding Co /NV/,2020,10-K,2020-05-27,2020-03-31,2020-05-27T20:21:06.000Z,0000004457-20-000053,uhal-20200331.htm,"MARCH 31, 2020 10-K",19200298,1,1,https://www.sec.gov/Archives/edgar/data/4457/000000445720000053/uhal-20200331.htm,https://www.sec.gov/Archives/edgar/data/4457/000000445720000053/ diff --git a/raw/filings/0000004457/2020/0000004457-20-000053/item1.txt b/raw/filings/0000004457/2020/0000004457-20-000053/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..f74acc979d52d301f21ccbdc182668f516a6082e --- /dev/null +++ b/raw/filings/0000004457/2020/0000004457-20-000053/item1.txt @@ -0,0 +1,268 @@ +Item 1. Business +Company Overview +We are North America’s largest “do-it-yourself” moving and storage operator through our subsidiary U-Haul International, Inc. (“U-Haul”). U-Haul is synonymous with “do-it-yourself” moving and storage and is a leader in supplying products and services to help people move and store their household and commercial goods. Our primary service objective is to “provide a better and better product and service to more and more people at a lower and lower cost.” Unless the context otherwise requires, the terms “AMERCO,” “Company,” “we,” “us,” or “our” refer to AMERCO, a Nevada corporation, and all of its legal subsidiaries, on a consolidated basis. +We were founded in 1945 as a sole proprietorship under the name "U-Haul Trailer Rental Company" and have rented trailers ever since. Starting in 1959, we rented trucks on a one-way and in-town basis exclusively through independent U-Haul +® +dealers. In 1973, we began developing our network of U-Haul +® +managed retail stores, through which we rent our trucks and trailers, self-storage units and portable moving and storage units and sell moving and self-storage products and services to complement our independent dealer network. +We rent our distinctive orange and white U-Haul +® +trucks and trailers as well as offer self-storage units through a network of 2,065 Company-operated retail moving stores and over 20,100 independent U-Haul +® +dealers. We also sell U-Haul +® +brand boxes, tape and other moving and self-storage products and services to “do-it-yourself” moving and storage customers at all of our distribution outlets and through our uhaul.com +® +and eMove +® +websites. +We believe U-Haul +® +is the most convenient supplier of products and services addressing the needs of the United States and Canada’s “do-it-yourself” moving and storage markets. Our broad geographic coverage throughout the United States and Canada and our extensive selection of U-Haul +® +brand moving equipment rentals, self-storage units, portable moving and storage units and related moving and storage products and services provide our customers with convenient “one-stop” shopping. +Since 1945, U-Haul +® +has incorporated sustainable practices into its everyday operations. We believe that our basic business premise of equipment sharing helps reduce greenhouse gas emissions and reduces the inventory of total large capacity vehicles. We continue to look for ways to reduce waste within our business and are dedicated to manufacturing reusable components and recyclable products. We believe that our commitment to sustainability, through our products and services and everyday operations has helped us to reduce our impact on the environment. +Through Repwest Insurance Company (“Repwest”) and ARCOA Risk Retention Group ("ARCOA"), our property and casualty insurance subsidiaries, we manage the property, liability and related insurance claims processing for U-Haul +® +. Oxford Life Insurance Company (“Oxford”), our life insurance subsidiary, sells life insurance, Medicare supplement insurance, annuities and other related products to the senior market. +Available Information +AMERCO +® +and U-Haul +® +are each incorporated in Nevada. The internet address for U-Haul is uhaul.com. On AMERCO’s investor relations website, amerco.com, we post the following filings as soon as practicable after they are electronically filed with or furnished to the United States Securities and Exchange Commission (“SEC”): our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, proxy statements related to meetings of our stockholders, and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We also use our investor relations website as a means of disclosing material information and for complying with our disclosure obligations under Regulation FD. All such filings on our website are available free of charge. Additionally, you will find these materials on the SEC’s website at sec.gov. +1 +Products and Rental Equipment +Our customers are primarily “do-it-yourself” household movers. U-Haul +® +moving equipment is specifically designed, engineered and manufactured for the “do-it-yourself” household mover. These “do-it-yourself” movers include individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and “do-it-yourself” home remodeling and gardening enthusiasts who need to transport materials. +As of March 31, 2020, our rental fleet consisted of approximately 176,000 trucks, 127,000 trailers and 41,000 towing devices. This equipment and our U-Haul brand of self-moving products and services are available through our network of managed retail moving stores and independent U-Haul dealers. Independent U-Haul dealers receive rental equipment from the Company, act as rental agents and are paid a commission based on gross revenues generated from their U-Haul +® +rentals. +Our rental truck chassis are engineered by domestic truck manufacturers. These chassis are joined with the U-Haul +® +designed and manufactured van boxes primarily at U-Haul +® +operated manufacturing and assembly facilities strategically located throughout the United States. U-Haul +® +rental trucks feature our proprietary Lowest Deck +SM +, which provides our customers with extra ease of loading. The loading ramps on our trucks are the widest in the industry, which reduce the effort needed to move belongings. Our trucks are fitted with convenient, padded rub rails with tie downs on every interior wall. Our Gentle Ride Suspension +SM +helps our customers safely move delicate and prized possessions. Also, the engineers at our U-Haul Technical Center determined that the softest ride in our trucks was at the front of the van box. Consequently, we designed the part of the van box that hangs over the front cab of the truck to be the location for our customers to place their most fragile items during their move. We call this area Mom’s Attic +® +. +Our distinctive trailers are also manufactured at these same U-Haul +® +operated manufacturing and assembly facilities. These trailers are well suited to the low profile of many of today’s newly manufactured automobiles. Our engineering staff is committed to making our trailers easy to tow, safe, aerodynamic and fuel efficient. +To provide our self-move customers with added value, our rental trucks and trailers are designed with fuel efficiency in mind. Many of our trucks are fitted with fuel economy gauges, another tool that assists our customers in conserving fuel. To help make our rental equipment more reliable, we routinely perform extensive preventive maintenance and repairs. +We also provide customers with equipment to transport their vehicles. We provide two towing options: auto transport, in which all four wheels are off the ground, and a tow dolly, in which the front wheels of the towed vehicle are off the ground. +To help our customers load their boxes and larger household appliances and furniture, we offer several accessory rental items. Our utility dolly has a lightweight design and is easy to maneuver. Another rental accessory is our four wheel dolly, which provides a large, flat surface for moving dressers, wall units, pianos and other large household items. U-Haul +® +appliance dollies provide the leverage needed to move refrigerators, freezers, washers and dryers easily and safely. These utility, furniture and appliance dollies, along with the low decks and the wide loading ramps on U-Haul +® +trucks and trailers, are designed for easy loading and unloading of our customers’ belongings. +The total package U-Haul +® +offers to the “do-it-yourself” household mover doesn’t end with trucks, trailers and accessory rental items. Our moving supplies include a wide array of affordably priced U-Haul +® +brand boxes, tape and packing materials. We also provide specialty boxes for dishes, computers and sensitive electronic equipment, as well as tape, security locks, and packing supplies. U-Haul +® +brand boxes are specifically sized to make loading easier. +We estimate that U-Haul +® +is North America’s largest seller and installer of hitches and towing systems. In addition to towing U-Haul +® +equipment, these hitching and towing systems can tow jet skis, motorcycles, boats, campers and horse trailers. Each year, millions of customers visit our locations for expertise on complete towing systems, trailer rentals and the latest in towing accessories. +U-Haul +® +has one of North America’s largest propane refilling networks, with nearly 1,200 locations providing this convenient service. We employ trained, certified personnel to refill propane cylinders and alternative fuel vehicles. Our network of propane dispensing locations is one of the largest automobile alternative refueling networks in North America. +2 +Our self-storage business was a natural outgrowth of our self-moving operations. Conveniently located U-Haul +® +self-storage rental facilities provide clean, dry and secure space for storage of household and commercial goods. Storage units range in size from 6 square feet to over 1,000 square feet. As of March 31, 2020, we operate 1,745 self-storage locations in the United States and Canada, with over 774,000 rentable storage units comprising 66.7 million square feet of rentable storage space. Our self-storage centers feature a wide array of security measures, ranging from electronic property access control gates to individually alarmed storage units. At many centers, we offer climate-controlled storage units to protect temperature sensitive goods such as video tapes, albums, photographs and precious wood furniture. +Another extension of our strategy to make “do-it-yourself” moving and storage easier is our U-Box +® +program. +A U-Box +® +portable moving and storage unit is delivered to a location of our customer’s choosing either by the customers themselves through the use of a U-Box +® +trailer, with the assistance of a Moving Helper or by Company personnel. Once the U-Box +® +portable moving and storage unit is filled, it can be stored at the customer’s location, or taken to one of our Company operated locations, a participating independent dealer, or moved to a location of the customer’s choice. +Additionally, we offer moving and storage protection packages such as Safemove +® +and Safetow +® +. These programs provide moving and towing customers with a damage waiver, cargo protection and medical and life insurance coverage. Safestor +® +provides protection for storage customers from loss on their goods in storage. Safestor Mobile +® +provides protection for customers stored belongings when using our U-Box +® +portable moving and storage units. For our customers who desire additional coverage over and above the standard Safemove +® +protection, we also offer our Safemove Plus +® +product. This package provides the rental customer with a layer of primary liability protection. +We believe that through our website, uhaul.com, we have aggregated the largest network of customers and independent businesses in the self-moving and self-storage industry. In particular, our Moving Helper program connects “do-it-yourself” movers with thousands of independent service providers in the United States and Canada to assist our customers in packing, loading, unloading, cleaning and performing other services. +Through the U-Haul Storage Affiliates +® +program, independent storage businesses can join one of the world’s largest self-storage reservation systems. Self-storage customers making a reservation through uhaul.com +® +can access all of the U-Haul self-storage centers and all of our independent storage affiliate partners for even greater convenience to meet their self-storage needs. For the independent storage operator, our network gives them access to products and services allowing them to compete with larger operators more cost effectively. +We own numerous trademarks and service marks that contribute to the identity and recognition of our Company and its products and services. Certain of these marks are integral to the conduct of our business, a loss of any of which could have a material adverse affect on our business. We consider the trademark “U-Haul +® +” to be of material importance to our business in addition, but not limited to, the U.S. trademarks and service marks “AMERCO +® +”, “eMove +® +”, “Gentle Ride Suspension +SM +”, “In-Town +® +”, “Lowest Decks +SM +”, “Moving made Easier +® +”, “Make Moving Easier +® +”, “Mom’s Attic +® +”, “Moving Help +® +”, “Moving Helper +® +”, “Safemove +® +”, “Safemove Plus +® +”, “Safestor +® +”, “Safestor Mobile +® +”, +“Safetow +® +”, +“U-Box +® +”, “uhaul.com +® +”, “U-Haul Investors Club +® +”, “U-Haul Truck Share +® +”, “U-Haul Truck Share 24/7 +® +“ “U-Note +® +”, “WebSelfStorage +® +”, and “U-Haul Smart Mobility Center +®” +, among others, for use in connection with the moving and storage business. +Description of Operating Segments +AMERCO’s three reportable segments are: +Moving and Storage, comprised of AMERCO +® +, U-Haul +® +, and Amerco Real Estate Company +(“Real Estate”), and the subsidiaries of U-Haul +® +and Real Estate, +Property and Casualty Insurance, comprised of Repwest and its subsidiaries and ARCOA, and +Life Insurance, comprised of Oxford and its subsidiaries. +Financial information for each of our operating segments is included in the Notes to Consolidated Financial Statements as part of Item 8: Financial Statements and Supplementary Data of this Annual Report on Form 10-K. +3 +Moving and Storage Operating Segment +Moving and Storage operating segment (“Moving and Storage”) consists of the rental of trucks, trailers, portable moving and storage units, specialty rental items and self-storage spaces primarily to the household mover as well as sales of moving supplies, towing accessories and propane. Operations are conducted under the registered trade name U-Haul +® +throughout the United States and Canada. +Net revenue from Moving and Storage was approximately 91.8%, 94.0% and 91.3% of consolidated net revenue in fiscal 2020, 2019 and 2018, respectively. +The total number of rental trucks in the fleet increased during fiscal 2020 as the pace of new additions was greater than those trucks removed for retirement and sale. These additions and replacements to the fleet were a combination of U-Haul +® +manufactured vehicles and purchases. As new trucks are added to the fleet, we typically remove older trucks from the fleet. +Within our truck and trailer rental operation, we are focused on expanding our independent dealer network to provide added convenience for our customers. U-Haul +® +maximizes vehicle utilization by managing distribution of the truck and trailer fleets among the 2,065 Company-operated stores and over 20,100 independent dealers. Utilizing its proprietary reservations management system, our centers and dealers electronically report their inventory in real-time, which facilitates matching equipment to customer demand. Over half of all U-Move +® +rental revenue originated from our operated centers. +At our owned and operated retail stores we are implementing new initiatives to improve customer service. These initiatives include improving management of our rental equipment to provide our retail centers with the right type of rental equipment, at the right time and at the most convenient location for our customers, effectively marketing our broad line of self-moving related products and services, expanding accessibility to provide more convenience to our customers, and enhancing our ability to properly staff locations during our peak hours of operations by attracting and retaining “moonlighters” (part-time U-Haul +® +employees with full-time jobs elsewhere) during our peak hours of operation. +As of April 2017, U-Haul expanded it’s offering of U-Haul Truck Share 24/7 +® +to our entire network in the United States and Canada. U-Haul currently has several U.S. Patents pending on its U-Haul Truck Share 24/7 +® +system. +Our self-moving related products and services, such as boxes, pads and insurance, help our customers have a better moving experience and help them to protect their belongings from potential damage during the moving process. We are committed to providing a complete line of products selected with the “do-it-yourself” moving and storage customer in mind. +Our self-storage business operations consist of the rental of +self-storage units, portable moving and storage units, sales of self-storage related products, the facilitation of sales of services, and the management of self-storage facilities owned by others. +U-Haul +® +is one of the largest North American operators of self-storage and has been a leader in the self-storage industry since 1974. U-Haul +® +operates nearly 774,000 rentable storage units, comprising 66.7 million square feet of rentable storage space with locations in 50 states and 10 Canadian provinces. Our owned and managed self-storage facility locations range in size up to 309,000 square feet of storage space, with individual storage units in sizes ranging from 6 square feet to over 1,000 square feet. +The primary market for storage units is the storage of household goods. We believe that our self-storage services provide a competitive advantage through such things as Max Security, an electronic system that monitors the storage facility 24 hours a day, climate control in select units, individually alarmed units, extended hours access, and an internet-based customer reservation and account management system. +4 +Moving +Help +® +and U-Haul Storage Affiliates +® +on uhaul.com are online marketplaces that connect consumers to independent Moving Help +® +service providers and thousands of independent Self-Storage Affiliates. Our network of customer-rated Moving Help +® +and affiliates provide pack and load help, cleaning help, self-storage and similar services all over the United States and Canada. Our goal is to further utilize our web-based technology platform to increase service to consumers and businesses in the moving and storage market. +Compliance with environmental requirements of federal, state and local governments significantly affects our business. Our truck and trailer rental business is subject to regulation by various federal, state and foreign governmental entities. Specifically, the U.S. Department of Transportation and various state, federal and Canadian agencies exercise broad powers over our motor carrier operations, safety, and the generation, handling, storage, treatment and disposal of waste materials. In addition, our storage business is also subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Environmental laws and regulations are complex, change frequently and could become more stringent in the future. +Moving and Storage business is seasonal and our results of operations and cash flows fluctuate significantly from quarter to quarter. Historically, revenues have been stronger in the first and second fiscal quarters due to the overall increase in moving activity during the spring and summer months. The fourth fiscal quarter is generally our weakest. +Property and Casualty Insurance Operating Segment +Our Property and Casualty Insurance operating segment (“Property and Casualty Insurance”) provides loss adjusting and claims handling for U-Haul through regional offices across the United States and Canada. Property and Casualty Insurance also underwrites components of the Safemove +® +, Safetow +® +, Safemove Plus +® +, Safestore Mobile +® +and Safestor +® +protection packages to U-Haul customers. We attempt to price our products to be a good value to our customers. The business plan for Property and Casualty Insurance includes offering property and casualty products in other U-Haul related programs. +Net revenue from Property and Casualty Insurance was approximately 2.2%, 1.9% and 2.0% of consolidated net revenue in fiscal 2020, 2019 and 2018, respectively. +Life Insurance Operating Segment +Life Insurance provides life and health insurance products primarily to the senior market through the direct writing and reinsuring of life insurance, Medicare supplement and annuity policies. +Net revenue from Life Insurance was approximately 6.0%, 4.1% and 6.7% of consolidated net revenue in fiscal 2020, 2019 and 2018, respectively. +Employees +As of March 31, 2020, we employed approximately 30,000 people throughout the United States and Canada with approximately 99% of these employees working within Moving and Storage and approximately 52% of these employees working on a part-time basis. +Sales and Marketing +We promote U-Haul +® +brand awareness through direct and co-marketing arrangements. Our direct marketing activities consist of web-based initiatives, print and social media as well as trade events, movie and television cameos of our rental fleet and boxes, television commercials, and industry and consumer communications. We believe that our rental equipment is our best form of advertisement. We support our independent U-Haul +® +dealers through marketing U-Haul +® +moving and self-storage rentals, products and services. +Our marketing plan focuses on maintaining our leadership position in the “do-it-yourself” moving and storage industry by continually improving the ease of use and economy of our rental equipment, by providing added convenience to our retail centers, through independent U-Haul dealers, and by expanding the capabilities of our U-Haul websites. +A significant driver of rental transaction volume is our utilization of an online reservation and sales system, through uhaul.com and our 24-hour 1-800-GO-U-HAUL telephone reservations system. These points of contact are prominently featured and are a major driver of customer lead sources. +5 +Competition +Moving and Storage Operating Segment +The truck rental industry is highly competitive and includes a number of significant national, regional and local competitors. Generally speaking, we consider there to be two distinct users of rental trucks: commercial and “do-it-yourself” residential users. We primarily focus on the “do-it-yourself” residential user. Within this segment, we believe the principal competitive factors are convenience of rental locations, availability of quality rental moving equipment, breadth of essential products and services, and total cost to the user. Our major national competitors in both the in-town and one-way moving equipment rental market include Avis Budget Group, Inc. and Penske Truck Leasing. We have numerous competitors throughout the United States and Canada who compete with us in the in-town market. +The self-storage market is large and very fragmented. We believe the principal competitive factors in this industry are convenience of storage rental locations, cleanliness, security and price. Our largest competitors in the self-storage market are Public Storage Inc., Extra Space Storage, Inc., CubeSmart and Life Storage, Inc. +Insurance Operating Segments +The insurance industry is highly competitive. In addition, the marketplace includes financial services firms offering both insurance and financial products. Some of the insurance companies are owned by stockholders and others are owned by policyholders. Many competitors have been in business for a longer period of time or possess substantially greater financial resources and broader product portfolios than our insurance companies. We compete in the insurance business based upon price, product design, and services rendered to agents and policyholders. +Financial Data of Segment and Geographic Areas +For financial data of our segments and geographic areas please see Note 22, Financial Information by Geographic Area, and Note 22A, Consolidating Financial Information by Consolidating Industry Segment, of our Notes to Consolidated Financial Statements. +Cautionary Statement Regarding Forward-Looking Statements +This Annual Report on Form 10-K (“Annual Report”), contains “forward-looking statements” regarding future events and our future results of operations. We may make additional written or oral forward-looking statements from time to time in filings with the SEC or otherwise. We believe such forward-looking statements are within the meaning of the safe-harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Such statements may include, but are not limited to, the risk associated with COVID-19 or similar events on employees or customers, impact on the economic environment or demand of our products and the cost and availability of debt and capital estimates of capital expenditures, plans for future operations, products or services, financing needs and plans, our perceptions of our legal positions and anticipated outcomes of government investigations and pending litigation against us, liquidity and the availability of financial resources to meet our needs, goals and strategies, plans for new business, storage occupancy, growth rate assumptions, pricing, costs, and access to capital and leasing markets, the impact of our compliance with environmental laws and cleanup costs, our used vehicle disposition strategy, the sources and availability of funds for our rental equipment and self-storage expansion and replacement strategies and plans, our plan to expand our U-Haul storage affiliate program, that additional leverage can be supported by our operations and business, the availability of alternative vehicle manufacturers, our estimates of the residual values of our equipment fleet, our plans with respect to off-balance sheet arrangements, our plans to continue to invest in the U-Box +® +program, the impact of interest rate and foreign currency exchange rate changes on our operations, the sufficiency of our capital resources, and the sufficiency of capital of our insurance subsidiaries as well as assumptions relating to the foregoing. The words “believe,” “expect,” “anticipate,” “plan,” “may,” “will,” “could,” “estimate,” “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. +6 +Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Factors that could significantly affect results include, without limitation, the risk factors enumerated below under the heading “Risk Factors” and other factors described in this Annual Report or the other documents we file with the SEC. These factors, the following disclosures, as well as other statements in this Annual Report and in the Notes to Consolidated Financial Statements, could contribute to or cause such risks or uncertainties, or could cause our stock price to fluctuate dramatically. Consequently, the forward-looking statements should not be regarded as representations or warranties by us that such matters will be realized. We assume no obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by law. \ No newline at end of file diff --git a/raw/filings/0000004457/2020/0000004457-20-000053/item13.txt b/raw/filings/0000004457/2020/0000004457-20-000053/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..7b1e49c464e7612e99132133fcd6b35e171cf679 --- /dev/null +++ b/raw/filings/0000004457/2020/0000004457-20-000053/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +41 \ No newline at end of file diff --git a/raw/filings/0000004904/2018/0000004904-19-000009/filing.txt b/raw/filings/0000004904/2018/0000004904-19-000009/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..4bf74517be0a6cedaa99b03448b9730774dd71f7 --- /dev/null +++ b/raw/filings/0000004904/2018/0000004904-19-000009/filing.txt @@ -0,0 +1,4686 @@ +10-K +1 +aep10klegal20184q.htm +AMERICAN ELECTRIC POWER 2018 10-K +Document +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON , D.C. 20549 +FORM 10-K +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2018 +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from __________ to_________ +Commission +File Number +Registrants; States of Incorporation; +Address and Telephone Number +I.R.S. Employer +Identification Nos. +1-3525 +AMERICAN ELECTRIC POWER COMPANY, INC. (A New York Corporation) +13-4922640 +333-221643 +AEP TEXAS INC. (A Delaware Corporation) +51-0007707 +333-217143 +AEP TRANSMISSION COMPANY, LLC (A Delaware Limited Liability Company) +46-1125168 +1-3457 +APPALACHIAN POWER COMPANY (A Virginia Corporation) +54-0124790 +1-3570 +INDIANA MICHIGAN POWER COMPANY (An Indiana Corporation) +35-0410455 +1-6543 +OHIO POWER COMPANY (An Ohio Corporation) +31-4271000 +0-343 +PUBLIC SERVICE COMPANY OF OKLAHOMA (An Oklahoma Corporation) +73-0410895 +1-3146 +SOUTHWESTERN ELECTRIC POWER COMPANY (A Delaware Corporation) +1 Riverside Plaza, Columbus, Ohio 43215 +Telephone (614) 716-1000 +72-0323455 +Securities registered pursuant to Section 12(b) of the Act: +Registrant +Title of each class +Name of Each Exchange +on Which Registered +American Electric Power Company, Inc. +Common Stock, $6.50 par value +New York Stock Exchange +AEP Texas Inc. +None +AEP Transmission Company, LLC +None +Appalachian Power Company +None +Indiana Michigan Power Company +None +Ohio Power Company +None +Public Service Company of Oklahoma +None +Southwestern Electric Power Company +None +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant American Electric Power Company, Inc. is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes x +No ¨ +Indicate by check mark if the registrants AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company, are well-known seasoned issuers, as defined in Rule 405 of the Securities Act. +Yes ¨ +No x +Indicate by check mark if the registrants are not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. +Yes ¨ +No x +Indicate by check mark whether the registrants American Electric Power Company, Inc., AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. +Yes x +No ¨ +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes x +No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein and will not be contained, to the best of registrants’ knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. +x +Indicate by check mark whether American Electric Power Company, Inc. is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer +x +Accelerated filer +¨ +Non-accelerated filer +¨ +Smaller reporting company +¨ +Emerging growth company +¨ +Indicate by check mark whether AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company are large accelerated filers, accelerated filers, non-accelerated filers, smaller reporting companies, or emerging growth companies. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer +¨ +Accelerated filer +¨ +Non-accelerated filer +x +Smaller reporting company +¨ +Emerging growth company +¨ +If an emerging growth company, indicate by check mark if the registrants have elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark if the registrants are shell companies, as defined in Rule 12b-2 of the Exchange Act. +Yes ¨ +No x +AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company meet the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and are therefore filing this Form 10-K with the reduced disclosure format specified in General Instruction I(2) to such Form 10-K. +Aggregate Market Value of Voting and Non-Voting Common Equity Held by Non-Affiliates of the Registrants as of June 30, 2018 the Last Trading Date of the Registrants' Most Recently Completed Second Fiscal Quarter +Number of Shares of Common Stock Outstanding of the Registrants as of December 31, 2018 +American Electric Power Company, Inc. +$34,157,276,913 +493,245,876 +($6.50 par value) +AEP Texas Inc. +None +100 +($0.01 par value) +AEP Transmission Company, LLC (a) +None +NA +Appalachian Power Company +None +13,499,500 +(no par value) +Indiana Michigan Power Company +None +1,400,000 +(no par value) +Ohio Power Company +None +27,952,473 +(no par value) +Public Service Company of Oklahoma +None +9,013,000 +($15 par value) +Southwestern Electric Power Company +None +7,536,640 +($18 par value) +(a) +100% interest is held by AEP Transmission Holdco. +NA +Not applicable. +Note on Market Value of Common Equity Held by Non-Affiliates +American Electric Power Company, Inc. owns all of the common stock of AEP Texas Inc., Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company and all of the LLC membership interest in AEP Transmission Company, LLC (see Item 12 herein). +Documents Incorporated By Reference +Description +Part of Form 10-K into which Document is Incorporated +Portions of Annual Reports of the following companies for the fiscal year ended December 31, 2018: +Part II +American Electric Power Company, Inc. +AEP Texas Inc. +AEP Transmission Company, LLC +Appalachian Power Company +Indiana Michigan Power Company +Ohio Power Company +Public Service Company of Oklahoma +Southwestern Electric Power Company +Portions of Proxy Statement of American Electric Power Company, Inc. for 2019 Annual Meeting of Shareholders. +Part III +This combined Form 10-K is separately filed by American Electric Power Company, Inc., AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company. Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. Except for American Electric Power Company, Inc., each registrant makes no representation as to information relating to the other registrants. +You can access financial and other information at AEP’s website, including AEP’s Principles of Business Conduct, certain committee charters and Principles of Corporate Governance. The address is www.AEP.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC website at www.sec.gov. +TABLE OF CONTENTS +Item +Number +Page +Number +Glossary of Terms +i +Forward-Looking Information +iv +PART I +1 +Business +General +1 +Business Segments +14 +Vertically Integrated Utilities +15 +Transmission and Distribution Utilities +23 +AEP Transmission Holdco +25 +Generation & Marketing +28 +Executive Officers of AEP +31 +1A +Risk Factors +32 +1B +Unresolved Staff Comments +43 +2 +Properties +43 +Generation Facilities +43 +Transmission and Distribution Facilities +47 +Title to Property +47 +System Transmission Lines and Facility Siting +48 +Construction Program +48 +Potential Uninsured Losses +48 +3 +Legal Proceedings +48 +4 +Mine Safety Disclosure +48 +PART II +5 +Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +49 +6 +Selected Financial Data +49 +7 +Management’s Discussion and Analysis of Financial Condition and Results of Operations +49 +7A +Quantitative and Qualitative Disclosures about Market Risk +50 +8 +Financial Statements and Supplementary Data +50 +9 +Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +50 +9A +Controls and Procedures +50 +9B +Other Information +51 +PART III +10 +Directors, Executive Officers and Corporate Governance +52 +11 +Executive Compensation +52 +12 +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +53 +13 +Certain Relationships and Related Transactions and Director Independence +53 +14 +Principal Accounting Fees and Services +54 +PART IV +15 +Exhibits and Financial Statement Schedules +55 +Financial Statements +55 +Signatures +57 +Index of Financial Statement Schedules +S-1 +Reports of Independent Registered Public Accounting Firm +S-2 +Exhibit Index +E-1 +GLOSSARY OF TERMS +When the following terms and abbreviations appear in the text of this report, they have the meanings indicated below. +Term +Meaning +AEGCo +AEP Generating Company, an AEP electric utility subsidiary. +AEP +American Electric Power Company, Inc., an investor-owned electric public utility holding company which includes American Electric Power Company, Inc. (Parent) and majority-owned consolidated subsidiaries and consolidated affiliates. +AEP Clean Energy Resources, LLC +A nonregulated holding company for AEP’s competitive renewable generation and a wholly-owned subsidiary of AEP Energy Supply, LLC. +AEP Energy +AEP Energy, Inc., a wholly-owned retail electric supplier for customers in Ohio, Illinois and other deregulated electricity markets throughout the United States. +AEP Energy Supply, LLC +A nonregulated holding company for AEP’s competitive generation, wholesale and retail businesses, and a wholly-owned subsidiary of AEP. +AEP OnSite Partners, LLC +A wholly-owned subsidiary of AEP Energy Supply, LLC. +AEP Renewables, LLC +A wholly-owned subsidiary of AEP Energy Supply, LLC. +AEP System +American Electric Power System, an electric system, owned and operated by AEP subsidiaries. +AEP Texas +AEP Texas Inc., an AEP electric utility subsidiary. +AEP Transmission Holdco +AEP Transmission Holding Company, LLC, a wholly-owned subsidiary of AEP. +AEPEP +AEP Energy Partners, Inc., a subsidiary of AEP dedicated to wholesale marketing and trading, hedging activities, asset management and commercial and industrial sales in the deregulated Ohio and Texas markets. +AEPSC +American Electric Power Service Corporation, an AEP service subsidiary providing management and professional services to AEP and its subsidiaries. +AEPTCo +AEP Transmission Company, LLC, a wholly-owned subsidiary of AEP Transmission Holdco, is an intermediate holding company that owns the State Transcos. +AEPTCo Parent +AEP Transmission Company, LLC, the holding company of the State Transcos within the AEPTCo consolidation. +AEPTHCo +AEP Transmission Holding Company, LLC, a subsidiary of AEP, an intermediate holding company that owns transmission operations joint ventures and AEPTCo. +AFUDC +Allowance for Funds Used During Construction. +AGR +AEP Generation Resources Inc., a competitive AEP subsidiary in the Generation & Marketing segment. +APCo +Appalachian Power Company, an AEP electric utility subsidiary. +CAA +Clean Air Act. +CO 2 +Carbon dioxide and other greenhouse gases. +Conesville Plant +A generation plant consisting of three coal-fired generating units totaling 1,695 MW located in Conesville, Ohio. The plant is jointly owned by AGR and a nonaffiliate. +Cook Plant +Donald C. Cook Nuclear Plant, a two-unit, 2,278 MW nuclear plant owned by I&M. +CSPCo +Columbus Southern Power Company, a former AEP electric utility subsidiary that was merged into OPCo effective December 31, 2011. +ERCOT +Electric Reliability Council of Texas regional transmission organization. +ETT +Electric Transmission Texas, LLC, an equity interest joint venture between AEP Transmission Holdco and Berkshire Hathaway Energy Company formed to own and operate electric transmission facilities in ERCOT. +Federal EPA +United States Environmental Protection Agency. +FERC +Federal Energy Regulatory Commission. +FIP +Federal Implementation Plan. +I&M +Indiana Michigan Power Company, an AEP electric utility subsidiary. +IMTCo +AEP Indiana Michigan Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +IURC +Indiana Utility Regulatory Commission. +KGPCo +Kingsport Power Company, an AEP electric utility subsidiary. +i +Term +Meaning +KPCo +Kentucky Power Company, an AEP electric utility subsidiary. +kV +Kilovolt. +MISO +Midwest Independent Transmission System Operator. +MMBtu +Million British Thermal Units. +MW +Megawatt. +MWh +Megawatt-hour. +Nonutility Money Pool +Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain nonutility subsidiaries. +NO x +Nitrogen oxide. +NRC +Nuclear Regulatory Commission. +OATT +Open Access Transmission Tariff. +OCC +Corporation Commission of the State of Oklahoma. +OHTCo +AEP Ohio Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +Oklaunion Power Station +A single unit coal-fired generation plant totaling 650 MW located in Vernon, Texas. The plant is jointly owned by AEP Texas, PSO and certain nonaffiliated entities. +OKTCo +AEP Oklahoma Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +OPCo +Ohio Power Company, an AEP electric utility subsidiary. +OTC +Over the counter. +OVEC +Ohio Valley Electric Corporation, which is 43.47% owned by AEP. +Parent +American Electric Power Company, Inc., the equity owner of AEP subsidiaries within the AEP consolidation. +PJM +Pennsylvania – New Jersey – Maryland regional transmission organization. +PPA +Purchase Power and Sale Agreement. +PSO +Public Service Company of Oklahoma, an AEP electric utility subsidiary. +PUCO +Public Utilities Commission of Ohio. +PUCT +Public Utility Commission of Texas. +Racine +A generation plant consisting of two hydroelectric generating units totaling 47.5 MWs located in Racine, Ohio and owned by AGR. +Registrant Subsidiaries +AEP subsidiaries which are SEC registrants: AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo. +Registrants +SEC registrants: AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo. +REP +Texas Retail Electric Provider. +Rockport Plant +A generation plant, consisting of two 1,310 MW coal-fired generating units near Rockport, Indiana. AEGCo and I&M jointly-own Unit 1. In 1989, AEGCo and I&M entered into a sale-and-leaseback transaction with Wilmington Trust Company, an unrelated, unconsolidated trustee for Rockport Plant, Unit 2. +ROE +Return on Equity. +RTO +Regional Transmission Organization, responsible for moving electricity over large interstate areas. +SEC +U.S. Securities and Exchange Commission. +SIP +State Implementation Plan. +SNF +Spent Nuclear Fuel. +SO 2 +Sulfur dioxide. +SPP +Southwest Power Pool regional transmission organization. +State Transcos +AEPTCo’s seven wholly-owned, FERC regulated, transmission only electric utilities, each of which is geographically aligned with AEP existing utility operating companies. +SWEPCo +Southwestern Electric Power Company, an AEP electric utility subsidiary. +TA +Transmission Agreement, effective November 2010, among APCo, I&M, KGPCo, KPCo, OPCo and WPCo with AEPSC as agent. +ii +Term +Meaning +TCA +Transmission Coordination Agreement dated January 1, 1997, by and among, PSO, SWEPCo and AEPSC, in connection with the operation of the transmission assets of the two public utility subsidiaries. +Turk Plant +John W. Turk, Jr. Plant, a 600 MW coal-fired plant in Arkansas that is 73% owned by SWEPCo. +UPA +Unit Power Agreement. +Utility Money Pool +Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain utility subsidiaries. +Virginia SCC +Virginia State Corporation Commission. +WPCo +Wheeling Power Company, an AEP electric utility subsidiary. +WVPSC +Public Service Commission of West Virginia. +WVTCo +AEP West Virginia Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +iii +FORWARD-LOOKING INFORMATION +This report made by the Registrants contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Many forward-looking statements appear in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” but there are others throughout this document which may be identified by words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “will,” “should,” “could,” “would,” “project,” “continue” and similar expressions, and include statements reflecting future results or guidance and statements of outlook. These matters are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Forward-looking statements in this document are presented as of the date of this document. Except to the extent required by applicable law, management undertakes no obligation to update or revise any forward-looking statement. Among the factors that could cause actual results to differ materially from those in the forward-looking statements are: +Ÿ +Changes in economic conditions, electric market demand and demographic patterns in AEP service territories. +Ÿ +Inflationary or deflationary interest rate trends. +Ÿ +Volatility in the financial markets, particularly developments affecting the availability or cost of capital to finance new capital projects and refinance existing debt. +Ÿ +The availability and cost of funds to finance working capital and capital needs, particularly during periods when the time lag between incurring costs and recovery is long and the costs are material. +Ÿ +Electric load and customer growth. +Ÿ +Weather conditions, including storms and drought conditions, and the ability to recover significant storm restoration costs. +Ÿ +The cost of fuel and its transportation, the creditworthiness and performance of fuel suppliers and transporters and the cost of storing and disposing of used fuel, including coal ash and SNF. +Ÿ +Availability of necessary generation capacity, the performance of generation plants and the availability of fuel. +Ÿ +The ability to recover fuel and other energy costs through regulated or competitive electric rates. +Ÿ +The ability to build or acquire renewable generation, transmission lines and facilities (including the ability to obtain any necessary regulatory approvals and permits) when needed at acceptable prices and terms and to recover those costs. +Ÿ +New legislation, litigation and government regulation, including oversight of nuclear generation, energy commodity trading and new or heightened requirements for reduced emissions of sulfur, nitrogen, mercury, carbon, soot or particulate matter and other substances that could impact the continued operation, cost recovery and/or profitability of generation plants and related assets. +Ÿ +Evolving public perception of the risks associated with fuels used before, during and after the generation of electricity, including nuclear fuel. +Ÿ +Timing and resolution of pending and future rate cases, negotiations and other regulatory decisions, including rate or other recovery of new investments in generation, distribution and transmission service and environmental compliance. +Ÿ +Resolution of litigation. +Ÿ +The ability to constrain operation and maintenance costs. +Ÿ +Prices and demand for power generated and sold at wholesale. +Ÿ +Changes in technology, particularly with respect to energy storage and new, developing, alternative or distributed sources of generation. +Ÿ +The ability to recover through rates any remaining unrecovered investment in generation units that may be retired before the end of their previously projected useful lives. +Ÿ +Volatility and changes in markets for capacity and electricity, coal and other energy-related commodities, particularly changes in the price of natural gas. +Ÿ +Changes in utility regulation and the allocation of costs within regional transmission organizations, including ERCOT, PJM and SPP. +Ÿ +Changes in the creditworthiness of the counterparties with contractual arrangements, including participants in the energy trading market. +Ÿ +Actions of rating agencies, including changes in the ratings of debt. +Ÿ +The impact of volatility in the capital markets on the value of the investments held by the pension, other postretirement benefit plans, captive insurance entity and nuclear decommissioning trust and the impact of such volatility on future funding requirements. +Ÿ +Accounting pronouncements periodically issued by accounting standard-setting bodies. +iv +Ÿ +Other risks and unforeseen events, including wars, the effects of terrorism (including increased security costs), embargoes, naturally occurring and human-caused fires, cyber security threats and other catastrophic events. +The forward-looking statements of the Registrants speak only as of the date of this report or as of the date they are made. The Registrants expressly disclaim any obligation to update any forward-looking information, except as required by law. For a more detailed discussion of these factors, see “Risk Factors” in Part I of this report. +Investors should note that the Registrants announce material financial information in SEC filings, press releases and public conference calls. Based on guidance from the SEC, the Registrants may use the Investors section of AEP’s website (www.aep.com) to communicate with investors about the Registrants. It is possible that the financial and other information posted there could be deemed to be material information. The information on AEP’s website is not part of this report. +v +PART I +ITEM 1. BUSINESS +GENERAL +Overview and Description of Major Subsidiaries +AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company that owns, directly or indirectly, all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries. +The service areas of AEP’s public utility subsidiaries cover portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Transmission networks are interconnected with extensive distribution facilities in the territories served. The public utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers. Restructuring laws in Michigan, Ohio and the ERCOT area of Texas have caused AEP public utility subsidiaries in those states to unbundle previously integrated regulated rates for their retail customers. +The member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity and transportation and handling of fuel. The companies of the AEP System also obtain certain accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost from a common provider, AEPSC. +As of December 31, 2018 , the subsidiaries of AEP had a total of 17,582 employees. Because it is a holding company rather than an operating company, AEP has no employees. The material subsidiaries of AEP are as follows: +AEP Texas +Organized in Delaware in 1925, AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,050,000 retail customers through REPs in west, central and southern Texas. As of December 31, 2018 , AEP Texas had 1,549 employees. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and primary metal manufacturing. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. AEP Texas is part of AEP’s Transmission and Distribution Utilities segment. +AEPTCo +Organized in Delaware in 2006, AEPTCo is a holding company for the State Transcos. The State Transcos develop and own new transmission assets that are physically connected to the AEP System. Individual State Transcos (a) have obtained the approvals necessary to operate in Indiana, Kentucky, Michigan, Ohio, Oklahoma and West Virginia, subject to any applicable siting requirements, (b) are authorized to submit projects for commission approval in Virginia and (c) have been granted consent to enter into a joint license agreement that will support investment in Tennessee. Neither AEPTCo nor its subsidiaries have any employees. Instead, AEPSC and certain AEP utility subsidiaries provide the services required by these entities. AEPTCo is part of the AEP Transmission Holdco segment. +1 +APCo +Organized in Virginia in 1926, APCo is engaged in the generation, transmission and distribution of electric power to approximately 956,000 retail customers in the southwestern portion of Virginia and southern West Virginia, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. APCo owns 6,629 MWs of generating capacity. APCo uses its generation to serve its retail and other customers. As of December 31, 2018 , APCo had 1,797 employees. Among the principal industries served by APCo are coal mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. APCo is a member of PJM. APCo is part of AEP’s Vertically Integrated Utilities segment. +I&M +Organized in Indiana in 1907, I&M is engaged in the generation, transmission and distribution of electric power to approximately 596,000 retail customers in northern and eastern Indiana and southwestern Michigan, and in supplying and marketing electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities and other market participants. I&M owns or leases 3,624 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2018 , I&M had 2,400 employees. Among the principal industries served are primary metals, transportation equipment, chemical manufacturing, plastics and rubber products and fabricated metal product manufacturing. I&M is a member of PJM. I&M is part of AEP’s Vertically Integrated Utilities segment. +KPCo +Organized in Kentucky in 1919, KPCo is engaged in the generation, transmission and distribution of electric power to approximately 166,000 retail customers in eastern Kentucky, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. KPCo owns 1,060 MWs of generating capacity. KPCo uses its generation to serve its retail and other customers. As of December 31, 2018 , KPCo had 522 employees. Among the principal industries served are petroleum and coal products manufacturing, chemical manufacturing, coal mining, oil and gas extraction and primary metals. KPCo is a member of PJM. KPCo is part of AEP’s Vertically Integrated Utilities segment. +KGPCo +Organized in Virginia in 1917, KGPCo provides electric service to approximately 48,000 retail customers in Kingsport and eight neighboring communities in northeastern Tennessee. KGPCo does not own any generating facilities and is a member of PJM. It purchases electric power from APCo for distribution to its customers. As of December 31, 2018 , KGPCo had 55 employees. KGPCo is part of AEP’s Vertically Integrated Utilities segment. +OPCo +Organized in Ohio in 1907 and re-incorporated in 1924, OPCo is engaged in the transmission and distribution of electric power to approximately 1,486,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. As of December 31, 2018 , OPCo had 1,704 employees. Among the principal industries served by OPCo are primary metals, petroleum and coal products manufacturing, plastics and rubber products, chemical manufacturing, fabricated metal product manufacturing and data centers. OPCo is a member of PJM. OPCo is part of AEP’s Transmission and Distribution Utilities segment. +PSO +Organized in Oklahoma in 1913, PSO is engaged in the generation, transmission and distribution of electric power to approximately 556,000 retail customers in eastern and southwestern Oklahoma, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. PSO owns 3,893 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2018 , PSO had 1,125 employees. Among the principal industries served by PSO are paper manufacturing, oil and gas extraction, petroleum and coal products manufacturing, transportation equipment and pipeline transportation. PSO is a member of SPP. PSO is part of AEP’s Vertically Integrated Utilities segment. +2 +SWEPCo +Organized in Delaware in 1912, SWEPCo is engaged in the generation, transmission and distribution of electric power to approximately 537,000 retail customers in northeastern and panhandle of Texas, northwestern Louisiana and western Arkansas and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. SWEPCo owns 5,240 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2018 , SWEPCo had 1,469 employees. Among the principal industries served by SWEPCo are petroleum and coal products manufacturing, food manufacturing, paper manufacturing, oil and gas extraction and chemical manufacturing. The territory served by SWEPCo includes several military installations, colleges and universities. SWEPCo also owns and operates a lignite coal mining operation. SWEPCo is a member of SPP. SWEPCo is part of AEP’s Vertically Integrated Utilities segment. +WPCo +Organized in West Virginia in 1883 and reincorporated in 1911, WPCo provides electric service to approximately 42,000 retail customers in northern West Virginia. WPCo owns 780 MWs of generating capacity which it uses to serve its retail and other customers. WPCo is a member of PJM. As of December 31, 2018 , WPCo had 57 employees. WPCo is part of AEP’s Vertically Integrated Utilities segment. +Service Company Subsidiary +AEPSC is a service company subsidiary that provides accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost to AEP subsidiaries. The executive officers of AEP and certain of its public utility subsidiaries are employees of AEPSC. As of December 31, 2018 , AEPSC had 6,335 employees. +Company Website and Availability of SEC Filings +Our principal corporate website address is www.aep.com. Information on our website is not incorporated by reference herein and is not part of this Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding AEP. +3 +Public Utility Subsidiaries by Jurisdiction +The following table illustrates certain regulatory information with respect to the jurisdictions in which the public utility subsidiaries of AEP operate: +Principal Jurisdiction +AEP Utility Subsidiaries Operating in that Jurisdiction +Authorized Return on Equity (a) +FERC +AEPTCo - PJM +10.99% +(b) +AEPTCo - SPP +10.70% +(c) +Ohio +OPCo +10.20% +(d) +West Virginia +APCo +9.75% +WPCo +9.75% +Virginia +APCo +9.70% +Indiana +I&M +9.95% +Michigan +I&M +9.90% +Texas +AEP Texas +9.96% +SWEPCo +9.60% +Tennessee +KGPCo +9.85% +Kentucky +KPCo +9.70% +Louisiana +SWEPCo +9.80% +Arkansas +SWEPCo +10.25% +Oklahoma +PSO +9.30% +(a) +Identifies the predominant authorized ROE and may not include other, less significant, permitted recovery. Actual ROE varies from authorized ROE. +(b) +Current authorized ROE is 10.99%. In March 2018, a settlement agreement was filed at FERC lowering the ROE to 9.85% (10.35% inclusive of the RTO incentive adder of 0.5%). See “FERC Transmission Complaint - AEP’s PJM Participants” section of Note 4 included in the 2018 Annual Report. +(c) +Current authorized ROE is being challenged. See “FERC Transmission Complaint - AEP’s SPP Participants” section of Note 4 included in the 2018 Annual Report. +(d) +Authorized ROE was approved in OPCo’s last distribution base case. The authorized ROE for riders with an approved equity return (e.g. Distribution Investment Rider) is 10.00%. See “Ohio Electric Security Plan Filings” section of Note 4 included in the 2018 Annual Report. +(a) +Pretax income does not include intercompany eliminations. +4 +CLASSES OF SERVICE +The principal classes of service from which the public utility subsidiaries of AEP derive revenues and the amount of such revenues during the years ended December 31, 2018 , 2017 and 2016 are as follows: +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Vertically Integrated Utilities Segment +Retail Revenues +Residential Sales +$ +3,818.5 +$ +3,399.8 +$ +3,423.1 +Commercial Sales +2,251.4 +2,148.6 +2,102.2 +Industrial Sales +2,234.1 +2,156.9 +2,050.6 +PJM Net Charges +0.4 +(1.1 +) +(0.4 +) +Other Retail Sales +186.4 +181.4 +172.9 +Total Retail Revenues +8,490.8 +7,885.6 +7,748.4 +Wholesale Revenues +Off-system Sales +888.0 +907.4 +921.5 +Transmission +263.7 +202.2 +198.2 +Total Wholesale Revenues +1,151.7 +1,109.6 +1,119.7 +Other Electric Revenues +93.7 +106.1 +114.5 +Provision for Rate Refund +(210.1 +) +(46.4 +) +(10.0 +) +Other Operating Revenues +30.6 +40.2 +39.9 +Sales to Affiliates +88.8 +96.9 +79.4 +Total Revenues Vertically Integrated Utilities Segment +$ +9,645.5 +$ +9,192.0 +$ +9,091.9 +Transmission and Distribution Utilities Segment +Retail Revenues +Residential Sales +$ +2,213.5 +$ +2,085.3 +$ +2,217.9 +Commercial Sales +1,288.3 +1,225.3 +1,210.0 +Industrial Sales +499.2 +473.0 +498.2 +Other Retail Sales +39.6 +39.8 +38.9 +Total Retail Revenues +4,040.6 +3,823.4 +3,965.0 +Wholesale Revenues +Off-system Sales +119.3 +100.5 +131.0 +Transmission +394.7 +359.6 +327.0 +Total Wholesale Revenues +514.0 +460.1 +458.0 +Other Electric Revenues +54.5 +48.4 +55.6 +Provision for Rate Refund +(69.2 +) +(11.4 +) +(159.3 +) +Other Operating Revenues +12.4 +8.4 +8.9 +Sales to Affiliates +100.8 +90.4 +94.2 +Total Revenues Transmission and Distribution Utilities Segment +$ +4,653.1 +$ +4,419.3 +$ +4,422.4 +AEP Transmission Holdco Segment +Transmission Revenues +$ +291.3 +$ +204.3 +$ +150.6 +Other Electric Revenues +0.3 +— +— +Other Operating Revenues +0.3 +0.8 +0.1 +Sales to Affiliates +555.5 +588.3 +366.9 +Provision for Rate Refund +(43.3 +) +(26.7 +) +(4.8 +) +Total Revenues AEP Transmission Holdco Segment +$ +804.1 +$ +766.7 +$ +512.8 +Generation & Marketing Segment +Generation Revenues +Affiliated +$ +— +$ +— +$ +0.1 +Nonaffiliated +431.5 +534.6 +1,534.0 +Marketing, Competitive Retail and Renewable Revenues +Affiliated +122.2 +103.7 +127.2 +Nonaffiliated +1,386.6 +1,236.8 +1,324.7 +Total Revenues Generation & Marketing Segment +$ +1,940.3 +$ +1,875.1 +$ +2,986.0 +5 +AEP Texas +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +594.6 +$ +573.9 +$ +551.2 +Commercial Sales +448.1 +449.3 +421.2 +Industrial Sales +113.0 +107.0 +102.9 +Other Retail Sales +26.6 +26.6 +24.8 +Total Retail Revenues +1,182.3 +1,156.8 +1,100.1 +Wholesale Revenues +Transmission +313.4 +293.8 +258.0 +Other Electric Revenues +21.9 +20.8 +25.1 +Provision for Rate Refund +(31.3 +) +(1.1 +) +— +Total Electric Transmission and Distribution Revenues +1,486.3 +1,470.3 +1,383.2 +Sales to Affiliates +105.2 +65.7 +75.7 +Other Revenues +3.8 +2.4 +2.5 +Total Revenues +$ +1,595.3 +$ +1,538.4 +$ +1,461.4 +AEPTCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Transmission Revenues +$ +212.8 +$ +167.9 +$ +114.3 +Other Electric Revenues +0.3 +— +— +Other Operating Revenues +0.2 +0.8 +0.1 +Sales to Affiliates +598.9 +580.5 +367.5 +Provision for Rate Refund +(36.1 +) +(26.0 +) +(3.9 +) +Total Revenues +$ +776.1 +$ +723.2 +$ +478.0 +APCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +1,372.0 +$ +1,242.8 +$ +1,314.8 +Commercial Sales +598.3 +586.0 +603.0 +Industrial Sales +618.8 +639.0 +628.9 +PJM Net Charges +(0.2 +) +(0.4 +) +(0.6 +) +Other Retail Sales +79.5 +78.0 +80.5 +Total Retail Revenues +2,668.4 +2,545.4 +2,626.6 +Wholesale Revenues +Off-system Sales +116.4 +126.8 +137.8 +Transmission +56.3 +57.1 +45.9 +Total Wholesale Revenues +172.7 +183.9 +183.7 +Other Electric Revenues +31.1 +33.4 +40.5 +Provision for Rate Refund +(95.1 +) +(13.7 +) +(3.4 +) +Total Electric Generation, Transmission and Distribution Revenues +2,777.1 +2,749.0 +2,847.4 +Sales to Affiliates +181.4 +172.0 +142.1 +Other Revenues +9.0 +13.2 +11.7 +Total Revenues +$ +2,967.5 +$ +2,934.2 +$ +3,001.2 +6 +I&M +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +736.5 +$ +620.9 +$ +620.4 +Commercial Sales +494.6 +442.7 +440.1 +Industrial Sales +565.3 +518.1 +510.0 +PJM Net Charges +0.2 +(1.0 +) +0.1 +Other Retail Sales +7.2 +7.1 +7.1 +Total Retail Revenues +1,803.8 +1,587.8 +1,577.7 +Wholesale Revenues +Off-system Sales +459.3 +431.2 +446.6 +Transmission +18.4 +17.2 +23.9 +Total Wholesale Revenues +477.7 +448.4 +470.5 +Other Electric Revenues +15.7 +13.5 +15.2 +Provision for Rate Refund +(24.6 +) +(7.2 +) +(1.1 +) +Total Electric Generation, Transmission and Distribution Revenues +2,272.6 +2,042.5 +2,062.3 +Sales to Affiliates +85.5 +64.4 +88.3 +Other Revenues +12.6 +14.3 +17.0 +Total Revenues +$ +2,370.7 +$ +2,121.2 +$ +2,167.6 +OPCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +1,618.9 +$ +1,511.3 +$ +1,665.0 +Commercial Sales +840.2 +776.1 +785.0 +Industrial Sales +386.2 +365.9 +395.0 +Other Retail Sales +13.0 +13.2 +14.0 +Total Retail Revenues +2,858.3 +2,666.5 +2,859.0 +Wholesale Revenues +Off-system Sales +119.3 +100.5 +131.0 +Transmission +61.4 +65.8 +68.9 +Total Wholesale Revenues +180.7 +166.3 +199.9 +Other Electric Revenues +32.7 +31.0 +30.5 +Provision for Rate Refund +(37.9 +) +(10.3 +) +(159.3 +) +Total Electricity, Transmission and Distribution Revenues +3,033.8 +2,853.5 +2,930.1 +Sales to Affiliates +21.0 +24.4 +17.3 +Other Revenues +8.6 +6.0 +6.5 +Total Revenues +$ +3,063.4 +$ +2,883.9 +$ +2,953.9 +PSO +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +668.5 +$ +601.4 +$ +538.0 +Commercial Sales +411.3 +398.5 +348.6 +Industrial Sales +298.6 +273.4 +220.6 +Other Retail Sales +84.2 +80.9 +70.8 +Total Retail Revenues +1,462.6 +1,354.2 +1,178.0 +Wholesale Revenues +Off-system Sales +36.3 +13.9 +13.1 +Transmission +47.4 +42.3 +38.3 +Total Wholesale Revenues +83.7 +56.2 +51.4 +Other Electric Revenues +10.3 +8.5 +14.9 +Provision for Rate Refund +(19.0 +) +(1.4 +) +(0.1 +) +Total Electric Generation, Transmission and Distribution Revenues +1,537.6 +1,417.5 +1,244.2 +Sales to Affiliates +5.4 +4.3 +3.1 +Other Revenues +4.3 +5.4 +4.4 +Total Revenues +$ +1,547.3 +$ +1,427.2 +$ +1,251.7 +7 +SWEPCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +665.9 +$ +597.0 +$ +587.7 +Commercial Sales +510.6 +492.5 +479.0 +Industrial Sales +338.3 +331.4 +307.1 +Other Retail Sales +8.9 +8.8 +8.1 +Total Retail Revenues +1,523.7 +1,429.7 +1,381.9 +Wholesale Revenues +Off-system Sales +216.8 +251.3 +243.9 +Transmission +94.2 +71.7 +78.4 +Total Wholesale Revenues +311.0 +323.0 +322.3 +Other Electric Revenues +20.9 +20.4 +20.0 +Provision for Rate Refund +(63.7 +) +(21.0 +) +(4.4 +) +Total Electric Generation, Transmission and Distribution Revenues +1,791.9 +1,752.1 +1,719.8 +Sales to Affiliates +28.4 +25.9 +24.5 +Other Revenues +1.6 +1.9 +2.0 +Total Revenues +$ +1,821.9 +$ +1,779.9 +$ +1,746.3 +FINANCING +General +Companies within the AEP System generally use short-term debt to finance working capital needs. Short-term debt may also be used to finance acquisitions, construction and redemption or repurchase of outstanding securities until such needs can be financed with long-term debt. In recent history, short-term funding needs have been provided for by cash on hand and AEP’s commercial paper program. Funds are made available to subsidiaries under the AEP corporate borrowing program. Certain public utility subsidiaries of AEP also sell accounts receivable to provide liquidity. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +AEP’s revolving credit agreement (which backstops the commercial paper program) includes covenants and events of default typical for this type of facility, including a maximum debt/capital test. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of its major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under the credit agreement. As of December 31, 2018 , AEP was in compliance with its debt covenants. With the exception of a voluntary bankruptcy or insolvency, any event of default has either or both a cure period or notice requirement before termination of the agreement. A voluntary bankruptcy or insolvency of AEP or one of its significant subsidiaries would be considered an immediate termination event. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +AEP’s subsidiaries have also utilized, and expect to continue to utilize, additional financing arrangements, such as securitization financings and leasing arrangements, including the leasing of coal transportation equipment and facilities. +8 +ENVIRONMENTAL AND OTHER MATTERS +General +AEP subsidiaries are currently subject to regulation by federal, state and local authorities with regard to air and water-quality control and other environmental matters, and are subject to zoning and other regulation by local authorities. The environmental issues that management believes are potentially material to the AEP System are outlined below. +Clean Water Act Requirements +Operations for AEP subsidiaries are subject to the Federal Clean Water Act, which prohibits the discharge of pollutants into waters of the United States except pursuant to appropriate permits and regulates systems that withdraw surface water for use in power plants. In 2014, the Federal EPA issued a final rule setting forth standards for existing power plants that is intended to reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water. The standards affect all plants withdrawing more than two million gallons of cooling water per day. Compliance with this standard is required within eight years of the effective date of the final rule. +In November 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for electricity generating facilities. The rule establishes limits on Flue Gas Desulfurization wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed as soon as possible after November 2018 and no later than December 2023. See “Environmental Issues - Clean Water Act Regulations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Coal Ash Regulation +AEP’s operations produce a number of different coal combustion by-products, including fly ash, bottom ash, gypsum and other materials. The Federal EPA rule regulates the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units. The rule requires certain standards for location, groundwater monitoring and dam stability to be met at landfills and certain surface impoundments at operating facilities. If existing disposal facilities cannot meet these standards, they will be required to close. See “Environmental Issues - Coal Combustion Residual Rule” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control mobile and stationary sources of air emissions. The major CAA programs affecting AEP’s power plants are described below. The states implement and administer many of these programs and could impose additional or more stringent requirements. +The Acid Rain Program +The CAA includes a cap-and-trade emission reduction program for SO 2 emissions from power plants and requirements for power plants and requirements for power plants to reduce NO x emissions through the use of available combustion controls, collectively called the Acid Rain Program. AEP continues to meet its obligations under the Acid Rain Program through the installation of controls, use of alternate fuels and participation in the emissions allowance markets. +9 +National Ambient Air Quality Standards (NAAQS) +The CAA requires the Federal EPA to review the available scientific data for criteria pollutants periodically and establish a concentration level in the ambient air for those substances that is adequate to protect the public health and welfare with an extra safety margin. The Federal EPA also can list additional pollutants and develop concentration levels for them. These concentration levels are known as NAAQS. +Each state identifies the areas within its boundaries that meet the NAAQS (attainment areas) and those that do not (non-attainment areas). Each state must develop a SIP to bring non-attainment areas into compliance with the NAAQS and maintain good air quality in attainment areas. All SIPs are submitted to the Federal EPA for approval. If a state fails to develop adequate plans, the Federal EPA develops and implements a plan. As the Federal EPA reviews the NAAQS and establishes new concentration levels, the attainment status of areas can change and states may be required to develop new SIPs. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Hazardous Air Pollutants (HAP) +The CAA also requires the Federal EPA to investigate HAP emissions from the electric utility sector and submit a report to Congress to determine whether those emissions should be regulated. In 2011, the Federal EPA issued a rule setting Maximum Achievable Control Technology standards for new and existing coal and oil-fired utility units and New Source Performance Standards for emissions from new and modified power plants. In 2014, the U.S. Supreme Court determined that the Federal EPA acted unreasonably in refusing to consider costs in determining if it was appropriate and necessary to regulate HAP emissions from electric generating units. The Federal EPA has engaged in additional rulemaking activity but the 2011 rule remains in effect. See “Environmental Issues - Hazardous Air Pollutants” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Regional Haze +The CAA establishes visibility goals for certain federally designated areas, including national parks, and requires states to submit SIPs that will demonstrate reasonable progress toward preventing impairment of visibility in these areas Regional Haze program. In 2005, the Federal EPA issued its Clean Air Visibility Rule, detailing how the CAA’s best available retrofit technology requirements will be applied to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants. +PSO executed a settlement with the Federal EPA and the State of Oklahoma to comply with Regional Haze program requirements in Oklahoma, and the settlement is now codified in the Oklahoma SIP and approved by the Federal EPA. The Federal EPA disapproved portions of the Arkansas and Texas SIPs, and finalized FIPs for both states. Challenges to both federal plans are pending in the courts. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Climate Change +AEP has taken action to reduce and offset CO 2 emissions from its generating fleet and expects CO 2 emissions from its operations to continue to decline due to the retirement of some of its coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. In 2018, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, regulations, grid reliability and resiliency, and reflect the company’s current business strategy. The intermediate goal is a 60% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is an 80% reduction of CO 2 emissions from AEP generating facilities from 2000 levels by 2050. AEP’s total estimated CO 2 emissions in 2018 were approximately 69 million metric tons, a 59% reduction from AEP’s 2000 CO 2 emissions of approximately 167 million metric tons. +10 +The Federal EPA has taken action to regulate CO 2 emissions from new and existing fossil fueled electric generating units under the existing provisions of the CAA. The Clean Power Plan was adopted in October 2015 but the U.S. Supreme Court issued a stay of its implementation, including all of the deadlines for submission of initial or final state plans. In 2017, the Federal EPA issued a proposal to repeal the Clean Power Plan and in 2018 the Federal EPA issued a proposal to revise the standards for new and modified sources and less stringent proposed guidelines to replace the Clean Power Plan. See “Environmental Issues - Climate Change, CO 2 Regulation and Energy Policy” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Management expects emissions to continue to decline over time as AEP diversifies generating sources and operates fewer coal units. The projected decline in coal-fired generation is due to a number of factors, including the ongoing cost of operating older units, the relative cost of coal and natural gas as fuel sources, increasing environmental regulations requiring significant capital investments and changing commodity market fundamentals. Management’s strategy for this transformation includes diversifying AEP’s fuel portfolio and generating more electricity from natural gas, increasing energy efficiency and investing in renewable resources, where there is regulatory support. +Transforming our Generation Fleet +The electric utility industry is in the midst of an historic transformation, driven by changing customer needs, policy demands, demographics, competitive offerings, technologies and commodity prices. Amid this changing landscape, AEP is also transforming to be more agile and customer-focused as a valued provider of energy solutions. AEP’s long-term commitment to reduce CO2 emissions reflects the current direction of the company’s resource plans to meet those needs. AEP’s exposure to carbon regulation has been greatly reduced over the last several years. From 2000 to 2017, AEP’s CO2 emissions declined 57 percent. In 2018, coal represented 47 percent of AEP’s generating capacity, compared with 70 percent in 2005. Management expects the percentage of AEP’s generating resources fueled by coal will continue to decline. Transforming AEP’s generation portfolio to include more renewable energy and focusing on the efficient use of energy, demand response, distributed resources and technology solutions to more efficiently manage the grid over time is part of this strategy. +The graph below summarizes AEP’s generation capacity by resource type for the years 1999, 2005 and 2018: +(a) +Energy Efficiency/Demand Response represents avoided capacity rather than physical assets. +11 +Renewable Sources of Energy +The states AEP serves, other than Kentucky, West Virginia and Tennessee, have established mandatory or voluntary programs to increase the use of energy efficiency, alternative energy or renewable energy sources. +As of December 31, 2018 , AEP’s regulated utilities had long-term contracts for 2,750 MWs of wind and 10 MWs of solar power delivering renewable energy to the companies’ customers. In addition, I&M owns four solar projects that make up I&M’s 15 MW Clean Energy Solar Pilot Project. Management actively manages AEP’s compliance position and is on pace to meet the relevant requirements or benchmarks in each applicable jurisdiction. +The growth of AEP’s renewable portfolio reflects the company’s strategy to diversify its generation resources to provide clean energy options to customers. In addition to gradually reducing AEP’s reliance on coal-fueled generating units, the growth of renewables and natural gas helps AEP to maintain a diversity of generation resources. +The integrated resource plans filed with state regulatory commissions by AEP’s regulated utility subsidiaries reflect AEP’s renewable strategy to balance reliability and cost with customers’ desire for clean energy in a carbon-constrained world. AEP has committed significant capital investments to modernize the electric grid and integrate these new resources. Transmission assets of the AEP System interconnect approximately 11,900 MWs of renewable energy resources. AEP’s transmission development initiatives are designed to facilitate the interconnection of additional renewable energy resources. +AEP Energy Supply, LLC owned 261 MWs of wind capacity in Texas as of December 31, 2018 . AEP Renewables, LLC develops and/or acquires large scale renewable projects backed with long-term contracts with creditworthy counterparties. As of December 2018, AEP Renewables, LLC owned two 20 MW solar projects in California and Utah and a 50 MW solar project in Nevada. In December 2018, AEP Renewables, LLC entered into an agreement to own an additional 227 MWs of Texas wind capacity which is expected to be placed in-service in mid-2019. +AEP OnSite Partners, LLC works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. The company targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners, LLC pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2018, AEP OnSite Partners, LLC owned projects operating in 15 states, including approximately 85 MWs of installed solar capacity, and approximately 57 MWs of solar projects under construction. +In February 2019, AEP Clean Energy Resources, LLC signed an agreement to purchase Sempra Renewables, LLC and its 724 MWs of wind generation and battery assets for approximately $1.1 billion, subject to closing and working capital adjustments. As part of the purchase price, AEP Clean Energy Resources, LLC will pay $551 million in cash and assume $343 million of existing project debt obligations of the non-consolidated joint ventures. Additionally, the acquisition will be accompanied by the recognition of non-controlling tax equity interest of $162 million associated with certain of the acquired wind farms. The wind generation portfolio includes seven wholly or jointly-owned wind farms with long-term PPAs for 100% of their energy production. The transaction is expected to close in mid-2019 and is subject to regulatory approvals from the FERC and federal clearance pursuant to the Hart-Scott-Rodino Antitrust Improvements Act of 1976. +Competitive Renewable Generation Facilities +Size of +Renewable +In-Service or +Energy Resource +AEP Entity +Energy Resource +Location +Under Construction +261 MW +AEP Energy Supply LLC +Wind +Texas +In-service +20 MW +AEP Renewables, LLC +Solar +California +In-service +20 MW +AEP Renewables, LLC +Solar +Utah +In-service +50 MW +AEP Renewables, LLC +Solar +Nevada +In-service +85 MW +AEP OnSite Partners, LLC +Solar +Fifteen states (a) +In-service +57 MW +AEP OnSite Partners, LLC +Solar +Four states (b) +Under Construction +(a) +California, Colorado, Connecticut, Florida, Hawaii, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(b) +California, Minnesota, New Mexico and Hawaii. +12 +End Use Energy Efficiency +AEP has reduced energy consumption and peak demand through the introduction of additional energy efficiency and demand response programs. These programs, commonly and collectively referred to as demand side management, were implemented in jurisdictions where appropriate cost recovery was available. AEP’s operating companies’ programs have reduced annual consumption by over 8 million MWhs and peak demand by approximately 2,555 MWs since 2008. AEP estimates that its operating companies spent approximately $1.4 billion during that period to achieve these levels. +Energy efficiency and demand reduction programs have received regulatory support in most of the states AEP serves. Appropriate cost recovery will be essential for AEP operating companies to continue and expand these consumer offerings. Appropriate recovery of program costs, lost revenues and an opportunity to earn a reasonable return ensures that energy efficiency programs are considered equally with supply side investments. As AEP continues to transition to a cleaner, more efficient energy future, energy efficiency and demand response programs will continue to play an important role in how the company serves its customers. AEP believes its experience providing robust energy efficiency programs in several states positions the company to be a cost-effective provider of these programs as states develop their implementation plans. +Corporate Governance +In response to environmental issues and in connection with its assessment of AEP’s strategic plan, the Board of Directors continually reviews the risks posed by new environmental rules and requirements that could accelerate the retirement of coal-fired generation assets. The Board of Directors is informed of any new environmental regulations and proposed regulation or legislation that would significantly affect the company. The Board’s Committee on Directors and Corporate Governance oversees the company’s annual Corporate Accountability Report, which includes information about the company’s environmental, social, governance and financial performance. In addition, as a result of ongoing corporate governance outreach efforts with shareholders, AEP set new CO 2 emission reduction goals that were published in a new report in February 2018, “American Electric Power: Strategic Vision for a Clean Energy Future.” +Other Environmental Issues and Matters +The Comprehensive Environmental Response, Compensation and Liability Act of 1980 imposes costs for environmental remediation upon owners and previous owners of sites, as well as transporters and generators of hazardous material disposed of at such sites. See “The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation” section of Note 6 included in the 2018 Annual Report for additional information. +Environmental Investments +Investments related to improving AEP System plants’ environmental performance and compliance with air and water quality standards during 2016 , 2017 and 2018 and the current estimate for 2019 are shown below. These investments include both environmental as well as other related spending. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends and the ability to access capital. In addition to the amounts set forth below, AEP expects to make substantial investments in future years in connection with the modification and addition at generation plants’ facilities for environmental quality controls. Such future investments are needed in order to comply with air and water quality standards that have been adopted and have deadlines for compliance after 2018 or have been proposed and may be adopted. Future investments could be significantly greater if emissions reduction requirements are accelerated or otherwise become more stringent. The cost of complying with applicable environmental laws, regulations and rules is expected to be material to the AEP System. AEP typically recovers costs of complying with environmental standards from customers through rates in regulated jurisdictions. Failure to recover these costs could reduce future net income and cash flows and possibly harm AEP’s financial condition. See “Environmental Issues” section of Management’s Discussion and Analysis of Financial +13 +Condition and Results of Operations and Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report for additional information. +Historical and Projected Environmental Investments +2016 +2017 +2018 +2019 +Actual +Actual +Actual +Estimate (b) +(in millions) +AEP (a) +$ +383.7 +$ +135.9 +$ +115.6 +$ +237.7 +APCo +50.0 +25.6 +20.4 +32.7 +I&M +65.0 +41.9 +31.1 +76.8 +PSO +34.8 +0.6 +— +2.5 +SWEPCo +82.1 +11.7 +14.1 +25.1 +(a) +Includes expenditures of the subsidiaries shown and other subsidiaries not shown. The figures reflect construction expenditures, not investments in subsidiary companies. +(b) +Estimated amounts are exclusive of debt AFUDC. +Management continues to refine the cost estimates of complying with air and water quality standards and other impacts of the environmental proposals. The following cost estimates for the years 2019 through 2025 will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules. These cost estimates will also change based on: (a) the states’ implementation of these regulatory programs, including the potential for SIPs or FIPs that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) the actual performance of the pollution control technologies installed on the units, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired, replaced or sold, including the type and amount of such replacement capacity and (g) other factors. Management’s current ranges of estimates of new major environmental investments beginning in 2019 , exclusive of debt AFUDC, are set forth below: +Projected (2019 - 2025) +Environmental Investment +Company +Low +High +(in millions) +AEP +$ +650 +$ +1,500 +APCo +135 +240 +I&M +105 +200 +PSO +15 +45 +SWEPCo +140 +230 +BUSINESS SEGMENTS +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. AEP’s reportable segments are as follows: +• +Vertically Integrated Utilities +• +Transmission and Distribution Utilities +• +AEP Transmission Holdco +• +Generation & Marketing +The remainder of AEP’s activities is presented as Corporate and Other, which is not considered a reportable segment. See Note 9 - Business Segments included in the 2018 Annual Report for additional information on AEP’s segments. +14 +VERTICALLY INTEGRATED UTILITIES +GENERAL +AEP’s vertically integrated utility operations are engaged in the generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. AEPSC, as agent for AEP’s public utility subsidiaries, performs marketing, generation dispatch, fuel procurement and power-related risk management and trading activities on behalf of each of these subsidiaries. +ELECTRIC GENERATION +Facilities +As of December 31, 2018 , AEP’s vertically integrated public utility subsidiaries owned or leased approximately 23,000 MWs of domestic generation. See Item 2 – Properties for more information regarding the generation capacity of vertically integrated public utility subsidiaries. +Fuel Supply +The following table shows the owned and leased generation sources by type (including wind purchase agreements), on an actual net generation (MWhs) basis, used by the Vertically Integrated Utilities: +2018 +2017 +2016 +Coal and Lignite +58% +61% +61% +Nuclear +18% +18% +16% +Natural Gas +14% +11% +13% +Renewables +10% +10% +10% +A price increase/decrease in one or more fuel sources relative to other fuels, as well as the addition of renewable resources, may result in the decreased/increased use of other fuels. AEP’s overall 2018 fossil fuel costs for the Vertically Integrated Utilities remained flat on a dollar per MMBtu basis from 2017 . +Coal and Lignite +AEP’s Vertically Integrated Utilities procure coal and lignite under a combination of purchasing arrangements including long-term contracts, affiliate operations and spot agreements with various producers, marketers and coal trading firms. Coal consumption in 2018 decreased approximately 2% from 2017 . +Management believes that the Vertically Integrated Utilities will be able to secure and transport coal and lignite of adequate quality and in adequate quantities to operate their coal and lignite-fired units. Through subsidiaries, AEP owns, leases or controls more than 3,664 railcars, 468 barges, 9 towboats and a coal handling terminal with approximately 18 million tons of annual capacity to move and store coal for use in AEP generating facilities. +Spot market prices for coal started to strengthen in the second half of 2018 . The increased spot coal prices reflect tighter supplies and increased demand for export coal. As of December 31, 2018 , approximately half of the coal purchased by AEP’s subsidiaries was procured through term contracts. As those contracts expire or re-open for price adjustments, needed tonnage is replaced at current market prices as necessary. The price impact of this process is reflected in subsequent periods. The price paid for coal delivered in 2018 decreased approximately 2% from 2017 . +15 +The following table shows the amount of coal and lignite delivered to the Vertically Integrated Utilities’ plants during the past three years and the average delivered price of coal purchased by the Vertically Integrated Utilities: +2018 +2017 +2016 +Total coal delivered to the plants (millions of tons) +29.0 +29.3 +30.0 +Average cost per ton of coal delivered +$ +43.21 +$ +44.24 +$ +45.92 +The coal supplies at the Vertically Integrated Utilities plants vary from time to time depending on various factors, including, but not limited to, demand for electric power, unit outages, transportation infrastructure limitations, space limitations, plant coal consumption rates, availability of acceptable coals, labor issues and weather conditions, which may interrupt production or deliveries. As of December 31, 2018 , the Vertically Integrated Utilities’ coal inventory was approximately 32 days of full load burn. While inventory targets vary by plant and are changed as necessary, the current coal inventory target for the Vertically Integrated Utilities is approximately 30 days. +Natural Gas +The Vertically Integrated Utilities consumed approximately 112 billion cubic feet of natural gas during 2018 for generating power. This represents an increase of 29% from 2017 . Total gas consumption for the Vertically Integrated Utilities was higher year over year primarily due to lower natural gas prices and increased demand for electricity. Several of AEP’s natural gas-fired power plants are connected to at least two pipelines which allow greater access to competitive supplies and improve delivery reliability. A portfolio of term, monthly, seasonal and daily supply and transportation agreements provide natural gas requirements for each plant, as appropriate. AEP’s natural gas supply agreements are entered into on a competitive basis and based on market prices. +The following table shows the amount of natural gas delivered to the Vertically Integrated Utilities’ plants during the past three years and the average delivered price of natural gas purchased by the Vertically Integrated Utilities. +2018 +2017 +2016 +Total natural gas delivered to the plants (billion of cubic feet) +111.6 +86.3 +103.9 +Average price per MMBtu of purchased natural gas +$ +3.26 +$ +3.37 +$ +2.77 +Nuclear +I&M has made commitments to meet the current nuclear fuel requirements of the Cook Plant. I&M has made and will make purchases of uranium in various forms in the spot, short-term and mid-term markets. I&M also continues to finance its nuclear fuel through leasing. +For purposes of the storage of high-level radioactive waste in the form of SNF, I&M completed modifications to its SNF storage pool in the early 1990’s. I&M entered into an agreement to provide for onsite dry cask storage of SNF to permit normal operations to continue. I&M is scheduled to conduct further dry cask loading and storage projects on an ongoing periodic basis. I&M completed its initial loading of SNF into the dry casks in 2012, which consisted of 12 casks (32 SNF assemblies contained within each). The second loading of SNF into dry casks, which consisted of 16 casks, was completed in 2015. The third dry cask loading campaign, which also consisted of 16 casks, was completed in 2018. +Nuclear Waste and Decommissioning +As the owner of the Cook Plant, I&M has a significant future financial commitment to dispose of SNF and decommission and decontaminate the plant safely. The cost to decommission a nuclear plant is affected by NRC regulations and the SNF disposal program. The most recent decommissioning cost study was completed in 2018. The estimated cost of decommissioning and disposal of low-level radioactive waste for the Cook Plant was $2 billion in 2018 non-discounted dollars, with additional ongoing estimated costs of $6 million per year for post decommissioning storage of SNF and an eventual estimated cost of $37 million for the subsequent decommissioning of the spent fuel storage facility, also +16 +in 2018 non-discounted dollars. As of December 31, 2018 and 2017 , the total decommissioning trust fund balance for the Cook Plant was approximately $2.2 billion. The balance of funds available to eventually decommission Cook Plant will differ based on contributions and investment returns. The ultimate cost of retiring the Cook Plant may be materially different from estimates and funding targets as a result of the: +• +Escalation of various cost elements (including, but not limited to, general inflation and the cost of energy). +• +Further development of regulatory requirements governing decommissioning. +• +Technology available at the time of decommissioning differing significantly from that assumed in studies. +• +Availability of nuclear waste disposal facilities. +• +Availability of a United States Department of Energy facility for permanent storage of SNF. +Accordingly, management is unable to provide assurance that the ultimate cost of decommissioning the Cook Plant will not be significantly different than current projections. AEP will seek recovery from customers through regulated rates if actual decommissioning costs exceed projections. See the “Nuclear Contingencies” section of Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report for information with respect to nuclear waste and decommissioning. +Low-Level Radioactive Waste +The Low-Level Waste Policy Act of 1980 mandates that the responsibility for the disposal of low-level radioactive waste rests with the individual states. Low-level radioactive waste consists largely of ordinary refuse and other items that have come in contact with radioactive materials. Michigan does not currently have a disposal site for such waste available. I&M cannot predict when such a site may be available. However, the states of Utah and Texas have licensed low level radioactive waste disposal sites which currently accept low level radioactive waste from Michigan waste generators. There is currently no set date limiting I&M’s access to either of these facilities. The Cook Plant has a facility onsite designed specifically for the storage of low level radioactive waste. In the event that low level radioactive waste disposal facility access becomes unavailable, it can be stored onsite at this facility. +Counterparty Risk Management +The Vertically Integrated Utilities segment also sells power and enters into related energy transactions with wholesale customers and other market participants. As a result, counterparties and exchanges may require cash or cash related instruments to be deposited on transactions as margin against open positions. As of December 31, 2018 , counterparties posted approximately $9 million in cash, cash equivalents or letters of credit with AEPSC for the benefit of AEP’s public utility subsidiaries (while, as of that date, AEP’s public utility subsidiaries posted approximately $54 million with counterparties and exchanges). Since open trading contracts are valued based on market prices of various commodities, exposures change daily. See the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Certain Power Agreements +I&M +The UPA between AEGCo and I&M, dated March 31, 1982, provides for the sale by AEGCo to I&M of all the capacity (and the energy associated therewith) available to AEGCo at the Rockport Plant. Whether or not power is available from AEGCo, I&M is obligated to pay a demand charge for the right to receive such power (and an energy charge for any associated energy taken by I&M). The agreement will continue in effect until the last of the lease terms of Unit 2 of the Rockport Plant have expired (currently December 2022) unless extended in specified circumstances. +17 +Pursuant to an assignment between I&M and KPCo, and a UPA between AEGCo and KPCo, AEGCo sells KPCo 30% of the capacity (and the energy associated therewith) available to AEGCo from both units of the Rockport Plant. KPCo has agreed to pay to AEGCo the amounts that I&M would have paid AEGCo under the terms of the UPA between AEGCo and I&M for such entitlement. The KPCo UPA expires in December 2022. +OVEC +AEP and several nonaffiliated utility companies jointly own OVEC. The aggregate equity participation of AEP in OVEC is 43.47%. Parent owns 39.17% and OPCo owns 4.3%. Under the Inter-Company Power Agreement (ICPA), which defines the rights of the owners and sets the power participation ratio of each, the sponsoring companies are entitled to receive and are obligated to pay for all OVEC capacity (approximately 2,400 MWs) in proportion to their respective power participation ratios. The aggregate power participation ratio of APCo, I&M and OPCo is 43.47%. The ICPA terminates in June 2040. The proceeds from the sale of power by OVEC are designed to be sufficient for OVEC to meet its operating expenses and fixed costs. AEP and the other owners have authorized environmental investments related to their ownership interests. OVEC financed capital expenditures totaling $1.3 billion in connection with flue gas desulfurization projects and the associated scrubber waste disposal landfills at its two generation plants through debt issuances, including tax-advantaged debt issuances. Both OVEC generation plants are operating with the new environmental controls in service. OPCo attempted to assign its rights and obligations under the ICPA to an affiliate as part of its transfer of its generation assets and liabilities in keeping with corporate separation required by Ohio law. OPCo failed to obtain the consent to assignment from the other owners of OVEC and therefore filed a request with the PUCO seeking authorization to maintain its ownership of OVEC. In December 2013, the PUCO approved OPCo’s request, subject to the condition that energy from the OVEC entitlements are sold into the day-ahead or real-time PJM energy markets, or on a forward basis through a bilateral arrangement. In November 2016, the PUCO approved OPCo’s request to approve a cost-based purchased power agreement (PPA) rider, effective in January 2017, that would initially be based upon OPCo’s contractual entitlement under the ICPA which is approximately 20% of OVEC’s capacity. In late 2016, two nonaffiliated parties to the ICPA owned by First Energy Corp. announced their intention to exit its merchant business and that it may pursue restructuring or bankruptcy. In March 2018 FirstEnergy Solutions (“FES”), with an aggregate power participation ratio of approximately 5% under the ICPA, filed bankruptcy. In July 2018, the Bankruptcy Court granted FES’s motion to reject the ICPA. OVEC is currently appealing this decision in the United States Court of Appeals for the Sixth Circuit. If OVEC does not have sufficient funds to honor its payment obligations, there is risk that APCo, I&M and/or OPCo may need to make payments in addition to their power participation ratio payments. Further, if OVEC’s indebtedness is accelerated for any reason, there is risk that APCo, I&M and/or OPCo may be required to pay some or all of such accelerated indebtedness in amounts equal to their aggregate power participation ratio of 43.47%. The foregoing and other related actions have adversely impacted the credit ratings of OVEC. +ELECTRIC DELIVERY +General +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries own and operate transmission and distribution lines and other facilities to deliver electric power. See Item 2 – Properties for more information regarding the transmission and distribution lines. Most of the transmission and distribution services are sold to retail customers of AEP’s vertically integrated public utility subsidiaries in their service territories. These sales are made at rates approved by the state utility commissions of the states in which they operate, and in some instances, approved by the FERC. See Item 1. Business – Vertically Integrated Utilities – Regulation – Rates. The FERC regulates and approves the rates for both wholesale transmission transactions and wholesale generation contracts. The use and the recovery of costs associated with the transmission assets of the AEP vertically integrated public utility subsidiaries are subject to the rules, principles, protocols and agreements in place with PJM and SPP, and as approved by the FERC. See Item 1. Business – Vertically Integrated Utilities – Regulation – FERC. As discussed below, some transmission services also are separately sold to nonaffiliated companies. +18 +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries hold franchises or other rights to provide electric service in various municipalities and regions in their service areas. In some cases, these franchises provide the utility with the exclusive right to provide electric service within a specific territory. These franchises have varying provisions and expiration dates. In general, the operating companies consider their franchises to be adequate for the conduct of their business. For a discussion of competition in the sale of power, see Item 1. Business – Vertically Integrated Utilities – Competition. +Transmission Agreement (TA) +APCo, I&M, KGPCo, KPCo and WPCo own and operate transmission facilities that are used to provide transmission service under the PJM OATT and are parties to the TA. OPCo, which is a subsidiary in AEP’s Transmission and Distribution Utilities segment that provides transmission service under the PJM OATT, is also a party to the TA. The TA defines how the parties to the agreement share the revenues associated with their transmission facilities and the costs of transmission service provided by PJM. The TA has been approved by the FERC. +TCA and OATT +PSO, SWEPCo and AEPSC are parties to the TCA. Under the TCA, a coordinating committee is charged with the responsibility of (a) overseeing the coordinated planning of the transmission facilities of the parties to the agreement, including the performance of transmission planning studies, (b) the interaction of such subsidiaries with independent system operators and other regional bodies interested in transmission planning and (c) compliance with the terms of the OATT filed with the FERC and the rules of the FERC relating to such tariff. Pursuant to the TCA, AEPSC has responsibility for monitoring the reliability of their transmission systems and administering the OATT on behalf of the other parties to the agreement. The TCA also provides for the allocation among the parties of revenues collected for transmission and ancillary services provided under the OATT. These allocations have been determined by the FERC-approved OATT for the SPP. +Regional Transmission Organizations +AEGCo, APCo, I&M, KGPCo, KPCo and WPCo are members of PJM, and PSO and SWEPCo are members of SPP (both FERC-approved RTOs). RTOs operate, plan and control utility transmission assets in a manner designed to provide open access to such assets in a way that prevents discrimination between participants owning transmission assets and those that do not. +REGULATION +General +AEP’s vertically integrated public utility subsidiaries’ retail rates and certain other matters are subject to traditional cost-based regulation by the state utility commissions. AEP’s vertically integrated public utility subsidiaries are also subject to regulation by the FERC under the Federal Power Act with respect to wholesale power and transmission service transactions. I&M is subject to regulation by the NRC under the Atomic Energy Act of 1954, as amended, with respect to the operation of the Cook Plant. AEP and its vertically integrated public utility subsidiaries are also subject to the regulatory provisions of, much of the Energy Policy Act of 2005, which is administered by the FERC. +Rates +Historically, state utility commissions have established electric service rates on a cost-of-service basis, which is designed to allow a utility an opportunity to recover its cost of providing service and to earn a reasonable return on its investment used in providing that service. A utility’s cost of service generally reflects its operating expenses, including operation and maintenance expense, depreciation expense and taxes. State utility commissions periodically adjust rates pursuant to a review of (a) a utility’s adjusted revenues and expenses during a defined test period and (b) such utility’s level of investment. Absent a legal limitation, such as a law limiting the frequency of rate changes or capping rates for a period +19 +of time, a state utility commission can review and change rates on its own initiative. Some states may initiate reviews at the request of a utility, customer, governmental or other representative of a group of customers. Such parties may, however, agree with one another not to request reviews of or changes to rates for a specified period of time. +Public utilities have traditionally financed capital investments until the new asset is placed in service. Provided the asset was found to be a prudent investment, it was then added to rate base and entitled to a return through rate recovery. Given long lead times in construction, the high costs of plant and equipment and volatile capital markets, management actively pursues strategies to accelerate rate recognition of investments and cash flow. AEP representatives continue to engage state commissioners and legislators on alternative ratemaking options to reduce regulatory lag and enhance certainty in the process. These options include pre-approvals, a return on construction work in progress, rider/trackers, formula rates and the inclusion of future test-year projections into rates. +The rates of AEP’s vertically integrated public utility subsidiaries are generally based on the cost of providing traditional bundled electric service (i.e., generation, transmission and distribution service). Historically, the state regulatory frameworks in the service area of the AEP vertically integrated public utility subsidiaries reflected specified fuel costs as part of bundled (or, more recently, unbundled) rates or incorporated fuel adjustment clauses in a utility’s rates and tariffs. Fuel adjustment clauses permit periodic adjustments to fuel cost recovery from customers and therefore provide protection against exposure to fuel cost changes. +The following state-by-state analysis summarizes the regulatory environment of certain major jurisdictions in which AEP’s vertically integrated public utility subsidiaries operate. Several public utility subsidiaries operate in more than one jurisdiction. See Note 4 - Rate Matters included in the 2018 Annual Report for more information regarding pending rate matters. +Indiana +I&M provides retail electric service in Indiana at bundled rates approved by the IURC, with rates set on a cost-of-service basis. Indiana provides for timely fuel and purchased power cost recovery through a fuel cost recovery mechanism. +Oklahoma +PSO provides retail electric service in Oklahoma at bundled rates approved by the OCC. PSO’s rates are set on a cost-of-service basis. Fuel and purchased energy costs are recovered or refunded by applying fuel adjustment and other factors to retail kilowatt-hour sales. +Virginia +APCo currently provides retail electric service in Virginia at unbundled generation and distribution rates approved by the Virginia SCC. Virginia generally allows for timely recovery of fuel costs through a fuel adjustment clause. In addition to base rates and fuel cost recovery, APCo is permitted to recover a variety of costs through rate adjustment clauses including transmission services provided at OATT rates based on rates established by the FERC. +West Virginia +APCo and WPCo provide retail electric service at bundled rates approved by the WVPSC, with rates set on a combined cost-of-service basis. West Virginia generally allows for timely recovery of fuel costs through an expanded net energy cost which trues-up to actual expenses. +20 +FERC +The FERC regulates rates for interstate power sales at wholesale, transmission of electric power, accounting and other matters, including construction and operation of hydroelectric projects. The FERC regulations require AEP’s vertically integrated public utility subsidiaries to provide open access transmission service at FERC-approved rates, and AEP has approved cost-based formula transmission rates on file at the FERC. The FERC also regulates unbundled transmission service to retail customers. In addition, the FERC regulates the sale of power for resale in interstate commerce by (a) approving contracts for wholesale sales to municipal and cooperative utilities and (b) granting authority to public utilities to sell power at wholesale at market-based rates upon a showing that the seller lacks the ability to improperly influence market prices. AEP’s vertically integrated public utility subsidiaries have market-based rate authority from the FERC, under which much of their wholesale marketing activity takes place. The FERC requires each public utility that owns or controls interstate transmission facilities to, directly or through an RTO, to file an open access network and point-to-point transmission tariff that offers services comparable to the utility’s own uses of its transmission system. The FERC also requires all transmitting utilities, directly or through an RTO, to establish an Open Access Same-time Information System, which electronically posts transmission information such as available capacity and prices, and requires utilities to comply with Standards of Conduct that prohibit utilities’ transmission employees from providing non-public transmission information to the utility’s marketing employees. Additionally, the vertically integrated public utility subsidiaries are subject to reliability standards promulgated by the North American Electric Reliability Corporation, with the approval of the FERC. +The FERC oversees RTOs, entities created to operate, plan and control utility transmission assets. AEGCo, APCo, I&M, KGPCo, KPCo and WPCo are members of PJM. PSO and SWEPCo are members of SPP. +The FERC has jurisdiction over the issuances of securities of most of AEP’s public utility subsidiaries, the acquisition of securities of utilities, the acquisition or sale of certain utility assets and mergers with another electric utility or holding company. In addition, both the FERC and state regulators are permitted to review the books and records of any company within a holding company system. +COMPETITION +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries generate, transmit and distribute electricity to retail customers of AEP’s vertically integrated public utility subsidiaries in their service territories. These sales are made at rates approved by the state utility commissions of the states in which they operate, and in some instances, approved by the FERC, and are not subject to competition from other vertically integrated public utilities. Other than AEGCo, AEP’s vertically integrated public utility subsidiaries hold franchises or other rights that effectively grant the exclusive ability to provide electric service in various municipalities and regions in their service areas. +AEP’s vertically integrated public utility subsidiaries compete with self-generation and with distributors of other energy sources, such as natural gas, fuel oil, renewables and coal, within their service areas. The primary factors in such competition are price, reliability of service and the capability of customers to utilize alternative sources of energy other than electric power. With respect to competing generators and self-generation, the public utility subsidiaries of AEP believe that they currently maintain a competitive position. +Changes in regulatory policies and advances in newer technologies for batteries or energy storage, fuel cells, microturbines, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production. The costs of photovoltaic solar cells in particular have continued to become increasingly competitive. The ability to maintain relatively low cost, efficient and reliable operations and to provide cost-effective programs and services to customers are significant determinants of AEP’s competitiveness. +21 +SEASONALITY +The consumption of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter. The pattern of this fluctuation may change due to the nature and location of AEP’s facilities and the terms of power sale contracts into which AEP enters. In addition, AEP has historically sold less power, and consequently earned less income, when weather conditions are milder. Unusually mild weather in the future could diminish AEP’s results of operations. Conversely, unusually extreme weather conditions could increase AEP’s results of operations. +22 +TRANSMISSION AND DISTRIBUTION UTILITIES +GENERAL +This segment consists of the transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo. OPCo is engaged in the transmission and distribution of electric power to approximately 1,486,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,050,000 retail customers through REPs in west, central and southern Texas. +AEP’s transmission and distribution utility subsidiaries own and operate transmission and distribution lines and other facilities to deliver electric power. See Item 2 – Properties, for more information regarding the transmission and distribution lines. Transmission and distribution services are sold to retail customers of AEP’s transmission and distribution utility subsidiaries in their service territories. These sales are made at rates approved by the PUCT for AEP Texas and by the PUCO and the FERC for OPCo. The FERC regulates and approves the rates for wholesale transmission transactions. As discussed below, some transmission services also are separately sold to nonaffiliated companies. +AEP’s transmission and distribution utility subsidiaries hold franchises or other rights to provide electric service in various municipalities and regions in their service areas. In some cases, these franchises provide the utility with the exclusive right to provide electric service. These franchises have varying provisions and expiration dates. In general, the operating companies consider their franchises to be adequate for the conduct of their business. +The use and the recovery of costs associated with the transmission assets of the AEP transmission and distribution utility subsidiaries are subject to the rules, protocols and agreements in place with PJM and ERCOT, and as approved by the FERC. In addition to providing transmission services in connection with power sales in their service areas, AEP’s transmission and distribution utility subsidiaries also provide transmission services for nonaffiliated companies through RTOs. +Transmission Agreement +OPCo owns and operates transmission facilities that are used to provide transmission service under the PJM OATT; OPCo is a party to the TA with other utility subsidiary affiliates. The TA defines how the parties to the agreement share the revenues associated with their transmission facilities and the costs of transmission service provided by PJM. The TA has been approved by the FERC. +Regional Transmission Organizations +OPCo is a member of PJM, a FERC-approved RTO. RTOs operate, plan and control utility transmission assets to provide open access to such assets in a way that prevents discrimination between participants owning transmission assets and those that do not. AEP Texas is a member of ERCOT. +REGULATION +OPCo provides distribution and transmission services to retail customers within its service territory at cost-based rates approved by the PUCO or by the FERC. AEP Texas provides transmission and distribution service on a cost-of-service basis at rates approved by the PUCT and wholesale transmission service under tariffs approved by the FERC consistent with PUCT rules. Transmission and distribution rates are established on a cost-of-service basis, which is designed to allow a utility an opportunity to recover its cost of providing service and to earn a reasonable return on its investment used in providing that service. The cost of service generally reflects operating expenses, including operation and maintenance expense, depreciation expense and taxes. Utility commissions periodically adjust rates pursuant to a review of: (a) a utility’s adjusted revenues and expenses during a defined test period and (b) such utility’s level of investment. +23 +FERC +The FERC regulates rates for transmission of electric power, accounting and other matters. The FERC regulations require AEP to provide open access transmission service at FERC-approved rates, and it has approved cost-based formula transmission rates on file at the FERC. The FERC also regulates unbundled transmission service to retail customers. The FERC requires each public utility that owns or controls interstate transmission facilities to, directly or through an RTO, file an open access network and point-to-point transmission tariff that offers services comparable to the utility’s own uses of its transmission system. The FERC also requires all transmitting utilities, directly or through an RTO, to establish an Open Access Same-time Information System, which electronically posts transmission information such as available capacity and prices, and requires utilities to comply with Standards of Conduct that prohibit utilities’ transmission employees from providing non-public transmission information to the utility’s marketing employees. In addition, both the FERC and state regulators are permitted to review the books and records of any company within a holding company system. Additionally, the transmission and distribution utility subsidiaries are subject to reliability standards as set forth by the North American Electric Reliability Corporation, with the approval of the FERC. +SEASONALITY +The delivery of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months. In other areas, power demand peaks during the winter months. The pattern of this fluctuation may change due to the nature and location of AEP’s transmission and distribution facilities. In addition, AEP transmission and distribution has historically delivered less power, and consequently earned less income, when weather conditions are milder. In Texas, and to a lesser extent, in Ohio, where there is residential decoupling, unusually mild weather in the future could diminish AEP’s results of operations. Conversely, unusually extreme weather conditions could increase AEP’s results of operations. +24 +AEP TRANSMISSION HOLDCO +GENERAL +AEPTHCo is a holding company for (a) AEPTCo, which is the direct holding company for the State Transcos and (b) AEP’s Transmission Joint Ventures. +AEPTCo +AEPTCo wholly owns the State Transcos: +• +AEP Appalachian Transmission Company, Inc. (APTCo) +• +AEP Indiana Michigan Transmission Company, Inc. (IMTCo) +• +AEP Kentucky Transmission Company, Inc. (KTCo) +• +AEP Ohio Transmission Company, Inc. (OHTCo) +• +AEP West Virginia Transmission Company, Inc. (WVTCo) +• +AEP Oklahoma Transmission Company, Inc. (OKTCo) +• +AEP Southwestern Transmission Company, Inc. (SWTCo) +The State Transcos are independent of, but respectively overlay, the following AEP electric utility operating companies: APCo, I&M, KPCo, KGPCo, OPCo, PSO, SWEPCo, and WPCo. The State Transcos develop, own, operate, and maintain their respective transmission assets. Assets of the State Transcos interconnect to transmission facilities owned by the aforementioned operating companies and nonaffiliated transmission owners within the footprints of PJM, MISO and SPP. APTCo, IMTCo, KTCo, OHTCo, and WVTCo are located within PJM. IMTCo also owns portions of the Greentown station assets located in MISO. OKTCo and SWTCo are located within SPP. +IMTCo, KTCo, OHTCo, OKTCo, and WVTCo own and operate transmission assets in their respective jurisdictions. In December 2016, the Virginia SCC and WVPSC granted consent for APCo and APTCo to enter into a joint license agreement that will support APTCo investment in the state of Tennessee. SWTCo does not currently own or operate transmission assets. +The State Transcos are regulated for rate-making purposes exclusively by the FERC and earn revenues through tariff rates charged for the use of their electric transmission systems. The State Transcos establish transmission rates each year through formula rate filings with the FERC. The rate filings calculate the revenue requirement needed to cover the costs of operation and debt service and to earn an allowed ROE. These rates are then included in an OATT for PJM, MISO and SPP. +The State Transcos own, operate, maintain and invest in transmission infrastructure in order to maintain and enhance system integrity and grid reliability, grid security, safety, reduce transmission constraints and facilitate interconnections of new generating resources and new wholesale customers, as well as enhance competitive wholesale electricity markets. A key part of AEP’s business is replacing and upgrading transmission facilities, assets and components of the existing AEP System as needed to maintain reliability. +The State Transcos provide the capability to replace and upgrade existing facilities. As of December 31, 2018 , the State Transcos had $6.7 billion of transmission and other assets in-service with plans to construct approximately $4.5 billion of additional transmission assets through 2021. Additional investment in transmission infrastructure is needed within PJM and SPP to maintain the required level of grid reliability, resiliency, security and efficiency and to address an aging transmission infrastructure. Additional transmission facilities will be needed based on changes in generating resources, such as wind or solar projects, generation additions or retirements, and additional new customer interconnections. The State Transcos will continue their investment to enhance physical and cyber security of assets, and are also investing in improving the telecommunication network that supports the operation and control of the grid. +25 +AEPTHCO JOINT VENTURE INITIATIVES +AEP has established joint ventures with other electric utility companies for the purpose of developing, building, and owning transmission assets that seek to improve reliability and market efficiency and provide transmission access to remote generation sources in North America (Transmission Joint Ventures). +The Transmission Joint Ventures currently include: +Joint Venture Name +Location +Projected or Actual Completion Date +Owners +(Ownership %) +Total Estimated/Actual Project Costs at Completion +Approved Return on Equity +(in millions) +ETT +Texas +(a) +Berkshire Hathaway +$ +3,310.9 +(a) +9.6 +% +(ERCOT) +Energy (50%) +AEP (50%) +Prairie Wind +Kansas +2014 +Westar Energy (50%) +158.0 +12.8 +% +Berkshire Hathaway Energy (25%) +AEP (25%) (b) +Pioneer +Indiana +2018 +Duke Energy (50%) +187.4 +10.82 +% +AEP (50%) +Transource +Missouri +2016 +Evergy, Inc. +310.5 +11.2 +% +(d) +Missouri +(13.5%) (c) +AEP (86.5%) (c) +Transource +West +2019 +Evergy, Inc. +78.1 +10.5 +% +West Virginia +Virginia +(13.5%) (c) +AEP (86.5%) (c) +Transource +Maryland +2020 +Evergy, Inc. +25.0 +(e) +10.4 +% +(f) +Maryland +(13.5%) (c) +AEP (86.5%) (c) +Transource +Pennsylvania +2020 +Evergy, Inc. +192.0 +(e) +10.4 +% +(f) +Pennsylvania +(13.5%) (c) +AEP (86.5%) (c) +(a) +ETT is undertaking multiple projects and the completion dates will vary for those projects. ETT’s investment in completed, current and future projects in ERCOT over the next ten years is expected to be $3.3 billion. Future projects will be evaluated on a case-by-case basis. +(b) +AEP owns 25% of Prairie Wind Transmission, LLC (Prairie Wind) through its ownership interest in Electric Transmission America, LLC. which is a 50/50 joint venture with Berkshire Hathaway Energy (formerly known as MidAmerican Energy) and AEP. +(c) +AEP owns 86.5% of Transource Missouri, Transource West Virginia, Transource Maryland and Transource Pennsylvania through its ownership interest in Transource Energy, LLC (Transource). Transource is a joint venture with AEPTHCo and Evergy, Inc. formed to pursue competitive transmission projects. AEPTHCo and Evergy, Inc. own 86.5% and 13.5% of Transource, respectively. +(d) +The ROE represents the weighted average approved ROE based on the costs of two projects developed by Transource Missouri; the $64 million Iatan-Nashua project (10.3%) and the $247 million Sibley-Nebraska City project (11.3%). +(e) +In August 2016, Transource Maryland and Transource Pennsylvania received approval from the PJM Interconnection Board to construct portions of a transmission project located in both Maryland and Pennsylvania. The project is expected to go in service in 2020. Project costs are in 2018 dollars. +(f) +In January 2018, Transource Maryland and Transource Pennsylvania received FERC approval of a settlement authorizing an ROE of 10.4%. This reflects a 9.9% base plus 0.5% RTO participation adder. +Transource Missouri, Transource West Virginia, Transource Maryland and Transource Pennsylvania are consolidated joint ventures by AEP. All other joint ventures in the table above are not consolidated by AEP. AEP’s joint ventures do not have employees. Business services for the joint ventures are provided by AEPSC and other AEP subsidiaries and the joint venture partners. During 2018 , approximately 537 AEPSC employees and 283 operating company employees provided service to one or more joint ventures. +26 +REGULATION +The State Transcos and the Transmission Joint Ventures located outside of ERCOT establish transmission rates annually through forward looking formula rate filings with the FERC pursuant to FERC-approved implementation protocols. The protocols include a transparent, formal review process to ensure the updated transmission rates are prudently incurred and reasonably calculated. The IMTCo-owned Greentown station assets acquired from Duke Energy Indiana, LLC in December 2018 are located in MISO. IMTCo plans to utilize historic costs for recovery. +The State Transcos’ and the Transmission Joint Ventures’ (where applicable) rates are included in the respective OATT for PJM and SPP. An OATT is the FERC rate schedule that provides the terms and conditions for transmission and related services on a transmission provider’s transmission system. The FERC requires transmission providers such as PJM and SPP to offer transmission service to all eligible customers (for example, load-serving entities, power marketers, generators and customers) on a non-discriminatory basis. +The FERC-approved formula rates establish the annual transmission revenue requirement (ATRR) and transmission service rates for transmission owners in annual rate base filings with the FERC. The formula rates establish rates for a one-year period based on the current projects in-service and proposed projects for a defined timeframe. The formula rates also include a true-up calculation for the previous year’s billings, allowing for over/under-recovery of the transmission owner’s ATRR. PJM and SPP pay the transmission owners their ATRR for use of their facilities and bill transmission customers taking service under the PJM and SPP OATTs, based on the terms and conditions in the respective OATT for the service taken. Additionally, the State Transcos are subject to reliability standards promulgated by the North American Electric Reliability Corporation, with the approval of the FERC. +AEP’s transmission owning subsidiaries within PJM and six of the complainants filed a settlement agreement with the FERC, which is awaiting FERC approval. The pending formula rate mechanism allows for a total ROE of 10.35% based on a capital structure of up to 55% equity for APTCo, IMTCo, KTCo, OHTCo and WVTCo (the East Transcos). OKTCo and SWTCo (the West Transcos) are allowed a ROE of 11.2% without a cap on the capital structure. The authorized returns on equity for the State Transcos are the FERC-authorized returns on equity in the PJM and SPP OATTs, respectively. These returns have been challenged by parties in filings before the FERC. The West Transcos’ case is ongoing. +In the annual rate base filings described above, the State Transcos in aggregate filed rate base totals of $4.6 billion for 2018 , $3.8 billion for 2017 and $3.2 billion for 2016 . The total transmission revenue requirements filed in the ATRR, including prior year over/under-recovery of revenue and associated carrying charges, for 2018 , 2017 , and 2016 was $829 million, $690 million and $555 million, respectively. +The rates of ETT, which is located in ERCOT, are determined by the PUCT. ETT sets its rates through a combination of base rate cases and interim Transmission Cost of Services (TCOS) filings. ETT may file interim TCOS filings semi-annually to update its rates to reflect changes in its net invested capital. +The Transmission Joint Ventures have approved ROEs ranging from 9.6% to 12.8% based on equity capital structures ranging from 40% to 60%. +27 +GENERATION & MARKETING +GENERAL +The AEP Generation & Marketing segment subsidiaries consist of competitive generating assets, a wholesale energy trading and marketing business and a retail supply and energy management business. The primary fossil generation subsidiary in the Generation & Marketing segment is AGR. In January 2017, AGR sold 4,143 MWs of generation capacity to a nonaffiliated third-party and terminated a 1,186 MW UPA. As of December 31, 2018 , AGR owns 2,114 MWs of generating capacity. Management plans to close 39% of this generation capacity in May 2019 and 31% in May 2020. 28% of this generating capacity is operated by Buckeye Power, a nonaffiliated electric cooperative. Other subsidiaries in this segment own or have the right to receive power from additional generation assets. See Item 2 – Properties for more information regarding the generation assets of the Generation & Marketing segment. AGR is a competitive generation subsidiary. +With respect to the wholesale energy trading and marketing business, AEP Generation & Marketing segment subsidiaries enter into short-term and long-term transactions to buy or sell capacity, energy and ancillary services in ERCOT, SPP, MISO and PJM. These subsidiaries sell power into the market and engage in power, natural gas and emissions allowances risk management and trading activities. +These activities primarily involve the purchase-and-sale of electricity (and to a lesser extent, natural gas and emissions allowances) under forward contracts at fixed and variable prices. These contracts include physical transactions, exchange-traded futures, and to a lesser extent, OTC swaps and options. The majority of forward contracts are typically settled by entering into offsetting contracts. These transactions are executed with numerous counterparties or on exchanges. +With respect to the retail supply and energy management business, AEP Energy is a retail energy supplier that supplies electricity and/or natural gas to residential, commercial, and industrial customers. AEP Energy provides various energy solutions in Illinois, Pennsylvania, Delaware, Maryland, New Jersey, Ohio and Washington, D.C. AEP Energy also provides demand-side management solutions nationwide. AEP Energy had approximately 415,000 customer accounts as of December 31, 2018 . +AEP Energy Supply, LLC owns 261 MWs of wind capacity in Texas. AEP Renewables, LLC develops and/or acquires large scale renewable projects backed with long-term contracts with creditworthy counterparties. As of December 2018, AEP Renewables, LLC owns a 20 MW solar project in California, a 20 MW solar project in Utah and a 50 MW solar project in Nevada. In December 2018, AEP Renewables, LLC entered into an agreement to own an additional 227 MW of Texas wind capacity which is expected to be placed in-service in mid-2019. +AEP OnSite Partners, LLC works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. The company targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners, LLC pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2018, AEP OnSite Partners, LLC owned projects operating in 15 states, including approximately 85 MWs of installed solar capacity, and approximately 57 MWs of solar projects under construction. +In February 2019, AEP Clean Energy Resources, LLC signed an agreement to purchase Sempra Renewables, LLC and its 724 MWs of wind generation and battery assets for approximately $1.1 billion, subject to closing and working capital adjustments. As part of the purchase price, AEP Clean Energy Resources, LLC will pay $551 million in cash and assume $343 million of existing project debt obligations of the non-consolidated joint ventures. Additionally, the acquisition will be accompanied by the recognition of non-controlling tax equity interest of $162 million associated with certain of the acquired wind farms. The wind generation portfolio includes seven wholly or jointly-owned wind farms with long-term PPAs for 100% of their energy production. The transaction is expected to close in mid-2019 and is subject to regulatory approvals from the FERC and federal clearance pursuant to the Hart-Scott-Rodino Antitrust Improvements Act of 1976. +28 +REGULATION +AGR is a public utility under the Federal Power Act, and is subject to the FERC’s exclusive ratemaking jurisdiction over wholesale sales of electricity and the transmission of electricity in interstate commerce. Under the Federal Power Act, the FERC has the authority to grant or deny market-based rates for sales of energy, capacity and ancillary services to ensure that such sales are just and reasonable. The FERC granted AGR market-based rate authority in December 2013. The FERC’s jurisdiction over ratemaking also includes the authority to suspend the market-based rates of AGR and set cost-based rates if the FERC subsequently determines that it can exercise market power, create barriers to entry or engage in abusive affiliate transactions. Periodically, AGR is required to file a market power update to show that it continues to meet the FERC’s standards with respect to generation market power and other criteria used to evaluate whether it continues to qualify for market-based rates. Other matters subject to the FERC jurisdiction include, but are not limited to, review of mergers, and dispositions of jurisdictional facilities and acquisitions of securities of another public utility or an existing operational generating facility. +Specific operations of AGR are also subject to the jurisdiction of various other federal, state, regional and local agencies, including federal and state environmental protection agencies. AGR is also regulated by the PUCT for transactions inside ERCOT. Additionally, AGR is subject to mandatory reliability standards promulgated by the North American Electric Reliability Corporation, with the approval of the FERC. +COMPETITION +The AEP Generation & Marketing segment subsidiaries face competition for the sale of available power, capacity and ancillary services. The principal factors of impact are electricity and fuel prices, new market entrants, construction or retirement of generating assets by others and technological advances in power generation. Because most of AGR’s remaining generation is coal-fired, lower relative natural gas prices will favor competitors that have a higher concentration of natural gas fueled generation. Other factors impacting competitiveness include environmental regulation, transmission congestion or transportation constraints at or near generation facilities, inoperability or inefficiencies, outages and deactivations and retirements at generation facilities. +Technology advancements, increased demand for clean energy, changing consumer behaviors, low-priced and abundant natural gas, and regulatory and public policy reforms are among the catalysts for transformation within the industry that impact competition for AEP’s Generation & Marketing segment. AGR also competes with self-generation and with distributors of other energy sources, such as natural gas, fuel oil, renewables and coal, within their service areas. The primary factors in such competition are price, unit availability and the capability of customers to utilize sources of energy other than electric power. +Changes in regulatory policies and advances in newer technologies for batteries or energy storage, fuel cells, microturbines, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production. The ability to maintain relatively low cost, efficient and reliable operations and to provide cost-effective programs and services to customers are significant determinants of AGR’s competitiveness. The costs of photovoltaic solar cells in particular have continued to become increasingly competitive. +In the event that alternative generation resources are mandated, subsidized or encouraged through climate legislation or regulation or otherwise are economically competitive and added to the available generation supply, such resources could displace a higher marginal cost fossil plant, which could reduce the price at which market participants sell their electricity. These events could cause AGR to retire generating capacity prior to the end of its estimated useful life. +This segment’s retail operations provide competitive electricity and natural gas in deregulated retail energy markets in six states and Washington, D.C. Each such retail choice jurisdiction establishes its own laws and regulations governing its competitive market, and public utility commission communications and utility default service pricing can affect customer participation in retail competition. Sustained low natural gas and power prices, low market volatility and maturing competitive environments can adversely affect this business. +This segment also engages in procuring and selling output from renewable generation sources under long-term contracts to creditworthy counterparties. New sources are not acquired without first securing a long-term placement of such +29 +power. Existing sources do not face competitive exposure. Competitive nonaffiliated suppliers of renewable or other generation could limit opportunities for future transactions for new sources and related output contracts. +SEASONALITY +The consumption of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter months. The pattern of this fluctuation may change. +Fuel Supply +The following table shows the generation sources by type, on an actual net generation (MWhs) basis, used by the Generation & Marketing segment, not including AEP Energy Partners’ offtake agreement from the Oklaunion Power Station: +2018 +2017 +2016 +Coal +88% +85% +62% +Natural Gas +—% +8% +36% +Renewables +12% +7% +2% +Coal and Consumables +AGR procures coal and consumables needed to burn the coal under a combination of purchasing arrangements including long-term and spot contracts with various producers and coal trading firms. As contracts expire, they are replaced, as needed, with contracts at market prices. Coal and consumable inventories remain adequate to meet generation requirements. +Management believes that AGR will be able to secure and transport coal and consumables of adequate quality and in adequate quantities to operate their coal fired units. AGR, through its contracts with third party transporters, has the ability to adequately move and store coal and consumables for use in its generating facilities. AGR plants consumed 3 million tons of coal in 2018 . +The coal supplies at AGR plants vary from time to time depending on various factors, including, but not limited to, demand for electric power, unit outages, transportation infrastructure limitations, space limitations, plant coal consumption rates, coal quality, availability of acceptable coals, labor issues and weather conditions, which may interrupt production or deliveries. AGR aims to maintain the coal inventory of its managed plants in the range of 15 to 40 days of full load burn. As of December 31, 2018 , the coal inventory of AGR was within the target range. +Counterparty Risk Management +Counterparties and exchanges may require cash or cash related instruments to be deposited on these transactions as margin against open positions. As of December 31, 2018 , counterparties posted approximately $22 million in cash, cash equivalents or letters of credit with AEP for the benefit of AEP’s Generation & Marketing segment subsidiaries (while, as of that date, AEP’s Generation & Marketing segment subsidiaries posted approximately $101 million with counterparties and exchanges). Since open trading contracts are valued based on market prices of various commodities, exposures change daily. See the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Certain Power Agreements +As of December 31, 2018 , the assets utilized in this segment included approximately 261 MWs of company-owned domestic wind power facilities, 177 MWs of domestic wind power from long-term purchase power agreements and 355 MWs of coal-fired capacity which was obtained through an agreement effective through 2027 that transfers the interest of AEP Texas in the Oklaunion Power Station to AEPEP. Management has announced plans to close Oklaunion Power Station by October 2020. The power obtained from the Oklaunion Power Station is marketed and sold in ERCOT. +30 +EXECUTIVE OFFICERS OF AEP +The following persons are executive officers of AEP. Their ages are given as of February 21, 2019 . The officers are appointed annually for a one-year term by the board of directors of AEP. +Nicholas K. Akins +Chairman of the Board, President and Chief Executive Officer +Age 58 +Chairman of the Board since January 2014, President since January 2011 and Chief Executive Officer since November 2011. +Lisa M. Barton +Executive Vice President - Utilities +Age 53 +Executive Vice President - Transmission from August 2011 to December 2018. +Paul Chodak, III +Executive Vice President - Generation +Age 55 +Executive Vice President - Utilities from January 2017 to December 2018. President and Chief Operating Officer of I&M from July 2010 to December 2016. +David M. Feinberg +Executive Vice President, General Counsel and Secretary +Age 49 +Executive Vice President since January 2013. +Lana L. Hillebrand +Executive Vice President and Chief Administrative Officer +Age 58 +Chief Administrative Officer since December 2012 and Senior Vice President from December 2012 to December 2016. +Mark C. McCullough +Executive Vice President - Transmission +Age 59 +Executive Vice President - Generation from January 2011 to December 2018. +Charles R. Patton +Executive Vice President - External Affairs +Age 59 +Executive Vice President - External Affairs since January 2017. President and Chief Operating Officer of APCo from June 2010 to December 2016. +Brian X. Tierney +Executive Vice President and Chief Financial Officer +Age 51 +Executive Vice President and Chief Financial Officer since October 2009. +Charles E. Zebula +Executive Vice President - Energy Supply +Age 58 +Executive Vice President - Energy Supply since January 2013. +31 +ITEM 1A. RISK FACTORS +GENERAL RISKS OF REGULATED OPERATIONS +AEP may not be able to recover the costs of substantial planned investment in capital improvements and additions. (Applies to all Registrants) +AEP’s business plan calls for extensive investment in capital improvements and additions, including the installation of environmental upgrades and retrofits, construction of additional transmission facilities, modernizing existing infrastructure as well as other initiatives. AEP’s public utility subsidiaries currently provide service at rates approved by one or more regulatory commissions. If these regulatory commissions do not approve adjustments to the rates charged, affected AEP subsidiaries would not be able to recover the costs associated with their investments. This would cause financial results to be diminished. +Regulated electric revenues and earnings are dependent on federal and state regulation that may limit AEP’s ability to recover costs and other amounts. (Applies to all Registrants) +The rates customers pay to AEP regulated utility businesses are subject to approval by the FERC and the respective state utility commissions of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. In certain instances, AEP’s applicable regulated utility businesses may agree to negotiated settlements related to various rate matters that are subject to regulatory approval. AEP cannot predict the ultimate outcomes of any settlements or the actions by the FERC or the respective state commissions in establishing rates. +If regulated utility earnings exceed the returns established by the relevant commissions, retail electric rates may be subject to review and possible reduction by the commissions, which may decrease future earnings. Additionally, if regulatory bodies do not allow recovery of costs incurred in providing service on a timely basis, it could reduce future net income and cash flows and negatively impact financial condition. Similarly, if recovery or other rate relief authorized in the past is overturned or reversed on appeal, future earnings could be negatively impacted. Any regulatory action or litigation outcome that triggers a reversal of a regulatory asset or deferred cost generally results in an impairment to the balance sheet and a charge to the income statement of the company involved. See Note 4 – Rate Matters included in the 2018 Annual Report for additional information. +AEP’s transmission investment strategy and execution are dependent on federal and state regulatory policy. (Applies to all Registrants) +A significant portion of AEP’s earnings is derived from transmission investments and activities. FERC policy currently favors the expansion and updating of the transmission infrastructure within its jurisdiction. If the FERC were to adopt a different policy, if states were to limit or restrict such policies, or if transmission needs do not continue or develop as projected, AEP’s strategy of investing in transmission could be impacted. Management believes AEP’s experience with transmission facilities construction and operation gives AEP an advantage over other competitors in securing authorization to install, construct and operate new transmission lines and facilities. However, there can be no assurance that PJM, SPP, ERCOT or other RTOs will authorize new transmission projects or will award such projects to AEP. +Certain elements of AEP’s transmission formula rates have been challenged, which could result in lowered rates and/or refunds of amounts previously collected and thus have an adverse effect on AEP’s business, financial condition, results of operations and cash flows. (Applies to all Registrants other than AEP Texas) +AEP provides transmission service under rates regulated by the FERC. The FERC has approved the cost-based formula rate templates used by AEP to calculate its respective annual revenue requirements, but it has not expressly approved the amount of actual capital and operating expenditures to be used in the formula rates. All aspects of AEP’s rates accepted or approved by the FERC, including the formula rate templates, the rates of return on the actual equity portion of its respective capital structures and the approved targeted capital structures, are subject to challenge by interested parties at the FERC, or by the FERC on its own initiative. In addition, interested parties may challenge the annual +32 +implementation and calculation by AEP of its projected rates and formula rate true up pursuant to its approved formula rate templates under AEP’s formula rate implementation protocols. If a challenger can establish that any of these aspects are unjust, unreasonable, unduly discriminatory or preferential, then the FERC will make appropriate prospective adjustments to them and/or disallow any of AEP’s inclusion of those aspects in the rate setting formula. +Parties have challenged AEP’s formula rates in proceedings at the FERC. If the FERC orders revenue reductions as a result of these or other complaints, including refunds from the date of any complaint filing, it could reduce future net income and cash flows and impact financial condition. +End-use consumers and entities supplying electricity to end-use consumers may also attempt to influence government and/or regulators to change the rate setting methodologies that apply to AEP, particularly if rates for delivered electricity increase substantially. +Changes in technology and regulatory policies may lower the value of electric utility facilities and franchises. (Applies to all Registrants) +AEP primarily generates electricity at large central facilities and delivers that electricity to customers over its transmission and distribution facilities to customers usually situated within an exclusive franchise. This method results in economies of scale and generally lower costs than newer technologies such as fuel cells and microturbines, and distributed generation using either new or existing technology. Other technologies, such as light emitting diodes (LEDs), increase the efficiency of electricity and, as a result, lower the demand for it. Changes in regulatory policies and advances in batteries or energy storage, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production and delivery. These developments can challenge AEP’s competitive ability to maintain relatively low cost, efficient and reliable operations, to establish fair regulatory mechanisms and to provide cost-effective programs and services to customers. Further, in the event that alternative generation resources are mandated, subsidized or encouraged through legislation or regulation or otherwise are economically competitive and added to the available generation supply, such resources could displace a higher marginal cost generating units, which could reduce the price at which market participants sell their electricity. +AEP may not recover costs incurred to begin construction on projects that are canceled. (Applies to all Registrants) +AEP’s business plan for the construction of new projects involves a number of risks, including construction delays, nonperformance by equipment and other third-party suppliers, and increases in equipment and labor costs. To limit the risks of these construction projects, AEP’s subsidiaries enter into equipment purchase orders and construction contracts and incur engineering and design service costs in advance of receiving necessary regulatory approvals and/or siting or environmental permits. If any of these projects are canceled for any reason, including failure to receive necessary regulatory approvals and/or siting or environmental permits, significant cancellation penalties under the equipment purchase orders and construction contracts could occur. In addition, if any construction work or investments have been recorded as an asset, an impairment may need to be recorded in the event the project is canceled. +AEP is exposed to nuclear generation risk. (Applies to AEP and I&M) +I&M owns the Cook Plant, which consists of two nuclear generating units for a rated capacity of 2,278 MWs, or about 7% of the generating capacity in the AEP System. AEP and I&M are, therefore, subject to the risks of nuclear generation, which include the following: +• +The potential harmful effects on the environment and human health due to an adverse incident/event resulting from the operation of nuclear facilities and the storage, handling and disposal of radioactive materials such as SNF. +• +Limitations on the amounts and types of insurance commercially available to cover losses that might arise in connection with nuclear operations. +33 +• +Uncertainties with respect to contingencies and assessment amounts triggered by a loss event (federal law requires owners of nuclear units to purchase the maximum available amount of nuclear liability insurance and potentially contribute to the coverage for losses of others). +• +Uncertainties with respect to the technological and financial aspects of decommissioning nuclear plants at the end of their licensed lives. +There can be no assurance that I&M’s preparations or risk mitigation measures will be adequate if these risks are triggered. +The NRC has broad authority under federal law to impose licensing and safety-related requirements for the operation of nuclear generation facilities. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. Revised safety requirements promulgated by the NRC could necessitate substantial capital expenditures at nuclear plants. In addition, although management has no reason to anticipate a serious nuclear incident at the Cook Plant, if an incident did occur, it could harm results of operations or financial condition. A major incident at a nuclear facility anywhere in the world could cause the NRC to limit or prohibit the operation or licensing of any domestic nuclear unit. Moreover, a major incident at any nuclear facility in the U.S. could require AEP or I&M to make material contributory payments. +Costs associated with the operation (including fuel), maintenance and retirement of nuclear plants continue to be more significant and less predictable than costs associated with other sources of generation, in large part due to changing regulatory requirements and safety standards, availability of nuclear waste disposal facilities and experience gained in the operation of nuclear facilities. Costs also may include replacement power, any unamortized investment at the end of the useful life of the Cook Plant (whether scheduled or premature), the carrying costs of that investment and retirement costs. The ability to obtain adequate and timely recovery of costs associated with the Cook Plant is not assured. +AEP subsidiaries are exposed to risks through participation in the market and transmission structures in various regional power markets that are beyond their control. (Applies to all Registrants) +Results are likely to be affected by differences in the market and transmission structures in various regional power markets. The rules governing the various RTOs, including SPP and PJM, may also change from time to time which could affect costs or revenues. Existing, new or changed rules of these RTOs could result in significant additional fees and increased costs to participate in those structures, including the cost of transmission facilities built by others due to changes in transmission rate design. In addition, these RTOs may assess costs resulting from improved transmission reliability, reduced transmission congestion and firm transmission rights. As members of these RTOs, AEP’s subsidiaries are subject to certain additional risks, including the allocation among existing members, of losses caused by unreimbursed defaults of other participants in these markets and resolution of complaint cases that may seek refunds of revenues previously earned by members of these markets. +AEP could be subject to higher costs and/or penalties related to mandatory reliability standards. (Applies to all Registrants) +Owners and operators of the bulk power transmission system are subject to mandatory reliability standards promulgated by the North American Electric Reliability Corporation and enforced by the FERC. The standards are based on the functions that need to be performed to ensure the bulk power system operates reliably and are guided by reliability and market interface principles. Compliance with new reliability standards may subject AEP to higher operating costs and/or increased capital expenditures. While management expects to recover costs and expenditures from customers through regulated rates, there can be no assurance that the applicable commissions will approve full recovery in a timely manner. If AEP were found not to be in compliance with the mandatory reliability standards, AEP could be subject to sanctions, including substantial monetary penalties, which likely would not be recoverable from customers through regulated rates. +34 +A substantial portion of the receivables of AEP Texas is concentrated in a small number of REPs, and any delay or default in payment could adversely affect its cash flows, financial condition and results of operations. (Applies to AEP and AEP Texas) +AEP Texas collects receivables from the distribution of electricity from REPs that supply the electricity it distributes to its customers. As of December 31, 2018 , AEP Texas did business with approximately 124 REPs. Adverse economic conditions, structural problems in the market served by ERCOT or financial difficulties of one or more REPs could impair the ability of these REPs to pay for these services or could cause them to delay such payments. AEP Texas depends on these REPs to remit payments on a timely basis. Applicable regulatory provisions require that customers be shifted to another REP or a provider of last resort if a REP cannot make timely payments. Applicable PUCT regulations significantly limit the extent to which AEP Texas can apply normal commercial terms or otherwise seek credit protection from firms desiring to provide retail electric service in its service territory, and AEP Texas thus remains at risk for payments related to services provided prior to the shift to another REP or the provider of last resort. In 2018 , AEP Texas’ first, second and third largest REPs accounted for 19%, 15% and 11%, respectively, of its operating revenue. Any delay or default in payment by REPs could adversely affect cash flows, financial condition and results of operations. If a REP were unable to meet its obligations, it could consider, among various options, restructuring under the bankruptcy laws, in which event such REP might seek to avoid honoring its obligations, and claims might be made by creditors involving payments AEP Texas had received from such REP. +RISKS RELATED TO MARKET, ECONOMIC OR FINANCIAL VOLATILITY AND OTHER RISKS +AEP’s financial performance may be adversely affected if AEP is unable to successfully operate facilities or perform certain corporate functions. (Applies to all Registrants) +Performance is highly dependent on the successful operation of generation, transmission and/or distribution facilities. Operating these facilities involves many risks, including: +• +Operator error and breakdown or failure of equipment or processes. +• +Operating limitations that may be imposed by environmental or other regulatory requirements. +• +Labor disputes. +• +Compliance with mandatory reliability standards, including mandatory cyber security standards. +• +Information technology failure that impairs AEP’s information technology infrastructure or disrupts normal business operations. +• +Information technology failure that affects AEP’s ability to access customer information or causes loss of confidential or proprietary data that materially and adversely affects AEP’s reputation or exposes AEP to legal claims. +• +Fuel or water supply interruptions caused by transportation constraints, adverse weather such as drought, non-performance by suppliers and other factors. +• +Catastrophic events such as fires, earthquakes, explosions, hurricanes, tornados, ice storms, terrorism (including cyber-terrorism), floods or other similar occurrences. +• +Fuel costs and related requirements triggered by financial stress in the coal industry. +Physical attacks or hostile cyber intrusions could severely impair operations, lead to the disclosure of confidential information and damage AEP’s reputation. (Applies to all Registrants) +AEP and its regulated utility businesses face physical security and cybersecurity risks as the owner-operators of generation, transmission and/or distribution facilities and as participants in commodities trading. AEP and its regulated utility businesses own assets deemed as critical infrastructure, the operation of which is dependent on information technology systems. Further, the computer systems that run these facilities are not completely isolated from external networks. Parties that wish to disrupt the U.S. bulk power system or AEP operations could view these computer systems, software or networks as targets for cyber attack. In addition, the electric utility business requires the collection of sensitive customer data, as well as confidential employee and shareholder information, which is subject to electronic theft or loss. +35 +A security breach of AEP or its regulated utility businesses’ physical assets or information systems, interconnected entities in RTOs, or regulators could impact the operation of the generation fleet and/or reliability of the transmission and distribution system or subject AEP and its regulated utility businesses to financial harm associated with theft or inappropriate release of certain types of information, including sensitive customer, vendor, employee, trading or other confidential data. A successful cyber attack on the systems that control generation, transmission, distribution or other assets could severely disrupt business operations, preventing service to customers or collection of revenues. The breach of certain business systems could affect the ability to correctly record, process and report financial information. A major cyber incident could result in significant expenses to investigate and repair security breaches or system damage and could lead to litigation, fines, other remedial action, heightened regulatory scrutiny and damage to AEP’s reputation. In addition, the misappropriation, corruption or loss of personally identifiable information and other confidential data could lead to significant breach notification expenses and mitigation expenses such as credit monitoring. For these reasons, a significant cyber incident could reduce future net income and cash flows and negatively impact financial condition. +If AEP is unable to access capital markets on reasonable terms, it could reduce future net income and cash flows and negatively impact financial condition. (Applies to all Registrants) +AEP relies on access to capital markets as a significant source of liquidity for capital requirements not satisfied by operating cash flows. Volatility, increased interest rates and reduced liquidity in the financial markets could affect AEP’s ability to raise capital on reasonable terms to fund capital needs, including construction costs and refinancing maturing indebtedness. Certain sources of debt and equity capital expressed increasing unwillingness to invest in companies, such as AEP, that rely on fossil fuels. If sources of capital for AEP are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could reduce future net income and cash flows and negatively impact financial condition. +The potential phasing out of LIBOR after 2021 may adversely affect the costs and availability of financing. (Applies to all Registrants) +A portion of the Registrants’ indebtedness bears interest at fluctuating interest rates, primarily based on the London interbank offered rate (“LIBOR”) for deposits of U.S. dollars. LIBOR tends to fluctuate based on general interest rates, rates set by the U.S. Federal Reserve and other central banks, the supply of and demand for credit in the London interbank market and general economic conditions. AEP has not hedged its interest rate exposure with respect to its floating rate debt. Accordingly, Registrants’ interest expense for any particular period will fluctuate based on LIBOR and other variable interest rates. On July 27, 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, is considering replacing U.S. dollar LIBOR with a newly created index, calculated based on repurchase agreements backed by treasury securities. It is not possible to predict the effect of these changes, other reforms or the establishment of alternative reference rates in the United Kingdom, the United States or elsewhere. To the extent these interest rates increase, interest expense will increase. If sources of capital for the Registrants are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could reduce future net income and cash flows and negatively impact financial condition and/or liquidity. +Downgrades in AEP’s credit ratings could negatively affect its ability to access capital. (Applies to all Registrants) +The credit ratings agencies periodically review AEP’s capital structure and the quality and stability of earnings and cash flows. Any negative ratings actions could constrain the capital available to AEP and could limit access to funding for operations. AEP’s business is capital intensive, and AEP is dependent upon the ability to access capital at rates and on terms management determines to be attractive. If AEP’s ability to access capital becomes significantly constrained, AEP’s interest costs will likely increase and could reduce future net income and cash flows and negatively impact financial condition. +36 +AEP has no income or cash flow apart from dividends paid or other payments due from its subsidiaries. (Applies to AEP) +AEP is a holding company and has no operations of its own. Its ability to meet its financial obligations associated with its indebtedness and to pay dividends on its common stock is primarily dependent on the earnings and cash flows of its operating subsidiaries, primarily its regulated utilities, and the ability of its subsidiaries to pay dividends to, or repay loans from, AEP. Its subsidiaries are separate and distinct legal entities that have no obligation (apart from loans from AEP) to provide AEP with funds for its payment obligations, whether by dividends, distributions or other payments. Payments to AEP by its subsidiaries are also contingent upon their earnings and business considerations. AEP indebtedness and common stock dividends are structurally subordinated to all subsidiary indebtedness. +AEP’s operating results may fluctuate on a seasonal or quarterly basis and with general economic and weather conditions. (Applies to all Registrants) +Electric power consumption is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter. As a result, overall operating results in the future may fluctuate substantially on a seasonal basis. In addition, AEP has historically sold less power, and consequently earned less income, when weather conditions are milder. Unusually mild weather in the future could reduce future net income and cash flows and negatively impact financial condition. In addition, unusually extreme weather conditions could impact AEP’s results of operations in a manner that would not likely be sustainable. +Further, deteriorating economic conditions generally result in reduced consumption by customers, particularly industrial customers who may curtail operations or cease production entirely, while an expanding economic environment generally results in increased revenues. As a result, prevailing economic conditions may reduce future net income and cash flows and negatively impact financial condition. +Volatility in the securities markets, interest rates, and other factors could substantially increase defined benefit pension and other postretirement plan costs and the costs of nuclear decommissioning. (Applies to all Registrants and to AEP and I&M with respect to the costs of nuclear decommissioning) +The costs of providing pension and other postretirement benefit plans are dependent on a number of factors, such as the rates of return on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plan, changes in actuarial assumptions, future government regulation, changes in life expectancy, and the frequency and amount of AEP’s required or voluntary contributions made to the plans. Changes in actuarial assumptions and differences between the assumptions and actual values, as well as a significant decline in the value of investments that fund the pension and other postretirement plans, if not offset or mitigated by a decline in plan liabilities, could increase pension and other postretirement expense, and AEP could be required from time to time to fund the pension plan with significant amounts of cash. Such cash funding obligations could have a material impact on liquidity by reducing cash flows and could negatively affect results of operations. +Additionally, I&M holds a significant amount of assets in its nuclear decommissioning trusts to satisfy obligations to decommission its nuclear plant. The rate of return on assets held in those trusts can significantly impact both the costs of decommissioning and the funding requirements for the trusts. +37 +AEP’s results of operations and cash flows may be negatively affected by a lack of growth or slower growth in the number of customers, or decline in customer demand. (Applies to all Registrants) +Growth in customer accounts and growth of customer usage each directly influence demand for electricity and the need for additional power generation and delivery facilities. Customer growth and customer usage are affected by a number of factors outside the control of AEP, such as mandated energy efficiency measures, demand-side management goals, distributed generation resources and economic and demographic conditions, such as population changes, job and income growth, housing starts, new business formation and the overall level of economic activity. +Certain regulatory and legislative bodies have introduced or are considering requirements and/or incentives to further reduce energy consumption. Additionally, technological advances or other improvements in or applications of technology could lead to declines in per capita energy consumption. Some or all of these factors, could impact the demand for electricity. +Failure to attract and retain an appropriately qualified workforce could harm results of operations. (Applies to all Registrants) +Certain events, such as an aging workforce without appropriate replacements, mismatch of skillset or complement to future needs, or unavailability of contract resources may lead to operating challenges and increased costs. The challenges include lack of resources, loss of knowledge and a lengthy time period associated with skill development. In this case, costs, including costs for contractors to replace employees, productivity costs and safety costs, may rise. Failure to hire and adequately train replacement employees, including the transfer of significant internal historical knowledge and expertise to the new employees, or the future availability and cost of contract labor may adversely affect the ability to manage and operate the business. If AEP is unable to successfully attract and retain an appropriately qualified workforce, future net income and cash flows may be reduced. +Changes in the price of commodities, emission allowances for criteria pollutants and the costs of transport may increase AEP’s cost of producing power, impacting financial performance. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +AEP is exposed to changes in the price and availability of fuel (including coal and gas) and the price and availability to transport fuel. AEP has existing contracts of varying durations for the supply of fuel, but as these contracts end or if they are not honored, AEP may not be able to purchase fuel on terms as favorable as the current contracts. Similarly, AEP is exposed to changes in the price and availability of emission allowances. AEP uses emission allowances based on the amount of fuel used and reductions achieved through emission controls and other measures. Based on current environmental programs remaining in effect, AEP has sufficient emission allowances to cover the majority of the projected needs for the next two years and beyond. If the Federal EPA attempts to further reduce interstate transport, and it is acceptable by the courts, additional costs may be incurred either to acquire additional allowances or to achieve further reductions in emissions. If AEP needs to obtain allowances, those purchases may not be on as favorable terms as those under the current environmental programs. AEP’s risks relative to the price and availability to transport coal include the volatility of the price of diesel which is the primary fuel used in transporting coal by barge. +Prices for coal, natural gas and emission allowances have shown material swings in the past. Changes in the cost of fuel, emission allowances or natural gas and changes in the relationship between such costs and the market prices of power could reduce future net income and cash flows and negatively impact financial condition. +In addition, actual power prices and fuel costs will differ from those assumed in financial projections used to value trading and marketing transactions, and those differences may be material. As a result, as those transactions are marked to market, they may impact future results of operations and cash flows and impact financial condition. +38 +AEP is subject to physical and financial risks associated with climate change. (Applies to all Registrants) +Climate change creates physical and financial risk. Physical risks from climate change may include an increase in sea level and changes in weather conditions, such as changes in precipitation and extreme weather events, such as fires. Customers’ energy needs vary with weather conditions, primarily temperature and humidity. For residential customers, heating and cooling represent their largest energy use. To the extent weather conditions are affected by climate change, customers’ energy use could increase or decrease depending on the duration and magnitude of the changes. +Increased energy use due to weather changes may require AEP to invest in additional generating assets, transmission and other infrastructure to serve increased load. Decreased energy use due to weather changes may affect financial condition through decreased revenues. Extreme weather conditions in general require more system backup, adding to costs, and can contribute to increased system stress, including service interruptions. Weather conditions outside of the AEP service territory could also have an impact on revenues. AEP buys and sells electricity depending upon system needs and market opportunities. Extreme weather conditions creating high energy demand on AEP’s own and/or other systems may raise electricity prices as AEP buys short-term energy to serve AEP’s own system, which would increase the cost of energy AEP provides to customers. +Severe weather and weather-related events impact AEP’s service territories, primarily when thunderstorms, tornadoes, hurricanes, fires, floods and snow or ice storms occur. To the extent the frequency and intensity of extreme weather events and storms increase, AEP’s cost of providing service will increase, and these costs may not be recoverable. Changes in precipitation resulting in droughts, water shortages or floods could adversely affect operations, principally the fossil fuel generating units. A negative impact to water supplies due to long-term drought conditions or severe flooding could adversely impact AEP’s ability to provide electricity to customers, as well as increase the price they pay for energy. AEP may not recover all costs related to mitigating these physical and financial risks. +To the extent climate change impacts a region’s economic health, it may also impact revenues. AEP’s financial performance is tied to the health of the regional economies AEP serves. The price of energy, as a factor in a region’s cost of living as well as an important input into the cost of goods and services, has an impact on the economic health of the communities within the AEP System. +Management cannot predict the outcome of the legal proceedings relating to AEP’s business activities. (Applies to all Registrants) +AEP is involved in legal proceedings, claims and litigation arising out of its business operations, the most significant of which are summarized in Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report. Adverse outcomes in these proceedings could require significant expenditures that could reduce future net income and cash flows and negatively impact financial condition. +Disruptions at power generation facilities owned by third-parties could interrupt the sales of transmission and distribution services. (Applies to AEP and AEP Texas) +AEP Texas transmits and distributes electric power that the REPs obtain from power generation facilities owned by third-parties. If power generation is disrupted or if power generation capacity is inadequate, sales of transmission and distribution services may be diminished or interrupted, and results of operations, financial condition and cash flows could be adversely affected. +39 +Hazards associated with high-voltage electricity transmission may result in suspension of AEP’s operations or the imposition of civil or criminal penalties. (Applies to all Registrants) +AEP operations are subject to the usual hazards associated with high-voltage electricity transmission, including explosions, fires, inclement weather, natural disasters, mechanical failure, unscheduled downtime, equipment interruptions, remediation, chemical spills, discharges or releases of toxic or hazardous substances or gases and other environmental risks. The hazards can cause personal injury and loss of life, severe damage to or destruction of property and equipment and environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. AEP maintains property and casualty insurance, but AEP is not fully insured against all potential hazards incident to AEP’s business, such as damage to poles, towers and lines or losses caused by outages. +AEPTCo depends on its affiliates in the AEP System for a substantial portion of its revenues. (Applies to AEPTCo) +AEPTCo’s principal transmission service customers are its affiliates in the AEP System. Management expects that these affiliates will continue to be AEPTCo’s principal transmission service customers for the foreseeable future. For the year ended December 31, 2018 , its affiliates were responsible for approximately 77% of the consolidated transmission revenues of AEPTCo. +Most of the real property rights on which the assets of AEPTCo are situated result from affiliate license agreements and are dependent on the terms of the underlying easements and other rights of its affiliates. (Applies to AEPTCo) +AEPTCo does not hold title to the majority of real property on which its electric transmission assets are located. Instead, under the provisions of certain affiliate contracts, it is permitted to occupy and maintain its facilities upon real property held by the respective AEP System utility affiliate that overlay its operations. The ability of AEPTCo to continue to occupy such real property is dependent upon the terms of such affiliate contracts and upon the underlying real property rights of these utility affiliates, which may be encumbered by easements, mineral rights and other similar encumbrances that may affect the use of such real property. AEP can give no assurance that (a) the relevant AEP System utility affiliates will continue to be affiliates of AEPTCo, (b) suitable replacement arrangements can be obtained in the event that the relevant AEP System utility affiliates are not its affiliates and (c) the underlying easements and other rights are sufficient to permit AEPTCo to operate its assets in a manner free from interruption. +RISKS RELATED TO OWNING AND OPERATING GENERATION ASSETS AND SELLING POWER +Costs of compliance with existing environmental laws are significant. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +Operations are subject to extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality, waste management, natural resources and health and safety. A majority of the electricity generated by the AEP System is produced by the combustion of fossil fuels. Emissions of nitrogen and sulfur oxides, mercury and particulates from fossil fueled generation plants are subject to increased regulations, controls and mitigation expenses. Compliance with these legal requirements requires AEP to commit significant capital toward environmental monitoring, installation of pollution control equipment, emission fees and permits at all AEP facilities and could cause AEP to retire generating capacity prior to the end of its estimated useful life. Costs of compliance with environmental regulations could reduce future net income and negatively impact financial condition, especially if emission and/or discharge limits are tightened, more extensive permitting requirements are imposed or additional substances become regulated. Although AEP typically recovers expenditures for pollution control technologies, replacement generation, undepreciated plant balances and associated operating costs from customers, there can be no assurance that AEP will recover the remaining costs associated with such plants. Failure to recover these costs could reduce future net income and cash flows and possibly harm financial condition. +40 +Regulation of CO 2 emissions could materially increase costs to AEP and its customers or cause some electric generating units to be uneconomical to operate or maintain. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +In 2014, the Federal EPA issued standards for new, modified and reconstructed units, and a guideline for the development of SIPs that would reduce carbon emissions from existing utility units. The standards and guidelines were finalized in 2015, and have been challenged by several dozen states as well as industry groups and other stakeholders. The U.S. Supreme Court has stayed the implementation of the guidelines for existing sources, known as the Clean Power Plan, until a final decision is issued by the courts. In 2017, the Federal EPA issued a proposal to repeal the Clean Power Plan, and an advance notice of proposed rulemaking seeking information that should be considered in the development of new emission guidelines. In 2018, the Federal EPA issued proposed guidelines that would allow states to establish unit-specific performance standards based on their evaluation of past performance and whether certain efficiency improvement measures could be applied at existing coal-fired units. The Federal EPA also proposed to change the new source performance standard for new coal-fired utility units to 1,900 - 2,000 pounds per MWh depending on the size of the unit, an increase from the current standard of 1,400 pounds per MWh, based on its determination that carbon capture and storage is not available everywhere and is not sufficiently cost-effective to be considered the best available control technology for coal-fired units. +CO 2 standards could require significant increases in capital expenditures and operating costs and could impact the dates for retirement of AEP’s coal-fired units. While AEP typically recovers costs of complying with new requirements, such as the potential CO 2 and other greenhouse gases emission standards from customers, there can be no assurance that AEP would recover such costs. +Courts adjudicating nuisance and other similar claims in the future may order AEP to pay damages or to limit or reduce emissions. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +In the past, there have been several cases seeking damages based on allegations of federal and state common law nuisance in which AEP, among others, were defendants. In general, the actions allege that emissions from the defendants’ power plants constitute a public nuisance. The plaintiffs in these actions generally seek recovery of damages and other relief. If future actions are resolved against AEP, substantial modifications of AEP’s existing coal-fired power plants could be required and AEP might be required to limit or reduce emissions. Such remedies could require AEP to purchase power from third-parties to fulfill AEP’s commitments to supply power to AEP customers. This could have a material impact on costs. In addition, AEP could be required to invest significantly in additional emission control equipment, accelerate the timing of capital expenditures, pay damages or penalties and/or halt operations. Unless recovered, those costs could reduce future net income and cash flows and harm financial condition. Moreover, results of operations and financial position could be reduced due to the timing of recovery of these investments and the expense of ongoing litigation. +Commodity trading and marketing activities are subject to inherent risks which can be reduced and controlled but not eliminated. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +AEP routinely has open trading positions in the market, within guidelines set by AEP, resulting from the management of AEP’s trading portfolio. To the extent open trading positions exist, fluctuating commodity prices can improve or diminish financial results and financial position. +AEP’s power trading activities also expose AEP to risks of commodity price movements. To the extent that AEP’s power trading does not hedge the price risk associated with the generation it owns, or controls, AEP would be exposed to the risk of rising and falling spot market prices. +In connection with these trading activities, AEP routinely enters into financial contracts, including futures and options, OTC options, financially-settled swaps and other derivative contracts. These activities expose AEP to risks from price movements. If the values of the financial contracts change in a manner AEP does not anticipate, it could harm financial position or reduce the financial contribution of trading operations. +41 +Parties with whom AEP has contracts may fail to perform their obligations, which could harm AEP’s results of operations. (Applies to all Registrants) +AEP sells power from its generation facilities into the spot market and other competitive power markets on a contractual basis. AEP also enters into contracts to purchase and sell electricity, natural gas, emission allowances and coal as part of its power marketing and energy trading operations. AEP is exposed to the risk that counterparties that owe AEP money or the delivery of a commodity, including power, could breach their obligations. Should the counterparties to these arrangements fail to perform, AEP may be forced to enter into alternative hedging arrangements or honor underlying commitments at then-current market prices that may exceed AEP’s contractual prices, which would cause financial results to be diminished and AEP might incur losses. Although estimates take into account the expected probability of default by a counterparty, actual exposure to a default by a counterparty may be greater than the estimates predict. +AEP relies on electric transmission facilities that AEP does not own or control. If these facilities do not provide AEP with adequate transmission capacity, AEP may not be able to deliver wholesale electric power to the purchasers of AEP’s power. (Applies to all Registrants) +AEP depends on transmission facilities owned and operated by other nonaffiliated power companies to deliver the power AEP sells at wholesale. This dependence exposes AEP to a variety of risks. If transmission is disrupted, or transmission capacity is inadequate, AEP may not be able to sell and deliver AEP wholesale power. If a region’s power transmission infrastructure is inadequate, AEP’s recovery of wholesale costs and profits may be limited. If restrictive transmission price regulation is imposed, the transmission companies may not have sufficient incentive to invest in expansion of transmission infrastructure. +The FERC has issued electric transmission initiatives that require electric transmission services to be offered unbundled from commodity sales. Although these initiatives are designed to encourage wholesale market transactions, access to transmission systems may not be available if transmission capacity is insufficient because of physical constraints or because it is contractually unavailable. Management also cannot predict whether transmission facilities will be expanded in specific markets to accommodate competitive access to those markets. +OVEC may require additional liquidity and other capital support. (Applies to AEP, APCo, I&M and OPCo) +AEP and several nonaffiliated utility companies own OVEC. The Inter-Company Power Agreement (ICPA) defines the rights and obligations and sets the power participation ratio of the parties to it. Under the ICPA, parties are entitled to receive and are obligated to pay for all OVEC capacity (approximately 2,400 MWs) in proportion to their respective power participation ratios. The aggregate power participation ratio of APCo, I&M and OPCo is 43.47%. If a party fails to make payments owed by it under the ICPA, OVEC may not have sufficient funds to honor its payment obligations, including its ongoing operating expenses as well as its indebtedness. As of December 31, 2018, OVEC has outstanding indebtedness of approximately $1.4 billion, of which APCo, I&M, and OPCo are collectively responsible for $604 million through the ICPA. Although they are not an obligor or guarantor, APCo, I&M, and OPCo are responsible for their respective ratio of OVEC’s outstanding debt through the ICPA. +FirstEnergy Solutions (“FES”), a nonaffiliated party, whose aggregate power participation ratio is 4.85% under the ICPA, has filed a petition seeking protection under bankruptcy law. The bankruptcy court has granted the motion of FES to reject the ICPA. Litigation related to these filings continues. In addition, as a result of these and prior related developments, OVEC’s credit ratings have been adversely impacted. +If OVEC does not have sufficient funds to honor its payment obligations, there is risk that APCo, I&M and/or OPCo may need to make payments in addition to their power participation ratio payments. Further, if OVEC’s indebtedness is accelerated for any reason, there is risk that APCo, I&M and/or OPCo may be required to pay some or all of such accelerated indebtedness in amounts equal to their aggregate power participation ratio of 43.47%. Also, as a result of the credit rating agencies’ actions, OVEC’s ability to access capital markets on terms as favorable as previously may diminish and its financing costs will increase. +42 +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +GENERATION FACILITIES +As of December 31, 2018 the AEP System owned (or leased where indicated) generation plants, with locations and net maximum power capabilities (winter rating), are shown in the following tables: +Vertically Integrated Utilities Segment +AEGCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Rockport, Units 1 and 2 – 50% of each (a) +2 +IN +Steam - Coal +1,310 +1984 +(a) +Rockport Plant, Unit 2 is leased. +AEP Texas +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Oklaunion Power Station (a) (b) +1 +TX +Steam - Coal +355 +1986 +(a) +Jointly-owned with PSO and nonaffiliated entities. Figures presented reflect only the portion owned by AEP Texas. +(b) +In September 2018, management announced plans to close the plant by October 2020. +a +APCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Buck +3 +VA +Hydro +11 +1912 +Byllesby +4 +VA +Hydro +19 +1912 +Claytor +4 +VA +Hydro +75 +1939 +Leesville +2 +VA +Hydro +50 +1964 +London +3 +WV +Hydro +14 +1935 +Marmet +3 +WV +Hydro +14 +1935 +Niagara +2 +VA +Hydro +2 +1906 +Winfield +3 +WV +Hydro +15 +1938 +Ceredo +6 +WV +Natural Gas +516 +2001 +Dresden +3 +OH +Natural Gas +613 +2012 +Smith Mountain +5 +VA +Pumped Storage +585 +1965 +Amos +3 +WV +Steam - Coal +2,930 +1971 +Mountaineer +1 +WV +Steam - Coal +1,320 +1980 +Clinch River +2 +VA +Steam - Natural Gas +465 +1958 +Total MWs +6,629 +43 +I&M +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Berrien Springs +12 +MI +Hydro +6 +1908 +Buchanan +10 +MI +Hydro +3 +1919 +Constantine +4 +MI +Hydro +1 +1921 +Elkhart +3 +IN +Hydro +3 +1913 +Mottville +4 +MI +Hydro +2 +1923 +Twin Branch Hydro +8 +IN +Hydro +5 +1904 +Deer Creek Solar Farm +NA +IN +Solar +3 +2016 +Olive Solar Farm +NA +IN +Solar +5 +2016 +Twin Branch Solar Farm +NA +IN +Solar +3 +2016 +Watervliet +NA +MI +Solar +5 +2016 +Rockport (Units 1 and 2, 50% of each) (a) +2 +IN +Steam - Coal +1,310 +1984 +Cook +2 +MI +Steam - Nuclear +2,278 +1975 +Total MWs +3,624 +NA Not applicable. +(a) +Rockport Plant, Unit 2 is leased. +The following table provides operating information related to the Cook Plant: +Cook Plant +Unit 1 +Unit 2 +Year Placed in Operation +1975 +1978 +Year of Expiration of NRC License +2034 +2037 +Nominal Net Electrical Rating in MWs +1,084 +1,194 +Annual Capacity Utilization +2018 +97.9 +% +79.5 +% +2017 +76.5 +% +98.8 +% +2016 +87.3 +% +72.5 +% +KPCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Mitchell (a) +2 +WV +Steam - Coal +780 +1971 +Big Sandy +1 +KY +Steam - Natural Gas +280 +1963 +Total MWs +1,060 +(a) +KPCo owns a 50% interest in the Mitchell Plant units. WPCo owns the remaining 50%. Figures presented reflect only the portion owned by KPCo. +44 +PSO +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Comanche +3 +OK +Natural Gas +248 +1973 +Riverside, Units 3 and 4 +2 +OK +Natural Gas +160 +2008 +Southwestern, Units 4 and 5 +2 +OK +Natural Gas +170 +2008 +Weleetka (a) +3 +OK +Natural Gas +160 +1975 +Northeastern, Unit 1 +1 +OK +Natural Gas +470 +1961 +Northeastern, Unit 3 +1 +OK +Steam - Coal +469 +1979 +Oklaunion Power Station (b) (c) +1 +TX +Steam - Coal +105 +1986 +Northeastern, Unit 2 +1 +OK +Steam - Natural Gas +434 +1961 +Riverside, Units 1 and 2 +2 +OK +Steam - Natural Gas +901 +1974 +Southwestern, Units 1, 2 and 3 +3 +OK +Steam - Natural Gas +451 +1952 +Tulsa +2 +OK +Steam - Natural Gas +325 +1956 +Total MWs +3,893 +(a) +Weleetka Unit 6 is scheduled for retirement in March 2019. +(b) +Jointly-owned with AEP Texas and nonaffiliated entities. Figures presented reflect only the portion owned by PSO. +(c) +In September 2018, management announced plans to close the plant by October 2020. +SWEPCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Mattison +4 +AR +Natural Gas +315 +2007 +Stall +3 +LA +Natural Gas +534 +2010 +Flint Creek (a) +1 +AR +Steam - Coal +258 +1978 +Turk (a) +1 +AR +Steam - Coal +477 +2012 +Welsh +2 +TX +Steam - Coal +1,053 +1977 +Dolet Hills (a) +1 +LA +Steam - Lignite +257 +1986 +Pirkey (a) +1 +TX +Steam - Lignite +580 +1985 +Arsenal Hill +1 +LA +Steam - Natural Gas +110 +1960 +Knox Lee (b) +4 +TX +Steam - Natural Gas +475 +1950 +Lieberman +3 +LA +Steam - Natural Gas +242 +1947 +Lone Star +1 +TX +Steam - Natural Gas +50 +1954 +Wilkes +3 +TX +Steam - Natural Gas +889 +1964 +Total MWs +5,240 +(a) +Jointly-owned with nonaffiliated entities. Figures presented reflect only the portion owned by SWEPCo. The Arkansas jurisdictional portion of SWEPCo’s interest in Turk Plant is not in rate base. +(b) +Knox Lee Unit 4 was retired in January 2019. Figures presented include Unit 4 in the total. +WPCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Mitchell (a) +2 +WV +Steam - Coal +780 +1971 +(a) +17.5% of WPCo’s interest in the Mitchell Plant units is not in rate base. KPCo owns the remaining 50%. Figures presented reflect only the portion owned by WPCo. +45 +Generation & Marketing Segment +AGR +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Racine +2 +OH +Hydro +48 +1982 +Cardinal +1 +OH +Steam - Coal +595 +1967 +Conesville (a) (b) +3 +OH +Steam - Coal +1,471 +1957 +Total MWs +2,114 +(a) +Jointly-owned with nonaffiliated entities. Figures presented reflect only the portion owned by AGR. +(b) +In the fourth quarter of 2018, management announced plans to close Conesville Plant Units 5 and 6 in May 2019 and Unit 4 in May 2020. +Renewable Power +Size of Energy Resource +Renewable Energy Resource +Location +In-Service or +Under Construction +261 MW +Wind +Texas +In service +20 MW +Solar +California +In service +20 MW +Solar +Utah +In service +50 MW +Solar +Nevada +In service +85 MW +Solar +Fifteen states (a) +In service +57 MW +Solar +Four states (b) +Under Construction +(a) +California, Colorado, Connecticut, Florida, Hawaii, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(b) +Colorado, Minnesota, New Mexico and Hawaii. +In addition to the AGR and Renewable Power generation set forth above, a subsidiary in the Generation & Marketing segment has contractual rights through 2027 from AEP Texas to 355 MWs from the Oklaunion Power Station. AEP Texas co-owns the Oklaunion Power Station with PSO and several nonaffiliated entities. Management has announced plans to close Oklaunion Power Station by October 2020. +46 +TRANSMISSION AND DISTRIBUTION FACILITIES +The following tables set forth the total overhead circuit miles of transmission and distribution lines of the AEP System and its operating companies. +Vertically Integrated Utilities Segment +Total Overhead Circuit Miles of Transmission and Distribution Lines +APCo +51,632 +I&M +21,453 +KGPCo +1,405 +KPCo +11,147 +PSO +18,334 +SWEPCo +26,093 +WPCo +1,744 +Total Circuit Miles +131,808 +Transmission and Distribution Utilities Segment +Total Overhead Circuit Miles of Transmission and Distribution Lines +OPCo +44,944 +AEP Texas +45,838 +Total Circuit Miles +90,782 +AEP Transmission Holdco Segment +The following table sets forth the total overhead circuit miles of transmission lines of certain wholly-owned and joint venture-owned entities: +Total Overhead Circuit Miles of Transmission Lines +ETT +1,774 +IMTCo +425 +OHTCo +749 +OKTCo +720 +WVTCo +188 +Pioneer +43 +Prairie Wind Transmission +216 +Transource Missouri +167 +Total Circuit Miles +4,282 +TITLE TO PROPERTY +The AEP System’s generating facilities are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the AEP System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of AEP’s public utility subsidiaries in the realty on which their facilities are located are considered adequate for use in the conduct of their business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties. AEP’s public utility subsidiaries generally have the right of eminent domain which permits them, if necessary, to acquire, perfect or secure titles to or easements on privately held lands used or to be used in their utility operations. Legislation in Ohio and Virginia has restricted the right of eminent domain previously granted for power generation purposes. +47 +SYSTEM TRANSMISSION LINES AND FACILITY SITING +Laws in the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Tennessee, Texas, Virginia and West Virginia require prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. AEP has experienced delays and additional costs in constructing facilities as a result of proceedings conducted pursuant to such statutes and in proceedings in which AEP’s operating companies have sought to acquire rights-of-way through condemnation. These proceedings may result in additional delays and costs in future years. +CONSTRUCTION PROGRAM +With input from its state utility commissions, the AEP System continuously assesses the adequacy of its transmission, distribution, generation and other facilities to plan and provide for the reliable supply of electric power and energy to its customers. In this assessment process, assumptions are continually being reviewed as new information becomes available and assessments and plans are modified, as appropriate. AEP forecasts approximately $7.8 billion of construction expenditures for 2019 . Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends, weather and the ability to access capital. See the “Budgeted Construction Expenditures” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +POTENTIAL UNINSURED LOSSES +Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to AEP’s generation plants and costs of replacement power. Unless allowed to be recovered through rates, future losses or liabilities which are not completely insured could reduce net income and impact the financial conditions of AEP and other AEP System companies. For risks related to owning a nuclear generating unit, see the “Nuclear Contingencies” section of Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report for information with respect to nuclear incident liability insurance. +ITEM 3. LEGAL PROCEEDINGS +For a discussion of material legal proceedings, see Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report, incorporated by reference in Item 8 and herein. +ITEM 4. MINE SAFETY DISCLOSURE +The Federal Mine Safety and Health Act of 1977 (Mine Act) imposes stringent health and safety standards on various mining operations. The Mine Act and its related regulations affect numerous aspects of mining operations, including training of mine personnel, mining procedures, equipment used in mine emergency procedures, mine plans and other matters. SWEPCo, through its ownership of Dolet Hills Lignite Company (DHLC), a wholly-owned lignite mining subsidiary of SWEPCo, is subject to the provisions of the Mine Act. +The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires companies that operate mines to include in their periodic reports filed with the SEC, certain mine safety information covered by the Mine Act. Exhibit 95 “Mine Safety Disclosure Exhibit” contains the notices of violation and proposed assessments received by DHLC under the Mine Act for the quarter ended December 31, 2018 . +48 +PART II +ITEM 5. MARKET FOR REGISTRANTS’ COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +AEP +In addition to the discussion below, the remaining information required by this item is incorporated herein by reference to the material under AEP Common Stock Information and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Dividend Policy and Restrictions” included in the 2018 Annual Report. +AEP Texas, APCo, I&M, OPCo, PSO and SWEPCo +The common stock of these companies is held solely by AEP. For more information see the “Dividend Restrictions” section of Note 14 - Financing Activities included in the 2018 Annual Report. +AEPTCo +AEP owns the entire interest in AEPTCo through its wholly-owned subsidiary AEP Transmission Holdco. +During the quarter ended December 31, 2018 , neither AEP nor its publicly-traded subsidiaries purchased equity securities that are registered by AEP or its publicly-traded subsidiaries pursuant to Section 12 of the Exchange Act. +ITEM 6. SELECTED FINANCIAL DATA +AEP +The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the 2018 Annual Report. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(a). Management’s narrative analysis of the results of operations and other information required by Instruction I(2)(a) is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2018 Annual Report. +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +AEP +The information required by this item is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2018 Annual Report. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(a). Management’s narrative analysis of the results of operations and other information required by Instruction I(2)(a) is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2018 Annual Report. +49 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +The information required by this item is incorporated herein by reference to the material under the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2018 Annual Report. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +The information required by this item is incorporated herein by reference to the financial statements and financial statement schedules described under Item 15 herein. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Information required by this item is set forth under the caption Proposal to Ratify the Appointment of the Independent Registered Public Accounting Firm in the 2019 Proxy Statement, which is incorporated by reference into this item. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +During 2018 , management, including the principal executive officer and principal financial officer of each of American Electric Power Company, Inc. (“AEP”), AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company (each a “Registrant” and collectively the “Registrants”) evaluated each respective Registrant’s disclosure controls and procedures. Disclosure controls and procedures are defined as controls and other procedures of the Registrant that are designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act is accumulated and communicated to each Registrant’s management, including the principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. +As of December 31, 2018 , the principal executive officer and financial officer of each of the Registrants concluded that the disclosure controls and procedures in place were effective at the reasonable assurance level. The Registrants continually strive to improve their disclosure controls and procedures to enhance the quality of their financial reporting and to maintain dynamic systems that change as events warrant. +Changes in Internal Control over Financial Reporting +There have been no changes in the Registrants’ internal control over financial reporting (as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter 2018 that materially affected, or is reasonably likely to materially affect, the Registrants’ internal control over financial reporting. +50 +Internal Control over Financial Reporting +See Management’s Report on Internal Control over Financial Reporting for each Registrant under Item 8. As discussed in that report, management assessed and reported on the effectiveness of each Registrant’s internal control over financial reporting as of December 31, 2018 . As a result of that assessment, management concluded that each Registrant’s internal control over financial reporting was effective as of December 31, 2018 . +ITEM 9B. OTHER INFORMATION +On February 18, 2019, the HR Committee of AEP’s Board of Directors (the “HR Committee”) made a special equity award grant to Brian X. Tierney, AEP’s Chief Financial Officer and Lisa M. Barton, AEP’s Executive Vice President-Utilities. The HR Committee awarded one-time restricted stock unit (“RSU”) retention awards under the Company’s Long-Term Incentive Plan (the “LTIP”) to Mr. Tierney and Ms. Barton as part of a retention strategy. The retention awards were granted with the regular cycle LTIP awards in February 2019. The retention awards provided $2,000,000 in RSUs to each executive that will vest over a 40 month period, with 25% of the awards vesting on May 1, 2020, 37.5% of the awards vesting on May 1, 2021 and 37.5% of the awards vesting on May 1, 2022. The retention awards have no value to the executive unless he/she remains employed with the Company for the vesting period, and will be canceled if the executive’s employment with the Company terminates. +51 +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +AEP +Directors, Director Nomination Process and Audit Committee +Certain of the information called for in this Item 10, including the information relating to directors, is incorporated herein by reference to AEP’s definitive proxy information statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2019 Annual Meeting of Shareholders (the 2019 Annual Meeting) including under the captions “Election of Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “AEP’s Board of Directors and Committees,” “Directors” and “Shareholder Nominees for Directors.” +Executive Officers +Reference also is made to the information under the caption Executive Officers of AEP in Part I, Item 1 of this report. +Code of Ethics +AEP’s Principles of Business Conduct is the code of ethics that applies to AEP’s Chief Executive Officer, Chief Financial Officer and principal accounting officer. The Principles of Business Conduct is available on AEP’s website at www.aep.com. The Principles of Business Conduct will be made available, without charge, in print to any shareholder who requests such document from Investor Relations, American Electric Power Company, Inc., 1 Riverside Plaza, Columbus, Ohio 43215. +If any substantive amendments to the Principles of Business Conduct are made or any waivers are granted, including any implicit waiver, from a provision of the Principles of Business Conduct, to its Chief Executive Officer, Chief Financial Officer or principal accounting officer, AEP will disclose the nature of such amendment or waiver on AEP’s website, www.aep.com, or in a report on Form 8-K. +Section 16(a) Beneficial Ownership Reporting Compliance +The information required by this item is incorporated herein by reference to information contained in the definitive proxy statement of AEP for the 2019 Annual Meeting. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 11. EXECUTIVE COMPENSATION +AEP +The information called for by this Item 11 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2019 Annual Meeting including under the captions “Compensation Discussion and Analysis,” “Executive Compensation”, “Director Compensation” and “ 2018 Director Compensation Table”. The information set forth under the subcaption “Human Resources Committee Report” and “Audit Committee Report” should not be deemed filed nor should it be incorporated by reference into any other filing under the Securities Act of 1933, as amended, or the Exchange Act except to the extent AEP specifically incorporates such report by reference therein. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +52 +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +AEP +The information relating to Security Ownership of Certain Beneficial Owners is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to 2019 Annual Meeting under the caption “Share Ownership of Certain Beneficial Owners and Management” and “Share Ownership of Directors and Executive Officers.” +EQUITY COMPENSATION PLAN INFORMATION +The following table summarizes the ability of AEP to issue common stock pursuant to equity compensation plans as of December 31, 2018 : +Plan Category +Number of Securities to be Issued upon Exercise of Outstanding Options Warrants and Rights (a) +Weighted Average Exercise Price of Outstanding Options, Warrants and Rights (b) +Number of Securities Remaining +Available for Future Issuance under Equity Compensation Plans +Equity Compensation Plans Approved by Security Holders +2,266,358 +— +8,194,046 +Equity Compensation Plans Not Approved by Security Holders +— +— +— +Total +2,266,358 +— +8,194,046 +(a) +The balance includes unvested 2018 performance units and restricted stock units as well as vested performance units deferred as AEP career shares, all of which will be settled and paid in shares of AEP common stock. Performance units, restricted stock units and AEP career shares that are settled and paid in cash are not included. For performance units, the total includes the target number of shares that could be granted if performance meets target objectives. The number of securities that would be granted, with respect to performance units, if performance meets the maximum payout level, is two times the amount included in this total. +(b) +No consideration is required from participants for the exercise or vesting of any outstanding AEP equity compensation awards. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +AEP +The information called for by this Item 13 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2019 Annual Meeting under the captions “Transactions with Related Persons” and “Director Independence.” +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +53 +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +AEP +The information called for by this Item 14 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2019 Annual Meeting under the captions “Audit and Non-Audit Fees,” “Audit Committee Report” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of the Independent Auditor.” +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Each of the above is a wholly-owned subsidiary of AEP and does not have a separate audit committee. A description of the AEP Audit Committee pre-approval policies, which apply to these companies, is contained in the definitive proxy statement of AEP for the 2019 Annual Meeting of shareholders. The following table presents directly billed fees for professional services rendered by PricewaterhouseCoopers LLP for the audit of these companies’ annual financial statements for the years ended December 31, 2018 and 2017, and fees directly billed for other services rendered by PricewaterhouseCoopers LLP during those periods. PricewaterhouseCoopers LLP also provides additional professional and other services to the AEP System, the cost of which may ultimately be allocated to these companies though not billed directly to them. For a description of these fees and services, see the description of principal accounting fees and services for AEP above. +AEP Texas +AEPTCo +APCo +2018 +2017 +2018 +2017 +2018 +2017 +Audit Fees +$ +1,129,561 +$ +1,081,882 +$ +1,193,523 +$ +947,509 +$ +1,721,299 +$ +1,756,776 +Audit-Related Fees +76,000 +76,000 +— +— +42,571 +45,738 +Tax Fees +34,880 +— +33,001 +— +52,714 +— +All Other Fees +13,247 +— +12,534 +— +40,530 +— +Total +$ +1,253,688 +$ +1,157,882 +$ +1,239,058 +$ +947,509 +$ +1,857,114 +$ +1,802,514 +I&M +OPCo +PSO +2018 +2017 +2018 +2017 +2018 +2017 +Audit Fees +$ +1,510,574 +$ +1,503,971 +$ +1,093,392 +$ +1,042,136 +$ +603,527 +$ +654,569 +Audit-Related Fees +10,071 +7,738 +48,071 +45,738 +4,571 +7,738 +Tax Fees +43,472 +— +34,019 +— +19,475 +— +All Other Fees +24,715 +— +12,920 +— +21,415 +— +Total +$ +1,588,832 +$ +1,511,709 +$ +1,188,402 +$ +1,087,874 +$ +648,988 +$ +662,307 +SWEPCo +2018 +2017 +Audit Fees +$ +1,150,091 +$ +1,071,925 +Audit-Related Fees +24,571 +55,738 +Tax Fees +33,188 +— +All Other Fees +29,131 +— +Total +$ +1,236,981 +$ +1,127,663 +54 +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +The following documents are filed as a part of this report: +1. +FINANCIAL STATEMENTS: +The following financial statements have been incorporated herein by reference pursuant to Item 8. +AEP and Subsidiary Companies: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Changes in Equity for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Balance Sheets as of December 31, 2018 and 2017 ; Consolidated Statements of Cash Flows for the years ended December 31, 2018 , 2017 and 2016 ; Notes to Financial Statements of Registrants. +AEP Texas, APCo, I&M and OPCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Changes in Common Shareholder’s Equity for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Balance Sheets as of December 31, 2018 and 2017 ; Consolidated Statements of Cash Flows for the years ended December 31, 2018 , 2017 and 2016 ; Notes to Financial Statements of Registrants. +AEPTCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Changes in Member’s Equity for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Balance Sheets as of December 31, 2018 and 2017 ; Consolidated Statements of Cash Flows for the years ended December 31, 2018 , 2017 and 2016 ; Notes to Financial Statements of Registrants. +PSO: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Statements of Income for the years ended December 31, 2018 , 2017 and 2016 ; Statements of Comprehensive Income (Loss) for the years ended December 31, 2018 , 2017 and 2016 ; Statements of Changes in Common Shareholder’s Equity for the years ended December 31, 2018 , 2017 and 2016 ; Balance Sheets as of December 31, 2018 and 2017 ; Statements of Cash Flows for the years ended December 31, 2018 , 2017 and 2016 ; Notes to Financial Statements of Registrants. +SWEPCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Statements of Changes in Equity for the years ended December 31, 2018 , 2017 and 2016 ; Consolidated Balance Sheets as of December 31, 2018 and 2017 ; Consolidated Statements of Cash Flows for the years ended December 31, 2018 , 2017 and 2016 ; Notes to Financial Statements of Registrants. +55 +2. FINANCIAL STATEMENT SCHEDULES: +Page Number +Financial Statement Schedules are listed in the Index of Financial Statement Schedules. (Certain schedules have been omitted because the required information is contained in the notes to financial statements or because such schedules are not required or are not applicable). Reports of Independent Registered Public Accounting Firm. +S-1 +3. EXHIBITS: +Exhibits for AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. +E-1 +56 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +American Electric Power Company, Inc. +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Executive Vice President +and Chief Financial Officer) +Date: February 21, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, +Chief Executive Officer and Director +February 21, 2019 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Executive Vice President and Chief Financial Officer +February 21, 2019 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Senior Vice President, Controller and Chief Accounting Officer +February 21, 2019 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Directors: +*Nicholas K. Akins +*David J. Anderson +*J. Barnie Beasley, Jr. +*Ralph D. Crosby, Jr. +*Linda A. Goodspeed +*Thomas E. Hoaglin +*Sandra Beach Lin +*Richard C. Notebaert +*Lionel L. Nowell, III +*Stephen S. Rasmussen +*Oliver G. Richard, III +*Sara Martinez Tucker +*By: +/s/ Brian X. Tierney +February 21, 2019 +(Brian X. Tierney, Attorney-in-Fact) +57 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +AEP Texas Inc. +Appalachian Power Company +Ohio Power Company +Public Service Company of Oklahoma +Southwestern Electric Power Company +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Vice President and Chief Financial Officer) +Date: February 21, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, Chief Executive Officer and Director +February 21, 2019 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Vice President, Chief Financial Officer and Director +February 21, 2019 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Controller and Chief Accounting Officer +February 21, 2019 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Directors: +*Nicholas K. Akins +*Lisa M. Barton +*Paul Chodak III +*David M. Feinberg +*Lana L. Hillebrand +*Mark C. McCullough +*Charles R. Patton +Brian X. Tierney +*By: +/s/ Brian X. Tierney +February 21, 2019 +(Brian X. Tierney, Attorney-in-Fact) +58 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +Indiana Michigan Power Company +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Vice President +and Chief Financial Officer) +Date: February 21, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, Chief Executive Officer and Director +February 21, 2019 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Vice President, Chief Financial Officer and Director +February 21, 2019 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Controller and Chief Accounting Officer +February 21, 2019 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Directors: +*Nicholas K. Akins +*Lisa M. Barton +*Nicholas M. Elkins +*Thomas A. Kratt +*Marc E. Lewis +*David A. Lucas +*Mark C. McCullough +*Carla E. Simpson +*Toby L. Thomas +Brian X. Tierney +*By: +/s/ Brian X. Tierney +February 21, 2019 +(Brian X. Tierney, Attorney-in-Fact) +59 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +AEP Transmission Company, LLC +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Vice President, +Chief Financial Officer, and Manager) +Date: February 21, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, Chief Executive Officer and Manager +February 21, 2019 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Vice President, Chief Financial Officer and Manager +February 21, 2019 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Controller and Chief Accounting Officer +February 21, 2019 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Managers: +*Nicholas K. Akins +*David M. Feinberg +*Mark C. McCullough +*A. Wade Smith +Brian X. Tierney +*By: +/s/ Brian X. Tierney +February 21, 2019 +(Brian X. Tierney, Attorney-in-Fact) +60 +INDEX OF FINANCIAL STATEMENT SCHEDULES +Page +Number +Reports of Independent Registered Public Accounting Firm +S-2 +The following financial statement schedules are included in this report on the pages indicated: +American Electric Power Company, Inc. (Parent): +Schedule I – Condensed Financial Information +S-4 +Schedule I – Index of Condensed Notes to Condensed Financial Information +S-8 +American Electric Power Company, Inc. and Subsidiary Companies: +Schedule II – Valuation and Qualifying Accounts and Reserves +S-11 +S-1 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON +FINANCIAL STATEMENT SCHEDULES +To the Board of Directors and Shareholders of +American Electric Power Company, Inc. +Our audits of the consolidated financial statements referred to in our report dated February 21, 2019 appearing in the 2018 Annual Report to Shareholders of American Electric Power Company, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the accompanying schedule of condensed financial information and the schedule of valuation and qualifying accounts and reserves as of December 31, 2018 and 2017 and for each of the two years in the period ended December 31, 2018. In our opinion, these financial statement schedules as of December 31, 2018 and 2017 and for each of the two years in the period ended December 31, 2018 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 21, 2019 +S-2 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholders of +American Electric Power Company, Inc.: +We have audited the consolidated statements of income, comprehensive income (loss), changes in equity, and cash flows of American Electric Power Company, Inc. and subsidiary companies (the “Company”) for the year ended December 31, 2016, and have issued our report thereon dated February 27, 2017; such consolidated financial statements and report are included in the Company’s 2018 Annual Report and are incorporated herein by reference. Our audit also included the 2016 financial statement schedules of the Company listed in Item 15. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audit. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. +/s/ Deloitte & Touche LLP +Columbus, Ohio +February 27, 2017 +S-3 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF INCOME +For the Years Ended December 31, 2018 , 2017 and 2016 +(in millions, except per-share and share amounts) +Years Ended December 31, +2018 +2017 +2016 +REVENUES +Affiliated Revenues +$ +9.5 +$ +9.1 +$ +9.7 +Other Revenues +1.4 +5.9 +2.8 +TOTAL REVENUES +10.9 +15.0 +12.5 +EXPENSES +Other Operation +39.7 +35.9 +42.0 +Asset Impairments and Other Related Charges +9.3 +— +— +Depreciation +0.3 +0.3 +0.2 +TOTAL EXPENSES +49.3 +36.2 +42.2 +OPERATING LOSS +(38.4 +) +(21.2 +) +(29.7 +) +Other Income (Expense): +Interest Income +31.3 +20.5 +11.3 +Interest Expense +(87.5 +) +(43.1 +) +(26.8 +) +LOSS BEFORE INCOME TAX BENEFIT AND EQUITY EARNINGS +(94.6 +) +(43.8 +) +(45.2 +) +Income Tax Expense (Benefit) +(6.2 +) +0.1 +(87.5 +) +Equity Earnings of Unconsolidated Subsidiaries +2,012.2 +1,956.5 +571.1 +INCOME FROM CONTINUING OPERATIONS +1,923.8 +1,912.6 +613.4 +LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX +— +— +(2.5 +) +NET INCOME +1,923.8 +1,912.6 +610.9 +Other Comprehensive Income (Loss) +(23.7 +) +88.5 +(29.2 +) +TOTAL COMPREHENSIVE INCOME +$ +1,900.1 +$ +2,001.1 +$ +581.7 +WEIGHTED AVERAGE NUMBER OF BASIC AEP COMMON SHARES OUTSTANDING +492,774,600 +491,814,651 +491,495,458 +BASIC EARNINGS PER SHARE ATTRIBUTABLE TO COMMON SHAREHOLDERS FROM CONTINUING OPERATIONS +$ +3.90 +$ +3.89 +$ +1.25 +BASIC LOSS PER SHARE ATTRIBUTABLE TO COMMON SHAREHOLDERS FROM DISCONTINUED OPERATIONS +— +— +(0.01 +) +TOTAL BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS +$ +3.90 +$ +3.89 +$ +1.24 +WEIGHTED AVERAGE NUMBER OF DILUTED AEP COMMON SHARES OUTSTANDING +493,758,277 +492,611,067 +491,662,007 +DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO COMMON SHAREHOLDERS FROM CONTINUING OPERATIONS +$ +3.90 +$ +3.88 +$ +1.25 +DILUTED LOSS PER SHARE ATTRIBUTABLE TO COMMON SHAREHOLDERS FROM DISCONTINUED OPERATIONS +— +— +(0.01 +) +TOTAL DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS +$ +3.90 +$ +3.88 +$ +1.24 +See Condensed Notes to Condensed Financial Information beginning on page S-8 . +S-4 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +ASSETS +December 31, 2018 and 2017 +(in millions) +December 31, +2018 +2017 +CURRENT ASSETS +Cash and Cash Equivalents +$ +99.3 +$ +132.1 +Other Temporary Investments +2.3 +2.0 +Advances to Affiliates +1,096.4 +989.5 +Accounts Receivable: +Affiliated Companies +6.4 +2.5 +General +7.6 +7.6 +Total Accounts Receivable +14.0 +10.1 +Accrued Tax Benefits +— +40.3 +Prepayments and Other Current Assets +2.5 +4.1 +TOTAL CURRENT ASSETS +1,214.5 +1,178.1 +PROPERTY, PLANT AND EQUIPMENT +General +2.2 +1.8 +Total Property, Plant and Equipment +2.2 +1.8 +Accumulated Depreciation and Amortization +1.2 +0.8 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET +1.0 +1.0 +OTHER NONCURRENT ASSETS +Investments in Unconsolidated Subsidiaries +21,522.3 +19,720.8 +Affiliated Notes Receivable +50.0 +50.0 +Deferred Charges and Other Noncurrent Assets +114.1 +70.0 +TOTAL OTHER NONCURRENT ASSETS +21,686.4 +19,840.8 +TOTAL ASSETS +$ +22,901.9 +$ +21,019.9 +See Condensed Notes to Condensed Financial Information beginning on page S-8 . +S-5 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2018 and 2017 +(dollars in millions) +December 31, +2018 +2017 +CURRENT LIABILITIES +Advances from Affiliates +$ +313.6 +$ +465.1 +Accounts Payable: +General +5.9 +4.0 +Affiliated Companies +4.2 +6.1 +Short-term Debt +1,160.0 +898.6 +Long-term Debt Due Within One Year – Nonaffiliated (a) +(2.0 +) +2.5 +Accrued Taxes +13.2 +— +Other Current Liabilities +16.5 +9.9 +TOTAL CURRENT LIABILITIES +1,511.4 +1,386.2 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated (a) +2,268.4 +1,281.8 +Deferred Credits and Other Noncurrent Liabilities +54.3 +53.0 +TOTAL NONCURRENT LIABILITIES +2,322.7 +1,334.8 +TOTAL LIABILITIES +3,834.1 +2,721.0 +MEZZANINE EQUITY +Contingently Redeemable Performance Share Awards +39.4 +11.9 +COMMON SHAREHOLDERS’ EQUITY +Common Stock – Par Value – $6.50 Per Share: +2018 +2017 +Shares Authorized +600,000,000 +600,000,000 +Shares Issued +513,450,036 +512,210,644 +(20,204,160 and 20,205,046 Shares were Held in Treasury as of December 31, 2018 and December 31, 2017, Respectively) +3,337.4 +3,329.4 +Paid-in Capital +6,486.1 +6,398.7 +Retained Earnings +9,325.3 +8,626.7 +Accumulated Other Comprehensive Income (Loss) +(120.4 +) +(67.8 +) +TOTAL AEP COMMON SHAREHOLDERS’ EQUITY +19,028.4 +18,287.0 +TOTAL LIABILITIES, MEZZANINE EQUITY AND SHAREHOLDERS’ EQUITY +$ +22,901.9 +$ +21,019.9 +(a) +Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 included in the 2018 Annual Reports for additional information. +See Condensed Notes to Condensed Financial Information beginning on page S-8 . +S-6 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2018 , 2017 and 2016 +(in millions) +Years Ended December 31, +2018 +2017 +2016 +OPERATING ACTIVITIES +Net Income +$ +1,923.8 +$ +1,912.6 +$ +610.9 +Loss from Discontinued Operations +— +— +(2.5 +) +Income from Continuing Operations +1,923.8 +1,912.6 +613.4 +Adjustments to Reconcile Income from Continuing Operations to Net Cash +Flows from Continuing Operating Activities: +Depreciation and Amortization +0.3 +0.3 +0.2 +Deferred Income Taxes +(45.0 +) +33.7 +(54.1 +) +Asset Impairments and Other Related Charges +9.3 +— +— +Equity Earnings of Unconsolidated Subsidiaries +(2,012.2 +) +(1,956.5 +) +(571.1 +) +Cash Dividends Received from Unconsolidated Subsidiaries +855.6 +827.0 +859.1 +Change in Other Noncurrent Assets +(5.5 +) +(0.4 +) +(1.0 +) +Change in Other Noncurrent Liabilities +42.1 +74.0 +13.8 +Changes in Certain Components of Continuing Working Capital: +Accounts Receivable, Net +(3.9 +) +51.5 +11.1 +Accounts Payable +— +1.6 +2.4 +Other Current Assets +47.8 +70.0 +(33.3 +) +Other Current Liabilities +4.7 +0.7 +(1.7 +) +Net Cash Flows from Continuing Operating Activities +817.0 +1,014.5 +838.8 +INVESTING ACTIVITIES +Construction Expenditures +(0.4 +) +(0.7 +) +(0.4 +) +Change in Advances to Affiliates, Net +(106.9 +) +(76.4 +) +(276.2 +) +Capital Contributions to Unconsolidated Subsidiaries +(859.1 +) +(563.2 +) +(310.2 +) +Return of Capital Contributions from Unconsolidated Subsidiaries +199.7 +263.3 +— +Issuance of Notes Receivable to Affiliated Companies +— +(30.0 +) +— +Net Cash Flows Used for Continuing Investing Activities +(766.7 +) +(407.0 +) +(586.8 +) +FINANCING ACTIVITIES +Issuance of Common Stock, Net +73.6 +12.2 +34.2 +Issuance of Long-term Debt +991.9 +992.3 +— +Commercial Paper and Credit Facility Borrowings +205.6 +— +— +Change in Short-term Debt, Net +261.4 +(141.4 +) +915.0 +Retirement of Long-term Debt +— +(550.0 +) +— +Change in Advances from Affiliates, Net +(151.5 +) +266.7 +(46.2 +) +Commercial Paper and Credit Facility Repayments +(205.6 +) +— +— +Dividends Paid on Common Stock +(1,251.1 +) +(1,175.4 +) +(1,115.7 +) +Other Financing Activities +(7.4 +) +(5.1 +) +(4.8 +) +Net Cash Flows Used for Continuing Financing Activities +(83.1 +) +(600.7 +) +(217.5 +) +Net Cash Flows Used for Discontinued Operating Activities +— +— +(2.5 +) +Net Cash Flows from Discontinued Investing Activities +— +— +— +Net Cash Flows from Discontinued Financing Activities +— +— +— +Net Increase (Decrease) in Cash and Cash Equivalents +(32.8 +) +6.8 +32.0 +Cash and Cash Equivalents at Beginning of Period +132.1 +125.3 +93.3 +Cash and Cash Equivalents at End of Period +$ +99.3 +$ +132.1 +$ +125.3 +See Condensed Notes to Condensed Financial Information beginning on page S-8 . +S-7 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +INDEX OF CONDENSED NOTES TO CONDENSED FINANCIAL INFORMATION +1. Summary of Significant Accounting Policies +2. Commitments, Guarantees and Contingencies +3. Financing Activities +4. Related Party Transactions +S-8 +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +The condensed financial information of Parent is required as a result of the restricted net assets of AEP consolidated subsidiaries exceeding 25% of AEP consolidated net assets as of December 31, 2018 . Parent is a public utility holding company that owns all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries, including joint ventures and equity investments. The primary source of income for Parent is equity in its subsidiaries’ earnings. Its major source of cash is dividends from the subsidiaries. Parent borrows the funds for the money pool that is used by the subsidiaries for their short-term cash needs. +Income Taxes +Parent files a consolidated federal income tax return with its subsidiaries. AEP System’s current consolidated federal income tax is allocated to AEP System companies so that their current tax expense reflects a separate return result for each company in the consolidated group. The tax benefit of Parent is allocated to its subsidiaries with taxable income. +2. COMMITMENTS, GUARANTEES AND CONTINGENCIES +Parent and its subsidiaries are parties to environmental and other legal matters. For further discussion, see Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report. +3. FINANCING ACTIVITIES +The following details long-term debt outstanding as of December 31, 2018 and 2017 : +Long-term Debt +Weighted-Average +Interest Rate Ranges as of +Outstanding as of +Interest Rate as of +December 31, +December 31, +Type of Debt and Maturity +December 31, 2018 +2018 +2017 +2018 +2017 +(in millions) +Senior Unsecured Notes +2020-2028 +3.30% +2.15%-4.30% +2.15%-3.20% +$ +2,266.4 +$ +1,284.3 +Total Long-term Debt Outstanding +2,266.4 +1,284.3 +Long-term Debt Due Within One Year +— +2.5 +Long-term Debt +$ +2,266.4 +$ +1,281.8 +Long-term debt outstanding as of December 31, 2018 is payable as follows: +2019 +2020 +2021 +2022 +2023 +After 2023 +Total +(in millions) +Principal Amount (a) +$ +(2.0 +) +$ +498.6 +$ +399.2 +$ +299.2 +$ +(1.2 +) +$ +1,088.7 +$ +2,282.5 +Unamortized Discount, Net and Debt Issuance Costs +(16.1 +) +Total Long-term Debt Outstanding +$ +2,266.4 +(a) +Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 included in the 2018 Annual Report for additional information. +S-9 +Short-term Debt +Parent’s outstanding short-term debt was as follows: +December 31, 2018 +December 31, 2017 +Type of Debt +Outstanding +Amount +Weighted-Average +Interest Rate +Outstanding +Amount +Weighted-Average +Interest Rate +(in millions) +(in millions) +Commercial Paper +$ +1,160.0 +2.96 +% +$ +898.6 +1.85 +% +Total Short-term Debt +$ +1,160.0 +$ +898.6 +4. RELATED PARTY TRANSACTIONS +Payments on Behalf of Subsidiaries +Due to occasional time sensitivity and complexity of payments, Parent makes certain insurance, tax and benefit payments on behalf of subsidiary companies. Parent is then fully reimbursed by the subsidiary companies. +Short-term Lending to Subsidiaries +Parent uses a commercial paper program to meet the short-term borrowing needs of subsidiaries. The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds certain nonutility subsidiaries. In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons. The program also allows some direct borrowers to invest excess cash with Parent. +Interest expense related to Parent’s short-term borrowing is included in Interest Expense on Parent’s statements of income. Parent incurred interest expense for amounts borrowed from subsidiaries of $11 million, $8 million and $2 million for the years ended December 31, 2018 , 2017 and 2016 , respectively. +Interest income related to Parent’s short-term lending is included in Interest Income on Parent’s statements of income. Parent earned interest income for amounts advanced to subsidiaries of $27 million, $16 million and $10 million for the years ended December 31, 2018 , 2017 and 2016 , respectively. +Affiliated Notes +Parent issued long-term debt, portions of which were loaned to its subsidiaries. Parent pays interest on the affiliated notes, but the subsidiaries accrue interest for their share of the affiliated borrowing and remit the interest to Parent. Interest income related to Parent’s loans to subsidiaries is included in Interest Income on Parent’s statements of income. Parent earned interest income on loans to subsidiaries of $2 million, $2 million and $1 million for the years ended December 31, 2018 , 2017 and 2016 , respectively. +S-10 +SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS AND RESERVES +AEP +Additions +Description +Balance at +Beginning +of Period +Charged to +Costs and +Expenses +Charged to Other +Accounts (a) +Deductions (b) +Balance at +End of +Period +(in millions) +Deducted from Assets: +Accumulated Provision for Uncollectible Accounts: +Year Ended December 31, 2018 +$ +38.5 +$ +37.3 +$ +2.6 +$ +41.6 +$ +36.8 +Year Ended December 31, 2017 +37.9 +34.0 +2.5 +35.9 +38.5 +Year Ended December 31, 2016 +29.0 +40.7 +2.6 +34.4 +37.9 +(a) +Recoveries offset by reclasses to other assets and liabilities. +(b) +Uncollectible accounts written off. +Schedule II for the Registrant Subsidiaries is not presented because the amounts are not material. +S-11 +INDEX OF AEP TRANSMISSION COMPANY, LLC (AEPTCO PARENT) +FINANCIAL STATEMENT SCHEDULES +Page +Number +Report of Independent Registered Public Accounting Firm +S-13 +The following financial statement schedules are included in this report on the pages indicated: +AEP Transmission Company, LLC (AEPTCo Parent): +Schedule I – Condensed Financial Information +S-14 +Schedule I – Index of Condensed Notes to Condensed Financial Information +S-18 +S-12 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON +FINANCIAL STATEMENT SCHEDULE +To the Board of Directors and Member of +AEP Transmission Company, LLC +Our audits of the consolidated financial statements referred to in our report dated February 21, 2019 appearing in the 2018 Annual Report to the Member of AEP Transmission Company, LLC (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the accompanying schedule of condensed financial information as of December 31, 2018 and 2017 and for each of the two years in the period ended December 31, 2018. In our opinion, this financial statement schedule as of December 31, 2018 and 2017 and for each of the two years in the period ended December 31, 2018 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. +The financial statement schedule of the Company for the year ended December 31, 2016 was audited by other auditors whose report, dated April 4, 2017, expressed an unqualified opinion on that financial statement schedule. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 21, 2019 +S-13 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF INCOME +For the Years Ended December 31, 2018 , 2017 and 2016 +(in millions) +Years Ended December 31, +2018 +2017 +2016 +EXPENSES +Other Operation +$ +— +$ +— +$ +0.8 +TOTAL EXPENSES +— +— +0.8 +OPERATING LOSS +— +— +(0.8 +) +Other Income (Expense): +Interest Income – Affiliated +104.6 +82.9 +57.8 +Interest Expense +(103.4 +) +(82.4 +) +(57.9 +) +INCOME (LOSS) BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS +1.2 +0.5 +(0.9 +) +Income Tax Expense (Benefit) +0.2 +0.2 +(0.3 +) +Equity Earnings of Unconsolidated Subsidiaries +314.9 +270.4 +193.3 +NET INCOME +$ +315.9 +$ +270.7 +$ +192.7 +The 2017 amounts presented reflect the revisions made to AEPTCo’s previously issued financial statements. +See Condensed Notes to Condensed Financial Information beginning on page S-18 . +S-14 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +ASSETS +December 31, 2018 and 2017 +(in millions) +December 31, +2018 +2017 +CURRENT ASSETS +Advances to Affiliates +$ +17.0 +$ +22.5 +Accounts Receivable: +Affiliated Companies +17.1 +17.3 +Total Accounts Receivable +17.1 +17.3 +TOTAL CURRENT ASSETS +34.1 +39.8 +OTHER NONCURRENT ASSETS +Notes Receivable – Affiliated +2,823.0 +2,550.4 +Investments in Unconsolidated Subsidiaries +3,571.1 +2,592.1 +TOTAL OTHER NONCURRENT ASSETS +6,394.1 +5,142.5 +TOTAL ASSETS +$ +6,428.2 +$ +5,182.3 +The 2017 amounts presented reflect the revisions made to AEPTCo’s previously issued financial statements. +See Condensed Notes to Condensed Financial Information beginning on page S-18 . +S-15 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2018 and 2017 +(in millions) +December 31, +2018 +2017 +CURRENT LIABILITIES +Accounts Payable: +General +$ +0.3 +$ +0.4 +Affiliated Companies +17.7 +24.0 +Long-term Debt Due Within One Year – Nonaffiliated +85.0 +50.0 +Accrued Taxes +0.1 +0.1 +Accrued Interest +15.9 +15.0 +Other Current Liabilities +1.4 +2.5 +TOTAL CURRENT LIABILITIES +120.4 +92.0 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated +2,738.0 +2,500.4 +TOTAL NONCURRENT LIABILITIES +2,738.0 +2,500.4 +TOTAL LIABILITIES +2,858.4 +2,592.4 +MEMBER’S EQUITY +Paid-in Capital +2,480.6 +1,816.6 +Retained Earnings +1,089.2 +773.3 +TOTAL MEMBER’S EQUITY +3,569.8 +2,589.9 +TOTAL LIABILITIES AND MEMBER’S EQUITY +$ +6,428.2 +$ +5,182.3 +The 2017 amounts presented reflect the revisions made to AEPTCo’s previously issued financial statements. +See Condensed Notes to Condensed Financial Information beginning on page S-18 . +S-16 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2018 , 2017 and 2016 +(in millions) +Years Ended December 31, +2018 +2017 +2016 +OPERATING ACTIVITIES +Net Income +$ +315.9 +$ +270.7 +$ +192.7 +Adjustments to Reconcile Net Income to Net Cash Flows +from Operating Activities: +Deferred Income Taxes +— +1.6 +(1.7 +) +Equity Earnings of Unconsolidated Subsidiaries +(314.9 +) +(270.4 +) +(193.3 +) +Change in Other Noncurrent Assets +— +— +0.2 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net +0.2 +4.5 +2.2 +Accounts Payable +(6.4 +) +5.4 +2.8 +Accrued Taxes, Net +— +0.1 +0.1 +Accrued Interest +0.9 +4.5 +2.6 +Other Current Liabilities +(1.2 +) +(8.1 +) +(5.5 +) +Net Cash Flows from (Used for) Operating Activities +(5.5 +) +8.3 +0.1 +INVESTING ACTIVITIES +Change in Advances to Affiliates, Net +5.5 +(8.3 +) +(0.1 +) +Issuance of Notes Receivable to Affiliated Companies +(271.0 +) +(617.6 +) +(686.9 +) +Repayments of Notes Receivable from Affiliated Companies +— +— +300.0 +Capital Contributions to Subsidiaries +(664.0 +) +(361.6 +) +(212.0 +) +Net Cash Flows Used for Investing Activities +(929.5 +) +(987.5 +) +(599.0 +) +FINANCING ACTIVITIES +Capital Contribution from Member +664.0 +361.6 +212.0 +Issuance of Long-term Debt – Nonaffiliated +321.0 +617.6 +686.9 +Retirement of Long-term Debt – Nonaffiliated +(50.0 +) +— +(300.0 +) +Net Cash Flows from Financing Activities +935.0 +979.2 +598.9 +Net Change in Cash and Cash Equivalents +— +— +— +Cash and Cash Equivalents at Beginning of Period +— +— +— +Cash and Cash Equivalents at End of Period +$ +— +$ +— +$ +— +The 2017 amounts presented reflect the revisions made to AEPTCo’s previously issued financial statements. +See Condensed Notes to Condensed Financial Information beginning on page S-18 . +S-17 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +INDEX OF CONDENSED NOTES TO CONDENSED FINANCIAL INFORMATION +1. Summary of Significant Accounting Policies +2. Commitments, Guarantees and Contingencies +3. Financing Activities +4. Related Party Transactions +S-18 +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +The condensed financial information of AEPTCo Parent is required as a result of the restricted net assets of AEPTCo consolidated subsidiaries exceeding 25% of AEPTCo consolidated net assets as of December 31, 2018 . AEPTCo Parent is the direct holding company for the seven State Transcos. The primary source of income for AEPTCo Parent is equity in its subsidiaries’ earnings. +Income Taxes +AEPTCo Parent joins in the filing of a consolidated federal income tax return with its affiliates in the AEP System. The allocation of the AEP System’s current consolidated federal income tax to the AEP System companies allocates the benefit of current tax losses to the AEP System companies giving rise to such losses in determining their current tax expense. The tax benefit of AEP Parent is allocated to its subsidiaries with taxable income. +Revisions to Previously Issued Financial Statements +During 2018, management identified certain transmission assets that it believes should not have been included in AEPTCo's SPP transmission formula rates since 2013. Additionally, during 2018, management determined that AFUDC was improperly capitalized and that revenue should not have been recorded related to that AFUDC dating back to 2011. Accordingly, management revised the historical 2017 period of AEPTCo Parent’s financial statements included in Schedule I - Condensed Financial Information. The statements of income reflect the adjustments to Equity Earnings of Unconsolidated Subsidiaries and Net Income of $(15) million. The balance sheets reflect the adjustments to Investments in Unconsolidated Subsidiaries and Retained Earnings of $(15) million. The statements of cash flows reflect the adjustments to Net Income and Equity Earnings of Unconsolidated Subsidiaries of $(15) million. The effects of recording these adjustments in 2017 are not material to AEPTCo Parent's financial statements for 2017 or any earlier period. See the “Revisions to Previously Issued Financial Statements” section of Note 1 included in the 2018 Annual Reports for additional information. +2. COMMITMENTS, GUARANTEES AND CONTINGENCIES +AEPTCo Parent and its subsidiaries are parties to legal matters. For further discussion, see Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report. +3. FINANCING ACTIVITIES +For discussion of Financing Activities, see Note 14 - Financing Activities to AEPTCo’s audited consolidated financial statements included in the 2018 Annual Report. +4. RELATED PARTY TRANSACTIONS +Payments on Behalf of Subsidiaries +Due to occasional time sensitivity and complexity of payments, Parent makes certain insurance, tax and other payments on behalf of subsidiary companies. Parent is then fully reimbursed by the subsidiary companies. AEPTCo Parent also makes convenience payments on behalf of its State Transcos. AEPTCo Parent is then fully reimbursed by its State Transcos. +S-19 +Long-term Lending to Subsidiaries +AEPTCo Parent enters into debt arrangements with nonaffiliated entities. AEPTCo Parent has long-term debt of $2.8 billion and $2.6 billion as of December 31, 2018 and 2017 , respectively. AEPTCo Parent uses the proceeds from these nonaffiliated debt arrangements to make affiliated loans to its State Transcos using the same interest rates and maturity dates as the nonaffiliated debt arrangements. AEPTCo Parent has recorded Notes Receivable – Affiliated of $2.8 billion and $2.6 billion as of December 31, 2018 and 2017 , respectively. Related to these nonaffiliated and affiliated debt arrangements, AEPTCo Parent has recorded Accrued Interest of $16 million and $15 million as of December 31, 2018 and 2017 , respectively. AEPTCo Parent has also recorded Accounts Receivable – Affiliated Companies of $17 million and $17 million as of December 31, 2018 and 2017 , respectively. AEPTCo Parent has recorded Interest Income – Affiliated of $105 million, $83 million and $58 million for the years ended December 31, 2018 , 2017 and 2016 , respectively, related to the Notes Receivable – Affiliated. AEPTCo Parent has recorded Interest Expense of $103 million, $82 million and $58 million for the years ended December 31, 2018 , 2017 and 2016 , respectively, related to the nonaffiliated debt arrangements. +Short-term Lending to Subsidiaries +Parent uses a commercial paper program to meet the short-term borrowing needs of subsidiaries. The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds certain nonutility subsidiaries. In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons. The program also allows some direct borrowers to invest excess cash with Parent. +Interest expense related to AEPTCo Parent’s short-term borrowing is included in Interest Expense on AEPTCo Parent’s statements of income. AEPTCo Parent incurred immaterial interest expense for amounts borrowed from AEP affiliates for the years ended December 31, 2018 , 2017 and 2016 . +Interest income related to AEPTCo Parent’s short-term lending is included in Interest Income – Affiliated on AEPTCo Parent’s statements of income. AEPTCo Parent earned interest income for amounts advanced to AEP affiliates of $1 million and $1 million for the year ended December 31, 2018 and 2017 , respectively. The amount for the year ended December 31, 2016 was immaterial. +S-20 +EXHIBIT INDEX +The documents listed below are being filed or have previously been filed on behalf of the Registrants shown and are incorporated herein by reference to the documents indicated and made a part hereof. Exhibits (“Ex”) not identified as previously filed are filed herewith. Exhibits designated with a dagger (†) are management contracts or compensatory plans or arrangements required to be filed as an Exhibit to this Form. Exhibits designated with an asterisk (*) are filed herewith. +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +AEP‡ File No. 1-3525 +3(a) +Composite of the Restated Certificate of Incorporation of AEP, dated April 23, 2015. +Form 10-Q, Ex 3, June 30, 2015 +3(b) +Composite By-Laws of AEP, as amended as of October 20, 2015. +Form 8-K, Ex 3(b) dated October 21, 2015 +4(a) +Indenture (for unsecured debt securities), dated as of May 1, 2001, between AEP and The Bank of New York, as Trustee. +Registration Statement No. 333-86050, Ex 4( a )( b )( c ) +Registration Statement No. 333-105532, Ex 4( d )( e )( f ) +Registration Statement No. 333-200956, Ex 4(b) +Registration Statement No. 333-222068, Ex 4(b) +4(a)1 +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated November 30, 2018 of 3.65% Senior Notes Series I due 2021 and 4.30% Senior Notes, Series J due 2028. +Form 8-K, Ex. 4(a) dated November 30, 2018 +4(b) +First Amendment to Fourth Amended and Restated Credit Agreement dated June 30, 2016 among AEP, +the banks, financial institutions and other institutional lenders listed on the signature pages thereof and Wells Fargo Bank, N.A., as Administrative Agent. +Form 10-Q, Ex 4, September 30, 2018 +10(a) +Lease Agreements, dated as of December 1, 1989, between AEGCo or I&M and Wilmington Trust Company, as amended. +Registration Statement No. 33-32752, Ex 28(c)(1-6)(C) +Registration Statement No. 33-32753, Ex 28(a)(1-6)(C) +AEGCo 1993 Form 10-K, Ex 10(c)(1-6)(B) +I&M 1993 Form 10-K, Ex 10(e)(1-6)(B) +10(b) +Consent Decree with U.S. District Court dated October 9, 2007, as modified. +Form 8-K, Ex 10.1 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +†10(c) +AEP Retainer Deferral Plan for Non-Employee Directors, as Amended and Restated effective July 26, 2016. +2016 Form 10-K, Ex 10(h) +†10(d) +AEP Stock Unit Accumulation Plan for Non-Employee Directors as amended July 26, 2016. +2016 Form 10-K, Ex 10(i) +†10(e) +AEP System Excess Benefit Plan, Amended and Restated as of January 1, 2008. +2008 Form 10-K, Ex 10(l)(1)(A) +†10(e)(1) +Guaranty by AEP of AEPSC Excess Benefits Plan. +1990 Form 10-K, Ex 10(h)(1)(B) +†10(f) +AEP System Supplemental Retirement Savings Plan, Amended and Restated as of January 1, 2011 (Non-Qualified). +2010 Form 10-K, Ex 10 +†10(f)(1)(A) +Amendment to AEP System Supplemental Retirement Savings Plan, as Amended and Restated as of January 1, 2011 (Non-Qualified). +2014 Form 10-K, Ex 10(l)(1)(A) +†10(g) +AEPSC Umbrella Trust for Executives. +1993 Form 10-K, Ex 10(g)(3) +E-1 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +†10(g)(1)(A) +First Amendment to AEPSC Umbrella Trust for Executives. +2008 Form 10-K, Ex 10(l)(3)(A) +*†10(g)(2)(A) +Second Amendment to AEPSC Umbrella Trust for Executives. +†10(h) +AEP System Incentive Compensation Deferral Plan Amended and Restated as of January 1, 2008. +2008 Form 10-K, Ex 10(p) +†10(h)(1)(A) +First Amendment to AEP System Incentive Compensation Deferral Plan, as Amended and Restated effective January 1, 2008. +2011 Form 10-K, Ex 10(p)(1)(A) +†10(h)(2)(A) +Second Amendment to AEP System Incentive Compensation Deferral Plan, as Amended and Restated effective January 1, 2008. +2014 Form 10-K, Ex 10(q)(2)(A) +†10(i) +AEP Change In Control Agreement, as Revised Effective January 1, 2017. +Form 10-Q, Ex 10(c) , September 30, 2016 +†10(j) +Amended and Restated AEP System Long-Term Incentive Plan as of September 21, 2016. +Form 10-Q, Ex 10(a) , September 30, 2016 +†10(j)(1)(A) +Performance Share Award Agreement furnished to participants of the AEP System Long-Term Incentive Plan, as amended. +Form 10-Q, Ex 10(a), March 30, 2018 +†10(j)(2)(A) +Restricted Stock Unit Agreement furnished to participants of the AEP System Long-Term Incentive Plan as Amended and Restated. +Form 10-Q, Ex 10(b), March 30, 2018 +†10(k) +AEP System Stock Ownership Requirement Plan Amended and Restated effective June 20, 2017. +Form 10-Q, Ex 10, June 30, 2017 +†10(l) +Central and South West System Special Executive Retirement Plan Amended and Restated effective January 1, 2009. +2008 Form 10-K, Ex 10(v) +†10(m) +AEP Executive Severance Plan Amended and Restated effective October 24, 2016. +Form 10-Q, Ex 10(d) , September 30, 2016 +†10(n) +Letter Agreement dated November 20, 2012 between AEPSC and Lana Hillebrand. +2013 Form 10-K, Ex 10(x) +†10(o) +AEP Aircraft Timesharing Agreement dated September 17, 2018 between American Electric Power Service Corporation and Nicholas K. Akins. +Form 10-Q, Ex 10, September 30, 2018 +*13 +Copy of those portions of the AEP 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*21 +List of subsidiaries of AEP. +*23 (1) +Consent of PricewaterhouseCoopers LLP. +*23 (2) +Consent of Deloitte & Touche LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +E-2 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +AEP TEXAS‡ File No. 333-221643 +3(a) +Composite of the Restated Certificate of Incorporation, as amended. +Registration No. 333-221643, Ex 3(a) +3(b) +Bylaws. +Registration No. 333-221643, Ex 3(b) +4(a)(1) +Indenture, dated as of September 1, 2017, between AEP Texas Inc. and The Bank of New York Mellon Trust Company, N.A., as Trustee. +Registration No. 333-221643, Ex 4(a)-1 , 4(a)-2 +Form 8-K, Ex 4(a) dated May 17, 2018 +4(a)(2) +Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated January 11, 2018 of 2.40% Senior Notes, Series C due 2022 and 3.80% Senior Notes, Series D due 2047 +2017 Form 10-K, Ex4(a)(3) +4(a)(3) +Second Supplemental Indenture dated as of May 17, 2018, between AEP Texas Inc. and The Bank of New York Mellon Trust Company, N.A., as Trustee of 3.950 Senior Notes, Series E due 2028. +Form 8-K, Ex 4(a) dated May 17, 2018 +4(a)(4) +Company Order and Officer’s Certificate to The Bank of New York Mellon Trust Company, N.A. dated January 24, 2019 of 3.950% Senior Notes, Series F due 2028. +Form 8-K, Ex 4(a) dated January 24, 2019 +*13 +Copy of those portions of the AEP Texas 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +E-3 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +AEPTCo‡ File No. 333-217143 +3(a) +Limited Liability Company Agreement of AEP Transmission Company, LLC dated as of January 27, 2006. +Registration Statement No. 333-217143, Ex 3(a) +3(b) +First Amendment to Limited Liability Company Agreement dated as of May 21, 2013. +Registration Statement No. 333-217143, Ex 3(b) +4(a)(1) +Indenture, dated as of November 1, 2016, between AEP Transmission Company, LLC and The Bank of New York Mellon Trust Company, N.A., as Trustee. +Registration Statement No. 333-217143, Ex 4(a)-1 , 4(a)-2 +Registration Statement No. 333-225325, Ex 4 (b) (c) (d) +4(a)(2) +Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated September 7, 2018 of 4.25% Senior Notes, Series J due 2048. +Form 8-K, Ex 4(a) dated September 7, 2018 +4(c)(1) +Note Purchase Agreement, dated as of October 18, 2012 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-1 +4(c)(2) +Supplement to Note Purchase Agreement, dated as of November 7, 2013 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-2 +4(c)(3) +Supplement to Note Purchase Agreement, dated as of November 14, 2014 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-3 +*13 +Copy of those portions of the AEPTCo 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*23(1) +Consent of PricewaterhouseCoopers LLP. +*23(2) +Consent of Deloitte & Touche LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +E-4 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +APCo‡ File No. 1-3457 +3(a) +Composite of the Restated Articles of Incorporation of APCo, amended as of March 7, 1997. +1996 Form 10-K, Ex 3(d) +3(b) +Composite By-Laws of APCo, amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) +Indenture (for unsecured debt securities), dated as of January 1, 1998, between APCo and The Bank of New York, As Trustee. +Registration Statement No. 333-45927, Ex 4(a)(b) +Registration Statement No. 333-49071, Ex 4(b) +Registration Statement No. 333-84061, Ex 4(b)(c) +Registration Statement No. 333-100451, Ex 4(b) +Registration Statement No. 333-116284, Ex 4( b )( c ) +Registration Statement No. 333-123348, Ex 4( b )( c ) +Registration Statement No. 333-136432, Ex 4( b )( c )( d ) +Registration Statement No. 333-161940, Ex 4( b )( c )( d ) +Registration Statement No. 333-182336, Ex 4( b )( c ) +Registration Statement No. 333-200750, Ex. 4( b )( c ) +Registration Statement No. 333-214448, Ex. 4(b) +4(a)(1) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated May 11, 2017 of 3.30% Senior Notes Series X due 2027. +Form 8-K, Ex 4(a) dated May 11, 2017 +10(a) +Inter-Company Power Agreement, dated as of July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(d) +Consent Decree with U.S. District Court, as modified. +Form 8-K, Ex 10.1 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +*13 +Copy of those portions of the APCo 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*23 (1) +Consent of PricewaterhouseCoopers LLP. +*23 (2) +Consent of Deloitte & Touche LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +E-5 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +I&M‡ File No. 1-3570 +3(a) +Composite of the Amended Articles of Acceptance of I&M, dated of March 7, 1997. +1996 Form 10-K, Ex 3(c) +3(b) +Composite By-Laws of I&M, amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) +Indenture (for unsecured debt securities), dated as of October 1, 1998, between I&M and The Bank of New York, as Trustee. +Registration Statement No. 333-88523, Ex 4(a)(b)(c) +Registration Statement No. 333-58656, Ex 4( b )( c ) +Registration Statement No. 333-108975, Ex 4( b )( c )( d ) +Registration Statement No. 333-136538, Ex 4( b )( c ) +Registration Statement No. 333-156182, Ex 4(b) +Registration Statement No. 333-185087, Ex 4(b) +Registration Statement No. 333-207836, Ex 4(b) +Registration Statement No. 333-225103, Ex 4( b )( c )( d ) +4(b) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated August 8, 2018 of 4.25% Series N due 2048. +Form 8-K, Ex 4(a) dated August 8, 2018 +10(a) +Inter-Company Power Agreement, dated as of July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(b) +Unit Power Agreement dated as of March 31, 1982 between AEGCo and I&M, as amended. +Registration Statement No. 33-32752, Ex 28(b)(1)(A)(B) +10(c) +Consent Decree with U.S. District Court, as modified. +Form 8-K, Ex 10.1 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +10(d) +Lease Agreements, dated as of December 1, 1989, between I&M and Wilmington Trust Company, as amended. +Registration Statement No. 33-32753, Ex 28(a)(1-6)(C) +1993 Form 10-K, Ex 10(e)(1-6)(B) +*13 +Copy of those portions of the I&M 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*23 (1) +Consent of PricewaterhouseCoopers LLP. +*23 (2) +Consent of Deloitte & Touche LLP. +*24 +Power of Attorney. +E-6 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +OPCo‡ File No.1-6543 +3(a) +Composite of the Amended Articles of Incorporation of OPCo, dated June 3, 2002. +Form 10-Q, Ex 3(e), June 30, 2002 +3(b) +Amended Code of Regulations of OPCo. +Form 10-Q, Ex 3(b), June 30, 2008 +4(a) +Indenture (for unsecured debt securities), dated as of September 1, 1997, between OPCo and Bankers Trust Company (now The Bank of New York Mellon Trust Company, N.A. as assignee of Deutsche Bank Trust Company Americas), as Trustee. +Registration Statement No. 333-49595, Ex 4(a)(b)(c) +Registration Statement No. 333-106242, Ex 4( b )( c )( d ) +Registration Statement No. 333-127913, Ex 4( b )( c ) +Registration Statement No. 333-139802, Ex 4( b )( c )( d ) +Registration Statement No. 333-161537, Ex 4( b )( c )( d ) +Registration Statement No. 333-211192, Ex 4(b) +4a(1) +Resignation of Deutsche Bank Trust Company Americas, as Trustee and appointment of The Bank of New York Mellon Trust Company, N.A. as Trustee of Indenture with OPCo dated as of September 1, 1997. +Form 8-K, Item 8.01 dated October 8, 2018 +4(c) +Indenture (for unsecured debt securities), dated as of February 1, 2003, between OPCo and Bank One, N.A., as Trustee. +Registration Statement No. 333-127913, Ex 4( d )( e )( f ) +4(d) +Indenture (for unsecured debt securities), dated as of September 1, 1997, between CSPCo (predecessor in interest to OPCo) and Bankers Trust Company, as Trustee. +Registration Statement No. 333-54025, Ex 4(a)(b)(c)(d) +Registration Statement No. 333-128174, Ex 4( b )( c )( d ) +Registration Statement No. 333-150603, Ex 4(b) +4(e) +Indenture (for unsecured debt securities), dated as of February 1, 2003, between CSPCo (predecessor in interest to OPCo) and Bank One, N.A., as Trustee. +Registration Statement No. 333-128174, Ex 4( e )( f )( g ) +Registration Statement No. 333-150603, Ex 4(b) +4(f) +First Supplemental Indenture, dated as of December 31, 2011, by and between OPCo and The Bank of New York Mellon Trust Company, N.A., as trustee, supplementing the Indenture dated as of September 1, 1997 between CSPCo (predecessor in interest to OPCo) and the trustee. +Form 8-K, Ex 4.1 dated January 6, 2012 +E-7 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(g) +Third Supplemental Indenture, dated as of December 31, 2011, by and between OPCo and The Bank of New York Mellon Trust Company, N.A., as trustee, supplementing the Indenture dated as of February 14, 2003 between CSPCo (predecessor in interest to OPCo) and the trustee. +Form 8-K, Ex 4.2 dated January 6, 2012 +4(h) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated March 22, 2018 of 4.15% Series N due 2048. +Form 8-K, Ex 4(a), dated March 22, 2018 +10(a) +Inter-Company Power Agreement, dated July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(b) +Consent Decree with U.S. District Court, as modified. +Form 8-K, Item Ex 10.1 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +*13 +Copy of those portions of the OPCo 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*23 (1) +Consent of PricewaterhouseCoopers LLP. +*23 (2) +Consent of Deloitte & Touche LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +PSO‡ File No. 0-343 +3(a) +Certificate of Amendment to Restated Certificate of Incorporation of PSO. +Form 10-Q, Ex 3(a), June 30, 2008 +3(b) +Composite By-Laws of PSO amended as of February 26, 2008. +2007 Form 10-K, Ex 3 (b) +E-8 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(a) +Indenture (for unsecured debt securities), dated as of November 1, 2000, between PSO and The Bank of New York, as Trustee. +Registration Statement No. 333-100623, Ex 4( a )( b ) +Registration Statement No. 333-114665, Ex 4( b )( c ) +Registration Statement No. 333-133548, Ex 4( b )( c ) +Registration Statement No. 333-156319, Ex 4( b )( c ) +4(b) +Eighth Supplemental Indenture, dated as of November 13, 2009 between PSO and The Bank of New York Mellon, as Trustee, establishing terms of the 5.15% Senior Notes, Series H, due 2019. +Form 8-K, Ex 4(a), dated November 13, 2009 +4(c) +Ninth Supplemental Indenture, dated as of January 19, 2011 between PSO and The Bank of New York Mellon Trust Company, N.A., as Trustee, establishing terms of 4.40% Senior Notes, Series I, due 2021. +Form 8-K, Ex 4(a) dated January 20, 2011 +*13 +Copy of those portions of the PSO 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +SWEPCo‡ File No. 1-3146 +3(a) +Composite of Amended Restated Certificate of Incorporation of SWEPCo. +2008 Form 10-K, Ex 3(a) +3(b) +Composite By-Laws of SWEPCo amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) +Indenture (for unsecured debt securities), dated as of February 4, 2000, between SWEPCo and The Bank of New York, as Trustee. +Registration Statement No. 333-96213 +Registration Statement No. 333-87834, Ex 4( a )( b ) +Registration Statement No. 333-100632, Ex 4(b) +Registration Statement No. 333-108045, Ex 4(b) +Registration Statement No. 333-145669, Ex 4( c )( d ) +Registration Statement No. 333-161539, Ex 4( b )( c ) +Registration Statement No. 333-194991, Ex 4( b )( c ) +Registration Statement No. 333-208535, Ex 4( b )( c ) +Registration Statement No. 333-226856, Ex 4( b )( c ) +E-9 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(b) +Thirteenth Supplemental Indenture, dated as of September 1, 208 between SWEPCo and The Bank of New York Mellon Trust Company, N.A., as Trustee, establishing terms of the 4.10% Senior Notes, Series M. Due 2028. +Form 8-K, Ex 4(a) dated September 13, 2018 +*13 +Copy of those portions of the SWEPCo 2018 Annual Report (for the fiscal year ended December 31, 2018) which are incorporated by reference in this filing. +*23 (1) +Consent of PricewaterhouseCoopers LLP. +*23 (2) +Consent of Deloitte & Touche LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*95 +Mine Safety Disclosure. +101.INS +XBRL Instance Document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +‡ Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. +The agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time. +E-10 \ No newline at end of file diff --git a/raw/filings/0000004904/2018/0000004904-19-000009/filing_metadata.csv b/raw/filings/0000004904/2018/0000004904-19-000009/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..b52140e3d6636dcfe626a95993ca5d706eb18d2b --- /dev/null +++ b/raw/filings/0000004904/2018/0000004904-19-000009/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004904,AEP,AMERICAN ELECTRIC POWER CO INC,2018,10-K,2019-02-21,2018-12-31,2019-02-21T21:27:59.000Z,0000004904-19-000009,aep10klegal20184q.htm,AMERICAN ELECTRIC POWER 2018 10-K,112333041,1,0,https://www.sec.gov/Archives/edgar/data/4904/000000490419000009/aep10klegal20184q.htm,https://www.sec.gov/Archives/edgar/data/4904/000000490419000009/ diff --git a/raw/filings/0000004904/2018/0000004904-19-000009/item1.txt b/raw/filings/0000004904/2018/0000004904-19-000009/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..96a05946d3c77adc7f03510216ae042dd846dea3 --- /dev/null +++ b/raw/filings/0000004904/2018/0000004904-19-000009/item1.txt @@ -0,0 +1,977 @@ +ITEM 1. BUSINESS +GENERAL +Overview and Description of Major Subsidiaries +AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company that owns, directly or indirectly, all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries. +The service areas of AEP’s public utility subsidiaries cover portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Transmission networks are interconnected with extensive distribution facilities in the territories served. The public utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers. Restructuring laws in Michigan, Ohio and the ERCOT area of Texas have caused AEP public utility subsidiaries in those states to unbundle previously integrated regulated rates for their retail customers. +The member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity and transportation and handling of fuel. The companies of the AEP System also obtain certain accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost from a common provider, AEPSC. +As of December 31, 2018 , the subsidiaries of AEP had a total of 17,582 employees. Because it is a holding company rather than an operating company, AEP has no employees. The material subsidiaries of AEP are as follows: +AEP Texas +Organized in Delaware in 1925, AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,050,000 retail customers through REPs in west, central and southern Texas. As of December 31, 2018 , AEP Texas had 1,549 employees. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and primary metal manufacturing. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. AEP Texas is part of AEP’s Transmission and Distribution Utilities segment. +AEPTCo +Organized in Delaware in 2006, AEPTCo is a holding company for the State Transcos. The State Transcos develop and own new transmission assets that are physically connected to the AEP System. Individual State Transcos (a) have obtained the approvals necessary to operate in Indiana, Kentucky, Michigan, Ohio, Oklahoma and West Virginia, subject to any applicable siting requirements, (b) are authorized to submit projects for commission approval in Virginia and (c) have been granted consent to enter into a joint license agreement that will support investment in Tennessee. Neither AEPTCo nor its subsidiaries have any employees. Instead, AEPSC and certain AEP utility subsidiaries provide the services required by these entities. AEPTCo is part of the AEP Transmission Holdco segment. +1 +APCo +Organized in Virginia in 1926, APCo is engaged in the generation, transmission and distribution of electric power to approximately 956,000 retail customers in the southwestern portion of Virginia and southern West Virginia, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. APCo owns 6,629 MWs of generating capacity. APCo uses its generation to serve its retail and other customers. As of December 31, 2018 , APCo had 1,797 employees. Among the principal industries served by APCo are coal mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. APCo is a member of PJM. APCo is part of AEP’s Vertically Integrated Utilities segment. +I&M +Organized in Indiana in 1907, I&M is engaged in the generation, transmission and distribution of electric power to approximately 596,000 retail customers in northern and eastern Indiana and southwestern Michigan, and in supplying and marketing electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities and other market participants. I&M owns or leases 3,624 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2018 , I&M had 2,400 employees. Among the principal industries served are primary metals, transportation equipment, chemical manufacturing, plastics and rubber products and fabricated metal product manufacturing. I&M is a member of PJM. I&M is part of AEP’s Vertically Integrated Utilities segment. +KPCo +Organized in Kentucky in 1919, KPCo is engaged in the generation, transmission and distribution of electric power to approximately 166,000 retail customers in eastern Kentucky, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. KPCo owns 1,060 MWs of generating capacity. KPCo uses its generation to serve its retail and other customers. As of December 31, 2018 , KPCo had 522 employees. Among the principal industries served are petroleum and coal products manufacturing, chemical manufacturing, coal mining, oil and gas extraction and primary metals. KPCo is a member of PJM. KPCo is part of AEP’s Vertically Integrated Utilities segment. +KGPCo +Organized in Virginia in 1917, KGPCo provides electric service to approximately 48,000 retail customers in Kingsport and eight neighboring communities in northeastern Tennessee. KGPCo does not own any generating facilities and is a member of PJM. It purchases electric power from APCo for distribution to its customers. As of December 31, 2018 , KGPCo had 55 employees. KGPCo is part of AEP’s Vertically Integrated Utilities segment. +OPCo +Organized in Ohio in 1907 and re-incorporated in 1924, OPCo is engaged in the transmission and distribution of electric power to approximately 1,486,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. As of December 31, 2018 , OPCo had 1,704 employees. Among the principal industries served by OPCo are primary metals, petroleum and coal products manufacturing, plastics and rubber products, chemical manufacturing, fabricated metal product manufacturing and data centers. OPCo is a member of PJM. OPCo is part of AEP’s Transmission and Distribution Utilities segment. +PSO +Organized in Oklahoma in 1913, PSO is engaged in the generation, transmission and distribution of electric power to approximately 556,000 retail customers in eastern and southwestern Oklahoma, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. PSO owns 3,893 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2018 , PSO had 1,125 employees. Among the principal industries served by PSO are paper manufacturing, oil and gas extraction, petroleum and coal products manufacturing, transportation equipment and pipeline transportation. PSO is a member of SPP. PSO is part of AEP’s Vertically Integrated Utilities segment. +2 +SWEPCo +Organized in Delaware in 1912, SWEPCo is engaged in the generation, transmission and distribution of electric power to approximately 537,000 retail customers in northeastern and panhandle of Texas, northwestern Louisiana and western Arkansas and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. SWEPCo owns 5,240 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2018 , SWEPCo had 1,469 employees. Among the principal industries served by SWEPCo are petroleum and coal products manufacturing, food manufacturing, paper manufacturing, oil and gas extraction and chemical manufacturing. The territory served by SWEPCo includes several military installations, colleges and universities. SWEPCo also owns and operates a lignite coal mining operation. SWEPCo is a member of SPP. SWEPCo is part of AEP’s Vertically Integrated Utilities segment. +WPCo +Organized in West Virginia in 1883 and reincorporated in 1911, WPCo provides electric service to approximately 42,000 retail customers in northern West Virginia. WPCo owns 780 MWs of generating capacity which it uses to serve its retail and other customers. WPCo is a member of PJM. As of December 31, 2018 , WPCo had 57 employees. WPCo is part of AEP’s Vertically Integrated Utilities segment. +Service Company Subsidiary +AEPSC is a service company subsidiary that provides accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost to AEP subsidiaries. The executive officers of AEP and certain of its public utility subsidiaries are employees of AEPSC. As of December 31, 2018 , AEPSC had 6,335 employees. +Company Website and Availability of SEC Filings +Our principal corporate website address is www.aep.com. Information on our website is not incorporated by reference herein and is not part of this Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding AEP. +3 +Public Utility Subsidiaries by Jurisdiction +The following table illustrates certain regulatory information with respect to the jurisdictions in which the public utility subsidiaries of AEP operate: +Principal Jurisdiction +AEP Utility Subsidiaries Operating in that Jurisdiction +Authorized Return on Equity (a) +FERC +AEPTCo - PJM +10.99% +(b) +AEPTCo - SPP +10.70% +(c) +Ohio +OPCo +10.20% +(d) +West Virginia +APCo +9.75% +WPCo +9.75% +Virginia +APCo +9.70% +Indiana +I&M +9.95% +Michigan +I&M +9.90% +Texas +AEP Texas +9.96% +SWEPCo +9.60% +Tennessee +KGPCo +9.85% +Kentucky +KPCo +9.70% +Louisiana +SWEPCo +9.80% +Arkansas +SWEPCo +10.25% +Oklahoma +PSO +9.30% +(a) +Identifies the predominant authorized ROE and may not include other, less significant, permitted recovery. Actual ROE varies from authorized ROE. +(b) +Current authorized ROE is 10.99%. In March 2018, a settlement agreement was filed at FERC lowering the ROE to 9.85% (10.35% inclusive of the RTO incentive adder of 0.5%). See “FERC Transmission Complaint - AEP’s PJM Participants” section of Note 4 included in the 2018 Annual Report. +(c) +Current authorized ROE is being challenged. See “FERC Transmission Complaint - AEP’s SPP Participants” section of Note 4 included in the 2018 Annual Report. +(d) +Authorized ROE was approved in OPCo’s last distribution base case. The authorized ROE for riders with an approved equity return (e.g. Distribution Investment Rider) is 10.00%. See “Ohio Electric Security Plan Filings” section of Note 4 included in the 2018 Annual Report. +(a) +Pretax income does not include intercompany eliminations. +4 +CLASSES OF SERVICE +The principal classes of service from which the public utility subsidiaries of AEP derive revenues and the amount of such revenues during the years ended December 31, 2018 , 2017 and 2016 are as follows: +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Vertically Integrated Utilities Segment +Retail Revenues +Residential Sales +$ +3,818.5 +$ +3,399.8 +$ +3,423.1 +Commercial Sales +2,251.4 +2,148.6 +2,102.2 +Industrial Sales +2,234.1 +2,156.9 +2,050.6 +PJM Net Charges +0.4 +(1.1 +) +(0.4 +) +Other Retail Sales +186.4 +181.4 +172.9 +Total Retail Revenues +8,490.8 +7,885.6 +7,748.4 +Wholesale Revenues +Off-system Sales +888.0 +907.4 +921.5 +Transmission +263.7 +202.2 +198.2 +Total Wholesale Revenues +1,151.7 +1,109.6 +1,119.7 +Other Electric Revenues +93.7 +106.1 +114.5 +Provision for Rate Refund +(210.1 +) +(46.4 +) +(10.0 +) +Other Operating Revenues +30.6 +40.2 +39.9 +Sales to Affiliates +88.8 +96.9 +79.4 +Total Revenues Vertically Integrated Utilities Segment +$ +9,645.5 +$ +9,192.0 +$ +9,091.9 +Transmission and Distribution Utilities Segment +Retail Revenues +Residential Sales +$ +2,213.5 +$ +2,085.3 +$ +2,217.9 +Commercial Sales +1,288.3 +1,225.3 +1,210.0 +Industrial Sales +499.2 +473.0 +498.2 +Other Retail Sales +39.6 +39.8 +38.9 +Total Retail Revenues +4,040.6 +3,823.4 +3,965.0 +Wholesale Revenues +Off-system Sales +119.3 +100.5 +131.0 +Transmission +394.7 +359.6 +327.0 +Total Wholesale Revenues +514.0 +460.1 +458.0 +Other Electric Revenues +54.5 +48.4 +55.6 +Provision for Rate Refund +(69.2 +) +(11.4 +) +(159.3 +) +Other Operating Revenues +12.4 +8.4 +8.9 +Sales to Affiliates +100.8 +90.4 +94.2 +Total Revenues Transmission and Distribution Utilities Segment +$ +4,653.1 +$ +4,419.3 +$ +4,422.4 +AEP Transmission Holdco Segment +Transmission Revenues +$ +291.3 +$ +204.3 +$ +150.6 +Other Electric Revenues +0.3 +— +— +Other Operating Revenues +0.3 +0.8 +0.1 +Sales to Affiliates +555.5 +588.3 +366.9 +Provision for Rate Refund +(43.3 +) +(26.7 +) +(4.8 +) +Total Revenues AEP Transmission Holdco Segment +$ +804.1 +$ +766.7 +$ +512.8 +Generation & Marketing Segment +Generation Revenues +Affiliated +$ +— +$ +— +$ +0.1 +Nonaffiliated +431.5 +534.6 +1,534.0 +Marketing, Competitive Retail and Renewable Revenues +Affiliated +122.2 +103.7 +127.2 +Nonaffiliated +1,386.6 +1,236.8 +1,324.7 +Total Revenues Generation & Marketing Segment +$ +1,940.3 +$ +1,875.1 +$ +2,986.0 +5 +AEP Texas +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +594.6 +$ +573.9 +$ +551.2 +Commercial Sales +448.1 +449.3 +421.2 +Industrial Sales +113.0 +107.0 +102.9 +Other Retail Sales +26.6 +26.6 +24.8 +Total Retail Revenues +1,182.3 +1,156.8 +1,100.1 +Wholesale Revenues +Transmission +313.4 +293.8 +258.0 +Other Electric Revenues +21.9 +20.8 +25.1 +Provision for Rate Refund +(31.3 +) +(1.1 +) +— +Total Electric Transmission and Distribution Revenues +1,486.3 +1,470.3 +1,383.2 +Sales to Affiliates +105.2 +65.7 +75.7 +Other Revenues +3.8 +2.4 +2.5 +Total Revenues +$ +1,595.3 +$ +1,538.4 +$ +1,461.4 +AEPTCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Transmission Revenues +$ +212.8 +$ +167.9 +$ +114.3 +Other Electric Revenues +0.3 +— +— +Other Operating Revenues +0.2 +0.8 +0.1 +Sales to Affiliates +598.9 +580.5 +367.5 +Provision for Rate Refund +(36.1 +) +(26.0 +) +(3.9 +) +Total Revenues +$ +776.1 +$ +723.2 +$ +478.0 +APCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +1,372.0 +$ +1,242.8 +$ +1,314.8 +Commercial Sales +598.3 +586.0 +603.0 +Industrial Sales +618.8 +639.0 +628.9 +PJM Net Charges +(0.2 +) +(0.4 +) +(0.6 +) +Other Retail Sales +79.5 +78.0 +80.5 +Total Retail Revenues +2,668.4 +2,545.4 +2,626.6 +Wholesale Revenues +Off-system Sales +116.4 +126.8 +137.8 +Transmission +56.3 +57.1 +45.9 +Total Wholesale Revenues +172.7 +183.9 +183.7 +Other Electric Revenues +31.1 +33.4 +40.5 +Provision for Rate Refund +(95.1 +) +(13.7 +) +(3.4 +) +Total Electric Generation, Transmission and Distribution Revenues +2,777.1 +2,749.0 +2,847.4 +Sales to Affiliates +181.4 +172.0 +142.1 +Other Revenues +9.0 +13.2 +11.7 +Total Revenues +$ +2,967.5 +$ +2,934.2 +$ +3,001.2 +6 +I&M +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +736.5 +$ +620.9 +$ +620.4 +Commercial Sales +494.6 +442.7 +440.1 +Industrial Sales +565.3 +518.1 +510.0 +PJM Net Charges +0.2 +(1.0 +) +0.1 +Other Retail Sales +7.2 +7.1 +7.1 +Total Retail Revenues +1,803.8 +1,587.8 +1,577.7 +Wholesale Revenues +Off-system Sales +459.3 +431.2 +446.6 +Transmission +18.4 +17.2 +23.9 +Total Wholesale Revenues +477.7 +448.4 +470.5 +Other Electric Revenues +15.7 +13.5 +15.2 +Provision for Rate Refund +(24.6 +) +(7.2 +) +(1.1 +) +Total Electric Generation, Transmission and Distribution Revenues +2,272.6 +2,042.5 +2,062.3 +Sales to Affiliates +85.5 +64.4 +88.3 +Other Revenues +12.6 +14.3 +17.0 +Total Revenues +$ +2,370.7 +$ +2,121.2 +$ +2,167.6 +OPCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +1,618.9 +$ +1,511.3 +$ +1,665.0 +Commercial Sales +840.2 +776.1 +785.0 +Industrial Sales +386.2 +365.9 +395.0 +Other Retail Sales +13.0 +13.2 +14.0 +Total Retail Revenues +2,858.3 +2,666.5 +2,859.0 +Wholesale Revenues +Off-system Sales +119.3 +100.5 +131.0 +Transmission +61.4 +65.8 +68.9 +Total Wholesale Revenues +180.7 +166.3 +199.9 +Other Electric Revenues +32.7 +31.0 +30.5 +Provision for Rate Refund +(37.9 +) +(10.3 +) +(159.3 +) +Total Electricity, Transmission and Distribution Revenues +3,033.8 +2,853.5 +2,930.1 +Sales to Affiliates +21.0 +24.4 +17.3 +Other Revenues +8.6 +6.0 +6.5 +Total Revenues +$ +3,063.4 +$ +2,883.9 +$ +2,953.9 +PSO +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +668.5 +$ +601.4 +$ +538.0 +Commercial Sales +411.3 +398.5 +348.6 +Industrial Sales +298.6 +273.4 +220.6 +Other Retail Sales +84.2 +80.9 +70.8 +Total Retail Revenues +1,462.6 +1,354.2 +1,178.0 +Wholesale Revenues +Off-system Sales +36.3 +13.9 +13.1 +Transmission +47.4 +42.3 +38.3 +Total Wholesale Revenues +83.7 +56.2 +51.4 +Other Electric Revenues +10.3 +8.5 +14.9 +Provision for Rate Refund +(19.0 +) +(1.4 +) +(0.1 +) +Total Electric Generation, Transmission and Distribution Revenues +1,537.6 +1,417.5 +1,244.2 +Sales to Affiliates +5.4 +4.3 +3.1 +Other Revenues +4.3 +5.4 +4.4 +Total Revenues +$ +1,547.3 +$ +1,427.2 +$ +1,251.7 +7 +SWEPCo +Years Ended December 31, +Description +2018 +2017 +2016 +(in millions) +Retail Revenues +Residential Sales +$ +665.9 +$ +597.0 +$ +587.7 +Commercial Sales +510.6 +492.5 +479.0 +Industrial Sales +338.3 +331.4 +307.1 +Other Retail Sales +8.9 +8.8 +8.1 +Total Retail Revenues +1,523.7 +1,429.7 +1,381.9 +Wholesale Revenues +Off-system Sales +216.8 +251.3 +243.9 +Transmission +94.2 +71.7 +78.4 +Total Wholesale Revenues +311.0 +323.0 +322.3 +Other Electric Revenues +20.9 +20.4 +20.0 +Provision for Rate Refund +(63.7 +) +(21.0 +) +(4.4 +) +Total Electric Generation, Transmission and Distribution Revenues +1,791.9 +1,752.1 +1,719.8 +Sales to Affiliates +28.4 +25.9 +24.5 +Other Revenues +1.6 +1.9 +2.0 +Total Revenues +$ +1,821.9 +$ +1,779.9 +$ +1,746.3 +FINANCING +General +Companies within the AEP System generally use short-term debt to finance working capital needs. Short-term debt may also be used to finance acquisitions, construction and redemption or repurchase of outstanding securities until such needs can be financed with long-term debt. In recent history, short-term funding needs have been provided for by cash on hand and AEP’s commercial paper program. Funds are made available to subsidiaries under the AEP corporate borrowing program. Certain public utility subsidiaries of AEP also sell accounts receivable to provide liquidity. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +AEP’s revolving credit agreement (which backstops the commercial paper program) includes covenants and events of default typical for this type of facility, including a maximum debt/capital test. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of its major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under the credit agreement. As of December 31, 2018 , AEP was in compliance with its debt covenants. With the exception of a voluntary bankruptcy or insolvency, any event of default has either or both a cure period or notice requirement before termination of the agreement. A voluntary bankruptcy or insolvency of AEP or one of its significant subsidiaries would be considered an immediate termination event. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +AEP’s subsidiaries have also utilized, and expect to continue to utilize, additional financing arrangements, such as securitization financings and leasing arrangements, including the leasing of coal transportation equipment and facilities. +8 +ENVIRONMENTAL AND OTHER MATTERS +General +AEP subsidiaries are currently subject to regulation by federal, state and local authorities with regard to air and water-quality control and other environmental matters, and are subject to zoning and other regulation by local authorities. The environmental issues that management believes are potentially material to the AEP System are outlined below. +Clean Water Act Requirements +Operations for AEP subsidiaries are subject to the Federal Clean Water Act, which prohibits the discharge of pollutants into waters of the United States except pursuant to appropriate permits and regulates systems that withdraw surface water for use in power plants. In 2014, the Federal EPA issued a final rule setting forth standards for existing power plants that is intended to reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water. The standards affect all plants withdrawing more than two million gallons of cooling water per day. Compliance with this standard is required within eight years of the effective date of the final rule. +In November 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for electricity generating facilities. The rule establishes limits on Flue Gas Desulfurization wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed as soon as possible after November 2018 and no later than December 2023. See “Environmental Issues - Clean Water Act Regulations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Coal Ash Regulation +AEP’s operations produce a number of different coal combustion by-products, including fly ash, bottom ash, gypsum and other materials. The Federal EPA rule regulates the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units. The rule requires certain standards for location, groundwater monitoring and dam stability to be met at landfills and certain surface impoundments at operating facilities. If existing disposal facilities cannot meet these standards, they will be required to close. See “Environmental Issues - Coal Combustion Residual Rule” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control mobile and stationary sources of air emissions. The major CAA programs affecting AEP’s power plants are described below. The states implement and administer many of these programs and could impose additional or more stringent requirements. +The Acid Rain Program +The CAA includes a cap-and-trade emission reduction program for SO 2 emissions from power plants and requirements for power plants and requirements for power plants to reduce NO x emissions through the use of available combustion controls, collectively called the Acid Rain Program. AEP continues to meet its obligations under the Acid Rain Program through the installation of controls, use of alternate fuels and participation in the emissions allowance markets. +9 +National Ambient Air Quality Standards (NAAQS) +The CAA requires the Federal EPA to review the available scientific data for criteria pollutants periodically and establish a concentration level in the ambient air for those substances that is adequate to protect the public health and welfare with an extra safety margin. The Federal EPA also can list additional pollutants and develop concentration levels for them. These concentration levels are known as NAAQS. +Each state identifies the areas within its boundaries that meet the NAAQS (attainment areas) and those that do not (non-attainment areas). Each state must develop a SIP to bring non-attainment areas into compliance with the NAAQS and maintain good air quality in attainment areas. All SIPs are submitted to the Federal EPA for approval. If a state fails to develop adequate plans, the Federal EPA develops and implements a plan. As the Federal EPA reviews the NAAQS and establishes new concentration levels, the attainment status of areas can change and states may be required to develop new SIPs. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Hazardous Air Pollutants (HAP) +The CAA also requires the Federal EPA to investigate HAP emissions from the electric utility sector and submit a report to Congress to determine whether those emissions should be regulated. In 2011, the Federal EPA issued a rule setting Maximum Achievable Control Technology standards for new and existing coal and oil-fired utility units and New Source Performance Standards for emissions from new and modified power plants. In 2014, the U.S. Supreme Court determined that the Federal EPA acted unreasonably in refusing to consider costs in determining if it was appropriate and necessary to regulate HAP emissions from electric generating units. The Federal EPA has engaged in additional rulemaking activity but the 2011 rule remains in effect. See “Environmental Issues - Hazardous Air Pollutants” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Regional Haze +The CAA establishes visibility goals for certain federally designated areas, including national parks, and requires states to submit SIPs that will demonstrate reasonable progress toward preventing impairment of visibility in these areas Regional Haze program. In 2005, the Federal EPA issued its Clean Air Visibility Rule, detailing how the CAA’s best available retrofit technology requirements will be applied to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants. +PSO executed a settlement with the Federal EPA and the State of Oklahoma to comply with Regional Haze program requirements in Oklahoma, and the settlement is now codified in the Oklahoma SIP and approved by the Federal EPA. The Federal EPA disapproved portions of the Arkansas and Texas SIPs, and finalized FIPs for both states. Challenges to both federal plans are pending in the courts. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Climate Change +AEP has taken action to reduce and offset CO 2 emissions from its generating fleet and expects CO 2 emissions from its operations to continue to decline due to the retirement of some of its coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. In 2018, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, regulations, grid reliability and resiliency, and reflect the company’s current business strategy. The intermediate goal is a 60% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is an 80% reduction of CO 2 emissions from AEP generating facilities from 2000 levels by 2050. AEP’s total estimated CO 2 emissions in 2018 were approximately 69 million metric tons, a 59% reduction from AEP’s 2000 CO 2 emissions of approximately 167 million metric tons. +10 +The Federal EPA has taken action to regulate CO 2 emissions from new and existing fossil fueled electric generating units under the existing provisions of the CAA. The Clean Power Plan was adopted in October 2015 but the U.S. Supreme Court issued a stay of its implementation, including all of the deadlines for submission of initial or final state plans. In 2017, the Federal EPA issued a proposal to repeal the Clean Power Plan and in 2018 the Federal EPA issued a proposal to revise the standards for new and modified sources and less stringent proposed guidelines to replace the Clean Power Plan. See “Environmental Issues - Climate Change, CO 2 Regulation and Energy Policy” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2018 Annual Report for additional information. +Management expects emissions to continue to decline over time as AEP diversifies generating sources and operates fewer coal units. The projected decline in coal-fired generation is due to a number of factors, including the ongoing cost of operating older units, the relative cost of coal and natural gas as fuel sources, increasing environmental regulations requiring significant capital investments and changing commodity market fundamentals. Management’s strategy for this transformation includes diversifying AEP’s fuel portfolio and generating more electricity from natural gas, increasing energy efficiency and investing in renewable resources, where there is regulatory support. +Transforming our Generation Fleet +The electric utility industry is in the midst of an historic transformation, driven by changing customer needs, policy demands, demographics, competitive offerings, technologies and commodity prices. Amid this changing landscape, AEP is also transforming to be more agile and customer-focused as a valued provider of energy solutions. AEP’s long-term commitment to reduce CO2 emissions reflects the current direction of the company’s resource plans to meet those needs. AEP’s exposure to carbon regulation has been greatly reduced over the last several years. From 2000 to 2017, AEP’s CO2 emissions declined 57 percent. In 2018, coal represented 47 percent of AEP’s generating capacity, compared with 70 percent in 2005. Management expects the percentage of AEP’s generating resources fueled by coal will continue to decline. Transforming AEP’s generation portfolio to include more renewable energy and focusing on the efficient use of energy, demand response, distributed resources and technology solutions to more efficiently manage the grid over time is part of this strategy. +The graph below summarizes AEP’s generation capacity by resource type for the years 1999, 2005 and 2018: +(a) +Energy Efficiency/Demand Response represents avoided capacity rather than physical assets. +11 +Renewable Sources of Energy +The states AEP serves, other than Kentucky, West Virginia and Tennessee, have established mandatory or voluntary programs to increase the use of energy efficiency, alternative energy or renewable energy sources. +As of December 31, 2018 , AEP’s regulated utilities had long-term contracts for 2,750 MWs of wind and 10 MWs of solar power delivering renewable energy to the companies’ customers. In addition, I&M owns four solar projects that make up I&M’s 15 MW Clean Energy Solar Pilot Project. Management actively manages AEP’s compliance position and is on pace to meet the relevant requirements or benchmarks in each applicable jurisdiction. +The growth of AEP’s renewable portfolio reflects the company’s strategy to diversify its generation resources to provide clean energy options to customers. In addition to gradually reducing AEP’s reliance on coal-fueled generating units, the growth of renewables and natural gas helps AEP to maintain a diversity of generation resources. +The integrated resource plans filed with state regulatory commissions by AEP’s regulated utility subsidiaries reflect AEP’s renewable strategy to balance reliability and cost with customers’ desire for clean energy in a carbon-constrained world. AEP has committed significant capital investments to modernize the electric grid and integrate these new resources. Transmission assets of the AEP System interconnect approximately 11,900 MWs of renewable energy resources. AEP’s transmission development initiatives are designed to facilitate the interconnection of additional renewable energy resources. +AEP Energy Supply, LLC owned 261 MWs of wind capacity in Texas as of December 31, 2018 . AEP Renewables, LLC develops and/or acquires large scale renewable projects backed with long-term contracts with creditworthy counterparties. As of December 2018, AEP Renewables, LLC owned two 20 MW solar projects in California and Utah and a 50 MW solar project in Nevada. In December 2018, AEP Renewables, LLC entered into an agreement to own an additional 227 MWs of Texas wind capacity which is expected to be placed in-service in mid-2019. +AEP OnSite Partners, LLC works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. The company targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners, LLC pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2018, AEP OnSite Partners, LLC owned projects operating in 15 states, including approximately 85 MWs of installed solar capacity, and approximately 57 MWs of solar projects under construction. +In February 2019, AEP Clean Energy Resources, LLC signed an agreement to purchase Sempra Renewables, LLC and its 724 MWs of wind generation and battery assets for approximately $1.1 billion, subject to closing and working capital adjustments. As part of the purchase price, AEP Clean Energy Resources, LLC will pay $551 million in cash and assume $343 million of existing project debt obligations of the non-consolidated joint ventures. Additionally, the acquisition will be accompanied by the recognition of non-controlling tax equity interest of $162 million associated with certain of the acquired wind farms. The wind generation portfolio includes seven wholly or jointly-owned wind farms with long-term PPAs for 100% of their energy production. The transaction is expected to close in mid-2019 and is subject to regulatory approvals from the FERC and federal clearance pursuant to the Hart-Scott-Rodino Antitrust Improvements Act of 1976. +Competitive Renewable Generation Facilities +Size of +Renewable +In-Service or +Energy Resource +AEP Entity +Energy Resource +Location +Under Construction +261 MW +AEP Energy Supply LLC +Wind +Texas +In-service +20 MW +AEP Renewables, LLC +Solar +California +In-service +20 MW +AEP Renewables, LLC +Solar +Utah +In-service +50 MW +AEP Renewables, LLC +Solar +Nevada +In-service +85 MW +AEP OnSite Partners, LLC +Solar +Fifteen states (a) +In-service +57 MW +AEP OnSite Partners, LLC +Solar +Four states (b) +Under Construction +(a) +California, Colorado, Connecticut, Florida, Hawaii, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(b) +California, Minnesota, New Mexico and Hawaii. +12 +End Use Energy Efficiency +AEP has reduced energy consumption and peak demand through the introduction of additional energy efficiency and demand response programs. These programs, commonly and collectively referred to as demand side management, were implemented in jurisdictions where appropriate cost recovery was available. AEP’s operating companies’ programs have reduced annual consumption by over 8 million MWhs and peak demand by approximately 2,555 MWs since 2008. AEP estimates that its operating companies spent approximately $1.4 billion during that period to achieve these levels. +Energy efficiency and demand reduction programs have received regulatory support in most of the states AEP serves. Appropriate cost recovery will be essential for AEP operating companies to continue and expand these consumer offerings. Appropriate recovery of program costs, lost revenues and an opportunity to earn a reasonable return ensures that energy efficiency programs are considered equally with supply side investments. As AEP continues to transition to a cleaner, more efficient energy future, energy efficiency and demand response programs will continue to play an important role in how the company serves its customers. AEP believes its experience providing robust energy efficiency programs in several states positions the company to be a cost-effective provider of these programs as states develop their implementation plans. +Corporate Governance +In response to environmental issues and in connection with its assessment of AEP’s strategic plan, the Board of Directors continually reviews the risks posed by new environmental rules and requirements that could accelerate the retirement of coal-fired generation assets. The Board of Directors is informed of any new environmental regulations and proposed regulation or legislation that would significantly affect the company. The Board’s Committee on Directors and Corporate Governance oversees the company’s annual Corporate Accountability Report, which includes information about the company’s environmental, social, governance and financial performance. In addition, as a result of ongoing corporate governance outreach efforts with shareholders, AEP set new CO 2 emission reduction goals that were published in a new report in February 2018, “American Electric Power: Strategic Vision for a Clean Energy Future.” +Other Environmental Issues and Matters +The Comprehensive Environmental Response, Compensation and Liability Act of 1980 imposes costs for environmental remediation upon owners and previous owners of sites, as well as transporters and generators of hazardous material disposed of at such sites. See “The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation” section of Note 6 included in the 2018 Annual Report for additional information. +Environmental Investments +Investments related to improving AEP System plants’ environmental performance and compliance with air and water quality standards during 2016 , 2017 and 2018 and the current estimate for 2019 are shown below. These investments include both environmental as well as other related spending. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends and the ability to access capital. In addition to the amounts set forth below, AEP expects to make substantial investments in future years in connection with the modification and addition at generation plants’ facilities for environmental quality controls. Such future investments are needed in order to comply with air and water quality standards that have been adopted and have deadlines for compliance after 2018 or have been proposed and may be adopted. Future investments could be significantly greater if emissions reduction requirements are accelerated or otherwise become more stringent. The cost of complying with applicable environmental laws, regulations and rules is expected to be material to the AEP System. AEP typically recovers costs of complying with environmental standards from customers through rates in regulated jurisdictions. Failure to recover these costs could reduce future net income and cash flows and possibly harm AEP’s financial condition. See “Environmental Issues” section of Management’s Discussion and Analysis of Financial +13 +Condition and Results of Operations and Note 6 - Commitments, Guarantees and Contingencies included in the 2018 Annual Report for additional information. +Historical and Projected Environmental Investments +2016 +2017 +2018 +2019 +Actual +Actual +Actual +Estimate (b) +(in millions) +AEP (a) +$ +383.7 +$ +135.9 +$ +115.6 +$ +237.7 +APCo +50.0 +25.6 +20.4 +32.7 +I&M +65.0 +41.9 +31.1 +76.8 +PSO +34.8 +0.6 +— +2.5 +SWEPCo +82.1 +11.7 +14.1 +25.1 +(a) +Includes expenditures of the subsidiaries shown and other subsidiaries not shown. The figures reflect construction expenditures, not investments in subsidiary companies. +(b) +Estimated amounts are exclusive of debt AFUDC. +Management continues to refine the cost estimates of complying with air and water quality standards and other impacts of the environmental proposals. The following cost estimates for the years 2019 through 2025 will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules. These cost estimates will also change based on: (a) the states’ implementation of these regulatory programs, including the potential for SIPs or FIPs that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) the actual performance of the pollution control technologies installed on the units, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired, replaced or sold, including the type and amount of such replacement capacity and (g) other factors. Management’s current ranges of estimates of new major environmental investments beginning in 2019 , exclusive of debt AFUDC, are set forth below: +Projected (2019 - 2025) +Environmental Investment +Company +Low +High +(in millions) +AEP +$ +650 +$ +1,500 +APCo +135 +240 +I&M +105 +200 +PSO +15 +45 +SWEPCo +140 +230 +BUSINESS SEGMENTS +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. AEP’s reportable segments are as follows: +• +Vertically Integrated Utilities +• +Transmission and Distribution Utilities +• +AEP Transmission Holdco +• +Generation & Marketing +The remainder of AEP’s activities is presented as Corporate and Other, which is not considered a reportable segment. See Note 9 - Business Segments included in the 2018 Annual Report for additional information on AEP’s segments. +14 +VERTICALLY INTEGRATED UTILITIES +GENERAL +AEP’s vertically integrated utility operations are engaged in the generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. AEPSC, as agent for AEP’s public utility subsidiaries, performs marketing, generation dispatch, fuel procurement and power-related risk management and trading activities on behalf of each of these subsidiaries. +ELECTRIC GENERATION +Facilities +As of December 31, 2018 , AEP’s vertically integrated public utility subsidiaries owned or leased approximately 23,000 MWs of domestic generation. See \ No newline at end of file diff --git a/raw/filings/0000004904/2018/0000004904-19-000009/item13.txt b/raw/filings/0000004904/2018/0000004904-19-000009/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..4ca95638cd35b5cc3ef13b1938d650d3e7d889a5 --- /dev/null +++ b/raw/filings/0000004904/2018/0000004904-19-000009/item13.txt @@ -0,0 +1,6 @@ +ITEM 13. 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+aep:IndianaMichiganPowerCoMember +2019-04-01 +2019-06-30 +0000004904 +aep:AEPTransmissionCoMember +2019-04-01 +2019-06-30 +0000004904 +aep:IndianaMichiganPowerCoMember +2019-01-01 +2019-03-31 +0000004904 +aep:PublicServiceCoOfOklahomaMember +2019-01-01 +2019-03-31 +0000004904 +aep:AppalachianPowerCoMember +2019-04-01 +2019-06-30 +0000004904 +aep:AppalachianPowerCoMember +2019-01-01 +2019-03-31 +0000004904 +aep:IndianaMichiganPowerCoMember +2019-10-01 +2019-12-31 +0000004904 +aep:PublicServiceCoOfOklahomaMember +2019-10-01 +2019-12-31 +0000004904 +exch:XNYS +us-gaap:CommonStockMember +2019-01-01 +2019-12-31 +0000004904 +exch:XNYS +us-gaap:PreferredStockMember +2019-01-01 +2019-12-31 +xbrli:shares +iso4217:USD +xbrli:shares +iso4217:USD +xbrli:pure +utreg:MW +utreg:Rate +utreg:MWh +utreg:MMBTU +utreg:gal +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON , D.C. 20549 +FORM 10-K +(Mark One) +☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2019 +or +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from __________ to_________ +Commission +Registrants; +I.R.S. Employer +File Number +Address and Telephone Number +States of Incorporation +Identification Nos. +1-3525 +AMERICAN ELECTRIC POWER CO INC. +New York +13-4922640 +333-221643 +AEP TEXAS INC. +Delaware +51-0007707 +333-217143 +AEP TRANSMISSION COMPANY, LLC +Delaware +46-1125168 +1-3457 +APPALACHIAN POWER COMPANY +Virginia +54-0124790 +1-3570 +INDIANA MICHIGAN POWER COMPANY +Indiana +35-0410455 +1-6543 +OHIO POWER COMPANY +Ohio +31-4271000 +0-343 +PUBLIC SERVICE COMPANY OF OKLAHOMA +Oklahoma +73-0410895 +1-3146 +SOUTHWESTERN ELECTRIC POWER COMPANY +Delaware +72-0323455 +1 Riverside Plaza, +Columbus, +Ohio +43215-2373 +Telephone +(614) +716-1000 +Securities registered pursuant to Section 12(b) of the Act: +Registrant +Title of each class +Trading Symbol +Name of Each Exchange on Which Registered +American Electric Power Company Inc. +Common Stock, $6.50 par value +AEP +New York Stock Exchange +American Electric Power Company Inc. +6.125% Corporate Units +AEP PR B +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant American Electric Power Company, Inc., AEP Transmission Company, LLC, Indiana Michigan Power Company and Southwestern Electric Power Company, are well-known seasoned issuers, as defined in Rule 405 of the Securities Act. +Yes +x +No +¨ +Indicate by check mark if the registrants AEP Texas Inc., Appalachian Power Company, Ohio Power Company, Public Service Company of Oklahoma, are well-known seasoned issuers, as defined in Rule 405 of the Securities Act. +Yes +¨ +No +x +Indicate by check mark if the registrants are not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. +Yes +¨ +No +x +Indicate by check mark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. +Yes +x +No +¨ +Indicate by check mark whether the registrants have submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). +Yes +x +No +¨ +Indicate by check mark whether American Electric Power Company, Inc. is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated filer +x +Accelerated filer +☐ +Non-accelerated filer +☐ +Smaller reporting company +☐ +Emerging growth company +☐ +Indicate by check mark whether AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company are large accelerated filers, accelerated filers, non-accelerated filers, smaller reporting companies, or emerging growth companies. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated filer +☐ +Accelerated filer +☐ +Non-accelerated filer +x +Smaller reporting company +☐ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrants have elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. +☐ +Indicate by check mark whether the registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act). +Yes +☐ +No +x +AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company meet the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and are therefore filing this Form 10-K with the reduced disclosure format specified in General Instruction I(2) to such Form 10-K. +Aggregate Market Value of Voting and Non-Voting Common Equity Held by Nonaffiliates of the Registrants as of June 30, 2019 the Last Trading Date of the Registrants' Most Recently Completed Second Fiscal Quarter +Number of Shares of Common Stock Outstanding of the Registrants as of December 31, 2019 +American Electric Power Company, Inc. +$ 43,491,855,142 +494,169,471 +($6.50 par value) +AEP Texas Inc. +None +100 +($0.01 par value) +AEP Transmission Company, LLC (a) +None +NA +Appalachian Power Company +None +13,499,500 +(no par value) +Indiana Michigan Power Company +None +1,400,000 +(no par value) +Ohio Power Company +None +27,952,473 +(no par value) +Public Service Company of Oklahoma +None +9,013,000 +($15 par value) +Southwestern Electric Power Company +None +7,536,640 +($18 par value) +(a) +100% interest is held by AEP Transmission Holdco. +NA +Not applicable. +Note on Market Value of Common Equity Held by Nonaffiliates +American Electric Power Company, Inc. owns all of the common stock of AEP Texas Inc., Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company and all of the LLC membership interest in AEP Transmission Company, LLC (see Item 12 herein). +Documents Incorporated By Reference +Description +Part of Form 10-K into which Document is Incorporated +Portions of Annual Reports of the following companies for the fiscal year ended December 31, 2019: +Part II +American Electric Power Company, Inc. +AEP Texas Inc. +AEP Transmission Company, LLC +Appalachian Power Company +Indiana Michigan Power Company +Ohio Power Company +Public Service Company of Oklahoma +Southwestern Electric Power Company +Portions of Proxy Statement of American Electric Power Company, Inc. for 2020 Annual Meeting of Shareholders. +Part III +This combined Form 10-K is separately filed by American Electric Power Company, Inc., AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company. Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. Except for American Electric Power Company, Inc., each registrant makes no representation as to information relating to the other registrants. +You can access financial and other information at AEP’s website, including AEP’s Principles of Business Conduct, certain committee charters and Principles of Corporate Governance. The address is www.AEP.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC website at www.sec.gov. +TABLE OF CONTENTS +Item +Number +Page +Number +Glossary of Terms +i +Forward-Looking Information +iv +PART I +1 +Business +General +1 +Business Segments +15 +Vertically Integrated Utilities +15 +Transmission and Distribution Utilities +23 +AEP Transmission Holdco +25 +Generation & Marketing +28 +Executive Officers of AEP +31 +1A +Risk Factors +32 +1B +Unresolved Staff Comments +43 +2 +Properties +43 +Generation Facilities +43 +Transmission and Distribution Facilities +47 +Title to Property +48 +System Transmission Lines and Facility Siting +48 +Construction Program +48 +Potential Uninsured Losses +48 +3 +Legal Proceedings +48 +4 +Mine Safety Disclosure +49 +PART II +5 +Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +49 +6 +Selected Financial Data +49 +7 +Management’s Discussion and Analysis of Financial Condition and Results of Operations +50 +7A +Quantitative and Qualitative Disclosures about Market Risk +50 +8 +Financial Statements and Supplementary Data +50 +9 +Changes In and Disagreements with Accountants on Accounting and Financial Disclosure +50 +9A +Controls and Procedures +50 +9B +Other Information +51 +PART III +10 +Directors, Executive Officers and Corporate Governance +51 +11 +Executive Compensation +52 +12 +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +52 +13 +Certain Relationships and Related Transactions and Director Independence +53 +14 +Principal Accounting Fees and Services +53 +PART IV +15 +Exhibits and Financial Statement Schedules +55 +Financial Statements +55 +Form 10-K Summary +56 +Signatures +57 +Index of Financial Statement Schedules +S-1 +Reports of Independent Registered Public Accounting Firm +S-2 +Exhibit Index +E-1 +GLOSSARY OF TERMS +When the following terms and abbreviations appear in the text of this report, they have the meanings indicated below. +Term +Meaning +AEGCo +AEP Generating Company, an AEP electric utility subsidiary. +AEP +American Electric Power Company, Inc., an investor-owned electric public utility holding company which includes American Electric Power Company, Inc. (Parent) and majority-owned consolidated subsidiaries and consolidated affiliates. +AEP Energy +AEP Energy, Inc., a wholly-owned retail electric supplier for customers in Ohio, Illinois and other deregulated electricity markets throughout the United States. +AEP Energy Supply, LLC +A nonregulated holding company for AEP’s competitive generation, wholesale and retail businesses, and a wholly-owned subsidiary of AEP. +AEP OnSite Partners +A division of AEP Energy Supply, LLC that builds, owns, operates and maintains customer solutions utilizing existing and emerging distributed technologies. +AEP Renewables +A division of AEP Energy Supply, LLC that develops and/or acquires large scale renewable projects that are backed with long-term contracts with creditworthy counter parties. +AEP System +American Electric Power System, an electric system, owned and operated by AEP subsidiaries. +AEP Texas +AEP Texas Inc., an AEP electric utility subsidiary. +AEP Transmission Holdco +AEP Transmission Holding Company, LLC, a wholly-owned subsidiary of AEP. +AEPEP +AEP Energy Partners, Inc., a subsidiary of AEP dedicated to wholesale marketing and trading, hedging activities, asset management and commercial and industrial sales in deregulated markets. +AEPSC +American Electric Power Service Corporation, an AEP service subsidiary providing management and professional services to AEP and its subsidiaries. +AEPTCo +AEP Transmission Company, LLC, a wholly-owned subsidiary of AEP Transmission Holdco, is an intermediate holding company that owns the State Transcos. +AEPTCo Parent +AEP Transmission Company, LLC, the holding company of the State Transcos within the AEPTCo consolidation. +AEPTHCo +AEP Transmission Holding Company, LLC, a subsidiary of AEP, an intermediate holding company that owns transmission operations joint ventures and AEPTCo. +AFUDC +Allowance for Funds Used During Construction. +AGR +AEP Generation Resources Inc., a competitive AEP subsidiary in the Generation & Marketing segment. +APCo +Appalachian Power Company, an AEP electric utility subsidiary. +APTCo +AEP Appalachian Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +APSC +Arkansas Public Service Commission. +CAA +Clean Air Act. +CO 2 +Carbon dioxide and other greenhouse gases. +Conesville Plant +A single unit coal-fired generation plant totaling 651 MW located in Conesville, Ohio. The plant is jointly owned by AGR and a nonaffiliate. +Cook Plant +Donald C. Cook Nuclear Plant, a two-unit, 2,288 MW nuclear plant owned by I&M. +CSPCo +Columbus Southern Power Company, a former AEP electric utility subsidiary that was merged into OPCo effective December 31, 2011. +ERCOT +Electric Reliability Council of Texas regional transmission organization. +ETT +Electric Transmission Texas, LLC, an equity interest joint venture between AEP Transmission Holdco and Berkshire Hathaway Energy Company formed to own and operate electric transmission facilities in ERCOT. +Federal EPA +United States Environmental Protection Agency. +FERC +Federal Energy Regulatory Commission. +FIP +Federal Implementation Plan. +I&M +Indiana Michigan Power Company, an AEP electric utility subsidiary. +i +Term +Meaning +IMTCo +AEP Indiana Michigan Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +IURC +Indiana Utility Regulatory Commission. +KGPCo +Kingsport Power Company, an AEP electric utility subsidiary. +KPCo +Kentucky Power Company, an AEP electric utility subsidiary. +KTCo +AEP Kentucky Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +MISO +Midwest Independent Transmission System Operator. +MMBtu +Million British Thermal Units. +MW +Megawatt. +MWh +Megawatt-hour. +Nonutility Money Pool +Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain nonutility subsidiaries. +North Central Wind Energy Facilities +A proposed joint PSO and SWEPCo project, which includes three Oklahoma wind facilities totaling approximately 1,485 MWs of wind generation. +NO x +Nitrogen oxide. +NRC +Nuclear Regulatory Commission. +OATT +Open Access Transmission Tariff. +OCC +Corporation Commission of the State of Oklahoma. +OHTCo +AEP Ohio Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +Oklaunion Power Station +A single unit coal-fired generation plant totaling 650 MW located in Vernon, Texas. The plant is jointly owned by AEP Texas, PSO and certain nonaffiliated entities. +OKTCo +AEP Oklahoma Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +OPCo +Ohio Power Company, an AEP electric utility subsidiary. +OTC +Over the counter. +OVEC +Ohio Valley Electric Corporation, which is 43.47% owned by AEP. +Parent +American Electric Power Company, Inc., the equity owner of AEP subsidiaries within the AEP consolidation. +PJM +Pennsylvania – New Jersey – Maryland regional transmission organization. +PPA +Purchase Power and Sale Agreement. +PSO +Public Service Company of Oklahoma, an AEP electric utility subsidiary. +PUCO +Public Utilities Commission of Ohio. +PUCT +Public Utility Commission of Texas. +Racine +A generation plant consisting of two hydroelectric generating units totaling 48 MWs located in Racine, Ohio and owned by AGR. +Registrant Subsidiaries +AEP subsidiaries which are SEC registrants: AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo. +Registrants +SEC registrants: AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo. +REP +Texas Retail Electric Provider. +Rockport Plant +A generation plant, consisting of two 1,310 MW coal-fired generating units near Rockport, Indiana. AEGCo and I&M jointly-own Unit 1. In 1989, AEGCo and I&M entered into a sale-and-leaseback transaction with Wilmington Trust Company, an unrelated, unconsolidated trustee for Rockport Plant, Unit 2. +ROE +Return on Equity. +RTO +Regional Transmission Organization, responsible for moving electricity over large interstate areas. +SEC +U.S. Securities and Exchange Commission. +SIP +State Implementation Plan. +SNF +Spent Nuclear Fuel. +SO 2 +Sulfur dioxide. +SPP +Southwest Power Pool regional transmission organization. +ii +Term +Meaning +State Transcos +AEPTCo’s seven wholly-owned, FERC regulated, transmission only electric utilities, each of which is geographically aligned with AEP existing utility operating companies. +SWEPCo +Southwestern Electric Power Company, an AEP electric utility subsidiary. +SWTCo +AEP Southwestern Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +TA +Transmission Agreement, effective November 2010, among APCo, I&M, KGPCo, KPCo, OPCo and WPCo with AEPSC as agent. +TCA +Transmission Coordination Agreement dated January 1, 1997, by and among, PSO, SWEPCo and AEPSC, in connection with the operation of the transmission assets of the two public utility subsidiaries. +Turk Plant +John W. Turk, Jr. Plant, a 600 MW coal-fired plant in Arkansas that is 73% owned by SWEPCo. +UPA +Unit Power Agreement. +Utility Money Pool +Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain utility subsidiaries. +Virginia SCC +Virginia State Corporation Commission. +WPCo +Wheeling Power Company, an AEP electric utility subsidiary. +WVPSC +Public Service Commission of West Virginia. +WVTCo +AEP West Virginia Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +iii +FORWARD-LOOKING INFORMATION +This report made by the Registrants contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Many forward-looking statements appear in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” but there are others throughout this document which may be identified by words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “will,” “should,” “could,” “would,” “project,” “continue” and similar expressions, and include statements reflecting future results or guidance and statements of outlook. These matters are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Forward-looking statements in this document are presented as of the date of this document. Except to the extent required by applicable law, management undertakes no obligation to update or revise any forward-looking statement. Among the factors that could cause actual results to differ materially from those in the forward-looking statements are: +• +Changes in economic conditions, electric market demand and demographic patterns in AEP service territories. +• +Inflationary or deflationary interest rate trends. +• +Volatility in the financial markets, particularly developments affecting the availability or cost of capital to finance new capital projects and refinance existing debt. +• +The availability and cost of funds to finance working capital and capital needs, particularly during periods when the time lag between incurring costs and recovery is long and the costs are material. +• +Decreased demand for electricity. +• +Weather conditions, including storms and drought conditions, and the ability to recover significant storm restoration costs. +• +The cost of fuel and its transportation, the creditworthiness and performance of fuel suppliers and transporters and the cost of storing and disposing of used fuel, including coal ash and SNF. +• +The availability of fuel and necessary generation capacity and the performance of generation plants. +• +The ability to recover fuel and other energy costs through regulated or competitive electric rates. +• +The ability to build or acquire renewable generation, transmission lines and facilities (including the ability to obtain any necessary regulatory approvals and permits) when needed at acceptable prices and terms and to recover those costs. +• +New legislation, litigation and government regulation, including oversight of nuclear generation, energy commodity trading and new or heightened requirements for reduced emissions of sulfur, nitrogen, mercury, carbon, soot or particulate matter and other substances that could impact the continued operation, cost recovery and/or profitability of generation plants and related assets. +• +Evolving public perception of the risks associated with fuels used before, during and after the generation of electricity, including coal ash and nuclear fuel. +• +Timing and resolution of pending and future rate cases, negotiations and other regulatory decisions, including rate or other recovery of new investments in generation, distribution and transmission service and environmental compliance. +• +Resolution of litigation. +• +The ability to constrain operation and maintenance costs. +• +Prices and demand for power generated and sold at wholesale. +• +Changes in technology, particularly with respect to energy storage and new, developing, alternative or distributed sources of generation. +• +The ability to recover through rates any remaining unrecovered investment in generation units that may be retired before the end of their previously projected useful lives. +• +Volatility and changes in markets for coal and other energy-related commodities, particularly changes in the price of natural gas. +• +Changes in utility regulation and the allocation of costs within RTOs including ERCOT, PJM and SPP. +• +Changes in the creditworthiness of the counterparties with contractual arrangements, including participants in the energy trading market. +• +Actions of rating agencies, including changes in the ratings of debt. +• +The impact of volatility in the capital markets on the value of the investments held by the pension, other postretirement benefits, captive insurance entity and nuclear decommissioning trust and the impact of such volatility on future funding requirements. +• +Accounting standards periodically issued by accounting standard-setting bodies. +iv +• +Other risks and unforeseen events, including wars, the effects of terrorism (including increased security costs), embargoes, naturally occurring and human-caused fires, cyber security threats and other catastrophic events. +• +The ability to attract and retain the requisite work force and key personnel. +The forward-looking statements of the Registrants speak only as of the date of this report or as of the date they are made. The Registrants expressly disclaim any obligation to update any forward-looking information, except as required by law. For a more detailed discussion of these factors, see “Risk Factors” in Part I of this report. +Investors should note that the Registrants announce material financial information in SEC filings, press releases and public conference calls. Based on guidance from the SEC, the Registrants may use the Investors section of AEP’s website (www.aep.com) to communicate with investors about the Registrants. It is possible that the financial and other information posted there could be deemed to be material information. The information on AEP’s website is not part of this report. +v +PART I +ITEM 1. BUSINESS +GENERAL +Overview and Description of Major Subsidiaries +AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company that owns, directly or indirectly, all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries. +The service areas of AEP’s public utility subsidiaries cover portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Transmission networks are interconnected with extensive distribution facilities in the territories served. The public utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers. Restructuring laws in Michigan, Ohio and the ERCOT area of Texas have caused AEP public utility subsidiaries in those states to unbundle previously integrated regulated rates for their retail customers. +The member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity and transportation and handling of fuel. The companies of the AEP System also obtain certain accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost from a common provider, AEPSC. +As of December 31, 2019 , the subsidiaries of AEP had a total of 17,408 employees. Because it is a holding company rather than an operating company, AEP has no employees. The material subsidiaries of AEP are as follows: +AEP Texas +Organized in Delaware in 1925, AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,049,000 retail customers through REPs in west, central and southern Texas. As of December 31, 2019 , AEP Texas had 1,585 employees. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and primary metal manufacturing. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. AEP Texas is part of AEP’s Transmission and Distribution Utilities segment. +AEPTCo +Organized in Delaware in 2006, AEPTCo is a holding company for the State Transcos. The State Transcos develop and own new transmission assets that are physically connected to the AEP System. Individual State Transcos (a) have obtained the approvals necessary to operate in Indiana, Kentucky, Michigan, Ohio, Oklahoma and West Virginia, subject to any applicable siting requirements, (b) are authorized to submit projects for commission approval in Virginia and (c) have been granted consent to enter into a joint license agreement that will support investment in Tennessee. Neither AEPTCo nor its subsidiaries have any employees. Instead, AEPSC and certain AEP utility subsidiaries provide services to these entities. AEPTCo is part of the AEP Transmission Holdco segment. +1 +APCo +Organized in Virginia in 1926, APCo is engaged in the generation, transmission and distribution of electric power to approximately 956,000 retail customers in the southwestern portion of Virginia and southern West Virginia, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. APCo owns 6,629 MWs of generating capacity. APCo uses its generation to serve its retail and other customers. As of December 31, 2019 , APCo had 1,699 employees. Among the principal industries served by APCo are coal mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. APCo is a member of PJM. APCo is part of AEP’s Vertically Integrated Utilities segment. +I&M +Organized in Indiana in 1907, I&M is engaged in the generation, transmission and distribution of electric power to approximately 599,000 retail customers in northern and eastern Indiana and southwestern Michigan, and in supplying and marketing electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities and other market participants. I&M owns or leases 3,634 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2019 , I&M had 2,336 employees. Among the principal industries served are primary metals, transportation equipment, chemical manufacturing, plastics and rubber products and fabricated metal product manufacturing. I&M is a member of PJM. I&M is part of AEP’s Vertically Integrated Utilities segment. +KPCo +Organized in Kentucky in 1919, KPCo is engaged in the generation, transmission and distribution of electric power to approximately 165,000 retail customers in eastern Kentucky, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. KPCo owns 1,060 MWs of generating capacity. KPCo uses its generation to serve its retail and other customers. As of December 31, 2019 , KPCo had 500 employees. Among the principal industries served are petroleum and coal products manufacturing, chemical manufacturing, coal mining, oil and gas extraction and primary metals. KPCo is a member of PJM. KPCo is part of AEP’s Vertically Integrated Utilities segment. +KGPCo +Organized in Virginia in 1917, KGPCo provides electric service to approximately 48,000 retail customers in Kingsport and eight neighboring communities in northeastern Tennessee. KGPCo does not own any generating facilities and is a member of PJM. It purchases electric power from APCo for distribution to its customers. As of December 31, 2019 , KGPCo had 54 employees. KGPCo is part of AEP’s Vertically Integrated Utilities segment. +OPCo +Organized in Ohio in 1907 and reincorporated in 1924, OPCo is engaged in the transmission and distribution of electric power to approximately 1,494,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. As of December 31, 2019 , OPCo had 1,681 employees. Among the principal industries served by OPCo are primary metals, petroleum and coal products manufacturing, plastics and rubber products, chemical manufacturing, fabricated metal product manufacturing and data centers. OPCo is a member of PJM. OPCo is part of AEP’s Transmission and Distribution Utilities segment. +PSO +Organized in Oklahoma in 1913, PSO is engaged in the generation, transmission and distribution of electric power to approximately 559,000 retail customers in eastern and southwestern Oklahoma, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. PSO owns 3,833 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2019 , PSO had 1,097 employees. Among the principal industries served by PSO are paper manufacturing, oil and gas extraction, petroleum and coal products manufacturing, transportation equipment and pipeline transportation. PSO is a member of SPP. PSO is part of AEP’s Vertically Integrated Utilities segment. +2 +SWEPCo +Organized in Delaware in 1912, SWEPCo is engaged in the generation, transmission and distribution of electric power to approximately 540,000 retail customers in northeastern and panhandle of Texas, northwestern Louisiana and western Arkansas and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. SWEPCo owns 5,169 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2019 , SWEPCo had 1,469 employees. Among the principal industries served by SWEPCo are petroleum and coal products manufacturing, food manufacturing, paper manufacturing, oil and gas extraction and chemical manufacturing. The territory served by SWEPCo includes several military installations, colleges and universities. SWEPCo also owns and operates a lignite coal mining operation. SWEPCo is a member of SPP. SWEPCo is part of AEP’s Vertically Integrated Utilities segment. +WPCo +Organized in West Virginia in 1883 and reincorporated in 1911, WPCo provides electric service to approximately 42,000 retail customers in northern West Virginia and in supplying and marketing electric power at wholesale to other market participants. WPCo owns 780 MWs of generating capacity which it uses to serve its retail and other customers. Among the principal industries served by WPCo are coal mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. WPCo is a member of PJM. As of December 31, 2019 , WPCo had 50 employees. WPCo is part of AEP’s Vertically Integrated Utilities segment. +Service Company Subsidiary +AEPSC is a service company subsidiary that provides accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost to AEP subsidiaries. The executive officers of AEP and certain of the executive officers of its public utility subsidiaries are employees of AEPSC. As of December 31, 2019 , AEPSC had 6,439 employees. +Company Website and Availability of SEC Filings +Our principal corporate website address is www.aep.com. Information on our website is not incorporated by reference herein and is not part of this Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding AEP. +3 +Public Utility Subsidiaries by Jurisdiction +The following table illustrates certain regulatory information with respect to the jurisdictions in which the public utility subsidiaries of AEP operate: +Principal Jurisdiction +AEP Utility Subsidiaries Operating in that Jurisdiction +Authorized Return on Equity (a) +FERC +AEPTCo - PJM +10.35% +AEPTCo - SPP +10.50% +Ohio +OPCo +10.20% +(b) +West Virginia +APCo +9.75% +WPCo +9.75% +Virginia +APCo +9.42% +Indiana +I&M +9.95% +Michigan +I&M +9.86% +Texas +AEP Texas +9.96% +SWEPCo +9.60% +Tennessee +KGPCo +9.85% +Kentucky +KPCo +9.70% +Louisiana +SWEPCo +9.80% +Arkansas +SWEPCo +9.45% +Oklahoma +PSO +9.40% +(a) +Identifies the predominant authorized ROE and may not include other, less significant, permitted recovery. Actual ROE varies from authorized ROE. +(b) +Authorized ROE was approved in OPCo’s last distribution base case. The authorized ROE for riders with an approved equity return (e.g. Distribution Investment Rider) is 10.00%. See “Ohio Electric Security Plan Filings” section of Note 4 included in the 2019 Annual Report. +(a) +Pretax income does not include intercompany eliminations. +4 +CLASSES OF SERVICE +The principal classes of service from which AEP’s subsidiaries derive revenues and the amount of such revenues during the years ended December 31, 2019 , 2018 and 2017 are as follows: +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Vertically Integrated Utilities Segment +Retail Revenues +Residential Sales +$ +3,641.2 +$ +3,818.6 +$ +3,399.8 +Commercial Sales +2,151.1 +2,223.7 +2,124.4 +Industrial Sales +2,178.3 +2,261.3 +2,180.8 +PJM Net Charges +(0.2 +) +0.4 +(1.1 +) +Other Retail Sales +179.4 +186.8 +181.7 +Total Retail Revenues (a) +8,149.8 +8,490.8 +7,885.6 +Wholesale Revenues +Off-system Sales +814.5 +888.0 +907.4 +Transmission +200.7 +263.7 +202.2 +Total Wholesale Revenues +1,015.2 +1,151.7 +1,109.6 +Other Electric Revenues +93.8 +93.7 +106.1 +Provision for Rate Refund +(44.7 +) +(210.1 +) +(46.4 +) +Other Operating Revenues +31.6 +30.6 +40.2 +Sales to Affiliates +121.4 +88.8 +96.9 +Total Revenues Vertically Integrated Utilities Segment +$ +9,367.1 +$ +9,645.5 +$ +9,192.0 +Transmission and Distribution Utilities Segment +Retail Revenues +Residential Sales +$ +2,084.5 +$ +2,213.6 +$ +2,085.3 +Commercial Sales +1,148.8 +1,266.7 +1,205.8 +Industrial Sales +426.5 +517.2 +489.2 +Other Retail Sales +43.7 +43.1 +43.1 +Total Retail Revenues (a) +3,703.5 +4,040.6 +3,823.4 +Wholesale Revenues +Off-system Sales +93.0 +119.3 +100.5 +Transmission +437.7 +394.7 +359.6 +Total Wholesale Revenues +530.7 +514.0 +460.1 +Other Electric Revenues +58.6 +54.5 +48.4 +Provision for Rate Refund +12.5 +(69.2 +) +(11.4 +) +Other Operating Revenues +13.7 +12.4 +8.4 +Sales to Affiliates +163.5 +100.8 +90.4 +Total Revenues Transmission and Distribution Utilities Segment +$ +4,482.5 +$ +4,653.1 +$ +4,419.3 +AEP Transmission Holdco Segment +Transmission Revenues +$ +265.1 +$ +291.3 +$ +204.3 +Other Electric Revenues +0.3 +0.3 +— +Other Operating Revenues +0.1 +0.3 +0.8 +Sales to Affiliates +812.9 +555.5 +588.3 +Provision for Rate Refund +(5.2 +) +(43.3 +) +(26.7 +) +Total Revenues AEP Transmission Holdco Segment +$ +1,073.2 +$ +804.1 +$ +766.7 +Generation & Marketing Segment +Generation Revenues +Affiliated +$ +— +$ +— +$ +— +Nonaffiliated +264.4 +431.5 +528.5 +Renewable Generation +Affiliated +— +— +— +Nonaffiliated +77.7 +44.5 +33.4 +Retail, Trading and Marketing +Affiliated +135.7 +122.2 +103.7 +Nonaffiliated +1,379.8 +1,342.1 +1,209.5 +Total Revenues Generation & Marketing Segment +$ +1,857.6 +$ +1,940.3 +$ +1,875.1 +5 +AEP Texas +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +588.9 +$ +594.6 +$ +573.9 +Commercial Sales +424.0 +426.6 +431.0 +Industrial Sales +133.3 +131.0 +121.9 +Other Retail Sales +30.8 +30.1 +30.0 +Total Retail Revenues (a) +1,177.0 +1,182.3 +1,156.8 +Wholesale Revenues +Transmission +379.2 +313.4 +293.8 +Other Electric Revenues +24.4 +21.9 +20.8 +Provision for Rate Refund +(34.7 +) +(31.3 +) +(1.1 +) +Total Electric Transmission and Distribution Revenues +1,545.9 +1,486.3 +1,470.3 +Sales to Affiliates +160.5 +105.2 +65.7 +Other Revenues +2.9 +3.8 +2.4 +Total Revenues +$ +1,709.3 +$ +1,595.3 +$ +1,538.4 +AEPTCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Transmission Revenues +$ +217.2 +$ +212.8 +$ +167.9 +Other Electric Revenues +0.3 +0.3 +— +Other Operating Revenues +0.1 +0.2 +0.8 +Sales to Affiliates +806.7 +598.9 +580.5 +Provision for Rate Refund +(2.9 +) +(36.1 +) +(26.0 +) +Total Revenues +$ +1,021.4 +$ +776.1 +$ +723.2 +APCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +1,272.3 +$ +1,372.1 +$ +1,242.8 +Commercial Sales +562.2 +596.3 +584.2 +Industrial Sales +594.5 +620.7 +640.8 +PJM Net Charges +(0.2 +) +(0.2 +) +(0.4 +) +Other Retail Sales +75.6 +79.5 +78.0 +Total Retail Revenues (a) +2,504.4 +2,668.4 +2,545.4 +Wholesale Revenues +Off-system Sales +124.9 +116.4 +126.8 +Transmission +57.0 +56.3 +57.1 +Total Wholesale Revenues +181.9 +172.7 +183.9 +Other Electric Revenues +32.3 +31.1 +33.4 +Provision for Rate Refund +(10.4 +) +(95.1 +) +(13.7 +) +Total Electric Generation, Transmission and Distribution Revenues +2,708.2 +2,777.1 +2,749.0 +Sales to Affiliates +205.3 +181.4 +172.0 +Other Revenues +11.2 +9.0 +13.2 +Total Revenues +$ +2,924.7 +$ +2,967.5 +$ +2,934.2 +6 +I&M +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +730.9 +$ +736.5 +$ +620.9 +Commercial Sales +494.9 +489.3 +438.8 +Industrial Sales +551.4 +570.6 +522.0 +PJM Net Charges +0.1 +0.2 +(1.0 +) +Other Retail Sales +7.3 +7.2 +7.1 +Total Retail Revenues (a) +1,784.6 +1,803.8 +1,587.8 +Wholesale Revenues +Off-system Sales +406.4 +459.3 +431.2 +Transmission +19.3 +18.4 +17.2 +Total Wholesale Revenues +425.7 +477.7 +448.4 +Other Electric Revenues +14.4 +15.7 +13.5 +Provision for Rate Refund +(2.6 +) +(24.6 +) +(7.2 +) +Total Electric Generation, Transmission and Distribution Revenues +2,222.1 +2,272.6 +2,042.5 +Sales to Affiliates +73.9 +85.5 +64.4 +Other Revenues +10.7 +12.6 +14.3 +Total Revenues +$ +2,306.7 +$ +2,370.7 +$ +2,121.2 +OPCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +1,495.6 +$ +1,619.0 +$ +1,511.3 +Commercial Sales +724.9 +840.1 +774.8 +Industrial Sales +293.2 +386.2 +367.2 +Other Retail Sales +12.9 +13.0 +13.2 +Total Retail Revenues (a) +2,526.6 +2,858.3 +2,666.5 +Wholesale Revenues +Off-system Sales +93.0 +119.3 +100.5 +Transmission +58.5 +61.4 +65.8 +Total Wholesale Revenues +151.5 +180.7 +166.3 +Other Electric Revenues +34.2 +32.7 +31.0 +Provision for Rate Refund +47.2 +(37.9 +) +(10.3 +) +Total Electricity, Transmission and Distribution Revenues +2,759.5 +3,033.8 +2,853.5 +Sales to Affiliates +27.3 +21.0 +24.4 +Other Revenues +10.8 +8.6 +6.0 +Total Revenues +$ +2,797.6 +$ +3,063.4 +$ +2,883.9 +PSO +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +636.1 +$ +668.5 +$ +601.4 +Commercial Sales +377.3 +401.1 +387.7 +Industrial Sales +296.5 +308.5 +284.0 +Other Retail Sales +80.7 +84.5 +81.1 +Total Retail Revenues (a) +1,390.6 +1,462.6 +1,354.2 +Wholesale Revenues +Off-system Sales +39.5 +36.3 +13.9 +Transmission +31.9 +47.4 +42.3 +Total Wholesale Revenues +71.4 +83.7 +56.2 +Other Electric Revenues +9.6 +10.3 +8.5 +Provision for Rate Refund +(2.0 +) +(19.0 +) +(1.4 +) +Total Electric Generation, Transmission and Distribution Revenues +1,469.6 +1,537.6 +1,417.5 +Sales to Affiliates +6.1 +5.4 +4.3 +Other Revenues +6.1 +4.3 +5.4 +Total Revenues +$ +1,481.8 +$ +1,547.3 +$ +1,427.2 +7 +SWEPCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +645.3 +$ +666.0 +$ +597.0 +Commercial Sales +490.6 +502.6 +487.0 +Industrial Sales +342.3 +346.2 +336.9 +Other Retail Sales +9.1 +8.9 +8.8 +Total Retail Revenues (a) +1,487.3 +1,523.7 +1,429.7 +Wholesale Revenues +Off-system Sales +194.7 +216.8 +251.3 +Transmission +72.6 +94.2 +71.7 +Total Wholesale Revenues +267.3 +311.0 +323.0 +Other Electric Revenues +20.6 +20.9 +20.4 +Provision for Rate Refund +(30.6 +) +(63.7 +) +(21.0 +) +Total Electric Generation, Transmission and Distribution Revenues +1,744.6 +1,791.9 +1,752.1 +Sales to Affiliates +4.9 +28.4 +25.9 +Other Revenues +1.4 +1.6 +1.9 +Total Revenues +$ +1,750.9 +$ +1,821.9 +$ +1,779.9 +(a) +2018 and 2017 amounts have been revised to reflect the reclassification of certain customer accounts between Retail classes. This reclassification did not impact previously reported Total Retail Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate. +FINANCING +General +Companies within the AEP System generally use short-term debt to finance working capital needs. Short-term debt may also be used to finance acquisitions, construction and redemption or repurchase of outstanding securities until such needs can be financed with long-term debt. In recent history, short-term funding needs have been provided for by cash on hand and AEP’s commercial paper program. Funds are made available to subsidiaries under the AEP corporate borrowing program. Certain public utility subsidiaries of AEP also sell accounts receivable to provide liquidity. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +AEP’s revolving credit agreement (which backstops the commercial paper program) includes covenants and events of default typical for this type of facility, including a maximum debt/capital test. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of its major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under the credit agreement. As of December 31, 2019 , AEP was in compliance with its debt covenants. With the exception of a voluntary bankruptcy or insolvency, any event of default has either or both a cure period or notice requirement before termination of the agreement. A voluntary bankruptcy or insolvency of AEP or one of its significant subsidiaries would be considered an immediate termination event. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +AEP’s subsidiaries have also utilized, and expect to continue to utilize, additional financing arrangements, such as securitization financings and leasing arrangements, including the leasing of coal transportation equipment and facilities. +8 +ENVIRONMENTAL AND OTHER MATTERS +General +AEP subsidiaries are currently subject to regulation by federal, state and local authorities with regard to air and water-quality control and other environmental matters, and are subject to zoning and other regulation by local authorities. The environmental issues that management believes are potentially material to the AEP System are outlined below. +Clean Water Act Requirements +Operations for AEP subsidiaries are subject to the Federal Clean Water Act, which prohibits the discharge of pollutants into waters of the United States except pursuant to appropriate permits and regulates systems that withdraw surface water for use in power plants. In 2014, the Federal EPA issued a final rule setting forth standards for water withdrawals at existing power plants that is intended to reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water. The standards affect all plants withdrawing more than two million gallons of cooling water per day. Compliance with this standard is required within eight years of the effective date of the final rule. +In November 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for electricity generating facilities. The rule establishes limits on Flue Gas Desulfurization wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed as soon as possible after November 2018 and no later than December 2023. In January 2020, the Federal EPA issued a final rule revising the scope of the “waters of the United States” subject to Clean Water Act regulation. See “Environmental Issues - Clean Water Act Regulations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Coal Ash Regulation +AEP’s operations produce a number of different coal combustion by-products, including fly ash, bottom ash, gypsum and other materials. A Federal EPA rule regulates the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units. The rule requires certain standards for location, groundwater monitoring and dam stability to be met at landfills and certain surface impoundments at operating facilities. If existing disposal facilities cannot meet these standards, they will be required to close. See “Environmental Issues - Coal Combustion Residual Rule” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control mobile and stationary sources of air emissions. The major CAA programs affecting AEP’s power plants are described below. The states implement and administer many of these programs and could impose additional or more stringent requirements. +The Acid Rain Program +The CAA includes a cap-and-trade emission reduction program for SO 2 emissions from power plants and requirements for power plants to reduce NO x emissions through the use of available combustion controls, collectively called the Acid Rain Program. AEP continues to meet its obligations under the Acid Rain Program through the installation of controls, use of alternate fuels and participation in the emissions allowance markets. +9 +National Ambient Air Quality Standards (NAAQS) +The CAA requires the Federal EPA to review the available scientific data for criteria pollutants periodically and establish a concentration level in the ambient air for those substances that is adequate to protect the public health and welfare with an extra safety margin. The Federal EPA also can list additional pollutants and develop concentration levels for them. These concentration levels are known as NAAQS. +Each state identifies the areas within its boundaries that meet the NAAQS (attainment areas) and those that do not (non-attainment areas). Each state must develop a SIP to bring non-attainment areas into compliance with the NAAQS and maintain good air quality in attainment areas. All SIPs are submitted to the Federal EPA for approval. If a state fails to develop adequate plans, the Federal EPA develops and implements a plan. As the Federal EPA reviews the NAAQS and establishes new concentration levels, the attainment status of areas can change and states may be required to develop new SIPs. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Hazardous Air Pollutants (HAP) +The CAA also requires the Federal EPA to investigate HAP emissions from the electric utility sector and submit a report to Congress to determine whether those emissions should be regulated. In 2011, the Federal EPA issued a rule setting Maximum Achievable Control Technology standards for new and existing coal and oil-fired utility units and New Source Performance Standards for emissions from new and modified power plants. In 2014, the U.S. Supreme Court determined that the Federal EPA acted unreasonably in refusing to consider costs in determining if it was appropriate and necessary to regulate HAP emissions from electric generating units. The Federal EPA has engaged in additional rulemaking activity but the 2011 rule remains in effect. See “Environmental Issues - Hazardous Air Pollutants” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Regional Haze +The CAA establishes visibility goals for certain federally designated areas, including national parks, and requires states to submit SIPs that will demonstrate reasonable progress toward preventing impairment of visibility in these protected areas. In 2005, the Federal EPA issued its Clean Air Visibility Rule, detailing how the CAA’s best available retrofit technology requirements will be applied to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants. +PSO executed a settlement with the Federal EPA and the State of Oklahoma to comply with Regional Haze program requirements in Oklahoma, and the settlement is now codified in the Oklahoma SIP and approved by the Federal EPA. The Federal EPA disapproved portions of the Arkansas and Texas SIPs, and finalized FIPs for both states. Arkansas submitted and received approval of a revised SIP, and EPA developed a revised FIP for Texas. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Climate Change +AEP has taken action to reduce and offset CO 2 emissions from its generating fleet and expects CO 2 emissions from its operations to continue to decline due to the retirement of some of its coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. In 2019, AEP announced revised intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, regulations, grid reliability and resiliency, and reflect the company’s current business strategy. The intermediate goal is a 70% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is an 80% or more reduction of CO 2 emissions from AEP generating facilities from 2000 levels by 2050. AEP’s total estimated CO 2 emissions in 2019 were approximately 58 million metric tons, a 65% reduction from AEP’s 2000 CO 2 emissions. +10 +The Federal EPA has taken action to regulate CO 2 emissions from new and existing fossil fueled electric generating units under the existing provisions of the CAA. The Clean Power Plan was adopted in October 2015 but the U.S. Supreme Court issued a stay of its implementation, including all of the deadlines for submission of initial or final state plans. The Federal EPA issued a proposal in 2017 to repeal the Clean Power Plan and finalized the repeal in 2019. In 2018 the Federal EPA issued a proposal to revise the standards for new and modified sources. In 2019, the Federal EPA finalized new guidelines for states to use to develop CO 2 performance standards for coal–fired generating units. See “Environmental Issues - Climate Change, CO 2 Regulation and Energy Policy” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Management expects emissions to continue to decline over time as AEP diversifies generating sources and operates fewer coal units. The projected decline in coal-fired generation is due to a number of factors, including the ongoing cost of operating older units, the relative cost of coal and natural gas as fuel sources, increasing environmental regulations requiring significant capital investments and changing commodity market fundamentals. +Transforming AEP’s Generation Fleet +The electric utility industry is in the midst of an historic transformation, driven by changing customer needs, policy demands, demographics, competitive offerings, technologies and commodity prices. AEP is also transforming to be more agile and customer-focused as a valued provider of energy solutions. AEP’s long-term commitment to reduce CO 2 emissions reflects the current direction of the company’s resource plans to meet those needs. AEP’s exposure to carbon regulation has been greatly reduced over the last several years. From 2000 to 2019, AEP’s CO 2 emissions declined 65%. In 2019, coal represented 45% of AEP’s generating capacity, compared with 70% in 2005. Management expects the percentage of AEP’s generating resources fueled by coal will continue to decline. Transforming AEP’s generation portfolio to include, where there is regulatory support, more renewable energy and focusing on the efficient use of energy, demand response, distributed resources and technology solutions to more efficiently manage the grid over time is part of this strategy. +The graph below summarizes AEP’s generation capacity by resource type for the years 1999, 2005 and 2019: +(a) +Energy Efficiency/Demand Response represents avoided capacity rather than physical assets. +11 +Renewable Sources of Energy +The states AEP serves, other than Kentucky, West Virginia and Tennessee, have established mandatory or voluntary programs to increase the use of energy efficiency, alternative energy or renewable energy sources. +As of December 31, 2019 , AEP’s regulated utilities had long-term contracts for 2,750 MWs of wind, 80 MWs of hydro, and 10 MWs of solar power delivering renewable energy to the companies’ customers. In addition, I&M owns four solar projects that make up I&M’s 16 MW Clean Energy Solar Pilot Project. Management actively manages AEP’s compliance position and is on pace to meet the relevant requirements or benchmarks in each applicable jurisdiction. +In July 2019, PSO and SWEPCo submitted filings before their respective commissions for approval to acquire the North Central Wind Energy Facilities, comprised of three Oklahoma wind facilities totaling 1,485 MWs, on a fixed cost turn-key basis at completion. Subject to regulatory approval, PSO will own 45.5% and SWEPCo will own 54.5% of the project, which will cost approximately $2 billion. Two wind facilities, totaling 1,286 MWs, would qualify for 80% of the federal Production Tax Credits (PTCs) with year-end 2021 in-service dates. The third wind facility (199 MWs) would qualify for 100% of the PTCs with a year-end 2020 in-service date. The acquisition can be scaled, subject to commercial limitation, to align with individual state resource needs and approvals. In December 2019, PSO reached a joint stipulation and settlement agreement with the OCC, Oklahoma Attorney General’s office and customer groups. In January 2020, SWEPCo reached a joint settlement agreement with the APSC, Arkansas Attorney General’s office and Walmart, Inc. Hearings are scheduled for the first quarter of 2020. PSO and SWEPCo are seeking regulatory approvals by July 2020. +The growth of AEP’s renewable generation portfolio reflects the company’s strategy to diversify generation resources to provide clean energy options to customers that meet both their energy and capacity needs. In addition to gradually reducing AEP’s reliance on coal-fueled generating units, the growth of renewables and natural gas helps AEP to maintain a diversity of generation resources. +The integrated resource plans filed with state regulatory commissions by AEP’s regulated utility subsidiaries reflect AEP’s renewable strategy to balance reliability and cost with customers’ desire for clean energy in a carbon-constrained world. AEP has committed significant capital investments to modernize the electric grid and integrate these new resources. Transmission assets of the AEP System interconnect approximately 11,900 MWs of renewable energy resources. AEP’s transmission development initiatives are designed to facilitate the interconnection of additional renewable energy resources. +AEP Energy Supply, LLC is a holding company with several divisions, including AEP Renewables and AEP OnSite Partners. +AEP Renewables develops, owns and operates utility scale renewable projects backed with long-term contracts with creditworthy counterparties throughout the United States. AEP Renewables works directly with stakeholders to ensure that customers have clean, sustainable renewable energy to meet their environmental goals. As of December 31, 2019, AEP Renewables owned projects operating in 11 states, including approximately 1,212 MWs of installed wind capacity and 90 MWs of installed solar capacity. These figures include the 2019 addition of 724 MWs of wind generation and battery assets located in several states acquired from Sempra Renewables LLC and the 75% interest, or 227 MWs, of Santa Rita East wind generation located in west Texas. In October 2019, AEP Renewables entered into an agreement to construct Flat Ridge 3, a wind farm in Kansas. The 128 MW facility is expected to reach commercial operation before the end of 2020. +AEP OnSite Partners works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. AEP OnSite Partners targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2019, AEP OnSite Partners owned projects located in 17 states, including approximately 119 MWs of installed solar capacity, and approximately 28 MWs of solar projects under construction. +12 +Competitive Renewable Generation Facilities +Size of +Energy Resource +AEP Energy Supply, LLC Division +Renewable +Energy Resource +Location +In-Service or +Under Construction +1,212 MW +AEP Renewables +Wind +Eight states (a) +In-service +128 MW +AEP Renewables +Wind +Kansas +Under Construction +20 MW +AEP Renewables +Solar +California +In-service +20 MW +AEP Renewables +Solar +Utah +In-service +50 MW +AEP Renewables +Solar +Nevada +In-service +119 MW +AEP OnSite Partners +Solar +Fifteen states (b) +In-service +28 MW +AEP OnSite Partners +Solar +Three states (c) +Under Construction +(a) +Colorado, Hawaii, Indiana, Kansas, Michigan, Minnesota, Pennsylvania, and Texas. +(b) +California, Colorado, Florida, Hawaii, Iowa, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(c) +Illinois, New Mexico and Ohio. +End Use Energy Efficiency +AEP has reduced energy consumption and peak demand through the introduction of additional energy efficiency and demand response programs. These programs, commonly referred to as demand side management, were implemented in jurisdictions where appropriate cost recovery was available. AEP’s operating companies’ programs have reduced annual consumption by over 9 million MWhs and peak demand by approximately 2,806 MWs since 2008. AEP estimates that its operating companies spent approximately $1.5 billion during that period to achieve these levels. +Energy efficiency and demand reduction programs have received regulatory support in most of the states AEP serves. Appropriate cost recovery will be essential for AEP operating companies to continue and expand these consumer offerings. Appropriate recovery of program costs, lost revenues and an opportunity to earn a reasonable return ensures that energy efficiency programs are considered equally with supply side investments. As AEP continues to transition to a cleaner, more efficient energy future, energy efficiency and demand response programs will continue to play an important role in how the company serves its customers. AEP believes its experience providing robust energy efficiency programs in several states positions the company to be a cost-effective provider of these programs as states develop their implementation plans. +Corporate Governance +In response to environmental issues and in connection with its assessment of AEP’s strategic plan, the Board of Directors continually reviews the risks posed by new environmental rules and requirements that could accelerate the retirement of coal-fired generation assets. The Board of Directors is informed of any new environmental regulations and proposed regulation or legislation that would significantly affect AEP. The Board’s Committee on Directors and Corporate Governance oversees AEP’s annual Corporate Accountability Report, which includes information about AEP’s environmental, social, governance and financial performance. AEP set CO 2 emission reduction goals in 2018 after considering input from corporate governance outreach effort with shareholders. +In September 2019, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, grid reliability and resiliency, regulations and the company’s current business strategy. The intermediate goal is a 70% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is to surpass an 80% reduction of CO 2 emissions from AEP generating facilities from 2000 levels by 2050. AEP has made significant progress in reducing CO 2 emissions from its power generation fleet and expects its emissions to continue to decline. AEP’s aspirational emissions goal is zero CO 2 emissions by 2050. Technological advances, including energy storage, will determine how quickly AEP can achieve zero emissions while continuing to provide reliable, affordable power for customers. +13 +Other Environmental Issues and Matters +The Comprehensive Environmental Response, Compensation and Liability Act of 1980 imposes costs for environmental remediation upon owners and previous owners of sites, as well as transporters and generators of hazardous material disposed of at such sites. See “The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation” section of Note 6 included in the 2019 Annual Report for additional information. +Environmental Investments +Investments related to improving AEP System plants’ environmental performance and compliance with air and water quality standards during 2017 , 2018 and 2019 and the current estimate for 2020 are shown below. These investments include both environmental as well as other related spending. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends and the ability to access capital. In addition to the amounts set forth below, AEP expects to make substantial investments in future years in connection with the modification and addition at generation plants’ facilities for environmental quality controls. Such future investments are needed in order to comply with air and water quality standards that have been adopted and have deadlines for compliance after 2019 or have been proposed and may be adopted. Future investments could be significantly greater if emissions reduction requirements are accelerated or otherwise become more stringent. The cost of complying with applicable environmental laws, regulations and rules is expected to be material to the AEP System. AEP typically recovers costs of complying with environmental standards from customers through rates in regulated jurisdictions. Failure to recover these costs could reduce future net income and cash flows and possibly harm AEP’s financial condition. See “Environmental Issues” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report for additional information. +Historical and Projected Environmental Investments +2017 +2018 +2019 +2020 +Actual +Actual +Actual +Estimate (b) +(in millions) +AEP (a) +$ +135.9 +$ +115.6 +$ +167.2 +$ +176.1 +APCo +25.6 +20.4 +23.8 +37.3 +I&M +41.9 +31.1 +56.4 +33.4 +PSO +0.6 +— +— +6.0 +SWEPCo +11.7 +14.1 +10.5 +40.1 +(a) +Includes expenditures of the subsidiaries shown and other subsidiaries not shown. The figures reflect construction expenditures, not investments in subsidiary companies. +(b) +Estimated amounts are exclusive of debt AFUDC. +14 +Management continues to refine the cost estimates of complying with air and water quality standards and other impacts of the environmental proposals. The following cost estimates for the years 2020 through 2026 will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules. These cost estimates will also change based on: (a) the states’ implementation of these regulatory programs, including the potential for SIPs or FIPs that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) the actual performance of the pollution control technologies installed on the units, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired, replaced or sold, including the type and amount of such replacement capacity and (g) other factors. Management’s current ranges of estimates of new major environmental investments beginning in 2020 , exclusive of debt AFUDC, are set forth below: +Projected (2020 - 2026) +Environmental Investment +Company +Low +High +(in millions) +AEP +$ +500 +$ +1,000 +APCo +125 +230 +I&M +45 +85 +PSO +20 +30 +SWEPCo +150 +305 +BUSINESS SEGMENTS +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. AEP’s reportable segments are as follows: +• +Vertically Integrated Utilities +• +Transmission and Distribution Utilities +• +AEP Transmission Holdco +• +Generation & Marketing +The remainder of AEP’s activities is presented as Corporate and Other, which is not considered a reportable segment. See Note 9 - Business Segments included in the 2019 Annual Report for additional information on AEP’s segments. +VERTICALLY INTEGRATED UTILITIES +GENERAL +AEP’s vertically integrated utility operations are engaged in the generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. AEPSC, as agent for AEP’s public utility subsidiaries, performs marketing, generation dispatch, fuel procurement and power-related risk management and trading activities on behalf of each of these subsidiaries. +ELECTRIC GENERATION +Facilities +As of December 31, 2019 , AEP’s vertically integrated public utility subsidiaries owned or leased approximately 22,000 MWs of domestic generation. See Item 2 – Properties for more information regarding the generation capacity of vertically integrated public utility subsidiaries. +15 +Fuel Supply +The following table shows the owned and leased generation sources by type (including wind purchase agreements), on an actual net generation (MWhs) basis, used by the Vertically Integrated Utilities: +2019 +2018 +2017 +Coal and Lignite +54% +58% +61% +Nuclear +19% +18% +18% +Natural Gas +16% +14% +11% +Renewables +11% +10% +10% +A price increase/decrease in one or more fuel sources relative to other fuels, as well as the addition of renewable resources, may result in the decreased/increased use of other fuels. AEP’s overall 2019 fossil fuel costs for the Vertically Integrated Utilities increased 2.4% on a dollar per MMBtu basis from 2018 . +Coal and Lignite +AEP’s Vertically Integrated Utilities procure coal and lignite under a combination of purchasing arrangements including long-term contracts, affiliate operations and spot agreements with various producers, marketers and coal trading firms. Coal consumption in 2019 decreased approximately 18% from 2018 mainly due to lower dispatching of coal generation from weaker power market prices. +Management believes that the Vertically Integrated Utilities will be able to secure and transport coal and lignite of adequate quality and in adequate quantities to operate their coal and lignite-fired units. Through subsidiaries, AEP owns, leases or controls more than 4,004 railcars, 468 barges, 8 towboats and a coal handling terminal with approximately 18 million tons of annual capacity to move and store coal for use in AEP generating facilities. +Spot market prices for coal started to weaken in the second half of 2019 . The decreased spot coal prices reflect lower demand for domestic and export coal. AEP’s strategy for purchasing coal includes layering in supplies over time. The price impact of this process is reflected in subsequent periods and can occasionally cause current spot market prices to be trending opposite to the price of coal delivered. The price paid for coal delivered in 2019 increased approximately 6% from 2018 . +The following table shows the amount of coal and lignite delivered to the Vertically Integrated Utilities’ plants during the past three years and the average delivered price of coal purchased by the Vertically Integrated Utilities: +2019 +2018 +2017 +Total coal delivered to the plants (millions of tons) +30.4 +29.0 +29.3 +Average cost per ton of coal delivered +$ +45.85 +$ +43.21 +$ +44.24 +The coal supplies at the Vertically Integrated Utilities plants vary from time to time depending on various factors, including, but not limited to, demand for electric power, unit outages, transportation infrastructure limitations, space limitations, plant coal consumption rates, availability of acceptable coals, labor issues and weather conditions, which may interrupt production or deliveries. As of December 31, 2019 , the Vertically Integrated Utilities’ coal inventory was approximately 54 days of full load burn. While inventory targets vary by plant and are changed as necessary, the current coal inventory target for the Vertically Integrated Utilities is approximately 30 days of full load burn. +Natural Gas +The Vertically Integrated Utilities consumed approximately 117 billion cubic feet of natural gas during 2019 for generating power. This represents an increase of 5% from 2018 . Total gas consumption for the Vertically Integrated Utilities was higher year over year primarily due to lower natural gas prices. Several of AEP’s natural gas-fired power plants are connected to at least two pipelines which allow greater access to competitive supplies and improve delivery reliability. A portfolio of term, monthly, seasonal and daily supply and transportation agreements provide natural gas +16 +requirements for each plant, as appropriate. AEP’s natural gas supply agreements are entered into on a competitive basis and based on market prices. +The following table shows the amount of natural gas delivered to the Vertically Integrated Utilities’ plants during the past three years and the average delivered price of natural gas purchased by the Vertically Integrated Utilities. +2019 +2018 +2017 +Total natural gas delivered to the plants (billion of cubic feet) +117.0 +111.6 +86.3 +Average price per MMBtu of purchased natural gas +$ +2.64 +$ +3.26 +$ +3.37 +Nuclear +I&M has made commitments to meet the current nuclear fuel requirements of the Cook Plant. I&M has made and will make purchases of uranium in various forms in the spot, short-term and mid-term markets. I&M also continues to finance its nuclear fuel through leasing. +For purposes of the storage of high-level radioactive waste in the form of SNF, I&M completed modifications to its SNF storage pool in the early 1990’s. I&M entered into an agreement to provide for onsite dry cask storage of SNF to permit normal operations to continue. I&M is scheduled to conduct further dry cask loading and storage projects on an ongoing periodic basis. +Nuclear Waste and Decommissioning +As the owner of the Cook Plant, I&M has a significant future financial commitment to dispose of SNF and decommission and decontaminate the plant safely. The cost to decommission a nuclear plant is affected by NRC regulations and the SNF disposal program. The most recent decommissioning cost study was completed in 2018. The estimated cost of decommissioning and disposal of low-level radioactive waste for the Cook Plant was $2 billion in 2018 non-discounted dollars, with additional ongoing estimated costs of $6 million per year for post decommissioning storage of SNF and an eventual estimated cost of $37 million for the subsequent decommissioning of the spent fuel storage facility, also in 2018 non-discounted dollars. As of December 31, 2019 and 2018 , the total decommissioning trust fund balance for the Cook Plant was approximately $2.7 billion and $2.2 billion, respectively. The balance of funds available to eventually decommission Cook Plant will differ based on contributions and investment returns. The ultimate cost of retiring the Cook Plant may be materially different from estimates and funding targets as a result of the: +• +Escalation of various cost elements (including, but not limited to, general inflation and the cost of energy). +• +Further development of regulatory requirements governing decommissioning. +• +Technology available at the time of decommissioning differing significantly from that assumed in studies. +• +Availability of nuclear waste disposal facilities. +• +Availability of a United States Department of Energy facility for permanent storage of SNF. +Accordingly, management is unable to provide assurance that the ultimate cost of decommissioning the Cook Plant will not be significantly different than current projections. AEP will seek recovery from customers through regulated rates if actual decommissioning costs exceed projections. See the “Nuclear Contingencies” section of Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report for information with respect to nuclear waste and decommissioning. +17 +Low-Level Radioactive Waste +The Low-Level Waste Policy Act of 1980 mandates that the responsibility for the disposal of low-level radioactive waste rests with the individual states. Low-level radioactive waste consists largely of ordinary refuse and other items that have come in contact with radioactive materials. Michigan does not currently have a disposal site for such waste available. I&M cannot predict when such a site may be available. However, the states of Utah and Texas have licensed low level radioactive waste disposal sites which currently accept low level radioactive waste from Michigan waste generators. There is currently no set date limiting I&M’s access to either of these facilities. The Cook Plant has a facility onsite designed specifically for the storage of low level radioactive waste. In the event that low level radioactive waste disposal facility access becomes unavailable, it can be stored onsite at this facility. +Counterparty Risk Management +The Vertically Integrated Utilities segment also sells power and enters into related energy transactions with wholesale customers and other market participants. As a result, counterparties and exchanges may require cash or cash related instruments to be deposited on transactions as margin against open positions. As of December 31, 2019 , counterparties posted approximately $13 million in cash, cash equivalents or letters of credit with AEPSC for the benefit of AEP’s public utility subsidiaries (while, as of that date, AEP’s public utility subsidiaries posted approximately $24 million with counterparties and exchanges). Since open trading contracts are valued based on market prices of various commodities, exposures change daily. See the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Certain Power Agreements +I&M +The UPA between AEGCo and I&M, dated March 31, 1982, provides for the sale by AEGCo to I&M of all the capacity (and the energy associated therewith) available to AEGCo at the Rockport Plant. Whether or not power is available from AEGCo, I&M is obligated to pay a demand charge for the right to receive such power (and an energy charge for any associated energy taken by I&M). The agreement will continue in effect until the last of the lease terms of Unit 2 of the Rockport Plant have expired (currently December 2022) unless extended in specified circumstances. +Pursuant to an assignment between I&M and KPCo, and a UPA between AEGCo and KPCo, AEGCo sells KPCo 30% of the capacity (and the energy associated therewith) available to AEGCo from both units of the Rockport Plant. KPCo has agreed to pay to AEGCo the amounts that I&M would have paid AEGCo under the terms of the UPA between AEGCo and I&M for such entitlement. The KPCo UPA expires in December 2022. +OVEC +AEP and several nonaffiliated utility companies jointly own OVEC. The aggregate equity participation of AEP in OVEC is 43.47%. Parent owns 39.17% and OPCo owns 4.3%. Under the Inter-Company Power Agreement (ICPA), which defines the rights of the owners and sets the power participation ratio of each, the sponsoring companies are entitled to receive and are obligated to pay for all OVEC capacity (approximately 2,400 MWs) in proportion to their respective power participation ratios. The aggregate power participation ratio of APCo, I&M and OPCo is 43.47%. The ICPA terminates in June 2040. The proceeds from charges by OVEC to sponsoring companies under the ICPA based on their prower participation ratios are designed to be sufficient for OVEC to meet its operating expenses and fixed costs. OVEC’s Board of Directors, as elected by AEP and the other owners, has authorized environmental investments related to their ownership interests, with resulting expenses (including for related debt and interest thereon) included in charges under the ICPA. OVEC financed capital expenditures totaling $1.3 billion in connection with flue gas desulfurization projects and the associated scrubber waste disposal landfills at its two generation plants through debt issuances, including tax-advantaged debt issuances. Both OVEC generation plants are operating with the new environmental controls in service. OPCo attempted to assign its rights and obligations under the ICPA to an affiliate +18 +as part of its transfer of its generation assets and liabilities in keeping with corporate separation required by Ohio law. OPCo failed to obtain the consent to assignment from the other owners of OVEC and therefore filed a request with the PUCO seeking authorization to maintain its ownership of OVEC. In December 2013, the PUCO approved OPCo’s request, subject to the condition that energy from the OVEC entitlements are sold into the day-ahead or real-time PJM energy markets, or on a forward basis through a bilateral arrangement. In November 2016, the PUCO approved OPCo’s request to approve a cost-based purchased power agreement (PPA) rider, effective in January 2017, that would initially be based upon OPCo’s contractual entitlement under the ICPA which is approximately 20% of OVEC’s capacity. In January 2020, provisions enacted as part of Ohio Am. Sub. H.B. 6 went into effect that replace the PPA rider and enable OPCo to continue recovering the net cost associated with the ICPA, including any additional contractual entitlement received as a result of the FirstEnergy Solutions (FES) bankruptcy, through 2030. +In March 2018, FES, with an aggregate power participation ratio of approximately 5% under the ICPA, filed bankruptcy. In July 2018, the Bankruptcy Court granted FES’s motion to reject the ICPA. OVEC appealed this decision in the United States Court of Appeals for the Sixth Circuit and in December 2019 the Sixth Circuit remanded the rejection of the ICPA back to the Bankruptcy Court for further consideration based on reversing the Bankruptcy Court’s application of the business judgment standard in rejecting the ICPA. If OVEC does not have sufficient funds to honor its payment obligations, there is risk that APCo, I&M and/or OPCo may need to make payments in addition to their power participation ratio payments. Further, if OVEC’s indebtedness is accelerated for any reason, there is risk that APCo, I&M and/or OPCo may be required to pay some or all of such accelerated indebtedness in amounts equal to their aggregate power participation ratio of 43.47%. The foregoing and other related actions have adversely impacted the credit ratings of OVEC. +ELECTRIC DELIVERY +General +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries own and operate transmission and distribution lines and other facilities to deliver electric power. See Item 2 – Properties for more information regarding the transmission and distribution lines. Most of the transmission and distribution services are sold to retail customers of AEP’s vertically integrated public utility subsidiaries in their service territories. These sales are made at rates approved by the state utility commissions of the states in which they operate, and in some instances, approved by the FERC. See Item 1. Business – Vertically Integrated Utilities – Regulation – Rates. The FERC regulates and approves the rates for both wholesale transmission transactions and wholesale generation contracts. The use and the recovery of costs associated with the transmission assets of the AEP vertically integrated public utility subsidiaries are subject to the rules, principles, protocols and agreements in place with PJM and SPP, and as approved by the FERC. See Item 1. Business – Vertically Integrated Utilities – Regulation – FERC. As discussed below, some transmission services also are separately sold to nonaffiliated companies. +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries hold franchises or other rights to provide electric service in various municipalities and regions in their service areas. In some cases, these franchises provide the utility with the exclusive right to provide electric service within a specific territory. These franchises have varying provisions and expiration dates. In general, the operating companies consider their franchises to be adequate for the conduct of their business. For a discussion of competition in the sale of power, see Item 1. Business – Vertically Integrated Utilities – Competition. +Transmission Agreement (TA) +APCo, I&M, KGPCo, KPCo and WPCo own and operate transmission facilities that are used to provide transmission service under the PJM OATT and are parties to the TA. OPCo, which is a subsidiary in AEP’s Transmission and Distribution Utilities segment that provides transmission service under the PJM OATT, is also a party to the TA. The TA defines how the parties to the agreement share the revenues associated with their transmission facilities and the costs of transmission service provided by PJM. The TA has been approved by the FERC. +19 +TCA and OATT +PSO, SWEPCo and AEPSC are parties to the TCA. Under the TCA, a coordinating committee is charged with the responsibility of (a) overseeing the coordinated planning of the transmission facilities of the parties to the agreement, including the performance of transmission planning studies, (b) the interaction of such subsidiaries with independent system operators and other regional bodies interested in transmission planning and (c) compliance with the terms of the OATT filed with the FERC and the rules of the FERC relating to such tariff. Pursuant to the TCA, AEPSC has responsibility for monitoring the reliability of their transmission systems and administering the OATT on behalf of the other parties to the agreement. The TCA also provides for the allocation among the parties of revenues collected for transmission and ancillary services provided under the OATT. These allocations have been determined by the FERC-approved OATT for the SPP. +Regional Transmission Organizations +AEGCo, APCo, I&M, KGPCo, KPCo and WPCo are members of PJM, and PSO and SWEPCo are members of SPP (both FERC-approved RTOs). RTOs operate, plan and control utility transmission assets in a manner designed to provide open access to such assets in a way that prevents discrimination between participants owning transmission assets and those that do not. +REGULATION +General +AEP’s vertically integrated public utility subsidiaries’ retail rates and certain other matters are subject to traditional cost-based regulation by the state utility commissions. AEP’s vertically integrated public utility subsidiaries are also subject to regulation by the FERC under the Federal Power Act with respect to wholesale power and transmission service transactions. I&M is subject to regulation by the NRC under the Atomic Energy Act of 1954, as amended, with respect to the operation of the Cook Plant. AEP and its vertically integrated public utility subsidiaries are also subject to the regulatory provisions of, much of the Energy Policy Act of 2005, which is administered by the FERC. +Rates +Historically, state utility commissions have established electric service rates on a cost-of-service basis, which is designed to allow a utility an opportunity to recover its cost of providing service and to earn a reasonable return on its investment used in providing that service. A utility’s cost of service generally reflects its operating expenses, including operation and maintenance expense, depreciation expense and taxes. State utility commissions periodically adjust rates pursuant to a review of (a) a utility’s adjusted revenues and expenses during a defined test period and (b) such utility’s level of investment. Absent a legal limitation, such as a law limiting the frequency of rate changes or capping rates for a period of time, a state utility commission can review and change rates on its own initiative. Some states may initiate reviews at the request of a utility, customer, governmental or other representative of a group of customers. Such parties may, however, agree with one another not to request reviews of or changes to rates for a specified period of time. +Public utilities have traditionally financed capital investments until the new asset is placed in service. Provided the asset was found to be a prudent investment, it was then added to rate base and entitled to a return through rate recovery. Given long lead times in construction, the high costs of plant and equipment and volatile capital markets, management actively pursues strategies to accelerate rate recognition of investments and cash flow. AEP representatives continue to engage state commissioners and legislators on alternative ratemaking options to reduce regulatory lag and enhance certainty in the process. These options include pre-approvals, a return on construction work in progress, rider/trackers, formula rates and the inclusion of future test-year projections into rates. +The rates of AEP’s vertically integrated public utility subsidiaries are generally based on the cost of providing traditional bundled electric service (i.e., generation, transmission and distribution service). Historically, the state regulatory frameworks in the service area of the AEP vertically integrated public utility subsidiaries reflected specified fuel costs +20 +as part of bundled (or, more recently, unbundled) rates or incorporated fuel adjustment clauses in a utility’s rates and tariffs. Fuel adjustment clauses permit periodic adjustments to fuel cost recovery from customers and therefore provide protection against exposure to fuel cost changes. +The following state-by-state analysis summarizes the regulatory environment of certain major jurisdictions in which AEP’s vertically integrated public utility subsidiaries operate. Several public utility subsidiaries operate in more than one jurisdiction. See Note 4 - Rate Matters included in the 2019 Annual Report for more information regarding pending rate matters. +Indiana +I&M provides retail electric service in Indiana at bundled rates approved by the IURC, with rates set on a cost-of-service basis. Indiana provides for timely fuel and purchased power cost recovery through a fuel cost recovery mechanism. +Oklahoma +PSO provides retail electric service in Oklahoma at bundled rates approved by the OCC. PSO’s rates are set on a cost-of-service basis. Fuel and purchased energy costs are recovered or refunded by applying fuel adjustment and other factors to retail kilowatt-hour sales. +Virginia +APCo currently provides retail electric service in Virginia at unbundled generation and distribution rates approved by the Virginia SCC. Virginia generally allows for timely recovery of fuel costs through a fuel adjustment clause. In addition to base rates and fuel cost recovery, APCo is permitted to recover a variety of costs through rate adjustment clauses including transmission services provided at OATT rates based on rates established by the FERC. +West Virginia +APCo and WPCo provide retail electric service at bundled rates approved by the WVPSC, with rates set on a combined cost-of-service basis. West Virginia generally allows for timely recovery of fuel costs through an expanded net energy cost which trues-up to actual expenses. +FERC +The FERC regulates rates for interstate power sales at wholesale, transmission of electric power, accounting and other matters, including construction and operation of hydroelectric projects. The FERC regulations require AEP’s vertically integrated public utility subsidiaries to provide open access transmission service at FERC-approved rates, and AEP has approved cost-based formula transmission rates on file at the FERC. The FERC also regulates unbundled transmission service to retail customers. In addition, the FERC regulates the sale of power for resale in interstate commerce by (a) approving contracts for wholesale sales to municipal and cooperative utilities and (b) granting authority to public utilities to sell power at wholesale at market-based rates upon a showing that the seller lacks the ability to improperly influence market prices. AEP’s vertically integrated public utility subsidiaries have market-based rate authority from the FERC, under which much of their wholesale marketing activity takes place. The FERC requires each public utility that owns or controls interstate transmission facilities to, directly or through an RTO, to file an open access network and point-to-point transmission tariff that offers services comparable to the utility’s own uses of its transmission system. The FERC also requires all transmitting utilities, directly or through an RTO, to establish an Open Access Same-time Information System, which electronically posts transmission information such as available capacity and prices, and requires utilities to comply with Standards of Conduct that prohibit utilities’ transmission employees from providing non-public transmission information to the utility’s marketing employees. Additionally, the vertically integrated public utility subsidiaries are subject to reliability standards promulgated by the North American Electric Reliability Corporation, with the approval of the FERC. +21 +The FERC oversees RTOs, entities created to operate, plan and control utility transmission assets. AEGCo, APCo, I&M, KGPCo, KPCo and WPCo are members of PJM. PSO and SWEPCo are members of SPP. +The FERC has jurisdiction over the issuances of securities of most of AEP’s public utility subsidiaries, the acquisition of securities of utilities, the acquisition or sale of certain utility assets and mergers with another electric utility or holding company. In addition, both the FERC and state regulators are permitted to review the books and records of any company within a holding company system. +COMPETITION +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries generate, transmit and distribute electricity to retail customers of AEP’s vertically integrated public utility subsidiaries in their service territories. These sales are made at rates approved by the state utility commissions of the states in which they operate, and in some instances, approved by the FERC, and are not subject to competition from other vertically integrated public utilities. Other than AEGCo, AEP’s vertically integrated public utility subsidiaries hold franchises or other rights that effectively grant the exclusive ability to provide electric service in various municipalities and regions in their service areas. +AEP’s vertically integrated public utility subsidiaries compete with self-generation and with distributors of other energy sources, such as natural gas, fuel oil, renewables and coal, within their service areas. The primary factors in such competition are price, reliability of service and the capability of customers to utilize alternative sources of energy other than electric power. With respect to competing generators and self-generation, the public utility subsidiaries of AEP believe that they currently maintain a competitive position. +Changes in regulatory policies and advances in newer technologies for batteries or energy storage, fuel cells, microturbines, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production. The costs of photovoltaic solar cells in particular have continued to become increasingly competitive. The ability to maintain relatively low cost, efficient and reliable operations and to provide cost-effective programs and services to customers are significant determinants of AEP’s competitiveness. +SEASONALITY +The consumption of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter. The pattern of this fluctuation may change due to the nature and location of AEP’s facilities and the terms of power sale contracts into which AEP enters. In addition, AEP has historically sold less power, and consequently earned less income, when weather conditions are milder. Unusually mild weather in the future could diminish AEP’s results of operations. Conversely, unusually extreme weather conditions could increase AEP’s results of operations. +22 +TRANSMISSION AND DISTRIBUTION UTILITIES +GENERAL +This segment consists of the transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo. OPCo is engaged in the transmission and distribution of electric power to approximately 1,494,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,049,000 retail customers through REPs in west, central and southern Texas. +AEP’s transmission and distribution utility subsidiaries own and operate transmission and distribution lines and other facilities to deliver electric power. See Item 2 – Properties, for more information regarding the transmission and distribution lines. Transmission and distribution services are sold to retail customers of AEP’s transmission and distribution utility subsidiaries in their service territories. These sales are made at rates approved by the PUCT for AEP Texas and by the PUCO and the FERC for OPCo. The FERC regulates and approves the rates for wholesale transmission transactions. As discussed below, some transmission services also are separately sold to nonaffiliated companies. +AEP’s transmission and distribution utility subsidiaries hold franchises or other rights to provide electric service in various municipalities and regions in their service areas. In some cases, these franchises provide the utility with the exclusive right to provide electric service. These franchises have varying provisions and expiration dates. In general, the operating companies consider their franchises to be adequate for the conduct of their business. +The use and the recovery of costs associated with the transmission assets of the AEP transmission and distribution utility subsidiaries are subject to the rules, protocols and agreements in place with PJM and ERCOT, and as approved by the FERC. In addition to providing transmission services in connection with power sales in their service areas, AEP’s transmission and distribution utility subsidiaries also provide transmission services for nonaffiliated companies through RTOs. +Transmission Agreement +OPCo owns and operates transmission facilities that are used to provide transmission service under the PJM OATT; OPCo is a party to the TA with other utility subsidiary affiliates. The TA defines how the parties to the agreement share the revenues associated with their transmission facilities and the costs of transmission service provided by PJM. The TA has been approved by the FERC. +Regional Transmission Organizations +OPCo is a member of PJM, a FERC-approved RTO. RTOs operate, plan and control utility transmission assets to provide open access to such assets in a way that prevents discrimination between participants owning transmission assets and those that do not. AEP Texas is a member of ERCOT. +REGULATION +OPCo provides distribution and transmission services to retail customers within its service territory at cost-based rates approved by the PUCO or by the FERC. AEP Texas provides transmission and distribution service on a cost-of-service basis at rates approved by the PUCT and wholesale transmission service under tariffs approved by the FERC consistent with PUCT rules. Transmission and distribution rates are established on a cost-of-service basis, which is designed to allow a utility an opportunity to recover its cost of providing service and to earn a reasonable return on its investment used in providing that service. The cost of service generally reflects operating expenses, including operation and maintenance expense, depreciation expense and taxes. Utility commissions periodically adjust rates pursuant to a review of: (a) a utility’s adjusted revenues and expenses during a defined test period and (b) such utility’s level of investment. +23 +FERC +The FERC regulates rates for transmission of electric power, accounting and other matters. The FERC regulations require AEP to provide open access transmission service at FERC-approved rates, and it has approved cost-based formula transmission rates on file at the FERC. The FERC also regulates unbundled transmission service to retail customers. The FERC requires each public utility that owns or controls interstate transmission facilities to, directly or through an RTO, file an open access network and point-to-point transmission tariff that offers services comparable to the utility’s own uses of its transmission system. The FERC also requires all transmitting utilities, directly or through an RTO, to establish an Open Access Same-time Information System, which electronically posts transmission information such as available capacity and prices, and requires utilities to comply with Standards of Conduct that prohibit utilities’ transmission employees from providing non-public transmission information to the utility’s marketing employees. In addition, both the FERC and state regulators are permitted to review the books and records of any company within a holding company system. Additionally, the transmission and distribution utility subsidiaries are subject to reliability standards as set forth by the North American Electric Reliability Corporation, with the approval of the FERC. +SEASONALITY +The delivery of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months. In other areas, power demand peaks during the winter months. The pattern of this fluctuation may change due to the nature and location of AEP’s transmission and distribution facilities. In addition, AEP transmission and distribution has historically delivered less power, and consequently earned less income, when weather conditions are milder. In Texas, and to a lesser extent, in Ohio, where there is residential decoupling, unusually mild weather in the future could diminish AEP’s results of operations. Conversely, unusually extreme weather conditions could increase AEP’s results of operations. +24 +AEP TRANSMISSION HOLDCO +GENERAL +AEPTHCo is a holding company for (a) AEPTCo, which is the direct holding company for the State Transcos and (b) AEP’s Transmission Joint Ventures. +AEPTCo +AEPTCo wholly owns the State Transcos which are independent of, but respectively overlay, the following AEP electric utility operating companies: APCo, I&M, KPCo, OPCo, PSO, SWEPCo, and WPCo. The State Transcos develop, own, operate, and maintain their respective transmission assets. Assets of the State Transcos interconnect to transmission facilities owned by the aforementioned operating companies and nonaffiliated transmission owners within the footprints of PJM, MISO and SPP. APTCo, IMTCo, KTCo, OHTCo, and WVTCo are located within PJM. IMTCo also owns portions of the Greentown station assets located in MISO. OKTCo and SWTCo are located within SPP. +IMTCo, KTCo, OHTCo, OKTCo, and WVTCo own and operate transmission assets in their respective jurisdictions. The Virginia SCC and WVPSC granted consent for APCo and APTCo to enter into a joint license agreement that will support APTCo investment in the state of Tennessee. SWTCo does not currently own or operate transmission assets. +The State Transcos are regulated for rate-making purposes exclusively by the FERC and earn revenues through tariff rates charged for the use of their electric transmission systems. The State Transcos establish transmission rates each year through formula rate filings with the FERC. The rate filings calculate the revenue requirement needed to cover the costs of operation and debt service and to earn an allowed ROE. These rates are then included in an OATT for PJM, MISO and SPP. +The State Transcos own, operate, maintain and invest in transmission infrastructure in order to maintain and enhance system integrity and grid reliability, grid security, safety, reduce transmission constraints and facilitate interconnections of new generating resources and new wholesale customers, as well as enhance competitive wholesale electricity markets. A key part of AEP’s business is replacing and upgrading transmission facilities, assets and components of the existing AEP System as needed to maintain reliability. +The State Transcos provide the capability to build, replace and upgrade existing facilities. As of December 31, 2019 , the State Transcos had $8.4 billion of transmission and other assets in-service with plans to construct approximately $4.3 billion of additional transmission assets through 2022. Additional investment in transmission infrastructure is needed within PJM and SPP to maintain the required level of grid reliability, resiliency, security and efficiency and to address an aging transmission infrastructure. Additional transmission facilities will be needed based on changes in generating resources, such as wind or solar projects, generation additions or retirements, and additional new customer interconnections. The State Transcos will continue their investment to enhance physical and cyber security of assets, and are also investing in improving the telecommunication network that supports the operation and control of the grid. +25 +AEPTHCO JOINT VENTURE INITIATIVES +AEP has established joint ventures with other electric utility companies for the purpose of developing, building, and owning transmission assets that seek to improve reliability and market efficiency and provide transmission access to remote generation sources in North America (Transmission Joint Ventures). +The Transmission Joint Ventures currently include: +Joint Venture Name +Location +Projected or Actual Completion Date +Owners +(Ownership %) +Total Estimated/Actual Project Costs at Completion +Approved Return on Equity +(in millions) +ETT +Texas +(a) +Berkshire Hathaway +$ +3,376.1 +(a) +9.6 +% +(ERCOT) +Energy (50%) +AEP (50%) +Prairie Wind +Kansas +2014 +Evergy, Inc. (50%) +158.0 +12.8 +% +Berkshire Hathaway Energy (25%) +AEP (25%) +Pioneer +Indiana +2018 +Duke Energy (50%) +187.4 +10.38 +% +(b) +AEP (50%) +Transource +Missouri +2016 +Evergy, Inc. +310.5 +11.2 +% +(c) +Missouri +(13.5%) (d) +AEP (86.5%) (d) +Transource +West +2019 +Evergy, Inc. +82.0 +10.5 +% +West Virginia +Virginia +(13.5%) (d) +AEP (86.5%) (d) +Transource +Maryland +2022 +Evergy, Inc. +23.1 +(e) +10.4 +% +Maryland +(13.5%) (d) +AEP (86.5%) (d) +Transource +Pennsylvania +2022 +Evergy, Inc. +238.9 +(e) +10.4 +% +Pennsylvania +(13.5%) (d) +AEP (86.5%) (d) +(a) +ETT is undertaking multiple projects and the completion dates will vary for those projects. ETT’s investment in completed and active projects in ERCOT is expected to be $3.4 billion. Future projects will be evaluated on a case-by-case basis. +(b) +In November 2019, Pioneer received FERC approval authorizing an ROE of 9.88% (10.38% inclusive of the RTO incentive adder of 0.5%. +(c) +The ROE represents the weighted average approved ROE based on the costs of two projects developed by Transource Missouri; the $64 million Iatan-Nashua project (10.3%) and the $247 million Sibley-Nebraska City project (11.3%). +(d) +AEP owns 86.5% of Transource Missouri, Transource West Virginia, Transource Maryland and Transource Pennsylvania through its ownership interest in Transource Energy, LLC (Transource). Transource is a joint venture with AEPTHCo and Evergy, Inc. formed to pursue competitive transmission projects. AEPTHCo and Evergy, Inc. own 86.5% and 13.5% of Transource, respectively. +(e) +In August 2016, Transource Maryland and Transource Pennsylvania received approval from the PJM Interconnection Board to construct portions of a transmission project located in both Maryland and Pennsylvania. The project is expected to go in service in 2022. Project costs are in 2019 dollars. +Transource Missouri, Transource West Virginia, Transource Maryland and Transource Pennsylvania are consolidated joint ventures by AEP. All other joint ventures in the table above are not consolidated by AEP. AEP’s joint ventures do not have employees. Business services for the joint ventures are provided by AEPSC and other AEP subsidiaries and the joint venture partners. During 2019 , approximately 608 AEPSC employees and 291 operating company employees provided service to one or more joint ventures. +26 +REGULATION +The State Transcos and the Transmission Joint Ventures located outside of ERCOT establish transmission rates annually through forward looking formula rate filings with the FERC pursuant to FERC-approved implementation protocols. The protocols include a transparent, formal review process to ensure the updated transmission rates are prudently incurred and reasonably calculated. The IMTCo-owned Greentown station assets acquired from Duke Energy Indiana, LLC in December 2018 are located in MISO. IMTCo utilizes a historic cost recovery model to recover MISO assets. +The State Transcos’ and the Transmission Joint Ventures’ (where applicable) rates are included in the respective OATT for PJM and SPP. An OATT is the FERC rate schedule that provides the terms and conditions for transmission and related services on a transmission provider’s transmission system. The FERC requires transmission providers such as PJM and SPP to offer transmission service to all eligible customers (for example, load-serving entities, power marketers, generators and customers) on a non-discriminatory basis. +The FERC-approved formula rates establish the annual transmission revenue requirement (ATRR) and transmission service rates for transmission owners in annual rate base filings with the FERC. The formula rates establish rates for a one-year period based on the current projects in-service and proposed projects for a defined timeframe. The formula rates also include a true-up calculation for the previous year’s billings, allowing for over/under-recovery of the transmission owner’s ATRR. PJM and SPP pay the transmission owners their ATRR for use of their facilities and bill transmission customers taking service under the PJM and SPP OATTs, based on the terms and conditions in the respective OATT for the service taken. Additionally, the State Transcos are subject to reliability standards promulgated by the North American Electric Reliability Corporation, with the approval of the FERC. +The authorized returns on equity for the State Transcos are the FERC-authorized returns on equity in the PJM and SPP OATTs, respectively. These returns were challenged by parties in filings before the FERC. AEP’s transmission owning subsidiaries within PJM entered into a settlement agreement, approved by the FERC in May 2019, that established a total ROE of 9.85% (10.35% inclusive of the RTO incentive adder of 0.5%) based on a capital structure of up to 55% equity for APTCo, IMTCo, KTCo, OHTCo and WVTCo (the East Transcos). In June 2019, the FERC approved an unopposed settlement agreement between AEP’s transmission owning subsidiaries within SPP that established a total ROE of 10.0% (10.5% inclusive of the RTO incentive adder of 0.5%) without a cap on the capital structure for OKTCo and SWTCo (the West Transcos). +In the annual rate base filings described above, the State Transcos in aggregate filed rate base totals of $5.9 billion, $4.6 billion and $3.8 billion for 2019 , 2018 and 2017 , respectively. The total filed transmission revenue requirements, including prior year over/under-recovery of revenue and associated carrying charges were $992 million, $829 million and $690 million for 2019 , 2018 , and 2017 , respectively. +The rates of ETT, which is located in ERCOT, are determined by the PUCT. ETT sets its rates through a combination of base rate cases and interim Transmission Cost of Services (TCOS) filings. ETT may file interim TCOS filings semi-annually to update its rates to reflect changes in its net invested capital. +The Transmission Joint Ventures have approved ROEs ranging from 9.6% to 12.8% based on equity capital structures ranging from 40% to 60%. +27 +GENERATION & MARKETING +GENERAL +The AEP Generation & Marketing segment subsidiaries consist of competitive generating assets, a wholesale energy trading and marketing business and a retail supply and energy management business. The primary fossil generation subsidiary in the Generation & Marketing segment is AGR. As of December 31, 2019 , AGR owns 1,294 MWs of generating capacity. Management plans to close 51% of this generation capacity in May 2020. Almost all of the remaining generating capacity is operated by Buckeye Power, a nonaffiliated electric cooperative. Other subsidiaries in this segment own or have the right to receive power from additional generation assets. See Item 2 – Properties for more information regarding the generation assets of the Generation & Marketing segment. AGR is a competitive generation subsidiary. +With respect to the wholesale energy trading and marketing business, AEP Generation & Marketing segment subsidiaries enter into short-term and long-term transactions to buy or sell capacity, energy and ancillary services in ERCOT, SPP, MISO and PJM. These subsidiaries sell power into the market and engage in power, natural gas and emissions allowances risk management and trading activities. These activities primarily involve the purchase-and-sale of electricity (and to a lesser extent, natural gas and emissions allowances) under forward contracts at fixed and variable prices. These contracts include physical transactions, exchange-traded futures, and to a lesser extent, OTC swaps and options. The majority of forward contracts are typically settled by entering into offsetting contracts. These transactions are executed with numerous counterparties or on exchanges. +With respect to the retail supply and energy management business, AEP Energy is a retail energy supplier that supplies electricity and/or natural gas to residential, commercial, and industrial customers. AEP Energy provides various energy solutions in Illinois, Pennsylvania, Delaware, Maryland, New Jersey, Ohio and Washington, D.C. AEP Energy also provides demand-side management solutions nationwide. AEP Energy had approximately 470,000 customer accounts as of December 31, 2019 . +AEP Energy Supply, LLC is a holding company with several divisions, including AEP Renewables and AEP OnSite Partners. +AEP Renewables develops, owns and operates utility scale renewable projects backed with long-term contracts with creditworthy counterparties throughout the United States. AEP Renewables works directly with stakeholders to ensure that customers have clean, sustainable renewable energy to meet their environmental goals. As of December 31, 2019, AEP Renewables owned projects operating in 11 states, including approximately 1,212 MWs of installed wind capacity and approximately 90 MWs of installed solar capacity. These figures include the 2019 addition of 724 MWs of wind generation and battery assets located in several states acquired from Sempra Renewables LLC and the 75% interest, or 227 MWs, of Santa Rita East wind generation located in west Texas. In October 2019, AEP Renewables entered into an agreement to construct Flat Ridge 3, a wind farm in Kansas. The 128 MW facility is expected to reach commercial operation before the end of 2020. +AEP OnSite Partners works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. AEP OnSite Partners targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2019, AEP OnSite Partners owned projects located in 17 states, including approximately 119 MWs of installed solar capacity, and approximately 28 MWs of solar projects under construction. +28 +REGULATION +AGR is a public utility under the Federal Power Act, and is subject to the FERC’s exclusive ratemaking jurisdiction over wholesale sales of electricity and the transmission of electricity in interstate commerce. Under the Federal Power Act, the FERC has the authority to grant or deny market-based rates for sales of energy, capacity and ancillary services to ensure that such sales are just and reasonable. The FERC granted AGR market-based rate authority in December 2013. The FERC’s jurisdiction over ratemaking also includes the authority to suspend the market-based rates of AGR and set cost-based rates if the FERC subsequently determines that it can exercise market power, create barriers to entry or engage in abusive affiliate transactions. Periodically, AGR is required to file a market power update to show that it continues to meet the FERC’s standards with respect to generation market power and other criteria used to evaluate whether it continues to qualify for market-based rates. Other matters subject to the FERC jurisdiction include, but are not limited to, review of mergers, and dispositions of jurisdictional facilities and acquisitions of securities of another public utility or an existing operational generating facility. +Specific operations of AGR are also subject to the jurisdiction of various other federal, state, regional and local agencies, including federal and state environmental protection agencies. AGR is also regulated by the PUCT for transactions inside ERCOT. Additionally, AGR is subject to mandatory reliability standards promulgated by the North American Electric Reliability Corporation, with the approval of the FERC. +COMPETITION +The AEP Generation & Marketing segment subsidiaries face competition for the sale of available power, capacity and ancillary services. The principal factors of impact are electricity and fuel prices, new market entrants, construction or retirement of generating assets by others and technological advances in power generation. Because most of AGR’s remaining generation is coal-fired, lower relative natural gas prices will favor competitors that have a higher concentration of natural gas fueled generation. Other factors impacting competitiveness include environmental regulation, transmission congestion or transportation constraints at or near generation facilities, inoperability or inefficiencies, outages and deactivations and retirements at generation facilities. +Technology advancements, increased demand for clean energy, changing consumer behaviors, low-priced and abundant natural gas, and regulatory and public policy reforms are among the catalysts for transformation within the industry that impact competition for AEP’s Generation & Marketing segment. AGR also competes with self-generation and with distributors of other energy sources, such as natural gas, fuel oil, renewables and coal, within their service areas. The primary factors in such competition are price, unit availability and the capability of customers to utilize sources of energy other than electric power. +Changes in regulatory policies and advances in newer technologies for batteries or energy storage, fuel cells, microturbines, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production. The ability to maintain relatively low cost, efficient and reliable operations and to provide cost-effective programs and services to customers are significant determinants of AGR’s competitiveness. The costs of photovoltaic solar cells in particular have continued to become increasingly competitive. +This segment’s retail operations provide competitive electricity and natural gas in deregulated retail energy markets in six states and Washington, D.C. Each such retail choice jurisdiction establishes its own laws and regulations governing its competitive market, and public utility commission communications and utility default service pricing can affect customer participation in retail competition. Sustained low natural gas and power prices, low market volatility and maturing competitive environments can adversely affect this business. +This segment also engages in procuring and selling output from renewable generation sources under long-term contracts to creditworthy counterparties. New sources are not acquired without first securing a long-term placement of such power. Existing sources do not face competitive exposure. Competitive nonaffiliated suppliers of renewable or other generation could limit opportunities for future transactions for new sources and related output contracts. +29 +SEASONALITY +The consumption of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter months. The pattern of this fluctuation may change. +Fuel Supply +The following table shows the generation sources by type, on an actual net generation (MWhs) basis, used by the Generation & Marketing segment, not including AEP Energy Partners’ offtake agreement from the Oklaunion Power Station: +2019 +2018 +2017 +Coal +64% +88% +85% +Natural Gas +—% +—% +8% +Renewables +36% +12% +7% +Management expects the decline in coal generation sources to continue into 2020 due to the shutdown of Conesville Unit 4 in May 2020. +Coal and Consumables +AGR procures coal and consumables needed to burn the coal under a combination of purchasing arrangements including long-term and spot contracts with various producers and coal trading firms. As contracts expire, they are replaced, as needed, with contracts at market prices. Coal and consumable inventories remain adequate to meet generation requirements. +Management believes that AGR will be able to secure and transport coal and consumables of adequate quality and in adequate quantities to operate their coal-fired units. AGR, through its contracts with third party transporters, has the ability to adequately move and store coal and consumables for use in its generating facilities. AGR plants consumed 2.5 million tons of coal in 2019 . +The coal supplies at AGR plants vary from time to time depending on various factors, including, but not limited to, demand for electric power, unit outages, transportation infrastructure limitations, space limitations, plant coal consumption rates, coal quality, availability of acceptable coals, labor issues and weather conditions, which may interrupt production or deliveries. AGR aims to maintain the coal inventory of its managed plants in the range of 20 to 60 days of full load burn. As of December 31, 2019 , the coal inventory of AGR was within the target range. +Counterparty Risk Management +Counterparties and exchanges may require cash or cash related instruments to be deposited on these transactions as margin against open positions. As of December 31, 2019 , counterparties posted approximately $16 million in cash, cash equivalents or letters of credit with AEP for the benefit of AEP’s Generation & Marketing segment subsidiaries (while, as of that date, AEP’s Generation & Marketing segment subsidiaries posted approximately $169 million with counterparties and exchanges). Since open trading contracts are valued based on market prices of various commodities, exposures change daily. See the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Certain Power Agreements +As of December 31, 2019 , the assets utilized in this segment included approximately 1,212 MWs of company-owned domestic wind power facilities, 101 MWs of domestic wind power from long-term purchase power agreements and 355 MWs of coal-fired capacity which was obtained through an agreement effective through 2027 that transfers the interest of AEP Texas in the Oklaunion Power Station to AEPEP. Management has announced plans to close Oklaunion Power Station by October 2020. The power obtained from the Oklaunion Power Station is marketed and sold in ERCOT. +30 +INFORMATION ABOUT OUR EXECUTIVE OFFICERS +The following persons are executive officers of AEP. Their ages are given as of February 20, 2020 . The officers are appointed annually for a one-year term by the board of directors of AEP. +Nicholas K. Akins +Chairman of the Board, President and Chief Executive Officer +Age 59 +Chairman of the Board since January 2014, President since January 2011 and Chief Executive Officer since November 2011. +Lisa M. Barton +Executive Vice President - Utilities +Age 54 +Executive Vice President - Transmission from August 2011 to December 2018. +Paul Chodak, III +Executive Vice President - Generation +Age 56 +Executive Vice President - Utilities from January 2017 to December 2018. President and Chief Operating Officer of I&M from July 2010 to December 2016. +David M. Feinberg +Executive Vice President, General Counsel and Secretary +Age 50 +Executive Vice President since January 2013. +Lana L. Hillebrand +Executive Vice President and Chief Administrative Officer +Age 59 +Chief Administrative Officer since December 2012 and Senior Vice President from December 2012 to December 2016. +Mark C. McCullough +Executive Vice President - Transmission +Age 60 +Executive Vice President - Generation from January 2011 to December 2018. +Charles R. Patton +Executive Vice President - External Affairs +Age 60 +Executive Vice President - External Affairs since January 2017. President and Chief Operating Officer of APCo from June 2010 to December 2016. +Brian X. Tierney +Executive Vice President and Chief Financial Officer +Age 52 +Executive Vice President and Chief Financial Officer since October 2009. +Charles E. Zebula +Executive Vice President - Energy Supply +Age 59 +Executive Vice President - Energy Supply since January 2013. +31 +ITEM 1A. RISK FACTORS +GENERAL RISKS OF REGULATED OPERATIONS +AEP may not be able to recover the costs of substantial planned investment in capital improvements and additions. (Applies to all Registrants) +AEP’s business plan calls for extensive investment in capital improvements and additions, including the installation of environmental upgrades and retrofits, construction of additional transmission facilities, modernizing existing infrastructure as well as other initiatives. AEP’s public utility subsidiaries currently provide service at rates approved by one or more regulatory commissions. If these regulatory commissions do not approve adjustments to the rates charged, affected AEP subsidiaries would not be able to recover the costs associated with their investments. This would cause financial results to be diminished. +Regulated electric revenues and earnings are dependent on federal and state regulation that may limit AEP’s ability to recover costs and other amounts. (Applies to all Registrants) +The rates customers pay to AEP regulated utility businesses are subject to approval by the FERC and the respective state utility commissions of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. In certain instances, AEP’s applicable regulated utility businesses may agree to negotiated settlements related to various rate matters that are subject to regulatory approval. AEP cannot predict the ultimate outcomes of any settlements or the actions by the FERC or the respective state commissions in establishing rates. +If regulated utility earnings exceed the returns established by the relevant commissions, retail electric rates may be subject to review and possible reduction by the commissions, which may decrease future earnings. Additionally, if regulatory bodies do not allow recovery of costs incurred in providing service on a timely basis, it could reduce future net income and cash flows and negatively impact financial condition. Similarly, if recovery or other rate relief authorized in the past is overturned or reversed on appeal, future earnings could be negatively impacted. Any regulatory action or litigation outcome that triggers a reversal of a regulatory asset or deferred cost generally results in an impairment to the balance sheet and a charge to the income statement of the company involved. See Note 4 – Rate Matters included in the 2019 Annual Report for additional information. +AEP’s transmission investment strategy and execution are dependent on federal and state regulatory policy. (Applies to all Registrants) +A significant portion of AEP’s earnings is derived from transmission investments and activities. FERC policy currently favors the expansion and updating of the transmission infrastructure within its jurisdiction. If the FERC were to adopt a different policy, if states were to limit or restrict such policies, or if transmission needs do not continue or develop as projected, AEP’s strategy of investing in transmission could be impacted. Management believes AEP’s experience with transmission facilities construction and operation gives AEP an advantage over other competitors in securing authorization to install, construct and operate new transmission lines and facilities. However, there can be no assurance that PJM, SPP, ERCOT or other RTOs will authorize new transmission projects or will award such projects to AEP. +Certain elements of AEP’s transmission formula rates have been challenged, which could result in lowered rates and/or refunds of amounts previously collected and thus have an adverse effect on AEP’s business, financial condition, results of operations and cash flows. (Applies to all Registrants other than AEP Texas) +AEP provides transmission service under rates regulated by the FERC. The FERC has approved the cost-based formula rate templates used by AEP to calculate its respective annual revenue requirements, but it has not expressly approved the amount of actual capital and operating expenditures to be used in the formula rates. All aspects of AEP’s rates accepted or approved by the FERC, including the formula rate templates, the rates of return on the actual equity portion of its respective capital structures and the approved targeted capital structures, are subject to challenge by interested parties at the FERC, or by the FERC on its own initiative. In addition, interested parties may challenge the annual +32 +implementation and calculation by AEP of its projected rates and formula rate true up pursuant to its approved formula rate templates under AEP’s formula rate implementation protocols. If a challenger can establish that any of these aspects are unjust, unreasonable, unduly discriminatory or preferential, then the FERC can make appropriate prospective adjustments to them and/or disallow any of AEP’s inclusion of those aspects in the rate setting formula. +AEP settled challenges to its SPP and PJM formula rates in proceedings at the FERC in 2019. However, inquiries related to rates of return, as well as challenges to the formula rates of other utilities, are ongoing in other proceedings at the FERC. The results of these proceedings could potentially negatively impact AEP in any future challenges to AEP’s formula rates. If the FERC orders revenue reductions, including refunds, in any future cases related to its formula rates, it could reduce future net income and cash flows and impact financial condition. +End-use consumers and entities supplying electricity to end-use consumers may also attempt to influence government and/or regulators to change the rate setting methodologies that apply to AEP, particularly if rates for delivered electricity increase substantially. +Changes in technology and regulatory policies may lower the value of electric utility facilities and franchises. (Applies to all Registrants) +AEP primarily generates electricity at large central facilities and delivers that electricity to customers over its transmission and distribution facilities to customers usually situated within an exclusive franchise. This method results in economies of scale and generally lower costs than newer technologies such as fuel cells and microturbines, and distributed generation using either new or existing technology. Other technologies, such as light emitting diodes (LEDs), increase the efficiency of electricity and, as a result, lower the demand for it. Changes in regulatory policies and advances in batteries or energy storage, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production and delivery. These developments can challenge AEP’s competitive ability to maintain relatively low cost, efficient and reliable operations, to establish fair regulatory mechanisms and to provide cost-effective programs and services to customers. Further, in the event that alternative generation resources are mandated, subsidized or encouraged through legislation or regulation or otherwise are economically competitive and added to the available generation supply, such resources could displace a higher marginal cost generating units, which could reduce the price at which market participants sell their electricity. +AEP may not recover costs incurred to begin construction on projects that are canceled. (Applies to all Registrants) +AEP’s business plan for the construction of new projects involves a number of risks, including construction delays, nonperformance by equipment and other third-party suppliers, and increases in equipment and labor costs. To limit the risks of these construction projects, AEP’s subsidiaries enter into equipment purchase orders and construction contracts and incur engineering and design service costs in advance of receiving necessary regulatory approvals and/or siting or environmental permits. If any of these projects are canceled for any reason, including failure to receive necessary regulatory approvals and/or siting or environmental permits, significant cancellation penalties under the equipment purchase orders and construction contracts could occur. In addition, if any construction work or investments have been recorded as an asset, an impairment may need to be recorded in the event the project is canceled. +AEP is exposed to nuclear generation risk. (Applies to AEP and I&M) +I&M owns the Cook Plant, which consists of two nuclear generating units for a rated capacity of 2,288 MWs, or about 7% of the generating capacity in the AEP System. AEP and I&M are, therefore, subject to the risks of nuclear generation, which include the following: +• +The potential harmful effects on the environment and human health due to an adverse incident/event resulting from the operation of nuclear facilities and the storage, handling and disposal of radioactive materials such as SNF. +33 +• +Limitations on the amounts and types of insurance commercially available to cover losses that might arise in connection with nuclear operations. +• +Uncertainties with respect to contingencies and assessment amounts triggered by a loss event (federal law requires owners of nuclear units to purchase the maximum available amount of nuclear liability insurance and potentially contribute to the coverage for losses of others). +• +Uncertainties with respect to the technological and financial aspects of decommissioning nuclear plants at the end of their licensed lives. +There can be no assurance that I&M’s preparations or risk mitigation measures will be adequate if these risks are triggered. +The NRC has broad authority under federal law to impose licensing and safety-related requirements for the operation of nuclear generation facilities. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. Revised safety requirements promulgated by the NRC could necessitate substantial capital expenditures at nuclear plants. In addition, although management has no reason to anticipate a serious nuclear incident at the Cook Plant, if an incident did occur, it could harm results of operations or financial condition. A major incident at a nuclear facility anywhere in the world could cause the NRC to limit or prohibit the operation or licensing of any domestic nuclear unit. Moreover, a major incident at any nuclear facility in the U.S. could require AEP or I&M to make material contributory payments. +Costs associated with the operation (including fuel), maintenance and retirement of nuclear plants continue to be more significant and less predictable than costs associated with other sources of generation, in large part due to changing regulatory requirements and safety standards, availability of nuclear waste disposal facilities and experience gained in the operation of nuclear facilities. Costs also may include replacement power, any unamortized investment at the end of the useful life of the Cook Plant (whether scheduled or premature), the carrying costs of that investment and retirement costs. The ability to obtain adequate and timely recovery of costs associated with the Cook Plant is not assured. +AEP subsidiaries are exposed to risks through participation in the market and transmission structures in various regional power markets that are beyond their control. (Applies to all Registrants) +Results are likely to be affected by differences in the market and transmission structures in various regional power markets. The rules governing the various RTOs, including SPP and PJM, may also change from time to time which could affect costs or revenues. Existing, new or changed rules of these RTOs could result in significant additional fees and increased costs to participate in those structures, including the cost of transmission facilities built by others due to changes in transmission rate design. In addition, these RTOs may assess costs resulting from improved transmission reliability, reduced transmission congestion and firm transmission rights. As members of these RTOs, AEP’s subsidiaries are subject to certain additional risks, including the allocation among existing members, of losses caused by unreimbursed defaults of other participants in these markets and resolution of complaint cases that may seek refunds of revenues previously earned by members of these markets. +AEP could be subject to higher costs and/or penalties related to mandatory reliability standards. (Applies to all Registrants) +Owners and operators of the bulk power transmission system are subject to mandatory reliability standards promulgated by the North American Electric Reliability Corporation and enforced by the FERC. The standards are based on the functions that need to be performed to ensure the bulk power system operates reliably and are guided by reliability and market interface principles. Compliance with new reliability standards may subject AEP to higher operating costs and/or increased capital expenditures. While management expects to recover costs and expenditures from customers through regulated rates, there can be no assurance that the applicable commissions will approve full recovery in a timely manner. If AEP were found not to be in compliance with the mandatory reliability standards, AEP could be subject to sanctions, including substantial monetary penalties, which likely would not be recoverable from customers through regulated rates. +34 +A substantial portion of the receivables of AEP Texas is concentrated in a small number of REPs, and any delay or default in payment could adversely affect its cash flows, financial condition and results of operations. (Applies to AEP and AEP Texas) +AEP Texas collects receivables from the distribution of electricity from REPs that supply the electricity it distributes to its customers. As of December 31, 2019 , AEP Texas did business with approximately 120 REPs. Adverse economic conditions, structural problems in the market served by ERCOT or financial difficulties of one or more REPs could impair the ability of these REPs to pay for these services or could cause them to delay such payments. AEP Texas depends on these REPs to remit payments on a timely basis. Applicable regulatory provisions require that customers be shifted to another REP or a provider of last resort if a REP cannot make timely payments. Applicable PUCT regulations significantly limit the extent to which AEP Texas can apply normal commercial terms or otherwise seek credit protection from firms desiring to provide retail electric service in its service territory, and AEP Texas thus remains at risk for payments related to services provided prior to the shift to another REP or the provider of last resort. In 2019 , AEP Texas’ first, second and third largest REPs accounted for 20%, 14% and 14%, respectively, of its operating revenue. Any delay or default in payment by REPs could adversely affect cash flows, financial condition and results of operations. If a REP were unable to meet its obligations, it could consider, among various options, restructuring under the bankruptcy laws, in which event such REP might seek to avoid honoring its obligations, and claims might be made by creditors involving payments AEP Texas had received from such REP. +RISKS RELATED TO MARKET, ECONOMIC OR FINANCIAL VOLATILITY AND OTHER RISKS +AEP’s financial performance may be adversely affected if AEP is unable to successfully operate facilities or perform certain corporate functions. (Applies to all Registrants) +Performance is highly dependent on the successful operation of generation, transmission and/or distribution facilities. Operating these facilities involves many risks, including: +• +Operator error and breakdown or failure of equipment or processes. +• +Operating limitations that may be imposed by environmental or other regulatory requirements. +• +Labor disputes. +• +Compliance with mandatory reliability standards, including mandatory cyber security standards. +• +Information technology failure that impairs AEP’s information technology infrastructure or disrupts normal business operations. +• +Information technology failure that affects AEP’s ability to access customer information or causes loss of confidential or proprietary data that materially and adversely affects AEP’s reputation or exposes AEP to legal claims. +• +Fuel or water supply interruptions caused by transportation constraints, adverse weather such as drought, non-performance by suppliers and other factors. +• +Catastrophic events such as fires, earthquakes, explosions, hurricanes, tornados, ice storms, terrorism (including cyber-terrorism), floods or other similar occurrences. +• +Fuel costs and related requirements triggered by financial stress in the coal industry. +Physical attacks or hostile cyber intrusions could severely impair operations, lead to the disclosure of confidential information and damage AEP’s reputation. (Applies to all Registrants) +AEP and its regulated utility businesses face physical security and cybersecurity risks as the owner-operators of generation, transmission and/or distribution facilities and as participants in commodities trading. AEP and its regulated utility businesses own assets deemed as critical infrastructure, the operation of which is dependent on information technology systems. Further, the computer systems that run these facilities are not completely isolated from external networks. Parties that wish to disrupt the U.S. bulk power system or AEP operations could view these computer systems, software or networks as targets for cyber attack. In addition, the electric utility business requires the collection of sensitive customer data, as well as confidential employee and shareholder information, which is subject to electronic theft or loss. +35 +A security breach of AEP or its regulated utility businesses’ physical assets or information systems, interconnected entities in RTOs, or regulators could impact the operation of the generation fleet and/or reliability of the transmission and distribution system or subject AEP and its regulated utility businesses to financial harm associated with theft or inappropriate release of certain types of information, including sensitive customer, vendor, employee, trading or other confidential data. A successful cyber attack on the systems that control generation, transmission, distribution or other assets could severely disrupt business operations, preventing service to customers or collection of revenues. The breach of certain business systems could affect the ability to correctly record, process and report financial information. A major cyber incident could result in significant expenses to investigate and repair security breaches or system damage and could lead to litigation, fines, other remedial action, heightened regulatory scrutiny and damage to AEP’s reputation. In addition, the misappropriation, corruption or loss of personally identifiable information and other confidential data could lead to significant breach notification expenses and mitigation expenses such as credit monitoring. For these reasons, a significant cyber incident could reduce future net income and cash flows and negatively impact financial condition. +If AEP is unable to access capital markets on reasonable terms, it could reduce future net income and cash flows and negatively impact financial condition. (Applies to all Registrants) +AEP relies on access to capital markets as a significant source of liquidity for capital requirements not satisfied by operating cash flows. Volatility, increased interest rates and reduced liquidity in the financial markets could affect AEP’s ability to raise capital on reasonable terms to fund capital needs, including construction costs and refinancing maturing indebtedness. Certain sources of debt and equity capital expressed increasing unwillingness to invest in companies, such as AEP, that rely on fossil fuels. If sources of capital for AEP are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could reduce future net income and cash flows and negatively impact financial condition. +Shareholder activism could cause AEP to incur significant expense, hinder execution of AEP’s business strategy and impact AEP’s stock price. (Applies to all Registrants) +Shareholder activism, which can take many forms and arise in a variety of situations, could result in substantial costs and divert management’s and AEP’s board’s attention and resources from AEP’s business. Additionally, such shareholder activism could give rise to perceived uncertainties as to AEP’s future, adversely affect AEP’s relationships with its employees, customers or service providers and make it more difficult to attract and retain qualified personnel. Also, AEP may be required to incur significant fees and other expenses related to activist shareholder matters, including for third-party advisors. AEP’s stock price could be subject to significant fluctuation or otherwise be adversely affected by the events, risks and uncertainties of any shareholder activism. +The potential phasing out of LIBOR after 2021 may adversely affect the costs and availability of financing. (Applies to all Registrants) +A portion of the Registrants’ indebtedness bears interest at fluctuating interest rates, primarily based on the London interbank offered rate (“LIBOR”) for deposits of U.S. dollars. LIBOR tends to fluctuate based on general interest rates, rates set by the U.S. Federal Reserve and other central banks, the supply of and demand for credit in the London interbank market and general economic conditions. Accordingly, Registrants’ interest expense for any particular period will fluctuate based on LIBOR and other variable interest rates. On July 27, 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, is considering replacing U.S. dollar LIBOR with the Secured Overnight Funding Rate, which is calculated based on repurchase agreements backed by treasury securities. It is not possible to predict the effect of these changes, other reforms or the establishment of alternative reference rates in the United Kingdom, the United States or elsewhere. To the extent these interest rates increase, interest expense will increase. If sources of capital for the Registrants are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could reduce future net income and cash flows and negatively impact financial condition and/or liquidity. +36 +Downgrades in AEP’s credit ratings could negatively affect its ability to access capital. (Applies to all Registrants) +The credit ratings agencies periodically review AEP’s capital structure and the quality and stability of earnings and cash flows. Any negative ratings actions could constrain the capital available to AEP and could limit access to funding for operations. Recently a credit rating agency placed AEP’s credit rating on negative outlook primarily because a key criterion, the ratio of cash flow from operations (excluding working capital) to debt, is expected to decline due to higher capital spending and lower cash flows resulting from changes in tax law. AEP’s business is capital intensive, and AEP is dependent upon the ability to access capital at rates and on terms management determines to be attractive. If AEP’s ability to access capital becomes significantly constrained, AEP’s interest costs will likely increase and could reduce future net income and cash flows and negatively impact financial condition. +AEP and AEPTCo have no income or cash flow apart from dividends paid or other payments due from their subsidiaries. (Applies to AEP and AEPTCo) +AEP and AEPTCo are holding companies and have no operations of their own. Their ability to meet their financial obligations associated with their indebtedness and to pay dividends is primarily dependent on the earnings and cash flows of their operating subsidiaries, primarily their regulated utilities, and the ability of their subsidiaries to pay dividends to, or repay loans from them. Their subsidiaries are separate and distinct legal entities that have no obligation (apart from loans from AEP or AEPTCo) to provide them with funds for their payment obligations, whether by dividends, distributions or other payments. Payments to AEP or AEPTCo by their subsidiaries are also contingent upon their earnings and business considerations. AEP and AEPTCo indebtedness and dividends are structurally subordinated to all subsidiary indebtedness. +AEP’s operating results may fluctuate on a seasonal or quarterly basis and with general economic and weather conditions. (Applies to all Registrants) +Electric power consumption is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter. As a result, overall operating results in the future may fluctuate substantially on a seasonal basis. In addition, AEP has historically sold less power, and consequently earned less income, when weather conditions are milder. Unusually mild weather in the future could reduce future net income and cash flows and negatively impact financial condition. In addition, unusually extreme weather conditions could impact AEP’s results of operations in a manner that would not likely be sustainable. +Further, deteriorating economic conditions triggered by any cause, including international tariffs, generally result in reduced consumption by customers, particularly industrial customers who may curtail operations or cease production entirely, while an expanding economic environment generally results in increased revenues. As a result, prevailing economic conditions may reduce future net income and cash flows and negatively impact financial condition. +Volatility in the securities markets, interest rates, and other factors could substantially increase defined benefit pension and other postretirement plan costs and the costs of nuclear decommissioning. (Applies to all Registrants and to AEP and I&M with respect to the costs of nuclear decommissioning) +The costs of providing pension and other postretirement benefit plans are dependent on a number of factors, such as the rates of return on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plan, changes in actuarial assumptions, future government regulation, changes in life expectancy, and the frequency and amount of AEP’s required or voluntary contributions made to the plans. Changes in actuarial assumptions and differences between the assumptions and actual values, as well as a significant decline in the value of investments that fund the pension and other postretirement plans, if not offset or mitigated by a decline in plan liabilities, could increase pension and other postretirement expense, and AEP could be required from time to time to fund the pension plan with significant amounts of cash. Such cash funding obligations could have a material impact on liquidity by reducing cash flows and could negatively affect results of operations. +37 +Additionally, I&M holds a significant amount of assets in its nuclear decommissioning trusts to satisfy obligations to decommission its nuclear plant. The rate of return on assets held in those trusts can significantly impact both the costs of decommissioning and the funding requirements for the trusts. +AEP’s results of operations and cash flows may be negatively affected by a lack of growth or slower growth in the number of customers, or decline in customer demand. (Applies to all Registrants) +Growth in customer accounts and growth of customer usage each directly influence demand for electricity and the need for additional power generation and delivery facilities. Customer growth and customer usage are affected by a number of factors outside the control of AEP, such as mandated energy efficiency measures, demand-side management goals, distributed generation resources and economic and demographic conditions, such as population changes, job and income growth, housing starts, new business formation and the overall level of economic activity. +Certain regulatory and legislative bodies have introduced or are considering requirements and/or incentives to further reduce energy consumption. Additionally, technological advances or other improvements in or applications of technology could lead to declines in per capita energy consumption. Some or all of these factors, could impact the demand for electricity. +Failure to attract and retain an appropriately qualified workforce could harm results of operations. (Applies to all Registrants) +Certain events, such as an aging workforce without appropriate replacements, mismatch of skillset or complement to future needs, or unavailability of contract resources may lead to operating challenges and increased costs. The challenges include lack of resources, loss of knowledge and a lengthy time period associated with skill development. In this case, costs, including costs for contractors to replace employees, productivity costs and safety costs, may rise. Failure to hire and adequately train replacement employees, including the transfer of significant internal historical knowledge and expertise to the new employees, or the future availability and cost of contract labor may adversely affect the ability to manage and operate the business. If AEP is unable to successfully attract and retain an appropriately qualified workforce, future net income and cash flows may be reduced. +Changes in the price of commodities, the cost of procuring fuel, emission allowances for criteria pollutants and the costs of transport may increase AEP’s cost of producing power, impacting financial performance. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +AEP is exposed to changes in the price and availability of fuel (including the cost to procure coal and gas) and the price and availability to transport fuel. AEP has existing contracts of varying durations for the supply of fuel, but as these contracts end or if they are not honored, AEP may not be able to purchase fuel on terms as favorable as the current contracts. The inability to procure fuel at costs that are economical could cause AEP to retire generating capacity prior to the end of its useful life, and while AEP typically recovers expenditures for undepreciated plant balances, there can be no assurance in the future that AEP will recover such costs. Similarly, AEP is exposed to changes in the price and availability of emission allowances. AEP uses emission allowances based on the amount of fuel used and reductions achieved through emission controls and other measures. Based on current environmental programs remaining in effect, AEP has sufficient emission allowances to cover the majority of the projected needs for the next two years and beyond. If the Federal EPA attempts to further reduce interstate transport, and it is acceptable by the courts, additional costs may be incurred either to acquire additional allowances or to achieve further reductions in emissions. If AEP needs to obtain allowances, those purchases may not be on as favorable terms as those under the current environmental programs. AEP’s risks relative to the price and availability to transport coal include the volatility of the price of diesel which is the primary fuel used in transporting coal by barge. +Prices for coal, natural gas and emission allowances have shown material swings in the past. Changes in the cost of fuel, emission allowances or natural gas and changes in the relationship between such costs and the market prices of power could reduce future net income and cash flows and negatively impact financial condition. +38 +In addition, actual power prices and fuel costs will differ from those assumed in financial projections used to value trading and marketing transactions, and those differences may be material. As a result, as those transactions are marked-to-market, they may impact future results of operations and cash flows and impact financial condition. +AEP is subject to physical and financial risks associated with climate change. (Applies to all Registrants) +Climate change creates physical and financial risk. Physical risks from climate change may include an increase in sea level and changes in weather conditions, such as changes in precipitation and extreme weather events, such as fires. Customers’ energy needs vary with weather conditions, primarily temperature and humidity. For residential customers, heating and cooling represent their largest energy use. To the extent weather conditions are affected by climate change, customers’ energy use could increase or decrease depending on the duration and magnitude of the changes. +Increased energy use due to weather changes may require AEP to invest in additional generating assets, transmission and other infrastructure to serve increased load. Decreased energy use due to weather changes may affect financial condition through decreased revenues. Extreme weather conditions in general require more system backup, adding to costs, and can contribute to increased system stress, including service interruptions. Weather conditions outside of the AEP service territory could also have an impact on revenues. AEP buys and sells electricity depending upon system needs and market opportunities. Extreme weather conditions creating high energy demand on AEP’s own and/or other systems may raise electricity prices as AEP buys short-term energy to serve AEP’s own system, which would increase the cost of energy AEP provides to customers. +Severe weather and weather-related events impact AEP’s service territories, primarily when thunderstorms, tornadoes, hurricanes, fires, floods and snow or ice storms occur. To the extent the frequency and intensity of extreme weather events and storms increase, AEP’s cost of providing service will increase, and these costs may not be recoverable. Changes in precipitation resulting in droughts, water shortages or floods could adversely affect operations, principally the fossil fuel generating units. A negative impact to water supplies due to long-term drought conditions or severe flooding could adversely impact AEP’s ability to provide electricity to customers, as well as increase the price they pay for energy. AEP may not recover all costs related to mitigating these physical and financial risks. +To the extent climate change impacts a region’s economic health, it may also impact revenues. AEP’s financial performance is tied to the health of the regional economies AEP serves. The price of energy, as a factor in a region’s cost of living as well as an important input into the cost of goods and services, has an impact on the economic health of the communities within the AEP System. +Management cannot predict the outcome of the legal proceedings relating to AEP’s business activities. (Applies to all Registrants) +AEP is involved in legal proceedings, claims and litigation arising out of its business operations, the most significant of which are summarized in Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report. Adverse outcomes in these proceedings could require significant expenditures that could reduce future net income and cash flows and negatively impact financial condition. +Disruptions at power generation facilities owned by third-parties could interrupt the sales of transmission and distribution services. (Applies to AEP and AEP Texas) +AEP Texas transmits and distributes electric power that the REPs obtain from power generation facilities owned by third-parties. If power generation is disrupted or if power generation capacity is inadequate, sales of transmission and distribution services may be diminished or interrupted, and results of operations, financial condition and cash flows could be adversely affected. +39 +Hazards associated with high-voltage electricity transmission may result in suspension of AEP’s operations or the imposition of civil or criminal penalties. (Applies to all Registrants) +AEP operations are subject to the usual hazards associated with high-voltage electricity transmission, including explosions, fires, inclement weather, natural disasters, mechanical failure, unscheduled downtime, equipment interruptions, remediation, chemical spills, discharges or releases of toxic or hazardous substances or gases and other environmental risks. The hazards can cause personal injury and loss of life, severe damage to or destruction of property and equipment and environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. AEP maintains property and casualty insurance, but AEP is not fully insured against all potential hazards incident to AEP’s business, such as damage to poles, towers and lines or losses caused by outages. +AEPTCo depends on its affiliates in the AEP System for a substantial portion of its revenues. (Applies to AEPTCo) +AEPTCo’s principal transmission service customers are its affiliates in the AEP System. Management expects that these affiliates will continue to be AEPTCo’s principal transmission service customers for the foreseeable future. For the year ended December 31, 2019 , its affiliates were responsible for approximately 79% of the consolidated transmission revenues of AEPTCo. +Most of the real property rights on which the assets of AEPTCo are situated result from affiliate license agreements and are dependent on the terms of the underlying easements and other rights of its affiliates. (Applies to AEPTCo) +AEPTCo does not hold title to the majority of real property on which its electric transmission assets are located. Instead, under the provisions of certain affiliate contracts, it is permitted to occupy and maintain its facilities upon real property held by the respective AEP System utility affiliate that overlay its operations. The ability of AEPTCo to continue to occupy such real property is dependent upon the terms of such affiliate contracts and upon the underlying real property rights of these utility affiliates, which may be encumbered by easements, mineral rights and other similar encumbrances that may affect the use of such real property. AEP can give no assurance that (a) the relevant AEP System utility affiliates will continue to be affiliates of AEPTCo, (b) suitable replacement arrangements can be obtained in the event that the relevant AEP System utility affiliates are not its affiliates and (c) the underlying easements and other rights are sufficient to permit AEPTCo to operate its assets in a manner free from interruption. +RISKS RELATED TO OWNING AND OPERATING GENERATION ASSETS AND SELLING POWER +Costs of compliance with existing environmental laws are significant. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +Operations are subject to extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality, waste management, natural resources and health and safety. A majority of the electricity generated by the AEP System is produced by the combustion of fossil fuels. Emissions of nitrogen and sulfur oxides, mercury and particulates and the discharge and disposal of solid waste (including coal-combustion residuals or “CCR”) resulting from fossil fueled generation plants are subject to increased regulations, controls and mitigation expenses. Compliance with these legal requirements requires AEP to commit significant capital toward environmental monitoring, installation of pollution control equipment, emission fees, disposal and permits at AEP facilities and could cause AEP to retire generating capacity prior to the end of its estimated useful life. Costs of compliance with environmental statutes and regulations could reduce future net income and negatively impact financial condition, especially if emission, CCR waste and/or discharge obligations are tightened, more extensive operating and/or permitting requirements are imposed or additional substances become regulated. Although AEP typically recovers expenditures for pollution control technologies, replacement generation, undepreciated plant balances and associated operating costs from customers, there can be no assurance in the future that AEP will recover the remaining costs associated with such plants. Failure to recover these costs could reduce future net income and cash flows and possibly harm financial condition. +40 +Regulation of CO 2 emissions could materially increase costs to AEP and its customers or cause some electric generating units to be uneconomical to operate or maintain. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +In 2014, the Federal EPA issued standards for new, modified and reconstructed units, and a guideline for the development of SIPs that would reduce carbon emissions from existing utility units. The standards and guidelines were finalized in 2015, and were challenged by several dozen states as well as industry groups and other stakeholders. The U.S. Supreme Court stayed the implementation of the guidelines for existing sources, known as the Clean Power Plan, while the courts considered those challenges. In 2017, the Federal EPA issued a proposal to repeal the Clean Power Plan, and in 2018, the Federal EPA proposed new guidelines that would allow states to establish unit-specific performance standards based on their evaluation of past performance and whether certain efficiency improvement measures could be applied at existing coal-fired units. The Federal EPA also proposed to change the new source performance standard for new coal-fired utility units to 1,900 - 2,000 pounds per MWh depending on the size of the unit, an increase from the current standard of 1,400 pounds per MWh, based on its determination that carbon capture and storage is not available everywhere and is not sufficiently cost-effective to be considered the best available control technology for coal-fired units. The new guidelines were finalized in 2019, and the Clean Power Plan was repealed. Challenges to both of these actions are pending in the U.S. Court of Appeals for the District of Columbia Circuit. +CO 2 standards could require significant increases in capital expenditures and operating costs and could impact the dates for retirement of AEP’s coal-fired units. While AEP typically recovers costs of complying with new requirements, such as the potential CO 2 and other greenhouse gases emission standards from customers, there can be no assurance that AEP would recover such costs. +Courts adjudicating nuisance and other similar claims in the future may order AEP to pay damages or to limit or reduce emissions. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +In the past, there have been several cases seeking damages based on allegations of federal and state common law nuisance in which AEP, among others, were defendants. In general, the actions allege that emissions from the defendants’ power plants constitute a public nuisance. The plaintiffs in these actions generally seek recovery of damages and other relief. If future actions are resolved against AEP, substantial modifications or retirement of AEP’s existing coal-fired power plants could be required, and AEP might be required to purchase power from third-parties to fulfill AEP’s commitments to supply power to AEP customers. This could have a material impact on revenues. In addition, AEP could be required to invest significantly in additional emission control equipment, accelerate the timing of capital expenditures, pay damages or penalties and/or halt operations. Unless recovered, those costs could reduce future net income and cash flows and harm financial condition. Moreover, results of operations and financial position could be reduced due to the timing of recovery of these investments and the expense of ongoing litigation. +Commodity trading and marketing activities are subject to inherent risks which can be reduced and controlled but not eliminated. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +AEP routinely has open trading positions in the market, within guidelines set by AEP, resulting from the management of AEP’s trading portfolio. To the extent open trading positions exist, fluctuating commodity prices can improve or diminish financial results and financial position. +AEP’s power trading activities also expose AEP to risks of commodity price movements. To the extent that AEP’s power trading does not hedge the price risk associated with the generation it owns, or controls, AEP would be exposed to the risk of rising and falling spot market prices. +In connection with these trading activities, AEP routinely enters into financial contracts, including futures and options, OTC options, financially-settled swaps and other derivative contracts. These activities expose AEP to risks from price movements. If the values of the financial contracts change in a manner AEP does not anticipate, it could harm financial position or reduce the financial contribution of trading operations. +41 +Parties with whom AEP has contracts may fail to perform their obligations, which could harm AEP’s results of operations. (Applies to all Registrants) +AEP sells power from its generation facilities into the spot market and other competitive power markets on a contractual basis. AEP also enters into contracts to purchase and sell electricity, natural gas, emission allowances and coal as part of its power marketing and energy trading operations. AEP is exposed to the risk that counterparties that owe AEP money or the delivery of a commodity, including power, could breach their obligations. Should the counterparties to these arrangements fail to perform, AEP may be forced to enter into alternative hedging arrangements or honor underlying commitments at then-current market prices that may exceed AEP’s contractual prices, which would cause financial results to be diminished and AEP might incur losses. Although estimates take into account the expected probability of default by a counterparty, actual exposure to a default by a counterparty may be greater than the estimates predict. +AEP relies on electric transmission facilities that AEP does not own or control. If these facilities do not provide AEP with adequate transmission capacity, AEP may not be able to deliver wholesale electric power to the purchasers of AEP’s power. (Applies to all Registrants) +AEP depends on transmission facilities owned and operated by other nonaffiliated power companies to deliver the power AEP sells at wholesale. This dependence exposes AEP to a variety of risks. If transmission is disrupted, or transmission capacity is inadequate, AEP may not be able to sell and deliver AEP wholesale power. If a region’s power transmission infrastructure is inadequate, AEP’s recovery of wholesale costs and profits may be limited. If restrictive transmission price regulation is imposed, the transmission companies may not have sufficient incentive to invest in expansion of transmission infrastructure. +The FERC has issued electric transmission initiatives that require electric transmission services to be offered unbundled from commodity sales. Although these initiatives are designed to encourage wholesale market transactions, access to transmission systems may not be available if transmission capacity is insufficient because of physical constraints or because it is contractually unavailable. Management also cannot predict whether transmission facilities will be expanded in specific markets to accommodate competitive access to those markets. +OVEC may require additional liquidity and other capital support. (Applies to AEP, APCo, I&M and OPCo) +AEP and several nonaffiliated utility companies own OVEC. The Inter-Company Power Agreement (ICPA) defines the rights and obligations and sets the power participation ratio of the parties to it. Under the ICPA, parties are entitled to receive and are obligated to pay for all OVEC capacity (approximately 2,400 MWs) in proportion to their respective power participation ratios. The aggregate power participation ratio of APCo, I&M and OPCo is 43.47%. If a party fails to make payments owed by it under the ICPA, OVEC may not have sufficient funds to honor its payment obligations, including its ongoing operating expenses as well as its indebtedness. As of December 31, 2019, OVEC has outstanding indebtedness of approximately $1.4 billion , of which APCo, I&M, and OPCo are collectively responsible for $589 million through the ICPA. Although they are not an obligor or guarantor, APCo, I&M, and OPCo are responsible for their respective ratio of OVEC’s outstanding debt through the ICPA. +FirstEnergy Solutions (“FES”), a nonaffiliated party, whose aggregate power participation ratio is 4.85% under the ICPA, has filed a petition seeking protection under bankruptcy law. Litigation related to these filings continues. In addition, as a result of these and prior related developments, OVEC’s credit ratings have been adversely impacted. +If OVEC does not have sufficient funds to honor its payment obligations, there is risk that APCo, I&M and/or OPCo may need to make payments in addition to their power participation ratio payments. Further, if OVEC’s indebtedness is accelerated for any reason, there is risk that APCo, I&M and/or OPCo may be required to pay some or all of such accelerated indebtedness in amounts equal to their aggregate power participation ratio of 43.47%. Also, as a result of the credit rating agencies’ actions, OVEC’s ability to access capital markets on terms as favorable as previously may diminish and its financing costs will increase. +42 +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +GENERATION FACILITIES +As of December 31, 2019 , the AEP System owned (or leased where indicated) generation plants, with locations and net maximum power capabilities (winter rating), are shown in the following tables: +Vertically Integrated Utilities Segment +AEGCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Rockport, Units 1 and 2 – 50% of each (a) +2 +IN +Steam - Coal +1,310 +1984 +(a) +Rockport Plant, Unit 2 is leased. +a +APCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Buck +3 +VA +Hydro +11 +1912 +Byllesby +4 +VA +Hydro +19 +1912 +Claytor +4 +VA +Hydro +75 +1939 +Leesville +2 +VA +Hydro +50 +1964 +London +3 +WV +Hydro +14 +1935 +Marmet +3 +WV +Hydro +14 +1935 +Niagara +2 +VA +Hydro +2 +1906 +Winfield +3 +WV +Hydro +15 +1938 +Ceredo +6 +WV +Natural Gas +516 +2001 +Dresden +3 +OH +Natural Gas +613 +2012 +Smith Mountain +5 +VA +Pumped Storage +585 +1965 +Amos +3 +WV +Steam - Coal +2,930 +1971 +Mountaineer +1 +WV +Steam - Coal +1,320 +1980 +Clinch River +2 +VA +Steam - Natural Gas +465 +1958 +Total MWs +6,629 +43 +I&M +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Berrien Springs +12 +MI +Hydro +6 +1908 +Buchanan +10 +MI +Hydro +3 +1919 +Constantine +4 +MI +Hydro +1 +1921 +Elkhart +3 +IN +Hydro +3 +1913 +Mottville +4 +MI +Hydro +2 +1923 +Twin Branch Hydro +8 +IN +Hydro +5 +1904 +Deer Creek Solar Farm +NA +IN +Solar +3 +2016 +Olive Solar Farm +NA +IN +Solar +5 +2016 +Twin Branch Solar Farm +NA +IN +Solar +3 +2016 +Watervliet +NA +MI +Solar +5 +2016 +Rockport (Units 1 and 2, 50% of each) (a) +2 +IN +Steam - Coal +1,310 +1984 +Cook +2 +MI +Steam - Nuclear +2,288 +1975 +Total MWs +3,634 +NA Not applicable. +(a) +Rockport Plant, Unit 2 is leased. +The following table provides operating information related to the Cook Plant: +Cook Plant +Unit 1 +Unit 2 +Year Placed in Operation +1975 +1978 +Year of Expiration of NRC License +2034 +2037 +Nominal Net Electrical Rating in MWs +1,084 +1,204 +Annual Capacity Utilization +2019 +77.3 +% +84.3 +% +2018 +97.9 +% +79.5 +% +2017 +76.5 +% +98.8 +% +KPCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Mitchell (a) +2 +WV +Steam - Coal +780 +1971 +Big Sandy +1 +KY +Steam - Natural Gas +280 +1963 +Total MWs +1,060 +(a) +KPCo owns a 50% interest in the Mitchell Plant units. WPCo owns the remaining 50%. Figures presented reflect only the portion owned by KPCo. +44 +PSO +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Comanche +3 +OK +Natural Gas +248 +1973 +Riverside, Units 3 and 4 +2 +OK +Natural Gas +160 +2008 +Southwestern, Units 4 and 5 +2 +OK +Natural Gas +170 +2008 +Weleetka (a) +2 +OK +Natural Gas +100 +1975 +Northeastern, Unit 1 +1 +OK +Natural Gas +470 +1961 +Northeastern, Unit 3 +1 +OK +Steam - Coal +469 +1979 +Oklaunion Power Station (b) (c) +1 +TX +Steam - Coal +105 +1986 +Northeastern, Unit 2 +1 +OK +Steam - Natural Gas +434 +1961 +Riverside, Units 1 and 2 +2 +OK +Steam - Natural Gas +901 +1974 +Southwestern, Units 1, 2 and 3 +3 +OK +Steam - Natural Gas +451 +1952 +Tulsa +2 +OK +Steam - Natural Gas +325 +1956 +Total MWs +3,833 +(a) +Weleetka Unit 6 was retired in March 2019. +(b) +Jointly-owned with AEP Texas and nonaffiliated entities. Figures presented reflect only the portion owned by PSO. +(c) +In September 2018, management announced plans to close the plant by October 2020. +SWEPCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Mattison +4 +AR +Natural Gas +315 +2007 +Stall +3 +LA +Natural Gas +534 +2010 +Flint Creek (a) +1 +AR +Steam - Coal +258 +1978 +Turk (a) +1 +AR +Steam - Coal +477 +2012 +Welsh +2 +TX +Steam - Coal +1,053 +1977 +Dolet Hills (a)(b) +1 +LA +Steam - Lignite +257 +1986 +Pirkey (a) +1 +TX +Steam - Lignite +580 +1985 +Arsenal Hill +1 +LA +Steam - Natural Gas +110 +1960 +Knox Lee (c)(d) +4 +TX +Steam - Natural Gas +404 +1950 +Lieberman (d) +3 +LA +Steam - Natural Gas +242 +1947 +Lone Star (d) +1 +TX +Steam - Natural Gas +50 +1954 +Wilkes +3 +TX +Steam - Natural Gas +889 +1964 +Total MWs +5,169 +(a) +Jointly-owned with nonaffiliated entities. Figures presented reflect only the portion owned by SWEPCo. The Arkansas jurisdictional portion of SWEPCo’s interest in Turk Plant is not in rate base. +(b) +In January 2020, management announced plans to close the plant at the end of 2026. +(c) +Knox Lee Unit 4 was retired in January 2019. Figures presented include Unit 4 in the total. +(d) +Knox Lee Unit 2 and Unit 3, Lieberman Unit 2 and Lone Star are scheduled for retirement in May 2020. +45 +WPCo +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Mitchell (a) +2 +WV +Steam - Coal +780 +1971 +(a) +17.5% of WPCo’s interest in the Mitchell Plant units was not in rate base during 2019. In 2020 WPCo’s entire interest in the Mitchell Plant will be in rate base. KPCo owns the remaining 50%. Figures presented reflect only the portion owned by WPCo. +Transmission and Distribution Segment +AEP Texas +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Oklaunion Power Station (a) (b) (c) +1 +TX +Steam - Coal +355 +1986 +(a) +Jointly-owned with PSO and nonaffiliated entities. Figures presented reflect only the portion owned by AEP Texas. +(b) +In September 2018, management announced plans to close the plant by October 2020. +(c) +The capacity and energy from the Oklaunion Power Station is sold to AEPEP under a PPA. +Generation & Marketing Segment +AGR +Plant Name +Units +State +Fuel Type +Net Maximum +Capacity (MWs) +Year Plant +or First Unit Commissioned +Racine +2 +OH +Hydro +48 +1982 +Cardinal +1 +OH +Steam - Coal +595 +1967 +Conesville (a) (b) +1 +OH +Steam - Coal +651 +1957 +Total MWs +1,294 +(a) +Jointly-owned with nonaffiliated entities. Figures presented reflect only the portion owned by AGR. +(b) +Conesville Plant Units 5 and 6 closed effective May 31, 2019 and Unit 4 is scheduled to close in May 2020. +Renewable Power +Size of Energy Resource +AEP Energy Supply, LLC Division +Renewable +Energy Resource +Location +In-Service or +Under Construction +1,212 MW +AEP Renewables +Wind +Eight states (a) +In-service +128 MW +AEP Renewables +Wind +Kansas +Under Construction +20 MW +AEP Renewables +Solar +California +In-service +20 MW +AEP Renewables +Solar +Utah +In-service +50 MW +AEP Renewables +Solar +Nevada +In-service +119 MW +AEP OnSite Partners +Solar +Fifteen states (b) +In-service +28 MW +AEP OnSite Partners +Solar +Three states (c) +Under Construction +(a) +Colorado, Hawaii, Indiana, Kansas, Michigan, Minnesota, Pennsylvania, and Texas. +(b) +California, Colorado, Florida, Hawaii, Iowa, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(c) +Illinois, New Mexico and Ohio. +46 +In addition to the AGR and Renewable Power generation set forth above, a subsidiary in the Generation & Marketing segment has contractual rights through 2027 from AEP Texas to 355 MWs from the Oklaunion Power Station. AEP Texas co-owns the Oklaunion Power Station with PSO and several nonaffiliated entities. Management has announced plans to close Oklaunion Power Station by October 2020. +TRANSMISSION AND DISTRIBUTION FACILITIES +The following tables set forth the total overhead circuit miles of transmission and distribution lines of the AEP System and its operating companies. +Vertically Integrated Utilities Segment +Total Overhead Circuit Miles of Transmission and Distribution Lines +APCo +51,665 +I&M +21,262 +KGPCo +1,404 +KPCo +11,138 +PSO +18,234 +SWEPCo +26,101 +WPCo +1,740 +Total Circuit Miles +131,544 +Transmission and Distribution Utilities Segment +Total Overhead Circuit Miles of Transmission and Distribution Lines +OPCo +44,944 +AEP Texas +45,911 +Total Circuit Miles +90,855 +AEP Transmission Holdco Segment +The following table sets forth the total overhead circuit miles of transmission lines of certain wholly-owned and joint venture-owned entities: +Total Overhead Circuit Miles of Transmission Lines +ETT +1,777 +IMTCo +575 +OHTCo +810 +OKTCo +835 +WVTCo +242 +Pioneer +43 +Prairie Wind Transmission +216 +Transource Missouri +167 +Transource West Virginia +24 +Total Circuit Miles +4,689 +47 +TITLE TO PROPERTY +The AEP System’s generating facilities are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the AEP System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of AEP’s public utility subsidiaries in the realty on which their facilities are located are considered adequate for use in the conduct of their business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties. AEP’s public utility subsidiaries generally have the right of eminent domain which permits them, if necessary, to acquire, perfect or secure titles to or easements on privately held lands used or to be used in their utility operations. Legislation in Ohio and Virginia has restricted the right of eminent domain previously granted for power generation purposes. +SYSTEM TRANSMISSION LINES AND FACILITY SITING +Laws in the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Tennessee, Texas, Virginia and West Virginia require prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. AEP has experienced delays and additional costs in constructing facilities as a result of proceedings conducted pursuant to such statutes and in proceedings in which AEP’s operating companies have sought to acquire rights-of-way through condemnation. These proceedings may result in additional delays and costs in future years. +CONSTRUCTION PROGRAM +With input from its state utility commissions, the AEP System continuously assesses the adequacy of its transmission, distribution, generation and other facilities to plan and provide for the reliable supply of electric power and energy to its customers. In this assessment process, assumptions are continually being reviewed as new information becomes available and assessments and plans are modified, as appropriate. AEP forecasts approximately $6.3 billion of construction expenditures for 2020 . Capital expenditures related to North Central Wind Energy Facilities are excluded from this budgeted amount. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends, weather and the ability to access capital. See the “Budgeted Capital Expenditures” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +POTENTIAL UNINSURED LOSSES +Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to AEP’s generation plants and costs of replacement power. Unless allowed to be recovered through rates, future losses or liabilities which are not completely insured could reduce net income and impact the financial conditions of AEP and other AEP System companies. For risks related to owning a nuclear generating unit, see the “Nuclear Contingencies” section of Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report for additional information. +ITEM 3. LEGAL PROCEEDINGS +For a discussion of material legal proceedings, see Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report for additional information. +48 +ITEM 4. MINE SAFETY DISCLOSURE +The Federal Mine Safety and Health Act of 1977 (Mine Act) imposes stringent health and safety standards on various mining operations. The Mine Act and its related regulations affect numerous aspects of mining operations, including training of mine personnel, mining procedures, equipment used in mine emergency procedures, mine plans and other matters. SWEPCo, through its ownership of Dolet Hills Lignite Company (DHLC), a wholly-owned lignite mining subsidiary of SWEPCo, is subject to the provisions of the Mine Act. +The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires companies that operate mines to include in their periodic reports filed with the SEC, certain mine safety information covered by the Mine Act. Exhibit 95 “Mine Safety Disclosure Exhibit” contains the notices of violation and proposed assessments received by DHLC under the Mine Act for the quarter ended December 31, 2019 . +PART II +ITEM 5. MARKET FOR REGISTRANTS’ COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +AEP +In addition to the discussion below, the remaining information required by this item is incorporated herein by reference to the material under AEP Common Stock Information and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Dividend Policy and Restrictions” included in the 2019 Annual Report. +AEP Texas, APCo, I&M, OPCo, PSO and SWEPCo +The common stock of these companies is held solely by AEP. For more information see the “Dividend Restrictions” section of Note 14 - Financing Activities included in the 2019 Annual Report. +AEPTCo +AEP owns the entire interest in AEPTCo through its wholly-owned subsidiary AEP Transmission Holdco. +During the quarter ended December 31, 2019 , neither AEP nor its publicly-traded subsidiaries purchased equity securities that are registered by AEP or its publicly-traded subsidiaries pursuant to Section 12 of the Exchange Act. +ITEM 6. SELECTED FINANCIAL DATA +AEP +The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the 2019 Annual Report. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(a). Management’s narrative analysis of the results of operations and other information required by Instruction I(2)(a) is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2019 Annual Report. +49 +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +AEP +The information required by this item is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2019 Annual Report. Year-to-year comparisons between 2018 and 2017 have been omitted from this Form 10-K but may be found in "Management's Discussion and Analysis of Financial Condition" in Part II, Item 7 of our Form 10-K for the fiscal year ended December 31, 2018, which specific discussion is incorporated herein by reference. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(a). Management’s narrative analysis of the results of operations and other information required by Instruction I(2)(a) is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2019 Annual Report. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +The information required by this item is incorporated herein by reference to the material under the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2019 Annual Report. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Refer to AEP's 2019 Annual Reports , which are incorporated herein by reference. Also refer to the Index of Financial Statement Schedules on page S-1 of this Form 10-K. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Information required by this item is set forth under the caption Proposal to Ratify the Appointment of the Independent Registered Public Accounting Firm in the 2020 Proxy Statement, which is incorporated by reference into this item. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +During 2019 , management, including the principal executive officer and principal financial officer of each of American Electric Power Company, Inc. (“AEP”), AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company (each a “Registrant” and collectively the “Registrants”) evaluated each respective Registrant’s disclosure controls and procedures. Disclosure controls and procedures are defined as controls and other procedures of the Registrant that are designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures +50 +include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act is accumulated and communicated to each Registrant’s management, including the principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. +As of December 31, 2019 , the principal executive officer and financial officer of each of the Registrants concluded that the disclosure controls and procedures in place were effective at the reasonable assurance level. The Registrants continually strive to improve their disclosure controls and procedures to enhance the quality of their financial reporting and to maintain dynamic systems that change as events warrant. +Changes in Internal Control over Financial Reporting +There have been no changes in the Registrants’ internal control over financial reporting (as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter 2019 that materially affected, or is reasonably likely to materially affect, the Registrants’ internal control over financial reporting. +Internal Control over Financial Reporting +See Management’s Report on Internal Control over Financial Reporting for each Registrant under Item 8. As discussed in that report, management assessed and reported on the effectiveness of each Registrant’s internal control over financial reporting as of December 31, 2019 . As a result of that assessment, management concluded that each Registrant’s internal control over financial reporting was effective as of December 31, 2019 . +ITEM 9B. OTHER INFORMATION +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +AEP +Directors, Director Nomination Process and Audit Committee +Certain of the information called for in this Item 10, including the information relating to directors, is incorporated herein by reference to AEP’s definitive proxy information statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2020 Annual Meeting of Shareholders (the 2020 Annual Meeting) including under the captions “Election of Directors,” “AEP’s Board of Directors and Committees,” “Directors” and “Nominees for Directors.” +Executive Officers +Reference also is made under the caption “Information About our Executive Officers” in Part I, Item 1 of this report. +Code of Ethics +AEP’s Principles of Business Conduct is the code of ethics that applies to AEP’s Chief Executive Officer, Chief Financial Officer and principal accounting officer. The Principles of Business Conduct is available on AEP’s website at www.aep.com. The Principles of Business Conduct will be made available, without charge, in print to any shareholder who requests such document from Investor Relations, American Electric Power Company, Inc., 1 Riverside Plaza, Columbus, Ohio 43215. +51 +If any substantive amendments to the Principles of Business Conduct are made or any waivers are granted, including any implicit waiver, from a provision of the Principles of Business Conduct, to its Chief Executive Officer, Chief Financial Officer or principal accounting officer, AEP will disclose the nature of such amendment or waiver on AEP’s website, www.aep.com, or in a report on Form 8-K. +Section 16(a) Beneficial Ownership Reporting Compliance +The information required by this item is incorporated herein by reference to information contained in the definitive proxy statement of AEP for the 2020 Annual Meeting. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 11. EXECUTIVE COMPENSATION +AEP +The information called for by this Item 11 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2020 Annual Meeting including under the captions “Compensation Discussion and Analysis,” “Executive Compensation”, “Director Compensation” and “ 2019 Director Compensation Table”. The information set forth under the subcaption “Human Resources Committee Report” and “Audit Committee Report” should not be deemed filed nor should it be incorporated by reference into any other filing under the Securities Act of 1933, as amended, or the Exchange Act except to the extent AEP specifically incorporates such report by reference therein. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +AEP +The information relating to Security Ownership of Certain Beneficial Owners is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to 2020 Annual Meeting under the caption “Share Ownership of Certain Beneficial Owners and Management” and “Share Ownership of Directors and Executive Officers.” +52 +EQUITY COMPENSATION PLAN INFORMATION +The following table summarizes the ability of AEP to issue common stock pursuant to equity compensation plans as of December 31, 2019 : +Plan Category +Number of Securities to be Issued upon Exercise of Outstanding Options Warrants and Rights (a) +Weighted Average Exercise Price of Outstanding Options, Warrants and Rights (b) +Number of Securities Remaining +Available for Future Issuance under Equity Compensation Plans +Equity Compensation Plans Approved by Security Holders +3,011,366 +— +7,667,922 +Equity Compensation Plans Not Approved by Security Holders +— +— +— +Total +3,011,366 +— +7,667,922 +(a) +The balance includes unvested 2019 performance shares and restricted stock units as well as vested performance shares deferred as AEP career shares, all of which will be settled and paid in shares of AEP common stock. For performance shares, the total includes the target number of shares that could be granted if performance meets target objectives. The number of securities that would be granted, with respect to performance shares, if performance meets the maximum payout level, is two times the amount included in this total. +(b) +No consideration is required from participants for the exercise or vesting of any outstanding AEP equity compensation awards. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +AEP +The information called for by this Item 13 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2020 Annual Meeting under the captions “Transactions with Related Persons” and “Director Independence.” +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +AEP +The information called for by this Item 14 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2020 Annual Meeting under the captions “Audit and Non-Audit Fees,” “Audit Committee Report” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of the Independent Auditor.” +53 +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Each of the above is a wholly-owned subsidiary of AEP and does not have a separate audit committee. A description of the AEP Audit Committee pre-approval policies, which apply to these companies, is contained in the definitive proxy statement of AEP for the 2020 Annual Meeting of shareholders. The following table presents directly billed fees for professional services rendered by PricewaterhouseCoopers LLP for the audit of these companies’ annual financial statements for the years ended December 31, 2019 and 2018, and fees directly billed for other services rendered by PricewaterhouseCoopers LLP during those periods. PricewaterhouseCoopers LLP also provides additional professional and other services to the AEP System, the cost of which may ultimately be allocated to these companies though not billed directly to them. For a description of these fees and services, see the description of principal accounting fees and services for AEP above. +AEP Texas +AEPTCo +APCo +2019 +2018 +2019 +2018 +2019 +2018 +Audit Fees +$ +1,383,288 +$ +1,129,561 +$ +1,282,508 +$ +1,193,523 +$ +1,684,045 +$ +1,721,299 +Audit-Related Fees +132,667 +76,000 +— +— +70,904 +42,571 +Tax Fees +27,092 +34,880 +31,009 +33,001 +39,326 +52,714 +All Other Fees +— +13,247 +— +12,534 +— +40,530 +Total +$ +1,543,047 +$ +1,253,688 +$ +1,313,517 +$ +1,239,058 +$ +1,794,275 +$ +1,857,114 +I&M +OPCo +PSO +2019 +2018 +2019 +2018 +2019 +2018 +Audit Fees +$ +1,336,192 +$ +1,510,574 +$ +1,056,377 +$ +1,093,392 +$ +575,734 +$ +603,527 +Audit-Related Fees +10,071 +10,071 +10,071 +48,071 +4,571 +4,571 +Tax Fees +35,073 +43,472 +26,384 +34,019 +15,093 +19,475 +All Other Fees +— +24,715 +— +12,920 +— +21,415 +Total +$ +1,381,336 +$ +1,588,832 +$ +1,092,832 +$ +1,188,402 +$ +595,398 +$ +648,988 +SWEPCo +2019 +2018 +Audit Fees +$ +973,150 +$ +1,150,091 +Audit-Related Fees +24,571 +24,571 +Tax Fees +23,263 +33,188 +All Other Fees +— +29,131 +Total +$ +1,020,984 +$ +1,236,981 +54 +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +The following documents are filed as a part of this report: +1. +FINANCIAL STATEMENTS: +The following financial statements have been incorporated herein by reference pursuant to Item 8. +AEP and Subsidiary Companies: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Changes in Equity for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Balance Sheets as of December 31, 2019 and 2018 ; Consolidated Statements of Cash Flows for the years ended December 31, 2019 , 2018 and 2017 ; Notes to Financial Statements of Registrants. +AEP Texas, APCo, I&M and OPCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Changes in Common Shareholder’s Equity for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Balance Sheets as of December 31, 2019 and 2018 ; Consolidated Statements of Cash Flows for the years ended December 31, 2019 , 2018 and 2017 ; Notes to Financial Statements of Registrants. +AEPTCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Changes in Member’s Equity for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Balance Sheets as of December 31, 2019 and 2018 ; Consolidated Statements of Cash Flows for the years ended December 31, 2019 , 2018 and 2017 ; Notes to Financial Statements of Registrants. +PSO: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Statements of Income for the years ended December 31, 2019 , 2018 and 2017 ; Statements of Comprehensive Income (Loss) for the years ended December 31, 2019 , 2018 and 2017 ; Statements of Changes in Common Shareholder’s Equity for the years ended December 31, 2019 , 2018 and 2017 ; Balance Sheets as of December 31, 2019 and 2018 ; Statements of Cash Flows for the years ended December 31, 2019 , 2018 and 2017 ; Notes to Financial Statements of Registrants. +SWEPCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Statements of Changes in Equity for the years ended December 31, 2019 , 2018 and 2017 ; Consolidated Balance Sheets as of December 31, 2019 and 2018 ; Consolidated Statements of Cash Flows for the years ended December 31, 2019 , 2018 and 2017 ; Notes to Financial Statements of Registrants. +55 +2. FINANCIAL STATEMENT SCHEDULES: +Page Number +Financial Statement Schedules are listed in the Index of Financial Statement Schedules. (Certain schedules have been omitted because the required information is contained in the notes to financial statements or because such schedules are not required or are not applicable). Reports of Independent Registered Public Accounting Firm. +S-1 +3. EXHIBITS: +Exhibits for AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. +E-1 +ITEM 16. FORM 10-K SUMMARY +None. +56 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +American Electric Power Company, Inc. +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Executive Vice President +and Chief Financial Officer) +Date: February 20, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, +Chief Executive Officer and Director +February 20, 2020 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Executive Vice President and Chief Financial Officer +February 20, 2020 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Senior Vice President, Controller and Chief Accounting Officer +February 20, 2020 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Directors: +*Nicholas K. Akins +*David J. Anderson +*J. Barnie Beasley, Jr. +*Ralph D. Crosby, Jr. +*Art A. Garcia +*Linda A. Goodspeed +*Thomas E. Hoaglin +*Sandra Beach Lin +*Margaret M. McCarthy +*Richard C. Notebaert +*Lionel L. Nowell, III +*Stephen S. Rasmussen +*Oliver G. Richard, III +*Sara Martinez Tucker +*By: +/s/ Brian X. Tierney +February 20, 2020 +(Brian X. Tierney, Attorney-in-Fact) +57 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +AEP Texas Inc. +Appalachian Power Company +Ohio Power Company +Public Service Company of Oklahoma +Southwestern Electric Power Company +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Vice President and Chief Financial Officer) +Date: February 20, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, Chief Executive Officer and Director +February 20, 2020 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Vice President, Chief Financial Officer and Director +February 20, 2020 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Controller and Chief Accounting Officer +February 20, 2020 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Directors: +*Nicholas K. Akins +*Lisa M. Barton +*Paul Chodak III +*David M. Feinberg +*Lana L. Hillebrand +*Mark C. McCullough +*Charles R. Patton +Brian X. Tierney +*By: +/s/ Brian X. Tierney +February 20, 2020 +(Brian X. Tierney, Attorney-in-Fact) +58 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +Indiana Michigan Power Company +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Vice President +and Chief Financial Officer) +Date: February 20, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, Chief Executive Officer and Director +February 20, 2020 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Vice President, Chief Financial Officer and Director +February 20, 2020 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Controller and Chief Accounting Officer +February 20, 2020 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Directors: +*Nicholas K. Akins +*Lisa M. Barton +*Nicholas M. Elkins +*Thomas A. Kratt +*Marc E. Lewis +*David A. Lucas +*Mark C. McCullough +*Carla E. Simpson +*Toby L. Thomas +Brian X. Tierney +*By: +/s/ Brian X. Tierney +February 20, 2020 +(Brian X. Tierney, Attorney-in-Fact) +59 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +AEP Transmission Company, LLC +By: +/s/ Brian X. Tierney +(Brian X. Tierney, Vice President, +Chief Financial Officer, and Manager) +Date: February 20, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature +Title +Date +(i) +Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, Chief Executive Officer and Manager +February 20, 2020 +(Nicholas K. Akins) +(ii) +Principal Financial Officer: +/s/ Brian X. Tierney +Vice President, Chief Financial Officer and Manager +February 20, 2020 +(Brian X. Tierney) +(iii) +Principal Accounting Officer: +/s/ Joseph M. Buonaiuto +Controller and Chief Accounting Officer +February 20, 2020 +(Joseph M. Buonaiuto) +(iv) +A Majority of the Managers: +*Nicholas K. Akins +*David M. Feinberg +*Mark C. McCullough +*A. Wade Smith +Brian X. Tierney +*By: +/s/ Brian X. Tierney +February 20, 2020 +(Brian X. Tierney, Attorney-in-Fact) +60 +INDEX OF FINANCIAL STATEMENT SCHEDULES +Page +Number +Reports of Independent Registered Public Accounting Firm +S-2 +The following financial statement schedules are included in this report on the pages indicated: +American Electric Power Company, Inc. (Parent): +Schedule I – Condensed Financial Information +S-3 +Schedule I – Index of Condensed Notes to Condensed Financial Information +S-7 +American Electric Power Company, Inc. and Subsidiary Companies: +Schedule II – Valuation and Qualifying Accounts and Reserves +S-10 +S-1 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON +FINANCIAL STATEMENT SCHEDULES +To the Board of Directors and Shareholders of +American Electric Power Company, Inc. +Our audits of the consolidated financial statements referred to in our report dated February 20, 2020 appearing in the 2019 Annual Report of American Electric Power Company, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the accompanying schedule of condensed financial information as of December 31, 2019 and 2018 and for each of the three years in the period ended December 31, 2019 and schedule of valuation and qualifying accounts and reserves for each of the three years in the period ended December 31, 2019. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 20, 2020 +S-2 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF INCOME +For the Years Ended December 31, 2019 , 2018 and 2017 +(in millions, except per-share and share amounts) +Years Ended December 31, +2019 +2018 +2017 +REVENUES +Affiliated Revenues +$ +11.0 +$ +9.5 +$ +9.1 +Other Revenues +0.8 +1.4 +5.9 +TOTAL REVENUES +11.8 +10.9 +15.0 +EXPENSES +Other Operation +53.2 +39.7 +35.9 +Asset Impairments and Other Related Charges +— +9.3 +— +Depreciation +0.2 +0.3 +0.3 +TOTAL EXPENSES +53.4 +49.3 +36.2 +OPERATING LOSS +(41.6 +) +(38.4 +) +(21.2 +) +Other Income (Expense): +Interest Income +53.5 +31.3 +20.5 +Interest Expense +(159.2 +) +(87.5 +) +(43.1 +) +LOSS BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS +(147.3 +) +(94.6 +) +(43.8 +) +Income Tax Expense (Benefit) +22.8 +(6.2 +) +0.1 +Equity Earnings of Unconsolidated Subsidiaries +2,091.2 +2,012.2 +1,956.5 +NET INCOME +1,921.1 +1,923.8 +1,912.6 +Other Comprehensive Income (Loss) +(27.3 +) +(23.7 +) +88.5 +TOTAL COMPREHENSIVE INCOME +$ +1,893.8 +$ +1,900.1 +$ +2,001.1 +WEIGHTED AVERAGE NUMBER OF BASIC AEP COMMON SHARES OUTSTANDING +493,694,345 +492,774,600 +491,814,651 +TOTAL BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS +$ +3.89 +$ +3.90 +$ +3.89 +WEIGHTED AVERAGE NUMBER OF DILUTED AEP COMMON SHARES OUTSTANDING +495,306,238 +493,758,277 +492,611,067 +TOTAL DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS +$ +3.88 +$ +3.90 +$ +3.88 +See Condensed Notes to Condensed Financial Information beginning on page S-7 . +S-3 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +ASSETS +December 31, 2019 and 2018 +(in millions) +December 31, +2019 +2018 +CURRENT ASSETS +Cash and Cash Equivalents +$ +156.1 +$ +99.3 +Other Temporary Investments +2.0 +2.3 +Advances to Affiliates +2,197.9 +1,096.4 +Accounts Receivable: +Affiliated Companies +11.3 +6.4 +General +0.3 +7.6 +Total Accounts Receivable +11.6 +14.0 +Affiliated Notes Receivable +20.0 +— +Accrued Tax Benefits +7.1 +— +Prepayments and Other Current Assets +9.9 +2.5 +TOTAL CURRENT ASSETS +2,404.6 +1,214.5 +PROPERTY, PLANT AND EQUIPMENT +General +2.3 +2.2 +Construction Work in Progress +0.2 +— +Total Property, Plant and Equipment +2.5 +2.2 +Accumulated Depreciation, Depletion and Amortization +1.4 +1.2 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET +1.1 +1.0 +OTHER NONCURRENT ASSETS +Investments in Unconsolidated Subsidiaries +23,329.9 +21,522.3 +Affiliated Notes Receivable +39.0 +50.0 +Deferred Charges and Other Noncurrent Assets +95.7 +114.1 +TOTAL OTHER NONCURRENT ASSETS +23,464.6 +21,686.4 +TOTAL ASSETS +$ +25,870.3 +$ +22,901.9 +See Condensed Notes to Condensed Financial Information beginning on page S-7 . +S-4 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2019 and 2018 +(dollars in millions) +December 31, +2019 +2018 +CURRENT LIABILITIES +Advances from Affiliates +$ +252.6 +$ +313.6 +Accounts Payable: +General +0.5 +5.9 +Affiliated Companies +8.4 +4.2 +Short-term Debt +2,110.0 +1,160.0 +Long-term Debt Due Within One Year – Nonaffiliated (a) +501.9 +(2.0 +) +Accrued Taxes +44.2 +13.2 +Other Current Liabilities +38.1 +16.5 +TOTAL CURRENT LIABILITIES +2,955.7 +1,511.4 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated (a) +3,122.9 +2,268.4 +Deferred Credits and Other Noncurrent Liabilities +116.6 +54.3 +TOTAL NONCURRENT LIABILITIES +3,239.5 +2,322.7 +TOTAL LIABILITIES +6,195.2 +3,834.1 +MEZZANINE EQUITY +Contingently Redeemable Performance Share Awards +42.9 +39.4 +COMMON SHAREHOLDERS’ EQUITY +Common Stock – Par Value – $6.50 Per Share: +2019 +2018 +Shares Authorized +600,000,000 +600,000,000 +Shares Issued +514,373,631 +513,450,036 +(20,204,160 Shares were Held in Treasury as of December 31, 2019 and 2018, Respectively) +3,343.4 +3,337.4 +Paid-in Capital +6,535.6 +6,486.1 +Retained Earnings +9,900.9 +9,325.3 +Accumulated Other Comprehensive Income (Loss) +(147.7 +) +(120.4 +) +TOTAL AEP COMMON SHAREHOLDERS’ EQUITY +19,632.2 +19,028.4 +TOTAL LIABILITIES, MEZZANINE EQUITY AND TOTAL EQUITY +$ +25,870.3 +$ +22,901.9 +(a) +Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 included in the 2019 Annual Reports for additional information. +See Condensed Notes to Condensed Financial Information beginning on page S-7 . +S-5 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2019 , 2018 and 2017 +(in millions) +Years Ended December 31, +2019 +2018 +2017 +OPERATING ACTIVITIES +Net Income +$ +1,921.1 +$ +1,923.8 +$ +1,912.6 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization +0.2 +0.3 +0.3 +Deferred Income Taxes +26.5 +(45.0 +) +33.7 +Asset Impairments and Other Related Charges +— +9.3 +— +Equity Earnings of Unconsolidated Subsidiaries +(2,091.2 +) +(2,012.2 +) +(1,956.5 +) +Cash Dividends Received from Unconsolidated Subsidiaries +426.2 +855.6 +827.0 +Change in Other Noncurrent Assets +0.1 +(5.5 +) +(0.4 +) +Change in Other Noncurrent Liabilities +84.5 +42.1 +74.0 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net +2.4 +(3.9 +) +51.5 +Accounts Payable +(1.2 +) +— +1.6 +Other Current Assets +(0.8 +) +47.8 +70.0 +Other Current Liabilities +36.4 +4.7 +0.7 +Net Cash Flows from Operating Activities +404.2 +817.0 +1,014.5 +INVESTING ACTIVITIES +Construction Expenditures +(0.3 +) +(0.4 +) +(0.7 +) +Change in Advances to Affiliates, Net +(1,101.5 +) +(106.9 +) +(76.4 +) +Capital Contributions to Unconsolidated Subsidiaries +(212.8 +) +(859.1 +) +(563.2 +) +Return of Capital Contributions from Unconsolidated Subsidiaries +70.9 +199.7 +263.3 +Issuance of Notes Receivable to Affiliated Companies +(9.0 +) +— +(30.0 +) +Net Cash Flows Used for Investing Activities +(1,252.7 +) +(766.7 +) +(407.0 +) +FINANCING ACTIVITIES +Issuance of Common Stock, Net +65.3 +73.6 +12.2 +Issuance of Long-term Debt +1,321.3 +991.9 +992.3 +Commercial Paper and Credit Facility Borrowings +— +205.6 +— +Change in Short-term Debt, Net +950.0 +261.4 +(141.4 +) +Retirement of Long-term Debt +— +— +(550.0 +) +Change in Advances from Affiliates, Net +(61.0 +) +(151.5 +) +266.7 +Commercial Paper and Credit Facility Repayments +— +(205.6 +) +— +Dividends Paid on Common Stock +(1,345.5 +) +(1,251.1 +) +(1,175.4 +) +Other Financing Activities +(24.8 +) +(7.4 +) +(5.1 +) +Net Cash Flows from (Used for) Financing Activities +905.3 +(83.1 +) +(600.7 +) +Net Increase (Decrease) in Cash and Cash Equivalents +56.8 +(32.8 +) +6.8 +Cash and Cash Equivalents at Beginning of Period +99.3 +132.1 +125.3 +Cash and Cash Equivalents at End of Period +$ +156.1 +$ +99.3 +$ +132.1 +See Condensed Notes to Condensed Financial Information beginning on page S-7 . +S-6 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +INDEX OF CONDENSED NOTES TO CONDENSED FINANCIAL INFORMATION +1. Summary of Significant Accounting Policies +2. Commitments, Guarantees and Contingencies +3. Financing Activities +4. Related Party Transactions +S-7 +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +The condensed financial information of Parent is required as a result of the restricted net assets of AEP consolidated subsidiaries exceeding 25% of AEP consolidated net assets as of December 31, 2019 . Parent is a public utility holding company that owns all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries, including joint ventures and equity investments. The primary source of income for Parent is equity in its subsidiaries’ earnings. Its major source of cash is dividends from the subsidiaries. Parent borrows the funds for the money pool that is used by the subsidiaries for their short-term cash needs. +Income Taxes +Parent files a consolidated federal income tax return with its subsidiaries. AEP System’s current consolidated federal income tax is allocated to AEP System companies so that their current tax expense reflects a separate return result for each company in the consolidated group. The tax benefit of Parent is allocated to its subsidiaries with taxable income. +2. COMMITMENTS, GUARANTEES AND CONTINGENCIES +Parent and its subsidiaries are parties to environmental and other legal matters. For further discussion, see Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report. +3. FINANCING ACTIVITIES +The following details long-term debt outstanding as of December 31, 2019 and 2018 : +Long-term Debt +Weighted-Average +Interest Rate Ranges as of +Outstanding as of +Interest Rate as of +December 31, +December 31, +Type of Debt +Maturity +December 31, 2019 +2019 +2018 +2019 +2018 +(in millions) +Senior Unsecured Notes +2020-2028 +3.30% +2.15%-4.30% +2.15%-4.30% +$ +2,301.5 +$ +2,266.4 +Pollution Control Bonds +2024-2029 +2.26% +1.90%-2.60% +535.5 +— +Junior Subordinate Notes +2022 +3.40% +3.40% +787.8 +— +Total Long-term Debt Outstanding +3,624.8 +2,266.4 +Long-term Debt Due Within One Year +501.9 +— +Long-term Debt +$ +3,122.9 +$ +2,266.4 +Long-term debt outstanding as of December 31, 2019 is payable as follows: +2020 +2021 +2022 +2023 +2024 +After 2024 +Total +(in millions) +Principal Amount (a) +$ +501.9 +$ +402.8 +$ +1,107.6 +$ +2.4 +$ +300.9 +$ +1,342.9 +$ +3,658.5 +Unamortized Discount, Net and Debt Issuance Costs +(33.7 +) +Total Long-term Debt Outstanding +$ +3,624.8 +(a) +Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 included in the 2019 Annual Report for additional information. +S-8 +Short-term Debt +Parent’s outstanding short-term debt was as follows: +December 31, 2019 +December 31, 2018 +Type of Debt +Outstanding +Amount +Weighted-Average +Interest Rate +Outstanding +Amount +Weighted-Average +Interest Rate +(in millions) +(in millions) +Commercial Paper +$ +2,110.0 +2.10 +% +$ +1,160.0 +2.96 +% +Total Short-term Debt +$ +2,110.0 +$ +1,160.0 +4. RELATED PARTY TRANSACTIONS +Payments on Behalf of Subsidiaries +Due to occasional time sensitivity and complexity of payments, Parent makes certain insurance, tax and benefit payments on behalf of subsidiary companies. Parent is then fully reimbursed by the subsidiary companies. +Short-term Lending to Subsidiaries +Parent uses a commercial paper program to meet the short-term borrowing needs of subsidiaries. The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds certain nonutility subsidiaries. In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons. The program also allows some direct borrowers to invest excess cash with Parent. +Interest expense related to Parent’s short-term borrowing is included in Interest Expense on Parent’s statements of income. Parent incurred interest expense for amounts borrowed from subsidiaries of $8 million, $11 million and $8 million for the years ended December 31, 2019 , 2018 and 2017 , respectively. +Interest income related to Parent’s short-term lending is included in Interest Income on Parent’s statements of income. Parent earned interest income for amounts advanced to subsidiaries of $49 million, $27 million and $16 million for the years ended December 31, 2019 , 2018 and 2017 , respectively. +Affiliated Notes +Parent issued long-term debt, portions of which were loaned to its subsidiaries. Parent pays interest on the affiliated notes, but the subsidiaries accrue interest for their share of the affiliated borrowing and remit the interest to Parent. Interest income related to Parent’s loans to subsidiaries is included in Interest Income on Parent’s statements of income. Parent earned interest income on loans to subsidiaries of $2 million, $2 million and $2 million for the years ended December 31, 2019 , 2018 and 2017 , respectively. +S-9 +SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS AND RESERVES +AEP +Additions +Description +Balance at +Beginning +of Period +Charged to +Costs and +Expenses +Charged to Other +Accounts (a) +Deductions (b) +Balance at +End of +Period +(in millions) +Deducted from Assets: +Accumulated Provision for Uncollectible Accounts: +Year Ended December 31, 2019 +$ +36.8 +$ +41.3 +$ +3.6 +$ +38.0 +$ +43.7 +Year Ended December 31, 2018 +38.5 +37.3 +2.6 +41.6 +36.8 +Year Ended December 31, 2017 +37.9 +34.0 +2.5 +35.9 +38.5 +(a) +Recoveries offset by reclasses to other assets and liabilities. +(b) +Uncollectible accounts written off. +Schedule II for the Registrant Subsidiaries is not presented because the amounts are not material. +S-10 +INDEX OF AEP TRANSMISSION COMPANY, LLC (AEPTCO PARENT) +FINANCIAL STATEMENT SCHEDULES +Page +Number +Report of Independent Registered Public Accounting Firm +S-12 +The following financial statement schedules are included in this report on the pages indicated: +AEP Transmission Company, LLC (AEPTCo Parent): +Schedule I – Condensed Financial Information +S-13 +Schedule I – Index of Condensed Notes to Condensed Financial Information +S-17 +S-11 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON +FINANCIAL STATEMENT SCHEDULE +To the Board of Directors and Member of +AEP Transmission Company, LLC +Our audits of the consolidated financial statements referred to in our report dated February 20, 2020 appearing in the 2019 Annual Report of AEP Transmission Company, LLC (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the accompanying schedule of condensed financial information as of December 31, 2019 and 2018 and for each of the three years in the period ended December 31, 2019. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 20, 2020 +S-12 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF INCOME +For the Years Ended December 31, 2019 , 2018 and 2017 +(in millions) +Years Ended December 31, +2019 +2018 +2017 +EXPENSES +Other Operation +$ +0.3 +$ +— +$ +— +TOTAL EXPENSES +0.3 +— +— +OPERATING LOSS +(0.3 +) +— +— +Other Income (Expense): +Interest Income - Affiliated +123.8 +104.6 +82.9 +Interest Expense +(122.1 +) +(103.4 +) +(82.4 +) +INCOME BEFORE INCOME TAX EXPENSE AND EQUITY EARNINGS OF UNCONSOLIDATED SUBSIDIARIES +1.4 +1.2 +0.5 +Income Tax Expense +0.3 +0.2 +0.2 +Equity Earnings of Unconsolidated Subsidiaries +438.6 +314.9 +270.4 +NET INCOME +$ +439.7 +$ +315.9 +$ +270.7 +See Condensed Notes to Condensed Financial Information beginning on page S-17 . +S-13 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +ASSETS +December 31, 2019 and 2018 +(in millions) +December 31, +2019 +2018 +CURRENT ASSETS +Advances to Affiliates +$ +68.7 +$ +17.0 +Accounts Receivable: +Affiliated Companies +23.1 +17.1 +Total Accounts Receivable +23.1 +17.1 +TOTAL CURRENT ASSETS +91.8 +34.1 +OTHER NONCURRENT ASSETS +Notes Receivable - Affiliated +3,427.3 +2,823.0 +Investments in Unconsolidated Subsidiaries +4,009.7 +3,571.1 +TOTAL OTHER NONCURRENT ASSETS +7,437.0 +6,394.1 +TOTAL ASSETS +$ +7,528.8 +$ +6,428.2 +See Condensed Notes to Condensed Financial Information beginning on page S-17 . +S-14 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2019 and 2018 +(in millions) +December 31, +2019 +2018 +CURRENT LIABILITIES +Accounts Payable: +General +$ +35.6 +$ +0.3 +Affiliated Companies +35.0 +17.7 +Long-term Debt Due Within One Year – Nonaffiliated +— +85.0 +Accrued Taxes +— +0.1 +Accrued Interest +19.2 +15.9 +Other Current Liabilities +2.2 +1.4 +TOTAL CURRENT LIABILITIES +92.0 +120.4 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated +3,427.3 +2,738.0 +TOTAL NONCURRENT LIABILITIES +3,427.3 +2,738.0 +TOTAL LIABILITIES +3,519.3 +2,858.4 +MEMBER’S EQUITY +Paid-in Capital +2,480.6 +2,480.6 +Retained Earnings +1,528.9 +1,089.2 +TOTAL MEMBER’S EQUITY +4,009.5 +3,569.8 +TOTAL LIABILITIES AND MEMBER’S EQUITY +$ +7,528.8 +$ +6,428.2 +See Condensed Notes to Condensed Financial Information beginning on page S-17 . +S-15 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2019 , 2018 and 2017 +(in millions) +Years Ended December 31, +2019 +2018 +2017 +OPERATING ACTIVITIES +Net Income +$ +439.7 +$ +315.9 +$ +270.7 +Adjustments to Reconcile Net Income to Net Cash Flows from (Used for) Operating Activities: +Deferred Income Taxes +— +— +1.6 +Equity Earnings of Unconsolidated Subsidiaries +(438.6 +) +(314.9 +) +(270.4 +) +Change in Other Noncurrent Liabilities +11.9 +— +— +Changes in Certain Components of Working Capital: +Accounts Receivable, Net +(6.0 +) +0.2 +4.5 +Accounts Payable +18.8 +(6.4 +) +5.4 +Accrued Taxes, Net +(0.1 +) +— +0.1 +Accrued Interest +3.3 +0.9 +4.5 +Other Current Liabilities +34.7 +(1.2 +) +(8.1 +) +Net Cash Flows from (Used for) Operating Activities +63.7 +(5.5 +) +8.3 +INVESTING ACTIVITIES +Change in Advances to Affiliates, Net +(51.7 +) +5.5 +(8.3 +) +Issuance of Notes Receivable to Affiliated Companies +(615.0 +) +(271.0 +) +(617.6 +) +Capital Contributions to Subsidiaries +— +(664.0 +) +(361.6 +) +Net Cash Flows Used for Investing Activities +(666.7 +) +(929.5 +) +(987.5 +) +FINANCING ACTIVITIES +Capital Contributions from Member +— +664.0 +361.6 +Issuance of Long-term Debt – Nonaffiliated +688.0 +321.0 +617.6 +Retirement of Long-term Debt – Nonaffiliated +(85.0 +) +(50.0 +) +— +Net Cash Flows from Financing Activities +603.0 +935.0 +979.2 +Net Change in Cash and Cash Equivalents +— +— +— +Cash and Cash Equivalents at Beginning of Period +— +— +— +Cash and Cash Equivalents at End of Period +$ +— +$ +— +$ +— +See Condensed Notes to Condensed Financial Information beginning on page S-17 . +S-16 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +INDEX OF CONDENSED NOTES TO CONDENSED FINANCIAL INFORMATION +1. Summary of Significant Accounting Policies +2. Commitments, Guarantees and Contingencies +3. Financing Activities +4. Related Party Transactions +S-17 +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +The condensed financial information of AEPTCo Parent is required as a result of the restricted net assets of AEPTCo consolidated subsidiaries exceeding 25% of AEPTCo consolidated net assets as of December 31, 2019 . AEPTCo Parent is the direct holding company for the seven State Transcos. The primary source of income for AEPTCo Parent is equity in its subsidiaries’ earnings. AEPTCo Parent financial statements should be read in conjunction with the AEPTCo consolidated financial statements and the accompanying notes thereto. For purposes of these condensed financial statements, AEPTCo wholly owned and majority owned subsidiaries are recorded based upon its proportionate share of the subsidiaries’ net assets (similar to presenting them on the equity method). +Income Taxes +AEPTCo Parent joins in the filing of a consolidated federal income tax return with its affiliates in the AEP System. The allocation of the AEP System’s current consolidated federal income tax to the AEP System companies allocates the benefit of current tax losses (“Parent Company Loss Benefit”) to the AEP System companies giving rise to such losses in determining their current tax expense. The consolidated net operating loss of the AEP System is allocated to each company in the consolidated group with taxable losses. The tax benefit of AEP Parent is allocated to its subsidiaries with taxable income. With the exception of the allocation of the consolidated AEP System net operating loss, the loss of the AEP Parent and tax credits, the method of allocation reflects a separate return result for each company in the consolidated group. +2. COMMITMENTS, GUARANTEES AND CONTINGENCIES +AEPTCo Parent and its subsidiaries are parties to legal matters. For further discussion, see Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report. +3. FINANCING ACTIVITIES +For discussion of Financing Activities, see Note 14 - Financing Activities to AEPTCo’s audited consolidated financial statements included in the 2019 Annual Report. +4. RELATED PARTY TRANSACTIONS +Payments on Behalf of Subsidiaries +Due to occasional time sensitivity and complexity of payments, Parent makes certain insurance, tax and other payments on behalf of subsidiary companies. Parent is then fully reimbursed by the subsidiary companies. AEPTCo Parent also makes convenience payments on behalf of its State Transcos. AEPTCo Parent is then fully reimbursed by its State Transcos. +Long-term Lending to Subsidiaries +AEPTCo Parent enters into debt arrangements with nonaffiliated entities. AEPTCo Parent has long-term debt of $3.4 billion and $2.8 billion as of December 31, 2019 and 2018 , respectively. AEPTCo Parent uses the proceeds from these nonaffiliated debt arrangements to make affiliated loans to its State Transcos using the same interest rates and maturity dates as the nonaffiliated debt arrangements. AEPTCo Parent has recorded Notes Receivable – Affiliated of $3.4 billion and $2.8 billion as of December 31, 2019 and 2018 , respectively. Related to these nonaffiliated and affiliated debt arrangements, AEPTCo Parent has recorded Accrued Interest of $19 million and $16 million as of December 31, 2019 and 2018 , respectively. AEPTCo Parent has also recorded Accounts Receivable – Affiliated Companies of $23 million and $17 million as of December 31, 2019 and 2018 , respectively. AEPTCo Parent has recorded Interest Income – Affiliated of $124 million, $105 million and $83 million for the years ended December 31, 2019 , 2018 and 2017 , respectively, related to the Notes Receivable – Affiliated. AEPTCo Parent has recorded Interest Expense of $122 million, $103 million and $82 million for the years ended December 31, 2019 , 2018 and 2017 , respectively, related to the nonaffiliated debt arrangements. +S-18 +Short-term Lending to Subsidiaries +Parent uses a commercial paper program to meet the short-term borrowing needs of subsidiaries. The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds certain nonutility subsidiaries. In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons. The program also allows some direct borrowers to invest excess cash with Parent. +Interest expense related to AEPTCo Parent’s short-term borrowing is included in Interest Expense on AEPTCo Parent’s statements of income. AEPTCo Parent incurred immaterial interest expense for amounts borrowed from AEP affiliates for the years ended December 31, 2019 , 2018 and 2017 . +Interest income related to AEPTCo Parent’s short-term lending is included in Interest Income – Affiliated on AEPTCo Parent’s statements of income. AEPTCo Parent earned interest income for amounts advanced to AEP affiliates of $2 million, $1 million and $1 million for the year ended December 31, 2019 , 2018 and 2017 , respectively. +S-19 +EXHIBIT INDEX +The documents listed below are being filed or have previously been filed on behalf of the Registrants shown and are incorporated herein by reference to the documents indicated and made a part hereof. Exhibits (“Ex”) not identified as previously filed are filed herewith. Exhibits designated with a dagger (†) are management contracts or compensatory plans or arrangements required to be filed as an Exhibit to this Form. Exhibits designated with an asterisk (*) are filed herewith. +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +AEP‡ File No. 1-3525 +3(a) +Composite of the Restated Certificate of Incorporation of AEP, dated April 26, 2019. +Form 10-Q, Ex 3, June 30, 2019 +3(b) +Composite By-Laws of AEP, as amended as of October 20, 2015. +Form 8-K, Ex 3(b) dated October 21, 2015 +4(a) +Indenture (for unsecured debt securities), dated as of May 1, 2001, between AEP and The Bank of New York, as Trustee. +Registration Statement No. 333-86050, Ex 4( a )( b )( c ) +Registration Statement No. 333-105532, Ex 4( d )( e )( f ) +Registration Statement No. 333-200956, Ex 4(b) +Registration Statement No. 333-222068, Ex 4(b) +4(a)1 +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated November 30, 2018 of 3.65% Senior Notes Series I due 2021 and 4.30% Senior Notes, Series J due 2028. +Form 8-K, Ex. 4(a) dated November 30, 2018 +4(a)3 +Purchase Contract and Pledge Agreement, dated as of March 19, 2019, between the Company and The Bank of New York Mellon Trust Company, N.A., as purchase contract agent, collateral agent, custodial agent and securities intermediary. +Form 8-K, Ex 4.1 dated March 19, 2019 +4(a)4 +Junior Subordinated Indenture, dated March 1, 2008, between the Company and The Bank of New York Mellon Trust Company, N.A., as Trustee for the Junior Subordinated Debentures. +Registration Statement No 333-156387, Ex 4( c ) +4(a)5 +Supplemental Indenture No. 1, dated March 19, 2019, from the Company to The Bank of New York Mellon Trust Company, N.A., as trustee. +Form 8-K, Ex 4.3 dated March 19, 2019 +4(b) +First Amendment to Fourth Amended and Restated Credit Agreement dated June 30, 2016 among AEP, +the banks, financial institutions and other institutional lenders listed on the signature pages thereof and Wells Fargo Bank, N.A., as Administrative Agent. +Form 10-Q, Ex 4, September 30, 2018 +*4(c) +Description of Securities. +10(a) +Lease Agreements, dated as of December 1, 1989, between AEGCo or I&M and Wilmington Trust Company, as amended. +Registration Statement No. 33-32752, Ex 28(c)(1-6)(C) +Registration Statement No. 33-32753, Ex 28(a)(1-6)(C) +AEGCo 1993 Form 10-K, Ex 10(c)(1-6)(B) +I&M 1993 Form 10-K, Ex 10(e)(1-6)(B) +10(b) +Consent Decree with U.S. District Court dated October 9, 2007, as modified July 17, 2019. +Form 8-K, Ex. 10 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +Form 10-Q, Ex 10, June 30, 2019 +†10(c) +AEP Retainer Deferral Plan for Non-Employee Directors, as Amended and Restated effective July 26, 2016. +2016 Form 10-K, Ex 10(h) +E-1 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +†10(d) +AEP Stock Unit Accumulation Plan for Non-Employee Directors as amended July 26, 2016. +2016 Form 10-K, Ex 10(i) +*†10(e) +AEP System Excess Benefit Plan, Amended and Restated as of January 1, 2020. +†10(e)(1) +Guaranty by AEP of AEPSC Excess Benefits Plan. +1990 Form 10-K, Ex 10(h)(1)(B) +†10(f) +AEP System Supplemental Retirement Savings Plan, Amended and Restated as of January 1, 2011 (Non-Qualified). +2010 Form 10-K, Ex 10 +†10(f)(1)(A) +Amendment to AEP System Supplemental Retirement Savings Plan, as Amended and Restated as of January 1, 2011 (Non-Qualified). +2014 Form 10-K, Ex 10(l)(1)(A) +*†10(f)(2)(A) +Second Amendment to AEP System Supplemental Retirement Savings Plan, as Amended and Restated as of January 1, 2011 (Non-Qualified). +†10(g) +AEPSC Umbrella Trust for Executives. +1993 Form 10-K, Ex 10(g)(3) +†10(g)(1)(A) +First Amendment to AEPSC Umbrella Trust for Executives. +2008 Form 10-K, Ex 10(l)(3)(A) +†10(g)(2)(A) +Second Amendment to AEPSC Umbrella Trust for Executives. +2018 Form 10-K, Ex 10(g)(2)(A) +†10(h) +AEP System Incentive Compensation Deferral Plan Amended and Restated as of June 1, 2019. +Form 10-Q, Ex 10(1), September 30, 2019 +†10(h)(1)(A) +First Amendment to AEP System Incentive Compensation Deferral Plan, as Amended and Restated effective January 1, 2008. +2011 Form 10-K, Ex 10(p)(1)(A) +†10(h)(2)(A) +Second Amendment to AEP System Incentive Compensation Deferral Plan, as Amended and Restated effective January 1, 2008. +2014 Form 10-K, Ex 10(q)(2)(A) +†10(i) +AEP Change In Control Agreement, as Revised Effective January 1, 2017. +Form 10-Q, Ex 10(c) , September 30, 2016 +†10(j) +Amended and Restated AEP System Long-Term Incentive Plan as of September 21, 2016. +Form 10-Q, Ex 10(a) , September 30, 2016 +†10(j)(1)(A) +Performance Share Award Agreement furnished to participants of the AEP System Long-Term Incentive Plan, as amended. +Form 10-Q, Ex 10(a), March 30, 2018 +†10(j)(2)(A) +Restricted Stock Unit Agreement furnished to participants of the AEP System Long-Term Incentive Plan as Amended and Restated. +Form 10-Q, Ex 10(b), March 30, 2018 +†10(k) +AEP System Stock Ownership Requirement Plan Amended and Restated effective June 20, 2017. +Form 10-Q, Ex 10, June 30, 2017 +*†10(l) +Central and South West System Special Executive Retirement Plan Amended and Restated effective January 1, 2020. +†10(m) +AEP Executive Severance Plan Amended and Restated effective October 24, 2016. +Form 10-Q, Ex 10(d) , September 30, 2016 +†10(n) +Letter Agreement dated November 20, 2012 between AEPSC and Lana Hillebrand. +2013 Form 10-K, Ex 10(x) +E-2 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +†10(o) +AEP Aircraft Timesharing Agreement dated October 1, 2019 between American Electric Power Service Corporation and Nicholas K. Akins. +Form 10-Q, Ex 10(2), September 30, 2019 +*13 +Copy of those portions of the AEP 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*21 +List of subsidiaries of AEP. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +AEP TEXAS‡ File No. 333-221643 +3(a) +Composite of the Restated Certificate of Incorporation, as amended. +Registration No. 333-221643, Ex 3(a) +3(b) +Bylaws. +Registration No. 333-221643, Ex 3(b) +4(a)(1) +Indenture, dated as of September 1, 2017, between AEP Texas Inc. and The Bank of New York Mellon Trust Company, N.A., as Trustee. +Registration No. 333-221643, Ex 4(a)-1 , 4(a)-2 ; Registration No. 333-228657, Ex 4(a)-4 , 4(a)-5 ; Registration No. 333-230613, Ex 4(a) (b) +4(a)(2) +Company Order and Officer’s Certificate to The Bank of New York Mellon Trust Company, N.A. December 5, 2019 of 3.45% Senior Notes, Series H due 2050. +Form 8-K Ex 4(a) dated December 6, 2019 +*13 +Copy of those portions of the AEP Texas 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +E-3 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +AEPTCo‡ File No. 333-217143 +3(a) +Limited Liability Company Agreement of AEP Transmission Company, LLC dated as of January 27, 2006. +Registration Statement No. 333-217143, Ex 3(a) +3(b) +First Amendment to Limited Liability Company Agreement dated as of May 21, 2013. +Registration Statement No. 333-217143, Ex 3(b) +4(a)(1) +Indenture, dated as of November 1, 2016, between AEP Transmission Company, LLC and The Bank of New York Mellon Trust Company, N.A., as Trustee. +Registration Statement No. 333-217143, Ex 4(a)-1 , 4(a)-2 +Registration Statement No. 333-225325, Ex 4 (b) (c) (d) +4(a)(2) +Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated September 7, 2018 establishing the terms of the 4.25% Senior Notes, Series J due 2048. +Form 8-K, Ex 4(a) dated September 7, 2018 +4(a)(3) +Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated June 12, 2019 establishing the terms of the 3.80% Senior Notes, Series K due 2049. +Form 8-K Ex 4(a) dated June 12, 2019 +4(a)(4) +Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated September 11, 2019 establishing the terms of the 3.15% Senior Notes, Series L due 2049. +Form 8-K Ex 4(a) dated September 9, 2019 +E-4 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(c)(1) +Note Purchase Agreement, dated as of October 18, 2012 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-1 +4(c)(2) +Supplement to Note Purchase Agreement, dated as of November 7, 2013 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-2 +4(c)(3) +Supplement to Note Purchase Agreement, dated as of November 14, 2014 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-3 +*13 +Copy of those portions of the AEPTCo 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +APCo‡ File No. 1-3457 +3(a) +Composite of the Restated Articles of Incorporation of APCo, amended as of March 7, 1997. +1996 Form 10-K, Ex 3(d) +3(b) +Composite By-Laws of APCo, amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +E-5 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(a) +Indenture (for unsecured debt securities), dated as of January 1, 1998, between APCo and The Bank of New York, As Trustee. +Registration Statement No. 333-45927, Ex 4(a)(b) +Registration Statement No. 333-49071, Ex 4(b) +Registration Statement No. 333-84061, Ex 4(b)(c) +Registration Statement No. 333-100451, Ex 4(b) +Registration Statement No. 333-116284, Ex 4( b )( c ) +Registration Statement No. 333-123348, Ex 4( b )( c ) +Registration Statement No. 333-136432, Ex 4( b )( c )( d ) +Registration Statement No. 333-161940, Ex 4( b )( c )( d ) +Registration Statement No. 333-182336, Ex 4( b )( c ) +Registration Statement No. 333-200750, Ex. 4( b )( c ) +Registration Statement No. 333-214448, Ex. 4(b) +4(a)(1) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated May 11, 2017 of 3.30% Senior Notes Series X due 2027. +Form 8-K, Ex 4(a) dated May 11, 2017 +4(a)(2) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated March 6, 2019 of 4.50% Senior Notes Series Y due 2049. +Form 8-K, Ex 4(a) dated March 6, 2019 +10(a) +Inter-Company Power Agreement, dated as of July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(d) +Consent Decree with U.S. District Court dated October 9, 2007, as modified July 17, 2019. +Form 8-K, Ex. 10 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +Form 10-Q, Ex 10, June 30, 2019 +*13 +Copy of those portions of the APCo 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +I&M‡ File No. 1-3570 +3(a) +Composite of the Amended Articles of Acceptance of I&M, dated of March 7, 1997. +1996 Form 10-K, Ex 3(c) +3(b) +Composite By-Laws of I&M, amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) +Indenture (for unsecured debt securities), dated as of October 1, 1998, between I&M and The Bank of New York, as Trustee. +Registration Statement No. 333-88523, Ex 4(a)(b)(c) +Registration Statement No. 333-58656, Ex 4( b )( c ) +Registration Statement No. 333-108975, Ex 4( b )( c )( d ) +Registration Statement No. 333-136538, Ex 4( b )( c ) +Registration Statement No. 333-156182, Ex 4(b) +Registration Statement No. 333-185087, Ex 4(b) +Registration Statement No. 333-207836, Ex 4(b) +Registration Statement No. 333-225103, Ex 4( b )( c )( d ) +4(b) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated August 8, 2018 of 4.25% Series N due 2048. +Form 8-K, Ex 4(a) dated August 8, 2018 +10(a) +Inter-Company Power Agreement, dated as of July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(b) +Unit Power Agreement dated as of March 31, 1982 between AEGCo and I&M, as amended. +Registration Statement No. 33-32752, Ex 28(b)(1)(A)(B) +10(c) +Consent Decree with U.S. District Court dated October 9, 2007, as modified July 17, 2019. +Form 8-K, Ex. 10 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +Form 10-Q, Ex 10, June 30, 2019 +10(d) +Lease Agreements, dated as of December 1, 1989, between I&M and Wilmington Trust Company, as amended. +Registration Statement No. 33-32753, Ex 28(a)(1-6)(C) +1993 Form 10-K, Ex 10(e)(1-6)(B) +*13 +Copy of those portions of the I&M 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +E-7 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +OPCo‡ File No.1-6543 +3(a) +Composite of the Amended Articles of Incorporation of OPCo, dated June 3, 2002. +Form 10-Q, Ex 3(e), June 30, 2002 +3(b) +Amended Code of Regulations of OPCo. +Form 10-Q, Ex 3(b), June 30, 2008 +4(a) +Indenture (for unsecured debt securities), dated as of September 1, 1997, between OPCo and Bankers Trust Company (now The Bank of New York Mellon Trust Company, N.A. as assignee of Deutsche Bank Trust Company Americas), as Trustee. +Registration Statement No. 333-49595, Ex 4(a)(b)(c) +Registration Statement No. 333-106242, Ex 4( b )( c )( d ) +Registration Statement No. 333-127913, Ex 4( b )( c ) +Registration Statement No. 333-139802, Ex 4( b )( c )( d ) +Registration Statement No. 333-161537, Ex 4( b )( c )( d ) +Registration Statement No. 333-211192, Ex 4(b) +Registration Statement No. 333-230094, Ex 4(b) +4a(1) +Resignation of Deutsche Bank Trust Company Americas, as Trustee and appointment of The Bank of New York Mellon Trust Company, N.A. as Trustee of Indenture with OPCo dated as of September 1, 1997. +Form 8-K, Item 8.01 dated October 8, 2018 +4(c) +Indenture (for unsecured debt securities), dated as of February 1, 2003, between OPCo and Bank One, N.A., as Trustee. +Registration Statement No. 333-127913, Ex 4( d )( e )( f ) +4(d) +Indenture (for unsecured debt securities), dated as of September 1, 1997, between CSPCo (predecessor in interest to OPCo) and Bankers Trust Company, as Trustee. +Registration Statement No. 333-54025, Ex 4(a)(b)(c)(d) +Registration Statement No. 333-128174, Ex 4( b )( c )( d ) +Registration Statement No. 333-150603, Ex 4(b) +4(e) +Indenture (for unsecured debt securities), dated as of February 1, 2003, between CSPCo (predecessor in interest to OPCo) and Bank One, N.A., as Trustee. +Registration Statement No. 333-128174, Ex 4( e )( f )( g ) +Registration Statement No. 333-150603, Ex 4(b) +4(f) +First Supplemental Indenture, dated as of December 31, 2011, by and between OPCo and The Bank of New York Mellon Trust Company, N.A., as trustee, supplementing the Indenture dated as of September 1, 1997 between CSPCo (predecessor in interest to OPCo) and the trustee. +Form 8-K, Ex 4.1 dated January 6, 2012 +4(g) +Third Supplemental Indenture, dated as of December 31, 2011, by and between OPCo and The Bank of New York Mellon Trust Company, N.A., as trustee, supplementing the Indenture dated as of February 14, 2003 between CSPCo (predecessor in interest to OPCo) and the trustee. +Form 8-K, Ex 4.2 dated January 6, 2012 +E-8 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(h) +Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated May 22, 2019 of 4.00% Series O due 2049. +Form 8-K, Ex 4(a) dated May 22, 2019 +10(a) +Inter-Company Power Agreement, dated July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(b) +Consent Decree with U.S. District Court dated October 9, 2007, as modified July 17, 2019. +Form 8-K, Ex. 10 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +Form 10-Q, Ex 10, June 30, 2019 +*13 +Copy of those portions of the OPCo 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +PSO‡ File No. 0-343 +3(a) +Certificate of Amendment to Restated Certificate of Incorporation of PSO. +Form 10-Q, Ex 3(a), June 30, 2008 +3(b) +Composite By-Laws of PSO amended as of February 26, 2008. +2007 Form 10-K, Ex 3 (b) +4(a) +Indenture (for unsecured debt securities), dated as of November 1, 2000, between PSO and The Bank of New York, as Trustee. +Registration Statement No. 333-100623, Ex 4( a )( b ) +Registration Statement No. 333-114665, Ex 4( b )( c ) +Registration Statement No. 333-133548, Ex 4( b )( c ) +Registration Statement No. 333-156319, Ex 4( b )( c ) +E-9 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(b) +Eighth Supplemental Indenture, dated as of November 13, 2009 between PSO and The Bank of New York Mellon, as Trustee, establishing terms of the 5.15% Senior Notes, Series H, due 2019. +Form 8-K, Ex 4(a), dated November 13, 2009 +4(c) +Ninth Supplemental Indenture, dated as of January 19, 2011 between PSO and The Bank of New York Mellon Trust Company, N.A., as Trustee, establishing terms of 4.40% Senior Notes, Series I, due 2021. +Form 8-K, Ex 4(a) dated January 20, 2011 +*13 +Copy of those portions of the PSO 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS +XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +SWEPCo‡ File No. 1-3146 +3(a) +Composite of Amended Restated Certificate of Incorporation of SWEPCo. +2008 Form 10-K, Ex 3(a) +3(b) +Composite By-Laws of SWEPCo amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) +Indenture (for unsecured debt securities), dated as of February 4, 2000, between SWEPCo and The Bank of New York, as Trustee. +Registration Statement No. 333-96213 +Registration Statement No. 333-87834, Ex 4( a )( b ) +Registration Statement No. 333-100632, Ex 4(b) +Registration Statement No. 333-108045, Ex 4(b) +Registration Statement No. 333-145669, Ex 4( c )( d ) +Registration Statement No. 333-161539, Ex 4( b )( c ) +Registration Statement No. 333-194991, Ex 4( b )( c ) +Registration Statement No. 333-208535, Ex 4( b )( c ) +Registration Statement No. 333-226856, Ex 4( b )( c ) +E-10 +Exhibit +Designation +Nature of Exhibit +Previously Filed as Exhibit to: +4(b) +Thirteenth Supplemental Indenture, dated as of September 1, 2018 between SWEPCo and The Bank of New York Mellon Trust Company, N.A., as Trustee, establishing terms of the 4.10% Senior Notes, Series M. Due 2028. +Form 8-K, Ex 4(a) dated September 13, 2018 +*13 +Copy of those portions of the SWEPCo 2019 Annual Report (for the fiscal year ended December 31, 2019) which are incorporated by reference in this filing. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*95 +Mine Safety Disclosure. +101.INS +XBRL Instance Document. The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document. +101.SCH +XBRL Taxonomy Extension Schema. +101.CAL +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +XBRL Taxonomy Extension Label Linkbase. +101.PRE +XBRL Taxonomy Extension Presentation Linkbase. +104 +Cover Page Interactive Data File. Formatted as inline XBRL and contained in Exhibit 101. +‡ Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. +The agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time. +E-11 \ No newline at end of file diff --git a/raw/filings/0000004904/2019/0000004904-20-000007/filing_metadata.csv b/raw/filings/0000004904/2019/0000004904-20-000007/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..5898039656ade39340bece0264a0fe85502010fa --- /dev/null +++ b/raw/filings/0000004904/2019/0000004904-20-000007/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004904,AEP,AMERICAN ELECTRIC POWER CO INC,2019,10-K,2020-02-20,2019-12-31,2020-02-20T13:52:40.000Z,0000004904-20-000007,aep10klegal20194q.htm,AMERICAN ELECTRIC POWER 2019 10-K,119632048,1,1,https://www.sec.gov/Archives/edgar/data/4904/000000490420000007/aep10klegal20194q.htm,https://www.sec.gov/Archives/edgar/data/4904/000000490420000007/ diff --git a/raw/filings/0000004904/2019/0000004904-20-000007/item1.txt b/raw/filings/0000004904/2019/0000004904-20-000007/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..28cea73846e06934890444bec93bbc38acc2354c --- /dev/null +++ b/raw/filings/0000004904/2019/0000004904-20-000007/item1.txt @@ -0,0 +1,989 @@ +ITEM 1. BUSINESS +GENERAL +Overview and Description of Major Subsidiaries +AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company that owns, directly or indirectly, all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries. +The service areas of AEP’s public utility subsidiaries cover portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Transmission networks are interconnected with extensive distribution facilities in the territories served. The public utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers. Restructuring laws in Michigan, Ohio and the ERCOT area of Texas have caused AEP public utility subsidiaries in those states to unbundle previously integrated regulated rates for their retail customers. +The member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity and transportation and handling of fuel. The companies of the AEP System also obtain certain accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost from a common provider, AEPSC. +As of December 31, 2019 , the subsidiaries of AEP had a total of 17,408 employees. Because it is a holding company rather than an operating company, AEP has no employees. The material subsidiaries of AEP are as follows: +AEP Texas +Organized in Delaware in 1925, AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,049,000 retail customers through REPs in west, central and southern Texas. As of December 31, 2019 , AEP Texas had 1,585 employees. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and primary metal manufacturing. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. AEP Texas is part of AEP’s Transmission and Distribution Utilities segment. +AEPTCo +Organized in Delaware in 2006, AEPTCo is a holding company for the State Transcos. The State Transcos develop and own new transmission assets that are physically connected to the AEP System. Individual State Transcos (a) have obtained the approvals necessary to operate in Indiana, Kentucky, Michigan, Ohio, Oklahoma and West Virginia, subject to any applicable siting requirements, (b) are authorized to submit projects for commission approval in Virginia and (c) have been granted consent to enter into a joint license agreement that will support investment in Tennessee. Neither AEPTCo nor its subsidiaries have any employees. Instead, AEPSC and certain AEP utility subsidiaries provide services to these entities. AEPTCo is part of the AEP Transmission Holdco segment. +1 +APCo +Organized in Virginia in 1926, APCo is engaged in the generation, transmission and distribution of electric power to approximately 956,000 retail customers in the southwestern portion of Virginia and southern West Virginia, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. APCo owns 6,629 MWs of generating capacity. APCo uses its generation to serve its retail and other customers. As of December 31, 2019 , APCo had 1,699 employees. Among the principal industries served by APCo are coal mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. APCo is a member of PJM. APCo is part of AEP’s Vertically Integrated Utilities segment. +I&M +Organized in Indiana in 1907, I&M is engaged in the generation, transmission and distribution of electric power to approximately 599,000 retail customers in northern and eastern Indiana and southwestern Michigan, and in supplying and marketing electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities and other market participants. I&M owns or leases 3,634 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2019 , I&M had 2,336 employees. Among the principal industries served are primary metals, transportation equipment, chemical manufacturing, plastics and rubber products and fabricated metal product manufacturing. I&M is a member of PJM. I&M is part of AEP’s Vertically Integrated Utilities segment. +KPCo +Organized in Kentucky in 1919, KPCo is engaged in the generation, transmission and distribution of electric power to approximately 165,000 retail customers in eastern Kentucky, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. KPCo owns 1,060 MWs of generating capacity. KPCo uses its generation to serve its retail and other customers. As of December 31, 2019 , KPCo had 500 employees. Among the principal industries served are petroleum and coal products manufacturing, chemical manufacturing, coal mining, oil and gas extraction and primary metals. KPCo is a member of PJM. KPCo is part of AEP’s Vertically Integrated Utilities segment. +KGPCo +Organized in Virginia in 1917, KGPCo provides electric service to approximately 48,000 retail customers in Kingsport and eight neighboring communities in northeastern Tennessee. KGPCo does not own any generating facilities and is a member of PJM. It purchases electric power from APCo for distribution to its customers. As of December 31, 2019 , KGPCo had 54 employees. KGPCo is part of AEP’s Vertically Integrated Utilities segment. +OPCo +Organized in Ohio in 1907 and reincorporated in 1924, OPCo is engaged in the transmission and distribution of electric power to approximately 1,494,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. As of December 31, 2019 , OPCo had 1,681 employees. Among the principal industries served by OPCo are primary metals, petroleum and coal products manufacturing, plastics and rubber products, chemical manufacturing, fabricated metal product manufacturing and data centers. OPCo is a member of PJM. OPCo is part of AEP’s Transmission and Distribution Utilities segment. +PSO +Organized in Oklahoma in 1913, PSO is engaged in the generation, transmission and distribution of electric power to approximately 559,000 retail customers in eastern and southwestern Oklahoma, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. PSO owns 3,833 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2019 , PSO had 1,097 employees. Among the principal industries served by PSO are paper manufacturing, oil and gas extraction, petroleum and coal products manufacturing, transportation equipment and pipeline transportation. PSO is a member of SPP. PSO is part of AEP’s Vertically Integrated Utilities segment. +2 +SWEPCo +Organized in Delaware in 1912, SWEPCo is engaged in the generation, transmission and distribution of electric power to approximately 540,000 retail customers in northeastern and panhandle of Texas, northwestern Louisiana and western Arkansas and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. SWEPCo owns 5,169 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2019 , SWEPCo had 1,469 employees. Among the principal industries served by SWEPCo are petroleum and coal products manufacturing, food manufacturing, paper manufacturing, oil and gas extraction and chemical manufacturing. The territory served by SWEPCo includes several military installations, colleges and universities. SWEPCo also owns and operates a lignite coal mining operation. SWEPCo is a member of SPP. SWEPCo is part of AEP’s Vertically Integrated Utilities segment. +WPCo +Organized in West Virginia in 1883 and reincorporated in 1911, WPCo provides electric service to approximately 42,000 retail customers in northern West Virginia and in supplying and marketing electric power at wholesale to other market participants. WPCo owns 780 MWs of generating capacity which it uses to serve its retail and other customers. Among the principal industries served by WPCo are coal mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. WPCo is a member of PJM. As of December 31, 2019 , WPCo had 50 employees. WPCo is part of AEP’s Vertically Integrated Utilities segment. +Service Company Subsidiary +AEPSC is a service company subsidiary that provides accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost to AEP subsidiaries. The executive officers of AEP and certain of the executive officers of its public utility subsidiaries are employees of AEPSC. As of December 31, 2019 , AEPSC had 6,439 employees. +Company Website and Availability of SEC Filings +Our principal corporate website address is www.aep.com. Information on our website is not incorporated by reference herein and is not part of this Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding AEP. +3 +Public Utility Subsidiaries by Jurisdiction +The following table illustrates certain regulatory information with respect to the jurisdictions in which the public utility subsidiaries of AEP operate: +Principal Jurisdiction +AEP Utility Subsidiaries Operating in that Jurisdiction +Authorized Return on Equity (a) +FERC +AEPTCo - PJM +10.35% +AEPTCo - SPP +10.50% +Ohio +OPCo +10.20% +(b) +West Virginia +APCo +9.75% +WPCo +9.75% +Virginia +APCo +9.42% +Indiana +I&M +9.95% +Michigan +I&M +9.86% +Texas +AEP Texas +9.96% +SWEPCo +9.60% +Tennessee +KGPCo +9.85% +Kentucky +KPCo +9.70% +Louisiana +SWEPCo +9.80% +Arkansas +SWEPCo +9.45% +Oklahoma +PSO +9.40% +(a) +Identifies the predominant authorized ROE and may not include other, less significant, permitted recovery. Actual ROE varies from authorized ROE. +(b) +Authorized ROE was approved in OPCo’s last distribution base case. The authorized ROE for riders with an approved equity return (e.g. Distribution Investment Rider) is 10.00%. See “Ohio Electric Security Plan Filings” section of Note 4 included in the 2019 Annual Report. +(a) +Pretax income does not include intercompany eliminations. +4 +CLASSES OF SERVICE +The principal classes of service from which AEP’s subsidiaries derive revenues and the amount of such revenues during the years ended December 31, 2019 , 2018 and 2017 are as follows: +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Vertically Integrated Utilities Segment +Retail Revenues +Residential Sales +$ +3,641.2 +$ +3,818.6 +$ +3,399.8 +Commercial Sales +2,151.1 +2,223.7 +2,124.4 +Industrial Sales +2,178.3 +2,261.3 +2,180.8 +PJM Net Charges +(0.2 +) +0.4 +(1.1 +) +Other Retail Sales +179.4 +186.8 +181.7 +Total Retail Revenues (a) +8,149.8 +8,490.8 +7,885.6 +Wholesale Revenues +Off-system Sales +814.5 +888.0 +907.4 +Transmission +200.7 +263.7 +202.2 +Total Wholesale Revenues +1,015.2 +1,151.7 +1,109.6 +Other Electric Revenues +93.8 +93.7 +106.1 +Provision for Rate Refund +(44.7 +) +(210.1 +) +(46.4 +) +Other Operating Revenues +31.6 +30.6 +40.2 +Sales to Affiliates +121.4 +88.8 +96.9 +Total Revenues Vertically Integrated Utilities Segment +$ +9,367.1 +$ +9,645.5 +$ +9,192.0 +Transmission and Distribution Utilities Segment +Retail Revenues +Residential Sales +$ +2,084.5 +$ +2,213.6 +$ +2,085.3 +Commercial Sales +1,148.8 +1,266.7 +1,205.8 +Industrial Sales +426.5 +517.2 +489.2 +Other Retail Sales +43.7 +43.1 +43.1 +Total Retail Revenues (a) +3,703.5 +4,040.6 +3,823.4 +Wholesale Revenues +Off-system Sales +93.0 +119.3 +100.5 +Transmission +437.7 +394.7 +359.6 +Total Wholesale Revenues +530.7 +514.0 +460.1 +Other Electric Revenues +58.6 +54.5 +48.4 +Provision for Rate Refund +12.5 +(69.2 +) +(11.4 +) +Other Operating Revenues +13.7 +12.4 +8.4 +Sales to Affiliates +163.5 +100.8 +90.4 +Total Revenues Transmission and Distribution Utilities Segment +$ +4,482.5 +$ +4,653.1 +$ +4,419.3 +AEP Transmission Holdco Segment +Transmission Revenues +$ +265.1 +$ +291.3 +$ +204.3 +Other Electric Revenues +0.3 +0.3 +— +Other Operating Revenues +0.1 +0.3 +0.8 +Sales to Affiliates +812.9 +555.5 +588.3 +Provision for Rate Refund +(5.2 +) +(43.3 +) +(26.7 +) +Total Revenues AEP Transmission Holdco Segment +$ +1,073.2 +$ +804.1 +$ +766.7 +Generation & Marketing Segment +Generation Revenues +Affiliated +$ +— +$ +— +$ +— +Nonaffiliated +264.4 +431.5 +528.5 +Renewable Generation +Affiliated +— +— +— +Nonaffiliated +77.7 +44.5 +33.4 +Retail, Trading and Marketing +Affiliated +135.7 +122.2 +103.7 +Nonaffiliated +1,379.8 +1,342.1 +1,209.5 +Total Revenues Generation & Marketing Segment +$ +1,857.6 +$ +1,940.3 +$ +1,875.1 +5 +AEP Texas +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +588.9 +$ +594.6 +$ +573.9 +Commercial Sales +424.0 +426.6 +431.0 +Industrial Sales +133.3 +131.0 +121.9 +Other Retail Sales +30.8 +30.1 +30.0 +Total Retail Revenues (a) +1,177.0 +1,182.3 +1,156.8 +Wholesale Revenues +Transmission +379.2 +313.4 +293.8 +Other Electric Revenues +24.4 +21.9 +20.8 +Provision for Rate Refund +(34.7 +) +(31.3 +) +(1.1 +) +Total Electric Transmission and Distribution Revenues +1,545.9 +1,486.3 +1,470.3 +Sales to Affiliates +160.5 +105.2 +65.7 +Other Revenues +2.9 +3.8 +2.4 +Total Revenues +$ +1,709.3 +$ +1,595.3 +$ +1,538.4 +AEPTCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Transmission Revenues +$ +217.2 +$ +212.8 +$ +167.9 +Other Electric Revenues +0.3 +0.3 +— +Other Operating Revenues +0.1 +0.2 +0.8 +Sales to Affiliates +806.7 +598.9 +580.5 +Provision for Rate Refund +(2.9 +) +(36.1 +) +(26.0 +) +Total Revenues +$ +1,021.4 +$ +776.1 +$ +723.2 +APCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +1,272.3 +$ +1,372.1 +$ +1,242.8 +Commercial Sales +562.2 +596.3 +584.2 +Industrial Sales +594.5 +620.7 +640.8 +PJM Net Charges +(0.2 +) +(0.2 +) +(0.4 +) +Other Retail Sales +75.6 +79.5 +78.0 +Total Retail Revenues (a) +2,504.4 +2,668.4 +2,545.4 +Wholesale Revenues +Off-system Sales +124.9 +116.4 +126.8 +Transmission +57.0 +56.3 +57.1 +Total Wholesale Revenues +181.9 +172.7 +183.9 +Other Electric Revenues +32.3 +31.1 +33.4 +Provision for Rate Refund +(10.4 +) +(95.1 +) +(13.7 +) +Total Electric Generation, Transmission and Distribution Revenues +2,708.2 +2,777.1 +2,749.0 +Sales to Affiliates +205.3 +181.4 +172.0 +Other Revenues +11.2 +9.0 +13.2 +Total Revenues +$ +2,924.7 +$ +2,967.5 +$ +2,934.2 +6 +I&M +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +730.9 +$ +736.5 +$ +620.9 +Commercial Sales +494.9 +489.3 +438.8 +Industrial Sales +551.4 +570.6 +522.0 +PJM Net Charges +0.1 +0.2 +(1.0 +) +Other Retail Sales +7.3 +7.2 +7.1 +Total Retail Revenues (a) +1,784.6 +1,803.8 +1,587.8 +Wholesale Revenues +Off-system Sales +406.4 +459.3 +431.2 +Transmission +19.3 +18.4 +17.2 +Total Wholesale Revenues +425.7 +477.7 +448.4 +Other Electric Revenues +14.4 +15.7 +13.5 +Provision for Rate Refund +(2.6 +) +(24.6 +) +(7.2 +) +Total Electric Generation, Transmission and Distribution Revenues +2,222.1 +2,272.6 +2,042.5 +Sales to Affiliates +73.9 +85.5 +64.4 +Other Revenues +10.7 +12.6 +14.3 +Total Revenues +$ +2,306.7 +$ +2,370.7 +$ +2,121.2 +OPCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +1,495.6 +$ +1,619.0 +$ +1,511.3 +Commercial Sales +724.9 +840.1 +774.8 +Industrial Sales +293.2 +386.2 +367.2 +Other Retail Sales +12.9 +13.0 +13.2 +Total Retail Revenues (a) +2,526.6 +2,858.3 +2,666.5 +Wholesale Revenues +Off-system Sales +93.0 +119.3 +100.5 +Transmission +58.5 +61.4 +65.8 +Total Wholesale Revenues +151.5 +180.7 +166.3 +Other Electric Revenues +34.2 +32.7 +31.0 +Provision for Rate Refund +47.2 +(37.9 +) +(10.3 +) +Total Electricity, Transmission and Distribution Revenues +2,759.5 +3,033.8 +2,853.5 +Sales to Affiliates +27.3 +21.0 +24.4 +Other Revenues +10.8 +8.6 +6.0 +Total Revenues +$ +2,797.6 +$ +3,063.4 +$ +2,883.9 +PSO +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +636.1 +$ +668.5 +$ +601.4 +Commercial Sales +377.3 +401.1 +387.7 +Industrial Sales +296.5 +308.5 +284.0 +Other Retail Sales +80.7 +84.5 +81.1 +Total Retail Revenues (a) +1,390.6 +1,462.6 +1,354.2 +Wholesale Revenues +Off-system Sales +39.5 +36.3 +13.9 +Transmission +31.9 +47.4 +42.3 +Total Wholesale Revenues +71.4 +83.7 +56.2 +Other Electric Revenues +9.6 +10.3 +8.5 +Provision for Rate Refund +(2.0 +) +(19.0 +) +(1.4 +) +Total Electric Generation, Transmission and Distribution Revenues +1,469.6 +1,537.6 +1,417.5 +Sales to Affiliates +6.1 +5.4 +4.3 +Other Revenues +6.1 +4.3 +5.4 +Total Revenues +$ +1,481.8 +$ +1,547.3 +$ +1,427.2 +7 +SWEPCo +Years Ended December 31, +Description +2019 +2018 +2017 +(in millions) +Retail Revenues +Residential Sales +$ +645.3 +$ +666.0 +$ +597.0 +Commercial Sales +490.6 +502.6 +487.0 +Industrial Sales +342.3 +346.2 +336.9 +Other Retail Sales +9.1 +8.9 +8.8 +Total Retail Revenues (a) +1,487.3 +1,523.7 +1,429.7 +Wholesale Revenues +Off-system Sales +194.7 +216.8 +251.3 +Transmission +72.6 +94.2 +71.7 +Total Wholesale Revenues +267.3 +311.0 +323.0 +Other Electric Revenues +20.6 +20.9 +20.4 +Provision for Rate Refund +(30.6 +) +(63.7 +) +(21.0 +) +Total Electric Generation, Transmission and Distribution Revenues +1,744.6 +1,791.9 +1,752.1 +Sales to Affiliates +4.9 +28.4 +25.9 +Other Revenues +1.4 +1.6 +1.9 +Total Revenues +$ +1,750.9 +$ +1,821.9 +$ +1,779.9 +(a) +2018 and 2017 amounts have been revised to reflect the reclassification of certain customer accounts between Retail classes. This reclassification did not impact previously reported Total Retail Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate. +FINANCING +General +Companies within the AEP System generally use short-term debt to finance working capital needs. Short-term debt may also be used to finance acquisitions, construction and redemption or repurchase of outstanding securities until such needs can be financed with long-term debt. In recent history, short-term funding needs have been provided for by cash on hand and AEP’s commercial paper program. Funds are made available to subsidiaries under the AEP corporate borrowing program. Certain public utility subsidiaries of AEP also sell accounts receivable to provide liquidity. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +AEP’s revolving credit agreement (which backstops the commercial paper program) includes covenants and events of default typical for this type of facility, including a maximum debt/capital test. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of its major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under the credit agreement. As of December 31, 2019 , AEP was in compliance with its debt covenants. With the exception of a voluntary bankruptcy or insolvency, any event of default has either or both a cure period or notice requirement before termination of the agreement. A voluntary bankruptcy or insolvency of AEP or one of its significant subsidiaries would be considered an immediate termination event. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +AEP’s subsidiaries have also utilized, and expect to continue to utilize, additional financing arrangements, such as securitization financings and leasing arrangements, including the leasing of coal transportation equipment and facilities. +8 +ENVIRONMENTAL AND OTHER MATTERS +General +AEP subsidiaries are currently subject to regulation by federal, state and local authorities with regard to air and water-quality control and other environmental matters, and are subject to zoning and other regulation by local authorities. The environmental issues that management believes are potentially material to the AEP System are outlined below. +Clean Water Act Requirements +Operations for AEP subsidiaries are subject to the Federal Clean Water Act, which prohibits the discharge of pollutants into waters of the United States except pursuant to appropriate permits and regulates systems that withdraw surface water for use in power plants. In 2014, the Federal EPA issued a final rule setting forth standards for water withdrawals at existing power plants that is intended to reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water. The standards affect all plants withdrawing more than two million gallons of cooling water per day. Compliance with this standard is required within eight years of the effective date of the final rule. +In November 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for electricity generating facilities. The rule establishes limits on Flue Gas Desulfurization wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed as soon as possible after November 2018 and no later than December 2023. In January 2020, the Federal EPA issued a final rule revising the scope of the “waters of the United States” subject to Clean Water Act regulation. See “Environmental Issues - Clean Water Act Regulations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Coal Ash Regulation +AEP’s operations produce a number of different coal combustion by-products, including fly ash, bottom ash, gypsum and other materials. A Federal EPA rule regulates the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units. The rule requires certain standards for location, groundwater monitoring and dam stability to be met at landfills and certain surface impoundments at operating facilities. If existing disposal facilities cannot meet these standards, they will be required to close. See “Environmental Issues - Coal Combustion Residual Rule” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control mobile and stationary sources of air emissions. The major CAA programs affecting AEP’s power plants are described below. The states implement and administer many of these programs and could impose additional or more stringent requirements. +The Acid Rain Program +The CAA includes a cap-and-trade emission reduction program for SO 2 emissions from power plants and requirements for power plants to reduce NO x emissions through the use of available combustion controls, collectively called the Acid Rain Program. AEP continues to meet its obligations under the Acid Rain Program through the installation of controls, use of alternate fuels and participation in the emissions allowance markets. +9 +National Ambient Air Quality Standards (NAAQS) +The CAA requires the Federal EPA to review the available scientific data for criteria pollutants periodically and establish a concentration level in the ambient air for those substances that is adequate to protect the public health and welfare with an extra safety margin. The Federal EPA also can list additional pollutants and develop concentration levels for them. These concentration levels are known as NAAQS. +Each state identifies the areas within its boundaries that meet the NAAQS (attainment areas) and those that do not (non-attainment areas). Each state must develop a SIP to bring non-attainment areas into compliance with the NAAQS and maintain good air quality in attainment areas. All SIPs are submitted to the Federal EPA for approval. If a state fails to develop adequate plans, the Federal EPA develops and implements a plan. As the Federal EPA reviews the NAAQS and establishes new concentration levels, the attainment status of areas can change and states may be required to develop new SIPs. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Hazardous Air Pollutants (HAP) +The CAA also requires the Federal EPA to investigate HAP emissions from the electric utility sector and submit a report to Congress to determine whether those emissions should be regulated. In 2011, the Federal EPA issued a rule setting Maximum Achievable Control Technology standards for new and existing coal and oil-fired utility units and New Source Performance Standards for emissions from new and modified power plants. In 2014, the U.S. Supreme Court determined that the Federal EPA acted unreasonably in refusing to consider costs in determining if it was appropriate and necessary to regulate HAP emissions from electric generating units. The Federal EPA has engaged in additional rulemaking activity but the 2011 rule remains in effect. See “Environmental Issues - Hazardous Air Pollutants” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Regional Haze +The CAA establishes visibility goals for certain federally designated areas, including national parks, and requires states to submit SIPs that will demonstrate reasonable progress toward preventing impairment of visibility in these protected areas. In 2005, the Federal EPA issued its Clean Air Visibility Rule, detailing how the CAA’s best available retrofit technology requirements will be applied to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants. +PSO executed a settlement with the Federal EPA and the State of Oklahoma to comply with Regional Haze program requirements in Oklahoma, and the settlement is now codified in the Oklahoma SIP and approved by the Federal EPA. The Federal EPA disapproved portions of the Arkansas and Texas SIPs, and finalized FIPs for both states. Arkansas submitted and received approval of a revised SIP, and EPA developed a revised FIP for Texas. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Climate Change +AEP has taken action to reduce and offset CO 2 emissions from its generating fleet and expects CO 2 emissions from its operations to continue to decline due to the retirement of some of its coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. In 2019, AEP announced revised intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, regulations, grid reliability and resiliency, and reflect the company’s current business strategy. The intermediate goal is a 70% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is an 80% or more reduction of CO 2 emissions from AEP generating facilities from 2000 levels by 2050. AEP’s total estimated CO 2 emissions in 2019 were approximately 58 million metric tons, a 65% reduction from AEP’s 2000 CO 2 emissions. +10 +The Federal EPA has taken action to regulate CO 2 emissions from new and existing fossil fueled electric generating units under the existing provisions of the CAA. The Clean Power Plan was adopted in October 2015 but the U.S. Supreme Court issued a stay of its implementation, including all of the deadlines for submission of initial or final state plans. The Federal EPA issued a proposal in 2017 to repeal the Clean Power Plan and finalized the repeal in 2019. In 2018 the Federal EPA issued a proposal to revise the standards for new and modified sources. In 2019, the Federal EPA finalized new guidelines for states to use to develop CO 2 performance standards for coal–fired generating units. See “Environmental Issues - Climate Change, CO 2 Regulation and Energy Policy” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report for additional information. +Management expects emissions to continue to decline over time as AEP diversifies generating sources and operates fewer coal units. The projected decline in coal-fired generation is due to a number of factors, including the ongoing cost of operating older units, the relative cost of coal and natural gas as fuel sources, increasing environmental regulations requiring significant capital investments and changing commodity market fundamentals. +Transforming AEP’s Generation Fleet +The electric utility industry is in the midst of an historic transformation, driven by changing customer needs, policy demands, demographics, competitive offerings, technologies and commodity prices. AEP is also transforming to be more agile and customer-focused as a valued provider of energy solutions. AEP’s long-term commitment to reduce CO 2 emissions reflects the current direction of the company’s resource plans to meet those needs. AEP’s exposure to carbon regulation has been greatly reduced over the last several years. From 2000 to 2019, AEP’s CO 2 emissions declined 65%. In 2019, coal represented 45% of AEP’s generating capacity, compared with 70% in 2005. Management expects the percentage of AEP’s generating resources fueled by coal will continue to decline. Transforming AEP’s generation portfolio to include, where there is regulatory support, more renewable energy and focusing on the efficient use of energy, demand response, distributed resources and technology solutions to more efficiently manage the grid over time is part of this strategy. +The graph below summarizes AEP’s generation capacity by resource type for the years 1999, 2005 and 2019: +(a) +Energy Efficiency/Demand Response represents avoided capacity rather than physical assets. +11 +Renewable Sources of Energy +The states AEP serves, other than Kentucky, West Virginia and Tennessee, have established mandatory or voluntary programs to increase the use of energy efficiency, alternative energy or renewable energy sources. +As of December 31, 2019 , AEP’s regulated utilities had long-term contracts for 2,750 MWs of wind, 80 MWs of hydro, and 10 MWs of solar power delivering renewable energy to the companies’ customers. In addition, I&M owns four solar projects that make up I&M’s 16 MW Clean Energy Solar Pilot Project. Management actively manages AEP’s compliance position and is on pace to meet the relevant requirements or benchmarks in each applicable jurisdiction. +In July 2019, PSO and SWEPCo submitted filings before their respective commissions for approval to acquire the North Central Wind Energy Facilities, comprised of three Oklahoma wind facilities totaling 1,485 MWs, on a fixed cost turn-key basis at completion. Subject to regulatory approval, PSO will own 45.5% and SWEPCo will own 54.5% of the project, which will cost approximately $2 billion. Two wind facilities, totaling 1,286 MWs, would qualify for 80% of the federal Production Tax Credits (PTCs) with year-end 2021 in-service dates. The third wind facility (199 MWs) would qualify for 100% of the PTCs with a year-end 2020 in-service date. The acquisition can be scaled, subject to commercial limitation, to align with individual state resource needs and approvals. In December 2019, PSO reached a joint stipulation and settlement agreement with the OCC, Oklahoma Attorney General’s office and customer groups. In January 2020, SWEPCo reached a joint settlement agreement with the APSC, Arkansas Attorney General’s office and Walmart, Inc. Hearings are scheduled for the first quarter of 2020. PSO and SWEPCo are seeking regulatory approvals by July 2020. +The growth of AEP’s renewable generation portfolio reflects the company’s strategy to diversify generation resources to provide clean energy options to customers that meet both their energy and capacity needs. In addition to gradually reducing AEP’s reliance on coal-fueled generating units, the growth of renewables and natural gas helps AEP to maintain a diversity of generation resources. +The integrated resource plans filed with state regulatory commissions by AEP’s regulated utility subsidiaries reflect AEP’s renewable strategy to balance reliability and cost with customers’ desire for clean energy in a carbon-constrained world. AEP has committed significant capital investments to modernize the electric grid and integrate these new resources. Transmission assets of the AEP System interconnect approximately 11,900 MWs of renewable energy resources. AEP’s transmission development initiatives are designed to facilitate the interconnection of additional renewable energy resources. +AEP Energy Supply, LLC is a holding company with several divisions, including AEP Renewables and AEP OnSite Partners. +AEP Renewables develops, owns and operates utility scale renewable projects backed with long-term contracts with creditworthy counterparties throughout the United States. AEP Renewables works directly with stakeholders to ensure that customers have clean, sustainable renewable energy to meet their environmental goals. As of December 31, 2019, AEP Renewables owned projects operating in 11 states, including approximately 1,212 MWs of installed wind capacity and 90 MWs of installed solar capacity. These figures include the 2019 addition of 724 MWs of wind generation and battery assets located in several states acquired from Sempra Renewables LLC and the 75% interest, or 227 MWs, of Santa Rita East wind generation located in west Texas. In October 2019, AEP Renewables entered into an agreement to construct Flat Ridge 3, a wind farm in Kansas. The 128 MW facility is expected to reach commercial operation before the end of 2020. +AEP OnSite Partners works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. AEP OnSite Partners targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2019, AEP OnSite Partners owned projects located in 17 states, including approximately 119 MWs of installed solar capacity, and approximately 28 MWs of solar projects under construction. +12 +Competitive Renewable Generation Facilities +Size of +Energy Resource +AEP Energy Supply, LLC Division +Renewable +Energy Resource +Location +In-Service or +Under Construction +1,212 MW +AEP Renewables +Wind +Eight states (a) +In-service +128 MW +AEP Renewables +Wind +Kansas +Under Construction +20 MW +AEP Renewables +Solar +California +In-service +20 MW +AEP Renewables +Solar +Utah +In-service +50 MW +AEP Renewables +Solar +Nevada +In-service +119 MW +AEP OnSite Partners +Solar +Fifteen states (b) +In-service +28 MW +AEP OnSite Partners +Solar +Three states (c) +Under Construction +(a) +Colorado, Hawaii, Indiana, Kansas, Michigan, Minnesota, Pennsylvania, and Texas. +(b) +California, Colorado, Florida, Hawaii, Iowa, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(c) +Illinois, New Mexico and Ohio. +End Use Energy Efficiency +AEP has reduced energy consumption and peak demand through the introduction of additional energy efficiency and demand response programs. These programs, commonly referred to as demand side management, were implemented in jurisdictions where appropriate cost recovery was available. AEP’s operating companies’ programs have reduced annual consumption by over 9 million MWhs and peak demand by approximately 2,806 MWs since 2008. AEP estimates that its operating companies spent approximately $1.5 billion during that period to achieve these levels. +Energy efficiency and demand reduction programs have received regulatory support in most of the states AEP serves. Appropriate cost recovery will be essential for AEP operating companies to continue and expand these consumer offerings. Appropriate recovery of program costs, lost revenues and an opportunity to earn a reasonable return ensures that energy efficiency programs are considered equally with supply side investments. As AEP continues to transition to a cleaner, more efficient energy future, energy efficiency and demand response programs will continue to play an important role in how the company serves its customers. AEP believes its experience providing robust energy efficiency programs in several states positions the company to be a cost-effective provider of these programs as states develop their implementation plans. +Corporate Governance +In response to environmental issues and in connection with its assessment of AEP’s strategic plan, the Board of Directors continually reviews the risks posed by new environmental rules and requirements that could accelerate the retirement of coal-fired generation assets. The Board of Directors is informed of any new environmental regulations and proposed regulation or legislation that would significantly affect AEP. The Board’s Committee on Directors and Corporate Governance oversees AEP’s annual Corporate Accountability Report, which includes information about AEP’s environmental, social, governance and financial performance. AEP set CO 2 emission reduction goals in 2018 after considering input from corporate governance outreach effort with shareholders. +In September 2019, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, grid reliability and resiliency, regulations and the company’s current business strategy. The intermediate goal is a 70% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is to surpass an 80% reduction of CO 2 emissions from AEP generating facilities from 2000 levels by 2050. AEP has made significant progress in reducing CO 2 emissions from its power generation fleet and expects its emissions to continue to decline. AEP’s aspirational emissions goal is zero CO 2 emissions by 2050. Technological advances, including energy storage, will determine how quickly AEP can achieve zero emissions while continuing to provide reliable, affordable power for customers. +13 +Other Environmental Issues and Matters +The Comprehensive Environmental Response, Compensation and Liability Act of 1980 imposes costs for environmental remediation upon owners and previous owners of sites, as well as transporters and generators of hazardous material disposed of at such sites. See “The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation” section of Note 6 included in the 2019 Annual Report for additional information. +Environmental Investments +Investments related to improving AEP System plants’ environmental performance and compliance with air and water quality standards during 2017 , 2018 and 2019 and the current estimate for 2020 are shown below. These investments include both environmental as well as other related spending. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends and the ability to access capital. In addition to the amounts set forth below, AEP expects to make substantial investments in future years in connection with the modification and addition at generation plants’ facilities for environmental quality controls. Such future investments are needed in order to comply with air and water quality standards that have been adopted and have deadlines for compliance after 2019 or have been proposed and may be adopted. Future investments could be significantly greater if emissions reduction requirements are accelerated or otherwise become more stringent. The cost of complying with applicable environmental laws, regulations and rules is expected to be material to the AEP System. AEP typically recovers costs of complying with environmental standards from customers through rates in regulated jurisdictions. Failure to recover these costs could reduce future net income and cash flows and possibly harm AEP’s financial condition. See “Environmental Issues” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 6 - Commitments, Guarantees and Contingencies included in the 2019 Annual Report for additional information. +Historical and Projected Environmental Investments +2017 +2018 +2019 +2020 +Actual +Actual +Actual +Estimate (b) +(in millions) +AEP (a) +$ +135.9 +$ +115.6 +$ +167.2 +$ +176.1 +APCo +25.6 +20.4 +23.8 +37.3 +I&M +41.9 +31.1 +56.4 +33.4 +PSO +0.6 +— +— +6.0 +SWEPCo +11.7 +14.1 +10.5 +40.1 +(a) +Includes expenditures of the subsidiaries shown and other subsidiaries not shown. The figures reflect construction expenditures, not investments in subsidiary companies. +(b) +Estimated amounts are exclusive of debt AFUDC. +14 +Management continues to refine the cost estimates of complying with air and water quality standards and other impacts of the environmental proposals. The following cost estimates for the years 2020 through 2026 will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules. These cost estimates will also change based on: (a) the states’ implementation of these regulatory programs, including the potential for SIPs or FIPs that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) the actual performance of the pollution control technologies installed on the units, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired, replaced or sold, including the type and amount of such replacement capacity and (g) other factors. Management’s current ranges of estimates of new major environmental investments beginning in 2020 , exclusive of debt AFUDC, are set forth below: +Projected (2020 - 2026) +Environmental Investment +Company +Low +High +(in millions) +AEP +$ +500 +$ +1,000 +APCo +125 +230 +I&M +45 +85 +PSO +20 +30 +SWEPCo +150 +305 +BUSINESS SEGMENTS +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. AEP’s reportable segments are as follows: +• +Vertically Integrated Utilities +• +Transmission and Distribution Utilities +• +AEP Transmission Holdco +• +Generation & Marketing +The remainder of AEP’s activities is presented as Corporate and Other, which is not considered a reportable segment. See Note 9 - Business Segments included in the 2019 Annual Report for additional information on AEP’s segments. +VERTICALLY INTEGRATED UTILITIES +GENERAL +AEP’s vertically integrated utility operations are engaged in the generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. AEPSC, as agent for AEP’s public utility subsidiaries, performs marketing, generation dispatch, fuel procurement and power-related risk management and trading activities on behalf of each of these subsidiaries. +ELECTRIC GENERATION +Facilities +As of December 31, 2019 , AEP’s vertically integrated public utility subsidiaries owned or leased approximately 22,000 MWs of domestic generation. See \ No newline at end of file diff --git a/raw/filings/0000004904/2019/0000004904-20-000007/item13.txt b/raw/filings/0000004904/2019/0000004904-20-000007/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..5ad98df2aff9460cb3a5505c7c8c917ddaaf1d56 --- /dev/null +++ b/raw/filings/0000004904/2019/0000004904-20-000007/item13.txt @@ -0,0 +1,5 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +AEP +The information called for by this Item 13 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2020 Annual Meeting under the captions “Transactions with Related Persons” and “Director Independence.” +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). \ No newline at end of file diff --git a/raw/filings/0000004904/2020/0000004904-21-000010/filing.txt b/raw/filings/0000004904/2020/0000004904-21-000010/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..7955bbb06de3e98d484a18f6428cfa842454c655 --- /dev/null +++ b/raw/filings/0000004904/2020/0000004904-21-000010/filing.txt @@ -0,0 +1,11980 @@ +aep-20201231 +0000004904 false 2020 FY --12-31 0001721781 0001702494 0000006879 0000050172 0000073986 0000081027 0000092487 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us-gaap:SubsequentEventMember aep:SouthwesternElectricPowerCoMember 2021-01-01 2021-02-25 0000004904 srt:MaximumMember us-gaap:SubsequentEventMember aep:SouthwesternElectricPowerCoMember 2021-01-01 2021-02-25 0000004904 us-gaap:SubsequentEventMember aep:PublicServiceCoOfOklahomaMember 2021-01-01 2021-02-25 0000004904 us-gaap:SubsequentEventMember aep:SouthwesternElectricPowerCoMember 2021-01-01 2021-02-25 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +WASHINGTON , D.C. 20549 +FORM 10-K +(Mark One) +☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2020 +or +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from __________ to_________ +Commission Registrants; I.R.S. Employer +File Number Address and Telephone Number States of Incorporation Identification Nos. +1-3525 AMERICAN ELECTRIC POWER CO INC. New York 13-4922640 +333-221643 AEP TEXAS INC. Delaware 51-0007707 +333-217143 AEP TRANSMISSION COMPANY, LLC Delaware 46-1125168 +1-3457 APPALACHIAN POWER COMPANY Virginia 54-0124790 +1-3570 INDIANA MICHIGAN POWER COMPANY Indiana 35-0410455 +1-6543 OHIO POWER COMPANY Ohio 31-4271000 +0-343 PUBLIC SERVICE COMPANY OF OKLAHOMA Oklahoma 73-0410895 +1-3146 SOUTHWESTERN ELECTRIC POWER COMPANY Delaware 72-0323455 +1 Riverside Plaza, Columbus, Ohio 43215-2373 +Telephone (614) 716-1000 +Securities registered pursuant to Section 12(b) of the Act: +Registrant Title of each class Trading Symbol Name of Each Exchange on Which Registered +American Electric Power Company Inc. Common Stock, $6.50 par value AEP The NASDAQ Stock Market LLC +American Electric Power Company Inc. 6.125% Corporate Units AEPPL The NASDAQ Stock Market LLC +American Electric Power Company Inc. 6.125% Corporate Units AEPPZ The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant American Electric Power Company, Inc., AEP Texas Inc., AEP Transmission Company, LLC, Ohio Power Company and Southwestern Electric Power Company, are well-known seasoned issuers, as defined in Rule 405 of the Securities Act. Yes x No ¨ +Indicate by check mark if the registrants Appalachian Power Company, Indiana Michigan Power Company and Public Service Company of Oklahoma, are well-known seasoned issuers, as defined in Rule 405 of the Securities Act. Yes ¨ No x +Indicate by check mark if the registrants are not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x +Indicate by check mark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark whether the registrants have submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨ +Indicate by check mark whether American Electric Power Company, Inc. is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated filer x Accelerated filer ☐ Non-accelerated filer ☐ +Smaller reporting company ☐ Emerging growth company ☐ +Indicate by check mark whether AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company are large accelerated filers, accelerated filers, non-accelerated filers, smaller reporting companies, or emerging growth companies. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large Accelerated filer ☐ Accelerated filer ☐ Non-accelerated filer x +Smaller reporting company ☐ Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrants have elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. +☐ +Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. +☒ +Indicate by check mark whether the registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No x +AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company meet the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and are therefore filing this Form 10-K with the reduced disclosure format specified in General Instruction I(2) to such Form 10-K. +Aggregate Market Value of Voting and Non-Voting Common Equity Held by Nonaffiliates of the Registrants as of June 30, 2020 the Last Trading Date of the Registrants' Most Recently Completed Second Fiscal Quarter Number of Shares of Common Stock Outstanding of the Registrants as of December 31, 2020 +American Electric Power Company, Inc. $ 39,549,558,010 496,604,194 +($6.50 par value) +AEP Texas Inc. None 100 +($0.01 par value) +AEP Transmission Company, LLC (a) None NA +Appalachian Power Company None 13,499,500 +(no par value) +Indiana Michigan Power Company None 1,400,000 +(no par value) +Ohio Power Company None 27,952,473 +(no par value) +Public Service Company of Oklahoma None 9,013,000 +($15 par value) +Southwestern Electric Power Company None 3,680 +($18 par value) +(a) 100% interest is held by AEP Transmission Holdco. +NA Not applicable. +Note on Market Value of Common Equity Held by Nonaffiliates +American Electric Power Company, Inc. owns all of the common stock of AEP Texas Inc., Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company and, indirectly, all of the LLC membership interest in AEP Transmission Company, LLC (see Item 12 herein). +Documents Incorporated By Reference +Description Part of Form 10-K into which Document is Incorporated +Portions of Annual Reports of the following companies for the fiscal year ended December 31, 2020: +Part II +American Electric Power Company, Inc. +AEP Texas Inc. +AEP Transmission Company, LLC +Appalachian Power Company +Indiana Michigan Power Company +Ohio Power Company +Public Service Company of Oklahoma +Southwestern Electric Power Company +Portions of Proxy Statement of American Electric Power Company, Inc. for 2021 Annual Meeting of Shareholders. +Part III +This combined Form 10-K is separately filed by American Electric Power Company, Inc., AEP Texas Inc., AEP Transmission Company, LLC, Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company. Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. Except for American Electric Power Company, Inc., each registrant makes no representation as to information relating to the other registrants. +You can access financial and other information at AEP’s website, including AEP’s Principles of Business Conduct, certain committee charters and Principles of Corporate Governance. The address is www.AEP.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC website at www.sec.gov. +TABLE OF CONTENTS +Item +Number Page +Number +Glossary of Terms +i +Forward-Looking Information +vi +PART I +1 Business +General +1 +Business Segments +17 +Vertically Integrated Utilities +17 +Transmission and Distribution Utilities +24 +AEP Transmission Holdco +26 +Generation & Marketing +29 +Executive Officers of AEP +32 +1A Risk Factors +34 +1B Unresolved Staff Comments +46 +2 Properties +46 +Generation Facilities +46 +Transmission and Distribution Facilities +50 +Title to Property +51 +System Transmission Lines and Facility Siting +51 +Construction Program +51 +Potential Uninsured Losses +52 +3 Legal Proceedings +52 +4 Mine Safety Disclosure +52 +PART II +5 +Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +53 +6 Reserved +54 +7 +Management’s Discussion and Analysis of Financial Condition and Results of Operations +54 +7A Quantitative and Qualitative Disclosures about Market Risk +54 +8 Financial Statements and Supplementary Data +54 +9 +Changes i n and Disagreements with Accountants on Accounting and Financial Disclosure +420 +9A +Controls and Procedures +420 +9B +Other Information +420 +PART III +10 +Directors, Executive Officers and Corporate Governance +421 +11 +Executive Compensation +421 +12 +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +422 +13 +Certain Relationships and Related Transactions and Director Independence +422 +14 Principal Accounting Fees and Services +423 +PART IV +15 Exhibits and Financial Statement Schedules +Financial Statements +424 +Form 10-K Summary +425 +Signatures +426 +Index of Financial Statement Schedules +S- 1 +Report of Independent Registered Public Accounting Firm +S- 2 +Exhibit Index +E- 1 +GLOSSARY OF TERMS +When the following terms and abbreviations appear in the text of this report, they have the meanings indicated below. +Term Meaning +AEGCo AEP Generating Company, an AEP electric utility subsidiary. +AEP +American Electric Power Company, Inc., an investor-owned electric public utility holding company which includes American Electric Power Company, Inc. (Parent) and majority-owned consolidated subsidiaries and consolidated affiliates. +AEP Credit +AEP Credit, Inc., a consolidated VIE of AEP which securitizes accounts receivable and accrued utility revenues for affiliated electric utility companies. +AEP East Companies APCo, I&M, KGPCo, KPCo, OPCo and WPCo. +AEP Energy +AEP Energy, Inc., a wholly-owned retail electric supplier for customers in Ohio, Illinois and other deregulated electricity markets throughout the United States. +AEP Energy Supply, LLC +A nonregulated holding company for AEP’s competitive generation, wholesale and retail businesses, and a wholly-owned subsidiary of AEP. +AEP OnSite Partners +A division of AEP Energy Supply, LLC that builds, owns, operates and maintains customer solutions utilizing existing and emerging distributed technologies. +AEP Renewables +A division of AEP Energy Supply, LLC that develops and/or acquires large scale renewable projects that are backed with long-term contracts with creditworthy counter parties. +AEP System +American Electric Power System, an electric system, owned and operated by AEP subsidiaries. +AEP Texas +AEP Texas Inc., an AEP electric utility subsidiary. +AEP Transmission Holdco +AEP Transmission Holding Company, LLC, a wholly-owned subsidiary of AEP. +AEP Utilities +AEP Utilities, Inc., a former subsidiary of AEP and holding company for TCC, TNC and CSW Energy, Inc. Effective December 31, 2016, TCC and TNC were merged into AEP Utilities, Inc. Subsequently following this merger, the assets and liabilities of CSW Energy, Inc. were transferred to a competitive affiliate company and AEP Utilities, Inc. was renamed AEP Texas Inc. +AEP Wind Holdings LLC +Acquired in April 2019 as Sempra Renewables LLC, develops, owns and operates, or holds interests in, wind generation facilities in the United States. +AEPEP +AEP Energy Partners, Inc., a subsidiary of AEP dedicated to wholesale marketing and trading, hedging activities, asset management and commercial and industrial sales in deregulated markets. +AEPRO +AEP River Operations, LLC, a commercial barge operation sold in November 2015. +AEPSC +American Electric Power Service Corporation, an AEP service subsidiary providing management and professional services to AEP and its subsidiaries. +AEPTCo +AEP Transmission Company, LLC, a wholly-owned subsidiary of AEP Transmission Holdco, is an intermediate holding company that owns the State Transcos. +AEPTCo Parent +AEP Transmission Company, LLC, the holding company of the State Transcos within the AEPTCo consolidation. +AEPTHCo +AEP Transmission Holding Company, LLC, a subsidiary of AEP, an intermediate holding company that owns transmission operations joint ventures and AEPTCo. +AFUDC Allowance for Equity Funds Used During Construction. +AGR +AEP Generation Resources Inc., a competitive AEP subsidiary in the Generation & Marketing segment. +ALJ Administrative Law Judge. +AMI Advanced Metering Infrastructure. +AMT Alternative Minimum Tax. +AOCI Accumulated Other Comprehensive Income. +APCo Appalachian Power Company, an AEP electric utility subsidiary. +i +Term Meaning +Appalachian Consumer Rate Relief Funding +Appalachian Consumer Rate Relief Funding LLC, a wholly-owned subsidiary of APCo and a consolidated VIE formed for the purpose of issuing and servicing securitization bonds related to the under-recovered ENEC deferral balance. +APTCo +AEP Appalachian Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +APSC Arkansas Public Service Commission. +ARAM +Average Rate Assumption Method, an IRS approved method used to calculate the reversal of Excess ADIT for rate-making purposes. +ARO Asset Retirement Obligations. +ASU Accounting Standards Update. +CAA Clean Air Act. +CAA of 2021 Consolidated Appropriations Act of 2021 signed into law in December 2020. +Cardinal Operating Company +A jointly-owned organization between AGR and a nonaffiliate. The nonaffiliate operates the three unit Cardinal Plant and wholly-owns Units 2 and 3. +CARES Act Coronavirus Aid, Relief, and Economic Security Act signed into law in March 2020. +CLECO Central Louisiana Electric Company, a nonaffiliated utility company. +CO 2 +Carbon dioxide and other greenhouse gases. +Conesville Plant +A retired, single unit coal-fired generation plant totaling 651 MW located in Conesville, Ohio. The plant was jointly-owned by AGR and a nonaffiliate. +Cook Plant Donald C. Cook Nuclear Plant, a two-unit, 2,288 MW nuclear plant owned by I&M. +COVID-19 +Coronavirus 2019, a highly infectious respiratory disease. In March 2020, the World Health Organization declared COVID-19 a worldwide pandemic. +CRES provider +Competitive Retail Electric Service providers under Ohio law that target retail customers by offering alternative generation service. +CSAPR Cross-State Air Pollution Rule. +CSPCo +Columbus Southern Power Company, a former AEP electric utility subsidiary that was merged into OPCo effective December 31, 2011. +CWA Clean Water Act. +CWIP Construction Work in Progress. +DCC Fuel +DCC Fuel IX, DCC Fuel X, DCC Fuel XI, DCC Fuel XII, DCC Fuel XIII, DCC Fuel XIV and DCC Fuel XV, consolidated VIEs formed for the purpose of acquiring, owning and leasing nuclear fuel to I&M. +Desert Sky +Desert Sky Wind Farm LLC, a 170 MW wind electricity generation facility located on Indian Mesa in Pecos County, Texas in which AEP owns a 100% interest. +DHLC +Dolet Hills Lignite Company, LLC, a wholly-owned lignite mining subsidiary of SWEPCo. +DIR +Distribution Investment Rider. +DOE +U. S. Department of Energy. +EIS +Energy Insurance Services, Inc., a nonaffiliated captive insurance company and consolidated VIE of AEP. +ENEC Expanded Net Energy Cost. +Energy Supply +AEP Energy Supply LLC, a nonregulated holding company for AEP’s competitive generation, wholesale and retail businesses, and a wholly-owned subsidiary of AEP. +Equity Units AEP’s Equity Units issued in August 2020 and March 2019. +ERCOT Electric Reliability Council of Texas regional transmission organization. +ESP +Electric Security Plans, a PUCO requirement for electric utilities to adjust their rates by filing with the PUCO. +ETT +Electric Transmission Texas, LLC, an equity interest joint venture between AEP Transmission Holdco and Berkshire Hathaway Energy Company formed to own and operate electric transmission facilities in ERCOT. +Excess ADIT Excess accumulated deferred income taxes. +FAC Fuel Adjustment Clause. +ii +Term Meaning +FASB Financial Accounting Standards Board. +Federal EPA United States Environmental Protection Agency. +FERC Federal Energy Regulatory Commission. +FGD Flue Gas Desulfurization or scrubbers. +FIP Federal Implementation Plan. +FTR +Financial Transmission Right, a financial instrument that entitles the holder to receive compensation for certain congestion-related transmission charges that arise when the power grid is congested resulting in differences in locational prices. +GAAP Accounting Principles Generally Accepted in the United States of America. +Global Settlement +In February 2017, the PUCO approved a settlement agreement filed by OPCo in December 2016 which resolved all remaining open issues on remand from the Supreme Court of Ohio in OPCo’s 2009 - 2011 and June 2012 - May 2015 ESP filings. It also resolved all open issues in OPCo’s 2009, 2014 and 2015 SEET filings and 2009, 2012 and 2013 FAC Audits. +I&M Indiana Michigan Power Company, an AEP electric utility subsidiary. +IMTCo +AEP Indiana Michigan Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +IRS Internal Revenue Service. +ITC Investment Tax Credit. +IURC Indiana Utility Regulatory Commission. +KGPCo Kingsport Power Company, an AEP electric utility subsidiary. +KPCo Kentucky Power Company, an AEP electric utility subsidiary. +KPSC +Kentucky Public Service Commission. +KTCo +AEP Kentucky Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +kV Kilovolt. +KWh Kilowatt-hour. +LPSC Louisiana Public Service Commission. +MATS Mercury and Air Toxic Standards. +MISO +Midcontinent Independent System Operator. +MMBtu Million British Thermal Units. +MPSC Michigan Public Service Commission. +MTM Mark-to-Market. +MW Megawatt. +MWh Megawatt-hour. +NAAQS National Ambient Air Quality Standards. +NERC North American Electric Reliability Corporation. +Nonutility Money Pool +Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain nonutility subsidiaries. +North Central Wind Energy Facilities +A joint PSO and SWEPCo project, which includes three Oklahoma wind facilities totaling approximately 1,485 MWs of wind generation. +NO 2 +Nitrogen dioxide. +NOL Net operating losses. +NO x +Nitrogen oxide. +NPDES National Pollutant Discharge Elimination System. +NRC Nuclear Regulatory Commission. +NSR New Source Review. +OATT Open Access Transmission Tariff. +OCC Corporation Commission of the State of Oklahoma. +Ohio Phase-in-Recovery Funding +Ohio Phase-in-Recovery Funding LLC, a wholly-owned subsidiary of OPCo and a consolidated VIE formed for the purpose of issuing and servicing securitization bonds related to phase-in recovery property. In July 2019, the Ohio Phase-in Recovery funding securitization bonds matured. +iii +Term Meaning +OHTCo +AEP Ohio Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +Oklaunion Power Station +A retired, single unit coal-fired generation plant totaling 650 MW located in Vernon, Texas. The plant was jointly-owned by AEP Texas, PSO and certain nonaffiliated entities. +OKTCo +AEP Oklahoma Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +OPCo Ohio Power Company, an AEP electric utility subsidiary. +OPEB Other Postretirement Benefits. +Operating Agreement +Agreement, dated January 1, 1997, as amended, by and among PSO and SWEPCo governing generating capacity allocation, energy pricing, and revenues and costs of third-party sales. AEPSC acts as the agent. +OTC Over-the-counter. +OVEC Ohio Valley Electric Corporation, which is 43.47% owned by AEP. +Parent +American Electric Power Company, Inc., the equity owner of AEP subsidiaries within the AEP consolidation. +PATH-WV +PATH West Virginia Transmission Company, LLC, a joint venture-owned 50% by FirstEnergy and 50% by AEP. +PCA Power Coordination Agreement among APCo, I&M, KPCo and WPCo. +PJM Pennsylvania – New Jersey – Maryland regional transmission organization. +PM Particulate Matter. +PPA Purchase Power and Sale Agreement. +PSO Public Service Company of Oklahoma, an AEP electric utility subsidiary. +PTC Production Tax Credits. +PUCO Public Utilities Commission of Ohio. +PUCT Public Utility Commission of Texas. +Racine +A generation plant consisting of two hydroelectric generating units totaling 48 MWs located in Racine, Ohio and owned by AGR. +Reference Rate Reform +The global transition away from referencing the London Interbank Offered Rate and other interbank offered rates, and toward new reference rates that are more reliable and robust. +Registrant Subsidiaries +AEP subsidiaries which are SEC registrants: AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo. +Registrants +SEC registrants: AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo. +REP Texas Retail Electric Provider. +Restoration Funding +AEP Texas Restoration Funding LLC, a wholly-owned subsidiary of AEP Texas and a consolidated VIE formed for the purpose of issuing and servicing securitization bonds related to storm restoration in Texas primarily caused by Hurricane Harvey. +Risk Management Contracts +Trading and non-trading derivatives, including those derivatives designated as cash flow and fair value hedges. +Rockport Plant +A generation plant, consisting of two 1,310 MW coal-fired generating units near Rockport, Indiana. AEGCo and I&M jointly-own Unit 1. In 1989, AEGCo and I&M entered into a sale-and-leaseback transaction with Wilmington Trust Company, an unrelated, unconsolidated trustee for Rockport Plant, Unit 2. +ROE +Return on Equity. +RPM Reliability Pricing Model. +RTO +Regional Transmission Organization, responsible for moving electricity over large interstate areas. +Sabine +Sabine Mining Company, a lignite mining company that is a consolidated VIE for AEP and SWEPCo. +Santa Rita East +Santa Rita East Wind Holdings, LLC, a consolidated VIE whose sole purpose is to own and operate a 302 MW wind generation facility in west Texas in which AEP owns an 85% interest. +iv +Term Meaning +SEC U.S. Securities and Exchange Commission. +SEET Significantly Excessive Earnings Test. +Sempra Renewables LLC +Sempra Renewables LLC, acquired in April 2019, consists of 724 MWs of wind generation and battery assets in the United States. +SIA +System Integration Agreement, effective June 15, 2000, as amended, provides contractual basis for coordinated planning, operation and maintenance of the power supply sources of the combined AEP. +SIP State Implementation Plan. +SNF Spent Nuclear Fuel. +SO 2 +Sulfur dioxide. +SPP Southwest Power Pool regional transmission organization. +SSO Standard service offer. +State Transcos +AEPTCo’s seven wholly-owned, FERC regulated, transmission only electric utilities, which are geographically aligned with AEP's existing utility operating companies. +SWEPCo Southwestern Electric Power Company, an AEP electric utility subsidiary. +SWTCo +AEP Southwestern Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +TA +Transmission Agreement, effective November 2010, among APCo, I&M, KGPCo, KPCo, OPCo and WPCo with AEPSC as agent. +Tax Reform +On December 22, 2017, President Trump signed into law legislation referred to as the “Tax Cuts and Jobs Act” (the TCJA). The TCJA includes significant changes to the Internal Revenue Code of 1986, including a reduction in the corporate federal income tax rate from 35% to 21% effective January 1, 2018. +TCA +Transmission Coordination Agreement dated January 1, 1997, by and among, PSO, SWEPCo and AEPSC, in connection with the operation of the transmission assets of the two public utility subsidiaries. +TCC Formerly AEP Texas Central Company; now a division of AEP Texas. +Texas Restructuring Legislation +Legislation enacted in 1999 to restructure the electric utility industry in Texas. +TNC Formerly AEP Texas North Company; now a division of AEP Texas. +Transition Funding +AEP Texas Central Transition Funding II LLC and AEP Texas Central Transition Funding III LLC, wholly-owned subsidiaries of TCC and consolidated VIE formed for the purpose of issuing and servicing securitization bonds related to Texas Restructuring Legislation. In July 2020, the final AEP Texas Central Transition Funding II LLC securitization bond matured. +Transource Energy +Transource Energy, LLC, a consolidated VIE formed for the purpose of investing in utilities which develop, acquire, construct, own and operate transmission facilities in accordance with FERC-approved rates. +Trent +Trent Wind Farm LLC, a 156 MW wind electricity generation facility located between Abilene and Sweetwater in west Texas in which AEP owns a 100% interest. +Turk Plant +John W. Turk, Jr. Plant, a 650 MW coal-fired plant in Arkansas that is 73% owned by SWEPCo. +UMWA United Mine Workers of America. +UPA +Unit Power Agreement. +Utility Money Pool +Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain utility subsidiaries. +VIE Variable Interest Entity. +Virginia SCC Virginia State Corporation Commission. +WPCo Wheeling Power Company, an AEP electric utility subsidiary. +WVPSC Public Service Commission of West Virginia. +WVTCo +AEP West Virginia Transmission Company, Inc., a wholly-owned AEPTCo transmission subsidiary. +v +FORWARD-LOOKING INFORMATION +This report made by the Registrants contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Many forward-looking statements appear in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” but there are others throughout this document which may be identified by words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “will,” “should,” “could,” “would,” “project,” “continue” and similar expressions, and include statements reflecting future results or guidance and statements of outlook. These matters are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Forward-looking statements in this document are presented as of the date of this document. Except to the extent required by applicable law, management undertakes no obligation to update or revise any forward-looking statement. Among the factors that could cause actual results to differ materially from those in the forward-looking statements are: +• Changes in economic conditions, electric market demand and demographic patterns in AEP service territories. +• The impact of pandemics, including COVID-19, and any associated disruption of AEP’s business operations due to impacts on economic or market conditions, electricity usage, employees, customers, service providers, vendors and suppliers. +• Inflationary or deflationary interest rate trends. +• Volatility in the financial markets, particularly developments affecting the availability or cost of capital to finance new capital projects and refinance existing debt. +• The availability and cost of funds to finance working capital and capital needs, particularly during periods when the time lag between incurring costs and recovery is long and the costs are material. +• Decreased demand for electricity. +• Weather conditions, including storms and drought conditions, and the ability to recover significant storm restoration costs. +• The cost of fuel and its transportation, the creditworthiness and performance of fuel suppliers and transporters and the cost of storing and disposing of used fuel, including coal ash and SNF. +• The availability of fuel and necessary generation capacity and the performance of generation plants. +• The ability to recover fuel and other energy costs through regulated or competitive electric rates. +• The ability to build or acquire renewable generation, transmission lines and facilities (including the ability to obtain any necessary regulatory approvals and permits) when needed at acceptable prices and terms, including favorable tax treatment, and to recover those costs. +• New legislation, litigation and government regulation, including changes to tax laws and regulations, oversight of nuclear generation, energy commodity trading and new or heightened requirements for reduced emissions of sulfur, nitrogen, mercury, carbon, soot or PM and other substances that could impact the continued operation, cost recovery and/or profitability of generation plants and related assets. +• Evolving public perception of the risks associated with fuels used before, during and after the generation of electricity, including coal ash and nuclear fuel. +• Timing and resolution of pending and future rate cases, negotiations and other regulatory decisions, including rate or other recovery of new investments in generation, distribution and transmission service and environmental compliance. +• Resolution of litigation. +• The ability to constrain operation and maintenance costs. +• Prices and demand for power generated and sold at wholesale. +• Changes in technology, particularly with respect to energy storage and new, developing, alternative or distributed sources of generation. +• The ability to recover through rates any remaining unrecovered investment in generation units that may be retired before the end of their previously projected useful lives. +• Volatility and changes in markets for coal and other energy-related commodities, particularly changes in the price of natural gas. +• Changes in utility regulation and the allocation of costs within RTOs including ERCOT, PJM and SPP. +• Changes in the creditworthiness of the counterparties with contractual arrangements, including participants in the energy trading market. +• Actions of rating agencies, including changes in the ratings of debt. +vi +• The impact of volatility in the capital markets on the value of the investments held by the pension, OPEB, captive insurance entity and nuclear decommissioning trust and the impact of such volatility on future funding requirements. +• Accounting standards periodically issued by accounting standard-setting bodies. +• Other risks and unforeseen events, including wars, the effects of terrorism (including increased security costs), embargoes, naturally occurring and human-caused fires, cyber security threats and other catastrophic events. +• The ability to attract and retain the requisite work force and key personnel. +The forward-looking statements of the Registrants speak only as of the date of this report or as of the date they are made. The Registrants expressly disclaim any obligation to update any forward-looking information, except as required by law. For a more detailed discussion of these factors, see “Risk Factors” in Part I of this report. +Investors should note that the Registrants announce material financial information in SEC filings, press releases and public conference calls. Based on guidance from the SEC, the Registrants may use the Investors section of AEP’s website (www.aep.com) to communicate with investors about the Registrants. It is possible that the financial and other information posted there could be deemed to be material information. The information on AEP’s website is not part of this report. +vii +PART I +ITEM 1. BUSINESS +GENERAL +Overview and Description of Major Subsidiaries +AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company that owns, directly or indirectly, all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries. +The service areas of AEP’s public utility subsidiaries cover portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Transmission networks are interconnected with extensive distribution facilities in the territories served. The public utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers. Restructuring laws in Michigan, Ohio and the ERCOT area of Texas have caused AEP public utility subsidiaries in those states to unbundle previously integrated regulated rates for their retail customers. +The member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity and transportation and handling of fuel. The companies of the AEP System also obtain certain accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost from a common provider, AEPSC. +As of December 31, 2020, the subsidiaries of AEP had a total of 16,787 employees. Because it is a holding company rather than an operating company, AEP has no employees. The material subsidiaries of AEP are as follows: +AEP Texas +Organized in Delaware in 1925, AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,068,000 retail customers through REPs in west, central and southern Texas. As of December 31, 2020, AEP Texas had 1,570 employees. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and primary metal manufacturing. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. AEP Texas is part of AEP’s Transmission and Distribution Utilities segment. +AEPTCo +Organized in Delaware in 2006, AEPTCo is a holding company for the State Transcos. The State Transcos develop and own new transmission assets that are physically connected to the AEP System. Individual State Transcos (a) have obtained the approvals necessary to operate in Indiana, Kentucky, Michigan, Ohio, Oklahoma and West Virginia, subject to any applicable siting requirements, (b) are authorized to submit projects for commission approval in Virginia and (c) have been granted consent to enter into a joint license agreement that will support investment in Tennessee. Neither AEPTCo nor its subsidiaries have any employees. Instead, AEPSC and certain AEP utility subsidiaries provide services to these entities. AEPTCo is part of the AEP Transmission Holdco segment. +1 +APCo +Organized in Virginia in 1926, APCo is engaged in the generation, transmission and distribution of electric power to approximately 964,000 retail customers in the southwestern portion of Virginia and southern West Virginia, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. APCo owns 6,629 MWs of generating capacity. APCo uses its generation to serve its retail and other customers. As of December 31, 2020, APCo had 1,652 employees. Among the principal industries served by APCo are coal-mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. APCo is a member of PJM. APCo is part of AEP’s Vertically Integrated Utilities segment. +I&M +Organized in Indiana in 1907, I&M is engaged in the generation, transmission and distribution of electric power to approximately 602,000 retail customers in northern and eastern Indiana and southwestern Michigan, and in supplying and marketing electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities and other market participants. I&M owns or leases 3,634 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2020, I&M had 2,217 employees. Among the principal industries served are primary metals, transportation equipment, chemical manufacturing, plastics and rubber products and fabricated metal product manufacturing. I&M is a member of PJM. I&M is part of AEP’s Vertically Integrated Utilities segment. +KPCo +Organized in Kentucky in 1919, KPCo is engaged in the generation, transmission and distribution of electric power to approximately 166,000 retail customers in eastern Kentucky, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. KPCo owns 1,060 MWs of generating capacity. KPCo uses its generation to serve its retail and other customers. As of December 31, 2020, KPCo had 475 employees. Among the principal industries served are petroleum and coal products manufacturing, chemical manufacturing, coal-mining, oil and gas extraction and primary metals. KPCo is a member of PJM. KPCo is part of AEP’s Vertically Integrated Utilities segment. +KGPCo +Organized in Virginia in 1917, KGPCo provides electric service to approximately 49,000 retail customers in Kingsport and eight neighboring communities in northeastern Tennessee. KGPCo does not own any generating facilities and is a member of PJM. It purchases electric power from APCo for distribution to its customers. As of December 31, 2020, KGPCo had 52 employees. KGPCo is part of AEP’s Vertically Integrated Utilities segment. +OPCo +Organized in Ohio in 1907 and re-incorporated in 1924, OPCo is engaged in the transmission and distribution of electric power to approximately 1,507,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. As of December 31, 2020, OPCo had 1,646 employees. Among the principal industries served by OPCo are primary metals, petroleum and coal products manufacturing, plastics and rubber products, chemical manufacturing, fabricated metal product manufacturing and data centers. OPCo is a member of PJM. OPCo is part of AEP’s Transmission and Distribution Utilities segment. +2 +PSO +Organized in Oklahoma in 1913, PSO is engaged in the generation, transmission and distribution of electric power to approximately 565,000 retail customers in eastern and southwestern Oklahoma, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. PSO owns 3,728 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2020, PSO had 1,023 employees. Among the principal industries served by PSO are paper manufacturing, oil and gas extraction, petroleum and coal products manufacturing, transportation equipment and pipeline transportation. PSO is a member of SPP. PSO is part of AEP’s Vertically Integrated Utilities segment. +SWEPCo +Organized in Delaware in 1912, SWEPCo is engaged in the generation, transmission and distribution of electric power to approximately 545,000 retail customers in northeastern and panhandle of Texas, northwestern Louisiana and western Arkansas and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. SWEPCo owns 5,034 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2020, SWEPCo had 1,440 employees. Among the principal industries served by SWEPCo are petroleum and coal products manufacturing, food manufacturing, paper manufacturing, oil and gas extraction and chemical manufacturing. The territory served by SWEPCo includes several military installations, colleges and universities. SWEPCo also owns and operates a lignite coal-mining operation. SWEPCo is a member of SPP. SWEPCo is part of AEP’s Vertically Integrated Utilities segment. +WPCo +Organized in West Virginia in 1883 and re-incorporated in 1911, WPCo provides electric service to approximately 42,000 retail customers in northern West Virginia and in supplying and marketing electric power at wholesale to other market participants. WPCo owns 780 MWs of generating capacity which it uses to serve its retail and other customers. Among the principal industries served by WPCo are coal-mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. WPCo is a member of PJM. As of December 31, 2020, WPCo had 45 employees. WPCo is part of AEP’s Vertically Integrated Utilities segment. +Service Company Subsidiary +AEPSC is a service company subsidiary that provides accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost to AEP subsidiaries. The executive officers of AEP and certain of the executive officers of its public utility subsidiaries are employees of AEPSC. As of December 31, 2020, AEPSC had 6,295 employees. +Company Website and Availability of SEC Filings +Our principal corporate website address is www.aep.com. Information on our website is not incorporated by reference herein and is not part of this Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding AEP. +3 +Public Utility Subsidiaries by Jurisdiction +The following table illustrates certain regulatory information with respect to the jurisdictions in which the public utility subsidiaries of AEP operate: +Principal Jurisdiction AEP Utility Subsidiaries Operating in that Jurisdiction Authorized Return on Equity (a) +FERC AEPTCo - PJM 10.35% +AEPTCo - SPP 10.50% +Ohio OPCo 10.20% (b) +West Virginia APCo 9.75% +WPCo 9.75% +Virginia APCo 9.20% +Indiana I&M 9.70% +Michigan I&M 9.86% +Texas AEP Texas 9.40% +SWEPCo 9.60% +Tennessee KGPCo 9.85% +Kentucky KPCo 9.30% (c) +Louisiana SWEPCo 9.80% +Arkansas SWEPCo 9.45% +Oklahoma PSO 9.40% +(a) Identifies the predominant current authorized ROE, and may not include other, less significant, permitted recovery. Actual ROE varies from authorized ROE. +(b) Authorized ROE was approved in OPCo’s last distribution base case. The authorized ROE for riders with an approved equity return (e.g. Distribution Investment Rider) is 10.00%. +(c) Final order received and made effective in January 2021 that approved an authorized ROE of 9.30%. The authorized ROE for riders with an approved equity return (Decommissioning Rider and the Environmental Surcharge) is 9.10%. +(a) Pretax income does not include intercompany eliminations. +4 +CLASSES OF SERVICE +The principal classes of service from which AEP’s subsidiaries derive revenues and the amount of such revenues during the years ended December 31, 2020, 2019 and 2018 are as follows: +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Vertically Integrated Utilities Segment +Retail Revenues +Residential Sales $ 3,614.8 $ 3,641.2 $ 3,818.6 +Commercial Sales 2,021.0 2,151.1 2,223.7 +Industrial Sales 2,023.5 2,178.3 2,261.3 +PJM Net Charges (0.1) (0.2) 0.4 +Other Retail Sales 155.9 179.4 186.8 +Total Retail Revenues 7,815.1 8,149.8 8,490.8 +Wholesale Revenues +Off-system Sales 589.3 814.5 888.0 +Transmission 249.5 200.7 263.7 +Total Wholesale Revenues 838.8 1,015.2 1,151.7 +Other Electric Revenues 85.8 93.8 93.7 +Provision for Rate Refund (21.7) (44.7) (210.1) +Other Operating Revenues 35.2 31.6 30.6 +Sales to Affiliates 126.2 121.4 88.8 +Total Revenues Vertically Integrated Utilities Segment $ 8,879.4 $ 9,367.1 $ 9,645.5 +Transmission and Distribution Utilities Segment +Retail Revenues +Residential Sales $ 2,114.9 $ 2,084.5 $ 2,213.6 +Commercial Sales 1,049.5 1,148.8 1,266.7 +Industrial Sales 390.0 426.5 517.2 +Other Retail Sales 42.5 43.7 43.1 +Total Retail Revenues 3,596.9 3,703.5 4,040.6 +Wholesale Revenues +Off-system Sales 60.6 93.0 119.3 +Transmission 471.8 437.7 394.7 +Total Wholesale Revenues 532.4 530.7 514.0 +Other Electric Revenues 95.0 58.6 54.5 +Provision for Rate Refund 2.3 12.5 (69.2) +Other Operating Revenues 12.1 13.7 12.4 +Sales to Affiliates 107.2 163.5 100.8 +Total Revenues Transmission and Distribution Utilities Segment $ 4,345.9 $ 4,482.5 $ 4,653.1 +AEP Transmission Holdco Segment +Transmission Revenues $ 315.1 $ 265.1 $ 291.3 +Other Electric Revenues 0.4 0.3 0.3 +Other Operating Revenues 0.6 0.1 0.3 +Sales to Affiliates 901.4 812.9 555.5 +Provision for Rate Refund (18.7) (5.2) (43.3) +Total Revenues AEP Transmission Holdco Segment $ 1,198.8 $ 1,073.2 $ 804.1 +Generation & Marketing Segment +Generation Revenues - Nonaffiliated $ 136.4 $ 264.4 $ 431.5 +Renewable Generation - Nonaffiliated 85.7 77.7 44.5 +Retail, Trading and Marketing +Affiliated 104.6 135.7 122.2 +Nonaffiliated 1,398.9 1,379.8 1,342.1 +Total Revenues Generation & Marketing Segment $ 1,725.6 $ 1,857.6 $ 1,940.3 +5 +AEP Texas +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 562.3 $ 588.9 $ 594.6 +Commercial Sales 365.9 424.0 426.6 +Industrial Sales 119.9 133.3 131.0 +Other Retail Sales 29.4 30.8 30.1 +Total Retail Revenues 1,077.5 1,177.0 1,182.3 +Wholesale Revenues +Transmission 399.9 379.2 313.4 +Other Electric Revenues 45.2 24.4 21.9 +Provision for Rate Refund 2.3 (34.7) (31.3) +Total Electric Transmission and Distribution Revenues 1,524.9 1,545.9 1,486.3 +Sales to Affiliates 90.8 160.5 105.2 +Other Revenues 3.2 2.9 3.8 +Total Revenues $ 1,618.9 $ 1,709.3 $ 1,595.3 +AEPTCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Transmission Revenues $ 264.4 $ 217.2 $ 212.8 +Other Electric Revenues 0.4 0.3 0.3 +Other Operating Revenues 0.6 0.1 0.2 +Sales to Affiliates 896.3 806.7 598.9 +Provision for Rate Refund (16.0) (2.9) (36.1) +Total Revenues $ 1,145.7 $ 1,021.4 $ 776.1 +APCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 1,250.4 $ 1,272.3 $ 1,372.1 +Commercial Sales 517.0 562.2 596.3 +Industrial Sales 553.3 594.5 620.7 +PJM Net Charges (0.3) (0.2) (0.2) +Other Retail Sales 67.6 75.6 79.5 +Total Retail Revenues 2,388.0 2,504.4 2,668.4 +Wholesale Revenues +Off-system Sales 118.1 124.9 116.4 +Transmission 71.0 57.0 56.3 +Total Wholesale Revenues 189.1 181.9 172.7 +Other Electric Revenues 34.0 32.3 31.1 +Provision for Rate Refund (0.2) (10.4) (95.1) +Total Electric Generation, Transmission and Distribution Revenues 2,610.9 2,708.2 2,777.1 +Sales to Affiliates 174.7 205.3 181.4 +Other Revenues 10.6 11.2 9.0 +Total Revenues $ 2,796.2 $ 2,924.7 $ 2,967.5 +6 +I&M +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 794.1 $ 730.9 $ 736.5 +Commercial Sales 499.4 494.9 489.3 +Industrial Sales 547.5 551.4 570.6 +PJM Net Charges 0.2 0.1 0.2 +Other Retail Sales 6.6 7.3 7.2 +Total Retail Revenues 1,847.8 1,784.6 1,803.8 +Wholesale Revenues +Off-system Sales 275.4 406.4 459.3 +Transmission 31.0 19.3 18.4 +Total Wholesale Revenues 306.4 425.7 477.7 +Other Electric Revenues 11.3 14.4 15.7 +Provision for Rate Refund (0.2) (2.6) (24.6) +Total Electric Generation, Transmission and Distribution Revenues 2,165.3 2,222.1 2,272.6 +Sales to Affiliates 71.3 73.9 85.5 +Other Revenues 5.2 10.7 12.6 +Total Revenues $ 2,241.8 $ 2,306.7 $ 2,370.7 +OPCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 1,552.6 $ 1,495.6 $ 1,619.0 +Commercial Sales 683.5 724.9 840.1 +Industrial Sales 270.1 293.2 386.2 +Other Retail Sales 13.1 12.9 13.0 +Total Retail Revenues 2,519.3 2,526.6 2,858.3 +Wholesale Revenues +Off-system Sales 60.6 93.0 119.3 +Transmission 68.8 58.5 61.4 +Total Wholesale Revenues 129.4 151.5 180.7 +Other Electric Revenues 49.9 34.2 32.7 +Provision for Rate Refund — 47.2 (37.9) +Total Electricity, Transmission and Distribution Revenues 2,698.6 2,759.5 3,033.8 +Sales to Affiliates 41.5 27.3 21.0 +Other Revenues 9.0 10.8 8.6 +Total Revenues $ 2,749.1 $ 2,797.6 $ 3,063.4 +PSO +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 579.8 $ 636.1 $ 668.5 +Commercial Sales 320.4 377.3 401.1 +Industrial Sales 221.2 296.5 308.5 +Other Retail Sales 66.0 80.7 84.5 +Total Retail Revenues 1,187.4 1,390.6 1,462.6 +Wholesale Revenues +Off-system Sales 15.1 39.5 36.3 +Transmission 35.3 31.9 47.4 +Total Wholesale Revenues 50.4 71.4 83.7 +Other Electric Revenues 10.4 9.6 10.3 +Provision for Rate Refund (2.1) (2.0) (19.0) +Total Electric Generation, Transmission and Distribution Revenues 1,246.1 1,469.6 1,537.6 +Sales to Affiliates 5.2 6.1 5.4 +Other Revenues 14.8 6.1 4.3 +Total Revenues $ 1,266.1 $ 1,481.8 $ 1,547.3 +7 +SWEPCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 637.4 $ 645.3 $ 666.0 +Commercial Sales 471.5 490.6 502.6 +Industrial Sales 332.1 342.3 346.2 +Other Retail Sales 9.1 9.1 8.9 +Total Retail Revenues 1,450.1 1,487.3 1,523.7 +Wholesale Revenues +Off-system Sales 162.0 194.7 216.8 +Transmission 87.0 72.6 94.2 +Total Wholesale Revenues 249.0 267.3 311.0 +Other Electric Revenues 16.5 20.6 20.9 +Provision for Rate Refund (19.0) (30.6) (63.7) +Total Electric Generation, Transmission and Distribution Revenues 1,696.6 1,744.6 1,791.9 +Sales to Affiliates 39.0 4.9 28.4 +Other Revenues 2.9 1.4 1.6 +Total Revenues $ 1,738.5 $ 1,750.9 $ 1,821.9 +FINANCING +General +Companies within the AEP System generally use short-term debt to finance working capital needs. Short-term debt may also be used to finance acquisitions, construction and redemption or repurchase of outstanding securities until such needs can be financed with long-term debt. In recent history, short-term funding needs have been provided for by cash on hand and AEP’s commercial paper program. Funds are made available to subsidiaries under the AEP corporate borrowing program. Certain public utility subsidiaries of AEP also sell accounts receivable to provide liquidity. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +AEP’s revolving credit agreement (which backstops the commercial paper program) includes covenants and events of default typical for this type of facility, including a maximum debt/capital test. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of its major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under the credit agreement. As of December 31, 2020, AEP was in compliance with its debt covenants. With the exception of a voluntary bankruptcy or insolvency, any event of default has either or both a cure period or notice requirement before termination of the agreement. A voluntary bankruptcy or insolvency of AEP or one of its significant subsidiaries would be considered an immediate termination event. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +AEP’s subsidiaries have also utilized, and expect to continue to utilize, additional financing arrangements, such as securitization financings and leasing arrangements, including the leasing of coal transportation equipment and facilities. +ENVIRONMENTAL AND OTHER MATTERS +General +AEP subsidiaries are currently subject to regulation by federal, state and local authorities with regard to air and water-quality control and other environmental matters, and are subject to zoning and other regulation by local authorities. The environmental issues that management believes are potentially material to the AEP System are outlined below. +8 +Clean Water Act Requirements +Operations for AEP subsidiaries are subject to the CWA, which prohibits the discharge of pollutants into waters of the United States except pursuant to appropriate permits and regulates systems that withdraw surface water for use in power plants. In 2014, the Federal EPA issued a final rule setting forth standards for water withdrawals at existing power plants that is intended to reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water. The standards affect all plants withdrawing more than two million gallons of cooling water per day. A schedule for compliance with the standard is established by the permit agency and incorporated in NPDES permits. +In November 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for electricity generating facilities. The rule established limits on FGD wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed in NPDES permits as soon as possible after November 2018 and no later than December 2023. The Federal EPA further revised the rule in August 2020 for FGD wastewater and bottom ash transport water extending the compliance date to December 2025 and establishing additional options. In January 2020, the Federal EPA issued a final rule revising the scope of the “waters of the United States” subject to CWA regulation. See “Environmental Issues - Clean Water Act Regulations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Coal Ash Regulation +AEP’s operations produce a number of different coal combustion by-products, including fly ash, bottom ash, gypsum and other materials. A rule by the Federal EPA regulates the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units. The rule requires certain standards for location, groundwater monitoring and dam stability to be met at landfills and certain surface impoundments at operating facilities. If existing disposal facilities cannot meet these standards, they will be required to close. See “Environmental Issues - Coal Combustion Residual Rule” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control mobile and stationary sources of air emissions. The major CAA programs affecting AEP’s power plants are described below. The states implement and administer many of these programs and could impose additional or more stringent requirements. +The Acid Rain Program +The CAA includes a cap-and-trade emission reduction program for SO 2 emissions from power plants and requirements for power plants to reduce NO x emissions through the use of available combustion controls, collectively called the Acid Rain Program. AEP continues to meet its obligations under the Acid Rain Program through the installation of controls, use of alternate fuels and participation in the emissions allowance markets. +National Ambient Air Quality Standards +The CAA requires the Federal EPA to review the available scientific data for criteria pollutants periodically and establish a concentration level in the ambient air for those substances that is adequate to protect the public health and welfare with an extra safety margin. The Federal EPA also can list additional pollutants and develop concentration levels for them. These concentration levels are known as NAAQS. +9 +Each state identifies the areas within its boundaries that meet the NAAQS (attainment areas) and those that do not (non-attainment areas). Each state must develop a SIP to bring non-attainment areas into compliance with the NAAQS and maintain good air quality in attainment areas. All SIPs are submitted to the Federal EPA for approval. If a state fails to develop adequate plans, the Federal EPA develops and implements a plan. As the Federal EPA reviews the NAAQS and establishes new concentration levels, the attainment status of areas can change and states may be required to develop new SIPs. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Hazardous Air Pollutants (HAP) +The CAA also requires the Federal EPA to investigate HAP emissions from the electric utility sector and submit a report to Congress to determine whether those emissions should be regulated. In 2011, the Federal EPA issued a rule setting Maximum Achievable Control Technology standards for new and existing coal and oil-fired utility units and New Source Performance Standards for emissions from new and modified power plants. In 2014, the U.S. Supreme Court determined that the Federal EPA acted unreasonably in refusing to consider costs in determining if it was appropriate and necessary to regulate HAP emissions from electric generating units. The Federal EPA has engaged in additional rulemaking activity but the 2011 rule remains in effect. See “Environmental Issues - Mercury and Other Hazardous Air Pollutants Regulation” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Regional Haze +The CAA establishes visibility goals for certain federally designated areas, including national parks, and requires states to submit SIPs that will demonstrate reasonable progress toward preventing impairment of visibility in these protected areas. In 2005, the Federal EPA issued its Clean Air Visibility Rule, detailing how the CAA’s best available retrofit technology requirements will be applied to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants. +PSO executed a settlement with the Federal EPA and the State of Oklahoma to comply with Regional Haze program requirements in Oklahoma, and the settlement is now codified in the Oklahoma SIP and approved by the Federal EPA. The Federal EPA disapproved portions of the Arkansas and Texas SIPs, and finalized FIPs for both states. Arkansas submitted and received approval of a revised SIP, and the Federal EPA developed a revised FIP for Texas. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Climate Change +AEP has taken action to reduce and offset CO 2 emissions from its generating fleet and expects CO 2 emissions from its operations to continue to decline due to the retirement of coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. In 2021, AEP announced revised intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, regulations, grid reliability and resiliency, and reflect the company’s current business strategy. The intermediate goal is an 80% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. AEP’s total estimated CO 2 emissions in 2020 were approximately 44 million metric tons, a 73% reduction from AEP’s 2000 CO 2 emissions. AEP will publish a new report in 2021 on the results of a climate change scenario analysis. +To date, the Federal EPA has twice taken action to regulate CO 2 emissions from new and existing fossil fueled electric generating units under the existing provisions of the CAA. The Clean Power Plan was adopted in October 2015 but the U.S. Supreme Court issued a stay of its implementation, including all of the deadlines for submission +10 +of initial or final state plans. The Clean Power Plan was repealed by the Federal EPA in 2019 and replaced by the Affordable Clean Energy (ACE) Rule, which changed the Federal EPA’s approach to regulating CO 2 emissions from existing coal-fired generating units. In January 2021, the ACE Rule was vacated by the U.S. Court of Appeals for the District of Columbia Circuit and remanded to the Federal EPA for further proceedings. It is too soon to predict how the Federal EPA will respond to the court’s remand. Management expects emissions to continue to decline over time as AEP diversifies generating sources and operates fewer coal units. The projected decline in coal-fired generation is due to a number of factors, including the ongoing cost of operating older units, the relative cost of coal and natural gas as fuel sources, increasing environmental regulations requiring significant capital investments and changing commodity market fundamentals. +Transforming AEP’s Generation Fleet +The electric utility industry is in the midst of an historic transformation, driven by changing customer needs, policy demands, demographics, competitive offerings, technologies and commodity prices. AEP is also transforming to be more agile and customer-focused as a valued provider of energy solutions. AEP’s long-term commitment to reduce CO 2 emissions reflects the current direction of the company’s resource plans to meet those needs as well a new climate change scenario analysis to be published in 2021. AEP’s exposure to carbon regulation has been greatly reduced over the last several years. From 2000 to 2020, AEP’s CO 2 emissions declined 73%. In 2020, coal represented 44% of AEP’s generating capacity compared with 70% in 2005. Management expects the percentage of AEP’s generating resources fueled by coal will continue to decline and to represent only 24% of generating capacity by 2030. The long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. Transforming AEP’s generation portfolio to include, where there is regulatory support, more renewable energy and focusing on the efficient use of energy, demand response, distributed resources and technology solutions to more efficiently manage the grid over time is part of this strategy. +The graph below summarizes AEP’s generation capacity by resource type for the years 1999, 2005 and 2020: +(a) Energy Efficiency/Demand Response represents avoided capacity rather than physical assets. +11 +Renewable Sources of Energy +The states AEP serves, other than Kentucky, West Virginia and Tennessee, have established mandatory or voluntary programs to increase the use of energy efficiency, alternative energy or renewable energy sources. +As of December 31, 2020, AEP’s regulated utilities had long-term contracts for 2,750 MWs of wind, 80 MWs of hydro, and 10 MWs of solar power delivering renewable energy to the companies’ customers. In addition, I&M owns four solar projects that make up I&M’s 16 MW Clean Energy Solar Pilot Project. Management actively manages AEP’s compliance position and is on pace to meet the relevant requirements or benchmarks in each applicable jurisdiction. +In 2020, PSO received approval from the OCC and SWEPCo received approval from the APSC and LPSC to acquire the North Central Wind Energy Facilities, comprised of three Oklahoma wind facilities totaling 1,485 MWs, on a fixed cost turn-key basis at completion. Both the APSC and LPSC approved the flex-up option, agreeing to acquire the Texas portion, which the PUCT denied. PSO will own 45.5% and SWEPCo will own 54.5% of the project, which will cost approximately $2 billion. +In May 2020, the IRS issued a notice extending the “Continuity Safe Harbor” deadlines for qualifying renewable energy projects that began construction in 2016 and 2017 by one year as many projects are facing supply chain and other project development delays caused by COVID-19. Under the May 2020 IRS notice, qualifying renewable energy projects that began construction in 2016 and 2017 and which are placed in-service by the end of 2021 and 2022, respectively, will satisfy the Continuity Safe Harbor. Provided that each facility does satisfy the Continuity Safe Harbor, under the current IRS guidance, the 199 MW wind facility will qualify for 100% of the federal PTC, and the remaining two wind facilities, totaling 1,286 MWs, will qualify for 80% of the federal PTC. +Having regulatory approval, and the expectation that all three wind facilities will be eligible for the IRS extension of the “Continuity Safe Harbor,” PSO and SWEPCo are proceeding with the full 1,485 MW development of these three projects. The 199 MW wind facility is targeted to be acquired and placed in-service in March 2021. The 287 MW wind facility is targeted to be acquired and placed in-service in December 2021 and the 999 MW wind facility is targeted to be acquired and placed in-service between December 2021 and April 2022. +The growth of AEP’s renewable generation portfolio reflects the company’s strategy to diversify generation resources to provide clean energy options to customers that meet both their energy and capacity needs. In addition to gradually reducing AEP’s reliance on coal-fueled generating units, the growth of renewables and natural gas helps AEP to maintain a diversity of generation resources. +The integrated resource plans filed with state regulatory commissions by AEP’s regulated utility subsidiaries reflect AEP’s renewable strategy to balance reliability and cost with customers’ desire for clean energy in a carbon-constrained world. AEP has committed significant capital investments to modernize the electric grid and integrate these new resources. Transmission assets of the AEP System interconnect approximately 16,300 MWs of renewable energy resources. AEP’s transmission development initiatives are designed to facilitate the interconnection of additional renewable energy resources. +AEP Energy Supply, LLC is a holding company with several divisions, including AEP Renewables and AEP OnSite Partners. +AEP Renewables develops, owns and operates utility scale renewable projects backed with long-term contracts with creditworthy counterparties throughout the United States. AEP Renewables works directly with stakeholders to ensure that customers have clean, sustainable renewable energy to meet their environmental goals. As of December 31, 2020, AEP Renewables owned projects operating in 11 states, including approximately 1,307 MWs of installed wind capacity and 90 MWs of installed solar capacity. These figures include the 2020 acquisition of an additional 10% interest, or approximately 30 MWs, of Santa Rita East wind generation located in west Texas. In October 2019, AEP Renewables entered into an agreement to construct Flat Ridge 3, a wind farm in Kansas. The 128 MW facility is expected to reach commercial operation by May 2021. +12 +AEP OnSite Partners works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. AEP OnSite Partners targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2020, AEP OnSite Partners owned projects located in 21 states, including approximately 152 MWs of installed solar capacity, and approximately 9 MWs of solar projects under construction. +Competitive Renewable Generation Facilities +Size of +Energy Resource AEP Energy Supply, LLC Division Renewable +Energy Resource Location In-Service or +Under Construction +1,307 MW AEP Renewables Wind Eight states (a) In-service +128 MW AEP Renewables Wind Kansas Under Construction +20 MW AEP Renewables Solar California In-service +20 MW AEP Renewables Solar Utah In-service +50 MW AEP Renewables Solar Nevada In-service +152 MW AEP OnSite Partners Solar Sixteen states (b) In-service +9 MW AEP OnSite Partners Solar Two states (c) Under Construction +(a) Colorado, Hawaii, Indiana, Kansas, Michigan, Minnesota, Pennsylvania, and Texas. +(b) California, Colorado, Florida, Hawaii, Illinois, Iowa, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(c) Ohio and Wisconsin. +End Use Energy Efficiency +AEP has reduced energy consumption and peak demand through the introduction of additional energy efficiency and demand response programs. These programs, commonly referred to as demand-side management, were implemented in jurisdictions where appropriate cost recovery was available. AEP’s operating companies’ programs have reduced annual consumption by over 9 million MWhs and peak demand by approximately 2,900 MWs since 2008. AEP estimates that its operating companies spent approximately $1.5 billion during that period to achieve these levels. +Energy efficiency and demand reduction programs have received regulatory support in most of the states AEP serves. Appropriate cost recovery will be essential for AEP operating companies to continue and expand these consumer offerings. Appropriate recovery of program costs, lost revenues and an opportunity to earn a reasonable return ensures that energy efficiency programs are considered equally with supply side investments. As AEP continues to transition to a cleaner, more efficient energy future, energy efficiency and demand response programs will continue to play an important role in how the company serves its customers. AEP believes its experience providing robust energy efficiency programs in several states positions the company to be a cost-effective provider of these programs as states develop their implementation plans. +Corporate Governance +In response to environmental issues and in connection with its assessment of AEP’s strategic plan, the Board of Directors continually reviews the risks posed by new environmental rules and requirements that could accelerate the retirement of coal-fired generation assets. The Board of Directors is informed of any new environmental regulations and proposed regulation or legislation that would significantly affect AEP. The Board’s Committee on Directors and Corporate Governance oversees AEP’s annual Corporate Accountability Report, which includes information about AEP’s environmental, social, governance and financial performance. AEP set CO 2 emission reduction goals in 2018 after considering input from corporate governance outreach effort with shareholders. +In February 2021, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, grid reliability and resiliency, regulations and the company’s current business strategy. The intermediate goal is an 80% +13 +reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. AEP has made significant progress in reducing CO 2 emissions from its power generation fleet and expects its emissions to continue to decline. Technological advances, including advanced energy storage, modular nuclear, and green hydrogen, and public policies are among the factors that will determine how quickly AEP can achieve net-zero emissions while continuing to provide reliable, affordable power for customers. AEP will publish a new report in 2021 on the results of a climate change scenario analysis. +Other Environmental Issues and Matters +The Comprehensive Environmental Response, Compensation and Liability Act of 1980 imposes costs for environmental remediation upon owners and previous owners of sites, as well as transporters and generators of hazardous material disposed of at such sites. See “The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation” section of Note 6 included in the 2020 Annual Report for additional information. +Environmental Investments +Investments related to improving AEP System plants’ environmental performance and compliance with air and water quality standards during 2018, 2019 and 2020 and the current estimate for 2021 are shown below. These investments include both environmental as well as other related spending. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends and the ability to access capital. In addition to the amounts set forth below, AEP expects to make substantial investments in future years in connection with the modification and addition at generation plants’ facilities for environmental quality controls. Such future investments are needed in order to comply with air and water quality standards that have been adopted and have deadlines for compliance after 2020 or have been proposed and may be adopted. Future investments could be significantly greater if emissions reduction requirements are accelerated or otherwise become more stringent. The cost of complying with applicable environmental laws, regulations and rules is expected to be material to the AEP System. AEP typically recovers costs of complying with environmental standards from customers through rates in regulated jurisdictions. Failure to recover these costs could reduce future net income and cash flows and possibly harm AEP’s financial condition. See “Environmental Issues” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report for additional information. +Historical and Projected Environmental Investments +2018 2019 2020 2021 +Actual Actual Actual Estimate (b) +(in millions) +AEP (a) $ 115.6 $ 167.1 $ 102.2 $ 133.8 +AEP Texas — (0.2) — — +APCo 20.4 23.8 21.3 60.6 +I&M 31.1 56.4 31.8 16.8 +SWEPCo 14.1 10.5 (3.6) 8.8 +(a) Includes expenditures of the subsidiaries shown and other subsidiaries not shown. The figures reflect construction expenditures, not investments in subsidiary companies. +(b) Estimated amounts are exclusive of debt AFUDC. +Management continues to refine the cost estimates of complying with air and water quality standards and other impacts of the environmental proposals. The following cost estimates for the years 2021 through 2027 will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules. These cost estimates will also change based on: (a) potential state rules that impose more stringent standards, +14 +(b) additional rulemaking activities in response to court decisions, (c) actual performance of the pollution control technologies installed, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired and replaced, including the type and amount of such replacement capacity and (g) other factors. Management’s current ranges of estimates of new major environmental investments beginning in 2021, exclusive of debt AFUDC, are set forth below: +Projected (2021 - 2027) +Environmental Investment +Company Low High +(in millions) +AEP $ 350 $ 700 +APCo 175 290 +I&M 25 45 +PSO 5 10 +SWEPCo 45 90 +HUMAN CAPITAL MANAGEMENT +Attracting, developing and retaining employees with the skills and experience needed to provide service to our customers efficiently and effectively is crucial to our long-term success and is central to our long-term strategy. AEP invests in employees and continues to build a high performance and inclusive culture that inspires leadership, encourages innovative thinking and welcomes everyone. +The following table shows AEP’s number of employees by subsidiary as of December 31, 2020: +Subsidiary Number of Employees +AEPSC 6,295 +AEP Texas 1,570 +APCo 1,652 +I&M 2,217 +OPCo 1,646 +PSO 1,023 +SWEPCo 1,440 +Other 944 +Total AEP 16,787 +Of AEP’s 16,787 employees, less than 1% are Traditionalists (born before 1946), approximately 27% are Baby Boomers (born 1946-1964), approximately 37% are Generation X (born 1965-1980), approximately 34% are Millennials (born 1981-1996) and approximately 1% are Generation Z (born after 1996). +Safety +Achieving Zero Harm means every employee returns home at the end of their shift in the same or better condition than when they came to work. Zero Harm is what we value most and commit to wholeheartedly. It is hard work, as it requires full focus every moment of every day. We hold ourselves accountable and we are always striving to be better. For AEP, Zero Harm is not an option; it is a mandate we live by. AEP has put tools, training and processes in place to strengthen our safety-first culture and mindset. AEP’s focus is on learning from events and developing leading indicators to be even more proactive in preventing harm. One common industry safety metric utilized by AEP to track incidents is the Days Away/Restricted or Transferred (DART) rate. A DART event is an event that results in one or more lost days, one or more restricted days or results in an employee transferring to a different job within the company. The DART rate is a mathematical calculation (number of DART events multiplied by 200,000 work hours and divided by total YTD hours worked) that describes the number of recordable injuries per 100 full-time employees. In 2020, AEP recognized its best safety performance in the past five years with an employee DART Rate of 0.310. +15 +Diversity and Inclusion +AEP is committed to cultivating a diverse and inclusive environment that supports the development and advancement of all. We foster an inclusive workplace that encourages diversity of thought, culture and background, and actively work to eliminate unconscious biases. We believe our workforce should reflect the diversity of our customers and the communities we serve so that we may better understand how to tailor our services to meet their demands and expectations. As of December 31, 2020, females comprised approximately 20% of AEP’s workforce while approximately 19% was represented by minorities. +AEP has taken actions to denounce all forms of racism in the wake of the racial and social unrest across the country. AEP Chief Executive Officer (CEO) Nicholas Akins joined more than 1,400 other CEOs as a signatory to the CEO Action for Diversity and Inclusion pledge, the largest CEO-driven business commitment to advancing diversity and inclusion within the workplace. To accelerate our diversity and inclusion strategy, AEP has initiated a “Seize the Moment: Let’s Keep the Momentum Going” action plan that included candid conversations about race, Town Hall webcasts and “Let’s Talk” discussions with the top 20 African American leaders at AEP. +Culture +AEP believes in doing the right thing every time for our customers, each other and our future. AEP leaders at all levels are responsible for fostering an environment that supports a positive culture and for acting in a manner that positively models it. Employees are given an opportunity to share their perspectives by participating in the Employee Culture Survey, administered by Gallup, Inc., that measures the progress we are making in improving our culture. In addition to engagement, the survey measures well-being and inclusiveness. In 2020, 93% of our organization participated in the survey and we improved our grand mean score to the top decile compared to Gallup’s overall company database. Company executives also have candid meetings with employees to discuss our challenges, opportunities, what is going well and what can be even better. +Employee Resource Groups +One of the best ways for AEP to demonstrate our commitment to a trusting and inclusive work environment is to empower employees to form and participate in Employee Resource Groups (ERG). The ERGs at AEP include Abled and Disabled Allies Partnering Together, the African-American ERG, the Asian-American ERG, the Hispanic Origin Latin American ERG, the Military Veteran ERG, the Native American ERG and the Pride Partnership. Our ERGs reflect the diverse makeup of our workforce and enable us to gain valuable insight into the diverse communities we serve. They also help increase engagement across AEP by providing employees with a safe space to discuss work-related issues and to develop innovative solutions. ERGs also play an active role in AEP’s diversity and inclusion efforts, including recruitment of new employees. In addition to the ERG’s, AEP also sponsors the AEP Women’s Leadership Council. The mission of this council is to educate, inspire and encourage women to build confidence and reflect on their goals as they strive for career and personal growth. +Training and Professional Development +At AEP, we are preparing our workforce for the future by providing opportunities to learn new skills and engaging higher education institutions to better prepare the next generation with the skills that we will need. AEP has training alliances with several community colleges, universities and vocational and technical schools across our service territory. We work with these institutions to develop academic programs that will prepare employees for upward mobility opportunities and to attract external job seekers interested in careers in our industry. AEP also provides a broad range of training and assistance that supports lifelong learning and transition development. This is especially important as we move closer toward a digital future that requires a more flexible, innovative and diverse workforce. AEP has robust processes to achieve this, including ongoing performance coaching, operational skills training, resources to support our commitment to environment, safety and health, job progression training, tuition assistance, and other forms of training that help employees improve their skills and become better leaders. +16 +Compensation and Benefits +AEP recognizes the importance of our employees to our success and we offer physical, financial and other health, wellness and assistance programs to our associates and their families to help them thrive at home and work. We ensure the pay we offer is competitive in the marketplace by using an overall market pricing process. In addition to competitive wages, nearly all AEP employees participate in an annual incentive program that rewards outstanding performance and achievement of business goals. Our incentive compensation provides financial rewards to those who contribute to business results and meet or exceed their personal performance goals, which fosters a high performance culture. AEP also offers employees physical and mental health programs, including medical, dental and life insurance, along with a health and well-being program to help employees and their families stay healthy and feeling their best. Additionally, AEP’s retirement programs position our associates for financial stability in retirement. +Labor Relations +Nearly one fourth of AEP’s workforce is represented by labor unions. We value the relationships we have with our unionized employees and believe in a trusting, collaborative and respectful partnership. We are working with our labor partners to strengthen these relationships to ensure we have a culture that attracts and supports employees who can adapt to the rapid changes occurring in our company and industry. Our partnership with labor unions is critical to meeting the growing expectations of our customers and adapting to the challenges of rapidly changing technologies. +BUSINESS SEGMENTS +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. AEP’s reportable segments are as follows: +• Vertically Integrated Utilities +• Transmission and Distribution Utilities +• AEP Transmission Holdco +• Generation & Marketing +The remainder of AEP’s activities is presented as Corporate and Other, which is not considered a reportable segment. See Note 9 - Business Segments included in the 2020 Annual Report for additional information on AEP’s segments. +17 +VERTICALLY INTEGRATED UTILITIES +GENERAL +AEP’s vertically integrated utility operations are engaged in the generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. AEPSC, as agent for AEP’s public utility subsidiaries, performs marketing, generation dispatch, fuel procurement and power-related risk management and trading activities on behalf of each of these subsidiaries. +ELECTRIC GENERATION +Facilities +As of December 31, 2020, AEP’s vertically integrated public utility subsidiaries owned or leased approximately 22,000 MWs of domestic generation. See Item 2 – Properties for more information regarding the generation capacity of vertically integrated public utility subsidiaries. +Fuel Supply +The following table shows the owned and leased generation sources by type (including wind purchase agreements), on an actual net generation (MWhs) basis, used by the Vertically Integrated Utilities: +2020 2019 2018 +Coal and Lignite 45% 54% 58% +Nuclear 24% 19% 18% +Natural Gas 18% 16% 14% +Renewables 13% 11% 10% +A price increase/decrease in one or more fuel sources relative to other fuels, as well as the addition of renewable resources or retirement of traditional fossil fuel units, may result in the decreased/increased use of other fuels. AEP’s overall 2020 fossil fuel costs for the Vertically Integrated Utilities decreased 3% on a dollar per MMBtu basis from 2019. +Coal and Lignite +AEP’s Vertically Integrated Utilities procure coal and lignite under a combination of purchasing arrangements including long-term contracts, affiliate operations and spot agreements with various producers, marketers and coal trading firms. Coal consumption in 2020 decreased approximately 27% from 2019 mainly due to lower dispatching of coal generation from weaker power market prices. +Management believes that the Vertically Integrated Utilities will be able to secure and transport coal and lignite of adequate quality and quantities to operate their coal and lignite-fired units. Through subsidiaries, AEP owns, leases or controls 3,016 railcars, 411 barges, 6 towboats and a coal handling terminal with approximately 18 million tons of annual capacity to move and store coal for use in AEP generating facilities. +Spot market prices for coal weakened during the first half of 2020 before stabilizing or slightly rebounding in the second half of 2020. The decreased spot coal prices reflect lower demand for domestic and export coal. AEP’s strategy for purchasing coal includes layering in supplies over time. The price impact of this process is reflected in subsequent periods and can occasionally cause current spot market prices to be trending opposite to the price of coal delivered. The price paid for coal delivered in 2020 increased approximately 18% from 2019 mainly due to lignite mine related activities and closure costs. +18 +The following table shows the amount of coal and lignite delivered to the Vertically Integrated Utilities’ plants during the past three years and the average delivered price of coal and lignite purchased by the Vertically Integrated Utilities: +2020 2019 2018 +Total coal and lignite delivered to the plants (in millions of tons) 19.4 30.4 29.0 +Average cost per ton of coal and lignite delivered $ 53.95 $ 45.85 $ 43.21 +The coal supplies at the Vertically Integrated Utilities plants vary from time to time depending on various factors, including, but not limited to, demand for electric power, unit outages, transportation infrastructure limitations, space limitations, plant coal consumption rates, availability of acceptable coals, labor issues and weather conditions, which may interrupt production or deliveries. As of December 31, 2020, the Vertically Integrated Utilities’ coal inventory was approximately 64 days of full load burn. While inventory targets vary by plant and are changed as necessary, the current coal inventory target for the Vertically Integrated Utilities is approximately 30 days of full load burn. +Natural Gas +The Vertically Integrated Utilities consumed approximately 113 billion cubic feet of natural gas during 2020 for generating power. This represents a decrease of 3.33% from 2019. Several of AEP’s natural gas-fired power plants are connected to at least two pipelines which allow greater access to competitive supplies and improve delivery reliability. A portfolio of term, monthly and daily supply and transportation agreements provide natural gas requirements for each plant, as appropriate. AEP’s natural gas supply transactions are entered into on a competitive basis and based on market prices. +The following table shows the amount of natural gas delivered to the Vertically Integrated Utilities’ plants during the past three years and the average delivered price of natural gas purchased by the Vertically Integrated Utilities. +2020 2019 2018 +Total natural gas delivered to the plants (in billions cubic feet) 113.1 117.0 111.6 +Average delivered price per MMBtu of purchased natural gas $ 2.14 $ 2.64 $ 3.26 +Nuclear +I&M has made commitments to meet the current nuclear fuel requirements of the Cook Plant. I&M has made and will make purchases of uranium in various forms in the spot, short-term and mid-term markets. I&M also continues to finance its nuclear fuel through leasing. +For purposes of the storage of high-level radioactive waste in the form of SNF, I&M completed modifications to its SNF storage pool in the early 1990’s. I&M entered into an agreement to provide for onsite dry cask storage of SNF to permit normal operations to continue. I&M is scheduled to conduct further dry cask loading and storage projects on an ongoing periodic basis. The year of expiration of each NRC Operating License is 2034 for Unit 1 and 2037 for Unit 2. +Nuclear Waste and Decommissioning +As the owner of the Cook Plant, I&M has a significant future financial commitment to dispose of SNF and decommission and decontaminate the plant safely. The cost to decommission a nuclear plant is affected by NRC regulations and the SNF disposal program. The most recent decommissioning cost study was completed in 2018. The estimated cost of decommissioning and disposal of low-level radioactive waste for the Cook Plant was $2 billion in 2018 non-discounted dollars, with additional ongoing estimated costs of $6 million per year for post decommissioning storage of SNF and an eventual estimated cost of $37 million for the subsequent decommissioning of the spent fuel storage facility, also in 2018 non-discounted dollars. As of December 31, 2020 and 2019, the total decommissioning trust fund balance for the Cook Plant was approximately $3 billion and $2.7 +19 +billion, respectively. The balance of funds available to eventually decommission Cook Plant will differ based on contributions and investment returns. The ultimate cost of retiring the Cook Plant may be materially different from estimates and funding targets as a result of the: +• Escalation of various cost elements (including, but not limited to, general inflation and the cost of energy). +• Further development of regulatory requirements governing decommissioning. +• Technology available at the time of decommissioning differing significantly from that assumed in studies. +• Availability of nuclear waste disposal facilities. +• Availability of a United States Department of Energy facility for permanent storage of SNF. +Accordingly, management is unable to provide assurance that the ultimate cost of decommissioning the Cook Plant will not be significantly different than current projections. AEP will seek recovery from customers through regulated rates if actual decommissioning costs exceed projections. See the “Nuclear Contingencies” section of Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report for additional information with respect to nuclear waste and decommissioning. +Low-Level Radioactive Waste +The Low-Level Waste Policy Act of 1980 mandates that the responsibility for the disposal of low-level radioactive waste rests with the individual states. Low-level radioactive waste consists largely of ordinary refuse and other items that have come in contact with radioactive materials. Michigan does not currently have a disposal site for such waste available. I&M cannot predict when such a site may be available. However, the states of Utah and Texas have licensed low-level radioactive waste disposal sites which currently accept low-level radioactive waste from Michigan waste generators. There is currently no set date limiting I&M’s access to either of these facilities. The Cook Plant has a facility onsite designed specifically for the storage of low-level radioactive waste. In the event that low-level radioactive waste disposal facility access becomes unavailable, it can be stored onsite at this facility. +Counterparty Risk Management +The Vertically Integrated Utilities segment also sells power and enters into related energy transactions with wholesale customers and other market participants. As a result, counterparties and exchanges may require cash or cash related instruments to be deposited on transactions as margin against open positions. As of December 31, 2020, counterparties posted approximately $13 million in cash, cash equivalents or letters of credit with AEPSC for the benefit of AEP’s public utility subsidiaries (while, as of that date, AEP’s public utility subsidiaries posted approximately $19 million with counterparties and exchanges). Since open trading contracts are valued based on market prices of various commodities, exposures change daily. See the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Certain Power Agreements +I&M +The UPA between AEGCo and I&M, dated March 31, 1982 (the I&M Power Agreement), provides for the sale by AEGCo to I&M of all the capacity (and the energy associated therewith) available to AEGCo at the Rockport Plant. Whether or not power is available from AEGCo, I&M is obligated to pay a demand charge for the right to receive such power (and an energy charge for any associated energy taken by I&M). The I&M Power Agreement will continue in effect until the debt obligations of AEGCo secured by the Rockport Plant have been satisfied and discharged (currently expected to be December 2028). +20 +Pursuant to an assignment between I&M and KPCo, and a UPA between AEGCo and KPCo, AEGCo sells KPCo 30% of the capacity (and the energy associated therewith) available to AEGCo from both units of the Rockport Plant. KPCo has agreed to pay to AEGCo the amounts that I&M would have paid AEGCo under the terms of the UPA between AEGCo and I&M for such entitlement. The KPCo UPA expires in December 2022. +OVEC +AEP and several nonaffiliated utility companies jointly own OVEC. The aggregate equity participation of AEP in OVEC is 43.47%. Parent owns 39.17% and OPCo owns 4.3%. Under the Inter-Company Power Agreement (ICPA), which defines the rights of the owners and sets the power participation ratio of each, the sponsoring companies are entitled to receive and are obligated to pay for all OVEC capacity (approximately 2,400 MWs) in proportion to their respective power participation ratios. The aggregate power participation ratio of APCo, I&M and OPCo is 43.47%. The ICPA terminates in June 2040. The proceeds from charges by OVEC to sponsoring companies under the ICPA based on their power participation ratios are designed to be sufficient for OVEC to meet its operating expenses and fixed costs. OVEC’s Board of Directors, as elected by AEP and nonaffiliated owners, has authorized environmental investments related to their ownership interests, with resulting expenses (including for related debt and interest thereon) included in charges under the ICPA. OVEC financed capital expenditures totaling $1.3 billion in connection with flue gas desulfurization projects and the associated scrubber waste disposal landfills at its two generation plants through debt issuances, including tax-advantaged debt issuances. Both OVEC generation plants are operating with the new environmental controls in-service. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. +ELECTRIC DELIVERY +General +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries own and operate transmission and distribution lines and other facilities to deliver electric power. See Item 2 – Properties for more information regarding the transmission and distribution lines. Most of the transmission and distribution services are sold to retail customers of AEP’s vertically integrated public utility subsidiaries in their service territories. These sales are made at rates approved by the state utility commissions of the states in which they operate, and in some instances, approved by the FERC. See Item 1. Business – Vertically Integrated Utilities – Regulation – Rates. The FERC regulates and approves the rates for both wholesale transmission transactions and wholesale generation contracts. The use and the recovery of costs associated with the transmission assets of the AEP vertically integrated public utility subsidiaries are subject to the rules, principles, protocols and agreements in place with PJM and SPP, and as approved by the FERC. See Item 1. Business – Vertically Integrated Utilities – Regulation – FERC. As discussed below, some transmission services also are separately sold to nonaffiliated companies. +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries hold franchises or other rights to provide electric service in various municipalities and regions in their service areas. In some cases, these franchises provide the utility with the exclusive right to provide electric service within a specific territory. These franchises have varying provisions and expiration dates. In general, the operating companies consider their franchises to be adequate for the conduct of their business. For a discussion of competition in the sale of power, see Item 1. Business – Vertically Integrated Utilities – Competition. +Transmission Agreement +APCo, I&M, KGPCo, KPCo and WPCo own and operate transmission facilities that are used to provide transmission service under the PJM OATT and are parties to the TA. OPCo, which is a subsidiary in AEP’s Transmission and Distribution Utilities segment that provides transmission service under the PJM OATT, is also a party to the TA. The TA defines how the parties to the agreement share the revenues associated with their transmission facilities and the costs of transmission service provided by PJM. The TA has been approved by the FERC. +21 +Transmission Coordination Agreement and Open Access Transmission Tariff +PSO, SWEPCo and AEPSC are parties to the TCA. Under the TCA, a coordinating committee is charged with the responsibility of: (a) overseeing the coordinated planning of the transmission facilities of the parties to the agreement, including the performance of transmission planning studies, (b) the interaction of such subsidiaries with independent system operators and other regional bodies interested in transmission planning and (c) compliance with the terms of the OATT filed with the FERC and the rules of the FERC relating to such tariff. Pursuant to the TCA, AEPSC has responsibility for monitoring the reliability of their transmission systems and administering the OATT on behalf of the other parties to the agreement. The TCA also provides for the allocation among the parties of revenues collected for transmission and ancillary services provided under the OATT. These allocations have been determined by the FERC-approved OATT for the SPP. +Regional Transmission Organizations +AEGCo, APCo, I&M, KGPCo, KPCo and WPCo are members of PJM, and PSO and SWEPCo are members of SPP (both FERC-approved RTOs). RTOs operate, plan and control utility transmission assets in a manner designed to provide open access to such assets in a way that prevents discrimination between participants owning transmission assets and those that do not. +REGULATION +General +AEP’s vertically integrated public utility subsidiaries’ retail rates and certain other matters are subject to traditional cost-based regulation by the state utility commissions. AEP’s vertically integrated public utility subsidiaries are also subject to regulation by the FERC under the Federal Power Act with respect to wholesale power and transmission service transactions. I&M is subject to regulation by the NRC under the Atomic Energy Act of 1954, as amended, with respect to the operation of the Cook Plant. AEP and its vertically integrated public utility subsidiaries are also subject to the regulatory provisions of, much of the Energy Policy Act of 2005, which is administered by the FERC. +Rates +Historically, state utility commissions have established electric service rates on a cost-of-service basis, which is designed to allow a utility an opportunity to recover its cost of providing service and to earn a reasonable return on its investment used in providing that service. A utility’s cost-of-service generally reflects its operating expenses, including operation and maintenance expense, depreciation expense and taxes. State utility commissions periodically adjust rates pursuant to a review of: (a) a utility’s adjusted revenues and expenses during a defined test period and (b) such utility’s level of investment. Absent a legal limitation, such as a law limiting the frequency of rate changes or capping rates for a period of time, a state utility commission can review and change rates on its own initiative. Some states may initiate reviews at the request of a utility, customer, governmental or other representative of a group of customers. Such parties may, however, agree with one another not to request reviews of or changes to rates for a specified period of time. +Public utilities have traditionally financed capital investments until the new asset is placed in-service. Provided the asset was found to be a prudent investment, it was then added to rate base and entitled to a return through rate recovery. Given long lead times in construction, the high costs of plant and equipment and volatile capital markets, management actively pursues strategies to accelerate rate recognition of investments and cash flow. AEP representatives continue to engage state commissioners and legislators on alternative rate-making options to reduce regulatory lag and enhance certainty in the process. These options include pre-approvals, a return on construction work in progress, rider/trackers, formula rates and the inclusion of future test-year projections into rates. +22 +The rates of AEP’s vertically integrated public utility subsidiaries are generally based on the cost of providing traditional bundled electric service (i.e., generation, transmission and distribution service). Historically, the state regulatory frameworks in the service area of the AEP vertically integrated public utility subsidiaries reflected specified fuel costs as part of bundled (or, more recently, unbundled) rates or incorporated fuel adjustment clauses in a utility’s rates and tariffs. Fuel adjustment clauses permit periodic adjustments to fuel cost recovery from customers and therefore provide protection against exposure to fuel cost changes. +The following state-by-state analysis summarizes the regulatory environment of certain major jurisdictions in which AEP’s vertically integrated public utility subsidiaries operate. Several public utility subsidiaries operate in more than one jurisdiction. See Note 4 - Rate Matters included in the 2020 Annual Report for more information regarding pending rate matters. +Indiana +I&M provides retail electric service in Indiana at bundled rates approved by the IURC, with rates set on a cost-of-service basis. Indiana provides for timely fuel and purchased power cost recovery through a fuel cost recovery mechanism. +Oklahoma +PSO provides retail electric service in Oklahoma at bundled rates approved by the OCC. PSO’s rates are set on a cost-of-service basis. Fuel and purchased energy costs are recovered or refunded by applying fuel adjustment and other factors to retail kilowatt-hour sales. +Virginia +APCo currently provides retail electric service in Virginia at unbundled generation and distribution rates approved by the Virginia SCC. Virginia generally allows for timely recovery of fuel costs through a FAC. In addition to base rates and fuel cost recovery, APCo is permitted to recover a variety of costs through rate adjustment clauses including transmission services provided at OATT rates based on rates established by the FERC. +West Virginia +APCo and WPCo provide retail electric service at bundled rates approved by the WVPSC, with rates set on a combined cost-of-service basis. West Virginia generally allows for timely recovery of fuel costs through the ENEC which trues-up to actual expenses. +FERC +The FERC regulates rates for interstate power sales at wholesale, transmission of electric power, accounting and other matters, including construction and operation of hydroelectric projects. The FERC regulations require AEP’s vertically integrated public utility subsidiaries to provide open access transmission service at FERC-approved rates, and AEP has approved cost-based formula transmission rates on file at the FERC. The FERC also regulates unbundled transmission service to retail customers. In addition, the FERC regulates the sale of power for resale in interstate commerce by: (a) approving contracts for wholesale sales to municipal and cooperative utilities and (b) granting authority to public utilities to sell power at wholesale at market-based rates upon a showing that the seller lacks the ability to improperly influence market prices. AEP’s vertically integrated public utility subsidiaries have market-based rate authority from the FERC, under which much of their wholesale marketing activity takes place. The FERC requires each public utility that owns or controls interstate transmission facilities, directly or through an RTO, to file an open access network and point-to-point transmission tariff that offers services comparable to the utility’s own uses of its transmission system. The FERC also requires all transmitting utilities, directly or through an RTO, to establish an Open Access Same-time Information System, which electronically posts transmission information such as available capacity and prices, and requires utilities to comply with Standards of Conduct that prohibit utilities’ transmission employees from providing non-public transmission information to the utility’s marketing employees. Additionally, the vertically integrated public utility subsidiaries are subject to reliability standards promulgated by the NERC, with the approval of the FERC. +23 +The FERC oversees RTOs, entities created to operate, plan and control utility transmission assets. AEGCo, APCo, I&M, KGPCo, KPCo and WPCo are members of PJM. PSO and SWEPCo are members of SPP. +The FERC has jurisdiction over the issuances of securities of most of AEP’s public utility subsidiaries, the acquisition of securities of utilities, the acquisition or sale of certain utility assets and mergers with another electric utility or holding company. In addition, both the FERC and state regulators are permitted to review the books and records of any company within a holding company system. +COMPETITION +Other than AEGCo, AEP’s vertically integrated public utility subsidiaries generate, transmit and distribute electricity to retail customers of AEP’s vertically integrated public utility subsidiaries in their service territories. These sales are made at rates approved by the state utility commissions of the states in which they operate, and in some instances, approved by the FERC, and are not subject to competition from other vertically integrated public utilities. Other than AEGCo, AEP’s vertically integrated public utility subsidiaries hold franchises or other rights that effectively grant the exclusive ability to provide electric service in various municipalities and regions in their service areas. +AEP’s vertically integrated public utility subsidiaries compete with self-generation and with distributors of other energy sources, such as natural gas, fuel oil, renewables and coal, within their service areas. The primary factors in such competition are price, reliability of service and the capability of customers to utilize alternative sources of energy other than electric power. With respect to competing generators and self-generation, the public utility subsidiaries of AEP believe that they currently maintain a competitive position. +Changes in regulatory policies and advances in newer technologies for batteries or energy storage, fuel cells, microturbines, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production. The costs of photovoltaic solar cells in particular have continued to become increasingly competitive. The ability to maintain relatively low cost, efficient and reliable operations and to provide cost-effective programs and services to customers are significant determinants of AEP’s competitiveness. +SEASONALITY +The consumption of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter. The pattern of this fluctuation may change due to the nature and location of AEP’s facilities and the terms of power sale contracts into which AEP enters. In addition, AEP has historically sold less power, and consequently earned less income, when weather conditions are milder. Unusually mild weather in the future could diminish AEP’s results of operations. Conversely, unusually extreme weather conditions could increase AEP’s results of operations. +TRANSMISSION AND DISTRIBUTION UTILITIES +GENERAL +This segment consists of the transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo. OPCo is engaged in the transmission and distribution of electric power to approximately 1,507,000 retail customers in Ohio. OPCo purchases energy and capacity to serve standard service offer customers and provides transmission and distribution services for all connected load. AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,068,000 retail customers through REPs in west, central and southern Texas. +AEP’s transmission and distribution utility subsidiaries own and operate transmission and distribution lines and other facilities to deliver electric power. See Item 2 – Properties, for more information regarding the transmission +24 +and distribution lines. Transmission and distribution services are sold to retail customers of AEP’s transmission and distribution utility subsidiaries in their service territories. These sales are made at rates approved by the PUCT for AEP Texas and by the PUCO and the FERC for OPCo. The FERC regulates and approves the rates for wholesale transmission transactions. As discussed below, some transmission services also are separately sold to nonaffiliated companies. +AEP’s transmission and distribution utility subsidiaries hold franchises or other rights to provide electric service in various municipalities and regions in their service areas. In some cases, these franchises provide the utility with the exclusive right to provide electric service. These franchises have varying provisions and expiration dates. In general, the operating companies consider their franchises to be adequate for the conduct of their business. +The use and the recovery of costs associated with the transmission assets of the AEP transmission and distribution utility subsidiaries are subject to the rules, protocols and agreements in place with PJM and ERCOT, and as approved by the FERC. In addition to providing transmission services in connection with power sales in their service areas, AEP’s transmission and distribution utility subsidiaries also provide transmission services for nonaffiliated companies through RTOs. +Transmission Agreement +OPCo owns and operates transmission facilities that are used to provide transmission service under the PJM OATT; OPCo is a party to the TA with other utility subsidiary affiliates. The TA defines how the parties to the agreement share the revenues associated with their transmission facilities and the costs of transmission service provided by PJM. The TA has been approved by the FERC. +Regional Transmission Organizations +OPCo is a member of PJM, a FERC-approved RTO. RTOs operate, plan and control utility transmission assets to provide open access to such assets in a way that prevents discrimination between participants owning transmission assets and those that do not. AEP Texas is a member of ERCOT. +REGULATION +OPCo provides distribution and transmission services to retail customers within its service territory at cost-based rates approved by the PUCO or by the FERC. AEP Texas provides transmission and distribution service on a cost-of-service basis at rates approved by the PUCT and wholesale transmission service under tariffs approved by the FERC consistent with PUCT rules. Transmission and distribution rates are established on a cost-of-service basis, which is designed to allow a utility an opportunity to recover its cost of providing service and to earn a reasonable return on its investment used in providing that service. The cost-of-service generally reflects operating expenses, including operation and maintenance expense, depreciation expense and taxes. Utility commissions periodically adjust rates pursuant to a review of: (a) a utility’s adjusted revenues and expenses during a defined test period and (b) such utility’s level of investment. +FERC +The FERC regulates rates for transmission of electric power, accounting and other matters. The FERC regulations require AEP to provide open access transmission service at FERC-approved rates, and it has approved cost-based formula transmission rates on file at the FERC. The FERC also regulates unbundled transmission service to retail customers. The FERC requires each public utility that owns or controls interstate transmission facilities to, directly or through an RTO, file an open access network and point-to-point transmission tariff that offers services comparable to the utility’s own uses of its transmission system. The FERC also requires all transmitting utilities, directly or through an RTO, to establish an Open Access Same-time Information System, which electronically posts transmission information such as available capacity and prices, and requires utilities to comply with Standards of Conduct that prohibit utilities’ transmission employees from providing non-public transmission information to the utility’s marketing employees. In addition, both the FERC and state regulators are permitted to review the books +25 +and records of any company within a holding company system. Additionally, the transmission and distribution utility subsidiaries are subject to reliability standards as set forth by the NERC, with the approval of the FERC. +SEASONALITY +The delivery of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months. In other areas, power demand peaks during the winter months. The pattern of this fluctuation may change due to the nature and location of AEP’s transmission and distribution facilities. In addition, AEP transmission and distribution has historically delivered less power, and consequently earned less income, when weather conditions are milder. In Texas, and to a lesser extent, in Ohio, where there is residential decoupling, unusually mild weather in the future could diminish AEP’s results of operations. Conversely, unusually extreme weather conditions could increase AEP’s results of operations. +AEP TRANSMISSION HOLDCO +GENERAL +AEPTHCo is a holding company for (a) AEPTCo, which is the direct holding company for the State Transcos and (b) AEP’s Transmission Joint Ventures. +AEPTCo +AEPTCo wholly owns the State Transcos which are independent of, but respectively overlay, the following AEP electric utility operating companies: APCo, I&M, KPCo, OPCo, PSO, SWEPCo, and WPCo. The State Transcos develop, own, operate, and maintain their respective transmission assets. Assets of the State Transcos interconnect to transmission facilities owned by the aforementioned operating companies and nonaffiliated transmission owners within the footprints of PJM, MISO and SPP. APTCo, IMTCo, KTCo, OHTCo, and WVTCo are located within PJM. IMTCo also owns portions of the Greentown station assets located in MISO. OKTCo and SWTCo are located within SPP. +IMTCo, KTCo, OHTCo, OKTCo, and WVTCo own and operate transmission assets in their respective jurisdictions. The Virginia SCC and WVPSC granted consent for APCo and APTCo to enter into a joint license agreement that will support APTCo investment in the state of Tennessee. SWTCo does not currently own or operate transmission assets. +The State Transcos are regulated for rate-making purposes exclusively by the FERC and earn revenues through tariff rates charged for the use of their electric transmission systems. The State Transcos establish transmission rates each year through formula rate filings with the FERC. The rate filings calculate the revenue requirement needed to cover the costs of operation and debt service and to earn an allowed ROE. These rates are then included in an OATT for PJM, MISO and SPP. +The State Transcos own, operate, maintain and invest in transmission infrastructure in order to maintain and enhance system integrity and grid reliability, grid security, safety, reduce transmission constraints and facilitate interconnections of new generating resources and new wholesale customers, as well as enhance competitive wholesale electricity markets. A key part of AEP’s business is replacing and upgrading transmission facilities, assets and components of the existing AEP System as needed to maintain reliability. +The State Transcos provide the capability to build, replace and upgrade existing facilities. As of December 31, 2020, the State Transcos had $9.9 billion of transmission and other assets in-service with plans to construct approximately $4.2 billion of additional transmission assets through 2023. Additional investment in transmission infrastructure is needed within PJM and SPP to maintain the required level of grid reliability, resiliency, security and efficiency and to address an aging transmission infrastructure. Additional transmission facilities will be needed based on changes in generating resources, such as wind or solar projects, generation additions or retirements, and additional new customer interconnections. The State Transcos will continue their investment to enhance physical and cyber security of assets, and are also investing in improving the telecommunication network that supports the operation and control of the grid. +26 +AEPTHCO JOINT VENTURE INITIATIVES +AEP has established joint ventures with other electric utility companies for the purpose of developing, building, and owning transmission assets that seek to improve reliability and market efficiency and provide transmission access to remote generation sources in North America (Transmission Joint Ventures). +The Transmission Joint Ventures currently include: +Joint Venture Name Location Projected or Actual Completion Date Owners +(Ownership %) Total Estimated/Actual Project Costs at Completion Approved Return on Equity +(in millions) +ETT Texas (a) Berkshire Hathaway $ 3,500.0 (a) 9.6 % +(ERCOT) Energy (50%) +AEP (50%) +Prairie Wind Kansas 2014 Evergy, Inc. (50%) 158.0 12.8 % +Berkshire Hathaway Energy (25%) +AEP (25%) +Pioneer Indiana 2018 Duke Energy (50%) 191.0 10.52 % (b) +AEP (50%) +Transource Missouri 2016 Evergy, Inc. 310.5 11.1 % (c) +Missouri (13.5%) (d) +AEP (86.5%) (d) +Transource West 2019 Evergy, Inc. 84.0 10.5 % +West Virginia Virginia (13.5%) (d) +AEP (86.5%) (d) +Transource Maryland 2023 Evergy, Inc. 20.9 (e) 10.4 % +Maryland (13.5%) (d) +AEP (86.5%) (d) +Transource Pennsylvania 2023 Evergy, Inc. 248.6 (e) 10.4 % +Pennsylvania (13.5%) (d) +AEP (86.5%) (d) +Transource Oklahoma 2026 Evergy, Inc. 112.6 (f) 10.3 % +Oklahoma (13.5%(d) +AEP (86.5%) (d) +(a) ETT is undertaking multiple projects and the completion dates will vary for those projects. ETT’s investment in completed and active projects in ERCOT is expected to be $3.5 billion. Future projects will be evaluated on a case-by-case basis. +(b) In May 2020, Pioneer received FERC approval authorizing an ROE of 10.02% (10.52% inclusive of the RTO incentive adder of 0.5%). +(c) The ROE represents the weighted-average approved ROE based on the costs of two projects developed by Transource Missouri; the $64 million Iatan-Nashua project (10.3%) and the $247 million Sibley-Nebraska City project (11.3%). +(d) AEP owns 86.5% of Transource Missouri, Transource West Virginia, Transource Maryland, Transource Pennsylvania and Transource –Sooner-Wekiwa through its ownership interest in Transource Energy, LLC (Transource). Transource is a joint venture with AEPTHCo and Evergy, Inc. formed to pursue competitive transmission projects. AEPTHCo and Evergy, Inc. own 86.5% and 13.5% of Transource, respectively. +(e) In August 2016, Transource Maryland and Transource Pennsylvania received approval from the PJM Interconnection Board to construct portions of a transmission project located in both Maryland and Pennsylvania. The project is expected to go in-service in 2023. Project costs are in 2020 dollars. +(f) In 2016, Transource Kansas received approval from the FERC authorizing an ROE of 9.8% (10.3% inclusive of the RTO incentive adder of 0.5%) for future competitive transmission projects in SPP. In October 2020, Transource was awarded the Sooner-Wekiwa project by SPP and the project was assigned to Transource Kansas. In November 2020, Transource Kansas was renamed Transource Oklahoma. The project is expected to go in-service in 2026. +Transource Missouri, Transource West Virginia, Transource Maryland, Transource Pennsylvania and Transource Oklahoma are consolidated joint ventures by AEP. All other joint ventures in the table above are not consolidated by AEP. AEP’s joint ventures do not have employees. Business services for the joint ventures are provided by AEPSC and other AEP subsidiaries and the joint venture partners. During 2020, approximately 514 AEPSC employees and 271 operating company employees provided service to one or more joint ventures. +27 +REGULATION +The State Transcos and the Transmission Joint Ventures located outside of ERCOT establish transmission rates annually through forward-looking formula rate filings with the FERC pursuant to FERC-approved implementation protocols. The protocols include a transparent, formal review process to ensure the updated transmission rates are prudently-incurred and reasonably calculated. The IMTCo-owned Greentown station assets acquired from Duke Energy Indiana, LLC in December 2018 are located in MISO. IMTCo utilizes a historic cost recovery model to recover MISO assets. +The State Transcos’ and the Transmission Joint Ventures’ (where applicable) rates are included in the respective OATT for PJM and SPP. An OATT is the FERC rate schedule that provides the terms and conditions for transmission and related services on a transmission provider’s transmission system. The FERC requires transmission providers such as PJM and SPP to offer transmission service to all eligible customers (for example, load-serving entities, power marketers, generators and customers) on a non-discriminatory basis. +The FERC-approved formula rates establish the annual transmission revenue requirement (ATRR) and transmission service rates for transmission owners in annual rate base filings with the FERC. The formula rates establish rates for a one-year period based on the current projects in-service and proposed projects for a defined timeframe. The formula rates also include a true-up calculation for the previous year’s billings, allowing for over/under-recovery of the transmission owner’s ATRR. PJM and SPP pay the transmission owners their ATRR for use of their facilities and bill transmission customers taking service under the PJM and SPP OATTs, based on the terms and conditions in the respective OATT for the service taken. Additionally, the State Transcos are subject to reliability standards promulgated by the NERC, with the approval of the FERC. +Management continues to monitor the FERC’s 2019 Notice of Inquiry regarding base ROE policy, the FERC’s 2020 Notice of Proposed Rulemaking regarding transmission incentives policy, and various other matters pending before the FERC with the potential to affect the transmission ROE methodology. +In the second quarter of 2019, the FERC approved settlement agreements establishing base ROEs of 9.85% (10.35% inclusive of RTO incentive adder of 0.5%) and 10% (10.5% inclusive of RTO incentive adder of 0.5%) for AEP’s PJM and SPP transmission-owning subsidiaries, respectively. In the second quarter of 2020, FERC Order 569A determined the base ROE for MISO’s transmission owning members, including AEP’s MISO transmission-owning subsidiaries, should be 10.02% (10.52% inclusive of the RTO incentive adder of 0.5%). +If the FERC makes any changes to its ROE and incentive policies, they would be applied, as applicable, to AEP’s PJM, SPP and MISO transmission owning subsidiaries on a prospective basis, and could affect future net income and cash flows and impact financial condition. +In the annual rate base filings described above, the State Transcos in aggregate filed rate base totals of $7.0 billion, $5.9 billion and $4.6 billion for 2020, 2019 and 2018, respectively. The total filed transmission revenue requirements, including prior year over/under-recovery of revenue and associated carrying charges were $1.2 billion, $992 million and $829 million for 2020, 2019, and 2018, respectively. +The rates of ETT, which is located in ERCOT, are determined by the PUCT. ETT sets its rates through a combination of base rate cases and interim Transmission Cost of Services (TCOS) filings. ETT may file interim TCOS filings semi-annually to update its rates to reflect changes in its net invested capital. +The Transmission Joint Ventures have approved ROEs ranging from 9.6% to 12.8% based on equity capital structures ranging from 40% to 60%. +28 +GENERATION & MARKETING +GENERAL +The AEP Generation & Marketing segment subsidiaries consist of a wholesale energy trading and marketing business, a retail supply and energy management business and competitive generating assets. +AEP Energy Supply, LLC is a holding company with several divisions, including AEP Renewables and AEP OnSite Partners. +AEP Renewables develops, owns and operates utility scale renewable projects backed with long-term contracts with creditworthy counterparties throughout the United States. AEP Renewables works directly with stakeholders to ensure that customers have clean, sustainable renewable energy to meet their environmental goals. As of December 31, 2020, AEP Renewables owned projects operating in 11 states, including approximately 1,307 MWs of installed wind capacity and 90 MWs of installed solar capacity. In October 2019, AEP Renewables entered into an agreement to construct Flat Ridge 3, a wind farm in Kansas. The 128 MW facility is expected to reach commercial operation by May 2021. In November 2020, AEP Renewables signed a Purchase and Sale Agreement to acquire 75% of the Dry Lake Solar Project, a 100 MW solar facility in southern Nevada. This facility is expected to be in-service in the second quarter of 2021. +AEP OnSite Partners works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. AEP OnSite Partners targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2020, AEP OnSite Partners owned projects located in 21 states, including approximately 152 MWs of installed solar capacity, and approximately 9 MWs of solar projects under construction. +With respect to the wholesale energy trading and marketing business, AEP Generation & Marketing segment subsidiaries enter into short-term and long-term transactions to buy or sell capacity, energy and ancillary services in ERCOT, SPP, MISO and PJM. These subsidiaries sell power into the market and engage in power, natural gas and emissions allowances risk management and trading activities. These activities primarily involve the purchase-and-sale of electricity (and to a lesser extent, natural gas and emissions allowances) under forward contracts at fixed and variable prices. These contracts include physical transactions, exchange-traded futures, and to a lesser extent, OTC swaps and options. The majority of forward contracts are typically settled by entering into offsetting contracts. These transactions are executed with numerous counterparties or on exchanges. +With respect to the retail supply and energy management business, AEP Energy is a retail energy supplier that supplies electricity and/or natural gas to residential, commercial, and industrial customers. AEP Energy provides various energy solutions in Illinois, Pennsylvania, Delaware, Maryland, New Jersey, Ohio and Washington, D.C. AEP Energy had approximately 510,000 customer accounts as of December 31, 2020. +The primary fossil generation subsidiary in the Generation & Marketing segment is AGR. As of December 31, 2020, AGR owns 643 MWs of generating capacity, almost all of which is operated by Buckeye Power, a nonaffiliated electric cooperative. Other subsidiaries in this segment own or have the right to receive power from additional generation assets . See Item 2 – Properties for more information regarding the generation assets of the Generation & Marketing segment. AGR is a competitive generation subsidiary. +REGULATION +AGR is a public utility under the Federal Power Act, and is subject to the FERC’s exclusive rate-making jurisdiction over wholesale sales of electricity and the transmission of electricity in interstate commerce. Under the Federal Power Act, the FERC has the authority to grant or deny market-based rates for sales of energy, capacity and ancillary services to ensure that such sales are just and reasonable. The FERC granted AGR market-based rate authority in December 2013. The FERC’s jurisdiction over rate-making also includes the authority to suspend the +29 +market-based rates of AGR and set cost-based rates if the FERC subsequently determines that it can exercise market power, create barriers to entry or engage in abusive affiliate transactions. Periodically, AGR is required to file a market power update to show that it continues to meet the FERC’s standards with respect to generation market power and other criteria used to evaluate whether it continues to qualify for market-based rates. Other matters subject to the FERC jurisdiction include, but are not limited to, review of mergers, and dispositions of jurisdictional facilities and acquisitions of securities of another public utility or an existing operational generating facility. +Specific operations of AGR are also subject to the jurisdiction of various other federal, state, regional and local agencies, including federal and state environmental protection agencies. AGR is also regulated by the PUCT for transactions inside ERCOT. Additionally, AGR is subject to mandatory reliability standards promulgated by the NERC, with the approval of the FERC. +COMPETITION +The AEP Generation & Marketing segment subsidiaries face competition for the sale of available power, capacity and ancillary services. The principal factors of impact are electricity and fuel prices, new market entrants, construction or retirement of generating assets by others and technological advances in power generation. Because most of AGR’s remaining generation is coal-fired, lower relative natural gas prices will favor competitors that have a higher concentration of natural gas fueled generation. Other factors impacting competitiveness include environmental regulation, transmission congestion or transportation constraints at or near generation facilities, inoperability or inefficiencies, outages and deactivations and retirements at generation facilities. +Technology advancements, increased demand for clean energy, changing consumer behaviors, low-priced and abundant natural gas, and regulatory and public policy reforms are among the catalysts for transformation within the industry that impact competition for AEP’s Generation & Marketing segment. AGR also competes with self-generation and with distributors of other energy sources, such as natural gas, fuel oil, renewables and coal, within their service areas. The primary factors in such competition are price, unit availability and the capability of customers to utilize sources of energy other than electric power. +Changes in regulatory policies and advances in newer technologies for batteries or energy storage, fuel cells, microturbines, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production. The ability to maintain relatively low cost, efficient and reliable operations and to provide cost-effective programs and services to customers are significant determinants of AGR’s competitiveness. The costs of photovoltaic solar cells in particular have continued to become increasingly competitive. +This segment’s retail operations provide competitive electricity and natural gas in deregulated retail energy markets in six states and Washington, D.C. Each such retail choice jurisdiction establishes its own laws and regulations governing its competitive market, and public utility commission communications and utility default service pricing can affect customer participation in retail competition. Sustained low natural gas and power prices, low market volatility and maturing competitive environments can adversely affect this business. +This segment also engages in procuring and selling output from renewable generation sources under long-term contracts to creditworthy counterparties. New sources are not acquired without first securing a long-term placement of such power. Existing sources do not face competitive exposure. Competitive nonaffiliated suppliers of renewable or other generation could limit opportunities for future transactions for new sources and related output contracts. +SEASONALITY +The consumption of electric power is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter months. The pattern of this fluctuation may change. +30 +Fuel Supply +The following table shows the generation sources by type, on an actual net generation (MWhs) basis, used by the Generation & Marketing segment, not including AEP Energy Partners’ offtake agreement from the Oklaunion Power Station which was retired in September 2020: +2020 2019 2018 +Coal 46% 64% 88% +Renewables 54% 36% 12% +Coal and Consumables +AGR procures coal and consumables needed to burn the coal under a combination of purchasing arrangements including long-term and spot contracts with various producers and coal trading firms. As contracts expire, they are replaced, as needed, with contracts at market prices. Coal and consumable inventories remain adequate to meet generation requirements. +Management believes that AGR will be able to secure and transport coal and consumables of adequate quality and in adequate quantities to operate its coal-fired unit. AGR, through its contracts with third-party transporters, has the ability to adequately move and store coal and consumables for use in its generating facility. AGR plants consumed 1.6 million tons of coal in 2020. +The coal supplies at AGR’s plant vary from time to time depending on various factors, including, but not limited to, demand for electric power, unit outages, transportation infrastructure limitations, space limitations, plant coal consumption rates, coal quality, availability of acceptable coals, labor issues and weather conditions, which may interrupt production or deliveries. AGR aims to maintain the coal inventory of its managed plant in the range of 20 to 60 days of full load burn. As of December 31, 2020, the coal inventory of AGR was within the target range. +Counterparty Risk Management +Counterparties and exchanges may require cash or cash related instruments to be deposited on these transactions as margin against open positions. As of December 31, 2020, counterparties posted approximately $29 million in cash, cash equivalents or letters of credit with AEP for the benefit of AEP’s Generation & Marketing segment subsidiaries (while, as of that date, AEP’s Generation & Marketing segment subsidiaries posted approximately $122 million with counterparties and exchanges). Since open trading contracts are valued based on market prices of various commodities, exposures change daily. See the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Certain Power Agreements +As of December 31, 2020, the assets utilized in this segment included approximately 1,307 MWs of company-owned domestic wind power facilities and 101 MWs of domestic wind power from long-term purchase power agreements. Additional long term purchased power agreements have been entered into for 712 MWs of wind and 200 MWs of solar capacity which are all under construction. These agreements are all contingent on completion of construction which is expected by the end of 2022. An agreement which transferred 355 MWs of coal-fired capacity from the Oklaunion Power Station to this segment was terminated upon the closure of the facility in October. +31 +INFORMATION ABOUT OUR EXECUTIVE OFFICERS +The following persons are executive officers of AEP. Their ages are given as of February 25, 2021. The officers are appointed annually for a one-year term by the board of directors of AEP. +Nicholas K. Akins +Chairman of the Board, President and Chief Executive Officer +Age 60 +Chairman of the Board since January 2014, President since January 2011 and Chief Executive Officer since November 2011. +Lisa M. Barton +Executive Vice President and Chief Operating Officer +Age 55 +Executive Vice President - Utilities from January 2019 to December 2020, Executive Vice President - Transmission from August 2011 to December 2018. +Paul Chodak, III +Executive Vice President - Generation +Age 57 +Executive Vice President - Utilities from January 2017 to December 2018. President and Chief Operating Officer of I&M from July 2010 to December 2016. +David M. Feinberg +Executive Vice President, General Counsel and Secretary +Age 51 +Executive Vice President since January 2013. +Lana L. Hillebrand (Retired in 2020) +Executive Vice President and Chief Administrative Officer +Age 60 +Chief Administrative Officer since December 2012 and Senior Vice President from December 2012 to December 2016. +Mark C. McCullough +Executive Vice President - Energy Delivery +Age 61 +Executive Vice President - Transmission from January 2019 to December 2020, Executive Vice President - Generation from January 2011 to December 2018. +Charles R. Patton +Executive Vice President - External Affairs +Age 61 +Executive Vice President - External Affairs since January 2017. President and Chief Operating Officer of APCo from June 2010 to December 2016. +Julia A. Sloat +Executive Vice President and Chief Financial Officer +Age 51 +Senior Vice President, Treasury & Risk and Treasurer from January 2019 to December 2020. President and Chief Operating Officer of OPCo from May 2016 to December 2018. +32 +Brian X. Tierney +Executive Vice President - Strategy +Age 53 +Executive Vice President and Chief Financial Officer from October 2009 to December 2020. +Charles E. Zebula +Executive Vice President - Energy Supply +Age 60 +Executive Vice President - Energy Supply since January 2013. +33 +ITEM 1A. RISK FACTORS +GENERAL RISKS OF REGULATED OPERATIONS +AEP may not be able to recover the costs of substantial planned investment in capital improvements and additions. (Applies to all Registrants) +AEP’s business plan calls for extensive investment in capital improvements and additions, including the construction of additional transmission facilities, modernizing existing infrastructure, installation of environmental upgrades and retrofits as well as other initiatives. AEP’s public utility subsidiaries currently provide service at rates approved by one or more regulatory commissions. If these regulatory commissions do not approve adjustments to the rates charged, affected AEP subsidiaries would not be able to recover the costs associated with their investments. This would cause financial results to be diminished. +Regulated electric revenues and earnings are dependent on federal and state regulation that may limit AEP’s ability to recover costs and other amounts. (Applies to all Registrants) +The rates customers pay to AEP regulated utility businesses are subject to approval by the FERC and the respective state utility commissions of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. In certain instances, AEP’s applicable regulated utility businesses may agree to negotiated settlements related to various rate matters that are subject to regulatory approval. AEP cannot predict the ultimate outcomes of any settlements or the actions by the FERC or the respective state commissions in establishing rates. +If regulated utility earnings exceed the returns established by the relevant commissions, retail electric rates may be subject to review and possible reduction by the commissions, which may decrease future earnings. Additionally, if regulatory bodies do not allow recovery of costs incurred in providing service on a timely basis, it could reduce future net income and cash flows and negatively impact financial condition. Similarly, if recovery or other rate relief authorized in the past is overturned or reversed on appeal, future earnings could be negatively impacted. Any regulatory action or litigation outcome that triggers a reversal of a regulatory asset or deferred cost generally results in an impairment to the balance sheet and a charge to the income statement of the company involved. See Note 4 – Rate Matters included in the 2020 Annual Report for additional information. +AEP’s transmission investment strategy and execution are dependent on federal and state regulatory policy. (Applies to all Registrants) +A significant portion of AEP’s earnings is derived from transmission investments and activities. FERC policy currently favors the expansion and updating of the transmission infrastructure within its jurisdiction. If the FERC were to adopt a different policy, if states were to limit or restrict such policies, or if transmission needs do not continue or develop as projected, AEP’s strategy of investing in transmission could be impacted. Management believes AEP’s experience with transmission facilities construction and operation gives AEP an advantage over other competitors in securing authorization to install, construct and operate new transmission lines and facilities. However, there can be no assurance that PJM, SPP, ERCOT or other RTOs will authorize new transmission projects or will award such projects to AEP. +Certain elements of AEP’s transmission formula rates have been challenged, which could result in lowered rates and/or refunds of amounts previously collected and thus have an adverse effect on AEP’s business, financial condition, results of operations and cash flows. (Applies to all Registrants other than AEP Texas) +AEP provides transmission service under rates regulated by the FERC. The FERC has approved the cost-based formula rate templates used by AEP to calculate its respective annual revenue requirements, but it has not expressly approved the amount of actual capital and operating expenditures to be used in the formula rates. All aspects of AEP’s rates accepted or approved by the FERC, including the formula rate templates, the rates of return on the +34 +actual equity portion of its respective capital structures and the approved targeted capital structures, are subject to challenge by interested parties at the FERC, or by the FERC on its own initiative. In addition, interested parties may challenge the annual implementation and calculation by AEP of its projected rates and formula rate true-up pursuant to its approved formula rate templates under AEP’s formula rate implementation protocols. If a challenger can establish that any of these aspects are unjust, unreasonable, unduly discriminatory or preferential, then the FERC can make appropriate prospective adjustments to them and/or disallow any of AEP’s inclusion of those aspects in the rate setting formula. +AEP settled challenges to its SPP and PJM formula rates in proceedings at the FERC in 2019. However, inquiries related to rates of return, as well as challenges to the formula rates of other utilities, are ongoing in other proceedings at the FERC. The results of these proceedings could potentially negatively impact AEP in any future challenges to AEP’s formula rates. If the FERC orders revenue reductions, including refunds, in any future cases related to its formula rates, it could reduce future net income and cash flows and impact financial condition. +End-use consumers and entities supplying electricity to end-use consumers may also attempt to influence government and/or regulators to change the rate setting methodologies that apply to AEP, particularly if rates for delivered electricity increase substantially. +AEP faces risks related to project siting, financing, construction, permitting, governmental approvals and the negotiation of project development agreements that may impede their development and operating activities. (Applies to all Registrants) +AEP owns, develops, constructs, manages and operates electric generation, transmission and distribution facilities. A key component of AEP's growth is its ability to construct and operate these facilities. As part of these operations AEP must periodically apply for licenses and permits from various local, state, federal and other regulatory authorities and abide by their respective conditions. Should AEP be unsuccessful in obtaining necessary licenses or permits on acceptable terms or resolving third-party challenges to such licenses or permits, should there be a delay in obtaining or renewing necessary licenses or permits or should regulatory authorities initiate any associated investigations or enforcement actions or impose related penalties or disallowances, it could reduce future net income and cash flows and impact financial condition. Any failure to negotiate successful project development agreements for new facilities with third-parties could have similar results. +Changes in technology and regulatory policies may lower the value of electric utility facilities and franchises. (Applies to all Registrants) +AEP primarily generates electricity at large central facilities and delivers that electricity to customers over its transmission and distribution facilities to customers usually situated within an exclusive franchise. This method results in economies of scale and generally lower costs than newer technologies such as fuel cells and microturbines, and distributed generation using either new or existing technology. Other technologies, such as light emitting diodes (LEDs), increase the efficiency of electricity and, as a result, lower the demand for it. Changes in regulatory policies and advances in batteries or energy storage, wind turbines and photovoltaic solar cells are reducing costs of new technology to levels that are making them competitive with some central station electricity production and delivery. These developments can challenge AEP’s competitive ability to maintain relatively low cost, efficient and reliable operations, to establish fair regulatory mechanisms and to provide cost-effective programs and services to customers. Further, in the event that alternative generation resources are mandated, subsidized or encouraged through legislation or regulation or otherwise are economically competitive and added to the available generation supply, such resources could displace a higher marginal cost generating units, which could reduce the price at which market participants sell their electricity. +35 +AEP may not recover costs incurred to begin construction on projects that are canceled. (Applies to all Registrants) +AEP’s business plan for the construction of new projects involves a number of risks, including construction delays, non-performance by equipment and other third-party suppliers, and increases in equipment and labor costs. To limit the risks of these construction projects, AEP’s subsidiaries enter into equipment purchase orders and construction contracts and incur engineering and design service costs in advance of receiving necessary regulatory approvals and/or siting or environmental permits. If any of these projects are canceled for any reason, including failure to receive necessary regulatory approvals and/or siting or environmental permits, significant cancellation penalties under the equipment purchase orders and construction contracts could occur. In addition, if any construction work or investments have been recorded as an asset, an impairment may need to be recorded in the event the project is canceled. +AEP is exposed to nuclear generation risk. (Applies to AEP and I&M) +I&M owns the Cook Plant, which consists of two nuclear generating units for a rated capacity of 2,288 MWs, or about 7% of the generating capacity in the AEP System. AEP and I&M are, therefore, subject to the risks of nuclear generation, which include the following: +• The potential harmful effects on the environment and human health due to an adverse incident/event resulting from the operation of nuclear facilities and the storage, handling and disposal of radioactive materials such as SNF. +• Limitations on the amounts and types of insurance commercially available to cover losses that might arise in connection with nuclear operations. +• Uncertainties with respect to contingencies and assessment amounts triggered by a loss event (federal law requires owners of nuclear units to purchase the maximum available amount of nuclear liability insurance and potentially contribute to the coverage for losses of others). +• Uncertainties with respect to the technological and financial aspects of decommissioning nuclear plants at the end of their licensed lives. +There can be no assurance that I&M’s preparations or risk mitigation measures will be adequate if these risks are triggered. +The NRC has broad authority under federal law to impose licensing and safety-related requirements for the operation of nuclear generation facilities. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. Revised safety requirements promulgated by the NRC could necessitate substantial capital expenditures at nuclear plants. In addition, although management has no reason to anticipate a serious nuclear incident at the Cook Plant, if an incident did occur, it could harm results of operations or financial condition. A major incident at a nuclear facility anywhere in the world could cause the NRC to limit or prohibit the operation or licensing of any domestic nuclear unit. Moreover, a major incident at any nuclear facility in the U.S. could require AEP or I&M to make material contributory payments. +Costs associated with the operation (including fuel), maintenance and retirement of nuclear plants continue to be more significant and less predictable than costs associated with other sources of generation, in large part due to changing regulatory requirements and safety standards, availability of nuclear waste disposal facilities and experience gained in the operation of nuclear facilities. Costs also may include replacement power, any unamortized investment at the end of the useful life of the Cook Plant (whether scheduled or premature), the carrying costs of that investment and retirement costs. The ability to obtain adequate and timely recovery of costs associated with the Cook Plant is not assured. +36 +AEP subsidiaries are exposed to risks through participation in the market and transmission structures in various regional power markets that are beyond their control. (Applies to all Registrants) +Results are likely to be affected by differences in the market and transmission structures in various regional power markets. The rules governing the various RTOs, including SPP and PJM, may also change from time to time which could affect costs or revenues. Existing, new or changed rules of these RTOs could result in significant additional fees and increased costs to participate in those structures, including the cost of transmission facilities built by others due to changes in transmission rate design. In addition, these RTOs may assess costs resulting from improved transmission reliability, reduced transmission congestion and firm transmission rights. As members of these RTOs, AEP’s subsidiaries are subject to certain additional risks, including the allocation among existing members, of losses caused by unreimbursed defaults of other participants in these markets and resolution of complaint cases that may seek refunds of revenues previously earned by members of these markets. +AEP could be subject to higher costs and/or penalties related to mandatory reliability standards. (Applies to all Registrants) +Owners and operators of the bulk power transmission system are subject to mandatory reliability standards promulgated by the NERC and enforced by the FERC. The standards are based on the functions that need to be performed to ensure the bulk power system operates reliably and are guided by reliability and market interface principles. Compliance with new reliability standards may subject AEP to higher operating costs and/or increased capital expenditures. While management expects to recover costs and expenditures from customers through regulated rates, there can be no assurance that the applicable commissions will approve full recovery in a timely manner. If AEP were found not to be in compliance with the mandatory reliability standards, AEP could be subject to sanctions, including substantial monetary penalties, which likely would not be recoverable from customers through regulated rates. +A substantial portion of the receivables of AEP Texas is concentrated in a small number of REPs, and any delay or default in payment could adversely affect its cash flows, financial condition and results of operations. (Applies to AEP and AEP Texas) +AEP Texas collects receivables from the distribution of electricity from REPs that supply the electricity it distributes to its customers. As of December 31, 2020, AEP Texas did business with approximately 122 REPs. Adverse economic conditions, structural problems in the market served by ERCOT or financial difficulties of one or more REPs could impair the ability of these REPs to pay for these services or could cause them to delay such payments. AEP Texas depends on these REPs to remit payments on a timely basis. Applicable regulatory provisions require that customers be shifted to another REP or a provider of last resort if a REP cannot make timely payments. Applicable PUCT regulations significantly limit the extent to which AEP Texas can apply normal commercial terms or otherwise seek credit protection from firms desiring to provide retail electric service in its service territory, and AEP Texas thus remains at risk for payments related to services provided prior to the shift to another REP or the provider of last resort. In 2020, AEP Texas’ three largest REPs accounted for 46% of its operating revenue. Any delay or default in payment by REPs could adversely affect cash flows, financial condition and results of operations. If a REP were unable to meet its obligations, it could consider, among various options, restructuring under the bankruptcy laws, in which event such REP might seek to avoid honoring its obligations, and claims might be made by creditors involving payments AEP Texas had received from such REP. +Ohio House Bill 6 (HB 6), which provides for beneficial cost recovery for OPCo and for plants owned by OVEC, has come under public scrutiny. (Applies to AEP and OPCo) +In 2019, Ohio adopted and implemented HB 6 which benefits OPCo by authorizing rate recovery for certain costs including renewable energy contracts, OVEC’s coal-fired generating units and energy efficiency measures. AEP and OPCo engaged in lobbying efforts and provided testimony during the legislative process in connection with HB 6. In July 2020, an investigation led by the U.S. Attorney’s Office resulted in a federal grand jury indictment of an Ohio legislator and associates in connection with an alleged racketeering conspiracy involving the adoption of HB +37 +6. The outcome of the U.S. Attorney’s Office investigation and its impact on HB 6 is not known. If the provisions of HB 6 were to be eliminated, it is unclear whether new legislation addressing similar issues would be adopted. To the extent that OPCo is unable to recover the costs currently authorized by HB 6, it could reduce future net income and cash flows and impact financial condition. In addition, the impact of continued public scrutiny of HB 6 is not known, and may have an adverse impact on AEP and OPCo, including their relationship with regulatory and legislative authorities, customers and other stakeholders. AEP is a defendant in current litigation relating to HB6 and AEP or OPCo may be involved in future litigation. +RISKS RELATED TO MARKET, ECONOMIC OR FINANCIAL VOLATILITY AND OTHER RISKS +AEP’s financial condition and results of operations could continue to be adversely affected by the ongoing Coronavirus pandemic. (Applies to all Registrants) +The global 2019 novel coronavirus pandemic is an evolving situation that could lead to extended disruption of economic activity in AEP’s markets. COVID-19 could negatively affect AEP’s ability to operate its generating and transmission and distribution assets, its ability to access capital markets, and results of operations. AEP currently cannot estimate the potential impact to its financial position, results of operations and cash flows caused by COVID-19, which will depend on future developments and which are highly uncertain at this time. See Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Overview for additional information on COVID-19. +AEP’s financial performance may be adversely affected if AEP is unable to successfully operate facilities or perform certain corporate functions. (Applies to all Registrants) +Performance is highly dependent on the successful operation of generation, transmission and/or distribution facilities. Operating these facilities involves many risks, including: +• Operator error and breakdown or failure of equipment or processes. +• Operating limitations that may be imposed by environmental or other regulatory requirements. +• Labor disputes. +• Compliance with mandatory reliability standards, including mandatory cyber security standards. +• Information technology failure that impairs AEP’s information technology infrastructure or disrupts normal business operations. +• Information technology failure that affects AEP’s ability to access customer information or causes loss of confidential or proprietary data that materially and adversely affects AEP’s reputation or exposes AEP to legal claims. +• Fuel or water supply interruptions caused by transportation constraints, adverse weather such as drought, non-performance by suppliers and other factors. +• Catastrophic events such as fires, earthquakes, explosions, hurricanes, tornados, ice storms, terrorism (including cyber-terrorism), floods or other similar occurrences. +• Fuel costs and related requirements triggered by financial stress in the coal industry. +Physical attacks or hostile cyber intrusions could severely impair operations, lead to the disclosure of confidential information and damage AEP’s reputation. (Applies to all Registrants) +AEP and its regulated utility businesses face physical security and cybersecurity risks as the owner-operators of generation, transmission and/or distribution facilities and as participants in commodities trading. AEP and its regulated utility businesses own assets deemed as critical infrastructure, the operation of which is dependent on information technology systems. Further, the computer systems that run these facilities are not completely isolated from external networks. Parties that wish to disrupt the U.S. bulk power system or AEP operations could view these computer systems, software or networks as targets for cyber-attack. In addition, the electric utility business requires the collection of sensitive customer data, as well as confidential employee and shareholder information, which is subject to electronic theft or loss. +38 +A security breach of AEP or its regulated utility businesses’ physical assets or information systems, interconnected entities in RTOs, or regulators could impact the operation of the generation fleet and/or reliability of the transmission and distribution system. AEP and its regulated utility businesses could be subject to financial harm associated with theft or inappropriate release of certain types of information, including sensitive customer, vendor, employee, trading or other confidential data. A successful cyber-attack on the systems that control generation, transmission, distribution or other assets could severely disrupt business operations, preventing service to customers or collection of revenues. The breach of certain business systems could affect the ability to correctly record, process and report financial information. A major cyber incident could result in significant expenses to investigate and repair security breaches or system damage and could lead to litigation, fines, other remedial action, heightened regulatory scrutiny and damage to AEP’s reputation. In addition, the misappropriation, corruption or loss of personally identifiable information and other confidential data could lead to significant breach notification expenses and mitigation expenses such as credit monitoring. For these reasons, a significant cyber incident could reduce future net income and cash flows and negatively impact financial condition. +If AEP is unable to access capital markets or insurance markets on reasonable terms, it could reduce future net income and cash flows and negatively impact financial condition. (Applies to all Registrants) +AEP relies on access to capital markets as a significant source of liquidity for capital requirements not satisfied by operating cash flows; AEP also relies on access to insurance markets to assist in managing its risk and liability profile. Volatility, increased interest rates and reduced liquidity in the financial markets could affect AEP’s ability to raise capital on reasonable terms to fund capital needs, including construction costs and refinancing maturing indebtedness. Certain sources of insurance and debt and equity capital have expressed increasing unwillingness to procure insurance for or to invest in companies, such as AEP, that rely on fossil fuels. If sources of capital for AEP are reduced, capital costs could increase materially. Restricted access to capital or insurance markets and/or increased borrowing costs or insurance premiums could reduce future net income and cash flows and negatively impact financial condition. +Shareholder activism could cause AEP to incur significant expense, hinder execution of AEP’s business strategy and impact AEP’s stock price. (Applies to all Registrants) +Shareholder activism, which can take many forms and arise in a variety of situations, could result in substantial costs and divert management’s and AEP’s board’s attention and resources from AEP’s business. Additionally, such shareholder activism could give rise to perceived uncertainties as to AEP’s future, adversely affect AEP’s relationships with its employees, customers or service providers and make it more difficult to attract and retain qualified personnel. Also, AEP may be required to incur significant fees and other expenses related to activist shareholder matters, including for third-party advisors. AEP’s stock price could be subject to significant fluctuation or otherwise be adversely affected by the events, risks and uncertainties of any shareholder activism. +The announced phasing out of LIBOR after 2021 may adversely affect the costs and availability of financing. (Applies to all Registrants) +A portion of the Registrants’ indebtedness bears interest at fluctuating interest rates, primarily based on the London interbank offered rate (“LIBOR”) for deposits of U.S. dollars. On July 27, 2017, the Financial Conduct Authority in the United Kingdom announced that it would phase out LIBOR as a benchmark by the end of 2021. Subsequently, on November 30, 2020, the Federal Reserve and the Financial Conduct Authority in the United Kingdom announced that LIBOR would be phased out completely by June 20, 2023 and replaced by the Secured Overnight Financing Rate ("SOFR"). While this announcement extends the transition period to June 2023, the United States Federal Reserve concurrently issued a statement advising banks to stop new U.S. dollar LIBOR issuances by the end of 2021. However, because SOFR is a broad U.S. Treasury repo financing rate that represents overnight secured funding transactions, it differs fundamentally from U.S. dollar LIBOR. In addition, the overall financial markets may be disrupted as a result of the phase-out or replacement of LIBOR. Uncertainty as to the nature of such phase-out and alternative reference rates or disruption in the financial market could cause interest rates to increase. If sources of capital for the Registrants are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could reduce future net income and cash flows and negatively impact financial condition and/or liquidity. +39 +Downgrades in AEP’s credit ratings could negatively affect its ability to access capital. (Applies to all Registrants) +The credit ratings agencies periodically review AEP’s capital structure and the quality and stability of earnings and cash flows. Any negative ratings actions could constrain the capital available to AEP and could limit access to funding for operations. AEP’s business is capital intensive, and AEP is dependent upon the ability to access capital at rates and on terms management determines to be attractive. If AEP’s ability to access capital becomes significantly constrained, AEP’s interest costs will likely increase and could reduce future net income and cash flows and negatively impact financial condition. +AEP and AEPTCo have no income or cash flow apart from dividends paid or other payments due from their subsidiaries. (Applies to AEP and AEPTCo) +AEP and AEPTCo are holding companies and have no operations of their own. Their ability to meet their financial obligations associated with their indebtedness and to pay dividends is primarily dependent on the earnings and cash flows of their operating subsidiaries, primarily their regulated utilities, and the ability of their subsidiaries to pay dividends to, or repay loans from them. Their subsidiaries are separate and distinct legal entities that have no obligation (apart from loans from AEP or AEPTCo) to provide them with funds for their payment obligations, whether by dividends, distributions or other payments. Payments to AEP or AEPTCo by their subsidiaries are also contingent upon their earnings and business considerations. AEP and AEPTCo indebtedness and dividends are structurally subordinated to all subsidiary indebtedness. +AEP’s operating results may fluctuate on a seasonal or quarterly basis and with general economic and weather conditions. (Applies to all Registrants) +Electric power consumption is generally seasonal. In many parts of the country, demand for power peaks during the hot summer months, with market prices also peaking at that time. In other areas, power demand peaks during the winter. As a result, overall operating results in the future may fluctuate substantially on a seasonal basis. In addition, AEP has historically sold less power, and consequently earned less income, when weather conditions are milder. Unusually mild weather in the future could reduce future net income and cash flows and negatively impact financial condition. In addition, unusually extreme weather conditions could impact AEP’s results of operations in a manner that would not likely be sustainable. +Further, deteriorating economic conditions triggered by any cause, including international tariffs, generally result in reduced consumption by customers, particularly industrial customers who may curtail operations or cease production entirely, while an expanding economic environment generally results in increased revenues. As a result, prevailing economic conditions may reduce future net income and cash flows and negatively impact financial condition. +Volatility in the securities markets, interest rates, and other factors could substantially increase defined benefit pension and other postretirement plan costs and the costs of nuclear decommissioning. (Applies to all Registrants and to AEP and I&M with respect to the costs of nuclear decommissioning) +The costs of providing pension and other postretirement benefit plans are dependent on a number of factors, such as the rates of return on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plan, changes in actuarial assumptions, future government regulation, changes in life expectancy, and the frequency and amount of AEP’s required or voluntary contributions made to the plans. Changes in actuarial assumptions and differences between the assumptions and actual values, as well as a significant decline in the value of investments that fund the pension and other postretirement plans, if not offset or mitigated by a decline in plan liabilities, could increase pension and other postretirement expense, and AEP could be required from time to time to fund the pension plan with significant amounts of cash. Such cash funding obligations could have a material impact on liquidity by reducing cash flows and could negatively affect results of operations. +40 +Additionally, I&M holds a significant amount of assets in its nuclear decommissioning trusts to satisfy obligations to decommission its nuclear plant. The rate of return on assets held in those trusts can significantly impact both the costs of decommissioning and the funding requirements for the trusts. +AEP’s results of operations and cash flows may be negatively affected by a lack of growth or slower growth in the number of customers, or decline in customer demand. (Applies to all Registrants) +Growth in customer accounts and growth of customer usage each directly influence demand for electricity and the need for additional power generation and delivery facilities. Customer growth and customer usage are affected by a number of factors outside the control of AEP, such as mandated energy efficiency measures, demand-side management goals, distributed generation resources and economic and demographic conditions, such as population changes, job and income growth, housing starts, new business formation and the overall level of economic activity. +Certain regulatory and legislative bodies have introduced or are considering requirements and/or incentives to further reduce energy consumption. Additionally, technological advances or other improvements in or applications of technology could lead to declines in per capita energy consumption. Some or all of these factors, could impact the demand for electricity. +Failure to attract and retain an appropriately qualified workforce could harm results of operations. (Applies to all Registrants) +Certain events, such as an aging workforce without appropriate replacements, mismatch of skillset or complement to future needs, or unavailability of contract resources may lead to operating challenges and increased costs. The challenges include lack of resources, loss of knowledge and a lengthy time period associated with skill development. In this case, costs, including costs for contractors to replace employees, productivity costs and safety costs, may rise. Failure to hire and adequately train replacement employees, including the transfer of significant internal historical knowledge and expertise to the new employees, or the future availability and cost of contract labor may adversely affect the ability to manage and operate the business. If AEP is unable to successfully attract and retain an appropriately qualified workforce, future net income and cash flows may be reduced. +Changes in the price of commodities, the cost of procuring fuel, emission allowances for criteria pollutants and the costs of transport may increase AEP’s cost of producing power, impacting financial performance. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +AEP is exposed to changes in the price and availability of fuel (including the cost to procure coal and gas) and the price and availability to transport fuel. AEP has existing contracts of varying durations for the supply of fuel, but as these contracts end or if they are not honored, AEP may not be able to purchase fuel on terms as favorable as the current contracts. The inability to procure fuel at costs that are economical could cause AEP to retire generating capacity prior to the end of its useful life, and while AEP typically recovers expenditures for undepreciated plant balances, there can be no assurance in the future that AEP will recover such costs. Similarly, AEP is exposed to changes in the price and availability of emission allowances. AEP uses emission allowances based on the amount of fuel used and reductions achieved through emission controls and other measures. Based on current environmental programs remaining in effect, AEP has sufficient emission allowances to cover the majority of the projected needs for the next two years and beyond. If the Federal EPA attempts to further reduce interstate transport, and it is acceptable by the courts, additional costs may be incurred either to acquire additional allowances or to achieve further reductions in emissions. If AEP needs to obtain allowances, those purchases may not be on as favorable terms as those under the current environmental programs. AEP’s risks relative to the price and availability to transport coal include the volatility of the price of diesel which is the primary fuel used in transporting coal by barge. +Prices for coal, natural gas and emission allowances have shown material swings in the past. Changes in the cost of fuel, emission allowances or natural gas and changes in the relationship between such costs and the market prices of power could reduce future net income and cash flows and negatively impact financial condition. +41 +In addition, actual power prices and fuel costs will differ from those assumed in financial projections used to value trading and marketing transactions, and those differences may be material. As a result, as those transactions are marked-to-market, they may impact future results of operations and cash flows and impact financial condition. +AEP is subject to physical and financial risks associated with climate change. (Applies to all Registrants) +Climate change creates physical and financial risk. Physical risks from climate change may include an increase in sea level and changes in weather conditions, such as changes in precipitation and extreme weather events, such as fires. Customers’ energy needs vary with weather conditions, primarily temperature and humidity. For residential customers, heating and cooling represent their largest energy use. To the extent weather conditions are affected by climate change, customers’ energy use could increase or decrease depending on the duration and magnitude of the changes. +Increased energy use due to weather changes may require AEP to invest in additional generating assets, transmission and other infrastructure to serve increased load. Decreased energy use due to weather changes may affect financial condition through decreased revenues. Extreme weather conditions in general require more system backup, adding to costs, and can contribute to increased system stress, including service interruptions. Weather conditions outside of the AEP service territory could also have an impact on revenues. AEP buys and sells electricity depending upon system needs and market opportunities. Extreme weather conditions creating high energy demand on AEP’s own and/or other systems may raise electricity prices as AEP buys short-term energy to serve AEP’s own system, which would increase the cost of energy AEP provides to customers. +Severe weather and weather-related events impact AEP’s service territories, primarily when thunderstorms, tornadoes, hurricanes, fires, floods and snow or ice storms occur. To the extent the frequency and intensity of extreme weather events and storms increase, AEP’s cost of providing service will increase, including the costs and the availability of procuring insurance related to such impacts, and these costs may not be recoverable. Changes in precipitation resulting in droughts, water shortages or floods could adversely affect operations, principally the fossil fuel generating units. A negative impact to water supplies due to long-term drought conditions or severe flooding could adversely impact AEP’s ability to provide electricity to customers, as well as increase the price they pay for energy. AEP may not recover all costs related to mitigating these physical and financial risks. +To the extent climate change impacts a region’s economic health, it may also impact revenues. AEP’s financial performance is tied to the health of the regional economies AEP serves. The price of energy, as a factor in a region’s cost of living as well as an important input into the cost of goods and services, has an impact on the economic health of the communities within the AEP System. +Management cannot predict the outcome of the legal proceedings relating to AEP’s business activities. (Applies to all Registrants) +AEP is involved in legal proceedings, claims and litigation arising out of its business operations, the most significant of which are summarized in Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report. Adverse outcomes in these proceedings could require significant expenditures that could reduce future net income and cash flows and negatively impact financial condition. +Disruptions at power generation facilities owned by third-parties could interrupt the sales of transmission and distribution services. (Applies to AEP and AEP Texas) +AEP Texas transmits and distributes electric power that the REPs obtain from power generation facilities owned by third-parties. If power generation is disrupted or if power generation capacity is inadequate, sales of transmission and distribution services may be diminished or interrupted, and results of operations, financial condition and cash flows could be adversely affected. +42 +Management is unable to predict the course, results or impact, if any, of current or future litigation or investigations relating to the extreme winter weather in Texas in February 2021. (Applies to AEP and AEP Texas) +As a result of the February 2021 severe winter weather in Texas which caused a shortage of electric generation, ERCOT instructed AEP Texas and other Texas electric utilities to initiate power outages to avoid a sustained large-scale outage and prevent long-term damage to the electric system. At its peak, approximately 468,000 (44%) AEP Texas customers were without power. +In February 2021, a lawsuit was filed in Nueces, Texas County Court against AEP and AEP Texas alleging the failure to exercise reasonable care in maintaining and updating its generation, transmission and distribution facilities in order to prevent cold weather failures and other related negligence. The complaint seeks monetary damages among other forms of relief. +In February 2021, AEP Texas received a Civil Investigative Demand from the Office of the Attorney General of Texas requesting, among other data, information about its communications to and from ERCOT, PUCT, retail electric providers, utilities, or power generation companies, concerning power outages related to the February 2021 winter storm. The company intends to respond to the Civil Investigative Demand. +Management is unable to predict the course or outcome of these or any future litigation or investigations or their impact, if any, on future results of operations, financial condition and cash flows. +Hazards associated with high-voltage electricity transmission may result in suspension of AEP’s operations or the imposition of civil or criminal penalties. (Applies to all Registrants) +AEP operations are subject to the usual hazards associated with high-voltage electricity transmission, including explosions, fires, inclement weather, natural disasters, mechanical failure, unscheduled downtime, equipment interruptions, remediation, chemical spills, discharges or releases of toxic or hazardous substances or gases and other environmental risks. The hazards can cause personal injury and loss of life, severe damage to or destruction of property and equipment and environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. AEP maintains property and casualty insurance, but AEP is not fully insured against all potential hazards incident to AEP’s business, such as damage to poles, towers and lines or losses caused by outages. +AEPTCo depends on its affiliates in the AEP System for a substantial portion of its revenues. (Applies to AEPTCo) +AEPTCo’s principal transmission service customers are its affiliates in the AEP System. Management expects that these affiliates will continue to be AEPTCo’s principal transmission service customers for the foreseeable future. For the year ended December 31, 2020, its affiliates were responsible for approximately 78% of the consolidated transmission revenues of AEPTCo. +Most of the real property rights on which the assets of AEPTCo are situated result from affiliate license agreements and are dependent on the terms of the underlying easements and other rights of its affiliates. (Applies to AEPTCo) +AEPTCo does not hold title to the majority of real property on which its electric transmission assets are located. Instead, under the provisions of certain affiliate contracts, it is permitted to occupy and maintain its facilities upon real property held by the respective AEP System utility affiliate that overlay its operations. The ability of AEPTCo to continue to occupy such real property is dependent upon the terms of such affiliate contracts and upon the underlying real property rights of these utility affiliates, which may be encumbered by easements, mineral rights and other similar encumbrances that may affect the use of such real property. AEP can give no assurance that (a) the +43 +relevant AEP System utility affiliates will continue to be affiliates of AEPTCo, (b) suitable replacement arrangements can be obtained in the event that the relevant AEP System utility affiliates are not its affiliates and (c) the underlying easements and other rights are sufficient to permit AEPTCo to operate its assets in a manner free from interruption. +RISKS RELATED TO OWNING AND OPERATING GENERATION ASSETS AND SELLING POWER +Costs of compliance with existing environmental laws are significant. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +Operations are subject to extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality, waste management, natural resources and health and safety. A majority of the electricity generated by the AEP System is produced by the combustion of fossil fuels. Emissions of nitrogen and sulfur oxides, mercury and particulates and the discharge and disposal of solid waste (including coal-combustion residuals or CCR) resulting from fossil fueled generation plants are subject to increased regulations, controls and mitigation expenses. Compliance with these legal requirements requires AEP to commit significant capital toward environmental monitoring, installation of pollution control equipment, emission fees, disposal and permits at AEP facilities and could cause AEP to retire generating capacity prior to the end of its estimated useful life. Costs of compliance with environmental statutes and regulations could reduce future net income and negatively impact financial condition, especially if emission, CCR waste and/or discharge obligations are tightened, more extensive operating and/or permitting requirements are imposed or additional substances become regulated. Although AEP typically recovers expenditures for pollution control technologies, replacement generation, undepreciated plant balances and associated operating costs from customers, there can be no assurance in the future that AEP will recover the remaining costs associated with such plants. Failure to recover these costs could reduce future net income and cash flows and possibly harm financial condition. +Regulation of CO 2 emissions could materially increase costs to AEP and its customers or cause some electric generating units to be uneconomical to operate or maintain. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +In 2014, the Federal EPA issued standards for new, modified and reconstructed units, and a guideline for the development of SIPs that would reduce carbon CO 2 emissions from existing utility units (the Clean Power Plan). In 2019, the Federal EPA repealed the Clean Power Plan, and replaced it with new guidelines called the Affordable Clean Energy (ACE) rule. In January 2021, the U.S. Court of Appeals for the District of Columbia Circuit vacated the ACE Rule and remanded it to the Federal EPA. The new administration has announced addressing climate change as a policy priority. Costs of compliance with the environmental regulation of CO 2 emissions, if any, could reduce future net income and negatively impact financial condition and/or could cause AEP to retire generating capacity prior to the end of its estimated useful life. Although AEP typically recovers environmental expenditures, there can be no assurance in the future that AEP can recover such costs which could reduce future net income and cash flows and possibly harm financial condition. +Courts adjudicating nuisance and other similar claims in the future may order AEP to pay damages or to limit or reduce emissions. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +In the past, there have been several cases seeking damages based on allegations of federal and state common law nuisance in which AEP, among others, were defendants. In general, the actions allege that emissions from the defendants’ power plants constitute a public nuisance. The plaintiffs in these actions generally seek recovery of damages and other relief. If future actions are resolved against AEP, substantial modifications or retirement of AEP’s existing coal-fired power plants could be required, and AEP might be required to purchase power from third-parties to fulfill AEP’s commitments to supply power to AEP customers. This could have a material impact on revenues. In addition, AEP could be required to invest significantly in additional emission control equipment, accelerate the timing of capital expenditures, pay damages or penalties and/or halt operations. Unless recovered, those costs could reduce future net income and cash flows and harm financial condition. Moreover, results of operations and financial position could be reduced due to the timing of recovery of these investments and the expense of ongoing litigation. +44 +Commodity trading and marketing activities are subject to inherent risks which can be reduced and controlled but not eliminated. (Applies to all Registrants except AEP Texas, AEPTCo and OPCo) +AEP routinely has open trading positions in the market, within guidelines set by AEP, resulting from the management of AEP’s trading portfolio. To the extent open trading positions exist, fluctuating commodity prices can improve or diminish financial results and financial position. +AEP’s power trading activities also expose AEP to risks of commodity price movements. To the extent that AEP’s power trading does not hedge the price risk associated with the generation it owns, or controls, AEP would be exposed to the risk of rising and falling spot market prices. +In connection with these trading activities, AEP routinely enters into financial contracts, including futures and options, OTC options, financially-settled swaps and other derivative contracts. These activities expose AEP to risks from price movements. If the values of the financial contracts change in a manner AEP does not anticipate, it could harm financial position or reduce the financial contribution of trading operations. +Parties with whom AEP has contracts may fail to perform their obligations, which could harm AEP’s results of operations. (Applies to all Registrants) +AEP sells power from its generation facilities into the spot market and other competitive power markets on a contractual basis. AEP also enters into contracts to purchase and sell electricity, natural gas, emission allowances and coal as part of its power marketing and energy trading operations. AEP is exposed to the risk that counterparties that owe AEP money or the delivery of a commodity, including power, could breach their obligations. Should the counterparties to these arrangements fail to perform, AEP may be forced to enter into alternative hedging arrangements or honor underlying commitments at then-current market prices that may exceed AEP’s contractual prices, which would cause financial results to be diminished and AEP might incur losses. Although estimates take into account the expected probability of default by a counterparty, actual exposure to a default by a counterparty may be greater than the estimates predict. +AEP relies on electric transmission facilities that AEP does not own or control. If these facilities do not provide AEP with adequate transmission capacity, AEP may not be able to deliver wholesale electric power to the purchasers of AEP’s power. (Applies to all Registrants) +AEP depends on transmission facilities owned and operated by other nonaffiliated power companies to deliver the power AEP sells at wholesale. This dependence exposes AEP to a variety of risks. If transmission is disrupted, or transmission capacity is inadequate, AEP may not be able to sell and deliver AEP wholesale power. If a region’s power transmission infrastructure is inadequate, AEP’s recovery of wholesale costs and profits may be limited. If restrictive transmission price regulation is imposed, the transmission companies may not have sufficient incentive to invest in expansion of transmission infrastructure. +The FERC has issued electric transmission initiatives that require electric transmission services to be offered unbundled from commodity sales. Although these initiatives are designed to encourage wholesale market transactions, access to transmission systems may not be available if transmission capacity is insufficient because of physical constraints or because it is contractually unavailable. Management also cannot predict whether transmission facilities will be expanded in specific markets to accommodate competitive access to those markets. +45 +OVEC may require additional liquidity and other capital support. (Applies to AEP, APCo, I&M and OPCo) +AEP and several nonaffiliated utility companies, including Energy Harbor (formerly FirstEnergy Solutions), a nonaffiliated party, own OVEC. The Inter-Company Power Agreement (ICPA) defines the rights and obligations and sets the power participation ratio of the parties to it. Under the ICPA, parties are entitled to receive and are obligated to pay for all OVEC capacity (approximately 2,400 MWs) in proportion to their respective power participation ratios. The aggregate power participation ratio of APCo, I&M and OPCo is 43.47%. If a party fails to make payments owed by it under the ICPA, OVEC may not have sufficient funds to honor its payment obligations, including its ongoing operating expenses as well as its indebtedness. As of December 31, 2020, OVEC has outstanding indebtedness of approximately $1.3 billion, of which APCo, I&M, and OPCo are collectively responsible for $555 million through the ICPA. Although they are not an obligor or guarantor, APCo, I&M, and OPCo are responsible for their respective ratio of OVEC’s outstanding debt through the ICPA. +The aggregate power participation ratio of Energy Harbor under the ICPA is 4.85%. A portion of Energy Harbor’s revenues includes amounts authorized under HB 6. The PUCO has rescinded its prior authorization of certain HB 6 related recovery for eligible entities including Energy Harbor. If these amounts are not collected or if HB 6 is repealed and not replaced, Energy Harbor’s financial ability to participate in the ICPA could be adversely impacted. Management is currently unable to predict the outcome of the issues related to HB 6 and will continue to monitor the regulatory and legislative process and any potential impact to OVEC’s cash flows or financial condition. If OVEC does not have sufficient funds to honor its payment obligations, there is risk that APCo, I&M and/or OPCo may need to make payments in addition to their power participation ratio payments. Further, if OVEC’s indebtedness is accelerated for any reason, there is risk that APCo, I&M and/or OPCo may be required to pay some or all of such accelerated indebtedness in amounts equal to their aggregate power participation ratio of 43.47%. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +GENERATION FACILITIES +As of December 31, 2020, the AEP System owned (or leased where indicated) generation plants, with locations and net maximum power capabilities (winter rating), are shown in the following tables: +Vertically Integrated Utilities Segment +AEGCo +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Rockport, Units 1 and 2 – 50% of each (a) 2 IN Steam - Coal 1,310 1984 +(a) Rockport Plant, Unit 2 is leased. +46 +APCo +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Buck 3 VA Hydro 11 1912 +Byllesby 4 VA Hydro 19 1912 +Claytor 4 VA Hydro 75 1939 +Leesville 2 VA Hydro 50 1964 +London 3 WV Hydro 14 1935 +Marmet 3 WV Hydro 14 1935 +Niagara 2 VA Hydro 2 1906 +Winfield 3 WV Hydro 15 1938 +Ceredo 6 WV Natural Gas 516 2001 +Dresden 3 OH Natural Gas 613 2012 +Smith Mountain 5 VA Pumped Storage 585 1965 +Amos 3 WV Steam - Coal 2,930 1971 +Mountaineer 1 WV Steam - Coal 1,320 1980 +Clinch River 2 VA Steam - Natural Gas 465 1958 +Total MWs 6,629 +I&M +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Berrien Springs 12 MI Hydro 6 1908 +Buchanan 10 MI Hydro 3 1919 +Constantine 4 MI Hydro 1 1921 +Elkhart 3 IN Hydro 3 1913 +Mottville 4 MI Hydro 2 1923 +Twin Branch Hydro 8 IN Hydro 5 1904 +Deer Creek Solar Farm NA IN Solar 3 2016 +Olive Solar Farm NA IN Solar 5 2016 +Twin Branch Solar Farm NA IN Solar 3 2016 +Watervliet NA MI Solar 5 2016 +Rockport (Units 1 and 2, 50% of each) (a) +2 IN Steam - Coal 1,310 1984 +Cook 2 MI Steam - Nuclear 2,288 1975 +Total MWs 3,634 +NA Not applicable. +(a) Rockport Plant, Unit 2 is leased. +47 +The following table provides operating information related to the Cook Plant: +Cook Plant +Unit 1 Unit 2 +Year Placed in Operation 1975 1978 +Year of Expiration of NRC License 2034 2037 +Nominal Net Electrical Rating in MWs 1,084 1,204 +Annual Capacity Utilization +2020 87.2 % 94.2 % +2019 77.3 % 84.3 % +2018 97.9 % 79.5 % +KPCo +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Mitchell (a) 2 WV Steam - Coal 780 1971 +Big Sandy 1 KY Steam - Natural Gas 280 1963 +Total MWs 1,060 +(a) KPCo owns a 50% interest in the Mitchell Plant units. WPCo owns the remaining 50%. Figures presented reflect only the portion owned by KPCo. +PSO +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Comanche 3 OK Natural Gas 248 1973 +Riverside, Units 3 and 4 2 OK Natural Gas 160 2008 +Southwestern, Units 4 and 5 2 OK Natural Gas 170 2008 +Weleetka 2 OK Natural Gas 100 1975 +Northeastern, Unit 1 1 OK Natural Gas 470 1961 +Northeastern, Unit 3 1 OK Steam - Coal 469 1979 +Northeastern, Unit 2 1 OK Steam - Natural Gas 434 1961 +Riverside, Units 1 and 2 2 OK Steam - Natural Gas 901 1974 +Southwestern, Units 1, 2 and 3 3 OK Steam - Natural Gas 451 1952 +Tulsa 2 OK Steam - Natural Gas 325 1956 +Total MWs 3,728 +48 +SWEPCo +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Mattison 4 AR Natural Gas 315 2007 +Stall 3 LA Natural Gas 534 2010 +Flint Creek (a) 1 AR Steam - Coal 258 1978 +Turk (a) 1 AR Steam - Coal 477 2012 +Welsh (b) 2 TX Steam - Coal 1,053 1977 +Dolet Hills (a)(c) 1 LA Steam - Lignite 257 1986 +Pirkey (a)(d) 1 TX Steam - Lignite 580 1985 +Arsenal Hill 1 LA Steam - Natural Gas 110 1960 +Knox Lee 1 TX Steam - Natural Gas 344 1950 +Lieberman 3 LA Steam - Natural Gas 217 1947 +Wilkes 3 TX Steam - Natural Gas 889 1964 +Total MWs 5,034 +(a) Jointly-owned with nonaffiliated entities. Figures presented reflect only the portion owned by SWEPCo. The Arkansas jurisdictional portion of SWEPCo’s interest in Turk Plant is not in rate base. +(b) In November 2020, management announced it will cease using coal at the Welsh Plant in 2028. +(c) In March 2020, management announced plans to retire the plant in 2021. +(d) In November 2020, management announced plans to retire the plant in 2023. +WPCo +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Mitchell (a) 2 WV Steam - Coal 780 1971 +(a) WPCo owns 50% in the Mitchell Plant units. KPCo owns the remaining 50%. Figures presented reflect only the portion owned by WPCo. +Generation & Marketing Segment +AGR +Plant Name Units State Fuel Type Net Maximum +Capacity (MWs) Year Plant +or First Unit Commissioned +Racine 2 OH Hydro 48 1982 +Cardinal 1 OH Steam - Coal 595 1967 +Total MWs 643 +49 +Renewable Power +Size of Energy Resource AEP Energy Supply, LLC Division Renewable +Energy Resource Location In-Service or +Under Construction +1,307 MW AEP Renewables Wind Eight states (a) In-service +128 MW AEP Renewables Wind Kansas Under Construction +20 MW AEP Renewables Solar California In-service +20 MW AEP Renewables Solar Utah In-service +50 MW AEP Renewables Solar Nevada In-service +152 MW AEP OnSite Partners Solar Sixteen states (b) In-service +9 MW AEP OnSite Partners Solar Two states (c) Under Construction +(a) Colorado, Hawaii, Indiana, Kansas, Michigan, Minnesota, Pennsylvania, and Texas. +(b) California, Colorado, Florida, Hawaii, Illinois, Iowa, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(c) Ohio and Wisconsin . +TRANSMISSION AND DISTRIBUTION FACILITIES +The following tables set forth the total overhead circuit miles of transmission and distribution lines of the AEP System and its operating companies. +Vertically Integrated Utilities Segment +Total Overhead Circuit Miles of Transmission and Distribution Lines +APCo 51,675 +I&M 21,201 +KGPCo 1,407 +KPCo 11,152 +PSO 18,196 +SWEPCo 26,134 +WPCo 1,733 +Total Circuit Miles 131,498 +Transmission and Distribution Utilities Segment +Total Overhead Circuit Miles of Transmission and Distribution Lines +OPCo 44,838 +AEP Texas 46,079 +Total Circuit Miles 90,917 +50 +AEP Transmission Holdco Segment +The following table sets forth the total overhead circuit miles of transmission lines of certain wholly-owned and joint venture-owned entities: +Total Overhead Circuit Miles of Transmission Lines +ETT 1,808 +IMTCo 696 +OHTCo 863 +OKTCo 928 +WVTCo 250 +Pioneer 43 +Prairie Wind Transmission 216 +Transource Missouri 167 +Transource West Virginia 24 +Total Circuit Miles 4,995 +TITLE TO PROPERTY +The AEP System’s generating facilities are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the AEP System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of AEP’s public utility subsidiaries in the realty on which their facilities are located are considered adequate for use in the conduct of their business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties. AEP’s public utility subsidiaries generally have the right of eminent domain which permits them, if necessary, to acquire, perfect or secure titles to or easements on privately held lands used or to be used in their utility operations. Legislation in Ohio and Virginia has restricted the right of eminent domain previously granted for power generation purposes. +SYSTEM TRANSMISSION LINES AND FACILITY SITING +Laws in the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Tennessee, Texas, Virginia and West Virginia require prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. AEP has experienced delays and additional costs in constructing facilities as a result of proceedings conducted pursuant to such statutes and in proceedings in which AEP’s operating companies have sought to acquire rights-of-way through condemnation. These proceedings may result in additional delays and costs in future years. +CONSTRUCTION PROGRAM +With input from its state utility commissions, the AEP System continuously assesses the adequacy of its transmission, distribution, generation and other facilities to plan and provide for the reliable supply of electric power and energy to its customers. In this assessment process, assumptions are continually being reviewed as new information becomes available and assessments and plans are modified, as appropriate. AEP forecasts approximately $7.5 billion of construction expenditures for 2021. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends, weather, legal reviews and the ability to access capital. See the “Budgeted Capital Expenditures” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +51 +POTENTIAL UNINSURED LOSSES +Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to AEP’s generation plants and costs of replacement power. Unless allowed to be recovered through rates, future losses or liabilities which are not completely insured could reduce net income and impact the financial conditions of AEP and other AEP System companies. For risks related to owning a nuclear generating unit, see the “Nuclear Contingencies” section of Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report for additional information. +ITEM 3. LEGAL PROCEEDINGS +For a discussion of material legal proceedings, see Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report for additional information. +ITEM 4. MINE SAFETY DISCLOSURE +The Federal Mine Safety and Health Act of 1977 (Mine Act) imposes stringent health and safety standards on various mining operations. The Mine Act and its related regulations affect numerous aspects of mining operations, including training of mine personnel, mining procedures, equipment used in mine emergency procedures, mine plans and other matters. SWEPCo, through its ownership of DHLC, a wholly-owned lignite mining subsidiary of SWEPCo, is subject to the provisions of the Mine Act. +The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires companies that operate mines to include in their periodic reports filed with the SEC, certain mine safety information covered by the Mine Act. Exhibit 95 “Mine Safety Disclosure Exhibit” contains the notices of violation and proposed assessments received by DHLC under the Mine Act for the quarter ended December 31, 2020. +52 +PART II +ITEM 5. MARKET FOR REGISTRANTS’ COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +AEP +In addition to the AEP Common Stock Information section below, the remaining information required by this item is incorporated herein by reference to the material under the “Dividend Policy and Restrictions” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report. +During the quarter ended December 31, 2020, neither AEP nor its publicly-traded subsidiaries purchased equity securities that are registered by AEP or its publicly-traded subsidiaries pursuant to Section 12 of the Exchange Act. +AEP Texas, APCo, I&M, OPCo, PSO and SWEPCo +The common stock of these companies is held solely by AEP. For more information see the “Dividend Restrictions” section of Note 14 - Financing Activities included in the 2020 Annual Report. +AEPTCo +AEP owns the entire interest in AEPTCo through its wholly-owned subsidiary AEP Transmission Holdco. +AEP COMMON STOCK INFORMATION +AEP common stock is principally traded using the trading symbol “AEP” on the NASDAQ Stock Market. As of December 31, 2020, AEP had 55,475 registered shareholders. The performance graph below compares the cumulative total return among AEP, the S&P 500 Index and the S&P Electric Utilities Index over a five year period. The performance graph assumes an initial investment of $100 on December 31, 2015 and that all dividends were reinvested. +Source: S&P Dow Jones Indices LLC. Data as of December 31, 2020. Past performance is no guarantee of future results. Chart provided for illustrative purposes. +53 +ITEM 6. SELECTED FINANCIAL DATA +The selected financial data previously required by Item 301 of Regulation S-K has been omitted in reliance on SEC Release No. 33-10890, Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information. +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +AEP +The information required by this item is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2020 Annual Report. Year-to-year comparisons between 2019 and 2018 have been omitted from this Form 10-K but may be found in "Management's Discussion and Analysis of Financial Condition" in Part II, Item 7 of our Form 10-K for the fiscal year ended December 31, 2019, which specific discussion is incorporated herein by reference. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(a). Management’s narrative analysis of the results of operations and other information required by Instruction I(2)(a) is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2020 Annual Report. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +The information required by this item is incorporated herein by reference to the material under the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2020 Annual Report. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +54 +2020 Annual Reports +American Electric Power Company, Inc. and Subsidiary Companies +AEP Texas Inc. and Subsidiaries +AEP Transmission Company, LLC and Subsidiaries +Appalachian Power Company and Subsidiaries +Indiana Michigan Power Company and Subsidiaries +Ohio Power Company and Subsidiaries +Public Service Company of Oklahoma +Southwestern Electric Power Company Consolidated +Audited Financial Statements and +Management’s Discussion and Analysis of Financial Condition and Results of Operations +55 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +INDEX OF ANNUAL REPORTS +Page +Number +American Electric Power Company, Inc. and Subsidiary Companies: +Management’s Discussion and Analysis of Financial Condition and Results of Operations +57 +Report of Independent Registered Public Accounting Firm +121 +Management’s Report on Internal Control Over Financial Reporting +124 +Consolidated Financial Statements +125 +AEP Texas Inc. and Subsidiaries: +Management’s Narrative Discussion and Analysis of Results of Operations +132 +Report of Independent Registered Public Accounting Firm +137 +Management’s Report on Internal Control Over Financial Reporting +139 +Consolidated Financial Statements +140 +AEP Transmission Company, LLC and Subsidiaries: +Management’s Narrative Discussion and Analysis of Results of Operations +147 +Report of Independent Registered Public Accounting Firm +150 +Management’s Report on Internal Control Over Financial Reporting +152 +Consolidated Financial Statements +153 +Appalachian Power Company and Subsidiaries: +Management’s Narrative Discussion and Analysis of Results of Operations +159 +Report of Independent Registered Public Accounting Firm +163 +Management’s Report on Internal Control Over Financial Reporting +165 +Consolidated Financial Statements +166 +Indiana Michigan Power Company and Subsidiaries: +Management’s Narrative Discussion and Analysis of Results of Operations +173 +Report of Independent Registered Public Accounting Firm +177 +Management’s Report on Internal Control Over Financial Reporting +179 +Consolidated Financial Statements +180 +Ohio Power Company and Subsidiaries: +Management’s Narrative Discussion and Analysis of Results of Operations +187 +Report of Independent Registered Public Accounting Firm +191 +Management’s Report on Internal Control Over Financial Reporting +194 +Consolidated Financial Statements +195 +Public Service Company of Oklahoma: +Management’s Narrative Discussion and Analysis of Results of Operations +202 +Report of Independent Registered Public Accounting Firm +206 +Management’s Report on Internal Control Over Financial Reporting +208 +Financial Statements +209 +Southwestern Electric Power Company Consolidated: +Management’s Narrative Discussion and Analysis of Results of Operations +216 +Report of Independent Registered Public Accounting Firm +220 +Management’s Report on Internal Control Over Financial Reporting +222 +Consolidated Financial Statements +223 +Index of Notes to Financial Statements of Registrant s +229 +56 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND +RESULTS OF OPERATIONS +EXECUTIVE OVERVIEW +Company Overview +AEP is one of the largest investor-owned electric public utility holding companies in the United States. AEP’s electric utility operating companies provide generation, transmission and distribution services to more than five million retail customers in Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. +AEP’s subsidiaries operate an extensive portfolio of assets including: +• Approximately 223,000 circuit miles of distribution lines that deliver electricity to 5.5 million customers. +• Approximately 40,000 circuit miles of transmission lines, including approximately 2,200 circuit miles of 765 kV lines, the backbone of the electric interconnection grid in the eastern United States. +• Approximately 22,000 MWs of regulated owned generating capacity and approximately 4,700 MWs of regulated PPA capacity in 2 RTOs as of December 31, 2020, one of the largest complements of generation in the United States. +COVID-19 +In March 2020, COVID-19 was declared a pandemic by the World Health Organization and the Centers for Disease Control and Prevention. Its rapid spread around the world and throughout the United States prompted many countries, including the United States, to institute restrictions on travel, public gatherings and certain business operations. These restrictions significantly disrupted economic activity in AEP’s service territory and reduced demand for energy, particularly from commercial and industrial customers in 2020. Although AEP cannot predict the severity or duration of the impact of the COVID-19 pandemic, AEP currently anticipates a 0.2% increase in weather-normalized retail sales volume in 2021 as compared to 2020. For the year ended December 31, 2020, AEP experienced a reduction in weather-normalized retail sales volume of 2.2% as compared to the same period in 2019 primarily driven by a 5.7% decrease in the industrial customer class and a 4.2% decrease in the commercial customer class offset by an increase in demand of 3.2% from the residential customer class. The reduction in weather-normalized retail sales volume of 2.2% did not result in a significant decrease in the corresponding retail margins for the year ended December 31, 2020 as the increase in higher margin residential sales volumes partially offset the decreases in the industrial and commercial sales volumes. Furthermore, the rate design for certain industrial customers includes demand provisions designed to cover the fixed portion of utility costs minimizing the impact of the fluctuations in usage on revenues. AEP’s load forecast is highly dependent on many factors including, but not limited to, the speed and strength of economic recovery and the extent and duration of the next wave of COVID-19 infection. If the severity of the economic disruption increases, AEP’s future results of operations, financial condition, and cash flows could be further adversely impacted. See Customer Demand for additional information. +During the first quarter of 2020, AEP’s electric operating companies informed both retail customers and state regulators that disconnections for non-payment were temporarily suspended. Shortly thereafter, AEP’s state regulators also imposed temporary moratoria on customary disconnection practices. During the third and the fourth quarters of 2020, most state regulators began to lift restrictions on disconnects. As of December 31, 2020, AEP had resumed disconnections in its regulated jurisdictions with the exception of Virginia, Kentucky and Arkansas. Disconnections resumed in Kentucky during January 2021. AEP continues to work with regulators and stakeholders in Virginia and Arkansas and management currently anticipates resuming customary disconnection practices in the first half of 2021. However, this timing could change if there is new legislation or other regulatory directives issued in the future. Continuing adverse economic conditions may result in the inability of customers to pay for electric service, which could affect revenue recognition and the collectability of accounts receivable. +57 +Throughout 2020, the Registrants reviewed current collections experience with historical trends, specifically reviewing metrics such as cash collections, days sales outstanding, daily customer deposits and aging summaries. In addition, the Registrants reviewed historical loss information generally comprised of a rolling 12-month average, in conjunction with a qualitative assessment of elements that impact the collectability of receivables, such as changes in economic factors, regulatory matters, industry trends, customer credit factors, payment plan options and other programs available to customers. Based on this review, the Registrants’ accounts receivable aging was negatively impacted primarily due to the suspension of customer disconnects, but has continued to improve throughout the fourth quarter of 2020 as disconnect moratoriums have ended in most jurisdictions. Accounts receivable aging is also improving due to AEP proactively engaging with customers to collect payments or establish payment arrangements for outstanding balances. AEP has received, from the states of Virginia and West Virginia, $10 million and $20 million, respectively, to apply to residential customer balances that are past-due. In addition, customers in other states have access to various programs that assist customers who have accumulated larger than normal past-due balances. As of December 31, 2020, AEP currently does not expect accounts receivable aging to have a material adverse impact on the Registrants’ allowance for uncollectible accounts based on considerations of the COVID-19 impacts and past trends during times of economic instability. Management continues to monitor developments affecting suspensions of disconnections and its impact on customer collections. Further deterioration in AEP’s ability to collect from its customers could significantly impact AEP’s future results of operations, financial conditions and cash flows. +In May 2020, AEP Credit amended its receivables securitization agreement to increase the eligibility criteria related to aged receivable requirements for the participating affiliated utility subsidiaries in response to the COVID-19 pandemic. As of December 31, 2020, the affiliated utility subsidiaries are in compliance with all requirements under the agreement. To the extent that an affiliated utility subsidiary is deemed ineligible under the agreement, the affiliated utility subsidiary would no longer participate in the receivables securitization agreement and the Registrants would need to rely on additional sources of funding for operation and working capital, which may adversely impact liquidity. The receivables that are ineligible under the receivables securitization agreement are financed with short-term debt at AEP Credit. +The Registrants have worked with their state commissions to achieve deferral authority for incremental expenses incurred due to COVID-19. All of AEP’s regulated jurisdictions have issued COVID-19 orders, granting deferral authority for incremental COVID-19 expenses, with the exception of Kentucky and Tennessee. If any costs related to COVID-19 are not recoverable, it could reduce future net income and cash flows and impact financial condition. +The effects of the continued COVID-19 pandemic and related government responses could also include extended disruptions to supply chains, reduced labor availability, reduced dispatch for certain generation assets and a prolonged reduction in economic activity. These effects could have a variety of adverse impacts to the Registrants, including their ability to operate their facilities. As of December 31, 2020, there were no material adverse impacts to the Registrants’ operations and supplier contracts due to COVID-19. AEP will continue to monitor developments affecting facility operations and will take additional actions necessary in order to mitigate adverse impacts to the Registrants’ future results of operations, financial condition and cash flows. +In addition, the economic disruptions caused by COVID-19 could also adversely impact the impairment risks for certain long-lived assets, equity method investments and goodwill. AEP evaluated these impairment considerations and determined that no such impairments existed as of December 31, 2020. +Market volatility and reduction in collections coupled with longer collection periods due to the expansion of customer payment arrangements could reduce cash from operations and cause an adverse impact to liquidity. During 2020, AEP increased its liquidity position to mitigate the market risk and the collections risk due to COVID-19. During the first quarter of 2020, AEP entered into a $1 billion 364–day term loan to reduce reliance on commercial paper and help mitigate potential future liquidity risks. The $1 billion 364-day term loan was repaid in the fourth quarter of 2020. In addition, during 2020, AEP issued approximately $5.6 billion in long-term debt. As of December 31, 2020, AEP’s available liquidity was $2.5 billion. Management believes the Registrants have adequate liquidity under existing credit facilities. In the first quarter of 2020, AEP shifted capital expenditures of +58 +$500 million out of 2020 into future periods to further mitigate adverse liquidity impacts. In the second quarter of 2020, AEP reinstated $100 million of capital expenditures back into 2020 that had previously been deferred. To the extent that future access to the capital markets or the cost of funding is adversely affected by COVID-19, future results of operations, financial condition, and cash flows may be adversely impacted. +In March 2020, the CARES Act was signed into law. The CARES Act includes tax relief provisions such as: (a) an AMT Credit Refund, (b) a 5-year NOL carryback from years 2018-2020 and (c) delayed payment of employer payroll taxes. Pursuant to the CARES Act, AEP, APCo and OPCo requested and in July received refunds of AMT credit of $20 million, $7 million and $9 million, respectively. In the third quarter of 2020, AEP also requested a $95 million refund of taxes paid in 2014 under the 5-year NOL carryback provision of the CARES Act. AEP carried back a NOL generated on the 2019 Federal income tax return at a 21% federal corporate income tax rate to the 2014 Federal income tax return at a 35% corporate income tax rate. As a result of the change in the corporate income tax rates between the two periods, AEP realized a tax benefit of $48 million primarily at the Generation & Marketing segment. Management will continue to monitor potential legislation and any impacts to the AMT Credit and NOL refunds that were filed in 2020 pursuant to the CARES Act. The Registrants deferred payments of the employer share of payroll taxes for the period March 27, 2020 through December 31, 2020 and will pay 50% of the obligation by December 31, 2021 and the remaining 50% by December 31, 2022. As of December 31, 2020, the Registrants have deferred $55 million of the employer share of payroll taxes. +In December 2020, the CAA of 2021 was signed into law. The CAA of 2021 includes: (a) COVID-19 tax relief and tax extender provisions including extensions of time to begin construction on and placed in-service assets generating PTCs and ITCs, (b) 100% deductibility of business meals in 2021 and 2022 and (c) an extension of the work opportunity tax credit. The ITC percentage has been increased for projects starting construction through 2023 and placed in-service by the end of 2025. The PTC has been extended for an additional year, to include projects started in 2021 and completed in 2025. These provisions provide time and flexibility on the construction start and in-service dates. +The Registrants have taken steps to mitigate the potential risks to customers, suppliers and employees posed by the spread of COVID-19. The Registrants have updated and implemented a company-wide pandemic plan to address specific aspects of COVID-19. This plan guides emergency response, business continuity and the precautionary measures AEP is taking on behalf of its employees and the public. The Registrants have taken extra precautions for employees who work in the field and for employees who work in their facilities, and have work from home policies where appropriate. The Registrants will continue to monitor developments affecting both their workforce and customers, and will take additional precautions that management determines are necessary in order to mitigate the impacts. AEP continues to focus on providing safe, uninterrupted service to its customers, which includes the implementation of strong physical and cyber-security measures to ensure that its systems remain functional with a partially remote workforce. As of December 31, 2020, there has been no material adverse impact to the Registrants’ business operations and customer service due to remote work. Management will continue to review and modify plans as conditions change. Despite efforts to manage these impacts to the Registrants, the ultimate impact of COVID-19 also depends on factors beyond management’s knowledge or control, including the duration and severity of this outbreak as well as third-party actions taken to contain its spread and mitigate its public health effects. Therefore, management cannot estimate the potential future impact to financial position, results of operations and cash flows, but the impacts could be material. +Customer Demand +AEP’s weather-normalized retail sales volumes for the year ended December 31, 2020 decreased by 2.2% from the year ended December 31, 2019. Weather-normalized residential sales increased 3.2% for the year ended December 31, 2020 compared to the year ended December 31, 2019. AEP’s 2020 industrial sales volumes decreased 5.7% compared to 2019. The decline in industrial sales was spread across many industries. Weather-normalized commercial sales decreased by 4.2% in 2020 compared to 2019. +59 +In 2021, AEP anticipates weather-normalized retail sales volumes will increase by 0.2%. The industrial class is expected to increase by 1.9% in 2021, while weather-normalized residential sales volumes are projected to decrease by 1.1%. Finally, AEP projects weather-normalized commercial sales volumes to decrease by 0.5%. +(a) Percentage change for the year ended December 31, 2020 as compared to the year ended December 31, 2019. +(b) Forecasted percentage change for the year ended December 31, 2021 compared to the year ended December 31, 2020. +Regulatory Matters +AEP’s public utility subsidiaries are involved in rate and regulatory proceedings at the FERC and their state commissions. Depending on the outcomes, these rate and regulatory proceedings can have a material impact on results of operations, cash flows and possibly financial condition. AEP is currently involved in the following key proceedings. See Note 4 - Rate Matters for additional information. +• 2017-2019 Virginia Triennial Review - In March 2020, APCo submitted its 2017-2019 Virginia triennial earnings review filing and base rate case with the Virginia SCC as required by state law. APCo requested a $65 million annual increase in base rates based upon a proposed 9.9% ROE. Triennial reviews are subject to an earnings test, which provides that 70% of any earnings in excess of 70 basis points above APCo’s Virginia SCC authorized ROE would be refunded to customers. In such case, the Virginia SCC could also lower APCo’s Virginia retail base rates on a prospective basis. Virginia law provides that costs associated with asset impairments of retired coal generation assets, or automated meters, or both, which a utility records as an expense, shall be attributed to the test periods under review in a triennial review proceeding, and be deemed recovered. In 2015, APCo retired the Sporn Plant, the Kanawha River Plant, the Glen Lyn Plant, Clinch River Unit 3 and the coal portions of Clinch River Units 1 and 2 (collectively, the retired coal-fired generation assets). The net book value of the Virginia jurisdictional share of these plants was $93 million before cost of removal, including materials and supplies inventory and ARO balances. Based on management’s interpretation of Virginia law and more certainty regarding APCo’s triennial revenues, expenses and resulting earnings upon reaching the end of the three-year review period, APCo recorded a pretax expense of $93 million related to its previously retired coal-fired generation assets in December 2019. As a result, management deemed these costs to be substantially recovered by APCo during the triennial review period. Inclusive of the Virginia jurisdictional share of the $93 million expense associated with APCo’s retired coal-fired generation assets, APCo calculated its 2017-2019 Virginia earnings for the triennial period to be below the authorized ROE range. +60 +In November 2020, the Virginia SCC issued an order concluding that APCo earned above its authorized ROE but within its ROE band for the 2017-2019 period, resulting in no refund to customers and no change to APCo base rates on a prospective basis. The Virginia SCC also disagreed with APCo’s treatment of the retired coal-fired generation assets for regulatory purposes, and instead adopted the Virginia SCC Staff’s recommendation to treat the remaining unrecovered costs of the retired coal-fired generation assets as a regulatory asset to be amortized over 10 years as of the June 2015 retirement date. The Virginia SCC’s adoption of the Staff’s recommended regulatory treatment of the coal-fired generation assets resulted in a net $40 million increase to APCo’s 2020 pretax income. In addition, the Virginia SCC’s order also included: (a) implementation of the Staff-modified APCo 2017 depreciation study effective January 1, 2018 and (b) implementation of the Staff-modified APCo 2019 depreciation study effective January 1, 2020. The adoption of these depreciation studies resulted in an approximate $47 million reduction to APCo’s 2020 pretax income comprised of a $44 million reduction to revenues for amounts recognized in advance of the recording of depreciation expense for the periods January 2018 through October 2020 and a $3 million increase in depreciation expense for the periods November and December 2020. A corresponding regulatory liability was recorded for the $44 million reduction to revenues. Also in November 2020, APCo filed a notice of appeal of the Virginia SCC’s order with the Virginia Supreme Court. In December 2020, an intervenor filed a petition at the Virginia SCC requesting reconsideration of: (a) the failure of the Virginia SCC to apply a threshold earnings test to the approved regulatory asset for APCo’s closed coal-fired generation assets, (b) the Virginia SCC’s use of a 2011 benchmark study to measure the replacement value of capacity for purposes of APCo’s 2017 – 2019 earnings test and (c) the reasonableness and prudency of APCo’s investments in AMI meters. Also in December 2020, APCo filed a petition at the Virginia SCC requesting reconsideration of: (a) certain issues related to APCo’s going-forward rates and (b) the Virginia SCC’s decision to deny APCo tariff changes that align rates with underlying costs. For APCo’s going-forward rates, APCo requested that the Virginia SCC clarify its final order and whether APCo’s current rates will allow it to earn a fair return. If the Virginia SCC’s order did conclude on APCo’s ability to earn a fair return through existing base rates, APCo further requested that the Virginia SCC clarify whether it has the authority to also permit an increase in base rates. If the Virginia SCC did not conclude on APCo’s ability to earn a fair return, APCo requested the Virginia SCC provide such a conclusion. In January 2021, as requested by the Virginia SCC, APCo filed briefs related to the petition for reconsideration. +• 2020 Ohio Base Rate Case - In June 2020, OPCo filed a request with the PUCO for a $42 million annual increase in base rates based upon a proposed 10.15% ROE net of existing riders. In November 2020, PUCO staff filed testimony supporting an annual revenue decrease ranging from $102 million to $123 million based upon an ROE of 8.76% to 9.78%. The staff’s proposal included a disallowance of plant in-service which could result in a write-off of up to $27 million. In addition, the staff recommended that capitalized incentives be excluded from base rates prospectively and also recommended annual revenue caps for the DIR of $57 million in 2021, $78 million in 2022, $96 million in 2023 and $46 million for the first five months of 2024. In December 2020, OPCo and intervenors filed objections. A procedural schedule for the case is pending due to ongoing settlement discussions. +• Hurricane Laura - In August 2020, Hurricane Laura hit the coasts of Louisiana and Texas, causing power outages to more than 130,000 customers across SWEPCo’s service territories. Prior to Hurricane Laura, SWEPCo did not have a catastrophe reserve or automatic deferral authority within any of its jurisdictions. In October 2020, the LPSC issued an order allowing Louisiana utilities, including SWEPCo, to establish a regulatory asset to track and defer expenses associated with Hurricane Laura. In October 2020, as part of the 2020 Texas Base Rate Case, SWEPCo requested deferral authority of incremental other operation and maintenance expenses. As of December 31, 2020, management estimates that SWEPCo has incurred incremental other operation and maintenance expenses of $84 million ($82 million of which has been deferred as a regulatory asset related to the Louisiana jurisdiction) and incremental capital expenditures of $23 million, all of which is related to the Louisiana jurisdiction. +61 +• 2012 Texas Base Rate Case - In 2012, SWEPCo filed a request with the PUCT to increase annual base rates primarily due to the completion of the Turk Plant. In 2013, the PUCT issued an order affirming the prudence of the Turk Plant. In July 2018, the Texas Third Court of Appeals reversed the PUCT’s judgment affirming the prudence of the Turk Plant and remanded the issue back to the PUCT. In January 2019, SWEPCo and the PUCT filed petitions for review with the Texas Supreme Court. In the fourth quarter of 2019 and first quarter of 2020, SWEPCo and various intervenors filed briefs with the Texas Supreme Court. In August 2020, the Texas Supreme Court granted SWEPCo’s petition for review and oral arguments were held in December 2020. SWEPCo expects a decision from the Texas Supreme Court in 2021. As of December 31, 2020, the net book value of Turk Plant was $1.4 billion, before cost of removal, including materials and supplies inventory and CWIP. SWEPCo’s Texas jurisdictional share of the Turk Plant investment is approximately 33%. +• In July 2019, clean energy legislation (HB 6) which offers incentives for power-generating facilities with zero or reduced carbon emissions was signed into law by the Ohio Governor. HB 6 phased out current energy efficiency programs as of December 31, 2020, including shared savings revenues of $26 million annually and renewable mandates after 2026. HB 6 also provided for the recovery of existing renewable energy contracts on a bypassable basis through 2032 and included a provision for recovery of OVEC costs through 2030 which will be allocated to all electric distribution utilities on a non-bypassable basis. OPCo’s Inter-Company Power Agreement for OVEC terminates in June 2040. In July 2020, an investigation led by the U.S. Attorney’s Office resulted in a federal grand jury indictment of the Speaker of the Ohio House of Representatives, Larry Householder, four other individuals, and Generation Now, an entity registered as a 501(c)(4) social welfare organization, in connection with a racketeering conspiracy involving the adoption of HB 6. In light of the allegations in the indictment, proposed legislation has been introduced that would repeal HB 6. The outcome of the U.S. Attorney’s Office investigation and its impact on HB 6 is not known. If the provisions of HB 6 were to be eliminated, it is unclear whether and in what form the Ohio General Assembly would pass new legislation addressing similar issues. In August 2020, an AEP shareholder filed a putative class action lawsuit against AEP and certain of its officers for alleged violations of securities laws. In January and February 2021, two AEP shareholders filed two derivative actions purporting to assert claims on behalf of AEP against certain AEP officers and directors based on allegations similar to those in the putative securities class action. See Litigation Related to Ohio House Bill 6 section of Litigation below for additional information. To the extent that OPCo is unable to recover the costs of renewable energy contracts on a bypassable basis by the end of 2032, recover costs of OVEC after 2030, fully recover energy efficiency costs incurred through 2020 or incurs significant costs defending against the securities class action or the derivative actions, it could reduce future net income and cash flows and impact financial condition. +• In April 2020, the Virginia Clean Economy Act was signed into law by the Virginia Governor and became effective in July 2020. The law includes the following requirements: (a) Virginia electric utilities to retire no later than 2045 all electric generating units located in Virginia that emit carbon as a by-product, (b) APCo to produce 100% of the company’s power to serve Virginia customers from renewable sources by 2050 with increasing percentages of mandatory renewable energy sources each year and (c) Virginia electric utilities to achieve increasing annual energy efficiency savings from 2022-2025 using 2019 as the base year. This law also provides that if the Virginia SCC finds in any triennial review that revenue reductions related to energy efficiency programs approved and deployed since the utility's previous triennial review have caused the utility to earn more than 70 basis points below its authorized rate of return, the Virginia SCC shall order increases to the utility's rates necessary to recover such revenue reductions. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +• In December 2020, APCo and WPCo filed a proposal with the WVPSC to implement an investment tracker surcharge mechanism for recovering costs associated with capital investment made between base rate cases. The initial filing requests a total annual increase of $50 million ($41 million related to APCo), which represents recovery of costs associated with infrastructure investments made over an approximate three-year period since the companies’ last base rate case filing in 2018. The filing also proposes that APCo and +62 +WPCo could submit annual filings with requested increases capped to a percentage of total retail revenues (3.5% in the first year and 3% in subsequent filings with an overall cap of 9.5%). If a future base rate case is filed, the surcharge would reset to zero on implementation of the new rates. In January 2021, WVPSC staff filed a motion recommending that the WVPSC reject the proposal. If APCo and WPCo do not receive approval to recover these incremental investments through the proposed tracker surcharge mechanism between base rate cases, it could cause a temporary reduction in future net income and cash flows and impact financial condition until APCo and WPCo can seek approval in their next base rate case. +Utility Rates and Rate Proceedings +The Registrants file rate cases with their regulatory commissions in order to establish fair and appropriate electric service rates to recover their costs and earn a fair return on their investments. The outcomes of these regulatory proceedings impact the Registrants’ current and future results of operations, cash flows and financial position. +The following tables show the Registrants’ completed and pending base rate case proceedings in 2020. See Note 4 - Rate Matters for additional information. +Completed Base Rate Case Proceedings +Approved Revenue Approved New Rates +Company Jurisdiction Requirement Increase (Decrease) ROE Effective +(in millions) +I&M Michigan $ 36.4 (a) 9.86% February 2020 +I&M Indiana 60.0 (b) 9.7% March 2020 +AEP Texas Texas (40.0) 9.4% June 2020 +APCo Virginia — (c) 9.2% February 2021 +KPCo Kentucky 52.7 9.3% January 2021 +(a) See “2019 Michigan Base Rate Case” section of Note 4 Rate Matters in the 2019 Annual Report for additional information. +(b) Phased-in through an increase in base rates which included: (a) an annual increase in base rates of $44 million effective March 2020 and (b) an annual increase in base rates of $60 million effective January 2021 based on the IURC-approved forecast of December 31, 2020 Indiana jurisdictional electric plant in-service. The order rejected I&M’s proposed re-allocation of capacity costs related to the loss of a significant FERC wholesale contract, which negatively impacted I&M’s annual pretax earnings by approximately $20 million starting June 2020. +(c) APCo filed a notice of appeal with the Virginia Supreme Court and a petition requesting reconsideration with the Virginia SCC. In addition, an intervenor has also filed a petition requesting reconsideration with the Virginia SCC. +Pending Base Rate Case Proceedings +Commission Staff/ +Filing Requested Revenue Requested Intervenor Range of +Company Jurisdiction Date Requirement Increase ROE Recommended ROE +(in millions) +OPCo Ohio June 2020 $ 42.3 10.15% 8.76% - 9.78% +SWEPCo Texas October 2020 105.0 (a) 10.35% (b) +SWEPCo Louisiana December 2020 134.0 10.35% (c) +(a) The request would move transmission and distribution interim revenues recovered through riders into base rates. Eliminating these riders would result in a net annual requested base rate increase of $90 million primarily due to increased investments. +(b) Intervenor and staff testimony is scheduled to be filed in March and April 2021, respectively. +(c) Awaiting procedural schedule. +63 +Dolet Hills Power Station and Related Fuel Operations +During the second quarter of 2019, the Dolet Hills Power Station initiated a seasonal operating schedule. In January 2020, in accordance with the terms of SWEPCo’s settlement of its base rate review filed with the APSC, management announced that SWEPCo will seek regulatory approval to retire the Dolet Hills Power Station by the end of 2026. DHLC provides 100% of the fuel supply to Dolet Hills Power Station. After careful consideration of current economic conditions, and particularly for the benefit of their customers, management of SWEPCo and CLECO determined DHLC would not proceed developing additional Oxbow Lignite Company (Oxbow) mining areas for future lignite extraction and ceased extraction of lignite at the mine in May 2020. Based on these actions, management revised the estimated useful life of DHLC’s and Oxbow’s assets to coincide with the date at which extraction was discontinued in the second quarter of 2020 and the date at which delivery of lignite is expected to cease in September 2021. Management also revised the useful life of the Dolet Hills Power Station to 2021 based on the remaining estimated fuel supply available for continued seasonal operation. In March 2020, primarily due to the revision in the useful life of DHLC, SWEPCo recorded a revision to increase estimated ARO liabilities by $21 million. In April 2020, SWEPCo and CLECO jointly filed a notification letter to the LPSC providing notice of the cessation of lignite mining. +The Dolet Hills Power Station costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Dolet Hills Power Station is $151 million, including CWIP and materials and supplies, before cost of removal. +Fuel costs incurred by the Dolet Hills Power Station are recoverable by SWEPCo through active fuel clauses. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $131 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $35 million, which includes fuel burned at the Dolet Hills Power Station. Additional operational and land-related costs are expected to be incurred by DHLC and Oxbow and billed to SWEPCo prior to the closure of the Dolet Hills Power Station and recovered through fuel clauses. +In October 2020, SWEPCo filed a request with the LPSC for recovery of the Louisiana share of these additional fuel costs. SWEPCo’s filing proposes to defer $36 million of fuel costs in 2021 and recover the deferral plus carrying costs over five years beginning in 2022. +If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +Pirkey Power Plant and Related Fuel Operations +In November 2020, management announced plans to retire the Pirkey Power Plant in 2023. The Pirkey Power Plant costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Pirkey Power Plant is $212 million, including CWIP, before cost of removal. Sabine is a mining operator providing mining services to the Pirkey Power Plant. Under the provisions of the mining agreement, SWEPCo is required to pay, as part of the cost of lignite delivered, an amount equal to mining costs plus a management fee. SWEPCo expects fuel deliveries, including billings of all fixed and operating costs, from Sabine to cease during the first quarter of 2023. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $193 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $35 million, which includes fuel burned at the Pirkey Power Plant. Additional operational costs are expected to be incurred by Sabine and billed to SWEPCo, as well as land-related costs incurred by SWEPCo, prior to the closure of the Pirkey Power Plant and recovered through fuel clauses. +If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +64 +Renewable Generation +The growth of AEP’s renewable generation portfolio reflects the company’s strategy to diversify generation resources to provide clean energy options to customers that meet both their energy and capacity needs. +Contracted Renewable Generation Facilities +AEP continues to develop its renewable portfolio within the Generation & Marketing segment. Activities include working directly with wholesale and large retail customers to provide tailored solutions based upon market knowledge, technology innovations and deal structuring which may include distributed solar, wind, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other forms of cost reducing energy technologies. The Generation & Marketing segment also develops and/or acquires large scale renewable generation projects that are backed with long-term contracts with creditworthy counterparties. +In November 2020, AEP acquired an additional 10% interest, or approximately 30 MWs, in Santa Rita East. The project is located in west Texas and was placed in-service in July 2019. Long-term virtual power purchase agreements are in place with nonaffiliates for the project’s generation. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. +In November 2020, AEP signed a Purchase and Sale Agreement with a nonaffiliate to acquire a 75% interest in the 100 MW Dry Lake Solar Project located in southern Nevada. Management expects the transaction to close in the first quarter of 2021 and the solar project is expected to be in-service in the second quarter of 2021. +As of December 31, 2020, subsidiaries within AEP’s Generation & Marketing segment had approximately 1,549 MWs of contracted renewable generation projects in-service. In addition, as of December 31, 2020, these subsidiaries had approximately 137 MWs of renewable generation projects under construction with total estimated capital costs of $208 million related to these projects. +Regulated Renewable Generation Facilities +In 2020, PSO received approval from the OCC and SWEPCo received approval from the APSC and LPSC to acquire the North Central Wind Energy Facilities, comprised of three Oklahoma wind facilities totaling 1,485 MWs, on a fixed cost turn-key basis at completion. Both the APSC and LPSC approved the flex-up option, agreeing to acquire the Texas portion, which the PUCT denied. PSO will own 45.5% and SWEPCo will own 54.5% of the project, which will cost approximately $2 billion. +In May 2020, the IRS issued a notice extending the “Continuity Safe Harbor” deadlines for qualifying renewable energy projects that began construction in 2016 and 2017 by one year as many projects are facing supply chain and other project development delays caused by COVID-19. Under the May 2020 IRS notice, qualifying renewable energy projects that began construction in 2016 and 2017 and which are placed in-service by the end of 2021 and 2022, respectively, will satisfy the Continuity Safe Harbor. Provided that each facility does satisfy the Continuity Safe Harbor, under the current IRS guidance, the 199 MW wind facility will qualify for 100% of the federal PTC, and the remaining two wind facilities, totaling 1,286 MWs, will qualify for 80% of the federal PTC. +Having regulatory approval, and the expectation that all three wind facilities will be eligible for the IRS extension of the “Continuity Safe Harbor,” PSO and SWEPCo are proceeding with the full 1,485 MW development of these three projects. The 199 MW wind facility is targeted to be acquired and placed in-service in March 2021. The 287 MW wind facility is targeted to be acquired and placed in-service in December 2021 and the 999 MW wind facility is targeted to be acquired and placed in-service between December 2021 and April 2022. +65 +Hydroelectric Generation +Evaluating Sale of Hydroelectric Generation +In March 2020, management placed 10 hydroelectric generation plants under study for a potential sale. In April 2020, the Virginia Clean Economy Act was signed into law by the Virginia Governor. The new law will provide renewable credits to APCo for its existing hydroelectric generation plants. As a result of the new law, management removed the three APCo hydroelectric generation plants (London, Marmet and Winfield) from the list of plants identified for potential sale. In December 2020, management decided they would only proceed with the potential sale of Racine. The two Racine units have a net maximum capacity of 48 MWs and the net book value is $45 million as of December 31, 2020. In February 2021, AEP signed an agreement to sell Racine to a nonaffiliated party. The sale of Racine requires FERC approval. The sale is expected to close in the second quarter of 2021 and result in an immaterial gain. Racine was not presented as Held for Sale on AEP’s Consolidated Balance Sheets due to immateriality. +Federal Tax Reform +Based on current regulatory orders received, management anticipates amortization of $233 million of Excess ADIT in 2021 ($64 million of Excess ADIT subject to normalization requirements and $169 million of Excess ADIT that is not subject to normalization requirements). Customer usage or new regulatory orders could result in changes to these estimates. Management anticipates amortizing the following ranges of Excess ADIT that is not subject to normalization requirements during the years 2022 through 2026: +Annual Amortization of Excess ADIT +Not Subject to Normalization Requirements +Year Range +(in millions) +2022 $ 75.0 - $ 105.0 +2023 68.0 - 98.0 +2024 35.0 - 65.0 +2025 5.0 - 26.0 +2026 5.0 - 25.0 +Merchant Portion of Turk Plant +SWEPCo constructed the Turk Plant, a base load 600 MW (650 MW net maximum capacity) pulverized coal ultra-supercritical generating unit in Arkansas, which was placed in-service in December 2012 and is included in the Vertically Integrated Utilities segment. SWEPCo owns 73% (440 MWs/477 MWs) of the Turk Plant and operates the facility. +The APSC granted approval for SWEPCo to build the Turk Plant by issuing a Certificate of Environmental Compatibility and Public Need (CECPN) for the SWEPCo Arkansas jurisdictional share of the Turk Plant (approximately 20%). Following an appeal by certain intervenors, the Arkansas Supreme Court issued a decision that reversed the APSC’s grant of the CECPN. In June 2010, in response to an Arkansas Supreme Court decision, the APSC issued an order which reversed and set aside the previously granted CECPN. This share of the Turk Plant output is currently not subject to cost-based rate recovery and is being sold into the wholesale market. Approximately 80% of the Turk Plant investment is recovered under cost-based rate recovery in Texas, Louisiana and through SWEPCo’s wholesale customers under FERC-based rates. As of December 31, 2020, the net book value of Turk Plant was $1.4 billion, before cost of removal, including materials and supplies inventory and CWIP. If SWEPCo cannot ultimately recover its investment and expenses related to the Turk Plant, it could reduce future net income and cash flows and impact financial condition. +66 +FERC Transmission ROE Methodology +Management continues to monitor FERC’s 2019 Notice of Inquiry regarding base ROE policy, FERC’s 2020 Notice of Proposed Rulemaking regarding transmission incentives policy, and various other matters pending before FERC with the potential to affect FERC transmission ROE methodology. +In the second quarter of 2019, FERC approved settlement agreements establishing base ROEs of 9.85% (10.35% inclusive of RTO incentive adder of 0.5%) and 10% (10.5% inclusive of RTO incentive adder of 0.5%) for AEP’s PJM and SPP transmission-owning subsidiaries, respectively. In the second quarter of 2020, FERC Order 569A determined the base ROE for MISO’s transmission owning members, including AEP’s MISO transmission-owning subsidiaries, should be 10.02% (10.52% inclusive of the RTO incentive adder of 0.5%). +If FERC makes any changes to its ROE and incentive policies, they would be applied, as applicable, to AEP’s PJM, SPP and MISO transmission owning subsidiaries on a prospective basis, and could affect future net income and cash flows and impact financial condition. +Impacts of Severe Winter Weather in February 2021 +In February 2021, many of AEP’s service territories and customers were impacted by severe winter weather and extreme cold temperatures resulting in power outages, extensive damage to transmission and distribution infrastructure and disruption to the energy markets. +Storm Costs +Based on the information currently available, APCo, KPCo and SWEPCo currently estimate significant February 2021 storm restoration expenditures as shown in the table below. Management currently anticipates the storm restoration expenditures will be more heavily weighted towards other operation and maintenance expenses as compared to capital expenditures. Management will continue to refine these storm cost estimates as restoration efforts are completed and final costs become available. +Total Estimated February 2021 +Storm Restoration Expenditures +(in millions) +APCo $65.0 - $75.0 +KPCo $75.0 - $95.0 +SWEPCo $30.0 - $40.0 +Management plans to seek regulatory recovery of these costs. If any of the storm costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +67 +February 2021 Severe Winter Weather Impacts in SPP +The February 2021 severe winter weather also had a significant impact in SPP resulting in the declaration of Energy Emergency Alert Levels 2 and 3 for the first time in SPP’s history. The winter storm increased the demand for natural gas and restricted the available natural gas supply resulting in significantly increased market prices for natural gas power plants to meet reliability needs for the SPP electric system. From February 9, 2021, to February 20, 2021, based on the information currently available, PSO’s and SWEPCo’s preliminary estimates of natural gas expenses and purchases of electricity are as follows: +PSO SWEPCo +(in millions) +Estimated Natural Gas Expenses $ 175.0 $ 375.0 +Estimated Electricity Purchases 650.0 — +$ 825.0 $ 375.0 +The amounts in the table above represent preliminary estimates as of February 25, 2021, and are subject to final settlement as additional information becomes available. In addition, SPP notified PSO and SWEPCo of additional collateral requirements of approximately $868 million on a cumulative basis for the companies due March 2, 2021. Subsequently, SPP filed a waiver request with the FERC that would grant a limited waiver for Load Serving Entities to post this additional collateral requirement between February 24, 2021 and March 11, 2021. FERC approved the waiver request on February 24, 2021. +PSO and SWEPCo have active fuel clauses that allow for the recovery of prudently incurred fuel and purchased power expenses. Given the significance of these costs, PSO and SWEPCo expect regulators to perform a heightened review of the costs. Management believes these costs are probable of future recovery. However, the recovery of these costs from customers may be extended over longer than usual time periods to mitigate the impact on customer bills. Nevertheless, PSO and SWEPCo’s payments to suppliers are due in March 2021. +PSO and SWEPCo are evaluating financing alternatives including funding contributions from Parent and long-term debt issuances to address the timing difference between the payment to suppliers and recovery from customers. If either PSO or SWEPCo is unable to recover these fuel and purchased power expenses or recover these expenses in a timely manner, it could reduce future net income and cash flows and impact financial condition. +ERCOT +In response to the extreme winter weather event, the Governor of Texas issued a Declaration of a State of Disaster for all counties in Texas. While recovery from the emergency conditions is continuing, some market conditions and activities have yet to return to normal. To assist with a return to normalcy, the PUCT issued an order that placed a temporary moratorium on customer disconnections due to non-payment for transmission and distribution utilities. This moratorium will be in effect until otherwise ordered by the PUCT. +68 +LITIGATION +In the ordinary course of business, AEP is involved in employment, commercial, environmental and regulatory litigation. Since it is difficult to predict the outcome of these proceedings, management cannot predict the eventual resolution, timing or amount of any loss, fine or penalty. Management assesses the probability of loss for each contingency and accrues a liability for cases that have a probable likelihood of loss if the loss can be estimated. Adverse results in these proceedings have the potential to reduce future net income and cash flows and impact financial condition. See Note 4 – Rate Matters and Note 6 – Commitments, Guarantees and Contingencies for additional information. +Rockport Plant Litigation +In 2013, the Wilmington Trust Company filed a complaint in the U.S. District Court for the Southern District of New York against AEGCo and I&M alleging that it would be unlawfully burdened by the terms of the modified NSR consent decree after the Rockport Plant, Unit 2 lease expiration in December 2022. The terms of the consent decree allow the installation of environmental emission control equipment, repowering, refueling or retirement of the unit. The plaintiffs seek a judgment declaring that the defendants breached the lease, must satisfy obligations related to installation of emission control equipment and indemnify the plaintiffs. The New York court granted a motion to transfer this case to the U.S. District Court for the Southern District of Ohio. +AEGCo and I&M sought and were granted dismissal by the U.S. District Court for the Southern District of Ohio of certain of the plaintiffs’ claims, including claims for compensatory damages, breach of contract, breach of the implied covenant of good faith and fair dealing and indemnification of costs. Plaintiffs voluntarily dismissed the surviving claims that AEGCo and I&M failed to exercise prudent utility practices with prejudice, and the court issued a final judgment. The plaintiffs subsequently filed an appeal in the U.S. Court of Appeals for the Sixth Circuit. +In 2017, the U.S. Court of Appeals for the Sixth Circuit issued an opinion and judgment affirming the district court’s dismissal of the owners’ breach of good faith and fair dealing claim as duplicative of the breach of contract claims, reversing the district court’s dismissal of the breach of contract claims and remanding the case for further proceedings. +Thereafter, AEP filed a motion with the U.S. District Court for the Southern District of Ohio in the original NSR litigation, seeking to modify the consent decree. The district court granted the owners’ unopposed motion to stay the lease litigation to afford time for resolution of AEP’s motion to modify the consent decree. The consent decree was modified based on an agreement among the parties in July 2019. The district court’s stay of the lease litigation expired in August 2020. Upon expiration of the stay, plaintiffs filed a motion for partial summary judgment, arguing that the consent decree violates the facility lease and the participation agreement and requesting that the district court enter a judgment for the plaintiffs on their breach of contract claim. AEP’s memorandum in opposition to plaintiffs’ motion for partial summary judgement was filed in October 2020. At the parties’ request, the district court stayed the case until February 16, 2021 to provide the parties an opportunity to resolve the case, and the court has since extended the stay until April 26, 2021. See “Modification of the New Source Review Litigation Consent Decree” section below for additional information. +Management will continue to defend against the claims and believes its financial statements appropriately reflect the potential outcome of the pending litigation. The ultimate outcome of the pending litigation could reduce future net income and cash flows and impact financial condition. +69 +Patent Infringement Complaint +In July 2019, Midwest Energy Emissions Corporation and MES Inc. (collectively, the plaintiffs) filed a patent infringement complaint against various parties, including AEP Texas, AGR, Cardinal Operating Company and SWEPCo (collectively, the AEP Defendants). The complaint alleges that the AEP Defendants infringed two patents owned by the plaintiffs by using specific processes for mercury control at certain coal-fired generating stations. The complaint was resolved in December 2020 and did not have a material impact on net income, cash flows or financial condition. +Claims Challenging Transition of American Electric Power System Retirement Plan to Cash Balance Formula +The American Electric Power System Retirement Plan (the Plan) has received a letter written on behalf of four participants (the Claimants) making a claim for additional plan benefits and purporting to advance such claims on behalf of a class. When the Plan’s benefit formula was changed in the year 2000, AEP provided a special provision for employees hired before January 1, 2001, allowing them to continue benefit accruals under the then benefit formula for a full 10 years alongside of the new cash balance benefit formula then being implemented. Employees who were hired on or after January 1, 2001 accrued benefits only under the new cash balance benefit formula. The Claimants have asserted claims that: (a) the Plan violates the requirements under the Employee Retirement Income Security Act (ERISA) intended to preclude back-loading the accrual of benefits to the end of a participant’s career, (b) the Plan violates the age discrimination prohibitions of ERISA and the Age Discrimination in Employment Act and (c) the company failed to provide required notice regarding the changes to the Plan. AEP has responded to the Claimants providing a reasoned explanation for why each of their claims have been denied. The denial of those claims was appealed to the AEP System Retirement Plan Appeal Committee and the Committee upheld the denial of claims. Management will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring. +Litigation Related to Ohio House Bill 6 +In August 2020, an AEP shareholder filed a putative class action lawsuit in the United States District Court for the Southern District of Ohio against AEP and certain of its officers for alleged violations of securities laws. The complaint alleges misrepresentations or omissions by AEP regarding: (a) its alleged participation in public corruption with respect to the passage of Ohio House Bill 6, (b) its regulatory, legislative and lobbying activities in Ohio and (c) its clean energy strategy. The complaint seeks monetary damages among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring. +In January 2021, an AEP shareholder filed a derivative action in the United States District Court for the Southern District of Ohio purporting to assert claims on behalf of AEP against certain AEP officers and directors. In February 2021, a second AEP shareholder filed a similar derivative action in the Court of Common Pleas of Franklin County, Ohio. The derivative complaints allege the officers and directors made misrepresentations and omissions similar to those alleged in the putative securities class action lawsuit filed against AEP. The complaints assert claims for: (a) breach of fiduciary duty, (b) waste of corporate assets and (c) unjust enrichment and seek monetary damages and changes to AEP’s corporate governance and internal policies among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring. +ENVIRONMENTAL ISSUES +AEP has a substantial capital investment program and incurs additional operational costs to comply with environmental control requirements. Additional investments and operational changes will be made in response to existing and anticipated requirements to reduce emissions from fossil generation and in response to rules governing the beneficial use and disposal of coal combustion by-products, clean water and renewal permits for certain water discharges. +AEP is engaged in litigation about environmental issues, was notified of potential responsibility for the clean-up of contaminated sites and incurred costs for disposal of SNF and future decommissioning of the nuclear units. AEP, +70 +along with other parties, challenged some of the Federal EPA requirements. Management is engaged in the development of possible future requirements including the items discussed below. Management believes that further analysis and better coordination of these environmental requirements would facilitate planning and lower overall compliance costs while achieving the same environmental goals. +AEP will seek recovery of expenditures for pollution control technologies and associated costs from customers through rates in regulated jurisdictions. Environmental rules could result in accelerated depreciation, impairment of assets or regulatory disallowances. If AEP cannot recover the costs of environmental compliance, it would reduce future net income and cash flows and impact financial condition. +Environmental Controls Impact on the Generating Fleet +The rules and proposed environmental controls discussed below will have a material impact on AEP System generating units. Management continues to evaluate the impact of these rules, project scope and technology available to achieve compliance. As of December 31, 2020, the AEP System owned generating capacity of approximately 24,400 MWs, of which approximately 12,100 MWs were coal-fired. Management continues to refine the cost estimates of complying with these rules and other impacts of the environmental proposals on fossil generation. Based upon management estimates, AEP’s future investment to meet these existing and proposed requirements ranges from approximately $350 million to $700 million through 2027. +The cost estimates will change depending on the timing of implementation and whether the Federal EPA provides flexibility in finalizing proposed rules or revising certain existing requirements. The cost estimates will also change based on: (a) potential state rules that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) actual performance of the pollution control technologies installed, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired and replaced, including the type and amount of such replacement capacity and (g) other factors. In addition, management continues to evaluate the economic feasibility of environmental investments on regulated and competitive plants. +Modification of the New Source Review Litigation Consent Decree +In 2007, the U.S. District Court for the Southern District of Ohio approved a consent decree between AEP subsidiaries in the eastern area of the AEP System and the Department of Justice, the Federal EPA, eight northeastern states and other interested parties to settle claims that the AEP subsidiaries violated the NSR provisions of the CAA when they undertook various equipment repair and replacement projects over a period of nearly 20 years. The consent decree’s terms include installation of environmental control equipment on certain generating units, a declining cap on SO 2 and NO X emissions from the AEP System and various mitigation projects. +In 2017, AEP filed a motion with the district court seeking to modify the consent decree to eliminate an obligation to install future controls at Rockport Plant, Unit 2 if AEP does not acquire ownership of that unit, and to modify the consent decree in other respects to preserve the environmental benefits of the consent decree. The other parties to the consent decree opposed AEP’s motion. The district court granted AEP’s request to delay the deadline to install Selective Catalytic Reduction (SCR) technology at Rockport Plant, Unit 2 until June 2020. Construction of the SCR technology was completed by June 1, 2020, testing was conducted, and the unit was released for dispatch on June 5, 2020. +In May 2019, the parties filed a proposed order to modify the consent decree. The proposed order requires AEP to enhance the dry sorbent injection (DSI) system on both units at the Rockport Plant by the end of 2020, and meet 30-day rolling average emission rates for SO 2 and NO X at the combined stack for the Rockport Plant beginning in 2021. Total SO 2 emissions from the Rockport Plant are limited to 10,000 tons per year beginning in 2021 and reduce to 5,000 tons per year when Rockport Plant, Unit 1 retires in 2028. The proposed modification was approved by the district court and became effective in July 2019. As part of the modification to the consent decree, I&M agreed to provide an additional $7.5 million to citizens’ groups and the states for environmental mitigation projects. As joint-owners in the Rockport Plant, the $7.5 million payment was shared between AEGCo and I&M based on the joint-ownership agreement. +71 +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control sources of air emissions. The states implement and administer many of these programs and could impose additional or more stringent requirements. The primary regulatory programs that continue to drive investments in AEP’s existing generating units include: (a) periodic revisions to NAAQS and the development of SIPs to achieve any more stringent standards, (b) implementation of the regional haze program by the states and the Federal EPA, (c) regulation of hazardous air pollutant emissions under MATS, (d) implementation and review of CSAPR and (e) the Federal EPA’s regulation of greenhouse gas emissions from fossil generation under Section 111 of the CAA. Notable developments in significant CAA regulatory requirements affecting AEP’s operations are discussed in the following sections. +National Ambient Air Quality Standards +The Federal EPA reviewed the existing standards for NO 2 and SO 2 in 2018 and 2019, respectively, and decided to retain the standards without change. Implementation of these standards is underway. The Federal EPA recently reviewed the existing standards for PM and ozone and in December 2020 announced both standards would be retained without change. +The Federal EPA finalized non-attainment designations for the 2015 ozone standard in 2018. The Federal EPA confirmed that for states included in the CSAPR program, there are no additional interstate transport obligations, as all areas of the country are expected to attain the 2008 ozone standard before 2023. Challenges to the 2015 ozone standard and the Federal EPA’s determination that CSAPR satisfies certain states’ interstate transport obligations were filed in the U.S. Court of Appeals for the District of Columbia Circuit. In August 2019, the court upheld the 2015 primary ozone standard, but remanded the secondary welfare-based standard for further review. The court vacated the Federal EPA’s determination that CSAPR fulfilled the states’ interstate transport obligations, because the Federal EPA’s modeling analysis did not demonstrate that all significant contributions would be eliminated by the attainment deadlines for downwind states. Any further changes will require additional rulemaking. Management cannot currently predict the nature, stringency or timing of additional requirements for AEP’s facilities based on the outcome of these activities. +Regional Haze +The Federal EPA issued a Clean Air Visibility Rule (CAVR), detailing how the CAA’s requirement that certain facilities install best available retrofit technology (BART) would address regional haze in federal parks and other protected areas. BART requirements apply to certain power plants. CAVR will be implemented through SIPs or FIPs. In 2017, the Federal EPA revised the rules governing submission of SIPs to implement the visibility programs, including a provision that postpones the due date for the next comprehensive SIP revisions until 2021. Petitions for review of the final rule revisions have been filed in the U.S. Court of Appeals for the District of Columbia Circuit. +The Federal EPA initially disapproved portions of the Arkansas regional haze SIP, but has approved a revised SIP and all of SWEPCo's affected units are in compliance with the relevant requirements. +The Federal EPA also disapproved portions of the Texas regional haze SIP. In 2017, the Federal EPA finalized a FIP that allows participation in the CSAPR ozone season program to satisfy the NO X regional haze obligations for electric generating units in Texas. Additionally, the Federal EPA finalized an intrastate SO 2 emissions trading program based on CSAPR allowance allocations. A challenge to the FIP was filed in the U.S. Court of Appeals for the Fifth Circuit and the case is pending the Federal EPA’s reconsideration of the final rule. In August 2018, the Federal EPA proposed to affirm its 2017 FIP approval. In November 2019, in response to comment, the Federal EPA proposed revisions to the intrastate trading program. The Federal EPA finalized the intrastate trading program in July 2020, and that rule has been challenged in the U.S. Court of Appeals for the Fifth Circuit as well as in the U.S. Court of Appeals for the District of Columbia Circuit. Management cannot predict the outcome of that litigation, although management supports the intrastate trading program as a compliance alternative to source-specific controls and has intervened in the litigation in support of the Federal EPA. +72 +Cross-State Air Pollution Rule +In 2011, the Federal EPA issued CSAPR as a replacement for the Clean Air Interstate Rule, a regional trading program designed to address interstate transport of emissions that contributed significantly to downwind non-attainment with the 1997 ozone and PM NAAQS. CSAPR relies on SO 2 and NO X allowances and individual state budgets to compel further emission reductions from electric utility generating units. Interstate trading of allowances is allowed on a restricted sub-regional basis. +Petitions to review the CSAPR were filed in the U.S. Court of Appeals for the District of Columbia Circuit. In 2015, the court found that the Federal EPA over-controlled the SO 2 and/or NO X budgets of 14 states. The court remanded the rule to the Federal EPA for revision consistent with the court’s opinion while CSAPR remained in place. +In 2016, the Federal EPA issued a final rule, the CSAPR Update, to address the remand and to incorporate additional changes necessary to address the 2008 ozone standard. The CSAPR Update significantly reduced ozone season budgets in many states and discounted the value of banked CSAPR ozone season allowances beginning with the 2017 ozone season. In 2019, the appeals court remanded the CSAPR Update to the Federal EPA because it determined the Federal EPA had not properly considered the attainment dates for downwind areas in establishing its partial remedy, and should have considered whether there were available measures to control emissions from sources other than generating units. Any further changes to the CSAPR rule will require additional rulemaking. +In October 2020, the Federal EPA proposed a revised CSAPR Update rule, which would substantially reduce the ozone season NO X budgets in 2021-2024. The Federal EPA recently released the underlying modeling and budget allocations and management is evaluating the potential impacts of this proposed rule. +Mercury and Other Hazardous Air Pollutants (HAPs) Regulation +In 2012, the Federal EPA issued a rule addressing a broad range of HAPs from coal and oil-fired power plants. The rule established unit-specific emission rates for units burning coal on a 30-day rolling average basis for mercury, PM (as a surrogate for particles of non-mercury metals) and hydrogen chloride (as a surrogate for acid gases). In addition, the rule proposed work practice standards for controlling emissions of organic HAPs and dioxin/furans, with compliance required within three years. Management obtained administrative extensions for up to one year at several units to facilitate the installation of controls or to avoid a serious reliability problem. +In 2014, the U.S. Court of Appeals for the District of Columbia Circuit denied all of the petitions for review of the 2012 final rule. Various intervenors filed petitions for further review in the U.S. Supreme Court. +In 2015, the U.S. Supreme Court reversed the decision of the U.S. Court of Appeals for the District of Columbia Circuit. The court remanded the MATS rule to the Federal EPA to consider costs in determining whether to regulate emissions of HAPs from power plants. In 2016, the Federal EPA issued a supplemental finding concluding that, after considering the costs of compliance, it was appropriate and necessary to regulate HAP emissions from coal and oil-fired units. Petitions for review of the Federal EPA’s determination were filed in the U.S. Court of Appeals for the District of Columbia Circuit. In 2018, the Federal EPA released a revised finding that the costs of reducing HAP emissions to the level in the current rule exceed the benefits of those HAP emission reductions. The Federal EPA also determined that there are no significant changes in control technologies and the remaining risks associated with HAP emissions do not justify any more stringent standards. Therefore, the Federal EPA proposed to retain the current MATS standards without change. In April 2020, the Federal EPA released a final rule adopting the conclusions set forth in the proposal and retaining the existing MATS standards. The rule has been challenged in the U.S. Court of Appeals for the District of Columbia Circuit. +Climate Change, CO 2 Regulation and Energy Policy +In 2015, the Federal EPA published the final CO 2 emissions standards for new, modified and reconstructed fossil generating units, and final guidelines for the development of state plans to regulate CO 2 emissions from existing sources, known as the Clean Power Plan (CPP). Implementation of the CPP was stayed by the U.S. Supreme Court pending the outcome of legal challenges, and the CPP was ultimately repealed by the Federal EPA in 2019 and +73 +replaced with the Affordable Clean Energy (ACE) rule. ACE established a framework for states to adopt standards of performance for utility boilers based on heat rate improvements for such boilers. States were to submit their plans for implementing the ACE rule in 2022, and the Federal EPA would have had up to two years to review and approve a plan or disapprove it and adopt a federal plan. However, in January 2021, the U.S. Court of Appeals for the D.C. Circuit vacated the ACE rule and remanded it to the Federal EPA. It is too soon to predict how the Federal EPA will respond to the court’s remand. +In 2018, the Federal EPA filed a proposed rule revising the standards for new sources and determined that partial carbon capture and storage is not the best system of emission reduction because it is not available throughout the U.S. and is not cost-effective. That rule has not been finalized. Management continues to actively monitor these rulemaking activities. +While no federal regulatory requirements to reduce CO 2 emissions are in place, AEP has taken action to reduce and offset CO 2 emissions from its generating fleet. AEP expects CO 2 emissions from its operations to continue to decline due to the retirement of some of its coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. The majority of the states where AEP has generating facilities passed legislation establishing renewable energy, alternative energy and/or energy efficiency requirements that can assist in reducing carbon emissions. In April 2020, Virginia enacted clean energy legislation to allow the state to participate in the Regional Greenhouse Gas Initiative, require the retirement of all fossil-fueled generation by 2045 and require 100% renewable energy to be provided to Virginia customers by 2050. Management is taking steps to comply with these requirements, including increasing wind and solar installations, purchasing renewable power and broadening AEP System’s portfolio of energy efficiency programs. +In February 2021, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, grid reliability and resiliency, regulations and the company’s current business strategy. The intermediate goal is an 80% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. AEP’s total estimated CO 2 emissions in 2020 were approximately 44 million metric tons, a 73% reduction from AEP’s 2000 CO 2 emissions. AEP has made significant progress in reducing CO 2 emissions from its power generation fleet and expects its emissions to continue to decline. Technological advances, including energy storage, will determine how quickly AEP can achieve zero emissions while continuing to provide reliable, affordable power for customers. +Excessive costs to comply with future legislation or regulations has led to the announcement of early plant closures and could force AEP to close additional coal-fired generation facilities earlier than their estimate useful life. If AEP is unable to recover the costs of its investments, it would reduce future net income and cash flows and impact financial condition. +Coal Combustion Residual (CCR) Rule +In 2015, the Federal EPA published a final rule to regulate the disposal and beneficial re-use of CCR, including fly ash and bottom ash created from coal-fired generating units and FGD gypsum generated at some coal-fired plants. The rule applies to active CCR landfills and surface impoundments at operating electric utility or independent generation facilities. The rule imposes construction and operating obligations, including location restrictions, liner criteria, structural integrity requirements for impoundments, operating criteria and additional groundwater monitoring requirements to be implemented on a schedule spanning an approximate four-year implementation period. In 2018, some of AEP’s facilities were required to begin monitoring programs to determine if unacceptable groundwater impacts will trigger future corrective measures. Based on additional groundwater data, further studies to design and assess appropriate corrective measures have been undertaken at two facilities. +In a challenge to the final 2015 rule, the parties initially agreed to settle some of the issues. In 2018, the U.S. Court of Appeals for the District of Columbia Circuit addressed or dismissed the remaining issues in its decision vacating and remanding certain provisions of the 2015 rule. The provisions addressed by the court’s decision, including changes to the provisions for unlined impoundments and legacy sites, are the subject of further rulemaking that has not been finalized. +74 +Prior to the court’s decision, the Federal EPA issued the July 2018 rule that modifies certain compliance deadlines and other requirements in the 2015 rule. In December 2018, challengers filed a motion for partial stay or vacatur of the July 2018 rule. On the same day, the Federal EPA filed a motion for partial remand of the July 2018 rule. The court granted the Federal EPA’s motion. In November 2019, the Federal EPA proposed revisions to implement the court’s decision regarding the timing for closure of unlined surface impoundments along with impoundments not meeting the required distance from an aquifer. The final rule was published in August 2020. In December 2019, the Federal EPA proposed a federal permit program, implementing the Water Infrastructure Improvements for the Nation Act that would apply in states that do not have an approved CCR program. +Other utilities and industrial sources have been engaged in litigation with environmental advocacy groups who claim that releases of contaminants from wells, CCR units, pipelines and other facilities to groundwaters that have a hydrologic connection to a surface water body represent an “unpermitted discharge” under the CWA. Two cases were accepted by the U.S. Supreme Court for further review of the scope of CWA jurisdiction. In April 2020, the Supreme Court issued an opinion remanding one of these cases to the Ninth Circuit based on its determination that discharges from an injection well that make their way to the Pacific Ocean through ground water may require a permit if the distance traveled through ground water, length of time to reach the surface water and other factors make it “functionally equivalent” to a direct discharge from a point source. The second case was also remanded to the lower court. Prior to the Supreme Court’s decision, the Federal EPA opened a rulemaking docket to solicit information to determine whether it should provide additional clarification of the scope of CWA permitting requirements for discharges to groundwater, and issued an interpretive statement finding that discharges to groundwater are not subject to NPDES permitting requirements under the CWA. In December 2020, the Federal EPA issued draft guidance for public comment on applying the outcome of the Supreme Court’s decision and consideration of functionally equivalent factors. Management is unable to predict the impact of these developments on AEP’s facilities. +In August 2020, the Federal EPA revised the CCR rule to include a requirement that unlined CCR storage ponds cease operations and initiate closure by April 11, 2021. The revised rule provides two options that allow facilities to extend the date by which they must cease receipt of coal ash and close the ponds. +The first option provides an extension to cease receipt of CCR no later than October 15, 2023 for most units, and October 15, 2024 for a narrow subset of units; however, the Federal EPA’s grant of such an extension will be based upon a satisfactory demonstration of the need for additional time to develop alternative ash disposal capacity and will be limited to the soonest timeframe technically feasible to cease receipt of CCR. Additionally, each request must undergo formal review, including public comments, and be approved by the Federal EPA. AEP filed applications for additional time to develop alternative disposal capacity at the following plants: +Company Plant Name and Unit Generating +Capacity Net Book Value (a) Projected +Retirement Date +(in MWs) (in millions) +APCo Amos 2,930 $ 2,171.8 2040 +APCo Mountaineer 1,320 980.2 2040 +SWEPCo Flint Creek Plant 258 279.2 2038 +KPCo Mitchell Plant 780 605.1 2040 +WPCo Mitchell Plant 780 603.7 2040 +AEGCo Rockport Plant, Unit 1 655 248.9 2028 +I&M Rockport Plant, Unit 1 655 573.8 (b) 2028 +(a) Net book value before cost of removal including CWIP and inventory. +(b) Amount includes a $191 million regulatory asset related to the retired Tanners Creek Plant. The IURC and MPSC authorized recovery of the Tanners Creek Plant regulatory asset over the useful life of Rockport Plant, Unit 1 in 2015 and 2014, respectively. +75 +In December 2020, APCo filed requests with the Virginia SCC and WVPSC to obtain the regulatory approvals necessary to implement the compliance plans and seek recovery of the estimated $240 million investment for the Amos and Mountaineer plants. In December 2020 and February 2021, WPCo and KPCo filed requests with the WVPSC and KPSC, respectively, to obtain the regulatory approvals necessary to implement the compliance plans and seek recovery of the estimated $132 million investment for the Mitchell Plant. Within those requests, WPCo and KPCo also filed a $25 million alternative with the WVPSC and KPSC, respectively, which would allow the Mitchell Plant to continue operating only through 2028. +The second option is a retirement option, which provides a generating facility an extended operating time without developing alternative CCR disposal. Under the retirement option, a generating facility would have until October 17, 2023 to cease operation and to close CCR storage ponds 40 acres or less in size, or through October 17, 2028 for facilities with CCR storage ponds greater than 40 acres in size. Pursuant to this option, AEP informed the Federal EPA of its intent to retire the Pirkey Power Plant and cease using coal at the Welsh Plant: +Company Plant Name and Unit Generating +Capacity Net Investment (a) Accelerated Depreciation Regulatory Asset Projected +Retirement Date +(in MWs) (in millions) +SWEPCo Pirkey Power Plant 580 $ 199.5 $ 12.2 2023 (b) +SWEPCo Welsh Plants, Units 1 & 3 1,053 549.8 3.6 2028 (c)(d) +(a) Net book value including CWIP excluding cost of removal and materials and supplies. +(b) Pirkey Power Plant is currently being recovered through 2025 in the Louisiana jurisdiction and through 2045 in the Arkansas and Texas jurisdictions. +(c) In November 2020, management announced it will cease using coal at the Welsh Plant in 2028. +(d) Unit 1 is currently being recovered through 2027 in the Louisiana jurisdiction and through 2037 in the Arkansas and Texas jurisdictions. Unit 3 is currently being recovered through 2032 in the Louisiana jurisdiction and through 2042 in the Arkansas and Texas jurisdictions. +AEP may incur significant costs to upgrade or close and replace surface impoundments and landfills used to manage CCR and to conduct any required remedial actions. Under the retirement option above, AEP may need to recover remaining depreciation and estimated closure costs associated with retiring plants over a shorter period. If AEP cannot ultimately recover the costs of environmental compliance and/or the remaining depreciation and estimated closure costs associated with retiring plants in a timely manner, it would reduce future net income and cash flows and impact financial condition. +Closure and post-closure costs have been included in ARO in accordance with the requirements in the final rule. Additional ARO revisions will occur on a site-by-site basis if groundwater monitoring activities conclude that corrective actions are required to mitigate groundwater impacts, which could include costs to remove ash from some unlined units. +In March 2020, Virginia’s Governor signed House Bill 443 (HB 443), effective July 2020, requiring APCo to close certain ash disposal units at the retired Glen Lyn Station by removal of all coal combustion material. As a result, in June 2020, APCo recorded a $199 million revision to increase estimated Glen Lyn Station ash disposal ARO liabilities. The closure is required to be completed within 15 years from the start of the excavation process. HB 443 provides for the recovery of all costs associated with closure by removal through the Virginia environmental rate adjustment clause (E-RAC). APCo is permitted to record carrying costs on the unrecovered balance of closure costs at a weighted-average cost of capital approved by the Virginia SCC. HB 443 also allows any closure costs allocated to non-Virginia jurisdictional customers, but not collected from such non-Virginia jurisdictional customers, to be recovered from Virginia jurisdictional customers through the E-RAC. APCo will submit filings with the Virginia SCC and the WVPSC requesting recovery of the respective Virginia and West Virginia jurisdictional shares of these Glen Lyn Station ARO costs. As of December 31, 2020, APCo has not yet incurred any incremental costs associated with the removal of coal combustion material at the Glen Lyn Station. +If removal of ash is required without providing similar assurances of cost recovery in regulated jurisdictions, it would impose significant additional operating costs on AEP, which could lead to increased financing costs and liquidity needs. Other units in Virginia, Ohio, West Virginia and Kentucky have already been closed in place in +76 +accordance with state law programs. Management will continue to participate in rulemaking activities and make adjustments based on new federal and state requirements affecting its ash disposal units. +Clean Water Act Regulations +In 2014, the Federal EPA issued a final rule setting forth standards for existing power plants that is intended to reduce mortality of aquatic organisms impinged or entrained in the cooling water. The rule was upheld on review by the U.S. Court of Appeals for the Second Circuit. Compliance timeframes are established by the permit agency through each facility’s NPDES permit as those permits are renewed and have been incorporated into permits at several AEP facilities. AEP facilities that have had their wastewater discharge permits renewed have been asked to monitor intake flows or to enhance monitoring practices to assure the current technology is being properly managed to ensure compliance with this rule. +In 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for generating facilities. The rule established limits on FGD wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed as soon as possible after November 2018 and no later than December 2023. These requirements would be implemented through each facility’s wastewater discharge permit. The rule was challenged in the U.S. Court of Appeals for the Fifth Circuit. In 2017, the Federal EPA announced its intent to reconsider and potentially revise the standards for FGD wastewater and bottom ash transport water. The Federal EPA postponed the compliance deadlines for those wastewater categories to be no earlier than 2020, to allow for reconsideration. In April 2019, the Fifth Circuit vacated the standards for landfill leachate and legacy wastewater, and remanded them to the Federal EPA for reconsideration. In November 2019, the Federal EPA proposed revisions to the guidelines for existing generation facilities. A final rule was signed by the Federal EPA in August 2020 and was published in October 2020. The final rule establishes additional options for reusing and discharging small volumes of bottom ash transport water, provides an exception for retiring units, and extends the compliance deadline to a date as soon as possible beginning one year after the rule was published but no later than December 2025. Management has assessed technology additions and retrofits to comply with the rule and the impacts of the Federal EPA’s recent actions on facilities’ wastewater discharge permitting for FGD wastewater and bottom ash transport water. Permit modifications for affected facilities were filed in January 2021 that reflect the outcome of that assessment. +In 2015, the Federal EPA and the U.S. Army Corps of Engineers jointly issued a final rule to clarify the scope of the regulatory definition of “waters of the United States” in light of recent U.S. Supreme Court cases. Various parties challenged the 2015 rule in different U.S. District Courts, which resulted in a patchwork of applicability of the 2015 rule and its predecessor. In December 2018, the Federal EPA and the U.S. Army Corps of Engineers proposed a replacement rule. In September 2019, the Federal EPA repealed the 2015 rule. The final replacement rule was published in the Federal Register in April 2020 and became effective in June 2020. The final rule limits the scope of CWA jurisdiction to four categories of waters, and clarifies exclusions for ground water, ephemeral streams, artificial ponds and waste treatment systems. Challenges to the final rule and requests for a preliminary injunction have been brought by states and other groups in multiple U.S. District Courts. At this time, none of the jurisdictions in which AEP operates are impacted by a stay. Management is monitoring these various proceedings but is unable to predict the actions of the various courts. +In April 2020, the U.S. District Court for the District of Montana issued a decision vacating the U.S. Army Corps of Engineers’ (Corps) General Nationwide Permit (NWP) 12, which provides standard conditions governing linear utility projects in streams, wetlands and other waters of the United States having minimal adverse environmental impacts. The Court found that in reissuing NWP 12 in 2017, the Corps failed to comply with Section 7 of the Endangered Species Act (ESA), which requires the Corps to consult with the U.S. Fish and Wildlife Service regarding potential impacts on endangered species. The Court remanded the permit back to the Corps to complete its ESA consultation, and also enjoined the Corps from authorizing any dredge or fill activities under NWP 12 pending completion of the consultation process. The Department of Justice filed a motion to stay the injunction and tailor the remedy imposed by the Court. In May 2020, the Court revised its order lifting the injunction for non-oil and gas pipeline construction activities and routine maintenance, inspection and repair activities on existing NWP 12 projects. The Department of Justice appealed the Court’s decision to the Court of Appeals for the Ninth Circuit +77 +and moved for stay pending appeal, which was denied. In June 2020, the Department of Justice submitted an application to the U.S. Supreme Court requesting a stay of the District Court’s Order, and the Court granted the request with respect to all oil and gas pipelines except the Keystone Pipeline. Management is monitoring the litigation, but is currently unable to predict the impact of future proceedings on current and planned projects. +In September 2020, the Corps issued for public comment the proposed renewal of all General Nationwide Permits. As part of that proposal the Corps narrowed the focus of NWP 12 to only oil and natural gas pipeline activities. The Corps proposed two new Nationwide Permits governing electric utility line and telecommunications activities, and other utility lines (e.g., conveyance of potable water, sewage, other substances), respectively. In January 2021, the Corps issued 16 final Nationwide Permits, including NWP 12 and the two new utility line permits, NWP 57 and NWP 58. The Corps chose not to reissue or modify the remaining Nationwide Permits at this time. The 2017 versions of those permits remain in effect. Management is currently assessing impacts of the rulemaking on current and planned projects. +Impact of Environmental Regulation on Coal-Fired Generation +Compliance with extensive environmental regulations requires significant capital investment in environmental monitoring, installation of pollution control equipment, emission fees, disposal costs and permits. Management continuously evaluates cost estimates of complying with these regulations which may result in a decision to retire coal-fired generating facilities earlier than their currently estimated useful lives. +In addition to the November 2020 announcement related to the Federal EPA’s CCR rules, management also decided not to renew the Rockport Plant, Unit 2 lease when it expires in 2022. Previously, management retired or announced early closure plans for Welsh Unit 2, Oklaunion Power Station, Dolet Hills Power Station and Northeastern Plant Unit 3. +The table below summarizes the net book value, as of December 31, 2020, of generating facilities retired or planned for early retirement: +Company Plant Net +Investment (a) Accelerated Depreciation Regulatory Asset Actual/Projected +Retirement +Date Current Authorized +Recovery +Period Annual Depreciation (b) +(in millions) (in millions) +SWEPCo +Dolet Hills Power Station +$ 74.4 $ 71.2 2021 (c) $ 60.8 +PSO Northeastern Plant, Unit 3 198.4 110.4 2026 (d) 14.9 +PSO Oklaunion Power Station — 34.4 2020 (e) — +SWEPCo Pirkey Power Plant 199.5 12.2 2023 (f) 13.8 +SWEPCo Welsh Plant, Units 1 and 3 549.8 3.6 2028 (g) (h) 33.3 +SWEPCo Welsh Plant, Unit 2 — 35.2 2016 (i) — +(a) Net book value including CWIP excluding cost of removal and materials and supplies. +(b) These amounts represent the amount of annual depreciation that has been collected from customers over the prior 12-month period. +(c) Dolet Hills Power Station is current being recovered through 2026 in the Louisiana jurisdiction and through 2046 in the Arkansas and Texas jurisdictions. +(d) Northeastern Plant, Unit 3 is currently being recovered through 2040. +(e) Oklaunion Power Station is currently being recovered through 2046. +(f) Pirkey Power Plant is currently being recovered through 2025 in the Louisiana jurisdiction and through 2045 in the Arkansas and Texas jurisdictions. +(g) In November 2020, management announced it will cease using coal at the Welsh Plant in 2028. +(h) Welsh Plant, Unit 1 is being recovered through 2027 in the Louisiana jurisdiction and through 2037 in the Arkansas and Texas jurisdictions. Welsh Plant, Unit 3 is being recovered through 2032 in the Louisiana jurisdiction and through 2042 in the Arkansas and Texas jurisdictions. +(i) Welsh Plant, Unit 2 is being recovered over the blended useful life of Welsh Plant, Units 1 and 3. +Management is seeking or will seek regulatory recovery, as necessary, for any net book value remaining when the plants are retired. To the extent the net book value of these generation assets are not deemed recoverable, it could materially reduce future net income, cash flows and impact financial condition. +78 +RESULTS OF OPERATIONS +SEGMENTS +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. +AEP’s reportable segments and their related business activities are outlined below: +Vertically Integrated Utilities +• Generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. +Transmission and Distribution Utilities +• Transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo. +• OPCo purchases energy and capacity at auction to serve standard service offer customers and provides transmission and distribution services for all connected load. +AEP Transmission Holdco +• Development, construction and operation of transmission facilities through investments in AEPTCo. These investments have FERC-approved returns on equity. +• Development, construction and operation of transmission facilities through investments in AEP’s transmission-only joint ventures. These investments have PUCT-approved or FERC-approved returns on equity. +Generation & Marketing +• Contracted renewable energy investments and management services. +• Marketing, risk management and retail activities in ERCOT, MISO, PJM and SPP. +• Competitive generation in PJM. +The remainder of AEP’s activities are presented as Corporate and Other. While not considered a reportable segment, Corporate and Other primarily includes the purchasing of receivables from certain AEP utility subsidiaries, Parent’s guarantee revenue received from affiliates, investment income, interest income and interest expense and other nonallocated costs. +The following discussion of AEP’s 2020 results of operations by operating segment includes an analysis of Gross Margin, which is a non-GAAP financial measure. Gross Margin includes Total Revenues less the costs of Fuel and Other Consumables Used for Electric Generation as well as Purchased Electricity for Resale and Amortization of Generation Deferrals as presented in the Registrants’ statements of income as applicable. Under the various state utility rate-making processes, these expenses are generally reimbursable directly from and billed to customers. As a result, they do not typically impact Operating Income or Earnings Attributable to AEP Common Shareholders. Management believes that Gross Margin provides a useful measure for investors and other financial statement users to analyze AEP’s financial performance in that it excludes the effect on Total Revenues caused by volatility in these expenses. Operating Income, which is presented in accordance with GAAP in AEP’s statements of income, is the most directly comparable GAAP financial measure to the presentation of Gross Margin. AEP’s definition of Gross Margin may not be directly comparable to similarly titled financial measures used by other companies. +79 +A detailed discussion of AEP’s 2019 results of operations by operating segment can be found in Management’s Discussion and Analysis of Financial Condition and Results of Operation section included in the 2019 Annual Report on Form 10-K filed with the SEC on February 20, 2020. +The following table presents Earnings (Loss) Attributable to AEP Common Shareholders by segment: +Years Ended December 31, +2020 2019 2018 +(in millions) +Vertically Integrated Utilities $ 1,061.6 $ 982.0 $ 990.5 +Transmission and Distribution Utilities 496.4 451.0 527.4 +AEP Transmission Holdco 504.8 516.3 369.9 +Generation & Marketing 226.9 112.8 135.3 +Corporate and Other (89.6) (141.0) (99.3) +Earnings Attributable to AEP Common Shareholders $ 2,200.1 $ 1,921.1 $ 1,923.8 +Note: 2020 Earnings Attributable to AEP Common Shareholders by Segment excludes Corporate and Other which is not considered a reportable segment. +AEP CONSOLIDATED +2020 Compared to 2019 +Earnings Attributable to AEP Common Shareholders increased from $1.9 billion in 2019 to $2.2 billion in 2020 primarily due to: +• Favorable rate proceedings in AEP’s various jurisdictions. +• A planned decrease in Other Operation and Maintenance expenses. +• Continued transmission investment, which resulted in higher revenues and income. +These increases were partially offset by: +• A decrease in weather-related usage. +• A one-time reversal of a regulatory provision in 2019. +AEP’s results of operations by reportable segment are discussed below. +80 +VERTICALLY INTEGRATED UTILITIES +(a) Other AEP Segments excludes Corporate and Other which is not considered a reportable segment. +Years Ended December 31, +Vertically Integrated Utilities 2020 2019 2018 +(in millions) +Revenues $ 8,879.4 $ 9,367.1 $ 9,645.5 +Fuel and Purchased Electricity 2,544.9 3,103.1 3,488.9 +Gross Margin 6,334.5 6,264.0 6,156.6 +Other Operation and Maintenance 2,754.3 2,934.4 2,959.8 +Asset Impairments and Other Related Charges — 92.9 3.4 +Depreciation and Amortization 1,600.5 1,447.0 1,316.2 +Taxes Other Than Income Taxes 472.6 460.9 433.2 +Operating Income 1,507.1 1,328.8 1,444.0 +Other Income 2.4 6.1 17.0 +Allowance for Equity Funds Used During Construction 42.2 50.7 35.4 +Non-Service Cost Components of Net Periodic Benefit Cost 67.9 67.6 69.9 +Interest Expense (565.0) (568.3) (567.8) +Income Before Income Tax Expense (Benefit) and +Equity Earnings 1,054.6 884.9 998.5 +Income Tax Expense (Benefit) (7.0) (97.7) 5.7 +Equity Earnings of Unconsolidated Subsidiary 2.9 3.0 2.7 +Net Income 1,064.5 985.6 995.5 +Net Income Attributable to Noncontrolling Interests 2.9 3.6 5.0 +Earnings Attributable to AEP Common Shareholders $ 1,061.6 $ 982.0 $ 990.5 +81 +Summary of KWh Energy Sales for Vertically Integrated Utilities +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 31,526 32,359 33,908 +Commercial 22,225 23,839 24,452 +Industrial 32,860 35,252 35,730 +Miscellaneous 2,185 2,302 2,330 +Total Retail 88,796 93,752 96,420 +Wholesale (a) 16,987 20,090 22,682 +Total KWhs 105,783 113,842 119,102 +(a) Includes Off-system Sales, municipalities and cooperatives, unit power and other wholesale customers. +82 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. In general, degree day changes in the eastern region have a larger effect on revenues than changes in the western region due to the relative size of the two regions and the number of customers within each region. +Summary of Heating and Cooling Degree Days for Vertically Integrated Utilities +Years Ended December 31, +2020 2019 2018 +(in degree days) +Eastern Region +Actual – Heating (a) 2,295 2,617 2,886 +Normal – Heating (b) 2,727 2,732 2,738 +Actual – Cooling (c) 1,222 1,369 1,443 +Normal – Cooling (b) 1,104 1,092 1,083 +Western Region +Actual – Heating (a) 1,160 1,512 1,599 +Normal – Heating (b) 1,464 1,473 1,475 +Actual – Cooling (c) 2,117 2,328 2,502 +Normal – Cooling (b) 2,253 2,240 2,230 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 65 degree temperature base. +83 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Earnings Attributable to AEP Common Shareholders from Vertically Integrated Utilities +(in millions) +Year Ended December 31, 2019 $ 982.0 +Changes in Gross Margin: +Retail Margins 30.7 +Margins from Off-system Sales (12.5) +Transmission Revenues 60.3 +Other Revenues (8.0) +Total Change in Gross Margin 70.5 +Changes in Expenses and Other: +Other Operation and Maintenance 180.1 +Asset Impairments and Other Related Charges 92.9 +Depreciation and Amortization (153.5) +Taxes Other Than Income Taxes (11.7) +Other Income (3.7) +Allowance for Equity Funds Used During Construction (8.5) +Non-Service Cost Components of Net Periodic Pension Cost 0.3 +Interest Expense 3.3 +Total Change in Expenses and Other 99.2 +Income Tax Expense (90.7) +Equity Earnings of Unconsolidated Subsidiary (0.1) +Net Income Attributable to Noncontrolling Interests 0.7 +Year Ended December 31, 2020 $ 1,061.6 +The major components of the increase in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows: +• Retail Margins increased $31 million primarily due to the following: +• A $35 million increase in deferred fuel at APCo and WPCo primarily due to the timing of recoverable PJM expenses. +• A $20 million increase at APCo and WPCo due to the WVPSC approval of the Mitchell Plant surcharge effective January 1, 2020. Pursuant to the WVPSC approval of the surcharge, this increase was partially offset by the amortization of Excess ADIT not subject to normalization requirements in Income Tax Expense below. +• A $17 million increase due to a decrease in customer refunds related to Tax Reform. This increase was partially offset in Income Tax Expense below. +• A $14 million increase due to the impact of the 2019 WVPSC order which required APCo and WPCo to offset Excess ADIT not subject to normalization requirements against the deferred fuel under-recovery balance in 2019. +• A $10 million increase at APCo and WPCo due to revenue from rate riders primarily in West Virginia. This increase was partially offset in other expense items below. +• A $9 million increase due to an environmental expense deferral at APCo. +• An $8 million increase in weather-normalized retail margins driven by a $111 million increase in the residential customer class partially offset by a $97 million decrease in the commercial and industrial classes. +84 +• The effect of rate proceedings in AEP’s service territories which included: +• A $109 million increase at I&M primarily due to the Indiana and Michigan base rate cases and increases in rider revenues. This increase was partially offset in other expense items below. +• A $45 million increase at SWEPCo primarily due to rider increases in all jurisdictions and a base rate revenue increase in Arkansas. This increase was partially offset in other expense items below. +• A $10 million increase at PSO due to new base rates implemented in April 2019. +• An $8 million increase at APCo and WPCo due to new base rates implemented in 2019 in West Virginia. This increase was partially offset in Depreciation and Amortization expenses below. +These increases were partially offset by: +• A $128 million decrease in weather-related usage primarily in the eastern region and primarily in the residential class. +• A $66 million decrease in weather-normalized margins for wholesale contracts, including the loss of a significant wholesale contract at I&M. +• A $44 million decrease due to the cumulative impact of the implementation of APCo’s 2017 and 2019 generation and distribution depreciation studies as ordered in the Virginia triennial base rate case. +• A $13 million decrease in revenue from rate riders at PSO. This decrease was partially offset in other expense items below. +• Margins from Off-system Sales decreased $13 million due to weaker market prices for energy in the RTOs which caused a decrease in sales margins and volume. In addition, the historical merchant portion of WPCo’s Mitchell Plant moved to retail rates beginning in January 2020. +• Transmission Revenues increased $60 million primarily due to the following: +• A $31 million increase as a result of the annual transmission formula rate true-up primarily at SWEPCo. This increase was partially offset by an increase in transmission expenses in SPP. +• A $22 million increase due to continued investment in transmission projects primarily at SWEPCo. +• A $12 million increase at APCo resulting from the 2017-2019 Virginia triennial base rate case. This increase was offset in Depreciation Expense below. +• Other Revenues decreased $8 million primarily due to the following: +• A $10 million decrease at I&M primarily due to a decrease in barging revenues by River Transportation Division. This decrease was partially offset in Other Operation and Maintenance expenses below. +• An $8 million decrease primarily due to suspension of late fees and disconnections in 2020 as a result of the COVID-19 pandemic. +These decreases were partially offset by: +• A $9 million increase at PSO primarily due to business development revenue. This increase was partially offset in other expense items below. +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses decreased $180 million primarily due to the following: +• A $49 million decrease due to the re-establishment of a regulatory asset in 2020 as result of APCo’s 2017-2019 Virginia triennial review which authorized the recovery of previously retired coal-fired generation assets. +• A $47 million decrease in plant outage and maintenance expenses primarily at APCo, I&M, WPCo, KPCo and PSO. +• A $34 million decrease in charitable contributions primarily driven by the contribution to the AEP Foundation in 2019. +• A $32 million decrease in distribution expenses primarily related to vegetation management and other distribution expenses. +• A $28 million decrease in transmission expenses primarily related to accelerated vegetation management and maintenance in 2019. +• A $15 million decrease due to the capitalization of previously expensed North Central Wind Energy Facilities costs at SWEPCo and PSO. +• A $14 million decrease related to a 2020 insurance settlement primarily at SWEPCo and PSO. +• An $8 million decrease due to the modification of the NSR consent decree impacting I&M and AEGCo in 2019. +85 +• A $7 million decrease at I&M due to an increased Nuclear Electric Insurance Limited distribution in 2020. +These decreases were partially offset by: +• A $39 million increase due to SPP transmission services including the annual formula rate true-up. +• A $37 million increase in employee-related expenses. +• Asset Impairments and Other Related Charges decreased $93 million primarily due to a pretax expense recorded in 2019 related to previously retired coal-fired assets. +• Depreciation and Amortization expenses increased $154 million primarily due to a higher depreciable base and increased depreciation rates approved at I&M, APCo and SWEPCo. This increase was partially offset in Retail Margins above. +• Taxes Other Than Income Taxes increased $12 million primarily due to increased property taxes primarily at APCo, I&M, PSO and SWEPCo. +• Other Income decreased $4 million primarily due to a decrease in affiliated interest income due to a decrease in interest rates in 2020. +• Allowance for Equity Funds Used During Construction decreased $9 million primarily due to a decrease in the AFUDC base at I&M and the favorable impact of a FERC settlement agreement recorded in 2019. +• Interest Expense decreased $3 million primarily due to the following: +• A $10 million decrease primarily due to lower interest rates on long-term debt primarily at PSO and AEGCo. +• A $6 million decrease primarily due to lower interest rates on variable rate loans and carrying charges recorded on various riders at I&M. This decrease was partially offset by a decrease in AFUDC base. +These decreases were partially offset by: +• A $13 million increase primarily due to higher long-term debt balances at APCo. +• Income Tax Expense increased $91 million primarily due to a decrease in amortization of Excess ADIT and an increase in pretax book income. The decrease in amortization of Excess ADIT not subject to normalization requirements is partially offset above in Gross Margin and Other Operation and Maintenance expenses. +86 +TRANSMISSION AND DISTRIBUTION UTILITIES +(a) Other AEP Segments excludes Corporate and Other which is not considered a reportable segment. +Years Ended December 31, +Transmission and Distribution Utilities 2020 2019 2018 +(in millions) +Revenues $ 4,345.9 $ 4,482.5 $ 4,653.1 +Purchased Electricity 682.7 794.3 858.3 +Amortization of Generation Deferrals — 65.3 223.9 +Gross Margin 3,663.2 3,622.9 3,570.9 +Other Operation and Maintenance 1,575.4 1,628.1 1,541.7 +Asset Impairments and Other Related Charges — 32.5 — +Depreciation and Amortization 751.1 789.5 734.1 +Taxes Other Than Income Taxes 586.7 575.0 545.3 +Operating Income 750.0 597.8 749.8 +Interest and Investment Income 2.4 6.6 4.2 +Carrying Costs Income 1.6 1.0 1.7 +Allowance for Equity Funds Used During Construction 31.9 33.4 29.9 +Non-Service Cost Components of Net Periodic Benefit Cost 29.4 30.3 32.3 +Interest Expense (289.2) (243.3) (248.1) +Income Before Income Tax Expense (Benefit) 526.1 425.8 569.8 +Income Tax Expense (Benefit) 29.7 (25.2) 42.4 +Net Income 496.4 451.0 527.4 +Net Income Attributable to Noncontrolling Interests — — — +Earnings Attributable to AEP Common Shareholders $ 496.4 $ 451.0 $ 527.4 +87 +Summary of KWh Energy Sales for Transmission and Distribution Utilities +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 26,518 26,407 27,042 +Commercial 23,998 25,018 24,877 +Industrial 22,432 23,289 23,908 +Miscellaneous 749 779 760 +Total Retail (a) 73,697 75,493 76,587 +Wholesale (b) 1,859 2,335 2,441 +Total KWhs 75,556 77,828 79,028 +(a) Represents energy delivered to distribution customers. +(b) Primarily Ohio’s contractually obligated purchases of OVEC power sold into PJM. +88 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. In general, degree day changes in the eastern region have a larger effect on revenues than changes in the western region due to the relative size of the two regions and the number of customers within each region. +Summary of Heating and Cooling Degree Days for Transmission and Distribution Utilities +Years Ended December 31, +2020 2019 2018 +(in degree days) +Eastern Region +Actual – Heating (a) 2,743 3,071 3,357 +Normal – Heating (b) 3,202 3,208 3,215 +Actual – Cooling (c) 1,140 1,224 1,402 +Normal – Cooling (b) 1,006 992 980 +Western Region +Actual – Heating (a) 189 301 354 +Normal – Heating (b) 313 322 325 +Actual – Cooling (d) 2,846 2,989 2,861 +Normal – Cooling (b) 2,711 2,699 2,688 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Eastern Region cooling degree days are calculated on a 65 degree temperature base. +(d) Western Region cooling degree days are calculated on a 70 degree temperature base. +89 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Earnings Attributable to AEP Common Shareholders from Transmission and Distribution Utilities +(in millions) +Year Ended December 31, 2019 $ 451.0 +Changes in Gross Margin: +Retail Margins 90.4 +Margins from Off-system Sales (39.3) +Transmission Revenues 44.2 +Other Revenues (55.0) +Total Change in Gross Margin 40.3 +Changes in Expenses and Other: +Other Operation and Maintenance 52.7 +Asset Impairments and Other Related Charges 32.5 +Depreciation and Amortization 38.4 +Taxes Other Than Income Taxes (11.7) +Interest and Investment Income (4.2) +Carrying Costs Income 0.6 +Allowance for Equity Funds Used During Construction (1.5) +Non-Service Cost Components of Net Periodic Benefit Cost (0.9) +Interest Expense (45.9) +Total Change in Expenses and Other 60.0 +Income Tax Expense (54.9) +Year Ended December 31, 2020 $ 496.4 +The major components of the increase in Gross Margin, defined as revenues less the related direct cost of purchased electricity and amortization of generation deferrals were as follows: +• Retail Margins increased $90 million primarily due to the following: +• A $69 million net increase related to other various rider revenues in Ohio. This increase was partially offset in other expense items below. +• A $61 million increase in rider revenues in Ohio associated with the DIR. This increase was partially offset in other expense items below. +• A $30 million increase due to a provision for refund recorded in December 2019 as part of the 2019 Texas base rate case. +• A $16 million increase from interim rate increases driven by increased distribution investment in Texas. +• A $13 million increase due to new base rates implemented in June 2020 in Texas. +• A $12 million increase from interim rate increases driven by increased transmission investment in Texas. +• A $9 million increase in weather-normalized margins primarily in the residential class and partially offset in the industrial and commercial classes. +• A $6 million increase in revenues associated with Ohio smart grid riders. This increase was partially offset in other expense items below. +• A $5 million increase due to the change in the recording of merger savings as authorized by the PUCT in the most recent base rate case. +These increases were partially offset by: +• A $58 million decrease due to a reversal of a regulatory provision in Ohio in the first quarter of 2019. +• A $38 million decrease due to refunds in Texas of Excess ADIT and excess federal income taxes collected as a result of Tax Reform. This decrease was offset in Income Tax Expense below. +90 +• A $17 million net decrease in margin in Ohio for the Rate Stability Rider including associated amortizations which ended in the third quarter of 2019. +• A $17 million decrease in weather-related usage in Texas primarily due to a 5% decrease in cooling degree days. +• A $6 million decrease due to refunds to customers associated with the most recent base rate case in Texas. This decrease was offset in Other Revenues below. +• Margins from Off-system Sales decreased $39 million primarily due to the following: +• A $52 million decrease in Texas due to lower Oklaunion Power Station PPA revenues. This decrease was offset in Other Operation and Maintenance expenses below. +• A $17 million decrease in sales in Ohio due to lower market prices and decreased sales volumes in 2020. This decrease was offset in Retail Margins above. +These decreases were partially offset by: +• A $26 million increase in Ohio due to higher OVEC PPA deferrals. This increase was offset in Retail Margins above. +• Transmission Revenues increased $44 million primarily due to the following: +• A $48 million increase from interim rate increases driven by increased transmission investment in Texas. +• A $16 million increase in Ohio due to the annual transmission formula rate true-up. +• A $6 million increase due to additional investment in transmission assets in Ohio. +These increases were partially offset by: +• A $14 million decrease in Texas due to a one-time credit to transmission customers as a result of Tax Reform and the most recent base rate case. This decrease was offset in Income Tax Expense below. +• A $12 million decrease due to refunds to customers associated with the most recent base rate case in Texas. This decrease is offset in Other Revenues below. +• Other Revenues decreased $55 million primarily due to the following: +• A $96 million decrease in securitization revenue due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset in Depreciation and Amortization expenses and Interest Expense below. +This decrease was partially offset by: +• A $19 million increase in Ohio primarily due to third-party Legacy Generation Resource Rider revenue related to the recovery of OVEC costs. This increase was offset in Retail Margins above. +• An $18 million increase in revenues due to the amortization of a provision for refund recorded in December 2019 as part of the most recent base rate case in Texas. This increase was offset in Retail Margins and Transmission Revenues above. +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses decreased $53 million primarily due to the following: +• A $67 million decrease due to prior year partial amortization of the AEP Texas Storm Restoration Securitization regulatory asset as a result of the AEP Texas Storm Cost Securitization financing order issued by the PUCT in June 2019. This decrease was offset in Income Tax Expense below. +• An $18 million decrease in distribution expenses primarily due to vegetation management. This decrease was partially offset in Retail Margins above. +• A $17 million decrease due to the revision of the Oklaunion Power Station ARO. This decrease was offset in Margins from Off-System Sales above. +• A $16 million decrease in affiliated PPA expenses in Texas. This decrease was offset in Margins from Off-system Sales above. +• A $12 million decrease due to a charitable contribution to the AEP Foundation in 2019. +• A $7 million decrease in customer-related expenses. +• A $5 million decrease due to a PUCO order to refund unused 2018 major storm reserve collections to customers. This decrease was offset in Retail Margins above. +These decreases were partially offset by: +• A $62 million net increase in PJM transmission expenses, primarily due to a $94 million increase in recoverable expenses, partially offset by a $28 million decrease related to the annual transmission formula rate true-up. This increase was offset in Gross Margin above. +91 +• A $19 million increase in remitted USF surcharge payments to the Ohio Department of Development to fund an energy assistance program for qualified Ohio customers. This increase was offset in Retail Margins above. +• A $17 million increase in ERCOT transmission expenses. This increase was partially offset in Gross Margin above. +• Asset Impairments and Other Related Charges decreased $33 million due to prior year regulatory disallowances in the 2019 Texas Base Rate Case. +• Depreciation and Amortization expenses decreased $38 million primarily due to the following: +• An $87 million decrease in securitization amortizations due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset in Other Revenues above and Interest Expense below. +• A $24 million decrease in amortizations associated with the Deferred Asset Phase-In-Recovery Rider in Ohio which ended in the second quarter of 2019. This decrease was offset in Retail Margins above. +These decreases were partially offset by: +• A $31 million increase in depreciation expense due to an increase in the depreciable base of transmission and distribution assets. +• A $22 million increase in Ohio recoverable DIR depreciation expense. This increase was partially offset in Retail Margins above. +• An $11 million increase due to lower deferred equity amortizations associated with the Deferred Asset Phase-In-Recovery Rider in Ohio which ended in the second quarter of 2019. +• A $6 million increase due to prior year under-recovery of revenues in Ohio associated with the Deferred Asset Phase-In-Recovery securitization which ended in the 2nd quarter of 2019. This decrease was offset in Retail Margins above. +• Taxes Other Than Income Taxes increased $12 million primarily due to the following: +• A $19 million increase in property taxes driven by additional investments in transmission and distribution assets and higher tax rates. +This increase was partially offset by: +• A $6 million decrease in excise taxes due to lower demand in 2020 in Ohio. This decrease was offset in Retail Margins above. +• Interest Expense increased $46 million primarily due to the following: +• A $32 million increase due to higher long-term debt balances. +• A $22 million increase due to the prior year deferral of previously recorded interest expense approved for recovery as a result of the Texas Storm Cost Securitization financing order issued by the PUCT in June 2019. +• An $8 million increase due to due to a decrease in the debt component of AFUDC. +These increases were partially offset by: +• An $8 million decrease in expense related to securitization assets. This decrease was offset above in Other Revenues and Depreciation and Amortization expenses. +• A $6 million decrease due to lower short-term debt balances. +• Income Tax Expense increased $55 million primarily due to an increase in pretax book income and a decrease in Excess ADIT not subject to normalization requirements as approved in the Texas Storm Cost Securitization financing order issued by the PUCT in 2019. The decrease in Excess ADIT not subject to normalization requirements was partially offset in Gross Margins and Other Operation and Maintenance Expenses above. +92 +AEP TRANSMISSION HOLDCO +(a) Other AEP Segments excludes Corporate and Other which is not considered a reportable segment. +Years Ended December 31, +AEP Transmission Holdco 2020 2019 2018 +(in millions) +Transmission Revenues $ 1,198.8 $ 1,073.2 $ 804.1 +Other Operation and Maintenance 119.0 119.0 105.6 +Depreciation and Amortization 257.6 183.4 137.8 +Taxes Other Than Income Taxes 211.0 174.4 142.3 +Operating Income 611.2 596.4 418.4 +Interest and Investment Income 2.9 3.4 2.1 +Allowance for Equity Funds Used During Construction 74.0 84.3 67.2 +Non-Service Cost Components of Net Periodic Benefit Cost 2.0 2.7 2.6 +Interest Expense (133.2) (103.3) (90.7) +Income Before Income Tax Expense and Equity Earnings 556.9 583.5 399.6 +Income Tax Expense 130.8 136.2 95.3 +Equity Earnings of Unconsolidated Subsidiary 82.4 72.8 68.7 +Net Income 508.5 520.1 373.0 +Net Income Attributable to Noncontrolling Interests 3.7 3.8 3.1 +Earnings Attributable to AEP Common Shareholders $ 504.8 $ 516.3 $ 369.9 +93 +Summary of Investment in Transmission Assets for AEP Transmission Holdco +December 31, +2020 2019 2018 +(in millions) +Plant in Service $ 10,327.5 $ 8,812.2 $ 7,008.4 +Construction Work in Progress 1,499.7 1,521.8 1,651.1 +Accumulated Depreciation and Amortization 595.7 418.9 282.8 +Total Transmission Property, Net $ 11,231.5 $ 9,915.1 $ 8,376.7 +94 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Earnings Attributable to AEP Common Shareholders from AEP Transmission Holdco +(in millions) +Year Ended December 31, 2019 $ 516.3 +Changes in Transmission Revenues: +Transmission Revenues 125.6 +Total Change in Transmission Revenues 125.6 +Changes in Expenses and Other: +Depreciation and Amortization (74.2) +Taxes Other Than Income Taxes (36.6) +Other Income (0.5) +Allowance for Equity Funds Used During Construction (10.3) +Non-Service Cost Components of Net Periodic Pension Cost (0.7) +Interest Expense (29.9) +Total Change in Expenses and Other (152.2) +Income Tax Expense 5.4 +Equity Earnings of Unconsolidated Subsidiary 9.6 +Net Income Attributable to Noncontrolling Interests 0.1 +Year Ended December 31, 2020 $ 504.8 +The major components of the increase in transmission revenues, which consists of wholesale sales to affiliates and nonaffiliates were as follows: +• Transmission Revenues increased $126 million primarily due to the following: +• A $208 million increase due to continued investment in transmission assets. +This increase was partially offset by the following: +• A $65 million decrease as a result of the affiliated annual transmission formula rate true-up which is offset in Other Operation and Maintenance expense across affiliated load-serving entities. +• A $17 million decrease as a result of the nonaffiliated annual transmission formula rate true-up. +Expenses and Other, Income Tax Expense and Equity Earnings of Unconsolidated Subsidiary changed between years as follows: +• Depreciation and Amortization expenses increased $74 million primarily due to a higher depreciable base and an increase in depreciation rates as a result of regulatory orders in 2020 in Indiana, Virginia and Michigan. +• Taxes Other Than Income Taxes increased $37 million primarily due to higher property taxes as a result of increased transmission investment. +• Allowance for Equity Funds Used During Construction decreased $10 million primarily due to the following: +• A $13 million decrease due to lower CWIP. +• A $12 million decrease driven by the favorable impact of a FERC settlement agreement recorded in 2019. +These decreases were partially offset by: +• A $13 million increase driven by FERC audit findings recorded in 2019. +• Interest Expense increased $30 million primarily due to higher long-term debt balances. +• Income Tax Expense decreased $5 million primarily due to lower pretax book income and an increase in amortization of Excess ADIT. +• Equity Earnings of Unconsolidated Subsidiary increased $10 million primarily due to higher pretax equity earnings at PATH-WV and ETT. +95 +GENERATION & MARKETING +(a) Other AEP Segments excludes Corporate and Other which is not considered a reportable segment. +Years Ended December 31, +Generation & Marketing 2020 2019 2018 +(in millions) +Revenues $ 1,725.6 $ 1,857.6 $ 1,940.3 +Fuel, Purchased Electricity and Other 1,403.6 1,456.2 1,537.3 +Gross Margin 322.0 401.4 403.0 +Other Operation and Maintenance 124.9 223.8 229.3 +Asset Impairments and Other Related Charges — 31.0 47.7 +Depreciation and Amortization 72.8 69.5 41.0 +Taxes Other Than Income Taxes 13.2 15.6 13.4 +Operating Income 111.1 61.5 71.6 +Interest and Investment Income 3.2 7.7 13.1 +Non-Service Cost Components of Net Periodic Benefit Cost 15.4 14.9 15.2 +Interest Expense (24.0) (30.0) (14.9) +Income Before Income Tax Benefit and Equity Earnings (Loss) 105.7 54.1 85.0 +Income Tax Benefit (108.0) (53.8) (49.2) +Equity Earnings (Loss) of Unconsolidated Subsidiaries 3.2 (3.8) 0.5 +Net Income 216.9 104.1 134.7 +Net Loss Attributable to Noncontrolling Interests (10.0) (8.7) (0.6) +Earnings Attributable to AEP Common Shareholders $ 226.9 $ 112.8 $ 135.3 +96 +Summary of MWhs Generated for Generation & Marketing +Years Ended December 31, +2020 2019 2018 +(in millions of MWhs) +Fuel Type: +Coal 4 6 8 +Renewables 3 2 1 +Total MWhs 7 8 9 +97 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Earnings Attributable to AEP Common Shareholders from Generation & Marketing +(in millions) +Year Ended December 31, 2019 $ 112.8 +Changes in Gross Margin: +Merchant Generation (78.2) +Renewable Generation 9.7 +Retail, Trading and Marketing (10.9) +Total Change in Gross Margin (79.4) +Changes in Expenses and Other: +Other Operation and Maintenance 98.9 +Asset Impairments and Other Related Charges 31.0 +Depreciation and Amortization (3.3) +Taxes Other Than Income Taxes 2.4 +Interest and Investment Income (4.5) +Non-Service Cost Components of Net Periodic Benefit Cost 0.5 +Interest Expense 6.0 +Total Change in Expenses and Other 131.0 +Income Tax Benefit 54.2 +Equity Earnings of Unconsolidated Subsidiaries 7.0 +Net Loss Attributable to Noncontrolling Interests 1.3 +Year Ended December 31, 2020 $ 226.9 +The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, purchased electricity and certain cost-of-service for retail operations were as follows: +• Merchant Generation decreased $78 million primarily due to the reduction of capacity revenues and energy margins in 2020 and the retirement of the Conesville Plant, Units 5 and 6 in 2019, Unit 4 in 2020 and the Oklaunion Power Station in 2020. +• Renewable Generation increased $10 million primarily due to the Sempra Renewables LLC acquisition and other renewable projects placed in-service. +• Retail, Trading and Marketing decreased $11 million primarily due to lower retail margins. +Expenses and Other, Income Tax Benefit and Equity Earnings of Unconsolidated Subsidiaries changed between years as follows: +• Other Operation and Maintenance expenses decreased $99 million primarily due to following: +• A $36 million decrease due to the retirements of Conesville Plant Units 5 and 6 in 2019 and Unit 4 in 2020. +• A $34 million decrease due to a gain recorded on the sale of land. +• An $18 million decrease related to the Oklaunion PPA with AEP Texas primarily due to an ARO revision. +• An $11 million decrease primarily in employee expenses due to the sale of the Stuart Plant in 2019. +• Asset Impairments and Other Related Charges decreased $31 million primarily due to impairment charges related to the Conesville Plant in 2019. +• Depreciation and Amortization expenses increased $3 million primarily due to a higher depreciable base from increased investments in renewable energy sources. +98 +• Interest and Investment Income decreased $5 million due to lower returns on investments. +• Interest Expense decreased $6 million primarily due lower borrowing costs in 2020. +• Income Tax Benefit increased $54 million primarily due to the realization of tax benefit related to the 5-year NOL carryback provision of the CARES Act and an increase in PTCs. This decrease was partially offset by an increase in pretax book income. +• Equity Earnings of Unconsolidated Subsidiaries increased $7 million primarily due to the Sempra Renewables LLC acquisition. +99 +CORPORATE AND OTHER +2020 Compared to 2019 +Earnings attributable to AEP Common Shareholders from Corporate and Other increased from a loss of $141 million in 2019 to a loss of $90 million in 2020 primarily due to: +• A $32 million decrease in tax expense primarily due to the following: +• A $21 million decrease in state income tax expense related to unitary state filing requirements. +• A $5 million decrease in permanent tax expense. +• A $3 million decrease due to a favorable true-up related to the 2019 federal income tax return. +• A $2 million decrease due to the realization of tax benefit related to the 5-year NOL carryback provision of the CARES Act. +• A $32 million gain on the valuation of common share warrants for an interest in a privately held investee. +• A $5 million write-off of an equity investment and related assets in 2019. +These items were partially offset by: +• A $12 million decrease in interest income from affiliates. +• A $7 million increase in general corporate expenses. +AEP SYSTEM INCOME TAXES +2020 Compared to 2019 +Income Tax Expense increased $53 million primarily due to a decrease in amortization of Excess ADIT and an increase in pretax book income. This increase is partially offset by the recognition of tax benefit related to the 5-year NOL carryback provision as a result of the CARES Act, an increase in PTCs and a decrease in state tax expense. +100 +FINANCIAL CONDITION +AEP measures financial condition by the strength of its balance sheet and the liquidity provided by its cash flows. +LIQUIDITY AND CAPITAL RESOURCES +Debt and Equity Capitalization +December 31, +2020 2019 +(dollars in millions) +Long-term Debt, including amounts due within one year +$ 31,072.5 57.2 % $ 26,725.5 54.1 % +Short-term Debt 2,479.3 4.6 2,838.3 5.7 +Total Debt 33,551.8 61.8 29,563.8 59.8 +AEP Common Equity 20,550.9 37.8 19,632.2 39.6 +Noncontrolling Interests 223.6 0.4 281.0 0.6 +Total Debt and Equity Capitalization $ 54,326.3 100.0 % $ 49,477.0 100.0 % +AEP’s ratio of debt-to-total capital increased from 59.8% to 61.8% as of December 31, 2019 and 2020, respectively, primarily due to an increase in debt to support distribution, transmission and renewable investment growth. +Liquidity +Liquidity, or access to cash, is an important factor in determining AEP’s financial stability. Management believes AEP has adequate liquidity under its existing credit facilities. As of December 31, 2020, AEP had a $4 billion revolving credit facility to support its commercial paper program. Additional liquidity is available from cash from operations and a receivables securitization agreement. Management is committed to maintaining adequate liquidity. AEP generally uses short-term borrowings to fund working capital needs, property acquisitions and construction until long-term funding is arranged. Sources of long-term funding include issuance of long-term debt, leasing agreements, hybrid securities or common stock. There was increased volatility in the capital markets during the first quarter of 2020 resulting in higher commercial paper cost and limited access. To address these issues and the uncertainty around COVID-19, in March 2020, AEP entered into a $1 billion 364-day Term Loan and borrowed the full amount. In November 2020, AEP repaid the 364-day Term Loan. +Net Available Liquidity +AEP manages liquidity by maintaining adequate external financing commitments. As of December 31, 2020, available liquidity was approximately $2.5 billion as illustrated in the table below: +Amount Maturity +(in millions) +Commercial Paper Backup: +Revolving Credit Facility +$ 4,000.0 June 2022 +Cash and Cash Equivalents 392.7 +Total Liquidity Sources 4,392.7 +Less: AEP Commercial Paper Outstanding 1,852.3 +Net Available Liquidity $ 2,540.4 +AEP uses its commercial paper program to meet the short-term borrowing needs of its subsidiaries. The program funds a Utility Money Pool, which funds AEP’s utility subsidiaries; a Nonutility Money Pool, which funds certain AEP nonutility subsidiaries; and the short-term debt requirements of subsidiaries that are not participating in either money pool for regulatory or operational reasons, as direct borrowers. The maximum amount of commercial paper outstanding during 2020 was $3 billion. The weighted-average interest rate for AEP’s commercial paper during 2020 was 1.28%. +101 +Other Credit Facilities +An uncommitted facility gives the issuer of the facility the right to accept or decline each request made under the facility. AEP issues letters of credit on behalf of subsidiaries under six uncommitted facilities totaling $405 million. The Registrants’ maximum future payments for letters of credit issued under the uncommitted facilities as of December 31, 2020, was $180 million with maturities ranging from January 2021 to December 2021. +Financing Plan +As of December 31, 2020, AEP had $2.1 billion of long-term debt due within one year. This included $235 million of Pollution Control Bonds with mandatory tender dates and credit support for variable interest rates that requires the debt be classified as current and $190 million of securitization bonds and DCC Fuel notes. Management plans to refinance the majority of the maturities due within one year on a long-term basis. +Securitized Accounts Receivables +AEP receivables securitization agreement provides a commitment of $750 million from bank conduits to purchase receivables and expires in September 2022. +In May 2020, AEP Credit amended its receivables securitization agreement to increase the eligibility criteria related to aged receivable requirements for the participating affiliated utility subsidiaries in response to the COVID-19 pandemic. As of December 31, 2020, the affiliated utility subsidiaries are in compliance with all requirements under the agreement. To the extent that an affiliated utility subsidiary is deemed ineligible under the agreement, the affiliated utility subsidiary would no longer participate in the receivables securitization agreement and the Registrants would need to rely on additional sources of funding for operation and working capital, which may adversely impact liquidity. The receivables that are ineligible under the receivables securitization agreement are financed with short-term debt at AEP Credit. +Debt Covenants and Borrowing Limitations +AEP’s credit agreements contain certain covenants and require it to maintain a percentage of debt-to-total capitalization at a level that does not exceed 67.5%. The method for calculating outstanding debt and capitalization is contractually-defined in AEP’s credit agreements. Debt as defined in the revolving credit agreement excludes securitization bonds and debt of AEP Credit. As of December 31, 2020, this contractually-defined percentage was 58.6%. Non-performance under these covenants could result in an event of default under these credit agreements. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of AEP’s major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under these credit agreements. This condition also applies in a majority of AEP’s non-exchange-traded commodity contracts and would similarly allow lenders and counterparties to declare the outstanding amounts payable. However, a default under AEP’s non-exchange-traded commodity contracts would not cause an event of default under its credit agreements. +The revolving credit facility does not permit the lenders to refuse a draw on any facility if a material adverse change occurs. +Utility Money Pool borrowings and external borrowings may not exceed amounts authorized by regulatory orders and AEP manages its borrowings to stay within those authorized limits. +Equity Units +In August 2020, AEP issued 17 million Equity Units initially in the form of corporate units, at a stated amount of $50 per unit, for a total stated amount of $850 million. Net proceeds from the issuance were approximately $833 million. Each corporate unit represents a 1/20 undivided beneficial ownership interest in $1,000 principal amount of AEP’s 1.30% Junior Subordinated Notes due in 2025 and a forward equity purchase contract which settles after three years in 2023. The proceeds were used to support AEP’s overall capital expenditure plans. +102 +In March 2019, AEP issued 16.1 million Equity Units initially in the form of corporate units, at a stated amount of $50 per unit, for a total stated amount of $805 million. Net proceeds from the issuance were approximately $785 million. Each corporate unit represents a 1/20 undivided beneficial ownership interest in $1,000 principal amount of AEP’s 3.40% Junior Subordinated Notes due in 2024 and a forward equity purchase contract which settles after three years in 2022. The proceeds from this issuance were used to support AEP’s overall capital expenditure plans including the recent acquisition of Sempra Renewables LLC. +See Note 14 - Financing Activities for additional information. +Dividend Policy and Restrictions +The Board of Directors declared a quarterly dividend of $0.74 per-share in January 2021. Future dividends may vary depending upon AEP’s profit levels, operating cash flow levels and capital requirements, as well as financial and other business conditions existing at the time. Parent’s income primarily derives from common stock equity in the earnings of its utility subsidiaries. Various financing arrangements and regulatory requirements may impose certain restrictions on the ability of the subsidiaries to transfer funds to Parent in the form of dividends. Management does not believe these restrictions will have any significant impact on its ability to access cash to meet the payment of dividends on its common stock. See “Dividend Restrictions” section of Note 14 for additional information. +Credit Ratings +AEP and its utility subsidiaries do not have any credit arrangements that would require material changes in payment schedules or terminations as a result of a credit downgrade, but its access to the commercial paper market may depend on its credit ratings. In addition, downgrades in AEP’s credit ratings by one of the rating agencies could increase its borrowing costs. Counterparty concerns about the credit quality of AEP or its utility subsidiaries could subject AEP to additional collateral demands under adequate assurance clauses under its derivative and non-derivative energy contracts. +CASH FLOW +AEP relies primarily on cash flows from operations, debt issuances and its existing cash and cash equivalents to fund its liquidity and investing activities. AEP’s investing and capital requirements are primarily capital expenditures, repaying of long-term debt and paying dividends to shareholders. AEP uses short-term debt, including commercial paper, as a bridge to long-term debt financing. The levels of borrowing may vary significantly due to the timing of long-term debt financings and the impact of fluctuations in cash flows. +Years Ended December 31, +2020 2019 2018 +(in millions) +Cash, Cash Equivalents and Restricted Cash at Beginning of Period $ 432.6 $ 444.1 $ 412.6 +Net Cash Flows from Operating Activities 3,832.9 4,270.1 5,223.2 +Net Cash Flows Used for Investing Activities (6,233.9) (7,144.5) (6,353.6) +Net Cash Flows from Financing Activities 2,406.7 2,862.9 1,161.9 +Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash 5.7 (11.5) 31.5 +Cash, Cash Equivalents and Restricted Cash at End of Period $ 438.3 $ 432.6 $ 444.1 +103 +Operating Activities +Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 2,196.7 $ 1,919.8 $ 1,931.3 +Non-Cash Adjustments to Net Income (a) 2,946.3 2,685.7 2,400.0 +Mark-to-Market of Risk Management Contracts 66.5 (29.2) (66.4) +Pension Contributions to Qualified Plan Trust (110.3) — — +Property Taxes (43.3) (73.8) (59.1) +Deferred Fuel Over/Under Recovery, Net (31.8) 85.2 189.7 +Change in Regulatory Assets (337.9) 49.5 354.1 +Change in Other Noncurrent Assets (142.5) (112.8) (172.1) +Change in Other Noncurrent Liabilities (54.5) (116.1) 129.0 +Change in Certain Components of Working Capital (656.3) (138.2) 516.7 +Net Cash Flows from Operating Activities $ 3,832.9 $ 4,270.1 $ 5,223.2 +(a) Non-Cash Adjustments to Net Income includes Depreciation and Amortization, Rockport Plant Unit 2 Operating Lease Amortization, Deferred Income Taxes, Asset Impairments and Other Related Charges, Allowance for Equity Funds Used During Construction, Amortization of Nuclear Fuel and Pension and Postemployment Benefit Reserves. +2020 Compared to 2019 +Net Cash Flows from Operating Activities decreased by $437 million primarily due to the following: +• A $518 million decrease in cash from Changes in Certain Components of Working Capital. This decrease is primarily due to an increase in accounts receivable driven by increased sales in December 2020 and increased days sales outstanding. +• A $387 million decrease in cash from Changes in Regulatory Assets primarily due to deferred storm costs related to Hurricanes Laura and Delta, the establishment of regulatory assets as a result of the Virginia SCC order issued in the 2017-2019 Virginia Triennial Review and the settlement of deferred restoration costs from the Texas Storm Cost Securitization financing order received in 2019. See Note 4 - Rate Matters and Note 5 - Effects of Regulation for additional information. +• A $117 million decrease in cash from Deferred Fuel Over/Under Recovery, Net primarily due to an increase in the under recovered fuel balances at PSO. +• A $110 million decrease in cash due to a discretionary contribution to the qualified pension plan. See Note 8 - Benefit Plans for additional information. +These decreases in cash were partially offset by: +• A $538 million increase in cash from Net Income, after non-cash adjustments. See Results of Operations for further detail. +• A $96 million increase in the fair value of risk management contracts due to pricing movement in the commodities markets. +104 +Investing Activities +Years Ended December 31, +2020 2019 2018 +(in millions) +Construction Expenditures $ (6,246.3) $ (6,051.4) $ (6,310.9) +Acquisitions of Nuclear Fuel (69.7) (92.3) (46.1) +Acquisition of Sempra Renewables LLC and Santa Rita East, net of cash and restricted cash acquired — (918.4) — +Other 82.1 (82.4) 3.4 +Net Cash Flows Used for Investing Activities $ (6,233.9) $ (7,144.5) $ (6,353.6) +2020 Compared to 2019 +Net Cash Flows Used for Investing Activities decreased by $911 million primarily due to the following: +• A $918 million decrease due to the acquisition of Sempra Renewables LLC and Santa Rita East. The $918 million represents a cash payment of $936 million, net of cash and restricted cash acquired of $18 million. See Note 7 - Acquisitions, Dispositions and Impairments for additional information. +This decrease in the use of cash was partially offset by: +• A $195 million increase in construction expenditures primarily due to increases in Transmission Operations of $190 million and Generation & Marketing of $110 million, partially offset by a decrease in Vertically Integrated of $146 million. +Financing Activities +Years Ended December 31, +2020 2019 2018 +(in millions) +Issuance of Common Stock $ 155.0 $ 65.3 $ 73.6 +Issuance/Retirement of Debt, Net 3,927.3 4,244.1 2,435.1 +Dividends Paid on Common Stock (1,424.9) (1,350.0) (1,255.5) +Redemption of Noncontrolling Interests (100.2) — — +Other (150.5) (96.5) (91.3) +Net Cash Flows from Financing Activities $ 2,406.7 $ 2,862.9 $ 1,161.9 +2020 Compared to 2019 +Net Cash Flows from Financing Activities decreased by $456 million primarily due to the following: +• A $1.3 billion decrease in short-term debt primarily due to increased repayments of commercial paper. See Note 14 - Financing Activities for additional information. +• A $119 million decrease due to increased retirements of long-term debt. See Note 14 - Financing Activities for additional information. +• A $100 million decrease due to the redemption of noncontrolling interests in Desert Sky Wind Farm LLC and Trent Wind Farm LLC as well as the acquisition of an additional 10% interest in Santa Rita East. See Note 7 - Acquisitions, Dispositions and Impairments for additional information. +These decreases in cash were partially offset by: +• A $1.1 billion increase in issuances of long-term debt. See Note 14 - Financing Activities for additional information. +105 +The following financing activities occurred during 2020: +AEP Common Stock: +• During 2020, AEP issued 2.4 million shares of common stock under the incentive compensation, employee saving and dividend reinvestment plans and received net proceeds of $155 million. +Debt: +• During 2020, AEP issued approximately $5.6 billion of long-term debt, including $4.4 billion of senior unsecured notes at interest rates ranging from 0.75% to 3.7%, $850 million of junior subordinated debenture notes at an interest rate of 1.3%, $175 million of pollution control bonds at interest rates ranging from 0.625% to 1.00%, and $238 million of other debt at various interest rates. The proceeds from these issuances were used to fund long-term debt maturities and construction programs. +• During 2020, AEP entered into interest rate derivatives with notional amounts totaling $1.8 billion that were designated as either fair value or cash flow hedges. During 2020, settlements of AEP’s interest rate derivatives resulted in net cash received of $59 million for derivatives designated as fair value hedges and net cash paid of $38 million for derivatives designated as cash flow hedges. As of December 31, 2020, AEP had a total notional amount of $950 million of outstanding interest rate derivatives designated as fair value hedges and $200 million designated as cash flow hedges. +See “Long-term Debt Subsequent Events” section of Note 14 for Long-term debt and other securities issued, retired and principal payments made after December 31, 2020 through February 25, 2021, the date that the 10-K was issued. +BUDGETED CAPITAL EXPENDITURES +Management forecasts approximately $7.5 billion of capital expenditures in 2021. For the four year period, 2022 through 2025, management forecasts capital expenditures of $29.8 billion. The expenditures are generally for transmission, generation, distribution, regulated and contracted renewables, and required environmental investment to comply with the Federal EPA rules. Estimated capital expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends, weather, legal reviews and the ability to access capital. Management expects to fund these capital expenditures through cash flows from operations and financing activities. Generally, the Registrant Subsidiaries use cash or short-term borrowings under the money pool to fund these expenditures until long-term funding is arranged. The 2021 estimated capital expenditures include generation, transmission and distribution related investments, as well as expenditures for compliance with environmental regulations as follows: +2021 Budgeted Capital Expenditures +Segment Environmental Generation Renewables Transmission Distribution Other (a) Total +(in millions) +Vertically Integrated Utilities $ 124.7 $ 264.7 $ 711.3 $ 787.1 $ 1,040.5 $ 364.3 $ 3,292.6 +Transmission and Distribution Utilities — — — 833.9 977.3 233.1 2,044.3 +AEP Transmission Holdco — — — 1,564.5 — 32.8 1,597.3 +Generation & Marketing 9.1 39.9 434.1 — — 17.7 500.8 +Corporate and Other — — — — — 31.8 31.8 +Total $ 133.8 $ 304.6 $ 1,145.4 $ 3,185.5 $ 2,017.8 $ 679.7 $ 7,466.8 +(a) Amount primarily consists of facilities, software and telecommunications. +106 +The 2021 estimated capital expenditures by Registrant Subsidiary include distribution, transmission and generation-related investments, as well as expenditures for compliance with environmental regulations as follows: +2021 Budgeted Capital Expenditures +Company Environmental Generation Renewables Transmission Distribution Other (a) Total +(in millions) +AEP Texas $ — $ — $ — $ 606.8 $ 513.7 $ 104.8 $ 1,225.3 +AEPTCo — — — 1,451.7 — 33.4 1,485.1 +APCo 60.6 64.1 1.0 309.6 341.8 100.7 877.8 +I&M 16.8 75.9 1.3 98.3 268.1 114.4 574.8 +OPCo — — — 227.1 463.6 128.3 819.0 +PSO — 42.5 322.3 102.3 210.7 48.5 726.3 +SWEPCo 8.8 43.9 386.7 205.4 135.8 67.1 847.7 +(a) Amount primarily consists of facilities, software and telecommunications. +107 +CYBER SECURITY +The electric utility industry is an identified critical infrastructure function with mandatory cyber security requirements under the authority of FERC. The NERC, which FERC certified as the nation’s Electric Reliability Organization, developed mandatory critical infrastructure protection cyber security reliability standards. AEP’s service territory covers multiple NERC regions, and is audited at least annually by one or more of the regions. AEP began participating in the NERC grid security and emergency response exercises, GridEx, in 2013 and continues to participate in the bi-yearly exercises. These efforts, led by NERC, test and further develop the coordination, threat sharing and interaction between utilities and various government agencies relative to potential cyber and physical threats against the nation’s electric grid. The operations of AEP’s electric utility subsidiaries are subject to extensive and rigorous mandatory cyber and physical security requirements that are developed and enforced by NERC to protect grid security and reliability. AEP’s Enterprise Security program uses the National Institute of Standards and Technology Cybersecurity Framework as a guideline. AEP’s Chief Security Officer (CSO) is also its NERC Critical Infrastructure Protection Senior Manager, ensuring alignment of compliance with the enterprise security program. +Critical cyber assets, such as data centers, power plants, transmission operations centers and business networks are protected using multiple layers of cyber security controls and authentication. Cyber hackers have been successful in breaching a number of very secure facilities, including federal agencies, banks and retailers. As understanding of these events develop, AEP has adopted a defense in depth approach to cyber security and continually assesses its cyber security tools and processes to determine where to strengthen its defenses. These strategies include monitoring, alerting and emergency response, forensic analysis, disaster recovery, threat sharing and criminal activity reporting. This approach has allowed AEP to deal with threats in real-time and to limit the impact of cyber and related events to levels that would be expected in the ordinary course of business in the absence of such activity. +AEP has undertaken a variety of actions to monitor and address cyber-related risks. Cyber security and the effectiveness of AEP’s cyber security processes are reviewed annually with the Board of Directors and at several meetings with the Audit Committee throughout the year. AEP’s Chief Executive Officer and Executive team participate in interactive threat briefings from AEP’s CSO and cyber security team on a monthly basis. AEP’s strategy for managing cyber-related risks is integrated within its enterprise risk management processes. AEP enterprise security continually adjusts staff and resources in response to the evolving threat landscape. In addition, AEP maintains cyber liability insurance to cover certain damages caused by cyber incidents. +AEP’s CSO leads the cyber security and physical security teams and is responsible for the design, implementation and execution of AEP’s security risk management strategy, which includes cyber security. AEP’s cyber security team operates a 24/7 Cyber Security Intelligence and Response Center responsible for monitoring the AEP System for cyber risks and threats. Under the direction of the CSO, the cyber security team actively monitors best practices, performs penetration testing, leads response exercises and internal campaigns and provides training and communication across the organization. +The cyber security team constantly scans the AEP System for risks and threats. AEP also continually reviews its business continuity plan to develop an effective recovery strategy that seeks to decrease response times, limit financial impacts and maintain customer confidence during any business interruption. AEP has implemented a third-party risk governance program to identify potential risks introduced through third-party relationships, such as vendors, software and hardware manufacturers or professional service providers. As warranted, AEP obtains certain contractual security guarantees and assurances with these third-party relationships to help ensure the security and safety of its information. The cyber security team works closely with a broad range of departments, including legal, regulatory, corporate communications and audit services and information technology. +The cyber security team collaborates with partners from both industry and government, and routinely participates in industry-wide programs that exchange knowledge of threats with utility peers, industry and federal agencies. AEP is an active member of a number of industry specific threat and information sharing communities including the Department of Homeland Security and the Electricity Information Sharing and Analysis Center. AEP continues to work with nonaffiliated entities to do penetration testing and to design and implement appropriate remediation strategies. There can be no assurance, however, that these efforts will be effective to prevent interruption of services or other damages to AEP's business or operations in connection with any cyber-related incident. +108 +CRITICAL ACCOUNTING POLICIES AND ESTIMATES AND ACCOUNTING STANDARDS +CRITICAL ACCOUNTING POLICIES AND ESTIMATES +The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures, including amounts related to legal matters and contingencies. Management considers an accounting estimate to be critical if: +• It requires assumptions to be made that were uncertain at the time the estimate was made; and +• Changes in the estimate or different estimates that could have been selected could have a material effect on net income or financial condition. +Management discusses the development and selection of critical accounting estimates as presented below with the Audit Committee of AEP’s Board of Directors and the Audit Committee reviews the disclosures relating to them. +Management believes that the current assumptions and other considerations used to estimate amounts reflected in the financial statements are appropriate. However, actual results can differ significantly from those estimates. +The sections that follow present information about critical accounting estimates, as well as the effects of hypothetical changes in the material assumptions used to develop each estimate. +Regulatory Accounting +Nature of Estimates Required +The Registrants’ financial statements reflect the actions of regulators that can result in the recognition of revenues and expenses in different time periods than enterprises that are not rate-regulated. +The Registrants recognize regulatory assets (deferred expenses to be recovered in the future) and regulatory liabilities (deferred future revenue reductions or refunds) for the economic effects of regulation. Specifically, the timing of expense and income recognition is matched with regulated revenues. Liabilities are also recorded for refunds, or probable refunds, to customers that have not been made. +Assumptions and Approach Used +When incurred costs are probable of recovery through regulated rates, regulatory assets are recorded on the balance sheets. Management reviews the probability of recovery at each balance sheet date and whenever new events occur. Similarly, regulatory liabilities are recorded when a determination is made that a refund is probable or when ordered by a commission. Examples of new events that affect probability include changes in the regulatory environment, issuance of a regulatory commission order or passage of new legislation. The assumptions and judgments used by regulatory authorities continue to have an impact on the recovery of costs as well as the return of revenues, rate of return earned on invested capital and timing and amount of assets to be recovered through regulated rates. If recovery of a regulatory asset is no longer probable, that regulatory asset is written-off as a charge against earnings. A write-off of regulatory assets or establishment of a regulatory liability may also reduce future cash flows since there will be no recovery through regulated rates. +Effect if Different Assumptions Used +A change in the above assumptions may result in a material impact on net income. See Note 5 - Effects of Regulation for additional information related to regulatory assets and regulatory liabilities. +109 +Revenue Recognition – Unbilled Revenues +Nature of Estimates Required +AEP recognizes revenues from customers as the performance obligations of delivering energy to customers are satisfied. The determination of sales to individual customers is based on the reading of their meters, which is performed on a systematic basis throughout the month. At the end of each month, amounts of energy delivered to customers since the date of the last meter reading are estimated and the corresponding unbilled revenue accrual is recorded. This estimate is reversed in the following month and actual revenue is recorded based on meter readings. PSO and SWEPCo do not include the fuel portion in unbilled revenue in accordance with the applicable state commission regulatory treatment in Arkansas, Louisiana, Oklahoma and Texas. +Accrued unbilled revenues for the Vertically Integrated Utilities segment were $288 million and $248 million as of December 31, 2020 and 2019, respectively. The changes in unbilled electric utility revenues for AEP’s Vertically Integrated Utilities segment were $40 million, $(7) million and $(23) million for the years ended December 31, 2020, 2019 and 2018, respectively. The changes in unbilled electric revenues are primarily due to changes in weather and rates. +Accrued unbilled revenues for the Transmission and Distribution Utilities segment were $171 million and $166 million as of December 31, 2020 and 2019, respectively. The changes in unbilled electric utility revenues for AEP’s Transmission and Distribution Utilities segment were $5 million, $(12) million and $(24) million for the years ended December 31, 2020, 2019 and 2018, respectively. The changes in unbilled electric revenues are primarily due to changes in weather and rates. +Accrued unbilled revenues for the Generation & Marketing segment were $86 million and $75 million as of December 31, 2020 and 2019, respectively. The changes in unbilled electric utility revenues for AEP’s Generation & Marketing segment were $11 million, $16 million and $5 million for the years ended December 31, 2020, 2019 and 2018, respectively. +Assumptions and Approach Used +For each Registrant except AEPTCo, the monthly estimate for unbilled revenues is based upon a primary computation of net generation (generation plus purchases less sales) less the current month’s billed KWh and estimated line losses, plus the prior month’s unbilled KWh. However, due to the potential for meter reading issues, meter drift and other anomalies, a secondary computation is made, based upon an allocation of billed KWh to the current month and previous month, on a billing cycle-by-cycle basis, and by dividing the current month aggregated result by the billed KWh. The two methodologies are evaluated to confirm that they are not statistically different. +For AEP’s Generation & Marketing segment, management calculates unbilled based on a primary computation of load as provided by PJM less the current month’s billed KWh and estimated line losses, plus the prior month’s unbilled KWh. However, due to the potential for meter reading issues, meter drift and other anomalies, a secondary computation is made, based upon using the most recent historic daily activity on a per contract basis. The two methodologies are evaluated to confirm that they are not statistically different. +Effect if Different Assumptions Used +If the two methodologies used to estimate unbilled revenue are statistically different, a limiter adjustment is made to bring the primary computation within one standard deviation of the secondary computation. Additionally, significant fluctuations in energy demand for the unbilled period, weather, line losses or changes in the composition of customer classes could impact the estimate of unbilled revenue. +110 +Accounting for Derivative Instruments +Nature of Estimates Required +Management considers fair value techniques, valuation adjustments related to credit and liquidity and judgments related to the probability of forecasted transactions occurring within the specified time period to be critical accounting estimates. These estimates are considered significant because they are highly susceptible to change from period to period and are dependent on many subjective factors. +Assumptions and Approach Used +The Registrants measure the fair values of derivative instruments and hedge instruments accounted for using MTM accounting based primarily on exchange prices and broker quotes. If a quoted market price is not available, the fair value is estimated based on the best market information available including valuation models that estimate future energy prices based on existing market and broker quotes and other assumptions. Fair value estimates, based upon the best market information available, involve uncertainties and matters of significant judgment. These uncertainties include projections of future commodity prices, including future price volatility. +The Registrants reduce fair values by estimated valuation adjustments for items such as discounting, liquidity and credit quality. Liquidity adjustments are calculated by utilizing bid/ask spreads to estimate the potential fair value impact of liquidating open positions over a reasonable period of time. Credit adjustments on risk management contracts are calculated using estimated default probabilities and recovery rates relative to the counterparties or counterparties with similar credit profiles and contractual netting agreements. +With respect to hedge accounting, management assesses hedge effectiveness and evaluates a forecasted transaction’s probability of occurrence within the specified time period as provided in the original hedge documentation. +Effect if Different Assumptions Used +There is inherent risk in valuation modeling given the complexity and volatility of energy markets. Therefore, it is possible that results in future periods may be materially different as contracts settle. +The probability that hedged forecasted transactions will not occur by the end of the specified time period could change operating results by requiring amounts currently classified in Accumulated Other Comprehensive Income (Loss) to be classified into operating income. +For additional information see Note 10 - Derivatives and Hedging and Note 11 - Fair Value Measurements. See “Fair Value Measurements of Assets and Liabilities” section of Note 1 for AEP’s fair value calculation policy. +111 +Long-Lived Assets +Nature of Estimates Required +In accordance with the requirements of “Property, Plant and Equipment” accounting guidance and “Regulated Operations” accounting guidance, the Registrants evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of any such assets may not be recoverable. Such events or changes in circumstance include planned abandonments, probable disallowances for rate-making purposes of assets determined to be recently completed plant, and assets that meet the held-for-sale criteria. The Registrants utilize a group composite method of depreciation to estimate the useful lives of long-lived assets. +An impairment evaluation of a long-lived, held and used asset may result from an abandonment, significant decreases in the market price of an asset, a significant adverse change in the extent or manner in which an asset is being used or in its physical condition, a significant adverse change in legal factors or in the business climate that could affect the value of an asset, as well as other economic or operations analyses. If the carrying amount of the asset is not recoverable, the Registrants record an impairment to the extent that the fair value of the asset is less than its book value. Performing an impairment evaluation involves a significant degree of estimation and judgment in areas such as identifying circumstances that indicate an impairment may exist, identifying and grouping affected assets and developing the non-discounted and discounted future cash flows (used to estimate fair value in the absence of market-based value, in some instances) associated with the asset. Assets held for sale must be measured at the lower of the book value or fair value less cost to sell. An impairment is recognized if an asset’s fair value less costs to sell is less than its book value. Any impairment charge is recorded as a reduction to earnings. +Assumptions and Approach Used +The fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are used as the basis for the measurement, if available. In the absence of quoted prices for identical or similar assets in active markets, the Registrants estimate fair value using various internal and external valuation methods including cash flow projections or other market indicators of fair value such as bids received, comparable sales or independent appraisals. Cash flow estimates are based on relevant information available at the time the estimates are made. Estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Also, when measuring fair value, management evaluates the characteristics of the asset or liability to determine if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the condition and location of the asset or restrictions on the use of the asset. The Registrants perform depreciation studies that include a review of any external factors that may affect the useful life to determine composite depreciation rates and related lives which are subject to periodic review by state regulatory commissions for regulated assets. The fair value of the asset could be different using different estimates and assumptions in these valuation techniques. +Effect if Different Assumptions Used +In connection with the evaluation of long-lived assets in accordance with the requirements of “Property, Plant and Equipment” accounting guidance, the fair value of the asset can vary if different estimates and assumptions are used in the applied valuation techniques. Estimates for depreciation rates contemplate the history of interim capital replacements and the amount of salvage expected. In cases of impairment, the best estimate of fair value was made using valuation methods based on the most current information at that time. Fluctuations in realized sales proceeds versus the estimated fair value of the asset are generally due to a variety of factors including, but not limited to, differences in subsequent market conditions, the level of bidder interest, the timing and terms of the transactions and management’s analysis of the benefits of the transaction. +112 +Pension and OPEB +AEP maintains a qualified, defined benefit pension plan (Qualified Plan), which covers substantially all nonunion and certain union employees, and unfunded, non-qualified supplemental plans (Nonqualified Plans) to provide benefits in excess of amounts permitted under the provisions of the tax law for participants in the Qualified Plan (collectively the Pension Plans). AEP also sponsors OPEB plans to provide health and life insurance benefits for retired employees. The Pension Plans and OPEB plans are collectively referred to as the Plans. +For a discussion of investment strategy, investment limitations, target asset allocations and the classification of investments within the fair value hierarchy, see “Investments Held in Trust for Future Liabilities” and “Fair Value Measurements of Assets and Liabilities” sections of Note 1. See Note 8 - Benefit Plans for information regarding costs and assumptions for the Plans. +The following table shows the net periodic cost (credit) of the Plans: +Years Ended December 31, +Net Periodic Cost (Credit) 2020 2019 2018 +(in millions) +Pension Plans $ 108.6 $ 61.5 $ 82.9 +OPEB (109.7) (80.7) (101.8) +The net periodic benefit cost is calculated based upon a number of actuarial assumptions, including expected long-term rates of return on the Plans’ assets. In developing the expected long-term rate of return assumption for 2021, management evaluated input from actuaries and investment consultants, including their reviews of asset class return expectations as well as long-term inflation assumptions. Management also considered historical returns of the investment markets and tax rates which affect a portion of the OPEB plans’ assets. Management anticipates that the investment managers employed for the Plans will invest the assets to generate future returns averaging 4.75% for the Qualified Plan and 4.75% for the OPEB plans. +The expected long-term rate of return on the Plans’ assets is based on management’s targeted asset allocation and expected investment returns for each investment category. Assumptions for the Plans are summarized in the following table: +Pension Plans OPEB +Assumed/ Assumed/ +2021 Expected 2021 Expected +Target Long-Term Target Long-Term +Asset Rate of Asset Rate of +Allocation Return Allocation Return +Equity 25 % 6.79 % 49 % 6.45 % +Fixed Income 59 3.30 49 3.18 +Other Investments 15 7.88 — — +Cash and Cash Equivalents 1 1.21 2 1.21 +Total 100 % 100 % +Management regularly reviews the actual asset allocation and periodically rebalances the investments to the targeted allocation. Management believes that 4.75% for the Qualified Plan and 4.75% for the OPEB plans are reasonable estimates of the long-term rate of return on the Plans’ assets. The Pension Plans’ assets had an actual gain of 16.91% and 15.81% for the year ended December 31, 2020 and 2019, respectively. The OPEB plans’ assets had an actual gain of 16.33% and 20.93% for the year ended December 31, 2020 and 2019, respectively. Management will continue to evaluate the actuarial assumptions, including the expected rate of return, at least annually, and will adjust the assumptions as necessary. +113 +AEP bases the determination of pension expense or income on a market-related valuation of assets, which reduces year-to-year volatility. This market-related valuation recognizes investment gains or losses over a five-year period from the year in which they occur. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of assets and the actual return based on the market-related value of assets. Since the market-related value of assets recognizes gains or losses over a five-year period, the future value of assets will be impacted as previously deferred gains or losses are recorded. As of December 31, 2020, AEP had cumulative gains of approximately $575 million for the Qualified Plan that remain to be recognized in the calculation of the market-related value of assets. These unrecognized market-related net actuarial gains may result in decreases in the future pension costs depending on several factors, including whether such gains at each measurement date exceed the corridor in accordance with “Compensation – Retirement Benefits” accounting guidance. +The method used to determine the discount rate that AEP utilizes for determining future obligations is a duration-based method in which a hypothetical portfolio of high quality corporate bonds is constructed with cash flows matching the benefit plan liability. The composite yield on the hypothetical bond portfolio is used as the discount rate for the plan. The discount rate as of December 31, 2020 under this method was 2.5% for the Qualified Plan, 2.25% for the Nonqualified Plans and 2.55% for the OPEB plans. Due to the effect of the unrecognized net actuarial losses and based on an expected rate of return on the Pension Plans’ assets of 4.75%, discount rates of 2.5% and 2.25% and various other assumptions, management estimates that the pension costs for the Pension Plans will approximate $137 million, $137 million and $137 million in 2021, 2022 and 2023, respectively. Based on an expected rate of return on the OPEB plans’ assets of 4.75%, a discount rate of 2.55% and various other assumptions, management estimates OPEB plan credits will approximate $121 million, $120 million and $112 million in 2021, 2022 and 2023, respectively. Future actual costs will depend on future investment performance, changes in future discount rates and various other factors related to the populations participating in the Plans. The actuarial assumptions used may differ materially from actual results. The effects of a 50 basis point change to selective actuarial assumptions are included in the “Effect if Different Assumptions Used” section below. +The value of AEP’s Pension Plans’ assets increased to $5.6 billion as of December 31, 2020 from $5.0 billion as of December 31, 2019 primarily due to higher investment returns. During 2020, the Qualified Plan paid $402 million and the Nonqualified Plans paid $5 million in benefits to plan participants. The value of AEP’s OPEB plans’ assets increased to $1.9 billion as of December 31, 2020 from $1.8 billion as of December 31, 2019 primarily due to higher investment returns. The OPEB plans paid $131 million in benefits to plan participants during 2020. +Nature of Estimates Required +AEP sponsors pension and OPEB plans in various forms covering all employees who meet eligibility requirements. These benefits are accounted for under “Compensation” and “Plan Accounting” accounting guidance. The measurement of pension and OPEB obligations, costs and liabilities is dependent on a variety of assumptions. +Assumptions and Approach Used +The critical assumptions used in developing the required estimates include the following key factors: +• Discount rate +• Compensation increase rate +• Cash balance crediting rate +• Health care cost trend rate +• Expected return on plan assets +Other assumptions, such as retirement, mortality and turnover, are evaluated periodically and updated to reflect actual experience. +114 +Effect if Different Assumptions Used +The actuarial assumptions used may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, longer or shorter life spans of participants or higher or lower lump sum versus annuity payout elections by plan participants. These differences may result in a significant impact to the amount of pension and OPEB expense recorded. If a 50 basis point change were to occur for the following assumptions, the approximate effect on the financial statements would be as follows: +Pension Plans OPEB ++0.5% -0.5% +0.5% -0.5% +(in millions) +Effect on December 31, 2020 Benefit Obligations +Discount Rate $ (286.9) $ 316.2 $ (66.6) $ 73.7 +Compensation Increase Rate 32.9 (30.3) NA NA +Cash Balance Crediting Rate 81.2 (75.4) NA NA +Health Care Cost Trend Rate NA NA 12.7 (11.7) +Effect on 2020 Periodic Cost +Discount Rate $ (12.5) $ 13.6 $ (3.2) $ 3.4 +Compensation Increase Rate 6.5 (5.9) NA NA +Cash Balance Crediting Rate 14.1 (13.2) NA NA +Health Care Cost Trend Rate NA NA 0.9 (0.8) +Expected Return on Plan Assets (23.0) 23.0 (8.7) 8.7 +NA Not applicable. +115 +CONTRACTUAL OBLIGATION INFORMATION +AEP’s contractual cash obligations include amounts reported on the balance sheets and other obligations disclosed in the footnotes. The following table summarizes AEP’s contractual cash obligations as of December 31, 2020: +Payments Due by Period +Contractual Cash Obligations Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Short-term Debt (a) $ 2,479.3 $ — $ — $ — $ 2,479.3 +Interest on Fixed Rate Portion of Long-term Debt (b) 1,310.7 2,373.0 2,209.0 14,918.9 20,811.6 +Fixed Rate Portion of Long-term Debt (c) 1,533.1 4,481.8 2,443.1 20,599.2 29,057.2 +Variable Rate Portion of Long-term Debt (d) 553.0 1,715.9 6.6 — 2,275.5 +Finance Lease Obligations (e) 72.2 120.2 96.2 48.9 337.5 +Operating Lease Obligations (e) 270.8 357.5 149.6 193.0 970.9 +Fuel Purchase Contracts (f) 763.9 715.1 212.9 381.5 2,073.4 +Energy and Capacity Purchase Contracts 211.6 291.8 277.0 928.5 1,708.9 +Construction Contracts for Capital Assets (g) 1,624.2 3,211.8 2,347.4 4,379.1 11,562.5 +Total $ 8,818.8 $ 13,267.1 $ 7,741.8 $ 41,449.1 $ 71,276.8 +(a) Represents principal only, excluding interest. +(b) Interest payments are estimated based on final maturity dates of debt securities outstanding as of December 31, 2020 and do not reflect anticipated future refinancing, early redemptions or debt issuances. +(c) See “Long-term Debt” section of Note 14 for additional information. Represents principal only, excluding interest. +(d) See “Long-term Debt” section of Note 14 for additional information. Represents principal only, excluding interest. Variable rate debt had interest rates that ranged between 0.18% and 2.25% as of December 31, 2020. +(e) See Note 13 - Leases for additional information. +(f) Represents contractual obligations to purchase coal, natural gas, uranium and other consumables as fuel for electric generation along with related transportation of the fuel. +(g) Represents only capital assets for which there are signed contracts. Actual payments are dependent upon and may vary significantly based upon the decision to build, regulatory approval schedules, timing and escalation of project costs. +AEP’s pension funding requirements are not included in the above table. As of December 31, 2020, AEP expects to make contributions to the pension plans totaling $133 million in 2021. Estimated contributions of $135 million in 2022 and $136 million in 2023 may vary significantly based on market returns, changes in actuarial assumptions and other factors. Based upon the projected benefit obligation and fair value of assets available to pay pension benefits, the pension plans were 100.2% funded as of December 31, 2020. See “Estimated Future Benefit Payments and Contributions” section of Note 8 for additional information. +In addition to the amounts disclosed in the contractual cash obligations table above, standby letters of credit are entered into with third-parties. These letters of credit are issued in the ordinary course of business and cover items such as natural gas and electricity risk management contracts, construction contracts, insurance programs, security deposits and debt service reserves. There is no collateral held in relation to any guarantees in excess of the ownership percentages. In the event any letters of credit are drawn, there is no recourse to third-parties. See “Letters of Credit” section of Note 6 for additional information. +SIGNIFICANT TAX LEGISLATION +In March 2020, the CARES Act was signed into law and includes tax relief provisions such as: (a) an AMT Credit Refund, (b) a 5-year NOL carryback from years 2018-2020 and (c) delayed payment of employer payroll taxes. See “Federal Tax Legislation” section of Note 12 for additional information. +In December 2020, the CAA of 2021 was signed into law and includes: (a) COVID-19 tax relief and tax extender provisions including, extensions of time to begin construction on and placed in-service assets generating PTCs and ITCs, (b) 100% deductibility of business meals in 2021 and 2022 and (c) an extension of the work opportunity tax credit. See “Federal Tax Legislation” section of Note 12 for additional information. +116 +ACCOUNTING STANDARDS +See Note 2 - New Accounting Standards for information related to accounting standards adopted in 2020 and standards effective in the future. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Market Risks +The Vertically Integrated Utilities segment is exposed to certain market risks as a major power producer and through transactions in power, coal, natural gas and marketing contracts. These risks include commodity price risks which may be subject to capacity risk, credit risk as well as interest rate risk. These risks represent the risk of loss that may impact this segment due to changes in the underlying market prices or rates. +The Transmission and Distribution Utilities segment is exposed to energy procurement risk and interest rate risk. +The Generation & Marketing segment conducts marketing, risk management and retail activities in ERCOT, PJM, SPP and MISO. This segment is exposed to certain market risks as a marketer of wholesale and retail electricity. These risks include commodity price risks which may be subject to capacity risk, credit risk as well as interest rate risk. These risks represent the risk of loss that may impact this segment due to changes in the underlying market prices or rates. In addition, the Generation & Marketing segment is also exposed to certain market risks as a power producer and through transactions in wholesale electricity, natural gas and marketing contracts. +Management employs risk management contracts including physical forward and financial forward purchase-and-sale contracts. Management engages in risk management of power, capacity, coal, natural gas and, to a lesser extent, heating oil, gasoline and other commodity contracts to manage the risk associated with the energy business. As a result, AEP is subject to price risk. The amount of risk taken is determined by the Commercial Operations, Energy Supply and Finance groups in accordance with established risk management policies as approved by the Finance Committee of the Board of Directors. AEPSC’s market risk oversight staff independently monitors risk policies, procedures and risk levels and provides members of the Commercial Operations Risk Committee (Regulated Risk Committee) and the Energy Supply Risk Committee (Competitive Risk Committee) various reports regarding compliance with policies, limits and procedures. The Regulated Risk Committee consists of AEPSC’s Chief Financial Officer, Executive Vice President of Generation, Executive Vice President of Utilities, Senior Vice President of Commercial Operations, Senior Vice President of Treasury and Risk and Chief Risk Officer. The Competitive Risk Committee consists of AEPSC’s Chief Financial Officer, Senior Vice President of Treasury and Risk and Chief Risk Officer in addition to Energy Supply’s President and Vice President. When commercial activities exceed predetermined limits, positions are modified to reduce the risk to be within the limits unless specifically approved by the respective committee. +The effects of COVID-19 may adversely impact AEP’s risk management contracts on a forward basis. Markets could experience reduced market liquidity as they face potential uncertainties. Credit risk may increase as counterparties encounter business and supply chain disruptions and overall solvency. Also, interest rates could continue to see increased volatility as capital markets confront uncertainty. +117 +The following table summarizes the reasons for changes in total MTM value as compared to December 31, 2019: +MTM Risk Management Contract Net Assets (Liabilities) +Year Ended December 31, 2020 +Vertically +Integrated +Utilities Transmission +and +Distribution +Utilities Generation +& +Marketing Total +(in millions) +Total MTM Risk Management Contract Net Assets (Liabilities) as of December 31, 2019 $ 75.9 $ (103.6) $ 163.4 $ 135.7 +Gain from Contracts Realized/Settled During the Period and Entered in a Prior Period (44.3) (7.2) (17.9) (69.4) +Fair Value of New Contracts at Inception When Entered During the Period (a) — — 15.2 15.2 +Changes in Fair Value Due to Market Fluctuations During the Period (b) — — 7.4 7.4 +Changes in Fair Value Allocated to Regulated Jurisdictions (c) 9.6 1.3 — 10.9 +Total MTM Risk Management Contract Net Assets (Liabilities) as of December 31, 2020 $ 41.2 $ (109.5) $ 168.1 99.8 +Commodity Cash Flow Hedge Contracts (75.4) +Interest Rate Cash Flow Hedge Contracts (1.0) +Fair Value Hedge Contracts (1.5) +Collateral Deposits 3.4 +Total MTM Derivative Contract Net Assets as of December 31, 2020 $ 25.3 +(a) Reflects fair value on primarily long-term structured contracts which are typically with customers that seek fixed pricing to limit their risk against fluctuating energy prices. The contract prices are valued against market curves associated with the delivery location and delivery term. A significant portion of the total volumetric position has been economically hedged. +(b) Market fluctuations are attributable to various factors such as supply/demand, weather, etc. +(c) Relates to the net gains (losses) of those contracts that are not reflected on the statements of income. These net gains (losses) are recorded as regulatory liabilities/assets or accounts payable. +See Note 10 – Derivatives and Hedging and Note 11 – Fair Value Measurements for additional information related to risk management contracts. The following tables and discussion provide information on credit risk and market volatility risk. +118 +Credit Risk +Credit risk is mitigated in wholesale marketing and trading activities by assessing the creditworthiness of potential counterparties before entering into transactions with them and continuing to evaluate their creditworthiness on an ongoing basis. Management uses credit agency ratings and current market-based qualitative and quantitative data as well as financial statements to assess the financial health of counterparties on an ongoing basis. +AEP has risk management contracts (includes non-derivative contracts) with numerous counterparties. Since open risk management contracts are valued based on changes in market prices of the related commodities, exposures change daily. As of December 31, 2020, credit exposure net of collateral to sub investment grade counterparties was approximately 6.6%, expressed in terms of net MTM assets, net receivables and the net open positions for contracts not subject to MTM (representing economic risk even though there may not be risk of accounting loss). As of December 31, 2020, the following table approximates AEP’s counterparty credit quality and exposure based on netting across commodities, instruments and legal entities where applicable: +Counterparty Credit Quality Exposure +Before +Credit +Collateral Credit +Collateral Net +Exposure Number of +Counterparties +>10% of +Net Exposure Net Exposure +of +Counterparties +>10% +(in millions, except number of counterparties) +Investment Grade $ 412.2 $ — $ 412.2 2 $ 198.2 +Split Rating 1.1 — 1.1 1 1.1 +No External Ratings: +Internal Investment Grade +133.8 — 133.8 3 91.8 +Internal Noninvestment Grade +49.4 10.5 38.9 2 25.6 +Total as of December 31, 2020 $ 596.5 $ 10.5 $ 586.0 +All exposure in the table above relates to AEPSC and AEPEP as AEPSC is agent for and transacts on behalf of AEP subsidiaries, including the Registrant Subsidiaries and AEPEP is agent for and transacts on behalf of other AEP subsidiaries. +In addition, AEP is exposed to credit risk related to participation in RTOs. For each of the RTOs in which AEP participates, this risk is generally determined based on the proportionate share of member gross activity over a specified period of time. +Value at Risk (VaR) Associated with Risk Management Contracts +Management uses a risk measurement model, which calculates VaR, to measure AEP’s commodity price risk in the risk management portfolio. The VaR is based on the variance-covariance method using historical prices to estimate volatilities and correlations and assumes a 95% confidence level and a one-day holding period. Based on this VaR analysis, as of December 31, 2020, a near term typical change in commodity prices is not expected to materially impact net income, cash flows or financial condition. +Management calculates the VaR for both a trading and non-trading portfolio. The trading portfolio consists primarily of contracts related to energy trading and marketing activities. The non-trading portfolio consists primarily of economic hedges of generation and retail supply activities. +119 +The following tables show the end, high, average and low market risk as measured by VaR for the periods indicated: +VaR Model +Trading Portfolio +Twelve Months Ended Twelve Months Ended +December 31, 2020 December 31, 2019 +End High Average Low End High Average Low +(in millions) (in millions) +$ 0.1 $ 0.3 $ 0.1 $ — $ 0.1 $ 1.2 $ 0.2 $ 0.1 +VaR Model +Non-Trading Portfolio +Twelve Months Ended Twelve Months Ended +December 31, 2020 December 31, 2019 +End High Average Low End High Average Low +(in millions) (in millions) +$ 2.2 $ 2.9 $ 1.0 $ 0.1 $ 0.2 $ 8.5 $ 1.1 $ 0.2 +Management back-tests VaR results against performance due to actual price movements. Based on the assumed 95% confidence interval, the performance due to actual price movements would be expected to exceed the VaR at least once every 20 trading days. +As the VaR calculation captures recent price movements, management also performs regular stress testing of the trading portfolio to understand AEP’s exposure to extreme price movements. A historical-based method is employed whereby the current trading portfolio is subjected to actual, observed price movements from the last several years in order to ascertain which historical price movements translated into the largest potential MTM loss. Management then researches the underlying positions, price movements and market events that created the most significant exposure and reports the findings to the Risk Executive Committee, Regulated Risk Committee or Competitive Risk Committee as appropriate. +Interest Rate Risk +AEP is exposed to interest rate market fluctuations in the normal course of business operations. AEP has outstanding short and long-term debt which is subject to a variable rate. AEP manages interest rate risk by limiting variable-rate exposures to a percentage of total debt, by entering into interest rate derivative instruments and by monitoring the effects of market changes in interest rates. For the 12 months ended December 31, 2020, 2019 and 2018, a 100 basis point change in the benchmark rate on AEP’s variable rate debt would impact pretax interest expense annually by $32 million, $24 million and $25 million, respectively. +120 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholders of +American Electric Power Company, Inc. +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of American Electric Power Company, Inc. and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in +Internal Control - Integrated Framework (2013) issued by the COSO. +Change in Accounting Principle +As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinions +The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +121 +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $3.6 billion of deferred costs included in regulatory assets, $0.4 billion of which were pending final regulatory approval, and $8.4 billion of regulatory liabilities awaiting potential refund or future rate reduction, $0.5 billion of which were pending final regulatory determination. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +122 +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +Valuation of Level 3 Risk Management Commodity Contracts +As described in Notes 1, 10 and 11 to the consolidated financial statements, the Company employs risk management commodity contracts including physical and financial forward purchase-and-sale contracts and, to a lesser extent, over-the-counter swaps and options to accomplish its risk management strategies. Certain over-the-counter and bilaterally executed derivative instruments are executed in less active markets with a lower availability of pricing information. The fair value of these risk management commodity contracts is estimated based on available market information including valuation models that estimate future energy prices based on existing market and broker quotes, and other assumptions. Fair value estimates involve significant uncertainties and matters of significant judgement including future commodity prices and future price volatility. The main driver of contracts being classified as Level 3 is the inability to substantiate energy price curves in the market. Management utilized such unobservable pricing data to value its Level 3 risk management commodity contract assets and liabilities, which totaled $256.3 million and $174.8 million, as of December 31, 2020, respectively. +The principal considerations for our determination that performing procedures relating to the valuation of Level 3 risk management commodity contracts is a critical audit matter are the significant judgment and estimation by management when developing the fair value of the commodity contracts; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to the unobservable assumptions for projections of future commodity prices and future price volatilities used within management’s discounted cash flow models. In addition, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s valuation of the risk management commodity contracts, including controls over the assumptions used to value the Level 3 risk management commodity contracts. These procedures also included, among others, testing the data used in and management’s process for developing the fair value of the Level 3 risk management commodity contracts. Professionals with specialized skill and knowledge were used to assist in evaluating the appropriateness of the discounted cash flow models and reasonableness of the future commodity prices and future price volatilities assumptions. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company’s auditor since 2017. +123 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of American Electric Power Company, Inc. and Subsidiary Companies (AEP) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. AEP’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of AEP’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded AEP’s internal control over financial reporting was effective as of December 31, 2020. +PricewaterhouseCoopers LLP, AEP’s independent registered public accounting firm has issued an audit report on the effectiveness of AEP’s internal control over financial reporting as of December 31, 2020. The Report of Independent Registered Public Accounting Firm appears on the previous page. +124 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions, except per-share and share amounts) +Years Ended December 31, +2020 2019 2018 +REVENUES +Vertically Integrated Utilities $ 8,753.2 $ 9,245.7 $ 9,556.7 +Transmission and Distribution Utilities 4,238.7 4,319.0 4,552.3 +Generation & Marketing 1,621.0 1,721.8 1,818.1 +Other Revenues 305.6 274.9 268.6 +TOTAL REVENUES 14,918.5 15,561.4 16,195.7 +EXPENSES +Fuel and Other Consumables Used for Electric Generation 1,439.3 1,940.9 2,359.4 +Purchased Electricity for Resale 2,930.4 3,165.2 3,427.1 +Other Operation 2,572.4 2,743.7 2,979.2 +Maintenance 1,010.4 1,213.9 1,247.4 +Asset Impairments and Other Related Charges — 156.4 70.6 +Depreciation and Amortization 2,682.8 2,514.5 2,286.6 +Taxes Other Than Income Taxes 1,295.5 1,234.5 1,142.7 +TOTAL EXPENSES 11,930.8 12,969.1 13,513.0 +OPERATING INCOME 2,987.7 2,592.3 2,682.7 +Other Income (Expense): +Other Income 57.0 26.6 18.2 +Allowance for Equity Funds Used During Construction 148.1 168.4 132.5 +Non-Service Cost Components of Net Periodic Benefit Cost 119.0 120.0 124.5 +Interest Expense ( 1,165.7 ) ( 1,072.5 ) ( 984.4 ) +INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS 2,146.1 1,834.8 1,973.5 +Income Tax Expense (Benefit) 40.5 ( 12.9 ) 115.3 +Equity Earnings of Unconsolidated Subsidiaries 91.1 72.1 73.1 +NET INCOME 2,196.7 1,919.8 1,931.3 +Net Income (Loss) Attributable to Noncontrolling Interests ( 3.4 ) ( 1.3 ) 7.5 +EARNINGS ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS $ 2,200.1 $ 1,921.1 $ 1,923.8 +WEIGHTED AVERAGE NUMBER OF BASIC AEP COMMON SHARES OUTSTANDING +495,718,223 493,694,345 492,774,600 +TOTAL BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS +$ 4.44 $ 3.89 $ 3.90 +WEIGHTED AVERAGE NUMBER OF DILUTED AEP COMMON SHARES OUTSTANDING 497,226,867 495,306,238 493,758,277 +TOTAL DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS +$ 4.42 $ 3.88 $ 3.90 +See Notes to Financial Statements of Registrants beginning on page 229 . +125 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 2,196.7 $ 1,919.8 $ 1,931.3 +OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES +Cash Flow Hedges, Net of Tax of $ 1.8 , $( 21.1 ) and $ 3.9 in 2020, 2019 and 2018, Respectively +6.9 ( 79.4 ) 14.6 +Amortization of Pension and OPEB Deferred Costs, Net of Tax of $( 1.9 ), $( 1.5 ) and $( 1.4 ) in 2020, 2019 and 2018, Respectively +( 7.0 ) ( 5.6 ) ( 5.3 ) +Pension and OPEB Funded Status, Net of Tax of $ 16.7 , $ 15.3 and $( 8.8 ) in 2020, 2019 and 2018, Respectively +62.7 57.7 ( 33.0 ) +TOTAL OTHER COMPREHENSIVE INCOME (LOSS) 62.6 ( 27.3 ) ( 23.7 ) +TOTAL COMPREHENSIVE INCOME 2,259.3 1,892.5 1,907.6 +Total Comprehensive Income (Loss) Attributable To Noncontrolling Interests ( 3.4 ) ( 1.3 ) 7.5 +TOTAL COMPREHENSIVE INCOME ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS $ 2,262.7 $ 1,893.8 $ 1,900.1 +See Notes to Financial Statements of Registrants beginning on page 229 . +126 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +AEP Common Shareholders +Common Stock Accumulated +Other +Comprehensive +Income (Loss) +Shares Amount Paid-in +Capital Retained +Earnings Noncontrolling +Interests Total +TOTAL EQUITY – DECEMBER 31, 2017 512.2 $ 3,329.4 $ 6,398.7 $ 8,626.7 $ ( 67.8 ) $ 26.6 $ 18,313.6 +Issuance of Common Stock 1.3 8.0 65.6 73.6 +Common Stock Dividends ( 1,251.1 ) (a) ( 4.4 ) ( 1,255.5 ) +Other Changes in Equity 21.8 1.3 23.1 +ASU 2018-02 Adoption 14.0 ( 17.0 ) ( 3.0 ) +ASU 2016-01 Adoption 11.9 ( 11.9 ) — +Net Income 1,923.8 7.5 1,931.3 +Other Comprehensive Loss ( 23.7 ) ( 23.7 ) +TOTAL EQUITY – DECEMBER 31, 2018 513.5 3,337.4 6,486.1 9,325.3 ( 120.4 ) 31.0 19,059.4 +Issuance of Common Stock 0.9 6.0 59.3 65.3 +Common Stock Dividends ( 1,345.5 ) (a) ( 4.5 ) ( 1,350.0 ) +Other Changes in Equity ( 9.8 ) (b) 2.2 ( 7.6 ) +Acquisition of Sempra Renewables LLC 134.8 134.8 +Acquisition of Santa Rita East 118.8 118.8 +Net Income (Loss) 1,921.1 ( 1.3 ) 1,919.8 +Other Comprehensive Loss ( 27.3 ) ( 27.3 ) +TOTAL EQUITY – DECEMBER 31, 2019 514.4 3,343.4 6,535.6 9,900.9 ( 147.7 ) 281.0 19,913.2 +Issuance of Common Stock 2.4 15.9 139.1 155.0 +Common Stock Dividends ( 1,415.0 ) (a) ( 9.9 ) ( 1,424.9 ) +Other Changes in Equity ( 85.8 ) (c) ( 0.4 ) ( 86.2 ) +ASU 2016-13 Adoption 1.8 1.8 +Acquisition of Incremental Interest +in Santa Rita East ( 43.7 ) ( 43.7 ) +Net Income (Loss) 2,200.1 ( 3.4 ) 2,196.7 +Other Comprehensive Income 62.6 62.6 +TOTAL EQUITY – DECEMBER 31, 2020 516.8 $ 3,359.3 $ 6,588.9 $ 10,687.8 $ ( 85.1 ) $ 223.6 $ 20,774.5 +(a) Cash dividends declared per AEP common share were $ 2.84 , $ 2.71 and $ 2.53 for the years ended December 31, 2020, 2019 and 2018, respectively. +(b) Includes $(62) million related to a forward equity purchase contract associated with the issuance of Equity Units. See “Equity Units” section of Note 14 for additional information. +(c) Includes $(121) million related to a forward equity purchase contract associated with the issuance of Equity Units. See “Equity Units” section of Note 14 for additional information. +See Notes to Financial Statements of Registrants beginning on page 229 . +127 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 392.7 $ 246.8 +Restricted Cash +(December 31, 2020 and 2019 Amounts Include $ 45.6 and $ 185.8 , Respectively, Related to Transition Funding, Restoration Funding, Appalachian Consumer Rate Relief Funding and Santa Rita East) +45.6 185.8 +Other Temporary Investments +(December 31, 2020 and 2019 Amounts Include $ 194.6 and $ 187.8 , Respectively, Related to EIS and Transource Energy) +200.8 202.7 +Accounts Receivable: +Customers 613.6 625.3 +Accrued Unbilled Revenues 248.7 222.4 +Pledged Accounts Receivable – AEP Credit 1,018.4 873.9 +Miscellaneous 33.1 27.2 +Allowance for Uncollectible Accounts ( 71.1 ) ( 43.7 ) +Total Accounts Receivable 1,842.7 1,705.1 +Fuel 629.4 528.5 +Materials and Supplies 680.6 640.7 +Risk Management Assets 94.7 172.8 +Accrued Tax Benefits 185.3 85.8 +Regulatory Asset for Under-Recovered Fuel Costs 90.7 92.9 +Margin Deposits 62.0 60.4 +Prepayments and Other Current Assets 127.0 156.3 +TOTAL CURRENT ASSETS 4,351.5 4,077.8 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Generation 23,133.9 22,762.4 +Transmission 27,886.7 24,808.6 +Distribution 23,972.1 22,443.4 +Other Property, Plant and Equipment (Including Coal Mining and Nuclear Fuel) 5,294.6 4,811.5 +Construction Work in Progress 4,025.7 4,319.8 +Total Property, Plant and Equipment 84,313.0 79,145.7 +Accumulated Depreciation and Amortization 20,411.4 19,007.6 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 63,901.6 60,138.1 +OTHER NONCURRENT ASSETS +Regulatory Assets 3,527.0 3,158.8 +Securitized Assets 657.0 858.1 +Spent Nuclear Fuel and Decommissioning Trusts 3,306.7 2,975.7 +Goodwill 52.5 52.5 +Long-term Risk Management Assets 242.2 266.6 +Operating Lease Assets 866.4 957.4 +Deferred Charges and Other Noncurrent Assets 3,852.3 3,407.3 +TOTAL OTHER NONCURRENT ASSETS 12,504.1 11,676.4 +TOTAL ASSETS $ 80,757.2 $ 75,892.3 +See Notes to Financial Statements of Registrants beginning on page 229 . +128 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2020 and 2019 +(dollars in millions) +December 31, +2020 2019 +CURRENT LIABILITIES +Accounts Payable $ 1,709.7 $ 2,085.8 +Short-term Debt: +Securitized Debt for Receivables – AEP Credit 592.0 710.0 +Other Short-term Debt 1,887.3 2,128.3 +Total Short-term Debt 2,479.3 2,838.3 +Long-term Debt Due Within One Year +(December 31, 2020 and 2019 Amounts Include $ 198.3 and $ 565.1 , Respectively, Related to Sabine, DCC Fuel, Transition Funding, Restoration Funding, Appalachian Consumer Rate Relief Funding and Transource Energy) +2,086.1 1,598.7 +Risk Management Liabilities 78.8 114.3 +Customer Deposits 335.6 366.1 +Accrued Taxes 1,476.4 1,357.8 +Accrued Interest 267.6 243.6 +Obligations Under Operating Leases 241.3 234.1 +Regulatory Liability for Over-Recovered Fuel Costs 52.6 86.6 +Other Current Liabilities 1,199.3 1,373.8 +TOTAL CURRENT LIABILITIES 9,926.7 10,299.1 +NONCURRENT LIABILITIES +Long-term Debt +(December 31, 2020 and 2019 Amounts Include $ 950.1 and $ 907 , Respectively, Related to Sabine, DCC Fuel, Transition Funding, Restoration Funding, Appalachian Consumer Rate Relief Funding and Transource Energy) +28,986.4 25,126.8 +Long-term Risk Management Liabilities 232.8 261.8 +Deferred Income Taxes 8,240.9 7,588.2 +Regulatory Liabilities and Deferred Investment Tax Credits 8,378.7 8,457.6 +Asset Retirement Obligations 2,469.2 2,216.6 +Employee Benefits and Pension Obligations 336.4 466.0 +Obligations Under Operating Leases 638.4 734.6 +Deferred Credits and Other Noncurrent Liabilities 728.0 719.8 +TOTAL NONCURRENT LIABILITIES 50,010.8 45,571.4 +TOTAL LIABILITIES 59,937.5 55,870.5 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +MEZZANINE EQUITY +Redeemable Noncontrolling Interest — 65.7 +Contingently Redeemable Performance Share Awards 45.2 42.9 +TOTAL MEZZANINE EQUITY 45.2 108.6 +EQUITY +Common Stock – Par Value – $ 6.50 Per Share: +2020 2019 +Shares Authorized 600,000,000 600,000,000 +Shares Issued 516,808,354 514,373,631 +( 20,204,160 Shares were Held in Treasury as of December 31, 2020 and 2019, Respectively) +3,359.3 3,343.4 +Paid-in Capital 6,588.9 6,535.6 +Retained Earnings 10,687.8 9,900.9 +Accumulated Other Comprehensive Income (Loss) ( 85.1 ) ( 147.7 ) +TOTAL AEP COMMON SHAREHOLDERS’ EQUITY 20,550.9 19,632.2 +Noncontrolling Interests 223.6 281.0 +TOTAL EQUITY 20,774.5 19,913.2 +TOTAL LIABILITIES, MEZZANINE EQUITY AND EQUITY $ 80,757.2 $ 75,892.3 +See Notes to Financial Statements of Registrants beginning on page 229 . +129 +AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 2,196.7 $ 1,919.8 $ 1,931.3 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization +2,682.8 2,514.5 2,286.6 +Rockport Plant, Unit 2 Operating Lease Amortization +136.5 136.5 — +Deferred Income Taxes +196.1 ( 17.8 ) 104.3 +Asset Impairments and Other Related Charges +— 156.4 70.6 +Allowance for Equity Funds Used During Construction +( 148.1 ) ( 168.4 ) ( 132.5 ) +Mark-to-Market of Risk Management Contracts +66.5 ( 29.2 ) ( 66.4 ) +Amortization of Nuclear Fuel +87.5 89.1 113.8 +Pension and Postemployment Benefit Reserves +( 8.5 ) ( 24.6 ) ( 42.8 ) +Pension Contributions to Qualified Plan Trust +( 110.3 ) — — +Property Taxes +( 43.3 ) ( 73.8 ) ( 59.1 ) +Deferred Fuel Over/Under-Recovery, Net +( 31.8 ) 85.2 189.7 +Change in Regulatory Assets ( 337.9 ) 49.5 354.1 +Change in Other Noncurrent Assets +( 142.5 ) ( 112.8 ) ( 172.1 ) +Change in Other Noncurrent Liabilities +( 54.5 ) ( 116.1 ) 129.0 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net +( 129.3 ) 247.8 145.9 +Fuel, Materials and Supplies +( 142.9 ) ( 248.2 ) 20.7 +Accounts Payable +( 35.3 ) 5.8 36.6 +Accrued Taxes, Net +20.1 138.9 153.2 +Rockport Plant, Unit 2 Operating Lease Payments +( 147.7 ) ( 147.7 ) — +Other Current Assets +34.3 70.7 10.5 +Other Current Liabilities +( 255.5 ) ( 205.5 ) 149.8 +Net Cash Flows from Operating Activities 3,832.9 4,270.1 5,223.2 +INVESTING ACTIVITIES +Construction Expenditures ( 6,246.3 ) ( 6,051.4 ) ( 6,310.9 ) +Purchases of Investment Securities ( 1,678.8 ) ( 1,576.0 ) ( 2,067.8 ) +Sales of Investment Securities 1,644.3 1,494.2 2,010.0 +Acquisitions of Nuclear Fuel ( 69.7 ) ( 92.3 ) ( 46.1 ) +Acquisition of Sempra Renewables LLC and Santa Rita East, Net of Cash and Restricted Cash Acquired — ( 918.4 ) — +Other Investing Activities 116.6 ( 0.6 ) 61.2 +Net Cash Flows Used for Investing Activities ( 6,233.9 ) ( 7,144.5 ) ( 6,353.6 ) +FINANCING ACTIVITIES +Issuance of Common Stock 155.0 65.3 73.6 +Issuance of Long-term Debt 5,626.1 4,536.6 4,945.7 +Issuance of Short-term Debt with Original Maturities Greater Than 90 Days 1,396.5 — 205.6 +Change in Short-term Debt with Original Maturities Less Than 90 Day, Net ( 448.4 ) 928.3 271.4 +Retirement of Long-term Debt ( 1,339.8 ) ( 1,220.8 ) ( 2,782.0 ) +Redemption of Short-term Debt with Original Maturities Greater Than 90 Days ( 1,307.1 ) — ( 205.6 ) +Principal Payments for Finance Lease Obligations ( 61.7 ) ( 70.7 ) ( 65.1 ) +Dividends Paid on Common Stock ( 1,424.9 ) ( 1,350.0 ) ( 1,255.5 ) +Redemption of Noncontrolling Interests ( 100.2 ) — — +Other Financing Activities ( 88.8 ) ( 25.8 ) ( 26.2 ) +Net Cash Flows from Financing Activities 2,406.7 2,862.9 1,161.9 +Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash 5.7 ( 11.5 ) 31.5 +Cash, Cash Equivalents and Restricted Cash at Beginning of Period 432.6 444.1 412.6 +Cash, Cash Equivalents and Restricted Cash at End of Period $ 438.3 $ 432.6 $ 444.1 +See Notes to Financial Statements of Registrants beginning on page 229 . +130 +AEP TEXAS INC. +AND SUBSIDIARIES +131 +AEP TEXAS INC. AND SUBSIDIARIES +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +AEP Texas was formed by the merger of TCC and TNC into AEP Utilities on December 31, 2016. The merging parties consolidated the majority of their rate structures following the completion of their 2019 base rate case. See Note 4 - Rate Matters for additional information related to the 2019 base rate case. Following the merger, AEP Utilities changed its name to AEP Texas. +AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,068,000 retail customers through REPs in west, central and southern Texas. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and support activities for mining. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. Under Texas Restructuring Legislation, AEP Texas’ utility predecessors, TCC and TNC, exited the generation business and ceased serving retail load. However, AEP Texas continued as part owner in the Oklaunion Power Station operated by PSO until the Oklaunion Power Station was retired in September 2020 and subsequently sold to a nonaffiliated third-party in October 2020. See “Oklaunion Power Station” section of Note 7 for additional information about the sale. +AEP Texas consolidates AEP Texas North Generation Company, LLC, AEP Texas Central Transition Funding II LLC, AEP Texas Central Transition Funding III LLC and AEP Texas Restoration Funding LLC, its wholly-owned subsidiaries. The AEP Texas Central Transition Funding II LLC securitization bonds matured in July 2020. +132 +RESULTS OF OPERATIONS +KWh Sales/Degree Days +Summary of KWh Energy Sales +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 12,163 11,996 12,101 +Commercial 10,065 10,419 10,220 +Industrial 9,085 8,882 9,053 +Miscellaneous 636 665 646 +Total Retail 31,949 31,962 32,020 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. +Summary of Heating and Cooling Degree Days +Years Ended December 31, +2020 2019 2018 +(in degree days) +Actual – Heating (a) 189 301 354 +Normal – Heating (b) 313 322 325 +Actual – Cooling (c) 2,846 2,989 2,861 +Normal – Cooling (b) 2,711 2,699 2,688 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 70 degree temperature base. +133 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Net Income +(in millions) +Year Ended December 31, 2019 $ 178.3 +Changes in Gross Margin: +Retail Margins 34.2 +Margins from Off-system Sales (52.2) +Transmission Revenues 21.6 +Other Revenues (76.6) +Total Change in Gross Margin (73.0) +Changes in Expenses and Other: +Other Operation and Maintenance 81.4 +Asset Impairments and Other Related Charges 32.5 +Depreciation and Amortization 92.5 +Taxes Other Than Income Taxes 4.2 +Interest Income (2.0) +Allowance for Equity Funds Used During Construction 4.2 +Non-Service Cost Components of Net Periodic Benefit Cost (0.1) +Interest Expense (34.6) +Total Change in Expenses and Other 178.1 +Income Tax Expense (42.4) +Year Ended December 31, 2020 $ 241.0 +The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals were as follows: +• Retail Margins increased $34 million primarily due to the following: +• A $30 million increase due to a provision for refund recorded in December 2019 as part of the most recent base rate case. +• A $19 million increase in weather-normalized margins primarily driven by the residential class and partially offset by a decrease in the industrial and commercial classes. +• A $16 million increase from interim rate increases driven by increased distribution investment. +• A $13 million increase due to new base rates implemented in June 2020. +• A $12 million increase from interim rate increases driven by increased transmission investment. +• A $5 million increase due to the change in the recording of merger savings as authorized by the PUCT in the most recent base rate case. +These increases were partially offset by: +• A $38 million decrease due to refunds of Excess ADIT and excess federal income taxes collected as a result of Tax Reform. This decrease was partially offset in Income Tax Expense below. +• A $17 million decrease in weather-related usage primarily due to a 5% decrease in cooling degree days and a 37% decrease in heating degree days. +• A $6 million decrease due to refunds to customers associated with the most recent base rate case. This decrease was offset in Other Revenues below. +• Margins from Off-system Sales decreased $52 million due to lower Oklaunion Power Station PPA revenues. This decrease was partially offset in Other Operation and Maintenance expenses below. +134 +• Transmission Revenues increased $22 million primarily due to the following: +• A $48 million increase from interim rate increases driven by increased transmission investment. +This increase was partially offset by: +• A $14 million decrease due to a one-time credit to transmission customers as a result of Tax Reform and the most recent base rate case. This decrease was offset in Income Tax Expense below. +• An $11 million decrease due to refunds to customers associated with the most recent base rate case. This decrease was offset in Other Revenues below. +• Other Revenues decreased $77 million primarily due to the following: +• A $96 million decrease related to securitization revenues primarily due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset below in Depreciation and Amortization expenses and in Interest Expense. +This decrease was partially offset by: +• An $18 million increase in revenues due to the amortization of a provision for refund recorded in December 2019 as part of the most recent base rate case. This increase was offset in Retail Margins and Transmission Revenues above. +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses decreased $81 million primarily due to the following: +• A $67 million decrease due to prior year partial amortization of the AEP Texas Storm Restoration Securitization regulatory asset as a result of the AEP Texas Storm Cost Securitization financing order issued by the PUCT in June 2019. This decrease was offset in Income Tax Expense below. +• A $17 million decrease due to the revision of the Oklaunion Power Station ARO. This decrease was offset in Margins from Off-system Sales above. +• A $6 million decrease due to a charitable contribution to the AEP Foundation in 2019. +These decreases were partially offset by: +• A $17 million increase in transmission expenses. This increase was partially offset in Gross Margin above. +• Asset Impairments and Other Related Charges decreased $33 million due to prior year regulatory disallowances in the 2019 Texas Base Rate Case. +• Depreciation and Amortization expenses decreased $93 million primarily due to the following: +• An $87 million decrease in securitization amortizations primarily due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset in Other Revenues above and in Interest Expense below. +• A $16 million decrease in depreciation expense due to the retirement of the Oklaunion Power Station in September 2020. This decrease was partially offset above in Margins from Off-system Sales and Other Operation and Maintenance expenses. +These decreases were partially offset by: +• A $16 million increase in depreciation expense due to an increase in the depreciable base of transmission and distribution assets. +• Taxes Other Than Income Taxes decreased $4 million primarily due to lower property taxes. +• Allowance for Equity Funds Used During Construction increased $4 million primarily due to an increase in the equity component of AFUDC as a result of lower short-term balances and increased transmission projects. +• Interest Expense increased $35 million primarily due to the following: +• A $22 million increase due to the prior year deferral of previously recorded interest expense approved for recovery as a result of the Texas Storm Cost Securitization financing order issued by the PUCT in June 2019. +• A $19 million increase due to higher long-term debt balances. +• An $8 million increase due to a decrease in the debt component of AFUDC. +These increases were partially offset by: +• An $8 million decrease in expense related to securitization assets. This decrease was offset in Other Revenues and Depreciation and Amortization expenses above. +• A $5 million decrease due to lower short-term debt balances. +135 +• Income Tax Expense increased $42 million primarily due to an increase in pretax book income and the prior year amortization of Excess ADIT not subject to normalization requirements as approved in the Texas Storm Cost Securitization financing order issued by the PUCT in 2019. This increase is partially offset by a decrease in state tax expense. The amortization of Excess ADIT was partially offset in Gross Margins and Other Operation and Maintenance expenses above. +136 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholder of +AEP Texas Inc. +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of AEP Texas Inc. and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Change in Accounting Principle +As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that +our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +137 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $266.8 million of deferred costs included in regulatory assets, $32.9 million of which were pending final regulatory approval, and $1,270.8 million of regulatory +liabilities awaiting potential refund or future rate reduction, ($5.7) million of which were pending final regulatory determination. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +138 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of AEP Texas Inc. and Subsidiaries (AEP Texas) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. AEP Texas’ internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of AEP Texas’ internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded AEP Texas’ internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, AEP Texas’ registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit AEP Texas to provide only management’s report in this annual report. +139 +AEP TEXAS INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Electric Transmission and Distribution $ 1,524.9 $ 1,545.9 $ 1,486.3 +Sales to AEP Affiliates 90.8 160.5 105.2 +Other Revenues 3.2 2.9 3.8 +TOTAL REVENUES 1,618.9 1,709.3 1,595.3 +EXPENSES +Fuel and Other Consumables Used for Electric Generation 13.7 31.1 38.5 +Other Operation 488.9 492.0 488.9 +Maintenance 80.5 158.8 89.4 +Asset Impairments and Other Related Charges — 32.5 — +Depreciation and Amortization 529.8 622.3 499.6 +Taxes Other Than Income Taxes 136.4 140.6 132.6 +TOTAL EXPENSES 1,249.3 1,477.3 1,249.0 +OPERATING INCOME 369.6 232.0 346.3 +Other Income (Expense): +Interest Income 1.4 3.4 0.8 +Allowance for Equity Funds Used During Construction 19.4 15.2 20.0 +Non-Service Cost Components of Net Periodic Benefit Cost 11.2 11.3 12.3 +Interest Expense ( 171.8 ) ( 137.2 ) ( 147.3 ) +INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) 229.8 124.7 232.1 +Income Tax Expense (Benefit) ( 11.2 ) ( 53.6 ) 20.8 +NET INCOME $ 241.0 $ 178.3 $ 211.3 +The common stock of AEP Texas is wholly-owned by Parent. +See Notes to Financial Statements of Registrants beginning on page 229 . +140 +AEP TEXAS INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 241.0 $ 178.3 $ 211.3 +OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES +Cash Flow Hedges, Net of Tax of $ 0.3 , $ 0.3 and $ 0.3 in 2020, 2019 and 2018, Respectively +1.1 1.0 1.0 +Amortization of Pension and OPEB Deferred Costs, Net of Tax of $ 0 , $ 0 and $ 0.1 in 2020, 2019 and 2018, Respectively +0.2 0.2 0.2 +Pension and OPEB Funded Status, Net of Tax of $ 0.7 , $ 0.3 and $( 0.3 ) in 2020, 2019 and 2018, Respectively +2.6 1.1 ( 1.0 ) +TOTAL OTHER COMPREHENSIVE INCOME 3.9 2.3 0.2 +TOTAL COMPREHENSIVE INCOME $ 244.9 $ 180.6 $ 211.5 +See Notes to Financial Statements of Registrants beginning on page 229 . +141 +AEP TEXAS INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Paid-in +Capital Retained +Earnings Accumulated +Other +Comprehensive +Income (Loss) Total +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017 $ 1,057.9 $ 1,124.6 $ ( 12.6 ) $ 2,169.9 +Capital Contribution from Parent 200.0 200.0 +ASU 2018-02 Adoption 1.8 ( 2.7 ) ( 0.9 ) +Net Income 211.3 211.3 +Other Comprehensive Income 0.2 0.2 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018 1,257.9 1,337.7 ( 15.1 ) 2,580.5 +Capital Contribution from Parent 200.0 200.0 +Net Income 178.3 178.3 +Other Comprehensive Income 2.3 2.3 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019 1,457.9 1,516.0 ( 12.8 ) 2,961.1 +Net Income 241.0 241.0 +Other Comprehensive Income 3.9 3.9 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020 $ 1,457.9 $ 1,757.0 $ ( 8.9 ) $ 3,206.0 +See Notes to Financial Statements of Registrants beginning on page 229 . +142 +AEP TEXAS INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 0.1 $ 3.1 +Restricted Cash +(December 31, 2020 and 2019 Amounts Include $ 28.7 and $ 154.7 , Respectively, Related to Transition Funding and Restoration Funding) +28.7 154.7 +Advances to Affiliates 7.1 207.2 +Accounts Receivable: +Customers 112.8 116.0 +Affiliated Companies 5.1 10.1 +Accrued Unbilled Revenues 65.8 68.8 +Miscellaneous — 0.3 +Allowance for Uncollectible Accounts ( 0.1 ) ( 1.8 ) +Total Accounts Receivable 183.6 193.4 +Fuel — 5.9 +Materials and Supplies 70.0 56.7 +Accrued Tax Benefits 16.8 66.1 +Prepayments and Other Current Assets 4.6 5.8 +TOTAL CURRENT ASSETS 310.9 692.9 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Generation — 351.7 +Transmission 5,279.6 4,466.5 +Distribution 4,580.8 4,215.2 +Other Property, Plant and Equipment 868.4 805.9 +Construction Work in Progress 614.1 763.9 +Total Property, Plant and Equipment 11,342.9 10,603.2 +Accumulated Depreciation and Amortization 1,529.3 1,758.1 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 9,813.6 8,845.1 +OTHER NONCURRENT ASSETS +Regulatory Assets 266.8 280.6 +Securitized Assets +(December 31, 2020 and 2019 Amounts Include $ 446.8 and $ 621.2 , Respectively, Related to Transition Funding and Restoration Funding) +446.8 623.4 +Deferred Charges and Other Noncurrent Assets 192.1 147.1 +TOTAL OTHER NONCURRENT ASSETS 905.7 1,051.1 +TOTAL ASSETS $ 11,030.2 $ 10,589.1 +See Notes to Financial Statements of Registrants beginning on page 229 . +143 +AEP TEXAS INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND COMMON SHAREHOLDER’S EQUITY +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT LIABILITIES +Advances from Affiliates $ 67.1 $ — +Accounts Payable: +General 231.7 256.8 +Affiliated Companies 44.0 35.6 +Long-term Debt Due Within One Year – Nonaffiliated +(December 31, 2020 and 2019 Amounts Include $ 88.7 and $ 281.4 , Respectively, Related to Transition Funding and Restoration Funding) +88.7 392.1 +Accrued Taxes 78.3 84.9 +Accrued Interest +(December 31, 2020 and 2019 Amounts Include $ 2.5 and $ 7.5 , Respectively, Related to Transition Funding and Restoration Funding) +43.9 35.7 +Oklaunion Purchase Power Agreement — 22.1 +Obligations Under Operating Leases 14.5 12.0 +Provision for Refund 20.1 64.7 +Other Current Liabilities 88.5 123.3 +TOTAL CURRENT LIABILITIES 676.8 1,027.2 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated +(December 31, 2020 and 2019 Amounts Include $ 403.9 and $ 495.4 , Respectively, Related to Transition Funding and Restoration Funding) +4,731.7 4,166.3 +Deferred Income Taxes 1,016.7 965.4 +Regulatory Liabilities and Deferred Investment Tax Credits 1,270.8 1,316.9 +Obligations Under Operating Leases 71.0 71.1 +Deferred Credits and Other Noncurrent Liabilities 57.2 81.1 +TOTAL NONCURRENT LIABILITIES 7,147.4 6,600.8 +TOTAL LIABILITIES 7,824.2 7,628.0 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +COMMON SHAREHOLDER’S EQUITY +Paid-in Capital 1,457.9 1,457.9 +Retained Earnings 1,757.0 1,516.0 +Accumulated Other Comprehensive Income (Loss) ( 8.9 ) ( 12.8 ) +TOTAL COMMON SHAREHOLDER’S EQUITY 3,206.0 2,961.1 +TOTAL LIABILITIES AND COMMON SHAREHOLDER'S EQUITY $ 11,030.2 $ 10,589.1 +See Notes to Financial Statements of Registrants beginning on page 229 . +144 +AEP TEXAS INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 241.0 $ 178.3 $ 211.3 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 529.8 622.3 499.6 +Deferred Income Taxes ( 15.2 ) ( 23.5 ) ( 16.5 ) +Asset Impairments and Other Related Charges — 32.5 — +Allowance for Equity Funds Used During Construction ( 19.4 ) ( 15.2 ) ( 20.0 ) +Mark-to-Market of Risk Management Contracts — ( 0.2 ) 0.7 +Pension Contributions to Qualified Plan Trust ( 11.3 ) — — +Change in Other Noncurrent Assets ( 74.0 ) 9.3 ( 60.3 ) +Change in Other Noncurrent Liabilities ( 24.7 ) 11.3 44.9 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net 9.8 3.5 ( 2.9 ) +Fuel, Materials and Supplies ( 7.4 ) ( 1.0 ) ( 6.0 ) +Accounts Payable 30.2 7.5 ( 20.3 ) +Accrued Taxes, Net 42.7 ( 11.8 ) ( 5.6 ) +Other Current Assets 0.8 ( 0.4 ) 0.8 +Other Current Liabilities ( 88.1 ) 10.8 26.2 +Net Cash Flows from Operating Activities 614.2 823.4 651.9 +INVESTING ACTIVITIES +Construction Expenditures ( 1,295.0 ) ( 1,275.1 ) ( 1,428.8 ) +Change in Advances to Affiliates, Net 200.1 ( 199.2 ) 103.9 +Other Investing Activities 29.5 2.1 35.2 +Net Cash Flows Used for Investing Activities ( 1,065.4 ) ( 1,472.2 ) ( 1,289.7 ) +FINANCING ACTIVITIES +Capital Contribution from Parent — 200.0 200.0 +Issuance of Long-term Debt – Nonaffiliated 652.7 1,070.4 494.0 +Change in Advances from Affiliates, Net 67.1 ( 216.0 ) 216.0 +Retirement of Long-term Debt – Nonaffiliated ( 392.1 ) ( 401.8 ) ( 266.1 ) +Principal Payments for Finance Lease Obligations ( 6.3 ) ( 5.1 ) ( 4.7 ) +Other Financing Activities 0.8 ( 0.7 ) 1.2 +Net Cash Flows from Financing Activities 322.2 646.8 640.4 +Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash ( 129.0 ) ( 2.0 ) 2.6 +Cash, Cash Equivalents and Restricted Cash at Beginning of Period 157.8 159.8 157.2 +Cash, Cash Equivalents and Restricted Cash at End of Period $ 28.8 $ 157.8 $ 159.8 +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 153.2 $ 148.6 $ 145.9 +Net Cash Paid (Received) for Income Taxes ( 42.9 ) ( 11.0 ) 7.9 +Noncash Acquisitions Under Finance Leases 5.6 11.4 10.6 +Construction Expenditures Included in Current Liabilities as of December 31, 177.8 225.5 243.1 +See Notes to Financial Statements of Registrants beginning on page 229 . +145 +AEP TRANSMISSION COMPANY, LLC +AND SUBSIDIARIES +146 +AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +AEPTCo is a holding company for seven FERC regulated transmission-only electric utilities. AEPTCo is an indirect wholly-owned subsidiary of American Electric Power Company, Inc. (AEP). +AEPTCo’s seven wholly-owned public utility companies are (collectively referred to herein as the State Transcos): +• AEP Appalachian Transmission Company, Inc. (APTCo) +• AEP Indiana Michigan Transmission Company, Inc. (IMTCo) +• AEP Kentucky Transmission Company, Inc. (KTCo) +• AEP Ohio Transmission Company, Inc. (OHTCo) +• AEP West Virginia Transmission Company, Inc. (WVTCo) +• AEP Oklahoma Transmission Company, Inc. (OKTCo) +• AEP Southwestern Transmission Company, Inc. (SWTCo) +AEPTCo’s business activities are the development, construction and operation of transmission facilities through investments in seven wholly-owned FERC-regulated transmission only electric subsidiaries. +147 +RESULTS OF OPERATIONS +Summary of Investment in Transmission Assets for AEPTCo +As of December 31, +2020 2019 2018 +(in millions) +Plant In Service $ 9,923.0 $ 8,407.5 $ 6,689.8 +CWIP 1,422.6 1,485.7 1,578.3 +Accumulated Depreciation 572.8 402.3 271.9 +Total Transmission Property, Net $ 10,772.8 $ 9,490.9 $ 7,996.2 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Net Income +(in millions) +Year Ended December 31, 2019 $ 439.7 +Changes in Transmission Revenues: +Transmission Revenues 124.3 +Total Change in Transmission Revenues 124.3 +Changes in Expenses and Other: +Other Operation and Maintenance (0.7) +Depreciation and Amortization (73.0) +Taxes Other Than Income Taxes (36.3) +Interest Income - Affiliated (0.6) +Allowance for Equity Funds Used During Construction (10.3) +Interest Expense (30.4) +Total Change in Expenses and Other (151.3) +Income Tax Expense 10.7 +Year Ended December 31, 2020 $ 423.4 +The major components of the increase in transmission revenues, which consists of wholesale sales to affiliates and nonaffiliates were as follows: +• Transmission Revenues increased $124 million primarily due to the following: +• A $205 million increase due to continued investment in transmission assets. +This increase was partially offset by the following: +• A $65 million decrease as a result of the affiliated annual transmission formula rate true-up which is offset in Other Operation and Maintenance expense across affiliated load-serving entities. +• A $17 million decrease as a result of the nonaffiliated annual transmission formula rate true-up. +Expenses and Other and Income Tax Expense changed between years as follows: +• Depreciation and Amortization expenses increased $73 million primarily due to a higher depreciable base and an increase in depreciation rates as a result of regulatory orders in 2020 in Indiana, Virginia and Michigan. +• Taxes Other Than Income Taxes increased $36 million primarily due to higher property taxes as a result of increased transmission investment. +148 +• Allowance for Equity Funds Used During Construction decreased $10 million primarily due to the following: +• A $13 million decrease due to lower CWIP. +• A $12 million decrease driven by the favorable impact of a FERC settlement agreement recorded in 2019. +These decreases were partially offset by: +• A $13 million increase driven by FERC audit findings recorded in 2019. +• Interest Expense increased $30 million primarily due to higher long-term debt balances. +• Income Tax Expense decreased $11 million primarily due to lower pretax book income, a decrease in state tax expense and an increase in Excess ADIT amortization. +149 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Member of +AEP Transmission Company, LLC +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of AEP Transmission Company, LLC and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of changes in member's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +150 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $15.1 million of deferred costs included in regulatory assets and $581.8 million of regulatory liabilities awaiting potential refund or future rate reduction. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +151 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of AEP Transmission Company, LLC and Subsidiaries (AEPTCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. AEPTCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of AEPTCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded AEPTCo’s internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, AEPTCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit AEPTCo to provide only management’s report in this annual report. +152 +AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Transmission Revenues $ 248.8 $ 214.6 $ 177.0 +Sales to AEP Affiliates 896.3 806.7 598.9 +Other Revenues 0.6 0.1 0.2 +TOTAL REVENUES 1,145.7 1,021.4 776.1 +EXPENSES +Other Operation 99.8 93.9 83.8 +Maintenance 10.2 15.4 10.5 +Depreciation and Amortization 249.0 176.0 133.9 +Taxes Other Than Income Taxes 205.2 168.9 137.8 +TOTAL EXPENSES 564.2 454.2 366.0 +OPERATING INCOME 581.5 567.2 410.1 +Other Income (Expense): +Interest Income - Affiliated 2.4 3.0 2.5 +Allowance for Equity Funds Used During Construction 74.0 84.3 70.6 +Interest Expense ( 127.8 ) ( 97.4 ) ( 83.2 ) +INCOME BEFORE INCOME TAX EXPENSE 530.1 557.1 400.0 +Income Tax Expense 106.7 117.4 84.1 +NET INCOME $ 423.4 $ 439.7 $ 315.9 +See Notes to Financial Statements of Registrants beginning on page 229 . +153 +AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN MEMBER’S EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Paid-in +Capital Retained +Earnings Total Member’s Equity +TOTAL MEMBER'S EQUITY - DECEMBER 31, 2017 $ 1,816.6 $ 773.3 $ 2,589.9 +Capital Contribution from Member 664.0 664.0 +Net Income 315.9 315.9 +TOTAL MEMBER'S EQUITY - DECEMBER 31, 2018 2,480.6 1,089.2 3,569.8 +Net Income 439.7 439.7 +TOTAL MEMBER'S EQUITY - DECEMBER 31, 2019 2,480.6 1,528.9 4,009.5 +Capital Contribution from Member 335.0 335.0 +Capital Distribution of Radial Assets to Member ( 50.0 ) ( 50.0 ) +Dividends Paid to Member ( 5.0 ) ( 5.0 ) +Net Income 423.4 423.4 +TOTAL MEMBER'S EQUITY - DECEMBER 31, 2020 $ 2,765.6 $ 1,947.3 $ 4,712.9 +See Notes to Financial Statements of Registrants beginning on page 229 . +154 +AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Advances to Affiliates $ 109.1 $ 85.4 +Accounts Receivable: +Customers 22.9 19.0 +Affiliated Companies 81.2 66.1 +Total Accounts Receivable 104.1 85.1 +Materials and Supplies 8.5 13.8 +Accrued Tax Benefits 9.9 9.3 +Prepayments and Other Current Assets 4.2 3.8 +TOTAL CURRENT ASSETS 235.8 197.4 +TRANSMISSION PROPERTY +Transmission Property 9,593.5 8,137.9 +Other Property, Plant and Equipment 329.5 269.6 +Construction Work in Progress 1,422.6 1,485.7 +Total Transmission Property 11,345.6 9,893.2 +Accumulated Depreciation and Amortization 572.8 402.3 +TOTAL TRANSMISSION PROPERTY – NET +10,772.8 9,490.9 +OTHER NONCURRENT ASSETS +Regulatory Assets 15.1 4.2 +Deferred Property Taxes 220.1 193.5 +Deferred Charges and Other Noncurrent Assets 2.2 4.8 +TOTAL OTHER NONCURRENT ASSETS 237.4 202.5 +TOTAL ASSETS $ 11,246.0 $ 9,890.8 +See Notes to Financial Statements of Registrants beginning on page 229 . +155 +AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND MEMBER’S EQUITY +December 31, 2020 and 2019 +December 31, +2020 2019 +(in millions) +CURRENT LIABILITIES +Advances from Affiliates $ 156.7 $ 137.0 +Accounts Payable: +General 380.4 493.4 +Affiliated Companies 97.3 71.2 +Long-term Debt Due Within One Year – Nonaffiliated 50.0 — +Accrued Taxes 418.1 355.6 +Accrued Interest 23.9 19.2 +Obligations Under Operating Leases 1.2 2.1 +Other Current Liabilities 9.9 14.6 +TOTAL CURRENT LIABILITIES 1,137.5 1,093.1 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 3,898.5 3,427.3 +Deferred Income Taxes 906.9 817.8 +Regulatory Liabilities 581.8 540.9 +Obligations Under Operating Leases 0.4 1.9 +Deferred Credits and Other Noncurrent Liabilities 8.0 0.3 +TOTAL NONCURRENT LIABILITIES 5,395.6 4,788.2 +TOTAL LIABILITIES 6,533.1 5,881.3 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +MEMBER’S EQUITY +Paid-in Capital 2,765.6 2,480.6 +Retained Earnings 1,947.3 1,528.9 +TOTAL MEMBER’S EQUITY 4,712.9 4,009.5 +TOTAL LIABILITIES AND MEMBER’S EQUITY $ 11,246.0 $ 9,890.8 +See Notes to Financial Statements of Registrants beginning on page 229 . +156 +AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 423.4 $ 439.7 $ 315.9 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 249.0 176.0 133.9 +Deferred Income Taxes 81.6 91.3 98.9 +Allowance for Equity Funds Used During Construction ( 74.0 ) ( 84.3 ) ( 70.6 ) +Property Taxes ( 26.6 ) ( 35.6 ) ( 32.9 ) +Change in Other Noncurrent Assets ( 8.2 ) 9.6 14.6 +Change in Other Noncurrent Liabilities 8.3 ( 8.1 ) 17.4 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net ( 19.0 ) ( 5.4 ) 36.7 +Materials and Supplies 5.3 5.2 ( 5.4 ) +Accounts Payable 77.8 37.6 ( 7.5 ) +Accrued Taxes, Net 62.7 90.8 73.4 +Accrued Interest 4.7 3.3 0.9 +Other Current Assets 0.7 ( 0.3 ) ( 0.3 ) +Other Current Liabilities ( 14.5 ) ( 11.2 ) ( 26.4 ) +Net Cash Flows from Operating Activities 771.2 708.6 548.6 +INVESTING ACTIVITIES +Construction Expenditures ( 1,615.9 ) ( 1,410.1 ) ( 1,526.4 ) +Change in Advances to Affiliates, Net ( 23.7 ) 11.5 49.4 +Acquisitions of Assets ( 6.0 ) ( 9.4 ) ( 37.4 ) +Other Investing Activities 5.2 4.8 1.1 +Net Cash Flows Used for Investing Activities ( 1,640.4 ) ( 1,403.2 ) ( 1,513.3 ) +FINANCING ACTIVITIES +Capital Contributions from Member 335.0 — 664.0 +Issuance of Long-term Debt – Nonaffiliated 519.5 688.0 321.0 +Change in Advances from Affiliates, Net 19.7 91.6 29.7 +Retirement of Long-term Debt – Nonaffiliated — ( 85.0 ) ( 50.0 ) +Dividends Paid to Member ( 5.0 ) — — +Net Cash Flows from Financing Activities 869.2 694.6 964.7 +Net Change in Cash and Cash Equivalents — — — +Cash and Cash Equivalents at Beginning of Period — — — +Cash and Cash Equivalents at End of Period $ — $ — $ — +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 119.7 $ 90.6 $ 80.2 +Net Cash Paid (Received) for Income Taxes 22.9 1.5 ( 30.7 ) +Construction Expenditures Included in Current Liabilities as of December 31, 311.9 472.7 345.0 +Noncash Distribution of Radial Assets to Member ( 50.0 ) — — +See Notes to Financial Statements of Registrants beginning on page 229 . +157 +APPALACHIAN POWER COMPANY +AND SUBSIDIARIES +158 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +As a public utility, APCo engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 964,000 retail customers in its service territory in southwestern Virginia and southern West Virginia. APCo consolidates Cedar Coal Company, Central Appalachian Coal Company, Southern Appalachian Coal Company and Appalachian Consumer Rate Relief Funding LLC, its wholly-owned subsidiaries. APCo sells power at wholesale to municipalities. +To minimize the credit requirements and operating constraints when operating within PJM, participating AEP companies, including APCo, agreed to a netting of certain payment obligations incurred by the participating AEP companies against certain balances due to such AEP companies and to hold PJM harmless from actions that any one or more AEP companies may take with respect to PJM. +159 +RESULTS OF OPERATIONS +KWh Sales/Degree Days +Summary of KWh Energy Sales +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 10,916 11,253 11,871 +Commercial 5,887 6,365 6,581 +Industrial 8,873 9,546 9,576 +Miscellaneous 794 857 866 +Total Retail 26,470 28,021 28,894 +Wholesale 3,281 3,085 2,693 +Total KWhs 29,751 31,106 31,587 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. +Summary of Heating and Cooling Degree Days +Years Ended December 31, +2020 2019 2018 +(in degree days) +Actual – Heating (a) 1,764 2,057 2,400 +Normal – Heating (b) 2,216 2,224 2,230 +Actual – Cooling (c) 1,379 1,597 1,587 +Normal – Cooling (b) 1,236 1,221 1,208 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 65 degree temperature base. +160 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Net Income +(in millions) +Year Ended December 31, 2019 $ 306.3 +Changes in Gross Margin: +Retail Margins (0.8) +Margins from Off-system Sales (3.7) +Transmission Revenues 3.0 +Other Revenues (2.1) +Total Change in Gross Margin (3.6) +Changes in Expenses and Other: +Other Operation and Maintenance 65.7 +Asset Impairment and Other Related Charges - Coal Fired Generation 92.9 +Re-Establishment of Regulatory Asset - Coal Fired Generation 49.0 +Depreciation and Amortization (40.7) +Taxes Other Than Income Taxes (4.0) +Interest Income (0.8) +Allowance for Equity Funds Used During Construction (2.0) +Non-Service Cost Components of Net Periodic Benefit Cost 1.8 +Interest Expense (12.6) +Total Change in Expenses and Other 149.3 +Income Tax Expense (82.3) +Year Ended December 31, 2020 $ 369.7 +The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows: +• Retail Margins decreased $1 million primarily due to the following: +• A $58 million decrease in weather-related usage primarily driven by a 14% decrease in heating degree days and a 14% decrease in cooling degree days. +• A $44 million decrease due to the cumulative impact of the implementation of APCo’s 2017 and 2019 generation and distribution depreciation studies as ordered in the Virginia triennial base rate case. +• A $19 million decrease in weather-normalized margins primarily in the commercial and industrial classes, partially offset in the residential class. +These decreases were partially offset by: +• A $33 million increase due to a decrease in customer refunds related to Tax Reform. This increase was partially offset in Income Tax Expense below. +• A $26 million increase in deferred fuel primarily due to the timing of recoverable PJM expenses. +• A $16 million increase due to the WVPSC approval of the Mitchell Plant surcharge effective January 2020. Pursuant to the WVPSC approval of the surcharge, this increase was partially offset by the amortization of Excess ADIT not subject to normalization requirements in Income Tax Expense below. +• A $13 million increase due to rider revenues primarily in West Virginia. This increase was partially offset in other expense items below. +• A $12 million increase due to the impact of the 2019 WVPSC order which required APCo to offset Excess ADIT not subject to normalization requirements against the deferred fuel under-recovery balance in 2019. +• A $10 million increase due to a West Virginia base rate increase implemented in March 2019. This increase was partially offset in Depreciation and Amortization expenses below. +• A $9 million increase due to an environmental expense deferral. +161 +• Margins from Off-system Sales decreased $4 million due to weaker market prices for energy in RTOs which caused a decrease in sales volume and margins. +• Transmission Revenues increased $3 million primarily due to the following: +• A $12 million increase due to the implementation of updated depreciation rates as ordered in the 2017-2019 Virginia triennial base rate case. The impact of the revised depreciation rates will be reflected in the annual transmission formula rate true-up. This increase was offset in Depreciation Expense below. +• A $4 million increase from investment in transmission assets. +These increases were partially offset by: +• A $13 million decrease from the annual transmission formula rate true-up. +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses decreased $66 million primarily due to the following: +• A $24 million decrease in transmission expenses primarily due to the annual transmission formula rate true-up. +• A $24 million decrease as a result of prior year contributions to benefit low income West Virginia residential customers as a result of the West Virginia Tax Reform settlement. This decrease was offset in Income Tax Expense below. +• A $13 million decrease in storm-related expenses. +• A $9 million decrease in maintenance expense at various generation plants. +These decreases were partially offset by: +• A $9 million increase in expense due to the current year amortization of regulatory assets related to the 2017-2019 Virginia triennial review which authorized regulatory recovery of previously retired coal-fired generation assets. +• An $8 million increase in vegetation management services. This increase was offset in Retail Margin above. +• Asset Impairments and Other Related Charges - Coal Fired Generation decreased $93 million due to a pretax expense recorded in 2019 related to previously retired coal-fired generation assets. +• Re-Establishment of Regulatory Asset - Coal Fired Generation increased $49 million due to the 2017-2019 Virginia triennial review which authorized regulatory recovery of previously retired coal-fired generation assets. +• Depreciation and Amortization expenses increased $41 million primarily due to: +• A $35 million increase due to a higher depreciable base. +• A $17 million increase in West Virginia depreciation rates beginning in March 2019. +These increases were partially offset by: +• A $12 million decrease due to the cumulative impact of the implementation of APCo’s 2017 and 2019 depreciation studies as ordered in the Virginia triennial base rate case. +• Taxes Other Than Income Taxes increased $4 million primarily due to an increase in West Virginia business and occupational taxes. +• Interest Expense increased $13 million primarily due to higher long-term debt balances. +• Income Tax Expense increased $82 million primarily due to an increase in pretax book income as well as a decrease in amortization of Excess ADIT not subject to normalization requirements. The decrease in Excess ADIT was partially offset in Gross Margin and Other Operation and Maintenance expenses above. +162 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholder of +Appalachian Power Company +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Appalachian Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Change in Accounting Principle +As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that +our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +163 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1, 4, and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment, which included a $49.0 million gain recorded for the year ended December 31, 2020 for the re-establishment of a regulatory asset related to previously retired coal fired generation assets as the result of the 2017-2019 Virginia triennial review. As of December 31, 2020, there were $691.6 million of deferred costs included in regulatory assets, $43.8 million of which were pending final regulatory approval, and $1,224.7 million of regulatory liabilities awaiting potential refund or future rate reduction. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +164 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of Appalachian Power Company and Subsidiaries (APCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. APCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of APCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded APCo’s internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, APCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit APCo to provide only management’s report in this annual report. +165 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Electric Generation, Transmission and Distribution $ 2,610.9 $ 2,708.2 $ 2,777.1 +Sales to AEP Affiliates 174.7 205.3 181.4 +Other Revenues 10.6 11.2 9.0 +TOTAL REVENUES 2,796.2 2,924.7 2,967.5 +EXPENSES +Fuel and Other Consumables Used for Electric Generation 513.3 607.5 588.9 +Purchased Electricity for Resale 360.3 391.0 503.5 +Other Operation 530.5 567.6 511.6 +Maintenance 226.8 255.4 316.9 +Asset Impairments and Other Related Charges - Coal Fired Generation — 92.9 — +Re-Establishment of Regulatory Asset - Coal Fired Generation ( 49.0 ) — — +Depreciation and Amortization 507.5 466.8 428.4 +Taxes Other Than Income Taxes 150.2 146.2 134.7 +TOTAL EXPENSES 2,239.6 2,527.4 2,484.0 +OPERATING INCOME 556.6 397.3 483.5 +Other Income (Expense): +Interest Income 1.6 2.4 1.8 +Carrying Costs Income — — 1.3 +Allowance for Equity Funds Used During Construction 14.6 16.6 13.2 +Non-Service Cost Components of Net Periodic Benefit Cost 18.8 17.0 17.9 +Interest Expense ( 217.6 ) ( 205.0 ) ( 194.8 ) +INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) 374.0 228.3 322.9 +Income Tax Expense (Benefit) 4.3 ( 78.0 ) ( 44.9 ) +NET INCOME $ 369.7 $ 306.3 $ 367.8 +The common stock of APCo is wholly-owned by Parent. +See Notes to Financial Statements of Registrants beginning on page 229 . +166 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 369.7 $ 306.3 $ 367.8 +OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES +Cash Flow Hedges, Net of Tax of $( 0.5 ), $( 0.2 ) and $( 0.2 ) in 2020, 2019 and 2018, Respectively +( 1.7 ) ( 0.9 ) ( 0.9 ) +Amortization of Pension and OPEB Deferred Costs, Net of Tax of $( 1.0 ), $( 0.7 ) and $( 0.8 ) in 2020, 2019 and 2018, Respectively +( 3.8 ) ( 2.5 ) ( 3.1 ) +Pension and OPEB Funded Status, Net of Tax of $ 2.0 , $ 3.6 and $( 0.7 ) in 2020, 2019 and 2018, Respectively +7.7 13.4 ( 2.6 ) +TOTAL OTHER COMPREHENSIVE INCOME (LOSS) 2.2 10.0 ( 6.6 ) +TOTAL COMPREHENSIVE INCOME $ 371.9 $ 316.3 $ 361.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +167 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Common +Stock Paid-in +Capital Retained +Earnings Accumulated +Other +Comprehensive +Income (Loss) Total +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017 $ 260.4 $ 1,828.7 $ 1,714.1 $ 1.3 $ 3,804.5 +Common Stock Dividends ( 160.0 ) ( 160.0 ) +ASU 2018-02 Adoption 0.1 0.3 0.4 +Net Income 367.8 367.8 +Other Comprehensive Loss ( 6.6 ) ( 6.6 ) +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018 260.4 1,828.7 1,922.0 ( 5.0 ) 4,006.1 +Common Stock Dividends ( 150.0 ) ( 150.0 ) +Net Income 306.3 306.3 +Other Comprehensive Income 10.0 10.0 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019 260.4 1,828.7 2,078.3 5.0 4,172.4 +Common Stock Dividends ( 200.0 ) ( 200.0 ) +Net Income 369.7 369.7 +Other Comprehensive Income 2.2 2.2 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020 $ 260.4 $ 1,828.7 $ 2,248.0 $ 7.2 $ 4,344.3 +See Notes to Financial Statements of Registrants beginning on page 229 . +168 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 5.8 $ 3.3 +Restricted Cash for Securitized Funding 16.9 23.5 +Advances to Affiliates 21.4 22.1 +Accounts Receivable: +Customers 142.8 129.0 +Affiliated Companies 64.3 64.3 +Accrued Unbilled Revenues 80.1 59.7 +Miscellaneous 0.3 0.5 +Allowance for Uncollectible Accounts ( 3.1 ) ( 2.6 ) +Total Accounts Receivable 284.4 250.9 +Fuel 193.6 149.7 +Materials and Supplies 99.6 105.2 +Risk Management Assets 22.4 39.4 +Regulatory Asset for Under-Recovered Fuel Costs 5.3 42.5 +Prepayments and Other Current Assets 24.7 64.0 +TOTAL CURRENT ASSETS 674.1 700.6 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Generation 6,633.7 6,563.7 +Transmission 3,900.5 3,584.1 +Distribution 4,464.3 4,201.7 +Other Property, Plant and Equipment 627.2 571.3 +Construction Work in Progress 484.6 593.4 +Total Property, Plant and Equipment 16,110.3 15,514.2 +Accumulated Depreciation and Amortization 4,716.2 4,432.3 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 11,394.1 11,081.9 +OTHER NONCURRENT ASSETS +Regulatory Assets 686.3 457.2 +Securitized Assets 210.1 234.7 +Employee Benefits and Pension Assets 150.1 92.0 +Operating Lease Assets 78.8 78.5 +Deferred Charges and Other Noncurrent Assets 121.7 123.4 +TOTAL OTHER NONCURRENT ASSETS 1,247.0 985.8 +TOTAL ASSETS $ 13,315.2 $ 12,768.3 +See Notes to Financial Statements of Registrants beginning on page 229 . +169 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND COMMON SHAREHOLDER’S EQUITY +December 31, 2020 and 2019 +December 31, +2020 2019 +(in millions) +CURRENT LIABILITIES +Advances from Affiliates $ 18.6 $ 236.7 +Accounts Payable: +General 212.0 307.8 +Affiliated Companies 97.1 92.5 +Long-term Debt Due Within One Year - Nonaffiliated 518.3 215.6 +Risk Management Liabilities 4.6 1.9 +Customer Deposits 77.8 85.8 +Accrued Taxes 109.9 99.6 +Obligations Under Operating Leases 14.9 15.2 +Other Current Liabilities 164.5 170.9 +TOTAL CURRENT LIABILITIES 1,217.7 1,226.0 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 4,315.8 4,148.2 +Deferred Income Taxes 1,749.9 1,680.8 +Regulatory Liabilities and Deferred Investment Tax Credits 1,224.7 1,268.7 +Asset Retirement Obligations 304.8 102.1 +Employee Benefits and Pension Obligations 44.0 50.9 +Obligations Under Operating Leases 64.4 64.0 +Deferred Credits and Other Noncurrent Liabilities 49.6 55.2 +TOTAL NONCURRENT LIABILITIES 7,753.2 7,369.9 +TOTAL LIABILITIES 8,970.9 8,595.9 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +COMMON SHAREHOLDER’S EQUITY +Common Stock – No Par Value: +Authorized – 30,000,000 Shares +Outstanding – 13,499,500 Shares +260.4 260.4 +Paid-in Capital 1,828.7 1,828.7 +Retained Earnings 2,248.0 2,078.3 +Accumulated Other Comprehensive Income (Loss) 7.2 5.0 +TOTAL COMMON SHAREHOLDER’S EQUITY 4,344.3 4,172.4 +TOTAL LIABILITIES AND COMMON SHAREHOLDER’S EQUITY $ 13,315.2 $ 12,768.3 +See Notes to Financial Statements of Registrants beginning on page 229 . +170 +APPALACHIAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 369.7 $ 306.3 $ 367.8 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 507.5 466.8 428.4 +Deferred Income Taxes ( 26.2 ) ( 126.2 ) ( 16.8 ) +Asset Impairments and Other Related Charges - Coal Fired Generation — 92.9 — +Allowance for Equity Funds Used During Construction ( 14.6 ) ( 16.6 ) ( 13.2 ) +Mark-to-Market of Risk Management Contracts 18.8 19.9 ( 33.0 ) +Pension Contributions to Qualified Plan Trust ( 7.0 ) — — +Deferred Fuel Over/Under-Recovery, Net 37.2 57.1 ( 10.8 ) +Re-Establishment of Regulatory Asset - Coal Fired Generation ( 49.0 ) — — +Change in Other Noncurrent Assets ( 40.4 ) ( 38.2 ) 58.1 +Change in Other Noncurrent Liabilities 11.2 ( 40.3 ) ( 4.8 ) +Changes in Certain Components of Working Capital: +Accounts Receivable, Net ( 30.2 ) 35.7 33.6 +Fuel, Materials and Supplies ( 38.2 ) ( 93.4 ) 27.8 +Accounts Payable ( 48.1 ) 37.7 ( 13.3 ) +Accrued Taxes, Net 31.3 ( 10.2 ) ( 13.2 ) +Other Current Assets 18.3 15.4 ( 6.1 ) +Other Current Liabilities ( 28.3 ) ( 45.5 ) 42.1 +Net Cash Flows from Operating Activities 712.0 661.4 846.6 +INVESTING ACTIVITIES +Construction Expenditures ( 767.4 ) ( 862.6 ) ( 780.7 ) +Change in Advances to Affiliates, Net 0.7 0.9 0.5 +Other Investing Activities 8.8 24.3 10.8 +Net Cash Flows Used for Investing Activities ( 757.9 ) ( 837.4 ) ( 769.4 ) +FINANCING ACTIVITIES +Issuance of Long-term Debt – Nonaffiliated 606.9 478.2 203.2 +Change in Advances from Affiliates, Net ( 218.1 ) 31.1 19.6 +Retirement of Long-term Debt – Nonaffiliated ( 140.3 ) ( 180.5 ) ( 124.0 ) +Principal Payments for Finance Lease Obligations ( 7.4 ) ( 6.7 ) ( 6.9 ) +Dividends Paid on Common Stock ( 200.0 ) ( 150.0 ) ( 160.0 ) +Other Financing Activities 0.7 0.9 1.5 +Net Cash Flows from (Used for) Financing Activities 41.8 173.0 ( 66.6 ) +Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash for Securitized Funding ( 4.1 ) ( 3.0 ) 10.6 +Cash, Cash Equivalents and Restricted Cash for Securitized Funding at Beginning of Period 26.8 29.8 19.2 +Cash, Cash Equivalents and Restricted Cash for Securitized Funding at End of Period $ 22.7 $ 26.8 $ 29.8 +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 207.1 $ 190.7 $ 182.0 +Net Cash Paid (Received) for Income Taxes — 63.0 ( 13.0 ) +Noncash Acquisitions Under Finance Leases 7.2 8.8 5.5 +Construction Expenditures Included in Current Liabilities as of December 31, 105.6 149.7 134.4 +See Notes to Financial Statements of Registrants beginning on page 229 . +171 +INDIANA MICHIGAN POWER COMPANY +AND SUBSIDIARIES +172 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +As a public utility, I&M engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 602,000 retail customers in its service territory in northern and eastern Indiana and southwestern Michigan. I&M consolidates Blackhawk Coal Company and Price River Coal Company, its wholly-owned subsidiaries. I&M also consolidates DCC Fuel. I&M sells power at wholesale to municipalities and electric cooperatives. I&M’s River Transportation Division provides barging services to affiliates and nonaffiliated companies. The revenues from barging represent the majority of other revenues. +AEGCo holds a 50% interest in each of the Rockport Plant units and is entitled to 50% of the capacity and associated energy from each unit. Under unit power agreements approved by the FERC, I&M and KPCo purchase approximately 920 MWs and 390 MWs, respectively, of the output from AEGCo’s 50% share of the Rockport Plant. +To minimize the credit requirements and operating constraints when operating within PJM, participating AEP companies, including I&M, agreed to a netting of certain payment obligations incurred by the participating AEP companies against certain balances due to such AEP companies and to hold PJM harmless from actions that any one or more AEP companies may take with respect to PJM. +173 +RESULTS OF OPERATIONS +KWh Sales/Degree Days +Summary of KWh Energy Sales +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 5,464 5,409 5,731 +Commercial 4,475 4,685 4,851 +Industrial 7,225 7,589 7,836 +Miscellaneous 67 69 71 +Total Retail 17,231 17,752 18,489 +Wholesale 7,135 8,268 10,873 +Total KWhs 24,366 26,020 29,362 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. +Summary of Heating and Cooling Degree Days +Years Ended December 31, +2020 2019 2018 +(in degree days) +Actual – Heating (a) +3,352 3,782 3,886 +Normal – Heating (b) +3,742 3,740 3,747 +Actual – Cooling (c) +928 940 1,132 +Normal – Cooling (b) +854 849 849 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 65 degree temperature base. +174 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Net Income +(in millions) +Year Ended December 31, 2019 $ 269.4 +Changes in Gross Margin: +Retail Margins 55.1 +Margins from Off-system Sales 0.1 +Transmission Revenues 11.0 +Other Revenues (10.3) +Total Change in Gross Margin 55.9 +Changes in Expenses and Other: +Other Operation and Maintenance 29.2 +Depreciation and Amortization (61.0) +Taxes Other Than Income Taxes (2.0) +Other Income (8.2) +Non-Service Cost Components of Net Periodic Benefit Cost (1.0) +Interest Expense 5.6 +Total Change in Expenses and Other (37.4) +Income Tax Expense (3.1) +Year Ended December 31, 2020 $ 284.8 +The major components of the increase in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows: +• Retail Margins increased $55 million primarily due to the following: +• A $109 million increase primarily due to the Indiana and Michigan base rate cases and increases in rider revenues. This increase was partially offset in other expense items below. +• A $5 million increase in weather-normalized retail margins primarily in the residential class, partially offset in the commercial and industrial classes. +These increases were partially offset by: +• A $53 million decrease in weather-normalized wholesale margins, including the loss of a significant wholesale contract. +• A $16 million decrease in weather-related usage primarily due to an 11% decrease in heating degree days. +• Transmission Revenues increased $11 million primarily due to the following: +• A $6 million increase from the annual transmission formula rate true-up. +• A $5 million increase from investment in transmission assets. +• Other Revenues decreased $10 million primarily due to a decrease in barging revenues by River Transportation Division (RTD). This decrease was partially offset in Other Operation and Maintenance expenses below. +175 +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses decreased $29 million primarily due to the following: +• A $15 million decrease in Cook Plant refueling outage expenses and various maintenance activities. +• An $11 million decrease in nonutility operation expenses primarily due to a decrease in RTD expenses. This decrease was partially offset in Other Revenues above. +• A $10 million decrease in distribution expenses primarily due to a decrease in vegetation management expenses. +• A $9 million decrease due to a charitable contribution to the AEP Foundation in 2019. +• A $7 million decrease due to an increased Nuclear Electric Insurance Limited distribution in 2020. +• A $5 million decrease in steam generation expense primarily due to 2019 NSR Consent Decree modifications. +These decreases were partially offset by: +• A $15 million increase in employee-related expenses. +• A $12 million increase in transmission expenses primarily due to a $24 million increase in recoverable PJM expenses, partially offset by an $11 million decrease from the annual transmission formula rate true-up. This increase was partially offset in Retail Margins above. +• Depreciation and Amortization expenses increased $61 million primarily due to a higher depreciable base and an increase in depreciation rates. This increase was partially offset in Retail Margins above. +• Other Income decreased $8 million primarily due to a decrease in the AFUDC base and the favorable impact of a FERC settlement agreement recorded in 2019. +• Interest Expense decreased $6 million primarily due to lower interest rates on variable rate loans and carrying charges recorded on various riders. This decrease was partially offset by a decrease in AFUDC base. +• Income Tax Expense increased $3 million due to an increase in pretax book income, state tax expense and AFUDC equity partially offset by an increase in amortization of Excess ADIT not subject to normalization requirements. The increase in amortization of Excess ADIT was partially offset in Gross Margin above. +176 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholder of +Indiana Michigan Power Company +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Indiana Michigan Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Change in Accounting Principle +As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that +our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +177 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $410.2 million of deferred costs included in regulatory assets, $4.3 million of which were pending final regulatory approval, and $2,062.7 million of regulatory liabilities awaiting potential refund or future rate reduction. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +/s/ PricewaterhouseCoopers +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +178 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of Indiana Michigan Power Company and Subsidiaries (I&M) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. I&M’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of I&M’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded I&M’s internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, I&M’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit I&M to provide only management’s report in this annual report. +179 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Electric Generation, Transmission and Distribution $ 2,165.3 $ 2,222.1 $ 2,272.6 +Sales to AEP Affiliates 10.5 10.5 22.1 +Other Revenues - Affiliated 60.8 63.4 63.4 +Other Revenues - Nonaffiliated 5.2 10.7 12.6 +TOTAL REVENUES 2,241.8 2,306.7 2,370.7 +EXPENSES +Fuel and Other Consumables Used for Electric Generation 162.0 190.6 318.3 +Purchased Electricity for Resale 182.2 232.3 221.8 +Purchased Electricity from AEP Affiliates 172.8 214.9 237.9 +Other Operation 650.0 641.2 585.4 +Maintenance 193.2 231.2 238.1 +Depreciation and Amortization 411.6 350.6 293.1 +Taxes Other Than Income Taxes 107.1 105.1 98.9 +TOTAL EXPENSES 1,878.9 1,965.9 1,993.5 +OPERATING INCOME 362.9 340.8 377.2 +Other Income (Expense): +Other Income 10.0 18.2 19.2 +Non-Service Cost Components of Net Periodic Benefit Cost 16.7 17.7 18.1 +Interest Expense ( 112.3 ) ( 117.9 ) ( 124.1 ) +INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) 277.3 258.8 290.4 +Income Tax Expense (Benefit) ( 7.5 ) ( 10.6 ) 29.1 +NET INCOME $ 284.8 $ 269.4 $ 261.3 +The common stock of I&M is wholly-owned by Parent. +See Notes to Financial Statements of Registrants beginning on page 229 . +180 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 284.8 $ 269.4 $ 261.3 +OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES +Cash Flow Hedges, Net of Tax of $ 0.4 , $ 0.4 and $ 0.4 in 2020, 2019 and 2018, Respectively +1.6 1.6 1.6 +Amortization of Pension and OPEB Deferred Costs, Net of Tax of $ 0 , $ 0 and $ 0 in 2020, 2019 and 2018, Respectively +( 0.1 ) ( 0.2 ) — +Pension and OPEB Funded Status, Net of Tax of $ 0.8 , $ 0.2 and $( 0.2 ) in 2020, 2019 and 2018, Respectively +3.1 0.8 ( 0.6 ) +TOTAL OTHER COMPREHENSIVE INCOME 4.6 2.2 1.0 +TOTAL COMPREHENSIVE INCOME $ 289.4 $ 271.6 $ 262.3 +See Notes to Financial Statements of Registrants beginning on page 229 . +181 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Common +Stock Paid-in +Capital Retained Earnings Accumulated +Other +Comprehensive +Income (Loss) Total +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017 +$ 56.6 $ 980.9 $ 1,192.2 $ ( 12.1 ) $ 2,217.6 +Common Stock Dividends ( 124.7 ) ( 124.7 ) +ASU 2018-02 Adoption 0.3 ( 2.7 ) ( 2.4 ) +Net Income 261.3 261.3 +Other Comprehensive Income 1.0 1.0 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018 +56.6 980.9 1,329.1 ( 13.8 ) 2,352.8 +Common Stock Dividends ( 80.0 ) ( 80.0 ) +Net Income 269.4 269.4 +Other Comprehensive Income 2.2 2.2 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019 +56.6 980.9 1,518.5 ( 11.6 ) 2,544.4 +Common Stock Dividends ( 85.0 ) ( 85.0 ) +ASU 2016-13 Adoption 0.4 0.4 +Net Income 284.8 284.8 +Other Comprehensive Income 4.6 4.6 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020 +$ 56.6 $ 980.9 $ 1,718.7 $ ( 7.0 ) $ 2,749.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +182 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 3.3 $ 2.0 +Advances to Affiliates 13.3 13.2 +Accounts Receivable: +Customers 44.0 53.6 +Affiliated Companies 51.3 53.7 +Accrued Unbilled Revenues — 2.5 +Miscellaneous 2.0 0.3 +Allowance for Uncollectible Accounts ( 0.3 ) ( 0.6 ) +Total Accounts Receivable 97.0 109.5 +Fuel 86.0 56.2 +Materials and Supplies 175.8 171.3 +Risk Management Assets 3.6 9.8 +Accrued Tax Benefits 10.3 — +Regulatory Asset for Under-Recovered Fuel Costs 5.4 3.0 +Accrued Reimbursement of Spent Nuclear Fuel Costs 14.2 24.0 +Prepayments and Other Current Assets 9.9 14.0 +TOTAL CURRENT ASSETS 418.8 403.0 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Generation 5,264.7 5,099.7 +Transmission 1,696.4 1,641.8 +Distribution 2,594.6 2,437.6 +Other Property, Plant and Equipment (Including Coal Mining and Nuclear Fuel) 686.7 632.6 +Construction Work in Progress 362.4 382.3 +Total Property, Plant and Equipment 10,604.8 10,194.0 +Accumulated Depreciation, Depletion and Amortization 3,552.5 3,294.3 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 7,052.3 6,899.7 +OTHER NONCURRENT ASSETS +Regulatory Assets 404.8 482.1 +Spent Nuclear Fuel and Decommissioning Trusts 3,306.7 2,975.7 +Operating Lease Assets 218.1 294.9 +Deferred Charges and Other Noncurrent Assets 237.6 182.0 +TOTAL OTHER NONCURRENT ASSETS 4,167.2 3,934.7 +TOTAL ASSETS $ 11,638.3 $ 11,237.4 +See Notes to Financial Statements of Registrants beginning on page 229 . +183 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND COMMON SHAREHOLDER’S EQUITY +December 31, 2020 and 2019 +(dollars in millions) +December 31, +2020 2019 +CURRENT LIABILITIES +Advances from Affiliates $ 103.0 $ 114.4 +Accounts Payable: +General 153.2 169.4 +Affiliated Companies 80.5 68.4 +Long-term Debt Due Within One Year – Nonaffiliated +(December 31, 2020 and 2019 Amounts Include $ 75.7 and $ 86.1 Respectively, Related to DCC Fuel) +369.6 139.7 +Customer Deposits 41.7 39.4 +Accrued Taxes 102.5 112.4 +Accrued Interest 35.6 36.2 +Obligations Under Operating Leases 85.6 87.3 +Regulatory Liability for Over-Recovered Fuel Costs 20.8 6.1 +Other Current Liabilities 112.0 110.1 +TOTAL CURRENT LIABILITIES 1,104.5 883.4 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 2,660.3 2,910.5 +Deferred Income Taxes 1,064.4 979.7 +Regulatory Liabilities and Deferred Investment Tax Credits 2,041.9 1,891.4 +Asset Retirement Obligations 1,812.9 1,748.6 +Obligations Under Operating Leases 135.9 211.6 +Deferred Credits and Other Noncurrent Liabilities 69.2 67.8 +TOTAL NONCURRENT LIABILITIES 7,784.6 7,809.6 +TOTAL LIABILITIES 8,889.1 8,693.0 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +COMMON SHAREHOLDER’S EQUITY +Common Stock – No Par Value: +Authorized – 2,500,000 Shares +Outstanding – 1,400,000 Shares +56.6 56.6 +Paid-in Capital 980.9 980.9 +Retained Earnings 1,718.7 1,518.5 +Accumulated Other Comprehensive Income (Loss) ( 7.0 ) ( 11.6 ) +TOTAL COMMON SHAREHOLDER’S EQUITY 2,749.2 2,544.4 +TOTAL LIABILITIES AND COMMON SHAREHOLDER'S EQUITY $ 11,638.3 $ 11,237.4 +See Notes to Financial Statements of Registrants beginning on page 229 . +184 +INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 284.8 $ 269.4 $ 261.3 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 411.6 350.6 293.1 +Rockport Plant, Unit 2 Operating Lease Amortization 69.2 69.2 — +Deferred Income Taxes ( 16.2 ) ( 52.7 ) ( 42.9 ) +Amortization (Deferral) of Incremental Nuclear Refueling Outage Expenses, Net 24.4 ( 26.4 ) 29.2 +Allowance for Equity Funds Used During Construction ( 11.5 ) ( 19.4 ) ( 11.9 ) +Mark-to-Market of Risk Management Contracts 5.9 ( 0.6 ) ( 4.1 ) +Amortization of Nuclear Fuel 87.5 89.1 113.8 +Pension Contributions to Qualified Plan Trust ( 6.4 ) — — +Deferred Fuel Over/Under-Recovery, Net 12.4 ( 24.3 ) 39.7 +Change in Other Noncurrent Assets 6.1 8.3 ( 36.5 ) +Change in Other Noncurrent Liabilities 45.0 33.7 72.1 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net 14.5 35.4 4.8 +Fuel, Materials and Supplies ( 34.7 ) ( 22.4 ) ( 11.2 ) +Accounts Payable ( 10.8 ) 3.6 ( 14.1 ) +Accrued Taxes, Net ( 20.2 ) 48.3 41.2 +Rockport Plant, Unit 2 Operating Lease Payments ( 73.9 ) ( 73.9 ) — +Other Current Assets 14.3 11.2 1.5 +Other Current Liabilities ( 25.7 ) ( 13.9 ) ( 10.3 ) +Net Cash Flows from Operating Activities 776.3 685.2 725.7 +INVESTING ACTIVITIES +Construction Expenditures ( 544.7 ) ( 585.9 ) ( 568.5 ) +Change in Advances to Affiliates, Net ( 0.1 ) ( 0.5 ) ( 0.3 ) +Purchases of Investment Securities ( 1,637.2 ) ( 1,531.0 ) ( 2,064.7 ) +Sales of Investment Securities 1,593.4 1,473.0 2,010.0 +Acquisitions of Nuclear Fuel ( 69.7 ) ( 92.3 ) ( 46.1 ) +Other Investing Activities 9.4 16.6 14.8 +Net Cash Flows Used for Investing Activities ( 648.9 ) ( 720.1 ) ( 654.8 ) +FINANCING ACTIVITIES +Issuance of Long-term Debt - Nonaffiliated 69.5 123.3 1,168.1 +Change in Advances from Affiliates, Net ( 11.4 ) 113.3 ( 210.5 ) +Retirement of Long-term Debt - Nonaffiliated ( 93.2 ) ( 117.1 ) ( 884.9 ) +Principal Payments for Finance Lease Obligations ( 6.5 ) ( 5.7 ) ( 8.8 ) +Dividends Paid on Common Stock ( 85.0 ) ( 80.0 ) ( 124.7 ) +Other Financing Activities 0.5 0.7 ( 9.0 ) +Net Cash Flows from (Used for) Financing Activities ( 126.1 ) 34.5 ( 69.8 ) +Net Increase (Decrease) in Cash and Cash Equivalents 1.3 ( 0.4 ) 1.1 +Cash and Cash Equivalents at Beginning of Period 2.0 2.4 1.3 +Cash and Cash Equivalents at End of Period $ 3.3 $ 2.0 $ 2.4 +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 107.6 $ 111.9 $ 116.9 +Net Cash Paid for Income Taxes 42.1 3.4 32.6 +Noncash Acquisitions Under Finance Leases 3.0 11.9 5.8 +Construction Expenditures Included in Current Liabilities as of December 31, 62.8 86.0 93.0 +Acquisition of Nuclear Fuel Included in Current Liabilities as of December 31, 33.4 0.1 4.0 +Expected Reimbursement for Capital Cost of Spent Nuclear Fuel Dry Cask Storage 2.6 0.3 2.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +185 +OHIO POWER COMPANY AND SUBSIDIARIES +186 +OHIO POWER COMPANY AND SUBSIDIARIES +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +As a public utility, OPCo engages in the transmission and distribution of power to approximately 1,507,000 retail customers in the northwestern, central, eastern and southern sections of Ohio. Effective January 2014, OPCo purchases power from both affiliated and nonaffiliated entities, subject to auction requirements and PUCO approval, to meet the energy and capacity needs of its remaining SSO customers. OPCo consolidates Ohio Phase-in-Recovery Funding LLC, its wholly-owned subsidiary. The Ohio Phase-in-Recovery Funding LLC securitization bonds matured in July 2019. +To minimize the credit requirements and operating constraints when operating within PJM, participating AEP companies, including OPCo, agreed to a netting of certain payment obligations incurred by the participating AEP companies against certain balances due to such AEP companies and to hold PJM harmless from actions that any one or more AEP companies may take with respect to PJM. +187 +RESULTS OF OPERATIONS +KWh Sales/Degree Days +Summary of KWh Energy Sales +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 14,355 14,411 14,940 +Commercial 13,933 14,599 14,655 +Industrial 13,347 14,407 14,857 +Miscellaneous 113 114 115 +Total Retail (a) 41,748 43,531 44,567 +Wholesale (b) 1,859 2,335 2,441 +Total KWhs 43,607 45,866 47,008 +(a) Represents energy delivered to distribution customers. +(b) Primarily Ohio’s contractually obligated purchases of OVEC power sold into PJM. +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. +Summary of Heating and Cooling Degree Days +Years Ended December 31, +2020 2019 2018 +(in degree days) +Actual – Heating (a) +2,743 3,071 3,357 +Normal – Heating (b) +3,202 3,208 3,215 +Actual – Cooling (c) +1,140 1,224 1,402 +Normal – Cooling (b) +1,006 992 980 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 65 degree temperature base. +188 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Net Income +(in millions) +Year Ended December 31, 2019 $ 297.1 +Changes in Gross Margin: +Retail Margins 58.8 +Margins from Off-system Sales 10.7 +Transmission Revenues 22.6 +Other Revenues 19.1 +Total Change in Gross Margin 111.2 +Changes in Expenses and Other: +Other Operation and Maintenance (57.0) +Depreciation and Amortization (35.7) +Taxes Other Than Income Taxes (16.0) +Interest Income (2.2) +Carrying Costs Income 0.6 +Allowance for Equity Funds Used During Construction (5.7) +Non-Service Cost Components of Net Periodic Benefit Cost 0.4 +Interest Expense (11.0) +Total Change in Expenses and Other (126.6) +Income Tax Expense (10.3) +Year Ended December 31, 2020 $ 271.4 +The major components of the increase in Gross Margin, defined as revenues less the related direct cost of purchased electricity and amortization of generation deferrals were as follows: +• Retail Margins increased $59 million primarily due to the following: +• A $69 million net increase related to other various rider revenues. This increase was partially offset in other expense items below. +• A $61 million increase in rider revenues associated with the DIR. This increase was partially offset in other expense items below. +• A $6 million increase in revenues associated with smart grid riders. This increase was partially offset in other expense items below. +These increases were partially offset by: +• A $58 million decrease due to a reversal of a regulatory provision in the first quarter of 2019. +• A $17 million net decrease in margin for the Rate Stability Rider including associated amortizations which ended in the third quarter of 2019. +• A $10 million decrease in usage primarily in the commercial class, partially offset by an increase in the retail class. +• Margins from Off-system Sales increased $11 million primarily due to the following: +• A $26 million increase due to higher OVEC PPA deferrals. This increase was offset in Retail Margins above. +This increase was partially offset by: +• A $17 million decrease in sales due to lower market prices and decreased sales volumes in 2020. This decrease was offset in Retail Margins above. +• Transmission Revenues increased $23 million primarily due to the following: +• A $16 million increase from the annual transmission formula rate true-up. +• A $6 million increase due to additional investment in transmission assets. +189 +• Other Revenues increased $19 million primarily due to third-party Legacy Generation Resource Rider revenue related to the recovery of OVEC costs. This increase was offset in Retail Margins above. +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses increased $57 million primarily due to the following: +• A $62 million net increase in transmission expenses, primarily due to a $94 million increase in recoverable PJM expenses, partially offset by a $28 million decrease related to the annual transmission formula rate true-up. This increase was offset in Gross Margins above. +• A $19 million increase in remitted Universal Service Fund surcharge payments to the Ohio Department of Development to fund an energy assistance program for qualified Ohio customers. This increase was offset in Retail Margins above. +These increases were partially offset by: +• A $12 million decrease in recoverable distribution expenses primarily related to vegetation management. This decrease was offset in Retail Margins above. +• A $5 million decrease due to a charitable contribution to the AEP Foundation in 2019. +• A $5 million decrease due to a PUCO order to refund unused 2018 major storm reserve collections to customers. This decrease was offset in Retail Margins above. +• Depreciation and Amortization expenses increased $36 million primarily due to the following: +• A $22 million increase in recoverable DIR depreciation expense. This increase was partially offset in Retail Margins above. +• A $19 million increase in depreciation expense due to an increase in the depreciable base of transmission and distribution assets. +• An $11 million increase due to lower deferred equity amortizations associated with the Deferred Asset Phase-In-Recovery Rider which ended in the second quarter of 2019. +• A $6 million increase due to prior year under-recovery of revenues associated with the Deferred Asset Phase-In-Recovery securitization which ended in the 2nd quarter of 2019. This decrease was offset in Retail Margins above. +These increases were partially offset by: +• A $24 million decrease in amortizations associated with the Deferred Asset Phase-In-Recovery Rider which ended in the second quarter of 2019. This decrease was offset in Retail Margins above. +• Taxes Other Than Income Taxes increased $16 million primarily due to the following: +• A $22 million increase in property taxes driven by additional investments in transmission and distribution assets and higher tax rates. +This increase was partially offset by: +• A $6 million decrease in excise taxes due to lower demand in 2020. This decrease was offset in Retail Margins above. +• Allowance for Equity Funds Used During Construction decreased $6 million primarily due to adjustments that resulted from 2019 FERC audit findings and a decrease in AFUDC base. +• Interest Expense increased $11 million primarily due to higher long-term debt balances. +• Income Tax Expense increased $10 million primarily due to an increase in tax expense for benefits previously flowed through to customers. +190 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholder of +Ohio Power Company +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Ohio Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Change in Accounting Principle +As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +191 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $385.8 million of deferred costs included in regulatory assets, $8.4 million of which were pending final regulatory approval, and $1,009.1 million of regulatory liabilities awaiting potential refund or future rate reduction, $0.2 million of which were pending final regulatory determination. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +Valuation of Level 3 Risk Management Commodity Contracts +As described in Notes 1, 10 and 11 to the consolidated financial statements, the Company employs risk management commodity contracts including physical and financial forward purchase-and-sale contracts and, to a lesser extent, over-the-counter swaps and options to accomplish its risk management strategies. Certain over-the-counter and bilaterally executed derivative instruments are executed in less active markets with a lower availability of pricing information. The fair value of these risk management commodity contracts is estimated based on available market information including valuation models that estimate future energy prices based on existing market and broker quotes, and other assumptions. Fair value estimates involve significant uncertainties and matters of significant judgement including future commodity prices and future price volatility. The main driver of contracts being classified as Level 3 is the inability to substantiate energy price curves in the market. Management utilized such unobservable pricing data to value its Level 3 risk management commodity contract liabilities, which totaled $110.3 +million, as of December 31, 2020. +The principal considerations for our determination that performing procedures relating to the valuation of Level 3 risk management commodity contracts is a critical audit matter are the significant judgment and estimation by management when developing the fair value of the commodity contracts; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to the unobservable assumptions for projections of future commodity prices and future price volatilities used within management’s discounted cash flow models. In addition, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained. +192 +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s valuation of the risk management commodity contracts, including controls over the assumptions used to value the Level 3 risk management commodity contracts. These procedures also included, among others, testing the data used in and management’s process for developing the fair value of the Level 3 risk management commodity contracts. Professionals with specialized skill and knowledge were used to assist in evaluating the appropriateness of the discounted cash flow models and reasonableness of the future commodity prices and future price volatilities assumptions. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +193 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of Ohio Power Company and Subsidiaries (OPCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. OPCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of OPCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded OPCo’s internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, OPCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit OPCo to provide only management’s report in this annual report. +194 +OHIO POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Electricity, Transmission and Distribution $ 2,698.6 $ 2,759.5 $ 3,033.8 +Sales to AEP Affiliates 41.5 27.3 21.0 +Other Revenues 9.0 10.8 8.6 +TOTAL REVENUES 2,749.1 2,797.6 3,063.4 +EXPENSES +Purchased Electricity for Resale 549.2 607.3 684.6 +Purchased Electricity from AEP Affiliates 119.7 156.0 135.3 +Amortization of Generation Deferrals — 65.3 223.9 +Other Operation 822.6 742.6 771.3 +Maintenance 127.1 150.1 156.0 +Depreciation and Amortization 276.6 240.9 259.7 +Taxes Other Than Income Taxes 450.2 434.2 412.8 +TOTAL EXPENSES 2,345.4 2,396.4 2,643.6 +OPERATING INCOME 403.7 401.2 419.8 +Other Income (Expense): +Interest Income 1.0 3.2 3.4 +Carrying Costs Income 1.6 1.0 1.7 +Allowance for Equity Funds Used During Construction 12.5 18.2 9.8 +Non-Service Cost Components of Net Periodic Benefit Cost 15.0 14.6 15.5 +Interest Expense ( 117.2 ) ( 106.2 ) ( 100.7 ) +INCOME BEFORE INCOME TAX EXPENSE 316.6 332.0 349.5 +Income Tax Expense 45.2 34.9 24.0 +NET INCOME $ 271.4 $ 297.1 $ 325.5 +The common stock of OPCo is wholly-owned by Parent. +See Notes to Financial Statements of Registrants beginning on page 229 . +195 +OHIO POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 271.4 $ 297.1 $ 325.5 +OTHER COMPREHENSIVE LOSS, NET OF TAXES +Cash Flow Hedges, Net of Tax of $ 0 , $( 0.3 ) and $( 0.4 ) in 2020, 2019 and 2018, Respectively +— ( 1.0 ) ( 1.3 ) +TOTAL COMPREHENSIVE INCOME $ 271.4 $ 296.1 $ 324.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +196 +OHIO POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Common +Stock Paid-in +Capital Retained Earnings Accumulated +Other +Comprehensive +Income (Loss) Total +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017 +$ 321.2 $ 838.8 $ 1,148.4 $ 1.9 $ 2,310.3 +Common Stock Dividends ( 337.5 ) ( 337.5 ) +ASU 2018-02 Adoption 0.4 0.4 +Net Income 325.5 325.5 +Other Comprehensive Loss ( 1.3 ) ( 1.3 ) +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018 +321.2 838.8 1,136.4 1.0 2,297.4 +Common Stock Dividends ( 85.0 ) ( 85.0 ) +Net Income 297.1 297.1 +Other Comprehensive Loss ( 1.0 ) ( 1.0 ) +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019 +321.2 838.8 1,348.5 — 2,508.5 +Common Stock Dividends ( 87.5 ) ( 87.5 ) +ASU 2016-13 Adoption 0.3 0.3 +Net Income 271.4 271.4 +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020 +$ 321.2 $ 838.8 $ 1,532.7 $ — $ 2,692.7 +See Notes to Financial Statements of Registrants beginning on page 229 . +197 +OHIO POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 7.4 $ 3.7 +Accounts Receivable: +Customers 50.0 53.0 +Affiliated Companies 65.1 59.3 +Accrued Unbilled Revenues 14.8 20.3 +Miscellaneous 3.9 0.5 +Allowance for Uncollectible Accounts ( 0.6 ) ( 0.7 ) +Total Accounts Receivable 133.2 132.4 +Materials and Supplies 66.9 52.3 +Renewable Energy Credits 29.5 30.9 +Prepayments and Other Current Assets 19.3 19.2 +TOTAL CURRENT ASSETS 256.3 238.5 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Transmission 2,831.9 2,686.3 +Distribution 5,708.3 5,323.5 +Other Property, Plant and Equipment 899.6 765.8 +Construction Work in Progress 362.3 394.4 +Total Property, Plant and Equipment 9,802.1 9,170.0 +Accumulated Depreciation and Amortization 2,350.0 2,263.0 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 7,452.1 6,907.0 +OTHER NONCURRENT ASSETS +Regulatory Assets 385.8 351.8 +Deferred Charges and Other Noncurrent Assets 616.2 546.3 +TOTAL OTHER NONCURRENT ASSETS 1,002.0 898.1 +TOTAL ASSETS $ 8,710.4 $ 8,043.6 +See Notes to Financial Statements of Registrants beginning on page 229 . +198 +OHIO POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND COMMON SHAREHOLDER’S EQUITY +December 31, 2020 and 2019 +(dollars in millions) +December 31, +2020 2019 +CURRENT LIABILITIES +Advances from Affiliates $ 259.2 $ 131.0 +Accounts Payable: +General 181.0 233.7 +Affiliated Companies 118.4 103.6 +Long-term Debt Due Within One Year – Nonaffiliated 500.1 0.1 +Risk Management Liabilities 8.7 7.3 +Customer Deposits 55.1 70.6 +Accrued Taxes 631.0 587.9 +Obligations Under Operating Leases 13.1 12.5 +Other Current Liabilities 139.6 151.2 +TOTAL CURRENT LIABILITIES 1,906.2 1,297.9 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 1,930.1 2,081.9 +Long-term Risk Management Liabilities 101.6 96.3 +Deferred Income Taxes 955.1 849.4 +Regulatory Liabilities and Deferred Investment Tax Credits 1,005.2 1,090.9 +Obligations Under Operating Leases 79.5 76.0 +Deferred Credits and Other Noncurrent Liabilities 40.0 42.7 +TOTAL NONCURRENT LIABILITIES 4,111.5 4,237.2 +TOTAL LIABILITIES 6,017.7 5,535.1 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +COMMON SHAREHOLDER'S EQUITY +Common Stock – No Par Value: +Authorized – 40,000,000 Shares +Outstanding – 27,952,473 Shares +321.2 321.2 +Paid-in Capital 838.8 838.8 +Retained Earnings 1,532.7 1,348.5 +TOTAL COMMON SHAREHOLDER’S EQUITY 2,692.7 2,508.5 +TOTAL LIABILITIES AND COMMON SHAREHOLDER'S EQUITY $ 8,710.4 $ 8,043.6 +See Notes to Financial Statements of Registrants beginning on page 229 . +199 +OHIO POWER COMPANY AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 271.4 $ 297.1 $ 325.5 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 276.6 240.9 259.7 +Amortization of Generation Deferrals — 65.3 223.9 +Deferred Income Taxes 77.2 43.8 ( 36.2 ) +Allowance for Equity Funds Used During Construction ( 12.5 ) ( 18.2 ) ( 9.8 ) +Mark-to-Market of Risk Management Contracts 6.7 4.0 ( 32.2 ) +Property Taxes ( 16.6 ) ( 33.7 ) ( 12.5 ) +Refund of Global Settlement — ( 16.5 ) ( 5.5 ) +Reversal of Regulatory Provision — ( 56.2 ) — +Change in Regulatory Assets ( 69.4 ) ( 20.1 ) 171.5 +Change in Other Noncurrent Assets ( 49.4 ) ( 35.3 ) ( 11.5 ) +Change in Other Noncurrent Liabilities ( 66.4 ) ( 93.2 ) 53.8 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net 4.2 75.0 43.1 +Materials and Supplies ( 23.9 ) ( 16.4 ) ( 11.3 ) +Accounts Payable 10.3 0.4 ( 13.8 ) +Accrued Taxes, Net 43.3 38.7 26.8 +Other Current Assets 1.9 0.8 8.1 +Other Current Liabilities ( 42.5 ) ( 55.2 ) 49.1 +Net Cash Flows from Operating Activities 410.9 421.2 1,028.7 +INVESTING ACTIVITIES +Construction Expenditures ( 813.2 ) ( 799.2 ) ( 725.9 ) +Other Investing Activities 22.2 55.1 18.4 +Net Cash Flows Used for Investing Activities ( 791.0 ) ( 744.1 ) ( 707.5 ) +FINANCING ACTIVITIES +Issuance of Long-term Debt – Nonaffiliated 347.0 444.3 392.8 +Change in Advances from Affiliates, Net 128.2 16.9 26.3 +Retirement of Long-term Debt – Nonaffiliated ( 0.1 ) ( 80.3 ) ( 397.1 ) +Principal Payments for Finance Lease Obligations ( 4.7 ) ( 3.5 ) ( 3.8 ) +Dividends Paid on Common Stock ( 87.5 ) ( 85.0 ) ( 337.5 ) +Other Financing Activities 0.9 1.7 0.9 +Net Cash Flows from (Used for) Financing Activities 383.8 294.1 ( 318.4 ) +Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash for Securitized Funding 3.7 ( 28.8 ) 2.8 +Cash, Cash Equivalents and Restricted Cash for Securitized Funding at Beginning of Period 3.7 32.5 29.7 +Cash, Cash Equivalents and Restricted Cash for Securitized Funding at End of Period $ 7.4 $ 3.7 $ 32.5 +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 111.2 $ 100.6 $ 97.1 +Net Cash Paid (Received) for Income Taxes ( 26.9 ) 7.3 51.3 +Noncash Acquisitions Under Finance Leases 6.1 11.3 4.4 +Construction Expenditures Included in Current Liabilities as of December 31, 76.7 125.9 98.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +200 +PUBLIC SERVICE COMPANY OF OKLAHOMA +201 +PUBLIC SERVICE COMPANY OF OKLAHOMA +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +As a public utility, PSO engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 565,000 retail customers in its service territory in eastern and southwestern Oklahoma. PSO sells electric power at wholesale to other utilities, municipalities and electric cooperatives. +202 +RESULTS OF OPERATIONS +KWh Sales/Degree Days +Summary of KWh Energy Sales +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 6,117 6,273 6,452 +Commercial 4,673 4,958 5,005 +Industrial 5,713 6,156 6,120 +Miscellaneous 1,199 1,246 1,263 +Total Retail 17,702 18,633 18,840 +Wholesale 345 714 758 +Total KWhs 18,047 19,347 19,598 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. +Summary of Heating and Cooling Degree Days +Years Ended December 31, +2020 2019 2018 +(in degree days) +Actual – Heating (a) +1,454 1,846 1,886 +Normal – Heating (b) +1,744 1,751 1,752 +Actual – Cooling (c) +2,069 2,265 2,445 +Normal – Cooling (b) +2,174 2,160 2,149 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 65 degree temperature base. +203 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Net Income +(in millions) +Year Ended December 31, 2019 $ 137.6 +Changes in Gross Margin: +Retail Margins (a) (14.0) +Margins from Off-system Sales (1.6) +Transmission Revenues 1.9 +Other Revenues 8.5 +Total Change in Gross Margin (5.2) +Changes in Expenses and Other: +Other Operation and Maintenance (10.0) +Depreciation and Amortization (4.0) +Taxes Other Than Income Taxes (4.2) +Interest Income (1.1) +Allowance for Funds Used During Construction 1.3 +Non-Service Cost Components of Net Periodic Benefit Cost 0.1 +Interest Expense 6.2 +Total Change in Expenses and Other (11.7) +Income Tax Expense 2.3 +Year Ended December 31, 2020 $ 123.0 +(a) Includes firm wholesale sales to municipals and cooperatives. +The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows: +• Retail Margins decreased $14 million primarily due to the following: +• A $15 million decrease in weather-related usage due to a 21% decrease in heating degree days and a 9% decrease in cooling degree days. +• A $13 million decrease in revenue from rate riders. This decrease was partially offset in other expense items below. +• An $8 million decrease due to customer refunds related to Tax Reform. This decrease is partially offset in Income Tax Expense. +These decreases were partially offset by: +• An $11 million increase in weather-normalized margins primarily in the residential class. +• A $10 million increase due to new base rates implemented in April 2019. +• Other Revenues increased $9 million primarily due to business development revenue. This increase was offset in other expense items below. +Expenses and Other changed between years as follows: +• Other Operation and Maintenance expenses increased $10 million primarily due to the following: +• A $20 million increase in transmission expenses primarily due to the annual transmission formula rate true-up. This increase was partially offset in Retail Margins above. +• A $9 million increase in business development expenses. This increase was offset in Other Revenues above. +• A $6 million increase in customer-related expenses primarily related to energy efficiency programs. This increase was partially offset in Retail Margins above. +204 +These increases were partially offset by: +• A $7 million decrease in administrative and general expenses primarily due to the receipt of an insurance settlement. +• A $6 million decrease due to the capitalization of previously expensed North Central Wind Energy Facilities costs. +• A $4 million decrease in expenses at various generation plants. +• A $3 million decrease due to a charitable contribution to the AEP Foundation in 2019. +• A $3 million decrease in fees for factoring accounts receivable. +• Depreciation and Amortization expenses increased $4 million primarily due to higher a depreciable base. +• Taxes Other Than Income Taxes increased $4 million primarily due to increased property taxes. +• Interest Expense decreased $6 million primarily due to lower interest rates on long-term debt. +205 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholder of +Public Service Company of Oklahoma +Opinion on the Financial Statements +We have audited the accompanying balance sheets of Public Service Company of Oklahoma (the “Company”) as of December 31, 2020 and 2019, and the related statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Change in Accounting Principle +As discussed in Note 13 to the financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinion +These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +206 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the financial statements, the Company’s financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $405.1 million of deferred costs included in regulatory assets, $50.5 million of which were pending final regulatory approval, and $802.2 million of regulatory liabilities awaiting potential refund or future rate reduction. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +207 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of Public Service Company of Oklahoma (PSO) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. PSO’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of PSO’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded PSO’s internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, PSO’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit PSO to provide only management’s report in this annual report. +208 +PUBLIC SERVICE COMPANY OF OKLAHOMA +STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Electric Generation, Transmission and Distribution $ 1,246.1 $ 1,469.6 $ 1,537.6 +Sales to AEP Affiliates 5.2 6.1 5.4 +Other Revenues 14.8 6.1 4.3 +TOTAL REVENUES 1,266.1 1,481.8 1,547.3 +EXPENSES +Fuel and Other Consumables Used for Electric Generation 15.6 195.1 240.5 +Purchased Electricity for Resale 427.9 458.9 479.9 +Other Operation 327.3 315.0 372.8 +Maintenance 98.4 100.7 104.8 +Depreciation and Amortization 173.5 169.5 164.0 +Taxes Other Than Income Taxes 47.5 43.3 42.8 +TOTAL EXPENSES 1,090.2 1,282.5 1,404.8 +OPERATING INCOME 175.9 199.3 142.5 +Other Income (Expense): +Interest Income 0.1 1.2 0.1 +Allowance for Equity Funds Used During Construction 4.0 2.7 0.4 +Non-Service Cost Components of Net Periodic Benefit Cost 8.5 8.4 8.7 +Interest Expense ( 60.3 ) ( 66.5 ) ( 63.5 ) +INCOME BEFORE INCOME TAX EXPENSE 128.2 145.1 88.2 +Income Tax Expense 5.2 7.5 5.0 +NET INCOME $ 123.0 $ 137.6 $ 83.2 +The common stock of PSO is wholly-owned by Parent. +See Notes to Financial Statements of Registrants beginning on page 229 . +209 +PUBLIC SERVICE COMPANY OF OKLAHOMA +STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 123.0 $ 137.6 $ 83.2 +OTHER COMPREHENSIVE LOSS, NET OF TAXES +Cash Flow Hedges, Net of Tax of $( 0.3 ), $( 0.3 ) and $( 0.3 ) in 2020, 2019 and 2018, Respectively +( 1.0 ) ( 1.0 ) ( 1.0 ) +TOTAL COMPREHENSIVE INCOME $ 122.0 $ 136.6 $ 82.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +210 +PUBLIC SERVICE COMPANY OF OKLAHOMA +STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Common +Stock Paid-in +Capital Retained Earnings Accumulated +Other +Comprehensive +Income (Loss) Total +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017 $ 157.2 $ 364.0 $ 691.5 $ 2.6 $ 1,215.3 +Common Stock Dividends ( 50.0 ) ( 50.0 ) +ASU 2018-02 Adoption 0.5 0.5 +Net Income 83.2 83.2 +Other Comprehensive Loss ( 1.0 ) ( 1.0 ) +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018 157.2 364.0 724.7 2.1 1,248.0 +Common Stock Dividends ( 11.3 ) ( 11.3 ) +Net Income 137.6 137.6 +Other Comprehensive Loss ( 1.0 ) ( 1.0 ) +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019 157.2 364.0 851.0 1.1 1,373.3 +Capital Contribution of Radial Assets from Parent 50.0 50.0 +ASU 2016-13 Adoption 0.3 0.3 +Net Income 123.0 123.0 +Other Comprehensive Loss ( 1.0 ) ( 1.0 ) +TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020 $ 157.2 $ 414.0 $ 974.3 $ 0.1 $ 1,545.6 +See Notes to Financial Statements of Registrants beginning on page 229 . +211 +PUBLIC SERVICE COMPANY OF OKLAHOMA +BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 2.6 $ 1.5 +Advances to Affiliates — 38.8 +Accounts Receivable: +Customers 30.8 28.9 +Affiliated Companies 15.6 20.6 +Miscellaneous 2.0 0.6 +Allowance for Uncollectible Accounts — ( 0.3 ) +Total Accounts Receivable 48.4 49.8 +Fuel 17.9 12.2 +Materials and Supplies 54.0 46.8 +Risk Management Assets 10.3 15.8 +Accrued Tax Benefits 10.9 11.3 +Regulatory Asset for Under-Recovered Fuel Costs 30.1 — +Prepayments and Other Current Assets 7.1 12.0 +TOTAL CURRENT ASSETS 181.3 188.2 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Generation 1,480.7 1,574.6 +Transmission 1,069.9 948.5 +Distribution 2,853.0 2,684.8 +Other Property, Plant and Equipment 393.3 342.1 +Construction Work in Progress 128.7 133.4 +Total Property, Plant and Equipment 5,925.6 5,683.4 +Accumulated Depreciation and Amortization 1,605.6 1,580.1 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET +4,320.0 4,103.3 +OTHER NONCURRENT ASSETS +Regulatory Assets 375.0 375.2 +Employee Benefits and Pension Assets 65.8 43.9 +Operating Lease Assets 42.6 36.8 +Deferred Charges and Other Noncurrent Assets 6.0 4.1 +TOTAL OTHER NONCURRENT ASSETS 489.4 460.0 +TOTAL ASSETS $ 4,990.7 $ 4,751.5 +See Notes to Financial Statements of Registrants beginning on page 229 . +212 +PUBLIC SERVICE COMPANY OF OKLAHOMA +BALANCE SHEETS +LIABILITIES AND COMMON SHAREHOLDER’S EQUITY +December 31, 2020 and 2019 +December 31, +2020 2019 +(in millions) +CURRENT LIABILITIES +Advances from Affiliates $ 155.4 $ — +Accounts Payable: +General 107.0 134.3 +Affiliated Companies 43.4 59.3 +Long-term Debt Due Within One Year – Nonaffiliated 0.5 13.2 +Customer Deposits 54.8 58.9 +Accrued Taxes 26.8 22.9 +Obligations Under Operating Leases 6.5 5.8 +Regulatory Liability for Over-Recovered Fuel Costs — 63.9 +Other Current Liabilities 84.2 87.5 +TOTAL CURRENT LIABILITIES 478.6 445.8 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 1,373.3 1,373.0 +Deferred Income Taxes 688.5 628.3 +Regulatory Liabilities and Deferred Investment Tax Credits 802.2 837.2 +Asset Retirement Obligations 45.7 44.5 +Obligations Under Operating Leases 36.2 31.0 +Deferred Credits and Other Noncurrent Liabilities 20.6 18.4 +TOTAL NONCURRENT LIABILITIES 2,966.5 2,932.4 +TOTAL LIABILITIES 3,445.1 3,378.2 +Rate Matters (Note 4) +Commitments and Contingencies (Note 6) +COMMON SHAREHOLDER’S EQUITY +Common Stock – Par Value – $ 15 Per Share: +Authorized – 11,000,000 Shares +Issued – 10,482,000 Shares +Outstanding – 9,013,000 Shares +157.2 157.2 +Paid-in Capital 414.0 364.0 +Retained Earnings 974.3 851.0 +Accumulated Other Comprehensive Income (Loss) 0.1 1.1 +TOTAL COMMON SHAREHOLDER’S EQUITY 1,545.6 1,373.3 +TOTAL LIABILITIES AND COMMON SHAREHOLDER’S EQUITY $ 4,990.7 $ 4,751.5 +See Notes to Financial Statements of Registrants beginning on page 229 . +213 +PUBLIC SERVICE COMPANY OF OKLAHOMA +STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 123.0 $ 137.6 $ 83.2 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 173.5 169.5 164.0 +Deferred Income Taxes 17.0 ( 18.2 ) ( 31.1 ) +Allowance for Equity Funds Used During Construction ( 4.0 ) ( 2.7 ) ( 0.4 ) +Mark-to-Market of Risk Management Contracts 5.5 ( 6.4 ) ( 3.0 ) +Deferred Fuel Over/Under-Recovery, Net ( 94.0 ) 43.8 57.4 +Change in Other Noncurrent Assets ( 17.9 ) 5.7 — +Change in Other Noncurrent Liabilities 1.6 ( 7.3 ) 21.4 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net 1.4 15.4 5.1 +Fuel, Materials and Supplies ( 14.1 ) ( 1.9 ) ( 2.6 ) +Accounts Payable ( 29.5 ) 7.0 17.7 +Accrued Taxes, Net 3.6 3.9 13.2 +Other Current Assets 4.6 ( 0.7 ) ( 0.8 ) +Other Current Liabilities ( 13.7 ) 4.6 6.4 +Net Cash Flows from Operating Activities 157.0 350.3 330.5 +INVESTING ACTIVITIES +Construction Expenditures ( 337.9 ) ( 291.9 ) ( 240.2 ) +Change in Advances to Affiliates, Net 38.8 ( 38.8 ) — +Other Investing Activities 4.0 2.6 7.2 +Net Cash Flows Used for Investing Activities ( 295.1 ) ( 328.1 ) ( 233.0 ) +FINANCING ACTIVITIES +Issuance of Long-term Debt – Nonaffiliated — 349.5 — +Change in Advances from Affiliates, Net 155.4 ( 105.5 ) ( 44.1 ) +Retirement of Long-term Debt – Nonaffiliated ( 13.2 ) ( 250.5 ) ( 0.5 ) +Principal Payments for Finance Lease Obligations ( 3.5 ) ( 3.1 ) ( 3.3 ) +Dividends Paid on Common Stock — ( 11.3 ) ( 50.0 ) +Other Financing Activities 0.5 ( 1.8 ) 0.8 +Net Cash Flows from (Used for) Financing Activities 139.2 ( 22.7 ) ( 97.1 ) +Net Increase (Decrease) in Cash and Cash Equivalents 1.1 ( 0.5 ) 0.4 +Cash and Cash Equivalents at Beginning of Period 1.5 2.0 1.6 +Cash and Cash Equivalents at End of Period $ 2.6 $ 1.5 $ 2.0 +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 59.1 $ 61.1 $ 62.0 +Net Cash Paid (Received) for Income Taxes ( 11.8 ) 22.4 17.9 +Noncash Acquisitions Under Finance Leases 3.2 5.3 4.3 +Construction Expenditures Included in Current Liabilities as of December 31, 35.5 46.0 33.2 +Noncash Contribution of Radial Assets from Parent 50.0 — — +See Notes to Financial Statements of Registrants beginning on page 229 . +214 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +215 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +MANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS +COMPANY OVERVIEW +As a public utility, SWEPCo engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 545,000 retail customers in its service territory in northeastern and the panhandle of Texas, northwestern Louisiana and western Arkansas. SWEPCo consolidates its wholly-owned subsidiary, Southwest Arkansas Utilities Corporation. SWEPCo also consolidates Sabine Mining Company, a VIE. SWEPCo sells electric power at wholesale to other utilities, municipalities and electric cooperatives. +216 +RESULTS OF OPERATIONS +KWh Sales/Degree Days +Summary of KWh Energy Sales +Years Ended December 31, +2020 2019 2018 +(in millions of KWhs) +Retail: +Residential 5,988 6,303 6,564 +Commercial 5,296 5,776 5,911 +Industrial 4,891 5,337 5,391 +Miscellaneous 79 80 79 +Total Retail 16,254 17,496 17,945 +Wholesale 5,838 6,791 7,071 +Total KWhs 22,092 24,287 25,016 +Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. +Summary of Heating and Cooling Degree Days +Years Ended December 31, +2020 2019 2018 +(in degree days) +Actual – Heating (a) +862 1,174 1,308 +Normal – Heating (b) +1,181 1,191 1,195 +Actual – Cooling (c) +2,165 2,392 2,560 +Normal – Cooling (b) +2,333 2,321 2,311 +(a) Heating degree days are calculated on a 55 degree temperature base. +(b) Normal Heating/Cooling represents the thirty-year average of degree days. +(c) Cooling degree days are calculated on a 65 degree temperature base. +217 +2020 Compared to 2019 +Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 +Earnings Attributable to SWEPCo Common Shareholder +(in millions) +Year Ended December 31, 2019 $ 158.6 +Changes in Gross Margin: +Retail Margins (a) (14.9) +Margins from Off-system Sales (0.1) +Transmission Revenues 52.8 +Other Revenues (2.4) +Total Change in Gross Margin 35.4 +Changes in Expenses and Other: +Other Operation and Maintenance 25.6 +Depreciation and Amortization (23.6) +Taxes Other Than Income Taxes (2.6) +Interest Income (0.5) +Allowance for Equity Funds Used During Construction 0.9 +Non-Service Cost Components of Net Periodic Benefit Cost (0.1) +Interest Expense 0.6 +Total Change in Expenses and Other 0.3 +Income Tax Expense (14.1) +Equity Earnings of Unconsolidated Subsidiary (0.1) +Net Income Attributable to Noncontrolling Interest 0.7 +Year Ended December 31, 2020 $ 180.8 +(a) Includes firm wholesale sales to municipals and cooperatives. +The major components of the increase in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows: +• Retail Margins decreased $15 million primarily due to the following: +• A $30 million decrease in weather-related usage primarily due to a 9% decrease in cooling degree days and a 27% decrease in heating degree days. +• An $11 million decrease in weather-normalized margins primarily in the commercial and industrial classes, partially offset in the residential class. +• An $11 million decrease in weather-normalized wholesale margins, including the loss of a wholesale contract. +• A $10 million decrease due to a 2020 regulatory provision. +These decreases were partially offset by: +• A $45 million increase primarily due to rider increases in all jurisdictions and a base rate revenue increase in Arkansas. This increase was partially offset in other expense items below. +• Transmission Revenues increased $53 million primarily due to the following: +• A $31 million increase as a result of the annual transmission formula rate true-up. This increase was partially offset by an increase in transmission expenses in SPP. +• A $22 million increase due to continued investment in transmission projects. +218 +Expenses and Other and Income Tax Expense changed between years as follows: +• Other Operation and Maintenance expenses decreased $26 million primarily due to the following: +• A $10 million decrease in expenses at various generation plants. +• A $10 million decrease in administrative and general expenses primarily due to an insurance settlement. +• A $9 million decrease due to the capitalization of previously expensed North Central Wind Energy Facilities costs. +• A $6 million decrease in customer-related expenses primarily in energy efficiency programs. This decrease was offset in Retail Margins above. +• A $6 million decrease due to a charitable contribution to the AEP Foundation in 2019. +These decreases were partially offset by: +• A $19 million increase in SPP transmission expenses primarily due to the annual formula rate true-up. This increase was offset in Transmission Revenues above. +• Depreciation and Amortization expenses increased $24 million primarily due to a higher depreciable base and an increase in Arkansas depreciation rates beginning in January 2020. This increase was partially offset in Retail Margins above. +• Income Tax Expense increased $14 million primarily due to an increase in pretax book income and a decrease in Excess ADIT amortization. This decrease of Excess ADIT not subject to normalization requirements amortization was partially offset in Retail Margins above. +219 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +To the Board of Directors and Shareholder of +Southwestern Electric Power Company +Opinion on the Financial Statements +We have audited the accompanying consolidated balance sheets of Southwestern Electric Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. +Change in Accounting Principle +As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. +Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +Critical Audit Matters +The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. +220 +Accounting for the Effects of Cost-Based Regulation +As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $405.7 million of deferred costs included in regulatory assets, $247.3 million of which were pending final regulatory approval, and $901.0 million of regulatory liabilities awaiting potential refund or future rate reduction, $313.4 million of which were pending final regulatory determination. +The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +We have served as the Company's auditor since 2017. +221 +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +The management of Southwestern Electric Power Company Consolidated (SWEPCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. SWEPCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Management assessed the effectiveness of SWEPCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded SWEPCo’s internal control over financial reporting was effective as of December 31, 2020. +This annual report does not include an audit report from PricewaterhouseCoopers LLP, SWEPCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit SWEPCo to provide only management’s report in this annual report. +222 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +CONSOLIDATED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +REVENUES +Electric Generation, Transmission and Distribution $ 1,696.6 $ 1,744.6 $ 1,791.9 +Sales to AEP Affiliates 41.0 36.9 35.1 +Provision for Refund - Affiliated ( 2.0 ) ( 32.0 ) ( 6.7 ) +Other Revenues 2.9 1.4 1.6 +TOTAL REVENUES 1,738.5 1,750.9 1,821.9 +EXPENSES +Fuel and Other Consumables Used for Electric Generation 443.5 472.8 502.3 +Purchased Electricity for Resale 161.0 179.5 177.1 +Other Operation 338.3 348.0 384.2 +Maintenance 129.7 145.6 141.5 +Depreciation and Amortization 272.7 249.1 239.5 +Taxes Other Than Income Taxes 102.8 100.2 99.6 +TOTAL EXPENSES 1,448.0 1,495.2 1,544.2 +OPERATING INCOME 290.5 255.7 277.7 +Other Income (Expense): +Interest Income 2.1 2.6 5.4 +Allowance for Equity Funds Used During Construction 7.7 6.8 6.0 +Non-Service Cost Components of Net Periodic Benefit Cost 8.4 8.5 8.7 +Interest Expense ( 118.5 ) ( 119.1 ) ( 127.9 ) +INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS 190.2 154.5 169.9 +Income Tax Expense (Benefit) 9.4 ( 4.7 ) 20.4 +Equity Earnings of Unconsolidated Subsidiary 2.9 3.0 2.7 +NET INCOME 183.7 162.2 152.2 +Net Income Attributable to Noncontrolling Interest 2.9 3.6 5.0 +EARNINGS ATTRIBUTABLE TO SWEPCo COMMON SHAREHOLDER $ 180.8 $ 158.6 $ 147.2 +The common stock of SWEPCo is wholly-owned by Parent. +See Notes to Financial Statements of Registrants beginning on page 229 . +223 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +Net Income $ 183.7 $ 162.2 $ 152.2 +OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES +Cash Flow Hedges, Net of Tax of $ 0.4 , $ 0.4 and $ 1.1 in 2020, 2019 and 2018, Respectively +1.5 1.5 4.0 +Amortization of Pension and OPEB Deferred Costs, Net of Tax of $( 0.4 ), $( 0.3 ) and $( 0.4 ) in 2020, 2019 and 2018, Respectively +( 1.5 ) ( 1.1 ) ( 1.4 ) +Pension and OPEB Funded Status, Net of Tax of $ 0.9 , $ 1.0 and $( 0.8 ) in 2020, 2019 and 2018, Respectively +3.2 3.7 ( 3.1 ) +TOTAL OTHER COMPREHENSIVE INCOME (LOSS) 3.2 4.1 ( 0.5 ) +TOTAL COMPREHENSIVE INCOME 186.9 166.3 151.7 +Total Comprehensive Income Attributable to Noncontrolling Interest 2.9 3.6 5.0 +TOTAL COMPREHENSIVE INCOME ATTRIBUTABLE TO SWEPCo COMMON SHAREHOLDER +$ 184.0 $ 162.7 $ 146.7 +See Notes to Financial Statements of Registrants beginning on page 229 . +224 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +SWEPCo Common Shareholder +Common +Stock Paid-in +Capital Retained +Earnings Accumulated +Other +Comprehensive +Income (Loss) Noncontrolling +Interest Total +TOTAL EQUITY – DECEMBER 31, 2017 $ 135.7 $ 676.6 $ 1,426.6 $ ( 4.0 ) $ ( 0.4 ) $ 2,234.5 +Common Stock Dividends ( 65.0 ) ( 65.0 ) +Common Stock Dividends – Nonaffiliated ( 4.3 ) ( 4.3 ) +ASU 2018-02 Adoption ( 0.4 ) ( 0.9 ) ( 1.3 ) +Net Income 147.2 5.0 152.2 +Other Comprehensive Loss ( 0.5 ) ( 0.5 ) +TOTAL EQUITY – DECEMBER 31, 2018 135.7 676.6 1,508.4 ( 5.4 ) 0.3 2,315.6 +Common Stock Dividends ( 37.5 ) ( 37.5 ) +Common Stock Dividends – Nonaffiliated ( 3.3 ) ( 3.3 ) +Net Income 158.6 3.6 162.2 +Other Comprehensive Income 4.1 4.1 +TOTAL EQUITY – DECEMBER 31, 2019 135.7 676.6 1,629.5 ( 1.3 ) 0.6 2,441.1 +Reverse Common Stock Split (a) ( 135.6 ) 135.6 — +Common Stock Dividends – Nonaffiliated ( 1.9 ) ( 1.9 ) +ASU 2016-03 Adoption 1.6 1.6 +Net Income 180.8 2.9 183.7 +Other Comprehensive Income 3.2 3.2 +TOTAL EQUITY – DECEMBER 31, 2020 $ 0.1 $ 812.2 $ 1,811.9 $ 1.9 $ 1.6 $ 2,627.7 +(a) See Note 14 - Financing Activities for additional information. +See Notes to Financial Statements of Registrants beginning on page 229 . +225 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +CONSOLIDATED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents +(December 31, 2020 and 2019 Amounts Include $ 10.1 and $ 0 , Respectively, Related to Sabine) +$ 13.2 $ 1.6 +Advances to Affiliates 2.1 2.1 +Accounts Receivable: +Customers 27.1 29.0 +Affiliated Companies 25.1 34.5 +Miscellaneous 12.7 13.5 +Allowance for Uncollectible Accounts — ( 1.7 ) +Total Accounts Receivable 64.9 75.3 +Fuel +(December 31, 2020 and 2019 Amounts Include $ 35.2 and $ 47 , Respectively, Related to Sabine) +191.1 140.1 +Materials and Supplies +(December 31, 2020 and 2019 Amounts Include $ 23.3 and $ 23.1 , Respectively, Related to Sabine) +95.8 94.0 +Risk Management Assets 3.2 6.4 +Accrued Tax Benefits 29.9 7.6 +Regulatory Asset for Under-Recovered Fuel Costs 2.6 4.9 +Prepayments and Other Current Assets 25.2 22.1 +TOTAL CURRENT ASSETS 428.0 354.1 +PROPERTY, PLANT AND EQUIPMENT +Electric: +Generation 4,681.4 4,691.4 +Transmission 2,165.7 2,056.5 +Distribution 2,382.5 2,270.7 +Other Property, Plant and Equipment +(December 31, 2020 and 2019 Amounts Include $ 223.7 and $ 212.3 , Respectively, Related to Sabine) +788.8 733.4 +Construction Work in Progress 228.3 216.9 +Total Property, Plant and Equipment 10,246.7 9,968.9 +Accumulated Depreciation and Amortization +(December 31, 2020 and 2019 Amounts Include $ 126.5 and $ 107.5 , Respectively, Related to Sabine) +3,158.5 2,873.7 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 7,088.2 7,095.2 +OTHER NONCURRENT ASSETS +Regulatory Assets 403.1 222.4 +Deferred Charges and Other Noncurrent Assets 234.8 160.5 +TOTAL OTHER NONCURRENT ASSETS 637.9 382.9 +TOTAL ASSETS $ 8,154.1 $ 7,832.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +226 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +CONSOLIDATED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2020 and 2019 +December 31, +2020 2019 +(in millions) +CURRENT LIABILITIES +Advances from Affiliates $ 124.6 $ 59.9 +Accounts Payable: +General 135.9 138.0 +Affiliated Companies 43.0 53.6 +Short-term Debt – Nonaffiliated 35.0 18.3 +Long-term Debt Due Within One Year – Nonaffiliated 106.2 121.2 +Risk Management Liabilities 0.7 1.9 +Customer Deposits 61.3 65.0 +Accrued Taxes 41.0 41.8 +Accrued Interest 34.6 34.6 +Obligations Under Operating Leases 7.9 6.5 +Other Current Liabilities 173.4 133.9 +TOTAL CURRENT LIABILITIES 763.6 674.7 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 2,530.2 2,534.4 +Long-term Risk Management Liabilities 1.0 3.1 +Deferred Income Taxes 1,017.6 940.9 +Regulatory Liabilities and Deferred Investment Tax Credits 863.4 892.3 +Asset Retirement Obligations 193.7 196.7 +Employee Benefits and Pension Obligations 18.6 28.1 +Obligations Under Operating Leases 44.1 34.7 +Deferred Credits and Other Noncurrent Liabilities 94.2 86.2 +TOTAL NONCURRENT LIABILITIES 4,762.8 4,716.4 +TOTAL LIABILITIES 5,526.4 5,391.1 +Rate Matters (Notes 4) +Commitments and Contingencies (Note 6) +EQUITY +Common Stock – Par Value – $ 18 Per Share: +Authorized – 3,680 Shares +Outstanding – 3,680 Shares +0.1 135.7 +Paid-in Capital 812.2 676.6 +Retained Earnings 1,811.9 1,629.5 +Accumulated Other Comprehensive Income (Loss) 1.9 ( 1.3 ) +TOTAL COMMON SHAREHOLDER’S EQUITY 2,626.1 2,440.5 +Noncontrolling Interest 1.6 0.6 +TOTAL EQUITY 2,627.7 2,441.1 +TOTAL LIABILITIES AND EQUITY $ 8,154.1 $ 7,832.2 +See Notes to Financial Statements of Registrants beginning on page 229 . +227 +SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 183.7 $ 162.2 $ 152.2 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 272.7 249.1 239.5 +Deferred Income Taxes 32.4 ( 11.0 ) 1.2 +Allowance for Equity Funds Used During Construction ( 7.7 ) ( 6.8 ) ( 6.0 ) +Mark-to-Market of Risk Management Contracts ( 0.1 ) 0.8 4.0 +Pension Contributions to Qualified Plan Trust ( 8.9 ) — — +Deferred Fuel Over/Under-Recovery, Net 26.3 16.5 ( 2.4 ) +Change in Regulatory Assets ( 108.4 ) 3.5 ( 0.7 ) +Change in Other Noncurrent Assets 16.1 2.7 ( 18.1 ) +Change in Other Noncurrent Liabilities 25.2 2.7 42.8 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net 7.3 — 53.5 +Fuel, Materials and Supplies ( 46.4 ) ( 46.1 ) 3.5 +Accounts Payable 11.1 ( 28.4 ) 0.9 +Accrued Taxes, Net ( 23.1 ) ( 3.2 ) 2.3 +Other Current Assets ( 2.8 ) ( 8.9 ) 15.6 +Other Current Liabilities ( 21.1 ) 6.7 16.5 +Net Cash Flows from Operating Activities 356.3 339.8 504.8 +INVESTING ACTIVITIES +Construction Expenditures ( 402.7 ) ( 412.7 ) ( 451.0 ) +Change in Advances to Affiliates, Net — 81.3 ( 81.4 ) +Proceeds from Sales of Assets 4.4 0.2 1.4 +Other Investing Activities 5.7 1.0 2.1 +Net Cash Flows Used for Investing Activities ( 392.6 ) ( 330.2 ) ( 528.9 ) +FINANCING ACTIVITIES +Issuance of Long-term Debt – Nonaffiliated — — 1,065.7 +Change in Short-term Debt – Nonaffiliated 16.7 18.3 ( 22.0 ) +Change in Advances from Affiliates, Net 64.7 59.9 ( 118.7 ) +Retirement of Long-term Debt – Nonaffiliated ( 21.2 ) ( 59.7 ) ( 794.5 ) +Principal Payments for Finance Lease Obligations ( 10.9 ) ( 11.0 ) ( 11.5 ) +Dividends Paid on Common Stock — ( 37.5 ) ( 65.0 ) +Dividends Paid on Common Stock – Nonaffiliated ( 1.9 ) ( 3.3 ) ( 4.3 ) +Other Financing Activities 0.5 0.8 ( 2.7 ) +Net Cash Flows from (Used for) Financing Activities 47.9 ( 32.5 ) 47.0 +Net Increase (Decrease) in Cash and Cash Equivalents 11.6 ( 22.9 ) 22.9 +Cash and Cash Equivalents at Beginning of Period 1.6 24.5 1.6 +Cash and Cash Equivalents at End of Period $ 13.2 $ 1.6 $ 24.5 +SUPPLEMENTARY INFORMATION +Cash Paid for Interest, Net of Capitalized Amounts $ 110.7 $ 111.1 $ 125.7 +Net Cash Paid for Income Taxes 4.3 8.6 18.8 +Noncash Acquisitions Under Finance Leases 8.9 7.4 3.6 +Construction Expenditures Included in Current Liabilities as of December 31, 46.0 69.1 42.0 +See Notes to Financial Statements of Registrants beginning on page 229 . +228 +INDEX OF NOTES TO FINANCIAL STATEMENTS OF REGISTRANTS +The notes to financial statements are a combined presentation for the Registrants. The following list indicates Registrants to which the notes apply. Specific disclosures within each note apply to all Registrants unless indicated otherwise. +Note Registrant Page +Number +Organization and Summary of Significant Accounting Policies +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +230 +New Accounting Standards +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +247 +Comprehensive Income +AEP, AEP Texas, APCo, I&M, OPCo, PSO, SWEPCo +248 +Rate Matters +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +256 +Effects of Regulation +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +264 +Commitments, Guarantees and Contingencies +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +282 +Acquisitions, Dispositions and Impairments +AEP, AEP Texas, APCo, I&M, SWEPCo +289 +Benefit Plans +AEP, AEP Texas, APCo, I&M, OPCo, PSO, SWEPCo +293 +Business Segments +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +316 +Derivatives and Hedging +AEP, AEP Texas, APCo, I&M, OPCo, PSO, SWEPCo +322 +Fair Value Measurements +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +335 +Income Taxes +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +349 +Leases +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +360 +Financing Activities +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +366 +Stock-based Compensation +AEP +377 +Related Party Transactions +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +382 +Variable Interest Entities and Equity Method Investments +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +390 +Property, Plant and Equipment +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +401 +Revenue from Contracts with Customers +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo +408 +Goodwill +AEP +417 +Subsequent Events AEP, AEP Texas, APCo, PSO, SWEPCo +418 +229 +1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +The disclosures in this note apply to all Registrants unless indicated otherwise. +ORGANIZATION +The Registrants engage in the generation, transmission and distribution of electric power. The Registrant Subsidiaries that conduct most of these activities are regulated by the FERC under the Federal Power Act and the Energy Policy Act of 2005 and maintain accounts in accordance with the FERC and other regulatory guidelines. Most of these companies are subject to further regulation with regard to rates and other matters by state regulatory commissions. +AEP provides competitive electric and gas supply for residential, commercial and industrial customers in deregulated electricity markets and also provides energy management solutions throughout the United States, including energy efficiency services through its independent retail electric supplier. +The Registrants also engage in wholesale electricity, natural gas and other commodity marketing and risk management activities in the United States and provide various energy-related services. In addition, AEP operates competitive wind and solar farms. I&M provides barging services to both affiliated and nonaffiliated companies. SWEPCo, through consolidated and non-consolidated affiliates, conducts lignite mining operations to fuel certain of its generation facilities. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Rates and Service Regulation +AEP’s public utility subsidiaries’ rates are regulated by the FERC and state regulatory commissions in the eleven state operating territories in which they operate. The FERC also regulates the Registrants’ affiliated transactions, including AEPSC intercompany service billings which are generally at cost, under the 2005 Public Utility Holding Company Act and the Federal Power Act. The FERC also has jurisdiction over the issuances and acquisitions of securities of the public utility subsidiaries, the acquisition or sale of certain utility assets and mergers with another electric utility or holding company. The state regulatory commissions also regulate certain intercompany transactions under various orders and affiliate statutes. Both the FERC and state regulatory commissions are permitted to review and audit the relevant books and records of companies within a public utility holding company system. +The FERC regulates wholesale power markets and wholesale power transactions. The Registrants’ wholesale power transactions are generally market-based. Wholesale power transactions are cost-based regulated when a cost-based contract is negotiated and filed with the FERC or the FERC determines that the Registrants have “market power” in the region where the transaction occurs. Wholesale power supply contracts have been entered into with various municipalities and cooperatives that are FERC-regulated, cost-based contracts. These contracts are generally formula rate mechanisms, which are trued-up to actual costs annually. +The state regulatory commissions regulate all of the retail distribution operations and rates of the Registrants’ retail public utility subsidiaries on a cost basis. The state regulatory commissions also regulate the retail generation/power supply operations and rates except in Ohio and the ERCOT region of Texas. For generation in Ohio, customers who have not switched to a CRES provider for generation pay market-based auction rates. In addition, all OPCo distribution customers paid for certain legacy generation deferral balances that were fully recovered as of December 31, 2019 and continue to pay for certain legacy deferred generation-related costs through PUCO approved riders. In the ERCOT region of Texas, the generation/supply business is under customer choice and market pricing is conducted by REPs. AEP has one active REP in ERCOT. AEP’s nonregulated subsidiaries enter into short and long-term wholesale transactions to buy or sell capacity, energy and ancillary services in the ERCOT market. In addition, these nonregulated subsidiaries control certain wind assets, the power from which is marketed and sold in ERCOT. Power from the Oklaunion Power Station was also marketed and sold by these nonregulated subsidiaries in ERCOT prior to its retirement in September 2020. +230 +The FERC also regulates the Registrants’ wholesale transmission operations and rates. Retail transmission rates are based upon the FERC OATT rate when retail rates are unbundled in connection with restructuring. Retail transmission rates are based on formula rates included in the PJM OATT that are cost-based and are unbundled in Ohio for OPCo, in Virginia for APCo and in Michigan for I&M. AEP Texas’ retail transmission rates in Texas are unbundled but the retail transmission rates are regulated, on a cost basis, by the PUCT. Bundled retail transmission rates are regulated, on a cost basis, by the state commissions. Transmission rates for AEPTCo’s seven wholly-owned transmission subsidiaries within the AEP Transmission Holdco segment are based on formula rates included in the applicable RTO’s OATT that are cost-based. +In West Virginia, APCo and WPCo provide retail electric service at bundled rates approved by the WVPSC, with rates set on a combined cost-of-service basis. +In addition, the FERC regulates the SIA, Operating Agreement, TA and TCA, all of which allocate shared system costs and revenues among the utility subsidiaries that are parties to each agreement. The FERC also regulates the PCA. See Note 16 - Related Party Transactions for additional information. +Principles of Consolidation +AEP’s consolidated financial statements include its wholly-owned and majority-owned subsidiaries and VIEs of which AEP is the primary beneficiary. The consolidated financial statements for AEP Texas include the Registrant Subsidiary, its wholly-owned subsidiaries, Transition Funding (consolidated VIEs) and Restoration Funding (a consolidated VIE). The consolidated financial statements for APCo include the Registrant Subsidiary, its wholly-owned subsidiaries and Appalachian Consumer Rate Relief Funding (a consolidated VIE). The consolidated financial statements for I&M include the Registrant Subsidiary, its wholly-owned subsidiaries and DCC Fuel (consolidated VIEs). The consolidated statements of cash flows for OPCo include the Registrant Subsidiary and Ohio Phase-in Recovery Funding (a consolidated VIE) for the years ended December 31, 2019 and 2018. In July 2019, the Ohio Phase-in Recovery funding securitization bonds matured. The consolidated financial statements for SWEPCo include the Registrant Subsidiary, its wholly-owned subsidiary and Sabine (a consolidated VIE). Intercompany items are eliminated in consolidation. +The equity method of accounting is used for equity investments where the Registrants exercise significant influence but do not hold a controlling financial interest. Such investments are initially recorded at cost in Deferred Charges and Other Noncurrent Assets on the balance sheets. The proportionate share of the investee’s equity earnings or losses is included in Equity Earnings of Unconsolidated Subsidiaries on the statements of income. +AEP, I&M and SWEPCo have ownership interests in generating units that are jointly-owned. The proportionate share of the operating costs associated with such facilities is included on the income statements and the assets and liabilities are reflected on the balance sheets. See Note 17 - Variable Interest Entities and Equity Method Investments and Note 18 - Property, Plant and Equipment for additional information. In October 2020, AEP Texas, PSO and a nonaffiliated joint-owner executed an Environmental Liability and Property Transfer and Asset Purchase Agreement with a nonaffiliated third-party related to the Oklaunion Power Station site. See Note 7 – Acquisitions, Dispositions and Impairments for additional information. +Accounting for the Effects of Cost-Based Regulation +The Registrants’ financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. In accordance with accounting guidance for “Regulated Operations,” regulatory assets (deferred expenses) and regulatory liabilities (deferred revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and by matching income with its passage to customers in cost-based regulated rates. +231 +Use of Estimates +The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates include, but are not limited to, inventory valuation, allowance for doubtful accounts, goodwill, intangible and long-lived asset impairment, unbilled electricity revenue, valuation of long-term energy contracts, the effects of regulation, long-lived asset recovery, storm costs, the effects of contingencies and certain assumptions made in accounting for pension and postretirement benefits. The estimates and assumptions used are based upon management’s evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results could ultimately differ from those estimates. +Cash and Cash Equivalents +Cash and Cash Equivalents include temporary cash investments with original maturities of three months or less. +Restricted Cash (Applies to AEP, AEP Texas and APCo) +Restricted Cash primarily includes funds held by trustees for the payment of securitization bonds. +Reconciliation of Cash, Cash Equivalents and Restricted Cash +The following tables provide a reconciliation of Cash, Cash Equivalents and Restricted Cash reported within the balance sheets that sum to the total of the same amounts shown on the statement of cash flows: +December 31, 2020 +AEP AEP Texas APCo +(in millions) +Cash and Cash Equivalents $ 392.7 $ 0.1 $ 5.8 +Restricted Cash 45.6 28.7 16.9 +Total Cash, Cash Equivalents and Restricted Cash $ 438.3 $ 28.8 $ 22.7 +December 31, 2019 +AEP AEP Texas APCo +(in millions) +Cash and Cash Equivalents $ 246.8 $ 3.1 $ 3.3 +Restricted Cash 185.8 154.7 23.5 +Total Cash, Cash Equivalents and Restricted Cash $ 432.6 $ 157.8 $ 26.8 +Other Temporary Investments (Applies to AEP) +Other Temporary Investments primarily include marketable securities and investments by its protected cell of EIS. These securities have readily determinable fair values and are carried at fair value with changes in fair value recognized in net income. The cost of securities sold is based on the specific identification or weighted-average cost method. See “Fair Value Measurements of Other Temporary Investments” section of Note 11 for additional information. +Inventory +Fossil fuel inventories are carried at average cost with the exception of AGR, which is carried at the lower of average cost or net realizable value. Materials and supplies inventories are carried at average cost. +232 +Accounts Receivable +Customer accounts receivable primarily include receivables from wholesale and retail energy customers, receivables from energy contract counterparties related to risk management activities and customer receivables primarily related to other revenue-generating activities. +Revenue is recognized over time as the performance obligations of delivering energy to customers are satisfied. To the extent that deliveries have occurred but a bill has not been issued, the Registrants accrue and recognize, as Accrued Unbilled Revenues on the balance sheets, an estimate of the revenues for energy delivered since the last billing. +AEP Credit factors accounts receivable on a daily basis, excluding receivables from risk management activities, through purchase agreements with I&M, KGPCo, KPCo, OPCo, PSO, SWEPCo and a portion of APCo. Since APCo does not have regulatory authority to sell accounts receivable in its West Virginia regulatory jurisdiction, only a portion of APCo’s accounts receivable are sold to AEP Credit. AEP Credit has a receivables securitization agreement with bank conduits. Under the securitization agreement, AEP Credit receives financing from bank conduits for the interest in the billed and unbilled receivables they acquire from affiliated utility subsidiaries. See “Securitized Accounts Receivable – AEP Credit” section of Note 14 for additional information. +Allowance for Uncollectible Accounts +Generally, AEP Credit records bad debt expense based upon a 12-month rolling average of bad debt write-offs in proportion to gross accounts receivable purchased from participating AEP subsidiaries. The assessment is performed separately by each participating AEP subsidiary, which inherently contemplates any differences in geographical risk characteristics for the allowance. For receivables related to APCo’s West Virginia operations, the bad debt reserve is calculated based on a rolling two-year average write-off in proportion to gross accounts receivable. For customer accounts receivables relating to risk management activities, accounts receivables are reviewed for bad debt reserves at a specific counterparty level basis. For AEP Texas, bad debt reserves are calculated using the specific identification of receivable balances greater than 120 days delinquent, and for those balances less than 120 days where the collection is doubtful. For miscellaneous accounts receivable, bad debt expense is recorded based upon a 12-month rolling average of bad debt write-offs in proportion to gross accounts receivable, unless specifically identified. In addition to these processes, management contemplates available current information, as well as any reasonable and supportable forecast information, to determine if allowances for uncollectible accounts should be further adjusted in accordance with the accounting guidance for “Credit Losses.” Management’s assessments contemplate expected losses over the life of the accounts receivable. +Concentrations of Credit Risk and Significant Customers (Applies to Registrant Subsidiaries) +APCo, I&M, OPCo, PSO and SWEPCo do not have any significant customers that comprise 10 % or more of their operating revenues. AEP Texas had significant transactions with REPs which on a combined basis account for the following percentages of Total Revenues for the years ended December 31 and Accounts Receivable – Customers as of December 31: +Significant Customers of AEP Texas: +Reliant Energy, Direct Energy and TXU Energy (a) 2020 2019 2018 +Percentage of Total Revenues 46 % 48 % 45 % +Percentage of Accounts Receivable – Customers 40 % 43 % 35 % +(a) In January 2021, NRG Energy, parent company of Reliant Energy, completed a deal to purchase Direct Energy from Centrica. +233 +AEPTCo had significant transactions with AEP Subsidiaries which on a combined basis account for the following percentages of Total Revenues for the years ended December 31 and Total Accounts Receivable as of December 31: +Significant Customers of AEPTCo: +AEP Subsidiaries 2020 2019 2018 +Percentage of Total Revenues 78 % 79 % 77 % +Percentage of Total Accounts Receivable 78 % 78 % 84 % +The Registrant Subsidiaries monitor credit levels and the financial condition of their customers on a continuous basis to minimize credit risk. The regulatory commissions allow recovery in rates for a reasonable level of bad debt costs. Management believes adequate provisions for credit loss have been made in the accompanying Registrant Subsidiary financial statements. +Renewable Energy Credits (Applies to all Registrants except AEP Texas and AEPTCo) +In regulated jurisdictions, the Registrants record renewable energy credits (RECs) at cost. For AEP’s competitive generation business, management records RECs at the lower of cost or market. The Registrants follow the inventory model for these RECs. RECs expected to be consumed within one year are reported in Materials and Supplies on the balance sheets. RECs with expected consumption beyond one year are included in Deferred Charges and Other Noncurrent Assets on the balance sheets. The purchases and sales of RECs are reported in the Operating Activities section of the statements of cash flows. RECs are consumed to meet applicable state renewable portfolio standards and are recorded in Fuel and Other Consumables Used for Electric Generation at an average cost on the statements of income. The net margin on sales of RECs affects the determination of deferred fuel and REC costs and the amortization of regulatory assets for certain jurisdictions. +Property, Plant and Equipment +Regulated +Electric utility property, plant and equipment for rate-regulated operations are stated at original cost. Additions, major replacements and betterments are added to the plant accounts. Under the group composite method of depreciation, continuous interim routine replacements of items such as boiler tubes, pumps, motors, etc. result in original cost retirements, less salvage, being charged to accumulated depreciation. The group composite method of depreciation assumes that on average, asset components are retired at the end of their useful lives and thus there is no gain or loss. The equipment in each primary electric plant account is identified as a separate group. The depreciation rates that are established take into account the past history of interim capital replacements and the amount of removal cost incurred and salvage received. These rates and the related lives are subject to periodic review. Removal costs accrued are typically recorded as regulatory liabilities when the revenue received for removal costs accrued exceeds actual removal costs incurred. The asset removal costs liability is relieved as removal costs are incurred. A regulatory asset balance will occur if actual removal costs incurred exceed accumulated removal costs accrued. +The costs of labor, materials and overhead incurred to operate and maintain plant and equipment are included in operating expenses. +Nuclear fuel, including nuclear fuel in the fabrication phase, is included in Other Property, Plant and Equipment on the balance sheets. +Long-lived assets are required to be tested for impairment when it is determined that the carrying value of the assets may no longer be recoverable or when the assets meet the held-for-sale criteria under the accounting guidance for “Impairment or Disposal of Long-Lived Assets.” When it becomes probable that an asset in-service or an asset under construction will be abandoned and regulatory cost recovery has been disallowed or is not probable, the cost +234 +of that asset shall be removed from plant-in-service or CWIP and charged to expense. The fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties, as opposed to a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are used as the basis for the measurement, if available. In the absence of quoted prices for identical or similar assets in active markets, fair value is estimated using various internal and external valuation methods including cash flow analysis and appraisals. +Nonregulated +Nonregulated operations generally follow the policies of rate-regulated operations listed above but with the following exceptions. Property, plant and equipment of nonregulated operations are stated at original cost (or as adjusted for any applicable impairments) plus the original cost of property acquired or constructed since the acquisition, less disposals. Normal and routine retirements from the plant accounts, net of salvage, are charged to accumulated depreciation for most nonregulated operations under the group composite method of depreciation. A gain or loss would be recorded if the retirement is not considered an interim routine replacement. Removal costs are charged to expense. +Allowance for Funds Used During Construction and Interest Capitalization +For regulated operations, AFUDC represents the estimated cost of borrowed and equity funds used to finance construction projects that is capitalized and recovered through depreciation over the service life of regulated electric utility plant. The Registrants record the equity component of AFUDC in Allowance for Equity Funds Used During Construction and the debt component of AFUDC as a reduction to Interest Expense on the statements of income. For nonregulated operations, including certain generating assets, interest is capitalized during construction in accordance with the accounting guidance for “Capitalization of Interest.” +Valuation of Nonderivative Financial Instruments +The book values of Cash and Cash Equivalents, Advances to/from Affiliates, Accounts Receivable, Accounts Payable and Short-term Debt approximate fair value because of the short-term maturity of these instruments. +Fair Value Measurements of Assets and Liabilities (Applies to all Registrants except AEPTCo) +The accounting guidance for “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). Where observable inputs are available for substantially the full term of the asset or liability, the instrument is categorized in Level 2. When quoted market prices are not available, pricing may be completed using comparable securities, dealer values, operating data and general market conditions to determine fair value. Valuation models utilize various inputs such as commodity, interest rate and, to a lesser degree, volatility and credit that include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, market corroborated inputs (i.e. inputs derived principally from, or correlated to, observable market data) and other observable inputs for the asset or liability. +For commercial activities, exchange-traded derivatives, namely futures contracts, are generally fair valued based on unadjusted quoted prices in active markets and are classified as Level 1. Level 2 inputs primarily consist of OTC broker quotes in moderately active or less active markets, as well as exchange-traded derivatives where there is insufficient market liquidity to warrant inclusion in Level 1. Management verifies price curves using these broker quotes and classifies these fair values within Level 2 when substantially all of the fair value can be corroborated. Management typically obtains multiple broker quotes, which are nonbinding in nature but are based on recent trades in the marketplace. When multiple broker quotes are obtained, the quoted bid and ask prices are averaged. In certain circumstances, a broker quote may be discarded if it is a clear outlier. Management uses a historical correlation analysis between the broker quoted location and the illiquid locations. If the points are highly +235 +correlated, these locations are included within Level 2 as well. Certain OTC and bilaterally executed derivative instruments are executed in less active markets with a lower availability of pricing information. Illiquid transactions, complex structured transactions, FTRs and counterparty credit risk may require nonmarket-based inputs. Some of these inputs may be internally developed or extrapolated and utilized to estimate fair value. When such inputs have a significant impact on the measurement of fair value, the instrument is categorized as Level 3. The main driver of contracts being classified as Level 3 is the inability to substantiate energy price curves in the market. A portion of the Level 3 instruments have been economically hedged which limits potential earnings volatility. +AEP utilizes its trustee’s external pricing service to estimate the fair value of the underlying investments held in the benefit plan and nuclear trusts. AEP’s investment managers review and validate the prices utilized by the trustee to determine fair value. AEP’s management performs its own valuation testing to verify the fair values of the securities. AEP receives audit reports of the trustee’s operating controls and valuation processes. +Assets in the benefits and nuclear trusts, cash and cash equivalents, other temporary investments and restricted cash for securitized funding are classified using the following methods. Equities are classified as Level 1 holdings if they are actively traded on exchanges. Items classified as Level 1 are investments in money market funds, fixed income and equity mutual funds and equity securities. They are valued based on observable inputs, primarily unadjusted quoted prices in active markets for identical assets. Items classified as Level 2 are primarily investments in individual fixed income securities. Fixed income securities generally do not trade on exchanges and do not have an official closing price but their valuation inputs are based on observable market data. Pricing vendors calculate bond valuations using financial models and matrices. The models use observable inputs including yields on benchmark securities, quotes by securities brokers, rating agency actions, discounts or premiums on securities compared to par prices, changes in yields for U.S. Treasury securities, corporate actions by bond issuers, prepayment schedules and histories, economic events and, for certain securities, adjustments to yields to reflect changes in the rate of inflation. Other securities with model-derived valuation inputs that are observable are also classified as Level 2 investments. Investments with unobservable valuation inputs are classified as Level 3 investments. Investments classified as Other are valued using Net Asset Value as a practical expedient. Items classified as Other are primarily cash equivalent funds, common collective trusts, commingled funds, structured products, private equity, real estate, infrastructure and alternative credit investments. These investments do not have a readily determinable fair value or they contain redemption restrictions which may include the right to suspend redemptions under certain circumstances. Redemption restrictions may also prevent certain investments from being redeemed at the reporting date for the underlying value. +Deferred Fuel Costs (Applies to all Registrants except AEP Texas and AEPTCo) +The cost of fuel and related emission allowances and emission control chemicals/consumables is charged to Fuel and Other Consumables Used for Electric Generation expense when the fuel is burned or the allowance or consumable is utilized. The cost of fuel also includes the cost of nuclear fuel burned which is computed primarily using the units-of-production method. In regulated jurisdictions with an active FAC, fuel cost over-recoveries (the excess of fuel-related revenues over applicable fuel costs incurred) are generally deferred as current regulatory liabilities and under-recoveries (the excess of applicable fuel costs incurred over fuel-related revenues) are generally deferred as current regulatory assets. Fuel cost over-recovery and under-recovery balances are classified as noncurrent when there is a commission-approved plan to delay refunds or recoveries beyond a one year period. These deferrals are amortized when refunded or when billed to customers in later months with the state regulatory commissions’ review and approval. The amount of an over-recovery or under-recovery can also be affected by actions of the state regulatory commissions. On a routine basis, state regulatory commissions review and/or audit the Registrants’ fuel procurement policies and practices, the fuel cost calculations and FAC deferrals. FAC deferrals are adjusted when costs are no longer probable of recovery or when refunds of fuel reserves are probable. The Registrants share the majority of their Off-system Sales margins to customers either through an active FAC or other rate mechanisms. Where the FAC or Off-system Sales sharing mechanism is capped, frozen or non-existent, changes in fuel costs or sharing of off-system sales impact earnings. +236 +Revenue Recognition +Regulatory Accounting +The Registrants’ financial statements reflect the actions of regulators that can result in the recognition of revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses or alternative revenues recognized in accordance with the guidance for “Regulated Operations”) and regulatory liabilities (deferred revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and by matching revenue with its passage to customers in cost-based regulated rates. +When regulatory assets are probable of recovery through regulated rates, assets are recorded on the balance sheets. Regulatory assets are tested for probability of recovery at each balance sheet date or whenever new events occur. Examples of new events include the issuance of a regulatory commission order or passage of new legislation. If it is determined that recovery of a regulatory asset is no longer probable, the regulatory asset is derecognized as a charge against income. +Retail and Wholesale Supply and Delivery of Electricity +The Registrants recognize revenues from customers for retail and wholesale electricity sales and electricity transmission and distribution delivery services. The Registrants recognize such revenues on the statements of income as the performance obligations of delivering energy to customers are satisfied. Recognized revenues include both billed and unbilled amounts. In accordance with the applicable state commission’s regulatory treatment, PSO and SWEPCo do not include the fuel portion in unbilled revenue, but rather recognize such revenues when billed to customers. +Wholesale transmission revenue is based on FERC-approved formula rate filings made for each calendar year using estimated costs. Revenues initially recognized per the annual rate filing are compared to actual costs, resulting in the subsequent recognition of an over or under-recovered amount, with interest, that is refunded or recovered, respectively, in a future year’s rates. These annual true-ups meet the definition of alternative revenues in accordance with the accounting guidance for “Regulated Operations”, and are recognized by the Registrants in the second quarter of each calendar year following the filing of annual FERC reports. Any portion of the true-ups applicable to an affiliated company is recorded as Accounts Receivable - Affiliated Companies or Accounts Payable - Affiliated Companies on the balance sheets. Any portion of the true-ups applicable to third-parties is recorded as Regulatory Assets or Regulatory Liabilities on the balance sheets. See Note 19 - Revenue from Contracts with Customers for additional information. +Gross versus Net Presentation of Certain Electricity Supply and Delivery Activities +Most of the power produced at the generation plants is sold to PJM or SPP. The Registrants also purchase power from PJM and SPP to supply power to customers. Generally, these power sales and purchases are reported on a net basis as revenues on the statements of income. However, purchases of power in excess of sales to PJM or SPP, on an hourly net basis, used to serve retail load are recorded gross as Purchased Electricity for Resale on the statements of income. With the exception of certain dedicated load bilateral power supply contracts, the transactions of AEP’s nonregulated subsidiaries are reported as gross purchases or sales. +Physical energy purchases arising from non-derivative contracts are accounted for on a gross basis in Purchased Electricity for Resale on the statements of income. Energy purchases arising from non-trading derivative contracts are recorded based on the transaction’s facts and circumstances. Purchases under non-trading derivatives used to serve accrual based obligations are recorded in Purchased Electricity for Resale on the statements of income. All other non-trading derivative purchases are recorded net in revenues. +237 +In general, the Registrants record expenses when purchased electricity is received and when expenses are incurred, with the exception of certain power purchase contracts that are derivatives and accounted for using MTM accounting where generation/supply rates are not cost-based regulated. In jurisdictions where the generation/supply business is subject to cost-based regulation, the unrealized MTM amounts are deferred as regulatory assets (for losses) and regulatory liabilities (for gains). +Energy Marketing and Risk Management Activities (Applies to all Registrants except AEPTCo) +The Registrants engage in power, capacity and, to a lesser extent, natural gas marketing as major power producers and participants in electricity and natural gas markets. The Registrants also engage in power, capacity, coal, natural gas and, to a lesser extent, heating oil, gasoline and other commodity risk management activities focused on markets where the AEP System owns assets and on adjacent markets. These activities include the purchase-and-sale of energy under forward contracts at fixed and variable prices. These contracts include physical transactions, exchange-traded futures, and to a lesser extent, OTC swaps and options. Certain energy marketing and risk management transactions are with RTOs. +The Registrants recognize revenues from marketing and risk management transactions that are not derivatives as the performance obligation of delivering the commodity is satisfied. Expenses from marketing and risk management transactions that are not derivatives are also recognized upon delivery of the commodity. +The Registrants use MTM accounting for marketing and risk management transactions that are derivatives unless the derivative is designated in a qualifying cash flow hedge relationship or elected normal under the normal purchase normal sale election. The Registrants include realized gains and losses on marketing and risk management transactions in revenues or expense based on the transaction’s facts and circumstances. In certain jurisdictions subject to cost-based regulation, unrealized MTM amounts and some realized gains and losses are deferred as regulatory assets (for losses) and regulatory liabilities (for gains). Unrealized MTM gains and losses are included on the balance sheets as Risk Management Assets or Liabilities as appropriate. +Certain qualifying marketing and risk management derivatives transactions are designated as hedges of variability in future cash flows as a result of forecasted transactions (cash flow hedge). In the event the Registrants designate a cash flow hedge, the cash flow hedge’s gain or loss is initially recorded as a component of AOCI. When the forecasted transaction is realized and affects net income, the Registrants subsequently reclassify the gain or loss on the hedge from AOCI into revenues or expenses within the same financial statement line item as the forecasted transaction on their statements of income. See “Accounting for Cash Flow Hedging Strategies” section of Note 10 for additional information. +Levelization of Nuclear Refueling Outage Costs (Applies to AEP and I&M) +In accordance with regulatory orders, I&M defers incremental operation and maintenance costs associated with periodic refueling outages at its Cook Plant and amortizes the costs over approximately 18 months, beginning with the month following the start of each unit’s refueling outage and lasting until the end of the month in which the same unit’s next scheduled refueling outage begins. +Maintenance +The Registrants expense maintenance costs as incurred. If it becomes probable that the Registrants will recover specifically-incurred costs through future rates, a regulatory asset is established to match the expensing of those maintenance costs with their recovery in cost-based regulated revenues. In certain regulated jurisdictions, the Registrants defer costs above the level included in base rates and amortize those deferrals commensurate with recovery through rate riders. +238 +Income Taxes and Investment and Production Tax Credits +The Registrants use the liability method of accounting for income taxes. Under the liability method, deferred income taxes are provided for all temporary differences between the book and tax basis of assets and liabilities which will result in a future tax consequence. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to be recovered or settled. +When the flow-through method of accounting for temporary differences is required by a regulator to be reflected in regulated revenues (that is, when deferred taxes are not included in the cost-of-service for determining regulated rates for electricity), deferred income taxes are recorded and related regulatory assets and liabilities are established to match the regulated revenues and tax expense. +AEP and subsidiaries apply the deferral methodology for the recognition of ITCs. Deferred ITCs are amortized to income tax expense over the life of the asset that generated the credit. Amortization of deferred ITCs begins when the asset is placed in-service, except where regulatory commissions reflect ITCs in the rate-making process, then amortization begins when the cash tax benefit is recognized. Alternatively, PTCs reduce income tax expense as they are earned. PTCs are earned when electricity is produced. +The Registrants account for uncertain tax positions in accordance with the accounting guidance for “Income Taxes.” The Registrants classify interest expense or income related to uncertain tax positions as interest expense or income as appropriate and classify penalties as Other Operation expense on the statements of income. +Excise Taxes (Applies to all Registrants except AEPTCo) +As agents for some state and local governments, the Registrants collect from customers certain excise taxes levied by those state or local governments on customers. The Registrants do not record these taxes as revenue or expense. +Debt +Gains and losses from the reacquisition of debt used to finance regulated electric utility plants are deferred and amortized over the remaining term of the reacquired debt in accordance with their rate-making treatment unless the debt is refinanced. If the reacquired debt associated with the regulated business is refinanced, the reacquisition costs attributable to the portions of the business that are subject to cost-based regulatory accounting are generally deferred and amortized over the term of the replacement debt consistent with its recovery in rates. Operations not subject to cost-based rate regulation report gains and losses on the reacquisition of debt in Interest Expense on the statements of income upon reacquisition. +Debt discount or premium and debt issuance expenses are deferred and amortized generally utilizing the straight-line method over the term of the related debt. The straight-line method approximates the effective interest method and is consistent with the treatment in rates for regulated operations. The net amortization expense is included in Interest Expense on the statements of income. +Goodwill (Applies to AEP) +When AEP acquires a business, as defined by the accounting guidance for “Business Combinations,” management recognizes all acquired assets and liabilities at their fair value. To the extent that consideration exceeds the net fair value of the identified assets and liabilities, goodwill is recognized on the balance sheets. Goodwill is not amortized. Management tests acquired goodwill at the reporting unit level for impairment at least annually at its estimated fair value. Fair value is the amount at which an asset or liability could be bought or sold in a current transaction between willing parties other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are used as the basis for the measurement, if available. In the absence of quoted prices for identical or similar assets in active markets, management estimates fair value using various internal and external valuation methods. +239 +Pension and OPEB Plans (Applies to all Registrants except AEPTCo) +AEP sponsors a qualified pension plan and two unfunded non-qualified pension plans. Substantially all AEP employees are covered by the qualified plan or both the qualified and a non-qualified pension plan. AEP also sponsors OPEB plans to provide health and life insurance benefits for retired employees. The Registrant Subsidiaries account for their participation in the AEP sponsored pension and OPEB plans using multiple-employer accounting. See Note 8 - Benefit Plans for additional information including significant accounting policies associated with the plans. +Investments Held in Trust for Future Liabilities (Applies to all Registrants except AEPTCo) +AEP has several trust funds with significant investments intended to provide for future payments of pension and OPEB benefits, nuclear decommissioning and SNF disposal. All of the trust funds’ investments are diversified and managed in compliance with all laws and regulations. The investment strategy for the trust funds is to use a diversified portfolio of investments to achieve an acceptable rate of return while managing the investment risk of the assets relative to the associated liabilities. To minimize investment risk, the trust funds are broadly diversified among classes of assets, investment strategies and investment managers. Management regularly reviews the actual asset allocations and periodically rebalances the investments to targeted allocations when appropriate. Investment policies and guidelines allow investment managers in approved strategies to use financial derivatives to obtain or manage market exposures and to hedge assets and liabilities. The investments are reported at fair value under the “Fair Value Measurements and Disclosures” accounting guidance. +Benefit Plans +All benefit plan assets are invested in accordance with each plan’s investment policy. The investment policy outlines the investment objectives, strategies and target asset allocations by plan. +The investment philosophies for AEP’s benefit plans support the allocation of assets to minimize risks and optimize net returns. Strategies used include: +• Maintaining a long-term investment horizon. +• Diversifying assets to help control volatility of returns at acceptable levels. +• Managing fees, transaction costs and tax liabilities to maximize investment earnings. +• Using active management of investments where appropriate risk/return opportunities exist. +• Keeping portfolio structure style-neutral to limit volatility compared to applicable benchmarks. +• Using alternative asset classes such as real estate and private equity to maximize return and provide additional portfolio diversification. +The objective of the investment policy for the pension fund is to maintain the funded status of the plan while providing for growth in the plan assets to offset the growth in the plan liabilities. The current target asset allocations are as follows: +Pension Plan Assets Target +Equity 25 % +Fixed Income 59 % +Other Investments 15 % +Cash and Cash Equivalents 1 % +OPEB Plans Assets Target +Equity 49 % +Fixed Income 49 % +Cash and Cash Equivalents 2 % +240 +The investment policy for each benefit plan contains various investment limitations. The investment policies establish concentration limits for securities and prohibit the purchase of securities issued by AEP (with the exception of proportionate and immaterial holdings of AEP securities in passive index strategies or certain commingled funds). However, the investment policies do not preclude the benefit trust funds from receiving contributions in the form of AEP securities, provided that the AEP securities acquired by each plan may not exceed the limitations imposed by law. +For equity investments, the concentration limits are generally as follows: +• No security in excess of 5% of all equities. +• Cash equivalents must be less than 10% of an investment manager’s equity portfolio. +• No individual stock may be more than 10% and 7% for pension and OPEB investments, respectively, of each manager’s equity portfolio. +• No securities may be bought or sold on margin or other use of leverage. +For fixed income investments, each investment manager’s portfolio is compared to investment grade, diversified long and intermediate benchmark indices. +A portion of the pension assets is invested in real estate funds to provide diversification, add return and hedge against inflation. Real estate properties are illiquid, difficult to value and not actively traded. The pension plan uses external real estate investment managers to invest in commingled funds that hold real estate properties. To mitigate investment risk in the real estate portfolio, commingled real estate funds are used to ensure that holdings are diversified by region, property type and risk classification. Real estate holdings include core, value-added and opportunistic classifications. +A portion of the pension assets is invested in private equity. Private equity investments add return and provide diversification and typically require a long-term time horizon to evaluate investment performance. Private equity is classified as an alternative investment because it is illiquid, difficult to value and not actively traded. The pension plan uses limited partnerships to invest across the private equity investment spectrum. The private equity holdings are with multiple general partners who help monitor the investments and provide investment selection expertise. The holdings are currently comprised of venture capital, buyout and hybrid debt and equity investments. +AEP participates in a securities lending program with BNY Mellon to provide incremental income on idle assets and to provide income to offset custody fees and other administrative expenses. AEP lends securities to borrowers approved by BNY Mellon in exchange for collateral. All loans are collateralized by at least 102% of the loaned asset’s market value and the collateral is invested. The difference between the rebate owed to the borrower and the collateral rate of return determines the earnings on the loaned security. The securities lending program’s objective is to provide modest incremental income with a limited increase in risk. As of December 31, 2020 and 2019, the fair value of securities on loan as part of the program was $ 177 million and $ 246 million, respectively. Cash and securities obtained as collateral exceeded the fair value of the securities loaned as of December 31, 2020 and 2019. +Trust owned life insurance (TOLI) underwritten by The Prudential Insurance Company is held in the OPEB plan trusts. The strategy for holding life insurance contracts in the taxable Voluntary Employees’ Beneficiary Association trust is to minimize taxes paid on the asset growth in the trust. Earnings on plan assets are tax-deferred within the TOLI contract and can be tax-free if held until claims are paid. Life insurance proceeds remain in the trust and are used to fund future retiree medical benefit liabilities. With consideration to other investments held in the trust, the cash value of the TOLI contracts is invested in two diversified funds. A portion is invested in a commingled fund with underlying investments in stocks that are actively traded on major international equity exchanges. The other portion of the TOLI cash value is invested in a diversified, commingled fixed income fund with underlying investments in government bonds, corporate bonds and asset-backed securities. +241 +Cash and cash equivalents are held in each trust to provide liquidity and meet short-term cash needs. Cash equivalent funds are used to provide diversification and preserve principal. The underlying holdings in the cash funds are investment grade money market instruments including commercial paper, certificates of deposit, treasury bills and other types of investment grade short-term debt securities. The cash funds are valued each business day and provide daily liquidity. +Nuclear Trust Funds (Applies to AEP and I&M) +Nuclear decommissioning and SNF trust funds represent funds that regulatory commissions allow I&M to collect through rates to fund future decommissioning and SNF disposal liabilities. By rules or orders, the IURC, the MPSC and the FERC established investment limitations and general risk management guidelines. In general, limitations include: +• Acceptable investments (rated investment grade or above when purchased). +• Maximum percentage invested in a specific type of investment. +• Prohibition of investment in obligations of AEP, I&M or their affiliates. +• Withdrawals permitted only for payment of decommissioning costs and trust expenses. +I&M maintains trust funds for each regulatory jurisdiction. Regulatory approval is required to withdraw decommissioning funds. These funds are managed by an external investment manager that must comply with the guidelines and rules of the applicable regulatory authorities. The trust assets are invested to optimize the net of tax earnings of the trust giving consideration to liquidity, risk, diversification and other prudent investment objectives. +I&M records securities held in these trust funds in Spent Nuclear Fuel and Decommissioning Trusts on its balance sheets. I&M records these securities at fair value. I&M classifies debt securities in the trust funds as available-for-sale due to their long-term purpose. +Other-than-temporary impairments for investments in debt securities are considered realized losses as a result of securities being managed by an external investment management firm. The external investment management firm makes specific investment decisions regarding the debt and equity investments held in these trusts and generally intends to sell debt securities in an unrealized loss position as part of a tax optimization strategy. Impairments reduce the cost basis of the securities which will affect any future unrealized gain or realized gain or loss due to the adjusted cost of investment. I&M records unrealized gains, unrealized losses and other-than-temporary impairments from securities in these trust funds as adjustments to the regulatory liability account for the nuclear decommissioning trust funds and to regulatory assets or liabilities for the SNF disposal trust funds in accordance with their treatment in rates. Consequently, changes in fair value of trust assets do not affect earnings or AOCI. See the “Nuclear Contingencies” section of Note 6 for additional discussion of nuclear matters. See “Fair Value Measurements of Trust Assets for Decommissioning and SNF Disposal” section of Note 11 for disclosure of the fair value of assets within the trusts. +Comprehensive Income (Loss) (Applies to all Registrants except AEPTCo) +Comprehensive income (loss) is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income (loss) has two components: net income (loss) and other comprehensive income (loss). +Stock-Based Compensation Plans +As of December 31, 2020, AEP had performance shares and restricted stock units outstanding under the American Electric Power System 2015 Long-Term Incentive Plan (2015 LTIP). Upon vesting, all outstanding performance shares and restricted stock units settle in AEP common stock. Performance units awarded prior to 2017 and restricted stock units granted after January 1, 2013 and prior to January 1, 2017 that vested to executive officers +242 +were settled in cash. During 2019, all of the remaining performance units and restricted stock units that settle in cash were settled. The impact of AEP’s stock-based compensation plans are insignificant to the financial statements of the Registrant Subsidiaries. +AEP maintains a variety of tax qualified and non-qualified deferred compensation plans for employees and non-employee directors that include, among other options, an investment in or an investment return equivalent to that of AEP common stock. This includes AEP career shares maintained under the American Electric Power System Stock Ownership Requirement Plan (SORP), which facilitates executives in meeting minimum stock ownership requirements assigned to them by the Human Resources Committee of the Board of Directors. AEP career shares are derived from vested performance shares granted to employees under the 2015 LTIP. AEP career shares accrue additional dividend shares in an amount equal to dividends paid on AEP common shares at the closing market price on the dividend payments date. All AEP career shares are settled in shares of AEP common stock after the executive’s service with AEP ends. +Performance shares awarded after January 1, 2017 are classified as temporary equity in the Mezzanine Equity section of the balance sheets until the awards vest. Upon vesting, the performance shares are classified as permanent equity. These awards may be settled in cash upon an employee’s qualifying termination due to a change in control. Because such event is not solely within the control of the company, these awards are classified outside of permanent equity until the awards vest. +AEP compensates their non-employee directors, in part, with stock units under the American Electric Power Company, Inc. Stock Unit Accumulation Plan for Non-Employee Directors. These stock units become payable in cash to directors after their service ends. +Management measures and recognizes compensation expense for all share-based payment awards to employees and directors based on estimated fair values. For share-based payment awards with service only vesting conditions, management recognizes compensation expense on a straight-line basis. Stock-based compensation expense recognized on the statements of income for the years ended December 31, 2020, 2019 and 2018 is based on the number of outstanding awards at the end of each period without a reduction for estimated forfeitures. AEP accounts for forfeitures in the period in which they occur. +For the years ended December 31, 2020, 2019 and 2018, compensation cost is included in Net Income for the performance shares, career shares, restricted stock units and the non-employee director’s stock units. Compensation cost may also be capitalized. See Note 15 - Stock-based Compensation for additional information. +Equity Investment in Unconsolidated Entities (Applies to AEP and SWEPCo) +The equity method of accounting is used for equity investments where either AEP or SWEPCo exercise significant influence but do not hold a controlling financial interest. Such investments are initially recorded at cost in Deferred Charges and Other Noncurrent Assets on the balance sheets. The proportionate share of the investee’s equity earnings or losses is included in Equity Earnings (Loss) of Unconsolidated Subsidiaries on the statements of income. AEP and SWEPCo regularly monitor and evaluate equity method investments to determine whether they are impaired. An impairment is recorded when the investment has experienced a decline in value that is other-than-temporary in nature. +AEP has various significant equity method investments, which include ETT, DHLC and five wind farms acquired in the purchase of Sempra Renewables LLC. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. +243 +COVID-19 +In March 2020, COVID-19 was declared a pandemic by the World Health Organization and the Centers for Disease Control and Prevention. Its rapid spread around the world and throughout the United States prompted many countries, including the United States, to institute restrictions on travel, public gatherings and certain business operations. These restrictions significantly disrupted economic activity in AEP’s service territory and reduced demand for energy, particularly from commercial and industrial customers in 2020. The Registrants have taken steps to mitigate the potential risks to customers, suppliers and employees posed by the spread of COVID-19. +As of December 31, 2020 and through the date of this report, the Registrants assessed certain accounting matters that require consideration of forecasted financial information, including, but not limited to, the allowance for credit losses and the carrying value of long-lived assets. While there were not any impairments or significant increases in credit allowances resulting from these assessments for the year ended December 31, 2020, the ultimate impact of COVID-19 also depends on factors beyond management’s knowledge or control, including the duration and severity of this outbreak as well as third-party actions taken to contain its spread and mitigate its public health effects. Therefore, management cannot estimate the potential future impact to financial position, results of operations and cash flows, but the impacts could be material. +Voluntary Retirement Incentive Program +In June 2020, AEP announced a voluntary retirement incentive program. Eligible employees volunteered for retirement from the date of the announcement through July 6, 2020, with most having an effective retirement date of August 1, 2020. Participating employees were eligible to receive up to six months base pay and a medical premium subsidy. Certain participating employees were also eligible to receive a long-term incentive plan grant, with immediate vesting, of AEP common shares. A total of 200 employees participated in the voluntary retirement program. In August 2020, AEP recorded a charge to expense of $ 13 million primarily related to lump sum salary payments and cash subsidies. AEP also recorded a charge to expense of $ 5 million related to the incremental Long-Term Incentive Plan grants issued related to this initiative. Approximately 92 % of the expense was initially recorded within the AEPSC and then allocated among affiliated entities including the Registrant Subsidiaries. The impact of this program was immaterial on the Registrants’ financial statements as of December 31, 2020. +Earnings Per Share (EPS) (Applies to AEP) +Basic EPS is calculated by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted EPS is calculated by adjusting the weighted-average outstanding common shares, assuming conversion of all potentially dilutive stock options and awards. +The following table presents AEP’s basic and diluted EPS calculations included on the statements of income: +Years Ended December 31, +2020 2019 2018 +(in millions, except per-share data) +$/share $/share $/share +Earnings Attributable to AEP Common Shareholders +$ 2,200.1 $ 1,921.1 $ 1,923.8 +Weighted-Average Number of Basic AEP Common Shares Outstanding 495.7 $ 4.44 493.7 $ 3.89 492.8 $ 3.90 +Weighted-Average Dilutive Effect of Stock-Based Awards 1.5 ( 0.02 ) 1.6 ( 0.01 ) 1.0 — +Weighted-Average Number of Diluted AEP Common Shares Outstanding 497.2 $ 4.42 495.3 $ 3.88 493.8 $ 3.90 +244 +Equity Units are potentially dilutive securities but were excluded from the calculation of diluted EPS for the years ended December 31, 2020 and 2019, as the dilutive stock price thresholds were not met. See Note 14 - Financing Activities for additional information related to Equity Units. +There were 128 thousand antidilutive shares outstanding as of December 31, 2020. There were no antidilutive shares outstanding as of December 31, 2019 and 2018. +Reclassifications +Certain reclassifications have been made in the 2019 financial statements and notes to conform to the 2020 presentation. +Supplementary Income Statement Information +The following tables provide the components of Depreciation and Amortization for the years ended December 31, 2020, 2019 and 2018: +2020 +Depreciation and Amortization AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Depreciation and Amortization of Property, Plant and Equipment +$ 2,487.5 $ 364.2 $ 249.0 $ 507.8 $ 393.3 $ 275.0 $ 171.9 $ 271.2 +Amortization of Certain Securitized Assets +171.3 171.3 — — — — — — +Amortization of Regulatory Assets and Liabilities +24.0 ( 5.7 ) — ( 0.3 ) 18.3 1.6 1.6 1.5 +Total Depreciation and Amortization +$ 2,682.8 $ 529.8 $ 249.0 $ 507.5 $ 411.6 $ 276.6 $ 173.5 $ 272.7 +2019 +Depreciation and Amortization AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Depreciation and Amortization of Property, Plant and Equipment +$ 2,203.7 $ 365.9 $ 176.0 $ 466.5 $ 330.6 $ 229.4 $ 162.5 $ 247.9 +Amortization of Certain Securitized Assets +280.7 258.7 — — — 22.0 — — +Amortization of Regulatory Assets and Liabilities +30.1 ( 2.3 ) — 0.3 20.0 ( 10.5 ) 7.0 1.2 +Total Depreciation and Amortization +$ 2,514.5 $ 622.3 $ 176.0 $ 466.8 $ 350.6 $ 240.9 $ 169.5 $ 249.1 +2018 +Depreciation and Amortization AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Depreciation and Amortization of Property, Plant and Equipment +$ 1,965.0 $ 262.2 $ 133.9 $ 428.1 $ 278.9 $ 232.6 $ 155.5 $ 237.0 +Amortization of Certain Securitized Assets +287.9 240.0 — — — 47.9 — — +Amortization of Regulatory Assets and Liabilities +33.7 ( 2.6 ) — 0.3 14.2 ( 20.8 ) 8.5 2.5 +Total Depreciation and Amortization +$ 2,286.6 $ 499.6 $ 133.9 $ 428.4 $ 293.1 $ 259.7 $ 164.0 $ 239.5 +245 +Supplementary Cash Flow Information (Applies to AEP) +Years Ended December 31, +Cash Flow Information 2020 2019 2018 +(in millions) +Cash Paid (Received) for: +Interest, Net of Capitalized Amounts $ 1,029.1 $ 1,022.5 $ 939.3 +Income Taxes ( 49.1 ) 6.1 ( 24.7 ) +Noncash Investing and Financing Activities: +Acquisitions Under Finance Leases 44.2 87.5 55.6 +Construction Expenditures Included in Current Liabilities as of December 31, +975.4 1,341.1 1,120.4 +Construction Expenditures Included in Noncurrent Liabilities as of December 31, +5.5 — — +Acquisition of Nuclear Fuel Included in Current Liabilities as of December 31, +33.4 0.1 4.0 +Noncash Contribution of Assets by Noncontrolling Interest — — 84.0 +Expected Reimbursement for Spent Nuclear Fuel Dry Cask Storage +2.6 0.3 2.2 +Noncontrolling Interest Assumed with Sempra Renewables LLC and Santa Rita East Acquisition +— 253.4 — +Liabilities Assumed with Sempra Renewable LLC and Santa Rita East Acquisition +— 32.4 — +Forward Equity Purchase Contracts Included in Current and Noncurrent Liabilities as of December 31, 110.6 47.3 — +246 +2. NEW ACCOUNTING STANDARDS +The disclosures in this note apply to all Registrants unless indicated otherwise. +During the FASB’s standard-setting process and upon issuance of final standards, management reviews the new accounting literature to determine its relevance, if any, to the Registrants’ business. The following standards will impact the financial statements. +ASU 2016-13 “Measurement of Credit Losses on Financial Instruments” (ASU 2016-13) +In June 2016, the FASB issued ASU 2016-13 requiring the recognition of an allowance for expected credit losses for financial instruments within its scope. Examples of financial instruments that are in scope include trade receivables, certain financial guarantees and held-to-maturity debt securities. The allowance for expected credit losses should be based on historical information, current conditions and reasonable and supportable forecasts. Entities are required to evaluate, and if necessary, recognize expected credit losses at the inception or initial acquisition of a financial instrument (or pool of financial instruments that share similar risk characteristics) subject to ASU 2016-13, and subsequently as of each reporting date. The new standard also revises the other-than-temporary impairment model for available-for-sale debt securities. +New standard implementation activities included: (a) the identification and evaluation of the population of financial instruments within the AEP system that are subject to the new standard, (b) the development of supporting valuation models to also contemplate appropriate metrics for current and supportable forecasted information and (c) the development of disclosures to comply with the requirements of ASU 2016-13. As required by ASU 2016-13, the financial instruments subject to the new standard were evaluated on a pool-basis to the extent such financial instruments shared similar risk characteristics. +Management adopted ASU 2016-13 and its related implementation guidance effective January 1, 2020, by means of an immaterial cumulative-effect adjustment to Retained Earnings on the balance sheets. The adoption of the new standard did not have a material impact to financial position and had no impact on the results of operations or cash flows. Additionally, the adoption of the new standard did not result in any changes to current accounting systems. +ASU 2020-04 “Reference Rate Reform: Facilitation of the Effects of Reference Rate Reform on Financial Reporting” (ASU 2020-04) +In March 2020, the FASB issued ASU 2020-04 providing guidance to ease the potential burden in accounting for Reference Rate Reform on financial reporting. The new standard is elective and applies to all entities, subject to meeting certain criteria, that have contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued because of Reference Rate Reform. The new standard establishes a general contract modification principle that entities can apply in other areas that may be affected by Reference Rate Reform and certain elective hedge accounting expedients. Under the new standard, an entity may make a one-time election to sell or to transfer to the available-for-sale or trading classifications (or both sell and transfer), debt securities that both reference an affected rate, and were classified as held-to-maturity before January 1, 2020. +Management adopted ASU 2020-04 and its related implementation guidance effective January 1, 2021. There was no impact to results of operations, financial position or cash flows upon initial adoption. Management is applying the accounting guidance as relevant contract and hedge accounting relationship modifications are made during the course of the reference rate reform transition period, which ends on December 31, 2022. The guidance generally allows for contract modifications solely related to the replacement of the reference rate to be accounted for as a continuation of the existing contract instead of as an extinguishment of the contract, and would therefore, not trigger certain accounting impacts that would otherwise be required. It also allows entities to change certain critical terms of existing hedge accounting relationships that are affected by reference rate reform. These changes would not require de-designating the hedge accounting relationship. +247 +3. COMPREHENSIVE INCOME +The disclosures in this note apply to all Registrants except for AEPTCo. AEPTCo does not have any components of other comprehensive income for any period presented in the financial statements. +Presentation of Comprehensive Income +The following tables provide the components of changes in AOCI and details of reclassifications from AOCI for the years ended December 31, 2020, 2019 and 2018. The amortization of pension and OPEB AOCI components are included in the computation of net periodic pension and OPEB costs. See Note 8 - Benefit Plans for additional information. +AEP +Cash Flow Hedges Pension and OPEB +For the Year Ended December 31, 2020 Commodity Interest Rate Amortization of Deferred Costs Changes in Funded Status Total +(in millions) +Balance in AOCI as of December 31, 2019 $ ( 103.5 ) $ ( 11.5 ) $ 130.7 $ ( 163.4 ) $ ( 147.7 ) +Change in Fair Value Recognized in AOCI ( 89.2 ) ( 39.9 ) (a) — 62.7 ( 66.4 ) +Amount of (Gain) Loss Reclassified from AOCI +Generation & Marketing Revenues (b) +( 0.4 ) — — — ( 0.4 ) +Purchased Electricity for Resale (b) +167.6 — — — 167.6 +Interest Expense (b) +— 4.9 — — 4.9 +Amortization of Prior Service Cost (Credit) +— — ( 19.2 ) — ( 19.2 ) +Amortization of Actuarial (Gains) Losses +— — 10.3 — 10.3 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +167.2 4.9 ( 8.9 ) — 163.2 +Income Tax (Expense) Benefit +35.1 1.0 ( 1.9 ) — 34.2 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +132.1 3.9 ( 7.0 ) — 129.0 +Net Current Period Other Comprehensive Income (Loss) +42.9 ( 36.0 ) ( 7.0 ) 62.7 62.6 +Balance in AOCI as of December 31, 2020 $ ( 60.6 ) $ ( 47.5 ) $ 123.7 $ ( 100.7 ) $ ( 85.1 ) +248 +AEP +Cash Flow Hedges Pension and OPEB +For the Year Ended December 31, 2019 Commodity Interest Rate Amortization of Deferred Costs Changes in Funded Status Total +(in millions) +Balance in AOCI as of December 31, 2018 $ ( 23.0 ) $ ( 12.6 ) $ 136.3 $ ( 221.1 ) $ ( 120.4 ) +Change in Fair Value Recognized in AOCI ( 127.2 ) ( 0.2 ) (a) — 57.7 ( 69.7 ) +Amount of (Gain) Loss Reclassified from AOCI +Generation & Marketing Revenues (b) +( 0.2 ) — — — ( 0.2 ) +Purchased Electricity for Resale (b) +59.5 — — — 59.5 +Interest Expense (b) +— 1.5 — — 1.5 +Amortization of Prior Service Cost (Credit) +— — ( 19.2 ) — ( 19.2 ) +Amortization of Actuarial (Gains) Losses +— — 12.1 — 12.1 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +59.3 1.5 ( 7.1 ) — 53.7 +Income Tax (Expense) Benefit +12.6 0.2 ( 1.5 ) — 11.3 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +46.7 1.3 ( 5.6 ) — 42.4 +Net Current Period Other Comprehensive Income (Loss) +( 80.5 ) 1.1 ( 5.6 ) 57.7 ( 27.3 ) +Balance in AOCI as of December 31, 2019 $ ( 103.5 ) $ ( 11.5 ) $ 130.7 $ ( 163.4 ) $ ( 147.7 ) +Cash Flow Hedges Pension and OPEB +For the Year Ended December 31, 2018 Commodity Interest Rate Securities +Available for Sale Amortization of Deferred Costs Changes in Funded Status Total +(in millions) +Balance in AOCI as of December 31, 2017 $ ( 28.4 ) $ ( 13.0 ) $ 11.9 $ 141.6 $ ( 179.9 ) $ ( 67.8 ) +Change in Fair Value Recognized in AOCI 37.3 2.3 — — ( 33.0 ) 6.6 +Amount of (Gain) Loss Reclassified from AOCI +Generation & Marketing Revenues (b) +( 0.1 ) — — — — ( 0.1 ) +Purchased Electricity for Resale (b) +( 32.6 ) — — — — ( 32.6 ) +Interest Expense (b) +— 1.1 — — — 1.1 +Amortization of Prior Service Cost (Credit) +— — — ( 19.5 ) — ( 19.5 ) +Amortization of Actuarial (Gains) Losses +— — — 12.8 — 12.8 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 32.7 ) 1.1 — ( 6.7 ) — ( 38.3 ) +Income Tax (Expense) Benefit +( 6.9 ) 0.3 — ( 1.4 ) — ( 8.0 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 25.8 ) 0.8 — ( 5.3 ) — ( 30.3 ) +Net Current Period Other Comprehensive Income (Loss) +11.5 3.1 — ( 5.3 ) ( 33.0 ) ( 23.7 ) +ASU 2018-02 Adoption ( 6.1 ) ( 2.7 ) — — ( 8.2 ) ( 17.0 ) +ASU 2016-01 Adoption — — ( 11.9 ) — — ( 11.9 ) +Balance in AOCI as of December 31, 2018 $ ( 23.0 ) $ ( 12.6 ) $ — $ 136.3 $ ( 221.1 ) $ ( 120.4 ) +249 +AEP Texas +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2020 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2019 $ ( 3.4 ) $ 4.9 $ ( 14.3 ) $ ( 12.8 ) +Change in Fair Value Recognized in AOCI +0.1 — 2.6 2.7 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +1.3 — — 1.3 +Amortization of Prior Service Cost (Credit) +— ( 0.1 ) — ( 0.1 ) +Amortization of Actuarial (Gains) Losses +— 0.3 — 0.3 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +1.3 0.2 — 1.5 +Income Tax (Expense) Benefit +0.3 — — 0.3 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.0 0.2 — 1.2 +Net Current Period Other Comprehensive Income (Loss) 1.1 0.2 2.6 3.9 +Balance in AOCI as of December 31, 2020 $ ( 2.3 ) $ 5.1 $ ( 11.7 ) $ ( 8.9 ) +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2019 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2018 $ ( 4.4 ) $ 4.7 $ ( 15.4 ) $ ( 15.1 ) +Change in Fair Value Recognized in AOCI +— — 1.1 1.1 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +1.3 — — 1.3 +Amortization of Prior Service Cost (Credit) +— ( 0.1 ) — ( 0.1 ) +Amortization of Actuarial (Gains) Losses +— 0.3 — 0.3 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +1.3 0.2 — 1.5 +Income Tax (Expense) Benefit +0.3 — — 0.3 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.0 0.2 — 1.2 +Net Current Period Other Comprehensive Income (Loss) 1.0 0.2 1.1 2.3 +ASU 2018-02 Adoption — — — — +Balance in AOCI as of December 31, 2019 $ ( 3.4 ) $ 4.9 $ ( 14.3 ) $ ( 12.8 ) +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2018 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2017 $ ( 4.5 ) $ 4.5 $ ( 12.6 ) $ ( 12.6 ) +Change in Fair Value Recognized in AOCI +— — ( 1.0 ) ( 1.0 ) +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +1.3 — — 1.3 +Amortization of Prior Service Cost (Credit) +— ( 0.1 ) — ( 0.1 ) +Amortization of Actuarial (Gains) Losses +— 0.4 — 0.4 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +1.3 0.3 — 1.6 +Income Tax (Expense) Benefit +0.3 0.1 — 0.4 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.0 0.2 — 1.2 +Net Current Period Other Comprehensive Income (Loss) 1.0 0.2 ( 1.0 ) 0.2 +ASU 2018-02 Adoption ( 0.9 ) — ( 1.8 ) ( 2.7 ) +Balance in AOCI as of December 31, 2018 $ ( 4.4 ) $ 4.7 $ ( 15.4 ) $ ( 15.1 ) +250 +APCo +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2020 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2019 $ 0.9 $ 9.2 $ ( 5.1 ) $ 5.0 +Change in Fair Value Recognized in AOCI +( 0.7 ) — 7.7 7.0 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.3 ) — — ( 1.3 ) +Amortization of Prior Service Cost (Credit) +— ( 5.3 ) — ( 5.3 ) +Amortization of Actuarial (Gains) Losses +— 0.5 — 0.5 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.3 ) ( 4.8 ) — ( 6.1 ) +Income Tax (Expense) Benefit +( 0.3 ) ( 1.0 ) — ( 1.3 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 1.0 ) ( 3.8 ) — ( 4.8 ) +Net Current Period Other Comprehensive Income (Loss) ( 1.7 ) ( 3.8 ) 7.7 2.2 +Balance in AOCI as of December 31, 2020 $ ( 0.8 ) $ 5.4 $ 2.6 $ 7.2 +Pension and OPEB +Amortization Changes in +Cash Flow Hedges - of Deferred Funded +For the Year Ended December 31, 2019 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2018 $ 1.8 $ 11.7 $ ( 18.5 ) $ ( 5.0 ) +Change in Fair Value Recognized in AOCI +— — 13.4 13.4 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.1 ) — — ( 1.1 ) +Amortization of Prior Service Cost (Credit) +— ( 5.3 ) — ( 5.3 ) +Amortization of Actuarial (Gains) Losses +— 2.1 — 2.1 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.1 ) ( 3.2 ) — ( 4.3 ) +Income Tax (Expense) Benefit +( 0.2 ) ( 0.7 ) — ( 0.9 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 0.9 ) ( 2.5 ) — ( 3.4 ) +Net Current Period Other Comprehensive Income (Loss) ( 0.9 ) ( 2.5 ) 13.4 10.0 +Balance in AOCI as of December 31, 2019 $ 0.9 $ 9.2 $ ( 5.1 ) $ 5.0 +Pension and OPEB +Amortization Changes in +Cash Flow Hedges of Deferred Funded +For the Year Ended December 31, 2018 Commodity Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2017 $ — $ 2.2 $ 14.8 $ ( 15.7 ) $ 1.3 +Change in Fair Value Recognized in AOCI +( 0.7 ) — — ( 2.6 ) ( 3.3 ) +Amount of (Gain) Loss Reclassified from AOCI +Purchased Electricity for Resale (b) 0.9 — — — 0.9 +Interest Expense (b) +— ( 1.1 ) — — ( 1.1 ) +Amortization of Prior Service Cost (Credit) +— — ( 5.2 ) — ( 5.2 ) +Amortization of Actuarial (Gains) Losses +— — 1.3 — 1.3 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +0.9 ( 1.1 ) ( 3.9 ) — ( 4.1 ) +Income Tax (Expense) Benefit +0.2 ( 0.2 ) ( 0.8 ) — ( 0.8 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +0.7 ( 0.9 ) ( 3.1 ) — ( 3.3 ) +Net Current Period Other Comprehensive Income (Loss) — ( 0.9 ) ( 3.1 ) ( 2.6 ) ( 6.6 ) +ASU 2018-02 Adoption — 0.5 — ( 0.2 ) 0.3 +Balance in AOCI as of December 31, 2018 $ — $ 1.8 $ 11.7 $ ( 18.5 ) $ ( 5.0 ) +251 +I&M +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2020 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2019 $ ( 9.9 ) $ 4.9 $ ( 6.6 ) $ ( 11.6 ) +Change in Fair Value Recognized in AOCI +— — 3.1 3.1 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +2.0 — — 2.0 +Amortization of Prior Service Cost (Credit) +— ( 0.8 ) — ( 0.8 ) +Amortization of Actuarial (Gains) Losses +— 0.7 — 0.7 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +2.0 ( 0.1 ) — 1.9 +Income Tax (Expense) Benefit +0.4 — — 0.4 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.6 ( 0.1 ) — 1.5 +Net Current Period Other Comprehensive Income (Loss) 1.6 ( 0.1 ) 3.1 4.6 +Balance in AOCI as of December 31, 2020 $ ( 8.3 ) $ 4.8 $ ( 3.5 ) $ ( 7.0 ) +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2019 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2018 $ ( 11.5 ) $ 5.1 $ ( 7.4 ) $ ( 13.8 ) +Change in Fair Value Recognized in AOCI +— — 0.8 0.8 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +2.0 — — 2.0 +Amortization of Prior Service Cost (Credit) +— ( 0.8 ) — ( 0.8 ) +Amortization of Actuarial (Gains) Losses +— 0.6 — 0.6 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +2.0 ( 0.2 ) — 1.8 +Income Tax (Expense) Benefit +0.4 — — 0.4 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.6 ( 0.2 ) — 1.4 +Net Current Period Other Comprehensive Income (Loss) 1.6 ( 0.2 ) 0.8 2.2 +Balance in AOCI as of December 31, 2019 $ ( 9.9 ) $ 4.9 $ ( 6.6 ) $ ( 11.6 ) +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2018 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2017 $ ( 10.7 ) $ 5.1 $ ( 6.5 ) $ ( 12.1 ) +Change in Fair Value Recognized in AOCI +— — ( 0.6 ) ( 0.6 ) +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +2.0 — — 2.0 +Amortization of Prior Service Cost (Credit) +— ( 0.8 ) — ( 0.8 ) +Amortization of Actuarial (Gains) Losses +— 0.8 — 0.8 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +2.0 — — 2.0 +Income Tax (Expense) Benefit +0.4 — — 0.4 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.6 — — 1.6 +Net Current Period Other Comprehensive Income (Loss) 1.6 — ( 0.6 ) 1.0 +ASU 2018-02 Adoption ( 2.4 ) — ( 0.3 ) ( 2.7 ) +Balance in AOCI as of December 31, 2018 $ ( 11.5 ) $ 5.1 $ ( 7.4 ) $ ( 13.8 ) +252 +OPCo +Cash Flow Hedge – +For the Year Ended December 31, 2020 Interest Rate +(in millions) +Balance in AOCI as of December 31, 2019 $ — +Change in Fair Value Recognized in AOCI +— +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +— +Reclassifications from AOCI, before Income Tax (Expense) Benefit +— +Income Tax (Expense) Benefit +— +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +— +Net Current Period Other Comprehensive Income (Loss) — +Balance in AOCI as of December 31, 2020 $ — +Cash Flow Hedge – +For the Year Ended December 31, 2019 Interest Rate +(in millions) +Balance in AOCI as of December 31, 2018 $ 1.0 +Change in Fair Value Recognized in AOCI +— +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.3 ) +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.3 ) +Income Tax (Expense) Benefit +( 0.3 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 1.0 ) +Net Current Period Other Comprehensive Income (Loss) ( 1.0 ) +Balance in AOCI as of December 31, 2019 $ — +Cash Flow Hedge – +For the Year Ended December 31, 2018 Interest Rate +(in millions) +Balance in AOCI as of December 31, 2017 $ 1.9 +Change in Fair Value Recognized in AOCI +— +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.7 ) +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.7 ) +Income Tax (Expense) Benefit +( 0.4 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 1.3 ) +Net Current Period Other Comprehensive Income (Loss) ( 1.3 ) +ASU 2018-02 Adoption 0.4 +Balance in AOCI as of December 31, 2018 $ 1.0 +253 +PSO +Cash Flow Hedge – +For the Year Ended December 31, 2020 Interest Rate +(in millions) +Balance in AOCI as of December 31, 2019 $ 1.1 +Change in Fair Value Recognized in AOCI +— +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.3 ) +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.3 ) +Income Tax (Expense) Benefit +( 0.3 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 1.0 ) +Net Current Period Other Comprehensive Income (Loss) ( 1.0 ) +Balance in AOCI as of December 31, 2020 $ 0.1 +Cash Flow Hedge – +For the Year Ended December 31, 2019 Interest Rate +(in millions) +Balance in AOCI as of December 31, 2018 $ 2.1 +Change in Fair Value Recognized in AOCI +— +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.3 ) +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.3 ) +Income Tax (Expense) Benefit +( 0.3 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 1.0 ) +Net Current Period Other Comprehensive Income (Loss) ( 1.0 ) +Balance in AOCI as of December 31, 2019 $ 1.1 +Cash Flow Hedge – +For the Year Ended December 31, 2018 Interest Rate +(in millions) +Balance in AOCI as of December 31, 2017 $ 2.6 +Change in Fair Value Recognized in AOCI +— +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +( 1.3 ) +Reclassifications from AOCI, before Income Tax (Expense) Benefit +( 1.3 ) +Income Tax (Expense) Benefit +( 0.3 ) +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +( 1.0 ) +Net Current Period Other Comprehensive Income (Loss) ( 1.0 ) +ASU 2018-02 Adoption 0.5 +Balance in AOCI as of December 31, 2018 $ 2.1 +254 +SWEPCo +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2020 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2019 $ ( 1.8 ) $ ( 1.3 ) $ 1.8 $ ( 1.3 ) +Change in Fair Value Recognized in AOCI +— — 3.2 3.2 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +1.9 — — 1.9 +Amortization of Prior Service Cost (Credit) +— ( 2.0 ) — ( 2.0 ) +Amortization of Actuarial (Gains) Losses +— 0.1 — 0.1 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +1.9 ( 1.9 ) — — +Income Tax (Expense) Benefit +0.4 ( 0.4 ) — — +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.5 ( 1.5 ) — — +Net Current Period Other Comprehensive Income (Loss) 1.5 ( 1.5 ) 3.2 3.2 +Balance in AOCI as of December 31, 2020 $ ( 0.3 ) $ ( 2.8 ) $ 5.0 $ 1.9 +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2019 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2018 $ ( 3.3 ) $ ( 0.2 ) $ ( 1.9 ) $ ( 5.4 ) +Change in Fair Value Recognized in AOCI +— — 3.7 3.7 +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +1.9 — — 1.9 +Amortization of Prior Service Cost (Credit) +— ( 2.0 ) — ( 2.0 ) +Amortization of Actuarial (Gains) Losses +— 0.6 — 0.6 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +1.9 ( 1.4 ) — 0.5 +Income Tax (Expense) Benefit +0.4 ( 0.3 ) — 0.1 +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.5 ( 1.1 ) — 0.4 +Net Current Period Other Comprehensive Income (Loss) 1.5 ( 1.1 ) 3.7 4.1 +Balance in AOCI as of December 31, 2019 $ ( 1.8 ) $ ( 1.3 ) $ 1.8 $ ( 1.3 ) +Pension and OPEB +Amortization Changes in +Cash Flow Hedge – of Deferred Funded +For the Year Ended December 31, 2018 Interest Rate Costs Status Total +(in millions) +Balance in AOCI as of December 31, 2017 $ ( 6.0 ) $ 1.2 $ 0.8 $ ( 4.0 ) +Change in Fair Value Recognized in AOCI +2.3 — ( 3.1 ) ( 0.8 ) +Amount of (Gain) Loss Reclassified from AOCI +Interest Expense (b) +2.1 — — 2.1 +Amortization of Prior Service Cost (Credit) +— ( 2.0 ) — ( 2.0 ) +Amortization of Actuarial (Gains) Losses +— 0.2 — 0.2 +Reclassifications from AOCI, before Income Tax (Expense) Benefit +2.1 ( 1.8 ) — 0.3 +Income Tax (Expense) Benefit +0.4 ( 0.4 ) — — +Reclassifications from AOCI, Net of Income Tax (Expense) Benefit +1.7 ( 1.4 ) — 0.3 +Net Current Period Other Comprehensive Income (Loss) 4.0 ( 1.4 ) ( 3.1 ) ( 0.5 ) +ASU 2018-02 Adoption ( 1.3 ) — 0.4 ( 0.9 ) +Balance in AOCI as of December 31, 2018 $ ( 3.3 ) $ ( 0.2 ) $ ( 1.9 ) $ ( 5.4 ) +(a) The change in fair value includes $ 6 million and $ 4 million related to AEP's investment in joint venture wind farms acquired as part of the purchase of Sempra Renewables LLC for the years ended December 31, 2020 and December 31, 2019. See “Sempra Renewables LLC” section of Note 17 for additional information. +(b) Amounts reclassified to the referenced line item on the statements of income. +255 +4. RATE MATTERS +The disclosures in this note apply to all Registrants unless indicated otherwise. +The Registrants are involved in rate and regulatory proceedings at the FERC and their state commissions. Rate matters can have a material impact on net income, cash flows and possibly financial condition. The Registrants’ recent significant rate orders and pending rate filings are addressed in this note. +COVID-19 Pandemic +During the first quarter of 2020, AEP’s electric operating companies informed both retail customers and state regulators that disconnections for non-payment were temporarily suspended. Shortly thereafter, AEP’s state regulators also imposed temporary moratoria on customary disconnection practices. During the third and the fourth quarters of 2020, most state regulators began to lift restrictions on disconnects. As of December 31, 2020, AEP had resumed disconnections in its regulated jurisdictions with the exception of Virginia, Kentucky and Arkansas. Disconnections resumed in Kentucky during January 2021. AEP continues to work with regulators and stakeholders in Virginia and Arkansas and management currently anticipates resuming customary disconnection practices in the first half of 2021. However, this timing could change if there is new legislation or other regulatory directives issued in the future. Continuing adverse economic conditions may result in the inability of customers to pay for electric service, which could affect revenue recognition and the collectability of accounts receivable. The Registrants have worked with their state commissions to achieve deferral authority for incremental expenses incurred due to COVID-19. All of AEP’s regulated jurisdictions have issued COVID-19 orders, granting deferral authority for incremental COVID-19 expenses, with the exception of Kentucky and Tennessee. If any costs related to COVID-19 are not recoverable, it could reduce future net income and cash flows and impact financial condition. +AEP Texas Rate Matters (Applies to AEP and AEP Texas) +2019 Texas Base Rate Case +In May 2019, AEP Texas filed a request with the PUCT for a $ 56 million annual increase in rates based upon a proposed 10.5 % ROE. The filing included a proposed Income Tax Refund Rider that will refund $ 21 million annually of Excess ADIT that is primarily not subject to normalization requirements. The rate case also sought a prudence determination on all transmission and distribution capital additions through 2018 included in interim rates from 2008 to December 2019. +In April 2020, the PUCT issued an order approving a stipulation and settlement agreement. The order includes an annual base rate reduction of $ 40 million based upon a 9.4 % ROE with a capital structure of 57.5 % debt and 42.5 % common equity effective with the first billing cycle in June 2020. The order provides recovery of $ 26 million in capitalized vegetation management expenses that were incurred through 2018. The order includes disallowances of $ 23 million related to capital investments recorded through 2018 and $ 4 million related to rate case expenses. In addition, AEP Texas will refund: (a) $ 77 million of Excess ADIT and excess federal income taxes collected as a result of Tax Reform to distribution customers over a one year period, (b) $ 31 million of Excess ADIT and excess federal income taxes collected as a result of Tax Reform to transmission customers as a one-time credit and (c) $ 30 million of previously collected rates that were subject to reconciliation in this proceeding over a one year period with no carrying costs. The order requires AEP Texas to file its next base rate case within four years of the date that the final order was issued. The order also states future financially based capital incentives will not be included in interim transmission and distribution rates and contains various ring-fencing provisions. As a result of the final order, AEP Texas will refund $ 275 million of Excess ADIT associated with certain depreciable property using ARAM to transmission customers. AEP Texas will determine how to refund the remaining Excess ADIT that is not subject to normalization requirements in future proceedings. +256 +In December 2019, as a result of the initial stipulation and settlement agreement, AEP Texas (a) recorded an impairment of $ 33 million related to capital investments, which included $ 10 million of 2019 investments, in Asset Impairments and Other Related Charges on the statements of income, (b) recorded a $ 30 million provision for refund on the statements of income for revenues previously collected through rates and (c) wrote-off $ 4 million of rate case expenses to Other Operation on the statements of income. +AEP Texas Interim Transmission and Distribution Rates +Through December 31, 2020, AEP Texas’ cumulative revenues from interim base rate increases that are subject to review is estimated to be $ 79 million. A base rate review could result in a refund to customers if AEP Texas incurs a disallowance of the transmission or distribution investment on which an interim increase was based. Management is unable to determine a range of potential losses, if any, that are reasonably possible of occurring. A revenue decrease, including a refund of interim transmission and distribution rates, could reduce future net income and cash flows and impact financial condition. AEP Texas is required to file for a comprehensive rate review no later than April 3, 2024. +APCo and WPCo Rate Matters (Applies to AEP and APCo) +2017-2019 Virginia Triennial Review +Amendments to Virginia law impacting investor-owned utilities were enacted, effective July 1, 2018, that required APCo to file a generation and distribution base rate case by March 31, 2020 using 2017, 2018 and 2019 earnings test years (triennial review). Triennial reviews are subject to an earnings test, which provides that 70 % of any earnings in excess of 70 basis points above APCo’s Virginia SCC authorized ROE would be refunded to customers. In such case, the Virginia SCC could also lower APCo’s Virginia retail base rates on a prospective basis. In November 2018, the Virginia SCC authorized a ROE of 9.42 % applicable to APCo base rate earnings for the 2017-2019 triennial period. +Virginia law provides that costs associated with asset impairments of retired coal generation assets, or automated meters, or both, which a utility records as an expense, shall be attributed to the test periods under review in a triennial review proceeding, and be deemed recovered. In 2015, APCo retired the Sporn Plant, the Kanawha River Plant, the Glen Lyn Plant, Clinch River Unit 3 and the coal portions of Clinch River Units 1 and 2 (collectively, the retired coal-fired generation assets). The net book value of the Virginia jurisdictional share of these plants was $ 93 million before cost of removal, including materials and supplies inventory and ARO balances. Based on management’s interpretation of Virginia law and more certainty regarding APCo’s triennial revenues, expenses and resulting earnings upon reaching the end of the three-year review period, APCo recorded a pretax expense of $ 93 million related to its previously retired coal-fired generation assets in December 2019. As a result, management deemed these costs to be substantially recovered by APCo during the triennial review period. +In March 2020, APCo submitted its 2017-2019 Virginia triennial earnings review filing and base rate case with the Virginia SCC as required by state law. APCo requested a $ 65 million annual increase in base rates based upon a proposed 9.9 % ROE. The requested annual increase included $ 19 million related to depreciation for updated test year end depreciable balances and a proposed increase in APCo’s Virginia depreciation rates and $ 8 million related to APCo’s calculated shortfall in 2017-2019 Virginia earnings. Inclusive of the Virginia jurisdictional share of the $ 93 million expense associated with APCo’s retired coal-fired generation assets, APCo calculated its 2017-2019 Virginia earnings for the triennial period to be below the authorized ROE range. +APCo is currently in the process of retiring and replacing its Virginia jurisdictional Automated Meter Reading (AMR) meters with AMI meters. As of December 31, 2020 and 2019, APCo had approximately $ 35 million and $ 51 million of Virginia jurisdictional AMR meters as well as $ 73 million and $ 75 million of Virginia jurisdictional AMI meters recorded on its balance sheets. APCo pursued full recovery of these assets through its Virginia depreciation rates as discussed above. +257 +In November 2020, the Virginia SCC issued an order concluding that APCo earned above its authorized ROE but within its ROE band for the 2017-2019 period, resulting in no refund to customers and no change to APCo base rates on a prospective basis. The Virginia SCC approved a prospective 9.2 % ROE for APCo's 2020-2022 triennial review period with the continuation of a 140 basis point band ( 8.5 % bottom, 9.2 % midpoint, 9.9 % top). This 9.2 % authorized ROE will also be applied to certain APCo rate adjustment clauses. APCo’s earnings for the 2020-2022 triennial review will continue to be subject to an earnings test, which provides that 70 % of any earnings in excess of 70 basis points above APCo’s Virginia SCC authorized ROE would be refunded to customers. Conversely, as defined by Virginia law, APCo is also eligible to defer for future recovery certain environmental and major storm operation and maintenance expenses up to the bottom of APCo’s authorized Virginia 2020-2022 earnings ROE band. The Virginia SCC also disagreed with APCo’s treatment of the retired coal-fired generation assets for regulatory purposes, and instead adopted the Virginia SCC Staff’s recommendation to treat the remaining unrecovered costs of the retired coal-fired generation assets as a regulatory asset to be amortized over 10 years as of the June 2015 retirement date. The Virginia SCC’s adoption of the Staff’s recommended regulatory treatment of the coal-fired generation assets resulted in a net $ 40 million increase to APCo’s 2020 pretax income. In addition, the Virginia SCC’s order also included: (a) implementation of the Staff-modified APCo 2017 depreciation study effective January 1, 2018 and (b) implementation of the Staff-modified APCo 2019 depreciation study effective January 1, 2020. The adoption of these depreciation studies resulted in an approximate $ 47 million reduction to APCo’s 2020 pretax income comprised of a $ 44 million reduction to revenues for amounts recognized in advance of the recording of depreciation expense for the periods January 2018 through October 2020 and a $ 3 million increase in depreciation expense for the periods November and December 2020. A corresponding regulatory liability was recorded for the $ 44 million reduction to revenues. The Virginia SCC’s approval of APCo’s 2019 depreciation study included the ongoing depreciation and recovery of APCo’s Virginia AMI/AMR meter balances. In November 2020, APCo filed a notice of appeal with the Virginia Supreme Court. +In December 2020, an intervenor filed a petition at the Virginia SCC requesting reconsideration of: (a) the failure of the Virginia SCC to apply a threshold earnings test to the approved regulatory asset for APCo’s closed coal-fired generation assets, (b) the Virginia SCC’s use of a 2011 benchmark study to measure the replacement value of capacity for purposes of APCo’s 2017 – 2019 earnings test and (c) the reasonableness and prudency of APCo’s investments in AMI meters. +In December 2020, APCo filed a petition at the Virginia SCC requesting reconsideration of: (a) certain issues related to APCo’s going-forward rates and (b) the Virginia SCC’s decision to deny APCo tariff changes that align rates with underlying costs. For APCo’s going-forward rates, APCo requested that the Virginia SCC clarify its final order and whether APCo’s current rates will allow it to earn a fair return. If the Virginia SCC’s order did conclude on APCo’s ability to earn a fair return through existing base rates, APCo further requested that the Virginia SCC clarify whether it has the authority to also permit an increase in base rates. If the Virginia SCC did not conclude on APCo’s ability to earn a fair return, APCo requested the Virginia SCC provide such a conclusion. In January 2021, as requested by the Virginia SCC, APCo filed briefs related to the petition for reconsideration. +If the Virginia SCC issues an unfavorable ruling related to the intervenor petition, it could reduce future net income and cash flows and impact financial condition. +West Virginia ENEC and Vegetation Management Riders +In June 2020, the WVPSC issued an order directing APCo and WPCo to increase rider rates relating to ENEC and vegetation management by a combined $ 101 million ($ 81 million related to APCo) over twelve months beginning September 2020. This increase will be partially offset by a refund of $ 38 million ($ 31 million related to APCo) of Excess ADIT that is not subject to normalization requirements over ten months beginning September 2020. These transactions will result in no overall impact to net income. +258 +ETT Rate Matters (Applies to AEP) +ETT Interim Transmission Rates +AEP has a 50 % equity ownership interest in ETT. Predominantly all of ETT’s revenues are based on interim rate changes that can be filed twice annually and are subject to review and possible true-up in the next base rate proceeding. Through December 31, 2020, AEP’s share of ETT’s cumulative revenues that are subject to review is estimated to be $ 1.2 billion. A base rate review could produce a refund if ETT incurs a disallowance of the transmission investment on which an interim increase was based. A revenue decrease, including a refund of interim transmission rates, could reduce future net income and cash flows and impact financial condition. Management is unable to determine a range of potential losses, if any, that are reasonably possible of occurring. +In 2018, the PUCT adopted a rule requiring investor-owned utilities operating solely inside ERCOT to make periodic filings for base rate proceedings. The rule required ETT to file for a comprehensive base rate review no later than February 1, 2021. In December 2020, ETT and various intervenors filed a stipulation and settlement agreement with the PUCT. The agreement maintained ETT’s previously allowed ROE and capital structure and includes: (a) an $ 8 million decrease to the current annual revenue requirement effective February 1, 2021, (b) ETT must make an interim transmission cost of service filing by April 1, 2021, (c) a $ 2 million line item decrease to the revenue requirement determined in each interim transmission cost of service filing until the filing of the next comprehensive base rate review and (d) no determination of prudence on any transmission investment added since ETT’s last comprehensive base rate review, which would leave the $ 1.2 billion of cumulative revenues above subject to review in the next comprehensive base rate review. In January 2021, the PUCT approved the stipulation and settlement agreement. As part of the approved agreement, new rates were implemented in February 2021 and ETT is required to file for a comprehensive base rate review no later than February 1, 2023. +I&M Rate Matters (Applies to AEP and I&M) +2019 Indiana Base Rate Case +In May 2019, I&M filed a request with the IURC for a $ 172 million annual increase. The requested increase in Indiana rates would be phased-in through January 2021 and was based upon a proposed 10.5 % ROE. The proposed annual increase included $ 78 million related to a proposed annual increase in depreciation expense. The requested annual increase in depreciation expense included $ 52 million related to proposed investments and $ 26 million related to increased depreciation rates. The request included the continuation of all existing riders and a new AMI rider for proposed meter projects. +In March 2020, the IURC issued an order approving a phased-in increase in base rates of up to $ 77 million based upon an ROE of 9.7 %. This approved phase-in increase includes: (a) an annual increase in base rates of $ 44 million effective March 2020 and (b) an annual increase in base rates of up to $ 77 million, effective January 2021, based on the IURC-approved forecast of December 31, 2020 Indiana jurisdictional electric plant in service. In January 2021, I&M updated its Indiana retail rates with the IURC based on actual December 31, 2020 I&M Indiana jurisdictional electric plant in service, resulting in a $ 60 million net annual base rate increase when compared to I&M Indiana base rate levels prior to March 2020. The order also approved the majority of I&M’s proposed changes in depreciation as well as the test year level of AMI deployment, but did not approve a cost recovery rider for AMI investments made in subsequent years. The order rejected I&M’s proposed re-allocation of capacity costs related to the loss of a significant FERC wholesale contract, which negatively impacts I&M’s annual pretax earnings by approximately $ 20 million starting June 2020. +259 +KPCo Rate Matters (Applies to AEP) +2020 Kentucky Base Rate Case +In June 2020, KPCo filed a request with the KPSC for a $ 65 million net annual increase in base rates based upon a proposed 10 % ROE with the increase to be implemented no earlier than January 2021. The filing proposes that KPCo would offset the first year of rate increases by refunding Excess ADIT that is not subject to normalization requirements to customers. Additionally, KPCo requested recovery of the previously authorized deferral of $ 50 million of Rockport Plant UPA expenses and related carrying charges over a 5-year period beginning in December 2022, through an existing purchased power rider. +In January 2021, the KPSC issued an order approving an annual increase in base rates of $ 52 million based upon an ROE of 9.3 % effective with billing cycles mid-January 2021. The order shortened the previously authorized refund period for Excess ADIT that is not subject to normalization requirements being refunded through a rider from 18 years to 3 years. In addition, the order approved recovery of certain annual PJM OATT expenses above/below the corresponding level recovered in base rates through a rider until KPCo’s next base case; however, recovery of these transmission costs will be re-examined by the KPSC in KPCo’s next base case. The KPSC deferred KPCo’s request to authorize a specific recovery period and mechanism for the previously authorized deferral of $ 50 million of Rockport Plant UPA expenses and related carrying charges to a future proceeding. The order requires KPCo to submit its next base case in June 2023 for rates effective in January 2024. +In February 2021, KPCo filed for rehearing with the KPSC challenging various adjustments that were made in the order and requesting certain clarifications. Also in February 2021, the KPSC issued an order on rehearing that modified the approved annual increase in base rates from $ 52 million to $ 53 million and clarified several items, including the timing of the future proceeding to address a specific recovery period and mechanism for the previously authorized deferral of $ 50 million of Rockport Plant Unit Power Agreement expenses and related carrying charges. The KPSC will initiate a future proceeding to address a specific recovery period and mechanism for the deferral after KPCo makes a written filing identifying the capacity replacement for the Rockport Unit Power Agreement, including the name of the capacity resource and related reasonably anticipated costs. +OPCo Rate Matters (Applies to AEP and OPCo) +2020 Ohio Base Rate Case +In June 2020, OPCo filed a request with the PUCO for a $ 42 million annual increase in base rates based upon a proposed 10.15 % ROE net of existing riders. Additionally, OPCo filed a request with the PUCO for a 60-day temporary delay of the normal rate case proceeding due to the COVID-19 pandemic with rates expected to be effective approximately mid-2021. +In November 2020, PUCO staff filed testimony supporting an annual revenue decrease ranging from $ 102 million to $ 123 million based upon an ROE of 8.76 % to 9.78 %. The difference between OPCo’s request and the staff testimony are primarily due to reductions in: (a) demand-side management programs of $ 40 million, (b) ROE ranging from $ 9 million to $ 30 million, (c) employee-related expenses of $ 23 million, (d) rate base of $ 19 million, (e) property taxes of $ 17 million, (f) other various expenses of $ 15 million, (g) depreciation expense of $ 11 million and (h) vegetation management programs of $ 10 million which is subject to over/under-recovery through a rider. The staff’s proposed disallowance of plant in service could also result in a write-off of up to $ 27 million. In addition, the staff recommended that capitalized incentives be excluded from base rates prospectively and also recommended annual revenue caps for the DIR of $ 57 million in 2021, $ 78 million in 2022, $ 96 million in 2023 and $ 46 million for the first five months of 2024. In December 2020, OPCo and intervenors filed objections. A procedural schedule for the case is pending due to ongoing settlement discussions. If any of the requested costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +260 +2019 Ohio DIR Audit +OPCo conducts business under an ESP as approved by the PUCO which subjects the DIR to annual audits. In August 2020, a third-party consulting company filed an audit report with the PUCO indicating that OPCo exceeded its 2019 authorized revenue limit by $ 17 million. Management disagrees with the audit results and believes that OPCo was below its authorized revenue limit in 2019. The PUCO has not yet issued a procedural schedule to address the audit results. If the results of the audit are upheld by the PUCO and any refunds to customers or revenue reductions are ordered, it could reduce future net income and cash flows and impact financial condition. +SWEPCo Rate Matters (Applies to AEP and SWEPCo) +2012 Texas Base Rate Case +In 2012, SWEPCo filed a request with the PUCT to increase annual base rates primarily due to the completion of the Turk Plant. In 2013, the PUCT issued an order affirming the prudence of the Turk Plant but determined that the Turk Plant’s Texas jurisdictional capital cost cap established in a previous Certificate of Convenience and Necessity case also limited SWEPCo’s recovery of AFUDC in addition to limits on its recovery of cash construction costs. +Upon rehearing in 2014, the PUCT reversed its initial ruling and determined that AFUDC was excluded from the Turk Plant’s Texas jurisdictional capital cost cap. As a result, SWEPCo reversed $ 114 million of a previously recorded regulatory disallowance in 2013. The resulting annual base rate increase was approximately $ 52 million. In 2017, the Texas District Court upheld the PUCT’s 2014 order and intervenors filed appeals with the Texas Third Court of Appeals. +In July 2018, the Texas Third Court of Appeals reversed the PUCT’s judgment affirming the prudence of the Turk Plant and remanded the issue back to the PUCT. In January 2019, SWEPCo and the PUCT filed petitions for review with the Texas Supreme Court. In the fourth quarter of 2019 and first quarter of 2020, SWEPCo and various intervenors filed briefs with the Texas Supreme Court. In August 2020, the Texas Supreme Court granted SWEPCo’s petition for review and oral arguments were held in December 2020. SWEPCo expects a decision from the Texas Supreme Court in 2021. +As of December 31, 2020, the net book value of Turk Plant was $ 1.4 billion, before cost of removal, including materials and supplies inventory and CWIP. If certain parts of the PUCT order are overturned and if SWEPCo cannot ultimately fully recover its approximate 33 % Texas jurisdictional share of the Turk Plant investment, including AFUDC, it could reduce future net income and cash flows and impact financial condition. +2016 Texas Base Rate Case +In 2016, SWEPCo filed a request with the PUCT for a net increase in Texas annual revenues of $ 69 million based upon a 10 % ROE. In January 2018, the PUCT issued a final order approving a net increase in Texas annual revenues of $ 50 million based upon a ROE of 9.6 %, effective May 2017. The final order also included: (a) approval to recover the Texas jurisdictional share of environmental investments placed in- service, as of June 30, 2016, at various plants, including Welsh Plant, Units 1 and 3, (b) approval of recovery of, but no return on, the Texas jurisdictional share of the net book value of Welsh Plant, Unit 2, (c) approval of $ 2 million in additional vegetation management expenses and (d) the rejection of SWEPCo’s proposed transmission cost recovery mechanism. +As a result of the final order, in 2017 SWEPCo: (a) recorded an impairment charge of $ 19 million, which included $ 7 million associated with the lack of return on Welsh Plant, Unit 2 and $ 12 million related to other disallowed plant investments, (b) recognized $ 32 million of additional revenues, for the period of May 2017 through December 2017, that was surcharged to customers in 2018 and (c) recognized an additional $ 7 million of expenses consisting primarily of depreciation expense and vegetation management expense, offset by the deferral of rate case expense. SWEPCo implemented new rates in February 2018 billings. The $ 32 million of additional 2017 revenues was collected during 2018. In March 2018, the PUCT clarified and corrected portions of the final order, without +261 +changing the overall decision or amounts of the rate change. The order has been appealed by various intervenors. If certain parts of the PUCT order are overturned, it could reduce future net income and cash flows and impact financial condition. +2018 Louisiana Formula Rate Filing +In April 2018, SWEPCo filed its formula rate plan for test year 2017 with the LPSC. The filing included a net $ 28 million annual increase, which was effective August 2018 and included SWEPCo’s Louisiana jurisdictional share of Welsh Plant and Flint Creek Plant environmental controls. The filing also included a reduction in the federal income tax rate due to Tax Reform but did not address the return of Excess ADIT benefits to customers. +In July 2018, SWEPCo made a supplemental filing to its formula rate plan with the LPSC to reduce the requested annual increase to $ 18 million. The difference between SWEPCo’s requested $ 28 million annual increase and the $ 18 million annual increase in the supplemental filing is primarily the result of the return of Excess ADIT benefits to customers. +In October 2018, the LPSC staff issued a recommendation that SWEPCo refund $ 11 million of excess federal income taxes collected, as a result of Tax Reform, from January 1, 2018 through July 31, 2018. In June 2019, the LPSC staff issued its report which reaffirmed its $ 11 million refund recommendation. The report also contends that SWEPCo’s requested annual rate increase of $ 18 million, which was implemented in August 2018, is overstated by $ 4 million and proposes an annual rate increase of $ 14 million. Additionally, the report recommends SWEPCo refund the excess over-collections associated with the $ 4 million difference for the period of August 2018 through the implementation of new rates. In July 2019, the LPSC approved the $ 11 million refund. In July 2020, the LPSC issued an order approving an unopposed stipulation and settlement agreement for a one-time refund of $ 6 million over three months beginning in August 2020. +Hurricane Laura +In August 2020, Hurricane Laura hit the coasts of Louisiana and Texas, causing power outages to more than 130,000 customers across SWEPCo’s service territories. Prior to Hurricane Laura, SWEPCo did not have a catastrophe reserve or automatic deferral authority within any of its jurisdictions. In October 2020, the LPSC issued an order allowing Louisiana utilities, including SWEPCo, to establish a regulatory asset to track and defer expenses associated with Hurricane Laura. In October 2020, as part of the 2020 Texas Base Rate Case, SWEPCo requested deferral authority of incremental other operation and maintenance expenses. As of December 31, 2020, management estimates that SWEPCo has incurred incremental other operation and maintenance expenses of $ 84 million ($ 82 million of which has been deferred as a regulatory asset related to the Louisiana jurisdiction) and incremental capital expenditures of $ 23 million, all of which is related to the Louisiana jurisdiction. If any costs related to Hurricane Laura are not recoverable, it could reduce future net income and cash flows and impact financial condition. +Hurricane Delta +In October 2020, Hurricane Delta hit the coast of Louisiana, causing power outages to more than 23,000 customers in SWEPCo’s Louisiana jurisdiction. In November 2020, the LPSC issued an order allowing Louisiana utilities, including SWEPCo, to establish a regulatory asset to track and defer expenses associated with Hurricane Delta. As of December 31, 2020, management estimates that SWEPCo has incurred incremental other operation and maintenance expenses of $ 17 million, which has been deferred as a regulatory asset. Also, management estimates that SWEPCo has incurred incremental capital expenditures of $ 2 million. If any costs related to Hurricane Delta are not recoverable, it could reduce future net income and cash flows and impact financial condition. +262 +2020 Texas Base Rate Case +In October 2020, SWEPCo filed a request with the PUCT for a $ 105 million annual increase in Texas base rates based upon a proposed 10.35 % ROE. The request would move transmission and distribution interim revenues recovered through riders into base rates. Eliminating these riders would result in a net annual requested base rate increase of $ 90 million primarily due to increased investments. The proposed net annual increase: (a) includes $ 5 million related to vegetation management to maintain and improve the reliability of its Texas jurisdictional distribution system, (b) requests a $ 10 million annual depreciation increase and (c) seeks $ 2 million annually to establish a storm catastrophe reserve. In addition, SWEPCo also requested recovery of the Texas jurisdictional share of the Dolet Hills Power Station of $ 45 million which is expected to be retired by the end of 2021. Intervenor and staff testimony is scheduled to be filed in March and April 2021, respectively. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +2020 Louisiana Base Rate Case +In December 2020, SWEPCo filed a request with the LPSC for a $ 134 million annual increase in Louisiana base rates based upon a proposed 10.35 % ROE. The request would extend the formula rate plan for five years and includes modifications to the formula rate plan to allow for forward-looking transmission costs, reflects the impact of net operating losses associated with the acceleration of certain tax benefits and incorporates future federal corporate income tax changes. The proposed net annual increase: (a) requests a $ 32 million annual depreciation increase to recover Louisiana’s share of the Dolet Hills Power Station, Pirkey Power Plant and Welsh Plant, all of which are expected to be retired early, and (b) includes $ 10 million annually to recover deferred other operation and maintenance expenses related to Hurricanes Laura and Delta. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +FERC Rate Matters +AFUDC Waiver (Applies to all Registrants except AEP Texas) +In June 2020, FERC granted a temporary waiver providing utilities the option to elect to modify the existing AFUDC rate calculations in response to the COVID-19 pandemic. As a result of the waiver, the AFUDC formula for the 12-month period starting with March 2020 may be calculated using the simple average of the actual historical short-term debt balances for 2019, instead of current period short-term balances. All other aspects of the AFUDC formula remained unchanged. AEP subsidiaries including certain Registrant Subsidiaries elected to apply the waiver in July 2020. The impact upon election was immaterial on the Registrants’ financial statements. In February 2021, FERC issued an order extending the waiver through September 2021. +OKTCo Radial Asset Transfer (Applies to AEP, AEPTCo and PSO) +In August 2020, AEPSC filed a request with FERC, on behalf of PSO and OKTCo, to transfer OKTCo’s interests in its radial assets to PSO. OKTCo had previously constructed radial assets in the PSO service territory and after the radial assets were placed into service, management determined the radial assets were not eligible to be included as part of OKTCo’s SPP OATT formula rates. In October 2020, FERC approved the request and in December 2020, OKTCo completed the transfer of its interest in the radial assets to PSO, through Parent, at net book value. At the transfer date, the net book value of the radial assets were $ 60 million, before associated tax liabilities. PSO will seek recovery of the radial assets in its next base rate case, which must be filed by October 2021. If PSO does not receive approval to recover the radial assets, it could reduce future net income and cash flows and impact financial condition. +263 +5. EFFECTS OF REGULATION +The disclosures in this note apply to all Registrants unless indicated otherwise. +Coal-Fired Generation Plants (Applies to AEP, PSO and SWEPCo) +Compliance with extensive environmental regulations requires significant capital investment in environmental monitoring, installation of pollution control equipment, emission fees, disposal costs and permits. Management continuously evaluates cost estimates of complying with these regulations which has resulted in, and in the future may result in, a decision to retire coal-fired generating facilities earlier than their currently estimated useful lives. +Management is seeking or will seek regulatory recovery, as necessary, for any net book value remaining when the plants are retired. To the extent the net book value of these generation assets are not deemed recoverable, it could materially reduce future net income and cash flows and impact financial condition. +Regulated Generating Units that have been Retired +PSO +In September 2020, the Oklaunion Power Station was retired. As of December 31, 2020, PSO has a regulatory asset for accelerated depreciation pending approval recorded on its balance sheet for $ 34 million. PSO will seek recovery of the Oklaunion Power Station in its next base rate case. In October 2020, the Oklaunion Power Station site was sold to a nonaffiliated third-party. See “Oklaunion Power Station” section of Note 7 for additional information. +SWEPCo +In April 2016, Welsh Plant, Unit 2 was retired. As part of the 2016 Texas Base Rate Case, SWEPCo received approval from the PUCT to recover the Texas jurisdictional share of Welsh Plant, Unit 2. See “2016 Texas Base Rate Case” section of Note 4 for additional information. As part of the 2019 Arkansas Base Rate Case, SWEPCo received approval from the APSC to recover the Arkansas jurisdictional share of Welsh Plant, Unit 2. In December 2020, SWEPCo filed a request with the LPSC to recover the Louisiana jurisdictional share of Welsh Plant, Unit 2. As of December 31, 2020, SWEPCo has a regulatory asset for plant retirement costs pending approval recorded on its balance sheet for $ 35 million related to the Louisiana jurisdictional share of Welsh Plant, Unit 2. See “2020 Louisiana Base Rate Case” section of Note 4 for additional information. +Regulated Generating Units to be Retired +PSO +In 2014, PSO received final approval from the EPA to close Northeastern Plant, Unit 3, in 2026. The plant was originally scheduled to close in 2040. As a result of the early retirement date, PSO revised the useful life of Northeastern Plant, Unit 3, to the projected retirement date of 2026 and the incremental depreciation is being deferred as a regulatory asset. In 2016, as part of the 2015 Oklahoma Base Rate Case, the OCC issued an order approving the continued depreciation of Northeastern Plant, Unit 3 through 2040. The order did not approve accelerating the recovery of the incremental depreciation based on the revised retirement date of 2026. +SWEPCo +In January 2020, as part of the 2019 Arkansas Base Rate Case, management announced that the Dolet Hills Power Station was probable of abandonment and was to be retired by December 2026. As a result of the announcement, SWEPCo began recording a regulatory asset for accelerated depreciation. In March 2020, management announced plans to retire the plant in 2021. +In November 2020, management announced plans to retire Pirkey Power Plant in 2023 and that it will cease using coal at the Welsh Plant in 2028. As a result of the announcement, SWEPCo began recording a regulatory asset for accelerated depreciation. +264 +The table below summarizes the net book value including CWIP, before cost of removal and materials and supplies, as of December 31, 2020, of generating facilities planned for early retirement: +Plant Net +Investment Accelerated Depreciation Regulatory Asset Cost of Removal +Regulatory Liability Projected +Retirement Date Current Authorized +Recovery Period Annual +Depreciation (a) +(dollars in millions) +Northeastern Plant, Unit 3 $ 198.4 $ 110.4 $ 19.8 (b) 2026 (c) $ 14.9 +Dolet Hills Power Station +74.4 71.2 24.0 2021 (d) 60.8 +Pirkey Power Plant 199.5 12.2 38.7 2023 (e) 13.8 +Welsh Plant, Units 1 and 3 549.8 3.6 57.6 (f) 2028 (g) 33.3 +(a) Represents the amount of annual depreciation that has been collected from customers over the prior 12-month period. +(b) Includes Northeastern Plant, Unit 4, which was retired in 2016. Removal of Northeastern Plant, Unit 4, will be performed with Northeastern Plant, Unit 3, after retirement. +(c) Northeastern Plant, Unit 3 is currently being recovered through 2040. +(d) Dolet Hills Power Station is current being recovered through 2026 in the Louisiana jurisdiction and through 2046 in the Arkansas and Texas jurisdictions. +(e) Pirkey Power Plant is currently being recovered through 2025 in the Louisiana jurisdiction and through 2045 in the Arkansas and Texas jurisdictions. +(f) Includes Welsh Plant, Unit 2, which was retired in 2016. Removal of Welsh Plant, Unit 2, will be performed with Welsh Plant, Units 1 and 3, after retirement. +(g) Unit 1 is being recovered through 2027 in the Louisiana jurisdiction and through 2037 in the Arkansas and Texas jurisdictions. Unit 3 is being recovered through 2032 in the Louisiana jurisdiction and through 2042 in the Arkansas and Texas jurisdictions. +Dolet Hills Power Station and Related Fuel Operations (Applies to AEP and SWEPCo) +During the second quarter of 2019, the Dolet Hills Power Station initiated a seasonal operating schedule. In January 2020, in accordance with the terms of SWEPCo’s settlement of its base rate review filed with the APSC, management announced that SWEPCo will seek regulatory approval to retire the Dolet Hills Power Station by the end of 2026. DHLC provides 100 % of the fuel supply to Dolet Hills Power Station. After careful consideration of current economic conditions, and particularly for the benefit of their customers, management of SWEPCo and CLECO determined DHLC would not proceed developing additional Oxbow Lignite Company (Oxbow) mining areas for future lignite extraction and ceased extraction of lignite at the mine in May 2020. Based on these actions, management revised the estimated useful life of DHLC’s and Oxbow’s assets to coincide with the date at which extraction was discontinued in the second quarter of 2020 and the date at which delivery of lignite is expected to cease in September 2021. Management also revised the useful life of the Dolet Hills Power Station to 2021 based on the remaining estimated fuel supply available for continued seasonal operation. In March 2020, primarily due to the revision in the useful life of DHLC, SWEPCo recorded a revision to increase estimated ARO liabilities by $ 21 million. In April 2020, SWEPCo and CLECO jointly filed a notification letter to the LPSC providing notice of the cessation of lignite mining. +The Dolet Hills Power Station costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Dolet Hills Power Station is $ 151 million, including CWIP and materials and supplies, before cost of removal. +Fuel costs incurred by the Dolet Hills Power Station are recoverable by SWEPCo through active fuel clauses. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $ 131 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $ 35 million, which includes fuel burned at the Dolet Hills Power Station. Additional operational and land-related costs are expected to be incurred by DHLC and Oxbow and billed to SWEPCo prior to the closure of the Dolet Hills Power Station and recovered through fuel clauses. +In October 2020, SWEPCo filed a request with the LPSC for recovery of the Louisiana share of these additional fuel costs. SWEPCo’s filing proposes to defer $ 36 million of fuel costs in 2021 and recover the deferral plus carrying costs over five years beginning in 2022. +If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +265 +Pirkey Power Plant and Related Fuel Operations (Applies to AEP and SWEPCo) +In November 2020, management announced plans to retire the Pirkey Power Plant in 2023. The Pirkey Power Plant costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Pirkey Power Plant is $ 212 million, including CWIP, before cost of removal. Sabine is a mining operator providing mining services to the Pirkey Power Plant. Under the provisions of the mining agreement, SWEPCo is required to pay, as part of the cost of lignite delivered, an amount equal to mining costs plus a management fee. SWEPCo expects fuel deliveries, including billings of all fixed and operating costs, from Sabine to cease during the first quarter of 2023. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $ 193 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $ 35 million, which includes fuel burned at the Pirkey Power Plant. Additional operational costs are expected to be incurred by Sabine and billed to SWEPCo, as well as land-related costs incurred by SWEPCo, prior to the closure of the Pirkey Power Plant and recovered through fuel clauses. +If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +2020 Texas Fuel Reconciliation (Applies to AEP and SWEPCo) +In June 2020, SWEPCo filed a fuel reconciliation with the PUCT for its retail operations in Texas for the reconciliation period of March 1, 2017 to December 31, 2019. The fuel reconciliation included total fuel costs of $ 1.7 billion ($ 616 million of which is related to the Texas jurisdiction). In January 2021, various parties filed testimony recommending fuel cost disallowances totaling $ 125 million relating to the Texas jurisdiction. Also in January 2021, SWEPCo filed rebuttal testimony disputing the recommended disallowances. In February 2021, SWEPCo and various parties reached a settlement in principle which resulted in an immaterial impact to SWEPCo’s 2020 financial statements. If additional costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +266 +Regulatory Assets and Liabilities +Regulatory assets and liabilities are comprised of the following items: +AEP +December 31, Remaining Recovery Period +2020 2019 +Current Regulatory Assets (in millions) +Under-recovered Fuel Costs - earns a return $ 41.4 $ 44.7 1 year +Under-recovered Fuel Costs - does not earn a return 49.3 48.2 1 year +Total Current Regulatory Assets $ 90.7 $ 92.9 +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Earning a Return +Dolet Hills Power Station Accelerated Depreciation $ 71.2 $ — +Kentucky Deferred Purchased Power Expenses 41.3 30.2 +Plant Retirement Costs - Unrecovered Plant, Louisiana 35.2 35.2 +Oklaunion Power Station Accelerated Depreciation 34.4 27.4 +Other Regulatory Assets Pending Final Regulatory Approval 38.6 0.7 +Total Regulatory Assets Currently Earning a Return 220.7 93.5 +Regulatory Assets Currently Not Earning a Return +Storm-Related Costs 134.2 7.2 +Plant Retirement Costs - Asset Retirement Obligation Costs 25.9 30.1 +COVID-19 24.9 — +Vegetation Management Program - AEP Texas 3.8 29.4 +Other Regulatory Assets Pending Final Regulatory Approval 32.7 21.5 +Total Regulatory Assets Currently Not Earning a Return 221.5 88.2 +Total Regulatory Assets Pending Final Regulatory Approval 442.2 181.7 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Plant Retirement Costs - Unrecovered Plant (a) 713.1 690.5 23 years +Plant Retirement Costs - Asset Retirement Obligation Costs 107.1 87.4 20 years +Meter Replacement Costs 55.5 65.4 7 years +Ohio Distribution Decoupling 46.6 31.4 2 years +Environmental Control Projects 38.6 41.0 20 years +Rockport Plant Dry Sorbent Injection System and Selective Catalytic Reduction 34.4 13.5 8 years +Cook Plant Uprate Project 30.2 32.6 13 years +Storm-Related Costs 11.5 21.3 2 years +Advanced Metering System — 26.5 +Other Regulatory Assets Approved for Recovery 94.4 79.6 various +Total Regulatory Assets Currently Earning a Return 1,131.4 1,089.2 +Regulatory Assets Currently Not Earning a Return +Pension and OPEB Funded Status 1,088.6 1,309.8 12 years +Plant Retirement Costs - Asset Retirement Obligation Costs 212.7 28.8 22 years +Unamortized Loss on Reacquired Debt 120.0 129.0 28 years +Unrealized Loss on Forward Commitments 111.3 106.8 12 years +Vegetation Management 67.8 43.6 5 years +Cook Plant Nuclear Refueling Outage Levelization 39.5 63.8 2 years +PJM/SPP Annual Formula Rate True-up 33.0 7.3 2 years +Postemployment Benefits 29.1 34.2 3 years +OVEC Purchased Power 27.4 1.5 2 years +Fuel and Purchased Power Adjustment Rider 24.0 7.1 2 years +Medicare Subsidy 18.6 23.2 4 years +Other Regulatory Assets Approved for Recovery 181.4 132.8 various +Total Regulatory Assets Currently Not Earning a Return 1,953.4 1,887.9 +Total Regulatory Assets Approved for Recovery 3,084.8 2,977.1 +Total Noncurrent Regulatory Assets $ 3,527.0 $ 3,158.8 +(a) Northeastern Plant, Unit 3 is approved for recovery through 2040, but expected to retire in 2026. PSO records a regulatory asset for accelerated depreciation. See “Regulated Generating Units to be Retired” section above for additional information. +267 +AEP +December 31, Remaining +2020 2019 Refund Period +Current Regulatory Liabilities (in millions) +Over-recovered Fuel Costs - pays a return $ 27.6 $ 77.5 1 year +Over-recovered Fuel Costs - does not pay a return 25.0 9.1 1 year +Total Current Regulatory Liabilities $ 52.6 $ 86.6 +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities pending final regulatory determination: +Regulatory Liabilities Currently Paying a Return +Other Regulatory Liabilities Pending Final Regulatory Determination $ 2.5 $ — +Total Regulatory Liabilities Currently Paying a Return 2.5 — +Regulatory Liabilities Currently Not Paying a Return +Other Regulatory Liabilities Pending Final Regulatory Determination 1.5 0.2 +Total Regulatory Liabilities Currently Not Paying a Return 1.5 0.2 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 291.6 571.8 +Excess ADIT that is Not Subject to Rate Normalization Requirements 193.3 291.0 (b) +Total Income Tax Related Regulatory Liabilities 484.9 862.8 +Total Regulatory Liabilities Pending Final Regulatory Determination 488.9 863.0 +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs 3,061.9 2,876.7 (c) +Deferred Investment Tax Credits 4.1 6.2 33 years +Ohio Basic Transmission Cost Rider — 37.2 +Other Regulatory Liabilities Approved for Payment 25.2 14.4 various +Total Regulatory Liabilities Currently Paying a Return 3,091.2 2,934.5 +Regulatory Liabilities Currently Not Paying a Return +Excess Nuclear Decommissioning Funding 1,476.6 1,236.0 (d) +Deferred Investment Tax Credits 216.7 215.3 34 years +PJM Transmission Enhancement Refund 56.2 67.3 5 years +Transition and Restoration Charges - Texas 48.2 50.5 9 years +2017-2019 Virginia Triennial Revenue Provision 44.2 — 28 years +Spent Nuclear Fuel 43.1 43.6 (d) +Peak Demand Reduction/Energy Efficiency 26.3 23.0 2 years +Deferred Gain on Sale of Rockport Unit 2 17.9 27.2 2 years +Ohio Enhanced Service Reliability Plan 5.7 29.7 2 years +Virginia Transmission Rate Adjustment Clause — 28.1 +Other Regulatory Liabilities Approved for Payment 71.0 87.7 various +Total Regulatory Liabilities Currently Not Paying a Return 2,005.9 1,808.4 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 3,485.7 3,303.0 (e) +Excess ADIT that is Not Subject to Rate Normalization Requirements 714.9 890.5 10 years +Income Taxes Subject to Flow Through ( 1,407.9 ) ( 1,341.8 ) 54 years +Total Income Tax Related Regulatory Liabilities 2,792.7 2,851.7 +Total Regulatory Liabilities Approved for Payment 7,889.8 7,594.6 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits +$ 8,378.7 $ 8,457.6 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) 2020 and 2019 amounts include approximately $ 173 million and $ 172 million, respectively, related to AEP Transmission Holdco’s investment in ETT and Transource Energy. AEP Transmission Holdco expects to amortize the balance commensurate with the return of Excess ADIT to ETT and Transource Energy’s customers. +(c) Relieved as removal costs are incurred. +(d) Relieved when plant is decommissioned. +(e) Refunded using ARAM. +268 +AEP Texas +December 31, Remaining +Recovery +Period +Regulatory Assets: 2020 2019 +(in millions) +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Earning a Return +Advanced Metering System $ 16.3 $ — +Total Regulatory Assets Currently Earning a Return 16.3 — +Regulatory Assets Currently Not Earning a Return +COVID-19 10.5 — +Vegetation Management Program 3.8 29.4 +Other Regulatory Assets Pending Final Regulatory Approval 2.3 1.4 +Total Regulatory Assets Currently Not Earning a Return 16.6 30.8 +Total Regulatory Assets Pending Final Regulatory Approval 32.9 30.8 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Meter Replacement Costs 29.3 35.2 6 years +Advanced Metering System — 26.5 +Total Regulatory Assets Currently Earning a Return 29.3 61.7 +Regulatory Assets Currently Not Earning a Return +Pension and OPEB Funded Status 145.0 172.0 12 years +Vegetation Management Program 22.4 — 5 years +Storm-Related Costs 17.1 — 4 years +Peak Demand Reduction/Energy Efficiency 7.7 3.5 2 years +Other Regulatory Assets Approved for Recovery 12.4 12.6 various +Total Regulatory Assets Currently Not Earning a Return 204.6 188.1 +Total Regulatory Assets Approved for Recovery 233.9 249.8 +Total Noncurrent Regulatory Assets $ 266.8 $ 280.6 +269 +AEP Texas +December 31, Remaining +Refund +Period +Regulatory Liabilities: 2020 2019 +(in millions) +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities pending final regulatory determination: +Regulatory Liabilities Currently Paying a Return +Other Regulatory Liabilities Pending Final Regulatory Determination $ 2.5 $ — +Total Regulatory Liabilities Currently Paying a Return 2.5 — +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property — 274.9 +Excess ADIT that is Not Subject to Rate Normalization Requirements ( 8.2 ) 87.1 +Total Income Tax Related Regulatory Liabilities ( 8.2 ) 362.0 +Total Regulatory Liabilities Pending Final Regulatory Determination ( 5.7 ) 362.0 +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs 718.3 689.6 (b) +Other Regulatory Liabilities Approved for Payment 5.3 10.1 various +Total Regulatory Liabilities Currently Paying a Return 723.6 699.7 +Regulatory Liabilities Currently Not Paying a Return +Transition and Restoration Charges 48.2 50.5 9 years +Deferred Investment Tax Credits 8.5 9.6 20 years +Other Regulatory Liabilities Approved for Payment 1.2 4.8 various +Total Regulatory Liabilities Currently Not Paying a Return 57.9 64.9 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 506.0 236.5 (c) +Excess ADIT that is Not Subject to Rate Normalization Requirements 41.7 — 1 years +Income Taxes Subject to Flow Through ( 52.7 ) ( 46.2 ) 28 years +Total Income Tax Related Regulatory Liabilities 495.0 190.3 +Total Regulatory Liabilities Approved for Payment 1,276.5 954.9 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits $ 1,270.8 $ 1,316.9 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) Relieved as removal costs are incurred. +(c) Refunded using ARAM. +270 +AEPTCo +December 31, Remaining +Recovery +Period +Regulatory Assets: 2020 2019 +(in millions) +Noncurrent Regulatory Assets +Regulatory assets approved for recovery: +Regulatory Assets Currently Not Earning a Return +PJM/SPP Annual Formula Rate True-up $ 15.1 $ 4.2 2 years +Total Regulatory Assets Approved for Recovery 15.1 4.2 +Total Noncurrent Regulatory Assets $ 15.1 $ 4.2 +AEPTCo +December 31, Remaining +Refund +Period +Regulatory Liabilities: 2020 2019 +(in millions) +Noncurrent Regulatory Liabilities +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs $ 198.6 $ 141.0 (b) +Total Regulatory Liabilities Currently Paying a Return 198.6 141.0 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 531.5 535.7 (c) +Excess ADIT that is Not Subject to Rate Normalization Requirements ( 30.6 ) ( 35.4 ) 8 years +Income Taxes Subject to Flow Through ( 117.7 ) ( 100.4 ) 38 years +Total Income Tax Related Regulatory Liabilities 383.2 399.9 +Total Regulatory Liabilities Approved for Payment 581.8 540.9 +Total Noncurrent Regulatory Liabilities $ 581.8 $ 540.9 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) Relieved as removal costs are incurred. +(c) Refunded using ARAM. +271 +APCo +December 31, Remaining +Recovery +Period +Regulatory Assets: 2020 2019 +(in millions) +Current Regulatory Assets +Under-recovered Fuel Costs, Virginia - earns a return $ 3.3 $ 36.8 1 year +Under-recovered Fuel Costs - does not earn a return 2.0 5.7 1 year +Total Current Regulatory Assets $ 5.3 $ 42.5 +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Earning a Return +COVID-19 - Virginia $ 3.7 $ — +Plant Retirement Costs - Materials and Supplies — 0.5 +Total Regulatory Assets Currently Earning a Return 3.7 0.5 +Regulatory Assets Currently Not Earning a Return +Plant Retirement Costs - Asset Retirement Obligation Costs 25.9 30.1 +Environmental Expense Deferral - Virginia 9.3 — +COVID-19 - West Virginia 1.5 — +Other Regulatory Assets Pending Final Regulatory Approval 3.4 — +Total Regulatory Assets Currently Not Earning a Return 40.1 30.1 +Total Regulatory Assets Pending Final Regulatory Approval 43.8 30.6 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Plant Retirement Costs - Unrecovered Plant (a) 122.4 86.4 23 years +Other Regulatory Assets Approved for Recovery 1.0 0.5 various +Total Regulatory Assets Currently Earning a Return 123.4 86.9 +Regulatory Assets Currently Not Earning a Return +Plant Retirement Costs - Asset Retirement Obligation Costs 202.7 — 15 years +Pension and OPEB Funded Status 114.4 160.8 12 years +Unamortized Loss on Reacquired Debt 82.1 85.5 25 years +Vegetation Management Program - West Virginia 45.4 43.6 2 years +Virginia Transmission Rate Adjustment Clause 18.8 — 2 years +Peak Demand Reduction/Energy Efficiency 16.8 19.5 6 years +Postemployment Benefits 13.5 15.9 3 years +PJM Annual Formula Rate True-up 12.7 — 2 years +Other Regulatory Assets Approved for Recovery 12.7 14.4 various +Total Regulatory Assets Currently Not Earning a Return 519.1 339.7 +Total Regulatory Assets Approved for Recovery 642.5 426.6 +Total Noncurrent Regulatory Assets $ 686.3 $ 457.2 +(a) December 31, 2020 amount includes Virginia and West Virginia jurisdictions. December 31, 2019 amount includes West Virginia jurisdiction. +272 +APCo +December 31, Remaining +Refund +Period +Regulatory Liabilities: 2020 2019 +(in millions) +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs $ 678.9 $ 635.3 (b) +Deferred Investment Tax Credits 0.3 0.5 33 years +Total Regulatory Liabilities Currently Paying a Return 679.2 635.8 +Regulatory Liabilities Currently Not Paying a Return +2017-2019 Virginia Triennial Revenue Provision 44.2 — 28 years +PJM Transmission Enhancement Refund 16.3 19.5 5 years +Virginia Transmission Rate Adjustment Clause — 28.1 +Other Regulatory Liabilities Approved for Payment 12.3 18.0 various +Total Regulatory Liabilities Currently Not Paying a Return 72.8 65.6 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 690.0 718.9 (c) +Excess ADIT that is Not Subject to Rate Normalization Requirements 139.1 210.7 8 years +Income Taxes Subject to Flow Through ( 356.4 ) ( 362.3 ) 24 years +Total Income Tax Related Regulatory Liabilities 472.7 567.3 +Total Regulatory Liabilities Approved for Payment 1,224.7 1,268.7 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits +$ 1,224.7 $ 1,268.7 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) Relieved as removal costs are incurred. +(c) Refunded using ARAM. +273 +I&M +December 31, Remaining +Recovery +Period +Regulatory Assets: 2020 2019 +(in millions) +Current Regulatory Assets +Under-recovered Fuel Costs - earns a return $ 5.4 $ 3.0 1 year +Total Current Regulatory Assets $ 5.4 $ 3.0 +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Earning a Return +Other Regulatory Assets Pending Final Regulatory Approval $ 0.5 $ — +Total Regulatory Assets Currently Earning a Return 0.5 — +Regulatory Assets Currently Not Earning a Return +COVID-19 3.8 — +Cook Plant Study Costs — 7.6 +Other Regulatory Assets Pending Final Regulatory Approval — 0.1 +Total Regulatory Assets Currently Not Earning a Return 3.8 7.7 +Total Regulatory Assets Pending Final Regulatory Approval 4.3 7.7 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Plant Retirement Costs - Unrecovered Plant 191.5 214.9 8 years +Rockport Plant Dry Sorbent Injection System and Selective Catalytic Reduction 34.4 13.5 8 years +Cook Plant Uprate Project 30.2 32.6 13 years +Deferred Cook Plant Life Cycle Management Project Costs 14.1 15.1 14 years +Cook Plant Turbine 11.1 13.4 18 years +Cook Plant Study Costs - Indiana 10.1 — 15 years +Other Regulatory Assets Approved for Recovery 7.0 6.9 various +Total Regulatory Assets Currently Earning a Return 298.4 296.4 +Regulatory Assets Currently Not Earning a Return +Cook Plant Nuclear Refueling Outage Levelization 39.5 63.8 2 years +Pension and OPEB Funded Status 25.7 67.5 12 years +Unamortized Loss on Reacquired Debt 15.7 17.2 28 years +Postemployment Benefits 4.9 7.2 3 years +Other Regulatory Assets Approved for Recovery 16.3 22.3 various +Total Regulatory Assets Currently Not Earning a Return 102.1 178.0 +Total Regulatory Assets Approved for Recovery 400.5 474.4 +Total Noncurrent Regulatory Assets $ 404.8 $ 482.1 +274 +I&M +December 31, Remaining +Refund +Period +Regulatory Liabilities: 2020 2019 +(in millions) +Current Regulatory Liabilities +Over-recovered Fuel Costs, Indiana - does not pay a return $ 20.8 $ 6.1 1 year +Total Current Regulatory Liabilities $ 20.8 $ 6.1 +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs $ 168.2 $ 166.7 (b) +Other Regulatory Liabilities Approved for Payment 17.4 0.3 various +Total Regulatory Liabilities Currently Paying a Return 185.6 167.0 +Regulatory Liabilities Currently Not Paying a Return +Excess Nuclear Decommissioning Funding 1,476.6 1,236.0 (c) +Spent Nuclear Fuel 43.1 43.6 (c) +Deferred Investment Tax Credits 21.3 25.8 19 years +PJM Costs and Off-system Sales Margin Sharing - Indiana 13.3 17.0 2 years +PJM Transmission Enhancement Refund 9.9 11.8 5 years +Deferred Gain on Sale of Rockport Unit 2 7.2 10.9 2 years +Other Regulatory Liabilities Approved for Payment 30.1 24.9 various +Total Regulatory Liabilities Currently Not Paying a Return 1,601.5 1,370.0 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 450.6 470.9 (d) +Excess ADIT that is Not Subject to Rate Normalization Requirements 136.2 184.5 4 years +Income Taxes Subject to Flow Through ( 332.0 ) ( 301.0 ) 20 years +Total Income Tax Related Regulatory Liabilities 254.8 354.4 +Total Regulatory Liabilities Approved for Payment 2,041.9 1,891.4 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits +$ 2,041.9 $ 1,891.4 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) Relieved as removal costs are incurred. +(c) Relieved when plant is decommissioned. +(d) Refunded using ARAM. +275 +OPCo +December 31, Remaining +Recovery +Period +Regulatory Assets: 2020 2019 +(in millions) +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Not Earning a Return +COVID-19 $ 4.4 $ — +Storm-Related Costs 4.0 — +Other Regulatory Assets Pending Final Regulatory Approval — 0.1 +Total Regulatory Assets Pending Final Regulatory Approval 8.4 0.1 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Ohio Distribution Decoupling 46.6 31.4 2 years +Ohio Basic Transmission Cost Rider 12.3 — 2 years +Other Regulatory Assets Approved for Recovery 1.3 — various +Total Regulatory Assets Currently Earning a Return 60.2 31.4 +Regulatory Assets Currently Not Earning a Return +Pension and OPEB Funded Status 130.7 167.3 12 years +Unrealized Loss on Forward Commitments 110.0 103.6 12 years +OVEC Purchased Power 27.4 1.5 2 years +Smart Grid Costs 19.2 13.7 2 years +Distribution Investment Rider 7.4 10.9 2 years +Postemployment Benefits 6.7 7.6 3 years +Other Regulatory Assets Approved for Recovery 15.8 15.7 various +Total Regulatory Assets Currently Not Earning a Return 317.2 320.3 +Total Regulatory Assets Approved for Recovery 377.4 351.7 +Total Noncurrent Regulatory Assets $ 385.8 $ 351.8 +276 +OPCo +December 31, Remaining +Refund +Period +2020 2019 +Regulatory Liabilities: (in millions) +Current Regulatory Liabilities +Over-recovered Fuel Costs - does not pay a return $ 3.9 $ 2.8 1 year +Total Current Regulatory Liabilities $ 3.9 $ 2.8 +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities pending final regulatory determination: +Regulatory Liabilities Currently Not Paying a Return +Other Regulatory Liabilities Pending Final Regulatory Determination $ 0.2 $ 0.2 +Total Regulatory Liabilities Pending Final Regulatory Determination 0.2 0.2 +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs 458.4 446.3 (b) +Ohio Basic Transmission Cost Rider — 37.2 +Other Regulatory Liabilities Approved for Payment — 1.3 +Total Regulatory Liabilities Currently Paying a Return 458.4 484.8 +Regulatory Liabilities Currently Not Paying a Return +PJM Transmission Enhancement Refund 24.5 29.4 5 years +Peak Demand Reduction/Energy Efficiency 19.9 19.7 2 years +Ohio Enhanced Service Reliability Plan 5.7 29.7 2 years +Other Regulatory Liabilities Approved for Payment 0.7 2.9 various +Total Regulatory Liabilities Currently Not Paying a Return 50.8 81.7 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 334.6 341.6 (c) +Excess ADIT that is Not Subject to Rate Normalization Requirements 223.9 252.3 8 years +Income Taxes Subject to Flow Through ( 62.7 ) ( 69.7 ) 29 years +Total Income Tax Related Regulatory Liabilities 495.8 524.2 +Total Regulatory Liabilities Approved for Payment 1,005.0 1,090.7 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits +$ 1,005.2 $ 1,090.9 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) Relieved as removal costs are incurred. +(c) Refunded using ARAM. +277 +PSO +December 31, Remaining +Recovery +Period +2020 2019 +Regulatory Assets: (in millions) +Current Regulatory Assets +Under-recovered Fuel Costs - earns a return $ 30.1 $ — 1 year +Total Current Regulatory Assets $ 30.1 $ — +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Earning a Return +Oklaunion Power Station Accelerated Depreciation $ 34.4 $ 27.4 +Total Regulatory Assets Currently Earning a Return 34.4 27.4 +Regulatory Assets Currently Not Earning a Return +Storm-Related Costs 15.8 7.2 +COVID-19 0.3 — +Total Regulatory Assets Currently Not Earning a Return 16.1 7.2 +Total Regulatory Assets Pending Final Regulatory Approval 50.5 34.6 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Plant Retirement Costs - Unrecovered Plant (a) 180.8 167.0 20 years +Environmental Control Projects 26.5 27.8 20 years +Meter Replacement Costs 26.2 30.2 7 years +Storm-Related Costs 11.5 21.3 2 years +Red Rock Generating Facility 8.2 8.4 36 years +Other Regulatory Assets Approved for Recovery 0.5 0.6 various +Total Regulatory Assets Currently Earning a Return 253.7 255.3 +Regulatory Assets Currently Not Earning a Return +Pension and OPEB Funded Status 52.3 73.4 12 years +Unamortized Loss on Reacquired Debt 6.1 6.5 18 years +Other Regulatory Assets Approved for Recovery 12.4 5.4 various +Total Regulatory Assets Currently Not Earning a Return 70.8 85.3 +Total Regulatory Assets Approved for Recovery 324.5 340.6 +Total Noncurrent Regulatory Assets $ 375.0 $ 375.2 +(a) Northeastern Plant, Unit 3 is approved for recovery through 2040, but expected to retire in 2026. PSO records a regulatory asset for accelerated depreciation. See “Regulated Generating Units to be Retired” section above for additional information. +278 +PSO +December 31, Remaining +Refund +Period +2020 2019 +Regulatory Liabilities: (in millions) +Current Regulatory Liabilities +Over-recovered Fuel Costs - pays a return $ — $ 63.9 +Total Current Regulatory Liabilities $ — $ 63.9 +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs $ 289.9 $ 286.8 (b) +Total Regulatory Liabilities Currently Paying a Return 289.9 286.8 +Regulatory Liabilities Currently Not Paying a Return +Deferred Investment Tax Credits 51.0 51.5 24 years +Other Regulatory Liabilities Approved for Payment 1.3 4.7 various +Total Regulatory Liabilities Currently Not Paying a Return 52.3 56.2 +Income Tax Related Regulatory Liabilities (a) +Excess ADIT Associated with Certain Depreciable Property 397.0 405.8 (c) +Excess ADIT that is Not Subject to Rate Normalization Requirements 71.3 96.3 4 years +Income Taxes Subject to Flow Through ( 8.3 ) ( 7.9 ) 27 years +Total Income Tax Related Regulatory Liabilities 460.0 494.2 +Total Regulatory Liabilities Approved for Payment 802.2 837.2 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits +$ 802.2 $ 837.2 +(a) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(b) Relieved as removal costs are incurred. +(c) Refunded using ARAM. +279 +SWEPCo +December 31, Remaining +Recovery +Period +2020 2019 +Regulatory Assets: (in millions) +Current Regulatory Assets +Under-recovered Fuel Costs - earns a return (a) $ 2.6 $ 4.9 1 year +Total Current Regulatory Assets $ 2.6 $ 4.9 +Noncurrent Regulatory Assets +Regulatory assets pending final regulatory approval: +Regulatory Assets Currently Earning a Return +Dolet Hills Power Station Accelerated Depreciation $ 71.2 $ — +Plant Retirement Costs - Unrecovered Plant, Louisiana 35.2 35.2 +Pirkey Power Plant Accelerated Depreciation 12.2 — +Welsh Plant, Units 1 and 3 Accelerated Depreciation 3.6 — +Other Regulatory Assets Pending Final Regulatory Approval 2.2 0.2 +Total Regulatory Assets Currently Earning a Return 124.4 35.4 +Regulatory Assets Currently Not Earning a Return +Storm-Related Costs 99.3 — +Asset Retirement Obligation - Louisiana 9.1 7.2 +Other Regulatory Assets Pending Final Regulatory Approval 14.5 3.7 +Total Regulatory Assets Currently Not Earning a Return 122.9 10.9 +Total Regulatory Assets Pending Final Regulatory Approval 247.3 46.3 +Regulatory assets approved for recovery: +Regulatory Assets Currently Earning a Return +Plant Retirement Costs - Unrecovered Plant, Arkansas 14.4 15.1 22 years +Environmental Controls Projects 12.1 13.2 12 years +Other Regulatory Assets Approved for Recovery 7.1 8.9 various +Total Regulatory Assets Currently Earning a Return 33.6 37.2 +Regulatory Assets Currently Not Earning a Return +Pension and OPEB Funded Status 89.1 102.6 12 years +Plant Retirement Costs - Unrecovered Plant, Texas 16.1 16.6 21 years +Other Regulatory Assets Approved for Recovery 17.0 19.7 various +Total Regulatory Assets Currently Not Earning a Return 122.2 138.9 +Total Regulatory Assets Approved for Recovery 155.8 176.1 +Total Noncurrent Regulatory Assets $ 403.1 $ 222.4 +(a) December 31, 2020 amount includes Louisiana jurisdiction. December 31, 2019 amount includes Arkansas jurisdiction. +280 +SWEPCo +December 31, Remaining +Refund +Period +2020 2019 +Regulatory Liabilities: (in millions) +Current Regulatory Liabilities +Over-recovered Fuel Costs - pays a return (a) $ 37.6 $ 13.6 1 year +Total Current Regulatory Liabilities $ 37.6 $ 13.6 +Noncurrent Regulatory Liabilities and +Deferred Investment Tax Credits +Regulatory liabilities pending final regulatory determination: +Income Tax Related Regulatory Liabilities (b) +Excess ADIT Associated with Certain Depreciable Property $ 291.6 $ 297.0 +Excess ADIT that is Not Subject to Rate Normalization Requirements 21.8 22.7 +Total Regulatory Liabilities Pending Final Regulatory Determination 313.4 319.7 +Regulatory liabilities approved for payment: +Regulatory Liabilities Currently Paying a Return +Asset Removal Costs 470.9 453.4 (c) +Other Regulatory Liabilities Approved for Payment 2.4 2.8 various +Total Regulatory Liabilities Currently Paying a Return 473.3 456.2 +Regulatory Liabilities Currently Not Paying a Return +Peak Demand Reduction/Energy Efficiency 5.2 6.0 2 years +Deferred Investment Tax Credits 1.8 3.1 10 years +Other Regulatory Liabilities Approved for Payment 1.2 1.7 various +Total Regulatory Liabilities Currently Not Paying a Return 8.2 10.8 +Income Tax Related Regulatory Liabilities (b) +Excess ADIT Associated with Certain Depreciable Property 332.5 339.4 (d) +Excess ADIT that is Not Subject to Rate Normalization Requirements 11.5 27.8 (e) +Income Taxes Subject to Flow Through ( 275.5 ) ( 261.6 ) 28 years +Total Income Tax Related Regulatory Liabilities 68.5 105.6 +Total Regulatory Liabilities Approved for Payment 550.0 572.6 +Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits +$ 863.4 $ 892.3 +(a) December 31, 2020 amount includes Arkansas and Texas jurisdictions. December 31, 2019 amount includes Texas and Louisiana jurisdictions. +(b) This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35 % to 21 % related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. +(c) Relieved as removal costs are incurred. +(d) Refunded using ARAM. +(e) Current balance represents revisions to balances for jurisdictions having previously issued orders on treatment for refund, refund period to be addressed in future proceedings. +281 +6. COMMITMENTS, GUARANTEES AND CONTINGENCIES +The disclosures in this note apply to all Registrants unless indicated otherwise. +The Registrants are subject to certain claims and legal actions arising in the ordinary course of business. In addition, the Registrants business activities are subject to extensive governmental regulation related to public health and the environment. The ultimate outcome of such pending or potential litigation against the Registrants cannot be predicted. Management accrues contingent liabilities only when management concludes that it is both probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. When management determines that it is not probable, but rather reasonably possible that a liability has been incurred at the date of the financial statements, management discloses such contingencies and the possible loss or range of loss if such estimate can be made. Any estimated range is based on currently available information and involves elements of judgment and significant uncertainties. Any estimated range of possible loss may not represent the maximum possible loss exposure. Circumstances change over time and actual results may vary significantly from estimates. +For current proceedings not specifically discussed below, management does not anticipate that the liabilities, if any, arising from such proceedings would have a material effect on the financial statements. +COMMITMENTS (Applies to all Registrants except AEP Texas and AEPTCo) +The AEP System has substantial commitments for fuel, energy and capacity contracts as part of the normal course of business. Certain contracts contain penalty provisions for early termination. +In accordance with the accounting guidance for “Commitments”, the following tables summarize the Registrants’ actual contractual commitments as of December 31, 2020: +Contractual Commitments - AEP Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Fuel Purchase Contracts (a) $ 763.9 $ 715.1 $ 212.9 $ 381.5 $ 2,073.4 +Energy and Capacity Purchase Contracts 211.6 291.8 277.0 928.5 1,708.9 +Total $ 975.5 $ 1,006.9 $ 489.9 $ 1,310.0 $ 3,782.3 +Contractual Commitments - APCo Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Fuel Purchase Contracts (a) $ 362.8 $ 217.6 $ 11.6 $ 16.3 $ 608.3 +Energy and Capacity Purchase Contracts 35.5 72.5 73.9 230.2 412.1 +Total $ 398.3 $ 290.1 $ 85.5 $ 246.5 $ 1,020.4 +Contractual Commitments - I&M Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Fuel Purchase Contracts (a) $ 157.7 $ 278.9 $ 189.3 $ 332.7 $ 958.6 +Energy and Capacity Purchase Contracts 165.2 196.7 60.9 254.6 677.4 +Total $ 322.9 $ 475.6 $ 250.2 $ 587.3 $ 1,636.0 +Contractual Commitments - OPCo Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Energy and Capacity Purchase Contracts $ 28.8 $ 58.2 $ 58.1 $ 263.3 $ 408.4 +282 +Contractual Commitments - PSO Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Fuel Purchase Contracts (a) $ 25.3 $ 36.2 $ — $ — $ 61.5 +Energy and Capacity Purchase Contracts 89.6 77.4 66.8 160.0 393.8 +Total $ 114.9 $ 113.6 $ 66.8 $ 160.0 $ 455.3 +Contractual Commitments - SWEPCo Less Than +1 Year 2-3 Years 4-5 Years After +5 Years Total +(in millions) +Fuel Purchase Contracts (a) $ 68.5 $ 39.2 $ — $ — $ 107.7 +Energy and Capacity Purchase Contracts 8.3 8.4 8.4 4.2 29.3 +Total $ 76.8 $ 47.6 $ 8.4 $ 4.2 $ 137.0 +(a) Represents contractual commitments to purchase coal, natural gas, uranium and other consumables as fuel for electric generation along with related transportation of the fuel. +GUARANTEES +Liabilities for guarantees are recorded in accordance with the accounting guidance for “Guarantees.” There is no collateral held in relation to any guarantees. In the event any guarantee is drawn, there is no recourse to third-parties unless specified below. +Letters of Credit (Applies to AEP and AEP Texas) +Standby letters of credit are entered into with third-parties. These letters of credit are issued in the ordinary course of business and cover items such as natural gas and electricity risk management contracts, construction contracts, insurance programs, security deposits and debt service reserves. +AEP has a $ 4 billion revolving credit facility due in June 2022, under which up to $ 1.2 billion may be issued as letters of credit on behalf of subsidiaries. As of December 31, 2020, no letters of credit were issued under the revolving credit facility. +An uncommitted facility gives the issuer of the facility the right to accept or decline each request made under the facility. AEP issues letters of credit on behalf of subsidiaries under six uncommitted facilities totaling $ 405 million. The Registrants’ maximum future payments for letters of credit issued under the uncommitted facilities as of December 31, 2020 were as follows: +Company Amount Maturity +(in millions) +AEP $ 179.8 January 2021 to December 2021 +AEP Texas 2.2 July 2021 +Guarantees of Equity Method Investees (Applies to AEP) +In April 2019, AEP acquired Sempra Renewables LLC. The transaction resulted in the acquisition of a 50% ownership interest in five non-consolidated joint ventures and the acquisition of two tax equity partnerships. Parent has issued guarantees over the performance of the joint ventures. If a joint venture were to default on payments or performance, Parent would be required to make payments on behalf of the joint venture. As of December 31, 2020, the maximum potential amount of future payments associated with these guarantees was $ 157 million, with the last guarantee expiring in December 2037. The non-contingent liability recorded associated with these guarantees was $ 31 million, with an additional $ 1 million expected credit loss liability for the contingent portion of the guarantees. Management considered historical losses, economic conditions, and reasonable and supportable forecasts in the calculation of the expected credit loss. As the joint ventures generate cash flows through PPAs, the measurement of the contingent portion of the guarantee liability is based upon assessments of the credit quality and default probabilities of the respective PPA counterparties. See “Acquisitions” section of Note 7 for additional information. +283 +Indemnifications and Other Guarantees +Contracts +The Registrants enter into certain types of contracts which require indemnifications. Typically these contracts include, but are not limited to, sale agreements, lease agreements, purchase agreements and financing agreements. Generally, these agreements may include, but are not limited to, indemnifications around certain tax, contractual and environmental matters. With respect to sale agreements, exposure generally does not exceed the sale price. As of December 31, 2020, there were no material liabilities recorded for any indemnifications. +AEPSC conducts power purchase-and-sale activity on behalf of APCo, I&M, KPCo and WPCo, who are jointly and severally liable for activity conducted on their behalf. AEPSC also conducts power purchase-and-sale activity on behalf of PSO and SWEPCo, who are jointly and severally liable for activity conducted on their behalf. +Lease Obligations +Certain Registrants lease equipment under master lease agreements. See “Master Lease Agreements” and “AEPRO Boat and Barge Leases” sections of Note 13 for additional information. +ENVIRONMENTAL CONTINGENCIES (Applies to All Registrants except AEPTCo) +The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation +By-products from the generation of electricity include materials such as ash, slag, sludge, low-level radioactive waste and SNF. Coal combustion by-products, which constitute the overwhelming percentage of these materials, are typically treated and deposited in captive disposal facilities or are beneficially utilized. In addition, the generation plants and transmission and distribution facilities have used asbestos, polychlorinated biphenyls and other hazardous and non-hazardous materials. The Registrants currently incur costs to dispose of these substances safely. +Superfund addresses clean-up of hazardous substances that are released to the environment. The Federal EPA administers the clean-up programs. Several states enacted similar laws. As of December 31, 2020, APCo, OPCo and SWEPCo are named as a Potentially Responsible Party (PRP) for one, three and one sites, respectively, by the Federal EPA for which alleged liability is unresolved. There are 11 additional sites for which APCo, I&M, KPCo, OPCo and SWEPCo received information requests which could lead to PRP designation. I&M has also been named potentially liable at three sites under state law. In those instances where a PRP or defendant has been named, disposal or recycling activities were in accordance with the then-applicable laws and regulations. Superfund does not recognize compliance as a defense, but imposes strict liability on parties who fall within its broad statutory categories. Liability has been resolved for a number of sites with no significant effect on net income. +Management evaluates the potential liability for each Superfund site separately, but several general statements can be made about potential future liability. Allegations that materials were disposed at a particular site are often unsubstantiated and the quantity of materials deposited at a site can be small and often non-hazardous. Although Superfund liability has been interpreted by the courts as joint and several, typically many parties are named as PRPs for each site and several of the parties are financially sound enterprises. As of December 31, 2020, management’s estimates do not anticipate material clean-up costs for identified Superfund sites. +284 +Virginia House Bill 443 (Applies to AEP and APCo) +In March 2020, Virginia’s Governor signed House Bill 443 (HB 443), effective July 2020, requiring APCo to close certain ash disposal units at the retired Glen Lyn Station by removal of all coal combustion material. As a result, in June 2020, APCo recorded a $ 199 million revision to increase estimated Glen Lyn Station ash disposal ARO liabilities. The closure is required to be completed within 15 years from the start of the excavation process. HB 443 provides for the recovery of all costs associated with closure by removal through the Virginia environmental rate adjustment clause (E-RAC). APCo is permitted to record carrying costs on the unrecovered balance of closure costs at a weighted-average cost of capital approved by the Virginia SCC. HB 443 also allows any closure costs allocated to non-Virginia jurisdictional customers, but not collected from such non-Virginia jurisdictional customers, to be recovered from Virginia jurisdictional customers through the E-RAC. APCo will submit filings with the Virginia SCC and the WVPSC requesting recovery of the respective Virginia and West Virginia jurisdictional shares of these Glen Lyn Station ARO costs. As of December 31, 2020, APCo has not yet incurred any incremental costs associated with the removal of coal combustion material at the Glen Lyn Station. +NUCLEAR CONTINGENCIES (APPLIES TO AEP AND I&M) +I&M owns and operates the two-unit 2,288 MW Cook Plant under licenses granted by the NRC. I&M has a significant future financial commitment to dispose of SNF and to safely decommission and decontaminate the plant. The licenses to operate the two nuclear units at the Cook Plant expire in 2034 and 2037. The operation of a nuclear facility also involves special risks, potential liabilities and specific regulatory and safety requirements. By agreement, I&M is partially liable, together with all other electric utility companies that own nuclear generation units, for a nuclear power plant incident at any nuclear plant in the U.S. Should a nuclear incident occur at any nuclear power plant in the U.S., the resultant liability could be substantial. +Decommissioning and Low-Level Waste Accumulation Disposal +The costs to decommission a nuclear plant are affected by NRC regulations and the SNF disposal program. Decommissioning costs are accrued over the service life of Cook Plant. The most recent decommissioning cost study was performed in 2018. According to that study, the estimated cost of decommissioning and disposal of low-level radioactive waste was $ 2 billion in 2018 non-discounted dollars, with additional ongoing costs of $ 6 million per year for post decommissioning storage of SNF and an eventual cost of $ 37 million for the subsequent decommissioning of the SNF storage facility, also in 2018 non-discounted dollars. I&M recovers estimated decommissioning costs for the Cook Plant in its rates. The amounts recovered in rates were $ 4 million, $ 7 million and $ 8 million for the years ended December 31, 2020, 2019 and 2018, respectively. Decommissioning costs recovered from customers are deposited in external trusts. +As of December 31, 2020 and 2019, the total decommissioning trust fund balances were $ 3 billion and $ 2.7 billion, respectively. Trust fund earnings increase the fund assets and decrease the amount remaining to be recovered from customers. The decommissioning costs (including unrealized gains and losses, interest and trust funds expenses) increase or decrease the recorded liability. +I&M continues to work with regulators and customers to recover the remaining estimated costs of decommissioning the Cook Plant. However, future net income and cash flows would be reduced and financial condition could be impacted if the cost of SNF disposal and decommissioning continues to increase and cannot be recovered. +285 +Spent Nuclear Fuel Disposal +The federal government is responsible for permanent SNF disposal and assesses fees to nuclear plant owners for SNF disposal. A fee of one-mill per KWh for fuel consumed after April 6, 1983 at the Cook Plant was collected from customers and remitted to the DOE through May 14, 2014. In May 2014, pursuant to court order from the U.S Court of Appeals for the District of Columbia Circuit, the DOE adjusted the fee to $ 0 . As of December 31, 2020 and 2019, fees and related interest of $ 281 million and $ 280 million, respectively, for fuel consumed prior to April 7, 1983 were recorded as Long-term Debt and funds collected from customers along with related earnings totaling $ 324 million and $ 323 million, respectively, to pay the fee were recorded as part of Spent Nuclear Fuel and Decommissioning Trusts on the balance sheets. I&M has not paid the government the pre-April 1983 fees due to continued delays and uncertainties related to the federal disposal program. +In 2011, I&M signed a settlement agreement with the federal government which permits I&M to make annual filings to recover certain SNF storage costs incurred as a result of the government’s delay in accepting SNF for permanent storage. Under the settlement agreement, I&M received $ 24 million, $ 8 million and $ 11 million in 2020, 2019 and 2018, respectively, to recover costs and will be eligible to receive additional payment of annual claims for allowed costs that are incurred through December 31, 2022. The proceeds reduced costs for dry cask storage. As of December 31, 2020 and 2019, I&M deferred $ 14 million and $ 24 million, respectively, in Prepayments and Other Current Assets and $ 1 million and $ 1 million, respectively, in Deferred Charges and Other Noncurrent Assets on the balance sheets for dry cask storage and related operation and maintenance costs for recovery under this agreement. See “Fair Value Measurements of Trust Assets for Decommissioning and SNF Disposal” section of Note 11 for additional information. +Nuclear Insurance +I&M carries nuclear property insurance of $ 2.7 billion to cover an incident at Cook Plant including coverage for decontamination and stabilization, as well as premature decommissioning caused by an extraordinary incident. Insurance coverage for a nonnuclear property incident at Cook Plant is $ 500 million. Additional insurance provides coverage for a weekly indemnity payment resulting from an insured accidental outage. I&M utilizes industry mutual insurers for the placement of this insurance coverage. Coverage from these industry mutual insurance programs require a contingent financial obligation of up to $ 42 million for I&M, which is assessable if the insurer’s financial resources would be inadequate to pay for industry losses. +The Price-Anderson Act, extended through December 31, 2025, establishes insurance protection for public nuclear liability arising from a nuclear incident of $ 13.8 billion and applies to any incident at a licensed reactor in the U.S. Commercially available insurance, which must be carried for each licensed reactor, provides $ 450 million of coverage. In the event of a nuclear incident at any nuclear plant in the U.S., the remainder of the liability would be provided by a deferred premium assessment of $ 275 million per nuclear incident on Cook Plant’s reactors payable in annual installments of $ 41 million. The number of incidents for which payments could be required is not limited. +In the event of an incident of a catastrophic nature, I&M is covered for public nuclear liability for the first $ 450 million through commercially available insurance. The next level of liability coverage of up to $ 13.3 billion would be covered by claim premium assessments made under the Price-Anderson Act. In the event nuclear losses or liabilities are underinsured or exceed accumulated funds, I&M would seek recovery of those amounts from customers through a rate increase. If recovery from customers is not possible, it could reduce future net income and cash flows and impact financial condition. +286 +OPERATIONAL CONTINGENCIES +Insurance and Potential Losses +The Registrants maintain insurance coverage normal and customary for electric utilities, subject to various deductibles. The Registrants also maintain property and casualty insurance that may cover certain physical damage or third-party injuries caused by cyber security incidents. Insurance coverage includes all risks of physical loss or damage to nonnuclear assets, subject to insurance policy conditions and exclusions. Covered property generally includes power plants, substations, facilities and inventories. Excluded property generally includes transmission and distribution lines, poles and towers. The insurance programs also generally provide coverage against loss arising from certain claims made by third-parties and are in excess of retentions absorbed by the Registrants. Coverage is generally provided by a combination of the protected cell of EIS and/or various industry mutual and/or commercial insurance carriers. See “Nuclear Contingencies” section above for additional information. +Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including, but not limited to, liabilities relating to a cyber security incident or damage to the Cook Plant and costs of replacement power in the event of an incident at the Cook Plant. Future losses or liabilities, if they occur, which are not completely insured, unless recovered from customers, could reduce future net income and cash flows and impact financial condition. +Rockport Plant Litigation (Applies to AEP and I&M) +In 2013, the Wilmington Trust Company filed a complaint in the U.S. District Court for the Southern District of New York against AEGCo and I&M alleging that it would be unlawfully burdened by the terms of the modified NSR consent decree after the Rockport Plant, Unit 2 lease expiration in December 2022. The terms of the consent decree allow the installation of environmental emission control equipment, repowering, refueling or retirement of the unit. The plaintiffs seek a judgment declaring that the defendants breached the lease, must satisfy obligations related to installation of emission control equipment and indemnify the plaintiffs. The New York court granted a motion to transfer this case to the U.S. District Court for the Southern District of Ohio. +AEGCo and I&M sought and were granted dismissal by the U.S. District Court for the Southern District of Ohio of certain of the plaintiffs’ claims, including claims for compensatory damages, breach of contract, breach of the implied covenant of good faith and fair dealing and indemnification of costs. Plaintiffs voluntarily dismissed the surviving claims that AEGCo and I&M failed to exercise prudent utility practices with prejudice, and the court issued a final judgment. The plaintiffs subsequently filed an appeal in the U.S. Court of Appeals for the Sixth Circuit. +In 2017, the U.S. Court of Appeals for the Sixth Circuit issued an opinion and judgment affirming the district court’s dismissal of the owners’ breach of good faith and fair dealing claim as duplicative of the breach of contract claims, reversing the district court’s dismissal of the breach of contract claims and remanding the case for further proceedings. +Thereafter, AEP filed a motion with the U.S. District Court for the Southern District of Ohio in the original NSR litigation, seeking to modify the consent decree. The district court granted the owners’ unopposed motion to stay the lease litigation to afford time for resolution of AEP’s motion to modify the consent decree. The consent decree was modified based on an agreement among the parties in July 2019. The district court’s stay of the lease litigation expired in August 2020. Upon expiration of the stay, plaintiffs filed a motion for partial summary judgment, arguing that the consent decree violates the facility lease and the participation agreement and requesting that the district court enter a judgment for the plaintiffs on their breach of contract claim. AEP’s memorandum in opposition to plaintiffs’ motion for partial summary judgement was filed in October 2020. At the parties’ request, the district court stayed the case until February 16, 2021 to provide the parties an opportunity to resolve the case, and the court has since extended the stay until April 26, 2021. +287 +Management will continue to defend against the claims and believes its financial statements appropriately reflect the potential outcome of the pending litigation. The ultimate outcome of the pending litigation could reduce future net income and cash flows and impact financial condition. +Patent Infringement Complaint +In July 2019, Midwest Energy Emissions Corporation and MES Inc. (collectively, the plaintiffs) filed a patent infringement complaint against various parties, including AEP Texas, AGR, Cardinal Operating Company and SWEPCo (collectively, the AEP Defendants). The complaint alleges that the AEP Defendants infringed two patents owned by the plaintiffs by using specific processes for mercury control at certain coal-fired generating stations. The complaint was resolved in December 2020 and did not have a material impact on net income, cash flows or financial condition. +Claims Challenging Transition of American Electric Power System Retirement Plan to Cash Balance Formula +The American Electric Power System Retirement Plan (the Plan) has received a letter written on behalf of four participants (the Claimants) making a claim for additional plan benefits and purporting to advance such claims on behalf of a class. When the Plan’s benefit formula was changed in the year 2000, AEP provided a special provision for employees hired before January 1, 2001, allowing them to continue benefit accruals under the then benefit formula for a full 10 years alongside of the new cash balance benefit formula then being implemented. Employees who were hired on or after January 1, 2001 accrued benefits only under the new cash balance benefit formula. The Claimants have asserted claims that: (a) the Plan violates the requirements under the Employee Retirement Income Security Act (ERISA) intended to preclude back-loading the accrual of benefits to the end of a participant’s career, (b) the Plan violates the age discrimination prohibitions of ERISA and the Age Discrimination in Employment Act and (c) the company failed to provide required notice regarding the changes to the Plan. AEP has responded to the Claimants providing a reasoned explanation for why each of their claims have been denied. The denial of those claims was appealed to the AEP System Retirement Plan Appeal Committee and the Committee upheld the denial of claims. Management will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring. +Litigation Related to Ohio House Bill 6 (Applies to AEP and OPCo) +In August 2020, an AEP shareholder filed a putative class action lawsuit in the United States District Court for the Southern District of Ohio against AEP and certain of its officers for alleged violations of securities laws. The complaint alleges misrepresentations or omissions by AEP regarding: (a) its alleged participation in public corruption with respect to the passage of Ohio House Bill 6, (b) its regulatory, legislative and lobbying activities in Ohio and (c) its clean energy strategy. The complaint seeks monetary damages among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring. +In January 2021, an AEP shareholder filed a derivative action in the United States District Court for the Southern District of Ohio purporting to assert claims on behalf of AEP against certain AEP officers and directors. In February 2021, a second AEP shareholder filed a similar derivative action in the Court of Common Pleas of Franklin County, Ohio. The derivative complaints allege the officers and directors made misrepresentations and omissions similar to those alleged in the putative securities class action lawsuit filed against AEP. The complaints assert claims for: (a) breach of fiduciary duty, (b) waste of corporate assets and (c) unjust enrichment and seek monetary damages and changes to AEP’s corporate governance and internal policies among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring. +288 +7. ACQUISITIONS, DISPOSITIONS AND IMPAIRMENTS +The disclosures in this note apply to AEP unless indicated otherwise. +ACQUISITIONS +2020 +Santa Rita East (Generation & Marketing Segment) +In November 2020, AEP acquired an additional 10 % interest in Santa Rita East for approximately $ 44 million resulting in AEP having a total interest of 85 %. The acquisition of the incremental ownership interest was accounted for as an equity transaction in accordance with the accounting guidance for "Consolidation" and reduced Noncontrolling Interests on the balance sheets by approximately $ 44 million. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. +Desert Sky Wind Farm and Trent Wind Farm (Generation & Marketing Segment) +In August 2020, AEP exercised its call right which required the nonaffiliated member of Desert Sky Wind Farm LLC and Trent Wind Farm LLC (collectively the LLCs) to sell its noncontrolling interest to AEP. The exercise price for the call right was determined using a discounted cash flow model with agreed input assumptions as well as updates to certain assumptions reasonably expected based on the actual results of the LLCs. As a result, the LLCs are wholly-owned by AEP and management has concluded that the LLCs are no longer VIEs. AEP paid $ 57 million in cash, derecognized $ 63 million of Redeemable Noncontrolling Interest within Mezzanine Equity and recorded an increase of $ 6 million of Paid-In Capital on the balance sheets. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. +2019 +Sempra Renewables LLC (Generation & Marketing Segment) +In April 2019, AEP acquired Sempra Renewables LLC and its ownership interests in 724 MWs of wind generation and battery assets valued at approximately $ 1.1 billion. This acquisition is part of AEP’s strategy to grow its renewable generation portfolio and to diversify generation resources. AEP paid $580 million in cash and acquired a 50 % ownership interest in five non-consolidated joint ventures with net assets valued at $404 million as of the acquisition date (which includes $ 364 million of existing debt obligations). Additionally, the transaction included the acquisition of two tax equity partnerships and the associated recognition of noncontrolling tax equity interest of $135 million. +Purchase Price Allocation of Sempra Renewables LLC at Acquisition Date - April 22nd, 2019 +Assets: Liabilities and Equity: Net Purchase Price +(in millions) +Current Assets $ 8.8 Current Liabilities $ 12.9 +Property, Plant and Equipment 238.1 Asset Retirement Obligations 5.7 +Investment in Joint Ventures 404.0 Total Liabilities 18.6 +Other Noncurrent Assets 82.9 Noncontrolling Interest 134.8 +Total Assets $ 733.8 Liabilities and Noncontrolling Interest $ 153.4 $ 580.4 +Management allocated the purchase price based upon the relative fair value of the assets acquired and noncontrolling interests assumed. The fair value of the primary assets acquired and the noncontrolling interests assumed was determined using a discounted cash flow method under the income approach. The key input assumptions utilized in the determination of the fair value of these assets were the pricing and terms of the existing PPAs, forecasted market power prices, expected wind farm net capacity and discount rates reflecting risk inherent in the future cash flows and future power prices. Estimating forecasted market power prices involved determining the +289 +cost of constructing and operating a new wind plant over an assumed life in the same geographic region as of the acquisition date using third-party market participant assumptions. The expected wind farm net capacity was developed by evaluating each wind farm’s historical and expected generation against historical generation of comparable wind farms in the same locations. Discount rates were evaluated by considering the cost of capital of comparable businesses. Additional key input assumptions for the fair value of the noncontrolling interests include the terms of the limited liability company agreements that dictate the sharing of the tax attributes and cash flows associated with the tax equity partnerships. +Upon closing of the purchase, Sempra Renewables LLC was legally renamed AEP Wind Holdings LLC. AEP Wind Holdings LLC develops, owns and operates, or holds interests in, wind generation facilities in the United States. The operating wind generation portfolio includes seven wind farms. Five wind farms are jointly-owned with BP Wind Energy, and two wind farms are consolidated by AEP and are tax equity partnerships with nonaffiliated noncontrolling interests. All seven wind farms have long-term PPAs for 100% of their energy production. The PPAs with I&M, OPCo and SWEPCo were executed prior to the acquisition of the wind farms and will be accounted for in accordance with the accounting guidance for “Related Parties.” See “Sempra Renewables LLC PPAs” section of Note 16 for additional information. +The acquired business contributed revenues and net income to AEP that were not material for the period April 22, 2019 to December 31, 2019. The pro-forma revenue and net income related to the acquisition of Sempra Renewables LLC were not material for the year ended December 31, 2019. +See Note 17 - Variable Interest Entities and Equity Method Investments for additional information related to the purchased wind farms. +Santa Rita East (Generation & Marketing Segment) +In July 2019, AEP acquired a 75 % interest, or 227 MWs, in Santa Rita East for approximately $ 356 million. In accordance with the accounting guidance for “Business Combinations,” management determined that the acquisition of Santa Rita East represents an asset acquisition. Additionally, and in accordance with the accounting guidance for “Consolidation,” management concluded that Santa Rita East is a VIE. As a result, to account for the initial consolidation of Santa Rita East, management applied the acquisition method by allocating the purchase price based on the relative fair value of the assets acquired and noncontrolling interest assumed. The fair value of the primary assets acquired and the noncontrolling interest assumed was determined using the market approach. The key input assumptions were the transaction price paid for AEP’s interest in Santa Rita East and recent third-party market transactions for similar wind farms. See “Santa Rita East” section of Note 17 for additional information. +290 +DISPOSITIONS +2020 +Conesville Plant (Generation & Marketing Segment) +In June 2020, AEP and a nonaffiliated joint-owner executed an Environmental Liability and Property Transfer and Asset Purchase Agreement with a nonaffiliated third-party related to the merchant Conesville Plant site. The purchaser took ownership of the assets and assumed responsibility for environmental liabilities, including ash pond closure, asbestos abatement and decommissioning and demolition of the Conesville Plant site. In consideration of the transfer of the acquired assets to the purchaser and the purchaser’s assumption of liabilities, AEP will pay a total of approximately $ 98 million over three years, derecognized $ 106 million in ARO and recorded an immaterial gain on the transaction which is recorded in Other Operation on the statements of income. AEP paid approximately $ 26 million at closing in June 2020 and made an additional payment of $ 10 million in the fourth quarter of 2020. AEP will make additional payments as detailed in the table below: +2021 2022 +(in millions) +First Quarter $ 9.6 $ 9.6 +Second Quarter 9.6 9.6 +Third Quarter 9.6 5.2 +Fourth Quarter 9.6 — +Total $ 38.4 $ 24.4 +Oklaunion Power Station (Transmission and Distribution Segment and Vertically Integrated Utilities Segment) (Applies to AEP, AEP Texas and PSO) +In October 2020, AEP Texas, PSO and a nonaffiliated joint-owner executed an Environmental Liability and Property Transfer and Asset Purchase Agreement with a nonaffiliated third-party related to the Oklaunion Power Station site. The purchaser took ownership of the assets and assumed responsibility for environmental liabilities, including ash pond closure, asbestos abatement and decommissioning and demolition of the Oklaunion Power Station site. The sale had an immaterial impact on the financial statements in the fourth quarter of 2020. +IMPAIRMENTS +2019 +2019 Texas Base Rate Case (Transmission and Distribution Segment) (Applies to AEP and AEP Texas) +In December 2019, AEP Texas recorded a pretax impairment of $ 33 million in Asset Impairments and Other Related Charges on the statements of income due to regulatory disallowances in the 2019 Texas Base Rate Case. See “2019 Texas Base Rate Case” section of Note 4 for additional information. +Virginia Jurisdictional Book Value of Retired Coal-Fired Plants (Vertically Integrated Utilities Segment) (Applies to AEP and APCo) +In December 2019, based on management’s interpretation of Virginia law and more certainty regarding APCo’s triennial revenues, expenses and resulting earnings upon reaching the end of the three-year review period, APCo recorded a pretax expense of $ 93 million in Asset Impairments and Other Related Charges on the statements of income related to its previously retired coal-fired generation. As a result, management deemed these costs to be substantially recovered by APCo during the triennial review period. See “2017-2019 Virginia Triennial Review” section of Note 4 for additional information. +291 +Merchant Generating Assets (Generation & Marketing Segment) +Due to a significant increase in the asset retirement costs recorded in December 2019 for the Ash Pond Complex at Conesville Plant, AEP performed an impairment analysis on Conesville Plant in accordance with accounting guidance for impairments of long-lived assets. AEP performed step one and step two of the impairment analysis using a cash flow model for the estimated useful life of Conesville Plant based upon energy and capacity price curves, which were developed internally with both observable Level 2 third-party quotations and unobservable Level 3 inputs, as well as management’s forecasts of operating expenses. The step two analysis resulted in a fair value determination for Conesville Plant of $ 0 and AEP recorded a $ 31 million pretax impairment, equal to the net book value of the plant, in Asset Impairments and Other Related Charges on AEP’s statements of income in the fourth quarter of 2019. +2018 +Other Assets (Corporate and Other) (Vertically Integrated Utilities Segment) (Applies to AEP and APCo) +In the first quarter of 2018, AEP was notified by an equity investee that it had ceased operations. AEP recorded a pretax impairment of $ 21 million in Asset Impairments and Other Related Charges on the statements of income related to the equity investment and related assets. The impairment also had an immaterial impact to APCo. +Merchant Generating Assets (Generation & Marketing Segment) +A project to reconstruct a defective dam structure at Racine began in the first quarter of 2017 and reconstruction activities continued throughout 2018. AEP initially impaired Racine in 2017 as discussed in the “2017 Merchant Generating Assets” section of the Acquisitions, Dispositions and Impairments Note within the 2019 Annual Report. +Through the third quarter of 2018, the Racine reconstruction project had accumulated new capital expenditures of $ 35 million. Due to a significant increase in estimated costs to complete the reconstruction project, an impairment analysis was performed. AEP performed step one of the impairment analysis using undiscounted cash flows for the estimated useful life of Racine based upon energy and capacity price curves, which were developed internally with observable Level 2 third-party quotations and unobservable Level 3 inputs, as well as management’s forecasts of operating expenses and capital expenditures. AEP performed step two of the impairment analysis on Racine using a ten-year discounted cash flow model based upon similar forecasted information used in the step one test. The step two analysis resulted in a determination that the fair value of Racine in its condition as of September 30, 2018 was $ 0 . As a result, AEP recorded a pretax impairment of $ 35 million in Other Operation on the statements of income in the third quarter of 2018. In October 2018, AEP received authorization from the FERC to restart generation at Racine and generation resumed in November 2018. Reconstruction activities at Racine were completed in 2020. +292 +8. BENEFIT PLANS +The disclosures in this note apply to all Registrants except AEPTCo unless indicated otherwise. +For a discussion of investment strategy, investment limitations, target asset allocations and the classification of investments within the fair value hierarchy, see “Fair Value Measurements of Assets and Liabilities” and “Investments Held in Trust for Future Liabilities” sections of Note 1. +AEP sponsors a qualified pension plan and two unfunded non-qualified pension plans. Substantially all AEP employees are covered by the qualified plan or both the qualified and a non-qualified pension plan. AEP also sponsors OPEB plans to provide health and life insurance benefits for retired employees. +Due to the Registrant Subsidiaries’ participation in AEP’s benefit plans, the assumptions used by the actuary, with the exception of the rate of compensation increase, and the accounting for the plans by each subsidiary are the same. This section details the assumptions that apply to all Registrants and the rate of compensation increase for each Registrant. +The Registrants recognize the funded status associated with defined benefit pension and OPEB plans on the balance sheets. Disclosures about the plans are required by the “Compensation – Retirement Benefits” accounting guidance. The Registrants recognize an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, and recognize, as a component of other comprehensive income, the changes in the funded status of the plan that arise during the year that are not recognized as a component of net periodic benefit cost. The Registrants record a regulatory asset instead of other comprehensive income for qualifying benefit costs of regulated operations that for rate-making purposes are deferred for future recovery. The cumulative funded status adjustment is equal to the remaining unrecognized deferrals for unamortized actuarial losses or gains, prior service costs and transition obligations, such that remaining deferred costs result in an AOCI equity reduction or regulatory asset and deferred gains result in an AOCI equity addition or regulatory liability. +Actuarial Assumptions for Benefit Obligations +The weighted-average assumptions used in the measurement of the Registrants’ benefit obligations are shown in the following tables: +Pension Plans OPEB +December 31, +Assumption 2020 2019 2020 2019 +Discount Rate 2.50 % 3.25 % 2.55 % 3.30 % +Interest Crediting Rate 4.00 % 4.00 % NA NA +NA Not applicable. +Pension Plans +December 31, +Assumption – Rate of Compensation Increase (a) +2020 2019 +AEP 5.00 % 4.95 % +AEP Texas 5.05 % 5.00 % +APCo 4.85 % 4.80 % +I&M 5.00 % 4.95 % +OPCo 5.25 % 5.15 % +PSO 5.05 % 5.05 % +SWEPCo 4.90 % 4.90 % +(a) Rates are for base pay only. In addition, an amount is added to reflect target incentive compensation for exempt employees and overtime and incentive pay for nonexempt employees. +293 +A duration-based method is used to determine the discount rate for the plans. A hypothetical portfolio of high quality corporate bonds is constructed with cash flows matching the benefit plan liability. The composite yield on the hypothetical bond portfolio is used as the discount rate for the plan. The discount rate is the same for each Registrant. +For 2020, the rate of compensation increase assumed varies with the age of the employee, ranging from 3 % per year to 11.5 % per year, with the average increase shown in the table above. The compensation increase rates reflect variations in each Registrants’ population participating in the pension plan. +Actuarial Assumptions for Net Periodic Benefit Costs +The weighted-average assumptions used in the measurement of each Registrants’ benefit costs are shown in the following tables: +Pension Plans OPEB +Year Ended December 31, +Assumption 2020 2019 2018 2020 2019 2018 +Discount Rate 3.25 % 4.30 % 3.65 % 3.30 % 4.30 % 3.60 % +Interest Crediting Rate 4.00 % 4.00 % 4.00 % NA NA NA +Expected Return on Plan Assets 5.75 % 6.25 % 6.00 % 5.50 % 6.25 % 6.00 % +NA Not applicable. +Pension Plans +Year Ended December 31, +Assumption – Rate of Compensation Increase (a) +2020 2019 2018 +AEP 5.00 % 4.95 % 4.85 % +AEP Texas 5.05 % 5.00 % 4.95 % +APCo 4.85 % 4.75 % 4.75 % +I&M 5.00 % 4.95 % 4.90 % +OPCo 5.25 % 5.20 % 5.00 % +PSO 5.05 % 5.05 % 4.90 % +SWEPCo 4.90 % 4.90 % 4.85 % +(a) Rates are for base pay only. In addition, an amount is added to reflect target incentive compensation for exempt employees and overtime and incentive pay for nonexempt employees. +The expected return on plan assets was determined by evaluating historical returns, the current investment climate (yield on fixed income securities and other recent investment market indicators), rate of inflation, third-party forecasts and current prospects for economic growth. The expected return on plan assets is the same for each Registrant. +The health care trend rate assumptions used for OPEB plans measurement purposes are shown below: +December 31, +Health Care Trend Rates 2020 2019 +Initial 6.50 % 6.00 % +Ultimate 4.50 % 4.50 % +Year Ultimate Reached 2029 2026 +294 +Significant Concentrations of Risk within Plan Assets +In addition to establishing the target asset allocation of plan assets, the investment policy also places restrictions on securities to limit significant concentrations within plan assets. The investment policy establishes guidelines that govern maximum market exposure, security restrictions, prohibited asset classes, prohibited types of transactions, minimum credit quality, average portfolio credit quality, portfolio duration and concentration limits. The guidelines were established to mitigate the risk of loss due to significant concentrations in any investment. Management monitors the plans to control security diversification and ensure compliance with the investment policy. As of December 31, 2020, the assets were invested in compliance with all investment limits. See “Investments Held in Trust for Future Liabilities” section of Note 1 for limit details. +Benefit Plan Obligations, Plan Assets, Funded Status and Amounts Recognized on the Balance Sheets +For the year ended December 31, 2020, the pension plans had an actuarial loss primarily due to a decrease in the discount rate, partially offset by a decrease in the assumed rate used to convert account balances to annuities. For the year ended December 31, 2020, the OPEB plans had an actuarial loss primarily due to a decrease in the discount rate and an update to the health care trend assumption, partially offset by updated projected per capita claims costs due to rate negotiations for Medicare advantage premium rates. For the year ended December 31, 2019, the pension plans had an actuarial loss due to a decrease in the discount rate, partially offset by updates to the mortality table. For the year ended December 31, 2019, the OPEB plans had an actuarial loss due to a decrease in the discount rate and an update to the persistency assumption, partially offset by an update to the projected per capita cost assumption as well as savings resulting from legislation signed in December 2019 which eliminated two Affordable Care Act taxes. The following tables provide a reconciliation of the changes in the plans’ benefit obligations, fair value of plan assets, funded status and the presentation on the balance sheets. The benefit obligation for the defined benefit pension and OPEB plans are the projected benefit obligation and the accumulated benefit obligation, respectively. +AEP Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 5,236.8 $ 4,810.3 $ 1,225.4 $ 1,194.5 +Service Cost 111.9 95.5 10.0 9.5 +Interest Cost 167.9 204.4 39.8 50.5 +Actuarial Loss 434.7 493.6 39.3 58.8 +Plan Amendments — 0.2 ( 11.4 ) ( 11.0 ) +Benefit Payments ( 406.8 ) ( 367.2 ) ( 131.0 ) ( 113.0 ) +Participant Contributions — — 38.2 35.5 +Medicare Subsidy — — 0.6 0.6 +Benefit Obligation as of December 31, $ 5,544.5 $ 5,236.8 $ 1,210.9 $ 1,225.4 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 5,015.4 $ 4,695.9 $ 1,781.8 $ 1,534.2 +Actual Gain on Plan Assets 832.4 681.1 253.0 321.0 +Company Contributions (a) 115.6 5.6 4.7 4.1 +Participant Contributions — — 38.2 35.5 +Benefit Payments ( 406.8 ) ( 367.2 ) ( 131.0 ) ( 113.0 ) +Fair Value of Plan Assets as of December 31, $ 5,556.6 $ 5,015.4 $ 1,946.7 $ 1,781.8 +Funded (Underfunded) Status as of December 31, $ 12.1 $ ( 221.4 ) $ 735.8 $ 556.4 +(a) Contributions to the qualified pension plan were $ 110 million and $ 0 for the years ended December 31, 2020 and 2019, respectively. Contributions to the non-qualified pension plans were $ 6 million and $ 6 million for the years ended December 31, 2020 and 2019, respectively. +295 +Pension Plans OPEB +December 31, +AEP +2020 2019 2020 2019 +(in millions) +Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs +$ 93.5 $ — $ 771.9 $ 590.8 +Other Current Liabilities – Accrued Short-term Benefit Liability +( 6.7 ) ( 6.1 ) ( 2.4 ) ( 2.6 ) +Employee Benefits and Pension Obligations – Accrued Long-term Benefit Liability +( 74.7 ) ( 215.3 ) ( 33.7 ) ( 31.8 ) +Funded (Underfunded) Status $ 12.1 $ ( 221.4 ) $ 735.8 $ 556.4 +AEP Texas Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 441.2 $ 409.3 $ 97.8 $ 95.9 +Service Cost 10.0 8.6 0.8 0.8 +Interest Cost 13.9 17.5 3.2 4.0 +Actuarial Loss 28.1 40.1 2.4 3.9 +Plan Amendments — — ( 1.0 ) ( 0.9 ) +Benefit Payments ( 40.0 ) ( 34.3 ) ( 10.0 ) ( 8.8 ) +Participant Contributions — — 3.1 2.9 +Benefit Obligation as of December 31, $ 453.2 $ 441.2 $ 96.3 $ 97.8 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 435.1 $ 410.7 $ 148.1 $ 129.9 +Actual Gain on Plan Assets 67.2 58.3 21.1 24.0 +Company Contributions 11.7 0.4 — 0.1 +Participant Contributions — — 3.1 2.9 +Benefit Payments ( 40.0 ) ( 34.3 ) ( 10.0 ) ( 8.8 ) +Fair Value of Plan Assets as of December 31, $ 474.0 $ 435.1 $ 162.3 $ 148.1 +Funded (Underfunded) Status as of December 31, $ 20.8 $ ( 6.1 ) $ 66.0 $ 50.3 +Pension Plans OPEB +December 31, +AEP Texas +2020 2019 2020 2019 +(in millions) +Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs +$ 24.7 $ — $ 66.0 $ 50.3 +Other Current Liabilities – Accrued Short-term Benefit Liability +( 0.4 ) ( 0.4 ) — — +Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability +( 3.5 ) ( 5.7 ) — — +Funded (Underfunded) Status $ 20.8 $ ( 6.1 ) $ 66.0 $ 50.3 +296 +APCo Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 647.2 $ 603.1 $ 203.5 $ 205.5 +Service Cost 10.5 9.4 1.0 1.0 +Interest Cost 20.3 25.2 6.6 8.7 +Actuarial Loss 40.0 52.9 5.6 4.7 +Plan Amendments — — ( 1.8 ) ( 1.7 ) +Benefit Payments ( 47.2 ) ( 43.4 ) ( 23.2 ) ( 20.8 ) +Participant Contributions — — 6.3 5.9 +Medicare Subsidy — — 0.2 0.2 +Benefit Obligation as of December 31, $ 670.8 $ 647.2 $ 198.2 $ 203.5 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 637.0 $ 593.3 $ 271.0 $ 238.4 +Actual Gain on Plan Assets 104.5 87.1 36.8 45.3 +Company Contributions 7.0 — 2.1 2.2 +Participant Contributions — — 6.3 5.9 +Benefit Payments ( 47.2 ) ( 43.4 ) ( 23.2 ) ( 20.8 ) +Fair Value of Plan Assets as of December 31, $ 701.3 $ 637.0 $ 293.0 $ 271.0 +Funded (Underfunded) Status as of December 31, $ 30.5 $ ( 10.2 ) $ 94.8 $ 67.5 +Pension Plans OPEB +December 31, +APCo +2020 2019 2020 2019 +(in millions) +Employee Benefits and Pension Assets – Prepaid Benefit Costs $ 31.0 $ — $ 119.1 $ 92.0 +Other Current Liabilities – Accrued Short-term Benefit Liability +— — ( 1.8 ) ( 2.0 ) +Employee Benefits and Pension Obligations – Accrued Long-term Benefit Liability +( 0.5 ) ( 10.2 ) ( 22.5 ) ( 22.5 ) +Funded (Underfunded) Status $ 30.5 $ ( 10.2 ) $ 94.8 $ 67.5 +297 +I&M Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 616.1 $ 567.0 $ 142.9 $ 138.3 +Service Cost 15.4 13.4 1.4 1.4 +Interest Cost 19.7 23.8 4.7 5.8 +Actuarial Loss 44.3 49.8 5.1 8.1 +Plan Amendments — — ( 1.6 ) ( 1.5 ) +Benefit Payments ( 42.2 ) ( 37.9 ) ( 15.9 ) ( 13.6 ) +Participant Contributions — — 4.8 4.4 +Benefit Obligation as of December 31, $ 653.3 $ 616.1 $ 141.4 $ 142.9 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 630.5 $ 583.8 $ 216.3 $ 187.3 +Actual Gain on Plan Assets 103.3 84.6 33.0 38.2 +Company Contributions 6.5 — — — +Participant Contributions — — 4.8 4.4 +Benefit Payments ( 42.2 ) ( 37.9 ) ( 15.9 ) ( 13.6 ) +Fair Value of Plan Assets as of December 31, $ 698.1 $ 630.5 $ 238.2 $ 216.3 +Funded Status as of December 31, $ 44.8 $ 14.4 $ 96.8 $ 73.4 +Pension Plans OPEB +December 31, +I&M +2020 2019 2020 2019 +(in millions) +Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs +$ 46.5 $ 15.8 $ 96.8 $ 73.4 +Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability +( 1.7 ) ( 1.4 ) — — +Funded Status $ 44.8 $ 14.4 $ 96.8 $ 73.4 +298 +OPCo Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 487.8 $ 453.9 $ 130.2 $ 129.5 +Service Cost 9.7 7.9 0.9 0.8 +Interest Cost 15.4 19.1 4.2 5.5 +Actuarial Loss 33.4 40.5 3.1 4.9 +Plan Amendments — — ( 1.3 ) ( 1.2 ) +Benefit Payments ( 36.0 ) ( 33.6 ) ( 15.0 ) ( 13.5 ) +Participant Contributions — — 4.3 4.1 +Medicare Subsidy — — — 0.1 +Benefit Obligation as of December 31, $ 510.3 $ 487.8 $ 126.4 $ 130.2 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 499.1 $ 466.1 $ 197.1 $ 175.4 +Actual Gain on Plan Assets 79.9 66.6 26.6 31.1 +Company Contributions 0.1 — — — +Participant Contributions — — 4.3 4.1 +Benefit Payments ( 36.0 ) ( 33.6 ) ( 15.0 ) ( 13.5 ) +Fair Value of Plan Assets as of December 31, $ 543.1 $ 499.1 $ 213.0 $ 197.1 +Funded Status as of December 31, $ 32.8 $ 11.3 $ 86.6 $ 66.9 +Pension Plans OPEB +December 31, +OPCo +2020 2019 2020 2019 +(in millions) +Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs +$ 33.3 $ 11.7 $ 86.6 $ 66.9 +Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability +( 0.5 ) ( 0.4 ) — — +Funded Status $ 32.8 $ 11.3 $ 86.6 $ 66.9 +299 +PSO Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 267.5 $ 253.8 $ 64.7 $ 62.3 +Service Cost 7.3 6.5 0.7 0.6 +Interest Cost 8.5 10.6 2.1 2.6 +Actuarial Loss 17.7 16.8 1.9 3.8 +Plan Amendments — — ( 0.7 ) ( 0.7 ) +Benefit Payments ( 21.1 ) ( 20.2 ) ( 6.8 ) ( 5.9 ) +Participant Contributions — — 2.1 2.0 +Benefit Obligation as of December 31, $ 279.9 $ 267.5 $ 64.0 $ 64.7 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 276.2 $ 261.2 $ 98.0 $ 84.3 +Actual Gain on Plan Assets 44.6 34.7 14.5 17.6 +Company Contributions 0.1 0.5 — — +Participant Contributions — — 2.1 2.0 +Benefit Payments ( 21.1 ) ( 20.2 ) ( 6.8 ) ( 5.9 ) +Fair Value of Plan Assets as of December 31, $ 299.8 $ 276.2 $ 107.8 $ 98.0 +Funded Status as of December 31, $ 19.9 $ 8.7 $ 43.8 $ 33.3 +Pension Plans OPEB +December 31, +PSO +2020 2019 2020 2019 +(in millions) +Employee Benefits and Pension Assets – Prepaid Benefit Costs +$ 21.9 $ 10.6 $ 43.8 $ 33.3 +Other Current Liabilities – Accrued Short-term Benefit Liability +( 0.1 ) ( 0.1 ) — — +Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability +( 1.9 ) ( 1.8 ) — — +Funded Status $ 19.9 $ 8.7 $ 43.8 $ 33.3 +300 +SWEPCo Pension Plans OPEB +2020 2019 2020 2019 +Change in Benefit Obligation (in millions) +Benefit Obligation as of January 1, $ 314.2 $ 291.4 $ 77.4 $ 72.7 +Service Cost 9.9 8.6 0.8 0.8 +Interest Cost 10.2 12.4 2.5 3.1 +Actuarial Loss 27.4 25.5 2.5 6.0 +Plan Amendments — — ( 0.8 ) ( 0.8 ) +Benefit Payments ( 27.2 ) ( 23.7 ) ( 7.7 ) ( 6.6 ) +Participant Contributions — — 2.4 2.2 +Benefit Obligation as of December 31, $ 334.5 $ 314.2 $ 77.1 $ 77.4 +Change in Fair Value of Plan Assets +Fair Value of Plan Assets as of January 1, $ 296.9 $ 281.0 $ 117.2 $ 98.5 +Actual Gain on Plan Assets 48.2 39.5 18.0 23.1 +Company Contributions 9.0 0.1 — — +Participant Contributions — — 2.4 2.2 +Benefit Payments ( 27.2 ) ( 23.7 ) ( 7.7 ) ( 6.6 ) +Fair Value of Plan Assets as of December 31, $ 326.9 $ 296.9 $ 129.9 $ 117.2 +Funded (Underfunded) Status as of December 31, $ ( 7.6 ) $ ( 17.3 ) $ 52.8 $ 39.8 +Pension Plans OPEB +December 31, +SWEPCo +2020 2019 2020 2019 +(in millions) +Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs +$ — $ — $ 52.8 $ 39.8 +Other Current Liabilities – Accrued Short-term Benefit Liability +( 0.1 ) ( 0.1 ) — — +Employee Benefits and Pension Obligations – Accrued Long-term Benefit Liability +( 7.5 ) ( 17.2 ) — — +Funded (Underfunded) Status $ ( 7.6 ) $ ( 17.3 ) $ 52.8 $ 39.8 +301 +Amounts Included in Regulatory Assets, Deferred Income Taxes and AOCI +The following tables show the components of the plans included in Regulatory Assets, Deferred Income Taxes and AOCI and the items attributable to the change in these components: +AEP +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 1,179.6 $ 1,406.2 $ 101.9 $ 225.8 +Prior Service Cost (Credit) 0.2 0.2 ( 227.3 ) ( 285.7 ) +Recorded as +Regulatory Assets $ 1,182.4 $ 1,351.8 $ ( 99.0 ) $ ( 46.8 ) +Deferred Income Taxes ( 0.5 ) 11.5 ( 5.5 ) ( 2.7 ) +Net of Tax AOCI ( 2.1 ) 43.1 ( 20.9 ) ( 10.4 ) +AEP +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial (Gain) Loss During the Year $ ( 132.9 ) $ 108.6 $ ( 118.0 ) $ ( 171.9 ) +Amortization of Actuarial Loss ( 93.7 ) ( 57.6 ) ( 5.9 ) ( 22.1 ) +Prior Service (Credit) Cost — 0.2 ( 11.4 ) ( 7.6 ) +Amortization of Prior Service Credit — — 69.8 69.1 +Change for the Year Ended December 31, $ ( 226.6 ) $ 51.2 $ ( 65.5 ) $ ( 132.5 ) +AEP Texas +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 160.5 $ 184.7 $ 12.3 $ 23.5 +Prior Service Credit — — ( 19.3 ) ( 24.2 ) +Recorded as +Regulatory Assets $ 151.3 $ 172.2 $ ( 6.3 ) $ ( 0.2 ) +Deferred Income Taxes 2.0 2.7 ( 0.1 ) ( 0.1 ) +Net of Tax AOCI 7.2 9.8 ( 0.6 ) ( 0.4 ) +AEP Texas +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial (Gain) Loss During the Year $ ( 16.4 ) $ 7.6 $ ( 10.7 ) $ ( 12.7 ) +Amortization of Actuarial Loss ( 7.8 ) ( 4.9 ) ( 0.5 ) ( 1.8 ) +Prior Service Credit — — ( 1.0 ) ( 0.6 ) +Amortization of Prior Service Credit — — 5.9 5.9 +Change for the Year Ended December 31, $ ( 24.2 ) $ 2.7 $ ( 6.3 ) $ ( 9.2 ) +302 +APCo +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 126.3 $ 168.3 $ 11.1 $ 28.8 +Prior Service Credit — — ( 33.2 ) ( 41.6 ) +Recorded as +Regulatory Assets $ 124.7 $ 166.3 $ ( 10.3 ) $ ( 5.5 ) +Deferred Income Taxes 0.3 0.3 ( 2.5 ) ( 1.5 ) +Net of Tax AOCI 1.3 1.7 ( 9.3 ) ( 5.8 ) +APCo +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial (Gain) Loss During the Year $ ( 30.8 ) $ 3.1 $ ( 16.8 ) $ ( 26.4 ) +Amortization of Actuarial Loss ( 11.2 ) ( 7.0 ) ( 0.9 ) ( 3.7 ) +Prior Service Credit — — ( 1.8 ) ( 1.3 ) +Amortization of Prior Service Credit — — 10.2 10.1 +Change for the Year Ended December 31, $ ( 42.0 ) $ ( 3.9 ) $ ( 9.3 ) $ ( 21.3 ) +I&M +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 39.5 $ 76.0 $ 15.6 $ 32.7 +Prior Service Credit — — ( 31.0 ) ( 39.0 ) +Recorded as +Regulatory Assets $ 40.3 $ 73.7 $ ( 14.6 ) $ ( 6.2 ) +Deferred Income Taxes ( 0.1 ) 0.5 ( 0.2 ) — +Net of Tax AOCI ( 0.7 ) 1.8 ( 0.6 ) ( 0.1 ) +I&M +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial (Gain) Loss During the Year $ ( 25.7 ) $ 2.0 $ ( 16.4 ) $ ( 19.3 ) +Amortization of Actuarial Loss ( 10.8 ) ( 6.6 ) ( 0.7 ) ( 2.7 ) +Prior Service Credit — — ( 1.5 ) ( 1.0 ) +Amortization of Prior Service Credit — — 9.5 9.4 +Change for the Year Ended December 31, $ ( 36.5 ) $ ( 4.6 ) $ ( 9.1 ) $ ( 13.6 ) +303 +OPCo +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 150.0 $ 178.7 $ 3.6 $ 17.2 +Prior Service Credit — — ( 22.9 ) ( 28.6 ) +Recorded as +Regulatory Assets $ 150.0 $ 178.7 $ ( 19.3 ) $ ( 11.4 ) +OPCo +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial (Gain) Loss During the Year $ ( 20.2 ) $ 3.3 $ ( 12.9 ) $ ( 15.8 ) +Amortization of Actuarial Loss ( 8.5 ) ( 5.3 ) ( 0.7 ) ( 2.5 ) +Prior Service Credit — — ( 1.3 ) ( 0.8 ) +Amortization of Prior Service Credit — — 7.0 6.9 +Change for the Year Ended December 31, $ ( 28.7 ) $ ( 2.0 ) $ ( 7.9 ) $ ( 12.2 ) +PSO +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 55.9 $ 73.0 $ 10.5 $ 18.2 +Prior Service Credit — — ( 14.1 ) ( 17.8 ) +Recorded as +Regulatory Assets $ 55.9 $ 73.0 $ ( 3.6 ) $ 0.4 +PSO +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial Gain During the Year $ ( 12.4 ) $ ( 1.7 ) $ ( 7.4 ) $ ( 8.9 ) +Amortization of Actuarial Loss ( 4.7 ) ( 2.9 ) ( 0.3 ) ( 1.2 ) +Prior Service Credit — — ( 0.7 ) ( 0.5 ) +Amortization of Prior Service Credit — — 4.4 4.3 +Change for the Year Ended December 31, $ ( 17.1 ) $ ( 4.6 ) $ ( 4.0 ) $ ( 6.3 ) +304 +SWEPCo +Pension Plans OPEB +December 31, +2020 2019 2020 2019 +Components (in millions) +Net Actuarial Loss $ 86.9 $ 97.8 $ 11.5 $ 21.1 +Prior Service Credit — — ( 17.2 ) ( 21.6 ) +Recorded as +Regulatory Assets $ 86.9 $ 97.8 $ ( 3.0 ) $ — +Deferred Income Taxes — — ( 0.5 ) — +Net of Tax AOCI — — ( 2.2 ) ( 0.5 ) +SWEPCo +Pension Plans OPEB +2020 2019 2020 2019 +Components (in millions) +Actuarial (Gain) Loss During the Year $ ( 5.2 ) $ 3.8 $ ( 9.2 ) $ ( 11.4 ) +Amortization of Actuarial Loss ( 5.7 ) ( 3.4 ) ( 0.4 ) ( 1.4 ) +Prior Service Credit — — ( 0.8 ) ( 0.6 ) +Amortization of Prior Service Credit — — 5.2 5.2 +Change for the Year Ended December 31, $ ( 10.9 ) $ 0.4 $ ( 5.2 ) $ ( 8.2 ) +Determination of Pension Expense +The determination of pension expense or income is based on a market-related valuation of assets which reduces year-to-year volatility. This market-related valuation recognizes investment gains or losses over a five-year period from the year in which they occur. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of assets and the actual return. +Pension and OPEB Assets +The fair value tables within Pension and OPEB Assets present the classification of assets for AEP within the fair value hierarchy. All Level 1, 2, 3 and Other amounts can be allocated to the Registrant Subsidiaries using the percentages in the table below: +Pension Plan OPEB +December 31, +Company 2020 2019 2020 2019 +AEP Texas 8.5 % 8.7 % 8.3 % 8.3 % +APCo 12.6 % 12.7 % 15.1 % 15.2 % +I&M 12.6 % 12.6 % 12.2 % 12.1 % +OPCo 9.8 % 10.0 % 10.9 % 11.1 % +PSO 5.4 % 5.5 % 5.5 % 5.5 % +SWEPCo 5.9 % 5.9 % 6.7 % 6.6 % +305 +The following table presents the classification of pension plan assets for AEP within the fair value hierarchy as of December 31, 2020: +Asset Class Level 1 Level 2 Level 3 Other Total Year End +Allocation +(in millions) +Equities (a): +Domestic +$ 542.3 $ — $ — $ — $ 542.3 9.7 % +International +676.3 — — — 676.3 12.2 % +Common Collective Trusts (c) +— — — 650.0 650.0 11.7 % +Subtotal – Equities 1,218.6 — — 650.0 1,868.6 33.6 % +Fixed Income (a): +United States Government and Agency Securities +( 1.4 ) 1,134.1 — — 1,132.7 20.4 % +Corporate Debt — 1,425.0 — — 1,425.0 25.6 % +Foreign Debt — 214.0 — — 214.0 3.9 % +State and Local Government — 56.0 — — 56.0 1.0 % +Other – Asset Backed — 0.8 — — 0.8 — % +Subtotal – Fixed Income ( 1.4 ) 2,829.9 — — 2,828.5 50.9 % +Infrastructure (c) — — — 91.1 91.1 1.6 % +Real Estate (c) — — — 231.6 231.6 4.2 % +Alternative Investments (c) — — — 431.8 431.8 7.8 % +Cash and Cash Equivalents (c) — 49.3 — 58.2 107.5 1.9 % +Other – Pending Transactions and Accrued Income (b) +— — — ( 2.5 ) ( 2.5 ) — % +Total $ 1,217.2 $ 2,879.2 $ — $ 1,460.2 $ 5,556.6 100.0 % +(a) Includes investment securities loaned to borrowers under the securities lending program. See the “Investments Held in Trust for Future Liabilities” section of Note 1 for additional information. +(b) Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement. +(c) Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share. +306 +The following table presents the classification of OPEB plan assets for AEP within the fair value hierarchy as of December 31, 2020: +Asset Class Level 1 Level 2 Level 3 Other Total Year End +Allocation +(in millions) +Equities: +Domestic +$ 399.9 $ — $ — $ — $ 399.9 20.6 % +International +290.7 — — — 290.7 14.9 % +Common Collective Trusts (b) +— — — 264.7 264.7 13.6 % +Subtotal – Equities 690.6 — — 264.7 955.3 49.1 % +Fixed Income: +Common Collective Trust – Debt (b) — — — 186.4 186.4 9.6 % +United States Government and Agency Securities +( 0.2 ) 199.7 — — 199.5 10.2 % +Corporate Debt — 248.7 — — 248.7 12.8 % +Foreign Debt — 34.9 — — 34.9 1.8 % +State and Local Government 73.9 13.1 — — 87.0 4.5 % +Subtotal – Fixed Income 73.7 496.4 — 186.4 756.5 38.9 % +Trust Owned Life Insurance: +International Equities — 64.8 — — 64.8 3.3 % +United States Bonds — 135.9 — — 135.9 7.0 % +Subtotal – Trust Owned Life Insurance — 200.7 — — 200.7 10.3 % +Cash and Cash Equivalents (b) 26.3 — — 5.7 32.0 1.6 % +Other – Pending Transactions and Accrued Income (a) +— — — 2.2 2.2 0.1 % +Total $ 790.6 $ 697.1 $ — $ 459.0 $ 1,946.7 100.0 % +(a) Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement. +(b) Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share. +307 +The following table presents the classification of pension plan assets for AEP within the fair value hierarchy as of December 31, 2019: +Asset Class Level 1 Level 2 Level 3 Other Total Year End +Allocation +(in millions) +Equities (a): +Domestic +$ 387.8 $ — $ — $ — $ 387.8 7.8 % +International +609.1 — — — 609.1 12.1 % +Common Collective Trusts (c) +— — — 547.3 547.3 10.9 % +Subtotal – Equities 996.9 — — 547.3 1,544.2 30.8 % +Fixed Income (a): +United States Government and Agency Securities +( 5.8 ) 1,248.6 — — 1,242.8 24.8 % +Corporate Debt +— 1,143.7 — — 1,143.7 22.8 % +Foreign Debt +— 211.6 — — 211.6 4.2 % +State and Local Government +— 55.1 — — 55.1 1.1 % +Other – Asset Backed +— 3.6 — — 3.6 0.1 % +Subtotal – Fixed Income ( 5.8 ) 2,662.6 — — 2,656.8 53.0 % +Infrastructure (c) — — — 85.8 85.8 1.7 % +Real Estate (c) — — — 239.4 239.4 4.8 % +Alternative Investments (c) — — — 448.3 448.3 8.9 % +Cash and Cash Equivalents (c) — 24.4 — 37.2 61.6 1.2 % +Other – Pending Transactions and Accrued Income (b) +— — — ( 20.7 ) ( 20.7 ) ( 0.4 ) % +Total $ 991.1 $ 2,687.0 $ — $ 1,337.3 $ 5,015.4 100.0 % +(a) Includes investment securities loaned to borrowers under the securities lending program. See the “Investments Held in Trust for Future Liabilities” section of Note 1 for additional information. +(b) Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement. +(c) Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share. +308 +The following table presents the classification of OPEB plan assets for AEP within the fair value hierarchy as of December 31, 2019: +Asset Class Level 1 Level 2 Level 3 Other Total Year End +Allocation +(in millions) +Equities: +Domestic +$ 312.2 $ — $ — $ — $ 312.2 17.5 % +International +251.5 — — — 251.5 14.1 % +Common Collective Trusts (b) +— — — 260.8 260.8 14.7 % +Subtotal – Equities 563.7 — — 260.8 824.5 46.3 % +Fixed Income: +Common Collective Trust – Debt (b) +— — — 177.6 177.6 10.0 % +United States Government and Agency Securities +( 0.1 ) 214.4 — — 214.3 12.0 % +Corporate Debt +— 206.7 — — 206.7 11.6 % +Foreign Debt +— 35.5 — — 35.5 2.0 % +State and Local Government +58.8 14.8 — — 73.6 4.1 % +Other – Asset Backed +— 0.2 — — 0.2 — % +Subtotal – Fixed Income 58.7 471.6 — 177.6 707.9 39.7 % +Trust Owned Life Insurance: +International Equities +— 60.2 — — 60.2 3.4 % +United States Bonds +— 151.6 — — 151.6 8.5 % +Subtotal – Trust Owned Life Insurance — 211.8 — — 211.8 11.9 % +Cash and Cash Equivalents (b) 26.7 — — 6.7 33.4 1.9 % +Other – Pending Transactions and Accrued Income (a) +— — — 4.2 4.2 0.2 % +Total $ 649.1 $ 683.4 $ — $ 449.3 $ 1,781.8 100.0 % +(a) Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement. +(b) Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share. +Accumulated Benefit Obligation +The accumulated benefit obligation for the pension plans is as follows: +Accumulated Benefit Obligation AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Qualified Pension Plan $ 5,171.3 $ 424.5 $ 645.8 $ 615.8 $ 479.2 $ 258.3 $ 307.1 +Nonqualified Pension Plans 72.9 3.6 0.2 0.8 0.2 1.6 1.4 +Total as of December 31, 2020 $ 5,244.2 $ 428.1 $ 646.0 $ 616.6 $ 479.4 $ 259.9 $ 308.5 +Accumulated Benefit Obligation AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Qualified Pension Plan $ 4,929.0 $ 417.5 $ 627.3 $ 586.3 $ 464.2 $ 248.9 $ 291.9 +Nonqualified Pension Plans 69.7 3.6 0.2 0.6 0.1 1.6 1.3 +Total as of December 31, 2019 $ 4,998.7 $ 421.1 $ 627.5 $ 586.9 $ 464.3 $ 250.5 $ 293.2 +309 +Obligations in Excess of Fair Values +The tables below show the underfunded pension plans that had obligations in excess of plan assets. +Projected Benefit Obligation +AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Projected Benefit Obligation $ 81.4 $ 3.9 $ 0.5 $ 1.7 $ 0.6 $ 2.0 $ 334.5 +Fair Value of Plan Assets — — — — — — 326.9 +Underfunded Projected Benefit Obligation as of December 31, 2020 +$ ( 81.4 ) $ ( 3.9 ) $ ( 0.5 ) $ ( 1.7 ) $ ( 0.6 ) $ ( 2.0 ) $ ( 7.6 ) +AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Projected Benefit Obligation $ 5,236.8 $ 441.2 $ 647.2 $ 1.5 $ 0.4 $ 1.9 $ 314.2 +Fair Value of Plan Assets 5,015.4 435.1 637.0 — — — 296.9 +Underfunded Projected Benefit Obligation as of December 31, 2019 +$ ( 221.4 ) $ ( 6.1 ) $ ( 10.2 ) $ ( 1.5 ) $ ( 0.4 ) $ ( 1.9 ) $ ( 17.3 ) +Accumulated Benefit Obligation +AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Accumulated Benefit Obligation $ 72.9 $ 3.6 $ 0.2 $ 0.8 $ 0.2 $ 1.6 $ 1.4 +Fair Value of Plan Assets — — — — — — — +Underfunded Accumulated Benefit Obligation as of December 31, 2020 +$ ( 72.9 ) $ ( 3.6 ) $ ( 0.2 ) $ ( 0.8 ) $ ( 0.2 ) $ ( 1.6 ) $ ( 1.4 ) +AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Accumulated Benefit Obligation $ 69.7 $ 3.6 $ 0.2 $ 0.6 $ 0.1 $ 1.6 $ 1.3 +Fair Value of Plan Assets — — — — — — — +Underfunded Accumulated Benefit Obligation as of December 31, 2019 +$ ( 69.7 ) $ ( 3.6 ) $ ( 0.2 ) $ ( 0.6 ) $ ( 0.1 ) $ ( 1.6 ) $ ( 1.3 ) +Estimated Future Benefit Payments and Contributions +The estimated pension benefit payments and contributions to the trust are at least the minimum amount required by the Employee Retirement Income Security Act plus payment of unfunded non-qualified benefits. For the qualified pension plan, additional discretionary contributions may also be made to maintain the funded status of the plan. For OPEB plans, expected payments include the payment of unfunded benefits. The following table provides the estimated contributions and payments by Registrant for 2021: +Company Pension Plans OPEB +(in millions) +AEP $ 132.8 $ 3.1 +AEP Texas 5.1 0.1 +APCo 1.8 1.8 +I&M 1.3 — +PSO 0.1 — +SWEPCo 7.1 — +310 +The tables below reflect the total benefits expected to be paid from the plan or from the Registrants’ assets. The payments include the participants’ contributions to the plan for their share of the cost. Future benefit payments are dependent on the number of employees retiring, whether the retiring employees elect to receive pension benefits as annuities or as lump sum distributions, future integration of the benefit plans with changes to Medicare and other legislation, future levels of interest rates and variances in actuarial results. The estimated payments for the pension benefits and OPEB are as follows: +Pension Plans AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +2021 $ 385.3 $ 36.3 $ 44.7 $ 40.2 $ 35.4 $ 21.8 $ 25.2 +2022 382.8 35.9 45.1 42.4 36.0 21.2 25.4 +2023 384.3 36.1 45.1 41.5 34.2 22.3 25.7 +2024 384.0 35.9 45.7 42.7 34.0 21.9 25.7 +2025 377.1 35.2 44.0 42.7 33.3 21.1 25.3 +Years 2026 to 2030, in Total 1,763.1 154.1 209.7 205.2 155.0 94.8 115.7 +OPEB Benefit Payments AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +2021 $ 121.6 $ 9.5 $ 21.1 $ 15.1 $ 13.7 $ 6.4 $ 7.5 +2022 122.5 9.9 20.8 15.3 13.9 6.7 7.8 +2023 117.4 9.7 19.8 14.7 13.2 6.6 7.6 +2024 121.9 10.3 20.5 15.3 13.7 6.9 8.2 +2025 120.9 10.4 20.0 15.1 13.4 6.9 8.2 +Years 2026 to 2030, in Total 573.9 48.6 93.3 70.9 61.7 32.1 39.1 +OPEB Medicare +Subsidy Receipts AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +2021 $ 0.2 $ — $ 0.1 $ — $ — $ — $ — +2022 0.2 — 0.1 — — — — +2023 0.3 — 0.1 — — — — +2024 0.3 — 0.1 — — — — +2025 0.3 — 0.1 — — — — +Years 2026 to 2030, in Total 1.5 — 0.6 — — — — +Components of Net Periodic Benefit Cost +The following tables provide the components of net periodic benefit cost (credit) by Registrant for the plans: +AEP +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 111.9 $ 95.5 $ 97.6 $ 10.0 $ 9.5 $ 11.6 +Interest Cost 167.9 204.4 187.8 39.8 50.5 47.4 +Expected Return on Plan Assets ( 264.9 ) ( 296.0 ) ( 290.3 ) ( 95.6 ) ( 93.7 ) ( 102.2 ) +Amortization of Prior Service Credit — — — ( 69.8 ) ( 69.1 ) ( 69.1 ) +Amortization of Net Actuarial Loss 93.7 57.6 85.2 5.9 22.1 10.5 +Settlements — — 2.6 — — — +Net Periodic Benefit Cost (Credit) 108.6 61.5 82.9 ( 109.7 ) ( 80.7 ) ( 101.8 ) +Capitalized Portion ( 47.0 ) ( 38.6 ) ( 41.1 ) ( 4.2 ) ( 3.8 ) ( 4.9 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 61.6 $ 22.9 $ 41.8 $ ( 113.9 ) $ ( 84.5 ) $ ( 106.7 ) +311 +AEP Texas +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 10.0 $ 8.6 $ 9.2 $ 0.8 $ 0.8 $ 0.9 +Interest Cost 13.9 17.5 16.0 3.2 4.0 3.8 +Expected Return on Plan Assets ( 22.7 ) ( 25.8 ) ( 25.6 ) ( 8.0 ) ( 7.8 ) ( 8.6 ) +Amortization of Prior Service Credit — — — ( 5.9 ) ( 5.9 ) ( 5.9 ) +Amortization of Net Actuarial Loss 7.8 4.9 7.2 0.5 1.8 0.8 +Net Periodic Benefit Cost (Credit) 9.0 5.2 6.8 ( 9.4 ) ( 7.1 ) ( 9.0 ) +Capitalized Portion ( 5.5 ) ( 4.5 ) ( 4.8 ) ( 0.4 ) ( 0.4 ) ( 0.5 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 3.5 $ 0.7 $ 2.0 $ ( 9.8 ) $ ( 7.5 ) $ ( 9.5 ) +APCo +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 10.5 $ 9.4 $ 9.3 $ 1.0 $ 1.0 $ 1.1 +Interest Cost 20.3 25.2 23.5 6.6 8.7 8.2 +Expected Return on Plan Assets ( 33.6 ) ( 37.4 ) ( 36.6 ) ( 14.4 ) ( 14.6 ) ( 16.0 ) +Amortization of Prior Service Credit — — — ( 10.2 ) ( 10.1 ) ( 10.0 ) +Amortization of Net Actuarial Loss 11.2 7.0 10.6 0.9 3.7 1.9 +Net Periodic Benefit Cost (Credit) 8.4 4.2 6.8 ( 16.1 ) ( 11.3 ) ( 14.8 ) +Capitalized Portion ( 4.5 ) ( 4.0 ) ( 3.8 ) ( 0.4 ) ( 0.4 ) ( 0.5 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 3.9 $ 0.2 $ 3.0 $ ( 16.5 ) $ ( 11.7 ) $ ( 15.3 ) +I&M +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 15.4 $ 13.4 $ 13.6 $ 1.4 $ 1.4 $ 1.6 +Interest Cost 19.7 23.8 22.1 4.7 5.8 5.4 +Expected Return on Plan Assets ( 33.3 ) ( 36.8 ) ( 35.7 ) ( 11.7 ) ( 11.4 ) ( 12.3 ) +Amortization of Prior Service Credit — — — ( 9.5 ) ( 9.4 ) ( 9.5 ) +Amortization of Net Actuarial Loss 10.8 6.6 9.8 0.7 2.7 1.2 +Net Periodic Benefit Cost (Credit) 12.6 7.0 9.8 ( 14.4 ) ( 10.9 ) ( 13.6 ) +Capitalized Portion ( 4.3 ) ( 3.4 ) ( 5.6 ) ( 0.4 ) ( 0.4 ) ( 0.7 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 8.3 $ 3.6 $ 4.2 $ ( 14.8 ) $ ( 11.3 ) $ ( 14.3 ) +312 +OPCo +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 9.7 $ 7.9 $ 7.7 $ 0.9 $ 0.8 $ 0.9 +Interest Cost 15.4 19.1 17.7 4.2 5.5 5.1 +Expected Return on Plan Assets ( 26.3 ) ( 29.3 ) ( 28.8 ) ( 10.5 ) ( 10.8 ) ( 11.7 ) +Amortization of Prior Service Credit — — — ( 7.0 ) ( 6.9 ) ( 6.9 ) +Amortization of Net Actuarial Loss 8.5 5.3 8.0 0.7 2.5 1.1 +Net Periodic Benefit Cost (Credit) 7.3 3.0 4.6 ( 11.7 ) ( 8.9 ) ( 11.5 ) +Capitalized Portion ( 5.0 ) ( 3.7 ) ( 3.6 ) ( 0.5 ) ( 0.4 ) ( 0.4 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 2.3 $ ( 0.7 ) $ 1.0 $ ( 12.2 ) $ ( 9.3 ) $ ( 11.9 ) +PSO +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 7.3 $ 6.5 $ 7.0 $ 0.7 $ 0.6 $ 0.7 +Interest Cost 8.5 10.6 9.9 2.1 2.6 2.5 +Expected Return on Plan Assets ( 14.5 ) ( 16.3 ) ( 16.1 ) ( 5.2 ) ( 5.1 ) ( 5.6 ) +Amortization of Prior Service Credit — — — ( 4.4 ) ( 4.3 ) ( 4.3 ) +Amortization of Net Actuarial Loss 4.7 2.9 4.4 0.3 1.2 0.5 +Net Periodic Benefit Cost (Credit) 6.0 3.7 5.2 ( 6.5 ) ( 5.0 ) ( 6.2 ) +Capitalized Portion ( 2.8 ) ( 2.4 ) ( 2.6 ) ( 0.3 ) ( 0.2 ) ( 0.3 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 3.2 $ 1.3 $ 2.6 $ ( 6.8 ) $ ( 5.2 ) $ ( 6.5 ) +SWEPCo +Pension Plans OPEB +Years Ended December 31, +2020 2019 2018 2020 2019 2018 +(in millions) +Service Cost $ 9.9 $ 8.6 $ 9.3 $ 0.8 $ 0.8 $ 0.9 +Interest Cost 10.2 12.4 11.3 2.5 3.1 2.8 +Expected Return on Plan Assets ( 15.7 ) ( 17.7 ) ( 17.3 ) ( 6.3 ) ( 5.9 ) ( 6.4 ) +Amortization of Prior Service Credit — — — ( 5.2 ) ( 5.2 ) ( 5.2 ) +Amortization of Net Actuarial Loss 5.7 3.4 5.1 0.4 1.4 0.6 +Settlements — — 0.4 — — — +Net Periodic Benefit Cost (Credit) 10.1 6.7 8.8 ( 7.8 ) ( 5.8 ) ( 7.3 ) +Capitalized Portion ( 3.4 ) ( 2.9 ) ( 3.1 ) ( 0.3 ) ( 0.3 ) ( 0.3 ) +Net Periodic Benefit Cost (Credit) Recognized in Expense $ 6.7 $ 3.8 $ 5.7 $ ( 8.1 ) $ ( 6.1 ) $ ( 7.6 ) +American Electric Power System Retirement Savings Plan +AEP sponsors the American Electric Power System Retirement Savings Plan, a defined contribution retirement savings plan for substantially all employees who are not covered by a retirement savings plan of the UMWA. This qualified plan offers participants an opportunity to contribute a portion of their pay, includes features under Section 401(k) of the Internal Revenue Code and provides for company matching contributions. The matching contributions to the plan are 100 % of the first 1 % of eligible employee contributions and 70 % of the next 5 % of contributions. +313 +The following table provides the cost for matching contributions to the retirement savings plans by Registrant: +Year Ended December 31, +Company 2020 2019 2018 +(in millions) +AEP $ 81.8 $ 76.4 $ 71.8 +AEP Texas 6.4 5.9 5.7 +APCo 7.7 7.5 7.5 +I&M 11.3 11.0 10.5 +OPCo 7.3 6.6 6.3 +PSO 4.9 4.6 4.5 +SWEPCo 6.7 6.2 5.9 +UMWA Benefits +Health and Welfare Benefits (Applies to AEP and APCo) +AEP provides health and welfare benefits negotiated with the UMWA for certain unionized employees, retirees and their survivors who meet eligibility requirements. APCo also provides the same UMWA health and welfare benefits for certain unionized mining retirees and their survivors who meet eligibility requirements. AEP and APCo administer the health and welfare benefits and pay them from their general assets. +Multiemployer Pension Benefits (Applies to AEP) +UMWA pension benefits are provided through the United Mine Workers of America 1974 Pension Plan (Employer Identification Number: 52-1050282, Plan Number 002), a multiemployer plan. The UMWA pension benefits are administered by a board of trustees appointed in equal numbers by the UMWA and the Bituminous Coal Operators’ Association (BCOA), an industry bargaining association. AEP makes contributions to the United Mine Workers of America 1974 Pension Plan based on provisions in its labor agreement and the plan documents. The UMWA pension plan is different from single-employer plans as an employer’s contributions may be used to provide benefits to employees of other participating employers. A withdrawing employer may be subject to a withdrawal liability, which is calculated based upon that employer’s share of the plan’s unfunded benefit obligations. If an employer fails to make required contributions or if its payments in connection with its withdrawal liability fall short of satisfying its share of the plan’s unfunded benefit obligations, the remaining employers may be allocated a greater share of the remaining unfunded plan obligations. Under the Pension Protection Act of 2006 (PPA), the UMWA pension plan was in Critical and Declining Status for the plan years ending June 30, 2020 and 2019, without utilization of extended amortization provisions. As required under the PPA, the Plan adopted a Rehabilitation Plan in 2015. The Rehabilitation Plan has been updated annually, most recently in April 2020. +The amounts contributed by AEP affiliates in 2020, 2019 and 2018 were immaterial and represent less than 5% of the total contributions in the plan’s latest annual report based on the plan year ended June 30, 2019. The contributions in 2020, 2019 and 2018 did not include surcharges. +Under the terms of the UMWA pension plan, contributions will be required to continue beyond the December 31, 2020 expiration of the current collective bargaining agreement between the Cook Coal Terminal (CCT) facility and the UMWA, whether or not the term of that agreement is extended or a subsequent agreement is entered, so long as both the UMWA pension plan remains in effect and an AEP affiliate continues to operate the facility covered by the current collective bargaining agreement. The contribution rate applicable would be determined in accordance with the terms of the UMWA pension plan by reference to the National Bituminous Coal Wage Agreement, subject to periodic revisions, between the UMWA and the BCOA. If the UMWA pension plan would terminate or an AEP affiliate would cease operation of the facility without arranging for a successor operator to assume its liability, the withdrawal liability obligation would be triggered. +314 +Based upon the planned closure of CCT in 2022, AEP records a UMWA pension withdrawal liability on the balance sheet. The UMWA pension withdrawal liability is re-measured annually and is the estimated value of the company’s anticipated contributions toward its proportionate share of the plan’s unfunded vested liabilities. As of December 31, 2020 and 2019, the liability balance was $ 25 million and $ 20 million, respectively. AEP recovers the estimated value of its UMWA pension withdrawal liability through fuel clauses in certain regulated jurisdictions. AEP records a regulatory asset on the balance sheets when the UMWA pension withdrawal liability exceeds the cumulative billings collected and a regulatory liability on the balance sheets when the cumulative billings collected exceed the withdrawal liability. As of December 31, 2020 and 2019, AEP recorded a regulatory asset on the balance sheets for $ 6 million and $ 2 million, respectively. If any portion of the UMWA pension withdrawal liability is not recoverable, it could reduce future net income and cash flows and impact financial condition. +315 +9. BUSINESS SEGMENTS +The disclosures in this note apply to all Registrants unless indicated otherwise. +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. +AEP’s reportable segments and their related business activities are outlined below: +Vertically Integrated Utilities +• Generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. +Transmission and Distribution Utilities +• Transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo. +• OPCo purchases energy and capacity to serve standard service offer customers and provides transmission and distribution services for all connected load. +AEP Transmission Holdco +• Development, construction and operation of transmission facilities through investments in AEPTCo. These investments have FERC-approved returns on equity. +• Development, construction and operation of transmission facilities through investments in AEP’s transmission-only joint ventures. These investments have PUCT-approved or FERC-approved returns on equity. +Generation & Marketing +• Contracted renewable energy investments and management services. +• Marketing, risk management and retail activities in ERCOT, MISO, PJM and SPP. +• Competitive generation in PJM. +The remainder of AEP’s activities are presented as Corporate and Other. While not considered a reportable segment, Corporate and Other primarily includes the purchasing of receivables from certain AEP utility subsidiaries, Parent’s guarantee revenue received from affiliates, investment income, interest income and interest expense, income tax expense and other nonallocated costs. +316 +The tables below present AEP’s reportable segment income statement information for the years ended December 31, 2020, 2019 and 2018 and reportable segment balance sheet information as of December 31, 2020 and 2019. +Vertically Integrated Utilities Transmission and Distribution Utilities AEP Transmission Holdco Generation & Marketing Corporate and Other (a) Reconciling Adjustments Consolidated +(in millions) +2020 +Revenues from: +External Customers +$ 8,753.2 $ 4,238.7 $ 297.4 $ 1,621.0 $ 8.2 $ — $ 14,918.5 +Other Operating Segments +126.2 107.2 901.4 104.6 88.6 ( 1,328.0 ) — +Total Revenues $ 8,879.4 $ 4,345.9 $ 1,198.8 $ 1,725.6 $ 96.8 $ ( 1,328.0 ) $ 14,918.5 +Depreciation and Amortization +$ 1,600.5 $ 751.1 $ 257.6 $ 72.8 $ 0.8 $ — $ 2,682.8 +Interest Expense 565.0 289.2 133.2 24.0 196.4 ( 42.1 ) 1,165.7 +Income Tax Expense (Benefit) +( 7.0 ) 29.7 130.8 ( 108.0 ) ( 5.0 ) — 40.5 +Equity Earnings of Unconsolidated Subsidiaries 2.9 — 82.4 3.2 2.6 — 91.1 +Net Income (Loss) $ 1,064.5 $ 496.4 $ 508.5 $ 216.9 $ ( 89.6 ) $ — $ 2,196.7 +Gross Property Additions +$ 2,291.2 $ 2,108.1 $ 1,649.3 $ 197.0 $ 16.0 $ ( 15.3 ) $ 6,246.3 +Total Property, Plant and Equipment +$ 49,023.3 $ 21,145.0 $ 11,827.2 $ 1,910.2 $ 407.3 $ — $ 84,313.0 +Accumulated Depreciation and Amortization +15,586.2 3,879.3 595.7 166.1 184.1 — 20,411.4 +Total Property, Plant and Equipment – Net +$ 33,437.1 $ 17,265.7 $ 11,231.5 $ 1,744.1 $ 223.2 $ — $ 63,901.6 +Total Assets $ 42,752.7 $ 19,765.9 $ 12,627.3 $ 3,585.9 $ 5,987.1 (b) $ ( 3,961.7 ) (c) $ 80,757.2 +Investments in Equity Method Investees +$ 37.1 $ 2.1 $ 831.3 $ 467.0 $ 68.8 $ — $ 1,406.3 +Long-term Debt Due Within One Year: +Nonaffiliated +$ 1,034.6 $ 588.8 $ 52.3 $ — $ 410.4 (d) $ — $ 2,086.1 +Long-term Debt: +Affiliated +65.0 — — — — ( 65.0 ) — +Nonaffiliated +12,375.6 6,661.9 4,075.7 — 5,873.2 (d) — 28,986.4 +Total Long-term Debt +$ 13,475.2 $ 7,250.7 $ 4,128.0 $ — $ 6,283.6 $ ( 65.0 ) $ 31,072.5 +317 +Vertically Integrated Utilities Transmission and Distribution Utilities AEP Transmission Holdco Generation & Marketing Corporate and Other (a) Reconciling Adjustments Consolidated +(in millions) +2019 +Revenues from: +External Customers +$ 9,245.7 $ 4,319.0 $ 260.2 $ 1,721.8 $ 14.7 $ — $ 15,561.4 +Other Operating Segments +121.4 163.5 813.0 135.8 81.1 ( 1,314.8 ) — +Total Revenues $ 9,367.1 $ 4,482.5 $ 1,073.2 $ 1,857.6 $ 95.8 $ ( 1,314.8 ) $ 15,561.4 +Asset Impairments and Other Related Charges +$ 92.9 $ 32.5 $ — $ 31.0 $ — $ — $ 156.4 +Depreciation and Amortization +1,447.0 789.5 183.4 69.5 0.6 24.5 (e) 2,514.5 +Interest Expense 568.3 243.3 103.3 30.0 193.7 ( 66.1 ) (e) 1,072.5 +Income Tax Expense (Benefit) +( 97.7 ) ( 25.2 ) 136.2 ( 53.8 ) 27.6 — ( 12.9 ) +Equity Earnings (Loss) of Unconsolidated Subsidiaries 3.0 — 72.8 ( 3.8 ) 0.1 — 72.1 +Net Income (Loss) $ 985.6 $ 451.0 $ 520.1 $ 104.1 $ ( 141.0 ) $ — $ 1,919.8 +Gross Property Additions +$ 2,437.4 $ 2,074.3 $ 1,458.9 $ 1,005.1 $ 14.5 $ ( 20.4 ) $ 6,969.8 +Total Property, Plant and Equipment +$ 47,323.7 $ 19,773.3 $ 10,334.0 $ 1,650.8 $ 418.4 $ ( 354.5 ) (e) $ 79,145.7 +Accumulated Depreciation and Amortization +14,580.4 3,911.2 418.9 99.0 184.5 ( 186.4 ) (e) 19,007.6 +Total Property, Plant and Equipment – Net +$ 32,743.3 $ 15,862.1 $ 9,915.1 $ 1,551.8 $ 233.9 $ ( 168.1 ) (e) $ 60,138.1 +Total Assets $ 41,228.8 $ 18,757.5 $ 11,143.5 $ 3,123.8 $ 5,440.0 (b) $ ( 3,801.3 ) (c)(e) $ 75,892.3 +Investments in Equity Method Investees +$ 41.7 $ 2.5 $ 787.5 $ 459.5 $ 65.4 $ — $ 1,356.6 +Long-term Debt Due Within One Year: +Affiliated $ 20.0 $ — $ — $ — $ — $ ( 20.0 ) — +Nonaffiliated +704.7 392.2 — — 501.8 (d) — 1,598.7 +Long-term Debt: +Affiliated +39.0 — — — — ( 39.0 ) — +Nonaffiliated +12,162.0 6,248.1 3,593.8 — 3,122.9 — 25,126.8 +Total Long-term Debt +$ 12,925.7 $ 6,640.3 $ 3,593.8 $ — $ 3,624.7 (d) $ ( 59.0 ) $ 26,725.5 +318 +Vertically Integrated Utilities Transmission and Distribution Utilities AEP Transmission Holdco Generation & Marketing Corporate and Other(a) Reconciling Adjustments Consolidated +(in millions) +2018 +Revenues from: +External Customers +$ 9,556.7 $ 4,552.3 $ 248.6 $ 1,818.1 $ 20.0 $ — $ 16,195.7 +Other Operating Segments +88.8 100.8 555.5 122.2 75.1 ( 942.4 ) — +Total Revenues $ 9,645.5 $ 4,653.1 $ 804.1 $ 1,940.3 $ 95.1 $ ( 942.4 ) $ 16,195.7 +Asset Impairments and Other Related Charges +$ 3.4 $ — $ — $ 47.7 $ 19.5 $ — $ 70.6 +Depreciation and Amortization +1,316.2 734.1 137.8 41.0 0.4 57.1 (e) 2,286.6 +Interest Expense +567.8 248.1 90.7 14.9 122.6 ( 59.7 ) (e) 984.4 +Income Tax Expense +5.7 42.4 95.3 ( 49.2 ) 21.1 — 115.3 +Equity Earnings of Unconsolidated Subsidiaries 2.7 — 68.7 0.5 1.2 — 73.1 +Net Income (Loss) +$ 995.5 $ 527.4 $ 373.0 $ 134.7 $ ( 99.3 ) $ — $ 1,931.3 +Gross Property Additions +$ 2,282.2 $ 2,162.4 $ 1,614.1 $ 289.7 $ 16.3 $ ( 39.2 ) $ 6,325.5 +Total Assets +$ 38,874.3 $ 17,083.4 $ 9,543.7 $ 1,979.7 $ 4,036.5 (b) $ ( 2,714.8 ) (c)(e) $ 68,802.8 +(a) Corporate and Other primarily includes the purchasing of receivables from certain AEP utility subsidiaries. This segment also includes Parent’s guarantee revenue received from affiliates, investment income, interest income, interest expense and other nonallocated costs. +(b) Includes elimination of AEP Parent’s investments in wholly-owned subsidiary companies. +(c) Reconciling Adjustments for Total Assets primarily include elimination of intercompany advances to affiliates and intercompany accounts receivable. +(d) Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 for additional information. +(e) Includes eliminations due to an intercompany finance lease. +Registrant Subsidiaries’ Reportable Segments (Applies to all Registrant Subsidiaries except AEPTCo) +The Registrant Subsidiaries each have one reportable segment, an integrated electricity generation, transmission and distribution business for APCo, I&M, PSO and SWEPCo, and an integrated electricity transmission and distribution business for AEP Texas and OPCo. Other activities are insignificant. The Registrant Subsidiaries’ operations are managed on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight on the business process, cost structures and operating results. +319 +AEPTCo’s Reportable Segments +AEPTCo Parent is the holding company of seven FERC-regulated transmission-only electric utilities. The seven State Transcos have been identified as operating segments of AEPTCo under the accounting guidance for “Segment Reporting.” The State Transcos business consists of developing, constructing and operating transmission facilities at the request of the RTOs in which they operate and in replacing and upgrading facilities, assets and components of the existing AEP transmission system as needed to maintain reliability standards and provide service to AEP’s wholesale and retail customers. The State Transcos are regulated for rate-making purposes exclusively by the FERC and earn revenues through tariff rates charged for the use of their electric transmission systems. +AEPTCo’s Chief Operating Decision Maker makes operating decisions, allocates resources to and assesses performance-based on these operating segments. The seven State Transcos operating segments all have similar economic characteristics and meet all of the criteria under the accounting guidance for “Segment Reporting” to be aggregated into one operating segment. As a result, AEPTCo has one reportable segment. The remainder of AEPTCo’s activity is presented in AEPTCo Parent. While not considered a reportable segment, AEPTCo Parent represents the activity of the holding company which primarily relates to debt financing activity and general corporate activities. +The tables below present AEPTCo’s reportable segment income statement information for the years ended December 31, 2020, 2019 and 2018 and reportable segment balance sheet information as of December 31, 2020 and 2019. +State Transcos AEPTCo Parent Reconciling Adjustments AEPTCo +Consolidated +2020 (in millions) +Revenues from: +External Customers +$ 248.8 $ — $ — $ 248.8 +Sales to AEP Affiliates +896.3 — — 896.3 +Other Revenues +0.6 — — 0.6 +Total Revenues $ 1,145.7 $ — $ — $ 1,145.7 +Depreciation and Amortization +$ 249.0 $ — $ — $ 249.0 +Interest Income +0.9 149.6 ( 148.1 ) (a) 2.4 +Allowance for Equity Funds Used During Construction 74.0 — — 74.0 +Interest Expense 127.8 148.1 ( 148.1 ) (a) 127.8 +Income Tax Expense 106.5 0.2 — 106.7 +Net Income $ 422.3 $ 1.1 (b) $ — $ 423.4 +Gross Property Additions $ 1,621.9 $ — $ — $ 1,621.9 +Total Transmission Property $ 11,345.6 $ — $ — $ 11,345.6 +Accumulated Depreciation and Amortization 572.8 — — 572.8 +Total Transmission Property - Net $ 10,772.8 $ — $ — $ 10,772.8 +Notes Receivable - Affiliated $ — $ 3,948.5 $ ( 3,948.5 ) (c) $ — +Total Assets $ 11,185.1 $ 4,084.0 (d) $ ( 4,023.1 ) (e) $ 11,246.0 +Total Long-Term Debt $ 3,990.0 $ 3,948.5 $ ( 3,990.0 ) (c) $ 3,948.5 +320 +State Transcos AEPTCo Parent Reconciling Adjustments AEPTCo +Consolidated +2019 (in millions) +Revenues from: +External Customers +$ 214.6 $ — $ — $ 214.6 +Sales to AEP Affiliates +806.7 — — 806.7 +Other Revenues +0.1 — — 0.1 +Total Revenues $ 1,021.4 $ — $ — $ 1,021.4 +Depreciation and Amortization +$ 176.0 $ — $ — $ 176.0 +Interest Income +1.3 123.8 ( 122.1 ) (a) 3.0 +Allowance for Equity Funds Used During Construction 84.3 — — 84.3 +Interest Expense 97.4 122.1 ( 122.1 ) (a) 97.4 +Income Tax Expense 117.1 0.3 — 117.4 +Net Income $ 438.6 $ 1.1 (b) $ — $ 439.7 +Gross Property Additions $ 1,419.5 $ — $ — $ 1,419.5 +Total Transmission Property $ 9,893.2 $ — $ — $ 9,893.2 +Accumulated Depreciation and Amortization 402.3 — — 402.3 +Total Transmission Property - Net $ 9,490.9 $ — $ — $ 9,490.9 +Notes Receivable - Affiliated $ — $ 3,427.3 $ ( 3,427.3 ) (c) $ — +Total Assets $ 9,865.0 $ 3,519.1 (d) $ ( 3,493.3 ) (e) $ 9,890.8 +Total Long-Term Debt $ 3,465.0 $ 3,427.3 $ ( 3,465.0 ) (c) $ 3,427.3 +State Transcos AEPTCo Parent Reconciling Adjustments AEPTCo +Consolidated +2018 (in millions) +Revenues from: +External Customers +$ 177.0 $ — $ — $ 177.0 +Sales to AEP Affiliates +598.9 — — 598.9 +Other +0.2 — — 0.2 +Total Revenues $ 776.1 $ — $ — $ 776.1 +Depreciation and Amortization +$ 133.9 $ — $ — $ 133.9 +Interest Income +1.3 104.6 ( 103.4 ) (a) 2.5 +Allowance for Equity Funds Used During Construction 70.6 — — 70.6 +Interest Expense 83.2 103.4 ( 103.4 ) (a) 83.2 +Income Tax Expense 83.9 0.2 — 84.1 +Net Income $ 314.9 $ 1.0 (b) $ — $ 315.9 +Gross Property Additions $ 1,570.8 $ — $ — $ 1,570.8 +Total Assets $ 8,406.8 $ 2,857.1 (d) $ ( 2,869.8 ) (e) $ 8,394.1 +(a) Elimination of intercompany interest income/interest expense on affiliated debt arrangement. +(b) Includes elimination of AEPTCo Parent’s equity earnings in the State Transcos. +(c) Elimination of intercompany debt. +(d) Includes elimination of AEPTCo Parent’s investments in the State Transcos. +(e) Primarily relates to elimination of Notes Receivable from the State Transcos. +321 +10. DERIVATIVES AND HEDGING +The disclosures in this note apply to all Registrants unless indicated otherwise. For the periods presented, AEPTCo did not have any derivative and hedging activity. +OBJECTIVES FOR UTILIZATION OF DERIVATIVE INSTRUMENTS +AEPSC is agent for and transacts on behalf of AEP subsidiaries, including the Registrant Subsidiaries. AEPEP is agent for and transacts on behalf of other AEP subsidiaries. +The Registrants are exposed to certain market risks as major power producers and participants in the electricity, capacity, natural gas, coal and emission allowance markets. These risks include commodity price risks which may be subject to capacity risk, interest rate risk and credit risk. These risks represent the risk of loss that may impact the Registrants due to changes in the underlying market prices or rates. Management utilizes derivative instruments to manage these risks. +STRATEGIES FOR UTILIZATION OF DERIVATIVE INSTRUMENTS TO ACHIEVE OBJECTIVES +Risk Management Strategies +The strategy surrounding the use of derivative instruments primarily focuses on managing risk exposures, future cash flows and creating value utilizing both economic and formal hedging strategies. The risk management strategies also include the use of derivative instruments for trading purposes which focus on seizing market opportunities to create value driven by expected changes in the market prices of the commodities. To accomplish these objectives, the Registrants primarily employ risk management contracts including physical and financial forward purchase-and-sale contracts and, to a lesser extent, OTC swaps and options. Not all risk management contracts meet the definition of a derivative under the accounting guidance for “Derivatives and Hedging.” Derivative risk management contracts elected normal under the normal purchases and normal sales scope exception are not subject to the requirements of this accounting guidance. +The Registrants utilize power, capacity, coal, natural gas, interest rate and, to a lesser extent, heating oil, gasoline and other commodity contracts to manage the risk associated with the energy business. The Registrants utilize interest rate derivative contracts in order to manage the interest rate exposure associated with the commodity portfolio. For disclosure purposes, such risks are grouped as “Commodity,” as these risks are related to energy risk management activities. The Registrants also utilize derivative contracts to manage interest rate risk associated with debt financing. For disclosure purposes, these risks are grouped as “Interest Rate.” The amount of risk taken is determined by the Commercial Operations, Energy Supply and Finance groups in accordance with established risk management policies as approved by the Finance Committee of the Board of Directors. +322 +The following tables represent the gross notional volume of the Registrants’ outstanding derivative contracts: +December 31, 2020 +Primary Risk +Exposure Unit of +Measure AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Commodity: +Power MWhs 331.3 — 46.9 19.7 3.0 11.9 4.0 +Natural Gas MMBtus 26.9 — — — — — 7.9 +Heating Oil and Gasoline Gallons 6.9 1.8 1.1 0.6 1.4 0.7 0.9 +Interest Rate USD $ 129.8 $ — $ — $ — $ — $ — $ — +Interest Rate on Long-term Debt USD $ 1,150.0 $ — $ 200.0 $ — $ — $ — $ — +December 31, 2019 +Primary Risk +Exposure Unit of +Measure AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Commodity: +Power MWhs 365.9 — 61.0 26.8 7.1 14.9 4.4 +Natural Gas MMBtus 40.7 — — — — — 11.6 +Heating Oil and Gasoline Gallons 6.9 1.8 1.1 0.6 1.4 0.7 0.9 +Interest Rate USD $ 140.1 $ — $ — $ — $ — $ — $ — +Interest Rate on Long-term Debt USD $ 625.0 $ — $ — $ — $ — $ — $ — +Fair Value Hedging Strategies (Applies to AEP) +Parent enters into interest rate derivative transactions as part of an overall strategy to manage the mix of fixed-rate and floating-rate debt. Certain interest rate derivative transactions effectively modify exposure to interest rate risk by converting a portion of fixed-rate debt to a floating-rate. Provided specific criteria are met, these interest rate derivatives may be designated as fair value hedges. +Cash Flow Hedging Strategies +The Registrants utilize cash flow hedges on certain derivative transactions for the purchase-and-sale of power (“Commodity”) in order to manage the variable price risk related to forecasted purchases and sales. Management monitors the potential impacts of commodity price changes and, where appropriate, enters into derivative transactions to protect profit margins for a portion of future electricity sales and purchases. The Registrants do not hedge all commodity price risk. +The Registrants utilize a variety of interest rate derivative transactions in order to manage interest rate risk exposure. The Registrants also utilize interest rate derivative contracts to manage interest rate exposure related to future borrowings of fixed-rate debt. The Registrants do not hedge all interest rate exposure. +323 +ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND THE IMPACT ON THE FINANCIAL STATEMENTS +The accounting guidance for “Derivatives and Hedging” requires recognition of all qualifying derivative instruments as either assets or liabilities on the balance sheets at fair value. The fair values of derivative instruments accounted for using MTM accounting or hedge accounting are based on exchange prices and broker quotes. If a quoted market price is not available, the estimate of fair value is based on the best information available including valuation models that estimate future energy prices based on existing market and broker quotes and other assumptions. In order to determine the relevant fair values of the derivative instruments, the Registrants apply valuation adjustments for discounting, liquidity and credit quality. +Credit risk is the risk that a counterparty will fail to perform on the contract or fail to pay amounts due. Liquidity risk represents the risk that imperfections in the market will cause the price to vary from estimated fair value based upon prevailing market supply and demand conditions. Since energy markets are imperfect and volatile, there are inherent risks related to the underlying assumptions in models used to fair value risk management contracts. Unforeseen events may cause reasonable price curves to differ from actual price curves throughout a contract’s term and at the time a contract settles. Consequently, there could be significant adverse or favorable effects on future net income and cash flows if market prices are not consistent with management’s estimates of current market consensus for forward prices in the current period. This is particularly true for longer term contracts. Cash flows may vary based on market conditions, margin requirements and the timing of settlement of risk management contracts. +According to the accounting guidance for “Derivatives and Hedging,” the Registrants reflect the fair values of derivative instruments subject to netting agreements with the same counterparty net of related cash collateral. For certain risk management contracts, the Registrants are required to post or receive cash collateral based on third-party contractual agreements and risk profiles. AEP netted cash collateral received from third-parties against short-term and long-term risk management assets in the amounts of $ 3 million and $ 5 million as of December 31, 2020 and 2019, respectively. AEP netted cash collateral paid to third-parties against short-term and long-term risk management liabilities in the amounts of $ 7 million and $ 39 million as of December 31, 2020 and 2019, respectively. The netted cash collateral from third-parties against short-term and long-term risk management assets and netted cash collateral paid to third-parties against short-term and long-term risk management liabilities were immaterial for the Registrant Subsidiaries as of December 31, 2020 and 2019. +324 +The following tables represent the gross fair value of the Registrants’ derivative activity on the balance sheets: +AEP +December 31, 2020 +Risk +Management +Contracts Hedging Contracts Gross Amounts +of Risk +Management +Assets/ +Liabilities +Recognized Gross +Amounts +Offset in the +Statement of +Financial +Position (b) Net Amounts of +Assets/Liabilities +Presented in the +Statement of +Financial +Position (c) +Balance Sheet Location Commodity (a) Commodity (a) Interest Rate (a) +(in millions) +Current Risk Management Assets $ 239.1 $ 21.1 $ 5.0 $ 265.2 $ ( 170.5 ) $ 94.7 +Long-term Risk Management Assets 275.9 18.0 — 293.9 ( 51.7 ) 242.2 +Total Assets 515.0 39.1 5.0 559.1 ( 222.2 ) 336.9 +Current Risk Management Liabilities 193.0 54.4 3.4 250.8 ( 172.0 ) 78.8 +Long-term Risk Management Liabilities 222.2 60.1 4.1 286.4 ( 53.6 ) 232.8 +Total Liabilities 415.2 114.5 7.5 537.2 ( 225.6 ) 311.6 +Total MTM Derivative Contract Net Assets (Liabilities) $ 99.8 $ ( 75.4 ) $ ( 2.5 ) $ 21.9 $ 3.4 $ 25.3 +December 31, 2019 +Risk +Management +Contracts Hedging Contracts Gross Amounts +of Risk +Management +Assets/ +Liabilities +Recognized Gross +Amounts +Offset in the +Statement of +Financial +Position (b) Net Amounts of +Assets/Liabilities +Presented in the +Statement of +Financial +Position (c) +Balance Sheet Location Commodity (a) Commodity (a) Interest Rate (a) +(in millions) +Current Risk Management Assets $ 513.9 $ 11.5 $ 6.5 $ 531.9 $ ( 359.1 ) $ 172.8 +Long-term Risk Management Assets 290.8 11.0 12.6 314.4 ( 47.8 ) 266.6 +Total Assets 804.7 22.5 19.1 846.3 ( 406.9 ) 439.4 +Current Risk Management Liabilities 424.5 72.3 — 496.8 ( 382.5 ) 114.3 +Long-term Risk Management Liabilities 244.5 75.7 — 320.2 ( 58.4 ) 261.8 +Total Liabilities 669.0 148.0 — 817.0 ( 440.9 ) 376.1 +Total MTM Derivative Contract Net Assets (Liabilities) $ 135.7 $ ( 125.5 ) $ 19.1 $ 29.3 $ 34.0 $ 63.3 +325 +AEP Texas +December 31, 2020 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 0.4 $ ( 0.4 ) $ — +Long-term Risk Management Assets — — — +Total Assets 0.4 ( 0.4 ) — +Current Risk Management Liabilities — — — +Long-term Risk Management Liabilities — — — +Total Liabilities — — — +Total MTM Derivative Net Assets (Liabilities) $ 0.4 $ ( 0.4 ) $ — +December 31, 2019 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ — $ — $ — +Long-term Risk Management Assets — — — +Total Assets — — — +Current Risk Management Liabilities — — — +Long-term Risk Management Liabilities — — — +Total Liabilities — — — +Total MTM Derivative Contract Net Assets $ — $ — $ — +326 +APCo +December 31, 2020 +Risk Gross Amounts of Risk Gross Amounts Net Amounts of Assets/ +Management Hedging Management Offset in the Liabilities Presented in +Contracts - Contracts - Assets/Liabilities Statement of the Statement of +Balance Sheet Location Commodity (a) Interest Rate (a) Recognized Financial Position (b) Financial Position (c) +(in millions) +Current Risk Management Assets $ 38.8 $ 2.4 $ 41.2 $ ( 18.8 ) $ 22.4 +Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets 0.7 — 0.7 ( 0.6 ) 0.1 +Total Assets 39.5 2.4 41.9 ( 19.4 ) 22.5 +Current Risk Management Liabilities 19.7 3.4 23.1 ( 18.5 ) 4.6 +Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities 0.6 — 0.6 ( 0.5 ) 0.1 +Total Liabilities 20.3 3.4 23.7 ( 19.0 ) 4.7 +Total MTM Derivative Contract Net Assets (Liabilities) $ 19.2 $ ( 1.0 ) $ 18.2 $ ( 0.4 ) $ 17.8 +December 31, 2019 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 124.4 $ ( 85.0 ) $ 39.4 +Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets 0.9 ( 0.8 ) 0.1 +Total Assets 125.3 ( 85.8 ) 39.5 +Current Risk Management Liabilities 86.2 ( 84.3 ) 1.9 +Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities 0.7 ( 0.7 ) — +Total Liabilities 86.9 ( 85.0 ) 1.9 +Total MTM Derivative Contract Net Assets (Liabilities) $ 38.4 $ ( 0.8 ) $ 37.6 +327 +I&M +December 31, 2020 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 17.2 $ ( 13.6 ) $ 3.6 +Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets 0.5 ( 0.4 ) 0.1 +Total Assets 17.7 ( 14.0 ) 3.7 +Other Current Liabilities - Current Risk Management Liabilities 12.1 ( 12.0 ) 0.1 +Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities 0.4 ( 0.3 ) 0.1 +Total Liabilities 12.5 ( 12.3 ) 0.2 +Total MTM Derivative Contract Net Assets (Liabilities) $ 5.2 $ ( 1.7 ) $ 3.5 +December 31, 2019 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 66.9 $ ( 57.1 ) $ 9.8 +Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets 0.5 ( 0.4 ) 0.1 +Total Assets 67.4 ( 57.5 ) 9.9 +Other Current Liabilities - Current Risk Management Liabilities 55.2 ( 54.7 ) 0.5 +Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities 0.4 ( 0.4 ) — +Total Liabilities 55.6 ( 55.1 ) 0.5 +Total MTM Derivative Contract Net Assets (Liabilities) $ 11.8 $ ( 2.4 ) $ 9.4 +OPCo +December 31, 2020 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 0.3 $ ( 0.3 ) $ — +Long-term Risk Management Assets — — — +Total Assets 0.3 ( 0.3 ) — +Current Risk Management Liabilities 8.7 — 8.7 +Long-term Risk Management Liabilities 101.6 — 101.6 +Total Liabilities 110.3 — 110.3 +Total MTM Derivative Contract Net Liabilities $ ( 110.0 ) $ ( 0.3 ) $ ( 110.3 ) +December 31, 2019 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ — $ — $ — +Long-term Risk Management Assets — — — +Total Assets — — — +Current Risk Management Liabilities 7.3 — 7.3 +Long-term Risk Management Liabilities 96.3 — 96.3 +Total Liabilities 103.6 — 103.6 +Total MTM Derivative Contract Net Liabilities $ ( 103.6 ) $ — $ ( 103.6 ) +328 +PSO +December 31, 2020 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 10.5 $ ( 0.2 ) $ 10.3 +Long-term Risk Management Assets — — — +Total Assets 10.5 ( 0.2 ) 10.3 +Current Risk Management Liabilities — — — +Long-term Risk Management Liabilities — — — +Total Liabilities — — — +Total MTM Derivative Net Assets (Liabilities) $ 10.5 $ ( 0.2 ) $ 10.3 +December 31, 2019 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 16.3 $ ( 0.5 ) $ 15.8 +Long-term Risk Management Assets — — — +Total Assets 16.3 ( 0.5 ) 15.8 +Current Risk Management Liabilities 0.5 ( 0.5 ) — +Long-term Risk Management Liabilities — — — +Total Liabilities 0.5 ( 0.5 ) — +Total MTM Derivative Contract Net Assets $ 15.8 $ — $ 15.8 +SWEPCo +December 31, 2020 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 3.4 $ ( 0.2 ) $ 3.2 +Long-term Risk Management Assets — — — +Total Assets 3.4 ( 0.2 ) 3.2 +Current Risk Management Liabilities 0.7 — 0.7 +Long-term Risk Management Liabilities 1.0 — 1.0 +Total Liabilities 1.7 — 1.7 +Total MTM Derivative Net Assets (Liabilities) $ 1.7 $ ( 0.2 ) $ 1.5 +December 31, 2019 +Risk Management Gross Amounts Offset Net Amounts of Assets/Liabilities +Contracts - in the Statement of Presented in the Statement +Balance Sheet Location Commodity (a) Financial Position (b) of Financial Position (c) +(in millions) +Current Risk Management Assets $ 6.5 $ ( 0.1 ) $ 6.4 +Long-term Risk Management Assets — — — +Total Assets 6.5 ( 0.1 ) 6.4 +Current Risk Management Liabilities 2.0 ( 0.1 ) 1.9 +Long-term Risk Management Liabilities 3.1 — 3.1 +Total Liabilities 5.1 ( 0.1 ) 5.0 +Total MTM Derivative Contract Net Assets $ 1.4 $ — $ 1.4 +(a) Derivative instruments within these categories are reported gross. These instruments are subject to master netting agreements and are presented on the balance sheets on a net basis in accordance with the accounting guidance for “Derivatives and Hedging.” +(b) Amounts include counterparty netting of risk management and hedging contracts and associated cash collateral in accordance with the accounting guidance for “Derivatives and Hedging.” +(c) All derivative contracts subject to a master netting arrangement or similar agreement are offset in the statement of financial position. +329 +The tables below present the Registrants’ amount of gain (loss) recognized on risk management contracts: +Year Ended December 31, 2020 +Location of Gain (Loss) AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Vertically Integrated Utilities Revenues $ 0.8 $ — $ — $ — $ — $ — $ — +Generation & Marketing Revenues 9.5 — — — — — — +Electric Generation, Transmission and Distribution Revenues — — 0.4 0.1 — — 0.1 +Purchased Electricity for Resale 1.4 — 1.2 0.1 — — — +Other Operation ( 2.0 ) ( 0.6 ) ( 0.2 ) ( 0.2 ) ( 0.3 ) ( 0.2 ) ( 0.3 ) +Maintenance ( 2.9 ) ( 0.8 ) ( 0.4 ) ( 0.3 ) ( 0.5 ) ( 0.3 ) ( 0.4 ) +Regulatory Assets (a) ( 4.8 ) — — ( 0.1 ) ( 6.6 ) — 1.4 +Regulatory Liabilities (a) 114.9 0.4 20.3 12.4 12.4 39.1 20.2 +Total Gain (Loss) on Risk Management Contracts $ 116.9 $ ( 1.0 ) $ 21.3 $ 12.0 $ 5.0 $ 38.6 $ 21.0 +Year Ended December 31, 2019 +Location of Gain (Loss) AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Vertically Integrated Utilities Revenues $ 0.7 $ — $ — $ — $ — $ — $ — +Generation & Marketing Revenues 25.1 — — — — — — +Electric Generation, Transmission and Distribution Revenues — — 0.1 0.5 — — 0.1 +Purchased Electricity for Resale 1.9 — 1.6 0.1 — — — +Other Operation ( 0.8 ) ( 0.2 ) ( 0.1 ) ( 0.1 ) ( 0.2 ) ( 0.1 ) ( 0.1 ) +Maintenance ( 0.8 ) ( 0.2 ) ( 0.2 ) ( 0.1 ) ( 0.2 ) ( 0.1 ) ( 0.1 ) +Regulatory Assets (a) ( 3.7 ) 0.7 0.3 0.3 ( 3.7 ) 1.2 ( 1.5 ) +Regulatory Liabilities (a) 102.6 — 2.4 24.5 10.1 34.6 26.6 +Total Gain on Risk Management Contracts $ 125.0 $ 0.3 $ 4.1 $ 25.2 $ 6.0 $ 35.6 $ 25.0 +Year Ended December 31, 2018 +Location of Gain (Loss) AEP AEP Texas APCo I&M OPCo PSO SWEPCo +(in millions) +Vertically Integrated Utilities Revenues $ ( 10.4 ) $ — $ — $ — $ — $ — $ — +Generation & Marketing Revenues 38.9 — — — — — — +Electric Generation, Transmission and Distribution Revenues — — ( 1.9 ) ( 8.2 ) — — 0.1 +Purchased Electricity for Resale 8.6 — 7.6 0.8 — — — +Other Operation 1.7 0.4 0.2 0.2 0.3 0.2 0.2 +Maintenance 1.9 0.4 0.4 0.2 0.4 0.2 0.2 +Regulatory Assets (a) 27.9 ( 0.7 ) ( 0.7 ) 7.1 24.9 ( 1.1 ) ( 1.2 ) +Regulatory Liabilities (a) 222.7 ( 0.5 ) 135.5 11.6 — 37.3 11.9 +Total Gain (Loss) on Risk Management Contracts $ 291.3 $ ( 0.4 ) $ 141.1 $ 11.7 $ 25.6 $ 36.6 $ 11.2 +(a) Represents realized and unrealized gains and losses subject to regulatory accounting treatment recorded as either current or noncurrent on the balance sheets. +330 +Certain qualifying derivative instruments have been designated as normal purchase or normal sale contracts, as provided in the accounting guidance for “Derivatives and Hedging.” Derivative contracts that have been designated as normal purchases or normal sales under that accounting guidance are not subject to MTM accounting treatment and are recognized on the statements of income on an accrual basis. +The accounting for the changes in the fair value of a derivative instrument depends on whether it qualifies for and has been designated as part of a hedging relationship and further, on the type of hedging relationship. Depending on the exposure, management designates a hedging instrument as a fair value hedge or a cash flow hedge. +For contracts that have not been designated as part of a hedging relationship, the accounting for changes in fair value depends on whether the derivative instrument is held for trading purposes. Unrealized and realized gains and losses on derivative instruments held for trading purposes are included in revenues on a net basis on the statements of income. Unrealized and realized gains and losses on derivative instruments not held for trading purposes are included in revenues or expenses on the statements of income depending on the relevant facts and circumstances. Certain derivatives that economically hedge future commodity risk are recorded in the same expense line item on the statements of income as that of the associated risk. However, unrealized and some realized gains and losses in regulated jurisdictions for both trading and non-trading derivative instruments are recorded as regulatory assets (for losses) or regulatory liabilities (for gains) in accordance with the accounting guidance for “Regulated Operations.” +Accounting for Fair Value Hedging Strategies (Applies to AEP) +For fair value hedges (i.e. hedging the exposure to changes in the fair value of an asset, liability or an identified portion thereof attributable to a particular risk), the gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item associated with the hedged risk impacts net income during the period of change. +AEP records realized and unrealized gains or losses on interest rate swaps that are designated and qualify for fair value hedge accounting treatment and any offsetting changes in the fair value of the debt being hedged in Interest Expense on the statements of income. +The following table shows the impacts recognized on the balance sheets related to the hedged items in fair value hedging relationships: +Carrying Amount of the Hedged +Assets/(Liabilities) Cumulative Amount of Fair Value Hedging Adjustment Included in the Carrying Amount of the Hedged Assets/(Liabilities) +December 31, 2020 December 31, 2019 December 31, 2020 December 31, 2019 +(in millions) +Long-term Debt (a) (b) $ ( 995.9 ) $ ( 510.8 ) $ ( 51.7 ) $ ( 14.5 ) +(a) Amounts included on the balance sheets within Long-term Debt Due within One Year and Long-term Debt, respectively. +(b) Amounts include $( 53 ) million and $ 0 as of December 31, 2020 and 2019, respectively, for the fair value hedge adjustment of hedged debt obligations for which hedge accounting has been discontinued . +The pretax effects of fair value hedge accounting on income were as follows: +Years Ended December 31, +2020 2019 2018 +(in millions) +Gain (Loss) on Interest Rate Contracts: +Fair Value Hedging Instruments (a) $ 41.1 $ 31.9 $ ( 11.3 ) +Fair Value Portion of Long-term Debt (a) ( 41.1 ) ( 31.9 ) 11.3 +(a) Gain (Loss) is included in Interest Expense on the statements of income. +331 +In June 2020, AEP terminated a $ 500 million notional amount interest rate swap resulting in the discontinuance of the hedging relationship. A gain of $ 57 million on the fair value of the hedging instrument was settled in cash and recorded within operating activities on the statement of cash flows. Subsequent to the discontinuation of hedge accounting, the remaining adjustment to the carrying amount of the hedged item of $ 57 million will be amortized on a straight-line basis through November 2027 in Interest Expense on the statements of income. +Accounting for Cash Flow Hedging Strategies +For cash flow hedges (i.e. hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the Registrants initially report the gain or loss on the derivative instrument as a component of Accumulated Other Comprehensive Income (Loss) on the balance sheets until the period the hedged item affects net income. +Realized gains and losses on derivative contracts for the purchase and sale of power designated as cash flow hedges are included in Total Revenues or Purchased Electricity for Resale on the statements of income or in Regulatory Assets or Regulatory Liabilities on the balance sheets, depending on the specific nature of the risk being hedged. During the years ended 2020, 2019 and 2018, AEP applied cash flow hedging to outstanding power derivatives. During the years ended 2020, 2019 and 2018, the Registrant Subsidiaries did not apply cash flow hedging to outstanding power derivatives. +The Registrants reclassify gains and losses on interest rate derivative hedges related to debt financings from Accumulated Other Comprehensive Income (Loss) on the balance sheets into Interest Expense on the statements of income in those periods in which hedged interest payments occur. During the years ended 2020, 2019 and 2018, AEP applied cash flow hedging to outstanding interest rate derivatives. During the year ended 2020, APCo applied cash flow hedging to outstanding interest rate derivatives and the other Registrant Subsidiaries did not. During the year ended 2019, the Registrant Subsidiaries did not apply cash flow hedging to outstanding interest rate derivatives. During the year ended 2018, SWEPCo applied cash flow hedging to outstanding interest rate derivatives and the other Registrant Subsidiaries did not. +For details on effective cash flow hedges included in Accumulated Other Comprehensive Income (Loss) on the balance sheets and the reasons for changes in cash flow hedges, see Note 3 - Comprehensive Income. +Cash flow hedges included in Accumulated Other Comprehensive Income (Loss) on the balance sheets were: +Impact of Cash Flow Hedges on AEP’s Balance Sheets +December 31, 2020 December 31, 2019 +Commodity Interest Rate Commodity Interest Rate +(in millions) +AOCI Gain (Loss) Net of Tax $ ( 60.6 ) $ ( 47.5 ) $ ( 103.5 ) $ ( 11.5 ) +Portion Expected to be Reclassed to Net Income During the Next Twelve Months ( 27.1 ) ( 5.7 ) ( 51.7 ) ( 2.1 ) +As of December 31, 2020 the maximum length of time that AEP is hedging its exposure to variability in future cash flows related to forecasted transactions is 123 months and 120 months for commodity and interest rate hedges, respectively. +332 +Impact of Cash Flow Hedges on the Registrant Subsidiaries’ Balance Sheets +December 31, 2020 December 31, 2019 +Interest Rate +Expected to be Expected to be +Reclassified to Reclassified to +Net Income During Net Income During +AOCI Gain (Loss) the Next AOCI Gain (Loss) the Next +Company Net of Tax Twelve Months Net of Tax Twelve Months +(in millions) +AEP Texas $ ( 2.3 ) $ ( 1.1 ) $ ( 3.4 ) $ ( 1.1 ) +APCo ( 0.8 ) 0.4 0.9 0.9 +I&M ( 8.3 ) ( 1.6 ) ( 9.9 ) ( 1.6 ) +PSO 0.1 0.1 1.1 1.0 +SWEPCo ( 0.3 ) ( 1.5 ) ( 1.8 ) ( 1.5 ) +The actual amounts reclassified from Accumulated Other Comprehensive Income (Loss) to Net Income can differ from the estimate above due to market price changes. +Credit Risk +Management mitigates credit risk in wholesale marketing and trading activities by assessing the creditworthiness of potential counterparties before entering into transactions with them and continuing to evaluate their creditworthiness on an ongoing basis. Management uses credit agency ratings and current market-based qualitative and quantitative data as well as financial statements to assess the financial health of counterparties on an ongoing basis. +Master agreements are typically used to facilitate the netting of cash flows associated with a single counterparty and may include collateral requirements. Collateral requirements in the form of cash, letters of credit, surety bonds and parental/affiliate guarantees may be obtained as security from counterparties in order to mitigate credit risk. Some master agreements include margining, which requires a counterparty to post cash or letters of credit in the event exposure exceeds the established threshold. The threshold represents an unsecured credit limit which may be supported by a parental/affiliate guaranty, as determined in accordance with AEP’s credit policy. In addition, master agreements allow for termination and liquidation of all positions in the event of a default including a failure or inability to post collateral when required. +Collateral Triggering Events +Credit Downgrade Triggers (Applies to AEP, APCo, I&M, PSO and SWEPCo) +A limited number of derivative contracts include collateral triggering events, which include a requirement to maintain certain credit ratings. On an ongoing basis, AEP’s risk management organization assesses the appropriateness of these collateral triggering events in contracts. The Registrants have not experienced a downgrade below a specified credit rating threshold that would require the posting of additional collateral. The Registrants had no derivative contracts with collateral triggering events in a net liability position as of December 31, 2020 and 2019. +333 +Cross-Default Triggers (Applies to AEP, APCo, I&M and SWEPCo) +In addition, a majority of non-exchange-traded commodity contracts contain cross-default provisions that, if triggered, would permit the counterparty to declare a default and require settlement of the outstanding payable. These cross-default provisions could be triggered if there was a non-performance event by Parent or the obligor under outstanding debt or a third-party obligation that is $ 50 million or greater. On an ongoing basis, AEP’s risk management organization assesses the appropriateness of these cross-default provisions in the contracts. The following tables represent: (a) the fair value of these derivative liabilities subject to cross-default provisions prior to consideration of contractual netting arrangements, (b) the amount that the exposure has been reduced by cash collateral posted and (c) if a cross-default provision would have been triggered, the settlement amount that would be required after considering contractual netting arrangements: +December 31, 2020 +Liabilities for Additional +Contracts with Cross Settlement +Default Provisions Liability if Cross +Prior to Contractual Amount of Cash Default Provision +Company Netting Arrangements Collateral Posted is Triggered +(in millions) +AEP $ 188.4 $ — $ 169.2 +APCo 4.3 — 3.5 +I&M 0.5 — 0.1 +SWEPCo 1.8 — 1.8 +December 31, 2019 +Liabilities for Additional +Contracts with Cross Settlement +Default Provisions Liability if Cross +Prior to Contractual Amount of Cash Default Provision +Company Netting Arrangements Collateral Posted is Triggered +(in millions) +AEP $ 267.3 $ 3.7 $ 246.7 +APCo 2.3 — 0.4 +I&M 1.3 — 0.2 +SWEPCo 5.1 — 5.1 +Warrants Held in Investee (Applies to AEP) +As of December 31, 2020, AEP held an $ 8 million investment in a privately held investee that is anticipated to complete an initial public offering (IPO) in the first quarter of 2021 . The IPO is expected to be completed via a reverse merger with a public special purpose acquisition company. AEP’s interests in the investee as of December 31, 2020 consisted of a noncontrolling equity interest of preferred shares, which were accounted for at historical cost until completion of the IPO, and common share warrants, which management has determined are derivative instruments based on the accounting guidance for “Derivatives and Hedging”. +As of December 31, 2020, the warrants were valued at $ 32 million and were recorded in Deferred Charges and Other Noncurrent Assets on AEP’s balance sheet. AEP recognized an unrealized gain of $ 32 million associated with the warrants for the year ended December 31, 2020, presented in Other Income on AEP’s statement of income. +Management utilized a Black-Scholes options pricing model to value the warrants as of December 31, 2020. As the reverse merger and IPO did not close prior to the end of 2020, the valuation contemplated a liquidity adjustment that resulted in the overall fair value of the warrants being categorized as Level 3 in the fair value hierarchy. See “Fair Value Measurements of Financial Assets and Liabilities” section of Note 11 for additional information. +334 +11. FAIR VALUE MEASUREMENTS +The disclosures in this note apply to all Registrants except AEPTCo unless indicated otherwise. +Fair Value Measurements of Long-term Debt (Applies to all Registrants) +The fair values of Long-term Debt are based on quoted market prices, without credit enhancements, for the same or similar issues and the current interest rates offered for instruments with similar maturities classified as Level 2 measurement inputs. These instruments are not marked-to-market. The estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange. The fair value of AEP’s Equity Units (Level 1) are valued based on publicly-traded securities issued by AEP. +The book values and fair values of Long-term Debt are summarized in the following table: +December 31, +2020 2019 +Company Book Value Fair Value Book Value Fair Value +(in millions) +AEP (a) $ 31,072.5 $ 37,457.0 $ 26,725.5 $ 30,172.0 +AEP Texas 4,820.4 5,682.6 4,558.4 4,981.5 +AEPTCo 3,948.5 4,984.3 3,427.3 3,868.0 +APCo 4,834.1 6,391.8 4,363.8 5,253.1 +I&M 3,029.9 3,775.3 3,050.2 3,453.8 +OPCo 2,430.2 3,154.9 2,082.0 2,554.3 +PSO 1,373.8 1,732.1 1,386.2 1,603.3 +SWEPCo 2,636.4 3,210.1 2,655.6 2,927.9 +(a) The fair value amounts include debt related to AEP’s Equity Units and had a fair value of $ 1.7 billion and $ 871 million as of December 31, 2020 and 2019, respectively. See “Equity Units” section of Note 14 for additional information. +Fair Value Measurements of Other Temporary Investments (Applies to AEP) +Other Temporary Investments include marketable securities that management intends to hold for less than one year and investments by AEP’s protected cell of EIS. See “Other Temporary Investments” section of Note 1 for additional information. +The following is a summary of Other Temporary Investments: +December 31, 2020 +Gross Gross +Unrealized Unrealized Fair +Other Temporary Investments Cost Gains Losses Value +(in millions) +Restricted Cash and Other Cash Deposits (a) $ 68.3 $ — $ — $ 68.3 +Fixed Income Securities – Mutual Funds (b) 120.7 2.8 — 123.5 +Equity Securities – Mutual Funds 25.9 28.7 — 54.6 +Total Other Temporary Investments $ 214.9 $ 31.5 $ — $ 246.4 +335 +December 31, 2019 +Gross Gross +Unrealized Unrealized Fair +Other Temporary Investments Cost Gains Losses Value +(in millions) +Restricted Cash and Other Cash Deposits (a) $ 214.7 $ — $ — $ 214.7 +Fixed Income Securities – Mutual Funds (b) 123.2 0.1 — 123.3 +Equity Securities – Mutual Funds 29.2 21.3 — 50.5 +Total Other Temporary Investments $ 367.1 $ 21.4 $ — $ 388.5 +(a) Primarily represents amounts held for the repayment of debt. +(b) Primarily short and intermediate maturities which may be sold and do not contain maturity dates. +The following table provides the activity for fixed income and equity securities within Other Temporary Investments: +Years Ended December 31, +2020 2019 2018 +(in millions) +Proceeds from Investment Sales $ 50.9 $ 21.2 $ — +Purchases of Investments 41.6 45.0 3.1 +Gross Realized Gains on Investment Sales 3.8 — — +Gross Realized Losses on Investment Sales 0.2 0.4 — +Fair Value Measurements of Trust Assets for Decommissioning and SNF Disposal (Applies to AEP and I&M) +Securities held in trust funds for decommissioning nuclear facilities and for the disposal of SNF are recorded at fair value. See “Nuclear Trust Funds” section of Note 1 for additional information. +The following is a summary of nuclear trust fund investments: +December 31, +2020 2019 +Gross Other-Than- Gross Other-Than- +Fair Unrealized Temporary Fair Unrealized Temporary +Value Gains Impairments Value Gains Impairments +(in millions) +Cash and Cash Equivalents $ 25.8 $ — $ — $ 15.3 $ — $ — +Fixed Income Securities: +United States Government 1,025.6 98.5 ( 7.1 ) 1,112.5 55.5 ( 6.1 ) +Corporate Debt 86.3 9.6 ( 1.7 ) 72.4 5.3 ( 1.6 ) +State and Local Government 114.3 0.9 ( 0.4 ) 7.6 0.7 ( 0.2 ) +Subtotal Fixed Income Securities 1,226.2 109.0 ( 9.2 ) 1,192.5 61.5 ( 7.9 ) +Equity Securities - Domestic (a) 2,054.7 1,400.8 — 1,767.9 1,144.4 — +Spent Nuclear Fuel and Decommissioning Trusts $ 3,306.7 $ 1,509.8 $ ( 9.2 ) $ 2,975.7 $ 1,205.9 $ ( 7.9 ) +(a) Amount reported as Gross Unrealized Gains includes unrealized gains of $ 1.4 billion and $ 1.1 billion and unrealized losses of $ 9 million and $ 5 million as of December 31, 2020 and 2019, respectively. +336 +The following table provides the securities activity within the decommissioning and SNF trusts: +Years Ended December 31, +2020 2019 2018 +(in millions) +Proceeds from Investment Sales $ 1,593.4 $ 1,473.0 $ 2,010.0 +Purchases of Investments 1,637.2 1,531.0 2,064.7 +Gross Realized Gains on Investment Sales 26.4 76.5 47.5 +Gross Realized Losses on Investment Sales 26.1 24.3 32.8 +The base cost of fixed income securities was $ 1.1 billion and $ 1.1 billion as of December 31, 2020 and 2019, respectively. The base cost of equity securities was $ 654 million and $ 623 million as of December 31, 2020 and 2019, respectively. +The fair value of fixed income securities held in the nuclear trust funds, summarized by contractual maturities, as of December 31, 2020 was as follows: +Fair Value of Fixed +Income Securities +(in millions) +Within 1 year $ 294.8 +After 1 year through 5 years 371.3 +After 5 years through 10 years 214.4 +After 10 years 345.7 +Total $ 1,226.2 +337 +Fair Value Measurements of Financial Assets and Liabilities +For a discussion of fair value accounting and the classification of assets and liabilities within the fair value hierarchy, see the “Fair Value Measurements of Assets and Liabilities” section of Note 1. +The following tables set forth, by level within the fair value hierarchy, the Registrants’ financial assets and liabilities that were accounted for at fair value on a recurring basis. As required by the accounting guidance for “Fair Value Measurements and Disclosures,” financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Management’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. There have not been any significant changes in management’s valuation techniques. +AEP +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Other Temporary Investments +Restricted Cash and Other Cash Deposits (a) $ 57.8 $ — $ — $ 10.5 $ 68.3 +Fixed Income Securities – Mutual Funds 123.5 — — — 123.5 +Equity Securities – Mutual Funds (b) 54.6 — — — 54.6 +Total Other Temporary Investments 235.9 — — 10.5 246.4 +Risk Management Assets +Risk Management Commodity Contracts (c) (d) 0.9 258.8 252.4 ( 190.0 ) 322.1 +Cash Flow Hedges: +Commodity Hedges (c) — 34.4 3.9 ( 28.5 ) 9.8 +Interest Rate Hedges — 2.4 — — 2.4 +Fair Value Hedges — 2.6 — — 2.6 +Total Risk Management Assets 0.9 298.2 256.3 ( 218.5 ) 336.9 +Spent Nuclear Fuel and Decommissioning Trusts +Cash and Cash Equivalents (e) 16.8 — — 9.0 25.8 +Fixed Income Securities: +United States Government — 1,025.6 — — 1,025.6 +Corporate Debt — 86.3 — — 86.3 +State and Local Government — 114.3 — — 114.3 +Subtotal Fixed Income Securities — 1,226.2 — — 1,226.2 +Equity Securities – Domestic (b) 2,054.7 — — — 2,054.7 +Total Spent Nuclear Fuel and Decommissioning Trusts 2,071.5 1,226.2 — 9.0 3,306.7 +Other Investments (h) — — 31.8 — 31.8 +Total Assets $ 2,308.3 $ 1,524.4 $ 288.1 $ ( 199.0 ) $ 3,921.8 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (d) $ 0.9 $ 244.2 $ 167.2 $ ( 193.4 ) $ 218.9 +Cash Flow Hedges: +Commodity Hedges (c) — 106.1 7.6 ( 28.5 ) 85.2 +Interest Rate Hedges — 3.4 — — 3.4 +Fair Value Hedges — 4.1 — — 4.1 +Total Risk Management Liabilities $ 0.9 $ 357.8 $ 174.8 $ ( 221.9 ) $ 311.6 +338 +AEP +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Other Temporary Investments +Restricted Cash and Other Cash Deposits (a) $ 197.6 $ — $ — $ 17.1 $ 214.7 +Fixed Income Securities – Mutual Funds 123.3 — — — 123.3 +Equity Securities – Mutual Funds (b) 50.5 — — — 50.5 +Total Other Temporary Investments 371.4 — — 17.1 388.5 +Risk Management Assets +Risk Management Commodity Contracts (c) (f) 4.0 440.1 369.2 ( 404.5 ) 408.8 +Cash Flow Hedges: +Commodity Hedges (c) — 15.0 3.2 ( 6.7 ) 11.5 +Interest Rate Hedges — 4.6 — — 4.6 +Fair Value Hedges — 14.5 — — 14.5 +Total Risk Management Assets 4.0 474.2 372.4 ( 411.2 ) 439.4 +Spent Nuclear Fuel and Decommissioning Trusts +Cash and Cash Equivalents (e) 6.7 — — 8.6 15.3 +Fixed Income Securities: +United States Government — 1,112.5 — — 1,112.5 +Corporate Debt — 72.4 — — 72.4 +State and Local Government — 7.6 — — 7.6 +Subtotal Fixed Income Securities — 1,192.5 — — 1,192.5 +Equity Securities – Domestic (b) 1,767.9 — — — 1,767.9 +Total Spent Nuclear Fuel and Decommissioning Trusts 1,774.6 1,192.5 — 8.6 2,975.7 +Total Assets $ 2,150.0 $ 1,666.7 $ 372.4 $ ( 385.5 ) $ 3,803.6 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (f) $ 3.8 $ 450.0 $ 224.0 $ ( 438.8 ) $ 239.0 +Cash Flow Hedges: +Commodity Hedges (c) — 105.3 38.5 ( 6.7 ) 137.1 +Total Risk Management Liabilities $ 3.8 $ 555.3 $ 262.5 $ ( 445.5 ) $ 376.1 +339 +AEP Texas +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Restricted Cash for Securitized Funding $ 28.7 $ — $ — $ — $ 28.7 +Risk Management Assets +Risk Management Commodity Contracts (c) — 0.4 — ( 0.4 ) — +Total Assets $ 28.7 $ 0.4 $ — $ ( 0.4 ) $ 28.7 +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Restricted Cash for Securitized Funding $ 154.7 $ — $ — $ — $ 154.7 +APCo +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Restricted Cash for Securitized Funding $ 16.9 $ — $ — $ — $ 16.9 +Risk Management Assets +Risk Management Commodity Contracts (c) (g) — 19.4 19.9 ( 19.2 ) 20.1 +Cash Flow Hedges: +Interest Rate Hedges — 2.4 — — 2.4 +Total Risk Management Assets — 21.8 19.9 ( 19.2 ) 22.5 +Total Assets $ 16.9 $ 21.8 $ 19.9 $ ( 19.2 ) $ 39.4 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ 19.5 $ 0.6 $ ( 18.8 ) $ 1.3 +Cash Flow Hedges: +Interest Rate Hedges — 3.4 — — 3.4 +Total Risk Management Liabilities $ — $ 22.9 $ 0.6 $ ( 18.8 ) $ 4.7 +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Restricted Cash for Securitized Funding $ 23.5 $ — $ — $ — $ 23.5 +Risk Management Assets +Risk Management Commodity Contracts (c) (g) — 84.6 40.5 ( 85.6 ) 39.5 +Total Assets $ 23.5 $ 84.6 $ 40.5 $ ( 85.6 ) $ 63.0 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ 84.0 $ 2.8 $ ( 84.9 ) $ 1.9 +340 +I&M +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ 15.1 $ 2.5 $ ( 13.9 ) $ 3.7 +Spent Nuclear Fuel and Decommissioning Trusts +Cash and Cash Equivalents (e) 16.8 — — 9.0 25.8 +Fixed Income Securities: +United States Government — 1,025.6 — — 1,025.6 +Corporate Debt — 86.3 — — 86.3 +State and Local Government — 114.3 — — 114.3 +Subtotal Fixed Income Securities — 1,226.2 — — 1,226.2 +Equity Securities - Domestic (b) 2,054.7 — — — 2,054.7 +Total Spent Nuclear Fuel and Decommissioning Trusts 2,071.5 1,226.2 — 9.0 3,306.7 +Total Assets $ 2,071.5 $ 1,241.3 $ 2.5 $ ( 4.9 ) $ 3,310.4 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ 12.0 $ 0.4 $ ( 12.2 ) $ 0.2 +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ 59.5 $ 8.0 $ ( 57.6 ) $ 9.9 +Spent Nuclear Fuel and Decommissioning Trusts +Cash and Cash Equivalents (e) 6.7 — — 8.6 15.3 +Fixed Income Securities: +United States Government — 1,112.5 — — 1,112.5 +Corporate Debt — 72.4 — — 72.4 +State and Local Government — 7.6 — — 7.6 +Subtotal Fixed Income Securities — 1,192.5 — — 1,192.5 +Equity Securities - Domestic (b) 1,767.9 — — — 1,767.9 +Total Spent Nuclear Fuel and Decommissioning Trusts 1,774.6 1,192.5 — 8.6 2,975.7 +Total Assets $ 1,774.6 $ 1,252.0 $ 8.0 $ ( 49.0 ) $ 2,985.6 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ 53.4 $ 2.2 $ ( 55.1 ) $ 0.5 +341 +OPCo +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ 0.3 $ — $ ( 0.3 ) $ — +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ — $ 110.3 $ — $ 110.3 +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Liabilities: (in millions) +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ — $ 103.6 $ — $ 103.6 +PSO +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ 0.2 $ 10.3 $ ( 0.2 ) $ 10.3 +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ — $ 16.3 $ ( 0.5 ) $ 15.8 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ — $ 0.5 $ ( 0.5 ) $ — +342 +SWEPCo +December 31, 2020 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ 0.1 $ 3.3 $ ( 0.2 ) $ 3.2 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ — $ 1.7 $ — $ 1.7 +December 31, 2019 +Level 1 Level 2 Level 3 Other Total +Assets: (in millions) +Risk Management Assets +Risk Management Commodity Contracts (c) (g) $ — $ — $ 6.5 $ ( 0.1 ) $ 6.4 +Liabilities: +Risk Management Liabilities +Risk Management Commodity Contracts (c) (g) $ — $ — $ 5.1 $ ( 0.1 ) $ 5.0 +(a) Amounts in “Other” column primarily represent cash deposits in bank accounts with financial institutions or third-parties. Level 1 and Level 2 amounts primarily represent investments in money market funds. +(b) Amounts represent publicly-traded equity securities and equity-based mutual funds. +(c) Amounts in “Other” column primarily represent counterparty netting of risk management and hedging contracts and associated cash collateral under the accounting guidance for “Derivatives and Hedging.” +(d) The December 31, 2020 maturities of the net fair value of risk management contracts prior to cash collateral, assets/(liabilities), were as follows: Level 2 matures $ 3 million in periods 2022-2024, $ 11 million in periods 2025-2026 and $ 1 million in periods 2027-2033; Level 3 matures $ 47 million in 2021, $ 37 million in periods 2022-2024, $ 14 million in periods 2025-2026 and $( 13 ) million in periods 2027-2033. Risk management commodity contracts are substantially comprised of power contracts. +(e) Amounts in “Other” column primarily represent accrued interest receivables from financial institutions. Level 1 amounts primarily represent investments in money market funds. +(f) The December 31, 2019 maturities of the net fair value of risk management contracts prior to cash collateral, assets/(liabilities), were as follows: Level 2 matures $( 7 ) million in 2020 and $( 3 ) million in periods 2021-2023; Level 3 matures $ 96 million in 2020, $ 36 million in periods 2021-2023, $ 25 million in periods 2024-2025 and $( 12 ) million in periods 2026-2032. Risk management commodity contracts are substantially comprised of power contracts. +(g) Substantially comprised of power contracts for the Registrant Subsidiaries. +(h) See “Warrants Held in Investee” section of Note 10 for additional information. +343 +The following tables set forth a reconciliation of changes in the fair value of net trading derivatives classified as Level 3 in the fair value hierarchy: +Year Ended December 31, 2020 AEP APCo I&M OPCo PSO SWEPCo +(in millions) +Balance as of December 31, 2019 $ 109.9 $ 37.7 $ 5.8 $ ( 103.6 ) $ 15.8 $ 1.4 +Realized Gain (Loss) Included in Net Income (or Changes in Net Assets) (a) (b) 39.5 13.2 2.5 ( 1.6 ) 11.9 2.8 +Unrealized Gain (Loss) Included in Net Income (or Changes in Net Assets) Relating to Assets Still Held at the Reporting Date (a) 35.3 — — — — — +Realized and Unrealized Gains (Losses) Included in Other Comprehensive Income (c) 13.8 — — — — — +Settlements ( 113.1 ) ( 51.6 ) ( 8.6 ) 8.9 ( 27.6 ) ( 6.6 ) +Transfers into Level 3 (d) (e) ( 3.8 ) — — — — — +Transfers out of Level 3 (e) 5.6 0.7 0.4 — — — +Changes in Fair Value Allocated to Regulated Jurisdictions (f) 26.1 19.3 2.0 ( 14.0 ) 10.2 4.0 +Balance as of December 31, 2020 $ 113.3 $ 19.3 $ 2.1 $ ( 110.3 ) $ 10.3 $ 1.6 +Year Ended December 31, 2019 AEP APCo I&M OPCo PSO SWEPCo +(in millions) +Balance as of December 31, 2018 $ 131.2 $ 57.8 $ 8.9 $ ( 99.4 ) $ 9.5 $ 2.3 +Realized Gain (Loss) Included in Net Income (or Changes in Net Assets) (a) (b) 15.8 ( 13.9 ) 4.7 ( 0.9 ) 13.5 6.0 +Unrealized Gain (Loss) Included in Net Income (or Changes in Net Assets) Relating to Assets Still Held at the Reporting Date (a) ( 0.1 ) — — — — — +Realized and Unrealized Gains (Losses) Included in Other Comprehensive Income (c) ( 15.1 ) — — — — — +Settlements ( 117.6 ) ( 42.5 ) ( 13.0 ) 6.6 ( 23.0 ) ( 9.6 ) +Transfers into Level 3 (d) (e) ( 0.6 ) ( 0.5 ) ( 0.3 ) — — — +Transfers out of Level 3 (e) 35.6 ( 0.7 ) ( 0.4 ) — — — +Changes in Fair Value Allocated to Regulated Jurisdictions (f) 60.7 37.5 5.9 ( 9.9 ) 15.8 2.7 +Balance as of December 31, 2019 $ 109.9 $ 37.7 $ 5.8 $ ( 103.6 ) $ 15.8 $ 1.4 +Year Ended December 31, 2018 AEP APCo I&M OPCo PSO SWEPCo +(in millions) +Balance as of December 31, 2017 $ 40.3 $ 24.7 $ 7.6 $ ( 132.4 ) $ 6.2 $ 5.9 +Realized Gain (Loss) Included in Net Income (or Changes in Net Assets) (a) (b) 148.9 104.1 14.2 1.8 18.1 ( 4.8 ) +Unrealized Gain (Loss) Included in Net Income (or Changes in Net Assets) Relating to Assets Still Held at the Reporting Date (a) 9.8 — — — — — +Realized and Unrealized Gains (Losses) Included in Other Comprehensive Income (c) 15.7 — — — — — +Settlements ( 214.0 ) ( 127.9 ) ( 21.3 ) 4.6 ( 24.3 ) ( 2.1 ) +Transfers into Level 3 (d) (e) 15.8 — — — — — +Transfers out of Level 3 (e) ( 1.6 ) — ( 0.3 ) — — — +Changes in Fair Value Allocated to Regulated Jurisdictions (f) +116.3 56.9 8.7 26.6 9.5 3.3 +Balance as of December 31, 2018 $ 131.2 $ 57.8 $ 8.9 $ ( 99.4 ) $ 9.5 $ 2.3 +(a) Included in revenues on the statements of income. +(b) Represents the change in fair value between the beginning of the reporting period and the settlement of the risk management commodity contract. +(c) Included in cash flow hedges on the statements of comprehensive income. +(d) Represents existing assets or liabilities that were previously categorized as Level 2. +(e) Transfers are recognized based on their value at the beginning of the reporting period that the transfer occurred. +(f) Relates to the net gains (losses) of those contracts that are not reflected on the statements of income. These net gains (losses) are recorded as regulatory assets/liabilities or accounts payable. +344 +The following tables quantify the significant unobservable inputs used in developing the fair value of Level 3 positions: +AEP +December 31, 2020 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input Low High Average +(in millions) +Energy Contracts $ 213.5 $ 169.7 Discounted Cash Flow Forward Market Price (a) (c) $ 5.33 $ 100.47 $ 32.73 +Natural Gas Contracts — 1.7 Discounted Cash Flow Forward Market Price (b) (c) 2.18 2.77 2.40 +FTRs 42.8 3.4 Discounted Cash Flow Forward Market Price (a) (c) ( 15.08 ) 9.66 0.19 +Other Investments 31.8 — Black-Scholes Model Liquidity Adjustment (d) 10 % 20 % 15 % +Total $ 288.1 $ 174.8 +December 31, 2019 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input Low High Average (c) +(in millions) +Energy Contracts $ 296.7 $ 249.3 Discounted Cash Flow Forward Market Price (a) $ ( 0.05 ) $ 177.30 $ 31.31 +Natural Gas Contracts — 4.9 Discounted Cash Flow Forward Market Price (b) 1.89 2.51 2.19 +FTRs 75.7 8.3 Discounted Cash Flow Forward Market Price (a) ( 8.52 ) 9.34 0.42 +Total $ 372.4 $ 262.5 +345 +APCo +December 31, 2020 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +Energy Contracts $ 1.0 $ 0.6 Discounted Cash Flow Forward Market Price $ 10.84 $ 41.09 $ 25.08 +FTRs 18.9 — Discounted Cash Flow Forward Market Price 0.04 5.61 1.13 +Total $ 19.9 $ 0.6 +December 31, 2019 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +Energy Contracts $ 5.7 $ 2.6 Discounted Cash Flow Forward Market Price $ 12.70 $ 41.20 $ 25.92 +FTRs 34.8 0.2 Discounted Cash Flow Forward Market Price ( 0.14 ) 7.08 1.70 +Total $ 40.5 $ 2.8 +I&M +December 31, 2020 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +Energy Contracts $ 0.6 $ 0.3 Discounted Cash Flow Forward Market Price $ 10.84 $ 41.09 $ 25.08 +FTRs 1.9 0.1 Discounted Cash Flow Forward Market Price ( 1.96 ) 3.69 0.33 +Total $ 2.5 $ 0.4 +December 31, 2019 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +Energy Contracts $ 3.4 $ 1.5 Discounted Cash Flow Forward Market Price $ 12.70 $ 41.20 $ 25.92 +FTRs 4.6 0.7 Discounted Cash Flow Forward Market Price ( 0.75 ) 4.07 0.74 +Total $ 8.0 $ 2.2 +346 +OPCo +December 31, 2020 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +Energy Contracts $ — $ 110.3 Discounted Cash Flow Forward Market Price $ 16.19 $ 46.98 $ 28.30 +December 31, 2019 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +Energy Contracts $ — $ 103.6 Discounted Cash Flow Forward Market Price $ 29.23 $ 61.43 $ 42.46 +PSO +December 31, 2020 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +FTRs $ 10.3 $ — Discounted Cash Flow Forward Market Price $ ( 6.93 ) $ 0.48 $ ( 1.93 ) +December 31, 2019 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input (a) Low High Average (c) +(in millions) +FTRs $ 16.3 $ 0.5 Discounted Cash Flow Forward Market Price $ ( 8.52 ) $ 0.85 $ ( 2.31 ) +347 +SWEPCo +December 31, 2020 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input Low High Average (c) +(in millions) +Natural Gas Contracts $ — $ 1.7 Discounted Cash Flow Forward Market Price (b) $ 2.18 $ 2.77 $ 2.41 +FTRs 3.3 — Discounted Cash Flow Forward Market Price (a) ( 6.93 ) 0.48 ( 1.93 ) +Total $ 3.3 $ 1.7 +December 31, 2019 +Significant Input/Range +Fair Value Valuation Unobservable Weighted +Assets Liabilities Technique Input Low High Average (c) +(in millions) +Natural Gas Contracts $ — $ 4.9 Discounted Cash Flow Forward Market Price (b) $ 1.89 $ 2.51 $ 2.18 +FTRs 6.5 0.2 Discounted Cash Flow Forward Market Price (a) ( 8.52 ) 0.85 ( 2.31 ) +Total $ 6.5 $ 5.1 +(a) Represents market prices in dollars per MWh. +(b) Represents market prices in dollars per MMBtu. +(c) The weighted-average is the product of the forward market price of the underlying commodity and volume weighted by term. +(d) Represents percentage discount applied to the publically available share price. +The following table provides the measurement uncertainty of fair value measurements to increases (decreases) in significant unobservable inputs related to Energy Contracts, Natural Gas Contracts, FTRs and Other Investments for the Registrants as of December 31, 2020 and 2019: +Uncertainty of Fair Value Measurements +Significant Unobservable Input Position Change in Input Impact on Fair Value +Measurement +Forward Market Price +Buy +Increase (Decrease) Higher (Lower) +Forward Market Price Sell Increase (Decrease) Lower (Higher) +Liquidity Adjustment Buy Increase (Decrease) Lower (Higher) +348 +12. INCOME TAXES +The disclosures in this note apply to all Registrants unless indicated otherwise. +Income Tax Expense (Benefit) +The details of the Registrants’ Income Tax Expense (Benefit) as reported are as follows: +Year Ended December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Federal: +Current $ ( 138.2 ) $ 5.2 $ 22.2 $ 21.4 $ 11.3 $ ( 26.6 ) $ ( 11.4 ) $ ( 13.6 ) +Deferred 146.9 ( 15.4 ) 65.4 ( 27.1 ) ( 20.6 ) 74.0 8.3 19.6 +Total Federal 8.7 ( 10.2 ) 87.6 ( 5.7 ) ( 9.3 ) 47.4 ( 3.1 ) 6.0 +State and Local: +Current ( 16.7 ) ( 0.1 ) 2.8 9.3 1.9 ( 5.4 ) 0.1 ( 8.2 ) +Deferred 48.5 ( 0.9 ) 16.3 0.7 ( 0.1 ) 3.2 8.2 11.6 +Total State and Local 31.8 ( 1.0 ) 19.1 10.0 1.8 ( 2.2 ) 8.3 3.4 +Income Tax Expense (Benefit) $ 40.5 $ ( 11.2 ) $ 106.7 $ 4.3 $ ( 7.5 ) $ 45.2 $ 5.2 $ 9.4 +Year Ended December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Federal: +Current $ ( 7.4 ) $ ( 31.8 ) $ 23.7 $ 36.7 $ 48.1 $ ( 10.0 ) $ 25.5 $ 6.9 +Deferred ( 71.6 ) ( 24.7 ) 71.7 ( 126.1 ) ( 57.1 ) 40.6 ( 26.0 ) ( 10.0 ) +Total Federal ( 79.0 ) ( 56.5 ) 95.4 ( 89.4 ) ( 9.0 ) 30.6 ( 0.5 ) ( 3.1 ) +State and Local: +Current 4.4 2.9 2.4 12.0 ( 2.4 ) 1.1 0.2 0.8 +Deferred 61.7 — 19.6 ( 0.6 ) 0.8 3.2 7.8 ( 2.4 ) +Total State and Local 66.1 2.9 22.0 11.4 ( 1.6 ) 4.3 8.0 ( 1.6 ) +Income Tax Expense (Benefit) $ ( 12.9 ) $ ( 53.6 ) $ 117.4 $ ( 78.0 ) $ ( 10.6 ) $ 34.9 $ 7.5 $ ( 4.7 ) +Year Ended December 31, 2018 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Federal: +Current $ ( 31.7 ) $ 37.0 $ ( 14.2 ) $ ( 31.9 ) $ 60.9 $ 55.6 $ 35.6 $ 18.3 +Deferred 122.0 ( 17.9 ) 82.3 ( 24.5 ) ( 48.8 ) ( 36.9 ) ( 36.7 ) ( 1.9 ) +Total Federal 90.3 19.1 68.1 ( 56.4 ) 12.1 18.7 ( 1.1 ) 16.4 +State and Local: +Current 30.8 1.8 ( 0.6 ) 3.7 15.8 4.6 ( 0.2 ) 2.3 +Deferred ( 5.8 ) ( 0.1 ) 16.6 7.8 1.2 0.7 6.3 1.7 +Total State and Local 25.0 1.7 16.0 11.5 17.0 5.3 6.1 4.0 +Income Tax Expense (Benefit) $ 115.3 $ 20.8 $ 84.1 $ ( 44.9 ) $ 29.1 $ 24.0 $ 5.0 $ 20.4 +349 +The following are reconciliations for the Registrants between the federal income taxes computed by multiplying pretax income by the federal statutory tax rate and the income taxes reported: +AEP Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 2,196.7 $ 1,919.8 $ 1,931.3 +Less: Equity Earnings – Dolet Hills ( 2.9 ) ( 3.0 ) ( 2.7 ) +Income Tax Expense (Benefit) 40.5 ( 12.9 ) 115.3 +Pretax Income $ 2,234.3 $ 1,903.9 $ 2,043.9 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 469.2 $ 399.8 $ 429.2 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 26.5 20.4 24.6 +Investment Tax Credit Amortization ( 18.8 ) ( 13.0 ) ( 20.4 ) +Production Tax Credits ( 83.1 ) ( 59.6 ) ( 10.3 ) +State and Local Income Taxes, Net 25.1 52.2 19.7 +Removal Costs ( 18.6 ) ( 22.2 ) ( 18.6 ) +AFUDC ( 32.5 ) ( 37.1 ) ( 29.4 ) +Tax Reform Adjustments — — ( 10.9 ) +Tax Reform Excess ADIT Reversal ( 268.2 ) ( 353.2 ) ( 257.2 ) +CARES Act ( 48.0 ) — — +Other ( 11.1 ) ( 0.2 ) ( 11.4 ) +Income Tax Expense (Benefit) $ 40.5 $ ( 12.9 ) $ 115.3 +Effective Income Tax Rate 1.8 % ( 0.7 ) % 5.6 % +AEP Texas Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 241.0 $ 178.3 $ 211.3 +Income Tax Expense (Benefit) ( 11.2 ) ( 53.6 ) 20.8 +Pretax Income $ 229.8 $ 124.7 $ 232.1 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 48.3 $ 26.2 $ 48.7 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 1.0 1.0 0.7 +Investment Tax Credit Amortization ( 1.1 ) ( 1.2 ) ( 2.3 ) +State and Local Income Taxes, Net ( 0.8 ) 2.3 1.3 +AFUDC ( 4.1 ) ( 3.2 ) ( 4.2 ) +Parent Company Loss Benefit ( 4.5 ) ( 3.8 ) ( 3.0 ) +Tax Reform Adjustments — — ( 11.0 ) +Tax Reform Excess ADIT Reversal ( 47.9 ) ( 73.4 ) ( 11.8 ) +Other ( 2.1 ) ( 1.5 ) 2.4 +Income Tax Expense (Benefit) $ ( 11.2 ) $ ( 53.6 ) $ 20.8 +Effective Income Tax Rate ( 4.9 ) % ( 43.0 ) % 9.0 % +350 +AEPTCo Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 423.4 $ 439.7 $ 315.9 +Income Tax Expense 106.7 117.4 84.1 +Pretax Income $ 530.1 $ 557.1 $ 400.0 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 111.3 $ 117.0 $ 84.0 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +State and Local Income Taxes, Net 15.1 17.4 12.6 +AFUDC ( 15.5 ) ( 17.7 ) ( 14.1 ) +Parent Company Loss Benefit ( 7.0 ) ( 4.2 ) ( 0.6 ) +Other 2.8 4.9 2.2 +Income Tax Expense $ 106.7 $ 117.4 $ 84.1 +Effective Income Tax Rate 20.1 % 21.1 % 21.0 % +APCo Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 369.7 $ 306.3 $ 367.8 +Income Tax Expense (Benefit) 4.3 ( 78.0 ) ( 44.9 ) +Pretax Income $ 374.0 $ 228.3 $ 322.9 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 78.5 $ 47.9 $ 67.8 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 12.7 10.8 9.4 +State and Local Income Taxes, Net 7.9 9.0 9.1 +Removal Costs ( 5.7 ) ( 6.4 ) ( 7.9 ) +AFUDC ( 4.5 ) ( 5.2 ) ( 4.3 ) +Parent Company Loss Benefit ( 6.2 ) ( 4.1 ) ( 3.6 ) +Tax Reform Excess ADIT Reversal ( 72.3 ) ( 130.4 ) ( 108.5 ) +Federal Return to Provision ( 7.2 ) ( 1.0 ) ( 6.6 ) +Other 1.1 1.4 ( 0.3 ) +Income Tax Expense (Benefit) $ 4.3 $ ( 78.0 ) $ ( 44.9 ) +Effective Income Tax Rate 1.1 % ( 34.2 ) % ( 13.9 ) % +351 +I&M Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 284.8 $ 269.4 $ 261.3 +Income Tax Expense (Benefit) ( 7.5 ) ( 10.6 ) 29.1 +Pretax Income $ 277.3 $ 258.8 $ 290.4 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 58.2 $ 54.3 $ 61.0 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 1.6 4.0 1.5 +Investment Tax Credit Amortization ( 4.5 ) ( 3.6 ) ( 4.7 ) +State and Local Income Taxes, Net 1.5 ( 1.2 ) 13.4 +Removal Costs ( 10.5 ) ( 12.8 ) ( 8.0 ) +AFUDC ( 2.4 ) ( 4.1 ) ( 2.5 ) +Parent Company Loss Benefit ( 6.4 ) ( 3.3 ) ( 2.3 ) +Tax Reform Excess ADIT Reversal ( 46.8 ) ( 42.5 ) ( 25.8 ) +Federal Return to Provision 1.9 ( 0.3 ) ( 4.6 ) +Other ( 0.1 ) ( 1.1 ) 1.1 +Income Tax Expense (Benefit) $ ( 7.5 ) $ ( 10.6 ) $ 29.1 +Effective Income Tax Rate ( 2.7 ) % ( 4.1 ) % 10.0 % +OPCo Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 271.4 $ 297.1 $ 325.5 +Income Tax Expense 45.2 34.9 24.0 +Pretax Income $ 316.6 $ 332.0 $ 349.5 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 66.5 $ 69.7 $ 73.4 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 3.7 ( 1.4 ) 2.4 +State and Local Income Taxes, Net ( 1.7 ) 3.4 4.2 +AFUDC ( 2.6 ) ( 3.8 ) ( 2.1 ) +Parent Company Loss Benefit — ( 1.8 ) ( 6.0 ) +Tax Reform Excess ADIT Reversal ( 27.2 ) ( 27.3 ) ( 51.0 ) +Federal Return to Provision 6.5 ( 3.7 ) 0.2 +Other — ( 0.2 ) 2.9 +Income Tax Expense $ 45.2 $ 34.9 $ 24.0 +Effective Income Tax Rate 14.3 % 10.5 % 6.9 % +352 +PSO Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 123.0 $ 137.6 $ 83.2 +Income Tax Expense 5.2 7.5 5.0 +Pretax Income $ 128.2 $ 145.1 $ 88.2 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 26.9 $ 30.5 $ 18.5 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 1.1 0.6 0.7 +Investment Tax Credit Amortization ( 2.1 ) ( 0.5 ) ( 1.7 ) +State and Local Income Taxes, Net 6.5 6.3 4.8 +Parent Company Loss Benefit ( 0.2 ) ( 2.1 ) ( 1.4 ) +Tax Reform Excess ADIT Reversal ( 25.5 ) ( 24.5 ) ( 15.5 ) +Other ( 1.5 ) ( 2.8 ) ( 0.4 ) +Income Tax Expense $ 5.2 $ 7.5 $ 5.0 +Effective Income Tax Rate 4.1 % 5.2 % 5.7 % +SWEPCo Years Ended December 31, +2020 2019 2018 +(in millions) +Net Income $ 183.7 $ 162.2 $ 152.2 +Less: Equity Earnings – Dolet Hills ( 2.9 ) ( 3.0 ) ( 2.7 ) +Income Tax Expense (Benefit) 9.4 ( 4.7 ) 20.4 +Pretax Income $ 190.2 $ 154.5 $ 169.9 +Income Taxes on Pretax Income at Statutory Rate ( 21 %) +$ 39.9 $ 32.4 $ 35.7 +Increase (Decrease) in Income Taxes Resulting from the Following Items: +Depreciation 1.9 1.9 1.9 +Depletion ( 3.4 ) ( 3.4 ) ( 3.4 ) +State and Local Income Taxes, Net 2.7 ( 1.3 ) 3.2 +AFUDC ( 1.5 ) ( 1.4 ) ( 1.3 ) +Parent Company Loss Benefit ( 5.6 ) ( 1.6 ) ( 0.6 ) +Tax Reform Excess ADIT Reversal ( 21.9 ) ( 29.9 ) ( 16.0 ) +Other ( 2.7 ) ( 1.4 ) 0.9 +Income Tax Expense (Benefit) $ 9.4 $ ( 4.7 ) $ 20.4 +Effective Income Tax Rate 4.9 % ( 3.0 ) % 12.0 % +353 +Net Deferred Tax Liability +The following tables show elements of the net deferred tax liability and significant temporary differences for each Registrant: +AEP December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 3,259.7 $ 3,246.1 +Deferred Tax Liabilities ( 11,500.6 ) ( 10,834.3 ) +Net Deferred Tax Liabilities $ ( 8,240.9 ) $ ( 7,588.2 ) +Property Related Temporary Differences $ ( 7,340.5 ) $ ( 6,602.9 ) +Amounts Due to Customers for Future Income Taxes 1,075.8 1,173.5 +Deferred State Income Taxes ( 1,317.6 ) ( 1,198.0 ) +Securitized Assets ( 140.0 ) ( 178.7 ) +Regulatory Assets ( 391.6 ) ( 371.1 ) +Accrued Nuclear Decommissioning ( 626.4 ) ( 557.4 ) +Net Operating Loss Carryforward 112.9 77.6 +Tax Credit Carryforward 323.6 247.2 +Operating Lease Liability 183.7 182.6 +Investment in Partnership ( 362.0 ) ( 446.6 ) +All Other, Net 241.2 85.6 +Net Deferred Tax Liabilities $ ( 8,240.9 ) $ ( 7,588.2 ) +AEP Texas December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 183.6 $ 220.0 +Deferred Tax Liabilities ( 1,200.3 ) ( 1,185.4 ) +Net Deferred Tax Liabilities $ ( 1,016.7 ) $ ( 965.4 ) +Property Related Temporary Differences $ ( 1,039.6 ) $ ( 973.5 ) +Amounts Due to Customers for Future Income Taxes 114.4 126.7 +Deferred State Income Taxes ( 29.1 ) ( 27.5 ) +Securitized Transition Assets ( 90.2 ) ( 124.3 ) +Regulatory Assets ( 47.4 ) ( 51.2 ) +Operating Lease Liability 18.0 17.2 +All Other, Net 57.2 67.2 +Net Deferred Tax Liabilities $ ( 1,016.7 ) $ ( 965.4 ) +AEPTCo December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 166.5 $ 162.9 +Deferred Tax Liabilities ( 1,073.4 ) ( 980.7 ) +Net Deferred Tax Liabilities $ ( 906.9 ) $ ( 817.8 ) +Property Related Temporary Differences $ ( 937.8 ) $ ( 847.1 ) +Amounts Due to Customers for Future Income Taxes 118.9 119.9 +Deferred State Income Taxes ( 98.3 ) ( 86.1 ) +Net Operating Loss Carryforward 13.2 12.3 +All Other, Net ( 2.9 ) ( 16.8 ) +Net Deferred Tax Liabilities $ ( 906.9 ) $ ( 817.8 ) +354 +APCo December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 500.6 $ 486.2 +Deferred Tax Liabilities ( 2,250.5 ) ( 2,167.0 ) +Net Deferred Tax Liabilities $ ( 1,749.9 ) $ ( 1,680.8 ) +Property Related Temporary Differences $ ( 1,412.0 ) $ ( 1,420.0 ) +Amounts Due to Customers for Future Income Taxes 198.3 222.8 +Deferred State Income Taxes ( 336.5 ) ( 337.2 ) +Securitized Assets ( 44.7 ) ( 49.3 ) +Regulatory Assets ( 114.8 ) ( 71.0 ) +Operating Lease Liability 16.7 16.5 +All Other, Net ( 56.9 ) ( 42.6 ) +Net Deferred Tax Liabilities $ ( 1,749.9 ) $ ( 1,680.8 ) +I&M December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 989.5 $ 970.5 +Deferred Tax Liabilities ( 2,053.9 ) ( 1,950.2 ) +Net Deferred Tax Liabilities $ ( 1,064.4 ) $ ( 979.7 ) +Property Related Temporary Differences $ ( 409.2 ) $ ( 430.7 ) +Amounts Due to Customers for Future Income Taxes 147.9 169.6 +Deferred State Income Taxes ( 211.1 ) ( 194.4 ) +Regulatory Assets ( 16.5 ) ( 26.9 ) +Accrued Nuclear Decommissioning ( 626.4 ) ( 557.4 ) +Operating Lease Liability 46.6 61.9 +All Other, Net 4.3 ( 1.8 ) +Net Deferred Tax Liabilities $ ( 1,064.4 ) $ ( 979.7 ) +OPCo December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 210.8 $ 202.3 +Deferred Tax Liabilities ( 1,165.9 ) ( 1,051.6 ) +Net Deferred Tax Liabilities $ ( 955.1 ) $ ( 849.3 ) +Property Related Temporary Differences $ ( 1,016.0 ) $ ( 890.8 ) +Amounts Due to Customers for Future Income Taxes 121.1 130.2 +Deferred State Income Taxes ( 40.7 ) ( 35.5 ) +Regulatory Assets ( 53.7 ) ( 48.0 ) +Operating Lease Liability 19.4 18.3 +All Other, Net 14.8 ( 23.5 ) +Net Deferred Tax Liabilities $ ( 955.1 ) $ ( 849.3 ) +355 +PSO December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 239.8 $ 257.4 +Deferred Tax Liabilities ( 928.3 ) ( 885.7 ) +Net Deferred Tax Liabilities $ ( 688.5 ) $ ( 628.3 ) +Property Related Temporary Differences $ ( 661.8 ) $ ( 627.6 ) +Amounts Due to Customers for Future Income Taxes 118.5 127.2 +Deferred State Income Taxes ( 107.7 ) ( 100.4 ) +Regulatory Assets ( 39.1 ) ( 44.6 ) +Net Operating Loss Carryforward 12.9 10.2 +All Other, Net ( 11.3 ) 6.9 +Net Deferred Tax Liabilities $ ( 688.5 ) $ ( 628.3 ) +SWEPCo December 31, +2020 2019 +(in millions) +Deferred Tax Assets $ 338.1 $ 359.6 +Deferred Tax Liabilities ( 1,355.7 ) ( 1,300.5 ) +Net Deferred Tax Liabilities $ ( 1,017.6 ) $ ( 940.9 ) +Property Related Temporary Differences $ ( 985.1 ) $ ( 947.6 ) +Amounts Due to Customers for Future Income Taxes 162.7 169.8 +Deferred State Income Taxes ( 214.7 ) ( 200.3 ) +Regulatory Assets ( 26.2 ) ( 30.2 ) +Net Operating Loss Carryforward 33.4 38.2 +All Other, Net 12.3 29.2 +Net Deferred Tax Liabilities $ ( 1,017.6 ) $ ( 940.9 ) +AEP System Tax Allocation Agreement +AEP and subsidiaries join in the filing of a consolidated federal income tax return. The allocation of the AEP System’s current consolidated federal income tax to the AEP System companies allocates the benefit of current tax loss of the parent company (Parent Company Loss Benefit) to the AEP System subsidiaries with taxable income reducing their current tax expense proportionately. The consolidated NOL of the AEP System is allocated to each company in the consolidated group with taxable losses. With the exception of the allocation of the consolidated AEP System NOL, the loss of the Parent and tax credits, the method of allocation reflects a separate return result for each company in the consolidated group. +Federal Income Tax Audit Status +The statute of limitations for the IRS to examine AEP and subsidiaries originally filed federal return has expired for tax years 2016 and earlier. In the third quarter of 2019, AEP and subsidiaries elected to amend the 2014 and 2015 federal returns. In the first quarter of 2020, the IRS notified AEP that it was beginning an examination of these amended returns, including the NOL carryback to 2015 that originated in the 2017 return. As of December 31, 2020, the IRS has not challenged any items on these returns and the IRS is limited in their proposed adjustments to the amount AEP claimed on the amended returns. +356 +Net Income Tax Operating Loss Carryforward +As of December 31, 2020, AEP has no federal net income tax operating loss carryforward. AEP, AEPTCo, I&M, PSO and SWEPCo have state net income tax operating loss carryforwards as indicated in the table below: +State Net Income +Tax Operating Loss Years of +Company State/Municipality Carryforward Expiration +(in millions) +AEP Arkansas $ 87.2 2021 - 2028 +AEP Kentucky 163.7 2030 - 2037 +AEP Louisiana 466.8 2025 - 2040 +AEP Oklahoma 569.4 2034 - 2037 +AEP Tennessee 31.1 2028 - 2035 +AEP Virginia 29.4 2025 - 2037 +AEP West Virginia 21.9 2029 - 2037 +AEP Ohio Municipal 649.8 2021 - 2025 +AEP Indiana 145.7 2039 +AEP Colorado 95.7 NA +AEP Pennsylvania 56.5 2030 - 2040 +AEP New Jersey 60.2 2036 - 2040 +AEP Illinois 15.6 2031 +AEP Michigan 14.9 2029 +AEPTCo Oklahoma 195.4 2034 - 2037 +AEPTCo Ohio Municipal 18.4 2023 +I&M West Virginia 2.5 2032 - 2037 +PSO Oklahoma 354.5 2034 - 2037 +SWEPCo Arkansas 86.4 2021 - 2024 +SWEPCo Louisiana 454.3 2032 - 2037 +As of December 31, 2020, AEP recorded a valuation allowance of $ 9 million, against certain state and municipal net income tax operating loss carryforwards since future taxable income is not expected to be sufficient to realize the remaining state net income tax operating loss tax benefits before the carryforward expires. Management anticipates future taxable income will be sufficient to realize the remaining state net income tax operating loss tax benefits before the carryforward expires for each state. +Tax Credit Carryforward +Federal and state net income tax operating losses sustained in 2016, 2017 and 2019 resulted in unused federal and state income tax credits. As of December 31, 2020, the Registrants have federal tax credit carryforwards and AEP and PSO have state tax credit carryforwards as indicated in the table below. If these credits are not utilized, federal general business tax credits will expire in the years 2036 through 2040 and state tax credits will remain available indefinitely. +Total Federal Total State +Tax Credit Tax Credit +Company Carryforward Carryforward +(in millions) +AEP $ 323.6 $ 38.4 +AEP Texas 1.2 — +AEPTCo 0.1 — +APCo 1.6 — +I&M 9.7 — +OPCo 0.5 — +PSO 0.5 38.4 +SWEPCo 1.3 — +The Registrants anticipate future federal taxable income will be sufficient to realize the tax benefits of the federal tax credits before they expire unused. +357 +Valuation Allowance +AEP assesses the available positive and negative evidence to estimate whether sufficient future taxable income of the appropriate tax character will be generated to realize the benefits of existing deferred tax assets. When the evaluation of the evidence indicates that AEP will not be able to realize the benefits of existing deferred tax assets, a valuation allowance is recorded to reduce existing deferred tax assets to the net realizable amount. Objective evidence evaluated includes whether AEP has a history of recognizing income, future reversals of existing temporary differences and tax planning strategies. +Valuation allowance activity for the years ended December 31, 2020, 2019 and 2018 was immaterial. +Uncertain Tax Positions +The reconciliations of the beginning and ending amounts of unrecognized tax benefits for AEP are presented below. The amount and activity of unrecognized tax benefits for Registrants Subsidiaries was immaterial for periods presented: +AEP +2020 2019 2018 +(in millions) +Balance as of January 1, $ 24.1 $ 14.6 $ 86.6 +Increase – Tax Positions Taken During a Prior Period 0.6 8.8 0.1 +Decrease – Tax Positions Taken During a Prior Period ( 14.5 ) ( 2.1 ) — +Increase – Tax Positions Taken During the Current Year 3.0 2.8 — +Decrease – Tax Positions Taken During the Current Year — — — +Decrease – Settlements with Taxing Authorities — — ( 71.0 ) +Decrease – Lapse of the Applicable Statute of Limitations — — ( 1.1 ) +Balance as of December 31, $ 13.2 $ 24.1 $ 14.6 +Management believes that there will be no significant net increase or decrease in unrecognized benefits within 12 months of the reporting date. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate for AEP as of December 31, 2020, 2019 and 2018 were $ 12 million, $ 20 million and $ 12 million, respectively. +Federal Tax Legislation +In March 2020, the CARES Act was signed into law. The CARES Act includes tax relief provisions such as: (a) an AMT Credit Refund, (b) a 5-year NOL carryback from years 2018-2020 and (c) delayed payment of employer payroll taxes. Pursuant to the CARES Act, AEP, APCo and OPCo requested and in July received refunds of AMT credit of $ 20 million, $ 7 million and $ 9 million, respectively. In the third quarter of 2020, AEP also requested a $ 95 million refund of taxes paid in 2014 under the 5-year NOL carryback provision of the CARES Act. AEP carried back a NOL generated on the 2019 Federal income tax return at a 21% federal corporate income tax rate to the 2014 Federal income tax return at a 35 % corporate income tax rate. As a result of the change in the corporate income tax rates between the two periods, AEP realized a tax benefit of $ 48 million primarily at the Generation & Marketing segment. Management will continue to monitor potential legislation and any impacts to the AMT Credit and NOL refunds that were filed in 2020 pursuant to the CARES Act. +In December 2020, the CAA of 2021 was signed into law. The CAA of 2021 includes: (a) COVID-19 tax relief and tax extender provisions including extensions of time to begin construction on and placed in-service assets generating PTCs and ITCs, (b) 100 % deductibility of business meals in 2021 and 2022 and (c) an extension of the work opportunity tax credit. The ITC percentage has been increased for projects starting construction through 2023 and placed in-service by the end of 2025. The PTC has been extended for an additional year, to include projects started in 2021 and completed in 2025. These provisions provide time and flexibility on the construction start and in-service dates. +358 +In September and November 2020, the IRS issued final regulations that provide guidance regarding the additional first-year depreciation deduction under Section 168(k). The final regulations reflect changes as a result of Tax Reform, which affects taxpayers with qualified depreciable property acquired and placed in-service after September 27, 2017. Generally, AEP’s regulated utilities will not be eligible for any bonus depreciation for property acquired and placed in-service after December 31, 2017. AEP’s competitive businesses will be eligible for 100 % expensing. +The IRS issued final regulations in 2020 that provide guidance concerning potential limitations on the deduction of business interest expense. These regulations require an allocation of net interest expense between regulated and competitive businesses within the consolidated tax return. This allocation is based upon net tax basis, and the proposed regulations provide de minimis tests under which all interest is deductible if less than 10 % is allocable to the competitive businesses. AEP will deduct materially all business interest expense under this de minimis provision. +On December 30, 2020, the IRS issued regulations that provide guidance on the non-deductibility of certain executives compensation above $ 1 million under Internal Revenue Code Section 162(m). The regulations clarify the application of rules passed under Tax Reform that expanded the application of Section 162(m) to SEC registered companies that issue either public equity or debt. These rules also expanded the type of compensation and the number of executives subject to this deduction disallowance. AEP limits certain executives’ compensation to the $1 million limitation on its federal income tax return. +359 +13. LEASES +The disclosures in this note apply to all Registrants unless indicated otherwise. Management adopted ASU 2016-02 effective January 1, 2019 by means of a cumulative-effect adjustment to the balance sheets. +The Registrants lease property, plant and equipment including, but not limited to, fleet, information technology and real estate leases. These leases require payments of non-lease components, including related property taxes, operating and maintenance costs. AEP does not separate non-lease components from associated lease components. Many of these leases have purchase or renewal options. Leases not renewed are often replaced by other leases. Options to renew or purchase a lease are included in the measurement of lease assets and liabilities if it is reasonably certain the Registrant will exercise the option. +Lease obligations are measured using the discount rate implicit in the lease when that rate is readily determinable. AEP has visibility into the rate implicit in the lease when assets are leased from selected financial institutions under master leasing agreements. When the implicit rate is not readily determinable, the Registrants measure their lease obligation using their estimated secured incremental borrowing rate. Incremental borrowing rates are comprised of an underlying risk-free rate and a secured credit spread relative to the lessee on a matched maturity basis. +Operating lease rentals and finance lease amortization costs are generally charged to Other Operation and Maintenance expense in accordance with rate-making treatment for regulated operations. Effective in 2019, interest on finance lease liabilities is generally charged to Interest Expense. Finance lease interest for periods prior to 2019 were charged to Other Operation and Maintenance expense. Lease costs associated with capital projects are included in Property, Plant and Equipment on the balance sheets. For regulated operations with finance leases, a finance lease asset and offsetting liability are recorded at the present value of the remaining lease payments for each reporting period. Finance leases for nonregulated property are accounted for as if the assets were owned and financed. The components of rental costs were as follows: +Year Ended December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Operating Lease Cost +$ 279.6 $ 17.4 $ 2.6 $ 19.1 $ 101.5 $ 17.1 $ 7.8 $ 9.4 +Finance Lease Cost: +Amortization of Right-of-Use Assets +61.9 6.3 — 7.4 6.5 4.7 3.5 10.9 +Interest on Lease Liabilities +15.4 1.5 — 2.7 3.1 0.9 0.7 2.2 +Total Lease Rental Costs (a) $ 356.9 $ 25.2 $ 2.6 $ 29.2 $ 111.1 $ 22.7 $ 12.0 $ 22.5 +Year Ended December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Operating Lease Cost +$ 286.0 $ 16.5 $ 2.5 $ 19.5 $ 93.1 $ 18.0 $ 6.8 $ 8.0 +Finance Lease Cost: +Amortization of Right-of-Use Assets +70.8 5.1 0.1 6.7 5.7 3.5 3.1 11.0 +Interest on Lease Liabilities +16.4 1.4 — 2.9 2.9 0.7 0.6 2.9 +Total Lease Rental Costs (a) $ 373.2 $ 23.0 $ 2.6 $ 29.1 $ 101.7 $ 22.2 $ 10.5 $ 21.9 +Year Ended December 31, 2018 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Operating Lease Cost +$ 245.0 $ 13.6 $ 2.7 $ 18.2 $ 89.2 $ 10.7 $ 5.7 $ 6.5 +Finance Lease Cost: +Amortization of Right-of-Use Assets +62.4 4.8 0.1 7.0 6.6 3.9 3.2 11.2 +Interest on Lease Liabilities +16.4 1.2 — 3.0 3.3 0.5 0.4 3.2 +Total Lease Rental Costs $ 323.8 $ 19.6 $ 2.8 $ 28.2 $ 99.1 $ 15.1 $ 9.3 $ 20.9 +(a) Excludes variable and short-term lease costs, which were immaterial for the twelve months ended December 31, 2020 and December 31, 2019. +360 +Supplemental information related to leases are shown in the tables below: +December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +Weighted-Average Remaining Lease Term (years): +Operating Leases +5.30 6.51 2.01 6.27 3.50 7.44 7.03 7.54 +Finance Leases +5.43 6.07 0.00 5.75 5.79 5.90 6.16 4.95 +Weighted-Average Discount Rate: +Operating Leases +3.44 % 3.60 % 1.51 % 3.48 % 3.42 % 3.60 % 3.39 % 3.45 % +Finance Leases +5.68 % 4.39 % — % 7.33 % 8.29 % 4.25 % 4.35 % 4.77 % +December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +Weighted-Average Remaining Lease Term (years): +Operating Leases +5.23 6.93 2.25 6.28 3.91 7.94 7.07 6.64 +Finance Leases +5.85 6.69 0.25 6.12 6.55 6.49 6.23 5.16 +Weighted-Average Discount Rate: +Operating Leases +3.60 % 3.77 % 3.14 % 3.64 % 3.45 % 3.76 % 3.64 % 3.76 % +Finance Leases +5.98 % 4.62 % 9.33 % 8.08 % 8.47 % 4.54 % 4.62 % 5.01 % +Year Ended December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Cash paid for amounts included in the measurement of lease liabilities: +Operating Cash Flows Used for Operating Leases +$ 280.3 $ 17.1 $ 2.6 $ 19.2 $ 102.2 $ 16.9 $ 7.7 $ 9.4 +Operating Cash Flows Used for Finance Leases +15.4 1.5 — 2.7 3.1 0.9 0.7 2.2 +Financing Cash Flows Used for Finance Leases +61.7 6.3 — 7.4 6.5 4.7 3.5 10.9 +Non-cash Acquisitions Under Operating Leases $ 161.7 $ 15.8 $ 1.8 $ 16.2 $ 18.1 $ 18.1 $ 12.3 $ 18.4 +Year Ended December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Cash paid for amounts included in the measurement of lease liabilities: +Operating Cash Flows Used for Operating Leases +$ 284.7 $ 15.3 $ 2.4 $ 19.0 $ 94.3 $ 18.0 $ 6.7 $ 7.9 +Operating Cash Flows Used for Finance Leases +16.4 1.4 — 2.9 3.1 0.7 0.6 3.0 +Financing Cash Flows Used for Finance Leases +70.7 5.1 — 6.7 5.7 3.5 3.1 11.0 +Non-cash Acquisitions Under Operating Leases $ 125.0 $ 13.8 $ 0.6 $ 10.2 $ 18.7 $ 35.4 $ 8.2 $ 11.4 +361 +The following tables show property, plant and equipment under finance leases and noncurrent assets under operating leases and related obligations recorded on the balance sheets. Unless shown as a separate line on the balance sheets due to materiality, net operating lease assets are included in Deferred Charges and Other Noncurrent Assets, current finance lease obligations are included in Other Current Liabilities and long-term finance lease obligations are included in Deferred Credits and Other Noncurrent Liabilities on the balance sheets. Lease obligations are not recognized on the balance sheets for lease agreements with a lease term of less than twelve months. +December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Property, Plant and Equipment Under Finance Leases: +Generation $ 138.2 $ — $ — $ 42.8 $ 28.8 $ — $ 0.7 $ 37.7 +Other Property, Plant and Equipment 322.8 49.7 — 20.3 40.2 31.4 23.0 52.4 +Total Property, Plant and Equipment 461.0 49.7 — 63.1 69.0 31.4 23.7 90.1 +Accumulated Amortization 176.8 16.6 — 21.4 27.3 9.8 8.7 36.5 +Net Property, Plant and Equipment Under Finance Leases +$ 284.2 $ 33.1 $ — $ 41.7 $ 41.7 $ 21.6 $ 15.0 $ 53.6 +Obligations Under Finance Leases: +Noncurrent Liability $ 231.0 $ 26.8 $ — $ 34.4 $ 35.3 $ 16.9 $ 11.9 $ 44.6 +Liability Due Within One Year 58.1 6.3 — 7.3 6.4 4.7 3.1 10.7 +Total Obligations Under Finance Leases +$ 289.1 $ 33.1 $ — $ 41.7 $ 41.7 $ 21.6 $ 15.0 $ 55.3 +December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Property, Plant and Equipment Under Finance Leases: +Generation $ 131.6 $ — $ — $ 39.9 $ 28.8 $ — $ 0.6 $ 34.1 +Other Property, Plant and Equipment 323.0 45.9 0.2 18.9 39.3 27.3 21.6 51.6 +Total Property, Plant and Equipment 454.6 45.9 0.2 58.8 68.1 27.3 22.2 85.7 +Accumulated Amortization 151.5 11.8 0.2 17.0 23.0 7.2 7.1 28.4 +Net Property, Plant and Equipment Under Finance Leases +$ 303.1 $ 34.1 $ — $ 41.8 $ 45.1 $ 20.1 $ 15.1 $ 57.3 +Obligations Under Finance Leases: +Noncurrent Liability $ 249.2 $ 28.2 $ — $ 35.0 $ 38.8 $ 16.2 $ 11.9 $ 47.1 +Liability Due Within One Year 57.6 5.9 — 6.8 6.3 3.9 3.2 10.5 +Total Obligations Under Finance Leases +$ 306.8 $ 34.1 $ — $ 41.8 $ 45.1 $ 20.1 $ 15.1 $ 57.6 +362 +December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Operating Lease Assets +$ 866.4 $ 84.1 $ 1.6 $ 78.8 $ 218.1 $ 92.0 $ 42.6 $ 48.5 +Obligations Under Operating Leases: +Noncurrent Liability $ 638.4 $ 71.0 $ 0.4 $ 64.4 $ 135.9 $ 79.5 $ 36.2 $ 44.1 +Liability Due Within One Year 241.3 14.5 1.2 14.9 85.6 13.1 6.5 7.9 +Total Obligations Under Operating Leases +$ 879.7 $ 85.5 $ 1.6 $ 79.3 $ 221.5 $ 92.6 $ 42.7 $ 52.0 +December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Operating Lease Assets +$ 957.4 $ 81.8 $ 3.8 $ 78.5 $ 294.9 $ 88.0 $ 36.8 $ 40.5 +Obligations Under Operating Leases: +Noncurrent Liability $ 734.6 $ 71.1 $ 1.9 $ 64.0 $ 211.6 $ 76.0 $ 31.0 $ 34.7 +Liability Due Within One Year 234.1 12.0 2.1 15.2 87.3 12.5 5.8 6.5 +Total Obligations Under Operating Leases +$ 968.7 $ 83.1 $ 4.0 $ 79.2 $ 298.9 $ 88.5 $ 36.8 $ 41.2 +Future minimum lease payments consisted of the following as of December 31, 2020: +Finance Leases AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +2021 $ 72.2 $ 7.6 $ — $ 9.9 $ 9.3 $ 5.5 $ 3.6 $ 13.1 +2022 64.0 6.9 — 9.4 8.6 4.6 3.1 11.8 +2023 56.2 6.2 — 8.7 7.9 3.9 2.7 10.9 +2024 63.5 5.4 — 8.1 11.1 3.3 2.3 15.3 +2025 32.7 4.0 — 7.0 5.5 2.2 1.6 5.7 +Later Years 48.9 7.8 — 6.4 12.2 4.9 3.8 5.8 +Total Future Minimum Lease Payments +337.5 37.9 — 49.5 54.6 24.4 17.1 62.6 +Less: Imputed Interest +48.4 4.8 — 7.8 12.9 2.8 2.1 7.3 +Estimated Present Value of Future Minimum Lease Payments +$ 289.1 $ 33.1 $ — $ 41.7 $ 41.7 $ 21.6 $ 15.0 $ 55.3 +Operating Leases AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +2021 $ 270.8 $ 17.5 $ 1.2 $ 17.7 $ 92.5 $ 16.6 $ 7.9 $ 10.1 +2022 263.3 16.4 0.2 17.0 92.5 16.0 7.6 9.6 +2023 94.2 14.8 0.1 14.2 11.4 14.9 7.3 8.4 +2024 81.6 13.3 0.1 11.3 10.0 13.2 6.5 6.9 +2025 68.0 10.9 — 8.5 8.9 11.5 5.4 5.8 +Later Years 193.0 23.9 — 20.0 21.8 34.0 13.3 17.4 +Total Future Minimum Lease Payments +970.9 96.8 1.6 88.7 237.1 106.2 48.0 58.2 +Less: Imputed Interest 91.2 11.3 — 9.4 15.6 13.6 5.3 6.2 +Estimated Present Value of Future Minimum Lease Payments +$ 879.7 $ 85.5 $ 1.6 $ 79.3 $ 221.5 $ 92.6 $ 42.7 $ 52.0 +363 +Future minimum lease payments consisted of the following as of December 31, 2019: +Finance Leases AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +2020 $ 72.7 $ 7.3 $ — $ 9.6 $ 9.4 $ 4.7 $ 3.8 $ 12.9 +2021 64.9 6.7 — 8.9 8.7 4.3 3.2 11.9 +2022 56.4 6.0 — 8.2 8.0 3.4 2.6 10.6 +2023 49.6 5.4 — 7.7 7.5 2.8 2.3 9.8 +2024 57.4 4.6 — 7.1 10.8 2.4 1.8 14.2 +Later Years 64.4 9.8 — 9.8 16.4 5.7 3.8 6.8 +Total Future Minimum Lease Payments +365.4 39.8 — 51.3 60.8 23.3 17.5 66.2 +Less: Imputed Interest +58.6 5.7 — 9.5 15.7 3.2 2.4 8.6 +Estimated Present Value of Future Minimum Lease Payments +$ 306.8 $ 34.1 $ — $ 41.8 $ 45.1 $ 20.1 $ 15.1 $ 57.6 +Operating Leases AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +2020 $ 269.9 $ 16.0 $ 2.2 $ 18.3 $ 97.0 $ 16.2 $ 7.3 $ 8.6 +2021 253.6 15.3 1.2 15.7 92.9 14.2 6.4 8.2 +2022 245.6 14.2 0.6 14.7 92.8 13.5 6.0 7.6 +2023 74.8 13.0 0.1 11.9 10.1 12.3 5.6 6.4 +2024 62.0 11.4 — 9.0 8.6 10.7 4.8 5.0 +Later Years 169.7 26.0 — 20.0 21.0 36.5 12.0 11.8 +Total Future Minimum Lease Payments +1,075.6 95.9 4.1 89.6 322.4 103.4 42.1 47.6 +Less : Imputed Interest +106.9 12.8 0.1 10.4 23.5 14.9 5.3 6.4 +Estimated Present Value of Future Minimum Lease Payments +$ 968.7 $ 83.1 $ 4.0 $ 79.2 $ 298.9 $ 88.5 $ 36.8 $ 41.2 +Master Lease Agreements (Applies to all Registrants except AEPTCo) +The Registrants lease certain equipment under master lease agreements. Under the lease agreements, the lessor is guaranteed a residual value up to a stated percentage of the equipment cost at the end of the lease term. If the actual fair value of the leased equipment is below the guaranteed residual value at the end of the lease term, the Registrants are committed to pay the difference between the actual fair value and the residual value guarantee. Historically, at the end of the lease term the fair value has been in excess of the amount guaranteed. As of December 31, 2020, the maximum potential loss by the Registrants for these lease agreements assuming the fair value of the equipment is zero at the end of the lease term was as follows: +Company Maximum +Potential Loss +(in millions) +AEP $ 50.3 +AEP Texas 11.7 +APCo 6.6 +I&M 4.4 +OPCo 8.1 +PSO 4.8 +SWEPCo 5.4 +364 +Rockport Lease (Applies to AEP and I&M) +AEGCo and I&M entered into a sale-and-leaseback transaction in 1989 with Wilmington Trust Company (Owner Trustee), an unrelated, unconsolidated trustee for Rockport Plant, Unit 2 (the Plant). The Owner Trustee was capitalized with equity from six owner participants with no relationship to AEP or any of its subsidiaries and debt from a syndicate of banks and securities in a private placement to certain institutional investors. In the first quarter of 2019, in accordance with ASU 2016-02, the $ 37 million unamortized gain ($ 15 million related to I&M) associated with the sale-and-leaseback of the Plant was recognized as an adjustment to equity. The adjustment to equity was then reclassified to regulatory liabilities in accordance with accounting guidance for “Regulated Operations” as AEGCo and I&M will continue to provide the benefit of the unamortized gain to customers in future periods. +The Owner Trustee owns the Plant and leases equal portions to AEGCo and I&M. The lease is accounted for as an operating lease with the payment obligations included in the future minimum lease payments schedule earlier in this note. The lease term is for 33 years and at the end of the lease term, AEGCo and I&M have the option to renew the lease at a rate that approximates fair value. In November 2020, management announced that AEP will not renew the lease when it expires in 2022. AEP, AEGCo and I&M have no ownership interest in the Owner Trustee and do not guarantee its debt. The future minimum lease payments for this sale-and-leaseback transaction as of December 31, 2020 were as follows: +Future Minimum Lease Payments AEP (a) I&M +(in millions) +2021 $ 147.8 $ 73.9 +2022 147.6 73.8 +Total Future Minimum Lease Payments $ 295.4 $ 147.7 +(a) AEP’s future minimum lease payments include equal shares from AEGCo and I&M. +AEPRO Boat and Barge Leases (Applies to AEP) +In 2015, AEP sold its commercial barge transportation subsidiary, AEPRO, to a nonaffiliated party. Certain boat and barge leases acquired by the nonaffiliated party are subject to an AEP guarantee in favor of the respective lessors, ensuring future payments under such leases with maturities up to 2027. As of December 31, 2020, the maximum potential amount of future payments required under the guaranteed leases was $ 48 million. Under the terms of certain of the arrangements, upon the lessors exercising their rights after an event of default by the nonaffiliated party, AEP is entitled to enter into new lease arrangements as a lessee that would have substantially the same terms as the existing leases. Alternatively, for the arrangements with one of the lessors, upon an event of default by the nonaffiliated party and the lessor exercising its rights, payment to the lessor would allow AEP to step into the lessor’s rights as well as obtaining title to the assets. Under either situation, AEP would have the ability to utilize the assets in the normal course of barging operations. AEP would also have the right to sell the acquired assets for which it obtained title. As of December 31, 2020, AEP’s boat and barge lease guarantee liability was $ 3 million, of which $ 1 million was recorded in Other Current Liabilities and $ 2 million was recorded in Deferred Credits and Other Noncurrent Liabilities on AEP’s balance sheet. +In February 2020, the nonaffiliated party filed Chapter 11 bankruptcy. The party entered into a restructuring support agreement and has announced it expects to continue their operations as normal. In March 2020, the bankruptcy court approved the party’s recapitalization plan. In April 2020, the nonaffiliated party emerged from bankruptcy. Management has determined that it is reasonably possible that enforcement of AEP’s liability for future payments under these leases will be exercised within the next twelve months. In such an event, if AEP is unable to sell or incorporate any of the acquired assets into its fleet operations, it could reduce future net income and cash flows and impact financial condition. +Lessor Activity +The Registrants’ lessor activity was immaterial as of and for the twelve months ended December 31, 2020 and December 31, 2019, respectively. +365 +14. FINANCING ACTIVITIES +The disclosures in this note apply to all Registrants, unless indicated otherwise. +Common Stock (Applies to AEP) +The following table is a reconciliation of common stock share activity: +Shares of AEP Common Stock Issued Held in Treasury +Balance, December 31, 2017 512,210,644 20,205,046 +Issued 1,239,392 — +Treasury Stock Reissued — ( 886 ) (a) +Balance, December 31, 2018 513,450,036 20,204,160 +Issued 923,595 — +Balance, December 31, 2019 514,373,631 20,204,160 +Issued 2,434,723 — +Balance, December 31, 2020 516,808,354 20,204,160 +(a) Reissued Treasury Stock used to fulfill share commitments related to AEP’s Share-based Compensation. See “Shared-based Compensation Plans” section of Note 15 for additional information. +At-the-Market (ATM) Program +In November 2020, AEP filed a prospectus supplement and executed an Equity Distribution Agreement (EDA), pursuant to which AEP may sell, from time to time, up to an aggregate of $ 1 billion of its common stock through an ATM offering program, including an equity forward sales component. The compensation paid to the selling agents by AEP may be up to 2 % of the gross offering proceeds of the shares. There were no issuances under the ATM program for the year ended December 31, 2020. +Reverse Stock Split (Applies to SWEPCo) +In August 2020, SWEPCo executed a reverse stock split with each 2,048 shares of common stock issued and outstanding being combined into one share of common stock. The common stock of SWEPCo is wholly-owned by Parent. +366 +Long-term Debt +The following table details long-term debt outstanding: +Weighted-Average Interest Rate Ranges as of Outstanding as of +Interest Rate as of December 31, December 31, +Company Maturity December 31, 2020 2020 2019 2020 2019 +AEP (in millions) +Senior Unsecured Notes 2020-2050 3.97 % 0.70%-8.13% 2.15%-8.13% $ 25,116.1 $ 21,180.7 +Pollution Control Bonds (a) 2020-2036 (b) 2.39 % 0.18%-4.63% 1.35%-5.38% 1,936.7 1,998.8 +Notes Payable – Nonaffiliated (c) 2020-2032 2.34 % 0.84%-6.37% 2.42%-6.37% 239.1 234.3 +Securitization Bonds 2020-2029 (d) 2.78 % 2.01%-3.77% 1.98%-5.31% 716.4 1,025.1 +Spent Nuclear Fuel Obligation (e) 281.2 279.8 +Junior Subordinated Notes (f) 2022-2023 2.32 % 1.30%-3.40% 3.40% 1,624.1 787.8 +Other Long-term Debt 2020-2059 1.59 % 0.81%-13.72% 1.15%-13.718% 1,158.9 1,219.0 +Total Long-term Debt Outstanding +$ 31,072.5 $ 26,725.5 +AEP Texas +Senior Unsecured Notes 2022-2050 3.70 % 2.10%-6.76% 2.40%-6.76% $ 3,687.6 $ 3,090.9 +Pollution Control Bonds 2020-2030 (b) 3.42 % 0.90%-4.55% 1.75%-4.55% 439.7 490.3 +Securitization Bonds 2020-2029 (d) 2.55 % 2.06%-2.84% 1.98%-5.31% 492.6 776.8 +Other Long-term Debt 2022-2059 1.41 % 1.40%-4.50% 3.05%-4.50% 200.5 200.4 +Total Long-term Debt Outstanding +$ 4,820.4 $ 4,558.4 +AEPTCo +Senior Unsecured Notes 2021-2050 3.83 % 3.10%-5.52% 3.10%-5.52% $ 3,948.5 $ 3,427.3 +Total Long-term Debt Outstanding +$ 3,948.5 $ 3,427.3 +APCo +Senior Unsecured Notes 2021-2050 4.94 % 3.30%-7.00% 3.30%-7.00% $ 3,937.2 $ 3,442.7 +Pollution Control Bonds (a) 2020-2036 (b) 1.77 % 0.19%-4.63% 1.67%-5.38% 546.3 546.1 +Securitization Bonds 2023-2028 (d) 3.29 % 2.01%-3.77% 2.008%-3.772% 223.8 248.3 +Other Long-term Debt 2022-2026 1.51 % 1.32%-13.72% 2.97%-13.718% 126.8 126.7 +Total Long-term Debt Outstanding +$ 4,834.1 $ 4,363.8 +I&M +Senior Unsecured Notes 2023-2048 4.38 % 3.20%-6.05% 3.20%-6.05% $ 2,152.2 $ 2,150.7 +Pollution Control Bonds (a) 2021-2025 (b) 2.21 % 0.18%-3.05% 1.79%-3.05% 240.5 240.0 +Notes Payable – Nonaffiliated (c) 2020-2025 1.06 % 0.84%-1.29% 2.42%-2.80% 146.7 168.7 +Spent Nuclear Fuel Obligation (e) 281.2 279.8 +Other Long-term Debt 2021-2025 1.49 % 1.28%-6.00% 2.93%-6.00% 209.3 211.0 +Total Long-term Debt Outstanding +$ 3,029.9 $ 3,050.2 +OPCo +Senior Unsecured Notes 2021-2049 4.82 % 2.60%-6.60% 4.00%-6.60% $ 2,429.4 $ 2,081.0 +Other Long-term Debt 2028 1.15 % 1.15% 1.15% 0.8 1.0 +Total Long-term Debt Outstanding +$ 2,430.2 $ 2,082.0 +PSO +Senior Unsecured Notes 2021-2049 4.55 % 3.05%-6.63% 3.05%-6.625% $ 1,246.3 $ 1,245.6 +Pollution Control Bonds 2020 4.45% — 12.7 +Other Long-term Debt 2022-2027 1.47 % 1.42%-3.00% 3.00%-3.20% 127.5 127.9 +Total Long-term Debt Outstanding +$ 1,373.8 $ 1,386.2 +SWEPCo +Senior Unsecured Notes 2022-2048 4.04 % 2.75%-6.20% 2.75%-6.20% $ 2,430.8 $ 2,428.9 +Notes Payable – Nonaffiliated (c) 2024-2032 5.30 % 4.58%-6.37% 4.58%-6.37% 62.4 65.6 +Other Long-term Debt 2021-2035 2.99 % 2.25%-4.68% 3.08%-4.68% 143.2 161.1 +Total Long-term Debt Outstanding +$ 2,636.4 $ 2,655.6 +(a) For certain series of Pollution Control Bonds, interest rates are subject to periodic adjustment. Certain series may be purchased on demand at periodic interest adjustment dates. Letters of credit from banks and insurance policies support certain series. Consequently, these bonds have been classified for maturity purposes as Long-term Debt Due Within One Year - Nonaffiliated on the balance sheets. +(b) Certain Pollution Control Bonds are subject to redemption earlier than the maturity date. +(c) Notes payable represent outstanding promissory notes issued under term loan agreements and credit agreements with a number of banks and other financial institutions. At expiration, all notes then issued and outstanding are due and payable. Interest rates are both fixed and variable. Variable rates generally relate to specified short-term interest rates. +(d) Dates represent the scheduled final payment dates for the securitization bonds. The legal maturity date is one to two years later. These bonds have been classified for maturity and repayment purposes based on the scheduled final payment date. +(e) Spent Nuclear Fuel Obligation consists of a liability along with accrued interest for disposal of SNF. See “Spent Nuclear Fuel Disposal” section of Note 6 for additional information. +(f) See “Equity Units” section below for additional information. +367 +As of December 31, 2020, outstanding long-term debt was payable as follows: +AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +2021 $ 2,086.1 $ 88.7 $ 50.0 $ 518.3 $ 369.6 $ 500.1 $ 0.5 $ 106.2 +2022 3,538.4 (a) 716.0 104.0 355.4 45.1 0.1 375.5 281.2 +2023 2,659.3 (b) 278.5 60.0 26.6 273.9 0.1 0.5 6.2 +2024 723.4 96.0 95.0 113.5 8.1 0.1 0.6 31.2 +2025 1,726.3 324.5 90.0 443.9 151.5 0.1 125.6 6.2 +After 2025 20,599.2 3,357.0 3,591.0 3,418.3 2,206.2 1,950.3 875.8 2,225.5 +Principal Amount 31,332.7 4,860.7 3,990.0 4,876.0 3,054.4 2,450.8 1,378.5 2,656.5 +Unamortized Discount, Net and Debt Issuance Costs +( 260.2 ) ( 40.3 ) ( 41.5 ) ( 41.9 ) ( 24.5 ) ( 20.6 ) ( 4.7 ) ( 20.1 ) +Total Long-term Debt Outstanding +$ 31,072.5 $ 4,820.4 $ 3,948.5 $ 4,834.1 $ 3,029.9 $ 2,430.2 $ 1,373.8 $ 2,636.4 +(a) Amount includes $805 million of Junior Subordinated Notes. See “Equity Units” section below for additional information. +(b) Amount includes $850 million of Junior Subordinated Notes. See “Equity Units” section below for additional information. +Long-term Debt Subsequent Events +In January and February 2021, I&M retired $ 8 million and $ 7 million, respectively, of Notes Payable related to DCC Fuel. +In January 2021, OPCo issued $ 450 million of Senior Unsecured Notes. +In January 2021, PSO issued $ 400 million of variable rate Other Long-term Debt due in 2022 , which it used to retire $ 250 million of Senior Unsecured Notes in February 2021. +In January and February 2021, Transource Energy issued $ 5 million and $ 9 million, respectively, of variable rate Other Long-term Debt due in 2023 . +In February 2021, AEP Texas retired $ 11 million of Securitization Bonds. +In February 2021, APCo retired $ 12 million of Securitization Bonds. +Equity Units (Applies to AEP) +2020 Equity Units +In August 2020, AEP issued 17 million Equity Units initially in the form of corporate units, at a stated amount of $ 50 per unit, for a total stated amount of $ 850 million. Net proceeds from the issuance were approximately $ 833 million. The proceeds were used to support AEP’s overall capital expenditure plans. +Each corporate unit represents a 1/20 undivided beneficial ownership interest in $ 1,000 principal amount of AEP’s 1.30 % Junior Subordinated Notes (notes) due in 2025 and a forward equity purchase contract which settles after three years in 2023 . The notes are expected to be remarketed in 2023, at which time the interest rate will reset at the then-current market rate. Investors may choose to remarket their notes to receive the remarketing proceeds and use those funds to settle the forward equity purchase contract, or accept the remarketed debt and use other funds for the equity purchase. If the remarketing is unsuccessful, investors have the right to put their notes to AEP at a price equal to the principal. The Equity Units carry an annual distribution rate of 6.125 %, which is comprised of a quarterly coupon rate of interest of 1.30 % and a quarterly forward equity purchase contract payment of 4.825 %. +368 +Each forward equity purchase contract obligates the holder to purchase, and AEP to sell, for $50 a number of shares in common stock in accordance with the conversion ratios set forth below (subject to an anti-dilution adjustment): +• If the AEP common stock market price is equal to or greater than $ 99.95 : 0.5003 shares per contract. +• If the AEP common stock market price is less than $99.95 but greater than $ 83.29 : a number of shares per contract equal to $50 divided by the applicable market price. The holder receives a variable number of shares at $50. +• If the AEP common stock market price is less than or equal to $83.29: 0.6003 shares per contract. +A holder’s ownership interest in the notes is pledged to AEP to secure the holder’s obligation under the related forward equity purchase contract. If a holder of the forward equity purchase contract chooses at any time to no longer be a holder of the notes, such holder’s obligation under the forward equity purchase contract must be secured by a U.S. Treasury security which must be equal to the aggregate principal amount of the notes. +At the time of issuance, the $ 850 million of notes were recorded within Long-term Debt on the balance sheets. The present value of the purchase contract payments of $ 121 million were recorded in Deferred Credits and Other Noncurrent Liabilities with a current portion in Other Current Liabilities at the time of issuance, representing the obligation to make forward equity contract payments, with an offsetting reduction to Paid-in Capital. The difference between the face value and present value of the purchase contract payments will be accreted to Interest Expense on the statements of income over the three year period ending in 2023. The liability recorded for the contract payments is considered non-cash and excluded from the statements of cash flows. Until settlement of the forward equity purchase contract, earnings per-share dilution resulting from the equity unit issuance will be determined under the treasury stock method. The maximum amount of shares AEP will be required to issue to settle the purchase contract is 10,205,100 shares (subject to an anti-dilution adjustment). +2019 Equity Units +In March 2019, AEP issued 16.1 million Equity Units initially in the form of corporate units, at a stated amount of $ 50 per unit, for a total stated amount of $ 805 million. Net proceeds from the issuance were approximately $ 785 million. The proceeds were used to support AEP’s overall capital expenditure plans including the acquisition of Sempra Renewables LLC. +Each corporate unit represents a 1/20 undivided beneficial ownership interest in $ 1,000 principal amount of AEP’s 3.40 % Junior Subordinated Notes (notes) due in 2024 and a forward equity purchase contract which settles after three years in 2022 . The notes are expected to be remarketed in 2022, at which time the interest rate will reset at the then-current market rate. Investors may choose to remarket their notes to receive the remarketing proceeds and use those funds to settle the forward equity purchase contract, or accept the remarketed debt and use other funds for the equity purchase. If the remarketing is unsuccessful, investors have the right to put their notes to AEP at a price equal to the principal. The Equity Units carry an annual distribution rate of 6.125 %, which is comprised of a quarterly coupon rate of interest of 3.40 % and a quarterly forward equity purchase contract payment of 2.725 %. +Each forward equity purchase contract obligates the holder to purchase, and AEP to sell, for $50 a number of shares in common stock in accordance with the conversion ratios set forth below (subject to an anti-dilution adjustment): +• If the AEP common stock market price is equal to or greater than $ 99.58 : 0.5021 shares per contract. +• If the AEP common stock market price is less than $99.58 but greater than $ 82.98 : a number of shares per contract equal to $50 divided by the applicable market price. The holder receives a variable number of shares at $50. +• If the AEP common stock market price is less than or equal to $82.98: 0.6026 shares per contract. +A holder’s ownership interest in the notes is pledged to AEP to secure the holder’s obligation under the related forward equity purchase contract. If a holder of the forward equity purchase contract chooses at any time to no longer be a holder of the notes, such holder’s obligation under the forward equity purchase contract must be secured by a U.S. Treasury security which must be equal to the aggregate principal amount of the notes. +369 +At the time of issuance, the $ 805 million of notes were recorded within Long-term Debt on the balance sheets. The present value of the purchase contract payments of $ 62 million were recorded in Deferred Credits and Other Noncurrent Liabilities with a current portion in Other Current Liabilities at the time of issuance, representing the obligation to make forward equity contract payments, with an offsetting reduction to Paid-in Capital. The difference between the face value and present value of the purchase contract payments will be accreted to Interest Expense on the statements of income over the three year period ending in 2022. The liability recorded for the contract payments is considered non-cash and excluded from the statements of cash flows. Until settlement of the forward equity purchase contract, earnings per-share dilution resulting from the equity unit issuance will be determined under the treasury stock method. The maximum amount of shares AEP will be required to issue to settle the purchase contract is 9,701,860 shares (subject to an anti-dilution adjustment). +Debt Covenants (Applies to AEP and AEPTCo) +Covenants in AEPTCo’s note purchase agreements and indenture limit the amount of contractually-defined priority debt (which includes a further sub-limit of $ 50 million of secured debt) to 10 % of consolidated tangible net assets. AEPTCo’s contractually-defined priority debt was 1.6 % of consolidated tangible net assets as of December 31, 2020. The method for calculating the consolidated tangible net assets is contractually-defined in the note purchase agreement. +Dividend Restrictions +Utility Subsidiaries’ Restrictions +Parent depends on its utility subsidiaries to pay dividends to shareholders. AEP utility subsidiaries pay dividends to Parent provided funds are legally available. Various financing arrangements and regulatory requirements may impose certain restrictions on the ability of the subsidiaries to transfer funds to Parent in the form of dividends. +All of the dividends declared by AEP’s utility subsidiaries that provide transmission or local distribution services are subject to a Federal Power Act restriction that prohibits the payment of dividends out of capital accounts without regulatory approval; payment of dividends is allowed out of retained earnings only. The Federal Power Act also creates a reserve on retained earnings attributable to hydroelectric generation plants. Because of their ownership of such plants, this reserve applies to AGR, APCo and I&M. +Certain AEP subsidiaries have credit agreements that contain covenants that limit their debt to capitalization ratio to 67.5 %. The method for calculating outstanding debt and capitalization is contractually-defined in the credit agreements. +The most restrictive dividend limitation for certain AEP subsidiaries is through the Federal Power Act restriction, while for other AEP subsidiaries the most restrictive dividend limitation is through the credit agreements. As of December 31, 2020, the maximum amount of restricted net assets of AEP’s subsidiaries that may not be distributed to the Parent in the form of a loan, advance or dividend was $ 14 billion. +The Federal Power Act restriction limits the ability of the AEP subsidiaries owning hydroelectric generation to pay dividends out of retained earnings. Additionally, the credit agreement covenant restrictions can limit the ability of the AEP subsidiaries to pay dividends out of retained earnings. As of December 31, 2020, the amount of any such restrictions were as follows: +AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Restricted Retained Earnings +$ 2,369.5 (a) $ 694.0 $ — $ 175.1 $ 519.7 $ — $ 182.3 $ 571.9 +(a) Includes the restrictions of consolidated and non-consolidated subsidiaries. +370 +Parent Restrictions (Applies to AEP) +The holders of AEP’s common stock are entitled to receive the dividends declared by the Board of Directors provided funds are legally available for such dividends. Parent’s income primarily derives from common stock equity in the earnings of its utility subsidiaries. +Pursuant to the leverage restrictions in credit agreements, AEP must maintain a percentage of debt-to-total capitalization at a level that does not exceed 67.5 %. The method for calculating outstanding debt and capitalization is contractually-defined in the credit agreements. As of December 31, 2020, AEP had $ 7.1 billion of available retained earnings to pay dividends to common shareholders. AEP paid $ 1.4 billion, $ 1.3 billion and $ 1.3 billion of dividends to common shareholders for the years ended December 31, 2020, 2019 and 2018, respectively. +Lines of Credit and Short-term Debt (Applies to AEP and SWEPCo) +AEP uses its commercial paper program to meet the short-term borrowing needs of its subsidiaries. The program funds a Utility Money Pool, which funds AEP’s utility subsidiaries; a Nonutility Money Pool, which funds certain AEP nonutility subsidiaries; and the short-term debt requirements of subsidiaries that are not participating in either money pool for regulatory or operational reasons, as direct borrowers. As of December 31, 2020, AEP had a $ 4 billion revolving credit facility to support its commercial paper program. The commercial paper program for the year ended 2020, had a weighted-average interest rate of 1.28 % and a maximum amount outstanding of $ 3 billion. AEP’s outstanding short-term debt was as follows: +December 31, +2020 2019 +Company Type of Debt Outstanding +Amount Interest +Rate (a) Outstanding +Amount Interest +Rate (a) +(in millions) (in millions) +AEP Securitized Debt for Receivables (b) $ 592.0 0.85 % $ 710.0 2.42 % +AEP Commercial Paper 1,852.3 0.29 % 2,110.0 2.10 % +SWEPCo Notes Payable 35.0 2.55 % 18.3 3.29 % +Total Short-term Debt $ 2,479.3 $ 2,838.3 +(a) Weighted-average rate. +(b) Amount of securitized debt for receivables as accounted for under the “Transfers and Servicing” accounting guidance. +371 +Corporate Borrowing Program – AEP System (Applies to Registrant Subsidiaries) +The AEP System uses a corporate borrowing program to meet the short-term borrowing needs of AEP’s subsidiaries. The corporate borrowing program includes a Utility Money Pool, which funds AEP’s utility subsidiaries; a Nonutility Money Pool, which funds certain AEP nonutility subsidiaries; and direct borrowing from AEP. The AEP System Utility Money Pool operates in accordance with the terms and conditions of its agreement filed with the FERC. The amounts of outstanding loans to (borrowings from) the Utility Money Pool as of December 31, 2020 and 2019 are included in Advances to Affiliates and Advances from Affiliates, respectively, on the Registrant Subsidiaries’ balance sheets. The Utility Money Pool participants’ money pool activity and corresponding authorized borrowing limits are described in the following tables: +Year Ended December 31, 2020: +Maximum Average Net Loans to +Borrowings Maximum Borrowings Average (Borrowings from) Authorized +from the Loans to the from the Loans to the the Utility Money Short-term +Utility Utility Utility Utility Pool as of Borrowing +Company Money Pool Money Pool Money Pool Money Pool December 31, 2020 Limit +(in millions) +AEP Texas $ 320.4 $ 313.4 $ 132.0 $ 139.0 $ ( 67.1 ) $ 500.0 +AEPTCo 358.4 259.7 116.3 55.0 ( 155.4 ) 820.0 (a) +APCo 434.3 189.0 242.8 76.3 2.8 500.0 +I&M 218.6 13.4 114.5 13.3 ( 89.7 ) 500.0 +OPCo 353.9 32.8 182.4 25.2 ( 259.2 ) 500.0 +PSO 155.4 57.1 72.3 28.4 ( 155.4 ) 300.0 +SWEPCo 178.9 — 113.0 — ( 124.6 ) 350.0 +Year Ended December 31, 2019: +Maximum Average Net Loans to +Borrowings Maximum Borrowings Average (Borrowings from) Authorized +from the Loans to the from the Loans to the the Utility Money Short-term +Utility Utility Utility Utility Pool as of Borrowing +Company Money Pool Money Pool Money Pool Money Pool December 31, 2019 Limit +(in millions) +AEP Texas $ 390.7 $ 213.1 $ 239.3 $ 194.4 $ 199.7 $ 500.0 +AEPTCo 374.9 244.4 152.0 52.8 ( 119.0 ) 795.0 (a) +APCo 270.0 232.2 115.9 51.9 ( 214.6 ) 500.0 +I&M 158.8 66.0 71.5 16.2 ( 101.2 ) 500.0 +OPCo 291.2 178.6 129.2 50.1 ( 131.0 ) 500.0 +PSO 140.5 215.6 63.9 98.3 38.8 300.0 +SWEPCo 105.1 81.4 53.3 13.6 ( 59.9 ) 350.0 +(a) Amount represents the combined authorized short-term borrowing limit the State Transcos have from FERC or state regulatory commissions. +372 +The activity in the above tables does not include short-term lending activity of certain AEP nonutility subsidiaries. AEP Texas’ wholly-owned subsidiary, AEP Texas North Generation Company, LLC and SWEPCo’s wholly-owned subsidiary, Mutual Energy SWEPCo, LLC participate in the Nonutility Money Pool. The amounts of outstanding loans to the Nonutility Money Pool as of December 31, 2020 and 2019 are included in Advances to Affiliates on each subsidiaries’ balance sheets. The Nonutility Money Pool participants’ money pool activity is described in the following tables: +Year Ended December 31, 2020: +Maximum Loans Average Loans Loans to the Nonutility +to the Nonutility to the Nonutility Money Pool as of +Company Money Pool Money Pool December 31, 2020 +(in millions) +AEP Texas $ 7.5 $ 7.1 $ 7.1 +SWEPCo 2.1 2.1 2.1 +Year Ended December 31, 2019: +Maximum Loans Average Loans Loans to the Nonutility +to the Nonutility to the Nonutility Money Pool as of +Company Money Pool Money Pool December 31, 2019 +(in millions) +AEP Texas $ 8.0 $ 7.7 $ 7.5 +SWEPCo 2.1 2.0 2.1 +AEP has a direct financing relationship with AEPTCo to meet its short-term borrowing needs. The amounts of outstanding loans to and borrowings from AEP as of December 31, 2020 and 2019 are included in Advances to Affiliates and Advances from Affiliates, respectively, on AEPTCo’s balance sheets. AEPTCo’s direct financing activities with AEP and corresponding authorized borrowing limits are described in the following tables: +Year Ended December 31, 2020: +Maximum Maximum Average Average Borrowings from Loans to Authorized +Borrowings Loans Borrowings Loans AEP as of AEP as of Short-term +from AEP to AEP from AEP to AEP December 31, 2020 December 31, 2020 Borrowing Limit +(in millions) +$ 1.4 $ 215.3 $ 1.3 $ 132.6 $ 1.2 $ 109.0 $ 50.0 (a) +Year Ended December 31, 2019: +Maximum Maximum Average Average Borrowings from Loans to Authorized +Borrowings Loans Borrowings Loans AEP as of AEP as of Short-term +from AEP to AEP from AEP to AEP December 31, 2019 December 31, 2019 Borrowing Limit +(in millions) +$ 1.3 $ 153.5 $ 1.3 $ 68.0 $ 1.3 $ 68.7 $ 75.0 (a) +(a) Amount represents the combined authorized short-term borrowing limit the State Transcos have from FERC or state regulatory commissions. +The maximum and minimum interest rates for funds either borrowed from or loaned to the Utility Money Pool are summarized in the following table: +Years Ended December 31, +2020 2019 2018 +Maximum Interest Rate 2.70 % 3.43 % 2.97 % +Minimum Interest Rate 0.27 % 1.77 % 1.81 % +373 +The average interest rates for funds borrowed from and loaned to the Utility Money Pool are summarized in the following table: +Average Interest Rate for Funds Borrowed +from the Utility Money Pool for the +Years Ended December 31, Average Interest Rate for Funds Loaned +to the Utility Money Pool for the +Years Ended December 31, +Company 2020 2019 2018 2020 2019 2018 +AEP Texas 1.51 % 2.63 % 2.26 % 0.81 % 2.03 % 2.29 % +AEPTCo 1.29 % 2.64 % 2.27 % 1.99 % 2.41 % 2.10 % +APCo 2.12 % 2.45 % 2.26 % 0.85 % 2.66 % 2.21 % +I&M 1.07 % 2.34 % 2.16 % 1.18 % 2.60 % 2.08 % +OPCo 0.99 % 2.67 % 2.18 % 2.06 % 2.68 % 2.47 % +PSO 0.92 % 2.85 % 2.27 % 1.95 % 2.27 % 1.98 % +SWEPCo 1.27 % 2.72 % 2.31 % — % 2.22 % 2.00 % +Maximum, minimum and average interest rates for funds loaned to the Nonutility Money Pool are summarized in the following table: +Maximum Interest Rate Minimum Interest Rate Average Interest Rate +Year Ended for Funds Loaned to for Funds Loaned to for Funds Loaned to +December 31, Company the Nonutility Money Pool the Nonutility Money Pool the Nonutility Money Pool +2020 AEP Texas 2.70 % 0.27 % 1.18 % +2020 SWEPCo 2.70 % 0.27 % 1.18 % +2019 AEP Texas 3.02 % 1.91 % 2.56 % +2019 SWEPCo 3.02 % 1.91 % 2.55 % +2018 AEP Texas 2.97 % 1.83 % 2.36 % +2018 SWEPCo 2.97 % 1.83 % 2.36 % +AEPTCo’s maximum, minimum and average interest rates for funds either borrowed from or loaned to AEP are summarized in the following table: +Maximum Minimum Maximum Minimum Average Average +Interest Rate Interest Rate Interest Rate Interest Rate Interest Rate Interest Rate +for Funds for Funds for Funds for Funds for Funds for Funds +Year Ended Borrowed from Borrowed from Loaned to Loaned to Borrowed from Loaned to +December 31, AEP AEP AEP AEP AEP AEP +2020 2.70 % 0.27 % 2.70 % 0.27 % 1.20 % 1.13 % +2019 3.02 % 1.91 % 3.02 % 1.91 % 2.55 % 2.51 % +2018 2.97 % 1.76 % 2.97 % 1.76 % 2.36 % 2.36 % +Interest expense and interest income related to the Utility Money Pool, Nonutility Money Pool and direct borrowing financing relationship are included in Interest Expense and Interest Income, respectively, on each of the Registrant Subsidiaries’ statements of income. The interest expense and interest income related to the corporate borrowing programs were immaterial for the years ended December 31, 2020, 2019 and 2018. +Credit Facilities +See “Letters of Credit” section of Note 6 for additional information. +374 +Securitized Accounts Receivables – AEP Credit (Applies to AEP) +AEP Credit has a receivables securitization agreement that provides a commitment of $ 750 million from bank conduits to purchase receivables and expires in September 2022. Under the securitization agreement, AEP Credit receives financing from the bank conduits for the interest in the receivables AEP Credit acquires from affiliated utility subsidiaries. These securitized transactions allow AEP Credit to repay its outstanding debt obligations, continue to purchase the operating companies’ receivables and accelerate AEP Credit’s cash collections. +In May 2020, AEP Credit amended its receivables securitization agreement to increase the eligibility criteria related to aged receivable requirements for the participating affiliated utility subsidiaries in response to the COVID-19 pandemic. As of December 31, 2020, the affiliated utility subsidiaries are in compliance with all requirements under the agreement. To the extent that an affiliated utility subsidiary is deemed ineligible under the agreement, the affiliated utility subsidiary would no longer participate in the receivables securitization agreement and the Registrants would need to rely on additional sources of funding for operation and working capital, which may adversely impact liquidity. The receivables that are ineligible under the receivables securitization agreement are financed with short-term debt at AEP Credit. +Accounts receivable information for AEP Credit was as follows: +Years Ended December 31, +2020 2019 2018 +(dollars in millions) +Effective Interest Rates on Securitization of Accounts Receivable +0.85 % 2.42 % 2.16 % +Net Uncollectible Accounts Receivable Written Off $ 15.3 $ 26.6 $ 27.6 +December 31, +2020 2019 +(in millions) +Accounts Receivable Retained Interest and Pledged as Collateral Less Uncollectible Accounts +$ 958.4 $ 841.8 +Short-term – Securitized Debt of Receivables +592.0 710.0 +Delinquent Securitized Accounts Receivable 62.3 39.6 +Bad Debt Reserves Related to Securitization 60.0 32.1 +Unbilled Receivables Related to Securitization 296.8 266.8 +AEP Credit’s delinquent customer accounts receivable represent accounts greater than 30 days past due. +Securitized Accounts Receivables – AEP Credit (Applies to Registrant Subsidiaries, except AEP Texas and AEPTCo) +Under this sale of receivables arrangement, the Registrant Subsidiaries sell, without recourse, certain of their customer accounts receivable and accrued unbilled revenue balances to AEP Credit and are charged a fee based on AEP Credit’s financing costs, administrative costs and uncollectible accounts experience for each Registrant Subsidiary’s receivables. APCo does not have regulatory authority to sell its West Virginia accounts receivable. The costs of customer accounts receivable sold are reported in Other Operation expense on the Registrant Subsidiaries’ statements of income. The Registrant Subsidiaries manage and service their customer accounts receivable, which are sold to AEP Credit. AEP Credit securitizes the eligible receivables for the operating companies and retains the remainder. +375 +The amount of accounts receivable and accrued unbilled revenues under the sale of receivables agreement were: +December 31, +Company 2020 2019 +(in millions) +APCo $ 136.0 $ 120.9 +I&M 170.5 141.8 +OPCo 398.8 330.3 +PSO 85.0 101.1 +SWEPCo 158.6 125.2 +The fees paid to AEP Credit for customer accounts receivable sold were: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +APCo $ 5.2 $ 7.4 $ 7.0 +I&M 7.9 11.1 9.2 +OPCo 24.1 27.1 26.3 +PSO 4.8 7.8 7.9 +SWEPCo 6.7 10.2 8.9 +The proceeds on the sale of receivables to AEP Credit were: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +APCo $ 1,272.9 $ 1,310.3 $ 1,421.0 +I&M 1,891.8 1,824.2 1,843.0 +OPCo 2,366.2 2,293.6 2,674.5 +PSO 1,221.0 1,442.5 1,484.6 +SWEPCo 1,593.8 1,618.5 1,736.1 +376 +15. STOCK-BASED COMPENSATION +The disclosures in this note apply to AEP only. The impact of AEP’s share-based compensation plans is insignificant to the financial statements of the Registrant Subsidiaries. +Awards under AEP’s long-term incentive plan may be granted to employees and directors. The Amended and Restated American Electric Power System Long-Term Incentive Plan (Prior Plan), was replaced prospectively for new grants by the American Electric Power System 2015 Long-Term Incentive Plan (2015 LTIP) effective in April 2015. The 2015 LTIP was subsequently amended in September 2016. The 2015 LTIP provides for a maximum of 10 million AEP common shares to be available for grant to eligible employees and directors. As of December 31, 2020, 6,712,148 shares remained available for issuance under the 2015 LTIP. No new awards may be granted under the Prior Plan. The 2015 LTIP awards may be stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units, cash-based awards and other stock-based awards. Shares issued pursuant to a stock option or a stock appreciation right reduce the shares remaining available for grants under the 2015 LTIP by 0.286 of a share. Each share issued for any other award that settles in AEP stock reduces the shares remaining available for grants under the 2015 LTIP by one share. Cash settled awards do not reduce the number of shares remaining available under the 2015 LTIP. The following sections provide further information regarding each type of stock-based compensation award granted under these plans. +Performance Shares +Performance units granted prior to 2017 were settled in cash rather than AEP common stock and did not reduce the number of shares remaining available under the 2015 LTIP. Those performance units had a fair value upon vesting equal to the average closing market price of AEP common stock for the last 20 trading days of the performance period. Performance shares granted in and after 2017 are settled in AEP common stock and reduce the aggregate share authorization. In all cases the number of performance shares held at the end of the three-year performance period is multiplied by the performance score for such period to determine the actual number of performance shares that participants realize. The performance score can range from 0 % to 200 % and is determined at the end of the performance period based on performance measures, which include both performance and market conditions, established for each grant at the beginning of the performance period by the Human Resources Committee of AEP’s Board of Directors (HR Committee). +Certain employees must satisfy a minimum stock ownership requirement. If those employees have not met their stock ownership requirement, a portion or all of their performance shares are mandatorily deferred as AEP career shares to the extent needed to meet their stock ownership requirement. AEP career shares are a form of non-qualified deferred compensation that has a value equivalent to a share of AEP common stock. AEP career shares are settled in AEP common stock after the participant’s termination of employment. +AEP career shares are recorded in Paid-in Capital on the balance sheets. Amounts equivalent to cash dividends on both performance shares and AEP career shares accrue as additional shares. Management records compensation cost for performance shares over an approximately three-year vesting period. Performance shares are recorded as mezzanine equity on the balance sheets until the vesting date and compensation cost is calculated at fair value based on metrics for each grant. Performance shares granted in 2020 had three performance metrics: (a) three-year cumulative operating earnings per-share with a 50% weight, (b) total shareholder return with a 40% weight and (c) non-emitting generation capacity as a percentage of total owned and purchased capacity with a 10% weight. Performance shares granted prior to 2020 had two equally-weighted performance metrics: (a) three-year cumulative operating earnings per-share and (b) total shareholder return. The three-year cumulative operating earnings per-share metric and non-emitting generating capacity metric are adjusted quarterly for changes in performance relative to a target approved by the HR Committee. The total shareholder return metric is measured relative to a peer group of similar companies and is based on a third-party Monte Carlo valuation. The value related to this metric does not change over the three-year vesting period. +377 +The HR Committee awarded performance shares and reinvested dividends on outstanding performance shares and AEP career shares as follows: +Years Ended December 31, +Performance Shares 2020 2019 2018 +Awarded Shares (in thousands) 424.8 535.0 581.4 +Weighted-Average Share Fair Value at Grant Date $ 116.56 $ 83.21 $ 67.21 +Vesting Period (in years) 3 3 3 +Performance Shares and AEP Career Shares +(Reinvested Dividends Portion) Years Ended December 31, +2020 2019 2018 +Awarded Shares (in thousands) (a) 73.4 66.4 80.2 +Weighted-Average Fair Value at Grant Date $ 84.87 $ 88.73 $ 70.58 +Vesting Period (in years) (b) (b) (b) +(a) All awarded dividends in both 2020 and 2019 were equity awards and awarded dividends in 2018 were a mix of equity awards and liability awards. +(b) The vesting period for the reinvested dividends on performance shares is equal to the remaining life of the related performance shares. Dividends on AEP career shares vest immediately when the dividend is awarded but are not settled in AEP common stock until after the participant’s AEP employment ends. +Performance scores and final awards are determined and approved by the HR Committee in accordance with the pre-established performance measures within approximately two months after the end of the performance period. +The certified performance scores and shares earned for the three-year periods were as follows: +Years Ended December 31, +Performance Shares 2020 2019 2018 +Certified Performance Score 128.2 % 132.7 % 136.7 % +Performance Shares Earned 757,858 792,897 820,780 +Performance Shares Mandatorily Deferred as AEP Career Shares 13,614 10,063 11,248 +Performance Shares Voluntarily Deferred into the Incentive Compensation Deferral Program +26,936 49,392 56,826 +Performance Shares to be Settled (a) 717,308 733,442 752,706 +(a) Performance shares settled for the three-year periods ended December 31, 2020 and 2019 settled in AEP common stock. Performance units settled for the three-year period ended December 31, 2018 settled in cash. In all cases, the settlement of common stock or cash occurs in the quarter following the end of the year shown. +The settlements were as follows: +Years Ended December 31, +Performance Shares and AEP Career Shares 2020 2019 2018 +(in millions) +Cash Settlements for Performance Units $ — $ 58.3 $ 66.9 +AEP Common Stock Settlements for Performance Shares 75.4 — — +AEP Common Stock Settlements for Career Share Distributions 1.9 6.6 5.1 +378 +A summary of the status of AEP’s nonvested Performance Shares as of December 31, 2020 and changes during the year ended December 31, 2020 were as follows: +Nonvested Performance Shares Shares Weighted +Average +Grant Date +Fair Value +(in thousands) +Nonvested as of January 1, 2020 1,113.4 $ 73.64 +Awarded 424.8 116.56 +Dividends 53.8 84.91 +Vested (a) ( 597.0 ) 66.45 +Forfeited ( 56.4 ) 87.58 +Nonvested as of December 31, 2020 938.6 98.05 +(a) The vested Performance Shares will be converted to 717 thousand shares based on the closing share price on the day before settlement. +Monte Carlo Valuation +AEP engages a third-party for a Monte Carlo valuation to calculate the fair value of the total shareholder return metric for the performance shares awarded during and after 2017. The valuations use a lattice model and the expected volatility assumptions used were the historical volatilities for AEP and the members of their peer group. The assumptions used in the Monte Carlo valuations were as follows: +Years Ended December 31, +Assumptions 2020 2019 2018 +Valuation Period (in years) (a) 2.87 2.87 2.87 +Expected Volatility Minimum 13.67 % 14.83 % 14.77 % +Expected Volatility Maximum 28.15 % 25.57 % 26.72 % +Expected Volatility Average 16.39 % 17.39 % 17.90 % +Dividend Rate (b) — % — % — % +Risk Free Rate 1.40 % 2.49 % 2.34 % +(a) Period from award date to vesting date. +(b) Equivalent to reinvesting dividends. +Restricted Stock Units +The HR Committee grants restricted stock units (RSUs), which generally vest, subject to the participant’s continued employment, over at least three years in approximately equal annual increments. The RSUs accrue dividends as additional RSUs. The additional RSUs granted as dividends vest on the same date as the underlying RSUs. RSUs are converted into shares of AEP common stock upon vesting, except the RSUs granted prior to 2017 to AEP’s executive officers which settled in cash. Executive officers are those officers who are subject to the disclosure requirements set forth in Section 16 of the Securities Exchange Act of 1934. For RSUs that settle in shares, compensation cost is measured at fair value on the grant date and recorded over the vesting period. Fair value is determined by multiplying the number of RSUs granted by the grant date market closing price. For RSUs that settled in cash, compensation cost was recorded over the vesting period and adjusted for changes in fair value until vested. The fair value at vesting was determined by multiplying the number of RSUs vested by the 20-day average closing price of AEP common stock. The maximum contractual term of outstanding RSUs is approximately 40 months from the grant date. +379 +The HR Committee awarded RSUs, including additional units awarded as dividends, as follows: +Years Ended December 31, +Restricted Stock Units 2020 2019 2018 +Awarded Units (in thousands) 268.7 304.8 260.0 +Weighted-Average Grant Date Fair Value $ 94.38 $ 81.57 $ 67.96 +The total fair value and total intrinsic value of restricted stock units vested were as follows: +Years Ended December 31, +Restricted Stock Units 2020 2019 2018 +(in millions) +Fair Value of Restricted Stock Units Vested $ 22.9 $ 16.3 $ 16.6 +Intrinsic Value of Restricted Stock Units Vested (a) 25.2 21.6 19.2 +(a) Intrinsic value is calculated as market price at the vesting date. +A summary of the status of AEP’s nonvested RSUs as of December 31, 2020 and changes during the year ended December 31, 2020 were as follows: +Nonvested Restricted Stock Units Shares/Units Weighted +Average +Grant Date +Fair Value +(in thousands) +Nonvested as of January 1, 2020 516.9 $ 75.55 +Awarded 268.7 94.38 +Vested ( 307.6 ) 74.58 +Forfeited ( 30.0 ) 84.27 +Nonvested as of December 31, 2020 448.0 86.56 +The total aggregate intrinsic value of nonvested RSUs as of December 31, 2020 was $ 37 million and the weighted-average remaining contractual life was 1.6 years . +Retirement Incentive and Severance Awards +In 2020 64,186 shares with a weighted-average grant date fair value of $ 83.74 were granted in connection with the voluntary retirement incentive program and other executive severance. The shares were fully vested on the grant date with a fair value of $ 5 million. See “Voluntary Retirement Incentive Program” section of Note 1 for additional information. +Other Stock-Based Plans +AEP also has a Stock Unit Accumulation Plan for Non-Employee Directors providing each non-employee director with AEP stock units as a substantial portion of the compensation for their services as a director. The number of stock units provided is based on the closing price of AEP common stock on the last trading day of the quarter for which the stock units were earned. Amounts equivalent to cash dividends on the stock units accrue as additional AEP stock units. The stock units granted to non-employee directors are fully vested on their grant date. Stock units are settled in cash upon termination of board service or up to 10 years later if the participant so elects. Cash settlements for stock units are calculated based on the average closing price of AEP common stock for the last 20 trading days prior to the distribution date. After five years of service on the Board of Directors, non-employee directors receive subsequent AEP stock units as contributions to an AEP stock fund awarded under the Stock Unit Accumulation Plan. Such amounts may be exchanged into other market-based investments that are similar to the investment options available to employees that participate in AEP’s Incentive Compensation Deferral Plan. These balances are also paid in cash upon termination of board service or up to 10 years later if the participant so elects. +380 +Management records compensation cost for stock units when the units are awarded and adjusts the liability for changes in value based on the current 20-day average closing price of AEP common stock on the valuation date. +For the years ended December 31, 2020, 2019 and 2018, cash settlements for stock unit distributions were immaterial. +The Board of Directors awarded stock units, including units awarded for dividends, as follows: +Years Ended December 31, +Stock Unit Accumulation Plan for Non-Employee Directors 2020 2019 2018 +Awarded Units (in thousands) 12.1 10.0 11.4 +Weighted-Average Grant Date Fair Value $ 83.80 $ 89.13 $ 70.41 +Share-based Compensation Plans +For share-based payment arrangements the compensation cost, the actual tax benefit from the tax deductions for compensation cost recognized in income and the total compensation cost capitalized were as follows: +Years Ended December 31, +Share-based Compensation Plans 2020 2019 2018 +(in millions) +Compensation Cost for Share-based Payment Arrangements (a) $ 53.8 $ 57.9 $ 53.2 +Actual Tax Benefit 7.2 8.4 7.7 +Total Compensation Cost Capitalized 20.4 20.0 19.7 +(a) Compensation cost for share-based payment arrangements is included in Other Operation and Maintenance expenses on the statements of income. +As of December 31, 2020, there was $ 78 million of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under the 2015 LTIP. Unrecognized compensation cost related to unvested share-based arrangements will change as the fair value of performance shares is adjusted each period and as forfeitures for all award types are realized. AEP’s unrecognized compensation cost will be recognized over a weighted-average period of 1.39 years . +Under the 2015 LTIP, AEP is permitted to use authorized but unissued shares, treasury shares, shares acquired in the open market specifically for distribution under these plans, or any combination thereof to fulfill share commitments. AEP’s current practice is to use authorized but unissued shares to fulfill share commitments. The number of shares used to fulfill share commitments is generally reduced to offset tax withholding obligations. +381 +16. RELATED PARTY TRANSACTIONS +The disclosures in this note apply to all Registrant Subsidiaries unless indicated otherwise. +For other related party transactions, also see “AEP System Tax Allocation Agreement” section of Note 12 in addition to “Corporate Borrowing Program – AEP System” and “Securitized Accounts Receivables – AEP Credit” sections of Note 14. +Power Coordination Agreement (Applies to all Registrant Subsidiaries except AEP Texas and AEPTCo) +Effective January 1, 2014, the FERC approved the PCA. Under the PCA, APCo, I&M, KPCo and WPCo are individually responsible for planning their respective capacity obligations. The PCA allows, but does not obligate, APCo, I&M, KPCo and WPCo to participate collectively under a common fixed resource requirement capacity plan in PJM and to participate in specified collective Off-system Sales and purchase activities. +AEPSC conducts power, capacity, coal, natural gas, interest rate and, to a lesser extent, heating oil, gasoline and other risk management activities on behalf of APCo, I&M, KPCo, PSO, SWEPCo and WPCo. Certain power and natural gas risk management activities for APCo, I&M, KPCo and WPCo are allocated based on the four member companies’ respective equity positions, while power and natural gas risk management activities for PSO and SWEPCo are allocated based on the Operating Agreement. With the transfer of OPCo’s generation assets to AGR in 2014, AEPSC conducts only gasoline, diesel fuel, energy procurement and risk management activities on OPCo’s behalf. +System Integration Agreement (Applies to APCo, I&M, PSO and SWEPCo) +Under the SIA, AEPSC allocates physical and financial revenues and expenses from transactions with neighboring utilities, power marketers and other power and natural gas risk management activities based upon the location of such activity. Margins resulting from trading and marketing activities originating in PJM generally accrue to the benefit of APCo, I&M, KPCo and WPCo, while trading and marketing activities originating in SPP generally accrue to the benefit of PSO and SWEPCo. Margins resulting from other transactions are allocated among APCo, I&M, KPCo, PSO, SWEPCo and WPCo based upon the equity positions of these companies. +382 +Affiliated Revenues and Purchases +The tables below represent revenues from affiliates, net of respective provisions for refund, by type of revenue for the Registrant Subsidiaries: +Related Party Revenues AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Year Ended December 31, 2020 +Direct Sales to East Affiliates $ — $ — $ 112.5 $ — $ — $ — $ — +Auction Sales to OPCo (a) — — 5.3 3.1 — — — +Direct Sales to AEPEP 87.5 — — — — — — +Transmission Revenues +— 885.0 49.1 2.9 16.6 — 37.4 +Other Revenues 3.3 11.3 7.8 4.5 24.9 5.2 1.6 +Total Affiliated Revenues $ 90.8 $ 896.3 $ 174.7 $ 10.5 $ 41.5 $ 5.2 $ 39.0 +Related Party Revenues AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Year Ended December 31, 2019 +Direct Sales to East Affiliates $ — $ — $ 128.6 $ — $ — $ — $ — +Auction Sales to OPCo (a) — — 11.4 6.7 — — — +Direct Sales to AEPEP 157.2 — — — — — ( 0.1 ) +Transmission Revenues +— 795.5 58.5 0.7 7.7 1.3 3.6 +Other Revenues 3.3 11.2 6.8 3.1 19.6 4.8 1.4 +Total Affiliated Revenues $ 160.5 $ 806.7 $ 205.3 $ 10.5 $ 27.3 $ 6.1 $ 4.9 +Related Party Revenues AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Year Ended December 31, 2018 +Direct Sales to East Affiliates $ — $ — $ 133.2 $ 0.1 $ — $ — $ — +Auction Sales to OPCo (a) — — 5.8 7.1 — — — +Direct Sales to AEPEP 103.6 — — — — — — +Transmission Revenues +— 591.4 36.4 11.7 3.9 0.9 26.9 +Other Revenues 1.6 7.5 6.0 3.2 17.1 4.5 1.5 +Total Affiliated Revenues $ 105.2 $ 598.9 $ 181.4 $ 22.1 $ 21.0 $ 5.4 $ 28.4 +(a) Refer to the Ohio Auctions section below for further information regarding these amounts. +383 +The tables below represent the purchased power expenses incurred for purchases from affiliates. AEP Texas, AEPTCo, APCo, PSO and SWEPCo did not purchase any power from affiliates for the years ended December 31, 2020, 2019 and 2018. +Related Party Purchases I&M OPCo +(in millions) +Year Ended December 31, 2020 +Auction Purchases from AEPEP (a) $ — $ 51.0 +Auction Purchases from AEP Energy (a) — 58.7 +Auction Purchases from AEPSC (a) — 10.0 +Direct Purchases from AEGCo 172.8 — +Total Affiliated Purchases $ 172.8 $ 119.7 +Related Party Purchases I&M OPCo +(in millions) +Year Ended December 31, 2019 +Auction Purchases from AEPEP (a) $ — $ 64.6 +Auction Purchases from AEP Energy (a) — 69.9 +Auction Purchases from AEPSC (a) — 21.5 +Direct Purchases from AEGCo 214.9 — +Total Affiliated Purchases $ 214.9 $ 156.0 +Related Party Purchases I&M OPCo +(in millions) +Year Ended December 31, 2018 +Auction Purchases from AEPEP (a) $ — $ 79.7 +Auction Purchases from AEP Energy (a) — 41.0 +Auction Purchases from AEPSC (a) — 14.6 +Direct Purchases from AEGCo 237.9 — +Total Affiliated Purchases $ 237.9 $ 135.3 +(a) Refer to the Ohio Auctions section below for further information regarding this amount. +The above summarized related party revenues and expenses are reported in Sales to AEP Affiliates and Purchased Electricity from AEP Affiliates, respectively, on the Registrant Subsidiaries’ statements of income. Since the Registrant Subsidiaries are included in AEP’s consolidated results, the above summarized related party transactions are eliminated in total in AEP’s consolidated revenues and expenses. +PJM and SPP Transmission Service Charges (Applies to all Registrant Subsidiaries except AEP Texas) +The AEP East Companies are parties to the TA, which defines how transmission costs through the PJM OATT are allocated among the AEP East Companies on a 12-month average coincident peak basis. Additional costs for transmission services provided by AEPTCo and other transmission affiliates are billed to AEP East Companies through the PJM OATT. +The following table shows the net transmission service charges recorded by APCo, I&M and OPCo: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +APCo $ 243.2 $ 222.3 $ 128.3 +I&M 145.9 143.5 91.4 +OPCo 417.4 373.4 210.1 +The charges shown above are recorded in Other Operation expenses on the statements of income. +384 +PSO, SWEPCo and AEPSC are parties to the TCA in connection with the operation of the transmission assets of PSO and SWEPCo. The TCA has been approved by the FERC and establishes a coordinating committee, which is charged with overseeing the coordinated planning of the transmission facilities of the parties to the agreement. This includes the performance of transmission planning studies, the interaction of such companies with independent system operators and other regional bodies interested in transmission planning and compliance with the terms of the OATT filed with the FERC and the rules of the FERC relating to such a tariff. +Under the TCA, the parties to the agreement delegated to AEPSC the responsibility of monitoring the reliability of their transmission systems and administering the OATT on their behalf. The allocations have been governed by the FERC-approved OATT for the SPP. Additional costs for transmission services provided by AEPTCo and other transmission affiliates are billed to PSO and SWEPCo through the SPP OATT. +The following table shows the net transmission service charges recorded by PSO and SWEPCo: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +PSO $ 69.7 $ 46.9 $ 65.9 +SWEPCo 31.3 20.1 10.5 +The charges shown above are recorded in Other Operation expenses on the statements of income. +AEPTCo provides transmission services to affiliates in accordance with the OATT, TA and TCA. AEPTCo recorded affiliated transmission revenues in Sales to AEP Affiliates on the statements of income. Refer to the Affiliated Revenues and Purchases section above for amounts related to these transactions. +ERCOT Transmission Service Charges (Applies to AEP and AEP Texas) +Pursuant to an order from the PUCT, ETT bills AEP Texas for its ERCOT wholesale transmission services. ETT billed AEP Texas $ 28 million, $ 27 million and $ 27 million for transmission services in 2020, 2019 and 2018, respectively. The billings are recorded in Other Operation expenses on AEP Texas’ statements of income. +Oklaunion PPA between AEP Texas and AEPEP (Applies to AEP Texas) +In 2007, AEP Texas entered into a PPA with an affiliate, AEPEP, whereby AEP Texas agreed to sell AEPEP 100% of AEP Texas’ capacity and associated energy from its undivided interest ( 54.69 %) in the Oklaunion Power Station. The PPA was approved by the FERC. In September 2018, the co-owners of Oklaunion Power Station voted to close the plant in 2020. Effective October 2018, AEP Texas increased depreciation expense to ensure the plant balances are fully depreciated as of September 2020 and recovered through the PPA billings to AEPEP. Under the early termination provisions of the PPA, AEPEP paid AEP Texas the full Property, Plant and Equipment balance through depreciation payments until termination of the PPA due to the plant closing in September 2020. See “Dispositions” section of Note 7 for additional information. +AEP Texas recorded revenue of $ 88 million, $ 157 million and $ 104 million from AEPEP for the years ended December 31, 2020, 2019 and 2018, respectively. These amounts are included in Sales to AEP Affiliates on AEP Texas’ statements of income. +385 +Joint License Agreement (Applies to AEPTCo, APCo, I&M, OPCo and PSO) +AEPTCo entered into a 50-year joint license agreement with APCo, I&M, KPCo, OPCo and PSO, respectively, allowing either party to occupy the granting party’s facilities or real property. In addition, AEPTCo entered into a 5-year joint license agreement with APCo and WPCo. After the expiration of these agreements, the term shall automatically renew for successive one-year terms unless either party provides notice. The joint license billing provides compensation to the granting party for the cost of carrying assets, including depreciation expense, property taxes, interest expense, return on equity and income taxes. AEPTCo recorded the following costs in Other Operation expense related to these agreements: +Years Ended December 31, +Billing Company 2020 2019 2018 +(in millions) +APCo $ 0.9 $ 0.2 $ — +I&M 3.0 1.5 2.2 +KPCo 0.4 0.3 0.2 +OPCo 4.5 2.2 2.9 +PSO 0.4 0.3 0.3 +WPCo 0.2 0.1 — +APCo, I&M, KPCo, OPCo, PSO and WPCo recorded income related to these agreements in Sales to AEP Affiliates on the statements of income. +Ohio Auctions (Applies to APCo, I&M and OPCo) +In connection with OPCo’s June 2012 - May 2015 ESP, the PUCO ordered OPCo to conduct energy and capacity auctions for its entire SSO load for delivery beginning in June 2015. AEP Energy, AEPEP, APCo, KPCo, I&M and WPCo participate in the auction process and have been awarded tranches of OPCo’s SSO load. Refer to the Affiliated Revenues and Purchases section above for amounts related to these transactions. +Unit Power Agreements (Applies to I&M) +UPA between AEGCo and I&M +A UPA between AEGCo and I&M (the I&M Power Agreement) provides for the sale by AEGCo to I&M of all the power (and the energy associated therewith) available to AEGCo at the Rockport Plant unless it is sold to another utility. Subsequently, I&M assigns 30 % of the power to KPCo. See the “UPA between AEGCo and KPCo” section below. I&M is obligated, whether or not power is available from AEGCo, to pay as a demand charge for the right to receive such power (and as an energy charge for any associated energy taken by I&M) net of amounts received by AEGCo from any other sources, sufficient to enable AEGCo to pay all its operating and other expenses, including a rate of return on the common equity of AEGCo as approved by the FERC. In November 2020, management announced that AEP will not renew the Rockport Plant, Unit 2 lease when it expires in December 2022. The I&M Power Agreement will continue in effect until the debt obligations of AEGCo secured by the Rockport Plant have been satisfied and discharged (currently expected to be December 2028). +UPA between AEGCo and KPCo +Pursuant to an assignment between I&M and KPCo and a UPA between AEGCo and KPCo, AEGCo sells KPCo 30 % of the power (and the energy associated therewith) available to AEGCo from both units of the Rockport Plant. KPCo pays to AEGCo in consideration for the right to receive such power the same amounts which I&M would have paid AEGCo under the terms of the I&M Power Agreement for such entitlement. In November 2020, management announced that AEP will not renew the Rockport Plant, Unit 2 lease when it expires in December 2022. The KPCo UPA ends in December 2022. +386 +Cook Coal Terminal (Applies to I&M, PSO and SWEPCo) +Cook Coal Terminal, which is owned by AEGCo, performs coal transloading and storage services at cost for I&M. The coal transloading costs were $ 12 million, $ 13 million and $ 12 million in 2020, 2019 and 2018, respectively. I&M recorded the cost of transloading services in Fuel on the balance sheets. +Cook Coal Terminal also performs railcar maintenance services at cost for I&M, PSO and SWEPCo. The railcar maintenance costs were as follows: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +I&M $ 0.9 $ 1.3 $ 1.5 +PSO 0.7 0.8 0.7 +SWEPCo 3.0 4.0 3.4 +I&M, PSO and SWEPCo recorded the cost of the railcar maintenance services in Fuel on the balance sheets. +I&M Barging, Urea Transloading and Other Services (Applies to APCo and I&M) +I&M provides barging, urea transloading and other transportation services to affiliates. Urea is a chemical used to control NO x emissions at certain generation plants in the AEP System. I&M recorded revenues from barging, transloading and other services in Other Revenues – Affiliated on the statements of income. The affiliated companies recorded these costs paid to I&M as fuel expenses or other operation expenses. The amounts of affiliated expenses were: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AEGCo $ 10.6 $ 14.9 $ 19.9 +APCo 43.7 38.9 35.1 +KPCo 3.2 4.8 4.2 +WPCo +3.3 4.8 4.2 +Central Machine Shop (Applies to APCo, I&M, PSO and SWEPCo) +APCo operates a facility which repairs and rebuilds specialized components for the generation plants across the AEP System. APCo defers the cost of performing these services on the balance sheet and then transfers the cost to the affiliate for reimbursement. The AEP subsidiaries recorded these billings as capital or maintenance expenses depending on the nature of the services received. These billings are recoverable from customers. The following table provides the amounts billed by APCo to the following affiliates: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AGR $ 2.9 $ 0.8 $ 1.6 +I&M 3.2 2.3 2.4 +KPCo 0.9 1.4 1.7 +PSO 0.9 1.1 0.5 +SWEPCo 0.5 1.1 0.7 +387 +Sales and Purchases of Property +Certain AEP subsidiaries had affiliated sales and purchases of electric property individually amounting to $100 thousand or more, sales and purchases of meters and transformers, and sales and purchases of transmission property. There were no gains or losses recorded on the transactions. The following tables show the sales and purchases, recorded at net book value: +Sales +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AEP Texas $ 0.9 $ 0.9 $ 0.3 +AEPTCo 0.2 — — +APCo 5.7 5.5 5.4 +I&M 1.5 7.5 8.2 +OPCo 7.0 7.0 10.7 +PSO 1.1 0.8 1.0 +SWEPCo 0.8 0.2 0.8 +Purchases +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AEP Texas $ 1.5 $ 0.3 $ 0.1 +AEPTCo 6.0 10.2 18.5 +APCo 1.3 6.0 0.6 +I&M 3.4 0.9 2.0 +OPCo 1.2 3.0 2.8 +PSO 0.4 0.5 1.3 +SWEPCo 2.8 0.7 0.8 +The amounts above are recorded in Property, Plant and Equipment on the balance sheets. +Sempra Renewables LLC PPAs (Applies to I&M, OPCo and SWEPCo) +In April 2019, AEP acquired Sempra Renewables LLC and its ownership interests in 724 MWs of wind generation. The operating wind generation portfolio includes seven wind farms. Prior to the acquisition, two wind farms had existing PPAs with I&M, OPCo and SWEPCo. One of the joint venture wind farms has PPAs with I&M and OPCo for a portion of its energy production. The I&M portion totaled $ 11 million and $ 9 million and the OPCo portion totaled $ 23 million and $ 17 million, respectively, for the years ended December 31, 2020 and 2019. Another joint venture wind farm has a PPA with SWEPCo for a portion of its energy production which totaled $ 14 million and $ 10 million, respectively, of purchased electricity for the years ended December 31, 2020 and 2019. See “Acquisitions” section of Note 7 for additional information. +Intercompany Billings +The Registrant Subsidiaries and other AEP subsidiaries perform certain utility services for each other when necessary or practical. The costs of these services are billed on a direct-charge basis, whenever possible, or on reasonable basis of proration for services that benefit multiple companies. The billings for services are made at cost and include no compensation for the use of equity capital. +388 +Charitable Contributions to AEP Foundation +The American Electric Power Foundation is funded by American Electric Power and its utility operating units. The Foundation provides a permanent, ongoing resource for charitable initiatives and multi-year commitments in the communities served by AEP and initiatives outside of AEP’s 11-state service area. Charitable contributions to the AEP Foundation were recorded in Other Operation on the statements of income. In 2020, there were no charitable contributions made to the AEP Foundation. The charitable contributions to the AEP Foundation recorded in 2019 were as follows: +Year Ended +Company December 31, 2019 +(in millions) +AEP $ 50.0 +AEP Texas 6.2 +AEPTCo 6.5 +APCo 8.9 +I&M 9.0 +OPCo 5.4 +PSO 3.4 +SWEPCo 5.5 +OKTCo Radial Assets Transfer (Applies to AEP, AEPTCo and PSO) +In August 2020, AEPSC filed a request with FERC, on behalf of PSO and OKTCo, to transfer OKTCo's interests in its radial assets to PSO. See “FERC Rate Matters” section of Note 4 for additional information. +389 +17. VARIABLE INTEREST ENTITIES AND EQUITY METHOD INVESTMENTS +The disclosures in this note apply to all Registrants unless indicated otherwise. +The accounting guidance for “Variable Interest Entities” is a consolidation model that considers if a company has a variable interest in a VIE. A VIE is a legal entity that possesses any of the following conditions: the entity’s equity at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support, equity owners are unable to direct the activities that most significantly impact the legal entity’s economic performance (or they possess disproportionate voting rights in relation to the economic interest in the legal entity), or the equity owners lack the obligation to absorb the legal entity’s expected losses or the right to receive the legal entity’s expected residual returns. Entities are required to consolidate a VIE when it is determined that they have a controlling financial interest in a VIE and therefore, are the primary beneficiary of that VIE, as defined by the accounting guidance for “Variable Interest Entities.” In determining whether AEP is the primary beneficiary of a VIE, management considers whether AEP has the power to direct the most significant activities of the VIE and is obligated to absorb losses or receive the expected residual returns that are significant to the VIE. Management believes that significant assumptions and judgments were applied consistently. +AEP holds ownership interests in businesses with varying ownership structures. Partnership interests and other variable interests are evaluated to determine if each entity is a VIE, and if so, whether or not the VIE should be consolidated into AEP’s financial statements. AEP has not provided material financial or other support that was not previously contractually required to any of its consolidated VIEs. If an entity is determined not to be a VIE, or if the entity is determined to be a VIE and AEP is not deemed to be the primary beneficiary, the entity is accounted for under the equity method of accounting. +Consolidated Variable Interests Entities (Applies to all Registrants except AEPTCo, OPCo and PSO) +Sabine +Sabine is a mining operator providing mining services to SWEPCo. SWEPCo has no equity investment in Sabine but is Sabine’s only customer. SWEPCo guarantees the debt obligations and lease obligations of Sabine. Under the terms of the note agreements, substantially all assets are pledged and all rights under the lignite mining agreement are assigned to SWEPCo. The creditors of Sabine have no recourse to any AEP entity other than SWEPCo. Under the provisions of the mining agreement, SWEPCo is required to pay, as a part of the cost of lignite delivered, an amount equal to mining costs plus a management fee. In addition, SWEPCo determines how much coal will be mined each year. Based on these facts, management concluded that SWEPCo is the primary beneficiary and is required to consolidate Sabine. SWEPCo’s total billings from Sabine for the years ended December 31, 2020, 2019 and 2018 were $ 131 million, $ 110 million and $ 152 million, respectively. See the tables below for the classification of Sabine’s assets and liabilities on SWEPCo’s balance sheets. +As part of the process to receive a renewal of a Texas Railroad Commission permit for lignite mining, SWEPCo provides guarantees of mine reclamation of $ 155 million. Since SWEPCo uses self-bonding, the guarantee commits SWEPCo to complete the reclamation, in the event, Sabine does not complete the work. This guarantee ends upon completion of reclamation. The mine end-of-life has been adjusted to March 2023, in order to align with the announced closure of the Pirkey Power Plant. Reclamation is expected to be complete by 2037 at an estimated cost of $ 104 million. Actual reclamation costs could vary due to inflation and scope changes to the mine reclamation. SWEPCo recovers these costs through its fuel clauses. As of December 31, 2020, SWEPCo has recorded $ 89 million of mine reclamation costs in Asset Retirement Obligations and has collected $ 81 million through a rider for reclamation costs. The remaining $ 8 million is recorded in Deferred Charges and Other Noncurrent Assets on SWEPCo’s balance sheets. +390 +DCC Fuel +I&M has nuclear fuel lease agreements with DCC Fuel, which was formed for the purpose of acquiring, owning and leasing nuclear fuel to I&M. DCC Fuel purchased the nuclear fuel from I&M with funds received from the issuance of notes to financial institutions. Each DCC Fuel entity is a single-lessee leasing arrangement with only one asset and is capitalized with all debt. Each is a separate legal entity from I&M, the assets of which are not available to satisfy the debts of I&M. Payments on the leases for the years ended December 31, 2020, 2019 and 2018 were $ 94 million, $ 95 million and $ 113 million, respectively. The leases were recorded as finance leases on I&M’s balance sheets as title to the nuclear fuel transfers to I&M at the end of the respective lease terms, which do not exceed 54 months. Based on I&M’s control of DCC Fuel, management concluded that I&M is the primary beneficiary and is required to consolidate DCC Fuel. The finance leases are eliminated upon consolidation. See the tables below for the classification of DCC Fuel’s assets and liabilities on I&M’s balance sheets. +Transition Funding +Transition Funding was formed for the sole purpose of issuing and servicing securitization bonds related to Texas Restructuring Legislation. Management has concluded that AEP Texas is the primary beneficiary of Transition Funding because AEP Texas has the power to direct the most significant activities of the VIE and AEP Texas’ equity interest could potentially be significant. Therefore, AEP Texas is required to consolidate Transition Funding. As of December 31, 2020 and 2019, $ 66 million and $ 267 million of the securitized bonds were included in Long-term Debt Due Within One Year - Nonaffiliated, respectively, and $ 209 million and $ 274 million were included in Long-term Debt - Nonaffiliated, respectively, on the balance sheets. Transition Funding has securitized transition assets of $ 242 million and $ 389 million as of December 31, 2020 and 2019, respectively, which are presented separately on the face of the balance sheets. The securitized transition assets represent the right to impose and collect Texas true-up costs from customers receiving electric transmission or distribution service from AEP Texas under-recovery mechanisms approved by the PUCT. The securitization bonds are payable only from and secured by the securitized transition assets. The bondholders have no recourse to AEP Texas or any other AEP entity. AEP Texas acts as the servicer for Transition Funding’s securitized transition assets and remits all related amounts collected from customers to Transition Funding for interest and principal payments on the securitization bonds and related costs. See the tables below for the classification of Transition Funding’s assets and liabilities on the balance sheets. +Restoration Funding +Restoration Funding was formed for the sole purpose of issuing and servicing securitization bonds related to storm restoration of AEP Texas’ distribution system primarily due to damage caused by Hurricane Harvey. Management has concluded that AEP Texas is the primary beneficiary of Restoration Funding because AEP Texas has the power to direct the most significant activities of the VIE and AEP Texas’ equity interest could potentially be significant. Therefore, AEP Texas is required to consolidate Restoration Funding. As of December 2020 and 2019, $ 23 million and $ 14 million of the securitized bonds were included in Long-term Debt Due Within One Year - Nonaffiliated, respectively, and $ 195 million and $ 221 million were included in Long-term Debt - Nonaffiliated, respectively, on the balance sheets. Restoration Funding has securitized assets of $ 205 million and $ 232 million as of December 31, 2020 and 2019, respectively, which are presented separately on the face of the balance sheets. The securitized restoration assets represent the right to impose and collect Texas storm restoration costs from customers receiving electric transmission or distribution service from AEP Texas under-recovery mechanisms approved by the PUCT. The securitization bonds are payable only from and secured by the securitized assets. The bondholders have no recourse to AEP Texas or any other AEP entity. AEP Texas acts as the servicer for Restoration Funding’s securitized assets and remits all related amounts collected from customers to Restoration Funding for interest and principal payments on the securitization bonds and related costs. See the table below for the classification of Restoration Funding’s assets and liabilities on the balance sheets. +391 +Appalachian Consumer Rate Relief Funding +Appalachian Consumer Rate Relief Funding was formed for the sole purpose of issuing and servicing securitization bonds related to APCo’s under-recovered ENEC deferral balance. Management has concluded that APCo is the primary beneficiary of Appalachian Consumer Rate Relief Funding because APCo has the power to direct the most significant activities of the VIE and APCo’s equity interest could potentially be significant. Therefore, APCo is required to consolidate Appalachian Consumer Rate Relief Funding. As of December 31, 2020 and 2019, $ 25 million and $ 25 million of the securitized bonds were included in Long-term Debt Due Within One Year - Nonaffiliated, respectively, and $ 199 million and $ 223 million were included in Long-term Debt - Nonaffiliated, respectively, on the balance sheets. Appalachian Consumer Rate Relief Funding has securitized assets of $ 210 million and $ 235 million as of December 31, 2020 and 2019, respectively, which are presented separately on the face of the balance sheets. The phase-in recovery property represents the right to impose and collect West Virginia deferred generation charges from customers receiving electric transmission, distribution and generation service from APCo under a recovery mechanism approved by the WVPSC. In November 2013, securitization bonds were issued. The securitization bonds are payable only from and secured by the securitized assets. The bondholders have no recourse to APCo or any other AEP entity. APCo acts as the servicer for Appalachian Consumer Rate Relief Funding’s securitized assets and remits all related amounts collected from customers to Appalachian Consumer Rate Relief Funding for interest and principal payments on the securitization bonds and related costs. See the tables below for the classification of Appalachian Consumer Rate Relief Funding’s assets and liabilities on APCo’s balance sheets. +AEP Credit +AEP Credit is a wholly-owned subsidiary of Parent. AEP Credit purchases, without recourse, accounts receivable from certain utility subsidiaries of AEP to reduce working capital requirements. AEP provides a minimum of 5 % equity and up to 25 % of AEP Credit’s short-term borrowing needs in excess of third-party financings. Any third-party financing of AEP Credit only has recourse to the receivables securitized for such financing. Based on AEP’s control of AEP Credit, management concluded that AEP is the primary beneficiary and is required to consolidate AEP Credit. See the tables below for the classification of AEP Credit’s assets and liabilities on the balance sheets. See “Securitized Accounts Receivables - AEP Credit” section of Note 14. +EIS +AEP’s subsidiaries participate in one protected cell of EIS for six lines of insurance. EIS has multiple protected cells. Neither AEP nor its subsidiaries have an equity investment in EIS. The AEP System is essentially this EIS cell’s only participant, but allows certain third-parties access to this insurance. AEP’s subsidiaries and any allowed third-parties share in the insurance coverage, premiums and risk of loss from claims. Based on AEP’s control and the structure of the protected cell of EIS, management concluded that AEP is the primary beneficiary of the protected cell and is required to consolidate the protected cell of EIS. The insurance premium expense to the protected cell for the years ended December 31, 2020, 2019 and 2018 was $ 31 million, $ 34 million and $ 34 million, respectively. See the tables below for the classification of the protected cell’s assets and liabilities on the balance sheets. The amount reported as equity is the protected cell’s policy holders’ surplus. +392 +Transource Energy +Transource Energy was formed for the purpose of investing in utilities which develop, acquire, construct, own and operate transmission facilities in accordance with FERC-approved rates. AEP has equity and voting ownership of 86.5 % with the other owner having 13.5 % interest. Management has concluded that Transource Energy is a VIE and that AEP is the primary beneficiary because AEP has the power to direct the most significant activities of the entity and AEP’s equity interest could potentially be significant. Therefore, AEP is required to consolidate Transource Energy. Transource Energy’s activities consist of the development, construction and operation of FERC-regulated transmission assets in Missouri, West Virginia, Pennsylvania, Maryland and Oklahoma. Transource Energy has a credit facility agreement where borrowings are loaned through intercompany lending agreements to its subsidiaries. The creditor to the agreement has no recourse to the general credit of AEP. Transource Energy’s credit facility agreement contains certain covenants and require it to maintain a percentage of debt-to-total capitalization at a level that does not exceed 67.5 %. See the tables below for the classification of Transource Energy’s assets and liabilities on the balance sheets. +Desert Sky Wind Farm LLC and Trent Wind Farm LLC +Desert Sky Wind Farm LLC and Trent Wind Farm LLC (collectively the LLCs) were established for the purpose of repowering, owning and operating wind-powered electric energy generation facilities in Texas. In January 2018, AEP admitted a nonaffiliate as a member of the LLCs to own and repower Desert Sky and Trent. The nonaffiliate contributed full turbine sets to each project in exchange for a 20.1 % interest in the LLCs. The nonaffiliates’ contribution of $ 84 million was recorded as Net Property, Plant and Equipment on the balance sheets, which was the fair value as of the contribution date determined based on key input assumptions of the original cost of the full turbine sets and the discounted cash flow benefit associated with the production tax credits available from repowering Desert Sky and Trent based on their expected net capacity, capacity factor and the operational availability. From January 2018 through July 2020, AEP owned 79.9 % of the LLCs. As a result, management concluded that the LLCs were VIEs and that AEP was the primary beneficiary based on its power to direct the activities that most significantly impact their economic performance. Also in January 2018, the LLCs entered into a forward PPA for the sale of power to AEPEP related to deliveries of electricity beginning January 1, 2021 for a 12 year period. Prior to the effective date of the PPA, the LLCs sold power at market rates into ERCOT. AEP and the nonaffiliate shared tax attributes including PTC and cash distributions from the operation of the LLCs generally consistent with the ownership percentages. See the tables below for the classification of the LLCs’ assets and liabilities on the balance sheets. +In August 2020, AEP exercised its call right which required the nonaffiliate to sell its noncontrolling interest in the LLCs to AEP. The nonaffiliates’ interest in the LLCs was presented as Redeemable Noncontrolling Interest on the balance sheets. The exercise price for the call right was determined using a discounted cash flow model with agreed input assumptions as well as updates to certain assumptions reasonably expected based on the actual results of the LLCs. As a result, the LLCs are wholly-owned by AEP and management has concluded that the LLCs are no longer VIEs. As of December 31, 2020 and 2019, AEP recorded $ 0 and $ 66 million, respectively, of Redeemable Noncontrolling Interest in Mezzanine Equity on the balance sheets. +393 +Apple Blossom Wind Holdings LLC and Black Oak Getty Wind Holdings LLC +In April 2019, AEP acquired an equity interest in Apple Blossom Wind Holdings LLC (Apple Blossom) and Black Oak Getty Wind Holdings LLC (Black Oak) (collectively the Project Entities) as part of the purchase of Sempra Renewables LLC. Both of the Project Entities have long-term PPAs for 100% of their energy production. The Project Entities are tax equity partnerships with nonaffiliated noncontrolling interests to which a percentage of earnings, tax attributes and cash flows are allocated in accordance with the respective limited liability company agreements. Management has concluded that the Project Entities are VIEs and that AEP is the primary beneficiary based on its power as managing member to direct the activities that most significantly impact the Project Entities’ economic performance. In addition, AEP has not provided material financial or other support to the Project Entities that was not previously contractually required. As the primary beneficiary of the Project Entities, AEP consolidates the Project Entities into its financial statements. See the table below for the classification of Project Entities’ assets and liabilities on the balance sheets. +The nonaffiliated interests in the Project Entities is presented in Noncontrolling Interests on the balance sheets. As of December 31, 2020 and 2019, AEP recorded $ 119 million and $ 128 million, respectively, of Noncontrolling Interests related to the Project Entities in Equity on the balance sheets. +The Project Entities’ tax equity partnerships represent substantive profit-sharing arrangements. The method for attributing income and loss to the noncontrolling interests is a balance sheet approach referred to as the hypothetical liquidation at book value (HLBV) method. Under the HLBV method, the income and loss attributable to the noncontrolling interests reflect changes in the amounts the members would hypothetically receive at each balance sheet date under the liquidation provisions of the respective limited liability company agreements, assuming the net assets of these entities were liquidated at recorded amounts, after taking into account any capital transactions, such as contributions or distributions, between the entities and the members. For the years ended December 31, 2020 and 2019, the HLBV method resulted in a loss of $ 6 million and $ 6 million, respectively, allocated to Noncontrolling Interests. +Santa Rita East +In July 2019, AEP acquired a 75 % interest in Santa Rita East Wind Energy Holdings, LLC and its wholly-owned subsidiary, Santa Rita East Wind Energy, LLC (collectively, Santa Rita East). In November 2020, AEP acquired an additional 10 % interest in Santa Rita East resulting in AEP having a total interest of 85 %. Santa Rita East is a partnership whose sole purpose is to own and operate a 302 MW wind generation facility in west Texas. Santa Rita East delivers energy and provides renewable energy credits through three long-term PPAs totaling 260 MWs. The remaining 42 MWs of energy are sold at wholesale into ERCOT. Management has concluded that Santa Rita East is a VIE and that AEP is the primary beneficiary based on its power as managing member of the partnership to direct the activities that most significantly impact Santa Rita East’s economic performance. As the primary beneficiary of Santa Rita East, AEP consolidates Santa Rita East into its financial statements. See the table below for the classification of Santa Rita East’s assets and liabilities on the balance sheets. +AEP recognized $ 23 million and $ 10 million of PTC attributable to Santa Rita East for the years ended December 31, 2020 and 2019, respectively, which was recorded in Income Tax Expense (Benefit) on the statements of income. The nonaffiliated interest in Santa Rita East is presented in Noncontrolling Interests on the balance sheets. As of December 31, 2020 and 2019, AEP recorded $ 61 million and $ 118 million, respectively, of Noncontrolling Interests related to Santa Rita East in Equity on the balance sheets. +394 +The balances below represent the assets and liabilities of the VIEs that are consolidated. These balances include intercompany transactions that are eliminated upon consolidation. +American Electric Power Company, Inc. and Subsidiary Companies +Variable Interest Entities +December 31, 2020 +Registrant Subsidiaries +SWEPCo +Sabine I&M +DCC Fuel AEP Texas Transition Funding AEP Texas Restoration Funding APCo +Appalachian +Consumer +Rate +Relief Funding +(in millions) +ASSETS +Current Assets $ 88.0 $ 76.1 $ 61.2 $ 23.3 $ 16.8 +Net Property, Plant and Equipment 97.3 138.9 — — — +Other Noncurrent Assets 99.3 70.9 273.9 (a) 214.9 (b) 212.7 (c) +Total Assets $ 284.6 $ 285.9 $ 335.1 $ 238.2 $ 229.5 +LIABILITIES AND EQUITY +Current Liabilities $ 57.7 $ 76.0 $ 69.8 $ 33.9 $ 28.7 +Noncurrent Liabilities 225.3 209.9 246.5 203.1 198.9 +Equity 1.6 — 18.8 1.2 1.9 +Total Liabilities and Equity $ 284.6 $ 285.9 $ 335.1 $ 238.2 $ 229.5 +(a) Includes an intercompany item eliminated in consolidation of $ 32 million. +(b) Includes an intercompany item eliminated in consolidation of $ 9 million. +(c) Includes an intercompany item eliminated in consolidation of $ 3 million. +American Electric Power Company, Inc. and Subsidiary Companies +Variable Interest Entities +December 31, 2020 +Other Consolidated VIEs +AEP Credit Protected +Cell +of EIS Transource Energy Apple Blossom and Black Oak Santa Rita East +(in millions) +ASSETS +Current Assets $ 960.4 $ 198.1 $ 22.2 $ 9.6 $ 6.0 +Net Property, Plant and Equipment — — 458.7 223.1 453.1 +Other Noncurrent Assets 12.9 — 3.7 12.1 — +Total Assets $ 973.3 $ 198.1 $ 484.6 $ 244.8 $ 459.1 +LIABILITIES AND EQUITY +Current Liabilities $ 827.2 $ 43.1 $ 32.6 $ 5.3 $ 3.5 +Noncurrent Liabilities 0.8 62.5 185.0 4.9 6.7 +Equity 145.3 92.5 267.0 234.6 448.9 +Total Liabilities and Equity $ 973.3 $ 198.1 $ 484.6 $ 244.8 $ 459.1 +395 +American Electric Power Company, Inc. and Subsidiary Companies +Variable Interest Entities +December 31, 2019 +Registrant Subsidiaries +SWEPCo +Sabine I&M +DCC Fuel AEP Texas Transition Funding AEP Texas Restoration Funding APCo +Appalachian +Consumer +Rate +Relief Funding +(in millions) +ASSETS +Current Assets $ 80.0 $ 86.5 $ 187.0 $ 9.4 $ 21.5 +Net Property, Plant and Equipment 111.6 156.8 — — — +Other Noncurrent Assets 93.2 82.5 428.1 (a) 234.4 (b) 237.5 (c) +Total Assets $ 284.8 $ 325.8 $ 615.1 $ 243.8 $ 259.0 +LIABILITIES AND EQUITY +Current Liabilities $ 50.6 $ 86.4 $ 280.2 $ 16.3 $ 28.3 +Noncurrent Liabilities 233.6 239.4 316.3 226.3 228.8 +Equity 0.6 — 18.6 1.2 1.9 +Total Liabilities and Equity $ 284.8 $ 325.8 $ 615.1 $ 243.8 $ 259.0 +(a) Includes an intercompany item eliminated in consolidation of $ 39 million. +(b) Includes an intercompany item eliminated in consolidation of $ 1 million. +(c) Includes an intercompany item eliminated in consolidation of $ 3 million. +American Electric Power Company, Inc. and Subsidiary Companies +Variable Interest Entities +December 31, 2019 +Other Consolidated VIEs +AEP Credit Protected +Cell +of EIS Transource Energy Desert Sky +and +Trent Apple Blossom and Black Oak Santa Rita East +(in millions) +ASSETS +Current Assets $ 842.8 $ 194.6 $ 25.8 $ 7.8 $ 10.1 $ 17.7 +Net Property, Plant and Equipment — — 424.1 330.6 231.4 465.2 +Other Noncurrent Assets 7.1 — 3.2 10.1 13.1 0.3 +Total Assets $ 849.9 $ 194.6 $ 453.1 $ 348.5 $ 254.6 $ 483.2 +LIABILITIES AND EQUITY +Current Liabilities $ 805.2 $ 40.7 $ 192.4 $ 5.5 $ 5.4 $ 3.9 +Noncurrent Liabilities 0.9 78.0 4.8 15.8 4.7 7.5 +Equity 43.8 75.9 255.9 327.2 244.5 471.8 +Total Liabilities and Equity $ 849.9 $ 194.6 $ 453.1 $ 348.5 $ 254.6 $ 483.2 +396 +Non-Consolidated Significant Variable Interests +DHLC +DHLC is a mining operator which sells 50 % of the lignite produced to SWEPCo and 50 % to CLECO. The operations of DHLC are governed by the lignite mining agreement among SWEPCo, CLECO and DHLC. SWEPCo and CLECO share the executive board seats and voting rights equally. In accordance with the lignite mining agreement, each entity is responsible for 50 % of DHLC’s obligations, including debt. SWEPCo and CLECO equally approve DHLC’s annual budget. The creditors of DHLC have no recourse to any AEP entity other than SWEPCo. As SWEPCo is the sole equity owner of DHLC, it receives 100 % of the management fee. SWEPCo’s total billings from DHLC for the years ended December 31, 2020, 2019 and 2018 were $ 142 million, $ 55 million and $ 58 million, respectively. SWEPCo is not required to consolidate DHLC as it is not the primary beneficiary, although SWEPCo holds a significant variable interest in DHLC. SWEPCo’s equity investment in DHLC is included in Deferred Charges and Other Noncurrent Assets on SWEPCo’s balance sheets. +SWEPCo’s investment in DHLC was: +December 31, +2020 2019 +As Reported on +the Balance Sheet Maximum +Exposure As Reported on +the Balance Sheet Maximum +Exposure +(in millions) +Capital Contribution from SWEPCo $ 7.6 $ 7.6 $ 7.6 $ 7.6 +Retained Earnings 20.4 20.4 17.5 17.5 +SWEPCo’s Share of Obligations — 98.5 — 130.0 +Total Investment in DHLC $ 28.0 $ 126.5 $ 25.1 $ 155.1 +OVEC +AEP and several nonaffiliated utility companies jointly own OVEC. As of December 31, 2020, AEP’s ownership in OVEC was 43.47 %. Parent owns 39.17 % and OPCo owns 4.3 %. APCo, I&M and OPCo are members to an intercompany power agreement. The Registrants’ power participation ratios are 15.69 % for APCo, 7.85 % for I&M and 19.93 % for OPCo. Participants of this agreement are entitled to receive and are obligated to pay for all OVEC generating capacity, approximately 2,400 MWs, in proportion to their respective power participation ratios. The proceeds from the sale of power by OVEC are designed to be sufficient for OVEC to meet its operating expenses and fixed costs, including outstanding indebtedness, and provide a return on capital. The intercompany power agreement ends in June 2040 . +AEP and other nonaffiliated owners authorized environmental investments related to their ownership interests. OVEC financed capital expenditures in connection with the engineering and construction of FGD projects and the associated waste disposal landfills at its two generation plants. These environmental projects were funded through debt issuances. As of December 31, 2020 and 2019, OVEC’s outstanding indebtedness was approximately $ 1.3 billion and $ 1.4 billion, respectively. Although they are not an obligor or guarantor, the Registrants’ are responsible for their respective ratio of OVEC’s outstanding debt through the intercompany power agreement. Principal and interest payments related to OVEC’s outstanding indebtedness are disclosed in accordance with the accounting guidance for “Commitments.” See the “Commitments” section of Note 6 for additional information. +AEP is not required to consolidate OVEC as it is not the primary beneficiary, although AEP and its subsidiary holds a significant variable interest in OVEC. Power to control decision making that significantly impacts the economic performance of OVEC is shared amongst the owners through their representation on the Board of Directors of OVEC and the representation of the sponsoring companies on the Operating Committee under the intercompany power agreement. +397 +AEP’s investment in OVEC was: +December 31, +2020 2019 +As Reported on +the Balance Sheet Maximum +Exposure As Reported on +the Balance Sheet Maximum Exposure +(in millions) +Capital Contribution from AEP $ 4.4 $ 4.4 $ 4.4 $ 4.4 +AEP’s Ratio of OVEC Debt (a) — 555.0 — 588.9 +Total Investment in OVEC $ 4.4 $ 559.4 $ 4.4 $ 593.3 +(a) Based on the Registrants’ power participation ratios APCo, I&M and OPCo’s share of OVEC debt was $ 200 million, $ 100 million and $ 255 million as of December 31, 2020 and $ 213 million, $ 106 million and $ 270 million as of December 31, 2019, respectively. +Power purchased by the Registrant Subsidiaries from OVEC is included in Purchased Electricity for Resale on the statements of income and is shown in the table below: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +APCo $ 94.4 $ 104.5 $ 100.4 +I&M 47.2 52.3 50.2 +OPCo 120.8 132.7 127.5 +AEPSC +AEPSC provides certain managerial and professional services to AEP’s subsidiaries. Parent is the sole equity owner of AEPSC. AEP management controls the activities of AEPSC. The costs of the services are based on a direct-charge or on a prorated basis and billed to the AEP subsidiary companies at AEPSC’s cost. AEP subsidiaries have not provided financial or other support outside of the reimbursement of costs for services rendered. AEPSC finances its operations through cost reimbursement from other AEP subsidiaries. There are no other terms or arrangements between AEPSC and any of the AEP subsidiaries that could require additional financial support from an AEP subsidiary or expose them to losses outside of the normal course of business. AEPSC and its billings are subject to regulation by the FERC. AEP subsidiaries are exposed to losses to the extent they cannot recover the costs of AEPSC through their normal business operations. AEP subsidiaries are considered to have a significant interest in AEPSC due to their activity in AEPSC’s cost reimbursement structure. However, AEP subsidiaries do not have control over AEPSC. AEPSC is consolidated by AEP. In the event AEPSC would require financing or other support outside the cost reimbursement billings, this financing would be provided by AEP. +398 +Total AEPSC billings to the Registrant Subsidiaries were as follows: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AEP Texas $ 199.4 $ 206.6 $ 184.3 +AEPTCo 270.3 242.3 220.4 +APCo 294.9 308.3 295.6 +I&M 210.2 184.8 173.5 +OPCo 232.8 230.4 214.9 +PSO 113.2 125.7 121.5 +SWEPCo 161.8 169.5 164.4 +The carrying amount and classification of variable interest in AEPSC’s accounts payable were as follows: +December 31, +2020 2019 +Company As Reported on +the Balance Sheet Maximum +Exposure As Reported on +the Balance Sheet Maximum +Exposure +(in millions) +AEP Texas $ 30.5 $ 30.5 $ 32.4 $ 32.4 +AEPTCo 45.9 45.9 33.4 33.4 +APCo 42.8 42.8 44.1 44.1 +I&M 27.1 27.1 28.6 28.6 +OPCo 33.9 33.9 33.2 33.2 +PSO 15.7 15.7 18.1 18.1 +SWEPCo 22.0 22.0 23.4 23.4 +AEGCo +AEGCo, a wholly-owned subsidiary of Parent, is consolidated by AEP. AEGCo owns a 50 % ownership interest in Rockport Plant, Unit 1 and leases a 50 % interest in Rockport Plant, Unit 2. AEGCo sells all the output from the Rockport Plant to I&M and KPCo. AEP has agreed to provide AEGCo with the funds necessary to satisfy all of the debt obligations of AEGCo. I&M is considered to have a significant interest in AEGCo due to these transactions. I&M is exposed to losses to the extent it cannot recover the costs of AEGCo through its normal business operations. In the event AEGCo would require financing or other support outside the billings to I&M and KPCo, this financing would be provided by AEP. Total billings to I&M from AEGCo for the years ended December 31, 2020, 2019 and 2018 were $ 173 million, $ 215 million and $ 238 million, respectively. The carrying amounts of I&M’s liabilities associated with AEGCo as of December 31, 2020 and 2019 were $ 9 million and $ 10 million, respectively. Management estimates the maximum exposure of loss to be equal to the amount of such liability. See “Rockport Lease” section of Note 13 for additional information. +399 +Significant Equity Method Investments in Unconsolidated Entities +For a discussion of the equity method of accounting, see the “Equity Investment in Unconsolidated Entities” section of Note 1. +Sempra Renewables LLC +In April 2019, AEP acquired a 50 % interest in five wind farms in multiple states as part of the purchase of Sempra Renewables LLC. The wind farms are joint ventures with BP Wind Energy who holds the other 50 % interest. All five wind farms have long-term PPAs for 100% of their energy production. One of the jointly-owned wind farms has PPAs with I&M and OPCo for a portion of its energy production. Another jointly-owned wind farm has a PPA with SWEPCo for a portion of its energy production. The joint venture wind farms are not considered VIEs and AEP is not required to consolidate them as AEP does not have a controlling financial interest. However, AEP is able to exercise significant influence over the wind farms and therefore applies the equity method of accounting. As of December 31, 2020 and 2019, AEP’s investment in the five joint venture wind farms was $ 376 million and $ 394 million, respectively. The investment includes amounts recognized in AOCI related to interest rate cash flow hedges. The investment is comprised of a historical investment of $ 399 million plus a basis difference of $( 12 ) million. AEP’s equity earnings associated with the five joint venture wind farms was $ 2 million and a loss of $ 4 million for the years ended December 31, 2020 and 2019, respectively. AEP recognized $ 36 million and $ 27 million of PTC attributable to the joint venture wind farms for the years ended December 31, 2020 and 2019, respectively, which was recorded in Income Tax Expense (Benefit) on the statements of income. +ETT +ETT designs, acquires, constructs, owns and operates certain transmission facilities in ERCOT. Berkshire Hathaway Energy, a nonaffiliated entity, holds a 50 % membership interest in ETT and AEP Transmission Holdco holds a 50 % membership interest in ETT. As a result, AEP, through its wholly-owned subsidiary, holds a 50% membership interest in ETT. As of December 31, 2020 and 2019, AEP’s investment in ETT was $ 732 million and $ 695 million, respectively. AEP’s equity earnings associated with ETT were $ 68 million, $ 66 million and $ 62 million for the years ended December 31, 2020, 2019 and 2018 respectively. +400 +18. PROPERTY, PLANT AND EQUIPMENT +The disclosures in this note apply to all Registrants unless indicated otherwise. +Property, Plant and Equipment is shown functionally on the face of the balance sheets. The following tables include the total plant balances as of December 31, 2020 and 2019: +December 31, 2020 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Regulated Property, Plant and Equipment +Generation +$ 21,587.8 (a) $ — $ — $ 6,633.7 $ 5,264.7 $ — $ 1,480.7 $ 4,681.4 (a) +Transmission 27,841.5 5,279.6 9,593.5 3,900.5 1,696.4 2,831.9 1,069.9 2,165.7 +Distribution 23,972.1 4,580.8 — 4,464.3 2,594.6 5,708.3 2,853.0 2,382.5 +Other 4,852.4 866.0 328.8 598.0 644.6 888.5 388.1 564.5 +CWIP 3,815.0 (a) 614.1 1,422.6 484.6 362.4 362.3 128.7 228.3 (a) +Less: Accumulated Depreciation +20,094.2 1,528.1 572.8 4,711.0 3,538.6 2,348.8 1,607.3 3,032.0 +Total Regulated Property, Plant and Equipment - Net +61,974.6 9,812.4 10,772.1 11,370.1 7,024.1 7,442.2 4,313.1 6,990.4 +Nonregulated Property, Plant and Equipment - Net +1,927.0 1.2 0.7 24.0 28.2 9.9 6.9 97.8 +Total Property, Plant and Equipment - Net +$ 63,901.6 $ 9,813.6 $ 10,772.8 $ 11,394.1 $ 7,052.3 $ 7,452.1 $ 4,320.0 $ 7,088.2 +December 31, 2019 AEP AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Regulated Property, Plant and Equipment +Generation +$ 21,323.5 (a) $ — $ — $ 6,563.7 $ 5,099.7 $ — $ 1,574.6 $ 4,691.4 (a) +Transmission 24,763.4 4,466.5 8,137.9 3,584.1 1,641.8 2,686.3 948.5 2,056.5 +Distribution 22,440.8 4,215.2 — 4,201.7 2,437.6 5,323.5 2,684.8 2,270.7 +Other 4,369.6 803.4 268.2 542.0 590.9 754.7 337.2 520.6 +CWIP 4,261.2 (a) 763.9 1,485.7 593.4 382.3 394.4 133.4 210.1 (a) +Less: Accumulated Depreciation +18,778.1 1,465.0 402.3 4,425.6 3,281.4 2,261.7 1,579.9 2,766.2 +Total Regulated Property, Plant and Equipment - Net +58,380.4 8,784.0 9,489.5 11,059.3 6,870.9 6,897.2 4,098.6 6,983.1 +Nonregulated Property, Plant and Equipment - Net +1,757.7 61.1 1.4 22.6 28.8 9.8 4.7 112.1 +Total Property, Plant and Equipment - Net +$ 60,138.1 $ 8,845.1 $ 9,490.9 $ 11,081.9 $ 6,899.7 $ 6,907.0 $ 4,103.3 $ 7,095.2 +(a) AEP and SWEPCo’s regulated generation and regulated CWIP include amounts related to SWEPCo’s Arkansas jurisdictional share of the Turk Plant. +401 +Depreciation, Depletion and Amortization +The Registrants provide for depreciation of Property, Plant and Equipment, excluding coal-mining properties, on a straight-line basis over the estimated useful lives of property, generally using composite rates by functional class. The following tables provide total regulated annual composite depreciation rates and depreciable lives for the Registrants: +AEP +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Ranges Depreciable +Life Ranges Annual Composite +Depreciation Rate Ranges Depreciable +Life Ranges Annual Composite +Depreciation Rate Ranges Depreciable +Life Ranges +(in years) (in years) (in years) +Generation 2.7 % - 6.3 % 20 - 132 2.5 % - 5.5 % 20 - 132 2.4 % - 4.0 % 20 - 132 +Transmission 2.0 % - 2.6 % 15 - 75 1.8 % - 2.6 % 15 - 81 1.6 % - 2.7 % 15 - 81 +Distribution 2.7 % - 3.7 % 7 - 78 2.7 % - 3.7 % 7 - 78 2.7 % - 3.6 % 7 - 78 +Other 2.8 % - 11.3 % 5 - 75 2.6 % - 9.5 % 5 - 75 2.3 % - 9.8 % 5 - 75 +AEP Texas +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Transmission 2.0 % 50 - 75 1.8 % 45 - 81 1.7 % 45 - 81 +Distribution 3.1 % 7 - 70 3.5 % 7 - 70 3.6 % 7 - 70 +Other 6.1 % 5 - 50 6.3 % 5 - 50 6.0 % 5 - 50 +AEPTCo +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Transmission 2.4 % 24 - 75 2.0 % 24 - 75 1.9 % 20 - 75 +Other 6.3 % 5 - 64 5.8 % 5 - 64 5.6 % 5 - 64 +APCo +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Generation 3.3 % 35 - 118 3.2 % 35 - 118 3.1 % 35 - 112 +Transmission 2.2 % 15 - 75 1.8 % 15 - 71 1.6 % 15 - 68 +Distribution 3.7 % 12 - 57 3.7 % 12 - 57 3.6 % 10 - 57 +Other 7.8 % 5 - 55 7.2 % 5 - 55 7.4 % 5 - 55 +I&M +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Generation 4.6 % 20 - 132 4.0 % 20 - 132 3.4 % 20 - 132 +Transmission 2.3 % 45 - 70 1.9 % 50 - 73 1.8 % 50 - 73 +Distribution 3.4 % 14 - 71 3.4 % 9 - 75 3.1 % 9 - 75 +Other 10.2 % 5 - 51 9.4 % 5 - 50 8.9 % 5 - 50 +OPCo +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Transmission 2.3 % 39 - 60 2.3 % 39 - 60 2.3 % 39 - 60 +Distribution 3.1 % 14 - 65 3.1 % 14 - 65 3.0 % 14 - 65 +Other 5.0 % 5 - 50 4.9 % 5 - 50 6.3 % 5 - 50 +402 +PSO +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Generation 3.1 % 35 - 75 2.9 % 35 - 75 2.9 % 35 - 75 +Transmission 2.2 % 45 - 75 2.4 % 45 - 75 2.3 % 45 - 75 +Distribution 2.9 % 15 - 78 2.9 % 15 - 78 2.9 % 15 - 78 +Other 5.7 % 5 - 64 5.6 % 5 - 64 6.3 % 5 - 64 +SWEPCo +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges Annual Composite +Depreciation Rate Depreciable +Life Ranges +(in years) (in years) (in years) +Generation 2.7 % 35 - 65 2.5 % 40 - 70 2.4 % 40 - 70 +Transmission 2.3 % 47 - 73 2.4 % 50 - 73 2.2 % 50 - 73 +Distribution 2.7 % 15 - 67 2.7 % 25 - 70 2.7 % 25 - 70 +Other 8.5 % 5 - 52 7.6 % 5 - 55 8.0 % 5 - 55 +The following table includes the nonregulated annual composite depreciation rate ranges and nonregulated depreciable life ranges for AEP. Depreciation rate ranges and depreciable life ranges are not meaningful for nonregulated property of AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo for 2020, 2019 and 2018. +2020 2019 2018 +Functional Class of Property Annual Composite +Depreciation Rate Ranges Depreciable +Life Ranges Annual Composite +Depreciation Rate Ranges Depreciable +Life Ranges Annual Composite +Depreciation Rate Ranges Depreciable +Life Ranges +(in years) (in years) (in years) +Generation 3.6 % - 4.0 % 15 - 59 3.2 % - 21.2 % 15 - 59 3.4 % - 22.3 % 15 - 59 +Transmission 2.5 % 30 - 40 2.5 % 30 - 40 2.4 % 40 +Distribution NA NA 2.3 % 40 2.3 % 40 +Other 16.1 % 5 - 50 (a) 17.6 % 5 - 50 (a) 16.3 % 5 - 50 (a) +(a) SWEPCo’s nonregulated property, plant and equipment is depreciated using the straight-line method over a range of 3 to 20 years. +NA Not applicable. +SWEPCo provides for depreciation, depletion and amortization of coal-mining assets over each asset’s estimated useful life or the estimated life of each mine, whichever is shorter, using the straight-line method for mining structures and equipment. SWEPCo uses either the straight-line method or the units-of-production method to amortize mine development costs and deplete coal rights based on estimated recoverable tonnages. SWEPCo includes these costs in fuel expense. +For regulated operations, the composite depreciation rate generally includes a component for non-ARO removal costs, which is credited to Accumulated Depreciation and Amortization on the balance sheets. Actual removal costs incurred are charged to Accumulated Depreciation and Amortization. Any excess of accrued non-ARO removal costs over actual removal costs incurred is reclassified from Accumulated Depreciation and Amortization and reflected as a regulatory liability. For nonregulated operations, non-ARO removal costs are expensed as incurred. +Asset Retirement Obligations (Applies to all Registrants except AEPTCo) +The Registrants record ARO in accordance with the accounting guidance for “Asset Retirement and Environmental Obligations” for legal obligations for asbestos removal and for the retirement of certain ash disposal facilities, wind farms, solar farms and certain coal-mining facilities. I&M records ARO for the decommissioning of the Cook Plant. The Registrants have identified, but not recognized, ARO liabilities related to electric transmission and distribution assets as a result of certain easements on property on which assets are owned. Generally, such easements are perpetual and require only the retirement and removal of assets upon the cessation of the property’s use. The retirement obligation is not estimable for such easements since the Registrants plan to use their facilities indefinitely. The retirement obligation would only be recognized if and when the Registrants abandon or cease the use of specific easements, which is not expected. +403 +The Registrants recorded the following revisions to ARO estimates as of December 31, 2020: +• In March 2020, SWEPCo recorded a revision to increase estimated ARO liabilities by $ 21 million primarily due to the revision in the useful life of DHLC. See Note 5 - Effects of Regulation for additional information. In September 2020, SWEPCo recorded an $ 18 million revision due to a reduction in estimated ash pond closure costs. +• In June 2020, AEP Texas and PSO recorded a revision to decrease estimated ARO liabilities by $ 17 million and $ 5 million, respectively, due to the retirement of the Oklaunion Power Station in September 2020. See Note 5 - Effects of Regulation for additional information. +• In June 2020, AGR derecognized $ 106 million of Conesville Plant related ARO liabilities as a result of the Environmental Liability and Property Transfer and Asset Purchase Agreement executed with a non-affiliated third-party. See Note 7 - Acquisitions and Dispositions for additional information. +• In June 2020, APCo recorded a revision to increase estimated Glen Lyn Station ash disposal ARO liabilities by $ 199 million due to the enactment of House Bill 443. This bill requires APCo to close the ash disposal units at the retired Glen Lyn Station by removal of all coal combustion material. The legislation provides for regulatory recovery of these costs. See Note 6 - Commitments, Guarantees and Contingencies for additional information. +As of December 31, 2020 and 2019, I&M’s ARO liability for nuclear decommissioning of the Cook Plant was $ 1.80 billion and $ 1.73 billion, respectively. These liabilities are reflected in Asset Retirement Obligations on I&M’s balance sheets. As of December 31, 2020 and 2019, the fair value of I&M’s assets that are legally restricted for purposes of settling decommissioning liabilities totaled $ 2.98 billion and $ 2.65 billion, respectively. These assets are included in Spent Nuclear Fuel and Decommissioning Trusts on I&M’s balance sheets. +The following is a reconciliation of the 2020 and 2019 aggregate carrying amounts of ARO by Registrant: +Company ARO as of December 31, 2019 Accretion +Expense Liabilities +Incurred Liabilities +Settled Revisions in +Cash Flow +Estimates (a) ARO as of December 31, 2020 +(in millions) +AEP (b)(c)(d)(e) $ 2,418.9 $ 102.4 $ 0.3 $ ( 188.0 ) $ 183.1 $ 2,516.7 +AEP Texas (b)(e) 29.1 0.8 — ( 8.5 ) ( 16.8 ) 4.6 +APCo (b)(e) 111.1 8.9 — ( 7.8 ) 200.9 313.1 +I&M (b)(c)(e) 1,748.6 70.2 0.1 ( 0.2 ) ( 4.9 ) 1,813.8 +OPCo (e) 1.8 0.1 — — — 1.9 +PSO (b)(e) 52.2 3.1 — ( 3.1 ) ( 4.8 ) 47.4 +SWEPCo (b)(d)(e) 212.2 10.7 — ( 10.9 ) 10.1 222.1 +Company ARO as of December 31, 2018 Accretion +Expense Liabilities +Incurred Liabilities +Settled Revisions in +Cash Flow +Estimates (a) ARO as of December 31, 2019 +(in millions) +AEP (b)(c)(d)(e) $ 2,355.5 $ 102.5 $ 12.0 $ ( 118.1 ) $ 67.0 $ 2,418.9 +AEP Texas (b)(e) 27.9 1.3 — ( 0.2 ) 0.1 29.1 +APCo (b)(e) 116.1 5.9 — ( 17.6 ) 6.7 111.1 +I&M (b)(c)(e) 1,681.3 67.4 — ( 0.2 ) 0.1 1,748.6 +OPCo (e) 1.8 0.1 — ( 0.3 ) 0.2 1.8 +PSO (b)(e) 46.9 3.1 — ( 0.4 ) 2.6 52.2 +SWEPCo (b)(d)(e) 206.8 10.3 — ( 11.8 ) 6.9 212.2 +(a) Unless discussed above, primarily related to ash ponds, landfills and mine reclamation, generally due to changes in estimated closure area, volumes and/or unit costs. +(b) Includes ARO related to ash disposal facilities. +(c) Includes ARO related to nuclear decommissioning costs for the Cook Plant of $ 1.80 billion and $ 1.73 billion as of December 31, 2020 and 2019, respectively. +(d) Includes ARO related to Sabine and DHLC. +404 +(e) Includes ARO related to asbestos removal. +Allowance for Funds Used During Construction and Interest Capitalization +The Registrants’ amounts of Allowance for Equity Funds Used During Construction are summarized in the following table: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AEP $ 148.1 $ 168.4 $ 132.5 +AEP Texas 19.4 15.2 20.0 +AEPTCo 74.0 84.3 70.6 +APCo 14.6 16.6 13.2 +I&M 11.5 19.4 11.9 +OPCo 12.5 18.2 9.8 +PSO 4.0 2.7 0.4 +SWEPCo 7.7 6.8 6.0 +The Registrants’ amounts of allowance for borrowed funds used during construction, including capitalized interest, are summarized in the following table: +Years Ended December 31, +Company 2020 2019 2018 +(in millions) +AEP $ 66.0 $ 88.7 $ 73.6 +AEP Texas 12.5 20.0 18.4 +AEPTCo 25.5 32.2 26.1 +APCo 7.9 9.3 8.4 +I&M 5.7 8.9 7.4 +OPCo 6.2 6.7 5.8 +PSO 2.0 1.9 0.9 +SWEPCo 3.9 4.0 4.8 +405 +Jointly-owned Electric Facilities (Applies to AEP, AEP Texas, I&M, PSO and SWEPCo) +The Registrants have electric facilities that are jointly-owned with affiliated and nonaffiliated companies. Using its own financing, each participating company is obligated to pay its share of the costs of these jointly-owned facilities in the same proportion as its ownership interest. Each Registrant’s proportionate share of the operating costs associated with these facilities is included in its statements of income and the investments and accumulated depreciation are reflected in its balance sheets under Property, Plant and Equipment as follows: +Registrant’s Share as of December 31, 2020 +Fuel +Type Percent of +Ownership Utility Plant +in Service Construction +Work in +Progress Accumulated +Depreciation +(in millions) +AEP +Dolet Hills Power Station, Unit 1 (a) Lignite 40.2 % $ 342.4 $ 4.6 $ 295.4 +Flint Creek Generating Station, Unit 1 (b) Coal 50.0 % 377.2 3.0 116.0 +Pirkey Power Plant, Unit 1 (b) Lignite 85.9 % 602.8 3.7 441.0 +Oklaunion Power Station (f)(g) Coal 70.3 % — — — +Turk Generating Plant (b) Coal 73.3 % 1,594.3 2.8 257.3 +Total +$ 2,916.7 $ 14.1 $ 1,109.7 +AEP Texas +Oklaunion Power Station (f)(g) Coal 54.7 % $ — $ — $ — +I&M +Rockport Generating Plant (c)(d)(e) Coal 50.0 % $ 1,228.5 $ 19.6 $ 677.3 +PSO +Oklaunion Power Station (f)(g) Coal 15.6 % $ — $ — $ — +SWEPCo +Dolet Hills Power Station, Unit 1 (a) Lignite 40.2 % $ 342.4 $ 4.6 $ 295.4 +Flint Creek Generating Station, Unit 1 (b) Coal 50.0 % 377.2 3.0 116.0 +Pirkey Power Plant, Unit 1 (b) Lignite 85.9 % 602.8 3.7 441.0 +Turk Generating Plant (b) Coal 73.3 % 1,594.3 2.8 257.3 +Total +$ 2,916.7 $ 14.1 $ 1,109.7 +406 +Registrant’s Share as of December 31, 2019 +Fuel +Type Percent of +Ownership Utility Plant +in Service Construction +Work in +Progress Accumulated +Depreciation +(in millions) +AEP +Dolet Hills Power Station, Unit 1 (a) Lignite 40.2 % $ 337.3 $ 6.2 $ 216.5 +Flint Creek Generating Station, Unit 1 (b) Coal 50.0 % 374.3 3.4 101.1 +Pirkey Power Plant, Unit 1 (b) Lignite 85.9 % 607.8 7.7 416.8 +Oklaunion Power Station (f)(g) Coal 70.3 % 106.6 0.1 91.7 +Turk Generating Plant (b) Coal 73.3 % 1,593.3 1.7 225.8 +Total +$ 3,019.3 $ 19.1 $ 1,051.9 +AEP Texas +Oklaunion Power Station (f)(g) Coal 54.7 % $ 351.7 $ — $ 291.9 +I&M +Rockport Generating Plant (c)(d)(e) Coal 50.0 % $ 1,114.2 $ 105.5 $ 586.2 +PSO +Oklaunion Power Station (f)(g) Coal 15.6 % $ 106.6 $ 0.1 $ 91.7 +SWEPCo +Dolet Hills Power Station, Unit 1 (a) Lignite 40.2 % $ 337.3 $ 6.2 $ 216.5 +Flint Creek Generating Station, Unit 1 (b) Coal 50.0 % 374.3 3.4 101.1 +Pirkey Power Plant, Unit 1 (b) Lignite 85.9 % 607.8 7.7 416.8 +Turk Generating Plant (b) Coal 73.3 % 1,593.3 1.7 225.8 +Total +$ 2,912.7 $ 19.0 $ 960.2 +(a) Operated by CLECO, a nonaffiliated company. +(b) Operated by SWEPCo. +(c) Operated by I&M. +(d) Amounts include I&M’s 50 % ownership of both Unit 1 and capital additions for Unit 2. Unit 2 is subject to an operating lease with a nonaffiliated company. See the “Rockport Lease” section of Note 13 for additional information. +(e) AEGCo owns 50 % of Unit 1 with I&M and 50 % of capital additions for Unit 2. +(f) Operated by PSO, which owned 15.6 %. Also was jointly-owned ( 54.7 %) by AEP Texas and various nonaffiliated companies. +(g) Oklaunion Power Station was retired in September 2020 and sold to a nonaffiliated third-party in October 2020. See the “Dispositions” section of Note 7 for additional information. +407 +19. REVENUE FROM CONTRACTS WITH CUSTOMERS +The disclosures in this note apply to all Registrants, unless indicated otherwise. +Disaggregated Revenues from Contracts with Customers +The table below represents AEP’s reportable segment revenues from contracts with customers, net of respective provisions for refund, by type of revenue: +Year Ended December 31, 2020 +Vertically Integrated Utilities Transmission and Distribution Utilities AEP Transmission Holdco Generation & Marketing Corporate and Other Reconciling Adjustments AEP Consolidated +(in millions) +Retail Revenues: +Residential Revenues $ 3,606.8 $ 2,086.9 $ — $ — $ — $ — $ 5,693.7 +Commercial Revenues 2,016.2 1,048.6 — — — — 3,064.8 +Industrial Revenues 2,018.0 390.1 — — — ( 0.7 ) 2,407.4 +Other Retail Revenues 155.6 42.5 — — — — 198.1 +Total Retail Revenues 7,796.6 3,568.1 — — — ( 0.7 ) 11,364.0 +Wholesale and Competitive Retail Revenues: +Generation Revenues 588.3 — — 131.9 — — 720.2 +Transmission Revenues (a) 334.5 467.0 1,257.0 — — ( 1,006.7 ) 1,051.8 +Renewable Generation Revenues (b) — — — 60.9 — ( 1.6 ) 59.3 +Retail, Trading and Marketing Revenues (c) — — — 1,486.9 ( 5.5 ) ( 103.0 ) 1,378.4 +Total Wholesale and Competitive Retail Revenues +922.8 467.0 1,257.0 1,679.7 ( 5.5 ) ( 1,111.3 ) 3,209.7 +Other Revenues from Contracts with Customers (b) 163.2 157.8 22.4 2.3 92.5 ( 148.6 ) 289.6 +Total Revenues from Contracts with Customers +8,882.6 4,192.9 1,279.4 1,682.0 87.0 ( 1,260.6 ) 14,863.3 +Other Revenues: +Alternative Revenues (b) ( 3.2 ) 70.0 ( 80.6 ) — — 7.5 ( 6.3 ) +Other Revenues (b) — 83.0 — 43.6 9.8 ( 74.9 ) 61.5 +Total Other Revenues ( 3.2 ) 153.0 ( 80.6 ) 43.6 9.8 ( 67.4 ) 55.2 +Total Revenues $ 8,879.4 $ 4,345.9 $ 1,198.8 $ 1,725.6 $ 96.8 $ ( 1,328.0 ) $ 14,918.5 +(a) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEP Transmission Holdco was $ 965 million. The remaining affiliated amounts were immaterial. +(b) Amounts include affiliated and nonaffiliated revenues. +(c) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for Generation & Marketing was $ 103 million. The remaining affiliated amounts were immaterial. +408 +Year Ended December 31, 2019 +Vertically Integrated Utilities Transmission and Distribution Utilities AEP Transmission Holdco Generation & Marketing Corporate and Other Reconciling Adjustments AEP Consolidated +(in millions) +Retail Revenues: +Residential Revenues $ 3,643.7 $ 2,069.9 $ — $ — $ — $ — $ 5,713.6 +Commercial Revenues 2,155.3 1,152.9 — — — — 3,308.2 +Industrial Revenues 2,179.0 429.1 — — — ( 0.9 ) 2,607.2 +Other Retail Revenues 179.1 43.8 — — — — 222.9 +Total Retail Revenues 8,157.1 3,695.7 — — — ( 0.9 ) 11,851.9 +Wholesale and Competitive Retail Revenues: +Generation Revenues 807.6 — — 254.8 — — 1,062.4 +Transmission Revenues (a) 292.1 435.1 1,077.2 — — ( 825.0 ) 979.4 +Renewable Generation Revenues (b) — — — 57.3 — — 57.3 +Retail, Trading and Marketing Revenues (c) — — — 1,480.7 — ( 135.6 ) 1,345.1 +Total Wholesale and Competitive Retail Revenues +1,099.7 435.1 1,077.2 1,792.8 — ( 960.6 ) 3,444.2 +Other Revenues from Contracts with Customers (b) 168.2 169.4 16.6 4.9 104.7 ( 147.1 ) 316.7 +Total Revenues from Contracts with Customers +9,425.0 4,300.2 1,093.8 1,797.7 104.7 ( 1,108.6 ) 15,612.8 +Other Revenues: +Alternative Revenues (b) ( 57.9 ) 32.3 ( 20.6 ) — — ( 66.9 ) ( 113.1 ) +Other Revenues (b) — 150.0 — 59.9 ( 8.9 ) ( 139.3 ) 61.7 +Total Other Revenues ( 57.9 ) 182.3 ( 20.6 ) 59.9 ( 8.9 ) ( 206.2 ) ( 51.4 ) +Total Revenues $ 9,367.1 $ 4,482.5 $ 1,073.2 $ 1,857.6 $ 95.8 $ ( 1,314.8 ) $ 15,561.4 +(a) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEP Transmission Holdco was $ 794 million. The remaining affiliated amounts were immaterial. +(b) Amounts include affiliated and nonaffiliated revenues. +(c) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for Generation & Marketing was $ 136 million. The remaining affiliated amounts were immaterial. +409 +Year Ended December 31, 2018 +Vertically Integrated Utilities Transmission and Distribution Utilities AEP Transmission Holdco Generation & Marketing Corporate and Other Reconciling Adjustments AEP Consolidated +(in millions) +Retail Revenues: +Residential Revenues $ 3,751.8 $ 2,189.4 $ — $ — $ — $ — $ 5,941.2 +Commercial Revenues 2,183.4 1,251.7 — — — — 3,435.1 +Industrial Revenues 2,212.8 512.5 — — — — 2,725.3 +Other Retail Revenues 183.5 42.7 — — — — 226.2 +Total Retail Revenues (a) 8,331.5 3,996.3 — — — — 12,327.8 +Wholesale and Competitive Retail Revenues: +Generation Revenues 899.8 — — 423.7 — ( 7.3 ) (e) 1,316.2 +Transmission Revenues (b) 282.2 372.1 849.3 — — ( 737.1 ) 766.5 +Renewable Generation Revenues (c) — — — 50.8 — — 50.8 +Retail, Trading and Marketing Revenues (d) — — — 1,422.9 — ( 120.7 ) 1,302.2 +Total Wholesale and Competitive Retail Revenues +1,182.0 372.1 849.3 1,897.4 — ( 865.1 ) 3,435.7 +Other Revenues from Contracts with Customers (c) 158.4 204.6 15.2 20.6 86.2 ( 32.0 ) 453.0 +Total Revenues from Contracts with Customers +9,671.9 4,573.0 864.5 1,918.0 86.2 ( 897.1 ) 16,216.5 +Other Revenues: +Alternative Revenues (c) ( 15.9 ) ( 22.2 ) ( 60.4 ) — — 52.7 ( 45.8 ) +Other Revenues (c) ( 10.5 ) 102.3 — 22.3 8.9 ( 98.0 ) (e) 25.0 +Total Other Revenues ( 26.4 ) 80.1 ( 60.4 ) 22.3 8.9 ( 45.3 ) ( 20.8 ) +Total Revenues $ 9,645.5 $ 4,653.1 $ 804.1 $ 1,940.3 $ 95.1 $ ( 942.4 ) $ 16,195.7 +(a) 2018 amounts have been revised to reflect the reclassification of certain customer accounts between Retail classes. This reclassification did not impact previously reported Total Retail Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate. +(b) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEP Transmission Holdco was $ 643 million. The remaining affiliated amounts were immaterial. +(c) Amounts include affiliated and nonaffiliated revenues. +(d) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for Generation & Marketing was $ 121 million. The remaining affiliated amounts were immaterial. +(e) 2018 amounts have been revised to reflect the reclassification of $ 98 million of affiliated revenues between Generation Revenues and Other Revenues. This reclassification did not impact previously reported Total Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate. +410 +The table below represents revenues from contracts with customers, net of respective provisions for refund, by type of revenue for the Registrant Subsidiaries: +Year Ended December 31, 2020 +AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Retail Revenues: +Residential Revenues $ 563.6 $ — $ 1,250.6 $ 794.1 $ 1,523.4 $ 579.4 $ 630.8 +Commercial Revenues 366.7 — 517.0 499.3 682.0 320.1 466.7 +Industrial Revenues 120.1 — 553.5 547.4 270.0 221.1 328.8 +Other Retail Revenues 29.5 — 67.6 6.6 13.1 66.0 9.1 +Total Retail Revenues 1,079.9 — 2,388.7 1,847.4 2,488.5 1,186.6 1,435.4 +Wholesale Revenues: +Generation Revenues (a) — — 230.2 274.6 — 15.1 162.0 +Transmission Revenues (b) 399.9 1,210.3 130.8 29.0 67.0 27.5 111.2 +Total Wholesale Revenues 399.9 1,210.3 361.0 303.6 67.0 42.6 273.2 +Other Revenues from Contracts with Customers (c) +48.2 22.4 59.5 85.0 109.5 34.7 26.7 +Total Revenues from Contracts with Customers +1,528.0 1,232.7 2,809.2 2,236.0 2,665.0 1,263.9 1,735.3 +Other Revenues: +Alternative Revenues (d) 3.4 ( 87.0 ) ( 13.0 ) 5.8 66.6 2.2 3.2 +Other Revenues (d) 87.5 — — — 17.5 — — +Total Other Revenues 90.9 ( 87.0 ) ( 13.0 ) 5.8 84.1 2.2 3.2 +Total Revenues $ 1,618.9 $ 1,145.7 $ 2,796.2 $ 2,241.8 $ 2,749.1 $ 1,266.1 $ 1,738.5 +(a) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for APCo was $ 112 million primarily relating to the PPA with KGPCo. The remaining affiliated amounts were immaterial. +(b) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEPTCo was $ 952 million. The remaining affiliated amounts were immaterial. +(c) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for I&M was $ 69 million primarily relating to barging, urea transloading and other transportation services. The remaining affiliated amounts were immaterial. +(d) Amounts include affiliated and nonaffiliated revenues. +411 +Year Ended December 31, 2019 +AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Retail Revenues: +Residential Revenues $ 571.5 $ — $ 1,266.9 $ 730.0 $ 1,502.0 $ 650.2 $ 638.6 +Commercial Revenues 411.5 — 559.9 494.2 738.5 388.5 485.4 +Industrial Revenues 129.4 — 592.2 550.7 299.9 303.5 338.7 +Other Retail Revenues 29.9 — 75.2 7.3 13.1 81.6 9.0 +Total Retail Revenues 1,142.3 — 2,494.2 1,782.2 2,553.5 1,423.8 1,471.7 +Wholesale Revenues: +Generation Revenues (a) — — 251.5 402.4 — 39.5 194.7 +Transmission Revenues (b) 379.2 1,025.5 103.6 25.1 56.0 27.5 106.7 +Total Wholesale Revenues 379.2 1,025.5 355.1 427.5 56.0 67.0 301.4 +Other Revenues from Contracts with Customers (c) 30.1 16.6 61.8 98.4 139.3 22.0 26.1 +Total Revenues from Contracts with Customers +1,551.6 1,042.1 2,911.1 2,308.1 2,748.8 1,512.8 1,799.2 +Other Revenues: +Alternative Revenues (d) 0.6 ( 20.7 ) 13.6 ( 1.4 ) 31.7 ( 31.0 ) ( 48.3 ) +Other Revenues (d) 157.1 — — — 17.1 — — +Total Other Revenues 157.7 ( 20.7 ) 13.6 ( 1.4 ) 48.8 ( 31.0 ) ( 48.3 ) +Total Revenues $ 1,709.3 $ 1,021.4 $ 2,924.7 $ 2,306.7 $ 2,797.6 $ 1,481.8 $ 1,750.9 +(a) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for APCo was $ 129 million primarily relating to the PPA with KGPCo. The remaining affiliated amounts were immaterial. +(b) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEPTCo was $ 782 million. The remaining affiliated amounts were immaterial. +(c) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for I&M was $ 73 million primarily relating to barging, urea transloading and other transportation services. The remaining affiliated amounts were immaterial. +(d) Amounts include affiliated and nonaffiliated revenues. +412 +Year Ended December 31, 2018 +AEP Texas AEPTCo APCo I&M OPCo PSO SWEPCo +(in millions) +Retail Revenues: +Residential Revenues $ 578.9 $ — $ 1,342.7 $ 730.0 $ 1,611.6 $ 659.0 $ 641.6 +Commercial Revenues 414.7 — 580.4 485.0 835.6 394.2 483.9 +Industrial Revenues 128.0 — 604.3 565.6 385.2 304.0 333.7 +Other Retail Revenues 29.4 — 77.4 7.2 12.9 83.6 8.6 +Total Retail Revenues (a) 1,151.0 — 2,604.8 1,787.8 2,845.3 1,440.8 1,467.8 +Wholesale Revenues: +Generation Revenues (b) — — 250.4 470.5 — 36.3 216.8 +Transmission Revenues (c) 313.4 816.9 82.7 23.1 58.5 40.2 108.4 +Total Wholesale Revenues 313.4 816.9 333.1 493.6 58.5 76.5 325.2 +Other Revenues from Contracts with Customers (d) +28.6 15.1 55.3 99.6 176.1 19.1 24.0 +Total Revenues from Contracts with Customers +1,493.0 832.0 2,993.2 2,381.0 3,079.9 1,536.4 1,817.0 +Other Revenues: +Alternative Revenues (e) ( 1.3 ) ( 55.9 ) ( 23.8 ) ( 2.1 ) ( 20.8 ) 10.9 4.9 +Other Revenues (e) 103.6 — ( 1.9 ) ( 8.2 ) 4.3 — — +Total Other Revenues 102.3 ( 55.9 ) ( 25.7 ) ( 10.3 ) ( 16.5 ) 10.9 4.9 +Total Revenues $ 1,595.3 $ 776.1 $ 2,967.5 $ 2,370.7 $ 3,063.4 $ 1,547.3 $ 1,821.9 +(a) 2018 amounts have been revised to reflect the reclassification of certain customer accounts between Retail classes. This reclassification did not impact previously reported Total Retail Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate. +(b) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for APCo was $ 134 million primarily relating to the PPA with KGPCo. The remaining affiliated amounts were immaterial. +(c) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEPTCo was $ 646 million. The remaining affiliated amounts were immaterial . +(d) Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for I&M was $ 70 million primarily relating to barging, urea transloading and other transportation services. The remaining affiliated amounts were immaterial . +(e) Amounts include affiliated and nonaffiliated revenues. +Performance Obligations +AEP has performance obligations as part of its normal course of business. A performance obligation is a promise to transfer a distinct good or service, or a series of distinct goods or services that are substantially the same and have the same pattern of transfer to a customer. The invoice practical expedient within the accounting guidance for “Revenue from Contracts with Customers” allows for the recognition of revenue from performance obligations in the amount of consideration to which there is a right to invoice the customer and when the amount for which there is a right to invoice corresponds directly to the value transferred to the customer. +The purpose of the invoice practical expedient is to depict an entity’s measure of progress toward completion of the performance obligation within a contract and can only be applied to performance obligations that are satisfied over time and when the invoice is representative of services provided to date. AEP subsidiaries elected to apply the invoice practical expedient to recognize revenue for performance obligations satisfied over time as the invoices from the respective revenue streams are representative of services or goods provided to date to the customer. Performance obligations for AEP’s subsidiaries are summarized as follows: +413 +Retail Revenues +AEP’s subsidiaries within the Vertically Integrated Utilities and Transmission and Distribution Utilities segments have performance obligations to generate, transmit and distribute electricity for sale to rate-regulated retail customers. The performance obligation to deliver electricity is satisfied over time as the customer simultaneously receives and consumes the benefits provided. Revenues are variable as they are subject to the customer’s usage requirements. +Rate-regulated retail customers typically have the right to discontinue receiving service at will, therefore these contracts between AEP’s subsidiaries and their customers for rate-regulated services are generally limited to the services requested and received to date for such arrangements. Retail customers are generally billed on a monthly basis, and payment is typically due within 15 to 20 days after the issuance of the invoice. Payments from REPs are due to AEP Texas within 35 days. +Wholesale Revenues - Generation +AEP’s subsidiaries within the Vertically Integrated Utilities and Generation & Marketing segments have performance obligations to sell electricity to wholesale customers from generation assets in PJM, SPP and ERCOT. The performance obligation to deliver electricity from generation assets is satisfied over time as the customer simultaneously receives and consumes the benefits provided. Wholesale generation revenues are variable as they are subject to the customer’s usage requirements. +AEP’s subsidiaries within the Vertically Integrated Utilities and Generation & Marketing segments also have performance obligations to stand ready in order to promote grid reliability. Stand ready services are sold into PJM’s RPM capacity market. RPM entails a base auction and at least three incremental auctions for a specific PJM delivery year, with the incremental auctions spanning three years. The performance obligation to stand ready is satisfied over time and the consideration for which is variable until the occurrence of the final incremental auction, at which point the performance obligation becomes fixed. +Payments from the RTO for stand ready services are typically received within one week from the issuance of the invoice, which is typically issued weekly. Gross margin resulting from generation sales within the Vertically Integrated Utilities segment are primarily subject to margin sharing agreements with customers and vary by state, where the revenues are reflected gross in the disaggregated revenues tables above. +APCo has a performance obligation to supply wholesale electricity to KGPCo through a PPA. The FERC regulates the cost-based wholesale power transactions between APCo and KGPCo. The purchased power agreement includes a component for the recovery of transmission costs under the FERC OATT. The transmission cost component of purchased power is cost-based and regulated by the Tennessee Regulatory Authority. APCo’s performance obligation under the purchased power agreement is satisfied over time as KGPCo simultaneously receives and consumes the wholesale electricity. APCo’s revenues from the purchased power agreement are presented within the Generation Revenues line in the disaggregated revenues tables above. +Wholesale Revenues - Transmission +AEP’s subsidiaries within the Vertically Integrated Utilities, Transmission and Distribution Utilities and AEP Transmission Holdco segments have performance obligations to transmit electricity to wholesale customers through assets owned and operated by AEP subsidiaries. The performance obligation to provide transmission services in PJM, SPP and ERCOT encompass a time frame greater than a year, where the performance obligation within each RTO is partially fixed for a period of one year or less. Payments from the RTO for transmission services are typically received within one week from the issuance of the invoice, which is issued monthly for SPP and ERCOT and weekly for PJM. +414 +AEP subsidiaries within the PJM and SPP regions collect revenues through transmission formula rates. The FERC-approved rates establish the annual transmission revenue requirement (ATRR) and transmission service rates for transmission owners. The formula rates establish rates for a one year period and also include a true-up calculation for the prior year’s billings, allowing for over/under-recovery of the transmission owner’s ATRR. The annual true-ups meet the definition of alternative revenues in accordance with the accounting guidance for “Regulated Operations,” and are therefore presented as such in the disaggregated revenues tables above. AEP subsidiaries within the ERCOT region collect revenues through a combination of base rates and interim Transmission Costs of Services filings that are approved by the PUCT. +The AEP East Companies are parties to the TA, which defines how transmission costs are allocated among the AEP East Companies on a 12-month average coincident peak basis. PSO, SWEPCo and AEPSC are parties to the TCA by and among PSO, SWEPCo and AEPSC, in connection with the operation of the transmission assets of the two AEP utility subsidiaries. AEPTCo is a transmission owner within the PJM and SPP regions providing transmission services to affiliates in accordance with the OATT, TA and TCA. Affiliate revenues as a result of the respective TA and the TCA are reflected as Transmission Revenues in the disaggregated revenues tables above. +Marketing, Competitive Retail and Renewable Revenues +AEP’s subsidiaries within the Generation & Marketing segment have performance obligations to deliver electricity to competitive retail and wholesale customers. Performance obligations for marketing, competitive retail and renewable offtake sales are satisfied over time as the customer simultaneously receives and consumes the benefits provided. Revenues are primarily variable as they are subject to customer’s usage requirements; however, certain contracts mandate a delivery of a set quantity of electricity at a predetermined price, resulting in a fixed performance obligation. +Payment terms under marketing arrangements typically follow standard Edison Electric Institute and International Swaps and Derivatives Association terms, which call for payment in 20 days. Payments for competitive retail and offtake arrangements for renewable assets range from 15 to 60 days and are dependent on the product sold, location and the creditworthiness of customer. Invoices for marketing arrangements, competitive retail and offtake arrangements for renewable assets are issued monthly. +Fixed Performance Obligations +The following table represents the Registrants’ remaining fixed performance obligations satisfied over time as of December 31, 2020. Fixed performance obligations primarily include wholesale transmission services, electricity sales for fixed amounts of energy and stand ready services into PJM’s RPM market. The Registrant Subsidiaries amounts shown in the table below include affiliated and nonaffiliated revenues. +Company 2021 2022-2023 2024-2025 After 2025 Total +(in millions) +AEP $ 1,122.9 $ 164.1 $ 162.2 $ 161.5 $ 1,610.7 +AEP Texas 465.4 — — — 465.4 +AEPTCo 1,319.5 — — — 1,319.5 +APCo 173.4 32.3 23.2 11.6 240.5 +I&M 35.1 8.8 8.8 4.5 57.2 +OPCo 68.1 — — 0.1 68.2 +PSO 14.8 — — — 14.8 +SWEPCo 41.6 — — — 41.6 +415 +Contract Assets and Liabilities +Contract assets are recognized when the Registrants have a right to consideration that is conditional upon the occurrence of an event other than the passage of time, such as future performance under a contract. The Registrants did not have any material contract assets as of December 31, 2020 and 2019. +When the Registrants receive consideration, or such consideration is unconditionally due from a customer prior to transferring goods or services to the customer under the terms of a sales contract, they recognize a contract liability on the balance sheet in the amount of that consideration. Revenue for such consideration is subsequently recognized in the period or periods in which the remaining performance obligations in the contract are satisfied. The Registrants’ contract liabilities typically arise from services provided under joint use agreements for utility poles. The Registrants did not have any material contract liabilities as of December 31, 2020 and 2019. +Accounts Receivable from Contracts with Customers +Accounts receivable from contracts with customers are presented on the Registrants’ balance sheets within the Accounts Receivable - Customers line item. The Registrants’ balances for receivables from contracts that are not recognized in accordance with the accounting guidance for “Revenue from Contracts with Customers” included in Accounts Receivable - Customers were not material as of December 31, 2020 and 2019. See “Securitized Accounts Receivable - AEP Credit” section of Note 14 for additional information. +The following table represents the amount of affiliated accounts receivable from contracts with customers included in Accounts Receivable - Affiliated Companies on the Registrant Subsidiaries’ balance sheets: +Years Ended December 31, +Company 2020 2019 +(in millions) +AEPTCo $ 81.0 $ 65.9 +APCo 52.7 47.3 +I&M 34.8 37.1 +OPCo 45.9 33.9 +PSO 7.8 9.7 +SWEPCo 11.2 17.6 +Contract Costs +Contract costs to obtain or fulfill a contract for AEP subsidiaries within the Generation & Marketing segment are accounted for under the guidance for “Other Assets and Deferred Costs” and presented as a single asset and are neither bifurcated nor reclassified between current and noncurrent assets on the Registrants’ balance sheets. Contract costs to acquire a contract are amortized in a manner consistent with the transfer of goods or services to the customer in Other Operation on the Registrants’ income statements. The Registrants did not have material contract costs as of December 31, 2020 and 2019. +416 +20. GOODWILL +The disclosure in this note applies to AEP only. +The changes in AEP’s carrying amount of goodwill for the years ended December 31, 2020 and 2019 by operating segment are as follows: +Corporate and Other Generation +& +Marketing AEP Consolidated +(in millions) +Balance as of December 31, 2018 $ 37.1 $ 15.4 $ 52.5 +Impairment Losses — — — +Balance as of December 31, 2019 37.1 15.4 52.5 +Impairment Losses — — — +Balance as of December 31, 2020 $ 37.1 $ 15.4 $ 52.5 +In the fourth quarters of 2020 and 2019, annual impairment tests were performed. The fair values of the reporting units with goodwill were estimated using cash flow projections and other market value indicators. There were no goodwill impairment losses. AEP does not have any accumulated impairment on existing goodwill. +417 +21. SUBSEQUENT EVENTS +Impacts of Severe Winter Weather in February 2021 +In February 2021, many of AEP’s service territories and customers were impacted by severe winter weather and extreme cold temperatures resulting in power outages, extensive damage to transmission and distribution infrastructure and disruption to the energy markets. +Storm Costs (Applies to AEP, APCo and SWEPCo) +Based on the information currently available, APCo, KPCo and SWEPCo currently estimate significant February 2021 storm restoration expenditures as shown in the table below. Management currently anticipates the storm restoration expenditures will be more heavily weighted towards other operation and maintenance expenses as compared to capital expenditures. Management will continue to refine these storm cost estimates as restoration efforts are completed and final costs become available. +Total Estimated February 2021 +Storm Restoration Expenditures +(in millions) +APCo $ 65.0 - $ 75.0 +KPCo $ 75.0 - $ 95.0 +SWEPCo $ 30.0 - $ 40.0 +Management plans to seek regulatory recovery of these costs. If any of the storm costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. +February 2021 Severe Winter Weather Impacts in SPP (Applies to AEP, PSO and SWEPCo) +The February 2021 severe winter weather also had a significant impact in SPP resulting in the declaration of Energy Emergency Alert Levels 2 and 3 for the first time in SPP’s history. The winter storm increased the demand for natural gas and restricted the available natural gas supply resulting in significantly increased market prices for natural gas power plants to meet reliability needs for the SPP electric system. From February 9, 2021, to February 20, 2021, based on the information currently available, PSO’s and SWEPCo’s preliminary estimates of natural gas expenses and purchases of electricity are as follows: +PSO SWEPCo +(in millions) +Estimated Natural Gas Expenses $ 175.0 $ 375.0 +Estimated Electricity Purchases 650.0 — +$ 825.0 $ 375.0 +The amounts in the table above represent preliminary estimates as of February 25, 2021, and are subject to final settlement as additional information becomes available. In addition, SPP notified PSO and SWEPCo of additional collateral requirements of approximately $ 868 million on a cumulative basis for the companies due March 2, 2021. Subsequently, SPP filed a waiver request with the FERC that would grant a limited waiver for Load Serving Entities to post this additional collateral requirement between February 24, 2021 and March 11, 2021. FERC approved the waiver request on February 24, 2021. +PSO and SWEPCo have active fuel clauses that allow for the recovery of prudently incurred fuel and purchased power expenses. Given the significance of these costs, PSO and SWEPCo expect regulators to perform a heightened review of the costs. Management believes these costs are probable of future recovery. However, the recovery of these costs from customers may be extended over longer than usual time periods to mitigate the impact on customer bills. Nevertheless, PSO and SWEPCo’s payments to suppliers are due in March 2021. +418 +PSO and SWEPCo are evaluating financing alternatives including funding contributions from Parent and long-term debt issuances to address the timing difference between the payment to suppliers and recovery from customers. If either PSO or SWEPCo is unable to recover these fuel and purchased power expenses or recover these expenses in a timely manner, it could reduce future net income and cash flows and impact financial condition. +ERCOT (Applies to AEP and AEP Texas) +In response to the extreme winter weather event, the Governor of Texas issued a Declaration of a State of Disaster for all counties in Texas. While recovery from the emergency conditions is continuing, some market conditions and activities have yet to return to normal. To assist with a return to normalcy, the PUCT issued an order that placed a temporary moratorium on customer disconnections due to non-payment for transmission and distribution utilities. This moratorium will be in effect until otherwise ordered by the PUCT. +419 +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Information required by this item is set forth under the caption Proposal to Ratify the Appointment of the Independent Registered Public Accounting Firm in the 2021 Proxy Statement, which is incorporated by reference into this item. +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +During 2020, management, including the principal executive officer and principal financial officer of each of the Registrants evaluated each respective Registrant’s disclosure controls and procedures. Disclosure controls and procedures are defined as controls and other procedures of the Registrant that are designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act is accumulated and communicated to each Registrant’s management, including the principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. +As of December 31, 2020, the principal executive officer and financial officer of each of the Registrants concluded that the disclosure controls and procedures in place were effective at the reasonable assurance level. The Registrants continually strive to improve their disclosure controls and procedures to enhance the quality of their financial reporting and to maintain dynamic systems that change as events warrant. +Changes in Internal Control over Financial Reporting +There have been no changes in the Registrants’ internal control over financial reporting (as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter 2020 that materially affected, or are reasonably likely to materially affect, the Registrants’ internal control over financial reporting. +Internal Control over Financial Reporting +See Management’s Report on Internal Control over Financial Reporting for each Registrant under Item 8. As discussed in that report, management assessed and reported on the effectiveness of each Registrant’s internal control over financial reporting as of December 31, 2020. As a result of that assessment, management concluded that each Registrant’s internal control over financial reporting was effective as of December 31, 2020. +ITEM 9B. OTHER INFORMATION +None. +420 +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +AEP +Directors, Director Nomination Process and Audit Committee +Certain of the information called for in this Item 10, including the information relating to directors, is incorporated herein by reference to AEP’s definitive proxy information statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2021 Annual Meeting of Shareholders (the 2021 Annual Meeting) including under the captions “Election of Directors,” “AEP’s Board of Directors and Committees,” “Directors” and “Nominees for Directors.” +Executive Officers +Reference also is made under the caption “Information About our Executive Officers” in Part I, Item 1 of this report. +Code of Ethics +AEP’s Principles of Business Conduct is the code of ethics that applies to AEP’s Chief Executive Officer, Chief Financial Officer and principal accounting officer. The Principles of Business Conduct is available on AEP’s website at www.aep.com. The Principles of Business Conduct will be made available, without charge, in print to any shareholder who requests such document from Investor Relations, American Electric Power Company, Inc., 1 Riverside Plaza, Columbus, Ohio 43215. +If any substantive amendments to the Principles of Business Conduct are made or any waivers are granted, including any implicit waiver, from a provision of the Principles of Business Conduct, to its Chief Executive Officer, Chief Financial Officer or principal accounting officer, AEP will disclose the nature of such amendment or waiver on AEP’s website, www.aep.com, or in a report on Form 8-K. +Delinquent Section 16(a) Reports +None. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 11. EXECUTIVE COMPENSATION +AEP +The information called for by this Item 11 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2021 Annual Meeting including under the captions “Compensation Discussion and Analysis,” “Executive Compensation”, “Director Compensation” and “2020 Director Compensation Table”. The information set forth under the subcaption “Human Resources Committee Report” and “Audit Committee Report” should not be deemed filed nor should it be incorporated by reference into any other filing under the Securities Act of 1933, as amended, or the Exchange Act except to the extent AEP specifically incorporates such report by reference therein. +421 +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +AEP +The information relating to Security Ownership of Certain Beneficial Owners is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to 2021 Annual Meeting under the caption “Share Ownership of Certain Beneficial Owners and Management” and “Share Ownership of Directors and Executive Officers.” +EQUITY COMPENSATION PLAN INFORMATION +The following table summarizes the ability of AEP to issue common stock pursuant to equity compensation plans as of December 31, 2020: +Plan Category Number of Securities to be Issued upon Exercise of Outstanding Options Warrants and Rights (a) Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights (b) Number of Securities Remaining +Available for Future Issuance under Equity Compensation Plans +Equity Compensation Plans Approved by Security Holders 2,744,760 — 6,712,148 +Equity Compensation Plans Not Approved by Security Holders — — — +Total 2,744,760 — 6,712,148 +(a) The balance includes unvested 2020 performance units and restricted stock units as well as vested performance units deferred as AEP career shares, all of which will be settled and paid in shares of AEP common stock. Performance units, restricted stock units and AEP career shares that are settled and paid in cash are not included. For performance units, the total includes the target number of shares that could be granted if performance meets target objectives. The number of securities that would be granted, with respect to performance units, if performance meets the maximum payout level, is two times the amount included in this total. +(b) No consideration is required from participants for the exercise or vesting of any outstanding AEP equity compensation awards. +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +AEP +The information called for by this Item 13 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2021 Annual Meeting under the captions “Transactions with Related Persons” and “Director Independence.” +422 +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +AEP +The information called for by this Item 14 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2021 Annual Meeting under the captions “Audit and Non-Audit Fees,” “Audit Committee Report” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of the Independent Auditor.” +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Each of the above is a wholly-owned subsidiary of AEP and does not have a separate audit committee. A description of the AEP Audit Committee pre-approval policies, which apply to these companies, is contained in the definitive proxy statement of AEP for the 2021 Annual Meeting of shareholders. The following table presents directly billed fees for professional services rendered by PricewaterhouseCoopers LLP for the audit of these companies’ annual financial statements for the years ended December 31, 2020 and 2019, and fees directly billed for other services rendered by PricewaterhouseCoopers LLP during those periods. PricewaterhouseCoopers LLP also provides additional professional and other services to the AEP System, the cost of which may ultimately be allocated to these companies though not billed directly to them. For a description of these fees and services, see the description of principal accounting fees and services for AEP above. +AEP Texas AEPTCo APCo +2020 2019 2020 2019 2020 2019 +Audit Fees $ 1,204,518 $ 1,383,288 $ 1,249,959 $ 1,282,508 $ 1,747,977 $ 1,684,045 +Audit-Related Fees 80,000 132,667 — — 44,857 70,904 +Tax Fees 6,349 27,092 6,433 31,009 9,090 39,326 +Total $ 1,290,867 $ 1,543,047 $ 1,256,392 $ 1,313,517 $ 1,801,924 $ 1,794,275 +I&M OPCo PSO +2020 2019 2020 2019 2020 2019 +Audit Fees $ 1,383,356 $ 1,336,192 $ 1,096,241 $ 1,056,377 $ 577,138 $ 575,734 +Audit-Related Fees 10,607 10,071 10,607 10,071 4,857 4,571 +Tax Fees 8,169 35,073 5,701 26,384 3,281 15,093 +Total $ 1,402,132 $ 1,381,336 $ 1,112,549 $ 1,092,832 $ 585,276 $ 595,398 +SWEPCo +2020 2019 +Audit Fees $ 951,594 $ 973,150 +Audit-Related Fees 25,857 24,571 +Tax Fees 5,523 23,263 +Total $ 982,974 $ 1,020,984 +423 +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +The following documents are filed as a part of this report: +1. FINANCIAL STATEMENTS: +The following financial statements have been incorporated herein by reference pursuant to Item 8. +AEP and Subsidiary Companies: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Changes in Equity for the years ended December 31, 2020, 2019 and 2018; Consolidated Balance Sheets as of December 31, 2020 and 2019; Consolidated Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018; Notes to Financial Statements of Registrants. +AEP Texas, APCo, I&M and OPCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Changes in Common Shareholder’s Equity for the years ended December 31, 2020, 2019 and 2018; Consolidated Balance Sheets as of December 31, 2020 and 2019; Consolidated Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018; Notes to Financial Statements of Registrants. +AEPTCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Changes in Member’s Equity for the years ended December 31, 2020, 2019 and 2018; Consolidated Balance Sheets as of December 31, 2020 and 2019; Consolidated Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018; Notes to Financial Statements of Registrants. +PSO: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Statements of Income for the years ended December 31, 2020, 2019 and 2018; Statements of Comprehensive Income (Loss) for the years ended December 31, 2020, 2019 and 2018; Statements of Changes in Common Shareholder’s Equity for the years ended December 31, 2020, 2019 and 2018; Balance Sheets as of December 31, 2020 and 2019; Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018; Notes to Financial Statements of Registrants. +SWEPCo: +Report of Independent Registered Public Accounting Firm; Management’s Report on Internal Control over Financial Reporting; Consolidated Statements of Income for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2020, 2019 and 2018; Consolidated Statements of Changes in Equity for the years ended December 31, 2020, 2019 and 2018; Consolidated Balance Sheets as of December 31, 2020 and 2019; Consolidated Statements of Cash Flows for the years ended December 31, 2020, 2019 and 2018; Notes to Financial Statements of Registrants. +424 +2. FINANCIAL STATEMENT SCHEDULES: Page Number +Financial Statement Schedules are listed in the Index of Financial Statement Schedules. (Certain schedules have been omitted because the required information is contained in the notes to financial statements or because such schedules are not required or are not applicable). Reports of Independent Registered Public Accounting Firm. +S- 1 +3. EXHIBITS: +Exhibits for AEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. +E- 1 +ITEM 16. FORM 10-K SUMMARY +None. +425 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +American Electric Power Company, Inc. +By: /s/ Julia A. Sloat +(Julia A. Sloat, Executive Vice President +and Chief Financial Officer) +Date: February 25, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +Signature Title Date +(i) Principal Executive Officer: +/s/ Nicholas K. Akins +Chairman of the Board, +Chief Executive Officer and Director February 25, 2021 +(Nicholas K. Akins) +(ii) Principal Financial Officer: +/s/ Julia A. Sloat Executive Vice President and Chief Financial Officer February 25, 2021 +(Julia A. Sloat) +(iii) Principal Accounting Officer: +/s/ Joseph M. Buonaiuto Senior Vice President, Controller and Chief Accounting Officer February 25, 2021 +(Joseph M. Buonaiuto) +(iv) A Majority of the Directors: +*Nicholas K. Akins +*David J. Anderson +*J. Barnie Beasley, Jr. +*Ralph D. Crosby, Jr. +*Art A. Garcia +*Linda A. Goodspeed +*Thomas E. Hoaglin +*Sandra Beach Lin +*Margaret M. McCarthy +*Richard C. Notebaert +*Stephen S. Rasmussen +*Oliver G. Richard, III +*Daryl Roberts +*Sara Martinez Tucker +*By: /s/ Julia A. Sloat February 25, 2021 +(Julia A. Sloat, Attorney-in-Fact +426 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +AEP Texas Inc. +Appalachian Power Company +Ohio Power Company +Public Service Company of Oklahoma +Southwestern Electric Power Company +By: /s/ Julia A. Sloat +(Julia A. Sloat, Vice President and Chief Financial Officer +Date: February 25, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature Title Date +(i) Principal Executive Officer: +/s/ Nicholas K. Akins Chairman of the Board, Chief Executive Officer and Director February 25, 2021 +(Nicholas K. Akins) +(ii) Principal Financial Officer: +/s/ Julia A. Sloat Vice President, Chief Financial Officer and Director February 25, 2021 +(Julia A. Sloat) +(iii) Principal Accounting Officer: +/s/ Joseph M. Buonaiuto Controller and Chief Accounting Officer February 25, 2021 +(Joseph M. Buonaiuto) +(iv) A Majority of the Directors: +*Nicholas K. Akins +*Lisa M. Barton +*Paul Chodak III +*David M. Feinberg +*Mark C. McCullough +*Charles R. Patton +Julia A. Sloat +*Brian X. Tierney +*By: /s/ Julia A. Sloat February 25, 2021 +(Julia A. Sloat, Attorney-in-Fact) +427 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +Indiana Michigan Power Company +By: /s/ Julia A. Sloat +(Julia A. Sloat, Vice President, +and Chief Financial Officer) +Date: February 25, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature Title Date +(i) Principal Executive Officer: +/s/ Nicholas K. Akins Chairman of the Board, Chief Executive Officer and Director February 25, 2021 +(Nicholas K. Akins) +(ii) Principal Financial Officer: +/s/ Julia A. Sloat Vice President, Chief Financial Officer and Director February 25, 2021 +(Julia A. Sloat) +(iii) Principal Accounting Officer: +/s/ Joseph M. Buonaiuto Controller and Chief Accounting Officer February 25, 2021 +(Joseph M. Buonaiuto) +(iv) A Majority of the Directors: +*Nicholas K. Akins +*Lisa M. Barton +*Nicholas M. Elkins +*David M. Feinberg +*David S. Isaacson +*Marc E. Lewis +*David A. Lucas +*Mark C. McCullough +Julia A. Sloat +*Toby L. Thomas +*Brian X. Tierney +*By: /s/ Julia A. Sloat February 25, 2021 +(Julia A. Sloat, Attorney-in-Fact) +428 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. +AEP Transmission Company, LLC +By: /s/ Julia A. Sloat +(Julia A. Sloat, Vice President +and Chief Financial Officer) +Date: February 25, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. +Signature Title Date +(i) Principal Executive Officer: +/s/ Nicholas K. Akins Chairman of the Board, Chief Executive Officer and Manager February 25, 2021 +(Nicholas K. Akins) +(ii) Principal Financial Officer: +/s/ Julia A. Sloat Vice President, Chief Financial Officer and Manager February 25, 2021 +(Julia A. Sloat) +(iii) Principal Accounting Officer: +/s/ Joseph M. Buonaiuto Controller and Chief Accounting Officer February 25, 2021 +(Joseph M. Buonaiuto) +(iv) A Majority of the Managers: +*Nicholas K. Akins +*David M. Feinberg +*Mark C. McCullough +Julia A. Sloat +*A. Wade Smith +*By: /s/ Julia A. Sloat February 25, 2021 +(Julia A. Sloat, Attorney-in-Fact) +429 +INDEX OF FINANCIAL STATEMENT SCHEDULES +Page +Number +Reports of Independent Registered Public Accounting Firm +S- 2 +The following financial statement schedules are included in this report on the pages indicated: +American Electric Power Company, Inc. (Parent): +Schedule I – Condensed Financial Information +S- 3 +Schedule I – Index of Condensed Notes to Condensed Financial Information +S- 7 +American Electric Power Company, Inc. and Subsidiary Companies: +Schedule II – Valuation and Qualifying Accounts and Reserves +S- 11 +S-1 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON +FINANCIAL STATEMENT SCHEDULES +To the Board of Directors and Shareholders of +American Electric Power Company, Inc. +Our audits of the consolidated financial statements referred to in our report dated February 25, 2021 appearing in the 2020 Annual Report to Shareholders of American Electric Power Company, Inc (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the accompanying schedule of condensed financial information as of December 31, 2020 and 2019 and for each of the three years in the period ended December 31, 2020 and schedule of valuation and qualifying accounts and reserves for each of the three years in the period ended December 31, 2020. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +S-2 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions, except per-share and share amounts) +Years Ended December 31, +2020 2019 2018 +REVENUES +Affiliated Revenues $ 14.1 $ 11.0 $ 9.5 +Other Revenues 1.1 1.3 1.4 +MTM – Interest Rate Hedge (5.4) (0.5) — +TOTAL REVENUES 9.8 11.8 10.9 +EXPENSES +Other Operation 21.4 53.2 39.7 +Asset Impairments and Other Related Charges — — 9.3 +Depreciation and Amortization 0.3 0.2 0.3 +TOTAL EXPENSES 21.7 53.4 49.3 +OPERATING LOSS (11.9) (41.6) (38.4) +Other Income (Expense): +Interest Income 39.2 53.5 31.3 +Interest Expense (178.5) (159.2) (87.5) +LOSS BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS (151.2) (147.3) (94.6) +Income Tax Expense (Benefit) (0.6) 22.8 (6.2) +Equity Earnings of Unconsolidated Subsidiaries 2,350.7 2,091.2 2,012.2 +NET INCOME 2,200.1 1,921.1 1,923.8 +Other Comprehensive Income (Loss) 62.6 (27.3) (23.7) +TOTAL COMPREHENSIVE INCOME $ 2,262.7 $ 1,893.8 $ 1,900.1 +WEIGHTED AVERAGE NUMBER OF BASIC AEP COMMON SHARES OUTSTANDING 495,718,223 493,694,345 492,774,600 +TOTAL BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS $ 4.44 $ 3.89 $ 3.90 +WEIGHTED AVERAGE NUMBER OF DILUTED AEP COMMON SHARES OUTSTANDING 497,226,867 495,306,238 493,758,277 +TOTAL DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS $ 4.42 $ 3.88 $ 3.90 +See Condensed Notes to Condensed Financial Information beginning on page S- 7 . +S-3 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Cash and Cash Equivalents $ 299.7 $ 156.1 +Other Temporary Investments 2.4 2.0 +Advances to Affiliates 3,163.7 2,197.9 +Accounts Receivable: +Affiliated Companies 35.8 11.3 +General 0.3 0.3 +Total Accounts Receivable 36.1 11.6 +Affiliated Notes Receivable — 20.0 +Accrued Tax Benefits 27.1 7.1 +Prepayments and Other Current Assets 4.6 9.9 +TOTAL CURRENT ASSETS 3,533.6 2,404.6 +PROPERTY, PLANT AND EQUIPMENT +General 2.0 2.3 +Construction Work in Progress — 0.2 +Total Property, Plant and Equipment 2.0 2.5 +Accumulated Depreciation, Depletion and Amortization 1.0 1.4 +TOTAL PROPERTY, PLANT AND EQUIPMENT – NET 1.0 1.1 +OTHER NONCURRENT ASSETS +Investments in Unconsolidated Subsidiaries 25,764.2 23,329.9 +Affiliated Notes Receivable 65.0 39.0 +Deferred Charges and Other Noncurrent Assets 79.2 95.7 +TOTAL OTHER NONCURRENT ASSETS 25,908.4 23,464.6 +TOTAL ASSETS $ 29,443.0 $ 25,870.3 +See Condensed Notes to Condensed Financial Information beginning on page S- 7 . +S-4 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2020 and 2019 +(dollars in millions) +December 31, +2020 2019 +CURRENT LIABILITIES +Advances from Affiliates $ 447.2 $ 252.6 +Accounts Payable: +General 3.0 0.5 +Affiliated Companies 8.0 8.4 +Short-term Debt 1,852.3 2,110.0 +Long-term Debt Due Within One Year – Nonaffiliated (a) 410.4 501.9 +Accrued Taxes 3.8 44.2 +Other Current Liabilities 87.4 38.1 +TOTAL CURRENT LIABILITIES 2,812.1 2,955.7 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated (a) 5,873.2 3,122.9 +Deferred Credits and Other Noncurrent Liabilities 161.6 116.6 +TOTAL NONCURRENT LIABILITIES 6,034.8 3,239.5 +TOTAL LIABILITIES 8,846.9 6,195.2 +MEZZANINE EQUITY +Contingently Redeemable Performance Share Awards 45.2 42.9 +COMMON SHAREHOLDERS’ EQUITY +Common Stock – Par Value – $6.50 Per Share: +2020 2019 +Shares Authorized 600,000,000 600,000,000 +Shares Issued 516,808,354 514,373,631 +(20,204,160 Shares were Held in Treasury as of December 31, 2020 and 2019, Respectively) 3,359.3 3,343.4 +Paid-in Capital 6,588.9 6,535.6 +Retained Earnings 10,687.8 9,900.9 +Accumulated Other Comprehensive Income (Loss) (85.1) (147.7) +TOTAL AEP COMMON SHAREHOLDERS’ EQUITY 20,550.9 19,632.2 +TOTAL LIABILITIES, MEZZANINE EQUITY AND TOTAL EQUITY $ 29,443.0 $ 25,870.3 +(a) +Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 included in the 2020 Annual Reports for additional information. +See Condensed Notes to Condensed Financial Information beginning on page S- 7 . +S-5 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 2,200.1 $ 1,921.1 $ 1,923.8 +Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: +Depreciation and Amortization 0.3 0.2 0.3 +Deferred Income Taxes 8.2 26.5 (45.0) +Asset Impairments and Other Related Charges — — 9.3 +Interest Rate Hedge Settlement 57.5 — — +Equity Earnings of Unconsolidated Subsidiaries (2,350.7) (2,091.2) (2,012.2) +Cash Dividends Received from Unconsolidated Subsidiaries 454.0 426.2 855.6 +Change in Other Noncurrent Assets 1.1 0.1 (5.5) +Change in Other Noncurrent Liabilities 39.2 84.5 42.1 +Changes in Certain Components of Working Capital: +Accounts Receivable, Net (24.5) 2.4 (3.9) +Accounts Payable 2.1 (1.2) — +Other Current Assets 1.3 (0.8) 47.8 +Other Current Liabilities (55.8) 36.4 4.7 +Net Cash Flows from Operating Activities 332.8 404.2 817.0 +INVESTING ACTIVITIES +Construction Expenditures (0.2) (0.3) (0.4) +Change in Advances to Affiliates, Net (965.8) (1,101.5) (106.9) +Capital Contributions to Unconsolidated Subsidiaries (436.5) (212.8) (859.1) +Repayment of Notes Receivable from Unconsolidated Subsidiaries 20.0 70.9 199.7 +Issuance of Notes Receivable to Unconsolidated Subsidiaries (26.0) (9.0) — +Other Investing Activities 2.7 — — +Net Cash Flows Used for Investing Activities (1,405.8) (1,252.7) (766.7) +FINANCING ACTIVITIES +Issuance of Common Stock, Net 155.0 65.3 73.6 +Issuance of Long-term Debt 3,113.9 1,321.3 991.9 +Issuance of Short-term Debt with Original Maturities Greater Than 90 Days 1,396.5 — 205.6 +Change in Short-term Debt with Original Maturities Less Than 90 Day, Net (347.1) 950.0 261.4 +Retirement of Long-term Debt (500.0) — — +Change in Advances from Affiliates, Net 194.6 (61.0) (151.5) +Redemption of Short-term Debt with Original Maturities Greater Than 90 Days (1,307.1) — (205.6) +Dividends Paid on Common Stock (1,415.0) (1,345.5) (1,251.1) +Other Financing Activities (74.2) (24.8) (7.4) +Net Cash Flows from (Used for) Financing Activities 1,216.6 905.3 (83.1) +Net Increase (Decrease) in Cash and Cash Equivalents 143.6 56.8 (32.8) +Cash and Cash Equivalents at Beginning of Period 156.1 99.3 132.1 +Cash and Cash Equivalents at End of Period $ 299.7 $ 156.1 $ 99.3 +See Condensed Notes to Condensed Financial Information beginning on page S- 7 . +S-6 +SCHEDULE I +AMERICAN ELECTRIC POWER COMPANY, INC. (Parent) +INDEX OF CONDENSED NOTES TO CONDENSED FINANCIAL INFORMATION +1. Summary of Significant Accounting Policies +2. Commitments, Guarantees and Contingencies +3. Financing Activities +4. Related Party Transactions +S-7 +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +The condensed financial information of Parent is required as a result of the restricted net assets of AEP consolidated subsidiaries exceeding 25% of AEP consolidated net assets as of December 31, 2020. Parent is a public utility holding company that owns all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries, including joint ventures and equity investments. The primary source of income for Parent is equity in its subsidiaries’ earnings. Its major source of cash is dividends from the subsidiaries. Parent borrows the funds for the money pool that is used by the subsidiaries for their short-term cash needs. Parent financial statements should be read in conjunction with the AEP consolidated financial statements and the accompanying notes thereto. For purposes of these condensed financial statements, AEP wholly-owned and majority-owned subsidiaries are recorded based upon its proportionate share of the subsidiaries’ net assets (similar to presenting them on the equity method). +Income Taxes +Parent files a consolidated federal income tax return with its subsidiaries. The tax benefit of Parent is allocated to its subsidiaries with taxable income reducing their current tax expense proportionately. With the exception of the allocation of the consolidated AEP System NOL, the loss of parent and tax credits, the method of allocation reflects a separate return result for each company in the consolidated group. +2. COMMITMENTS, GUARANTEES AND CONTINGENCIES +Parent and its subsidiaries are parties to environmental and other legal matters. Parent has issued guarantees over the performance of certain equity method investees. +Guarantees of Equity Method Investees (Applies to AEP) +In April 2019, AEP acquired Sempra Renewables LLC. The transaction resulted in the acquisition of a 50% ownership interest in five non-consolidated joint ventures and the acquisition of two tax equity partnerships. Parent has issued guarantees over the performance of the joint ventures. If a joint venture were to default on payments or performance, Parent would be required to make payments on behalf of the joint venture. As of December 31, 2020, the maximum potential amount of future payments associated with these guarantees was $157 million, with the last guarantee expiring in December 2037. The non-contingent liability recorded associated with these guarantees was $31 million, with an additional $1 million expected credit loss liability for the contingent portion of the guarantees. Management considered historical losses, economic conditions, and reasonable and supportable forecasts in the calculation of the expected credit loss. As the joint ventures generate cash flows through PPAs, the measurement of the contingent portion of the guarantee liability is based upon assessments of the credit quality and default probabilities of the respective PPA counterparties. +For further discussion, see Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report. +S-8 +3. FINANCING ACTIVITIES +The following details long-term debt outstanding as of December 31, 2020 and 2019: +Long-term Debt +Weighted-Average Interest Rate Ranges as of Outstanding as of +Interest Rate as of December 31, December 31, +Type of Debt Maturity December 31, 2020 2020 2019 2020 2019 +(in millions) +Senior Unsecured Notes 2020-2050 2.44% 0.70%-4.30% 2.15%-4.30% $ 4,123.6 $ 2,301.5 +Pollution Control Bonds 2024-2029 (a) 2.26% 1.90%-2.60% 1.90%-2.60% 535.9 535.5 +Junior Subordinate Notes 2022-2023 2.32% 1.30%-3.40% 3.40% 1,624.1 787.8 +Total Long-term Debt Outstanding 6,283.6 3,624.8 +Long-term Debt Due Within One Year 410.4 501.9 +Long-term Debt $ 5,873.2 $ 3,122.9 +(a) Certain Pollution Control Bonds are subject to redemption earlier than the maturity date. +Long-term debt outstanding as of December 31, 2020 is payable as follows: +2021 2022 2023 2024 2025 After 2025 Total +(in millions) +Principal Amount (a) $ 410.4 $ 1,115.7 $ 1,909.6 $ 306.5 $ 454.9 $ 2,148.6 $ 6,345.7 +Unamortized Discount, Net and Debt Issuance Costs (62.1) +Total Long-term Debt Outstanding $ 6,283.6 +(a) Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 included in the 2020 Annual Report for additional information. +Short-term Debt +Parent’s outstanding short-term debt was as follows: +December 31, 2020 December 31, 2019 +Type of Debt Outstanding +Amount Weighted-Average +Interest Rate Outstanding +Amount Weighted-Average +Interest Rate +(in millions) (in millions) +Commercial Paper $ 1,852.3 0.29 % $ 2,110.0 2.10 % +Total Short-term Debt $ 1,852.3 $ 2,110.0 +4. RELATED PARTY TRANSACTIONS +Payments on Behalf of Subsidiaries +Due to occasional time sensitivity and complexity of payments, Parent makes certain insurance, tax and benefit payments on behalf of subsidiary companies. Parent is then fully reimbursed by the subsidiary companies. +S-9 +Short-term Lending to Subsidiaries +Parent uses a commercial paper program to meet the short-term borrowing needs of subsidiaries. The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds certain nonutility subsidiaries. In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons. The program also allows some direct borrowers to invest excess cash with Parent. +Interest expense related to Parent’s short-term borrowing is included in Interest Expense on Parent’s statements of income. Parent incurred interest expense for amounts borrowed from subsidiaries of $4 million, $8 million and $11 million for the years ended December 31, 2020, 2019 and 2018, respectively. +Interest income related to Parent’s short-term lending is included in Interest Income on Parent’s statements of income. Parent earned interest income for amounts advanced to subsidiaries of $36 million, $49 million and $27 million for the years ended December 31, 2020, 2019 and 2018, respectively. +Affiliated Notes +Parent issued long-term debt, portions of which were loaned to its subsidiaries. Parent pays interest on the affiliated notes, but the subsidiaries accrue interest for their share of the affiliated borrowing and remit the interest to Parent. Interest income related to Parent’s loans to subsidiaries is included in Interest Income on Parent’s statements of income. Parent earned interest income on loans to subsidiaries of $2 million, $2 million and $2 million for the years ended December 31, 2020, 2019 and 2018, respectively. +S-10 +SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS AND RESERVES +AEP Additions +Description Balance at +Beginning +of Period Charged to +Costs and +Expenses Charged to Other +Accounts (a) Deductions (b) Balance at +End of +Period +(in millions) +Deducted from Assets: +Accumulated Provision for Uncollectible Accounts: +Year Ended December 31, 2020 $ 43.7 $ 46.0 $ 5.9 $ 24.5 $ 71.1 +Year Ended December 31, 2019 36.8 41.3 3.6 38.0 43.7 +Year Ended December 31, 2018 38.5 37.3 2.6 41.6 36.8 +(a) Recoveries offset by reclasses to other assets and liabilities. +(b) Uncollectible accounts written off. +Schedule II for the Registrant Subsidiaries is not presented because the amounts are not material. +S-11 +INDEX OF AEP TRANSMISSION COMPANY, LLC (AEPTCO PARENT) +FINANCIAL STATEMENT SCHEDULES +Page +Number +Report of Independent Registered Public Accounting Firm on Financial Statement Schedule +S- 13 +The following financial statement schedules are included in this report on the pages indicated: +AEP Transmission Company, LLC (AEPTCo Parent): +Schedule I – Condensed Financial Information +S- 14 +Schedule I – Index of Condensed Notes to Condensed Financial Information +S- 18 +S-12 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON +FINANCIAL STATEMENT SCHEDULE +To the Board of Directors and Member of +AEP Transmission Company, LLC +Our audits of the consolidated financial statements referred to in our report dated February 25, 2021 appearing in the 2020 Annual Report to Shareholders of AEP Transmission Company, LLC (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the accompanying schedule of condensed financial information as of December 31, 2020 and 2019 and for each of the three years in the period ended December 31, 2020. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. +/s/ PricewaterhouseCoopers LLP +Columbus, Ohio +February 25, 2021 +S-13 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF INCOME +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +EXPENSES +Other Operation $ 0.2 $ 0.3 $ — +TOTAL EXPENSES 0.2 0.3 — +OPERATING LOSS (0.2) (0.3) — +Other Income (Expense): +Interest Income - Affiliated 149.6 123.8 104.6 +Interest Expense (148.1) (122.1) (103.4) +INCOME BEFORE INCOME TAX EXPENSE AND EQUITY EARNINGS OF UNCONSOLIDATED SUBSIDIARIES 1.3 1.4 1.2 +Income Tax Expense 0.2 0.3 0.2 +Equity Earnings of Unconsolidated Subsidiaries 422.3 438.6 314.9 +NET INCOME $ 423.4 $ 439.7 $ 315.9 +See Condensed Notes to Condensed Financial Information beginning on page S- 18 . +S-14 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +ASSETS +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT ASSETS +Advances to Affiliates $ 109.0 $ 68.7 +Accounts Receivable: +Affiliated Companies 26.5 23.1 +Total Accounts Receivable 26.5 23.1 +Notes Receivable - Affiliated 50.0 — +TOTAL CURRENT ASSETS 185.5 91.8 +OTHER NONCURRENT ASSETS +Notes Receivable - Affiliated 3,898.5 3,427.3 +Investments in Unconsolidated Subsidiaries 4,712.0 4,009.7 +TOTAL OTHER NONCURRENT ASSETS 8,610.5 7,437.0 +TOTAL ASSETS $ 8,796.0 $ 7,528.8 +See Condensed Notes to Condensed Financial Information beginning on page S- 18 . +S-15 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED BALANCE SHEETS +LIABILITIES AND EQUITY +December 31, 2020 and 2019 +(in millions) +December 31, +2020 2019 +CURRENT LIABILITIES +Accounts Payable: +General $ 62.2 $ 35.6 +Affiliated Companies 41.0 35.0 +Long-term Debt Due Within One Year – Nonaffiliated 50.0 — +Accrued Interest 23.9 19.2 +Other Current Liabilities 7.5 2.2 +TOTAL CURRENT LIABILITIES 184.6 92.0 +NONCURRENT LIABILITIES +Long-term Debt – Nonaffiliated 3,898.5 3,427.3 +TOTAL NONCURRENT LIABILITIES 3,898.5 3,427.3 +TOTAL LIABILITIES 4,083.1 3,519.3 +MEMBER’S EQUITY +Paid-in Capital 2,765.6 2,480.6 +Retained Earnings 1,947.3 1,528.9 +TOTAL MEMBER’S EQUITY 4,712.9 4,009.5 +TOTAL LIABILITIES AND MEMBER’S EQUITY $ 8,796.0 $ 7,528.8 +See Condensed Notes to Condensed Financial Information beginning on page S- 18 . +S-16 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +CONDENSED FINANCIAL INFORMATION +CONDENSED STATEMENTS OF CASH FLOWS +For the Years Ended December 31, 2020, 2019 and 2018 +(in millions) +Years Ended December 31, +2020 2019 2018 +OPERATING ACTIVITIES +Net Income $ 423.4 $ 439.7 $ 315.9 +Adjustments to Reconcile Net Income to Net Cash Flows from (Used for) Operating Activities: +Equity Earnings of Unconsolidated Subsidiaries (422.3) (438.6) (314.9) +Change in Other Noncurrent Liabilities 5.6 11.9 — +Changes in Certain Components of Working Capital: +Accounts Receivable, Net (3.4) (6.0) 0.2 +Accounts Payable 5.3 18.8 (6.4) +Accrued Interest 4.7 3.3 0.9 +Other Current Liabilities 32.5 34.6 (1.2) +Net Cash Flows from (Used for) Operating Activities 45.8 63.7 (5.5) +INVESTING ACTIVITIES +Change in Advances to Affiliates, Net (40.3) (51.7) 5.5 +Issuance of Notes Receivable to Affiliated Companies (525.0) (615.0) (271.0) +Return of Capital Contributions from Unconsolidated Subsidiaries 5.0 — — +Capital Contributions to Subsidiaries (335.0) — (664.0) +Net Cash Flows Used for Investing Activities (895.3) (666.7) (929.5) +FINANCING ACTIVITIES +Capital Contributions from Member 335.0 — 664.0 +Issuance of Long-term Debt – Nonaffiliated 519.5 688.0 321.0 +Retirement of Long-term Debt – Nonaffiliated — (85.0) (50.0) +Dividends Paid to Member (5.0) — — +Net Cash Flows from Financing Activities 849.5 603.0 935.0 +Net Change in Cash and Cash Equivalents — — — +Cash and Cash Equivalents at Beginning of Period — — — +Cash and Cash Equivalents at End of Period $ — $ — $ — +See Condensed Notes to Condensed Financial Information beginning on page S- 18 . +S-17 +SCHEDULE I +AEP TRANSMISSION COMPANY, LLC (AEPTCo Parent) +INDEX OF CONDENSED NOTES TO CONDENSED FINANCIAL INFORMATION +1. Summary of Significant Accounting Policies +2. Commitments, Guarantees and Contingencies +3. Financing Activities +4. Related Party Transactions +S-18 +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Basis of Presentation +The condensed financial information of AEPTCo Parent is required as a result of the restricted net assets of AEPTCo consolidated subsidiaries exceeding 25% of AEPTCo consolidated net assets as of December 31, 2020. AEPTCo Parent is the direct holding company for the seven State Transcos. The primary source of income for AEPTCo Parent is equity in its subsidiaries’ earnings. AEPTCo Parent financial statements should be read in conjunction with the AEPTCo consolidated financial statements and the accompanying notes thereto. For purposes of these condensed financial statements, AEPTCo wholly-owned and majority-owned subsidiaries are recorded based upon its proportionate share of the subsidiaries’ net assets (similar to presenting them on the equity method). +Income Taxes +AEPTCo Parent joins in the filing of a consolidated federal income tax return with its affiliates in the AEP System. The allocation of the AEP System’s current consolidated federal income tax to the AEP System companies allocates the benefit of current tax loss of the parent company (Parent Company Loss Benefit) to the AEP System subsidiaries with taxable income reducing their current tax expense proportionately. The consolidated net operating loss of the AEP System is allocated to each company in the consolidated group with taxable losses. The tax benefit of AEP Parent is allocated to its subsidiaries with taxable income. With the exception of the allocation of the consolidated AEP System net operating loss, the loss of the AEP Parent and tax credits, the method of allocation reflects a separate return result for each company in the consolidated group. +2. COMMITMENTS, GUARANTEES AND CONTINGENCIES +AEPTCo Parent and its subsidiaries are parties to legal matters. For further discussion, see Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report. +3. FINANCING ACTIVITIES +For discussion of Financing Activities, see Note 14 - Financing Activities to AEPTCo’s audited consolidated financial statements included in the 2020 Annual Report. +4. RELATED PARTY TRANSACTIONS +Payments on Behalf of Subsidiaries +Due to occasional time sensitivity and complexity of payments, Parent makes certain insurance, tax and other payments on behalf of subsidiary companies. Parent is then fully reimbursed by the subsidiary companies. AEPTCo Parent also makes convenience payments on behalf of its State Transcos. AEPTCo Parent is then fully reimbursed by its State Transcos. +Long-term Lending to Subsidiaries +AEPTCo Parent enters into debt arrangements with nonaffiliated entities. AEPTCo Parent has long-term debt of $3.9 billion and $3.4 billion as of December 31, 2020 and 2019, respectively. AEPTCo Parent uses the proceeds from these nonaffiliated debt arrangements to make affiliated loans to its State Transcos using the same interest rates and maturity dates as the nonaffiliated debt arrangements. AEPTCo Parent has recorded Notes Receivable – Affiliated of $3.9 billion and $3.4 billion as of December 31, 2020 and 2019, respectively. Related to these nonaffiliated and affiliated debt arrangements, AEPTCo Parent has recorded Accrued Interest of $24 million and $19 million as of December 31, 2020 and 2019, respectively. AEPTCo Parent has also recorded Accounts Receivable – Affiliated Companies of $27 million and $23 million as of December 31, 2020 and 2019, respectively. AEPTCo Parent has recorded Interest Income – Affiliated of $150 million, $124 million and $105 million for the years ended December 31, 2020, 2019 and 2018, respectively, related to the Notes Receivable – Affiliated. AEPTCo Parent has recorded Interest Expense of $148 million, $122 million and $103 million for the years ended December 31, 2020, 2019 and 2018, respectively, related to the nonaffiliated debt arrangements. +S-19 +Short-term Lending to Subsidiaries +Parent uses a commercial paper program to meet the short-term borrowing needs of subsidiaries. The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds certain nonutility subsidiaries. In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons. The program also allows some direct borrowers to invest excess cash with Parent. +Interest expense related to AEPTCo Parent’s short-term borrowing is included in Interest Expense on AEPTCo Parent’s statements of income. AEPTCo Parent incurred immaterial interest expense for amounts borrowed from AEP affiliates for the years ended December 31, 2020, 2019 and 2018. +Interest income related to AEPTCo Parent’s short-term lending is included in Interest Income – Affiliated on AEPTCo Parent’s statements of income. AEPTCo Parent earned interest income for amounts advanced to AEP affiliates of $2 million, $2 million and $1 million for the year ended December 31, 2020, 2019 and 2018, respectively. +S-20 +EXHIBIT INDEX +The documents listed below are being filed or have previously been filed on behalf of the Registrants shown and are incorporated herein by reference to the documents indicated and made a part hereof. Exhibits (“Ex”) not identified as previously filed are filed herewith. Exhibits designated with a dagger (†) are management contracts or compensatory plans or arrangements required to be filed as an Exhibit to this Form. Exhibits designated with an asterisk (*) are filed herewith. +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +AEP‡ File No. 1-3525 +3(a) Composite of the Restated Certificate of Incorporation of AEP, dated April 26, 2019. +Form 10-Q, Ex 3, June 30, 2019 +3(b) Composite By-Laws of AEP, as amended as of October 20, 2015. +Form 8-K, Ex 3(b) dated October 21, 2015 +4(a) Indenture (for unsecured debt securities), dated as of May 1, 2001, between AEP and The Bank of New York, as Trustee. +Registration Statement No. 333-86050, Ex 4 (a) (b) (c) +Registration Statement No. 333-105532, Ex 4 (d) (e) (f) +Registration Statement No. 333-200956, Ex 4(b) +Registration Statement No. 333-222068, Ex 4(b) Registration Statement No. 333-249918, Ex 4 (b) (c) +4(a)1 Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated November 20, 2020 establishing terms of 0.75% Senior Notes Series M due 2023, 1.00% Senior Notes, Series N due 2025 and Floating Rate Notes, Series A due 2023. +Form 8-K, Ex 4(a) dated November 18, 2020 +4(a)2 Purchase Contract and Pledge Agreement, dated as of March 19, 2019, between the Company and The Bank of New York Mellon Trust Company, N.A., as purchase contract agent, collateral agent, custodial agent and securities intermediary. +Registration Statement No. 333-249918, Ex 4(h) +4(a)3 Purchase Contract dated as of August 14, 2020, between the Company and The Bank of New York Mellon Trust Company, N.A., as purchase contract agent, collateral agent, custodial agent and securities intermediary. +Registration Statement No. 333-249918, Ex 4(i) +4(a)4 Junior Subordinated Indenture, dated March 1, 2008, between the Company and The Bank of New York Mellon Trust Company, N.A., as Trustee for the Junior Subordinated Debentures. +Registration Statement No. 333-156387, Ex 4(c) (d) +Registration Statement No. 333-249918, Ex 4 (f) (g) +4(b) First Amendment to Fourth Amended and Restated Credit Agreement dated June 30, 2016 among AEP, the banks, financial institutions and other institutional lenders listed on the signature pages thereof and Wells Fargo Bank, N.A., as Administrative Agent. +Form 10-Q, Ex 4, September 30, 2018 +E-1 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +*4(c) +Description of Securities. +4(d) Credit Agreement among AEP, initial lenders and PNC Bank, National Association as Administrative Agent. +Form 10-Q, Ex 4.3, March 31, 2020 +4(e) Distribution Agreement, dated November 6, 2020, between American Electric Power Company, Inc. and Credit Suisse Securities (USA) LLC, Barclays Capital Inc., BofA Securities, Inc., BNY Mellon Capital Markets, LLC, Citigroup Global Markets Inc., Scotia Capital (USA) Inc., Credit Suisse Capital LLC, Barclays Bank PLC, Bank of America, N.A. and Citibank, N.A. +Form 8-K, Ex 1.1, November 6, 2020 +10(a) Lease Agreements, dated as of December 1, 1989, between AEGCo or I&M and Wilmington Trust Company, as amended. Registration Statement No. 33-32752, Ex 28(c)(1-6)(C) +Registration Statement No. 33-32753, Ex 28(a)(1-6)(C) +AEGCo 1993 Form 10-K, Ex 10(c)(1-6)(B) +I&M 1993 Form 10-K, Ex 10(e)(1-6)(B) +10(b) Consent Decree with U.S. District Court dated October 9, 2007, as modified July 17, 2019. +Form 8-K, Ex. 10 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +Form 10-Q, Ex 10, June 30, 2019 +†10(c) AEP Retainer Deferral Plan for Non-Employee Directors, as Amended and Restated effective October 1, 2020. +Form 10-Q, Ex 10.2, September 30, 2020 +†10(d) AEP Stock Unit Accumulation Plan for Non-Employee Directors as amended October 1, 2020. +Form 10-Q, Ex 10.3, September 30, 2020 +†10(e) AEP System Excess Benefit Plan, Amended and Restated as of January 1, 2020. +2019 Form 10-K, Ex 10(e) +†10(e)(1) Guaranty by AEP of AEPSC Excess Benefits Plan. 1990 Form 10-K, Ex 10(h)(1)(B) +†10(f) AEP System Supplemental Retirement Savings Plan, Amended and Restated as of January 1, 2011 (Non-Qualified). +2010 Form 10-K, Ex 10 +†10(f)(1)(A) Amendment to AEP System Supplemental Retirement Savings Plan, as Amended and Restated as of January 1, 2011 (Non-Qualified). +2014 Form 10-K, Ex 10(l)(1)(A) +†10(f)(2)(A) Second Amendment to AEP System Supplemental Retirement Savings Plan, as Amended and Restated as of January 1, 2011 (Non-Qualified). +2019 Form 10-K, Ex 10(f)(2)(A) +†10(g) AEPSC Umbrella Trust for Executives. 1993 Form 10-K, Ex 10(g)(3) +E-2 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +†10(g)(1)(A) First Amendment to AEPSC Umbrella Trust for Executives. +2008 Form 10-K, Ex 10(l)(3)(A) +†10(g)(2)(A) Second Amendment to AEPSC Umbrella Trust for Executives. +2018 Form 10-K, Ex 10(g)(2)(A) +†10(h) AEP System Incentive Compensation Deferral Plan Amended and Restated as of June 1, 2019. +Form 10-Q, Ex 10(1), September 30, 2019 +†10(h)(1)(A) First Amendment to AEP System Incentive Compensation Deferral Plan, as Amended and Restated effective January 1, 2008. +2011 Form 10-K, Ex 10(p)(1)(A) +†10(h)(2)(A) Second Amendment to AEP System Incentive Compensation Deferral Plan, as Amended and Restated effective January 1, 2008. +2014 Form 10-K, Ex 10(q)(2)(A) +†10(i) AEP Change In Control Agreement, as Revised Effective January 1, 2017. +Form 10-Q, Ex 10(c) , September 30, 2016 +†10(j) Amended and Restated AEP System Long-Term Incentive Plan as of September 21, 2016. +Form 10-Q, Ex 10(a) , September 30, 2016 +†10(j)(1)(A) Performance Share Award Agreement furnished to participants of the AEP System Long-Term Incentive Plan, as amended. +Form 10-Q, Ex 10(a), March 30, 2018 +†10(j)(2)(A) Restricted Stock Unit Agreement furnished to participants of the AEP System Long-Term Incentive Plan as Amended and Restated. +Form 10-Q, Ex 10(b), March 30, 2018 +†10(k) AEP System Stock Ownership Requirement Plan Amended and Restated effective June 20, 2017. +Form 10-Q, Ex 10, June 30, 2017 +†10(k)(A) AEP System Stock Ownership Requirement Plan Amended and Restated effective October 1, 2020. +Form 10-Q, Ex 10.1, September 30, 2020 +†10(l) Central and South West System Special Executive Retirement Plan Amended and Restated effective January 1, 2020. +2019 Form 10-K, Ex 10(l) +†10(m) AEP Executive Severance Plan Amended and Restated effective October 24, 2016. +Form 10-Q, Ex 10(d) , September 30, 2016 +†10(m)1(A) AEP Executive Severance Plan Amended effective June 17, 2020. +Form 10-Q, Ex 10, June 30, 2020 +*†10(n) +AEP Executive Severance Plan Amended effective January 4, 2021. +†10(o) Severance, Stock Award, Release of All Claims and Noncompetition Agreement dated October 21, 2020 between AEPSC and Lana Hillebrand. +Form 10-Q, Ex 10.4 dated September 30, 2020 +E-3 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +†10(p) AEP Aircraft Timesharing Agreement dated October 1, 2019 between American Electric Power Service Corporation and Nicholas K. Akins. +Form 10-Q, Ex 10(2), September 30, 2019 +*21 +List of subsidiaries of AEP. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +AEP TEXAS‡ File No. 333-221643 +3(a) Composite of the Restated Certificate of Incorporation, as amended. +Registration No. 333-221643, Ex 3(a) +3(b) Bylaws. +Registration No. 333-221643, Ex 3(b) +E-4 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +4(a) Indenture, dated as of September 1, 2017, between AEP Texas Inc. and The Bank of New York Mellon Trust Company, N.A., as Trustee. +Registration No. 333-221643, Ex 4(a)-1 , 4(a)-2 ; Registration No. 333-228657, Ex 4(a)-4 , 4(a)-5 ; Registration No. 333-230613, Ex 4(a) (b) +4(b) Company Order and Officer’s Certificate to The Bank of New York Mellon Trust Company, N.A. dated May 1, 2019 establishing the terms of 4.15% Senior Notes, Series G due 2049. +Form 8-K Ex 4(a) dated April 29, 2019 +4(c) Company Order and Officer’s Certificate to The Bank of New York Mellon Trust Company, N.A. dated December 5, 2019 establishing the terms of 3.45% Senior Notes, Series H due 2050. +Form 8-K Ex 4(a) dated December 6, 2019 +4(d) Company Order and Officer’s Certificate to The Bank of New York Mellon Trust Company, N.A. dated July 1, 2020 establishing the terms of 2.10% Senior Notes, Series I due 2030. +Form 8-K Ex. 4(a) dated July 1, 2020 +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +AEPTCo‡ File No. 333-217143 +3(a) Limited Liability Company Agreement of AEP Transmission Company, LLC dated as of January 27, 2006. +Registration Statement No. 333-217143, Ex 3(a) +3(b) First Amendment to Limited Liability Company Agreement dated as of May 21, 2013. +Registration Statement No. 333-217143, Ex 3(b) +4(a) Indenture, dated as of November 1, 2016, between AEP Transmission Company, LLC and The Bank of New York Mellon Trust Company, N.A., as Trustee. +Registration Statement No. 333-217143, Ex 4(a)-1 , 4(a)-2 +Registration Statement No. 333-225325, Ex 4 (b) (c) (d) +4(b) Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated September 7, 2018 establishing the terms of the 4.25% Senior Notes, Series J due 2048. +Form 8-K, Ex 4(a) dated September 7, 2018 +4(c) Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated June 12, 2019 establishing the terms of the 3.80% Senior Notes, Series K due 2049. +Form 8-K Ex 4(a) dated June 12, 2019 +4(d) Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated September 11, 2019 establishing the terms of the 3.15% Senior Notes, Series L due 2049. +Form 8-K Ex 4(a) dated September 9, 2019 +4(e) Company Order and Officers’ Certificate to The Bank of New York Mellon Trust Company, N.A. dated April 1, 2020 establishing the terms of the 3.65% Senior Notes, Series M due 2050. +Form 8-K Ex 4(a) dated April 1, 2020 +4(f) Note Purchase Agreement, dated as of October 18, 2012 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-1 +4(f)(1) Supplement to Note Purchase Agreement, dated as of November 7, 2013 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-2 +4(f)(2) Supplement to Note Purchase Agreement, dated as of November 14, 2014 between AEP Transmission Company, LLC and the Initial Purchasers. +Registration Statement No. 333-217143, Ex 4(c)-3 +E-6 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +I&M‡ File No. 1-3570 +3(a) Composite of the Amended Articles of Acceptance of I&M, dated of March 7, 1997. +1996 Form 10-K, Ex 3(c) +3(b) Composite By-Laws of I&M, amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) Indenture (for unsecured debt securities), dated as of October 1, 1998, between I&M and The Bank of New York, as Trustee. +Registration Statement No. 333-88523, Ex 4(a)(b)(c) +Registration Statement No. 333-58656, Ex 4( b )( c ) +Registration Statement No. 333-108975, Ex 4( b )( c )( d ) +Registration Statement No. 333-136538, Ex 4( b )( c ) +Registration Statement No. 333-156182, Ex 4(b) +Registration Statement No. 333-185087, Ex 4(b) +Registration Statement No. 333-207836, Ex 4(b) +Registration Statement No. 333-225103, Ex 4( b )( c )( d ) +4(b) Company Order and Officers Certificate to The Bank of New York Mellon Trust Company, N.A. dated August 8, 2018 of 4.25% Series N due 2048. +Form 8-K, Ex 4(a) dated August 8, 2018 +10(a) Inter-Company Power Agreement, dated as of July 10, 1953, among OVEC and the Sponsoring Companies, as amended September 10, 2010. +2013 Form 10-K, Ex 10(a) +10(b) Unit Power Agreement dated as of March 31, 1982 between AEGCo and I&M, as amended. Registration Statement No. 33-32752, Ex 28(b)(1)(A)(B) +E-9 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +10(c) Consent Decree with U.S. District Court dated October 9, 2007, as modified July 17, 2019. +Form 8-K, Ex. 10 dated October 9, 2007 +Form 10-Q, Ex 10, June 30, 2013 +Form 10-Q, Ex 10, June 30, 2019 +10(d) Lease Agreements, dated as of December 1, 1989, between I&M and Wilmington Trust Company, as amended. Registration Statement No. 33-32753, Ex 28(a)(1-6)(C) +1993 Form 10-K, Ex 10(e)(1-6)(B) +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +101.INS XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +PSO‡ File No. 0-343 +3(a) Certificate of Amendment to Restated Certificate of Incorporation of PSO. +Form 10-Q, Ex 3(a), June 30, 2008 +3(b) Composite By-Laws of PSO amended as of February 26, 2008. +2007 Form 10-K, Ex 3 (b) +4(a) Indenture (for unsecured debt securities), dated as of November 1, 2000, between PSO and The Bank of New York, as Trustee. +Registration Statement No. 333-100623, Ex 4( a )( b ) +Registration Statement No. 333-114665, Ex 4( b )( c ) +Registration Statement No. 333-133548, Ex 4( b )( c ) +Registration Statement No. 333-156319, Ex 4( b )( c ) +4(b) Eighth Supplemental Indenture, dated as of November 13, 2009 between PSO and The Bank of New York Mellon, as Trustee, establishing terms of the 5.15% Senior Notes, Series H, due 2019. +Form 8-K, Ex 4(a), dated November 13, 2009 +4(c) Ninth Supplemental Indenture, dated as of January 19, 2011 between PSO and The Bank of New York Mellon Trust Company, N.A., as Trustee, establishing terms of 4.40% Senior Notes, Series I, due 2021. +Form 8-K, Ex 4(a) dated January 20, 2011 +*4(d) +Credit Agreement dated as of January 19, 2021 among PSO as Borrower, Initial Lenders and Sumitomo Mitsui Banking Corporation as Administrative Agent. +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +E-13 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +101.INS XBRL Instance Document. 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Formatted as inline XBRL and contained in Exhibit 101. +SWEPCo‡ File No. 1-3146 +3(a) Composite of Amended Restated Certificate of Incorporation of SWEPCo. +2008 Form 10-K, Ex 3(a) +3(a)(A) Amendment to Amended Restated Certificate of Incorporation. +Form 8-K Ex 3.1 dated September 1, 2020 +3(b) Composite By-Laws of SWEPCo amended as of February 26, 2008. +2007 Form 10-K, Ex 3(b) +4(a) Indenture (for unsecured debt securities), dated as of February 4, 2000, between SWEPCo and The Bank of New York, as Trustee. +Registration Statement No. 333-96213 +Registration Statement No. 333-87834, Ex 4( a )( b ) +Registration Statement No. 333-100632, Ex 4(b) +Registration Statement No. 333-108045, Ex 4(b) +Registration Statement No. 333-145669, Ex 4( c )( d ) +Registration Statement No. 333-161539, Ex 4( b )( c ) +Registration Statement No. 333-194991, Ex 4( b )( c ) +Registration Statement No. 333-208535, Ex 4( b )( c ) +Registration Statement No. 333-226856, Ex 4( b )( c ) +Registration Statement No. 333-238159, Ex 4(b) +*23 +Consent of PricewaterhouseCoopers LLP. +*24 +Power of Attorney. +*31(a) +Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +E-14 +Exhibit +Designation Nature of Exhibit Previously Filed as Exhibit to: +*31(b) +Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. +*32(a) +Certification of Chief Executive Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*32(b) +Certification of Chief Financial Officer Pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. +*95 +Mine Safety Disclosure. +101.INS XBRL Instance Document. 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The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. +The agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time. +E-15 \ No newline at end of file diff --git a/raw/filings/0000004904/2020/0000004904-21-000010/filing_metadata.csv b/raw/filings/0000004904/2020/0000004904-21-000010/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..d2c32e37ce665531b7e21f173626f358b300638c --- /dev/null +++ b/raw/filings/0000004904/2020/0000004904-21-000010/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004904,AEP,AMERICAN ELECTRIC POWER CO INC,2020,10-K,2021-02-25,2020-12-31,2021-02-25T13:27:36.000Z,0000004904-21-000010,aep-20201231.htm,10-K,102915233,1,1,https://www.sec.gov/Archives/edgar/data/4904/000000490421000010/aep-20201231.htm,https://www.sec.gov/Archives/edgar/data/4904/000000490421000010/ diff --git a/raw/filings/0000004904/2020/0000004904-21-000010/item1.txt b/raw/filings/0000004904/2020/0000004904-21-000010/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..023866dd8508f1df38c967c6f61b215a3c22f7ab --- /dev/null +++ b/raw/filings/0000004904/2020/0000004904-21-000010/item1.txt @@ -0,0 +1,387 @@ +ITEM 1. BUSINESS +GENERAL +Overview and Description of Major Subsidiaries +AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company that owns, directly or indirectly, all of the outstanding common stock of its public utility subsidiaries and varying percentages of other subsidiaries. +The service areas of AEP’s public utility subsidiaries cover portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Transmission networks are interconnected with extensive distribution facilities in the territories served. The public utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers. Restructuring laws in Michigan, Ohio and the ERCOT area of Texas have caused AEP public utility subsidiaries in those states to unbundle previously integrated regulated rates for their retail customers. +The member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity and transportation and handling of fuel. The companies of the AEP System also obtain certain accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost from a common provider, AEPSC. +As of December 31, 2020, the subsidiaries of AEP had a total of 16,787 employees. Because it is a holding company rather than an operating company, AEP has no employees. The material subsidiaries of AEP are as follows: +AEP Texas +Organized in Delaware in 1925, AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,068,000 retail customers through REPs in west, central and southern Texas. As of December 31, 2020, AEP Texas had 1,570 employees. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and primary metal manufacturing. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. AEP Texas is part of AEP’s Transmission and Distribution Utilities segment. +AEPTCo +Organized in Delaware in 2006, AEPTCo is a holding company for the State Transcos. The State Transcos develop and own new transmission assets that are physically connected to the AEP System. Individual State Transcos (a) have obtained the approvals necessary to operate in Indiana, Kentucky, Michigan, Ohio, Oklahoma and West Virginia, subject to any applicable siting requirements, (b) are authorized to submit projects for commission approval in Virginia and (c) have been granted consent to enter into a joint license agreement that will support investment in Tennessee. Neither AEPTCo nor its subsidiaries have any employees. Instead, AEPSC and certain AEP utility subsidiaries provide services to these entities. AEPTCo is part of the AEP Transmission Holdco segment. +1 +APCo +Organized in Virginia in 1926, APCo is engaged in the generation, transmission and distribution of electric power to approximately 964,000 retail customers in the southwestern portion of Virginia and southern West Virginia, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. APCo owns 6,629 MWs of generating capacity. APCo uses its generation to serve its retail and other customers. As of December 31, 2020, APCo had 1,652 employees. Among the principal industries served by APCo are coal-mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. APCo is a member of PJM. APCo is part of AEP’s Vertically Integrated Utilities segment. +I&M +Organized in Indiana in 1907, I&M is engaged in the generation, transmission and distribution of electric power to approximately 602,000 retail customers in northern and eastern Indiana and southwestern Michigan, and in supplying and marketing electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities and other market participants. I&M owns or leases 3,634 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2020, I&M had 2,217 employees. Among the principal industries served are primary metals, transportation equipment, chemical manufacturing, plastics and rubber products and fabricated metal product manufacturing. I&M is a member of PJM. I&M is part of AEP’s Vertically Integrated Utilities segment. +KPCo +Organized in Kentucky in 1919, KPCo is engaged in the generation, transmission and distribution of electric power to approximately 166,000 retail customers in eastern Kentucky, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities and other market participants. KPCo owns 1,060 MWs of generating capacity. KPCo uses its generation to serve its retail and other customers. As of December 31, 2020, KPCo had 475 employees. Among the principal industries served are petroleum and coal products manufacturing, chemical manufacturing, coal-mining, oil and gas extraction and primary metals. KPCo is a member of PJM. KPCo is part of AEP’s Vertically Integrated Utilities segment. +KGPCo +Organized in Virginia in 1917, KGPCo provides electric service to approximately 49,000 retail customers in Kingsport and eight neighboring communities in northeastern Tennessee. KGPCo does not own any generating facilities and is a member of PJM. It purchases electric power from APCo for distribution to its customers. As of December 31, 2020, KGPCo had 52 employees. KGPCo is part of AEP’s Vertically Integrated Utilities segment. +OPCo +Organized in Ohio in 1907 and re-incorporated in 1924, OPCo is engaged in the transmission and distribution of electric power to approximately 1,507,000 retail customers in Ohio. OPCo purchases energy and capacity at auction to serve generation service customers who have not switched to a competitive generation supplier. As of December 31, 2020, OPCo had 1,646 employees. Among the principal industries served by OPCo are primary metals, petroleum and coal products manufacturing, plastics and rubber products, chemical manufacturing, fabricated metal product manufacturing and data centers. OPCo is a member of PJM. OPCo is part of AEP’s Transmission and Distribution Utilities segment. +2 +PSO +Organized in Oklahoma in 1913, PSO is engaged in the generation, transmission and distribution of electric power to approximately 565,000 retail customers in eastern and southwestern Oklahoma, and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. PSO owns 3,728 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2020, PSO had 1,023 employees. Among the principal industries served by PSO are paper manufacturing, oil and gas extraction, petroleum and coal products manufacturing, transportation equipment and pipeline transportation. PSO is a member of SPP. PSO is part of AEP’s Vertically Integrated Utilities segment. +SWEPCo +Organized in Delaware in 1912, SWEPCo is engaged in the generation, transmission and distribution of electric power to approximately 545,000 retail customers in northeastern and panhandle of Texas, northwestern Louisiana and western Arkansas and in supplying and marketing electric power at wholesale to other electric utility companies, municipalities, rural electric cooperatives and other market participants. SWEPCo owns 5,034 MWs of generating capacity, which it uses to serve its retail and other customers. As of December 31, 2020, SWEPCo had 1,440 employees. Among the principal industries served by SWEPCo are petroleum and coal products manufacturing, food manufacturing, paper manufacturing, oil and gas extraction and chemical manufacturing. The territory served by SWEPCo includes several military installations, colleges and universities. SWEPCo also owns and operates a lignite coal-mining operation. SWEPCo is a member of SPP. SWEPCo is part of AEP’s Vertically Integrated Utilities segment. +WPCo +Organized in West Virginia in 1883 and re-incorporated in 1911, WPCo provides electric service to approximately 42,000 retail customers in northern West Virginia and in supplying and marketing electric power at wholesale to other market participants. WPCo owns 780 MWs of generating capacity which it uses to serve its retail and other customers. Among the principal industries served by WPCo are coal-mining, primary metals, pipeline transportation, chemical manufacturing and paper manufacturing. WPCo is a member of PJM. As of December 31, 2020, WPCo had 45 employees. WPCo is part of AEP’s Vertically Integrated Utilities segment. +Service Company Subsidiary +AEPSC is a service company subsidiary that provides accounting, administrative, information systems, engineering, financial, legal, maintenance and other services at cost to AEP subsidiaries. The executive officers of AEP and certain of the executive officers of its public utility subsidiaries are employees of AEPSC. As of December 31, 2020, AEPSC had 6,295 employees. +Company Website and Availability of SEC Filings +Our principal corporate website address is www.aep.com. Information on our website is not incorporated by reference herein and is not part of this Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding AEP. +3 +Public Utility Subsidiaries by Jurisdiction +The following table illustrates certain regulatory information with respect to the jurisdictions in which the public utility subsidiaries of AEP operate: +Principal Jurisdiction AEP Utility Subsidiaries Operating in that Jurisdiction Authorized Return on Equity (a) +FERC AEPTCo - PJM 10.35% +AEPTCo - SPP 10.50% +Ohio OPCo 10.20% (b) +West Virginia APCo 9.75% +WPCo 9.75% +Virginia APCo 9.20% +Indiana I&M 9.70% +Michigan I&M 9.86% +Texas AEP Texas 9.40% +SWEPCo 9.60% +Tennessee KGPCo 9.85% +Kentucky KPCo 9.30% (c) +Louisiana SWEPCo 9.80% +Arkansas SWEPCo 9.45% +Oklahoma PSO 9.40% +(a) Identifies the predominant current authorized ROE, and may not include other, less significant, permitted recovery. Actual ROE varies from authorized ROE. +(b) Authorized ROE was approved in OPCo’s last distribution base case. The authorized ROE for riders with an approved equity return (e.g. Distribution Investment Rider) is 10.00%. +(c) Final order received and made effective in January 2021 that approved an authorized ROE of 9.30%. The authorized ROE for riders with an approved equity return (Decommissioning Rider and the Environmental Surcharge) is 9.10%. +(a) Pretax income does not include intercompany eliminations. +4 +CLASSES OF SERVICE +The principal classes of service from which AEP’s subsidiaries derive revenues and the amount of such revenues during the years ended December 31, 2020, 2019 and 2018 are as follows: +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Vertically Integrated Utilities Segment +Retail Revenues +Residential Sales $ 3,614.8 $ 3,641.2 $ 3,818.6 +Commercial Sales 2,021.0 2,151.1 2,223.7 +Industrial Sales 2,023.5 2,178.3 2,261.3 +PJM Net Charges (0.1) (0.2) 0.4 +Other Retail Sales 155.9 179.4 186.8 +Total Retail Revenues 7,815.1 8,149.8 8,490.8 +Wholesale Revenues +Off-system Sales 589.3 814.5 888.0 +Transmission 249.5 200.7 263.7 +Total Wholesale Revenues 838.8 1,015.2 1,151.7 +Other Electric Revenues 85.8 93.8 93.7 +Provision for Rate Refund (21.7) (44.7) (210.1) +Other Operating Revenues 35.2 31.6 30.6 +Sales to Affiliates 126.2 121.4 88.8 +Total Revenues Vertically Integrated Utilities Segment $ 8,879.4 $ 9,367.1 $ 9,645.5 +Transmission and Distribution Utilities Segment +Retail Revenues +Residential Sales $ 2,114.9 $ 2,084.5 $ 2,213.6 +Commercial Sales 1,049.5 1,148.8 1,266.7 +Industrial Sales 390.0 426.5 517.2 +Other Retail Sales 42.5 43.7 43.1 +Total Retail Revenues 3,596.9 3,703.5 4,040.6 +Wholesale Revenues +Off-system Sales 60.6 93.0 119.3 +Transmission 471.8 437.7 394.7 +Total Wholesale Revenues 532.4 530.7 514.0 +Other Electric Revenues 95.0 58.6 54.5 +Provision for Rate Refund 2.3 12.5 (69.2) +Other Operating Revenues 12.1 13.7 12.4 +Sales to Affiliates 107.2 163.5 100.8 +Total Revenues Transmission and Distribution Utilities Segment $ 4,345.9 $ 4,482.5 $ 4,653.1 +AEP Transmission Holdco Segment +Transmission Revenues $ 315.1 $ 265.1 $ 291.3 +Other Electric Revenues 0.4 0.3 0.3 +Other Operating Revenues 0.6 0.1 0.3 +Sales to Affiliates 901.4 812.9 555.5 +Provision for Rate Refund (18.7) (5.2) (43.3) +Total Revenues AEP Transmission Holdco Segment $ 1,198.8 $ 1,073.2 $ 804.1 +Generation & Marketing Segment +Generation Revenues - Nonaffiliated $ 136.4 $ 264.4 $ 431.5 +Renewable Generation - Nonaffiliated 85.7 77.7 44.5 +Retail, Trading and Marketing +Affiliated 104.6 135.7 122.2 +Nonaffiliated 1,398.9 1,379.8 1,342.1 +Total Revenues Generation & Marketing Segment $ 1,725.6 $ 1,857.6 $ 1,940.3 +5 +AEP Texas +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 562.3 $ 588.9 $ 594.6 +Commercial Sales 365.9 424.0 426.6 +Industrial Sales 119.9 133.3 131.0 +Other Retail Sales 29.4 30.8 30.1 +Total Retail Revenues 1,077.5 1,177.0 1,182.3 +Wholesale Revenues +Transmission 399.9 379.2 313.4 +Other Electric Revenues 45.2 24.4 21.9 +Provision for Rate Refund 2.3 (34.7) (31.3) +Total Electric Transmission and Distribution Revenues 1,524.9 1,545.9 1,486.3 +Sales to Affiliates 90.8 160.5 105.2 +Other Revenues 3.2 2.9 3.8 +Total Revenues $ 1,618.9 $ 1,709.3 $ 1,595.3 +AEPTCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Transmission Revenues $ 264.4 $ 217.2 $ 212.8 +Other Electric Revenues 0.4 0.3 0.3 +Other Operating Revenues 0.6 0.1 0.2 +Sales to Affiliates 896.3 806.7 598.9 +Provision for Rate Refund (16.0) (2.9) (36.1) +Total Revenues $ 1,145.7 $ 1,021.4 $ 776.1 +APCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 1,250.4 $ 1,272.3 $ 1,372.1 +Commercial Sales 517.0 562.2 596.3 +Industrial Sales 553.3 594.5 620.7 +PJM Net Charges (0.3) (0.2) (0.2) +Other Retail Sales 67.6 75.6 79.5 +Total Retail Revenues 2,388.0 2,504.4 2,668.4 +Wholesale Revenues +Off-system Sales 118.1 124.9 116.4 +Transmission 71.0 57.0 56.3 +Total Wholesale Revenues 189.1 181.9 172.7 +Other Electric Revenues 34.0 32.3 31.1 +Provision for Rate Refund (0.2) (10.4) (95.1) +Total Electric Generation, Transmission and Distribution Revenues 2,610.9 2,708.2 2,777.1 +Sales to Affiliates 174.7 205.3 181.4 +Other Revenues 10.6 11.2 9.0 +Total Revenues $ 2,796.2 $ 2,924.7 $ 2,967.5 +6 +I&M +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 794.1 $ 730.9 $ 736.5 +Commercial Sales 499.4 494.9 489.3 +Industrial Sales 547.5 551.4 570.6 +PJM Net Charges 0.2 0.1 0.2 +Other Retail Sales 6.6 7.3 7.2 +Total Retail Revenues 1,847.8 1,784.6 1,803.8 +Wholesale Revenues +Off-system Sales 275.4 406.4 459.3 +Transmission 31.0 19.3 18.4 +Total Wholesale Revenues 306.4 425.7 477.7 +Other Electric Revenues 11.3 14.4 15.7 +Provision for Rate Refund (0.2) (2.6) (24.6) +Total Electric Generation, Transmission and Distribution Revenues 2,165.3 2,222.1 2,272.6 +Sales to Affiliates 71.3 73.9 85.5 +Other Revenues 5.2 10.7 12.6 +Total Revenues $ 2,241.8 $ 2,306.7 $ 2,370.7 +OPCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 1,552.6 $ 1,495.6 $ 1,619.0 +Commercial Sales 683.5 724.9 840.1 +Industrial Sales 270.1 293.2 386.2 +Other Retail Sales 13.1 12.9 13.0 +Total Retail Revenues 2,519.3 2,526.6 2,858.3 +Wholesale Revenues +Off-system Sales 60.6 93.0 119.3 +Transmission 68.8 58.5 61.4 +Total Wholesale Revenues 129.4 151.5 180.7 +Other Electric Revenues 49.9 34.2 32.7 +Provision for Rate Refund — 47.2 (37.9) +Total Electricity, Transmission and Distribution Revenues 2,698.6 2,759.5 3,033.8 +Sales to Affiliates 41.5 27.3 21.0 +Other Revenues 9.0 10.8 8.6 +Total Revenues $ 2,749.1 $ 2,797.6 $ 3,063.4 +PSO +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 579.8 $ 636.1 $ 668.5 +Commercial Sales 320.4 377.3 401.1 +Industrial Sales 221.2 296.5 308.5 +Other Retail Sales 66.0 80.7 84.5 +Total Retail Revenues 1,187.4 1,390.6 1,462.6 +Wholesale Revenues +Off-system Sales 15.1 39.5 36.3 +Transmission 35.3 31.9 47.4 +Total Wholesale Revenues 50.4 71.4 83.7 +Other Electric Revenues 10.4 9.6 10.3 +Provision for Rate Refund (2.1) (2.0) (19.0) +Total Electric Generation, Transmission and Distribution Revenues 1,246.1 1,469.6 1,537.6 +Sales to Affiliates 5.2 6.1 5.4 +Other Revenues 14.8 6.1 4.3 +Total Revenues $ 1,266.1 $ 1,481.8 $ 1,547.3 +7 +SWEPCo +Years Ended December 31, +Description 2020 2019 2018 +(in millions) +Retail Revenues +Residential Sales $ 637.4 $ 645.3 $ 666.0 +Commercial Sales 471.5 490.6 502.6 +Industrial Sales 332.1 342.3 346.2 +Other Retail Sales 9.1 9.1 8.9 +Total Retail Revenues 1,450.1 1,487.3 1,523.7 +Wholesale Revenues +Off-system Sales 162.0 194.7 216.8 +Transmission 87.0 72.6 94.2 +Total Wholesale Revenues 249.0 267.3 311.0 +Other Electric Revenues 16.5 20.6 20.9 +Provision for Rate Refund (19.0) (30.6) (63.7) +Total Electric Generation, Transmission and Distribution Revenues 1,696.6 1,744.6 1,791.9 +Sales to Affiliates 39.0 4.9 28.4 +Other Revenues 2.9 1.4 1.6 +Total Revenues $ 1,738.5 $ 1,750.9 $ 1,821.9 +FINANCING +General +Companies within the AEP System generally use short-term debt to finance working capital needs. Short-term debt may also be used to finance acquisitions, construction and redemption or repurchase of outstanding securities until such needs can be financed with long-term debt. In recent history, short-term funding needs have been provided for by cash on hand and AEP’s commercial paper program. Funds are made available to subsidiaries under the AEP corporate borrowing program. Certain public utility subsidiaries of AEP also sell accounts receivable to provide liquidity. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +AEP’s revolving credit agreement (which backstops the commercial paper program) includes covenants and events of default typical for this type of facility, including a maximum debt/capital test. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of its major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under the credit agreement. As of December 31, 2020, AEP was in compliance with its debt covenants. With the exception of a voluntary bankruptcy or insolvency, any event of default has either or both a cure period or notice requirement before termination of the agreement. A voluntary bankruptcy or insolvency of AEP or one of its significant subsidiaries would be considered an immediate termination event. See “Financial Condition” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +AEP’s subsidiaries have also utilized, and expect to continue to utilize, additional financing arrangements, such as securitization financings and leasing arrangements, including the leasing of coal transportation equipment and facilities. +ENVIRONMENTAL AND OTHER MATTERS +General +AEP subsidiaries are currently subject to regulation by federal, state and local authorities with regard to air and water-quality control and other environmental matters, and are subject to zoning and other regulation by local authorities. The environmental issues that management believes are potentially material to the AEP System are outlined below. +8 +Clean Water Act Requirements +Operations for AEP subsidiaries are subject to the CWA, which prohibits the discharge of pollutants into waters of the United States except pursuant to appropriate permits and regulates systems that withdraw surface water for use in power plants. In 2014, the Federal EPA issued a final rule setting forth standards for water withdrawals at existing power plants that is intended to reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water. The standards affect all plants withdrawing more than two million gallons of cooling water per day. A schedule for compliance with the standard is established by the permit agency and incorporated in NPDES permits. +In November 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for electricity generating facilities. The rule established limits on FGD wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed in NPDES permits as soon as possible after November 2018 and no later than December 2023. The Federal EPA further revised the rule in August 2020 for FGD wastewater and bottom ash transport water extending the compliance date to December 2025 and establishing additional options. In January 2020, the Federal EPA issued a final rule revising the scope of the “waters of the United States” subject to CWA regulation. See “Environmental Issues - Clean Water Act Regulations” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Coal Ash Regulation +AEP’s operations produce a number of different coal combustion by-products, including fly ash, bottom ash, gypsum and other materials. A rule by the Federal EPA regulates the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units. The rule requires certain standards for location, groundwater monitoring and dam stability to be met at landfills and certain surface impoundments at operating facilities. If existing disposal facilities cannot meet these standards, they will be required to close. See “Environmental Issues - Coal Combustion Residual Rule” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Clean Air Act Requirements +The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control mobile and stationary sources of air emissions. The major CAA programs affecting AEP’s power plants are described below. The states implement and administer many of these programs and could impose additional or more stringent requirements. +The Acid Rain Program +The CAA includes a cap-and-trade emission reduction program for SO 2 emissions from power plants and requirements for power plants to reduce NO x emissions through the use of available combustion controls, collectively called the Acid Rain Program. AEP continues to meet its obligations under the Acid Rain Program through the installation of controls, use of alternate fuels and participation in the emissions allowance markets. +National Ambient Air Quality Standards +The CAA requires the Federal EPA to review the available scientific data for criteria pollutants periodically and establish a concentration level in the ambient air for those substances that is adequate to protect the public health and welfare with an extra safety margin. The Federal EPA also can list additional pollutants and develop concentration levels for them. These concentration levels are known as NAAQS. +9 +Each state identifies the areas within its boundaries that meet the NAAQS (attainment areas) and those that do not (non-attainment areas). Each state must develop a SIP to bring non-attainment areas into compliance with the NAAQS and maintain good air quality in attainment areas. All SIPs are submitted to the Federal EPA for approval. If a state fails to develop adequate plans, the Federal EPA develops and implements a plan. As the Federal EPA reviews the NAAQS and establishes new concentration levels, the attainment status of areas can change and states may be required to develop new SIPs. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Hazardous Air Pollutants (HAP) +The CAA also requires the Federal EPA to investigate HAP emissions from the electric utility sector and submit a report to Congress to determine whether those emissions should be regulated. In 2011, the Federal EPA issued a rule setting Maximum Achievable Control Technology standards for new and existing coal and oil-fired utility units and New Source Performance Standards for emissions from new and modified power plants. In 2014, the U.S. Supreme Court determined that the Federal EPA acted unreasonably in refusing to consider costs in determining if it was appropriate and necessary to regulate HAP emissions from electric generating units. The Federal EPA has engaged in additional rulemaking activity but the 2011 rule remains in effect. See “Environmental Issues - Mercury and Other Hazardous Air Pollutants Regulation” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Regional Haze +The CAA establishes visibility goals for certain federally designated areas, including national parks, and requires states to submit SIPs that will demonstrate reasonable progress toward preventing impairment of visibility in these protected areas. In 2005, the Federal EPA issued its Clean Air Visibility Rule, detailing how the CAA’s best available retrofit technology requirements will be applied to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants. +PSO executed a settlement with the Federal EPA and the State of Oklahoma to comply with Regional Haze program requirements in Oklahoma, and the settlement is now codified in the Oklahoma SIP and approved by the Federal EPA. The Federal EPA disapproved portions of the Arkansas and Texas SIPs, and finalized FIPs for both states. Arkansas submitted and received approval of a revised SIP, and the Federal EPA developed a revised FIP for Texas. See “Environmental Issues - Clean Air Act Requirements” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2020 Annual Report for additional information. +Climate Change +AEP has taken action to reduce and offset CO 2 emissions from its generating fleet and expects CO 2 emissions from its operations to continue to decline due to the retirement of coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. In 2021, AEP announced revised intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, regulations, grid reliability and resiliency, and reflect the company’s current business strategy. The intermediate goal is an 80% reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. AEP’s total estimated CO 2 emissions in 2020 were approximately 44 million metric tons, a 73% reduction from AEP’s 2000 CO 2 emissions. AEP will publish a new report in 2021 on the results of a climate change scenario analysis. +To date, the Federal EPA has twice taken action to regulate CO 2 emissions from new and existing fossil fueled electric generating units under the existing provisions of the CAA. The Clean Power Plan was adopted in October 2015 but the U.S. Supreme Court issued a stay of its implementation, including all of the deadlines for submission +10 +of initial or final state plans. The Clean Power Plan was repealed by the Federal EPA in 2019 and replaced by the Affordable Clean Energy (ACE) Rule, which changed the Federal EPA’s approach to regulating CO 2 emissions from existing coal-fired generating units. In January 2021, the ACE Rule was vacated by the U.S. Court of Appeals for the District of Columbia Circuit and remanded to the Federal EPA for further proceedings. It is too soon to predict how the Federal EPA will respond to the court’s remand. Management expects emissions to continue to decline over time as AEP diversifies generating sources and operates fewer coal units. The projected decline in coal-fired generation is due to a number of factors, including the ongoing cost of operating older units, the relative cost of coal and natural gas as fuel sources, increasing environmental regulations requiring significant capital investments and changing commodity market fundamentals. +Transforming AEP’s Generation Fleet +The electric utility industry is in the midst of an historic transformation, driven by changing customer needs, policy demands, demographics, competitive offerings, technologies and commodity prices. AEP is also transforming to be more agile and customer-focused as a valued provider of energy solutions. AEP’s long-term commitment to reduce CO 2 emissions reflects the current direction of the company’s resource plans to meet those needs as well a new climate change scenario analysis to be published in 2021. AEP’s exposure to carbon regulation has been greatly reduced over the last several years. From 2000 to 2020, AEP’s CO 2 emissions declined 73%. In 2020, coal represented 44% of AEP’s generating capacity compared with 70% in 2005. Management expects the percentage of AEP’s generating resources fueled by coal will continue to decline and to represent only 24% of generating capacity by 2030. The long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. Transforming AEP’s generation portfolio to include, where there is regulatory support, more renewable energy and focusing on the efficient use of energy, demand response, distributed resources and technology solutions to more efficiently manage the grid over time is part of this strategy. +The graph below summarizes AEP’s generation capacity by resource type for the years 1999, 2005 and 2020: +(a) Energy Efficiency/Demand Response represents avoided capacity rather than physical assets. +11 +Renewable Sources of Energy +The states AEP serves, other than Kentucky, West Virginia and Tennessee, have established mandatory or voluntary programs to increase the use of energy efficiency, alternative energy or renewable energy sources. +As of December 31, 2020, AEP’s regulated utilities had long-term contracts for 2,750 MWs of wind, 80 MWs of hydro, and 10 MWs of solar power delivering renewable energy to the companies’ customers. In addition, I&M owns four solar projects that make up I&M’s 16 MW Clean Energy Solar Pilot Project. Management actively manages AEP’s compliance position and is on pace to meet the relevant requirements or benchmarks in each applicable jurisdiction. +In 2020, PSO received approval from the OCC and SWEPCo received approval from the APSC and LPSC to acquire the North Central Wind Energy Facilities, comprised of three Oklahoma wind facilities totaling 1,485 MWs, on a fixed cost turn-key basis at completion. Both the APSC and LPSC approved the flex-up option, agreeing to acquire the Texas portion, which the PUCT denied. PSO will own 45.5% and SWEPCo will own 54.5% of the project, which will cost approximately $2 billion. +In May 2020, the IRS issued a notice extending the “Continuity Safe Harbor” deadlines for qualifying renewable energy projects that began construction in 2016 and 2017 by one year as many projects are facing supply chain and other project development delays caused by COVID-19. Under the May 2020 IRS notice, qualifying renewable energy projects that began construction in 2016 and 2017 and which are placed in-service by the end of 2021 and 2022, respectively, will satisfy the Continuity Safe Harbor. Provided that each facility does satisfy the Continuity Safe Harbor, under the current IRS guidance, the 199 MW wind facility will qualify for 100% of the federal PTC, and the remaining two wind facilities, totaling 1,286 MWs, will qualify for 80% of the federal PTC. +Having regulatory approval, and the expectation that all three wind facilities will be eligible for the IRS extension of the “Continuity Safe Harbor,” PSO and SWEPCo are proceeding with the full 1,485 MW development of these three projects. The 199 MW wind facility is targeted to be acquired and placed in-service in March 2021. The 287 MW wind facility is targeted to be acquired and placed in-service in December 2021 and the 999 MW wind facility is targeted to be acquired and placed in-service between December 2021 and April 2022. +The growth of AEP’s renewable generation portfolio reflects the company’s strategy to diversify generation resources to provide clean energy options to customers that meet both their energy and capacity needs. In addition to gradually reducing AEP’s reliance on coal-fueled generating units, the growth of renewables and natural gas helps AEP to maintain a diversity of generation resources. +The integrated resource plans filed with state regulatory commissions by AEP’s regulated utility subsidiaries reflect AEP’s renewable strategy to balance reliability and cost with customers’ desire for clean energy in a carbon-constrained world. AEP has committed significant capital investments to modernize the electric grid and integrate these new resources. Transmission assets of the AEP System interconnect approximately 16,300 MWs of renewable energy resources. AEP’s transmission development initiatives are designed to facilitate the interconnection of additional renewable energy resources. +AEP Energy Supply, LLC is a holding company with several divisions, including AEP Renewables and AEP OnSite Partners. +AEP Renewables develops, owns and operates utility scale renewable projects backed with long-term contracts with creditworthy counterparties throughout the United States. AEP Renewables works directly with stakeholders to ensure that customers have clean, sustainable renewable energy to meet their environmental goals. As of December 31, 2020, AEP Renewables owned projects operating in 11 states, including approximately 1,307 MWs of installed wind capacity and 90 MWs of installed solar capacity. These figures include the 2020 acquisition of an additional 10% interest, or approximately 30 MWs, of Santa Rita East wind generation located in west Texas. In October 2019, AEP Renewables entered into an agreement to construct Flat Ridge 3, a wind farm in Kansas. The 128 MW facility is expected to reach commercial operation by May 2021. +12 +AEP OnSite Partners works directly with wholesale and large retail customers to provide tailored solutions to reduce their energy costs based upon market knowledge, innovative applications of technology and deal structuring capabilities. AEP OnSite Partners targets opportunities in distributed solar, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other energy solutions that create value for customers. AEP OnSite Partners pursues and develops behind the meter projects with creditworthy customers. As of December 31, 2020, AEP OnSite Partners owned projects located in 21 states, including approximately 152 MWs of installed solar capacity, and approximately 9 MWs of solar projects under construction. +Competitive Renewable Generation Facilities +Size of +Energy Resource AEP Energy Supply, LLC Division Renewable +Energy Resource Location In-Service or +Under Construction +1,307 MW AEP Renewables Wind Eight states (a) In-service +128 MW AEP Renewables Wind Kansas Under Construction +20 MW AEP Renewables Solar California In-service +20 MW AEP Renewables Solar Utah In-service +50 MW AEP Renewables Solar Nevada In-service +152 MW AEP OnSite Partners Solar Sixteen states (b) In-service +9 MW AEP OnSite Partners Solar Two states (c) Under Construction +(a) Colorado, Hawaii, Indiana, Kansas, Michigan, Minnesota, Pennsylvania, and Texas. +(b) California, Colorado, Florida, Hawaii, Illinois, Iowa, Minnesota, Nebraska, New Hampshire, New Jersey, New Mexico, New York, Ohio, Rhode Island, Texas and Vermont. +(c) Ohio and Wisconsin. +End Use Energy Efficiency +AEP has reduced energy consumption and peak demand through the introduction of additional energy efficiency and demand response programs. These programs, commonly referred to as demand-side management, were implemented in jurisdictions where appropriate cost recovery was available. AEP’s operating companies’ programs have reduced annual consumption by over 9 million MWhs and peak demand by approximately 2,900 MWs since 2008. AEP estimates that its operating companies spent approximately $1.5 billion during that period to achieve these levels. +Energy efficiency and demand reduction programs have received regulatory support in most of the states AEP serves. Appropriate cost recovery will be essential for AEP operating companies to continue and expand these consumer offerings. Appropriate recovery of program costs, lost revenues and an opportunity to earn a reasonable return ensures that energy efficiency programs are considered equally with supply side investments. As AEP continues to transition to a cleaner, more efficient energy future, energy efficiency and demand response programs will continue to play an important role in how the company serves its customers. AEP believes its experience providing robust energy efficiency programs in several states positions the company to be a cost-effective provider of these programs as states develop their implementation plans. +Corporate Governance +In response to environmental issues and in connection with its assessment of AEP’s strategic plan, the Board of Directors continually reviews the risks posed by new environmental rules and requirements that could accelerate the retirement of coal-fired generation assets. The Board of Directors is informed of any new environmental regulations and proposed regulation or legislation that would significantly affect AEP. The Board’s Committee on Directors and Corporate Governance oversees AEP’s annual Corporate Accountability Report, which includes information about AEP’s environmental, social, governance and financial performance. AEP set CO 2 emission reduction goals in 2018 after considering input from corporate governance outreach effort with shareholders. +In February 2021, AEP announced new intermediate and long-term CO 2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, grid reliability and resiliency, regulations and the company’s current business strategy. The intermediate goal is an 80% +13 +reduction from 2000 CO 2 emission levels from AEP generating facilities by 2030; the long-term goal is net-zero CO 2 emissions from AEP generating facilities by 2050. AEP has made significant progress in reducing CO 2 emissions from its power generation fleet and expects its emissions to continue to decline. Technological advances, including advanced energy storage, modular nuclear, and green hydrogen, and public policies are among the factors that will determine how quickly AEP can achieve net-zero emissions while continuing to provide reliable, affordable power for customers. AEP will publish a new report in 2021 on the results of a climate change scenario analysis. +Other Environmental Issues and Matters +The Comprehensive Environmental Response, Compensation and Liability Act of 1980 imposes costs for environmental remediation upon owners and previous owners of sites, as well as transporters and generators of hazardous material disposed of at such sites. See “The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation” section of Note 6 included in the 2020 Annual Report for additional information. +Environmental Investments +Investments related to improving AEP System plants’ environmental performance and compliance with air and water quality standards during 2018, 2019 and 2020 and the current estimate for 2021 are shown below. These investments include both environmental as well as other related spending. Estimated construction expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends and the ability to access capital. In addition to the amounts set forth below, AEP expects to make substantial investments in future years in connection with the modification and addition at generation plants’ facilities for environmental quality controls. Such future investments are needed in order to comply with air and water quality standards that have been adopted and have deadlines for compliance after 2020 or have been proposed and may be adopted. Future investments could be significantly greater if emissions reduction requirements are accelerated or otherwise become more stringent. The cost of complying with applicable environmental laws, regulations and rules is expected to be material to the AEP System. AEP typically recovers costs of complying with environmental standards from customers through rates in regulated jurisdictions. Failure to recover these costs could reduce future net income and cash flows and possibly harm AEP’s financial condition. See “Environmental Issues” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 6 - Commitments, Guarantees and Contingencies included in the 2020 Annual Report for additional information. +Historical and Projected Environmental Investments +2018 2019 2020 2021 +Actual Actual Actual Estimate (b) +(in millions) +AEP (a) $ 115.6 $ 167.1 $ 102.2 $ 133.8 +AEP Texas — (0.2) — — +APCo 20.4 23.8 21.3 60.6 +I&M 31.1 56.4 31.8 16.8 +SWEPCo 14.1 10.5 (3.6) 8.8 +(a) Includes expenditures of the subsidiaries shown and other subsidiaries not shown. The figures reflect construction expenditures, not investments in subsidiary companies. +(b) Estimated amounts are exclusive of debt AFUDC. +Management continues to refine the cost estimates of complying with air and water quality standards and other impacts of the environmental proposals. The following cost estimates for the years 2021 through 2027 will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules. These cost estimates will also change based on: (a) potential state rules that impose more stringent standards, +14 +(b) additional rulemaking activities in response to court decisions, (c) actual performance of the pollution control technologies installed, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired and replaced, including the type and amount of such replacement capacity and (g) other factors. Management’s current ranges of estimates of new major environmental investments beginning in 2021, exclusive of debt AFUDC, are set forth below: +Projected (2021 - 2027) +Environmental Investment +Company Low High +(in millions) +AEP $ 350 $ 700 +APCo 175 290 +I&M 25 45 +PSO 5 10 +SWEPCo 45 90 +HUMAN CAPITAL MANAGEMENT +Attracting, developing and retaining employees with the skills and experience needed to provide service to our customers efficiently and effectively is crucial to our long-term success and is central to our long-term strategy. AEP invests in employees and continues to build a high performance and inclusive culture that inspires leadership, encourages innovative thinking and welcomes everyone. +The following table shows AEP’s number of employees by subsidiary as of December 31, 2020: +Subsidiary Number of Employees +AEPSC 6,295 +AEP Texas 1,570 +APCo 1,652 +I&M 2,217 +OPCo 1,646 +PSO 1,023 +SWEPCo 1,440 +Other 944 +Total AEP 16,787 +Of AEP’s 16,787 employees, less than 1% are Traditionalists (born before 1946), approximately 27% are Baby Boomers (born 1946-1964), approximately 37% are Generation X (born 1965-1980), approximately 34% are Millennials (born 1981-1996) and approximately 1% are Generation Z (born after 1996). +Safety +Achieving Zero Harm means every employee returns home at the end of their shift in the same or better condition than when they came to work. Zero Harm is what we value most and commit to wholeheartedly. It is hard work, as it requires full focus every moment of every day. We hold ourselves accountable and we are always striving to be better. For AEP, Zero Harm is not an option; it is a mandate we live by. AEP has put tools, training and processes in place to strengthen our safety-first culture and mindset. AEP’s focus is on learning from events and developing leading indicators to be even more proactive in preventing harm. One common industry safety metric utilized by AEP to track incidents is the Days Away/Restricted or Transferred (DART) rate. A DART event is an event that results in one or more lost days, one or more restricted days or results in an employee transferring to a different job within the company. The DART rate is a mathematical calculation (number of DART events multiplied by 200,000 work hours and divided by total YTD hours worked) that describes the number of recordable injuries per 100 full-time employees. In 2020, AEP recognized its best safety performance in the past five years with an employee DART Rate of 0.310. +15 +Diversity and Inclusion +AEP is committed to cultivating a diverse and inclusive environment that supports the development and advancement of all. We foster an inclusive workplace that encourages diversity of thought, culture and background, and actively work to eliminate unconscious biases. We believe our workforce should reflect the diversity of our customers and the communities we serve so that we may better understand how to tailor our services to meet their demands and expectations. As of December 31, 2020, females comprised approximately 20% of AEP’s workforce while approximately 19% was represented by minorities. +AEP has taken actions to denounce all forms of racism in the wake of the racial and social unrest across the country. AEP Chief Executive Officer (CEO) Nicholas Akins joined more than 1,400 other CEOs as a signatory to the CEO Action for Diversity and Inclusion pledge, the largest CEO-driven business commitment to advancing diversity and inclusion within the workplace. To accelerate our diversity and inclusion strategy, AEP has initiated a “Seize the Moment: Let’s Keep the Momentum Going” action plan that included candid conversations about race, Town Hall webcasts and “Let’s Talk” discussions with the top 20 African American leaders at AEP. +Culture +AEP believes in doing the right thing every time for our customers, each other and our future. AEP leaders at all levels are responsible for fostering an environment that supports a positive culture and for acting in a manner that positively models it. Employees are given an opportunity to share their perspectives by participating in the Employee Culture Survey, administered by Gallup, Inc., that measures the progress we are making in improving our culture. In addition to engagement, the survey measures well-being and inclusiveness. In 2020, 93% of our organization participated in the survey and we improved our grand mean score to the top decile compared to Gallup’s overall company database. Company executives also have candid meetings with employees to discuss our challenges, opportunities, what is going well and what can be even better. +Employee Resource Groups +One of the best ways for AEP to demonstrate our commitment to a trusting and inclusive work environment is to empower employees to form and participate in Employee Resource Groups (ERG). The ERGs at AEP include Abled and Disabled Allies Partnering Together, the African-American ERG, the Asian-American ERG, the Hispanic Origin Latin American ERG, the Military Veteran ERG, the Native American ERG and the Pride Partnership. Our ERGs reflect the diverse makeup of our workforce and enable us to gain valuable insight into the diverse communities we serve. They also help increase engagement across AEP by providing employees with a safe space to discuss work-related issues and to develop innovative solutions. ERGs also play an active role in AEP’s diversity and inclusion efforts, including recruitment of new employees. In addition to the ERG’s, AEP also sponsors the AEP Women’s Leadership Council. The mission of this council is to educate, inspire and encourage women to build confidence and reflect on their goals as they strive for career and personal growth. +Training and Professional Development +At AEP, we are preparing our workforce for the future by providing opportunities to learn new skills and engaging higher education institutions to better prepare the next generation with the skills that we will need. AEP has training alliances with several community colleges, universities and vocational and technical schools across our service territory. We work with these institutions to develop academic programs that will prepare employees for upward mobility opportunities and to attract external job seekers interested in careers in our industry. AEP also provides a broad range of training and assistance that supports lifelong learning and transition development. This is especially important as we move closer toward a digital future that requires a more flexible, innovative and diverse workforce. AEP has robust processes to achieve this, including ongoing performance coaching, operational skills training, resources to support our commitment to environment, safety and health, job progression training, tuition assistance, and other forms of training that help employees improve their skills and become better leaders. +16 +Compensation and Benefits +AEP recognizes the importance of our employees to our success and we offer physical, financial and other health, wellness and assistance programs to our associates and their families to help them thrive at home and work. We ensure the pay we offer is competitive in the marketplace by using an overall market pricing process. In addition to competitive wages, nearly all AEP employees participate in an annual incentive program that rewards outstanding performance and achievement of business goals. Our incentive compensation provides financial rewards to those who contribute to business results and meet or exceed their personal performance goals, which fosters a high performance culture. AEP also offers employees physical and mental health programs, including medical, dental and life insurance, along with a health and well-being program to help employees and their families stay healthy and feeling their best. Additionally, AEP’s retirement programs position our associates for financial stability in retirement. +Labor Relations +Nearly one fourth of AEP’s workforce is represented by labor unions. We value the relationships we have with our unionized employees and believe in a trusting, collaborative and respectful partnership. We are working with our labor partners to strengthen these relationships to ensure we have a culture that attracts and supports employees who can adapt to the rapid changes occurring in our company and industry. Our partnership with labor unions is critical to meeting the growing expectations of our customers and adapting to the challenges of rapidly changing technologies. +BUSINESS SEGMENTS +AEP’s Reportable Segments +AEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements. AEP’s reportable segments are as follows: +• Vertically Integrated Utilities +• Transmission and Distribution Utilities +• AEP Transmission Holdco +• Generation & Marketing +The remainder of AEP’s activities is presented as Corporate and Other, which is not considered a reportable segment. See Note 9 - Business Segments included in the 2020 Annual Report for additional information on AEP’s segments. +17 +VERTICALLY INTEGRATED UTILITIES +GENERAL +AEP’s vertically integrated utility operations are engaged in the generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo. AEPSC, as agent for AEP’s public utility subsidiaries, performs marketing, generation dispatch, fuel procurement and power-related risk management and trading activities on behalf of each of these subsidiaries. +ELECTRIC GENERATION +Facilities +As of December 31, 2020, AEP’s vertically integrated public utility subsidiaries owned or leased approximately 22,000 MWs of domestic generation. See \ No newline at end of file diff --git a/raw/filings/0000004904/2020/0000004904-21-000010/item13.txt b/raw/filings/0000004904/2020/0000004904-21-000010/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..39ce5bd79755d3fe7d11cfb17a2a4e8437a5e50c --- /dev/null +++ b/raw/filings/0000004904/2020/0000004904-21-000010/item13.txt @@ -0,0 +1,6 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE +AEP +The information called for by this Item 13 is incorporated herein by reference to AEP’s definitive proxy statement (which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act) relating to the 2021 Annual Meeting under the captions “Transactions with Related Persons” and “Director Independence.” +422 +AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo +Omitted pursuant to Instruction I(2)(c). \ No newline at end of file diff --git a/raw/filings/0000004962/2018/0000004962-19-000018/filing.txt b/raw/filings/0000004962/2018/0000004962-19-000018/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..88d3e36379e9425ecef9b3a0183bcc393ca27178 --- /dev/null +++ b/raw/filings/0000004962/2018/0000004962-19-000018/filing.txt @@ -0,0 +1,11972 @@ +10-K +1 +axp201810k.htm +FORM 10-K OF AMERICAN EXPRESS COMPANY +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +Form 10-K + +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2018 +OR + +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File No. 1-7657 +American Express Company +(Exact name of registrant as specified in its charter) +New York +13-4922250 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +200 Vesey Street +New York, New York +10285 +(Address of principal executive offices) +(Zip Code) +Registrant’s telephone number, including area code: (212) 640-2000 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Shares (par value $0.20 per Share) +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  No  +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes  No  +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes  No  +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes  No  +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer  +Accelerated filer  +Non-accelerated filer  +Smaller reporting company  +Emerging growth company  +(Do not check if a smaller reporting company) +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes  No  +As of June 30, 2018, the aggregate market value of the registrant’s voting shares held by non-affiliates of the registrant was approximately $84.3 billion based on the closing sale price as reported on the New York Stock Exchange. +As of February 4, 2019, there were 843,368,671 common shares of the registrant outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III: Portions of Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Annual Meeting of Shareholders to be held on May 7, 2019. +Table of Contents +TABLE OF CONTENTS +Form 10-K +Item Number +Page +PART I +1. +Business +Introduction +1 +Business Operations +2 +Competition +4 +Supervision and Regulation +5 +Executive Officers of the Company +14 +Employees +15 +Additional Information +15 +1A. +Risk Factors +15 +1B. +Unresolved Staff Comments +29 +2. +Properties +29 +3. +Legal Proceedings +30 +4. +Mine Safety Disclosures +30 +PART II +5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +31 +6. +Selected Financial Data +33 +7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) +34 +Executive Overview +34 +Consolidated Results of Operations +36 +Business Segment Results +43 +Consolidated Capital Resources and Liquidity +52 +Off-Balance Sheet Arrangements and Contractual Obligations +58 +Risk Management +59 +Critical Accounting Estimates +65 +Other Matters +67 +7A. +Quantitative and Qualitative Disclosures about Market Risk +71 +8. +Financial Statements and Supplementary Data +71 +Management’s Report on Internal Control Over Financial Reporting +71 +Report of Independent Registered Public Accounting Firm +72 +Index to Consolidated Financial Statements +74 +Consolidated Financial Statements +75 +Notes to Consolidated Financial Statements +80 +9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +132 +9A. +Controls and Procedures +132 +9B. +Other Information +132 +Table of Contents +PART III +10. +Directors, Executive Officers and Corporate Governance +133 +11. +Executive Compensation +133 +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +133 +13. +Certain Relationships and Related Transactions, and Director Independence +133 +14. +Principal Accounting Fees and Services +133 +PART IV +15. +Exhibits, Financial Statement Schedules +134 +16. +Form 10-K Summary +134 +Signatures +Guide 3 — Statistical Disclosure by Bank Holding Companies +135 +A-1 +Exhibit Index +E-1 +This Annual Report on Form 10-K, including the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties. You can identify forward-looking statements by words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” “estimate,” “predict,” “potential,” “continue” or other similar expressions. We discuss certain factors that affect our business and operations and that may cause our actual results to differ materially from these forward-looking statements under “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements. +This report includes trademarks, such as American Express ® , which are protected under applicable intellectual property laws and are the property of American Express Company or its subsidiaries. This report also contains trademarks, service marks, copyrights and trade names of other companies, which are the property of their respective owners. Solely for convenience, our trademarks and trade names referred to in this report may appear without the ® or TM symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the right of the applicable licensor to these trademarks and trade names. +Throughout this report the terms “American Express,” “we,” “our” or “us,” refer to American Express Company and its subsidiaries on a consolidated basis, unless stated or the context implies otherwise. Refer to the “MD&A ― Glossary of Selected Terminology” for the definitions of other key terms used in this report. +Table of Contents +PART I +ITEM 1. +BUSINESS +INTRODUCTION +Overview +American Express is a globally integrated payments company that provides customers with access to products, insights and experiences that enrich lives and build business success. Our principal products and services are charge and credit card products and travel-related services offered to consumers and businesses around the world. +We were founded in 1850 as a joint stock association and were incorporated in 1965 as a New York corporation. American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. (TRS), are bank holding companies under the Bank Holding Company Act of 1956, as amended (the BHC Act), subject to supervision and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). +Our headquarters are located in lower Manhattan, New York, New York. We also have offices in other locations throughout the world. +We principally engage in businesses comprising three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant & Network Services (GMNS). Corporate functions and certain other businesses are included in Corporate & Other. +Products and Services +Our range of products and services includes: + +Charge card, credit card and other payment and financing products + +Merchant acquisition and processing, servicing and settlement, and point-of-sale marketing and information products and services for merchants + +Network services + +Other fee services, including fraud prevention services and the design and operation of customer loyalty programs + +Expense management products and services + +Travel-related services +Our various products and services are sold globally to diverse customer groups through various channels, including mobile and online applications, third-party vendors and business partners, direct mail, telephone, in-house sales teams and direct response advertising. * Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +Our general-purpose card network, card-issuing and merchant-acquiring and processing businesses are global in scope. We are a world leader in providing charge and credit cards to consumers, small businesses, mid-sized companies and large corporations. These cards include cards issued by American Express as well as cards issued by third-party banks and other institutions that are accepted by merchants on the American Express network. American Express ® cards permit Card Members to charge purchases of goods and services at the millions of merchants around the world that accept cards bearing our logo. +Our business as a whole has not experienced significant seasonal fluctuations, although card billed business tends to be moderately higher in the fourth quarter than in other quarters. As a result, the amount of Card Member loans and receivables outstanding tend to be moderately higher during that quarter. The average discount rate also tends to be slightly lower during the fourth quarter due to a higher level of retail-related billed business volumes. +* The use of the term “partner” or “partnering” does not mean or imply a formal legal partnership, and is not meant in any way to alter the terms of American Express’ relationship with any third parties. +1 +Table of Contents +The American Express Brand +Our brand and its attributes—trust, security and service—are key assets. We invest heavily in managing, marketing, promoting and protecting our brand, including through the delivery of our products and services in a manner consistent with our brand promise. Our brand has consistently been rated one of the most valuable brands in the world. In 2018, we launched a new worldwide brand platform with one common message across consumer and business segments. Additionally, we place significant importance on trademarks, service marks and patents, and seek to secure our intellectual property rights around the world. +Our Integrated Network and Spend-Centric Model +Wherever we manage both the card-issuing activities of the business and the acquiring relationship with merchants, there is a “closed loop” in that we have direct access to information at both ends of the card transaction, which distinguishes our integrated network from the bankcard networks. We maintain direct relationships with both our Card Members (as a card issuer) and merchants (as an acquirer), and we handle all key aspects of those relationships. Through contractual relationships, we also obtain data from third-party card issuers, merchant acquirers and processors with whom we do business. Our integrated network allows us to analyze information on Card Member spending and build algorithms and other analytical tools that we use to underwrite risk, reduce fraud and provide targeted marketing and other information services for merchants and special offers and services to Card Members, all while respecting Card Member preferences and protecting Card Member and merchant data in compliance with applicable policies and legal requirements. +Our “spend-centric” business model focuses on generating revenues primarily by driving spending on our cards and secondarily by finance charges and fees. Spending on our cards, which is higher on average on a per-card basis versus our competitors, offers superior value to merchants in the form of loyal customers and larger transactions. Because of the revenues generated from having high-spending Card Members, we are able to invest in attractive rewards and other benefits for Card Members, as well as targeted marketing and other programs and investments for merchants. This creates incentives for Card Members to spend more on their cards and positively differentiates American Express cards. +We believe our integrated network and spend-centric model give us the ability to provide differentiated value to Card Members, merchants and business partners. +BUSINESS OPERATIONS +Global Consumer Services Group +We offer a wide range of charge cards and revolving credit cards to consumers around the world. GCSG also offers services that complement our core business, including Card Member features and benefits, deposit products, travel services and non-card financing products such as installment lending. +Our global proprietary card business offers a broad set of card products, rewards and services to acquire and retain high-spending, engaged and creditworthy Card Members. Core elements of our strategy are: + +Designing innovative products and features that appeal to our target customer base and meet their spending and borrowing needs + +Using incentives to drive spending on our various card products and engender loyal Card Members, including our Membership Rewards ® program, cash-back reward features and participation in loyalty programs sponsored by our cobrand and other partners + +Providing exceptional customer care, digital and mobile services and an array of benefits and experiences across card products to address travel and other needs and increase Card Member engagement + +Developing a wide range of partner relationships, including with other corporations and institutions that sponsor certain of our cards under cobrand arrangements and provide benefits and services to our Card Members +Our charge cards are designed primarily as a method of payment with Card Members generally paying the full amount billed each month. Charges are approved based on a variety of factors, including a Card Member’s current spending patterns, payment history, credit record and financial resources. Some charge card accounts have features that allow Card Members to revolve certain charges. Revolving credit card products provide Card Members with the flexibility to pay their bill in full each month or carry a monthly balance on their cards to finance the purchase of goods or services. Some revolving credit cards also allow eligible Card Members to set up monthly payments for certain purchases or purchase amounts over a fixed period of time. Certain of our cards are issued under cobrand arrangements with business partners, such as Delta Air Lines, our largest cobrand partner, as well as many others globally. We also partner with Delta to offer benefits to Card Member participants in our Membership Rewards program and provide travel-related benefits and services, including airport lounge access for certain American Express Card Members. +2 +Table of Contents +Global Commercial Services +We offer a wide range of card and payment programs, expense management tools, consulting services, business financing and cross-border payments solutions to small businesses, mid-size companies and large corporations around the world. We have a suite of business-to-business payment solutions to help companies manage their spending and realize other potential benefits, including cost savings, process control and efficiency, and improved cash flow management. We offer local currency corporate cards and other expense management products in approximately 95 countries and territories, and have global U.S. dollar and euro corporate cards available in approximately 110 countries and territories. We also provide products and services, including charge cards, revolving credit cards and non-card payment and financing solutions, to small and mid-sized businesses in the United States and internationally. +Core elements of our strategy to become the leading payments and working capital provider to small and mid-sized business customers and a leader in business-to-business payments for large and global enterprises include: + +Expanding our leadership in our core card business by evolving our card value propositions, launching cobrand products and further differentiating our corporate card and accounts payable expense management solutions + +Designing innovative products and features, including financing and supplier payment solutions for our business customers +Global Merchant & Network Services +We operate a global payments network that processes and settles card transactions, acquires merchants and provides fraud-prevention tools, marketing solutions, data analytics and other programs and services to merchants that leverage the capabilities of our integrated network. GMNS builds and manages relationships with millions of merchants around the world that choose to accept American Express cards and signs new merchants to accept our cards, agreeing on the discount rate (a fee charged to the merchant for accepting our cards) and handling servicing for these merchants. We also build and maintain relationships with merchant acquirers, aggregators and processors to manage aspects of our merchant services business. For example, through our OptBlue ® merchant-acquiring program, third-party processors contract directly with small merchants for card acceptance and determine merchant pricing. +We continue to grow merchant acceptance of American Express cards around the world. We made progress towards our goal of having American Express cards accepted at virtually all merchant locations that accept both Visa and Mastercard in the United States, adding more than a million new merchant locations in the United States in 2018. We are also focused on increasing merchant coverage strategically in countries outside the United States, with double-digit growth in merchant locations internationally in 2018. We estimate that our international merchant network as a whole could accommodate more than 80 percent of general-purpose card spending, based on comparing spending on all networks' general-purpose credit and charge cards at merchants outside the United States that accept American Express cards with total general-purpose credit and charge card spending at all merchants outside the United States. +GMNS also establishes and maintains relationships with third-party banks and other institutions in approximately 130 countries and territories, licensing the American Express brand and extending the reach of our global network. Under independent operator arrangements, partners are licensed to issue local currency cards in their countries and serve as the merchant acquirer and processor for local merchants. Under network card license arrangements, partners are licensed to issue American Express-branded cards primarily in countries where we have a proprietary card-issuing and/or merchant-acquiring business. +GMNS also manages loyalty coalition programs, such as the Payback ® program in Germany, India, Mexico, Italy, Poland and Austria. Our loyalty coalition programs enable consumers to earn rewards points and use them to save on purchases from a variety of participating merchants through multi-category rewards platforms. Merchants in these programs generally fund the consumer offers and are responsible to us for the cost of rewards points; we earn revenue from operating the loyalty platform and by providing marketing support. +3 +Table of Contents +COMPETITION +We compete in the global payments industry with charge, credit and debit card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and Automated Clearing House, or ACH), as well as evolving and growing alternative payment and financing providers. As the payments industry continues to evolve, we face increasing competition from non-traditional players that leverage new technologies, business models and customer relationships to create payment or financing solutions. +As a card issuer, we compete with financial institutions that issue general-purpose charge and revolving credit cards and debit cards. We also encounter competition from businesses that issue their own private label cards, operate their own mobile wallets or extend credit to their customers. We face intense competition for cobrand relationships, as both card issuer and network competitors have targeted key business partners with attractive value propositions. +Our global card network competes in the global payments industry with other card networks, including, among others, China UnionPay, Visa, Mastercard, JCB, Discover and Diners Club International (which is owned by Discover). We are the fourth largest general-purpose card network globally based on purchase volume, behind China UnionPay, Visa and Mastercard. In addition to such networks, a range of companies globally, including merchant acquirers, processors and web- and mobile-based payment platforms (e.g., Alipay, PayPal and Venmo), as well as regional payment networks (such as the National Payments Corporation of India), carry out some activities similar to those performed by our GMNS business. +The principal competitive factors that affect the card-issuing, merchant and network businesses include: + +The features, value and quality of the products and services, including customer care, rewards programs, partnerships, benefits and digital and mobile services, and the costs associated with providing such features and services + +Reputation and brand recognition + +The number, spending characteristics and credit performance of customers + +The quantity, diversity and quality of the establishments where the cards can be used + +The attractiveness of the value proposition to card issuers, merchant acquirers, cardholders, corporate clients and merchants (including the relative cost of using or accepting the products and services, and capabilities such as fraud prevention and data analytics) + +The number and quality of other payment cards and other forms of payment available to customers + +The success of marketing and promotional campaigns + +The speed of innovation and investment in systems, technologies, and product and service offerings + +The nature and quality of expense management tools, electronic payment methods and data capture and reporting capabilities, particularly for business customers + +The security of cardholder and merchant information +Another aspect of competition is the dynamic and rapid growth of alternative payment mechanisms, systems and products, which include aggregators (e.g., PayPal, Square and Amazon), marketplace lenders, wireless payment technologies (including using mobile telephone networks to carry out transactions), financial technology companies, electronic wallet and push payment providers (including handset manufacturers, telecommunication providers, retailers, banks and technology companies), prepaid systems, digital currencies, gift cards, blockchain and similar distributed ledger technologies, and systems linked to payment cards or that provide payment solutions. Partnerships have been formed by various competitors to integrate more financial services into their product offerings and competitors are attempting to replicate our closed-loop functionality, such as the merchant-processing platform ChaseNet. New payments competitors continue to emerge in response to evolving technologies, consumer habits and merchant needs. +In addition to the discussion in this section, see “ Our operating results may suffer because of substantial and increasingly intense competition worldwide in the payments industry ” in “Risk Factors” for further discussion of the potential impact of competition on our business, and “ Our business is subject to comprehensive government regulation and supervision, which could adversely affect our results of operations and financial condition” and “ Ongoing legal proceedings regarding provisions in our merchant contracts could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand ” in “Risk Factors” for a discussion of the potential impact on our ability to compete effectively due to government regulations or if ongoing legal proceedings limit our ability to prevent merchants from engaging in various actions to discriminate against our card products. +4 +Table of Contents +SUPERVISION AND REGULATION +Overview +We are subject to extensive government regulation and supervision in jurisdictions around the world, and the costs of compliance are substantial. In recent years, the financial services industry has been subject to rigorous scrutiny, high regulatory expectations, and a stringent and unpredictable enforcement environment. Governmental authorities have focused, and we believe will continue to focus, considerable attention on reviewing compliance by financial services firms with laws and regulations. Reviews to assess compliance with laws and regulations by governmental authorities, as well as our own internal reviews, have resulted in, and are likely to continue to result in, changes to our practices, products and procedures, restitution to our customers and increased costs related to regulatory oversight, supervision and examination. We have also been subject to regulatory actions and may continue to be the subject of such actions, including governmental inquiries, investigations, enforcement proceedings and the imposition of fines or civil money penalties, in the event of noncompliance or alleged noncompliance with laws or regulations. In addition, legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +See “Risk Factors—Legal, Regulatory and Compliance Risks” for a discussion of the potential impact legislative and regulatory changes may have on our results of operations and financial condition. +Banking Regulation +Federal and state banking laws, regulations and policies extensively regulate the Company (which, for purposes of this section, refers to American Express Company as a bank holding company), TRS and our U.S. bank subsidiary, American Express National Bank (AENB). Both the Company and TRS are subject to comprehensive consolidated supervision, regulation and examination by the Federal Reserve and AENB is likewise supervised, regulated and examined by the Office of the Comptroller of the Currency (OCC). The Company and its subsidiaries are also subject to the rulemaking, enforcement and examination authority of the Consumer Financial Protection Bureau (CFPB). Banking regulators have broad examination and enforcement power, including the power to impose substantial fines, limit dividends and other capital distributions, restrict operations and acquisitions and require divestitures. Many aspects of our business also are subject to rigorous regulation by other U.S. federal and state regulatory agencies and by non-U.S. government agencies and regulatory bodies. +In November 2018, the Federal Reserve adopted a new rating system for large financial institutions, such as the Company, which is intended to align with the Federal Reserve’s existing supervisory program for large financial institutions and which includes component ratings for capital planning, liquidity risk management, and governance and controls. In August 2017 and January 2018, the Federal Reserve proposed related guidance for the governance and controls component. +Activities +The BHC Act generally limits bank holding companies to activities that are considered to be banking activities and certain closely related activities. As noted above, each of the Company and TRS is a bank holding company and each has elected to become a financial holding company, which is authorized to engage in a broader range of financial and related activities. In order to remain eligible for financial holding company status, we must meet certain eligibility requirements. Those requirements include that each of the Company and AENB must be “well capitalized” and “well managed,” and AENB must have received at least a “satisfactory” rating on its most recent assessment under the Community Reinvestment Act of 1977 (the CRA). The Company and TRS engage in various activities permissible only for financial holding companies, including, in particular, providing travel agency services, acting as a finder and engaging in certain insurance underwriting and agency services. If the Company fails to meet eligibility requirements for financial holding company status, it is likely to be barred from engaging in new types of financial activities or making certain types of acquisitions or investments in reliance on its status as a financial holding company, and ultimately could be required to either discontinue the broader range of activities permitted to financial holding companies or divest AENB. In addition, the Company and its subsidiaries are prohibited by law from engaging in practices that the relevant regulatory authority deems unsafe or unsound (which such authorities generally interpret broadly). +Acquisitions and Investments +Applicable federal and state laws place limitations on the ability of persons to invest in or acquire control of us without providing notice to or obtaining the approval of one or more of our regulators. In addition, we are subject to banking laws and regulations that limit our investments and acquisitions and, in some cases, subject them to the prior review and approval of our regulators, including the Federal Reserve and the OCC. Federal banking regulators have broad discretion in evaluating proposed acquisitions and investments that are subject to their prior review or approval. +5 +Table of Contents +Financial Regulatory Reform +The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the Federal Reserve’s implementing regulations impose heightened prudential requirements on bank holding companies with at least $50 billion in total consolidated assets, such as the Company, that are more stringent than those applicable to smaller bank holding companies. The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), enacted in May 2018, preserves the fundamental elements of the post-Dodd-Frank regulatory framework, but, among other things, revises certain aspects of the U.S. financial regulatory regime for bank holding companies with less than $250 billion in total consolidated assets, such as the Company. +Under Dodd-Frank, federal banking regulators were required to apply enhanced prudential standards to bank holding companies, such as the Company, with total consolidated assets of $50 billion or more. Following the enactment of EGRRCPA, effective November 2019, federal banking regulators will no longer be required to apply most Dodd-Frank enhanced prudential standards to bank holding companies, such as the Company, with total consolidated assets of $100 billion but less than $250 billion. For example, holding company resolution planning and company-run stress testing would no longer be mandatory and supervisory stress testing (which is currently conducted annually) would be conducted on a “periodic” basis. Depository institutions, such as AENB, with total consolidated assets between $100 billion and $250 billion will also not be required to conduct annual company-run stress tests effective November 2019. Much of the Dodd-Frank enhanced prudential standards were implemented by the federal banking regulators through regulations. EGRRCPA, however, does not itself amend those regulations, which will require action by the federal banking regulators. Additionally, EGRRCPA permits the Federal Reserve, by order or rule, to apply enhanced prudential standards to bank holding companies, such as the Company, with total consolidated assets of $100 billion or more. Lastly, there are several regulations not directly affected by EGRRCPA but that federal banking regulators may modify to conform to the new higher asset thresholds, such as the Comprehensive Capital Analysis and Review (CCAR) process. +In October 2018, the Federal Reserve released two proposals, one jointly with the OCC and the Federal Deposit Insurance Corporation (FDIC) and one on its own, that would tailor the applicable capital and liquidity requirements and prudential standards for large U.S. banking organizations, such as the Company, based on their size and other risk-based indicators, consistent with EGRRCPA (the Tailoring Proposals). The Tailoring Proposals are not yet final and may be modified prior to their final adoption by the Federal Reserve, the OCC and the FDIC. +The Tailoring Proposals would assign each U.S. bank holding company with $100 billion or more in total consolidated assets, as well as its bank subsidiaries, to one of four categories based on its size and five risk-based indicators: (i) cross-jurisdictional activity, (ii) weighted short-term wholesale funding, (iii) non-bank assets, (iv) off-balance sheet exposure, and (v) status as a U.S. global systemically important banking organization. The Federal Reserve indicated which firms would fall into each of the four categories based on data for the second quarter of 2018, with the Company in “Category IV.” Firms subject to Category IV standards would generally be subject to the same capital and liquidity requirements as firms with under $100 billion in total consolidated assets, but would also be required to monitor and report certain risk-based indicators. As a result, under the Tailoring Proposals, Category IV firms such as the Company would (i) no longer be subject to the advanced approaches capital requirements, (ii) no longer be subject to the supplementary leverage ratio, (iii) no longer be subject to the countercyclical capital buffer, (iv) no longer be subject to company-run stress testing requirements, (v) become subject to supervisory stress testing on an every-other-year basis rather than an annual basis; and (vi) no longer be subject to the liquidity coverage ratio or the proposed net stable funding ratio minimum requirements. +The ultimate impact from EGRRCPA and the related regulatory changes is subject to the final implementing regulations adopted by federal banking regulators, which may differ from the proposals described herein. +Stress Testing and Capital Planning +Under the Federal Reserve’s regulations, the Company is currently subject to annual supervisory and semiannual company-run stress testing requirements that are designed to evaluate whether a bank holding company has sufficient capital on a total consolidated basis to absorb losses and support operations under adverse economic conditions. Under the Tailoring Proposals, Category IV firms, such as the Company, would no longer be subject to company-run stress testing requirements, but would remain subject to the quantitative review of their capital plans under CCAR, which the Federal Reserve has indicated it plans to conduct on an every-other-year, instead of annual, basis for Category IV firms. In connection with the release of the Tailoring Proposals, the Federal Reserve also indicated that it expects to revise its guidance on capital planning to align with the proposed categories of standards set forth in the Tailoring Proposals. We continue to evaluate the impact of the Tailoring Proposals and forthcoming related proposals on the Company and its capital planning process. +The results of the Company’s stress testing are incorporated into our annual capital plan, which must cover a “planning horizon” of at least nine quarters and which we are required to submit to the Federal Reserve for review under its CCAR process. As part of CCAR, the Federal Reserve evaluates whether the Company has sufficient capital to continue operations under various scenarios of economic and financial market stress (developed by both the Company and the Federal Reserve), including after taking into account planned capital distributions, such as dividend payments and common stock repurchases. Sufficient capital for these purposes is likely to require us to maintain capital ratios appreciably above applicable minimum requirements and buffers. The scenarios are designed to stress our risks and vulnerabilities and assess our pro-forma capital position and ratios under hypothetical stress environments. +We are required to submit our capital plans and stress testing results to the Federal Reserve on or before April 5 of each year in which they are required. The Federal Reserve is expected to publish the decisions for all the bank holding companies participating in CCAR, including the reasons for any objection to capital plans, by June 30th of each year. In addition, the Federal Reserve will publish separately the results of its supervisory stress test under the supervisory severely adverse scenarios. The information to be released will include, among other things, the Federal Reserve’s projection of company-specific information, including post-stress capital ratio information over the planning horizon. +We may be required to revise and resubmit our capital plan as required by the Federal Reserve following certain events, such as a significant acquisition. In addition to other limitations, our ability to make any capital distributions (including dividends and share repurchases) is contingent on the Federal Reserve’s non-objection to our capital plan. +On February 5, 2019, the Federal Reserve announced that certain firms with total consolidated assets between $100 billion and $250 billion, such as the Company, would not be subject to supervisory stress testing, company-run stress testing or CCAR for the 2019 cycle. The Federal Reserve stated that permitted capital distributions for the 2019 cycle for such firms would be largely based on the results of the 2018 supervisory stress tests. We remain subject to the requirement to develop and maintain an annual capital plan. +6 +Table of Contents +Dividends and Other Capital Distributions +The Company and TRS, as well as AENB and the Company’s insurance and other regulated subsidiaries, are limited in their ability to pay dividends by statutes, regulations and supervisory policy. +Dividend payments by the Company to shareholders are subject to the oversight of the Federal Reserve. See “Stress Testing and Capital Planning.” Even if the Federal Reserve has not objected to a distribution, the Company may still not make a distribution without Federal Reserve approval if, among other things, the Company would not meet a minimum regulatory capital ratio after giving effect to the capital distribution, changes in facts would require resubmission of our capital plan or the Company’s earnings are materially underperforming its projections in the capital plan. +In general, federal laws and regulations prohibit, without first obtaining the OCC’s approval, AENB from making dividend distributions to TRS, if such distributions are not paid out of available recent earnings or would cause AENB to fail to meet capital adequacy standards. In addition to specific limitations on the dividends AENB can pay to TRS, federal banking regulators have authority to prohibit or limit the payment of a dividend if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the institution. +Capital, Leverage and Liquidity Regulation +Capital Rules +The Company and AENB are required to comply with the applicable capital adequacy rules established by federal banking regulators. These rules are intended to ensure that bank holding companies and depository institutions (collectively, banking organizations) have adequate capital given their level of assets and off-balance sheet obligations. The federal banking regulators’ current capital rules, which, subject to phase-in provisions, generally became applicable to the Company and AENB’s predecessor institutions in 2014 (the Capital Rules), largely implement the Basel Committee on Banking Supervision’s (the Basel Committee) framework for strengthening international capital regulation, known as Basel III. The minimum capital and buffer requirements under the Capital Rules have been fully phased in as of January 1, 2019. For additional information regarding our capital ratios, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Under the Capital Rules, banking organizations are required to maintain minimum ratios for Common Equity Tier 1 (CET1), Tier 1 capital (that is, CET1 plus additional Tier 1 capital) and Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. Since 2014, we have reported our capital adequacy ratios on a parallel basis to federal banking regulators using both risk-weighted assets calculated under the Basel III standardized approach, as adjusted for certain items, and the requirements for an advanced approaches institution. During this parallel period, federal banking regulators assess our compliance with the advanced approaches requirements. The parallel period will continue until we receive regulatory notification to exit parallel reporting, at which point we will begin publicly reporting regulatory risk-based capital ratios calculated under both the advanced approaches and the standardized approach under the Capital Rules, and will be required to use the lower of these ratios in order to determine whether we are in compliance with minimum capital and buffer requirements for the Company and AENB. Depending on how the advanced approaches are ultimately implemented for our asset types, our capital ratios calculated under the advanced approaches may be lower than under the standardized approach. The standardized approach is currently the applicable measurement used in CCAR. +In December 2017, the Basel Committee published standards that, among other things, revise the standardized approach for credit risk (including by recalibrating risk weights and introducing additional capital requirements for certain “unconditionally cancellable commitments” such as unused credit card lines of credit) and provide a new standardized calculation for operational risk capital requirements. If adopted in the United States as issued by the Basel Committee and applicable to us, the new standards could result in higher capital requirements for us. +The Company and AENB must each maintain CET1, Tier 1 capital and Total capital ratios of at least 4.5 percent, 6.0 percent and 8.0 percent, respectively. The Capital Rules also implement a 2.5 percent capital conservation buffer composed entirely of CET1, on top of these minimum risk-weighted asset ratios. As a result, the minimum ratios are effectively 7.0 percent, 8.5 percent and 10.5 percent for the CET1, Tier 1 capital and Total capital ratios, respectively, as of January 1, 2019. The required minimum capital ratios for the Company may be further increased by a countercyclical capital buffer composed entirely of CET1 up to 2.5 percent, which may be assessed when federal banking regulators determine that such a buffer is necessary to protect the banking system from disorderly downturns associated with excessively expansionary periods. Subject to adjustment by the Federal Reserve, the current countercyclical capital buffer is zero percent. Assuming the maximum countercyclical capital buffer was in place, the Company’s effective minimum CET1, Tier 1 capital and Total capital ratios could be 9.5 percent, 11.0 percent and 13.0 percent, respectively. +7 +Table of Contents +Banking institutions whose ratio of CET1, Tier 1 Capital or Total capital to risk-weighted assets is above the minimum but below the capital conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on discretionary distributions such as dividends, repurchases and redemptions of capital securities, and executive compensation based on the amount of the shortfall and the institution's "eligible retained income" (that is, four quarter trailing net income, net of distributions and tax effects not reflected in net income). +As noted above, Category IV firms, such as the Company, would no longer be subject to the countercyclical capital buffer requirements under the Tailoring Proposals. +The Federal Reserve proposed a rule in April 2018 that would, among other things, replace the static 2.5 percent capital conservation buffer with a stress capital buffer requirement for bank holding companies subject to the CCAR process. The stress capital buffer would reflect stressed losses in the supervisory severely adverse scenario of the Federal Reserve’s CCAR stress tests and would also include four quarters of planned common stock dividends. The proposal also included a stress leverage buffer requirement, similar to the stress capital buffer, which would apply to the Tier 1 leverage ratio. The proposal would require bank holding companies to reduce their planned capital distributions if those distributions would not be consistent with the applicable capital buffer constraints based on the bank holding companies’ own baseline scenario projections. The Federal Reserve has indicated that it intends to propose revisions to the stress buffer requirements that would be applicable to Category IV firms, such as the Company, to align with the proposed two-year supervisory stress-testing cycle for Category IV bank holding companies. +Leverage Requirements +We are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its average total consolidated assets (as defined for regulatory purposes). All banking organizations are required to maintain a leverage ratio of at least 4.0 percent. +The Capital Rules also establish a supplementary leverage ratio (SLR) requirement for advanced approaches banking organizations such as the Company. The SLR is the ratio of Tier 1 capital to an expanded concept of leverage exposure that includes both on-balance sheet and certain off-balance sheet exposures. The Capital Rules require a minimum SLR of 3.0 percent. +As noted above, Category IV firms, such as the Company, would no longer be subject to the SLR requirement under the Tailoring Proposals. +Liquidity Regulation +The Federal Reserve’s enhanced prudential standards rule includes heightened liquidity and overall risk management requirements. The rule requires the maintenance of a liquidity buffer, consisting of highly liquid assets, that is sufficient to meet projected net outflows for 30 days over a range of liquidity stress scenarios. +In addition, the Company and AENB are currently subject to a liquidity coverage ratio (LCR) requirement, which is provided for in the Basel III liquidity framework and is designed to ensure that a banking entity maintains an adequate level of unencumbered high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors. The LCR measures the ratio of a firm’s high-quality liquid assets to its projected net outflows. The Company and AENB are required to calculate the LCR each business day, maintain a minimum ratio of 100 percent and disclose certain LCR calculation data and other information on a quarterly basis. +A second standard provided for in the Basel III liquidity framework, referred to as the net stable funding ratio (NSFR), requires a minimum amount of longer-term funding based on the assets and activities of banking entities. The LCR and NSFR requirements may cause banking entities generally to increase their holdings of cash, U.S. Treasury securities and other sovereign debt as a proportion of total assets and/or increase the proportion of longer-term debt. Federal banking regulators issued a proposed rule in May 2016 that would implement the NSFR for advanced approaches banking organizations, such as the Company. A final rule has not yet been issued and timing for implementation of the NSFR requirements is uncertain. If implemented as proposed, the rule would require that “available stable funding” be no less than “required stable funding” for the Company and AENB, as each such measure is calculated under the rule. +As noted above, Category IV firms, such as the Company and AENB, would no longer be subject to the LCR requirement or the proposed NSFR requirements under the Tailoring Proposals. +8 +Table of Contents +Prompt Corrective Action +The Federal Deposit Insurance Act (FDIA) requires, among other things, that federal banking regulators take prompt corrective action in respect of depository institutions insured by the FDIC (such as AENB) that do not meet minimum capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. In order to be considered “well capitalized,” AENB must maintain CET1, Tier 1 capital, Total capital and Tier 1 leverage ratios of 6.5 percent, 8.0 percent, 10.0 percent and 5.0 percent, respectively. +Under the FDIA, AENB could be prohibited from accepting brokered deposits (i.e., deposits raised through third-party brokerage networks) or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A significant amount of our outstanding U.S. retail deposits are considered brokered deposits for bank regulatory purposes. If a federal regulator determines that we are in an unsafe or unsound condition or that we are engaging in unsafe or unsound banking practices, the regulator may reclassify our capital category or otherwise place restrictions on our ability to accept or solicit brokered deposits. +Resolution Planning +The Company is required to prepare and provide to regulators a plan for its rapid and orderly resolution under the U.S. Bankruptcy Code in the event of material distress or failure. This resolution planning requirement may, as a practical matter, present additional constraints on our structure, operations and business strategy, and on transactions and business arrangements between our bank and non-bank subsidiaries, because we must consider the impact of these matters on our ability to prepare and submit a resolution plan that demonstrates that we may be resolved under the Bankruptcy Code in a rapid and orderly manner. If the Federal Reserve and the FDIC determine that the Company’s plan is not credible and we fail to cure the deficiencies, we may be subject to more stringent capital, leverage or liquidity requirements; may be subject to more restrictions on our growth, activities or operations; or may ultimately be required to divest certain assets or operations to facilitate an orderly resolution. The Federal Reserve has indicated it expects to release a proposal to amend, with the FDIC, their joint resolution plan rule to address the applicability of resolution plan requirements for U.S. bank holding companies with between $100 billion and $250 billion in total consolidated assets, such as the Company. +Separately, AENB is required to prepare and provide a separate resolution plan to the FDIC that would enable the FDIC, as receiver, to effectively resolve AENB under the FDIA in the event of failure. The resolution planning requirement applicable to AENB is not affected by EGRRCPA. +Orderly Liquidation Authority +The Company could become subject to the Orderly Liquidation Authority (OLA), a resolution regime under which the Treasury Secretary may appoint the FDIC as receiver to liquidate a systemically important financial company, if the Company is in danger of default and is determined to present a systemic risk to U.S. financial stability. As under the FDIC resolution model, under the OLA, the FDIC has broad power as receiver. Substantial differences exist, however, between the OLA and the FDIC resolution model for depository institutions, including the right of the FDIC under the OLA to disregard the strict priority of creditor claims in limited circumstances, the use of an administrative claims procedure to determine creditor claims (as opposed to the judicial procedure used in bankruptcy proceedings), and the right of the FDIC to transfer claims to a “bridge” entity. The OLA is separate from the Company’s resolution plan discussed in “Resolution Planning.” +The FDIC has developed a strategy under OLA, referred to as the “single point of entry” or “SPOE” strategy, under which the FDIC would resolve a failed financial holding company by transferring its assets (including shares of its operating subsidiaries) and, potentially, very limited liabilities to a “bridge” holding company; utilize the resources of the failed financial holding company to recapitalize the operating subsidiaries; and satisfy the claims of unsecured creditors of the failed financial holding company and other claimants in the receivership by delivering securities of one or more new financial companies that would emerge from the bridge holding company. Under this strategy, management of the failed financial holding company would be replaced and its shareholders and creditors would bear the losses resulting from the failure. +9 +Table of Contents +FDIC Powers upon Insolvency of AENB +If the FDIC is appointed the conservator or receiver of AENB, the FDIC has the power: (1) to transfer any of AENB’s assets and liabilities to a new obligor without the approval of AENB’s creditors; (2) to enforce the terms of AENB’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which AENB is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmation or repudiation of which is determined by the FDIC to promote the orderly administration of AENB. In addition, the claims of holders of U.S. deposit liabilities and certain claims for administrative expenses of the FDIC against AENB would be afforded priority over other general unsecured claims against AENB, including claims of debt holders and depositors in non-U.S. offices, in the liquidation or other resolution of AENB. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of AENB, the debt holders and depositors in non-U.S. offices would be treated differently from, and could receive substantially less, if anything, than the depositors in the U.S. offices of AENB. +Other Banking Regulations +Source of Strength +The Company is required to act as a source of financial and managerial strength to its U.S. bank subsidiary, AENB, and may be required to commit capital and financial resources to support AENB. Such support may be required at times when, absent this requirement, the Company otherwise might determine not to provide it. Capital loans by the Company to AENB are subordinate in right of payment to deposits and to certain other indebtedness of AENB. In the event of the Company’s bankruptcy, any commitment by the Company to a federal banking regulator to maintain the capital of AENB will be assumed by the bankruptcy trustee and entitled to a priority of payment. +Transactions Between AENB and its Affiliates +Certain transactions (including loans and credit extensions from AENB) between AENB and its affiliates (including the Company, TRS and their other subsidiaries) are subject to quantitative and qualitative limitations, collateral requirements and other restrictions imposed by statute and regulation. Transactions subject to these restrictions are generally required to be made on an arm’s-length basis. +FDIC Deposit Insurance and Insurance Assessments +AENB accepts deposits that are insured by the FDIC up to the applicable limits. Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices; is in an unsafe or unsound condition to continue operations; or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that might lead to termination of deposit insurance at AENB. The FDIC’s deposit insurance fund is funded by assessments on insured depository institutions, including AENB, which are subject to adjustment by the FDIC. +Community Reinvestment Act +AENB is subject to the CRA, which imposes affirmative, ongoing obligations on depository institutions to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. +Other Enhanced Prudential Standards +The Federal Reserve has not yet finalized prudential requirements, mandated by Dodd-Frank, regarding early remediation requirements for large bank holding companies experiencing financial distress. +Consumer Financial Products Regulation +In the United States, our marketing, sale and servicing of consumer financial products and our compliance with certain federal consumer financial laws are supervised and examined by the CFPB, which has broad rulemaking and enforcement authority over providers of credit, savings and payment services and products, and authority to prevent “unfair, deceptive or abusive” acts or practices. In addition, a number of U.S. states have significant consumer credit protection, disclosure and other laws (in certain cases more stringent than U.S. federal laws). U.S. federal law also regulates abusive debt collection practices, which, along with bankruptcy and debtor relief laws, can affect our ability to collect amounts owed to us or subject us to regulatory scrutiny. +We are also regulated in the United States under the “money transmitter” or “sale of check” laws in effect in most states. In addition, we are required by the laws of many states to comply with unclaimed and abandoned property laws, under which we must pay to states the face amount of any Travelers Cheque or prepaid card that is uncashed or unredeemed after a period of time depending on the type of product. +10 +Table of Contents +In countries outside the United States, we have seen an increase in regulatory focus in relation to a number of key areas impacting our card-issuing businesses, particularly consumer protection (such as in the European Union (EU), the United Kingdom and Canada) and responsible lending (such as in Australia, Mexico, New Zealand and Singapore). Regulators in a number of countries are shifting their focus from just ensuring compliance with local rules and regulations toward paying greater attention to the product design and operation with a focus on customers and outcomes. Regulators’ expectations of firms in relation to their compliance, risk and control frameworks continue to increase and regulators are placing significant emphasis on a firm’s systems and controls relating to the identification and resolution of issues. +Payments Regulation +Legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +The EU, Australia and other jurisdictions have focused on the fees merchants pay to accept cards, including the way bankcard network members collectively set the “interchange” (that is, the fee paid by the bankcard merchant acquirer to the card issuer in “four party” networks like Visa and Mastercard), as well as the rules, contract terms and practices governing merchant card acceptance. For example, in December 2018, the European Commission announced that it is taking comments on separate proposals by Visa and Mastercard to cap inter-regional multilateral interchange fees. +Regulation and other governmental actions relating to merchant pricing or terms of merchant rules and contracts could affect all networks directly or indirectly, as well as adversely impact consumers and merchants. Among other things, regulation of bankcard fees has negatively impacted and may continue to negatively impact the discount revenue we earn, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business and we have largely exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions, for example. +In various countries, such as certain Member States in the EU and Australia, merchants are permitted by law to surcharge card purchases. In addition, the laws of a number of states in the United States that prohibit surcharging have been challenged in litigation brought by merchant groups and some such laws have been overturned. Surcharging is an adverse customer experience and could have a material adverse effect on us if it becomes widespread, particularly where it only or disproportionately impacts our business. In addition, other steering practices that are permitted by regulation in some countries could also have a material adverse effect on us if they become widespread. +In Canada, regulators have prompted the major international card networks to make voluntary commitments on pricing, specifically interchange fee levels; as American Express does not operate with interchange fees in Canada, our commitments extend to maintaining current pricing practices and complying with certain other practices. +In some countries governments have established regulatory regimes that require international card networks to be locally licensed and/or to localize aspects of their operations. For example, card network operators in India must obtain authorization from the Reserve Bank of India, which has broad power under the Payment and Settlement Systems Act, 2007 to regulate the membership and operations of card networks. In Russia, card network operators must be authorized by the central bank, and regulation requires networks to place security deposits with the central bank, process all local transactions using government-owned infrastructure and ensure that local transaction data remains within the country. The development and enforcement of these and other similar laws, regulations and policies may adversely affect our ability to compete effectively in those countries and maintain and extend our global network. +Governments in some countries also provide resources or protection to select domestic payment card networks. In November 2018, we received preparatory approval from the People’s Bank of China to begin building a network to process domestic currency transactions through a joint venture in mainland China. Once the network has been established, we can apply for a business operating license. There can be no assurance that we will receive such a license, or, if we do, that we will be able to successfully compete in China with domestic payment card networks and alternative payment providers. +Privacy, Data Protection, Information and Cyber Security +Regulatory and legislative activity in the areas of privacy, data protection and information and cyber security continues to increase worldwide. We have established and continue to maintain policies that provide a framework for compliance with applicable privacy, data protection and information and cyber security laws, meet evolving customer expectations and support and enable business innovation and growth. +Our regulators are increasingly focused on ensuring that our privacy, data protection and information and cyber security-related policies and practices are adequate to inform customers of our data collection, use, sharing and/or security practices, to provide them with choices, if required, about how we use and share their information, and to appropriately safeguard their personal information and account access. +11 +Table of Contents +In the United States, certain of our businesses are subject to the privacy, disclosure and safeguarding provisions of the Gramm-Leach-Bliley Act (GLBA) and its implementing regulations and guidance. Among other things, the GLBA imposes certain limitations on our ability to share consumers’ nonpublic personal information with nonaffiliated third parties and requires us to develop, implement and maintain a written comprehensive information security program containing safeguards that are appropriate to the size and complexity of our business, the nature and scope of our activities and the sensitivity of customer information that we process. Effective January 2020, the California Consumer Privacy Act will require us to offer expanded privacy rights to California residents who are not covered by GLBA. Various regulators, U.S. states and territories are considering similar requirements or have adopted laws, rules and regulations pertaining to privacy and/or information and cyber security that may be more stringent and/or expansive than federal requirements. +We are also subject to certain privacy, data protection and information and cyber security laws in other countries in which we operate (including countries in the EU, Australia, Canada, Japan, Hong Kong, India, Mexico and Singapore), some of which are more stringent and/or expansive than those in the United States. Some countries have also instituted laws requiring in-country data processing and/or in-country storage of the personal data of its citizens. Compliance with such laws could result in higher technology, administrative and other costs for us and could limit our ability to optimize the use of our closed-loop data. Data breach notification laws or regulatory activities to encourage breach notification are also becoming more prevalent in jurisdictions outside the United States in which we operate. +In Europe, the EU General Data Protection Regulation (GDPR) went into effect in May 2018 with significant fines for non-compliance (up to 4 percent of total annual worldwide revenue). It created additional legal and compliance obligations on companies that process personal data of individuals in the EU, irrespective of the geographical location of the company. We have made changes to our privacy practices to comply with these requirements, and continue to rely on our binding corporate rules as the primary method for lawfully transferring data from our European affiliates to our affiliates in the United States and elsewhere globally. The GDPR includes, among other things, a requirement for prompt notice of data breaches, in certain circumstances, to affected individuals and supervisory authorities. +In addition, the European Directive 2002/58/EC (the ePrivacy Directive) will continue to set out requirements for the processing of personal data and the protection of privacy in the electronic communications sector until the approval of the forthcoming ePrivacy Regulation. The ePrivacy Directive places restrictions on, among other things, the sending of unsolicited marketing communications, as well as on the collection and use of data about internet users. +In 2015, the European Central Bank and the European Banking Authority enacted secondary legislation focused on security breaches, strong customer authentication and information security-related policies. Likewise, a network and information security directive has been implemented into national laws by Member States in the European Union. The Revised Payment Services Directive (PSD2) also contains regulatory requirements on strong customer authentication, open access to customer data and payment capabilities, and measures to prevent security incidents. +Anti-Money Laundering, Sanctions and Anti-Corruption Compliance +We are subject to significant supervision and regulation, and an increasingly stringent enforcement environment, with respect to compliance with anti-money laundering (AML), sanctions and anti-corruption laws and regulations in the United States and in other jurisdictions in which we operate. Failure to maintain and implement adequate programs and policies and procedures for AML, sanctions and anti-corruption compliance could have serious financial, legal and reputational consequences. +Anti-Money Laundering +American Express is subject to a significant number of AML laws and regulations as a result of being a financial company headquartered in the United States, as well as having a global presence. In the United States, the majority of AML requirements are derived from the Currency and Foreign Transactions Reporting Act and the accompanying regulations issued by the U.S. Department of the Treasury (collectively referred to as the Bank Secrecy Act), as amended by the USA PATRIOT Act of 2001 (the Patriot Act). In Europe, AML requirements are largely the result of countries transposing the 4th EU Anti-Money Laundering Directive (and preceding EU Anti-Money Laundering Directives) into local laws and regulations. Numerous other countries, such as Argentina, Australia, Canada, India, Mexico, New Zealand and Russia, have also enacted or proposed new or enhanced AML legislation and regulations applicable to American Express. +Among other things, these laws and regulations require us to establish AML programs that meet certain standards, including, in some instances, expanded reporting, particularly in the area of suspicious transactions, and enhanced information gathering and recordkeeping requirements. Any errors, failures or delays in complying with federal, state or foreign AML and counter-terrorist financing laws could result in significant criminal and civil lawsuits, penalties and forfeiture of significant assets or other enforcement actions. +12 +Table of Contents +Office of Foreign Assets Control Regulation +The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. The United States prohibits U.S. persons from engaging with individuals and entities identified as “Specially Designated Nationals,” such as terrorists and narcotics traffickers. These prohibitions are administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) and are typically known as the OFAC rules. The OFAC rules prohibit U.S. persons from engaging in financial transactions with or relating to the prohibited individual, entity or country, require the blocking of assets in which the individual, entity or country has an interest, and prohibit transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons) to such individual, entity or country. Blocked assets (e.g., property or bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. We maintain a global sanctions program designed to ensure compliance with OFAC requirements. Failure to comply with such requirements could subject us to serious legal and reputational consequences, including criminal penalties. +Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) to the Securities Exchange Act of 1934, as amended (the Exchange Act), an issuer is required to disclose in its annual or quarterly reports, as applicable, whether it or any of its affiliates knowingly engaged in certain activities, transactions or dealings relating to Iran or with individuals or entities designated pursuant to certain Executive Orders. Disclosure is generally required even where the activities, transactions or dealings were conducted outside the United States by non-U.S. affiliates in compliance with applicable law, and whether or not the activities are sanctionable under U.S. law. +American Express Global Business Travel (GBT) and certain entities that may be considered affiliates of GBT have informed us that during the year ended December 31, 2018, approximately 123 visas were obtained from Iranian embassies and consulates around the world in connection with certain travel arrangements on behalf of clients and reservations were booked at two hotels that may be owned, directly or indirectly, or may otherwise be affiliated with, the Government of Iran. GBT had negligible gross revenues and net profits attributable to these transactions and intends to continue to engage in these activities on a limited basis so long as such activities are permitted under U.S. law. +Anti-Corruption +We are subject to complex international and U.S. anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act (the FCPA), the UK Bribery Act and other laws that prohibit the making or offering of improper payments. The FCPA makes it illegal to corruptly offer or provide anything of value to foreign government officials, political parties or political party officials for the purpose of obtaining or retaining business or an improper advantage. The FCPA also requires us to strictly comply with certain accounting and internal controls standards. In recent years, enforcement of the FCPA has become more intense. The UK Bribery Act also prohibits commercial bribery and the receipt of a bribe, and makes it a corporate offense to fail to prevent bribery by an associated person, in addition to prohibiting improper payments to foreign government officials. Failure of the Company, our subsidiaries, employees, contractors or agents to comply with the FCPA, the UK Bribery Act and other laws can expose us and/or individual employees to investigation, prosecution and potentially severe criminal and civil penalties. +Compensation Practices +Our compensation practices are subject to oversight by the Federal Reserve. The federal banking regulators’ guidance on sound incentive compensation practices sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation plans do not encourage imprudent risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should (1) provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks, (2) be compatible with effective internal controls and risk management, and (3) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in our compensation practices that are identified by the Federal Reserve or other banking regulators in connection with its review of our compensation practices may be incorporated into our supervisory ratings, which can affect our ability to make acquisitions or perform other actions. Enforcement actions may be taken against us if our incentive compensation arrangements or related risk-management control or governance processes are determined to pose a risk to our safety and soundness and we have not taken prompt and effective measures to correct the deficiencies. +In May 2016, the federal banking regulators, the SEC, the Federal Housing Finance Agency and the National Credit Union Administration re-proposed a rule, originally proposed in 2011, on incentive-based compensation practices. The re-proposed rule would apply deferral, downward adjustment and forfeiture, and clawback requirements to incentive-based compensation arrangements granted to senior executive officers and significant risk-takers of covered institutions, with specific requirements varying based on the asset size of the covered institution and the category of employee. If these or other regulations are adopted in a form similar to what has been proposed, they will impose limitations on the manner in which we may structure compensation for our employees, which could adversely affect our ability to hire, retain and motivate key employees. +13 +Table of Contents +EXECUTIVE OFFICERS OF THE COMPANY +Set forth below, in alphabetical order, is a list of our executive officers as of February 13, 2019, including each executive officer’s principal occupation and employment during the past five years and reflecting recent organizational changes. None of our executive officers has any family relationship with any other executive officer, and none of our executive officers became an officer pursuant to any arrangement or understanding with any other person. Each executive officer has been elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer’s age is indicated by the number in parentheses next to his or her name. +DOUGLAS E. BUCKMINSTER — +Group President, Global Consumer Services Group +Mr. Buckminster (58) has been Group President, Global Consumer Services Group since February 2018. Prior thereto, he had been President, Global Consumer Services Group since October 2015 and President, Global Network and International Card Services since February 2012. +JEFFREY C. CAMPBELL — +Chief Financial Officer +Mr. Campbell (58) has been Chief Financial Officer since August 2013. +PAUL D. FABARA — +President, Global Services Group +Mr. Fabara (53) has been President, Global Services Group since February 2018. Prior thereto, he had been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2016 and President, Global Banking Group since February 2013. He also served as President, Global Network Business from September 2014 to October 2015. +MARC D. GORDON — +Chief Information Officer +Mr. Gordon (58) has been Chief Information Officer since September 2012. +ANNA MARRS — +President, Global Commercial Services +Ms. Marrs (45) has been President, Global Commercial Services since September 2018. Ms. Marrs joined American Express from Standard Chartered Bank, where she served as Regional CEO, ASEAN and South Asia since November 2016 and CEO, Commercial and Private Banking since October 2015. She joined Standard Chartered Bank as Group Head, Strategy and Corporate Development in January 2012. +MICHAEL J. O’NEILL — +Chief Corporate Affairs Officer +Mr. O’Neill (65) has been Chief Corporate Affairs Officer since September 2014. Prior thereto, he had been Senior Vice President, Corporate Affairs and Communications since March 1991. +DENISE PICKETT — +Chief Risk Officer and President, Global Risk, Banking & Compliance +Ms. Pickett (53) has been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2018. Prior thereto, she had been President, U.S. Consumer Services since October 2015. She also served as President, American Express OPEN from February 2014 to October 2015 and Executive Vice President and Chief Executive Officer, U.S. Loyalty from January 2013 to February 2014. +ELIZABETH RUTLEDGE — +Chief Marketing Officer +Ms. Rutledge (57) has been Chief Marketing Officer since February 2018. Prior thereto, she had been Executive Vice President, Global Advertising & Media since February 2016 and Executive Vice President, Card Products & Benefits since May 2013. +LAUREEN E. SEEGER — +Chief Legal Officer +Ms. Seeger (57) has been Chief Legal Officer since July 2014. Ms. Seeger joined American Express from McKesson Corporation, where she served as Executive Vice President, General Counsel and Chief Compliance Officer from March 2006 until June 2014. +STEPHEN J. SQUERI — +Chairman and Chief Executive Officer +Mr. Squeri (59) has been Chairman and Chief Executive Officer since February 2018. Prior thereto, he had been Vice Chairman since July 2015. Prior thereto, he had been Group President, Global Corporate Services since November 2011. +ANRÉ WILLIAMS — +Group President, Global Merchant and Network Services +Mr. Williams (53) has been Group President, Global Merchant and Network Services since February 2018. Prior thereto, he had been President of Global Merchant Services and Loyalty since October 2015 and President, Global Merchant Services since November 2011. +14 +Table of Contents +EMPLOYEES +We had approximately 59,000 employees as of December 31, 2018. +ADDITIONAL INFORMATION +We maintain an Investor Relations website at http://ir.americanexpress.com. We make available free of charge, on or through this website, our annual, quarterly and current reports and any amendments to those reports as soon as reasonably practicable following the time they are electronically filed with or furnished to the Securities and Exchange Commission (SEC). To access these materials, click on the “SEC Filings” link under the caption “Financial Information” on our Investor Relations homepage. +You can also access our Investor Relations website through our main website at www.americanexpress.com by clicking on the “Investor Relations” link, which is located at the bottom of our homepage. Information contained on our Investor Relations website, our main website and other websites referred to in this report is not incorporated by reference into this report or any other report filed with or furnished to the SEC. We have included such website addresses only as inactive textual references and do not intend them to be active links. +You can find certain statistical disclosures required of bank holding companies starting on page A-1, which are incorporated herein by reference. +ITEM 1A. +RISK FACTORS +This section highlights specific risks that could affect us and our businesses. You should carefully consider each of the following risks and all of the other information set forth in this Annual Report on Form 10-K. Based on the information currently known to us, we believe the following information identifies the most significant risk factors affecting us. However, the risks and uncertainties we face are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. +If any of the following risks and uncertainties develop into actual events or if the circumstances described in the risks and uncertainties occur or continue to occur, these events or circumstances could have a material adverse effect on our business, financial condition or results of operations. These events could also have a negative effect on the trading price of our securities. +Strategic, Business and Competitive Risks +Difficult conditions in the business and economic environment, as well as political conditions in the United States and elsewhere, may materially adversely affect our business and results of operations. +Our results of operations are materially affected by economic, market, political and social conditions in the United States and abroad. We offer a broad array of products and services to consumers, small businesses and commercial clients and thus are very dependent upon the level of consumer and business activity and the demand for payment and financing products. Slow economic growth, volatile or deteriorating economic conditions or shifts in broader consumer and business trends could change customer behaviors, including spending on our cards, the ability and willingness of Card Members to borrow and pay amounts owed to us, and demand for fee-based products and services. Political conditions, prolonged or recurring government shutdowns, regional hostilities, social upheaval, fiscal and monetary policies, trade concerns and tariffs could also negatively affect consumer and business spending, including travel patterns and business investment, and demand for credit. +Factors such as consumer spending and confidence, unemployment rates, business investment, government spending, trade relationships with other countries, interest rates, taxes, energy costs, the volatility and strength of the capital markets, inflation and deflation all affect the economic environment and, ultimately, our profitability. Such factors may also cause our earnings, billings, loan balances, credit metrics and margins to fluctuate and diverge from expectations of analysts and investors, who may have differing assumptions regarding their impact on our business, adversely affecting, and/or increasing the volatility of, the trading price of our common shares. +15 +Table of Contents +Travel and entertainment expenditures, which comprised approximately 25 percent of our U.S. billed business during 2018, for example, are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns. Likewise, spending by small businesses and corporate clients, which comprised approximately 41 percent of our worldwide billed business during 2018, depends in part on the economic environment and a favorable climate for continued business investment and new business formation. Increases in delinquencies and write-off rates as a result of increases in bankruptcies, unemployment rates, changes in customer behaviors or otherwise could also have a material adverse effect on our results of operations. The consequences of negative circumstances impacting us or the environment generally can be sudden and severe. +The exit of the United Kingdom from the European Union could adversely impact our business, results of operations and financial condition. +Our business in the United Kingdom and elsewhere may be negatively impacted by the uncertainty regarding the exit of the United Kingdom from the European Union (commonly referred to as Brexit), including from a deterioration of consumer and business activity in the United Kingdom and other countries and general uncertainty in the overall business environment in which we operate. The exit itself could negatively impact the United Kingdom and other economies, which could adversely affect spending on our cards and the ability and willingness of Card Members to pay amounts owed to us. We may also experience increased volatility in the value of the pound sterling, the euro and other European currencies, which could further strengthen the U.S. dollar, adversely impacting the results of operations from our international activities. In addition, Brexit could lead to legal uncertainty and potentially divergent national laws and regulations in the United Kingdom and the European Union, and we may incur additional costs or need to make operational changes that reduce revenue as we adapt to potentially divergent regulatory frameworks. Any of these effects of Brexit, among others, could adversely affect our business and financial results. As of December 31, 2018, the United Kingdom constituted approximately 4 percent of our worldwide billed business and the EMEA region as a whole constituted approximately 11 percent. We have made changes to the structure of our business operations in Europe in anticipation of Brexit, although the financial, trade and legal implications of Brexit are still uncertain and may be more severe than expected given that the final terms upon which the United Kingdom will exit the EU are still not known and the lack of comparable precedent. +Our operating results may suffer because of substantial and increasingly intense competition worldwide in the payments industry. +The payments industry is highly competitive, and we compete with charge, credit and debit card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and ACH), as well as evolving and growing alternative, non-traditional payment and financing providers. If we are not able to differentiate ourselves from our competitors, develop compelling value propositions for our customers and/or effectively grow in areas such as mobile and online payments and emerging technologies, we may not be able to compete effectively. +We believe Visa and Mastercard are larger than we are in most countries. As a result, card issuers and acquirers on the Visa and Mastercard networks may be able to benefit from the dominant position, scale, resources, marketing and pricing of those networks. Our business may also be increasingly negatively affected if we are unable to increase merchant acceptance and our cards are not accepted at merchants that accept cards on the Visa and Mastercard networks. +Some of our competitors have developed, or may develop, substantially greater financial and other resources than we have and may offer richer value propositions or a wider range of programs and services than we offer or may use more effective advertising, marketing or cross-selling strategies to acquire and retain more customers, capture a greater share of spending and borrowings, establish and develop more attractive cobrand card and other partner programs and maintain greater merchant acceptance than we have. We may not be able to compete effectively against these threats or respond or adapt to changes in consumer spending habits as effectively as our competitors. We expect expenses such as Card Member rewards and Card Member services expenses to continue to increase as we improve our value propositions for Card Members, including in response to increased competition. +Spending on our cards could continue to be impacted by increasing consumer usage of charge, credit and debit cards issued on other networks, as well as adoption of alternative payment systems. To the extent other payment mechanisms, systems and products continue to successfully expand, our discount revenues and our ability to access transaction data through our integrated network could be negatively impacted. For example, companies that control access to consumer and merchant payment method choices at the point of sale or through digital wallets, commerce-related experiences, mobile applications or other technologies could choose not to accept, suppress use of, or degrade the experience of using our products or could restrict our access to our customers and transaction data. Such companies could also require payments from us to participate in such digital wallets, experiences or applications, impacting our profitability on transactions. +The competitive value of our closed-loop data may also be diminished as traditional and non-traditional competitors use other, new data sources and technologies to derive similar insights. Certain regulations, such as PSD2 in Europe and open banking initiatives in various jurisdictions around the world, could also diminish the value of our closed-loop data or the demand for our products and services by disintermediating existing financial services providers. +16 +Table of Contents +To the extent we expand into new business areas and new geographic regions, we may face competitors with more experience and more established relationships with relevant customers, regulators and industry participants, which could adversely affect our ability to compete. Laws and business practices that favor local competitors, require card transactions to be routed over domestic networks or prohibit or limit foreign ownership of certain businesses could limit our growth in international regions. We may face additional compliance and regulatory risks to the extent that we expand into new business areas, and we may need to dedicate more expense, time and resources to comply with regulatory requirements than our competitors, particularly those that are not regulated financial institutions. +Many of our competitors are subject to different, and in some cases, less stringent, legislative and regulatory regimes, and some may have lower cost structures and more agile business models and systems. More restrictive laws and regulations that do not apply to all of our competitors can put us at a disadvantage, including prohibiting us from engaging in certain transactions, regulating our business practices or adversely affecting our cost structure. +We face intense competition for partner relationships, which could result in a loss or renegotiation of these arrangements that could have a material adverse impact on our business and results of operations. +In the ordinary course of our business we enter into different types of contractual arrangements with business partners in a variety of industries. For example, we have partnered with Delta Air Lines, as well as many others globally, to offer cobranded cards for consumers and small businesses, and through our Membership Rewards program we have partnered with businesses in many industries, including the airline industry, to offer benefits to Card Member participants. Competition for relationships with key business partners is very intense and there can be no assurance we will be able to grow or maintain these partner relationships or that they will remain as profitable. Establishing and retaining attractive cobrand card partnerships is particularly competitive among card issuers and networks as these partnerships typically appeal to high-spending loyal customers. All of our cobrand portfolios in the aggregate accounted for approximately 17 percent of our worldwide billed business for the year ended December 31, 2018. Card Member loans related to our cobrand portfolios accounted for approximately 36 percent of our worldwide Card Member loans as of December 31, 2018. +We have partnered with Delta Air Lines across many aspects of our business. We issue cards under cobrand arrangements with Delta and the Delta cobrand portfolio, our largest cobrand portfolio, accounted for approximately 8 percent of our worldwide billed business for the year ended December 31, 2018 and approximately 21 percent of worldwide Card Member loans as of December 31, 2018. The Delta cobrand portfolio generates fee revenue and interest income from Card Members and discount revenue from Delta and other merchants for spending on Delta cobrand cards. Our relationships with, and revenues related to, Delta are significant and extend beyond cobrand accounts. Delta is a key participant in our Membership Rewards program, provides travel-related benefits and services, including airport lounge access for certain American Express Card Members, accepts American Express cards as a merchant and is a corporate payments customer. +Cobrand arrangements are entered into for a fixed period, generally ranging from five to eight years, and will terminate in accordance with their terms, including at the end of the fixed period unless extended or renewed at the option of the parties, or upon early termination as a result of an event of default or otherwise. We work with our cobrand partners on an ongoing basis to demonstrate the value we deliver and evolve our relationships for the benefit of both parties. We face the risk that we could lose partner relationships, even after we have invested significant resources in the relationships. We may also choose to not renew certain cobrand relationships. The volume of billed business could decline and Card Member attrition could increase, in each case, significantly as a result of the termination of one or more cobrand partnership relationships. In addition, some of our cobrand arrangements provide that, upon expiration or termination, the cobrand partner may purchase or designate a third party to purchase the loans generated with respect to its program, which could result in the loss of the card accounts and a significant decline in our Card Member loans outstanding. +We regularly seek to extend or renew cobrand arrangements in advance of the end of the contract term and face the risk that existing relationships will be renegotiated with less favorable terms for us or that we may be unable to renegotiate on terms that are acceptable to us, as competition for such relationships continues to increase. We make payments to our cobrand partners, which can be significant, based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The amount we pay to our cobrand partners has increased, particularly in the United States, and may continue to increase as arrangements are renegotiated due to increasingly intense competition for cobrand partners among card issuers and networks. See "Off-Balance Sheet Arrangements and Contractual Obligations" under "MD&A" for additional information regarding commitments for payments to certain cobrand partners. +The loss of exclusivity arrangements with business partners, the loss of the partner relationship altogether (whether by non-renewal at the end of the contract period, such as the end of our relationship with Costco in the United States in 2016, or as the result of a merger, legal or regulatory action or otherwise, such as the withdrawal of American Airlines in 2014 from our Airport Club Access program for Centurion ® and Platinum Card ® Members) or the renegotiation of existing partnerships with terms that are significantly worse for us could have a material adverse impact on our business and results of operations. See "Our business is subject to comprehensive government regulation and supervision, which could adversely affect our results of operations and financial condition" for information on the uncertainty regarding our cobrand and agent relationships in the EU. In addition, any publicity associated with the loss of any of our key business partners could harm our reputation, making it more difficult to attract and retain Card Members and merchants, and could weaken our negotiating position with our remaining and prospective business partners. +17 +Table of Contents +We face continued intense competitive pressure that may impact the prices we charge merchants that accept our cards for payment for goods and services. +Unlike our competitors in the payments industry that rely on revolving credit balances to drive profits, our business model is more focused on Card Member spending. Discount revenue, which represents fees generally charged to merchants when Card Members use their cards to purchase goods and services on our network, is primarily driven by billed business volumes and is our largest single revenue source. In recent years, we experienced some reduction in our average merchant discount rate, including as a result of rate pressure resulting from regulatory changes affecting competitor pricing in certain international countries. We also face pressure from competitors that have other sources of income or lower costs that can make their pricing more attractive to business partners and merchants. Merchants are also able to negotiate incentives and pricing concessions from us as a condition to accepting our cards or being cobrand partners. As merchants consolidate and become even larger, we may have to increase the amount of incentives and/or concessions we provide to such merchants, which could materially and adversely affect our results of operations. Competitive and regulatory pressures on pricing could make it difficult to offset the costs of these incentives. We have also experienced erosion of our average merchant discount rate as we increase merchant acceptance. We may not be successful in significantly expanding merchant acceptance or offsetting rate erosion with volumes at new merchants. +In addition, the regulatory environment and differentiated payment models and technologies from non-traditional players in the alternative payments space could pose challenges to our traditional payment model and adversely impact our average merchant discount rate. Some merchants continue to invest in their own payment solutions, such as proprietary-branded mobile wallets, using both traditional and new technology platforms. If merchants are able to drive broad consumer adoption and usage, it could adversely impact our average merchant discount rate and billed business volumes. +A continuing priority of ours is to drive greater and differentiated value to our merchants which, if not successful, could negatively impact our discount revenue and financial results. We may not succeed in maintaining merchant discount rates or offsetting the impact of declining merchant discount rates, which could materially and adversely affect our revenues and profitability, and therefore our ability to invest in innovation and in value-added services for merchants and Card Members. +Surcharging or steering by merchants could materially adversely affect our business and results of operations. +In certain countries, such as Australia and certain Member States in the EU, merchants are expressly permitted by law to surcharge certain card purchases. In jurisdictions allowing surcharging, we have seen merchant surcharging on American Express cards in certain merchant categories, and in some cases, either the surcharge is greater than that applied to Visa and Mastercard cards or Visa and Mastercard cards are not surcharged at all (practices that are known as differential surcharging), even though there are many cards issued on competing networks that have an equal or greater cost of acceptance for the merchant. In addition, the laws of a number of states in the United States that prohibit surcharging have been overturned in litigation brought by merchant groups. +We also encounter merchants that accept our cards, but tell their customers that they prefer to accept another type of payment or otherwise seek to suppress use of our cards. Our Card Members value the ability to use their cards where and when they want to, and we, therefore, take steps to meet our Card Members’ expectations and to protect the American Express brand by prohibiting this form of discrimination, subject to local legal requirements. +If surcharging, steering or other forms of discrimination become widespread, American Express cards and credit and charge cards generally could become less desirable to consumers, which could result in a decrease in cards-in-force and transaction volumes. The impact could vary depending on such factors as the industry or manner in which a surcharge is levied, how Card Members are steered to other card products or payment forms at the point of sale, the size and recurrence of the underlying charges, and whether and to what extent these actions are applied to other forms of payment, including whether it varies depending on the type of card, product, network, acquirer or issuer. Discrimination against American Express cards could have a material adverse effect on our business, financial condition and results of operations, particularly to the extent it disproportionately impacts our Card Members or our business. +We may not be successful in our efforts to promote card usage through marketing and promotion, merchant acceptance and Card Member rewards and services, or to effectively control the costs of such investments, both of which may impact our profitability. +Revenue growth is dependent on increasing consumer and business spending on our cards, growing loan balances and increasing fee revenue. We have been investing in a number of growth initiatives, including to attract new Card Members, reduce Card Member attrition and capture a greater share of customers’ total spending and borrowings. There can be no assurance that our investments to acquire Card Members, provide differentiated features and services and increase usage of our cards will continue to be effective. In addition, if we develop new products or offers that attract customers looking for short-term incentives rather than incentivize long-term loyalty, Card Member attrition and costs could increase. Increasing spending on our cards also depends on our continued expansion of merchant acceptance of our cards. If the rate of merchant acceptance growth slows or reverses itself, our business could suffer. Further, expanding our service offerings, adding customer acquisition channels and forming new partnerships or renewing current partnerships could have higher costs than our current arrangements, and could adversely impact our average discount rate or dilute our brand. +18 +Table of Contents +Another way we invest in customer value is through our Membership Rewards program, as well as other Card Member benefits. Any significant change in, or failure by management to reasonably estimate, actual redemptions of Membership Rewards points and associated redemption costs could adversely affect our profitability. We rely on third parties, such as Amazon and Delta, for certain redemption options and may not be able to continue to offer such redemption options in the future, which could diminish the value of the program for our Card Members. In addition, many credit card issuers have instituted rewards and cobrand programs and may introduce programs and services that are similar to or more attractive than ours. Our inability to continue to differentiate our products and services generally could materially adversely affect us. +We may not be able to cost-effectively manage and expand Card Member benefits, including containing the growth of marketing, promotion, rewards and Card Member services expenses in the future. If such expenses continue to increase beyond our expectations, we will need to find ways to offset the financial impact by increasing payments volume, increasing other areas of revenues such as fee-based revenues, or both. We may not succeed in doing so, particularly in the current competitive and regulatory environment. +Our brand and reputation are key assets of our Company, and our business may be affected by how we are perceived in the marketplace. +Our brand and its attributes are key assets, and we believe our continued success depends on our ability to preserve, grow and leverage the value of our brand. Our ability to attract and retain consumer and small business Card Members and corporate clients is highly dependent upon the external perceptions of our level of service, trustworthiness, business practices, data use and protection, management, workplace culture, merchant acceptance, financial condition, our response to unexpected events and other subjective qualities. Negative perceptions or publicity regarding these matters — even if related to seemingly isolated incidents and whether or not factually correct—could erode trust and confidence and damage our reputation among existing and potential Card Members and corporate clients, which could make it difficult for us to attract new Card Members and customers and maintain existing ones. Negative public opinion could result from actual or alleged conduct in any number of activities or circumstances, including card practices, regulatory compliance, the use and protection of customer information and conduct by our employees, and from actions taken by regulators or others in response thereto. Social media channels can also cause rapid, widespread reputational harm to our brand. +Our brand and reputation may also be harmed by actions taken by third parties that are outside our control. For example, any shortcoming of or controversy related to a third-party vendor, business partner, merchant acquirer or network partner may be attributed by Card Members and merchants to us, thus damaging our reputation and brand value. The lack of acceptance, suppression of card usage or surcharging by merchants can also negatively impact perceptions of our brand and our products, lower overall transaction volume and increase the attractiveness of other payment products or systems. Adverse developments with respect to our industry may also, by association, negatively impact our reputation, or result in greater regulatory or legislative scrutiny or litigation against us. Furthermore, as a corporation with headquarters and operations located in the United States, a negative perception of the United States arising from its political or other positions could harm the perception of our company and our brand. Although we monitor developments for areas of potential risk to our reputation and brand, negative perceptions or publicity could materially and adversely affect our revenues and profitability. +A major information or cyber security incident or an increase in fraudulent activity could lead to reputational damage to our brand and significant legal, regulatory and financial exposure, and could reduce the use and acceptance of our charge and credit cards. +We and third parties process, transmit, store and provide access to account information in connection with our charge and credit cards and other products, and in the normal course of our business, we collect, analyze and retain significant volumes of certain types of personally identifiable and other information pertaining to our customers and employees. +Our networks and systems are subject to constant attempts to identify and exploit potential vulnerabilities in our operating environment with intent to disrupt our business operations and capture, destroy, manipulate or expose various types of information relating to corporate trade secrets, customer information, including Card Member, travel and loyalty program data, employee information and other sensitive business information, including acquisition activity, financial results and intellectual property. There are a number of motivations for cyber threat actors, including criminal activities such as fraud, identity theft and ransom, corporate or nation-state espionage, political agendas, public embarrassment with the intent to cause financial or reputational harm, intent to disrupt information technology systems, and to expose and exploit potential security and privacy vulnerabilities in corporate systems and websites. +Global financial institutions like us have experienced a significant increase in information and cyber security risk in recent years and will likely continue to be the target of increasingly sophisticated cyberattacks, including computer viruses, malicious or destructive code, ransomware, social engineering attacks (including phishing, impersonation and identity takeover attempts), hacking, website defacement, denial-of-service attacks and other attacks and similar disruptions from the misconfiguration or unauthorized use of or access to computer systems. For example, we and other U.S. financial services providers have been the targets of distributed denial-of-service attacks from sophisticated third parties. +19 +Table of Contents +We develop and maintain systems and processes aimed at detecting and preventing information and cyber security incidents and fraudulent activity, which require significant investment, maintenance and ongoing monitoring and updating as technologies and regulatory requirements change and as efforts to overcome security measures become more sophisticated. Despite our efforts, the possibility of information and cyber security incidents, malicious social engineering, fraudulent or other malicious activities and human error or malfeasance cannot be eliminated entirely and will evolve as new technology is deployed. Risks associated with each of these include theft of funds and other monetary loss, the disruption of our operations and the unauthorized disclosure, release, gathering, monitoring, misuse, modification, loss or destruction of confidential, proprietary or other information (including account data information), the effects of which could be compounded if not detected quickly. +Information or cyber security incidents, fraudulent activity and other actual or perceived failures to maintain confidentiality, integrity, privacy and/or security may lead to regulatory investigations and intervention (such as mandatory card reissuance), increased litigation (including class action litigation), remediation, fines and response costs, negative assessments of us and our subsidiaries by banking regulators and rating agencies, reputational and financial damage to our brand, and reduced usage and acceptance of our cards, all of which could have a material adverse impact on our business. The disclosure of sensitive company information could also undermine our competitive advantage and divert management attention and resources. +Successful cyberattacks, data breaches, disruptions or other incidents related to the actual or perceived failures to maintain confidentiality, integrity, privacy and/or security at other large financial institutions, large retailers, travel and hospitality companies or other market participants, whether or not we are impacted, could lead to a general loss of customer confidence that could negatively affect us, including harming the market perception of the effectiveness of our security measures or harming the reputation of the financial system in general, which could result in reduced use of our products and services. Such events could also result in legislation and additional regulatory requirements. Although we have insurance for losses related to cyber risks and attacks and information and cyber security and privacy liability, it may not be sufficient to offset the impact of a material loss event. +The uninterrupted operation of our information systems is critical to our success and a significant disruption could have a material adverse effect on our business and results of operations. +Our information technology systems, including our transaction authorization, clearing and settlement systems, and data centers, may experience service disruptions or degradation because of technology malfunction, sudden increases in customer transaction volume, natural disasters, accidents, power outages, internet outages, telecommunications failures, fraud, denial-of-service and other cyberattacks, terrorism, computer viruses, vulnerabilities in hardware or software, physical or electronic break-ins, or similar events. Service disruptions could prevent access to our online services and account information, compromise or limit access to company or customer data, and impede transaction processing and financial reporting. Any interruption or degradation could adversely affect the perception of the reliability of our products and services and materially adversely affect our overall business, reputation and results of operations. +We rely on third-party providers for acquiring customers, technology, platforms and other services integral to the operations of our businesses. These third parties may act in ways that could harm our business. +We rely on third-party service providers, merchants, customer acquisition channels, processors, aggregators, network partners and other third parties for services that are integral to our operations and are subject to the risk that activities of such third parties may adversely affect our business. As outsourcing, specialization of functions, third-party digital services and technology innovation within the payments industry increase (including with respect to mobile technologies, tokenization, big data and cloud storage solutions), more third parties are involved in processing card transactions and handling our data. For example, we rely on third parties for the timely transmission of accurate information across our global network, card acquisition and provision of services to our customers. If a service provider or other third party ceases to provide the data quality or communications capacity we expect or services upon which we rely, as a result of natural disaster, operational disruptions or errors, terrorism, information or cyber security incidents, or any other reason, the failure could interrupt or compromise the quality of our services to customers or impact our ability to grow our business. +The confidentiality, integrity, privacy and/or security of data communicated over third-party networks or platforms or held by, or accessible to, third parties, including merchants that accept our cards, payment processors, payment intermediaries and our third-party vendors and business partners, could become compromised, which could lead to unauthorized use of our data or fraudulent transactions on our cards, as well as costs associated with responding to such an incident. For example, in March 2018, we were alerted by Expedia that certain customers who used Expedia’s Orbitz platform may have been victims of a cyberattack. The attack involved an Orbitz platform that served as the underlying booking engine for online travel websites, including Amextravel.com and travel booked through Amex Travel Representatives. +We are also exposed to the risk that a disruption or other event at a third party affecting one of our service providers or partners could impede their ability to provide to us services or data on which we rely to operate our business. Service providers or other third parties could also cease providing data to us if we are unable to negotiate for data use rights or use our data for purposes that do not benefit us, which could diminish the competitive value of our closed loop. +The management of multiple vendors increases our operational complexity and decreases our control. A failure to exercise adequate oversight over service providers, including compliance with service level agreements or regulatory or legal requirements, could result in regulatory actions, fines, sanctions or economic and reputational harm to us. In addition, we may not be able to effectively monitor or mitigate operational risks relating to our vendors’ service providers. +20 +Table of Contents +We have agreements with business partners in a variety of industries, including the airline industry, that represent a significant portion of our business. We are exposed to risks associated with these industries, including bankruptcies, liquidations, restructurings, consolidations and alliances of our partners, and the possible obligation to make payments to our partners. +We may be obligated to make or accelerate payments to certain business partners such as cobrand partners upon the occurrence of certain triggering events such as a shortfall in certain performance and revenue levels. If we are not able to effectively manage these triggering events, we could unexpectedly have to make payments to these partners, which could have a negative effect on our financial condition and results of operations. +Similarly, we are exposed to risk from bankruptcies, liquidations, insolvencies, financial distress, restructurings, consolidations and other similar events that may occur in any industry representing a significant portion of our billed business, which could negatively impact particular card products and services (and billed business generally) and our financial condition and results of operations. For example, we could be materially impacted if we were obligated to or elected to reimburse Card Members for products and services purchased from merchants that have ceased operations or stopped accepting our cards. +We are exposed to credit risk in the airline industry to the extent we protect Card Members against non-delivery of goods and services, such as where we have remitted payment to an airline for a Card Member purchase of tickets that have not yet been used or “flown.” If we are unable to collect the amount from the airline, we may bear the loss for the amount credited to the Card Member. Spending at airline merchants accounted for approximately 8 percent of our worldwide billed business for the year ended December 31, 2018. +For additional information relating to the general risks related to the airline industry, see “Risk Management—Institutional Credit Risk—Exposure to the Airline and Travel Industry” under “MD&A.” +If we are not able to invest successfully in, and compete at the leading edge of, technological developments across all our businesses, our revenue and profitability could be negatively affected. +Our industry is subject to rapid and significant technological changes. In order to compete in our industry, we need to continue to invest in technology across all areas of our business, including in transaction processing, data management and analytics, machine learning and artificial intelligence, customer interactions and communications, alternative payment mechanisms, authentication technologies and risk management and compliance systems. Incorporating new technologies into our products and services may require substantial expenditures and take considerable time, and ultimately may not be successful. We expect that new technologies in the payments industry will continue to emerge, and these new technologies may be superior to, or render obsolete, our existing technology. +The process of developing new products and services, enhancing existing products and services and adapting to technological changes and evolving industry standards is complex, costly and uncertain, and any failure by us to anticipate customers’ changing needs and emerging technological trends accurately could significantly impede our ability to compete effectively. Consumer and merchant adoption is a key competitive factor and our competitors may develop products, platforms or technologies that become more widely adopted than ours. In addition, we may underestimate the time and expense we must invest in new products and services before they generate material revenues, if at all. +Our ability to develop, acquire or access competitive technologies or business processes on acceptable terms may also be limited by intellectual property rights that third parties, including competitors and potential competitors, may assert. In addition, our ability to adopt new technologies may be inhibited by the emergence of industry-wide standards, a changing legislative and regulatory environment, the need for internal product and engineering expertise, resistance to change from Card Members or merchants, or the complexity of our systems. +We may not be successful in realizing the benefits associated with our acquisitions, strategic alliances, joint ventures and investment activity, and our business and reputation could be negatively impacted. +We have acquired a number of businesses and have made a number of strategic investments, and continue to evaluate potential transactions. These transactions could be material to our financial condition and results of operations. There is no assurance that we will be able to successfully identify and secure future acquisition candidates on terms and conditions that are acceptable to us, or successfully complete proposed acquisitions and investments, which could impair our growth. The process of integrating an acquired company, business or technology could create unforeseen operating difficulties and expenditures, result in unanticipated liabilities and harm our business generally. It may take us longer than expected to fully realize the anticipated benefits of these transactions, and those benefits may ultimately be smaller than anticipated or may not be realized at all, which could adversely affect our business and operating results, including as a result of write-downs of goodwill and other intangible assets. +21 +Table of Contents +We may also face risks with other types of strategic transactions, such as the sale to InComm of the operations relating to our prepaid reloadable and gift card business in the United States. The reloadable operations have experienced disruptions in the past, impacting the ability of our prepaid customers to load and use their cards. If such operations are interrupted, suspended or terminated in the future, it could further negatively impact our customers’ experience, result in additional costs, litigation and regulatory action, and harm our business and reputation. +Joint ventures, including our GBT JV, and minority investments inherently involve a lesser degree of control over business operations, thereby potentially increasing the financial, legal, operational and/or compliance risks associated with the joint venture or minority investment. In addition, we may be dependent on joint venture partners, controlling shareholders or management who may have business interests, strategies or goals that are inconsistent with ours. Business decisions or other actions or omissions of the joint venture partner, controlling shareholders or management may adversely affect the value of our investment, result in litigation or regulatory action against us and otherwise damage our reputation and brand. +Our business is subject to the effects of geopolitical events, weather, natural disasters and other conditions. +Geopolitical events, terrorist attacks, natural disasters, severe weather conditions, floods, health pandemics, information or cyber security incidents (including intrusion into or degradation of systems or technology by cyberattackers) and other catastrophic events can have a negative effect on our business. Because of our proximity to the World Trade Center, our headquarters were damaged as a result of the terrorist attacks of September 11, 2001. Recent hurricanes and other natural disasters have impacted spending and credit performance in the areas affected. Similar events or other disasters or catastrophic events in the future, and events impacting other sectors of the economy, including the telecommunications and energy sectors, could have a negative effect on our businesses and infrastructure, including our technology and systems. Card Members in California, New York, Florida, Texas and Georgia account for a significant portion of U.S. Consumer billed business and Card Members loans, and our results of operations could be impacted by events or conditions that disproportionately or specifically affect one or more of those states. +Because we derive a portion of our revenues from travel-related spending, our business is sensitive to safety concerns related to travel and tourism, limitations on travel and mobility, and health-related risks. In addition, disruptions in air travel and other forms of travel can result in the payment of claims under travel interruption insurance policies we offer and, if such disruptions to travel are prolonged, they can materially adversely affect overall travel-related spending. +If the conditions described above (or similar ones) result in widespread or lengthy disruptions to travel, they could have a material adverse effect on our results of operations. Card Member spending may also be negatively impacted in areas affected by natural disasters or other catastrophic events. The impact of such events on the overall economy may also adversely affect our financial condition or results of operations. +Our success is dependent, in part, upon our executive officers and other key personnel, and misconduct by or loss of key personnel could materially adversely affect our business. +Our success depends, in part, on our executive officers and other key personnel. Our senior management team has significant industry experience and would be difficult to replace. We rely upon our key personnel not only for business success, but also to lead with integrity. To the extent our leaders behave in a manner that does not comport with our company’s values, the consequences to our brand and reputation could be severe and could negatively affect our financial condition and results of operations. +The market for qualified individuals is highly competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel. Changes in immigration and work permit laws and regulations or the administration or enforcement of such laws or regulations can also impair our ability to attract and retain qualified personnel, or to employ such personnel in the location(s) of our choice. As further described in “Supervision and Regulation—Compensation Practices,” our compensation practices are subject to review and oversight by the Federal Reserve and the compensation practices of AENB is subject to review and oversight by the OCC. This regulatory review and oversight could further affect our ability to attract and retain our executive officers and other key personnel. The loss of key personnel could materially adversely affect our business. +Legal, Regulatory and Compliance Risks +Ongoing legal proceedings regarding provisions in our merchant contracts could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand. +We are a defendant in a number of actions, including proposed class actions, filed by merchants that challenge the non-discrimination and honor-all-cards provisions in our card acceptance agreements and seek damages. A description of these legal proceedings is contained in “Legal Proceedings.” +22 +Table of Contents +It is possible that the resolution of one or any combination of these merchant claims could have a material adverse effect on our business and results of operations, require us to change our merchant agreements in a way that could expose our cards to increased merchant steering and other forms of discrimination that could impair the Card Member experience, result in additional litigation and/or arbitrations, impose substantial monetary damages and damage our reputation and brand. Even if we were not required to change our merchant agreements, changes in Visa’s and Mastercard’s policies or practices as a result of legal proceedings, lawsuit settlements or regulatory actions pending against them could result in changes to our business practices and materially and adversely impact our profitability. +Our business is subject to comprehensive government regulation and supervision, which could adversely affect our results of operations and financial condition. +We are subject to comprehensive government regulation and supervision in jurisdictions around the world, which significantly affects our business, and has the potential to restrict the scope of our existing businesses, increase our costs of doing business, limit our ability to pursue certain business opportunities, require changes to business practices, and affect our relationships with partners, merchants and Card Members. Regulatory oversight and supervision of our businesses are generally designed to protect consumers and enhance financial stability and are not designed to protect our security holders. +New laws or regulations, enhanced supervision efforts or changes in the enforcement of existing laws or regulations applicable to our businesses could impact the profitability of our business activities, limit our ability to pursue business opportunities or adopt new technologies, require us to change certain of our business practices or alter our relationships with partners, merchants and Card Members, or affect retention of our key personnel. Such changes also may require us to invest significant management attention and resources to make any necessary changes and could adversely affect our results of operations and financial condition. Legislators and regulators around the world are aware of each other’s approaches to the regulation of the payments industry. Consequently, a development in one country, state or region may influence regulatory approaches in another. To the extent that different regulatory systems impose overlapping or inconsistent requirements on the conduct of our business, we face complexity and additional costs in our compliance efforts. +If we fail to satisfy regulatory requirements or maintain our financial holding company status, our financial condition and results of operations could be adversely affected, and we may be restricted in our ability to take certain capital actions (such as declaring dividends or repurchasing outstanding shares) or engage in certain activities or acquisitions. Additionally, our banking regulators have wide discretion in the examination and the enforcement of applicable banking statutes and regulations and may restrict our ability to engage in certain activities or acquisitions or require us to maintain more capital. +In recent years, legislators and regulators have focused on the operation of card networks, including interchange fees paid to card issuers in payment networks such as Visa and Mastercard and the fees merchants are charged to accept cards. Even where we are not directly regulated, regulation of bankcard fees can significantly negatively impact the discount revenue derived from our business, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or terms of card acceptance for merchants, including terms relating to non-discrimination and honor-all-cards. For example, we have largely exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions. In addition, there is uncertainty as to when or how interchange fee caps and other provisions of the EU payments legislation might apply when we work with cobrand partners and agents in the EU. In a ruling issued on February 7, 2018, the EU Court of Justice confirmed the validity of the application of the fee caps and other provisions in circumstances where three-party networks issue cards with a cobrand partner or through an agent, although the ruling provided only limited guidance as to when or how the provisions might apply in such circumstances. As a result, there can be no assurance we will be able to maintain our cobrand and agent relationships in their current form in the EU. +We are subject to certain provisions of the Bank Secrecy Act, as amended by the Patriot Act, with regard to maintaining effective AML programs. Similar AML requirements apply under the laws of most jurisdictions where we operate. Increased regulatory focus in this area could result in additional obligations or restrictions with respect to the types of products and services we may offer to consumers, the countries in which our cards may be used, and the types of customers and merchants who can obtain or accept our cards. Emerging technologies, such as digital currencies, could limit our ability to track the movement of funds. Money laundering, terrorist financing and other illicit activities involving our cards could result in enforcement action, and our reputation may suffer due to our customers’ association with certain countries, persons or entities or the existence of any such transactions. +Various regulatory agencies and legislatures are also considering regulations and legislation covering identity theft, account management guidelines, credit bureau reporting, disclosure rules, security and marketing that would impact us directly, in part due to increased scrutiny of our underwriting and account management standards. These new requirements may restrict our ability to issue charge and credit cards or partner with other financial institutions, which could adversely affect our revenue growth. +See “Supervision and Regulation” for more information about certain laws and regulations to which we are subject and their impact on us. +23 +Table of Contents +Litigation and regulatory actions could subject us to significant fines, penalties, judgments and/or requirements resulting in significantly increased expenses, damage to our reputation and/or a material adverse effect on our business. +Businesses in the financial services and payments industries have historically been subject to significant legal actions, including class action lawsuits. Many of these actions have included claims for substantial compensatory or punitive damages. While we have historically relied on our arbitration clause in agreements with customers to limit our exposure to class action litigation, there can be no assurance that we will continue to be successful in enforcing our arbitration clause in the future and claims of the type we previously arbitrated could be subject to the complexities, risks and costs associated with class action cases. The continued focus of merchants on issues relating to the acceptance of various forms of payment may lead to additional litigation and other legal actions. Given the inherent uncertainties involved in litigation, and the very large or indeterminate damages sought in some matters asserted against us, there is significant uncertainty as to the ultimate liability we may incur from litigation matters. +We have been subject to regulatory actions and may continue to be subject to such actions, including governmental inquiries, investigations and enforcement proceedings, in the event of noncompliance or alleged noncompliance with laws or regulations. For example, we have been cooperating with certain governmental authorities that have requested information from, or served subpoenas on, us seeking information relating to a small, specialized part of our business, known as foreign exchange international payments (FXIP), which offers cross-border payments services primarily to small and middle market business customers in five countries, including the United States. In particular, we received investigative subpoenas from both the civil and criminal divisions of the U.S. Department of Justice as well as inquiries from the Federal Reserve, the OCC, the CFPB, the FDIC and others. FXIP accounts for less than one half of one percent of our total revenue net of interest expense and is unrelated to our card businesses. Relatedly, we are conducting a review with an outside law firm of FXIP’s pricing practices. We do not believe this matter will have a material adverse impact on our operations or results. +We expect that regulators will continue taking formal enforcement actions against financial institutions in addition to addressing supervisory concerns through non-public supervisory actions or findings, which could involve restrictions on our activities, among other limitations that could adversely affect our business. In addition, a violation of law or regulation by another financial institution is likely to give rise to an investigation by regulators and other governmental agencies of the same or similar practices by us. Further, a single event may give rise to numerous and overlapping investigations and proceedings. Regulatory action could subject us to significant fines, penalties or other requirements resulting in Card Member reimbursements, increased expenses, limitations or conditions on our business activities, and damage to our reputation and our brand, which could adversely affect our results of operations and financial condition. +We are subject to capital adequacy and liquidity rules, and if we fail to meet these rules, our business would be adversely affected. +Failure to meet current or future capital or liquidity requirements could compromise our competitive position and could result in restrictions imposed by the Federal Reserve, including limiting our ability to pay dividends, repurchase our capital stock, invest in our business, expand our business or engage in acquisitions. +Some elements of the capital and liquidity regimes are not yet final and certain developments could significantly impact the requirements applicable to financial institutions. For example, the Basel Committee finalized revisions to the standardized approach for credit risk and operational risk capital requirements. If these revisions are adopted in the United States, we could be required to hold significantly more capital. As a result, the ultimate impact on our long-term capital and liquidity planning and our results of operations is not certain, although an increase in our capital and liquid asset levels could lower our return on equity. As part of our required stress testing, we must continue to comply with applicable capital standards as calculated under the standardized approach in the severely adverse economic scenario published by the Federal Reserve each year. To satisfy these requirements, it may be necessary for us to hold additional capital in excess of that required by the Capital Rules. +Compliance with capital adequacy and liquidity rules requires a material investment of resources. An inability to meet regulatory expectations regarding our compliance with applicable capital adequacy and liquidity rules may also negatively impact the assessment of us and our U.S. bank subsidiary by federal banking regulators. +We continue to progress through the parallel run phase of Basel III advanced approaches implementation. To the extent that the advanced approaches requirements apply to us, our capital ratios calculated under the advanced approaches may be lower than under the standardized approach. In such a case, we may need to hold significantly more regulatory capital in order to maintain a given capital ratio. +For more information on capital adequacy requirements, see “Stress Testing and Capital Planning” and “Capital, Leverage and Liquidity Regulation” under “Supervision and Regulation.” +24 +Table of Contents +We are subject to restrictions that limit our ability to pay dividends and repurchase our capital stock. Our subsidiaries are also subject to restrictions that limit their ability to pay dividends to us, which may adversely affect our liquidity. +We are limited in our ability to pay dividends and repurchase capital stock by our regulators, who have broad authority to prohibit any action that would be considered an unsafe or unsound banking practice. For example, we are subject to a requirement to submit capital plans that include, among other things, projected dividend payments and repurchases of capital stock to the Federal Reserve for review. As part of the capital planning and stress testing process, our proposed capital actions are assessed against our ability to satisfy applicable capital requirements in the event of a stressed market environment. If the Federal Reserve objects to our capital plan or if we fail to satisfy applicable capital requirements, our ability to undertake capital actions may be restricted. +In addition, the Capital Rules include buffers that can be satisfied only with CET1 capital. If our risk-based capital ratios were to fall below the applicable buffer levels, we would be subject to certain restrictions on dividends, stock repurchases and other capital distributions, as well as discretionary bonus payments to executive officers. +Our ability to declare or pay dividends on, or to purchase, redeem or otherwise acquire, shares of our common stock will be prohibited, subject to certain exceptions, in the event that we do not declare and pay in full dividends for the last preceding dividend period of our Series B and Series C preferred stock. +American Express Company relies on dividends from its subsidiaries for liquidity, and federal and state laws, regulations and supervisory policy limit the amount of dividends that our subsidiaries may pay to the parent company. For example, our U.S. bank subsidiary, AENB, is subject to various statutory and regulatory limitations on its declaration and payment of dividends. These limitations may hinder our ability to access funds we may need to make payments on our obligations, make dividend payments on outstanding American Express Company capital stock or otherwise achieve strategic objectives. +Any reduction of, or elimination of, our common stock dividend or share repurchase program would likely adversely affect the market price of our common stock and market perceptions of American Express. For more information on bank holding company and depository institution dividend restrictions, see “Dividends and Other Capital Distributions” under “Supervision and Regulation,” as well as “Consolidated Capital Resources and Liquidity—Share Repurchases and Dividends” under “MD&A” and Note 23 to our “Consolidated Financial Statements.” +Regulation in the areas of privacy, data protection, account access and information and cyber security could increase our costs and affect or limit our business opportunities and how we collect and/or use personal information. +Legislators and regulators in the United States and other countries in which we operate are increasingly adopting or revising privacy, data protection and information and cyber security laws, including data localization, authentication and account access laws. As such laws are interpreted and applied (in some cases, with significant differences or conflicting requirements across jurisdictions), compliance and technology costs will continue to increase, particularly in the context of ensuring that adequate data protection, data transfer and account access mechanisms are in place. +Compliance with current or future privacy, data protection, account access and information and cyber security laws could significantly impact our collection, use, sharing, retention and safeguarding of consumer and/or employee information and could restrict our ability to fully maximize our closed-loop capability or provide certain products and services, which could materially and adversely affect our profitability. +Our failure to comply with privacy, data protection, account access and information and cyber security laws could result in potentially significant regulatory and/or governmental investigations and/or actions, litigation, fines, sanctions, ongoing regulatory monitoring, customer attrition, decreases in the use or acceptance of our cards and damage to our reputation and our brand. In recent years, there has been increasing regulatory enforcement and litigation activity in the areas of privacy, data protection and information and cyber security in the United States and in various countries in which we operate. +For more information on regulatory and legislative activity in this area, see “Privacy, Data Protection, Information and Cyber Security” under “Supervision and Regulation.” +We may not be able to effectively manage the operational, conduct and compliance risks to which we are exposed. +We consider operational risk to be the risk of not achieving business objectives due to inadequate or failed processes or information systems, poor data quality, human error or the external environment (e.g., natural disasters). Operational risk includes, among others, the risk that error or misconduct could result in a material financial misstatement, a failure to monitor a third party’s compliance with regulatory or legal requirements, or a failure to adequately monitor and control access to, or use of, data in our systems we grant to third-parties. As processes or organizations are changed, or new products and services are introduced, we may not fully appreciate or identify new operational risks that may arise from such changes. Through human error, fraud or malfeasance, conduct risk can result in harm to customers, broader markets and the company and its employees. +Compliance risk arises from the failure to adhere to applicable laws, rules, regulations and internal policies and procedures. Operational, conduct and compliance risks can expose us to reputational and legal risks as well as fines, civil money penalties or payment of damages and can lead to diminished business opportunities and diminished ability to expand key operations. +25 +Table of Contents +If we are not able to protect our intellectual property, or successfully defend against any infringement or misappropriation assertions brought against us, our revenue and profitability could be negatively affected. +We rely on a variety of measures to protect our intellectual property and control access to, and distribution of, our proprietary information. These measures may not prevent infringement of our intellectual property rights or misappropriation of our proprietary information and a resulting loss of competitive advantage. In addition, competitors or other third parties may allege that our systems, processes or technologies infringe on their intellectual property rights. Given the complex, rapidly changing and competitive technological and business environments in which we operate, and the potential risks and uncertainties of intellectual property-related litigation, a future assertion of an infringement or misappropriation claim against us could cause us to lose significant revenues, incur significant defense, license, royalty or technology development expenses, and/or pay significant monetary damages. +Tax legislative initiatives or assessments by governmental authorities could adversely affect our results of operations and financial condition. +We are subject to income and other taxes in the United States and in various foreign jurisdictions. The laws and regulations related to tax matters are extremely complex and subject to varying interpretations. Although management believes our positions are reasonable, we are subject to audit by the Internal Revenue Service in the United States and by tax authorities in all the jurisdictions in which we conduct business operations. We are being challenged in a number of countries regarding our application of value-added taxes (VAT) to certain transactions. While we believe we comply with all applicable VAT and other tax laws, rules and regulations in the relevant jurisdictions, the tax authorities may determine that we owe additional taxes or apply existing laws and regulations more broadly, which could result in a significant increase in liabilities for taxes and interest in excess of accrued liabilities. +New tax legislative initiatives may be proposed from time to time, which may impact our effective tax rate and could adversely affect our tax positions or tax liabilities. New guidance or modifications to the Tax Cuts and Jobs Act of 2017 (the Tax Act) could have an adverse effect on our results of operations. In addition, unilateral or multi-jurisdictional actions by various tax authorities, including an increase in tax audit activity, could have an adverse impact on our tax liabilities. +Changes in accounting principles or standards could adversely affect our reported financial results in a particular period, even if there are no underlying changes in the economics of the business. +We are subject to changes in and interpretations of financial accounting matters, which could change certain of the assumptions or estimates we previously used in preparing our financial statements, even if we do not change the way in which we transact or conduct our business. A change in accounting guidance can have a significant effect on our reported results, may retroactively affect previously reported results and could cause fluctuations in our reported results. For more information on recently issued accounting standards, see Note 1 to our “Consolidated Financial Statements.” +Credit, Liquidity and Market Risks +Our risk management policies and procedures may not be effective. +Our risk management framework seeks to identify and mitigate risk and appropriately balance risk and return. We have established policies and procedures intended to identify, monitor and manage the types of risk to which we are subject, including credit risk, market risk, asset liability risk, liquidity risk, operational risk, compliance risk, model risk, strategic and business risk and reputational risk. See “Risk Management” under “MD&A” for a discussion of the policies and procedures we use to identify, monitor and manage the risks we assume in conducting our businesses. Although we have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future, these policies and procedures, as well as our risk management techniques, such as our hedging strategies, may not be fully effective. There may also be risks that exist, or develop in the future, that we have not appropriately anticipated, identified or mitigated. As regulations and markets in which we operate continue to evolve, our risk management framework may not always keep sufficient pace with those changes. If our risk management framework does not effectively identify or mitigate our risks, we could suffer unexpected losses and could be materially adversely affected. +26 +Table of Contents +Management of our risks in some cases depends upon the use of analytical and/or forecasting models. Although we have a governance framework for model development and independent model validation, the modeling methodology or key assumptions could be erroneous or the models could be misused. In addition, issues with the quality or effectiveness of our data aggregation and validation procedures, as well as the quality and integrity of data inputs, could result in ineffective or inaccurate model outputs and reports. For example, models based on historical data sets might not be accurate predictors of future outcomes and their ability to appropriately predict future outcomes may degrade over time. If our decisions are based on incorrect or misused models and assumptions or we fail to manage data inputs effectively and to aggregate or analyze data in an accurate and timely manner, we may face adverse consequences, such as financial loss, poor business and strategic decision-making, or damage to our reputation. In addition, some decisions our regulators make, including those related to our capital distribution plans, may be adversely impacted if they perceive the quality of our models to be insufficient. +We may not be able to effectively manage individual or institutional credit risk, or credit trends that can affect spending on card products and the ability of customers and partners to pay us, which could have a material adverse effect on our results of operations and financial condition. +We are exposed to both individual credit risk, principally from consumer and small business Card Member receivables and loans, and institutional credit risk from corporate Card Member receivables and loans, merchants, network partners, loyalty coalition partners and treasury and investment counterparties. Third parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. General economic factors, such as the rate of inflation, unemployment levels and interest rates, may result in greater delinquencies that lead to greater credit losses. Country, regional and political risks can also contribute to credit risk. A customer’s ability and willingness to repay us can be negatively impacted not only by economic, market, political and social conditions but also a customer’s other payment obligations. +Our ability to assess creditworthiness may be impaired if the criteria or models we use to manage our credit risk prove inaccurate in predicting future losses, which could cause our losses to rise and have a negative impact on our results of operations. Further, our pricing strategies may not offset the negative impact on profitability caused by increases in delinquencies and losses; thus any material increases in delinquencies and losses beyond our current estimates could have a material adverse impact on us. +Rising delinquencies and rising rates of bankruptcy are often precursors of future write-offs and may require us to increase our reserve for loan losses. Higher write-off rates and the resulting increase in our reserves for loan and receivable losses adversely affect our profitability and the performance of our securitizations, and may increase our cost of funds. +Although we make estimates to provide for credit losses in our outstanding portfolio of loans and receivables, these estimates may not be accurate. In addition, the information we use in managing our credit risk may be inaccurate or incomplete. Although we regularly review our credit exposure to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to foresee or detect, such as fraud. In addition, our ability to manage credit risk may be adversely affected by legal or regulatory changes (such as restrictions on collections or changes in bankruptcy laws, minimum payment regulations and re-age guidance). Increased credit risk, whether resulting from underestimating the credit losses inherent in our portfolio of loans and receivables, deteriorating economic conditions (particularly in the United States where approximately 74 percent of our revenues were generated in 2018), increases in the level of loan balances, changes in our mix of business or otherwise, could require us to increase our provisions for losses and could have a material adverse effect on our results of operations and financial condition. +Continued interest rate increases and changes to reference rates could materially adversely affect our earnings. +If the rate of interest we pay on our borrowings increases more than the rate of interest we earn on our loans, our net interest yield, and consequently our net income, could fall. Our interest expense was approximately $2.9 billion for the year ended December 31, 2018. A hypothetical 100 basis point increase in market interest rates would have resulted in a decrease to our annual net interest income of approximately $177 million as of December 31, 2018. We expect the rates we pay on our deposits will increase as benchmark interest rates increase. In addition, interest rate changes may affect customer behavior, such as impacting the loan balances Card Members carry on their credit cards or their ability to make payments as higher interest rates lead to higher payment requirements, further impacting our results of operations. +As a result of recent regulatory and other legal proceedings, actions by regulators or law enforcement agencies may result in changes to the manner in which the London interbank offered rate (LIBOR) is determined, its discontinuance or the establishment of alternative reference rates. At this time, it is not possible to predict the effect that these developments, any discontinuance, modification or other reforms to LIBOR or any other reference rate, the establishment of alternative reference rates, or the impact of any such events on contractual mechanisms may have on the markets, us or our floating rate debt securities. Uncertainty as to the nature of such potential discontinuance, modification, alternative reference rates or other reforms may negatively impact market liquidity, our access to funding required to operate our business and the trading market for our floating rate debt securities. Furthermore, the use of alternative reference rates or other reforms could cause the interest payable on our outstanding floating rate debt securities to be materially different, and potentially higher, than expected. +For a further discussion of our interest rate risk, see “Risk Management ― Market Risk Management Process” under “MD&A.” +27 +Table of Contents +Adverse financial market conditions may significantly affect our ability to meet liquidity needs, access to capital and cost of capital. +We need liquidity to pay merchants, operating and other expenses, interest on debt and dividends on capital stock and to repay maturing liabilities. The principal sources of our liquidity are payments from Card Members, proceeds from the issuance of unsecured medium- and long-term notes and asset securitizations and direct and third-party sourced deposits, cash flows from our investment portfolio, cash and cash equivalents, securitized borrowings through our secured financing facilities, a committed bank borrowing facility and the Federal Reserve discount window. +Our ability to obtain financing in the debt capital markets for unsecured term debt and asset securitizations is dependent on market conditions. Disruptions, uncertainty or volatility across the financial markets, as well as adverse developments affecting our competitors and the financial industry generally, could negatively impact market liquidity and limit our access to funding required to operate our business. Such market conditions may also limit our ability to replace, in a timely manner, maturing liabilities, satisfy regulatory capital requirements and access the funding necessary to grow our business. In some circumstances, we may incur an unattractive cost to raise capital, which could decrease profitability and significantly reduce financial flexibility. +For a further discussion of our liquidity and funding needs, see “Consolidated Capital Resources and Liquidity ― Funding Programs and Activities” under “MD&A.” +Any reduction in our and our subsidiaries’ credit ratings could increase the cost of our funding from, and restrict our access to, the capital markets and have a material adverse effect on our results of operations and financial condition. +Rating agencies regularly evaluate us and our subsidiaries, and their ratings of our and our subsidiaries’ long-term and short-term debt and deposits are based on a number of factors, including financial strength, as well as factors not within our control, including conditions affecting the financial services industry generally, and the wider state of the economy. Our and our subsidiaries’ ratings could be downgraded at any time and without any notice by any of the rating agencies, which could, among other things, adversely limit our access to the capital markets and adversely affect the cost and other terms upon which we and our subsidiaries are able to obtain funding. +Adverse currency fluctuations and foreign exchange controls could decrease earnings we receive from our international operations and impact our capital. +During 2018, approximately 26 percent of our total revenues net of interest expense were generated from activities outside the United States. We are exposed to foreign exchange risk from our international operations, and accordingly the revenue we generate outside the United States is subject to unpredictable fluctuations if the values of other currencies change relative to the U.S. dollar (including as a result of Brexit), which could have a material adverse effect on our results of operations. +Foreign exchange regulations or capital controls might restrict or prohibit the conversion of other currencies into U.S. dollars or our ability to transfer them. Political and economic conditions in other countries could also impact the availability of foreign exchange for the payment by the local card issuer of obligations arising out of local Card Members’ spending outside such country and for the payment by Card Members who are billed in a currency other than their local currency. Substantial and sudden devaluation of local Card Members’ currency can also affect their ability to make payments to the local issuer of the card in connection with spending outside the local country. The occurrence of any of these circumstances could further impact our results of operations. +Continuing concerns regarding the euro may cause the value of the euro to continue to fluctuate and could lead to the reintroduction of individual currencies in one or more Eurozone countries, or, in more extreme circumstances, the possible dissolution of the euro currency entirely. The reintroduction of certain individual country currencies, a significant devaluation of the euro or the complete dissolution of the euro could adversely affect the value of our euro-denominated assets and liabilities. +Potential developments regarding the euro could also have an adverse impact on consumer and business behavior in Europe and globally, which could have a material adverse effect on our business, financial condition and results of operations. +An inability to accept or maintain deposits due to market demand or regulatory constraints could materially adversely affect our liquidity position and our ability to fund our business. +Our U.S. bank subsidiary, AENB, accepts deposits directly from consumers through American Express Personal Savings, as well as from individuals through third-party brokerage networks, and uses the proceeds as a source of funding. As of December 31, 2018, we had approximately $69.1 billion in total U.S. retail deposits, of which a significant amount had been raised through third-party brokerage networks. We face strong competition with regard to deposits, and pricing and product changes may adversely affect our ability to attract and retain cost-effective deposit balances. If we are required to offer higher interest rates to attract or maintain deposits, our funding costs will be adversely impacted. +28 +Table of Contents +Our ability to obtain deposit funding and offer competitive interest rates on deposits is also dependent on AENB’s capital levels. The FDIA’s brokered deposit provisions and related FDIC rules in certain circumstances prohibit banks from accepting or renewing brokered deposits and apply other restrictions, such as a cap on interest rates that can be paid. Additionally, our regulators can adjust applicable capital requirements at any time and have authority to place limitations on our deposit businesses. An inability to attract or maintain deposits in the future could materially adversely affect our ability to fund our business. +The value of our assets or liabilities may be adversely impacted by economic, political or market conditions. +Market risk includes the loss in value of portfolios and financial instruments due to adverse changes in market variables, which could negatively impact our financial condition. We held approximately $4.7 billion of investment securities as of December 31, 2018. In the event that actual default rates of these investment securities were to significantly change from historical patterns due to economic conditions or otherwise, it could have a material adverse impact on the value of our investment portfolio, potentially resulting in impairment charges. Defaults or economic disruptions, even in countries or territories in which we do not have material investment exposure, conduct business or have operations, could adversely affect us. +ITEM 1B. +UNRESOLVED STAFF COMMENTS +Not applicable. +ITEM 2. +PROPERTIES +Our principal executive offices are in a 2.2 million square foot building located in lower Manhattan on land leased from the Battery Park City Authority for a term expiring in 2069. We have an approximately 49 percent ownership interest in the building and an affiliate of Brookfield Financial Properties owns the remaining approximately 51 percent interest in the building. We also lease space in the building from Brookfield’s affiliate. +Other owned or leased principal locations include American Express offices in Sunrise, Florida, Phoenix, Arizona, Salt Lake City, Utah, Mexico City, Mexico, Sydney, Australia, Singapore, Gurgaon, India, Manila, Philippines, and Brighton, England; the American Express data centers in Phoenix, Arizona and Greensboro, North Carolina; the headquarters for American Express Services Europe Limited in London, England; and the Amex Bank of Canada and Amex Canada Inc. headquarters in Toronto, Ontario, Canada. +Generally, we lease the premises we occupy in other locations. We believe the facilities we own or occupy suit our needs and are well maintained. +29 +Table of Contents +ITEM 3. +LEGAL PROCEEDINGS +In the ordinary course of business, we are subject to various pending and potential legal actions, arbitration proceedings, claims, investigations, examinations, information gathering requests, subpoenas, inquiries and matters relating to compliance with laws and regulations (collectively, legal proceedings). +We do not believe we are a party to, nor are any of our properties the subject of, any legal proceeding that would have a material adverse effect on our consolidated financial condition or liquidity. However, in light of the uncertainties involved in such matters, including the fact that some pending legal proceedings are at preliminary stages and seek an indeterminate amount of damages, it is possible that the outcome of legal proceedings could have a material impact on our results of operations. In addition, it is possible that significantly increased merchant steering or other actions impairing the Card Member experience as a result of an adverse resolution in one or any combination of the merchant cases described below could have a material adverse effect on our business. Certain legal proceedings involving us or our subsidiaries are described below. For additional information, see Note 13 to our “Consolidated Financial Statements.” +Antitrust Matters +Individual merchant cases and a putative merchant class action, which were consolidated in 2011 and collectively captioned In re: American Express Anti-Steering Rules Antitrust Litigation (II) , are pending in the Eastern District of New York against us alleging that provisions in our merchant agreements prohibiting merchants from differentially surcharging our cards or steering a customer to use another network’s card or another type of general-purpose card (“anti-steering” and “non-discrimination” contractual provisions) violate U.S. antitrust laws. The individual merchant cases seek damages in unspecified amounts and injunctive relief. Following the Supreme Court decision in Ohio v. American Express Co. in favor of American Express, plaintiffs in both the individual merchant cases and the putative merchant class action filed amended complaints. Trial has been scheduled in the individual merchant cases for June 2019. +In July 2004, we were named as a defendant in another putative class action filed in the Southern District of New York and subsequently transferred to the Eastern District of New York, captioned The Marcus Corporation v. American Express Co., et al. , in which the plaintiffs allege an unlawful antitrust tying arrangement between certain of our charge cards and credit cards in violation of various state and federal laws. The plaintiffs in this action seek injunctive relief and an unspecified amount of damages. +On March 8, 2016, plaintiffs B&R Supermarket, Inc. d/b/a Milam’s Market and Grove Liquors LLC, on behalf of themselves and others, filed a suit, captioned B&R Supermarket, Inc. d/b/a Milam’s Market, et al. v. Visa Inc., et al. , for violations of the Sherman Antitrust Act, the Clayton Antitrust Act, California’s Cartwright Act and unjust enrichment in the United States District Court for the Northern District of California, against American Express Company, other credit and charge card networks, other issuing banks and EMVCo, LLC. Plaintiffs allege that the defendants, through EMVCo, conspired to shift liability for fraudulent, faulty and otherwise rejected consumer credit card transactions from themselves to merchants after the implementation of EMV chip payment terminals. Plaintiffs seek damages and injunctive relief. An amended complaint was filed on July 15, 2016. On September 30, 2016, the court denied our motion to dismiss as to claims brought by merchants who do not accept American Express cards, and on May 4, 2017, the California court transferred the case to the United States District Court for the Eastern District of New York. +Corporate Matters +On July 30, 2015, plaintiff Plumbers and Steamfitters Local 137 Pension Fund, on behalf of themselves and other purchasers of American Express stock, filed a suit, captioned Plumbers and Steamfitters Local 137 Pension Fund v. American Express Co., Kenneth I. Chenault and Jeffrey C. Campbell , in the United States District Court for the Southern District of New York for violation of federal securities law, alleging that the Company deliberately issued false and misleading statements to, and omitted important information from, the public relating to the financial importance of the Costco cobrand relationship to the Company, including, but not limited to, the decision to accelerate negotiations to renew the cobrand agreement. The plaintiff sought damages and injunctive relief. On October 2, 2017, the Court granted defendants’ motion to dismiss the plaintiff’s amended complaint. The plaintiff has appealed the court’s decision. +ITEM 4. +MINE SAFETY DISCLOSURES +Not applicable. +30 +Table of Contents +Table of Contents +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +(a) +Our common stock trades principally on The New York Stock Exchange under the trading symbol AXP. As of December 31, 2018, we had 21,078 common shareholders of record. You can find price and dividend information concerning our common stock in Note 27 to our “Consolidated Financial Statements.” For information on dividend restrictions, see “Dividends and Other Capital Distributions” under “Supervision and Regulation” and Note 23 to our “Consolidated Financial Statements.” You can find information on securities authorized for issuance under our equity compensation plans under the caption “Executive Compensation — Equity Compensation Plans” to be contained in our definitive 2019 proxy statement for our Annual Meeting of Shareholders, which is scheduled to be held on May 7, 2019. The information to be found under such caption is incorporated herein by reference. Our definitive 2019 proxy statement for our Annual Meeting of Shareholders is expected to be filed with the Securities and Exchange Commission (SEC) in March 2019 (and, in any event, not later than 120 days after the close of our most recently completed fiscal year). +Stock Performance Graph +The information contained in this Stock Performance Graph section shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the SEC, or subject to the liabilities of Section 18 of the Exchange Act, except to the extent that we specifically incorporate it by reference into a document filed under the Securities Act or the Exchange Act. +The following graph compares the cumulative total shareholder return on our common shares with the total return on the S&P 500 Index and the S&P Financial Index for the last five years. It shows the growth of a $100 investment on December 31, 2013, including the reinvestment of all dividends. +Year-end Data +2013 +2014 +2015 +2016 +2017 +2018 +American Express +$ +100.00 +$ +103.67 +$ +78.56 +$ +85.29 +$ +116.18 +$ +113.12 +S&P 500 Index +$ +100.00 +$ +113.68 +$ +115.24 +$ +129.02 +$ +157.17 +$ +150.27 +S&P Financial Index +$ +100.00 +$ +115.18 +$ +113.38 +$ +139.17 +$ +169.98 +$ +147.82 +31 +Table of Contents +(b) Not applicable. +(c) Issuer Purchases of Securities +The table below sets forth the information with respect to purchases of our common stock made by or on behalf of us during the quarter ended December 31, 2018. +Total Number of Shares Purchased +Average Price Paid Per Share +Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (c) +Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs +October 1-31, 2018 +Repurchase program (a) +4,651,950 +$ +104.50 +4,651,950 +72,927,442 +Employee transactions (b) +4 +$ +110.90 +N/A +N/A +November 1-30, 2018 +Repurchase program (a) +― +N/A +― +72,927,442 +Employee transactions (b) +40,693 +$ +101.25 +N/A +N/A +December 1-31, 2018 +Repurchase program (a) +2,987,808 +$ +101.01 +2,987,808 +69,939,634 +Employee transactions (b) +― +N/A +N/A +N/A +Total +Repurchase program (a) +7,639,758 +$ +103.14 +7,639,758 +69,939,634 +Employee transactions (b) +40,697 +$ +101.25 +N/A +N/A +(a) +On September 26, 2016, the Board of Directors authorized the repurchase of up to 150 million shares of common stock from time to time, subject to market conditions and the Federal Reserve’s non-objection to our capital plans. This authorization replaced the prior repurchase authorization and does not have an expiration date. See “MD&A – Consolidated Capital Resources and Liquidity” for additional information regarding share repurchases. +(b) +Includes: (i) shares surrendered by holders of employee stock options who exercised options (granted under our incentive compensation plans) in satisfaction of the exercise price and/or tax withholding obligation of such holders and (ii) restricted shares withheld (under the terms of grants under our incentive compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares. Our incentive compensation plans provide that the value of the shares delivered or attested to, or withheld, be based on the price of our common stock on the date the relevant transaction occurs. +(c) +Share purchases under publicly announced programs are made pursuant to open market purchases or privately negotiated transactions (including employee benefit plans) as market conditions warrant and at prices we deem appropriate. +32 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +2018 +2017 (a) +2016 (a) +2015 +2014 +Operating Results ($ in Millions) +Total revenues net of interest expense +$ +40,338 +$ +36,878 +$ +35,438 +$ +32,818 +$ +34,188 +Provisions for losses (b) +3,352 +2,760 +2,027 +1,988 +2,044 +Expenses (c) +28,864 +26,693 +25,369 +22,892 +23,153 +Pretax income +8,122 +7,425 +8,042 +7,938 +8,991 +Income tax provision +1,201 +4,677 +2,667 +2,775 +3,106 +Net income +$ +6,921 +$ +2,748 +$ +5,375 +$ +5,163 +$ +5,885 +Return on average equity (d) +33.5 +% +13.2 +% +25.8 +% +24.0 +% +29.1 +% +Return on average assets (d) +3.8 +% +1.6 +% +3.4 +% +3.3 +% +3.8 +% +Balance Sheet ($ in Millions) +Cash and cash equivalents +$ +27,445 +$ +32,927 +$ +25,208 +$ +22,762 +$ +22,288 +Card Member loans and receivables HFS +― +― +― +14,992 +― +Accounts receivable, net +58,227 +56,735 +50,123 +46,695 +47,000 +Loans, net +83,396 +74,300 +65,461 +58,799 +70,104 +Investment securities +4,647 +3,159 +3,157 +3,759 +4,431 +Total assets +188,602 +181,196 +158,917 +161,184 +159,103 +Customer deposits +69,960 +64,452 +53,042 +54,997 +44,171 +Travelers Cheques outstanding and other prepaid products +2,295 +2,555 +2,774 +3,247 +3,673 +Short-term borrowings +3,100 +3,278 +5,581 +4,812 +3,480 +Long-term debt +58,423 +55,804 +46,990 +48,061 +57,955 +Shareholders’ equity +$ +22,290 +$ +18,261 +$ +20,523 +$ +20,673 +$ +20,673 +Average shareholders' equity to average total assets ratio +11.3 +% +12.5 +% +13.2 +% +13.5 +% +13.1 +% +Common Share Statistics (e) +Earnings per share: +Net income attributable to common shareholders: (f) +Basic +$ +7.93 +$ +3.00 +$ +5.63 +$ +5.07 +$ +5.58 +Diluted +7.91 +2.99 +5.61 +5.05 +5.56 +Cash dividends declared per common share +1.48 +1.34 +1.22 +1.13 +1.01 +Dividend payout ratio (g) +18.7 +% +44.7 +% +21.7 +% +22.3 +% +18.1 +% +Book value per common share +24.45 +19.42 +20.95 +19.71 +20.21 +Average common shares outstanding (millions) : +Basic +856 +883 +933 +999 +1,045 +Diluted +859 +886 +935 +1,003 +1,051 +Shares outstanding at period end (millions) +847 +859 +904 +969 +1,023 +Other Statistics +Number of employees at period end (thousands) : +United States +21 +20 +21 +21 +22 +Outside the United States +38 +35 +35 +34 +32 +Total +59 +55 +56 +55 +54 +Number of shareholders of record +21,078 +22,262 +23,572 +24,704 +25,767 +(a) +Previously disclosed amounts have been restated in conjunction with the adoption of the new revenue recognition standard. Refer to Note 1 to the “Consolidated Financial Statements” for additional information. +(b) +Beginning December 1, 2015 through to the sale completion dates, did not reflect provisions for Card Member loans and receivables related to our cobrand partnerships with JetBlue Airways Corporation (JetBlue) and Costco Wholesale Corporation (Costco) in the United States (the HFS portfolios). +(c) +Beginning December 1, 2015 through to the sale completion dates, included the valuation allowance adjustment associated with the HFS portfolios. +(d) +Return on average equity and return on average assets are calculated by dividing one-year period of net income by one-year average of total shareholders’ equity or total assets, respectively. +(e) +Our common stock trades principally on The New York Stock Exchange under the trading symbol AXP . +(f) +Represents net income, less earnings allocated to participating share awards and dividends on preferred shares. +(g) +Calculated on year’s dividends declared per common share as a percentage of the year’s net income available per common share. +33 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) +EXECUTIVE OVERVIEW +BUSINESS INTRODUCTION +We are a global services company with three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses and operations are included in Corporate & Other. +The following types of revenue are generated from our various products and services: +• +Discount revenue, our largest revenue source, primarily represents the amount we earn on transactions occurring at merchants that have entered into a card acceptance agreement with us, or a Global Network Services (GNS) partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. The amount of fees charged for accepting our cards as payment for goods or services, or merchant discount, varies with, among other factors, the industry in which the merchant does business, the merchant’s overall American Express-related transaction volume, the method of payment, the settlement terms with the merchant, the method of submission of transactions and, in certain instances, the geographic scope for the related card acceptance agreement between the merchant and us (e.g., domestic or global) and the transaction amount. In some instances, an additional flat transaction fee is assessed as part of the merchant discount, and additional fees may be charged such as a variable fee for “non-swiped” card transactions or for transactions using cards issued outside the United States at merchants located in the United States; +• +Interest on loans, principally represents interest income earned on outstanding balances; +• +Net card fees, represent revenue earned from annual card membership fees, which vary based on the type of card and the number of cards for each account; +• +Other fees and commissions, primarily represent Card Member delinquency fees, foreign currency conversion fees charged to Card Members, Membership Rewards program fees, loyalty coalition-related fees, travel commissions and fees, and service fees earned from merchants; and +• +Other revenue, primarily represents revenues arising from contracts with partners of our Global Network Services (GNS) business (including commissions and signing fees less issuer rate payments), cross-border Card Member spending, ancillary merchant-related fees, insurance premiums earned from Card Members, prepaid card and Travelers Cheque-related revenue and earnings from equity method investments (including the American Express Global Business Travel Joint Venture (the GBT JV)). +FINANCIAL HIGHLIGHTS +For 2018, we reported net income of $6.9 billion and diluted earnings per share of $7.91. This compared to $2.7 billion of net income and $2.99 diluted earnings per share for 2017, and $5.4 billion of net income and $5.61 diluted earnings per share for 2016. +2018 results included: +• +$496 million of certain discrete tax benefits in the fourth quarter. +2017 results included: +• +A $2.6 billion tax charge related to the Tax Cuts and Jobs Act (the Tax Act) in the fourth quarter. +2016 results included: +• +A $1.1 billion ($677 million after tax) gain on the sale of Card Member loans and receivables related to our cobrand partnership with Costco in the second quarter; +• +$410 million ($266 million after tax) of net restructuring charges; and +• +A $127 million ($79 million after tax) gain on the sale of Card Member loans and receivables related to our cobrand partnership with JetBlue in the first quarter. +NON-GAAP MEASURES +We prepare our Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America (GAAP). However, certain information included within this report constitutes non-GAAP financial measures. Our calculations of non-GAAP financial measures may differ from the calculations of similarly titled measures by other companies. +34 +Table of Contents +TAX CUTS AND JOBS ACT +On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Act, which made broad and complex changes to the U.S. federal corporate income tax rules. Most notably, effective January 1, 2018, the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35 percent to 21 percent, introduced a territorial tax system in which future dividends paid from earnings outside the United States to a U.S. corporation are not subject to U.S. federal taxation and imposed new U.S. federal corporate income taxes on certain foreign operations. For 2019, we estimate that our tax rate will be approximately 22 percent, before discrete tax items. +BUSINESS ENVIRONMENT +Our results for 2018 reflect strong performance and our focus on, and investment in, our four strategic imperatives – expand our leadership in the premium consumer space, build on our strong position in commercial payments, strengthen our global, integrated network and make American Express an essential part of our customers’ digital lives. Billings and revenue growth reflected momentum across our businesses. We continued to invest in new services and Card Member benefits, new card acquisitions and expanding our merchant network. During the year, we returned a significant amount of capital to our shareholders through our share buyback program and an increase in our dividend, while increasing our capital ratios. Our results also included the benefit of a lower tax provision due to a reduction in the U.S. corporate income tax rate resulting from the Tax Act, along with several discrete tax benefits. +Our worldwide billed business increased 9 percent over the prior year, reflecting strong proprietary billings growth both in the U.S. and internationally, and across customer segments. Proprietary billings growth was driven by increased spending within our premium consumer base, as well as consistent double digit growth throughout the year from our small and medium enterprise business customers. GNS billed business declined due to the ongoing and expected impact of changes in the regulatory environment in the EU and Australia; excluding the billings from those geographies, GNS billed business grew 8 percent year-over-year. +Revenues net of interest expense increased 9 percent, reflecting growth in Card Member spending, net interest income and card fees, partially offset by a year-over-year decline in the average discount rate. We continue to be focused on driving discount revenue growth, not the average discount rate. Card fee revenue saw double digit year-over-year growth and reflected increased engagement from both new and existing customers as a result of the benefits that we have added to our card products around the world. +Card Member loans grew year-over-year, as we continued to expand our lending relationships with existing customers and acquired new Card Members, including the acquisition of the portion of the Hilton cobrand portfolio that we did not previously own (the acquired Hilton portfolio). Provisions for losses increased, reflecting growth in the loan portfolio and a higher lending write-off rate. Write-off rates continue to modestly increase due to ongoing seasoning of our loan portfolio. +Spending on customer engagement (the aggregate of rewards, Card Member services and marketing and business development expenses) increased year-over-year across all categories. Increases in rewards and Card Member services reflected the growth in billings and continued higher levels of investment across many of our premium travel services. Marketing and business development expense increased due to higher spending on growth initiatives, including new card acquisition, our global brand campaign, continued investments in our cobrand partnerships and higher corporate client incentives. While impacted by several discrete items, operating expenses were flat year-over-year and remained well controlled, which allowed for additional investment in customer engagement. +We plan to continue making investments in our business to generate and sustain a strong level of revenue growth, which we believe is the foundation for steady and consistent double-digit EPS growth. While we continue to see some headwinds from an uncertain economic environment, regulation in countries around the world and intense competition, we remain focused on delivering differentiated value to our merchants, Card Members and business partners and delivering appropriate returns to our shareholders. +See “Supervision and Regulation” in “Business” for information on legislative and regulatory changes that could have a material adverse effect on our results of operations and financial condition and “Risk Factors” for information on the potential impacts of economic, political and competitive conditions and certain litigation and regulatory matters on our business. +35 +Table of Contents +CONSOLIDATED RESULTS OF OPERATIONS +Effective January 1, 2018, we adopted new revenue recognition guidance using the full retrospective method, which applies the new standard to each prior reporting period presented, starting January 1, 2016. The adoption changed the recognition timing and classification of certain revenues and expenses, including changes to the presentation of certain credit and charge card related costs that were previously netted against discount revenue. The adoption did not have a significant impact on our consolidated financial position, net income, equity or cash flows. Refer to Note 1 to the “Consolidated Financial Statements” for additional information. In addition, we reclassified certain business development expenses, from Other expenses to Marketing and business development expenses, which was not directly attributable to the adoption of the new revenue recognition guidance. +During 2018, we changed the methodology used to allocate certain corporate overhead costs and interest income and expense to the operating segments, and made minor changes to the intercompany settlement process. Prior period amounts have been revised to conform to the current period presentation. +TABLE 1: SUMMARY OF FINANCIAL PERFORMANCE +Years Ended December 31, +Change +Change +(Millions, except percentages and per share amounts) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Total revenues net of interest expense +$ +40,338 +$ +36,878 +$ +35,438 +$ +3,460 +9 +% +$ +1,440 +4 +% +Provisions for losses +3,352 +2,760 +2,027 +592 +21 +733 +36 +Expenses +28,864 +26,693 +25,369 +2,171 +8 +1,324 +5 +Pretax income +8,122 +7,425 +8,042 +697 +9 +(617 +) +(8 +) +Income tax provision +1,201 +4,677 +2,667 +(3,476 +) +(74 +) +2,010 +75 +Net income +6,921 +2,748 +5,375 +4,173 +# +(2,627 +) +(49 +) +Earnings per common share — diluted (a) +$ +7.91 +$ +2.99 +$ +5.61 +$ +4.92 +# +% +$ +(2.62 +) +(47 +)% +Return on average equity (b) +33.5 +% +13.2 +% +25.8 +% +Effective tax rate (ETR) +14.8 +% +63.0 +% +33.2 +% +Adjustments to ETR (c) +6.1 +% +(34.7 +)% +Adjusted ETR (c) +20.9 +% +28.3 +% +# Denotes a variance greater than 100 percent +(a) +Earnings per common share — diluted was reduced by the impact of (i) earnings allocated to participating share awards and other items of $54 million, $21 million and $43 million for the years ended December 31, 2018, 2017 and 2016, respectively, and (ii) dividends on preferred shares of $80 million, $81 million and $80 million for the years ended December 31, 2018, 2017 and 2016, respectively. +(b) +Return on average equity (ROE) is computed by dividing (i) one-year period net income ($6.9 billion, $2.7 billion and $5.4 billion for 2018, 2017 and 2016, respectively) by (ii) one-year average total shareholders’ equity ($20.7 billion for 2018 and $20.9 billion for both 2017 and 2016). +(c) The adjusted ETRs for 2018 and 2017 are non-GAAP measures. The 2018 adjusted ETR excludes a benefit of $496 million relating to changes in the tax method of accounting for certain expenses, the resolution of certain prior years’ tax audits, and a final adjustment to our 2017 provisional tax charge related to the Tax Act. The 2017 adjusted ETR excludes the $2.6 billion charge related to the Tax Act. Management believes the adjusted ETRs are useful in evaluating our tax rates in comparison with the other presented periods. Refer to Note 21 of the “Consolidated Financial Statements” for additional information. +TABLE 2: TOTAL REVENUES NET OF INTEREST EXPENSE SUMMARY +Years Ended December 31, +Change +Change +(Millions, except percentages) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Discount revenue +$ +24,721 +$ +22,890 +$ +22,377 +$ +1,831 +8 +% +$ +513 +2 +% +Net card fees +3,441 +3,090 +2,886 +351 +11 +204 +7 +Other fees and commissions +3,153 +2,990 +2,718 +163 +5 +272 +10 +Other +1,360 +1,457 +1,678 +(97 +) +(7 +) +(221 +) +(13 +) +Total non-interest revenues +32,675 +30,427 +29,659 +2,248 +7 +768 +3 +Total interest income +10,606 +8,563 +7,484 +2,043 +24 +1,079 +14 +Total interest expense +2,943 +2,112 +1,705 +831 +39 +407 +24 +Net interest income +7,663 +6,451 +5,779 +1,212 +19 +672 +12 +Total revenues net of interest expense +$ +40,338 +$ +36,878 +$ +35,438 +$ +3,460 +9 +% +$ +1,440 +4 +% +36 +Table of Contents +TOTAL REVENUES NET OF INTEREST EXPENSE +Discount revenue increased in both periods, primarily due to growth in billed business, partially offset by decreases in the average discount rate. U.S. billed business increased 10 percent in 2018 compared to 2017 and 1 percent in 2017 compared to 2016. Non-U.S. billed business increased 8 percent in 2018 compared to 2017 and 12 percent in 2017 compared to 2016. See Tables 5 and 6 for more details on billed business performance. +The average discount rate was 2.37 percent, 2.40 percent and 2.43 percent for 2018, 2017 and 2016, respectively. Several factors continued to drive the average discount rate decline, including impacts from decisions we made with respect to certain strategic partners, the impact of regulatory changes in Europe and Australia, and the continued roll out of the OptBlue program, though the impacts began to moderate in the latter half of the year. +Net card fees increased in both periods, primarily driven by growth in the Platinum and Delta portfolios, as well as growth in certain key international countries. +Other fees and commissions increased in both periods, primarily driven by growth in foreign exchange conversion revenue and increases in delinquency fees. +Other revenues decreased in both periods. The decrease in 2018 was partly driven by a modification of one of our GNS arrangements, lower breakage related to our prepaid cards and a decline in revenues related to the GBT JV. The decrease in 2017 was primarily driven by prior-year revenues related to the Loyalty Edge business, which was sold in the fourth quarter of 2016, and a contractual payment from a GNS partner also in the prior year. +Interest income increased in both periods, primarily reflecting higher average Card Member loans and higher yields. The growth in average Card Member loans in 2018 was primarily driven by expanding relationships with existing customers, as well as the inclusion of the acquired Hilton portfolio. The growth in average Card Member loans in 2017 was primarily driven by a mix shift towards non-cobrand lending products, where Card Members tend to revolve more of their loan balances. The increase in yields in both periods was primarily driven by a greater percentage of loans at higher rate buckets, specific pricing actions and increases in benchmark interest rates. +Interest expense increased in both periods, primarily driven by higher interest rates and higher average long-term debt and, additionally in 2018, by higher average deposits. +TABLE 3: PROVISIONS FOR LOSSES SUMMARY +Years Ended December 31, +Change +Change +(Millions, except percentages) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Charge card +$ +937 +$ +795 +$ +696 +$ +142 +18 +% +$ +99 +14 +% +Card Member loans +2,266 +1,868 +1,235 +398 +21 +633 +51 +Other +149 +97 +96 +52 +54 +1 +1 +Total provisions for losses +$ +3,352 +$ +2,760 +$ +2,027 +$ +592 +21 +% +$ +733 +36 +% +PROVISIONS FOR LOSSES +Charge card provision for losses increased in both periods, primarily driven by growth in receivables due to increased billed business and higher net write-offs, largely in the corporate and small business portfolios. +Card Member loans provision for losses increased in both periods, driven by strong loan growth, higher net write-offs and a modest increase in delinquencies. The increases in write-offs and delinquencies were due in part to the seasoning of recent loan vintages. +Other provision for losses increased in 2018 compared to 2017 and was relatively flat in 2017 compared to 2016. The increase in 2018 was primarily due to growth in the non-card lending and commercial financing portfolios. 2017 compared to 2016 also reflected growth in the non-card lending portfolio, which was offset by improving credit performance in the commercial financing portfolio. +37 +Table of Contents +TABLE 4: EXPENSES SUMMARY +Years Ended December 31, +Change +Change +(Millions, except percentages) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Marketing and business development (a) +$ +6,470 +$ +5,722 +$ +6,249 +$ +748 +13 +% +$ +(527 +) +(8 +)% +Card Member rewards +9,696 +8,687 +7,819 +1,009 +12 +868 +11 +Card Member services +1,777 +1,392 +1,100 +385 +28 +292 +27 +Total marketing, business development, rewards and Card Member services +17,943 +15,801 +15,168 +2,142 +14 +633 +4 +Salaries and employee benefits +5,250 +5,258 +5,259 +(8 +) +― +(1 +) +― +Other, net (a) +5,671 +5,634 +4,942 +37 +1 +692 +14 +Total expenses +$ +28,864 +$ +26,693 +$ +25,369 +$ +2,171 +8 +% +$ +1,324 +5 +% +(a) +Effective January 1, 2018, includes reclassification of certain business development expenses from Other expenses to Marketing and business development that are not directly attributable to the adoption of the new revenue recognition guidance. Prior periods have been conformed to the current period presentation. +EXPENSES +Marketing and business development expense increased in 2018 compared to 2017 and decreased in 2017 compared to 2016. The variances for both periods were primarily driven by lower levels of spending on growth initiatives in 2017 compared to the preceding and subsequent years. The higher spending on growth initiatives in 2018 included our new global brand campaign, continued investments in partnerships, and increased corporate client incentives driven by higher volumes. +Card Member rewards expense increased in both periods. The increase in 2018 was driven by increases in Membership Rewards and cash-back reward expenses of $558 million and cobrand rewards expense of $451 million, both of which were primarily driven by higher spending volumes. The increase in 2017 was primarily driven by higher spending volumes and enhancements to U.S. Consumer and Small Business Platinum rewards during 2017. +The Membership Rewards Ultimate Redemption Rate (URR) for current program participants increased to 96 percent ( rounded up ) at December 31, 2018, compared to 95 percent (rounded down) at December 31, 2017 and 2016. +Card Member services expense increased in both periods, primarily driven by higher usage of travel-related benefits and enhanced Platinum card benefits. +Salaries and employee benefits expense was flat for both periods, reflecting increases in incentive compensation, offset by lower restructuring charges compared to the respective prior year. +Other expense increased in both periods. The increase in 2018 was primarily driven by higher technology expenses, a loss in the current year on a transaction involving the operations of our prepaid reloadable and gift card business, and a foreign exchange loss related to the devaluation of the Argentine peso, which was deemed a highly inflationary currency as of July 1, 2018, all partially offset by current-year unrealized gains on certain equity investments and charges in the prior year related to our U.S. loyalty coalition and prepaid businesses. The increase in 2017 was primarily driven by gains in 2016 on the sales of the HFS portfolios, which were recognized as an expense reduction, partially offset by lower technology-related costs in 2017 and higher Loyalty Edge-related costs in 2016. +INCOME TAXES +The effective tax rate for 2018 was 14.8 percent and reflects a benefit of $496 million relating to changes in the tax method of accounting for certain expenses, the resolution of certain prior years’ tax audits and an adjustment to the 2017 provisional tax charge related to the Tax Act. The tax rate for 2018 also reflects the reduction in the U.S. federal statutory rate from 35 percent to 21 percent as a result of the Tax Act. +The effective tax rate for 2017 was 63.0 percent and reflects the charge of $2.6 billion related to the Tax Act that was accounted for as a provisional estimate under Staff Accounting Bulletin No. 118. Refer to Note 21 to the “Consolidated Financial Statements” for additional information. +The tax rates in all periods reflect the level of pretax income in relation to recurring permanent tax benefits and the geographic mix of business. +38 +Table of Contents +TABLE 5: SELECTED CARD-RELATED STATISTICAL INFORMATION +Change +Change +Years Ended December 31, +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Billed business: (billions) +U.S. +$ +777.6 +$ +708.3 +$ +700.4 +10 +% +1 +% +Outside the U.S. +406.4 +376.9 +337.1 +8 +12 +Total +$ +1,184.0 +$ +1,085.2 +$ +1,037.5 +9 +5 +Proprietary +$ +1,002.6 +$ +900.6 +$ +863.8 +11 +% +4 +% +GNS +181.4 +184.6 +173.7 +(2 +) +6 +Total +$ +1,184.0 +$ +1,085.2 +$ +1,037.5 +9 +5 +Cards-in-force: (millions) +U.S. +53.7 +50.0 +47.5 +7 +5 +Outside the U.S. +60.3 +62.8 +62.4 +(4 +) +1 +Total +114.0 +112.8 +109.9 +1 +3 +Proprietary +69.1 +64.6 +61.3 +7 +5 +GNS +44.9 +48.2 +48.6 +(7 +) +(1 +) +Total +114.0 +112.8 +109.9 +1 +3 +Basic cards-in-force: (millions) +U.S. +42.3 +39.4 +37.4 +7 +5 +Outside the U.S. +50.3 +52.2 +51.7 +(4 +) +1 +Total +92.6 +91.6 +89.1 +1 +3 +Average proprietary basic Card Member spending: (dollars) +U.S. +$ +20,840 +$ +20,317 +$ +18,808 +3 +8 +Outside the U.S. +$ +15,756 +$ +14,277 +$ +13,073 +10 +9 +Worldwide Average +$ +19,340 +$ +18,519 +$ +17,216 +4 +8 +Card Member loans: (billions) +U.S. +$ +72.0 +$ +64.5 +$ +58.3 +12 +11 +Outside the U.S. +9.9 +8.9 +7.0 +11 +27 +Total +$ +81.9 +$ +73.4 +$ +65.3 +12 +12 +Average discount rate (a) +2.37 +% +2.40 +% +2.43 +% +Average fee per card (dollars) (b) +$ +51 +$ +49 +$ +44 +4 +% +11 +% +(a) +Effective January 1, 2018, we began including billed business related to certain business-to-business products in the calculation of the average discount rate to reflect our expanding business-to-business product offerings. Prior periods have been conformed to the current period presentation. +(b) +Average fee per card is computed based on proprietary basic net card fees divided by average proprietary basic cards-in-force. +39 +Table of Contents +TABLE 6: BILLED BUSINESS GROWTH +2018 +2017 +Percentage Increase (Decrease) +Percentage Increase (Decrease) Assuming No Changes in FX Rates (a) +Percentage Increase (Decrease) +Percentage Increase (Decrease) Assuming No Changes in FX Rates (a) +Worldwide +Proprietary +Proprietary consumer +12 +% +12 +% +1 +% +1 +% +Proprietary commercial +11 +11 +7 +7 +Total Proprietary +11 +11 +4 +4 +GNS +(2) +(1) +6 +5 +Worldwide Total +9 +9 +5 +4 +Airline-related volume (8% of Worldwide Total for both 2018 and 2017) +8 +7 +3 +3 +U.S. +Proprietary +Proprietary consumer +10 +(2) +Proprietary commercial +10 +6 +Total Proprietary +10 +2 +U.S. Total +10 +1 +T&E-related volume (25% of U.S. Total for both 2018 and 2017) +8 +― +Non-T&E-related volume (75% of U.S. Total for both 2018 and 2017) +10 +1 +Airline-related volume (7% of U.S. Total for both 2018 and 2017) +8 +― +Outside the U.S. +Proprietary +Proprietary consumer +17 +17 +13 +12 +Proprietary commercial +16 +16 +14 +12 +Total Proprietary +17 +17 +14 +12 +Outside the U.S. Total +8 +8 +12 +11 +Japan, Asia Pacific & Australia +8 +7 +13 +12 +Latin America & Canada +4 +11 +10 +9 +Europe, the Middle East & Africa +10 +% +8 +% +12 +% +10 +% +(a) +The foreign currency adjusted information assumes a constant exchange rate between the periods being compared for purposes of currency translation into U.S. dollars (i.e., assumes the foreign exchange rates used to determine results for the current year apply to the corresponding prior year period against which such results are being compared). +40 +Table of Contents +TABLE 7: SELECTED CREDIT-RELATED STATISTICAL INFORMATION +As of or for the Years Ended December 31, +Change +Change +(Millions, except percentages and where indicated) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Worldwide Card Member loans +Total loans (billions) +$ +81.9 +$ +73.4 +$ +65.3 +12 +% +12 +% +Loss reserves: +Beginning balance +$ +1,706 +$ +1,223 +$ +1,028 +39 +19 +Provisions - principal, interest and fees +2,266 +1,868 +1,235 +21 +51 +Net write-offs — principal less recoveries +(1,539 +) +(1,181 +) +(930 +) +30 +27 +Net write-offs — interest and fees less recoveries +(304 +) +(227 +) +(175 +) +34 +30 +Other (a) +5 +23 +65 +(78 +) +(65 +) +Ending balance +$ +2,134 +$ +1,706 +$ +1,223 +25 +39 +Ending reserves — principal +$ +2,028 +$ +1,622 +$ +1,160 +25 +40 +Ending reserves — interest and fees +$ +106 +$ +84 +$ +63 +26 +33 +% of loans +2.6 +% +2.3 +% +1.9 +% +% of past due +182 +% +177 +% +161 +% +Average loans (billions) +$ +75.8 +$ +66.7 +$ +59.9 +14 +% +11 +% +Net write-off rate — principal only (b) +2.0 +% +1.8 +% +1.6 +% +Net write-off rate — principal, interest and fees (b) +2.4 +% +2.1 +% +1.8 +% +30+ days past due as a % of total (b) +1.4 +% +1.3 +% +1.2 +% +Worldwide Card Member receivables +Total receivables (billions) +$ +55.9 +$ +54.0 +$ +47.3 +4 +% +14 +% +Loss reserves: +Beginning balance +$ +521 +$ +467 +$ +462 +12 +1 +Provisions - principal and fees +937 +795 +696 +18 +14 +Net write-offs - principal and fees less recoveries +(859 +) +(736 +) +(674 +) +17 +9 +Other (a) +(26 +) +(5 +) +(17 +) +# +(71 +) +Ending balance +$ +573 +$ +521 +$ +467 +10 +% +12 +% +% of receivables +1.0 +% +1.0 +% +1.0 +% +Net write-off rate — principal only (b) +1.7 +% +1.6 +% +1.5 +% +Net write-off rate — principal and fees (b) +1.8 +% +1.7 +% +1.8 +% +30+ days past due as a % of total (b) +1.4 +% +1.4 +% +1.4 +% +Net loss ratio as a % of charge volume — GCP (c) +0.11 +% +0.10 +% +0.09 +% +90+ days past billing as a % of total — GCP (c) +0.7 +% +0.9 +% +0.9 +% +# Denotes a variance greater than 100 percent +(a) +Other includes foreign currency translation adjustments and for 2016, Worldwide Card Member loans include reserves associated with Card Member loans reclassified from HFS to held for investment. Refer to Changes in Card Member loans reserve for losses under Note 4 to the “Consolidated Financial Statements” for additional information. +(b) +We present a net write-off rate based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, as our practice is to include uncollectible interest and/or fees as part of our total provision for losses, a net write-off rate including principal, interest and/or fees is also presented. The net write-off rates and 30+ days past due as a percentage of total for Card Member receivables relate to GCSG and Global Small Business Services (GSBS) Card Member receivables . +(c) +Global Corporate Payments ( GCP) reflects global, large and middle market corporate accounts. For GCP Card Member receivables, delinquency data is tracked based on days past billing status rather than days past due. A Card Member account is considered 90 days past billing if payment has not been received within 90 days of the Card Member’s billing statement date. In addition, if we initiate collection procedures on an account prior to the account becoming 90 days past billing, the associated Card Member receivable balance is classified as 90 days past billing. These amounts are shown above as 90+ Days Past Due for presentation purposes. GCP delinquency data for periods other than 90+ days past billing is not available due to system constraints. +41 +Table of Contents +TABLE 8: NET INTEREST YIELD ON AVERAGE CARD MEMBER LOANS +Years Ended December 31, +(Millions, except percentages and where indicated) +2018 +2017 +2016 +Net interest income +$ +7,663 +$ +6,451 +$ +5,779 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +1,456 +1,149 +954 +Interest income not attributable to our Card Member loan portfolio (b) +(1,010 +) +(637 +) +(405 +) +Adjusted net interest income (c) +$ +8,109 +$ +6,963 +$ +6,328 +Average Card Member loans including HFS loan portfolios (billions) +$ +75.8 +$ +66.7 +$ +65.8 +Net interest income divided by average Card Member loans (c) +10.1 +% +9.7 +% +8.8 +% +Net interest yield on average Card Member loans (c) +10.7 +% +10.4 +% +9.6 +% +(a) +Primarily represents interest expense attributable to maintaining our corporate liquidity pool and funding Card Member receivables. +(b) +Primarily represents interest income attributable to Other loans, interest-bearing deposits and the fixed income investment portfolios. +(c) +Adjusted net interest income and net interest yield on average Card Member loans are non-GAAP measures. Refer to “Glossary of Selected Terminology” for the definitions of these terms. We believe adjusted net interest income is useful to investors because it represents the interest expense and interest income attributable to our Card Member loan portfolio and is a component of net interest yield on average Card Member loans, which provides a measure of profitability of our Card Member loan portfolio. Net interest yield on average Card Member loans reflects adjusted net interest income divided by average Card Member loans, computed on an annualized basis. Net interest income divided by average Card Member loans, computed on an annualized basis, a GAAP measure, includes elements of total interest income and total interest expense that are not attributable to the Card Member loan portfolio, and thus is not representative of net interest yield on average Card Member loans. +42 +Table of Contents +BUSINESS SEGMENT RESULTS +We consider a combination of factors when evaluating the composition of our reportable operating segments, including the results reviewed by the chief operating decision maker, economic characteristics, products and services offered, classes of customers, product distribution channels, geographic considerations (primarily United States versus outside the United States) and regulatory considerations. Refer to Note 25 to the “Consolidated Financial Statements” and Part I, Item 1. “Business” for additional discussion of products and services that comprise each segment. +Effective for the second quarter of 2018, we realigned our reportable operating segments to reflect the organizational changes announced during the first quarter of 2018. Prior periods have been revised to conform to the new reportable operating segments, which are as follows: + +GCSG, including proprietary consumer cards globally, consumer services including travel services and non-card financing products, certain international joint ventures and our partnership agreements in China; + +GCS, including the proprietary GCP business, GSBS and commercial financing products; and + +GMNS, including the GNS business, the Global Merchant Services business, global loyalty coalition businesses, reloadable prepaid and gift card businesses. +Corporate functions and certain other businesses and operations, including the GBT JV, are included in Corporate & Other. +Results of the reportable operating segments generally treat each segment as a stand-alone business. The management reporting process that derives these results allocates revenue and expense using various methodologies as described below. +TOTAL REVENUES NET OF INTEREST EXPENSE +We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue. +Net card fees and other fees and commissions are directly attributable to the segment in which they are reported. +Interest and fees on loans and certain investment income is directly attributable to the segment in which it is reported. Interest expense represents an allocated funding cost based on a combination of segment funding requirements and internal funding rates. +PROVISIONS FOR LOSSES +The provisions for losses are directly attributable to the segment in which they are reported. +EXPENSES +Marketing and business development expense is included in each segment based on the actual expenses incurred. Global brand advertising is primarily reflected in Corporate & Other and may be allocated to the segments based on the actual expense incurred. Rewards and Card Member services expenses are included in each segment based on the actual expenses incurred within the segment. +Salaries and employee benefits and other operating expenses reflect expenses such as professional services, occupancy and equipment and communications incurred directly within each segment. In addition, expenses related to support services, such as technology costs, are allocated to each segment primarily based on support service activities directly attributable to the segment. Certain other overhead expenses are allocated from Corporate & Other to the segments based on the relative levels of revenue and Card Member loans and receivables. +INCOME TAXES +An income tax provision (benefit) is allocated to each reportable operating segment based on the effective tax rates applicable to the various businesses that comprise the segment. The 2017 $2.6 billion charge related to the Tax Act was allocated in full to Corporate & Other. +43 +Table of Contents +GLOBAL CONSUMER SERVICES GROUP +TABLE 9: GCSG SELECTED INCOME STATEMENT DATA +Years Ended December 31, +Change +Change +(Millions, except percentages) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Revenues +Non-interest revenues +$ +14,675 +$ +13,378 +$ +12,993 +$ +1,297 +10 +% +$ +385 +3 +% +Interest income +8,323 +6,789 +6,005 +1,534 +23 +784 +13 +Interest expense +1,542 +1,047 +828 +495 +47 +219 +26 +Net interest income +6,781 +5,742 +5,177 +1,039 +18 +565 +11 +Total revenues net of interest expense +21,456 +19,120 +18,170 +2,336 +12 +950 +5 +Provisions for losses +2,430 +1,996 +1,390 +434 +22 +606 +44 +Total revenues net of interest expense after provisions for losses +19,026 +17,124 +16,780 +1,902 +11 +344 +2 +Expenses +Marketing, business development, rewards and Card Member services +10,774 +9,233 +8,714 +1,541 +17 +519 +6 +Salaries and employee benefits and other operating expenses +4,538 +4,246 +3,558 +292 +7 +688 +19 +Total expenses +15,312 +13,479 +12,272 +1,833 +14 +1,207 +10 +Pretax segment income +3,714 +3,645 +4,508 +69 +2 +(863 +) +(19 +) +Income tax provision +637 +1,053 +1,469 +(416 +) +(40 +) +(416 +) +(28 +) +Segment income +$ +3,077 +$ +2,592 +$ +3,039 +$ +485 +19 +% +$ +(447 +) +(15 +)% +Effective tax rate +17.2 +% +28.9 +% +32.6 +% +GCSG primarily issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues increased in 2018 compared to 2017, primarily driven by discount revenue, which increased 10 percent, reflecting an increase in proprietary consumer billed business of 12 percent, partially offset by a decline in the average discount rate. U.S. proprietary consumer billed business increased 10 percent and non-U.S. proprietary consumer billed business increased 17 percent. The increases in billed business reflected higher cards-in-force and higher average spend per card. +The increase in non-interest revenues was also driven by 13 percent growth in net card fees and increased other fees and commissions. The increase in net card fees was driven primarily by growth in the Platinum and Delta portfolios, as well as growth in card fees across certain key international countries. The increase in other fees and commissions was primarily driven by increases in delinquency fees, travel commissions and foreign exchange conversion revenue. +Net interest income increased in 2018 compared to 2017, primarily driven by growth in average Card Member loans and higher yields, partially offset by higher interest expense, primarily driven by higher cost of funds. The growth in average Card Member loans was primarily driven by expanding relationships with existing customers, as well as the inclusion of the acquired Hilton portfolio. The increase in yields was primarily driven by a greater percentage of loans at higher rate buckets and specific pricing actions. +Total revenues net of interest expense increased in 2017 compared to 2016, primarily driven by higher discount revenue, reflecting billed business growth. The increase also reflected higher net interest income, primarily driven by growth in average Card Member loans and higher yields, partially offset by higher interest expense. +PROVISIONS FOR LOSSES +Provisions for losses increased in both periods, primarily driven by increased Card Member loans provision, reflecting strong loan growth and higher write-offs, in part due to the seasoning of recent loan vintages. The increase in 2017 was additionally driven by a shift in mix towards non-cobrand lending products, which tend to have higher write-off rates. +Refer to Table 10 for the charge card and lending write-off rates for 2018, 2017 and 2016. +44 +Table of Contents +EXPENSES +Marketing, business development, rewards and Card Member services expenses increased in 2018 compared to 2017. Card Member rewards expense increased 13 percent, primarily driven by increased spending volumes. Marketing and business development expense increased 18 percent, primarily due to higher spending on growth initiatives and continued investments in partnerships. Card Member services expense increased 29 percent, primarily driven by higher usage of travel-related benefits and the enhanced Platinum card benefits. +Salaries and employee benefits and other operating expense increased in 2018 compared to 2017, primarily driven by increases in payroll costs and higher technology and other servicing-related costs, partially offset by unrealized gains on certain equity investments. +Total expenses increased in 2017 compared to 2016, primarily reflecting the gains on the sales of the HFS portfolios in the prior year, which were recognized as an expense reduction in other expenses, higher Card Member rewards expense resulting from higher spending volumes and increased Card Member services expense resulting from higher usage of travel-related benefits. +Income tax provision decreased in 2018 compared to 2017, primarily reflecting the resolution of certain prior years’ tax audits and the reduction in the U.S. federal statutory tax rate as a result of the Tax Act. +TABLE 10: GCSG SELECTED STATISTICAL INFORMATION +As of or for the Years Ended December 31, +Change +Change +(Millions, except percentages and where indicated) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Proprietary billed business: (billions) +U.S. +$ +371.1 +$ +336.9 +$ +345.2 +10 +% +(2 +)% +Outside the U.S. +140.3 +119.8 +105.9 +17 +13 +Total +$ +511.4 +$ +456.7 +$ +451.1 +12 +1 +Proprietary cards-in-force: +U.S. +37.7 +34.9 +32.7 +8 +7 +Outside the U.S. +16.8 +15.8 +15.1 +6 +5 +Total +54.5 +50.7 +47.8 +7 +6 +Proprietary basic cards-in-force +U.S. +27.0 +25.0 +23.3 +8 +7 +Outside the U.S. +11.6 +10.9 +10.4 +6 +5 +Total +38.6 +35.9 +33.7 +8 +7 +Average proprietary basic Card Member spending (dollars) +U.S. +$ +14,161 +$ +13,950 +$ +13,447 +2 +4 +Outside the U.S. +$ +12,348 +$ +11,225 +$ +10,386 +10 +8 +Average +$ +13,613 +$ +13,115 +$ +12,577 +4 +4 +Total segment assets (billions) (a) +$ +150.7 +$ +123.5 +$ +114.0 +22 +8 +Card Member loans: +Total loans (billions) +U.S. +$ +59.9 +$ +53.7 +$ +48.8 +12 +10 +Outside the U.S. +9.6 +8.6 +6.9 +12 +25 +Total +$ +69.5 +$ +62.3 +$ +55.7 +12 +12 +Average loans (billions) +U.S. +$ +55.1 +$ +49.0 +$ +44.4 +12 +10 +Outside the U.S. +8.9 +7.4 +6.8 +20 +9 +Total +$ +64.0 +$ +56.4 +$ +51.2 +13 +% +10 +% +Lending Credit Metrics: +U.S. +Net write-off rate — principal only (b) +2.1 +% +1.8 +% +1.5 +% +Net write-off rate — principal, interest and fees (b) +2.5 +% +2.1 +% +1.8 +% +30+ days past due as a % of total +1.4 +% +1.3 +% +1.1 +% +Outside the U.S. +Net write-off rate — principal only (b) +2.1 +% +2.1 +% +2.0 +% +Net write-off rate — principal, interest and fees (b) +2.6 +% +2.5 +% +2.5 +% +30+ days past due as a % of total +1.6 +% +1.4 +% +1.6 +% +Total +Net write-off rate — principal only (b) +2.1 +% +1.8 +% +1.6 +% +Net write-off rate — principal, interest and fees (b) +2.5 +% +2.2 +% +1.9 +% +30+ days past due as a % of total +1.5 +% +1.3 +% +1.2 +% +45 +Table of Contents +Change +Change +(Millions, except percentages and where indicated) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Card Member receivables: (billions) +U.S. +$ +13.7 +$ +13.1 +$ +12.3 +5 +% +7 +% +Outside the U.S. +7.8 +7.8 +6.0 +― +30 +Total receivables +$ +21.5 +$ +20.9 +$ +18.3 +3 +% +14 +% +Charge Credit Metrics: +U.S. +Net write-off rate — principal only (b) +1.3 +% +1.3 +% +1.4 +% +Net write-off rate — principal and fees (b) +1.5 +% +1.4 +% +1.6 +% +30+ days past due as a % of total +1.1 +% +1.1 +% +1.2 +% +Outside the U.S. +Net write-off rate — principal only (b) +2.1 +% +2.0 +% +2.0 +% +Net write-off rate — principal and fees (b) +2.3 +% +2.1 +% +2.2 +% +30+ days past due as a % of total +1.3 +% +1.3 +% +1.3 +% +Total +Net write-off rate — principal only (b) +1.6 +% +1.5 +% +1.6 +% +Net write-off rate — principal and fees (b) +1.8 +% +1.7 +% +1.8 +% +30+ days past due as a % of total +1.2 +% +1.2 +% +1.2 +% +(a) +During 2018, we changed the methodology used to allocate certain corporate overhead costs and interest income and expense to the operating segments, and made minor changes to the intercompany settlement process. Prior period amounts have been revised to conform to the current period presentation. +(b) +Refer to Table 7 footnote (b). +46 +Table of Contents +TABLE 11: GCSG NET INTEREST YIELD ON AVERAGE CARD MEMBER LOANS +As of or for the Years Ended December 31, +(Millions, except percentages and where indicated) +2018 +2017 +2016 +U.S. +Net interest income +$ +5,895 +$ +4,961 +$ +4,476 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +202 +164 +133 +Interest income not attributable to our Card Member loan portfolio (b) +(178 +) +(101 +) +(24 +) +Adjusted net interest income (c) +$ +5,919 +$ +5,024 +$ +4,585 +Average Card Member loans including HFS loan portfolios (billions) +$ +55.1 +$ +48.9 +$ +49.4 +Net interest income divided by average Card Member loans (c) +10.7 +% +10.1 +% +9.1 +% +Net interest yield on average Card Member loans (c) +10.7 +% +10.3 +% +9.3 +% +Outside the U.S. +Net interest income +$ +886 +$ +781 +$ +701 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +70 +54 +38 +Interest income not attributable to our Card Member loan portfolio (b) +(8 +) +(8 +) +1 +Adjusted net interest income (c) +$ +948 +$ +827 +$ +740 +Average Card Member loans (billions) +$ +8.9 +$ +7.4 +$ +6.8 +Net interest income divided by average Card Member loans (c) +10.0 +% +10.6 +% +10.3 +% +Net interest yield on average Card Member loans (c) +10.6 +% +11.1 +% +10.9 +% +Total +Net interest income +$ +6,781 +$ +5,742 +$ +5,177 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +272 +218 +171 +Interest income not attributable to our Card Member loan portfolio (b) +(186 +) +(110 +) +(23 +) +Adjusted net interest income (c) +$ +6,867 +$ +5,850 +$ +5,325 +Average Card Member loans including HFS loan portfolios (billions) +$ +64.0 +$ +56.4 +$ +56.2 +Net interest income divided by average Card Member loans (c) +10.6 +% +10.2 +% +9.2 +% +Net interest yield on average Card Member loans (c) +10.7 +% +10.4 +% +9.5 +% +(a) +Refer to Table 8 footnote (a). +(b) +Refer to Table 8 footnote (b). +(c) +Refer to Table 8 footnote (c). +47 +Table of Contents +GLOBAL COMMERCIAL SERVICES +TABLE 12: GCS SELECTED INCOME STATEMENT DATA +Years Ended December 31, +Change +Change +(Millions, except percentages) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Revenues +Non-interest revenues +$ +11,882 +$ +10,942 +$ +10,373 +$ +940 +9 +% +$ +569 +5 +% +Interest income +1,621 +1,361 +1,209 +260 +19 +152 +13 +Interest expense +827 +595 +472 +232 +39 +123 +26 +Net interest income +794 +766 +737 +28 +4 +29 +4 +Total revenues net of interest expense +12,676 +11,708 +11,110 +968 +8 +598 +5 +Provisions for losses +899 +743 +604 +156 +21 +139 +23 +Total revenues net of interest expense after provisions for losses +11,777 +10,965 +10,506 +812 +7 +459 +4 +Expenses +Marketing, business development, rewards and Card Member services +5,853 +5,311 +4,866 +542 +10 +445 +9 +Salaries and employee benefits and other operating expenses +3,029 +2,811 +2,707 +218 +8 +104 +4 +Total expenses +8,882 +8,122 +7,573 +760 +9 +549 +7 +Pretax segment income +2,895 +2,843 +2,933 +52 +2 +(90 +) +(3 +) +Income tax provision +555 +914 +1,032 +(359 +) +(39 +) +(118 +) +(11 +) +Segment income +$ +2,340 +$ +1,929 +$ +1,901 +$ +411 +21 +% +$ +28 +1 +% +Effective tax rate +19.2 +% +32.1 +% +35.2 +% +GCS primarily issues a wide range of proprietary corporate and small business cards and provides payment and expense management services globally. In addition, GCS provides commercial financing products. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues increased in 2018 compared to 2017, reflecting a 9 percent increase in discount revenue, primarily driven by growth in billed business from small and medium sized businesses, partially offset by a decline in the average discount rate. +Net interest income increased in 2018 compared to 2017, primarily driven by an increase in average Card Member loans and higher yields, partially offset by higher interest expense, reflecting an increase in the cost of funds. +Total revenues net of interest expense increased in 2017 compared to 2016, primarily driven by higher discount revenue due to increases in billed business, higher net card fees and higher other fees and commissions, primarily due to growth in the U.S. small business Platinum portfolio and higher delinquency fees, respectively. +PROVISIONS FOR LOSSES +Provisions for losses increased in both periods. The increase in 2018 compared to 2017 was primarily driven by growth in Card Member loans and receivables and the commercial financing portfolio, as well as higher net write-offs across both corporate and small business portfolios. The increase in 2017 compared to 2016 was primarily due to growth in both Card Member receivables and loans, as well as increases in net write-off and delinquency rates, all of which were partially offset by improving credit performance in the commercial financing portfolio. +EXPENSES +Marketing, business development, rewards and Card Member services expenses increased in 2018 compared to 2017, primarily driven by Card Member rewards expense, which increased 9 percent reflecting higher spending volumes, and marketing and business development expense, which increased primarily due to an increase in spending on growth initiatives. +Salaries and employee benefits and other operating expenses increased in 2018 compared to 2017, primarily driven by higher technology and other servicing-related costs. +Total expenses increased in 2017 compared to 2016, primarily driven by increased Card Member rewards expense due to the Platinum rewards enhancements and higher spending volumes, and the prior-year gains on the sales of the HFS portfolios. +Income tax provision decreased in 2018 compared to 2017, primarily reflecting the resolution of certain prior years’ tax audits and the reduction in the U.S. federal statutory tax rate as a result of the Tax Act. +48 +Table of Contents +TABLE 13: GCS SELECTED STATISTICAL INFORMATION +As of or for the Years Ended December 31, +Change +Change +(Millions, except percentages and where indicated) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Proprietary billed business (billions) +$ +486.2 +$ +438.1 +$ +408.0 +11 +% +7 +% +Proprietary cards-in-force +14.5 +14.0 +13.6 +4 +3 +Average Card Member spending (dollars) +$ +34,058 +$ +31,729 +$ +28,515 +7 +11 +Total segment assets (billions) (a) +$ +51.8 +$ +49.1 +$ +43.3 +5 +13 +Card Member loans (billions) +$ +12.4 +$ +11.1 +$ +9.5 +12 +17 +Card Member receivables (billions) +$ +34.4 +$ +33.1 +$ +29.0 +4 +14 +GSBS Card Member loans: (b) +Total loans (billions) +$ +12.4 +$ +11.0 +$ +9.5 +13 +16 +Average loans (billions) +$ +11.7 +$ +10.3 +$ +8.6 +14 +% +20 +% +Net write-off rate - principal only (c) +1.7 +% +1.6 +% +1.4 +% +Net write-off rate - principal, interest and fees (c) +2.0 +% +1.9 +% +1.7 +% +30+ days past due as a % of total +1.3 +% +1.2 +% +1.1 +% +Calculation of Net Interest Yield on Average Card Member Loans: +Net interest income +$ +794 +$ +766 +$ +737 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (d) +609 +461 +380 +Interest income not attributable to our Card Member loan portfolio (e) +(161 +) +(114 +) +(114 +) +Adjusted net interest income (f) +$ +1,242 +$ +1,113 +$ +1,003 +Average Card Member loans including HFS loan portfolios (billions) +$ +11.8 +$ +10.3 +$ +9.7 +Net interest income divided by average Card Member loans (f) +6.7 +% +7.4 +% +7.6 +% +Net interest yield on average Card Member loans (f) +10.5 +% +10.8 +% +10.4 +% +GCP Card Member receivables: +Total receivables (billions) +$ +17.7 +$ +17.0 +$ +14.8 +4 +% +15 +% +90+ days past billing as a % of total (g) +0.7 +% +0.9 +% +0.9 +% +Net loss ratio (as a % of charge volume) (h) +0.11 +% +0.10 +% +0.09 +% +GSBS Card Member receivables: +Total receivables (billions) +$ +16.7 +$ +16.1 +$ +14.3 +4 +% +13 +% +Net write-off rate - principal only (c) +1.7 +% +1.6 +% +1.5 +% +Net write-off rate - principal and fees (c) +2.0 +% +1.8 +% +1.7 +% +30+ days past due as a % of total +1.6 +% +1.6 +% +1.6 +% +(a) +During 2018, we changed the methodology used to allocate certain corporate overhead costs and interest income and expense to the operating segments. Prior period amounts have been revised to conform to the current period presentation. +(b) +Effective July 1, 2017, GSBS loans and associated metrics reflect worldwide small business services loans. Prior to July 1, 2017, due to certain system limitations, small business services loans outside the U.S. and associated credit metrics are reflected within GCSG, and were not significant to either GCSG or GCS. +(c) +Refer to Table 7 footnote (b). +(d) +Refer to Table 8 footnote (a). +(e) +Refer to Table 8 footnote (b). +(f) +Refer to Table 8 footnote (c). +(g) +Refer to Table 7 footnote (c). +(h) +Represents the ratio of GCP charge card write-offs, consisting of principal (resulting from authorized transactions) and fee components, less recoveries, on Card Member receivables expressed as a percentage of gross amounts billed to corporate Card Members. +49 +Table of Contents +GLOBAL MERCHANT AND NETWORK SERVICES +TABLE 14: GMNS SELECTED INCOME STATEMENT AND OTHER DATA +Years Ended December 31, +Change +Change +(Millions, except percentages and where indicated) +2018 +2017 +2016 +2018 vs. 2017 +2017 vs. 2016 +Revenues +Non-interest revenues +$ +6,069 +$ +6,025 +$ +6,093 +$ +44 +1 +% +$ +(68 +) +(1 +)% +Interest income +30 +42 +37 +(12 +) +(29 +) +5 +14 +Interest expense +(294 +) +(188 +) +(133 +) +(106 +) +56 +(55 +) +41 +Net interest income +324 +230 +170 +94 +41 +60 +35 +Total revenues net of interest expense +6,393 +6,255 +6,263 +138 +2 +(8 +) +― +Provisions for losses +22 +16 +24 +6 +38 +(8 +) +(33 +) +Total revenues net of interest expense after provisions for losses +6,371 +6,239 +6,239 +132 +2 +― +― +Expenses +Marketing, business development, rewards and Card Member services +1,250 +1,227 +1,549 +23 +2 +(322 +) +(21 +) +Salaries and employee benefits and other operating expenses +2,277 +2,367 +2,299 +(90 +) +(4 +) +68 +3 +Total expenses +3,527 +3,594 +3,848 +(67 +) +(2 +) +(254 +) +(7 +) +Pretax segment income +2,844 +2,645 +2,391 +199 +8 +254 +11 +Income tax provision +704 +857 +861 +(153 +) +(18 +) +(4 +) +― +Segment income +$ +2,140 +$ +1,788 +$ +1,530 +$ +352 +20 +$ +258 +17 +Effective tax rate +24.8 +% +32.4 +% +36.0 +% +Total segment assets (billions) (a) +$ +44.5 +$ +30.6 +$ +25.9 +$ +13.9 +45 +% +$ +5 +18 +% +(a) +During 2018, we changed the methodology used to allocate certain corporate overhead costs and interest income and expense to the operating segments, and made minor changes to the intercompany settlement process. Prior period amounts have been revised to conform to the current period presentation. +GMNS operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses in certain countries. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues increased in 2018 compared to 2017, primarily driven by an increase in discount revenue, which reflected growth in billed business, partially offset by a decline in the average discount rate and a modification of one of our GNS arrangements. +Net interest income increased in 2018 compared to 2017, reflecting a higher interest expense credit relating to internal transfer pricing and funding rates, which resulted in a net benefit for GMNS due to its merchant payables. +Total revenues net of interest expense was flat in 2017 compared to 2016, primarily driven by a decrease in non-interest revenues reflecting a prior-year contractual payment from a GNS partner, offset by an increase in net interest income reflecting a higher interest expense credit. +EXPENSES +Marketing, business development, rewards and Card Member services expenses increased in 2018 compared to 2017, primarily driven by payments related to a new partnership agreement with our prepaid reloadable and gift card program manager, partially offset by lower levels of spending on growth initiatives. +Salaries and employee benefits and other operating expense decreased in 2018 compared to 2017, primarily driven by prior-year charges related to our U.S. loyalty coalition and prepaid businesses, partially offset by a prior-year benefit from a change in the liability related to non-delivery of goods and services by merchants. +Total expenses decreased in 2017 compared to 2016, primarily driven by lower marketing and business development expenses, reflecting lower levels of spending on growth initiatives, partially offset by an increase in operating expenses reflecting charges related to the US. loyalty coalition and prepaid businesses. +Income tax provision decreased in 2018 compared to 2017, primarily reflecting the resolution of certain prior years’ tax audits and the reduction in the U.S. federal statutory tax rate as a result of the Tax Act. +50 +Table of Contents +CORPORATE & OTHER +Corporate functions and certain other businesses are included in Corporate & Other. +Corporate & Other net expense was $0.6 billion, $3.6 billion and $1.1 billion in 2018, 2017 and 2016, respectively. The decrease in 2018 compared to 2017 was primarily driven by the 2017 Tax Act charge and unrealized gains on certain equity investments, partially offset by a loss on a transaction involving the operations of our prepaid reloadable and gift card business and a foreign exchange loss related to the devaluation of the Argentine peso, which was deemed a highly inflationary currency as of July 1, 2018. The increase in 2017 compared to 2016 was primarily driven by the Tax Act charge, partially offset by higher restructuring charges in 2016 . +51 +Table of Contents +CONSOLIDATED CAPITAL RESOURCES AND LIQUIDITY +Our balance sheet management objectives are to maintain: +• +A solid and flexible equity capital profile; +• +A broad, deep and diverse set of funding sources to finance our assets and meet operating requirements; and +• +Liquidity programs that enable us to continuously meet expected future financing obligations and business requirements for at least a twelve-month period in the event we are unable to continue to raise new funds under our traditional funding programs during a substantial weakening in economic conditions. +CAPITAL STRATEGY +Our objective is to retain sufficient levels of capital generated through earnings and other sources to maintain a solid equity capital base and to provide flexibility to support future business growth. We believe capital allocated to growing businesses with a return on risk-adjusted equity in excess of our costs will generate shareholder value. +The level and composition of our consolidated capital position are determined through our Internal Capital Adequacy Assessment Process, which takes into account our business activities, as well as marketplace conditions and requirements or expectations of credit rating agencies, regulators and shareholders, among others. Our consolidated capital position is also influenced by subsidiary capital requirements. As a bank holding company, we are also subject to regulatory requirements administered by the U.S. federal banking agencies. The Federal Reserve has established specific capital adequacy guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items. +We report our capital ratios using the Basel III capital definitions and the Basel III standardized approach for calculating risk-weighted assets. The Basel III minimum requirements were fully phased in as of January 1, 2018 and the Basel III buffers were fully phased in as of January 1, 2019. +We also report capital adequacy standards on a parallel basis to regulators under Basel requirements for advanced approaches institutions. The parallel period will continue until we receive regulatory approval to exit parallel reporting, at which point we will begin publicly disclosing regulatory risk-based capital ratios using both the standardized and advanced approaches, and will be required to use the lower of the regulatory risk-based capital ratios based on the standardized or advanced approaches to determine whether we are in compliance with minimum capital requirements. As described in Part I, Item 1. "Supervision and Regulation," the Economic Growth, Regulatory Relief, and Consumer Protection Act and related proposed rules may exempt certain banking organizations, such as us, from the advanced approaches requirements. +The following table presents our regulatory risk-based capital ratios and leverage ratios as of December 31, 2018. Effective April 1, 2018, our bank subsidiaries, American Express Centurion Bank and American Express Bank, FSB, were merged to become American Express National Bank (AENB). Refer to Note 23 to the “Consolidated Financial Statements” for additional information. +TABLE 15: REGULATORY RISK-BASED CAPITAL AND LEVERAGE RATIOS +Basel III Standards 2018 (a) +Ratios as of December 31, 2018 +Risk-Based Capital +Common Equity Tier 1 +6.4 +% +American Express Company +11.0 +% +American Express National Bank +12.1 +Tier 1 +7.9 +American Express Company +12.0 +American Express National Bank +12.1 +Total +9.9 +American Express Company +13.6 +American Express National Bank +14.2 +Tier 1 Leverage +4.0 +American Express Company +10.4 +American Express National Bank +9.9 +Supplementary Leverage Ratio +3.0 +% +American Express Company +8.9 +American Express National Bank +8.2 +% +(a) +Basel III minimum capital requirement and additional transitional capital conservation buffer as defined by the Federal Reserve for calendar year 2018 for advanced approaches institutions. +52 +Table of Contents +TABLE 16: REGULATORY RISK-BASED CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS +American Express Company +($ in Billions) +December 31, +2018 +Risk-Based Capital +Common Equity Tier 1 +$ +17.5 +Tier 1 Capital +19.1 +Tier 2 Capital (a) +2.6 +Total Capital +21.7 +Risk-Weighted Assets +158.8 +Average Total Assets to calculate the Tier 1 Leverage Ratio +183.2 +Total Leverage Exposure to calculate supplementary leverage ratio +$ +214.4 +(a) +Tier 2 capital is the sum of the allowance for loan and receivable losses (limited to 1.25 percent of risk-weighted assets) and $600 million of subordinated notes adjusted for capital held by insurance subsidiaries. +We seek to maintain capital levels and ratios in excess of the minimum regulatory requirements and finance such capital in a cost efficient manner; failure to maintain minimum capital levels at American Express or AENB could affect our status as a financial holding company and cause the regulatory agencies with oversight of American Express or AENB to take actions that could limit our business operations. +Our primary source of equity capital has been the generation of net income. Capital generated through net income and other sources, such as the exercise of stock options by employees, is used to maintain a strong balance sheet, support asset growth and engage in acquisitions, with excess available for distribution to shareholders through dividends and share repurchases. We currently expect that the portion of generated capital we allocate to support asset growth will be greater going forward than it has been historically due to projected asset growth. +We maintain certain flexibility to shift capital across our businesses as appropriate. For example, we may infuse additional capital into subsidiaries to maintain capital at targeted levels in consideration of debt ratings and regulatory requirements. These infused amounts can affect the capital profile and liquidity levels at the American Express parent company level. +The following are definitions for our regulatory risk-based capital ratios and leverage ratio, which are calculated as per standard regulatory guidance: +Risk-Weighted Assets — Assets are weighted for risk according to a formula used by the Federal Reserve to conform to capital adequacy guidelines. On- and off-balance sheet items are weighted for risk, with off-balance sheet items converted to balance sheet equivalents, using risk conversion factors, before being allocated a risk-adjusted weight. Off-balance sheet exposures comprise a minimal part of the total risk-weighted assets. +Common Equity Tier 1 Risk-Based Capital Ratio — Calculated as Common Equity Tier 1 capital (CET1), divided by risk-weighted assets. CET1 is the sum of common shareholders’ equity, adjusted for ineligible goodwill and intangible assets, certain deferred tax assets, as well as certain other comprehensive income items as follows: net unrealized gains/losses on securities and derivatives, and net unrealized pension and other postretirement benefit/losses, all net of tax. +Tier 1 Risk-Based Capital Ratio — Calculated as Tier 1 capital divided by risk-weighted assets. Tier 1 capital is the sum of CET1, our perpetual preferred stock and third-party non-controlling interests in consolidated subsidiaries adjusted for capital held by insurance subsidiaries and deferred tax assets from net operating losses not deducted from CET1. The minimum requirement for the Tier 1 risk-based capital ratio is 1.5 percent higher than the minimum for the CET1 risk-based capital ratio. We have $1.6 billion of preferred shares outstanding to help address a portion of the Tier 1 capital requirements in excess of common equity requirements. +Total Risk-Based Capital Ratio — Calculated as the sum of Tier 1 capital and Tier 2 capital, divided by risk-weighted assets. Tier 2 capital is the sum of the allowance for loan and receivable losses (limited to 1.25 percent of risk-weighted assets), a portion of the unrealized gains on equity securities and $600 million of subordinated notes, adjusted for capital held by insurance subsidiaries. +Tier 1 Leverage Ratio — Calculated by dividing Tier 1 capital by our average total consolidated assets for the most recent quarter. +Supplementary Leverage Ratio — Calculated by dividing Tier 1 capital by total leverage exposure under Basel III. Total leverage exposure reflects average total consolidated assets with adjustments for Tier 1 capital deductions, average off-balance sheet derivative exposures, average securities purchased under agreements to resell, and average credit equivalents of conditionally and unconditionally cancellable undrawn commitments. +53 +Table of Contents +In December 2018, federal banking regulators issued a final rule that would provide an optional three-year phase-in period for the day-one adverse regulatory capital effects upon adopting the Current Expected Credit Losses (CECL) model pursuant to new accounting guidance for the recognition of credit losses on financial instruments, effective January 1, 2020. The Federal Reserve also released a statement indicating that it plans to maintain the current framework for calculating credit loss allowances on loans in supervisory stress tests through the 2021 stress test cycle. See Note 1 to our “Consolidated Financial Statements” for further information about CECL. +SHARE REPURCHASES AND DIVIDENDS +We return capital to common shareholders through dividends and share repurchases. The share repurchases reduce common shares outstanding and more than offset the issuance of new shares as part of employee compensation plans. We suspended our share buyback program for the first half of 2018 in order to rebuild our capital levels and ratios pursuant to the 2018 CCAR capital plan process. +During the year ended December 31, 2018, we returned $2.9 billion to our shareholders in the form of common stock dividends of $1.3 billion and share repurchases of $1.6 billion. We repurchased 15 million common shares at an average price of $104.09 in 2018. These dividend and share repurchase amounts collectively represent approximately 41 percent of total capital generated during the year. +In addition, during the year ended December 31, 2018, we paid $80 million in dividends on $1.6 billion of non-cumulative perpetual preferred shares outstanding. For additional information on our preferred shares, refer to Note 17 and Note 22 to the “Consolidated Financial Statements.” +FUNDING STRATEGY +Our principal funding objective is to maintain broad and well-diversified funding sources to allow us to meet our maturing obligations, cost-effectively finance current and future asset growth in our global businesses, as well as to maintain a strong liquidity profile. The diversity of funding sources by type of instrument, by maturity and by investor base, among other factors, provides additional insulation from the impact of disruptions in any one type of instrument, maturity or investor. The mix of our funding in any period will seek to achieve cost efficiency consistent with both maintaining diversified sources and achieving our liquidity objectives. While we diversify our funding sources by maintaining scale and relevance in unsecured debt, asset securitizations and deposits, we currently expect that the Personal Savings High Yield Savings Account program will become a larger proportion of our funding over time. Our funding strategy and activities are integrated into our asset-liability management activities. We have in place a funding policy covering American Express Company and all of our subsidiaries. +Our proprietary card businesses are the primary asset-generating businesses, with significant assets in both domestic and international Card Member lending and receivable activities. Our financing needs are in large part a consequence of our proprietary card-issuing businesses, and the maintenance of a liquidity position to support all of our business activities, such as merchant payments. We generally pay merchants for card transactions prior to reimbursement by Card Members and therefore fund the merchant payments during the period Card Member loans and receivables are outstanding. We also have additional financing needs associated with general corporate purposes. +FUNDING PROGRAMS AND ACTIVITIES +We meet our funding needs through a variety of sources, including direct and third-party distributed deposits and debt instruments, such as senior unsecured debentures, asset securitizations, borrowings through secured borrowing facilities and a long-term committed bank borrowing facility. +We had the following consolidated debt and customer deposits outstanding as of December 31: +TABLE 17: SUMMARY OF CONSOLIDATED DEBT AND CUSTOMER DEPOSITS +(Billions) +2018 +2017 +Short-term borrowings +$ +3.1 +$ +3.3 +Long-term debt +58.4 +55.8 +Total debt +61.5 +59.1 +Customer deposits +70.0 +64.5 +Total debt and customer deposits +$ +131.5 +$ +123.6 +54 +Table of Contents +We may redeem from time to time certain debt securities within 31 days prior to the original contractual maturity dates in accordance with the optional redemption provisions of those debt securities. +Our funding plan for the full year 2019 includes, among other sources, approximately $6 billion to $13 billion of unsecured term debt issuance and approximately $4 billion to $11 billion of secured term debt issuance. Our funding plans are subject to various risks and uncertainties, such as future business growth, the impact of global economic, political and other events on market capacity, demand for securities offered by us, regulatory changes, ability to securitize and sell receivables, and the performance of receivables previously sold in securitization transactions. Many of these risks and uncertainties are beyond our control. +Our equity capital and funding strategies are designed, among other things, to maintain appropriate and stable unsecured debt ratings from the major credit rating agencies: Moody’s Investor Services (Moody’s), Standard & Poor’s (S&P) and Fitch Ratings (Fitch). Such ratings help support our access to cost-effective unsecured funding as part of our overall funding strategy. Our asset securitization activities are rated separately. +TABLE 18: UNSECURED DEBT RATINGS +Credit Agency +American Express Entity +Short-Term Ratings +Long-Term Ratings +Outlook +Fitch +All rated entities +F1 +A +Stable +Moody’s +TRS and rated operating subsidiaries (a) +Prime-1 +A2 +Stable +Moody's +American Express Company +Prime-2 +A3 +Stable +S&P +TRS (a) +N/A +A- +Stable +S&P +Other rated operating subsidiaries +A-2 +A- +Stable +S&P +American Express Company +A-2 +BBB+ +Stable +(a) +American Express Travel Related Services Company, Inc. +Downgrades in the ratings of our unsecured debt or asset securitization program securities could result in higher funding costs, as well as higher fees related to borrowings under our unused lines of credit. Declines in credit ratings could also reduce our borrowing capacity in the unsecured debt and asset securitization capital markets. We believe our funding mix, including the proportion of U.S. retail deposits insured by the Federal Deposit Insurance Corporation (FDIC), should reduce the impact that credit rating downgrades would have on our funding capacity and costs. +SHORT-TERM FUNDING PROGRAMS +Short-term borrowings, such as commercial paper, are defined as any debt with an original maturity of twelve months or less, as well as interest-bearing overdrafts with banks. Our short-term funding programs are used primarily to meet working capital needs, such as managing seasonal variations in receivables balances. The amount of short-term borrowings issued in the future will depend on our funding strategy, our needs and market conditions. As of December 31, 2018, we had $0.8 billion in commercial paper outstanding and we had an average of $0.23 billion in commercial paper outstanding during 2018. Refer to Note 9 to the “Consolidated Financial Statements” for a further description of these borrowings. +DEPOSIT PROGRAMS +We offer deposits within our U.S. bank subsidiary, AENB. These funds are currently insured up to $250,000 per account holder through the FDIC. Our ability to obtain deposit funding and offer competitive interest rates is dependent on the capital level of AENB. We, through AENB, have a direct retail deposit program, American Express Personal Savings, which is our primary deposit product channel. The direct retail program makes FDIC-insured certificates of deposit (CDs) and high-yield savings account products available directly to consumers. We also source deposits through third-party distribution channels as needed to meet our overall funding objectives. As of December 31, 2018 we had $70.0 billion in customer deposits. Refer to Note 8 to the “Consolidated Financial Statements” for a further description of these deposits. +LONG-TERM DEBT AND ASSET SECURITIZATION PROGRAMS +As of December 31, 2018, we had $58.4 billion in long-term debt outstanding. During 2018, we and our subsidiaries issued $15.9 billion of unsecured debt and asset-backed securities with maturities ranging from 2 to 7 years. Refer to Note 9 to the “Consolidated Financial Statements” for a further description of these borrowings. +We periodically securitize Card Member loans and receivables arising from our card business, as the securitization market provides us with cost-effective funding. Securitization of Card Member loans and receivables is accomplished through the transfer of those assets to a trust, which in turn issues securities collateralized by the transferred assets to third-party investors. The proceeds from issuance are distributed to us, through our wholly-owned subsidiaries, as consideration for the transferred assets. Refer to Note 6 to the “Consolidated Financial Statements” for a further description of these borrowings. +55 +Table of Contents +Our 2018 long-term debt and asset securitization issuances were as follows: +TABLE 19: DEBT ISSUANCES +(Billions) +2018 +American Express Company: +Fixed Rate Senior Notes (weighted-average coupon of 3.63%) +$ +6.6 +Floating Rate Senior Notes (3-month LIBOR plus 61 basis points) +2.7 +American Express Credit Account Master Trust: +Fixed Rate Class A Certificates (weighted-average coupon of 2.97%) +4.4 +Fixed Rate Class B Certificates (weighted-average coupon of 3.35%) +― +Floating Rate Class A Certificates (1-month LIBOR plus 35 basis points) +2.1 +Floating Rate Class B Certificates (1-month LIBOR plus 57 basis points) +0.1 +Total +$ +15.9 +LIQUIDITY MANAGEMENT +Our liquidity objective is to maintain access to a diverse set of on- and off-balance sheet liquidity sources. We seek to maintain liquidity sources in amounts sufficient to meet our expected future financial obligations and business requirements for liquidity for a period of at least twelve months in the event we are unable to raise new funds under our regular funding programs during a substantial weakening in economic conditions. +Our liquidity management strategy includes a number of elements, including, but not limited to: + +Maintaining diversified funding sources (refer to the “Funding Strategy” section for more details); + +Maintaining unencumbered liquid assets and off-balance sheet liquidity sources; + +Projecting cash inflows and outflows under a variety of economic and market scenarios; + +Establishing clear objectives for liquidity risk management, including compliance with regulatory requirements; and + +Incorporating liquidity risk management as appropriate into our capital adequacy framework. +We seek to maintain access to a diverse set of on-balance sheet and off-balance sheet liquidity sources, including cash and other liquid assets, committed bank credit facilities and asset securitization conduit facilities. Through our U.S. bank subsidiary, AENB, we also hold collateral eligible for use at the Federal Reserve’s discount window. +The amount and type of liquidity resources we maintain can vary over time, based upon the results of stress scenarios required under Dodd Frank and other various regulatory liquidity requirements, such as the Liquidity Coverage Ratio , as well as additional stress scenarios required under our liquidity risk policy. These stress scenarios possess distinct characteristics, varying by cash flow assumptions, time horizon and qualifying liquidity sources, among other factors. Scenarios under our liquidity risk policy include market-wide, firm-specific and combined liquidity stresses. The LCR rule prescribes cash flow assumptions over a 30-day period and establishes qualifying criteria for high-quality liquid assets. We consider other factors in determining the amount and type of liquidity we maintain, such as economic and financial market conditions, seasonality in business operations, growth in our businesses, potential acquisitions or dispositions, the cost and availability of alternative liquidity sources and credit rating agency guidelines and requirements. +The investment income we receive on liquidity resources is less than the interest expense on the sources of funding for these balances. The net interest costs to maintain these resources have been substantial. The level of future net interest costs depends on the amount of liquidity resources we maintain and the difference between our cost of funding these amounts and their investment yields. +Securitized Borrowing Capacity +As of December 31, 2018, we maintained our committed, revolving, secured borrowing facility, with a maturity date of July 15, 2020, which gives us the right to sell up to $3.0 billion face amount of eligible AAA notes from the American Express Issuance Trust II (the Charge Trust). We also maintained our committed, revolving, secured borrowing facility, with a maturity date of September 15, 2020, which gives us the right to sell up to $2.0 billion face amount of eligible AAA certificates from the American Express Credit Account Master Trust (the Lending Trust). Both facilities are used in the ordinary course of business to fund seasonal working capital needs, as well as to further enhance our contingent funding resources. As of December 31, 2018, $1.5 billion was drawn on the Charge Trust facility, which was subsequently repaid on January 15, 2019. No amounts were drawn on the Lending Trust facility. +56 +Table of Contents +Federal Reserve Discount Window +As an insured depository institution, AENB may borrow from the Federal Reserve Bank of San Francisco, subject to the amount of qualifying collateral that it may pledge. The Federal Reserve has indicated that both credit and charge card receivables are a form of qualifying collateral for secured borrowings made through the discount window. Whether specific assets will be considered qualifying collateral and the amount that may be borrowed against the collateral, remain at the discretion of the Federal Reserve. +We had approximately $70.5 billion as of December 31, 2018 in U.S. credit card loans and charge card receivables that could be sold over time through our securitization trusts or pledged in return for secured borrowings to provide further liquidity, subject in each case to applicable market conditions and eligibility criteria. +Committed Bank Credit Facility +In addition to the secured borrowing facilities described above, we maintained a committed syndicated bank credit facility as of December 31, 2018 of $3.5 billion, with a maturity date of October 16, 2020. The availability of this credit line is subject to our compliance with certain financial covenants, principally the maintenance by American Express Credit Corporation (Credco) of a certain ratio of combined earnings and fixed charges to fixed charges. As of December 31, 2018, we were in compliance with each of our covenants. As of December 31, 2018, no amounts were drawn on the committed credit facility. The capacity of the facility mainly served to further enhance our contingent funding resources. +Our committed bank credit facility does not contain a material adverse change clause, which might otherwise preclude borrowing under the credit facility, nor is it dependent on our credit rating. +CASH FLOWS +The following table summarizes our cash flow activity, followed by a discussion of the major drivers impacting operating, investing and financing cash flows. +TABLE 20: CASH FLOWS +(Billions) +2018 +2017 +2016 +Total cash provided by (used in): +Operating activities +$ +8.9 +$ +13.5 +$ +8.3 +Investing activities +(19.6 +) +(18.2 +) +1.8 +Financing activities +5.1 +12.2 +(7.6 +) +Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash +0.1 +0.3 +(0.2 +) +Net (decrease) increase in cash, cash equivalents and restricted cash +$ +(5.5 +) +$ +7.8 +$ +2.3 +Cash Flows from Operating Activities +Our cash flows from operating activities primarily include net income adjusted for (i) non-cash items included in net income, such as provisions for losses, depreciation and amortization, deferred taxes and stock-based compensation and (ii) changes in the balances of operating assets and liabilities, which can vary significantly in the normal course of business due to the amount and timing of payments. +The decrease in net cash provided by operating activities was driven by the amount and timing of payments of accounts payable and other liabilities, partially offset by an increase in net income from normal business operations. +Cash Flows from Investing Activities +Our cash flows from investing activities primarily include changes in Card Member receivables and loans, as well as changes in our available-for-sale investment securities portfolio. +The increase in net cash used in investing activities was driven by a larger net increase in the investment securities portfolio, partially offset by less growth in Card Member receivables and loans. +Cash Flows from Financing Activities +Our cash flows from financing activities primarily include changes in customer deposits, long-term debt and short-term borrowings, as well as dividend payments and share repurchases. +The decrease in net cash provided by financing activities was primarily driven by a lower increase in customer deposits and long-term debt, partially offset by a lower level of share repurchases. +57 +Table of Contents +OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS +We have identified both on- and off-balance sheet transactions, arrangements, obligations and other relationships that may have a material current or future effect on our financial condition, changes in financial condition, results of operations, or liquidity and capital resources. +CONTRACTUAL OBLIGATIONS +The table below identifies transactions that represent our contractually committed future obligations. Purchase obligations include our agreements to purchase goods and services that are enforceable and legally binding and that specify significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. +TABLE 21: COMMITTED FUTURE OBLIGATIONS BY YEAR +Payments due by year (a) +(Millions) +2019 +2020-2021 +2022-2023 +2024 and thereafter +Total +Long-term debt +$ +11,315 +$ +27,342 +$ +14,611 +$ +6,284 +$ +59,552 +Interest payments on long-term debt (b) +1,661 +2,157 +1,002 +1,450 +6,270 +Certificates of deposit +4,748 +6,159 +2,595 +― +13,502 +Other long-term liabilities (c) (d) +295 +61 +6 +17 +379 +Operating lease obligations +140 +213 +143 +832 +1,328 +Purchase obligations (e) +384 +310 +26 +4 +724 +Deemed repatriation tax (f) +148 +268 +268 +1,005 +1,689 +Total +$ +18,691 +$ +36,510 +$ +18,651 +$ +9,592 +$ +83,444 +(a) +The table above excludes approximately $0.7 billion of tax liabilities related to the uncertainty in income taxes as inherent complexities and the number of tax years currently open for examination in multiple jurisdictions do not permit reasonable estimates of payments, if any, to be made over a range of years. Refer to Note 21 to the “Consolidated Financial Statements” for additional information. +(b) +Estimated interest payments were calculated using the effective interest rates as of December 31, 2018, and includes the effect of existing interest rate swaps. Actual cash flows may differ from estimated payments. +(c) +As of December 31, 2018, there were no minimum required contributions, and no contributions are currently planned, for the U.S. American Express Retirement Plan. For the U.S. American Express Retirement Restoration Plan and non-U.S. defined benefit pension and postretirement benefit plans, contributions in 2019 are anticipated to be approximately $46 million, and this amount has been included within other long-term liabilities. Remaining obligations under defined benefit pension and postretirement benefit plans aggregating $517 million have not been included in the table above as the timing of such obligations is not determinable. Additionally, other long-term liabilities do not include $8.4 billion of Membership Rewards liabilities, which are not considered long-term liabilities as Card Members in good standing can redeem points immediately, without restrictions, and because the timing of point redemption is not determinable. +(d) +As of December 31, 2018, we had committed to provide funding related to certain tax credit investments resulting in a $237 million unfunded commitment included in other long-term liabilities. In addition to this amount, there was a further $59 million of contractual off-balance sheet obligations that have not been included in the table above as the timing of such obligations is not determinable. Refer to Note 7 to the “Consolidated Financial Statements” for additional information. +(e) +The purchase obligation amounts represent either the early termination fees or non-cancelable minimum contractual obligations, as applicable, by period under contracts that were in effect as of December 31, 2018. +(f) +Represents our estimated obligation under the Tax Act to pay the deemed repatriation tax on certain non-US earnings over eight years. Refer to Note 21 to the “Consolidated Financial Statements” for additional information. +In addition to the contractual obligations noted in Table 21, we have financial commitments related to agreements with certain cobrand partners under which we are required to make a certain level of minimum payments over the life of the agreement, generally ranging from five to eight years. We make payments to such cobrand partners primarily based on Card Members' spending and earning rewards on their cobrand cards and as we acquire new Card Members. In the event these payments do not fully satisfy the commitment, we will pay the cobrand partner up to the amount of the commitment in exchange for an equivalent value of reward points. As of December 31, 2018, we had $5.0 billion in such commitments outstanding. +We also have off-balance sheet arrangements that include guarantees, indemnifications and certain other off-balance sheet arrangements. +GUARANTEES +As of December 31, 2018, we had guarantees and indemnifications totaling approximately $1 billion related primarily to real estate and business dispositions in the ordinary course of business. Refer to Note 16 to the “Consolidated Financial Statements” for further discussion regarding our guarantees. +58 +Table of Contents +CERTAIN OTHER OFF-BALANCE SHEET ARRANGEMENTS +As of December 31, 2018, we had approximately $302 billion of unused credit outstanding as part of established lending product agreements. Total unused credit does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no pre-set limit, and therefore are not reflected in unused credit available to Card Members. +We provide Card Member protection plans that cover losses associated with purchased products. The maximum potential liability related to these plans is the portion of annual billed business for which timely and valid disputes may be raised under applicable law and relevant customer agreements. However, based on historical experience, we believe that this total amount is not representative of our actual potential loss exposure. The actual amount of the potential exposure cannot be quantified as the billed business volumes which may include or result in claims under these plans are not sufficiently estimable. Losses related to these protection plans were immaterial for the years ended December 31, 2018, 2017 and 2016. +Refer to Notes 7 and 13 to the “Consolidated Financial Statements” for discussion regarding our other off-balance sheet arrangements. +RISK MANAGEMENT +GOVERNANCE +We use our comprehensive Enterprise-wide Risk Management (ERM) program to identify, aggregate, monitor, and manage risks. The program also defines our risk appetite, governance, culture and capabilities. The implementation and execution of the ERM program is headed by our Chief Risk Officer. +Risk management is overseen by our Board of Directors through three Board committees: the Risk Committee, the Audit and Compliance Committee, and the Compensation and Benefits Committee. Each committee consists entirely of independent directors and provides regular reports to the full Board regarding matters reviewed at their committee. The committees meet regularly in private sessions with our Chief Risk Officer, the Chief Compliance & Ethics Officer, the Chief Audit Executive and other senior management with regard to our risk management processes, controls, talent and capabilities. The Board monitors the “tone at the top,” our risk culture, and oversees emerging and strategic risks. +The Risk Committee of our Board of Directors provides oversight of our enterprise-wide risk management framework, processes and methodologies. The Risk Committee approves our ERM policy. The ERM policy governs risk governance, risk oversight and risk appetite for risks, including individual credit risk, institutional credit risk, market risk, liquidity risk, operational risk, reputational risk, compliance risk, model risk, asset/liability risk and strategic and business risk. Risk appetite defines the authorized risk limits to control exposures within our risk capacity and risk tolerance, including stressed forward-looking scenarios. In addition, it establishes principles for risk taking in the aggregate and for each risk type, and is supported by a comprehensive system for monitoring limits, escalation triggers and assessing control programs. +The Risk Committee reviews and concurs in the appointment, replacement, performance and compensation of our Chief Risk Officer and receives regular updates from the Chief Risk Officer on key risks, transactions and exposures. +The Risk Committee reviews our risk profile against the tolerances specified in the Risk Appetite Framework, including significant risk exposures, risk trends in our portfolios and major risk concentrations. +The Risk Committee also provides oversight of our compliance with Basel capital and liquidity standards, our Internal Capital Adequacy Assessment Process, including its Comprehensive Capital Analysis and Review (CCAR) submissions, and resolution planning. +The Audit and Compliance Committee of our Board of Directors reviews and approves compliance policies, which include our Compliance Risk Tolerance Statement. In addition, the Audit and Compliance Committee reviews the effectiveness of our Corporate-wide Compliance Risk Management Program. More broadly, this committee is responsible for assisting the Board in its oversight responsibilities relating to the integrity of our financial statements and financial reporting process, internal and external auditing, including the qualifications and independence of the independent registered public accounting firm and the performance of our internal audit services function, and the integrity of our systems of internal controls. +The Audit and Compliance Committee provides oversight of our Internal Audit Group. The Audit and Compliance Committee reviews and concurs in the appointment, replacement, performance and compensation of our Chief Audit Executive and approves Internal Audit’s annual audit plan, charter, policies and budget. The Audit and Compliance Committee also receives regular updates on the audit plan’s status and results including significant reports issued by Internal Audit and the status of our corrective actions. +59 +Table of Contents +The Compensation and Benefits Committee of our Board of Directors works with the Chief Risk Officer to ensure our overall compensation programs, as well as those covering our risk-taking employees, appropriately balance risk with business incentives and how business performance is achieved without taking imprudent or excessive risk. Our Chief Risk Officer is actively involved in setting goals. Our Chief Risk Officer also reviews the current and forward-looking risk profiles of each business unit, and provides input into performance evaluation. The Chief Risk Officer meets with the Compensation and Benefits Committee and attests whether performance goals and results have been achieved without taking imprudent risks. The Compensation and Benefits Committee uses a risk-balanced incentive compensation framework to decide on our bonus pools and the compensation of senior executives. +There are several internal management committees, including the Enterprise-wide Risk Management Committee (ERMC), chaired by our Chief Risk Officer. The ERMC is the highest-level management committee to oversee all firm-wide risks and is responsible for risk governance, risk oversight and risk appetite. It maintains the enterprise-wide risk appetite framework and monitors compliance with limits and escalations defined in it. The ERMC oversees implementation of risk policies company-wide. The ERMC reviews key risk exposures, trends and concentrations, significant compliance matters, and provides guidance on the steps to monitor, control and report major risks. +As defined in the ERM policy, we follow the “three lines of defense” approach to risk management. The first line of defense comprises functions and management committees directly initiating risk taking. Business unit presidents, our Chief Credit Officer, Chief Market Risk Officer and Functional Risk Officer are part of the first line of defense. The second line comprises independent functions overseeing risk-taking activities of the first line. The Chief Risk Officer, the Chief Compliance & Ethics Officer, the Chief Operational Risk Officer and certain control groups, both at the enterprise level and within regulated entities, are part of the second line of defense. The global risk oversight team oversees the policies, strategies, frameworks, models, processes and capabilities deployed by the first line teams and provides challenges and independent assessments on how the first line of defense is managing risks. In addition, the Asset Liability Committee, chaired by our Chief Financial Officer, is responsible for managing market, liquidity and asset/liability risk, capital and resolution planning. +Our Internal Audit Group constitutes the third line of defense, and provides independent assessments and effective challenge of the first and second lines of defense. +CREDIT RISK MANAGEMENT PROCESS +Credit risk is defined as loss due to obligor or counterparty default or changes in the credit quality of a counterparty or security. Our credit risks are divided into two broad categories: individual and institutional. Each has distinct risk management capabilities, strategies, and tools. Business units that create individual or institutional credit risk exposures of significant importance are supported by dedicated risk management teams, each led by a Chief Credit Officer. +INDIVIDUAL CREDIT RISK +Individual credit risk arises from consumer and small business charge cards, credit cards, lines of credit, and term loans. These portfolios consist of millions of customers across multiple geographies, industries and levels of net worth. We benefit from the high-quality profile of our customers, which is driven by our brand, premium customer servicing, product features and risk management capabilities, which span underwriting, customer management and collections. Externally, the risk in these portfolios is generally correlated to broad economic trends, such as unemployment rates and gross domestic product (GDP) growth. +The business unit leaders and their Chief Credit Officers take the lead in managing the credit risk process. These Chief Credit Officers are guided by the Individual Credit Risk Committee (ICRC), which is responsible for implementation and enforcement of the Individual Credit Risk Management Policy. The ICRC ensures compliance with ERMC guidelines and procedures and escalates to the ERMC as appropriate. The Individual Credit Risk Management Policy is further supported by subordinate policies and operating manuals covering decision logic and processes of credit extension, including prospecting, new account approvals, point-of-sale authorizations, credit line management and collections. The subordinate risk policies and operating manuals are designed to ensure consistent application of risk management principles and standardized reporting of asset quality and loss recognition. +Credit risk management is supported by sophisticated proprietary scoring and decision-making models that use up-to-date information on prospects and customers, such as spending and payment history and data feeds from credit bureaus. We have developed data-driven economic decision logic for customer interactions to better serve our customers. +INSTITUTIONAL CREDIT RISK +Institutional credit risk arises principally within our GCS, GMS, GNS and Foreign Exchange Services businesses, as well as investment and liquidity management activities. Unlike individual credit risk, institutional credit risk is characterized by a lower loss frequency but higher severity. It is affected both by general economic conditions and by client-specific events. The absence of large losses in any given year or over several years is not necessarily representative of the level of risk of institutional portfolios, given the infrequency of loss events in such portfolios. +60 +Table of Contents +Similar to Individual Credit Risk, business units taking institutional credit risks are supported by Chief Credit Officers. These officers are guided by the Institutional Risk Management Committee (IRMC), which is responsible for implementation and enforcement of the Institutional Credit Risk Management Policy and for providing guidance to the credit officers of each business unit with substantial institutional credit risk exposures. The committee, along with the business unit Chief Credit Officers, makes investment decisions in core risk capabilities, ensures proper implementation of the underwriting standards and contractual rights for risk mitigation, monitors risk exposures, and determines risk mitigation actions. The IRMC formally reviews large institutional risk exposures to ensure compliance with ERMC guidelines and procedures and escalates them to the ERMC as appropriate. At the same time, the IRMC provides guidance to the business unit risk management teams to optimize risk-adjusted returns on capital. A centralized risk rating unit provides risk assessment of our institutional obligors. +Exposure to the Airline and Travel Industry +We have multiple important cobrand, rewards, merchant acceptance and corporate payments arrangements with airlines. The ERM program evaluates the risks posed by our airline partners and the overall airline strategy companywide through comprehensive business analysis of global airlines, and the travel industry more broadly, including cruise lines, travel agencies and tour operators. Our largest airline partner is Delta, and this relationship includes exclusive cobrand credit card partnerships and other arrangements including Membership Rewards redemption, merchant acceptance, travel and corporate payments. See "We face intense competition for partner relationships, which could result in a loss or renegotiation of these arrangements that could have a material adverse impact on our business and results of operations" under “Risk Factors” for additional information. +Debt Exposure +As part of our ongoing risk management process, we monitor our financial exposure to both sovereign and non-sovereign customers and counterparties, and measure and manage concentrations of risk by geographic regions, as well as by economic sectors and industries. A primary focus area for monitoring is credit deterioration due to weaknesses in economic and fiscal profiles. We evaluate countries based on the market assessment of the riskiness of their sovereign debt and our assessment of the economic and financial outlook and closely monitor those deemed high risk. As of December 31, 2018, we considered our gross credit exposures to government entities, financial institutions and corporations in those countries deemed high risk to be individually and collectively not material. +OPERATIONAL RISK MANAGEMENT PROCESS +We define operational risk as the risk of not achieving business objectives due to inadequate or failed processes, people, or information systems, or the external environment, including failures to comply with laws and regulations. Operational risk is inherent in all business activities and can impact an organization through direct or indirect financial loss, brand damage, customer dissatisfaction, or legal and regulatory penalties. +To appropriately measure and manage operational risk, we have implemented a comprehensive operational risk framework that is defined in the Operational Risk Management Policy approved by the Risk Committee. The Operational Risk Management Committee (ORMC), chaired by the Chief Operational Risk Officer, coordinates with all control groups on effective risk assessments and controls and oversees the preventive, responsive and mitigation efforts by Operational Excellence teams in the business units and staff groups. +We use the operational risk framework to identify, measure, monitor and report inherent and emerging operational risks. This framework, supervised by the ORMC, consists of (a) operational risk event capture, (b) a project office to coordinate issue management and control enhancements, (c) key risk indicators, and (d) process and entity-level risk assessments. +The framework requires the assessment of operational risk events to determine root causes, impact to customers and/or us, and resolution plan accountability to correct any defect, remediate customers, and enhance controls and testing to mitigate future issues. The impact is assessed from an operational, financial, brand, regulatory compliance and legal perspective. +INFORMATION AND CYBER SECURITY +We have implemented an Information Security Program and Operating Model that is designed to protect the confidentiality, integrity and availability of information and information systems from unauthorized access, use, disclosure, disruption, modification or destruction. +Our Information Security Program and Operating Model are based on the National Institute of Standards and Technology (NIST) Cybersecurity Common Standards Framework, which consist of controls designed to identify, protect, detect, respond and recover from information and cyber security incidents. The framework defines risks and associated controls which are embedded in our processes and technology. Those controls are measured and monitored by a combination of subject matter experts and a security operations center with our integrated cyber detection, response and recovery capabilities. +Chaired by the Chief Information Security Officer, our Information Security Risk Management Committee, a sub-committee of the ORMC, provides governance for our information security risk management program. The Information Security and Technology Oversight team provides independent challenge and assessment of the information, cyber security and technology risk management programs. +See “A major information or cyber security incident or an increase in fraudulent activity could lead to reputational damage to our brand and significant legal, regulatory and financial exposure, and could reduce the use and acceptance of our charge and credit cards” under “Risk Factors” for additional information. +61 +Table of Contents +PRIVACY AND DATA GOVERNANCE +Our Privacy Framework and Operating Model follow a similar structure. Chaired by the Chief Privacy Officer, our Privacy Risk Management Committee, a sub-committee of the ORMC, provides oversight and governance for our privacy program. The committee is responsible for the governance over the collection, notice, use, sharing, transfer, confidentiality and retention of personal data. +Our Enterprise Data Governance Framework and Policy defines governance requirements for data used in critical processes. +COMPLIANCE RISK MANAGEMENT PROCESS +We define compliance risk as the risk of legal or reputational harm, fines, monetary penalties and payment of damages or other forms of sanction as a result of non-compliance with applicable laws, regulations, rules or standards of conduct. +We view our ability to effectively mitigate compliance risk as an important aspect of our business model. Our Global Compliance and Ethics organization is responsible for establishing and maintaining our corporate-wide Compliance Risk Management Program. Pursuant to this program, we seek to manage and mitigate compliance risk by assessing, controlling, monitoring, measuring and reporting the legal and regulatory risks to which we are exposed. The Compliance Risk Management Committee (CRMC), chaired by the Chief Compliance and Ethics Officer, is responsible for identifying, evaluating, managing, and escalating compliance risks. The CRMC has a dual reporting relationship directly to both the ERMC and the Audit and Compliance Committee. +We have a comprehensive Anti-Money Laundering program that monitors and reports suspicious activity to the appropriate government authorities. As part of that program, the Global Risk Oversight team provides independent risk assessment of the rules used by the Anti-Money Laundering team. In addition, the Internal Audit Group reviews the processes for practices consistent with regulatory guidance. +REPUTATIONAL RISK MANAGEMENT PROCESS +We define reputational risk as the risk that negative stakeholder reaction to our products, services, client and partner relationships, business activities and policies, management and workplace culture, or our response to unexpected events, could cause sustained, critical media coverage, a decline in revenue or investment, talent attrition, litigation, or government or regulatory scrutiny . +We view protecting our reputation for excellent customer service, trust, security and high integrity as core to our vision of providing the world’s best customer experience and fundamental to our long-term success. +Our business leaders are responsible for considering the reputational risk implications of business activities and strategies and ensuring the relevant subject matter experts are engaged as needed. The ERMC is responsible for ensuring reputational risk considerations are included in the scope of appropriate subordinate risk policies and committees and properly reflected in all decisions escalated to the ERMC. +MARKET RISK MANAGEMENT PROCESS +Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. Our market risk exposures include interest rate risk and foreign exchange risk. Interest rate risk is driven by the relationship between interest rates on assets (such as loans, receivables and investment securities) and interest rates on liabilities (such as debt and deposits). Foreign exchange risk arises from transactions, funding, investments and earnings in currencies other than the U.S. dollar. +Our Asset-Liability Management (ALM) and Market Risk policies establish the framework that guides and governs market risk management, including quantitative limits and escalation triggers. These policies are approved by the Risk Committee of the Board of Directors or Market Risk Management Committee. +Market risk is managed by the Market Risk Management Committee. The Market Risk Oversight Officer provides an independent risk assessment and oversight over the policies and exposure management for market risk and ALM activities, as well as overseeing compliance with the Volcker Rule and other regulatory requirements. Market risk management is also guided and governed by policies covering the use of derivative financial instruments, funding, liquidity and investments. +We analyze a variety of interest rate scenarios to inform us of the potential impacts from interest rate changes on earnings and the value of assets, liabilities and the economic value of equity. Our interest rate exposure can vary over time as a result of, among other things, the proportion of our total funding provided by variable-and fixed-rate debt and deposits compared to our Card Member loans and receivables. Interest rate swaps are used from time to time to effectively convert debt issuances to (or from) variable-rate, from (or to) fixed-rate. We do not engage in derivative financial instruments for trading purposes other than with respect to our Foreign Exchange International Payments business activities. Refer to Note 14 to the “Consolidated Financial Statements” for further discussion of our derivative financial instruments. +62 +Table of Contents +As of December 31, 2018, a hypothetical, immediate 100 basis point increase in market interest rates would have a detrimental effect on our annual net interest income of approximately $177 million. This measure first projects net interest income over the following twelve-month time horizon considering forecasted business growth and anticipated future market interest rates. The detrimental impact from a rate increase is then measured by instantaneously increasing the anticipated future interest rates by 100 basis points. It is further assumed that our interest-rate sensitive assets and the majority of our liabilities that reprice within the twelve-month horizon generally reprice by 100 basis points. Our estimated repricing risk assumes that certain deposit liabilities reprice at a lower magnitude than benchmark rate movements consistent with historical deposit repricing experience in the industry and within our own portfolio. Actual changes in our net interest income will depend on many factors, and therefore may differ from our estimated risk to changes in market interest rates. +In addition to parallel rate changes, our net interest income is subject to changes in the relationship between market benchmark rates. For example, movements in Prime rate change the yield on a large portion of our variable-rate U.S. lending receivables and loans, while LIBOR rates determine the effective interest rate on a significant portion of our outstanding funding. Differences in the rate of change of these two benchmark indices, commonly referred to as basis risk, would thus impact our net interest income. The detrimental effect on our net interest income of a hypothetical 10 basis point decrease in the spread between Prime and LIBOR over the next twelve months is estimated to be $27 million. We currently have approximately $45 billion of Prime-based, variable-rate U.S. lending receivables and loans and $27 billion of LIBOR-indexed debt, including asset securitizations. The replacement of LIBOR as a benchmark rate can have a further detrimental impact on our LIBOR-indexed debt if rates suddenly rise as new market activity transfers to other benchmark curves, such as the Secured Overnight Financing Rate. +Foreign exchange exposures arise in four principal ways: 1) Card Member spending in currencies that are not the billing currency, 2) cross-currency transactions and balances from our funding activities, 3) cross-currency investing activities, such as in the equity of foreign subsidiaries, and 4) revenues generated and expenses incurred in foreign currencies, which impact earnings. +These foreign exchange risks are managed primarily by entering into foreign exchange spot transactions or hedged with foreign exchange forward contracts when the hedge costs are economically justified and in notional amounts designed to offset pretax impacts from currency movements in the period in which they occur. As of December 31, 2018 and 2017, foreign currency derivative instruments with total notional amounts of approximately $29 billion and $30 billion were outstanding, respectively. +With respect to Card Member spending and cross-currency transactions, including related foreign exchange forward contracts outstanding, a hypothetical 10 percent strengthening of the U.S. dollar would result in an immaterial impact to projected earnings as of December 31, 2018. With respect to translation exposure of foreign subsidiary equity balances, including related foreign exchange forward contracts outstanding, a hypothetical 10 percent strengthening of the U.S. dollar would result in an immaterial reduction in other comprehensive income and equity as of December 31, 2018. With respect to earnings denominated in foreign currencies, the adverse impact on pretax income of a hypothetical 10 percent strengthening of the U.S. dollar related to anticipated overseas operating results for the next twelve months would be approximately $140 million as of December 31, 2018. We refined our process to forecast future earnings denominated in foreign currencies that resulted in a reclassification of certain forecasted expenses from U.S. dollar to foreign currencies. The same sensitivity analysis as of December 31, 2017, using the refined process, would have been approximately $154 million. +To a much lesser extent, we are also subject to market risk arising from activities conducted by our Foreign Exchange International Payments business. We aim to minimize market risk from these activities through hedging, where appropriate, and the establishment of limits to define and protect the company from excessive exposure. +The actual impact of interest rate and foreign exchange rate changes will depend on, among other factors, the timing of rate changes, the extent to which different rates do not move in the same direction or in the same direction to the same degree, changes in the cost, volume and mix of our hedging activities and changes in the volume and mix of our businesses. +FUNDING & LIQUIDITY RISK MANAGEMENT PROCESS +Liquidity risk is defined as our inability to meet our ongoing financial and business obligations as they become due at a reasonable cost. +Our Board-approved Liquidity Risk Policy establishes the framework that guides and governs liquidity risk management. +Liquidity risk is managed by the Funding and Liquidity Committee. In addition, the Market Risk Oversight Officer provides independent oversight of liquidity risk management. We manage liquidity risk by maintaining access to a diverse set of cash, readily-marketable securities and contingent sources of liquidity, such that we can continuously meet our business requirements and expected future financing obligations for at least a twelve-month period in the event we are unable to raise new funds under our regular funding programs during a substantial weakening in economic conditions. We consider the trade-offs between maintaining too much liquidity, which can be costly and limit financial flexibility, and having inadequate liquidity, which may result in financial distress during a liquidity event. +Liquidity risk is managed at an aggregate consolidated level as well as at certain subsidiaries in order to ensure that sufficient and accessible liquidity resources are maintained. The Funding and Liquidity Committee reviews forecasts of our aggregate and subsidiary cash positions and financing requirements, approves funding plans designed to satisfy those requirements under normal and stressed conditions, establishes guidelines to identify the amount of liquidity resources required and monitors positions and determines any actions to be taken. +63 +Table of Contents +MODEL RISK MANAGEMENT PROCESS +We define model risk as the risk of adverse consequences, such as financial loss, poor business and strategic decision making, or damage to our reputation, from decisions based on incorrect or misused model outputs and reports. +We manage model risk through a comprehensive model governance framework, including policies and procedures for model development, independent model validation and change management capabilities that seek to minimize erroneous model methodology, outputs and misuse. We also assess model performance on an ongoing basis. +STRATEGIC AND BUSINESS RISK MANAGEMENT PROCESS +Strategic and business risk is the risk related to our inability to achieve our business objectives due to poor strategic decisions, including decisions related to mergers, acquisitions, and divestitures, poor implementation of strategic decisions or declining demand for our products and services. +Strategic decisions are reviewed and approved by business leaders and various committees and must be aligned with company policies. We seek to manage strategic and business risks through risk controls embedded in these processes as well as overall risk management oversight over business goals. Existing product performance is reviewed periodically by committees and business leaders. Mergers, acquisitions and divestitures can only be approved following Deal Committee due diligence, a comprehensive risk assessment by operational, market, credit and oversight leaders provided to the Chief Risk Officer and approval by either the Chief Risk Officer or appropriate risk committees. All new products and material changes in business processes are reviewed and approved by the New Products Committee and appropriate credit or risk committees. +64 +Table of Contents +CRITICAL ACCOUNTING ESTIMATES +Refer to Note 1 to the “Consolidated Financial Statements” for a summary of our significant accounting policies. Certain of our accounting policies requiring significant management assumptions and judgments are as follows: +RESERVES FOR CARD MEMBER LOSSES +Reserves for Card Member losses represent our best estimate of the probable losses inherent in our outstanding portfolio of Card Member loans and receivables, as of the balance sheet date. +In estimating these losses, we use statistical and analytical models that analyze portfolio performance and reflect our judgment regarding the quantitative components of the reserve. The models take into account several factors, including delinquency-based loss migration rates, loss emergence periods and average losses and recoveries over an appropriate historical period. We also consider whether to adjust the quantitative reserve for certain external and internal qualitative factors that may increase or decrease the reserves for losses on Card Member loans and receivables. Refer to Note 4 to the "Consolidated Financial Statements" for additional information. +The process of estimating these reserves requires a high degree of judgment. To the extent historical credit experience, updated for any external and internal qualitative factors such as environmental trends, is not indicative of future performance, actual losses could differ significantly from our judgments and expectations, resulting in either higher or lower future provisions for Card Member losses in any quarter. +As of December 31, 2018, a 10 percent increase in our estimate of losses inherent in the outstanding portfolio of Card Member loans and receivables, evaluated collectively for impairment, would increase reserves for losses with a corresponding change to provisions for losses by approximately $271 million. This sensitivity analysis is provided as a hypothetical scenario to assess the sensitivity of the provisions for losses. It does not represent our expectations for losses in the future, nor does it include how other portfolio factors such as delinquency-based loss migration rates or recoveries, or the amount of outstanding balances, may impact the level of reserves for losses and the corresponding impact on the provisions for losses. +LIABILITY FOR MEMBERSHIP REWARDS +The Membership Rewards program is our largest card-based rewards program. Card Members can earn points for purchases charged on their enrolled card products. A significant portion of our cards, by their terms, allow Card Members to earn bonus points for purchases at merchants in particular industry categories. Membership Rewards points are redeemable for a broad variety of rewards, including travel, shopping, gift cards, and covering eligible charges. Points typically do not expire, and there is no limit on the number of points a Card Member may earn. Membership Rewards expense is driven by charge volume on enrolled cards, customer participation in the program and contractual arrangements with redemption partners. +We record a Membership Rewards liability that represents the estimated cost of points earned that are expected to be redeemed by Card Members in the future. The Membership Rewards liability is impacted over time by enrollment levels, attrition, the volume of points earned and redeemed, and the associated redemption costs. We estimate the Membership Rewards liability by determining the URR and the WAC per point, which are applied to the points of current enrollees. Refer to Note 10 to the “Consolidated Financial Statements” for additional information. +The URR assumption is used to estimate the number of points earned by current enrollees that will ultimately be redeemed in future periods. We use statistical and actuarial models to estimate the URR of points earned to date by current Card Members based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. The WAC per point assumption is used to estimate future redemption costs and is primarily based on redemption choices made by Card Members, reward offerings by partners, and Membership Rewards program changes. The WAC per point is derived from the previous 12 months of redemptions and is adjusted as appropriate for certain changes in redemption costs that are not representative of future cost expectations. +We periodically evaluate our liability estimation process and assumptions based on developments in redemption patterns, cost per point redeemed, partner contract changes and other factors. +The process of estimating the Membership Rewards liability includes a high degree of judgment. Actual redemptions and associated redemption costs could differ significantly from our estimates, resulting in either higher or lower Membership Rewards expense. +Changes in the Membership Rewards URR and WAC per point have the effect of either increasing or decreasing the liability through the current period Membership Rewards expense by an amount estimated to cover the cost of all points previously earned but not yet redeemed by current enrollees as of the end of the reporting period. As of December 31, 2018, an increase in the estimated URR of current enrollees of 25 basis points would increase the Membership Rewards liability and corresponding rewards expense by approximately $113 million. Similarly, an increase in the WAC per point of 1 basis point would increase the Membership Rewards liability and corresponding rewards expense by approximately $106 million. +65 +Table of Contents +GOODWILL RECOVERABILITY +Goodwill represents the excess of acquisition cost of an acquired business over the fair value of assets acquired and liabilities assumed. Goodwill is not amortized but is tested for impairment at the reporting unit level annually or when events or circumstances arise, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value. Our methodology for conducting this goodwill impairment testing contains both a qualitative and quantitative assessment. +We have the option to initially perform an assessment of qualitative factors in order to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The qualitative factors may include, but are not limited to, economic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit and other company and reporting unit-specific events. If we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then perform the impairment evaluation using a more detailed quantitative assessment. We could also directly perform this quantitative assessment for any reporting unit, bypassing the qualitative assessment. +Our methodology for conducting the quantitative goodwill impairment testing is fundamentally based on the measurement of fair value for our reporting units, which inherently entails the use of significant management judgment. For valuation, we use a combination of the income approach (discounted cash flows) and market approach (market multiples) in estimating the fair value of our reporting units. +When preparing discounted cash flow models under the income approach, we estimate future cash flows using the reporting unit’s internal multi-year forecast, and a terminal value calculated using a growth rate that we believe is appropriate in light of current and expected future economic conditions. To discount these cash flows we use our expected cost of equity, determined using a capital asset pricing model. When using the market method under the market approach, we apply comparable publicly traded companies’ multiples (e.g., earnings, revenues) to our reporting units’ actual results. The judgment in estimating forecasted cash flows, discount rates and market comparables is significant, and imprecision could materially affect the fair value of our reporting units. +We could be exposed to an increased risk of further goodwill impairment if future operating results or macroeconomic conditions differ significantly from management’s current assumptions. +INCOME TAXES +We are subject to the income tax laws of the United States, its states and municipalities and those of the foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to the taxpayer’s facts is sometimes open to interpretation. In establishing a provision for income tax expense, we must make judgments about the application of inherently complex tax laws. +In particular, the Tax Act is complex and requires interpretation of certain provisions to estimate the impact on our income tax expense. The estimates are based on the information available and our current interpretation of the Tax Act, and may change due to changes in interpretations and assumptions we make and additional guidance or context from the Internal Revenue Service, the U.S. Treasury Department, the Financial Accounting Standards Board or others regarding the Tax Act. Refer to Note 21 to the "Consolidated Financial Statements" for additional information. +Unrecognized Tax Benefits +We establish a liability for unrecognized tax benefits, which are the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized in the financial statements. +In establishing a liability for an unrecognized tax benefit, assumptions may be made in determining whether, and the extent to which, a tax position should be sustained. A tax position is recognized only when it is more likely than not to be sustained upon examination by the relevant taxing authority, based on its technical merits. The amount of tax benefit recognized is the largest benefit that we believe is more likely than not to be realized on ultimate settlement. As new information becomes available, we evaluate our tax positions and adjust our unrecognized tax benefits, as appropriate . +Tax benefits ultimately realized can differ from amounts previously recognized due to uncertainties, with any such differences generally impacting the provision for income tax. +Deferred Tax Asset Realization +Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using the enacted tax rates expected to be in effect for the years in which the differences are expected to reverse. +Since deferred taxes measure the future tax effects of items recognized in the Consolidated Financial Statements, certain estimates and assumptions are required to determine whether it is more likely than not that all or some portion of the benefit of a deferred tax asset will not be realized. In making this assessment, we analyze and estimate the impact of future taxable income, reversing temporary differences and available tax planning strategies. These assessments are performed quarterly, taking into account any new information. +Changes in facts or circumstances can lead to changes in the ultimate realization of deferred tax assets due to uncertainties. +66 +Table of Contents +OTHER MATTERS +RECENTLY ISSUED ACCOUNTING STANDARDS +Refer to the Recently Issued Accounting Standards section of Note 1 to the “Consolidated Financial Statements.” +GLOSSARY OF SELECTED TERMINOLOGY +Adjusted net interest income — A non-GAAP measure that represents net interest income attributable to our Card Member loans and loans HFS (which includes, on a GAAP basis, interest that is deemed uncollectible), excluding the impact of interest expense and interest income not attributable to our Card Member loans. We believe adjusted net interest income is useful to investors because it represents the interest expense and interest income attributable to our Card Member loan portfolio and it is a component of net interest yield on average Card Member loans. +Asset securitizations — Asset securitization involves the transfer and sale of loans or receivables to a special-purpose entity created for the securitization activity, typically a trust. The trust, in turn, issues securities, commonly referred to as asset-backed securities that are secured by the transferred loans and receivables. The trust uses the proceeds from the sale of such securities to pay the purchase price for the underlying loans or receivables. The loans and receivables of our Lending Trust and Charge Trust (collectively, the Trusts) securitized are reported as assets and the securities issued by the Trusts are reported as liabilities on our “Consolidated Balance Sheets.” +Average discount rate — This calculation is generally designed to reflect the average pricing at all merchants accepting American Express cards and represents the percentage of proprietary and GNS billed business retained by us from merchants we acquire, or from merchants acquired by third parties on our behalf, net of amounts retained by such third parties. +Billed business — Represents transaction volumes (including cash advances) on cards and other payment products issued by American Express (proprietary billed business) and cards issued under network partnership agreements with banks and other institutions, including joint ventures (GNS billed business). In-store spending activity within GNS retail cobrand portfolios, from which we earn no revenue, is not included in billed business. Billed business is reported as in the United States or outside the United States based on the location of the issuer. +Capital ratios — Represents the minimum standards established by the regulatory agencies as a measure to determine whether the regulated entity has sufficient capital to absorb on- and off-balance sheet losses beyond current loss accrual estimates. Refer to the Capital Strategy section under “Consolidated Capital Resources and Liquidity” for further related definitions under Basel III. +Cards-in-force — Represents the number of cards that are issued and outstanding by American Express (proprietary cards-in-force) and cards issued and outstanding under network partnership agreements with banks and other institutions, including joint ventures (GNS cards-in-force), except for GNS retail cobrand cards that had no out-of-store spending activity during the prior twelve months. Basic cards-in-force excludes supplemental cards issued on consumer accounts. +Card Member — The individual holder of an issued American Express-branded charge, credit and certain prepaid cards. +Card Member loans — Represents the outstanding amount due from Card Members for charges made on their American Express credit cards, as well as any interest charges and card-related fees. Card Member loans also include revolving balances on certain American Express charge card products. +Card Member loans and receivables HFS — Beginning as of December 1, 2015 and continuing until the sales were completed, represents Card Member loans and receivables related to our cobrand partnerships with Costco in the United States and JetBlue. The JetBlue and Costco portfolio sales were completed on March 18 and June 17, 2016, respectively. +Card Member receivables — Represents the outstanding amount due from Card Members for charges made on their American Express charge cards, as well as any card-related fees, other than revolving balances on certain American Express charge cards with Pay Over Time features. Such revolving balances are included within Card Member loans. +Charge cards — Represents cards that generally carry no pre-set spending limits and are primarily designed as a method of payment and not as a means of financing purchases. Charge Card Members generally must pay the full amount billed each month. No finance charges are assessed on charge cards. Each charge card transaction is authorized based on its likely economics reflecting a Card Member’s most recent credit information and spend patterns. Some charge card accounts have additional Pay Over Time feature(s) that allow revolving of certain charges. +Cobrand cards — Cards issued under cobrand agreements with selected commercial firms. Pursuant to the cobrand agreements, we make payments to our cobrand partners, which can be significant, based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The partner is then liable for providing rewards to the Card Member under the cobrand partner’s own loyalty program. +67 +Table of Contents +Credit cards — Represents cards that have a range of revolving payment terms, grace periods, and rate and fee structures. +Discount revenue — Primarily represents revenue earned from fees charged to merchants who have entered into a card acceptance agreement. The discount fee is generally deducted from our payment for Card Member purchases. +Interest expense — Includes interest incurred primarily to fund Card Member loans and receivables, general corporate purposes and liquidity needs, and is recognized as incurred. Interest expense is divided principally into two categories: (i) deposits, which primarily relates to interest expense on deposits taken from customers and institutions, and (ii) debt, which primarily relates to interest expense on our long-term financing and short-term borrowings, (e.g., commercial paper, federal funds purchased, bank overdrafts and other short-term borrowings), as well as the realized impact of derivatives hedging interest rate risk on our long-term debt. +Interest income — Includes (i) interest on loans, (ii) interest and dividends on investment securities and (iii) interest income on deposits with banks and other. +Interest on loans — Assessed using the average daily balance method for Card Member loans and loans HFS. Unless the loan is classified as non-accrual, interest is recognized based upon the principal amount outstanding in accordance with the terms of the applicable account agreement until the outstanding balance is paid or written off. +Interest and dividends on investment securities — Primarily relates to our performing fixed-income securities. Interest income is recognized as earned using the effective interest method, which adjusts the yield for security premiums and discounts, fees and other payments, so a constant rate of return is recognized on the outstanding balance of the related investment security throughout its term. Amounts are recognized until securities are in default or when it is likely that future interest payments will not be made as scheduled. +Interest income on deposits with banks and other — Recognized as earned, and primarily relates to the placement of cash in excess of near-term funding requirements in interest-bearing time deposits, overnight sweep accounts, and other interest-bearing demand and call accounts. +Liquidity Coverage Ratio — Represents the minimum standards established by the regulatory agencies as a measure to determine whether the regulated entity has sufficient liquidity to meet liquidity needs in periods of financial and economic stress. +Merchant acquisition — Represents our process of entering into agreements with merchants to accept American Express-branded cards. +Net card fees — Represents the card membership fees earned during the period. These fees are recognized as revenue over the covered card membership period (typically one year), net of the provision for projected refunds for Card Membership cancellation and deferred acquisition costs. +Net interest yield on average Card Member loans — A non-GAAP measure that is computed by dividing adjusted net interest income by average Card Member loans, computed on an annualized basis. Reserves and net write-offs related to uncollectible interest are recorded through provisions for losses, and are thus not included in the net interest yield calculation. We believe net interest yield on average Card Member loans is useful to investors because it provides a measure of profitability of our Card Member loan portfolio. +Net loss ratio — Represents the ratio of GCP charge card write-offs, consisting of principal (resulting from authorized transactions) and fee components, less recoveries, on Card Member receivables expressed as a percentage of gross amounts billed to corporate Card Members. +Net write-off rate — principal only — Represents the amount of proprietary consumer or small business Card Member loans or receivables written off, consisting of principal (resulting from authorized transactions), less recoveries, as a percentage of the average loan or receivables balance during the period. +Net write-off rate — principal, interest and fees — Includes, in the calculation of the net write-off rate, amounts for interest and fees in addition to principal for Card Member loans and fees in addition to principal for Card Member receivables. +Operating expenses — Represents salaries and employee benefits, professional services, occupancy and equipment, and other expenses. +Return on average equity — Calculated by dividing one-year period net income by one-year average total shareholders’ equity. +68 +Table of Contents +CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS +This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which are subject to risks and uncertainties. The forward-looking statements, which address our current expectations regarding business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” and similar expressions. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update or revise any forward-looking statements. Factors that could cause actual results to differ materially from these forward-looking statements, include, but are not limited to, the following: + +our ability to grow earnings per share in the future, which will depend in part on revenue growth, credit performance and the effective tax rate remaining consistent with current expectations, the company’s ability to control operating expense growth and generate operating leverage, and the company’s ability to continue executing its share repurchase program, any of which could be impacted by, among other things, the factors identified in the subsequent paragraphs as well as the following: issues impacting brand perceptions and our reputation; the impact of any future contingencies, including, but not limited to, litigation-related settlements, judgments or expenses, the imposition of fines or civil money penalties, increases in Card Member reimbursements, restructurings, impairments and changes in reserves; the amount we spend on customer engagement and our inability to drive growth from such investments; changes in interest rates beyond current expectations (including the impact of hedge ineffectiveness and deposit rate increases); a greater impact from new or renegotiated cobrand agreements than expected, which could be affected by spending volumes and customer engagement; and the impact of regulation and litigation, which could affect the profitability of our business activities, limit our ability to pursue business opportunities, require changes to business practices or alter our relationships with partners, merchants and Card Members; + +our ability to grow revenues net of interest expense, which could be impacted by, among other things, weakening economic conditions in the United States or internationally, a decline in consumer confidence impacting the willingness and ability of Card Members to sustain and grow spending and revolve balances, growth in Card Member loans and the yield on Card Member loans not remaining consistent with current expectations, a greater decline of the average discount rate than expected, the strengthening of the U.S. dollar beyond expectations, the willingness of Card Members to pay higher card fees, lower spending on new cards acquired than estimated, and our inability to address competitive pressures and implement our strategies and business initiatives, including within the premium consumer segment, commercial payments, the global network and digital environment; + +changes in the substantial and increasing worldwide competition in the payments industry, including competitive pressure that may impact the prices we charge merchants that accept American Express cards, competition for new and existing cobrand relationships, competition from new and non-traditional competitors and the success of marketing, promotion and rewards programs; + +the average discount rate changing by a greater amount than anticipated, including as a result of changes in the mix of spending by location and industry, merchant negotiations (including merchant incentives, concessions and volume-related pricing discounts), pricing initiatives, competition, pricing regulation (including regulation of competitors’ interchange rates in the European Union and elsewhere) and other factors; + +our delinquency and write-off rates and growth of provisions for losses being higher or lower than current expectations, which will depend in part on changes in the level of loan and receivable balances and delinquencies generally, as well as macroeconomic factors, the mix of balances, newer vintages and balance transfers, loans and receivables related to new Card Members and other borrowers performing as expected, credit performance of new and enhanced lending products, unemployment rates, the volume of bankruptcies, collections capabilities and recoveries of previously written-off loans and receivables; + +our ability to continue to grow loans, which may be affected by increasing competition, brand perceptions and reputation, our ability to manage risk, the behavior of Card Members and their actual spending and borrowing patterns, and our ability to issue new and enhanced card products, offer attractive non-card lending products, capture a greater share of existing Card Members’ spending and borrowings, reduce Card Member attrition and attract new customers; + +our net interest yield on average Card Member loans not remaining consistent with current expectations, which will be influenced by, among other things, the difference between the prime rate and our cost of funds, changes in consumer behavior that affect loan balances (such as paydown rates), our Card Member acquisition strategy, product mix, credit actions, including line size and other adjustments to credit availability, changes in the level of loans at promotional rates and other pricing changes, which could be impacted by, among other things, changes in benchmark interest rates, competitive pressure and regulatory constraints; + +the actual amount to be spent on customer engagement, which will be based in part on management’s assessment of competitive opportunities; overall business performance and changes in macroeconomic conditions; our ability to cost effectively enhance card products and services to make them attractive to Card Members; Card Member behavior as it relates to their spending patterns (including the level of spend in bonus categories) and the redemption of rewards and offers, as well as the degree of interest of Card Members in the value propositions we offer; the costs related to reward point redemptions, advertising and Card Member acquisition; our ability to continue to shift Card Member acquisition to digital channels; new and renegotiated contractual obligations with business partners; and the pace and cost of the expansion of our global lounge collection; +69 +Table of Contents + +our ability to control operating expense growth, which could be impacted by the need to increase significant categories of operating expenses, such as consulting or professional fees, including as a result of increased litigation, compliance or regulatory-related costs, or cyber or fraud costs; higher than expected employee levels; an inability to innovate efficient channels of customer interactions, such as chat supported by artificial intelligence, or customer acquisition; the impact of changes in foreign currency exchange rates on costs; the payment of civil money penalties, disgorgement, restitution, non-income tax assessments and litigation-related settlements; impairments of goodwill or other assets; management’s decision to increase or decrease spending in such areas as technology, business and product development and sales forces; greater -than -expected inflation; and the level of M&A activity and related expenses; + +our ability to satisfy our commitments to certain of our cobrand partners as part of the ongoing operations of the business, which will be impacted in part by competition, brand perceptions and reputation, and our ability to develop and market value propositions that appeal to current cobrand Card Members and new customers and offer attractive services and rewards programs, which will depend in part on ongoing investments, new product innovation and development, Card Member acquisition efforts and enrollment processes, including through digital channels, and infrastructure to support new products, services and benefits; + +changes affecting our plans regarding the return of capital to shareholders through dividends and share repurchases, which will depend on factors such as our capital levels and regulatory capital ratios; changes in the stress testing and capital planning process and the continued non-objection by our primary regulators to our capital plans; the amount of capital required to support asset growth; the amount we spend on acquisitions of companies; and our results of operations and financial condition; and the economic environment and market conditions in any given period; + +our tax rate not remaining consistent with current expectations, which could be impacted by, among other things, the company’s geographic mix of income, further changes in tax laws and regulation, unfavorable tax audits and other unanticipated tax items; + +a failure in or breach of our operational or security systems, processes or infrastructure, or those of third parties, including as a result of cyberattacks, which could compromise the confidentiality, integrity, privacy and/or security of data, disrupt our operations, reduce the use and acceptance of American Express cards and lead to regulatory scrutiny, litigation, remediation and response costs, and reputational harm; + +our deposit rates increasing faster or slower than current expectations and changes affecting our ability to grow Personal Savings deposits due to market demand, changes in benchmark interest rates, competition or regulatory restrictions on our ability to obtain deposit funding or offer competitive interest rates, which could affect our net interest yield and ability to fund our businesses; + +our funding plan being implemented in a manner inconsistent with current expectations, which will depend on various factors such as future business growth, the impact of global economic, political and other events on market capacity, demand for securities we offer, regulatory changes, ability to securitize and sell receivables and the performance of receivables previously sold in securitization transactions; + +changes in global economic and business conditions, consumer and business spending generally, the availability and cost of capital, unemployment rates, geopolitical conditions, Brexit, prolonged or recurring government shutdowns, trade policies, foreign currency rates and interest rates, all of which may significantly affect demand for and spending on American Express cards, delinquency rates, loan and receivable balances and other aspects of our business and results of operations; + +changes in capital and credit market conditions, which may significantly affect our ability to meet our liquidity needs, expectations regarding capital and liquidity ratios, access to capital and cost of capital, including changes in interest rates; changes in market conditions affecting the valuation of our assets; or any reduction in our credit ratings or those of our subsidiaries, which could materially increase the cost and other terms of our funding or restrict our access to the capital markets; + +legal and regulatory developments, which could require us to make fundamental changes to many of our business practices, including our ability to continue certain cobrand and agent relationships in their current form; exert further pressure on the average discount rate and GNS volumes; result in increased costs related to regulatory oversight, litigation-related settlements, judgments or expenses, restitution to Card Members or the imposition of fines or civil money penalties; materially affect our capital or liquidity requirements, results of operations or ability to pay dividends or repurchase stock; or result in harm to the American Express brand; + +changes in the financial condition and creditworthiness of our business partners, such as bankruptcies, restructurings or consolidations, including merchants that represent a significant portion of our business, such as the airline industry, or our partners in GNS or financial institutions that we rely on for routine funding and liquidity, which could materially affect our financial condition or results of operations; and + +factors beyond our control such as fire, power loss, disruptions in telecommunications, severe weather conditions, natural disasters, health pandemics or terrorism, any of which could significantly affect demand for and spending on American Express cards, delinquency rates, loan and receivable balances and other aspects of our business and results of operations or disrupt our global network systems and ability to process transactions. +A further description of these uncertainties and other risks can be found in “Risk Factors” above and our other reports filed with the Securities and Exchange Commission. +70 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Refer to “Risk Management” under “MD&A” for quantitative and qualitative disclosures about market risk. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. +Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (GAAP), and includes those policies and procedures that: +• +Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of assets; +• +Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and +• +Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2018. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control —Integrated Framework (2013). +Based on management’s assessment and those criteria, we conclude that, as of December 31, 2018, our internal control over financial reporting is effective. +PricewaterhouseCoopers LLP, our independent registered public accounting firm, has issued an audit report appearing on the following page on the effectiveness of our internal control over financial reporting as of December 31, 2018. +71 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF AMERICAN EXPRESS COMPANY: +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of American Express Company and its subsidiaries ("the Company") as of December 31, 2018 and 2017, and the related consolidated statements of income, comprehensive income, cash flows and shareholders’ equity for each of the three years in the period ended December 31, 2018, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +72 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +New York, New York +February 13, 2019 +We have served as the Company’s auditor since 2005. +73 +Table of Contents +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +CONSOLIDATED FINANCIAL STATEMENTS +PAGE +Consolidated Statements of Income – For the Years Ended December 31, 2018, 2017 and 2016 +75 +Consolidated Statements of Comprehensive Income – For the Years Ended December 31, 2018, 2017 and 2016 +76 +Consolidated Balance Sheets – December 31, 2018 and 2017 +77 +Consolidated Statements of Cash Flows – For the Years Ended December 31, 2018, 2017 and 2016 +78 +Consolidated Statements of Shareholders’ Equity – For the Years Ended December 31, 2018, 2017 and 2016 +79 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +Note 1 – Summary of Significant Accounting Policies +80 +Note 2 – Business Events +86 +Note 3 – Loans and Accounts Receivable +87 +Note 4 – Reserves for Losses +93 +Note 5 – Investment Securities +95 +Note 6 – Asset Securitizations +97 +Note 7 – Other Assets +98 +Note 8 – Customer Deposits +100 +Note 9 – Debt +101 +Note 10 – Other Liabilities +104 +Note 11 – Stock Plans +105 +Note 12 – Retirement Plans +107 +Note 13 – Contingencies and Commitments +107 +Note 14 – Derivatives and Hedging Activities +109 +Note 15 – Fair Values +112 +Note 16 – Guarantees +116 +Note 17 – Common and Preferred Shares +116 +Note 18 – Changes in Accumulated Other Comprehensive Income +118 +Note 19 – Other Fees and Commissions, Other Revenues and Other Expenses +119 +Note 20 – Restructuring +119 +Note 21 – Income Taxes +120 +Note 22 – Earnings Per Common Share +123 +Note 23 – Regulatory Matters and Capital Adequacy +124 +Note 24 – Significant Credit Concentrations +126 +Note 25 – Reportable Operating Segments and Geographic Operations +127 +Note 26 – Parent Company +130 +Note 27 – Quarterly Financial Data (Unaudited) +131 +74 +Table of Contents +CONSOLIDATED STATEMENTS OF INCOME +Years Ended December 31 (Millions, except per share amounts) +2018 +2017 +2016 +Revenues +Non-interest revenues +Discount revenue +$ +24,721 +$ +22,890 +$ +22,377 +Net card fees +3,441 +3,090 +2,886 +Other fees and commissions +3,153 +2,990 +2,718 +Other +1,360 +1,457 +1,678 +Total non-interest revenues +32,675 +30,427 +29,659 +Interest income +Interest on loans +9,941 +8,148 +7,214 +Interest and dividends on investment securities +118 +89 +131 +Deposits with banks and other +547 +326 +139 +Total interest income +10,606 +8,563 +7,484 +Interest expense +Deposits +1,287 +779 +598 +Long-term debt and other +1,656 +1,333 +1,107 +Total interest expense +2,943 +2,112 +1,705 +Net interest income +7,663 +6,451 +5,779 +Total revenues net of interest expense +40,338 +36,878 +35,438 +Provisions for losses +Charge card +937 +795 +696 +Card Member loans +2,266 +1,868 +1,235 +Other +149 +97 +96 +Total provisions for losses +3,352 +2,760 +2,027 +Total revenues net of interest expense after provisions for losses +36,986 +34,118 +33,411 +Expenses +Marketing and business development +6,470 +5,722 +6,249 +Card Member rewards +9,696 +8,687 +7,819 +Card Member services +1,777 +1,392 +1,100 +Salaries and employee benefits +5,250 +5,258 +5,259 +Other, net +5,671 +5,634 +4,942 +Total expenses +28,864 +26,693 +25,369 +Pretax income +8,122 +7,425 +8,042 +Income tax provision +1,201 +4,677 +2,667 +Net income +$ +6,921 +$ +2,748 +$ +5,375 +Earnings per Common Share — (Note 22) (a) +Basic +$ +7.93 +$ +3.00 +$ +5.63 +Diluted +$ +7.91 +$ +2.99 +$ +5.61 +Average common shares outstanding for earnings per common share: +Basic +856 +883 +933 +Diluted +859 +886 +935 +(a) +Represents net income less (i) earnings allocated to participating share awards of $54 million, $21 million and $43 million for the years ended December 31, 2018, 2017 and 2016, respectively, and (ii) dividends on preferred shares of $80 million, $81 million and $80 million for the years ended December 31, 2018, 2017 and 2016, respectively. +See Notes to Consolidated Financial Statements. +75 +Table of Contents +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +Years Ended December 31 (Millions) +2018 +2017 +2016 +Net income +$ +6,921 +$ +2,748 +$ +5,375 +Other comprehensive (loss) income: +Net unrealized securities losses, net of tax +(8 +) +(7 +) +(51 +) +Foreign currency translation adjustments, net of tax +(172 +) +301 +(218 +) +Net unrealized pension and other postretirement benefits, net of tax +11 +62 +19 +Other comprehensive (loss) income: +(169 +) +356 +(250 +) +Comprehensive income +$ +6,752 +$ +3,104 +$ +5,125 +See Notes to Consolidated Financial Statements. +76 +Table of Contents +CONSOLIDATED BALANCE SHEETS +December 31 (Millions, except share data) +2018 +2017 +Assets +Cash and cash equivalents +Cash and due from banks +$ +3,253 +$ +5,148 +Interest-bearing deposits in other banks (includes securities purchased under resale agreements: 2018, $64; 2017, $48) +24,026 +27,709 +Short-term investment securities +166 +70 +Total cash and cash equivalents +27,445 +32,927 +Accounts receivable +Card Member receivables (includes gross receivables available to settle obligations of a consolidated variable interest entity: 2018, $8,539; 2017, $8,919), less reserves: 2018, $573; 2017, $521 +55,320 +53,526 +Other receivables, less reserves: 2018, $25; 2017, $31 +2,907 +3,209 +Loans +Card Member loans (includes gross loans available to settle obligations of a consolidated variable interest entity: 2018, $33,194; 2017, $25,695), less reserves: 2018, $2,134; 2017, $1,706 +79,720 +71,693 +Other loans, less reserves: 2018, $124; 2017, $80 +3,676 +2,607 +Investment securities +4,647 +3,159 +Premises and equipment, less accumulated depreciation and amortization: 2018, $6,015; 2017, $5,455 +4,416 +4,329 +Other assets (includes restricted cash of consolidated variable interest entities: 2018, $70; 2017, $62) +10,471 +9,746 +Total assets +$ +188,602 +$ +181,196 +Liabilities and Shareholders’ Equity +Liabilities +Customer deposits +$ +69,960 +$ +64,452 +Travelers Cheques and other prepaid products +2,295 +2,555 +Accounts payable +12,255 +14,657 +Short-term borrowings +3,100 +3,278 +Long-term debt (includes debt issued by consolidated variable interest entities: 2018, $19,509; 2017, $18,560) +58,423 +55,804 +Other liabilities +20,279 +22,189 +Total liabilities +$ +166,312 +$ +162,935 +Contingencies and Commitments (Note 13) +Shareholders’ Equity +Preferred shares, $1.66 2/3 par value, authorized 20 million shares; issued and outstanding 1,600 shares as of December 31, 2018 and 2017 (Note 17) +― +― +Common shares, $0.20 par value, authorized 3.6 billion shares; issued and outstanding 847 million shares as of December 31, 2018 and 859 million shares as of December 31, 2017 +170 +172 +Additional paid-in capital +12,218 +12,210 +Retained earnings +12,499 +8,307 +Accumulated other comprehensive loss +Net unrealized securities losses, net of tax of: 2018,$(1); 2017, $1 +(8 +) +― +Foreign currency translation adjustments, net of tax of: 2018, $(300); 2017, $(363) +(2,133 +) +(1,961 +) +Net unrealized pension and other postretirement benefits, net of tax of: 2018, $(170); 2017, $(179) +(456 +) +(467 +) +Total accumulated other comprehensive loss +(2,597 +) +(2,428 +) +Total shareholders’ equity +22,290 +18,261 +Total liabilities and shareholders’ equity +$ +188,602 +$ +181,196 +See Notes to Consolidated Financial Statements. +77 +Table of Contents +CONSOLIDATED STATEMENTS OF CASH FLOWS +Years Ended December 31 (Millions) +2018 +2017 +2016 +Cash Flows from Operating Activities +Net income +$ +6,921 +$ +2,748 +$ +5,375 +Adjustments to reconcile net income to net cash provided by operating activities: +Provisions for losses +3,352 +2,760 +2,027 +Depreciation and amortization +1,293 +1,321 +1,095 +Deferred taxes and other +455 +782 +(1,066 +) +Stock-based compensation +283 +282 +254 +Changes in operating assets and liabilities, net of effects of acquisitions and dispositions: +Other receivables +248 +475 +(332 +) +Other assets +743 +(77 +) +206 +Accounts payable and other liabilities +(4,121 +) +5,506 +1,180 +Travelers Cheques and other prepaid products +(244 +) +(257 +) +(448 +) +Net cash provided by operating activities +8,930 +13,540 +8,291 +Cash Flows from Investing Activities +Sales of available-for-sale investment securities +4 +2 +88 +Maturities and redemptions of available-for-sale investment securities +3,499 +2,494 +2,429 +Sales of other investments +― +― +10 +Purchases of investments +(5,434 +) +(2,612 +) +(2,162 +) +Net (increase) decrease in Card Member loans and receivables, including held for sale (a) +(15,854 +) +(16,853 +) +3,220 +Purchase of premises and equipment, net of sales: 2018, $1; 2017, $1; 2016, $2 +(1,310 +) +(1,062 +) +(1,375 +) +Acquisitions/dispositions, net of cash acquired +(520 +) +(211 +) +(487 +) +Net cash (used in) provided by investing activities +(19,615 +) +(18,242 +) +1,723 +Cash Flows from Financing Activities +Net increase (decrease) in customer deposits +5,542 +11,385 +(1,935 +) +Net (decrease) increase in short-term borrowings +(148 +) +(2,300 +) +888 +Proceeds from long-term borrowings +21,524 +32,764 +8,824 +Payments of long-term borrowings +(18,895 +) +(24,082 +) +(9,848 +) +Issuance of American Express common shares +87 +129 +177 +Repurchase of American Express common shares and other +(1,685 +) +(4,400 +) +(4,498 +) +Dividends paid +(1,324 +) +(1,251 +) +(1,207 +) +Net cash provided by (used in) financing activities +5,101 +12,245 +(7,599 +) +Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash +129 +226 +(160 +) +Net (decrease) increase in cash, cash equivalents and restricted cash +(5,455 +) +7,769 +2,255 +Cash, cash equivalents and restricted cash at beginning of year +33,263 +25,494 +23,239 +Cash, cash equivalents and restricted cash at end of year +$ +27,808 +$ +33,263 +$ +25,494 +(a) Refer to Note 2 for additional information. +Supplemental cash flow information +Cash, cash equivalents and restricted cash reconciliation +Dec-18 +Dec-17 +Dec-16 +Cash and cash equivalents per Consolidated Balance Sheets +$ +27,445 +$ +32,927 +$ +25,208 +Restricted cash included in Other assets per Consolidated Balance Sheets +363 +336 +286 +Total cash, cash equivalents and restricted cash +$ +27,808 +$ +33,263 +$ +25,494 +See Notes to Consolidated Financial Statements. +78 +Table of Contents +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +(Millions, except per share amounts) +Total +Preferred Shares +Common Shares +Additional Paid-in Capital +Accumulated Other Comprehensive Loss +Retained Earnings +Balances as of December 31, 2015 +$ +20,673 +$ +― +$ +194 +$ +13,348 +$ +(2,534 +) +$ +9,665 +Cumulative effect of a change in accounting principle - Revenue Recognition +55 +― +― +― +― +55 +Net income +5,375 +― +― +― +― +5,375 +Other comprehensive loss +(250 +) +― +― +― +(250 +) +― +Repurchase of common shares +(4,421 +) +― +(14 +) +(924 +) +― +(3,483 +) +Other changes, primarily employee plans +308 +― +1 +309 +― +(2 +) +Cash dividends declared preferred Series B, $52.00 per share +(39 +) +― +― +― +― +(39 +) +Cash dividends declared preferred Series C, $49.00 per share +(41 +) +― +― +― +― +(41 +) +Cash dividends declared common, $1.22 per share +(1,137 +) +― +― +― +― +(1,137 +) +Balances as of December 31, 2016 +20,523 +― +181 +12,733 +(2,784 +) +10,393 +Net income +2,748 +― +― +― +― +2,748 +Other comprehensive income +356 +― +― +― +356 +― +Repurchase of common shares +(4,314 +) +― +(10 +) +(742 +) +― +(3,562 +) +Other changes, primarily employee plans +212 +― +1 +219 +― +(8 +) +Cash dividends declared preferred Series B, $52.00 per share +(39 +) +― +― +― +― +(39 +) +Cash dividends declared preferred Series C, $49.00 per share +(42 +) +― +― +― +― +(42 +) +Cash dividends declared common, $1.34 per share +(1,183 +) +― +― +― +― +(1,183 +) +Balances as of December 31, 2017 +18,261 +― +172 +12,210 +(2,428 +) +8,307 +Net income +6,921 +― +― +― +― +6,921 +Other comprehensive loss +(169 +) +― +― +― +(169 +) +― +Repurchase of common shares +(1,570 +) +― +(3 +) +(216 +) +― +(1,351 +) +Other changes, primarily employee plans +200 +― +1 +224 +― +(25 +) +Cash dividends declared preferred Series B, $52.00 per share +(39 +) +― +― +― +― +(39 +) +Cash dividends declared preferred Series C, $49.00 per share +(41 +) +― +― +― +― +(41 +) +Cash dividends declared common, $1.48 per share +(1,273 +) +― +― +― +― +(1,273 +) +Balances as of December 31, 2018 +$ +22,290 +$ +― +$ +170 +$ +12,218 +$ +(2,597 +) +$ +12,499 +See Notes to Consolidated Financial Statements. +79 +Table of Contents +NOTES TO CONSOLID ATED FINANCIAL STATEMENTS +NOTE 1 +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +THE COMPANY +American Express Company is a globally integrated payments company that provides customers with access to products, insights and experiences that enrich lives and build business success. Our principal products and services are charge and credit card products and travel-related services offered to consumers and businesses around the world. Business travel-related services are offered through the non-consolidated joint venture, American Express Global Business Travel (the GBT JV). Our various products and services are sold globally to diverse customer groups, including consumers, small businesses, mid-sized companies and large corporations. These products and services are sold through various channels, including mobile and online applications, direct mail, in-house sales teams, third-party vendors and direct response advertising. +Effective for the second quarter of 2018, we realigned our reportable operating segments to reflect the organizational changes announced during the first quarter of 2018. Prior periods have been revised to conform to the new reportable operating segments, which are as follows: + +Global Consumer Services Group (GCSG), which primarily issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. + +Global Commercial Services (GCS), which primarily issues a wide range of proprietary corporate and small business cards and provides payment and expense management services globally. In addition, GCS provides commercial financing products. + +Global Merchant and Network Services (GMNS), which operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses in certain countries around the world. +Corporate functions and certain other businesses and operations are included in Corporate & Other. +PRINCIPLES OF CONSOLIDATION +The Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Significant intercompany transactions are eliminated. +We consolidate entities in which we hold a “controlling financial interest.” For voting interest entities, we are considered to hold a controlling financial interest when we are able to exercise control over the investees’ operating and financial decisions. For variable interest entities (VIEs), the determination of which is based on the amount and characteristics of the entity’s equity, we are considered to hold a controlling financial interest when we are determined to be the primary beneficiary. A primary beneficiary is the party that has both: (1) the power to direct the activities that most significantly impact that VIE’s economic performance, and (2) the obligation to absorb the losses of, or the right to receive the benefits from, the VIE that could potentially be significant to that VIE. +Entities in which our voting interest in common equity does not provide it with control, but allows us to exert significant influence over operating and financial decisions, are accounted for under the equity method. We also have investments in equity securities where our voting interest is below the level of significant influence, including investments that we make in non-public companies in the ordinary course of business. Such investments are initially recorded at cost and adjusted to fair value through earnings for observable price changes in orderly transactions for identical or similar transactions of the same company or if they are determined to be impaired. See Note 5 for the accounting policy for our marketable equity securities. +FOREIGN CURRENCY +Monetary assets and liabilities denominated in foreign currencies are translated into U.S. dollars based upon exchange rates prevailing at the end of the reporting period; non-monetary assets and liabilities are translated at the historic exchange rate at the date of the transaction; revenues and expenses are translated at the average month-end exchange rates during the year. Resulting translation adjustments, along with any related qualifying hedge and tax effects, are included in accumulated other comprehensive income (loss) (AOCI), a component of shareholders’ equity. Translation adjustments, including qualifying hedge and tax effects, are reclassified to earnings upon the sale or substantial liquidation of investments in foreign operations. Gains and losses related to transactions in a currency other than the functional currency are reported net in Other expenses, in our Consolidated Statements of Income. +80 +Table of Contents +AMOUNTS BASED ON ESTIMATES AND ASSUMPTIONS +Accounting estimates are an integral part of the Consolidated Financial Statements. These estimates are based, in part, on management’s assumptions concerning future events. Among the more significant assumptions are those that relate to reserves for Card Member losses on loans and receivables, Membership Rewards liability, goodwill and income taxes. These accounting estimates reflect the best judgment of management, but actual results could differ. +INCOME STATEMENT +Discount Revenue +Discount revenue primarily represents the amount we earn on transactions occurring at merchants that have entered into a card acceptance agreement with us, or a Global Network Services (GNS) partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. The amount of fees charged for accepting our cards as payment for goods or services, or merchant discount, varies with, among other factors, the industry in which the merchant conducts business, the merchant’s overall American Express-related transaction volume, the method of payment, the settlement terms with the merchant, the method of submission of transactions and, in certain instances, the geographic scope of the card acceptance agreement between the merchant and us (e.g., local or global) and the transaction amount. The merchant discount is generally deducted from the payment to the merchant and recorded as discount revenue at the time the Card Member transaction occurs. +The card acceptance agreements, which include the agreed-upon terms for charging the merchant discount fee, vary in duration. Our contracts with small- and medium-sized merchants generally have no fixed contractual duration, while those with large merchants are generally for fixed periods, which typically range from three to seven years in duration. Our fixed-period agreements may include auto-renewal features, which may allow the existing terms to continue beyond the stated expiration date until a new agreement is reached. We satisfy our obligations under these agreements over the contract term, often on a daily basis, including through the processing of Card Member transactions and the availability of our payment network. +In cases where the merchant acquirer is a third party (which is the case, for example, under our OptBlue program, or with certain of our GNS partners), we receive a network rate fee in our settlement with the merchant acquirer, which is individually negotiated between us and that merchant acquirer and is recorded as discount revenue at the time the Card Member transaction occurs. In our role as the operator of the American Express network, we also settle with merchants on behalf of our GNS card issuing partners, who in turn receive an issuer rate that is individually negotiated between that issuer and us and is recorded as expense in Marketing and business development (see below) or as contra-revenue in Other revenue. +Net Card Fees +Net card fees represent revenue earned from annual card membership fees, which vary based on the type of card and the number of cards for each account. These fees, net of acquisition costs and a reserve for projected refunds for Card Member cancellations, are deferred and recognized on a straight-line basis over the twelve-month card membership period as Net card fees in the Consolidated Statements of Income. The unamortized net card fee balance is reported in Other liabilities on the Consolidated Balance Sheets (refer to Note 10). +Other Fees and Commissions +Other fees and commissions includes certain fees charged to Card Members, including delinquency fees and foreign currency conversion fees, which are primarily recognized in the period in which they are charged to the Card Member. Other fees and commissions also includes Membership Rewards program fees, which are deferred and recognized over the period covered by the fee, typically one year, the unamortized portion of which is included in Other liabilities on the Consolidated Balance Sheets. In addition, Other fees and commissions includes loyalty coalition-related fees, travel commissions and fees and service fees earned from merchants, that are recognized when the service is performed, which is generally in the period the fee is charged. Refer to Note 19 for additional information. +Contra-revenue +P ayments made pursuant to contractual arrangements with our merchants, GNS partners, and other customers are classified as contra-revenue, except where we receive goods, services or other benefits for which the fair value is determinable and measurable, in which case they are recorded as expense. +81 +Table of Contents +Interest Income +Interest on Card Member loans is assessed using the average daily balance method. Unless the loan is classified as non-accrual, interest is recognized based upon the principal amount outstanding, in accordance with the terms of the applicable account agreement, until the outstanding balance is paid, or written off. +Interest and dividends on investment securities primarily relate to our performing fixed-income securities. Interest income is recognized as earned using the effective interest method, which adjusts the yield for security premiums and discounts, fees and other payments, so that a constant rate of return is recognized on the investment security’s outstanding balance. Amounts are recognized until securities are in default or when it becomes likely that future interest payments will not be made as scheduled. +Interest on deposits with banks and other is recognized as earned, and primarily relates to the placement of cash, in excess of near-term funding requirements, in interest-bearing time deposits, overnight sweep accounts, and other interest-bearing demand and call accounts. +Interest Expense +Interest expense includes interest incurred primarily to fund Card Member loans and receivables, general corporate purposes and liquidity needs, and is recognized as incurred. Interest expense is divided principally into two categories: (i) deposits, which primarily relates to interest expense on deposits taken from customers and institutions, and (ii) debt, which primarily relates to interest expense on our long-term debt and short-term borrowings, as well as the realized impact of derivatives used to hedge interest rate risk on our long-term debt. +Marketing and Business Development +As further described below under “Recently Adopted Accounting Standards,” effective January 1, 2018, in conjunction with the adoption of the new revenue recognition standard, the previously disclosed “Marketing and promotion” line on the Consolidated Statements of Income was changed to “Marketing and business development” to reflect the inclusion of certain reclassified costs from contra-discount revenue and Other expenses. Marketing and business development provides a more comprehensive view of costs related to building and growing our business, including the reclassified costs. +Marketing and business development expense includes costs incurred in the development and initial placement of advertising, which are expensed in the year in which the advertising first takes place. Also included in Marketing and business development expense are Card Member statement credits for qualifying charges on eligible card accounts, corporate incentive payments earned on achievement of preset targets, and certain payments to GNS card issuing partners. These costs are generally expensed as incurred. +Card Member Rewards +We issue charge and credit cards that allow Card Members to participate in various rewards programs (e.g., Membership Rewards, cobrand and cash back). Rewards expense is recognized in the period Card Members earn rewards, generally by spending on their enrolled card products. We record a Card Member rewards liability that represents the estimated cost of points earned that are expected to be redeemed. Pursuant to cobrand agreements, we make payments to our cobrand partners based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The partner is then liable for providing rewards to the Card Member under the cobrand partner’s own loyalty program. Card Member rewards liabilities are impacted over time by enrollment levels, attrition, the volume of points earned and redeemed, and the associated redemption costs. Changes in the Card Member rewards liabilities during the period are taken as an increase or decrease to the Card Member rewards expense in the Consolidated Statement of Income. +Effective January 1, 2018, in conjunction with the adoption of the new revenue recognition standard, Card Member rewards also includes cash-back rewards, which were reclassified from contra discount revenue. +BALANCE SHEET +Cash and Cash Equivalents +Cash and cash equivalents include cash and amounts due from banks, interest-bearing bank balances, including securities purchased under resale agreements, and other highly liquid investments with original maturities of 90 days or less. +82 +Table of Contents +Goodwill +Goodwill represents the excess of acquisition cost of an acquired business over the fair value of assets acquired and liabilities assumed. We allocate goodwill to our reporting units for the purpose of impairment testing. A reporting unit is defined as an operating segment, or a business that is one level below an operating segment, for which discrete financial information is regularly reviewed by the operating segment manager. +We evaluate goodwill for impairment annually as of June 30, or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of one or more of our reporting units below its carrying value. Prior to completing the assessment of goodwill for impairment, we also perform a recoverability test of certain long-lived assets. We have the option to perform a qualitative assessment of goodwill impairment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. Alternatively, we can perform a more detailed quantitative assessment of goodwill impairment. +This qualitative assessment entails the evaluation of factors such as economic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit and other company and reporting unit-specific events. If we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then perform the impairment evaluation using the quantitative assessment. +Under the quantitative assessment, the first step identifies whether there is a potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds the fair value, then a test is performed to determine the implied fair value of goodwill. An impairment loss is recognized based on the amount that the carrying amount of goodwill exceeds the implied fair value. +When measuring the fair value of our reporting units in the quantitative assessment, we use widely accepted valuation techniques, applying a combination of the income approach (discounted cash flows) and market approach (market multiples). When preparing discounted cash flow models under the income approach, we use internal forecasts to estimate future cash flows expected to be generated by the reporting units. To discount these cash flows, we use the expected cost of equity, determined by using a capital asset pricing model. We believe the discount rates used appropriately reflect the risks and uncertainties in the financial markets generally and specifically in our internally-developed forecasts. When using market multiples under the market approach, we apply comparable publicly traded companies’ multiples (e.g., earnings or revenues) to our reporting units’ actual results. +For the years ended December 31, 2018 and 2017, we performed a qualitative assessment in connection with our annual goodwill impairment evaluation and determined that it was more likely than not that the fair values of our reporting units exceeded their carrying values. +Premises and Equipment +Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation. Costs incurred during construction are capitalized and are depreciated once an asset is placed in service. Depreciation is generally computed using the straight-line method over the estimated useful lives of the assets, which range from 3 to 10 years for equipment, furniture and building improvements, and from 40 to 50 years for premises, which are depreciated based upon their estimated useful life at the acquisition date. +Leasehold improvements are depreciated using the straight-line method over the lesser of the remaining term of the leased facility, or the economic life of the improvement, and ranges from 5 to 10 years. We maintain operating leases worldwide for facilities and equipment. Rent expense for facility leases is recognized ratably over the lease term, and includes adjustments for rent concessions, rent escalations and leasehold improvement allowances. We recognize lease restoration obligations at the fair value of the restoration liabilities when incurred and amortize the restoration assets over the lease term. +Certain costs associated with the acquisition or development of internal-use software are also capitalized and recorded in Premises and equipment. Once the software is ready for its intended use, these costs are amortized on a straight-line basis over the software’s estimated useful life, generally 5 years. We review these assets for impairment using the same impairment methodology used for our intangible assets. +83 +Table of Contents +OTHER SIGNIFICANT ACCOUNTING POLICIES +The following table identifies our other significant accounting policies, along with the related Note and page number where the Note can be found. +Significant Accounting Policy +Note +Number +Note Title +Page +Accounts Receivable +Note 3 +Loans and Accounts Receivable +Page 86 +Loans +Note 3 +Loans and Accounts Receivable +Page 86 +Reserves for Losses +Note 4 +Reserves for Losses +Page 92 +Investment Securities +Note 5 +Investment Securities +Page 94 +Asset Securitizations +Note 6 +Asset Securitizations +Page 96 +Membership Rewards +Note 10 +Other Liabilities +Page 103 +Stock-based Compensation +Note 11 +Stock Plans +Page 104 +Retirement Plans +Note 12 +Retirement Plans +Page 106 +Legal Contingencies +Note 13 +Contingencies and Commitments +Page 106 +Derivative Financial Instruments and Hedging Activities +Note 14 +Derivatives and Hedging Activities +Page 108 +Fair Value Measurements +Note 15 +Fair Values +Page 111 +Income Taxes +Note 21 +Income Taxes +Page 119 +Regulatory Matters and Capital Adequacy +Note 23 +Regulatory Matters and Capital Adequacy +Page 123 +Reportable Operating Segments +Note 25 +Reportable Operating Segments and Geographic Operations +Page 126 +CLASSIFICATION OF VARIOUS ITEMS +Certain reclassifications of prior period amounts have been made to conform to the current period presentation, including the reclassification of certain business development expenses from Other expenses to Marketing and business development, that were not directly attributable to the adoption of the new revenue recognition guidance. +RECENTLY ISSUED AND ADOPTED ACCOUNTING STANDARDS +Recently Issued Accounting Standards +In February 2016, the Financial Accounting Standards Board (FASB) issued new accounting guidance on leases. The accounting standard, effective January 1, 2019, requires virtually all leases to be recognized on the Consolidated Balance Sheets. Beginning with the quarter ending March 31, 2019, our financial statements will reflect the adoption of this standard using the modified retrospective method. We have elected the package of practical expedients and transition provisions allowing us to bring our existing operating leases onto the Consolidated Balance Sheet without adjusting comparative periods. +We have operating leases worldwide for facilities and equipment, which will be recorded as lease-related assets and liabilities upon adoption of the new guidance for those leases with terms greater than 12 months. Under the guidance, we have also elected to not separate lease and non-lease components in the recognition of the assets and liabilities, as well as the related lease expense. Lease-related assets, or right-of-use assets, will be recognized at the lease commencement date at amounts equal to the respective lease liabilities, adjusted for prepaid lease payments, and initial direct costs, and offset by lease incentives received. Lease-related liabilities will be recognized at the present value of the remaining contractual fixed lease payments, discounted using the Company’s incremental borrowing rate. Operating lease expense will continue to be recognized on a straight-line basis over the lease term, while variable lease payments will continue to be expensed as incurred. +The adoption of the standard will have the impact of increasing consolidated assets and liabilities by approximately $700 million and will not have a material impact on our financial position, results of operations, cash flows or regulatory risk-based capital. In conjunction with the adoption, we are upgrading our lease administration software and modifying our business processes and internal controls. +In June 2016, the FASB issued new accounting guidance for the recognition of credit losses on financial instruments, effective January 1, 2020, with early adoption permitted on January 1, 2019. We do not intend to early adopt the new standard. The guidance introduces a new credit reserving model known as the Current Expected Credit Loss (CECL) model, which is based on expected losses, and differs significantly from the incurred loss approach used today. The CECL model requires measurement of expected credit losses not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. In addition, for available-for-sale debt securities, the new guidance replaces the other-than-temporary impairment model, and requires the recognition of an allowance for reductions in a security’s fair value attributable to declines in credit quality, instead of a direct write-down of the security, when a valuation decline is determined to be other-than-temporary. The guidance also requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption. We continue to evaluate the impact the new guidance will have on our financial position, results of operations, cash flows, credit ratings and regulatory risk-based capital. We expect that the CECL model will alter the assumptions used in estimating credit losses on Card Member loans and receivables, and may result in material increases to our credit reserves as the new guidance involves earlier recognition of expected losses for the life of the assets. However, the extent of the impact will depend on the characteristics of our loan portfolio, macroeconomic conditions and forecasted information at the date of adoption. We continue to be actively engaged in cross-functional implementation efforts and are in the process of developing and implementing CECL models that satisfy the requirements of the new standard, along with appropriate business processes and controls. +In February 2018, as a result of the enactment of the Tax Cuts and Jobs Act (the Tax Act), the FASB issued new accounting guidance on the reclassification of certain tax effects from AOCI to retained earnings. The optional reclassification is effective January 1, 2019. We are evaluating the new guidance, along with any impacts on our financial position, results of operations and cash flows, none of which are expected to be material. +84 +Table of Contents +Recently Adopted Accounting Standards +Effective January 1, 2018, we adopted new revenue recognition guidance issued by the FASB related to contracts with customers. The scope of the new guidance excludes financial instruments such as credit and charge card arrangements. We elected to adopt the standard using the full retrospective method, which we believe is most useful to our investors. Under the full retrospective method, we are applying the standard back to January 1, 2016. As shown below, the most significant impacts of adoption are changes to the classification of certain revenues and expenses, including certain credit and charge card related costs previously netted against discount revenue, such as Card Member cash-back reward costs and statement credits, corporate incentive payments, as well as payments to third-party GNS card issuing partners. Under the new revenue standard, these costs are not considered components of the transaction price of our card acceptance agreements with merchants and thus are not netted against discount revenue, but instead are recognized as expenses. Our payments to third-party GNS card issuing partners are presented net of related revenues earned from the partners. +The impact to the 2017 fiscal quarters and years ended December 31, 2017 and 2016 were as follows: +Increase (Decrease) +Three months ended +Year Ended December +(Millions) +December 31, 2017 +September 30, 2017 +June 30, 2017 +March 31, 2017 +2017 +2016 +Revenues +Discount revenue +$ +981 +$ +930 +$ +928 +$ +868 +$ +3,707 +$ +3,699 +Other +(78 +) +(71 +) +(64 +) +(65 +) +(278 +) +(253 +) +Expenses +Marketing and business development +617 +591 +593 +549 +2,350 +2,420 +Card Member rewards +$ +286 +$ +268 +$ +271 +$ +254 +$ +1,079 +$ +1,026 +In addition, the cumulative impact to our retained earnings on January 1, 2016 was an increase of $55.2 million. +The adoption of the new guidance also resulted in changes to the recognition timing of certain revenues, the impact of which is not material to net income. Similarly, the adoption did not have a material impact on our financial position or cash flows. We had no material contract assets, contract liabilities or deferred contract costs recorded on the Consolidated Balance Sheet as of December 31, 2018 and 2017. Contract assets and liabilities are reported in a net position on a contract-by-contract basis at the end of each reporting period. In adopting the guidance, we implemented changes to our accounting policies, business processes, systems and internal controls to support the recognition, measurement and disclosure requirements under the new standard. Such changes were not material. +In January 2016, the FASB issued new accounting guidance on the recognition and measurement of financial assets and financial liabilities, which was effective and adopted by us as of January 1, 2018. The guidance makes targeted changes to GAAP; specifically to the classification and measurement of equity securities, and to certain disclosure requirements associated with the fair value of financial assets and liabilities. This applies to investments we make in non-public companies in the ordinary course of business, which historically were recognized under the cost method of accounting. These investments will be prospectively adjusted through earnings for observable price changes upon the identification of identical or similar transactions of the same company. The adoption of the guidance did not have a material impact on our financial position, results of operations and cash flows. We implemented changes to our accounting policies, business processes and internal controls in support of the new guidance. Such changes were not material. +In August 2017, the FASB issued new accounting guidance providing targeted improvements to the accounting for hedging activities, effective January 1, 2019, with early adoption permitted in any interim period or fiscal year before the effective date. The guidance introduces a number of amendments, several of which are optional, that are designed to simplify the application of hedge accounting, improve financial statement transparency and more closely align hedge accounting with an entity’s risk management strategies. Effective January 1, 2018, we adopted the guidance, with no material impact on our financial position, results of operations and cash flows, along with associated changes to our accounting policies, business processes and internal controls in support of the new guidance. Such changes were not material. +85 +Table of Contents +NOTE 2 +BUSINESS EVENTS +LOANS AND RECEIVABLES PORTFOLIO DISPOSITIONS +During the fourth quarter of 2015, it was determined we would sell the Card Member loans and receivables related to our cobrand partnerships with JetBlue Airways Corporation (JetBlue) and Costco Wholesale Corporation (Costco) in the United States (the HFS portfolios). As a result, the HFS portfolios were presented as held for sale (HFS) on the Consolidated Balance Sheets within Card Member loans and receivables HFS as of December 31, 2015. During the first half of 2016, we completed the sales of substantially all of these outstanding Card Member loans and receivables HFS and recognized gains, as an expense reduction in Other expenses, of $127 million and $1.1 billion during the three months ended March 31, 2016 and June 30, 2016, respectively. The impact of the sales, including the recognition of the proceeds received and the reclassification of the retained Card Member loans and receivables, was reported within the investing section of the Consolidated Statements of Cash Flows as a net decrease in Card Member receivables and loans, including HFS. From the point of classification as HFS through the sale completion dates, we continued to recognize discount revenue, interest income, other revenues and expenses related to the HFS portfolios in the respective line items on the Consolidated Statements of Income, with changes in the valuation of the HFS portfolios recognized in Other expenses. +LOAN PORTFOLIO ACQUISITION +During the first quarter of 2018, we acquired the portion of the Hilton Worldwide Holdings Inc. cobrand credit card loan portfolio that we did not previously own (the acquired Hilton portfolio). The acquired Hilton portfolio had an outstanding principal and interest balance of approximately $1 billion at acquisition. None of the credit card loans acquired were considered purchased credit impaired at acquisition date. The cash outflows related to this acquisition are reported within the investing section of the Consolidated Statements of Cash Flows primarily as a net increase in Card Member receivables and loans. +86 +Table of Contents +NOTE 3 +LOANS AND ACCOUNTS RECEIVABLE +Our lending and charge payment card products result in the generation of Card Member loans and Card Member receivables, respectively. +CARD MEMBER AND OTHER LOANS +Card Member loans are recorded at the time a Card Member enters into a point-of-sale transaction with a merchant and represent revolving amounts due on lending card products, as well as amounts due from charge Card Members who utilize the Pay Over Time features on their account and elect to revolve a portion of the outstanding balance by entering into a revolving payment arrangement with us. These loans have a range of terms such as credit limits, interest rates, fees and payment structures, which can be revised over time based on new information about Card Members, and in accordance with applicable regulations and the respective product’s terms and conditions. Card Members holding revolving loans are typically required to make monthly payments based on pre-established amounts and the amounts that Card Members choose to revolve are subject to finance charges. +Card Member loans are presented on the Consolidated Balance Sheets net of reserves for losses (refer to Note 4), and include principal and any related accrued interest and fees. Our policy generally is to cease accruing interest on a Card Member loan at the time the account is written off, and establish reserves for interest that we believe will not be collected. +Card Member loans by segment and Other loans as of December 31, 2018 and 2017 consisted of: +(Millions) +2018 +2017 +Global Consumer Services Group (a) +$ +69,458 +$ +62,319 +Global Commercial Services +12,396 +11,080 +Card Member loans +81,854 +73,399 +Less: Reserve for losses +2,134 +1,706 +Card Member loans, net +$ +79,720 +$ +71,693 +Other loans, net (b) +$ +3,676 +$ +2,607 +(a) +Includes approximately $33.2 billion and $25.7 billion of gross Card Member loans available to settle obligations of a consolidated VIE as of December 31, 2018 and 2017, respectively. The balance as of December 31, 2018 also includes loans related to the acquired Hilton portfolio (refer to Note 2). +(b) +Other loans primarily represent consumer and commercial non-card financing products. Other loans are presented net of reserves for losses of $124 million and $80 million as of December 31, 2018 and 2017, respectively. +CARD MEMBER AND OTHER RECEIVABLES +Card Member receivables are also recorded at the time a Card Member enters into a point-of-sale transaction with a merchant and represent amounts due on charge card products. Each charge card transaction is authorized based on its likely economics, a Card Member’s most recent credit information and spend patterns. Additionally, global spend limits are established to limit our maximum exposure. +Charge Card Members generally must pay the full amount billed each month. Card Member receivable balances are presented on the Consolidated Balance Sheets net of reserves for losses (refer to Note 4), and include principal and any related accrued fees. +Card Member accounts receivable by segment and Other receivables as of December 31, 2018 and 2017 consisted of: +(Millions) +2018 +2017 +Global Consumer Services Group (a) +$ +21,455 +$ +20,946 +Global Commercial Services +34,438 +33,101 +Card Member receivables +55,893 +54,047 +Less: Reserve for losses +573 +521 +Card Member receivables, net +$ +55,320 +$ +53,526 +Other receivables, net (b) +$ +2,907 +$ +3,209 +(a) +Includes $8.5 billion and $8.9 billion of gross Card Member receivables available to settle obligations of a consolidated VIE as of both December 31, 2018 and 2017, respectively. +(b) +Other receivables primarily represent amounts related to (i) GNS partners for items such as royalty and franchise fees, (ii) tax-related receivables, (iii) certain merchants for billed discount revenue, and (iv) loyalty coalition partners for points issued, as well as program participation and servicing fees. Other receivables are presented net of reserves for losses of $25 million and $31 million as of December 31, 2018 and 2017, respectively. +87 +Table of Contents +CARD MEMBER LOANS AND CARD MEMBER RECEIVABLES AGING +Generally, a Card Member account is considered past due if payment is not received within 30 days after the billing statement date. The following table presents the aging of Card Member loans and receivables as of December 31, 2018 and 2017: +2018 (Millions) +Current +30-59 +Days Past Due +60-89 +Days Past Due +90+ +Days Past Due +Total +Card Member Loans: +Global Consumer Services Group +$ +68,442 +$ +290 +$ +220 +$ +506 +$ +69,458 +Global Commercial Services +Global Small Business Services +12,195 +51 +32 +73 +12,351 +Global Corporate Payments (a) +(b) +(b) +(b) +― +45 +Card Member Receivables: +Global Consumer Services Group +21,207 +80 +50 +118 +21,455 +Global Commercial Services +Global Small Business Services +$ +16,460 +$ +101 +$ +53 +$ +114 +$ +16,728 +Global Corporate Payments (a) +(b) +(b) +(b) +$ +129 +$ +17,710 +2017 (Millions) +Current +30-59 +Days Past Due +60-89 +Days Past Due +90+ +Days Past Due +Total +Card Member Loans: +Global Consumer Services Group +$ +61,491 +$ +238 +$ +190 +$ +400 +$ +62,319 +Global Commercial Services +Global Small Business Services +10,892 +43 +31 +59 +11,025 +Global Corporate Payments (a) +(b) +(b) +(b) +― +55 +Card Member Receivables: +Global Consumer Services Group +20,696 +82 +54 +114 +20,946 +Global Commercial Services +Global Small Business Services +$ +15,868 +$ +91 +$ +54 +$ +106 +$ +16,119 +Global Corporate Payments (a) +(b) +(b) +(b) +$ +148 +$ +16,982 +(a) +For Global Corporate Payments (GCP) Card Member loans and receivables in GCS, delinquency data is tracked based on days past billing status rather than days past due. A Card Member account is considered 90 days past billing if payment has not been received within 90 days of the Card Member’s billing statement date. In addition, if we initiate collection procedures on an account prior to the account becoming 90 days past billing, the associated Card Member loan or receivable balance is classified as 90 days past billing. These amounts are shown above as 90+ Days Past Due for presentation purposes. See also (b). +(b) +Delinquency data for periods other than 90+ days past billing is not available due to system constraints. Therefore, such data has not been utilized for risk management purposes. The balances that are current to 89 days past due can be derived as the difference between the Total and the 90+ Days Past Due balances. +CREDIT QUALITY INDICATORS FOR CARD MEMBER LOANS AND RECEIVABLES +The following tables present the key credit quality indicators as of or for the years ended December 31: +2018 +2017 +Net Write-Off Rate +Net Write-Off Rate +Principal +Only (a) +Principal, +Interest, & +Fees (a) +30+ +Days Past Due +as a % of +Total +Principal +Only (a) +Principal, +Interest, & +Fees (a) +30+ +Days Past Due +as a % of +Total +Card Member Loans: +Global Consumer Services Group +2.1 +% +2.5 +% +1.5 +% +1.8 +% +2.2 +% +1.3 +% +Global Small Business Services +1.7 +% +2.0 +% +1.3 +% +1.6 +% +1.9 +% +1.2 +% +Card Member Receivables: +Global Consumer Services Group +1.6 +% +1.8 +% +1.2 +% +1.5 +% +1.7 +% +1.2 +% +Global Small Business Services +1.7 +% +2.0 +% +1.6 +% +1.6 +% +1.8 +% +1.6 +% +2018 +2017 +Net Loss +Ratio as +a % of +Charge +Volume +90+ +Days Past Billing +as a % of +Receivables +Net Loss +Ratio as +a % of +Charge +Volume +90+ +Days Past Billing +as a % of +Receivables +Card Member Receivables: +Global Corporate Payments +0.11 +% +0.7 +% +0.10 +% +0.9 +% +(a) +We present a net write-off rate based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, because we consider uncollectible interest and/or fees in estimating our reserves for credit losses, a net write-off rate including principal, interest and/or fees is also presented. +Refer to Note 4 for additional indicators, including external environmental qualitative factors, management considers in its monthly evaluation process for reserves for losses. +88 +Table of Contents +IMPAIRED CARD MEMBER LOANS AND RECEIVABLES +Impaired Card Member loans and receivables are individual larger balance or homogeneous pools of smaller balance loans and receivables for which it is probable that we will be unable to collect all amounts due according to the original contractual terms of the Card Member agreement. We consider impaired loans and receivables to include: (i) loans over 90 days past due still accruing interest, (ii) nonaccrual loans and (iii) loans and receivables modified as troubled debt restructurings (TDRs). +In instances where the Card Member is experiencing financial difficulty, we may modify, through various programs, Card Member loans and receivables in order to minimize losses and improve collectability, while providing Card Members with temporary or permanent financial relief. We have classified Card Member loans and receivables in these modification programs as TDRs and continue to classify Card Member accounts that have exited a modification program as a TDR, with such accounts identified as “Out of Program TDRs.” +Such modifications to the loans and receivables primarily include (i) temporary interest rate reductions (possibly as low as zero percent, in which case the loan is characterized as non-accrual in our TDR disclosures), (ii) placing the Card Member on a fixed payment plan not to exceed 60 months and (iii) suspending delinquency fees until the Card Member exits the modification program. Upon entering the modification program, the Card Member’s ability to make future purchases is either cancelled, or in certain cases suspended until the Card Member successfully exits the modification program. In accordance with the modification agreement with the Card Member, loans may revert back to the original contractual terms (including the contractual interest rate) when the Card Member exits the modification program, which is (i) when all payments have been made in accordance with the modification agreement or, (ii) when the Card Member defaults out of the modification program. We establish a reserve for Card Member interest charges and fees considered to be uncollectible. +Reserves for Card Member loans and receivables modified as TDRs are determined as the difference between the cash flows expected to be received from the Card Member (taking into consideration the probability of subsequent defaults), discounted at the original effective interest rates, and the carrying value of the related Card Member loan or receivables balance. We determine the original effective interest rate as the interest rate in effect prior to the imposition of any penalty interest rate. All changes in the impairment measurement are included in Provisions for losses in the Consolidated Statements of Income. +89 +Table of Contents +The following tables provide additional information with respect to our impaired Card Member loans and receivables as of December 31, 2018, 2017 and 2016. Impaired Card Member loans and receivables outside the U.S. are not significant as of December 31, 2018, 2017 and 2016; therefore, such loans and receivables are not included in the following tables unless otherwise noted. +As of December 31, 2018 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance +Unpaid Principal Balance +Allowance for TDRs +Card Member Loans: +Global Consumer Services Group (f) +$ +344 +$ +236 +$ +313 +$ +131 +$ +1,024 +$ +923 +$ +80 +Global Commercial Services +43 +43 +59 +29 +174 +161 +14 +Card Member Receivables: +Global Consumer Services Group +― +― +29 +13 +42 +42 +2 +Global Commercial Services +― +― +61 +25 +86 +86 +5 +Total +$ +387 +$ +279 +$ +462 +$ +198 +$ +1,326 +$ +1,212 +$ +101 +As of December 31, 2017 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance +Unpaid Principal Balance +Allowance for TDRs +Card Member Loans: +Global Consumer Services Group (f) +$ +289 +$ +168 +$ +178 +$ +131 +$ +766 +$ +694 +$ +49 +Global Commercial Services +38 +31 +31 +27 +127 +118 +8 +Card Member Receivables: +Global Consumer Services Group +― +― +15 +9 +24 +24 +1 +Global Commercial Services +― +― +37 +19 +56 +56 +2 +Total +$ +327 +$ +199 +$ +261 +$ +186 +$ +973 +$ +892 +$ +60 +As of December 31, 2016 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance +Unpaid Principal Balance +Allowance for TDRs +Card Member Loans: +Global Consumer Services Group (f) +$ +230 +$ +139 +$ +165 +$ +129 +$ +663 +$ +609 +$ +51 +Global Commercial Services +30 +30 +26 +26 +112 +103 +9 +Card Member Receivables: +Global Consumer Services Group +― +― +11 +6 +17 +17 +7 +Global Commercial Services +― +― +28 +10 +38 +38 +21 +Total +$ +260 +$ +169 +$ +230 +$ +171 +$ +830 +$ +767 +$ +88 +(a) +Our policy is generally to accrue interest through the date of write-off (typically 180 days past due). We establish reserves for interest that we believe will not be collected. Amounts presented exclude Card Member loans classified as a TDR. +(b) +Non-accrual loans not in modification programs primarily include certain Card Member loans placed with outside collection agencies for which we have ceased accruing interest. Amounts presented exclude Card Member loans classified as a TDR. +(c) +Accounts classified as a TDR include $17 million, $15 million and $20 million that are over 90 days past due and accruing interest and $6 million, $5 million and $11 million that are non-accruals as of December 31, 2018, 2017 and 2016, respectively. +(d) +In Program TDRs include Card Member accounts that are currently enrolled in a modification program. +(e) +Out of Program TDRs include $148 million, $141 million and $132 million of Card Member accounts that have successfully completed a modification program and $50 million, $45 million and $39 million of Card Member accounts that were not in compliance with the terms of the modification programs as of December 31, 2018, 2017 and 2016, respectively. +(f) +GCSG includes balances outside the U.S. of $69 million, $56 million and $52 million that are over 90 days and accruing interest and $68 million, $55 million and $51 million in unpaid principal as of December 31, 2018, 2017 and 2016, respectively. +90 +Table of Contents +The following table provides information with respect to our average balances and interest income recognized from impaired Card Member loans and the average balances of impaired Card Member receivables for the years ended December 31: +2018 (Millions) +Average Balance +Interest Income Recognized +Card Member Loans: +Global Consumer Services Group +$ +878 +$ +109 +Global Commercial Services +150 +21 +Card Member Receivables: +Global Consumer Services Group +33 +― +Global Commercial Services +73 +― +Total +$ +1,134 +130 +Interest Income +2017 (Millions) +Average Balance +Recognized +Card Member Loans: +Global Consumer Services Group +$ +699 +$ +85 +Global Commercial Services +120 +17 +Card Member Receivables: +Global Consumer Services Group +20 +― +Global Commercial Services +45 +― +Total +$ +884 +$ +102 +Interest Income +2016 (Millions) +Average Balance +Recognized +Card Member Loans: +Global Consumer Services Group +$ +612 +$ +68 +Global Commercial Services +103 +13 +Card Member Receivables: +Global Consumer Services Group +14 +― +Global Commercial Services +28 +― +Total +$ +757 +$ +81 +CARD MEMBER LOANS AND RECEIVABLES MODIFIED AS TDRS +The following table provides additional information with respect to Card Member loans and receivables modified as TDRs for the years ended December 31: +2018 +Number of Accounts +(in thousands) +Outstanding Balances +($ in millions) (a) +Average Interest Rate Reduction +(% points) +Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans +51 +$ +377 +12 +(b) +Card Member Receivables +6 +110 +(c) +28 +Total +57 +$ +487 +2017 +Number of Accounts +(in thousands) +Outstanding Balances +($ in millions) (a) +Average Interest Rate Reduction +(% points) +Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans +33 +$ +224 +10 +(b) +Card Member Receivables +6 +83 +(c) +28 +Total +39 +$ +307 +2016 +Number of Accounts +(in thousands) +Outstanding Balances +($ in millions) (a) +Average Interest Rate Reduction +(% points) +Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans +31 +$ +220 +9 +(b) +Card Member Receivables +9 +123 +(c) +18 +Total +40 +$ +343 +(a) +Represents the outstanding balance immediately prior to modification. The outstanding balance includes principal, fees and accrued interest on Card Member loans and principal and fees on Card Member receivables. Modifications did not reduce the principal balance. +(b) +For Card Member loans, there have been no payment term extensions. +(c) +We do not offer interest rate reduction programs for Card Member receivables as the receivables are non-interest bearing. +91 +Table of Contents +The following table provides information with respect to Card Member loans and receivables modified as TDRs that subsequently defaulted within 12 months of modification for the years ended December 31, 2018, 2017 and 2016. A Card Member is considered in default of a modification program after one and up to two missed payments, depending on the terms of the modification program. For all Card Members that defaulted from a modification program, the probability of default is factored into the reserves for Card Member loans and receivables. +Number of Accounts +Aggregated Outstanding Balances Upon Default (a) +2018 +(thousands) +(millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans +8 +$ +46 +Card Member Receivables +4 +11 +Total +12 +$ +57 +Number of Accounts +Aggregated Outstanding Balances Upon Default (a) +2017 +(thousands) +(millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans +6 +$ +39 +Card Member Receivables +3 +7 +Total +9 +$ +46 +Number of Accounts +Aggregated Outstanding Balances Upon Default (a) +2016 +(thousands) +(millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans +7 +$ +41 +Card Member Receivables +3 +4 +Total +10 +$ +45 +(a) +The outstanding balances upon default include principal, fees and accrued interest on Card Member loans, and principal and fees on Card Member receivables. +92 +Table of Contents +NOTE 4 +RESERVES FOR LOSSES +Reserves for losses relating to Card Member loans and receivables represent management’s best estimate of the probable inherent losses in our outstanding portfolio of loans and receivables, as of the balance sheet date. Management’s evaluation process requires certain estimates and judgments. +Reserves for losses are primarily based upon statistical and analytical models that analyze portfolio performance and reflect management’s judgment regarding the quantitative components of the reserve. The models take into account several factors, including delinquency-based loss migration rates, loss emergence periods and average losses and recoveries over an appropriate historical period. Management considers whether to adjust the quantitative reserves for certain external and internal qualitative factors, which may increase or decrease the reserves for losses on Card Member loans and receivables. These external factors include employment, spend, sentiment, housing and credit, and changes in the legal and regulatory environment, while the internal factors include increased risk in certain portfolios, impact of risk management initiatives, changes in underwriting requirements and overall process stability. As part of this evaluation process, management also considers various reserve coverage metrics, such as reserves as a percentage of past due amounts, reserves as a percentage of Card Member loans or receivables, and net write-off coverage ratios. +Card Member loans and receivables balances are written off when management considers amounts to be uncollectible, which is generally determined by the number of days past due and is typically no later than 180 days past due. Card Member loans and receivables in bankruptcy or owed by deceased individuals are generally written off upon notification. +CHANGES IN CARD MEMBER LOANS RESERVE FOR LOSSES +The following table presents changes in the Card Member loans reserve for losses for the years ended December 31: +(Millions) +2018 +2017 +2016 +Balance, January 1 +$ +1,706 +$ +1,223 +$ +1,028 +Provisions (a) +2,266 +1,868 +1,235 +Net write-offs (b) +Principal +(1,539 +) +(1,181 +) +(930 +) +Interest and fees +(304 +) +(227 +) +(175 +) +Other (c) +5 +23 +65 +Balance, December 31 +$ +2,134 +$ +1,706 +$ +1,223 +(a) +Provisions for principal, interest and fee reserve components. +(b) +Principal write-offs are presented less recoveries of $444 million, $409 million and $379 million for the years ended December 31, 2018, 2017 and 2016, respectively. Recoveries of interest and fees were not significant. Amounts include net (write-offs) recoveries from TDRs of $(33) million, $(30) million and $(34) million, for the years ended December 31, 2018, 2017 and 2016, respectively. +(c) +Includes foreign currency translation adjustments of $(11) million, $8 million and $(10) million, and other adjustments of $16 million, $15 million and $8 million for the years ended December 31, 2018, 2017 and 2016, respectively. The year ended December 31, 2016 included reserves of $67 million associated with $265 million of retained Card Member loans reclassified from HFS to held for investment as a result of retaining certain loans in connection with the respective sales of JetBlue and Costco cobrand card portfolios. +CARD MEMBER LOANS EVALUATED INDIVIDUALLY AND COLLECTIVELY FOR IMPAIRMENT +The following table presents Card Member loans evaluated individually and collectively for impairment and related reserves as of December 31: +(Millions) +2018 +2017 +2016 +Card Member loans evaluated individually for impairment (a) +$ +532 +$ +367 +$ +346 +Related reserves (a) +$ +94 +$ +57 +$ +60 +Card Member loans evaluated collectively for impairment (b) +$ +81,322 +$ +73,032 +$ +64,919 +Related reserves (b) +$ +2,040 +$ +1,649 +$ +1,163 +(a) +Represents loans modified as a TDR and related reserves. +(b) +Represents current loans and loans less than 90 days past due, loans over 90 days past due and accruing interest, and non-accrual loans. The reserves include the quantitative results of analytical models that are specific to individual pools of loans, and reserves for internal and external qualitative risk factors that apply to loans that are collectively evaluated for impairment. +93 +Table of Contents +CHANGES IN CARD MEMBER RECEIVABLES RESERVE FOR LOSSES +The following table presents changes in the Card Member receivables reserve for losses for the years ended December 31: +(Millions) +2018 +2017 +2016 +Balance, January 1 +$ +521 +$ +467 +$ +462 +Provisions (a) +937 +795 +696 +Net write-offs (b) +(859 +) +(736 +) +(674 +) +Other (c) +(26 +) +(5 +) +(17 +) +Balance, December 31 +$ +573 +$ +521 +$ +467 +(a) +Provisions for principal and fee reserve components. +(b) +Net write-offs are presented less recoveries of $367 million, $366 million and $394 million for the years ended December 31, 2018, 2017 and 2016, respectively. Amounts include net recoveries (write-offs) from TDRs of nil, $2 million and $(16) million, for the years ended December 31, 2018, 2017 and 2016, respectively. +(c) +Includes foreign currency translation adjustments of $(6) million, $12 million and $(12) million, and other adjustments of $(20) million, $(17) million and $(5) million for the years ended December 31, 2018, 2017 and 2016, respectively. +CARD MEMBER RECEIVABLES EVALUATED INDIVIDUALLY AND COLLECTIVELY FOR IMPAIRMENT +The following table presents Card Member receivables evaluated individually and collectively for impairment and related reserves as of December 31: +(Millions) +2018 +2017 +2016 +Card Member receivables evaluated individually for impairment (a) +$ +128 +$ +80 +$ +55 +Related reserves (a) +$ +7 +$ +3 +$ +28 +Card Member receivables evaluated collectively for impairment +$ +55,765 +$ +53,967 +$ +47,253 +Related reserves (b) +$ +566 +$ +518 +$ +439 +(a) +Represents receivables modified as a TDR and related reserves. +(b) +The reserves include the quantitative results of analytical models that are specific to individual pools of receivables, and reserves for internal and external qualitative risk factors that apply to receivables that are collectively evaluated for impairment. +94 +Table of Contents +NOTE 5 +INVESTMENT SECURITIES +Investment securities principally include available-for-sale debt securities carried at fair value on the Consolidated Balance Sheets, with unrealized gains and losses recorded in AOCI, net of income taxes. Realized gains and losses are recognized upon disposition of the securities using the specific identification method. +Investment securities also include equity securities carried at fair value on the Consolidated Balance Sheets. Effective January 1, 2018, the unrealized gains and losses on equity securities are recorded in the Consolidated Statements of Income; prior to January 1, 2018, the unrealized gains and losses on equity securities were recorded in AOCI, net of income taxes. +Refer to Note 15 for a description of our methodology for determining the fair value of investment securities. +The following is a summary of investment securities as of December 31: +2018 +2017 +2016 +Description of Securities (Millions) +Cost +Gross Unrealized Gains +Gross Unrealized Losses +Estimated Fair Value +Cost +Gross Unrealized Gains +Gross Unrealized Losses +Estimated Fair Value +Cost +Gross Unrealized Gains +Gross Unrealized Losses +Estimated Fair Value +Available-for-sale debt securities: +State and municipal obligations +$ +594 +$ +4 +$ +(2 +) +$ +596 +$ +1,369 +$ +11 +$ +(3 +) +$ +1,377 +$ +2,019 +$ +28 +$ +(11 +) +$ +2,036 +U.S. Government agency obligations +10 +― +― +10 +11 +― +― +11 +12 +― +― +12 +U.S. Government treasury obligations +3,452 +5 +(17 +) +3,440 +1,051 +3 +(9 +) +1,045 +465 +3 +(8 +) +460 +Corporate debt securities +28 +― +― +28 +28 +― +― +28 +19 +― +― +19 +Mortgage-backed securities (a) +50 +1 +― +51 +67 +2 +― +69 +92 +3 +― +95 +Foreign government bonds and obligations +474 +― +― +474 +581 +― +― +581 +486 +1 +(1 +) +486 +Equity securities (b) +51 +― +(3 +) +48 +51 +― +(3 +) +48 +51 +― +(2 +) +49 +Total +$ +4,659 +$ +10 +$ +(22 +) +$ +4,647 +$ +3,158 +$ +16 +$ +(15 +) +$ +3,159 +$ +3,144 +$ +35 +$ +(22 +) +$ +3,157 +(a) +Represents mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. +(b) +Equity securities comprise investments in common stock and mutual funds. +The following table provides information about our investment securities with gross unrealized losses and the length of time that individual securities have been in an unrealized loss position as of December 31: +2018 +2017 +Less than 12 months +12 months or more +Less than 12 months +12 months or more +Description of Securities (Millions) +Estimated Fair Value +Gross Unrealized Losses +Estimated Fair Value +Gross Unrealized Losses +Estimated Fair Value +Gross Unrealized Losses +Estimated Fair Value +Gross Unrealized Losses +State and municipal obligations +$ +― +$ +― +$ +82 +$ +(1 +) +$ +157 +$ +(3 +) +$ +― +$ +― +U.S. Government treasury obligations +224 +(2 +) +791 +(15 +) +650 +(3 +) +175 +(6 +) +Equity securities +(a) +(a) +(a) +(a) +― +― +36 +(2 +) +Total +$ +224 +$ +(2 +) +$ +873 +$ +(16 +) +$ +807 +$ +(6 +) +$ +211 +$ +(8 +) +(a) +Effective January 1, 2018, the unrealized gains and losses on equity securities are recorded in the Consolidated Statements of Income and are no longer assessed for other-than-temporary impairment. +The following table summarizes the gross unrealized losses due to temporary impairments by ratio of fair value to amortized cost as of December 31: +Less than 12 months +12 months or more +Total +Ratio of Fair Value to +Amortized Cost (Dollars in millions) +Number of Securities +Estimated Fair Value +Gross Unrealized Losses +Number of Securities +Estimated Fair Value +Gross Unrealized Losses +Number of Securities +Estimated Fair Value +Gross Unrealized Losses +2018: +90%–100% +2 +$ +224 +$ +(2 +) +29 +$ +873 +$ +(16 +) +31 +$ +1,097 +$ +(18 +) +Total as of December 31, 2018 +2 +$ +224 +$ +(2 +) +29 +$ +873 +$ +(16 +) +31 +$ +1,097 +$ +(18 +) +2017: +90%–100% +34 +$ +807 +$ +(6 +) +13 +$ +211 +$ +(8 +) +47 +$ +1,018 +$ +(14 +) +Total as of December 31, 2017 +34 +$ +807 +$ +(6 +) +13 +$ +211 +$ +(8 +) +47 +$ +1,018 +$ +(14 +) +95 +Table of Contents +The gross unrealized losses for available-for-sale debt securities are attributed to wider credit spreads for specific issuers, adverse changes in benchmark interest rates, or a combination thereof, all compared to those prevailing when the investment securities were purchased. +Overall, for the available-for-sale debt securities in gross unrealized loss positions, (i) we do not intend to sell the securities, (ii) it is more likely than not that we will not be required to sell the securities before recovery of the unrealized losses, and (iii) we expect that the contractual principal and interest will be received on the securities. As a result, we recognized no other-than-temporary impairment during the periods presented. +Weighted average yields and contractual maturities for investment securities with stated maturities as of December 31, 2018 were as follows: +(Millions) +Due within 1 year +Due after 1 year but +within 5 years +Due after 5 years but +within 10 years +Due after 10 years +Total +State and municipal obligations (a) +$ +13 +$ +47 +$ +66 +$ +470 +$ +596 +U.S. Government agency obligations +― +― +― +10 +10 +U.S. Government treasury obligations +1,773 +1,534 +131 +2 +3,440 +Corporate debt securities +2 +26 +― +― +28 +Mortgage-backed securities (a) +― +― +― +51 +51 +Foreign government bonds and obligations +474 +― +― +― +474 +Total Estimated Fair Value +$ +2,262 +$ +1,607 +$ +197 +$ +533 +$ +4,599 +Total Cost +$ +2,261 +$ +1,617 +$ +199 +$ +531 +$ +4,608 +Weighted average yields (b) +2.81 +% +2.15 +% +3.49 +% +3.53 +% +2.69 +% +(a) +The expected payments on state and municipal obligations and mortgage-backed securities may not coincide with their contractual maturities because the issuers have the right to call or prepay certain obligations. +(b) +Average yields for investment securities have been calculated using the effective yield on the date of purchase. Yields on tax-exempt investment securities have been computed on a tax-equivalent basis using the U.S. federal statutory tax rate of 21 percent. +96 +Table of Contents +NOTE 6 +ASSET SECURITIZATIONS +We periodically securitize Card Member loans and receivables arising from our card businesses through the transfer of those assets to securitization trusts, American Express Credit Account Master Trust (the Lending Trust) and American Express Issuance Trust II (the Charge Trust and together with the Lending Trust, the Trusts). The Trusts then issue debt securities collateralized by the transferred assets to third-party investors. +The Trusts are considered VIEs as they have insufficient equity at risk to finance their activities, which are to issue debt securities that are collateralized by the underlying Card Member loans and receivables. Refer to Note 1 for further details on the principles of consolidation. We perform the servicing and key decision making for the Trusts, and therefore have the power to direct the activities that most significantly impact the Trusts’ economic performance, which are the collection of the underlying Card Member loans and receivables. In addition, we hold all of the variable interests in both Trusts, with the exception of the debt securities issued to third-party investors. As of December 31, 2018, our ownership of variable interests was $15.5 billion and $7 billion for the Lending Trust and the Charge Trust, respectively. These variable interests held by us provide us with the right to receive benefits and the obligation to absorb losses, which could be significant to both the Lending Trust and the Charge Trust. Based on these considerations, we are the primary beneficiary of the Trusts and therefore consolidate the Trusts. +The debt securities issued by the Trusts are non-recourse to us. The securitized Card Member loans and receivables held by the Lending Trust and the Charge Trust, respectively, are available only for payment of the debt securities or other obligations issued or arising in the securitization transactions (refer to Note 3). The long-term debt of each Trust is payable only out of collections on their respective underlying securitized assets (refer to Note 9). +The following table provides information on the restricted cash held by the Trusts as of December 31, 2018 and 2017, included in Other assets on the Consolidated Balance Sheets: +(Millions) +2018 +2017 +Lending Trust +$ +67 +$ +55 +Charge Trust +3 +7 +Total +$ +70 +$ +62 +These amounts relate to collections of Card Member loans and receivables to be used by the Trusts to fund future expenses and obligations, including interest on debt securities, credit losses and upcoming debt maturities. +Under the respective terms of the Lending Trust and the Charge Trust agreements, the occurrence of certain triggering events associated with the performance of the assets of each Trust could result in payment of trust expenses, establishment of reserve funds, or, in a worst-case scenario, early amortization of debt securities. During the year ended December 31, 2018, no such triggering events occurred. +97 +Table of Contents +NOTE 7 +OTHER ASSETS +The following is a summary of Other assets as of December 31: +(Millions) +2018 +2017 +Goodwill +$ +3,072 +$ +3,009 +Deferred tax assets, net (a) +1,480 +1,637 +Prepaid expenses (b) +1,458 +684 +Tax credit investments +1,043 +1,023 +Derivative assets (a) +396 +124 +Restricted cash (c) +363 +336 +Other intangible assets, at amortized cost (b) +275 +899 +Other +2,384 +2,034 +Total +$ +10,471 +$ +9,746 +(a) +Refer to Notes 14 and 21 for a discussion of derivative assets and deferred tax assets, net. For 2018 and 2017, $174 million and $98 million, respectively, of foreign deferred tax liabilities is reflected in Other liabilities. Derivative assets reflect the impact of master netting agreements and cash collateral. +(b) +As of September 30, 2018, $796 million of net assets previously included within Other intangible assets were reclassified to Prepaid expenses. +(c) +Includes restricted cash available to settle obligations related to certain Card Member credit balances and customer deposits, as well as coupon and maturity obligations of consolidated VIEs. +GOODWILL +The changes in the carrying amount of goodwill reported in our reportable operating segments were as follows: +(Millions) +GCSG +GCS +GMNS +Total +Balance as of December 31, 2016 +$ +590 +$ +1,711 +$ +626 +$ +2,927 +Acquisitions +19 +― +― +19 +Dispositions +― +― +― +― +Other (a) +28 +13 +22 +63 +Balance as of December 31, 2017 +$ +637 +$ +1,724 +$ +648 +$ +3,009 +Acquisitions +90 +― +― +90 +Dispositions +― +― +― +― +Other (a) +(20 +) +(6 +) +(1 +) +(27 +) +Balance as of December 31, 2018 +$ +707 +$ +1,718 +$ +647 +$ +3,072 +(a) +Primarily includes foreign currency translation. +Accumulated impairment losses were $221 million and $220 million as of December 31, 2018 and 2017, respectively. +OTHER INTANGIBLE ASSETS +Intangible assets are amortized on a straight-line basis over their estimated useful lives of 1 to 22 years. We review long-lived assets and asset groups, including intangible assets, for impairment whenever events and circumstances indicate their carrying amounts may not be recoverable. An impairment is recognized if the carrying amount is not recoverable and exceeds the asset or asset group’s fair value. +The gross carrying amount for other intangible assets as of December 31, 2018 and 2017 was $702 million and $2,105 million, respectively, with accumulated amortization of $427 million and $1,206 million, respectively. As of September 30, 2018, certain assets previously classified within Other intangible assets were reclassified to Prepaid expenses. +Amortization expense for the years ended December 31, 2018, 2017 and 2016 was $212 million, $207 million and $194 million, respectively. +98 +Table of Contents +TAX CREDIT INVESTMENTS +We account for our tax credit investments, including Qualified Affordable Housing (QAH) investments, using the equity method of accounting. As of December 31, 2018 and 2017, we had $1,043 million and $1,023 million in tax credit investments, respectively, included in Other assets on the Consolidated Balance Sheets, of which $1,006 million and $1,018 million, respectively, specifically related to QAH investments. Included in QAH investments as of December 31, 2018 and 2017, we had $936 million and $933 million, respectively, specifically related to investments in unconsolidated VIEs for which we do not have a controlling financial interest. +As of December 31, 2018, we had committed to provide funding related to certain of these QAH investments, which is expected to be paid between 2019 and 2033, resulting in a $237 million unfunded commitment reported in Other liabilities, of which $228 million specifically related to unconsolidated VIEs. +In addition, we had contractual off-balance sheet obligations, which were not deemed probable of being drawn, to provide additional funding up to $59 million for these QAH investments as of December 31, 2018, fully related to unconsolidated VIEs. +During the years ended December 31, 2018 and 2017, we recognized equity method losses related to our QAH investments of $126 million and $112 million, respectively, which were recognized in Other, net expenses; and associated tax credits of $97 million and $74 million, respectively, recognized in Income tax provision. +99 +Table of Contents +NOTE 8 +CUSTOMER DEPOSITS +As of December 31, customer deposits were categorized as interest-bearing or non-interest-bearing as follows: +(Millions) +2018 +2017 +U.S.: +Interest-bearing +$ +69,144 +$ +63,666 +Non-interest-bearing (includes Card Member credit balances of: 2018, $376 million; 2017, $358 million) +412 +395 +Non-U.S.: +Interest-bearing +28 +34 +Non-interest-bearing (includes Card Member credit balances of: 2018, $367 million; 2017, $344 million) +376 +357 +Total customer deposits +$ +69,960 +$ +64,452 +Customer deposits by deposit type as of December 31 were as follows: +(Millions) +2018 +2017 +U.S. retail deposits: +Savings accounts ― Direct +$ +39,491 +$ +31,915 +Certificates of deposit: (a) +Direct +817 +290 +Third-party (brokered) +12,667 +16,684 +Sweep accounts ―Third-party (brokered) +16,169 +14,777 +Other deposits: +U.S. non-interest bearing deposits +36 +37 +Non-U.S. deposits +37 +47 +Card Member credit balances ― U.S. and non-U.S. +743 +702 +Total customer deposits +$ +69,960 +$ +64,452 +(a) +The weighted average remaining maturity and weighted average interest rate at issuance on the total portfolio of U.S. retail certificates of deposit issued through direct and third-party programs were 47 months and 2.38 percent, respectively, as of December 31, 2018. +The scheduled maturities of certificates of deposit as of December 31, 2018 were as follows: +(Millions) +U.S. +Non-U.S. +Total +2019 +$ +4,730 +$ +18 +$ +4,748 +2020 +4,290 +― +4,290 +2021 +1,869 +― +1,869 +2022 +2,278 +― +2,278 +2023 +317 +― +317 +After 5 years +― +― +― +Total +$ +13,484 +$ +18 +$ +13,502 +As of December 31, certificates of deposit in denominations of $250,000 or more, in the aggregate, were as follows: +(Millions) +2018 +2017 +U.S. +$ +276 +$ +114 +Non-U.S. +9 +11 +Total +$ +285 +$ +125 +100 +Table of Contents +NOTE 9 +DEBT +SHORT-TERM BORROWINGS +Our short-term borrowings outstanding, defined as borrowings with original contractual maturity dates of less than one year, as of December 31 were as follows: +2018 +2017 +(Millions, except percentages) +Outstanding Balance +Year-End Stated Interest Rate on Debt (a) +Outstanding Balance +Year-End Stated Interest Rate on Debt (a) +Commercial paper (b) +$ +752 +2.71 +% +$ +1,168 +1.54 +% +Other short-term borrowings (c) +2,348 +1.94 +2,110 +2.34 +Total +$ +3,100 +2.13 +% +$ +3,278 +2.05 +% +(a) +For floating-rate issuances, the stated interest rates are weighted based on the outstanding principal balances and interest rates in effect as of December 31, 2018 and 2017. +(b) +Average commercial paper outstanding was $228 million and $1,076 million in 2018 and 2017, respectively. +(c) +Primarily includes book overdrafts with banks due to timing differences arising in the ordinary course of business. +We maintained a three-year committed, revolving, secured borrowing facility that gives us the right to sell up to $2.0 billion face amount of eligible certificates issued from the Lending Trust at any time through September 15, 2020. The facility was undrawn as of both December 31, 2018 and 2017. +We paid $7.8 million and $9.2 million in fees to maintain the secured borrowing facility in 2018 and 2017, respectively. The committed facility does not contain a material adverse change clause, which might otherwise preclude borrowing under the facility, nor is it dependent on our credit rating. +101 +Table of Contents +LONG-TERM DEBT +Our long-term debt outstanding, defined as debt with original contractual maturity dates of one year or greater, as of December 31 was as follows: +2018 +2017 +(Millions, except percentages) +Original Contractual Maturity Dates +Outstanding Balance (a) +Year-End Interest Rate on Debt (b) +Year-End Interest Rate with Swaps (b)(c) +Outstanding Balance (a) +Year-End Interest Rate on Debt (b) +Year-End Interest Rate with Swaps (b)(c) +American Express Company +(Parent Company only) +Fixed Rate Senior Notes +2019 - 2042 +$ +14,043 +3.48 +% +3.64 +% +$ +10,377 +3.85 +% +3.17 +% +Floating Rate Senior Notes +2020 - 2023 +3,600 +3.17 +1,750 +1.93 +― +Subordinated Notes +2024 +598 +3.63 +3.66 +598 +3.63 +2.66 +American Express Credit Corporation +Fixed Rate Senior Notes +2019 - 2027 +16,677 +2.28 +3.06 +19,652 +2.24 +2.27 +Floating Rate Senior Notes +2019 - 2022 +3,800 +3.31 +― +4,550 +2.09 +― +American Express National Bank (d) +Floating Rate Senior Notes +― +― +― +125 +1.89 +― +American Express Lending Trust +Fixed Rate Senior Notes +2019 - 2023 +12,474 +2.28 +― +8,099 +1.90 +― +Floating Rate Senior Notes +2019 - 2023 +5,125 +2.80 +― +5,800 +2.03 +― +Fixed Rate Subordinated Notes +2020 - 2022 +240 +2.37 +― +206 +2.21 +― +Floating Rate Subordinated Notes +2019 - 2023 +167 +2.96 +― +192 +2.05 +― +American Express Charge Trust II +Floating Rate Senior Notes +2020 +1,535 +2.89 +― +4,200 +1.79 +― +Floating Rate Subordinated Notes +― +― +― +87 +2.11 +― +Other +Capitalized Leases +2021 - 2033 +19 +5.54 +― +23 +5.59 +― +Floating Rate Borrowings +2019 - 2021 +262 +0.42 +― +% +256 +0.42 +― +% +Unamortized Underwriting Fees +(117 +) +(111 +) +Total Long-Term Debt +$ +58,423 +2.77 +% +$ +55,804 +2.44 +% +(a) +The outstanding balances include (i) unamortized discount, (ii) the impact of movements in exchange rates on foreign currency denominated debt and (iii) the impact of fair value hedge accounting on certain fixed-rate notes that have been swapped to floating rate through the use of interest rate swaps. Refer to Note 14 for more details on our treatment of fair value hedges. +(b) +For floating-rate issuances, the stated interest rate on debt is weighted based on the outstanding principal balances and interest rates in effect as of December 31, 2018 and 2017. +(c) +Interest rates with swaps are only presented when swaps are in place to hedge the underlying debt. The interest rates with swaps are weighted based on the outstanding principal balances and the interest rates on the floating leg of the swaps in effect as of December 31, 2018 and 2017. +(d) +2017 balances are those of American Express Centurion Bank prior to the merger of two former bank entities into a new single bank entity effective April 1, 2018. As of December 31, 2017, American Express Centurion Bank was the only legacy entity of American Express National Bank (AENB) to have debt securities outstanding. +102 +Table of Contents +Aggregate annual maturities on long-term debt obligations (based on contractual maturity or anticipated redemption dates) as of December 31, 2018 were as follows: +(Millions) +2019 +2020 +2021 +2022 +2023 +Thereafter +Total +American Express Company (Parent Company only) +$ +641 +$ +2,000 +$ +4,250 +$ +3,525 +$ +4,350 +$ +4,273 +$ +19,039 +American Express Credit Corporation +7,150 +6,600 +2,890 +2,050 +― +2,000 +20,690 +American Express Lending Trust +3,488 +6,924 +2,909 +2,001 +2,685 +― +18,007 +American Express Charge Trust II +― +1,535 +― +― +― +― +1,535 +Other +36 +90 +144 +― +― +11 +281 +$ +11,315 +$ +17,149 +$ +10,193 +$ +7,576 +$ +7,035 +$ +6,284 +$ +59,552 +Unamortized Underwriting Fees +(117 +) +Unamortized Discount and Premium +(771 +) +Impacts due to Fair Value Hedge Accounting +(241 +) +Total Long-Term Debt +$ +58,423 +We maintained a bank line of credit of $3.5 billion as of December 31, 2018 and 2017, all of which was undrawn as of the respective dates. These undrawn amounts support contingent funding needs. The availability of the credit line is subject to our compliance with certain financial covenants, principally the maintenance by American Express Credit Corporation (Credco) of a 1.25 ratio of combined earnings and fixed charges, to fixed charges. As of December 31, 2018 and 2017, we were not in violation of any of our debt covenants. +Additionally, we maintained a three-year committed, revolving, secured borrowing facility that gives us the right to sell up to $3.0 billion face amount of eligible notes issued from the Charge Trust at any time through July 15, 2020. As of December 31, 2018 and 2017, $1.5 billion and $3.0 billion, respectively, were drawn on this facility. +We paid $14.2 million and $16.3 million in fees to maintain these lines in 2018 and 2017, respectively. These committed facilities do not contain material adverse change clauses, which might otherwise preclude borrowing under the credit facilities, nor are they dependent on our credit rating. +We paid total interest, primarily related to short- and long-term debt, corresponding interest rate swaps and customer deposits, of $2.7 billion, $2.0 billion and $1.7 billion in 2018, 2017 and 2016, respectively. +103 +Table of Contents +NOTE 10 +OTHER LIABILITIES +The following is a summary of Other liabilities as of December 31: +(Millions) +2018 +2017 +Membership Rewards liability +$ +8,414 +$ +7,751 +Employee-related liabilities (a) +2,164 +2,277 +Deferred card and other fees, net +1,759 +1,554 +Repatriation tax liability (b) +1,689 +1,703 +Card Member rebate and reward accruals (c) +1,596 +1,564 +Book overdraft balances +1,028 +2,837 +Other (d) +3,629 +4,503 +Total +$ +20,279 +$ +22,189 +(a) +Employee-related liabilities include employee benefit plan obligations and incentive compensation. +(b) +Refer to Note 21 for additional information. +(c) +Card Member rebate and reward accruals include payments to third-party reward partners and cash-back rewards. +(d) +Other includes accruals for general operating expenses, client incentives, merchant rebates, payments to third-party card-issuing partners, marketing and business development, restructuring and reengineering reserves, QAH unfunded commitments and derivatives. +MEMBERSHIP REWARDS +The Membership Rewards program allows enrolled Card Members to earn points that can be redeemed for a broad range of rewards including travel, shopping, gift cards, and covering eligible charges. We record a balance sheet liability that represents management’s best estimate of the cost of points earned that are expected to be redeemed in the future. The weighted average cost (WAC) per point and the Ultimate Redemption Rate (URR) are key assumptions used to estimate the Membership Rewards liability. We use statistical and actuarial models to estimate the URR based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. +The expense for Membership Rewards points is included in Card Member rewards expense. We periodically evaluate our liability estimation process and assumptions based on developments in redemption patterns, cost per point redeemed, partner contract changes and other factors. +DEFERRED CARD AND OTHER FEES, NET +The carrying amount of deferred card and other fees, net of deferred direct acquisition costs and reserves for membership cancellations as of December 31, was as follows: +(Millions) +2018 +2017 +Deferred card and other fees (a) +$ +2,208 +$ +1,996 +Deferred direct acquisition costs +(282 +) +(280 +) +Reserves for membership cancellations +(167 +) +(162 +) +Deferred card and other fees, net +$ +1,759 +$ +1,554 +(a) +Includes deferred fees for Membership Rewards program participants. +104 +Table of Contents +NOTE 11 +STOCK PLANS +STOCK OPTION AND AWARD PROGRAMS +Under our 2016 Incentive Compensation Plan and previously under our 2007 Incentive Compensation Plan, awards may be granted to employees and other key individuals who perform services for us and our participating subsidiaries. These awards may be in the form of stock options, restricted stock awards or units (RSAs/RSUs), portfolio grants (PGs) or other incentives, and similar awards designed to meet the requirements of non-U.S. jurisdictions. +For our Incentive Compensation Plans, there were a total of 12 million, 14 million and 17 million common shares unissued and available for grant as of December 31, 2018, 2017, and 2016, respectively, as authorized by our Board of Directors and shareholders. +A summary of stock option and RSA/RSU activity as of December 31, 2018, and changes during the year, is presented below: +Stock Options +RSAs/RSUs +(Shares in thousands) +Shares +Weighted-Average Exercise Price +Shares +Weighted-Average Grant Price +Outstanding as of December 31, 2017 +7,262 +$ +58.92 +7,215 +$ +70.29 +Granted +282 +98.47 +2,221 +98.20 +Exercised/vested +(1,844 +) +46.95 +(2,407 +) +77.41 +Forfeited +(216 +) +65.36 +(463 +) +78.80 +Expired +― +― +― +― +Outstanding as of December 31, 2018 +5,484 +64.73 +6,566 +$ +76.52 +Options vested and expected to vest as of December 31, 2018 +5,473 +64.73 +Options exercisable as of December 31, 2018 +3,230 +$ +57.04 +We recognize the cost of employee stock awards granted in exchange for employee services based on the grant-date fair value of the award, net of expected forfeitures. Those costs are recognized ratably over the vesting period. +STOCK OPTIONS +Each stock option has an exercise price equal to the market price of our common stock on the date of grant. Stock options generally vest 100 percent on the third anniversary of the grant date and have a contractual term of 10 years from the date of grant. +The weighted-average remaining contractual life and the aggregate intrinsic value (the amount by which the fair value of our stock exceeds the exercise price of the option) of the stock options outstanding, exercisable, vested, and expected to vest as of December 31, 2018, were as follows: +Outstanding +Exercisable +Vested and Expected to Vest +Weighted-average remaining contractual life (in years) +5.6 +4.0 +5.6 +Aggregate intrinsic value (millions) +$ +169 +$ +124 +$ +168 +The intrinsic value of options exercised during 2018, 2017 and 2016 was $104 million, $197 million and $51 million, respectively, (based upon the fair value of our stock price at the date of exercise). Cash received from the exercise of stock options in 2018, 2017 and 2016 was $87 million, $130 million and $175 million, respectively. +Effective January 1, 2017, we adopted new accounting guidance for employee share-based payments and accordingly, income tax benefits related to stock option exercises were recognized in our Consolidated Statements of Income in the amount of $18 million and $59 million for the years ended December 31, 2018 and 2017, respectively. Previously, such benefits were recorded in Additional paid-in capital. The tax benefit realized from income tax impacts of stock option exercises, which was recorded in Additional paid-in capital, in 2016 was $4 million. +105 +Table of Contents +The fair value of each option is estimated on the date of grant using a Black-Scholes-Merton option-pricing model. The following weighted-average assumptions were used for options granted in 2018, 2017 and 2016: +2018 +2017 +2016 +Dividend yield +1.4 +% +1.8 +% +1.9 +% +Expected volatility (a) +22 +% +24 +% +25 +% +Risk-free interest rate +2.7 +% +2.3 +% +1.5 +% +Expected life of stock option ( in years ) (b) +7.1 +6.9 +6.3 +Weighted-average fair value per option +$ +23.17 +$ +18.18 +$ +13.67 +(a) +The expected volatility is based on both weighted historical and implied volatilities of our common stock price. +(b) +The expected life of stock options was determined using both historical data and expectations of option exercise behavior. +On October 31, 2017, certain senior executives were awarded stock options with a term of seven years, and include a three-year service condition, as well as performance and market conditions. Therefore, the fair values of these options were estimated at the grant date using a Monte Carlo Valuation model with the following assumptions: +October 31, 2017 +Dividend yield +1.58 +% +Expected volatility (a) +21.41 +% +Risk-free interest rate +2.26 +% +Expected life of stock option ( in years ) +7 +Fair value per option +$ +19.18 +(a) +The expected volatility is based on both weighted historical and implied volatilities of our common stock price. +RESTRICTED STOCK AWARDS AND UNITS +RSAs/RSUs are valued based on the stock price on the date of grant and contain either a) service conditions or b) both service and performance conditions. RSAs/RSUs containing only service conditions generally vest 25 percent per year beginning with the first anniversary of the grant date. RSAs/RSUs containing both service and performance conditions generally vest on the third anniversary of the grant date, and the number of shares earned depends on the achievement of predetermined Company metrics. All RSA/RSU holders receive non-forfeitable dividends or dividend equivalents. The total fair value of shares vested during 2018, 2017 and 2016, was $239 million, $180 million and $171 million, respectively (based upon our stock price at the vesting date). +The weighted-average grant date fair value of RSAs/RSUs granted in 2018, 2017 and 2016 was $98.20, $77.80 and $55.55, respectively. +LIABILITY-BASED AWARDS +Certain employees are awarded PGs and other incentive awards that can be settled with cash or equity shares at our discretion, and final Compensation and Benefits Committee payout approval. These awards earn value based on performance, market and/or service conditions, and vest over periods of one to three years. +PGs and other incentive awards are generally settled with cash and thus are classified as liabilities; therefore, the fair value is determined at the date of grant and remeasured quarterly as part of compensation expense over the vesting period. Cash paid upon vesting of these awards in 2018, 2017 and 2016 was $56 million, $48 million and $41 million, respectively. +SUMMARY OF STOCK PLAN EXPENSE +The components of our total stock-based compensation expense (net of forfeitures) for the years ended December 31 are as follows: +(Millions) +2018 +2017 +2016 +Restricted stock awards (a) +$ +181 +$ +170 +$ +178 +Stock options (a) +19 +21 +14 +Liability-based awards +88 +92 +60 +Total stock-based compensation expense (b) +$ +288 +$ +283 +$ +252 +(a) +As of December 31, 2018, the total unrecognized compensation cost related to unvested RSAs/RSUs and options of $179 million and $12 million, respectively, will be recognized ratably over the weighted-average remaining vesting period of 2.1 years and 1.6 years, respectively. +(b) +The total income tax benefit recognized in the Consolidated Statements of Income for stock-based compensation arrangements for the years ended December 31, 2018, 2017 and 2016 was $69 million, $102 million and $89 million, respectively. +106 +Table of Contents +NOTE 12 +RETIREMENT PLANS +DEFINED CONTRIBUTION RETIREMENT PLANS +We sponsor defined contribution retirement plans, the principal plan being the Retirement Savings Plan (RSP), a 401(k) savings plan with a profit-sharing component. The RSP is a tax-qualified retirement plan subject to the Employee Retirement Income Security Act of 1974 and covers most employees in the United States. The total expense for all defined contribution retirement plans globally was $272 million, $349 million and $234 million in 2018, 2017 and 2016, respectively. +DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS +Our primary defined benefit pension plans that cover certain employees in the United States and United Kingdom are closed to new entrants and existing participants do not accrue any additional benefits. Most employees outside the United States and United Kingdom are covered by local retirement plans, some of which are funded, while other employees receive payments at the time of retirement or termination under applicable labor laws or agreements. We comply with minimum funding requirements in all countries. We sponsor unfunded other postretirement benefit plans that provide health care and life insurance to certain retired U.S. employees. For these plans, the total net benefit was $0.4 million in 2018, and the total net expense was $25 million and $24 million in 2017 and 2016, respectively. +We recognize the funded status of our defined benefit pension plans and other postretirement benefit plans, measured as the difference between the fair value of the plan assets and the projected benefit obligation, in the Consolidated Balance Sheets. As of December 31, 2018 and 2017, the unfunded status related to the defined benefit pension plans and other postretirement benefit plans was $563 million and $626 million, respectively, and is recorded in Other liabilities. +NOTE 13 +CONTINGENCIES AND COMMITMENTS +CONTINGENCIES +In the ordinary course of business, we and our subsidiaries are subject to various pending and potential legal actions, arbitration proceedings, claims, investigations, examinations, information gathering requests, subpoenas, inquiries and matters relating to compliance with laws and regulations (collectively, legal proceedings). We disclose our material legal proceedings under Part I, Item 3. “Legal Proceedings.” +In addition to the matters disclosed under “Legal Proceedings,” we are being challenged in a number of countries regarding our application of value-added taxes (VAT) to certain of our international transactions, which are in various stages of audit, or are being contested in legal actions (collectively, VAT matters). While we believe we have complied with all applicable tax laws, rules and regulations in the relevant jurisdictions, the tax authorities may determine that we owe additional VAT. In certain jurisdictions where we are contesting the assessments, we were required to pay the VAT assessments prior to contesting. +Our legal proceedings range from cases brought by a single plaintiff to class actions with millions of putative class members. These legal proceedings involve various lines of business and a variety of claims (including, but not limited to, common law tort, contract, application of tax laws, antitrust and consumer protection claims), some of which present novel factual allegations and/or unique legal theories. While some matters pending against us specify the damages claimed by the plaintiff or class, many seek an unspecified amount of damages or are at very early stages of the legal process. Even when the amount of damages claimed against us are stated, the claimed amount may be exaggerated and/or unsupported. As a result, some matters have not yet progressed sufficiently through discovery and/or development of important factual information and legal issues to enable us to estimate an amount of loss or a range of possible loss, while other matters have progressed sufficiently such that we are able to estimate an amount of loss or a range of possible loss. +We have accrued for certain of our outstanding legal proceedings. An accrual is recorded when it is both (a) probable that a loss has occurred and (b) the amount of loss can be reasonably estimated. There may be instances in which an exposure to loss exceeds the accrual. We evaluate, on a quarterly basis, developments in legal proceedings that could cause an increase or decrease in the amount of the accrual that has been previously recorded, or a revision to the disclosed estimated range of possible losses, as applicable. +107 +Table of Contents +For those disclosed material legal proceedings and VAT matters where a loss is reasonably possible in future periods, whether in excess of a recorded accrual for legal or tax contingencies or where there is no such accrual, and for which we are able to estimate a range of possible loss, the current estimated range is zero to $400 million in excess of any accruals related to those matters. This range represents management’s estimate based on currently available information and does not represent our maximum loss exposure; actual results may vary significantly. As such legal proceedings evolve, we may need to increase our range of possible loss or recorded accruals. In addition, it is possible that significantly increased merchant steering or other actions impairing the Card Member experience as a result of an adverse resolution in one or any combination of the merchant cases disclosed in Part I, Item 3. "Legal Proceedings" could have a material adverse effect on our business. +Based on our current knowledge, and taking into consideration our litigation-related liabilities, we believe we are not a party to, nor are any of our properties the subject of, any legal proceeding that would have a material adverse effect on our consolidated financial condition or liquidity. However, in light of the uncertainties involved in such matters, it is possible that the outcome of legal proceedings, including the possible resolution of merchant claims, could have a material impact on our results of operations. +COMMITMENTS +We lease certain facilities and equipment under non-cancelable and cancelable agreements, for which total rental expense was $142 million, $151 million and $169 million in 2018, 2017 and 2016, respectively. +As of December 31, 2018, the minimum aggregate rental commitment under all non-cancelable operating leases (net of subleases of $14 million) was as follows: +(Millions) +2019 +$ +140 +2020 +118 +2021 +95 +2022 +78 +2023 +65 +Thereafter +832 +Total +$ +1,328 +As of December 31, 2018, our future minimum lease payments under capital leases or other similar arrangements is approximately $4 million in each of 2019 and 2020, $1 million in each of 2021 and 2022, $2 million in 2023 and $8 million in aggregate thereafter. +As of December 31, 2018, we had $5.0 billion in commitments related to agreements with certain cobrand partners under which we make payments based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. +108 +Table of Contents +NOTE 14 +DERIVATIVES AND HEDGING ACTIVITIES +We use derivative financial instruments to manage exposures to various market risks. These instruments derive their value from an underlying variable or multiple variables, including interest rates, foreign exchange rates, and an equity index or price, and are carried at fair value on the Consolidated Balance Sheets. These instruments enable end users to increase, reduce or alter exposure to various market risks and, for that reason, are an integral component of our market risk management. We do not transact in derivatives for trading purposes. +Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. Our market risk exposures include: +• +Interest rate risk due to changes in the relationship between interest rates on our assets (such as loans, receivables and investment securities) and interest rates on our liabilities (such as debt and deposits); and +• +Foreign exchange risk related to earnings, funding, transactions and investments in currencies other than the U.S. dollar. +We centrally monitor market risks using market risk limits and escalation triggers as defined in our Asset/Liability Management Policy. Our market exposures are in large part by-products of the delivery of our products and services. +Interest rate risk primarily arises through the funding of Card Member receivables and fixed-rate loans with variable-rate borrowings, as well as through the risk to net interest margin from changes in the relationship between benchmark rates such as Prime, LIBOR and the overnight indexed swap rate. Interest rate exposure within our charge card and fixed-rate lending products is managed by varying the proportion of total funding provided by short-term and variable-rate debt and deposits compared to fixed-rate debt and deposits. In addition, interest rate swaps are used from time to time to economically convert fixed-rate debt obligations to variable-rate obligations, or to convert variable-rate debt obligations to fixed-rate obligations. We may change the mix between variable-rate and fixed-rate funding based on changes in business volumes and mix, among other factors. +Foreign exchange risk is generated by Card Member cross-currency spend, foreign currency balance sheet exposures, foreign subsidiary equity and foreign currency earnings in entities outside the United States. Our foreign exchange risk is managed primarily by entering into agreements to buy and sell currencies on a spot basis or by hedging this market exposure, to the extent it is economical, through various means, including the use of derivatives such as foreign exchange forwards and cross-currency swap contracts. +Derivatives may give rise to counterparty credit risk, which is the risk that a derivative counterparty will default on, or otherwise be unable to perform pursuant to, an uncollateralized derivative exposure. We manage this risk by considering the current exposure, which is the replacement cost of contracts on the measurement date, as well as estimating the maximum potential value of the contracts over the next 12 months, considering such factors as the volatility of the underlying or reference index. To mitigate derivative credit risk, counterparties are required to be pre-approved by us and rated as investment grade, and counterparty risk exposures are centrally monitored. +Additionally, in order to mitigate the bilateral counterparty credit risk associated with derivatives, we have in certain instances entered into master netting agreements with our derivative counterparties, which provide a right of offset for certain exposures between the parties. A majority of our derivative assets and liabilities as of December 31, 2018 and 2017 are subject to such master netting agreements with our derivative counterparties, and there are no instances in which management makes an accounting policy election to not net assets and liabilities subject to an enforceable master netting agreement on our Consolidated Balance Sheets. To further mitigate counterparty credit risk, we exercise our rights under executed credit support agreements with the respective derivative counterparties for most of our bilateral interest rate swaps and select foreign exchange contracts. These agreements require that, in the event the fair value change in the net derivatives position between the two parties exceeds certain dollar thresholds, the party in the net liability position posts collateral to its counterparty. All derivative contracts cleared through a central clearinghouse are collateralized to the full amount of the fair value of the contracts. +In relation to our credit risk, certain of our bilateral derivative agreements include provisions that allow our counterparties to terminate the agreement in the event of a downgrade of our debt credit rating below investment grade and settle the outstanding net liability position. As of December 31, 2018, these derivatives were not in a net liability position. We have no individually significant derivative counterparties and therefore, no significant risk exposure to any single derivative counterparty. Based on our assessment of the credit risk of our derivative counterparties as of December 31, 2018 and 2017, no credit risk adjustment to the derivative portfolio was required. +Our derivatives are carried at fair value on the Consolidated Balance Sheets. The accounting for changes in fair value depends on the instruments’ intended use and the resulting hedge designation, if any, as discussed below. Refer to Note 15 for a description of our methodology for determining the fair value of derivatives. +109 +Table of Contents +The following table summarizes the total fair value, excluding interest accruals, of derivative assets and liabilities as of December 31: +Other Assets Fair Value +Other Liabilities Fair Value +(Millions) +2018 +2017 +2018 +2017 +Derivatives designated as hedging instruments: +Fair value hedges - Interest rate contracts (a) +$ +34 +$ +11 +$ +74 +$ +34 +Net investment hedges - Foreign exchange contracts +222 +117 +61 +89 +Total derivatives designated as hedging instruments +256 +128 +135 +123 +Derivatives not designated as hedging instruments: +Foreign exchange contracts, including certain embedded derivatives (b) +258 +82 +79 +95 +Total derivatives, gross +514 +210 +214 +218 +Less: Cash collateral netting (c) (d) +(28 +) +(6 +) +(78 +) +(45 +) +Derivative asset and derivative liability netting (e) +(90 +) +(80 +) +(90 +) +(80 +) +Total derivatives, net +$ +396 +$ +124 +$ +46 +$ +93 +(a) +For our centrally cleared derivatives, variation margin payments are legally characterized as settlement payments as opposed to collateral. +(b) +Includes foreign currency derivatives embedded in certain operating agreements. +(c) +Represents the offsetting of the fair value of bilateral interest rate contracts and certain foreign exchange contracts with the right to cash collateral held from the counterparty or cash collateral posted with the counterparty. +(d) +We posted $84 million and $146 million as of December 31, 2018 and 2017, respectively, as initial margin on our centrally cleared interest rate swaps; such amounts are recorded within Other receivables on the Consolidated Balance Sheets and are not netted against the derivative balances. +(e) +Represents the amount of netting of derivative assets and derivative liabilities executed with the same counterparty under an enforceable master netting arrangement. +DERIVATIVE FINANCIAL INSTRUMENTS THAT QUALIFY FOR HEDGE ACCOUNTING +Derivatives executed for hedge accounting purposes are documented and designated as such when we enter into the contracts. In accordance with our risk management policies, we structure our hedges with terms similar to those of the item being hedged. We formally assess, at inception of the hedge accounting relationship and on a quarterly basis, whether derivatives designated as hedges are highly effective in offsetting the fair value or cash flows of the hedged items. These assessments usually are made through the application of a regression analysis method. If it is determined that a derivative is not highly effective as a hedge, we will discontinue the application of hedge accounting. +FAIR VALUE HEDGES +A fair value hedge involves a derivative designated to hedge our exposure to future changes in the fair value of an asset or a liability, or an identified portion thereof, that is attributable to a particular risk. +Interest Rate Contracts +We are exposed to interest rate risk associated with our fixed-rate long-term debt obligations. At the time of issuance, certain fixed-rate debt obligations are designated in fair value hedging relationships, using interest rate swaps, to economically convert the fixed interest rate to a floating interest rate. We have $24.0 billion and $23.8 billion of fixed-rate debt obligations designated in fair value hedging relationships as of December 31, 2018 and 2017, respectively. +Gains or losses on the fair value hedging instrument principally offset the losses or gains on the hedged item attributable to the hedged risk. The changes in the fair value of the derivative and the changes in the hedged item may not fully offset due to differences between a debt obligation’s interest rate and the benchmark rate, primarily due to credit spreads at inception of the hedging relationship that are not reflected in the fair value of the interest rate swap. Furthermore, the difference may be caused by changes in 1-month LIBOR, 3-month LIBOR and the overnight indexed swap rate, as spreads between these rates impact the fair value of the interest rate swap without an exact offsetting impact to the fair value of the hedged debt. +The following table presents the gains and losses associated with the fair value hedges of our fixed-rate long-term debt for the years ended December 31: +Gains (losses) +(Millions) +2018 +2017 +2016 +Interest expense (a) +Other expenses +Other expenses +Fixed-rate long-term debt +$ +59 +$ +206 +$ +163 +Derivatives designated as hedging instruments +(43 +) +(246 +) +(184 +) +Total +$ +16 +$ +(40 +) +$ +(21 +) +(a) +We adopted new accounting guidance providing targeted improvements to the accounting for hedging activities effective January 1, 2018. In compliance with the standard, amounts previously recorded in Other expenses have been prospectively recorded in Total interest expense. Refer to Note 1 for additional information. +110 +Table of Contents +The carrying values of the hedged liabilities, recorded within Long-term debt on the Consolidated Balance Sheets, were $23.7 billion and $23.6 billion as of December 31, 2018 and 2017, respectively, including offsetting amounts of $241 million and $182 million for the respective periods, related to the cumulative amount of fair value hedging adjustments. +We recognized a net increase of $51 million in Interest expense on Long-term debt for the year ended December 31, 2018, and net reductions of $133 million and $224 million for the years ended December 31, 2017 and 2016, respectively, primarily related to the net settlements (interest accruals) on our interest rate derivatives designated as fair value hedges. +NET INVESTMENT HEDGES +A net investment hedge is used to hedge future changes in currency exposure of a net investment in a foreign operation. We primarily designate foreign currency derivatives, typically foreign exchange forwards, and on occasion foreign currency denominated debt, as hedges of net investments in certain foreign operations. These instruments reduce exposure to changes in currency exchange rates on our investments in non-U.S. subsidiaries. We had notionals of approximately $9.6 billion and $9.5 billion of foreign currency derivatives designated as net investment hedges as of December 31, 2018 and 2017, respectively. The gain or loss on net investment hedges, net of taxes, recorded in AOCI as part of the cumulative translation adjustment, was a gain of $328 million, a loss of $370 million and a gain of $281 million for the years ended December 31, 2018, 2017 and 2016, respectively. Accumulated gains within AOCI of $1 million for the year ended December 31, 2018, and losses of $31 million and $5 million for the years ended December 31, 2017 and 2016, respectively, were reclassified into Other expenses upon investment sales or liquidations. +DERIVATIVES NOT DESIGNATED AS HEDGES +We have derivatives that act as economic hedges, but are not designated as such for hedge accounting purposes. Foreign currency transactions from time to time may be partially or fully economically hedged through foreign currency contracts, primarily foreign exchange forwards. These hedges generally mature within one year. Foreign currency contracts involve the purchase and sale of designated currencies at an agreed upon rate for settlement on a specified date. +We also have certain operating agreements containing payments that may be linked to a market rate or price, primarily foreign currency rates. The payment components of these agreements may meet the definition of an embedded derivative, in which case the embedded derivative is accounted for separately and is classified as a foreign exchange contract based on its primary risk exposure. +The changes in the fair value of derivatives that are not designated as hedges are intended to offset the related foreign exchange gains or losses of the underlying foreign currency exposures. The changes in the fair value of the derivatives and the related underlying foreign currency exposures resulted in a net gain of $60 million, a net loss of $29 million and a net gain of $1 million for the years ended December 31, 2018, 2017 and 2016, respectively, and are recognized in Other expenses. +The changes in the fair value of an embedded derivative resulted in losses of $11 million and nil for the years ended December 31, 2018 and 2017, respectively, and a gain of $9 million for the year ended December 31, 2016, and are recognized in Card Member services expense. +111 +Table of Contents +NOTE 15 +FAIR VALUES +Fair value is defined as the price that would be required to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, based on the principal or, in the absence of a principal, most advantageous market for the specific asset or liability. +GAAP provides for a three-level hierarchy of inputs to valuation techniques used to measure fair value, defined as follows: + +Level 1 ― Inputs that are quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity can access. + +Level 2 ― Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability, including: +- +Quoted prices for similar assets or liabilities in active markets; +- +Quoted prices for identical or similar assets or liabilities in markets that are not active; +- +Inputs other than quoted prices that are observable for the asset or liability; and +- +Inputs that are derived principally from or corroborated by observable market data by correlation or other means. + +Level 3 ― Inputs that are unobservable and reflect our own estimates about the estimates market participants would use in pricing the asset or liability based on the best information available in the circumstances (e.g., internally derived assumptions surrounding the timing and amount of expected cash flows). We did not measure any financial instruments presented on the Consolidated Balance Sheets at fair value on a recurring basis using significant unobservable inputs (Level 3) during the years ended December 31, 2018 and 2017, although the disclosed fair value of certain assets that are not carried at fair value, as presented later in this Note, are classified within Level 3. +We monitor the market conditions and evaluate the fair value hierarchy levels at least quarterly. For the years ended December 31, 2018 and 2017, there were no Level 3 transfers. +FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT FAIR VALUE +The following table summarizes our financial assets and financial liabilities measured at fair value on a recurring basis, categorized by GAAP’s fair value hierarchy (as described in the preceding paragraphs), as of December 31: +2018 +2017 +(Millions) +Total +Level 1 +Level 2 +Level 3 +Total +Level 1 +Level 2 +Level 3 +Assets: +Investment securities: (a) +Equity securities +$ +48 +$ +1 +$ +47 +$ +― +$ +48 +$ +1 +$ +47 +$ +― +Debt securities +4,599 +― +4,599 +― +3,111 +1,045 +2,066 +― +Derivatives, gross (a) +514 +― +514 +― +210 +― +210 +― +Total Assets +5,161 +1 +5,160 +― +3,369 +1,046 +2,323 +― +Liabilities: +Derivatives, gross (a) +214 +― +214 +― +218 +― +218 +― +Total Liabilities +$ +214 +$ +― +$ +214 +$ +― +$ +218 +― +218 +― +(a) +Refer to Note 5 for the fair values of investment securities and to Note 14 for the fair values of derivative assets and liabilities, on a further disaggregated basis. +112 +Table of Contents +VALUATION TECHNIQUES USED IN THE FAIR VALUE MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT FAIR VALUE +For the financial assets and liabilities measured at fair value on a recurring basis (categorized in the valuation hierarchy table above), we apply the following valuation techniques: +Investment Securities +When available, quoted prices of identical investment securities in active markets are used to estimate fair value. Such investment securities are classified within Level 1 of the fair value hierarchy. +When quoted prices of identical investment securities in active markets are not available, the fair values for our investment securities are obtained primarily from pricing services engaged by us, and we receive one price for each security. The fair values provided by the pricing services are estimated using pricing models, where the inputs to those models are based on observable market inputs or recent trades of similar securities. Such investment securities are classified within Level 2 of the fair value hierarchy. The inputs to the valuation techniques applied by the pricing services vary depending on the type of security being priced but are typically benchmark yields, benchmark security prices, credit spreads, prepayment speeds, reported trades and broker-dealer quotes, all with reasonable levels of transparency. The pricing services did not apply any adjustments to the pricing models used. In addition, we did not apply any adjustments to prices received from the pricing services. +We reaffirm our understanding of the valuation techniques used by our pricing services at least annually. In addition, we corroborate the prices provided by our pricing services by comparing them to alternative pricing sources. In instances where price discrepancies are identified between different pricing sources, we evaluate such discrepancies to ensure that the prices used for our valuation represent the fair value of the underlying investment securities. Refer to Note 5 for additional fair value information. +Derivative Financial Instruments +The fair value of our derivative financial instruments is estimated internally by using third-party pricing models, where the inputs to those models are readily observable from actively quoted markets. The pricing models used are consistently applied and reflect the contractual terms of the derivatives as described below. We reaffirm our understanding of the valuation techniques at least annually and validate the valuation output on a quarterly basis. Our derivative instruments are classified within Level 2 of the fair value hierarchy. +The fair value of our interest rate swaps is determined based on a discounted cash flow method using the following significant inputs: the contractual terms of the swap such as the notional amount, fixed coupon rate, floating coupon rate and tenor, as well as discount rates consistent with the underlying economic factors of the currency in which the cash flows are denominated. +The fair value of foreign exchange forward contracts is determined based on a discounted cash flow method using the following significant inputs: the contractual terms of the forward contracts such as the notional amount, maturity dates and contract rate, as well as relevant foreign currency forward curves, and discount rates consistent with the underlying economic factors of the currency in which the cash flows are denominated. +Credit valuation adjustments are necessary when the market parameters, such as a benchmark curve, used to value derivatives are not indicative of our credit quality or that of our counterparties. We consider the counterparty credit risk by applying an observable forecasted default rate to the current exposure. Refer to Note 14 for additional fair value information. +113 +Table of Contents +FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT OTHER THAN FAIR VALUE +The following table summarizes the estimated fair values of our financial assets and financial liabilities that are measured at amortized cost, and not required to be carried at fair value on a recurring basis, as of December 31, 2018 and 2017. The fair values of these financial instruments are estimates based upon the market conditions and perceived risks as of December 31, 2018 and 2017, and require management’s judgment. These figures may not be indicative of future fair values, nor can our fair value be estimated by aggregating the amounts presented. +Carrying +Corresponding Fair Value Amount +2018 (Billions) +Value +Total +Level 1 +Level 2 +Level 3 +Financial Assets: +Financial assets for which carrying values equal or +approximate fair value +Cash and cash equivalents (a) +$ +27 +$ +27 +$ +26 +$ +1 +$ +― +Other financial assets (b) +58 +58 +― +58 +― +Financial assets carried at other than fair value +Loans, net (c) +83 +84 +― +― +84 +Financial Liabilities: +Financial liabilities for which carrying values equal or +approximate fair value +81 +81 +― +81 +― +Financial liabilities carried at other than fair value +Certificates of deposit (d) +13 +13 +― +13 +― +Long-term debt (c) +$ +58 +$ +59 +$ +― +$ +59 +$ +― +Carrying +Corresponding Fair Value Amount +2017 (Billions) +Value +Total +Level 1 +Level 2 +Level 3 +Financial Assets: +Financial assets for which carrying values equal or +approximate fair value +Cash and cash equivalents (a) +$ +33 +$ +33 +$ +32 +$ +1 +$ +― +Other financial assets (b) +57 +57 +― +57 +― +Financial assets carried at other than fair value +Loans, net (c) +74 +75 +― +― +75 +Financial Liabilities: +Financial liabilities for which carrying values equal or +approximate fair value +76 +76 +― +76 +― +Financial liabilities carried at other than fair value +Certificates of deposit (d) +17 +17 +― +17 +― +Long-term debt (c) +$ +56 +$ +57 +$ +― +$ +57 +$ +― +(a) +Level 2 amounts reflect time deposits and short-term investments. +(b) +Includes Card Member receivables (including fair values of Card Member receivables of $8.5 billion and $8.9 billion held by a consolidated VIE as of December 31, 2018 and 2017, respectively), Other receivables, restricted cash and other miscellaneous assets. +(c) +Balances include amounts held by a consolidated VIE for which the fair values of Card Member loans were $33.0 billion and $25.6 billion as of December 31, 2018 and 2017, respectively, and the fair values of Long-term debt were $19.4 billion and $18.6 billion as of December 31, 2018 and 2017, respectively. +(d) +Presented as a component of Customer deposits on the Consolidated Balance Sheets. +114 +Table of Contents +VALUATION TECHNIQUES USED IN THE FAIR VALUE MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT OTHER THAN FAIR VALUE +For the financial assets and liabilities that are not required to be carried at fair value on a recurring basis (categorized in the valuation hierarchy table), we apply the following valuation techniques to measure fair value: +Financial Assets For Which Carrying Values Equal Or Approximate Fair Value +Financial assets for which carrying values equal or approximate fair value include cash and cash equivalents, Card Member receivables, accrued interest and certain other assets. For these assets, the carrying values approximate fair value because they are short term in duration, have no defined maturity or have a market-based interest rate. +Financial Assets Carried At Other Than Fair Value +Loans, net +Loans are recorded at historical cost, less reserves, on the Consolidated Balance Sheets. In estimating the fair value for our loans, we use a discounted cash flow model. Due to the lack of a comparable whole loan sales market for similar loans and the lack of observable pricing inputs thereof, we use various inputs to estimate fair value. Such inputs include projected income, discount rates and relevant credit losses. The valuation does not include economic value attributable to future receivables generated by the accounts associated with the loans. +Financial Liabilities For Which Carrying Values Equal Or Approximate Fair Value +Financial liabilities for which carrying values equal or approximate fair value include accrued interest, customer deposits (excluding certificates of deposit, which are described further below), Travelers Cheques and other prepaid products outstanding, accounts payable, short-term borrowings and certain other liabilities for which the carrying values approximate fair value because they are short term in duration, have no defined maturity or have a market-based interest rate. +Financial Liabilities Carried At Other Than Fair Value +Certificates of Deposit +Certificates of deposit (CDs) are recorded at their historical issuance cost on the Consolidated Balance Sheets. Fair value is estimated using a discounted cash flow methodology based on the future cash flows and the discount rate that reflects the current market rates for similar types of CDs within similar markets. +Long-term Debt +Long-term debt is recorded at historical issuance cost on the Consolidated Balance Sheets adjusted for (i) unamortized discount and unamortized fees, (ii) the impact of movements in exchange rates on foreign currency denominated debt and (iii) the impact of fair value hedge accounting on certain fixed-rate notes that have been swapped to floating rate through the use of interest rate swaps. The fair value of our long-term debt is measured using quoted offer prices when quoted market prices are available. If quoted market prices are not available, the fair value is determined by discounting the future cash flows of each instrument at rates currently observed in publicly-traded debt markets for debt of similar terms and credit risk. For long-term debt, where there are no rates currently observable in publicly traded debt markets of similar terms and comparable credit risk, we use market interest rates and adjust those rates for necessary risks, including our own credit risk. In determining an appropriate spread to reflect our credit standing, we consider credit default swap spreads, bond yields of other long-term debt offered by us, and interest rates currently offered to us for similar debt instruments of comparable maturities. +NONRECURRING FAIR VALUE MEASUREMENTS +We have certain assets that are subject to measurement at fair value on a nonrecurring basis. For these assets, measurement at fair value in periods subsequent to their initial recognition is applicable if they are determined to be impaired or where there are observable price changes for equity investments without readily determinable fair values. During the years ended December 31, 2018 and 2017, we did not have any material assets that were measured at fair value due to impairment. Equity investments previously held at cost that are adjusted through earnings for observable price changes are not material. +115 +Table of Contents +NOTE 16 +GUARANTEES +As of December 31, 2018, the maximum potential undiscounted future payments and related liability resulting from guarantees and indemnifications provided by us in the ordinary course of business were $1 billion and $46 million, respectively, and related primarily to our real estate and business dispositions. As of December 31, 2017, the maximum potential undiscounted future payments and related liability were $1 billion and $52 million, respectively. +To date, we have not experienced any significant losses related to guarantees or indemnifications. Our recognition of these instruments is at fair value. In addition, we establish reserves when a loss is probable and the amount can be reasonably estimated. +NOTE 17 +COMMON AND PREFERRED SHARES +The following table shows authorized shares and provides a reconciliation of common shares issued and outstanding for the years ended December 31: +(Millions, except where indicated) +2018 +2017 +2016 +Common shares authorized (billions) (a) +3.6 +3.6 +3.6 +Shares issued and outstanding at beginning of year +859 +904 +969 +Repurchases of common shares +(15 +) +(50 +) +(70 +) +Other, primarily stock option exercises and restricted stock awards granted +3 +5 +5 +Shares issued and outstanding as of December 31 +847 +859 +904 +(a) +Of the common shares authorized but unissued as of December 31, 2018, approximately 24 million shares are reserved for issuance under employee stock and employee benefit plans. +On September 26, 2016, the Board of Directors authorized the repurchase of 150 million of common shares over time in accordance with our capital distribution plans submitted to the Board of Governors of the Federal Reserve System (the Federal Reserve) and subject to market conditions. This authorization replaces all prior repurchase authorizations. During 2018, 2017 and 2016, we repurchased 15 million common shares with a cost basis of $1.6 billion, 50 million common shares with a cost basis of $4.3 billion, and 70 million common shares with a cost basis of $4.4 billion, respectively. The cost basis includes commissions paid of $2.2 million, $2.9 million and $1.2 million in 2018, 2017 and 2016, respectively. As of December 31, 2018, we had approximately 70 million common shares remaining under the Board share repurchase authorization. Such authorization does not have an expiration date. +Common shares are generally retired by us upon repurchase (except for 2.7 million, 2.9 million and 3.0 million shares held as treasury shares as of December 31, 2018, 2017 and 2016, respectively); retired common shares and treasury shares are excluded from the shares outstanding in the table above. The treasury shares, with a cost basis of $207 million, $217 million and $197 million as of December 31, 2018, 2017 and 2016, respectively, are included as a reduction to Additional paid-in capital in Shareholders’ equity on the Consolidated Balance Sheets. +116 +Table of Contents +PREFERRED SHARES +The Board of Directors is authorized to permit us to issue up to 20 million Preferred Shares at a par value of $1.66 2/3 without further shareholder approval. We have the following perpetual Fixed Rate/Floating Rate Noncumulative Preferred Share series issued and outstanding as of December 31, 2018: +Series B +Series C +Issuance date +November 10, 2014 +March 2, 2015 +Securities issued +750 Preferred Shares; represented by 750,000 depositary shares +850 Preferred Shares; represented by 850,000 depositary shares +Aggregate liquidation preference +$750 million +$850 million +Fixed dividend rate per annum +5.20% +4.90% +Semi-annual fixed dividend payment dates +Beginning May 15, 2015 +Beginning September 15, 2015 +Floating dividend rate per annum +3 month LIBOR+ 3.428% +3 month LIBOR+ 3.285% +Quarterly floating dividend payment dates +Beginning February 15, 2020 +Beginning June 15, 2020 +Fixed to floating rate conversion date (a) +November 15, 2019 +March 15, 2020 +(a) +The date on which dividends convert from a fixed-rate calculation to a floating rate calculation. +In the event of the voluntary or involuntary liquidation, dissolution or winding up of the Company, the preferred stock then outstanding takes precedence over our common stock for the payment of dividends and the distribution of assets out of funds legally available for distribution to shareholders. Each outstanding series of Preferred Shares has a liquidation price of $1 million per Preferred Share, plus any accrued but unpaid dividends. We may redeem these Preferred Shares at $1 million per Preferred Share (equivalent to $1,000 per depositary share) plus any declared but unpaid dividends in whole or in part, from time to time, on any dividend payment date on or after the respective fixed to floating rate conversion date, or in whole, but not in part, within 90 days of certain bank regulatory changes. +There were no warrants issued and outstanding as of December 31, 2018, 2017 and 2016. +117 +Table of Contents +NOTE 18 +CHANGES IN ACCUMULATED OTHER COMPREHENSIVE INCOME +AOCI is a balance sheet item in Shareholders’ equity on the Consolidated Balance Sheets. It is comprised of items that have not been recognized in earnings but may be recognized in earnings in the future when certain events occur. Changes in each component for the three years ended December 31 were as follows: +(Millions) , net of tax +Net Unrealized (Losses) Gains on Investment Securities +Foreign Currency Translation Adjustment (Losses) Gains +Net Unrealized Pension and Other Postretirement Benefit (Losses) Gains +Accumulated Other Comprehensive (Loss) Income +Balances as of December 31, 2015 +$ +58 +$ +(2,044 +) +$ +(548 +) +$ +(2,534 +) +Net unrealized losses +(45 +) +― +― +(45 +) +(Decrease) increase due to amounts reclassified into earnings +(6 +) +4 +― +(2 +) +Net translation losses on investments in foreign operations +― +(503 +) +― +(503 +) +Net gains related to hedges of investments in foreign operations +― +281 +― +281 +Pension and other postretirement benefits +― +― +19 +19 +Net change in accumulated other comprehensive (loss) income +(51 +) +(218 +) +19 +(250 +) +Balances as of December 31, 2016 +7 +(2,262 +) +(529 +) +(2,784 +) +Net unrealized losses +(7 +) +― +― +(7 +) +Decrease due to amounts reclassified into earnings +― +(7 +) +― +(7 +) +Net translation gains on investments in foreign operations (a) +― +678 +― +678 +Net losses related to hedges of investments in foreign operations +― +(370 +) +― +(370 +) +Pension and other postretirement benefits +― +― +62 +62 +Net change in accumulated other comprehensive (loss) income +(7 +) +301 +62 +356 +Balances as of December 31, 2017 +― +(1,961 +) +(467 +) +(2,428 +) +Net unrealized losses +(10 +) +― +― +(10 +) +Net translation losses on investments in foreign operations +― +(500 +) +― +(500 +) +Net gains related to hedges of investments in foreign operations +― +328 +― +328 +Pension and other postretirement benefits +― +― +11 +11 +Other (b) +2 +― +― +2 +Net change in accumulated other comprehensive (loss) income +(8 +) +(172 +) +11 +(169 +) +Balances as of December 31, 2018 +$ +(8 +) +$ +(2,133 +) +$ +(456 +) +$ +(2,597 +) +(a) +Includes $289 million of recognized tax benefits in the year ended December 31, 2017 (refer to Note 21). +(b) +Represents unrealized gains pertaining to equity securities moved from AOCI to retained earnings as of January 1, 2018, due to the prospective adoption of the financial instruments guidance effective January 1, 2018 (refer to Note 1). +The following table shows the tax impact for the years ended December 31 for the changes in each component of AOCI presented above: +Tax expense (benefit) +(Millions) +2018 +2017 +2016 +Net unrealized investment securities +$ +(2 +) +$ +(4 +) +$ +(27 +) +Net translation on investments in foreign operations (a) +(44 +) +(172 +) +(15 +) +Net hedges of investments in foreign operations +107 +(215 +) +139 +Pension and other postretirement benefits +9 +7 +37 +Total tax impact +$ +70 +$ +(384 +) +$ +134 +(a) Includes $289 million of recognized tax benefits in the year ended December 31, 2017 (refer to Note 21). +The following table presents the effects of reclassifications out of AOCI and into the Consolidated Statements of Income for the years ended December 31: +Gains (losses) recognized in earnings +Description (Millions) +Income Statement Line Item +2018 +2017 +Foreign currency translation adjustments +Reclassification of translation adjustments and related hedges +Other expenses +$ +1 +$ +(7 +) +Related income tax +Income tax provision +(1 +) +14 +Reclassification of foreign currency translation adjustments +$ +― +$ +7 +118 +Table of Contents +NOTE 19 +OTHER FEES AND COMMISSIONS, OTHER REVENUES AND OTHER EXPENSES +The following is a detail of Other fees and commissions for the years ended December 31: +(Millions) +2018 +2017 +2016 +Fees charged to Card Members: +Delinquency fees +$ +959 +$ +888 +$ +762 +Foreign currency conversion fee revenue +921 +851 +809 +Other customer fees: +Loyalty coalition-related fees +461 +452 +409 +Travel commissions and fees +395 +364 +332 +Service fees and other (a) +417 +435 +406 +Total Other fees and commissions +$ +3,153 +$ +2,990 +$ +2,718 +(a) +Other includes Membership Rewards program fees that are not related to contracts with customers. +The following is a detail of Other revenues for the years ended December 31: +(Millions) +2018 +2017 +2016 +Global Network Services partner revenues +$ +260 +$ +327 +$ +350 +Other (a) +1,100 +1,130 +1,328 +Total Other revenues +$ +1,360 +$ +1,457 +$ +1,678 +(a) +Other includes revenues arising from net revenue earned on cross-border Card Member spending, merchant-related fees, insurance premiums earned from Card Member travel and other insurance programs, revenues related to the GBT JV transition services agreement, prepaid card and Travelers Cheque-related revenues, earnings from equity method investments (including the GBT JV), and other miscellaneous revenue and fees. +Revenue expected to be recognized in future periods related to contracts that have an original expected duration of one year or less and contracts with variable consideration (e.g. discount revenue) are not required to be disclosed. Non-interest revenue expected to be recognized in future periods through remaining contracts with customers is not material. +The following is a detail of Other expenses for the years ended December 31: +(Millions) +2018 +2017 +2016 +Professional services +$ +2,125 +$ +2,040 +$ +2,508 +Occupancy and equipment +2,033 +2,018 +1,837 +Gain on sale of HFS portfolios (a) +― +― +(1,218 +) +Other (b) +1,513 +1,576 +1,815 +Total Other expenses +$ +5,671 +$ +5,634 +$ +4,942 +(a) +Refer to Note 2 for additional information. +(b) +Other expense includes general operating expenses, communication expenses, Card and merchant-related fraud losses, foreign currency-related gains and losses, and gains on the sale of equity investments. For the year ended December 31, 2018, Other expense also includes the loss on a transaction involving the operations of our prepaid reloadable and gift card business and unrealized gains on certain equity investments previously carried at cost. For the year ended December 31, 2017, Other expense also includes charges related to our U.S. loyalty coalition and prepaid businesses. +NOTE 20 +RESTRUCTURING +We periodically initiate restructuring programs to support new business strategies and to enhance our overall effectiveness and efficiency. In connection with these programs, we will typically incur severance and other exit costs. +We had $69 million, $199 million and $383 million accrued in total restructuring reserves as of December 31, 2018, 2017 and 2016, respectively. New charges, including net revisions to existing restructuring reserves, which primarily relate to the redeployment of displaced colleagues to other positions, were $(23) million, $42 million and $329 million, for the years ended December 31, 2018, 2017 and 2016, respectively. Cumulatively, we recognized $554 million relating to the restructuring programs that were in progress during 2018 and initiated at various dates between 2011 and 2018, the majority of which has been reflected within Corporate & Other. +119 +Table of Contents +NOTE 21 +INCOME TAXES +The Tax Act, enacted by the U.S. government on December 22, 2017, made broad and complex changes to the U.S. tax code which required time to interpret. The SEC issued Staff Accounting Bulletin No. 118 (SAB 118) in December, 2017, to provide guidance on accounting for the effects of the Tax Act. SAB 118 provides for a measurement period of up to one year from the Tax Act enactment date for companies to complete their assessment of and accounting for those effects of the Tax Act required under ASC 740 “Implementation Guidance on Accounting for Uncertainty in Income Taxes” to be reported in the period of enactment. Under SAB 118, a company must first reflect the income tax effects of the Tax Act for which the accounting is complete in the period of the date of enactment. To the extent the accounting for other income tax effects is incomplete, but a reasonable estimate can be determined, companies must record a provisional estimate to be included in their financial statements. For any income tax effect for which a reasonable estimate cannot be determined, an entity must continue to apply ASC 740 based on the provisions of the tax laws in effect immediately prior to the Tax Act being enacted until such time as a reasonable estimate can be determined. +In 2017, we recorded a net discrete tax charge of $2.6 billion related to the Tax Act that was accounted for as a provisional estimate under SAB 118. We have completed our assessment of and accounting for the Tax Act, and recorded a net discrete tax benefit of $0.1 billion in the current period which represents the final adjustment to our 2017 provisional estimate, which is further explained below. + +Impacts of Deemed Repatriation: In 2017, we recorded a provisional tax charge of $1.7 billion related to the one-time transition tax on unrepatriated post-1986 accumulated earnings and profits (E&P) of certain foreign subsidiaries. We have completed our assessment of the transition tax, which resulted in no material change to our original estimate of $1.7 billion. We also recorded a provisional deferred tax liability of $0.3 billion to account for the state income and foreign withholding tax on potential future cash dividends paid from such E&P. We have completed our assessment and reduced the deferred tax liability for state income and foreign withholding taxes related to certain foreign subsidiaries, which resulted in a discrete tax benefit adjustment of $0.1 billion to our original provisional estimate. + +Remeasurement of Deferred Tax Assets and Liabilities: In 2017, we recorded a provisional deferred tax charge of $0.6 billion related to the remeasurement of our U.S. federal net deferred tax assets to reflect the change in the corporate tax rate from 35 percent to 21 percent, as well as other provisions of the Tax Act. We have completed our assessment of the remeasurement of deferred tax assets and liabilities, which resulted in no material change to our original estimate. +The global intangible low tax income (GILTI) provisions of the Tax Act impose a minimum tax on foreign income in excess of a deemed return on tangible assets. We have elected to account for GILTI as a current period expense when incurred. +The components of income tax expense for the years ended December 31 included in the Consolidated Statements of Income were as follows: +(Millions) +2018 +2017 +2016 +Current income tax expense: +U.S. federal +$ +70 +$ +3,408 +$ +2,180 +U.S. state and local +150 +259 +272 +Non-U.S. +681 +387 +340 +Total current income tax expense +901 +4,054 +2,792 +Deferred income tax (benefit) expense: +U.S. federal +276 +544 +(63 +) +U.S. state and local +78 +(12 +) +(10 +) +Non-U.S. +(54 +) +91 +(52 +) +Total deferred income tax (benefit) expense +300 +623 +(125 +) +Total income tax expense +$ +1,201 +$ +4,677 +$ +2,667 +120 +Table of Contents +A reconciliation of the U.S. federal statutory rate of 21 percent as of December 31, 2018, and 35 percent as of both December 31, 2017 and 2016, to our actual income tax rate on continuing operations was as follows: +2018 +2017 +2016 +U.S. statutory federal income tax rate +21.0 +% +35.0 +% +35.0 +% +(Decrease) increase in taxes resulting from: +Tax-exempt income +(1.7) +(1.7) +(1.7) +State and local income taxes, net of federal benefit +2.8 +2.3 +2.7 +Non-U.S. subsidiaries' earnings (a) +(0.5) +(5.7) +(2.0) +Tax settlements (b) +(1.9) +(0.7) +(0.6) +U.S. Tax Act (c) +(1.1) +34.8 +― +U.S. Tax Act - related adjustments (d) +(3.2) +― +― +Other +(0.6) +(1.0) +(0.2) +Actual tax rates +14.8 +% +63.0 +% +33.2 +% +(a) +Results for 2017 and 2016 primarily included tax benefits associated with the undistributed earnings of certain non-U.S. subsidiaries that were previously deemed to be reinvested indefinitely. In addition, 2017 included tax benefits of $156 million, which decreased the actual tax rate by 2.1 percent, related to the realization of certain foreign tax credits. +(b) +Results for 2018 relate to the settlement of the IRS examination for tax years 2008-2014, as well as the resolution of certain tax matters in various jurisdictions. +(c) +Relates to the $2.6 billion provisional charge for the impacts of the Tax Act in 2017 and the adjustments thereto in 2018. +(d) +Relates to changes to the tax method of accounting for certain expenses. +We record a deferred income tax (benefit) provision when there are differences between assets and liabilities measured for financial reporting and for income tax return purposes. These temporary differences result in taxable or deductible amounts in future years and are measured using the tax rates and laws that will be in effect when such differences are expected to reverse. In particular, the 2017 balances were reduced to reflect the remeasurement of certain federal net deferred tax assets due to the enacted lower federal tax rate of 21 percent. +The significant components of deferred tax assets and liabilities as of December 31 are reflected in the following table: +(Millions) +2018 +2017 +Deferred tax assets: +Reserves not yet deducted for tax purposes +$ +2,612 +$ +2,724 +Employee compensation and benefits +360 +403 +Other +431 +409 +Gross deferred tax assets +3,403 +3,536 +Valuation allowance +(61 +) +(46 +) +Deferred tax assets after valuation allowance +3,342 +3,490 +Deferred tax liabilities: +Intangibles and fixed assets +1,083 +1,057 +Deferred revenue +435 +306 +Deferred interest +171 +183 +Investment in joint ventures +137 +137 +Other +210 +269 +Gross deferred tax liabilities +2,036 +1,952 +Net deferred tax assets +$ +1,306 +$ +1,538 +A valuation allowance is established when management determines that it is more likely than not that all or some portion of the benefit of the deferred tax assets will not be realized. The valuation allowances as of December 31, 2018 and 2017 are associated with net operating losses and other deferred tax assets in certain non-U.S. operations. +Accumulated earnings of certain non-U.S. subsidiaries, which totaled approximately $0.7 billion as of December 31, 2018, are intended to be permanently reinvested outside the U.S. We do not provide for state income and foreign withholding taxes on foreign earnings intended to be permanently reinvested outside the U.S. Accordingly, state income and foreign withholding taxes, which would have aggregated to approximately $0.1 billion as of December 31, 2018, have not been provided on those earnings. +Net income taxes paid by us during 2018, 2017 and 2016, were approximately $2.0 billion, $1.4 billion and $3.0 billion, respectively. These amounts include estimated tax payments and cash settlements relating to prior tax years. +121 +Table of Contents +We are subject to the income tax laws of the United States, its states and municipalities and those of the foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to the taxpayer’s facts is sometimes open to interpretation. Given these inherent complexities, we must make judgments in assessing the likelihood that a tax position will be sustained upon examination by the taxing authorities based on the technical merits of the tax position. A tax position is recognized only when, based on management’s judgment regarding the application of income tax laws, it is more likely than not that the tax position will be sustained upon examination. The amount of benefit recognized for financial reporting purposes is based on management’s best judgment of the largest amount of benefit that is more likely than not to be realized on ultimate settlement with the taxing authority given the facts, circumstances and information available at the reporting date. We adjust the level of unrecognized tax benefits when there is new information available to assess the likelihood of the outcome. +We are under continuous examination by the Internal Revenue Service (IRS) and tax authorities in other countries and states in which we have significant business operations. The tax years under examination and open for examination vary by jurisdiction. In 2018 we settled our US federal income tax audits for tax years 2008-2014, and the statute of limitations for these years remain open through 2019. Tax years from 2015 onwards are open for examination by the IRS. +The following table presents changes in unrecognized tax benefits: +(Millions) +2018 +2017 +2016 +Balance, January 1 +$ +821 +$ +974 +$ +870 +Increases: +Current year tax positions +152 +200 +167 +Tax positions related to prior years +47 +39 +117 +Decreases: +Tax positions related to prior years (a) +(74 +) +(289 +) +(81 +) +Settlements with tax authorities (b) +(192 +) +(77 +) +(76 +) +Lapse of statute of limitations +(44 +) +(26 +) +(22 +) +Effects of foreign currency translations +(9 +) +― +(1 +) +Balance, December 31 +$ +701 +$ +821 +$ +974 +(a) +Decrease in 2017 due to the resolution with the IRS of an uncertain tax position in January 2017, which resulted in the recognition of $289 million in AOCI. +(b) +2018 relates to the settlement of the IRS examination for tax years 2008-2014, as well as the resolution of certain tax matters in various jurisdictions. +Included in the unrecognized tax benefits of $0.7 billion, $0.8 billion and $1.0 billion for December 31, 2018, 2017 and 2016, respectively, are approximately $599 million, $723 million and $516 million, respectively, that, if recognized, would favorably affect the effective tax rate in a future period. +We believe it is reasonably possible that our unrecognized tax benefits could decrease within the next 12 months by as much as $151 million, principally as a result of potential resolutions of prior years’ tax items with various taxing authorities. The prior years’ tax items include unrecognized tax benefits relating to the deductibility of certain expenses or losses and the attribution of taxable income to a particular jurisdiction or jurisdictions. Of the $151 million of unrecognized tax benefits, approximately $127 million relates to amounts that, if recognized, would impact the effective tax rate in a future period. +Interest and penalties relating to unrecognized tax benefits are reported in the income tax provision. For the years ended December 31, 2018 and 2017, we recognized benefits of approximately $18 million and $90 million, respectively, for interest and penalties. For the year ended December 31, 2016, we recognized approximately $9 million in expenses for interest and penalties. The interest expense benefit in 2017 includes approximately $56 million related to the resolution of an uncertain tax position with the IRS in January 2017, which had no net impact on the income tax provision. +We had approximately $65 million and $83 million accrued for the payment of interest and penalties as of December 31, 2018 and 2017, respectively. +122 +Table of Contents +NOTE 22 +EARNINGS PER COMMON SHARE (EPS) +The computations of basic and diluted EPS for the years ended December 31 were as follows: +(Millions, except per share amounts) +2018 +2017 +2016 +Numerator: +Basic and diluted: +Net income +$ +6,921 +$ +2,748 +$ +5,375 +Preferred dividends +(80 +) +(81 +) +(80 +) +Net income available to common shareholders +6,841 +2,667 +5,295 +Earnings allocated to participating share awards (a) +(54 +) +(21 +) +(43 +) +Net income attributable to common shareholders +$ +6,787 +$ +2,646 +$ +5,252 +Denominator: (a) +Basic: Weighted-average common stock +856 +883 +933 +Add: Weighted-average stock options (b) +3 +3 +2 +Diluted +859 +886 +935 +Basic EPS +$ +7.93 +$ +3.00 +$ +5.63 +Diluted EPS +$ +7.91 +$ +2.99 +$ +5.61 +(a) +Our unvested restricted stock awards, which include the right to receive non-forfeitable dividends or dividend equivalents, are considered participating securities. Calculations of EPS under the two-class method exclude from the numerator any dividends paid or owed on participating securities and any undistributed earnings considered to be attributable to participating securities. The related participating securities are similarly excluded from the denominator. +(b) +The dilutive effect of unexercised stock options excludes from the computation of EPS 0.7 million, 0.6 million and 2.4 million of options for the years ended December 31, 2018, 2017 and 2016, respectively, because inclusion of the options would have been anti-dilutive. +123 +Table of Contents +NOTE 23 +REGULATORY MATTERS AND CAPITAL ADEQUACY +We are supervised and regulated by the Board of Governors of the Federal Reserve System (the Federal Reserve) and are subject to the Federal Reserve’s requirements for risk-based capital and leverage ratios. Our U.S. bank subsidiary, AENB, is the surviving entity that resulted from the conversion of American Express Centurion Bank, a Utah state-chartered industrial bank, into a national banking association, and the subsequent merger of American Express Bank, FSB, a federal savings bank, into the successor entity as of April 1, 2018. AENB is subject to supervision and regulation, including regulatory capital and leverage requirements, by the Office of the Comptroller of the Currency (OCC). +Under the risk-based capital guidelines of the Federal Reserve, we are required to maintain minimum ratios of CET1, Tier 1 and Total (Tier 1 plus Tier 2) capital to risk-weighted assets, as well as a minimum Tier 1 leverage ratio (Tier 1 capital to average adjusted on-balance sheet assets) and a supplementary leverage ratio (Tier 1 capital to both on-balance sheet and certain off-balance sheet exposures). +Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional, discretionary actions by regulators, that, if undertaken, could have a direct material effect on our operating activities. +As of December 31, 2018 and 2017, we met all capital requirements to which we were subject and maintained regulatory capital ratios in excess of those required to qualify as well capitalized. +The following table presents the regulatory capital ratios: +(Millions, except percentages) +CET 1 capital +Tier 1 capital +Total capital +CET 1 Capital ratio +Tier 1 capital ratio +Total capital ratio +Tier 1 leverage ratio +Supplementary Leverage Ratio +December 31, 2018: (a) +American Express Company +$ +17,498 +$ +19,070 +$ +21,653 +11.0 +% +12.0 +% +13.6 +% +10.4 +% +8.9 +% +American Express National Bank +$ +11,564 +$ +11,564 +$ +13,574 +12.1 +% +12.1 +% +14.2 +% +9.9 +% +8.2 +% +December 31, 2017: (a) +American Express Company +$ +13,189 +$ +14,721 +$ +17,142 +9.0 +% +10.1 +% +11.8 +% +8.6 +% +(b) +% +American Express Centurion Bank +$ +5,954 +$ +5,954 +$ +6,547 +12.7 +% +12.7 +% +14.0 +% +10.2 +% +(b) +% +American Express Bank, FSB +$ +6,065 +$ +6,065 +$ +6,653 +12.9 +% +12.9 +% +14.2 +% +11.7 +% +(b) +% +Well-capitalized ratios (c) +6.5 +% +8.0 +% +10.0 +% +5.0 +% +N/A +Basel III Standards 2018 (d) +6.4 +% +7.9 +% +9.9 +% +4.0 +% +3.0 +% +Minimum capital ratios (e) +4.5 +% +6.0 +% +8.0 +% +4.0 +% +3.0 +% +(a) +As a Basel III advanced approaches institution in parallel run, capital ratios are reported using Basel III capital definitions, inclusive of transition provisions for the capital ratios and risk-weighted assets using the Basel III standardized approach. +(b) +The minimum supplementary leverage ratio (SLR) requirement of 3 percent became effective January 1, 2018. +(c) +Represents requirements for banking subsidiaries to be considered “well capitalized” pursuant to regulations issued under the Federal Deposit Insurance Corporation Improvement Act. There is no CET1 capital ratio, Tier 1 leverage ratio or SLR requirement for a bank holding company to be considered “well capitalized.” +(d) +Basel III minimum capital requirement and additional transitional capital conservation buffer as defined by the Federal Reserve and OCC for calendar year 2018 for advanced approaches institutions. The additional capital conservation buffer does not apply to Tier 1 leverage ratio or SLR. +(e) +As defined by the regulations issued by the Federal Reserve and OCC. +RESTRICTED NET ASSETS OF SUBSIDIARIES +Certain of our subsidiaries are subject to restrictions on the transfer of net assets under debt agreements and regulatory requirements. These restrictions have not had any effect on our shareholder dividend policy and management does not anticipate any impact in the future. Procedures exist to transfer net assets between the Company and its subsidiaries, while ensuring compliance with the various contractual and regulatory constraints. As of December 31, 2018, the aggregate amount of net assets of subsidiaries that are restricted to be transferred was approximately $8.8 billion. +124 +Table of Contents +BANK HOLDING COMPANY DIVIDEND RESTRICTIONS +We are limited in our ability to pay dividends by the Federal Reserve, which could prohibit a dividend that would be considered an unsafe or unsound banking practice. It is the policy of the Federal Reserve that bank holding companies generally should pay dividends on preferred and common stock only out of net income available to common shareholders generated over the past year, and only if prospective earnings retention is consistent with the organization’s current and expected future capital needs, asset quality and overall financial condition. Moreover, bank holding companies are required by statute to be a source of strength to their insured depository institution subsidiaries and should not maintain dividend levels that undermine their ability to do so. On an annual basis, we are required to develop and maintain a capital plan, which includes planned dividends over a two-year horizon. We may be limited in our ability to pay dividends if the Federal Reserve objects to our capital plan. +In addition, the Capital Rules include a capital conservation buffer of 1.875 percent as of December 31, 2018. The Capital Rules also include a countercyclical capital buffer, which is currently set at zero but which could be increased by the Federal Reserve in the future. These buffers can be satisfied only with CET1 capital. If our risk-based capital ratios were to fall below the applicable buffer levels, we would be subject to certain restrictions on dividends, stock repurchases and other capital distributions, as well as discretionary bonus payments to executive officers. +BANK DIVIDEND RESTRICTIONS +In the year ended December 31, 2018, American Express National Bank paid dividends from retained earnings to its parent of $5.9 billion. +AENB is limited in its ability to pay dividends by banking statutes, regulations and supervisory policy. In general, applicable federal and state banking laws prohibit, without first obtaining regulatory approval, insured depository institutions, such as AENB, from making dividend distributions if such distributions are not paid out of available retained earnings or would cause the institution to fail to meet capital adequacy standards. AENB must maintain a capital conservation buffer (and countercyclical buffer if in effect). If AENB's risk-based capital ratios do not satisfy minimum requirements plus the combined capital conservation buffer (and the countercyclical capital buffer, if applicable), it will face graduated constraints on dividends and other capital distributions based on the amount of the shortfall. As of December 31, 2018, AENB's retained earnings available for the payment of dividends was $3.9 billion. In determining the dividends to pay its parent, AENB must also consider the effects on applicable risk-based capital and leverage ratio requirements, as well as policy statements of the federal regulatory agencies. In addition, AENB's banking regulators have authority to limit or prohibit the payment of a dividend by AENB under a number of circumstances, including if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound banking practice in light of the financial condition of the banking organization. +125 +Table of Contents +NOTE 24 +SIGNIFICANT CREDIT CONCENTRATIONS +Concentrations of credit risk exist when changes in economic, industry or geographic factors similarly affect groups of counterparties whose aggregate credit exposure is material in relation to American Express’ total credit exposure. Our customers operate in diverse industries, economic sectors and geographic regions. +The following table details our maximum credit exposure of the on-balance sheet assets by category as of December 31: +(Billions) +2018 +2017 +On-balance sheet: +Individuals (a) +$ +123 +$ +112 +Institutions (b) +20 +20 +Financial Services (c) +30 +35 +U.S. Government and agencies (d) +4 +3 +Total on-balance sheet +$ +177 +$ +170 +(a) +Primarily reflects loans and receivables from global consumer and small business Card Members, which are governed by individual credit risk management. +(b) +Primarily reflects loans and receivables from global corporate Card Members, which are governed by institutional credit risk management. +(c) +Represents banks, broker-dealers, insurance companies and savings and loan associations. +(d) +Represent debt obligations of the U.S. Government and its agencies, states and municipalities and government-sponsored entities. +As of December 31, 2018 and 2017, our most significant concentration of credit risk was with individuals, including Card Member loans and receivables. These amounts are generally advanced on an unsecured basis. However, we review each potential customer’s credit application and evaluate the applicant’s financial history and ability and willingness to repay. We also consider credit performance by customer tenure, industry and geographic location in managing credit exposure. +The following table details our Card Member loans and receivables exposure (including unused lines-of-credit available to Card Members as part of established lending product agreements) in the United States and outside the United States as of December 31: +(Billions) +2018 +2017 +On-balance sheet: +U.S. +$ +111 +$ +102 +Non-U.S. +27 +25 +On-balance sheet +138 +127 +Unused lines-of-credit: (a) +U.S. +249 +224 +Non-U.S. +53 +49 +Total unused lines-of-credit +$ +302 +$ +273 +(a) +Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Because our charge card products generally have no preset spending limit, the associated credit limit on charge products is not quantifiable, and therefore is not reflected in unused credit available to Card Members. +126 +Table of Contents +NOTE 25 +REPORTABLE OPERATING SEGMENTS AND GEOGRAPHIC OPERATIONS +REPORTABLE OPERATING SEGMENTS +We are a global services company that is principally engaged in businesses comprising three reportable operating segments: GCSG, GCS and GMNS. +We consider a combination of factors when evaluating the composition of our reportable operating segments, including the results reviewed by the chief operating decision maker, economic characteristics, products and services offered, classes of customers, product distribution channels, +geographic considerations (primarily United States versus outside the United States), and regulatory environment considerations. +The following is a brief description of the primary business activities of our three reportable operating segments: + +GCSG issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. + +GCS issues a wide range of proprietary corporate and small business cards and provides payment and expense management services globally. In addition, GCS provides commercial financing products. + +GMNS operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses in certain countries. +Corporate functions and certain other businesses and operations are included in Corporate & Other. During 2018, we changed the methodology used to allocate certain corporate overhead costs and interest income and expense to the operating segments, and made minor changes to the intercompany settlement process. Prior period amounts have been revised to conform to the current period presentation. +127 +Table of Contents +The following table presents certain selected financial information for our reportable operating segments and Corporate & Other as of or for the years ended December 31, 2018, 2017 and 2016: +(Millions, except where indicated) +GCSG +GCS +GMNS +Corporate & Other (a) +Consolidated +2018 +Non-interest revenues +$ +14,675 +$ +11,882 +$ +6,069 +$ +49 +$ +32,675 +Revenue from contracts with customers (b) +10,294 +10,309 +5,988 +16 +26,607 +Interest income +8,323 +1,621 +30 +632 +10,606 +Interest expense +1,542 +827 +(294 +) +868 +2,943 +Total revenues net of interest expense +21,456 +12,676 +6,393 +(187 +) +40,338 +Total provisions +2,430 +899 +22 +1 +3,352 +Pretax income (loss) from continuing operations +3,714 +2,895 +2,844 +(1,331 +) +8,122 +Income tax provision (benefit) +637 +555 +704 +(695 +) +1,201 +Net income (loss) +3,077 +2,340 +2,140 +(636 +) +6,921 +Total assets (billions) +$ +151 +$ +52 +$ +45 +$ +(59 +) +$ +189 +2017 +Non-interest revenues +$ +13,378 +$ +10,942 +$ +6,025 +$ +82 +$ +30,427 +Revenue from contracts with customers (b) +9,448 +9,471 +5,846 +15 +24,780 +Interest income +6,789 +1,361 +42 +371 +8,563 +Interest expense +1,047 +595 +(188 +) +658 +2,112 +Total revenues net of interest expense +19,120 +11,708 +6,255 +(205 +) +36,878 +Total provisions (b) +1,996 +743 +16 +5 +2,760 +Pretax income (loss) from continuing operations +3,645 +2,843 +2,645 +(1,708 +) +7,425 +Income tax provision +1,053 +914 +857 +1,853 +4,677 +Net income (loss) +2,592 +1,929 +1,788 +(3,561 +) +2,748 +Total assets (billions) +$ +124 +$ +49 +$ +31 +$ +(23 +) +$ +181 +2016 +Non-interest revenues +$ +12,993 +$ +10,373 +$ +6,093 +$ +200 +$ +29,659 +Revenue from contracts with customers (b) +9,386 +8,918 +5,826 +105 +24,235 +Interest income +6,005 +1,209 +37 +233 +7,484 +Interest expense +828 +472 +(133 +) +538 +1,705 +Total revenues net of interest expense +18,170 +11,110 +6,263 +(105 +) +35,438 +Total provisions (b) +1,390 +604 +24 +9 +2,027 +Pretax income (loss) from continuing operations +4,508 +2,933 +2,391 +(1,790 +) +8,042 +Income tax provision (benefit) +1,469 +1,032 +861 +(695 +) +2,667 +Net income (loss) +3,039 +1,901 +1,530 +(1,095 +) +5,375 +Total assets (billions) +$ +114 +$ +43 +$ +26 +$ +(24 +) +$ +159 +(a) +Corporate & Other includes adjustments and eliminations for intersegment activity. +(b) +Includes discount revenue, certain other fees and commissions and other revenues from customers. +Total Revenues Net of Interest Expense +We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue. +Net card fees and other fees and commissions are directly attributable to the segment in which they are reported. +Interest and fees on loans and certain investment income is directly attributable to the segment in which it is reported. Interest expense represents an allocated funding cost based on a combination of segment funding requirements and internal funding rates. +Provisions for Losses +The provisions for losses are directly attributable to the segment in which they are reported. +128 +Table of Contents +Expenses +Marketing and business development expense is included in each segment based on the actual expenses incurred. Global brand advertising is primarily reflected in Corporate & Other and may be allocated to the segments based on the actual expense incurred. Rewards and Card Member services expenses are included in each segment based on the actual expenses incurred within the segment. +Salaries and employee benefits and other operating expenses reflect expenses such as professional services, occupancy and equipment and communications incurred directly within each segment. In addition, expenses related to support services, such as technology costs, are allocated to each segment primarily based on support service activities directly attributable to the segment. Certain other overhead expenses are allocated from Corporate & Other to the segments based on the relative levels of revenue and Card Member loans and receivables. +Income Taxes +An income tax provision (benefit) is allocated to each reportable operating segment based on the effective tax rates applicable to various businesses that comprise the segment. The charge of $2.6 billion related to the Tax Act in the fourth quarter of 2017 was allocated in full to Corporate & Other. +GEOGRAPHIC OPERATIONS +The following table presents our total revenues net of interest expense and pretax income (loss) from continuing operations in different geographic regions based, in part, upon internal allocations, which necessarily involve management’s judgment: +(Millions) +United States +EMEA (a) +JAPA (a) +LACC (a) +Other Unallocated (b) +Consolidated +2018 +Total revenues net of interest expense +$ +29,864 +$ +4,419 +$ +3,656 +$ +2,584 +$ +(185 +) +$ +40,338 +Pretax income (loss) from continuing operations +6,696 +1,212 +764 +782 +(1,332 +) +8,122 +2017 +Total revenues net of interest expense +$ +27,187 +$ +3,927 +$ +3,464 +$ +2,505 +$ +(205 +) +$ +36,878 +Pretax income (loss) from continuing operations +6,412 +1,150 +763 +806 +(1,706 +) +7,425 +2016 +Total revenues net of interest expense +$ +26,339 +$ +3,570 +$ +3,275 +$ +2,360 +$ +(106 +) +$ +35,438 +Pretax income (loss) from continuing operations +7,943 +698 +556 +635 +(1,790 +) +8,042 +(a) +EMEA represents Europe, the Middle East and Africa; JAPA represents Japan, Asia/Pacific and Australia; and LACC represents Latin America, Canada and the Caribbean. +(b) +Other Unallocated includes net costs which are not directly allocable to specific geographic regions, including costs related to the net negative interest spread on excess liquidity funding and executive office operations expenses. +129 +Table of Contents +NOTE 26 +PARENT COMPANY +PARENT COMPANY – CONDENSED STATEMENTS OF INCOME +Years Ended December 31 (Millions) +2018 +2017 +2016 +Revenues +Non-interest revenues +Other +$ +426 +$ +358 +$ +391 +Total non-interest revenues +426 +358 +391 +Interest income +422 +258 +196 +Interest expense +615 +493 +515 +Total revenues net of interest expense +233 +123 +72 +Expenses +Salaries and employee benefits +336 +362 +388 +Other +607 +553 +510 +Total expenses +943 +915 +898 +Pretax loss +(710 +) +(792 +) +(826 +) +Income tax benefit +(179 +) +(354 +) +(327 +) +Net loss before equity in net income of subsidiaries and affiliates +(531 +) +(438 +) +(499 +) +Equity in net income of subsidiaries and affiliates +7,452 +3,186 +5,874 +Net income +$ +6,921 +$ +2,748 +$ +5,375 +PARENT COMPANY – CONDENSED BALANCE SHEETS +As of December 31 (Millions) +2018 +2017 +Assets +Cash and cash equivalents +$ +3,287 +$ +4,726 +Equity in net assets of subsidiaries and affiliates +22,298 +18,225 +Loans to subsidiaries and affiliates +17,945 +11,664 +Due from subsidiaries and affiliates +1,783 +1,962 +Other assets +297 +361 +Total assets +45,610 +36,938 +Liabilities and Shareholders’ Equity +Liabilities +Accounts payable and other liabilities +1,961 +3,076 +Due to subsidiaries and affiliates +577 +175 +Short-term debt of subsidiaries and affiliates +2,591 +2,731 +Long-term debt +18,191 +12,695 +Total liabilities +23,320 +18,677 +Shareholders’ Equity +Total shareholders’ equity +22,290 +18,261 +Total liabilities and shareholders’ equity +$ +45,610 +$ +36,938 +130 +Table of Contents +PARENT COMPANY – CONDENSED STATEMENTS OF CASH FLOWS +Years Ended December 31 (Millions) +2018 +2017 +2016 +Cash Flows from Operating Activities +Net income +$ +6,921 +$ +2,748 +$ +5,375 +Adjustments to reconcile net income to cash provided by operating activities: +Equity in net income of subsidiaries and affiliates +(7,452 +) +(3,186 +) +(5,870 +) +Dividends received from subsidiaries and affiliates +3,222 +5,755 +4,999 +Other operating activities, primarily with subsidiaries and affiliates +(257 +) +659 +(102 +) +Net cash provided by operating activities +2,434 +5,976 +4,402 +Cash Flows from Investing Activities +Purchase of premises and equipment +― +― +(1 +) +Loans to subsidiaries and affiliates +(6,281 +) +(4,044 +) +4,142 +Investments in subsidiaries and affiliates +(30 +) +― +(25 +) +Net cash (used in) provided by investing activities +(6,311 +) +(4,044 +) +4,116 +Cash Flows from Financing Activities +Proceeds from long-term debt +9,350 +5,900 +― +Payments on long-term debt +(3,850 +) +(1,500 +) +(1,350 +) +Short-term debt of subsidiaries and affiliates +(140 +) +(1,313 +) +(2,879 +) +Issuance of American Express common shares and other +87 +129 +176 +Repurchase of American Express common shares +(1,685 +) +(4,400 +) +(4,430 +) +Dividends paid +(1,324 +) +(1,251 +) +(1,206 +) +Net cash provided by (used in) financing activities +2,438 +(2,435 +) +(9,689 +) +Net decrease in cash and cash equivalents +(1,439 +) +(503 +) +(1,171 +) +Cash and cash equivalents at beginning of year +4,726 +5,229 +6,400 +Cash and cash equivalents at end of year +$ +3,287 +$ +4,726 +$ +5,229 +NOTE 27 +QUARTERLY FINANCIAL DATA (UNAUDITED ) +(Millions, except per share amounts) +2018 +2017 +Quarters Ended +12/31 +9/30 +6/30 +3/31 +12/31 +9/30 +6/30 +3/31 +Total revenues net of interest expense +$ +10,474 +$ +10,144 +$ +10,002 +$ +9,718 +$ +9,707 +$ +9,290 +$ +9,172 +$ +8,709 +Pretax income +1,831 +2,118 +2,091 +2,082 +1,798 +1,831 +1,957 +1,839 +Net income (loss) +2,010 +1,654 +1,623 +1,634 +(1,206 +) +1,359 +1,344 +1,251 +Earnings Per Common Share — Basic: +Net income attributable to common +shareholders (a) +2.33 +1.89 +1.85 +1.86 +(1.42 +) +1.51 +1.48 +1.36 +Earnings Per Common Share — Diluted: +Net income attributable to common +shareholders (a) +2.32 +1.88 +1.84 +1.86 +(1.42 +) +1.51 +1.47 +1.35 +Cash dividends declared per common share +$ +0.39 +$ +0.39 +$ +0.35 +$ +0.35 +$ +0.35 +$ +0.35 +$ +0.32 +$ +0.32 +(a) +Represents net income, less (i) earnings allocated to participating share awards of $16 million, $13 million, $12 million and $13 million for the quarters ended December 31, September 30, June 30 and March 31, 2018, respectively, and $2 million, $11 million, $11 million and $10 million for the quarters ended December 31, September 30, June 30 and March 31, 2017, respectively, and (ii) dividends on preferred shares of $19 million, $20 million, $20 million and $21 million for the quarters ended December 31, September 30, June 30 and March 31, 2018, respectively, and $20 million, $21 million, $19 million and $21 million for the quarters ended December 31, September 30, June 30 and March 31, 2017, respectively. +131 +Table of Contents +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not applicable. +ITEM 9A. +CONTROLS AND PROCEDURES +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods specified in the applicable rules and forms, and that it is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. +There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company’s fourth quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +“Management’s Report on Internal Control over Financial Reporting,” which sets forth management’s evaluation of internal control over financial reporting, and the “Report of Independent Registered Public Accounting Firm” on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2018 are set forth in “Financial Statements and Supplementary Data.” +ITEM 9B. +OTHER INFORMATION +Not applicable. +132 +Table of Contents +PART III +ITEMS 10, 11, 12 and 13. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +We expect to file with the SEC in March 2019 (and, in any event, not later than 120 days after the close of our last fiscal year), a definitive proxy statement, pursuant to SEC Regulation 14A in connection with our Annual Meeting of Shareholders to be held May 7, 2019, which involves the election of directors. The following information to be included in such proxy statement is incorporated herein by reference: + +Information included under the caption “Corporate Governance at American Express — Our Corporate Governance Framework — Our Board’s Independence” + +Information included under the caption “Corporate Governance at American Express — Our Board Committees — Board Committee Responsibilities” + +Information included under the caption “Corporate Governance at American Express — Our Corporate Governance Framework — Director Attendance” + +Information included under the caption “Corporate Governance at American Express — Compensation of Directors” + +Information included under the caption “Stock Ownership Information” + +Information included under the caption “Corporate Governance at American Express — Item 1 — Election of Directors for a Term of One Year” + +Information included under the caption “Executive Compensation” + +Information under the caption “Corporate Governance at American Express — Certain Relationships and Transactions” + +Information under the caption “Stock Ownership Information — Section 16(a) Beneficial Ownership Reporting Compliance” +In addition, the information regarding executive officers called for by Item 401(b) of Regulation S-K may be found under the caption “Executive Officers of the Company” in this Report. +We have adopted a set of Corporate Governance Principles, which together with the charters of the six standing committees of the Board of Directors (Audit and Compliance; Compensation and Benefits; Innovation and Technology; Nominating and Governance; Public Responsibility; and Risk), our Code of Conduct (which constitutes our code of ethics) and the Code of Business Conduct for the Members of the Board of Directors, provide the framework for our governance. A complete copy of our Corporate Governance Principles, the charters of each of the Board committees, the Code of Conduct (which applies not only to our Chief Executive Officer, Chief Financial Officer and Controller, but also to all our other employees) and the Code of Business Conduct for the Members of the Board of Directors may be found by clicking on the “Corporate Governance” link found on our Investor Relations website at http://ir.americanexpress.com. We also intend to disclose any amendments to our Code of Conduct, or waivers of our Code of Conduct on behalf of our Chief Executive Officer, Chief Financial Officer or Controller, on our website. You may also access our Investor Relations website through our main website at www.americanexpress.com by clicking on the “About American Express” link, which is located at the bottom of the Company’s homepage. (Information from such sites is not incorporated by reference into this Report.) You may also obtain free copies of these materials by writing to our Corporate Secretary at our headquarters. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information set forth under the heading “Item 2 — Ratification of Appointment of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP Fees and Services,” which will appear in our definitive proxy statement in connection with our Annual Meeting of Shareholders to be held May 7, 2019, is incorporated herein by reference. +133 +Table of Contents +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) +1. +Financial Statements : +See the “Index to Consolidated Financial Statements” under “Financial Statements and Supplementary Data.” +2. +Financial Statement Schedules : +All schedules are omitted since the required information is either not applicable, not deemed material, or shown in the Consolidated Financial Statements. +3. +Exhibits : +The list of exhibits required to be filed as exhibits to this Report is listed on pages E-1 through E-4 hereof under “Exhibit Index.” +ITEM 16. +FORM 10-K SUMMARY +Not applicable. +134 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +AMERICAN EXPRESS COMPANY +/s/ JEFFREY C. CAMPBELL +Jeffrey C. Campbell +Chief Financial Officer +February 13, 2019 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the date indicated. +/s/ STEPHEN J. SQUERI +/s/ MICHAEL O. LEAVITT +Stephen J. Squeri +Chairman, Chief Executive Officer and Director +Michael O. Leavitt +Director +/s/ JEFFREY C. CAMPBELL +/s/ THEODORE J. LEONSIS +Jeffrey C. Campbell +Chief Financial Officer +Theodore J. Leonsis +Director +/s/ RICHARD PETRINO +/s/ RICHARD C. LEVIN +Richard Petrino +Executive Vice President and Corporate Controller +Richard C. Levin +Director +(Principal Accounting Officer) +/s/ CHARLENE BARSHEFSKY +/s/ SAMUEL J. PALMISANO +Charlene Barshefsky +Director +Samuel J. Palmisano +Director +/s/ JOHN J. BRENNAN +/s/ DANIEL L. VASELLA +John J. Brennan +Director +Daniel L. Vasella +Director +/s/ PETER CHERNIN +/s/ RONALD A. WILLIAMS +Peter Chernin +Director +Ronald A. Williams +Director +/s/ RALPH DE LA VEGA +/s/ CHRISTOPHER D. YOUNG +Ralph de la Vega +Director +Christopher D. Young +Director +/s/ ANNE LAUVERGEON +Anne Lauvergeon +Director +February 13, 2019 +135 +Table of Contents +Appendix +GUIDE 3 – STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES +The accompanying supplemental information should be read in conjunction with the “MD&A”, “Consolidated Financial Statements” and notes thereto. The disclosures presented are excluding amounts associated with Card Member loans and receivables HFS, unless otherwise indicated. Refer to Note 2 to the “Consolidated Financial Statements” for additional information. +Certain reclassifications of prior period amounts have been made to conform to the current period presentation, including amounts restated in conjunction with the adoption of the new revenue recognition standard. These reclassifications did not have a material impact on our financial position or results of operations. Refer to Note 1 to the “Consolidated Financial Statements” for additional information. +Distribution of Assets, Liabilities, and Shareholders’ Equity; Interest Rates and Interest Differential +The following tables provide a summary of our consolidated average balances including major categories of interest-earning assets and interest-bearing liabilities along with an analysis of net interest earnings. Consolidated average balances, interest, and average yields are segregated between U.S. and non-U.S. offices. Assets, liabilities, interest income and interest expense are attributed to the United States and outside the United States based on the location of the office recording such items. +2018 +2017 +2016 +Years Ended December 31, +Average +Interest +Average +Average +Interest +Average +Average +Interest +Average +(Millions, except percentages) +Balance (a) +Income +Yield +Balance (a) +Income +Yield +Balance (a) +Income +Yield +Interest-earning assets +Interest-bearing deposits in other banks (b) +U.S. +$ +25,001 +$ +491 +2.0 +% +$ +24,510 +$ +277 +1.1 +% +$ +21,282 +$ +116 +0.5 +% +Non-U.S. +1,830 +33 +1.8 +1,773 +17 +1.0 +1,884 +11 +0.6 +Federal funds sold and securities purchased +under agreements to resell +Non-U.S. +58 +7 +12.1 +80 +6 +7.5 +110 +5 +4.5 +Short-term investment securities +U.S. +3 +― +― +182 +1 +0.5 +170 +― +― +Non-U.S. +149 +1 +0.7 +1,070 +7 +0.7 +551 +4 +0.7 +Card Member loans, including loans HFS (c)(d) +U.S. +66,620 +8,387 +12.6 +58,853 +6,894 +11.7 +58,900 +6,169 +10.5 +Non-U.S. +9,136 +1,206 +13.2 +7,847 +1,038 +13.2 +6,828 +907 +13.3 +Other loans (c) +U.S. +3,110 +312 +10.0 +1,887 +195 +10.3 +1,077 +110 +10.2 +Non-U.S. +145 +36 +24.8 +148 +27 +18.2 +150 +28 +18.7 +Taxable investment securities (e) +U.S. +3,025 +68 +2.2 +1,216 +24 +2.0 +721 +12 +1.7 +Non-U.S. +562 +23 +4.1 +547 +17 +3.1 +543 +15 +2.8 +Non-taxable investment securities (e) +U.S. +855 +25 +3.7 +1,510 +48 +4.9 +2,390 +104 +6.9 +Other assets (f) +Primarily U.S. +1 +17 +n.m. +1 +12 +n.m. +1 +3 +n.m. +Total interest-earning assets (g) +$ +110,495 +$ +10,606 +9.6 +% +$ +99,624 +$ +8,563 +8.6 +% +$ +94,607 +$ +7,484 +8.0 +% +U.S. +98,615 +9,300 +88,159 +7,451 +84,541 +6,514 +Non-U.S. +11,880 +1,306 +11,465 +1,112 +10,066 +970 +n.m. Denotes rates determined to not be meaningful. +(a) +Averages based on month-end balances. +(b) +Amounts include (i) average interest-bearing restricted cash balances of $ 663 million, $868 million and $358 million for 2018, 2017 and 2016, respectively, which are included in other assets on the Consolidated Balance Sheets, and (ii) the associated interest income. +(c) +Average non-accrual loans were included in the average Card Member loan balances in amounts of $230 million, $187 million and $173 million in U.S. for 2018, 2017 and 2016, respectively. Average other loan balances for U.S. include average non-accrual loans of $4 million, $3 million and $5 million for 2018, 2017 and 2016, respectively. Average non-accrual loans are considered to determine the average yield on loans. +(d) +Amounts for 2018 includes average Card Member loans related to the acquired Hilton portfolio. Amounts for 2016 include average Card Member loans HFS of $5,828 million and the associated interest income. During the first half of 2016, we completed the sales of substantially all of our outstanding Card Member loans HFS. Refer to Note 2 to the “Consolidated Financial Statements” for additional information. +(e) +Average yields for both taxable and non-taxable investment securities have been calculated using amortized cost balances and do not include changes in fair value recorded in other comprehensive loss. Average yield on non-taxable investment securities is calculated on a tax-equivalent basis using the U.S. federal statutory tax rate of 21 percent for 2018 and 35 percent for both 2017 and 2016. +(f) +Amounts include (i) average equity securities balances, which are included in investment securities on the Consolidated Balance Sheets, and (ii) the associated income. +(g) +The average yield on total interest-earning assets is adjusted for the impacts of the items mentioned in footnote (e). +A-1 +Table of Contents +2018 +2017 +2016 +Years Ended December 31, (Millions, except percentages) +Average Balance (a) +Average Balance (a) +Average Balance (a) +Non-interest-earning assets +Cash and due from banks +U.S. +$ +2,793 +$ +2,393 +$ +2,653 +Non-U.S. +527 +489 +478 +Card Member receivables, net, including receivables HFS (b) ++ +U.S. +26,435 +21,262 +22,622 +Non-U.S. +27,100 +27,621 +22,102 +Other receivables, net +U.S. +1,591 +1,756 +1,753 +Non-U.S. +1,241 +1,111 +1,115 +Reserves for Card Member and other loans losses +U.S. +(1,740 +) +(1,264 +) +(961 +) +Non-U.S. +(217 +) +(177 +) +(150 +) +Other assets (c) ++ +U.S. +10,760 +10,706 +10,165 +Non-U.S. +3,836 +3,889 +3,931 +Total non-interest-earning assets +72,326 +67,786 +63,708 +U.S. +39,839 +34,853 +36,232 +Non-U.S. +32,487 +32,933 +27,476 +Total assets +$ +182,821 +$ +167,410 +$ +158,315 +U.S. +138,454 +123,012 +120,773 +Non-U.S. +44,367 +44,398 +37,542 +Percentage of total average assets attributable to non-U.S. activities +24.3 +% +26.5 +% +23.7 +% +(a) +Averages based on month-end balances. +(b) +Amounts for 2016 include average Card Member receivables HFS of $51 million. During the first half of 2016, we completed the sale of substantially all of our outstanding Card Member receivables HFS. Refer to Note 2 to the “Consolidated Financial Statements” for additional information. +(c) +Includes premises and equipment, net of accumulated depreciation and amortization. +A-2 +Table of Contents +2018 +2017 +2016 +Years Ended December 31, +Average +Interest +Average +Average +Interest +Average +Average +Interest +Average +(Millions, except percentages) +Balance (a) +Expense +Rate +Balance (a) +Expense +Rate +Balance (a) +Expense +Rate +Interest-bearing liabilities +Customer deposits +U.S. +Savings +$ +50,499 +$ +919 +1.8 +% +$ +42,134 +$ +471 +1.1 +% +$ +39,975 +$ +334 +0.8 +% +Time +15,975 +357 +2.2 +14,701 +301 +2.0 +13,450 +258 +1.9 +Demand +285 +6 +2.1 +215 +3 +1.4 +162 +1 +0.6 +Non-U.S. +Other time and savings +21 +1 +4.8 +17 +1 +5.9 +10 +1 +10.0 +Other demand +12 +4 +33.3 +18 +3 +16.7 +74 +4 +5.4 +Short-term borrowings +U.S. +274 +14 +5.1 +1,188 +15 +1.3 +1,017 +6 +0.6 +Non-U.S. +2,106 +19 +0.9 +2,145 +18 +0.8 +2,048 +19 +0.9 +Long-term debt and other (b) +U.S. +54,631 +1,613 +3.0 +51,366 +1,281 +2.5 +46,521 +1,058 +2.3 +Non-U.S. +390 +10 +2.6 +725 +19 +2.6 +931 +24 +2.6 +Total interest-bearing liabilities +$ +124,193 +$ +2,943 +2.4 +% +$ +112,509 +$ +2,112 +1.9 +% +$ +104,188 +$ +1,705 +1.6 +% +U.S. +121,664 +2,909 +109,604 +2,071 +101,125 +1,657 +Non-U.S. +2,529 +34 +2,905 +41 +3,063 +48 +Non-interest-bearing liabilities +Travelers Cheques and other prepaid products +U.S. +2,240 +2,453 +2,733 +Non-U.S. +76 +76 +84 +Accounts payable +U.S. +7,120 +6,788 +7,005 +Non-U.S. +6,064 +5,254 +4,757 +Customer Deposits (c) +U.S. +377 +351 +372 +Non-U.S. +370 +331 +311 +Other liabilities +U.S. +16,379 +13,913 +13,445 +Non-U.S. +5,352 +4,878 +4,570 +Total non-interest-bearing liabilities +37,978 +34,044 +33,277 +U.S. +26,116 +23,505 +23,555 +Non-U.S. +11,862 +10,539 +9,722 +Total liabilities +162,171 +146,553 +137,465 +U.S. +147,780 +133,109 +124,680 +Non-U.S. +14,391 +13,444 +12,785 +Total shareholders' equity +20,650 +20,857 +20,850 +Total liabilities and shareholders' equity +$ +182,821 +$ +167,410 +$ +158,315 +Percentage of total average liabilities +attributable to non-U.S. activities +8.9 +% +9.2 +% +9.3 +% +Interest rate spread +7.2 +% +6.7 +% +6.4 +% +Net interest income and net average yield +on interest-earning assets (d) +$ +7,663 +6.9 +% +$ +6,451 +6.5 +% +$ +5,779 +6.2 +% +(a) Averages based on month-end balances. +(b) Interest expense primarily reflects interest on long-term financing and interest incurred on derivative instruments in qualifying hedging relationships on the hedged debt instruments. Additionally, we adopted new accounting guidance providing targeted improvements to the accounting for hedging activities effective January 1, 2018. In compliance with the standard, amounts previously recorded in Other expenses have been prospectively recorded in Total interest expense. Refer to Note 1 to the “Consolidated Financial Statements” for additional information. +(c) U.S. non-interest-bearing Customer deposits include average Card Member credit balances of $ 342 million, $314 million and $328 million for 2018, 2017 and 2016, respectively. Non-U.S. non-interest-bearing Customer deposits include average Card Member credit balances of $ 359 million, $318 million and $297 million for 2018, 2017 and 2016, respectively. +(d) Net average yield on interest-earning assets is defined as net interest income divided by average total interest-earning assets as adjusted for the items mentioned in footnote (e) from the previous table. +A-3 +Table of Contents +Changes in Net Interest Income − Volume and Rate Analysis (a) +The following table presents the amount of changes in interest income and interest expense due to changes in both average volume and average rate. Major categories of interest-earning assets and interest-bearing liabilities have been segregated between U.S. and non-U.S. offices. Average volume/rate changes have been allocated between the average volume and average rate variances on a consistent basis based upon the respective percentage changes in average balances and average rates. +2018 Versus 2017 +2017 Versus 2016 +Increase (Decrease) +Increase (Decrease) +due to change in: +due to change in: +Average +Average +Average +Average +Years Ended December 31, (Millions) +Volume +Rate +Net Change +Volume +Rate +Net Change +Interest-earning assets +Interest-bearing deposits in other banks +U.S. +$ +6 +$ +208 +$ +214 +$ +18 +$ +143 +$ +161 +Non-U.S. +1 +15 +16 +(1 +) +7 +6 +Federal funds sold and securities purchased +under agreements to resell +Non-U.S. +(2 +) +3 +1 +(1 +) +2 +1 +Short-term investment securities +U.S. +(1 +) +― +(1 +) +― +1 +1 +Non-U.S. +(6 +) +― +(6 +) +4 +(1 +) +3 +Card Member loans, including loans HFS +U.S. +910 +583 +1,493 +(5 +) +730 +725 +Non-U.S. +170 +(2 +) +168 +135 +(4 +) +131 +Other loans +U.S. +126 +(9 +) +117 +83 +2 +85 +Non-U.S. +(1 +) +10 +9 +― +(1 +) +(1 +) +Taxable investment securities +U.S. +36 +8 +44 +9 +3 +12 +Non-U.S. +1 +5 +6 +― +2 +2 +Non-taxable investment securities +U.S. +(17 +) +(6 +) +(23 +) +(37 +) +(19 +) +(56 +) +Other assets +Primarily U.S. +― +5 +5 +― +9 +9 +Change in interest income +1,223 +820 +2,043 +205 +874 +1,079 +Interest-bearing liabilities +Customer deposits +U.S. +Savings +94 +354 +448 +18 +119 +137 +Time +26 +30 +56 +24 +19 +43 +Demand +1 +2 +3 +― +2 +2 +Non-U.S. +Other time and savings +― +― +― +1 +(1 +) +― +Other demand +(1 +) +2 +1 +(3 +) +2 +(1 +) +Short-term borrowings +U.S. +(12 +) +11 +(1 +) +1 +8 +9 +Non-U.S. +― +1 +1 +1 +(2 +) +(1 +) +Long-term debt and other +U.S. +81 +251 +332 +110 +113 +223 +Non-U.S. +(9 +) +― +(9 +) +(5 +) +― +(5 +) +Change in interest expense +180 +651 +831 +147 +260 +407 +Change in net interest income +$ +1,043 +$ +169 +$ +1,212 +$ +58 +$ +614 +$ +672 +(a) +Refer to footnotes from “Distribution of Assets, Liabilities and Shareholders’ Equity” for additional information. +A-4 +Table of Contents +Loans and Card Member Receivables Portfolios +The following table presents gross loans and Card Member receivables by customer type, segregated between U.S. and non-U.S., based on the domicile of the borrowers. Refer to Notes 3 and 4 to the “Consolidated Financial Statements” for additional information. +December 31, (Millions) +2018 +2017 +2016 +2015 +2014 +Loans (a) (b) +U.S. loans +Card Member (c) +$ +72,007 +$ +64,542 +$ +58,242 +$ +51,446 +$ +62,592 +Other (d) +3,666 +2,554 +1,350 +1,073 +726 +Non-U.S. loans +Card Member (c) +9,847 +8,857 +7,023 +7,127 +7,793 +Other (d) +134 +133 +111 +201 +206 +Total loans +$ +85,654 +$ +76,086 +$ +66,726 +$ +59,847 +$ +71,317 +Card Member receivables (a) (b) +U.S. Card Member receivables +Consumer (e) +27,558 +26,754 +24,768 +23,255 +22,468 +Commercial (f) +11,478 +10,868 +9,685 +8,961 +9,082 +Non-U.S. Card Member receivables +Consumer (e) +10,625 +10,311 +7,772 +7,101 +7,800 +Commercial (f) +6,232 +6,114 +5,083 +4,816 +5,501 +Total Card Member receivables +$ +55,893 +$ +54,047 +$ +47,308 +$ +44,133 +$ +44,851 +(a) +As of December 31, 2018, we had approximately $302 billion of unused credit available to Card Members as part of established lending product agreements. Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no preset spending limit, the associated credit limit on charge products is not quantifiable, and therefore is not reflected in unused credit available to Card Members. +(b) +As of December 31, 2018, our exposure to any concentration of gross loans and Card Member receivables combined, which exceeds 10 percent of total loans and Card Member receivables is further split between $123 billion for individuals and $19 billion for commercial. Loans and Card Member receivables concentrations are defined as loans and Card Member receivables due from multiple borrowers engaged in similar activities that would cause these borrowers to be impacted similarly to certain economic or other related conditions. Refer to Note 24 to the “Consolidated Financial Statements” for additional information on concentrations. +(c) +Primarily represents loans to individuals and small businesses. +(d) +Other loans primarily represent consumer and commercial non-card financing products. +(e) +Represents receivables from individual and small business charge card customers. +(f) +Represents receivables from corporate charge card clients. +A-5 +Table of Contents +Maturities and Sensitivities to Changes in Interest Rates +The following table presents contractual maturities of loans and Card Member receivables by customer type, and segregated between U.S. and non-U.S. borrowers, and distribution between fixed and floating interest rates for loans due after one year based upon the stated terms of the loan agreements. +December 31, (Millions) +2018 +Within +1-5 +After +1 year (a) (b) +years (b) (c) +5 years (c) +Total +Loans +U.S. loans +Card Member +$ +71,800 +$ +207 +$ +― +$ +72,007 +Other +1,326 +2,147 +193 +3,666 +Non-U.S. loans +Card Member +9,846 +1 +― +9,847 +Other +73 +61 +― +134 +Total loans +$ +83,045 +$ +2,416 +$ +193 +$ +85,654 +Loans due after one year at fixed interest rates +$ +2,348 +$ +75 +$ +2,423 +Loans due after one year at variable interest rates +68 +118 +186 +Total loans +$ +2,416 +$ +193 +$ +2,609 +Card Member receivables +U.S. Card Member receivables +Consumer +$ +27,507 +$ +51 +$ +― +$ +27,558 +Commercial +11,478 +― +― +11,478 +Non-U.S. Card Member receivables +Consumer +10,625 +― +― +10,625 +Commercial +6,232 +― +― +6,232 +Total Card Member receivables +$ +55,842 +$ +51 +$ +― +$ +55,893 +(a) +Card Member loans have no stated maturity and are therefore included in the due within one year category. However, many of our Card Members will revolve their balances, which may extend their repayment period beyond one year for balances outstanding as of December 31, 2018. +(b) +Card Member receivables are immediately due upon receipt of Card Member statements, have no stated interest rate and are included within the due within one year category. Receivables due after one year represent modification programs classified as Troubled Debt Restructurings (TDRs), wherein the terms of a receivable have been modified for Card Members that are experiencing financial difficulties and a long-term concession (more than 12 months) has been granted to the borrower. +(c) +Card Member and other loans due after one year primarily represent installment loans and TDRs. +A-6 +Table of Contents +Risk Elements +The following table presents the amounts of non-performing loans and Card Member receivables that are either non-accrual, past due, or restructured, segregated between U.S. and non-U.S. borrowers. Past due loans are loans that are contractually past due 90 days or more as to principal or interest payments. Restructured loans and Card Member receivables are those that meet the definition of a TDR. +December 31, (Millions) +2018 +2017 +2016 +2015 +2014 +Loans +Non-accrual loans (a) +U.S. +$ +286 +$ +203 +$ +173 +$ +154 +$ +241 +Total non-accrual loans +286 +203 +173 +154 +241 +Loans contractually 90 days past-due and still accruing interest (b) +U.S. +321 +273 +208 +164 +162 +Non-U.S. +69 +56 +52 +52 +58 +Total loans contractually 90 days past-due and still accruing interest +390 +329 +260 +216 +220 +Restructured loans (c) +U.S. +532 +367 +346 +279 +286 +Total restructured loans +532 +367 +346 +279 +286 +Total non-performing loans +$ +1,208 +$ +899 +$ +779 +$ +649 +$ +747 +Card Member receivables +Restructured Card Member receivables (c) +U.S. +128 +80 +55 +33 +48 +Total restructured Card Member receivables +$ +128 +$ +80 +$ +55 +$ +33 +$ +48 +(a) Non-accrual loans not in modification programs primarily include certain Card Member loans placed with outside collection agencies for which we have ceased accruing interest. Amounts presented exclude Card Member loans classified as a TDR. +(b) +Our policy is generally to accrue interest through the date of write-off (typically 180 days past due). We establish reserves for interest that we believe will not be collected. Amounts presented exclude loans classified as a TDR. +(c) +In instances where the Card Member is experiencing financial difficulty, we may modify, through various programs, Card Member loans and receivables in order to minimize losses and improve collectability, while providing Card Members with temporary or permanent financial relief. We have classified Card Member loans and receivables in these modification programs as TDRs and continue to classify Card Member accounts that have exited a modification program as a TDR, with such accounts identified as “Out of Program TDRs.” Such modifications to the loans and receivables primarily include (i) temporary interest rate reductions (possibly as low as zero percent, in which case the loan is characterized as non-accrual in our TDR disclosures), (ii) placing the Card Member on a fixed payment plan not to exceed 60 months and (iii) suspending delinquency fees until the Card Member exits the modification program. Refer to Note 3 to the “Consolidated Financial Statements” for additional information. +A-7 +Table of Contents +Impact of Non-performing Loans on Interest Income +The following table presents the gross interest income for both non-accrual and restructured loans for 2018 that would have been recognized if such loans had been current in accordance with their original contractual terms and had been outstanding throughout the period or since origination if held for only part of 2018. The table also presents the interest income related to these loans that was actually recognized for the period. These amounts are segregated between U.S. and non-U.S. borrowers. +2018 +Year Ended December 31, (Millions) +U.S. +Non-U.S. +Total +Gross amount of interest income that would have been recorded +in accordance with the original contractual terms (a) +$ +96 +$ +― +$ +96 +Interest income actually recognized +24 +― +24 +Total interest revenue foregone +$ +72 +$ +― +$ +72 +(a) +We determine the original effective interest rate as the interest rate in effect prior to the imposition of any penalty interest rate. +Potential Problem Loans and Receivables +This disclosure presents outstanding amounts as well as specific reserves for certain loans and receivables where information about possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present repayment terms. At December 31, 2018 , we did not identify any potential problem loans or receivables within the Card Member loans and receivables portfolio that were not already included in the “Risk Elements” section. +A-8 +Table of Contents +Cross-border Outstandings +Cross-border disclosure is based upon the Federal Financial Institutions Examinations Council’s (FFIEC) guidelines governing the determination of cross-border risk. +The following table presents the aggregate amount of cross-border outstandings from borrowers or counterparties for each foreign country that exceeds 1 percent of consolidated total assets for any of the periods reported below. +The table separately presents the amounts of cross-border outstandings by type of borrower including Governments and official institutions, Banks and other financial institutions, Non-Bank Financial Institutions (NBFIs) and Other. +Banks and +Gross +Total +Governments +other +Total +foreign- +exposure +Years Ended December 31, +and official +financial +cross-border +office +(net of +Cross-border +(Millions) +institutions +institutions +NBFIs +Other +outstandings (a) +liabilities +liabilities) +commitments +Australia +2018 +$ +2 +$ +207 +$ +― +$ +3,633 +$ +3,842 +$ +366 +$ +3,476 +$ +6,948 +2017 +― +259 +― +3,594 +3,853 +504 +3,349 +6,635 +2016 +― +389 +― +2,986 +3,375 +453 +2,922 +5,567 +Canada +2018 +$ +346 +$ +676 +$ +41 +$ +2,706 +$ +3,769 +$ +465 +$ +3,304 +$ +9,970 +2017 +355 +992 +40 +2,730 +4,117 +1,032 +3,085 +12,174 +2016 +1,284 +1,028 +35 +2,408 +4,755 +977 +3,778 +11,590 +United Kingdom +2018 +$ +42 +$ +1,807 +$ +9 +$ +5,012 +$ +6,870 +$ +3,928 +$ +2,942 +$ +18,234 +2017 +68 +1,286 +86 +4,568 +6,008 +3,884 +2,124 +15,578 +2016 +77 +2,213 +63 +3,390 +5,743 +3,222 +2,521 +11,919 +Mexico +2018 +$ +85 +$ +237 +$ +40 +$ +2,512 +$ +2,874 +$ +665 +$ +2,209 +$ +1,254 +2017 +85 +97 +7 +2,229 +2,418 +556 +1,862 +1,125 +2016 +106 +167 +6 +1,820 +2,099 +531 +1,568 +961 +Japan +2018 +$ +2 +$ +298 +$ +226 +$ +3,729 +$ +4,255 +$ +3,890 +$ +365 +$ +2,924 +2017 +4 +74 +177 +3,082 +3,337 +3,106 +231 +2,290 +2016 +5 +55 +130 +2,504 +2,694 +2,526 +168 +87 +Other countries (b) +2018 +$ +209 +$ +200 +$ +10 +$ +2,980 +$ +3,399 +$ +300 +$ +3,099 +$ +720 +2017 +154 +140 +14 +3,077 +3,385 +504 +2,881 +682 +2016 +135 +134 +13 +2,161 +2,443 +415 +2,028 +562 +(a) +Total cross-border outstandings include loans, receivables, interest-bearing deposits with other banks, other interest-bearing investments, derivative contracts and other monetary assets. +(b) +Cross-border outstandings between 0.75 percent and 1.0 percent of consolidated total assets are included in Other Countries. For comparability, countries that meet the threshold for any year presented are included for all years. Countries included are France and Italy. +A-9 +Table of Contents +Summary of Loan Loss Experience – Analysis of the Allowance for Loan Losses +The following table summarizes the changes to our allowance for Card Member loan losses. The table segregates such changes between U.S. and non-U.S. borrowers. +Years Ended December 31, (Millions, except percentages) +2018 +2017 +2016 +2015 +2014 +Card Member loans +Allowance for loan losses at beginning of year +U.S. loans +$ +1,507 +$ +1,068 +$ +882 +$ +1,036 +$ +1,083 +Non-U.S. loans +199 +155 +146 +165 +178 +Total allowance for losses +1,706 +1,223 +1,028 +1,201 +1,261 +Card Member lending provisions (a) +U.S. loans +2,003 +1,655 +1,056 +1,032 +944 +Non-U.S. loans +263 +213 +179 +158 +194 +Total Card Member lending provisions +2,266 +1,868 +1,235 +1,190 +1,138 +Write-offs +U.S. loans +(2,002 +) +(1,572 +) +(1,262 +) +(1,321 +) +(1,346 +) +Non-U.S. loans +(285 +) +(245 +) +(222 +) +(226 +) +(269 +) +Total write-offs +(2,287 +) +(1,817 +) +(1,484 +) +(1,547 +) +(1,615 +) +Recoveries +U.S. loans +391 +356 +325 +359 +356 +Non-U.S. loans +53 +53 +54 +59 +72 +Total recoveries +444 +409 +379 +418 +428 +Net write-offs (b) +(1,843 +) +(1,408 +) +(1,105 +) +(1,129 +) +(1,187 +) +Transfer of reserves on HFS loans portfolios +U.S. loans +― +― +― +(224 +) +― +Other (c) +U.S. loans +― +― +67 +― +(1 +) +Non-U.S. loans +5 +23 +(2 +) +(10 +) +(10 +) +Total other +5 +23 +65 +(10 +) +(11 +) +Allowance for loan losses at end of year +U.S. loans +1,899 +1,507 +1,068 +882 +1,036 +Non-U.S. loans +235 +199 +155 +146 +165 +Total allowance for losses +$ +2,134 +$ +1,706 +$ +1,223 +$ +1,028 +$ +1,201 +Principal only net write-offs / average Card Member loans +outstanding (d) (e) +2.0 +% +1.8 +% +1.6 +% +1.4 +% +1.5 +% +Principal, interest and fees net write-offs / average Card Member +loans outstanding (d) (e) +2.4 +% +2.1 +% +1.8 +% +1.7 +% +1.8 +% +(a) +Refer to Note 4 to the “Consolidated Financial Statements” for a discussion of management’s process for evaluating the allowance for loan losses. +(b) +Net write-offs include principal, interest and fees balances. +(c) +Includes foreign currency translation adjustments and other items. The year ended December 31, 2016, included reserves of $67 million associated with $265 million of retained Card Member loans reclassified from HFS to held for investment as a result of retaining certain loans in connection with the respective sales of JetBlue and Costco cobrand card portfolios . The year ended December 31, 2014, included an adjustment related to reserves for card related fraud losses of $(6) million, which was reclassified to Other liabilities. +(d) +The net write-off rate presented is on a worldwide basis and is based on principal losses only (i.e., excluding interest and fees) to be consistent with industry convention. In addition, because we consider uncollectible interest and fees in estimating our reserves for credit losses, a net write-off rate including principal, interest and fees is also presented. The year ended December 31, 2015, reflected the impact of a change in the timing of charge-offs for Card Member loans in certain modification programs from 180 days past due to 120 days past due, which was fully recognized during the three months ended March 31, 2015. +(e) +Average Card Member loans outstanding are based on month-end balances. +A-10 +Table of Contents +The following table summarizes the changes to our allowance for other loan losses. The table segregates such changes between U.S. and non-U.S. borrowers. +Years Ended December 31, (Millions, except percentages) +2018 +2017 +2016 +2015 +2014 +Other loans +Allowance for loan losses at beginning of year +U.S. loans +$ +78 +$ +39 +$ +17 +$ +8 +$ +8 +Non-U.S. loans +2 +3 +3 +4 +5 +Total allowance for losses +80 +42 +20 +12 +13 +Provisions for other loan losses (a) +U.S. loans +121 +71 +56 +21 +5 +Non-U.S. loans +1 +1 +1 +1 +3 +Total provisions for other loan losses +122 +72 +57 +22 +8 +Write-offs +U.S. loans +(82 +) +(37 +) +(39 +) +(15 +) +(7 +) +Non-U.S. loans +(2 +) +(3 +) +(2 +) +(3 +) +(7 +) +Total write-offs +(84 +) +(40 +) +(41 +) +(18 +) +(14 +) +Recoveries +U.S. loans +5 +5 +5 +3 +2 +Non-U.S. loans +1 +1 +1 +1 +3 +Total recoveries +6 +6 +6 +4 +5 +Net write-offs +(78 +) +(34 +) +(35 +) +(14 +) +(9 +) +Allowance for loan losses at end of year +U.S. loans +122 +78 +39 +17 +8 +Non-U.S. loans +2 +2 +3 +3 +4 +Total allowance for losses +$ +124 +$ +80 +$ +42 +$ +20 +$ +12 +Net write-offs/average other loans outstanding (b) +2.4 +% +1.7 +% +2.9 +% +1.3 +% +1.2 +% +(a) +Provisions for other loan losses are determined based on a specific identification methodology and models that analyze specific portfolio statistics. +(b) +The net write-off rate presented is on a worldwide basis and is based on write-offs of principal, interest and fees. Average other loans outstanding are based on month-end balances. +A-11 +Table of Contents +The following table summarizes the changes to our allowance for Card Member receivables losses. The table segregates such changes between U.S. and non-U.S. borrowers. +Years Ended December 31, (Millions, except percentages) +2018 +2017 +2016 +2015 +2014 +Card Member receivables +Allowance for losses at beginning of year +U.S. receivables +Consumer +$ +277 +$ +266 +$ +268 +$ +276 +$ +216 +Commercial +73 +53 +51 +53 +35 +Total U.S. receivables +350 +319 +319 +329 +251 +Non-U.S. receivables +Consumer +119 +95 +93 +93 +98 +Commercial +52 +53 +50 +43 +37 +Total non-U.S. receivables +171 +148 +143 +136 +135 +Total allowance for losses +521 +467 +462 +465 +386 +Provisions for losses (a) +U.S. receivables +Consumer +471 +413 +366 +420 +451 +Commercial +92 +114 +69 +76 +98 +Total U.S. provisions +563 +527 +435 +496 +549 +Non-U.S. receivables +Consumer +245 +201 +176 +169 +172 +Commercial +129 +67 +85 +72 +71 +Total non-U.S. provisions +374 +268 +261 +241 +243 +Total provisions for losses +937 +795 +696 +737 +792 +Write-offs +U.S. receivables +Consumer +(659 +) +(633 +) +(637 +) +(698 +) +(618 +) +Commercial +(151 +) +(139 +) +(112 +) +(123 +) +(120 +) +Total U.S. write-offs +(810 +) +(772 +) +(749 +) +(821 +) +(738 +) +Non-U.S. receivables +Consumer +(278 +) +(233 +) +(218 +) +(204 +) +(211 +) +Commercial +(138 +) +(97 +) +(101 +) +(89 +) +(92 +) +Total non-U.S. write-offs +(416 +) +(330 +) +(319 +) +(293 +) +(303 +) +Total write-offs +$ +(1,226 +) +$ +(1,102 +) +$ +(1,068 +) +$ +(1,114 +) +$ +(1,041 +) +(a) +Refer to Note 4 to the “Consolidated Financial Statements” for a discussion of management’s process for evaluating the allowance for receivable losses. +A-12 +Table of Contents +Years Ended December 31, (Millions, except percentages) +2018 +2017 +2016 +2015 +2014 +Card Member receivables +Recoveries +U.S. receivables +Consumer +$ +210 +$ +233 +$ +269 +$ +271 +$ +230 +Commercial +56 +45 +43 +45 +41 +Total U.S. recoveries +266 +278 +312 +316 +271 +Non-U.S. receivables +Consumer +70 +63 +59 +57 +58 +Commercial +31 +25 +23 +28 +29 +Total non-U.S. recoveries +101 +88 +82 +85 +87 +Total recoveries +367 +366 +394 +401 +358 +Net write-offs (a) +(859 +) +(736 +) +(674 +) +(713 +) +(683 +) +Other (b) +U.S. receivables +Consumer +― +(2 +) +― +(1 +) +(3 +) +Commercial +― +― +2 +― +(1 +) +Total U.S. other +― +(2 +) +2 +(1 +) +(4 +) +Non-U.S. receivables +Consumer +(21 +) +(7 +) +(15 +) +(22 +) +(24 +) +Commercial +(5 +) +4 +(4 +) +(4 +) +(2 +) +Total non-U.S. other +(26 +) +(3 +) +(19 +) +(26 +) +(26 +) +Total other +(26 +) +(5 +) +(17 +) +(27 +) +(30 +) +Allowance for losses at end of year +U.S. receivables +Consumer +299 +277 +266 +268 +276 +Commercial +70 +73 +53 +51 +53 +Total U.S. receivables +369 +350 +319 +319 +329 +Non-U.S. receivables +Consumer +135 +119 +95 +93 +93 +Commercial +69 +52 +53 +50 +43 +Total non-U.S. receivables +204 +171 +148 +143 +136 +Total allowance for losses +$ +573 +$ +521 +$ +467 +$ +462 +$ +465 +Net write-offs / average Card Member receivables outstanding (c) (d) +1.6 +% +1.5 +% +1.5 +% +1.6 +% +1.5 +% +(a) +Net write-offs include principal and fees balances. +(b) +Includes foreign currency translation adjustments and other adjustments. Additionally, 2015 included the impact of transfer of the HFS receivables portfolio, which was not significant and 2014, included an adjustment related to reserves for card-related fraud losses of $(7) million, which was reclassified to Other liabilities. +(c) +The net write-off rate presented is on a worldwide basis and is based on write-offs of principal and fees. The year ended December 31, 2015, reflected the impact of a change in the timing of charge-offs for Card Member receivables in certain modification programs from 180 days past due to 120 days past due, which was fully recognized during the three months ended March 31, 2015. +(d) +Averages Card Member receivables outstanding are based on month-end balances. +A-13 +Table of Contents +Allocation of Allowance for Losses +The following table presents an allocation of the allowance for loans and Card Member receivables and the percentage of allowance for losses on loans and Card Member receivables in each category, to the total allowance, respectively, by customer type. The table segre gates allowance for losses on loans and Card Member receivables between U.S. and non-U.S. borrowers. +December 31, +(Millions, except percentages) +2018 +2017 +2016 +2015 +2014 +Allowance for losses +at end of year applicable to +Amount +Percentage (a) +Amount +Percentage (a) +Amount +Percentage (a) +Amount +Percentage (a) +Amount +Percentage (a) +Loans +U.S. loans +Card Member +$ +1,899 +84 +% +$ +1,507 +85 +% +$ +1,068 +85 +% +$ +882 +84 +% +$ +1,036 +85 +% +Other +122 +5 +78 +4 +39 +3 +17 +2 +8 +1 +Non-U.S. loans +Card Member +235 +11 +199 +11 +155 +12 +146 +14 +165 +14 +Other +2 +― +2 +― +3 +― +3 +― +4 +― +$ +2,258 +100 +% +$ +1,786 +100 +% +$ +1,265 +100 +% +$ +1,048 +100 +% +$ +1,213 +100 +% +Card Member receivables +U.S. Card Member receivables +Consumer +$ +299 +52 +% +$ +277 +53 +% +$ +266 +57 +% +$ +268 +58 +% +$ +276 +59 +% +Commercial +70 +12 +73 +14 +53 +11 +51 +11 +53 +12 +Non-U.S. Card Member receivables +Consumer +135 +24 +119 +23 +95 +21 +93 +20 +93 +20 +Commercial +69 +12 +52 +10 +53 +11 +50 +11 +43 +9 +$ +573 +100 +% +$ +521 +100 +% +$ +467 +100 +% +$ +462 +100 +% +$ +465 +100 +% +(a) +Percentage of allowance for losses on loans and Card Member receivables in each category to the total allowance. +Time Certificates of Deposit of $100,000 or More +The following table presents the amount of time certificates of deposit of $100,000 or more issued by us in our U.S. offices, further segregated by time remaining until maturity. +By remaining maturity as of December 31, 2018 +3 months +Over 3 months +Over 6 months +Over +(Millions) +or less +but within 6 months +but within 12 months +12 months +Total +U.S. time certificates of deposit ($100,000 or more) +$ +61 +$ +9 +$ +53 +$ +430 +$ +553 +As of December 31, 2018, time certificates of deposit and other time deposits in amounts of $100,000 or more issued by non-U.S. offices was $12 million. +A-14 +Table of Contents +EXHIBIT INDEX +The following exhibits are filed as part of this Annual Report. The exhibit numbers preceded by an asterisk (*) indicate exhibits electronically filed herewith. All other exhibit numbers indicate exhibits previously filed and are hereby incorporated herein by reference. Exhibits numbered 10.1 through 10.42 are management contracts or compensatory plans or arrangements. +3.1 +Company's Amended and Restated Certificate of Incorporation as amended through February 27, 2015 (incorporated by reference to Exhibit 3.1 the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2015). +3.2 +Company's By-Laws, as amended through September 26, 2016 (incorporated by reference to Exhibit 3.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated September 26, 2016). +4.1 +The instruments defining the rights of holders of long-term debt securities of the Company and its subsidiaries are omitted pursuant to Section (b)(4)(iii)(A) of Item 601 of Regulation S-K. The Company hereby agrees to furnish copies of these instruments to the SEC upon request. +10.1 +American Express Company Deferred Compensation Plan for Directors and Advisors, as amended and restated effective April 1, 2018 (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2018). +10.2 +American Express Company 2007 Pay-for-Performance Deferral Program Document (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 20, 2006 (filed November 22, 2006)). +10.3 +Description of amendments to 1994–2006 Pay-for-Performance Deferral Programs (incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2006). +10.4 +American Express Company 2006 Pay-for-Performance Deferral Program Guide (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 21, 2005 (filed November 23, 2005)). +10.5 +American Express Company 2005 Pay-for-Performance Deferral Program Guide (incorporated by reference to Exhibit 10.10 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2004). +10.6 +Description of American Express Company Pay-for-Performance Deferral Program (incorporated by reference to Exhibit 10.2 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 22, 2004 (filed January 28, 2005)). +10.7 +Amendment to the Pre-2008 Nonqualified Deferred Compensation Plans of American Express Company (incorporated by reference to Exhibit 10.19 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2008). +10.8 +American Express Company Retirement Plan for Non-Employee Directors, as amended (incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1988). +10.9 +Certificate of Amendment of the American Express Company Retirement Plan for Non-Employee Directors dated March 21, 1996 (incorporated by reference to Exhibit 10.11 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1995). +10.10 +American Express Key Executive Life Insurance Plan, as amended (incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the fiscal year ended December 31, 1991). +10.11 +Amendment to American Express Company Key Executive Life Insurance Plan (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1994). +10.12 +Amendment to American Express Company Key Executive Life Insurance Plan, effective as of January 22, 2007 (incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2006). +E-1 +Table of Contents +10.13 +Amendment to American Express Company Key Executive Life Insurance Plan, effective as of January 1, 2011 (incorporated by reference to Exhibit 10.24 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2010). +10.14 +American Express Key Employee Charitable Award Program for Education (incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1990). +10.15 +American Express Directors' Charitable Award Program (incorporated by reference to Exhibit 10.14 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1990). +10.16 +American Express Company Salary/Bonus Deferral Plan (incorporated by reference to Exhibit 10.20 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1988). +10.17 +Amendment to American Express Company Salary/Bonus Deferral Plan (incorporated by reference to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1994). +10.18 +American Express Senior Executive Severance Plan, as amended and restated effective May 1, 2018 (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended June 30, 2018). +10.19 +Amendments of (i) the American Express Salary/Bonus Deferral Plan and (ii) the American Express Key Executive Life Insurance Plan (incorporated by reference to Exhibit 10.37 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1997). +10.20 +Second Amendment and Restatement of the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (as amended and restated effective as of January 1, 2012) (incorporated by reference to Exhibit 10.28 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2011). +10.21 +Third Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated March 29, 2012) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2012). +10.22 +Fourth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated October 24, 2012) (incorporated by reference to Exhibit 10.31 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2012). +10.23 +Fifth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated May 1, 2013) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2013). +10.24 +Sixth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated August 16, 2013) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2013). +10.25 +Seventh Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated September 26, 2013) (incorporated by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2013). +10.26 +Eighth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 1, 2013) (incorporated by reference to Exhibit 10.36 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2013). +10.27 +Ninth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 14, 2016) (incorporated by reference to Exhibit 10.30 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016) . +*10.28 +Tenth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 17, 2018) . +10.29 +American Express Company 2003 Share Equivalent Unit Plan for Directors, as amended and restated, effective January 1, 2015 (incorporated by reference to Exhibit 10.38 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +E-2 +Table of Contents +10.30 +Description of Compensation Payable to Non-Management Directors effective January 1, 2015 (incorporated by reference to Exhibit 10.39 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2014). +10.31 +American Express Company 2007 Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated April 23, 2007 (filed April 27, 2007)). +10.32 +American Express Company 2007 Incentive Compensation Plan Master Agreement (as amended and restated effective January 1, 2011) (incorporated by reference to Exhibit 10.8 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2010). +10.33 +American Express Company 2007 Incentive Compensation Plan Master Agreement (as amended and restated effective January 23, 2012) (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated January 23, 2012 (filed January 27, 2012)). +10.34 +Form of nonqualified stock option award agreement for executive officers under the American Express Company 2007 Incentive Compensation Plan (for awards made after January 26, 2016) (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +10.35 +Form of restricted stock unit award agreement for executive officers under the American Express Company 2007 Incentive Compensation Plan (for awards made after January 26, 2016) (incorporated by reference to Exhibit 10.44 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +10.36 +Form of award agreement for executive officers in connection with Portfolio Grant awards under the American Express Company 2007 Incentive Compensation Plan (for awards made after January 29, 2013) (incorporated by reference to Exhibit 10.39 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2012). +10.37 +American Express Company 2016 Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated May 2, 2016). +10.38 +Form of nonqualified stock option award agreement for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.41 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.39 +Form of restricted stock unit award agreement for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.42 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016) . +10.40 +Form of award agreement for executive officers in connection with Performance Grant awards (a/k/a Executive Annual Incentive Awards) under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016) . +10.41 +Form of award agreement for executive officers in connection with Portfolio Grant awards under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.44 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.42 +Post-employment Arrangements with Kenneth I. Chenault (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2017). +10.43 +Agreement dated February 27, 1995 between the Company and Berkshire Hathaway Inc., on behalf of itself and its subsidiaries (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1994). +10.44 +Agreement dated July 20, 1995 between the Company and Berkshire Hathaway Inc. and its subsidiaries (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1995). +E-3 +Table of Contents +10.45 +Amendment dated September 8, 2000 to the agreement dated February 27, 1995 between the Company and Berkshire Hathaway Inc., on behalf of itself and its subsidiaries (incorporated by reference to Exhibit 99.3 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated January 22, 2001 (filed January 22, 2001)). +10.46 +Amendment dated January 29, 2018 to the agreement dated February 27, 1995 between the Company and Berkshire Hathaway Inc., on behalf of itself and its subsidiaries (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated January 29, 2018 (filed January 30, 2018)). +10.47 +Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.48 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2017). +*21 +Subsidiaries of the Company. +*23 +Consent of PricewaterhouseCoopers LLP. +*31.1 +Certification of Stephen J. Squeri, Chief Executive Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended. +*31.2 +Certification of Jeffrey C. Campbell, Chief Financial Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended. +*32.1 +Certification of Stephen J. Squeri, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +*32.2 +Certification of Jeffrey C. Campbell, Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +*101.INS +XBRL Instance Document +*101.SCH +XBRL Taxonomy Extension Schema Document +*101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +*101.LAB +XBRL Taxonomy Extension Label Linkbase Document +*101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +*101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +E-4 \ No newline at end of file diff --git a/raw/filings/0000004962/2018/0000004962-19-000018/filing_metadata.csv b/raw/filings/0000004962/2018/0000004962-19-000018/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..9fbdb6149a477591ec9d48437872458903f7e344 --- /dev/null +++ b/raw/filings/0000004962/2018/0000004962-19-000018/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004962,AXP,AMERICAN EXPRESS CO,2018,10-K,2019-02-13,2018-12-31,2019-02-13T22:21:47.000Z,0000004962-19-000018,axp201810k.htm,FORM 10-K OF AMERICAN EXPRESS COMPANY,26909330,1,0,https://www.sec.gov/Archives/edgar/data/4962/000000496219000018/axp201810k.htm,https://www.sec.gov/Archives/edgar/data/4962/000000496219000018/ diff --git a/raw/filings/0000004962/2018/0000004962-19-000018/item1.txt b/raw/filings/0000004962/2018/0000004962-19-000018/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..a8bf4c967def99f8b38a04481c957eeef1dfc928 --- /dev/null +++ b/raw/filings/0000004962/2018/0000004962-19-000018/item1.txt @@ -0,0 +1,254 @@ +ITEM 1. +BUSINESS +INTRODUCTION +Overview +American Express is a globally integrated payments company that provides customers with access to products, insights and experiences that enrich lives and build business success. Our principal products and services are charge and credit card products and travel-related services offered to consumers and businesses around the world. +We were founded in 1850 as a joint stock association and were incorporated in 1965 as a New York corporation. American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. (TRS), are bank holding companies under the Bank Holding Company Act of 1956, as amended (the BHC Act), subject to supervision and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). +Our headquarters are located in lower Manhattan, New York, New York. We also have offices in other locations throughout the world. +We principally engage in businesses comprising three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant & Network Services (GMNS). Corporate functions and certain other businesses are included in Corporate & Other. +Products and Services +Our range of products and services includes: + +Charge card, credit card and other payment and financing products + +Merchant acquisition and processing, servicing and settlement, and point-of-sale marketing and information products and services for merchants + +Network services + +Other fee services, including fraud prevention services and the design and operation of customer loyalty programs + +Expense management products and services + +Travel-related services +Our various products and services are sold globally to diverse customer groups through various channels, including mobile and online applications, third-party vendors and business partners, direct mail, telephone, in-house sales teams and direct response advertising. * Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +Our general-purpose card network, card-issuing and merchant-acquiring and processing businesses are global in scope. We are a world leader in providing charge and credit cards to consumers, small businesses, mid-sized companies and large corporations. These cards include cards issued by American Express as well as cards issued by third-party banks and other institutions that are accepted by merchants on the American Express network. American Express ® cards permit Card Members to charge purchases of goods and services at the millions of merchants around the world that accept cards bearing our logo. +Our business as a whole has not experienced significant seasonal fluctuations, although card billed business tends to be moderately higher in the fourth quarter than in other quarters. As a result, the amount of Card Member loans and receivables outstanding tend to be moderately higher during that quarter. The average discount rate also tends to be slightly lower during the fourth quarter due to a higher level of retail-related billed business volumes. +* The use of the term “partner” or “partnering” does not mean or imply a formal legal partnership, and is not meant in any way to alter the terms of American Express’ relationship with any third parties. +1 +Table of Contents +The American Express Brand +Our brand and its attributes—trust, security and service—are key assets. We invest heavily in managing, marketing, promoting and protecting our brand, including through the delivery of our products and services in a manner consistent with our brand promise. Our brand has consistently been rated one of the most valuable brands in the world. In 2018, we launched a new worldwide brand platform with one common message across consumer and business segments. Additionally, we place significant importance on trademarks, service marks and patents, and seek to secure our intellectual property rights around the world. +Our Integrated Network and Spend-Centric Model +Wherever we manage both the card-issuing activities of the business and the acquiring relationship with merchants, there is a “closed loop” in that we have direct access to information at both ends of the card transaction, which distinguishes our integrated network from the bankcard networks. We maintain direct relationships with both our Card Members (as a card issuer) and merchants (as an acquirer), and we handle all key aspects of those relationships. Through contractual relationships, we also obtain data from third-party card issuers, merchant acquirers and processors with whom we do business. Our integrated network allows us to analyze information on Card Member spending and build algorithms and other analytical tools that we use to underwrite risk, reduce fraud and provide targeted marketing and other information services for merchants and special offers and services to Card Members, all while respecting Card Member preferences and protecting Card Member and merchant data in compliance with applicable policies and legal requirements. +Our “spend-centric” business model focuses on generating revenues primarily by driving spending on our cards and secondarily by finance charges and fees. Spending on our cards, which is higher on average on a per-card basis versus our competitors, offers superior value to merchants in the form of loyal customers and larger transactions. Because of the revenues generated from having high-spending Card Members, we are able to invest in attractive rewards and other benefits for Card Members, as well as targeted marketing and other programs and investments for merchants. This creates incentives for Card Members to spend more on their cards and positively differentiates American Express cards. +We believe our integrated network and spend-centric model give us the ability to provide differentiated value to Card Members, merchants and business partners. +BUSINESS OPERATIONS +Global Consumer Services Group +We offer a wide range of charge cards and revolving credit cards to consumers around the world. GCSG also offers services that complement our core business, including Card Member features and benefits, deposit products, travel services and non-card financing products such as installment lending. +Our global proprietary card business offers a broad set of card products, rewards and services to acquire and retain high-spending, engaged and creditworthy Card Members. Core elements of our strategy are: + +Designing innovative products and features that appeal to our target customer base and meet their spending and borrowing needs + +Using incentives to drive spending on our various card products and engender loyal Card Members, including our Membership Rewards ® program, cash-back reward features and participation in loyalty programs sponsored by our cobrand and other partners + +Providing exceptional customer care, digital and mobile services and an array of benefits and experiences across card products to address travel and other needs and increase Card Member engagement + +Developing a wide range of partner relationships, including with other corporations and institutions that sponsor certain of our cards under cobrand arrangements and provide benefits and services to our Card Members +Our charge cards are designed primarily as a method of payment with Card Members generally paying the full amount billed each month. Charges are approved based on a variety of factors, including a Card Member’s current spending patterns, payment history, credit record and financial resources. Some charge card accounts have features that allow Card Members to revolve certain charges. Revolving credit card products provide Card Members with the flexibility to pay their bill in full each month or carry a monthly balance on their cards to finance the purchase of goods or services. Some revolving credit cards also allow eligible Card Members to set up monthly payments for certain purchases or purchase amounts over a fixed period of time. Certain of our cards are issued under cobrand arrangements with business partners, such as Delta Air Lines, our largest cobrand partner, as well as many others globally. We also partner with Delta to offer benefits to Card Member participants in our Membership Rewards program and provide travel-related benefits and services, including airport lounge access for certain American Express Card Members. +2 +Table of Contents +Global Commercial Services +We offer a wide range of card and payment programs, expense management tools, consulting services, business financing and cross-border payments solutions to small businesses, mid-size companies and large corporations around the world. We have a suite of business-to-business payment solutions to help companies manage their spending and realize other potential benefits, including cost savings, process control and efficiency, and improved cash flow management. We offer local currency corporate cards and other expense management products in approximately 95 countries and territories, and have global U.S. dollar and euro corporate cards available in approximately 110 countries and territories. We also provide products and services, including charge cards, revolving credit cards and non-card payment and financing solutions, to small and mid-sized businesses in the United States and internationally. +Core elements of our strategy to become the leading payments and working capital provider to small and mid-sized business customers and a leader in business-to-business payments for large and global enterprises include: + +Expanding our leadership in our core card business by evolving our card value propositions, launching cobrand products and further differentiating our corporate card and accounts payable expense management solutions + +Designing innovative products and features, including financing and supplier payment solutions for our business customers +Global Merchant & Network Services +We operate a global payments network that processes and settles card transactions, acquires merchants and provides fraud-prevention tools, marketing solutions, data analytics and other programs and services to merchants that leverage the capabilities of our integrated network. GMNS builds and manages relationships with millions of merchants around the world that choose to accept American Express cards and signs new merchants to accept our cards, agreeing on the discount rate (a fee charged to the merchant for accepting our cards) and handling servicing for these merchants. We also build and maintain relationships with merchant acquirers, aggregators and processors to manage aspects of our merchant services business. For example, through our OptBlue ® merchant-acquiring program, third-party processors contract directly with small merchants for card acceptance and determine merchant pricing. +We continue to grow merchant acceptance of American Express cards around the world. We made progress towards our goal of having American Express cards accepted at virtually all merchant locations that accept both Visa and Mastercard in the United States, adding more than a million new merchant locations in the United States in 2018. We are also focused on increasing merchant coverage strategically in countries outside the United States, with double-digit growth in merchant locations internationally in 2018. We estimate that our international merchant network as a whole could accommodate more than 80 percent of general-purpose card spending, based on comparing spending on all networks' general-purpose credit and charge cards at merchants outside the United States that accept American Express cards with total general-purpose credit and charge card spending at all merchants outside the United States. +GMNS also establishes and maintains relationships with third-party banks and other institutions in approximately 130 countries and territories, licensing the American Express brand and extending the reach of our global network. Under independent operator arrangements, partners are licensed to issue local currency cards in their countries and serve as the merchant acquirer and processor for local merchants. Under network card license arrangements, partners are licensed to issue American Express-branded cards primarily in countries where we have a proprietary card-issuing and/or merchant-acquiring business. +GMNS also manages loyalty coalition programs, such as the Payback ® program in Germany, India, Mexico, Italy, Poland and Austria. Our loyalty coalition programs enable consumers to earn rewards points and use them to save on purchases from a variety of participating merchants through multi-category rewards platforms. Merchants in these programs generally fund the consumer offers and are responsible to us for the cost of rewards points; we earn revenue from operating the loyalty platform and by providing marketing support. +3 +Table of Contents +COMPETITION +We compete in the global payments industry with charge, credit and debit card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and Automated Clearing House, or ACH), as well as evolving and growing alternative payment and financing providers. As the payments industry continues to evolve, we face increasing competition from non-traditional players that leverage new technologies, business models and customer relationships to create payment or financing solutions. +As a card issuer, we compete with financial institutions that issue general-purpose charge and revolving credit cards and debit cards. We also encounter competition from businesses that issue their own private label cards, operate their own mobile wallets or extend credit to their customers. We face intense competition for cobrand relationships, as both card issuer and network competitors have targeted key business partners with attractive value propositions. +Our global card network competes in the global payments industry with other card networks, including, among others, China UnionPay, Visa, Mastercard, JCB, Discover and Diners Club International (which is owned by Discover). We are the fourth largest general-purpose card network globally based on purchase volume, behind China UnionPay, Visa and Mastercard. In addition to such networks, a range of companies globally, including merchant acquirers, processors and web- and mobile-based payment platforms (e.g., Alipay, PayPal and Venmo), as well as regional payment networks (such as the National Payments Corporation of India), carry out some activities similar to those performed by our GMNS business. +The principal competitive factors that affect the card-issuing, merchant and network businesses include: + +The features, value and quality of the products and services, including customer care, rewards programs, partnerships, benefits and digital and mobile services, and the costs associated with providing such features and services + +Reputation and brand recognition + +The number, spending characteristics and credit performance of customers + +The quantity, diversity and quality of the establishments where the cards can be used + +The attractiveness of the value proposition to card issuers, merchant acquirers, cardholders, corporate clients and merchants (including the relative cost of using or accepting the products and services, and capabilities such as fraud prevention and data analytics) + +The number and quality of other payment cards and other forms of payment available to customers + +The success of marketing and promotional campaigns + +The speed of innovation and investment in systems, technologies, and product and service offerings + +The nature and quality of expense management tools, electronic payment methods and data capture and reporting capabilities, particularly for business customers + +The security of cardholder and merchant information +Another aspect of competition is the dynamic and rapid growth of alternative payment mechanisms, systems and products, which include aggregators (e.g., PayPal, Square and Amazon), marketplace lenders, wireless payment technologies (including using mobile telephone networks to carry out transactions), financial technology companies, electronic wallet and push payment providers (including handset manufacturers, telecommunication providers, retailers, banks and technology companies), prepaid systems, digital currencies, gift cards, blockchain and similar distributed ledger technologies, and systems linked to payment cards or that provide payment solutions. Partnerships have been formed by various competitors to integrate more financial services into their product offerings and competitors are attempting to replicate our closed-loop functionality, such as the merchant-processing platform ChaseNet. New payments competitors continue to emerge in response to evolving technologies, consumer habits and merchant needs. +In addition to the discussion in this section, see “ Our operating results may suffer because of substantial and increasingly intense competition worldwide in the payments industry ” in “Risk Factors” for further discussion of the potential impact of competition on our business, and “ Our business is subject to comprehensive government regulation and supervision, which could adversely affect our results of operations and financial condition” and “ Ongoing legal proceedings regarding provisions in our merchant contracts could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand ” in “Risk Factors” for a discussion of the potential impact on our ability to compete effectively due to government regulations or if ongoing legal proceedings limit our ability to prevent merchants from engaging in various actions to discriminate against our card products. +4 +Table of Contents +SUPERVISION AND REGULATION +Overview +We are subject to extensive government regulation and supervision in jurisdictions around the world, and the costs of compliance are substantial. In recent years, the financial services industry has been subject to rigorous scrutiny, high regulatory expectations, and a stringent and unpredictable enforcement environment. Governmental authorities have focused, and we believe will continue to focus, considerable attention on reviewing compliance by financial services firms with laws and regulations. Reviews to assess compliance with laws and regulations by governmental authorities, as well as our own internal reviews, have resulted in, and are likely to continue to result in, changes to our practices, products and procedures, restitution to our customers and increased costs related to regulatory oversight, supervision and examination. We have also been subject to regulatory actions and may continue to be the subject of such actions, including governmental inquiries, investigations, enforcement proceedings and the imposition of fines or civil money penalties, in the event of noncompliance or alleged noncompliance with laws or regulations. In addition, legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +See “Risk Factors—Legal, Regulatory and Compliance Risks” for a discussion of the potential impact legislative and regulatory changes may have on our results of operations and financial condition. +Banking Regulation +Federal and state banking laws, regulations and policies extensively regulate the Company (which, for purposes of this section, refers to American Express Company as a bank holding company), TRS and our U.S. bank subsidiary, American Express National Bank (AENB). Both the Company and TRS are subject to comprehensive consolidated supervision, regulation and examination by the Federal Reserve and AENB is likewise supervised, regulated and examined by the Office of the Comptroller of the Currency (OCC). The Company and its subsidiaries are also subject to the rulemaking, enforcement and examination authority of the Consumer Financial Protection Bureau (CFPB). Banking regulators have broad examination and enforcement power, including the power to impose substantial fines, limit dividends and other capital distributions, restrict operations and acquisitions and require divestitures. Many aspects of our business also are subject to rigorous regulation by other U.S. federal and state regulatory agencies and by non-U.S. government agencies and regulatory bodies. +In November 2018, the Federal Reserve adopted a new rating system for large financial institutions, such as the Company, which is intended to align with the Federal Reserve’s existing supervisory program for large financial institutions and which includes component ratings for capital planning, liquidity risk management, and governance and controls. In August 2017 and January 2018, the Federal Reserve proposed related guidance for the governance and controls component. +Activities +The BHC Act generally limits bank holding companies to activities that are considered to be banking activities and certain closely related activities. As noted above, each of the Company and TRS is a bank holding company and each has elected to become a financial holding company, which is authorized to engage in a broader range of financial and related activities. In order to remain eligible for financial holding company status, we must meet certain eligibility requirements. Those requirements include that each of the Company and AENB must be “well capitalized” and “well managed,” and AENB must have received at least a “satisfactory” rating on its most recent assessment under the Community Reinvestment Act of 1977 (the CRA). The Company and TRS engage in various activities permissible only for financial holding companies, including, in particular, providing travel agency services, acting as a finder and engaging in certain insurance underwriting and agency services. If the Company fails to meet eligibility requirements for financial holding company status, it is likely to be barred from engaging in new types of financial activities or making certain types of acquisitions or investments in reliance on its status as a financial holding company, and ultimately could be required to either discontinue the broader range of activities permitted to financial holding companies or divest AENB. In addition, the Company and its subsidiaries are prohibited by law from engaging in practices that the relevant regulatory authority deems unsafe or unsound (which such authorities generally interpret broadly). +Acquisitions and Investments +Applicable federal and state laws place limitations on the ability of persons to invest in or acquire control of us without providing notice to or obtaining the approval of one or more of our regulators. In addition, we are subject to banking laws and regulations that limit our investments and acquisitions and, in some cases, subject them to the prior review and approval of our regulators, including the Federal Reserve and the OCC. Federal banking regulators have broad discretion in evaluating proposed acquisitions and investments that are subject to their prior review or approval. +5 +Table of Contents +Financial Regulatory Reform +The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the Federal Reserve’s implementing regulations impose heightened prudential requirements on bank holding companies with at least $50 billion in total consolidated assets, such as the Company, that are more stringent than those applicable to smaller bank holding companies. The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), enacted in May 2018, preserves the fundamental elements of the post-Dodd-Frank regulatory framework, but, among other things, revises certain aspects of the U.S. financial regulatory regime for bank holding companies with less than $250 billion in total consolidated assets, such as the Company. +Under Dodd-Frank, federal banking regulators were required to apply enhanced prudential standards to bank holding companies, such as the Company, with total consolidated assets of $50 billion or more. Following the enactment of EGRRCPA, effective November 2019, federal banking regulators will no longer be required to apply most Dodd-Frank enhanced prudential standards to bank holding companies, such as the Company, with total consolidated assets of $100 billion but less than $250 billion. For example, holding company resolution planning and company-run stress testing would no longer be mandatory and supervisory stress testing (which is currently conducted annually) would be conducted on a “periodic” basis. Depository institutions, such as AENB, with total consolidated assets between $100 billion and $250 billion will also not be required to conduct annual company-run stress tests effective November 2019. Much of the Dodd-Frank enhanced prudential standards were implemented by the federal banking regulators through regulations. EGRRCPA, however, does not itself amend those regulations, which will require action by the federal banking regulators. Additionally, EGRRCPA permits the Federal Reserve, by order or rule, to apply enhanced prudential standards to bank holding companies, such as the Company, with total consolidated assets of $100 billion or more. Lastly, there are several regulations not directly affected by EGRRCPA but that federal banking regulators may modify to conform to the new higher asset thresholds, such as the Comprehensive Capital Analysis and Review (CCAR) process. +In October 2018, the Federal Reserve released two proposals, one jointly with the OCC and the Federal Deposit Insurance Corporation (FDIC) and one on its own, that would tailor the applicable capital and liquidity requirements and prudential standards for large U.S. banking organizations, such as the Company, based on their size and other risk-based indicators, consistent with EGRRCPA (the Tailoring Proposals). The Tailoring Proposals are not yet final and may be modified prior to their final adoption by the Federal Reserve, the OCC and the FDIC. +The Tailoring Proposals would assign each U.S. bank holding company with $100 billion or more in total consolidated assets, as well as its bank subsidiaries, to one of four categories based on its size and five risk-based indicators: (i) cross-jurisdictional activity, (ii) weighted short-term wholesale funding, (iii) non-bank assets, (iv) off-balance sheet exposure, and (v) status as a U.S. global systemically important banking organization. The Federal Reserve indicated which firms would fall into each of the four categories based on data for the second quarter of 2018, with the Company in “Category IV.” Firms subject to Category IV standards would generally be subject to the same capital and liquidity requirements as firms with under $100 billion in total consolidated assets, but would also be required to monitor and report certain risk-based indicators. As a result, under the Tailoring Proposals, Category IV firms such as the Company would (i) no longer be subject to the advanced approaches capital requirements, (ii) no longer be subject to the supplementary leverage ratio, (iii) no longer be subject to the countercyclical capital buffer, (iv) no longer be subject to company-run stress testing requirements, (v) become subject to supervisory stress testing on an every-other-year basis rather than an annual basis; and (vi) no longer be subject to the liquidity coverage ratio or the proposed net stable funding ratio minimum requirements. +The ultimate impact from EGRRCPA and the related regulatory changes is subject to the final implementing regulations adopted by federal banking regulators, which may differ from the proposals described herein. +Stress Testing and Capital Planning +Under the Federal Reserve’s regulations, the Company is currently subject to annual supervisory and semiannual company-run stress testing requirements that are designed to evaluate whether a bank holding company has sufficient capital on a total consolidated basis to absorb losses and support operations under adverse economic conditions. Under the Tailoring Proposals, Category IV firms, such as the Company, would no longer be subject to company-run stress testing requirements, but would remain subject to the quantitative review of their capital plans under CCAR, which the Federal Reserve has indicated it plans to conduct on an every-other-year, instead of annual, basis for Category IV firms. In connection with the release of the Tailoring Proposals, the Federal Reserve also indicated that it expects to revise its guidance on capital planning to align with the proposed categories of standards set forth in the Tailoring Proposals. We continue to evaluate the impact of the Tailoring Proposals and forthcoming related proposals on the Company and its capital planning process. +The results of the Company’s stress testing are incorporated into our annual capital plan, which must cover a “planning horizon” of at least nine quarters and which we are required to submit to the Federal Reserve for review under its CCAR process. As part of CCAR, the Federal Reserve evaluates whether the Company has sufficient capital to continue operations under various scenarios of economic and financial market stress (developed by both the Company and the Federal Reserve), including after taking into account planned capital distributions, such as dividend payments and common stock repurchases. Sufficient capital for these purposes is likely to require us to maintain capital ratios appreciably above applicable minimum requirements and buffers. The scenarios are designed to stress our risks and vulnerabilities and assess our pro-forma capital position and ratios under hypothetical stress environments. +We are required to submit our capital plans and stress testing results to the Federal Reserve on or before April 5 of each year in which they are required. The Federal Reserve is expected to publish the decisions for all the bank holding companies participating in CCAR, including the reasons for any objection to capital plans, by June 30th of each year. In addition, the Federal Reserve will publish separately the results of its supervisory stress test under the supervisory severely adverse scenarios. The information to be released will include, among other things, the Federal Reserve’s projection of company-specific information, including post-stress capital ratio information over the planning horizon. +We may be required to revise and resubmit our capital plan as required by the Federal Reserve following certain events, such as a significant acquisition. In addition to other limitations, our ability to make any capital distributions (including dividends and share repurchases) is contingent on the Federal Reserve’s non-objection to our capital plan. +On February 5, 2019, the Federal Reserve announced that certain firms with total consolidated assets between $100 billion and $250 billion, such as the Company, would not be subject to supervisory stress testing, company-run stress testing or CCAR for the 2019 cycle. The Federal Reserve stated that permitted capital distributions for the 2019 cycle for such firms would be largely based on the results of the 2018 supervisory stress tests. We remain subject to the requirement to develop and maintain an annual capital plan. +6 +Table of Contents +Dividends and Other Capital Distributions +The Company and TRS, as well as AENB and the Company’s insurance and other regulated subsidiaries, are limited in their ability to pay dividends by statutes, regulations and supervisory policy. +Dividend payments by the Company to shareholders are subject to the oversight of the Federal Reserve. See “Stress Testing and Capital Planning.” Even if the Federal Reserve has not objected to a distribution, the Company may still not make a distribution without Federal Reserve approval if, among other things, the Company would not meet a minimum regulatory capital ratio after giving effect to the capital distribution, changes in facts would require resubmission of our capital plan or the Company’s earnings are materially underperforming its projections in the capital plan. +In general, federal laws and regulations prohibit, without first obtaining the OCC’s approval, AENB from making dividend distributions to TRS, if such distributions are not paid out of available recent earnings or would cause AENB to fail to meet capital adequacy standards. In addition to specific limitations on the dividends AENB can pay to TRS, federal banking regulators have authority to prohibit or limit the payment of a dividend if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the institution. +Capital, Leverage and Liquidity Regulation +Capital Rules +The Company and AENB are required to comply with the applicable capital adequacy rules established by federal banking regulators. These rules are intended to ensure that bank holding companies and depository institutions (collectively, banking organizations) have adequate capital given their level of assets and off-balance sheet obligations. The federal banking regulators’ current capital rules, which, subject to phase-in provisions, generally became applicable to the Company and AENB’s predecessor institutions in 2014 (the Capital Rules), largely implement the Basel Committee on Banking Supervision’s (the Basel Committee) framework for strengthening international capital regulation, known as Basel III. The minimum capital and buffer requirements under the Capital Rules have been fully phased in as of January 1, 2019. For additional information regarding our capital ratios, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Under the Capital Rules, banking organizations are required to maintain minimum ratios for Common Equity Tier 1 (CET1), Tier 1 capital (that is, CET1 plus additional Tier 1 capital) and Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. Since 2014, we have reported our capital adequacy ratios on a parallel basis to federal banking regulators using both risk-weighted assets calculated under the Basel III standardized approach, as adjusted for certain items, and the requirements for an advanced approaches institution. During this parallel period, federal banking regulators assess our compliance with the advanced approaches requirements. The parallel period will continue until we receive regulatory notification to exit parallel reporting, at which point we will begin publicly reporting regulatory risk-based capital ratios calculated under both the advanced approaches and the standardized approach under the Capital Rules, and will be required to use the lower of these ratios in order to determine whether we are in compliance with minimum capital and buffer requirements for the Company and AENB. Depending on how the advanced approaches are ultimately implemented for our asset types, our capital ratios calculated under the advanced approaches may be lower than under the standardized approach. The standardized approach is currently the applicable measurement used in CCAR. +In December 2017, the Basel Committee published standards that, among other things, revise the standardized approach for credit risk (including by recalibrating risk weights and introducing additional capital requirements for certain “unconditionally cancellable commitments” such as unused credit card lines of credit) and provide a new standardized calculation for operational risk capital requirements. If adopted in the United States as issued by the Basel Committee and applicable to us, the new standards could result in higher capital requirements for us. +The Company and AENB must each maintain CET1, Tier 1 capital and Total capital ratios of at least 4.5 percent, 6.0 percent and 8.0 percent, respectively. The Capital Rules also implement a 2.5 percent capital conservation buffer composed entirely of CET1, on top of these minimum risk-weighted asset ratios. As a result, the minimum ratios are effectively 7.0 percent, 8.5 percent and 10.5 percent for the CET1, Tier 1 capital and Total capital ratios, respectively, as of January 1, 2019. The required minimum capital ratios for the Company may be further increased by a countercyclical capital buffer composed entirely of CET1 up to 2.5 percent, which may be assessed when federal banking regulators determine that such a buffer is necessary to protect the banking system from disorderly downturns associated with excessively expansionary periods. Subject to adjustment by the Federal Reserve, the current countercyclical capital buffer is zero percent. Assuming the maximum countercyclical capital buffer was in place, the Company’s effective minimum CET1, Tier 1 capital and Total capital ratios could be 9.5 percent, 11.0 percent and 13.0 percent, respectively. +7 +Table of Contents +Banking institutions whose ratio of CET1, Tier 1 Capital or Total capital to risk-weighted assets is above the minimum but below the capital conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on discretionary distributions such as dividends, repurchases and redemptions of capital securities, and executive compensation based on the amount of the shortfall and the institution's "eligible retained income" (that is, four quarter trailing net income, net of distributions and tax effects not reflected in net income). +As noted above, Category IV firms, such as the Company, would no longer be subject to the countercyclical capital buffer requirements under the Tailoring Proposals. +The Federal Reserve proposed a rule in April 2018 that would, among other things, replace the static 2.5 percent capital conservation buffer with a stress capital buffer requirement for bank holding companies subject to the CCAR process. The stress capital buffer would reflect stressed losses in the supervisory severely adverse scenario of the Federal Reserve’s CCAR stress tests and would also include four quarters of planned common stock dividends. The proposal also included a stress leverage buffer requirement, similar to the stress capital buffer, which would apply to the Tier 1 leverage ratio. The proposal would require bank holding companies to reduce their planned capital distributions if those distributions would not be consistent with the applicable capital buffer constraints based on the bank holding companies’ own baseline scenario projections. The Federal Reserve has indicated that it intends to propose revisions to the stress buffer requirements that would be applicable to Category IV firms, such as the Company, to align with the proposed two-year supervisory stress-testing cycle for Category IV bank holding companies. +Leverage Requirements +We are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its average total consolidated assets (as defined for regulatory purposes). All banking organizations are required to maintain a leverage ratio of at least 4.0 percent. +The Capital Rules also establish a supplementary leverage ratio (SLR) requirement for advanced approaches banking organizations such as the Company. The SLR is the ratio of Tier 1 capital to an expanded concept of leverage exposure that includes both on-balance sheet and certain off-balance sheet exposures. The Capital Rules require a minimum SLR of 3.0 percent. +As noted above, Category IV firms, such as the Company, would no longer be subject to the SLR requirement under the Tailoring Proposals. +Liquidity Regulation +The Federal Reserve’s enhanced prudential standards rule includes heightened liquidity and overall risk management requirements. The rule requires the maintenance of a liquidity buffer, consisting of highly liquid assets, that is sufficient to meet projected net outflows for 30 days over a range of liquidity stress scenarios. +In addition, the Company and AENB are currently subject to a liquidity coverage ratio (LCR) requirement, which is provided for in the Basel III liquidity framework and is designed to ensure that a banking entity maintains an adequate level of unencumbered high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors. The LCR measures the ratio of a firm’s high-quality liquid assets to its projected net outflows. The Company and AENB are required to calculate the LCR each business day, maintain a minimum ratio of 100 percent and disclose certain LCR calculation data and other information on a quarterly basis. +A second standard provided for in the Basel III liquidity framework, referred to as the net stable funding ratio (NSFR), requires a minimum amount of longer-term funding based on the assets and activities of banking entities. The LCR and NSFR requirements may cause banking entities generally to increase their holdings of cash, U.S. Treasury securities and other sovereign debt as a proportion of total assets and/or increase the proportion of longer-term debt. Federal banking regulators issued a proposed rule in May 2016 that would implement the NSFR for advanced approaches banking organizations, such as the Company. A final rule has not yet been issued and timing for implementation of the NSFR requirements is uncertain. If implemented as proposed, the rule would require that “available stable funding” be no less than “required stable funding” for the Company and AENB, as each such measure is calculated under the rule. +As noted above, Category IV firms, such as the Company and AENB, would no longer be subject to the LCR requirement or the proposed NSFR requirements under the Tailoring Proposals. +8 +Table of Contents +Prompt Corrective Action +The Federal Deposit Insurance Act (FDIA) requires, among other things, that federal banking regulators take prompt corrective action in respect of depository institutions insured by the FDIC (such as AENB) that do not meet minimum capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. In order to be considered “well capitalized,” AENB must maintain CET1, Tier 1 capital, Total capital and Tier 1 leverage ratios of 6.5 percent, 8.0 percent, 10.0 percent and 5.0 percent, respectively. +Under the FDIA, AENB could be prohibited from accepting brokered deposits (i.e., deposits raised through third-party brokerage networks) or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A significant amount of our outstanding U.S. retail deposits are considered brokered deposits for bank regulatory purposes. If a federal regulator determines that we are in an unsafe or unsound condition or that we are engaging in unsafe or unsound banking practices, the regulator may reclassify our capital category or otherwise place restrictions on our ability to accept or solicit brokered deposits. +Resolution Planning +The Company is required to prepare and provide to regulators a plan for its rapid and orderly resolution under the U.S. Bankruptcy Code in the event of material distress or failure. This resolution planning requirement may, as a practical matter, present additional constraints on our structure, operations and business strategy, and on transactions and business arrangements between our bank and non-bank subsidiaries, because we must consider the impact of these matters on our ability to prepare and submit a resolution plan that demonstrates that we may be resolved under the Bankruptcy Code in a rapid and orderly manner. If the Federal Reserve and the FDIC determine that the Company’s plan is not credible and we fail to cure the deficiencies, we may be subject to more stringent capital, leverage or liquidity requirements; may be subject to more restrictions on our growth, activities or operations; or may ultimately be required to divest certain assets or operations to facilitate an orderly resolution. The Federal Reserve has indicated it expects to release a proposal to amend, with the FDIC, their joint resolution plan rule to address the applicability of resolution plan requirements for U.S. bank holding companies with between $100 billion and $250 billion in total consolidated assets, such as the Company. +Separately, AENB is required to prepare and provide a separate resolution plan to the FDIC that would enable the FDIC, as receiver, to effectively resolve AENB under the FDIA in the event of failure. The resolution planning requirement applicable to AENB is not affected by EGRRCPA. +Orderly Liquidation Authority +The Company could become subject to the Orderly Liquidation Authority (OLA), a resolution regime under which the Treasury Secretary may appoint the FDIC as receiver to liquidate a systemically important financial company, if the Company is in danger of default and is determined to present a systemic risk to U.S. financial stability. As under the FDIC resolution model, under the OLA, the FDIC has broad power as receiver. Substantial differences exist, however, between the OLA and the FDIC resolution model for depository institutions, including the right of the FDIC under the OLA to disregard the strict priority of creditor claims in limited circumstances, the use of an administrative claims procedure to determine creditor claims (as opposed to the judicial procedure used in bankruptcy proceedings), and the right of the FDIC to transfer claims to a “bridge” entity. The OLA is separate from the Company’s resolution plan discussed in “Resolution Planning.” +The FDIC has developed a strategy under OLA, referred to as the “single point of entry” or “SPOE” strategy, under which the FDIC would resolve a failed financial holding company by transferring its assets (including shares of its operating subsidiaries) and, potentially, very limited liabilities to a “bridge” holding company; utilize the resources of the failed financial holding company to recapitalize the operating subsidiaries; and satisfy the claims of unsecured creditors of the failed financial holding company and other claimants in the receivership by delivering securities of one or more new financial companies that would emerge from the bridge holding company. Under this strategy, management of the failed financial holding company would be replaced and its shareholders and creditors would bear the losses resulting from the failure. +9 +Table of Contents +FDIC Powers upon Insolvency of AENB +If the FDIC is appointed the conservator or receiver of AENB, the FDIC has the power: (1) to transfer any of AENB’s assets and liabilities to a new obligor without the approval of AENB’s creditors; (2) to enforce the terms of AENB’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which AENB is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmation or repudiation of which is determined by the FDIC to promote the orderly administration of AENB. In addition, the claims of holders of U.S. deposit liabilities and certain claims for administrative expenses of the FDIC against AENB would be afforded priority over other general unsecured claims against AENB, including claims of debt holders and depositors in non-U.S. offices, in the liquidation or other resolution of AENB. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of AENB, the debt holders and depositors in non-U.S. offices would be treated differently from, and could receive substantially less, if anything, than the depositors in the U.S. offices of AENB. +Other Banking Regulations +Source of Strength +The Company is required to act as a source of financial and managerial strength to its U.S. bank subsidiary, AENB, and may be required to commit capital and financial resources to support AENB. Such support may be required at times when, absent this requirement, the Company otherwise might determine not to provide it. Capital loans by the Company to AENB are subordinate in right of payment to deposits and to certain other indebtedness of AENB. In the event of the Company’s bankruptcy, any commitment by the Company to a federal banking regulator to maintain the capital of AENB will be assumed by the bankruptcy trustee and entitled to a priority of payment. +Transactions Between AENB and its Affiliates +Certain transactions (including loans and credit extensions from AENB) between AENB and its affiliates (including the Company, TRS and their other subsidiaries) are subject to quantitative and qualitative limitations, collateral requirements and other restrictions imposed by statute and regulation. Transactions subject to these restrictions are generally required to be made on an arm’s-length basis. +FDIC Deposit Insurance and Insurance Assessments +AENB accepts deposits that are insured by the FDIC up to the applicable limits. Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices; is in an unsafe or unsound condition to continue operations; or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that might lead to termination of deposit insurance at AENB. The FDIC’s deposit insurance fund is funded by assessments on insured depository institutions, including AENB, which are subject to adjustment by the FDIC. +Community Reinvestment Act +AENB is subject to the CRA, which imposes affirmative, ongoing obligations on depository institutions to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. +Other Enhanced Prudential Standards +The Federal Reserve has not yet finalized prudential requirements, mandated by Dodd-Frank, regarding early remediation requirements for large bank holding companies experiencing financial distress. +Consumer Financial Products Regulation +In the United States, our marketing, sale and servicing of consumer financial products and our compliance with certain federal consumer financial laws are supervised and examined by the CFPB, which has broad rulemaking and enforcement authority over providers of credit, savings and payment services and products, and authority to prevent “unfair, deceptive or abusive” acts or practices. In addition, a number of U.S. states have significant consumer credit protection, disclosure and other laws (in certain cases more stringent than U.S. federal laws). U.S. federal law also regulates abusive debt collection practices, which, along with bankruptcy and debtor relief laws, can affect our ability to collect amounts owed to us or subject us to regulatory scrutiny. +We are also regulated in the United States under the “money transmitter” or “sale of check” laws in effect in most states. In addition, we are required by the laws of many states to comply with unclaimed and abandoned property laws, under which we must pay to states the face amount of any Travelers Cheque or prepaid card that is uncashed or unredeemed after a period of time depending on the type of product. +10 +Table of Contents +In countries outside the United States, we have seen an increase in regulatory focus in relation to a number of key areas impacting our card-issuing businesses, particularly consumer protection (such as in the European Union (EU), the United Kingdom and Canada) and responsible lending (such as in Australia, Mexico, New Zealand and Singapore). Regulators in a number of countries are shifting their focus from just ensuring compliance with local rules and regulations toward paying greater attention to the product design and operation with a focus on customers and outcomes. Regulators’ expectations of firms in relation to their compliance, risk and control frameworks continue to increase and regulators are placing significant emphasis on a firm’s systems and controls relating to the identification and resolution of issues. +Payments Regulation +Legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +The EU, Australia and other jurisdictions have focused on the fees merchants pay to accept cards, including the way bankcard network members collectively set the “interchange” (that is, the fee paid by the bankcard merchant acquirer to the card issuer in “four party” networks like Visa and Mastercard), as well as the rules, contract terms and practices governing merchant card acceptance. For example, in December 2018, the European Commission announced that it is taking comments on separate proposals by Visa and Mastercard to cap inter-regional multilateral interchange fees. +Regulation and other governmental actions relating to merchant pricing or terms of merchant rules and contracts could affect all networks directly or indirectly, as well as adversely impact consumers and merchants. Among other things, regulation of bankcard fees has negatively impacted and may continue to negatively impact the discount revenue we earn, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business and we have largely exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions, for example. +In various countries, such as certain Member States in the EU and Australia, merchants are permitted by law to surcharge card purchases. In addition, the laws of a number of states in the United States that prohibit surcharging have been challenged in litigation brought by merchant groups and some such laws have been overturned. Surcharging is an adverse customer experience and could have a material adverse effect on us if it becomes widespread, particularly where it only or disproportionately impacts our business. In addition, other steering practices that are permitted by regulation in some countries could also have a material adverse effect on us if they become widespread. +In Canada, regulators have prompted the major international card networks to make voluntary commitments on pricing, specifically interchange fee levels; as American Express does not operate with interchange fees in Canada, our commitments extend to maintaining current pricing practices and complying with certain other practices. +In some countries governments have established regulatory regimes that require international card networks to be locally licensed and/or to localize aspects of their operations. For example, card network operators in India must obtain authorization from the Reserve Bank of India, which has broad power under the Payment and Settlement Systems Act, 2007 to regulate the membership and operations of card networks. In Russia, card network operators must be authorized by the central bank, and regulation requires networks to place security deposits with the central bank, process all local transactions using government-owned infrastructure and ensure that local transaction data remains within the country. The development and enforcement of these and other similar laws, regulations and policies may adversely affect our ability to compete effectively in those countries and maintain and extend our global network. +Governments in some countries also provide resources or protection to select domestic payment card networks. In November 2018, we received preparatory approval from the People’s Bank of China to begin building a network to process domestic currency transactions through a joint venture in mainland China. Once the network has been established, we can apply for a business operating license. There can be no assurance that we will receive such a license, or, if we do, that we will be able to successfully compete in China with domestic payment card networks and alternative payment providers. +Privacy, Data Protection, Information and Cyber Security +Regulatory and legislative activity in the areas of privacy, data protection and information and cyber security continues to increase worldwide. We have established and continue to maintain policies that provide a framework for compliance with applicable privacy, data protection and information and cyber security laws, meet evolving customer expectations and support and enable business innovation and growth. +Our regulators are increasingly focused on ensuring that our privacy, data protection and information and cyber security-related policies and practices are adequate to inform customers of our data collection, use, sharing and/or security practices, to provide them with choices, if required, about how we use and share their information, and to appropriately safeguard their personal information and account access. +11 +Table of Contents +In the United States, certain of our businesses are subject to the privacy, disclosure and safeguarding provisions of the Gramm-Leach-Bliley Act (GLBA) and its implementing regulations and guidance. Among other things, the GLBA imposes certain limitations on our ability to share consumers’ nonpublic personal information with nonaffiliated third parties and requires us to develop, implement and maintain a written comprehensive information security program containing safeguards that are appropriate to the size and complexity of our business, the nature and scope of our activities and the sensitivity of customer information that we process. Effective January 2020, the California Consumer Privacy Act will require us to offer expanded privacy rights to California residents who are not covered by GLBA. Various regulators, U.S. states and territories are considering similar requirements or have adopted laws, rules and regulations pertaining to privacy and/or information and cyber security that may be more stringent and/or expansive than federal requirements. +We are also subject to certain privacy, data protection and information and cyber security laws in other countries in which we operate (including countries in the EU, Australia, Canada, Japan, Hong Kong, India, Mexico and Singapore), some of which are more stringent and/or expansive than those in the United States. Some countries have also instituted laws requiring in-country data processing and/or in-country storage of the personal data of its citizens. Compliance with such laws could result in higher technology, administrative and other costs for us and could limit our ability to optimize the use of our closed-loop data. Data breach notification laws or regulatory activities to encourage breach notification are also becoming more prevalent in jurisdictions outside the United States in which we operate. +In Europe, the EU General Data Protection Regulation (GDPR) went into effect in May 2018 with significant fines for non-compliance (up to 4 percent of total annual worldwide revenue). It created additional legal and compliance obligations on companies that process personal data of individuals in the EU, irrespective of the geographical location of the company. We have made changes to our privacy practices to comply with these requirements, and continue to rely on our binding corporate rules as the primary method for lawfully transferring data from our European affiliates to our affiliates in the United States and elsewhere globally. The GDPR includes, among other things, a requirement for prompt notice of data breaches, in certain circumstances, to affected individuals and supervisory authorities. +In addition, the European Directive 2002/58/EC (the ePrivacy Directive) will continue to set out requirements for the processing of personal data and the protection of privacy in the electronic communications sector until the approval of the forthcoming ePrivacy Regulation. The ePrivacy Directive places restrictions on, among other things, the sending of unsolicited marketing communications, as well as on the collection and use of data about internet users. +In 2015, the European Central Bank and the European Banking Authority enacted secondary legislation focused on security breaches, strong customer authentication and information security-related policies. Likewise, a network and information security directive has been implemented into national laws by Member States in the European Union. The Revised Payment Services Directive (PSD2) also contains regulatory requirements on strong customer authentication, open access to customer data and payment capabilities, and measures to prevent security incidents. +Anti-Money Laundering, Sanctions and Anti-Corruption Compliance +We are subject to significant supervision and regulation, and an increasingly stringent enforcement environment, with respect to compliance with anti-money laundering (AML), sanctions and anti-corruption laws and regulations in the United States and in other jurisdictions in which we operate. Failure to maintain and implement adequate programs and policies and procedures for AML, sanctions and anti-corruption compliance could have serious financial, legal and reputational consequences. +Anti-Money Laundering +American Express is subject to a significant number of AML laws and regulations as a result of being a financial company headquartered in the United States, as well as having a global presence. In the United States, the majority of AML requirements are derived from the Currency and Foreign Transactions Reporting Act and the accompanying regulations issued by the U.S. Department of the Treasury (collectively referred to as the Bank Secrecy Act), as amended by the USA PATRIOT Act of 2001 (the Patriot Act). In Europe, AML requirements are largely the result of countries transposing the 4th EU Anti-Money Laundering Directive (and preceding EU Anti-Money Laundering Directives) into local laws and regulations. Numerous other countries, such as Argentina, Australia, Canada, India, Mexico, New Zealand and Russia, have also enacted or proposed new or enhanced AML legislation and regulations applicable to American Express. +Among other things, these laws and regulations require us to establish AML programs that meet certain standards, including, in some instances, expanded reporting, particularly in the area of suspicious transactions, and enhanced information gathering and recordkeeping requirements. Any errors, failures or delays in complying with federal, state or foreign AML and counter-terrorist financing laws could result in significant criminal and civil lawsuits, penalties and forfeiture of significant assets or other enforcement actions. +12 +Table of Contents +Office of Foreign Assets Control Regulation +The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. The United States prohibits U.S. persons from engaging with individuals and entities identified as “Specially Designated Nationals,” such as terrorists and narcotics traffickers. These prohibitions are administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) and are typically known as the OFAC rules. The OFAC rules prohibit U.S. persons from engaging in financial transactions with or relating to the prohibited individual, entity or country, require the blocking of assets in which the individual, entity or country has an interest, and prohibit transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons) to such individual, entity or country. Blocked assets (e.g., property or bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. We maintain a global sanctions program designed to ensure compliance with OFAC requirements. Failure to comply with such requirements could subject us to serious legal and reputational consequences, including criminal penalties. +Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) to the Securities Exchange Act of 1934, as amended (the Exchange Act), an issuer is required to disclose in its annual or quarterly reports, as applicable, whether it or any of its affiliates knowingly engaged in certain activities, transactions or dealings relating to Iran or with individuals or entities designated pursuant to certain Executive Orders. Disclosure is generally required even where the activities, transactions or dealings were conducted outside the United States by non-U.S. affiliates in compliance with applicable law, and whether or not the activities are sanctionable under U.S. law. +American Express Global Business Travel (GBT) and certain entities that may be considered affiliates of GBT have informed us that during the year ended December 31, 2018, approximately 123 visas were obtained from Iranian embassies and consulates around the world in connection with certain travel arrangements on behalf of clients and reservations were booked at two hotels that may be owned, directly or indirectly, or may otherwise be affiliated with, the Government of Iran. GBT had negligible gross revenues and net profits attributable to these transactions and intends to continue to engage in these activities on a limited basis so long as such activities are permitted under U.S. law. +Anti-Corruption +We are subject to complex international and U.S. anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act (the FCPA), the UK Bribery Act and other laws that prohibit the making or offering of improper payments. The FCPA makes it illegal to corruptly offer or provide anything of value to foreign government officials, political parties or political party officials for the purpose of obtaining or retaining business or an improper advantage. The FCPA also requires us to strictly comply with certain accounting and internal controls standards. In recent years, enforcement of the FCPA has become more intense. The UK Bribery Act also prohibits commercial bribery and the receipt of a bribe, and makes it a corporate offense to fail to prevent bribery by an associated person, in addition to prohibiting improper payments to foreign government officials. Failure of the Company, our subsidiaries, employees, contractors or agents to comply with the FCPA, the UK Bribery Act and other laws can expose us and/or individual employees to investigation, prosecution and potentially severe criminal and civil penalties. +Compensation Practices +Our compensation practices are subject to oversight by the Federal Reserve. The federal banking regulators’ guidance on sound incentive compensation practices sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation plans do not encourage imprudent risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should (1) provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks, (2) be compatible with effective internal controls and risk management, and (3) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in our compensation practices that are identified by the Federal Reserve or other banking regulators in connection with its review of our compensation practices may be incorporated into our supervisory ratings, which can affect our ability to make acquisitions or perform other actions. Enforcement actions may be taken against us if our incentive compensation arrangements or related risk-management control or governance processes are determined to pose a risk to our safety and soundness and we have not taken prompt and effective measures to correct the deficiencies. +In May 2016, the federal banking regulators, the SEC, the Federal Housing Finance Agency and the National Credit Union Administration re-proposed a rule, originally proposed in 2011, on incentive-based compensation practices. The re-proposed rule would apply deferral, downward adjustment and forfeiture, and clawback requirements to incentive-based compensation arrangements granted to senior executive officers and significant risk-takers of covered institutions, with specific requirements varying based on the asset size of the covered institution and the category of employee. If these or other regulations are adopted in a form similar to what has been proposed, they will impose limitations on the manner in which we may structure compensation for our employees, which could adversely affect our ability to hire, retain and motivate key employees. +13 +Table of Contents +EXECUTIVE OFFICERS OF THE COMPANY +Set forth below, in alphabetical order, is a list of our executive officers as of February 13, 2019, including each executive officer’s principal occupation and employment during the past five years and reflecting recent organizational changes. None of our executive officers has any family relationship with any other executive officer, and none of our executive officers became an officer pursuant to any arrangement or understanding with any other person. Each executive officer has been elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer’s age is indicated by the number in parentheses next to his or her name. +DOUGLAS E. BUCKMINSTER — +Group President, Global Consumer Services Group +Mr. Buckminster (58) has been Group President, Global Consumer Services Group since February 2018. Prior thereto, he had been President, Global Consumer Services Group since October 2015 and President, Global Network and International Card Services since February 2012. +JEFFREY C. CAMPBELL — +Chief Financial Officer +Mr. Campbell (58) has been Chief Financial Officer since August 2013. +PAUL D. FABARA — +President, Global Services Group +Mr. Fabara (53) has been President, Global Services Group since February 2018. Prior thereto, he had been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2016 and President, Global Banking Group since February 2013. He also served as President, Global Network Business from September 2014 to October 2015. +MARC D. GORDON — +Chief Information Officer +Mr. Gordon (58) has been Chief Information Officer since September 2012. +ANNA MARRS — +President, Global Commercial Services +Ms. Marrs (45) has been President, Global Commercial Services since September 2018. Ms. Marrs joined American Express from Standard Chartered Bank, where she served as Regional CEO, ASEAN and South Asia since November 2016 and CEO, Commercial and Private Banking since October 2015. She joined Standard Chartered Bank as Group Head, Strategy and Corporate Development in January 2012. +MICHAEL J. O’NEILL — +Chief Corporate Affairs Officer +Mr. O’Neill (65) has been Chief Corporate Affairs Officer since September 2014. Prior thereto, he had been Senior Vice President, Corporate Affairs and Communications since March 1991. +DENISE PICKETT — +Chief Risk Officer and President, Global Risk, Banking & Compliance +Ms. Pickett (53) has been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2018. Prior thereto, she had been President, U.S. Consumer Services since October 2015. She also served as President, American Express OPEN from February 2014 to October 2015 and Executive Vice President and Chief Executive Officer, U.S. Loyalty from January 2013 to February 2014. +ELIZABETH RUTLEDGE — +Chief Marketing Officer +Ms. Rutledge (57) has been Chief Marketing Officer since February 2018. Prior thereto, she had been Executive Vice President, Global Advertising & Media since February 2016 and Executive Vice President, Card Products & Benefits since May 2013. +LAUREEN E. SEEGER — +Chief Legal Officer +Ms. Seeger (57) has been Chief Legal Officer since July 2014. Ms. Seeger joined American Express from McKesson Corporation, where she served as Executive Vice President, General Counsel and Chief Compliance Officer from March 2006 until June 2014. +STEPHEN J. SQUERI — +Chairman and Chief Executive Officer +Mr. Squeri (59) has been Chairman and Chief Executive Officer since February 2018. Prior thereto, he had been Vice Chairman since July 2015. Prior thereto, he had been Group President, Global Corporate Services since November 2011. +ANRÉ WILLIAMS — +Group President, Global Merchant and Network Services +Mr. Williams (53) has been Group President, Global Merchant and Network Services since February 2018. Prior thereto, he had been President of Global Merchant Services and Loyalty since October 2015 and President, Global Merchant Services since November 2011. +14 +Table of Contents +EMPLOYEES +We had approximately 59,000 employees as of December 31, 2018. +ADDITIONAL INFORMATION +We maintain an Investor Relations website at http://ir.americanexpress.com. We make available free of charge, on or through this website, our annual, quarterly and current reports and any amendments to those reports as soon as reasonably practicable following the time they are electronically filed with or furnished to the Securities and Exchange Commission (SEC). To access these materials, click on the “SEC Filings” link under the caption “Financial Information” on our Investor Relations homepage. +You can also access our Investor Relations website through our main website at www.americanexpress.com by clicking on the “Investor Relations” link, which is located at the bottom of our homepage. Information contained on our Investor Relations website, our main website and other websites referred to in this report is not incorporated by reference into this report or any other report filed with or furnished to the SEC. 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0000004962 axp:LaccGeographicRegionMember 2017-01-01 2017-12-31 0000004962 axp:OtherUnallocatedMember 2017-01-01 2017-12-31 0000004962 srt:ParentCompanyMember 2019-01-01 2019-12-31 0000004962 srt:ParentCompanyMember 2018-01-01 2018-12-31 0000004962 srt:ParentCompanyMember 2017-01-01 2017-12-31 0000004962 srt:ParentCompanyMember 2018-12-31 0000004962 srt:ParentCompanyMember 2017-12-31 0000004962 srt:ParentCompanyMember 2016-12-31 0000004962 2019-10-01 2019-12-31 0000004962 2019-07-01 2019-09-30 0000004962 2019-04-01 2019-06-30 0000004962 2019-01-01 2019-03-31 0000004962 2018-10-01 2018-12-31 0000004962 2018-07-01 2018-09-30 0000004962 2018-04-01 2018-06-30 0000004962 2018-01-01 2018-03-31 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +Form 10-K +☑ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2019 +OR +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File No. 1-7657 +American Express Co mpany +(Exact name of registrant as specified in its charter) +New York 13-4922250 +(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) +200 Vesey Street +New York , New York +10285 +(Address of principal executive offices) (Zip Code) +Registrant’s telephone number, including area code: ( 212 ) 640-2000 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol(s) Name of each exchange on which registered +Common Shares (par value $0.20 per Share) AXP New York Stock Exchange +Securities registered pursuant to section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes þ No o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer þ +Accelerated filer o +Non-accelerated filer o +Smaller reporting company ☐ +Emerging growth company ☐ +(Do not check if a smaller reporting company) +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No þ +As of June 30, 2019, the aggregate market value of the registrant’s voting shares held by non-affiliates of the registrant was approximately $ 102.7 billion based on the closing sale price as reported on the New York Stock Exchange. +As of January 30, 2020, there were 808,040,664 common shares of the registrant outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III: Portions of Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Annual Meeting of Shareholders to be held on May 5, 2020. +Table of Contents +TABLE OF CONTENTS +Form 10-K +Item Number Page +PART I +1. +Business +1 +Competition +4 +Supervision and Regulation +6 +Information about our Executive Officers +15 +Additional Information +17 +1A. +Risk Factors +17 +1B. +Unresolved Staff Comments +33 +2. +Properties +33 +3. +Legal Proceedings +33 +4. +Mine Safety Disclosures +33 +PART II +5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +34 +6. +Selected Financial Data +36 +7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) +36 +Executive Overview +37 +Consolidated Results of Operations +39 +Business Segment Results of Operations +44 +Consolidated Capital Resources and Liquidity +53 +Off-Balance Sheet Arrangements and Contractual Obligations +59 +Risk Management +60 +Critical Accounting Estimates +66 +Other Matters +68 +7A. +Quantitative and Qualitative Disclosures about Market Risk +73 +8. +Financial Statements and Supplementary Data +74 +Management’s Report on Internal Control Over Financial Reporting +74 +Report of Independent Registered Public Accounting Firm +75 +Index to Consolidated Financial Statements +77 +Consolidated Financial Statements +78 +Notes to Consolidated Financial Statements +83 +9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +132 +9A. +Controls and Procedures +132 +9B. +Other Information +132 +PART III +10. +Directors, Executive Officers and Corporate Governance +133 +11. +Executive Compensation +133 +Table of Contents +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +133 +13. +Certain Relationships and Related Transactions, and Director Independence +133 +14. +Principal Accounting Fees and Services +134 +PART IV +15. +Exhibits, Financial Statement Schedules +135 +16. +Form 10-K Summary +139 +Signatures +140 +Guide 3 — Statistical Disclosure by Bank Holding Companies +A- 1 +This Annual Report on Form 10-K, including the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties. You can identify forward-looking statements by words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” “estimate,” “predict,” “potential,” “continue” or other similar expressions. We discuss certain factors that affect our business and operations and that may cause our actual results to differ materially from these forward-looking statements under “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements. +This report includes trademarks, such as American Express ® , which are protected under applicable intellectual property laws and are the property of American Express Company or its subsidiaries. This report also contains trademarks, service marks, copyrights and trade names of other companies, which are the property of their respective owners. Solely for convenience, our trademarks and trade names referred to in this report may appear without the ® or ™ symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the right of the applicable licensor to these trademarks and trade names. +Throughout this report the terms “American Express,” “we,” “our” or “us,” refer to American Express Company and its subsidiaries on a consolidated basis, unless stated or the context implies otherwise. The use of the term “partner” or “partnering” in this report does not mean or imply a formal legal partnership, and is not meant in any way to alter the terms of American Express’ relationship with any third parties. Refer to the “MD&A ― Glossary of Selected Terminology” for the definitions of other key terms used in this report. +Table of Contents +PART I +ITEM 1. BUSINESS +Overview +American Express is a globally integrated payments company that provides customers with access to products, insights and experiences that enrich lives and build business success. We are a leader in providing credit and charge cards to consumers, small businesses, mid-sized companies and large corporations around the world. American Express ® cards issued by American Express as well as by third-party banks and other institutions on the American Express network permit Card Members to charge purchases of goods and services at the millions of merchants around the world that accept cards bearing our logo. +Our various products and services are sold globally to diverse customer groups through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams and direct response advertising. Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +We were founded in 1850 as a joint stock association and were incorporated in 1965 as a New York corporation. American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. (TRS), are bank holding companies under the Bank Holding Company Act of 1956, as amended (the BHC Act), subject to supervision and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). As of December 31, 2019, we employed approximately 64,500 people, whom we refer to as colleagues. +We principally engage in businesses comprising three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses are included in Corporate & Other. Our businesses are global in scope and function together to form our end-to-end integrated payments platform, which we believe is a differentiator that underpins our business model. For further information about our reportable operating segments, please see “Business Segment Results” under “MD&A.” +Our Integrated Payments Platform +Through our general-purpose card-issuing, merchant-acquiring and card network businesses, we are able to connect participants and provide differentiated value across the commerce path. We maintain direct relationships with both our Card Members (as a card issuer) and merchants (as an acquirer), and we handle all key aspects of those relationships. These relationships create a “closed loop” in that we have direct access to information at both ends of the card transaction, which distinguishes our integrated payments platform from the bankcard networks. +1 +Table of Contents +Our integrated payments platform allows us to analyze information on Card Member spending and build algorithms and other analytical tools that we use to underwrite risk, reduce fraud and provide targeted marketing and other information services for merchants and special offers and services to Card Members, all while respecting Card Member preferences and protecting Card Member and merchant data in compliance with applicable policies and legal requirements. Through contractual relationships, we also obtain information from third-party card issuers, merchant acquirers and processors with whom we do business. +Card Issuing Businesses +Our global proprietary card-issuing businesses are conducted through our GCSG and GCS reportable operating segments. We offer a broad set of card products, rewards and services to a diverse consumer and commercial customer base, in the United States and internationally. We acquire and retain high-spending, engaged and creditworthy Card Members by: +• Designing innovative products and features that appeal to our target customer base and meet their spending and borrowing needs +• Using incentives to drive spending on our various card products and engender loyal Card Members, including our Membership Rewards ® program, cash-back reward features and participation in loyalty programs sponsored by our cobrand and other partners +• Providing digital and mobile services and an array of benefits and experiences across card products, such as airport lounge access and other travel and lifestyle benefits, which we believe are difficult for others to replicate and help increase Card Member engagement +• Creating world-class service experiences by delivering exceptional customer care +• Developing a wide range of partner relationships, including with other corporations and institutions that sponsor certain of our cards under cobrand arrangements and provide benefits and services to our Card Members +For the year ended December 31, 2019, worldwide proprietary billed business (spending on American Express cards issued by us) was $1,071 billion and at December 31, 2019, we had 70 million proprietary cards-in-force worldwide. +Merchant Acquiring Business +Our GMNS reportable operating segment builds and manages relationships with millions of merchants around the world that choose to accept American Express cards. This includes signing new merchants to accept our cards, agreeing on the discount rate (a fee charged to the merchant for accepting our cards) and handling servicing for merchants. We also build and maintain relationships with merchant acquirers, aggregators and processors to manage aspects of our merchant services business. For example, through our OptBlue ® merchant-acquiring program, third-party processors contract directly with small merchants for card acceptance and determine merchant pricing. +We continue to grow merchant acceptance of American Express cards around the world. As of year-end 2019, based on our internal tracking and our understanding of the latest industry data, we believe we achieved our goal of reaching virtual parity coverage with Mastercard and Visa credit card-accepting merchants in the United States. We are also focused on increasing merchant coverage strategically in targeted countries, cities and merchant categories outside the United States, with continued growth in merchant locations internationally in 2019. As we continue to grow our network, we will seek to work with merchant partners in the United States and around the world to ensure that our Card Members are warmly welcomed and encouraged to spend in the millions of places where their American Express cards are accepted. +Card Network Business +GMNS operates a payments network through which it establishes and maintains relationships with third-party banks and other institutions in approximately 94 countries and territories, licensing the American Express brand and extending the reach of our global network. Under independent operator arrangements, partners are licensed to issue local currency American Express-branded cards in their countries and serve as the merchant acquirer for local merchants. Under network card license arrangements, partners are licensed to issue American Express-branded cards on our network. +For the year ended December 31, 2019, worldwide network services billed business (spending on American Express cards issued by third parties) was $170 billion and at December 31, 2019, we had 44 million cards-in-force issued by third parties worldwide. +GMNS also provides fraud-prevention tools, marketing solutions, data analytics and other programs and services to merchants and other partners that leverage the capabilities of our integrated payments platform. +2 +Table of Contents +Diverse Customer Base and Global Footprint +The following charts provide a summary of our diverse set of customers and broad geographic footprint: +Partners and Relationships +Our integrated payments platform allows us to work with a range of business partners, and our partners in return help drive the scale and relevance of the platform. +There are many examples of how we connect partners with our integrated payments platform, including: issuing cards under cobrand arrangements with other corporations and institutions (e.g., Delta Air Lines, Marriott International, British Airways and Hilton Worldwide Holdings); offering innovative ways for our Card Members to earn and use points with our merchants (e.g., Pay with Points at Amazon.com); expanding merchant acceptance with third-party acquirers and processors (e.g., OptBlue partners); developing new capabilities and features with our digital partners (e.g., PayPal and Venmo); integrating into the supplier payment processes of our corporate card clients (e.g., SAP Ariba); and extending the platform into travel services with American Express leisure and business travel (e.g., Fine Hotels and Resorts). +Delta Air Lines is our largest strategic partner. Our relationships with, and revenues and expenses related to, Delta are significant and represent a significant source of value for our Card Members. We issue cards under cobrand arrangements with Delta and the Delta cobrand portfolio represented approximately 8 percent of our worldwide billed business and approximately 22 percent of worldwide Card Member loans as of December 31, 2019. The Delta cobrand portfolio generates fee revenue and interest income from Card Members and discount revenue from Delta and other merchants for spending on Delta cobrand cards. During 2019, we signed an 11-year renewal extending the Delta cobrand relationship through the end of 2029 and expect to continue to make significant investments in this partnership going forward. Among other things, Delta is also a key participant in our Membership Rewards program, provides travel-related benefits and services, including airport lounge access for certain American Express Card Members, accepts American Express cards as a merchant and is a corporate payments customer. +Working with all of our partners, we will continue to seek to provide value, choice and unique experiences across our customer base. +Our Spend-Centric Model and Revenue Mix +Our “spend-centric” business model focuses on generating revenues primarily by driving spending on our cards and secondarily through finance charges and fees. Spending on our cards, which is higher on average on a per-card basis versus our competitors, offers superior value to merchants in the form of loyal customers and larger transactions. Because of the revenues generated from having high-spending Card Members and the annual card fees we charge on many of our products, we are able to invest in attractive rewards and other benefits for Card Members, as well as targeted marketing and other programs and investments for merchants. This creates incentives for Card Members to spend more on their cards and positively differentiates American Express cards. +We believe our spend-centric model gives us the ability to provide differentiated value to Card Members, merchants and business partners. +3 +Table of Contents +The American Express Brand and Service Excellence +Our brand and its attributes—trust, security and service—are key assets. We invest heavily in managing, marketing, promoting and protecting our brand, including through the delivery of our products and services in a manner consistent with our brand promise. The American Express brand is consistently ranked as one of the most valuable brands in the world. We place significant importance on trademarks, service marks and patents, and seek to secure our intellectual property rights around the world. +We aim to provide the world’s best customer experience every day and our reputation for world-class service has been recognized by numerous awards over the years. Our customer care professionals and partners treat servicing interactions as an opportunity to bring the brand to life for our customers, add meaningful value and deepen relationships. +Our Business Strategies +We seek to grow our business by focusing on four strategic imperatives: +First, we aim to expand our leadership in the premium consumer space by continuing to deliver membership benefits that span our customers’ everyday spending, borrowing, travel and lifestyle needs, expanding our roster of business partners around the globe and developing a range of experiences that attract high-spending customers. +Second, we will look to build on our strong position in commercial payments by evolving our card value propositions, further differentiating our corporate card and accounts payable expense management solutions, and designing innovative products and features, including financing and supplier payment solutions for our business customers. +Third, we are focused on strengthening our global network to provide unique value by continuing to help merchants navigate the convergence of online and offline commerce with fraud protection services, marketing insights and digital connections to higher-spending Card Members, and continuing to work with our network partners to offer expanded products and services. +Finally, we want to continue to make American Express an essential part of our customers’ digital lives by developing more digital features, solutions and services, expanding our digital partnerships and making targeted acquisitions. +COMPETITION +We compete in the global payments industry with card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and Automated Clearing House, or ACH), as well as evolving and growing alternative payment and financing providers. As the payments industry continues to evolve, we face increasing competition from non-traditional players that leverage new technologies, business models and customer relationships to create payment or financing solutions. +As a card issuer, we compete with financial institutions that issue general-purpose charge and credit cards and debit cards. We also encounter competition from businesses that issue their own private label cards, operate their own mobile wallets or extend credit to their customers. We face intense competition for cobrand relationships, as both card issuer and network competitors have targeted key business partners with attractive value propositions. +Our global card network competes in the global payments industry with other card networks, including, among others, China UnionPay, Visa, Mastercard, JCB, Discover and Diners Club International (which is owned by Discover). We are the fourth largest general-purpose card network globally based on purchase volume, behind China UnionPay, Visa and Mastercard. In addition to such networks, a range of companies globally, including merchant acquirers, processors and web- and mobile-based payment platforms (e.g., Alipay, PayPal and Venmo), as well as regional payment networks (such as the National Payments Corporation of India), carry out some activities similar to those performed by our GMNS business. +The principal competitive factors that affect the card-issuing, merchant and network businesses include: +• The features, value and quality of the products and services, including customer care, rewards programs, partnerships, benefits and digital and mobile services, and the costs associated with providing such features and services +• Reputation and brand recognition +• The number, spending characteristics and credit performance of customers +4 +Table of Contents +• The quantity, diversity and quality of the establishments where the cards can be used +• The attractiveness of the value proposition to card issuers, merchant acquirers, cardholders, corporate clients and merchants (including the relative cost of using or accepting the products and services, and capabilities such as fraud prevention and data analytics) +• The number and quality of other payment cards and other forms of payment available to customers +• The success of marketing and promotional campaigns +• The speed of innovation and investment in systems, technologies, and product and service offerings +• The nature and quality of expense management tools, electronic payment methods and data capture and reporting capabilities, particularly for business customers +• The security of cardholder and merchant information +Another aspect of competition is the dynamic and rapid growth of alternative payment mechanisms, systems and products, which include payment aggregators (e.g., PayPal, Square and Amazon), marketplace lenders, wireless payment technologies (including using mobile telephone networks to carry out transactions), financial technology companies, electronic wallet and push payment providers (including handset manufacturers, telecommunication providers, retailers, banks and technology companies), digital currencies developed by both governments and the private sector, blockchain and similar distributed ledger technologies, real-time settlement and processing, prepaid systems and gift cards, and systems linked to payment cards or that provide payment solutions. Various competitors are working to integrate more financial services into their product offerings and competitors are attempting to replicate our closed-loop functionality, such as the merchant-processing platform ChaseNet. New payments competitors continue to emerge in response to evolving technologies, consumer habits and merchant needs. +In addition to the discussion in this section, see “ Our operating results may materially suffer because of substantial and increasingly intense competition worldwide in the payments industry ” in “Risk Factors” for further discussion of the potential impact of competition on our business, and “ Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition” and “ Legal proceedings regarding provisions in our merchant contracts could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand ” in “Risk Factors” for a discussion of the potential impact on our ability to compete effectively due to government regulations or if ongoing legal proceedings limit our ability to prevent merchants from engaging in various actions to discriminate against our card products. +5 +Table of Contents +SUPERVISION AND REGULATION +Overview +We are subject to extensive government regulation and supervision in jurisdictions around the world, and the costs of compliance are substantial. In recent years, the financial services industry has been subject to rigorous scrutiny, high regulatory expectations, an increasing range of regulations and a stringent and unpredictable enforcement environment. +Governmental authorities have focused, and we believe will continue to focus, considerable attention on reviewing compliance by financial services firms with laws and regulations, and as a result, we continually work to evolve and improve our risk management framework, governance structures, practices and procedures. Reviews to assess compliance with laws and regulations by governmental authorities, as well as our own internal reviews, have resulted in, and are likely to continue to result in, changes to our products, practices and procedures, restitution to our customers and increased costs related to regulatory oversight, supervision and examination. We have also been subject to regulatory actions and may continue to be the subject of such actions, including governmental inquiries, investigations, enforcement proceedings and the imposition of fines or civil money penalties, in the event of noncompliance or alleged noncompliance with laws or regulations. In addition, legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +See “Risk Factors—Legal, Regulatory and Compliance Risks” for a discussion of the potential impact legislative and regulatory changes may have on our results of operations and financial condition. +Banking Regulation +Federal and state banking laws, regulations and policies extensively regulate the Company (which, for purposes of this section, refers to American Express Company as a bank holding company), TRS and our U.S. bank subsidiary, American Express National Bank (AENB). Both the Company and TRS are subject to comprehensive consolidated supervision, regulation and examination by the Federal Reserve and AENB is likewise supervised, regulated and examined by the Office of the Comptroller of the Currency (OCC). The Company and its subsidiaries are also subject to the rulemaking, enforcement and examination authority of the Consumer Financial Protection Bureau (CFPB). Banking regulators have broad examination and enforcement power, including the power to impose substantial fines, limit dividends and other capital distributions, restrict operations and acquisitions and require divestitures. Many aspects of our business also are subject to rigorous regulation by other U.S. federal and state regulatory agencies and by non-U.S. government agencies and regulatory bodies. +The Federal Reserve has established a new rating system for large financial institutions, such as the Company, which is intended to align with the Federal Reserve’s existing supervisory program for large financial institutions and which includes component ratings for capital planning, liquidity risk management, and governance and controls. In August 2017 and January 2018, the Federal Reserve proposed related guidance for the governance and controls component. +Activities +The BHC Act generally limits bank holding companies to activities that are considered to be banking activities and certain closely related activities. As noted above, each of the Company and TRS is a bank holding company and each has elected to become a financial holding company, which is authorized to engage in a broader range of financial and related activities. In order to remain eligible for financial holding company status, we must meet certain eligibility requirements. Those requirements include that each of the Company and AENB must be “well capitalized” and “well managed,” and AENB must have received at least a “satisfactory” rating on its most recent assessment under the Community Reinvestment Act of 1977 (the CRA). The Company and TRS engage in various activities permissible only for financial holding companies, including, in particular, providing travel agency services, acting as a finder and engaging in certain insurance underwriting and agency services. If the Company fails to meet eligibility requirements for financial holding company status, it is likely to be barred from engaging in new types of financial activities or making certain types of acquisitions or investments in reliance on its status as a financial holding company, and ultimately could be required to either discontinue the broader range of activities permitted to financial holding companies or divest AENB. In addition, the Company and its subsidiaries are prohibited by law from engaging in practices that the relevant regulatory authority deems unsafe or unsound (which such authorities generally interpret broadly). +6 +Table of Contents +Acquisitions and Investments +Applicable federal and state laws place limitations on the ability of persons to invest in or acquire control of us without providing notice to or obtaining the approval of one or more of our regulators. In addition, we are subject to banking laws and regulations that limit our investments and acquisitions and, in some cases, subject them to the prior review and approval of our regulators, including the Federal Reserve and the OCC. Federal banking regulators have broad discretion in evaluating proposed acquisitions and investments that are subject to their prior review or approval. +Financial Regulatory Reform +In October 2019, the U.S. federal bank regulatory agencies finalized rules that tailor the application of the enhanced prudential standards to bank holding companies and depository institutions (the Tailoring Rules) pursuant to the amendments to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank) introduced by the Economic Growth, Regulatory Relief, and Consumer Protection Act. The Tailoring Rules assign each U.S. bank holding company with $100 billion or more in total consolidated assets, as well as its bank subsidiaries, to one of four categories based on its status as a U.S. global systemically important banking organization and five other risk-based indicators: (i) size, (ii) cross-jurisdictional activity, (iii) non-bank assets, (iv) off-balance sheet exposure, and (v) weighted short-term wholesale funding. +Under the Tailoring Rules, the Company (and, pursuant to the Tailoring Rules, its depository institution subsidiary, AENB) is subject to Category IV standards. As a Category IV firm, the Company is, among other things, (i) no longer subject to the advanced approaches capital requirements, (ii) no longer subject to the supplementary leverage ratio (SLR), (iii) no longer subject to the countercyclical capital buffer, (iv) no longer subject to company-run stress testing requirements, (v) subject to supervisory stress testing on an every-other-year basis rather than an annual basis, and (vi) no longer subject to the requirement to prepare and submit a holding company-level resolution plan. In addition, as a Category IV firm with less than $50 billion in weighted short-term wholesale funding, the Company is no longer subject to the liquidity coverage ratio (LCR). +Because a firm’s categorization under the Tailoring Rules is determined by, and can change over time dependent upon, how the firm measures against the risk-based indicator thresholds, we are required to monitor and periodically report these risk-based indicators and there can be no assurance that the Company will continue to be a Category IV firm in the future. +Stress Testing and Capital Planning +Under the Federal Reserve’s regulations, the Company is subject to supervisory stress testing requirements that are designed to evaluate whether a bank holding company has sufficient capital on a total consolidated basis to absorb losses and support operations under adverse economic conditions. As a Category IV firm, the Company will be subject to the Federal Reserve’s supervisory stress tests every other year, beginning in 2020, rather than on an annual cycle. +We remain subject to the requirement to develop and submit to the Federal Reserve an annual capital plan. The Federal Reserve has stated it plans to propose changes, which would include providing firms subject to Category IV standards additional flexibility to develop their capital plans. As part of the Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve evaluates whether the Company has sufficient capital to continue operations by assessing our pro-forma capital position and ratios under a scenario of economic and financial market stress. Sufficient capital for these purposes is likely to require us to maintain capital ratios appreciably above applicable minimum requirements and buffers. +The Federal Reserve is expected to publish the decisions for all the bank holding companies participating in CCAR, including the reasons for any objection to capital plans, by June 30. In addition, the Federal Reserve will publish separately the results of its supervisory stress test under the supervisory severely adverse scenario. The information to be released will include, among other things, the Federal Reserve’s projection of company-specific information, including post-stress capital ratio information over the planning horizon. +We may be required to revise and resubmit our capital plan as required by the Federal Reserve following certain events, such as a significant acquisition. In addition to other limitations, our ability to make any capital distributions (including dividends and share repurchases) is contingent on the Federal Reserve’s non-objection to our capital plan. +Dividends and Other Capital Distributions +The Company and TRS, as well as AENB and the Company’s insurance and other regulated subsidiaries, are limited in their ability to pay dividends by statutes, regulations and supervisory policy. +Dividend payments by the Company to shareholders are subject to the oversight of the Federal Reserve. See “Stress Testing and Capital Planning.” Even if the Federal Reserve has not objected to a distribution, the Company may still not make a distribution +7 +Table of Contents +without Federal Reserve approval if, among other things, the Company would not meet a minimum regulatory capital ratio after giving effect to the capital distribution, changes in facts would require resubmission of our capital plan or the Company’s earnings are materially underperforming its projections in the capital plan. +In general, federal laws and regulations prohibit, without first obtaining the OCC’s approval, AENB from making dividend distributions to TRS, if such distributions are not paid out of available recent earnings or would cause AENB to fail to meet capital adequacy standards. In addition to specific limitations on the dividends AENB can pay to TRS, federal banking regulators have authority to prohibit or limit the payment of a dividend if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the institution. +Capital, Leverage and Liquidity Regulation +Capital Rules +The Company and AENB are required to comply with the applicable capital adequacy rules established by federal banking regulators. These rules are intended to ensure that bank holding companies and depository institutions (collectively, banking organizations) have adequate capital given their level of assets and off-balance sheet obligations. The federal banking regulators’ current capital rules (the Capital Rules) implement the Basel Committee on Banking Supervision’s (the Basel Committee) framework for strengthening international capital regulation, known as Basel III. For additional information regarding our capital ratios, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Under the Capital Rules, banking organizations are required to maintain minimum ratios for Common Equity Tier 1 (CET1), Tier 1 capital (that is, CET1 plus additional Tier 1 capital) and Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. Since 2014, we have reported our capital adequacy ratios on a parallel basis to federal banking regulators using both risk-weighted assets calculated under the Basel III standardized approach, as adjusted for certain items, and the requirements for an advanced approaches institution. As a Category IV firm, we are no longer subject to the Basel III advanced approaches capital requirements. +In December 2017, the Basel Committee published standards that, among other things, revise the standardized approach for credit risk (including by recalibrating risk weights and introducing additional capital requirements for certain “unconditionally cancellable commitments” such as unused credit card lines of credit) and provide a new standardized calculation for operational risk capital requirements. If adopted in the United States as issued by the Basel Committee and applicable to us, the new standards could result in higher capital requirements for us. +The Company and AENB must each maintain CET1, Tier 1 capital and Total capital ratios of at least 4.5 percent, 6.0 percent and 8.0 percent, respectively. The Capital Rules also implement a 2.5 percent capital conservation buffer composed entirely of CET1, on top of these minimum risk-weighted asset ratios. As a result, the minimum ratios are effectively 7.0 percent, 8.5 percent and 10.5 percent for the CET1, Tier 1 capital and Total capital ratios, respectively. +Federal banking regulators may further increase required minimum capital ratios by a countercyclical capital buffer composed entirely of CET1 up to 2.5 percent if they determine that such a buffer is necessary to protect the banking system from disorderly downturns associated with excessively expansionary periods. Under the Tailoring Rules, Category IV firms, such as the Company, would not be subject to such a countercyclical capital buffer. +Banking institutions whose ratio of CET1, Tier 1 Capital or Total capital to risk-weighted assets is above the minimum but below the capital conservation buffer will face constraints on discretionary distributions such as dividends, repurchases and redemptions of capital securities, and executive compensation based on the amount of the shortfall and the institution’s “eligible retained income” (that is, four quarter trailing net income, net of distributions and tax effects not reflected in net income). +The Federal Reserve proposed a rule in April 2018 that would, among other things, replace the static 2.5 percent capital conservation buffer with a stress capital buffer requirement for bank holding companies subject to the CCAR process. The stress capital buffer would reflect stressed losses in the supervisory severely adverse scenario of the Federal Reserve’s CCAR stress tests and would also include four quarters of planned common stock dividends. The proposal also included a stress leverage buffer requirement, similar to the stress capital buffer, which would apply to the Tier 1 leverage ratio. The proposal would require bank holding companies to reduce their planned capital distributions if those distributions would not be consistent with the applicable capital buffer constraints based on the bank holding companies’ own baseline scenario projections. The Federal Reserve has indicated that it intends to propose revisions to the stress buffer requirements that would be applicable to Category IV firms, such as the Company, to align with the two-year supervisory stress-testing cycle for Category IV bank holding companies. +8 +Table of Contents +Leverage Requirements +We are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its average total consolidated assets (as defined for regulatory purposes). All banking organizations are required to maintain a leverage ratio of at least 4.0 percent. +The Capital Rules also establish an SLR requirement for advanced approaches banking organizations. The SLR is the ratio of Tier 1 capital to an expanded concept of leverage exposure that includes both on-balance sheet and certain off-balance sheet exposures. The Capital Rules require a minimum SLR of 3.0 percent. As noted above, Category IV firms, such as the Company, are not subject to the SLR requirement under the Tailoring Rules. +Liquidity Regulation +The Federal Reserve’s enhanced prudential standards rule includes heightened liquidity and overall risk management requirements. The rule requires the maintenance of a liquidity buffer, consisting of highly liquid assets, that is sufficient to meet projected net outflows for 30 days over a range of liquidity stress scenarios, and a minimum LCR that measures a firm’s high-quality liquid assets to its projected net outflows. Under the Tailoring Rules, Category IV firms with less than $50 billion in weighted short-term wholesale funding, such as the Company, are no longer subject to any LCR requirement. +A second standard provided for in the Basel III liquidity framework, referred to as the net stable funding ratio (NSFR), requires a minimum amount of longer-term funding based on the assets and activities of banking entities. Although the NSFR has not been finalized, the Federal Reserve staff’s memorandum has indicated it will be applied in a manner consistent with the application of the LCR under the Tailoring Rules, provided a Category IV firm’s weighted short-term wholesale funding remains below $50 billion. +Prompt Corrective Action +The Federal Deposit Insurance Act (FDIA) requires, among other things, that federal banking regulators take prompt corrective action in respect of depository institutions insured by the FDIC (such as AENB) that do not meet minimum capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. In order to be considered “well capitalized,” AENB must maintain CET1, Tier 1 capital, Total capital and Tier 1 leverage ratios of 6.5 percent, 8.0 percent, 10.0 percent and 5.0 percent, respectively. +Under the FDIA, AENB could be prohibited from accepting brokered deposits (i.e., deposits raised through third-party brokerage networks) or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A significant amount of our outstanding U.S. retail deposits are considered brokered deposits for bank regulatory purposes. If a federal regulator determines that we are in an unsafe or unsound condition or that we are engaging in unsafe or unsound banking practices, the regulator may reclassify our capital category or otherwise place restrictions on our ability to accept or solicit brokered deposits. +In December 2019, the FDIC issued a proposed rule intended to update and modernize the FDIC’s brokered deposit regulations. The proposed rule, among other things, would revise the definition of “deposit broker” and the accompanying exceptions. +Resolution Planning +Pursuant to Dodd Frank, certain bank holding companies are required to submit resolution plans to the Federal Reserve and FDIC providing for the company’s strategy for rapid and orderly resolution in the event of its material financial distress or failure. However, in connection with the release of the Tailoring Rules, the Federal Reserve and FDIC finalized rules in October 2019 which, among other things, adjust the review cycles and applicability of the agencies’ resolution planning requirements. Under these new rules, Category IV firms such as the Company are no longer required to submit a holding company resolution plan. +AENB continues to be required to prepare and provide a separate resolution plan to the FDIC that would enable the FDIC, as receiver, to effectively resolve AENB under the FDIA in the event of failure. The FDIC has issued an Advance Notice of Proposed Rulemaking on potential revisions to this separate resolution plan requirement for insured depository institutions, and the next round of insured depository institution resolution plan submissions will not be required until the rulemaking process is complete. +9 +Table of Contents +Orderly Liquidation Authority +The Company could become subject to the Orderly Liquidation Authority (OLA), a resolution regime under which the Treasury Secretary may appoint the FDIC as receiver to liquidate a systemically important financial institution, if the Company is in danger of default and is determined to present a systemic risk to U.S. financial stability. As under the FDIC resolution model, under the OLA, the FDIC has broad power as receiver. Substantial differences exist, however, between the OLA and the FDIC resolution model for depository institutions, including the right of the FDIC under the OLA to disregard the strict priority of creditor claims in limited circumstances, the use of an administrative claims procedure to determine creditor claims (as opposed to the judicial procedure used in bankruptcy proceedings), and the right of the FDIC to transfer claims to a “bridge” entity. +The FDIC has developed a strategy under OLA, referred to as the “single point of entry” or “SPOE” strategy, under which the FDIC would resolve a failed financial holding company by transferring its assets (including shares of its operating subsidiaries) and, potentially, very limited liabilities to a “bridge” holding company; utilize the resources of the failed financial holding company to recapitalize the operating subsidiaries; and satisfy the claims of unsecured creditors of the failed financial holding company and other claimants in the receivership by delivering securities of one or more new financial companies that would emerge from the bridge holding company. Under this strategy, management of the failed financial holding company would be replaced and its shareholders and creditors would bear the losses resulting from the failure. +FDIC Powers upon Insolvency of AENB +If the FDIC is appointed the conservator or receiver of AENB, the FDIC has the power: (1) to transfer any of AENB’s assets and liabilities to a new obligor without the approval of AENB’s creditors; (2) to enforce the terms of AENB’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which AENB is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmation or repudiation of which is determined by the FDIC to promote the orderly administration of AENB. In addition, the claims of holders of U.S. deposit liabilities and certain claims for administrative expenses of the FDIC against AENB would be afforded priority over other general unsecured claims against AENB, including claims of debt holders and depositors in non-U.S. offices, in the liquidation or other resolution of AENB. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of AENB, the debt holders and depositors in non-U.S. offices would be treated differently from, and could receive substantially less, if anything, than the depositors in the U.S. offices of AENB. +Other Banking Regulations +Source of Strength +The Company is required to act as a source of financial and managerial strength to its U.S. bank subsidiary, AENB, and may be required to commit capital and financial resources to support AENB. Such support may be required at times when, absent this requirement, the Company otherwise might determine not to provide it. Capital loans by the Company to AENB are subordinate in right of payment to deposits and to certain other indebtedness of AENB. In the event of the Company’s bankruptcy, any commitment by the Company to a federal banking regulator to maintain the capital of AENB will be assumed by the bankruptcy trustee and entitled to a priority of payment. +Transactions Between AENB and its Affiliates +Certain transactions (including loans and credit extensions from AENB) between AENB and its affiliates (including the Company, TRS and their other subsidiaries) are subject to quantitative and qualitative limitations, collateral requirements and other restrictions imposed by statute and regulation. Transactions subject to these restrictions are generally required to be made on an arm’s-length basis. +FDIC Deposit Insurance and Insurance Assessments +AENB accepts deposits that are insured by the FDIC up to the applicable limits. Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices; is in an unsafe or unsound condition to continue operations; or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that might lead to termination of deposit insurance at AENB. The FDIC’s deposit insurance fund is funded by assessments on insured depository institutions, including AENB, which are subject to adjustment by the FDIC. +10 +Table of Contents +Community Reinvestment Act +AENB is subject to the CRA, which imposes affirmative, ongoing obligations on depository institutions to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. In December 2019, the OCC and FDIC issued a notice of proposed rulemaking intended to (i) clarify which activities qualify for CRA credit; (ii) update where activities count for CRA credit; and (iii) change the methods for CRA measurement, data collection, recordkeeping and reporting. +Consumer Financial Products Regulation +In the United States, our marketing, sale and servicing of consumer financial products and our compliance with certain federal consumer financial laws are supervised and examined by the CFPB, which has broad rulemaking and enforcement authority over providers of credit, savings and payment services and products, and authority to prevent “unfair, deceptive or abusive” acts or practices. In addition, a number of U.S. states have significant consumer credit protection, disclosure and other laws (in certain cases more stringent than U.S. federal laws). U.S. federal law also regulates abusive debt collection practices, which, along with bankruptcy and debtor relief laws, can affect our ability to collect amounts owed to us or subject us to regulatory scrutiny. +On May 7, 2019, the CFPB issued proposed rules that would set forth additional requirements for third-party debt collection agencies, which we use in the ordinary course of business. This proposal is not expected to result in final rules, if any, becoming effective before 2021. +We are also regulated in the United States under the “money transmitter” or “sale of check” laws in effect in most states. In addition, we are required by the laws of many states to comply with unclaimed and abandoned property laws, under which we must pay to states the face amount of any Travelers Cheque or prepaid card that is uncashed or unredeemed after a period of time depending on the type of product. +In countries outside the United States, regulators continue to focus on a number of key areas impacting our card-issuing businesses, particularly consumer protection (such as in the European Union (EU), the United Kingdom and Canada) and responsible lending (such as in Australia, Mexico, New Zealand and Singapore), with increasing importance on and attention to customers and outcomes rather than just ensuring compliance with local rules and regulations. Regulators’ expectations of firms in relation to their compliance, risk and control frameworks continue to increase and regulators are placing significant emphasis on a firm’s systems and controls relating to the identification and resolution of issues. +Payments Regulation +Legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +The EU, Australia and other jurisdictions have focused on interchange fees (that is, the fee paid by the bankcard merchant acquirer to the card issuer in payment networks like Visa and Mastercard), as well as the rules, contract terms and practices governing merchant card acceptance. For example, in April 2019, the European Commission accepted commitments by Visa and Mastercard to significantly reduce inter-regional multilateral interchange fees. +Regulation and other governmental actions relating to pricing or practices could affect all networks directly or indirectly, as well as adversely impact consumers and merchants. Among other things, regulation of bankcard fees has negatively impacted and may continue to negatively impact the discount revenue we earn, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or the terms of card acceptance for merchants, and we have largely exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions, for example. +In various countries, such as certain Member States in the EU and Australia, merchants are permitted by law to surcharge card purchases. In addition, the laws of a number of states in the United States that prohibit surcharging have been challenged in litigation brought by merchant groups and some such laws have been overturned. Surcharging is an adverse customer experience and could have a material adverse effect on us if it becomes widespread, particularly where it only or disproportionately impacts our business. In addition, other steering practices that are permitted by regulation in some countries could also have a material adverse effect on us if they become widespread. See “ Surcharging or steering by merchants could materially adversely affect our business and results of operations ” under “Risk Factors.” +11 +Table of Contents +In Canada, regulators have prompted the major international card networks to make voluntary commitments on pricing, specifically interchange fee levels; as American Express does not operate with interchange fees in Canada, our commitments extend to maintaining current pricing practices and complying with certain other practices. +In some countries governments have established regulatory regimes that require international card networks to be locally licensed and/or to localize aspects of their operations. For example, the Reserve Bank of India, which has broad power under the Payment and Settlement Systems Act, 2007 to regulate the membership and operations of card networks, has issued a mandate requiring payment systems operators in India to store certain payments data locally. The development and enforcement of payment system regulatory regimes generally continue to grow and may adversely affect our ability to compete effectively and maintain and extend our global network. +Governments in some countries also provide resources or protection to select domestic payment card networks. The People’s Bank of China officially accepted our application for a business operating license to process domestic currency transactions through a joint venture in mainland China. There can be no assurance that we will receive such a license, or, if we do, that we will be able to successfully compete in China with domestic payment card networks and alternative payment providers. +Privacy, Data Protection, Information and Cyber Security +Regulatory and legislative activity in the areas of privacy, data protection and information and cyber security continues to increase worldwide. We have established and continue to maintain policies and a governance framework to comply with applicable privacy, data protection and information and cyber security laws, meet evolving customer expectations and support and enable business innovation and growth. +Our regulators are increasingly focused on ensuring that our privacy, data protection and information and cyber security-related policies and practices are adequate to inform customers of our data collection, use, sharing and/or security practices, to provide them with choices, if required, about how we use and share their information, and to appropriately safeguard their personal information and account access. Regulators are also focused on the policies and practices of our third-party vendors that may have access to our customer data or other information. +In the United States, certain of our businesses are subject to the privacy, disclosure and safeguarding provisions of the Gramm-Leach-Bliley Act (GLBA) and its implementing regulations and guidance. Among other things, GLBA imposes certain limitations on our ability to share consumers’ nonpublic personal information with nonaffiliated third parties and requires us to develop, implement and maintain a written comprehensive information security program containing safeguards that are appropriate to the size and complexity of our business, the nature and scope of our activities and the sensitivity of customer information that we process. Effective January 2020, the California Consumer Privacy Act requires us to offer expanded privacy rights to California residents who are not covered by GLBA. Various regulators, U.S. states and territories are considering similar requirements or have adopted laws, rules and regulations pertaining to privacy and/or information and cyber security that may be more stringent and/or expansive than federal requirements. +We are also subject to certain privacy, data protection and information and cyber security laws in other countries in which we operate (including countries in the EU, Australia, Canada, Japan, Hong Kong, India, Mexico, Singapore and the United Kingdom), some of which are more stringent and/or expansive than those in the United States. Some countries have also instituted laws requiring in-country data processing and/or in-country storage of data. Compliance with such laws could result in higher technology, administrative and other costs for us, could limit our ability to optimize the use of our closed-loop data, and could require use of local technology services. Some of these laws also require us to provide foreign governments broader access to our proprietary data and intellectual property. Data breach notification laws or regulatory activities to encourage breach notification are also becoming more prevalent in jurisdictions outside the United States in which we operate. +In Europe, the EU General Data Protection Regulation (GDPR) went into effect in May 2018 with significant fines for non-compliance (up to 4 percent of total annual worldwide revenue). It created additional legal and compliance obligations on companies that process personal data of individuals in the EU, irrespective of the geographical location of the company. We have made changes to our privacy practices to comply with these requirements, and continue to rely on our binding corporate rules as the primary method for lawfully transferring data from our European affiliates to our affiliates in the United States and elsewhere globally. The GDPR includes, among other things, a requirement for prompt notice of data breaches, in certain circumstances, to affected individuals and supervisory authorities. +In addition, the European Directive 2002/58/EC (the ePrivacy Directive) will continue to set out requirements for the processing of personal data and the protection of privacy in the electronic communications sector until the approval of the forthcoming ePrivacy Regulation. The ePrivacy Directive places restrictions on, among other things, the sending of unsolicited marketing communications, as well as on the collection and use of data about internet users. +12 +Table of Contents +The European Central Bank and the European Banking Authority have enacted secondary legislation focused on security breaches, outsourcing, strong customer authentication and information security-related policies. Likewise, a network and information security directive has been implemented into national laws by Member States in the EU. The Revised Payment Services Directive (PSD2) also contains regulatory requirements on strong customer authentication, open access to customer data and payment capabilities, and measures to prevent security incidents. +Anti-Money Laundering, Sanctions and Anti-Corruption Compliance +We are subject to significant supervision and regulation, and an increasingly stringent enforcement environment, with respect to compliance with anti-money laundering (AML), sanctions and anti-corruption laws and regulations in the United States and in other jurisdictions in which we operate. Failure to maintain and implement adequate programs and policies and procedures for AML, sanctions and anti-corruption compliance could have serious financial, legal and reputational consequences. +Anti-Money Laundering +American Express is subject to a significant number of AML laws and regulations as a result of being a financial company headquartered in the United States, as well as having a global presence. In the United States, the majority of AML requirements are derived from the Currency and Foreign Transactions Reporting Act and the accompanying regulations issued by the U.S. Department of the Treasury (collectively referred to as the Bank Secrecy Act), as amended by the USA PATRIOT Act of 2001 (the Patriot Act). In Europe, AML requirements are largely the result of countries transposing the 4th EU Anti-Money Laundering Directive (and preceding EU Anti-Money Laundering Directives) into local laws and regulations. EU Member States are required to implement the 5th and 6th EU Anti-Money Laundering Directives by January 10, 2020 and December 3, 2020, respectively. Numerous other countries, such as Argentina, Australia, Canada, India, Mexico, New Zealand and Russia, have also enacted or proposed new or enhanced AML legislation and regulations applicable to American Express. +Among other things, these laws and regulations require us to establish AML programs that meet certain standards, including, in some instances, expanded reporting, particularly in the area of suspicious transactions, and enhanced information gathering and recordkeeping requirements. Any errors, failures or delays in complying with federal, state or foreign AML and counter-terrorist financing laws could result in significant criminal and civil lawsuits, penalties and forfeiture of significant assets or other enforcement actions. +Office of Foreign Assets Control Regulation +The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. The United States prohibits U.S. persons from engaging with individuals and entities identified as “Specially Designated Nationals,” such as terrorists and narcotics traffickers. These prohibitions are administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) and are typically known as the OFAC rules. The OFAC rules prohibit U.S. persons from engaging in financial transactions with or relating to the prohibited individual, entity or country, require the blocking of assets in which the individual, entity or country has an interest, and prohibit transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons) to such individual, entity or country. Blocked assets (e.g., property or bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. We maintain a global sanctions program designed to ensure compliance with OFAC requirements. Failure to comply with such requirements could subject us to serious legal and reputational consequences, including criminal penalties. +Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) to the Securities Exchange Act of 1934, as amended (the Exchange Act), an issuer is required to disclose in its annual or quarterly reports, as applicable, whether it or any of its affiliates knowingly engaged in certain activities, transactions or dealings relating to Iran or with individuals or entities designated pursuant to certain Executive Orders. Disclosure is generally required even where the activities, transactions or dealings were conducted outside the United States by non-U.S. affiliates in compliance with applicable law, and whether or not the activities are sanctionable under U.S. law. +American Express Global Business Travel (GBT) and certain entities that may be considered affiliates of GBT have informed us that during the year ended December 31, 2019, approximately 30 visas were obtained from Iranian embassies and consulates around the world in connection with certain travel arrangements on behalf of clients and reservations were booked at one hotel that may be owned, directly or indirectly, or may otherwise be affiliated with, the Government of Iran. GBT had negligible gross revenues and net profits attributable to these transactions and intends to continue to engage in these activities on a limited basis so long as such activities are permitted under U.S. law. +13 +Table of Contents +Anti-Corruption +We are subject to complex international and U.S. anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act (the FCPA), the UK Bribery Act and other laws that prohibit the making or offering of improper payments. The FCPA makes it illegal to corruptly offer or provide anything of value to foreign government officials, political parties or political party officials for the purpose of obtaining or retaining business or an improper advantage. The FCPA also requires us to strictly comply with certain accounting and internal controls standards. In recent years, enforcement of the FCPA has become more intense. The UK Bribery Act also prohibits commercial bribery and the receipt of a bribe, and makes it a corporate offense to fail to prevent bribery by an associated person, in addition to prohibiting improper payments to foreign government officials. Failure of the Company, our subsidiaries, colleagues, contractors or agents to comply with the FCPA, the UK Bribery Act and other laws can expose us and/or individual colleagues to investigation, prosecution and potentially severe criminal and civil penalties. +Compensation Practices +Our compensation practices are subject to oversight by the Federal Reserve. The federal banking regulators’ guidance on sound incentive compensation practices sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation plans do not encourage imprudent risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should (1) provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks, (2) be compatible with effective internal controls and risk management, and (3) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in our compensation practices that are identified by the Federal Reserve or other banking regulators in connection with its review of our compensation practices may be incorporated into our supervisory ratings, which can affect our ability to make acquisitions or perform other actions. Enforcement actions may be taken against us if our incentive compensation arrangements or related risk-management control or governance processes are determined to pose a risk to our safety and soundness and we have not taken prompt and effective measures to correct the deficiencies. +In May 2016, the federal banking regulators, the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency and the National Credit Union Administration re-proposed a rule, originally proposed in 2011, on incentive-based compensation practices. The re-proposed rule would apply deferral, downward adjustment and forfeiture, and clawback requirements to incentive-based compensation arrangements granted to senior executive officers and significant risk-takers of covered institutions, with specific requirements varying based on the asset size of the covered institution and the category of employee. If these or other regulations are adopted in a form similar to what has been proposed, they will impose limitations on the manner in which we may structure compensation for our colleagues, which could adversely affect our ability to hire, retain and motivate key colleagues. +14 +Table of Contents +INFORMATION ABOUT OUR EXECUTIVE OFFICERS +Set forth below, in alphabetical order, is a list of our executive officers as of February 13, 2020, including each executive officer’s principal occupation and employment during the past five years and reflecting recent organizational changes. None of our executive officers has any family relationship with any other executive officer, and none of our executive officers became an officer pursuant to any arrangement or understanding with any other person. Each executive officer has been elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer’s age is indicated by the number in parentheses next to his or her name. +15 +Table of Contents +DOUGLAS E. BUCKMINSTER — Group President, Global Consumer Services Group +Mr. Buckminster (59) has been Group President, Global Consumer Services Group since February 2018. Prior thereto, he had been President, Global Consumer Services Group since October 2015 and President, Global Network and International Card Services since February 2012. +JEFFREY C. CAMPBELL — Chief Financial Officer +Mr. Campbell (59) has been Chief Financial Officer since August 2013. +MARC D. GORDON — Chief Information Officer +Mr. Gordon (59) has been Chief Information Officer since September 2012. +MONIQUE HERENA — Chief Colleague Experience Officer +Ms. Herena (48) has been Chief Colleague Experience Officer since April 2019. Ms. Herena joined American Express from BNY Mellon, where she served as the Chief Human Resources Officer and Senior Executive Vice President, Human Resources, Marketing and Communications since 2014. +RAYMOND JOABAR — Chief Risk Officer and President, Global Risk, Banking & Compliance +Mr. Joabar (54) has been Chief Risk Officer and President, Global Risk, Banking & Compliance since September 2019. Prior thereto, he had been President of International Consumer Services and Global Travel and Lifestyle Services since February 2018. He also served as Executive Vice President, Global Servicing Network from February 2016 to February 2018 and Executive Vice President, World Service from November 2015 to February 2016. Prior thereto, he had been Executive Vice President, Global Credit Administration from February 2014 to November 2015. +ANNA MARRS — President, Global Commercial Services +Ms. Marrs (46) has been President, Global Commercial Services since September 2018. Ms. Marrs joined American Express from Standard Chartered Bank, where she served as Regional CEO, ASEAN and South Asia since November 2016 and CEO, Commercial and Private Banking since October 2015. She joined Standard Chartered Bank as Group Head, Strategy and Corporate Development in January 2012. +DENISE PICKETT — President, Global Services Group +Ms. Pickett (54) has been President, Global Services Group since September 2019. Prior thereto, she had been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2018 and President, U.S. Consumer Services since October 2015. She also served as President, American Express OPEN from February 2014 to October 2015. +ELIZABETH RUTLEDGE — Chief Marketing Officer +Ms. Rutledge (58) has been Chief Marketing Officer since February 2018. Prior thereto, she had been Executive Vice President, Global Advertising & Media since February 2016 and Executive Vice President, Card Products & Benefits since May 2013. +LAUREEN E. SEEGER — Chief Legal Officer +Ms. Seeger (58) has been Chief Legal Officer since July 2014. +JENNIFER SKYLER — Chief Corporate Affairs Officer +Ms. Skyler (43) has been Chief Corporate Affairs Officer since October 2019. Ms. Skyler joined American Express from the We Company, where she had been Chief Communications Officer from January 2018 to September 2019. Prior thereto, she had been Global Head of Public Affairs from January 2016 to January 2018. Prior thereto, she had been Director, Consumer Communications at Facebook from December 2012 to December 2015. +STEPHEN J. SQUERI — Chairman and Chief Executive Officer +Mr. Squeri (60) has been Chairman and Chief Executive Officer since February 2018. Prior thereto, he had been Vice Chairman since July 2015. Prior thereto, he had been Group President, Global Corporate Services since November 2011. +ANRÉ WILLIAMS — Group President, Global Merchant and Network Services +Mr. Williams (54) has been Group President, Global Merchant and Network Services since February 2018. Prior thereto, he had been President of Global Merchant Services and Loyalty since October 2015 and President, Global Merchant Services since November 2011. +16 +Table of Contents +ADDITIONAL INFORMATION +We maintain an Investor Relations website at http://ir.americanexpress.com. We make available free of charge, on or through this website, our annual, quarterly and current reports and any amendments to those reports as soon as reasonably practicable following the time they are electronically filed with or furnished to the SEC. +In addition, we routinely post financial and other information, some of which could be material to investors, on our Investor Relations website. Information regarding our corporate responsibility and sustainability initiatives are available on our Corporate Responsibility website at http://about.americanexpress.com/corporate-responsibility. +The content of any of our websites referred to in this report is not incorporated by reference into this report or any other report filed with or furnished to the SEC. We have included such website addresses only as inactive textual references and do not intend them to be active links. +You can find certain statistical disclosures required of bank holding companies starting on page A-1, which are incorporated herein by reference. +Our business as a whole has not experienced significant seasonal fluctuations, although card billed business tends to be moderately higher in the fourth quarter than in other quarters. As a result, the amount of Card Member loans and receivables outstanding tend to be moderately higher during that quarter. The average discount rate also tends to be slightly lower during the fourth quarter due to a higher level of retail-related billed business volumes. +ITEM 1A. RISK FACTORS +This section highlights specific risks that could affect us and our businesses, broadly categorized as “Strategic, Business and Competitive Risks,” “Legal, Regulatory and Compliance Risks” and “Credit, Liquidity and Market Risks.” You should carefully consider each of the following risks and all of the other information set forth in this Annual Report on Form 10-K, including the “Risk Management” section under “MD&A,” which describes our approach to identifying, monitoring and managing the risks we assume in conducting our businesses and provides certain quantitative and qualitative disclosures about market risks. Based on the information currently known to us, we believe the following information identifies the most significant risk factors affecting us. However, the risks and uncertainties we face are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. +If any of the following risks develop into actual events or if the circumstances described in the risks occur or continue to occur, these events or circumstances could have a material adverse effect on our business, financial condition or results of operations. These events or circumstances could also have a negative effect on the trading price of our securities. +Strategic , Business and Competitive Risks +Difficult conditions in the business and economic environment, as well as political conditions in the United States and elsewhere, may materially adversely affect our business and results of operations. +Our results of operations are materially affected by economic, market, political and social conditions in the United States and abroad. We offer a broad array of products and services to consumers, small businesses and commercial clients and thus are very dependent upon the level of consumer and business activity and the demand for payment and financing products. Slow economic growth, volatile or deteriorating economic conditions or shifts in broader consumer and business trends significantly impact customer behaviors, including spending on our cards, the ability and willingness of Card Members to borrow and pay amounts owed to us, and demand for fee-based products and services. Political conditions, prolonged or recurring government shutdowns, regional hostilities and the prospect or occurrence of more widespread conflicts, social upheaval, fiscal and monetary policies, trade wars and tariffs could also negatively affect consumer and business spending, including travel patterns and business investment, and demand for credit. +Factors such as consumer spending and confidence, unemployment rates, business investment, geopolitical instability, election results, government spending, trade relationships with other countries, interest rates, taxes, energy costs, the volatility and strength of the capital markets, inflation and deflation all affect the economic environment and, ultimately, our profitability. Such factors may also cause our earnings, billings, loan balances, credit metrics and margins to fluctuate and diverge from expectations of analysts and investors, who may have differing assumptions regarding their impact on our business, adversely affecting, and/or increasing the volatility of, the trading price of our common shares. +17 +Table of Contents +Travel and entertainment expenditures, which comprised approximately 25 percent of our U.S. billed business during 2019, for example, are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns. Likewise, spending by small businesses and corporate clients, which comprised approximately 41 percent of our worldwide billed business during 2019, depends in part on the economic environment and a favorable climate for continued business investment and new business formation. Increases in delinquencies and write-off rates as a result of increases in bankruptcies, unemployment rates, changes in customer behaviors or otherwise could also have a material adverse effect on our results of operations. The consequences of negative circumstances impacting us or the environment generally can be sudden and severe. +Our business is subject to the effects of geopolitical events, weather, natural disasters and other conditions. +Geopolitical events, terrorist attacks, natural disasters, severe weather conditions, floods, health pandemics (including the recent coronavirus outbreak), information or cyber security incidents (including intrusion into or degradation of systems or technology by cyberattackers) and other catastrophic events can have a material adverse effect on our business. Because of our proximity to the World Trade Center, our headquarters were damaged as a result of the terrorist attacks of September 11, 2001. Recent hurricanes and other natural disasters have impacted spending and credit performance in the areas affected. Similar events or other disasters or catastrophic events in the future, and events impacting other sectors of the economy, including the telecommunications and energy sectors, could have a negative effect on our businesses and infrastructure, including our technology and systems. Climate change may exacerbate certain of these threats, including the frequency and severity of weather-related events. Card Members in California, New York, Florida, Texas, Georgia and New Jersey account for a significant portion of U.S. Consumer billed business and Card Members loans, and our results of operations could be impacted by events or conditions that disproportionately or specifically affect one or more of those states. +Because we derive a portion of our revenues from travel-related spending, our business is sensitive to safety concerns related to travel and tourism, limitations on travel and mobility, and health-related risks, including travel restrictions and bans as a result of the recent coronavirus outbreak. In addition, disruptions in air travel and other forms of travel can result in the payment of claims under travel interruption insurance policies we offer and, if such disruptions to travel are prolonged, they can materially adversely affect overall travel-related spending. +If the conditions described above (or similar ones) result in widespread or lengthy disruptions to travel, they could have a material adverse effect on our results of operations. Card Member spending may also be negatively impacted in areas affected by natural disasters or other catastrophic events. The impact of such events on the overall economy may also adversely affect our financial condition or results of operations. +The exit of the United Kingdom from the European Union could materially adversely impact our business, results of operations and financial condition. +Our business in the United Kingdom and elsewhere may be negatively impacted by the exit of the United Kingdom from the EU (commonly referred to as Brexit) on January 31, 2020, including from a deterioration of the economic environment in the United Kingdom and other countries in which we operate that adversely affects spending on our cards and the ability and willingness of Card Members to pay amounts owed to us. We may also experience increased volatility in the value of the pound sterling, the euro and other European currencies, which could further strengthen the U.S. dollar, adversely impacting the results of operations from our international activities. In addition, Brexit could lead to legal uncertainty and potentially divergent national laws and regulations in the United Kingdom and the EU, and we may incur additional costs or need to make operational changes that reduce revenue as we adapt to potentially divergent regulatory frameworks. Any of these effects of Brexit, among others, could adversely affect our business and financial results. As of December 31, 2019, the United Kingdom constituted approximately 4 percent of our worldwide billed business and the EMEA region as a whole constituted approximately 11 percent. We have made changes to the structure of our business operations in Europe in anticipation of Brexit, although the financial, trade and legal implications of Brexit remain uncertain and may be more severe than expected given the lack of comparable precedent. +Our operating results may materially suffer because of substantial and increasingly intense competition worldwide in the payments industry. +The payments industry is highly competitive, and we compete with card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and ACH), as well as evolving and growing alternative, non-traditional payment and financing providers. If we are not able to differentiate ourselves from our competitors, develop compelling value propositions for our customers and/or effectively grow in areas such as mobile and online payments and emerging technologies, we may not be able to compete effectively. +18 +Table of Contents +We believe Visa and Mastercard are larger than we are in most countries. As a result, card issuers and acquirers on the Visa and Mastercard networks may be able to benefit from the dominant position, scale, resources, marketing and pricing of those networks. Our business may also be increasingly negatively affected if we are unable to increase or maintain merchant acceptance and our cards are not accepted at merchants that accept cards on the Visa and Mastercard networks. +Some of our competitors have developed, or may develop, substantially greater financial and other resources than we have and may offer richer value propositions or a wider range of programs and services than we offer or may use more effective advertising, marketing or cross-selling strategies to acquire and retain more customers, capture a greater share of spending and borrowings, establish and develop more attractive cobrand card and other partner programs and maintain greater merchant acceptance than we have. We may not be able to compete effectively against these threats or respond or adapt to changes in consumer spending habits as effectively as our competitors. Expenses such as Card Member rewards and Card Member services expenses could continue to increase as we improve our value propositions for Card Members, including in response to increased competition. +Spending on our cards could continue to be impacted by increasing consumer usage of charge, credit and debit cards issued on other networks, as well as adoption of alternative payment systems. The fragmentation of customer spending to take advantage of different merchant or card incentives or for convenience with technological solutions may continue to increase. To the extent other payment mechanisms, systems and products continue to successfully expand, our discount revenues and our ability to access transaction data through our integrated payments platform could be negatively impacted. For example, companies that control access to consumer and merchant payment method choices at the point of sale or through digital wallets, commerce-related experiences, mobile applications or other technologies could choose not to accept, suppress use of, or degrade the experience of using our products or could restrict our access to our customers and transaction data. Such companies could also require payments from us to participate in such digital wallets, experiences or applications, impacting our profitability on transactions. +The competitive value of our closed-loop data may also be diminished as traditional and non-traditional competitors use other, new data sources and technologies to derive similar insights. Certain regulations, such as PSD2 in Europe and open banking initiatives in various jurisdictions around the world, could also diminish the value of our closed-loop data or the demand for our products and services by disintermediating existing financial services providers. +To the extent we expand into new business areas and new geographic regions, we may face competitors with more experience and more established relationships with relevant customers, regulators and industry participants, which could adversely affect our ability to compete. Laws and business practices that favor local competitors, require card transactions to be routed over domestic networks or prohibit or limit foreign ownership of certain businesses could limit our growth in international regions. We may face additional compliance and regulatory risks to the extent that we expand into new business areas, and we may need to dedicate more expense, time and resources to comply with regulatory requirements than our competitors, particularly those that are not regulated financial institutions. +Many of our competitors are subject to different, and in some cases, less stringent, legislative and regulatory regimes, and some may have lower cost structures and more agile business models and systems. More restrictive laws and regulations that do not apply to all of our competitors can put us at a disadvantage, including prohibiting us from engaging in certain transactions, regulating our business practices or adversely affecting our cost structure. +We face intense competition for partner relationships, which could result in a loss or renegotiation of these arrangements that could have a material adverse impact on our business and results of operations. +In the ordinary course of our business we enter into different types of contractual arrangements with business partners in a variety of industries. For example, we have partnered with Delta, Marriott, British Airways and Hilton, as well as many others globally, to offer cobranded cards for consumers and small businesses, and through our Membership Rewards program we have partnered with businesses in many industries, including Delta and others in the airline industry, to offer benefits to Card Member participants. See “Business Partners and Relationships” under “Business” for additional information on our business partnerships, including with Delta. +Competition for relationships with key business partners is very intense and there can be no assurance we will be able to grow or maintain these partner relationships or that they will remain as profitable. Establishing and retaining attractive cobrand card partnerships is particularly competitive among card issuers and networks as these partnerships typically appeal to high-spending loyal customers. All of our cobrand portfolios in the aggregate accounted for approximately 18 percent of our worldwide billed business for the year ended December 31, 2019. Card Member loans related to our cobrand portfolios accounted for approximately 38 percent of our worldwide Card Member loans as of December 31, 2019. +19 +Table of Contents +Cobrand arrangements are entered into for a fixed period, generally ranging from five to ten years, and will terminate in accordance with their terms, including at the end of the fixed period unless extended or renewed at the option of the parties, or upon early termination as a result of an event of default or otherwise. We work with our cobrand partners on an ongoing basis to demonstrate the value we deliver and evolve our relationships for the benefit of both parties. We face the risk that we could lose partner relationships, even after we have invested significant resources in the relationships. We may also choose to not renew certain cobrand relationships. The volume of billed business could decline and Card Member attrition could increase, in each case, significantly as a result of the termination of one or more cobrand partnership relationships. In addition, some of our cobrand arrangements provide that, upon expiration or termination, the cobrand partner may purchase or designate a third party to purchase the loans generated with respect to its program, which could result in the loss of the card accounts and a significant decline in our Card Member loans outstanding. +We regularly seek to extend or renew cobrand arrangements in advance of the end of the contract term and face the risk that existing relationships will be renegotiated with less favorable terms for us or that we may be unable to renegotiate on terms that are acceptable to us, as competition for such relationships continues to increase. We make payments to our cobrand partners, which can be significant, based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The amount we pay to our cobrand partners has increased, particularly in the United States, and may continue to increase as arrangements are renegotiated due to increasingly intense competition for cobrand partners among card issuers and networks. See "Off-Balance Sheet Arrangements and Contractual Obligations" under "MD&A" for additional information regarding commitments for payments to certain cobrand partners. +The loss of exclusivity arrangements with business partners, the loss of the partner relationship altogether (whether by non-renewal at the end of the contract period, such as the end of our relationship with Costco in the United States in 2016, or as the result of a merger, legal or regulatory action or otherwise, such as the withdrawal of American Airlines in 2014 from our Airport Club Access program for Centurion ® and Platinum Card ® Members) or the renegotiation of existing partnerships with terms that are significantly worse for us could have a material adverse impact on our business and results of operations. See "Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition" for information on the uncertainty regarding our cobrand and agent relationships in the EU. In addition, any publicity associated with the loss of any of our key business partners could harm our reputation, making it more difficult to attract and retain Card Members and merchants, and could weaken our negotiating position with our remaining and prospective business partners. +Arrangements with our business partners represent a significant portion of our business. We are exposed to risks associated with our business partners, including reputational issues, business slowdowns, bankruptcies, liquidations, restructurings and consolidations, and the possible obligation to make payments to our partners. +Our success is, in many ways, dependent on the success of our business partners. From customer acquisition to cobranding arrangements, from participation in our rewards programs to facilitating B2B supplier payments for our corporate clients, we rely on our business partners across many aspects of our company and our arrangements with business partners represent a significant portion of our business. See “Business Partners and Relationships” under “Business” for additional information on our business partnerships. To the extent any of our partners fail to effectively promote and support our products, experience a slowdown in their business, operational disruptions, reputational issues or loss of consumer confidence, or are otherwise unable to meet our expectations or those of their other stakeholders, our business may be materially negatively impacted. In addition, we may be obligated to make or accelerate payments to certain business partners such as cobrand partners upon the occurrence of certain triggering events such as a shortfall in certain performance and revenue levels. If we are not able to effectively manage these triggering events, we could unexpectedly have to make payments to these partners, which could have a negative effect on our financial condition and results of operations. See “Contractual Obligations” under “MD&A” for additional information on financial commitments related to agreements with certain cobrand partners. +Similarly, we are exposed to risk from bankruptcies, liquidations, insolvencies, financial distress, restructurings, consolidations and other similar events that may occur in any industry representing a significant portion of our billed business, which could negatively impact particular card products and services (and billed business generally) and our financial condition and results of operations. We could also be materially impacted if we were obligated or elected to reimburse Card Members for products and services purchased from merchants that have ceased operations or stopped accepting our cards. For example, we are exposed to credit risk in the airline industry to the extent we protect Card Members against non-delivery of goods and services, such as where we have remitted payment to an airline for a Card Member purchase of tickets that have not yet been used or “flown.” If we are unable to collect the amount from the airline, we may bear the loss for the amount credited to the Card Member. Spending at airline merchants accounted for approximately 8 percent of our worldwide billed business for the year ended December 31, 2019. +For additional information relating to the general risks related to the airline industry, see “Risk Management—Institutional Credit Risk—Exposure to the Airline and Travel Industry” under “MD&A.” +20 +Table of Contents +We face continued intense competitive pressure that may materially impact the prices we charge merchants that accept our cards for payment for goods and services. +Unlike our competitors in the payments industry that rely on revolving credit balances to drive profits, our business model is more focused on Card Member spending. Discount revenue, which represents fees generally charged to merchants when Card Members use their cards to purchase goods and services on our network, is primarily driven by billed business volumes and is our largest single revenue source. Our average merchant discount rate has been impacted by regulatory changes affecting competitor pricing in certain international countries. We also face pressure from competitors that have other sources of income or lower costs that can make their pricing more attractive to business partners and merchants. Merchants are also able to negotiate incentives and pricing concessions from us as a condition to accepting our cards or being cobrand partners. As merchants consolidate and become even larger, we may have to increase the amount of incentives and/or concessions we provide to such merchants, which could materially and adversely affect our results of operations. Competitive and regulatory pressures on pricing could make it difficult to offset the costs of these incentives. We have also experienced erosion of our average merchant discount rate as we increase merchant acceptance. We may not be successful in significantly expanding merchant acceptance or offsetting rate erosion with volumes at new merchants. +In addition, the regulatory environment and differentiated payment models and technologies from non-traditional players in the alternative payments space could pose challenges to our traditional payment model and adversely impact our average merchant discount rate. Some merchants continue to invest in their own payment solutions, such as proprietary-branded mobile wallets, using both traditional and new technology platforms. If merchants are able to drive broad consumer adoption and usage, it could adversely impact our average merchant discount rate and billed business volumes. +A continuing priority of ours is to drive greater and differentiated value to our merchants which, if not successful, could negatively impact our discount revenue and financial results. We may not succeed in maintaining merchant discount rates or offsetting the impact of declining merchant discount rates, which could materially and adversely affect our revenues and profitability, and therefore our ability to invest in innovation and in value-added services for merchants and Card Members. +Surcharging or steering by merchants could materially adversely affect our business and results of operations. +In certain countries, such as Australia and certain Member States in the EU, merchants are expressly permitted by law to surcharge certain card purchases. In jurisdictions allowing surcharging, we have seen merchant surcharging on American Express cards in certain merchant categories, and in some cases, either the surcharge is greater than that applied to Visa and Mastercard cards or Visa and Mastercard cards are not surcharged at all (practices that are known as differential surcharging), even though there are many cards issued on competing networks that have an equal or greater cost of acceptance for the merchant. In addition, the laws of a number of states in the United States that prohibit surcharging have been overturned in litigation brought by merchant groups. +We also encounter merchants that accept our cards, but tell their customers that they prefer to accept another type of payment or otherwise seek to suppress use of our cards. Our Card Members value the ability to use their cards where and when they want to, and we, therefore, take steps to meet our Card Members’ expectations and to protect the American Express brand by prohibiting this form of discrimination, subject to local legal requirements. +If surcharging, steering or other forms of discrimination become widespread, American Express cards and credit and charge cards generally could become less desirable to consumers, which could result in a decrease in cards-in-force and transaction volumes. The impact could vary depending on such factors as: the industry or manner in which a surcharge is levied; how Card Members are surcharged or steered to other card products or payment forms at the point of sale; the ease and speed of implementation for merchants, including as a result of new or emerging technologies; the size and recurrence of the underlying charges; and whether and to what extent these actions are applied to other forms of payment, including whether it varies depending on the type of card (e.g., credit or debit), product, network, acquirer or issuer. Discrimination against American Express cards could have a material adverse effect on our business, financial condition and results of operations, particularly to the extent it disproportionately impacts our Card Members or our business. +21 +Table of Contents +We may not be successful in our efforts to promote card usage through marketing and promotion, merchant acceptance and Card Member rewards and services, or to effectively control the costs of such investments, both of which may materially impact our profitability. +Revenue growth is dependent on increasing consumer and business spending on our cards, growing loan balances and increasing fee revenue. We have been investing in a number of growth initiatives, including to attract new Card Members, reduce Card Member attrition and capture a greater share of customers’ total spending and borrowings. There can be no assurance that our investments to acquire Card Members, provide differentiated features and services and increase usage of our cards will continue to be effective. In addition, if we develop new products or offers that attract customers looking for short-term incentives rather than incentivize long-term loyalty, Card Member attrition and costs could increase. Increasing spending on our cards also depends on our continued expansion of merchant acceptance of our cards. If we are unable to continue growing merchant acceptance or merchants decide to no longer accept American Express cards, our business could suffer. Further, expanding our service offerings, adding customer acquisition channels and forming new partnerships or renewing current partnerships could have higher costs than our current arrangements, and could adversely impact our average discount rate or dilute our brand. +Another way we invest in customer value is through our Membership Rewards program, as well as other Card Member benefits. Any significant change in, or failure by management to reasonably estimate, actual redemptions of Membership Rewards points and associated redemption costs could adversely affect our profitability. We rely on third parties for certain redemption options and may not be able to continue to offer such redemption options in the future, which could diminish the value of the program for our Card Members. Our two largest redemption partners are Amazon and Delta. In addition, many credit card issuers have instituted rewards and cobrand programs and may introduce programs and services that are similar to or more attractive than ours. Our inability to continue to differentiate our products and services generally could materially adversely affect us. +We may not be able to cost-effectively manage and expand Card Member benefits, including containing the growth of marketing, promotion, rewards and Card Member services expenses in the future. If such expenses increase beyond our expectations, we will need to find ways to offset the financial impact by increasing payments volume, increasing other areas of revenues such as fee-based revenues, or both. We may not succeed in doing so, particularly in the current competitive and regulatory environment. +Our brand and reputation are key assets of our Company, and our business may be materially affected by how we are perceived in the marketplace. +Our brand and its attributes are key assets, and we believe our continued success depends on our ability to preserve, grow and leverage the value of our brand. Our ability to attract and retain consumer and small business Card Members and corporate clients is highly dependent upon the external perceptions of our level of service, trustworthiness, business practices, data use and protection, management, workplace culture, merchant acceptance, financial condition, our response to unexpected events and other subjective qualities. Negative perceptions or publicity regarding these matters — even if related to seemingly isolated incidents and whether or not factually correct—could erode trust and confidence and damage our reputation among existing and potential Card Members, corporate clients, merchants and partners, which could make it difficult for us to attract new customers and maintain existing ones. Negative public opinion could result from actual or alleged conduct in any number of activities or circumstances, including card practices, regulatory compliance, the use and protection of customer information and conduct by our colleagues, and from actions taken by regulators or others in response thereto. Discussion about such matters in social media channels can also cause rapid, widespread reputational harm to our brand. +Our brand and reputation may also be harmed by actions taken by third parties that are outside our control. For example, any shortcoming of or controversy related to a third-party vendor, business partner, merchant acquirer or network partner may be attributed by Card Members and merchants to us, thus damaging our reputation and brand value. The lack of acceptance, suppression of card usage or surcharging by merchants can also negatively impact perceptions of our brand and our products, lower overall transaction volume and increase the attractiveness of other payment products or systems. Adverse developments with respect to our industry may also, by association, negatively impact our reputation, or result in greater regulatory or legislative scrutiny or litigation against us. Furthermore, as a corporation with headquarters and operations located in the United States, a negative perception of the United States arising from its political or other positions could harm the perception of our company and our brand. Although we monitor developments for areas of potential risk to our reputation and brand, negative perceptions or publicity could materially and adversely affect our business volumes, revenues and profitability. +22 +Table of Contents +A major information or cyber security incident or an increase in fraudulent activity could lead to reputational damage to our brand and material legal, regulatory and financial exposure, and could reduce the use and acceptance of our charge and credit cards. +We and third parties process, transmit, store and provide access to account information in connection with our charge and credit cards and other products, and in the normal course of our business, we collect, analyze and retain significant volumes of certain types of personally identifiable and other information pertaining to our customers and colleagues. +Our networks and systems are subject to constant attempts to identify and exploit potential vulnerabilities in our operating environment with intent to disrupt our business operations and capture, destroy, manipulate or expose various types of information relating to corporate trade secrets, customer information, including Card Member, travel and loyalty program data, colleague information and other sensitive business information, including acquisition activity, non-public financial results and intellectual property. There are a number of motivations for cyber threat actors, including criminal activities such as fraud, identity theft and ransom, corporate or nation-state espionage, political agendas, public embarrassment with the intent to cause financial or reputational harm, intent to disrupt information technology systems, and to expose and exploit potential security and privacy vulnerabilities in corporate systems and websites. +Global financial institutions like us, as well as our customers, colleagues, regulators, vendors and other third parties, have experienced a significant increase in information and cyber security risk in recent years and will likely continue to be the target of increasingly sophisticated cyberattacks, including computer viruses, malicious or destructive code, ransomware, social engineering attacks (including phishing, impersonation and identity takeover attempts), corporate espionage, hacking, website defacement, denial-of-service attacks and other attacks and similar disruptions from the misconfiguration or unauthorized use of or access to computer systems. For example, we and other U.S. financial services providers have been the target of distributed denial-of-service attacks from sophisticated third parties. These threats can arise from external parties as well as insiders who knowingly or unknowingly engage in or enable malicious cyber activities. +We develop and maintain systems and processes aimed at detecting and preventing information and cyber security incidents and fraudulent activity, which require significant investment, maintenance and ongoing monitoring and updating as technologies and regulatory requirements change and as efforts to overcome security measures become more sophisticated. Despite our efforts, the possibility of information and cyber security incidents, malicious social engineering, corporate espionage, fraudulent or other malicious activities and human error or malfeasance cannot be eliminated entirely and will evolve as new and emerging technology is deployed, including the increasing use of personal mobile and computing devices that are outside of our network and control environments. Risks associated with each of these include theft of funds and other monetary loss, the disruption of our operations and the unauthorized disclosure, release, gathering, monitoring, misuse, modification, loss or destruction of confidential, proprietary, trade secret or other information (including account data information), the effects of which could be compounded if not detected quickly. Indeed, an information or cyber security incident may not be detected until well after it occurs and the severity and potential impact may not be fully known for a substantial period of time after it has been discovered. +Information or cyber security incidents, fraudulent activity and other actual or perceived failures to maintain confidentiality, integrity, privacy and/or security has led to increased regulatory scrutiny and may lead to regulatory investigations and intervention (such as mandatory card reissuance), increased litigation (including class action litigation), remediation, fines and response costs, negative assessments of us and our subsidiaries by banking regulators and rating agencies, reputational and financial damage to our brand, and reduced usage of our products and services, all of which could have a material adverse impact on our business. The disclosure of sensitive company information could also undermine our competitive advantage and divert management attention and resources. +Successful cyberattacks, data breaches, disruptions or other incidents related to the actual or perceived failures to maintain confidentiality, integrity, privacy and/or security at other large financial institutions, large retailers, travel and hospitality companies, government agencies or other market participants, whether or not we are impacted, could lead to a general loss of customer confidence that could negatively affect us, including harming the market perception of the effectiveness of our security measures or harming the reputation of the financial system in general, which could result in reduced use of our products and services. Such events could also result in legislation and additional regulatory requirements. Although we maintain cyber insurance, there can be no assurance that liabilities or losses we may incur will be covered under such policies or that the amount of insurance will be adequate. +23 +Table of Contents +The uninterrupted operation of our information systems is critical to our success and a significant disruption could have a material adverse effect on our business and results of operations. +Our information technology systems, including our transaction authorization, clearing and settlement systems, and data centers, may experience service disruptions or degradation because of technology malfunction, sudden increases in customer transaction volume, natural disasters, accidents, power outages, internet outages, telecommunications failures, fraud, denial-of-service and other cyberattacks, terrorism, computer viruses, vulnerabilities in hardware or software, physical or electronic break-ins, or similar events. Service disruptions or degradations could prevent access to our online services and account information, compromise or limit access to company or customer data, impede transaction processing and financial reporting, and lead to regulatory investigations and fines, increased regulatory oversight and litigation. Any such service disruption or degradation could adversely affect the perception of the reliability of our products and services and materially adversely affect our overall business, reputation and results of operations. +We rely on third-party providers for acquiring and servicing customers, technology, platforms and other services integral to the operations of our businesses. These third parties may act in ways that could materially harm our business. +We rely on third-party service providers, cobrand partners, merchants, customer acquisition channels, processors, aggregators, network partners and other third parties for services that are integral to our operations and are subject to the risk that activities of such third parties may adversely affect our business. As outsourcing, specialization of functions, third-party digital services and technology innovation within the payments industry increase (including with respect to mobile technologies, tokenization, big data, artificial intelligence and cloud storage solutions), more third parties are involved in processing card transactions and handling our data. For example, we rely on third parties for the timely transmission of accurate information across our global network, card acquisition and provision of services to our customers. If a service provider or other third party ceases to provide the data quality or communications capacity we expect or services upon which we rely, as a result of natural disaster, operational disruptions or errors, terrorism, information or cyber security incidents, or any other reason, the failure could interrupt or compromise the quality of our services to customers or impact our ability to grow our business. +The confidentiality, integrity, privacy, availability and/or security of data communicated over third-party networks or platforms or held by, or accessible to, third parties, including merchants that accept our cards, payment processors, payment intermediaries and our third-party vendors and business partners, could become compromised, which could lead to unauthorized use of our data or fraudulent transactions on our cards, as well as costs associated with responding to such an incident, including regulatory investigations and fines, increased regulatory oversight and litigation. For example, in March 2018, we were alerted by Expedia that certain customers who used Expedia’s Orbitz platform may have been victims of a cyberattack. The attack involved an Orbitz platform that served as the underlying booking engine for online travel websites, including Amextravel.com and travel booked through Amex Travel Representatives. +We are also exposed to the risk that a disruption or other event at a third party affecting one of our service providers or partners could impede their ability to provide to us services or data on which we rely to operate our business. Service providers or other third parties could also cease providing data to us or use our data in a way that diminishes the competitive value of our closed loop. +The management and oversight of multiple vendors increases our operational complexity and governance challenges and decreases our control. A failure to exercise adequate oversight over service providers, including compliance with service level agreements or regulatory or legal requirements, could result in regulatory actions, fines, litigation, sanctions or economic and reputational harm to us. In addition, we may not be able to effectively monitor or mitigate operational risks relating to our vendors’ service providers. We are also exposed to the risk that a service disruption at a common service provider to our vendors could impede their ability to provide services to us. Notwithstanding any attempts to diversify our reliance on third parties, we may not be able to effectively mitigate operational risks relating to our vendors’ use of common service providers. +If we are not able to invest successfully in, and compete at the leading edge of, technological developments across all our businesses, our revenue and profitability could be materially adversely affected. +Our industry is subject to rapid and significant technological changes. In order to compete in our industry, we need to continue to invest in technology across all areas of our business, including in transaction processing, data management and analytics, machine learning and artificial intelligence, customer interactions and communications, open banking and alternative payment mechanisms, authentication technologies and digital identification, tokenization, real-time settlement, and risk management and compliance systems. Incorporating new technologies into our products and services, including developing the appropriate governance and controls consistent with regulatory expectations, may require substantial expenditures and take considerable time, and ultimately may not be successful. We expect that new technologies in the payments industry will continue to emerge, and these new technologies may be superior to, or render obsolete, our existing technology. +24 +Table of Contents +The process of developing new products and services, enhancing existing products and services and adapting to technological changes and evolving industry standards is complex, costly and uncertain, and any failure by us to anticipate customers’ changing needs and emerging technological trends accurately could significantly impede our ability to compete effectively. Consumer and merchant adoption is a key competitive factor and our competitors may develop products, platforms or technologies that become more widely adopted than ours. In addition, we may underestimate the time and expense we must invest in new products and services before they generate significant revenues, if at all. +Our ability to develop, acquire or access competitive technologies or business processes on acceptable terms may also be limited by intellectual property rights that third parties, including competitors and potential competitors, may assert. In addition, our ability to adopt new technologies may be inhibited by the emergence of industry-wide standards, a changing legislative and regulatory environment, an inability to develop appropriate governance and controls, a lack of internal product and engineering expertise, resistance to change from Card Members or merchants, or the complexity of our systems. +We may not be successful in realizing the benefits associated with our acquisitions, strategic alliances, joint ventures and investment activity, and our business and reputation could be materially adversely affected. +We have acquired a number of businesses and have made a number of strategic investments, and continue to evaluate potential transactions. These transactions could be material to our financial condition and results of operations. There is no assurance that we will be able to successfully identify and secure future acquisition candidates on terms and conditions that are acceptable to us, or successfully complete proposed acquisitions and investments, which could impair our growth. The process of integrating an acquired company, business or technology could create unforeseen operating difficulties and expenditures, result in unanticipated liabilities, including legal claims, violations of laws, commercial disputes and information security vulnerabilities or breaches, and harm our business generally. It may take us longer than expected to fully realize the anticipated benefits of these transactions, and those benefits may ultimately be smaller than anticipated or may not be realized at all, which could materially adversely affect our business and operating results, including as a result of write-downs of goodwill and other intangible assets. +We may also face risks with other types of strategic transactions, such as the sale to InComm of the operations relating to our prepaid reloadable and gift card business. The reloadable operations have experienced disruptions in the past, impacting the ability of our prepaid customers to load and use their cards. If such operations are interrupted, suspended or terminated in the future, it could further negatively impact our customers’ experience, result in additional costs, litigation and regulatory action, and harm our business and reputation. +Joint ventures, including our GBT JV and our new joint venture in China, and minority investments inherently involve a lesser degree of control over business operations, thereby potentially increasing the financial, legal, operational and/or compliance risks associated with the joint venture or minority investment. In addition, we may be dependent on joint venture partners, controlling shareholders or management who may have business interests, strategies or goals that are inconsistent with ours. For example, trade secrets and other proprietary information we may provide to a joint venture may become available to third parties beyond our control. The ability to enforce intellectual property and contractual rights to prevent disclosure of our trade secrets and other proprietary information may be limited in certain jurisdictions. Business decisions or other actions or omissions of the joint venture partner, controlling shareholders or management may adversely affect the value of our investment, result in litigation or regulatory action against us and otherwise damage our reputation and brand. +Our success is dependent on maintaining a culture of integrity and respect as well as upon our executive officers and other key personnel, and misconduct by or loss of key personnel could materially adversely affect our business. +We rely upon our key personnel not only for business success, but also to lead with integrity and promote a culture of respect. To the extent our leaders behave in a manner that does not comport with our company’s values, the consequences to our brand and reputation could be severe and could negatively affect our financial condition and results of operations. +The market for qualified individuals is highly competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel who voluntarily or involuntarily leave the company. Changes in immigration and work permit laws and regulations or the administration or enforcement of such laws or regulations can also impair our ability to attract and retain qualified personnel, or to employ such personnel in the location(s) of our choice. As further described in “Supervision and Regulation—Compensation Practices,” our compensation practices are subject to review and oversight by the Federal Reserve and the compensation practices of AENB is subject to review and oversight by the OCC. This regulatory review and oversight could further affect our ability to attract and retain our executive officers and other key personnel. The loss of key personnel could materially adversely affect our business. +25 +Table of Contents +Legal, Regulatory and Compliance Risks +Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition. +We are subject to comprehensive government regulation and supervision in jurisdictions around the world, which significantly affects our business and requires continual enhancement of our compliance efforts. Regulatory oversight and supervision of our businesses are generally designed to protect consumers and enhance financial stability and are not designed to protect our security holders. +Supervision efforts and the enforcement of existing laws and regulations impact the scope and profitability of our existing business activities, limit our ability to pursue certain business opportunities and adopt new technologies, and affect our relationships with Card Members, partners, merchants, vendors and other third parties. New laws or regulations could similarly affect our business, increase our costs of doing business and require us to change certain of our business practices and invest significant management attention and resources, all of which could adversely affect our results of operations and financial condition. Legislators and regulators around the world are aware of each other’s approaches to the regulation of the payments industry. Consequently, a development in one country, state or region may influence regulatory approaches in another. To the extent that different regulatory systems impose overlapping or inconsistent requirements on the conduct of our business, we face complexity and additional costs in our compliance efforts. +If we fail to satisfy regulatory requirements or maintain our financial holding company status, our financial condition and results of operations could be adversely affected, and we may be restricted in our ability to take certain capital actions (such as declaring dividends or repurchasing outstanding shares) or engage in certain business activities or acquisitions. Additionally, our banking regulators have wide discretion in the examination and the enforcement of applicable banking statutes and regulations and may restrict our ability to engage in certain business activities or acquisitions or require us to maintain more capital. +In recent years, legislators and regulators have focused on the operation of card networks, including interchange fees paid to card issuers in payment networks such as Visa and Mastercard and the fees merchants are charged to accept cards. Even where we are not directly regulated, regulation of bankcard fees significantly negatively impacts the discount revenue derived from our business, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or the terms of card acceptance for merchants, including terms relating to non-discrimination and honor-all-cards. For example, we have largely exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions. In addition, there is uncertainty as to when or how interchange fee caps and other provisions of the EU payments legislation might apply when we work with cobrand partners and agents in the EU. In a ruling issued on February 7, 2018, the EU Court of Justice confirmed the validity of the application of the fee caps and other provisions in circumstances where three-party networks issue cards with a cobrand partner or through an agent, although the ruling provided only limited guidance as to when or how the provisions might apply in such circumstances and remains subject to differing interpretations by regulators and participants in cobrand arrangements. As a result, there can be no assurance we will be able to maintain our existing cobrand and agent relationships in the EU. Furthermore, the European Commission is in the process of conducting an impact assessment of the interchange fee caps, which could potentially result in lower and/or additional interchange fee caps and restrictions. +We are subject to certain provisions of the Bank Secrecy Act, as amended by the Patriot Act, with regard to maintaining effective AML programs. Similar AML requirements apply under the laws of most jurisdictions where we operate. Increased regulatory focus in this area is likely to result in increased costs related to oversight, supervision and fines, and may result in changes to our business practices, including restrictions with respect to the types of products and services we may offer to consumers, the countries in which our cards may be used, and the types of customers and merchants who can obtain or accept our cards. Emerging technologies, such as digital currencies, could limit our ability to track the movement of funds. Money laundering, terrorist financing and other illicit activities involving our business could result in enforcement action, and our reputation may suffer due to our customers’ association with certain countries, persons or entities or the existence of any such transactions. +Various regulatory agencies and legislatures are also considering regulations and legislation covering identity theft, account management guidelines, credit bureau reporting, disclosure rules, security and marketing that would impact us directly, in part due to increased scrutiny of our underwriting and account management standards. These new requirements may restrict our ability to issue charge and credit cards or partner with other financial institutions, which could adversely affect our revenue growth. +See “Supervision and Regulation” for more information about certain laws and regulations to which we are subject and their impact on us. +26 +Table of Contents +Litigation and regulatory actions could subject us to significant fines, penalties, judgments and/or requirements resulting in significantly increased expenses, damage to our reputation and/or a material adverse effect on our business. +Businesses in the financial services and payments industries have historically been subject to significant legal actions, including class action lawsuits. Many of these actions have included claims for substantial compensatory or punitive damages. While we have historically relied on our arbitration clause in agreements with customers to limit our exposure to class action litigation, there can be no assurance that we will continue to be successful in enforcing our arbitration clause in the future and claims of the type we previously arbitrated could be subject to the complexities, risks and costs associated with class action cases. The continued focus of merchants on issues relating to the acceptance of various forms of payment may lead to additional litigation and other legal actions. Given the inherent uncertainties involved in litigation, and the very large or indeterminate damages sought in some matters asserted against us, there is significant uncertainty as to the ultimate liability we may incur from litigation matters. +We have been subject to regulatory actions and may continue to be subject to such actions, including governmental inquiries, investigations and enforcement proceedings, in the event of noncompliance or alleged noncompliance with laws or regulations. For example, we have been cooperating with certain governmental authorities that have requested information from, or served subpoenas on, us seeking information relating to a small, specialized part of our business, known as foreign exchange international payments (FXIP), which offers cross-border payments services primarily to small and middle market business customers in five countries, including the United States. In particular, we received investigative subpoenas from both the civil and criminal divisions of the U.S. Department of Justice as well as inquiries from the Federal Reserve, the OCC, the CFPB, the FDIC and others. +FXIP accounts for less than one half of one percent of our total revenue net of interest expense and is unrelated to our card businesses. Relatedly, our review of FXIP’s pricing practices conducted with an outside law firm has concluded and as a result, we voluntarily provided approximately $1.5 million of remediation to certain customers covering a five-year period and took disciplinary action where appropriate. We do not believe this matter will have a material adverse impact on our operations or results. +We expect that regulators will continue taking formal enforcement actions against financial institutions in addition to addressing supervisory concerns through non-public supervisory actions or findings, which could involve restrictions on our activities, among other limitations that could adversely affect our business. In addition, a violation of law or regulation by another financial institution could give rise to an investigation by regulators and other governmental agencies of the same or similar practices by us. Further, a single event may give rise to numerous and overlapping investigations and proceedings. Regulatory action could subject us to significant fines, penalties or other requirements resulting in Card Member reimbursements, increased expenses, limitations or conditions on our business activities, and damage to our reputation and our brand, which could adversely affect our results of operations and financial condition. +Legal proceedings regarding provisions in our merchant contracts could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand. +We are, and have been in the past, a defendant in a number of actions, including legal proceedings and proposed class actions filed by merchants, challenging certain provisions of our card acceptance agreements. A description of the outstanding legal proceedings is contained in “Legal Proceedings.” +An adverse outcome in these proceedings could have a material adverse effect on our business and results of operations, require us to change our merchant agreements in a way that could expose our cards to increased merchant steering and other forms of discrimination that could impair the Card Member experience, result in additional litigation and/or arbitrations, impose substantial monetary damages and damage our reputation and brand. Even if we were not required to change our merchant agreements, changes in Visa’s and Mastercard’s policies or practices as a result of legal proceedings, lawsuit settlements or regulatory actions pending against them could result in changes to our business practices and materially and adversely impact our profitability. +We are subject to capital adequacy and liquidity rules, and if we fail to meet these rules, our business would be materially adversely affected. +Failure to meet current or future capital or liquidity requirements could compromise our competitive position and could result in restrictions imposed by the Federal Reserve, including limiting our ability to pay dividends, repurchase our capital stock, invest in our business, expand our business or engage in acquisitions. +27 +Table of Contents +Some elements of the capital and liquidity regimes are not yet final and certain developments could significantly impact the requirements applicable to financial institutions. For example, the Basel Committee finalized revisions to the standardized approach for credit risk and operational risk capital requirements. If these revisions are adopted in the United States, we could be required to hold significantly more capital. As a result, the ultimate impact on our long-term capital and liquidity planning and our results of operations is not certain, although an increase in our capital and liquid asset levels could lower our return on equity. As part of our required stress testing, we must continue to comply with applicable capital standards as calculated under the standardized approach in the severely adverse economic scenario published by the Federal Reserve. To satisfy these requirements, it may be necessary for us to hold additional capital in excess of that required by the Capital Rules. +Compliance with capital adequacy and liquidity rules requires a material investment of resources. An inability to meet regulatory expectations regarding our compliance with applicable capital adequacy and liquidity rules may also negatively impact the assessment of us and our U.S. bank subsidiary by federal banking regulators. +For more information on capital adequacy requirements, see “Stress Testing and Capital Planning” and “Capital, Leverage and Liquidity Regulation” under “Supervision and Regulation.” +We are subject to restrictions that limit our ability to pay dividends and repurchase our capital stock. Our subsidiaries are also subject to restrictions that limit their ability to pay dividends to us, which may adversely affect our liquidity. +We are limited in our ability to pay dividends and repurchase capital stock by our regulators, who have broad authority to prohibit any action that would be considered an unsafe or unsound banking practice. For example, we are subject to a requirement to submit capital plans that include, among other things, projected dividend payments and repurchases of capital stock to the Federal Reserve for review. As part of the capital planning and stress testing process, our proposed capital actions are assessed against our ability to satisfy applicable capital requirements in the event of a stressed market environment. If the Federal Reserve objects to our capital plan or if we fail to satisfy applicable capital requirements, our ability to undertake capital actions may be restricted. +In addition, the Capital Rules include buffers that can be satisfied only with CET1 capital. If our risk-based capital ratios were to fall below the applicable buffer levels, we would be subject to certain restrictions on dividends, stock repurchases and other capital distributions, as well as discretionary bonus payments to executive officers. +Our ability to declare or pay dividends on, or to purchase, redeem or otherwise acquire, shares of our common stock will be prohibited, subject to certain exceptions, in the event that we do not declare and pay in full dividends for the last preceding dividend period of our Series B and Series C preferred stock. +American Express Company relies on dividends from its subsidiaries for liquidity, and federal and state laws, regulations and supervisory policy limit the amount of dividends that our subsidiaries may pay to the parent company. For example, our U.S. bank subsidiary, AENB, is subject to various statutory and regulatory limitations on its declaration and payment of dividends. These limitations may hinder our ability to access funds we may need to make payments on our obligations, make dividend payments on outstanding American Express Company capital stock or otherwise achieve strategic objectives. +Any reduction of, or elimination of, our common stock dividend or share repurchase program would likely adversely affect the market price of our common stock and market perceptions of American Express. For more information on bank holding company and depository institution dividend restrictions, see “Dividends and Other Capital Distributions” under “Supervision and Regulation,” as well as “Consolidated Capital Resources and Liquidity—Share Repurchases and Dividends” under “MD&A” and Note 22 to our “Consolidated Financial Statements.” +Regulation in the areas of privacy, data protection, account access and information and cyber security could increase our costs and affect or limit our business opportunities and how we collect and/or use personal information. +Legislators and regulators in the United States and other countries in which we operate are increasingly adopting or revising privacy, data protection and information and cyber security laws, including data localization, authentication and account access laws. As such laws are interpreted and applied (in some cases, with significant differences or conflicting requirements across jurisdictions), compliance and technology costs will continue to increase, particularly in the context of ensuring that adequate data protection, data transfer and account access mechanisms are in place. +Compliance with current or future privacy, data protection, account access and information and cyber security laws could significantly impact our collection, use, sharing, retention and safeguarding of consumer and/or colleague information and could restrict our ability to fully maximize our closed-loop capability or provide certain products and services, which could materially and adversely affect our profitability. +28 +Table of Contents +Our failure to comply with privacy, data protection, account access and information and cyber security laws could result in potentially significant regulatory and/or governmental investigations and/or actions, litigation, fines, sanctions, ongoing regulatory monitoring, customer attrition, decreases in the use or acceptance of our cards and damage to our reputation and our brand. In recent years, there has been increasing regulatory enforcement and litigation activity in the areas of privacy, data protection and information and cyber security in the United States, the EU and various other countries in which we operate. +For more information on regulatory and legislative activity in this area, see “Privacy, Data Protection, Information and Cyber Security” under “Supervision and Regulation.” +We may not be able to effectively manage the operational, conduct and compliance risks to which we are exposed. +We consider operational risk to be the risk of not achieving business objectives due to inadequate or failed processes or information systems, poor data quality, human error or the external environment (e.g., natural disasters). Operational risk includes, among others, the risk that error or misconduct could result in a material financial misstatement, a failure to monitor a third party’s compliance with regulatory or legal requirements, or a failure to adequately monitor and control access to, or use of, data in our systems we grant to third-parties. As processes or organizations are changed, or new products and services are introduced, we may not fully appreciate or identify new operational risks that may arise from such changes. Through human error, fraud or malfeasance, conduct risk can result in harm to customers, broader markets and the company and its employees. +Compliance risk arises from the failure to adhere to applicable laws, rules, regulations and internal policies and procedures. Operational, conduct and compliance risks can expose us to reputational and legal risks as well as fines, civil money penalties or payment of damages and can lead to diminished business opportunities and diminished ability to expand key operations. +If we are not able to protect our intellectual property, or successfully defend against any infringement or misappropriation assertions brought against us, our revenue and profitability could be negatively affected. +We rely on a variety of measures to protect our intellectual property and control access to, and distribution of, our trade secrets and other proprietary information. These measures may not prevent infringement of our intellectual property rights or misappropriation of our proprietary information and a resulting loss of competitive advantage. The ability to enforce intellectual property rights to prevent disclosure of our trade secrets and other proprietary information may be limited in certain jurisdictions. In addition, competitors or other third parties may allege that our systems, processes or technologies infringe on their intellectual property rights. Given the complex, rapidly changing and competitive technological and business environments in which we operate, and the potential risks and uncertainties of intellectual property-related litigation, a future assertion of an infringement or misappropriation claim against us could cause us to lose significant revenues, incur significant defense, license, royalty or technology development expenses, and/or pay significant monetary damages. +Tax legislative initiatives or assessments by governmental authorities could adversely affect our results of operations and financial condition. +We are subject to income and other taxes in the United States and in various foreign jurisdictions. The laws and regulations related to tax matters are extremely complex and subject to varying interpretations. Although management believes our positions are reasonable, we are subject to audit by the Internal Revenue Service in the United States and by tax authorities in all the jurisdictions in which we conduct business operations. We are being challenged in a number of countries regarding our application of value-added taxes (VAT) to certain transactions. While we believe we comply with all applicable VAT and other tax laws, rules and regulations in the relevant jurisdictions, the tax authorities may determine that we owe additional taxes or apply existing laws and regulations more broadly, which could result in a significant increase in liabilities for taxes and interest in excess of accrued liabilities. +New tax legislative initiatives may be proposed from time to time, which may impact our effective tax rate and could adversely affect our tax positions or tax liabilities. New guidance or modifications to the Tax Cuts and Jobs Act of 2017 (the Tax Act) could have an adverse effect on our results of operations. In addition, unilateral or multi-jurisdictional actions by various tax authorities, including an increase in tax audit activity, could have an adverse impact on our tax liabilities. +29 +Table of Contents +Credit, Liquidity and Market Risks +Our risk management policies and procedures may not be effective. +Our risk management framework seeks to identify and mitigate risk and appropriately balance risk and return. We have established policies and procedures intended to identify, monitor and manage the types of risk to which we are subject, including credit risk, market risk, asset liability risk, liquidity risk, operational risk, compliance risk, model risk, strategic and business risk and reputational risk. See “Risk Management” under “MD&A” for a discussion of the policies and procedures we use to identify, monitor and manage the risks we assume in conducting our businesses. Although we have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future, these policies and procedures, as well as our risk management techniques, such as our hedging strategies, may not be fully effective. There may also be risks that exist, or develop in the future, that we have not appropriately anticipated, identified or mitigated. As regulations and markets in which we operate continue to evolve, our risk management framework may not always keep sufficient pace with those changes. If our risk management framework does not effectively identify or mitigate our risks, we could suffer unexpected losses and could be materially adversely affected. +Management of our risks in some cases depends upon the use of analytical and/or forecasting models. Although we have a governance framework for model development and independent model validation, the modeling methodology or key assumptions could be erroneous or the models could be misused. In addition, issues with the quality or effectiveness of our data aggregation and validation procedures, as well as the quality and integrity of data inputs, could result in ineffective or inaccurate model outputs and reports. For example, models based on historical data sets might not be accurate predictors of future outcomes and their ability to appropriately predict future outcomes may degrade over time. Upon the adoption of the new accounting guidance for the recognition of credit losses on certain financial instruments, effective January 1, 2020, we began using a new credit reserve methodology, which requires measurement of expected credit losses for the estimated life of the financial instrument, not only based on historical experience and current conditions, but also by including forecasts incorporating forward-looking information. If our business decisions or estimates for credit losses are based on incorrect or misused models and assumptions or we fail to manage data inputs effectively and to aggregate or analyze data in an accurate and timely manner, our results of operations and financial condition may be materially adversely affected. +We may not be able to effectively manage individual or institutional credit risk, or credit trends that can affect spending on card products and the ability of customers and partners to pay us, which could have a material adverse effect on our results of operations and financial condition. +We are exposed to both individual credit risk, principally from consumer and small business Card Member loans and receivables, and institutional credit risk, principally from corporate Card Member loans and receivables, merchants, network partners, loyalty coalition partners and treasury and investment counterparties. Third parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. General economic factors, such as the rate of inflation, unemployment levels and interest rates, may result in greater delinquencies that lead to greater credit losses. Country, regional and political risks can also contribute to credit risk. A customer’s ability and willingness to repay us can be negatively impacted not only by economic, market, political and social conditions but by a customer’s other payment obligations, and increasing leverage can result in a higher risk that customers will default or become delinquent in their obligations to us. +We rely principally on the customer’s creditworthiness for repayment of the loan or receivable and therefore have no other recourse for collection. Our ability to assess creditworthiness may be impaired if the criteria or models we use to manage our credit risk prove inaccurate in predicting future losses, which could cause our losses to rise and have a negative impact on our results of operations. Further, our pricing strategies may not offset the negative impact on profitability caused by increases in delinquencies and losses; thus any material increases in delinquencies and losses beyond our current estimates could have a material adverse impact on us. +Rising delinquencies and rising rates of bankruptcy are often precursors of future write-offs and may require us to increase our reserve for loan losses. Higher write-off rates and the resulting increase in our reserves for loan and receivable losses adversely affect our profitability and the performance of our securitizations, and may increase our cost of funds. +Although we make estimates to provide for credit losses in our outstanding portfolio of loans and receivables, these estimates may not be accurate. In addition, the information we use in managing our credit risk may be inaccurate or incomplete. As noted above, we began using a new credit reserve methodology, effective January 1, 2020, which differs significantly from our previous approach and alters the estimation process, inputs and assumptions used in estimating expected credit losses for loans and receivables. The new methodology may have a significant effect on our reported results and could cause fluctuations in our reported results, even if there are no underlying changes in the economics of the business. For more information on recently issued accounting standards, see Note 1 to our “Consolidated Financial Statements.” +30 +Table of Contents +Although we regularly review our credit exposure to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to foresee or detect, such as fraud. In addition, our ability to manage credit risk may be adversely affected by legal or regulatory changes (such as restrictions on collections or changes in bankruptcy laws, minimum payment regulations and re-age guidance). Increased credit risk, whether resulting from underestimating the credit losses inherent in our portfolio of loans and receivables, deteriorating economic conditions (particularly in the United States where approximately 75 percent of our revenues were generated in 2019), increases in the level of loan balances, changes in our mix of business or otherwise, could require us to increase our provisions for losses and could have a material adverse effect on our results of operations and financial condition. +Interest rate increases could materially adversely affect our earnings. +If the rate of interest we pay on our borrowings increases more than the rate of interest we earn on our loans, our net interest yield, and consequently our net interest income, could fall. Our interest expense was approximately $3.5 billion for the year ended December 31, 2019. A hypothetical 100 basis point increase in market interest rates would have resulted in a decrease to our annual net interest income of approximately $141 million as of December 31, 2019. We expect the rates we pay on our deposits will increase if benchmark interest rates increase. In addition, interest rate changes may affect customer behavior, such as impacting the loan balances Card Members carry on their credit cards or their ability to make payments as higher interest rates lead to higher payment requirements, further impacting our results of operations. +For a further discussion of our interest rate risk, see “Risk Management ― Market Risk Management Process” under “MD&A.” +Uncertainty relating to LIBOR and other reference rates and their potential discontinuance may negatively impact our access to funding and the value of our financial instruments and commercial agreements. +Due to uncertainty surrounding the suitability and sustainability of the London interbank offered rate (LIBOR), central banks and global regulators have called for financial market participants to prepare for the discontinuance of LIBOR by the end of 2021 and the establishment of alternative reference rates. At this time, it is not possible to predict the effect that any discontinuance, modification or other reforms to LIBOR or any other reference rate, the establishment of alternative reference rates, or the impact of any such events on contractual mechanisms may have on the markets, us, or our financial instruments or commercial agreements that reference LIBOR. +Certain of our financial instruments and commercial agreements contain provisions to replace LIBOR as the benchmark following the occurrence of specified transition events. Such provisions may not be sufficient to trigger a change in the benchmark at all times when LIBOR is no longer representative of market interest rates, or that these events will align with similar events in the market generally or in other parts of the financial markets, such as the derivatives market. +Alternative reference rates are calculated using components different from those used in the calculation of LIBOR and may fluctuate differently than, and not be representative of, LIBOR. In order to compensate for these differences, certain of our financial instruments and commercial agreements allow for a benchmark replacement adjustment. However, there is no assurance that any benchmark replacement adjustment will be sufficient to produce the economic equivalent of LIBOR, either at the benchmark replacement date or over the life of such instruments and agreements. +Uncertainty as to the nature and timing of the potential discontinuance or modification of LIBOR, the replacement of LIBOR with one or more alternative reference rates or other reforms may negatively impact market liquidity, our access to funding required to operate our business and the trading market for our financial instruments. Furthermore, the timing of implementation and use of alternative reference rates and corresponding adjustments or other reforms could be subject to disputes, could cause the interest payable on our outstanding financial instruments and commercial agreements to be materially different than expected and may impact the value of our financial instruments and commercial agreements. +For a further discussion on LIBOR Transition, see “Risk Management ― LIBOR Transition” under “MD&A.” +Adverse financial market conditions may significantly affect our ability to meet liquidity needs, access to capital and cost of capital. +We need liquidity to pay merchants, operating and other expenses, interest on debt and dividends on capital stock and to repay maturing liabilities. The principal sources of our liquidity are payments from Card Members, proceeds from the issuance of unsecured medium- and long-term notes and asset securitizations and direct and third-party sourced deposits, cash flows from our investment portfolio, cash and cash equivalents, securitized borrowings through our secured borrowing facilities, a committed bank credit facility and the Federal Reserve discount window. +Our ability to obtain financing in the debt capital markets for unsecured term debt and asset securitizations is dependent on market conditions. Disruptions, uncertainty or volatility across the financial markets, as well as adverse developments affecting our competitors and the financial industry generally, could negatively impact market liquidity and limit our access to funding required to operate our business. Such market conditions may also limit our ability to replace, in a timely manner, maturing +31 +Table of Contents +liabilities, satisfy regulatory capital requirements and access the funding necessary to grow our business. In some circumstances, we may incur an unattractive cost to raise capital, which could decrease profitability and significantly reduce financial flexibility. +For a further discussion of our liquidity and funding needs, see “Consolidated Capital Resources and Liquidity ― Funding Programs and Activities” under “MD&A.” +Any reduction in our and our subsidiaries’ credit ratings could increase the cost of our funding from, and restrict our access to, the capital markets and have a material adverse effect on our results of operations and financial condition. +Rating agencies regularly evaluate us and our subsidiaries, and their ratings of our and our subsidiaries’ long-term and short-term debt and deposits are based on a number of factors, including financial strength, as well as factors not within our control, including conditions affecting the financial services industry generally, and the wider state of the economy. Our and our subsidiaries’ ratings could be downgraded at any time and without any notice by any of the rating agencies, which could, among other things, adversely limit our access to the capital markets and adversely affect the cost and other terms upon which we and our subsidiaries are able to obtain funding. +Adverse currency fluctuations and foreign exchange controls could decrease earnings we receive from our international operations and impact our capital. +During 2019, approximately 25 percent of our total revenues net of interest expense were generated from activities outside the United States. We are exposed to foreign exchange risk from our international operations, and accordingly the revenue we generate outside the United States is subject to unpredictable fluctuations if the values of other currencies change relative to the U.S. dollar (including as a result of Brexit), which could have a material adverse effect on our results of operations. +Foreign exchange regulations or capital controls might restrict or prohibit the conversion of other currencies into U.S. dollars or our ability to transfer them. Political and economic conditions in other countries could also impact the availability of foreign exchange for the payment by the local card issuer of obligations arising out of local Card Members’ spending outside such country and for the payment by Card Members who are billed in a currency other than their local currency. Substantial and sudden devaluation of local Card Members’ currency can also affect their ability to make payments to the local issuer of the card in connection with spending outside the local country. The occurrence of any of these circumstances could further impact our results of operations. +An inability to accept or maintain deposits due to market demand or regulatory constraints could materially adversely affect our liquidity position and our ability to fund our business. +Our U.S. bank subsidiary, AENB, accepts deposits directly from consumers through American Express Personal Savings, as well as from individuals through third-party brokerage networks, and uses the proceeds as a source of funding. As of December 31, 2019, we had approximately $72.4 billion in total U.S. retail deposits, of which a significant amount had been raised through third-party brokerage networks. We face strong and increasing competition with regard to deposits, and pricing and product changes may adversely affect our ability to attract and retain cost-effective deposit balances. If we are required to offer higher interest rates to attract or maintain deposits, our funding costs will be adversely impacted. +Our ability to obtain deposit funding and offer competitive interest rates on deposits is also dependent on AENB’s capital levels. The FDIA’s brokered deposit provisions and related FDIC rules in certain circumstances prohibit banks from accepting or renewing brokered deposits and apply other restrictions, such as a cap on interest rates that can be paid. Additionally, our regulators can adjust applicable capital requirements at any time and have authority to place limitations on our deposit businesses. An inability to attract or maintain deposits in the future could materially adversely affect our ability to fund our business. +The value of our investments may be adversely impacted by economic, political or market conditions. +Market risk includes the loss in value of portfolios and financial instruments due to adverse changes in market variables, which could negatively impact our financial condition. We held approximately $8.4 billion of investment securities as of December 31, 2019. In the event that actual default rates of these investment securities were to significantly change from historical patterns due to economic conditions or otherwise, it could have a material adverse impact on the value of our investment portfolio, potentially resulting in impairment charges. Defaults or economic disruptions, even in countries or territories in which we do not have material investment exposure, conduct business or have operations, could adversely affect us. +32 +Table of Contents +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not applicable. +ITEM 2. PROPERTIES +Our principal executive offices are in a 2.2 million square foot building located in lower Manhattan on land leased from the Battery Park City Authority for a term expiring in 2069. We have an approximately 49 percent ownership interest in the building and an affiliate of Brookfield Financial Properties owns the remaining approximately 51 percent interest in the building. We also lease space in the building from Brookfield’s affiliate. +Other owned or leased principal locations include American Express offices in Sunrise, Florida, Phoenix, Arizona, Salt Lake City, Utah, Mexico City, Mexico, Sydney, Australia, Singapore, Gurgaon, India, Manila, Philippines, and Brighton, England; the American Express data centers in Phoenix, Arizona and Greensboro, North Carolina; the headquarters for American Express Services Europe Limited in London, England; the headquarters for American Express Europe, S.A. in Madrid, Spain; and the Amex Bank of Canada and Amex Canada Inc. headquarters in Toronto, Ontario, Canada. +Generally, we lease the premises we occupy in other locations. We believe the facilities we own or occupy suit our needs and are well maintained. +ITEM 3. LEGAL PROCEEDINGS +Refer to Note 12 to our “Consolidated Financial Statements,” which is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +33 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +(a) Our common stock trades principally on The New York Stock Exchange under the trading symbol AXP. As of December 31, 2019, we had 19,974 common shareholders of record. You can find dividend information concerning our common stock in Note 26 to our “Consolidated Financial Statements.” For information on dividend restrictions, see “Dividends and Other Capital Distributions” under “Supervision and Regulation” and Note 22 to our “Consolidated Financial Statements.” You can find information on securities authorized for issuance under our equity compensation plans under the caption “Executive Compensation — Equity Compensation Plans” to be contained in our definitive 2020 proxy statement for our Annual Meeting of Shareholders, which is scheduled to be held on May 5, 2020. The information to be found under such caption is incorporated herein by reference. Our definitive 2020 proxy statement for our Annual Meeting of Shareholders is expected to be filed with the SEC in March 2020 (and, in any event, not later than 120 days after the close of our most recently completed fiscal year). +Stock Performance Graph +The information contained in this Stock Performance Graph section shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the SEC, or subject to the liabilities of Section 18 of the Exchange Act, except to the extent that we specifically incorporate it by reference into a document filed under the Securities Act or the Exchange Act. +The following graph compares the cumulative total shareholder return on our common shares with the total return on the S&P 500 Index and the S&P Financial Index for the last five years. It shows the growth of a $100 investment on December 31, 2014, including the reinvestment of all dividends. +Year-end Data 2014 2015 2016 2017 2018 2019 +American Express $ 100.00 $ 75.78 $ 82.28 $ 112.07 $ 109.12 $ 144.60 +S&P 500 Index $ 100.00 $ 101.37 $ 113.49 $ 138.26 $ 132.19 $ 173.80 +S&P Financial Index $ 100.00 $ 98.44 $ 120.83 $ 147.58 $ 128.33 $ 169.52 +(b) Not applicable. +(c) Issuer Purchases of Securities +34 +Table of Contents +The table below sets forth the information with respect to purchases of our common stock made by or on behalf of us during the quarter ended December 31, 2019. +Total Number of Shares +Purchased Average Price Paid Per +Share +Total Number of Shares +Purchased as Part of +Publicly Announced Plans +or Programs (c) +Maximum Number of +Shares that May +Yet Be +Purchased Under the +Plans +or Programs +October 1-31, 2019 +Repurchase program (a) +5,039,911 $ 115.67 5,039,911 114,960,089 +Employee transactions (b) +27 $ 116.80 N/A N/A +November 1-30, 2019 +Repurchase program (a) +2,226,779 $ 120.74 2,226,779 112,733,310 +Employee transactions (b) +3,205 $ 118.07 N/A N/A +December 1-31, 2019 +Repurchase program (a) +3,338,428 $ 122.26 3,338,428 109,394,882 +Employee transactions (b) +— $ — N/A N/A +Total +Repurchase program (a) +10,605,118 $ 118.81 10,605,118 109,394,882 +Employee transactions (b) +3,232 $ 118.06 N/A N/A +(a) On September 23, 2019, the Board of Directors authorized the repurchase of up to 120 million common shares from time to time, subject to market conditions and in accordance with our capital plans. This authorization replaced the prior repurchase authorization and does not have an expiration date. See “MD&A – Consolidated Capital Resources and Liquidity” for additional information regarding share repurchases. +(b) Includes: (i) shares surrendered by holders of employee stock options who exercised options (granted under our incentive compensation plans) in satisfaction of the exercise price and/or tax withholding obligation of such holders and (ii) restricted shares withheld (under the terms of grants under our incentive compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares. Our incentive compensation plans provide that the value of the shares delivered or attested to, or withheld, be based on the price of our common stock on the date the relevant transaction occurs. +(c) Share purchases under publicly announced programs are made pursuant to open market purchases or privately negotiated transactions (including employee benefit plans) as market conditions warrant and at prices we deem appropriate. +35 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +2019 2018 2017 2016 +2015 (a) +Operating Results ($ in Millions) +Total revenues net of interest expense $ 43,556 $ 40,338 $ 36,878 $ 35,438 $ 32,818 +Provisions for losses (b) +3,573 3,352 2,760 2,027 1,988 +Expenses (b) +31,554 28,864 26,693 25,369 22,892 +Pretax income 8,429 8,122 7,425 8,042 7,938 +Income tax provision 1,670 1,201 4,677 2,667 2,775 +Net income 6,759 $ 6,921 $ 2,748 $ 5,375 $ 5,163 +Return on average equity (c) +29.6 % 33.5 % 13.2 % 25.8 % 24.0 % +Return on average assets (c) +3.5 % 3.8 % 1.6 % 3.4 % 3.3 % +Balance Sheet ($ in Millions) +Cash and cash equivalents $ 23,932 $ 27,445 $ 32,927 $ 25,208 $ 22,762 +Card Member loans and receivables HFS (b) +— — — — 14,992 +Card Member receivables, net 56,794 55,320 53,526 46,841 43,671 +Loans, net 89,624 83,396 74,300 65,461 58,799 +Investment securities 8,406 4,647 3,159 3,157 3,759 +Total assets 198,321 188,602 181,196 158,917 161,184 +Customer deposits 73,287 69,960 64,452 53,042 54,997 +Short-term borrowings 6,442 3,100 3,278 5,581 4,812 +Long-term debt 57,835 58,423 55,804 46,990 48,061 +Shareholders’ equity $ 23,071 $ 22,290 $ 18,261 $ 20,523 $ 20,673 +Average shareholders' equity to average total assets ratio 11.7 % 11.3 % 12.5 % 13.2 % 13.5 % +Common Share Statistics (d) +Earnings per share: +Net income attributable to common shareholders: (e) +Basic $ 8.00 $ 7.93 $ 3.00 $ 5.63 $ 5.07 +Diluted 7.99 7.91 2.99 5.61 5.05 +Cash dividends declared per common share 1.64 $ 1.48 $ 1.34 $ 1.22 $ 1.13 +Dividend payout ratio (f) +20.5 % 18.7 % 44.7 % 21.7 % 22.3 % +Book value per common share 26.51 $ 24.45 $ 19.42 $ 20.95 $ 19.71 +Average common shares outstanding (millions) : +Basic 828 856 883 933 999 +Diluted 830 859 886 935 1,003 +Shares outstanding at period end (millions) +810 847 859 904 969 +Other Statistics +Number of colleagues at period end (thousands) : +United States 23 21 20 21 21 +Outside the United States 41 38 35 35 34 +Total 64 59 55 56 55 +Number of shareholders of record 19,974 21,078 22,262 23,572 24,704 +(a) 2015 amounts were not restated in conjunction with the adoption of the new revenue recognition standard. +(b) Beginning December 1, 2015 through to the sale completion dates in the first half of 2016, Card Member loans and receivables related to our cobrand partnerships with JetBlue Airways Corporation and Costco Wholesale Corporation in the United States were held for sale on the Consolidated Balance Sheets and credit costs were reported in Expenses through a valuation allowance adjustment and not reflected in Provisions for losses. +(c) Return on average equity and return on average assets are calculated by dividing one-year period of net income by one-year average of total shareholders’ equity or total assets, respectively. +(d) Our common stock trades principally on The New York Stock Exchange under the trading symbol AXP. +(e) Represents net income, less earnings allocated to participating share awards and dividends on preferred shares. +(f) Calculated on year’s dividends declared per common share as a percentage of the year’s net income available per common share. +36 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) +EXECUTIVE OVERVIEW +BUSINESS INTRODUCTION +We are a globally integrated payments company with three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses and operations are included in Corporate & Other. +Our range of products and services includes: +• Credit card, charge card and other payment and financing products +• Merchant acquisition and processing, servicing and settlement, and point-of-sale marketing and information products and services for merchants +• Network services +• Other fee services, including fraud prevention services and the design and operation of customer loyalty programs +• Expense management products and services +• Travel and lifestyle services +Our various products and services are sold globally to diverse customer groups, including consumers, small businesses, mid-sized companies and large corporations. These products and services are sold through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams, and direct response advertising. Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +The following types of revenue are generated from our various products and services: +• Discount revenue, our largest revenue source, primarily represents the amount we earn on transactions occurring at merchants that have entered into a card acceptance agreement with us, or a Global Network Services (GNS) partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. The amount of fees charged for accepting our cards as payment for goods or services, or merchant discount, varies with, among other factors, the industry in which the merchant does business, the merchant’s overall American Express-related transaction volume, the method of payment, the settlement terms with the merchant, the method of submission of transactions and, in certain instances, the geographic scope for the related card acceptance agreement between the merchant and us (e.g., domestic or global) and the transaction amount. In some instances, an additional flat transaction fee is assessed as part of the merchant discount, and additional fees may be charged such as a variable fee for “non-swiped” card transactions or for transactions using cards issued outside the United States at merchants located in the United States; +• Interest on loans, principally represents interest income earned on outstanding balances; +• Net card fees, represent revenue earned from annual card membership fees, which vary based on the type of card and the number of cards for each account; +• Other fees and commissions, primarily represent Card Member delinquency fees, foreign currency conversion fees charged to Card Members, loyalty coalition-related fees, travel commissions and fees, service fees earned from merchants, and Membership Rewards program fees; and +• Other revenue, primarily represents revenues arising from contracts with partners of our GNS business (including commissions and signing fees less issuer rate payments), cross-border Card Member spending, earnings from equity method investments (including the GBT JV), ancillary merchant-related fees, insurance premiums earned from Card Members, and prepaid card and Travelers Cheque-related revenue. +37 +Table of Contents +FINANCIAL HIGHLIGHTS +For 2019, we reported net income of $6.8 billion and diluted earnings per share of $7.99. This compared to $6.9 billion of net income and $7.91 diluted earnings per share for 2018. +2019 results included: +• a $0.21 per share impact of a litigation-related charge in the first quarter. +2018 results included: +• a $0.58 per share impact of certain discrete tax benefits in the fourth quarter. +NON-GAAP MEASURES +We prepare our Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America (GAAP). However, certain information included within this report constitutes non-GAAP financial measures. Our calculations of non-GAAP financial measures may differ from the calculations of similarly titled measures by other companies. +BUSINESS ENVIRONMENT +Our results for 2019 continued the steady, consistent performance that we have delivered over the past two years. These results reflect our strategy of investing in share, scale and relevance and demonstrate our success in executing against our four strategic imperatives. We continued to invest in new card acquisitions, new services and Card Member benefits, refreshing and launching new products, and expanding our merchant network . During the year, we returned $5.9 billion of capital to our shareholders through our share buyback program and an increase in our dividend, while maintaining strong capital ratios. +Our worldwide billed business increased 5 percent over the prior year and worldwide proprietary billings, which comprised 86% of our total billings, grew 7 percent, led by consumers. After adjusting for foreign currency exchange (FX) rates, worldwide proprietary billed business increased 8 percent over the prior year, with international proprietary billings growing 13 percent. 1 This spending occurred against the backdrop of an economy that grew at a more modest pace relative to 2018. U.S. Consumer proprietary billed business grew at 7 percent reflecting continued strong acquisition performance and solid underlying spend growth from existing customers. International proprietary consumer growth remained in double digits on an FX-adjusted basis. We also saw 6 percent growth from our commercial customers, driven by steady acquisition and retention of U.S. small and mid-sized enterprise (SME) customers and strong growth in international SME customers. GNS billed business declined 6 percent (2 percent on an FX-adjusted basis) as we exited the network business in Europe and Australia due to certain regulatory changes; excluding the billings from those geographies, GNS billed business grew 5 percent year-over-year on an FX-adjusted basis. 1 +Revenues net of interest expense increased 8 percent (9 percent on an FX-adjusted basis), driven by a well-balanced mix of growth in card fees, Card Member spending and net interest income. 1 The fourth quarter of 2019 was the tenth consecutive quarter with FX-adjusted revenue growth of 8 percent or better. 1 Card fees continue to be our fastest growing revenue line, with an increase of 17 percent year-over-year reflecting our approach of enhancing the value of our premium products to drive higher customer engagement. Discount revenue increased 6 percent year-over-year primarily driven by the previously mentioned billings growth. Net interest income grew at 12 percent year-over-year, driven by growth in loans and net yield, reflecting continued positive impacts from mix and pricing initiatives. +Card Member loans grew 7 percent year-over-year, as we continued to expand our lending relationships with existing customers and acquired new Card Members. Provisions for losses increased 7 percent, driven by a modest increase in net write-offs, which reflects the impact of our lending strategy, as well as the relatively stable economy and low unemployment rate. +Spending on customer engagement (the aggregate of rewards, Card Member services, and marketing and business development expenses) increased 10 percent year-over-year with growth across all categories. Increases in rewards and Card Member services reflected the growth in proprietary billings and continued investment and usage across many of our premium travel-related benefits. Card Member services costs continue to be our fastest growing expense category, as it includes the costs of many components of our differentiated value propositions that support strong Card Member acquisition and engagement. Marketing and business development expense grew due to continued investments in our partnerships, including the impact of the renewal of our relationship with Delta Air Lines earlier in 2019, and higher corporate client incentives. Operating expenses increased 8 percent year-over-year, reflecting investments we are making across our business and the litigation-related charge in the first quarter of 2019. +1 The foreign currency adjusted information assumes a constant exchange rate between the periods being compared for purposes of currency translation into U.S. dollars (i.e., assumes the foreign exchange rates used to determine results for the current period apply to the corresponding prior year period against which such results are being compared). FX-adjusted revenues and expenses constitute non-GAAP measures. We believe the presentation of information on a foreign currency adjusted basis is helpful to investors by making it easier to compare our performance in one period to that of another period without the variability caused by fluctuations in currency exchange rates. +38 +Table of Contents +We continue to see attractive growth opportunities across our businesses and plan to invest to take advantage of them in order to generate and sustain a strong level of revenue growth, which we believe is the foundation for steady and consistent double-digit EPS growth. While we continue to see some headwinds in the environment, including from economic and geopolitical uncertainty, regulation in countries around the world and intense competition, we remain focused on delivering differentiated value to our merchants, Card Members and business partners and delivering appropriate returns to our shareholders. +See “Supervision and Regulation” in “Business” for information on legislative and regulatory changes that could have a material adverse effect on our results of operations and financial condition and “Risk Factors” for information on the potential impacts of economic, geopolitical and competitive conditions and certain litigation and regulatory matters on our business. +CONSOLIDATED RESULTS OF OPERATIONS +The discussions in the “Financial Highlights”, “Consolidated Results of Operations” and “Business Segment Results” provide commentary on the variances for the year ended December 31, 2019 compared to the year ended December 31, 2018, as presented in the accompanying tables. For a discussion of the financial condition and results of operations for 2018 compared to 2017, please refer to Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 13, 2019. +TABLE 1: SUMMARY OF FINANCIAL PERFORMANCE +Years Ended December 31, Change Change +(Millions, except percentages and per share amounts) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Total revenues net of interest expense $ 43,556 $ 40,338 $ 36,878 $ 3,218 8 % $ 3,460 9 % +Provisions for losses 3,573 3,352 2,760 221 7 592 21 +Expenses 31,554 28,864 26,693 2,690 9 2,171 8 +Pretax income 8,429 8,122 7,425 307 4 697 9 +Income tax provision 1,670 1,201 4,677 469 39 (3,476) (74) +Net income 6,759 6,921 2,748 (162) (2) 4,173 # +Earnings per common share — diluted (a) +$ 7.99 $ 7.91 $ 2.99 $ 0.08 1 % $ 4.92 # % +Return on average equity (b) +29.6 % 33.5 % 13.2 % +Effective tax rate (ETR) 19.8 % 14.8 % 63.0 % +Adjustments to ETR (c) +6.1 % (34.7) % +Adjusted ETR (c) +20.9 % 28.3 % +# Denotes a variance greater than 100 percent +(a) Represents net income, less (i) earnings allocated to participating share awards of $47 million, $54 million and $21 million for the years ended December 31, 2019, 2018 and 2017, respectively, and (ii) dividends on preferred shares of $81 million, $80 million and $81 million for the years ended December 31, 2019, 2018 and 2017, respectively. +(b) Return on average equity (ROE) is computed by dividing (i) one-year period net income ($6.8 billion, $6.9 billion and $2.7 billion for 2019, 2018 and 2017, respectively) by (ii) one-year average total shareholders’ equity ($22.8 billion, $20.7 billion and $20.9 billion for 2019, 2018 and 2017, respectively). +(c) The adjusted ETRs for 2018 and 2017 are non-GAAP measures. The 2018 adjusted ETR excludes a benefit of $496 million relating to changes in the tax method of accounting for certain expenses, the resolution of certain prior years’ tax audits, and a final adjustment to our 2017 provisional tax charge related to the Tax Cuts and Jobs Act enacted on December 22, 2017 (Tax Act). The 2017 adjusted ETR excludes the $2.6 billion charge related to the Tax Act. Management believes the adjusted ETRs are useful in evaluating our tax rates in comparison with the other presented periods. Refer to Note 20 of the “Consolidated Financial Statements” for additional information. +TABLE 2: TOTAL REVENUES NET OF INTEREST EXPENSE SUMMARY +Years Ended December 31, Change Change +(Millions, except percentages) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Discount revenue $ 26,167 $ 24,721 $ 22,890 $ 1,446 6 % $ 1,831 8 % +Net card fees 4,042 3,441 3,090 601 17 351 11 +Other fees and commissions 3,297 3,153 2,990 144 5 163 5 +Other 1,430 1,360 1,457 70 5 (97) (7) +Total non-interest revenues 34,936 32,675 30,427 2,261 7 2,248 7 +Total interest income 12,084 10,606 8,563 1,478 14 2,043 24 +Total interest expense 3,464 2,943 2,112 521 18 831 39 +Net interest income 8,620 7,663 6,451 957 12 1,212 19 +Total revenues net of interest expense $ 43,556 $ 40,338 $ 36,878 $ 3,218 8 % $ 3,460 9 % +39 +Table of Contents +TOTAL REVENUES NET OF INTEREST EXPENSE +Discount revenue increased, primarily due to growth in billed business. U.S. billed business increased 6 percent and non-U.S. billed business increased 2 percent. See Tables 5 and 6 for more details on billed business performance. The average discount rate remained flat at 2.37 percent for both 2019 and 2018. +Net card fees increased, primarily driven by growth in the Platinum, Delta and Gold portfolios, as well as growth in certain key international countries. +Other fees and commissions increased, primarily driven by growth in foreign exchange conversion revenue and delinquency fees. +Other revenues increased, primarily due to higher revenues related to the GBT JV and a modification of one of our GNS arrangements, partially offset by lower revenue earned on cross-border Card Member spending. +Interest income increased, primarily reflecting higher average Card Member loans and higher yields. +Interest expense increased, driven by higher cost of funds, average long-term debt and average deposits . +TABLE 3: PROVISIONS FOR LOSSES SUMMARY +Years Ended December 31, Change Change +(Millions, except percentages) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Charge card $ 963 $ 937 $ 795 $ 26 3 % $ 142 18 % +Card Member loans 2,462 2,266 1,868 196 9 398 21 +Other 148 149 97 (1) (1) 52 54 +Total provisions for losses $ 3,573 $ 3,352 $ 2,760 $ 221 7 % $ 592 21 % +PROVISIONS FOR LOSSES +Charge card provision for losses increased, primarily due to growth in receivables and higher net write-offs in the consumer and small business portfolios, partially offset by lower net write-offs in the corporate portfolio. +Card Member loans provision for losses increased, driven by higher net write-offs, partially offset by a lower reserve build due to slower loan growth. +See Note 1 to our "Consolidated Financial Statements" for information about the implementation and expected impact of new accounting guidance for the recognition of credit losses on financial instruments, effective January 1, 2020, and the new credit reserving methodology known as the Current Expected Credit Loss (CECL) methodology. Following the adoption, the future effects of CECL on our provisions for losses will ultimately be dependent on a number of internal and external factors. Assuming no change in the growth in Card Member loans, current macroeconomic conditions, and portfolio quality, we estimate our provisions for losses will likely be higher under CECL and may result in more quarter-to-quarter fluctuations relative to the current accounting methodology. +TABLE 4: EXPENSES SUMMARY +Years Ended December 31, Change Change +(Millions, except percentages) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Marketing and business development +$ 7,114 $ 6,470 $ 5,722 $ 644 10 % $ 748 13 % +Card Member rewards 10,439 9,696 8,687 743 8 1,009 12 +Card Member services 2,222 1,777 1,392 445 25 385 28 +Total marketing, business development, rewards and Card Member services 19,775 17,943 15,801 1,832 10 2,142 14 +Salaries and employee benefits 5,911 5,250 5,258 661 13 (8) — +Other, net +5,868 5,671 5,634 197 3 37 1 +Total expenses $ 31,554 $ 28,864 $ 26,693 $ 2,690 9 % $ 2,171 8 % +EXPENSES +Marketing and business development expense increased, primarily due to continued investments in partnerships (including as a result of the recent renewal of our cobrand relationship with Delta Air Lines), increased network partner payments and +40 +Table of Contents +increased corporate client incentives driven by higher volumes, partially offset by higher marketing costs in the prior year with the launch of our new global brand campaign. +Card Member rewards expense increased, primarily driven by increases in Membership Rewards and cash back rewards expenses of $505 million and cobrand rewards expense of $238 million, both of which were primarily driven by higher spending volumes. +The Membership Rewards Ultimate Redemption Rate for current program participants at both December 31, 2019 and 2018 was 96 percent (rounded up). +Card Member services expense increased, primarily driven by higher usage of travel-related benefits. +Salaries and employee benefits expense increased, reflecting higher payroll costs, higher restructuring charges and higher incentive and deferred compensation. +Other expenses increased, primarily driven by lower unrealized gains on certain equity investments, higher technology costs and litigation-related expenses, partially offset by non-income tax-related benefits and a prior-year loss on a transaction involving the operations of our prepaid reloadable and gift card business. +INCOME TAXES +The effective tax rate for 2019 was 19.8 percent. The effective tax rate for 2018 was 14.8 percent, and reflects a benefit of $496 million relating to changes in the tax method of accounting for certain expenses, the resolution of certain prior years’ tax audits and an adjustment to the 2017 provisional tax charge related to the Tax Act. +The tax rates in both periods reflect the level of pretax income in relation to recurring permanent tax benefits and the geographic mix of business. +TABLE 5: SELECTED CARD-RELATED STATISTICAL INFORMATION +Change Change +Years Ended December 31, 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Billed business: (billions) +U.S. $ 827.7 $ 777.6 $ 708.3 6 % 10 % +Outside the U.S. 413.1 406.4 376.9 2 8 +Total $ 1,240.8 $ 1,184.0 $ 1,085.2 5 9 +Proprietary $ 1,070.5 $ 1,002.6 $ 900.6 7 11 +GNS 170.3 181.4 184.6 (6) (2) +Total $ 1,240.8 $ 1,184.0 $ 1,085.2 5 9 +Cards-in-force: (millions) +U.S. 54.7 53.7 50.0 2 7 +Outside the U.S. 59.7 60.3 62.8 (1) (4) +Total 114.4 114.0 112.8 — 1 +Proprietary 70.3 69.1 64.6 2 7 +GNS 44.1 44.9 48.2 (2) (7) +Total 114.4 114.0 112.8 — 1 +Basic cards-in-force: (millions) +U.S. 43.0 42.3 39.4 2 7 +Outside the U.S. 50.0 50.3 52.2 (1) (4) +Total 93.0 92.6 91.6 — 1 +Average proprietary basic Card Member spending: (dollars) +U.S. $ 21,515 $ 20,840 $ 20,317 3 3 +Outside the U.S. $ 16,351 $ 15,756 $ 14,277 4 10 +Worldwide Average $ 19,972 $ 19,340 $ 18,519 3 4 +Average discount rate +2.37 % 2.37 % 2.40 % +Average fee per card (dollars) (a) +$ 58 $ 51 $ 49 14 % 4 % +(a) Average fee per card is computed based on proprietary net card fees divided by average proprietary total cards-in-force. +41 +Table of Contents +TABLE 6: BILLED BUSINESS GROWTH +2019 2018 +Percentage Increase +(Decrease) +Percentage Increase (Decrease) Assuming No Changes in FX Rates (a) +Percentage Increase +(Decrease) +Percentage Increase (Decrease) +Assuming No Changes in FX Rates (a) +Worldwide +Proprietary +Proprietary consumer 8 % 9 % 12 % 12 % +Proprietary commercial 6 6 11 11 +Total Proprietary 7 8 11 11 +GNS (6) (2) (2) (1) +Worldwide Total 5 6 9 9 +Airline-related volume (8% of Worldwide Total for both 2019 and 2018) +1 3 8 7 +U.S. +Proprietary +Proprietary consumer 7 10 +Proprietary commercial 5 10 +Total Proprietary 6 10 +U.S. Total 6 10 +T&E-related volume (25% of U.S. Total for both 2019 and 2018) +6 8 +Non-T&E-related volume (75% of U.S. Total for both 2019 and 2018) +6 10 +Airline-related volume (7% of U.S. Total for both 2019 and 2018) +4 8 +Outside the U.S. +Proprietary +Proprietary consumer 10 14 17 17 +Proprietary commercial 7 11 16 16 +Total Proprietary 9 13 17 17 +Outside the U.S. Total 2 6 8 8 +Japan, Asia Pacific & Australia 1 5 8 7 +Latin America & Canada 4 10 4 11 +Europe, the Middle East & Africa 1 % 5 % 10 % 8 % +(a) The foreign currency adjusted information assumes a constant exchange rate between the periods being compared for purposes of currency translation into U.S. dollars (i.e., assumes the foreign exchange rates used to determine results for the current year apply to the corresponding prior-year period against which such results are being compared). +42 +Table of Contents +TABLE 7: SELECTED CREDIT-RELATED STATISTICAL INFORMATION +As of or for the Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Worldwide Card Member loans +Card Member loans: (billions) +U.S. $ 76.0 $ 72.0 $ 64.5 6 % 12 % +Outside the U.S. 11.4 9.9 8.9 15 11 +Total +$ 87.4 $ 81.9 $ 73.4 7 12 +Loss reserves: +Beginning balance $ 2,134 $ 1,706 $ 1,223 25 39 +Provisions - principal, interest and fees 2,462 2,266 1,868 9 21 +Net write-offs — principal less recoveries (1,860) (1,539) (1,181) 21 30 +Net write-offs — interest and fees less recoveries (375) (304) (227) 23 34 +Other (a) +22 5 23 # (78) +Ending balance $ 2,383 $ 2,134 $ 1,706 12 25 +Ending reserves — principal $ 2,252 $ 2,028 $ 1,622 11 25 +Ending reserves — interest and fees $ 131 $ 106 $ 84 24 26 +% of loans 2.7 % 2.6 % 2.3 % +% of past due 177 % 182 % 177 % +Average loans (billions) +$ 82.8 $ 75.8 $ 66.7 9 14 +Net write-off rate — principal only (b) +2.2 % 2.0 % 1.8 % +Net write-off rate — principal, interest and fees (b) +2.7 % 2.4 % 2.1 % +30+ days past due as a % of total (b) +1.5 % 1.4 % 1.3 % +Worldwide Card Member receivables +Card Member receivables: (billions) +U.S. $ 39.0 $ 39.0 $ 37.6 — 4 +Outside the U.S. 18.4 16.9 16.4 9 3 +Total +$ 57.4 $ 55.9 $ 54.0 3 4 +Loss reserves: +Beginning balance $ 573 $ 521 $ 467 10 12 +Provisions - principal and fees 963 937 795 3 18 +Net write-offs - principal and fees less recoveries (900) (859) (736) 5 17 +Other (a) +(17) (26) (5) (35) # +Ending balance $ 619 $ 573 $ 521 8 % 10 % +% of receivables 1.1 % 1.0 % 1.0 % +Net write-off rate — principal only (b) +1.8 % 1.7 % 1.6 % +Net write-off rate — principal and fees (b) +2.0 % 1.8 % 1.7 % +30+ days past due as a % of total (b) +1.4 % 1.4 % 1.4 % +Net loss ratio as a % of charge volume — GCP (c) +0.08 % 0.11 % 0.10 % +90+ days past billing as a % of total — GCP (c) +0.8 % 0.7 % 0.9 % +# Denotes a variance greater than 100 percent +(a) Other includes foreign currency translation adjustments. +(b) We present a net write-off rate based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, as our practice is to include uncollectible interest and/or fees as part of our total provision for losses, a net write-off rate including principal, interest and/or fees is also presented. The net write-off rates and 30+ days past due as a percentage of total for Card Member receivables relate to GCSG and Global Small Business Services (GSBS) Card Member receivables. +(c) Global Corporate Payments (GCP) reflects global, large and middle market corporate accounts. For GCP Card Member receivables, delinquency data is tracked based on days past billing status rather than days past due. A Card Member account is considered 90 days past billing if payment has not been received within 90 days of the Card Member’s billing statement date. In addition, if we initiate collection procedures on an account prior to the account becoming 90 days past billing, the associated Card Member receivable balance is classified as 90 days past billing. These amounts are shown above as 90+ Days Past Due for presentation purposes. GCP delinquency data for periods other than 90+ days past billing is not available due to system constraints. The net loss ratio for GCP represents the ratio of GCP charge card write-offs, consisting of principal (resulting from authorized transactions) and fee components, less recoveries, on Card Member receivables expressed as a percentage of gross amounts billed to corporate Card Members. +43 +Table of Contents +TABLE 8: NET INTEREST YIELD ON AVERAGE CARD MEMBER LOANS +Years Ended December 31, +(Millions, except percentages and where indicated) 2019 2018 2017 +Net interest income $ 8,620 $ 7,663 $ 6,451 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +1,732 1,456 1,149 +Interest income not attributable to our Card Member loan portfolio (b) +(1,226) (1,010) (637) +Adjusted net interest income (c) +$ 9,126 $ 8,109 $ 6,963 +Average Card Member loans (billions) +$ 82.8 $ 75.8 $ 66.7 +Net interest income divided by average Card Member loans (c) +10.4 % 10.1 % 9.7 % +Net interest yield on average Card Member loans (c) +11.0 % 10.7 % 10.4 % +(a) Primarily represents interest expense attributable to maintaining our corporate liquidity pool and funding Card Member receivables. +(b) Primarily represents interest income attributable to Other loans, interest-bearing deposits and the fixed income investment portfolios. +(c) Adjusted net interest income and net interest yield on average Card Member loans are non-GAAP measures. Refer to “Glossary of Selected Terminology” for the definitions of these terms. We believe adjusted net interest income is useful to investors because it represents the interest expense and interest income attributable to our Card Member loan portfolio and is a component of net interest yield on average Card Member loans, which provides a measure of profitability of our Card Member loan portfolio. Net interest yield on average Card Member loans reflects adjusted net interest income divided by average Card Member loans, computed on an annualized basis. Net interest income divided by average Card Member loans, computed on an annualized basis, a GAAP measure, includes elements of total interest income and total interest expense that are not attributable to the Card Member loan portfolio, and thus is not representative of net interest yield on average Card Member loans. +44 +Table of Contents +BUSINESS SEGMENT RESULTS OF OPERATIONS +We consider a combination of factors when evaluating the composition of our reportable operating segments, including the results reviewed by the chief operating decision maker, economic characteristics, products and services offered, classes of customers, product distribution channels, geographic considerations (primarily United States versus outside the United States) and regulatory considerations. Refer to Note 24 to the “Consolidated Financial Statements” and Part I, Item 1. “Business” for additional discussion of products and services that comprise each segment. +Effective for the first quarter of 2019, we moved intercompany assets and liabilities, previously recorded in the operating segments, to Corporate & Other. Prior period amounts have been revised to conform to the current period presentation. +Results of the reportable operating segments generally treat each segment as a stand-alone business. The management reporting process that derives these results allocates revenue and expense using various methodologies as described below. +TOTAL REVENUES NET OF INTEREST EXPENSE +We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue. +Net card fees and Other fees and commissions are directly attributable to the segment in which they are reported. +Interest and fees on loans and certain investment income is directly attributable to the segment in which it is reported. Interest expense represents an allocated funding cost based on a combination of segment funding requirements and internal funding rates. +PROVISIONS FOR LOSSES +The provisions for losses are directly attributable to the segment in which they are reported. +EXPENSES +Marketing and business development expense is included in each segment based on the actual expenses incurred. Global brand advertising is primarily reflected in Corporate & Other and may be allocated to the segments based on the actual expenses incurred. Rewards and Card Member services expenses are included in each segment based on the actual expenses incurred. +Salaries and employee benefits and other operating expenses reflect expenses such as professional services, occupancy and equipment and communications incurred directly within each segment. In addition, expenses related to support services, such as technology costs, are allocated to each segment primarily based on support service activities directly attributable to the segment. Certain other overhead expenses are allocated from Corporate & Other to the segments based on the relative levels of revenue and Card Member loans and receivables. +INCOME TAXES +An income tax provision (benefit) is allocated to each reportable operating segment based on the effective tax rates applicable to the various businesses that comprise the segment. +45 +Table of Contents +GLOBAL CONSUMER SERVICES GROUP +TABLE 9: GCSG SELECTED INCOME STATEMENT DATA +Years Ended December 31, Change Change +(Millions, except percentages) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Revenues +Non-interest revenues $ 15,972 $ 14,675 $ 13,378 $ 1,297 9 % $ 1,297 10 % +Interest income 9,413 8,323 6,789 1,090 13 1,534 23 +Interest expense 1,806 1,542 1,047 264 17 495 47 +Net interest income 7,607 6,781 5,742 826 12 1,039 18 +Total revenues net of interest expense 23,579 21,456 19,120 2,123 10 2,336 12 +Provisions for losses 2,636 2,430 1,996 206 8 434 22 +Total revenues net of interest expense after provisions for losses 20,943 19,026 17,124 1,917 10 1,902 11 +Expenses +Marketing, business development, rewards and Card Member services 12,023 10,774 9,233 1,249 12 1,541 17 +Salaries and employee benefits and other operating expenses 4,896 4,538 4,246 358 8 292 7 +Total expenses 16,919 15,312 13,479 1,607 10 1,833 14 +Pretax segment income 4,024 3,714 3,645 310 8 69 2 +Income tax provision 762 637 1,053 125 20 (416) (40) +Segment income $ 3,262 $ 3,077 $ 2,592 $ 185 6 % $ 485 19 % +Effective tax rate 18.9 % 17.2 % 28.9 % +GCSG primarily issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel and lifestyle services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues increased, primarily driven by discount revenue and net card fees. Discount revenue increased 8 percent reflecting a corresponding increase in proprietary consumer billed business. See Tables 5, 6 and 10 for more details on billed business performance. The increase in proprietary consumer billed business reflected higher average spend per card and higher cards-in-force. Net card fees increased 19 percent, driven primarily by growth in the Delta, Platinum and Gold portfolios, as well as growth in certain key international countries. +Net interest income increased, primarily driven by growth in average Card Member loans and higher yields, partially offset by higher cost of funds. +PROVISIONS FOR LOSSES +Provisions for losses increased, primarily driven by higher net write-offs, partially offset by a lower reserve build in Card Member loans due to slower loan growth. +Refer to Table 10 for the Card Member loan and receivable write-off rates for 2019 and 2018. +EXPENSES +Marketing, business development, rewards and Card Member services expenses increased across all expense categories. The increase in Card Member rewards expense was primarily driven by higher proprietary and cobrand spending volumes. The increase in Card Member services expense was primarily driven by higher usage of travel-related benefits. The increase in marketing and business development expenses was primarily due to higher cobrand partner payments. +Salaries and employee benefits and other operating expenses increased, primarily driven by higher technology and other servicing-related costs, and increased payroll costs, partially offset by non-income tax-related benefits. +46 +Table of Contents +TABLE 10: GCSG SELECTED STATISTICAL INFORMATION +As of or for the Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Proprietary billed business: (billions) +U.S. $ 398.8 $ 371.1 $ 336.9 7 % 10 % +Outside the U.S. 154.0 140.3 119.8 10 17 +Total $ 552.8 $ 511.4 $ 456.7 8 12 +Proprietary cards-in-force: +U.S. 37.9 37.7 34.9 1 8 +Outside the U.S. 17.5 16.8 15.8 4 6 +Total 55.4 54.5 50.7 2 7 +Proprietary basic cards-in-force: +U.S. 26.9 27.0 25.0 — 8 +Outside the U.S. 12.1 11.6 10.9 4 6 +Total 39.0 38.6 35.9 1 8 +Average proprietary basic Card Member spending: (dollars) +U.S. $ 14,801 $ 14,161 $ 13,950 5 2 +Outside the U.S. $ 12,884 $ 12,348 $ 11,225 4 10 +Average $ 14,212 $ 13,613 $ 13,115 4 4 +Total segment assets (billions) (a) +$ 106.3 $ 102.4 $ 94.9 4 8 +Card Member loans: +Total loans (billions) +U.S. $ 62.4 $ 59.9 $ 53.7 4 12 +Outside the U.S. 10.9 9.6 8.6 14 12 +Total $ 73.3 $ 69.5 $ 62.3 5 12 +Average loans (billions) +U.S. $ 59.4 $ 55.1 $ 49.0 8 12 +Outside the U.S. 10.0 8.9 7.4 12 20 +Total $ 69.4 $ 64.0 $ 56.4 8 % 13 % +U.S. +Net write-off rate — principal only (b) +2.3 % 2.1 % 1.8 % +Net write-off rate — principal, interest and fees (b) +2.8 % 2.5 % 2.1 % +30+ days past due as a % of total 1.6 % 1.4 % 1.3 % +Outside the U.S. +Net write-off rate — principal only (b) +2.4 % 2.1 % 2.1 % +Net write-off rate — principal, interest and fees (b) +2.9 % 2.6 % 2.5 % +30+ days past due as a % of total 1.8 % 1.6 % 1.4 % +Total +Net write-off rate — principal only (b) +2.3 % 2.1 % 1.8 % +Net write-off rate — principal, interest and fees (b) +2.8 % 2.5 % 2.2 % +30+ days past due as a % of total 1.6 % 1.5 % 1.3 % +47 +Table of Contents +Change Change +(Millions, except percentages and where indicated) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Card Member receivables: (billions) +U.S. $ 14.2 $ 13.7 $ 13.1 4 % 5 % +Outside the U.S. 8.6 7.8 7.8 10 — +Total receivables $ 22.8 $ 21.5 $ 20.9 6 % 3 % +U.S. +Net write-off rate — principal only (b) +1.4 % 1.3 % 1.3 % +Net write-off rate — principal and fees (b) +1.6 % 1.5 % 1.4 % +30+ days past due as a % of total 1.2 % 1.1 % 1.1 % +Outside the U.S. +Net write-off rate — principal only (b) +2.2 % 2.1 % 2.0 % +Net write-off rate — principal and fees (b) +2.4 % 2.3 % 2.1 % +30+ days past due as a % of total 1.3 % 1.3 % 1.3 % +Total +Net write-off rate — principal only (b) +1.7 % 1.6 % 1.5 % +Net write-off rate — principal and fees (b) +1.9 % 1.8 % 1.7 % +30+ days past due as a % of total 1.2 % 1.2 % 1.2 % +(a) During 2019, we moved intercompany assets and liabilities, previously recorded in the operating segments, to Corporate & Other. Prior period amounts have been revised to conform to the current period presentation. +(b) Refer to Table 7 footnote (b). +48 +Table of Contents +TABLE 11: GCSG NET INTEREST YIELD ON AVERAGE CARD MEMBER LOANS +As of or for the Years Ended December 31, +(Millions, except percentages and where indicated) 2019 2018 2017 +U.S. +Net interest income $ 6,557 $ 5,895 $ 4,961 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +257 202 164 +Interest income not attributable to our Card Member loan portfolio (b) +(219) (178) (101) +Adjusted net interest income (c) +$ 6,595 $ 5,919 $ 5,024 +Average Card Member loans (billions) +$ 59.4 $ 55.1 $ 48.9 +Net interest income divided by average Card Member loans (c) +11.0 % 10.7 % 10.1 % +Net interest yield on average Card Member loans (c) +11.1 % 10.7 % 10.3 % +Outside the U.S. +Net interest income $ 1,050 $ 886 $ 781 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +85 70 54 +Interest income not attributable to our Card Member loan portfolio (b) +(15) (8) (8) +Adjusted net interest income (c) +$ 1,120 $ 948 $ 827 +Average Card Member loans (billions) +$ 10.0 $ 8.9 $ 7.4 +Net interest income divided by average Card Member loans (c) +10.5 % 10.0 % 10.6 % +Net interest yield on average Card Member loans (c) +11.2 % 10.6 % 11.1 % +Total +Net interest income $ 7,607 $ 6,781 $ 5,742 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +342 272 218 +Interest income not attributable to our Card Member loan portfolio (b) +(234) (186) (110) +Adjusted net interest income (c) +$ 7,715 $ 6,867 $ 5,850 +Average Card Member loans (billions) +$ 69.4 $ 64.0 $ 56.4 +Net interest income divided by average Card Member loans (c) +11.0 % 10.6 % 10.2 % +Net interest yield on average Card Member loans (c) +11.1 % 10.7 % 10.4 % +(a) Refer to Table 8 footnote (a). +(b) Refer to Table 8 footnote (b). +(c) Refer to Table 8 footnote (c). +49 +Table of Contents +GLOBAL COMMERCIAL SERVICES +TABLE 12: GCS SELECTED INCOME STATEMENT DATA +Years Ended December 31, Change Change +(Millions, except percentages) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Revenues +Non-interest revenues $ 12,623 $ 11,882 $ 10,942 $ 741 6 % $ 940 9 % +Interest income 1,900 1,621 1,361 279 17 260 19 +Interest expense 995 827 595 168 20 232 39 +Net interest income 905 794 766 111 14 28 4 +Total revenues net of interest expense 13,528 12,676 11,708 852 7 968 8 +Provisions for losses 917 899 743 18 2 156 21 +Total revenues net of interest expense after provisions for losses 12,611 11,777 10,965 834 7 812 7 +Expenses +Marketing, business development, rewards and Card Member services 6,241 5,853 5,311 388 7 542 10 +Salaries and employee benefits and other operating expenses 3,304 3,029 2,811 275 9 218 8 +Total expenses 9,545 8,882 8,122 663 7 760 9 +Pretax segment income 3,066 2,895 2,843 171 6 52 2 +Income tax provision 590 555 914 35 6 (359) (39) +Segment income $ 2,476 $ 2,340 $ 1,929 $ 136 6 % $ 411 21 % +Effective tax rate 19.2 % 19.2 % 32.1 % +GCS primarily issues a wide range of proprietary corporate and small business cards and provides payment and expense management services globally. In addition, GCS provides commercial financing products. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues increased, primarily driven by higher discount revenue, which increased 6 percent, reflecting growth in billed business from small and medium sized businesses, and higher net card fees, primarily due to growth in the U.S. small business Platinum portfolio. See Tables 5, 6 and 13 for more details on billed business performance. +Net interest income increased, primarily driven by growth in average Card Member loans, partially offset by higher cost of funds. +PROVISIONS FOR LOSSES +Provisions for losses increased, driven by higher net write-offs in the small business portfolio due to continued portfolio growth, partially offset by lower net write-offs in the corporate portfolio. +EXPENSES +Marketing, business development, rewards and Card Member services expenses increased, primarily driven by increases in Card Member rewards expense and marketing and business development expense, which primarily reflected higher spending volumes and increased corporate client incentives. +Salaries and employee benefits and other operating expenses increased, primarily driven by higher technology and other servicing-related costs, and higher payroll costs. +50 +Table of Contents +TABLE 13: GCS SELECTED STATISTICAL INFORMATION +As of or for the Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Proprietary billed business (billions) +$ 513.3 $ 486.2 $ 438.1 6 % 11 % +Proprietary cards-in-force 14.9 14.5 14.0 3 4 +Average Card Member spending (dollars) +$ 34,905 $ 34,058 $ 31,729 2 7 +Total segment assets (billions) (a) +$ 52.8 $ 51.3 $ 48.5 3 6 +Card Member loans (billions) +$ 14.1 $ 12.4 $ 11.1 14 12 +Card Member receivables (billions) +$ 34.6 $ 34.4 $ 33.1 1 4 +GSBS Card Member loans: (b) +Total loans (billions) +$ 14.1 $ 12.4 $ 11.0 14 13 +Average loans (billions) +$ 13.3 $ 11.7 $ 10.3 14 % 14 % +Net write-off rate - principal only (c) +1.9 % 1.7 % 1.6 % +Net write-off rate - principal, interest and fees (c) +2.2 % 2.0 % 1.9 % +30+ days past due as a % of total 1.3 % 1.3 % 1.2 % +Calculation of Net Interest Yield on Average Card Member Loans: +Net interest income $ 905 $ 794 $ 766 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (d) +727 609 461 +Interest income not attributable to our Card Member loan portfolio (e) +(221) (161) (114) +Adjusted net interest income (f) +$ 1,411 $ 1,242 $ 1,113 +Average Card Member loans (billions) +$ 13.4 $ 11.8 $ 10.3 +Net interest income divided by average Card Member loans (f) +6.8 % 6.7 % 7.4 % +Net interest yield on average Card Member loans (f) +10.5 % 10.5 % 10.8 % +GCP Card Member receivables: +Total receivables (billions) +$ 17.2 $ 17.7 $ 17.0 (3) % 4 % +90+ days past billing as a % of total (g) +0.8 % 0.7 % 0.9 % +Net loss ratio (as a % of charge volume) (g) +0.08 % 0.11 % 0.10 % +GSBS Card Member receivables: +Total receivables (billions) +$ 17.4 $ 16.7 $ 16.1 4 % 4 % +Net write-off rate - principal only (c) +1.9 % 1.7 % 1.6 % +Net write-off rate - principal and fees (c) +2.1 % 2.0 % 1.8 % +30+ days past due as a % of total 1.7 % 1.6 % 1.6 % +(a) During 2019, we moved intercompany assets and liabilities, previously recorded in the operating segments, to Corporate & Other. Prior period amounts have been revised to conform to the current period presentation. +(b) Effective July 1, 2017, GSBS loans and associated metrics reflect worldwide small business services loans. Prior to July 1, 2017, due to certain system limitations, small business services loans outside the U.S. and associated credit metrics are reflected within GCSG, and were not significant to either GCSG or GCS. +(c) Refer to Table 7 footnote (b). +(d) Refer to Table 8 footnote (a). +(e) Refer to Table 8 footnote (b). +(f) Refer to Table 8 footnote (c). +(g) Refer to Table 7 footnote (c). +51 +Table of Contents +GLOBAL MERCHANT AND NETWORK SERVICES +TABLE 14: GMNS SELECTED INCOME STATEMENT AND OTHER DATA +Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2019 2018 2017 +2019 vs. 2018 +2018 vs. 2017 +Revenues +Non-interest revenues $ 6,252 $ 6,069 $ 6,025 $ 183 3 % $ 44 1 % +Interest income 28 30 42 (2) (7) (12) (29) +Interest expense (365) (294) (188) (71) 24 (106) 56 +Net interest income 393 324 230 69 21 94 41 +Total revenues net of interest expense 6,645 6,393 6,255 252 4 138 2 +Provisions for losses 20 22 16 (2) (9) 6 38 +Total revenues net of interest expense after provisions for losses 6,625 6,371 6,239 254 4 132 2 +Expenses +Marketing, business development, rewards and Card Member services 1,427 1,250 1,227 177 14 23 2 +Salaries and employee benefits and other operating expenses 2,050 2,277 2,367 (227) (10) (90) (4) +Total expenses 3,477 3,527 3,594 (50) (1) (67) (2) +Pretax segment income 3,148 2,844 2,645 304 11 199 8 +Income tax provision 736 704 857 32 5 (153) (18) +Segment income $ 2,412 $ 2,140 $ 1,788 $ 272 13 $ 352 20 +Effective tax rate 23.4 % 24.8 % 32.4 % +Total segment assets (billions) (a) +$ 17.5 $ 15.5 $ 19.7 $ 2.0 13 % $ (4) (21) % +(a) During 2019, we moved intercompany assets and liabilities, previously recorded in the operating segments, to Corporate & Other. Prior period amounts have been revised to conform to the current period presentation. +GMNS operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses in certain countries. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues increased, primarily driven by worldwide billed business growth. +Net interest income increased, reflecting a higher interest expense credit relating to internal transfer pricing, which results in a net benefit for GMNS due to its merchant payables. +EXPENSES +Marketing, business development, rewards and Card Member services expenses increased, primarily driven by marketing and business development expense reflecting increased network issuer expense due to higher U.S. volumes and payments related to the partnership agreement with our prepaid reloadable and gift card program manager, partially offset by lower levels of spending on growth initiatives. +Salaries and employee benefits and other operating expenses decreased, reflecting, in part, lower technology and other service-related costs, and the prior-year loss on a transaction involving the operations of our prepaid reloadable and gift card business . +CORPORATE & OTHER +Corporate functions and certain other businesses are included in Corporate & Other. +Corporate & Other net loss was $1.4 billion and $0.6 billion in 2019 and 2018, respectively. The increase in the net loss in 2019 compared to 2018 was primarily driven by lower discrete tax benefits, lower unrealized gains on certain equity investments and higher restructuring charges. +52 +Table of Contents +CONSOLIDATED CAPITAL RESOURCES AND LIQUIDITY +Our balance sheet management objectives are to maintain: +• A solid and flexible equity capital profile; +• A broad, deep and diverse set of funding sources to finance our assets and meet operating requirements; and +• Liquidity programs that enable us to continuously meet expected future financing obligations and business requirements for at least a twelve-month period in the event we are unable to continue to raise new funds under our traditional funding programs during a substantial weakening in economic conditions. +CAPITAL STRATEGY +Our objective is to retain sufficient levels of capital generated through earnings and other sources to maintain a solid equity capital base and to provide flexibility to support future business growth. We believe capital allocated to growing businesses with a return on risk-adjusted equity in excess of our costs will generate shareholder value. +The level and composition of our consolidated capital position are determined through our Internal Capital Adequacy Assessment Process, which takes into account our business activities, as well as marketplace conditions and requirements or expectations of credit rating agencies, regulators and shareholders, among others. Our consolidated capital position is also influenced by subsidiary capital requirements. As a bank holding company, we are also subject to regulatory requirements administered by the U.S. federal banking agencies. The Federal Reserve has established specific capital adequacy guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items. +We report our capital ratios using the Basel III capital definitions and the Basel III standardized approach for calculating risk-weighted assets. The Basel III minimum requirements and the capital conservation buffers have been fully phased in as of January 1, 2019. +As a Category IV firm, we are no longer subject to the Basel III advanced approaches capital requirements. Refer to "Financial Regulatory Reform" under Part I, Item I. "Business ― Supervision and Regulation" for additional details. +The following table presents our regulatory risk-based capital ratios and leverage ratios and those of our significant bank subsidiary, American Express National Bank (AENB) as of December 31, 2019. +TABLE 15: REGULATORY RISK-BASED CAPITAL AND LEVERAGE RATIOS +Basel III Minimum +Ratios as of December 31, 2019 +Risk-Based Capital +Common Equity Tier 1 7.0 % +American Express Company 10.7 % +American Express National Bank 13.4 +Tier 1 8.5 +American Express Company 11.6 +American Express National Bank 13.4 +Total 10.5 +American Express Company 13.2 +American Express National Bank 15.4 +Tier 1 Leverage 4.0 +American Express Company 10.2 +American Express National Bank 11.1 +Supplementary Leverage Ratio 3.0 % +American Express Company 8.8 +American Express National Bank 9.3 % +53 +Table of Contents +TABLE 16: REGULATORY RISK-BASED CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS +American Express Company +($ in Billions) +December 31, 2019 +Risk-Based Capital +Common Equity Tier 1 $ 18.1 +Tier 1 Capital 19.6 +Tier 2 Capital +2.6 +Total Capital 22.2 +Risk-Weighted Assets 168.5 +Average Total Assets to calculate the Tier 1 Leverage Ratio 192.3 +Total Leverage Exposure to calculate supplementary leverage ratio $ 224.0 +We seek to maintain capital levels and ratios in excess of the minimum regulatory requirements, specifically within a 10 to 11 percent target range for American Express' Common Equity Tier 1 risk-based capital ratio, and finance such capital in a cost efficient manner. Failure to maintain minimum capital levels at American Express or AENB could affect our status as a financial holding company and cause the regulatory agencies with oversight of American Express or AENB to take actions that could limit our business operations. +Our primary source of equity capital has been the generation of net income. Capital generated through net income and other sources, such as the exercise of stock options by employees, is used to maintain a strong balance sheet, support asset growth and engage in acquisitions, with excess available for distribution to shareholders through dividends and share repurchases. +We maintain certain flexibility to shift capital across our businesses as appropriate. For example, we may infuse additional capital into subsidiaries to maintain capital at targeted levels in consideration of debt ratings and regulatory requirements. These infused amounts can affect the capital profile and liquidity levels at the American Express parent company level. +The following are definitions for our regulatory risk-based capital ratios and leverage ratio, which are calculated as per standard regulatory guidance: +Risk-Weighted Assets — Assets are weighted for risk according to a formula used by the Federal Reserve to conform to capital adequacy guidelines. On- and off-balance sheet items are weighted for risk, with off-balance sheet items converted to balance sheet equivalents, using risk conversion factors, before being allocated a risk-adjusted weight. Off-balance sheet exposures comprise a minimal part of the total risk-weighted assets. +Common Equity Tier 1 Risk-Based Capital Ratio — Calculated as Common Equity Tier 1 capital (CET1), divided by risk-weighted assets. CET1 is the sum of common shareholders’ equity, adjusted for ineligible goodwill and intangible assets, certain deferred tax assets, as well as certain other comprehensive income items as follows: net unrealized gains/losses on securities, foreign currency translation adjustments and net unrealized pension and other postretirement benefit/losses, all net of tax. +Tier 1 Risk-Based Capital Ratio — Calculated as Tier 1 capital divided by risk-weighted assets. Tier 1 capital is the sum of CET1, our perpetual preferred stock and third-party non-controlling interests in consolidated subsidiaries, adjusted for capital held by insurance subsidiaries. The minimum requirement for the Tier 1 risk-based capital ratio is 1.5 percent higher than the minimum for the CET1 risk-based capital ratio. We have $1.6 billion of preferred shares outstanding to help address a portion of the Tier 1 capital requirements in excess of common equity requirements. +Total Risk-Based Capital Ratio — Calculated as the sum of Tier 1 capital and Tier 2 capital, divided by risk-weighted assets. Tier 2 capital is the sum of the allowance for loan and receivable losses (limited to 1.25 percent of risk-weighted assets), minority interest that is not included in Tier 1 capital and $480 million of eligible subordinated notes, adjusted for capital held by insurance subsidiaries. The $480 million of eligible subordinated notes reflect a 20 percent, or $120 million, reduction of Tier 2 capital credit for the $600 million subordinated debt issued in December 2014. +Tier 1 Leverage Ratio — Calculated by dividing Tier 1 capital by our average total consolidated assets for the most recent quarter. +Supplementary Leverage Ratio — Calculated by dividing Tier 1 capital by total leverage exposure under Basel III. Total leverage exposure reflects average total consolidated assets with adjustments for Tier 1 capital deductions, average off-balance sheet derivative exposures, average securities purchased under agreements to resell, and average credit equivalents of conditionally and unconditionally cancellable undrawn commitments. +54 +Table of Contents +In December 2018, federal banking regulators issued a final rule that provides an optional three-year phase-in period for the adverse regulatory capital effects upon adopting the CECL model pursuant to new accounting guidance for the recognition of credit losses on financial instruments, effective January 1, 2020. We plan to elect to phase-in the regulatory capital impact of adopting CECL, at 25 percent per year through January 1, 2023. The Federal Reserve also released a statement indicating that it plans to maintain the current framework for calculating credit loss allowances on loans in supervisory stress tests through the 2021 stress test cycle. Refer to Note 1 to the “Consolidated Financial Statements” for further information about CECL. +SHARE REPURCHASES AND DIVIDENDS +We return capital to common shareholders through dividends and share repurchases. The share repurchases reduce common shares outstanding and more than offset the issuance of new shares as part of employee compensation plans. +During the year ended December 31, 2019, we returned $5.9 billion to our shareholders in the form of common stock dividends of $1.4 billion and share repurchases of $4.6 billion. We repurchased 40 million common shares at an average price of $115.50 in 2019. These dividend and share repurchase amounts collectively represent approximately 87 percent of total capital generated during the year. +In addition, during the year ended December 31, 2019, we paid $81 million in dividends on non-cumulative perpetual preferred shares outstanding. For additional information on our preferred shares, refer to Note 16 to the “Consolidated Financial Statements.” +FUNDING STRATEGY +Our principal funding objective is to maintain broad and well-diversified funding sources to allow us to meet our maturing obligations, cost-effectively finance current and future asset growth in our global businesses, as well as to maintain a strong liquidity profile. The diversity of funding sources by type of instrument, by maturity and by investor base, among other factors, provides additional insulation from the impact of disruptions in any one type of instrument, maturity or investor. The mix of our funding in any period will seek to achieve cost efficiency consistent with both maintaining diversified sources and achieving our liquidity objectives. While we seek to diversify our funding sources by maintaining scale and relevance in unsecured debt, asset securitizations and deposits, we currently expect that direct deposits, such as the Personal Savings program, will become a larger proportion of our funding over time. Our funding strategy and activities are integrated into our asset-liability management activities. We have in place a funding policy covering American Express Company and all of our subsidiaries. +Our global proprietary card-issuing businesses generate significant assets in both domestic and international Card Member lending and receivable activities. Our financing needs are in large part a consequence of our proprietary card-issuing businesses, and the maintenance of a liquidity position to meet regulatory requirements and support all of our business activities, such as merchant payments. We generally pay merchants for card transactions prior to reimbursement by Card Members and therefore fund the merchant payments during the period Card Member loans and receivables are outstanding. We also have additional financing needs associated with general corporate purposes. Our funding plan to meet these financing needs is in turn driven by, among other factors, our liquidity position, size and mix of business asset growth, choice of funding sources, and our maturing obligations. +FUNDING PROGRAMS AND ACTIVITIES +We meet our funding needs through a variety of sources, including direct and third-party distributed deposits and debt instruments, such as senior unsecured debt, asset securitizations, borrowings through secured borrowing facilities and a committed bank credit facility. +We had the following consolidated debt and customer deposits outstanding as of December 31: +TABLE 17: SUMMARY OF CONSOLIDATED DEBT AND CUSTOMER DEPOSITS +(Billions) 2019 2018 +Short-term borrowings $ 6.4 $ 3.1 +Long-term debt 57.8 58.4 +Total debt 64.2 61.5 +Customer deposits 73.3 70.0 +Total debt and customer deposits $ 137.5 $ 131.5 +We may redeem from time to time certain debt securities within 31 days prior to the original contractual maturity dates in accordance with the optional redemption provisions of those debt securities. +55 +Table of Contents +Our funding plan for the full year 2020 includes, among other sources, approximately zero to $3 billion of unsecured term debt issuance and approximately $7 billion to $10 billion of secured term debt issuance. Our annual funding plans can vary due to various risks and uncertainties, such as future business growth, the impact of global economic, political and other events on market capacity, demand for securities offered by us, regulatory changes, ability to securitize and sell receivables, and the performance of receivables previously sold in securitization transactions. Many of these risks and uncertainties are beyond our control. +Our equity capital and funding strategies are designed, among other things, to maintain appropriate and stable unsecured debt ratings from the major credit rating agencies: Moody’s Investor Services (Moody’s), Standard & Poor’s (S&P) and Fitch Ratings (Fitch). Such ratings help support our access to cost-effective unsecured funding as part of our overall funding strategy. Our asset securitization activities are rated separately. +TABLE 18: UNSECURED DEBT RATINGS +Credit Agency American Express Entity Short-Term Ratings Long-Term Ratings Outlook +Fitch All rated entities F1 A Stable +Moody’s +American Express Travel Related Services Company, Inc. +N/A A2 Stable +Moody's American Express Credit Corporation Prime-1 A2 Stable +Moody’s American Express National Bank Prime-1 A3 Stable +Moody's American Express Company N/A A3 Stable +S&P +American Express Travel Related Services Company, Inc. +N/A A- Stable +S&P American Express Credit Corporation and American Express National Bank A-2 A- Stable +S&P American Express Company A-2 BBB+ Stable +Downgrades in the ratings of our unsecured debt or asset securitization program securities could result in higher funding costs, as well as higher fees related to borrowings under our unused lines of credit. Declines in credit ratings could also reduce our borrowing capacity in the unsecured debt and asset securitization capital markets. We believe our funding mix, including the proportion of U.S. retail deposits insured by the Federal Deposit Insurance Corporation (FDIC) to total funding, should reduce the impact that credit rating downgrades would have on our funding capacity and costs. +SHORT-TERM FUNDING PROGRAMS +Short-term borrowings, such as commercial paper, are defined as any debt with an original maturity of twelve months or less, as well as interest-bearing overdrafts with banks. Our short-term funding programs are used primarily to fund working capital needs, such as managing seasonal variations in receivables balances. The amount of short-term borrowings issued in the future will depend on our funding strategy, our needs and market conditions. As of December 31, 2019, we had $3.0 billion in commercial paper outstanding and we had an average of $0.3 billion in commercial paper outstanding during 2019. Refer to Note 8 to the “Consolidated Financial Statements” for a further description of these borrowings. +DEPOSIT PROGRAMS +We offer deposits within our U.S. bank subsidiary, AENB. These funds are currently insured up to $250,000 per account holder through the FDIC. Our ability to obtain deposit funding and offer competitive interest rates is dependent on the capital level of AENB. We, through AENB, have a Personal Savings program, which is our primary deposit product channel. The direct retail program makes FDIC-insured certificates of deposit (CDs) and high-yield savings account products available directly to consumers. We also source deposits through third-party distribution channels as needed to meet our overall funding objectives. As of December 31, 2019 we had $73.3 billion in customer deposits. Refer to Note 7 to the “Consolidated Financial Statements” for a further description of these deposits. +56 +Table of Contents +LONG-TERM DEBT AND ASSET SECURITIZATION PROGRAMS +As of December 31, 2019, we had $57.8 billion in long-term debt outstanding. During 2019, we and our subsidiaries issued $11.7 billion of unsecured debt and asset-backed securities with maturities ranging from 2 to 7 years. Refer to Note 8 to the “Consolidated Financial Statements” for a further description of these borrowings. +We periodically securitize Card Member loans and receivables arising from our card business, as the securitization market provides us with cost-effective funding. Securitization of Card Member loans and receivables is accomplished through the transfer of those assets to a trust, which in turn issues securities collateralized by the transferred assets to third-party investors. The proceeds from issuance are distributed to us, through our wholly-owned subsidiaries, as consideration for the transferred assets. Refer to Note 5 to the “Consolidated Financial Statements” for a further description of our asset securitizations. +On February 1, 2020, we removed U.S. consumer and small business Card Member receivables from the American Express Issuance Trust II (the Charge Trust) and substantially replaced them with U.S. corporate Card Member receivables. +Our 2019 long-term debt and asset securitization issuances were as follows: +TABLE 19: DEBT ISSUANCES +(Billions) 2019 +American Express Company: +Fixed Rate Senior Notes (weighted-average coupon of 2.92%) $ 5.6 +Floating Rate Senior Notes (3-month LIBOR plus 62 basis points) 0.9 +American Express Credit Account Master Trust: +Fixed Rate Class A Certificates (weighted-average coupon of 2.55%) 4.2 +Fixed Rate Class B Certificates (weighted-average coupon of 2.75%) 0.2 +Floating Rate Class A Certificates (1-month LIBOR plus 24 basis points) 0.8 +Total $ 11.7 +LIQUIDITY MANAGEMENT +Our liquidity objective is to maintain access to a diverse set of on- and off-balance sheet liquidity sources. We seek to maintain liquidity sources in amounts sufficient to meet our expected future financial obligations and business requirements for liquidity for a period of at least twelve months in the event we are unable to raise new funds under our regular funding programs during a substantial weakening in economic conditions. +Our liquidity management strategy includes a number of elements, including, but not limited to: +• Maintaining diversified funding sources (refer to the “Funding Strategy” section for more details); +• Maintaining unencumbered liquid assets and off-balance sheet liquidity sources; +• Projecting cash inflows and outflows under a variety of economic and market scenarios; +• Establishing clear objectives for liquidity risk management, including compliance with regulatory requirements; and +• Incorporating liquidity risk management as appropriate into our capital adequacy framework. +We seek to maintain access to a diverse set of on-balance sheet and off-balance sheet liquidity sources, including cash and other liquid assets, committed bank credit facilities and secured borrowing facilities. Through our U.S. bank subsidiary, AENB, we also hold collateral eligible for use at the Federal Reserve’s discount window. +The amount and type of liquidity resources we maintain can vary over time, based upon the results of stress scenarios required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as additional stress scenarios required under our liquidity risk policy. These stress scenarios possess distinct characteristics, varying by cash flow assumptions, time horizon and qualifying liquidity sources, among other factors. Scenarios under our liquidity risk policy include market-wide, firm-specific and combined liquidity stresses. We consider other factors in determining the amount and type of liquidity we maintain, such as economic and financial market conditions, seasonality in business operations, growth in our businesses, potential acquisitions or dispositions, the cost and availability of alternative liquidity sources and credit rating agency guidelines and requirements. +The investment income we receive on liquidity resources is less than the interest expense on the sources of funding for these balances. The level of future net interest costs to maintain these resources can be substantial, as it depends on the amount of liquidity resources we maintain and the difference between our cost of funding these amounts and their investment yields. +57 +Table of Contents +Securitized Borrowing Capacity +As of December 31, 2019, we maintained our committed, revolving, secured borrowing facility, with a maturity date of July 15, 2022, which gives us the right to sell up to $3.0 billion face amount of eligible AAA notes from the Charge Trust. We also maintained our committed, revolving, secured borrowing facility, with a maturity date of September 15, 2022, which gives us the right to sell up to $2.0 billion face amount of eligible AAA certificates from the American Express Credit Account Master Trust (the Lending Trust). Both facilities are used in the ordinary course of business to fund working capital needs, as well as to further enhance our contingent funding resources. As of December 31, 2019, no amounts were drawn on the Charge Trust facility or the Lending Trust facility. +Federal Reserve Discount Window +As an insured depository institution, AENB may borrow from the Federal Reserve Bank of San Francisco, subject to the amount of qualifying collateral that it may pledge. The Federal Reserve has indicated that both credit and charge card receivables are a form of qualifying collateral for secured borrowings made through the discount window. Whether specific assets will be considered qualifying collateral and the amount that may be borrowed against the collateral, remain at the discretion of the Federal Reserve. +We had approximately $76.6 billion as of December 31, 2019 in U.S. credit card loans and charge card receivables that could be sold over time through our securitization trusts or pledged in return for secured borrowings to provide further liquidity, subject in each case to applicable market conditions and eligibility criteria. +Committed Bank Credit Facility +In addition to the secured borrowing facilities described above, we maintained a committed syndicated bank credit facility as of December 31, 2019 of $3.5 billion, with a maturity date of October 15, 2022. The availability of this credit line is subject to our compliance with certain financial covenants, principally the maintenance by American Express Credit Corporation (Credco) of a certain ratio of combined earnings and fixed charges to fixed charges. As of December 31, 2019 and 2018, we were in compliance with each of our covenants. As of December 31, 2019, no amounts were drawn on the committed credit facility. We may, from time to time, use this facility in the ordinary course of business to fund working capital needs. Any undrawn portion of this facility could serve as backstop for the amount of commercial paper outstanding. +Our committed bank credit facility does not contain a material adverse change clause, which might otherwise preclude borrowing under the credit facility, nor is it dependent on our credit rating. +CASH FLOWS +The following table summarizes our cash flow activity, followed by a discussion of the major drivers impacting operating, investing and financing cash flows. +TABLE 20: CASH FLOWS +(Billions) 2019 2018 2017 +Total cash provided by (used in): +Operating activities $ 13.6 $ 8.9 $ 13.5 +Investing activities (16.7) (19.6) (18.2) +Financing activities (0.5) 5.1 12.2 +Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash 0.2 0.1 0.3 +Net (decrease) increase in cash, cash equivalents and restricted cash $ (3.4) $ (5.5) $ 7.8 +Cash Flows from Operating Activities +Our cash flows from operating activities primarily include net income adjusted for (i) non-cash items included in net income, such as provisions for losses, depreciation and amortization, deferred taxes and stock-based compensation and (ii) changes in the balances of operating assets and liabilities, which can vary significantly in the normal course of business due to the amount and timing of payments. +The increase in net cash provided by operating activities was primarily driven by the amount and timing of payments of accounts payable and other liabilities. +58 +Table of Contents +Cash Flows from Investing Activities +Our cash flows from investing activities primarily include changes in Card Member receivables and loans, as well as changes in our available-for-sale investment securities portfolio. +The decrease in net cash used in investing activities was primarily driven by lower growth in Card Member receivables and loans, partially offset by a larger net increase in the investment securities portfolio. +Cash Flows from Financing Activities +Our cash flows from financing activities primarily include changes in customer deposits, long-term debt and short-term borrowings, as well as dividend payments and share repurchases. +The increase in net cash used in financing activities was primarily driven by a higher level of share repurchases and lower growth in customer deposits. +OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS +We have identified both on- and off-balance sheet transactions, arrangements, obligations and other relationships that may have a material current or future effect on our financial condition, changes in financial condition, results of operations, or liquidity and capital resources. +CONTRACTUAL OBLIGATIONS +The table below identifies transactions that represent our contractually committed future obligations. Purchase obligations include our agreements to purchase goods and services that are enforceable and legally binding and that specify significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. +TABLE 21: COMMITTED FUTURE OBLIGATIONS BY YEAR +Payments due by year (a) +(Millions) 2020 2021-2022 2023-2024 2025 and thereafter Total +Long-term debt $ 15,615 $ 25,898 $ 12,050 $ 4,883 $ 58,446 +Certificates of deposit 4,632 4,687 625 — 9,944 +Interest payments on long-term debt (b) +1,426 1,844 743 1,246 5,259 +Lease obligations 134 214 166 842 1,356 +Deemed repatriation tax (c) +— — 263 749 1,012 +Purchase obligations (d) +269 188 33 — 490 +Other long-term liabilities (e) (f) +217 101 3 20 341 +Total 22,293 32,932 13,883 7,740 76,848 +(a) The table above excludes approximately $0.7 billion of tax reserves related to the uncertainty in income taxes as inherent complexities and the number of tax years currently open for examination in multiple jurisdictions do not permit reasonable estimates of payments, if any, to be made over a range of years. Refer to Note 20 to the “Consolidated Financial Statements” for additional information. +(b) Estimated interest payments were calculated using the effective interest rates as of December 31, 2019, and includes the effect of existing interest rate swaps. Actual cash flows may differ from estimated payments. +(c) Represents the remaining obligation under the Tax Act to pay a one-time transition tax on unrepatriated earnings and profits of certain foreign subsidiaries. In 2019, the Internal Revenue Service applied our prior year U.S. federal income tax return over-payment against a portion of the remaining obligation. +(d) The purchase obligation amounts represent either the early termination fees or non-cancelable minimum contractual obligations, as applicable, by period under contracts that were in effect as of December 31, 2019. +(e) As of December 31, 2019, there were no minimum required contributions, and no contributions are currently planned, for the U.S. American Express Retirement Plan. For the U.S. American Express Retirement Restoration Plan and non-U.S. defined benefit pension and postretirement benefit plans, contributions in 2020 are anticipated to be approximately $45 million, and this amount has been included within other long-term liabilities. Remaining obligations under defined benefit pension and postretirement benefit plans aggregating $595 million have not been included in the table above as the timing of such obligations is not determinable. Additionally, other long-term liabilities do not include $8.9 billion of Membership Rewards liabilities, which are not considered long-term liabilities as Card Members in good standing can redeem points immediately, without restrictions, and because the timing of point redemption is not determinable. +(f) As of December 31, 2019, we had committed to provide funding related to certain tax credit investments resulting in a $211 million unfunded commitment included in other long-term liabilities. In addition to this amount, there was a further $78 million of contractual off-balance sheet obligations that have not been included in the table above as the timing of such obligations is not determinable. Refer to Note 6 to the “Consolidated Financial Statements” for additional information. +59 +Table of Contents +In addition to the contractual obligations noted in Table 21, we have financial commitments related to agreements with certain cobrand partners under which we are required to make a certain level of minimum payments over the life of the agreement, generally ranging from five to ten years. Such commitments are designed to be satisfied by the payments we make to such cobrand partners primarily based on Card Members' spending and earning rewards on their cobrand cards and as we acquire new Card Members. In the event these payments do not fully satisfy the commitment, we will pay the cobrand partner up to the amount of the commitment in exchange for an equivalent value of reward points. As of December 31, 2019, we had $5 billion in such commitments outstanding and also had certain cobrand arrangements that include commitments based on variables, the values of which are not yet determinable and thus the amount is not quantifiable. +We also have off-balance sheet arrangements that include guarantees, indemnifications and certain other off-balance sheet arrangements. +GUARANTEES +As of December 31, 2019, we had guarantees and indemnifications totaling approximately $1 billion related primarily to real estate and business dispositions in the ordinary course of business. Refer to Note 15 to the “Consolidated Financial Statements” for further discussion regarding our guarantees. +CERTAIN OTHER OFF-BALANCE SHEET ARRANGEMENTS +As of December 31, 2019, we had approximately $306 billion of unused credit available to Card Members as part of established lending product agreements. Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no pre-set spending limit, and therefore are not reflected in unused credit available to Card Members. +We provide Card Member protection plans that cover losses associated with purchased products. The maximum potential liability related to these plans is the portion of annual billed business for which timely and valid disputes may be raised under applicable law and relevant customer agreements. However, based on historical experience, we believe that this total amount is not representative of our actual potential loss exposure. The actual amount of the potential exposure cannot be quantified as the billed business volumes which may include or result in claims under these plans are not sufficiently estimable. Losses related to these protection plans were immaterial for the years ended December 31, 2019, 2018 and 2017. +Refer to Notes 6 and 12 to the “Consolidated Financial Statements” for discussion regarding our other off-balance sheet arrangements. +RISK MANAGEMENT +GOVERNANCE +We use our comprehensive Enterprise-wide Risk Management (ERM) program to identify, aggregate, monitor, and manage risks. The program also defines our risk appetite, governance, culture and capabilities. The implementation and execution of the ERM program is headed by our Chief Risk Officer. +Risk management is overseen by our Board of Directors through three Board committees: the Risk Committee, the Audit and Compliance Committee, and the Compensation and Benefits Committee. Each committee consists entirely of independent directors and provides regular reports to the full Board regarding matters reviewed at their committee. The committees meet regularly in private sessions with our Chief Risk Officer, the Chief Compliance & Ethics Officer, the Chief Audit Executive and other senior management with regard to our risk management processes, controls, talent and capabilities. The Board monitors the “tone at the top,” our risk culture, and oversees emerging and strategic risks. +The Risk Committee of our Board of Directors provides oversight of our enterprise-wide risk management framework, processes and methodologies. The Risk Committee approves our ERM policy. The ERM policy governs risk governance, risk oversight and risk appetite for risks, including individual credit risk, institutional credit risk, market risk, liquidity risk, operational risk, reputational risk, compliance risk, model risk, asset/liability risk, strategic and business risk, and foreign country risk. Risk appetite defines the authorized risk limits to control exposures within our risk capacity and risk tolerance, including stressed forward-looking scenarios. In addition, it establishes principles for risk taking in the aggregate and for each risk type, and is supported by a comprehensive system for monitoring limits, escalation triggers and assessing control programs. +The Risk Committee reviews and concurs in the appointment, replacement, performance and compensation of our Chief Risk Officer and receives regular updates from the Chief Risk Officer on key risks, transactions and exposures. +60 +Table of Contents +The Risk Committee reviews our risk profile against the tolerances specified in the Risk Appetite Framework, including significant risk exposures, risk trends in our portfolios and major risk concentrations. +The Risk Committee also provides oversight of our compliance with Basel capital and liquidity standards, our Internal Capital Adequacy Assessment Process, including its Comprehensive Capital Analysis and Review (CCAR) submissions, and resolution planning. +The Audit and Compliance Committee of our Board of Directors reviews and approves compliance policies, which include our Compliance Risk Tolerance Statement. In addition, the Audit and Compliance Committee reviews the effectiveness of our Corporate-wide Compliance Risk Management Program. More broadly, this committee is responsible for assisting the Board in its oversight responsibilities relating to the integrity of our financial statements and financial reporting process, internal and external auditing, including the qualifications and independence of the independent registered public accounting firm and the performance of our internal audit services function, and the integrity of our systems of internal controls. +The Audit and Compliance Committee provides oversight of our Internal Audit Group. The Audit and Compliance Committee reviews and concurs in the appointment, replacement, performance and compensation of our Chief Audit Executive and approves Internal Audit’s annual audit plan, charter, policies and budget. The Audit and Compliance Committee also receives regular updates on the audit plan’s status and results including significant reports issued by Internal Audit and the status of our corrective actions. +The Compensation and Benefits Committee of our Board of Directors works with the Chief Risk Officer to ensure our overall compensation programs, as well as those covering our risk-taking employees, appropriately balance risk with business incentives and how business performance is achieved without taking imprudent or excessive risk. Our Chief Risk Officer is actively involved in setting goals. Our Chief Risk Officer also reviews the current and forward-looking risk profiles of each business unit and provides input into performance evaluation. The Chief Risk Officer meets with the Compensation and Benefits Committee and attests whether performance goals and results have been achieved without taking imprudent risks. The Compensation and Benefits Committee uses a risk-balanced incentive compensation framework to decide on our bonus pools and the compensation of senior executives. +There are several internal management committees, including the Enterprise-wide Risk Management Committee (ERMC), chaired by our Chief Risk Officer. The ERMC is the highest-level management committee to oversee all firm-wide risks and is responsible for risk governance, risk oversight and risk appetite. It maintains the enterprise-wide risk appetite framework and monitors compliance with limits and escalations defined in it. The ERMC oversees implementation of risk policies company-wide. The ERMC reviews key risk exposures, trends and concentrations, significant compliance matters, and provides guidance on the steps to monitor, control and report major risks. +As defined in the ERM policy, we follow the “three lines of defense” approach to risk management. The first line of defense comprises functions and management committees directly initiating risk taking. Business unit presidents, our Chief Credit Officer, Chief Market Risk Officer and Functional Risk Officer are part of the first line of defense. The second line comprises independent functions overseeing risk-taking activities of the first line. The Chief Risk Officer, the Chief Compliance & Ethics Officer, the Chief Operational Risk Officer and certain control groups, both at the enterprise level and within regulated entities, are part of the second line of defense. The global risk oversight team oversees the policies, strategies, frameworks, models, processes and capabilities deployed by the first line teams and provides challenges and independent assessments on how the first line of defense is managing risks. In addition, the Asset Liability Committee, chaired by our Chief Financial Officer, is responsible for managing market, liquidity and asset/liability risk, capital and resolution planning. +Our Internal Audit Group constitutes the third line of defense, and provides independent assessments and effective challenge of the first and second lines of defense. +CREDIT RISK MANAGEMENT PROCESS +Credit risk is defined as loss due to obligor or counterparty default or changes in the credit quality of a counterparty or security. Our credit risks are divided into two broad categories: individual and institutional. Each has distinct risk management capabilities, strategies, and tools. Business units that create individual or institutional credit risk exposures of significant importance are supported by dedicated risk management teams, each led by a Chief Credit Officer. +INDIVIDUAL CREDIT RISK +Individual credit risk arises from consumer and small business charge cards, credit cards, and term loans. These portfolios consist of millions of customers across multiple geographies, industries and levels of net worth. We benefit from the high- +61 +Table of Contents +quality profile of our customers, which is driven by our brand, premium customer servicing, product features and risk management capabilities, which span underwriting, customer management and collections. The risk in these portfolios is generally correlated to broad economic trends, such as unemployment rates and gross domestic product (GDP) growth. +The business unit leaders and their Chief Credit Officers take the lead in managing the credit risk process. These Chief Credit Officers are guided by the Individual Credit Risk Committee (ICRC), which is responsible for implementation and enforcement of the Individual Credit Risk Management Policy. The ICRC ensures compliance with ERMC guidelines and procedures and escalates to the ERMC as appropriate. The Individual Credit Risk Management Policy is further supported by subordinate policies and operating manuals covering decision logic and processes of credit extension, including prospecting, new account approvals, point-of-sale authorizations, credit line management and collections. The subordinate risk policies and operating manuals are designed to ensure consistent application of risk management principles and standardized reporting of asset quality and loss recognition. +Credit risk management is supported by sophisticated proprietary scoring and decision-making models that use up-to-date information on prospects and customers, such as spending and payment history and data feeds from credit bureaus. We have developed data-driven economic decision logic for customer interactions to better serve our customers. +INSTITUTIONAL CREDIT RISK +Institutional credit risk arises principally within our GCS, GMS and GNS businesses, as well as investment and liquidity management activities. Unlike individual credit risk, institutional credit risk is characterized by a lower loss frequency but higher severity. It is affected both by general economic conditions and by client-specific events. The absence of large losses in any given year or over several years is not necessarily representative of the level of risk of institutional portfolios, given the infrequency of loss events in such portfolios. +Similar to individual credit risk, business units taking institutional credit risks are supported by Chief Credit Officers. These officers are guided by the Institutional Risk Management Committee (IRMC), which is responsible for implementation and enforcement of the Institutional Credit Risk Management Policy and for providing guidance to the credit officers of each business unit with substantial institutional credit risk exposures. The committee, along with the business unit Chief Credit Officers, makes investment decisions in core risk capabilities, ensures proper implementation of the underwriting standards and contractual rights for risk mitigation, monitors risk exposures, and determines risk mitigation actions. The IRMC formally reviews large institutional risk exposures to ensure compliance with ERMC guidelines and procedures and escalates them to the ERMC as appropriate. At the same time, the IRMC provides guidance to the business unit risk management teams to optimize risk-adjusted returns on capital. A centralized risk rating unit provides risk assessment of our institutional obligors. +Exposure to the Airline and Travel Industry +We have multiple important cobrand, rewards, merchant acceptance and corporate payments arrangements with airlines. The ERM program evaluates the risks posed by our airline partners and the overall airline strategy companywide through comprehensive business analysis of global airlines, and the travel industry more broadly, including cruise lines, travel agencies and tour operators. Our largest airline partner is Delta, and this relationship includes an exclusive cobrand credit card partnership and other arrangements including Membership Rewards redemption, merchant acceptance, travel and corporate payments. See "We face intense competition for partner relationships, which could result in a loss or renegotiation of these arrangements that could have a material adverse impact on our business and results of operations" and "Arrangements with our business partners represent a significant portion of our business. We are exposed to risks associated with our business partners, including reputational issues, business slowdowns, bankruptcies, liquidations, restructurings and consolidations, and the possible obligation to make payments to our partners" under “Risk Factors” for additional information. +Debt Exposure +As part of our ongoing risk management process, we monitor our financial exposure to both sovereign and non-sovereign customers and counterparties, and measure and manage concentrations of risk by geographic regions, as well as by economic sectors and industries. A primary focus area for monitoring is credit deterioration due to weaknesses in economic and fiscal profiles. We evaluate countries based on the market assessment of the riskiness of their sovereign debt and our assessment of the economic and financial outlook and closely monitor those deemed high risk. As of December 31, 2019, we considered our gross credit exposures to government entities, financial institutions and corporations in those countries deemed high risk to be individually and collectively not material. +62 +Table of Contents +OPERATIONAL RISK MANAGEMENT PROCESS +We define operational risk as the risk of not achieving business objectives due to inadequate or failed processes, people, or information systems, or the external environment, including failures to comply with laws and regulations as well as impacts from relationships with third parties. Operational risk is inherent in all business activities and can impact an organization through direct or indirect financial loss, brand damage, customer dissatisfaction, or legal and regulatory penalties. +To appropriately measure and manage operational risk, we have implemented a comprehensive operational risk framework that is defined in the Operational Risk Management Policy approved by the Risk Committee. The Operational Risk Management Committee (ORMC), chaired by the Chief Operational Risk Officer, coordinates with all control groups on effective risk assessments and controls and oversees the preventive, responsive and mitigation efforts by Operational Excellence teams in the business units and staff groups. +We use the operational risk framework to identify, measure, monitor and report inherent and emerging operational risks. This framework, supervised by the ORMC, consists of (a) operational risk event capture, (b) a project office to coordinate issue management and control enhancements, (c) key risk indicators, and (d) process and entity-level risk assessments. +The framework requires the assessment of operational risk events to determine root causes, impact to customers and/or us, and resolution plan accountability to correct any defect, remediate customers, and enhance controls and testing to mitigate future issues. The impact is assessed from an operational, financial, brand, regulatory compliance and legal perspective. +INFORMATION AND CYBER SECURITY +We have implemented an Information Security Program and Operating Model that is designed to protect the confidentiality, integrity and availability of information and information systems from unauthorized access, use, disclosure, disruption, modification or destruction. +Our Information Security Program and Operating Model are based on the National Institute of Standards and Technology Cybersecurity Common Standards Framework, which consist of controls designed to identify, protect, detect, respond and recover from information and cyber security incidents. The framework defines risks and associated controls which are embedded in our processes and technology. Those controls are measured and monitored by a combination of subject matter experts and a security operations center with our integrated cyber detection, response and recovery capabilities. +Chaired by the Chief Information Security Officer, our Information Security Risk Management Committee, a sub-committee of the ORMC, provides governance for our information security risk management program. The Information Security and Technology Oversight team provides independent challenge and assessment of the information, cyber security and technology risk management programs. +See “A major information or cyber security incident or an increase in fraudulent activity could lead to reputational damage to our brand and material legal, regulatory and financial exposure, and could reduce the use and acceptance of our charge and credit cards” under “Risk Factors” for additional information. +PRIVACY AND DATA GOVERNANCE +Our Privacy Framework and Operating Model follow a similar structure. Chaired by the Chief Privacy Officer, our Privacy Risk Management Committee, a sub-committee of the ORMC, provides oversight and governance for our privacy program. The committee is responsible for the governance over the collection, notice, use, sharing, transfer, confidentiality and retention of personal data. +Our Enterprise Data Governance Framework and Policy defines governance requirements for data used in critical processes. +COMPLIANCE RISK MANAGEMENT PROCESS +We define compliance risk as the risk of legal or reputational harm, fines, monetary penalties and payment of damages or other forms of sanction as a result of non-compliance with applicable laws, regulations, rules or standards of conduct. +We view our ability to effectively mitigate compliance risk as an important aspect of our business model. Our Global Compliance and Ethics organization is responsible for establishing and maintaining our corporate-wide Compliance Risk Management Program. Pursuant to this program, we seek to manage and mitigate compliance risk by assessing, controlling, monitoring, measuring and reporting the legal and regulatory risks to which we are exposed. The Compliance Risk Management Committee (CRMC), chaired by the Chief Compliance and Ethics Officer, is responsible for identifying, evaluating, managing, and escalating compliance risks. The CRMC has a dual reporting relationship directly to both the ERMC and the Audit and Compliance Committee. +63 +Table of Contents +We have a comprehensive Anti-Money Laundering program that monitors and reports suspicious activity to the appropriate government authorities. As part of that program, the Global Risk Oversight team provides independent risk assessment of the rules used by the Anti-Money Laundering team. In addition, the Internal Audit Group reviews the processes for practices consistent with regulatory guidance. +REPUTATIONAL RISK MANAGEMENT PROCESS +We define reputational risk as the risk that negative stakeholder reaction to our products, services, client and partner relationships, business activities and policies, management and workplace culture, or our response to unexpected events, could cause sustained, critical media coverage, a decline in revenue or investment, talent attrition, litigation, or government or regulatory scrutiny. +We view protecting our reputation for excellent customer service, trust, security and high integrity as core to our vision of providing the world’s best customer experience and fundamental to our long-term success. +Our business leaders are responsible for considering the reputational risk implications of business activities and strategies and ensuring the relevant subject matter experts are engaged as needed. The ERMC is responsible for ensuring reputational risk considerations are included in the scope of appropriate subordinate risk policies and committees and properly reflected in all decisions escalated to the ERMC. +MARKET RISK MANAGEMENT PROCESS +Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. Our market risk exposures include interest rate risk and foreign exchange risk. Interest rate risk is driven by the relationship between interest rates on assets (such as loans, receivables and investment securities) and interest rates on liabilities (such as debt and deposits). Foreign exchange risk arises from transactions, funding, investments and earnings in currencies other than the U.S. dollar. +Our Asset-Liability Management (ALM) and Market Risk policies establish the framework that guides and governs market risk management, including quantitative limits and escalation triggers. These policies are approved by the Asset Liability Committee or Market Risk Management Committee. +Market risk is managed by the Market Risk Management Committee. The Market Risk Oversight Officer provides an independent risk assessment and oversight over the policies and exposure management for market risk and ALM activities, as well as overseeing compliance with the Volcker Rule and other regulatory requirements. Market risk management is also guided and governed by policies covering the use of derivative financial instruments, funding, liquidity and investments. +Interest Rate Risk +We analyze a variety of interest rate scenarios to inform us of the potential impacts from interest rate changes on earnings and the value of assets, liabilities and the economic value of equity. Our interest rate exposure can vary over time as a result of, among other things, the proportion of our total funding provided by variable-and fixed-rate debt and deposits compared to our Card Member loans and receivables. Interest rate swaps are used from time to time to effectively convert debt issuances to (or from) variable-rate, from (or to) fixed-rate. We do not engage in derivative financial instruments for trading purposes other than with respect to our Foreign Exchange International Payments business activities. Refer to Note 13 to the “Consolidated Financial Statements” for further discussion of our derivative financial instruments. +As of December 31, 2019, a hypothetical, immediate 100 basis point increase in market interest rates would have a detrimental effect on our annual net interest income of approximately $141 million. This measure first projects net interest income over the following twelve-month time horizon considering forecasted business growth and anticipated future market interest rates. The detrimental impact from a rate increase is then measured by instantaneously increasing the anticipated future interest rates by 100 basis points. It is further assumed that our interest-rate sensitive assets and the majority of our liabilities that reprice within the twelve-month horizon generally reprice by 100 basis points. Our estimated repricing risk assumes that certain deposit liabilities reprice at a lower magnitude than benchmark rate movements consistent with historical deposit repricing experience in the industry and within our own portfolio. Actual changes in our net interest income will depend on many factors, and therefore may differ from our estimated risk to changes in market interest rates. +In addition to parallel rate changes, our net interest income is subject to changes in the relationship between market benchmark rates. For example, movements in Prime rate change the yield on a large portion of our variable-rate U.S. lending receivables and loans, while LIBOR rates determine the effective interest rate on a significant portion of our outstanding funding. Differences in the rate of change of these two benchmark indices, commonly referred to as basis risk, would thus impact our net interest income. The detrimental effect on our net interest income of a hypothetical 10 basis point decrease in the spread +64 +Table of Contents +between Prime and LIBOR over the next twelve months is estimated to be $20 million. We currently have approximately $48 billion of Prime-based, variable-rate U.S. lending receivables and loans and $20 billion of LIBOR-indexed debt, including asset securitizations. +LIBOR Transition +Due to uncertainty surrounding the suitability and sustainability of LIBOR, central banks and global regulators have called for financial market participants to prepare for the discontinuance of LIBOR by the end of 2021 and the establishment of alternative reference rates. +We have financial instruments and commercial agreements that will be impacted by the discontinuance of LIBOR, including floating rate debt and equity instruments, derivatives, borrowings and other contracts. We have established an enterprise-wide, cross-functional initiative to identify, assess and monitor risks associated with LIBOR, engage with the industry participants and regulators and to transition to new alternative reference rates. As part of this initiative, we are reviewing and updating our operational processes, IT systems and models for a timely transition. +See “ Uncertainty relating to LIBOR and other reference rates and their potential discontinuance may negatively impact our access to funding and the value of our financial instruments and commercial agreements ” under “Risk Factors” for additional information. +Foreign Exchange Risk +Foreign exchange exposures arise in four principal ways: 1) Card Member spending in currencies that are not the billing currency, 2) cross-currency transactions and balances from our funding activities, 3) cross-currency investing activities, such as in the equity of foreign subsidiaries, and 4) revenues generated and expenses incurred in foreign currencies, which impact earnings. +These foreign exchange risks are managed primarily by entering into foreign exchange spot transactions or hedged with foreign exchange forward contracts when the hedge costs are economically justified and in notional amounts designed to offset pretax impacts from currency movements in the period in which they occur. As of December 31, 2019, foreign currency derivative instruments with total notional amounts of approximately $36 billion were outstanding. +With respect to Card Member spending and cross-currency transactions, including related foreign exchange forward contracts outstanding, a hypothetical 10 percent strengthening of the U.S. dollar would result in an immaterial impact to projected earnings as of December 31, 2019. With respect to translation exposure of foreign subsidiary equity balances, including related foreign exchange forward contracts outstanding, a hypothetical 10 percent strengthening of the U.S. dollar would result in an immaterial reduction in other comprehensive income and equity as of December 31, 2019. With respect to earnings denominated in foreign currencies, the adverse impact on pretax income of a hypothetical 10 percent strengthening of the U.S. dollar related to anticipated overseas operating results for the next twelve months would be approximately $146 million as of December 31, 2019. +To a much lesser extent, we are also subject to market risk arising from activities conducted by our Foreign Exchange International Payments business. We aim to minimize market risk from these activities through hedging, where appropriate, and the establishment of limits to define and protect the company from excessive exposure. +The actual impact of interest rate and foreign exchange rate changes will depend on, among other factors, the timing of rate changes, the extent to which different rates do not move in the same direction or in the same direction to the same degree, changes in the cost, volume and mix of our hedging activities and changes in the volume and mix of our businesses. +FUNDING & LIQUIDITY RISK MANAGEMENT PROCESS +Liquidity risk is defined as our inability to meet our ongoing financial and business obligations as they become due at a reasonable cost. +Our Board-approved Liquidity Risk Policy establishes the framework that guides and governs liquidity risk management. +Liquidity risk is managed by the Funding and Liquidity Committee. In addition, the Market Risk Oversight Officer provides independent oversight of liquidity risk management. We manage liquidity risk by maintaining access to a diverse set of cash, readily-marketable securities and contingent sources of liquidity, such that we can continuously meet our business requirements and expected future financing obligations for at least a twelve-month period in the event we are unable to raise new funds under our regular funding programs during a substantial weakening in economic conditions. We consider the trade-offs between maintaining too much liquidity, which can be costly and limit financial flexibility, and having inadequate liquidity, which may result in financial distress during a liquidity event. +65 +Table of Contents +Liquidity risk is managed at an aggregate consolidated level as well as at certain subsidiaries in order to ensure that sufficient and accessible liquidity resources are maintained. The Funding and Liquidity Committee reviews forecasts of our aggregate and subsidiary cash positions and financing requirements, approves funding plans designed to satisfy those requirements under normal and stressed conditions, establishes guidelines to identify the amount of liquidity resources required and monitors positions and determines any actions to be taken. +MODEL RISK MANAGEMENT PROCESS +We define model risk as the risk of adverse consequences, such as financial loss, poor business and strategic decision making, or damage to our reputation, from decisions based on incorrect or misused model outputs and reports. +We manage model risk through a comprehensive model governance framework, including policies and procedures for model development, independent model validation and change management capabilities that seek to minimize erroneous model methodology, outputs and misuse. We also assess model performance on an ongoing basis. +STRATEGIC AND BUSINESS RISK MANAGEMENT PROCESS +Strategic and business risk is the risk related to our inability to achieve our business objectives due to poor strategic decisions, including decisions related to mergers, acquisitions, and divestitures, poor implementation of strategic decisions or declining demand for our products and services. +Strategic decisions are reviewed and approved by business leaders and various committees and must be aligned with company policies. We seek to manage strategic and business risks through risk controls embedded in these processes as well as overall risk management oversight over business goals. Existing product performance is reviewed periodically by committees and business leaders. Mergers, acquisitions and divestitures can only be approved following Deal Committee due diligence, a comprehensive risk assessment by operational, market, credit and oversight leaders provided to the Chief Risk Officer and approval by either the Chief Risk Officer or appropriate risk committees. All new products and material changes in business processes are reviewed and approved by the New Products Committee and appropriate credit or risk committees. +FOREIGN COUNTRY RISK MANAGEMENT PROCESS +Foreign country risk is defined as the risk that economic, social, and/or political conditions and events in a foreign country will adversely impact us, primarily as a result of greater credit losses, increased operational risk or the inability to repatriate capital. We manage foreign country risk as part of the normal course of business. Policies and procedures establish foreign country risk escalation thresholds to control and limit exposure, driven by processes that enable the monitoring of foreign country conditions in which we have exposure. +CRITICAL ACCOUNTING ESTIMATES +Refer to Note 1 to the “Consolidated Financial Statements” for a summary of our significant accounting policies. Certain of our accounting policies requiring significant management assumptions and judgments are as follows: +RESERVES FOR CARD MEMBER LOSSES +Reserves for Card Member losses represent our best estimate of the probable losses inherent in our outstanding portfolio of Card Member loans and receivables, as of the balance sheet date. +In estimating these losses, we use statistical and analytical models that analyze portfolio performance and reflect our judgment regarding the quantitative components of the reserve. The models take into account several factors, including delinquency-based loss migration rates, loss emergence periods and average losses and recoveries over an appropriate historical period. We also consider whether to adjust the quantitative reserve for certain external and internal qualitative factors that may increase or decrease the reserves for losses on Card Member loans and receivables. Refer to Note 3 to the "Consolidated Financial Statements" for additional information. +The process of estimating these reserves requires a high degree of judgment. To the extent historical credit experience, updated for any external and internal qualitative factors such as environmental trends, is not indicative of future performance, actual losses could differ significantly from our judgments and expectations, resulting in either higher or lower future provisions for Card Member losses in any quarter. +66 +Table of Contents +As of December 31, 2019, a 10 percent increase in our estimate of losses inherent in the outstanding portfolio of Card Member loans and receivables, evaluated collectively for impairment, would increase reserves for losses with a corresponding change to provisions for losses by approximately $300 million. This sensitivity analysis is provided as a hypothetical scenario to assess the sensitivity of the provisions for losses. It does not represent our expectations for losses in the future, nor does it include how other portfolio factors such as delinquency-based loss migration rates or recoveries, or the amount of outstanding balances, may impact the level of reserves for losses and the corresponding impact on the provisions for losses. +Refer to Note 1 to the "Consolidated Financial Statements" for information about the implementation and impact of new accounting guidance for the recognition of credit losses on financial instruments, effective January 1, 2020, and the new credit reserving methodology known as the CECL methodology. +LIABILITY FOR MEMBERSHIP REWARDS +The Membership Rewards program is our largest card-based rewards program. Card Members can earn points for purchases charged on their enrolled card products. A significant portion of our cards, by their terms, allow Card Members to earn bonus points for purchases at merchants in particular industry categories. Membership Rewards points are redeemable for a broad variety of rewards, including travel, shopping, gift cards, and covering eligible charges. Points typically do not expire, and there is no limit on the number of points a Card Member may earn. Membership Rewards expense is driven by charge volume on enrolled cards, customer participation in the program and contractual arrangements with redemption partners. +We record a Membership Rewards liability that represents the estimated cost of points earned that are expected to be redeemed by Card Members in the future. The Membership Rewards liability is impacted over time by enrollment levels, attrition, the volume of points earned and redeemed, and the associated redemption costs. We estimate the Membership Rewards liability by determining the Ultimate Redemption Rate (URR) and the weighted average cost (WAC) per point, which are applied to the points of current enrollees. Refer to Note 9 to the “Consolidated Financial Statements” for additional information. +The URR assumption is used to estimate the number of points earned by current enrollees that will ultimately be redeemed in future periods. We use statistical and actuarial models to estimate the URR of points earned to date by current Card Members based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. The WAC per point assumption is used to estimate future redemption costs and is primarily based on redemption choices made by Card Members, reward offerings by partners, and Membership Rewards program changes. The WAC per point is derived from the previous 12 months of redemptions and is adjusted as appropriate for certain changes in redemption costs that are not representative of future cost expectations. +We periodically evaluate our liability estimation process and assumptions based on developments in redemption patterns, cost per point redeemed, partner contract changes and other factors. +The process of estimating the Membership Rewards liability includes a high degree of judgment. Actual redemptions and associated redemption costs could differ significantly from our estimates, resulting in either higher or lower Membership Rewards expense. +Changes in the Membership Rewards URR and WAC per point have the effect of either increasing or decreasing the liability through the current period Membership Rewards expense by an amount estimated to cover the cost of all points previously earned but not yet redeemed by current enrollees as of the end of the reporting period. As of December 31, 2019, an increase in the estimated URR of current enrollees of 25 basis points would increase the Membership Rewards liability and corresponding rewards expense by approximately $123 million. Similarly, an increase in the WAC per point of 1 basis point would increase the Membership Rewards liability and corresponding rewards expense by approximately $114 million. +GOODWILL RECOVERABILITY +Goodwill represents the excess of acquisition cost of an acquired business over the fair value of assets acquired and liabilities assumed. Goodwill is not amortized but is tested for impairment at the reporting unit level annually or when events or circumstances arise, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value. Our methodology for conducting this goodwill impairment testing contains both a qualitative and quantitative assessment. +We have the option to initially perform an assessment of qualitative factors in order to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The qualitative factors may include, but are not limited to, economic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit and other company and reporting unit-specific events. If we determine that it is more likely than not that the fair value of a +67 +Table of Contents +reporting unit is less than its carrying amount, we then perform the impairment evaluation using a more detailed quantitative assessment. We could also directly perform this quantitative assessment for any reporting unit, bypassing the qualitative assessment. +Our methodology for conducting the quantitative goodwill impairment testing is fundamentally based on the measurement of fair value for our reporting units, which inherently entails the use of significant management judgment. For valuation, we use a combination of the income approach (discounted cash flows) and market approach (market multiples) in estimating the fair value of our reporting units. +When preparing discounted cash flow models under the income approach, we estimate future cash flows using the reporting unit’s internal multi-year forecast, and a terminal value calculated using a growth rate that we believe is appropriate in light of current and expected future economic conditions. To discount these cash flows we use our expected cost of equity, determined using a capital asset pricing model. When using the market method under the market approach, we apply comparable publicly traded companies’ multiples (e.g., earnings, revenues) to our reporting units’ actual results. The judgment in estimating forecasted cash flows, discount rates and market comparables is significant, and imprecision could materially affect the fair value of our reporting units. +We could be exposed to an increased risk of further goodwill impairment if future operating results or macroeconomic conditions differ significantly from management’s current assumptions. +INCOME TAXES +We are subject to the income tax laws of the United States, its states and municipalities and those of the foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to the taxpayer’s facts is sometimes open to interpretation. In establishing a provision for income tax expense, we must make judgments about the application of inherently complex tax laws. +In particular, the Tax Act is complex and requires interpretation of certain provisions to estimate the impact on our income tax expense. The estimates are based on our current interpretations of the Tax Act, and may change due to additional guidance or context from the Internal Revenue Service, the U.S. Treasury Department or others. +Unrecognized Tax Benefits +We establish a liability for unrecognized tax benefits, which are the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized in the financial statements. +In establishing a liability for an unrecognized tax benefit, assumptions may be made in determining whether, and the extent to which, a tax position should be sustained. A tax position is recognized only when it is more likely than not to be sustained upon examination by the relevant taxing authority, based on its technical merits. The amount of tax benefit recognized is the largest benefit that we believe is more likely than not to be realized on ultimate settlement. As new information becomes available, we evaluate our tax positions and adjust our unrecognized tax benefits, as appropriate . +Tax benefits ultimately realized can differ from amounts previously recognized due to uncertainties, with any such differences generally impacting the provision for income tax. +Deferred Tax Asset Realization +Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using the enacted tax rates expected to be in effect for the years in which the differences are expected to reverse. +Since deferred taxes measure the future tax effects of items recognized in the Consolidated Financial Statements, certain estimates and assumptions are required to determine whether it is more likely than not that all or some portion of the benefit of a deferred tax asset will not be realized. In making this assessment, we analyze and estimate the impact of future taxable income, reversing temporary differences and available tax planning strategies. These assessments are performed quarterly, taking into account any new information. +Changes in facts or circumstances can lead to changes in the ultimate realization of deferred tax assets due to uncertainties. +68 +Table of Contents +OTHER MATTERS +RECENTLY ISSUED ACCOUNTING STANDARDS +Refer to the Recently Issued Accounting Standards section of Note 1 to the “Consolidated Financial Statements.” +GLOSSARY OF SELECTED TERMINOLOGY +Adjusted net interest income — A non-GAAP measure that represents net interest income attributable to our Card Member loans (which includes, on a GAAP basis, interest that is deemed uncollectible), excluding the impact of interest expense and interest income not attributable to our Card Member loans. +Asset securitizations — Asset securitization involves the transfer and sale of loans or receivables to a special-purpose entity created for the securitization activity, typically a trust. The trust, in turn, issues securities, commonly referred to as asset-backed securities that are secured by the transferred loans and receivables. The trust uses the proceeds from the sale of such securities to pay the purchase price for the transferred loans or receivables. The securitized loans and receivables of our Lending Trust and Charge Trust (collectively, the Trusts) are reported as assets and the securities issued by the Trusts are reported as liabilities on our Consolidated Balance Sheets. +Average discount rate — This calculation is generally designed to reflect the average pricing at all merchants accepting American Express cards and represents the percentage of proprietary and GNS billed business retained by us from merchants we acquire, or from merchants acquired by third parties on our behalf, net of amounts retained by such third parties. The average discount rate, together with billed business, drive our discount revenue. +Billed business — Represents transaction volumes (including cash advances) on cards and other payment products issued by American Express (proprietary billed business) and cards issued under network partnership agreements with banks and other institutions, including joint ventures (GNS billed business). In-store spending activity within GNS retail cobrand portfolios, from which we earn no revenue, is not included in billed business. Billed business is reported as inside the United States or outside the United States based on the location of the issuer. Billed business, together with the average discount rate, drive our discount revenue. +Capital ratios — Represents the minimum standards established by regulatory agencies as a measure to determine whether the regulated entity has sufficient capital to absorb on- and off-balance sheet losses beyond current loss accrual estimates. Refer to the Capital Strategy section under “Consolidated Capital Resources and Liquidity” for further related definitions under Basel III. +Cards-in-force — Represents the number of cards that are issued and outstanding by American Express (proprietary cards-in-force) and cards issued and outstanding under network partnership agreements with banks and other institutions, including joint ventures (GNS cards-in-force), except for GNS retail cobrand cards that had no out-of-store spending activity during the prior twelve months. Basic cards-in-force excludes supplemental cards issued on consumer accounts. Cards-in-force is useful in understanding the size of our Card Member base. +Card Member — The individual holder of an issued American Express-branded card. +Card Member loans — Represents the outstanding amount due from Card Members for charges made on their American Express credit cards, as well as any interest charges and card-related fees. Card Member loans also include revolving balances on certain American Express charge card products. +Card Member receivables — Represents the outstanding amount due from Card Members for charges made on their American Express charge cards, as well as any card-related fees, other than revolving balances on certain American Express charge cards with Pay Over Time features. Such revolving balances are included within Card Member loans. +Charge cards — Represents cards that generally carry no pre-set spending limits and are primarily designed as a method of payment and not as a means of financing purchases. Charge Card Members generally must pay the full amount billed each month. No finance charges are assessed on charge cards. Each charge card transaction is authorized based on its likely economics reflecting a Card Member’s most recent credit information and spend patterns. Some charge cards have additional Pay Over Time feature(s) that allow revolving of certain charges. +Cobrand cards — Cards issued under cobrand agreements with selected commercial partners. Pursuant to the cobrand agreements, we make payments to our cobrand partners, which can be significant, based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The partner is then liable for providing rewards to the Card Member under the cobrand partner’s own loyalty program. +69 +Table of Contents +Credit cards — Represents cards that have a range of revolving payment terms, grace periods, and rate and fee structures. +Discount revenue — Primarily represents revenue earned from fees charged to merchants who have entered into a card acceptance agreement. The discount fee is generally deducted from our payment for Card Member purchases. +Interest expense — Includes interest incurred primarily to fund Card Member loans and receivables, general corporate purposes and liquidity needs. Interest expense is divided principally into two categories: (i) deposits, which primarily relates to interest expense on deposits taken from customers and institutions, and (ii) debt, which primarily relates to interest expense on our long-term financing and short-term borrowings, (e.g., commercial paper, federal funds purchased, bank overdrafts and other short-term borrowings), as well as the realized impact of derivatives hedging interest rate risk on our long-term debt. +Interest income — Includes (i) interest on loans, (ii) interest and dividends on investment securities and (iii) interest income on deposits with banks and other. +Interest on loans — Assessed using the average daily balance method for Card Member loans. Unless the loan is classified as non-accrual, interest is recognized based upon the principal amount outstanding in accordance with the terms of the applicable account agreement until the outstanding balance is paid or written off. +Interest and dividends on investment securities — Primarily relates to our performing fixed-income securities. Interest income is recognized using the effective interest method, which adjusts the yield for security premiums and discounts, fees and other payments, so a constant rate of return is recognized on the outstanding balance of the related investment security throughout its term. Amounts are recognized until securities are in default or when it is likely that future interest payments will not be made as scheduled. +Interest income on deposits with banks and other — Primarily relates to the placement of cash in excess of near-term funding requirements in interest-bearing time deposits, overnight sweep accounts, and other interest-bearing demand and call accounts. +Loyalty Coalitions — Programs that enable consumers to earn rewards points and use them to save on purchases from a variety of participating merchants through multi-category rewards platforms. Merchants in these programs generally fund the consumer offers and are responsible to us for the cost of rewards points; we earn revenue from operating the loyalty platform and by providing marketing support. +Net card fees — Represents the card membership fees earned during the period recognized as revenue over the covered card membership period (typically one year), net of the provision for projected refunds for Card Membership cancellation and deferred acquisition costs. +Net interest yield on average Card Member loans — A non-GAAP measure that is computed by dividing adjusted net interest income by average Card Member loans, computed on an annualized basis. Reserves and net write-offs related to uncollectible interest are recorded through provision for losses, and are thus not included in the net interest yield calculation. +Net loss ratio — Represents the ratio of GCP charge card write-offs, consisting of principal (resulting from authorized transactions) and fee components, less recoveries, on Card Member receivables expressed as a percentage of gross amounts billed to corporate Card Members. +Net write-off rate — principal only — Represents the amount of proprietary consumer or small business Card Member loans or receivables written off, consisting of principal (resulting from authorized transactions), less recoveries, as a percentage of the average loan or receivable balance during the period. +Net write-off rate — principal, interest and fees — Includes, in the calculation of the net write-off rate, amounts for interest and fees in addition to principal for Card Member loans, and fees in addition to principal for Card Member receivables. +Operating expenses — Represents salaries and employee benefits, professional services, occupancy and equipment, and other expenses. +Return on average equity — Calculated by dividing one-year period net income by one-year average total shareholders’ equity. +70 +Table of Contents +CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS +This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which are subject to risks and uncertainties. The forward-looking statements, which address our current expectations regarding business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” “estimate,” “predict,” “potential,” “continue” and similar expressions. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update or revise any forward-looking statements. Factors that could cause actual results to differ materially from these forward-looking statements, include, but are not limited to, the following: +• our ability to grow earnings per share in the future, which will depend in part on revenue growth, credit performance and the effective tax rate remaining consistent with current expectations, the company’s ability to control operating expense growth and generate operating leverage, and the company’s ability to continue executing its share repurchase program, any of which could be impacted by, among other things, the factors identified in the subsequent paragraphs as well as the following: issues impacting brand perceptions and our reputation; the impact of any future contingencies, including, but not limited to, restructurings, impairments, changes in reserves, legal costs, the imposition of fines or civil money penalties and increases in Card Member reimbursements; the amount and efficacy of investments in share, scale and relevance; changes in interest rates beyond current expectations; a greater impact from new or renegotiated cobrand and other partner agreements than expected, which could be affected by spending volumes and customer acquisition; and the impact of regulation and litigation, which could affect the profitability of our business activities, limit our ability to pursue business opportunities, require changes to business practices or alter our relationships with Card Members, partners, merchants, vendors and other third parties; +• our ability to grow revenues net of interest expense and the composition and relative growth of fee, spend and lend revenues remaining consistent with expectations, which could be impacted by, among other things, weakening economic conditions in the United States or internationally; a decline in consumer confidence impacting the willingness and ability of Card Members to sustain and grow spending, pay higher card fees and revolve balances; concerns related to the recent coronavirus outbreak and travel restrictions and bans; a slowdown in corporate spending; growth in Card Member loans and the yield on Card Member loans not remaining consistent with current expectations; the average discount rate changing by a greater amount than expected; the strengthening of the U.S. dollar beyond expectations; Card Members continuing to be attracted to our premium card products; and our inability to address competitive pressures and implement our strategies and business initiatives, including within the premium consumer segment, commercial payments, the global network and digital environment; +• changes in the substantial and increasing worldwide competition in the payments industry, including competitive pressure that may materially impact the prices we charge merchants that accept American Express cards, competition for new and existing cobrand relationships, competition from new and non-traditional competitors and the success of marketing, promotion and rewards programs; +• net interest income not growing consistent with current expectations, which will be influenced by, among other things, changes in benchmark interest rates and our cost of funds, changes in consumer behavior that affect loan balances (such as paydown rates) and our ability to continue to grow loans, our Card Member acquisition strategy, pricing changes, product mix and credit actions, including line size and other adjustments to credit availability; +• write-off rates being higher or lower than current expectations, which will depend in part on changes in the level of loan and receivable balances and delinquencies, macroeconomic factors such as unemployment rates and the volume of bankruptcies, the mix of balances and the credit performance of newer vintages and non-card lending products; +• our ability to continue to grow loans, which may be affected by increasing competition, brand perceptions and our reputation, our ability to manage risk, the behavior of Card Members and their actual spending and borrowing patterns, and our ability to issue new and enhanced card products, offer attractive non-card lending products, capture a greater share of existing Card Members’ spending and borrowings, reduce Card Member attrition and attract new customers; +• the growth of provisions for losses being higher or lower than current expectations, which will depend in part on changes in the level of loan and receivable balances and delinquency and write-off rates; the impact of new accounting guidance and the CECL methodology; collections capabilities and recoveries of previously written-off loans and receivables; and macroeconomic factors like unemployment rates and the volume of bankruptcies; +71 +Table of Contents +• the actual amount to be spent on customer engagement, which will be based in part on management’s assessment of competitive opportunities; overall business performance and changes in macroeconomic conditions; the growth in the cost of Card Member services, which could be impacted by, among other things, the factors identified in the subsequent paragraph; Card Member behavior as it relates to their spending patterns (including the level of spend in bonus categories) and the redemption of rewards and offers; the costs related to reward point redemptions, advertising and Card Member acquisition; our ability to continue to shift Card Member acquisition to digital channels; and new and renegotiated contractual obligations with business partners; +• the cost of Card Member services not growing consistently with current expectations, which could be impacted by the degree of interest of Card Members in the value propositions we offer; increasing competition, which could result in pressure to further enhance card products and services to make them attractive to Card Members, potentially in a manner that is not cost effective; and the pace and cost of the expansion of our global lounge collection; +• our ability to control operating expense growth and grow operating expenses more slowly than revenues, which could be impacted by increases in costs, such as cyber, fraud or compliance expenses or consulting, legal and other professional fees, including as a result of increased litigation or internal and regulatory reviews; higher than expected employee levels; an inability to innovate efficient channels of customer interactions, such as chat supported by artificial intelligence, or customer acquisition; the impact of changes in foreign currency exchange rates on costs; the payment of civil money penalties, disgorgement, restitution, non-income tax assessments and litigation-related settlements; impairments of goodwill or other assets; management’s decision to increase or decrease spending in such areas as technology, business and product development, sales force, premium servicing and digital capabilities; and the level of M&A activity and related expenses; +• our ability to satisfy our commitments to certain of our cobrand partners as part of the ongoing operations of the business, which will be impacted in part by competition, brand perceptions and our reputation, and our ability to develop and market value propositions that appeal to current cobrand Card Members and new customers and offer attractive services and rewards programs, which will depend in part on ongoing investments, new product innovation and development, Card Member acquisition efforts and enrollment processes, including through digital channels, and infrastructure to support new products, services and benefits; +• changes affecting our plans regarding the return of capital to shareholders through dividends and share repurchases, which will depend on factors such as our capital levels and regulatory capital ratios and the actual impact of CECL on those ratios; changes in the stress testing and capital planning process and approval of our capital plans; the amount of capital required to support asset growth; the amount we spend on acquisitions of companies; and our results of operations and financial condition; and the economic environment and market conditions in any given period; +• our tax rate not remaining consistent with current expectations, which could be impacted by, among other things, our geographic mix of income, further changes in tax laws and regulation, unfavorable tax audits and other unanticipated tax items; +• a failure in or breach of our operational or security systems, processes or infrastructure, or those of third parties, including as a result of cyberattacks, which could compromise the confidentiality, integrity, privacy and/or security of data, disrupt our operations, reduce the use and acceptance of American Express cards and lead to regulatory scrutiny, litigation, remediation and response costs, and reputational harm; +• our deposit rates increasing faster or slower than current expectations and changes affecting our ability to grow Personal Savings deposits due to market demand, changes in benchmark interest rates, competition or regulatory restrictions on our ability to obtain deposit funding or offer competitive interest rates, which could affect our net interest yield and ability to fund our businesses; +• our funding plan being implemented in a manner inconsistent with current expectations, which will depend on various factors such as future business growth, the impact of global economic, political and other events on market capacity, demand for securities we offer, regulatory changes, ability to securitize and sell receivables and the performance of receivables previously sold in securitization transactions; +• changes in global economic and business conditions, consumer and business spending generally, the availability and cost of capital, unemployment rates, geopolitical conditions, travel restrictions and bans, including as a result of the recent coronavirus outbreak, Brexit, prolonged or recurring government shutdowns, trade policies, foreign currency rates and +72 +Table of Contents +interest rates, all of which may significantly affect demand for and spending on American Express cards, delinquency rates, loan and receivable balances and other aspects of our business and results of operations; +• changes in capital and credit market conditions, which may significantly affect our ability to meet our liquidity needs, expectations regarding capital and liquidity ratios, access to capital and cost of capital, including changes in interest rates; changes in market conditions affecting the valuation of our assets; or any reduction in our credit ratings or those of our subsidiaries, which could materially increase the cost and other terms of our funding or restrict our access to the capital markets; +• legal and regulatory developments, which could require us to make fundamental changes to many of our business practices, including our ability to continue certain cobrand and agent relationships in the EU; exert further pressure on the average discount rate and GNS volumes; result in increased costs related to regulatory oversight, litigation-related settlements, judgments or expenses, restitution to Card Members or the imposition of fines or civil money penalties; materially affect our capital or liquidity requirements, results of operations or ability to pay dividends or repurchase stock; or result in harm to the American Express brand; +• changes in the financial condition and creditworthiness of our business partners, such as bankruptcies, restructurings or consolidations, including merchants that represent a significant portion of our business, such as the airline industry, or our partners in GNS or financial institutions that we rely on for routine funding and liquidity, which could materially affect our financial condition or results of operations; and +• factors beyond our control such as fire, power loss, disruptions in telecommunications, severe weather conditions, natural and man-made disasters, health pandemics or terrorism, any of which could significantly affect demand for and spending on American Express cards, delinquency rates, loan and receivable balances and other aspects of our business and results of operations or disrupt our global network systems and ability to process transactions. +A further description of these uncertainties and other risks can be found in “Risk Factors” above and our other reports filed with the SEC. +73 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Refer to “Risk Management” under “MD&A” for quantitative and qualitative disclosures about market risk. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. +Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (GAAP), and includes those policies and procedures that: +• Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of assets; +• Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and +• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2019. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control —Integrated Framework (2013). +Based on management’s assessment and those criteria, we conclude that, as of December 31, 2019, our internal control over financial reporting is effective. +PricewaterhouseCoopers LLP, our independent registered public accounting firm, has issued an audit report appearing on the following page on the effectiveness of our internal control over financial reporting as of December 31, 2019. +74 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF AMERICAN EXPRESS COMPANY +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of American Express Company and its subsidiaries (the “Company”) as of December 31, 2019 and 2018, and the related consolidated statements of income, of comprehensive income, of shareholders’ equity and of cash flows for each of the three years in the period ended December 31, 2019, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated +75 +Table of Contents +financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +Membership Rewards Liability - Ultimate Redemption Rate +As described in Note 9 to the consolidated financial statements, the Membership Rewards liability represents management’s estimate of the cost of Membership Rewards points earned that are expected to be redeemed in the future. The Membership Rewards liability was $8.9 billion as of December 31, 2019. The weighted average cost per point and the ultimate redemption rate (URR) are key assumptions used to estimate the liability. The URR assumption is used by management to estimate the number of points earned that will ultimately be redeemed in future periods. Management uses statistical and actuarial models to estimate the URR based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. +The principal considerations for our determination that performing procedures relating to the URR for the Membership Rewards liability is a critical audit matter are (i) the estimate of the URR involved significant judgment by management, which in turn led to a high degree of auditor judgment, effort and subjectivity in performing procedures and evaluating results relating to the models, significant inputs and assumptions used by management; and (ii) the audit effort involved the use of professionals with specialized skill and knowledge. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to the estimate of the Membership Rewards liability, including the URR assumption. These procedures also included, among others, (i) testing the completeness and accuracy of certain inputs to the statistical and actuarial models used to estimate the URR assumption, including redemption trends, card product type, enrollment tenure, and card spend levels, (ii) the involvement of professionals with specialized skill and knowledge to assist in developing an independent estimate of the URR assumption and comparing the independent estimate to management’s assumption to evaluate its reasonableness, and (iii) comparing the independent estimate of the Membership Rewards liability to management’s estimate. +Reserves for Losses on Card Member Loans - Qualitative Reserve Component +As described in Note 3 to the consolidated financial statements, reserves for losses on Card Member loans represent management’s estimate of the probable inherent losses in the Company’s outstanding portfolio of loans, as of the balance sheet date. Reserves for losses are primarily based upon statistical and analytical models that analyze portfolio performance and reflect management’s judgments regarding the quantitative components of the reserve. These models take into account several factors, including delinquency-based loss migration rates, loss emergence periods and average losses and recoveries over an appropriate historical period. Management considers whether to adjust the quantitative reserves for certain external and internal qualitative factors, which may increase or decrease the reserves for losses on Card Member loans (the “qualitative reserve component”). These external factors include employment, spend, sentiment, housing and credit, and changes in the legal and regulatory environment, while the internal factors include increased risk in certain portfolios, impact of risk management initiatives, changes in underwriting requirements and overall process stability. The qualitative reserve component represents a portion of the total reserves for losses on Card Member loans of $2.4 billion as of December 31, 2019. +The principal considerations for our determination that performing procedures relating to the qualitative reserve component of the reserves for losses on Card Member loans is a critical audit matter are (i) there was significant judgment required by management in estimating the qualitative reserve component, including determination of underlying factors, which led to a high degree of auditor judgment and subjectivity in performing procedures relating to the methodology and the underlying factors; and (ii) the audit effort involved the use of professionals with specialized skill and knowledge. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to the reserves for losses on Card Member loans, including the qualitative reserve component. These procedures also included, among others, testing management’s process for determining the qualitative reserve component of the reserves for losses on Card Member loans through (i) the involvement of professionals with specialized skill and knowledge to evaluate the appropriateness of management’s methodology for estimating the qualitative reserve component, including evaluating whether certain factors are reasonable given the current macroeconomic conditions and portfolio characteristics and (ii) testing the completeness and accuracy of specific data inputs and evaluating the reasonableness of specific assumptions related to certain external factors applied by management in estimating the qualitative reserve component. +/s/ PricewaterhouseCoopers LLP +New York, New York +February 13, 2020 +We have served as the Company’s auditor since 2005. +76 +Table of Contents +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +CONSOLIDATED FINANCIAL STATEMENTS +PAGE +Consolidated Statements of Income – For the Years Ended December 31, 201 9 , 201 8 and 201 7 +78 +Consolidated Statements of Comprehensive Income – For the Years Ended December 31, 201 9 , 201 8 and 201 7 +79 +Consolidated Balance Sheets – December 31, 201 9 and 201 8 +80 +Consolidated Statements of Cash Flows – For the Years Ended December 31, 201 9 , 201 8 and 201 7 +81 +Consolidated Statements of Shareholders’ Equity – For the Years Ended December 31, 201 9 , 201 8 and 201 7 +82 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +83 +Note 1 – Summary of Significant Accounting Policies +83 +Note 2 – Loans and Accounts Receivable +87 +Note 3 – Reserves for Losses +94 +Note 4 – Investment Securities +96 +Note 5 – Asset Securitizations +98 +Note 6 – Other Assets +98 +Note 7 – Customer Deposits +100 +Note 8 – Debt +101 +Note 9 – Other Liabilities +103 +Note 1 0 – Stock Plans +104 +Note 1 1 – Retirement Plans +106 +Note 1 2 – Contingencies and Commitments +106 +Note 1 3 – Derivatives and Hedging Activities +108 +Note 1 4 – Fair Values +112 +Note 1 5 – Guarantees +116 +Note 1 6 – Common and Preferred Shares +116 +Note 1 7 – Changes in Accumulated Other Comprehensive Income +117 +Note 18 – Other Fees and Commissions and Other Expenses +119 +Note 19 – Restructuring +119 +Note 2 0 – Income Taxes +120 +Note 2 1 – Earnings Per Common Share +123 +Note 2 2 – Regulatory Matters and Capital Adequacy +123 +Note 2 3 – Significant Credit Concentrations +125 +Note 2 4 – Reportable Operating Segments and Geographic Operations +126 +Note 2 5 – Parent Company +130 +Note 2 6 – Quarterly Financial Data (Unaudited) +131 +77 +Table of Contents +CONSOLIDATED STATEMENTS OF INCOME +Year Ended December 31 (Millions, except per share amounts) +2019 2018 2017 +Revenues +Non-interest revenues +Discount revenue $ 26,167 $ 24,721 $ 22,890 +Net card fees 4,042 3,441 3,090 +Other fees and commissions 3,297 3,153 2,990 +Other 1,430 1,360 1,457 +Total non-interest revenues 34,936 32,675 30,427 +Interest income +Interest on loans 11,308 9,941 8,148 +Interest and dividends on investment securities 188 118 89 +Deposits with banks and other 588 547 326 +Total interest income 12,084 10,606 8,563 +Interest expense +Deposits 1,559 1,287 779 +Long-term debt and other 1,905 1,656 1,333 +Total interest expense 3,464 2,943 2,112 +Net interest income 8,620 7,663 6,451 +Total revenues net of interest expense 43,556 40,338 36,878 +Provisions for losses +Charge card 963 937 795 +Card Member loans 2,462 2,266 1,868 +Other 148 149 97 +Total provisions for losses 3,573 3,352 2,760 +Total revenues net of interest expense after provisions for losses 39,983 36,986 34,118 +Expenses +Marketing and business development 7,114 6,470 5,722 +Card Member rewards 10,439 9,696 8,687 +Card Member services 2,222 1,777 1,392 +Salaries and employee benefits 5,911 5,250 5,258 +Other, net 5,868 5,671 5,634 +Total expenses 31,554 28,864 26,693 +Pretax income 8,429 8,122 7,425 +Income tax provision 1,670 1,201 4,677 +Net income $ 6,759 $ 6,921 $ 2,748 +Earnings per Common Share — (Note 21) (a) +Basic $ 8.00 $ 7.93 $ 3.00 +Diluted $ 7.99 $ 7.91 $ 2.99 +Average common shares outstanding for earnings per common share: +Basic 828 856 883 +Diluted 830 859 886 +(a) Represents net income less (i) earnings allocated to participating share awards of $ 47 million, $ 54 million and $ 21 million for the years ended December 31, 2019, 2018 and 2017, respectively, and (ii) dividends on preferred shares of $ 81 million, $ 80 million and $ 81 million for the years ended December 31, 2019, 2018 and 2017, respectively. +See Notes to Consolidated Financial Statements. +78 +Table of Contents +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +Year Ended December 31 (Millions) +2019 2018 2017 +Net income $ 6,759 $ 6,921 $ 2,748 +Other comprehensive (loss) income: +Net unrealized securities gains (losses), net of tax 41 ( 8 ) ( 7 ) +Foreign currency translation adjustments, net of tax ( 56 ) ( 172 ) 301 +Net unrealized pension and other postretirement benefits, net of tax ( 125 ) 11 62 +Other comprehensive (loss) income ( 140 ) ( 169 ) 356 +Comprehensive income $ 6,619 $ 6,752 $ 3,104 +See Notes to Consolidated Financial Statements. +79 +Table of Contents +CONSOLIDATED BALANCE SHEETS +December 31 (Millions, except share data) +2019 2018 +Assets +Cash and cash equivalents +Cash and due from banks $ 3,402 $ 3,253 +Interest-bearing deposits in other banks (includes securities purchased under resale agreements: 2019, $ 87 ; 2018, $ 64 ) +20,392 24,026 +Short-term investment securities 138 166 +Total cash and cash equivalents 23,932 27,445 +Card Member receivables (includes gross receivables available to settle obligations of a consolidated variable interest entity: 2019, $ 8,284 ; 2018, $ 8,539 ), less reserves: 2019, $ 619 ; 2018, $ 573 +56,794 55,320 +Card Member loans (includes gross loans available to settle obligations of a consolidated variable interest entity: 2019, $ 32,230 ; 2018, $ 33,194 ), less reserves: 2019, $ 2,383 ; 2018, $ 2,134 +84,998 79,720 +Other loans, less reserves: 2019, $ 152 ; 2018, $ 124 +4,626 3,676 +Investment securities 8,406 4,647 +Premises and equipment, less accumulated depreciation and amortization: 2019, $ 6,562 ; 2018, $ 6,015 +4,834 4,416 +Other assets (includes restricted cash of consolidated variable interest entities: 2019, $ 85 ; 2018, $ 70 ) +14,731 13,378 +Total assets $ 198,321 $ 188,602 +Liabilities and Shareholders’ Equity +Liabilities +Customer deposits $ 73,287 $ 69,960 +Accounts payable 12,738 12,255 +Short-term borrowings 6,442 3,100 +Long-term debt (includes debt issued by consolidated variable interest entities: 2019, $ 19,668 ; 2018, $ 19,509 ) +57,835 58,423 +Other liabilities 24,948 22,574 +Total liabilities $ 175,250 $ 166,312 +Contingencies and Commitments (Note 12) +Shareholders’ Equity +Preferred shares, $1.66 2/3 par value, authorized 20 million shares; issued and outstanding 1,600 shares as of December 31, 2019 and 2018 (Note 16) +— — +Common shares, $ 0.20 par value, authorized 3.6 billion shares; issued and outstanding 810 million shares as of December 31, 2019 and 847 million shares as of December 31, 2018 +163 170 +Additional paid-in capital 11,774 12,218 +Retained earnings 13,871 12,499 +Accumulated other comprehensive loss +Net unrealized debt securities gains (losses), net of tax of: 2019, $ 11 ; 2018, $( 1 ) +33 ( 8 ) +Foreign currency translation adjustments, net of tax of: 2019, $( 319 ); 2018, $( 300 ) +( 2,189 ) ( 2,133 ) +Net unrealized pension and other postretirement benefits, net of tax of: 2019, $( 208 ); 2018, $( 170 ) +( 581 ) ( 456 ) +Total accumulated other comprehensive loss ( 2,737 ) ( 2,597 ) +Total shareholders’ equity 23,071 22,290 +Total liabilities and shareholders’ equity $ 198,321 $ 188,602 +See Notes to Consolidated Financial Statements. +80 +Table of Contents +CONSOLIDATED STATEMENTS OF CASH FLOWS +Years Ended December 31 (Millions) +2019 2018 2017 +Cash Flows from Operating Activities +Net income $ 6,759 $ 6,921 $ 2,748 +Adjustments to reconcile net income to net cash provided by operating activities: +Provisions for losses 3,573 3,352 2,760 +Depreciation and amortization 1,188 1,293 1,321 +Deferred taxes and other 426 455 782 +Stock-based compensation 283 283 282 +Changes in operating assets and liabilities, net of effects of acquisitions and dispositions: +Other assets ( 368 ) 991 398 +Accounts payable & other liabilities 1,771 ( 4,365 ) 5,249 +Net cash provided by operating activities 13,632 8,930 13,540 +Cash Flows from Investing Activities +Sale of available-for-sale investment securities 22 4 2 +Maturities and redemptions of investment securities 7,329 3,499 2,494 +Purchase of investments ( 11,166 ) ( 5,434 ) ( 2,612 ) +Net increase in Card Member loans and receivables, and other loans ( 11,047 ) ( 15,854 ) ( 16,853 ) +Purchase of premises and equipment, net of sales: 2019, $ 43 ; 2018, $ 1 ; 2017, $ 1 +( 1,645 ) ( 1,310 ) ( 1,062 ) +Acquisitions/dispositions, net of cash acquired ( 352 ) ( 520 ) ( 211 ) +Other investing activities 152 — — +Net cash used in investing activities ( 16,707 ) ( 19,615 ) ( 18,242 ) +Cash Flows from Financing Activities +Net increase in customer deposits 3,330 5,542 11,385 +Net increase (decrease) in short-term borrowings 3,316 ( 148 ) ( 2,300 ) +Proceeds from long-term debt 12,706 21,524 32,764 +Payments of long-term debt ( 13,850 ) ( 18,895 ) ( 24,082 ) +Issuance of American Express common shares 86 87 129 +Repurchase of American Express common shares and other ( 4,685 ) ( 1,685 ) ( 4,400 ) +Dividends paid ( 1,422 ) ( 1,324 ) ( 1,251 ) +Net cash (used in) provided by financing activities ( 519 ) 5,101 12,245 +Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash 232 129 226 +Net (decrease) increase in cash, cash equivalents and restricted cash ( 3,362 ) ( 5,455 ) 7,769 +Cash, cash equivalents and restricted cash at beginning of year 27,808 33,263 25,494 +Cash, cash equivalents and restricted cash at end of year $ 24,446 $ 27,808 $ 33,263 +Supplemental cash flow information +Cash, cash equivalents and restricted cash reconciliation Dec-19 Dec-18 Dec-17 +Cash and cash equivalents per Consolidated Balance Sheets $ 23,932 $ 27,445 $ 32,927 +Restricted cash included in Other assets per Consolidated Balance Sheets 514 363 336 +Total cash, cash equivalents and restricted cash $ 24,446 $ 27,808 $ 33,263 +See Notes to Consolidated Financial Statements. +81 +Table of Contents +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +(Millions, except per share amounts) Total Preferred Shares Common Shares Additional Paid-in +Capital Accumulated Other +Comprehensive +Loss Retained Earnings +Balances as of December 31, 2016 $ 20,523 $ — $ 181 $ 12,733 $ ( 2,784 ) $ 10,393 +Net income 2,748 — — — — 2,748 +Other comprehensive income 356 — — — 356 — +Repurchase of common shares ( 4,314 ) — ( 10 ) ( 742 ) — ( 3,562 ) +Other changes, primarily employee plans 212 — 1 219 — ( 8 ) +Cash dividends declared preferred Series B, $ 52.00 per share +( 39 ) — — — — ( 39 ) +Cash dividends declared preferred Series C, $ 49.00 per share +( 42 ) — — — — ( 42 ) +Cash dividends declared common, $ 1.34 per share +( 1,183 ) — — — — ( 1,183 ) +Balances as of December 31, 2017 18,261 — 172 12,210 ( 2,428 ) 8,307 +Net income 6,921 — — — — 6,921 +Other comprehensive loss ( 169 ) — — — ( 169 ) — +Repurchase of common shares ( 1,570 ) — ( 3 ) ( 216 ) — ( 1,351 ) +Other changes, primarily employee plans 200 — 1 224 — ( 25 ) +Cash dividends declared preferred Series B, $ 52.00 per share +( 39 ) — — — — ( 39 ) +Cash dividends declared preferred Series C, $ 49.00 per share +( 41 ) — — — — ( 41 ) +Cash dividends declared common, $ 1.48 per share +( 1,273 ) — — — — ( 1,273 ) +Balances as of December 31, 2018 22,290 — 170 12,218 ( 2,597 ) 12,499 +Net income 6,759 — — — — 6,759 +Other comprehensive loss ( 140 ) — — — ( 140 ) — +Repurchase of common shares ( 4,585 ) — ( 8 ) ( 671 ) — ( 3,906 ) +Other changes, primarily employee plans 186 — 1 227 — ( 42 ) +Cash dividends declared preferred Series B, $ 52.00 per share +( 39 ) — — — — ( 39 ) +Cash dividends declared preferred Series C, $ 49.00 per share +( 42 ) — — — — ( 42 ) +Cash dividends declared common, $ 1.64 per share +( 1,358 ) — — — — ( 1,358 ) +Balances as of December 31, 2019 $ 23,071 $ — $ 163 $ 11,774 $ ( 2,737 ) $ 13,871 +See Notes to Consolidated Financial Statements. +82 +Table of Contents +NOTES TO CONSOLID ATED FINANCIAL STATEMENTS +NOTE 1 +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +THE C OMPANY +We are a globally integrated payments company that provides our customers with access to products, insights and experiences that enrich lives and build business success. Our principal products and services are credit and charge card products, along with travel and lifestyle related services, offered to consumers and businesses around the world. Business travel-related services are offered through the non-consolidated joint venture, American Express Global Business Travel. Our various products and services are sold globally to diverse customer groups, including consumers, small businesses, mid-sized companies and large corporations. These products and services are sold through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams, and direct response advertising. +Effective for the first quarter of 2019, we moved intercompany assets and liabilities, previously recorded in the operating segments, to Corporate & Other. Prior period amounts have been revised to conform to the current period presentation. +Refer to Note 24 for additional discussion of the products and services that comprise each segment. Corporate functions and certain other businesses and operations are included in Corporate & Other. +PRINCIPLES OF CONSOLIDATION +The Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Significant intercompany transactions are eliminated. +We consolidate entities in which we hold a “controlling financial interest.” For voting interest entities, we are considered to hold a controlling financial interest when we are able to exercise control over the investees’ operating and financial decisions. For variable interest entities (VIEs), the determination of which is based on the amount and characteristics of the entity’s equity, we are considered to hold a controlling financial interest when we are determined to be the primary beneficiary. A primary beneficiary is the party that has both: (1) the power to direct the activities that most significantly impact that VIE’s economic performance, and (2) the obligation to absorb the losses of, or the right to receive the benefits from, the VIE that could potentially be significant to that VIE. +Entities in which our voting interest in common equity does not provide it with control, but allows us to exert significant influence over operating and financial decisions, are accounted for under the equity method. We also have investments in equity securities where our voting interest is below the level of significant influence, including investments that we make in non-public companies in the ordinary course of business. Such investments are initially recorded at cost and adjusted to fair value through earnings for observable price changes in orderly transactions for identical or similar transactions of the same company or if they are determined to be impaired. See Note 4 for the accounting policy for our marketable equity securities. +FOREIGN CURRENCY +Monetary assets and liabilities denominated in foreign currencies are translated into U.S. dollars based upon exchange rates prevailing at the end of the reporting period; non-monetary assets and liabilities are translated at the historic exchange rate at the date of the transaction; revenues and expenses are translated at the average month-end exchange rates during the year. Resulting translation adjustments, along with any related qualifying hedge and tax effects, are included in accumulated other comprehensive income (loss) (AOCI), a component of shareholders’ equity. Translation adjustments, including qualifying hedge and tax effects, are reclassified to earnings upon the sale or substantial liquidation of investments in foreign operations. Gains and losses related to transactions in a currency other than the functional currency are reported in Other, net expenses in the Consolidated Statements of Income. +83 +Table of Contents +AMOUNTS BASED ON ESTIMATES AND ASSUMPTIONS +Accounting estimates are an integral part of the Consolidated Financial Statements. These estimates are based, in part, on management’s assumptions concerning future events. Among the more significant assumptions are those that relate to reserves for Card Member losses on loans and receivables, Membership Rewards liability, goodwill and income taxes. These accounting estimates reflect the best judgment of management, but actual results could differ. +INCOME STATEMENT +Discount Revenue +Discount revenue primarily represents the amount we earn on transactions occurring at merchants that have entered into a card acceptance agreement with us, or a Global Network Services (GNS) partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. The amount of fees charged for accepting our cards as payment for goods or services, or merchant discount, varies with, among other factors, the industry in which the merchant conducts business, the merchant’s overall American Express-related transaction volume, the method of payment, the settlement terms with the merchant, the method of submission of transactions and, in certain instances, the geographic scope of the card acceptance agreement between the merchant and us (e.g., local or global) and the transaction amount. The merchant discount is generally deducted from the payment to the merchant and recorded as discount revenue at the time the Card Member transaction occurs. +The card acceptance agreements, which include the agreed-upon terms for charging the merchant discount fee, vary in duration. Our contracts with small- and medium-sized merchants generally have no fixed contractual duration, while those with large merchants are generally for fixed periods, which typically range from three to seven years in duration. Our fixed-period agreements may include auto-renewal features, which may allow the existing terms to continue beyond the stated expiration date until a new agreement is reached. We satisfy our obligations under these agreements over the contract term, often on a daily basis, including through the processing of Card Member transactions and the availability of our payment network. +In cases where the merchant acquirer is a third party (which is the case, for example, under our OptBlue program, or with certain of our GNS partners), we receive a network rate fee in our settlement with the merchant acquirer, which is individually negotiated between us and that merchant acquirer and is recorded as discount revenue at the time the Card Member transaction occurs. In our role as the operator of the American Express network, we also settle with merchants on behalf of our GNS card issuing partners, who in turn receive an issuer rate that is individually negotiated between that issuer and us and is recorded as expense in Marketing and business development (see below) or as contra-revenue in Other revenue. +Revenue expected to be recognized in future periods related to contracts that have an original expected duration of one year or less and contracts with variable consideration (e.g. discount revenue) is not required to be disclosed. Non-interest revenue expected to be recognized in future periods through remaining contracts with customers is not material. +Net Card Fees +Net card fees represent revenue earned from annual card membership fees, which vary based on the type of card and the number of cards for each account. These fees, net of acquisition costs and a reserve for projected refunds for Card Member cancellations, are deferred and recognized on a straight-line basis over the twelve-month card membership period as Net card fees in the Consolidated Statements of Income. The unamortized net card fee balance is reported in Other liabilities on the Consolidated Balance Sheets (refer to Note 9). +Other Fees and Commissions +Other fees and commissions includes certain fees charged to Card Members, including delinquency fees and foreign currency conversion fees, which are primarily recognized in the period in which they are charged to the Card Member. Other fees and commissions also includes Membership Rewards program fees, which are deferred and recognized over the period covered by the fee, typically one year, the unamortized portion of which is included in Other liabilities on the Consolidated Balance Sheets. In addition, Other fees and commissions includes loyalty coalition-related fees, travel commissions and fees and service fees earned from merchants, that are recognized when the service is performed, which is generally in the period the fee is charged. Refer to Note 18 for additional information. +Contra-revenue +Payments made pursuant to contractual arrangements with our merchants, GNS partners, and other customers are classified as contra-revenue, except where we receive goods, services or other benefits for which the fair value is determinable and measurable, in which case they are recorded as expense. +84 +Table of Contents +Interest Income +Interest on Card Member loans is assessed using the average daily balance method. Unless the loan is classified as non-accrual, interest is recognized based upon the principal amount outstanding, in accordance with the terms of the applicable account agreement, until the outstanding balance is paid, or written off. +Interest and dividends on investment securities primarily relate to our performing fixed-income securities. Interest income is recognized as earned using the effective interest method, which adjusts the yield for security premiums and discounts, fees and other payments, so that a constant rate of return is recognized on the investment security’s outstanding balance. Amounts are recognized until securities are in default or when it becomes likely that future interest payments will not be made as scheduled. +Interest on deposits with banks and other is recognized as earned, and primarily relates to the placement of cash, in excess of near-term funding requirements, in interest-bearing time deposits, overnight sweep accounts, and other interest-bearing demand and call accounts. +Interest Expense +Interest expense includes interest incurred primarily to fund Card Member loans and receivables, general corporate purposes and liquidity needs, and is recognized as incurred. Interest expense is divided principally into two categories: (i) deposits, which primarily relates to interest expense on deposits taken from customers and institutions, and (ii) debt, which primarily relates to interest expense on our long-term debt and short-term borrowings, as well as the realized impact of derivatives used to hedge interest rate risk on our long-term debt. +Marketing and Business Development +Marketing and business development expense includes costs incurred in the development and initial placement of advertising, which are expensed in the year in which the advertising first takes place. Also included in Marketing and business development expense are payments to our cobrand partners, Card Member statement credits for qualifying charges on eligible card accounts, corporate incentive payments earned on achievement of pre-set targets, and certain payments to GNS card issuing partners. These costs are generally expensed as incurred. +Card Member Rewards +We issue charge and credit cards that allow Card Members to participate in various rewards programs (e.g., Membership Rewards, cobrand and cash back). Rewards expense is recognized in the period Card Members earn rewards, generally by spending on their enrolled card products. We record a Card Member rewards liability that represents the estimated cost of points earned that are expected to be redeemed. Pursuant to cobrand agreements, we make payments to our cobrand partners based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The partner is then liable for providing rewards to the Card Member under the cobrand partner’s own loyalty program. Card Member rewards liabilities are impacted over time by enrollment levels, attrition, the volume of points earned and redeemed, and the associated redemption costs. Changes in the Card Member rewards liabilities during the period are taken as an increase or decrease to the Card Member rewards expense in the Consolidated Statement of Income. +BALANCE SHEET +Cash and Cash Equivalents +Cash and cash equivalents include cash and amounts due from banks, interest-bearing bank balances, including securities purchased under resale agreements, and other highly liquid investments with original maturities of 90 days or less. +Goodwill +Goodwill represents the excess of the acquisition cost of an acquired business over the fair value of assets acquired and liabilities assumed. We allocate goodwill to our reporting units for the purpose of impairment testing. A reporting unit is defined as an operating segment, or a business that is one level below an operating segment, for which discrete financial information is regularly reviewed by the operating segment manager. +85 +Table of Contents +We evaluate goodwill for impairment annually as of June 30, or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of one or more of our reporting units below its carrying value. Prior to completing the assessment of goodwill for impairment, we also perform a recoverability test of certain long-lived assets. We have the option to perform a qualitative assessment of goodwill impairment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. Alternatively, we can perform a more detailed quantitative assessment of goodwill impairment. +This qualitative assessment entails the evaluation of factors such as economic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit and other company and reporting unit-specific events. If we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then perform the impairment evaluation using the quantitative assessment. +Under the quantitative assessment, the first step identifies whether there is a potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds the fair value, then a test is performed to determine the implied fair value of goodwill. An impairment loss is recognized based on the amount that the carrying amount of goodwill exceeds the implied fair value. +When measuring the fair value of our reporting units in the quantitative assessment, we use widely accepted valuation techniques, applying a combination of the income approach (discounted cash flows) and market approach (market multiples). When preparing discounted cash flow models under the income approach, we use internal forecasts to estimate future cash flows expected to be generated by the reporting units. To discount these cash flows, we use the expected cost of equity, determined by using a capital asset pricing model. We believe the discount rates used appropriately reflect the risks and uncertainties in the financial markets generally and specifically in our internally-developed forecasts. When using market multiples under the market approach, we apply comparable publicly traded companies’ multiples (e.g., earnings or revenues) to our reporting units’ actual results. +For the years ended December 31, 2019 and 2018, we performed a qualitative assessment in connection with our annual goodwill impairment evaluation and determined that it was more likely than not that the fair values of each of our reporting units exceeded their carrying values. +Premises and Equipment +Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation. Costs incurred during construction are capitalized and are depreciated once an asset is placed in service. Depreciation is generally computed using the straight-line method over the estimated useful lives of the assets, which range from 3 to 10 years for equipment, furniture and building improvements, and from 40 to 50 years for premises, which are depreciated based upon their estimated useful life at the acquisition date. +Certain costs associated with the acquisition or development of internal-use software are also capitalized and recorded in Premises and equipment. Once the software is ready for its intended use, these costs are amortized on a straight-line basis over the software’s estimated useful life, generally 5 years. We review these assets for impairment using the same impairment methodology used for our intangible assets. +Leasehold improvements are depreciated using the straight-line method over the lesser of the remaining term of the leased facility, or the economic life of the improvement, and range from 5 to 10 years. We recognize lease restoration obligations at the fair value of the restoration liabilities when incurred and amortize the restoration assets over the lease term. +Leases +On January 1, 2019, we adopted the new accounting guidance on leases using the modified retrospective method. We elected the package of practical expedients and transition provisions allowing us to bring our existing operating leases onto the Consolidated Balance Sheet on January 1, 2019 without adjusting comparative periods. The adoption of the new lease guidance did not have a material impact on our financial position, results of operations and cash flows. +We have operating leases worldwide for facilities and equipment, which, for those leases with terms greater than 12 months, are recorded as lease-related assets and liabilities. We do not separate lease and non-lease components. Lease-related assets, or right-of-use assets, are recognized at the lease commencement date at amounts equal to the respective lease liabilities, adjusted for prepaid lease payments, initial direct costs and lease incentives. Lease liabilities are recognized at the present value of the contractual fixed lease payments, discounted using our incremental borrowing rate as of the lease commencement date or upon modification of the lease. Operating lease expense is recognized on a straight-line basis over the lease term, while variable lease payments are expensed as incurred. +86 +Table of Contents +OTHER SIGNIFICANT ACCOUNTING POLICIES +The following table identifies our other significant accounting policies, along with the related Note. +Significant Accounting Policy Note +Number Note Title +Loans and Accounts Receivable Note 2 Loans and Accounts Receivable +Reserves for Losses Note 3 Reserves for Losses +Investment Securities Note 4 Investment Securities +Asset Securitizations Note 5 Asset Securitizations +Legal Contingencies Note 12 Contingencies and Commitments +Derivative Financial Instruments and Hedging Activities Note 13 Derivatives and Hedging Activities +Fair Value Measurements Note 14 Fair Values +Guarantees Note 15 Guarantees +Income Taxes Note 20 Income Taxes +CLASSIFICATION OF VARIOUS ITEMS +Certain reclassifications of prior period amounts have been made to conform to the current period presentation. +RECENTLY ISSUED ACCOUNTING STANDARDS +In June 2016, the Financial Accounting Standards Board (FASB) issued new accounting guidance for the recognition of credit losses on certain financial instruments. The guidance, as amended and effective January 1, 2020, introduces a new credit reserving methodology known as the Current Expected Credit Loss (CECL) approach, which differs significantly from the incurred loss approach used through December 31, 2019 and alters the estimation process, inputs and assumptions used in estimating credit losses. The CECL methodology requires measurement of expected credit losses for the estimated life of the financial instrument, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. Our approach incorporates separate reasonable and supportable periods for loans and receivables and uses a weighted average of multiple future economic scenarios. Additionally, the guidance requires a modified retrospective transition, which records the difference between the reserves measured using the CECL methodology and the reserves using the incurred loss approach, tax effected, as a cumulative effect adjustment upon adoption through retained earnings. As a result, our financial position, results of operations and regulatory risk-based capital for periods prior to January 1, 2020 will not be restated. +We currently estimate an increase to total loan reserves of approximately $ 1.7 billion and a decrease to total receivable reserves of approximately $ 0.5 billion, along with the associated current and deferred tax impact of approximately $ 0.3 billion, and an offset to the opening balance of retained earnings, net of tax, of approximately $ 0.9 billion as of January 1, 2020. Our cross-functional implementation team is finalizing our operational processes, controls and governance. +In addition, for available-for-sale debt securities, the new guidance replaces the other-than-temporary impairment model and requires the recognition of an allowance for reductions in a security’s fair value attributable to declines in credit quality, instead of a direct write-down of the security, when a valuation decline is determined to be other-than-temporary. We have completed our evaluation of the new guidance for our available-for-sale debt securities and, while there was no impact of the new guidance on adoption, we have updated our processes to evaluate and measure potential future credit losses. +87 +Table of Contents +NOTE 2 +LOANS AND ACCOUNTS RECEIVABLE +Our lending and charge payment card products result in the generation of Card Member loans and Card Member receivables. +CARD MEMBER AND OTHER LOANS +Card Member loans are recorded at the time a Card Member enters into a point-of-sale transaction with a merchant and represent revolving amounts due on lending card products, as well as amounts due from charge Card Members who utilize the Pay Over Time features on their account and revolve a portion of the outstanding balance by entering into a revolving payment arrangement with us. These loans have a range of terms such as credit limits, interest rates, fees and payment structures, which can be revised over time based on new information about Card Members, and in accordance with applicable regulations and the respective product’s terms and conditions. Card Members holding revolving loans are typically required to make monthly payments based on pre-established amounts and the amounts that Card Members choose to revolve are subject to finance charges. +Card Member loans are presented on the Consolidated Balance Sheets net of reserves for losses (refer to Note 3), and include principal and any related accrued interest and fees. Our policy generally is to cease accruing interest on a Card Member loan at the time the account is written off, and establish reserves for interest that we believe will not be collected. +Other loans are recorded at the time any extension of credit is provided to consumer and commercial customers for non-card financing products. These loans have a range of fixed terms such as interest rates, fees and repayment periods. Borrowers are typically required to make pre-established monthly payments over the term of the loan. Non-card financing products are not associated with a Card Member agreement, and instead are governed by a separate borrowing relationship. Other loans are presented on the Consolidated Balance Sheets net of reserves for losses, and include principal and any related accrued interest and fees. +Card Member loans by segment and Other loans as of December 31, 2019 and 2018 consisted of: +(Millions) 2019 2018 +Global Consumer Services Group (a) +$ 73,266 $ 69,458 +Global Commercial Services 14,115 12,396 +Card Member loans 87,381 81,854 +Less: Reserve for losses 2,383 2,134 +Card Member loans, net $ 84,998 $ 79,720 +Other loans, net (b) +$ 4,626 $ 3,676 +(a) Includes approximately $ 32.2 billion and $ 33.2 billion of gross Card Member loans available to settle obligations of a consolidated VIE as of December 31, 2019 and 2018, respectively. +(b) Other loans primarily represent consumer and commercial non-card financing products. Other loans are presented net of reserves for losses of $ 152 million and $ 124 million as of December 31, 2019 and 2018, respectively. +CARD MEMBER RECEIVABLES +Card Member receivables are also recorded at the time a Card Member enters into a point-of-sale transaction with a merchant and represent amounts due on charge card products. Each charge card transaction is authorized based on its likely economics, a Card Member’s most recent credit information and spend patterns. +Charge Card Members generally must pay the full amount billed each month. Card Member receivable balances are presented on the Consolidated Balance Sheets net of reserves for losses (refer to Note 3), and include principal and any related accrued fees. +88 +Table of Contents +Card Member receivables by segment as of December 31, 2019 and 2018 consisted of: +(Millions) 2019 2018 +Global Consumer Services Group (a) +$ 22,844 $ 21,455 +Global Commercial Services 34,569 34,438 +Card Member receivables 57,413 55,893 +Less: Reserve for losses 619 573 +Card Member receivables, net $ 56,794 $ 55,320 +(a) Includes $ 8.3 billion and $ 8.5 billion of gross Card Member receivables available to settle obligations of a consolidated VIE as of December 31, 2019 and 2018, respectively. +CARD MEMBER LOANS AND CARD MEMBER RECEIVABLES AGING +Generally, a Card Member account is considered past due if payment is not received within 30 days after the billing statement date. The following table presents the aging of Card Member loans and receivables as of December 31, 2019 and 2018: +2019 (millions) Current 30-59 +Days Past Due 60-89 +Days Past Due 90+ +Days Past +Due Total +Card Member Loans: +Global Consumer Services Group $ 72,101 $ 322 $ 253 $ 590 $ 73,266 +Global Commercial Services +Global Small Business Services 13,898 56 40 85 14,079 +Global Corporate Payments (a) +(b) (b) (b) — 36 +Card Member Receivables: +Global Consumer Services Group 22,560 86 58 140 22,844 +Global Commercial Services +Global Small Business Services $ 17,113 $ 99 $ 58 $ 134 $ 17,404 +Global Corporate Payments (a) +(b) (b) (b) $ 136 $ 17,165 +2018 (millions) Current 30-59 +Days Past Due 60-89 +Days Past Due 90+ +Days Past +Due Total +Card Member Loans: +Global Consumer Services Group $ 68,442 $ 290 $ 220 $ 506 $ 69,458 +Global Commercial Services +Global Small Business Services 12,195 51 32 73 12,351 +Global Corporate Payments (a) +(b) (b) (b) — 45 +Card Member Receivables: +Global Consumer Services Group 21,207 80 50 118 21,455 +Global Commercial Services +Global Small Business Services $ 16,460 $ 101 $ 53 $ 114 $ 16,728 +Global Corporate Payments (a) +(b) (b) (b) $ 129 $ 17,710 +(a) Delinquency data is tracked based on days past billing status rather than days past due. A Card Member account is considered 90 days past billing if payment has not been received within 90 days of the Card Member’s billing statement date. In addition, if we initiate collection procedures on an account prior to the account becoming 90 days past billing, the associated Card Member loan or receivable balance is classified as 90 days past billing. These amounts are shown above as 90+ Days Past Due for presentation purposes. See also (b). +(b) Delinquency data for periods other than 90+ days past billing is not available due to system constraints. Therefore, such data has not been utilized for risk management purposes. The balances that are current to 89 days past due can be derived as the difference between the Total and the 90+ Days Past Due balances. +89 +Table of Contents +CREDIT QUALITY INDICATORS FOR CARD MEMBER LOANS AND RECEIVABLES +The following tables present the key credit quality indicators as of or for the years ended December 31: +2019 2018 +Net Write-Off Rate Net Write-Off Rate +Principal +Only (a) +Principal, +Interest, & +Fees (a) +30+ +Days Past Due +as a % of +Total +Principal +Only (a) +Principal, +Interest, & +Fees (a) +30+ +Days Past Due +as a % of +Total +Card Member Loans: +Global Consumer Services Group 2.3 % 2.8 % 1.6 % 2.1 % 2.5 % 1.5 % +Global Small Business Services 1.9 % 2.2 % 1.3 % 1.7 % 2.0 % 1.3 % +Card Member Receivables: +Global Consumer Services Group 1.7 % 1.9 % 1.2 % 1.6 % 1.8 % 1.2 % +Global Small Business Services 1.9 % 2.1 % 1.7 % 1.7 % 2.0 % 1.6 % +2019 2018 +Net Loss +Ratio as +a % of +Charge +Volume 90+ +Days Past Billing +as a % of +Receivables Net Loss +Ratio as +a % of +Charge +Volume 90+ +Days Past Billing +as a % of +Receivables +Card Member Receivables: +Global Corporate Payments 0.08 % 0.8 % 0.11 % 0.7 % +(a) We present a net write-off rate based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, because we consider uncollectible interest and/or fees in estimating our reserves for credit losses, a net write-off rate including principal, interest and/or fees is also presented. +Refer to Note 3 for additional indicators, including external environmental qualitative factors, management considers in its monthly evaluation process for reserves for losses. +IMPAIRED CARD MEMBER LOANS AND RECEIVABLES +Impaired Card Member loans and receivables are individual larger balance or homogeneous pools of smaller balance loans and receivables for which it is probable that we will be unable to collect all amounts due according to the original contractual terms of the Card Member agreement. We consider impaired loans and receivables to include: (i) loans over 90 days past due still accruing interest, (ii) nonaccrual loans and (iii) loans and receivables modified as troubled debt restructurings (TDRs). +In instances where the Card Member is experiencing financial difficulty, we may modify, through various programs, Card Member loans and receivables in order to minimize losses and improve collectability, while providing Card Members with temporary or permanent financial relief. We have classified Card Member loans and receivables in these modification programs as TDRs and continue to classify Card Member accounts that have exited a modification program as a TDR, with such accounts identified as “Out of Program TDRs.” +Such modifications to the loans and receivables primarily include (i) temporary interest rate reductions (possibly as low as zero percent, in which case the loan is characterized as non-accrual in our TDR disclosures), (ii) placing the Card Member on a fixed payment plan not to exceed 60 months and (iii) suspending delinquency fees until the Card Member exits the modification program. Upon entering the modification program, the Card Member’s ability to make future purchases is either canceled, or in certain cases suspended until the Card Member successfully exits the modification program. In accordance with the modification agreement with the Card Member, loans may revert back to the original contractual terms (including the contractual interest rate) when the Card Member exits the modification program, which is (i) when all payments have been made in accordance with the modification agreement or, (ii) when the Card Member defaults out of the modification program. We establish a reserve for Card Member interest charges and fees considered to be uncollectible. +Reserves for Card Member loans and receivables modified as TDRs are determined as the difference between the cash flows expected to be received from the Card Member (taking into consideration the probability of subsequent defaults), discounted at the original effective interest rates, and the carrying value of the related Card Member loan or receivables balance. We determine the original effective interest rate as the interest rate in effect prior to the imposition of any penalty interest rate. All changes in the impairment measurement are included in Provisions for losses in the Consolidated Statements of Income. +90 +Table of Contents +The following tables provide additional information with respect to our impaired Card Member loans and receivables as of December 31, 2019, 2018 and 2017. Impaired Card Member loans and receivables outside the U.S. are not significant as of December 31, 2019, 2018 and 2017; therefore, such loans and receivables are not included in the following tables unless otherwise noted. +As of December 31, 2019 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance Unpaid Principal Balance Allowance for TDRs +Card Member Loans: +Global Consumer Services Group (f) +$ 384 $ 284 $ 500 $ 175 $ 1,343 $ 1,199 $ 137 +Global Commercial Services 44 54 97 38 233 220 22 +Card Member Receivables: +Global Consumer Services Group — — 56 16 72 72 3 +Global Commercial Services — — 109 30 139 138 6 +Total $ 428 $ 338 $ 762 $ 259 $ 1,787 $ 1,629 $ 168 +As of December 31, 2018 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance Unpaid Principal Balance Allowance for TDRs +Card Member Loans: +Global Consumer Services Group (f) +$ 344 $ 236 $ 313 $ 131 $ 1,024 $ 923 $ 80 +Global Commercial Services 43 43 59 29 174 161 14 +Card Member Receivables: +Global Consumer Services Group — — 29 13 42 42 2 +Global Commercial Services — — 61 25 86 86 5 +Total $ 387 $ 279 $ 462 $ 198 $ 1,326 $ 1,212 $ 101 +As of December 31, 2017 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance Unpaid Principal Balance Allowance for TDRs +Card Member Loans: +Global Consumer Services Group (f) +$ 289 $ 168 $ 178 $ 131 $ 766 $ 694 $ 49 +Global Commercial Services 38 31 31 27 127 118 8 +Card Member Receivables: +Global Consumer Services Group — — 15 9 24 24 1 +Global Commercial Services — — 37 19 56 56 2 +Total $ 327 $ 199 $ 261 $ 186 $ 973 $ 892 $ 60 +(a) Our policy is generally to accrue interest through the date of write-off (typically 180 days past due). We establish reserves for interest that we believe will not be collected. Amounts presented exclude Card Member loans classified as a TDR. +(b) Non-accrual loans not in modification programs primarily include certain Card Member loans placed with outside collection agencies for which we have ceased accruing interest. Amounts presented exclude Card Member loans classified as a TDR. +(c) Accounts classified as a TDR include $ 26 million, $ 17 million and $ 15 million that are over 90 days past due and accruing interest and $ 10 million, $ 6 million and $ 5 million that are non-accruals as of December 31, 2019, 2018 and 2017, respectively. +(d) In Program TDRs include Card Member accounts that are currently enrolled in a modification program. +(e) Out of Program TDRs include $ 188 million, $ 148 million and $ 141 million of Card Member accounts that have successfully completed a modification program and $ 72 million, $ 50 million and $ 45 million of Card Member accounts that were not in compliance with the terms of the modification programs as of December 31, 2019, 2018 and 2017, respectively. +(f) GCSG includes balances outside the U.S. of $ 93 million, $ 69 million and $ 56 million that are over 90 days and accruing interest and $ 77 million, $ 68 million and $ 55 million in unpaid principal as of December 31, 2019, 2018 and 2017, respectively. +91 +Table of Contents +The following table provides information with respect to our average balances and interest income recognized from impaired Card Member loans and the average balances of impaired Card Member receivables for the years ended December 31: +2019 (Millions) Average Balance Interest Income Recognized +Card Member Loans: +Global Consumer Services Group $ 1,159 $ 136 +Global Commercial Services 203 25 +Card Member Receivables: +Global Consumer Services Group 56 — +Global Commercial Services 112 — +Total $ 1,530 $ 161 +2018 (Millions) Average Balance Interest Income Recognized +Card Member Loans: +Global Consumer Services Group $ 878 $ 109 +Global Commercial Services 150 21 +Card Member Receivables: +Global Consumer Services Group 33 — +Global Commercial Services 73 — +Total $ 1,134 $ 130 +2017 (Millions) Average Balance Interest Income Recognized +Card Member Loans: +Global Consumer Services Group $ 699 $ 85 +Global Commercial Services 120 17 +Card Member Receivables: +Global Consumer Services Group 20 — +Global Commercial Services 45 — +Total $ 884 $ 102 +92 +Table of Contents +CARD MEMBER LOANS AND RECEIVABLES MODIFIED AS TDRs +The following table provides additional information with respect to Card Member loans and receivables modified as TDRs for the years ended December 31: +2019 Number of Accounts +(in thousands) +Outstanding Balances +($ in millions) (a) +Average Interest Rate Reduction +(% points) Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans 78 $ 602 13 (b) +Card Member Receivables 9 210 (c) 26 +Total 87 $ 812 +2018 Number of Accounts +(in thousands) +Outstanding Balances +($ in millions) (a) +Average Interest Rate Reduction +(% points) Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans 51 $ 377 12 (b) +Card Member Receivables 6 110 (c) 28 +Total 57 $ 487 +2017 Number of Accounts +(in thousands) +Outstanding Balances +($ in millions) (a) +Average Interest Rate Reduction +(% points) Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans 33 $ 224 10 (b) +Card Member Receivables 6 83 (c) 28 +Total 39 $ 307 +(a) Represents the outstanding balance immediately prior to modification. The outstanding balance includes principal, fees and accrued interest on Card Member loans and principal and fees on Card Member receivables. Modifications did not reduce the principal balance. +(b) For Card Member loans, there have been no payment term extensions. +(c) We do not offer interest rate reduction programs for Card Member receivables as the receivables are non-interest bearing. +93 +Table of Contents +The following table provides information with respect to Card Member loans and receivables modified as TDRs that subsequently defaulted within 12 months of modification for the years ended December 31, 2019, 2018 and 2017. A Card Member is considered in default of a modification program after one and up to two missed payments, depending on the terms of the modification program. For all Card Members that defaulted from a modification program, the probability of default is factored into the reserves for Card Member loans and receivables. +2019 Number of Accounts +(thousands) +Aggregated +Outstanding Balances +Upon Default (a) +(millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans 12 $ 86 +Card Member Receivables 4 20 +Total 16 $ 106 +Number of Accounts +Aggregated +Outstanding Balances +Upon Default (a) +2018 (thousands) (millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans 8 $ 46 +Card Member Receivables 4 11 +Total 12 $ 57 +Number of Accounts +Aggregated Outstanding +Balances +Upon Default (a) +2017 (thousands) (millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans 6 $ 39 +Card Member Receivables 3 7 +Total 9 $ 46 +(a) The outstanding balances upon default include principal, fees and accrued interest on Card Member loans, and principal and fees on Card Member receivables. +NOTE 3 +RESERVES FOR LOSSES +Reserves for losses relating to Card Member loans and receivables represent management’s best estimate of the probable inherent losses in our outstanding portfolio of loans and receivables, as of the balance sheet date. Management’s evaluation process requires certain estimates and judgments. +Reserves for losses are primarily based upon statistical and analytical models that analyze portfolio performance and reflect management’s judgments regarding the quantitative components of the reserve. The models take into account several factors, including delinquency-based loss migration rates, loss emergence periods and average losses and recoveries over an appropriate historical period. Management considers whether to adjust the quantitative reserves for certain external and internal qualitative factors, which may increase or decrease the reserves for losses on Card Member loans and receivables. These external factors include employment, spend, sentiment, housing and credit, and changes in the legal and regulatory environment, while the internal factors include increased risk in certain portfolios, impact of risk management initiatives, changes in underwriting requirements and overall process stability. As part of this evaluation process, management also considers various reserve coverage metrics, such as reserves as a percentage of past due amounts, reserves as a percentage of Card Member loans or receivables, and net write-off coverage ratios. +Card Member loans and receivables balances are written off when management considers amounts to be uncollectible, which is generally determined by the number of days past due and is typically no later than 180 days past due, or 120 days past due for closed-end loans categorized as Other loans. Card Member loans and receivables and Other loans in bankruptcy or owed by deceased individuals are generally written off upon notification. +94 +Table of Contents +CHANGES IN CARD MEMBER LOANS RESERVE FOR LOSSES +The following table presents changes in the Card Member loans reserve for losses for the years ended December 31: +(Millions) 2019 2018 2017 +Balance, January 1 $ 2,134 $ 1,706 $ 1,223 +Provisions (a) +2,462 2,266 1,868 +Net write-offs (b) +Principal ( 1,860 ) ( 1,539 ) ( 1,181 ) +Interest and fees ( 375 ) ( 304 ) ( 227 ) +Other (c) +22 5 23 +Balance, December 31 $ 2,383 $ 2,134 $ 1,706 +(a) Provisions for principal, interest and fee reserve components. +(b) Principal write-offs are presented less recoveries of $ 525 million, $ 444 million and $ 409 million for the years ended December 31, 2019, 2018 and 2017, respectively. Recoveries of interest and fees were not significant. Amounts include net (write-offs) recoveries from TDRs of $( 79 ) million, $( 33 ) million and $( 30 ) million for the years ended December 31, 2019, 2018 and 2017, respectively. +(c) Includes foreign currency translation adjustments of $ 4 million, $( 11 ) million and $ 8 million, and other adjustments of $ 18 million, $ 16 million and $ 15 million for the years ended December 31, 2019, 2018 and 2017, respectively. +CARD MEMBER LOANS EVALUATED INDIVIDUALLY AND COLLECTIVELY FOR IMPAIRMENT +The following table presents Card Member loans evaluated individually and collectively for impairment and related reserves as of December 31: +(Millions) 2019 2018 2017 +Card Member loans evaluated individually for impairment (a) +$ 810 $ 532 $ 367 +Related reserves (a) +$ 159 $ 94 $ 57 +Card Member loans evaluated collectively for impairment (b) +$ 86,571 $ 81,322 $ 73,032 +Related reserves (b) +$ 2,224 $ 2,040 $ 1,649 +(a) Represents loans modified as a TDR and related reserves. +(b) Represents current loans and loans less than 90 days past due, loans over 90 days past due and accruing interest, and non-accrual loans. The reserves include the quantitative results of analytical models that are specific to individual pools of loans, and reserves for internal and external qualitative risk factors that apply to loans that are collectively evaluated for impairment. +CHANGES IN CARD MEMBER RECEIVABLES RESERVE FOR LOSSES +The following table presents changes in the Card Member receivables reserve for losses for the years ended December 31: +(Millions) 2019 2018 2017 +Balance, January 1 $ 573 $ 521 $ 467 +Provisions (a) +963 937 795 +Net write-offs (b) +( 900 ) ( 859 ) ( 736 ) +Other (c) +( 17 ) ( 26 ) ( 5 ) +Balance, December 31 $ 619 $ 573 $ 521 +(a) Provisions for principal and fee reserve components. +(b) Net write-offs are presented less recoveries of $ 374 million, $ 367 million and $ 366 million for the years ended December 31, 2019, 2018 and 2017, respectively. Amounts include net recoveries (write-offs) from TDRs of $( 16 ) million, nil and $ 2 million, for the years ended December 31, 2019, 2018 and 2017, respectively. +(c) Includes foreign currency translation adjustments of nil, $( 6 ) million and $ 12 million, and other adjustments of $( 17 ) million, $( 20 ) million and $( 17 ) million for the years ended December 31, 2019, 2018 and 2017, respectively. +95 +Table of Contents +CARD MEMBER RECEIVABLES EVALUATED INDIVIDUALLY AND COLLECTIVELY FOR IMPAIRMENT +The following table presents Card Member receivables evaluated individually and collectively for impairment and related reserves as of December 31: +(Millions) 2019 2018 2017 +Card Member receivables evaluated individually for impairment (a) +$ 211 $ 128 $ 80 +Related reserves (a) +$ 9 $ 7 $ 3 +Card Member receivables evaluated collectively for impairment $ 57,202 $ 55,765 $ 53,967 +Related reserves (b) +$ 610 $ 566 $ 518 +(a) Represents receivables modified as a TDR and related reserves. +(b) The reserves include the quantitative results of analytical models that are specific to individual pools of receivables, and reserves for internal and external qualitative risk factors that apply to receivables that are collectively evaluated for impairment. +NOTE 4 +INVESTMENT SECURITIES +Investment securities principally include available-for-sale debt securities carried at fair value on the Consolidated Balance Sheets, with unrealized gains and losses recorded in AOCI, net of income taxes. Investment securities also include equity securities carried at fair value on the Consolidated Balance Sheets. Effective January 1, 2018, the unrealized gains and losses on equity securities are recorded in the Consolidated Statements of Income; prior to January 1, 2018, the unrealized gains and losses on equity securities were recorded in AOCI, net of income taxes. +Realized gains and losses are recognized upon disposition of available-for-sale securities using the specific identification method. +Refer to Note 14 for a description of our methodology for determining the fair value of investment securities. +The following is a summary of investment securities as of December 31: +2019 2018 2017 +Description of Securities (Millions) +Cost Gross +Unrealized +Gains Gross +Unrealized +Losses Estimated +Fair +Value Cost Gross +Unrealized +Gains Gross +Unrealized +Losses Estimated +Fair +Value Cost Gross +Unrealized +Gains Gross +Unrealized +Losses Estimated +Fair +Value +Available-for-sale debt securities: +State and municipal obligations $ 236 $ 8 $ ( 1 ) $ 243 $ 594 $ 4 $ ( 2 ) $ 596 $ 1,369 $ 11 $ ( 3 ) $ 1,377 +U.S. Government agency obligations 9 — — 9 10 — — 10 11 — — 11 +U.S. Government treasury obligations 7,395 35 ( 1 ) 7,429 3,452 5 ( 17 ) 3,440 1,051 3 ( 9 ) 1,045 +Corporate debt securities 27 — — 27 28 — — 28 28 — — 28 +Mortgage-backed securities (a) +39 2 — 41 50 1 — 51 67 2 — 69 +Foreign government bonds and obligations 578 1 — 579 474 — — 474 581 — — 581 +Equity securities (b) +55 25 +(c) +( 2 ) 78 51 — ( 3 ) 48 51 — ( 3 ) 48 +Total $ 8,339 $ 71 $ ( 4 ) $ 8,406 $ 4,659 $ 10 $ ( 22 ) $ 4,647 $ 3,158 $ 16 $ ( 15 ) $ 3,159 +(a) Represents mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. +(b) Equity securities comprise investments in common stock, exchange-traded funds and mutual funds. +(c) During 2019, an equity investment transferred from Other assets to Investment securities following the completion of an initial public offering by the issuer of the securities. The investment had a fair value of $ 28 million with an associated cost of $ 3 million as of December 31, 2019. The gross unrealized gains include $ 9 million that were recognized during 2018. +96 +Table of Contents +The following table provides information about our investment securities with gross unrealized losses and the length of time that individual securities have been in an unrealized loss position as of December 31: +2019 2018 +Less than 12 months 12 months or more Less than 12 months 12 months or more +Description of Securities (Millions) +Estimated Fair +Value Gross Unrealized +Losses Estimated Fair +Value Gross Unrealized +Losses Estimated Fair +Value Gross Unrealized +Losses Estimated Fair +Value Gross Unrealized +Losses +State and municipal obligations $ 18 $ ( 1 ) $ — $ — $ — $ — $ 82 $ ( 1 ) +U.S. Government treasury obligations — — 324 ( 1 ) 224 ( 2 ) 791 ( 15 ) +Total $ 18 $ ( 1 ) $ 324 $ ( 1 ) $ 224 $ ( 2 ) $ 873 $ ( 16 ) +The following table summarizes the gross unrealized losses due to temporary impairments by ratio of fair value to amortized cost as of December 31: +Less than 12 months 12 months or more Total +Ratio of Fair Value to +Amortized Cost (Dollars in millions) +Number of +Securities Estimated +Fair Value Gross +Unrealized +Losses Number of +Securities Estimated +Fair Value Gross +Unrealized +Losses Number of +Securities Estimated +Fair Value Gross +Unrealized +Losses +2019: +90%–100% 2 $ 18 $ ( 1 ) 3 $ 324 $ ( 1 ) 5 $ 342 $ ( 2 ) +Total as of December 31, 2019 2 $ 18 $ ( 1 ) 3 $ 324 $ ( 1 ) 5 $ 342 $ ( 2 ) +2018: +90%–100% 2 $ 224 $ ( 2 ) 29 $ 873 $ ( 16 ) 31 $ 1,097 $ ( 18 ) +Total as of December 31, 2018 2 $ 224 $ ( 2 ) 29 $ 873 $ ( 16 ) 31 $ 1,097 $ ( 18 ) +The gross unrealized losses for available-for-sale debt securities are attributed to wider credit spreads for specific issuers, adverse changes in benchmark interest rates, or a combination thereof, all compared to those prevailing when the investment securities were purchased. +Overall, for the available-for-sale debt securities in gross unrealized loss positions, (i) we do not intend to sell the securities, (ii) it is more likely than not that we will not be required to sell the securities before recovery of the unrealized losses, and (iii) we expect that the contractual principal and interest will be received on the securities. As a result, we recognized no other-than-temporary impairment during the periods presented. +Weighted average yields and contractual maturities for investment securities with stated maturities as of December 31, 2019 were as follows: +(Millions) Due within 1 year Due after 1 year but within 5 years Due after 5 years but within 10 years Due after 10 years Total +State and municipal obligations (a) +$ 6 $ 39 $ 30 $ 168 $ 243 +U.S. Government agency obligations (a) +— — — 9 9 +U.S. Government treasury obligations 6,019 1,270 140 — 7,429 +Corporate debt securities 5 22 — — 27 +Mortgage-backed securities (a) +— — — 41 41 +Foreign government bonds and obligations 577 1 1 — 579 +Total Estimated Fair Value $ 6,607 $ 1,332 $ 171 $ 218 $ 8,328 +Total Cost $ 6,602 $ 1,307 $ 166 $ 209 $ 8,284 +Weighted average yields (b) +2.17 % 2.27 % 3.01 % 3.99 % 2.25 % +(a) The expected payments on state and municipal obligations, U.S. government agency obligations and mortgage-backed securities may not coincide with their contractual maturities because the issuers have the right to call or prepay certain obligations. +(b) Average yields for investment securities have been calculated using the effective yield on the date of purchase. Yields on tax-exempt investment securities have been computed on a tax-equivalent basis using the U.S. federal statutory tax rate of 21 percent. +97 +Table of Contents +NOTE 5 +ASSET SECURITIZATIONS +We periodically securitize Card Member loans and receivables arising from our card businesses through the transfer of those assets to securitization trusts, American Express Credit Account Master Trust (the Lending Trust) and American Express Issuance Trust II (the Charge Trust and together with the Lending Trust, the Trusts). The Trusts then issue debt securities collateralized by the transferred assets to third-party investors. +The Trusts are considered VIEs as they have insufficient equity at risk to finance their activities, which are to issue debt securities that are collateralized by the underlying Card Member loans and receivables. Refer to Note 1 for further details on the principles of consolidation. We perform the servicing and key decision making for the Trusts, and therefore have the power to direct the activities that most significantly impact the Trusts’ economic performance, which are the collection of the underlying Card Member loans and receivables. In addition, we hold all of the variable interests in both Trusts, with the exception of the debt securities issued to third-party investors. As of December 31, 2019 and 2018, our ownership of variable interests was $ 12.9 billion and $ 15.5 billion, respectively, for the Lending Trust and $ 8.3 billion and $ 7.0 billion, respectively, for the Charge Trust. These variable interests held by us provide us with the right to receive benefits and the obligation to absorb losses, which could be significant to both the Lending Trust and the Charge Trust. Based on these considerations, we are the primary beneficiary of the Trusts and therefore consolidate the Trusts. +The debt securities issued by the Trusts are non-recourse to us. The securitized Card Member loans and receivables held by the Lending Trust and the Charge Trust, respectively, are available only for payment of the debt securities or other obligations issued or arising in the securitization transactions (refer to Note 2). The long-term debt of each Trust is payable only out of collections on their respective underlying securitized assets (refer to Note 8). +The following table provides information on the restricted cash held by the Trusts as of December 31, 2019 and 2018, included in Other assets on the Consolidated Balance Sheets: +(Millions) 2019 2018 +Lending Trust $ 85 $ 67 +Charge Trust — 3 +Total $ 85 $ 70 +These amounts relate to collections of Card Member loans and receivables to be used by the Trusts to fund future expenses and obligations, including interest on debt securities, credit losses and upcoming debt maturities. +Under the respective terms of the Lending Trust and the Charge Trust agreements, the occurrence of certain triggering events associated with the performance of the assets of each Trust could result in payment of trust expenses, establishment of reserve funds, or, in a worst-case scenario, early amortization of debt securities. During the year ended December 31, 2019, no such triggering events occurred. +NOTE 6 +OTHER ASSETS +The following is a summary of Other assets as of December 31: +(Millions) 2019 2018 +Goodwill $ 3,315 $ 3,072 +Other intangible assets, at amortized cost 267 275 +Other (a) +11,149 10,031 +Total $ 14,731 $ 13,378 +(a) Primarily includes other receivables net of reserves, investments in non-consolidated entities, prepaid expenses, net deferred tax assets, tax credit investments, right-of-use lease assets and restricted cash. Restricted cash represents amounts available to settle obligations related to certain Card Member credit balances and customer deposits, as well as coupon and maturity obligations of consolidated VIEs. +98 +Table of Contents +GOODWILL +The changes in the carrying amount of goodwill reported in our reportable operating segments were as follows: +(Millions) GCSG GCS GMNS Total +Balance as of December 31, 2017 $ 637 $ 1,724 $ 648 $ 3,009 +Acquisitions 90 — — 90 +Dispositions — — — — +Other (a) +( 20 ) ( 6 ) ( 1 ) ( 27 ) +Balance as of December 31, 2018 $ 707 $ 1,718 $ 647 $ 3,072 +Acquisitions 189 66 — 255 +Dispositions — — — — +Other (a) +( 7 ) ( 3 ) ( 2 ) ( 12 ) +Balance as of December 31, 2019 $ 889 $ 1,781 $ 645 $ 3,315 +(a) Primarily includes foreign currency translation. +Accumulated impairment losses were $ 221 million as of both December 31, 2019 and 2018. +OTHER INTANGIBLE ASSETS +Intangible assets are amortized on a straight-line basis over their estimated useful lives of 1 to 22 years. We review long-lived assets and asset groups, including intangible assets, for impairment whenever events and circumstances indicate their carrying amounts may not be recoverable. An impairment is recognized if the carrying amount is not recoverable and exceeds the asset or asset group’s fair value. +The gross carrying amount for other intangible assets as of December 31, 2019 and 2018 was $ 704 million and $ 702 million, respectively, with accumulated amortization of $ 437 million and $ 427 million, respectively. +Amortization expense, which is recorded within Other expense in the Consolidated Statements of Income, was $ 49 million, $ 212 million and $ 207 million for the years ended December 31, 2019, 2018 and 2017, respectively. +TAX CREDIT INVESTMENTS +We account for our tax credit investments, including Qualified Affordable Housing (QAH) investments, using the equity method of accounting. As of December 31, 2019 and 2018, we had $ 1,154 million and $ 1,043 million in tax credit investments, respectively, included in Other assets on the Consolidated Balance Sheets, of which $ 1,109 million and $ 1,006 million, respectively, related to QAH investments. Included in QAH investments as of December 31, 2019 and 2018, we had $ 1,032 million and $ 936 million, respectively, related to investments in unconsolidated VIEs for which we do not have a controlling financial interest. +As of December 31, 2019, we committed to provide funding related to certain of these QAH investments, which is expected to be paid between 2020 and 2043 , resulting in $ 211 million in unfunded commitments reported in Other liabilities, of which $ 187 million specifically related to unconsolidated VIEs. +In addition, as of December 31, 2019 we had contractual off-balance sheet obligations, which were not deemed probable of being drawn, to provide additional funding up to $ 78 million for these QAH investments, fully related to unconsolidated VIEs. +During the years ended December 31, 2019 and 2018, we recognized equity method losses related to our QAH investments of $ 101 million and $ 126 million, respectively, which were recognized in Other, net expenses; and associated tax credits of $ 119 million and $ 97 million, respectively, recognized in Income tax provision. +99 +Table of Contents +NOTE 7 +CUSTOMER DEPOSITS +As of December 31, customer deposits were categorized as interest-bearing or non-interest-bearing as follows: +(Millions) 2019 2018 +U.S.: +Interest-bearing $ 72,445 $ 69,144 +Non-interest-bearing (includes Card Member credit balances of: 2019, $ 389 million; 2018, $ 376 million) +415 412 +Non-U.S.: +Interest-bearing 23 28 +Non-interest-bearing (includes Card Member credit balances of: 2019, $ 401 million; 2018, $ 367 million) +404 376 +Total customer deposits $ 73,287 $ 69,960 +Customer deposits by deposit type as of December 31 were as follows: +(Millions) 2019 2018 +U.S. retail deposits: +Savings accounts ― Direct $ 46,394 $ 39,491 +Certificates of deposit: (a) +Direct 1,854 817 +Third-party (brokered) 8,076 12,667 +Sweep accounts ―Third-party (brokered) 16,121 16,169 +Other deposits: +U.S. non-interest-bearing deposits 26 36 +Non-U.S. deposits 26 37 +Card Member credit balances ― U.S. and non-U.S. 790 743 +Total customer deposits $ 73,287 $ 69,960 +(a) The weighted average remaining maturity and weighted average interest rate at issuance on the total portfolio of U.S. retail certificates of deposit issued through direct and third-party programs were 48 months and 2.53 percent, respectively, as of December 31, 2019. +The scheduled maturities of certificates of deposit as of December 31, 2019 were as follows: +(Millions) U.S. Non-U.S. Total +2020 $ 4,618 $ 14 $ 4,632 +2021 2,302 — 2,302 +2022 2,385 — 2,385 +2023 374 — 374 +2024 251 — 251 +After 5 years — — — +Total $ 9,930 $ 14 $ 9,944 +As of December 31, certificates of deposit in denominations of $250,000 or more, in the aggregate, were as follows: +(Millions) 2019 2018 +U.S. $ 622 $ 276 +Non-U.S. 4 9 +Total $ 626 $ 285 +100 +Table of Contents +NOTE 8 +DEBT +SHORT-TERM BORROWINGS +Our short-term borrowings outstanding, defined as borrowings with original contractual maturity dates of less than one year, as of December 31 were as follows: +2019 2018 +(Millions, except percentages) Outstanding Balance +Year-End Stated +Interest Rate on +Debt (a) +Outstanding Balance +Year-End Stated +Interest Rate on +Debt (a) +Commercial paper (b) +$ 3,001 1.94 % $ 752 2.71 % +Other short-term borrowings (c) +3,441 1.28 2,348 1.94 +Total $ 6,442 1.59 % $ 3,100 2.13 % +(a) For floating-rate issuances, the stated interest rates are weighted based on the outstanding principal balances and interest rates in effect as of December 31, 2019 and 2018. +(b) Average commercial paper outstanding was $ 299 million and $ 228 million in 2019 and 2018, respectively. +(c) Primarily includes book overdrafts with banks due to timing differences arising in the ordinary course of business. +We maintained a three-year committed, revolving, secured borrowing facility that gives us the right to sell up to $ 2.0 billion face amount of eligible certificates issued from the Lending Trust at any time through September 15, 2022 . The facility was undrawn as of both December 31, 2019 and 2018. +We paid $ 7.7 million and $ 7.8 million in fees to maintain the secured borrowing facility in 2019 and 2018, respectively. The committed facility does not contain a material adverse change clause, which might otherwise preclude borrowing under the facility, nor is it dependent on our credit rating. +101 +Table of Contents +LONG-TERM DEBT +Our long-term debt outstanding, defined as debt with original contractual maturity dates of one year or greater, as of December 31 was as follows: +2019 2018 +(Millions, except percentages) Original +Contractual +Maturity +Dates +Outstanding +Balance (a) +Year-End +Interest Rate +on Debt (b) +Year-End +Interest Rate with +Swaps (b)(c) +Outstanding +Balance (a) +Year-End +Interest Rate +on Debt (b) +Year-End +Interest Rate +with +Swaps (b)(c) +American Express Company +(Parent Company only) +Fixed Rate Senior Notes 2020 - 2042 $ 19,326 3.17 % 2.86 % $ 14,043 3.48 % 3.64 % +Floating Rate Senior Notes 2020 - 2023 4,500 3.16 — 3,600 3.17 — +Fixed Rate Subordinated Notes 2024 598 3.63 2.99 598 3.63 3.66 +American Express Credit Corporation +Fixed Rate Senior Notes 2020 - 2027 11,839 2.40 2.56 16,677 2.28 3.06 +Floating Rate Senior Notes 2020 - 2022 1,650 3.36 — 3,800 3.31 — +American Express Lending Trust +Fixed Rate Senior Notes 2020 - 2023 15,074 2.42 2.43 12,474 2.28 — +Floating Rate Senior Notes 2021 - 2023 4,125 2.74 — 5,125 2.80 — +Fixed Rate Subordinated Notes 2020 - 2022 420 2.53 — 240 2.37 — +Floating Rate Subordinated Notes 2022 - 2023 79 2.45 — 167 2.96 — +American Express Charge Trust II +Floating Rate Conduit Borrowings — — — 1,535 2.89 — +Other +Finance Leases 2024 - 2033 25 5.65 — 19 5.54 — +Floating Rate Borrowings 2020 - 2022 311 0.40 — % 262 0.42 — % +Unamortized Underwriting Fees ( 112 ) ( 117 ) +Total Long-Term Debt $ 57,835 2.78 % $ 58,423 2.77 % +(a) The outstanding balances include (i) unamortized discount, (ii) the impact of movements in exchange rates on foreign currency denominated debt and (iii) the impact of fair value hedge accounting on certain fixed-rate notes that have been swapped to floating rate through the use of interest rate swaps. Refer to Note 13 for more details on our treatment of fair value hedges. +(b) For floating-rate issuances, the stated interest rate on debt is weighted based on the outstanding principal balances and interest rates in effect as of December 31, 2019 and 2018. +(c) Interest rates with swaps are only presented when swaps are in place to hedge the underlying debt. The interest rates with swaps are weighted based on the outstanding principal balances and the interest rates on the floating leg of the swaps in effect as of December 31, 2019 and 2018. +Aggregate annual maturities on long-term debt obligations (based on contractual maturity or anticipated redemption dates) as of December 31, 2019 were as follows: +(Millions) 2020 2021 2022 2023 2024 Thereafter Total +American Express Company (Parent Company only) $ 2,000 $ 5,000 $ 5,675 $ 4,350 $ 5,000 $ 2,872 $ 24,897 +American Express Credit Corporation 6,600 2,864 2,050 — — 2,000 13,514 +American Express Lending Trust 6,924 3,709 6,381 2,685 — — 19,699 +Other 91 137 82 — 15 11 336 +$ 15,615 $ 11,710 $ 14,188 $ 7,035 $ 5,015 $ 4,883 $ 58,446 +Unamortized Underwriting Fees ( 112 ) +Unamortized Discount and Premium ( 716 ) +Impacts due to Fair Value Hedge Accounting 217 +Total Long-Term Debt $ 57,835 +102 +Table of Contents +We maintained a bank line of credit of $ 3.5 billion as of December 31, 2019 and 2018, all of which was undrawn as of the respective dates. The availability of the credit line is subject to our compliance with certain financial covenants, principally the maintenance by American Express Credit Corporation (Credco) of a 1.25 ratio of combined earnings and fixed charges, to fixed charges. As of December 31, 2019 and 2018, we were not in violation of any of our debt covenants. +Additionally, we maintained a three-year committed, revolving, secured borrowing facility that gives us the right to sell up to $ 3.0 billion face amount of eligible notes issued from the Charge Trust at any time through July 15, 2022 . As of December 31, 2019 and 2018, nil and $ 1.5 billion, respectively, were drawn on this facility. +We paid $ 16.5 million and $ 14.2 million in fees to maintain these lines in 2019 and 2018, respectively. These committed facilities do not contain material adverse change clauses, which might otherwise preclude borrowing under the credit facilities, nor are they dependent on our credit rating. +We paid total interest, primarily related to short- and long-term debt, corresponding interest rate swaps and customer deposits, of $ 3.4 billion, $ 2.7 billion and $ 2.0 billion in 2019, 2018 and 2017, respectively. +NOTE 9 +OTHER LIABILITIES +The following is a summary of Other liabilities as of December 31: +(Millions) +2019 2018 +Membership Rewards liability +$ 8,892 $ 8,414 +Employee-related liabilities (a) +2,429 2,164 +Card Member rebate and reward accruals (b) +1,790 1,596 +Income tax liability (c) +1,122 1,079 +Other (d) +10,715 9,321 +Total +$ 24,948 $ 22,574 +(a) Employee-related liabilities include employee benefit plan obligations and incentive compensation. +(b) Card Member rebate and reward accruals include payments to third-party reward partners and cash-back rewards. +(c) Includes repatriation tax liability of $ 1,012 million and $ 1,689 million as of December 31, 2019 and 2018, respectively, which represents our remaining obligation under the Tax Cuts and Jobs Act enacted on December 22, 2017 (Tax Act) to pay a one-time transition tax on unrepatriated earnings and profits of certain foreign subsidiaries. +(d) Primarily includes Travelers Cheques and other prepaid products, net deferred card and other fees, book overdraft balances, lease liabilities, client incentives, restructuring and reengineering reserves, dividends payable, and derivative and hedge liabilities. +MEMBERSHIP REWARDS +The Membership Rewards program allows enrolled Card Members to earn points that can be redeemed for a broad range of rewards including travel, shopping, gift cards, and covering eligible charges. We record a balance sheet liability that represents management’s best estimate of the cost of points earned that are expected to be redeemed in the future. The weighted average cost (WAC) per point and the Ultimate Redemption Rate (URR) are key assumptions used to estimate the Membership Rewards liability. We use statistical and actuarial models to estimate the URR based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. +The expense for Membership Rewards points is included in Card Member rewards expense. We periodically evaluate our liability estimation process and assumptions based on developments in redemption patterns, cost per point redeemed, partner contract changes and other factors. +DEFERRED CARD AND OTHER FEES, NET +The carrying amount of deferred card and other fees, net of deferred direct acquisition costs and reserves for membership cancellations as of December 31, was as follows: +(Millions) 2019 2018 +Deferred card and other fees (a) +$ 2,532 $ 2,208 +Deferred direct acquisition costs ( 270 ) ( 282 ) +Reserves for membership cancellations ( 200 ) ( 167 ) +Deferred card and other fees, net $ 2,062 $ 1,759 +(a) Includes deferred fees for Membership Rewards program participants. +103 +Table of Contents +NOTE 10 +STOCK PLANS +STOCK OPTION AND AWARD PROGRAMS +Under our 2016 Incentive Compensation Plan and previously under our 2007 Incentive Compensation Plan (collectively, Incentive Compensation Plans), awards may be granted to employees and other key individuals who perform services for us and our participating subsidiaries. These awards may be in the form of stock options, restricted stock units or awards (collectively referred to as RSUs), portfolio grants (PGs) or other incentives or similar awards designed to meet the requirements of non-U.S. jurisdictions. +For our Incentive Compensation Plans, there were a total of 9 million, 12 million and 14 million common shares unissued and available for grant as of December 31, 2019, 2018, and 2017, respectively, as authorized by our Board of Directors and shareholders. We generally issue new common shares upon exercise of options and vesting of RSUs. +Stock-based compensation expense recognized in Salaries and employee benefits in the Consolidated Statements of Income was $ 280 million, $ 288 million and $ 283 million in 2019, 2018, and 2017, respectively, with corresponding income tax benefits of $ 67 million, $ 69 million, and $ 102 million in those respective periods. +A summary of stock option and RSU activity as of December 31, 2019, and corresponding changes during the year, are as follows: +Stock Options Service-Based RSUs Service and Performance-Based RSUs +(Shares in thousands) Shares Weighted-Average +Exercise Price Shares Weighted- +Average Grant +Price Shares Weighted- +Average Grant +Price +Outstanding as of December 31, 2018 5,484 $ 64.73 2,544 $ 80.15 4,022 $ 74.22 +Granted 408 101.43 1,041 103.93 1,358 90.34 +Exercised/vested ( 1,626 ) 51.92 ( 1,001 ) 76.07 ( 1,819 ) 58.28 +Forfeited ( 94 ) 92.19 ( 172 ) 89.79 ( 169 ) 93.74 +Expired — — — — — — +Outstanding as of December 31, 2019 4,172 72.70 2,412 $ 91.42 3,392 $ 88.25 +Options vested and expected to vest as of December 31, 2019 4,171 72.70 +Options exercisable as of December 31, 2019 2,357 $ 61.15 +The cost of employee stock awards granted in exchange for employee services is generally recognized ratably based on the grant-date fair value of the award, net of expected forfeitures, over the vesting period. The vesting period is the shorter of the vesting schedule as defined in each award agreement or the date an individual will become eligible to retire. Retirement eligibility is dependent upon age and/or years of service. +STOCK OPTIONS +Each stock option has an exercise price equal to the market price of our common stock on the date of grant. Stock options generally vest on the third anniversary of the grant date and have a contractual term of 10 years from the date of grant. +The weighted-average remaining contractual life and the aggregate intrinsic value (the amount by which the fair value of our stock price exceeds the exercise price of the option) of the stock options outstanding, exercisable, and vested and expected to vest as of December 31, 2019, were as follows: +Outstanding Exercisable Vested and +Expected to Vest +Weighted-average remaining contractual life (in years) +5.3 4.0 5.3 +Aggregate intrinsic value (millions) +$ 216 $ 149 $ 216 +104 +Table of Contents +As of December 31, 2019, there was $ 7 million of total unrecognized compensation cost related to unvested options, which will be recognized ratably over the weighted-average remaining vesting period of 1.2 years. +The fair value of each option is estimated on the date of grant using a Black-Scholes-Merton option-pricing model. The following weighted-average assumptions were used for options granted in 2019, 2018 and 2017: +2019 2018 2017 +Dividend yield 1.5 % 1.4 % 1.8 % +Expected volatility (a) +24 % 22 % 24 % +Risk-free interest rate 2.6 % 2.7 % 2.3 % +Expected life of stock option ( in years ) (b) +7.1 7.1 6.9 +Weighted-average fair value per option $ 23.38 $ 23.17 $ 18.18 +(a) The expected volatility is based on both weighted historical and implied volatilities of our common stock price. +(b) The expected life of stock options was determined using both historical data and expectations of option exercise behavior. +On October 31, 2017, certain senior executives were granted stock options with a term of seven years , and include a three -year service condition, as well as performance and market conditions. Therefore, the fair values of these options were estimated at the grant date using a Monte Carlo valuation model with the following assumptions: +October 31, 2017 +Dividend yield 1.58 % +Expected volatility (a) +21.41 % +Risk-free interest rate 2.26 % +Expected life of stock option ( in years ) +7 +Fair value per option $ 19.18 +(a) The expected volatility is based on both weighted historical and implied volatilities of our common stock price. +For stock options that were exercised during 2019, 2018 and 2017, the intrinsic value, based upon the fair value of our stock price at the date the options were exercised, was $ 104 million, $ 104 million and $ 197 million, respectively; cash received from the exercise of stock options was $ 84 million, $ 87 million and $ 130 million during those respective periods. The income tax benefit recognized in the Consolidated Statements of Income related to stock option exercises was $ 18 million, $ 18 million and $ 59 million in 2019, 2018 and 2017, respectively. +RESTRICTED STOCK UNITS/AWARDS +We grant RSUs that contain either a) service conditions or b) both service and performance conditions. RSUs containing only service conditions generally vest 25 percent per year beginning with the first anniversary of the grant date. RSUs containing both service and performance conditions generally vest on the third anniversary of the grant date, and the number of shares earned depends on the achievement of predetermined Company metrics. All RSU holders receive non-forfeitable dividends or dividend equivalents. +We added a relative total shareholder return (r-TSR) modifier to the performance-based RSUs that were granted in 2019, so that our actual shareholder return relative to a competitive peer group is one of the performance conditions that determines the number of shares ultimately granted upon vesting. +The fair value of RSUs that do not include the r-TSR modifier, including those that contain only service conditions, is measured using our stock price on the grant date. The fair value of service and performance-based RSUs that include the r-TSR modifier is determined using a Monte Carlo valuation model with the following weighted-average assumptions: +2019 +Expected volatility (a) +20 % +Risk-free interest rate 2.5 % +Remaining performance period (in years) +2.9 +(a) The expected volatility is based on historical volatility of our common stock price. +105 +Table of Contents +As of December 31, 2019, there was $ 195 million of total unrecognized compensation cost related to non-vested RSUs, which will be recognized ratably over the weighted-average remaining vesting period of 2.1 years. +The weighted-average grant date fair value of RSUs granted in 2019, 2018 and 2017 was $ 96.24 , $ 98.20 and $ 77.80 , respectively. +For RSUs vested during 2019, 2018 and 2017, the total fair value, based upon our stock price at the date the RSUs vested, was $ 286 million, $ 239 million and $ 180 million, respectively. +LIABILITY-BASED AWARDS +In 2018 and 2017, certain employees were awarded PGs and other incentive awards that can be settled with cash or equity shares at our discretion, and final Compensation and Benefits Committee payout approval; beginning in 2019, we discontinued granting PGs. These awards earn value based on performance, market and/or service conditions, and vest over periods of one to three years. +PGs and other incentive awards are generally settled with cash and thus are classified as liabilities; therefore, the fair value is determined at the date of grant and remeasured quarterly as part of compensation expense over the vesting period. Cash paid upon vesting of these awards in 2019, 2018 and 2017 was $ 81 million, $ 56 million and $ 48 million, respectively. +NOTE 11 +RETIREMENT PLANS +DEFINED CONTRIBUTION RETIREMENT PLANS +We sponsor defined contribution retirement plans, the principal plan being the Retirement Savings Plan (RSP), a 401(k) savings plan with a profit-sharing component. The RSP is a tax-qualified retirement plan subject to the Employee Retirement Income Security Act of 1974 and covers most employees in the United States. The total expense for all defined contribution retirement plans globally was $ 278 million, $ 272 million and $ 349 million in 2019, 2018 and 2017, respectively. +DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS +Our primary defined benefit pension plans that cover certain employees in the United States and United Kingdom are closed to new entrants and existing participants do not accrue any additional benefits. Most employees outside the United States and United Kingdom are covered by local retirement plans, some of which are funded, while other employees receive payments at the time of retirement or termination under applicable labor laws or agreements. We comply with minimum funding requirements in all countries. We also sponsor unfunded other postretirement benefit plans that provide health care and life insurance to certain retired U.S. employees. For these plans, the total net benefit was $ 8 million and $ 0.4 million in 2019 and 2018, respectively, and the total net expense was $ 25 million in 2017. +We recognize the funded status of our defined benefit pension plans and other postretirement benefit plans, measured as the difference between the fair value of the plan assets and the projected benefit obligation, on the Consolidated Balance Sheets. As of December 31, 2019 and 2018, the unfunded status related to the defined benefit pension plans and other postretirement benefit plans was $ 640 million and $ 563 million, respectively, and is recorded in Other liabilities. +106 +Table of Contents +NOTE 12 +CONTINGENCIES AND COMMITMENTS +CONTINGENCIES +In the ordinary course of business, we and our subsidiaries are subject to various pending and potential legal actions, arbitration proceedings, claims, investigations, examinations, information gathering requests, subpoenas, inquiries and matters relating to compliance with laws and regulations (collectively, legal proceedings). +Based on our current knowledge, and taking into consideration our litigation-related liabilities, we do not believe we are a party to, nor are any of our properties the subject of, any legal proceeding that would have a material adverse effect on our consolidated financial condition or liquidity. However, in light of the uncertainties involved in such matters, including the fact that some pending legal proceedings are at preliminary stages or seek an indeterminate amount of damages, it is possible that the outcome of legal proceedings could have a material impact on our results of operations. Certain legal proceedings involving us or our subsidiaries are described below. +A putative merchant class action in the Eastern District of New York, consolidated in 2011 and collectively captioned In re: American Express Anti-Steering Rules Antitrust Litigation (II) , alleged that provisions in our merchant agreements prohibiting merchants from differentially surcharging our cards or steering a customer to use another network’s card or another type of general-purpose card (“anti-steering” and “non-discrimination” contractual provisions) violate U.S. antitrust laws. On January 15, 2020, our motion to compel arbitration of claims brought by merchants who accept American Express and to dismiss claims of merchants who do not was granted. +In July 2004, we were named as a defendant in another putative class action filed in the Southern District of New York and subsequently transferred to the Eastern District of New York, captioned The Marcus Corporation v. American Express Co., et al. , in which the plaintiffs allege an unlawful antitrust tying arrangement between certain of our charge cards and credit cards in violation of various state and federal laws. The plaintiffs in this action seek injunctive relief and an unspecified amount of damages. +On March 8, 2016, plaintiffs B&R Supermarket, Inc. d/b/a Milam’s Market and Grove Liquors LLC, on behalf of themselves and others, filed a suit, captioned B&R Supermarket, Inc. d/b/a Milam’s Market, et al. v. Visa Inc., et al. , for violations of the Sherman Antitrust Act, the Clayton Antitrust Act, California’s Cartwright Act and unjust enrichment in the United States District Court for the Northern District of California, against American Express Company, other credit and charge card networks, other issuing banks and EMVCo, LLC. Plaintiffs allege that the defendants, through EMVCo, conspired to shift liability for fraudulent, faulty and otherwise rejected consumer credit card transactions from themselves to merchants after the implementation of EMV chip payment terminals. Plaintiffs seek damages and injunctive relief. An amended complaint was filed on July 15, 2016. On September 30, 2016, the court denied our motion to dismiss as to claims brought by merchants who do not accept American Express cards, and on May 4, 2017, the California court transferred the case to the United States District Court for the Eastern District of New York. +We are being challenged in a number of countries regarding our application of value-added taxes (VAT) to certain of our international transactions, which are in various stages of audit, or are being contested in legal actions. While we believe we have complied with all applicable tax laws, rules and regulations in the relevant jurisdictions, the tax authorities may determine that we owe additional VAT. In certain jurisdictions where we are contesting the assessments, we were required to pay the VAT assessments prior to contesting. +Our legal proceedings range from cases brought by a single plaintiff to class actions with millions of putative class members to governmental proceedings. These legal proceedings involve various lines of business and a variety of claims (including, but not limited to, common law tort, contract, application of tax laws, antitrust and consumer protection claims), some of which present novel factual allegations and/or unique legal theories. While some matters pending against us specify the damages sought, many seek an unspecified amount of damages or are at very early stages of the legal process. Even when the amount of damages claimed against us are stated, the claimed amount may be exaggerated and/or unsupported. As a result, some matters have not yet progressed sufficiently through discovery and/or development of important factual information and legal issues to enable us to estimate an amount of loss or a range of possible loss, while other matters have progressed sufficiently such that we are able to estimate an amount of loss or a range of possible loss. +We have accrued for certain of our outstanding legal proceedings. An accrual is recorded when it is both (a) probable that a loss has occurred and (b) the amount of loss can be reasonably estimated. There may be instances in which an exposure to loss exceeds the accrual. We evaluate, on a quarterly basis, developments in legal proceedings that could cause an increase or decrease in the amount of the accrual that has been previously recorded, or a revision to the disclosed estimated range of possible losses, as applicable. +107 +Table of Contents +For those disclosed material legal proceedings where a loss is reasonably possible in future periods, whether in excess of a recorded accrual for legal or tax contingencies, or where there is no such accrual, and for which we are able to estimate a range of possible loss, the current estimated range is zero to $ 190 million in excess of any accruals related to those matters. This range represents management’s estimate based on currently available information and does not represent our maximum loss exposure; actual results may vary significantly. As such legal proceedings evolve, we may need to increase our range of possible loss or recorded accruals. In addition, it is possible that significantly increased merchant steering or other actions impairing the Card Member experience as a result of an adverse resolution in one or any combination of the disclosed merchant cases could have a material adverse effect on our business. +COMMITMENTS +Total lease expense includes rent expenses, adjustments for rent concessions, rent escalations and leasehold improvement allowances and is recognized on a straight-line basis over the lease term. Total lease expense for the years ended December 31, 2019, 2018 and 2017 was $ 151 million, $ 142 million and $ 151 million, respectively. +Effective January 1, 2019, we adopted the new accounting guidance on leases (refer to Note 1 for additional details). L ease liabilities are recognized at the present value of the contractual fixed lease payments, discounted using our incremental borrowing rate as of the lease commencement date or upon modification of the lease. For lease liabilities outstanding as of December 31, 2019, the weighted average remaining lease term was 22 years and the weighted average rate used to discount lease commitments was 4 percent. +The following represents the maturities of our outstanding lease commitments as of December 31, 2019: +(Millions) +2020 $ 134 +2021 114 +2022 100 +2023 89 +2024 77 +Thereafter 842 +Total Outstanding Fixed Lease Payments $ 1,356 +Less: Amount representing interest $ ( 573 ) +Lease Liabilities $ 783 +As of December 31, 2019, we had $ 5 billion in commitments outstanding related to agreements with certain cobrand arrangements under which we make payments based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of cobrand accounts acquired and retained. As of December 31, 2019, we also had certain cobrand arrangements that include commitments based on variables, the values of which are not yet determinable and thus the amount is not quantifiable. +108 +Table of Contents +NOTE 13 +DERIVATIVES AND HEDGING ACTIVITIES +We use derivative financial instruments to manage exposures to various market risks. These instruments derive their value from an underlying variable or multiple variables, including interest rates, foreign exchange rates, and an equity index or price, and are carried at fair value on the Consolidated Balance Sheets. These instruments enable end users to increase, reduce or alter exposure to various market risks and, for that reason, are an integral component of our market risk management. We do not transact in derivatives for trading purposes. +Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. Our market risk exposures include: +• Interest rate risk due to changes in the relationship between interest rates on our assets (such as loans, receivables and investment securities) and interest rates on our liabilities (such as debt and deposits); and +• Foreign exchange risk related to earnings, funding, transactions and investments in currencies other than the U.S. dollar. +We centrally monitor market risks using market risk limits and escalation triggers as defined in our Asset/Liability Management Policy. Our market exposures are in large part by-products of the delivery of our products and services. +Interest rate risk primarily arises through the funding of Card Member receivables and fixed-rate loans with variable-rate borrowings, as well as through the risk to net interest margin from changes in the relationship between benchmark rates such as Prime, LIBOR and the overnight indexed swap rate. Interest rate exposure within our charge card and fixed-rate lending products is managed by varying the proportion of total funding provided by short-term and variable-rate debt and deposits compared to fixed-rate debt and deposits. In addition, interest rate swaps are used from time to time to economically convert fixed-rate debt obligations to variable-rate obligations, or to convert variable-rate debt obligations to fixed-rate obligations. We may change the mix between variable-rate and fixed-rate funding based on changes in business volumes and mix, among other factors. +Foreign exchange risk is generated by Card Member cross-currency spend, foreign currency balance sheet exposures, foreign subsidiary equity and foreign currency earnings in entities outside the United States. Our foreign exchange risk is managed primarily by entering into agreements to buy and sell currencies on a spot basis or by hedging this market exposure, to the extent it is economical, through various means, including the use of derivatives such as foreign exchange forwards and cross-currency swap contracts. +Derivatives may give rise to counterparty credit risk, which is the risk that a derivative counterparty will default on, or otherwise be unable to perform pursuant to, an uncollateralized derivative exposure. We manage this risk by considering the current exposure, which is the replacement cost of contracts on the measurement date, as well as estimating the maximum potential value of the contracts over the next 12 months, considering such factors as the volatility of the underlying or reference index. To mitigate derivative credit risk, counterparties are required to be pre-approved by us and rated as investment grade, and counterparty risk exposures are centrally monitored. +Additionally, in order to mitigate the bilateral counterparty credit risk associated with derivatives, we have in certain instances entered into master netting agreements with our derivative counterparties, which provide a right of offset for certain exposures between the parties. A majority of our derivative assets and liabilities as of December 31, 2019 and 2018 are subject to such master netting agreements with our derivative counterparties, and there are no instances in which management makes an accounting policy election to not net assets and liabilities subject to an enforceable master netting agreement on the Consolidated Balance Sheets. To further mitigate counterparty credit risk, we exercise our rights under executed credit support agreements with the respective derivative counterparties for most of our bilateral interest rate swaps and select foreign exchange contracts. These agreements require that, in the event the fair value change in the net derivatives position between the two parties exceeds certain dollar thresholds, the party in the net liability position posts collateral to its counterparty. All derivative contracts cleared through a central clearinghouse are collateralized to the full amount of the fair value of the contracts. +In relation to our credit risk, certain of our bilateral derivative agreements include provisions that allow our counterparties to terminate the agreement in the event of a downgrade of our debt credit rating below investment grade and settle the outstanding net liability position. As of December 31, 2019, these derivatives were not in a significant net liability position. We have no individually significant derivative counterparties and therefore, no significant risk exposure to any single derivative counterparty. Based on our assessment of the credit risk of our derivative counterparties and our own credit risk as of December 31, 2019 and 2018, no credit risk adjustment to the derivative portfolio was required. +109 +Table of Contents +Our derivatives are carried at fair value on the Consolidated Balance Sheets. The accounting for changes in fair value depends on the instruments’ intended use and the resulting hedge designation, if any, as discussed below. Refer to Note 14 for a description of our methodology for determining the fair value of derivatives. +The following table summarizes the total fair value, excluding interest accruals, of derivative assets and liabilities as of December 31: +Other Assets Fair Value Other Liabilities Fair Value +(Millions) 2019 2018 2019 2018 +Derivatives designated as hedging instruments: +Fair value hedges - Interest rate contracts (a) +$ 185 $ 34 $ — $ 74 +Net investment hedges - Foreign exchange contracts 24 222 186 61 +Total derivatives designated as hedging instruments 209 256 186 135 +Derivatives not designated as hedging instruments: +Foreign exchange contracts, including certain embedded derivatives +134 258 254 79 +Total derivatives, gross 343 514 440 214 +Derivative asset and derivative liability netting (b) +( 90 ) ( 90 ) ( 90 ) ( 90 ) +Cash collateral netting (c) (d) +( 185 ) ( 28 ) ( 9 ) ( 78 ) +Total derivatives, net $ 68 $ 396 $ 341 $ 46 +(a) For our centrally cleared derivatives, variation margin payments are legally characterized as settlement payments as opposed to collateral. +(b) Represents the amount of netting of derivative assets and derivative liabilities executed with the same counterparty under an enforceable master netting arrangement. +(c) Represents the offsetting of the fair value of bilateral interest rate contracts and certain foreign exchange contracts with the right to cash collateral held from the counterparty or cash collateral posted with the counterparty. +(d) We posted $ 47 million and $ 84 million as of December 31, 2019 and 2018, respectively, as initial margin on our centrally cleared interest rate swaps; such amounts are recorded within Other assets on the Consolidated Balance Sheets and are not netted against the derivative balances. +DERIVATIVE FINANCIAL INSTRUMENTS THAT QUALIFY FOR HEDGE ACCOUNTING +Derivatives executed for hedge accounting purposes are documented and designated as such when we enter into the contracts. In accordance with our risk management policies, we structure our hedges with terms similar to those of the item being hedged. We formally assess, at inception of the hedge accounting relationship and on a quarterly basis, whether derivatives designated as hedges are highly effective in offsetting the fair value or cash flows of the hedged items. These assessments usually are made through the application of a regression analysis method. If it is determined that a derivative is not highly effective as a hedge, we will discontinue the application of hedge accounting. +FAIR VALUE HEDGES +A fair value hedge involves a derivative designated to hedge our exposure to future changes in the fair value of an asset or a liability, or an identified portion thereof, that is attributable to a particular risk. +Interest Rate Contracts +We are exposed to interest rate risk associated with our fixed-rate debt obligations. At the time of issuance, certain fixed-rate long-term debt obligations are designated in fair value hedging relationships, using interest rate swaps, to economically convert the fixed interest rate to a floating interest rate. We have $ 22.6 billion and $ 24.0 billion of fixed-rate debt obligations designated in fair value hedging relationships as of December 31, 2019 and 2018, respectively. +Gains or losses on the fair value hedging instrument principally offset the losses or gains on the hedged item attributable to the hedged risk. The changes in the fair value of the derivative and the changes in the hedged item may not fully offset due to differences between a debt obligation’s interest rate and the benchmark rate, primarily due to credit spreads at inception of the hedging relationship that are not reflected in the fair value of the interest rate swap. Furthermore, the difference may be caused by changes in 1-month LIBOR, 3-month LIBOR and the overnight indexed swap rate, as spreads between these rates impact the fair value of the interest rate swap without an exact offsetting impact to the fair value of the hedged debt. +110 +Table of Contents +The following table presents the gains and losses associated with the fair value hedges of our fixed-rate long-term debt for the years ended December 31: +Gains (losses) +(Millions) 2019 2018 2017 +Interest expense (a) +Interest expense (a) +Other, net expenses +Fixed-rate long-term debt $ ( 458 ) $ 59 $ 206 +Derivatives designated as hedging instruments 462 ( 43 ) ( 246 ) +Total $ 4 $ 16 $ ( 40 ) +(a) We adopted a new accounting guidance providing targeted improvements to the accounting for hedging activities effective January 1, 2018. In compliance with the standard, amounts previously recorded in Other expenses have been prospectively recorded in Total interest expense. +The carrying values of the hedged liabilities, recorded within Long-term debt on the Consolidated Balance Sheets, were $ 22.7 billion and $ 23.7 billion as of December 31, 2019 and 2018, respectively, including the cumulative amount of fair value hedging adjustments of $ 217 million and $( 241 ) million for the respective periods. +We recognized net increases of $ 102 million and $ 51 million in Interest expense on Long-term debt for the years ended December 31, 2019 and 2018, respectively, and a net reduction of $ 133 million for the year ended December 31, 2017, primarily related to the net settlements (interest accruals) on our interest rate derivatives designated as fair value hedges. +NET INVESTMENT HEDGES +A net investment hedge is used to hedge future changes in currency exposure of a net investment in a foreign operation. We primarily designate foreign currency derivatives, typically foreign exchange forwards, and on occasion foreign currency denominated debt, as hedges of net investments in certain foreign operations. These instruments reduce exposure to changes in currency exchange rates on our investments in non-U.S. subsidiaries. We had notional amounts of approximately $ 9.8 billion and $ 9.6 billion of foreign currency derivatives designated as net investment hedges as of December 31, 2019 and 2018, respectively. The gain or loss on net investment hedges, net of taxes, recorded in AOCI as part of the cumulative translation adjustment, were a loss of $ 140 million, a gain of $ 328 million and a loss of $ 370 million for the years ended December 31, 2019, 2018 and 2017, respectively. +DERIVATIVES NOT DESIGNATED AS HEDGES +We have derivatives that act as economic hedges, but are not designated as such for hedge accounting purposes. Foreign currency transactions from time to time may be partially or fully economically hedged through foreign currency contracts, primarily foreign exchange forwards. These hedges generally mature within one year. Foreign currency contracts involve the purchase and sale of designated currencies at an agreed upon rate for settlement on a specified date. +We also have certain operating agreements containing payments that may be linked to a market rate or price, primarily foreign currency rates. The payment components of these agreements may meet the definition of an embedded derivative, in which case the embedded derivative is accounted for separately and is classified as a foreign exchange contract based on its primary risk exposure. +The changes in the fair value of derivatives that are not designated as hedges are intended to offset the related foreign exchange gains or losses of the underlying foreign currency exposures. The changes in the fair value of the derivatives and the related underlying foreign currency exposures resulted in a net gain of $ 64 million, a net gain of $ 60 million, and a net loss of $ 29 million for the years ended December 31, 2019, 2018, and 2017, respectively, that are recognized in Other, net expenses in the Consolidated Statements of Income. Included in the net gain of $ 64 million for the year ended December 31, 2019, is a gain of $ 3 million, specifically related to a change in the fair value of an embedded derivative. The changes in the fair value of embedded derivatives for the years ended December 31, 2018 and 2017 resulted in losses of $ 11 million and nil, respectively, that are recognized in Card Member services expense in the Consolidated Statements of Income. +111 +Table of Contents +NOTE 14 +FAIR VALUES +Fair value is defined as the price that would be required to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, based on the principal or, in the absence of a principal, most advantageous market for the specific asset or liability. +GAAP provides for a three-level hierarchy of inputs to valuation techniques used to measure fair value, defined as follows: +• Level 1 ― Inputs that are quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity can access. +• Level 2 ― Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability, including: +– Quoted prices for similar assets or liabilities in active markets; +– Quoted prices for identical or similar assets or liabilities in markets that are not active; +– Inputs other than quoted prices that are observable for the asset or liability; and +– Inputs that are derived principally from or corroborated by observable market data by correlation or other means. +• Level 3 ― Inputs that are unobservable and reflect our own estimates about the estimates market participants would use in pricing the asset or liability based on the best information available in the circumstances (e.g., internally derived assumptions surrounding the timing and amount of expected cash flows). We did not measure any financial instruments presented on the Consolidated Balance Sheets at fair value on a recurring basis using significant unobservable inputs (Level 3) during the years ended December 31, 2019 and 2018, although the disclosed fair value of certain assets that are not carried at fair value, as presented later in this Note, are classified within Level 3. +We monitor the market conditions and evaluate the fair value hierarchy levels at least quarterly. For the years ended December 31, 2019 and 2018, there were no Level 3 transfers. +FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT FAIR VALUE +The following table summarizes our financial assets and financial liabilities measured at fair value on a recurring basis, categorized by GAAP’s fair value hierarchy (as described in the preceding paragraphs), as of December 31: +2019 2018 +(Millions) Total Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 +Assets: +Investment securities: (a) +Equity securities $ 78 $ 77 $ 1 $ — $ 48 $ 1 $ 47 $ — +Debt securities 8,328 — 8,328 — 4,599 — 4,599 — +Derivatives, gross (a) +343 — 343 — 514 — 514 — +Total Assets 8,749 77 8,672 — 5,161 1 5,160 — +Liabilities: +Derivatives, gross (a) +440 — 440 — 214 — 214 — +Total Liabilities $ 440 $ — $ 440 $ — $ 214 $ — $ 214 $ — +(a) Refer to Note 4 for the fair values of investment securities and to Note 13 for the fair values of derivative assets and liabilities, on a further disaggregated basis. +112 +Table of Contents +VALUATION TECHNIQUES USED IN THE FAIR VALUE MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT FAIR VALUE +For the financial assets and liabilities measured at fair value on a recurring basis (categorized in the valuation hierarchy table above), we apply the following valuation techniques: +Investment Securities +When available, quoted prices of identical investment securities in active markets are used to estimate fair value. Such investment securities are classified within Level 1 of the fair value hierarchy. +When quoted prices of identical investment securities in active markets are not available, the fair values for our investment securities are obtained primarily from pricing services engaged by us, and we receive one price for each security. The fair values provided by the pricing services are estimated using pricing models, where the inputs to those models are based on observable market inputs or recent trades of similar securities. Such investment securities are classified within Level 2 of the fair value hierarchy. The inputs to the valuation techniques applied by the pricing services vary depending on the type of security being priced but are typically benchmark yields, benchmark security prices, credit spreads, prepayment speeds, reported trades and broker-dealer quotes, all with reasonable levels of transparency. The pricing services did not apply any adjustments to the pricing models used. In addition, we did not apply any adjustments to prices received from the pricing services. +We reaffirm our understanding of the valuation techniques used by our pricing services at least annually. In addition, we corroborate the prices provided by our pricing services by comparing them to alternative pricing sources. In instances where price discrepancies are identified between different pricing sources, we evaluate such discrepancies to ensure that the prices used for our valuation represent the fair value of the underlying investment securities. Refer to Note 4 for additional fair value information. +Derivative Financial Instruments +The fair value of our derivative financial instruments is estimated internally by using third-party pricing models, where the inputs to those models are readily observable from active markets. The pricing models used are consistently applied and reflect the contractual terms of the derivatives as described below. We reaffirm our understanding of the valuation techniques at least annually and validate the valuation output on a quarterly basis. Our derivative instruments are classified within Level 2 of the fair value hierarchy. +The fair value of our interest rate swaps is determined based on a discounted cash flow method using the following significant inputs: the contractual terms of the swap such as the notional amount, fixed coupon rate, floating coupon rate and tenor, as well as discount rates consistent with the underlying economic factors of the currency in which the cash flows are denominated. +The fair value of foreign exchange forward contracts is determined based on a discounted cash flow method using the following significant inputs: the contractual terms of the forward contracts such as the notional amount, maturity dates and contract rate, as well as relevant foreign currency forward curves, and discount rates consistent with the underlying economic factors of the currency in which the cash flows are denominated. +Credit valuation adjustments are necessary when the market parameters, such as a benchmark curve, used to value derivatives are not indicative of our credit quality or that of our counterparties. We consider the counterparty credit risk by applying an observable forecasted default rate to the current exposure. Refer to Note 13 for additional fair value information. +113 +Table of Contents +FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT OTHER THAN FAIR VALUE +The following table summarizes the estimated fair values of our financial assets and financial liabilities that are measured at amortized cost, and not required to be carried at fair value on a recurring basis, as of December 31, 2019 and 2018. The fair values of these financial instruments are estimates based upon the market conditions and perceived risks as of December 31, 2019 and 2018, and require management’s judgment. These figures may not be indicative of future fair values, nor can the fair value of American Express be estimated by aggregating the amounts presented. +2019 (Billions) +Carrying +Value Corresponding Fair Value Amount +Total Level 1 Level 2 Level 3 +Financial Assets: +Financial assets for which carrying values equal or +approximate fair value +Cash and cash equivalents (a) +$ 24 $ 24 $ 23 $ 1 $ — +Other financial assets (b) +60 60 — 60 — +Financial assets carried at other than fair value +Loans, net (c) +90 91 — — 91 +Financial Liabilities: +Financial liabilities for which carrying values equal or approximate fair value 92 92 — 92 — +Financial liabilities carried at other than fair value +Certificates of deposit (d) +10 10 — 10 — +Long-term debt (c) +$ 58 $ 60 $ — $ 60 $ — +2018 (Billions) +Carrying +Value Corresponding Fair Value Amount +Total Level 1 Level 2 Level 3 +Financial Assets: +Financial assets for which carrying values equal or +approximate fair value +Cash and cash equivalents (a) +$ 27 $ 27 $ 26 $ 1 $ — +Other financial assets (b) +58 58 — 58 — +Financial assets carried at other than fair value +Loans, net (c) +83 84 — — 84 +Financial Liabilities: +Financial liabilities for which carrying values equal or approximate fair value 81 81 — 81 — +Financial liabilities carried at other than fair value +Certificates of deposit (d) +13 13 — 13 — +Long-term debt (c) +$ 58 $ 59 $ — $ 59 $ — +(a) Level 2 amounts reflect time deposits and short-term investments. +(b) Includes Card Member receivables (including fair values of Card Member receivables of $ 8.2 billion and $ 8.5 billion held by a consolidated VIE as of December 31, 2019 and 2018, respectively), other receivables, restricted cash and other miscellaneous assets. +(c) Balances include amounts held by a consolidated VIE for which the fair values of Card Member loans were $ 32.0 billion and $ 33.0 billion as of December 31, 2019 and 2018, respectively, and the fair values of Long-term debt were $ 19.8 billion and $ 19.4 billion as of December 31, 2019 and 2018, respectively. +(d) Presented as a component of Customer deposits on the Consolidated Balance Sheets. +114 +Table of Contents +VALUATION TECHNIQUES USED IN THE FAIR VALUE MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT OTHER THAN FAIR VALUE +For the financial assets and liabilities that are not required to be carried at fair value on a recurring basis (categorized in the valuation hierarchy table), we apply the following valuation techniques to measure fair value: +Financial Assets For Which Carrying Values Equal Or Approximate Fair Value +Financial assets for which carrying values equal or approximate fair value include cash and cash equivalents, Card Member receivables, accrued interest and certain other assets. For these assets, the carrying values approximate fair value because they are short term in duration, have no defined maturity or have a market-based interest rate. +Financial Assets Carried At Other Than Fair Value +Loans, net +Loans are recorded at historical cost, less reserves, on the Consolidated Balance Sheets. In estimating the fair value for our loans, we use a discounted cash flow model. Due to the lack of a comparable whole loan sales market for similar loans and the lack of observable pricing inputs thereof, we use various inputs to estimate fair value. Such inputs include projected income, discount rates and relevant credit losses. The valuation does not include economic value attributable to future receivables generated by the accounts associated with the loans. +Financial Liabilities For Which Carrying Values Equal Or Approximate Fair Value +Financial liabilities for which carrying values equal or approximate fair value include accrued interest, customer deposits (excluding certificates of deposit, which are described further below), Travelers Cheques and other prepaid products outstanding, accounts payable, short-term borrowings and certain other liabilities for which the carrying values approximate fair value because they are short term in duration, have no defined maturity or have a market-based interest rate. +Financial Liabilities Carried At Other Than Fair Value +Certificates of Deposit +Certificates of deposit (CDs) are recorded at their historical issuance cost on the Consolidated Balance Sheets. Fair value is estimated using a discounted cash flow methodology based on the future cash flows and the discount rate that reflects the current market rates for similar types of CDs within similar markets. +Long-term Debt +Long-term debt is recorded at historical issuance cost on the Consolidated Balance Sheets adjusted for (i) unamortized discount and unamortized fees, (ii) the impact of movements in exchange rates on foreign currency denominated debt and (iii) the impact of fair value hedge accounting on certain fixed-rate notes that have been swapped to floating rate through the use of interest rate swaps. The fair value of our long-term debt is measured using quoted offer prices when quoted market prices are available. If quoted market prices are not available, the fair value is determined by discounting the future cash flows of each instrument at rates currently observed in publicly-traded debt markets for debt of similar terms and credit risk. For long-term debt, where there are no rates currently observable in publicly traded debt markets of similar terms and comparable credit risk, we use market interest rates and adjust those rates for necessary risks, including our own credit risk. In determining an appropriate spread to reflect our credit standing, we consider credit default swap spreads, bond yields of other long-term debt offered by us, and interest rates currently offered to us for similar debt instruments of comparable maturities. +NONRECURRING FAIR VALUE MEASUREMENTS +We have certain assets that are subject to measurement at fair value on a nonrecurring basis. For these assets, measurement at fair value in periods subsequent to their initial recognition is applicable if they are determined to be impaired or where there are observable price changes for equity investments without readily determinable fair values. During the years ended December 31, 2019 and 2018, we did no t have any material assets that were measured at fair value due to impairment and there were no material fair value adjustments for equity investments without readily determinable fair values. +115 +Table of Contents +NOTE 15 +GUARANTEES +The maximum potential undiscounted future payments and related liability resulting from guarantees and indemnifications provided by us in the ordinary course of business were $ 1 billion and $ 29 million, respectively, as of December 31, 2019, and $ 1 billion and $ 46 million, respectively, as of December 31, 2018, all of which were primarily related to our real estate and business dispositions. +To date, we have not experienced any significant losses related to guarantees or indemnifications. Our recognition of these instruments is at fair value. In addition, we establish reserves when a loss is probable and the amount can be reasonably estimated. +NOTE 16 +COMMON AND PREFERRED SHARES +The following table shows authorized shares and provides a reconciliation of common shares issued and outstanding for the years ended December 31: +(Millions, except where indicated) 2019 2018 2017 +Common shares authorized (billions) (a) +3.6 3.6 3.6 +Shares issued and outstanding at beginning of year 847 859 904 +Repurchases of common shares ( 40 ) ( 15 ) ( 50 ) +Other, primarily stock option exercises and restricted stock awards granted 3 3 5 +Shares issued and outstanding as of December 31 810 847 859 +(a) Of the common shares authorized but unissued as of December 31, 2019, approximately 19 million shares are reserved for issuance under employee stock and employee benefit plans. +On September 23, 2019, the Board of Directors authorized the repurchase of up to 120 million common shares from time to time, subject to market conditions and in accordance with our capital plans. This authorization replaced the prior repurchase authorization and does not have an expiration date. During 2019, 2018 and 2017, we repurchased 40 million common shares with a cost basis of $ 4.6 billion, 15 million common shares with a cost basis of $ 1.6 billion, and 50 million common shares with a cost basis of $ 4.3 billion, respectively. The cost basis includes commissions paid of $ 6.2 million, $ 2.2 million and $ 2.9 million in 2019, 2018 and 2017, respectively. As of December 31, 2019, we had approximately 109 million common shares remaining under the Board share repurchase authorization. +Common shares are generally retired by us upon repurchase (except for 2.6 million, 2.7 million and 2.9 million shares held as treasury shares as of December 31, 2019, 2018 and 2017, respectively); retired common shares and treasury shares are excluded from the shares outstanding in the table above. The treasury shares, with a cost basis of $ 292 million, $ 207 million and $ 217 million as of December 31, 2019, 2018 and 2017, respectively, are included as a reduction to Additional paid-in capital in Shareholders’ equity on the Consolidated Balance Sheets. +116 +Table of Contents +PREFERRED SHARES +The Board of Directors is authorized to permit us to issue up to 20 million Preferred Shares at a par value of $1.66 2/3 without further shareholder approval. We have the following perpetual Fixed Rate/Floating Rate Noncumulative Preferred Share series issued and outstanding as of December 31, 2019: +Series B Series C +Issuance date November 10, 2014 March 2, 2015 +Securities issued +750 Preferred Shares; represented by 750,000 depositary shares +850 Preferred Shares; represented by 850,000 depositary shares +Aggregate liquidation preference $ 750 million $ 850 million +Fixed dividend rate per annum 5.20 % 4.90 % +Semi-annual fixed dividend payment dates +Beginning May 15, 2015 +Beginning September 15, 2015 +Floating dividend rate per annum +3 month LIBOR+ 3.428 % +3 month LIBOR+ 3.285 % +Quarterly floating dividend payment dates Beginning February 15, 2020 Beginning June 15, 2020 +Fixed to floating rate conversion date (a) +November 15, 2019 March 15, 2020 +(a) The date on which dividends convert from a fixed-rate calculation to a floating rate calculation. +In the event of the voluntary or involuntary liquidation, dissolution or winding up of the Company, the preferred stock then outstanding takes precedence over our common stock for the payment of dividends and the distribution of assets out of funds legally available for distribution to shareholders. Each outstanding series of Preferred Shares has a liquidation price of $ 1 million per Preferred Share, plus any accrued but unpaid dividends. We may redeem these Preferred Shares at $ 1 million per Preferred Share (equivalent to $ 1,000 per depositary share) plus any declared but unpaid dividends in whole or in part, from time to time, on any dividend payment date on or after the respective fixed to floating rate conversion date, or in whole, but not in part, within 90 days of certain bank regulatory changes. +There were no warrants issued and outstanding as of December 31, 2019, 2018 and 2017. +117 +Table of Contents +NOTE 17 +CHANGES IN ACCUMULATED OTHER COMPREHENSIVE INCOME +AOCI is a balance sheet item in Shareholders’ equity on the Consolidated Balance Sheets. It is comprised of items that have not been recognized in earnings but may be recognized in earnings in the future when certain events occur. Changes in each component for the three years ended December 31 were as follows: +(Millions) , net of tax +Net Unrealized Gains (Losses) on Investment +Securities Foreign Currency +Translation Adjustment +Gains (Losses) Net Unrealized Pension +and Other Postretirement Benefit +Gains (Losses) Accumulated Other +Comprehensive (Loss) +Income +Balance as of December 31, 2016 $ 7 $ ( 2,262 ) $ ( 529 ) $ ( 2,784 ) +Net unrealized losses ( 7 ) — — ( 7 ) +Decrease due to amounts reclassified into earnings — ( 7 ) — ( 7 ) +Net translation gains on investments in foreign operations (a) +— 678 — 678 +Net losses related to hedges of investments in foreign operations — ( 370 ) — ( 370 ) +Pension and other postretirement benefits — — 62 62 +Net change in accumulated other comprehensive (loss) income ( 7 ) 301 62 356 +Balance as of December 31, 2017 — ( 1,961 ) ( 467 ) ( 2,428 ) +Net unrealized losses ( 10 ) — — ( 10 ) +Net translation losses on investments in foreign operations +— ( 500 ) — ( 500 ) +Net gain related to hedges of investments in foreign operations — 328 — 328 +Pension and other postretirement benefits — — 11 11 +Other 2 — — 2 +Net change in accumulated other comprehensive (loss) income ( 8 ) ( 172 ) 11 ( 169 ) +Balance as of December 31, 2018 ( 8 ) ( 2,133 ) ( 456 ) ( 2,597 ) +Net unrealized gains 41 — — 41 +Net translation gains on investments in foreign operations — 84 — 84 +Net losses related to hedges of investments in foreign operations — ( 140 ) — ( 140 ) +Pension and other postretirement benefits — — ( 125 ) ( 125 ) +Net change in accumulated other comprehensive (loss) income 41 ( 56 ) ( 125 ) ( 140 ) +Balance as of December 31, 2019 $ 33 $ ( 2,189 ) $ ( 581 ) $ ( 2,737 ) +(a) Includes $ 289 million of recognized tax benefits in the year ended December 31, 2017 (refer to Note 20). +The following table shows the tax impact for the years ended December 31 for the changes in each component of AOCI presented above: +Tax expense (benefit) +(Millions) 2019 2018 2017 +Net unrealized investment securities $ 12 $ ( 2 ) $ ( 4 ) +Net translation on investments in foreign operations (a) +24 ( 44 ) ( 172 ) +Net hedges of investments in foreign operations ( 43 ) 107 ( 215 ) +Pension and other postretirement benefits ( 38 ) 9 7 +Total tax impact $ ( 45 ) $ 70 $ ( 384 ) +(a) Includes $ 289 million of recognized tax benefits in the year ended December 31, 2017 (refer to Note 20). +The following table presents the effects of reclassifications out of AOCI and into the Consolidated Statements of Income for the years ended December 31: +Gains (losses) recognized in earnings +Description (Millions) +Income Statement Line Item 2019 2018 2017 +Foreign currency translation adjustments +Reclassification of translation adjustments and related hedges Other expenses $ — $ 1 $ ( 7 ) +Related income tax Income tax provision — ( 1 ) 14 +Reclassification of foreign currency translation adjustments $ — $ — $ 7 +118 +Table of Contents +NOTE 18 +OTHER FEES AND COMMISSIONS AND OTHER EXPENSES +The following is a detail of Other fees and commissions for the years ended December 31: +(Millions) 2019 2018 2017 +Fees charged to Card Members: +Delinquency fees $ 1,028 $ 959 $ 888 +Foreign currency conversion fee revenue 982 921 851 +Other customer fees: +Loyalty coalition-related fees 456 461 452 +Travel commissions and fees 424 395 364 +Service fees and other (a) +407 417 435 +Total Other fees and commissions $ 3,297 $ 3,153 $ 2,990 +(a) Other includes Membership Rewards program fees that are not related to contracts with customers. +The following is a detail of Other expenses for the years ended December 31: +(Millions) 2019 2018 2017 +Professional services $ 2,091 $ 2,125 $ 2,040 +Occupancy and equipment 2,168 2,033 2,018 +Other (a) +1,609 1,513 1,576 +Total Other expenses $ 5,868 $ 5,671 $ 5,634 +(a) Other expense primarily includes general operating expenses, communication expenses, Card Member and merchant-related fraud losses, litigation expenses, other non-income taxes and unrealized gains and losses on certain equity investments. For the year ended December 31, 2018, Other expense also includes the loss on a transaction involving the operations of our prepaid reloadable and gift card business. For the year ended December 31, 2017, Other expense also includes charges related to our U.S. loyalty coalition and prepaid businesses. +NOTE 19 +RESTRUCTURING +We periodically initiate restructuring programs to support new business strategies and to enhance our overall effectiveness and efficiency. In connection with these programs, we will typically incur severance and other exit costs. +We had $ 135 million, $ 69 million and $ 199 million accrued in total restructuring reserves as of December 31, 2019, 2018 and 2017, respectively. New charges, including net revisions to existing restructuring reserves, which primarily relate to the redeployment of displaced colleagues to other positions, were $ 125 million, $( 23 ) million and $ 42 million, for the years ended December 31, 2019, 2018 and 2017, respectively. Cumulatively, we recognized $ 424 million relating to the restructuring programs that were in progress during 2019 and initiated at various dates between 2014 and 2019, the majority of which has been reflected within Corporate & Other. +119 +Table of Contents +NOTE 20 +INCOME TAXES +The Tax Act, enacted on December 22, 2017, made broad and complex changes to the U.S. federal corporate income tax rules. Most notably, effective January 1, 2018, the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35 percent to 21 percent, introduced a territorial tax system in which future dividends paid from earnings outside the United States to a U.S. corporation are not subject to U.S. federal taxation and imposed new U.S. federal corporate income taxes on certain foreign operations. +The components of income tax expense for the years ended December 31 included in the Consolidated Statements of Income were as follows: +(Millions) 2019 2018 2017 +Current income tax expense: +U.S. federal $ 1,108 $ 70 $ 3,408 +U.S. state and local 276 150 259 +Non-U.S. 437 681 387 +Total current income tax expense 1,821 901 4,054 +Deferred income tax (benefit) expense: +U.S. federal ( 58 ) 276 544 +U.S. state and local ( 31 ) 78 ( 12 ) +Non-U.S. ( 62 ) ( 54 ) 91 +Total deferred income tax (benefit) expense ( 151 ) 300 623 +Total income tax expense $ 1,670 $ 1,201 $ 4,677 +A reconciliation of the U.S. federal statutory rate of 21 percent as of both December 31, 2019 and 2018, and 35 percent as of December 31, 2017, to our actual income tax rate was as follows: +2019 2018 2017 +U.S. statutory federal income tax rate 21.0 % 21.0 % 35.0 % +(Decrease) increase in taxes resulting from: +Tax-exempt income ( 1.9 ) ( 1.7 ) ( 1.7 ) +State and local income taxes, net of federal benefit 2.8 2.8 2.3 +Non-U.S. subsidiaries' earnings (a) +( 0.7 ) ( 0.5 ) ( 5.7 ) +Tax settlements (b) +( 0.3 ) ( 1.9 ) ( 0.7 ) +U.S. Tax Act (c) +— ( 1.1 ) 34.8 +U.S. Tax Act - related adjustments (d) +— ( 3.2 ) — +Other ( 1.1 ) ( 0.6 ) ( 1.0 ) +Actual tax rates 19.8 % 14.8 % 63.0 % +(a) 2017 primarily included tax benefits associated with the undistributed earnings of certain non-U.S. subsidiaries that were previously deemed to be reinvested indefinitely. In addition, 2017 included tax benefits of $ 156 million, which decreased the actual tax rate by 2.1 percent, related to the realization of certain foreign tax credits. +(b) 2018 primarily included a settlement of the IRS examination for tax years 2008 - 2014 , as well as the resolution of certain tax matters in various jurisdictions. +(c) 2017 included a $ 2.6 billion provisional charge for the impacts of the Tax Act and the adjustments thereto are included in 2018. +(d) Related to changes to the tax method of accounting for certain expenses. +We record a deferred income tax (benefit) provision when there are differences between assets and liabilities measured for financial reporting and for income tax return purposes. These temporary differences result in taxable or deductible amounts in future years and are measured using the tax rates and laws that will be in effect when such differences are expected to reverse. +120 +Table of Contents +The significant components of deferred tax assets and liabilities as of December 31 are reflected in the following table: +(Millions) 2019 2018 +Deferred tax assets: +Reserves not yet deducted for tax purposes $ 2,633 $ 2,612 +Employee compensation and benefits 365 360 +Other 536 431 +Gross deferred tax assets 3,534 3,403 +Valuation allowance ( 66 ) ( 61 ) +Deferred tax assets after valuation allowance 3,468 3,342 +Deferred tax liabilities: +Intangibles and fixed assets 1,279 1,083 +Deferred revenue 315 435 +Deferred interest 162 171 +Investment in joint ventures 122 137 +Other 129 210 +Gross deferred tax liabilities 2,007 2,036 +Net deferred tax assets $ 1,461 $ 1,306 +A valuation allowance is established when management determines that it is more likely than not that all or some portion of the benefit of the deferred tax assets will not be realized. The valuation allowances as of December 31, 2019 and 2018 are associated with net operating losses and other deferred tax assets in certain non-U.S. operations. +Accumulated earnings of certain non-U.S. subsidiaries, which totaled approximately $ 0.7 billion as of December 31, 2019, are intended to be permanently reinvested outside the U.S. We do not provide for state income and foreign withholding taxes on foreign earnings intended to be permanently reinvested outside the U.S. Accordingly, state income and foreign withholding taxes, which would have aggregated to approximately $ 0.1 billion as of December 31, 2019, have not been provided on those earnings. +Net income taxes paid by us during 2019, 2018 and 2017, were approximately $ 1.7 billion, $ 2.0 billion and $ 1.4 billion, respectively. These amounts include estimated tax payments and cash settlements relating to prior tax years. +We are subject to the income tax laws of the United States, its states and municipalities and those of the foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to the taxpayer’s facts is sometimes open to interpretation. Given these inherent complexities, we must make judgments in assessing the likelihood that a tax position will be sustained upon examination by the taxing authorities based on the technical merits of the tax position. A tax position is recognized only when, based on management’s judgment regarding the application of income tax laws, it is more likely than not that the tax position will be sustained upon examination. The amount of benefit recognized for financial reporting purposes is based on management’s best judgment of the largest amount of benefit that is more likely than not to be realized on ultimate settlement with the taxing authority given the facts, circumstances and information available at the reporting date. We adjust the level of unrecognized tax benefits when there is new information available to assess the likelihood of the outcome. +We are under continuous examination by the Internal Revenue Service (IRS) and tax authorities in other countries and states in which we have significant business operations. The tax years under examination and open for examination vary by jurisdiction. Tax years from 2016 onwards are open for examination by the IRS. +121 +Table of Contents +The following table presents changes in unrecognized tax benefits: +(Millions) 2019 2018 2017 +Balance, January 1 $ 701 $ 821 $ 974 +Increases: +Current year tax positions 66 152 200 +Tax positions related to prior years 78 47 39 +Effects of foreign currency translations 10 — — +Decreases: +Tax positions related to prior years (a) +( 14 ) ( 74 ) ( 289 ) +Settlements with tax authorities (b) +( 40 ) ( 192 ) ( 77 ) +Lapse of statute of limitations ( 75 ) ( 44 ) ( 26 ) +Effects of foreign currency translations — ( 9 ) — +Balance, December 31 $ 726 $ 701 $ 821 +(a) Decrease in 2017 due to the resolution with the IRS of an uncertain tax position in January 2017, which resulted in the recognition of $ 289 million in AOCI. +(b) 2018 included a settlement of the IRS examination for tax years 2008 - 2014 and the resolution of certain tax matters in various jurisdictions. +Included in the unrecognized tax benefits of $ 0.7 billion, $ 0.7 billion and $ 0.8 billion for December 31, 2019, 2018 and 2017, respectively, are approximately $ 623 million, $ 599 million and $ 723 million, respectively, that, if recognized, would favorably affect the effective tax rate in a future period. +We believe it is reasonably possible that our unrecognized tax benefits could decrease within the next 12 months by as much as $ 113 million, principally as a result of potential resolutions of prior years’ tax items with various taxing authorities. The prior years’ tax items include unrecognized tax benefits relating to the deductibility of certain expenses or losses and the attribution of taxable income to a particular jurisdiction or jurisdictions. Of the $ 113 million of unrecognized tax benefits, approximately $ 96 million relates to amounts that, if recognized, would impact the effective tax rate in a future period. +Interest and penalties relating to unrecognized tax benefits are reported in the income tax provision. For the year ended December 31, 2019, we recognized approximately $ 5 million in expenses for interest and penalties. For the years ended December 31, 2018 and 2017, we recognized benefits of approximately $ 18 million and $ 90 million, respectively, for interest and penalties. The interest expense benefit in 2017 includes approximately $ 56 million related to the resolution of an uncertain tax position with the IRS in January 2017, which had no net impact on the income tax provision. +We had approximately $ 70 million and $ 65 million accrued for the payment of interest and penalties as of December 31, 2019 and 2018, respectively. +122 +Table of Contents +NOTE 21 +EARNINGS PER COMMON SHARE (EPS) +The computations of basic and diluted EPS for the years ended December 31 were as follows: +(Millions, except per share amounts) +2019 2018 2017 +Numerator: +Basic and diluted: +Net income +$ 6,759 $ 6,921 $ 2,748 +Preferred dividends ( 81 ) ( 80 ) ( 81 ) +Net income available to common shareholders 6,678 6,841 2,667 +Earnings allocated to participating share awards (a) +( 47 ) ( 54 ) ( 21 ) +Net income attributable to common shareholders +$ 6,631 $ 6,787 $ 2,646 +Denominator: (a) +Basic: Weighted-average common stock +828 856 883 +Add: Weighted-average stock options (b) +2 3 3 +Diluted +830 859 886 +Basic EPS +$ 8.00 $ 7.93 $ 3.00 +Diluted EPS $ 7.99 $ 7.91 $ 2.99 +(a) Our unvested restricted stock awards, which include the right to receive non-forfeitable dividends or dividend equivalents, are considered participating securities. Calculations of EPS under the two-class method exclude from the numerator any dividends paid or owed on participating securities and any undistributed earnings considered to be attributable to participating securities. The related participating securities are similarly excluded from the denominator. +(b) The dilutive effect of unexercised stock options excludes from the computation of EPS 0.2 million, 0.7 million and 0.6 million of options for the years ended December 31, 2019, 2018 and 2017, respectively, because inclusion of the options would have been anti-dilutive. +123 +Table of Contents +NOTE 22 +REGULATORY MATTERS AND CAPITAL ADEQUACY +We are supervised and regulated by the Board of Governors of the Federal Reserve System (the Federal Reserve) and are subject to the Federal Reserve’s requirements for risk-based capital and leverage ratios. Our U.S. bank subsidiary, American Express National Bank (AENB), is subject to supervision and regulation, including regulatory capital and leverage requirements, by the Office of the Comptroller of the Currency (OCC). +Under the risk-based capital guidelines of the Federal Reserve, we are required to maintain minimum ratios of CET1, Tier 1 and Total (Tier 1 plus Tier 2) capital to risk-weighted assets, as well as a minimum Tier 1 leverage ratio (Tier 1 capital to average adjusted on-balance sheet assets). +Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional, discretionary actions by regulators, that, if undertaken, could have a direct material effect on our operating activities. +As of December 31, 2019 and 2018, we met all capital requirements to which we were subject and maintained regulatory capital ratios in excess of those required to qualify as well capitalized. +The following table presents the regulatory capital ratios: +(Millions, except percentages) CET 1 +capital Tier 1 capital Total capital CET 1 Capital +ratio Tier 1 capital +ratio Total capital +ratio Tier 1 leverage +ratio Supplementary +Leverage +Ratio +December 31, 2019: (a) +American Express Company $ 18,056 $ 19,628 $ 22,213 10.7 % 11.6 % 13.2 % 10.2 % 8.8 % +American Express National Bank $ 13,600 $ 13,600 $ 15,688 13.4 % 13.4 % 15.4 % 11.1 % 9.3 % +December 31, 2018: (a) +American Express Company $ 17,498 $ 19,070 $ 21,653 11.0 % 12.0 % 13.6 % 10.4 % 8.9 % +American Express National Bank $ 11,564 $ 11,564 $ 13,574 12.1 % 12.1 % 14.2 % 9.9 % 8.2 % +Well-capitalized ratios (b) +6.5 % 8.0 % 10.0 % 5.0 % N/A +Basel III Standards 2019 (c) +7.0 % 8.5 % 10.5 % 4.0 % 3.0 % +Minimum capital ratios (d) +4.5 % 6.0 % 8.0 % 4.0 % 3.0 % +(a) Capital ratios are reported using Basel III capital definitions, inclusive of transition provisions for the capital ratios and risk-weighted assets using the Basel III standardized approach. +(b) Represents requirements for banking subsidiaries to be considered “well capitalized” pursuant to regulations issued under the Federal Deposit Insurance Corporation Improvement Act. There is no CET1 capital ratio, Tier 1 leverage ratio or supplementary leverage ratio (SLR) requirement for a bank holding company to be considered “well capitalized.” +(c) Basel III minimum capital requirement and additional capital conservation buffer as defined by the Federal Reserve and OCC for calendar year 2019. The additional capital conservation buffer does not apply to Tier 1 leverage ratio or SLR. +(d) As defined by the regulations issued by the Federal Reserve and OCC. +RESTRICTED NET ASSETS OF SUBSIDIARIES +Certain of our subsidiaries are subject to restrictions on the transfer of net assets under debt agreements and regulatory requirements. These restrictions have not had any effect on our shareholder dividend policy and management does not anticipate any impact in the future. Procedures exist to transfer net assets between the Company and its subsidiaries, while ensuring compliance with the various contractual and regulatory constraints. As of December 31, 2019, the aggregate amount of net assets of subsidiaries that are restricted to be transferred was approximately $ 10.0 billion. +BANK HOLDING COMPANY DIVIDEND RESTRICTIONS +We are limited in our ability to pay dividends by the Federal Reserve, which could prohibit a dividend that would be considered an unsafe or unsound banking practice. It is the policy of the Federal Reserve that bank holding companies generally should pay dividends on preferred and common stock only out of net income available to common shareholders generated over the past year, and only if prospective earnings retention is consistent with the organization’s current and expected future capital needs, asset quality and overall financial condition. Moreover, bank holding companies are required by statute to be a source of strength to their insured depository institution subsidiaries and should not maintain dividend levels that undermine their ability to do so. On an annual basis, we are required to develop and maintain a capital plan, which includes planned dividends over a two-year horizon. We may be limited in our ability to pay dividends if the Federal Reserve objects to our capital plan. +124 +Table of Contents +In addition, the Capital Rules include a capital conservation buffer of 2.5 percent as of December 31, 2019, which can be satisfied only with CET1 capital. If our risk-based capital ratios were to fall below the applicable buffer levels, we would be subject to certain restrictions on dividends, stock repurchases and other capital distributions, as well as discretionary bonus payments to executive officers. +BANK DIVIDEND RESTRICTIONS +In the year ended December 31, 2019, AENB paid dividends from retained earnings to its parent of $ 3.9 billion. +AENB is limited in its ability to pay dividends by banking statutes, regulations and supervisory policy. In general, applicable federal and state banking laws prohibit, without first obtaining regulatory approval, insured depository institutions, such as AENB, from making dividend distributions if such distributions are not paid out of available retained earnings or would cause the institution to fail to meet capital adequacy standards. AENB must maintain a capital conservation buffer. If AENB's risk-based capital ratios do not satisfy minimum requirements plus the combined capital conservation buffer, it will face graduated constraints on dividends and other capital distributions based on the amount of the shortfall. As of December 31, 2019, AENB's retained earnings available for the payment of dividends was $ 4.9 billion. In determining the dividends to pay its parent, AENB must also consider the effects on applicable risk-based capital and leverage ratio requirements, as well as policy statements of the federal regulatory agencies. In addition, AENB's banking regulators have authority to limit or prohibit the payment of a dividend by AENB under a number of circumstances, including if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound banking practice in light of the financial condition of the banking organization. +125 +Table of Contents +NOTE 23 +SIGNIFICANT CREDIT CONCENTRATIONS +Concentrations of credit risk exist when changes in economic, industry or geographic factors similarly affect groups of counterparties whose aggregate credit exposure is material in relation to American Express’ total credit exposure. Our customers operate in diverse industries, economic sectors and geographic regions. +The following table details our maximum credit exposure of the on-balance sheet assets by category as of December 31: +(Billions) 2019 2018 +Individuals (a) +$ 131 $ 123 +Financial Services (b) +26 30 +Institutions (c) +20 20 +U.S. Government and agencies (d) +8 4 +Total on-balance sheet $ 185 $ 177 +(a) Primarily reflects loans and receivables from global consumer and small business Card Members, which are governed by individual credit risk management. +(b) Represents banks, broker-dealers, insurance companies and savings and loan associations. +(c) Primarily reflects loans and receivables from global corporate Card Members, which are governed by institutional credit risk management. +(d) Represent debt obligations of the U.S. Government and its agencies, states and municipalities and government-sponsored entities. +As of December 31, 2019 and 2018, our most significant concentration of credit risk was with individuals, including Card Member loans and receivables. These amounts are generally advanced on an unsecured basis. However, we review each potential customer’s credit application and evaluate the applicant’s financial history and ability and willingness to repay. We also consider credit performance by customer tenure, industry and geographic location in managing credit exposure. +The following table details our Card Member loans and receivables exposure (including unused lines-of-credit available to Card Members as part of established lending product agreements) in the United States and outside the United States as of December 31: +(Billions) 2019 2018 +On-balance sheet: +U.S. $ 115 $ 111 +Non-U.S. 30 27 +On-balance sheet 145 138 +Unused lines-of-credit: (a) +U.S. 245 249 +Non-U.S. 61 53 +Total unused lines-of-credit $ 306 $ 302 +(a) Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no pre-set spending limit, and therefore are not reflected in unused credit available to Card Members. +126 +Table of Contents +NOTE 24 +REPORTABLE OPERATING SEGMENTS AND GEOGRAPHIC OPERATIONS +REPORTABLE OPERATING SEGMENTS +We consider a combination of factors when evaluating the composition of our reportable operating segments, including the results reviewed by the chief operating decision maker, economic characteristics, products and services offered, classes of customers, product distribution channels, geographic considerations (primarily United States versus outside the United States), and regulatory environment considerations. +The following is a brief description of the primary business activities of our three reportable operating segments: +• Global Consumer Services Group (GCSG) primarily issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel and lifestyle services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. +• Global Commercial Services (GCS) primarily issues a wide range of proprietary corporate and small business cards and provides payment and expense management services globally. In addition, GCS provides commercial financing products. +• Global Merchant and Network Services (GMNS) operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses in certain countries. +Corporate functions and certain other businesses and operations are included in Corporate & Other. +During 2019, we moved intercompany assets and liabilities, previously recorded in the operating segments, to Corporate & Other. Prior period amounts have been revised to conform to the current period presentation. +127 +Table of Contents +The following table presents certain selected financial information for our reportable operating segments and Corporate & Other as of or for the years ended December 31, 2019, 2018 and 2017: +(Millions, except where indicated) GCSG GCS GMNS +Corporate & Other (a) +Consolidated +2019 +Non-interest revenues $ 15,972 $ 12,623 $ 6,252 $ 89 $ 34,936 +Revenue from contracts with customers (b) +11,041 10,891 6,215 12 28,159 +Interest income 9,413 1,900 28 743 12,084 +Interest expense 1,806 995 ( 365 ) 1,028 3,464 +Total revenues net of interest expense 23,579 13,528 6,645 ( 196 ) 43,556 +Total provisions 2,636 917 20 — 3,573 +Pretax income (loss) from continuing operations 4,024 3,066 3,148 ( 1,809 ) 8,429 +Income tax provision (benefit) 762 590 736 ( 418 ) 1,670 +Net income (loss) 3,262 2,476 2,412 ( 1,391 ) 6,759 +Total assets (billions) +$ 106 $ 53 $ 18 $ 21 $ 198 +2018 +Non-interest revenues $ 14,675 $ 11,882 $ 6,069 $ 49 $ 32,675 +Revenue from contracts with customers (b) +10,294 10,309 5,988 16 26,607 +Interest income 8,323 1,621 30 632 10,606 +Interest expense 1,542 827 ( 294 ) 868 2,943 +Total revenues net of interest expense 21,456 12,676 6,393 ( 187 ) 40,338 +Total provisions +2,430 899 22 1 3,352 +Pretax income (loss) from continuing operations 3,714 2,895 2,844 ( 1,331 ) 8,122 +Income tax provision (benefit) 637 555 704 ( 695 ) 1,201 +Net income (loss) 3,077 2,340 2,140 ( 636 ) 6,921 +Total assets (billions) +$ 102 $ 51 $ 16 $ 20 $ 189 +2017 +Non-interest revenues $ 13,378 $ 10,942 $ 6,025 $ 82 $ 30,427 +Revenue from contracts with customers (b) +9,448 9,471 5,846 15 24,780 +Interest income 6,789 1,361 42 371 8,563 +Interest expense 1,047 595 ( 188 ) 658 2,112 +Total revenues net of interest expense 19,120 11,708 6,255 ( 205 ) 36,878 +Total provisions +1,996 743 16 5 2,760 +Pretax income (loss) from continuing operations 3,645 2,843 2,645 ( 1,708 ) 7,425 +Income tax provision 1,053 914 857 1,853 4,677 +Net income (loss) 2,592 1,929 1,788 ( 3,561 ) 2,748 +Total assets (billions) +$ 95 $ 49 $ 20 $ 17 $ 181 +(a) Corporate & Other includes adjustments and eliminations for intersegment activity. +(b) Includes discount revenue, certain other fees and commissions and other revenues from customers. +Total Revenues Net of Interest Expense +We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue. +Net card fees and other fees and commissions are directly attributable to the segment in which they are reported. +Interest and fees on loans and certain investment income is directly attributable to the segment in which it is reported. Interest expense represents an allocated funding cost based on a combination of segment funding requirements and internal funding rates. +Provisions for Losses +The provisions for losses are directly attributable to the segment in which they are reported. +128 +Table of Contents +Expenses +Marketing and business development expense is included in each segment based on the actual expenses incurred. Global brand advertising is primarily reflected in Corporate & Other and may be allocated to the segments based on the actual expense incurred. Rewards and Card Member services expenses are included in each segment based on the actual expenses incurred within the segment. +Salaries and employee benefits and other operating expenses reflect expenses such as professional services, occupancy and equipment and communications incurred directly within each segment. In addition, expenses related to support services, such as technology costs, are allocated to each segment primarily based on support service activities directly attributable to the segment. Certain other overhead expenses are allocated from Corporate & Other to the segments based on the relative levels of revenue and Card Member loans and receivables. +Income Taxes +An income tax provision (benefit) is allocated to each reportable operating segment based on the effective tax rates applicable to various businesses that comprise the segment. The charge of $ 2.6 billion related to the Tax Act in the fourth quarter of 2017 was allocated in full to Corporate & Other. +GEOGRAPHIC OPERATIONS +The following table presents our total revenues net of interest expense and pretax income (loss) from continuing operations in different geographic regions based, in part, upon internal allocations, which necessarily involve management’s judgment: +(Millions) United States +EMEA (a) +JAPA (a) +LACC (a) +Other Unallocated (b) +Consolidated +2019 +Total revenues net of interest expense $ 32,557 $ 4,465 $ 3,915 $ 2,816 $ ( 197 ) $ 43,556 +Pretax income (loss) from continuing operations 7,262 1,243 833 903 ( 1,812 ) 8,429 +2018 +Total revenues net of interest expense $ 29,864 $ 4,419 $ 3,656 $ 2,584 $ ( 185 ) $ 40,338 +Pretax income (loss) from continuing operations 6,696 1,212 764 782 ( 1,332 ) 8,122 +2017 +Total revenues net of interest expense $ 27,187 $ 3,927 $ 3,464 $ 2,505 $ ( 205 ) $ 36,878 +Pretax income (loss) from continuing operations 6,412 1,150 763 806 ( 1,706 ) 7,425 +(a) EMEA represents Europe, the Middle East and Africa; JAPA represents Japan, Asia/Pacific and Australia; and LACC represents Latin America, Canada and the Caribbean. +(b) Other Unallocated includes net costs which are not directly allocated to specific geographic regions, including costs related to the net negative interest spread on excess liquidity funding and executive office operations expenses. +129 +Table of Contents +NOTE 25 +PARENT COMPANY +PARENT COMPANY – CONDENSED STATEMENTS OF INCOME +Years Ended December 31 (Millions) +2019 2018 2017 +Revenues +Non-interest revenues +Other $ 598 $ 426 $ 358 +Total non-interest revenues 598 426 358 +Interest income 692 422 258 +Interest expense 902 615 493 +Total revenues net of interest expense 388 233 123 +Expenses +Salaries and employee benefits 366 336 362 +Other 816 607 553 +Total expenses 1,182 943 915 +Pretax loss ( 794 ) ( 710 ) ( 792 ) +Income tax benefit ( 282 ) ( 179 ) ( 354 ) +Net loss before equity in net income of subsidiaries and affiliates ( 512 ) ( 531 ) ( 438 ) +Equity in net income of subsidiaries and affiliates 7,271 7,452 3,186 +Net income $ 6,759 $ 6,921 $ 2,748 +PARENT COMPANY – CONDENSED BALANCE SHEETS +As of December 31 (Millions) +2019 2018 +Assets +Cash and cash equivalents $ 4,430 $ 3,287 +Equity in net assets of subsidiaries and affiliates 23,165 22,298 +Loans to subsidiaries and affiliates 22,350 17,945 +Due from subsidiaries and affiliates 1,168 1,783 +Other assets 223 297 +Total assets 51,336 45,610 +Liabilities and Shareholders’ Equity +Liabilities +Accounts payable and other liabilities 2,197 1,961 +Due to subsidiaries and affiliates 609 577 +Debt with subsidiaries and affiliates 1,091 2,591 +Long-term debt 24,368 18,191 +Total liabilities 28,265 23,320 +Shareholders’ Equity +Total shareholders’ equity 23,071 22,290 +Total liabilities and shareholders’ equity $ 51,336 $ 45,610 +130 +Table of Contents +PARENT COMPANY – CONDENSED STATEMENTS OF CASH FLOWS +Years Ended December 31 (Millions) +2019 2018 2017 +Cash Flows from Operating Activities +Net income $ 6,759 $ 6,921 $ 2,748 +Adjustments to reconcile net income to cash provided by operating activities: +Equity in net income of subsidiaries and affiliates ( 7,271 ) ( 7,452 ) ( 3,186 ) +Dividends received from subsidiaries and affiliates 6,370 3,222 5,755 +Other operating activities, primarily with subsidiaries and affiliates 1,315 ( 257 ) 659 +Net cash provided by operating activities 7,173 2,434 5,976 +Cash Flows from Investing Activities +Maturities and redemptions of investment securities 1 — — +Loans to subsidiaries and affiliates ( 4,405 ) ( 6,281 ) ( 4,044 ) +Investments in subsidiaries and affiliates ( 15 ) ( 30 ) — +Other investing activities 82 — — +Net cash used in investing activities ( 4,337 ) ( 6,311 ) ( 4,044 ) +Cash Flows from Financing Activities +Proceeds from long-term debt 6,469 9,350 5,900 +Payments of long-term debt ( 641 ) ( 3,850 ) ( 1,500 ) +Short-term debt of subsidiaries and affiliates ( 1,500 ) ( 140 ) ( 1,313 ) +Issuance of American Express common shares 86 87 129 +Repurchase of American Express common shares and other ( 4,685 ) ( 1,685 ) ( 4,400 ) +Dividends paid ( 1,422 ) ( 1,324 ) ( 1,251 ) +Net cash (used in) provided by financing activities ( 1,693 ) 2,438 ( 2,435 ) +Net increase (decrease) in cash and cash equivalents 1,143 ( 1,439 ) ( 503 ) +Cash and cash equivalents at beginning of year 3,287 4,726 5,229 +Cash and cash equivalents at end of year $ 4,430 $ 3,287 $ 4,726 +NOTE 26 +QUARTERLY FINANCIAL DATA (UNAUDITED ) +(Millions, except per share amounts) 2019 2018 +Quarters Ended 12/31 9/30 6/30 3/31 12/31 9/30 6/30 3/31 +Total revenues net of interest expense $ 11,365 $ 10,989 $ 10,838 $ 10,364 $ 10,474 $ 10,144 $ 10,002 $ 9,718 +Pretax income 1,986 2,266 2,219 1,958 1,831 2,118 2,091 2,082 +Net income 1,693 1,755 1,761 1,550 2,010 1,654 1,623 1,634 +Earnings Per Common Share — Basic: +Net income attributable to common shareholders (a) +2.04 2.09 2.07 1.81 2.33 1.89 1.85 1.86 +Earnings Per Common Share — Diluted: +Net income attributable to common shareholders (a) +2.03 2.08 2.07 1.80 2.32 1.88 1.84 1.86 +Cash dividends declared per common share $ 0.43 $ 0.43 $ 0.39 $ 0.39 $ 0.39 $ 0.39 $ 0.35 $ 0.35 +(a) Represents net income, less (i) earnings allocated to participating share awards of $ 12 million, $ 11 million, $ 13 million and $ 11 million for the quarters ended December 31, September 30, June 30 and March 31, 2019, respectively, and $ 16 million, $ 13 million, $ 12 million and $ 13 million for the quarters ended December 31, September 30, June 30 and March 31, 2018, respectively, and (ii) dividends on preferred shares of $ 20 million, $ 21 million, $ 19 million and $ 21 million for the quarters ended December 31, September 30, June 30 and March 31, 2019, respectively, and $ 19 million, $ 20 million, $ 20 million and $ 21 million for the quarters ended December 31, September 30, June 30 and March 31, 2018, respectively. +131 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not applicable. +ITEM 9A. CONTROLS AND PROCEDURES +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods specified in the applicable rules and forms, and that it is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. +There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company’s fourth quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. +“Management’s Report on Internal Control over Financial Reporting,” which sets forth management’s evaluation of internal control over financial reporting, and the “Report of Independent Registered Public Accounting Firm” on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2019 are set forth in “Financial Statements and Supplementary Data.” +ITEM 9B. OTHER INFORMATION +Not applicable. +132 +Table of Contents +PART III +ITEMS 10, 11, 12 and 13. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +We expect to file with the SEC in March 2020 (and, in any event, not later than 120 days after the close of our last fiscal year), a definitive proxy statement, pursuant to SEC Regulation 14A in connection with our Annual Meeting of Shareholders to be held May 5, 2020, which involves the election of directors. The following information to be included in such proxy statement is incorporated herein by reference: +• Information included under the caption “Corporate Governance at American Express — Our Corporate Governance Framework — Our Board’s Independence” +• Information included under the caption “Corporate Governance at American Express — Our Board Committees — Board Committee Responsibilities” +• Information included under the caption “Corporate Governance at American Express — Our Corporate Governance Framework — Director Attendance” +• Information included under the caption “Corporate Governance at American Express — Compensation of Directors” +• Information included under the caption “Stock Ownership Information” +• Information included under the caption “Corporate Governance at American Express — Item 1 — Election of Directors for a Term of One Year” +• Information included under the caption “Executive Compensation” +• Information under the caption “Corporate Governance at American Express — Certain Relationships and Transactions” +• Information under the caption “Stock Ownership Information — Delinquent Section 16(a) Reports” +In addition, the information regarding executive officers called for by Item 401(b) of Regulation S-K may be found under the caption “Information About Our Executive Officers” in this Report. +We have adopted a set of Corporate Governance Principles, which together with the charters of the four standing committees of the Board of Directors (Audit and Compliance; Compensation and Benefits; Nominating, Governance and Public Responsibility; and Risk), our Code of Conduct (which constitutes our code of ethics) and the Code of Business Conduct for the Members of the Board of Directors, provide the framework for our governance. A complete copy of our Corporate Governance Principles, the charters of each of the Board committees, the Code of Conduct (which applies not only to our Chief Executive Officer, Chief Financial Officer and Controller, but also to all our other colleagues) and the Code of Business Conduct for the Members of the Board of Directors may be found by clicking on the “Corporate Governance” link found on our Investor Relations website at http://ir.americanexpress.com. We also intend to disclose any amendments to our Code of Conduct, or waivers of our Code of Conduct on behalf of our Chief Executive Officer, Chief Financial Officer or Controller, on our website. You may also access our Investor Relations website through our main website at www.americanexpress.com by clicking on the “About American Express” link, which is located at the bottom of the Company’s homepage. (Information from such sites is not incorporated by reference into this Report.) You may also obtain free copies of these materials by writing to our Corporate Secretary at our headquarters. +133 +Table of Contents +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information set forth under the heading “Item 2 — Ratification of Appointment of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP Fees and Services,” which will appear in our definitive proxy statement in connection with our Annual Meeting of Shareholders to be held May 5, 2020, is incorporated herein by reference. +134 +Table of Contents +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) +1. Financial Statements : +See the “Index to Consolidated Financial Statements” under “Financial Statements and Supplementary Data.” +2. Financial Statement Schedules : +All schedules are omitted since the required information is either not applicable, not deemed material, or shown in the Consolidated Financial Statements. +3. Exhibits : +The following exhibits are filed as part of this report. The exhibit numbers preceded by an asterisk (*) indicate exhibits electronically filed herewith. All other exhibit numbers indicate exhibits previously filed and are hereby incorporated herein by reference. Exhibits numbered 10.1 through 10.43 are management contracts or compensatory plans or arrangements. +3.1 +Company's Amended and Restated Certificate of Incorporation as amended through February 27, 2015 (incorporated by reference to Exhibit 3.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2015). +3.2 +Company's By-Laws, as amended through September 26, 2016 (incorporated by reference to Exhibit 3.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated September 26, 2016). +4.1 The instruments defining the rights of holders of long-term debt securities of the Company and its subsidiaries are omitted pursuant to Section (b)(4)(iii)(A) of Item 601 of Regulation S-K. The Company hereby agrees to furnish copies of these instruments to the SEC upon request. +*4.2 +Description of American Express Company’s securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended. +10.1 +American Express Company Deferred Compensation Plan for Directors and Advisors, as amended and restated effective April 1, 2018 (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2018). +10.2 +American Express Company 2007 Pay-for-Performance Deferral Program Document (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 20, 2006 (filed November 22, 2006)). +10.3 +Description of amendments to 1994–2006 Pay-for-Performance Deferral Programs (incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2006). +10.4 +American Express Company 2006 Pay-for-Performance Deferral Program Guide (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 21, 2005 (filed November 23, 2005)). +10.5 +American Express Company 2005 Pay-for-Performance Deferral Program Guide (incorporated by reference to Exhibit 10.10 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2004). +10.6 +Description of American Express Company Pay-for-Performance Deferral Program (incorporated by reference to Exhibit 10.2 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 22, 2004 (filed January 28, 2005)). +135 +Table of Contents +10.7 +Amendment to the Pre-2008 Nonqualified Deferred Compensation Plans of American Express Company (incorporated by reference to Exhibit 10.19 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2008). +10.8 American Express Company Retirement Plan for Non-Employee Directors, as amended (incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1988). +10.9 +Certificate of Amendment of the American Express Company Retirement Plan for Non-Employee Directors dated March 21, 1996 (incorporated by reference to Exhibit 10.11 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1995). +10.10 American Express Key Executive Life Insurance Plan, as amended (incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the fiscal year ended December 31, 1991). +10.11 +Amendment to American Express Company Key Executive Life Insurance Plan (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1994). +10.12 +Amendment to American Express Company Key Executive Life Insurance Plan, effective as of January 22, 2007 (incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2006). +10.13 +Amendment to American Express Company Key Executive Life Insurance Plan, effective as of January 1, 2011 (incorporated by reference to Exhibit 10.24 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2010). +10.14 American Express Key Employee Charitable Award Program for Education (incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1990). +10.15 American Express Directors' Charitable Award Program (incorporated by reference to Exhibit 10.14 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1990). +10.16 American Express Company Salary/Bonus Deferral Plan (incorporated by reference to Exhibit 10.20 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1988). +10.17 +Amendment to American Express Company Salary/Bonus Deferral Plan (incorporated by reference to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1994). +10.18 +American Express Senior Executive Severance Plan, as amended and restated effective May 1, 2018 (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended June 30, 2018). +10.19 +Amendments of (i) the American Express Salary/Bonus Deferral Plan and (ii) the American Express Key Executive Life Insurance Plan (incorporated by reference to Exhibit 10.37 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1997). +10.20 +Second Amendment and Restatement of the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (as amended and restated effective as of January 1, 2012) (incorporated by reference to Exhibit 10.28 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2011). +136 +Table of Contents +10.21 +Third Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated March 29, 2012) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2012). +10.22 +Fourth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated October 24, 2012) (incorporated by reference to Exhibit 10.31 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2012). +10.23 +Fifth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated May 1, 2013) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2013). +10.24 +Sixth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated August 16, 2013) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2013). +10.25 +Seventh Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated September 26, 2013) (incorporated by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2013). +10.26 +Eighth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 1, 2013) (incorporated by reference to Exhibit 10.36 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2013). +10.27 +Ninth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 14, 2016) (incorporated by reference to Exhibit 10.30 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.28 +Tenth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 17, 2018) (incorporated by reference to Exhibit 10.28 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2018). +10.29 +American Express Company 2003 Share Equivalent Unit Plan for Directors, as amended and restated, effective January 1, 2015 (incorporated by reference to Exhibit 10.38 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +10.30 +Description of Compensation Payable to Non-Management Directors effective January 1, 2015 (incorporated by reference to Exhibit 10.39 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2014). +10.31 +American Express Company 2007 Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated April 23, 2007 (filed April 27, 2007)). +10.32 +American Express Company 2007 Incentive Compensation Plan Master Agreement (as amended and restated effective January 1, 2011) (incorporated by reference to Exhibit 10.8 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2010). +10.33 +American Express Company 2007 Incentive Compensation Plan Master Agreement (as amended and restated effective January 23, 2012) (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated January 23, 2012 (filed January 27, 2012)). +10.34 +Form of nonqualified stock option award agreement for executive officers under the American Express Company 2007 Incentive Compensation Plan (for awards made after January 26, 2016) (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +137 +Table of Contents +10.35 +Form of restricted stock unit award agreement for executive officers under the American Express Company 2007 Incentive Compensation Plan (for awards made after January 26, 2016) (incorporated by reference to Exhibit 10.44 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015) . +10.36 +American Express Company 2016 Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated May 2, 2016). +10.37 +Form of nonqualified stock option award agreement for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.41 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.38 +Form of restricted stock unit award agreement for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.42 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.39 +Form of award agreement for executive officers in connection with Performance Grant awards (a/k/a Executive Annual Incentive Awards) under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.40 +Form of award agreement for executive officers in connection with Portfolio Grant awards under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.44 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +*10.41 +Amendment to the Form of nonqualified stock option award agreement and Form of restricted stock unit award for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after January 29, 2020). +*10.42 +Form of notice agreement in connection with Annual Incentive Awards under the American Express Company 2016 Incentive Compensation Plan. +10.43 +Contract of Employment, dated March 11, 2018, by and between American Express Services Europe Limited and Anna Marrs (incorporated by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2019). +10.44 +Restated Letter Agreement, dated May 6, 2019, between American Express Company and Berkshire Hathaway Inc., on behalf of itself and its subsidiaries (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated May 6, 2019). +10.45 +Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.48 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2017). +10.46 +Amendment No. 1, dated March 29, 2019, to the Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2019). +10.47 +Amendment No. 2, dated July 26, 2019, to the Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2019). +*21 +Subsidiaries of the Company. +138 +Table of Contents +*23 +Consent of PricewaterhouseCoopers LLP. +*31.1 +Certification of Stephen J. Squeri, Chief Executive Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended. +*31.2 +Certification of Jeffrey C. Campbell, Chief Financial Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended. +*32.1 +Certification of Stephen J. Squeri, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +*32.2 +Certification of Jeffrey C. Campbell, Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +*101.INS XBRL Instance Document – The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document +*101.SCH XBRL Taxonomy Extension Schema Document +*101.CAL XBRL Taxonomy Extension Calculation Linkbase Document +*101.LAB XBRL Taxonomy Extension Label Linkbase Document +*101.PRE XBRL Taxonomy Extension Presentation Linkbase Document +*101.DEF XBRL Taxonomy Extension Definition Linkbase Document +*104 Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101) +ITEM 16. FORM 10-K SUMMARY +Not applicable. +139 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +AMERICAN EXPRESS COMPANY +/s/ JEFFREY C. CAMPBELL +Jeffrey C. Campbell +Chief Financial Officer +February 13, 2020 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the date indicated. +/s/ STEPHEN J. SQUERI /s/ MICHAEL O. LEAVITT +Stephen J. Squeri +Chairman, Chief Executive Officer and Director Michael O. Leavitt +Director +/s/ JEFFREY C. CAMPBELL /s/ THEODORE J. LEONSIS +Jeffrey C. Campbell +Chief Financial Officer Theodore J. Leonsis +Director +/s/ RICHARD PETRINO /s/ KAREN L. PARKHILL +Richard Petrino +Executive Vice President and Corporate Controller +(Principal Accounting Officer) Karen L. Parkhill +Director +/s/ CHARLENE BARSHEFSKY /s/ LYNN A. PIKE +Charlene Barshefsky +Director Lynn A. Pike +Director +/s/ JOHN J. BRENNAN /s/ DANIEL L. VASELLA +John J. Brennan +Director Daniel L. Vasella +Director +/s/ PETER CHERNIN /s/ RONALD A. WILLIAMS +Peter Chernin +Director Ronald A. Williams +Director +/s/ RALPH DE LA VEGA /s/ CHRISTOPHER D. YOUNG +Ralph de la Vega +Director Christopher D. Young +Director +/s/ ANNE LAUVERGEON +Anne Lauvergeon +Director +February 13, 2020 +140 +Table of Contents +Appendix +GUIDE 3 – STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES +The accompanying supplemental information should be read in conjunction with the “MD&A”, “Consolidated Financial Statements” and notes thereto. +Certain reclassifications of prior period amounts have been made to conform to the current period presentation. These reclassifications did not have a material impact on our financial position or results of operations. +Distribution of Assets, Liabilities, and Shareholders’ Equity; Interest Rates and Interest Differential +The following tables provide a summary of our consolidated average balances including major categories of interest-earning assets and interest-bearing liabilities along with an analysis of net interest earnings. Consolidated average balances, interest, and average yields are segregated between U.S. and non-U.S. offices. Assets, liabilities, interest income and interest expense are attributed to the United States and outside the United States based on the location of the office recording such items. +2019 2018 2017 +Years Ended December 31, +(Millions, except percentages) +Average +Balance (a) +Interest +Income Average +Yield +Average +Balance (a) +Interest +Income Average +Yield +Average +Balance (a) +Interest +Income Average +Yield +Interest-earning assets +Interest-bearing deposits in other banks (b) +U.S. $ 22,552 $ 527 2.3 % $ 25,001 $ 491 2.0 % $ 24,510 $ 277 1.1 % +Non-U.S. 2,085 48 2.3 1,830 33 1.8 1,773 17 1.0 +Federal funds sold and securities purchased under agreements to resell +U.S. 19 3 15.8 — — — — — — +Non-U.S. 56 6 10.7 58 7 12.1 80 6 7.5 +Short-term investment securities +U.S. 26 1 3.8 3 — — 182 1 0.5 +Non-U.S. 93 1 1.1 149 1 0.7 1,070 7 0.7 +Card Member loans (c) +U.S. 72,422 9,452 13.1 66,620 8,387 12.6 58,853 6,894 11.7 +Non-U.S. 10,362 1,400 13.5 9,136 1,206 13.2 7,847 1,038 13.2 +Other loans (c) +U.S. 4,101 413 10.1 3,110 312 10.0 1,887 195 10.3 +Non-U.S. 170 43 25.3 145 36 24.8 148 27 18.2 +Taxable investment securities (d) +U.S. 6,335 147 2.3 3,025 68 2.2 1,216 24 2.0 +Non-U.S. 589 27 4.6 562 23 4.1 547 17 3.1 +Non-taxable investment securities (d) +U.S. 237 11 5.9 855 25 3.7 1,510 48 4.9 +Other assets (e) +Primarily U.S. 17 5 n.m. 1 17 n.m. 1 12 n.m. +Total interest-earning assets (f) $ 119,064 $ 12,084 10.2 % $ 110,495 $ 10,606 9.6 % $ 99,624 $ 8,563 8.6 % +U.S. 105,709 10,559 98,615 9,300 88,159 7,451 +Non-U.S. 13,355 1,525 11,880 1,306 11,465 1,112 +n.m. Denotes rates determined to not be meaningful. +(a) Averages based on month-end balances. +(b) Amounts include (i) average interest-bearing restricted cash balances of $580 million, $663 million and $868 million for 2019, 2018 and 2017, respectively, which are included in other assets on the Consolidated Balance Sheets, and (ii) the associated interest income. +(c) Average non-accrual loans were included in the average Card Member loan balances in amounts of $307 million, $230 million and $187 million in U.S. for 2019, 2018 and 2017, respectively. Average other loan balances for U.S. include average non-accrual loans of $7 million, $4 million and $3 million for 2019, 2018 and 2017, respectively. Average non-accrual loans are considered to determine the average yield on loans. +(d) Average yields for both taxable and non-taxable investment securities have been calculated using amortized cost balances and do not include changes in fair value recorded in other comprehensive loss. Average yield on non-taxable investment securities is calculated on a tax-equivalent basis using the U.S. federal statutory tax rate of 21 percent for both 2019 and 2018 and 35 percent for 2017. +(e) Amounts include (i) average equity securities balances, which are included in investment securities on the Consolidated Balance Sheets, and (ii) the associated income. +(f) The average yield on total interest-earning assets is adjusted for the impacts of the items mentioned in footnote (d). +A-1 +Table of Contents +Years Ended December 31, +(Millions, except percentages) +2019 +Average Balance (a) +2018 +Average Balance (a) +2017 +Average Balance (a) +Non-interest-earning assets +Cash and due from banks +U.S. $ 2,842 $ 2,793 $ 2,393 +Non-U.S. 732 527 489 +Card Member receivables, net +U.S. 27,724 26,435 21,262 +Non-U.S. 28,040 27,100 27,621 +Reserves for Card Member and other loans losses +U.S. (2,057) (1,740) (1,264) +Non-U.S. (258) (217) (177) +Other assets (b) +U.S. 12,689 12,351 12,462 +Non-U.S. 5,593 5,077 5,000 +Total non-interest-earning assets 75,305 72,326 67,786 +U.S. 41,198 39,839 34,853 +Non-U.S. 34,107 32,487 32,933 +Total assets $ 194,369 $ 182,821 $ 167,410 +U.S. 146,908 138,454 123,012 +Non-U.S. 47,461 44,367 44,398 +Percentage of total average assets attributable to non-U.S. activities 24.4 % 24.3 % 26.5 % +(a) Averages based on month-end balances. +(b) Includes premises and equipment, net of accumulated depreciation and amortization. +A-2 +Table of Contents +2019 2018 2017 +Years Ended December 31, +(Millions, except percentages) +Average +Balance (a) +Interest +Expense Average +Rate +Average +Balance (a) +Interest +Expense Average +Rate +Average +Balance (a) +Interest +Expense Average +Rate +Interest-bearing liabilities +Customer deposits +U.S. +Savings $ 59,087 $ 1,247 2.1 % $ 50,499 $ 919 1.8 % $ 42,134 $ 471 1.1 % +Time 12,179 298 2.4 15,975 357 2.2 14,701 301 2.0 +Demand 447 9 2.0 285 6 2.1 215 3 1.4 +Non-U.S. +Other time and savings 16 1 6.3 21 1 4.8 17 1 5.9 +Other demand 10 4 40.0 12 4 33.3 18 3 16.7 +Short-term borrowings +U.S. 407 22 5.4 274 14 5.1 1,188 15 1.3 +Non-U.S. 2,621 15 0.6 2,106 19 0.9 2,145 18 0.8 +Long-term debt and other (b) +U.S. 57,936 1,859 3.2 54,631 1,613 3.0 51,366 1,281 2.5 +Non-U.S. 325 9 2.8 390 10 2.6 725 19 2.6 +Total interest-bearing liabilities $ 133,028 $ 3,464 2.6 % $ 124,193 $ 2,943 2.4 % $ 112,509 $ 2,112 1.9 % +U.S. 130,056 3,435 121,664 2,909 109,604 2,071 +Non-U.S. 2,972 29 2,529 34 2,905 41 +Non-interest-bearing liabilities +Accounts payable +U.S. 7,116 7,120 6,788 +Non-U.S. 6,202 6,064 5,254 +Customer Deposits (c) +U.S. 385 377 351 +Non-U.S. 387 370 331 +Other liabilities +U.S. 18,360 18,619 16,366 +Non-U.S. 6,079 5,428 4,954 +Total non-interest-bearing liabilities 38,529 37,978 34,044 +U.S. 25,861 26,116 23,505 +Non-U.S. 12,668 11,862 10,539 +Total liabilities 171,557 162,171 146,553 +U.S. 155,917 147,780 133,109 +Non-U.S. 15,640 14,391 13,444 +Total shareholders' equity 22,812 20,650 20,857 +Total liabilities and shareholders' equity +$ 194,369 $ 182,821 $ 167,410 +Percentage of total average liabilities attributable to non-U.S. activities +9.1 % 8.9 % 9.2 % +Interest rate spread 7.6 % 7.2 % 6.7 % +Net interest income and net average yield on interest-earning assets (d)` +$ 8,620 7.2 % $ 7,663 6.9 % $ 6,451 6.5 % +(a) Averages based on month-end balances. +(b) Interest expense primarily reflects interest on long-term financing and interest incurred on derivative instruments in qualifying hedging relationships on the hedged debt instruments. Additionally, we adopted new accounting guidance providing targeted improvements to the accounting for hedging activities effective January 1, 2018. In compliance with the standard, amounts previously recorded in Other expenses have been prospectively recorded in Total interest expense. +(c) U.S. non-interest-bearing Customer deposits include average Card Member credit balances of $353 million, $342 million and $314 million for 2019, 2018 and 2017, respectively. Non-U.S. non-interest-bearing Customer deposits include average Card Member credit balances of $381 million, $359 million and $318 million for 2019, 2018 and 2017, respectively. +(d) Net average yield on interest-earning assets is defined as net interest income divided by average total interest-earning assets as adjusted for the items mentioned in footnote (d) from the table on A-1. +A-3 +Table of Contents +Changes in Net Interest Income − Volume and Rate Analysis (a) +The following table presents the amount of changes in interest income and interest expense due to changes in both average volume and average rate. Major categories of interest-earning assets and interest-bearing liabilities have been segregated between U.S. and non-U.S. offices. Average volume/rate changes have been allocated between the average volume and average rate variances on a consistent basis based upon the respective percentage changes in average balances and average rates. +2019 Versus 2018 2018 Versus 2017 +Increase (Decrease) +due to change in: Increase (Decrease) +due to change in: +Years Ended December 31, (Millions) +Average +Volume Average +Rate Net Change Average +Volume Average +Rate Net Change +Interest-earning assets +Interest-bearing deposits in other banks +U.S. $ (48) $ 84 $ 36 $ 6 $ 208 $ 214 +Non-U.S. 5 10 15 1 15 16 +Federal funds sold and securities purchased under agreements to resell +U.S. — 3 3 — — — +Non-U.S. — (1) (1) (2) 3 1 +Short-term investment securities +U.S. — 1 1 (1) — (1) +Non-U.S. — — — (6) — (6) +Card Member loans +U.S. 730 335 1,065 910 583 1,493 +Non-U.S. 162 32 194 170 (2) 168 +Other loans +U.S. 99 2 101 126 (9) 117 +Non-U.S. 6 1 7 (1) 10 9 +Taxable investment securities +U.S. 72 7 79 36 8 44 +Non-U.S. 1 3 4 1 5 6 +Non-taxable investment securities +U.S. (18) 4 (14) (17) (6) (23) +Other assets +Primarily U.S. 272 (284) (12) — 5 5 +Change in interest income 1,281 197 1,478 1,223 820 2,043 +Interest-bearing liabilities +Customer deposits +U.S. +Savings 156 172 328 94 354 448 +Time (85) 26 (59) 26 30 56 +Demand 3 — 3 1 2 3 +Non-U.S. +Other time and savings — — — — — — +Other demand (1) 1 — (1) 2 1 +Short-term borrowings +U.S. 7 1 8 (12) 11 (1) +Non-U.S. 5 (9) (4) — 1 1 +Long-term debt and other +U.S. 98 148 246 81 251 332 +Non-U.S. (2) 1 (1) (9) — (9) +Change in interest expense 181 340 521 180 651 831 +Change in net interest income $ 1,100 $ (143) $ 957 $ 1,043 $ 169 $ 1,212 +(a) Refer to footnotes from “Distribution of Assets, Liabilities and Shareholders’ Equity” for additional information. +A-4 +Table of Contents +Loans and Card Member Receivables Portfolios +The following table presents gross loans and Card Member receivables by customer type, segregated between U.S. and non-U.S., based on the domicile of the borrowers. Refer to Notes 2 and 3 to the “Consolidated Financial Statements” for additional information. +December 31, (Millions) +2019 2018 2017 2016 2015 +Loans (a) (b) +U.S. loans +Card Member (c) +$ 76,027 $ 72,007 $ 64,542 $ 58,242 $ 51,446 +Other (d) 4,605 3,666 2,554 1,350 1,073 +Non-U.S. loans +Card Member (c) +11,354 9,847 8,857 7,023 7,127 +Other (d) +173 134 133 111 201 +Total loans $ 92,159 $ 85,654 $ 76,086 $ 66,726 $ 59,847 +Card Member receivables (a) (b) +U.S. Card Member receivables +Consumer (e) +28,187 27,558 26,754 24,768 23,255 +Commercial (f) +10,827 11,478 10,868 9,685 8,961 +Non-U.S. Card Member receivables +Consumer (e) +12,061 10,625 10,311 7,772 7,101 +Commercial (f) +6,338 6,232 6,114 5,083 4,816 +Total Card Member receivables $ 57,413 $ 55,893 $ 54,047 $ 47,308 $ 44,133 +(a) As of December 31, 2019, we had approximately $306 billion of unused credit available to Card Members as part of established lending product agreements. Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no pre-set spending limit, and therefore are not reflected in unused credit available to Card Members. +(b) As of December 31, 2019, our exposure to any concentration of gross loans and Card Member receivables combined, which exceeds 10 percent of total loans and Card Member receivables is further split between $131 billion for individuals and $19 billion for commercial. Loans and Card Member receivables concentrations are defined as loans and Card Member receivables due from multiple borrowers engaged in similar activities that would cause these borrowers to be impacted similarly to certain economic or other related conditions. Refer to Note 23 to the “Consolidated Financial Statements” for additional information on concentrations. +(c) Primarily represents loans to individuals and small businesses. +(d) Other loans primarily represent consumer and commercial non-card financing products. +(e) Represents receivables from individual and small business charge card customers. +(f) Represents receivables from global, large and middle market corporate accounts. +A-5 +Table of Contents +Maturities and Sensitivities to Changes in Interest Rates +The following table presents contractual maturities of loans and Card Member receivables by customer type, and segregated between U.S. and non-U.S. borrowers, and distribution between fixed and floating interest rates for loans due after one year based upon the stated terms of the loan agreements. +December 31, (Millions) +2019 +Within +1 year (a) (b) +1-5 +years (b) (c) +After +5 years (c) +Total +Loans +U.S. loans +Card Member $ 75,707 $ 320 $ — $ 76,027 +Other 1,606 2,810 189 4,605 +Non-U.S. loans +Card Member 11,354 — — 11,354 +Other 143 30 — 173 +Total loans $ 88,810 $ 3,160 $ 189 $ 92,159 +Loans due after one year at fixed interest rates $ 3,142 $ 65 $ 3,207 +Loans due after one year at variable interest rates 18 124 142 +Total loans $ 3,160 $ 189 $ 3,349 +Card Member receivables +U.S. Card Member receivables +Consumer $ 28,102 $ 85 $ — $ 28,187 +Commercial 10,827 — — 10,827 +Non-U.S. Card Member receivables +Consumer 12,061 — — 12,061 +Commercial 6,338 — — 6,338 +Total Card Member receivables $ 57,328 $ 85 $ — $ 57,413 +(a) Card Member loans have no stated maturity and are therefore included in the due within one year category. However, many of our Card Members will revolve their balances, which may extend their repayment period beyond one year for balances outstanding as of December 31, 2019. +(b) Card Member receivables are immediately due upon receipt of Card Member statements, have no stated interest rate and are included within the due within one year category. Receivables due after one year represent modification programs classified as Troubled Debt Restructurings (TDRs), wherein the terms of a receivable have been modified for Card Members that are experiencing financial difficulties and a long-term concession (more than 12 months) has been granted to the borrower. +(c) Card Member and other loans due after one year primarily represent installment loans and TDRs. +A-6 +Table of Contents +Risk Elements +The following table presents the amounts of non-performing loans and Card Member receivables that are either non-accrual, past due, or restructured, segregated between U.S. and non-U.S. borrowers. Past due loans are loans that are contractually past due 90 days or more as to principal or interest payments. Restructured loans and Card Member receivables are those that meet the definition of a TDR. +December 31, (Millions) +2019 2018 2017 2016 2015 +Loans +Non-accrual loans (a) +U.S. $ 346 $ 286 $ 203 $ 173 $ 154 +Total non-accrual loans $ 346 $ 286 $ 203 $ 173 $ 154 +Loans contractually 90 days past-due and still accruing interest (b) +U.S. $ 338 $ 321 $ 273 $ 208 $ 164 +Non-U.S. $ 94 $ 69 $ 56 $ 52 $ 52 +Total loans contractually 90 days past-due and still accruing interest $ 432 $ 390 $ 329 $ 260 $ 216 +Restructured loans (c) +U.S. $ 810 $ 532 $ 367 $ 346 $ 279 +Total restructured loans $ 810 $ 532 $ 367 $ 346 $ 279 +Total non-performing loans $ 1,588 $ 1,208 $ 899 $ 779 $ 649 +Card Member receivables +Restructured Card Member receivables (c) +U.S. $ 211 $ 128 $ 80 $ 55 $ 33 +Total restructured Card Member receivables $ 211 $ 128 $ 80 $ 55 $ 33 +(a) Non-accrual loans not in modification programs primarily include certain Card Member loans placed with outside collection agencies for which we have ceased accruing interest. Amounts presented exclude Card Member loans classified as a TDR. +(b) Our policy is generally to accrue interest through the date of write-off (typically 180 days past due). We establish reserves for interest that we believe will not be collected. Amounts presented exclude loans classified as a TDR. +(c) In instances where the Card Member is experiencing financial difficulty, we may modify, through various programs, Card Member loans and receivables in order to minimize losses and improve collectability, while providing Card Members with temporary or permanent financial relief. We have classified Card Member loans and receivables in these modification programs as TDRs and continue to classify Card Member accounts that have exited a modification program as a TDR, with such accounts identified as “Out of Program TDRs.” Such modifications to the loans and receivables primarily include (i) temporary interest rate reductions (possibly as low as zero percent, in which case the loan is characterized as non-accrual in our TDR disclosures), (ii) placing the Card Member on a fixed payment plan not to exceed 60 months and (iii) suspending delinquency fees until the Card Member exits the modification program. Refer to Note 2 to the “Consolidated Financial Statements” for additional information. +A-7 +Table of Contents +Impact of Non-performing Loans on Interest Income +The following table presents the gross interest income for both non-accrual and restructured loans for 2019 that would have been recognized if such loans had been current in accordance with their original contractual terms and had been outstanding throughout the period or since origination if held for only part of 2019. The table also presents the interest income related to these loans that was actually recognized for the period. These amounts are segregated between U.S. and non-U.S. borrowers. +2019 +Year Ended December 31, (Millions) +U.S. Non-U.S. Total +Gross amount of interest income that would have been recorded in accordance with the original contractual terms (a) +152 — 152 +Interest income actually recognized 38 — 38 +Total interest revenue foregone 114 — 114 +(a) We determine the original effective interest rate as the interest rate in effect prior to the imposition of any penalty interest rate. +Potential Problem Loans and Card Member Receivables +This disclosure presents outstanding amounts as well as specific reserves for certain loans and Card Member receivables where information about possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present repayment terms. At December 31, 2019, we did not identify any significant potential problem loans or receivables within the Card Member loans and receivables portfolio that were not already included in the “Risk Elements” section. +A-8 +Table of Contents +Cross-border Outstandings +Cross-border disclosure is based upon the Federal Financial Institutions Examinations Council’s (FFIEC) guidelines governing the determination of cross-border risk. +The following table presents the aggregate amount of cross-border outstandings from borrowers or counterparties for each foreign country that exceeds 1 percent of consolidated total assets for any of the periods reported below. +The table separately presents the amounts of cross-border outstandings by type of borrower including Governments and official institutions, Banks and other financial institutions, Non-Bank Financial Institutions (NBFIs) and Other. +Years Ended December 31, +(Millions) +Governments +and official +institutions Banks and +other +financial +institutions NBFIs Other +Total +cross-border +outstandings (a) +Gross +foreign- +office +liabilities Total +exposure +(net of +liabilities) Cross-border +commitments +Australia 2019 $ 173 $ 177 $ — $ 3,890 $ 4,240 $ 481 $ 3,759 $ 6,360 +2018 2 207 — 3,633 3,842 366 3,476 6,948 +2017 — 259 — 3,594 3,853 504 3,349 6,635 +Canada 2019 $ 427 $ 468 $ 39 $ 2,966 $ 3,900 $ 491 $ 3,409 $ 10,490 +2018 346 676 41 2,706 3,769 465 3,304 9,970 +2017 355 992 40 2,730 4,117 1,032 3,085 12,174 +United Kingdom 2019 $ 113 $ 2,254 $ 6 $ 5,702 $ 8,075 $ 3,575 $ 4,500 $ 21,830 +2018 42 1,807 9 5,012 6,870 3,928 2,942 18,234 +2017 68 1,286 86 4,568 6,008 3,884 2,124 15,578 +Mexico 2019 $ 278 $ 351 $ 22 $ 2,701 $ 3,352 $ 673 $ 2,679 $ 1,486 +2018 85 237 40 2,512 2,874 665 2,209 1,254 +2017 85 97 7 2,229 2,418 556 1,862 1,125 +Japan 2019 $ 321 $ 701 $ 206 $ 4,626 $ 5,854 $ 4,786 $ 1,068 $ 5,707 +2018 2 298 226 3,729 4,255 3,890 365 2,924 +2017 4 74 177 3,082 3,337 3,106 231 2,290 +Other countries (b) +2019 $ 355 $ 332 $ 7 $ 4,554 $ 5,248 $ 824 $ 4,424 $ 730 +2018 211 287 11 4,175 4,684 666 4,018 720 +2017 158 187 14 4,268 4,627 928 3,699 682 +(a) Total cross-border outstandings include loans, receivables, interest-bearing deposits with other banks, other interest-bearing investments, derivative contracts and other monetary assets. +(b) Cross-border outstandings between 0.75 percent and 1.0 percent of consolidated total assets are included in Other Countries. For comparability, countries that meet the threshold for any year presented are included for all years. Countries included are France, Italy and Germany. +A-9 +Table of Contents +Summary of Loan Loss Experience – Analysis of the Allowance for Loan Losses +The following table summarizes the changes to our allowance for Card Member loan losses. The table segregates such changes between U.S. and non-U.S. borrowers. +Years Ended December 31, +(Millions, except percentages) +2019 2018 2017 2016 2015 +Card Member loans +Allowance for loan losses at beginning of year +U.S. loans $ 1,899 $ 1,507 $ 1,068 $ 882 $ 1,036 +Non-U.S. loans 235 199 155 146 165 +Total allowance for losses 2,134 1,706 1,223 1,028 1,201 +Card Member lending provisions (a) +U.S. loans 2,123 2,003 1,655 1,056 1,032 +Non-U.S. loans 339 263 213 179 158 +Total Card Member lending provisions 2,462 2,266 1,868 1,235 1,190 +Write-offs +U.S. loans (2,403) (2,002) (1,572) (1,262) (1,321) +Non-U.S. loans (357) (285) (245) (222) (226) +Total write-offs (2,760) (2,287) (1,817) (1,484) (1,547) +Recoveries +U.S. loans 466 391 356 325 359 +Non-U.S. loans 59 53 53 54 59 +Total recoveries 525 444 409 379 418 +Net write-offs (b) +(2,235) (1,843) (1,408) (1,105) (1,129) +Transfer of reserves on HFS loans portfolios +U.S. loans — — — — (224) +Other (c) +U.S. loans — — — 67 — +Non-U.S. loans 22 5 23 (2) (10) +Total other 22 5 23 65 (10) +Allowance for loan losses at end of year +U.S. loans 2,085 1,899 1,507 1,068 882 +Non-U.S. loans 298 235 199 155 146 +Total allowance for losses $ 2,383 $ 2,134 $ 1,706 $ 1,223 $ 1,028 +Principal only net write-offs / average Card Member loans outstanding (d) (e) +2.2 % 2.0 % 1.8 % 1.6 % 1.4 % +Principal, interest and fees net write-offs / average Card Member loans outstanding (d) (e) +2.7 % 2.4 % 2.1 % 1.8 % 1.7 % +(a) Refer to Note 3 to the “Consolidated Financial Statements” for a discussion of management’s process for evaluating the allowance for loan losses. +(b) Net write-offs include principal, interest and fees balances. +(c) Includes foreign currency translation adjustments and other adjustments. The year ended December 31, 2016, included reserves of $67 million associated with $265 million of retained Card Member loans reclassified from HFS to held for investment as a result of retaining certain loans in connection with the respective sales of JetBlue and Costco cobrand card portfolios. +(d) The net write-off rate presented is on a worldwide basis and is based on principal losses only (i.e., excluding interest and fees) to be consistent with industry convention. In addition, because we consider uncollectible interest and fees in estimating our reserves for credit losses, a net write-off rate including principal, interest and fees is also presented. +(e) Average Card Member loans outstanding are based on month-end balances. +A-10 +Table of Contents +Th e following table summarizes the changes to our allowance for other loan losses. The table segregates such changes between U.S. and non-U.S. borrowers. +Years Ended December 31, (Millions, except percentages) +2019 2018 2017 2016 2015 +Other loans +Allowance for loan losses at beginning of year +U.S. loans $ 122 $ 78 $ 39 $ 17 $ 8 +Non-U.S. loans 2 2 3 3 4 +Total allowance for losses 124 80 42 20 12 +Provisions for other loan losses (a) +U.S. loans 124 121 71 56 21 +Non-U.S. loans 1 1 1 1 1 +Total provisions for other loan losses 125 122 72 57 22 +Write-offs +U.S. loans (111) (82) (37) (39) (15) +Non-U.S. loans (2) (2) (3) (2) (3) +Total write-offs (113) (84) (40) (41) (18) +Recoveries +U.S. loans 15 5 5 5 3 +Non-U.S. loans 1 1 1 1 1 +Total recoveries 16 6 6 6 4 +Net write-offs (97) (78) (34) (35) (14) +Allowance for loan losses at end of year +U.S. loans 150 122 78 39 17 +Non-U.S. loans 2 2 2 3 3 +Total allowance for losses $ 152 $ 124 $ 80 $ 42 $ 20 +Net write-offs/average other loans outstanding (b) +2.3 % 2.4 % 1.7 % 2.9 % 1.3 % +(a) Provisions for other loan losses are determined based on a specific identification methodology and models that analyze specific portfolio statistics. +(b) The net write-off rate presented is on a worldwide basis and is based on write-offs of principal, interest and fees. Average other loans outstanding are based on month-end balances. +A-11 +Table of Contents +The following table summarizes the changes to our allowance for Card Member receivables losses. The table segregates such changes between U.S. and non-U.S. borrowers. +Years Ended December 31, (Millions, except percentages) 2019 2018 2017 2016 2015 +Card Member receivables +Allowance for losses at beginning of year +U.S. receivables +Consumer $ 299 $ 277 $ 266 $ 268 $ 276 +Commercial 70 73 53 51 53 +Total U.S. receivables 369 350 319 319 329 +Non-U.S. receivables +Consumer 135 119 95 93 93 +Commercial 69 52 53 50 43 +Total non-U.S. receivables 204 171 148 143 136 +Total allowance for losses 573 521 467 462 465 +Provisions for losses (a) +U.S. receivables +Consumer 553 471 413 366 420 +Commercial 74 92 114 69 76 +Total U.S. provisions 627 563 527 435 496 +Non-U.S. receivables +Consumer 283 245 201 176 169 +Commercial 53 129 67 85 72 +Total non-U.S. provisions 336 374 268 261 241 +Total provisions for losses 963 937 795 696 737 +Write-offs +U.S. receivables +Consumer (722) (659) (633) (637) (698) +Commercial (131) (151) (139) (112) (123) +Total U.S. write-offs (853) (810) (772) (749) (821) +Non-U.S. receivables +Consumer (324) (278) (233) (218) (204) +Commercial (102) (138) (97) (101) (89) +Total non-U.S. write-offs +(426) (416) (330) (319) (293) +Total write-offs $ (1,279) $ (1,226) $ (1,102) $ (1,068) $ (1,114) +(a) Refer to Note 3 to the “Consolidated Financial Statements” for a discussion of management’s process for evaluating the allowance for receivable losses. +A-12 +Table of Contents +Years Ended December 31, (Millions, except percentages) +2019 2018 2017 2016 2015 +Card Member receivables +Recoveries +U.S. receivables +Consumer $ 214 $ 210 $ 233 $ 269 $ 271 +Commercial 49 56 45 43 45 +Total U.S. recoveries 263 266 278 312 316 +Non-U.S. receivables +Consumer 79 70 63 59 57 +Commercial 37 31 25 23 28 +Total non-U.S. recoveries 116 101 88 82 85 +Total recoveries 379 367 366 394 401 +Net write-offs (a) +(900) (859) (736) (674) (713) +Other (b) +U.S. receivables +Consumer — — (2) — (1) +Commercial — — — 2 — +Total U.S. other — — (2) 2 (1) +Non-U.S. receivables +Consumer (15) (21) (7) (15) (22) +Commercial (2) (5) 4 (4) (4) +Total non-U.S. other (17) (26) (3) (19) (26) +Total other (17) (26) (5) (17) (27) +Allowance for losses at end of year +U.S. receivables +Consumer 344 299 277 266 268 +Commercial 62 70 73 53 51 +Total U.S. receivables 406 369 350 319 319 +Non-U.S. receivables +Consumer 158 135 119 95 93 +Commercial 55 69 52 53 50 +Total non-U.S. receivables 213 204 171 148 143 +Total allowance for losses $ 619 $ 573 $ 521 $ 467 $ 462 +Net write-offs / average Card Member receivables outstanding (c) (d) +1.6 % 1.6 % 1.5 % 1.5 % 1.6 % +(a) Net write-offs include principal and fees balances. +(b) Includes foreign currency translation adjustments and other adjustments. Additionally, 2015 included the impact of transfer of the HFS receivables portfolio, which was not significant. +(c) The net write-off rate presented is on a worldwide basis and is based on write-offs of principal and fees. +(d) Average Card Member receivables outstanding are based on month-end balances. +A-13 +Table of Contents +Allocation of Allowance for Losses +The following table presents an allocation of the allowance for loans and Card Member receivables and the percentage of allowance for losses on loans and Card Member receivables in each category, to the total allowance, respectively, by customer type. The table segregates allowance for losses on loans and Card Member receivables between U.S. and non-U.S. borrowers. +December 31, 2019 2018 2017 2016 2015 +(Millions, except percentages) +Allowance for losses +at end of year applicable to +Amount +Percentage (a) +Amount +Percentage (a) +Amount +Percentage (a) +Amount +Percentage (a) +Amount +Percentage (a) +Loans +U.S. loans +Card Member $ 2,085 82 % $ 1,899 84 % $ 1,507 85 % $ 1,068 85 % $ 882 84 % +Other 150 6 122 5 78 4 39 3 17 2 +Non-U.S. loans +Card Member 298 12 235 11 199 11 155 12 146 14 +Other 2 — 2 — 2 — 3 — 3 — +$ 2,535 100 % $ 2,258 100 % $ 1,786 100 % $ 1,265 100 % $ 1,048 100 % +Card Member receivables +U.S. Card Member receivables +Consumer $ 344 56 % $ 299 52 % $ 277 53 % $ 266 57 % $ 268 58 % +Commercial 62 10 70 12 73 14 53 11 51 11 +Non-U.S. Card Member receivables +Consumer 158 25 135 24 119 23 95 21 93 20 +Commercial 55 9 69 12 52 10 53 11 50 11 +$ 619 100 % $ 573 100 % $ 521 100 % $ 467 100 % $ 462 100 % +(a) Percentage of allowance for losses on loans and Card Member receivables in each category to the total allowance. +Time Certificates of Deposit of $100,000 or More +The following table presents the amount of time certificates of deposit of $100,000 or more issued by us in our U.S. offices, further segregated by time remaining until maturity. +By remaining maturity as of December 31, 2019 +(Millions) 3 months +or less Over 3 months +but within 6 months Over 6 months +but within 12 months Over +12 months Total +U.S. time certificates of deposit ($100,000 or more) $ 194 $ 113 $ 288 $ 690 $ 1,285 +As of December 31, 2019, time certificates of deposit and other time deposits in amounts of $100,000 or more issued by non-U.S. offices was $7 million. +A-14 \ No newline at end of file diff --git a/raw/filings/0000004962/2019/0000004962-20-000030/filing_metadata.csv b/raw/filings/0000004962/2019/0000004962-20-000030/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..68a1929f1604ddb8032797db73feef28ea9c01c4 --- /dev/null +++ b/raw/filings/0000004962/2019/0000004962-20-000030/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004962,AXP,AMERICAN EXPRESS CO,2019,10-K,2020-02-13,2019-12-31,2020-02-13T21:04:42.000Z,0000004962-20-000030,axp-20191231.htm,FORM 10-K OF AMERICAN EXPRESS COMPANY,31280088,1,1,https://www.sec.gov/Archives/edgar/data/4962/000000496220000030/axp-20191231.htm,https://www.sec.gov/Archives/edgar/data/4962/000000496220000030/ diff --git a/raw/filings/0000004962/2019/0000004962-20-000030/item1.txt b/raw/filings/0000004962/2019/0000004962-20-000030/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..64ab48b4b53558770d515e699a7402f463a5afe2 --- /dev/null +++ b/raw/filings/0000004962/2019/0000004962-20-000030/item1.txt @@ -0,0 +1,221 @@ +ITEM 1. BUSINESS +Overview +American Express is a globally integrated payments company that provides customers with access to products, insights and experiences that enrich lives and build business success. We are a leader in providing credit and charge cards to consumers, small businesses, mid-sized companies and large corporations around the world. American Express ® cards issued by American Express as well as by third-party banks and other institutions on the American Express network permit Card Members to charge purchases of goods and services at the millions of merchants around the world that accept cards bearing our logo. +Our various products and services are sold globally to diverse customer groups through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams and direct response advertising. Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +We were founded in 1850 as a joint stock association and were incorporated in 1965 as a New York corporation. American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. (TRS), are bank holding companies under the Bank Holding Company Act of 1956, as amended (the BHC Act), subject to supervision and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). As of December 31, 2019, we employed approximately 64,500 people, whom we refer to as colleagues. +We principally engage in businesses comprising three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses are included in Corporate & Other. Our businesses are global in scope and function together to form our end-to-end integrated payments platform, which we believe is a differentiator that underpins our business model. For further information about our reportable operating segments, please see “Business Segment Results” under “MD&A.” +Our Integrated Payments Platform +Through our general-purpose card-issuing, merchant-acquiring and card network businesses, we are able to connect participants and provide differentiated value across the commerce path. We maintain direct relationships with both our Card Members (as a card issuer) and merchants (as an acquirer), and we handle all key aspects of those relationships. These relationships create a “closed loop” in that we have direct access to information at both ends of the card transaction, which distinguishes our integrated payments platform from the bankcard networks. +1 +Table of Contents +Our integrated payments platform allows us to analyze information on Card Member spending and build algorithms and other analytical tools that we use to underwrite risk, reduce fraud and provide targeted marketing and other information services for merchants and special offers and services to Card Members, all while respecting Card Member preferences and protecting Card Member and merchant data in compliance with applicable policies and legal requirements. Through contractual relationships, we also obtain information from third-party card issuers, merchant acquirers and processors with whom we do business. +Card Issuing Businesses +Our global proprietary card-issuing businesses are conducted through our GCSG and GCS reportable operating segments. We offer a broad set of card products, rewards and services to a diverse consumer and commercial customer base, in the United States and internationally. We acquire and retain high-spending, engaged and creditworthy Card Members by: +• Designing innovative products and features that appeal to our target customer base and meet their spending and borrowing needs +• Using incentives to drive spending on our various card products and engender loyal Card Members, including our Membership Rewards ® program, cash-back reward features and participation in loyalty programs sponsored by our cobrand and other partners +• Providing digital and mobile services and an array of benefits and experiences across card products, such as airport lounge access and other travel and lifestyle benefits, which we believe are difficult for others to replicate and help increase Card Member engagement +• Creating world-class service experiences by delivering exceptional customer care +• Developing a wide range of partner relationships, including with other corporations and institutions that sponsor certain of our cards under cobrand arrangements and provide benefits and services to our Card Members +For the year ended December 31, 2019, worldwide proprietary billed business (spending on American Express cards issued by us) was $1,071 billion and at December 31, 2019, we had 70 million proprietary cards-in-force worldwide. +Merchant Acquiring Business +Our GMNS reportable operating segment builds and manages relationships with millions of merchants around the world that choose to accept American Express cards. This includes signing new merchants to accept our cards, agreeing on the discount rate (a fee charged to the merchant for accepting our cards) and handling servicing for merchants. We also build and maintain relationships with merchant acquirers, aggregators and processors to manage aspects of our merchant services business. For example, through our OptBlue ® merchant-acquiring program, third-party processors contract directly with small merchants for card acceptance and determine merchant pricing. +We continue to grow merchant acceptance of American Express cards around the world. As of year-end 2019, based on our internal tracking and our understanding of the latest industry data, we believe we achieved our goal of reaching virtual parity coverage with Mastercard and Visa credit card-accepting merchants in the United States. We are also focused on increasing merchant coverage strategically in targeted countries, cities and merchant categories outside the United States, with continued growth in merchant locations internationally in 2019. As we continue to grow our network, we will seek to work with merchant partners in the United States and around the world to ensure that our Card Members are warmly welcomed and encouraged to spend in the millions of places where their American Express cards are accepted. +Card Network Business +GMNS operates a payments network through which it establishes and maintains relationships with third-party banks and other institutions in approximately 94 countries and territories, licensing the American Express brand and extending the reach of our global network. Under independent operator arrangements, partners are licensed to issue local currency American Express-branded cards in their countries and serve as the merchant acquirer for local merchants. Under network card license arrangements, partners are licensed to issue American Express-branded cards on our network. +For the year ended December 31, 2019, worldwide network services billed business (spending on American Express cards issued by third parties) was $170 billion and at December 31, 2019, we had 44 million cards-in-force issued by third parties worldwide. +GMNS also provides fraud-prevention tools, marketing solutions, data analytics and other programs and services to merchants and other partners that leverage the capabilities of our integrated payments platform. +2 +Table of Contents +Diverse Customer Base and Global Footprint +The following charts provide a summary of our diverse set of customers and broad geographic footprint: +Partners and Relationships +Our integrated payments platform allows us to work with a range of business partners, and our partners in return help drive the scale and relevance of the platform. +There are many examples of how we connect partners with our integrated payments platform, including: issuing cards under cobrand arrangements with other corporations and institutions (e.g., Delta Air Lines, Marriott International, British Airways and Hilton Worldwide Holdings); offering innovative ways for our Card Members to earn and use points with our merchants (e.g., Pay with Points at Amazon.com); expanding merchant acceptance with third-party acquirers and processors (e.g., OptBlue partners); developing new capabilities and features with our digital partners (e.g., PayPal and Venmo); integrating into the supplier payment processes of our corporate card clients (e.g., SAP Ariba); and extending the platform into travel services with American Express leisure and business travel (e.g., Fine Hotels and Resorts). +Delta Air Lines is our largest strategic partner. Our relationships with, and revenues and expenses related to, Delta are significant and represent a significant source of value for our Card Members. We issue cards under cobrand arrangements with Delta and the Delta cobrand portfolio represented approximately 8 percent of our worldwide billed business and approximately 22 percent of worldwide Card Member loans as of December 31, 2019. The Delta cobrand portfolio generates fee revenue and interest income from Card Members and discount revenue from Delta and other merchants for spending on Delta cobrand cards. During 2019, we signed an 11-year renewal extending the Delta cobrand relationship through the end of 2029 and expect to continue to make significant investments in this partnership going forward. Among other things, Delta is also a key participant in our Membership Rewards program, provides travel-related benefits and services, including airport lounge access for certain American Express Card Members, accepts American Express cards as a merchant and is a corporate payments customer. +Working with all of our partners, we will continue to seek to provide value, choice and unique experiences across our customer base. +Our Spend-Centric Model and Revenue Mix +Our “spend-centric” business model focuses on generating revenues primarily by driving spending on our cards and secondarily through finance charges and fees. Spending on our cards, which is higher on average on a per-card basis versus our competitors, offers superior value to merchants in the form of loyal customers and larger transactions. Because of the revenues generated from having high-spending Card Members and the annual card fees we charge on many of our products, we are able to invest in attractive rewards and other benefits for Card Members, as well as targeted marketing and other programs and investments for merchants. This creates incentives for Card Members to spend more on their cards and positively differentiates American Express cards. +We believe our spend-centric model gives us the ability to provide differentiated value to Card Members, merchants and business partners. +3 +Table of Contents +The American Express Brand and Service Excellence +Our brand and its attributes—trust, security and service—are key assets. We invest heavily in managing, marketing, promoting and protecting our brand, including through the delivery of our products and services in a manner consistent with our brand promise. The American Express brand is consistently ranked as one of the most valuable brands in the world. We place significant importance on trademarks, service marks and patents, and seek to secure our intellectual property rights around the world. +We aim to provide the world’s best customer experience every day and our reputation for world-class service has been recognized by numerous awards over the years. Our customer care professionals and partners treat servicing interactions as an opportunity to bring the brand to life for our customers, add meaningful value and deepen relationships. +Our Business Strategies +We seek to grow our business by focusing on four strategic imperatives: +First, we aim to expand our leadership in the premium consumer space by continuing to deliver membership benefits that span our customers’ everyday spending, borrowing, travel and lifestyle needs, expanding our roster of business partners around the globe and developing a range of experiences that attract high-spending customers. +Second, we will look to build on our strong position in commercial payments by evolving our card value propositions, further differentiating our corporate card and accounts payable expense management solutions, and designing innovative products and features, including financing and supplier payment solutions for our business customers. +Third, we are focused on strengthening our global network to provide unique value by continuing to help merchants navigate the convergence of online and offline commerce with fraud protection services, marketing insights and digital connections to higher-spending Card Members, and continuing to work with our network partners to offer expanded products and services. +Finally, we want to continue to make American Express an essential part of our customers’ digital lives by developing more digital features, solutions and services, expanding our digital partnerships and making targeted acquisitions. +COMPETITION +We compete in the global payments industry with card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and Automated Clearing House, or ACH), as well as evolving and growing alternative payment and financing providers. As the payments industry continues to evolve, we face increasing competition from non-traditional players that leverage new technologies, business models and customer relationships to create payment or financing solutions. +As a card issuer, we compete with financial institutions that issue general-purpose charge and credit cards and debit cards. We also encounter competition from businesses that issue their own private label cards, operate their own mobile wallets or extend credit to their customers. We face intense competition for cobrand relationships, as both card issuer and network competitors have targeted key business partners with attractive value propositions. +Our global card network competes in the global payments industry with other card networks, including, among others, China UnionPay, Visa, Mastercard, JCB, Discover and Diners Club International (which is owned by Discover). We are the fourth largest general-purpose card network globally based on purchase volume, behind China UnionPay, Visa and Mastercard. In addition to such networks, a range of companies globally, including merchant acquirers, processors and web- and mobile-based payment platforms (e.g., Alipay, PayPal and Venmo), as well as regional payment networks (such as the National Payments Corporation of India), carry out some activities similar to those performed by our GMNS business. +The principal competitive factors that affect the card-issuing, merchant and network businesses include: +• The features, value and quality of the products and services, including customer care, rewards programs, partnerships, benefits and digital and mobile services, and the costs associated with providing such features and services +• Reputation and brand recognition +• The number, spending characteristics and credit performance of customers +4 +Table of Contents +• The quantity, diversity and quality of the establishments where the cards can be used +• The attractiveness of the value proposition to card issuers, merchant acquirers, cardholders, corporate clients and merchants (including the relative cost of using or accepting the products and services, and capabilities such as fraud prevention and data analytics) +• The number and quality of other payment cards and other forms of payment available to customers +• The success of marketing and promotional campaigns +• The speed of innovation and investment in systems, technologies, and product and service offerings +• The nature and quality of expense management tools, electronic payment methods and data capture and reporting capabilities, particularly for business customers +• The security of cardholder and merchant information +Another aspect of competition is the dynamic and rapid growth of alternative payment mechanisms, systems and products, which include payment aggregators (e.g., PayPal, Square and Amazon), marketplace lenders, wireless payment technologies (including using mobile telephone networks to carry out transactions), financial technology companies, electronic wallet and push payment providers (including handset manufacturers, telecommunication providers, retailers, banks and technology companies), digital currencies developed by both governments and the private sector, blockchain and similar distributed ledger technologies, real-time settlement and processing, prepaid systems and gift cards, and systems linked to payment cards or that provide payment solutions. Various competitors are working to integrate more financial services into their product offerings and competitors are attempting to replicate our closed-loop functionality, such as the merchant-processing platform ChaseNet. New payments competitors continue to emerge in response to evolving technologies, consumer habits and merchant needs. +In addition to the discussion in this section, see “ Our operating results may materially suffer because of substantial and increasingly intense competition worldwide in the payments industry ” in “Risk Factors” for further discussion of the potential impact of competition on our business, and “ Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition” and “ Legal proceedings regarding provisions in our merchant contracts could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand ” in “Risk Factors” for a discussion of the potential impact on our ability to compete effectively due to government regulations or if ongoing legal proceedings limit our ability to prevent merchants from engaging in various actions to discriminate against our card products. +5 +Table of Contents +SUPERVISION AND REGULATION +Overview +We are subject to extensive government regulation and supervision in jurisdictions around the world, and the costs of compliance are substantial. In recent years, the financial services industry has been subject to rigorous scrutiny, high regulatory expectations, an increasing range of regulations and a stringent and unpredictable enforcement environment. +Governmental authorities have focused, and we believe will continue to focus, considerable attention on reviewing compliance by financial services firms with laws and regulations, and as a result, we continually work to evolve and improve our risk management framework, governance structures, practices and procedures. Reviews to assess compliance with laws and regulations by governmental authorities, as well as our own internal reviews, have resulted in, and are likely to continue to result in, changes to our products, practices and procedures, restitution to our customers and increased costs related to regulatory oversight, supervision and examination. We have also been subject to regulatory actions and may continue to be the subject of such actions, including governmental inquiries, investigations, enforcement proceedings and the imposition of fines or civil money penalties, in the event of noncompliance or alleged noncompliance with laws or regulations. In addition, legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +See “Risk Factors—Legal, Regulatory and Compliance Risks” for a discussion of the potential impact legislative and regulatory changes may have on our results of operations and financial condition. +Banking Regulation +Federal and state banking laws, regulations and policies extensively regulate the Company (which, for purposes of this section, refers to American Express Company as a bank holding company), TRS and our U.S. bank subsidiary, American Express National Bank (AENB). Both the Company and TRS are subject to comprehensive consolidated supervision, regulation and examination by the Federal Reserve and AENB is likewise supervised, regulated and examined by the Office of the Comptroller of the Currency (OCC). The Company and its subsidiaries are also subject to the rulemaking, enforcement and examination authority of the Consumer Financial Protection Bureau (CFPB). Banking regulators have broad examination and enforcement power, including the power to impose substantial fines, limit dividends and other capital distributions, restrict operations and acquisitions and require divestitures. Many aspects of our business also are subject to rigorous regulation by other U.S. federal and state regulatory agencies and by non-U.S. government agencies and regulatory bodies. +The Federal Reserve has established a new rating system for large financial institutions, such as the Company, which is intended to align with the Federal Reserve’s existing supervisory program for large financial institutions and which includes component ratings for capital planning, liquidity risk management, and governance and controls. In August 2017 and January 2018, the Federal Reserve proposed related guidance for the governance and controls component. +Activities +The BHC Act generally limits bank holding companies to activities that are considered to be banking activities and certain closely related activities. As noted above, each of the Company and TRS is a bank holding company and each has elected to become a financial holding company, which is authorized to engage in a broader range of financial and related activities. In order to remain eligible for financial holding company status, we must meet certain eligibility requirements. Those requirements include that each of the Company and AENB must be “well capitalized” and “well managed,” and AENB must have received at least a “satisfactory” rating on its most recent assessment under the Community Reinvestment Act of 1977 (the CRA). The Company and TRS engage in various activities permissible only for financial holding companies, including, in particular, providing travel agency services, acting as a finder and engaging in certain insurance underwriting and agency services. If the Company fails to meet eligibility requirements for financial holding company status, it is likely to be barred from engaging in new types of financial activities or making certain types of acquisitions or investments in reliance on its status as a financial holding company, and ultimately could be required to either discontinue the broader range of activities permitted to financial holding companies or divest AENB. In addition, the Company and its subsidiaries are prohibited by law from engaging in practices that the relevant regulatory authority deems unsafe or unsound (which such authorities generally interpret broadly). +6 +Table of Contents +Acquisitions and Investments +Applicable federal and state laws place limitations on the ability of persons to invest in or acquire control of us without providing notice to or obtaining the approval of one or more of our regulators. In addition, we are subject to banking laws and regulations that limit our investments and acquisitions and, in some cases, subject them to the prior review and approval of our regulators, including the Federal Reserve and the OCC. Federal banking regulators have broad discretion in evaluating proposed acquisitions and investments that are subject to their prior review or approval. +Financial Regulatory Reform +In October 2019, the U.S. federal bank regulatory agencies finalized rules that tailor the application of the enhanced prudential standards to bank holding companies and depository institutions (the Tailoring Rules) pursuant to the amendments to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank) introduced by the Economic Growth, Regulatory Relief, and Consumer Protection Act. The Tailoring Rules assign each U.S. bank holding company with $100 billion or more in total consolidated assets, as well as its bank subsidiaries, to one of four categories based on its status as a U.S. global systemically important banking organization and five other risk-based indicators: (i) size, (ii) cross-jurisdictional activity, (iii) non-bank assets, (iv) off-balance sheet exposure, and (v) weighted short-term wholesale funding. +Under the Tailoring Rules, the Company (and, pursuant to the Tailoring Rules, its depository institution subsidiary, AENB) is subject to Category IV standards. As a Category IV firm, the Company is, among other things, (i) no longer subject to the advanced approaches capital requirements, (ii) no longer subject to the supplementary leverage ratio (SLR), (iii) no longer subject to the countercyclical capital buffer, (iv) no longer subject to company-run stress testing requirements, (v) subject to supervisory stress testing on an every-other-year basis rather than an annual basis, and (vi) no longer subject to the requirement to prepare and submit a holding company-level resolution plan. In addition, as a Category IV firm with less than $50 billion in weighted short-term wholesale funding, the Company is no longer subject to the liquidity coverage ratio (LCR). +Because a firm’s categorization under the Tailoring Rules is determined by, and can change over time dependent upon, how the firm measures against the risk-based indicator thresholds, we are required to monitor and periodically report these risk-based indicators and there can be no assurance that the Company will continue to be a Category IV firm in the future. +Stress Testing and Capital Planning +Under the Federal Reserve’s regulations, the Company is subject to supervisory stress testing requirements that are designed to evaluate whether a bank holding company has sufficient capital on a total consolidated basis to absorb losses and support operations under adverse economic conditions. As a Category IV firm, the Company will be subject to the Federal Reserve’s supervisory stress tests every other year, beginning in 2020, rather than on an annual cycle. +We remain subject to the requirement to develop and submit to the Federal Reserve an annual capital plan. The Federal Reserve has stated it plans to propose changes, which would include providing firms subject to Category IV standards additional flexibility to develop their capital plans. As part of the Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve evaluates whether the Company has sufficient capital to continue operations by assessing our pro-forma capital position and ratios under a scenario of economic and financial market stress. Sufficient capital for these purposes is likely to require us to maintain capital ratios appreciably above applicable minimum requirements and buffers. +The Federal Reserve is expected to publish the decisions for all the bank holding companies participating in CCAR, including the reasons for any objection to capital plans, by June 30. In addition, the Federal Reserve will publish separately the results of its supervisory stress test under the supervisory severely adverse scenario. The information to be released will include, among other things, the Federal Reserve’s projection of company-specific information, including post-stress capital ratio information over the planning horizon. +We may be required to revise and resubmit our capital plan as required by the Federal Reserve following certain events, such as a significant acquisition. In addition to other limitations, our ability to make any capital distributions (including dividends and share repurchases) is contingent on the Federal Reserve’s non-objection to our capital plan. +Dividends and Other Capital Distributions +The Company and TRS, as well as AENB and the Company’s insurance and other regulated subsidiaries, are limited in their ability to pay dividends by statutes, regulations and supervisory policy. +Dividend payments by the Company to shareholders are subject to the oversight of the Federal Reserve. See “Stress Testing and Capital Planning.” Even if the Federal Reserve has not objected to a distribution, the Company may still not make a distribution +7 +Table of Contents +without Federal Reserve approval if, among other things, the Company would not meet a minimum regulatory capital ratio after giving effect to the capital distribution, changes in facts would require resubmission of our capital plan or the Company’s earnings are materially underperforming its projections in the capital plan. +In general, federal laws and regulations prohibit, without first obtaining the OCC’s approval, AENB from making dividend distributions to TRS, if such distributions are not paid out of available recent earnings or would cause AENB to fail to meet capital adequacy standards. In addition to specific limitations on the dividends AENB can pay to TRS, federal banking regulators have authority to prohibit or limit the payment of a dividend if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the institution. +Capital, Leverage and Liquidity Regulation +Capital Rules +The Company and AENB are required to comply with the applicable capital adequacy rules established by federal banking regulators. These rules are intended to ensure that bank holding companies and depository institutions (collectively, banking organizations) have adequate capital given their level of assets and off-balance sheet obligations. The federal banking regulators’ current capital rules (the Capital Rules) implement the Basel Committee on Banking Supervision’s (the Basel Committee) framework for strengthening international capital regulation, known as Basel III. For additional information regarding our capital ratios, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Under the Capital Rules, banking organizations are required to maintain minimum ratios for Common Equity Tier 1 (CET1), Tier 1 capital (that is, CET1 plus additional Tier 1 capital) and Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. Since 2014, we have reported our capital adequacy ratios on a parallel basis to federal banking regulators using both risk-weighted assets calculated under the Basel III standardized approach, as adjusted for certain items, and the requirements for an advanced approaches institution. As a Category IV firm, we are no longer subject to the Basel III advanced approaches capital requirements. +In December 2017, the Basel Committee published standards that, among other things, revise the standardized approach for credit risk (including by recalibrating risk weights and introducing additional capital requirements for certain “unconditionally cancellable commitments” such as unused credit card lines of credit) and provide a new standardized calculation for operational risk capital requirements. If adopted in the United States as issued by the Basel Committee and applicable to us, the new standards could result in higher capital requirements for us. +The Company and AENB must each maintain CET1, Tier 1 capital and Total capital ratios of at least 4.5 percent, 6.0 percent and 8.0 percent, respectively. The Capital Rules also implement a 2.5 percent capital conservation buffer composed entirely of CET1, on top of these minimum risk-weighted asset ratios. As a result, the minimum ratios are effectively 7.0 percent, 8.5 percent and 10.5 percent for the CET1, Tier 1 capital and Total capital ratios, respectively. +Federal banking regulators may further increase required minimum capital ratios by a countercyclical capital buffer composed entirely of CET1 up to 2.5 percent if they determine that such a buffer is necessary to protect the banking system from disorderly downturns associated with excessively expansionary periods. Under the Tailoring Rules, Category IV firms, such as the Company, would not be subject to such a countercyclical capital buffer. +Banking institutions whose ratio of CET1, Tier 1 Capital or Total capital to risk-weighted assets is above the minimum but below the capital conservation buffer will face constraints on discretionary distributions such as dividends, repurchases and redemptions of capital securities, and executive compensation based on the amount of the shortfall and the institution’s “eligible retained income” (that is, four quarter trailing net income, net of distributions and tax effects not reflected in net income). +The Federal Reserve proposed a rule in April 2018 that would, among other things, replace the static 2.5 percent capital conservation buffer with a stress capital buffer requirement for bank holding companies subject to the CCAR process. The stress capital buffer would reflect stressed losses in the supervisory severely adverse scenario of the Federal Reserve’s CCAR stress tests and would also include four quarters of planned common stock dividends. The proposal also included a stress leverage buffer requirement, similar to the stress capital buffer, which would apply to the Tier 1 leverage ratio. The proposal would require bank holding companies to reduce their planned capital distributions if those distributions would not be consistent with the applicable capital buffer constraints based on the bank holding companies’ own baseline scenario projections. The Federal Reserve has indicated that it intends to propose revisions to the stress buffer requirements that would be applicable to Category IV firms, such as the Company, to align with the two-year supervisory stress-testing cycle for Category IV bank holding companies. +8 +Table of Contents +Leverage Requirements +We are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its average total consolidated assets (as defined for regulatory purposes). All banking organizations are required to maintain a leverage ratio of at least 4.0 percent. +The Capital Rules also establish an SLR requirement for advanced approaches banking organizations. The SLR is the ratio of Tier 1 capital to an expanded concept of leverage exposure that includes both on-balance sheet and certain off-balance sheet exposures. The Capital Rules require a minimum SLR of 3.0 percent. As noted above, Category IV firms, such as the Company, are not subject to the SLR requirement under the Tailoring Rules. +Liquidity Regulation +The Federal Reserve’s enhanced prudential standards rule includes heightened liquidity and overall risk management requirements. The rule requires the maintenance of a liquidity buffer, consisting of highly liquid assets, that is sufficient to meet projected net outflows for 30 days over a range of liquidity stress scenarios, and a minimum LCR that measures a firm’s high-quality liquid assets to its projected net outflows. Under the Tailoring Rules, Category IV firms with less than $50 billion in weighted short-term wholesale funding, such as the Company, are no longer subject to any LCR requirement. +A second standard provided for in the Basel III liquidity framework, referred to as the net stable funding ratio (NSFR), requires a minimum amount of longer-term funding based on the assets and activities of banking entities. Although the NSFR has not been finalized, the Federal Reserve staff’s memorandum has indicated it will be applied in a manner consistent with the application of the LCR under the Tailoring Rules, provided a Category IV firm’s weighted short-term wholesale funding remains below $50 billion. +Prompt Corrective Action +The Federal Deposit Insurance Act (FDIA) requires, among other things, that federal banking regulators take prompt corrective action in respect of depository institutions insured by the FDIC (such as AENB) that do not meet minimum capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. In order to be considered “well capitalized,” AENB must maintain CET1, Tier 1 capital, Total capital and Tier 1 leverage ratios of 6.5 percent, 8.0 percent, 10.0 percent and 5.0 percent, respectively. +Under the FDIA, AENB could be prohibited from accepting brokered deposits (i.e., deposits raised through third-party brokerage networks) or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A significant amount of our outstanding U.S. retail deposits are considered brokered deposits for bank regulatory purposes. If a federal regulator determines that we are in an unsafe or unsound condition or that we are engaging in unsafe or unsound banking practices, the regulator may reclassify our capital category or otherwise place restrictions on our ability to accept or solicit brokered deposits. +In December 2019, the FDIC issued a proposed rule intended to update and modernize the FDIC’s brokered deposit regulations. The proposed rule, among other things, would revise the definition of “deposit broker” and the accompanying exceptions. +Resolution Planning +Pursuant to Dodd Frank, certain bank holding companies are required to submit resolution plans to the Federal Reserve and FDIC providing for the company’s strategy for rapid and orderly resolution in the event of its material financial distress or failure. However, in connection with the release of the Tailoring Rules, the Federal Reserve and FDIC finalized rules in October 2019 which, among other things, adjust the review cycles and applicability of the agencies’ resolution planning requirements. Under these new rules, Category IV firms such as the Company are no longer required to submit a holding company resolution plan. +AENB continues to be required to prepare and provide a separate resolution plan to the FDIC that would enable the FDIC, as receiver, to effectively resolve AENB under the FDIA in the event of failure. The FDIC has issued an Advance Notice of Proposed Rulemaking on potential revisions to this separate resolution plan requirement for insured depository institutions, and the next round of insured depository institution resolution plan submissions will not be required until the rulemaking process is complete. +9 +Table of Contents +Orderly Liquidation Authority +The Company could become subject to the Orderly Liquidation Authority (OLA), a resolution regime under which the Treasury Secretary may appoint the FDIC as receiver to liquidate a systemically important financial institution, if the Company is in danger of default and is determined to present a systemic risk to U.S. financial stability. As under the FDIC resolution model, under the OLA, the FDIC has broad power as receiver. Substantial differences exist, however, between the OLA and the FDIC resolution model for depository institutions, including the right of the FDIC under the OLA to disregard the strict priority of creditor claims in limited circumstances, the use of an administrative claims procedure to determine creditor claims (as opposed to the judicial procedure used in bankruptcy proceedings), and the right of the FDIC to transfer claims to a “bridge” entity. +The FDIC has developed a strategy under OLA, referred to as the “single point of entry” or “SPOE” strategy, under which the FDIC would resolve a failed financial holding company by transferring its assets (including shares of its operating subsidiaries) and, potentially, very limited liabilities to a “bridge” holding company; utilize the resources of the failed financial holding company to recapitalize the operating subsidiaries; and satisfy the claims of unsecured creditors of the failed financial holding company and other claimants in the receivership by delivering securities of one or more new financial companies that would emerge from the bridge holding company. Under this strategy, management of the failed financial holding company would be replaced and its shareholders and creditors would bear the losses resulting from the failure. +FDIC Powers upon Insolvency of AENB +If the FDIC is appointed the conservator or receiver of AENB, the FDIC has the power: (1) to transfer any of AENB’s assets and liabilities to a new obligor without the approval of AENB’s creditors; (2) to enforce the terms of AENB’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which AENB is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmation or repudiation of which is determined by the FDIC to promote the orderly administration of AENB. In addition, the claims of holders of U.S. deposit liabilities and certain claims for administrative expenses of the FDIC against AENB would be afforded priority over other general unsecured claims against AENB, including claims of debt holders and depositors in non-U.S. offices, in the liquidation or other resolution of AENB. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of AENB, the debt holders and depositors in non-U.S. offices would be treated differently from, and could receive substantially less, if anything, than the depositors in the U.S. offices of AENB. +Other Banking Regulations +Source of Strength +The Company is required to act as a source of financial and managerial strength to its U.S. bank subsidiary, AENB, and may be required to commit capital and financial resources to support AENB. Such support may be required at times when, absent this requirement, the Company otherwise might determine not to provide it. Capital loans by the Company to AENB are subordinate in right of payment to deposits and to certain other indebtedness of AENB. In the event of the Company’s bankruptcy, any commitment by the Company to a federal banking regulator to maintain the capital of AENB will be assumed by the bankruptcy trustee and entitled to a priority of payment. +Transactions Between AENB and its Affiliates +Certain transactions (including loans and credit extensions from AENB) between AENB and its affiliates (including the Company, TRS and their other subsidiaries) are subject to quantitative and qualitative limitations, collateral requirements and other restrictions imposed by statute and regulation. Transactions subject to these restrictions are generally required to be made on an arm’s-length basis. +FDIC Deposit Insurance and Insurance Assessments +AENB accepts deposits that are insured by the FDIC up to the applicable limits. Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices; is in an unsafe or unsound condition to continue operations; or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that might lead to termination of deposit insurance at AENB. The FDIC’s deposit insurance fund is funded by assessments on insured depository institutions, including AENB, which are subject to adjustment by the FDIC. +10 +Table of Contents +Community Reinvestment Act +AENB is subject to the CRA, which imposes affirmative, ongoing obligations on depository institutions to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. In December 2019, the OCC and FDIC issued a notice of proposed rulemaking intended to (i) clarify which activities qualify for CRA credit; (ii) update where activities count for CRA credit; and (iii) change the methods for CRA measurement, data collection, recordkeeping and reporting. +Consumer Financial Products Regulation +In the United States, our marketing, sale and servicing of consumer financial products and our compliance with certain federal consumer financial laws are supervised and examined by the CFPB, which has broad rulemaking and enforcement authority over providers of credit, savings and payment services and products, and authority to prevent “unfair, deceptive or abusive” acts or practices. In addition, a number of U.S. states have significant consumer credit protection, disclosure and other laws (in certain cases more stringent than U.S. federal laws). U.S. federal law also regulates abusive debt collection practices, which, along with bankruptcy and debtor relief laws, can affect our ability to collect amounts owed to us or subject us to regulatory scrutiny. +On May 7, 2019, the CFPB issued proposed rules that would set forth additional requirements for third-party debt collection agencies, which we use in the ordinary course of business. This proposal is not expected to result in final rules, if any, becoming effective before 2021. +We are also regulated in the United States under the “money transmitter” or “sale of check” laws in effect in most states. In addition, we are required by the laws of many states to comply with unclaimed and abandoned property laws, under which we must pay to states the face amount of any Travelers Cheque or prepaid card that is uncashed or unredeemed after a period of time depending on the type of product. +In countries outside the United States, regulators continue to focus on a number of key areas impacting our card-issuing businesses, particularly consumer protection (such as in the European Union (EU), the United Kingdom and Canada) and responsible lending (such as in Australia, Mexico, New Zealand and Singapore), with increasing importance on and attention to customers and outcomes rather than just ensuring compliance with local rules and regulations. Regulators’ expectations of firms in relation to their compliance, risk and control frameworks continue to increase and regulators are placing significant emphasis on a firm’s systems and controls relating to the identification and resolution of issues. +Payments Regulation +Legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through antitrust actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +The EU, Australia and other jurisdictions have focused on interchange fees (that is, the fee paid by the bankcard merchant acquirer to the card issuer in payment networks like Visa and Mastercard), as well as the rules, contract terms and practices governing merchant card acceptance. For example, in April 2019, the European Commission accepted commitments by Visa and Mastercard to significantly reduce inter-regional multilateral interchange fees. +Regulation and other governmental actions relating to pricing or practices could affect all networks directly or indirectly, as well as adversely impact consumers and merchants. Among other things, regulation of bankcard fees has negatively impacted and may continue to negatively impact the discount revenue we earn, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or the terms of card acceptance for merchants, and we have largely exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions, for example. +In various countries, such as certain Member States in the EU and Australia, merchants are permitted by law to surcharge card purchases. In addition, the laws of a number of states in the United States that prohibit surcharging have been challenged in litigation brought by merchant groups and some such laws have been overturned. Surcharging is an adverse customer experience and could have a material adverse effect on us if it becomes widespread, particularly where it only or disproportionately impacts our business. In addition, other steering practices that are permitted by regulation in some countries could also have a material adverse effect on us if they become widespread. See “ Surcharging or steering by merchants could materially adversely affect our business and results of operations ” under “Risk Factors.” +11 +Table of Contents +In Canada, regulators have prompted the major international card networks to make voluntary commitments on pricing, specifically interchange fee levels; as American Express does not operate with interchange fees in Canada, our commitments extend to maintaining current pricing practices and complying with certain other practices. +In some countries governments have established regulatory regimes that require international card networks to be locally licensed and/or to localize aspects of their operations. For example, the Reserve Bank of India, which has broad power under the Payment and Settlement Systems Act, 2007 to regulate the membership and operations of card networks, has issued a mandate requiring payment systems operators in India to store certain payments data locally. The development and enforcement of payment system regulatory regimes generally continue to grow and may adversely affect our ability to compete effectively and maintain and extend our global network. +Governments in some countries also provide resources or protection to select domestic payment card networks. The People’s Bank of China officially accepted our application for a business operating license to process domestic currency transactions through a joint venture in mainland China. There can be no assurance that we will receive such a license, or, if we do, that we will be able to successfully compete in China with domestic payment card networks and alternative payment providers. +Privacy, Data Protection, Information and Cyber Security +Regulatory and legislative activity in the areas of privacy, data protection and information and cyber security continues to increase worldwide. We have established and continue to maintain policies and a governance framework to comply with applicable privacy, data protection and information and cyber security laws, meet evolving customer expectations and support and enable business innovation and growth. +Our regulators are increasingly focused on ensuring that our privacy, data protection and information and cyber security-related policies and practices are adequate to inform customers of our data collection, use, sharing and/or security practices, to provide them with choices, if required, about how we use and share their information, and to appropriately safeguard their personal information and account access. Regulators are also focused on the policies and practices of our third-party vendors that may have access to our customer data or other information. +In the United States, certain of our businesses are subject to the privacy, disclosure and safeguarding provisions of the Gramm-Leach-Bliley Act (GLBA) and its implementing regulations and guidance. Among other things, GLBA imposes certain limitations on our ability to share consumers’ nonpublic personal information with nonaffiliated third parties and requires us to develop, implement and maintain a written comprehensive information security program containing safeguards that are appropriate to the size and complexity of our business, the nature and scope of our activities and the sensitivity of customer information that we process. Effective January 2020, the California Consumer Privacy Act requires us to offer expanded privacy rights to California residents who are not covered by GLBA. Various regulators, U.S. states and territories are considering similar requirements or have adopted laws, rules and regulations pertaining to privacy and/or information and cyber security that may be more stringent and/or expansive than federal requirements. +We are also subject to certain privacy, data protection and information and cyber security laws in other countries in which we operate (including countries in the EU, Australia, Canada, Japan, Hong Kong, India, Mexico, Singapore and the United Kingdom), some of which are more stringent and/or expansive than those in the United States. Some countries have also instituted laws requiring in-country data processing and/or in-country storage of data. Compliance with such laws could result in higher technology, administrative and other costs for us, could limit our ability to optimize the use of our closed-loop data, and could require use of local technology services. Some of these laws also require us to provide foreign governments broader access to our proprietary data and intellectual property. Data breach notification laws or regulatory activities to encourage breach notification are also becoming more prevalent in jurisdictions outside the United States in which we operate. +In Europe, the EU General Data Protection Regulation (GDPR) went into effect in May 2018 with significant fines for non-compliance (up to 4 percent of total annual worldwide revenue). It created additional legal and compliance obligations on companies that process personal data of individuals in the EU, irrespective of the geographical location of the company. We have made changes to our privacy practices to comply with these requirements, and continue to rely on our binding corporate rules as the primary method for lawfully transferring data from our European affiliates to our affiliates in the United States and elsewhere globally. The GDPR includes, among other things, a requirement for prompt notice of data breaches, in certain circumstances, to affected individuals and supervisory authorities. +In addition, the European Directive 2002/58/EC (the ePrivacy Directive) will continue to set out requirements for the processing of personal data and the protection of privacy in the electronic communications sector until the approval of the forthcoming ePrivacy Regulation. The ePrivacy Directive places restrictions on, among other things, the sending of unsolicited marketing communications, as well as on the collection and use of data about internet users. +12 +Table of Contents +The European Central Bank and the European Banking Authority have enacted secondary legislation focused on security breaches, outsourcing, strong customer authentication and information security-related policies. Likewise, a network and information security directive has been implemented into national laws by Member States in the EU. The Revised Payment Services Directive (PSD2) also contains regulatory requirements on strong customer authentication, open access to customer data and payment capabilities, and measures to prevent security incidents. +Anti-Money Laundering, Sanctions and Anti-Corruption Compliance +We are subject to significant supervision and regulation, and an increasingly stringent enforcement environment, with respect to compliance with anti-money laundering (AML), sanctions and anti-corruption laws and regulations in the United States and in other jurisdictions in which we operate. Failure to maintain and implement adequate programs and policies and procedures for AML, sanctions and anti-corruption compliance could have serious financial, legal and reputational consequences. +Anti-Money Laundering +American Express is subject to a significant number of AML laws and regulations as a result of being a financial company headquartered in the United States, as well as having a global presence. In the United States, the majority of AML requirements are derived from the Currency and Foreign Transactions Reporting Act and the accompanying regulations issued by the U.S. Department of the Treasury (collectively referred to as the Bank Secrecy Act), as amended by the USA PATRIOT Act of 2001 (the Patriot Act). In Europe, AML requirements are largely the result of countries transposing the 4th EU Anti-Money Laundering Directive (and preceding EU Anti-Money Laundering Directives) into local laws and regulations. EU Member States are required to implement the 5th and 6th EU Anti-Money Laundering Directives by January 10, 2020 and December 3, 2020, respectively. Numerous other countries, such as Argentina, Australia, Canada, India, Mexico, New Zealand and Russia, have also enacted or proposed new or enhanced AML legislation and regulations applicable to American Express. +Among other things, these laws and regulations require us to establish AML programs that meet certain standards, including, in some instances, expanded reporting, particularly in the area of suspicious transactions, and enhanced information gathering and recordkeeping requirements. Any errors, failures or delays in complying with federal, state or foreign AML and counter-terrorist financing laws could result in significant criminal and civil lawsuits, penalties and forfeiture of significant assets or other enforcement actions. +Office of Foreign Assets Control Regulation +The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. The United States prohibits U.S. persons from engaging with individuals and entities identified as “Specially Designated Nationals,” such as terrorists and narcotics traffickers. These prohibitions are administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) and are typically known as the OFAC rules. The OFAC rules prohibit U.S. persons from engaging in financial transactions with or relating to the prohibited individual, entity or country, require the blocking of assets in which the individual, entity or country has an interest, and prohibit transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons) to such individual, entity or country. Blocked assets (e.g., property or bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. We maintain a global sanctions program designed to ensure compliance with OFAC requirements. Failure to comply with such requirements could subject us to serious legal and reputational consequences, including criminal penalties. +Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) to the Securities Exchange Act of 1934, as amended (the Exchange Act), an issuer is required to disclose in its annual or quarterly reports, as applicable, whether it or any of its affiliates knowingly engaged in certain activities, transactions or dealings relating to Iran or with individuals or entities designated pursuant to certain Executive Orders. Disclosure is generally required even where the activities, transactions or dealings were conducted outside the United States by non-U.S. affiliates in compliance with applicable law, and whether or not the activities are sanctionable under U.S. law. +American Express Global Business Travel (GBT) and certain entities that may be considered affiliates of GBT have informed us that during the year ended December 31, 2019, approximately 30 visas were obtained from Iranian embassies and consulates around the world in connection with certain travel arrangements on behalf of clients and reservations were booked at one hotel that may be owned, directly or indirectly, or may otherwise be affiliated with, the Government of Iran. GBT had negligible gross revenues and net profits attributable to these transactions and intends to continue to engage in these activities on a limited basis so long as such activities are permitted under U.S. law. +13 +Table of Contents +Anti-Corruption +We are subject to complex international and U.S. anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act (the FCPA), the UK Bribery Act and other laws that prohibit the making or offering of improper payments. The FCPA makes it illegal to corruptly offer or provide anything of value to foreign government officials, political parties or political party officials for the purpose of obtaining or retaining business or an improper advantage. The FCPA also requires us to strictly comply with certain accounting and internal controls standards. In recent years, enforcement of the FCPA has become more intense. The UK Bribery Act also prohibits commercial bribery and the receipt of a bribe, and makes it a corporate offense to fail to prevent bribery by an associated person, in addition to prohibiting improper payments to foreign government officials. Failure of the Company, our subsidiaries, colleagues, contractors or agents to comply with the FCPA, the UK Bribery Act and other laws can expose us and/or individual colleagues to investigation, prosecution and potentially severe criminal and civil penalties. +Compensation Practices +Our compensation practices are subject to oversight by the Federal Reserve. The federal banking regulators’ guidance on sound incentive compensation practices sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation plans do not encourage imprudent risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should (1) provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks, (2) be compatible with effective internal controls and risk management, and (3) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in our compensation practices that are identified by the Federal Reserve or other banking regulators in connection with its review of our compensation practices may be incorporated into our supervisory ratings, which can affect our ability to make acquisitions or perform other actions. Enforcement actions may be taken against us if our incentive compensation arrangements or related risk-management control or governance processes are determined to pose a risk to our safety and soundness and we have not taken prompt and effective measures to correct the deficiencies. +In May 2016, the federal banking regulators, the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency and the National Credit Union Administration re-proposed a rule, originally proposed in 2011, on incentive-based compensation practices. The re-proposed rule would apply deferral, downward adjustment and forfeiture, and clawback requirements to incentive-based compensation arrangements granted to senior executive officers and significant risk-takers of covered institutions, with specific requirements varying based on the asset size of the covered institution and the category of employee. If these or other regulations are adopted in a form similar to what has been proposed, they will impose limitations on the manner in which we may structure compensation for our colleagues, which could adversely affect our ability to hire, retain and motivate key colleagues. +14 +Table of Contents +INFORMATION ABOUT OUR EXECUTIVE OFFICERS +Set forth below, in alphabetical order, is a list of our executive officers as of February 13, 2020, including each executive officer’s principal occupation and employment during the past five years and reflecting recent organizational changes. None of our executive officers has any family relationship with any other executive officer, and none of our executive officers became an officer pursuant to any arrangement or understanding with any other person. Each executive officer has been elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer’s age is indicated by the number in parentheses next to his or her name. +15 +Table of Contents +DOUGLAS E. BUCKMINSTER — Group President, Global Consumer Services Group +Mr. Buckminster (59) has been Group President, Global Consumer Services Group since February 2018. Prior thereto, he had been President, Global Consumer Services Group since October 2015 and President, Global Network and International Card Services since February 2012. +JEFFREY C. CAMPBELL — Chief Financial Officer +Mr. Campbell (59) has been Chief Financial Officer since August 2013. +MARC D. GORDON — Chief Information Officer +Mr. Gordon (59) has been Chief Information Officer since September 2012. +MONIQUE HERENA — Chief Colleague Experience Officer +Ms. Herena (48) has been Chief Colleague Experience Officer since April 2019. Ms. Herena joined American Express from BNY Mellon, where she served as the Chief Human Resources Officer and Senior Executive Vice President, Human Resources, Marketing and Communications since 2014. +RAYMOND JOABAR — Chief Risk Officer and President, Global Risk, Banking & Compliance +Mr. Joabar (54) has been Chief Risk Officer and President, Global Risk, Banking & Compliance since September 2019. Prior thereto, he had been President of International Consumer Services and Global Travel and Lifestyle Services since February 2018. He also served as Executive Vice President, Global Servicing Network from February 2016 to February 2018 and Executive Vice President, World Service from November 2015 to February 2016. Prior thereto, he had been Executive Vice President, Global Credit Administration from February 2014 to November 2015. +ANNA MARRS — President, Global Commercial Services +Ms. Marrs (46) has been President, Global Commercial Services since September 2018. Ms. Marrs joined American Express from Standard Chartered Bank, where she served as Regional CEO, ASEAN and South Asia since November 2016 and CEO, Commercial and Private Banking since October 2015. She joined Standard Chartered Bank as Group Head, Strategy and Corporate Development in January 2012. +DENISE PICKETT — President, Global Services Group +Ms. Pickett (54) has been President, Global Services Group since September 2019. Prior thereto, she had been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2018 and President, U.S. Consumer Services since October 2015. She also served as President, American Express OPEN from February 2014 to October 2015. +ELIZABETH RUTLEDGE — Chief Marketing Officer +Ms. Rutledge (58) has been Chief Marketing Officer since February 2018. Prior thereto, she had been Executive Vice President, Global Advertising & Media since February 2016 and Executive Vice President, Card Products & Benefits since May 2013. +LAUREEN E. SEEGER — Chief Legal Officer +Ms. Seeger (58) has been Chief Legal Officer since July 2014. +JENNIFER SKYLER — Chief Corporate Affairs Officer +Ms. Skyler (43) has been Chief Corporate Affairs Officer since October 2019. Ms. Skyler joined American Express from the We Company, where she had been Chief Communications Officer from January 2018 to September 2019. Prior thereto, she had been Global Head of Public Affairs from January 2016 to January 2018. Prior thereto, she had been Director, Consumer Communications at Facebook from December 2012 to December 2015. +STEPHEN J. SQUERI — Chairman and Chief Executive Officer +Mr. Squeri (60) has been Chairman and Chief Executive Officer since February 2018. Prior thereto, he had been Vice Chairman since July 2015. Prior thereto, he had been Group President, Global Corporate Services since November 2011. +ANRÉ WILLIAMS — Group President, Global Merchant and Network Services +Mr. Williams (54) has been Group President, Global Merchant and Network Services since February 2018. Prior thereto, he had been President of Global Merchant Services and Loyalty since October 2015 and President, Global Merchant Services since November 2011. +16 +Table of Contents +ADDITIONAL INFORMATION +We maintain an Investor Relations website at http://ir.americanexpress.com. We make available free of charge, on or through this website, our annual, quarterly and current reports and any amendments to those reports as soon as reasonably practicable following the time they are electronically filed with or furnished to the SEC. +In addition, we routinely post financial and other information, some of which could be material to investors, on our Investor Relations website. Information regarding our corporate responsibility and sustainability initiatives are available on our Corporate Responsibility website at http://about.americanexpress.com/corporate-responsibility. +The content of any of our websites referred to in this report is not incorporated by reference into this report or any other report filed with or furnished to the SEC. We have included such website addresses only as inactive textual references and do not intend them to be active links. +You can find certain statistical disclosures required of bank holding companies starting on page A-1, which are incorporated herein by reference. +Our business as a whole has not experienced significant seasonal fluctuations, although card billed business tends to be moderately higher in the fourth quarter than in other quarters. As a result, the amount of Card Member loans and receivables outstanding tend to be moderately higher during that quarter. 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2020-01-01 2020-03-31 0000004962 2019-10-01 2019-12-31 0000004962 2019-07-01 2019-09-30 0000004962 2019-04-01 2019-06-30 0000004962 2019-01-01 2019-03-31 +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +Form 10-K +☑ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31 , 2020 +OR +☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File No. 1-7657 +American Express Co mpany +(Exact name of registrant as specified in its charter) +New York 13-4922250 +(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) +200 Vesey Street +New York , New York +10285 +(Address of principal executive offices) (Zip Code) +Registrant’s telephone number, including area code: ( 212 ) 640-2000 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class Trading Symbol(s) Name of each exchange on which registered +Common Shares (par value $0.20 per Share) AXP New York Stock Exchange +Securities registered pursuant to section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes þ No o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer þ +Accelerated filer o +Non-accelerated filer o +Smaller reporting company ☐ +Emerging growth company ☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o +Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☑ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No þ +As of June 30, 2020, the aggregate market value of the registrant’s voting shares held by non-affiliates of the registrant was approximately $ 76.6 billion based on the closing sale price as reported on the New York Stock Exchange. +As of February 3, 2021, there were 805,588,980 common shares of the registrant outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III: Portions of Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Annual Meeting of Shareholders to be held on May 4, 2021. +Table of Contents +TABLE OF CONTENTS +Form 10-K +Item Number Page +PART I +1. +Business +1 +Competition +9 +Supervision and Regulation +11 +Additional Information +22 +1A. +Risk Factors +23 +1B. +Unresolved Staff Comments +38 +2. +Properties +38 +3. +Legal Proceedings +38 +4. +Mine Safety Disclosures +38 +PART II +5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +39 +6. +Selected Financial Data +41 +7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) +42 +Executive Overview +42 +Consolidated Results of Operations +45 +Business Segment Results of Operations +53 +Consolidated Capital Resources and Liquidity +62 +Off-Balance Sheet Arrangements and Contractual Obligations +70 +Risk Management +72 +Critical Accounting Estimates +80 +Other Matters +84 +7A. +Quantitative and Qualitative Disclosures about Market Risk +90 +8. +Financial Statements and Supplementary Data +90 +Management’s Report on Internal Control Over Financial Reporting +90 +Report of Independent Registered Public Accounting Firm +91 +Index to Consolidated Financial Statements +94 +Consolidated Financial Statements +95 +Notes to Consolidated Financial Statements +100 +9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +159 +9A. +Controls and Procedures +159 +9B. +Other Information +159 +Table of Contents +PART III +10. +Directors, Executive Officers and Corporate Governance +160 +11. +Executive Compensation +160 +12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +160 +13. +Certain Relationships and Related Transactions, and Director Independence +160 +14. +Principal Account ant Fees and Services +161 +PART IV +15. +Exhibit and Financial Statement Schedules +162 +16. +Form 10-K Summary +168 +Signatures +169 +Statistical Disclosure by Bank Holding Companies +A- 1 +This Annual Report on Form 10-K, including the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties. You can identify forward-looking statements by words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” “estimate,” “predict,” “potential,” “continue” or other similar expressions. We discuss certain factors that affect our business and operations and that may cause our actual results to differ materially from these forward-looking statements under “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements. +This report includes trademarks, such as American Express ® , which are protected under applicable intellectual property laws and are the property of American Express Company or its subsidiaries. This report also contains trademarks, service marks, copyrights and trade names of other companies, which are the property of their respective owners. Solely for convenience, our trademarks and trade names referred to in this report may appear without the ® or ™ symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the right of the applicable licensor to these trademarks and trade names. +Throughout this report the terms “American Express,” “we,” “our” or “us,” refer to American Express Company and its subsidiaries on a consolidated basis, unless stated or the context implies otherwise. The use of the term “partner” or “partnering” in this report does not mean or imply a formal legal partnership, and is not meant in any way to alter the terms of American Express’ relationship with any third parties. Refer to the “MD&A ― Glossary of Selected Terminology” for the definitions of other key terms used in this report. +Table of Contents +PART I +ITEM 1. BUSINESS +Overview +American Express is a globally integrated payments company that provides our customers with access to products, insights and experiences that enrich lives and build business success. We are a leader in providing credit and charge cards to consumers, small businesses, mid-sized companies and large corporations around the world. American Express ® cards issued by American Express as well as by third-party banks and other institutions on the American Express network permit Card Members to charge purchases of goods and services at the millions of merchants around the world that accept cards bearing our logo. +Our various products and services are sold globally to diverse customer groups through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams and direct response advertising. Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +We were founded in 1850 as a joint stock association and were incorporated in 1965 as a New York corporation. American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. (TRS), are bank holding companies under the Bank Holding Company Act of 1956, as amended (the BHC Act), subject to supervision and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). +We principally engage in businesses comprising three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses are included in Corporate & Other. Our businesses are global in scope and function together to form our end-to-end integrated payments platform, which we believe is a differentiator that underpins our business model. The COVID-19 pandemic has brought unprecedented challenges to businesses and economies around the world. While our business was significantly impacted by the pandemic in 2020 as further described in this report, we believe our progress in managing through it confirms the resilience of our differentiated business model. +For further information about our reportable operating segments, please see “Business Segment Results of Operations” under “MD&A.” +1 +Table of Contents +Our Integrated Payments Platform +Through our general-purpose card-issuing, merchant-acquiring and card network businesses, we are able to connect participants and provide differentiated value across the commerce path. We maintain direct relationships with both our Card Members (as a card issuer) and merchants (as an acquirer), and we handle all key aspects of those relationships. These relationships create a “closed loop” in that we have direct access to information at both ends of the card transaction, which distinguishes our integrated payments platform from the bankcard networks. +Our integrated payments platform allows us to analyze information on Card Member spending and build algorithms and other analytical tools that we use to underwrite risk, reduce fraud and provide targeted marketing and other information services for merchants and special offers and services to Card Members, all while respecting Card Member preferences and protecting Card Member and merchant data in compliance with applicable policies and legal requirements. Through contractual relationships, we also obtain information from third-party card issuers, merchant acquirers, aggregators and processors with whom we do business. +Card Issuing Businesses +Our global proprietary card-issuing businesses are conducted through our GCSG and GCS reportable operating segments. We offer a broad set of card products, rewards and services to a diverse consumer and commercial customer base, in the United States and internationally. We acquire and retain high-spending, engaged and creditworthy Card Members by: +• Designing innovative products and features that appeal to our target customer base and meet their spending and borrowing needs +• Using incentives to drive spending on our various card products and engender loyal Card Members, including our Membership Rewards ® program, cash-back reward features and participation in loyalty programs sponsored by our cobrand and other partners +• Providing digital and mobile services and an array of benefits and experiences across card products, such as airport lounge access and other travel and lifestyle benefits, which we believe are difficult for others to replicate and help increase Card Member engagement +• Creating world-class service experiences by delivering exceptional customer care +• Developing a wide range of partner relationships, including with other corporations and institutions that sponsor certain of our cards under cobrand arrangements and provide benefits and services to our Card Members +During 2020, we enhanced our value propositions on many of our card products, including adjusting our rewards programs and adding limited time offers and statement credits in categories that are relevant in the current environment, such as wireless, streaming services, business essentials and food delivery. We also created a Customer Pandemic Relief Program to provide short-term support for customers impacted by COVID-19, and we enhanced and expanded our longer-term Financial Relief Program for Card Members who need additional financial assistance during this time. Additionally, we participated in the U.S. Small Business Administration Paycheck Protection Program (PPP), designed to provide small businesses with support to cover payroll and certain other expenses. +For the year ended December 31, 2020, worldwide proprietary billed business (spending on American Express cards issued by us) was $870.7 billion and at December 31, 2020, we had 68.9 million proprietary cards-in-force worldwide. +Merchant Acquiring Business +Our GMNS reportable operating segment builds and manages relationships with millions of merchants around the world that choose to accept American Express cards. This includes signing new merchants to accept our cards, agreeing on the discount rate (a fee charged to the merchant for accepting our cards) and handling servicing for merchants. We also build and maintain relationships with merchant acquirers, aggregators and processors to manage aspects of our merchant services business. For example, through our OptBlue ® merchant-acquiring program, third-party acquirers contract directly with small merchants for card acceptance on our network and determine merchant pricing. We continue to grow merchant acceptance of American Express cards around the world and work with merchant partners so that our Card Members are warmly welcomed and encouraged to spend in the millions of places where their American Express cards are accepted. +2 +Table of Contents +GMNS also provides fraud-prevention tools, marketing solutions, data analytics and other programs and services to merchants and other partners that leverage the capabilities of our integrated payments platform. +During 2020, we adjusted certain policies to back our merchant partners in the current environment, including raising contactless transaction thresholds and reminding them that we do not require Card Members’ signatures at the point of sale. We also launched our largest-ever Shop Small campaign to support small businesses around the world, which have been significantly impacted by the pandemic. +Card Network Business +We operate a payments network through which we establish and maintain relationships with third-party banks and other institutions in approximately 98 countries and territories, licensing the American Express brand and extending the reach of our global network. These network partners are licensed to issue local currency American Express-branded cards in their countries and/or serve as the merchant acquirer for local merchants on our network. +During 2020, our joint venture with Lianlian DigiTech Co., Ltd, a Chinese fintech services company, received approval from the People’s Bank of China for a network clearing license and began processing transactions in mainland China. +For the year ended December 31, 2020, worldwide network services billed business (spending on American Express cards issued by third parties) was $139.9 billion and at December 31, 2020, we had 43.1 million cards-in-force issued by third parties worldwide. +Diverse Customer Base and Global Footprint +Our broad and diverse customer base spans consumers, small businesses, mid-sized companies and large corporations around the world. The following charts provide a summary of our diverse set of customers and broad geographic footprint based on billed business volumes: +3 +Table of Contents +Partners and Relationships +Our integrated payments platform allows us to work with a range of business partners, and our partners in return help drive the scale and relevance of the platform. +There are many examples of how we connect partners with our integrated payments platform, including: issuing cards under cobrand arrangements with other corporations and institutions (e.g., Delta Air Lines, Marriott International, Hilton Worldwide Holdings and British Airways); offering innovative ways for our Card Members to earn and use points with our merchants (e.g., Pay with Points at Amazon.com); expanding merchant acceptance with third-party acquirers (e.g., OptBlue partners); developing new capabilities and features with our digital partners (e.g., PayPal); integrating into the supplier payment processes of our business customers (e.g., Bill.com, SAP Ariba and Coupa); and extending the platform into travel services with American Express leisure and business travel (e.g., Fine Hotels and Resorts). +Delta Air Lines is our largest strategic partner. Our relationships with, and revenues and expenses related to, Delta are significant and represent a significant source of value for our Card Members. We issue cards under cobrand arrangements with Delta and the Delta cobrand portfolio represented approximately 9 percent of our worldwide billed business and approximately 21 percent of worldwide Card Member loans as of December 31, 2020. The Delta cobrand portfolio generates fee revenue and interest income from Card Members and discount revenue from Delta and other merchants for spending on Delta cobrand cards. The current Delta cobrand agreement runs through the end of 2029 and we expect to continue to make significant investments in this partnership. Among other things, Delta is also a key participant in our Membership Rewards program, provides travel-related benefits and services, including airport lounge access for certain American Express Card Members, accepts American Express cards as a merchant and is a corporate payments customer. +Working with all of our partners, we seek to provide value, choice and unique experiences across our customer base. +Our Spend-Centric Model and Revenue Mix +Our “spend-centric” business model focuses on generating revenues primarily by driving spending on our cards and secondarily through finance charges and fees. Spending on our cards, which is higher on average on a per-card basis versus our competitors, offers superior value to merchants in the form of loyal customers and larger transactions. Because of the revenues generated from having high-spending Card Members and the annual card fees we charge on many of our products, we are able to invest in attractive rewards and other benefits for Card Members, as well as targeted marketing and other programs and investments for merchants. This creates incentives for Card Members to spend more on their cards and positively differentiates American Express cards. +We believe our spend-centric model gives us the ability to provide differentiated value to Card Members, merchants and business partners. +The American Express Brand and Service Excellence +Our brand and its attributes—trust, security and service—are key assets. We invest heavily in managing, marketing, promoting and protecting our brand, including through the delivery of our products and services in a manner consistent with our brand promise. The American Express brand is consistently ranked as one of the most valuable brands in the world. We place significant importance on trademarks, service marks and patents, and seek to secure our intellectual property rights around the world. +We aim to provide the world’s best customer experience every day and our reputation for world-class service has been recognized by numerous awards over the years. Our customer care professionals and partners treat servicing interactions as an opportunity to bring the brand to life for our customers, add meaningful value and deepen relationships. +4 +Table of Contents +Our Business Strategies +Our framework for managing through the pandemic and the challenging economic environment is built on four principles: supporting our colleagues and winning as a team; protecting our customers and our brand; structuring the company for growth in the future; and remaining financially strong. We remain focused on what we can control in the short term while identifying opportunities across our businesses to position ourselves for growth in the longer term. And we seek to grow our business over the longer term by focusing on four strategic imperatives: +First, we aim to expand our leadership in the premium consumer space by continuing to deliver membership benefits that span our customers’ everyday spending, borrowing, travel and lifestyle needs, expanding our roster of business partners around the globe and developing a range of experiences that attract high-spending customers. +Second, we seek to build on our strong position in commercial payments by evolving our card value propositions, further differentiating our corporate card and accounts payable expense management solutions and designing innovative products and features, including financing and supplier payment solutions for our business customers. +Third, we are focused on strengthening our global network to provide unique value by continuing to help merchants navigate the convergence of online and offline commerce with fraud protection services, marketing insights and digital connections to higher-spending Card Members and continuing to work with our network partners to offer expanded products and services. +Finally, we want to continue to make American Express an essential part of our customers’ digital lives by developing more digital features, solutions and services, expanding our digital partnerships and making targeted acquisitions. +5 +Table of Contents +Our Colleagues +We are committed to delivering a great colleague experience every day, cultivating the best talent and developing new ways of working to unlock enterprise value. We work to foster an inclusive and diverse culture and help our colleagues thrive both professionally and personally. When we do, our colleagues are more engaged, committed, creative and effective in driving results. At the heart of our culture is what we call our Blue Box Values – a set of guiding principles that reflect who we are and what we stand for. In 2020, we updated our Blue Box Values to be more explicit about our efforts to create an inclusive and diverse workforce: +We Back Our Customers We Embrace Diversity +We Make It Great We Stand for Inclusion +We Do What's Right We Win as A Team +We Respect People We Support Our Communities +We take a holistic approach to serving our colleagues by offering them a variety of resources that support their physical, financial, emotional, social and overall well-being. Throughout the pandemic, one of our top priorities has been to ensure our colleagues have the flexibility and resources they need to stay safe, healthy and productive. +As of December 31, 2020, we employed approximately 63,700 people, whom we refer to as colleagues, with approximately 22,700 colleagues in the United States and approximately 41,000 colleagues outside the United States. We conduct an annual Colleague Experience Survey to better understand our colleagues’ needs and overall experience at American Express and in 2020, 94 percent of colleagues who participated in the survey said they would recommend American Express as a great place to work. Our 2020 annual company scorecard included talent retention and diversity representation goals to globally increase minority and women representation at management levels and retain our key talent. As of December 31, 2020, female colleagues comprised 52 percent of our global workforce and Asian, Black/African American and Hispanic/Latinx people represented 19.7 percent, 12.0 percent and 13.0 percent, respectively, of our U.S. workforce based on preliminary data for our 2020 U.S. EEO-1 submission. +We regularly review our compensation practices to ensure colleagues in the same job, level and location are compensated fairly regardless of gender globally, and race and ethnicity in the United States. These reviews consider several factors known to affect compensation, including role, level, tenure, performance and geography. In the few instances where a review has found inconsistencies, we have made adjustments. After making these adjustments, we believe we achieved 100 percent pay equity in 2020 for colleagues across genders globally and across races and ethnicities in the United States. +6 +Table of Contents +Information About Our Executive Officers +Set forth below, in alphabetical order, is a list of our executive officers as of February 12, 2021, including each executive officer’s principal occupation and employment during the past five years and reflecting recent organizational changes. None of our executive officers has any family relationship with any other executive officer, and none of our executive officers became an officer pursuant to any arrangement or understanding with any other person. Each executive officer has been elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer’s age is indicated by the number in parentheses next to his or her name. +7 +Table of Contents +DOUGLAS E. BUCKMINSTER — Group President, Global Consumer Services Group +Mr. Buckminster (60) has been Group President, Global Consumer Services Group since February 2018. Prior thereto, he had been President, Global Consumer Services Group since October 2015. +JEFFREY C. CAMPBELL — Chief Financial Officer +Mr. Campbell (60) has been Chief Financial Officer since August 2013. +MARC D. GORDON — Chief Information Officer +Mr. Gordon (60) has been Chief Information Officer since September 2012. +MONIQUE HERENA — Chief Colleague Experience Officer +Ms. Herena (49) has been Chief Colleague Experience Officer since April 2019. Ms. Herena joined American Express from BNY Mellon, where she served as the Chief Human Resources Officer and Senior Executive Vice President, Human Resources, Marketing and Communications since 2014. +RAYMOND JOABAR — Chief Risk Officer and President, Global Risk & Compliance +Mr. Joabar (55) has been Chief Risk Officer and President, Global Risk & Compliance since September 2019. Prior thereto, he had been President of International Consumer Services and Global Travel and Lifestyle Services since February 2018. He also served as Executive Vice President, Global Servicing Network from February 2016 to February 2018 and Executive Vice President, World Service from November 2015 to February 2016. +ANNA MARRS — President, Global Commercial Services +Ms. Marrs (47) has been President, Global Commercial Services since September 2018. Ms. Marrs joined American Express from Standard Chartered Bank, where she served as Regional CEO, ASEAN and South Asia since November 2016 and CEO, Commercial and Private Banking since October 2015. +DENISE PICKETT — President, Global Services Group +Ms. Pickett (55) has been President, Global Services Group since September 2019. Prior thereto, she had been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2018 and President, U.S. Consumer Services since October 2015. +ELIZABETH RUTLEDGE — Chief Marketing Officer +Ms. Rutledge (59) has been Chief Marketing Officer since February 2018. Prior thereto, she had been Executive Vice President, Global Advertising & Media since February 2016 and Executive Vice President, Card Products & Benefits since May 2013. +LAUREEN E. SEEGER — Chief Legal Officer +Ms. Seeger (59) has been Chief Legal Officer since July 2014. +JENNIFER SKYLER — Chief Corporate Affairs Officer +Ms. Skyler (44) has been Chief Corporate Affairs Officer since October 2019. Ms. Skyler joined American Express from The We Company, where she had been Chief Communications Officer from January 2018 to September 2019. Prior thereto, she had been Global Head of Public Affairs from January 2016 to January 2018. +STEPHEN J. SQUERI — Chairman and Chief Executive Officer +Mr. Squeri (61) has been Chairman and Chief Executive Officer since February 2018. Prior thereto, he had been Vice Chairman since July 2015. +ANRÉ WILLIAMS — Group President, Global Merchant and Network Services +Mr. Williams (55) has been Group President, Global Merchant and Network Services since February 2018. Prior thereto, he had been President of Global Merchant Services and Loyalty since October 2015. +8 +Table of Contents +COMPETITION +We compete in the global payments industry with card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and Automated Clearing House, or ACH), as well as evolving and growing alternative mechanisms, systems and products that leverage new technologies, business models and customer relationships to create payment or financing solutions. The payments industry continues to undergo dynamic changes in response to evolving technologies, consumer habits and merchant needs, some of which have accelerated as a result of the pandemic, such as an increased shift to e-commerce and demand for contactless payments. +As a card issuer, we compete with financial institutions that issue general-purpose credit and debit cards. We also encounter competition from businesses that issue private label cards, operate mobile wallets or extend credit. We face intense competition for cobrand relationships, as both card issuer and network competitors have targeted key business partners with attractive value propositions. +Our global card network competes in the global payments industry with other card networks, including, among others, China UnionPay, Visa, Mastercard, JCB, Discover and Diners Club International (which is owned by Discover). We are the fourth largest general-purpose card network globally based on purchase volume, behind China UnionPay, Visa and Mastercard. In addition to such networks, a range of companies globally, including merchant acquirers, processors and web- and mobile-based payment platforms (e.g., Alipay, PayPal and Venmo), as well as regional payment networks (such as the National Payments Corporation of India), carry out some activities similar to those performed by our GMNS business. +The principal competitive factors that affect the card-issuing, merchant and network businesses include: +• The features, value and quality of the products and services, including customer care, rewards programs, partnerships, benefits and digital and mobile services, and the costs associated with providing such features and services +• Reputation and brand recognition +• The number, spending characteristics and credit performance of customers +• The quantity, diversity and quality of the establishments where the cards can be used +• The attractiveness of the value proposition to card issuers, merchant acquirers, cardholders, corporate clients and merchants (including the relative cost of using or accepting the products and services, and capabilities such as fraud prevention and data analytics) +• The number and quality of other cards and other forms of payment and financing available to customers +• The success of marketing and promotional campaigns +• The speed of innovation and investment in systems, technologies, and product and service offerings +• The nature and quality of expense management tools, electronic payment methods and data capture and reporting capabilities, particularly for business customers +• The security of cardholder, merchant and network partner information +Another aspect of competition is the dynamic and rapid growth of alternative payment and financing mechanisms, systems and products, which include payment aggregators, digital payment and electronic wallet platforms, point-of-sale lenders, real-time settlement and processing systems, financial technology companies, digital currencies developed by both governments and the private sector, blockchain and similar distributed ledger technologies, prepaid systems and gift cards, and systems linked to customer accounts or that provide payment solutions. Various competitors are integrating more financial services into their product offerings and competitors are seeking to attain the benefits of closed-loop, loyalty and rewards functionalities, such as ours. +9 +Table of Contents +In addition to the discussion in this section, see “ Our operating results may materially suffer because of substantial and increasingly intense competition worldwide in the payments industry ” in “Risk Factors” for further discussion of the potential impact of competition on our business, and “ Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition” and “ Legal proceedings regarding provisions in our merchant contracts, including non-discrimination and honor-all-cards provisions, could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand ” in “Risk Factors” for a discussion of the potential impact on our ability to compete effectively due to government regulations or if ongoing legal proceedings limit our ability to prevent merchants from engaging in various actions to discriminate against our card products. +10 +Table of Contents +SUPERVISION AND REGULATION +Overview +We are subject to extensive government regulation and supervision in jurisdictions around the world, and the costs of compliance are substantial. The financial services industry is subject to rigorous scrutiny, high regulatory expectations, a range of regulations and a stringent and unpredictable enforcement environment. +Governmental authorities have focused, and we believe will continue to focus, considerable attention on reviewing compliance by financial services firms with laws and regulations, and as a result, we continually work to evolve and improve our risk management framework, governance structures, practices and procedures. Reviews to assess compliance with laws and regulations by governmental authorities, as well as our own internal reviews, have resulted in, and are likely to continue to result in, changes to our products, practices and procedures, restitution to our customers and increased costs related to regulatory oversight, supervision and examination. We have also been subject to regulatory actions and may continue to be the subject of such actions, including governmental inquiries, investigations, enforcement proceedings and the imposition of fines or civil money penalties, in the event of noncompliance or alleged noncompliance with laws or regulations. In addition, legislators and regulators in various countries in which we operate have focused on the offering of consumer financial products and the operation of payment networks, resulting in changes to certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, the establishment of broad and ongoing regulatory oversight regimes. +See “Risk Factors—Legal, Regulatory and Compliance Risks” for a discussion of the potential impact legislative and regulatory changes may have on our results of operations and financial condition. +Banking Regulation +Federal and state banking laws, regulations and policies extensively regulate the Company (which, for purposes of this section, refers to American Express Company as a bank holding company), TRS and our U.S. bank subsidiary, American Express National Bank (AENB). Both the Company and TRS are subject to comprehensive consolidated supervision, regulation and examination by the Federal Reserve and AENB is supervised, regulated and examined by the Office of the Comptroller of the Currency (OCC). The Company and its subsidiaries are also subject to the rulemaking, enforcement and examination authority of the Consumer Financial Protection Bureau (CFPB). Banking regulators have broad examination and enforcement power, including the power to impose substantial fines, limit dividends and other capital distributions, restrict operations and acquisitions and require divestitures, any of which could compromise our competitive position. Many aspects of our business also are subject to rigorous regulation by other U.S. federal and state regulatory agencies and by non-U.S. government agencies and regulatory bodies. +Activities +The BHC Act generally limits bank holding companies to activities that are considered to be banking activities and certain closely related activities. As noted above, each of the Company and TRS is a bank holding company and each has elected to become a financial holding company, which is authorized to engage in a broader range of financial and related activities. In order to remain eligible for financial holding company status, we must meet certain eligibility requirements. Those requirements include that each of the Company and AENB must be “well capitalized” and “well managed,” and AENB must have received at least a “satisfactory” rating on its most recent assessment under the Community Reinvestment Act of 1977 (the CRA). The Company and TRS engage in various activities permissible only for financial holding companies, including, in particular, providing travel agency services, acting as a finder and engaging in certain insurance underwriting and agency services. If the Company fails to meet eligibility requirements for financial holding company status, it and its subsidiaries are likely to be barred from engaging in new types of financial activities or making certain types of acquisitions or investments in reliance on its status as a financial holding company, and ultimately could be required to either discontinue the broader range of activities permitted to financial holding companies or divest AENB. In addition, the Company and its subsidiaries are prohibited by law from engaging in practices that the relevant regulatory authority deems unsafe or unsound (which such authorities generally interpret broadly). +11 +Table of Contents +Acquisitions and Investments +Applicable federal and state laws place limitations on the ability of persons to invest in or acquire control of us without providing notice to or obtaining the approval of one or more of our regulators. In addition, we are subject to banking laws and regulations that limit our investments and acquisitions and, in some cases, subject them to the prior review and approval of our regulators, including the Federal Reserve and the OCC. Federal banking regulators have broad discretion in evaluating proposed acquisitions and investments that are subject to their prior review or approval. +Financial Regulatory Reform +In October 2019, the U.S. federal bank regulatory agencies finalized rules that tailor the application of the enhanced prudential standards to bank holding companies and depository institutions (the Tailoring Rules) pursuant to the amendments to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank) introduced by the Economic Growth, Regulatory Relief, and Consumer Protection Act. The Tailoring Rules assign each U.S. bank holding company with $100 billion or more in total consolidated assets, as well as its bank subsidiaries, to one of four categories based on its status as a U.S. global systemically important banking organization and five other risk-based indicators: (i) size, (ii) cross-jurisdictional activity, (iii) non-bank assets, (iv) off-balance sheet exposure, and (v) weighted short-term wholesale funding. +Under the Tailoring Rules, the Company (and, pursuant to the Tailoring Rules, its depository institution subsidiary, AENB) is subject to Category IV standards. +Because a firm’s categorization under the Tailoring Rules is determined by, and can change over time dependent upon, how the firm measures against the risk-based indicator thresholds, we are required to monitor and periodically report these risk-based indicators and there can be no assurance that the Company will continue to be a Category IV firm in the future. +Capital and Liquidity Regulation +Capital Rules +The Company and AENB are required to comply with the applicable capital adequacy rules established by federal banking regulators. These rules are intended to ensure that bank holding companies and depository institutions (collectively, banking organizations) have adequate capital given their level of assets and off-balance sheet obligations. The federal banking regulators’ current capital rules (the Capital Rules) implement the Basel Committee on Banking Supervision’s (the Basel Committee) framework for strengthening international capital regulation, known as Basel III. For additional information regarding our capital ratios, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Under the Capital Rules, banking organizations are required to maintain minimum ratios for Common Equity Tier 1 (CET1), Tier 1 capital (that is, CET1 plus additional Tier 1 capital) and Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. We report our capital adequacy ratios using risk-weighted assets calculated under the standardized approach. As a Category IV firm, we are not subject to the advanced approaches capital requirements. +In December 2017, the Basel Committee published standards that, among other things, revise the standardized approach for credit risk (including by recalibrating risk weights and introducing additional capital requirements for certain “unconditionally cancellable commitments” such as unused credit card lines of credit) and provide a new standardized calculation for operational risk capital requirements. If adopted in the United States as issued by the Basel Committee and applicable to us, the new standards could result in higher capital requirements for us. +In December 2018, federal banking regulators issued a final rule that provides an optional three-year phase-in period for the adverse regulatory capital effects of adopting the Current Expected Credit Loss (CECL) methodology pursuant to new accounting guidance for the recognition of credit losses on certain financial instruments, which became effective January 1, 2020. In August 2020, federal banking regulators issued a final rule that provides an option to delay the estimated impact of the adoption of the CECL methodology on regulatory capital for up to two years, followed by the three-year phase-in period. We elected to adopt the two-year delay followed by the three-year phase-in period. Therefore, the Company will begin phasing in the cumulative amount that is not recognized in regulatory capital at 25 percent per year beginning January 1, 2022. See "Critical Accounting Estimates" under "MD&A" for additional information on CECL. +12 +Table of Contents +The Company and AENB must each maintain CET1, Tier 1 capital and Total capital ratios of at least 4.5 percent, 6.0 percent and 8.0 percent, respectively. On top of these minimum capital ratios, the Company is subject to a dynamic stress capital buffer (SCB) composed entirely of CET1 with a floor of 2.5 percent and AENB is subject to a static 2.5 percent capital conservation buffer (CCB). The SCB equals (i) the difference between a bank holding company’s starting and minimum projected CET1 capital ratios under the supervisory severely adverse scenario under the Federal Reserve's stress tests described below, plus (ii) one year of planned common stock dividends as a percentage of risk-weighted assets. +In August 2020, the SCB requirement for the Company was set at 2.5 percent. A bank holding company’s SCB requirement is generally effective on October 1 of each year and will remain in effect through September 30 of the following year unless it is reset in connection with resubmission of a capital plan, as discussed below. As a result, the effective minimum ratios for the Company (taking into account the SCB requirement) and AENB (taking into account the CCB requirement) are 7.0 percent, 8.5 percent and 10.5 percent for the CET1, Tier 1 capital and Total capital ratios, respectively. Banking organizations whose ratios of CET1, Tier 1 Capital or Total capital to risk-weighted assets are below these effective minimum ratios face constraints on discretionary distributions such as dividends, repurchases and redemptions of capital securities, and executive compensation. The capital distribution restrictions for the first quarter of 2021 discussed under “Stress Testing and Capital Planning” below are in addition to the SCB distribution constraints for bank holding companies at least through March 31, 2021. The Federal Reserve is expected to announce by March 31, 2021 any recalibration of the SCB requirements announced in August 2020. +We are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its average total consolidated assets (as defined for regulatory purposes). All banking organizations are required to maintain a leverage ratio of at least 4.0 percent. +Liquidity Regulation +The Federal Reserve’s enhanced prudential standards rule includes heightened liquidity and overall risk management requirements. The rule requires the maintenance of a liquidity buffer, consisting of highly liquid assets, that is sufficient to meet projected net outflows for 30 days over a range of liquidity stress scenarios, and a minimum liquidity coverage ratio (LCR) that measures a firm’s high-quality liquid assets to its projected net outflows. Under the Tailoring Rules, Category IV firms with less than $50 billion in weighted short-term wholesale funding, such as the Company, are not subject to any LCR requirement. +A second standard provided for in the Basel III liquidity framework, referred to as the net stable funding ratio (NSFR), requires a minimum amount of longer-term funding based on the assets and activities of banking entities. Under the final NSFR rule published in October 2020, Category IV firms with less than $50 billion in weighted short-term wholesale funding, such as the Company, are not subject to any NSFR requirement. +Stress Testing and Capital Planning +Under the Federal Reserve’s regulations, the Company is subject to supervisory stress testing requirements that are designed to evaluate whether a bank holding company has sufficient capital on a total consolidated basis to absorb losses and support operations under adverse economic conditions. As a Category IV firm, the Company was subject to the Federal Reserve’s supervisory stress tests in 2020 and will be required to participate in the supervisory stress tests every other year thereafter. +We are required to develop and submit to the Federal Reserve an annual capital plan. In January 2021, the Federal Reserve finalized changes to the capital plan rule, which will, among other things, provide firms subject to Category IV standards additional flexibility to develop their capital plans. In addition, these changes provide that for Category IV firms, such as the Company, the portion of the SCB based on the Federal Reserve's supervisory stress tests will be calculated every other year. During a year in which a Category IV firm does not undergo a supervisory stress test, the firm will receive an updated SCB that reflects the firm's updated planned common stock dividends. A Category IV firm will also be able to elect to participate in the supervisory stress test and consequently receive an updated SCB. The Company must notify the Federal Reserve by April 5, 2021 if it elects to participate in the 2021 supervisory stress test. As part of the Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve evaluates whether the Company has sufficient capital to continue operations by assessing our pro-forma capital position and ratios under a scenario of economic and financial market stress, and uses that information to determine the size of the SCB for each CCAR participating firm. +13 +Table of Contents +Due to the continued economic uncertainty from the coronavirus pandemic, in June 2020, the Federal Reserve required all bank holding companies participating in CCAR to resubmit their capital plans in November 2020. In addition, the Federal Reserve prohibited share repurchases in the third and fourth quarters of 2020 for all bank holding companies participating in CCAR and allowed them to pay common stock dividends provided (a) they did not increase the amount of the dividend and (b) the dividends did not exceed the average of a firm’s net income for the four preceding calendar quarters. On December 18, 2020, the Federal Reserve released the results of its second round of supervisory stress tests for all bank holding companies participating in CCAR based on economic scenarios reflecting changes in financial markets and the macroeconomic outlook. The Federal Reserve announced that it would allow bank holding companies participating in CCAR to pay common stock dividends and repurchase common stock in the first quarter of 2021 provided (a) the dividends and repurchases, in the aggregate, do not exceed the average of a firm’s net income for the four preceding calendar quarters and (b) the firm does not increase the amount of its common stock dividends beyond the level paid in the second quarter of 2020. The Federal Reserve also announced that it would permit stock repurchases equal to the amount of share issuances related to expensed employee compensation. For additional information regarding our capital distributions, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +We may be required to revise and resubmit our capital plan following certain events or developments, such as a significant acquisition or an event that could result in a material change in our risk profile or financial condition. If we are required to resubmit our capital plan, we must receive prior approval from the Federal Reserve for any capital distributions (including common stock dividend payments and share repurchases), other than a capital distribution on a newly issued capital instrument. +Dividends and Other Capital Distributions +The Company and TRS, as well as AENB and the Company’s insurance and other regulated subsidiaries, are limited in their ability to pay dividends by statutes, regulations and supervisory policy. +Common stock dividend payments and share repurchases by the Company are subject to the oversight of the Federal Reserve, as described above. The Company will be subject to limitations and restrictions on capital distributions if, among other things, (i) the Company's regulatory capital ratios do not satisfy applicable minimum requirements and buffers or (ii) the Company is required to resubmit its capital plan. +In general, federal laws and regulations prohibit, without first obtaining the OCC’s approval, AENB from making dividend distributions to TRS, if such distributions are not paid out of available recent earnings or would cause AENB to fail to meet capital adequacy standards. In addition to specific limitations on the dividends AENB can pay to TRS, federal banking regulators have authority to prohibit or limit the payment of a dividend if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the institution. +Prompt Corrective Action +The Federal Deposit Insurance Act (FDIA) requires, among other things, that federal banking regulators take prompt corrective action in respect of depository institutions insured by the FDIC (such as AENB) that do not meet minimum capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. In order to be considered “well capitalized,” AENB must maintain CET1, Tier 1 capital, Total capital and Tier 1 leverage ratios of 6.5 percent, 8.0 percent, 10.0 percent and 5.0 percent, respectively. +Under the FDIA, AENB could be prohibited from accepting brokered deposits (i.e., deposits raised through third-party brokerage networks) or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A portion of our outstanding U.S. retail deposits are considered brokered deposits for bank regulatory purposes. If a federal regulator determines that we are in an unsafe or unsound condition or that we are engaging in unsafe or unsound banking practices, the regulator may reclassify our capital category or otherwise place restrictions on our ability to accept or solicit brokered deposits. +On December 15, 2020, the FDIC finalized a rule intended to update and modernize the FDIC’s brokered deposit regulations. The final rule, among other things, expands the definition of “deposit broker” and updates the interest rate restrictions for less than well capitalized banks. The final rule is expected to become effective on April 1, 2021. +14 +Table of Contents +Resolution Planning +Pursuant to Dodd Frank, certain bank holding companies are required to submit resolution plans to the Federal Reserve and FDIC providing for the company’s strategy for rapid and orderly resolution in the event of its material financial distress or failure. However, in connection with the release of the Tailoring Rules, the Federal Reserve and FDIC finalized rules in October 2019 which, among other things, adjust the review cycles and applicability of the agencies’ resolution planning requirements. Under these rules, Category IV firms such as the Company are not required to submit a holding company resolution plan. +AENB continues to be required to prepare and provide a separate resolution plan to the FDIC that would enable the FDIC, as receiver, to effectively resolve AENB under the FDIA in the event of failure. The FDIC issued an Advance Notice of Proposed Rulemaking on potential revisions to this separate resolution plan requirement for insured depository institutions in April 2019 and temporarily suspended resolution planning requirements for insured depository institutions. In January 2021, the FDIC lifted the moratorium on resolution plan submissions for insured depository institutions with $100 billion or more in assets, including AENB, and will provide at least 12-months advance notice to firms required to submit resolution plans. +Orderly Liquidation Authority +The Company could become subject to the Orderly Liquidation Authority (OLA), a resolution regime under which the Treasury Secretary may appoint the FDIC as receiver to liquidate a systemically important financial institution, if the Company is in danger of default and is determined to present a systemic risk to U.S. financial stability. As under the FDIC resolution model, under the OLA, the FDIC has broad power as receiver. Substantial differences exist, however, between the OLA and the FDIC resolution model for depository institutions, including the right of the FDIC under the OLA to disregard the strict priority of creditor claims in limited circumstances, the use of an administrative claims procedure to determine creditor claims (as opposed to the judicial procedure used in bankruptcy proceedings), and the right of the FDIC to transfer claims to a “bridge” entity. +The FDIC has developed a strategy under OLA, referred to as the “single point of entry” or “SPOE” strategy, under which the FDIC would resolve a failed financial holding company by transferring its assets (including shares of its operating subsidiaries) and, potentially, very limited liabilities to a “bridge” holding company; utilize the resources of the failed financial holding company to recapitalize the operating subsidiaries; and satisfy the claims of unsecured creditors of the failed financial holding company and other claimants in the receivership by delivering securities of one or more new financial companies that would emerge from the bridge holding company. Under this strategy, management of the failed financial holding company would be replaced and its shareholders and creditors would bear the losses resulting from the failure. +FDIC Powers upon Insolvency of AENB +If the FDIC is appointed the conservator or receiver of AENB, the FDIC has the power: (1) to transfer any of AENB’s assets and liabilities to a new obligor without the approval of AENB’s creditors; (2) to enforce the terms of AENB’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which AENB is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmation or repudiation of which is determined by the FDIC to promote the orderly administration of AENB. In addition, the claims of holders of U.S. deposit liabilities and certain claims for administrative expenses of the FDIC against AENB would be afforded priority over other general unsecured claims against AENB, including claims of debt holders and depositors in non-U.S. offices, in the liquidation or other resolution of AENB. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of AENB, the debt holders and depositors in non-U.S. offices would be treated differently from, and could receive substantially less, if anything, than the depositors in the U.S. offices of AENB. +15 +Table of Contents +Other Banking Regulations +Source of Strength +The Company is required to act as a source of financial and managerial strength to its U.S. bank subsidiary, AENB, and may be required to commit capital and financial resources to support AENB. Such support may be required at times when, absent this requirement, the Company otherwise might determine not to provide it. Capital loans by the Company to AENB are subordinate in right of payment to deposits and to certain other indebtedness of AENB. In the event of the Company’s bankruptcy, any commitment by the Company to a federal banking regulator to maintain the capital of AENB will be assumed by the bankruptcy trustee and entitled to a priority of payment. +Transactions Between AENB and its Affiliates +Certain transactions (including loans and credit extensions from AENB) between AENB and its affiliates (including the Company, TRS and their other subsidiaries) are subject to quantitative and qualitative limitations, collateral requirements and other restrictions imposed by statute and regulation. Transactions subject to these restrictions are generally required to be made on an arm’s-length basis. +FDIC Deposit Insurance and Insurance Assessments +AENB accepts deposits that are insured by the FDIC up to the applicable limits. Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices; is in an unsafe or unsound condition to continue operations; or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that would lead to termination of deposit insurance at AENB. The FDIC’s deposit insurance fund is funded by assessments on insured depository institutions, including AENB, which are subject to adjustment by the FDIC. +Community Reinvestment Act +AENB is subject to the CRA, which imposes affirmative, ongoing obligations on depository institutions to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. In May 2020, the OCC issued a final rule intended to (i) clarify which activities qualify for CRA credit; (ii) update where activities count for CRA credit; and (iii) change the methods for CRA measurement, data collection, recordkeeping and reporting for national banks and federal savings associations. The final rule retains the current community development test for limited purpose banks, such as AENB, which evaluates a bank’s community development performance through its community development loans, investments and services. The final rule requires institutions like AENB to designate additional geographic assessment areas where CRA activities will be measured for significant concentrations of retail domestic deposits. AENB must comply with the final rule by January 1, 2023. +Consumer Financial Products Regulation +In the United States, our marketing, sale and servicing of consumer financial products and our compliance with certain federal consumer financial laws are supervised and examined by the CFPB, which has broad rulemaking and enforcement authority over providers of credit, savings and payment services and products, and authority to prevent “unfair, deceptive or abusive” acts or practices. In addition, a number of U.S. states have significant consumer credit protection, disclosure and other laws (in certain cases more stringent than U.S. federal laws). U.S. federal law also regulates abusive debt collection practices, which, along with bankruptcy and debtor relief laws, can affect our ability to collect amounts owed to us or subject us to regulatory scrutiny. +On October 30, 2020, the CFPB issued a final rule that sets forth additional requirements for third-party debt collection agencies, which we use in the ordinary course of business. See " We are exposed to credit risk and trends that affect Card Member spending and the ability of customers and partners to pay us, which could have a material adverse effect on our results of operations and financial condition " under "Risk Factors" for potential impacts related to legal and regulatory changes on our ability to collect amounts owed to us. +We are also regulated in the United States under the “money transmitter” or “sale of check” laws in effect in most states. In addition, we are required by the laws of many states to comply with unclaimed and abandoned property laws, under which we must pay to states the face amount of any Travelers Cheque or prepaid card that is uncashed or unredeemed after a period of time depending on the type of product. +16 +Table of Contents +In countries outside the United States, regulators continue to focus on a number of key areas impacting our card-issuing businesses, particularly consumer protection (such as in the European Union (EU), the United Kingdom and Canada) and responsible lending (such as in Australia, Mexico, New Zealand and Singapore), with increasing importance on and attention to customers and outcomes rather than just ensuring compliance with local rules and regulations. Regulators’ expectations of firms in relation to their compliance, risk and control frameworks continue to increase and regulators are placing significant emphasis on a firm’s systems and controls relating to the identification and resolution of issues. +Payments Regulation +Legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through enforcement actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +The EU, Australia and other jurisdictions have focused on interchange fees (that is, the fee paid by the bankcard merchant acquirer to the card issuer in payment networks like Visa and Mastercard), as well as the rules, contract terms and practices governing merchant card acceptance. +Regulation and other governmental actions relating to pricing or practices could affect all networks directly or indirectly, as well as adversely impact consumers and merchants. Among other things, regulation of bankcard fees has negatively impacted and may continue to negatively impact the discount revenue we earn, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or the terms of card acceptance for merchants, and we have exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions, for example. In addition, there is uncertainty as to when or how interchange fee caps and other provisions of the EU payments legislation might apply when we work with cobrand partners and agents in the EU. Given differing interpretations by regulators and participants in cobrand arrangements, we are subject to regulatory action, penalties and the possibility we will not be able to maintain our existing cobrand and agent relationships in the EU. +In various countries, such as certain Member States in the EU and Australia, merchants are permitted by law to surcharge card purchases. In addition, the laws of a number of states in the United States that prohibit surcharging have been challenged in litigation brought by merchant groups and some such laws have been overturned. Surcharging is an adverse customer experience and could have a material adverse effect on us if it becomes widespread, particularly where it only or disproportionately impacts credit card usage, our Card Members or our business. In addition, other steering or differential acceptance practices that are permitted by regulation in some countries could also have a material adverse effect on us if they become widespread. See “ Surcharging or steering by merchants could materially adversely affect our business and results of operations ” under “Risk Factors.” +In some countries, governments have established regulatory regimes that require international card networks to be locally licensed and/or to localize aspects of their operations. For example, the Reserve Bank of India, which has broad power under the Payment and Settlement Systems Act, 2007 to regulate the membership and operations of card networks, has issued a mandate requiring payment systems operators in India to store certain payments data locally. Governments in some countries also provide resources or protection to select domestic payment card networks. The development and enforcement of these and other similar laws, regulations and policies may adversely affect our ability to compete effectively and maintain and extend our global network. +Privacy, Data Protection, Data Governance, Information and Cyber Security +Regulatory and legislative activity in the areas of privacy, data protection, data governance and information and cyber security continues to increase worldwide. We have established and continue to maintain policies and a governance framework to comply with applicable privacy, data protection, data governance and information and cyber security laws and requirements, meet evolving customer and industry expectations and support and enable business innovation and growth. +Our regulators are increasingly focused on ensuring that our privacy, data protection, data governance and information and cyber security-related policies and practices are adequate to inform customers of our data collection, use, sharing and/or security practices, to provide them with choices, if required, about how we use and share their information, and to appropriately safeguard their personal information and account access. Regulators are also focused on data management, data governance and our third-party risk management policies and practices. +17 +Table of Contents +In the United States, certain of our businesses are subject to the privacy, disclosure and safeguarding provisions of the Gramm-Leach-Bliley Act (GLBA) and its implementing regulations and guidance. Among other things, GLBA imposes certain limitations on our ability to share consumers’ nonpublic personal information with nonaffiliated third parties and requires us to develop, implement and maintain a written comprehensive information security program containing safeguards that are appropriate to the size and complexity of our business, the nature and scope of our activities and the sensitivity of customer information that we process. We are required to offer expanded privacy rights to California residents who are not covered by GLBA, pursuant to the California Consumer Privacy Act. Various regulators, U.S. states and territories are considering similar requirements or have adopted laws, rules and regulations pertaining to privacy and/or information and cyber security that may be more stringent and/or expansive than federal requirements. +We are also subject to certain privacy, data protection, data governance and information and cyber security laws in other countries in which we operate (including countries in the EU, Australia, Canada, China, Japan, Hong Kong, India, Mexico, Singapore and the United Kingdom), some of which are more stringent and/or expansive than those in the United States. Some countries have also instituted laws requiring in-country data processing and/or in-country storage of data. Compliance with such laws could result in higher technology, administrative and other costs for us, could limit our ability to optimize the use of our closed-loop data, and could require use of local technology services. Certain laws also require us to provide foreign governments and other third parties broader access to our data and intellectual property. Data breach and operational outage notification laws or regulatory activities to encourage such notifications are also becoming more prevalent in jurisdictions outside the United States in which we operate. +In Europe, the EU General Data Protection Regulation (GDPR) imposes legal and compliance obligations on companies that process personal data of individuals in the EU, irrespective of the geographical location of the company, with significant fines for non-compliance (up to 4 percent of total annual worldwide revenue). We continue to rely on our binding corporate rules as the primary method for lawfully transferring data from our European affiliates to our affiliates in the United States and elsewhere globally. The GDPR includes, among other things, a requirement for prompt notice of data breaches, in certain circumstances, to affected individuals and supervisory authorities. +The GDPR was transposed into UK domestic law in January 2021 following the United Kingdom's exit from the EU. This is known as the UK GDPR and it supplements the United Kingdom's Data Protection Act of 2018. The UK GDPR mirrors the compliance requirements and fine structure of the GDPR. +In addition, the European Directive 2002/58/EC (the ePrivacy Directive) will continue to set out requirements for the processing of personal data and the protection of privacy in the electronic communications sector until the approval of the forthcoming ePrivacy Regulation. The ePrivacy Directive places restrictions on, among other things, the sending of unsolicited marketing communications, as well as on the collection and use of data about internet users. +The European Central Bank and the European Banking Authority have enacted or are considering secondary legislation focused on security breaches, outsourcing, resiliency, strong customer authentication and information security-related policies. Likewise, a network and information security directive has been implemented into national laws by Member States in the EU. The Revised Payment Services Directive (PSD2) also contains regulatory requirements on strong customer authentication, open access to customer data and payment capabilities, and measures to prevent security incidents. +18 +Table of Contents +Anti-Money Laundering, Sanctions and Anti-Corruption Compliance +We are subject to significant supervision and regulation, and an increasingly stringent enforcement environment, with respect to compliance with anti-money laundering (AML), sanctions and anti-corruption laws and regulations in the United States and in other jurisdictions in which we operate. Failure to maintain and implement adequate programs and policies and procedures for AML, sanctions and anti-corruption compliance could have material financial, legal and reputational consequences. +Anti-Money Laundering +American Express is subject to a significant number of AML laws and regulations as a result of being a financial company headquartered in the United States, as well as having a global presence. In the United States, the majority of AML requirements are derived from the Currency and Foreign Transactions Reporting Act and the accompanying regulations issued by the U.S. Department of the Treasury (collectively referred to as the Bank Secrecy Act), as amended by the USA PATRIOT Act of 2001 (the Patriot Act). The Anti-Money Laundering Act of 2020 (the AMLA), enacted in January 2021, amended the Bank Secrecy Act and is intended to comprehensively reform and modernize U.S. AML laws. Many of the statutory provisions in the AMLA will require additional rulemakings, reports and other measures, the effects of which are not known at this time. In Europe, AML requirements are largely the result of countries transposing the 5th and 6th EU Anti-Money Laundering Directives (and preceding EU Anti-Money Laundering Directives) into local laws and regulations. Numerous other countries, such as Argentina, Australia, Canada, India, Mexico, New Zealand and Russia, have also enacted or proposed new or enhanced AML legislation and regulations applicable to American Express. +Among other things, these laws and regulations require us to establish AML programs that meet certain standards, including, in some instances, expanded reporting, particularly in the area of suspicious transactions, and enhanced information gathering and recordkeeping requirements. Our AML programs have become the subject of heightened scrutiny in some countries. Any errors, failures or delays in complying with federal, state or foreign AML and counter-terrorist financing laws or perceived deficiencies in our AML programs could result in significant criminal and civil lawsuits, penalties and forfeiture of significant assets or other enforcement actions. +19 +Table of Contents +Office of Foreign Assets Control Regulation +The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. The United States prohibits U.S. persons from engaging with individuals and entities identified as “Specially Designated Nationals,” such as terrorists and narcotics traffickers. These prohibitions are administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) and are typically known as the OFAC rules. The OFAC rules prohibit U.S. persons from engaging in financial transactions with or relating to the prohibited individual, entity or country, require the blocking of assets in which the individual, entity or country has an interest, and prohibit transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons) to such individual, entity or country. Blocked assets (e.g., property or bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. We maintain a global sanctions program designed to ensure compliance with OFAC requirements. Failure to comply with such requirements could subject us to serious legal and reputational consequences, including criminal penalties. +Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) to the Securities Exchange Act of 1934, as amended (the Exchange Act), an issuer is required to disclose in its annual or quarterly reports, as applicable, whether it or any of its affiliates knowingly engaged in certain activities, transactions or dealings relating to Iran or with individuals or entities designated pursuant to certain Executive Orders. Disclosure is generally required even where the activities, transactions or dealings were conducted outside the United States by non-U.S. affiliates in compliance with applicable law, and whether or not the activities are sanctionable under U.S. law. +In 2020, we became aware of credit card accounts opened with American Express International, Inc. (Hong Kong branch) by the Acting Consul General of the Iranian Consulate in Hong Kong, and his predecessor, the now-former Consul General. We believe these cards were used only for personal expenses. The Acting Consul General had two cards, both of which were opened in 2018 and one of which was closed by client request on or about April 3, 2019, and the other of which was cancelled by us on or about June 16, 2020. The former Consul General’s card was issued in January 2019 and cancelled by us on or about March 13, 2019. We had negligible gross revenues and net profits attributable to these accounts. As all of the accounts were cancelled, we do not intend to continue to engage in this activity. +20 +Table of Contents +Anti-Corruption +We are subject to complex international and U.S. anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act (the FCPA), the UK Bribery Act and other laws that prohibit the making or offering of improper payments. The FCPA makes it illegal to corruptly offer or provide anything of value to foreign government officials, political parties or political party officials for the purpose of obtaining or retaining business or an improper advantage. The FCPA also requires us to strictly comply with certain accounting and internal controls standards. The UK Bribery Act also prohibits commercial bribery and the receipt of a bribe, and makes it a corporate offense to fail to prevent bribery by an associated person, in addition to prohibiting improper payments to foreign government officials. Failure of the Company, our subsidiaries, colleagues, contractors or agents to comply with the FCPA, the UK Bribery Act and other similar laws can expose us and/or individual colleagues to investigation, prosecution and potentially severe criminal and civil penalties. +Compensation Practices +Our compensation practices are subject to oversight by the Federal Reserve. The federal banking regulators’ guidance on sound incentive compensation practices sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation plans do not encourage imprudent risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should (1) provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks, (2) be compatible with effective internal controls and risk management, and (3) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in our compensation practices that are identified by the Federal Reserve or other banking regulators in connection with their review of our compensation practices may be incorporated into our supervisory ratings, which can affect our ability to make acquisitions or perform other actions. Enforcement actions may be taken against us if our incentive compensation arrangements or related risk-management control or governance processes are determined to pose a risk to our safety and soundness, and we have not taken prompt and effective measures to correct the deficiencies. +In May 2016, the federal banking regulators, the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency and the National Credit Union Administration re-proposed a rule, originally proposed in 2011, on incentive-based compensation practices. The re-proposed rule would apply deferral, downward adjustment and forfeiture, and clawback requirements to incentive-based compensation arrangements granted to senior executive officers and significant risk-takers of covered institutions, with specific requirements varying based on the asset size of the covered institution and the category of employee. If these or other regulations are adopted in a form similar to what has been proposed, they will impose limitations on the manner in which we may structure compensation for our colleagues, which could adversely affect our ability to hire, retain and motivate key colleagues. +21 +Table of Contents +ADDITIONAL INFORMATION +We maintain an Investor Relations website at http://ir.americanexpress.com. We make available free of charge, on or through this website, our annual, quarterly and current reports and any amendments to those reports as soon as reasonably practicable following the time they are electronically filed with or furnished to the SEC. +In addition, we routinely post financial and other information, some of which could be material to investors, on our Investor Relations website. Information regarding our corporate responsibility and sustainability initiatives, including our Environmental, Social and Governance reports, are available on our Corporate Responsibility website at http://about.americanexpress.com/corporate-responsibility. +The content of any of our websites referred to in this report is not incorporated by reference into this report or any other report filed with or furnished to the SEC. We have included such website addresses only as inactive textual references and do not intend them to be active links. +You can find certain statistical disclosures required of bank holding companies starting on page A-1, which are incorporated herein by reference. +Our business as a whole has not experienced significant seasonal fluctuations, although card billed business tends to be moderately higher in the fourth quarter than in other quarters. As a result, the amount of Card Member loans and receivables outstanding tend to be moderately higher during that quarter. The average discount rate also tends to be slightly lower during the fourth quarter due to a higher level of retail-related billed business volumes. +22 +Table of Contents +ITEM 1A. RISK FACTORS +This section highlights certain risks that could affect us and our businesses, broadly categorized as “Strategic, Business and Competitive Risks,” “Legal, Regulatory and Compliance Risks” and “Credit, Liquidity and Market Risks.” You should carefully consider each of the following risks and all of the other information set forth in this Annual Report on Form 10-K, including the “Risk Management” section under “MD&A,” which describes our approach to identifying, monitoring and managing the risks we assume in conducting our businesses and provides certain quantitative and qualitative disclosures about market risks. The risks and uncertainties we face are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. +Strategic, Business and Competitive Risks +The impact of the COVID-19 pandemic and the measures implemented to contain the spread of the virus have had, and are expected to continue to have, a material adverse impact on our business and results of operations. +The COVID-19 pandemic is having widespread, rapidly evolving and unpredictable impacts on global society, economies, financial markets and business practices. The pandemic and containment measures have contributed to, among other things: +• Widespread changes to, and significant reductions in, household and business activity and consumer and business spending, as well as economic concerns and a rise in unemployment. +• Adverse impacts on our cobrand and other partners in the travel and airline industries, our GBT JV and on our third-party service providers, merchants, customer acquisition channels, processors, aggregators, network partners and other third parties that we rely on for services that are integral to our operations. +• Adverse impacts on the creditworthiness of our customers and other counterparties and their ability to pay amounts owed to us and our ability to collect such amounts and required increases in our reserves for credit losses. +• Adverse impacts on industries representing a significant portion of our billed business (including, but not limited to, travel and entertainment (T&E) spending). +• Adverse impacts on capital and credit market conditions and our deposit base, which may limit our access to funding, increase our cost of capital, and affect our ability to meet liquidity needs. +• An increased risk of significantly higher Card Member reimbursements for goods or services purchased from merchants that cease operations or are otherwise unable to ultimately provide those goods or services or, in the case of our business partners, impairments of rewards points we purchased from those partners. +• An increased strain on our risk management policies generally, including, but not limited to, the effectiveness and accuracy of our models, given the lack of data inputs and comparable precedent. +• An increased risk of impairment, restructuring or other charges, including as a result of impairment of the value of our investments and other assets. +• Adverse impacts on our daily business operations and our colleagues’ ability to perform necessary business functions, including as a result of illness, office closures and other limitations, or restrictions on movement. +• Increased challenges in growing or retaining our Card Member base and in launching new products or businesses or refreshing existing products in line with expectations or the current and changing needs of our customers. +• Increased spending on our business continuity efforts, such as technology, service centers and our supply chain, and readiness efforts for returning to our offices, which may in turn require that we further cut costs and investments in other areas. +• An increased risk of an information or cyber security incident, fraud, a failure to maintain the uninterrupted operation of our information systems or a failure in the effectiveness of our AML and other compliance programs due to, among other things, an increase in remote work. +These and other impacts of the COVID-19 pandemic may continue even after the outbreak has subsided and containment measures are lifted, and may exacerbate many of the other risks described in this “Risk Factors” section. The extent to which our business and results of operations will continue to be adversely affected will depend on numerous evolving factors and future developments that we are not able to predict, including the continued spread and severity of the virus and new variants; the imposition of further containment measures and their ability to control the spread of the virus; the availability, distribution and use of effective treatments and vaccines; the extent and duration of the effect on the economy, unemployment, consumer confidence and consumer and business spending; the availability and effectiveness of government stimulus measures; and how quickly and to what extent normal operating conditions and customer behaviors resume, such as with respect to travel, dining and in-person events. +Difficult conditions in the business and economic environment, including as a result of the COVID-19 pandemic, have had and are expected to continue to have a material adverse effect on our business and results of operations. +We offer a broad array of products and services to consumers, small businesses and commercial clients and thus are very dependent upon the level of consumer and business activity and the demand for payment and financing products. Slow +23 +Table of Contents +economic growth, economic contraction or shifts in broader consumer and business trends significantly impact customer behaviors, including spending on our cards, the ability and willingness of Card Members to borrow and pay amounts owed to us, and demand for fee-based products and services. Factors such as consumer spending and confidence, unemployment rates, business investment, geopolitical instability, public policy decisions, government spending, international trade relationships, interest rates, taxes, energy costs, the volatility and strength of the capital markets, inflation and deflation all affect the economic environment and, ultimately, our profitability. Such factors may also cause our earnings, billings, loan balances, credit metrics and margins to fluctuate and diverge from expectations of analysts and investors, who may have differing assumptions regarding their impact on our business, adversely affecting, and/or increasing the volatility of, the trading price of our common shares. +Spending at T&E merchants, for example, is sensitive to business and personal discretionary spending levels and circumstances impacting travel. We experienced the effects of this sensitivity in 2020 as a result of the COVID-19 pandemic, with T&E spending decreasing 61 percent compared to 2019, while non-T&E spending decreased 1 percent. Likewise, spending by small businesses and corporate clients, which comprised approximately 40 percent of our worldwide billed business during 2020, depends in part on the economic environment and a favorable climate for continued business investment and new business formation, as well as on related volumes of business travel. During the pandemic, Card Member billed business decreased 19 percent in 2020 compared to 2019. +Increases in delinquencies and write-off rates as a result of increases in bankruptcies, unemployment rates, changes in customer behaviors or otherwise could also have a material adverse effect on our results of operations. We increased our reserves for credit losses significantly in 2020 due to the deterioration of the global macroeconomic outlook. +The consequences of negative circumstances impacting us or the environment generally can be sudden and severe, as we experienced from the end of the first quarter into the second quarter of 2020 due to the pandemic. +Our business is subject to the effects of geopolitical events, weather, natural disasters, other catastrophic events and other conditions. +Geopolitical events, terrorist attacks, natural disasters, severe weather conditions, health pandemics, information or cyber security incidents (including intrusion into or degradation of systems or technology by cyberattacks) and other catastrophic events can have a material adverse effect on our business. Political and social conditions, fiscal and monetary policies, trade wars and tariffs, prolonged or recurring government shutdowns, regional or domestic hostilities and the prospect or occurrence of more widespread conflicts could also negatively affect consumer and business spending, including travel patterns and business investment, and demand for credit. +As noted above, the COVID-19 pandemic has had, and is expected to continue to have, a material adverse impact on our business and results of operations. Because of our proximity to the World Trade Center site, our headquarters were damaged as a result of the terrorist attacks of September 11, 2001. Recent hurricanes and other natural disasters have impacted spending and credit performance in the areas affected. Other disasters or catastrophic events in the future, and the impact of such events on certain industries or the overall economy, could have a negative effect on our business, results of operations and infrastructure, including our technology and systems. Climate change may exacerbate certain of these threats, including the frequency and severity of weather-related events. Card Members in California, New York, Florida, Texas, Georgia and New Jersey account for a significant portion of U.S. Consumer billed business and Card Members loans, and our results of operations could be impacted by events or conditions that disproportionately or specifically affect one or more of those states. +Because we derive a portion of our revenues from travel-related spending, our business is sensitive to safety concerns related to travel and tourism, limitations on travel and mobility, and health-related risks, including travel restrictions and bans as a result of the COVID-19 pandemic and changes in customer behaviors that may continue even after the outbreak has subsided and containment measures are lifted, such as decisions to delay or forgo business or personal travel. In addition, disruptions in air travel and other forms of travel can result in the payment of claims under travel interruption insurance policies we offer. +The exit of the United Kingdom from the European Union could materially adversely impact our business, results of operations and financial condition. +Our business in the United Kingdom and elsewhere may be negatively impacted by the exit of the United Kingdom from the EU (commonly referred to as Brexit), including from a deterioration of the economic environment in the United Kingdom and other countries in which we operate. While a trade deal was agreed to between the United Kingdom and the EU at the end of 2020, the financial, trade and legal implications of Brexit remain uncertain. As of December 31, 2020, the United Kingdom constituted approximately 4 percent of our worldwide billed business and the EMEA (Europe, Middle East and Africa) region as a whole constituted approximately 9 percent. +Our operating results may materially suffer because of substantial and increasingly intense competition worldwide in the payments industry. +24 +Table of Contents +The payments industry is highly competitive, and we compete with card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and ACH), as well as evolving and growing alternative payment and financing providers. If we are not able to differentiate ourselves from our competitors, develop compelling value propositions for our customers and/or effectively grow in areas such as mobile and online payments and emerging technologies, we may not be able to compete effectively. +We believe Visa and Mastercard are larger than we are in most countries based on billed business volumes. As a result, card issuers and acquirers on the Visa and Mastercard networks may be able to benefit from the dominant position, scale, resources, marketing and pricing of those networks. Our business may also be negatively affected if we are unable to continue increasing merchant acceptance (including by merchants that accept cards on the Visa and Mastercard networks) and perceptions of coverage, or if our Card Members do not experience welcome acceptance of our cards. +Some of our competitors have developed, or may develop, substantially greater financial and other resources than we have and may offer richer value propositions or a wider range of programs and services than we offer or may use more effective advertising, marketing or cross-selling strategies to acquire and retain more customers, capture a greater share of spending and borrowings, establish and develop more attractive cobrand card and other partner programs and maintain greater merchant acceptance than we have. We may not be able to compete effectively against these threats or respond or adapt to changes in consumer spending habits as effectively as our competitors. Costs such as Card Member rewards and Card Member services expenses could continue to increase as we improve our value propositions for Card Members, including in response to increased competition. +Spending on our cards could continue to be impacted by increasing consumer usage of credit and debit cards issued on other networks, as well as adoption of alternative payment mechanisms, systems and products. The fragmentation of customer spending to take advantage of different merchant or card incentives or for convenience with technological solutions may continue to increase. Revolving credit balances on our cards could also be impacted by alternative financing providers, such as point-of-sale lenders. To the extent other payment and financing mechanisms, systems and products continue to successfully expand, our discount revenues earned from Card Member spending and our net interest income earned from Card Member borrowing could be negatively impacted. In addition, companies that control access to consumer and merchant payment method choices at the point of sale or through digital wallets, commerce-related experiences, mobile applications or other technologies could choose not to accept, suppress use of, or degrade the experience of using our products or could restrict our access to our customers and transaction data. Such companies could also require payments from us to participate in such digital wallets, experiences or applications or negotiate incentives or pricing concessions, impacting our profitability on transactions. +The competitive value of our closed-loop data may also be diminished as traditional and non-traditional competitors use other, new data sources and technologies to derive similar insights. Certain regulations, such as PSD2 in Europe and open banking initiatives in various jurisdictions around the world, could also diminish the value of our closed-loop data or the demand for our products and services by disintermediating existing financial services providers. +To the extent we expand into new business areas and new geographic regions, such as mainland China, we will face competitors with more experience and more established relationships with relevant customers, regulators and industry participants, which could adversely affect our ability to compete. Laws and business practices that favor local competitors, require card transactions to be routed over domestic networks or prohibit or limit foreign ownership of certain businesses could limit our growth in international regions. We may face additional compliance and regulatory risks to the extent that we expand into new business areas, and we may need to dedicate more expense, time and resources to comply with regulatory requirements than our competitors, particularly those that are not regulated financial institutions. +Many of our competitors are subject to different, and in some cases, less stringent, legislative and regulatory regimes, and some may have lower cost structures and more agile business models and systems. More restrictive laws and regulations that do not apply to all of our competitors can put us at a disadvantage, including prohibiting us from engaging in certain transactions, regulating our business practices or adversely affecting our cost structure. +We face intense competition for partner relationships, which could result in a loss or renegotiation of these arrangements that could have a material adverse impact on our business and results of operations. +In the ordinary course of our business we enter into different types of contractual arrangements with business partners in a variety of industries. For example, we have partnered with Delta, Marriott, Hilton and British Airways, as well as many others globally, to offer cobranded cards for consumers and small businesses, and through our Membership Rewards program we have partnered with businesses in many industries, including Delta and others in the airline industry, to offer benefits to Card Member participants. See “Partners and Relationships” under “Business” for additional information on our business partnerships, including with Delta. +Competition for relationships with key business partners is very intense and there can be no assurance we will be able to grow or maintain these partner relationships or that they will remain as profitable. Establishing and retaining attractive cobrand card partnerships is particularly competitive among card issuers and networks as these partnerships typically appeal to high-spending +25 +Table of Contents +loyal customers. All of our cobrand portfolios in the aggregate accounted for approximately 19 percent of our worldwide billed business for the year ended December 31, 2020. Card Member loans related to our cobrand portfolios accounted for approximately 37 percent of our worldwide Card Member loans as of December 31, 2020. +Cobrand arrangements are entered into for a fixed period, generally ranging from five to ten years, and will terminate in accordance with their terms, including at the end of the fixed period unless extended or renewed at the option of the parties, or upon early termination as a result of an event of default or otherwise. We face the risk that we could lose partner relationships, even after we have invested significant resources in the relationships. We may also choose to not renew certain cobrand relationships. The volume of billed business could decline and Card Member attrition could increase, in each case, significantly as a result of the termination of one or more cobrand partnership relationships. In addition, some of our cobrand arrangements provide that, upon expiration or termination, the cobrand partner may purchase or designate a third party to purchase the loans generated with respect to its program, which could result in the loss of the card accounts and a significant decline in our Card Member loans outstanding. +We regularly seek to extend or renew cobrand arrangements in advance of the end of the contract term and face the risk that existing relationships will be renegotiated with less favorable terms for us or that we may be unable to renegotiate on terms that are acceptable to us, as competition for such relationships continues to increase. We make payments to our cobrand partners, which can be significant, based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The amount we pay to our cobrand partners has increased, particularly in the United States, and may continue to increase as arrangements are renegotiated due to increasingly intense competition for cobrand partners among card issuers and networks. See "Off-Balance Sheet Arrangements and Contractual Obligations" under "MD&A" for additional information regarding commitments for payments to certain cobrand partners. +The loss of exclusivity arrangements with business partners, the loss of the partner relationship altogether (whether by non-renewal at the end of the contract period, such as the end of our relationship with Costco in the United States in 2016, or as the result of a merger, legal or regulatory action or otherwise, such as the withdrawal of American Airlines in 2014 from our Airport Club Access program for Centurion ® and Platinum Card ® Members) or the renegotiation of existing partnerships with terms that are significantly worse for us could have a material adverse impact on our business and results of operations. See "Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition" for information on the uncertainty regarding our cobrand and agent relationships in the EU. In addition, any publicity associated with the loss of any of our key business partners could harm our reputation, making it more difficult to attract and retain Card Members and merchants, and could weaken our negotiating position with our remaining and prospective business partners. +Arrangements with our business partners represent a significant portion of our business. We are exposed to risks associated with our business partners, including reputational issues, business slowdowns, bankruptcies, liquidations, restructurings and consolidations, and the possible obligation to make payments to our partners. +Our success is, in many ways, dependent on the success of our partners. From customer acquisition to cobranding arrangements, from participation in our rewards programs to facilitating B2B supplier payments for our corporate clients, we rely on our business partners across many aspects of our company and our arrangements with business partners represent a significant portion of our business. Some of our partners manage certain aspects of our customer relationships, such as our OptBlue partners. To the extent any of our partners fail to effectively promote and support our products, experience a slowdown in their business, operational disruptions, reputational issues or loss of consumer confidence, or are otherwise unable to meet our expectations or those of their other stakeholders, our business may be materially negatively impacted. We face the risk that existing relationships will be renegotiated with less favorable terms for us or that we may be unable to renegotiate on terms that are acceptable to us. In addition, we may be obligated to make or accelerate payments to certain business partners such as cobrand partners upon the occurrence of certain triggering events such as a shortfall in certain performance and revenue levels. If we are not able to effectively manage these triggering events, we could unexpectedly have to make payments to these partners, which could have a negative effect on our financial condition and results of operations. See “Contractual Obligations” under “MD&A” for additional information on financial commitments related to agreements with certain cobrand partners. +Similarly, we are exposed to risk from bankruptcies, liquidations, insolvencies, financial distress, restructurings, consolidations and other similar events that may occur in any industry representing a significant portion of our billed business, which could negatively impact particular card products and services (and billed business generally) and our financial condition and results of operations. During 2020, we pre-purchased loyalty points from certain of our travel cobrand partners, which we may use for future promotions, rewards and incentive programs for our customers. To the extent such partners cease operations or the loyalty points are no longer desired by our customers, the value of the pre-purchased points may be diminished and may result in an impairment charge. We could also be materially impacted if we were obligated or elected to reimburse Card Members for products and services purchased from merchants that have ceased operations or stopped accepting our cards. For example, we are exposed to credit risk in the airline industry to the extent we protect Card Members against non-delivery of goods and +26 +Table of Contents +services, such as where we have remitted payment to an airline for a Card Member purchase of tickets that have not yet been used or “flown.” If we are unable to collect the amount from the airline, we may bear the loss for the amount credited to the Card Member. At December 31, 2020, our best estimate of the maximum amount of billed business volumes for goods and services that had yet to be delivered by, or could be charged back to, merchants was $19 billion. This amount assumes all such merchants worldwide cease operations and thus are no longer available to deliver such goods and services or to accept such chargebacks, and that all such billed business results in claims-in-full by Card Members. Such a maximum amount has not been indicative of our actual loss exposure in the past and we have not experienced significant losses related to these exposures to date; however, our historical experience may not be representative in the current environment given the economic and financial disruptions, particularly to travel, caused by the COVID-19 pandemic and resulting containment measures. See Note 12 to the “Consolidated Financial Statements” for additional information regarding this exposure. +For additional information relating to the general risks related to the airline industry, see “Risk Management—Institutional Credit Risk—Exposure to the Airline and Travel Industry” under “MD&A.” +We face continued intense competitive pressure that may materially impact the prices we charge for accepting our cards for payment for goods and services, as well as the risk of losing merchant relationships, which could have a material adverse impact on our business and results of operations. +We face pressure from competitors that primarily rely on sources of revenue other than discount revenue or have lower costs that can make their pricing for card acceptance more attractive. Merchants, business partners and third-party merchant acquirers and aggregators are also able to negotiate incentives, pricing concessions and other contractual benefits from us as a condition to accepting our cards, being cobrand partners or signing merchants on our behalf. As merchants become even larger (such as the largest tech companies), we may have to increase the amount of incentives and/or concessions we provide to such merchants. We also face the risk of losing a merchant relationship that could materially adversely affect our billed business volumes, ability to retain current Card Members and attract new Card Members and therefore, our business and results of operations. +Our average merchant discount rate has been impacted by regulatory changes affecting competitor pricing in certain international countries. We have also experienced erosion of our average merchant discount rate as we increase merchant acceptance. We may not be successful in significantly expanding merchant acceptance or offsetting rate erosion with volumes at new merchants. +In addition, the regulatory environment and differentiated payment models and technologies from non-traditional players in the alternative payments space could pose challenges to our traditional payment model and adversely impact our average merchant discount rate. Some merchants continue to invest in their own payment solutions, such as proprietary-branded mobile wallets, using both traditional and new technology platforms. If merchants are able to drive broad consumer adoption and usage, it could adversely impact our average merchant discount rate and billed business volumes. +A continuing priority of ours is to drive greater and differentiated value to our merchants that, if not successful, could negatively impact our discount revenue and financial results. We may not succeed in maintaining merchant discount rates or offsetting the impact of declining merchant discount rates, for the reasons discussed above and others, which could materially and adversely affect our revenues and profitability, and therefore our ability to invest in innovation and in value-added services for merchants and Card Members. +Surcharging or steering by merchants could materially adversely affect our business and results of operations. +In certain countries, such as Australia and certain Member States in the EU, merchants are expressly permitted by law to surcharge certain card purchases. In jurisdictions allowing surcharging, we have seen merchant surcharging on American Express cards in certain merchant categories, and in some cases, either the surcharge is greater than that applied to Visa and Mastercard cards or Visa and Mastercard cards are not surcharged at all (practices that are known as differential surcharging), even though there are many cards issued on competing networks that have an equal or greater cost of acceptance for the merchant. In addition, the laws of a number of states in the United States that prohibit surcharging have been overturned in litigation brought by merchant groups. +We also encounter merchants that accept our cards, but tell their customers that they prefer to accept another type of payment or otherwise seek to suppress use of our cards. Our Card Members value the ability to use their cards where and when they want to, and we, therefore, take steps to meet our Card Members’ expectations and to protect the American Express brand by prohibiting this form of discrimination, subject to local legal requirements. When we work with merchant acquirers, aggregators and processors to manage certain aspects of the merchant relationship, we are dependent on them to promote and support the acceptance and usage of our cards, but such third parties may have business interests, strategies or goals that are inconsistent with ours. +If surcharging, steering or other forms of discrimination become widespread, American Express cards and credit and charge cards generally could become less desirable to consumers, which could result in a decrease in cards-in-force and transaction +27 +Table of Contents +volumes. The impact could vary depending on such factors as: the industry or manner in which a surcharge is levied; how Card Members are surcharged or steered to other card products or payment forms at the point of sale; the ease and speed of implementation for merchants, including as a result of new or emerging technologies; the size and recurrence of the underlying charges; and whether and to what extent these actions are applied to other forms of payment, including whether it varies depending on the type of card (e.g., credit or debit), product, network, acquirer or issuer. Discrimination against American Express cards could have a material adverse effect on our business, financial condition and results of operations, particularly where it only or disproportionately impacts credit card usage, our Card Members or our business. +We may not be successful in our efforts to promote card usage through marketing and promotion, merchant acceptance and Card Member rewards and services, or to effectively control the costs of such investments, both of which may materially impact our profitability. +Revenue growth is dependent on increasing consumer and business spending on our cards, growing loan balances and increasing fee revenue. We have been investing in a number of growth initiatives, including to attract new Card Members, reduce Card Member attrition and capture a greater share of customers’ total spending and borrowings. There can be no assurance that our investments to acquire Card Members, provide differentiated features and services and increase usage of our cards will continue to be effective, particularly with changing consumer and business behaviors as a result of the COVID-19 pandemic. In addition, if we develop new products or offers that attract customers looking for short-term incentives rather than incentivize long-term loyalty, Card Member attrition and costs could increase. Increasing spending on our cards also depends on our continued expansion of merchant acceptance of our cards. If we are unable to continue growing merchant acceptance and perceptions of coverage or merchants decide to no longer accept American Express cards, our business could suffer. Expanding our service offerings, adding customer acquisition channels and forming new partnerships or renewing current partnerships could have higher costs than our current arrangements, and could adversely impact our average discount rate or dilute our brand. +Another way we invest in customer value is through our Membership Rewards program, as well as other Card Member benefits. Any significant change in, or failure by management to reasonably estimate, actual redemptions of Membership Rewards points and associated redemption costs could adversely affect our profitability. We rely on third parties for certain redemption options and may not be able to continue to offer such redemption options in the future, which could diminish the value of the program for our Card Members. Our two largest redemption partners are Amazon and Delta. In addition, many credit card issuers have instituted rewards and cobrand programs and may introduce programs and services that are similar to or more attractive than ours. Our inability to differentiate our products and services could materially adversely affect us. +We may not be able to cost-effectively manage and expand Card Member benefits, including containing the growth of marketing, promotion, rewards and Card Member services expenses in the future. If such expenses increase beyond our expectations, we will need to find ways to offset the financial impact by increasing payment volumes, increasing other areas of revenues such as fee-based revenues, or both. We may not succeed in doing so, particularly in the current competitive and regulatory environment. +Our brand and reputation are key assets of our Company, and our business may be materially affected by how we are perceived in the marketplace. +Our brand and its attributes are key assets, and we believe our continued success depends on our ability to preserve, grow and realize the benefits of the value of our brand. Our ability to attract and retain consumer and small business Card Members and corporate clients is highly dependent upon the external perceptions of our level of service, trustworthiness, business practices, privacy and data protection, management, workplace culture, merchant acceptance, financial condition, response to political and social issues or catastrophic events (including our response to the COVID-19 pandemic and natural disasters) and other subjective qualities. Negative perceptions or publicity regarding these matters — even if related to seemingly isolated incidents and whether or not factually correct—could erode trust and confidence and damage our reputation among existing and potential Card Members, corporate clients, merchants and partners, which could make it difficult for us to attract new customers and maintain existing ones. Negative public opinion could result from actual or alleged conduct in any number of activities or circumstances, including card practices, regulatory compliance, the use and protection of customer information, conduct by our colleagues and policy engagement, including activities of the American Express Company Political Action Committee, and from actions taken by regulators or others in response thereto. Discussion about such matters in social media channels can also cause rapid, widespread reputational harm to our brand. +Our brand and reputation may also be harmed by actions taken by third parties that are outside our control. For example, any shortcoming of or controversy related to a third-party vendor, business partner, merchant acquirer or network partner may be attributed by Card Members and merchants to us, thus damaging our reputation and brand value. Acceptance of American Express cards by merchants in certain industries can also affect perceptions of us. The lack of acceptance, suppression of card usage or surcharging by merchants can also negatively impact perceptions of our brand and our products, lower overall transaction volume and increase the attractiveness of other payment products or systems. Adverse developments with respect to our industry may also, by association, negatively impact our reputation, or result in greater regulatory or legislative scrutiny or +28 +Table of Contents +litigation against us. Furthermore, as a corporation with headquarters and operations located in the United States, a negative perception of the United States arising from its political or other positions could harm the perception of our company and our brand. Although we monitor developments for areas of potential risk to our reputation and brand, negative perceptions or publicity could materially and adversely affect our business volumes, revenues and profitability. +A major information or cyber security incident or an increase in fraudulent activity could lead to reputational damage to our brand and material legal, regulatory and financial exposure, and could reduce the use and acceptance of our cards. +We and third parties process, transmit, store and provide access to account information in connection with our charge and credit cards and other products, and in the normal course of our business, we collect, analyze and retain significant volumes of certain types of personally identifiable and other information pertaining to our customers and colleagues. +Our networks and systems are subject to constant attempts to identify and exploit potential vulnerabilities in our operating environment with intent to disrupt our business operations and capture, destroy, manipulate or expose various types of information relating to corporate trade secrets, customer information, including Card Member, travel and loyalty program data, colleague information and other sensitive business information, including acquisition activity, non-public financial results and intellectual property. There are a number of motivations for cyber threat actors, including criminal activities such as fraud, identity theft and ransom, corporate or nation-state espionage, political agendas, public embarrassment with the intent to cause financial or reputational harm, intent to disrupt information technology systems, and to expose and exploit potential security and privacy vulnerabilities in corporate systems and websites. +Global financial institutions like us, as well as our customers, colleagues, regulators, vendors and other third parties, have experienced a significant increase in information and cyber security risk in recent years and will likely continue to be the target of increasingly sophisticated cyberattacks, including computer viruses, malicious or destructive code, ransomware, social engineering attacks (including phishing, impersonation and identity takeover attempts), corporate espionage, hacking, website defacement, denial-of-service attacks, exploitation of vulnerabilities and other attacks and similar disruptions from the misconfiguration or unauthorized use of or access to computer systems. For example, we and other U.S. financial services providers have been the target of distributed denial-of-service attacks from sophisticated third parties. These threats can arise from external parties as well as insiders who knowingly or unknowingly engage in or enable malicious cyber activities. +We develop and maintain systems and processes aimed at detecting and preventing information and cyber security incidents and fraudulent activity, which require significant investment, maintenance and ongoing monitoring and updating as technologies and regulatory requirements change and as efforts to overcome security measures become more sophisticated. Despite our efforts, the possibility of information and cyber security incidents, malicious social engineering, corporate espionage, fraudulent or other malicious activities and human error or malfeasance cannot be eliminated entirely and will evolve as new and emerging technology is deployed, including the increasing use of personal mobile and computing devices that are outside of our network and control environments. Risks associated with such incidents and activities include theft of funds and other monetary loss, the disruption of our operations and the unauthorized disclosure, release, gathering, monitoring, misuse, modification, loss or destruction of confidential, proprietary, trade secret or other information (including account data information), the effects of which could be compounded if not detected or reported quickly. Indeed, an information or cyber security incident may not be detected until well after it occurs and the severity and potential impact may not be fully known for a substantial period of time after it has been discovered. +Information or cyber security incidents, fraudulent activity and other actual or perceived failures to maintain confidentiality, integrity, privacy and/or security has led to increased regulatory scrutiny and may lead to regulatory investigations and intervention (such as mandatory card reissuance), increased litigation (including class action litigation), remediation, fines and response costs, negative assessments of us and our subsidiaries by banking regulators and rating agencies, reputational and financial damage to our brand, and reduced usage of our products and services, all of which could have a material adverse impact on our business. The disclosure of sensitive company information could also undermine our competitive advantage and divert management attention and resources. +Successful cyberattacks, data breaches, disruptions or other incidents related to the actual or perceived failures to maintain confidentiality, integrity, privacy and/or security at other large financial institutions, large retailers, travel and hospitality companies, government agencies or other market participants, whether or not we are impacted, could lead to a general loss of customer confidence that could negatively affect us, including harming the market perception of the effectiveness of our security measures or harming the reputation of the financial system in general, which could result in reduced use of our products and services. Such events could also result in legislation and additional regulatory requirements. Although we maintain cyber insurance, there can be no assurance that liabilities or losses we may incur will be covered under such policies or that the amount of insurance will be adequate. +The uninterrupted operation of our information systems is critical to our success and a significant disruption could have a material adverse effect on our business and results of operations. +29 +Table of Contents +Our information technology systems, including our transaction authorization, clearing and settlement systems, and data centers, may experience service disruptions or degradation because of technology malfunction, sudden increases in customer transaction volume, natural disasters, accidents, power outages, internet outages, telecommunications failures, fraud, denial-of-service and other cyberattacks, terrorism, computer viruses, vulnerabilities in hardware or software, physical or electronic break-ins, or similar events. Service disruptions or degradations could prevent access to our online services and account information, compromise or limit access to company or customer data, impede transaction processing and financial reporting, and lead to regulatory investigations and fines, increased regulatory oversight and litigation (including class action litigation). Any such service disruption or degradation could adversely affect the perception of the reliability of our products and services and materially adversely affect our overall business, reputation and results of operations. +We rely on third-party providers for acquiring and servicing customers, technology, platforms and other services integral to the operations of our businesses. These third parties may act in ways that could materially harm our business. +We rely on third-party service providers, cobrand partners, merchants, customer acquisition channels, processors, aggregators, network partners and other third parties for services that are integral to our operations and are subject to the risk that activities of such third parties may adversely affect our business. As outsourcing, specialization of functions, third-party digital services and technology innovation within the payments industry increase (including with respect to mobile technologies, tokenization, big data, artificial intelligence and cloud storage solutions), more third parties are involved in processing card transactions and handling our data. For example, we rely on third parties for the timely transmission of accurate information across our global network, card acquisition and provision of services to our customers. If a service provider or other third party ceases to provide the data quality or communications capacity we expect or services upon which we rely, as a result of natural disaster, operational disruptions or errors, including as a result of the impacts of COVID-19, terrorism, information or cyber security incidents, or any other reason, the failure could interrupt or compromise the quality of our services to customers or impact our business. A disruption or other event at a third party affecting one of our service providers or partners could also impede their ability to provide to us services or data on which we rely to operate our business. Service providers or other third parties could also cease providing data to us or use our data in a way that diminishes the value of our closed loop. +The confidentiality, integrity, privacy, availability and/or security of data communicated over third-party networks or platforms or held by, or accessible to, third parties, including merchants that accept our cards, payment processors, payment intermediaries and our third-party vendors and business partners, could become compromised, which could lead to unauthorized use of our data or fraudulent transactions on our cards, as well as costs associated with responding to such an incident, including regulatory investigations and fines, increased regulatory oversight and litigation. +The management and oversight of multiple vendors increases our operational complexity and governance challenges and decreases our control. A failure to exercise adequate oversight over service providers, including compliance with service level agreements or regulatory or legal requirements, could result in regulatory actions, fines, litigation, sanctions or economic and reputational harm to us. In addition, we may not be able to effectively monitor or mitigate operational risks relating to our third-party providers' service providers. We are also exposed to the risk that a service disruption at a service provider common to our third-party providers could impede their ability to provide services to us. Notwithstanding any attempts to diversify our reliance on third parties, we may not be able to effectively mitigate operational risks relating to our third-party providers’ use of common service providers. +If we are not able to invest successfully in, and compete at the leading edge of, technological developments across all our businesses, our revenue and profitability could be materially adversely affected. +Our industry is subject to rapid and significant technological changes. In order to compete in our industry, we need to continue to invest in technology across all areas of our business, including in transaction processing, data management and analytics, machine learning and artificial intelligence, customer interactions and communications, open banking and alternative payment and financing mechanisms, authentication technologies and digital identification, tokenization, real-time settlement, and risk management and compliance systems. Incorporating new technologies into our products and services, including developing the appropriate governance and controls consistent with regulatory expectations, requires substantial expenditures and takes considerable time, and ultimately may not be successful. We expect that new technologies in the payments industry will continue to emerge, and these new technologies may be superior to, or render obsolete, our existing technology. +The process of developing new products and services, enhancing existing products and services and adapting to technological changes and evolving industry standards is complex, costly and uncertain, and any failure by us to anticipate customers’ changing needs and emerging technological trends accurately could significantly impede our ability to compete effectively. Consumer and merchant adoption is a key competitive factor and our competitors may develop products, platforms or technologies that become more widely adopted than ours. In addition, we may underestimate the time and expense we must invest in new products and services before they generate significant revenues, if at all. Our use of artificial intelligence and machine learning is subject to risks related to flaws in our algorithms and datasets that may be insufficient or contain biased information. These deficiencies could undermine the decisions, predictions or analysis such technologies produce, subjecting us to competitive harm, legal liability, and brand or reputational harm. +30 +Table of Contents +Our ability to develop, acquire or access competitive technologies or business processes on acceptable terms may also be limited by intellectual property rights that third parties, including those that current and potential competitors, may assert. In addition, our ability to adopt new technologies may be inhibited by the emergence of industry-wide standards, a changing legislative and regulatory environment, an inability to develop appropriate governance and controls, a lack of internal product and engineering expertise, resistance to change from Card Members or merchants, lack of appropriate change management processes or the complexity of our systems. +We may not be successful in realizing the benefits associated with our acquisitions, strategic alliances, joint ventures and investment activity, and our business and reputation could be materially adversely affected. +We have acquired a number of businesses, including Kabbage, and have made a number of strategic investments, and continue to evaluate potential transactions. There is no assurance that we will be able to successfully identify suitable candidates, value potential investment or acquisition opportunities accurately, negotiate acceptable terms for those opportunities, or complete proposed acquisitions and investments. The process of integrating an acquired company, business or technology could create unforeseen operating difficulties and expenditures, result in unanticipated liabilities, including legal claims, violations of laws, commercial disputes and information security vulnerabilities or breaches (including from not integrating the acquired company, business or technology quickly or appropriately, from activities that occurred prior to the acquisition, and from exposure to third party relationships of the acquired company or business or new laws and regulations), and harm our business generally. It may take us longer than expected to fully realize the anticipated benefits of these transactions, and those benefits may ultimately be smaller than anticipated or may not be realized at all, which could materially adversely affect our business and operating results, including as a result of write-downs of goodwill and other intangible assets. +We may also face risks with other types of strategic transactions, such as the sale to InComm of the operations relating to our prepaid reloadable and gift card business. The reloadable operations have experienced disruptions in the past, impacting the ability of our prepaid customers to load and use their cards. If such operations are interrupted, suspended or terminated in the future, it could further negatively impact our customers’ experience, result in additional costs, litigation and regulatory action, and harm our business and reputation. +Joint ventures, including our GBT JV and our joint venture in China, and minority investments inherently involve a lesser degree of control over business operations, thereby potentially increasing the financial, legal, operational and/or compliance risks associated with the joint venture or minority investment, including as a result of becoming subject to different laws or regulations. In addition, we may be dependent on joint venture partners, controlling shareholders or management who may have business interests, strategies or goals that are inconsistent with ours. For example, trade secrets and other proprietary information we may provide to a joint venture may become available to third parties beyond our control. The ability to enforce intellectual property and contractual rights to prevent disclosure of our trade secrets and other proprietary information may be limited in certain jurisdictions. Business decisions or other actions or omissions of the joint venture partner, controlling shareholders or management may adversely affect the value of our investment, result in litigation or regulatory action against us and otherwise damage our reputation and brand. +Our success is dependent on maintaining a culture of integrity and respect, the resilience of our colleagues through the pandemic, and upon our executive officers and other key personnel, and misconduct by or loss of key personnel could materially adversely affect our business. +We rely upon our key personnel not only for business success, but also to lead with integrity and promote a culture of respect. To the extent our leaders behave in a manner that does not comport with our company’s values, the consequences to our brand and reputation could be severe and could negatively affect our financial condition and results of operations. Our colleagues have had to adapt to rapidly changing conditions during the pandemic, and if we are unable to continue addressing the safety, health and productivity of our colleagues, our business could suffer. +The market for qualified individuals is highly competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel who voluntarily or involuntarily leave the company. Changes in immigration and work permit laws and regulations or the administration or enforcement of such laws or regulations or other changes in the legal or regulatory environment, including as a result of Brexit, can also impair our ability to attract and retain qualified personnel, or to employ such personnel in the location(s) of our choice. Our compensation practices are subject to review and oversight by the Federal Reserve and the compensation practices of AENB are subject to review and oversight by the OCC. This regulatory review and oversight could further affect our ability to attract and retain our executive officers and other key personnel. The loss of key personnel could materially adversely affect our business. +Legal, Regulatory and Compliance Risks +Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition. +31 +Table of Contents +We are subject to comprehensive government regulation and supervision in jurisdictions around the world, which significantly affects our business and requires continual enhancement of our compliance efforts. Supervision efforts and the enforcement of existing laws and regulations impact the scope and profitability of our existing business activities, limit our ability to pursue certain business opportunities and adopt new technologies, compromise our competitive position, and affect our relationships with Card Members, partners, merchants, vendors and other third parties. New laws or regulations could similarly affect our business, increase our costs of doing business and require us to change certain of our business practices and invest significant management attention and resources, all of which could adversely affect our results of operations and financial condition. Legislators and regulators around the world are aware of each other’s approaches to the regulation of the payments industry. Consequently, a development in one country, state or region may influence regulatory approaches in another. To the extent that different regulatory systems impose overlapping or inconsistent requirements on the conduct of our business, we face complexity and additional costs in our compliance efforts. +If we fail to satisfy regulatory requirements or maintain our financial holding company status, our financial condition and results of operations could be adversely affected, and we may be restricted in our ability to take certain capital actions (such as declaring dividends or repurchasing outstanding shares) or engage in certain business activities or acquisitions, which could compromise our competitive position. Additionally, our banking regulators have wide discretion in the examination and the enforcement of applicable banking statutes and regulations and may restrict our ability to engage in certain business activities or acquisitions or require us to maintain more capital. +In recent years, legislators and regulators have focused on the operation of card networks, including interchange fees paid to card issuers in payment networks such as Visa and Mastercard and the fees merchants are charged to accept cards. Even where we are not directly regulated, regulation of bankcard fees significantly negatively impacts the discount revenue derived from our business, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or the terms of card acceptance for merchants, including terms relating to non-discrimination and honor-all-cards. For example, we have exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions. In addition, there is uncertainty as to when or how interchange fee caps and other provisions of the EU payments legislation might apply when we work with cobrand partners and agents in the EU. In a ruling issued on February 7, 2018, the EU Court of Justice confirmed the validity of the application of the fee caps and other provisions in circumstances where three-party networks issue cards with a cobrand partner or through an agent, although the ruling provided only limited guidance as to when or how the provisions might apply in such circumstances and remains subject to differing interpretations by regulators and participants in cobrand arrangements. As a result, we are subject to regulatory action, penalties and the possibility we will not be able to maintain our existing cobrand and agent relationships in the EU. +We are subject to certain provisions of the Bank Secrecy Act, as amended by the Patriot Act and the AMLA, with regard to maintaining effective AML programs. Similar AML requirements apply under the laws of most jurisdictions where we operate. As regulators increase their focus in this area, we are likely to face increased costs related to oversight, supervision and fines and changes to our business practices, including restrictions with respect to the types of products and services we may offer, the countries in which our cards may be used, and the types of customers and merchants who can obtain or accept our cards. Emerging technologies, such as digital currencies, could limit our ability to track the movement of funds. Money laundering, terrorist financing and other illicit activities involving our business could result in enforcement action, and our reputation may suffer due to our customers’ association with certain countries, persons or entities or the existence of any such transactions. +Various regulatory agencies and legislatures are also considering regulations and legislation covering identity theft, account management guidelines, credit bureau reporting, disclosure rules, security and marketing that would impact us directly, in part due to increased scrutiny of our underwriting and account management standards. These new requirements may restrict our ability to issue charge and credit cards or partner with other financial institutions, which could adversely affect our revenue growth. +See “Supervision and Regulation” for more information about certain laws and regulations to which we are subject and their impact on us. +Litigation and regulatory actions could subject us to significant fines, penalties, judgments and/or requirements resulting in significantly increased expenses, damage to our reputation and/or a material adverse effect on our business. +Businesses in the financial services and payments industries have historically been subject to significant legal actions, including class action lawsuits. Many of these actions have included claims for substantial compensatory or punitive damages. While we have historically relied on our arbitration clause in agreements with customers to limit our exposure to class action litigation, there can be no assurance that we will continue to be successful in enforcing our arbitration clause in the future, including as a result of regulation that would require that our consumer arbitration clause not apply to cases filed in court as class actions, and claims of the type we previously arbitrated could be subject to the complexities, risks and costs associated with class action cases. The continued focus of merchants on issues relating to the acceptance of various forms of payment may lead to additional litigation and other legal actions. Given the inherent uncertainties involved in litigation, and the very large or indeterminate +32 +Table of Contents +damages sought in some matters asserted against us, there is significant uncertainty as to the ultimate liability we may incur from litigation. +We have been subject to regulatory actions and may continue to be subject to such actions, including governmental inquiries, investigations and enforcement proceedings, in the event of noncompliance or alleged noncompliance with laws or regulations. External publicity concerning investigations, including those that are narrow in scope, can increase their scope and scale and lead to further regulatory inquiries. Beginning in May 2020, we began responding to a regulatory review led by the OCC and the Department of Justice Civil Division regarding historical sales practices relating to certain small business card sales. We also conducted an internal review of certain sales from 2015 and 2016 and have taken appropriate disciplinary and remedial actions, including voluntarily providing remediation to certain current and former customers. Information regarding our investigation has been provided to our other regulators, including the Federal Reserve. In January 2021, we received a grand jury subpoena from the United States Attorney’s Office for the Eastern District of New York regarding the sales practices for small business cards and a Civil Investigative Demand from the CFPB seeking information on sales practices related to consumers. We are cooperating with all of these inquiries and have continued to enhance our controls related to our sales practices. We do not believe this matter will have a material adverse impact on our business or results of operations. +We expect that regulators will continue taking formal enforcement actions against financial institutions in addition to addressing supervisory concerns through non-public supervisory actions or findings, which could involve restrictions on our activities, among other limitations that could adversely affect our business. In addition, a violation of law or regulation by another financial institution could give rise to an investigation by regulators and other governmental agencies of the same or similar practices by us. Further, a single event may give rise to numerous and overlapping investigations and proceedings. Regulatory action could subject us to significant fines, penalties or other requirements resulting in Card Member reimbursements, increased expenses, limitations or conditions on our business activities, and damage to our reputation and our brand, all of which could adversely affect our results of operations and financial condition. +Governmental authorities have adopted or proposed measures to provide economic assistance to individual households and businesses, stabilize markets and support economic growth. The future success of these measures is unknown and they may not be sufficient to mitigate the negative impact of the pandemic. Additionally, some measures, such as a suspension of loan payments and encouragement of forbearances, may have a negative impact on our business, results of operations and financial condition. We also face an increased risk of litigation and governmental and regulatory scrutiny as a result of the effects of the pandemic on market and economic conditions, such as a renewed focus on fair lending laws, and actions governmental authorities take in response to those conditions, including participation in the PPP. +Legal proceedings regarding provisions in our merchant contracts, including non-discrimination and honor-all-cards provisions, could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand. +We are, and have been in the past, a defendant in a number of actions, including legal proceedings and proposed class actions filed by merchants, challenging certain provisions of our card acceptance agreements. See Note 12 to the "Consolidated Financial Statements" for a description of our outstanding material legal proceedings. +An adverse outcome in these proceedings could have a material adverse effect on our business and results of operations, require us to change our merchant agreements in a way that could expose our cards to increased merchant steering and other forms of discrimination that could impair the Card Member experience, result in additional litigation and/or arbitrations, impose substantial monetary damages and damage our reputation and brand. Even if we were not required to change our merchant agreements, changes in Visa’s and Mastercard’s policies or practices as a result of legal proceedings, lawsuit settlements or regulatory actions pending against them could result in changes to our business practices and materially and adversely impact our profitability. +We are subject to capital adequacy and liquidity rules, and if we fail to meet these rules, our business would be materially adversely affected. +Failure to meet current or future capital or liquidity requirements could compromise our competitive position and could result in restrictions imposed by the Federal Reserve, including limiting our ability to pay dividends, repurchase our capital stock, invest in our business, expand our business or engage in acquisitions. Some elements of the capital and liquidity regimes are not yet final and certain developments could significantly impact the requirements applicable to financial institutions. For example, the Basel Committee finalized revisions to the standardized approach for credit risk and operational risk capital requirements. If these revisions are adopted in the United States, we could be required to hold significantly more capital. In addition, it may be necessary for us to hold additional capital because of an increase in the SCB requirement based on the results from a supervisory stress test. +Compliance with capital adequacy and liquidity rules requires a material investment of resources. An inability to meet regulatory expectations regarding our compliance with applicable capital adequacy and liquidity rules may also negatively impact the assessment of us and our U.S. bank subsidiary by federal banking regulators. +33 +Table of Contents +For more information on capital adequacy requirements, see “Capital and Liquidity Regulation” under “Supervision and Regulation.” +We are subject to restrictions that limit our ability to pay dividends and repurchase our capital stock. Our subsidiaries are also subject to restrictions that limit their ability to pay dividends to us, which may adversely affect our liquidity. +We are limited in our ability to pay dividends and repurchase capital stock by our regulators, who have broad authority to prohibit any action that would be considered an unsafe or unsound banking practice. For example, the Federal Reserve prohibited share repurchases in the third and fourth quarters of 2020 for all banking organizations participating in CCAR and has limited distributions for the first quarter of 2021. We are subject to a requirement to submit capital plans to the Federal Reserve for review that include, among other things, projected dividend payments and repurchases of capital stock. As part of the capital planning and stress testing process, our proposed capital actions are assessed against our ability to satisfy applicable capital requirements in the event of a stressed market environment. If we fail to satisfy applicable capital requirements, including the stress capital buffer, our ability to undertake capital actions may be restricted. +Our ability to declare or pay dividends on, or to purchase, redeem or otherwise acquire, shares of our common stock will be prohibited, subject to certain exceptions, in the event that we do not declare and pay in full dividends for the last preceding dividend period of our Series B and Series C preferred stock. +American Express Company relies on dividends from its subsidiaries for liquidity, and such dividends may be limited by law, regulation or supervisory policy. For example, our U.S. bank subsidiary, AENB, is subject to various statutory and regulatory limitations on its declaration and payment of dividends. These limitations may hinder our ability to access funds we may need to make payments on our obligations, make dividend payments on outstanding American Express Company capital stock or otherwise achieve strategic objectives. +Any future reduction or elimination of our common stock dividend or share repurchase program could adversely affect the market price of our common stock and market perceptions of American Express. For more information on bank holding company and depository institution dividend restrictions, see “Stress Testing and Capital Planning” and “Dividends and Other Capital Distributions” under “Supervision and Regulation,” as well as “Consolidated Capital Resources and Liquidity—Dividends and Share Repurchases” under “MD&A” and Note 22 to our “Consolidated Financial Statements.” +Regulation in the areas of privacy, data protection, data governance, account access and information and cyber security could increase our costs and affect or limit our business opportunities and how we collect and/or use personal information. +Legislators and regulators in the United States and other countries in which we operate are increasingly adopting or revising privacy, data protection, data governance, account access and information and cyber security laws, including data localization, authentication and notification laws. As such laws are interpreted and applied (in some cases, with significant differences or conflicting requirements across jurisdictions), compliance and technology costs will continue to increase, particularly in the context of ensuring that adequate data governance, data protection, data transfer and account access mechanisms are in place. +Compliance with current or future privacy, data protection, data governance, account access and information and cyber security laws could significantly impact our collection, use, sharing, retention and safeguarding of consumer and/or colleague information and could restrict our ability to fully maximize our closed-loop capability or provide certain products and services, which could materially and adversely affect our profitability. Our failure to comply with such laws could result in potentially significant regulatory and/or governmental investigations and/or actions, litigation, fines, sanctions, ongoing regulatory monitoring, customer attrition, decreases in the use or acceptance of our cards and damage to our reputation and our brand. In recent years, there has been increasing regulatory enforcement and litigation activity in the areas of privacy, data protection and information and cyber security in the United States, the EU and various other countries in which we operate. +For more information on regulatory and legislative activity in this area, see “Privacy, Data Protection, Data Governance, Information and Cyber Security” under “Supervision and Regulation.” +We may not be able to effectively manage the operational and compliance risks to which we are exposed. +We consider operational risk to be the risk of loss due to, among other things, inadequate or failed processes, people or information systems, or impacts from the external environment (e.g., natural disasters). Operational risk includes, among others, the risk that error or misconduct could result in a material financial misstatement, a failure to monitor a third party’s compliance with regulatory or legal requirements, or a failure to adequately monitor and control access to, or use of, data in our systems we grant to third parties. As processes or organizations are changed, or new products and services are introduced, we may not fully appreciate or identify new operational risks that may arise from such changes. Through human error, fraud or malfeasance, conduct risk can result in harm to customers, broader markets and the company and its employees. +Compliance risk arises from the failure to adhere to applicable laws, rules, regulations and internal policies and procedures. We need to continually update and enhance our control environment to address operational and compliance risks. Operational and compliance failures or deficiencies in our control environment can expose us to reputational and legal risks as well as fines, +34 +Table of Contents +civil money penalties or payment of damages and can lead to diminished business opportunities and diminished ability to expand key operations. +If we are not able to protect our intellectual property, or successfully defend against any infringement or misappropriation assertions brought against us, our revenue and profitability could be negatively affected. +We rely on a variety of measures to protect our intellectual property and control access to, and distribution of, our trade secrets and other proprietary information. These measures may not prevent infringement of our intellectual property rights or misappropriation of our proprietary information and a resulting loss of competitive advantage. The ability to enforce intellectual property rights to prevent disclosure of our trade secrets and other proprietary information may be limited in certain jurisdictions. In addition, competitors or other third parties may allege that our products, systems, processes or technologies infringe on their intellectual property rights. Given the complex, rapidly changing and competitive technological and business environments in which we operate, and the potential risks and uncertainties of intellectual property-related litigation, a future assertion of an infringement or misappropriation claim against us could cause us to lose significant revenues, incur significant defense, license, royalty or technology development expenses, and/or pay significant monetary damages. +Tax legislative initiatives or assessments could adversely affect our results of operations and financial condition. +We are subject to income and other taxes in the United States and in various foreign jurisdictions. The laws and regulations related to tax matters are extremely complex and subject to varying interpretations. Although management believes our positions are reasonable, we are subject to audit by the Internal Revenue Service in the United States and by tax authorities in all the jurisdictions in which we conduct business operations. We are being challenged in a number of countries regarding our application of value-added taxes (VAT) to certain transactions. While we believe we comply with all applicable VAT and other tax laws, rules and regulations in the relevant jurisdictions, the tax authorities may determine that we owe additional taxes or apply existing laws and regulations more broadly, which could result in a significant increase in liabilities for taxes and interest in excess of accrued liabilities. +New tax legislative initiatives, including increases in the corporate tax rate, may be enacted, impacting our effective tax rate and potentially adversely affecting our tax positions or tax liabilities. In addition, unilateral or multi-jurisdictional actions by various tax authorities, including an increase in tax audit activity, could have an adverse impact on our tax liabilities. +Credit, Liquidity and Market Risks +Our risk management policies and procedures may not be effective. +Our risk management framework seeks to identify and mitigate risk and appropriately balance risk and return. Although we have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future, these policies and procedures, as well as our risk management techniques, such as our hedging strategies, may not be fully effective. There may also be risks that exist, or develop in the future, that we have not appropriately identified or mitigated. As regulations and competition continue to evolve, our risk management framework may not always keep sufficient pace with those changes. If our risk management framework does not effectively identify or mitigate our risks, we could suffer unexpected losses and could be materially adversely affected. +Management of our risks in some cases depends upon the use of analytical and/or forecasting models. Although we have a governance framework for model development and independent model validation, the modeling methodology or key assumptions could be erroneous or the models could be misused. In addition, issues with the quality or effectiveness of our data aggregation and validation procedures, as well as the quality and integrity of data inputs, could result in ineffective or inaccurate model outputs and reports. For example, models based on historical data sets might not be accurate predictors of future outcomes and their ability to appropriately predict future outcomes may degrade over time. The CECL methodology requires measurement of expected credit losses for the estimated life of certain financial instruments, not only based on historical experience and current conditions, but also by including forecasts incorporating forward-looking information. Our ability to accurately forecast future losses under that methodology may be impaired by the significant uncertainty surrounding the pandemic and the lack of comparable precedent. If our business decisions or estimates for credit losses are based on incorrect or misused models and assumptions or we fail to manage data inputs effectively and to aggregate or analyze data in an accurate and timely manner, our results of operations and financial condition may be materially adversely affected. +We are exposed to credit risk and trends that affect Card Member spending and the ability of customers and partners to pay us, which could have a material adverse effect on our results of operations and financial condition. +We are exposed to both individual credit risk, principally from consumer and small business Card Member loans and receivables, and institutional credit risk, principally from corporate Card Member loans and receivables, merchants, network partners, loyalty coalition partners and treasury and investment counterparties. Third parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. General economic factors, such as GDP, unemployment, inflation and interest rates, may result in greater delinquencies that lead to greater credit losses. A customer’s ability and willingness to repay us can be negatively impacted not only by economic, market, political and social conditions but +35 +Table of Contents +also by a customer’s other payment obligations, and increasing leverage can result in a higher risk that customers will default or become delinquent in their obligations to us. Our caution about the potential for a significant downturn in the pace of economic recovery is reflected in the macroeconomic outlook that informs our reserves for credit losses. +We rely principally on the customer’s creditworthiness for repayment of loans or receivables and therefore have no other recourse for collection. Our ability to assess creditworthiness may be impaired if the criteria or models we use to manage our credit risk prove inaccurate in predicting future losses, which could cause our losses to rise and have a negative impact on our results of operations. Further, our pricing strategies may not offset the negative impact on profitability caused by increases in delinquencies and losses; thus any material increases in delinquencies and losses beyond our current estimates could have a material adverse impact on us. Although we make estimates to provide for credit losses in our outstanding portfolio of loans and receivables, these estimates may not be accurate. In addition, the information we use in managing our credit risk may be inaccurate or incomplete. +Rising delinquencies and rising rates of bankruptcy are often precursors of future write-offs and may require us to increase our reserve for credit losses. Higher write-off rates and the resulting increase in our reserves for credit losses adversely affect our profitability and the performance of our securitizations, and may increase our cost of funds. +Although we regularly review our credit exposure to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to foresee or detect, such as fraud. In addition, our ability to manage credit risk or collect amounts owed to us may be adversely affected by legal or regulatory changes (such as restrictions on collections or changes in bankruptcy laws, minimum payment regulations and re-age guidance). Increased credit risk, whether resulting from underestimating the credit losses inherent in our portfolio of loans and receivables, deteriorating economic conditions (particularly in the United States where, for example, Card Members were responsible for approximately 87 percent of our total Card Member loans outstanding as of December 31, 2020), increases in the level of loan balances, changes in our mix of business or otherwise, could require us to increase our provisions for losses and could have a material adverse effect on our results of operations and financial condition. +Interest rate changes could materially adversely affect our earnings. +Our interest expense was approximately $2.1 billion for the year ended December 31, 2020. If the rate of interest we pay on our borrowings increases more or decreases less than the rate of interest we earn on our loans, our net interest yield, and consequently our net interest income, could decrease. As of December 31, 2020, a hypothetical immediate 100 basis point increase in market interest rates would have a detrimental impact on our annual net interest income of up to $113 million. A hypothetical immediate 100 basis point decrease in market interest rates would have a smaller but still detrimental impact on our annual net interest income. We expect the rates we pay on our deposits will change if benchmark interest rates change. In addition, interest rate changes may affect customer behavior, such as impacting the loan balances Card Members carry on their credit cards or their ability to make payments as higher interest rates lead to higher payment requirements, further impacting our results of operations. For a further discussion of our interest rate risk, see “Risk Management ― Market Risk Management Process” under “MD&A.” +The discontinuance of LIBOR may negatively impact our access to funding and the value of our financial instruments and commercial agreements. +Central banks and global regulators have called for financial market participants to prepare for the discontinuance of the London interbank offered rate (LIBOR) and the establishment of alternative reference rates. Certain of our financial instruments and commercial agreements reference LIBOR, which will need to be amended or otherwise modified to replace LIBOR with an alternative reference rate. Some of those instruments and agreements contain provisions to replace LIBOR as the benchmark following the occurrence of specified transition events. Such provisions may not be sufficient to trigger a change in the benchmark at all times when LIBOR is no longer representative of market interest rates, or that these events will align with similar events in the market generally or in other parts of the financial markets, such as the derivatives market. +Alternative reference rates are calculated using components different from those used in the calculation of LIBOR and may fluctuate differently than, and not be representative of, LIBOR. In order to compensate for these differences, certain of our financial instruments and commercial agreements allow for a benchmark replacement adjustment. However, there is no assurance that any benchmark replacement adjustment will be sufficient to produce the economic equivalent of LIBOR, either at the benchmark replacement date or over the life of such instruments and agreements. +Uncertainty as to the nature and timing of the potential discontinuance or modification of LIBOR, the replacement of LIBOR with one or more alternative reference rates or other reforms may negatively impact market liquidity, our access to funding and the trading market for our financial instruments. Furthermore, the timing of implementation and use of alternative reference rates and corresponding adjustments or other reforms could be subject to disputes, could cause the interest payable on our outstanding financial instruments and commercial agreements to be materially different than expected and may impact the value of such instruments and agreements. +36 +Table of Contents +Adverse market conditions may significantly affect our access to, and cost of, capital and ability to meet liquidity needs. +Our ability to obtain financing in the debt capital markets for unsecured term debt and asset securitizations is dependent on financial market conditions. Disruptions, uncertainty or volatility across the financial markets, as well as adverse developments affecting our competitors and the financial industry generally, could negatively impact market liquidity and limit our access to funding required to operate our business. Such market conditions may also limit our ability to replace, in a timely manner, maturing liabilities, satisfy regulatory capital requirements and access the funding necessary to grow our business. In some circumstances, we may incur an unattractive cost to raise capital, which could decrease profitability and significantly reduce financial flexibility. For a further discussion of our liquidity and funding needs, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Any reduction in our and our subsidiaries’ credit ratings could increase the cost of our funding from, and restrict our access to, the capital markets and have a material adverse effect on our results of operations and financial condition. +Rating agencies regularly evaluate us and our subsidiaries, and their ratings of our and our subsidiaries’ long-term and short-term debt and deposits are based on a number of factors, including financial strength, as well as factors not within our control, including conditions affecting the financial services industry generally, and the wider state of the economy. Our and our subsidiaries’ ratings could be downgraded at any time and without any notice by any of the rating agencies, which could, among other things, adversely limit our access to the capital markets and adversely affect the cost and other terms upon which we and our subsidiaries are able to obtain funding. +Adverse currency fluctuations and foreign exchange controls could decrease earnings we receive from our international operations and impact our capital. +During 2020, approximately 22 percent of our total revenues net of interest expense were generated from activities outside the United States. We are exposed to foreign exchange risk from our international operations, and accordingly the revenue we generate outside the United States is subject to unpredictable fluctuations if the values of other currencies change relative to the U.S. dollar (including as a result of Brexit), which could have a material adverse effect on our results of operations. +Foreign exchange regulations or capital controls might restrict or prohibit the conversion of other currencies into U.S. dollars or our ability to transfer them. Political and economic conditions in other countries could also impact the availability of foreign exchange for the payment to us by the local card issuer for obligations arising out of local Card Members’ spending outside such country and for the payment by Card Members who are billed in a currency other than their local currency. Substantial and sudden devaluation of local Card Members’ currency can also affect their ability to make payments to the local issuer of the card in connection with spending outside the local country. The occurrence of any of these circumstances could further impact our results of operations. +An inability to accept or maintain deposits due to market demand or regulatory constraints could materially adversely affect our liquidity position and our ability to fund our business. +Our U.S. bank subsidiary, AENB, accepts deposits directly from consumers, as well as from individuals through third-party brokerage networks, and uses the proceeds as a source of funding. As of December 31, 2020, we had approximately $86 billion in total U.S. retail deposits, a portion of which had been raised through third-party brokerage networks. We face strong and increasing competition with regard to deposits, and pricing and product changes may adversely affect our ability to attract and retain cost-effective deposit balances. To the extent we offer higher interest rates to attract or maintain deposits, our funding costs will be adversely impacted. +Our ability to obtain deposit funding and offer competitive interest rates on deposits is also dependent on AENB’s capital levels. The FDIA’s brokered deposit provisions and related FDIC rules in certain circumstances prohibit banks from accepting or renewing brokered deposits and apply other restrictions, such as a cap on interest rates that can be paid. Additionally, our regulators can adjust applicable capital requirements at any time and have authority to place limitations on our deposit businesses. An inability to attract or maintain deposits in the future could materially adversely affect our ability to fund our business. +The value of our investments may be adversely impacted by economic, political or market conditions. +Market risk includes the loss in value of portfolios and financial instruments due to adverse changes in market variables, which could negatively impact our financial condition. We held approximately $22 billion of investment securities as of December 31, 2020. In the event that actual default rates of these investment securities were to significantly change from historical patterns due to economic conditions or otherwise, it could have a material adverse impact on the value of our investment portfolio, potentially resulting in impairment charges. Defaults or economic disruptions, even in countries or territories in which we do not have material investment exposure, conduct business or have operations, could adversely affect us. +37 +Table of Contents +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not applicable. +ITEM 2. PROPERTIES +Our principal executive offices are in a 2.2 million square foot building located in lower Manhattan on land leased from the Battery Park City Authority for a term expiring in 2069. We have an approximately 49 percent ownership interest in the building and an affiliate of Brookfield Financial Properties owns the remaining approximately 51 percent interest in the building. We also lease space in the building from Brookfield’s affiliate. +Other owned or leased principal locations include American Express offices in Phoenix, Arizona, Sunrise, Florida, Gurgaon, India, Brighton, England, Manila, Philippines, Tokyo, Japan, Kuala Lumpur, Malaysia and Sydney, Australia; the American Express data centers in Phoenix, Arizona and Greensboro, North Carolina; the headquarters for AENB in Sandy, Utah; the headquarters for American Express Services Europe Limited in London, England; the headquarters for American Express Europe, S.A. in Madrid, Spain; the headquarters for Amex Bank of Canada and Amex Canada Inc. in Toronto, Ontario, Canada; and the headquarters for American Express Bank (Mexico) S.A. Institucion de Banca Multiple and American Express Company (Mexico) S.A. de C.V. in Mexico City, Mexico. We also lease and operate multiple travel lounges as a benefit for our Card Members in major U.S. and global hub airports. +ITEM 3. LEGAL PROCEEDINGS +Refer to Note 12 to our “Consolidated Financial Statements,” which is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +38 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +(a) Our common stock trades principally on The New York Stock Exchange under the trading symbol AXP. As of December 31, 2020, we had 19,446 common shareholders of record. You can find dividend information concerning our common stock in Note 26 to our "Consolidated Financial Statements." For information on dividend restrictions, see “Dividends and Other Capital Distributions” under “Supervision and Regulation” and Note 22 to our “Consolidated Financial Statements.” You can find information on securities authorized for issuance under our equity compensation plans under the caption “Executive Compensation — Equity Compensation Plans” to be contained in our definitive 2021 proxy statement for our Annual Meeting of Shareholders, which is scheduled to be held on May 4, 2021. The information to be found under such caption is incorporated herein by reference. Our definitive 2021 proxy statement for our Annual Meeting of Shareholders is expected to be filed with the SEC in March 2021 (and, in any event, not later than 120 days after the close of our most recently completed fiscal year). +Stock Performance Graph +The information contained in this Stock Performance Graph section shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the SEC, or subject to the liabilities of Section 18 of the Exchange Act, except to the extent that we specifically incorporate it by reference into a document filed under the Securities Act or the Exchange Act. +The following graph compares the cumulative total shareholder return on our common shares with the total return on the S&P 500 Index and the S&P Financial Index for the last five years. It shows the growth of a $100 investment on December 31, 2015, including the reinvestment of all dividends. +Year-end Data 2015 2016 2017 2018 2019 2020 +American Express $ 100.00 $ 108.57 $ 147.88 $ 143.99 $ 190.82 $ 188.62 +S&P 500 Index $ 100.00 $ 111.95 $ 136.38 $ 130.39 $ 171.44 $ 202.96 +S&P Financial Index $ 100.00 $ 122.75 $ 149.92 $ 130.37 $ 172.21 $ 169.19 +39 +Table of Contents +(b) Not applicable. +(c) Issuer Purchases of Securities +The table below sets forth the information with respect to purchases of our common stock made by or on behalf of us during the quarter ended December 31, 2020. +Total Number of Shares +Purchased Average Price Paid Per +Share +Total Number of Shares +Purchased as Part of +Publicly Announced Plans +or Programs (c) +Maximum Number of +Shares that May +Yet Be +Purchased Under the +Plans +or Programs +October 1-31, 2020 +Repurchase program (a) +— $ — — 102,171,653 +Employee transactions (b) +— $ — N/A N/A +November 1-30, 2020 +Repurchase program (a) +— $ — — 102,171,653 +Employee transactions (b) +19,140 $ 91.24 N/A N/A +December 1-31, 2020 +Repurchase program (a) +— $ — — 102,171,653 +Employee transactions (b) +— $ — N/A N/A +Total +Repurchase program (a) +— $ — — 102,171,653 +Employee transactions (b) +19,140 $ 91.24 N/A N/A +(a) On September 23, 2019, the Board of Directors authorized the repurchase of up to 120 million common shares from time to time, subject to market conditions and in accordance with our capital plans. This authorization replaced the prior repurchase authorization and does not have an expiration date. See “MD&A – Consolidated Capital Resources and Liquidity” for additional information regarding share repurchases. +(b) Includes: (i) shares surrendered by holders of employee stock options who exercised options (granted under our incentive compensation plans) in satisfaction of the exercise price and/or tax withholding obligation of such holders and (ii) restricted shares withheld (under the terms of grants under our incentive compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares. Our incentive compensation plans provide that the value of the shares delivered or attested to, or withheld, be based on the price of our common stock on the date the relevant transaction occurs. +(c) Share purchases under publicly announced programs are made pursuant to open market purchases or privately negotiated transactions (including employee benefit plans) as market conditions warrant and at prices we deem appropriate. +40 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +2020 2019 2018 2017 2016 +Operating Results ($ in Millions) +Total revenues net of interest expense $ 36,087 $ 43,556 $ 40,338 $ 36,878 $ 35,438 +Provisions for credit losses (a) +4,730 3,573 3,352 2,760 2,027 +Expenses +27,061 31,554 28,864 26,693 25,369 +Pretax income 4,296 8,429 8,122 7,425 8,042 +Income tax provision 1,161 1,670 1,201 4,677 2,667 +Net income 3,135 $ 6,759 $ 6,921 $ 2,748 $ 5,375 +Return on average equity (b) +14.2 % 29.6 % 33.5 % 13.2 % 25.8 % +Balance Sheet ($ in Millions) +Cash and cash equivalents (c) +$ 32,965 $ 24,446 $ 27,808 $ 33,263 $ 25,494 +Card Member receivables, net 43,434 56,794 55,320 53,526 46,841 +Loans, net 70,643 89,624 83,396 74,300 65,461 +Investment securities 21,631 8,406 4,647 3,159 3,157 +Total assets 191,367 198,321 188,602 181,196 158,917 +Customer deposits 86,875 73,287 69,960 64,452 53,042 +Short-term borrowings 1,878 6,442 3,100 3,278 5,581 +Long-term debt 42,952 57,835 58,423 55,804 46,990 +Shareholders’ equity $ 22,984 $ 23,071 $ 22,290 $ 18,261 $ 20,523 +Common Share Statistics (d) +Earnings per share: +Net income attributable to common shareholders: (e) +Basic $ 3.77 $ 8.00 $ 7.93 $ 3.00 $ 5.63 +Diluted 3.77 7.99 7.91 2.99 5.61 +Cash dividends declared per common share 1.72 $ 1.64 $ 1.48 $ 1.34 $ 1.22 +Book value per common share 26.58 $ 26.51 $ 24.45 $ 19.42 $ 20.95 +Average common shares outstanding (millions) : +Basic 805 828 856 883 933 +Diluted 806 830 859 886 935 +Shares outstanding at period end (millions) +805 810 847 859 904 +Other Statistics +Number of colleagues at period end (thousands) : +United States 23 23 21 20 21 +Outside the United States 41 41 38 35 35 +Total 64 64 59 55 56 +Number of shareholders of record 19,446 19,974 21,078 22,262 23,572 +(a) Results for reporting periods beginning after January 1, 2020 are presented using the CECL methodology, while comparative information continues to be reported in accordance with the incurred loss methodology in effect for prior periods. Refer to Note 3 to the "Consolidated Financial Statements" for further information. +(b) Return on average equity is calculated by dividing one-year period of net income by one-year average of total shareholders’ equity. +(c) Effective December 31, 2020, we reclassified restricted cash from Other assets to Cash and cash equivalents on the Consolidated Balance Sheets. Prior period amounts have been revised to conform to the current period presentation. +(d) Our common stock trades principally on The New York Stock Exchange under the trading symbol AXP. +(e) Represents net income, less earnings allocated to participating share awards and dividends on preferred shares. +41 +Table of Contents +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) +EXECUTIVE OVERVIEW +BUSINESS INTRODUCTION +We are a globally integrated payments company with three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses and operations are included in Corporate & Other. +Our range of products and services includes: +• Credit card, charge card and other payment and financing products +• Merchant acquisition and processing, servicing and settlement, and point-of-sale marketing and information products and services for merchants +• Network services +• Other fee services, including fraud prevention services and the design and operation of customer loyalty programs +• Expense management products and services +• Travel and lifestyle services +Our various products and services are sold globally to diverse customer groups, including consumers, small businesses, mid-sized companies and large corporations. These products and services are sold through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams, and direct response advertising. Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +The following types of revenue are generated from our various products and services: +• Discount revenue, our largest revenue source, primarily represents the amount we earn on transactions occurring at merchants that have entered into a card acceptance agreement with us, or a Global Network Services (GNS) partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. The amount of fees charged for accepting our cards as payment for goods or services, or merchant discount, varies with, among other factors, the industry in which the merchant does business, the merchant’s overall American Express-related transaction volume, the method of payment, the settlement terms with the merchant, the method of submission of transactions and, in certain instances, the geographic scope for the related card acceptance agreement between the merchant and us (e.g., domestic or global) and the transaction amount. In some instances, an additional flat transaction fee is assessed as part of the merchant discount, and additional fees may be charged such as a variable fee for “non-swiped” card transactions or for transactions using cards issued outside the United States at merchants located in the United States; +• Interest on loans, principally represents interest income earned on outstanding balances; +• Net card fees, represent revenue earned from annual card membership fees, which vary based on the type of card and the number of cards for each account; +• Other fees and commissions, primarily represent Card Member delinquency fees, foreign currency conversion fees charged to Card Members, loyalty coalition-related fees, service fees earned from merchants, travel commissions and fees, and Membership Rewards program fees; and +• Other revenue, primarily represents revenues arising from contracts with partners of our GNS business (including commissions and signing fees less issuer rate payments), cross-border Card Member spending, ancillary merchant-related fees, earnings (losses) from equity method investments (including the GBT JV), insurance premiums earned from Card Members, and prepaid card and Travelers Cheque-related revenue. +42 +Table of Contents +NON-GAAP MEASURES +We prepare our Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America (GAAP). However, certain information included within this report constitutes non-GAAP financial measures. Our calculations of non-GAAP financial measures may differ from the calculations of similarly titled measures by other companies. +BUSINESS ENVIRONMENT +The COVID-19 pandemic has brought unprecedented challenges to businesses and economies around the world. Our 2020 financial results were significantly down year-over-year, reflecting the impact of the deterioration in the global economy due to the pandemic and the related containment measures. There remains a high degree of uncertainty relating to the ongoing spread and severity of the virus and new variants, as well as the availability, distribution and use of effective treatments and vaccines. To the extent that the global economy continues to be negatively impacted by the pandemic, our results will be affected, with credit trends and spending volumes being the key drivers of our financial performance. Throughout 2020, we focused and made substantial progress on our four priorities to manage through this period of uncertainty: supporting our colleagues and winning as a team; protecting our customers and our brand; structuring the company for growth in the future; and remaining financially strong. +Since the first quarter of 2020, our colleague base has successfully operated in a mostly remote working environment and we have sought to ensure that our colleagues have the flexibility and resources they needed to stay safe, healthy and productive. To support our customers and merchants, we offered financial and other assistance, added product benefits to reflect today’s environment, and provided the high level of customer service they expect and rely on. We experienced lower voluntary attrition rates on our proprietary products compared to the prior year. In addition, our Card Members continued to recognize our commitment to service excellence, ranking us number one in the J.D. Power U.S. Credit Card Satisfaction Study for the tenth time. We worked with our strategic partners on initiatives to support our communities and launched our largest ever Shop Small campaign to help support small merchants. In addition, we remained committed to strengthening inclusion and diversity, and committed to an action plan to promote racial, ethnic and gender equity for our colleagues, customers and communities. +Reflective of the impacts of the pandemic and the broader macroeconomic environment, our billed business for the year was down 19 percent compared to the prior year, with a low in mid-April followed by a gradual recovery over the remainder of the year. Proprietary billed business, which accounted for 86 percent of our total billings and drives most of our financial results, was also down by 19 percent. Since mid-April, we have seen steady improvement in our overall billed business, with different recovery trends in T&E and non-T&E spend. Non-T&E spend, which has historically accounted for a large portion of our billed business, recovered to pre-pandemic levels in the second half of the year resulting in a full year decline of 1 percent compared to the prior year. T&E spend continued to be significantly impacted throughout the course of the year, although we saw a modest improvement from the lows of mid-April primarily driven by proprietary consumer T&E spend, resulting in a year-over-year decline of 61 percent. +Revenues net of interest expense decreased 17 percent compared to the prior year, consistent with the trend in billings. Discount revenue, our largest revenue line, decreased 22 percent, which was a larger contraction than the decline in billed business for the year due to a decrease in the average discount rate. The average discount rate decrease was driven by a shift in spend mix to non-T&E categories. Other fees and commissions and Other revenues declined year-over-year, primarily driven by a reduction in travel-related revenues. Card fee revenues, which are recognized over a twelve-month period and therefore are slower to react to economic shifts, continued to grow as compared to the prior year. While Card Member retention remained high throughout the year, net card fee growth decelerated as we slowed new card acquisitions to manage through the peak of uncertainty during the crisis. Net interest income declined by 7 percent year-over-year, primarily driven by lower average loans. +As a result of the spend-centric nature of our business model, Card Member loans and receivables declined 16 percent and 24 percent year-over-year, respectively, due to lower billed business volumes. Provisions for credit losses increased, primarily due to a higher reserve build reflecting the deterioration of the global macroeconomic outlook, including unemployment and gross domestic product (GDP), partially offset by improved credit performance and lower loan and receivable volumes. +In order to provide support to our customers impacted by the pandemic, we created a short-term Customer Pandemic Relief program and enhanced our longer-term financial relief programs. The total balance of loans and receivables that were in a delinquent status or in one of our financial relief programs peaked in the second quarter and then declined sequentially through the remainder of the year. In addition, our write-offs and delinquencies were down year-over-year reflecting our strong risk management practices, the record levels of government stimulus and the broad availability of forbearance programs. +43 +Table of Contents +Card Member rewards, Card Member services and business development expenses are generally correlated to billings or are variable based on usage, and were lower this year due to the decline in billing volumes and lower usage of travel-related benefits. During the year, we remained focused on controlling operating expenses, while investing in marketing initiatives to support our customers, such as enhancements that we made to value propositions for many of our card products and our largest ever Shop Small campaign. +Throughout the year, our liquidity levels and capital position remained strong, with capital ratios that are well above our targets and regulatory requirements. These robust liquidity and capital levels provide us with significant flexibility to maintain the strength of our balance sheet through this uncertain period. Looking forward, we remain committed to capital distributions through dividend payments and resuming share repurchases up to our maximum capacity authorized by the Federal Reserve in the first quarter of 2021. +Our progress in managing through the pandemic over the last year confirms the resilience of our differentiated business model, which includes a loyal and diverse customer base, a valued brand, our global merchant network, and our integrated payments platform. All of this, supported by our resilient colleagues around the world, provides us with a solid foundation as we move into 2021, which we see as a transition year. We will still be managing through the effects of the pandemic, but with an increased focus on maximizing investments in areas that will enable us to rebuild growth momentum. +See “Supervision and Regulation” in “Business” for information on legislative and regulatory changes that could have a material adverse effect on our results of operations and financial condition and “Risk Factors” and “Cautionary Note Regarding Forward Looking Statements” for information on additional potential impacts of the COVID-19 pandemic and the potential impacts of economic, geopolitical and competitive conditions and certain litigation and regulatory matters on our business. +44 +Table of Contents +CONSOLIDATED RESULTS OF OPERATIONS +Refer to the "Glossary of Selected Terminology" for the definitions of certain key terms and related information appearing within this section. +The discussions in the “Financial Highlights”, “Consolidated Results of Operations” and “Business Segment Results of Operations” provide commentary on the variances for the year ended December 31, 2020 compared to the year ended December 31, 2019, as presented in the accompanying tables. These discussions should be read in conjunction with the discussion under "Business Environment," which contains further information on the COVID-19 pandemic and the related impacts on our consolidated results of operations. For a discussion of the financial condition and results of operations for 2019 compared to 2018, please refer to Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 13, 2020. +As a result of the adoption of CECL on January 1, 2020, there is a lack of comparability in both the reserves and provisions for credit losses for the periods presented. Results for reporting periods beginning after January 1, 2020 are presented using the CECL methodology, while comparative information continues to be reported in accordance with the incurred loss methodology in effect for prior periods. Refer to Note 3 to the "Consolidated Financial Statements" for further information. +TABLE 1: SUMMARY OF FINANCIAL PERFORMANCE +Years Ended December 31, Change Change +(Millions, except percentages and per share amounts) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Total revenues net of interest expense $ 36,087 $ 43,556 $ 40,338 $ (7,469) (17) % $ 3,218 8 % +Provisions for credit losses 4,730 3,573 3,352 1,157 32 221 7 +Expenses 27,061 31,554 28,864 (4,493) (14) 2,690 9 +Pretax income 4,296 8,429 8,122 (4,133) (49) 307 4 +Income tax provision 1,161 1,670 1,201 (509) (30) 469 39 +Net income 3,135 6,759 6,921 (3,624) (54) (162) (2) +Earnings per common share — diluted (a) +$ 3.77 $ 7.99 $ 7.91 $ (4.22) (53) % $ 0.08 1 % +Return on average equity (b) +14.2 % 29.6 % 33.5 % +Effective tax rate (ETR) 27.0 % 19.8 % 14.8 % +Adjustments to ETR (c) +6.1 % +Adjusted ETR (c) +20.9 % +(a) Represents net income, less (i) earnings allocated to participating share awards of $20 million, $47 million and $54 million for the years ended December 31, 2020, 2019 and 2018, respectively, and (ii) dividends on preferred shares of $79 million, $81 million and $80 million for the years ended December 31, 2020, 2019 and 2018, respectively. +(b) Return on average equity (ROE) is computed by dividing (i) one-year period of net income ($3.1 billion, $6.8 billion and $6.9 billion for 2020, 2019 and 2018, respectively) by (ii) one-year average of total shareholders’ equity ($22.0 billion, $22.8 billion and $20.7 billion for 2020, 2019 and 2018, respectively). +(c) The adjusted ETR for 2018 is a non-GAAP measure. The 2018 adjusted ETR excludes a benefit of $496 million relating to changes in the tax method of accounting for certain expenses, the resolution of certain prior years’ tax audits, and a final adjustment to our 2017 provisional tax charge related to the Tax Cuts and Jobs Act enacted on December 22, 2017 (Tax Act). +TABLE 2: TOTAL REVENUES NET OF INTEREST EXPENSE SUMMARY +Years Ended December 31, Change Change +(Millions, except percentages) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Discount revenue $ 20,401 $ 26,167 $ 24,721 $ (5,766) (22) % $ 1,446 6 % +Net card fees 4,664 4,042 3,441 622 15 601 17 +Other fees and commissions 2,163 3,297 3,153 (1,134) (34) 144 5 +Other 874 1,430 1,360 (556) (39) 70 5 +Total non-interest revenues 28,102 34,936 32,675 (6,834) (20) 2,261 7 +Total interest income 10,083 12,084 10,606 (2,001) (17) 1,478 14 +Total interest expense 2,098 3,464 2,943 (1,366) (39) 521 18 +Net interest income 7,985 8,620 7,663 (635) (7) 957 12 +Total revenues net of interest expense $ 36,087 $ 43,556 $ 40,338 $ (7,469) (17) % $ 3,218 8 % +45 +Table of Contents +TOTAL REVENUES NET OF INTEREST EXPENSE +Discount revenue decreased, primarily due to a decrease in worldwide billed business of 19 percent. U.S. billed business decreased 16 percent and non-U.S. billed business decreased 23 percent due to the impacts of the COVID-19 pandemic during 2020. +Additional billed business highlights for the full year 2020 as compared to full year 2019: +• Worldwide non-T&E billed business decreased 1 percent and T&E billed business decreased 61 percent. +• Proprietary consumer billed business decreased by 17 percent, primarily driven by declines in T&E, and offline non-T&E spend, which were partially offset by increased online and card-not-present spend at non-T&E merchants. +• Proprietary commercial billed business decreased by 21 percent, primarily driven by year-over-year decreases in T&E spend by large and global corporate card customers, with less pronounced billed business declines from small and mid-sized enterprises, where T&E volumes made up a lower proportion of spend. +See Tables 5 and 6 for more details on billed business performance. +The decrease in discount revenue was also driven by a decrease in the average discount rate primarily due to a shift in spend mix to non-T&E categories. The average discount rate was 2.28 percent for 2020 and 2.37 percent for 2019. +Net card fees increased, primarily driven by our premium card product portfolios. Card fees, which are recognized over a twelve-month period, are slower to react to economic shifts, such as those arising from the impacts of the COVID-19 pandemic. +Other fees and commissions decreased, primarily due to the impacts of travel restrictions related to the COVID-19 pandemic, which resulted in lower foreign exchange conversion revenue related to decreased cross-border Card Member spending and lower travel commissions and fees from our consumer travel business, as well as a decline in late fees due to lower delinquencies. +Other revenues decreased, primarily driven by a net loss in the current year, as compared to net income in the prior year, from the GBT JV and lower revenue earned on cross-border Card Member spending due to the impacts of the COVID-19 pandemic, including travel restrictions. +Interest income decreased, primarily driven by a reduction in benchmark interest rates and lower average Card Member loan volumes. +Interest expense decreased, primarily driven by lower interest rates paid on deposits and a reduction in outstanding debt. +46 +Table of Contents +TABLE 3: PROVISIONS FOR CREDIT LOSSES SUMMARY +Years Ended December 31, Change Change +(Millions, except percentages) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Card Member receivables +Net write-offs $ 881 $ 900 $ 859 $ (19) (2) % $ 41 5 % +Reserve build 134 63 78 71 113 (15) (19) +Total 1,015 963 937 52 5 26 3 +Card Member loans +Net write-offs 2,170 2,235 1,843 (65) (3) 392 21 +Reserve build 1,283 227 423 1,056 # (196) (46) +Total 3,453 2,462 2,266 991 40 196 9 +Other +Net write-offs - Other loans (a) +111 98 79 13 13 19 24 +Net write-offs - Other receivables (b) +27 20 32 7 35 (12) (38) +Reserve build - Other loans (a) +66 28 44 38 # (16) (36) +Reserve build (release) - Other receivables (b) +58 2 (6) 56 # 8 (133) +Total 262 148 149 114 77 (1) (1) +Total provisions for credit losses $ 4,730 $ 3,573 $ 3,352 $ 1,157 32 % $ 221 7 % +# Denotes a variance greater than 100 percent +(a) Relates to Other loans of $2.9 billion, $4.8 billion, and $3.8 billion less reserves of $238 million, $152 million, and $124 million, as of December 31, 2020, 2019 and 2018, respectively. +(b) Relates to Other receivables included in Other assets on the Consolidated Balance Sheets of $3 billion, $3.1 billion, and $2.9 billion, less reserves of $85 million, $27 million, $25 million as of December 31, 2020, 2019, and 2018, respectively. +PROVISIONS FOR CREDIT LOSSES +Card Member loans and receivables provision for credit losses increased, primarily driven by a higher reserve build reflecting the deterioration of the global macroeconomic outlook, including unemployment and GDP, partially offset by improved credit performance and a decline in the outstanding balance of Card Member loans and receivables. +Other provision for credit losses increased, primarily driven by a higher reserve build and higher net write-offs. +Refer to Note 1 to the "Consolidated Financial Statements" for further information about CECL, including the January 1, 2020 implementation impact on reserves. +TABLE 4: EXPENSES SUMMARY +Years Ended December 31, Change Change +(Millions, except percentages) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Marketing and business development +$ 6,747 $ 7,125 $ 6,477 $ (378) (5) % $ 648 10 % +Card Member rewards 8,041 10,439 9,696 (2,398) (23) 743 8 +Card Member services 1,230 2,223 1,777 (993) (45) 446 25 +Total marketing, business development, rewards and Card Member services 16,018 19,787 17,950 (3,769) (19) 1,837 10 +Salaries and employee benefits 5,718 5,911 5,250 (193) (3) 661 13 +Other, net +5,325 5,856 5,664 (531) (9) 192 3 +Total expenses $ 27,061 $ 31,554 $ 28,864 $ (4,493) (14) % $ 2,690 9 % +EXPENSES +In January 2020, we re-launched our Delta cobrand products following the renewal extending our cobrand relationship with Delta Air Lines on March 31, 2019. The contract renewal included new pricing terms, some of which became effective upon contract signing and others that were tied to the product re-launch. These pricing changes, as well as changes in the expense classification of certain benefits associated with the re-launch, resulted in an increase to Marketing and business development and decreases to both Card Member rewards and Card Member services expenses, as compared to the prior year. +47 +Table of Contents +Marketing and business development expense decreased, primarily due to a temporary reduction in proactive marketing for Card Member acquisitions, as well as decreases in corporate client incentives and network partner payments due to lower billed business, all of which were a result of the impacts of the COVID-19 pandemic, partially offset by incremental investments in limited time enhancements to our Card Member value proposition to maintain customer engagement and the Delta changes described above. +Card Member rewards expense decreased, primarily driven by decreases in Membership Rewards and cash back rewards expenses of $1,579 million and cobrand rewards expense of $819 million, both of which were primarily driven by lower billed business as a result of the impacts of the COVID-19 pandemic. In addition, changes in redemption mix due to a decline in higher cost travel redemptions since the onset of the COVID-19 pandemic contributed to a decrease in the Membership Rewards weighted average cost (WAC) per reward point and expense. Cobrand rewards expense also reflected the impact of the Delta changes described above. +The Membership Rewards Ultimate Redemption Rate (URR) for current program participants was 96 percent (rounded up) at both December 31, 2020 and 2019. +Card Member services expense decreased, primarily due to lower usage of travel-related benefits as a result of the impacts of the COVID-19 pandemic, as well as the Delta changes described above. +Salaries and employee benefits expense decreased, primarily driven by lower incentive compensation expenses, partially offset by increased payroll costs due to a higher full year average headcount as compared to the prior year. +Other expenses decreased, primarily driven by a prior year litigation-related charge, lower employee-related operating costs and lower professional services expense, partially offset by a prior year non-income tax-related benefit. +48 +Table of Contents +INCOME TAXES +The effective tax rate for 2020 was 27.0 percent. The effective tax rate for 2019 was 19.8 percent. The increase in the effective tax rate in the current period primarily reflected discrete tax charges related to the realizability of certain foreign deferred tax assets, resulting from cumulative losses in certain non-U.S. legal entities that were exacerbated by the impacts of the COVID-19 pandemic. The tax rates in both periods reflect the level of pretax income in relation to recurring permanent tax benefits and the geographic mix of business. +TABLE 5: SELECTED CARD-RELATED STATISTICAL INFORMATION +Change Change +Years Ended December 31, 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Billed business: (billions) +U.S. $ 693.1 $ 827.7 $ 777.6 (16) % 6 % +Outside the U.S. 317.5 413.1 406.4 (23) 2 +Total $ 1,010.6 $ 1,240.8 $ 1,184.0 (19) 5 +Proprietary $ 870.7 $ 1,070.5 $ 1,002.6 (19) 7 +GNS 139.9 170.3 181.4 (18) (6) +Total $ 1,010.6 $ 1,240.8 $ 1,184.0 (19) 5 +Cards-in-force: (millions) +U.S. 53.8 54.7 53.7 (2) 2 +Outside the U.S. 58.2 59.7 60.3 (3) (1) +Total 112.0 114.4 114.0 (2) — +Proprietary 68.9 70.3 69.1 (2) 2 +GNS 43.1 44.1 44.9 (2) (2) +Total 112.0 114.4 114.0 (2) — +Basic cards-in-force: (millions) +U.S. 42.2 43.0 42.3 (2) 2 +Outside the U.S. 49.1 50.0 50.3 (2) (1) +Total 91.3 93.0 92.6 (2) — +Average proprietary basic Card Member spending: (dollars) +U.S. $ 18,085 $ 21,515 $ 20,840 (16) 3 +Outside the U.S. $ 12,264 $ 16,351 $ 15,756 (25) 4 +Worldwide Average $ 16,352 $ 19,972 $ 19,340 (18) 3 +Average discount rate +2.28 % 2.37 % 2.37 % +Average fee per card (dollars) (a) +$ 67 $ 58 $ 51 16 % 14 % +(a) Average fee per card is computed based on proprietary net card fees divided by average proprietary total cards-in-force. +49 +Table of Contents +TABLE 6: BILLED BUSINESS-RELATED STATISTICAL INFORMATION +2020 2019 +Percentage Increase +(Decrease) +Percentage Increase (Decrease) Assuming No Changes in FX Rates (a) +Percentage Increase +(Decrease) +Percentage Increase (Decrease) +Assuming No Changes in FX Rates (a) +Worldwide +Proprietary +Proprietary consumer (17) % (17) % 8 % 9 % +Proprietary commercial (21) (21) 6 6 +Total Proprietary (19) (19) 7 8 +GNS (18) (17) (6) (2) +Worldwide Total (19) (18) 5 6 +T&E-related volume (14% and 30% of Worldwide Total for 2020 and 2019, respectively) (b) +(61) (60) 4 6 +Non-T&E-related volume (86% and 70% of Worldwide Total for 2020 and 2019, respectively) (b) +(1) (1) 6 7 +Airline-related volume (3% and 8% of Worldwide Total for 2020 and 2019, respectively) (b) +(76) (76) 1 3 +U.S. +Proprietary +Proprietary consumer (15) 7 +Proprietary commercial (18) 5 +Total Proprietary (16) 6 +U.S. Total (16) 6 +T&E-related volume (13% and 25% of U.S. Total for 2020 and 2019, respectively) (b) +(57) 6 +Non-T&E-related volume (87% and 75% of U.S. Total for 2020 and 2019, respectively) (b) +(1) 6 +Airline-related volume (2% and 7% of U.S. Total for 2020 and 2019, respectively) (b) +(75) 4 +Outside the U.S. +Proprietary +Proprietary consumer (21) (21) 10 14 +Proprietary commercial (32) (31) 7 11 +Total Proprietary (26) (25) 9 13 +Outside the U.S. Total (23) (22) 2 6 +Asia Pacific, Australia and New Zealand +(16) (16) 1 5 +Latin America & Canada (32) (26) 4 10 +Europe, the Middle East & Africa (30) % (31) % 1 % 5 % +(a) The foreign currency adjusted information assumes a constant exchange rate between the periods being compared for purposes of currency translation into U.S. dollars (i.e., assumes the foreign exchange rates used to determine results for the current year apply to the corresponding prior-year period against which such results are being compared). +(b) Based on billed business from merchants we acquire or merchants acquired by third parties on our behalf (e.g., OptBlue merchants). +50 +Table of Contents +TABLE 7: SELECTED CREDIT-RELATED STATISTICAL INFORMATION +As of or for the Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Worldwide Card Member loans: +Card Member loans: (billions) +U.S. $ 64.2 $ 76.0 $ 72.0 (16) % 6 % +Outside the U.S. 9.2 11.4 9.9 (19) 15 +Total +$ 73.4 $ 87.4 $ 81.9 (16) 7 +Credit loss reserves: +Beginning balance (a) +$ 4,027 $ 2,134 $ 1,706 89 25 +Provisions - principal, interest and fees 3,453 2,462 2,266 40 9 +Net write-offs — principal less recoveries (1,795) (1,860) (1,539) (3) 21 +Net write-offs — interest and fees less recoveries (375) (375) (304) — 23 +Other (b) +34 22 5 55 # +Ending balance $ 5,344 $ 2,383 $ 2,134 # 12 +% of loans 7.3 % 2.7 % 2.6 % +% of past due 727 % 177 % 182 % +Average loans (billions) +$ 74.6 $ 82.8 $ 75.8 (10) 9 +Net write-off rate — principal only (c) +2.4 % 2.2 % 2.0 % +Net write-off rate — principal, interest and fees (c) +2.9 % 2.7 % 2.4 % +30+ days past due as a % of total +1.0 % 1.5 % 1.4 % +Worldwide Card Member receivables: +Card Member receivables: (billions) +U.S. $ 30.5 $ 39.0 $ 39.0 (22) — +Outside the U.S. 13.2 18.4 16.9 (28) 9 +Total +$ 43.7 $ 57.4 $ 55.9 (24) 3 +Credit loss reserves: +Beginning balance (a) +$ 126 $ 573 $ 521 (78) 10 +Provisions - principal and fees 1,015 963 937 5 3 +Net write-offs - principal and fees less recoveries (881) (900) (859) (2) 5 +Other (b) +7 (17) (26) # (35) +Ending balance $ 267 $ 619 $ 573 (57) % 8 % +% of receivables 0.6 % 1.1 % 1.0 % +Net write-off rate — principal and fees (c)(d) +2.0 % 1.6 % 1.6 % +# Denotes a variance greater than 100 percent +(a) Includes an increase of $1,643 million and decrease of $493 million to the beginning reserve balances for Card Member loans and receivables, respectively, as of January 1, 2020, related to the adoption of the CECL methodology. Refer to Note 3 to the "Consolidated Financial Statements" for further information. +(b) Other includes foreign currency translation adjustments. +(c) We present a net write-off rate based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, as our practice is to include uncollectible interest and/or fees as part of our total provision for credit losses, a net write-off rate including principal, interest and/or fees is also presented. +(d) Refer to Tables 10 and 13 for Net write-off rate - principal only and 30+ days past due metrics for GCSG and Global Small Business Services (GSBS) receivables, respectively. A net write-off rate based on principal losses only for Global Corporate Payments (GCP), which reflects global, large and middle market corporate accounts, is not available due to system constraints. +51 +Table of Contents +TABLE 8: NET INTEREST YIELD ON AVERAGE CARD MEMBER LOANS +Effective for the first quarter of 2020, we made certain enhancements to our methodology related to the allocation of certain funding costs primarily related to our Card Member loan and Card Member receivable portfolios. These enhancements resulted in a change to the interest expense not attributable to our Card Member loan portfolio and therefore also on our Net Interest Yield on Average Card Member loans. Prior period amounts have been revised to conform to the current period presentation. +Years Ended December 31, +(Millions, except percentages and where indicated) 2020 2019 2018 +Net interest income $ 7,985 $ 8,620 $ 7,663 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +1,295 1,833 1,592 +Interest income not attributable to our Card Member loan portfolio (b) +(668) (1,227) (1,010) +Adjusted net interest income (c) +$ 8,612 $ 9,226 $ 8,245 +Average Card Member loans (billions) +$ 74.6 $ 82.8 $ 75.8 +Net interest income divided by average Card Member loans (c) +10.7 % 10.4 % 10.1 % +Net interest yield on average Card Member loans (c) +11.5 % 11.1 % 10.9 % +(a) Primarily represents interest expense attributable to maintaining our corporate liquidity pool and funding Card Member receivables. +(b) Primarily represents interest income attributable to Other loans, interest-bearing deposits and the fixed income investment portfolios. +(c) Adjusted net interest income and net interest yield on average Card Member loans are non-GAAP measures. Refer to “Glossary of Selected Terminology” for the definitions of these terms. We believe adjusted net interest income is useful to investors because it represents the interest expense and interest income attributable to our Card Member loan portfolio and is a component of net interest yield on average Card Member loans, which provides a measure of profitability of our Card Member loan portfolio. Net interest yield on average Card Member loans reflects adjusted net interest income divided by average Card Member loans, computed on an annualized basis. Net interest income divided by average Card Member loans, computed on an annualized basis, a GAAP measure, includes elements of total interest income and total interest expense that are not attributable to the Card Member loan portfolio, and thus is not representative of net interest yield on average Card Member loans. +52 +Table of Contents +BUSINESS SEGMENT RESULTS OF OPERATIONS +We consider a combination of factors when evaluating the composition of our reportable operating segments, including the results reviewed by the chief operating decision maker, economic characteristics, products and services offered, classes of customers, product distribution channels, geographic considerations (primarily United States versus outside the United States) and regulatory considerations. Refer to Note 24 to the “Consolidated Financial Statements” and Part I, Item 1. “Business” for additional discussion of products and services that comprise each segment. +Effective for the first quarter of 2020, we made certain enhancements to our transfer pricing methodology related to the sharing of revenues among our card issuing, network and merchant businesses, and our methodology related to the allocation of certain funding costs primarily related to our Card Member loan and Card Member receivable portfolios. These enhancements resulted in certain changes to Non-interest revenues and Interest expense within Total revenues net of interest expense and Operating expenses within Total expenses across our reportable operating segments. +The enhancements related to the allocation of certain funding costs also resulted in a change to our Net interest income divided by Average Card Member loans metric and Net Interest Yield on Average Card Member loans, a non-GAAP measure, within our reportable operating segments. +For all of the above-referenced changes, prior period amounts have been revised to conform to the current period presentation. +Results of the reportable operating segments generally treat each segment as a stand-alone business. The management reporting process that derives these results allocates revenue and expense using various methodologies as described below. +TOTAL REVENUES NET OF INTEREST EXPENSE +We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue. +Net card fees and Other fees and commissions are directly attributable to the segment in which they are reported. +Interest and fees on loans and certain investment income is directly attributable to the segment in which it is reported. Interest expense represents an allocated funding cost based on a combination of segment funding requirements and internal funding rates. +PROVISIONS FOR CREDIT LOSSES +The provisions for credit losses are directly attributable to the segment in which they are reported. +EXPENSES +Marketing and business development expense is included in each segment based on the actual expenses incurred. Global brand advertising is primarily allocated to the segments based on the relative levels of revenue. Rewards and Card Member services expenses are included in each segment based on the actual expenses incurred. +Salaries and employee benefits and other operating expenses reflect both costs incurred directly within each segment, as well as allocated expenses. The allocated expenses include service costs allocated based on activities directly attributable to the segment, and overhead expenses allocated based on the relative levels of revenue and Card Member loans and receivables. +INCOME TAXES +An income tax provision (benefit) is allocated to each reportable operating segment based on the effective tax rates applicable to the various businesses that comprise the segment. +53 +Table of Contents +GLOBAL CONSUMER SERVICES GROUP +TABLE 9: GCSG SELECTED INCOME STATEMENT DATA +Years Ended December 31, Change Change +(Millions, except percentages) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Revenues +Non-interest revenues $ 14,178 $ 16,702 $ 15,357 $ (2,524) (15) % $ 1,345 9 % +Interest income 8,199 9,413 8,323 (1,214) (13) 1,090 13 +Interest expense 1,051 1,730 1,448 (679) (39) 282 19 +Net interest income 7,148 7,683 6,875 (535) (7) 808 12 +Total revenues net of interest expense 21,326 24,385 22,232 (3,059) (13) 2,153 10 +Provisions for credit losses 3,148 2,635 2,431 513 19 204 8 +Total revenues net of interest expense after provisions for credit losses 18,178 21,750 19,801 (3,572) (16) 1,949 10 +Expenses +Marketing, business development, rewards and Card Member services 9,668 12,043 10,796 (2,375) (20) 1,247 12 +Salaries and employee benefits and other operating expenses 4,903 4,967 4,585 (64) (1) 382 8 +Total expenses 14,571 17,010 15,381 (2,439) (14) 1,629 11 +Pretax segment income 3,607 4,740 4,420 (1,133) (24) 320 7 +Income tax provision 906 933 805 (27) (3) 128 16 +Segment income $ 2,701 $ 3,807 $ 3,615 $ (1,106) (29) % $ 192 5 % +Effective tax rate 25.1 % 19.7 % 18.2 % +GCSG primarily issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel and lifestyle services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues decreased, primarily driven by lower discount revenue and other fees and commissions, partially offset by higher net card fees. Discount revenue decreased 20 percent, reflecting a decrease in proprietary consumer billed business of 17 percent. See Tables 5, 6 and 10 for more details on billed business performance. +Other fees and commissions decreased 40 percent, primarily due to the impacts of travel restrictions related to the COVID-19 pandemic, which resulted in lower travel commissions and fees from our consumer travel business and lower foreign exchange conversion revenue related to decreased cross-border spending, as well as a decline in late fees due to lower delinquencies. +Net card fees increased 16 percent, driven by a year-over-year increase in the average fee per card of our premium card products. +Net interest income decreased, primarily due to lower average Card Member loan volumes and a reduction in benchmark interest rates, partially offset by a lower cost of funds. +PROVISIONS FOR CREDIT LOSSES +Provisions for credit losses increased, primarily driven by a higher reserve build in Card Member loans, partially offset by lower net write-offs in both the Card Member loans and receivables portfolios. The higher reserve build primarily reflected the deterioration of the global macroeconomic outlook, including unemployment and GDP, partially offset by improved credit performance and a decline in the outstanding balance of loans and receivables. +54 +Table of Contents +EXPENSES +Marketing, business development, rewards and Card Member services expenses decreased due to reductions in Card Member rewards and Card Member services expenses, partially offset by increased Marketing and business development costs. The decrease in Card Member rewards expense was primarily driven by a decrease in billed business and a change in redemption mix due to a decline in higher cost travel redemptions since the onset of the COVID-19 pandemic. The decrease in Card Member services expense was primarily driven by lower usage of travel-related benefits. Those decreases were partially offset by increased Marketing and business development expense, primarily due to incremental investments in limited time enhancements to our Card Member value proposition to maintain customer engagement, partially offset by a temporary reduction in proactive marketing for Card Member acquisitions. +55 +Table of Contents +TABLE 10: GCSG SELECTED STATISTICAL INFORMATION +As of or for the Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Proprietary billed business: (billions) +U.S. $ 337.6 $ 398.8 $ 371.1 (15) % 7 % +Outside the U.S. 121.1 154.0 140.3 (21) 10 +Total $ 458.7 $ 552.8 $ 511.4 (17) 8 +Proprietary cards-in-force: +U.S. 37.7 37.9 37.7 (1) 1 +Outside the U.S. 16.7 17.5 16.8 (5) 4 +Total 54.4 55.4 54.5 (2) 2 +Proprietary basic cards-in-force: +U.S. 26.6 26.9 27.0 (1) — +Outside the U.S. 11.6 12.1 11.6 (4) 4 +Total 38.2 39.0 38.6 (2) 1 +Average proprietary basic Card Member spending: (dollars) +U.S. $ 12,641 $ 14,801 $ 14,161 (15) 5 +Outside the U.S. $ 10,175 $ 12,884 $ 12,348 (21) 4 +Average $ 11,881 $ 14,212 $ 13,613 (16) 4 +Total segment assets (billions) +$ 86.7 $ 106.3 $ 102.4 (18) 4 +Card Member loans: +Total loans (billions) +U.S. $ 51.4 $ 62.4 $ 59.9 (18) 4 +Outside the U.S. 8.7 10.9 9.6 (20) 14 +Total $ 60.1 $ 73.3 $ 69.5 (18) 5 +Average loans (billions) +U.S. $ 53.0 $ 59.4 $ 55.1 (11) 8 +Outside the U.S. 8.6 10.0 8.9 (14) 12 +Total $ 61.6 $ 69.4 $ 64.0 (11) % 8 % +U.S. +Net write-off rate — principal only (a) +2.4 % 2.3 % 2.1 % +Net write-off rate — principal, interest and fees (a) +2.9 % 2.8 % 2.5 % +30+ days past due as a % of total 1.0 % 1.6 % 1.4 % +Outside the U.S. +Net write-off rate — principal only (a) +3.0 % 2.4 % 2.1 % +Net write-off rate — principal, interest and fees (a) +3.7 % 2.9 % 2.6 % +30+ days past due as a % of total 1.7 % 1.8 % 1.6 % +Total +Net write-off rate — principal only (a) +2.5 % 2.3 % 2.1 % +Net write-off rate — principal, interest and fees (a) +3.0 % 2.8 % 2.5 % +30+ days past due as a % of total 1.1 % 1.6 % 1.5 % +56 +Table of Contents +Change Change +(Millions, except percentages and where indicated) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Card Member receivables: (billions) +U.S. $ 11.9 $ 14.2 $ 13.7 (16) % 4 % +Outside the U.S. 6.8 8.6 7.8 (21) 10 +Total receivables $ 18.7 $ 22.8 $ 21.5 (18) % 6 % +U.S. +Net write-off rate — principal only (a) +1.3 % 1.4 % 1.3 % +Net write-off rate — principal and fees (a) +1.4 % 1.6 % 1.5 % +30+ days past due as a % of total 0.4 % 1.2 % 1.1 % +Outside the U.S. +Net write-off rate — principal only (a) +2.5 % 2.2 % 2.1 % +Net write-off rate — principal and fees (a) +2.7 % 2.4 % 2.3 % +30+ days past due as a % of total 1.0 % 1.3 % 1.3 % +Total +Net write-off rate — principal only (a) +1.7 % 1.7 % 1.6 % +Net write-off rate — principal and fees (a) +1.9 % 1.9 % 1.8 % +30+ days past due as a % of total 0.6 % 1.2 % 1.2 % +(a) Refer to Table 7 footnote (c). +57 +Table of Contents +TABLE 11: GCSG NET INTEREST YIELD ON AVERAGE CARD MEMBER LOANS +As of or for the Years Ended December 31, +(Millions, except percentages and where indicated) 2020 2019 2018 +U.S. +Net interest income $ 6,222 $ 6,660 $ 5,985 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +288 276 233 +Interest income not attributable to our Card Member loan portfolio (b) +(189) (220) (179) +Adjusted net interest income (c) +$ 6,321 $ 6,716 $ 6,039 +Average Card Member loans (billions) +$ 53.0 $ 59.4 $ 55.1 +Net interest income divided by average Card Member loans (c) +11.7 % 11.2 % 10.9 % +Net interest yield on average Card Member loans (c) +11.9 % 11.3 % 11.0 % +Outside the U.S. +Net interest income $ 926 $ 1,024 $ 890 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +101 85 69 +Interest income not attributable to our Card Member loan portfolio (b) +(11) (15) (8) +Adjusted net interest income (c) +$ 1,016 $ 1,094 $ 951 +Average Card Member loans (billions) +$ 8.6 $ 10.0 $ 8.9 +Net interest income divided by average Card Member loans (c) +10.8 % 10.2 % 10.0 % +Net interest yield on average Card Member loans (c) +11.9 % 10.9 % 10.7 % +Total +Net interest income $ 7,148 $ 7,683 $ 6,875 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (a) +389 361 302 +Interest income not attributable to our Card Member loan portfolio (b) +(200) (234) (187) +Adjusted net interest income (c) +$ 7,337 $ 7,810 $ 6,990 +Average Card Member loans (billions) +$ 61.6 $ 69.4 $ 64.0 +Net interest income divided by average Card Member loans (c) +11.6 % 11.1 % 10.7 % +Net interest yield on average Card Member loans (c) +11.9 % 11.3 % 10.9 % +(a) Refer to Table 8 footnote (a). +(b) Refer to Table 8 footnote (b). +(c) Refer to Table 8 footnote (c). +58 +Table of Contents +GLOBAL COMMERCIAL SERVICES +TABLE 12: GCS SELECTED INCOME STATEMENT DATA +Years Ended December 31, Change Change +(Millions, except percentages) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Revenues +Non-interest revenues $ 9,652 $ 12,242 $ 11,481 $ (2,590) (21) % $ 761 7 % +Interest income 1,586 1,900 1,621 (314) (17) 279 17 +Interest expense 619 1,034 898 (415) (40) 136 15 +Net interest income 967 866 723 101 12 143 20 +Total revenues net of interest expense 10,619 13,108 12,204 (2,489) (19) 904 7 +Provisions for credit losses 1,493 918 900 575 63 18 2 +Total revenues net of interest expense after provisions for credit losses 9,126 12,190 11,304 (3,064) (25) 886 8 +Expenses +Marketing, business development, rewards and Card Member services 4,991 6,237 5,844 (1,246) (20) 393 7 +Salaries and employee benefits and other operating expenses 3,199 3,261 2,996 (62) (2) 265 9 +Total expenses 8,190 9,498 8,840 (1,308) (14) 658 7 +Pretax segment income 936 2,692 2,464 (1,756) (65) 228 9 +Income tax provision 200 501 452 (301) (60) 49 11 +Segment income $ 736 $ 2,191 $ 2,012 $ (1,455) (66) % $ 179 9 % +Effective tax rate 21.4 % 18.6 % 18.3 % +GCS primarily issues a wide range of proprietary corporate and small business cards. In addition, GCS provides payment, expense management and commercial financing products. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues decreased, primarily driven by lower discount revenue and other fees and commissions. Discount revenue decreased, primarily due to a decrease in commercial billed business of 21 percent. See Tables 5, 6 and 13 for more details on billed business performance. Other fees and commissions decreased, primarily due to a decline in late fees due to lower delinquencies, as well as lower foreign exchange conversion revenue related to decreased cross-border spending, primarily driven by the impacts of travel restrictions related to the COVID-19 pandemic. +Net interest income increased, primarily driven by a lower cost of funds, partially offset by a reduction in benchmark interest rates. +PROVISIONS FOR CREDIT LOSSES +Provisions for credit losses increased, primarily driven by a higher reserve build and higher net write-offs. The higher reserve build primarily reflected the deterioration of the global macroeconomic outlook, including unemployment and GDP, partially offset by improved credit performance and a decline in the outstanding balance of loans and receivables. +EXPENSES +Marketing, business development, rewards and Card Member services expenses decreased, primarily due to reductions in Card Member rewards expense and Marketing and business development expense. The decrease in Card Member rewards expense was primarily driven by a decrease in billed business. The decrease in Marketing and business development expense was primarily due to a decrease in corporate client incentives and a temporary reduction in proactive marketing for Card Member acquisitions, partially offset by incremental investments in limited time enhancements to our Card Member value proposition to maintain customer engagement. +59 +Table of Contents +TABLE 13: GCS SELECTED STATISTICAL INFORMATION +As of or for the Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Proprietary billed business (billions) +$ 406.5 $ 513.3 $ 486.2 (21) % 6 % +Proprietary cards-in-force 14.5 14.9 14.5 (3) 3 +Average Card Member spending (dollars) +$ 27,769 $ 34,905 $ 34,058 (20) 2 +Total segment assets (billions) +$ 42.1 $ 52.8 $ 51.3 (20) 3 +GSBS Card Member loans: +Total loans (billions) +$ 13.2 $ 14.1 $ 12.4 (6) 14 +Average loans (billions) +$ 12.9 $ 13.3 $ 11.7 (3) % 14 % +Net write-off rate - principal only (a) +2.1 % 1.9 % 1.7 % +Net write-off rate - principal, interest and fees (a) +2.4 % 2.2 % 2.0 % +30+ days past due as a % of total 0.7 % 1.3 % 1.3 % +Calculation of Net Interest Yield on Average Card Member Loans: +Net interest income $ 967 $ 866 $ 723 +Exclude: +Interest expense not attributable to our Card Member loan portfolio (b) +478 772 693 +Interest income not attributable to our Card Member loan portfolio (c) +(170) (222) (161) +Adjusted net interest income (d) +$ 1,275 $ 1,416 $ 1,255 +Average Card Member loans (billions) +$ 13.0 $ 13.4 $ 11.8 +Net interest income divided by average Card Member loans (d) +7.4 % 6.5 % 6.1 % +Net interest yield on average Card Member loans (d) +9.8 % 10.6 % 10.7 % +Card Member receivables: +Total receivables (billions) +$ 25.0 $ 34.6 $ 34.4 (28) % 1 % +Net write-off rate - principal and fees (a)(e) +2.1 % 1.4 % 1.5 % +GCP Card Member receivables: +Total receivables (billions) +$ 10.9 $ 17.2 $ 17.7 (37) % (3) % +90+ days past billing as a % of total (e) +0.6 % 0.8 % 0.7 % +Net write-off rate - principal and fees (a)(e) +1.9 % 0.8 % 1.1 % +GSBS Card Member receivables: +Total receivables (billions) +$ 14.1 $ 17.4 $ 16.7 (19) % 4 % +Net write-off rate - principal only (a) +2.1 % 1.9 % 1.7 % +Net write-off rate - principal and fees (a) +2.3 % 2.1 % 2.0 % +30+ days past due as a % of total 0.7 % 1.7 % 1.6 % +(a) Refer to Table 7 footnote (c). +(b) Refer to Table 8 footnote (a). +(c) Refer to Table 8 footnote (b). +(d) Refer to Table 8 footnote (c). +(e) For GCP Card Member receivables, delinquency data is tracked based on days past billing status rather than days past due. A Card Member account is considered 90 days past billing if payment has not been received within 90 days of the Card Member’s billing statement date. In addition, if we initiate collection procedures on an account prior to the account becoming 90 days past billing, the associated Card Member receivable balance is classified as 90 days past billing. GCP delinquency data for periods other than 90+ days past billing and the net write-off rate based on principal losses only are not available due to system constraints. +60 +Table of Contents +GLOBAL MERCHANT AND NETWORK SERVICES +TABLE 14: GMNS SELECTED INCOME STATEMENT AND OTHER DATA +Years Ended December 31, Change Change +(Millions, except percentages and where indicated) 2020 2019 2018 +2020 vs. 2019 +2019 vs. 2018 +Revenues +Non-interest revenues $ 4,595 $ 5,903 $ 5,790 $ (1,308) (22) % $ 113 2 % +Interest income 18 28 30 (10) (36) (2) (7) +Interest expense (80) (303) (244) 223 (74) (59) 24 +Net interest income 98 331 274 (233) (70) 57 21 +Total revenues net of interest expense 4,693 6,234 6,064 (1,541) (25) 170 3 +Provisions for credit losses 88 20 22 68 # (2) (9) +Total revenues net of interest expense after provisions for credit losses 4,605 6,214 6,042 (1,609) (26) 172 3 +Expenses +Marketing, business development, rewards and Card Member services 1,303 1,422 1,243 (119) (8) 179 14 +Salaries and employee benefits and other operating expenses 1,914 2,010 2,256 (96) (5) (246) (11) +Total expenses 3,217 3,432 3,499 (215) (6) (67) (2) +Pretax segment income 1,388 2,782 2,543 (1,394) (50) 239 9 +Income tax provision 434 650 633 (216) (33) 17 3 +Segment income $ 954 $ 2,132 $ 1,910 $ (1,178) (55) $ 222 12 +Effective tax rate 31.3 % 23.4 % 24.9 % +Total segment assets (billions) +$ 14.3 $ 17.5 $ 15.5 $ (3.2) (18) % $ 2 13 % +# Denotes a variance greater than 100 percent +GMNS operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses. +TOTAL REVENUES NET OF INTEREST EXPENSE +Non-interest revenues decreased, primarily driven by lower discount revenue due to lower worldwide billed business and a decline in the average discount rate, primarily due to a shift in spend mix to non-T&E categories, as well as a decrease in other fees and commissions, due to lower foreign exchange conversion revenue related to decreased cross-border spending as a result of the impacts of the COVID-19 pandemic. For a detailed discussion on billed business and the average discount rate, please refer to the “Consolidated Results of Operations.” +Net interest income decreased, primarily driven by a lower interest expense credit relating to internal transfer pricing, which results in a net benefit for GMNS due to its merchant payables. +EXPENSES +Marketing, business development, and rewards and Card Member services expenses decreased, primarily driven by lower Marketing and business development expense, including decreased network partner payments due to lower spend volumes as a result of the impacts of the COVID-19 pandemic. +Salaries and employee benefits and other operating expenses decreased, primarily reflecting lower incentive compensation expense and lower professional services expense. +61 +Table of Contents +CORPORATE & OTHER +Corporate functions and certain other businesses are included in Corporate & Other. +Corporate & Other net loss was $1.3 billion and $1.4 billion in 2020 and 2019, respectively. The decrease in the net loss in 2020 compared to 2019 was primarily driven by a prior year litigation-related charge, a higher gain in the current year related to our strategic investments and lower incentive compensation in the current year, partially offset by a net loss in the current year as compared to net income in the prior year, related to the GBT JV. +CONSOLIDATED CAPITAL RESOURCES AND LIQUIDITY +Our balance sheet management objectives are to maintain: +• A solid and flexible equity capital profile; +• A broad, deep and diverse set of funding sources to finance our assets and meet operating requirements; and +• Liquidity programs that enable us to continuously meet expected future financing obligations and business requirements for at least a twelve-month period in the event we are unable to continue to raise new funds under our traditional funding programs during a substantial weakening in economic conditions. +We are closely monitoring the changing macroeconomic environment and actively managing our balance sheet to reflect evolving circumstances. Our objective is to remain financially strong against a backdrop of an uncertain operating environment and outlook. +CAPITAL STRATEGY +We believe capital allocated to growing businesses with a return on risk-adjusted equity in excess of our costs will generate shareholder value. Our objective is to retain sufficient levels of capital generated through net income and other sources, such as the exercise of stock options by employees, to maintain a strong balance sheet, provide flexibility to support future business growth, and distribute excess capital to shareholders through dividends and share repurchases. See "Dividends and Share Repurchases" below. +The level and composition of our consolidated capital position are determined through our Internal Capital Adequacy Assessment Process, which takes into account our business activities, as well as marketplace conditions and requirements or expectations of credit rating agencies, regulators and shareholders, among others. As a bank holding company, we are subject to regulatory requirements administered by the U.S. federal banking agencies. The Federal Reserve has established specific capital adequacy guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items. Failure to maintain minimum regulatory capital levels at American Express or our U.S. bank subsidiary, American Express National Bank (AENB), could affect our status as a financial holding company and cause the banking regulators with oversight of American Express or AENB to take actions that could limit our business operations. +We seek to maintain capital levels and ratios in excess of the minimum regulatory requirements, specifically within a 10 to 11 percent target range for American Express' Common Equity Tier 1 risk-based capital ratio. +We maintain certain flexibility to shift capital across our businesses as appropriate. For example, we may infuse additional capital into subsidiaries to maintain capital at targeted levels in consideration of debt ratings and regulatory requirements. These infused amounts can affect our capital and liquidity positions at the American Express parent company level. +We report our capital ratios using the Basel III capital definitions and the Basel III standardized approach for calculating risk-weighted assets. +62 +Table of Contents +The following table presents our regulatory risk-based capital and leverage ratios and those of AENB, as of December 31, 2020. +TABLE 15: REGULATORY RISK-BASED CAPITAL AND LEVERAGE RATIOS +Effective Minimum (a) +Ratios as of December 31, 2020 +Risk-Based Capital +Common Equity Tier 1 7.0 % +American Express Company 13.5 % +American Express National Bank 16.2 +Tier 1 8.5 +American Express Company 14.7 +American Express National Bank 16.2 +Total 10.5 +American Express Company 16.2 +American Express National Bank 18.3 +Tier 1 Leverage 4.0 % +American Express Company 11.0 +American Express National Bank 10.9% +(a) Represents Basel III minimum requirements and applicable regulatory buffers as defined by the federal banking regulators, which includes the stress capital buffer (SCB) for American Express Company and the capital conservation buffer for American Express National Bank. Refer to “Capital and Liquidity Regulation” under “Supervision and Regulation” and Note 22 to our “Consolidated Financial Statements” for additional information. +The following table presents American Express Company's regulatory risk-based capital and risk-weighted assets, which are calculated in accordance with standard regulatory guidance as described below: +TABLE 16: REGULATORY RISK-BASED CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS +American Express Company +($ in Billions) +December 31, 2020 +Risk-Based Capital +Common Equity Tier 1 $ 18.7 +Tier 1 Capital 20.3 +Tier 2 Capital +2.1 +Total Capital 22.4 +Risk-Weighted Assets 138.3 +Average Total Assets to calculate the Tier 1 Leverage Ratio $ 185.1 +Risk-Weighted Assets — Assets are weighted for risk according to a formula used by the Federal Reserve to conform to capital adequacy guidelines. On- and off-balance sheet items are weighted for risk, with off-balance sheet items converted to balance sheet equivalents, using risk conversion factors, before being allocated a risk-adjusted weight. Off-balance sheet exposures comprise a minimal part of the total risk-weighted assets. +Common Equity Tier 1 Risk-Based Capital Ratio — Calculated as Common Equity Tier 1 capital (CET1), divided by risk-weighted assets. CET1 is the sum of common shareholders’ equity, adjusted for ineligible goodwill and intangible assets, certain deferred tax assets, as well as certain other comprehensive income items as follows: net unrealized gains/losses on securities, foreign currency translation adjustments and net unrealized pension and other postretirement benefit/losses, all net of tax. CET1 is also adjusted for the CECL final rules, as described below. +Tier 1 Risk-Based Capital Ratio — Calculated as Tier 1 capital divided by risk-weighted assets. Tier 1 capital is the sum of CET1, our perpetual preferred stock and third-party non-controlling interests in consolidated subsidiaries, adjusted for capital held by insurance subsidiaries. The minimum requirement for the Tier 1 risk-based capital ratio is 1.5 percent higher than the minimum for the CET1 risk-based capital ratio. We have $1.6 billion of preferred shares outstanding to help address a portion of the Tier 1 capital requirements in excess of common equity requirements. +Total Risk-Based Capital Ratio — Calculated as the sum of Tier 1 capital and Tier 2 capital, divided by risk-weighted assets. Tier 2 capital is the sum of the reserve for loan and receivable credit losses adjusted for the CECL final rules (limited to 1.25 percent of risk-weighted assets), and $360 million of eligible subordinated notes, adjusted for capital held by insurance +63 +Table of Contents +subsidiaries. The $360 million of eligible subordinated notes reflect a 40 percent, or $240 million, reduction of Tier 2 capital credit for the $600 million subordinated debt issued in December 2014. +Tier 1 Leverage Ratio — Calculated by dividing Tier 1 capital by our average total consolidated assets for the most recent quarter. +We elected to delay the impact of the adoption of the CECL methodology on regulatory capital for two years followed by a three-year phase-in period pursuant to rules issued by federal banking regulators (the CECL final rules). As of December 31, 2020, our reported regulatory capital excluded the $0.9 billion impact to retained earnings upon the adoption of the CECL methodology and 25 percent of the impact of the $1.5 billion increase in reserves for credit losses from January 1, 2020 to December 31, 2020. We will begin phasing in the cumulative amount that is not recognized in regulatory capital at 25 percent per year beginning January 1, 2022. Refer to "Capital and Liquidity Regulation" under Part 1, Item 1. "Business - Supervision and Regulation" for additional details. +DIVIDENDS AND SHARE REPURCHASES +We return capital to common shareholders through dividends and share repurchases. The share repurchases reduce common shares outstanding and generally more than offset the issuance of new shares as part of employee compensation plans. +During the year ended December 31, 2020, we returned $2.3 billion to our shareholders in the form of common stock dividends of $1.4 billion and share repurchases of $0.9 billion. We repurchased 7 million common shares at an average price of $121.14 in 2020. These dividend and share repurchase amounts collectively represent approximately 70 percent of total capital generated during the year. +In addition, during the year ended December 31, 2020, we paid $79 million in dividends on non-cumulative perpetual preferred shares outstanding. For additional information on our preferred shares, refer to Note 16 to the “Consolidated Financial Statements.” +Our decisions on capital distributions depend on various factors, including: our capital levels and regulatory capital requirements; actual and forecasted business results; economic and market conditions; revisions to, or revocation of, the Federal Reserve’s authorization of our capital plan; and the Comprehensive Capital Analysis and Review (CCAR) process. +Due to the uncertain business environment, we suspended share repurchases in March 2020 to maintain financial strength. Subsequently, the Federal Reserve announced that it would prohibit share repurchases in the third and fourth quarters of 2020 for all banking organizations participating in CCAR and would allow them to pay common stock dividends provided (a) they do not increase the amount of the dividend and (b) they do not exceed the average of a firm's net income for the four preceding calendar quarters. Based upon the results of its second round of 2020 stress testing, the Federal Reserve announced on December 18, 2020, certain modifications to its capital distribution restrictions that would apply for the first quarter of 2021. Refer to "Stress Testing and Capital Planning" under Part 1, Item 1. "Business - Supervision and Regulation" for additional details. +We plan to resume share repurchases under our previously disclosed share repurchase program in the first quarter of 2021, up to our maximum capacity of approximately $440 million authorized by the Federal Reserve. Share purchases under publicly announced programs are made pursuant to open market purchases or privately negotiated transactions (including employee benefit plans) as market conditions warrant and at prices we deem appropriate. +FUNDING STRATEGY +Our principal funding objective is to maintain broad and well-diversified funding sources to allow us to meet our maturing obligations, cost-effectively finance asset growth in our global businesses, as well as to maintain a strong liquidity profile. The diversity of funding sources by type of instrument, by maturity and by investor base, among other factors, mitigates the impact of disruptions in any one type of instrument, maturity or investor. The mix of our funding in any period will seek to achieve cost efficiency consistent with both maintaining diversified sources and achieving our liquidity objectives. We seek to diversify our funding sources by maintaining scale and relevance in unsecured debt, asset securitizations and deposits. Our direct retail deposits have become a larger proportion of our funding over time and we expect that will continue. Our funding strategy and activities are integrated into our asset-liability management activities. We have in place a funding policy covering American Express Company and all of our subsidiaries. +Our global proprietary card-issuing businesses generate significant assets in both domestic and international Card Member lending and receivable activities. Our financing needs are in large part a consequence of our proprietary card-issuing businesses, and the maintenance of a liquidity position to meet regulatory requirements and support all of our business activities, such as merchant payments. We generally pay merchants for card transactions prior to reimbursement by Card Members and therefore +64 +Table of Contents +fund the merchant payments during the period Card Member loans and receivables are outstanding. We also have additional financing needs associated with general corporate purposes. Our funding plan to meet these financing needs is in turn driven by, among other factors, our liquidity position, size and mix of business asset growth, choice of funding sources, and our maturing obligations. +Due to the impact of COVID-19, we experienced significant reductions in our business volumes and decline in the balances of our Card Member loans and receivables. The decline in Card Member loans and receivables balances resulted in substantial liquidity levels, which were further strengthened by the strong growth in our direct retail deposits in 2020. +FUNDING PROGRAMS AND ACTIVITIES +We meet our funding needs through a variety of sources, including direct and third-party distributed deposits and debt instruments, such as senior unsecured debt, asset securitizations, borrowings through secured borrowing facilities and a committed bank credit facility. +We had the following consolidated debt and customer deposits outstanding as of December 31: +TABLE 17: SUMMARY OF CONSOLIDATED DEBT AND CUSTOMER DEPOSITS +(Billions) 2020 2019 +Short-term borrowings $ 1.9 $ 6.4 +Long-term debt 43.0 57.8 +Total debt 44.9 64.2 +Customer deposits 86.9 73.3 +Total debt and customer deposits $ 131.8 $ 137.5 +We may redeem from time to time certain debt securities prior to the original contractual maturity dates in accordance with the optional redemption provisions of those debt securities. +Our funding plan for the full year 2021 includes, among other sources, a limited amount of unsecured and secured term debt issuance. Actual funding activities can vary from our plans due to various factors, such as future business growth, the impact of global economic, political and other events on market capacity and funding needs, demand for securities offered by us, regulatory changes, ability to securitize and sell receivables, and the performance of receivables previously sold in securitization transactions. Many of these factors are beyond our control. +Our equity capital and funding strategies are designed, among other things, to maintain appropriate and stable unsecured debt ratings from the major credit rating agencies: Moody’s Investor Services (Moody’s), Standard & Poor’s (S&P) and Fitch Ratings (Fitch). Such ratings help support our access to cost-effective unsecured funding as part of our overall funding strategy. Our asset securitization activities are rated separately. +TABLE 18: UNSECURED DEBT RATINGS +Credit Agency American Express Entity Short-Term Ratings Long-Term Ratings Outlook +Fitch All rated entities F1 A Negative +Moody’s +American Express Travel Related Services Company, Inc. +N/A A2 Negative +Moody's American Express Credit Corporation Prime-1 A2 Negative +Moody’s American Express National Bank Prime-1 A3 Negative +Moody's American Express Company N/A A3 Negative +S&P +American Express Travel Related Services Company, Inc. +N/A A- Stable +S&P American Express Credit Corporation and American Express National Bank A-2 A- Stable +S&P American Express Company A-2 BBB+ Stable +These ratings are not a recommendation to buy or hold any of our securities and they may be revised or revoked at any time at the sole discretion of the rating organization. +Downgrades in the ratings of our unsecured debt or asset securitization program securities could result in higher funding costs, as well as higher fees related to borrowings under our unused credit facilities. Declines in credit ratings could also reduce our borrowing capacity in the unsecured debt and asset securitization capital markets. We believe our funding mix, including the proportion of U.S. retail deposits insured by the Federal Deposit Insurance Corporation (FDIC) to total funding, should reduce the impact that credit rating downgrades would have on our funding capacity and costs. +65 +Table of Contents +SHORT-TERM FUNDING PROGRAMS +Short-term borrowings, such as commercial paper, are defined as any debt with an original maturity of twelve months or less, as well as interest-bearing overdrafts with banks. Our short-term funding programs are used primarily to fund working capital needs, such as managing seasonal variations in receivables balances. The amount of short-term borrowings issued in the future will depend on our funding strategy, our needs and market conditions. As of December 31, 2020, we had nil in commercial paper outstanding and we had an average of $628 million in commercial paper outstanding during 2020. Refer to Note 8 to the “Consolidated Financial Statements” for a further description of these borrowings. +DEPOSIT PROGRAMS +We offer deposits within our U.S. bank subsidiary, AENB. These funds are currently insured up to an amount that is at least $250,000 per account holder through the FDIC. Our ability to obtain deposit funding and offer competitive interest rates is dependent on, among other factors, the capital level of AENB. Direct retail deposits offered by AENB is our primary deposit product channel, which makes FDIC-insured high-yield savings account and certificates of deposit (CDs) products available directly to consumers. AENB also sources deposits through third-party distribution channels as needed to meet our overall funding objectives. As of December 31, 2020, we had $86.9 billion in deposits. Refer to Note 7 to the “Consolidated Financial Statements” for a further description of these deposits. +LONG-TERM DEBT AND ASSET SECURITIZATION PROGRAMS +As of December 31, 2020, we had $43.0 billion in long-term debt outstanding, including unsecured debt and asset-backed securities. Refer to Note 8 to the “Consolidated Financial Statements” for a further description of these borrowings. +We periodically securitize Card Member loans and receivables arising from our card business, as the securitization market provides us with cost-effective funding. Securitization of Card Member loans and receivables is accomplished through the transfer of those assets to a trust, which in turn issues securities collateralized by the transferred assets to third-party investors. The proceeds from issuance are distributed to us, through our wholly owned subsidiaries, as consideration for the transferred assets. Refer to Note 5 to the “Consolidated Financial Statements” for a further description of our asset securitizations. +On February 1, 2020, we removed U.S. consumer and small business Card Member receivables from the American Express Issuance Trust II (the Charge Trust) and substantially replaced them with U.S. corporate Card Member receivables. +On April 20, 2020, we added approximately $1.7 billion of additional U.S. corporate Card Member receivables to the Charge Trust. +Given the significant reductions in our business volumes and our resulting substantial cash and liquidity position, we did not issue any unsecured or secured term debt during 2020. +66 +Table of Contents +LIQUIDITY MANAGEMENT +Our liquidity objective is to maintain access to a diverse set of on- and off-balance sheet liquidity sources. We seek to maintain liquidity sources in amounts sufficient to meet our expected future financial obligations and business requirements for liquidity for a period of at least twelve months in the event we are unable to raise new funds under our regular funding programs during a substantial weakening in economic conditions. +Our liquidity management strategy includes a number of elements, including, but not limited to: +• Maintaining diversified funding sources (refer to the “Funding Strategy” section for more details); +• Maintaining unencumbered liquid assets and off-balance sheet liquidity sources; +• Projecting cash inflows and outflows under a variety of economic and market scenarios; and +• Establishing clear objectives for liquidity risk management, including compliance with regulatory requirements. +We seek to maintain access to a diverse set of on-balance sheet and off-balance sheet liquidity sources, including cash and other liquid assets, committed bank credit facilities and secured borrowing facilities. Through our U.S. bank subsidiary, AENB, we also hold collateral eligible for use at the Federal Reserve’s discount window. +The amount and type of liquidity resources we maintain can vary over time, based upon the results of stress scenarios required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as additional stress scenarios required under our liquidity risk policy. These stress scenarios possess distinct characteristics, varying by cash flow assumptions, time horizon and qualifying liquidity sources, among other factors. Scenarios under our liquidity risk policy include market-wide, firm-specific and combined liquidity stresses. We consider other factors in determining the amount and type of liquidity we maintain, such as economic and financial market conditions, seasonality in business operations, growth in our businesses, potential acquisitions or dispositions, the cost and availability of alternative liquidity sources and credit rating agency guidelines and requirements. +We believe that we currently maintain sufficient liquidity to meet all internal and regulatory liquidity requirements. As of December 31, 2020, we had a total of $54.6 billion in Cash and cash equivalents and Investment securities (which are substantially comprised of U.S. Government Treasury obligations). The increase of $21.7 billion from $32.9 billion as of December 31, 2019 was primarily driven by the decline in the balances of our Card Member loans and receivables and the growth in our direct retail deposits. +The net interest expense to maintain these liquidity resources depends on the amount of liquidity resources we maintain and the difference between our cost of funding these amounts and their investment yields. As the amount of our liquidity resources has substantially increased, the level of future net interest expense to maintain these resources is expected to be significant, as the investment income is less than the cost of funding. +67 +Table of Contents +Securitized Borrowing Capacity +As of December 31, 2020, we maintained our committed, revolving, secured borrowing facility, with a maturity date of July 15, 2022, which gives us the right to sell up to $3.0 billion face amount of eligible AAA notes from the Charge Trust. As the balance of Card Member receivables in the Charge Trust fluctuates over time in line with business volumes, our capacity to draw on the Charge Trust facility may be reduced when volumes decline. We also maintained our committed, revolving, secured borrowing facility, with a maturity date of September 15, 2022, which gives us the right to sell up to $2.0 billion face amount of eligible AAA certificates from the American Express Credit Account Master Trust (the Lending Trust). Both facilities are used in the ordinary course of business to fund working capital needs, as well as to further enhance our contingent funding resources. As of December 31, 2020, no amounts were drawn on the Charge Trust facility or the Lending Trust facility. +Federal Reserve Discount Window +As an insured depository institution, AENB may borrow from the Federal Reserve Bank of San Francisco, subject to the amount of qualifying collateral that it may pledge. The Federal Reserve has indicated that both credit and charge card receivables are a form of qualifying collateral for secured borrowings made through the discount window. Whether specific assets will be considered qualifying collateral and the amount that may be borrowed against the collateral remain at the discretion of the Federal Reserve. +We had approximately $64.8 billion as of December 31, 2020 in U.S. credit card loans and charge card receivables that could be sold over time through our securitization trusts or pledged in return for secured borrowings to provide further liquidity, subject in each case to applicable market conditions and eligibility criteria. +Committed Bank Credit Facility +In addition to the secured borrowing facilities described above, we maintained a committed syndicated bank credit facility as of December 31, 2020 of $3.5 billion, with a maturity date of October 15, 2022. The availability of this credit line is subject to compliance with certain covenants by American Express Credit Corporation (Credco), principally the maintenance by Credco of a 1.25 ratio of its combined earnings, certain capital contributions and fixed charges, to fixed charges. As of December 31, 2020 and 2019, Credco was in compliance with each of these covenants. As of December 31, 2020, no amounts were drawn on the committed credit facility. We may, from time to time, use this facility in the ordinary course of business to fund working capital needs. Any undrawn portion of this facility could serve as backstop for the amount of commercial paper outstanding. +Our committed bank credit facility does not contain a material adverse change clause, which might otherwise preclude borrowing under the credit facility, nor is it dependent on our credit rating. +68 +Table of Contents +CASH FLOWS +The following table summarizes our cash flow activity, followed by a discussion of the major drivers impacting operating, investing and financing cash flows for the year ended December 31, 2020 compared to the year ended December 31, 2019. +TABLE 19: CASH FLOWS +(Billions) 2020 2019 2018 +Total cash provided by (used in): +Operating activities $ 5.6 $ 13.6 $ 8.9 +Investing activities 11.6 (16.7) (19.6) +Financing activities (9.1) (0.5) 5.1 +Effect of foreign currency exchange rates on cash and cash equivalents 0.4 0.2 0.1 +Net increase (decrease) in cash and cash equivalents $ 8.5 $ (3.4) $ (5.5) +Cash Flows from Operating Activities +Our cash flows from operating activities primarily include net income adjusted for (i) non-cash items included in net income, such as provisions for credit losses, depreciation and amortization, deferred taxes and stock-based compensation and (ii) changes in the balances of operating assets and liabilities, which can vary significantly in the normal course of business due to the amount and timing of payments. +The decrease in net cash provided by operating activities was primarily driven by decreases in Net income and Accounts payable due to decreases in merchant payables reflecting the significant decline in billed business in the current year, and an increase in Other assets due to purchases of loyalty program points from certain of our cobrand partners. These points are held as prepaid assets until they are used for rewards, promotions and incentives. +Cash Flows from Investing Activities +Our cash flows from investing activities primarily include changes in Card Member loans and receivables, as well as changes in our available-for-sale investment securities portfolio. +The increase in net cash provided by investing activities was primarily due to a decline in the outstanding balances of Card Member loans and receivables driven by a significant decline in Card Member spending during the period as a result of the continued impacts of the COVID-19 pandemic and the resulting containment measures, combined with pay down of outstanding balances by Card Members, partially offset by a net increase in the investment securities portfolio. +Cash Flows from Financing Activities +Our cash flows from financing activities primarily include changes in customer deposits, long-term debt and short-term borrowings, as well as dividend payments and share repurchases. +The increase in net cash used in financing activities was primarily driven by higher net repayment of debt, partially offset by higher growth in customer deposits and the suspension of the share repurchase program. +69 +Table of Contents +OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS +We have identified both on- and off-balance sheet transactions, arrangements, obligations and other relationships that may have a material current or future effect on our financial condition, changes in financial condition, results of operations, or liquidity and capital resources. +CONTRACTUAL OBLIGATIONS +The table below identifies transactions that represent our contractually committed future obligations. Purchase obligations include our agreements to purchase goods and services that are enforceable and legally binding and that specify significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. +TABLE 20: COMMITTED FUTURE OBLIGATIONS BY YEAR +Payments due by year (a) +(Millions) 2021 2022-2023 2024-2025 2026 and thereafter Total +Long-term debt $ 11,829 $ 21,324 $ 5,757 $ 4,132 $ 43,042 +Certificates of deposit 3,828 3,698 483 — 8,009 +Interest payments on long-term debt (b) +713 760 402 1,058 2,933 +Lease obligations 141 273 232 1,024 1,670 +Deemed repatriation tax (c) +— 14 582 416 1,012 +Purchase obligations (d) +231 174 34 — 439 +Other long-term liabilities (e) (f) +243 36 6 38 323 +Total $ 16,985 $ 26,279 $ 7,496 $ 6,668 $ 57,428 +(a) The table above excludes approximately $0.8 billion of tax reserves related to the uncertainty in income taxes as inherent complexities and the number of tax years currently open for examination in multiple jurisdictions do not permit reasonable estimates of payments, if any, to be made over a range of years. Refer to Note 20 to the “Consolidated Financial Statements” for additional information. +(b) Estimated interest payments were calculated using the effective interest rates as of December 31, 2020, and includes the effect of existing interest rate swaps. Actual cash flows may differ from estimated payments. +(c) Represents the remaining obligation under the Tax Act to pay a one-time transition tax on unrepatriated earnings and profits of certain foreign subsidiaries. +(d) The purchase obligation amounts represent either the early termination fees or non-cancelable minimum contractual obligations, as applicable, by period under contracts that were in effect as of December 31, 2020. +(e) As of December 31, 2020, there were no minimum required contributions, and no contributions are currently planned, for the U.S. American Express Retirement Plan. For the U.S. American Express Retirement Restoration Plan and non-U.S. defined benefit pension and postretirement benefit plans, contributions in 2021 are anticipated to be approximately $47 million, and this amount has been included within other long-term liabilities. Remaining obligations under defined benefit pension and postretirement benefit plans aggregating $659 million have not been included in the table above as the timing of such obligations is not determinable. Additionally, other long-term liabilities do not include $9.8 billion of Membership Rewards liabilities, which are not considered long-term liabilities as Card Members in good standing can redeem points immediately, without restrictions, and because the timing of point redemption is not determinable. +(f) As of December 31, 2020, we had committed to provide funding related to certain tax credit investments resulting in a $208 million unfunded commitment included in other long-term liabilities. In addition to this amount, there was a further $106 million of contractual off-balance sheet obligations that have not been included in the table above as the timing of such obligations is not determinable. Refer to Note 6 to the “Consolidated Financial Statements” for additional information. +In addition to the contractual obligations noted in Table 20, we have financial commitments related to agreements with certain cobrand partners under which we are required to make a certain level of minimum payments over the life of the agreement, generally ranging from five to ten years. Such commitments are designed to be satisfied by the payments we make to such cobrand partners primarily based on Card Members' spending and earning rewards on their cobrand cards and as we acquire new Card Members. In the event these payments do not fully satisfy the commitment, we generally pay the cobrand partner up to the amount of the commitment in exchange for an equivalent value of reward points. As of December 31, 2020, we had approximately $4 billion in such commitments outstanding and also had certain cobrand arrangements that include commitments based on variables, the values of which are not yet determinable and thus the amount is not quantifiable. Refer to Note 12 to the "Consolidated Financial Statements" for further information. +We also have off-balance sheet arrangements that include guarantees, indemnifications and certain other off-balance sheet arrangements. +70 +Table of Contents +GUARANTEES +As of December 31, 2020, we had guarantees and indemnifications totaling approximately $1 billion related primarily to real estate and business dispositions in the ordinary course of business. Refer to Note 15 to the “Consolidated Financial Statements” for further discussion regarding our guarantees. +CERTAIN OTHER OFF-BALANCE SHEET ARRANGEMENTS +As of December 31, 2020, we had approximately $314 billion of unused credit available to Card Members as part of established lending product agreements. Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no pre-set spending limit, and therefore are not reflected in unused credit available to Card Members. +We provide Card Member protection that covers losses associated with purchased goods and services. We have an accrual of $58 million related to this exposure as of December 31, 2020. To date, we have not experienced significant losses related to this exposure; however, our historical experience may not be representative in the current environment given the economic and financial disruption cause by the COVID-19 pandemic and resulting containment measures. See "Arrangements with our business partners represent a significant portion of our business. We are exposed to risks associated with our business partners, including reputational issues, business slowdowns, bankruptcies, liquidations, restructurings and consolidations, and the possible obligation to make payments to our partners" under “Risk Factors” and Note 12 to the "Consolidated Financial Statements" for further information. +71 +Table of Contents +RISK MANAGEMENT +GOVERNANCE +We use our comprehensive Enterprise-wide Risk Management (ERM) program to identify, aggregate, monitor, and manage risks. The program also defines our risk appetite, governance, culture and capabilities. The implementation and execution of the ERM program is headed by our Chief Risk Officer. +Risk management is overseen by our Board of Directors through three Board committees: the Risk Committee, the Audit and Compliance Committee, and the Compensation and Benefits Committee. Each committee consists entirely of independent directors and provides regular reports to the full Board regarding matters reviewed at their committee. The committees meet regularly in private sessions with our Chief Risk Officer, the Chief Compliance & Ethics Officer, the Chief Audit Executive and other senior management with regard to our risk management processes, controls, talent and capabilities. The Board monitors the “tone at the top,” our risk culture, and oversees emerging and strategic risks. +The Risk Committee of our Board of Directors provides oversight of our ERM framework, processes and methodologies. The Risk Committee approves our ERM policy. The ERM policy governs risk governance, risk oversight and risk appetite for risks, including individual credit risk, institutional credit risk, operational risk, compliance risk, reputational risk, market risk, funding and liquidity risk, model risk, strategic and business risk, and country risk. Risk appetite defines the authorized risk limits to control exposures within our risk capacity and risk tolerance, including stressed forward-looking scenarios. In addition, it establishes principles for risk taking in the aggregate and for each risk type, and is supported by a comprehensive system for monitoring limits, escalation triggers and assessing control programs. +The Risk Committee reviews and concurs with the appointment, replacement, performance and compensation of our Chief Risk Officer and receives regular updates from the Chief Risk Officer on key risks, transactions and exposures. +The Risk Committee reviews our risk profile against the tolerances specified in the Risk Appetite Framework, including significant risk exposures, risk trends in our portfolios and major risk concentrations. +The Risk Committee also provides oversight of our compliance with Regulatory capital and liquidity standards, our Internal Capital Adequacy Assessment Process, including the CCAR submissions. +The Audit and Compliance Committee of our Board of Directors reviews and approves compliance policies, which include our Compliance Risk Tolerance Statement. In addition, the Audit and Compliance Committee reviews the effectiveness of our Corporate-wide Compliance Risk Management Program. More broadly, this committee is responsible for assisting the Board in its oversight responsibilities relating to the integrity of our financial statements and financial reporting process, internal and external auditing, including the qualifications and independence of the independent registered public accounting firm and the performance of our internal audit services function, and the integrity of our systems of internal controls. +The Audit and Compliance Committee provides oversight of our Internal Audit Group. The Audit and Compliance Committee reviews and concurs with the appointment, replacement, performance and compensation of our Chief Audit Executive, who reports to the Audit and Compliance Committee, and approves Internal Audit’s annual audit plan, charter, policies, budget and staffing levels, and overall risk assessment methodology. The Audit and Compliance Committee also receives regular updates on the audit plan’s status and results, including significant reports issued by Internal Audit and the status of our corrective actions. +The Compensation and Benefits Committee of our Board of Directors works with the Chief Risk Officer to ensure our overall compensation programs, as well as those covering our risk-taking employees, appropriately balance risk with business incentives and how business performance is achieved without taking imprudent or excessive risk. Our Chief Risk Officer is actively involved in setting risk goals for the Company. Our Chief Risk Officer also reviews the current and forward-looking risk profiles of each business unit and provides input into performance evaluation. The Chief Risk Officer meets with the Compensation and Benefits Committee and attests whether performance goals and results have been achieved without taking imprudent risks. The Compensation and Benefits Committee uses a risk-balanced incentive compensation framework to decide on our bonus pools and the compensation of senior executives. +72 +Table of Contents +There are several internal management committees, including the Enterprise-wide Risk Management Committee (ERMC), chaired by our Chief Risk Officer. The ERMC is the highest-level management committee to oversee all firm-wide risks and is responsible for risk governance, risk oversight and risk appetite. It maintains the enterprise-wide risk appetite framework and monitors compliance with limits and escalations defined in it. The ERMC oversees implementation of risk policies company-wide. The ERMC reviews key risk exposures, trends and concentrations, significant compliance matters, and provides guidance on the steps to monitor, control and report major risks. In addition, the Asset Liability Committee, chaired by our Chief Financial Officer, is responsible for managing our capital, funding and liquidity, investment, market risk and asset/liability activities in accordance with our policies and in compliance with applicable regulatory requirements. +As defined in the ERM policy, we follow the “three lines of defense” approach to risk management. The first line of defense comprises functions and management committees directly initiating risk taking. The Chief Executive Officer, business unit presidents and the Chief Financial Officer are part of the first line of defense. The second line comprises independent functions overseeing risk-taking activities of the first line. The Chief Risk Officer, the Chief Compliance & Ethics Officer, the Chief Operational Risk Officer and certain control groups, both at the enterprise level and within regulated entities, are part of the second line of defense. The global risk oversight team oversees the policies, strategies, frameworks, models, processes and capabilities deployed by the first line teams and provides challenges and independent assessments on how the first line of defense is managing risks. Our Internal Audit Group constitutes the third line of defense and provides independent assessments and effective challenge of the first and second lines of defense. +CREDIT RISK MANAGEMENT PROCESS +Credit risk is defined as loss due to obligor or counterparty default or changes in the credit quality of a counterparty or security. Our credit risks are divided into two broad categories: individual and institutional. Each has distinct risk management capabilities, strategies, and tools. Business units that create individual or institutional credit risk exposures of significant importance are supported by dedicated risk management teams, each led by a Chief Credit Officer. +INDIVIDUAL CREDIT RISK +Individual credit risk arises from consumer and small business charge cards, credit cards, and term loans. These portfolios consist of millions of customers across multiple geographies, industries and levels of net worth. We benefit from the high-quality profile of our customers, which is driven by our brand, premium customer servicing, product features and risk management capabilities, which span underwriting, customer management and collections. The risk in these portfolios is generally correlated to broad economic trends, such as unemployment rates and GDP growth. +The business unit leaders and their Chief Credit Officers take the lead in managing the credit risk process. These Chief Credit Officers are guided by the Individual Credit Risk Committee (ICRC), which is responsible for implementation and enforcement of the Individual Credit Risk Management Policy. The ICRC ensures compliance with ERMC guidelines and procedures and escalates to the ERMC as appropriate. +Credit risk management is supported by sophisticated proprietary scoring and decision-making models that use up-to-date information on prospects and customers, such as spending and payment history and data feeds from credit bureaus. We have developed data-driven economic decision logic for customer interactions to better serve our customers. +INSTITUTIONAL CREDIT RISK +Institutional credit risk arises principally within our GCS and GMNS businesses, as well as investment and liquidity management activities. Unlike individual credit risk, institutional credit risk is characterized by a lower loss frequency but higher severity. It is affected both by general economic conditions and by client-specific events. The absence of large losses in any given year or over several years is not necessarily representative of the level of risk of institutional portfolios, given the infrequency of loss events in such portfolios. +Similar to individual credit risk, business units taking institutional credit risks are supported by Chief Credit Officers. These officers are guided by the Institutional Risk Management Committee (IRMC), which is responsible for implementation and enforcement of the Institutional Credit Risk Management Policy and for providing guidance to the credit officers of each business unit with substantial institutional credit risk exposures. The committee, along with the business unit Chief Credit Officers, makes investment decisions in core risk capabilities, ensures proper implementation of the underwriting standards and contractual rights for risk mitigation, monitors risk exposures, and determines risk mitigation actions. The IRMC formally reviews large institutional risk exposures to ensure compliance with ERMC guidelines and procedures and escalates them to the ERMC as appropriate. At the same time, the IRMC provides guidance to the business unit risk management teams to optimize risk-adjusted returns on capital. A centralized risk rating unit provides risk assessment of our institutional obligors. +73 +Table of Contents +Exposure to the Airline and Travel Industry +We have multiple important cobrand, rewards, merchant acceptance and corporate payments arrangements with airlines. The ERM program evaluates the risks posed by our airline partners and the overall airline strategy company-wide through comprehensive business analysis of global airlines, and the travel industry more broadly, including cruise lines, travel agencies and tour operators. Our largest airline partner is Delta, and this relationship includes an exclusive cobrand credit card partnership and other arrangements including Membership Rewards redemption, merchant acceptance, travel and corporate payments. See "We face intense competition for partner relationships, which could result in a loss or renegotiation of these arrangements that could have a material adverse impact on our business and results of operations" and "Arrangements with our business partners represent a significant portion of our business. We are exposed to risks associated with our business partners, including reputational issues, business slowdowns, bankruptcies, liquidations, restructurings and consolidations, and the possible obligation to make payments to our partners" under “Risk Factors” for additional information. +Debt Exposure +As part of our ongoing risk management process, we monitor our financial exposure to both sovereign and non-sovereign customers and counterparties, and measure and manage concentrations of risk by geographic regions, as well as by economic sectors and industries. A primary focus area for monitoring is credit deterioration due to weaknesses in economic and fiscal profiles. We evaluate countries based on the market assessment of the riskiness of their sovereign debt and our assessment of the economic and financial outlook and closely monitor those deemed high risk. As of December 31, 2020, we considered our gross credit exposures to government entities, financial institutions and corporations in those countries deemed high risk to be individually and collectively not material. +OPERATIONAL RISK MANAGEMENT PROCESS +We consider operational risk to be the risk of loss due to, among other things, inadequate or failed processes, people or information systems, or impacts from the external environment, including failures to comply with laws and regulations as well as impacts from relationships with third parties. Operational risk is inherent in all business activities and can impact an organization through direct or indirect financial loss, brand damage, customer dissatisfaction, or legal and regulatory penalties. +To appropriately measure and manage operational risk, we have implemented a comprehensive operational risk framework that is defined in the Operational Risk Management Policy approved by the Risk Committee. The Operational Risk Management Committee (ORMC), chaired by the Chief Operational Risk Officer, coordinates with all control groups on effective risk assessments and controls and oversees the preventive, responsive and mitigation efforts by Operational Excellence teams in the business units and staff groups. +We use the operational risk framework to identify, measure, monitor and report inherent and emerging operational risks. This framework, supervised by the ORMC, consists of (a) operational risk event capture, (b) a project office to coordinate issue management and control enhancements, (c) key risk indicators, and (d) process and entity-level risk assessments. +The framework requires the assessment of operational risk events to determine root causes, impact to customers and/or us, and resolution plan accountability to correct any defect, remediate customers, and enhance controls and testing to mitigate future issues. The impact is assessed from an operational, financial, brand, regulatory compliance and legal perspective. +74 +Table of Contents +INFORMATION AND CYBER SECURITY +We define information and cyber security risk as the risk that a security incident could impact the confidentiality, integrity or availability of American Express customer, colleague or proprietary information. +Our information and cyber security program is designed to protect the confidentiality, integrity, and availability of information and information systems from unauthorized access, use, disclosure, disruption, modification, or destruction. The program is built upon a foundation of advanced security technology, a well-staffed and highly trained team of experts, and robust operations based on the National Institute of Standards and Technology Cybersecurity Framework. This consists of controls designed to identify, protect, detect, respond and recover from information and cyber security incidents. We continue to invest in enhancements to cyber security capabilities and engage in industry and government forums to promote advancements to the broader financial services cyber security ecosystem. +See “A major information or cyber security incident or an increase in fraudulent activity could lead to reputational damage to our brand and material legal, regulatory and financial exposure, and could reduce the use and acceptance of our cards” under “Risk Factors” for additional information. +75 +Table of Contents +INFORMATION TECHNOLOGY +We define information technology risk as the risk that events or circumstances could compromise the processing, stability, capacity, performance, or resilience of information technology and cause financial, reputational, and/or regulatory impacts. +We manage information technology risk through our policies, procedures, governance structure, and control framework to preserve the confidentiality, integrity, and availability of systems and processes across the Company. +See “The uninterrupted operation of our information systems is critical to our success and a significant disruption could have a material adverse effect on our business and results of operations” under “Risk Factors” for additional information. +PRIVACY +We define privacy risk as the risk of financial loss, reputational damage, or regulatory or legal action resulting from decisions related to the violation of applicable laws, rules, regulations, contractual obligations, or the non-adherence to privacy policies, disclosures, or standards that apply to the processing of personal data. +The Global Privacy Policy establishes the privacy framework and defines the American Express Data Protection & Privacy Principles, which governs the way we collect, use, store, share, transmit, delete or otherwise process our customer and colleague personal data globally. Chaired by the Chief Privacy Officer, the Privacy Risk Management Committee, a sub-committee of the ORMC, provides oversight and governance for our privacy program. +DATA MANAGEMENT AND GOVERNANCE +We define data management and governance risk as the risk of inadequate data governance and/or data management practices adversely impacting the accuracy, completeness, timeliness, comprehensiveness or usability of data within or throughout its lifecycle. +Our Enterprise Data Governance Policy establishes the framework and requirements for defining in-scope critical data and outlining the elements for managing data as a critical corporate asset. This policy is approved by the ERMC. +Chaired by the Chief Data Officer, our Enterprise Data Committee, a sub-committee of the ERMC, provides governance and oversight for our enterprise-wide data governance and management activities. The committee is responsible for overseeing the standards and procedures, governance structure and oversight framework, which includes independent assessments and validations, monitoring and reporting of data governance and management-related issues and concerns. +COMPLIANCE RISK MANAGEMENT PROCESS +We define compliance risk as the risk of legal or reputational harm, fines, monetary penalties and payment of damages or other forms of sanction as a result of non-compliance with applicable laws and/or regulations, internal policies and procedures and related practices, or ethical standards. +We view our ability to effectively mitigate compliance risk as an important aspect of our business model. Our Global Compliance and Ethics organization is responsible for establishing and maintaining our corporate-wide Compliance Risk Management Program. Pursuant to this program, we seek to manage and mitigate compliance risk by assessing, controlling, monitoring, measuring and reporting the legal and regulatory risks to which we are exposed. The Compliance Risk Management Committee (CRMC), chaired by the Chief Compliance and Ethics Officer, is responsible for identifying, evaluating, managing, and escalating compliance risks. The CRMC has a dual reporting relationship directly to both the ERMC and the Audit and Compliance Committee. +We have a comprehensive Anti-Money Laundering program that monitors and reports suspicious activity to the appropriate government authorities. As part of that program, the Global Risk Oversight team provides independent risk assessment of the rules used by the Anti-Money Laundering team. In addition, the Internal Audit Group reviews the processes for practices consistent with regulatory guidance. +76 +Table of Contents +REPUTATIONAL RISK MANAGEMENT PROCESS +We define reputational risk as the risk that negative stakeholder reaction to our products, services, client and partner relationships, business activities and policies, management and workplace culture, or our response to unexpected events, could cause sustained critical media coverage, a decline in revenue or investment, talent attrition, litigation, or government or regulatory scrutiny. +We view protecting our reputation for excellent customer service, trust, security and high integrity as core to our vision of providing the world’s best customer experience and fundamental to our long-term success. +Our business leaders are responsible for considering the reputational risk implications of business activities and strategies and ensuring the relevant subject matter experts are engaged as needed. The ERMC is responsible for ensuring reputational risk considerations are included in the scope of appropriate subordinate risk policies and committees and properly reflected in all decisions escalated to the ERMC. +MARKET RISK MANAGEMENT PROCESS +Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. Our market risk exposures include interest rate risk and foreign exchange risk. Interest rate risk is driven by the relationship between interest rates on assets (such as loans, receivables and investment securities) and interest rates on liabilities (such as debt and deposits). Foreign exchange risk arises from transactions, funding, investments and earnings in currencies other than the U.S. dollar. +Our risk policies establish the framework that guides and governs market risk management, including quantitative limits and escalation triggers. These policies are approved by the ERMC, Asset Liability Committee or Market Risk Management Committee. +Market risk is managed by the Market Risk Management Committee. The Market Risk Oversight Officer provides an independent risk assessment and oversight over the policies and exposure management for market risk and Asset Liability Management activities, as well as overseeing compliance with associated regulatory requirements. Market risk management is also guided and governed by policies covering the use of derivative financial instruments, funding, liquidity and investments. +Interest Rate Risk +We analyze a variety of interest rate scenarios to inform us of the potential impacts from interest rate changes on earnings and the value of assets, liabilities and the economic value of equity. Our interest rate exposure can vary over time as a result of, among other things, the proportion of our total funding provided by variable and fixed-rate debt and deposits compared to our Card Member loans and receivables. Interest rate swaps are used from time to time to effectively convert debt issuances to variable-rate from fixed-rate, or vice versa. Refer to Note 13 to the “Consolidated Financial Statements” for further discussion of our derivative financial instruments. +In 2020, the composition of our balance sheet shifted substantially. There was a substantial net reduction in total fixed-rate assets within Card Member loans and Card Member receivables and an increase in certain floating-rate assets such as Cash and cash equivalents. As of December 31, 2020, a hypothetical immediate 100 basis point increase in market interest rates would have a detrimental impact of approximately $113 million on our annual net interest income. A hypothetical immediate 100 basis point decrease in market interest rates, which are assumed to remain at or above zero percent, would have a smaller but still detrimental impact on our annual net interest income. This measure first projects net interest income over the following twelve-month time horizon considering forecasted business growth and anticipated future market interest rates. The detrimental impact from rate changes is then measured by instantaneously increasing or decreasing the anticipated future interest rates by 100 basis points. Our estimated repricing risk assumes that our interest-rate sensitive assets and liabilities that reprice within the twelve-month horizon generally reprice by the same magnitude as benchmark rate changes. It is further assumed that, within our interest-rate sensitive liabilities, certain deposits reprice at lower magnitudes than benchmark rate movements, and the magnitude of this repricing in turn depends on, among other factors, the direction of rate movements. These assumptions are consistent with historical deposit repricing experience in the industry and within our own portfolio. Actual changes in our net interest income will depend on many factors, and therefore may differ from our estimated risk to changes in market interest rates. +77 +Table of Contents +LIBOR Transition +Due to uncertainty surrounding the suitability and sustainability of LIBOR, central banks and global regulators have called for financial market participants to prepare for the discontinuance of LIBOR and the establishment of alternative reference rates. +We have financial instruments and commercial agreements that will be impacted by the discontinuance of LIBOR, including floating rate debt and equity instruments, derivatives, borrowings and other contracts. We have established an enterprise-wide, cross-functional initiative to identify, assess and monitor risks associated with LIBOR, engage with the industry participants and regulators and to transition to new alternative reference rates. As part of this initiative, we are updating our operational processes, IT systems and models for a timely transition. +See “ The discontinuance of LIBOR may negatively impact our access to funding and the value of our financial instruments and commercial agreements ” under “Risk Factors” for additional information. +Foreign Exchange Risk +Foreign exchange exposures arise in four principal ways: (1) Card Member spending in currencies that are not the billing currency, (2) cross-currency transactions and balances from our funding activities, (3) cross-currency investing activities, such as in the equity of foreign subsidiaries, and (4) revenues generated and expenses incurred in foreign currencies, which impact earnings. +These foreign exchange risks are managed primarily by entering into foreign exchange spot transactions or hedged with foreign exchange forward contracts when the hedge costs are economically justified and in notional amounts designed to offset pretax impacts from currency movements in the period in which they occur. As of December 31, 2020, foreign currency derivative instruments with total notional amounts of approximately $26 billion were outstanding. +With respect to Card Member spending and cross-currency transactions, including related foreign exchange forward contracts outstanding, the impact of a hypothetical 10 percent strengthening of the U.S. dollar would have been immaterial to projected earnings as of December 31, 2020. With respect to translation exposure of foreign subsidiary equity balances, including related foreign exchange forward contracts outstanding, a hypothetical 10 percent strengthening of the U.S. dollar would result in an immaterial reduction in other comprehensive income and equity as of December 31, 2020. With respect to anticipated earnings denominated in foreign currencies for the next twelve months, the adverse impact on pretax income of a hypothetical 10 percent strengthening of the U.S. dollar would be approximately $33 million as of December 31, 2020. +To a much lesser extent, we are also subject to market risk arising from activities conducted by our Foreign Exchange International Payments business. We aim to minimize market risk from these activities through hedging, where appropriate, and the establishment of limits. +The actual impact of interest rate and foreign exchange rate changes will depend on, among other factors, the timing of rate changes, the extent to which different rates do not move in the same direction or in the same direction to the same degree, changes in the cost, volume and mix of our hedging activities and changes in the volume and mix of our businesses. +FUNDING & LIQUIDITY RISK MANAGEMENT PROCESS +Funding and liquidity risk is defined as our inability to meet our ongoing financial and business obligations as they become due at a reasonable cost. +Our Board-approved Liquidity Risk Policy establishes the framework that guides and governs liquidity risk management. +Funding and Liquidity risk is managed by the Funding and Liquidity Committee. In addition, the Market Risk Oversight Officer provides independent oversight of liquidity risk management. We manage liquidity risk by maintaining access to a diverse set of cash, readily-marketable securities and contingent sources of liquidity, such that we can continuously meet our business requirements and expected future financing obligations for at least a twelve-month period in the event we are unable to raise new funds under our regular funding programs during a substantial weakening in economic conditions. We consider the trade-offs between maintaining too much liquidity, which can be costly and limit financial flexibility, and having inadequate liquidity, which may result in financial distress during a liquidity event. +Funding and Liquidity risk is managed at an aggregate consolidated level as well as at certain subsidiaries in order to ensure that sufficient and accessible liquidity resources are maintained. The Funding and Liquidity Committee reviews forecasts of our aggregate and subsidiary cash positions and financing requirements, approves funding plans designed to satisfy those requirements under normal and stressed conditions, establishes guidelines to identify the amount of liquidity resources required and monitors positions and determines any actions to be taken. +78 +Table of Contents +MODEL RISK MANAGEMENT PROCESS +We define model risk as the risk of adverse consequences, such as financial loss, poor business and strategic decision making, or damage to our reputation, from decisions based on incorrect or misused model outputs and reports. +We manage model risk through a comprehensive model governance framework, including policies and procedures for model development, independent model validation and change management capabilities that seek to minimize erroneous model methodology, outputs and misuse. We also assess model performance on an ongoing basis. +We utilize artificial intelligence and machine Learning (AI/ML) approaches for a variety of business use cases. We perform extensive reviews and testing to reduce the risk that these AI/ML techniques do not perform as intended. +STRATEGIC AND BUSINESS RISK MANAGEMENT PROCESS +Strategic and business risk is the risk related to our inability to achieve our business objectives due to poor strategic decisions, including decisions related to mergers, acquisitions, and divestitures, poor implementation of strategic decisions or declining demand for our products and services. +Strategic decisions are reviewed and approved by business leaders and various committees and must be aligned with company policies. We seek to manage strategic and business risks through risk controls embedded in these processes as well as overall risk management oversight over business goals. Existing product performance is reviewed periodically by committees and business leaders. Mergers, acquisitions and divestitures can only be approved following Executive Committee due diligence, a comprehensive risk assessment by operational, market, credit and oversight leaders provided to the Chief Risk Officer and approval by either the Chief Risk Officer or appropriate risk committees. All new products and material changes in business processes are reviewed and approved by the New Products Committee and appropriate credit or risk committees. +COUNTRY RISK MANAGEMENT PROCESS +Country risk is defined as the risk that economic, social, and/or political conditions and events in a country might adversely impact us, primarily as a result of greater credit losses, increased operational or market risk or the inability to repatriate capital. +We manage country risk as part of the normal course of business. Policies and procedures establish country risk escalation thresholds to control and limit exposure, driven by processes that enable the monitoring of conditions in countries where we have exposure. +79 +Table of Contents +CRITICAL ACCOUNTING ESTIMATES +Refer to Note 1 to the “Consolidated Financial Statements” for a summary of our significant accounting policies. Certain of our accounting policies requiring significant management assumptions and judgments are as follows: +RESERVES FOR CARD MEMBER CREDIT LOSSES +Reserves for Card Member credit losses represent our best estimate of the expected credit losses in our outstanding portfolio of Card Member loans and receivables as of the balance sheet date. The CECL methodology, which became effective January 1, 2020, requires us to estimate lifetime expected credit losses by incorporating historical loss experience and current and future economic conditions over a reasonable and supportable period (R&S Period) beyond the balance sheet date. +In estimating expected credit losses, we use a combination of statistically based models and analysis of the results produced by these models to determine the quantitative and qualitative components of our total balance sheet reserves for credit losses. These quantitative and qualitative components entail a significant amount of judgment. The primary areas of judgment used in measuring the quantitative components of our reserves relate to the determination of the appropriate R&S Period, the modeling of the probability of and exposure at default, and the methodology to incorporate current and future economic conditions. We use these models and assumptions, combined with historical loss experience, to determine the reserve rates that are applied to the outstanding loan or receivable balances to produce our reserves for expected credit losses for the R&S Period. The qualitative component is intended to capture expected losses that may not have been fully captured in the quantitative component. Through an established governance structure, we consider certain external and internal factors, including emerging portfolio characteristics and trends, which consequentially may increase or decrease the reserves for Card Member credit losses. +The R&S Period, which is approximately three years, represents the maximum time-period beyond the balance sheet date over which we can reasonably estimate expected credit losses, using all available portfolio information, current economic conditions and forecasts of future economic conditions. Card Member loan products do not have a contractual term and balances can revolve if minimum required payments are made, causing some balances to remain outstanding beyond the R&S Period. To determine expected credit losses beyond the R&S Period, we immediately revert to long-term average loss rates. Card Member receivable products are contractually required to be paid in full; therefore, we have assumed the balances will be either paid or written-off within the R&S Period. +Within the R&S Period, our models use past loss experience and current and future economic conditions to estimate the probability of default, exposure at default and expected recoveries to estimate net losses at default. A significant area of judgment relates to how we apply future Card Member payments to the reporting period balances when determining the exposure at default. The nature of revolving loan products inherently includes a relationship between future payments and spend behavior, which creates complexity in the application of how future payments are either partially or entirely attributable to the existing balance at the end of the reporting period. Using historical customer behavior and other factors, we have assumed that future payments are first allocated to interest and fees associated with the reporting period balance and future spend. We then allocate a portion of the payment to the estimated higher minimum payment amount due because of any future spend. Any remaining portion of the future payment is then allocated to the remaining reporting period balance. +CECL requires that the R&S Period include an assumption about current and future economic conditions. We incorporate multiple macroeconomic scenarios obtained from an independent third party. The estimated credit losses calculated from each macroeconomic scenario are reviewed and weighted to reflect management's judgment about uncertainty around the scenarios. These macroeconomic scenarios contain certain variables, including unemployment rates and real GDP, that are significant to our models. +80 +Table of Contents +Macroeconomic Sensitivity +To demonstrate the sensitivity of estimated credit losses to the macroeconomic scenarios, we compared our modeled estimates under a baseline scenario to that under a pessimistic downside scenario. For every 10 percentage points change in weighting from the baseline scenario to the pessimistic downside scenario, the estimated credit losses increased by approximately $200 million. +The modeled estimates under these scenarios were influenced by the duration, severity and timing of changes in economic variables within each scenario and these macroeconomic scenarios, under different conditions or using different assumptions, could result in significantly different estimated credit losses. It is difficult to estimate how potential changes in specific factors might affect the estimated credit losses, and current results may not be indicative of the potential future impact of macroeconomic forecast changes. +In addition, this sensitivity analysis relates only to the modeled credit loss estimates under two scenarios without considering management’s judgment on the relative weighting for those and other scenarios, including the weight that has been placed on downside scenarios at the balance sheet date, or any potential changes in other adjustments to the quantitative reserve component or the impact of management judgment for the qualitative reserve component, which may have a positive or negative effect on the results. Thus, the results of this sensitivity analysis are hypothetical and are not intended to estimate or reflect our expectations of any changes in the overall reserves for credit losses due to changes in the macroeconomic environment. +The following table reflects the range of key variables in the macroeconomic scenarios utilized for the computation of Reserves for Card Member credit losses as of December 31, 2020: +December 31, 2020 +U.S. Unemployment Rate +Fourth quarter of 2020 7% +First quarter of 2021 7% - 8% +Fourth quarter of 2021 7% - 11% +Fourth quarter of 2022 6% - 12% +U.S. GDP Growth (Contraction) (a) +Fourth quarter of 2020 3% +First quarter of 2021 4% - (5%) +Fourth quarter of 2021 6% - (2%) +Fourth quarter of 2022 4% - 3% +(a) Real GDP quarter over quarter percentage change seasonally adjusted to annualized rates. +Refer to "Business Environment" and Table 3 in MD&A and Note 1 and Note 3 to the "Consolidated Financial Statements" for a further description of the impact of CECL, both at implementation and for the year ended December 31, 2020. +The process of estimating these reserves requires a high degree of judgment. To the extent our expected credit loss models are not indicative of future performance, actual losses could differ significantly from our judgments and expectations, resulting in either higher or lower future provisions for credit losses in any period. +81 +Table of Contents +LIABILITY FOR MEMBERSHIP REWARDS +The Membership Rewards program is our largest card-based rewards program. Card Members can earn points for purchases charged on their enrolled card products. A significant portion of our cards, by their terms, allow Card Members to earn bonus points for purchases at merchants in particular industry categories. Membership Rewards points are redeemable for a broad variety of rewards, including travel, shopping, gift cards, and covering eligible charges. Points typically do not expire, and there is no limit on the number of points a Card Member may earn. Membership Rewards expense is driven by charge volume on enrolled cards, customer participation in the program and contractual arrangements with redemption partners. +We record a Membership Rewards liability that represents the estimated cost of points earned that are expected to be redeemed by Card Members in the future. The Membership Rewards liability is impacted over time by enrollment levels, attrition, the volume of points earned and redeemed, and the associated redemption costs. We estimate the Membership Rewards liability by determining the URR and the WAC per point, which are applied to the points of current enrollees. Refer to Note 9 to the “Consolidated Financial Statements” for additional information. +The URR assumption is used to estimate the number of points earned by current enrollees that will ultimately be redeemed in future periods. We use statistical and actuarial models to estimate the URR of points earned to date by current Card Members based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. The WAC per point assumption is used to estimate future redemption costs and is primarily based on redemption choices made by Card Members, reward offerings by partners, and Membership Rewards program changes. The WAC per point assumption is derived from 12 months of redemptions and is adjusted as appropriate for certain changes in redemption costs that are not representative of future cost expectations and expected developments in redemption patterns. +We periodically evaluate our liability estimation process and assumptions based on developments in redemption patterns, cost per point redeemed, partner contract changes and other factors. +The process of estimating the Membership Rewards liability includes a high degree of judgment. Actual redemptions and associated redemption costs could differ significantly from our estimates, resulting in either higher or lower Membership Rewards expense. +Changes in the Membership Rewards URR and WAC per point have the effect of either increasing or decreasing the liability through the current period Membership Rewards expense by an amount estimated to cover the cost of all points previously earned but not yet redeemed by current enrollees as of the end of the reporting period. As of December 31, 2020, an increase in the estimated URR of current enrollees of 25 basis points would increase the Membership Rewards liability and corresponding rewards expense by approximately $128 million. Similarly, an increase in the WAC per point of 1 basis point would increase the Membership Rewards liability and corresponding rewards expense by approximately $141 million. +GOODWILL RECOVERABILITY +Goodwill represents the excess of acquisition cost of an acquired business over the fair value of assets acquired and liabilities assumed. Goodwill is not amortized but is tested for impairment at the reporting unit level annually or when events or circumstances arise, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value. Our methodology for conducting this goodwill impairment testing contains both a qualitative and quantitative assessment. +We have the option to initially perform an assessment of qualitative factors in order to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The qualitative factors may include, but are not limited to, economic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit and other company and reporting unit-specific events. If we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then perform the impairment evaluation using a more detailed quantitative assessment. We could also directly perform this quantitative assessment for any reporting unit, bypassing the qualitative assessment. +Our methodology for conducting the quantitative goodwill impairment testing is fundamentally based on the measurement of fair value for our reporting units, which inherently entails the use of significant management judgment. For valuation, we use a combination of the income approach (discounted cash flows) and market approach (market multiples) in estimating the fair value of our reporting units. +82 +Table of Contents +When preparing discounted cash flow models under the income approach, we estimate future cash flows using the reporting unit’s internal multi-year forecast, and a terminal value calculated using a growth rate that we believe is appropriate in light of current and expected future economic conditions. To discount these cash flows we use our expected cost of equity, determined using a capital asset pricing model. When using the market method under the market approach, we apply comparable publicly traded companies’ multiples (e.g., earnings, revenues) to our reporting units’ actual results. The judgment in estimating forecasted cash flows, discount rates and market comparables is significant, and imprecision could materially affect the fair value of our reporting units. +We could be exposed to an increased risk of further goodwill impairment if future operating results or macroeconomic conditions differ significantly from management’s current assumptions. +INCOME TAXES +We are subject to the income tax laws of the United States, its states and municipalities and those of the foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to the taxpayer’s facts is sometimes open to interpretation. In establishing a provision for income tax expense, we must make judgments about the application of inherently complex tax laws. +Unrecognized Tax Benefits +We establish a liability for unrecognized tax benefits, which are the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized in the financial statements. +In establishing a liability for an unrecognized tax benefit, assumptions may be made in determining whether, and the extent to which, a tax position should be sustained. A tax position is recognized only when it is more likely than not to be sustained upon examination by the relevant taxing authority, based on its technical merits. The amount of tax benefit recognized is the largest benefit that we believe is more likely than not to be realized on ultimate settlement. As new information becomes available, we evaluate our tax positions and adjust our unrecognized tax benefits, as appropriate . +Tax benefits ultimately realized can differ from amounts previously recognized due to uncertainties, with any such differences generally impacting the provision for income tax. +Deferred Tax Asset Realization +Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using the enacted tax rates expected to be in effect for the years in which the differences are expected to reverse. +Since deferred taxes measure the future tax effects of items recognized in the Consolidated Financial Statements, certain estimates and assumptions are required to determine whether it is more likely than not that all or some portion of the benefit of a deferred tax asset will not be realized. In making this assessment, we analyze and estimate the impact of future taxable income, reversing temporary differences and available tax planning strategies. These assessments are performed quarterly, taking into account any new information. +Changes in facts or circumstances can lead to changes in the ultimate realization of deferred tax assets due to uncertainties. +83 +Table of Contents +OTHER MATTERS +RECENTLY ISSUED ACCOUNTING STANDARDS +Refer to the Recently Issued and Adopted Accounting Standards section of Note 1 to the “Consolidated Financial Statements.” +GLOSSARY OF SELECTED TERMINOLOGY +Adjusted net interest income — A non-GAAP measure that represents net interest income attributable to our Card Member loans (which includes, on a GAAP basis, interest that is deemed uncollectible), excluding the impact of interest expense and interest income not attributable to our Card Member loans. +Airline-related volume — Represents spend at airlines as a merchant. +Asset securitizations — Asset securitization involves the transfer and sale of loans or receivables to a special-purpose entity created for the securitization activity, typically a trust. The trust, in turn, issues securities, commonly referred to as asset-backed securities, that are secured by the transferred loans and receivables. The trust uses the proceeds from the sale of such securities to pay the purchase price for the transferred loans or receivables. The securitized loans and receivables of our Lending Trust and Charge Trust (collectively, the Trusts) are reported as assets and the securities issued by the Trusts are reported as liabilities on our Consolidated Balance Sheets. +Average discount rate — This calculation is generally designed to reflect the average pricing at all merchants accepting American Express cards and represents the percentage of proprietary and GNS billed business retained by us from merchants we acquire, or from merchants acquired by third parties on our behalf, net of amounts retained by such third parties. The average discount rate, together with billed business, drive our discount revenue. +Billed business — Represents transaction volumes (including cash advances) on cards and other payment products issued by American Express (proprietary billed business) and cards issued under network partnership agreements with banks and other institutions, including joint ventures (GNS billed business). In-store spending activity within GNS retail cobrand portfolios, from which we earn no revenue, is not included in billed business. Billed business is reported as inside the United States or outside the United States based on the location of the issuer. Billed business, together with the average discount rate, drive our discount revenue. +Capital ratios — Represents the minimum standards established by regulatory agencies as a measure to determine whether the regulated entity has sufficient capital to absorb on- and off-balance sheet losses beyond current loss accrual estimates. Refer to the Capital Strategy section under “Consolidated Capital Resources and Liquidity” for further related definitions under Basel III. +Cards-in-force — Represents the number of cards that are issued and outstanding by American Express (proprietary cards-in-force) and cards issued and outstanding under network partnership agreements with banks and other institutions, including joint ventures (GNS cards-in-force), except for GNS retail cobrand cards that had no out-of-store spending activity during the prior twelve months. Basic cards-in-force excludes supplemental cards issued on consumer accounts. Cards-in-force is useful in understanding the size of our Card Member base. +Card Member — The individual holder of an issued American Express-branded card. +Card Member loans — Represents the outstanding amount due from Card Members for charges made on their American Express credit cards, as well as any interest charges and card-related fees. Card Member loans also include revolving balances on certain American Express charge card products. +Card Member receivables — Represents the outstanding amount due from Card Members for charges made on their American Express charge cards, as well as any card-related fees, other than revolving balances on certain American Express charge cards with Pay Over Time features. Such revolving balances are included within Card Member loans. +Charge cards — Represents cards that generally carry no pre-set spending limits and are primarily designed as a method of payment and not as a means of financing purchases. Charge Card Members generally must pay the full amount billed each month. No finance charges are assessed on charge cards. Each charge card transaction is authorized based on its likely economics reflecting a Card Member’s most recent credit information and spend patterns. Some charge cards have additional Pay Over Time feature(s) that allow revolving of certain charges. +84 +Table of Contents +Cobrand cards — Cards issued under cobrand agreements with selected commercial partners. Pursuant to the cobrand agreements, we make payments to our cobrand partners, which can be significant, based primarily on the amount of Card Member spending and corresponding rewards earned on such spending and, under certain arrangements, on the number of accounts acquired and retained. The partner is then liable for providing rewards to the Card Member under the cobrand partner’s own loyalty program. +Credit cards — Represents cards that have a range of revolving payment terms, grace periods, and rate and fee structures. +Discount revenue — Primarily represents the amount earned on transactions occurring at merchants that have entered into a card acceptance agreement with us, a GNS partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. +Interest expense — Includes interest incurred primarily to fund Card Member loans and receivables, general corporate purposes and liquidity needs. Interest expense is divided principally into two categories: (i) deposits, which primarily relates to interest expense on deposits taken from customers and institutions, and (ii) debt, which primarily relates to interest expense on our long-term financing and short-term borrowings, (e.g., commercial paper, federal funds purchased, bank overdrafts and other short-term borrowings), as well as the realized impact of derivatives hedging interest rate risk on our long-term debt. +Interest income — Includes (i) interest on loans, (ii) interest and dividends on investment securities and (iii) interest income on deposits with banks and other. +Interest on loans — Assessed using the average daily balance method for Card Member loans. Unless the loan is classified as non-accrual, interest is recognized based upon the principal amount outstanding in accordance with the terms of the applicable account agreement until the outstanding balance is paid or written off. +Interest and dividends on investment securities — Primarily relates to our performing fixed-income securities. Interest income is recognized using the effective interest method, which adjusts the yield for security premiums and discounts, fees and other payments, so a constant rate of return is recognized on the outstanding balance of the related investment security throughout its term. Amounts are recognized until securities are in default or when it is likely that future interest payments will not be made as scheduled. +Interest income on deposits with banks and other — Primarily relates to the placement of cash in excess of near-term funding requirements in interest-bearing time deposits, overnight sweep accounts, and other interest-bearing demand and call accounts. +Loyalty Coalitions — Programs that enable consumers to earn rewards points and use them to save on purchases from a variety of participating merchants through multi-category rewards platforms. Merchants in these programs generally fund the consumer offers and are responsible to us for the cost of rewards points; we earn revenue from operating the loyalty platform and by providing marketing support. +Net card fees — Represents the card membership fees earned during the period recognized as revenue over the covered card membership period (typically one year), net of the provision for projected refunds for Card Membership cancellation and deferred acquisition costs. +Net interest yield on average Card Member loans — A non-GAAP measure that is computed by dividing adjusted net interest income by average Card Member loans, computed on an annualized basis. Reserves and net write-offs related to uncollectible interest are recorded through provision for credit losses and are thus not included in the net interest yield calculation. +Net write-off rate — principal only — Represents the amount of proprietary consumer or small business Card Member loans or receivables written off, consisting of principal (resulting from authorized transactions), less recoveries, as a percentage of the average loan or receivable balance during the period. +Net write-off rate — principal, interest and fees — Includes, in the calculation of the net write-off rate, amounts for interest and fees in addition to principal for Card Member loans, and fees in addition to principal for Card Member receivables. +Operating expenses — Represents salaries and employee benefits, professional services, occupancy and equipment, and other expenses. +85 +Table of Contents +Reserve build (release) — Represents the portion of the provisions for credit losses for the period related to increasing or decreasing reserves for credit losses as a result of, among other things, changes in volumes, macroeconomic outlook, portfolio composition and credit quality of portfolios. Reserve build represents the amount by which the provision for credit losses exceeds net write-offs, while reserve release represents the amount by which net write-offs exceed the provision for credit losses. +Return on average equity — Calculated by dividing one-year period net income by one-year average total shareholders’ equity. +T&E-related volume — Represents spend on travel and entertainment, which primarily includes airline, cruise, lodging and dining merchant categories. Non-T&E-related volume includes spend in all other merchant categories. +86 +Table of Contents +CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS +This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which are subject to risks and uncertainties. The forward-looking statements, which address our current expectations regarding business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” “estimate,” “predict,” “potential,” “continue” and similar expressions. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update or revise any forward-looking statements. Factors that could cause actual results to differ materially from these forward-looking statements, include, but are not limited to, the following: +• our ability to rebuild growth momentum and improve our financial performance to pre-pandemic levels, which will depend in part on a recovery in consumer travel and therefore on how soon lockdowns ease, travel restrictions lift and the general public begins to feel comfortable traveling again; discount revenue recovering broadly in-line with billed business; credit performance and reserve levels; identifying attractive investment opportunities that help rebuild growth momentum, product innovation and the pace at which we wind down our value injection efforts; our ability to control operating expenses and generate operating expense leverage; the effective tax rate remaining consistent with current expectations; and our ability to resume our share repurchase program; any of which could be impacted by, among other things, the factors identified in the subsequent paragraphs; +• our ability to grow billed business, revenues and EPS, which could be impacted by, among other things, uncertainty regarding the continued spread of COVID-19 (including new variants) and severity of the pandemic and the availability, distribution and use of effective treatments and vaccines; a further deterioration in global economic and business conditions; consumer and business spending not growing in line with expectations, including T&E spending not rebounding to 2019 levels by the end of 2021; an inability or unwillingness of Card Members to pay amounts owed to us; insufficient governmental stimulus and relief programs to address the ongoing impact of the pandemic; prolonged measures to contain the spread of COVID-19 (including travel restrictions) or premature easing of such containment measures, both of which could further exacerbate the effects on business activity and our Card Members, partners and merchants; health concerns associated with the pandemic continuing to affect consumer behavior, spending levels and preferences, and travel patterns and demand even after government restrictions are lifted and economies reopen; our inability to effectively manage risk in an uncertain environment; market volatility, changes in capital and credit market conditions and the availability and cost of capital; issues impacting brand perceptions and our reputation; the amount and efficacy of investments in share, scale and relevance; an inability of business partners to meet their obligations to us and our customers due to slowdowns or disruptions in their businesses, bankruptcy or liquidation, or otherwise; the impact of any future contingencies, including, but not limited to, restructurings, impairments, changes in reserves, legal costs, the imposition of fines or civil money penalties and increases in Card Member reimbursements; and the impact of regulation and litigation, which could affect the profitability of our business activities, limit our ability to pursue business opportunities, require changes to business practices or alter our relationships with partners, merchants and Card Members; +• future credit performance and the amount and timing of future credit reserve builds and releases, which will depend in part on changes in consumer behavior that affect loan and receivable balances (such as paydown and revolve rates) and delinquency and write-off rates; macroeconomic factors such as unemployment rates, GDP and the volume of bankruptcies; the impact of the CECL methodology; collections capabilities and recoveries of previously written-off loans and receivables; the enrollment in, and effectiveness of, hardship programs and troubled debt restructurings; the availability of government stimulus programs for borrowers; and governmental actions that provide forms of relief with respect to certain loans and fees, such as limiting debt collections efforts and encouraging or requiring extensions, modifications or forbearance; +• net interest income and the growth rate of loans outstanding being higher or lower than current expectations, which will depend on the behavior of Card Members and their actual spending and borrowing patterns; our ability to effectively manage risk and enhance Card Member value propositions; changes in interest rates and our cost of funds; credit actions, including line size and other adjustments to credit availability; and the effectiveness of our strategies to capture a greater share of existing Card Members’ spending and borrowings, reduce Card Member attrition and attract new customers; +• the actual amount we spend on marketing in the future, which will be based in part on continued changes in macroeconomic conditions and business performance; management’s identification and assessment of attractive investment opportunities and the receptivity of Card Members and prospective customers to advertising and customer acquisition initiatives; the pace at which we wind down our value injections efforts; our ability to balance expense control and investments in the business; and management’s ability to realize efficiencies and optimize investment spending; +• the actual amount to be spent on Card Member rewards and services and business development, and the relationship of these variable customer engagement costs to revenues, which could be impacted by continued changes in macroeconomic conditions and Card Member behavior as it relates to their spending patterns (including the level of spend in bonus categories) and the redemption of rewards and offers (including travel redemptions); the costs related to reward point +87 +Table of Contents +redemptions; Card Members’ interest in the value propositions we offer; further enhancements to product benefits to make them attractive to Card Members, potentially in a manner that is not cost-effective; and new and renegotiated contractual obligations with business partners; +• our ability to control our operating expenses and the actual amount we spend on operating expenses in the future, which could be impacted by, among other things, management’s decision to increase or decrease spending in such areas as technology, business and product development, sales force, premium servicing and digital capabilities depending on overall business performance; our ability to innovate efficient channels of customer interactions, such as chat supported by artificial intelligence; restructuring activity; fraud costs; information security or compliance expenses or consulting, legal and other professional services fees, including as a result of litigation or internal and regulatory reviews; the level of M&A activity and related expenses; the payment of civil money penalties, disgorgement, restitution, non-income tax assessments and litigation-related settlements; impairments of goodwill or other assets; the impact of changes in foreign currency exchange rates on costs; and higher-than-expected inflation; +• net card fees not growing consistent with current expectations, which could be impacted by, among other things, the further deterioration in macroeconomic conditions impacting the ability and desire of Card Members to pay card fees; higher Card Member attrition rates; Card Members continuing to be attracted to our premium card products and the pace of Card Member acquisition activity; and our inability to address competitive pressures and implement our strategies and business initiatives, including introducing new and enhanced benefits and services that are designed for the current environment; +• a further decline of the average discount rate, including as a result of further changes in the mix of spending by location and industry (including the pace of recovery in T&E spending), merchant negotiations (including merchant incentives, concessions and volume-related pricing discounts), competition, pricing regulation (including regulation of competitors’ interchange rates) and other factors; +• our tax rate not remaining consistent with current expectations, which could be impacted by, among other things, our geographic mix of income, further changes in tax laws and regulation, unfavorable tax audits and other unanticipated tax items; +• changes in the substantial and increasing worldwide competition in the payments industry, including competitive pressure that may materially impact the prices charged to merchants that accept American Express cards, competition for new and existing cobrand relationships, competition from new and non-traditional competitors and the success of marketing, promotion and rewards programs; +• changes affecting our plans regarding the return of capital to shareholders, including resuming our share repurchases in the first quarter of 2021, which will depend on factors such as capital levels and regulatory capital ratios; changes in the stress testing and capital planning process; our results of operations and financial condition; our credit ratings and rating agency considerations; and the economic environment and market conditions in any given period; +• our ability to increase Card Member acquisition activities, provide additional value to Card Members and refresh our premium products, which will be impacted in part by competition, brand perceptions and reputation, and our ability to develop and market value propositions that appeal to Card Members and new customers and offer attractive services and rewards programs, which will depend in part on ongoing investments in Card Member acquisition efforts, addressing changing customer behaviors, new product innovation and development, and enrollment processes, including through digital channels, and infrastructure to support new products, services and benefits; +• our ability to grow commercial payments, including through cash flow and supplier payment solutions, which will depend in part on competition, the willingness and ability of companies to use such solutions for procurement and other business expenditures, our ability to offer attractive value propositions to potential customers, our ability to enhance and expand our payment and lending solutions, and our ability to integrate Kabbage and re-launch its suite of products; +• our ability to innovate and strengthen our global network, which will depend in part on our ability to update our systems and platforms, the amount we invests in the network and our ability to make funds available for such investments, and technological developments, including capabilities that allow greater digital integration; +• the possibility that we will not execute on our plans to expand merchant coverage and improve perceptions of coverage, which will depend in part on the success of the company, OptBlue merchant acquirers and GNS partners in signing merchants to accept American Express, which could be impacted by our value propositions offered to merchants and merchant acquirers for card acceptance, as well as the awareness and willingness of Card Members to use American Express cards at merchants and whether Card Members experience welcome acceptance for American Express cards; +• our ability to introduce new and expanded digital capabilities, which will depend on our success in evolving our products and processes for the digital environment, developing new features in the Amex app and enhancing our digital channels, building partnerships and executing programs with other companies, effectively utilizing artificial intelligence to address servicing and other customer needs, and supporting the use of our products as a means of payment through online and mobile channels, all of which will be impacted by investment levels, new product innovation and development and infrastructure to support new products, services and benefits; +• a failure in or breach of our operational or security systems, processes or infrastructure, or those of third parties, including as a result of cyberattacks, which could compromise the confidentiality, integrity, privacy and/or security of data, disrupt +88 +Table of Contents +our operations, reduce the use and acceptance of American Express cards and lead to regulatory scrutiny, litigation, remediation and response costs, and reputational harm; +• changes in capital and credit market conditions, which may significantly affect our ability to meet our liquidity needs and expectations regarding capital ratios; our access to capital and funding costs; the valuation of our assets; and our credit ratings or those of our subsidiaries; +• our deposit rates increasing faster or slower than current expectations and changes affecting our ability to grow retail direct deposits, including due to market demand, changes in benchmark interest rates, competition or regulatory restrictions on our ability to obtain deposit funding or offer competitive interest rates, which could affect our net interest yield and ability to fund our businesses; +• our funding plan being implemented in a manner inconsistent with current expectations, which will depend on various factors such as future business growth, the impact of global economic, political and other events on market capacity, demand for securities we offer, regulatory changes, ability to securitize and sell receivables and the performance of receivables previously sold in securitization transactions; +• legal and regulatory developments, which could affect the profitability of our business activities; limit our ability to pursue business opportunities; require changes to business practices or alter our relationships with Card Members, partners, merchants and other third parties, including our ability to continue certain cobrand and agent relationships in the EU; exert further pressure on the average discount rate and GNS volumes; result in increased costs related to regulatory oversight, litigation-related settlements, judgments or expenses, restitution to Card Members or the imposition of fines or civil money penalties; materially affect capital or liquidity requirements, results of operations or ability to pay dividends; or result in harm to the American Express brand; +• changes in the financial condition and creditworthiness of our business partners, such as bankruptcies, restructurings or consolidations, including of cobrand partners and merchants that represent a significant portion of our business, such as the airline industry, or partners in GNS or financial institutions that we rely on for routine funding and liquidity, which could materially affect our financial condition or results of operations; and +• factors beyond our control such as resurgences of COVID-19 cases, whether and when populations achieve herd immunity, severe weather conditions, natural disasters, power loss, disruptions in telecommunications, terrorism and other catastrophic events, any of which could significantly affect demand for and spending on American Express cards, delinquency rates, loan and receivable balances and other aspects of our business and results of operations or disrupt our global network systems and ability to process transactions. +A further description of these uncertainties and other risks can be found in “Risk Factors” above and our other reports filed with the SEC. +89 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Refer to “Risk Management” under “MD&A” for quantitative and qualitative disclosures about market risk. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. +Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (GAAP), and includes those policies and procedures that: +• Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of assets; +• Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and +• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2020. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control —Integrated Framework (2013). +Based on management’s assessment and those criteria, we conclude that, as of December 31, 2020, our internal control over financial reporting is effective. +PricewaterhouseCoopers LLP, our independent registered public accounting firm, has issued an audit report appearing on the following page on the effectiveness of our internal control over financial reporting as of December 31, 2020. +90 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF AMERICAN EXPRESS COMPANY +Opinions on the Financial Statements and Internal Control over Financial Reporting +We have audited the accompanying consolidated balance sheets of American Express Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income, of shareholders’ equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. +Change in Accounting Principle +As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for credit losses on certain financial instruments in 2020. +Basis for Opinions +The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. +Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. +Definition and Limitations of Internal Control over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +91 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +Reserves for Credit Losses on Card Member Loans +As described in Note 3 to the consolidated financial statements, reserves for credit losses on Card Member loans represent management’s estimate of the expected credit losses in the Company’s outstanding portfolio of Card Member loans as of the balance sheet date. The reserves for credit losses on Card Member loans was $5.3 billion as of December 31, 2020. Management estimates lifetime expected credit losses by incorporating historical loss experience, as well as current and future economic conditions over a reasonable and supportable period (R&S Period) beyond the balance sheet date. In estimating expected credit losses, management uses a combination of statistically-based models that entail a significant amount of judgment. The primary areas of judgment used in measuring the quantitative components of the Company’s reserves relate to the determination of the appropriate R&S Period, the modeling of the probability of and exposure at default, and the methodology to incorporate current and future economic conditions. Management uses these models and assumptions, combined with historical loss experience, to determine the reserve rates that are applied to the outstanding loan balances to produce its reserves for expected credit losses. Within the R&S Period, the Company’s models use past loss experience and current and future economic conditions to estimate the probability of default, exposure at default and expected recoveries to estimate net losses at default. Beyond the R&S Period, expected credit losses are estimated by immediately reverting to long-term average loss rates. Management also estimates the likelihood and magnitude of recovery of previously written off loans considering how long ago the loan was written off and future economic conditions. Additionally, management evaluates whether to include qualitative reserves to cover losses that are expected but may not be adequately represented in the quantitative methods or the economic assumptions. The qualitative reserves address possible limitations within the models or factors not included within the models, such as external conditions, emerging portfolio trends, the nature and size of the portfolio, portfolio concentrations, the volume and severity of past due accounts, or management risk actions. +The principal considerations for our determination that performing procedures relating to the reserves for credit losses on Card Member loans is a critical audit matter are (i) the estimate of the reserves for credit losses on Card Member loans involved significant judgment by management, which in turn led to a high degree of auditor judgment, subjectivity and effort in performing procedures and evaluating the models, significant inputs, qualitative reserves, and significant assumptions, including the R&S Period and the loss rates used to estimate expected credit losses beyond the R&S Period and (ii) the audit effort involved the use of professionals with specialized skill and knowledge. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to the reserves for credit losses on Card Member loans. These procedures also included, among others, testing management’s process for estimating the reserves for credit losses on Card Member loans through (i) evaluating the appropriateness of management’s methodology, (ii) testing the completeness and accuracy of significant inputs and (iii) evaluating the reasonableness of certain qualitative reserves and significant assumptions used to estimate the reserves. Professionals with specialized skill and knowledge were used to assist in evaluating the appropriateness of management’s methodology and the reasonableness of certain qualitative reserves and certain significant assumptions, including the R&S Period and the loss rates used to estimate expected credit losses beyond the R&S Period. +92 +Table of Contents +Membership Rewards Liability +As described in Note 9 to the consolidated financial statements, the Membership Rewards liability represents management’s estimate of the cost of Membership Rewards points earned that are expected to be redeemed in the future. The Membership Rewards liability was $9.8 billion as of December 31, 2020. The weighted average cost (WAC) per point and the Ultimate Redemption Rate (URR) are key assumptions used to estimate the liability. The URR assumption is used by management to estimate the number of points earned that will ultimately be redeemed in future periods. Management uses statistical and actuarial models to estimate the URR based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. The WAC per point assumption is derived from the previous 12 months of redemptions and is adjusted as appropriate for certain changes in redemption costs that are not representative of future cost expectations and expected developments in redemption patterns. +The principal considerations for our determination that performing procedures relating to the Membership Rewards liability is a critical audit matter are (i) the estimate of the URR involved significant judgment by management, which in turn led to a high degree of auditor judgment, subjectivity and effort in performing procedures and evaluating the models, significant inputs and assumptions used by management, (ii) the audit effort involved the use of professionals with specialized skill and knowledge and (iii) the estimate of the WAC involved significant judgment by management, which in turn led to a high degree of auditor judgment and subjectivity in performing procedures and evaluating the methodology. +Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to the estimate of the Membership Rewards liability, including the URR and WAC assumptions. These procedures also included, among others, (i) testing the completeness and accuracy of significant inputs to the statistical and actuarial models used to estimate the URR assumption, including redemption trends, card product type, enrollment tenure, and card spend levels, (ii) the involvement of professionals with specialized skill and knowledge to assist in developing an independent estimate of the URR assumption and comparing the independent estimate to management’s assumption to evaluate its reasonableness, (iii) evaluating management’s methodology for determining the WAC assumption and (iv) comparing our independently calculated Membership Rewards liability to management’s estimate. +/s/ PricewaterhouseCoopers LLP +New York, New York +February 12, 2021 +We have served as the Company’s auditor since 2005. +93 +Table of Contents +INDEX TO CONSOLIDATED FINANCIAL STATEMENTS +CONSOLIDATED FINANCIAL STATEMENTS +PAGE +Consolidated Statements of Income – For the Years Ended December 31, 20 20 , 201 9 and 201 8 +95 +Consolidated Statements of Comprehensive Income – For the Years Ended December 31, 20 20 , 201 9 and 201 8 +96 +Consolidated Balance Sheets – December 31, 20 20 and 201 9 +97 +Consolidated Statements of Cash Flows – For the Years Ended December 31, 20 20 , 201 9 and 201 8 +98 +Consolidated Statements of Shareholders’ Equity – For the Years Ended December 31, 20 20 , 201 9 and 201 8 +99 +NOTES TO CONSOLIDATED FINANCIAL STATEMENTS +100 +Note 1 – Summary of Significant Accounting Policies +100 +Note 2 – Loans and Card Member Receivables +106 +Note 3 – Reserves for Credit Losses +114 +Note 4 – Investment Securities +117 +Note 5 – Asset Securitizations +119 +Note 6 – Other Assets +120 +Note 7 – Customer Deposits +122 +Note 8 – Debt +123 +Note 9 – Other Liabilities +126 +Note 1 0 – Stock Plans +127 +Note 1 1 – Retirement Plans +129 +Note 1 2 – Contingencies and Commitments +130 +Note 1 3 – Derivatives and Hedging Activities +133 +Note 1 4 – Fair Values +137 +Note 1 5 – Guarantees +141 +Note 1 6 – Common and Preferred Shares +141 +Note 1 7 – Changes in Accumulated Other Comprehensive Income +143 +Note 18 – Other Fees and Commissions and Other Expenses +144 +Note 19 – Restructuring +144 +Note 2 0 – Income Taxes +145 +Note 2 1 – Earnings Per Common Share (EPS) +148 +Note 2 2 – Regulatory Matters and Capital Adequacy +149 +Note 2 3 – Significant Credit Concentrations +151 +Note 2 4 – Reportable Operating Segments and Geographic Operations +152 +Note 2 5 – Parent Company +155 +Note 2 6 – Quarterly Financial Data (Unaudited) +158 +94 +Table of Contents +CONSOLIDATED STATEMENTS OF INCOME +Year Ended December 31 (Millions, except per share amounts) +2020 2019 2018 +Revenues +Non-interest revenues +Discount revenue $ 20,401 $ 26,167 $ 24,721 +Net card fees 4,664 4,042 3,441 +Other fees and commissions 2,163 3,297 3,153 +Other 874 1,430 1,360 +Total non-interest revenues 28,102 34,936 32,675 +Interest income +Interest on loans 9,779 11,308 9,941 +Interest and dividends on investment securities 127 188 118 +Deposits with banks and other 177 588 547 +Total interest income 10,083 12,084 10,606 +Interest expense +Deposits 943 1,559 1,287 +Long-term debt and other 1,155 1,905 1,656 +Total interest expense 2,098 3,464 2,943 +Net interest income 7,985 8,620 7,663 +Total revenues net of interest expense 36,087 43,556 40,338 +Provisions for credit losses +Card Member receivables 1,015 963 937 +Card Member loans 3,453 2,462 2,266 +Other 262 148 149 +Total provisions for credit losses 4,730 3,573 3,352 +Total revenues net of interest expense after provisions for credit losses 31,357 39,983 36,986 +Expenses +Marketing and business development 6,747 7,125 6,477 +Card Member rewards 8,041 10,439 9,696 +Card Member services 1,230 2,223 1,777 +Salaries and employee benefits 5,718 5,911 5,250 +Other, net 5,325 5,856 5,664 +Total expenses 27,061 31,554 28,864 +Pretax income 4,296 8,429 8,122 +Income tax provision 1,161 1,670 1,201 +Net income $ 3,135 $ 6,759 $ 6,921 +Earnings per Common Share — (Note 21) (a) +Basic $ 3.77 $ 8.00 $ 7.93 +Diluted $ 3.77 $ 7.99 $ 7.91 +Average common shares outstanding for earnings per common share: +Basic 805 828 856 +Diluted 806 830 859 +(a) Represents net income less (i) earnings allocated to participating share awards of $ 20 million, $ 47 million and $ 54 million for the years ended December 31, 2020, 2019 and 2018, respectively, and (ii) dividends on preferred shares of $ 79 million, $ 81 million and $ 80 million for the years ended December 31, 2020, 2019 and 2018, respectively. +See Notes to Consolidated Financial Statements. +95 +Table of Contents +CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME +Year Ended December 31 (Millions) +2020 2019 2018 +Net income $ 3,135 $ 6,759 $ 6,921 +Other comprehensive (loss) income: +Net unrealized securities gains (losses), net of tax 32 41 ( 8 ) +Foreign currency translation adjustments, net of tax ( 40 ) ( 56 ) ( 172 ) +Net unrealized pension and other postretirement benefits, net of tax ( 150 ) ( 125 ) 11 +Other comprehensive (loss) income ( 158 ) ( 140 ) ( 169 ) +Comprehensive income $ 2,977 $ 6,619 $ 6,752 +See Notes to Consolidated Financial Statements. +96 +Table of Contents +CONSOLIDATED BALANCE SHEETS +December 31 (Millions, except share data) +2020 2019 +Assets +Cash and cash equivalents +Cash and due from banks $ 2,984 $ 3,613 +Interest-bearing deposits in other banks (includes securities purchased under resale agreements: 2020, $ 92 ; 2019, $ 87 ) +29,824 20,610 +Short-term investment securities (includes restricted cash of consolidated variable interest entities: 2020 $ 47 ; 2019, $ 85 ) +157 223 +Total cash and cash equivalents 32,965 24,446 +Card Member receivables (includes gross receivables available to settle obligations of a consolidated variable interest entity: 2020, $ 4,296 ; 2019, $ 8,284 ), less reserves for credit losses: 2020, $ 267 ; 2019, $ 619 +43,434 56,794 +Card Member loans (includes gross loans available to settle obligations of a consolidated variable interest entity: 2020, $ 25,908 ; 2019, $ 32,230 ), less reserves for credit losses: 2020, $ 5,344 ; 2019, $ 2,383 +68,029 84,998 +Other loans, less reserves for credit losses: 2020, $ 238 ; 2019, $ 152 +2,614 4,626 +Investment securities 21,631 8,406 +Premises and equipment, less accumulated depreciation and amortization: 2020, $ 7,540 ; 2019, $ 6,562 +5,015 4,834 +Other assets, less reserves for credit losses: 2020, $ 85 ; 2019, $ 27 +17,679 14,217 +Total assets $ 191,367 $ 198,321 +Liabilities and Shareholders’ Equity +Liabilities +Customer deposits $ 86,875 $ 73,287 +Accounts payable 9,444 12,738 +Short-term borrowings 1,878 6,442 +Long-term debt (includes debt issued by consolidated variable interest entities: 2020, $ 12,760 ; 2019, $ 19,668 ) +42,952 57,835 +Other liabilities 27,234 24,948 +Total liabilities $ 168,383 $ 175,250 +Contingencies and Commitments (Note 12) +Shareholders’ Equity +Preferred shares, $1.66 2/3 par value, authorized 20 million shares; issued and outstanding 1,600 shares as of December 31, 2020 and 2019 (Note 16) +— — +Common shares, $ 0.20 par value, authorized 3.6 billion shares; issued and outstanding 805 million shares as of December 31, 2020 and 810 million shares as of December 31, 2019 +161 163 +Additional paid-in capital 11,881 11,774 +Retained earnings 13,837 13,871 +Accumulated other comprehensive loss +Net unrealized debt securities gains, net of tax of: 2020, $ 20 ; 2019, $ 11 +65 33 +Foreign currency translation adjustments, net of tax of: 2020, $( 381 ); 2019, $( 319 ) +( 2,229 ) ( 2,189 ) +Net unrealized pension and other postretirement benefits, net of tax of: 2020, $( 236 ); 2019, $( 208 ) +( 731 ) ( 581 ) +Total accumulated other comprehensive loss ( 2,895 ) ( 2,737 ) +Total shareholders’ equity 22,984 23,071 +Total liabilities and shareholders’ equity $ 191,367 $ 198,321 +See Notes to Consolidated Financial Statements. +97 +Table of Contents +CONSOLIDATED STATEMENTS OF CASH FLOWS +Years Ended December 31 (Millions) +2020 2019 2018 +Cash Flows from Operating Activities +Net income $ 3,135 $ 6,759 $ 6,921 +Adjustments to reconcile net income to net cash provided by operating activities: +Provisions for credit losses 4,730 3,573 3,352 +Depreciation and amortization 1,543 1,188 1,293 +Deferred taxes and other ( 256 ) 426 455 +Stock-based compensation 249 283 283 +Changes in operating assets and liabilities, net of effects of acquisitions and dispositions: +Other assets ( 1,785 ) ( 368 ) 991 +Accounts payable & other liabilities ( 2,025 ) 1,771 ( 4,365 ) +Net cash provided by operating activities 5,591 13,632 8,930 +Cash Flows from Investing Activities +Sale of investment securities 69 22 4 +Maturities and redemptions of investment securities 7,159 7,329 3,499 +Purchase of investments ( 20,562 ) ( 11,166 ) ( 5,434 ) +Net decrease (increase) in Card Member loans and receivables, and other loans 26,906 ( 11,047 ) ( 15,854 ) +Purchase of premises and equipment, net of sales: 2020, $ 1 ; 2019, $ 43 ; 2018, $ 1 +( 1,478 ) ( 1,645 ) ( 1,310 ) +Acquisitions/dispositions, net of cash acquired ( 597 ) ( 352 ) ( 520 ) +Other investing activities 135 152 — +Net cash provided by (used in) investing activities 11,632 ( 16,707 ) ( 19,615 ) +Cash Flows from Financing Activities +Net increase in customer deposits 13,542 3,330 5,542 +Net (decrease) increase in short-term borrowings ( 4,627 ) 3,316 ( 148 ) +Proceeds from long-term debt 69 12,706 21,524 +Payments of long-term debt ( 15,593 ) ( 13,850 ) ( 18,895 ) +Issuance of American Express common shares 44 86 87 +Repurchase of American Express common shares and other ( 1,029 ) ( 4,685 ) ( 1,685 ) +Dividends paid ( 1,474 ) ( 1,422 ) ( 1,324 ) +Net cash (used in) provided by financing activities ( 9,068 ) ( 519 ) 5,101 +Effect of foreign currency exchange rates on cash and cash equivalents 364 232 129 +Net increase (decrease) in cash and cash equivalents 8,519 ( 3,362 ) ( 5,455 ) +Cash and cash equivalents at beginning of year 24,446 27,808 33,263 +Cash and cash equivalents at end of year $ 32,965 $ 24,446 $ 27,808 +Supplemental cash flow information +Cash, cash equivalents and restricted cash reconciliation Dec-20 Dec-19 Dec-18 +Cash and cash equivalents per Consolidated Balance Sheets $ 32,965 $ 24,446 $ 27,808 +Restricted cash included in Cash and cash equivalents 606 514 363 +Total Cash and cash equivalents, excluding restricted cash $ 32,359 $ 23,932 $ 27,445 +See Notes to Consolidated Financial Statements. +98 +Table of Contents +CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY +(Millions, except per share amounts) Total Preferred Shares Common Shares Additional Paid-in +Capital Accumulated Other +Comprehensive +Loss Retained Earnings +Balances as of December 31, 2017 $ 18,261 $ — $ 172 $ 12,210 $ ( 2,428 ) $ 8,307 +Net income 6,921 — — — — 6,921 +Other comprehensive loss ( 169 ) — — — ( 169 ) — +Repurchase of common shares ( 1,570 ) — ( 3 ) ( 216 ) — ( 1,351 ) +Other changes, primarily employee plans 200 — 1 224 — ( 25 ) +Cash dividends declared preferred Series B, $ 52.00 per share +( 39 ) — — — — ( 39 ) +Cash dividends declared preferred Series C, $ 49.00 per share +( 41 ) — — — — ( 41 ) +Cash dividends declared common, $ 1.48 per share +( 1,273 ) — — — — ( 1,273 ) +Balances as of December 31, 2018 22,290 — 170 12,218 ( 2,597 ) 12,499 +Net income 6,759 — — — — 6,759 +Other comprehensive loss ( 140 ) — — — ( 140 ) — +Repurchase of common shares ( 4,585 ) — ( 8 ) ( 671 ) — ( 3,906 ) +Other changes, primarily employee plans 186 — 1 227 — ( 42 ) +Cash dividends declared preferred Series B, $ 52.00 per share +( 39 ) — — — — ( 39 ) +Cash dividends declared preferred Series C, $ 49.00 per share +( 42 ) — — — — ( 42 ) +Cash dividends declared common, $ 1.64 per share +( 1,358 ) — — — — ( 1,358 ) +Balances as of December 31, 2019 23,071 — 163 11,774 ( 2,737 ) 13,871 +Cumulative effect of change in accounting principle - Reserve for Credit Losses (a) +( 882 ) — — — — ( 882 ) +Net income 3,135 — — — — 3,135 +Other comprehensive loss ( 158 ) — — — ( 158 ) — +Repurchase of common shares ( 875 ) — ( 2 ) ( 105 ) — ( 768 ) +Other changes, primarily employee plans 164 — — 212 — ( 48 ) +Cash dividends declared preferred Series B, $ 45.81 per share +( 34 ) — — — — ( 34 ) +Cash dividends declared preferred Series C, $ 52.93 per share +( 45 ) — — — — ( 45 ) +Cash dividends declared common, $ 1.72 per share +( 1,392 ) — — — — ( 1,392 ) +Balances as of December 31, 2020 $ 22,984 $ — $ 161 $ 11,881 $ ( 2,895 ) $ 13,837 +(a) Represents $ 1,170 million, net of tax of $ 288 million, related to the impact as of January 1, 2020 of adopting the new accounting guidance for the recognition of credit losses on certain financial instruments. +See Notes to Consolidated Financial Statements. +99 +Table of Contents +NOTES TO CONSOLID ATED FINANCIAL STATEMENTS +NOTE 1 +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +THE C OMPANY +We are a globally integrated payments company that provides our customers with access to products, insights and experiences that enrich lives and build business success. Our principal products and services are credit and charge card products, along with travel and lifestyle related services, offered to consumers and businesses around the world. Business travel-related services are offered through the non-consolidated joint venture, American Express Global Business Travel. Our various products and services are sold globally to diverse customer groups, including consumers, small businesses, mid-sized companies and large corporations. These products and services are sold through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams, and direct response advertising. +Refer to Note 24 for additional discussion of the products and services that comprise each segment. Corporate functions and certain other businesses and operations are included in Corporate & Other. +PRINCIPLES OF CONSOLIDATION +The Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Significant intercompany transactions are eliminated. +We consolidate entities in which we hold a “controlling financial interest.” For voting interest entities, we are considered to hold a controlling financial interest when we are able to exercise control over the investees’ operating and financial decisions. For variable interest entities (VIEs), the determination of which is based on the amount and characteristics of the entity’s equity, we are considered to hold a controlling financial interest when we are determined to be the primary beneficiary. A primary beneficiary is the party that has both: (1) the power to direct the activities that most significantly impact that VIE’s economic performance, and (2) the obligation to absorb the losses of, or the right to receive the benefits from, the VIE that could potentially be significant to that VIE. +Entities in which our voting interest in common equity does not provide it with control, but allows us to exert significant influence over operating and financial decisions, are accounted for under the equity method. We also have investments in equity securities where our voting interest is below the level of significant influence, including investments that we make in non-public companies in the ordinary course of business. Such investments are initially recorded at cost and adjusted to fair value through earnings for observable price changes in orderly transactions for identical or similar transactions of the same company or if they are determined to be impaired. See Note 4 for the accounting policy for our marketable equity securities. +FOREIGN CURRENCY +Monetary assets and liabilities denominated in foreign currencies are translated into U.S. dollars based upon exchange rates prevailing at the end of the reporting period; non-monetary assets and liabilities are translated at the historic exchange rate at the date of the transaction; revenues and expenses are translated at the average month-end exchange rates during the year. Resulting translation adjustments, along with any related qualifying hedge and tax effects, are included in accumulated other comprehensive income (loss) (AOCI), a component of shareholders’ equity. Translation adjustments, including qualifying hedge and tax effects, are reclassified to earnings upon the sale or substantial liquidation of investments in foreign operations. Gains and losses related to transactions in a currency other than the functional currency are reported in Other, net expenses in the Consolidated Statements of Income. +100 +Table of Contents +AMOUNTS BASED ON ESTIMATES AND ASSUMPTIONS +Accounting estimates are an integral part of the Consolidated Financial Statements. These estimates are based, in part, on management’s assumptions concerning future events. Among the more significant assumptions are those that relate to reserves for Card Member credit losses on loans and receivables, Membership Rewards liability, goodwill and income taxes. These accounting estimates reflect the best judgment of management, but actual results could differ. +INCOME STATEMENT +Discount Revenue +Discount revenue primarily represents the amount we earn on transactions occurring at merchants that have entered into a card acceptance agreement with us, or a Global Network Services (GNS) partner or other third-party merchant acquirer, for facilitating transactions between the merchants and Card Members. The amount of fees charged for accepting our cards as payment for goods or services, or merchant discount, varies with, among other factors, the industry in which the merchant conducts business, the merchant’s overall American Express-related transaction volume, the method of payment, the settlement terms with the merchant, the method of submission of transactions and, in certain instances, the geographic scope of the card acceptance agreement between the merchant and us (e.g., local or global) and the transaction amount. The merchant discount is generally deducted from the payment to the merchant and recorded as discount revenue at the time the Card Member transaction occurs. +The card acceptance agreements, which include the agreed-upon terms for charging the merchant discount fee, vary in duration. Our contracts with small- and medium-sized merchants generally have no fixed contractual duration, while those with large merchants are generally for fixed periods, which typically range from three to seven years in duration. Our fixed-period agreements may include auto-renewal features, which may allow the existing terms to continue beyond the stated expiration date until a new agreement is reached. We satisfy our obligations under these agreements over the contract term, often on a daily basis, including through the processing of Card Member transactions and the availability of our payment network. +In cases where the merchant acquirer is a third party (which is the case, for example, under our OptBlue program, or with certain of our GNS partners), we receive a network rate fee in our settlement with the merchant acquirer, which is individually negotiated between us and that merchant acquirer and is recorded as discount revenue at the time the Card Member transaction occurs. In our role as the operator of the American Express network, we also settle with merchants on behalf of our GNS card issuing partners, who in turn receive an issuer rate that is individually negotiated between that issuer and us and is recorded as expense in Marketing and business development (see below) or as contra-revenue in Other revenue. +Revenue expected to be recognized in future periods related to contracts that have an original expected duration of one year or less and contracts with variable consideration (e.g. discount revenue) is not required to be disclosed. Non-interest revenue expected to be recognized in future periods through remaining contracts with customers is not material. +Net Card Fees +Net card fees represent revenue earned from annual card membership fees, which vary based on the type of card and the number of cards for each account. These fees, net of acquisition costs and a reserve for projected refunds for Card Member cancellations, are deferred and recognized on a straight-line basis over the twelve-month card membership period as Net card fees in the Consolidated Statements of Income. The unamortized net card fee balance is reported in Other liabilities on the Consolidated Balance Sheets (refer to Note 9). +Other Fees and Commissions +Other fees and commissions includes certain fees charged to Card Members, including delinquency fees and foreign currency conversion fees, which are primarily recognized in the period in which they are charged to the Card Member. Other fees and commissions also includes Membership Rewards program fees, which are deferred and recognized over the period covered by the fee, typically one year, the unamortized portion of which is included in Other liabilities on the Consolidated Balance Sheets. In addition, Other fees and commissions includes loyalty coalition-related fees, travel commissions and fees and service fees earned from merchants, that are recognized when the service is performed, which is generally in the period the fee is charged. Refer to Note 18 for additional information. +Contra-revenue +Payments made pursuant to contractual arrangements with our merchants, GNS partners, and other customers are classified as contra-revenue, except where we receive goods, services or other benefits for which the fair value is determinable and measurable, in which case they are recorded as expense. +101 +Table of Contents +Interest Income +Interest on Card Member loans is assessed using the average daily balance method. Unless the loan is classified as non-accrual, interest is recognized based upon the principal amount outstanding, in accordance with the terms of the applicable account agreement, until the outstanding balance is paid, or written off. +Interest and dividends on investment securities primarily relate to our performing fixed-income securities. Interest income is recognized as earned using the effective interest method, which adjusts the yield for security premiums and discounts, fees and other payments, so that a constant rate of return is recognized on the investment security’s outstanding balance. Amounts are recognized until securities are in default or when it becomes likely that future interest payments will not be made as scheduled. +Interest on deposits with banks and other is recognized as earned, and primarily relates to the placement of cash, in excess of near-term funding requirements, in interest-bearing time deposits, overnight sweep accounts, and other interest-bearing demand and call accounts. +Interest Expense +Interest expense includes interest incurred primarily to fund Card Member loans and receivables, general corporate purposes and liquidity needs, and is recognized as incurred. Interest expense is divided principally into two categories: (i) deposits, which primarily relates to interest expense on deposits taken from customers and institutions, and (ii) debt, which primarily relates to interest expense on our long-term debt and short-term borrowings, as well as the realized impact of derivatives used to hedge interest rate risk on our long-term debt. +Marketing and Business Development +Marketing and business development expense includes costs incurred in the development and initial placement of advertising, which are expensed in the year in which the advertising first takes place. Also included in Marketing and business development expense are payments to our cobrand partners, Card Member statement credits for qualifying charges on eligible card accounts, corporate incentive payments earned on achievement of pre-set targets, and certain payments to GNS card issuing partners. These costs are generally expensed as incurred. +Card Member Rewards +We issue charge and credit cards that allow Card Members to participate in various rewards programs (e.g., Membership Rewards, cobrand and cash back). Rewards expense is recognized in the period Card Members earn rewards, generally by spending on their enrolled card products. We record a Card Member rewards liability that represents the estimated cost of points earned that are expected to be redeemed. Pursuant to cobrand agreements, we make payments to our cobrand partners based primarily on the amount of Card Member spending and corresponding rewards earned on such spending. The partner is then liable for providing rewards to the Card Member under the cobrand partner’s own loyalty program. Card Member rewards liabilities are impacted over time by enrollment levels, attrition, the volume of points earned and redeemed, and the associated redemption costs. Changes in the Card Member rewards liabilities during the period are taken as an increase or decrease to the Card Member rewards expense in the Consolidated Statements of Income. +BALANCE SHEET +Cash and Cash Equivalents +Cash and cash equivalents include cash and amounts due from banks, interest-bearing bank balances, including securities purchased under resale agreements, restricted cash, and other highly liquid investments with original maturities of 90 days or less. Restricted cash primarily represents amounts related to Card Member credit balances as well as upcoming debt maturities of consolidated VIEs. +Goodwill +Goodwill represents the excess of the acquisition cost of an acquired business over the fair value of assets acquired and liabilities assumed. We allocate goodwill to our reporting units for the purpose of impairment testing. A reporting unit is defined as an operating segment, or a business that is one level below an operating segment, for which discrete financial information is regularly reviewed by the operating segment manager. +We evaluate goodwill for impairment annually as of June 30, or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of one or more of our reporting units below its carrying value. Prior to +102 +Table of Contents +completing the assessment of goodwill for impairment, we also perform a recoverability test of certain long-lived assets. We have the option to perform a qualitative assessment of goodwill impairment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. Alternatively, we can perform a more detailed quantitative assessment of goodwill impairment. +This qualitative assessment entails the evaluation of factors such as economic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit and other company and reporting unit-specific events. If we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then perform the impairment evaluation using the quantitative assessment. +Under the quantitative assessment, the first step identifies whether there is a potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds the fair value, then a test is performed to determine the implied fair value of goodwill. An impairment loss is recognized based on the amount that the carrying amount of goodwill exceeds the implied fair value. +When measuring the fair value of our reporting units in the quantitative assessment, we use widely accepted valuation techniques, applying a combination of the income approach (discounted cash flows) and market approach (market multiples). When preparing discounted cash flow models under the income approach, we use internal forecasts to estimate future cash flows expected to be generated by the reporting units. To discount these cash flows, we use the expected cost of equity, determined by using a capital asset pricing model. We believe the discount rates used appropriately reflect the risks and uncertainties in the financial markets generally and specifically in our internally-developed forecasts. When using market multiples under the market approach, we apply comparable publicly traded companies’ multiples (e.g., earnings or revenues) to our reporting units’ actual results. +For the years ended December 31, 2020 and 2019, we performed a qualitative assessment in connection with our annual goodwill impairment evaluation and determined that it was more likely than not that the fair values of each of our reporting units exceeded their carrying values. +Premises and Equipment +Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation. Costs incurred during construction are capitalized and are depreciated once an asset is placed in service. Depreciation is generally computed using the straight-line method over the estimated useful lives of the assets, which range from 3 to 10 years for equipment, furniture and building improvements, and from 40 to 50 years for premises, which are depreciated based upon their estimated useful life at the acquisition date. +Certain costs associated with the acquisition or development of internal-use software are also capitalized and recorded in Premises and equipment. Once the software is ready for its intended use, these costs are amortized on a straight-line basis over the software’s estimated useful life, generally 5 years. We review these assets for impairment using the same impairment methodology used for our intangible assets. +Leasehold improvements are depreciated using the straight-line method over the lesser of the remaining term of the leased facility, or the economic life of the improvement, and range from 5 to 10 years. We recognize lease restoration obligations at the fair value of the restoration liabilities when incurred and amortize the restoration assets over the lease term. +Leases +We have operating leases worldwide for facilities and equipment, which, for those leases with terms greater than 12 months, are recorded as lease-related assets and liabilities. We do not separate lease and non-lease components. Lease-related assets, or right-of-use assets, are recognized at the lease commencement date at amounts equal to the respective lease liabilities, adjusted for prepaid lease payments, initial direct costs and lease incentives. Lease liabilities are recognized at the present value of the contractual fixed lease payments, discounted using our incremental borrowing rate as of the lease commencement date or upon modification of the lease. Operating lease expense is recognized on a straight-line basis over the lease term, while variable lease payments are expensed as incurred. +103 +Table of Contents +OTHER SIGNIFICANT ACCOUNTING POLICIES +The following table identifies our other significant accounting policies, along with the related Note. +Significant Accounting Policy Note +Number Note Title +Loans and Card Member Receivables Note 2 Loans and Card Member Receivables +Reserves for Credit Losses Note 3 Reserves for Credit Losses +Investment Securities Note 4 Investment Securities +Asset Securitizations Note 5 Asset Securitizations +Legal Contingencies Note 12 Contingencies and Commitments +Derivative Financial Instruments and Hedging Activities Note 13 Derivatives and Hedging Activities +Fair Value Measurements Note 14 Fair Values +Guarantees Note 15 Guarantees +Income Taxes Note 20 Income Taxes +CLASSIFICATION OF VARIOUS ITEMS +Certain reclassifications of prior period amounts have been made to conform to the current period presentation, including reclassification of restricted cash from Other assets to Cash and cash equivalents on the Consolidated Balance Sheets. +104 +Table of Contents +RECENTLY ISSUED AND ADOPTED ACCOUNTING STANDARDS +In March 2020, the Financial Accounting Standards Board issued new accounting guidance related to the effects of reference rate reform on financial reporting. The guidance, effective for reporting periods through December 31, 2022, provides accounting relief for contract modifications that replace an interest rate impacted by reference rate reform (e.g., LIBOR) with a new alternative reference rate. The guidance is applicable to investment securities, receivables, loans, debt, leases, derivatives and hedge accounting elections and other contractual arrangements. We adopted the guidance as of March 31, 2020, with no material impact on our financial position, results of operations and cash flows. There were no significant changes to our accounting policies, business processes or internal controls as a result of adopting the new guidance. +Effective January 1, 2020, we adopted the new credit reserving methodology, applicable to certain financial instruments, known as the Current Expected Credit Loss (CECL) methodology under a modified retrospective transition. The CECL methodology requires measurement of expected credit losses for the estimated life of the financial instrument, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. Upon implementation, total loan reserves increased by $ 1,663 million and total receivable reserves decreased by $ 493 million, along with the associated current and deferred tax impact of $ 288 million, and an offset to the opening balance of retained earnings, net of tax, of $ 882 million. There were no material changes to our business processes or internal controls as a result of adopting the new guidance. Refer to Note 3 for additional information on how management estimates reserves for credit losses in accordance with the CECL methodology. +In addition, for available-for-sale debt securities, the new methodology replaces the other-than-temporary impairment model and requires the recognition of an allowance for reductions in a security’s fair value attributable to declines in credit quality, instead of a direct write-down of the security, when a valuation decline is determined to be other-than-temporary. There was no financial impact related to this implementation. Refer to Note 4 for additional information. +105 +Table of Contents +NOTE 2 +LOANS AND CARD MEMBER RECEIVABLES +Our lending and charge payment card products result in the generation of Card Member loans and Card Member receivables. We also extend credit to consumer and commercial customers through non-card financing products, resulting in Other loans. Reserves for reporting periods beginning after January 1, 2020 are presented using the CECL methodology, while comparative information continues to be reported in accordance with the incurred loss methodology in effect for prior periods. +CARD MEMBER AND OTHER LOANS +Card Member loans are recorded at the time a Card Member enters into a point-of-sale transaction with a merchant and represent revolving amounts due on lending card products, as well as amounts due from charge Card Members who utilize the Pay Over Time features on their account and revolve a portion of the outstanding balance by entering into a revolving payment arrangement with us. These loans have a range of terms such as credit limits, interest rates, fees and payment structures, which can be revised over time based on new information about Card Members, and in accordance with applicable regulations and the respective product’s terms and conditions. Card Members holding revolving loans are typically required to make monthly payments based on pre-established amounts and the amounts that Card Members choose to revolve are subject to finance charges. +Card Member loans are presented on the Consolidated Balance Sheets net of reserves for credit losses (refer to Note 3), and include principal and any related accrued interest and fees. Our policy generally is to cease accruing interest on a Card Member loan at the time the account is written off, and establish reserves for interest that we believe will not be collected. +Other loans are recorded at the time any extension of credit is provided to consumer and commercial customers for non-card financing products. These loans have a range of fixed terms such as interest rates, fees and repayment periods. Borrowers are typically required to make pre-established monthly payments over the term of the loan. Non-card financing products are not associated with a Card Member agreement, and instead are governed by a separate borrowing relationship. Other loans are presented on the Consolidated Balance Sheets net of reserves for credit losses, and include principal and any related accrued interest and fees. +Card Member loans by segment and Other loans as of December 31, 2020 and 2019 consisted of: +(Millions) 2020 2019 +Global Consumer Services Group (a) +$ 60,084 $ 73,266 +Global Commercial Services 13,289 14,115 +Card Member loans 73,373 87,381 +Less: Reserve for credit losses 5,344 2,383 +Card Member loans, net $ 68,029 $ 84,998 +Other loans, net (b) +$ 2,614 $ 4,626 +(a) Includes approximately $ 25.9 billion and $ 32.2 billion of gross Card Member loans available to settle obligations of a consolidated VIE as of December 31, 2020 and 2019, respectively. +(b) Other loans represent consumer and commercial non-card financing products, and Small Business Administration Paycheck Protection Program (PPP) loans. There were $ 0.6 billion of gross PPP loans outstanding as of December 31, 2020. Other loans are presented net of reserves for credit losses of $ 238 million and $ 152 million as of December 31, 2020 and 2019, respectively. +106 +Table of Contents +CARD MEMBER RECEIVABLES +Card Member receivables are also recorded at the time a Card Member enters into a point-of-sale transaction with a merchant and represent amounts due on charge card products. Each charge card transaction is authorized based on its likely economics, a Card Member’s most recent credit information and spend patterns. +Charge Card Members generally must pay the full amount billed each month. Card Member receivable balances are presented on the Consolidated Balance Sheets net of reserves for credit losses (refer to Note 3), and include principal and any related accrued fees. +Card Member receivables by segment as of December 31, 2020 and 2019 consisted of: +(Millions) 2020 2019 +Global Consumer Services Group (a) +$ 18,685 $ 22,844 +Global Commercial Services (b) +25,016 34,569 +Card Member receivables 43,701 57,413 +Less: Reserve for credit losses 267 619 +Card Member receivables, net $ 43,434 $ 56,794 +(a) Includes nil and $ 8.3 billion of gross Card Member receivables available to settle obligations of a consolidated VIE as of December 31, 2020 and 2019, respectively. +(b) Includes $ 4.3 billion and nil of gross Card Member receivables available to settle obligations of a consolidated VIE as of December 31, 2020 and 2019, respectively. +107 +Table of Contents +CARD MEMBER LOANS AND RECEIVABLES AGING +Generally, a Card Member account is considered past due if payment is not received within 30 days after the billing statement date. The following table presents the aging of Card Member loans and receivables as of December 31, 2020 and 2019: +2020 (millions) Current 30-59 +Days Past Due 60-89 +Days Past Due 90+ +Days Past +Due Total +Card Member Loans: +Global Consumer Services Group $ 59,442 $ 177 $ 148 $ 317 $ 60,084 +Global Commercial Services +Global Small Business Services 13,132 27 20 47 13,226 +Global Corporate Payments (a) +(b) (b) (b) — 63 +Card Member Receivables: +Global Consumer Services Group 18,570 33 26 56 18,685 +Global Commercial Services +Global Small Business Services $ 14,023 $ 37 $ 21 $ 38 $ 14,119 +Global Corporate Payments (a) +(b) (b) (b) $ 60 $ 10,897 +2019 (millions) Current 30-59 +Days Past Due 60-89 +Days Past Due 90+ +Days Past +Due Total +Card Member Loans: +Global Consumer Services Group $ 72,101 $ 322 $ 253 $ 590 $ 73,266 +Global Commercial Services +Global Small Business Services 13,898 56 40 85 14,079 +Global Corporate Payments (a) +(b) (b) (b) — 36 +Card Member Receivables: +Global Consumer Services Group 22,560 86 58 140 22,844 +Global Commercial Services +Global Small Business Services $ 17,113 $ 99 $ 58 $ 134 $ 17,404 +Global Corporate Payments (a) +(b) (b) (b) $ 136 $ 17,165 +(a) Global Corporate Payments (GCP) reflects global, large and middle market corporate accounts. Delinquency data is tracked based on days past billing status rather than days past due. A Card Member account is considered 90 days past billing if payment has not been received within 90 days of the Card Member’s billing statement date. In addition, if we initiate collection procedures on an account prior to the account becoming 90 days past billing, the associated Card Member loan or receivable balance is classified as 90 days past billing. These amounts are shown above as 90+ Days Past Due for presentation purposes. See also (b). +(b) Delinquency data for periods other than 90+ days past billing is not available due to system constraints. Therefore, such data has not been utilized for risk management purposes. The balances that are current to 89 days past due can be derived as the difference between the Total and the 90+ Days Past Due balances. +108 +Table of Contents +CREDIT QUALITY INDICATORS FOR CARD MEMBER LOANS AND RECEIVABLES +The following tables present the key credit quality indicators as of or for the years ended December 31: +2020 2019 +Net Write-Off Rate Net Write-Off Rate +Principal +Only (a) +Principal, +Interest, & +Fees (a) +30+ +Days Past Due +as a % of +Total +Principal +Only (a) +Principal, +Interest, & +Fees (a) +30+ +Days Past Due +as a % of +Total +Card Member Loans: +Global Consumer Services Group 2.5 % 3.0 % 1.1 % 2.3 % 2.8 % 1.6 % +Global Small Business Services 2.1 % 2.4 % 0.7 % 1.9 % 2.2 % 1.3 % +Card Member Receivables: +Global Consumer Services Group 1.7 % 1.9 % 0.6 % 1.7 % 1.9 % 1.2 % +Global Small Business Services 2.1 % 2.3 % 0.7 % 1.9 % 2.1 % 1.7 % +Global Corporate Payments (b) 1.9 % (c) (b) (d) (c) +(a) We present a net write-off rate based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, because we consider uncollectible interest and/or fees in estimating our reserves for credit losses, a net write-off rate including principal, interest and/or fees is also presented. +(b) Net write-off rate based on principal losses only is not available due to system constraints. +(c) For GCP Card Member receivables, delinquency data is tracked based on days past billing status rather than days past due. Delinquency data for periods other than 90+ days past billing is not available due to system constraints. 90+ Days Past Billing as a % of total was 0.6 % and 0.8 % for the years ended December 31, 2020 and 2019, respectively. +(d) Net loss ratio was the credit quality indicator for GCP Card Member receivables for prior periods and represents the ratio of GCP Card Member receivables write-offs, consisting of principal (resulting from authorized transactions) and fee components, less recoveries, on Card Member receivables expressed as a percentage of gross amounts billed to corporate Card Members. The net loss ratio for the year ended December 31, 2019 was 0.08 %. +Refer to Note 3 for additional indicators, including external environmental qualitative factors, management considers in its evaluation process for reserves for credit losses. +IMPAIRED LOANS AND RECEIVABLES +Impaired loans and receivables are individual larger balance or homogeneous pools of smaller balance loans and receivables for which it is probable that we will be unable to collect all amounts due according to the original contractual terms of the customer agreement. We consider impaired loans and receivables to include (i) loans over 90 days past due still accruing interest, (ii) nonaccrual loans and (iii) loans and receivables modified as troubled debt restructurings (TDRs). +In instances where the customer is experiencing financial difficulty, we may modify, through various financial relief programs, loans and receivables with the intention to minimize losses and improve collectability, while providing customers with temporary or permanent financial relief. We have classified loans and receivables in these modification programs as TDRs and continue to classify customer accounts that have exited a modification program as a TDR, with such accounts identified as “Out of Program TDRs.” +Such modifications to the loans and receivables primarily include (i) temporary interest rate reductions (possibly as low as zero percent, in which case the loan is characterized as non-accrual in our TDR disclosures), (ii) placing the customer on a fixed payment plan not to exceed 60 months and (iii) suspending delinquency fees until the customer exits the modification program. Upon entering the modification program, the customer’s ability to make future purchases is either limited, canceled, or in certain cases suspended until the customer successfully exits from the modification program. In accordance with the modification agreement with the customer, loans and/or receivables may revert back to the original contractual terms (including the contractual interest rate where applicable) when the customer exits the modification program, which is (i) when all payments have been made in accordance with the modification agreement or (ii) when the customer defaults out of the modification program. +109 +Table of Contents +Reserves for modifications deemed TDRs are measured individually and incorporate a discounted cash flow model. All changes in the impairment measurement are included within provisions for credit losses. +In response to the COVID-19 pandemic, the United States enacted legislation that provided the option to temporarily suspend (i) certain requirements under U.S. GAAP for loan modifications related to the COVID-19 pandemic that would otherwise be treated as TDRs and (ii) any determination that a loan modified as a result of the COVID-19 pandemic is a TDR (including impairment for accounting purposes). Based on the nature of our programs, we have not elected the accounting and reporting relief afforded by this legislation and continue to report modifications as TDRs. +In the first quarter of 2020, we created a Customer Pandemic Relief (CPR) program for customers who have been impacted by the COVID-19 pandemic to provide a concession in the form of payment deferrals and waivers of certain fees and interest. We assessed the CPR program and determined that eligible loan modifications were temporary in nature, for example, less than three months, and not considered TDRs. Our short-term CPR programs are no longer widely available with immaterial balances remaining in the program as of December 31, 2020. +110 +Table of Contents +The following tables provide additional information with respect to our impaired loans and receivables as of December 31, 2020, 2019 and 2018. +As of December 31, 2020 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance Reserve for Credit Losses - TDRs +Card Member Loans: +Global Consumer Services Group +$ 203 $ 146 $ 1,586 $ 248 $ 2,183 $ 782 +Global Commercial Services 21 29 478 67 595 285 +Card Member Receivables: +Global Consumer Services Group — — 240 34 274 60 +Global Commercial Services — — 534 75 609 139 +Other Loans (f) +2 1 248 6 257 80 +Total $ 226 $ 176 $ 3,086 $ 430 $ 3,918 $ 1,346 +As of December 31, 2019 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance Reserve for Credit Losses - TDRs +Card Member Loans: +Global Consumer Services Group +$ 384 $ 284 $ 500 $ 175 $ 1,343 $ 137 +Global Commercial Services 44 54 97 38 233 22 +Card Member Receivables: +Global Consumer Services Group — — 56 16 72 3 +Global Commercial Services — — 109 30 139 6 +Total $ 428 $ 338 $ 762 $ 259 $ 1,787 $ 168 +As of December 31, 2018 +Accounts Classified +as a TDR (c) +(Millions) +Over 90 days Past Due & Accruing Interest (a) +Non-Accruals (b) +In Program (d) +Out of Program (e) +Total Impaired Balance Reserve for Credit Losses - TDRs +Card Member Loans: +Global Consumer Services Group +$ 344 $ 236 $ 313 $ 131 $ 1,024 $ 80 +Global Commercial Services 43 43 59 29 174 14 +Card Member Receivables: +Global Consumer Services Group — — 29 13 42 2 +Global Commercial Services — — 61 25 86 5 +Total $ 387 $ 279 $ 462 $ 198 $ 1,326 $ 101 +(a) Our policy is generally to accrue interest through the date of write-off (typically 180 days past due). We establish reserves for interest that we believe will not be collected. Amounts presented exclude loans classified as a TDR. +(b) Non-accrual loans not in modification programs primarily include certain loans placed with outside collection agencies for which we have ceased accruing interest. Amounts presented exclude loans classified as TDRs. +(c) Accounts classified as a TDR include $ 32 million, $ 26 million and $ 17 million that are over 90 days past due and accruing interest and $ 11 million, $ 10 million and $ 6 million that are non-accruals as of December 31, 2020, 2019 and 2018, respectively. +(d) In Program TDRs include accounts that are currently enrolled in a modification program. +(e) Out of Program TDRs include $ 316 million, $ 188 million and $ 148 million of accounts that have successfully completed a modification program and $ 114 million, $ 72 million and $ 50 million of accounts that were not in compliance with the terms of the modification programs as of December 31, 2020, 2019 and 2018, respectively. +(f) Other loans primarily represent consumer and commercial non-card financing products. Prior period balances were not significant. +111 +Table of Contents +LOANS AND RECEIVABLES MODIFIED AS TDRs +The following table provides additional information with respect to loans and receivables modified as TDRs for the years ended December 31: +2020 Number of Accounts +(thousands) +Outstanding Balances +(millions) (a) +Average Interest Rate Reduction +(% points) Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans 272 $ 2,347 14 (b) +Card Member Receivables 47 1,202 (c) 19 +Other Loans (d) +9 $ 345 3 16 +Total 328 $ 3,894 +2019 Number of Accounts +(thousands) +Outstanding Balances +(millions) (a) +Average Interest Rate Reduction +(% points) Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans 78 $ 602 13 (b) +Card Member Receivables 9 210 (c) 26 +Total 87 $ 812 +2018 Number of Accounts +(thousands) +Outstanding Balances +(millions) (a) +Average Interest Rate Reduction +(% points) Average Payment Term Extensions +(# of months) +Troubled Debt Restructurings: +Card Member Loans 51 $ 377 12 (b) +Card Member Receivables 6 110 (c) 28 +Total 57 $ 487 +(a) Represents the outstanding balance immediately prior to modification. The outstanding balance includes principal, fees and accrued interest on loans and principal and fees on receivables. Modifications did not reduce the principal balance. +(b) For Card Member loans, there have been no payment term extensions. +(c) We do not offer interest rate reduction programs for Card Member receivables as the receivables are non-interest bearing. +(d) Other loans primarily represent consumer and commercial non-card financing products. Prior period balances were not significant. +112 +Table of Contents +The following table provides information with respect to loans and receivables modified as TDRs that subsequently defaulted within 12 months of modification for the years ended December 31, 2020, 2019 and 2018. A customer can miss up to three payments before being considered in default, depending on the terms of the modification program. For all customers that defaulted from a modification program, the probability of default is factored into the reserves for loans and receivables. +2020 Number of Accounts +(thousands) +Aggregated +Outstanding Balances +Upon Default (a) +(millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans 17 $ 127 +Card Member Receivables 3 55 +Other Loans (b) +3 $ 6 +Total 23 $ 188 +Number of Accounts +Aggregated +Outstanding Balances +Upon Default (a) +2019 (thousands) (millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans 12 $ 86 +Card Member Receivables 4 20 +Total 16 $ 106 +Number of Accounts +Aggregated Outstanding +Balances +Upon Default (a) +2018 (thousands) (millions) +Troubled Debt Restructurings That Subsequently Defaulted: +Card Member Loans 8 $ 46 +Card Member Receivables 4 11 +Total 12 $ 57 +(a) The outstanding balances upon default include principal, fees and accrued interest on loans, and principal and fees on receivables. +(b) Other loans primarily represent consumer and commercial non-card financing products. Prior period balances were not significant. +113 +Table of Contents +NOTE 3 +RESERVES FOR CREDIT LOSSES +Reserves for credit losses represent our best estimate of the expected credit losses in our outstanding portfolio of Card Member loans and receivables as of the balance sheet date. The CECL methodology, which became effective January 1, 2020, requires us to estimate lifetime expected credit losses by incorporating historical loss experience, as well as current and future economic conditions over a reasonable and supportable period (R&S Period), which is approximately three years, beyond the balance sheet date. We make various judgments combined with historical loss experience to determine a reserve rate that is applied to the outstanding loan or receivable balance to produce a reserve for expected credit losses . +We use a combination of statistically-based models that incorporate current and future economic conditions throughout the R&S Period. The process of estimating expected credit losses is based on several key models: Probability of Default (PD), Exposure at Default (EAD), and future recoveries for each month of the R&S Period. Beyond the R&S Period, we estimate expected credit losses by immediately reverting to long-term average loss rates. +• PD models are used to estimate the likelihood an account will be written-off. +• EAD models are used to estimate the balance of an account at the time of write-off. This includes balances less expected repayments based on historical payment and revolve behavior, which vary by customer. Due to the nature of revolving loan portfolios, the EAD models are complex and involve assumptions regarding the relationship between future spend and payment behaviors. +• Recovery models are used to estimate amounts that are expected to be received from Card Members after default occurs, typically as a result of collection efforts. Future recoveries are estimated taking into consideration the time of default, time elapsed since default and macroeconomic conditions. +We also estimate the likelihood and magnitude of recovery of previously written off accounts considering how long ago the account was written off and future economic conditions. Our models are developed using historical loss experience covering the economic cycle and consider the impact of account characteristics on expected losses. +Future economic conditions that are incorporated over the R&S Period include multiple macroeconomic scenarios provided to us by an independent third party. Management reviews these economic scenarios and applies judgment to weight them in order to reflect the uncertainty surrounding these scenarios. These macroeconomic scenarios contain certain variables, including unemployment rates and real gross domestic product, that are significant to our models. +We also evaluate whether to include qualitative reserves to cover losses that are expected but, in our assessment, may not be adequately represented in the quantitative methods or the economic assumptions. We consider whether to adjust the quantitative reserves (higher or lower) to address possible limitations within the models or factors not included within the models, such as external conditions, emerging portfolio trends, the nature and size of the portfolio, portfolio concentrations, the volume and severity of past due accounts, or management risk actions. +Lifetime losses for most of our loans and receivables are evaluated at an appropriate level of granularity, including assessment on a pooled basis where financial assets share similar risk characteristics, such as past spend and remittance behaviors, credit bureau scores where available, delinquency status, tenure of balance outstanding, amongst others. Credit losses on accrued interest are measured and presented as part of Reserves for credit losses on the Consolidated Balance Sheets and within the Provisions for credit losses in the Consolidated Statements of Income, rather than reversing interest income. Separate models are used for accounts deemed a troubled debt restructuring, which are measured individually using a discounted cash flow model. See Note 2 for information on troubled debt restructurings. +Loans and receivable balances are written off when we consider amounts to be uncollectible, which is generally determined by the number of days past due and is typically no later than 180 days past due for pay in full or revolving loans and 120 days past due for term loans. Loans and receivables in bankruptcy or owed by deceased individuals are generally written off upon notification. +Results for reporting periods beginning January 1, 2020 are presented using the CECL methodology while comparative information continues to be reported in accordance with the incurred loss methodology in effect for prior years. Reserves for credit losses under the incurred loss methodology were primarily based upon statistical and analytical models that analyzed portfolio performance and reflected management’s judgments regarding the quantitative components of the reserve. The models considered several factors, including delinquency-based loss migration rates, loss emergence periods and average losses and recoveries over an appropriate historical period. Similar to the CECL methodology, we considered whether to adjust the quantitative reserves for certain external and internal qualitative factors, which may increase or decrease the reserves for credit losses. +114 +Table of Contents +CHANGES IN CARD MEMBER LOANS RESERVE FOR CREDIT LOSSES +Card Member loans reserve for credit losses increased for the year ended December 31, 2020, primarily driven by deterioration of the global macroeconomic outlook, including unemployment and GDP, partially offset by improved credit performance and a decline in outstanding balances. +The following table presents changes in the Card Member loans reserve for credit losses for the years ended December 31: +(Millions) 2020 2019 2018 +Beginning Balance (a) +$ 4,027 $ 2,134 $ 1,706 +Provisions (b) +3,453 2,462 2,266 +Net write-offs (c) +Principal ( 1,795 ) ( 1,860 ) ( 1,539 ) +Interest and fees ( 375 ) ( 375 ) ( 304 ) +Other (d) +34 22 5 +Ending Balance $ 5,344 $ 2,383 $ 2,134 +(a) For the year ended December 31, 2020, beginning balance includes an increase of $ 1,643 million as of January 1, 2020, related to the adoption of the CECL methodology. +(b) Provisions for principal, interest and fee reserve components. Provisions for credit losses includes reserve build (release) and replenishment for net write-offs. +(c) Principal write-offs are presented less recoveries of $ 568 million, $ 525 million and $ 444 million for the years ended December 31, 2020, 2019 and 2018, respectively. Recoveries of interest and fees were not significant. Amounts include net (write-offs) recoveries from TDRs of $( 134 ) million, $( 79 ) million and $( 33 ) million for the years ended December 31, 2020, 2019 and 2018, respectively. +(d) Primarily includes foreign currency translation adjustments of $ 35 million, $ 4 million and $( 11 ) million for the years ended December 31, 2020, 2019 and 2018, respectively. +115 +Table of Contents +CHANGES IN CARD MEMBER RECEIVABLES RESERVE FOR CREDIT LOSSES +Card Member receivables reserve for credit losses increased for the year ended December 31, 2020, primarily driven by deterioration of the global macroeconomic outlook, including unemployment and GDP, partially offset by improved credit performance and a decline in outstanding balances. +The following table presents changes in the Card Member receivables reserve for credit losses for the years ended December 31: +(Millions) 2020 2019 2018 +Beginning Balance (a) +$ 126 $ 573 $ 521 +Provisions (b) +1,015 963 937 +Net write-offs (c) +( 881 ) ( 900 ) ( 859 ) +Other (d) +7 ( 17 ) ( 26 ) +Ending Balance $ 267 $ 619 $ 573 +(a) For the year ended December 31, 2020, beginning balance includes a decrease of $ 493 million as of January 1, 2020, related to the adoption of the CECL methodology. +(b) Provisions for principal and fee reserve components. Provisions for credit losses includes reserve build (release) and replenishment for net write-offs. +(c) Net write-offs are presented less recoveries of $ 386 million, $ 374 million and $ 367 million for the years ended December 31, 2020, 2019 and 2018, respectively. Amounts include net recoveries (write-offs) from TDRs of $( 47 ) million, $( 16 ) million and nil , for the years ended December 31, 2020, 2019 and 2018, respectively. +(d) Primarily includes foreign currency translation adjustments of $ 5 million, nil and $( 6 ) million for the years ended December 31, 2020, 2019 and 2018, respectively. +116 +Table of Contents +NOTE 4 +INVESTMENT SECURITIES +Investment securities principally include available-for-sale debt securities carried at fair value on the Consolidated Balance Sheets. The CECL methodology, which became effective January 1, 2020, requires us to estimate lifetime expected credit losses for all available-for-sale debt securities in an unrealized loss position. Comparative information continues to be reported in accordance with the methodology in effect for prior periods. When estimating a security’s probability of default and the recovery rate, we assess the security’s credit indicators, including credit ratings. If our assessment indicates that an expected credit loss exists, we determine the portion of the unrealized loss attributable to credit deterioration and record a reserve for the expected credit loss through the Consolidated Statements of Income in Other loans Provision for credit losses. Unrealized gains and any portion of a security’s unrealized loss attributable to non-credit losses are recorded in the Consolidated Statements of Comprehensive Income, net of tax. We had accrued interest on our available-for-sale debt securities totaling $ 26 million and $ 20 million, as of December 31, 2020 and 2019, respectively, presented as Other assets on the Consolidated Balance Sheets. +Investment securities also include equity securities carried at fair value on the Consolidated Balance Sheets with unrealized gains and losses recorded in the Consolidated Statements of Income as Other, net expense. +Realized gains and losses are recognized upon disposition of the securities using the specific identification method. +Refer to Note 14 for a description of our methodology for determining the fair value of investment securities. +The following is a summary of investment securities as of December 31: +2020 2019 +Description of Securities (Millions) +Cost Gross +Unrealized +Gains Gross +Unrealized +Losses Estimated +Fair +Value Cost Gross +Unrealized +Gains Gross +Unrealized +Losses Estimated +Fair +Value +Available-for-sale debt securities: +State and municipal obligations $ 172 $ 7 $ — $ 179 $ 236 $ 8 $ ( 1 ) $ 243 +U.S. Government agency obligations 7 — — 7 9 — — 9 +U.S. Government treasury obligations 20,655 76 — 20,731 7,395 35 ( 1 ) 7,429 +Corporate debt securities 22 — — 22 27 — — 27 +Mortgage-backed securities (a) +28 2 — 30 39 2 — 41 +Foreign government bonds and obligations 581 — — 581 578 1 — 579 +Equity securities (b) +56 27 ( 2 ) 81 55 25 ( 2 ) 78 +Total $ 21,521 $ 112 $ ( 2 ) $ 21,631 $ 8,339 $ 71 $ ( 4 ) $ 8,406 +(a) Represents mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. +(b) Equity securities comprise investments in common stock, exchange-traded funds and mutual funds. +The following table provides information about our available-for-sale debt securities with gross unrealized losses and the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2019. There were no available-for-sale debt securities with gross unrealized losses as of December 31, 2020. +2019 +Less than 12 months 12 months or more +Description of Securities (Millions) +Estimated Fair +Value Gross Unrealized +Losses Estimated Fair +Value Gross Unrealized +Losses +State and municipal obligations $ 18 $ ( 1 ) $ — $ — +U.S. Government treasury obligations — — 324 ( 1 ) +Total $ 18 $ ( 1 ) $ 324 $ ( 1 ) +117 +Table of Contents +The following table summarizes the gross unrealized losses by ratio of fair value to amortized cost as of December 31, 2019. There were no available-for-sale debt securities with gross unrealized losses as of December 31, 2020. +Less than 12 months 12 months or more Total +Ratio of Fair Value to +Amortized Cost (Dollars in millions) +Number of +Securities Estimated +Fair Value Gross +Unrealized +Losses Number of +Securities Estimated +Fair Value Gross +Unrealized +Losses Number of +Securities Estimated +Fair Value Gross +Unrealized +Losses +2019: +90%–100% 2 $ 18 $ ( 1 ) 3 $ 324 $ ( 1 ) 5 $ 342 $ ( 2 ) +Total as of December 31, 2019 2 $ 18 $ ( 1 ) 3 $ 324 $ ( 1 ) 5 $ 342 $ ( 2 ) +Weighted average yields and contractual maturities for investment securities with stated maturities as of December 31, 2020 were as follows: +(Millions) Due within 1 year Due after 1 year but within 5 years Due after 5 years but within 10 years Due after 10 years Total +State and municipal obligations (a) +$ 15 $ 21 $ 49 $ 94 $ 179 +U.S. Government agency obligations (a) +— — — 7 7 +U.S. Government treasury obligations 19,097 1,621 13 — 20,731 +Corporate debt securities 11 11 — — 22 +Mortgage-backed securities (a) +— — — 30 30 +Foreign government bonds and obligations 580 1 — — 581 +Total Estimated Fair Value $ 19,703 $ 1,654 $ 62 $ 131 $ 21,550 +Total Cost $ 19,685 $ 1,598 $ 55 $ 127 $ 21,465 +Weighted average yields (b) +0.31 % 1.87 % 5.53 % 4.06 % 0.46 % +(a) The expected payments on state and municipal obligations, U.S. government agency obligations and mortgage-backed securities may not coincide with their contractual maturities because the issuers have the right to call or prepay certain obligations. +(b) Average yields for investment securities have been calculated using the effective yield on the date of purchase. Yields on tax-exempt investment securities have been computed on a tax-equivalent basis using the U.S. federal statutory tax rate of 21 percent. +118 +Table of Contents +NOTE 5 +ASSET SECURITIZATIONS +We periodically securitize Card Member loans and receivables arising from our card businesses through the transfer of those assets to securitization trusts, American Express Credit Account Master Trust (the Lending Trust) and American Express Issuance Trust II (the Charge Trust and together with the Lending Trust, the Trusts). The Trusts then issue debt securities collateralized by the transferred assets to third-party investors. +The Trusts are considered VIEs as they have insufficient equity at risk to finance their activities, which are to issue debt securities that are collateralized by the underlying Card Member loans and receivables. Refer to Note 1 for further details on the principles of consolidation. We perform the servicing and key decision making for the Trusts, and therefore have the power to direct the activities that most significantly impact the Trusts’ economic performance, which are the collection of the underlying Card Member loans and receivables. In addition, we hold all of the variable interests in both Trusts, with the exception of the debt securities issued to third-party investors. As of December 31, 2020 and 2019, our ownership of variable interests was $ 13.4 billion and $ 12.9 billion, respectively, for the Lending Trust and $ 4.3 billion and $ 8.3 billion, respectively, for the Charge Trust. These variable interests held by us provide us with the right to receive benefits and the obligation to absorb losses, which could be significant to both the Lending Trust and the Charge Trust. Based on these considerations, we are the primary beneficiary of the Trusts and therefore consolidate the Trusts. +The debt securities issued by the Trusts are non-recourse to us. The securitized Card Member loans and receivables held by the Lending Trust and the Charge Trust, respectively, are available only for payment of the debt securities or other obligations issued or arising in the securitization transactions (refer to Note 2). The long-term debt of each Trust is payable only out of collections on their respective underlying securitized assets (refer to Note 8). +Restricted cash held by the Lending Trust and Charge Trust was $ 47 million and nil , respectively, as of December 31, 2020 and $ 85 million and nil , respectively, as of December 31, 2019. These amounts relate to collections of Card Member loans and receivables to be used by the Trusts to fund future expenses and obligations, including interest on debt securities, credit losses and upcoming debt maturities. +Under the respective terms of the Lending Trust and the Charge Trust agreements, the occurrence of certain triggering events associated with the performance of the assets of each Trust could result in payment of trust expenses, establishment of reserve funds, or, in a worst-case scenario, early amortization of debt securities. During the years ended December 31, 2020 and 2019, no such triggering events occurred. +119 +Table of Contents +NOTE 6 +OTHER ASSETS +The following is a summary of Other assets as of December 31: +(Millions) 2020 2019 +Goodwill $ 3,852 $ 3,315 +Other intangible assets, at amortized cost 265 267 +Other (a) +13,562 10,635 +Total $ 17,679 $ 14,217 +(a) Primarily includes prepaid assets, net deferred tax assets, other receivables net of reserves, investments in non-consolidated entities, tax credit investments and right-of-use lease assets. +GOODWILL +The changes in the carrying amount of goodwill reported in our reportable operating segments were as follows: +(Millions) GCSG GCS GMNS Total +Balance as of December 31, 2018 $ 707 $ 1,718 $ 647 $ 3,072 +Acquisitions 189 66 — 255 +Dispositions — — — — +Other (a) +( 7 ) ( 3 ) ( 2 ) ( 12 ) +Balance as of December 31, 2019 $ 889 $ 1,781 $ 645 $ 3,315 +Acquisitions +— 442 52 494 +Dispositions — — — — +Other (a) +25 11 7 43 +Balance as of December 31, 2020 $ 914 $ 2,234 $ 704 $ 3,852 +(a) Primarily includes foreign currency translation. +Accumulated impairment losses were $ 221 million as of both December 31, 2020 and 2019. +OTHER INTANGIBLE ASSETS +Intangible assets are amortized on a straight-line basis over their estimated useful lives of 1 to 22 years. We review long-lived assets and asset groups, including intangible assets, for impairment whenever events and circumstances indicate their carrying amounts may not be recoverable. An impairment is recognized if the carrying amount is not recoverable and exceeds the asset or asset group’s fair value. +The gross carrying amount for other intangible assets as of December 31, 2020 and 2019 was $ 759 million and $ 704 million, respectively, with accumulated amortization of $ 494 million and $ 437 million, respectively. +Amortization expense, which is recorded within Other expense in the Consolidated Statements of Income, was $ 54 million, $ 49 million and $ 212 million for the years ended December 31, 2020, 2019 and 2018, respectively. +120 +Table of Contents +TAX CREDIT INVESTMENTS +We account for our tax credit investments, including Qualified Affordable Housing (QAH) investments, using the equity method of accounting. As of December 31, 2020 and 2019, we had $ 1,147 million and $ 1,154 million in tax credit investments, respectively, included in Other assets on the Consolidated Balance Sheets, of which $ 1,095 million and $ 1,109 million, respectively, related to QAH investments. Included in QAH investments as of December 31, 2020 and 2019, we had $ 1,028 million and $ 1,032 million, respectively, related to investments in unconsolidated VIEs for which we do not have a controlling financial interest. +As of December 31, 2020, we committed to provide funding related to certain of these QAH investments, which is expected to be paid between 2021 and 2035 , resulting in $ 208 million in unfunded commitments reported in Other liabilities, of which $ 189 million specifically related to unconsolidated VIEs. +In addition, as of December 31, 2020 we had contractual off-balance sheet obligations, which were not deemed probable of being drawn, to provide additional funding up to $ 106 million for these QAH investments, fully related to unconsolidated VIEs. +During the years ended December 31, 2020, 2019 and 2018 we recognized equity method losses related to our QAH investments of $ 128 million, $ 101 million and $ 126 million, respectively, which were recognized in Other, net expenses; and associated tax credits of $ 129 million, $ 119 million and $ 97 million, respectively, recognized in Income tax provision. +121 +Table of Contents +NOTE 7 +CUSTOMER DEPOSITS +As of December 31, customer deposits were categorized as interest-bearing or non-interest-bearing as follows: +(Millions) 2020 2019 +U.S.: +Interest-bearing $ 85,583 $ 72,445 +Non-interest-bearing (includes Card Member credit balances of: 2020, $ 576 million; 2019, $ 389 million) +599 415 +Non-U.S.: +Interest-bearing 19 23 +Non-interest-bearing (includes Card Member credit balances of: 2020, $ 671 million; 2019, $ 401 million) +674 404 +Total customer deposits $ 86,875 $ 73,287 +Customer deposits by deposit type as of December 31 were as follows: +(Millions) 2020 2019 +U.S. retail deposits: +Savings accounts ― Direct $ 63,512 $ 46,394 +Certificates of deposit: +Direct 2,440 1,854 +Third-party (brokered) 5,561 8,076 +Sweep accounts ―Third-party (brokered) 14,070 16,121 +Other deposits: +U.S. non-interest-bearing deposits 23 26 +Non-U.S. deposits 22 26 +Card Member credit balances ― U.S. and non-U.S. 1,247 790 +Total customer deposits $ 86,875 $ 73,287 +The scheduled maturities of certificates of deposit as of December 31, 2020 were as follows: +(Millions) U.S. Non-U.S. Total +2021 $ 3,820 $ 8 $ 3,828 +2022 3,053 — 3,053 +2023 645 — 645 +2024 276 — 276 +2025 207 — 207 +After 5 years — — — +Total $ 8,001 $ 8 $ 8,009 +As of December 31, certificates of deposit in denominations of $250,000 or more, in the aggregate, were as follows: +(Millions) 2020 2019 +U.S. $ 930 $ 622 +Non-U.S. 1 4 +Total $ 931 $ 626 +122 +Table of Contents +NOTE 8 +DEBT +SHORT-TERM BORROWINGS +Our short-term borrowings outstanding, defined as borrowings with original contractual maturity dates of less than one year, as of December 31 were as follows: +2020 2019 +(Millions, except percentages) Outstanding Balance +Year-End Stated +Interest Rate on +Debt (a) +Outstanding Balance +Year-End Stated +Interest Rate on +Debt (a) +Commercial paper (b) +$ — — % $ 3,001 1.94 % +Other short-term borrowings (c) +1,878 0.61 3,441 1.28 +Total $ 1,878 0.61 % $ 6,442 1.59 % +(a) For floating-rate issuances, the stated interest rates are weighted based on the outstanding principal balances and interest rates in effect as of December 31, 2020 and 2019. +(b) Average commercial paper outstanding was $ 628 million and $ 299 million in 2020 and 2019, respectively. +(c) Includes borrowings from banks and book overdrafts with banks due to timing differences arising in the ordinary course of business. +We maintained a 3 -year committed, revolving, secured borrowing facility that gives us the right to sell up to $ 2.0 billion face amount of eligible certificates issued from the Lending Trust at any time through September 15, 2022 . The facility was undrawn as of both December 31, 2020 and 2019. Additionally, certain of our subsidiaries maintained total committed lines of credit of $ 148 million and $ 214 million as of December 31, 2020 and 2019, respectively. As of December 31, 2020 and 2019, nil and $ 58 million were drawn on these committed lines, respectively. +We paid $ 7.7 million in fees to maintain the secured borrowing facility in both 2020 and 2019. The committed facility does not contain a material adverse change clause, which might otherwise preclude borrowing under the facility, nor is it dependent on our credit rating. +123 +Table of Contents +LONG-TERM DEBT +Our long-term debt outstanding, defined as debt with original contractual maturity dates of one year or greater, as of December 31 was as follows: +2020 2019 +(Millions, except percentages) Original +Contractual +Maturity +Dates +Outstanding +Balance (a) +Year-End +Interest Rate +on Debt (b) +Year-End +Interest Rate with +Swaps (b)(c) +Outstanding +Balance (a) +Year-End +Interest Rate +on Debt (b) +Year-End +Interest Rate +with +Swaps (b)(c) +American Express Company +(Parent Company only) +Fixed Rate Senior Notes 2021 - 2042 $ 18,251 3.25 % 2.09 % $ 19,326 3.17 % 2.86 % +Floating Rate Senior Notes 2021 - 2023 4,000 0.84 — 4,500 2.49 — +Fixed Rate Subordinated Notes 2024 599 3.63 1.43 598 3.63 2.99 +American Express Credit Corporation +Fixed Rate Senior Notes 2021 - 2027 6,746 2.38 1.67 11,839 2.40 2.53 +Floating Rate Senior Notes 2022 300 0.93 — 1,650 2.64 — +Lending Trust +Fixed Rate Senior Notes 2021 - 2023 8,325 2.74 2.55 15,074 2.42 2.43 +Floating Rate Senior Notes 2021 - 2023 4,125 0.51 — 4,125 2.09 — +Fixed Rate Subordinated Notes 2021 - 2022 246 2.80 — 420 2.53 — +Floating Rate Subordinated Notes 2022 - 2023 79 0.73 — 79 2.31 — +Other +Finance Leases 2024 - 2033 17 5.54 — 25 5.65 — +Floating Rate Borrowings 2021 - 2023 328 0.42 — % 311 0.40 — % +Unamortized Underwriting Fees ( 64 ) ( 112 ) +Total Long-Term Debt $ 42,952 2.49 % $ 57,835 2.66 % +(a) The outstanding balances include (i) unamortized discount, (ii) the impact of movements in exchange rates on foreign currency denominated debt and (iii) the impact of fair value hedge accounting on certain fixed-rate notes that have been swapped to floating rate through the use of interest rate swaps. Refer to Note 13 for more details on our treatment of fair value hedges. +(b) For floating-rate issuances, the stated interest rate on debt is weighted based on the outstanding principal balances and interest rates in effect as of December 31, 2020 and 2019. +(c) Interest rates with swaps are only presented when swaps are in place to hedge the underlying debt. The interest rates with swaps are weighted based on the outstanding principal balances and the interest rates on the floating leg of the swaps in effect as of December 31, 2020 and 2019. +124 +Table of Contents +Aggregate annual maturities on long-term debt obligations (based on contractual maturity or anticipated redemption dates) as of December 31, 2020 were as follows: +(Millions) 2021 2022 2023 2024 2025 Thereafter Total +American Express Company (Parent Company only) $ 5,000 $ 5,675 $ 4,350 $ 5,000 $ 750 $ 2,122 $ 22,897 +American Express Credit Corporation 2,975 2,050 — — — 2,000 7,025 +Lending Trust 3,709 6,381 2,685 — — — 12,775 +Other 145 86 97 7 — 10 345 +$ 11,829 $ 14,192 $ 7,132 $ 5,007 $ 750 $ 4,132 $ 43,042 +Unamortized Underwriting Fees ( 64 ) +Unamortized Discount and Premium ( 648 ) +Impacts due to Fair Value Hedge Accounting 622 +Total Long-Term Debt $ 42,952 +We maintained a committed syndicated bank credit facility of $ 3.5 billion as of December 31, 2020 and 2019, all of which was undrawn as of the respective dates. The availability of the credit line is subject to compliance with certain covenants by American Express Credit Corporation (Credco), principally the maintenance by Credco of a 1.25 ratio of its combined earnings, certain capital contributions and fixed charges, to fixed charges. As of December 31, 2020 and 2019, Credco was not in violation of any of these covenants. +Additionally, we maintained a three-year committed, revolving, secured borrowing facility that gives us the right to sell up to $ 3.0 billion face amount of eligible notes issued from the Charge Trust at any time through July 15, 2022 . No amounts were drawn on this facility as of December 31, 2020 and 2019. +We paid $ 14.2 million and $ 16.5 million in fees to maintain these lines in 2020 and 2019, respectively. These committed facilities do not contain material adverse change clauses, which might otherwise preclude borrowing under the credit facilities, nor are they dependent on our credit rating. +We paid total interest, primarily related to short- and long-term debt, corresponding interest rate swaps and customer deposits, of $ 2.0 billion, $ 3.4 billion and $ 2.7 billion in 2020, 2019 and 2018, respectively. +125 +Table of Contents +NOTE 9 +OTHER LIABILITIES +The following is a summary of Other liabilities as of December 31: +(Millions) +2020 2019 +Membership Rewards liability +$ 9,750 $ 8,892 +Employee-related liabilities (a) +2,336 2,429 +Card Member rebate and reward accruals (b) +1,367 1,790 +Income tax liability (c) +943 1,122 +Other (d) +12,838 10,715 +Total +$ 27,234 $ 24,948 +(a) Includes employee benefit plan obligations and incentive compensation. +(b) Card Member rebate and reward accruals include payments to third-party reward partners and cash-back rewards. +(c) Includes repatriation tax liability of $ 1,012 million as of both December 31, 2020 and 2019, which represents our remaining obligation under the Tax Cuts and Jobs Act enacted on December 22, 2017 (Tax Act) to pay a one-time transition tax on unrepatriated earnings and profits of certain foreign subsidiaries, the net position for current federal, state and non-U.S. income tax liabilities, and deferred tax liabilities for foreign jurisdictions. +(d) Primarily includes book overdraft balances, net deferred card and other fees, Travelers Cheques and other prepaid products, lease liabilities, derivative and hedge liabilities, dividends payable, client incentives and restructuring and reengineering reserves. +MEMBERSHIP REWARDS +The Membership Rewards program allows enrolled Card Members to earn points that can be redeemed for a broad variety of rewards including travel, shopping, gift cards, and covering eligible charges. We record a Membership Rewards liability that represents management’s best estimate of the cost of points earned that are expected to be redeemed by Card Members in the future. The weighted average cost (WAC) per point and the Ultimate Redemption Rate (URR) are key assumptions used to estimate the liability. We use statistical and actuarial models to estimate the URR based on redemption trends, card product type, enrollment tenure, card spend levels and credit attributes. The WAC per point assumption is derived from 12 months of redemptions and is adjusted as appropriate for certain changes in redemption costs that are not representative of future cost expectations and expected developments in redemption patterns. +The expense for Membership Rewards points is included in Card Member rewards expense. We periodically evaluate our liability estimation process and assumptions based on developments in redemption patterns, cost per point redeemed, partner contract changes and other factors. +DEFERRED CARD AND OTHER FEES, NET +The carrying amount of deferred card and other fees, net of deferred direct acquisition costs and reserves for membership cancellations as of December 31, was as follows: +(Millions) 2020 2019 +Deferred card and other fees (a) +$ 2,639 $ 2,532 +Deferred direct acquisition costs ( 166 ) ( 270 ) +Reserves for membership cancellations ( 191 ) ( 200 ) +Deferred card and other fees, net $ 2,282 $ 2,062 +(a) Includes deferred fees for Membership Rewards program participants. +126 +Table of Contents +NOTE 10 +STOCK PLANS +STOCK OPTION AND AWARD PROGRAMS +Under our 2016 Incentive Compensation Plan (amended and restated effective May 5, 2020) and previously under our 2007 Incentive Compensation Plan (collectively, Incentive Compensation Plans), awards may be granted to employees and other key individuals who perform services for us and our participating subsidiaries. These awards may be in the form of stock options, restricted stock units or awards (collectively referred to as RSUs), portfolio grants (PGs) or other incentives or similar awards designed to meet the requirements of non-U.S. jurisdictions. +For our Incentive Compensation Plans, there were a total of 14 million, 9 million and 12 million common shares unissued and available for grant as of December 31, 2020, 2019, and 2018, respectively, as authorized by our Board of Directors and shareholders. We generally issue new common shares upon exercise of options and vesting of RSUs. +Stock-based compensation expense recognized in Salaries and employee benefits in the Consolidated Statements of Income was $ 247 million, $ 280 million and $ 288 million in 2020, 2019, and 2018, respectively, with corresponding income tax benefits of $ 59 million, $ 67 million and $ 69 million in those respective periods. +A summary of stock option and RSU activity as of December 31, 2020, and corresponding changes during the year, are as follows: +Stock Options Service-Based RSUs Service and Performance-Based RSUs +(Shares in thousands) Shares Weighted-Average +Exercise Price Shares Weighted- +Average Grant +Price Shares Weighted- +Average Grant +Price +Outstanding as of December 31, 2019 4,172 $ 72.70 2,412 $ 91.42 3,392 $ 88.25 +Granted 422 131.68 816 127.56 1,089 122.15 +Exercised/vested ( 822 ) 53.50 ( 1,042 ) 82.77 ( 1,193 ) 78.52 +Forfeited ( 21 ) 65.43 ( 108 ) 105.32 ( 142 ) 101.38 +Expired — — — — — — +Outstanding as of December 31, 2020 3,751 83.59 2,078 $ 109.23 3,146 $ 103.08 +Options vested and expected to vest as of December 31, 2020 3,751 83.59 +Options exercisable as of December 31, 2020 2,706 $ 72.26 +Stock-based compensation expense is generally recognized ratably based on the grant-date fair value of the awards, net of expected forfeitures, over the vesting period. The vesting period is the shorter of the vesting schedule as defined in each award agreement or the date an individual will become eligible to retire. Retirement eligibility is dependent upon age and/or years of service. +STOCK OPTIONS +Each stock option has an exercise price equal to the market price of our common stock on the date of grant. Stock options generally vest on the third anniversary of the grant date and have a contractual term of 10 years from the date of grant. +The weighted-average remaining contractual life and the aggregate intrinsic value (the amount by which the fair value of our stock price exceeds the exercise price of the option) of the stock options outstanding, exercisable, and vested and expected to vest as of December 31, 2020, were as follows: +Outstanding Exercisable Vested and +Expected to Vest +Weighted-average remaining contractual life (in years) +5.3 4.2 5.3 +Aggregate intrinsic value (millions) +$ 145 $ 132 $ 145 +As of December 31, 2020, there was $ 4 million of total unrecognized compensation cost related to unvested options, which will be recognized ratably over the weighted-average remaining vesting period of 1.5 years. +127 +Table of Contents +The fair value of each option is estimated on the date of grant using a Black-Scholes-Merton option-pricing model. The following weighted-average assumptions were used for options granted in 2020, 2019 and 2018: +2020 2019 2018 +Dividend yield 1.4 % 1.5 % 1.4 % +Expected volatility (a) +20 % 24 % 22 % +Risk-free interest rate 1.6 % 2.6 % 2.7 % +Expected life of stock option ( in years ) (b) +7.1 7.1 7.1 +Weighted-average fair value per option $ 25.83 $ 23.38 $ 23.17 +(a) The expected volatility is based on both weighted historical and implied volatilities of our common stock price. +(b) The expected life of stock options was determined using both historical data and expectations of option exercise behavior. +For stock options that were exercised during 2020, 2019 and 2018, the intrinsic value, based upon the fair value of our stock price at the date the options were exercised, was $ 47 million, $ 104 million and $ 104 million, respectively; cash received from the exercise of stock options was $ 44 million, $ 84 million and $ 87 million during those respective periods. The income tax benefit recognized in the Consolidated Statements of Income related to stock option exercises was $ 7 million, $ 18 million and $ 18 million in 2020, 2019 and 2018, respectively. +RESTRICTED STOCK UNITS/AWARDS +We grant RSUs that contain either a) service conditions or b) both service and performance conditions. RSUs containing only service conditions generally vest 25 percent per year beginning with the first anniversary of the grant date. RSUs containing both service and performance conditions generally vest on the third anniversary of the grant date, and the number of shares earned depends on the achievement of predetermined Company metrics. All RSU holders receive non-forfeitable dividends or dividend equivalents. +Beginning in 2019, a relative total shareholder return (r-TSR) modifier was added to the performance-based RSUs, so that our actual shareholder return relative to a competitive peer group is one of the performance conditions that determines the number of shares ultimately granted upon vesting. +The fair value of RSUs that do not include the r-TSR modifier, including those that contain only service conditions, is measured using our stock price on the grant date. The fair value of service and performance-based RSUs that include the r-TSR modifier is determined using a Monte Carlo valuation model with the following weighted-average assumptions for December 31: +2020 2019 +Expected volatility (a) +19 % 20 % +Risk-free interest rate 1.4 % 2.5 % +Remaining performance period (in years) +2.9 2.9 +(a) The expected volatility is based on historical volatility of our common stock price. +As of December 31, 2020, there was $ 204 million of total unrecognized compensation cost related to non-vested RSUs, which will be recognized ratably over the weighted-average remaining vesting period of 2.0 years. +The weighted-average grant date fair value of RSUs granted in 2020, 2019 and 2018 was $ 124.47 , $ 96.24 and $ 98.20 , respectively. +For RSUs vested during 2020, 2019 and 2018, the total fair value, based upon our stock price at the date the RSUs vested, was $ 291 million, $ 286 million and $ 239 million, respectively. +LIABILITY-BASED AWARDS +In 2018, certain employees were awarded PGs and other incentive awards that can be settled with cash or equity shares at our discretion and final Compensation and Benefits Committee payout approval; beginning in 2019, we discontinued granting PGs. These awards earn value based on performance, market and/or service conditions, and vest over a period of three years . +PGs and other incentive awards are generally settled with cash and thus are classified as liabilities; therefore, the fair value is determined at the date of grant and remeasured quarterly as part of compensation expense over the vesting period. Cash paid upon vesting of these awards in 2020, 2019 and 2018 was $ 81 million, $ 81 million and $ 56 million, respectively. +128 +Table of Contents +NOTE 11 +RETIREMENT PLANS +DEFINED CONTRIBUTION RETIREMENT PLANS +We sponsor defined contribution retirement plans, the principal plan being the Retirement Savings Plan (RSP), a 401(k) savings plan with a profit-sharing component. The RSP is a tax-qualified retirement plan subject to the Employee Retirement Income Security Act of 1974 and covers most employees in the United States. The total expense for all defined contribution retirement plans globally was $ 267 million, $ 278 million and $ 272 million in 2020, 2019 and 2018, respectively. +DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS +Our primary defined benefit pension plans that cover certain employees in the United States and United Kingdom are closed to new entrants and existing participants do not accrue any additional benefits. Most employees outside the United States and United Kingdom are covered by local retirement plans, some of which are funded, while other employees receive payments at the time of retirement or termination under applicable labor laws or agreements. We comply with minimum funding requirements in all countries. We also sponsor unfunded other postretirement benefit plans that provide health care and life insurance to certain retired U.S. employees. For these plans, the total net benefit was $ 8 million, $ 8 million and $ 0.4 million in 2020, 2019 and 2018, respectively. +We recognize the funded status of our defined benefit pension plans and other postretirement benefit plans, measured as the difference between the fair value of the plan assets and the projected benefit obligation, on the Consolidated Balance Sheets. As of December 31, 2020 and 2019, the unfunded status related to the defined benefit pension plans and other postretirement benefit plans was $ 706 million and $ 640 million, respectively, and is recorded in Other liabilities. +129 +Table of Contents +NOTE 12 +CONTINGENCIES AND COMMITMENTS +CONTINGENCIES +In the ordinary course of business, we and our subsidiaries are subject to various pending and potential legal actions, arbitration proceedings, claims, investigations, examinations, regulatory proceedings, information gathering requests, subpoenas, inquiries and matters relating to compliance with laws and regulations (collectively, legal proceedings). +Based on our current knowledge, and taking into consideration our litigation-related liabilities, we do not believe we are a party to, nor are any of our properties the subject of, any legal proceeding that would have a material adverse effect on our consolidated financial condition or liquidity. However, in light of the uncertainties involved in such matters, including the fact that some pending legal proceedings are at preliminary stages or seek an indeterminate amount of damages, it is possible that the outcome of legal proceedings could have a material impact on our results of operations. Certain legal proceedings involving us or our subsidiaries are described below. +A putative merchant class action in the Eastern District of New York, consolidated in 2011 and collectively captioned In re: American Express Anti-Steering Rules Antitrust Litigation (II) , alleged that provisions in our merchant agreements prohibiting merchants from differentially surcharging our cards or steering a customer to use another network’s card or another type of general-purpose card (“anti-steering” and “non-discrimination” contractual provisions) violate U.S. antitrust laws. On January 15, 2020, our motion to compel arbitration of claims brought by merchants who accept American Express and to dismiss claims of merchants who do not was granted. Plaintiffs have appealed part of this decision. +On February 25, 2020, we were named as a defendant in a case filed in the Superior Court of California, Los Angeles County, captioned Laurelwood Cleaners LLC v. American Express Co., et al. , in which the plaintiff seeks a public injunction prohibiting American Express from enforcing its anti-steering and non-discrimination provisions and from requiring merchants “to offer the service of Amex-card acceptance for free.” We intend to vigorously defend the case. +On January 29, 2019, we were named in a putative class action brought in the United States District Court for the Eastern District of New York, captioned Anthony Oliver, et al. v. American Express Company and American Express Travel Related Services Company Inc. , in which the plaintiffs are holders of MasterCard, Visa and/or Discover credit cards (but not American Express cards) and allege they paid higher prices as a result of our anti-steering and non-discrimination provisions in violation of federal antitrust law and the antitrust and consumer laws of various states. Plaintiffs seek unspecified damages and other forms of relief. The court dismissed plaintiffs’ federal antitrust claim, numerous state antitrust and consumer protection claims and their unjust enrichment claim. The remaining claims in plaintiffs’ complaint arise under the antitrust laws of 11 states and the consumer protection laws of six states. +In July 2004, we were named as a defendant in another putative class action filed in the Southern District of New York and subsequently transferred to the Eastern District of New York, captioned The Marcus Corporation v. American Express Co., et al. , in which the plaintiffs allege an unlawful antitrust tying arrangement between certain of our charge cards and credit cards in violation of various state and federal laws. The plaintiffs in this action seek injunctive relief and an unspecified amount of damages. +On March 8, 2016, plaintiffs B&R Supermarket, Inc. d/b/a Milam’s Market and Grove Liquors LLC, on behalf of themselves and others, filed a suit, captioned B&R Supermarket, Inc. d/b/a Milam’s Market, et al. v. Visa Inc., et al. , for violations of the Sherman Antitrust Act, the Clayton Antitrust Act, California’s Cartwright Act and unjust enrichment in the United States District Court for the Northern District of California, against American Express Company, other credit and charge card networks, other issuing banks and EMVCo, LLC. Plaintiffs allege that the defendants, through EMVCo, conspired to shift liability for fraudulent, faulty and otherwise rejected consumer credit card transactions from themselves to merchants after the implementation of EMV chip payment terminals. Plaintiffs seek damages and injunctive relief. An amended complaint was filed on July 15, 2016. On September 30, 2016, the court denied our motion to dismiss as to claims brought by merchants who do not accept American Express cards, and on May 4, 2017, the California court transferred the case to the United States District Court for the Eastern District of New York. On August 28, 2020, the court granted plaintiffs' motion for class certification. +130 +Table of Contents +We are being challenged in a number of countries regarding our application of value-added taxes (VAT) to certain of our international transactions, which are in various stages of audit, or are being contested in legal actions. While we believe we have complied with all applicable tax laws, rules and regulations in the relevant jurisdictions, the tax authorities may determine that we owe additional VAT. In certain jurisdictions where we are contesting the assessments, we were required to pay the VAT assessments prior to contesting. +Our legal proceedings range from cases brought by a single plaintiff to class actions with millions of putative class members to governmental proceedings. These legal proceedings involve various lines of business and a variety of claims (including, but not limited to, common law tort, contract, application of tax laws, antitrust and consumer protection claims), some of which present novel factual allegations and/or unique legal theories. While some matters pending against us specify the damages sought, many seek an unspecified amount of damages or are at very early stages of the legal process. Even when the amount of damages claimed against us are stated, the claimed amount may be exaggerated and/or unsupported. As a result, some matters have not yet progressed sufficiently through discovery and/or development of important factual information and legal issues to enable us to estimate an amount of loss or a range of possible loss, while other matters have progressed sufficiently such that we are able to estimate an amount of loss or a range of possible loss. +We have accrued for certain of our outstanding legal proceedings. An accrual is recorded when it is both (a) probable that a loss has occurred and (b) the amount of loss can be reasonably estimated. There may be instances in which an exposure to loss exceeds the accrual. We evaluate, on a quarterly basis, developments in legal proceedings that could cause an increase or decrease in the amount of the accrual that has been previously recorded, or a revision to the disclosed estimated range of possible losses, as applicable. +For those disclosed material legal proceedings where a loss is reasonably possible in future periods, whether in excess of a recorded accrual for legal or tax contingencies, or where there is no such accrual, and for which we are able to estimate a range of possible loss, the current estimated range is zero to $ 210 million in excess of any accruals related to those matters. This range represents management’s estimate based on currently available information and does not represent our maximum loss exposure; actual results may vary significantly. As such legal proceedings evolve, we may need to increase our range of possible loss or recorded accruals. In addition, it is possible that significantly increased merchant steering or other actions impairing the Card Member experience as a result of an adverse resolution in one or any combination of the disclosed merchant cases could have a material adverse effect on our business and results of operations. +In addition, we face exposure associated with Card Member purchases of goods and services, including with respect to the following: +• Return Protection — refunds the price of qualifying purchases made with eligible cards, where the merchant will not accept the return, for up to 90 days from the date of purchase; and +• Merchant Protection — protects Card Members primarily against non-delivery of goods and services, usually in the event of the bankruptcy or liquidation of a merchant. When this occurs, the Card Member may dispute the transaction for which we will generally credit the Card Member’s account. If we are unable to collect the amount from the merchant, we may bear the loss for the amount credited to the Card Member. The largest component of the exposure relates to Card Member transactions associated with travel-related merchants, primarily through business arrangements where we have remitted payment to such merchants for a Card Member travel purchase that has not yet been used or “flown.” +We have an accrual of $ 58 million related to these exposures as of December 31, 2020. To date, we have not experienced significant losses related to these exposures; however, our historical experience may not be representative in the current environment given the economic and financial disruptions caused by the COVID-19 pandemic and resulting containment measures. A reasonably possible loss related to these exposures in excess of the recorded accrual cannot be quantified as the Card Member purchases that may include or result in claims are not sufficiently estimable, although we believe our risk of loss has increased as a result of the COVID-19 pandemic. +131 +Table of Contents +COMMITMENTS +Total lease expense includes rent expenses, adjustments for rent concessions, rent escalations and leasehold improvement allowances and is recognized on a straight-line basis over the lease term. Total lease expense for the years ended December 31, 2020, 2019 and 2018 was $ 177 million, $ 151 million and $ 142 million, respectively. +Lease liabilities are recognized at the present value of the contractual fixed lease payments, discounted using our incremental borrowing rate as of the lease commencement date or upon modification of the lease. For lease liabilities outstanding as of December 31, 2020, the weighted average remaining lease term was 19 years and the weighted average rate used to discount lease commitments was 3 percent. +The following represents the maturities of our outstanding lease commitments as of December 31, 2020: +(Millions) +2021 $ 141 +2022 140 +2023 133 +2024 125 +2025 107 +Thereafter 1,024 +Total Outstanding Fixed Lease Payments $ 1,670 +Less: Amount representing interest $ ( 566 ) +Lease Liabilities $ 1,104 +As of December 31, 2020, we had approximately $ 4 billion in financial commitments outstanding related to agreements with certain cobrand partners under which we are required to make a certain level of minimum payments over the life of the agreement, generally ranging from five to ten years. Such commitments are designed to be satisfied by the payment we make to such cobrand partners primarily based on Card Members’ spending and earning rewards on their cobrand cards and as we acquire new Card Members. In the event these payments do not fully satisfy the commitment, we generally pay the cobrand partner up to the amount of the commitment in exchange for an equivalent value of reward points. As of December 31, 2020, we also had certain cobrand arrangements that include commitments based on variables, the values of which are not yet determinable and thus the amount is not quantifiable. +132 +Table of Contents +NOTE 13 +DERIVATIVES AND HEDGING ACTIVITIES +We use derivative financial instruments to manage exposures to various market risks. These instruments derive their value from an underlying variable or multiple variables, including interest rates and foreign exchange rates, and are carried at fair value on the Consolidated Balance Sheets. These instruments enable end users to increase, reduce or alter exposure to various market risks and, for that reason, are an integral component of our market risk management. We do not transact in derivatives for trading purposes. +Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. Our market risk exposures include: +• Interest rate risk due to changes in the relationship between interest rates on our assets (such as loans, receivables and investment securities) and interest rates on our liabilities (such as debt and deposits); and +• Foreign exchange risk related to earnings, funding, transactions and investments in currencies other than the U.S. dollar. +We centrally monitor market risks using market risk limits and escalation triggers as defined in our Asset/Liability Management Policy. Our market exposures are in large part by-products of the delivery of our products and services. +Interest rate risk primarily arises through the funding of Card Member receivables and fixed-rate loans with variable-rate borrowings, as well as through the risk to net interest margin from changes in the relationship between benchmark rates such as Prime, LIBOR and the overnight indexed swap rate. Interest rate exposure within our charge card and fixed-rate lending products is managed by varying the proportion of total funding provided by short-term and variable-rate debt and deposits compared to fixed-rate debt and deposits. In addition, interest rate swaps are used from time to time to economically convert fixed-rate debt obligations to variable-rate obligations, or to convert variable-rate debt obligations to fixed-rate obligations. We may change the mix between variable-rate and fixed-rate funding based on changes in business volumes and mix, among other factors. +Foreign exchange risk is generated by Card Member cross-currency spend, foreign currency balance sheet exposures, foreign subsidiary equity and foreign currency earnings in entities outside the United States. Our foreign exchange risk is managed primarily by entering into agreements to buy and sell currencies on a spot basis or by hedging this market exposure, to the extent it is economical, through various means, including the use of derivatives such as foreign exchange forwards. +Derivatives may give rise to counterparty credit risk, which is the risk that a derivative counterparty will default on, or otherwise be unable to perform pursuant to, an uncollateralized derivative exposure. We manage this risk by considering the current exposure, which is the replacement cost of contracts on the measurement date, as well as estimating the maximum potential future exposure of the contracts over the next 12 months, considering such factors as the volatility of the underlying or reference index. To mitigate derivative credit risk, counterparties are required to be pre-approved by us and rated as investment grade, and counterparty risk exposures are centrally monitored. +A majority of our derivative assets and liabilities as of December 31, 2020 and 2019 are subject to master netting agreements with our derivative counterparties. Accordingly, where appropriate, we have elected to present derivative assets and liabilities with the same counterparty on a net basis in the Consolidated Balance Sheets. To further mitigate counterparty credit risk, we exercise our rights under executed credit support agreements with the respective derivative counterparties for our bilateral interest rate swaps and select foreign exchange contracts. These agreements require that, in the event the fair value change in the net derivatives position between the two parties exceeds certain dollar thresholds, the party in the net liability position posts collateral to its counterparty. All derivative contracts cleared through a central clearinghouse are collateralized to the full amount of the fair value of the contracts. +In relation to our credit risk, certain of our bilateral derivative agreements include provisions that allow our counterparties to terminate the agreement in the event of a downgrade of our debt credit rating below investment grade and settle the outstanding net liability position. As of December 31, 2020, these derivatives were not in a material net liability position and we had no material risk exposure to any individual derivative counterparty. Based on our assessment of the credit risk of our derivative counterparties and our own credit risk as of December 31, 2020 and 2019, no credit risk adjustment to the derivative portfolio was required. +Our derivatives are carried at fair value on the Consolidated Balance Sheets. The accounting for changes in fair value depends on the instruments’ intended use and the resulting hedge designation, if any, as discussed below. Refer to Note 14 for a description of our methodology for determining the fair value of derivatives. +133 +Table of Contents +The following table summarizes the total fair value, excluding interest accruals, of derivative assets and liabilities as of December 31: +Other Assets Fair Value Other Liabilities Fair Value +(Millions) 2020 2019 2020 2019 +Derivatives designated as hedging instruments: +Fair value hedges - Interest rate contracts (a) +$ 500 $ 185 $ — $ — +Net investment hedges - Foreign exchange contracts 24 24 474 186 +Total derivatives designated as hedging instruments 524 209 474 186 +Derivatives not designated as hedging instruments: +Foreign exchange contracts +105 134 228 254 +Total derivatives, gross 629 343 702 440 +Derivative asset and derivative liability netting (b) +( 98 ) ( 90 ) ( 98 ) ( 90 ) +Cash collateral netting (c) (d) +( 500 ) ( 185 ) ( 16 ) ( 9 ) +Total derivatives, net $ 31 $ 68 $ 588 $ 341 +(a) For our centrally cleared derivatives, variation margin payments are legally characterized as settlement payments as opposed to collateral. +(b) Represents the amount of netting of derivative assets and derivative liabilities executed with the same counterparty under an enforceable master netting arrangement. +(c) Represents the offsetting of the fair value of bilateral interest rate contracts and certain foreign exchange contracts with the right to cash collateral held from the counterparty or cash collateral posted with the counterparty. +(d) We posted $ 34 million and $ 47 million as of December 31, 2020 and 2019, respectively, as initial margin on our centrally cleared interest rate swaps; such amounts are recorded within Other assets on the Consolidated Balance Sheets and are not netted against the derivative balances. +DERIVATIVE FINANCIAL INSTRUMENTS THAT QUALIFY FOR HEDGE ACCOUNTING +Derivatives executed for hedge accounting purposes are documented and designated as such when we enter into the contracts. In accordance with our risk management policies, we structure our hedges with terms similar to those of the item being hedged. We formally assess, at inception of the hedge accounting relationship and on a quarterly basis, whether derivatives designated as hedges are highly effective in offsetting the fair value or cash flows of the hedged items. These assessments usually are made through the application of a regression analysis method. If it is determined that a derivative is not highly effective as a hedge, we will discontinue the application of hedge accounting. +FAIR VALUE HEDGES +A fair value hedge involves a derivative designated to hedge our exposure to future changes in the fair value of an asset or a liability, or an identified portion thereof, that is attributable to a particular risk. +Interest Rate Contracts +We are exposed to interest rate risk associated with our fixed-rate debt obligations. At the time of issuance, certain fixed-rate long-term debt obligations are designated in fair value hedging relationships, using interest rate swaps, to economically convert the fixed interest rate to a floating interest rate. We have $ 15.8 billion and $ 22.6 billion of fixed-rate debt obligations designated in fair value hedging relationships as of December 31, 2020 and 2019, respectively. +Gains or losses on the fair value hedging instrument principally offset the losses or gains on the hedged item attributable to the hedged risk. The changes in the fair value of the derivative and the changes in the hedged item may not fully offset due to differences between a debt obligation’s interest rate and the benchmark rate, primarily due to credit spreads at inception of the hedging relationship that are not reflected in the fair value of the interest rate swap. Furthermore, the difference may be caused by changes in 1-month LIBOR, 3-month LIBOR and the overnight indexed swap rate, as spreads between these rates impact the fair value of the interest rate swap without an exact offsetting impact to the fair value of the hedged debt. +The following table presents the gains and losses recognized in Interest expense on the Consolidated Statements of Income associated with the fair value hedges of our fixed-rate long-term debt for the years ended December 31: +Gains (losses) +(Millions) 2020 2019 2018 +Fixed-rate long-term debt $ ( 405 ) $ ( 458 ) $ 59 +Derivatives designated as hedging instruments 409 462 ( 43 ) +Total $ 4 $ 4 $ 16 +134 +Table of Contents +The carrying values of the hedged liabilities, recorded within Long-term debt on the Consolidated Balance Sheets, were $ 16.4 billion and $ 22.7 billion as of December 31, 2020 and 2019, respectively, including the cumulative amount of fair value hedging adjustments of $ 622 million and $ 217 million for the respective periods. +We recognized a net decrease of $ 256 million and net increases of $ 102 million and $ 51 million in Interest expense on Long-term debt for the years ended December 31, 2020, 2019, and 2018, respectively, primarily related to the net settlements including interest accruals on our interest rate derivatives designated as fair value hedges. +NET INVESTMENT HEDGES +A net investment hedge is used to hedge future changes in currency exposure of a net investment in a foreign operation. We primarily designate foreign currency derivatives, typically foreign exchange forwards, and on occasion foreign currency denominated debt, as hedges of net investments in certain foreign operations. These instruments reduce exposure to changes in currency exchange rates on our investments in non-U.S. subsidiaries. We had notional amounts of approximately $ 10.5 billion and $ 9.8 billion of foreign currency derivatives designated as net investment hedges as of December 31, 2020 and 2019, respectively. The gain or loss on net investment hedges, net of taxes, recorded in AOCI as part of the cumulative translation adjustment, were losses of $ 252 million and $ 140 million and a gain of $ 328 million for the years ended December 31, 2020, 2019 and 2018, respectively. Net investment hedge reclassifications out of AOCI into the Consolidated Statements of Income associated with the sale or liquidation of a business, net of taxes, were $ 1 million, nil and $ 1 million for the years ended December 31, 2020, 2019, and 2018, respectively. +135 +Table of Contents +DERIVATIVES NOT DESIGNATED AS HEDGES +We have derivatives that act as economic hedges, but are not designated as such for hedge accounting purposes. Foreign currency transactions from time to time may be partially or fully economically hedged through foreign currency contracts, primarily foreign exchange forwards. These hedges generally mature within one year. Foreign currency contracts involve the purchase and sale of designated currencies at an agreed upon rate for settlement on a specified date. +We also have certain operating agreements containing payments that may be linked to a market rate or price, primarily foreign currency rates. The payment components of these agreements may meet the definition of an embedded derivative, in which case the embedded derivative is accounted for separately and is classified as a foreign exchange contract based on its primary risk exposure. +The changes in the fair value of derivatives that are not designated as hedges are intended to offset the related foreign exchange gains or losses of the underlying foreign currency exposures. The changes in the fair value of the derivatives and the related underlying foreign currency exposures resulted in net gains of $ 10 million, $ 64 million and $ 60 million for the years ended December 31, 2020, 2019, and 2018, respectively, that are recognized in Other, net expenses in the Consolidated Statements of Income. Changes in the fair value of an embedded derivative were nil for the year ended December 31, 2020. Included in the net gain of $ 64 million for the year ended December 31, 2019, is a gain of $ 3 million, related to a change in the fair value of an embedded derivative. The change in the fair value of the embedded derivative for the year ended December 31, 2018 resulted in a loss of $ 11 million that is recognized in Card Member services expense in the Consolidated Statements of Income. +136 +Table of Contents +NOTE 14 +FAIR VALUES +Fair value is defined as the price that would be required to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, based on the principal or, in the absence of a principal, most advantageous market for the specific asset or liability. +GAAP provides for a three-level hierarchy of inputs to valuation techniques used to measure fair value, defined as follows: +• Level 1 ― Inputs that are quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity can access. +• Level 2 ― Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability, including: +– Quoted prices for similar assets or liabilities in active markets; +– Quoted prices for identical or similar assets or liabilities in markets that are not active; +– Inputs other than quoted prices that are observable for the asset or liability; and +– Inputs that are derived principally from or corroborated by observable market data by correlation or other means. +• Level 3 ― Inputs that are unobservable and reflect our own estimates about the estimates market participants would use in pricing the asset or liability based on the best information available in the circumstances (e.g., internally derived assumptions surrounding the timing and amount of expected cash flows). We did not measure any financial instruments presented on the Consolidated Balance Sheets at fair value on a recurring basis using significant unobservable inputs (Level 3) during the years ended December 31, 2020 and 2019, although the disclosed fair value of certain assets that are not carried at fair value, as presented later in this Note, are classified within Level 3. +We monitor the market conditions and evaluate the fair value hierarchy levels at least quarterly. For the years ended December 31, 2020 and 2019, there were no Level 3 transfers. +FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT FAIR VALUE +The following table summarizes our financial assets and financial liabilities measured at fair value on a recurring basis, categorized by GAAP’s fair value hierarchy (as described in the preceding paragraphs), as of December 31: +2020 2019 +(Millions) Total Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 +Assets: +Investment securities: (a) +Equity securities $ 81 $ 80 $ 1 $ — $ 78 $ 77 $ 1 $ — +Debt securities 21,550 — 21,550 — 8,328 — 8,328 — +Derivatives, gross (a) +629 — 629 — 343 — 343 — +Total Assets 22,260 80 22,180 — 8,749 77 8,672 — +Liabilities: +Derivatives, gross (a) +702 — 702 — 440 — 440 — +Total Liabilities $ 702 $ — $ 702 $ — $ 440 $ — $ 440 $ — +(a) Refer to Note 4 for the fair values of investment securities and to Note 13 for the fair values of derivative assets and liabilities, on a further disaggregated basis. +137 +Table of Contents +VALUATION TECHNIQUES USED IN THE FAIR VALUE MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT FAIR VALUE +For the financial assets and liabilities measured at fair value on a recurring basis (categorized in the valuation hierarchy table above), we apply the following valuation techniques: +Investment Securities +When available, quoted prices of identical investment securities in active markets are used to estimate fair value. Such investment securities are classified within Level 1 of the fair value hierarchy. +When quoted prices of identical investment securities in active markets are not available, the fair values for our investment securities are obtained primarily from pricing services engaged by us, and we receive one price for each security. The fair values provided by the pricing services are estimated using pricing models, where the inputs to those models are based on observable market inputs or recent trades of similar securities. Such investment securities are classified within Level 2 of the fair value hierarchy. The inputs to the valuation techniques applied by the pricing services vary depending on the type of security being priced but are typically benchmark yields, benchmark security prices, credit spreads, prepayment speeds, reported trades and broker-dealer quotes, all with reasonable levels of transparency. The pricing services did not apply any adjustments to the pricing models used. In addition, we did not apply any adjustments to prices received from the pricing services. +We reaffirm our understanding of the valuation techniques used by our pricing services at least annually. In addition, we corroborate the prices provided by our pricing services by comparing them to alternative pricing sources. In instances where price discrepancies are identified between different pricing sources, we evaluate such discrepancies to ensure that the prices used for our valuation represent the fair value of the underlying investment securities. Refer to Note 4 for additional fair value information. +Derivative Financial Instruments +The fair value of our derivative financial instruments is estimated internally by using third-party pricing models, where the inputs to those models are readily observable from active markets. The pricing models used are consistently applied and reflect the contractual terms of the derivatives as described below. We reaffirm our understanding of the valuation techniques at least annually and validate the valuation output on a quarterly basis. Our derivative instruments are classified within Level 2 of the fair value hierarchy. +The fair value of our interest rate swaps is determined based on a discounted cash flow method using the following significant inputs: the contractual terms of the swap such as the notional amount, fixed coupon rate, floating coupon rate and tenor, as well as discount rates consistent with the underlying economic factors of the currency in which the cash flows are denominated. +The fair value of foreign exchange forward contracts is determined based on a discounted cash flow method using the following significant inputs: the contractual terms of the forward contracts such as the notional amount, maturity dates and contract rate, as well as relevant foreign currency forward curves, and discount rates consistent with the underlying economic factors of the currency in which the cash flows are denominated. +Credit valuation adjustments are necessary when the market parameters, such as a benchmark curve, used to value derivatives are not indicative of our credit quality or that of our counterparties. We consider the counterparty credit risk by applying an observable forecasted default rate to the current exposure. Refer to Note 13 for additional fair value information. +138 +Table of Contents +FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT OTHER THAN FAIR VALUE +The following table summarizes the estimated fair values of our financial assets and financial liabilities that are measured at amortized cost, and not required to be carried at fair value on a recurring basis, as of December 31, 2020 and 2019. The fair values of these financial instruments are estimates based upon the market conditions and perceived risks as of December 31, 2020 and 2019, and require management’s judgment. These figures may not be indicative of future fair values, nor can the fair value of American Express be estimated by aggregating the amounts presented. +2020 (Billions) +Carrying +Value Corresponding Fair Value Amount +Total Level 1 Level 2 Level 3 +Financial Assets: +Financial assets for which carrying values equal or +approximate fair value +Cash and cash equivalents (a) +$ 33 $ 33 $ 31 $ 2 $ — +Other financial assets (b) +46 46 — 46 — +Financial assets carried at other than fair value +Card Member and Other loans, less reserves (c) +71 75 — — 75 +Financial Liabilities: +Financial liabilities for which carrying values equal or approximate fair value 101 101 — 101 — +Financial liabilities carried at other than fair value +Certificates of deposit (d) +8 8 — 8 — +Long-term debt (c) +$ 43 $ 45 $ — $ 45 $ — +2019 (Billions) +Carrying +Value Corresponding Fair Value Amount +Total Level 1 Level 2 Level 3 +Financial Assets: +Financial assets for which carrying values equal or +approximate fair value +Cash and cash equivalents (a) +$ 24 $ 24 $ 23 $ 1 $ — +Other financial assets (b) +60 60 — 60 — +Financial assets carried at other than fair value +Card Member and Other loans, less reserves (c) +90 91 — — 91 +Financial Liabilities: +Financial liabilities for which carrying values equal or approximate fair value 92 92 — 92 — +Financial liabilities carried at other than fair value +Certificates of deposit (d) +10 10 — 10 — +Long-term debt (c) +$ 58 $ 60 $ — $ 60 $ — +(a) Level 2 amounts reflect time deposits and short-term investments. +(b) Balances include Card Member receivables (including fair values of Card Member receivables of $ 4.2 billion and $ 8.2 billion held by a consolidated VIE as of December 31, 2020 and 2019, respectively), other receivables and other miscellaneous assets. +(c) Balances include amounts held by a consolidated VIE for which the fair values of Card Member loans were $ 25.8 billion and $ 32.0 billion as of December 31, 2020 and 2019, respectively, and the fair values of Long-term debt were $ 13.0 billion and $ 19.8 billion as of December 31, 2020 and 2019, respectively. +(d) Presented as a component of Customer deposits on the Consolidated Balance Sheets. +139 +Table of Contents +VALUATION TECHNIQUES USED IN THE FAIR VALUE MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES CARRIED AT OTHER THAN FAIR VALUE +For the financial assets and liabilities that are not required to be carried at fair value on a recurring basis (categorized in the valuation hierarchy table), we apply the following valuation techniques to measure fair value: +Financial Assets For Which Carrying Values Equal Or Approximate Fair Value +Financial assets for which carrying values equal or approximate fair value include cash and cash equivalents, Card Member receivables, accrued interest and certain other assets. For these assets, the carrying values approximate fair value because they are short term in duration, have no defined maturity or have a market-based interest rate. +Financial Assets Carried At Other Than Fair Value +Card Member and Other loans, less reserves +Card Member and Other loans are recorded at historical cost, less reserves, on the Consolidated Balance Sheets. In estimating the fair value for our loans, we use a discounted cash flow model. Due to the lack of a comparable whole loan sales market for similar loans and the lack of observable pricing inputs thereof, we use various inputs to estimate fair value. Such inputs include projected income, discount rates and forecasted write-offs. The valuation does not include economic value attributable to future receivables generated by the accounts associated with the loans. +Financial Liabilities For Which Carrying Values Equal Or Approximate Fair Value +Financial liabilities for which carrying values equal or approximate fair value include accrued interest, customer deposits (excluding certificates of deposit, which are described further below), Travelers Cheques and other prepaid products outstanding, accounts payable, short-term borrowings and certain other liabilities for which the carrying values approximate fair value because they are short term in duration, have no defined maturity or have a market-based interest rate. +Financial Liabilities Carried At Other Than Fair Value +Certificates of Deposit +Certificates of deposit (CDs) are recorded at their historical issuance cost on the Consolidated Balance Sheets. Fair value is estimated using a discounted cash flow methodology based on the future cash flows and the discount rate that reflects the current market rates for similar types of CDs within similar markets. +Long-term Debt +Long-term debt is recorded at historical issuance cost on the Consolidated Balance Sheets adjusted for (i) unamortized discount and unamortized fees, (ii) the impact of movements in exchange rates on foreign currency denominated debt and (iii) the impact of fair value hedge accounting on certain fixed-rate notes that have been swapped to floating rate through the use of interest rate swaps. The fair value of our long-term debt is measured using quoted offer prices when quoted market prices are available. If quoted market prices are not available, the fair value is determined by discounting the future cash flows of each instrument at rates currently observed in publicly-traded debt markets for debt of similar terms and credit risk. For long-term debt, where there are no rates currently observable in publicly traded debt markets of similar terms and comparable credit risk, we use market interest rates and adjust those rates for necessary risks, including our own credit risk. In determining an appropriate spread to reflect our credit standing, we consider credit default swap spreads, bond yields of other long-term debt offered by us, and interest rates currently offered to us for similar debt instruments of comparable maturities. +NONRECURRING FAIR VALUE MEASUREMENTS +We have certain assets that are subject to measurement at fair value on a nonrecurring basis. For these assets, measurement at fair value in periods subsequent to their initial recognition is applicable if they are determined to be impaired or where there are observable price changes for equity investments without readily determinable fair values. During the years ended December 31, 2020 and 2019, we did no t have any material assets that were measured at fair value due to impairment and there were no material fair value adjustments for equity investments without readily determinable fair values. +140 +Table of Contents +NOTE 15 +GUARANTEES +The maximum potential undiscounted future payments and related liability resulting from guarantees and indemnifications provided by us in the ordinary course of business were $ 1 billion and $ 24 million, respectively, as of December 31, 2020, and $ 1 billion and $ 29 million, respectively, as of December 31, 2019, all of which were primarily related to our real estate and business dispositions. +To date, we have not experienced any significant losses related to guarantees or indemnifications. Our recognition of these instruments is at fair value. In addition, we establish reserves when a loss is probable and the amount can be reasonably estimated. +NOTE 16 +COMMON AND PREFERRED SHARES +The following table shows authorized shares and provides a reconciliation of common shares issued and outstanding for the years ended December 31: +(Millions, except where indicated) 2020 2019 2018 +Common shares authorized (billions) (a) +3.6 3.6 3.6 +Shares issued and outstanding at beginning of year 810 847 859 +Repurchases of common shares ( 7 ) ( 40 ) ( 15 ) +Other, primarily stock option exercises and restricted stock awards granted 2 3 3 +Shares issued and outstanding as of December 31 805 810 847 +(a) Of the common shares authorized but unissued as of December 31, 2020, approximately 23 million shares are reserved for issuance under employee stock and employee benefit plans. +On September 23, 2019, the Board of Directors authorized the repurchase of up to 120 million common shares from time to time, subject to market conditions and in accordance with our capital plans. This authorization replaced the prior repurchase authorization and does not have an expiration date. During 2020, 2019 and 2018, we repurchased 7 million common shares with a cost basis of $ 0.9 billion, 40 million common shares with a cost basis of $ 4.6 billion, and 15 million common shares with a cost basis of $ 1.6 billion, respectively. The cost basis includes commissions paid of $ 1.0 million, $ 6.2 million and $ 2.2 million in 2020, 2019 and 2018, respectively. As of December 31, 2020, we had approximately 102 million common shares remaining under the Board share repurchase authorization. +Common shares are generally retired by us upon repurchase (except for 2.5 million, 2.6 million and 2.7 million shares held as treasury shares as of December 31, 2020, 2019 and 2018, respectively); retired common shares and treasury shares are excluded from the shares outstanding in the table above. The treasury shares, with a cost basis of $ 279 million, $ 292 million and $ 207 million as of December 31, 2020, 2019 and 2018, respectively, are included as a reduction to Additional paid-in capital in Shareholders’ equity on the Consolidated Balance Sheets. +141 +Table of Contents +PREFERRED SHARES +The Board of Directors is authorized to permit us to issue up to 20 million Preferred Shares at a par value of $1.66 2/3 without further shareholder approval. We have the following perpetual Fixed Rate/Floating Rate Noncumulative Preferred Share series issued and outstanding as of December 31, 2020: +Series B Series C +Issuance date November 10, 2014 March 2, 2015 +Securities issued +750 Preferred Shares; represented by 750,000 depositary shares +850 Preferred Shares; represented by 850,000 depositary shares +Aggregate liquidation preference $ 750 million $ 850 million +Fixed dividend rate per annum 5.20 % 4.90 % +Semi-annual fixed dividend payment dates +Beginning May 15, 2015 +Beginning September 15, 2015 +Floating dividend rate per annum +3 month LIBOR+ 3.428 % +3 month LIBOR+ 3.285 % +Quarterly floating dividend payment dates Beginning February 15, 2020 Beginning June 15, 2020 +Fixed to floating rate conversion date (a) +November 15, 2019 March 15, 2020 +(a) The date on which dividends convert from a fixed-rate calculation to a floating rate calculation. +In the event of the voluntary or involuntary liquidation, dissolution or winding up of the Company, the preferred stock then outstanding takes precedence over our common stock for the payment of dividends and the distribution of assets out of funds legally available for distribution to shareholders. Each outstanding series of Preferred Shares has a liquidation price of $ 1 million per Preferred Share, plus any accrued but unpaid dividends. We may redeem these Preferred Shares at $ 1 million per Preferred Share (equivalent to $ 1,000 per depositary share) plus any declared but unpaid dividends in whole or in part, from time to time, on any dividend payment date on or after the respective fixed to floating rate conversion date, or in whole, but not in part, within 90 days of certain bank regulatory changes. +There were no warrants issued and outstanding as of December 31, 2020, 2019 and 2018. +142 +Table of Contents +NOTE 17 +CHANGES IN ACCUMULATED OTHER COMPREHENSIVE INCOME +AOCI is a balance sheet item in Shareholders’ equity on the Consolidated Balance Sheets. It is comprised of items that have not been recognized in earnings but may be recognized in earnings in the future when certain events occur. Changes in each component for the three years ended December 31 were as follows: +(Millions) , net of tax +Net Unrealized Gains (Losses) on Debt +Securities Foreign Currency +Translation Adjustment +Gains (Losses) Net Unrealized Pension +and Other Postretirement Benefit +Gains (Losses) Accumulated Other +Comprehensive (Loss) +Income +Balances as of December 31, 2017 $ — $ ( 1,961 ) $ ( 467 ) $ ( 2,428 ) +Net unrealized losses ( 10 ) — — ( 10 ) +Net translation on investments in foreign operations — ( 500 ) — ( 500 ) +Net hedges of investments in foreign operations — 328 — 328 +Pension and other postretirement benefits — — 11 11 +Other 2 — — 2 +Net change in accumulated other comprehensive (loss) income ( 8 ) ( 172 ) 11 ( 169 ) +Balances as of December 31, 2018 ( 8 ) ( 2,133 ) ( 456 ) ( 2,597 ) +Net unrealized gains 41 — — 41 +Net translation on investments in foreign operations +— 84 — 84 +Net hedges of investments in foreign operations — ( 140 ) — ( 140 ) +Pension and other postretirement benefits — — ( 125 ) ( 125 ) +Net change in accumulated other comprehensive (loss) income 41 ( 56 ) ( 125 ) ( 140 ) +Balances as of December 31, 2019 33 ( 2,189 ) ( 581 ) ( 2,737 ) +Net unrealized gains 32 — — 32 +Amounts reclassified into earnings — ( 3 ) — ( 3 ) +Net translation on investments in foreign operations — 215 — 215 +Net hedges of investments in foreign operations — ( 252 ) — ( 252 ) +Pension and other postretirement benefits — — ( 150 ) ( 150 ) +Net change in accumulated other comprehensive (loss) income 32 ( 40 ) ( 150 ) ( 158 ) +Balances as of December 31, 2020 $ 65 $ ( 2,229 ) $ ( 731 ) $ ( 2,895 ) +The following table shows the tax impact for the years ended December 31 for the changes in each component of AOCI presented above: +Tax expense (benefit) +(Millions) 2020 2019 2018 +Net unrealized investment securities $ 9 $ 12 $ ( 2 ) +Net translation on investments in foreign operations +17 24 ( 44 ) +Net hedges of investments in foreign operations ( 79 ) ( 43 ) 107 +Pension and other postretirement benefits ( 28 ) ( 38 ) 9 +Total tax impact $ ( 81 ) $ ( 45 ) $ 70 +The following table presents the effects of reclassifications out of AOCI and into the Consolidated Statements of Income associated with the sale or liquidation of a business, net of taxes for the years ended December 31: +Gains (losses) recognized in earnings +Description (Millions) +Income Statement Line Item 2020 2019 2018 +Foreign currency translation adjustments +Reclassification of translation adjustments and related hedges Other expenses $ 3 $ — $ 1 +Related income tax Income tax provision — — ( 1 ) +Reclassification of foreign currency translation adjustments $ 3 $ — $ — +143 +Table of Contents +NOTE 18 +OTHER FEES AND COMMISSIONS AND OTHER EXPENSES +The following is a detail of Other fees and commissions for the years ended December 31: +(Millions) 2020 2019 2018 +Fees charged to Card Members: +Delinquency fees $ 772 $ 1,028 $ 959 +Foreign currency conversion fee revenue 433 982 921 +Other customer fees: +Loyalty coalition-related fees 435 456 461 +Service fees and other (a) +421 407 417 +Travel commissions and fees 102 424 395 +Total Other fees and commissions $ 2,163 $ 3,297 $ 3,153 +(a) Other includes Membership Rewards program fees that are not related to contracts with customers. +The following is a detail of Other expenses for the years ended December 31: +(Millions) 2020 2019 2018 +Occupancy and equipment $ 2,334 $ 2,168 $ 2,033 +Professional services 1,789 2,091 2,125 +Other (a) +1,202 1,597 1,506 +Total Other expenses $ 5,325 $ 5,856 $ 5,664 +(a) Other expense primarily includes general operating expenses, communication expenses, non-income taxes, unrealized gains and losses on certain equity investments, Card Member and merchant-related fraud losses and litigation expenses. For the year ended December 31, 2018, Other expense also includes the loss on a transaction involving the operations of our prepaid reloadable and gift card business. +NOTE 19 +RESTRUCTURING +We periodically initiate restructuring programs to support new business strategies and to enhance our overall effectiveness and efficiency. In connection with these programs, we will typically incur severance and other exit costs. +We had $ 197 million, $ 135 million and $ 69 million accrued in total restructuring reserves as of December 31, 2020, 2019 and 2018, respectively. New charges, including net revisions to existing restructuring reserves, which primarily relate to the redeployment of displaced colleagues to other positions, were $ 125 million, $ 125 million and $( 23 ) million, for the years ended December 31, 2020, 2019 and 2018, respectively. Cumulatively, we recognized $ 383 million relating to the restructuring programs that were in progress during 2020 and initiated at various dates between 2016 and 2020, the majority of which has been reflected within Corporate & Other. +144 +Table of Contents +NOTE 20 +INCOME TAXES +The components of income tax expense for the years ended December 31 included in the Consolidated Statements of Income were as follows: +(Millions) 2020 2019 2018 +Current income tax expense: +U.S. federal $ 1,122 $ 1,108 $ 70 +U.S. state and local 339 276 150 +Non-U.S. 639 437 681 +Total current income tax expense 2,100 1,821 901 +Deferred income tax (benefit) expense: +U.S. federal ( 931 ) ( 58 ) 276 +U.S. state and local ( 119 ) ( 31 ) 78 +Non-U.S. 111 ( 62 ) ( 54 ) +Total deferred income tax (benefit) expense ( 939 ) ( 151 ) 300 +Total income tax expense $ 1,161 $ 1,670 $ 1,201 +A reconciliation of the U.S. federal statutory rate of 21 percent as of December 31, 2020, 2019 and 2018, to our actual income tax rate was as follows: +2020 2019 2018 +U.S. statutory federal income tax rate 21.0 % 21.0 % 21.0 % +(Decrease) increase in taxes resulting from: +Tax-exempt income ( 4.1 ) ( 1.9 ) ( 1.7 ) +State and local income taxes, net of federal benefit 3.7 2.8 2.8 +Non-U.S. subsidiaries' earnings +2.4 ( 0.5 ) ( 1.0 ) +Tax settlements (a) +( 0.3 ) ( 0.3 ) ( 1.9 ) +U.S. Tax Act and related adjustments (b) +— — ( 4.3 ) +Valuation allowances 4.0 ( 0.2 ) 0.5 +Other 0.3 ( 1.1 ) ( 0.6 ) +Actual tax rates 27.0 % 19.8 % 14.8 % +(a) 2018 primarily included a settlement of the IRS examination for tax years 2008 - 2014 , as well as the resolution of certain tax matters in various jurisdictions. +(b) 2018 included changes to the tax method of accounting for certain expenses and adjustments to the 2017 provisional Tax Act charge. +We record a deferred income tax (benefit) provision when there are differences between assets and liabilities measured for financial reporting and for income tax return purposes. These temporary differences result in taxable or deductible amounts in future years and are measured using the tax rates and laws that will be in effect when such differences are expected to reverse. +145 +Table of Contents +The significant components of deferred tax assets and liabilities as of December 31 are reflected in the following table: +(Millions) 2020 2019 +Deferred tax assets: +Reserves not yet deducted for tax purposes $ 3,905 $ 2,633 +Employee compensation and benefits 383 365 +Net operating loss and tax credit carryforwards 399 119 +Other 765 417 +Gross deferred tax assets 5,452 3,534 +Valuation allowance ( 418 ) ( 66 ) +Deferred tax assets after valuation allowance 5,034 3,468 +Deferred tax liabilities: +Intangibles and fixed assets 1,433 1,279 +Deferred revenue 252 315 +Deferred interest 148 162 +Investment in joint ventures 135 122 +Other 366 129 +Gross deferred tax liabilities 2,334 2,007 +Net deferred tax assets $ 2,700 $ 1,461 +The net operating loss and tax credit carryforward balance as of December 31, 2020, shown in the table above, is related to pre-tax U.S. federal and non-U.S. net operating loss (NOL) carryforwards of $ 140 million and $ 1.0 billion, respectively, and foreign tax credit (FTC) carryforwards of $ 100 million. If not utilized, certain U.S. federal and non-U.S. NOL carryforwards will expire between 2021 and 2037, whereas others have an unlimited carryforward period. The FTC carryforwards will expire between 2029 and 2030. +A valuation allowance is established when management determines that it is more likely than not that all or some portion of the benefit of the deferred tax assets will not be realized. The valuation allowances for both periods presented above are associated with certain non-U.S. deferred tax assets. In addition, the valuation allowances as of December 31, 2020 are also associated with FTC carryforwards. +Accumulated earnings of certain non-U.S. subsidiaries, which totaled approximately $ 1.0 billion as of December 31, 2020, are intended to be permanently reinvested outside the U.S. We do not provide for state income and foreign withholding taxes on foreign earnings intended to be permanently reinvested outside the U.S. Accordingly, state income and foreign withholding taxes, which would have aggregated to approximately $ 0.1 billion as of December 31, 2020, have not been provided on those earnings. +Net income taxes paid by us during 2020, 2019 and 2018, were approximately $ 2.2 billion, $ 1.7 billion and $ 2.0 billion, respectively. These amounts include estimated tax payments and cash settlements relating to prior tax years. +We are subject to the income tax laws of the United States, its states and municipalities and those of the foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to the taxpayer’s facts is sometimes open to interpretation. Given these inherent complexities, we must make judgments in assessing the likelihood that a tax position will be sustained upon examination by the taxing authorities based on the technical merits of the tax position. A tax position is recognized only when, based on management’s judgment regarding the application of income tax laws, it is more likely than not that the tax position will be sustained upon examination. The amount of benefit recognized for financial reporting purposes is based on management’s best judgment of the largest amount of benefit that is more likely than not to be realized on ultimate settlement with the taxing authority given the facts, circumstances and information available at the reporting date. We adjust the level of unrecognized tax benefits when there is new information available to assess the likelihood of the outcome. +We are under continuous examination by the Internal Revenue Service (IRS) and tax authorities in other countries and states in which we have significant business operations. The tax years under examination and open for examination vary by jurisdiction. We are currently under examination by the IRS for the 2017 and 2018 tax years. +146 +Table of Contents +The following table presents changes in unrecognized tax benefits: +(Millions) 2020 2019 2018 +Balance, January 1 $ 726 $ 701 $ 821 +Increases: +Current year tax positions 57 66 152 +Tax positions related to prior years 105 78 47 +Effects of foreign currency translations — 10 — +Decreases: +Tax positions related to prior years +( 24 ) ( 14 ) ( 74 ) +Settlements with tax authorities (a) +( 15 ) ( 40 ) ( 192 ) +Lapse of statute of limitations ( 58 ) ( 75 ) ( 44 ) +Effects of foreign currency translations ( 1 ) — ( 9 ) +Balance, December 31 $ 790 $ 726 $ 701 +(a) 2018 included a settlement of the IRS examination for tax years 2008 - 2014 and the resolution of certain tax matters in various jurisdictions. +Included in the unrecognized tax benefits of $ 0.8 billion, $ 0.7 billion and $ 0.7 billion for December 31, 2020, 2019 and 2018, respectively, are approximately $ 580 million, $ 623 million and $ 599 million, respectively, that, if recognized, would favorably affect the effective tax rate in a future period. +We believe it is reasonably possible that our unrecognized tax benefits could decrease within the next 12 months by as much as $ 130 million, principally as a result of potential resolutions of prior years’ tax items with various taxing authorities. The prior years’ tax items include unrecognized tax benefits relating to the deductibility of certain expenses or losses and the attribution of taxable income to a particular jurisdiction or jurisdictions. Of the $ 130 million of unrecognized tax benefits, approximately $ 110 million relates to amounts that, if recognized, would impact the effective tax rate in a future period. +Interest and penalties relating to unrecognized tax benefits are reported in the income tax provision. For the year ended December 31, 2020 and 2019, we recognized approximately $ 260 million and $ 5 million, respectively, in expenses for interest and penalties. For the year ended December 31, 2018, we recognized benefits of approximately $ 18 million, for interest and penalties. +We had approximately $ 350 million and $ 70 million accrued for the payment of interest and penalties as of December 31, 2020 and 2019, respectively. +147 +Table of Contents +NOTE 21 +EARNINGS PER COMMON SHARE (EPS) +The computations of basic and diluted EPS for the years ended December 31 were as follows: +(Millions, except per share amounts) +2020 2019 2018 +Numerator: +Basic and diluted: +Net income +$ 3,135 $ 6,759 $ 6,921 +Preferred dividends ( 79 ) ( 81 ) ( 80 ) +Net income available to common shareholders 3,056 6,678 6,841 +Earnings allocated to participating share awards (a) +( 20 ) ( 47 ) ( 54 ) +Net income attributable to common shareholders +$ 3,036 $ 6,631 $ 6,787 +Denominator: (a) +Basic: Weighted-average common stock +805 828 856 +Add: Weighted-average stock options (b) +1 2 3 +Diluted +806 830 859 +Basic EPS +$ 3.77 $ 8.00 $ 7.93 +Diluted EPS $ 3.77 $ 7.99 $ 7.91 +(a) Our unvested restricted stock awards, which include the right to receive non-forfeitable dividends or dividend equivalents, are considered participating securities. Calculations of EPS under the two-class method exclude from the numerator any dividends paid or owed on participating securities and any undistributed earnings considered to be attributable to participating securities. The related participating securities are similarly excluded from the denominator. +(b) The dilutive effect of unexercised stock options excludes from the computation of EPS 0.5 million, 0.2 million and 0.7 million of options for the years ended December 31, 2020, 2019 and 2018, respectively, because inclusion of the options would have been anti-dilutive. +148 +Table of Contents +NOTE 22 +REGULATORY MATTERS AND CAPITAL ADEQUACY +We are supervised and regulated by the Board of Governors of the Federal Reserve System (the Federal Reserve) and are subject to the Federal Reserve’s requirements for risk-based capital and leverage ratios. Our U.S. bank subsidiary, American Express National Bank (AENB), is subject to supervision and regulation, including regulatory capital and leverage requirements, by the Office of the Comptroller of the Currency (OCC). +Under the risk-based capital guidelines of the Federal Reserve, we are required to maintain minimum ratios of CET1, Tier 1 and Total (Tier 1 plus Tier 2) capital to risk-weighted assets, as well as a minimum Tier 1 leverage ratio (Tier 1 capital to average adjusted on-balance sheet assets). +Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional, discretionary actions by regulators, that, if undertaken, could have a direct material effect on our operating activities. +As of December 31, 2020 and 2019, we met all capital requirements to which we were subject and maintained regulatory capital ratios in excess of those required to qualify as well capitalized. +The following table presents the regulatory capital ratios: +(Millions, except percentages) CET 1 +capital Tier 1 capital Total capital CET 1 capital +ratio Tier 1 capital +ratio Total capital +ratio Tier 1 leverage +ratio +December 31, 2020: (a) +American Express Company $ 18,693 $ 20,277 $ 22,385 13.5 % 14.7 % 16.2 % 11.0 % +American Express National Bank $ 14,617 $ 14,617 $ 16,578 16.2 % 16.2 % 18.3 % 10.9 % +December 31, 2019: (a) +American Express Company $ 18,056 $ 19,628 $ 22,213 10.7 % 11.6 % 13.2 % 10.2 % +American Express National Bank $ 13,600 $ 13,600 $ 15,688 13.4 % 13.4 % 15.4 % 11.1 % +Well-capitalized ratios (b) +American Express Company N/A 6.0 % 10.0 % N/A +American Express National Bank 6.5 % 8.0 % 10.0 % 5.0 % +Effective Minimum (c) +American Express Company 7.0 % 8.5 % 10.5 % 4.0 % +American Express National Bank 7.0 % 8.5 % 10.5 % 4.0 % +Minimum capital ratios (d) +4.5 % 6.0 % 8.0 % 4.0 % +(a) Capital ratios reported using Basel III capital definitions and risk-weighted assets using the Basel III standardized approach. +(b) Represents requirements for bank holding companies and banking subsidiaries to be considered “well capitalized” pursuant to regulations issued under the Federal Reserve Regulation Y and the Federal Deposit Insurance Corporation Improvement Act, respectively. There is no CET1 capital ratio or Tier 1 leverage ratio requirement for a bank holding company to be considered “well capitalized.” +(c) Represents Basel III minimum capital requirement and applicable regulatory buffers as defined by the federal banking regulators, which includes the stress capital buffer for American Express Company and the capital conservation buffer for American Express National Bank. +(d) As defined by the regulations issued by the Federal Reserve and OCC. +RESTRICTED NET ASSETS OF SUBSIDIARIES +Certain of our subsidiaries are subject to restrictions on the transfer of net assets under debt agreements and regulatory requirements. These restrictions have not had any effect on our shareholder dividend policy and management does not anticipate any impact in the future. Procedures exist to transfer net assets between the Company and its subsidiaries, while ensuring compliance with the various contractual and regulatory constraints. As of December 31, 2020, the aggregate amount of net assets of subsidiaries that are restricted to be transferred was approximately $ 7.7 billion. +149 +Table of Contents +BANK HOLDING COMPANY DIVIDEND RESTRICTIONS +We are limited in our ability to pay dividends by the Federal Reserve, which could prohibit a dividend that would be considered an unsafe or unsound banking practice. It is the policy of the Federal Reserve that bank holding companies generally should pay dividends on preferred and common stock only out of net income available to common shareholders generated over the past year, and only if prospective earnings retention is consistent with the organization’s current and expected future capital needs, asset quality and overall financial condition. Moreover, bank holding companies are required by statute to be a source of strength to their insured depository institution subsidiaries and should not maintain dividend levels that undermine their ability to do so. On an annual basis, we are required to develop and maintain a capital plan, which includes planned dividends over a two-year horizon. We may be subject to limitations and restrictions on our dividends, if, among other things, (i) our regulatory capital ratios do not satisfy applicable minimum requirements and buffers or (ii) we are required to resubmit our capital plan. +BANK DIVIDEND RESTRICTIONS +In the year ended December 31, 2020, AENB paid dividends from retained earnings to its parent of $ 4.5 billion. AENB is limited in its ability to pay dividends by banking statutes, regulations and supervisory policy. In general, applicable federal and state banking laws prohibit, without first obtaining regulatory approval, insured depository institutions, such as AENB, from making dividend distributions if such distributions are not paid out of available retained earnings or would cause the institution to fail to meet capital adequacy standards. If AENB’s risk-based capital ratios do not satisfy minimum regulatory requirements and applicable buffers, it will face graduated constraints on dividends and other capital distributions. As of December 31, 2020, AENB's retained earnings available for the payment of dividends was $ 6.9 billion. In determining the dividends to pay its parent, AENB must also consider the effects on applicable risk-based capital and leverage ratio requirements, as well as policy statements of the federal regulatory agencies. In addition, AENB's banking regulators have authority to limit or prohibit the payment of a dividend by AENB under a number of circumstances, including if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound banking practice in light of the financial condition of the banking organization. +150 +Table of Contents +NOTE 23 +SIGNIFICANT CREDIT CONCENTRATIONS +Concentrations of credit risk exist when changes in economic, industry or geographic factors similarly affect groups of counterparties whose aggregate credit exposure is material in relation to American Express’ total credit exposure. Our customers operate in diverse industries, economic sectors and geographic regions. +The following table details our maximum credit exposure of the on-balance sheet assets by category as of December 31: +(Billions) 2020 2019 +Individuals (a) +$ 108 $ 131 +Financial Services (b) +34 26 +U.S. Government and agencies (c) +22 8 +Institutions (d) +13 20 +Total on-balance sheet $ 177 $ 185 +(a) Primarily reflects loans and receivables from global consumer and small business Card Members, which are governed by individual credit risk management. +(b) Represents banks, broker-dealers, insurance companies and savings and loan associations. +(c) Represent debt obligations of the U.S. Government and its agencies, states and municipalities and government-sponsored entities. +(d) Primarily reflects loans and receivables from global corporate Card Members, which are governed by institutional credit risk management. +As of December 31, 2020 and 2019, our most significant concentration of credit risk was with individuals, including Card Member loans and receivables. These amounts are generally advanced on an unsecured basis. However, we review each potential customer’s credit application and evaluate the applicant’s financial history and ability and willingness to repay. We also consider credit performance by customer tenure, industry and geographic location in managing credit exposure. +The following table details our Card Member loans and receivables exposure (including unused lines-of-credit available to Card Members as part of established lending product agreements) in the United States and outside the United States as of December 31: +(Billions) 2020 2019 +On-balance sheet: +U.S. $ 95 $ 115 +Non-U.S. 22 30 +On-balance sheet 117 145 +Unused lines-of-credit: (a) +U.S. 251 245 +Non-U.S. 63 61 +Total unused lines-of-credit $ 314 $ 306 +(a) Total unused credit available to Card Members does not represent potential future cash requirements, as a significant portion of this unused credit will likely not be drawn. Our charge card products generally have no pre-set spending limit, and therefore are not reflected in unused credit available to Card Members. +151 +Table of Contents +NOTE 24 +REPORTABLE OPERATING SEGMENTS AND GEOGRAPHIC OPERATIONS +REPORTABLE OPERATING SEGMENTS +We consider a combination of factors when evaluating the composition of our reportable operating segments, including the results reviewed by the chief operating decision maker, economic characteristics, products and services offered, classes of customers, product distribution channels, geographic considerations (primarily United States versus outside the United States), and regulatory environment considerations. +The following is a brief description of the primary business activities of our three reportable operating segments: +• Global Consumer Services Group (GCSG) primarily issues a wide range of proprietary consumer cards globally. GCSG also provides services to consumers, including travel and lifestyle services and non-card financing products, and manages certain international joint ventures and our partnership agreements in China. +• Global Commercial Services (GCS) primarily issues a wide range of proprietary corporate and small business cards. In addition, GCS provides payment, expense management, and commercial financing products. +• Global Merchant and Network Services (GMNS) operates a global payments network that processes and settles card transactions, acquires merchants and provides multi-channel marketing programs and capabilities, services and data analytics, leveraging our global integrated network. GMNS manages our partnership relationships with third-party card issuers, merchant acquirers and a prepaid reloadable and gift card program manager, licensing the American Express brand and extending the reach of the global network. GMNS also manages loyalty coalition businesses. +Corporate functions and certain other businesses and operations are included in Corporate & Other. +Effective for the first quarter of 2020, we made certain enhancements to our transfer pricing methodology related to the sharing of revenues between our card issuing, network and merchant businesses, and our methodology related to the allocation of certain funding costs primarily related to our Card Member loan and Card Member receivable portfolios. These enhancements resulted in certain changes to Non-interest revenues, Interest expense and operating expenses across our reportable operating segments and geographic regions. Prior period amounts have been revised to conform to the current period presentation. These changes had no impact on our Consolidated Results of Operations. +152 +Table of Contents +The following table presents certain selected financial information for our reportable operating segments and Corporate & Other as of or for the years ended December 31, 2020, 2019 and 2018: +(Millions, except where indicated) GCSG GCS GMNS +Corporate & Other (a) +Consolidated +2020 +Total non-interest revenues $ 14,178 $ 9,652 $ 4,595 $ ( 323 ) $ 28,102 +Revenue from contracts with customers (b) +9,536 8,145 4,320 ( 27 ) 21,974 +Interest income 8,199 1,586 18 280 10,083 +Interest expense 1,051 619 ( 80 ) 508 2,098 +Total revenues net of interest expense 21,326 10,619 4,693 ( 551 ) 36,087 +Net income (loss) 2,701 736 954 ( 1,256 ) 3,135 +Total assets (billions) +$ 87 $ 42 $ 14 $ 48 $ 191 +2019 +Total non-interest revenues $ 16,702 $ 12,242 $ 5,903 $ 89 $ 34,936 +Revenue from contracts with customers (b) +12,097 10,633 5,424 5 28,159 +Interest income 9,413 1,900 28 743 12,084 +Interest expense 1,730 1,034 ( 303 ) 1,003 3,464 +Total revenues net of interest expense 24,385 13,108 6,234 ( 171 ) 43,556 +Net income (loss) 3,807 2,191 2,132 ( 1,371 ) 6,759 +Total assets (billions) +$ 106 $ 53 $ 18 $ 21 $ 198 +2018 +Total non-interest revenues $ 15,357 $ 11,481 $ 5,790 $ 47 $ 32,675 +Revenue from contracts with customers (b) +11,264 10,019 5,312 12 26,607 +Interest income 8,323 1,621 30 632 10,606 +Interest expense 1,448 898 ( 244 ) 841 2,943 +Total revenues net of interest expense 22,232 12,204 6,064 ( 162 ) 40,338 +Net income (loss) 3,615 2,012 1,910 ( 616 ) 6,921 +Total assets (billions) +$ 102 $ 51 $ 16 $ 20 $ 189 +(a) Corporate & Other includes adjustments and eliminations for intersegment activity. +(b) Includes discount revenue, certain other fees and commissions and other revenues from customers. +Total Revenues Net of Interest Expense +We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue. +Net card fees and other fees and commissions are directly attributable to the segment in which they are reported. +Interest and fees on loans and certain investment income is directly attributable to the segment in which it is reported. Interest expense represents an allocated funding cost based on a combination of segment funding requirements and internal funding rates. +Provisions for Credit Losses +The provisions for credit losses are directly attributable to the segment in which they are reported. +Expenses +Marketing and business development expense is included in each segment based on the actual expenses incurred. Global brand advertising is primarily allocated to the segments based on the relative levels of revenue. Rewards and Card Member services expenses are included in each segment based on the actual expenses incurred. +Salaries and employee benefits and other operating expenses reflect both costs incurred directly within each segment, as well as allocated expenses. The allocated expenses include service costs allocated based on activities directly attributable to the segment, and overhead expenses allocated based on the relative levels of revenue and Card Member loans and receivables. +153 +Table of Contents +Income Taxes +An income tax provision (benefit) is allocated to each reportable operating segment based on the effective tax rates applicable to various businesses that comprise the segment. +GEOGRAPHIC OPERATIONS +The following table presents our total revenues net of interest expense and pretax income (loss) from continuing operations in different geographic regions based, in part, upon internal allocations, which necessarily involve management’s judgment: +(Millions) United States +EMEA (a) +APAC (a) +LACC (a) +Other Unallocated (b) +Consolidated +2020 +Total revenues net of interest expense $ 28,263 $ 3,087 $ 3,271 $ 2,019 $ ( 553 ) $ 36,087 +Pretax income (loss) from continuing operations 4,418 398 665 452 ( 1,638 ) 4,296 +2019 +Total revenues net of interest expense $ 32,629 $ 4,388 $ 3,934 $ 2,776 $ ( 171 ) $ 43,556 +Pretax income (loss) from continuing operations 7,302 1,177 853 884 ( 1,787 ) 8,429 +2018 +Total revenues net of interest expense $ 29,886 $ 4,348 $ 3,690 $ 2,576 $ ( 162 ) $ 40,338 +Pretax income (loss) from continuing operations 6,686 1,163 792 787 ( 1,306 ) 8,122 +(a) EMEA represents Europe, the Middle East and Africa; APAC represents Asia Pacific, Australia and New Zealand; and LACC represents Latin America, Canada and the Caribbean. +(b) Other Unallocated includes net costs which are not directly allocated to specific geographic regions, including costs related to the net negative interest spread on excess liquidity funding and executive office operations expenses. +154 +Table of Contents +NOTE 25 +PARENT COMPANY +PARENT COMPANY – CONDENSED STATEMENTS OF INCOME +Years Ended December 31 (Millions) +2020 2019 2018 +Revenues +Non-interest revenues +Other $ 480 $ 598 $ 426 +Total non-interest revenues 480 598 426 +Interest income 228 692 422 +Interest expense 630 902 615 +Total revenues net of interest expense 78 388 233 +Expenses +Salaries and employee benefits 333 366 336 +Other 562 816 607 +Total expenses 895 1,182 943 +Pretax loss ( 817 ) ( 794 ) ( 710 ) +Income tax benefit ( 236 ) ( 282 ) ( 179 ) +Net loss before equity in net income of subsidiaries and affiliates ( 581 ) ( 512 ) ( 531 ) +Equity in net income of subsidiaries and affiliates 3,716 7,271 7,452 +Net income $ 3,135 $ 6,759 $ 6,921 +155 +Table of Contents +PARENT COMPANY – CONDENSED BALANCE SHEETS +As of December 31 (Millions) +2020 2019 +Assets +Cash and cash equivalents $ 10,968 $ 4,430 +Equity in net assets of subsidiaries and affiliates 23,306 23,165 +Loans to subsidiaries and affiliates 15,887 22,350 +Due from subsidiaries and affiliates 1,084 1,168 +Other assets 164 223 +Total assets 51,409 51,336 +Liabilities and Shareholders’ Equity +Liabilities +Accounts payable and other liabilities 1,743 2,197 +Due to subsidiaries and affiliates 1,100 609 +Debt with subsidiaries and affiliates 2,772 1,091 +Long-term debt 22,810 24,368 +Total liabilities 28,425 28,265 +Shareholders’ Equity +Total shareholders’ equity 22,984 23,071 +Total liabilities and shareholders’ equity $ 51,409 $ 51,336 +156 +Table of Contents +PARENT COMPANY – CONDENSED STATEMENTS OF CASH FLOWS +Years Ended December 31 (Millions) +2020 2019 2018 +Cash Flows from Operating Activities +Net income $ 3,135 $ 6,759 $ 6,921 +Adjustments to reconcile net income to cash provided by operating activities: +Equity in net income of subsidiaries and affiliates ( 3,716 ) ( 7,271 ) ( 7,452 ) +Dividends received from subsidiaries and affiliates 2,679 6,370 3,222 +Other operating activities, primarily with subsidiaries and affiliates 732 1,315 ( 257 ) +Net cash provided by operating activities 2,830 7,173 2,434 +Cash Flows from Investing Activities +Maturities and redemptions of investment securities — 1 — +Decrease (increase) in loans to subsidiaries and affiliates 11,434 ( 4,405 ) ( 6,281 ) +Investments in subsidiaries and affiliates ( 52 ) ( 15 ) ( 30 ) +Other investing activities 74 82 — +Net cash provided by (used in) investing activities 11,456 ( 4,337 ) ( 6,311 ) +Cash Flows from Financing Activities +Proceeds from long-term debt — 6,469 9,350 +Payments of long-term debt ( 2,000 ) ( 641 ) ( 3,850 ) +Net decrease in short-term debt from subsidiaries and affiliates ( 3,289 ) ( 1,500 ) ( 140 ) +Issuance of American Express common shares 44 86 87 +Repurchase of American Express common shares and other ( 1,029 ) ( 4,685 ) ( 1,685 ) +Dividends paid ( 1,474 ) ( 1,422 ) ( 1,324 ) +Net cash (used in) provided by financing activities ( 7,748 ) ( 1,693 ) 2,438 +Net increase (decrease) in cash and cash equivalents 6,538 1,143 ( 1,439 ) +Cash and cash equivalents at beginning of year 4,430 3,287 4,726 +Cash and cash equivalents at end of year $ 10,968 $ 4,430 $ 3,287 +Supplemental cash flow information +Years Ended December 31 (Millions) +2020 2019 2018 +Non-Cash Investing Activities +Loans to subsidiaries and affiliates $ ( 4,971 ) $ — $ — +Non-Cash Financing Activities +Short-term debts from subsidiaries and affiliates $ 4,971 $ — $ — +157 +Table of Contents +NOTE 26 +QUARTERLY FINANCIAL DATA (UNAUDITED ) +(Millions, except per share amounts) 2020 2019 +Quarters Ended 12/31 9/30 6/30 3/31 12/31 9/30 6/30 3/31 +Total revenues net of interest expense $ 9,351 $ 8,751 $ 7,675 $ 10,310 $ 11,365 $ 10,989 $ 10,838 $ 10,364 +Pretax income 1,858 1,364 622 452 1,986 2,266 2,219 1,958 +Net income 1,438 1,073 257 367 1,693 1,755 1,761 1,550 +Earnings Per Common Share — Basic: +Net income attributable to common shareholders (a) +1.76 1.31 0.29 0.41 2.04 2.09 2.07 1.81 +Earnings Per Common Share — Diluted: +Net income attributable to common shareholders (a) +1.76 1.30 0.29 0.41 2.03 2.08 2.07 1.80 +Cash dividends declared per common share $ 0.43 $ 0.43 $ 0.43 $ 0.43 $ 0.43 $ 0.43 $ 0.39 $ 0.39 +(a) Represents net income, less (i) earnings allocated to participating share awards of $ 9 million, $ 7 million, $ 2 million and $ 2 million for the quarters ended December 31, September 30, June 30 and March 31, 2020, respectively, and $ 12 million, $ 11 million, $ 13 million and $ 11 million for the quarters ended December 31, September 30, June 30 and March 31, 2019, respectively, and (ii) dividends on preferred shares of $ 14 million, $ 16 million, $ 17 million and $ 32 million for the quarters ended December 31, September 30, June 30 and March 31, 2020, respectively, and $ 20 million, $ 21 million, $ 19 million and $ 21 million for the quarters ended December 31, September 30, June 30 and March 31, 2019, respectively. +158 +Table of Contents +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not applicable. +ITEM 9A. CONTROLS AND PROCEDURES +Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods specified in the applicable rules and forms, and that it is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter of 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +“Management’s Report on Internal Control over Financial Reporting,” which sets forth management’s evaluation of internal control over financial reporting, and the “Report of Independent Registered Public Accounting Firm” on the effectiveness of our internal control over financial reporting as of December 31, 2020 are set forth in “Financial Statements and Supplementary Data.” +ITEM 9B. OTHER INFORMATION +Not applicable. +159 +Table of Contents +PART III +ITEMS 10, 11, 12 and 13. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +We expect to file with the SEC in March 2021 (and, in any event, not later than 120 days after the close of our last fiscal year), a definitive proxy statement, pursuant to SEC Regulation 14A in connection with our Annual Meeting of Shareholders to be held May 4, 2021, which involves the election of directors. The following information to be included in such proxy statement is incorporated herein by reference: +• Information included under the caption “Corporate Governance at American Express — Our Corporate Governance Framework — Our Board’s Independence” +• Information included under the caption “Corporate Governance at American Express — Our Board Committees — Board Committee Responsibilities” +• Information included under the caption “Corporate Governance at American Express — Our Corporate Governance Framework — Director Attendance” +• Information included under the caption “Corporate Governance at American Express — Compensation of Directors” +• Information included under the caption “Stock Ownership Information” +• Information included under the caption “Corporate Governance at American Express — Item 1 — Election of Directors for a Term of One Year” +• Information included under the caption “Executive Compensation” +• Information under the caption “Corporate Governance at American Express — Certain Relationships and Transactions” +In addition, the information regarding executive officers called for by Item 401(b) of Regulation S-K may be found under the caption “Information About Our Executive Officers” in this Report. +We have adopted a set of Corporate Governance Principles, which together with the charters of the four standing committees of the Board of Directors (Audit and Compliance; Compensation and Benefits; Nominating, Governance and Public Responsibility; and Risk), our Code of Conduct (which constitutes our code of ethics) and the Code of Business Conduct for the Members of the Board of Directors, provide the framework for our governance. A complete copy of our Corporate Governance Principles, the charters of each of the Board committees, the Code of Conduct (which applies not only to our Chief Executive Officer, Chief Financial Officer and Controller, but also to all our other colleagues) and the Code of Business Conduct for the Members of the Board of Directors may be found by clicking on the “Corporate Governance” link found on our Investor Relations website at http://ir.americanexpress.com. We also intend to disclose any amendments to our Code of Conduct, or waivers of our Code of Conduct on behalf of our Chief Executive Officer, Chief Financial Officer or Controller, on our website. You may also access our Investor Relations website through our main website at www.americanexpress.com by clicking on the “Investor Relations” link, which is located at the bottom of the Company’s homepage. (Information from such sites is not incorporated by reference into this report.) You may also obtain free copies of these materials by writing to our Corporate Secretary at our headquarters. +160 +Table of Contents +ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES +The information set forth under the heading “Item 2 — Ratification of Appointment of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP Fees and Services,” which will appear in our definitive proxy statement in connection with our Annual Meeting of Shareholders to be held May 4, 2021, is incorporated herein by reference. +161 +Table of Contents +PART IV +ITEM 15. EXHIBIT AND FINANCIAL STATEMENT SCHEDULES +(a) +1. Financial Statements : +See the “Index to Consolidated Financial Statements” under “Financial Statements and Supplementary Data.” +2. Financial Statement Schedules : +All schedules are omitted since the required information is either not applicable, not deemed material, or shown in the Consolidated Financial Statements. +3. Exhibits : +The following exhibits are filed as part of this report. The exhibit numbers preceded by an asterisk (*) indicate exhibits electronically filed herewith. All other exhibit numbers indicate exhibits previously filed and are hereby incorporated herein by reference. Exhibits numbered 10.1 through 10.41 are management contracts or compensatory plans or arrangements. +162 +Table of Contents +3.1 +Company's Amended and Restated Certificate of Incorporation as amended through February 27, 2015 (incorporated by reference to Exhibit 3.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2015). +3.2 +Company's By-Laws, as amended through September 26, 2016 (incorporated by reference to Exhibit 3.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated September 26, 2016). +4.1 The instruments defining the rights of holders of long-term debt securities of the Company and its subsidiaries are omitted pursuant to Section (b)(4)(iii)(A) of Item 601 of Regulation S-K. The Company hereby agrees to furnish copies of these instruments to the SEC upon request. +*4.2 +Description of American Express Company’s securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended. +10.1 +American Express Company Deferred Compensation Plan for Directors and Advisors, as amended and restated effective April 1, 2018 (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2018). +10.2 +American Express Company 2007 Pay-for-Performance Deferral Program Document (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 20, 2006 (filed November 22, 2006)). +10.3 +Description of amendments to 1994–2006 Pay-for-Performance Deferral Programs (incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2006). +10.4 +American Express Company 2006 Pay-for-Performance Deferral Program Guide (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 21, 2005 (filed November 23, 2005)). +10.5 +American Express Company 2005 Pay-for-Performance Deferral Program Guide (incorporated by reference to Exhibit 10.10 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2004). +10.6 +Description of American Express Company Pay-for-Performance Deferral Program (incorporated by reference to Exhibit 10.2 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated November 22, 2004 (filed January 28, 2005)). +10.7 +Amendment to the Pre-2008 Nonqualified Deferred Compensation Plans of American Express Company (incorporated by reference to Exhibit 10.19 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2008). +10.8 American Express Company Retirement Plan for Non-Employee Directors, as amended (incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1988). +10.9 +Certificate of Amendment of the American Express Company Retirement Plan for Non-Employee Directors dated March 21, 1996 (incorporated by reference to Exhibit 10.11 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1995). +10.10 American Express Key Executive Life Insurance Plan, as amended (incorporated by reference to Exhibit 10.12 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the fiscal year ended December 31, 1991). +163 +Table of Contents +10.11 +Amendment to American Express Company Key Executive Life Insurance Plan (incorporated by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1994). +10.12 +Amendment to American Express Company Key Executive Life Insurance Plan, effective as of January 22, 2007 (incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2006). +10.13 +Amendment to American Express Company Key Executive Life Insurance Plan, effective as of January 1, 2011 (incorporated by reference to Exhibit 10.24 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2010). +10.14 American Express Key Employee Charitable Award Program for Education (incorporated by reference to Exhibit 10.13 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1990). +10.15 American Express Directors' Charitable Award Program (incorporated by reference to Exhibit 10.14 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1990). +10.16 American Express Company Salary/Bonus Deferral Plan (incorporated by reference to Exhibit 10.20 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1988). +10.17 +Amendment to American Express Company Salary/Bonus Deferral Plan (incorporated by reference to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 1994). +10.18 +American Express Senior Executive Severance Plan, as amended and restated effective May 1, 2018 (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended June 30, 2018). +10.19 +Amendments of (i) the American Express Salary/Bonus Deferral Plan and (ii) the American Express Key Executive Life Insurance Plan (incorporated by reference to Exhibit 10.37 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 1997). +10.20 +Second Amendment and Restatement of the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (as amended and restated effective as of January 1, 2012) (incorporated by reference to Exhibit 10.28 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2011). +10.21 +Third Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated March 29, 2012) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2012). +10.22 +Fourth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated October 24, 2012) (incorporated by reference to Exhibit 10.31 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2012). +10.23 +Fifth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated May 1, 2013) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2013). +10.24 +Sixth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated August 16, 2013) (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2013). +164 +Table of Contents +10.25 +Seventh Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated September 26, 2013) (incorporated by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2013). +10.26 +Eighth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 1, 2013) (incorporated by reference to Exhibit 10.36 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2013). +10.27 +Ninth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 14, 2016) (incorporated by reference to Exhibit 10.30 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.28 +Tenth Amendment to the American Express Retirement Restoration Plan (f/k/a Supplemental Retirement Plan) (dated December 17, 2018) (incorporated by reference to Exhibit 10.28 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2018). +10.29 +American Express Company 2003 Share Equivalent Unit Plan for Directors, as amended and restated, effective January 1, 2015 (incorporated by reference to Exhibit 10.38 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +10.30 +Description of Compensation Payable to Non-Management Directors effective January 1, 2015 (incorporated by reference to Exhibit 10.39 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2014). +10.31 +American Express Company 2007 Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated April 23, 2007 (filed April 27, 2007)). +10.32 +American Express Company 2007 Incentive Compensation Plan Master Agreement (as amended and restated effective January 1, 2011) (incorporated by reference to Exhibit 10.8 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2010). +10.33 +American Express Company 2007 Incentive Compensation Plan Master Agreement (as amended and restated effective January 23, 2012) (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated January 23, 2012 (filed January 27, 2012)). +10.34 +Form of nonqualified stock option award agreement for executive officers under the American Express Company 2007 Incentive Compensation Plan (for awards made after January 26, 2016) (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2015). +10.35 +American Express Company 2016 Incentive Compensation Plan (as amended and restated effective May 5, 2020) (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated May 5, 2020). +10.36 +Form of nonqualified stock option award agreement for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.41 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.37 +Form of restricted stock unit award agreement for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.42 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.38 +Form of award agreement for executive officers in connection with Performance Grant awards (a/k/a Executive Annual Incentive Awards) under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.43 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +165 +Table of Contents +10.39 +Form of award agreement for executive officers in connection with Portfolio Grant awards under the American Express Company 2016 Incentive Compensation Plan (for awards made after May 2, 2016) (incorporated by reference to Exhibit 10.44 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2016). +10.40 +Amendment to the Form of nonqualified stock option award agreement and Form of restricted stock unit award for executive officers under the American Express Company 2016 Incentive Compensation Plan (for awards made after January 29, 2020) (incorporated by reference to Exhibit 10.41 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2019). +10.41 +Form of notice agreement in connection with Annual Incentive Awards under the American Express Company 2016 Incentive Compensation Plan (incorporated by reference to Exhibit 10.42 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2019). +10.42 +Restated Letter Agreement, dated May 6, 2019, between American Express Company and Berkshire Hathaway Inc., on behalf of itself and its subsidiaries (incorporated by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K (Commission File No. 1-7657), dated May 6, 2019). +10.43 +Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.48 of the Company's Annual Report on Form 10-K (Commission File No. 1-7657) for the year ended December 31, 2017). +10.44 +Amendment No. 1, dated March 29, 2019, to the Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended March 31, 2019). +10.45 +Amendment No. 2, dated July 26, 2019, to the Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri (incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q (Commission File No. 1-7657) for the quarter ended September 30, 2019). +*10.46 +Amendment No. 3, dated December 15, 2020, to the Time Sharing Agreement, dated February 13, 2018, by and between American Express Travel Related Services Company, Inc. and Stephen J. Squeri. +*21 +Subsidiaries of the Company. +*23 +Consent of PricewaterhouseCoopers LLP. +*31.1 +Certification of Stephen J. Squeri, Chief Executive Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended. +*31.2 +Certification of Jeffrey C. Campbell, Chief Financial Officer, pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended. +*32.1 +Certification of Stephen J. Squeri, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +*32.2 +Certification of Jeffrey C. Campbell, Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +*101.INS XBRL Instance Document – The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document +*101.SCH XBRL Taxonomy Extension Schema Document +*101.CAL XBRL Taxonomy Extension Calculation Linkbase Document +166 +Table of Contents +*101.LAB XBRL Taxonomy Extension Label Linkbase Document +*101.PRE XBRL Taxonomy Extension Presentation Linkbase Document +*101.DEF XBRL Taxonomy Extension Definition Linkbase Document +*104 Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101) +167 +Table of Contents +ITEM 16. FORM 10-K SUMMARY +Not applicable. +168 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +AMERICAN EXPRESS COMPANY +/s/ JEFFREY C. CAMPBELL +Jeffrey C. Campbell +Chief Financial Officer +February 12, 2021 +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the date indicated. +/s/ STEPHEN J. SQUERI /s/ MICHAEL O. LEAVITT +Stephen J. Squeri +Chairman, Chief Executive Officer and Director Michael O. Leavitt +Director +/s/ JEFFREY C. CAMPBELL /s/ THEODORE J. LEONSIS +Jeffrey C. Campbell +Chief Financial Officer Theodore J. Leonsis +Director +/s/ JESSICA LIEBERMAN QUINN /s/ KAREN L. PARKHILL +Jessica Lieberman Quinn +Executive Vice President and Corporate Controller +(Principal Accounting Officer) Karen L. Parkhill +Director +/s/ THOMAS J. BALTIMORE, JR. +/s/ CHARLES E. PHILLIPS, JR. +Thomas J. Baltimore, Jr. +Director +Charles E. Phillips, Jr. +Director +Director +/s/ CHARLENE BARSHEFSKY /s/ LYNN A. PIKE +Charlene Barshefsky +Director Lynn A. Pike +Director +/s/ JOHN J. BRENNAN /s/ DANIEL L. VASELLA +John J. Brennan +Director Daniel L. Vasella +Director +/s/ PETER CHERNIN /s/ RONALD A. WILLIAMS +Peter Chernin +Director Ronald A. Williams +Director +/s/ RALPH DE LA VEGA +/s/ CHRISTOPHER D. YOUNG +Ralph de la Vega +Director +Christopher D. Young +Director +/s/ ANNE LAUVERGEON +Anne Lauvergeon +Director +February 12, 2021 +169 +Table of Contents +Appendix +STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES +The accompanying supplemental information should be read in conjunction with the “MD&A”, “Consolidated Financial Statements” and notes thereto. +Certain reclassifications of prior period amounts have been made to conform to the current period presentation. These reclassifications did not have a material impact on our financial position or results of operations. +A-1 +Table of Contents +Distribution of Assets, Liabilities, and Shareholders’ Equity; Interest Rates and Interest Differential +The following tables provide a summary of our consolidated average balances including major categories of interest-earning assets and interest-bearing liabilities along with an analysis of net interest earnings. Consolidated average balances, interest, and average yields are segregated between U.S. and non-U.S. offices. Assets, liabilities, interest income and interest expense are attributed to the United States and outside the United States based on the location of the office recording such items. +2020 2019 2018 +Years Ended December 31, +(Millions, except percentages) +Average +Balance (a) +Interest +Income Average +Yield +Average +Balance (a) +Interest +Income Average +Yield +Average +Balance (a) +Interest +Income Average +Yield +Interest-earning assets +Interest-bearing deposits in other banks +U.S. $ 31,446 $ 100 0.3 % $ 22,169 $ 517 2.3 % $ 24,570 $ 485 2.0 % +Non-U.S. 2,367 51 2.2 2,085 48 2.3 1,830 33 1.8 +Federal funds sold and securities purchased under agreements to resell +U.S. — — — 19 3 15.8 — — — +Non-U.S. 184 11 6.0 56 6 10.7 58 7 12.1 +Short-term investment securities +U.S. 658 7 1.1 409 11 2.7 434 6 1.4 +Non-U.S. 97 1 1.0 93 1 1.1 149 1 0.7 +Card Member loans (b) +U.S. 65,559 8,196 12.5 72,422 9,452 13.1 66,620 8,387 12.6 +Non-U.S. 9,018 1,196 13.3 10,362 1,400 13.5 9,136 1,206 13.2 +Other loans (b) +U.S. 4,078 342 8.4 4,101 413 10.1 3,110 312 10.0 +Non-U.S. 139 45 32.4 170 43 25.3 145 36 24.8 +Taxable investment securities (c) +U.S. 14,002 100 0.7 6,335 147 2.3 3,025 68 2.2 +Non-U.S. 612 21 3.4 589 27 4.6 562 23 4.1 +Non-taxable investment securities (c) +U.S. 128 5 5.1 237 11 5.9 855 25 3.7 +Other assets (d) +Primarily U.S. 38 8 n.m. 17 5 n.m. 1 17 n.m. +Total interest-earning assets (e) $ 128,326 $ 10,083 7.9 % $ 119,064 $ 12,084 10.2 % $ 110,495 $ 10,606 9.6 % +U.S. 115,909 8,758 105,709 10,559 98,615 9,300 +Non-U.S. 12,417 1,325 13,355 1,525 11,880 1,306 +n.m. Denotes rates determined to not be meaningful. +(a) Averages based on month-end balances. +(b) Average non-accrual loans were included in the average Card Member loan balances in amounts of $275 million, $307 million and $230 million in U.S. for 2020, 2019 and 2018, respectively. Average other loan balances for U.S. include average non-accrual loans of $3 million, $7 million and $4 million for 2020, 2019 and 2018, respectively. Average non-accrual loans are considered to determine the average yield on loans. +(c) Average yields for both taxable and non-taxable investment securities have been calculated using amortized cost balances and do not include changes in fair value recorded in other comprehensive loss. Average yield on non-taxable investment securities is calculated on a tax-equivalent basis using the U.S. federal statutory tax rate of 21 percent for 2020, 2019 and 2018. +(d) Amounts include (i) average equity securities balances, which are included in investment securities on the Consolidated Balance Sheets, and (ii) the associated income. +(e) The average yield on total interest-earning assets is adjusted for the impacts of the items mentioned in footnote (c). +A-2 +Table of Contents +Years Ended December 31, +(Millions, except percentages) +2020 +Average Balance (a) +2019 +Average Balance (a) +2018 +Average Balance (a) +Non-interest-earning assets +Cash and due from banks +U.S. $ 2,205 $ 2,842 $ 2,793 +Non-U.S. 823 732 527 +Card Member receivables, net +U.S. 27,414 27,724 26,435 +Non-U.S. 16,009 28,040 27,100 +Reserves for credit losses on Card Member and other loans +U.S. (4,682) (2,057) (1,740) +Non-U.S. (526) (258) (217) +Other assets (b) +U.S. 14,680 12,689 12,351 +Non-U.S. 5,830 5,593 5,077 +Total non-interest-earning assets 61,753 75,305 72,326 +U.S. 39,617 41,198 39,839 +Non-U.S. 22,136 34,107 32,487 +Total assets $ 190,079 $ 194,369 $ 182,821 +U.S. 155,526 146,908 138,454 +Non-U.S. 34,553 47,461 44,367 +Percentage of total average assets attributable to non-U.S. activities 18.2 % 24.4 % 24.3 % +(a) Averages based on month-end balances. +(b) Includes premises and equipment, net of accumulated depreciation and amortization. +A-3 +Table of Contents +2020 2019 2018 +Years Ended December 31, +(Millions, except percentages) +Average +Balance (a) +Interest +Expense Average +Rate +Average +Balance (a) +Interest +Expense Average +Rate +Average +Balance (a) +Interest +Expense Average +Rate +Interest-bearing liabilities +Customer deposits +U.S. +Savings $ 69,796 $ 697 1.0 % $ 59,087 $ 1,247 2.1 % $ 50,499 $ 919 1.8 % +Time 9,898 237 2.4 12,179 298 2.4 15,975 357 2.2 +Demand 752 5 0.7 447 9 2.0 285 6 2.1 +Non-U.S. +Other time and savings 11 1 9.1 16 1 6.3 21 1 4.8 +Other demand 11 3 27.3 10 4 40.0 12 4 33.3 +Short-term borrowings +U.S. 769 18 2.3 407 22 5.4 274 14 5.1 +Non-U.S. 2,017 11 0.5 2,621 15 0.6 2,106 19 0.9 +Long-term debt and other (b) +U.S. 48,690 1,123 2.3 57,936 1,859 3.2 54,631 1,613 3.0 +Non-U.S. 336 3 0.9 325 9 2.8 390 10 2.6 +Total interest-bearing liabilities $ 132,280 $ 2,098 1.6 % $ 133,028 $ 3,464 2.6 % $ 124,193 $ 2,943 2.4 % +U.S. 129,905 2,080 130,056 3,435 121,664 2,909 +Non-U.S. 2,375 18 2,972 29 2,529 34 +Non-interest-bearing liabilities +Accounts payable +U.S. 4,642 7,116 7,120 +Non-U.S. 4,737 6,202 6,064 +Customer Deposits (c) +U.S. 766 385 377 +Non-U.S. 682 387 370 +Other liabilities +U.S. 18,954 18,360 18,619 +Non-U.S. 6,016 6,079 5,428 +Total non-interest-bearing liabilities 35,797 38,529 37,978 +U.S. 24,362 25,861 26,116 +Non-U.S. 11,435 12,668 11,862 +Total liabilities 168,077 171,557 162,171 +U.S. 154,267 155,917 147,780 +Non-U.S. 13,810 15,640 14,391 +Total shareholders' equity 22,002 22,812 20,650 +Total liabilities and shareholders' equity +$ 190,079 $ 194,369 $ 182,821 +Percentage of total average liabilities attributable to non-U.S. activities +8.2 % 9.1 % 8.9 % +Interest rate spread 6.3 % 7.6 % 7.2 % +Net interest income and net average yield on interest-earning assets (d)` +$ 7,985 6.2 % $ 8,620 7.2 % $ 7,663 6.9 % +(a) Averages based on month-end balances. +(b) Interest expense primarily reflects interest on long-term financing and interest incurred on derivative instruments in qualifying hedging relationships on the hedged debt instruments. +(c) U.S. non-interest-bearing Customer deposits include average Card Member credit balances of $742 million, $353 million and $342 million for 2020, 2019 and 2018, respectively. Non-U.S. non-interest-bearing Customer deposits include average Card Member credit balances of $679 million, $381 million and $359 million for 2020, 2019 and 2018, respectively. +(d) Net average yield on interest-earning assets is defined as net interest income divided by average total interest-earning assets as adjusted for the items mentioned in footnote (c) from the table on A-1. +A-4 +Table of Contents +Changes in Net Interest Income − Volume and Rate Analysis (a) +The following table presents the amount of changes in interest income and interest expense due to changes in both average volume and average rate. Major categories of interest-earning assets and interest-bearing liabilities have been segregated between U.S. and non-U.S. offices. Average volume/rate changes have been allocated between the average volume and average rate variances on a consistent basis based upon the respective percentage changes in average balances and average rates. +2020 Versus 2019 2019 Versus 2018 +Increase (Decrease) +due to change in: Increase (Decrease) +due to change in: +Years Ended December 31, (Millions) +Average +Volume Average +Rate Net Change Average +Volume Average +Rate Net Change +Interest-earning assets +Interest-bearing deposits in other banks +U.S. $ 216 $ (633) $ (417) $ (47) $ 79 $ 32 +Non-U.S. 6 (3) 3 5 10 15 +Federal funds sold and securities purchased under agreements to resell +U.S. (3) — (3) — 3 3 +Non-U.S. 14 (9) 5 — (1) (1) +Short-term investment securities +U.S. 7 (11) (4) — 5 5 +Non-U.S. — — — — — — +Card Member loans +U.S. (896) (360) (1,256) 730 335 1,065 +Non-U.S. (182) (22) (204) 162 32 194 +Other loans +U.S. (2) (69) (71) 99 2 101 +Non-U.S. (8) 10 2 6 1 7 +Taxable investment securities +U.S. 177 (224) (47) 72 7 79 +Non-U.S. 1 (7) (6) 1 3 4 +Non-taxable investment securities +U.S. (7) 1 (6) (18) 4 (14) +Other assets +Primarily U.S. 6 (3) 3 272 (284) (12) +Change in interest income (671) (1,330) (2,001) 1,282 196 1,478 +Interest-bearing liabilities +Customer deposits +U.S. +Savings 226 (776) (550) 156 172 328 +Time (56) (5) (61) (85) 26 (59) +Demand 6 (10) (4) 3 — 3 +Non-U.S. +Other time and savings — — — — — — +Other demand — (1) (1) (1) 1 — +Short-term borrowings +U.S. 20 (24) (4) 7 1 8 +Non-U.S. (3) (1) (4) 5 (9) (4) +Long-term debt and other +U.S. (297) (439) (736) 98 148 246 +Non-U.S. — (6) (6) (2) 1 (1) +Change in interest expense (104) (1,262) (1,366) 181 340 521 +Change in net interest income $ (567) $ (68) $ (635) $ 1,101 $ (144) $ 957 +(a) Refer to footnotes from “Distribution of Assets, Liabilities and Shareholders’ Equity” for additional information. +A-5 +Table of Contents +Maturities and Sensitivities to Changes in Interest Rates +The following table presents contractual maturities of loans and Card Member receivables by customer type, and segregated between U.S. and non-U.S. based on domicile of the borrowers, and distribution between fixed and floating interest rates for loans due after one year based upon the stated terms of the loan agreements. +December 31, (Millions) +2020 +Within +1 year (a) +1-5 +years (b) (c) +5-15 +years (c) +After +15 years (c) +Total +Loans +U.S. loans +Card Member $ 63,662 $ 482 $ — $ — $ 64,144 +Other 497 2,068 112 57 2,734 +Non-U.S. loans +Card Member 9,229 — — — 9,229 +Other 92 26 — — 118 +Total loans $ 73,480 $ 2,576 $ 112 $ 57 $ 76,225 +Loans due after one year at fixed interest rates +Card Member $ 482 $ — $ — $ 482 +Other 2,070 — 57 2,127 +Loans due after one year at variable interest rates +Card Member — — — — +Other 24 112 — 136 +Total loans $ 2,576 $ 112 $ 57 $ 2,745 +Card Member receivables +U.S. $ 30,287 $ 193 $ — $ — $ 30,480 +Non-U.S. 13,221 — — — 13,221 +Total Card Member receivables $ 43,508 $ 193 $ — $ — $ 43,701 +(a) Card Member loans have no stated maturity and are therefore included in the due within one year category. However, many of our Card Members will revolve their balances, which may extend their repayment period beyond one year for balances outstanding as of December 31, 2020. Card member receivables are due upon receipt of Card Member statements and have no stated interest rate and are therefore included in the due within one year category. +(b) Card Member loans and receivables due after one year represent Troubled Debt Restructurings (TDRs). Card Members experiencing financial difficulties are offered modification programs wherein a long-term concession (more than 12 months) has been granted to the borrower and are classified as TDRs. +(c) Other loans due after one year primarily represents installment loans. +A-6 +Table of Contents +Credit Quality Indicators for Loans and Card Member Receivables +As a result of the adoption of CECL on January 1, 2020, there is a lack of comparability in both the reserves and provisions for credit losses for the periods presented. Results for reporting periods beginning after January 1, 2020 are presented using the CECL methodology, while comparative information continues to be reported in accordance with the incurred loss methodology in effect for prior periods. Refer to Note 1 and Note 3 to the “Consolidated Financial Statements” for further information. +The following table summarizes the ratio of all loans and Card Member receivables categories. +Years Ended December 31, +(Millions, except percentages and where indicated) +2020 2019 +Card Member loans +Net write-offs — principal less recoveries $ 1,795 $ 1,860 +Net write-offs — interest and fees less recoveries $ 375 $ 375 +Average Card Member loans (billions) (a) +$ 74.6 $ 82.8 +Principal only net write-offs / average Card Member loans outstanding (b) +2.4 % 2.2 % +Principal, interest and fees net write-offs / average Card Member loans outstanding (b) +2.9 % 2.7 % +Other loans +Net write-offs $ 111 $ 97 +Average Other loans (billions) (a) +$ 4.2 $ 4.3 +Net write-offs/average other loans outstanding (b) +2.6 % 2.3 % +Card Member receivables +Net write-offs — principal and fees less recoveries $ 881 $ 900 +Average Card Member receivables (billions) (a) +$ 43.9 $ 56.4 +Net write-offs / average Card Member receivables outstanding (b) +2.0 % 1.6 % +Reserve for credit losses $ 5,849 $ 3,154 +Non-accrual loans (c) +$ 176 $ 346 +Reserve for credit losses to total loans and Card Member receivables (d) +4.9 % 2.1 % +Non-accrual loans to total loans (e) +0.2 % 0.4 % +Reserve for credit losses to non-accrual loans (f) +3171.4 % 732.8 % +(a) Averages are based on month-end balances for the periods presented. +(b) The net write-off rate presented is on a worldwide basis and is based on principal losses only (i.e., excluding interest and/or fees) to be consistent with industry convention. In addition, as our practice is to include uncollectible interest and/or fees as part of our total provision for credit losses, a net write-off rate including principal, interest and/or fees is also presented. +(c) Non-accrual loans not in modification programs primarily include certain loans placed with outside collection agencies for which we have ceased accruing interest. Amounts presented exclude loans classified as TDR. Lower non-accrual loans are primarily driven by higher enrollments under In House TDR programs and lower delinquencies. +(d) Represents the reserve for credit losses as a percentage of total loans and Card Member receivables. Refer to “Maturities and Sensitivities to Changes in Interest Rates” for total outstanding balance of loans and Card Member receivables. +(e) Represents percentage of non-accrual loans to total loans. +(f) Represents the total reserve for credit losses on Card Member loans and other loans as a percentage of total non-accrual loans. Refer to “Allocation of reserve for credit losses” for reserve related to Card Member loans and other loans. +A-7 +Table of Contents +Allocation of Reserve for Credit Losses +The following table shows the reserve for credit losses allocated to each of loans and Card Member receivables by customer type, and between U.S. and non-U.S. borrowers. +December 31, 2020 2019 +(Millions, except percentages) +Reserve for credit losses at end of year applicable to +Amount +Percentage (a) +Amount +Percentage (a) +Loans +U.S. loans +Card Member $ 4,820 86 % $ 2,085 82 % +Other 228 4 150 6 +Non-U.S. loans +Card Member 524 10 298 12 +Other 10 — 2 — +$ 5,582 100 % $ 2,535 100 % +Card Member receivables +U.S. $ 216 81 % $ 406 66 % +Non-U.S. 51 19 213 34 +$ 267 100 % $ 619 100 % +(a) Percentage of reserve for credit losses on loans and Card Member receivables in each category to the total reserve. +A-8 +Table of Contents +Uninsured Time Certificates of Deposit +The following table presents the amount of uninsured time certificates of deposit issued by us in our U.S. and Non U.S. offices, further segregated by time remaining until maturity. For any account holder with aggregate deposits in excess of insured limits, the uninsured deposits are calculated proportionately as a percentage of total deposits for each category of deposits held as of the reporting date. +By remaining maturity as of December 31, 2020 +(Millions) 3 months +or less Over 3 months +but within 6 months Over 6 months +but within 12 months Over +12 months Total +U.S. (a) +$ 65 $ 53 $ 100 $ 118 $ 336 +Non U.S. (b) +$ 2 $ 1 $ 4 $ — $ 7 +(a) We offer deposits within our U.S. bank subsidiary, AENB. These funds are currently insured up to $250,000 per account holder through the FDIC. +(b) Includes time deposits in certain of our Non-U.S. offices, that exceed the insurance limit as defined by the regulatory rules in individual markets. +A-9 \ No newline at end of file diff --git a/raw/filings/0000004962/2020/0000004962-21-000013/filing_metadata.csv b/raw/filings/0000004962/2020/0000004962-21-000013/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..119a2bc767a6486a4e1e6a1f8a7c8285ad66cac4 --- /dev/null +++ b/raw/filings/0000004962/2020/0000004962-21-000013/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004962,AXP,AMERICAN EXPRESS CO,2020,10-K,2021-02-12,2020-12-31,2021-02-12T19:26:54.000Z,0000004962-21-000013,axp-20201231.htm,10-K,23801549,1,1,https://www.sec.gov/Archives/edgar/data/4962/000000496221000013/axp-20201231.htm,https://www.sec.gov/Archives/edgar/data/4962/000000496221000013/ diff --git a/raw/filings/0000004962/2020/0000004962-21-000013/item1.txt b/raw/filings/0000004962/2020/0000004962-21-000013/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..453bfa8b45c040ec0bd2dbef8bb49aaf7f9d9f27 --- /dev/null +++ b/raw/filings/0000004962/2020/0000004962-21-000013/item1.txt @@ -0,0 +1,239 @@ +ITEM 1. BUSINESS +Overview +American Express is a globally integrated payments company that provides our customers with access to products, insights and experiences that enrich lives and build business success. We are a leader in providing credit and charge cards to consumers, small businesses, mid-sized companies and large corporations around the world. American Express ® cards issued by American Express as well as by third-party banks and other institutions on the American Express network permit Card Members to charge purchases of goods and services at the millions of merchants around the world that accept cards bearing our logo. +Our various products and services are sold globally to diverse customer groups through various channels, including mobile and online applications, affiliate marketing, customer referral programs, third-party vendors and business partners, direct mail, telephone, in-house sales teams and direct response advertising. Business travel-related services are offered through our non-consolidated joint venture, American Express Global Business Travel (the GBT JV). +We were founded in 1850 as a joint stock association and were incorporated in 1965 as a New York corporation. American Express Company and its principal operating subsidiary, American Express Travel Related Services Company, Inc. (TRS), are bank holding companies under the Bank Holding Company Act of 1956, as amended (the BHC Act), subject to supervision and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). +We principally engage in businesses comprising three reportable operating segments: Global Consumer Services Group (GCSG), Global Commercial Services (GCS) and Global Merchant and Network Services (GMNS). Corporate functions and certain other businesses are included in Corporate & Other. Our businesses are global in scope and function together to form our end-to-end integrated payments platform, which we believe is a differentiator that underpins our business model. The COVID-19 pandemic has brought unprecedented challenges to businesses and economies around the world. While our business was significantly impacted by the pandemic in 2020 as further described in this report, we believe our progress in managing through it confirms the resilience of our differentiated business model. +For further information about our reportable operating segments, please see “Business Segment Results of Operations” under “MD&A.” +1 +Table of Contents +Our Integrated Payments Platform +Through our general-purpose card-issuing, merchant-acquiring and card network businesses, we are able to connect participants and provide differentiated value across the commerce path. We maintain direct relationships with both our Card Members (as a card issuer) and merchants (as an acquirer), and we handle all key aspects of those relationships. These relationships create a “closed loop” in that we have direct access to information at both ends of the card transaction, which distinguishes our integrated payments platform from the bankcard networks. +Our integrated payments platform allows us to analyze information on Card Member spending and build algorithms and other analytical tools that we use to underwrite risk, reduce fraud and provide targeted marketing and other information services for merchants and special offers and services to Card Members, all while respecting Card Member preferences and protecting Card Member and merchant data in compliance with applicable policies and legal requirements. Through contractual relationships, we also obtain information from third-party card issuers, merchant acquirers, aggregators and processors with whom we do business. +Card Issuing Businesses +Our global proprietary card-issuing businesses are conducted through our GCSG and GCS reportable operating segments. We offer a broad set of card products, rewards and services to a diverse consumer and commercial customer base, in the United States and internationally. We acquire and retain high-spending, engaged and creditworthy Card Members by: +• Designing innovative products and features that appeal to our target customer base and meet their spending and borrowing needs +• Using incentives to drive spending on our various card products and engender loyal Card Members, including our Membership Rewards ® program, cash-back reward features and participation in loyalty programs sponsored by our cobrand and other partners +• Providing digital and mobile services and an array of benefits and experiences across card products, such as airport lounge access and other travel and lifestyle benefits, which we believe are difficult for others to replicate and help increase Card Member engagement +• Creating world-class service experiences by delivering exceptional customer care +• Developing a wide range of partner relationships, including with other corporations and institutions that sponsor certain of our cards under cobrand arrangements and provide benefits and services to our Card Members +During 2020, we enhanced our value propositions on many of our card products, including adjusting our rewards programs and adding limited time offers and statement credits in categories that are relevant in the current environment, such as wireless, streaming services, business essentials and food delivery. We also created a Customer Pandemic Relief Program to provide short-term support for customers impacted by COVID-19, and we enhanced and expanded our longer-term Financial Relief Program for Card Members who need additional financial assistance during this time. Additionally, we participated in the U.S. Small Business Administration Paycheck Protection Program (PPP), designed to provide small businesses with support to cover payroll and certain other expenses. +For the year ended December 31, 2020, worldwide proprietary billed business (spending on American Express cards issued by us) was $870.7 billion and at December 31, 2020, we had 68.9 million proprietary cards-in-force worldwide. +Merchant Acquiring Business +Our GMNS reportable operating segment builds and manages relationships with millions of merchants around the world that choose to accept American Express cards. This includes signing new merchants to accept our cards, agreeing on the discount rate (a fee charged to the merchant for accepting our cards) and handling servicing for merchants. We also build and maintain relationships with merchant acquirers, aggregators and processors to manage aspects of our merchant services business. For example, through our OptBlue ® merchant-acquiring program, third-party acquirers contract directly with small merchants for card acceptance on our network and determine merchant pricing. We continue to grow merchant acceptance of American Express cards around the world and work with merchant partners so that our Card Members are warmly welcomed and encouraged to spend in the millions of places where their American Express cards are accepted. +2 +Table of Contents +GMNS also provides fraud-prevention tools, marketing solutions, data analytics and other programs and services to merchants and other partners that leverage the capabilities of our integrated payments platform. +During 2020, we adjusted certain policies to back our merchant partners in the current environment, including raising contactless transaction thresholds and reminding them that we do not require Card Members’ signatures at the point of sale. We also launched our largest-ever Shop Small campaign to support small businesses around the world, which have been significantly impacted by the pandemic. +Card Network Business +We operate a payments network through which we establish and maintain relationships with third-party banks and other institutions in approximately 98 countries and territories, licensing the American Express brand and extending the reach of our global network. These network partners are licensed to issue local currency American Express-branded cards in their countries and/or serve as the merchant acquirer for local merchants on our network. +During 2020, our joint venture with Lianlian DigiTech Co., Ltd, a Chinese fintech services company, received approval from the People’s Bank of China for a network clearing license and began processing transactions in mainland China. +For the year ended December 31, 2020, worldwide network services billed business (spending on American Express cards issued by third parties) was $139.9 billion and at December 31, 2020, we had 43.1 million cards-in-force issued by third parties worldwide. +Diverse Customer Base and Global Footprint +Our broad and diverse customer base spans consumers, small businesses, mid-sized companies and large corporations around the world. The following charts provide a summary of our diverse set of customers and broad geographic footprint based on billed business volumes: +3 +Table of Contents +Partners and Relationships +Our integrated payments platform allows us to work with a range of business partners, and our partners in return help drive the scale and relevance of the platform. +There are many examples of how we connect partners with our integrated payments platform, including: issuing cards under cobrand arrangements with other corporations and institutions (e.g., Delta Air Lines, Marriott International, Hilton Worldwide Holdings and British Airways); offering innovative ways for our Card Members to earn and use points with our merchants (e.g., Pay with Points at Amazon.com); expanding merchant acceptance with third-party acquirers (e.g., OptBlue partners); developing new capabilities and features with our digital partners (e.g., PayPal); integrating into the supplier payment processes of our business customers (e.g., Bill.com, SAP Ariba and Coupa); and extending the platform into travel services with American Express leisure and business travel (e.g., Fine Hotels and Resorts). +Delta Air Lines is our largest strategic partner. Our relationships with, and revenues and expenses related to, Delta are significant and represent a significant source of value for our Card Members. We issue cards under cobrand arrangements with Delta and the Delta cobrand portfolio represented approximately 9 percent of our worldwide billed business and approximately 21 percent of worldwide Card Member loans as of December 31, 2020. The Delta cobrand portfolio generates fee revenue and interest income from Card Members and discount revenue from Delta and other merchants for spending on Delta cobrand cards. The current Delta cobrand agreement runs through the end of 2029 and we expect to continue to make significant investments in this partnership. Among other things, Delta is also a key participant in our Membership Rewards program, provides travel-related benefits and services, including airport lounge access for certain American Express Card Members, accepts American Express cards as a merchant and is a corporate payments customer. +Working with all of our partners, we seek to provide value, choice and unique experiences across our customer base. +Our Spend-Centric Model and Revenue Mix +Our “spend-centric” business model focuses on generating revenues primarily by driving spending on our cards and secondarily through finance charges and fees. Spending on our cards, which is higher on average on a per-card basis versus our competitors, offers superior value to merchants in the form of loyal customers and larger transactions. Because of the revenues generated from having high-spending Card Members and the annual card fees we charge on many of our products, we are able to invest in attractive rewards and other benefits for Card Members, as well as targeted marketing and other programs and investments for merchants. This creates incentives for Card Members to spend more on their cards and positively differentiates American Express cards. +We believe our spend-centric model gives us the ability to provide differentiated value to Card Members, merchants and business partners. +The American Express Brand and Service Excellence +Our brand and its attributes—trust, security and service—are key assets. We invest heavily in managing, marketing, promoting and protecting our brand, including through the delivery of our products and services in a manner consistent with our brand promise. The American Express brand is consistently ranked as one of the most valuable brands in the world. We place significant importance on trademarks, service marks and patents, and seek to secure our intellectual property rights around the world. +We aim to provide the world’s best customer experience every day and our reputation for world-class service has been recognized by numerous awards over the years. Our customer care professionals and partners treat servicing interactions as an opportunity to bring the brand to life for our customers, add meaningful value and deepen relationships. +4 +Table of Contents +Our Business Strategies +Our framework for managing through the pandemic and the challenging economic environment is built on four principles: supporting our colleagues and winning as a team; protecting our customers and our brand; structuring the company for growth in the future; and remaining financially strong. We remain focused on what we can control in the short term while identifying opportunities across our businesses to position ourselves for growth in the longer term. And we seek to grow our business over the longer term by focusing on four strategic imperatives: +First, we aim to expand our leadership in the premium consumer space by continuing to deliver membership benefits that span our customers’ everyday spending, borrowing, travel and lifestyle needs, expanding our roster of business partners around the globe and developing a range of experiences that attract high-spending customers. +Second, we seek to build on our strong position in commercial payments by evolving our card value propositions, further differentiating our corporate card and accounts payable expense management solutions and designing innovative products and features, including financing and supplier payment solutions for our business customers. +Third, we are focused on strengthening our global network to provide unique value by continuing to help merchants navigate the convergence of online and offline commerce with fraud protection services, marketing insights and digital connections to higher-spending Card Members and continuing to work with our network partners to offer expanded products and services. +Finally, we want to continue to make American Express an essential part of our customers’ digital lives by developing more digital features, solutions and services, expanding our digital partnerships and making targeted acquisitions. +5 +Table of Contents +Our Colleagues +We are committed to delivering a great colleague experience every day, cultivating the best talent and developing new ways of working to unlock enterprise value. We work to foster an inclusive and diverse culture and help our colleagues thrive both professionally and personally. When we do, our colleagues are more engaged, committed, creative and effective in driving results. At the heart of our culture is what we call our Blue Box Values – a set of guiding principles that reflect who we are and what we stand for. In 2020, we updated our Blue Box Values to be more explicit about our efforts to create an inclusive and diverse workforce: +We Back Our Customers We Embrace Diversity +We Make It Great We Stand for Inclusion +We Do What's Right We Win as A Team +We Respect People We Support Our Communities +We take a holistic approach to serving our colleagues by offering them a variety of resources that support their physical, financial, emotional, social and overall well-being. Throughout the pandemic, one of our top priorities has been to ensure our colleagues have the flexibility and resources they need to stay safe, healthy and productive. +As of December 31, 2020, we employed approximately 63,700 people, whom we refer to as colleagues, with approximately 22,700 colleagues in the United States and approximately 41,000 colleagues outside the United States. We conduct an annual Colleague Experience Survey to better understand our colleagues’ needs and overall experience at American Express and in 2020, 94 percent of colleagues who participated in the survey said they would recommend American Express as a great place to work. Our 2020 annual company scorecard included talent retention and diversity representation goals to globally increase minority and women representation at management levels and retain our key talent. As of December 31, 2020, female colleagues comprised 52 percent of our global workforce and Asian, Black/African American and Hispanic/Latinx people represented 19.7 percent, 12.0 percent and 13.0 percent, respectively, of our U.S. workforce based on preliminary data for our 2020 U.S. EEO-1 submission. +We regularly review our compensation practices to ensure colleagues in the same job, level and location are compensated fairly regardless of gender globally, and race and ethnicity in the United States. These reviews consider several factors known to affect compensation, including role, level, tenure, performance and geography. In the few instances where a review has found inconsistencies, we have made adjustments. After making these adjustments, we believe we achieved 100 percent pay equity in 2020 for colleagues across genders globally and across races and ethnicities in the United States. +6 +Table of Contents +Information About Our Executive Officers +Set forth below, in alphabetical order, is a list of our executive officers as of February 12, 2021, including each executive officer’s principal occupation and employment during the past five years and reflecting recent organizational changes. None of our executive officers has any family relationship with any other executive officer, and none of our executive officers became an officer pursuant to any arrangement or understanding with any other person. Each executive officer has been elected to serve until the next annual election of officers or until his or her successor is elected and qualified. Each officer’s age is indicated by the number in parentheses next to his or her name. +7 +Table of Contents +DOUGLAS E. BUCKMINSTER — Group President, Global Consumer Services Group +Mr. Buckminster (60) has been Group President, Global Consumer Services Group since February 2018. Prior thereto, he had been President, Global Consumer Services Group since October 2015. +JEFFREY C. CAMPBELL — Chief Financial Officer +Mr. Campbell (60) has been Chief Financial Officer since August 2013. +MARC D. GORDON — Chief Information Officer +Mr. Gordon (60) has been Chief Information Officer since September 2012. +MONIQUE HERENA — Chief Colleague Experience Officer +Ms. Herena (49) has been Chief Colleague Experience Officer since April 2019. Ms. Herena joined American Express from BNY Mellon, where she served as the Chief Human Resources Officer and Senior Executive Vice President, Human Resources, Marketing and Communications since 2014. +RAYMOND JOABAR — Chief Risk Officer and President, Global Risk & Compliance +Mr. Joabar (55) has been Chief Risk Officer and President, Global Risk & Compliance since September 2019. Prior thereto, he had been President of International Consumer Services and Global Travel and Lifestyle Services since February 2018. He also served as Executive Vice President, Global Servicing Network from February 2016 to February 2018 and Executive Vice President, World Service from November 2015 to February 2016. +ANNA MARRS — President, Global Commercial Services +Ms. Marrs (47) has been President, Global Commercial Services since September 2018. Ms. Marrs joined American Express from Standard Chartered Bank, where she served as Regional CEO, ASEAN and South Asia since November 2016 and CEO, Commercial and Private Banking since October 2015. +DENISE PICKETT — President, Global Services Group +Ms. Pickett (55) has been President, Global Services Group since September 2019. Prior thereto, she had been Chief Risk Officer and President, Global Risk, Banking & Compliance since February 2018 and President, U.S. Consumer Services since October 2015. +ELIZABETH RUTLEDGE — Chief Marketing Officer +Ms. Rutledge (59) has been Chief Marketing Officer since February 2018. Prior thereto, she had been Executive Vice President, Global Advertising & Media since February 2016 and Executive Vice President, Card Products & Benefits since May 2013. +LAUREEN E. SEEGER — Chief Legal Officer +Ms. Seeger (59) has been Chief Legal Officer since July 2014. +JENNIFER SKYLER — Chief Corporate Affairs Officer +Ms. Skyler (44) has been Chief Corporate Affairs Officer since October 2019. Ms. Skyler joined American Express from The We Company, where she had been Chief Communications Officer from January 2018 to September 2019. Prior thereto, she had been Global Head of Public Affairs from January 2016 to January 2018. +STEPHEN J. SQUERI — Chairman and Chief Executive Officer +Mr. Squeri (61) has been Chairman and Chief Executive Officer since February 2018. Prior thereto, he had been Vice Chairman since July 2015. +ANRÉ WILLIAMS — Group President, Global Merchant and Network Services +Mr. Williams (55) has been Group President, Global Merchant and Network Services since February 2018. Prior thereto, he had been President of Global Merchant Services and Loyalty since October 2015. +8 +Table of Contents +COMPETITION +We compete in the global payments industry with card networks, issuers and acquirers, paper-based transactions (e.g., cash and checks), bank transfer models (e.g., wire transfers and Automated Clearing House, or ACH), as well as evolving and growing alternative mechanisms, systems and products that leverage new technologies, business models and customer relationships to create payment or financing solutions. The payments industry continues to undergo dynamic changes in response to evolving technologies, consumer habits and merchant needs, some of which have accelerated as a result of the pandemic, such as an increased shift to e-commerce and demand for contactless payments. +As a card issuer, we compete with financial institutions that issue general-purpose credit and debit cards. We also encounter competition from businesses that issue private label cards, operate mobile wallets or extend credit. We face intense competition for cobrand relationships, as both card issuer and network competitors have targeted key business partners with attractive value propositions. +Our global card network competes in the global payments industry with other card networks, including, among others, China UnionPay, Visa, Mastercard, JCB, Discover and Diners Club International (which is owned by Discover). We are the fourth largest general-purpose card network globally based on purchase volume, behind China UnionPay, Visa and Mastercard. In addition to such networks, a range of companies globally, including merchant acquirers, processors and web- and mobile-based payment platforms (e.g., Alipay, PayPal and Venmo), as well as regional payment networks (such as the National Payments Corporation of India), carry out some activities similar to those performed by our GMNS business. +The principal competitive factors that affect the card-issuing, merchant and network businesses include: +• The features, value and quality of the products and services, including customer care, rewards programs, partnerships, benefits and digital and mobile services, and the costs associated with providing such features and services +• Reputation and brand recognition +• The number, spending characteristics and credit performance of customers +• The quantity, diversity and quality of the establishments where the cards can be used +• The attractiveness of the value proposition to card issuers, merchant acquirers, cardholders, corporate clients and merchants (including the relative cost of using or accepting the products and services, and capabilities such as fraud prevention and data analytics) +• The number and quality of other cards and other forms of payment and financing available to customers +• The success of marketing and promotional campaigns +• The speed of innovation and investment in systems, technologies, and product and service offerings +• The nature and quality of expense management tools, electronic payment methods and data capture and reporting capabilities, particularly for business customers +• The security of cardholder, merchant and network partner information +Another aspect of competition is the dynamic and rapid growth of alternative payment and financing mechanisms, systems and products, which include payment aggregators, digital payment and electronic wallet platforms, point-of-sale lenders, real-time settlement and processing systems, financial technology companies, digital currencies developed by both governments and the private sector, blockchain and similar distributed ledger technologies, prepaid systems and gift cards, and systems linked to customer accounts or that provide payment solutions. Various competitors are integrating more financial services into their product offerings and competitors are seeking to attain the benefits of closed-loop, loyalty and rewards functionalities, such as ours. +9 +Table of Contents +In addition to the discussion in this section, see “ Our operating results may materially suffer because of substantial and increasingly intense competition worldwide in the payments industry ” in “Risk Factors” for further discussion of the potential impact of competition on our business, and “ Our business is subject to comprehensive government regulation and supervision, which could materially adversely affect our results of operations and financial condition” and “ Legal proceedings regarding provisions in our merchant contracts, including non-discrimination and honor-all-cards provisions, could have a material adverse effect on our business and result in additional litigation and/or arbitrations, substantial monetary damages and damage to our reputation and brand ” in “Risk Factors” for a discussion of the potential impact on our ability to compete effectively due to government regulations or if ongoing legal proceedings limit our ability to prevent merchants from engaging in various actions to discriminate against our card products. +10 +Table of Contents +SUPERVISION AND REGULATION +Overview +We are subject to extensive government regulation and supervision in jurisdictions around the world, and the costs of compliance are substantial. The financial services industry is subject to rigorous scrutiny, high regulatory expectations, a range of regulations and a stringent and unpredictable enforcement environment. +Governmental authorities have focused, and we believe will continue to focus, considerable attention on reviewing compliance by financial services firms with laws and regulations, and as a result, we continually work to evolve and improve our risk management framework, governance structures, practices and procedures. Reviews to assess compliance with laws and regulations by governmental authorities, as well as our own internal reviews, have resulted in, and are likely to continue to result in, changes to our products, practices and procedures, restitution to our customers and increased costs related to regulatory oversight, supervision and examination. We have also been subject to regulatory actions and may continue to be the subject of such actions, including governmental inquiries, investigations, enforcement proceedings and the imposition of fines or civil money penalties, in the event of noncompliance or alleged noncompliance with laws or regulations. In addition, legislators and regulators in various countries in which we operate have focused on the offering of consumer financial products and the operation of payment networks, resulting in changes to certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, the establishment of broad and ongoing regulatory oversight regimes. +See “Risk Factors—Legal, Regulatory and Compliance Risks” for a discussion of the potential impact legislative and regulatory changes may have on our results of operations and financial condition. +Banking Regulation +Federal and state banking laws, regulations and policies extensively regulate the Company (which, for purposes of this section, refers to American Express Company as a bank holding company), TRS and our U.S. bank subsidiary, American Express National Bank (AENB). Both the Company and TRS are subject to comprehensive consolidated supervision, regulation and examination by the Federal Reserve and AENB is supervised, regulated and examined by the Office of the Comptroller of the Currency (OCC). The Company and its subsidiaries are also subject to the rulemaking, enforcement and examination authority of the Consumer Financial Protection Bureau (CFPB). Banking regulators have broad examination and enforcement power, including the power to impose substantial fines, limit dividends and other capital distributions, restrict operations and acquisitions and require divestitures, any of which could compromise our competitive position. Many aspects of our business also are subject to rigorous regulation by other U.S. federal and state regulatory agencies and by non-U.S. government agencies and regulatory bodies. +Activities +The BHC Act generally limits bank holding companies to activities that are considered to be banking activities and certain closely related activities. As noted above, each of the Company and TRS is a bank holding company and each has elected to become a financial holding company, which is authorized to engage in a broader range of financial and related activities. In order to remain eligible for financial holding company status, we must meet certain eligibility requirements. Those requirements include that each of the Company and AENB must be “well capitalized” and “well managed,” and AENB must have received at least a “satisfactory” rating on its most recent assessment under the Community Reinvestment Act of 1977 (the CRA). The Company and TRS engage in various activities permissible only for financial holding companies, including, in particular, providing travel agency services, acting as a finder and engaging in certain insurance underwriting and agency services. If the Company fails to meet eligibility requirements for financial holding company status, it and its subsidiaries are likely to be barred from engaging in new types of financial activities or making certain types of acquisitions or investments in reliance on its status as a financial holding company, and ultimately could be required to either discontinue the broader range of activities permitted to financial holding companies or divest AENB. In addition, the Company and its subsidiaries are prohibited by law from engaging in practices that the relevant regulatory authority deems unsafe or unsound (which such authorities generally interpret broadly). +11 +Table of Contents +Acquisitions and Investments +Applicable federal and state laws place limitations on the ability of persons to invest in or acquire control of us without providing notice to or obtaining the approval of one or more of our regulators. In addition, we are subject to banking laws and regulations that limit our investments and acquisitions and, in some cases, subject them to the prior review and approval of our regulators, including the Federal Reserve and the OCC. Federal banking regulators have broad discretion in evaluating proposed acquisitions and investments that are subject to their prior review or approval. +Financial Regulatory Reform +In October 2019, the U.S. federal bank regulatory agencies finalized rules that tailor the application of the enhanced prudential standards to bank holding companies and depository institutions (the Tailoring Rules) pursuant to the amendments to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank) introduced by the Economic Growth, Regulatory Relief, and Consumer Protection Act. The Tailoring Rules assign each U.S. bank holding company with $100 billion or more in total consolidated assets, as well as its bank subsidiaries, to one of four categories based on its status as a U.S. global systemically important banking organization and five other risk-based indicators: (i) size, (ii) cross-jurisdictional activity, (iii) non-bank assets, (iv) off-balance sheet exposure, and (v) weighted short-term wholesale funding. +Under the Tailoring Rules, the Company (and, pursuant to the Tailoring Rules, its depository institution subsidiary, AENB) is subject to Category IV standards. +Because a firm’s categorization under the Tailoring Rules is determined by, and can change over time dependent upon, how the firm measures against the risk-based indicator thresholds, we are required to monitor and periodically report these risk-based indicators and there can be no assurance that the Company will continue to be a Category IV firm in the future. +Capital and Liquidity Regulation +Capital Rules +The Company and AENB are required to comply with the applicable capital adequacy rules established by federal banking regulators. These rules are intended to ensure that bank holding companies and depository institutions (collectively, banking organizations) have adequate capital given their level of assets and off-balance sheet obligations. The federal banking regulators’ current capital rules (the Capital Rules) implement the Basel Committee on Banking Supervision’s (the Basel Committee) framework for strengthening international capital regulation, known as Basel III. For additional information regarding our capital ratios, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +Under the Capital Rules, banking organizations are required to maintain minimum ratios for Common Equity Tier 1 (CET1), Tier 1 capital (that is, CET1 plus additional Tier 1 capital) and Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets. We report our capital adequacy ratios using risk-weighted assets calculated under the standardized approach. As a Category IV firm, we are not subject to the advanced approaches capital requirements. +In December 2017, the Basel Committee published standards that, among other things, revise the standardized approach for credit risk (including by recalibrating risk weights and introducing additional capital requirements for certain “unconditionally cancellable commitments” such as unused credit card lines of credit) and provide a new standardized calculation for operational risk capital requirements. If adopted in the United States as issued by the Basel Committee and applicable to us, the new standards could result in higher capital requirements for us. +In December 2018, federal banking regulators issued a final rule that provides an optional three-year phase-in period for the adverse regulatory capital effects of adopting the Current Expected Credit Loss (CECL) methodology pursuant to new accounting guidance for the recognition of credit losses on certain financial instruments, which became effective January 1, 2020. In August 2020, federal banking regulators issued a final rule that provides an option to delay the estimated impact of the adoption of the CECL methodology on regulatory capital for up to two years, followed by the three-year phase-in period. We elected to adopt the two-year delay followed by the three-year phase-in period. Therefore, the Company will begin phasing in the cumulative amount that is not recognized in regulatory capital at 25 percent per year beginning January 1, 2022. See "Critical Accounting Estimates" under "MD&A" for additional information on CECL. +12 +Table of Contents +The Company and AENB must each maintain CET1, Tier 1 capital and Total capital ratios of at least 4.5 percent, 6.0 percent and 8.0 percent, respectively. On top of these minimum capital ratios, the Company is subject to a dynamic stress capital buffer (SCB) composed entirely of CET1 with a floor of 2.5 percent and AENB is subject to a static 2.5 percent capital conservation buffer (CCB). The SCB equals (i) the difference between a bank holding company’s starting and minimum projected CET1 capital ratios under the supervisory severely adverse scenario under the Federal Reserve's stress tests described below, plus (ii) one year of planned common stock dividends as a percentage of risk-weighted assets. +In August 2020, the SCB requirement for the Company was set at 2.5 percent. A bank holding company’s SCB requirement is generally effective on October 1 of each year and will remain in effect through September 30 of the following year unless it is reset in connection with resubmission of a capital plan, as discussed below. As a result, the effective minimum ratios for the Company (taking into account the SCB requirement) and AENB (taking into account the CCB requirement) are 7.0 percent, 8.5 percent and 10.5 percent for the CET1, Tier 1 capital and Total capital ratios, respectively. Banking organizations whose ratios of CET1, Tier 1 Capital or Total capital to risk-weighted assets are below these effective minimum ratios face constraints on discretionary distributions such as dividends, repurchases and redemptions of capital securities, and executive compensation. The capital distribution restrictions for the first quarter of 2021 discussed under “Stress Testing and Capital Planning” below are in addition to the SCB distribution constraints for bank holding companies at least through March 31, 2021. The Federal Reserve is expected to announce by March 31, 2021 any recalibration of the SCB requirements announced in August 2020. +We are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its average total consolidated assets (as defined for regulatory purposes). All banking organizations are required to maintain a leverage ratio of at least 4.0 percent. +Liquidity Regulation +The Federal Reserve’s enhanced prudential standards rule includes heightened liquidity and overall risk management requirements. The rule requires the maintenance of a liquidity buffer, consisting of highly liquid assets, that is sufficient to meet projected net outflows for 30 days over a range of liquidity stress scenarios, and a minimum liquidity coverage ratio (LCR) that measures a firm’s high-quality liquid assets to its projected net outflows. Under the Tailoring Rules, Category IV firms with less than $50 billion in weighted short-term wholesale funding, such as the Company, are not subject to any LCR requirement. +A second standard provided for in the Basel III liquidity framework, referred to as the net stable funding ratio (NSFR), requires a minimum amount of longer-term funding based on the assets and activities of banking entities. Under the final NSFR rule published in October 2020, Category IV firms with less than $50 billion in weighted short-term wholesale funding, such as the Company, are not subject to any NSFR requirement. +Stress Testing and Capital Planning +Under the Federal Reserve’s regulations, the Company is subject to supervisory stress testing requirements that are designed to evaluate whether a bank holding company has sufficient capital on a total consolidated basis to absorb losses and support operations under adverse economic conditions. As a Category IV firm, the Company was subject to the Federal Reserve’s supervisory stress tests in 2020 and will be required to participate in the supervisory stress tests every other year thereafter. +We are required to develop and submit to the Federal Reserve an annual capital plan. In January 2021, the Federal Reserve finalized changes to the capital plan rule, which will, among other things, provide firms subject to Category IV standards additional flexibility to develop their capital plans. In addition, these changes provide that for Category IV firms, such as the Company, the portion of the SCB based on the Federal Reserve's supervisory stress tests will be calculated every other year. During a year in which a Category IV firm does not undergo a supervisory stress test, the firm will receive an updated SCB that reflects the firm's updated planned common stock dividends. A Category IV firm will also be able to elect to participate in the supervisory stress test and consequently receive an updated SCB. The Company must notify the Federal Reserve by April 5, 2021 if it elects to participate in the 2021 supervisory stress test. As part of the Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve evaluates whether the Company has sufficient capital to continue operations by assessing our pro-forma capital position and ratios under a scenario of economic and financial market stress, and uses that information to determine the size of the SCB for each CCAR participating firm. +13 +Table of Contents +Due to the continued economic uncertainty from the coronavirus pandemic, in June 2020, the Federal Reserve required all bank holding companies participating in CCAR to resubmit their capital plans in November 2020. In addition, the Federal Reserve prohibited share repurchases in the third and fourth quarters of 2020 for all bank holding companies participating in CCAR and allowed them to pay common stock dividends provided (a) they did not increase the amount of the dividend and (b) the dividends did not exceed the average of a firm’s net income for the four preceding calendar quarters. On December 18, 2020, the Federal Reserve released the results of its second round of supervisory stress tests for all bank holding companies participating in CCAR based on economic scenarios reflecting changes in financial markets and the macroeconomic outlook. The Federal Reserve announced that it would allow bank holding companies participating in CCAR to pay common stock dividends and repurchase common stock in the first quarter of 2021 provided (a) the dividends and repurchases, in the aggregate, do not exceed the average of a firm’s net income for the four preceding calendar quarters and (b) the firm does not increase the amount of its common stock dividends beyond the level paid in the second quarter of 2020. The Federal Reserve also announced that it would permit stock repurchases equal to the amount of share issuances related to expensed employee compensation. For additional information regarding our capital distributions, see “Consolidated Capital Resources and Liquidity” under “MD&A.” +We may be required to revise and resubmit our capital plan following certain events or developments, such as a significant acquisition or an event that could result in a material change in our risk profile or financial condition. If we are required to resubmit our capital plan, we must receive prior approval from the Federal Reserve for any capital distributions (including common stock dividend payments and share repurchases), other than a capital distribution on a newly issued capital instrument. +Dividends and Other Capital Distributions +The Company and TRS, as well as AENB and the Company’s insurance and other regulated subsidiaries, are limited in their ability to pay dividends by statutes, regulations and supervisory policy. +Common stock dividend payments and share repurchases by the Company are subject to the oversight of the Federal Reserve, as described above. The Company will be subject to limitations and restrictions on capital distributions if, among other things, (i) the Company's regulatory capital ratios do not satisfy applicable minimum requirements and buffers or (ii) the Company is required to resubmit its capital plan. +In general, federal laws and regulations prohibit, without first obtaining the OCC’s approval, AENB from making dividend distributions to TRS, if such distributions are not paid out of available recent earnings or would cause AENB to fail to meet capital adequacy standards. In addition to specific limitations on the dividends AENB can pay to TRS, federal banking regulators have authority to prohibit or limit the payment of a dividend if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the institution. +Prompt Corrective Action +The Federal Deposit Insurance Act (FDIA) requires, among other things, that federal banking regulators take prompt corrective action in respect of depository institutions insured by the FDIC (such as AENB) that do not meet minimum capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. In order to be considered “well capitalized,” AENB must maintain CET1, Tier 1 capital, Total capital and Tier 1 leverage ratios of 6.5 percent, 8.0 percent, 10.0 percent and 5.0 percent, respectively. +Under the FDIA, AENB could be prohibited from accepting brokered deposits (i.e., deposits raised through third-party brokerage networks) or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A portion of our outstanding U.S. retail deposits are considered brokered deposits for bank regulatory purposes. If a federal regulator determines that we are in an unsafe or unsound condition or that we are engaging in unsafe or unsound banking practices, the regulator may reclassify our capital category or otherwise place restrictions on our ability to accept or solicit brokered deposits. +On December 15, 2020, the FDIC finalized a rule intended to update and modernize the FDIC’s brokered deposit regulations. The final rule, among other things, expands the definition of “deposit broker” and updates the interest rate restrictions for less than well capitalized banks. The final rule is expected to become effective on April 1, 2021. +14 +Table of Contents +Resolution Planning +Pursuant to Dodd Frank, certain bank holding companies are required to submit resolution plans to the Federal Reserve and FDIC providing for the company’s strategy for rapid and orderly resolution in the event of its material financial distress or failure. However, in connection with the release of the Tailoring Rules, the Federal Reserve and FDIC finalized rules in October 2019 which, among other things, adjust the review cycles and applicability of the agencies’ resolution planning requirements. Under these rules, Category IV firms such as the Company are not required to submit a holding company resolution plan. +AENB continues to be required to prepare and provide a separate resolution plan to the FDIC that would enable the FDIC, as receiver, to effectively resolve AENB under the FDIA in the event of failure. The FDIC issued an Advance Notice of Proposed Rulemaking on potential revisions to this separate resolution plan requirement for insured depository institutions in April 2019 and temporarily suspended resolution planning requirements for insured depository institutions. In January 2021, the FDIC lifted the moratorium on resolution plan submissions for insured depository institutions with $100 billion or more in assets, including AENB, and will provide at least 12-months advance notice to firms required to submit resolution plans. +Orderly Liquidation Authority +The Company could become subject to the Orderly Liquidation Authority (OLA), a resolution regime under which the Treasury Secretary may appoint the FDIC as receiver to liquidate a systemically important financial institution, if the Company is in danger of default and is determined to present a systemic risk to U.S. financial stability. As under the FDIC resolution model, under the OLA, the FDIC has broad power as receiver. Substantial differences exist, however, between the OLA and the FDIC resolution model for depository institutions, including the right of the FDIC under the OLA to disregard the strict priority of creditor claims in limited circumstances, the use of an administrative claims procedure to determine creditor claims (as opposed to the judicial procedure used in bankruptcy proceedings), and the right of the FDIC to transfer claims to a “bridge” entity. +The FDIC has developed a strategy under OLA, referred to as the “single point of entry” or “SPOE” strategy, under which the FDIC would resolve a failed financial holding company by transferring its assets (including shares of its operating subsidiaries) and, potentially, very limited liabilities to a “bridge” holding company; utilize the resources of the failed financial holding company to recapitalize the operating subsidiaries; and satisfy the claims of unsecured creditors of the failed financial holding company and other claimants in the receivership by delivering securities of one or more new financial companies that would emerge from the bridge holding company. Under this strategy, management of the failed financial holding company would be replaced and its shareholders and creditors would bear the losses resulting from the failure. +FDIC Powers upon Insolvency of AENB +If the FDIC is appointed the conservator or receiver of AENB, the FDIC has the power: (1) to transfer any of AENB’s assets and liabilities to a new obligor without the approval of AENB’s creditors; (2) to enforce the terms of AENB’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which AENB is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmation or repudiation of which is determined by the FDIC to promote the orderly administration of AENB. In addition, the claims of holders of U.S. deposit liabilities and certain claims for administrative expenses of the FDIC against AENB would be afforded priority over other general unsecured claims against AENB, including claims of debt holders and depositors in non-U.S. offices, in the liquidation or other resolution of AENB. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of AENB, the debt holders and depositors in non-U.S. offices would be treated differently from, and could receive substantially less, if anything, than the depositors in the U.S. offices of AENB. +15 +Table of Contents +Other Banking Regulations +Source of Strength +The Company is required to act as a source of financial and managerial strength to its U.S. bank subsidiary, AENB, and may be required to commit capital and financial resources to support AENB. Such support may be required at times when, absent this requirement, the Company otherwise might determine not to provide it. Capital loans by the Company to AENB are subordinate in right of payment to deposits and to certain other indebtedness of AENB. In the event of the Company’s bankruptcy, any commitment by the Company to a federal banking regulator to maintain the capital of AENB will be assumed by the bankruptcy trustee and entitled to a priority of payment. +Transactions Between AENB and its Affiliates +Certain transactions (including loans and credit extensions from AENB) between AENB and its affiliates (including the Company, TRS and their other subsidiaries) are subject to quantitative and qualitative limitations, collateral requirements and other restrictions imposed by statute and regulation. Transactions subject to these restrictions are generally required to be made on an arm’s-length basis. +FDIC Deposit Insurance and Insurance Assessments +AENB accepts deposits that are insured by the FDIC up to the applicable limits. Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices; is in an unsafe or unsound condition to continue operations; or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that would lead to termination of deposit insurance at AENB. The FDIC’s deposit insurance fund is funded by assessments on insured depository institutions, including AENB, which are subject to adjustment by the FDIC. +Community Reinvestment Act +AENB is subject to the CRA, which imposes affirmative, ongoing obligations on depository institutions to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. In May 2020, the OCC issued a final rule intended to (i) clarify which activities qualify for CRA credit; (ii) update where activities count for CRA credit; and (iii) change the methods for CRA measurement, data collection, recordkeeping and reporting for national banks and federal savings associations. The final rule retains the current community development test for limited purpose banks, such as AENB, which evaluates a bank’s community development performance through its community development loans, investments and services. The final rule requires institutions like AENB to designate additional geographic assessment areas where CRA activities will be measured for significant concentrations of retail domestic deposits. AENB must comply with the final rule by January 1, 2023. +Consumer Financial Products Regulation +In the United States, our marketing, sale and servicing of consumer financial products and our compliance with certain federal consumer financial laws are supervised and examined by the CFPB, which has broad rulemaking and enforcement authority over providers of credit, savings and payment services and products, and authority to prevent “unfair, deceptive or abusive” acts or practices. In addition, a number of U.S. states have significant consumer credit protection, disclosure and other laws (in certain cases more stringent than U.S. federal laws). U.S. federal law also regulates abusive debt collection practices, which, along with bankruptcy and debtor relief laws, can affect our ability to collect amounts owed to us or subject us to regulatory scrutiny. +On October 30, 2020, the CFPB issued a final rule that sets forth additional requirements for third-party debt collection agencies, which we use in the ordinary course of business. See " We are exposed to credit risk and trends that affect Card Member spending and the ability of customers and partners to pay us, which could have a material adverse effect on our results of operations and financial condition " under "Risk Factors" for potential impacts related to legal and regulatory changes on our ability to collect amounts owed to us. +We are also regulated in the United States under the “money transmitter” or “sale of check” laws in effect in most states. In addition, we are required by the laws of many states to comply with unclaimed and abandoned property laws, under which we must pay to states the face amount of any Travelers Cheque or prepaid card that is uncashed or unredeemed after a period of time depending on the type of product. +16 +Table of Contents +In countries outside the United States, regulators continue to focus on a number of key areas impacting our card-issuing businesses, particularly consumer protection (such as in the European Union (EU), the United Kingdom and Canada) and responsible lending (such as in Australia, Mexico, New Zealand and Singapore), with increasing importance on and attention to customers and outcomes rather than just ensuring compliance with local rules and regulations. Regulators’ expectations of firms in relation to their compliance, risk and control frameworks continue to increase and regulators are placing significant emphasis on a firm’s systems and controls relating to the identification and resolution of issues. +Payments Regulation +Legislators and regulators in various countries in which we operate have focused on the operation of card networks, including through enforcement actions, legislation and regulations to change certain practices or pricing of card issuers, merchant acquirers and payment networks, and, in some cases, to establish broad and ongoing regulatory oversight regimes for payment systems. +The EU, Australia and other jurisdictions have focused on interchange fees (that is, the fee paid by the bankcard merchant acquirer to the card issuer in payment networks like Visa and Mastercard), as well as the rules, contract terms and practices governing merchant card acceptance. +Regulation and other governmental actions relating to pricing or practices could affect all networks directly or indirectly, as well as adversely impact consumers and merchants. Among other things, regulation of bankcard fees has negatively impacted and may continue to negatively impact the discount revenue we earn, including as a result of downward pressure on our discount rate from decreases in competitor pricing in connection with caps on interchange fees. In some cases, regulations also extend to certain aspects of our business, such as network and cobrand arrangements or the terms of card acceptance for merchants, and we have exited our network businesses in the EU and Australia as a result of regulation in those jurisdictions, for example. In addition, there is uncertainty as to when or how interchange fee caps and other provisions of the EU payments legislation might apply when we work with cobrand partners and agents in the EU. Given differing interpretations by regulators and participants in cobrand arrangements, we are subject to regulatory action, penalties and the possibility we will not be able to maintain our existing cobrand and agent relationships in the EU. +In various countries, such as certain Member States in the EU and Australia, merchants are permitted by law to surcharge card purchases. In addition, the laws of a number of states in the United States that prohibit surcharging have been challenged in litigation brought by merchant groups and some such laws have been overturned. Surcharging is an adverse customer experience and could have a material adverse effect on us if it becomes widespread, particularly where it only or disproportionately impacts credit card usage, our Card Members or our business. In addition, other steering or differential acceptance practices that are permitted by regulation in some countries could also have a material adverse effect on us if they become widespread. See “ Surcharging or steering by merchants could materially adversely affect our business and results of operations ” under “Risk Factors.” +In some countries, governments have established regulatory regimes that require international card networks to be locally licensed and/or to localize aspects of their operations. For example, the Reserve Bank of India, which has broad power under the Payment and Settlement Systems Act, 2007 to regulate the membership and operations of card networks, has issued a mandate requiring payment systems operators in India to store certain payments data locally. Governments in some countries also provide resources or protection to select domestic payment card networks. The development and enforcement of these and other similar laws, regulations and policies may adversely affect our ability to compete effectively and maintain and extend our global network. +Privacy, Data Protection, Data Governance, Information and Cyber Security +Regulatory and legislative activity in the areas of privacy, data protection, data governance and information and cyber security continues to increase worldwide. We have established and continue to maintain policies and a governance framework to comply with applicable privacy, data protection, data governance and information and cyber security laws and requirements, meet evolving customer and industry expectations and support and enable business innovation and growth. +Our regulators are increasingly focused on ensuring that our privacy, data protection, data governance and information and cyber security-related policies and practices are adequate to inform customers of our data collection, use, sharing and/or security practices, to provide them with choices, if required, about how we use and share their information, and to appropriately safeguard their personal information and account access. Regulators are also focused on data management, data governance and our third-party risk management policies and practices. +17 +Table of Contents +In the United States, certain of our businesses are subject to the privacy, disclosure and safeguarding provisions of the Gramm-Leach-Bliley Act (GLBA) and its implementing regulations and guidance. Among other things, GLBA imposes certain limitations on our ability to share consumers’ nonpublic personal information with nonaffiliated third parties and requires us to develop, implement and maintain a written comprehensive information security program containing safeguards that are appropriate to the size and complexity of our business, the nature and scope of our activities and the sensitivity of customer information that we process. We are required to offer expanded privacy rights to California residents who are not covered by GLBA, pursuant to the California Consumer Privacy Act. Various regulators, U.S. states and territories are considering similar requirements or have adopted laws, rules and regulations pertaining to privacy and/or information and cyber security that may be more stringent and/or expansive than federal requirements. +We are also subject to certain privacy, data protection, data governance and information and cyber security laws in other countries in which we operate (including countries in the EU, Australia, Canada, China, Japan, Hong Kong, India, Mexico, Singapore and the United Kingdom), some of which are more stringent and/or expansive than those in the United States. Some countries have also instituted laws requiring in-country data processing and/or in-country storage of data. Compliance with such laws could result in higher technology, administrative and other costs for us, could limit our ability to optimize the use of our closed-loop data, and could require use of local technology services. Certain laws also require us to provide foreign governments and other third parties broader access to our data and intellectual property. Data breach and operational outage notification laws or regulatory activities to encourage such notifications are also becoming more prevalent in jurisdictions outside the United States in which we operate. +In Europe, the EU General Data Protection Regulation (GDPR) imposes legal and compliance obligations on companies that process personal data of individuals in the EU, irrespective of the geographical location of the company, with significant fines for non-compliance (up to 4 percent of total annual worldwide revenue). We continue to rely on our binding corporate rules as the primary method for lawfully transferring data from our European affiliates to our affiliates in the United States and elsewhere globally. The GDPR includes, among other things, a requirement for prompt notice of data breaches, in certain circumstances, to affected individuals and supervisory authorities. +The GDPR was transposed into UK domestic law in January 2021 following the United Kingdom's exit from the EU. This is known as the UK GDPR and it supplements the United Kingdom's Data Protection Act of 2018. The UK GDPR mirrors the compliance requirements and fine structure of the GDPR. +In addition, the European Directive 2002/58/EC (the ePrivacy Directive) will continue to set out requirements for the processing of personal data and the protection of privacy in the electronic communications sector until the approval of the forthcoming ePrivacy Regulation. The ePrivacy Directive places restrictions on, among other things, the sending of unsolicited marketing communications, as well as on the collection and use of data about internet users. +The European Central Bank and the European Banking Authority have enacted or are considering secondary legislation focused on security breaches, outsourcing, resiliency, strong customer authentication and information security-related policies. Likewise, a network and information security directive has been implemented into national laws by Member States in the EU. The Revised Payment Services Directive (PSD2) also contains regulatory requirements on strong customer authentication, open access to customer data and payment capabilities, and measures to prevent security incidents. +18 +Table of Contents +Anti-Money Laundering, Sanctions and Anti-Corruption Compliance +We are subject to significant supervision and regulation, and an increasingly stringent enforcement environment, with respect to compliance with anti-money laundering (AML), sanctions and anti-corruption laws and regulations in the United States and in other jurisdictions in which we operate. Failure to maintain and implement adequate programs and policies and procedures for AML, sanctions and anti-corruption compliance could have material financial, legal and reputational consequences. +Anti-Money Laundering +American Express is subject to a significant number of AML laws and regulations as a result of being a financial company headquartered in the United States, as well as having a global presence. In the United States, the majority of AML requirements are derived from the Currency and Foreign Transactions Reporting Act and the accompanying regulations issued by the U.S. Department of the Treasury (collectively referred to as the Bank Secrecy Act), as amended by the USA PATRIOT Act of 2001 (the Patriot Act). The Anti-Money Laundering Act of 2020 (the AMLA), enacted in January 2021, amended the Bank Secrecy Act and is intended to comprehensively reform and modernize U.S. AML laws. Many of the statutory provisions in the AMLA will require additional rulemakings, reports and other measures, the effects of which are not known at this time. In Europe, AML requirements are largely the result of countries transposing the 5th and 6th EU Anti-Money Laundering Directives (and preceding EU Anti-Money Laundering Directives) into local laws and regulations. Numerous other countries, such as Argentina, Australia, Canada, India, Mexico, New Zealand and Russia, have also enacted or proposed new or enhanced AML legislation and regulations applicable to American Express. +Among other things, these laws and regulations require us to establish AML programs that meet certain standards, including, in some instances, expanded reporting, particularly in the area of suspicious transactions, and enhanced information gathering and recordkeeping requirements. Our AML programs have become the subject of heightened scrutiny in some countries. Any errors, failures or delays in complying with federal, state or foreign AML and counter-terrorist financing laws or perceived deficiencies in our AML programs could result in significant criminal and civil lawsuits, penalties and forfeiture of significant assets or other enforcement actions. +19 +Table of Contents +Office of Foreign Assets Control Regulation +The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. The United States prohibits U.S. persons from engaging with individuals and entities identified as “Specially Designated Nationals,” such as terrorists and narcotics traffickers. These prohibitions are administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) and are typically known as the OFAC rules. The OFAC rules prohibit U.S. persons from engaging in financial transactions with or relating to the prohibited individual, entity or country, require the blocking of assets in which the individual, entity or country has an interest, and prohibit transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons) to such individual, entity or country. Blocked assets (e.g., property or bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. We maintain a global sanctions program designed to ensure compliance with OFAC requirements. Failure to comply with such requirements could subject us to serious legal and reputational consequences, including criminal penalties. +Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) to the Securities Exchange Act of 1934, as amended (the Exchange Act), an issuer is required to disclose in its annual or quarterly reports, as applicable, whether it or any of its affiliates knowingly engaged in certain activities, transactions or dealings relating to Iran or with individuals or entities designated pursuant to certain Executive Orders. Disclosure is generally required even where the activities, transactions or dealings were conducted outside the United States by non-U.S. affiliates in compliance with applicable law, and whether or not the activities are sanctionable under U.S. law. +In 2020, we became aware of credit card accounts opened with American Express International, Inc. (Hong Kong branch) by the Acting Consul General of the Iranian Consulate in Hong Kong, and his predecessor, the now-former Consul General. We believe these cards were used only for personal expenses. The Acting Consul General had two cards, both of which were opened in 2018 and one of which was closed by client request on or about April 3, 2019, and the other of which was cancelled by us on or about June 16, 2020. The former Consul General’s card was issued in January 2019 and cancelled by us on or about March 13, 2019. We had negligible gross revenues and net profits attributable to these accounts. As all of the accounts were cancelled, we do not intend to continue to engage in this activity. +20 +Table of Contents +Anti-Corruption +We are subject to complex international and U.S. anti-corruption laws and regulations, including the U.S. Foreign Corrupt Practices Act (the FCPA), the UK Bribery Act and other laws that prohibit the making or offering of improper payments. The FCPA makes it illegal to corruptly offer or provide anything of value to foreign government officials, political parties or political party officials for the purpose of obtaining or retaining business or an improper advantage. The FCPA also requires us to strictly comply with certain accounting and internal controls standards. The UK Bribery Act also prohibits commercial bribery and the receipt of a bribe, and makes it a corporate offense to fail to prevent bribery by an associated person, in addition to prohibiting improper payments to foreign government officials. Failure of the Company, our subsidiaries, colleagues, contractors or agents to comply with the FCPA, the UK Bribery Act and other similar laws can expose us and/or individual colleagues to investigation, prosecution and potentially severe criminal and civil penalties. +Compensation Practices +Our compensation practices are subject to oversight by the Federal Reserve. The federal banking regulators’ guidance on sound incentive compensation practices sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation plans do not encourage imprudent risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should (1) provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks, (2) be compatible with effective internal controls and risk management, and (3) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in our compensation practices that are identified by the Federal Reserve or other banking regulators in connection with their review of our compensation practices may be incorporated into our supervisory ratings, which can affect our ability to make acquisitions or perform other actions. Enforcement actions may be taken against us if our incentive compensation arrangements or related risk-management control or governance processes are determined to pose a risk to our safety and soundness, and we have not taken prompt and effective measures to correct the deficiencies. +In May 2016, the federal banking regulators, the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency and the National Credit Union Administration re-proposed a rule, originally proposed in 2011, on incentive-based compensation practices. The re-proposed rule would apply deferral, downward adjustment and forfeiture, and clawback requirements to incentive-based compensation arrangements granted to senior executive officers and significant risk-takers of covered institutions, with specific requirements varying based on the asset size of the covered institution and the category of employee. If these or other regulations are adopted in a form similar to what has been proposed, they will impose limitations on the manner in which we may structure compensation for our colleagues, which could adversely affect our ability to hire, retain and motivate key colleagues. +21 +Table of Contents +ADDITIONAL INFORMATION +We maintain an Investor Relations website at http://ir.americanexpress.com. We make available free of charge, on or through this website, our annual, quarterly and current reports and any amendments to those reports as soon as reasonably practicable following the time they are electronically filed with or furnished to the SEC. +In addition, we routinely post financial and other information, some of which could be material to investors, on our Investor Relations website. Information regarding our corporate responsibility and sustainability initiatives, including our Environmental, Social and Governance reports, are available on our Corporate Responsibility website at http://about.americanexpress.com/corporate-responsibility. +The content of any of our websites referred to in this report is not incorporated by reference into this report or any other report filed with or furnished to the SEC. We have included such website addresses only as inactive textual references and do not intend them to be active links. +You can find certain statistical disclosures required of bank holding companies starting on page A-1, which are incorporated herein by reference. +Our business as a whole has not experienced significant seasonal fluctuations, although card billed business tends to be moderately higher in the fourth quarter than in other quarters. As a result, the amount of Card Member loans and receivables outstanding tend to be moderately higher during that quarter. The average discount rate also tends to be slightly lower during the fourth quarter due to a higher level of retail-related billed business volumes. +22 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000004962/2020/0000004962-21-000013/item13.txt b/raw/filings/0000004962/2020/0000004962-21-000013/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000004977/2018/0000004977-19-000049/filing.txt b/raw/filings/0000004977/2018/0000004977-19-000049/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..052683896fa383d5c672f6864134d4f52850da02 --- /dev/null +++ b/raw/filings/0000004977/2018/0000004977-19-000049/filing.txt @@ -0,0 +1,18358 @@ +Document +0 0 0.065 0.055 0.0185 0.01 0.0250 0.0100 0.045 0.04 0.06 0.035 0.0275 0.0225 0.045 0.04 0.055 0.0525 0.035 0.03 P5Y P364D P3Y P364D P364D 200000000 100000000 40000000 200000000 100000000 1 false --12-31 FY 2018 2018-12-31 0000004977 Yes false Large Accelerated Filer false false No Yes AFL 70594000000 1163000000 73007000000 1209000000 0.83 0.87 1.04 0.10 0.10 0.10 0.10 1900000000 1900000000 1900000000 1900000000 1345762000 1347540000 are generally entitled to one vote per share until they have been held by the same beneficial owner for a continuous period of 48 months, at which time they become entitled to 10 votes per share. 374000000 374000000 148000000 148000000 0 0 0 0 0.0060 0.0075 0.0020 0.0035 2027-10-23 60000000000 60000000000 5000000000 25000000000 60000000000 60000000000 5000000000 25000000000 15200000000 29300000000 8900000000 60000000000 60000000000 5000000000 25000000000 15200000000 29300000000 8900000000 60000000000 60000000000 5000000000 25000000000 0.04 0.04 0.00932 0.0645 0.069 0.03625 0.03625 0.0325 0.02875 0.024 0.02108 0.0032 0.0047 0.04 0.04 0.00932 0.0645 0.0690 0.03625 0.03625 0.0325 0.02875 0.024 0.02108 0.0032 0.0047 0.0475 0.04 0.04 0.01488 0.01159 0.0175 0.00932 0.0645 0.069 0.03625 0.03625 0.0325 0.02875 0.02108 0.0032 0.0047 0.0475 0.04 0.04 0.01488 0.01159 0.0175 0.00932 0.0645 0.0690 0.03625 0.03625 0.0325 0.02875 0.02108 0.0032 0.0047 bears an interest rate per annum equal to the Tokyo interbank market rate (TIBOR), or alternate TIBOR, if applicable, plus the applicable TIBOR margin and has a five-year maturity. 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+(Mark One) +ý +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2018 +or +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File Number: 001-07434 +Aflac Incorporated +(Exact name of registrant as specified in its charter) +Georgia +58-1167100 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +1932 Wynnton Road, Columbus, Georgia +31999 +(Address of principal executive offices) +(ZIP Code) +Registrant’s telephone number, including area code: 706.323.3431 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, $.10 Par Value +New York Stock Exchange +Tokyo Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes ¨ No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes þ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes ¨ No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). þ Yes ¨ No +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. +Large accelerated filer +þ +Accelerated filer +¨ +Non-accelerated filer +¨ +Smaller reporting company +¨ +Emerging growth company +¨ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes þ No +The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 30, 2018 , was $ 33,002,565,252 . +The number of shares of the registrant’s common stock outstanding at February 12, 2019 , with $.10 par value, was 750,332,375 . +Documents Incorporated By Reference +Certain information contained in the Notice and Proxy Statement for the Company’s 2019 Annual Meeting of Shareholders is incorporated by reference into Part III hereof. +Aflac Incorporated +Annual Report on Form 10-K +For the Year Ended December 31, 2018 +Table of Contents +PART I +Page +Item 1. +Business +1 +Item 1A. +Risk Factors +15 +Item 1B. +Unresolved Staff Comments +32 +Item 2. +Properties +32 +Item 3. +Legal Proceedings +32 +Item 4. +Mine Safety Disclosures +33 +PART II +Item 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +34 +Item 6. +Selected Financial Data +37 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +39 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +77 +Item 8. +Financial Statements and Supplementary Data +86 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +179 +Item 9A. +Controls and Procedures +179 +Item 9B. +Other Information +179 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +180 +Item 11. +Executive Compensation +180 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +180 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +180 +Item 14. +Principal Accounting Fees and Services +180 +PART IV +Item 15. +Exhibits, Financial Statement Schedules +181 +i +Item 1. Business +PART I +ITEM 1. BUSINESS +Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) prepare financial statements in accordance with U.S. generally accepted accounting principles (GAAP). This report includes certain forward-looking information that is based on current expectations and is subject to a number of risks and uncertainties. For details on forward-looking information, see Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A), Part II, Item 7, of this report. +Aflac Incorporated qualifies as a large accelerated filer within the meaning of Rule 12b-2 under the U.S. Securities Exchange Act of 1934 as amended (the Exchange Act). The Company's Internet address is aflac.com. The information on the Company's website is not incorporated by reference in this annual report on Form 10-K. The Company makes available, free of charge on the Investors portion of its website, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments thereto as soon as reasonably practicable after those forms have been electronically filed with or furnished to the Securities and Exchange Commission (SEC). +General Description +Aflac Incorporated was incorporated in 1973 under the laws of the state of Georgia. Aflac Incorporated is a general business holding company and acts as a management company, overseeing the operations of its subsidiaries by providing management services and making capital available. Its principal business is voluntary supplemental and life insurance, which is marketed and administered through American Family Life Assurance Company of Columbus (Aflac) in the United States (Aflac U.S.) and, effective April 1, 2018, through Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan). Prior to April 1, 2018, the Company's insurance business was marketed in Japan as a branch of Aflac. American Family Life Assurance Company of New York (Aflac New York) is a wholly owned subsidiary of Aflac. Most of Aflac's policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. The Company's insurance operations in the United States and Japan service the two markets for the Company's insurance business. +Effective April 1, 2018, the Company converted Aflac Japan from a branch to a subsidiary incorporated as a Japanese stock corporation. The transaction was accounted for as tax-neutral and did not have a material impact on the daily operations of either Aflac Japan or Aflac U.S. In addition, the Company obtained and expects to continue to obtain enhanced flexibility in capital management and business development as a result of the conversion. +The Company offers voluntary insurance policies in Japan and the United States that provide a layer of financial protection against income and asset loss. The Company continues to diversify its product offerings in both Japan and the United States. Aflac Japan sells voluntary supplemental insurance products, including cancer plans, general medical indemnity plans, medical/sickness riders, care plans, living benefit life plans, ordinary life insurance plans and annuities. Aflac U.S. sells voluntary supplemental insurance products including products designed to protect individuals from depletion of assets (accident, cancer, critical illness/care, hospital indemnity, fixed-benefit dental, and vision care plans) and loss-of-income products (life and short-term disability plans). +The Company is authorized to conduct insurance business in all 50 states, the District of Columbia, several U.S. territories and Japan. +Reporting Segments +The Company's insurance business consists of two reporting segments: Aflac Japan and Aflac U.S. Aflac Japan is the principal contributor to the Parent Company’s consolidated earnings. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 70% of the Company's total revenues in 2018 , compared with 70% in 2017 and 71% in 2016 . The percentage of the Company's total assets attributable to Aflac Japan was 84% and 83% at December 31, 2018 and 2017 , respectively. The conversion of Aflac Japan to a subsidiary structure did not affect the Company's segment reporting structure. +For information on the Company's results of operations and financial information by segment, see MD&A and Note 2 of the Notes to the Consolidated Financial Statements in this report. +1 +Item 1. Business +Certain Performance Measures +The Company evaluates its premium growth and sales efforts using the following performance measures: +• +Annualized premiums in force is defined as the amount of gross premium that a policyholder must pay over a full year in order to keep coverage. The growth of net premiums (defined below) is directly affected by the change in premiums in force and by the change in weighted-average yen/dollar exchange rates. +• +New annualized premium sales (sometimes referred to as new sales or sales) is an operating measure that is not reflected on the Company's financial statements. New annualized premium sales generally represents annual premiums on policies the Company sold and incremental increases from policy conversions, collected over a 12-month period, assuming the policies remain in force. For Aflac Japan, new annualized premium sales are determined by applications submitted during the reporting period. For Aflac U.S., new annualized premium sales are determined by applications that are issued during the reporting period. Conversions are defined as the positive difference in the annualized premium when a policy upgrades in the current reporting period. +• +Net premiums (sometimes referred to as net premium income or net earned premiums) is a financial measure that appears on the Company's Consolidated Statements of Earnings and in its segment reporting. This measure reflects collected or due premiums that have been earned ratably on policies in force during the reporting period, reduced by premiums that have been ceded to third parties and increased by premiums assumed through reinsurance. +Foreign Currency Translation +Aflac Japan’s premiums and approximately half of its investment income are received in yen. Claims and most expenses are paid in yen, and the Company purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into U.S. dollars for financial reporting purposes. For information regarding the effect of currency fluctuations on the Company's business, see the Hedging Activities subsection within the Analysis of Financial Condition section of MD&A, the Currency Risk subsection within Quantitative and Qualitative Disclosures about Market Risk, and Notes 1 and 2 of the Notes to the Consolidated Financial Statements in this report. For information regarding how the Company’s investment strategy supports management of foreign currency risk, refer to the Investments subsection below. +Insurance Products (1) +Aflac Japan +Aflac U.S. +Third Sector Insurance +Accident +Cancer +Short-Term Disability +Medical +Critical Care (2) +Income Support +Hospital Indemnity +First Sector Insurance +Dental +Life +Vision +Protection +Life (Term and Whole) +Term +Whole +Savings +WAYS +Child Endowment +(1) Actively marketed as of December 31, 2018 +(2) Includes cancer, critical illness, and hospital intensive care products +Japan +Aflac Japan's insurance products are designed to help consumers pay for medical and nonmedical costs that are not reimbursed under Japan's national health insurance system. Changes in Japan's economy and an aging population have put increasing pressure on Japan's national health care system. As a result, more costs have been shifted to Japanese +2 +Item 1. Business +consumers, who in turn have become increasingly interested in insurance products that help them manage those costs. Aflac Japan has responded to this consumer need by enhancing existing products and developing new products. +The foundation of Aflac Japan's product portfolio has been, and continues to be, its third sector products, which include cancer, medical and income support insurance products. Aflac pioneered the cancer insurance market in Japan in 1974, and remains the number one provider of cancer insurance in Japan today. Over the years, Aflac Japan has customized its cancer insurance product to respond to, and anticipate, the needs of its consumers and the advances in medical treatments. The cancer insurance plans the Company offers in Japan provide a lump-sum benefit upon initial diagnosis of internal cancer and benefits for treatment received due to internal cancer such as fixed daily benefits for hospitalization, outpatient services and convalescent care, surgical benefits, and outpatient treatments. Aflac Japan has a unique Aflac-branded cancer insurance product for Japan's postal system, Japan Post (see the Distribution - Japan section for background information). In April 2018, Aflac Japan introduced a new cancer insurance product, DAYS 1, with enhanced cancer benefits. In addition to providing benefits for hospitalization, outpatient treatment, surgery, radiation therapy and anti-cancer drug treatment, this product was designed to provide benefits to improve quality of life and to cover out-of-pocket expenses not directly related to medical treatment. At the same time, Aflac Japan introduced DAYS 1 Plus to provide existing holders with up-to-date coverage. As the number one provider of cancer insurance in Japan, the Company believes these products further strengthen its brand, and most importantly, provide valuable benefits to consumers who are looking for solutions to manage cancer-related costs. +Aflac Japan's EVER product is a stand-alone, whole-life medical insurance product which offers a basic level of hospitalization coverage with an affordable premium. The current version of this product includes riders to be associated with three critical illnesses (cancer, heart attack, and stroke) to better respond to consumers' needs for coverage of serious illnesses. These riders provide policyholders with a benefit upon the diagnosis for those three critical illnesses, waiver of premium payment thereafter and unlimited hospital days for such critical illnesses. Since its initial introduction, Aflac Japan has expanded its suite of EVER product offerings to appeal to specific types of Japanese consumers and achieve greater market penetration. In 2017, Aflac Japan revised the EVER product by introducing riders for lump-sum hospitalization benefits and surgeries for female-specific diseases as well as strengthening outpatient benefits and reducing premiums centered on the young- to middle-aged market segments. This product also offers a short-pay premium period to policyholders. Gentle EVER, Aflac Japan's non-standard medical insurance product, was designed to meet the needs of certain consumers who cannot qualify for the base EVER plan. +In October 2018, Aflac Japan launched a new type of medical product referred to as Health Promotion Medical Insurance where a policyholder is entitled to a partial refund of the premium if the policyholders' “health age” measured by certain health check items is lower than his or her actual age. This product is marketed exclusively online and targeted at younger generations. +The Company believes that the affordable cancer and medical insurance products Aflac Japan provides will continue to be an important part of its product portfolio. Nevertheless, as the Company continues its long history of product innovation, Aflac Japan's product portfolio has expanded beyond traditional health-related products. +Aflac Japan's Income Support Insurance provides fixed-benefit amounts in the event that a policyholder is unable to work due to significant illness or injury and was developed to supplement the disability coverage within Japan’s social security system. This product targets young to middle-aged consumers, and by focusing efforts on this demographic, Aflac Japan believes it is building relationships that lay the groundwork for the sale of its cancer and medical insurance later in life to the Income Support policyholders. +Beginning in 2013, Aflac Japan began to curtail sales of first sector savings-type products, such as WAYS, child endowment and fixed annuities, due to persistent low interest rates in Japan and, in particular, the relatively large capital commitment required by such products and their lower profitability, in such an environment. Aflac Japan continues to sell first sector protection-type products, which include term and whole life, to provide Aflac Japan’s traditional sales channels with a more comprehensive product portfolio to continue to cross-sell with third sector products. In July 2018, Aflac Japan introduced a first sector protection whole life product with low cash surrender value, which offers non-smoking policyholders further discounted premiums. +For additional information on Aflac Japan's products and composition of sales, see the Aflac Japan Segment subsection of MD&A in this report. +3 +Item 1. Business +U.S. +The Company designs its U.S. insurance products to provide supplemental coverage for people who already have major medical or primary insurance coverage. Most of Aflac's U.S. policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. started to market and administer group insurance products in 2009. +Aflac U.S. insurance policies pay benefits regardless of other insurance. Most of the Aflac U.S. insurance benefits are paid in cash directly to policyholders; therefore, customers have the opportunity to use this cash to help with expenses of their choosing. +Aflac U.S. offers accident coverage on both an individual and group basis. These policies pay cash benefits in the event of a covered injury. The accident portion of the policy includes lump-sum benefits for accidental death, dismemberment and specific injuries as well as fixed benefits for hospital confinement. Additional benefits are also available for home modifications, wellness and increased benefits for injuries related to participations in an organized sporting activity. +Aflac U.S. offers short-term disability benefits on both an individual and group basis. The individual short-term disability product has an Aflac Value Rider that pays a benefit, less claims, for every consecutive five-year term that the policy is in force. +Aflac U.S. offers coverage for critical care on both an individual and group basis. These policies are designed to pay cash benefits in the event of critical illnesses such as heart attack, stroke, or cancer. On an individually underwritten basis, Aflac U.S. offers cancer plans, critical illness plans, and critical care and recovery plans (formerly called specified health event). On a group basis Aflac U.S. offers critical illness plans. +Aflac U.S. offers hospital indemnity coverage on both an individual and group basis. Hospital indemnity products provide policyholders fixed dollar benefits triggered by hospitalization due to accident or sickness, or just sickness alone. Indemnity benefits for inpatient and outpatient surgeries, as well as various other diagnostic events, are also available. Aflac U.S. also offers a lump sum rider that can be added to its individual accident, short-term disability and hospital indemnity products. This rider, where available, provides a lump sum payment for a range of critical illness events including traumatic brain injury, Type 1 diabetes, advanced Alzheimer’s disease and many more. In January 2016, a new group hospital indemnity plan was introduced that includes 11 new benefits, including telemedicine and health screening. This plan provides flexibility, allowing the Company's clients to personalize their plan designs to complement the underlying medical coverage that is offered to employees. +Aflac U.S. offers additional coverages to those listed above, including dental, vision and life policies. Aflac U.S. offers fixed-benefit dental coverage on both an individual and group basis. Aflac U.S. offers Vision Now SM , an individually issued policy which provides benefits for serious eye health conditions and loss of sight as well as coverage for corrective eye materials and exam benefits. Aflac U.S. also offers term- and whole-life policies on both an individual and group basis. +For additional information on Aflac's U.S. products and composition of sales, see the Aflac U.S. Segment subsection of MD&A in this report. +Distribution Channels +Aflac Japan +Aflac U.S. +Individual/ Independent Corporate Agencies +Independent Associates +Affiliated Corporate Agencies +Brokers +Banks +Japan +The traditional channels through which Aflac Japan has sold its products consist of individual agents/agencies, independent corporate agencies, and affiliated corporate agencies. The individual agencies and independent corporate agencies that sell Aflac Japan's products give better access to workers at a vast number of small businesses in Japan. Agents' activities are primarily focused on insurance sales, with customer service support provided by the Aflac Contact Center. Affiliated corporate agencies are initially formed when companies establish subsidiary businesses to sell Aflac Japan's insurance products to employees as part of a benefit package, and in some cases expand to sell Aflac Japan products to other parties such as suppliers and customers.These agencies help Aflac Japan reach employees at large +4 +Item 1. Business +worksites, and some of them are also successful in approaching customers outside their business groups. The Company believes that new agencies will continue to be attracted to Aflac Japan's competitive commissions, attractive products, superior customer service and strong brand image. +The Company has sold products to employees of banks since its entry into Japan in 1974. However, December 2007 marked the first time it was permissible for banks to sell Aflac Japan's type of insurance products to their customers. By the end of 2018 , Aflac Japan had agreements with approximately 90% of the total number of banks in Japan, to sell its products. The Company believes Aflac Japan has more banks selling its supplemental health insurance products than any of its competitors. Japanese consumers rely on banks to provide traditional bank services, and also to provide insurance solutions and other services. The Company believes Aflac Japan's long-standing and strong relationships within the Japanese banking sector, along with its strategic preparations, have proven to be an advantage, particularly starting when this channel opened up for its products. Aflac Japan's partnerships throughout the banking sector provide Aflac Japan with a wider demographic of potential customers than it would otherwise have been able to reach, and it also allows banks to expand their product and service offerings to consumers. +In 2005, legislation aimed at privatizing Japan's postal system (Japan Post) was enacted into law. The privatization laws split Japan Post into four operating entities that began operating in October 2007. In 2007, one of these entities selected Aflac Japan as its provider of cancer insurance to be sold through its post offices, and, in 2008, Aflac Japan began selling cancer insurance through these post offices. Japan Post has historically been a popular place for consumers to purchase insurance products. Legislation to reform the postal system passed Japan’s legislature, the Diet, in April 2012 and resulted in the merger of two of the postal operating entities (the one that delivers the mail and the one that runs the post offices) in October 2012. In July 2013, Aflac Japan entered into a new agreement with Japan Post Holdings to further expand the partnership that was established in 2008. In June 2014, Japan Post Insurance (Kampo) received approval from Japan’s primary insurance regulator, the Financial Services Agency (FSA), to enter into an agency contract with Aflac Japan. Under this contract, Aflac Japan currently distributes its cancer insurance products through 76 of Kampo's directly managed sales offices. Aflac Japan has developed a unique Aflac-branded cancer insurance product for Japan Post and Kampo that was introduced in October 2014. In 2015, Japan Post expanded the number of post offices that offer Aflac's cancer insurance products to more than 20,000 postal outlets. +The Company believes this alliance with Japan Post, which is included in Aflac Japan's affiliated corporate agencies distribution channel, has benefited and will continue to benefit Aflac Japan's cancer insurance sales. For example, sales of cancer insurance policies by Japan Post constituted approximately 25% of Aflac Japan's third sector sales during the 2018 calendar year. In December 2018, the Company announced that in a further strengthening of this alliance. Japan Post Holdings Co., Ltd, a Japanese corporation, (Japan Post Holdings) plans to purchase approximately 7% of the Parent Company's outstanding common shares through a trust using open market and private block purchases. Like all common shares in the Parent Company, the shares purchased by the trust will be eligible for 10-for-1 voting rights after being held for 48 consecutive months. In connection with this announcement, on December 19, 2018, the Parent Company and Aflac Japan entered into a Basic Agreement regarding the "Strategic Alliance Based on Capital Relationship" with Japan Post Holdings (Basic Agreement), and the Parent Company entered into a letter agreement with Japan Post Holdings (Letter Agreement). Under the Letter Agreement, Japan Post Holdings agreed (i) to establish and fund a voting trust in accordance with a trust agreement (Trust Agreement) by no later than February 28, 2019, (ii) upon establishment of the trust, to instruct the trustee and the sole shareholder of the trust to enter into, and to itself enter into, a shareholders agreement with the Parent Company (Shareholders Agreement) providing for, among other things, a cap on share ownership, a minimum holding period and a standstill provision and voting restrictions that effectively limit the trustee's voting rights to no more than 20% of the voting rights of the Parent Company and further restrict the trustee's voting rights with respect to certain change in control transactions. The terms of the investment do not provide Japan Post Holdings with a right to a board seat on the Parent Company's board of directors or with any other rights to control, manage or intervene in the management of the Parent Company. This strategic investment is subject to certain regulatory approvals in Japan, and the U.S. The Company anticipates that regulatory approvals will be received in the second half of 2019. The foregoing summary is subject to and qualified in its entirety by reference to the full text of the Basic Agreement and Letter Agreement, including the forms of Trust Agreement and Shareholders Agreement attached to the Letter Agreement, copies of which are included as Exhibits 10.47 and 10.48 attached hereto and the terms of which are incorporated herein by reference. +For additional information on Aflac Japan's distribution, see the Aflac Japan Segment subsection of MD&A in this report. +5 +Item 1. Business +U.S. +As of December 31, 2018 , the U.S. sales force was composed of sales associates and brokers who are licensed to sell accident and health insurance. Many are also licensed to sell life insurance. Aflac U.S. utilizes dual-channel distribution to market its insurance products to businesses of all sizes. The career agent channel focuses on marketing Aflac to the small business market, which consists of employers with less than 100 employees. As such, Aflac U.S. has aligned its recruiting, training, compensation, marketing and incentives for its career agents to encourage specific activity and sales of individual policies in this market. The broker channel focuses on selling to the mid- and large-case market, which is comprised of employers with more than 100 employees and typically an average size of 1,000 employees or more. Since regional and national brokers have traditionally served the mid- and large-case market, the sales professionals in the broker channel are assigned a geographic market to strengthen relationships with the top brokers and sell Aflac products to their clients. As a result, Aflac U.S. is represented on 160 benefit administration platforms, sometimes referred to as exchanges, of various brokers. +Sales associates and brokers are independent contractors and are paid commissions based on first-year and renewal premiums from their sales of insurance products. In addition to receiving commissions on personal production, district and regional sales coordinators may also receive override commissions and incentive bonuses. +Aflac U.S. has continued to evolve its career and broker management infrastructure to drive growth in sales. In 2017, Aflac hired a Chief Distribution Officer to align the strategies of career and broker channels and to further expand U.S. distribution. All Aflac U.S. sales channels are now within the organizational structure of the Chief Distribution Officer. Prior to this change, the broker and career channels were part of separate organizational structures. Aflac U.S. believes the addition of this role will enhance performance management and augment its long-term sales strategy. +Aflac U.S. concentrates on marketing its insurance products at the worksite. This method offers policies to individuals through employment, trade and other associations. Historically, Aflac U.S. policies have been individually underwritten, however over the past several years, guaranteed issue options have become available. Premiums are generally paid by the employee. Additionally, Aflac's individual policies are portable, meaning that individuals may retain their full insurance coverage upon separation from employment or such affiliation, generally at the same premium. Individual policies are typically guaranteed-renewable for the lifetime of the policyholder (to age 75 for short-term disability policies). Aflac U.S. collects a major portion of premiums on such sales through payroll deduction or other forms of centralized billing. With Aflac U.S. brokerage sales expansion and CAIC, branded as Aflac Group Insurance, Aflac U.S. offers group voluntary insurance products desired by many large employers. These products are sold on a group basis and often have some element of guaranteed issue. Worksite marketing enables sales associates and brokers to reach a greater number of prospective policyholders and lowers distribution costs, compared with individually marketed business. +For additional information on Aflac's U.S. distribution, see the Aflac U.S. Segment subsection of MD&A in this report. +Competition +Japan +In 1974, Aflac was granted an operating license to sell life insurance in Japan, making Aflac the second non-Japanese life insurance company to gain direct access to the Japanese insurance market. Through 1981, Aflac Japan faced limited competition for cancer insurance policy sales. However, Japan has experienced two periods of deregulation since Aflac Japan entered the market. The first came in the early 1980s, when nine mid-sized insurers, including domestic and foreign companies, were allowed to sell cancer insurance products for the first time. The second period began in 2001 when all life and non-life insurers were allowed to sell stand-alone cancer and medical insurance products as well as other stand-alone health insurance products. As a result, the number of insurance companies offering stand-alone cancer and medical insurance has more than doubled since the market was deregulated in 2001. However, based on Aflac Japan's growth of annualized premiums in force and diversified distribution network, the Company does not believe that Aflac Japan's market-leading position has been significantly impacted by increased competition. Furthermore, the Company believes the continued development and maintenance of operating efficiencies will allow Aflac Japan to offer affordable products that appeal to consumers. Aflac Japan is the largest life insurer in Japan in terms of cancer and medical policies in force. As of December 31, 2018 , Aflac Japan exceeded 24 million individual policies in force in Japan. +Aflac Japan has experienced substantial success selling cancer policies in Japan, with more than 15 million cancer policies in force as of December 31, 2018 . Aflac Japan continued to be the number one seller of cancer insurance policies in Japan throughout 2018 . The Company believes Aflac Japan will remain a leading provider of cancer insurance +6 +Item 1. Business +coverage in Japan, principally due to its experience in the market, well-known brand, low-cost operations, expansive marketing system and product expertise. Further, the Company believes that its alliance with Japan Post will continue to benefit Aflac Japan's sales of cancer insurance in Japan. (See Distribution-Japan above for more information on Aflac Japan's marketing system and its alliance with Japan Post.) +Aflac Japan has also experienced substantial success selling medical insurance in Japan. While other companies have recognized the opportunities that Aflac Japan has seen in the medical insurance market and are frequently offering new products, Aflac Japan endeavors to keep its products attractive to consumers by revising benefits of medical insurance products more frequently than cancer insurance. +U.S. +Aflac U.S. competes against several voluntary supplemental insurance carriers on a national and regional basis. Aflac U.S. believes its policies, premium rates, platforms, value-added services and sales commissions are competitive by product type. Moreover, Aflac U.S. believes that its products are distinct from competitive offerings given its product focus (including features, benefits, and its claims service model), distribution capabilities, and brand awareness. For many companies with which Aflac U.S. competes, voluntary supplemental insurance products are sold as a secondary business. A growing number of major medical and life insurance carriers are also entering into the voluntary supplemental insurance market. For Aflac U.S., supplemental insurance products are its primary business and are sold via a distribution network of independent sales associates and brokers (see U.S. Distribution above). In addition, the Company believes that advertising campaigns for Aflac U.S. have increased name awareness and understanding among consumers and businesses of the value its products provide. +Both private and publicly-traded insurers offer major medical insurance for hospitalization and medical expenses. Much of this insurance is sold on a group basis to accounts that are both fully and self-insured. The federal and state governments also pay substantial costs of medical treatment through various programs. Major medical insurance generally covers a substantial portion of the medical expenses incurred by an insured. Aflac policies are designed to provide coverage that supplements major medical insurance by paying cash directly to the policyholder to use for expenses their major medical insurance is not designed to cover, or for any other uses that the policyholder chooses. Thus, Aflac U.S. does not compete directly with major medical insurers except those who sell supplemental insurance products as a secondary business. Any reduction of coverage, increase in employee participation costs, or increased deductibles and copayments by major medical commercial or government insurance carriers could favorably affect Aflac U.S. business opportunities. Since the implementation of the Affordable Care Act (ACA) beginning in 2010, some employers have shifted a larger burden of the cost of care to their employees, primarily through increases in premiums, copays, and/or deductibles, such as through the use of high-deductible health plans. In addition, the Company believes that some employers have made increasing use of supplemental insurance product offerings in order to improve their competitiveness in employee recruitment and retention. +Since Aflac products provide an additional level of financial protection for policyholders, the Company believes the increased financial exposure some employees may face creates a favorable opportunity for Aflac U.S. products. However, given the profitability erosion some major medical carriers are facing in their core lines of business, the Company has seen a more competitive landscape as they seek entry into Aflac's supplemental product segments and leverage their core benefit offerings by bundling and discounting products in order to gain voluntary market share. +One Day Pay SM is a claims initiative that Aflac U.S. introduced in 2015 to process, approve and pay eligible claims in just one day. The Company believes that along with its brand and relevant products, this claims practice has helped Aflac stand out from competitors. +Investments +Effective January 1, 2018, investments of Aflac U.S. as well as certain sub-advised assets of Aflac Japan, are managed by the Company’s U.S. asset management subsidiary, Aflac Asset Management LLC (AAM), and investments of Aflac Japan are managed pursuant to an investment advisory agreement between Aflac Japan and the Company's asset management subsidiary in Japan, Aflac Asset Management Japan Ltd. (AAMJ). AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. Beginning with the first quarter of 2018, AAM and AAMJ are reported in the "Corporate and other segment" category; however, the assets that they manage will be reported in the respective Aflac Japan and Aflac U.S. business segments. +7 +Item 1. Business +Japan +The Company’s investment strategy with respect to Aflac Japan utilizes disciplined asset and liability management while seeking diversification, long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives, as well as preserving shareholder value in the Aflac Japan business. +In attempting to optimally balance these objectives, the Company seeks to maintain on behalf of Aflac Japan a diversified portfolio of yen-denominated investment assets, U.S. dollar-denominated investment portfolio hedged back to yen and a portfolio of unhedged U.S. dollar-denominated assets. Each of these portfolios presents unique benefits and risks to the Company. +Yen-denominated investments included in Aflac Japan’s portfolio primarily consist of Japan Government Bonds (JGB), other public bonds and private placement fixed income instruments. The Company attempts to match both the duration and currency of these assets with Aflac Japan’s liabilities. This poses a difficulty in Aflac Japan due to the lack of suitable long-dated yen-denominated fixed income instruments. In 2012, the Company initiated a strategic approach to include U.S. dollar-denominated investments in Aflac Japan’s portfolio with the initial intent that they would be coupled with foreign exchange hedges. Today, this hedged U.S. dollar-denominated investment portfolio is mainly invested in long-term fixed and floating-rate loans and long-term investment-grade fixed income securities. The primary goals of the yen-denominated and hedged U.S. dollar portfolios are to provide sufficient yen cash flows to support the insurance liabilities and other yen-denominated obligations of Aflac Japan, and to seek appropriate long-term risk-adjusted investment returns supportive of solvency margin ratio (SMR) levels that provide sufficient dividend flows to the Parent Company . The hedges supporting this portion of the U.S. dollar portfolio pose derivative rollover risk that could amplify hedge costs in unfavorable market conditions, risk of counterparty default, and may require the Company to post collateral. In a declining yen environment, these hedges could result in negative cash settlements that may significantly increase liquidity requirements, thereby shifting funds away from other capital management opportunities including loss of investment income. If the combined yen-denominated and hedged U.S. dollar-denominated portfolios are larger than Aflac Japan's yen obligations, the economic value of these portfolios may be eroded under a long-term scenario of weakening yen due to foreign currency translation risk, one result of which may be to reduce the Company's dividend capacity. +The Company also maintains an unhedged U.S. dollar-denominated investment portfolio with the objectives of generating enhanced investment returns and mitigating certain of the risks posed by the yen and hedged U.S. dollar-denominated portfolios as outlined above. Further, the Company has determined that the unhedged portfolio acts as a natural economic currency hedge of a portion of the Company’s investment in Aflac Japan against erosion of economic value. However, the unhedged U.S. dollar-denominated investment portfolio creates an unmatched foreign currency exposure and subjects Aflac Japan to volatility in regulatory capital and earnings, which may adversely impact Aflac Japan’s ability to pay dividends to the Parent Company. The Company’s approach to sizing the unhedged U.S. dollar-denominated investment portfolio seeks to balance the unique risks presented by each of the three portfolios outlined above, but the overall investment strategy in Aflac Japan is guided primarily by the objective of securing the long-term financial strength of Aflac Japan and funding of yen liabilities. As a result, the Company has historically maintained and currently maintains the size of the unhedged portfolio at levels below the stressed economic surplus in Aflac Japan. +The determination of stressed economic surplus in Aflac Japan involves multiple models using multiple statistical approaches and assuming various economic and operating scenarios that are stressed to arrive at a range of potential outcomes. This range does not account for all economic scenarios, some of which may result in values outside of the range. The Company periodically assesses the stressed economic surplus in Aflac Japan, which fluctuates over time, and adjusts the size of the unhedged portfolio accordingly. The portfolio may include medium-term and long-term fixed-rate government and corporate (investment-grade and high-yield) bonds, floating-rate loans, public equities, and alternative asset classes. In determining the composition of the portfolio, the Company also considers diversification, hedge cost, investment returns relative to yen-denominated investment yields, and Aflac Japan capital requirements. At December 31, 2018, this unhedged U.S. dollar-denominated portfolio was approximately $14.4 billion , compared with approximately $13.0 billion at December 31, 2017. For additional discussion of business and market risks associated with the Company’s investment strategy in Japan, refer to the Risk Factors and Quantitative and Qualitative Disclosures about Market Risk sections. +U.S. +The Company’s investment strategy with respect to Aflac U.S. utilizes disciplined asset and liability management while seeking long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives. As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed-maturity investments and growth assets, including public equities and alternative investments in limited partnerships. +8 +Item 1. Business +Aflac U.S. has been investing in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loans. +For further information on the Company's investments and investment results, see the Insurance Operations and Analysis of Financial Condition sections of MD&A and Notes 3, 4 and 5 of the Notes to the Consolidated Financial Statements in this report. +Regulation +Japan +The financial and business affairs of Aflac Japan are subject to examination by Japan's FSA. Aflac Japan files annual reports and financial statements for the Japanese insurance operations based on a March 31 fiscal year end, prepared in accordance with Japanese regulatory accounting practices prescribed or permitted by the FSA. Japanese regulatory basis earnings are determined using accounting principles that differ materially from U.S. GAAP. For example, under Japanese regulatory accounting practices, policy acquisition costs are expensed immediately; policy benefit and claim reserving methods and assumptions are different; premium income is recognized on a cash basis; different consolidation criteria apply to variable interest entities (VIEs); different accounting applies to reinsurance; and investments can have a separate accounting classification and treatment referred to as policy reserve matching bonds (PRM), which are recorded at amortized cost. Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $6.4 billion at December 31, 2018 , compared with $6.7 billion at December 31, 2017 . +The FSA maintains a solvency standard, which is used by Japanese regulators to monitor the financial strength of insurance companies. As of December 31, 2018 , Aflac Japan's SMR was 965% , compared with 1,064% at December 31, 2017 . Aflac Japan's SMR is sensitive to interest rate, credit spread and foreign exchange rate changes. See the Capital Resources and Liquidity Section of MD&A for a discussion of measures the Company has taken to mitigate the sensitivity of Aflac Japan's SMR. +Prior to April 1, 2018, Aflac Japan repatriated a portion of its accumulated earnings, as determined on a Japanese regulatory accounting basis, to Aflac U.S. provided that Aflac Japan has determined that it adequately protected policyholders' interests as measured by its SMR. Starting in the fourth quarter of 2018, Aflac Japan distributes dividends to the Parent Company. Such dividends are subject to permitted dividend capacity under the Japan Company Law. +The Japanese insurance industry has a policyholder protection corporation that provides funds for the policyholders of insolvent insurers. For additional information regarding the policyholder protection fund, see the Policyholder Protection subsection of MD&A in this report. +In June 2013, a revision to the Financial Instruments and Exchange Act established a post-funded Orderly Resolution Regime for financial institutions to prevent a financial crisis in the event of a financial institution’s failure. This regime came into effect in March 2014 and has not had, and is not expected to have, a material impact on the Company's operations in Japan. +For additional information regarding Aflac Japan's operations and regulations, see the Aflac Japan Segment subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +U.S. +General +The Parent Company and its U.S. insurance subsidiaries, Aflac (a Nebraska-domiciled insurance company), American Family Life Assurance Company of New York (Aflac New York, a New York-domiciled insurance company), CAIC (redomiciled from South Carolina to Nebraska effective December 2016) and Tier One Insurance Company (TOIC, an Oklahoma-domiciled shell insurance company acquired by the Parent Company in 2017 with no operations) are subject to state regulations in the United States as an insurance holding company system. Such regulations generally provide that transactions between companies within the holding company system must be fair and equitable. In addition, transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries, and material transactions between companies within the system, including management fees, loans and advances are subject to prior notice to, or approval by, state regulatory authorities. These laws generally require, among other things, the insurance holding company and each insurance company directly owned by the holding company to register with the insurance departments of their respective domiciliary states and to furnish annually financial and other information about the +9 +Item 1. Business +operations of companies within the holding company system. +Like all U.S. insurance companies, Aflac, Aflac New York, CAIC and TOIC are subject to regulation and supervision in the jurisdictions in which they do business. In general, the insurance laws of the various jurisdictions establish supervisory agencies with broad administrative powers relating to, among other things: +• +granting and revoking licenses to transact business +• +regulating trade and claims practices +• +licensing of insurance agents and brokers +• +approval of policy forms and premium rates +• +standards of solvency and maintenance of specified policy benefit reserves and minimum loss ratio requirements +• +capital requirements +• +limitations on dividends to shareholders +• +the nature of and limitations on investments +• +deposits of securities for the benefit of policyholders +• +filing of financial statements prepared in accordance with statutory insurance accounting practices prescribed or permitted by regulatory authorities +• +periodic examinations of the market conduct, financial, and other affairs of insurance companies +The insurance laws of Nebraska that govern Aflac's activities provide that the acquisition or change of “control” of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Nebraska Department of Insurance. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company (in the case of Aflac, the Parent Company) must generally file with the Nebraska Department of Insurance (NDOI) an application for change of control containing certain information required by statute and published regulations and provide a copy to Aflac. In Nebraska, control is generally presumed to exist if any person, directly or indirectly, acquires 10% or more of an insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Similar laws apply in New York, the domiciliary jurisdiction of Aflac's New York insurance subsidiary. +State insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). In 2016, full-scope, risk-focused financial examinations were conducted by the NDOI, New York Department of Financial Services (NYDFS), and the South Carolina Department of Insurance (SCDOI) on their state domiciled insurance entities American Family Life Assurance Company of Columbus, American Family Life Assurance Company of New York, and Continental American Insurance Company, respectively. The NDOI and NYDFS exams covered a four-year period ending December 31, 2015, whereas the SCDOI exam covered a five-year period ending December 31, 2015. There were no material findings contained in the NDOI, NYDFS and SCDOI final exam reports. +The NAIC continually reviews regulatory matters , such as risk-based capital (RBC) modernization, group capital calculations, liquidity risk assessment and principle-based reserving. The NAIC has adopted a valuation manual containing a principle-based approach to calculation of life insurance reserves. The valuation manual became effective January 1, 2017. There is a three-year transition period, beginning January 1, 2017, during which companies can choose on a product by product basis to implement principle-based reserving for new business. The Company anticipates that the adoption of this manual will not cause a material impact on the statutory reserves of Aflac, Aflac New York or CAIC. The NAIC uses an RBC formula relating to insurance risk, business risk, asset risk and interest rate risk to facilitate identification by insurance regulators of inadequately capitalized insurance companies based upon the types and mix of risk inherent in the insurer's operations. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company's regulatory total adjusted capital to its authorized control level RBC as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels are company action, regulatory action, authorized control, and mandatory control. As of December 31, 2018 , based on year-end statutory accounting results, Aflac's company action level RBC ratio was 560% . The 2018 RBC as filed is lower than Aflac U.S. stand-alone RBC due to the inclusion of Aflac Japan for the first quarter of 2018. The RBC charge reflects the business risk without any total adjusted capital (TAC). Aflac's NAIC RBC ratio remains high and reflects a very strong capital and surplus position. +10 +Item 1. Business +Under state insurance guaranty association laws and similar laws in international jurisdictions, the Company is subject to assessments, based on the share of business the Company writes in the relevant jurisdiction, for certain obligations of insolvent insurance companies to policyholders and claimants. In the United States, some states permit member insurers to recover assessments paid through full or partial premium tax offsets. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. In most states, the definition is met with a declaration of financial insolvency by a court of competent jurisdiction. For additional information regarding state insurance guaranty assessments, see the U.S. Regulatory Environment subsection of MD&A in this report. +Healthcare Reform Legislation +Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. For example, the ACA, federal health care reform legislation, gave the U.S. federal government direct regulatory authority over the business of health insurance. The reform included major changes to the U.S. health care insurance marketplace. Among other changes, the reform legislation included an individual medical insurance coverage mandate (which has since been repealed effective 2019 by the Tax Act, discussed below), provided for penalties on certain employers for failing to provide adequate coverage, created health insurance exchanges, and addressed coverage and exclusions as well as medical loss ratios. It also imposed an excise tax on certain high cost plans, known as the “Cadillac tax,” that is currently scheduled to begin in 2022. The legislation also included changes in government reimbursements and tax credits for individuals and employers and altered federal and state regulation of health insurers. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. The United States Congress has considered and may continue to consider legislation that would repeal and replace key provisions of the ACA. There can be no assurance that any legislation affecting the ACA will be passed by Congress, nor as to the ultimate timing or provisions of any such legislation, nor as to the effect of any such legislation on the design or marketability of the Company's insurance products. Further, certain provisions of the ACA have been and may continue to be subject to challenge through litigation, the ultimate effects of which on the ACA are uncertain. +Tax Reform Legislation +A budget reconciliation act commonly referred to as the Tax Cuts and Job Act (Tax Act) was signed into law on December 22, 2017. Among other things, effective January 1, 2018, the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35% to 21%, eliminated or reduced certain deductions and credits, and limited the deductibility of interest expense and executive compensation. +The Tax Act also transitions international corporate taxation from a worldwide system to a modified territorial system, which in light of the current tax treatment of Aflac Japan has the effect of subjecting the earnings of Aflac Japan to Japan taxation and subjecting the Company’s other earnings, including the consolidated earnings of the Parent Company, to U.S. taxation. +These changes were effective on January 1, 2018. Because changes to tax rates are accounted for in the period of enactment, during the period ended December 31, 2017, the Company revalued its deferred tax assets and liabilities and recorded, as the Company’s reasonable estimate, a net deferred tax liability reduction of $1.9 billion as of that date. As of the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional amount of deferred tax liabilities (DTLs) related to the Japan tax computation and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. See Note 10 of the Notes to the Consolidated Financial Statements presented in this report. For information on the conversion of Aflac Japan from a branch to a subsidiary, see General Business under this Business section, above. +11 +Item 1. Business +Dodd-Frank Act +Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and regulations issued thereunder, in particular rules to require central clearing for certain types of derivatives, may have an impact on Aflac's derivative activity, including activity on behalf of Aflac Japan. In addition, in 2015 and 2016, six U.S. financial regulators, including the U.S. Commodity Futures Trading Commission (CFTC), issued final rules regarding the exchange of initial margin (IM) and variation margin (VM) for uncleared swaps that impose greater obligations on swap dealers regarding uncleared swaps with certain counterparties, such as Aflac. The requirements of such rules with respect to VM, as well as similar regulations in Europe, became effective on March 1, 2017. Full compliance with respect to all counterparties was required by September 1, 2017. The requirements of such rules with respect to IM are currently being phased in and will be fully implemented by September 1, 2020. In October of 2017, the CFTC and the European Commission each finalized comparability determinations that permit certain swap dealers who are subject to both regulatory margin regimes to take advantage of substituted compliance by complying with one set of margin requirements. The margin requirements are expected to result in more stringent collateral requirements and to affect other aspects of Aflac's derivatives activity. +The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of business lines other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. The FIO does not directly regulate the insurance industry, but under Dodd-Frank it has the power to preempt state insurance regulations that are inconsistent with international agreements reached by the federal government, subject to certain requirements and restrictions. The FIO and certain federal agencies must achieve consensus positions with the state insurance regulators when taking positions on insurance proposals by certain international forums. In December 2013, the FIO released a report entitled "How To Modernize And Improve The System Of Insurance Regulation In The United States." The report was required by the Dodd-Frank Act, and included 18 recommended areas of near-term reform for the states, including addressing capital adequacy and safety/soundness issues, reform of insurer resolution practices, and reform of marketplace regulation. The report also listed nine recommended areas for direct federal involvement in insurance regulation. Some of the recommendations outlined in the FIO report released in December 2013 have been implemented. The National Association of Registered Agents and Brokers Reform Act, signed into law in January 2015, simplifies the agent and broker licensing process across state lines. The FIO has also engaged with the supervisory colleges to monitor financial stability and identify regulatory gaps for large national and internationally active insurers. +The current U.S. presidential administration and Congress have made recent attempts to reform or repeal certain provisions of the Dodd-Frank Act, some of which have been implemented. For example, in 2018, President Trump signed into law the “Economic Growth, Regulatory Relief, and Consumer Protection Act.” Members of Congress have also introduced multiple bills that would impact or eliminate the FIO. The Federal Reserve is developing a rulemaking regarding the Financial Stability Oversight Council’s (the Council) ability to designate nonbank financial companies as Systemically Important Financial Institutions, and, pursuant to an Executive Order, the Treasury Department released a report on the Council’s designation authority. The Company cannot predict with any degree of certainty what impact, if any, such proposals will have on Aflac's business, financial condition, or results of operations. +Further Information +For further information concerning Aflac U.S. operations, regulation, change of control and dividend restrictions, see the Aflac U.S. Segment subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +Privacy and Cybersecurity +The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal Gramm-Leach-Bliley Act of 1999 (GLBA) and in the Health Insurance Portability and Accountability Act of 1996 (HIPAA). For example, in June 2018, California passed a data privacy law, scheduled to become effective January 2020, that requires businesses to provide California consumers rights to access, delete, and restrict certain uses of their personal information. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is +12 +Item 1. Business +regulated in Japan by the Act on the Protection of Personal Information (APPI) and guidelines issued by FSA and other governmental authorities. The FSA updated its guidelines regarding cybersecurity in October 2018. +Cybersecurity also continues to be an area of evolving focus for U.S. legislation and regulatory activity. In March 2017, new cybersecurity regulation issued by the New York Department of Financial Services (NYDFS) went into effect that requires covered entities, including Aflac New York, to maintain an information security program meeting certain security, data disposal, audit, activity monitoring, and data encryption requirements. In October 2017, the NAIC adopted an Insurance Data Security Model Law that may be adopted in whole or in part by U.S. states in which the Company’s subsidiaries are licensed. Other states have adopted and, the Company expects, will continue to pass legislation and issue regulations related to cybersecurity. The Company anticipates, assesses, and if necessary modifies its information security program to accommodate such changes. +The Company’s Board of Directors has adopted an information security policy directing management to establish and operate an information security program with the goal of ensuring that the Company’s information assets and data, and the data of its customers, are appropriately protected. The Board has delegated oversight of the Company’s information security program to the Audit and Risk Committee. The Company’s senior officers, including its Global Security and Chief Information Security Officer, are responsible for the operation of the information security program and regularly communicate with the Audit and Risk Committee on the program, including with respect to the state of the program, compliance with applicable regulations, current and evolving threats, and recommendations for changes in the information security program. The information security program also includes a cybersecurity incident response plan that is designed to provide a management framework across Company functions for a coordinated assessment and response to potential security incidents. This framework establishes a protocol to report certain incidents to the Global Security and Chief Information Security Officer and other senior officers, with the goal of timely assessing such incidents, determining applicable disclosure requirements and communicating with the Audit and Risk Committee. The incident response plan directs the executive officers to report certain incidents immediately and directly to the Lead Non-Management Director. +Other Operations +The Company's other operations include the Parent Company, results of reinsurance retrocession activities, and a printing subsidiary. For additional information on the Company's other operations, see the Corporate and Other subsection of MD&A and Note 8 in the Notes to the Consolidated Financial Statements. +Employees +As of December 31, 2018 , Aflac Japan had 6,121 employees, Aflac U.S. had 4,712 employees, and the Company's other operations had 557 employees. +13 +Item 1. Business +Executive Officers of the Registrant +NAME +PRINCIPAL OCCUPATION (1) +AGE +Daniel P. Amos +Chairman, Aflac Incorporated and Aflac, since 2001; Chief Executive Officer, Aflac Incorporated and Aflac, since 1990 +67 +Koji Ariyoshi +Executive Vice President, Director of Sales and Marketing, Aflac Japan, since 2012 +65 +Max K. Broden +Senior Vice President and Treasurer, Aflac Incorporated, since 2017; Senior Portfolio Manager, Norges Bank, from 2007 until 2017 +40 +Frederick J. Crawford +Executive Vice President, Chief Financial Officer, Aflac Incorporated, since 2015; Executive Vice President, Chief Financial Officer, CNO Financial Group from 2012 until 2015; Executive Vice President, Head of Investment and Corporate Development, Lincoln Financial Group from 2010 until 2012 +55 +J. Todd Daniels +Executive Vice President and Principal Financial Officer, Aflac Japan, since 2018; Executive Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2016 until 2018; Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2015 until 2016; Senior Vice President, Deputy Corporate Actuary and Global Chief Risk Officer, Aflac, from 2014 until 2015; Senior Vice President, Deputy Corporate Actuary, Aflac, from 2012 until 2014; Vice President, Financial Planning and Analysis, Aflac, from 2011 until 2012 +48 +June Howard +Chief Accounting Officer, Aflac Incorporated and Aflac, since 2010; Senior Vice President, Financial Services, Aflac Incorporated and Aflac, since 2010; Treasurer, Aflac, from 2011 until 2015 +52 +Eric M. Kirsch +Executive Vice President, Global Chief Investment Officer, Aflac, since 2012; President, Aflac Asset Management LLC, since 2017; First Senior Vice President, Global Chief Investment Officer, Aflac, from 2011 until 2012 +58 +Masatoshi Koide +President and Chief Operating Officer, Aflac Japan since 2017; Deputy President, Aflac Japan from 2016 until 2017; Executive Vice President, Aflac Japan from 2015 until 2016; First Senior Vice President, Aflac Japan from 2013 until 2015; Senior Vice President, Aflac Japan from 2012 until 2013 +58 +Charles D. Lake, II +President, Aflac International, since 2014; Chairman, Aflac Japan, since 2008 +57 +Albert A. Riggieri +Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, since 2018; Senior Vice President, Corporate Actuary, Aflac, from 2016 until 2018; Group Chief Actuary, Unum Group, until 2016 +63 +Audrey B. Tillman +Executive Vice President, General Counsel, Aflac Incorporated and Aflac, since 2014; Executive Vice President, Corporate Services, Aflac Incorporated, from 2008 until 2014 +54 +Teresa L. White +President, Aflac U.S., since 2014; Executive Vice President, Chief Operating Officer, Aflac, from 2013 until 2014; Executive Vice President, Chief Service Officer, Aflac, from 2012 until 2013; Executive Vice President, Chief Administrative Officer, Aflac, from 2008 until 2013 +52 +Richard L. Williams Jr. +Executive Vice President and Chief Distribution Officer, Aflac since 2017; Senior Vice President and General Manager, Stop Loss, Unum, U.S. in 2017; Senior Vice President, Growth Markets, Colonial Life and Accident Insurance Company from 2013 until 2017 +47 +(1) Unless specifically noted, the respective executive officer has held the occupation(s) set forth in the table for at least the last five years. Each executive officer is appointed annually by the board of directors and serves until his or her successor is chosen and qualified, or until his or her death, resignation or removal. +14 +Item 1A. Risk Factors +ITEM 1A. RISK FACTORS +The Company faces a wide range of risks, and its continued success depends on its ability to identify, prioritize and appropriately manage enterprise risk exposures. Readers should carefully consider each of the following risks and all of the other information set forth in this Form 10-K. These risks and other factors may affect forward-looking statements, including those in this document or made by the Company elsewhere, such as in earnings release webcasts, investor conference presentations or press releases. The risks and uncertainties described herein may not be the only ones facing the Company. Additional risks and uncertainties not presently known to the Company or that the Company currently believes to be immaterial may also adversely affect its business. If any of the following risks and uncertainties develops into actual events, there could be a material impact on the Company. +Difficult conditions in global capital markets and the economy could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business. +The Company's results of operations are materially affected by conditions in the global capital markets and the global economy generally, including in its two primary operating markets of the United States and Japan. Weak global financial markets impact the value of the Company's existing investment portfolio, influence opportunities for new investments, and may contribute to generally weak economic fundamentals, which can have a negative impact on its operating activities. +In recent years, global capital markets have been severely impacted by several major events. The financial crisis that began in the latter part of 2008 saw dramatic declines in investment values and weak economic conditions as the global financial system came under extreme pressure. Although U.S. markets began recovering in late 2009 and 2010, Europe continued to struggle under a severely weakened banking system and investor concerns with sovereign debt levels. Following a period of unprecedented intervention by governments and central banks, including the U.S. Federal Reserve and European Central Bank (ECB), financial conditions improved from the dire conditions of the global financial crisis, global recession, and European debt crisis. More recently, global markets have experienced bouts of volatility due to uncertainty surrounding a British exit from the European Union, Japan’s continued recovery amidst assorted policy changes, volatility in global commodity prices including oil, divergent monetary policies in the United States versus many other developed economies, heightened concerns surrounding the Chinese economy and increasing protectionism in U.S. foreign trade policy. While capital and market conditions have been generally favorable in the last year, volatility increased in the fourth quarter and the prospect for increased volatility remains. +A recent shift in the global trading policies by the U.S. and subsequent trade conflict with China has raised concerns about a slowdown of the Chinese economy. In addition, the U.S. and Japan are engaged in discussions regarding changes to tariffs and trade agreements. While it is not expected that the Company's products would be directly impacted by tariff, any resulting economic downturn could adversely affect the Company. +Activity by the government of North Korea in 2018 was the subject of increasing focus for a number of other governments, including those of the United States and Japan. Although hostile rhetoric has decreased, such North Korean activity and related geopolitical risk could have a significant impact on financial market conditions across the world. Under certain circumstances, government actions taken in response to the North Korean situation could have a material impact on the Company's Japan and U.S. operations and financial performance, including the indirect impact of potentially severe and prolonged capital market volatility and disruption. +As the Company holds a significant amount of fixed maturity securities issued by borrowers located in many different parts of the world, including a large portion issued by banks and financial institutions, sovereigns, and other corporate borrowers in the United States and Europe, its financial results are directly influenced by global financial markets. A retrenchment of the recent strength of the capital markets could adversely affect the Company's financial condition, including its capital position and overall profitability. Market volatility and recessionary pressures could result in significant realized or unrealized losses due to severe price declines driven by increases in interest rates or credit spreads, defaults in payment of principal or interest, or credit rating downgrades. +Following the election of Shinzo Abe as Prime Minister of Japan in December 2012, the new administration adopted a new set of financial measures to stimulate the Japanese economy, including imposing negative interest rates on excess bank reserves. In December 2014 and October 2017 snap-elections, the ruling Liberal Democratic Party (LDP) won decisive victories further strengthening Mr. Abe's ability to continue with economic reforms and address key policy challenges. In September 2018, Mr. Abe won reelection to another three-year term as president of the LDP. Most recently, the Bank of Japan (BoJ) signaled to hold its policy rate at zero and to continue yield curve control to maintain a targeted +15 +Item 1A. Risk Factors +yield on the 10-year Japan Government Bond (JGB). Prime Minister Abe’s election victories may result in the continuation of current monetary policy, but there can be no guarantee that this is the case. +Japan is the largest market for the Company's products, and the Company owns substantial holdings in JGBs. Government actions to stimulate the economy affect the value of the Company's existing holdings, its reinvestment rate on new investments in JGBs or other yen-denominated assets, and consumer behavior relative to the Company's suite of products. The additional government debt from fiscal stimulus actions could adversely impact the Japan sovereign credit profile, which could in turn lead to volatility in Japanese capital and currency markets. +The Company's investment portfolio has sizeable credit positions in many other geographic areas of the world including the Middle East, Latin America, Asia, and other emerging markets. Deterioration in their underlying economies, sovereign credit worthiness, or financial market conditions could negatively impact the Company's financial position. +While the Company has continued to add floating rate investments to its investment portfolio, most of its investment portfolio holdings are income-producing bonds that provide a fixed level of income. Many of the Company's investments were made at the relatively low level of interest rates prevailing over the last decade. Any increase in the market yields of the Company's holdings due to an increase in interest rates could create substantial unrealized losses in the Company's portfolio, as discussed further in a separate risk factor in this section of the Form 10-K. +The Company needs liquidity to pay its operating expenses, dividends on its common stock, interest on its debt, and liabilities. For a further description of the Company's liquidity needs, including maturing indebtedness, see the Capital Resources and Liquidity section of MD&A in this report. In the event the Company's current resources do not meet its needs, the Company may need to seek additional financing. The Company's access to additional funding will depend on a variety of factors such as market conditions, the general availability of credit to the financial services industry and its credit rating. +Should investors become concerned with any of the Company's investment holdings, including the concentration in JGBs, its access to market sources of funding could be negatively impacted. There is a possibility that lenders or debt investors may also become concerned if the Company incurs large investment losses or if the level of the Company's business activity decreases due to a market downturn or there are further adverse economic trends in the United States or Japan, specifically, or generally in developed markets. Similarly, the Company's access to funds may be impaired if regulatory authorities or rating agencies take negative actions. See more information on recent rating actions later in this Risk Factors section. +Broad economic factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, indirectly, the amount and profitability of the Company's business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for financial and insurance products could be adversely affected. This adverse effect could be particularly significant for companies such as Aflac that distribute supplemental, discretionary insurance products primarily through the worksite in the event that economic conditions result in a decrease in the number of new hires and total employees. Adverse changes in the economy could potentially lead the Company's customers to be less inclined to purchase supplemental insurance coverage or to decide to cancel or modify existing insurance coverage, which could adversely affect the Company's premium revenue, results of operations and financial condition. The Company is unable to predict the course of the global financial markets or the recurrence, duration or severity of disruptions in such markets. +The Company is exposed to significant interest rate risk, which may adversely affect its results of operations, financial condition and liquidity. +The Company has substantial investment portfolios that support its policy liabilities. Low levels of interest rates on investments experienced in Japan and the United States over the last decade have reduced the level of investment income earned by the Company. The Company's overall level of investment income will be negatively impacted in a persistent low-interest-rate environment. While the Company generally seeks to maintain a diversified portfolio of fixed-income investments that reflects the cash flow and duration characteristics of the liabilities it supports, the Company may not be able to fully mitigate the interest rate risk of its assets relative to its liabilities. The Company's exposure to interest rate risk relates primarily to the ability to invest future cash flows to support the interest rate assumption made at the time the Company's products were priced and the related reserving assumptions were established. A sustained decline in interest rates could hinder the Company's ability to earn the returns assumed in the pricing and the reserving for its products at the time they were sold and issued. Due to low interest rates, the Company's ability to earn the returns it expects may also influence the Company's ability to develop and price attractive new products and could impact its overall +16 +Item 1A. Risk Factors +sales levels. The Company's first sector products are more interest rate sensitive than third sector products. As discussed in Item 1. Business, beginning in 2013, Aflac Japan began to curtail sales of first sector savings-type products due to persistent low interest rates in Japan. The continuing negative interest rate imposed by the BoJ on excess bank reserves could continue to have a negative impact on the distribution and pricing of these products. +A rise in interest rates could improve the Company's ability to earn higher rates of return on future investments, as well as floating rate investments held in its investment portfolio. However, an increase in the differential of short-term U.S. and Japan interest rates would increase the cost of hedging a portion of the U.S. dollar-denominated assets in the Aflac Japan segment into yen, which could have a material adverse effect on the Company's business, results of operations or financial condition. T he Company’s floating rate investments typically bear interest based on the London Interbank Offered Rate (LIBOR). Regulatory and industry initiatives to eliminate LIBOR as an interest rate benchmark may create uncertainty in the valuation of LIBOR-based loans, as well as for other LIBOR-based derivatives and assets. This may adversely impact both pricing and liquidity in such instruments. The Company is unable to predict with certainty how LIBOR elimination may impact markets, pricing, liquidity and other factors or the Company's activities. +Changes in interest rates impact unrealized gains and losses of fixed income securities in the Company's investment portfolio; however, they do not have a direct impact on the related valuation of the corresponding liabilities. Prolonged periods of low interest rates, as have been experienced in recent years, heighten the risk of future increases in interest rates because an increasing proportion of the Company's investment portfolio includes investments that bear lower rates of return than the embedded book yield of the investment portfolio. A rise in interest rates could decrease the fair value of the Company's debt securities. Some of the insurance products that Aflac sells in the United States and Japan provide cash surrender values. A rise in interest rates could trigger significant policy surrenders, which might require the Company to sell investment assets and recognize unrealized losses. This situation is commonly referred to as disintermediation risk. The Company generally invests its assets to match the duration and cash flow characteristics of its policy liabilities, and therefore would not expect to realize most of these gains or losses, however, the Company's risk is that unforeseen events or economic conditions, such as changes in interest rates resulting from governmental monetary policies, domestic and international economic and political conditions, and other factors beyond the Company's control will reduce the effectiveness of this strategy. These events or economic conditions could either cause the Company to dispose of some or all of these investments prior to their maturity, or increase the risk that the issuers of these securities may default or may require impairment, which could result in the Company having to recognize such gains or losses. +Rising interest rates also negatively impact the SMR since unrealized losses on the available-for-sale investment portfolio factor into the ratio. For regulatory accounting purposes for Aflac Japan, there are certain requirements for realizing impairments that could be triggered by rising interest rates, negatively impacting Aflac Japan's earnings and corresponding dividends and capital deployment. +Further, interest rate risk is still an inherent portfolio, business and capital risk for the Company, and significant changes in interest rates could have a material adverse effect on the Company's consolidated results of operations, financial condition or cash flows through realized losses, impairments, changes in unrealized positions, and liquidity. +For more information regarding interest rate risk, see the Interest Rate Risk subsection within the Market Risks of Financial Instruments section of MD&A in this report. +The Company's concentration of business in Japan poses risks to its operations. +The Company's operations in Japan, including realized gains and losses on Aflac Japan's investment portfolio, accounted for 70% of the Company's total revenues for both 2018 and 2017 , compared with 71% in 2016 . The Japanese operations accounted for 84% of the Company's total assets at December 31, 2018 , compared with 83% at December 31, 2017 . +Further, because of the concentration of the Company's business in Japan and its need for long-dated yen-denominated assets, the Company has a substantial concentration of JGBs in its investment portfolio. As such the Company has material exposure to the Japanese economy, geo-political climate, political regime, and other factors that generally determine a country's creditworthiness. Specifically, the nationally recognized statistical rating organizations ( NRSROs, or "rating agencies"), credit rating agencies registered with the SEC, have placed increased scrutiny on JGBs, which are a significant component of the Company’s overall investment portfolio, resulting in downgrades as discussed later in this Risk Factors section. +The Company seeks to match investment currency and interest rate risk to its yen liabilities. The low level of interest rates available on yen-denominated securities has a negative effect on overall net investment income. A large portion of +17 +Item 1A. Risk Factors +the cash available for reinvestment each year is deployed in yen-denominated instruments and subject to the low level of yen interest rates. +Any potential deterioration in Japan ' s credit quality, market access, the overall economy of Japan, or Japanese market volatility could adversely impact the business of Aflac in general and specifically Aflac Japan and its related results of operations and financial condition. +The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate. +Due to the size of Aflac Japan, where functional currency is the Japanese yen, fluctuations in the rate of exchange between the yen and the U.S. dollar can have a significant effect on the Company's reported financial position and results of operations. Aflac Japan's premiums and approximately half of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into U.S. dollars for financial reporting purposes. Accordingly, fluctuations in the yen/dollar exchange rate can have a significant effect on the Company's reported financial position and results of operations. In periods when yen weakens, translating yen into U.S. dollars causes fewer U.S. dollars to be reported. When yen strengthens, translating yen into U.S. dollars causes more U.S. dollars to be reported. Any unrealized foreign currency translation adjustments are reported in accumulated other comprehensive income. As a result, yen weakening has the effect of suppressing current year results in relation to the prior year, while yen strengthening has the effect of magnifying current year results in relation to the prior year. In addition, the weakening of the yen relative to the U.S. dollar will generally adversely affect the value of the Company's yen-denominated investments in U.S. dollar terms. +The Company engages in certain foreign currency hedging activities for the purpose of hedging the yen exposure to its net investment in operations in Japan. These hedging activities are limited in scope, and the Company cannot provide assurance that these activities will be effective. +Unhedged U.S. dollar-denominated securities held by Aflac Japan are exposed to foreign exchange fluctuations, which impact SMR. In periods of yen strengthening, the unhedged U.S. dollar-denominated investments will experience unrealized foreign exchange losses, negatively impacting SMR. This impact increases when the size of the unhedged U.S. dollar-denominated portfolio increases, which can occur due to the purchase of additional unhedged U.S. dollar-denominated investments, or through termination or expiration of existing hedges. Unrealized currency gains and losses on unhedged U.S. dollar-denominated securities are monetized (or, in other words, are economically realized) only upon converting the proceeds from the sale, maturity or redemption of these securities to yen, which primarily occurs when yen are needed to satisfy policyholder obligations or other business expenses of Aflac Japan. To mitigate exposure to the foreign exchange risk from U.S. dollar-denominated investments and to reduce SMR volatility, the Company engages in certain currency hedging activities. However, these hedging activities are limited in scope and the Company cannot provide assurance that its hedging strategies will be effective. As a result, periods of unusually volatile currency exchange rates could result in limitations on dividends available to the Parent Company. +As indicated in the Item 1, Business, the Company has determined that the unhedged U.S. dollar-denominated investment portfolio acts as a natural economic currency hedge of a portion of the Company’s investment in Aflac Japan against erosion of economic value. However, the unhedged U.S. dollar-denominated investment portfolio at the same time creates an unmatched foreign currency exposure and subjects Aflac Japan to volatility in regulatory capital and earnings, which may adversely impact Aflac Japan’s ability to pay dividends to the Parent Company. The overall investment strategy in Aflac Japan is guided primarily by the objective of securing the long-term financial strength of Aflac Japan and funding of yen liabilities. As a result, the Company has historically maintained and currently maintains the size of the unhedged portfolio at levels below the stressed economic surplus in Aflac Japan. However, there can be no assurance that this strategy will be successful. +Furthermore, for regulatory accounting purposes, there are certain requirements for realizing impairments that could be triggered by changes in the rate of exchange between the yen and U.S. dollar and could negatively impact Aflac Japan's earnings and the corresponding dividends and capital deployment. +Additionally, the Company is exposed to currency risk when yen cash flows are converted into U.S. dollars, resulting in an increase or decrease in the Company's U.S. dollar-denominated cash flows and earnings when exchange gains or losses, respectively, are realized. This primarily occurs when the Company dividends funds from Aflac Japan to the Parent Company, but it also has an impact when cash in the form of yen is converted to U.S. dollars for investment into U.S. dollar-denominated assets. The exchange rates prevailing at the time of dividend payment may differ from the exchange rates prevailing at the time the yen profits were earned. In 2018, the Parent Company entered into forward contracts to +18 +Item 1A. Risk Factors +accomplish a dual objective of hedging foreign currency exchange rate risk related to dividend payments by Aflac Japan, and reducing enterprise-wide hedge costs. If the markets experience a significant strengthening of yen, this could cause cash strain at the Parent Company as a result of cash collateral and potentially cash settlement requirements. Based on the timing and severity of exchange rate fluctuations combined with the level of outstanding activity in this program, the cash strain at the Parent Company could be significant. +For more information regarding unhedged U.S. dollar-denominated securities, see the risk factor below entitled, “Lack of availability of acceptable yen-denominated investments could adversely affect the Company’s results of operations, financial position or liquidity”. For more information regarding foreign currency risk, see the Currency Risk subsection within the Market Risks of Financial Instruments section of MD&A. +Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity. +The Company attempts to match both the duration and currency of its assets with its liabilities. This is very difficult for Aflac Japan due to the lack of available long-dated yen-denominated fixed income instruments beyond JGBs. +Prior to the onset of the financial crisis of 2008, the Company was focused on investing cash flows in JGBs, which had relatively low yields, and utilizing private placement and perpetual securities to gain additional yield, extend the duration of the investment portfolio, and maintain yen exposure. Given call activity with respect to certain of the Company's legacy private placement investments, the Company has added a modest amount of yen-denominated private placements to its investment portfolio in recent periods. The investment in private placements carries risk associated with illiquidity, which is managed and monitored by the Company. +Starting in 2012, Aflac Japan augmented its investment strategy to include U.S. dollar-denominated investments, some of which could then be hedged back to yen. Initially this program focused on public investment-grade bonds but has evolved over time to include U.S. dollar-denominated investment-grade commercial mortgage loans, infrastructure debt, as well as other loan types, high yield bonds and U.S. equity securities. The Company plans to continue adding other instruments denominated in U.S. dollars, including floating rate investments, to improve the portfolio diversification and/or return profile. Some of the U.S. dollar-denominated asset classes that the Company has added, and anticipates continuing to add, have less liquidity than investment-grade corporate bonds. These strategies will continue to increase the Company's exposure to U.S. interest rates, credit spreads and other risks. The Company has increased foreign exchange risk exposure as the comprehensive hedging program may not always correlate to the underlying U.S. dollar-denominated assets, thereby increasing earnings volatility. These risks can significantly impact the Company's consolidated results of operations, financial position or liquidity. +Investing in U.S. dollar-denominated investments in Aflac Japan also creates an unmatched foreign currency exposure and related SMR volatility, as Aflac Japan’s insurance liabilities are yen-denominated. Although the Company engages in certain foreign exchange hedging activities to partially mitigate this risk, and such hedged assets may be used to satisfy yen-denominated insurance liabilities and other business obligations, important risks remain. +Foreign exchange derivatives used for hedging are periodically settled, which results in cash receipt or payment at maturity or early termination. The Company’s foreign exchange derivatives are typically shorter-dated than the underlying U.S. dollar-denominated investments being hedged, which creates roll-over risks within the hedging program that could increase the cost of such derivatives. If the Company reduces the notional amount of foreign exchange derivatives prior to the maturity of the hedged U.S. dollar-denominated investments, the foreign exchange gains or losses on the U.S. dollar-denominated investments remain economically unrealized. These gains or losses are only economically realized, or monetized , through sale , maturity or redemption of the investments and concurrent conversion to yen. However, the Company may not realize the benefit of offsetting adverse cash settlements on hedging derivatives with cash receipts on the U.S. dollar-denominated investments if the currency exchange rates move in an adverse direction before the investments are converted to yen, or if the investments are never converted to yen. As an example of the latter, if the Company’s actual insurance risk experience in Japan is as expected or more favorable than expected, the need for yen to pay expenses and claims would correspondingly remain at or below expected levels, thereby diminishing operational requirements to convert U.S. dollar-denominated investments to yen. Since 2012, the cumulative net cash settlements on derivatives hedging currency exposure of Aflac Japan’s U.S. dollar-denominated investments were an outflow of $3.9 billion as of December 31, 2018. These outflows or cumulative net negative settlements are associated with foreign exchange derivatives on existing U.S. dollar-denominated investments and hedged investments that have since been sold, matured or redeemed and may or may have not been converted to yen. Furthermore, the settlements include instances where the initial foreign exchange derivative notional amounts were reduced prior to the maturity of the hedged +19 +Item 1A. Risk Factors +investments. The settlement of the foreign exchange derivatives is reported in the investing activities section of the Company’s consolidated statements of cash flows in the line item “Settlement of derivatives, net.” +For more information regarding unhedged U.S. dollar-denominated securities, see the risk factor above entitled, “The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate.” For more information regarding Aflac Japan's U.S. dollar-denominated investments and hedging activities, see the Hedging Activities subsection within the Item 7. MD&A section in this report, and for more information regarding foreign currency risk, see the Currency Risk subsection within the Item 7A. Quantitative and Qualitative Disclosures about Market Risk section in this report. +U.S. tax audit risk related to conversion of the Japan branch to a subsidiary could adversely impact the Company's financial position. +The conversion of the Japan branch to a legal subsidiary, which the Company executed in the second quarter of 2018, was a complex, tax-free transaction that is conditioned on the continued validity of a private letter ruling the Company received from the Internal Revenue Service (IRS). Notwithstanding the receipt of the private letter ruling, the IRS could determine that the Japan branch conversion should be treated as a taxable transaction. For example, the IRS could conclude that the representations, assumptions and covenants on which the private letter ruling is based are untrue, not accurate, or have not been fulfilled. If the IRS made such a conclusion, the Company could incur significant U.S. federal income tax liabilities or litigation costs to defend the tax-free treatment of the transaction outlined by the private letter ruling. Such liabilities or costs could have a material adverse effect on the Company's business, results of operations and financial condition. +If future policy benefits, claims or expenses exceed those anticipated in establishing premiums and reserves, the Company's financial results would be adversely affected. +The Company establishes premiums for many of its policies on assumptions for morbidity, mortality, longevity and persistency. The Company also establishes and carries, as a liability, reserves based on estimates of how much will be required to pay for future benefits and claims on its policies. The Company calculates these reserves using various assumptions and estimates, including premiums the Company will receive over the assumed life of the policy; the timing, frequency and severity of the events covered by the insurance policy; and the investment returns on the assets the Company purchases with a portion of its net cash flow from operations. +The assumptions and estimates that the Company uses in establishing premiums and reserves depend on the Company's judgment regarding the likelihood of future events and are inherently uncertain. Many factors can cause actual outcomes to deviate from these assumptions and estimates, such as changes in economic conditions, changes in government healthcare policy, advances in medical technology, changes in treatment patterns, and changes in average lifespan. Accordingly, the Company cannot determine with precision the ultimate amounts that it will pay for, or the timing of payment of, actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level the Company assumes prior to payment of benefits or claims. If the Company's actual experience is different from its assumptions or estimates, the Company's reserves may prove inadequate. As a result, the Company would incur a charge to earnings in the period in which it determines such a shortfall exists, which could have a material adverse effect on the Company's business, results of operations and financial condition. +Generally, lower mortality decreases the profitability of third sector products in Japan, as more policyholders will survive into ages where they have a higher rate of claim incidence. This assumption can impact pricing and reserving. For instance, Japan FSA periodically requires updates to their Standard mortality tables for FSA reserves. An update to the Standard mortality tables was performed in April 2018 applicable to all business issued after that date. For business that is inforce prior to the update, the change in mortality table would not have an impact. For new issues, the updated mortality tables would be included in our reserve assumptions, and slow the emergence of FSA earnings for third sector products and therefore will have an impact on pricing returns. The Company adjusts pricing assumptions as new products are developed to adjust for these mortality assumptions. +The success of the Company's business depends in part on effective information technology systems and on continuing to develop and implement improvements in technology. +The Company's business depends in large part on its technology systems for interacting with employers, policyholders, sales associates, and brokers, and the Company's business strategy involves providing customers with easy-to-use products to meet their needs and ensuring employees have the technology in place to support those needs. Some of the Company's information technology systems and software are older, legacy-type systems that are less efficient and require an ongoing commitment of significant resources to maintain or upgrade to current standards including +20 +Item 1A. Risk Factors +adequate business continuity procedures. The Company is in a continual state of upgrading and enhancing its business systems; however, these changes tend to challenge the Company's complex integrated environment. The Company's success is dependent in large part on maintaining or improving the effectiveness of existing systems and continuing to develop and enhance information systems that support its business processes in a cost-efficient manner. If the Company does not maintain the effectiveness of its systems, the Company's operations and reputation could be adversely affected and it could be exposed to litigation as well as to regulatory proceedings and fines or penalties. +Competition could adversely affect the Company's ability to increase or maintain its market share or profitability. +The Company operates in a competitive environment and in an industry that is subject to ongoing changes from market pressures brought about by customer demands, legislative reform, marketing practices and changes to health care and health insurance delivery. These factors require the Company to anticipate market trends and make changes to differentiate the Company's products and services from those of its competitors. The Company also faces the potential of competition from existing or new companies in the United States and Japan that have not historically been active in the supplemental health insurance industry, but some of which have greater financial, marketing and management resources than the Company does. Failure to anticipate market trends and/or to differentiate the Company's products and services can affect the Company's ability to retain or grow profitable lines of business. +Further, as employers and brokers are increasingly requesting a full-suite of products from one insurance provider, a failure to react and adapt to these demands could result in decreased sales or market share. Similarly, a failure to meet evolving customer demands through innovative product development, effective distribution channels, and continuous investment in the Company's technology could result in lower revenues and less favorable policy terms and conditions, which could adversely affect the Company's operating results. +Events, including those external to the Company's operations, could damage the Company's reputation. +The Company has made significant investments in the Aflac brand over a long period of time. Because insurance products are intangible, the Company's ability to compete for and maintain policyholders relies to a large extent on consumer trust in the Company's business. The perception of unfavorable business practices or financial weakness could create doubt regarding the Company's ability to honor the commitments it has made to its policyholders. Maintaining the Company's stature as a trustworthy insurer and responsible corporate citizen, which helps support the strength of the Company's brand, is critical to the Company's reputation and the failure or perceived failure to do so could adversely affect the Company's brand value, financial condition and results of operations. For example, negative publicity or allegations of unfavorable business practices or poor governance can be rapidly and widely shared over social or traditional media or other means, and could reduce demand for the Company's insurance products, reduce the Company's ability to recruit and retain employees, or lead to greater regulatory scrutiny of the Company's operations. +Sales of the Company's products and services are dependent on its ability to attract, retain and support a network of qualified sales associates, brokers and employees in the United States and sales associates and other distribution partners in Japan. +The Company's sales could be adversely affected if its sales networks deteriorate or if the Company does not adequately provide support, training and education for its existing network. In the United States, competition exists for sales associates and brokers with demonstrated ability. In Japan, the Company's sales results are dependent upon its relationship with sales associates and other distribution partners, including its alliance partner, Japan Post, which in recent periods has accounted for approximately 25% of Aflac Japan's third sector sales. The Company competes with other insurers and financial institutions primarily on the basis of its products, compensation, support services and financial rating. The Company's inability to attract and retain qualified sales associates, brokers and other distribution partners, including its alliance partners in Japan, could have a material adverse effect on the Company's sales, results of operations and financial condition. +The Company's sales associates and brokers are independent contractors and may sell products of its competitors. If the Company's competitors offer products that are more attractive, or pay higher commissions than the Company does, any or all of these distribution partners may concentrate their efforts on selling the Company's competitors' products instead of the Company's. In addition to the Company's commissioned sales force in the United States, Aflac has expanded its sales leadership team to include a salaried sales force of over 200 market directors and broker sales professionals. The Company's ability to attract and retain top talent in these salaried roles has a material impact on its sales success. +21 +Item 1A. Risk Factors +Additionally, as the Japan and U.S. employment markets continue to evolve, there is risk that the Company's practices regarding attracting, developing, and retaining employees may not be fully effective. Failure to successfully meet and maintain sufficient levels of employees may diminish the Company's ability to achieve its financial and compliance objectives, both of which are time consuming and personnel-intensive. +Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality, integrity or privacy of sensitive data residing on such systems, could harm the Company's business. +The Company stores confidential policyholder, employee, agent, and other proprietary information on its information technology systems. In addition, the Company depends heavily on its telecommunication, information technology and other operational systems and on the integrity and timeliness of data it uses to run its businesses and service its customers. These systems may fail to operate properly or become disabled as a result of events or circumstances wholly or partly beyond the Company's control. Additionally, design flaws may exist in certain systems, processes, software, or configurations that in turn may result in system failure, data corruption, or compromise. Despite the Company's implementation of a variety of security measures to defend against threats incurred on a daily basis, its information technology and other systems, as well as those of third party providers and participants in the Company’s distribution channels, have been and will likely continue to be subject to physical or electronic break-ins, unauthorized tampering, security breaches or other cyber-attacks, that may result in the failure to adequately maintain the security, confidentiality, integrity, or privacy of sensitive data, including personal information relating to customers and prospective customers, or in the misappropriation of the Company's intellectual property or proprietary information. +From time to time, the Company, its third party providers and participants in the Company’s distribution channels have experienced and will likely continue to experience such events. Although the minor data leakage issues the Company has experienced to date have not had a material effect on its business, there is no assurance that the Company's security systems or processes will prevent or mitigate future break-ins, tampering, security breaches or other cyber-attacks. Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems, whether due to actions by the Company or others, including third party providers and participants in the company’s distribution channels, could delay or disrupt the Company's ability to do business and service its customers, seriously harm the Company's brand and reputation as well as the Company's ability to compete effectively, subject it to regulatory sanctions and other claims, lead to a loss of customers and revenues and otherwise adversely affect the Company's business. In addition, the costs to address or remediate system interruptions or security threats and vulnerabilities, whether before or after an incident, could be significant. +While the Company continues to invest in the infrastructure of its data security programs, the Company, as well as its third party providers and participants in the Company’s distribution channels, have been, and will likely continue to be, the target of unauthorized access, social engineering, phishing, cyber-attacks, web application attacks, computer viruses or other malicious codes, or other computer-related penetrations. Although the Company attempts to manage its exposure to such events through the purchase of cyber liability insurance, such events are inherently unpredictable and insurance may not be sufficient to protect the Company against all losses. As a result, events such as these could adversely affect the Company's financial condition or results of operation. +If the Company fails to comply with restrictions on customer privacy and information security, including taking steps to ensure that its third-party service providers and business associates who access, store, process or transmit sensitive customer information maintain its security, integrity, confidentiality and availability, the Company's reputation and business operations could be materially adversely affected. +The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal GLBA and in the HIPAA. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the APPI and guidelines issued by FSA and other governmental authorities. +The Company relies on third parties, and in some cases subcontractors, to provide information technology and data services. It also relies on various parties in its distribution channels including agencies, banks and Japan Post in Japan, as well as sales associates and brokers in the United States, to provide services to prospective and existing customers. +22 +Item 1A. Risk Factors +Although the Company provides for appropriate protections through its contracts and performs information security risk assessments of its third-party service providers and business associates, the Company still has limited control over their actions and practices. In addition, despite the security measures the Company has in place to ensure compliance with applicable laws and rules, the Company's facilities and systems, and those of the Company's third-party providers and participants in its distribution channels may be vulnerable to security breaches, acts of vandalism or theft, computer viruses, misplaced or lost data, programming and/or human errors or other similar events. From time to time, the Company, its third party providers and participants in the Company’s distribution channels have experienced and will likely continue to experience such events. In such cases, notification to affected individuals, state and federal regulators, state attorneys general and media may be required, depending upon the number of affected individuals and whether personal information including health or financial data was subject to unauthorized access. +The U.S. Congress and many states are considering new privacy and security requirements that would apply to the Company's business. Compliance with new privacy and security laws, requirements, and new regulations may result in cost increases due to necessary systems changes, new limitations or constraints on the Company's business models, the development of new administrative processes, and the effects of potential noncompliance by the Company's business associates. They also may impose further restrictions on the Company's collection, disclosure and use of customer identifiable data that are housed in one or more of the Company's administrative databases. Noncompliance with any privacy laws or any security breach involving the misappropriation, loss, theft or other unauthorized disclosure of sensitive or confidential customer information, whether by the Company or by one of its third parties, could have a material adverse effect on the Company's business, reputation, brand and results of operations, including: material fines and penalties; compensatory, special, punitive and statutory damages; consent orders regarding the Company's privacy and security practices; adverse actions against the Company's licenses to do business; and injunctive relief. +In addition, under Japanese laws and regulations, including the APPI, if a leak or loss of personal information by Aflac Japan or its business associates should occur, depending on factors such as the volume of personal data involved and the likelihood of other secondary damage, Aflac Japan may be required to file reports to the FSA; issue public releases explaining such incident to the public; or become subject to an FSA business improvement order, which could pose a risk to the Company's reputation. +Extensive regulation and changes in legislation can impact profitability and growth. +Aflac's insurance subsidiaries are subject to complex laws and regulations that are administered and enforced by a number of governmental authorities, including the FSA and Ministry of Finance (MOF) in Japan, and state insurance regulators, the SEC, the NAIC, the FIO, the U.S. Department of Justice, state attorneys general, the U.S. Commodity Futures Trading Commission, and the U.S. Treasury, including the IRS, in the United States, each of which exercises a degree of interpretive latitude. In addition, proposals regarding the global regulation of insurance are under discussion, and changes to corporate form that attend the conversion of Aflac Japan to a subsidiary may introduce new forms of regulation compared to those with which the Company has historically been subject. For example, AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. Consequently, the Company is subject to the risk that compliance with any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may not result in compliance with another regulator's or enforcement authority's interpretation of the same issue, particularly when compliance is judged in hindsight. There is also a risk that any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may change over time to the Company's detriment. In addition, changes in the overall legal or regulatory environment may, even absent any particular regulator's or enforcement authority's interpretation of an issue changing, cause us to change the Company's views regarding the actions the Company needs to take from a legal or regulatory risk management perspective, thus necessitating changes to the Company's practices that may, in some cases, limit its ability to grow or otherwise negatively impact the profitability of the Company's business. +The primary purpose of insurance company regulatory supervision is the protection of insurance policyholders, rather than investors. The extent of regulation varies, but generally is governed by state statutes in the United States and by the FSA and the MOF in Japan. These systems of supervision and regulation cover, among other things: +• +standards of establishing and setting premium rates and the approval thereof +• +standards of minimum capital and reserve requirements and solvency margins, including RBC measures +• +restrictions on, limitations on and required approval of certain transactions between the Company's insurance subsidiaries and their affiliates, including management fee arrangements +• +restrictions on the nature, quality and concentration of investments +23 +Item 1A. Risk Factors +• +restrictions on the types of terms and conditions that the Company can include in the insurance policies offered by its primary insurance operations +• +limitations on the amount of dividends that insurance subsidiaries can pay +• +the existence and licensing status of a company under circumstances where it is not writing new or renewal business +• +certain required methods of accounting +• +reserves for unearned premiums, losses and other purposes +• +assignment of residual market business and potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies +• +administrative practices requirements +• +imposition of fines and other sanctions +Regulatory authorities periodically re-examine existing laws and regulations applicable to insurance companies and their products. Changes in these laws and regulations, or in interpretations thereof, could have a material adverse effect on the Company's financial condition and results of operations. If the Company's subsidiaries fail to meet the minimum capital or operational requirements established by its respective regulators, they could be subject to examination or corrective action, or the Company's financial strength ratings could be downgraded, or both. +Various forms of federal oversight and regulation of insurance were signed into law by the prior U.S. presidential administration. For example, the ACA gave the U.S. federal government direct regulatory authority over the business of health insurance and made significant changes to the U.S. health care insurance marketplace, including the imposition of an individual medical insurance coverage mandate (which has since been repealed effective 2019 by the Tax Act), penalties on certain employers for failing to provide adequate coverage, the creation of health insurance exchanges, and proscriptions regarding coverage and exclusions as well as medical loss ratios. The legislation also includes changes in government reimbursements and tax credits for individuals and employers and alters federal and state regulation of health insurers. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. The United States Congress may continue to consider legislation that would repeal and replace key provisions of the ACA. There can be no assurance that any legislation affecting the ACA will be passed by Congress, nor as to the ultimate timing or provisions of any such legislation, nor as to the effect of any such legislation on the design or marketability of the Company's insurance products. +In addition, Dodd-Frank intended to reduce risk of a financial crisis, contains multiple provisions that could impact the Company's business as rules are finalized and implemented. While it is difficult to isolate the impact of Dodd Frank from other government and central bank actions and general market conditions since the financial crisis, the Company believes that the Dodd-Frank Act, in particular bank capital requirements, limits on proprietary trading and derivatives regulation, has affected the value of its holdings in banks and other financial institutions, and impacted pricing, liquidity, and the Company's general ability to conduct financial and capital market transactions. Dodd Frank is expansive in scope and, among other things, requires the adoption of extensive regulations and numerous regulating decisions, many of which have been adopted. The presidential administration in the United States and Congress have stated proposals to reform or repeal certain provisions of the Dodd-Frank Act, some of which have been implemented. The Company cannot predict with any degree of certainty the ultimate effects (if any) that Dodd Frank, or subsequent implementation of regulations and decisions, will have on its U.S. business, financial condition, or results of operations . +Compliance with applicable laws and regulations is time consuming and personnel-intensive, and changes in these laws and regulations may materially increase the Company's direct and indirect compliance and other expenses of doing business, thus having a material adverse effect on the Company's financial condition and results of operations. +Tax rates applicable to the Company may change. +The Company is subject to taxation in Japan, and in the U.S. under federal and numerous state and local tax jurisdictions. In preparing the Company's financial statements, the Company estimates the amount of tax that will become payable, but the Company's effective tax rate may be different than estimates due to numerous factors including accounting for income taxes, the mix of earnings from Japan and the U.S., the results of tax audits, adjustments to the value of uncertain tax positions, changes to estimates and other factors. Further, changes in U.S. or Japan tax laws or interpretations of such laws could increase the Company's corporate taxes and reduce earnings. +24 +Item 1A. Risk Factors +The Tax Act was signed into law on December 22, 2017. Among other things, effective January 1, 2018 the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35% to 21%, eliminated or reduced certain deductions and credits, and limited the deductibility of interest expense and executive compensation. +The Tax Act also transitions international corporate taxation from a worldwide system to a modified territorial system, which in light of the current tax treatment of Aflac Japan has the effect of subjecting the earnings of Aflac Japan to Japan taxation and subjecting the Company’s other earnings, including the consolidated earnings of the Parent Company, to U.S. taxation. +These changes became effective on January 1, 2018. Because changes to tax rates are accounted for in the period of enactment, during the period ended December 31, 2017, the Company revalued its deferred tax assets and liabilities and recorded a net deferred tax liability reduction of $1.9 billion benefit in 2017. During the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional amount of deferred tax liabilities (DTLs) related to the Japan tax computation and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. The impact of the Tax Act, including the preliminary estimate for the change in tax rate that was recorded during the fourth quarter of 2017, adjustments booked during the fourth quarter of 2018 which rendered final values related to the tax rate, and the Company's combined U.S. and Japanese effective income tax rate, may be adjusted in future periods, possibly materially, due to, among other things, changes in interpretations and assumptions the Company has made, tax guidance that may be issued and actions the Company make take as a result of the Tax Act. Without limiting the foregoing, additional forthcoming guidance from the U.S. Department of the Treasury and/or the U.S. IRS related to the Tax Act could significantly impact the level of valuation allowance respecting the amount of foreign tax credits claimed by the Company with regard to the operations of Aflac Japan. +In addition, it remains difficult to predict the timing and effect that future tax law changes could have on the Company's earnings both in the U.S. and in foreign jurisdictions. Any of these factors could cause the Company to experience an effective tax rate significantly different from previous periods or our current estimates. If the Company's effective tax rate were to increase, the Company's financial condition and results of operations could be adversely affected. +Defaults, downgrades, widening credit spreads or other events impairing the value of the fixed maturity securities and loan receivables in the Company's investment portfolio may reduce the Company's earnings and capital position. +The Company is subject to the risk that the issuers and/or guarantors of fixed maturity securities and loan receivables the Company owns may default on principal or interest. A significant portion of the Company's portfolio represents an unsecured obligation of the issuer, including some that may be subordinated to other debt in the issuer’s capital structure. In these cases, many factors can influence the overall creditworthiness of the issuer and ultimately its ability to service and repay the Company's holdings. This can include changes in the global economy, the company's assets, strategy, or management, shifts in the dynamics of the industries in which they compete, their access to additional funding, and the overall health of the credit markets. Factors unique to the Company's securities including contractual protections such as financial covenants or relative position in the issuer's capital structure also influence the value of the Company's holdings. +Most of the Company's investments carry a rating by one or more of the NRSROs. Any change in the rating agencies' approach to evaluating credit and assigning an opinion could negatively impact the fair value of the Company's portfolio. The Company employs a team of credit analysts to monitor the creditworthiness of the issuers in its portfolio. Any credit-related declines in the fair value of positions held in the Company's portfolio believed to be not temporary in nature will negatively impact the Company's net income and capital position through impairment and other credit related losses. These losses would also affect the Company's solvency ratios in the United States and Japan. Aflac Japan has certain regulatory accounting requirements for realizing impairments that could be triggered by credit-related losses, which may be different from U.S. GAAP and statutory requirements. These impairment losses could negatively impact Aflac Japan's earnings, and the corresponding dividends and capital deployment. +The Company is also subject to the risk that any collateral providing credit enhancement to the Company's positions could deteriorate. These instruments may include senior secured first lien loans, such as commercial mortgage loans, bank loans, middle market loans, and loan-backed securities where the underlying loan or collateral notes may default on principal, interest, or other payments, causing an adverse change in cash flows to the positions held in the Company's investment portfolio. +The Company is exposed to sovereign credit risk through instruments issued directly by governments and government entities as well as banks and other institutions that rely in part on the strength of the underlying government +25 +Item 1A. Risk Factors +for their credit quality. In addition to the United States and Japan, many governments, especially in Europe, have been subject to rating downgrades due to the need for fiscal and budgetary remediation and structural reforms, reduced economic activity, and investment needed to support banks or other systemically important entities. Additional downgrades or default of the Company's sovereign issuers will have a negative impact on its portfolio and could reduce the Company's earnings and capital. +In addition to the Company's exposure to the underlying fundamental credit strength of the issuers of its fixed maturity securities and the underlying risk of default, the Company is also exposed to the general movement in credit market spreads. A widening of credit spreads could reduce the value of the Company's existing portfolio, create unrealized losses on its investment portfolio, and reduce the Company's adjusted capital position which is used in determining the SMR in Japan. This widening of credit spreads could, however, increase the net investment income on new credit investments. Conversely, a tightening of credit spreads could increase the value of the Company's existing portfolio and create unrealized gains on its investment portfolio. This tightening of credit spreads could also reduce the net investment income available to the Company on new credit investments. Increased market volatility also makes it difficult to value certain of the Company's investment holdings (see the Critical Accounting Estimates section in Item 7, Management's Discussion and Analysis, of this Form 10-K). +For more information regarding credit risk, see the Credit Risk subsection of Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Form 10-K. +A decline in the creditworthiness of other financial institutions could adversely affect the Company. +The Company has exposure to and routinely executes transactions with counterparties in the financial services industry, including broker dealers, derivative counterparties, commercial banks and other institutions. +The Company uses derivative instruments to mitigate various risks associated with its investment portfolio, notes payable, and subsidiary dividends. The Company enters into a variety of agreements involving assorted instruments including foreign currency forward contracts; foreign currency options; foreign currency swaps; and interest rate swaptions. The Company ' s use of derivatives results in financial exposure to derivative counterparties. If the Company's counterparties fail or refuse to honor their obligations under derivative instruments, the Company's hedges of the risks will be ineffective, and the Company's financial condition and results of operations could be adversely affected. +The Company engages in derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements also include Credit Support Annexes (CSAs) provisions, which generally provide for two-way collateral postings at the first dollar of exposure. The Company mitigates the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value while generally requiring that collateral be posted at the outset of the transaction. In addition, a significant portion of the derivative transactions have provisions that give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength rating. The actual amount of payments that the Company could be required to make, depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of the downgrade. If the Company is required to post collateral to support derivative contracts and/or pay cash to settle the contracts at maturity, the Company's liquidity could be strained. In addition, the Company's cleared swaps result in counterparty exposure to clearing brokers and central clearinghouses; while this exposure is mitigated in part by clearinghouse and clearing broker capital and regulation, no assurance can be provided that these counterparties will fulfill their obligations. The Company also has exposure to counterparties to securities lending transactions in the event they fail to return loaned securities. The Company is also exposed to the risk that there may be a decline in value of securities posted as collateral for securities lending programs or a decline in value of investments made with cash posted as collateral for such programs. +Further, the Company has agreements with various financial institutions for the distribution of its insurance products. For example, at December 31, 2018 , the Company had agreements with 371 banks to market Aflac's products in Japan. Sales through these banks represented 4.6% of Aflac Japan's new annualized premium sales in 2018 . Any material adverse effect on these or other financial institutions could also have an adverse effect on the Company's sales. +The Company has entered into significant reinsurance transactions with large, highly rated counterparties. Negative events or developments affecting any one of these counterparties could have an adverse effect on the Company's financial position or results of operations. +All of these risks related to exposure to other financial institutions could adversely impact the Company's consolidated results of operations and financial condition. +26 +Item 1A. Risk Factors +The determination of the amount of impairments taken on the Company's investments is based on significant valuation judgments and could materially impact its results of operations or financial position. +An investment in a fixed maturity security is impaired if the fair value falls below book value. The Company regularly reviews its entire investment portfolio for declines in value. The majority of the Company's investments are evaluated for other-than-temporary impairment using the Company's debt impairment model. +The Company's debt impairment model includes emphasis on the ultimate collection of the cash flows from its investments. The determination of the amount of impairments under this model is based upon the Company's periodic evaluation and assessment of known and inherent risks associated with the respective securities. Such evaluations and assessments are revised as conditions change and new information becomes available. +For the Company's fixed maturity securities reported in the available-for-sale portfolio, the Company reports the investments at fair value in the statement of financial condition and records any unrealized gain or loss in the value of the asset in accumulated other comprehensive income. For the Company's held-to-maturity securities portfolio, the Company reports the investments at amortized cost. Under the debt impairment model, the determination of whether an impairment in value is other than temporary is based largely on the Company's evaluation of the issuer ' s creditworthiness. The Company must apply considerable judgment in determining the likelihood of the security recovering in value while the Company owns it. Factors that may influence this include the Company's assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. The Company also verifies whether it has the intent to sell or if it is more likely than not the Company would be required to sell the security prior to recovery of its amortized cost. If the Company determines it is unlikely to recover the book value of the instrument prior to disposal of the security, the Company will reduce the carrying value of the security to its fair value and recognize any associated impairment loss in the Company's consolidated statement of earnings or other comprehensive income, depending on the nature of the loss. +For regulatory accounting purposes for Aflac Japan, there are certain requirements for realizing impairments that could be triggered by rising interest rates, credit-related losses, or changes in foreign exchange, negatively impacting Aflac Japan's earnings and corresponding dividend and capital deployment. +The Company's management updates its evaluations regularly as conditions change and as new information becomes available and reflects impairment losses in the Company's income statement when considered necessary. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. +As a holding company, the Parent Company depends on the ability of its subsidiaries to transfer funds to it to meet its debt service and other obligations and to pay dividends on its common stock. +The Parent Company is a holding company and has no direct operations, and its most significant assets are the stock of its subsidiaries. Because the Parent Company conducts its operations through its operating subsidiaries, the Parent Company depends on those entities for dividends and other payments to generate the funds necessary to meet its debt service and other obligations, to pay dividends on and conduct repurchases of its common stock, and to make investments into its subsidiaries or external investment opportunities. +Aflac is domiciled in Nebraska and is subject to insurance regulations that impose certain limitations and restrictions on payments of dividends, management fees, loans and advances by Aflac to the Parent Company. The Nebraska insurance statutes require prior approval for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. In addition, the Nebraska insurance department must approve service arrangements and other transactions within the affiliated group of companies. After the Japan branch conversion, the Nebraska insurance department and the FSA approved their respective domiciled insurance company service arrangements and transactions. The FSA does not allow dividends or other payments from Aflac Japan unless it meets certain financial criteria as governed by Japanese corporate law. Under these criteria, dividend capacity at the Japan subsidiary will be defined as retained earnings plus other capital reserve less net after-tax net unrealized losses on available-for-sale securities. +The ability of Aflac and Aflac Japan to pay dividends or make other payments to the Parent Company could also be constrained by the Company's dependency on financial strength ratings from independent rating agencies. The Company's ratings from these agencies depend to a large extent on Aflac's capitalization level. Any inability of Aflac to pay +27 +Item 1A. Risk Factors +dividends or make other payments to the Parent Company could have a material adverse effect on the Company's financial condition and results of operations. +For the foregoing reasons, there is no assurance that the earnings from, or other available assets of, the Parent Company's operating subsidiaries will be sufficient to make distributions to enable the Company to operate. +Any decrease in the Company's financial strength or debt ratings may have an adverse effect on its competitive position and access to liquidity and capital. +Financial strength ratings can play an important role in establishing the competitive position of insurance companies. On an ongoing basis, NRSROs review the financial performance and condition of many insurers, including Aflac and its competitors. They may assign multiple ratings including a financial strength rating, reflecting their view of the insurer’s ability to pay claims on a timely basis, and ratings on an insurer’s senior and subordinated debt obligations, indicating their view of an insurer’s ability to make timely payments on their debt obligations. +NRSROs may change their ratings or outlook on an insurer's ratings due to a variety of factors including the NRSRO’s assessment of the insurer’s strength of operations and overall financial condition. Some factors that may influence ratings include competitive position; profitability; cash generation and other sources of liquidity; capital levels; quality of the investment portfolio; and perception of management capabilities. The ratings assigned to Aflac by the NRSROs are important factors in the Company's ability to access liquidity and capital from the bank market, debt capital markets or other available sources, such as reinsurance transactions. Downgrades to Aflac's credit ratings could give its derivative counterparties the right to require early termination of derivatives transactions or delivery of additional collateral, thereby adversely affecting the Company's liquidity. +In view of the difficulties experienced after the financial crisis by many financial institutions, including those in the insurance industry, the NRSROs have heightened the level of scrutiny that they apply to such institutions. Steps taken by the NRSROs include an increase in the frequency and scope of their reviews, additional information requests from the companies that they rate, including additional information regarding the valuation of investment securities held, and, in certain cases, an increase in the capital and other requirements employed in their models for maintenance of certain rating levels. +On September 16, 2015, S&P downgraded their credit rating of Japan’s sovereign debt. Following this action, they also downgraded several other foreign insurers, including Aflac. Although Aflac is a U.S.-based insurer, Aflac's significant operations in Japan and corresponding regulation by the Japanese FSA, combined with its significant exposure to JGBs as outlined above, resulted in S&P downgrading the financial strength rating of Aflac's core insurance operations to A+ and its senior debt rating to A-, both with a stable outlook. While S&P made no further downgrades to Aflac's ratings between 2016 and 2018, they have stated in the past that a downgrade of Japan's sovereign rating could lead to a downgrade of Aflac's financial strength rating. As a matter of policy, S&P rarely rates insurance companies above the sovereign long-term rating of the country of domicile because during times of stress, the sovereign’s regulatory and supervisory powers may restrict an insurer’s or financial system’s flexibility. +In addition to the impact on Aflac's access to liquidity, as mentioned above, a downgrade of Aflac's ratings could have a material adverse effect on agent recruiting and retention, sales, competitiveness and the marketability of its products which could negatively impact Aflac's liquidity, operating results and financial condition. Additionally, sales through the bank channel in Japan could be adversely affected as a result of their reliance and sensitivity to ratings levels. +The Company cannot predict what actions rating agencies may take, or what actions the Company may take in response to the actions of rating agencies, which could adversely affect Aflac's business. As with other companies in the financial services industry, Aflac's ratings could be downgraded at any time and without any notice by any NRSRO . +28 +Item 1A. Risk Factors +The Company's risk management policies and procedures may prove to be ineffective and leave the Company exposed to unidentified or unanticipated risk, which could adversely affect the Company's businesses or result in losses. +The Company has developed an enterprise-wide risk management and governance framework to mitigate risk and loss to the Company. The Company maintains policies, procedures and controls intended to identify, measure, monitor, report and analyze the risks to which the Company is exposed. +However, there are inherent limitations to risk management strategies because risk may exist, or emerge in the future, that the Company has not appropriately anticipated or identified. If the Company's risk management framework proves ineffective, the Company may suffer unexpected losses and could be materially adversely affected. As the Company's businesses change and the markets in which it operates evolve, the Company's risk management framework may not evolve at the same pace as those changes. As a result, there is a risk that new products or new business strategies may present risks that are not appropriately identified, monitored or managed. In times of market stress, unanticipated market movements or unanticipated claims experience resulting from greater than expected morbidity, mortality, longevity, or persistency, the effectiveness of the Company's risk management strategies may be limited, resulting in losses to the Company. In addition, under difficult or less liquid market conditions, the Company's risk management strategies may not be effective because other market participants may be using the same or similar strategies to manage risk under the same challenging market conditions. In such circumstances, it may be difficult or more expensive for the Company to mitigate risk due to the activity of such other market participants. +Many of the Company's risk management strategies or techniques are based upon historical customer and market behavior and all such strategies and techniques are based to some degree on management’s subjective judgment. The Company cannot provide assurance that its risk management framework, including the underlying assumptions or strategies, will be accurate and effective. +Management of operational, legal and regulatory risks requires, among other things, policies, procedures and controls to record properly and verify a large number of transactions and events, and these policies, procedures and controls may not be fully effective. Models are utilized by the Company's businesses and corporate areas primarily to project future cash flows associated with pricing products, calculating reserves and valuing assets, as well as in evaluating risk and determining capital requirements, among other uses. These models are utilized under a risk management policy approved by the Company's executive risk management committees, however, the models may not operate properly and rely on assumptions and projections that are inherently uncertain. As the Company's businesses continue to grow and evolve, the number and complexity of models the Company utilizes expands, increasing the Company's exposure to error in the design, implementation or use of models, including the associated input data and assumptions. +Past or future misconduct by the Company's employees or employees of the Company's third parties (suppliers which are cost-based relationships and alliance partners which are revenue-generating relationships) could result in violations of law by the Company, regulatory sanctions and/or serious reputational or financial harm and the precautions the Company takes to prevent and detect this activity may not be effective in all cases. Despite the Company's published Supplier Code of Conduct, due diligence of the Company's alliance partners, and rigorous contracting procedures (including financial, legal, IT security, and risk reviews), there can be no assurance that controls and procedures that the Company employs, which are designed to assess third party viability and prevent the Company from taking excessive or inappropriate risks, will be effective. Additionally, the use of third parties also poses operational risks that could result in financial loss, operational disruption, brand damage, or compliance issues. Inadequate oversight of Aflac’s third party suppliers due to the lack of policies, procedures, training and governance may lead to financial loss or damage to the Aflac brand. +The concentration of the Company's investment portfolios in any particular single-issuer or sector of the economy may have an adverse effect on the Company's financial position or results of operations. +Negative events or developments affecting any particular single issuer, industry, group of related industries, asset class or geographic sector may have an adverse impact on a particular holding or set of holdings, which may increase risk of loss from defaults due to non-payment of interest or principal. The Company seeks to minimize this risk by maintaining an appropriate level of diversification. To the extent the Company has concentrated positions, it could have an adverse effect on the Company's results of operations and financial position. The Company's global investment guidelines establish concentration limits for its investment portfolios. +29 +Item 1A. Risk Factors +For details on the concentrations within the Company's investment portfolios, see the Analysis of Financial Condition section of Item 7, MD&A, and the Credit Risk section of Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Form 10-K. +The valuation of the Company's investments and derivatives includes methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to investment valuations that may adversely affect the Company's results of operations or financial condition. +The Company reports a significant amount of its fixed maturity securities and other financial instruments at fair value. As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated, thereby resulting in values which may be greater or less than the value at which the investments may be ultimately sold. Rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within the Company's consolidated financial statements and the period-to-period changes in value could vary significantly. +Valuations of the Company's derivatives fluctuate with changes in underlying market variables, such as interest rates and foreign currency exchange rates. During periods of market turbulence created by political instability, economic uncertainty, government interventions or other factors, the Company may experience significant changes in the volatility of its derivative valuations. Extreme market conditions can also affect the liquidity of such instruments creating marked differences in transaction levels and counterparty valuations. Depending on the severity and direction of the movements in its derivative valuations, the Company will face increases in the amount of collateral required to be posted with its counterparties. Liquidity stresses to the Company may also occur if the required collateral amounts increase significantly over a very short period of time. Conversely, the Company may be exposed to an increase in counterparty credit risk for short periods of time while calling collateral from its counterparties. +Elimination of LIBOR as an interest rate benchmark may create uncertainty in valuation of loans, derivatives and other assets where valuation and interest rates are based on LIBOR, and may create uncertainty in the pricing of such assets in markets for their sale and disposition. +For further discussion on investment and derivative valuations, see the Critical Accounting Estimates section in Item 7, Management's Discussion and Analysis, and Notes 1, 3, 4, and 5 of the Notes to the Consolidated Financial Statements in this Form 10-K. +Managing key executive succession is critical to the Company's success. +The Company would be adversely affected if it fails to adequately plan for succession of its senior management and other key executives. While the Company has succession plans and employment arrangements with certain key executives, these plans cannot guarantee that the services of these executives will be available to the Company, and its operations could be adversely affected if they are not. +Catastrophic events could adversely affect the Company's financial condition and results of operations as well as the availability of the Company’s infrastructure and systems. +The Company's insurance operations are exposed to the risk of catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, war or other military action, and terrorism or other acts of violence. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Certain events such as earthquakes, tsunamis, hurricanes and man-made catastrophes could cause substantial damage or loss of life in larger areas, especially those that are heavily populated. Claims resulting from natural or man−made catastrophic events could cause substantial volatility in the Company's financial results for any fiscal quarter or year and could materially reduce its profitability or harm the Company's financial condition, as well as affect its ability to write new business. +Additionally, the Company's business operations may be adversely affected by such catastrophic events to the extent they disrupt the Company's physical infrastructure and systems that support its businesses and customers. Although the Company has a global crisis management framework to minimize the business disruption from a catastrophic event, such framework may not be effective to avoid an adverse impact to the Company from such an event. +30 +Item 1A. Risk Factors +Changes in accounting standards issued by the Financial Accounting Standard Boards (FASB) or other standard-setting bodies may adversely affect the Company's financial statements. +The Company's financial statements are subject to the application of U.S. GAAP, which is periodically revised and/or expanded. Accordingly, from time to time the Company is required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the FASB. The impact of accounting pronouncements that have been issued but not yet implemented and are applicable to the Company is disclosed in Note 1 of the Notes to the Consolidated Financial Statements. The pronouncements expected to have the most significant impact on the Company's financial position or results of operations are outlined below. +In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments . The amendments in this update require a financial asset (or a group of financial assets) measured on an amortized cost basis to be presented net of an allowance for credit losses in order to reflect the amount expected to be collected on the financial asset(s). The Company currently expects loans and loan receivables and held-to-maturity fixed maturity securities to be the asset classes most significantly impacted upon adoption of the guidance. The amendments are effective for fiscal years beginning after December 15, 2019. +Additionally, in August 2018 the FASB issued ASU 2018-12, Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts . The amendments in this update will significantly change how insurers account for long-duration contracts. Among the issues addressed in the amendments is the requirement to review and, if there is a change, update assumptions for liability for future policy benefits at least annually, and to update the discount rate assumption quarterly. The frequency of the reviews and updates varies according to the assumptions but will be at least annually in all cases. The Company anticipates that the requirement to review and update assumptions for liability for future policy benefits will have a significant impact on its results of operations, systems, processes, and controls, while the requirement to update the discount rate will have a significant impact on the other comprehensive income component of its equity. The amendments are effective for fiscal years beginning after December 15, 2020. +The accounting treatment that the Company applies to its consolidated financial statements will change due to new standards and could have a material adverse effect on the Company's results of operations and financial condition. For information on new accounting pronouncements and the impact, if any, on the Company's financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements in this report. +Changes in the Company's discount rate, expected rate of return, life expectancy, health care cost and expected compensation increase assumptions for its pension and other postretirement benefit plans may result in increased expenses and reduce the Company's profitability. +The Company determines its pension and other postretirement benefit plan costs based on assumed discount rates, expected rates of return on plan assets, life expectancy of plan participants and expected increases in compensation levels and trends in health care costs. Changes in these assumptions, including from the impact of a sustained low interest rate environment, may result in increased expenses and reduce the Company's profitability . +The Company faces risks related to litigation, regulatory investigations and inquiry and other matters. +The Company is a defendant in various lawsuits considered to be in the normal course of business. The final results of any litigation cannot be predicted with certainty, and plaintiffs may seek very large amounts in class actions or other litigation. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. However, a substantial legal liability or a significant federal, state or other regulatory action against us, as well as regulatory inquiries or investigations, could harm our reputation, result in changes in operations, result in material fines or penalties, result in significant costs due to legal fees, settlements or judgments against the Company, or otherwise have a material adverse effect on our business, financial condition and results of operations. Without limiting the foregoing, the litigation and regulatory matters we are, have been, or may become, subject to include matters related to sales agent recruiting, policy sales practices, claim payments and procedures including denial or delay of benefits, material misstatements or omissions in our financial reports or other public statements, and/or corporate governance, corporate culture or business ethics matters. Further, the Company may be subject to claims of or litigation regarding sexual or other forms of harassment, or discrimination on the basis of race, color, national origin, religion, gender, or other bases, notwithstanding that our Code of Business Conduct and Ethics prohibits such harassment and discrimination by our employees, we have ongoing training programs and provide opportunities to report claims of noncompliant conduct, and +31 +Item 1A. Risk Factors +we investigate and may take disciplinary action regarding alleged harassment or discrimination. Any violations of or deviation from laws, regulations, internal or external codes or standards of normative behavior, or perceptions of such violations or deviations, by our employees or by independent sales agents could adversely impact the Company's reputation and brand value, financial condition and results of operations. +Allegations or determinations of agent misclassification could adversely affect the Company’s results of operations, financial condition and liquidity. +A majority of our U.S. sales force is, and has historically been, comprised of independent agents. While we believe that we have properly classified such agents as independent contractors, we may be subject to claims, regulatory action by state or federal departments of labor or tax authorities or litigation asserting that such agents are employees. The laws and regulations governing the classification of workers in the United States may be changed or interpreted differently compared to past interpretations, including in states where the Company generates significant sales through independent agents. An allegation or determination that independent agents in the Company’s U.S. sales force have been misclassified as independent contractors could result in changes in the Company’s operations and U.S. business model, result in material fines or penalties, result in significant costs due to legal fees, settlements or judgments against the Company, or otherwise have a material adverse effect on our business, results of operation, financial condition and liquidity. +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not applicable. +ITEM 2. PROPERTIES +In the United States, Aflac owns land and buildings that comprise two primary campuses located in Columbus, Georgia. These campuses include buildings that serve as the Company's worldwide headquarters and house administrative support and information technology functions for U.S. operations. Aflac leases office space in Columbia, South Carolina, which houses the Company's CAIC subsidiary (branded as Aflac Group Insurance). Aflac leases office space in New York that houses the Company's Global Investment division. Aflac leases administrative office space in Georgia, South Carolina, New York, Nebraska, and in 39 additional states throughout the United States, as well as Washington, D.C. and Puerto Rico. +In Tokyo, Japan, Aflac has three primary campuses. The first campus includes a building, owned by Aflac, for the customer call center, the claims department, information technology departments, and training facility. It also includes a leased property, which houses Aflac Japan's policy administration and customer service departments. The second campus comprises leased space, which serves as Aflac Japan's headquarters and houses administrative and investment support functions. The third campus comprises leased space for the information technology departments. Aflac also leases additional office space in Tokyo, along with regional offices located throughout the country. +ITEM 3. LEGAL PROCEEDINGS +On December 14, 2017, three former independent sales contractors filed a shareholders derivative complaint in the U.S. District Court for the Southern District of New York naming the Parent Company as nominal defendant and the Parent Company’s Chairman and Chief Executive Officer, several of its directors, and a former officer and director as defendants. The complaint alleges breaches of fiduciary duty, misstatements and omissions in the Company’s public disclosures, and insider trading. The Company’s Board of Directors had previously established a special litigation committee (SLC) in July 2017 to investigate certain allegations underlying the derivative action. The SLC issued a report of its investigation in September 2017 and another report in February 2018, each of which determined that it was not in the best interests of the Company to pursue the action demanded by the shareholders. An amended complaint was filed on January 31, 2018. On February 12, 2018, this litigation was transferred to the U.S. District Court for the Middle District of Georgia. The SLC issued a third report of its investigation in May 2018 regarding certain additional allegations raised in the amended complaint, in which the SLC also determined that it was not in the best interests of the Company to pursue the action demanded by the shareholders. On August 31, 2018, the District Court granted the Company's motion and the amended complaint was dismissed. The plaintiffs have appealed the dismissal to the United States Court of Appeals for the Eleventh Circuit. The Company believes the outcome of this litigation will not have a material adverse effect on its financial position, results of operation or cash flows. +32 +Item 3. Legal Proceedings +The Company is a defendant in various lawsuits considered to be in the normal course of business. Members of the Company's senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +33 +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER +PURCHASES OF EQUITY SECURITIES +Market Information +Aflac Incorporated's common stock is principally traded on the New York Stock Exchange under the symbol AFL. Aflac Incorporated's stock is also listed on the Tokyo Stock Exchange under designator 8686. +Stock Split +On February 13, 2018, the Board of Directors of the Parent Company declared a two -for-one stock split of the Company’s common stock in the form of a 100% stock dividend payable on March 16, 2018 to shareholders of record at the close of business on March 2, 2018. The stock split was payable in the form of one additional common stock share for every share of common stock held. All equity and share-based data, including the number of shares outstanding and per share amounts, have been adjusted to reflect the stock split for all periods presented in this Annual Report on Form 10-K. +Holders +As of February 12, 2019 , there were 86,621 holders of record of the Company's common stock. +34 +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Stock Performance Graph +The following graph compares the five-year performance of the Company's common stock to the Standard & Poor's 500 Index (S&P 500) and the Standard & Poor's Life and Health Insurance Index (S&P Life and Health). The Standard & Poor's Life and Health Insurance Index includes: Aflac Incorporated, Brighthouse Financial Inc., Lincoln National Corporation, MetLife Inc., Principal Financial Group Inc., Prudential Financial Inc., Torchmark Corporation and Unum Group. +Performance Graphic Index +December 31, +2013 +2014 +2015 +2016 +2017 +2018 +Aflac Incorporated +100.00 +93.72 +94.20 +112.20 +144.74 +153.73 +S&P 500 +100.00 +113.69 +115.26 +129.05 +157.22 +150.33 +S&P Life & Health Insurance +100.00 +101.95 +95.51 +119.26 +138.85 +110.01 +Copyright © 2019 Standard & Poor’s, a division of S&P Global. All rights reserved. +35 +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Issuer Purchases of Equity Securities +During the year ended December 31, 2018 , we repurchased shares of Aflac common stock as follows: +Period +Total +Number of +Shares +Purchased +Average +Price Paid +Per Share +Total +Number +of Shares +Purchased +as Part of +Publicly +Announced +Plans or +Programs +Maximum +Number of +Shares that +May Yet Be +Purchased +Under the +Plans or +Programs +January 1 - January 31 +2,370,284 +$ +44.31 +2,370,284 +95,626,488 +February 1 - February 28 +2,349,600 +44.70 +2,349,600 +93,276,888 +March 1 - March 31 +1,937,161 +44.49 +1,920,400 +91,356,488 +April 1 - April 30 +2,082,500 +44.62 +2,082,500 +89,273,988 +May 1 - May 31 +2,558,472 +45.17 +2,542,900 +86,731,088 +June 1 - June 30 +2,175,100 +44.99 +2,175,100 +84,555,988 +July 1 - July 31 +2,008,123 +43.52 +1,994,900 +82,561,088 +August 1 - August 31 +2,358,317 +46.64 +2,352,500 +80,208,588 +September 1 - September 30 +2,668,990 +47.20 +2,654,401 +77,554,187 +October 1 - October 31 +2,817,600 +44.78 +2,817,600 +74,736,587 +November 1 - November 30 +2,337,607 +44.44 +2,336,400 +72,400,187 +December 1 - December 31 +3,382,043 +44.03 +3,352,300 +69,047,887 +Total +29,045,797 +(1) +$ +44.93 +28,948,885 +69,047,887 +(1) During the year ended December 31, 2018 , 96,912 shares were purchased in connection with income tax withholding obligations related to the vesting of restricted-share-based awards during the period. +As of December 31, 2018, a remaining balance of 69.0 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its Board of Directors. +36 +Item 6. Selected Financial Data +ITEM 6. SELECTED FINANCIAL DATA +Aflac Incorporated and Subsidiaries +Years Ended December 31, +(In millions, except for share and per-share amounts) +2018 +2017 +2016 +2015 +2014 +Revenues: +Net premiums, principally supplemental +health insurance +$ +18,677 +$ +18,531 +$ +19,225 +$ +17,570 +$ +19,072 +Net investment income +3,442 +3,220 +3,278 +3,135 +3,319 +Realized investment gains (losses) +(430 +) +(151 +) +(14 +) +106 +282 +Other income +69 +67 +70 +61 +55 +Total revenues +21,758 +21,667 +22,559 +20,872 +22,728 +Benefits and expenses: +Benefits and claims, net +12,000 +12,181 +12,919 +11,746 +12,937 +Expenses +5,775 +5,468 +5,573 +5,264 +5,300 +Total benefits and expenses +17,775 +17,649 +18,492 +17,010 +18,237 +Pretax earnings +3,983 +4,018 +4,067 +3,862 +4,491 +Income taxes +1,063 +(586 +) +1,408 +1,329 +1,540 +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +$ +2,533 +$ +2,951 +Share and Per-Share Amounts +Net earnings (basic) +$ +3.79 +$ +5.81 +$ +3.23 +$ +2.94 +$ +3.27 +Net earnings (diluted) +3.77 +5.77 +3.21 +2.92 +3.25 +Cash dividends paid +1.04 +.87 +.83 +.79 +.75 +Cash dividends declared +1.04 +.87 +.83 +.79 +.75 +Weighted-average common shares used for basic +EPS (In thousands) +769,588 +792,042 +822,942 +861,307 +902,408 +Weighted-average common shares used for diluted +EPS (In thousands) +774,650 +797,861 +827,841 +866,344 +907,999 +Supplemental Data +Yen/dollar exchange rate at year-end (yen) +111.00 +113.00 +116.49 +120.61 +120.55 +Weighted-average yen/dollar exchange rate (yen) +110.39 +112.16 +108.70 +120.99 +105.46 +Prior-year amounts have been adjusted for the two -for-one stock split of the Company’s common stock in March 2018. +37 +Item 6. Selected Financial Data +Aflac Incorporated and Subsidiaries +December 31, +(In millions) +2018 +2017 +2016 +2015 +2014 +Assets: +Investments and cash +$ +126,243 +$ +123,659 +$ +116,361 +$ +105,897 +$ +107,341 +Other +14,163 +13,558 +13,458 +12,359 +12,386 +Total assets +$ +140,406 +$ +137,217 +$ +129,819 +$ +118,256 +$ +119,727 +Liabilities and shareholders’ equity: +Policy liabilities +$ +103,188 +$ +99,147 +$ +93,726 +$ +87,631 +$ +83,933 +Income taxes +4,020 +4,745 +5,387 +4,340 +5,293 +Notes payable +5,778 +5,289 +5,360 +4,971 +5,242 +Other liabilities +3,958 +3,438 +4,864 +3,606 +6,912 +Shareholders’ equity +23,462 +24,598 +20,482 +17,708 +18,347 +Total liabilities and shareholders’ equity +$ +140,406 +$ +137,217 +$ +129,819 +$ +118,256 +$ +119,727 +Prior-year amounts have been adjusted for the adoption of accounting guidance on January 1, 2016 related to debt issuance costs. +38 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF +OPERATIONS +FORWARD-LOOKING INFORMATION +The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. The Company desires to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with the Securities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks and uncertainties. In particular, statements containing words such as the following or similar words as well as specific projections of future results, generally qualify as forward-looking. Aflac undertakes no obligation to update such forward-looking statements. +• expect +• anticipate +• believe +• goal +• objective +• may +• should +• estimate +• intends +• projects +• will +• assumes +• potential +• target +• outlook +The Company cautions readers that the following factors, in addition to other factors mentioned from time to time, could cause actual results to differ materially from those contemplated by the forward-looking statements: +• +difficult conditions in global capital markets and the economy +• +exposure to significant interest rate risk +• +concentration of business in Japan +• +foreign currency fluctuations in the yen/dollar exchange rate +• +limited availability of acceptable yen-denominated investments +• +U.S. tax audit risk related to conversion of the Japan branch to a subsidiary +• +deviations in actual experience from pricing and reserving assumptions +• +ability to continue to develop and implement improvements in information technology systems +• +competitive environment and ability to anticipate and respond to market trends +• +ability to protect the Aflac brand and the Company's reputation +• +ability to attract and retain qualified sales associates, brokers, employees, and distribution partners +• +interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems +• +failure to comply with restrictions on patient privacy and information security +• +extensive regulation and changes in law or regulation by governmental authorities +• +tax rates applicable to the Company may change +• +defaults and credit downgrades of investments +• +decline in creditworthiness of other financial institutions +• +significant valuation judgments in determination of amount of impairments taken on the Company's investments +• +subsidiaries' ability to pay dividends to the Parent Company +• +decreases in the Company's financial strength or debt ratings +• +inherent limitations to risk management policies and procedures +• +concentration of the Company's investments in any particular single-issuer or sector +• +differing judgments applied to investment valuations +• +ability to effectively manage key executive succession +• +catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, war or other military action, terrorism or other acts of violence, and damage incidental to such events +• +changes in accounting standards +• +increased expenses and reduced profitability resulting from changes in assumptions for pension and other postretirement benefit plans +• +level and outcome of litigation +• +allegations or determinations of worker misclassification in the United States +39 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +MD&A OVERVIEW +Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to inform the reader about matters affecting the financial condition and results of operations of Aflac Incorporated and its subsidiaries for the three-year period ended December 31, 2018 . As a result, the following discussion should be read in conjunction with the related consolidated financial statements and notes. This MD&A is divided into the following sections: +Page +The Company’s Business +40 +Performance Highlights +40 +Critical Accounting Estimates +42 +Results of Operations +47 +Insurance Operations +51 +Analysis of Financial Condition +61 +Capital Resources and Liquidity +70 +THE COMPANY'S BUSINESS +Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) primarily sell supplemental health and life insurance in the United States and Japan. The Company's insurance business is marketed and administered through American Family Life Assurance Company of Columbus (Aflac) in the United States (Aflac U.S.) and, effective April 1, 2018, through Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan). Prior to April 1, 2018, the Company's insurance business was marketed in Japan as a branch of Aflac. (For more information about the conversion of Aflac Japan to a legal subsidiary, see the Insurance Operations subsection of this MD&A). American Family Life Assurance Company of New York (Aflac New York) is a wholly owned subsidiary of Aflac. Most of Aflac's policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. The Company's insurance operations in the United States and Japan service the two markets for the Company's insurance business. +For more information on the Company's business, see Business, Part I, Item 1 of this report. +PERFORMANCE HIGHLIGHTS +Yen-denominated income statement accounts are translated to U.S. dollars using a weighted-average Japanese yen/U.S. dollar foreign exchange rate, while yen-denominated balance sheet accounts are translated to U.S. dollars using a spot Japanese yen/U.S. dollar foreign exchange rate (1) . The spot yen/dollar exchange rate at December 31, 2018 was 111.00 , or 1.8% stronger than the spot yen/dollar exchange rate of 113.00 at December 31, 2017 . The weighted-average yen/dollar exchange rate for the year ended December 31, 2018 was 110.39 , or 1.6% stronger than the weighted-average yen/dollar exchange rate of 112.16 for the same period in 2017 . +Total revenues increased .4% to $21.8 billion in 2018 , compared with $21.7 billion in 2017 . Net earnings in 2018 were $2.9 billion , or $3.77 per diluted share, compared with $4.6 billion , or $5.77 per diluted share, in 2017 . In 2017, net earnings and net earnings per diluted share included the impact of the estimated $1.9 billion, or $2.42 per diluted share, benefit as a result of the U.S. Tax Act. In the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional Japan deferred tax balances and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. +Results for 2018 included pretax net realized investment losses of $430 million , compared with net realized investment losses of $151 million in 2017 . Net investment losses in 2018 included $81 million of other-than-temporary impairment losses and changes in loan loss reserves and $ 234 million in net losses from derivatives and foreign currency gains or losses. Effective January 1, 2018 upon the adoption of new accounting guidance, changes in fair value of equity securities are recorded in earnings as a component of realized investment gains and losses. The Company reported net losses on equity securities of $131 million in 2018 . +(1) Yen/ U.S dollar exchange rates are based on the published MUFG Bank, Ltd. telegraphic transfer middle rate (TTM) +40 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +In October 2018, the Parent Company issued $550 million of senior notes and 53.4 billion yen of senior notes through public debt offerings under its U.S. shelf registration statement. In November 2018, the Parent Company used the net proceeds of the $550 million senior notes to redeem the Parent Company's 2.40% senior notes due in 2020. For further information regarding these transactions, see Note 9 of the Notes to the Consolidated Financial Statements and the Capital Resources and Liquidity section of this MD&A. +On February 13, 2018, the Board of Directors of the Parent Company declared a two-for-one stock split of the Company’s common stock in the form of a 100% stock dividend payable on March 16, 2018 to shareholders of record at the close of business on March 2, 2018. The stock split was paid in the form of one additional common stock share for every share of common stock held. All equity and share-based data, including the number of shares outstanding and per share amounts, have been adjusted to reflect the stock split for all periods presented in this Annual Report on Form 10-K. +The Company repurchased 28.9 million shares of its common stock in the open market for $1.3 billion under its share repurchase program in 2018 , compared with the repurchase of 35.5 million shares for $1.35 billion in 2017 . +Strategic Alliance with Japan Post Holdings +On December 19, 2018, the Parent Company and Aflac Japan entered into the Basic Agreement with Japan Post Holdings. Pursuant to the terms of the Basic Agreement, Japan Post Holdings agreed to form a capital relationship with the Parent Company, and Japan Post Holdings and Aflac Japan agreed to reconfirm existing initiatives regarding cancer insurance and to consider new joint initiatives, including leveraging digital technology in various processes, cooperation in new product development to promote customer-centric business management, cooperation in domestic and/or overseas business expansion and joint investment in third party entities and cooperation regarding asset management. +Pursuant to the terms of the Shareholders Agreement a voting trust established and funded by Japan Post Holdings (Trust) will use commercially reasonable efforts to acquire, through open market or private block purchases, ownership of approximately 7% of the outstanding shares of the Parent Company’s outstanding common stock within a year after the Trust begins acquiring such stock. The Trust has agreed not to own more than 10% of the Parent Company’s outstanding shares for a period expiring on the earlier of four years after the Trust acquires 7% of such shares, five years after it acquires 5% of such shares, or ten years after the Trust begins acquiring the Parent Company’s stock. After expiration of such period, the Trust has agreed not to own more than the greater of 10% of the Parent Company’s outstanding shares or such shares representing 22.5% of the voting rights in the Parent Company. +In light of the fact that the shares acquired by the Trust, like all Aflac Incorporated common shares, will be eligible for 10-for-1 voting rights after being held for 48 consecutive months, the Shareholders Agreement further provides for voting restrictions that effectively limit the trustee’s voting rights to no more than 20% of the voting rights in the Parent Company and further restrict the trustee’s voting rights with respect to certain change in control transactions. Japan Post Holdings will not have a Board seat on the Parent Company’s Board of Directors and will not have rights to control, manage or intervene in the management of the Parent Company. +This strategic investment is subject to certain regulatory approvals in Japan and the U.S. The Company anticipates that regulatory approvals will be received in the second half of 2019. +The foregoing summary is subject to and qualified in its entirety by reference to the full text of the Basic Agreement and Letter Agreement, including the forms of Trust Agreement and Shareholders Agreement attached to the Letter Agreement, copies of which are included as Exhibits 10.47 and 10.48 hereto and the terms of which are incorporated herein by reference. +As of December 31, 2018, the Trust owned no shares of the Parent Company’s outstanding stock. +41 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +CRITICAL ACCOUNTING ESTIMATES +The Company prepares its financial statements in accordance with U.S. GAAP. These principles are established primarily by the FASB. In this MD&A, references to U.S. GAAP issued by the FASB are derived from the FASB Accounting Standards Codification TM (ASC). The preparation of financial statements in conformity with U.S. GAAP requires the Company to make estimates based on currently available information when recording transactions resulting from business operations. The estimates that the Company deems to be most critical to an understanding of Aflac's results of operations and financial condition are those related to the valuation of investments and derivatives, deferred policy acquisition costs (DAC), liabilities for future policy benefits and unpaid policy claims, and income taxes. The preparation and evaluation of these critical accounting estimates involve the use of various assumptions developed from management's analyses and judgments. The application of these critical accounting estimates determines the values at which 94% of the Company's assets and 81% of its liabilities are reported as of December 31, 2018 , and thus has a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results. +Investments and Derivatives +Aflac's investments, primarily consisting of debt and equity securities, include both publicly issued and privately issued securities. For publicly issued securities, the Company determines the fair values from quoted market prices readily available from public exchange markets and price quotes and valuations from third party pricing vendors. For the majority of privately issued securities within the Company's investment portfolio, a third party pricing vendor has developed valuation models that the Company utilizes to determine fair values. For the remaining privately issued securities, the Company uses non-binding price quotes from outside brokers. +The Company estimates the fair values of its securities on a monthly basis. The Company monitors the estimated fair values obtained from its pricing vendors and brokers for consistency from month to month, while considering current market conditions. The Company also periodically discusses with its pricing brokers and vendors the pricing techniques they use to monitor the consistency of their approach and periodically assess the appropriateness of the valuation level assigned to the values obtained from them. If a fair value appears unreasonable, the Company will re-examine the inputs and assess the reasonableness of the pricing data with the vendor. Additionally, the Company may compare the inputs to relevant market indices and other performance measurements. Based on management's analysis, the valuation is confirmed or may be revised if there is evidence of a more appropriate estimate of fair value based on available market data. The Company has performed verification of the inputs and calculations in any valuation models to confirm that the valuations represent reasonable estimates of fair value. +The Company also routinely reviews its investments that have experienced declines in fair value to determine if the decline is other than temporary. The identification of distressed investments, the determination of fair value if not publicly traded and the assessment of whether a decline is other than temporary involve significant management judgment. The Company must apply considerable judgment in determining the likelihood of the security recovering in value while the Company owns it. Factors that may influence this include the Company's assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. This process requires consideration of risks, which can be controlled to a certain extent, such as credit risk, and risks which cannot be controlled, such as interest rate risk. Management updates its evaluations regularly and reflects impairment losses in the Company's net earnings or other comprehensive income, depending on the nature of the loss, as such evaluations are revised. +The Company's derivative activities include foreign currency forwards and options used in hedging foreign exchange risk and interest rate swaps and options on interest rate swaps (or interest rate swaptions) used in hedging interest rate risk on U.S. dollar-denominated securities in Aflac Japan's portfolio; foreign currency forwards and options used to economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long term exposure to a weakening yen; foreign currency swaps associated with certain senior notes and subordinated debentures; and foreign currency and credit default swaps in variable interest entities (VIEs) that are consolidated. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. +See Notes 1, 3, 4 and 5 of the Notes to the Consolidated Financial Statements for additional information. +Deferred Policy Acquisition Costs and Policy Liabilities +Insurance premiums for most of the Company's health and life policies, including cancer, accident, hospital, critical illness, dental, vision, term life, whole life, long-term care and disability, are recognized as revenue over the premium- +42 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +paying periods of the contracts when due from policyholders. When revenues are reported, the related amounts of benefits and expenses are charged against such revenues, so that profits are recognized in proportion to premium revenues during the period the policies are expected to remain in force. This association is accomplished by means of annual additions to the liability for future policy benefits and the deferral and subsequent amortization of policy acquisition costs. +Premiums from the Company's products with limited-pay features, including term life, whole life, WAYS, and child endowment, are collected over a significantly shorter period than the period over which benefits are provided. Premiums for these products are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. Any gross premium in excess of the net premium is deferred and recorded in earnings, such that profits are recognized in a constant relationship with insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net premium method. +Deferred Policy Acquisition Costs +The calculation of DAC and the liability for future policy benefits requires the use of estimates based on sound actuarial valuation techniques. For new policy issues, the Company reviews its actuarial assumptions and deferrable acquisition costs each year and revise them when necessary to more closely reflect recent experience and studies of actual acquisition costs. For policies in force, the Company evaluates DAC by major product groupings to determine that they are recoverable from future revenues, and any amounts determined not to be recoverable are charged against net earnings. See Note 6 of the Notes to the Consolidated Financial Statements for a detail of the DAC activity for the past two years. +Policy Liabilities +The following table provides details of policy liabilities by segment and in total as of December 31. +Policy Liabilities +(In millions) +2018 +2017 +Japan segment: +Future policy benefits +$ +77,812 +$ +73,661 +Unpaid policy claims +2,857 +2,692 +Other policy liabilities +12,122 +12,779 +Total Japan policy liabilities +$ +92,791 +$ +89,132 +U.S. segment: +Future policy benefits +$ +9,137 +$ +8,806 +Unpaid policy claims +1,727 +1,700 +Other policy liabilities +117 +119 +Total U.S. policy liabilities +$ +10,981 +$ +10,625 +Consolidated: +Future policy benefits +$ +86,368 +$ +81,857 +Unpaid policy claims +4,584 +4,392 +Other policy liabilities +12,236 +12,898 +Total consolidated policy liabilities (1) +$ +103,188 +$ +99,147 +(1) The sum of the Japan and U.S. segments exceeds the total due to reinsurance and retrocession activity. +The Company's policy liabilities, which are determined in accordance with applicable guidelines as defined under U.S. GAAP and Actuarial Standards of Practice, include two components that involve analysis and judgment: future policy benefits and unpaid policy claims, which accounted for 84% and 4% of total policy liabilities as of December 31, 2018 , respectively. +Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. The Company calculates future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are generally established at the time a policy is issued. The assumptions used in the calculations are closely +43 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +related to those used in developing the gross premiums for a policy. As required by U.S. GAAP, the Company also includes a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience. +Unpaid policy claims include those claims that have been incurred and are in the process of payment as well as an estimate of those claims that have been incurred but have not yet been reported to the Company. The Company computes unpaid policy claims on a non-discounted basis using statistical analyses of historical claims payments, adjusted for current trends and changed conditions. The Company updates the assumptions underlying the estimate of unpaid policy claims regularly and incorporates its historical experience as well as other data that provides information regarding the Company's outstanding liability. +The Company's insurance products provide fixed-benefit amounts per occurrence that are not subject to medical-cost inflation. Furthermore, the Company's business is widely dispersed in both the United States and Japan. This geographic dispersion and the nature of the Company's benefit structure mitigate the risk of a significant unexpected increase in claims payments due to epidemics and events of a catastrophic nature. Claims incurred under Aflac's policies are generally reported and paid in a relatively short time frame. The unpaid claims liability is sensitive to morbidity assumptions, in particular, severity and frequency of claims. Severity is the ultimate size of a claim, and frequency is the number of claims incurred. The Company's claims experience is primarily related to the demographics of its policyholders. +As a part of its established financial reporting and accounting practices and controls, the Company performs detailed annual actuarial reviews of its policyholder liabilities (gross premium valuation, GPV, analysis) and reflects the results of those reviews in its results of operations and financial condition as required by U.S. GAAP. For Aflac Japan, the Company's annual review in 2016 indicated that it needed to strengthen the liability associated with a block of care policies, primarily due to low investment yields. The Company strengthened its future policy benefits liability by $52 million in 2016 as a result of this review. Results of the Company’s annual review in 2018 and 2017 concluded that no further strengthening was required for these liabilities. For Aflac U.S., the Company's annual reviews in 2018, 2017 and 2016 indicated no need to strengthen liabilities associated with policies in the United States. In the U.S. and Japan, investment assumptions were reviewed in 2017 and the Company adopted expected forward rates in its GPV yield projections. In addition, in Japan, assets were allocated to blocks of business to align with yield and duration requirements of the businesses. +The table below reflects the growth of the future policy benefits liability for the years ended December 31. +Future Policy Benefits +(In millions of dollars and billions of yen) +2018 +2017 +2016 +Aflac U.S. +$ +9,137 +$ +8,806 +$ +8,442 +Growth rate +3.8 +% +4.3 +% +4.4 +% +Aflac Japan +$ +77,812 +$ +73,661 +$ +68,291 +Growth rate +5.6 +% +7.9 +% +9.7 +% +Consolidated +$ +86,368 +$ +81,857 +$ +76,106 +Growth rate +5.5 +% +7.6 +% +9.2 +% +Yen/dollar exchange rate (end of period) +111.00 +113.00 +116.49 +Aflac Japan (in yen) +8,637 +8,324 +7,955 +Growth rate +3.8 +% +4.6 +% +6.0 +% +The growth of the future policy benefits liability in yen for Aflac Japan and in dollars for Aflac U.S. has been due to the aging of the Company's in-force block of business and the addition of new business. +In computing the estimate of unpaid policy claims, the Company considers many factors, including the benefits and amounts available under the policy; the volume and demographics of the policies exposed to claims; and internal business practices, such as incurred date assignment and current claim administrative practices. The Company monitors these conditions closely and make adjustments to the liability as actual experience emerges. Claim levels are generally stable from period to period; however, fluctuations in claim levels may occur. In calculating the unpaid policy claim liability, the Company does not calculate a range of estimates. The following table shows the expected sensitivity of the unpaid policy claims liability as of December 31, 2018 , to changes in severity and frequency of claims. +44 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Sensitivity of Unpaid Policy Claims Liability +(In millions) +Total Severity +Total Frequency +Decrease +by 2% +Decrease +by 1% +Unchanged +Increase +by 1% +Increase +by 2% +Increase by 2% +$ +0 +$ +25 +$ +50 +$ +75 +$ +101 +Increase by 1% +(24 +) +0 +25 +50 +75 +Unchanged +(49 +) +(25 +) +0 +25 +50 +Decrease by 1% +(73 +) +(49 +) +(25 +) +0 +25 +Decrease by 2% +(97 +) +(73 +) +(49 +) +(24 +) +0 +Other policy liabilities, which accounted for 12% of total policy liabilities as of December 31, 2018 , consisted primarily of annuity and unearned premium reserves, and discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. Advanced premiums represented 29% and 34% of the December 31, 2018 and 2017 other policy liabilities balances, respectively. See the Aflac Japan segment subsection of this MD&A for further information. +Income Taxes +Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing the Company's income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the Company expects the temporary differences to reverse. The evaluation of a tax position in accordance with U.S. GAAP is a two-step process. Under the first step, the enterprise determines whether it is more likely than not that a tax position will be sustained upon examination by taxing authorities. The second step is measurement, whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized. The determination of a valuation allowance for deferred tax assets requires management to make certain judgments and assumptions. +In evaluating the ability to recover deferred tax assets, the Company's management considers all available evidence, including taxable income in open carry back years, the existence of cumulative losses in the most recent years, forecasted earnings, future taxable income exclusive of reversing temporary differences and carryforwards, future taxable temporary difference reversals, and prudent and feasible tax planning strategies. In the event the Company determines it is not more likely than not that it will be able to realize all or part of its deferred tax assets in the future, a valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed. Future economic conditions and market volatility, including increases in interest rates or widening credit spreads, can adversely impact the Company’s tax planning strategies and in particular the Company’s ability to utilize tax benefits on previously recognized capital losses. The Company's judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions. +The Tax Act was signed into law on December 22, 2017. Among other things, effective January 1, 2018 the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35% to 21%, eliminated or reduced certain deductions and credits, and limited the deductibility of interest expense and executive compensation. +The Tax Act also transitions international corporate taxation from a worldwide system to a modified territorial system, which in light of the current tax treatment of Aflac Japan has the effect of subjecting the earnings of Aflac Japan to Japan taxation and subjecting the Company’s other earnings, including the consolidated earnings of the Parent Company, to U.S. taxation. +These changes became effective on January 1, 2018. Because changes to tax rates are accounted for in the period of enactment, during the period ended December 31, 2017, the Company revalued its deferred tax assets and liabilities and recorded, as its reasonable estimate, a net deferred tax liability reduction of $1.9 billion as of that date. While the Company believes that this estimate was reasonable, it is relying upon guidance provided by SEC Staff Accounting Bulletin No. 118 (SAB 118) that provided a measurement period of up to one year from the enactment date of December 22, 2017, in order to complete the accounting for the effects of the Tax Act. This estimate was subject to new and +45 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +changing regulations, interpretations and tax guidance in the future, as well as further refinement of the Company’s calculations and changes in the interpretations and assumptions that the Company had made. In the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional Japan deferred tax balances and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. +For additional information on income tax, see Note 10 of the Notes to the Consolidated Financial Statements presented in this report. +Future Adoption of Accounting Standard for Long-Duration Insurance Contracts +In August 2018, the FASB issued Accounting Standards Update (ASU) 2018-12, “Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts.” The update, which is expected to significantly change how insurers account for long-duration contracts, amends existing recognition, measurement, presentation, and disclosure requirements applicable to the Company. Issues addressed in the new guidance include: 1) a requirement to review and, if there is a change, update assumptions for the liability for future policy benefits at least annually, and to update the discount rate assumption quarterly, 2) accounting for market risk benefits at fair value, 3) simplified amortization for deferred acquisition costs, and 4) enhanced financial statement presentation and disclosures. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early application of the amendments is permitted, however, the Company does not expect to early adopt the updated standard. +The Company is thoroughly evaluating the impact of adoption of ASU 2018-12 and expects that the adoption will have a significant impact on the Company’s reported financial position, results of operations, and disclosures under U.S. GAAP accounting. The Company anticipates that the requirement to update assumptions for liability for future policy benefits will have a significant impact on its results of operations, while the requirement to update the discount rate will have a significant impact on its accumulated other comprehensive income (AOCI) and equity. There are two permitted transition methods upon adoption, full retrospective and modified retrospective. Under the full retrospective method, the Company would restate all historical periods based upon actual historical experience as of contract inception and its updated view of the contractual cash flow projections at transition. A cumulative catch-up adjustment to opening retained earnings would be recognized to reflect the actual experience and updated projections. The update of the discount rate would be recognized in AOCI. The Company will be permitted to apply a full retrospective transition approach if actual historical information is available for all contracts that will be affected by the new guidance. Under the modified retrospective method, the opening reserve balance at the transition date, January 1, 2019, would generally be the same as the closing balance before transition, updated for changes in the discount rate. +The Company expects that under either transition method, the impact to its reported financial statements under U.S. GAAP will be greatly influenced by the nature of the Company’s business model. Adoption of the new guidance under either method will reflect the Company’s concentration in Japan third-sector business, in particular cancer insurance, with respect to which the duration of liabilities is materially longer than asset durations. Depending on the transition method chosen upon adoption, the impact of a low discount rate applied to long-duration third sector liabilities is recognized at adoption, while associated favorable morbidity margins are recognized over time thus driving a pronounced timing impact to U.S. GAAP equity. In addition, with respect to the Japan segment, the Company maintains a large portfolio of assets designated as held-to-maturity (HTM) as a strategy to reduce capital (solvency margin ratio or SMR) volatility. In a low interest rate environment, such as presently exists in Japan, assets designated as HTM that were purchased in a higher interest rate environment have significant embedded gains not reflected in AOCI, which serves as an economic offset to a low discount rate applied to policy liabilities. At December 31, 2018, the Company’s HTM portfolio was $30.3 billion at amortized cost and had $6.5 billion in net unrealized gains. After adoption of the new guidance, the Company also expects net earnings and net earnings per share (which were $2.9 billion and $3.77 per diluted share, respectively, in 2018) to reflect larger quarterly fluctuations due to the new requirement to update assumptions for liability for future policy benefits. +As an example of the potential impact of the new guidance, and for illustrative purposes only, under the modified retrospective method and in a low interest rate environment, the Company would expect AOCI (which was $2.2 billion at December 31, 2018) to significantly decline upon adoption and to thereafter reflect larger quarterly fluctuations due to the new requirement to quarterly adjust discount rates. Conversely, in a higher interest rate environment, and again assuming adoption of the modified retrospective method for illustrative purposes, the Company would expect AOCI to decline less or even increase (depending on the specifics of the interest rate environment), as well as to reflect quarterly fluctuations. Under the full retrospective method, the Company would expect lesser declines or increases in total equity upon adoption +46 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +compared to the modified retrospective method due to the potential offsetting effect from updating experience and cash flow projections +The ultimate impact on these items from the Company’s implementation of the updated standard is subject to assessments that are dependent on many variables, including but not limited to (i) the transition method selected by the Company, which the Company continues to evaluate, (ii) how certain aspects of the new standard will be interpreted and implemented by the Company and other similar companies, such as (but not limited to) amortization of deferred acquisition costs, as well as establishment of policies, processes and controls for setting, monitoring and periodically updating reserve assumptions, and (iii) changes in the interest rate environment in the US and Japan. +The Company is in the early stages of reviewing transition methods and has only begun to assess the full impact of adoption; as such, the Company expects to provide periodic updates on its continuing assessment. However, the Company expects that while the adoption of this new accounting guidance will affect the Company’s financial statements under U.S. GAAP, it will not impact financial statements for Aflac Japan under FSA requirements or for Aflac U.S. under applicable statutory requirements. Therefore, the Company does not expect adoption of the updated standard to impact its subsidiaries’ dividend capacity or their ability to meet applicable regulatory capital standards, nor does the Company anticipate adoption to affect its strategies for capital deployment. +New Accounting Pronouncements +During the last three years, various accounting standard-setting bodies have been active in soliciting comments and issuing statements, interpretations and exposure drafts. For information on new accounting pronouncements and the impact, if any, on the Company's financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements. +RESULTS OF OPERATIONS +The following discussion includes references to the Company's performance measures, adjusted earnings, adjusted earnings per diluted share, and amortized hedge costs, which are not calculated in accordance with U.S. GAAP. These measures exclude items that the Company believes may obscure the underlying fundamentals and trends in the Company's insurance operations because they tend to be driven by general economic conditions and events or related to infrequent activities not directly associated with its insurance operations. The Company's management uses adjusted earnings and adjusted earnings per diluted share to evaluate the financial performance of its insurance operations on a consolidated basis, and the Company believes that a presentation of these measures is vitally important to an understanding of its underlying profitability drivers and trends of its insurance business. The Company believes that amortized hedge costs, which are a component of adjusted earnings, measure the periodic currency risk management costs associated with hedging a portion of Aflac Japan’s U.S. dollar-denominated investments and are an important component of net investment income. +In 2018, the Company began utilizing the term “adjusted earnings” for the measure formerly referred to as "operating earnings" on both a pretax and after-tax basis, as well as an absolute and per-share basis. This change only pertained to the label of the measure and did not alter its definition or calculation. +Aflac defines adjusted earnings (a non-U.S. GAAP financial measure) as the profits derived from operations. The most comparative U.S. GAAP measure is net earnings. Adjusted earnings are adjusted revenues less benefits and adjusted expenses. The adjustments to both revenues and expenses account for certain items that cannot be predicted or that are outside management’s control. Adjusted revenues are U.S. GAAP total revenues excluding realized investment gains and losses, except for amortized hedge costs related to foreign currency exposure management strategies and net interest cash flows from derivatives associated with certain investment strategies. Adjusted expenses are U.S. GAAP total acquisition and operating expenses including the impact of interest cash flows from derivatives associated with notes payable but excluding any nonrecurring or other items not associated with the normal course of the Company’s insurance operations and that do not reflect Aflac’s underlying business performance. +The Company defines adjusted earnings per share (basic or diluted) to be adjusted earnings for the period divided by the weighted average outstanding shares (basic or diluted) for the period presented. The most comparable U.S. GAAP measure is net earnings per share. +Amortized hedge costs represent costs incurred in using foreign currency forward contracts to hedge the foreign exchange risk of a portion of U.S. dollar-denominated assets in the Company’s Japan segment investment portfolio. These amortized hedge costs are derived from the difference between the foreign currency spot rate at time of trade +47 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +inception and the contractual foreign currency forward rate, recognized on a straight line basis over the term of the hedge. There is no comparable U.S. GAAP financial measure for amortized hedge costs. +Because a significant portion of the Company's business is conducted in Japan and foreign exchange rates are outside of management’s control, the Company believes it is important to understand the impact of translating Japanese yen into U.S. dollars. Adjusted earnings and adjusted earnings per diluted share excluding current period foreign currency impact are computed using the average yen/dollar exchange rate for the comparable prior year period, which eliminates fluctuations driven solely by yen-to-dollar currency rate changes. +The following table is a reconciliation of items impacting adjusted earnings and adjusted earnings per diluted share to the most directly comparable U.S. GAAP measures of net earnings and net earnings per diluted share, respectively, for the years ended December 31. +Reconciliation of Net Earnings to Adjusted Earnings (1) +In Millions +Per Diluted Share +2018 +2017 +2016 +2018 +2017 +2016 +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +$ +3.77 +$ +5.77 +$ +3.21 +Items impacting net earnings: +Realized investment (gains) losses (2),(3),(4),(5) +297 +0 +(87 +) +.38 +.00 +(.10 +) +Other and non-recurring (income) loss +75 +69 +137 +.10 +.08 +.16 +Income tax (benefit) expense on items +excluded from adjusted earnings +(83 +) +(24 +) +(18 +) +(.11 +) +(.03 +) +(.02 +) +Tax reform adjustment (6) +18 +(1,933 +) +0 +.02 +(2.42 +) +.00 +Adjusted earnings +3,226 +2,716 +2,691 +4.16 +3.40 +3.25 +Current period foreign currency impact (7) +(28 +) +N/A +N/A +(.04 +) +N/A +N/A +Adjusted earnings excluding current period +foreign currency impact (8) +$ +3,198 +$ +2,716 +$ +2,691 +$ +4.13 +$ +3.40 +$ +3.25 +(1) "Adjusted earnings" was formerly referred to as "operating earnings." Amounts may not foot due to rounding. +(2) Excludes amortized hedge costs of $236 in 2018 , $228 in 2017 and $186 in 2016 , related to hedging U.S. dollar-denominated investments held in Aflac Japan which are classified as a component of adjusted earnings to conform to current year reporting. See "Hedge Costs" discussion below for further information. +(3) Amortized hedge costs in Aflac Japan were partially offset by derivatives entered into as part of corporate activities and resulted in a benefit of $36 in 2018 , which has been reclassified from realized investment gains (losses) and reported as an increase in net investment income when analyzing operations. +(4) An immaterial amount of net interest cash flows from derivatives associated with certain investment strategies in 2018 have been reclassified from realized investment gains (losses) into net investment income when analyzing operations. +(5) Excludes a gain of $67 in 2018 , $77 in 2017 and $85 in 2016 , related to the interest rate component of the change in fair value of foreign currency swaps on notes payable which is classified as an operating gain when analyzing segment operations +(6) The impact of Tax Reform was estimated in 2017 , and adjustments were recorded in 2018 for return-to-provision adjustments, various amended returns filed by the Company, and final true-ups of deferred tax liabilities. +(7) Prior period foreign currency impact reflected as “N/A” to isolate change for current period only. +(8) Amounts excluding current period foreign currency impact are computed using the average yen/dollar exchange rate for the comparable prior-year period, which eliminates dollar-based fluctuations driven solely from currency rate changes. +Realized Investment Gains and Losses +The Company's investment strategy is to invest primarily in fixed maturity securities to provide a reliable stream of investment income, which is one of the drivers of the Company’s growth and profitability. This investment strategy incorporates asset-liability matching (ALM) to align the expected cash flows of the portfolio to the needs of the Company's liability structure. The Company does not purchase securities with the intent of generating capital gains or losses. However, investment gains and losses may be realized as a result of changes in the financial markets and the creditworthiness of specific issuers, tax planning strategies, and/or general portfolio management and rebalancing. The realization of investment gains and losses is independent of the underwriting and administration of the Company's insurance products. Realized investment gains and losses include securities transactions, impairments, changes in loan loss reserves, and derivative and foreign currency activities. Effective January 1, 2018, changes in fair value of equity securities are also included in earnings as a component of realized investment gains and losses. +48 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Securities Transactions, Impairments, and Gains (Losses) on Equity Securities +Securities transactions include gains and losses from sales and redemptions of investments where the amount received is different from the amortized cost of the investment. Impairments include other-than-temporary-impairment losses on investment securities as well as changes in loan loss reserves for loan receivables. Starting in the first quarter of 2018, gains and losses from changes in fair value of equity securities are recorded in earnings. +Certain Derivative and Foreign Currency Gains (Losses) +The Company's derivative activities include foreign currency forwards and options on certain fixed maturity securities; foreign currency forwards and options that economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long-term exposure to a weakening yen; foreign currency swaps associated with certain senior notes and subordinated debentures; foreign currency swaps and credit defaults swaps held in consolidated VIEs; interest rate swaps used to economically hedge interest rate fluctuations in certain variable-rate investments; and interest rate swaptions to hedge changes in the fair value associated with interest rate changes for certain dollar-denominated available-for-sale securities. Gains and losses are recognized as a result of valuing these derivatives, net of the effects of hedge accounting. The Company also excludes the accounting impacts of remeasurement associated with changes in the yen/dollar exchange rate from adjusted earnings. Certain derivative and foreign currency gains (losses) exclude amortized hedge costs related to foreign currency exposure management strategies (see Hedge Cost section below), and net interest cash flows from derivatives associated with certain investment strategies and notes payable, all of which are included in adjusted earnings. +Hedge Costs +Effective January 1, 2017, adjusted earnings includes the impact of amortized hedge costs. Amortized hedge costs represent costs incurred in using foreign currency forward contracts to hedge the foreign exchange risk of a portion of U.S. dollar-denominated assets in the Company's Japan segment investment portfolio. Amortized hedge costs are offset by a hedge cost amortization benefit recognized for foreign currency forwards that economically hedge the Company's long-term exposure to a weakening yen. These amortized hedge costs are derived from the difference between the foreign currency spot rate at time of trade inception and the contractual foreign currency forward rate, recognized on a straight line basis over the term of the hedge. There is no comparable U.S. GAAP financial measure for amortized hedge costs. +Hedge costs can fluctuate based upon many factors, including the derivative notional amount, the length of time of the derivative contract, changes in both U.S. and Japan interest rates, and supply and demand for dollar funding. Hedge costs have increased in recent periods due to changes in the previously mentioned factors. In late 2017, the Company +took steps to mitigate rising hedge costs by increasing the amount of unhedged U.S. dollar-denominated investments held +in Aflac Japan and to reduce hedge cost volatility by extending hedge duration. For additional information regarding +currency hedging, refer to Hedging Activities in the Analysis of Financial Condition section of this MD&A. +For additional information regarding realized investment gains and losses, including details of reported amounts for the periods presented, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements. +Other and Non-recurring Items +The United States insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. The system can result in periodic charges to the Company as a result of insolvencies/bankruptcies that occur with other companies in the life insurance industry. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets. These charges neither relate to the ordinary course of the Company’s business nor reflect the Company’s underlying business performance, but result from external situations not controlled by the Company. Based on the underlying nature of these assessments in the United States, effective January 1, 2017, the Company adopted a policy of excluding any charges associated with U.S. guaranty fund assessments and the corresponding tax benefit or expense from adjusted earnings. +For the Penn Treaty liquidation that was recognized by judicial authority in March 2017, the Company estimated and recognized a discounted liability for assessments of $62 million (undiscounted $94 million ), offset by discounted premium tax credits of $48 million (undiscounted $74 million ), for a net $14 million impact to net income in the quarter ended March 31, 2017. For additional information regarding guaranty fund assessments, see Note 15 of the Notes to the Consolidated Financial Statements. +49 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +In Japan, the government also requires the insurance industry to contribute to a policyholder protection corporation that provides funds for the policyholders of insolvent insurers; however, these costs are calculated and administered differently than in the United States. In Japan, these costs are not directly related to specific insolvencies or bankruptcies, but are rather a regular operational cost for an insurance company. Based on this structure, the Company does not remove the Japan policyholder protection expenses from adjusted earnings. +Effective January 1, 2017, nonrecurring items also include conversion costs related to legally converting the Company's Japan branch to a subsidiary; these costs primarily consist of expenditures for legal, accounting, consulting, integration of systems and processes and other similar services. These Japan branch conversion costs amounted to $75 million in 2018 and $42 million in 2017 . +The Company considers the costs associated with the early redemption of its debt to be unrelated to the underlying fundamentals and trends in its insurance operations. Additionally, these costs are driven by changes in interest rates subsequent to the issuance of the debt, and the Company considers these interest rate changes to represent economic conditions not directly associated with its insurance operations. In November 2017, the Parent Company extinguished $500 million of its 5.50% subordinated debentures. The pretax non-operating expense due to the early redemption of these notes was $13 million . In 2016, the Parent Company completed a tender offer in which it extinguished $176 million principal of its 6.90% senior notes due 2039 and $193 million principal of its 6.45% senior notes due 2040. The pretax non-operating loss due to the early redemption of these notes was $137 million . +Tax Reform Adjustment +Among other changes, the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35% to 21% effective January 1, 2018. Because changes to tax rates are accounted for in the period of enactment, during the year ended December 31, 2017, the Company revalued its deferred tax assets and liabilities and recognized a non-recurring estimated $1.9 billion benefit for the reduction of the net deferred tax liability. In the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional Japan deferred tax balances and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. +For further information, see Critical Accounting Estimates - Income Taxes above in this MD&A, and Note 10 of the Notes to the Consolidated Financial Statements in this report. +Foreign Currency Translation +Aflac Japan’s premiums and a significant portion of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into dollars for financial reporting purposes. The Company translates Aflac Japan’s yen-denominated income statement into dollars using the average exchange rate for the reporting period, and the Company translates its yen-denominated balance sheet using the exchange rate at the end of the period. +Due to the size of Aflac Japan, whose functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on the Company's reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. Management evaluates the Company's financial performance both including and excluding the impact of foreign currency translation to monitor, respectively, cumulative currency impacts on book value and the currency-neutral operating performance over time. +Income Taxes +The Company's combined U.S. and Japanese effective income tax rate on pretax earnings was 26.7% in 2018 , (14.6)% in 2017 and 34.6% in 2016 . The reduction in the tax rate for 2017 was primarily due to the $1.9 billion benefit as a result of the Tax Act. The decrease in the U.S. federal statutory corporate income tax rate from 35% to 21% effective January 1, 2018 drove the reduction in the effective tax rate for 2018 compared with years prior to 2017 . Total income taxes were $1.1 billion in 2018 , compared with $(586) million in 2017 and $1.4 billion in 2016 . Japanese income taxes on Aflac Japan's results account for most of the Company's consolidated income tax expense. For further information, see Critical Accounting Estimates - Income Taxes above in this MD&A, and Note 10 of the Notes to the Consolidated Financial Statements for additional information. +50 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +2019 Outlook +The Company’s strategy to drive long-term shareholder value is to pursue growth through product development, distribution expansion and digital advancements to improve the customer experience. +The Company's objectives in 2019 are to maintain strong pre-tax margins in its Aflac Japan and Aflac U.S. segments through disciplined product pricing, stable investment returns and leveraging a period of favorable benefit ratios to invest in its platform for future growth and efficiency. The Company believes that its market-leading position, powerful brand recognition and diverse distribution in Japan and the United States will provide support toward these objectives. +The Company believes that its efforts will support its prudent strategies for capital deployment in the form of dividends, share repurchases, and opportunistic investments that enhance the Company’s business with a focus on digital distribution and leveraging the Company’s brand, distribution and scale. The Company has stated that the dividend payout ratio from its Aflac Japan segment is likely to be in the range of 80% - 100% of FSA earnings. In its Aflac U.S. segment, the Company plans to continue its RBC drawdown plan to an RBC in the 500% range by the end of 2019. +Aflac Japan Segment +In Japan, the Company anticipates that the shift in earned premium from first sector savings products to third sector cancer and medical products and first sector protection products, will continue to result in moderately lower benefit ratios in the Aflac Japan segment. The Company also expects this shift in business mix, plus continued investment in IT and digital advancements, to result in moderately higher expense ratios for Aflac Japan. The Company believes that the Japan segment will face revenue challenges in 2019 due to the run-off and paid-up status of first sector savings products. In addition, net investment income is expected to decline modestly as compared to 2018, due in part to the low rate environment in Japan, de-risking of the portfolio and rolling U.S. dollar hedge positions into higher cost contracts. +Aflac U.S. Segment +The Company expects the profit margins for the Aflac U.S. segment to remain strong, providing a prudent opportunity to reinvest profits back into the U.S. business. The Company believes that in 2019, benefit ratios in the U.S. will continue to trend favorably and that expense ratios will continue to be elevated in light of investments into U.S. platforms in both the individual and group channels. Net investment income is expected to decline modestly, primarily as the result of the Company’s U.S. capital and RBC draw-down plan. +Corporate Segment +The Company expects corporate segment results to benefit from net investment income driven by increased capital and liquidity held at the Parent Company, as well as the Company’s enterprise currency hedging strategy. The anticipated increase in investment income is expected to be partially offset by increased costs associated with continued investment in Aflac Corporate Ventures initiatives. +For important disclosures applicable to statements made in this 2019 Outlook, please see the Risk Factors section and the statement on “Forward-Looking Information” at the beginning of the Management’s Discussion and Analysis of Financial Condition and Results of Operations. +INSURANCE OPERATIONS +U.S. GAAP financial reporting requires that a company report financial and descriptive information about operating segments in its annual and interim period financial statements. Furthermore, the Company is required to report a measure of segment profit or loss, certain revenue and expense items, and segment assets. Aflac's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan is the principal contributor to consolidated earnings. Businesses that are not individually reportable, such as the Parent Company, and business activities, including reinsurance retrocession activities, not included in Aflac Japan or Aflac U.S. are included in the "Corporate and other" category. See the Item 1. Business section of this Form 10-K for a summary of each segment's products and distribution channels, and a discussion of the conversion of Aflac Japan from a branch to a subsidiary and the creation of asset management subsidiaries in 2018. +51 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +AFLAC JAPAN SEGMENT +Aflac Japan Pretax Adjusted Earnings +Changes in Aflac Japan's pretax adjusted earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac Japan for the years ended December 31. +Aflac Japan Summary of Operating Results +(In millions) +2018 +2017 +2016 +Net premium income +$ +12,762 +$ +12,752 +$ +13,537 +Net investment income: +Yen-denominated investment income +1,283 +1,294 +1,346 +U.S. dollar-denominated investment income +1,356 +1,169 +1,208 +Net investment income +2,639 +2,463 +2,554 +Amortized hedge costs related to foreign currency denominated investments +236 +228 +186 +Net investment income, less amortized hedge costs +2,403 +2,235 +2,368 +Other income (loss) +41 +41 +40 +Total adjusted revenues +15,206 +15,028 +15,945 +Benefits and claims, net +8,913 +9,087 +9,828 +Adjusted expenses: +Amortization of deferred policy acquisition costs +710 +630 +644 +Insurance commissions +735 +736 +787 +Insurance and other expenses +1,640 +1,521 +1,538 +Total adjusted expenses +3,085 +2,887 +2,969 +Total benefits and expenses +11,998 +11,974 +12,797 +Pretax adjusted earnings (1) +$ +3,208 +$ +3,054 +$ +3,148 +Weighted-average yen/dollar exchange rate +110.39 +112.16 +108.70 +In Dollars +In Yen +Percentage change over previous period: +2018 +2017 +2016 +2018 +2017 +2016 +Net premium income +.1 +% +(5.8 +)% +12.4 +% +(1.5 +)% +(2.7 +)% +.8 +% +Net investment income, less amortized +hedge costs +7.5 +(5.6 +) +.2 +5.5 +(2.0 +) +(10.3 +) +Total adjusted revenues +1.2 +(5.8 +) +10.4 +(.5 +) +(2.5 +) +(1.0 +) +Pretax adjusted earnings (1) +5.0 +(3.0 +) +1.5 +3.1 +.6 +(9.0 +) +(1) Aflac defines pretax adjusted earnings (a non-U.S. GAAP financial measure) as adjusted earnings before the application of income taxes. See the Results of Operations section of this MD&A for the Company's definition of adjusted earnings and a reconciliation of adjusted earnings to the most directly comparable U.S. GAAP measure of net earnings. +In yen terms, Aflac Japan's net premium income decreased in 2018 , with growth in third sector premium more than offset by an anticipated reduction in first sector premium due to savings products reaching premium paid-up status. Net investment income, net of amortized hedge costs, increased in 2018 largely due to higher income from U.S. dollar-denominated floating rate assets. Pretax adjusted earnings in yen increased, driven by higher net investment income and a favorable third sector benefit ratio. +Annualized premiums in force at December 31, 2018 , were 1.53 trillion yen, compared with 1.55 trillion yen in 2017 and 1.61 trillion yen in 2016 . The decrease in annualized premiums in force in yen of 1.6% in 2018 and 3.4% in 2017 was driven primarily by limited-pay policies becoming paid-up during the year. The decrease in annualized premiums in force in yen of .7% in 2016 reflects the net effect of sales of new policies combined with limited-pay policies becoming paid-up and the persistency of Aflac Japan’s business. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $13.8 billion in 2018 , $13.7 billion in 2017 , and $13.8 billion in 2016 . +52 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Aflac Japan's investment portfolios include U.S. dollar-denominated securities and reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments). In years when the yen strengthens in relation to the dollar, translating Aflac Japan's U.S. dollar-denominated investment income into yen lowers growth rates for net investment income, total adjusted revenues, and pretax adjusted earnings in yen terms. In years when the yen weakens, translating U.S. dollar-denominated investment income into yen magnifies growth rates for net investment income, total adjusted revenues, and pretax adjusted earnings in yen terms. +The following table illustrates the effect of translating Aflac Japan's U.S. dollar-denominated investment income and related items into yen by comparing certain segment results with those that would have been reported had dollar/yen exchange rates remained unchanged from the prior year. Amounts excluding foreign currency impact on U.S. dollar denominated investment income were determined using the average dollar/yen exchange rate for the comparable prior year period. +Aflac Japan Percentage Changes Over Prior Year +(Yen Operating Results) +Including Foreign +Currency Changes +Excluding Foreign +Currency Changes (2) +2018 +2017 +2016 +2018 +2017 +2016 +Net investment income, less +amortized hedge costs +5.5 +% +(2.0 +)% +(10.3 +)% +6.4 +% +(3.6 +)% +(5.1 +)% +Total adjusted revenues +(.5 +) +(2.5 +) +(1.0 +) +(.3 +) +(2.8 +) +(.1 +) +Pretax adjusted earnings (1) +3.1 +.6 +(9.0 +) +3.7 +(.5 +) +(5.3 +) +(1) Aflac defines pretax adjusted earnings (a non-U.S. GAAP financial measure) as adjusted earnings before the application of income taxes. See the Results of Operations section of this MD&A for the Company's definition of adjusted earnings and a reconciliation of adjusted earnings to the most directly comparable U.S. GAAP measure of net earnings. +(2) Amounts excluding foreign currency impact on U.S. dollar-denominated investment income (a non-U.S. GAAP financial measure) were determined using the average dollar/yen exchange rate for the comparable prior year period. +The following table presents a summary of operating ratios in yen terms for Aflac Japan for the years ended December 31. +Ratios to total adjusted revenues: +2018 +2017 +2016 +Benefits and claims, net +58.6 +% +60.4 +% +61.6 +% +Adjusted expenses: +Amortization of deferred policy acquisition costs +4.7 +4.2 +4.0 +Insurance commissions +4.8 +4.9 +4.9 +Insurance and other expenses +10.8 +10.1 +9.8 +Total adjusted expenses +20.3 +19.2 +18.7 +Pretax adjusted earnings (1) +21.1 +20.4 +19.7 +Ratios to total premiums: +Benefits and claims, net +69.9 +% +71.3 +% +72.6 +% +Adjusted expenses: +Amortization of deferred policy acquisition costs +5.6 +4.9 +4.8 +(1) Aflac defines pretax adjusted earnings (a non-U.S. GAAP financial measure) as adjusted earnings before the application of income taxes. See the Results of Operations section of this MD&A for the Company's definition of adjusted earnings and a reconciliation of adjusted earnings to the most directly comparable U.S. GAAP measure of net earnings. +In 2018 , the benefit ratio decreased, compared to the prior year, primarily due to the continued change in mix of first and third sector business as first sector products become paid-up, as well as continued favorable third sector claims trends, and higher surrender rates for the cancer products. In 2018 , the adjusted expense ratio increased due to lower premium income impacted by first sector products becoming paid-up, higher expenses primarily related to increased system development, outsourcing costs for new products, and DAC amortization due to the increase of surrender for cancer products. In total for 2018 , the pretax adjusted profit margin increased, reflecting the decrease in the benefit ratio partially offset by a smaller increase in the expense ratio. For 2019 , the Company anticipates the Aflac Japan pretax adjusted profit margin (calculated by dividing adjusted earnings by adjusted revenues) to remain stable. +53 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Aflac Japan Sales +The following table presents Aflac Japan's new annualized premium sales for the years ended December 31. +In Dollars +In Yen +(In millions of dollars and billions of yen) +2018 +2017 +2016 +2018 +2017 +2016 +New annualized premium sales +$ +869 +$ +846 +$ +1,045 +95.9 +94.9 +113.7 +Increase (decrease) over prior period +2.7 +% +(19.0 +)% +4.8 +% +1.1 +% +(16.6 +)% +(5.9 +)% +The following table details the contributions to Aflac Japan's new annualized premium sales by major insurance product for the years ended December 31. +2018 +2017 +2016 +Cancer +65.8 +% +55.8 +% +46.6 +% +Medical +25.0 +34.1 +26.0 +Income support +1.8 +2.3 +0.0 +Ordinary life: +WAYS +.5 +.6 +11.9 +Child endowment +.3 +.5 +6.4 +Other ordinary life (1) +6.1 +6.0 +6.2 +Other +.5 +.7 +2.9 +Total +100.0 +% +100.0 +% +100.0 +% +(1) Includes term and whole life +The foundation of Aflac Japan's product portfolio has been, and continues to be, third sector products, which include cancer, medical and Income Support insurance products. New annualized premium sales of third sector products on a yen basis increased 1.6% during 2018 , compared with 2017 . Third sector sales included growth in the new cancer insurance product that was launched in April 2018, however medical sales have declined compared with 2017 as a result of strong sales in 2017 driven by the introduction of the new medical insurance product in the second quarter of 2017. Aflac Japan has been focusing more on promotion of cancer and medical insurance products in this low-interest-rate environment. These products are less interest-rate sensitive and more profitable compared to first sector products. With continued cost pressure on Japan’s health care system, the Company expects the need for third sector products will continue to rise in the future and that the medical and cancer insurance products Aflac Japan provides will continue to be an important part of its product portfolio. +Independent corporate agencies and individual agencies contributed 40.1% of total new annualized premium sales for Aflac Japan in 2018 , compared with 42.8% in 2017 and 46.7% in 2016 . Affiliated corporate agencies, which include Japan Post, contributed 55.3% of total new annualized premium sales in 2018 , compared with 52.0% in 2017 and 44.4% in 2016 . Japan Post offers Aflac's cancer insurance products in more than 20,000 post offices. In 2018, Japan Post's sales of cancer insurance constituted approximately 25% of Aflac Japan's third sector sales. The Company believes this alliance with Japan Post has and will further benefit its cancer insurance sales. In 2018 , Aflac Japan recruited 85 new sales agencies. At December 31, 2018 , Aflac Japan was represented by more than 9,800 sales agencies, with more than 109,000 licensed sales associates employed by those agencies. +At December 31, 2018 , Aflac Japan had agreements to sell its products at 371 banks, approximately 90% of the total number of banks in Japan. Bank channel sales accounted for 4.6% of new annualized premium sales in 2018 for Aflac Japan, compared with 5.2% in 2017 and 8.9% in 2016 . +Aflac Japan Investments +The level of investment income in yen is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, the effect of yen/dollar exchange rates on U.S. dollar-denominated investment income, and other factors. +As part of the Company's portfolio management and asset allocation process, Aflac Japan invests in yen and U.S. dollar-denominated investments. Yen-denominated investments primarily consist of JGBs and public and private fixed maturity securities. Aflac Japan's U.S. dollar-denominated investments include fixed maturity investments and growth +54 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +assets, including public equity securities and alternative investments in limited partnerships or similar investment vehicles. Aflac Japan has been investing in both publicly-traded and privately originated U.S. dollar-denominated investment-grade and below-investment-grade fixed maturity securities and loan receivables, Aflac Japan has entered into foreign currency forwards and options to hedge the currency risk on the fair value of a portion of the U.S. dollar investments, interest rate swaptions to hedge interest rate fluctuations on some U.S. dollar investments, and interest rate swaps to economically hedge interest rate fluctuations in certain variable-rate investments. +The following table details the investment purchases for Aflac Japan for the years ended December 31. +(In millions) +2018 +2017 +Yen-denominated: +Fixed maturity securities: +Japan government and agencies +$ +3,895 +$ +5,367 +Other fixed maturity securities +1,981 +1,579 +Equity securities +221 +189 +Total yen-denominated +$ +6,097 +$ +7,135 +U.S. dollar-denominated: +Fixed maturity securities: +Other fixed maturity securities +$ +1,299 +$ +466 +Infrastructure debt +0 +134 +Bank loans +346 +0 +Equity securities +120 +158 +Other investments: +Transitional real estate loans +3,168 +1,063 +Commercial mortgage loans +13 +48 +Middle market loans +839 +548 +Limited partnerships +314 +96 +Total dollar-denominated +$ +6,099 +$ +2,513 +Total Aflac Japan purchases +$ +12,196 +$ +9,648 +Aflac Japan purchased $1.2 billion of yen-denominated private placements in 2018 , compared with $1.1 billion in 2017 . +See the Analysis of Financial Condition section of this MD&A for further discussion of these investment programs, and see Notes 1, 3 and 4 of the Notes to the Consolidated Financial Statements for more information regarding loans and loan receivables. +Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, securities lending, and other securities transactions. Securities lending is also used from time to time to accelerate the availability of funds for investment. Purchases of securities from period to period are determined based on multiple objectives including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to the Company's investment policy guidelines. +The following table presents the results of Aflac Japan's investment yields for the years ended and as of December 31. +55 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +2018 +2017 +2016 +Total purchases for the period (in millions) (1) +$ +11,882 +$ +9,552 +$ +10,903 +New money yield (1),(2) +3.06 +% +1.98 +% +1.40 +% +Return on average invested assets (3) +2.33 +2.31 +2.47 +Portfolio book yield, including U.S. dollar-denominated investments, +end of period (1) +2.61 +% +2.56 +% +2.62 +% +(1) Includes fixed maturity securities, loan receivables, equity securities, and excludes alternative investments in limited partnerships +(2) Reported on a gross yield basis; excludes investment expenses, external management fees, and amortized hedge costs +(3) Net of investment expenses and amortized hedge costs, year-to-date number reflected on a quarterly average basis +The increase in the Aflac Japan new money yield in 2018 was primarily due to increased allocations to higher yielding U.S. dollar-denominated asset classes. +See Notes 3, 4 and 5 of the Notes to the Consolidated Financial Statements and the Analysis of Financial Condition section of this MD&A for additional information on the Company's investments and hedging strategies. +AFLAC U.S. SEGMENT +Aflac U.S. Pretax Adjusted Earnings +Changes in Aflac U.S. pretax adjusted earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac U.S. for the years ended December 31. +Aflac U.S. Summary of Operating Results +(In millions) +2018 +2017 +2016 +Net premium income +$ +5,708 +$ +5,563 +$ +5,454 +Net investment income +727 +721 +703 +Other income +8 +5 +10 +Total adjusted revenues +6,443 +6,289 +6,167 +Benefits and claims +2,887 +2,885 +2,869 +Adjusted expenses: +Amortization of deferred policy acquisition costs +534 +502 +497 +Insurance commissions +585 +580 +580 +Insurance and other expenses +1,152 +1,077 +1,013 +Total adjusted expenses +2,271 +2,159 +2,090 +Total benefits and expenses +5,158 +5,044 +4,959 +Pretax adjusted earnings (1) +$ +1,285 +$ +1,245 +$ +1,208 +Percentage change over previous period: +Net premium income +2.6 +% +2.0 +% +2.0 +% +Net investment income +.8 +2.6 +3.8 +Total adjusted revenues +2.4 +2.0 +2.2 +Pretax adjusted earnings (1) +3.2 +3.1 +9.7 +(1) Aflac defines pretax adjusted earnings (a non-U.S. GAAP financial measure) as adjusted earnings before the application of income taxes. See the Results of Operations section of this MD&A for the Company's definition of adjusted earnings and a reconciliation of adjusted earnings to the most directly comparable U.S. GAAP measure of net earnings. +Net investment income increased in 2018, driven by higher income from floating rate assets partially offset from the drawdown of excess capital in the U.S. segment. Annualized premiums in force increased 3.0% in 2018 , 2.6% in 2017 and 2.4% in 2016 . Annualized premiums in force at December 31 were $6.2 billion in 2018 , compared with $6.1 billion in 2017 and $5.9 billion in 2016 . +56 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The following table presents a summary of operating ratios for Aflac U.S. for the years ended December 31. +Ratios to total adjusted revenues: +2018 +2017 +2016 +Benefits and claims +44.8 +% +45.9 +% +46.5 +% +Adjusted expenses: +Amortization of deferred policy acquisition costs +8.3 +8.0 +8.1 +Insurance commissions +9.1 +9.2 +9.4 +Insurance and other expenses +17.9 +17.1 +16.4 +Total adjusted expenses +35.2 +34.3 +33.9 +Pretax adjusted earnings (1) +19.9 +19.8 +19.6 +Ratios to total premiums: +Benefits and claims +50.6 +51.9 +52.6 +Adjusted expenses: +Amortization of deferred policy acquisition costs +9.4 +9.0 +9.1 +(1) Aflac defines pretax adjusted earnings (a non-U.S. GAAP financial measure) as adjusted earnings before the application of income taxes. See the Results of Operations section of this MD&A for the Company's definition of adjusted earnings and a reconciliation of adjusted earnings to the most directly comparable U.S. GAAP measure of net earnings. +The benefit ratio decreased in 2018 , compared with 2017 , due in large part to benefit reserve releases related to slightly elevated lapses of older individual cancer policies in the first and fourth quarters of 2018. The adjusted expense ratio increased slightly in 2018 compared with 2017, primarily due to planned spending increases reflecting elevated investments in the platform. The pretax adjusted profit margin increased slightly in 2018 when compared with 2017, primarily due to lower benefit ratios. In 2019, the Company expects benefit ratios to be slightly lower than 2018 levels, reflecting ongoing changes in business mix, and expects somewhat higher expense ratios reflecting further investments in its U.S. platform. Net investment income is expected to decline modestly, primarily the result of the Company’s U.S. capital and RBC drawdown plan. (Note that all of these ratios-to-revenue reflect reduced net investment income due to the Company's planned drawdown of excess capital to lower RBC ratios. See the Capital Resources and Liquidity section of this MD&A for further discussion of the planned reduction of RBC.) +Aflac U.S. Sales +The following table presents Aflac's U.S. new annualized premium sales for the years ended December 31. +(In millions) +2018 +2017 +2016 +New annualized premium sales +$ +1,601 +$ +1,552 +$ +1,482 +Increase (decrease) over prior period +3.2 +% +4.7 +% +(.3 +)% +The following table details the contributions to Aflac's U.S. new annualized premium sales by major insurance product category for the years ended December 31. +2018 +2017 +2016 +Accident +29.2 +% +29.4 +% +29.5 +% +Short-term disability +22.7 +22.9 +23.5 +Critical care (1) +22.1 +22.8 +22.1 +Hospital indemnity +15.8 +14.8 +14.8 +Dental/vision +4.7 +5.1 +5.0 +Life +5.5 +5.0 +5.1 +Total +100.0 +% +100.0% +100.0 +% +(1) Includes cancer, critical illness and hospital intensive care products +New annualized premium sales for accident insurance, the Aflac U.S. leading product category, increased 2.4% , short-term disability sales increased 1.8% , critical care insurance sales (including cancer insurance) decreased .1% , and hospital indemnity insurance sales increased 10.4% in 2018 , compared with 2017 . +57 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The addition of group products has expanded Aflac U.S.'s reach and enabled Aflac U.S. to generate more sales opportunities with larger employers and through brokers and sales agent channels. The Company anticipates that the appeal of Aflac U.S. group products will continue to enhance opportunities to connect with larger businesses and their employees. The Aflac U.S. portfolio of group and individual products offers businesses the opportunity to give their employees a more valuable and comprehensive selection of benefit options. +In 2018 , the Aflac U.S. sales forces included an average of more than 8,500 U.S. agents, including brokers, who were actively producing business on a weekly basis. The Company believes that this average weekly producer equivalent metric allows sales management to monitor progress and needs. +One Day Pay SM is a claims initiative that Aflac U.S. has focused on to process, approve and pay eligible claims in just one day. The Company believes that this claims practice enhances the Aflac U.S. brand reputation and the trust policyholders have in Aflac, and it helps Aflac stand out from competitors. +Aflac U.S. products provide cash benefits that can be used to help with increasing out-of-pocket medical expenses, help cover household costs, or protect against income and asset loss. Group products and relationships with insurance brokers that handle the larger-case market are helping Aflac U.S. expand its reach by selling to larger businesses. Aflac U.S. is regularly evaluating the marketplace to identify opportunities to bring the most relevant, cost-effective products to customers. The Company believes the need for its products remains very strong, and Aflac U.S. continues to work on enhancing its distribution capabilities to access employers of all sizes, including initiatives that benefit the field force and the broker community. At the same time, the Company is seeking opportunities to leverage its brand strength and attractive product portfolio in the evolving health care environment. +U.S. Regulatory Environment +Healthcare Reform Legislation +The Affordable Care Act (ACA), federal health care legislation, was intended to give Americans of all ages and income levels access to comprehensive major medical health insurance and gave the U.S. federal government direct regulatory authority over the business of health insurance. While the ACA was enacted in 2010, the major elements of the law became effective on January 1, 2014. The ACA included major changes to the U.S. health care insurance marketplace. Among other changes, the ACA included an individual medical insurance coverage mandate (which has since been repealed effective 2019 by the Tax Act), provided for penalties on certain employers for failing to provide adequate coverage, created health insurance exchanges, and addressed coverage and exclusions as well as medical loss ratios. It also imposed an excise tax on certain high cost plans, known as the “Cadillac tax,” that is currently scheduled to begin in 2022. The ACA also included changes in government reimbursements and tax credits for individuals and employers and altered federal and state regulation of health insurers. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. The United States Congress has considered and may continue to consider legislation that would repeal and replace key provisions of the ACA. There can be no assurance that any legislation affecting the ACA will be passed by Congress, nor as to the ultimate timing or provisions of any such legislation, nor as to the effect of any such legislation on the design or marketability of the Company's insurance products. Further, certain provisions of the ACA have been and may continue to be subject to challenge through litigation, the ultimate effects of which on the ACA are uncertain. +President Trump signed an Executive Order in October 2017 directing federal regulatory agencies to review and modify certain regulations issued under the ACA. The stated objectives of the Executive Order are to increase competition and consumer choices in health care markets, and to lower costs for health care, by making association health plans available to more employers, allowing employers to make better use of health reimbursement arrangements, and expanding coverage through short-term insurance. The Executive Order tasks three federal agencies, the Departments of Labor (DOL), Treasury, and Health and Human Services (HHS) with reviewing current rules and developing guidance to implement the order. While the details of any proposed modifications will not be known until further action by the agencies, the Company anticipates that the Executive Order will not have a significant impact on the availability or marketability of its products. +58 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Tax Reform Legislation +The Tax Act was signed into law on December 22, 2017. Among other things, effective January 1, 2018, the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35% to 21%, eliminated or reduced certain deductions and credits and limited the deductibility of interest expense and executive compensation. +The Tax Act also transitions international corporate taxation from a worldwide system to a modified territorial system, which in light of the current tax treatment of Aflac Japan as a branch has the effect of subjecting the earnings of Aflac Japan to Japan taxation and subjecting the Company's other earnings, including the consolidated earnings of the Parent Company, to U.S. taxation. The treatment of Aflac Japan as a branch for U.S. tax purposes did not change following the completion of its conversion from a branch structure to a subsidiary structure for legal purposes on April 1, 2018. +Aflac U.S. prices its business on an internal rate of return basis. The Aflac U.S. business has a financial structure that the Company expects to be neutral on a pricing basis from these tax changes. The Aflac U.S. products have high initial costs for marketing, underwriting and administration, which will have less tax relief under the changes and will increase the amount required to invest in new business. In addition, the Company expects that RBC requirements will increase on an after-tax basis, being another source of initial funding required for these products. The tax basis for reserves and DAC may also change the timing of tax payments in an accelerated or unfavorable direction. All of these effects will offset a favorable lower tax rate on income in later years. The overall impact is expected to be neutral on a pricing basis from these various effects. +The Tax Act changes became effective on January 1, 2018. However, because changes to tax rates are accounted for in the period of enactment, during the period ended December 31, 2017, the Company revalued its deferred tax assets and liabilities and recorded a net deferred tax liability reduction of $1.9 billion as of that date. In the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional Japan deferred tax balances and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. For information on the effects of the Tax Act during the period ended December 31, 2018, see Note 10 of the Notes to the Consolidated Financial Statements presented in this report. For information on the conversion of Aflac Japan from a branch to a subsidiary, see General Business under Item 1, Business, in this report. +Dodd-Frank Act +Title VII of the Dodd-Frank Act and regulations issued thereunder, in particular rules to require central clearing for certain types of derivatives, may have an impact on Aflac's derivative activity, including activity on behalf of Aflac Japan. In addition, in 2015 and 2016, six U.S. financial regulators, including the U.S. Commodity Futures Trading Commission (CFTC), issued final rules regarding the exchange of initial margin (IM) and variation margin (VM) for uncleared swaps that impose greater obligations on swap dealers regarding uncleared swaps with certain counterparties, such as Aflac. The requirements of such rules with respect to VM, as well as similar regulations in Europe, became effective on March 1, 2017. Full compliance with respect to all counterparties was required by September 1, 2017. The requirements of such rules with respect to IM are currently being phased in and will be fully implemented by September 1, 2020. In October of 2017, the CFTC and the European Commission each finalized comparability determinations that permit certain swap dealers who are subject to both regulatory margin regimes to take advantage of substituted compliance by complying with one set of margin requirements. The margin requirements are expected to result in more stringent collateral requirements and to affect other aspects of Aflac's derivatives activity. +The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. The FIO does not directly regulate the insurance industry, but under Dodd-Frank it has the power to preempt state insurance regulations that are inconsistent with international agreements reached by the federal government, subject to certain requirements and restrictions. The FIO and certain federal agencies must achieve consensus positions with the state insurance regulators when taking positions on insurance proposals by certain international forums. In December 2013, the FIO released a report entitled "How To Modernize And Improve The System Of Insurance Regulation In The United States." The report was required by the Dodd-Frank Act, and included 18 recommended areas of near-term reform for the states, including addressing capital adequacy and safety/soundness issues, reform of insurer resolution practices, and reform of marketplace regulation. The report also listed nine recommended areas for direct federal involvement in insurance regulation. Some of the recommendations outlined in the FIO report released in December 2013 have been implemented. The National Association of Registered Agents and Brokers Reform Act, signed into law in January 2015, simplifies the agent and broker licensing process across state lines. The FIO has also engaged with the supervisory colleges to monitor financial stability and identify regulatory gaps for large national and internationally active +59 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +insurers. The President and Congress have stated proposals to reform or repeal certain provisions of the Dodd-Frank Act, some of which have been implemented. The Company cannot predict with any degree of certainty what impact, if any, such proposals will have on Aflac's business, financial condition, or results of operations. +Insurance Guaranty Laws +Under state insurance guaranty association laws and similar laws in international jurisdictions, Aflac is subject to assessments, based on the share of business it writes in the relevant jurisdiction, for certain obligations of insolvent insurance companies to policyholders and claimants. In the United States, some states permit member insurers to recover assessments paid through full or partial premium tax offsets. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. In most states, the definition is met with a declaration of financial insolvency by a court of competent jurisdiction. +Aflac U.S. Investments +The level of investment income is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, and other factors. +As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships. Aflac U.S. has been investing in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loan receivables. +The following table details the investment purchases for Aflac U.S. as of December 31. +(In millions) +2018 +2017 +Fixed maturity securities: +Other fixed maturity securities +$ +1,068 +$ +836 +Infrastructure debt +97 +60 +Equity securities +76 +56 +Other investments: +Transitional real estate loans +610 +249 +Commercial mortgage loans +163 +34 +Middle market loans +141 +199 +Limited partnerships +44 +16 +Total Aflac U.S. Purchases +$ +2,199 +$ +1,450 +Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, and other securities transactions. Purchases of securities from period to period are determined based on multiple objectives, including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to the Company's investment policy guidelines. +The following table presents the results of Aflac's U.S. investment yields for the years ended and as of December 31. +2018 +2017 +2016 +Total purchases for period (in millions) (1) +$ +2,155 +$ +1,434 +$ +1,144 +New money yield (1), (2) +4.55 +% +4.49 +% +3.89 +% +Return on average invested assets (3) +5.16 +5.07 +5.04 +Portfolio book yield, end of period (1) +5.55 +% +5.52 +% +5.60 +% +(1) Includes fixed maturity securities, loan receivables, equity securities, and excludes alternative investments in limited partnerships +(2) Reported on a gross yield basis; excludes investment expenses and external management fees +(3) Net of investment expenses, year-to-date number reflected on a quarterly average basis +60 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The increase in the Aflac U.S. new money yield in 2018 was primarily due to increased allocations to higher yielding floating rate assets. +See Note 3 of the Notes to the Consolidated Financial Statements and the Market Risks of Financial Instruments - Credit Risk subsection of MD&A for more information regarding the sector concentrations of the Company's investments. +CORPORATE AND OTHER +Total revenue for corporate and other increased to $339 million in 2018, compared with $272 million in 2017 and $277 million in 2016. This increase in 2018 was primarily driven by an increase in net investment income. The increase in net investment income to $113 million in 2018, compared with $35 million in 2017, was driven by a $36 million pretax contribution from the Company’s corporate yen hedging program and increased income from over $600 million of invested assets transferred as part of the drawdown of excess capital in the U.S. segment beginning in the fourth quarter of 2017. +Corporate adjusted expenses consist primarily of personnel compensation, benefits, reinsurance retrocession benefits expense, and facilities expenses. Corporate expenses were $478 million in 2018, compared with $486 million in 2017, and $516 million in 2016. The decline in adjusted expenses in 2018 was considered insignificant. The decline in adjusted expenses from 2016 to 2017 was driven in large part by fluctuations in retrocession activity, which results in corresponding declines in total premiums. +Pretax adjusted earnings for corporate and other were a loss of $139 million in 2018, compared with a loss of $214 million in 2017 and a loss of $239 million in 2016. The improvement in pretax adjusted earnings in 2018 was driven primarily by the increase in net investment income as previously described. +ANALYSIS OF FINANCIAL CONDITION +The Company's financial condition has remained strong in the functional currencies of its operations. The yen/dollar exchange rate at the end of each period is used to translate yen-denominated balance sheet items to U.S. dollars for reporting purposes. +Investments +The Company’s investment strategy utilizes disciplined asset and liability management while seeking long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives, and preserving shareholder value. In attempting to optimally balance these objectives, the Company seeks to maintain on behalf of Aflac Japan a diversified portfolio of yen-denominated investment assets, U.S. dollar-denominated investment portfolio hedged back to yen and a portfolio of unhedged U.S. dollar-denominated assets. As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships. Aflac U.S. invests in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loans. +61 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The following table details investments by segment as of December 31. +Investment Securities by Segment +Aflac Japan +Aflac U.S. +(In millions) +2018 +2017 +2018 +2017 +Available for sale, fixed maturity securities, +at fair value (1) +$ +69,409 +$ +69,338 +$ +12,132 +$ +13,606 +Held to maturity, fixed maturity securities, +at amortized cost +30,318 +31,430 +0 +0 +Equity securities (1) +806 +868 +137 +92 +Other investments: +Transitional real estate loans +3,621 +986 +756 +249 +Commercial mortgage loans +763 +767 +301 +141 +Middle market loans +1,144 +527 +334 +332 +Policy loans +219 +198 +13 +12 +Short-term investments +0 +57 +141 +0 +Other +333 +98 +63 +31 +Total other investments +6,080 +2,633 +1,608 +765 +Total investments +106,613 +104,269 +13,877 +14,463 +Cash and cash equivalents +1,779 +636 +641 +1,011 +Total investments and cash (2) +$ +108,392 +$ +104,905 +$ +14,518 +$ +15,474 +(1) Includes perpetual securities +(2) Excludes investments and cash held by the Parent Company and other business segments of $3,333 in 2018 and $3,280 in 2017 . +Cash and cash equivalents totaled $4.3 billion , or 3.4% of total investments and cash, as of December 31, 2018 , compared with $3.5 billion , or 2.8% , at December 31, 2017 . For a discussion of the factors affecting the Company's cash balance, see the Operating Activities, Investing Activities and Financing Activities subsections of this MD&A. +In 2017, Aflac U.S. became a member of the Federal Home Loan Bank of Atlanta (FHLB). As a member, Aflac U.S. can access low-cost funding and also receive dividends on FHLB membership stock. Additional FHLB stock purchases are required based on funding activity with the FHLB. Aflac U.S. will be required to post acceptable forms of collateral for any funding from the FHLB. The FHLB stock purchased by the Company is classified as a restricted investment and is included in "other investments" in the consolidated balance sheets. +For additional information concerning the Company's investments, see Notes 3, 4, and 5 of the Notes to the Consolidated Financial Statements. +The ratings of the Company's securities referenced in the table below are based on the ratings designations provided by major Nationally Recognized Statistical Rating Organizations (NRSROs) (Moody's, S&P and Fitch) or, if not rated, are determined based on the Company's internal analysis of such securities. When the ratings issued by the rating agencies differ, the Company utilizes the second lowest rating when three or more rating agency ratings are available or the lowest rating when only two rating agency ratings are available. +62 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The distributions of debt securities the Company owns, by credit rating, as of December 31 were as follows: +Composition of Securities Portfolio by Credit Rating +2018 +2017 +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +AAA +1.0 +% +.9 +% +1.0 +% +.9 +% +AA +3.9 +4.0 +3.9 +4.0 +A +67.9 +69.9 +65.8 +66.9 +BBB +23.2 +21.6 +24.0 +23.3 +BB or lower +4.0 +3.6 +5.3 +4.9 +Total +100.0 +% +100.0 +% +100.0 +% +100.0 +% +As of December 31, 2018 , the Company's direct and indirect exposure to securities in its investment portfolio that were guaranteed by third parties was immaterial both individually and in the aggregate. +The following table presents the 10 largest unrealized loss positions in the Company's portfolio as of December 31, 2018 . +(In millions) +Credit +Rating +Amortized +Cost +Fair +Value +Unrealized +Loss +Diamond Offshore Drilling Inc. +B +$ +143 +$ +75 +$ +(68 +) +AXA +BBB +293 +242 +(51 +) +Autostrade Per Litalia Spa +BBB +180 +150 +(30 +) +Baker Hughes Inc. +A +122 +94 +(28 +) +Kommunal Landspensjonskasse (KLP) +BBB +135 +113 +(22 +) +Abbvie Inc. +BBB +177 +156 +(21 +) +Transocean Inc. +CCC +72 +52 +(20 +) +Commonwealth Bank of Australia +BBB +185 +166 +(19 +) +Time Warner Cable Inc. +AA +118 +99 +(19 +) +United Technologies Corporation +BBB +209 +192 +(17 +) +Generally, declines in fair values can be a result of changes in interest rates, yen/dollar exchange rate, and changes in net spreads driven by a broad market move or a change in the issuer's underlying credit quality. As the Company believes these issues have the ability to continue making timely payments of principal and interest, the Company views these changes in fair value to be temporary and does not believe it is necessary to impair the carrying value of these securities. See the Unrealized Investment Gains and Losses section in Note 3 of the Notes to the Consolidated Financial Statements for further discussions of unrealized losses related to financial institutions and other corporate investments. +Below-Investment-Grade +The Company's portfolio of below-investment-grade securities includes debt securities purchased while the issuer was rated investment grade plus other loans and bonds purchased as part of an allocation to that segment of the market. The following is the Company's below-investment-grade exposure. +63 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Below-Investment-Grade Investments +December 31, 2018 +(In millions) +Par +Value +Amortized +Cost +Fair +Value +Unrealized +Gain +(Loss) +Investcorp Capital Limited +$ +383 +$ +383 +$ +372 +$ +(11 +) +Republic of South Africa +360 +360 +372 +12 +KLM Royal Dutch Airlines +270 +199 +224 +25 +Navient Corp. +210 +114 +119 +5 +Republic of Tunisia +189 +111 +127 +16 +Telecom Italia SpA +180 +180 +208 +28 +Barclays Bank PLC +180 +111 +147 +36 +Transnet +135 +135 +135 +0 +Diamond Offshore Drilling Inc. +124 +143 +75 +(68 +) +IKB Deutsche Industriebank AG +117 +50 +94 +44 +Arconic Inc. +100 +84 +92 +8 +Noble Holdings International Ltd. +92 +57 +57 +0 +EMC Corp. +80 +80 +68 +(12 +) +Generalitat de Catalunya +72 +26 +64 +38 +Teck Resources Ltd. +70 +76 +67 +(9 +) +Teva Pharmaceuticals +68 +66 +58 +(8 +) +Transocean Inc. +68 +72 +52 +(20 +) +Petrobras International Finance Company +65 +65 +63 +(2 +) +National Gas Co. Trinidad and Tobago +52 +50 +50 +0 +CF Industries Inc. +50 +49 +47 +(2 +) +Other Issuers (below $50 million in par value) +232 +222 +214 +(8 +) +Subtotal (1) +3,097 +2,633 +2,705 +72 +Senior secured bank loans +1,093 +1,108 +1,061 +(47 +) +High yield corporate bonds +519 +513 +487 +(26 +) +Middle market loans, net of reserves (2) +1,497 +1,478 +1,475 +(3 +) +Grand Total +$ +6,206 +$ +5,732 +$ +5,728 +$ +(4 +) +(1) Securities initially purchased as investment grade, but have subsequently been downgraded to below investment grade +(2) Middle market loans are carried at amortized cost +The Company invests in senior secured bank loans and middle market loans primarily to U.S. corporate borrowers, most of which have below-investment-grade ratings. The objectives of these programs include enhancing the yield on invested assets, achieving further diversification of credit risk, and mitigating the risk of rising interest rates and hedge costs through the acquisition of floating rate assets. +The Company maintains an allocation to higher yielding corporate bonds within the Aflac Japan and Aflac U.S. portfolios. Most of these securities were rated below-investment-grade at the time of purchase, but the Company also purchased several that were rated investment grade which, because of market pricing, offer yields commensurate with below-investment-grade risk profiles. The objective of this allocation was to enhance the Company's yield on invested assets and further diversify credit risk. All investments must have a minimum rating of low BB using the Company's above described rating methodology and are managed by the Company's internal credit portfolio management team. +In January 2019, PG&E Corporation (PG&E) and its operating subsidiary, Pacific Gas & Electric Company (PG&E Utility) filed for Chapter 11 bankruptcy in the Northern District of California. At December 31, 2018, debt of the PG&E utility was rated investment grade and the Company's net exposure was $126 million (amortized cost), all of which was issued by PG&E utility. Subsequently, the rating on this exposure migrated to below investment grade. +64 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Oil and Gas Exposure +The following tables show the breakout of our exposure to the oil and gas industry as of December 31. +2018 +Cost or +Gross +Gross +Amortized +Unrealized +Unrealized +Fair +(In millions) +Cost +Gains +Losses +Value +Securities available for sale, +carried at fair value: +Fixed maturities: +Independent exploration and production +$ +813 +$ +72 +$ +36 +$ +849 +Integrated energy +426 +19 +30 +415 +Midstream +1,059 +91 +38 +1,112 +Oil field services +725 +9 +154 +580 +Refiners +346 +4 +20 +330 +Government owned - energy related +855 +167 +6 +1,016 +Natural gas utilities +472 +49 +6 +515 +Total securities available for sale +4,696 +411 +290 +4,817 +Securities held to maturity, +carried at amortized cost: +Fixed maturities: +Integrated energy +234 +5 +0 +239 +Government owned - energy related +270 +0 +8 +262 +Natural gas utilities +360 +34 +0 +394 +Total securities held to maturity +864 +39 +8 +895 +Equity Securities: +Independent exploration and production +2 +0 +0 +2 +Integrated energy +8 +0 +0 +8 +Oil field services +1 +0 +0 +1 +Refiners +4 +0 +0 +4 +Total equity securities +15 +0 +0 +15 +Total securities +$ +5,575 +$ +450 +$ +298 +$ +5,727 +Securities by Type of Issuance +The Company has investments in both publicly and privately issued securities. The Company's ability to sell either type of security is a function of overall market liquidity which is impacted by, among other things, the amount of outstanding securities of a particular issuer or issuance, trading history of the issue or issuer, overall market conditions, and idiosyncratic events affecting the specific issue or issuer. +The following table details investment securities by type of issuance as of December 31. +65 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Investment Securities by Type of Issuance +2018 +2017 +(In millions) +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +Publicly issued securities: +Fixed maturity securities (1) +$ +83,482 +$ +93,255 +$ +81,454 +$ +93,025 +Equity securities (1) +936 +936 +831 +1,006 +Total publicly issued +84,418 +94,191 +82,285 +94,031 +Privately issued securities: (2) +Fixed maturity securities (1) +23,692 +26,362 +25,108 +29,360 +Equity securities (1) +51 +51 +15 +17 +Total privately issued +23,743 +26,413 +25,123 +29,377 +Total investment securities +$ +108,161 +$ +120,604 +$ +107,408 +$ +123,408 +(1) Includes perpetual securities +(2) Includes Rule 144A securities +The Company held $1,202 million and $1,789 million of perpetual securities at fair value ( $1,201 million and $1,462 million at amortized cost) as of December 31, 2018 and 2017, respectively. The perpetual securities the Company holds were largely issued by banks that are systemically important to the financial markets of the sovereign country of domicile of the issuer. Generally, the Company believes regulatory changes made in the banking industry following the Global Financial Crisis and the European Sovereign Crisis, including increased capital and liquidity requirements and a reduction of business risk, have improved overall bank creditworthiness. However, bank capital securities may be subject to varying bail-in/resolution regimes in their home countries, which may include conversion or write-down provisions when bank regulators determine that the institution has reached the point of non-viability. Such actions could result in lower cash flows and ratings downgrades of the affected securities, which in turn could result in a reduction of fair value of the securities and increase the Company’s regulatory capital requirements. These factors are an integral part of the Company's credit review process. +The following table details the Company's privately issued investment securities as of December 31. +Privately Issued Securities +(Amortized cost, in millions) +2018 +2017 +Privately issued securities as a percentage of total investment securities +22.0 +% +23.4 +% +Privately issued securities held by Aflac Japan +$ +20,966 +$ +22,354 +Privately issued securities held by Aflac Japan as a percentage of total +investment securities +19.4 +% +20.8 +% +Reverse-Dual Currency Securities (1) +(Amortized cost, in millions) +2018 +2017 +Privately issued reverse-dual currency securities +$ +5,120 +$ +5,669 +Publicly issued collateral structured as reverse-dual currency securities +1,657 +1,390 +Total reverse-dual currency securities +$ +6,777 +$ +7,059 +Reverse-dual currency securities as a percentage of total investment +securities +6.3 +% +6.6 +% +(1) Principal payments in yen and interest payments in dollars +Aflac Japan has a portfolio of privately issued securities to better match liability characteristics and secure higher yields than those available on Japanese government or other public corporate bonds. Aflac Japan’s investments in yen-denominated privately issued securities consist primarily of non-Japanese issuers, are rated investment grade at purchase and have longer maturities, thereby allowing the Company to improve asset/liability matching and overall investment returns. These securities are generally either privately negotiated arrangements or issued under medium-term note programs and have standard documentation commensurate with credit ratings of the issuer, except when internal credit analysis indicates that additional protective and/or event-risk covenants were required. Many of these investments +66 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +have protective covenants appropriate to the specific investment. These may include a prohibition of certain activities by the borrower, maintenance of certain financial measures, and specific conditions impacting the payment of the Company's notes. +Hedging Activities +The Company uses derivative contracts to hedge foreign currency exchange rate risk and interest rate risk. Derivative hedges are designed to reduce risk on an economic basis while minimizing the impact on financial results. The Company’s derivative hedge programs vary depending on the type of risk being hedged. +Foreign Currency Exchange Rate Risk Hedge Program +The Company has deployed the following hedging strategies to mitigate exposure to foreign currency exchange rate risk: +1. +Aflac Japan hedges U.S. dollar-denominated investments back to yen (see Aflac Japan’s U.S. Dollar-Denominated Hedge Program below). +2. +Aflac Japan maintains certain unhedged U.S. dollar-denominated securities, which serve as an economic currency hedge of a portion of the Company's investment in Aflac Japan (see Aflac Japan’s U.S. Dollar-Denominated Hedge Program below). +3. +The Parent Company designates yen-denominated liabilities (notes payable and loans) as non-derivative hedging instruments and designates certain foreign currency forwards and options as derivative hedges of the Company’s net investment in Aflac Japan ( see Parent Company’s Foreign Currency Hedge Program below) . +4. +The Parent Company enters into forward contracts to accomplish a dual objective of hedging foreign currency exchange rate risk related to dividend payments by its subsidiary, Aflac Japan, and reducing enterprise-wide hedge costs. ( see Parent Company’s Foreign Currency Hedge Program below ). +Aflac Japan’s U.S. Dollar-Denominated Hedge Program +Aflac Japan buys U.S. dollar-denominated investments, typically corporate bonds, and hedges them back to yen with foreign currency forwards and options to hedge foreign currency exchange rate risk. This economically creates yen assets that match yen liabilities during the life of the derivative and provides liquidity and capital relief. The currency risk being hedged is generally based on fair value of hedged investments. The following table summarizes the U.S. dollar-denominated investments held by Aflac Japan as of December 31. +2018 +2017 +(In millions) +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +Available-for-sale securities: +Fixed maturity securities (excluding bank loans) (1) +$ +17,101 +$ +17,003 +$ +17,972 +$ +19,314 +Fixed maturity securities - bank loans (floating rate) +1,296 +1,238 +1,936 +1,865 +Fixed maturity securities - economically converted to yen +1,679 +2,269 +1,650 +2,549 +Equity securities (1), (2) +177 +177 +147 +173 +Other investments: +Transitional real estate loans (floating rate) +3,621 +3,625 +986 +984 +Commercial mortgage loans +763 +736 +767 +753 +Middle market loans (floating rate) +1,144 +1,146 +527 +530 +Alternative investments +333 +333 +97 +97 +Total U.S. dollar-denominated investments in Aflac Japan +$ +26,114 +$ +26,527 +$ +24,082 +$ +26,265 +(1) Includes perpetual securities +(2) See Note 1 of the Notes to the Consolidated Financial Statements in Item 8. for the adoption of accounting guidance related to financial instruments effective January 1, 2018. +As of December 31, 2018 , Aflac Japan had $9.9 billion outstanding notional amounts of foreign currency forwards and $9.5 billion outstanding notional amounts of foreign currency options, of which none were in-the-money, hedging the U.S. dollar-denominated investments. The fair value of Aflac Japan's unhedged dollar-denominated portfolio was $14.4 billion (excluding certain U.S. dollar-denominated assets shown in the table above as a result of consolidation that have been economically converted to yen using derivatives). +67 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Foreign exchange derivatives used for hedging are periodically settled, which results in cash receipt or payment at maturity or early termination. The Company had net cash settlements of $272 million , $(747) million and $1.3 billion for the years ended December 31, 2018, 2017 and 2016, respectively, associated with the currency derivatives used for hedging Aflac Japan’s U.S. dollar-denominated investments. +The following table presents metrics related to Aflac Japan hedge costs as of December 31. +Aflac Japan Hedge Cost Metrics (1) +2018 +2017 +2016 +FX forward notional at end of period (in billions of dollars) (2) +9.9 +9.3 +11.8 +Weighted average original tenor (in months) (3) +30.4 +33.1 +20.6 +Weighted average remaining tenor (in months) (4) +21.4 +27.7 +18.5 +Annualized amortized hedge costs (in basis points) (5) +241 +211 +149 +Amortized hedge costs for period (in millions of dollars) +(236) +(228) +(186) +(1) See the Results of Operations section of this MD&A for the Company's definition of amortized hedge costs. +(2) Notional is reported net of any offsetting positions +(3) Tenor based on derivative's original execution date to settlement date +(4) Tenor based on period reporting date to settlement date +(5) Based on annualized amortized hedge costs divided by average FX forward notional for the period +Parent Company's Foreign Currency Hedge Program +The Company has designated certain yen-denominated liabilities and foreign currency forwards and options of the Parent Company as accounting hedges of its net investment in Aflac Japan. The Company's consolidated yen-denominated net asset position was partially hedged at $1.8 billion as of December 31, 2018 , with hedging instruments comprised completely of yen-denominated debt, compared with a hedge of $1.8 billion as of December 31, 2017 , with hedging instruments comprised of $1.4 billion of yen-denominated debt and $.4 billion of foreign currency forwards and options. +The Company makes its accounting designation of net investment hedge at the beginning of each quarter. If the total of the designated Parent Company non-derivative and derivative notional is equal to or less than the Company's net investment in Aflac Japan, the hedge is deemed to be effective, and the currency exchange effect on the yen-denominated liabilities and the change in estimated fair value of the derivatives are reported in the unrealized foreign currency component of other comprehensive income. The Company's net investment hedge was effective during the years ended December 31, 2018 , 2017 and 2016 , respectively. +In order to economically mitigate risks associated with the enterprise-wide exposure to the yen and the level and volatility of hedge costs, the Parent Company enters into foreign exchange forward contracts. By buying U.S. dollars and selling yen, the Parent Company is effectively lowering its overall economic exposure to the yen, while Aflac Japan's U.S dollar exposure remains reduced as a result of Aflac Japan's U.S. dollar-denominated hedge program that synthetically creates yen assets. Among other objectives, this strategy is intended to reduce the enterprise-wide hedge costs. In 2018, the portion of the enterprise-wide hedge costs reduction contributed by this strategy was $36 million . This activity is reported in the Corporate and other segment. As this program evolves, the Company will continue to evaluate the program’s efficacy, including third-party review. +Interest Rate Risk Hedge Program +To mitigate the risk of investment income volatility, the Company economically hedges interest rate fluctuations for certain variable-rate investments. To manage interest rate risk associated with its U.S. dollar-denominated investments held by Aflac Japan, the Company also utilizes interest rate swaptions. +For additional discussion of the risks associated with the foreign currency exposure refer to the Currency Risk section in Item 1A, specifically to the Risk Factors titled “The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate“ and “Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity." For discussion of the Company’s view on the stressed economic surplus in Aflac Japan, refer to the Investments subsection within Item 1, Business. +68 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +See Note 4 of the Notes to the Consolidated Financial Statements for additional information on the Company's hedging activities. +Deferred Policy Acquisition Costs +The following table presents deferred policy acquisition costs by segment for the years ended December 31. +(In millions) +2018 +2017 +% Change +Aflac Japan +$ +6,384 +$ +6,150 +3.8 +% +(1) +Aflac U.S. +3,491 +3,355 +4.1 +Total +$ +9,875 +$ +9,505 +3.9 +% +(1) Aflac Japan’s deferred policy acquisition costs increased 2.0% in yen during the year ended December 31, 2018 . +See Note 6 of the Notes to the Consolidated Financial Statements for additional information on the Company's deferred policy acquisition costs. +Policy Liabilities +The following table presents policy liabilities by segment for the years ended December 31. +(In millions) +2018 +2017 +% Change +Aflac Japan +$ +92,791 +$ +89,132 +4.1 +% +(1) +Aflac U.S. +10,981 +10,625 +3.4 +Other +183 +138 +32.6 +Intercompany eliminations (2) +(767 +) +(748 +) +2.5 +Total +$ +103,188 +$ +99,147 +4.1 +% +(1) Aflac Japan’s policy liabilities increased 2.3% in yen during the year ended December 31, 2018 . +(2) Elimination entry necessary due to recapture of a portion of policy liabilities ceded externally, as a result of the reinsurance retrocession transaction as described in Note 8 of the Notes to the Consolidated Financial Statements. +See Note 7 of the Notes to the Consolidated Financial Statements for additional information on the Company's policy liabilities. +Notes Payable +Notes payable totaled $5.8 billion at December 31, 2018 , compared with $5.3 billion at December 31, 2017 . +In October 2018, the Parent Company issued $550 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.750% per annum, payable semi-annually, and have a 30-year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a United States Treasury security with a maturity comparable to the remaining term of the notes, plus 25 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. In November 2018, the Parent Company used the net proceeds from the October 2018 issuance of senior notes to redeem $550 million of the Parent Company's 2.40% senior notes due in 2020. +In October 2018, the Parent Company issued three series of senior notes totaling 53.4 billion yen through a public debt offering under its U.S. shelf registration statement. The first series, which totaled 29.3 billion yen, bears interest at a fixed rate of 1.159% per annum, payable semi-annually, and has a 12-year maturity. The second series, which totaled 15.2 billion yen, bears interest at a fixed rate of 1.488% per annum, payable semiannually, and has a 15-year maturity. The third series, which totaled 8.9 billion yen, bears interest at a fixed rate of 1.750% per annum, payable semi-annually, and has a 20-year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +See Note 9 of the accompanying Notes to the Consolidated Financial Statements for additional information on the Company's notes payable. +69 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Benefit Plans +Aflac Japan and Aflac U.S. have various benefit plans. For additional information on the Company's Japanese and U.S. plans, see Note 14 of the Notes to the Consolidated Financial Statements. +Policyholder Protection +Policyholder Protection Corporation +The Japanese insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. Legislation enacted regarding the framework of the Life Insurance Policyholder Protection Corporation (LIPPC) included government fiscal measures supporting the LIPPC. On March 30, 2012, the Diet approved legislation to enhance the stability of the LIPPC by extending the government's fiscal support of the LIPPC through March 2017. On November 25, 2016, Japan's Diet passed legislation that again extends the government's fiscal support of the LIPPC through March 2022. Effective April 2014, the annual LIPPC contribution amount for the total life industry was lowered from 40 billion yen to 33 billion yen. +Guaranty Fund Assessments +Under U.S. state guaranty association laws, certain insurance companies can be assessed (up to prescribed limits) for certain obligations to the policyholders and claimants of impaired or insolvent insurance companies that write the same line or similar lines of business. The amount of the guaranty fund assessment that an insurer is assessed is based on its proportionate share of premiums in that state. +As of December 31, 2018 , the Company has estimated and recognized the impact of its share of guaranty fund assessments resulting from the liquidation of a long-term care insurer. See Note 15 of the Notes to the Consolidated Financial Statements for further information on the assessment. +Off-Balance Sheet Arrangements +As of December 31, 2018 , the Company had no material letters of credit, standby letters of credit, guarantees or standby repurchase obligations. See Note 15 of the Notes to the Consolidated Financial Statements for information on material unconditional purchase obligations that are not recorded on the Company's balance sheet. +CAPITAL RESOURCES AND LIQUIDITY +Aflac Japan and Aflac U.S. provide the primary sources of liquidity to the Parent Company through dividends and management fees. The following table presents the amounts provided for the years ended December 31. +Liquidity Provided by Aflac Japan and Aflac U.S. to Parent Company +(In millions) +2018 +2017 +2016 +Dividends declared or paid by Aflac Japan and Aflac U.S. +$ +1,817 +$ +2,590 +(1) +$ +2,000 +Management fees paid by Aflac Japan and Aflac U.S. +204 +291 +260 +(1) Includes securities of $622 at fair value which had a value of $656 at amortized cost +The decline in dividends during 2018 was driven by a change in the dividend regulatory approval process subsequent to the conversion of Aflac Japan from a branch to a subsidiary on April 1, 2018. The Company resumed dividend payments from Aflac Japan in the fourth quarter of 2018. Management fees decreased during 2018 compared to prior years due to changes in the administration of intercompany expenses between legal entities subsequent to the conversion of Aflac Japan from a branch to a subsidiary on April 1, 2018. +The primary uses of cash by the Parent Company are shareholder dividends, the repurchase of its common stock and interest on its outstanding indebtedness and operating expenses. +At the end of September 2018, the Company announced a change in its internal dividend policy which allows the +Company to increase the proportion of regulatory earnings transferred from Aflac U.S. and Aflac Japan to the Parent +Company. The Company intends to maintain higher than historical levels of capital and liquidity at the Parent Company with the goals of addressing the Company’s hedge costs and related potential need for collateral and mitigating against long-term weakening of the Japanese yen. Further, the Company plans to continue to maintain a portfolio of unhedged U.S. dollar based investments at Aflac Japan and consider whether the amount of such investments should be increased +70 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +or decreased relative to the Company’s view of economic equity surplus in Aflac Japan in light of potentially rising hedge costs and other factors. See Item 2., Management’s Discussion and Analysis of Financial Condition and Results of Operations under “Forward-Looking Information,” for a description of factors that could cause actual results to differ materially from those contemplated by the Company in regards to its capital management intentions. +The Parent Company accesses debt security markets to provide additional sources of capital. In September 2018, the Parent Company filed a shelf registration statement with the SEC that allows the Company to issue an indefinite amount of debt securities, in one or more series, from time to time until September 2021. In August 2018, the Parent Company filed a shelf registration with Japanese regulatory authorities that allows the Parent Company to conduct public offerings of bonds in Japan, including yen-denominated Samurai notes, up to 200 billion yen or its equivalent through August 2020. The shelf registration statement is for possible public offerings in Japan, but the bonds issued under the shelf may be transferred by the bondholders to U.S. persons in compliance with U.S. law. The Company believes outside sources for additional debt and equity capital, if needed, will continue to be available. For additional information, see Note 9 of the Notes to the Consolidated Financial Statements. +The principal sources of cash for the Company's insurance operations are premiums and investment income. The primary uses of cash by the Company's insurance operations are investments, policy claims, commissions, operating expenses, income taxes and payments to the Parent Company for management fees and dividends. Both the sources and uses of cash are reasonably predictable. +When making an investment decision, the Company's first consideration is based on product needs. The Company's investment objectives provide for liquidity through the purchase of investment-grade debt securities. These objectives also take into account duration matching, and because of the long-term nature of the Company's business, the Company has adequate time to react to changing cash flow needs. +As a result of policyholder aging, claims payments are expected to gradually increase over the life of a policy. Therefore, future policy benefit reserves are accumulated in the early years of a policy and are designed to help fund future claims payments. The Company expects its future cash flows from premiums and its investment portfolio to be sufficient to meet its cash needs for benefits and expenses. +As of December 31, 2018 , the Parent Company and Aflac had four lines of credit with third parties as well as two intercompany lines of credit. For additional information on the Company's lines of credit, see Note 9 of the Notes to the Consolidated Financial Statements. +As part of the FHLB financing arrangement as discussed previously in the Analysis of Financial Condition section of this MD&A, Aflac U.S. borrowed and repaid $86 million during 2018. +The Company's financial statements convey its financing arrangements during the periods presented. The Company has not engaged in material intra-period short-term financings during the periods presented that are not otherwise reported in its balance sheet or disclosed therein. The Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2018 . The Company has not entered into transactions involving the transfer of financial assets with an obligation to repurchase financial assets that have been accounted for as a sale under applicable accounting standards, including securities lending transactions. See Notes 1, 3, and 4 of the Notes to the Consolidated Financial Statements for more information on the Company's securities lending and derivative activities. With the exception of disclosed activities in those referenced footnotes and the Risk Factors entitled, "The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate" and "Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity," the Company does not have a known trend, demand, commitment, event or uncertainty that would reasonably result in its liquidity increasing or decreasing by a material amount. As of December 31, 2018 , the Parent Company had $1.0 billion as a capital reserve and an additional $1.0 billion of contingent liquidity in order to mitigate liquidity risk of derivative positions that are reducing enterprise-wide foreign currency exposure. The Company's cash and cash equivalents include unrestricted cash on hand, money market instruments, and other debt instruments with a maturity of 90 days or less when purchased, all of which has minimal market, settlement or other risk exposure. +The following table presents the estimated payments by period of the Company's major contractual obligations as of December 31, 2018 . The Company translated its yen-denominated obligations using the December 31, 2018 , exchange rate. Actual future payments as reported in dollars will fluctuate with changes in the yen/dollar exchange rate. +71 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Distribution of Payments by Period +(In millions) +Total +Liability (1) +Total +Payments +Less +Than +One Year +One to +Three Years +Four to +Five Years +After +Five Years +Future policy benefits liability (Note 7) (2) +$ +86,368 +$ +251,577 +$ +8,980 +$ +17,817 +$ +17,807 +$ +206,973 +Unpaid policy claims liability (Note 7) (3) +4,584 +4,584 +2,950 +951 +387 +296 +Other policyholders' funds (Note 7) (3) +7,146 +9,920 +321 +360 +581 +8,658 +Long-term debt – principal (Note 9) +5,765 +5,813 +0 +45 +1,275 +4,493 +Long-term debt – interest (Note 9) +37 +2,086 +175 +327 +284 +1,300 +Cash collateral on loaned securities (Note 3) +1,052 +1,052 +1,052 +0 +0 +0 +Operating service agreements (Note 15) +N/A +(4) +553 +165 +289 +99 +0 +Operating lease obligations (Note 15) +N/A +(4) +202 +63 +82 +39 +18 +Capitalized lease obligations (Note 9) +13 +13 +5 +5 +2 +1 +Total contractual obligations +$ +104,965 +$ +275,800 +$ +13,711 +$ +19,876 +$ +20,474 +$ +221,739 +Liabilities for unrecognized tax benefits in the amount of $15 have been excluded from the tabular disclosure above because the timing of cash payment is not reasonably estimable. +(1) Liability amounts are those reported on the consolidated balance sheet as of December 31, 2018 . +(2) The estimated payments due by period reflect future estimated cash payments to be made to policyholders and others for future policy benefits. These projected cash outflows are based on assumptions for future policy persistency, mortality, morbidity, and other assumptions comparable with the Company's experience, consider future premium receipts on current policies in force, and assume market growth and interest crediting consistent with assumptions used in amortizing deferred acquisition costs. These cash outflows are undiscounted with respect to interest and, as a result, the sum of the cash outflows shown for all years in the table of $251,577 exceeds the corresponding liability amount of $86,368 . The Company has made significant assumptions to determine the future estimated cash outflows related to the underlying policies and contracts. Due to the significance of the assumptions used, actual cash outflow amounts and timing will differ, possibly materially, from these estimates. +(3) Includes assumptions as to the timing of policyholders reporting claims for prior periods and the amount of those claims. Actual amounts and timing of unpaid policy claims payments may differ significantly from the estimates above. +(4) Not applicable +For more information on the Company's major contractual obligations, see the applicable Note in the Notes to the Consolidated Financial Statements as indicated in the line items in the table above. +Consolidated Cash Flows +The Company translates cash flows for Aflac Japan's yen-denominated items into U.S. dollars using weighted-average exchange rates. In years when the yen weakens, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be reported. +The following table summarizes consolidated cash flows by activity for the years ended December 31. +(In millions) +2018 +2017 +2016 +Operating activities +$ +6,014 +$ +6,128 +$ +5,987 +Investing activities +(3,582 +) +(5,431 +) +(3,855 +) +Financing activities +(1,616 +) +(2,065 +) +(1,619 +) +Exchange effect on cash and cash equivalents +30 +0 +(4 +) +Net change in cash and cash equivalents +$ +846 +$ +(1,368 +) +$ +509 +Operating Activities +Consolidated cash flow from operations decreased 1.9% in 2018 , compared with 2017 . The following table summarizes operating cash flows by source for the years ended December 31. +(In millions) +2018 +2017 +2016 +Aflac Japan +$ +4,916 +$ +4,959 +$ +4,605 +Aflac U.S. and other operations +1,098 +1,169 +1,382 +Total +$ +6,014 +$ +6,128 +$ +5,987 +72 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Investing Activities +Operating cash flow is primarily used to purchase investments to meet future policy obligations. The following table summarizes investing cash flows by source for the years ended December 31. +(In millions) +2018 +2017 +2016 +Aflac Japan +$ +(2,938 +) +$ +(4,504 +) +$ +(3,075 +) +Aflac U.S. and other operations +(644 +) +(927 +) +(780 +) +Total +$ +(3,582 +) +$ +(5,431 +) +$ +(3,855 +) +Prudent portfolio management dictates that the Company attempts to match the duration of its assets with the duration of its liabilities. Currently, when the Company's fixed maturity securities mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of the Company's business and its strong cash flows provide the Company with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. From time to time or when market opportunities arise, the Company disposes of selected fixed maturity securities that are available for sale to improve the duration matching of assets and liabilities, improve future investment yields, and/or re-balance its portfolio. As a result, dispositions before maturity can vary significantly from year to year. +As part of its overall corporate strategy, the Company announced in September 2018 that it intends to increase its original investment in the Aflac Ventures Fund from $100 million over three years to $250 million over three to four years, as opportunities emerge. These investments are included in equity securities or the other investments line in the consolidated balance sheets. The Aflac Ventures Fund is a subsidiary of Aflac Corporate Ventures which is reported in the "Corporate and other" business segment. The central mission of Aflac Corporate Ventures is to support the organic growth and business development needs of Aflac Japan and Aflac U.S. with emphasis on digital applications designed to improve the customer experience, gain efficiencies, and develop new markets in an effort to enhance and defend long-term shareholder value. +See Note 3 of the Notes to the Consolidated Financial Statements for details on certain investment commitments. +Financing Activities +Consolidated cash used by financing activities was $1.6 billion in 2018 , $2.1 billion in 2017 and $1.6 billion in 2016 . +In October 2018, the Parent Company issued $550 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.750% per annum, payable semi-annually, and have a 30 -year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a United States Treasury security with a maturity comparable to the remaining term of the notes, plus 25 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. +In October 2018, the Parent Company issued three series of senior notes totaling 53.4 billion yen through a public debt offering under its U.S. shelf registration statement. The first series, which totaled 29.3 billion yen, bears interest at a fixed rate of 1.159% per annum, payable semi-annually, and has a 12 -year maturity. The second series, which totaled 15.2 billion yen, bears interest at a fixed rate of 1.488% per annum, payable semi-annually, and has a 15 -year maturity. The third series, which totaled 8.9 billion yen, bears interest at a fixed rate of 1.750% per annum, payable semi-annually, and has a 20 -year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In November 2018, the Parent Company used the net proceeds from the October 2018 issuance of its senior notes to redeem $550 million of the Parent Company's 2.40% senior notes due in 2020. +In January 2017, the Parent Company issued 60.0 billion yen of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of .932% per annum, payable semi-annually, and have a 10-year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +73 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +In February 2017, the Parent Company extinguished $650 million of 2.65% senior notes upon their maturity. +In October 2017, the Parent Company issued 60.0 billion yen of subordinated debentures through a U.S. public debt offering. The debentures bear interest at an initial rate of 2.108% per annum through October 22, 2027, or earlier redemption. Thereafter, the rate of the interest of the debentures will be reset every five years at a rate of interest equal to the then-current JPY 5-year Swap Offered Rate plus 205 basis points. The debentures are payable semi-annually in arrears and have a 30 -year maturity. The debentures are redeemable (i) at any time, in whole but not in part, upon the occurrence of certain tax events or certain rating agency events, as specified in the indenture governing the terms of the debentures or (ii) in 10 years, in whole or in part, at a redemption price equal to their principal amount plus accrued and unpaid interest to, but excluding, the date of redemption. In November 2017, the Parent Company used a portion of net proceeds from the debenture offering to redeem $500 million of the Parent Company's 5.50% subordinated debentures due 2052. The pretax non-operating expense due to the early redemption of these notes was $13 million . +In September 2016, the Parent Company issued two series of senior notes totaling $700 million through a U.S. public debt offering. The first series, which totaled $300 million, bears interest at a fixed rate of 2.875% per annum, payable semi-annually, and has a 10-year maturity. The second series, which totaled $400 million, bears interest at a fixed rate of 4.00% per annum, payable semi-annually, and has a 30-year maturity. +In September 2016, the Parent Company entered into two series of senior unsecured term loan facilities totaling 30.0 billion yen. The first series, which totaled 5.0 billion yen, bears an interest rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin. The applicable margin ranges between .20% and .60%, depending on the Parent Company's debt ratings as of the date of determination. The second series, which totaled 25.0 billion yen, bears an interest rate per annum equal to TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin. The applicable margin ranges between .35% and .75%, depending on the Parent Company's debt ratings as of the date of determination. +In December 2016, the Parent Company completed a tender offer in which it extinguished $176 million principal of its 6.90% senior notes due 2039 and $193 million principal of its 6.45% senior notes due 2040. The pretax non-operating loss due to the early redemption of these notes was $137 million ( $89 million after-tax, or $.21 per diluted share). +In September 2016, the Parent Company extinguished 8.0 billion yen of 2.26% fixed rate Uridashi notes upon their maturity and in July 2016, the Parent Company extinguished 15.8 billion yen of 1.84% fixed rate Samurai notes upon their maturity. +See Note 9 of the Notes to the Consolidated Financial Statements for further information on the debt issuances discussed above. +See the preceding discussion in this Capital Resources and Liquidity section of MD&A for details and any outstanding balances as of December 31, 2018 for the Company's lines of credit and FHLB financing arrangement. +The Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2018 . +Cash returned to shareholders through dividends and treasury stock purchases was $2.1 billion in 2018 , compared with $2.0 billion in 2017 and $2.1 billion in 2016 . +The following tables present a summary of treasury stock activity during the years ended December 31. +Treasury Stock Purchased +(In millions of dollars and thousands of shares) +2018 +2017 +2016 +Treasury stock purchases +$ +1,301 +$ +1,351 +$ +1,422 +Number of shares purchased: +Open market +28,949 +35,510 +43,236 +Other +392 +1,018 +660 +Total shares purchased +29,341 +36,528 +43,896 +74 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Treasury Stock Issued +(In millions of dollars and thousands of shares) +2018 +2017 +2016 +Stock issued from treasury: +Cash financing +$ +58 +$ +33 +$ +46 +Noncash financing +17 +59 +61 +Total stock issued from treasury +$ +75 +$ +92 +$ +107 +Number of shares issued +1,939 +2,554 +3,704 +Under share repurchase authorizations from the Company's board of directors, the Company purchased 28.9 million shares of its common stock in the open market in 2018 , compared with 35.5 million shares in 2017 and 43.2 million shares in 2016 . As of December 31, 2018 , a remaining balance of 69.0 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its board of directors. The Company currently plans to repurchase $1.3 billion to $1.7 billion of its common stock in 2019 , assuming stable capital conditions and absent compelling alternatives. See Note 11 of the Notes to the Consolidated Financial Statements for additional information. +Cash dividends paid to shareholders in 2018 of $1.04 per share increased 19.5% over 2017 . The 2017 dividend paid of $.87 per share increased 4.8% over 2016 . The following table presents the dividend activity for the years ended December 31. +(In millions) +2018 +2017 +2016 +Dividends paid in cash +$ +793 +$ +661 +$ +658 +Dividends through issuance of treasury shares +8 +29 +27 +Total dividends to shareholders +$ +801 +$ +690 +$ +685 +In January 2019 , the board of directors announced a 3.8% increase in the quarterly cash dividend, effective with the first quarter of 2019. The first quarter 2019 cash dividend of $.27 per share is payable on March 1, 2019 , to shareholders of record at the close of business on February 20, 2019 . +Regulatory Restrictions +Aflac and CAIC are domiciled in Nebraska and are subject to its regulations. Subsequent to the Japan branch conversion to a subsidiary, Aflac Japan is domiciled in Japan and subject to local regulations. See further discussion +below. The Nebraska Department of Insurance imposes certain limitations and restrictions on payments of dividends, management fees, loans and advances to the Parent Company. Under Nebraska insurance law, prior approval of the Nebraska Department of Insurance is required for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. In addition, the Nebraska insurance department must approve service arrangements and other transactions within the affiliated group of companies. These regulatory limitations are not expected to affect the level of management fees or dividends paid to the Parent Company. (See below for discussion of restrictions imposed by Japanese insurance regulators.) A life insurance company’s statutory capital and surplus is determined according to rules prescribed by the NAIC, as modified by the insurance department in the insurance company’s state of domicile. Statutory accounting rules are different from U.S. GAAP and are intended to emphasize policyholder protection and company solvency. Similar laws apply in New York, the domiciliary jurisdiction of Aflac's New York insurance subsidiary. As of December 2016, CAIC was redomiciled from South Carolina to Nebraska. +The continued long-term growth of the Company's business may require increases in the statutory capital and surplus of its insurance operations. Aflac’s insurance operations may secure additional statutory capital through various sources, such as internally generated statutory earnings, capital contributions by the Parent Company from funds generated through debt or equity offerings, or reinsurance transactions. The NAIC’s RBC formula is used by insurance regulators to help identify inadequately capitalized insurance companies. The RBC formula quantifies insurance risk, business risk, asset risk and interest rate risk by weighing the types and mixtures of risks inherent in the insurer’s operations. +As of December 31, 2018, Aflac's company action level RBC ratio was 560% . The 2018 RBC as filed is lower than Aflac U.S. standalone RBC due to the inclusion of Aflac Japan for the first quarter of 2018. The RBC charge reflects the business risk without any total adjusted capital (TAC). At December 31, 2017, Aflac's company action level RBC ratio was 831%, which included Aflac Japan. Aflac's RBC ratio remains high and reflects a strong capital and surplus position, even reflecting the full negative impact of the U.S. Tax Act, which was fully adopted in 2018. This reduction occurs as a result of +75 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +writing down deferred tax assets and the increase in required capital due to the reduction in tax rates. However, Aflac expects to recover from this negative impact over a period of three to five years through additional statutory income, assuming that the additional income is fully retained. As of December 31, 2018 , Aflac's total adjusted capital of $2.7 billion exceeded the company action level required capital and surplus of $.5 billion by $2.2 billion . +The maximum amount of dividends that can be paid to the Parent Company by Aflac without prior approval of Nebraska's director of insurance is the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2019 in excess of $1.3 billion would be considered extraordinary and require such approval. Following the Japan branch conversion to a subsidiary, the Company used extraordinary dividends as needed to actively manage to appropriate RBC levels that are lower yet sufficient to maintain ratings and support prudent capital management. See Note 13 of the Notes to the Consolidated Financial Statements for information regarding the impact of permitted practices by the Nebraska Department of Insurance on the Company's statutory capital and surplus. +The NAIC considers its Solvency Modernization Initiative (SMI) process relating to updating the U.S. insurance solvency regulation framework to be ongoing. The SMI has focused on key issues such as capital requirements, governance and risk management, group supervision, reinsurance, statutory accounting and financial reporting matters. Many of these key issues have been finalized and/or are near completion; however, the NAIC still has some ongoing initiatives related to SMI, such as monitoring the international efforts on group capital requirements as well as RBC. In addition, the NAIC is also considering changes to investment risk factors. Any negative developments by the NAIC in these areas could result in increased capital requirements for the Company. +Aflac is subject to the NAIC’s Own Risk and Solvency Assessment (ORSA), effective January 1, 2015. Through the ORSA requirements, Aflac is expected to regularly, no less than annually, conduct an ORSA to assess the adequacy of its risk management framework, and its current and estimated projected future solvency position; internally document the process and results of the assessment; and provide a confidential high-level ORSA Summary Report annually to the lead state commissioner if the insurer is a member of an insurance group. In November 2018, Aflac filed its ORSA report with the Nebraska Department of Insurance. +In addition to limitations and restrictions imposed by U.S. insurance regulators, after the Japan branch conversion on April 1, 2018, the new Japan subsidiary is required to meet certain financial criteria as governed by Japanese corporate law in order to provide dividends to the Parent Company. Under these criteria, dividend capacity at the Japan subsidiary is basically defined as retained earnings excluding capital reserves, which represent equity generated by capital profits that are statutorily required in Japan, less net after-tax unrealized losses on available-for-sale securities based on the previous fiscal year-end. These dividend capacity requirements are generally aligned with the solvency margin ratio (SMR). Japan's Financial Services Agency (FSA) maintains its own solvency standard which is quantified through the SMR. Aflac Japan's SMR is sensitive to interest rate, credit spread, and foreign exchange rate changes, therefore the Company continues to evaluate alternatives for reducing this sensitivity. In the event of a rapid change in market risk conditions causing SMR to decline, the Company has two senior unsecured revolving credit facilities in the amounts of 100 billion yen and 55 billion yen, respectively, and a committed reinsurance facility in the amount of approximately 110 billion yen as a capital contingency plan. Additionally, the Company could take action to enter into derivatives on unhedged U.S. dollar-denominated investments with foreign currency options or forwards. (See Notes 8 and 9 of the Notes to the Consolidated Financial Statements for additional information.) +The Company has already undertaken various measures to mitigate the sensitivity of Aflac Japan's SMR. For example, the Company employs policy reserve matching (PRM) investment strategies, which is a Japan-specific accounting treatment that reduces SMR interest rate sensitivity since PRM-designated investments are carried at amortized cost consistent with corresponding liabilities. In order for a PRM-designated asset to be held at amortized cost, there are certain criteria that must be maintained. The primary criteria relates to maintaining the duration of designated assets and liabilities within a specified tolerance range. If the duration difference is not maintained within the specified range without rebalancing, then a certain portion of the assets must be re-classified as available for sale and held at fair value with any associated unrealized gain or loss recorded in surplus. To rebalance, assets may need to be sold in order to maintain the duration with the specified range, resulting in realizing a gain or loss from the sale. For U.S. GAAP, PRM investments are categorized as available for sale. The Company also uses foreign currency derivatives to hedge a portion of its U.S. dollar-denominated investments. (See Notes 3, 4 and 8 of the Notes to the Consolidated Financial Statements for additional information on the Company's investment strategies, hedging activities, and reinsurance, respectively.) +Aflac's SMR ratio remains high and reflects a strong capital and surplus position. As of December 31, 2018 , Aflac Japan's SMR was 965% , compared with 1,064% at December 31, 2017 . As part of the conversion of Aflac Japan from a +76 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +branch to a subsidiary on April 1, 2018, the Company experienced an accounting-driven decline in the SMR of approximately 130 points, compared with the SMR as of December 31, 2017. The Company expects to be able to pay dividends out of certain accounts, thus restoring this accounting impact over an estimated three-year period. +The FSA has been conducting field testing with the insurance industry concerning the introduction of an economic value-based solvency regime. The field testing will assist the FSA in determining if an economic value-based solvency regime in Japan will be appropriate for the insurance industry. +Payments are made from Aflac Japan to the Parent Company for management fees, allocated expenses and remittances of earnings. Prior to the Aflac Japan branch conversion on April 1, 2018, Aflac Japan paid allocated expenses and profit remittances to Aflac U.S. The following table details Aflac Japan remittances for the years ended December 31. +Aflac Japan Remittances +(In millions of dollars and billions of yen) +2018 +2017 +2016 +Aflac Japan management fees paid to Parent Company +$ +136 +$ +93 +$ +79 +Expenses allocated to Aflac Japan (in dollars) +24 +109 +106 +Aflac Japan profit remittances to the Parent Company or Aflac U.S. (in dollars) +808 +1,150 +1,286 +Aflac Japan profit remittances to the Parent Company or Aflac U.S. (in yen) +89.7 +129.3 +138.5 +The decline in dividends during 2018 was driven by a change in the dividend regulatory approval process subsequent to the conversion of Aflac Japan from a branch to a subsidiary on April 1, 2018. The Company resumed dividend payments from Aflac Japan in the fourth quarter of 2018. Management fees decreased during 2018 compared to prior years due to changes in the administration of intercompany expenses between legal entities subsequent to the conversion of Aflac Japan from a branch to a subsidiary on April 1, 2018. See the preceding Hedging Activities subsection of this MD&A for discussion of Parent Company hedging of yen profit remittances. For additional information on regulatory restrictions on dividends, profit remittances and other transfers, see Note 13 of the Notes to the Consolidated Financial Statements. +Other +For information regarding commitments and contingent liabilities, see Note 15 of the Notes to the Consolidated Financial Statements. +Additional Information +Investors should note that the Company announces material financial information in its SEC filings, press releases and public conference calls. In accordance with SEC guidance, the Company may also use the Investor Relations section of the Company's website (http://investors.aflac.com) to communicate with investors about the Company. It is possible that the financial and other information the Company posts there could be deemed to be material information. The information on the Company's website is not part of this document. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company is exposed primarily to the following types of market risks: currency risk, interest rate risk, credit risk and equity risk. Fluctuations in these factors could impact the Company’s consolidated results of operations or financial condition. The Company regularly monitors its market risks and uses a variety of strategies to manage its exposure +to these market risks. +Currency Risk +Aflac Japan +The functional currency of Aflac Japan's insurance operations is the Japanese yen. Aflac Japan’s premiums and a significant portion of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into U.S. dollars for financial reporting purposes. Most of Aflac Japan's cash and liabilities are yen-denominated. +77 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +As discussed above in the Investment subsection of Item 1, Business, the Company engages in hedging activities to mitigate certain currency risks from holding U.S. dollar-denominated investments in Aflac Japan. However, this hedging program in turn poses a countervailing long-term risk of loss on hedging currency derivatives under the long-term scenario of weakening yen, and related derivative rollover risk that could amplify hedge cost in unfavorable market conditions and significantly increase liquidity requirements to support negative derivative settlements. Additionally, as discussed in detail in the Risk Factors section titled “Lack of availability of acceptable yen-denominated investments could adversely affect the Company’s results of operations, financial position or liquidity,” there is a risk that losses realized on derivative settlements during periods of weakening yen may not be recouped through realization of the corresponding holding currency gains on the hedged U.S. dollar-denominated investments if these investments are not ultimately converted to yen. The following table details Aflac Japan's portfolio allocation by currency as of December 31. +Japan Segment Portfolio Allocation by Currency +(In millions) +2018 +2017 +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +USD program +$ +24,435 +$ +24,258 +$ +22,432 +$ +23,716 +Fixed maturity securities - economically converted to yen +1,679 +2,269 +1,650 +2,549 +Total dollar-denominated investments +26,114 +26,527 +24,082 +26,265 +Total yen-denominated investments +74,974 +86,251 +72,369 +84,379 +Total +$ +101,088 +$ +112,778 +$ +96,451 +$ +110,644 +As of December 31, 2018 , Aflac Japan had $9.9 billion outstanding notional amounts of foreign currency forwards and $9.5 billion outstanding notional amounts of foreign currency options, of which none were in-the-money, hedging the U.S. dollar-denominated investments (USD Program). The fair value of Aflac Japan's unhedged U.S. dollar-denominated portfolio was $14.4 billion (excluding certain U.S. dollar-denominated assets shown in the table above as a result of consolidation that have been economically converted to yen using derivatives). +As noted above, in late 2017, the Company took steps to refine the strategy to mitigate currency exposure of Aflac Japan from U.S. dollar-denominated investments while balancing the consideration of the stressed economic surplus in Aflac Japan. This refinement in strategy resulted in an increased amount of the unhedged U.S. dollar-denominated investments held in Aflac Japan while at the same time mitigating hedge cost increases. Generally , Aflac Japan’s exposure to the currency risk increases when its portfolio of unhedged U.S. dollar-denominated investments increases. This increases the volatility of the SMR and FSA earnings and may result in an adverse impact on these regulatory measures when yen appreciates relatively to U.S. dollar. This in turn may reduce Aflac Japan’s dividend capacity, as well as increase the level of capital needed to support increased SMR volatility. The adverse impact on the regulatory measures could be amplified by regulatory accounting rules requiring impairment loss recognition on prolonged significant declines in U.S. dollar relative to yen. Furthermore, under the scenario where unhedged U.S. dollar-denominated investments are needed to pay Aflac Japan’s yen-denominated obligations, they would have to be converted to yen, which could force realization of the then potential currency losses. As the value of the U.S. dollar-denominated investment portfolio in Aflac Japan fluctuates and the Company’s business model evolves, the Company periodically reevaluates this size of the unhedged portfolio and may accordingly adjust up or down its currency hedging targets. +Aflac Inc. +The Company is exposed to currency risk as an economic event when yen funds are actually converted into U.S. dollars. This occurs when yen-denominated funds are paid as dividends and management fees from Aflac Japan to the Parent Company and with quarterly settlements of its reinsurance retrocession transactions. The exchange rates prevailing at the time of yen payments will differ from the exchange rates prevailing at the time the yen profits were earned. A portion of the yen dividend and management fee payments may be used to service Aflac Incorporated's yen-denominated notes payable with the remainder converted into U.S. dollars. +In addition to yen payments and the reinsurance retrocessions, certain investment activities for Aflac Japan expose the Company to economic currency risk when yen are converted into U.S. dollars. As noted above, the Company invests a portion of its yen cash flows in U.S. dollar-denominated assets. This requires that the Company convert the yen cash flows to U.S. dollars before investing. As previously discussed, for certain of its U.S. dollar-denominated securities, the Company enters into foreign currency forward and option contracts to hedge the currency risk on the fair value of hedged +78 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +investments. In 2018, the Parent Company entered into forward contracts to accomplish a dual objective of hedging foreign currency rate risk to dividend payments by Aflac Japan, and reducing enterprise-wide hedge costs. If the markets experience a significant strengthening of yen, this could cause cash strain at the Parent Company as a result of cash collateral and potentially cash settlement requirements. Based on the timing and severity of exchange rate fluctuations combined with the level of outstanding activity in this program, the cash strain at the Parent Company could be significant. +Aside from the activities discussed above, the Company generally does not convert yen into U.S. dollars; however, it does translate financial statement amounts from yen into U.S. dollars for financial reporting purposes. Therefore, reported amounts are affected by foreign currency fluctuations. The Company reports unrealized foreign currency translation gains and losses in accumulated other comprehensive income. In periods when the yen weakens against the dollar, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into U.S. dollars causes more U.S. dollars to be reported. The weakening of the yen relative to the U.S. dollar will generally adversely affect the value of the Company's yen-denominated investments in U.S. dollar terms. The Company also considers the stressed economic surplus in Aflac Japan and related exposure to foreign currency. The Company manages this currency risk by investing a portion of Aflac Japan's investment portfolio in U.S. dollar-denominated securities and by the Parent Company's issuance of yen-denominated debt (for additional information, see the discussion under the Investments subsection within Item 1, Business). As a result, the effect of currency fluctuations on the Company's net assets is reduced. +The following table demonstrates the effect of foreign currency fluctuations by presenting the dollar values of the Company's yen-denominated assets and liabilities, and its consolidated yen-denominated net asset exposure at selected exchange rates as of December 31. +79 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Dollar Value of Yen-Denominated Assets and Liabilities +at Selected Exchange Rates +(In millions) +2018 +2017 +Yen/dollar exchange rates +96.00 +111.00 (1) +126.00 +98.00 +113.00 (1) +128.00 +Yen-denominated financial instruments: +Assets: +Securities available for sale: +Fixed maturity securities (2) +$ +55,600 +$ +48,086 +$ +42,362 +$ +51,504 +$ +44,666 +$ +39,433 +Fixed maturity securities - consolidated +variable interest entities (3) +941 +814 +717 +1,089 +944 +834 +Securities held to maturity: +Fixed maturity securities +35,055 +30,318 +26,709 +36,240 +31,430 +27,747 +Equity securities +742 +641 +565 +126 +109 +96 +Equity securities - consolidated variable +interest entities +0 +0 +0 +675 +586 +517 +Cash and cash equivalents +988 +855 +753 +222 +193 +170 +Derivatives +2,712 +417 +949 +1,961 +331 +528 +Other financial instruments +253 +219 +192 +228 +198 +175 +Subtotal +96,291 +81,350 +72,247 +92,045 +78,457 +69,500 +Liabilities: +Notes payable +2,120 +1,831 +1,615 +1,535 +1,331 +1,175 +Derivatives +1,318 +387 +2,138 +516 +474 +2,177 +Subtotal +3,438 +2,218 +3,753 +2,051 +1,805 +3,352 +Net yen-denominated financial instruments +92,853 +79,132 +68,494 +89,994 +76,652 +66,148 +Other yen-denominated assets +10,795 +9,336 +8,225 +9,406 +8,157 +7,201 +Other yen-denominated liabilities +113,994 +98,590 +86,853 +107,761 +93,456 +82,504 +Consolidated yen-denominated net assets +(liabilities) subject to foreign currency +fluctuation (2) +$ +(10,346 +) +$ +(10,122 +) +$ +(10,134 +) +$ +(8,361 +) +$ +(8,647 +) +$ +(9,155 +) +(1) Actual period-end exchange rate +(2) Does not include the U.S. dollar-denominated corporate bonds for which the Company has entered into foreign currency derivatives as discussed in the Aflac Japan Investment subsection of MD&A +(3) Does not include U.S. dollar-denominated bonds that have corresponding cross-currency swaps in consolidated VIEs +The Company is required to consolidate certain VIEs. Some of the consolidated VIEs in Aflac Japan's portfolio use foreign currency swaps to convert foreign denominated cash flows to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations. Foreign currency swaps exchange an initial principal amount in two currencies, agreeing to re-exchange the currencies at a future date, at an agreed upon exchange rate. There may also be periodic exchanges of payments at specified intervals based on the agreed upon rates and notional amounts. Prior to consolidation, the Company's beneficial interest in these VIEs was a yen-denominated available-for-sale fixed maturity security. Upon consolidation, the original yen-denominated investment was derecognized and the underlying fixed maturity securities and cross-currency swaps were recognized. The combination of a U.S. dollar-denominated investment and cross-currency swap economically creates a yen-denominated investment and has no impact on the Company's net investment hedge position. +Similarly, the combination of the U.S. corporate bonds and the foreign currency forwards and options that the Company has entered into, as discussed in the Aflac Japan Investment subsection of MD&A, economically creates a yen-denominated investment that qualifies for inclusion as a component of the Company's investment in Aflac Japan for net investment hedge purposes. +For additional information regarding the Company's Aflac Japan net investment hedge, see the Hedging Activities subsection of MD&A. +80 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Interest Rate Risk +The Company's primary interest rate exposure is to the impact of changes in interest rates on the fair value of its investments in debt securities. The Company monitors its investment portfolio on a quarterly basis utilizing a full valuation methodology, measuring price volatility, and sensitivity of the fair values of its investments to interest rate changes on the debt securities the Company owns. For example, if the current duration of a debt security is 10 years, then the fair value of that security will increase by approximately 10% if market interest rates decrease by 100 basis points, assuming all other factors remain constant. Likewise, the fair value of the debt security will decrease by approximately 10% if market interest rates increase by 100 basis points, assuming all other factors remain constant. +The estimated effect of potential increases in interest rates on the fair values of debt securities the Company owns; derivatives, excluding credit default swaps, and notes payable as of December 31 follows: +Sensitivity of Fair Values of Financial Instruments +to Interest Rate Changes +2018 +2017 +(In millions) +Fair +Value ++100 +Basis +Points +Fair +Value ++100 +Basis +Points +Assets: +Debt securities: +Fixed maturity securities: +Yen-denominated +$ +85,622 +$ +73,673 +$ +83,682 +$ +72,146 +Dollar-denominated +33,995 +31,327 +38,703 +35,518 +Total debt securities +$ +119,617 +$ +105,000 +$ +122,385 +$ +107,664 +Loans and loan receivables (1) +$ +6,893 +$ +6,834 +$ +2,987 +$ +2,932 +Derivatives +$ +417 +$ +614 +$ +330 +$ +533 +Liabilities: +Notes payable (2) +$ +5,876 +$ +5,415 +$ +5,553 +$ +4,900 +Derivatives +387 +422 +474 +293 +(1) Includes TREs, CMLs and MMLs, excludes policy loans +(2) Excludes capitalized lease obligations +There are various factors that affect the fair value of the Company's investment in debt securities. Included in those factors are changes in the prevailing interest rate environment, which directly affect the balance of unrealized gains or losses for a given period in relation to a prior period. Decreases in market yields generally improve the fair value of debt securities, while increases in market yields generally have a negative impact on the fair value of the Company's debt securities. However, the Company does not expect to realize a majority of any unrealized gains or losses. For additional information on unrealized losses on debt securities, see Note 3 of the Notes to the Consolidated Financial Statements. +The Company attempts to match the duration of its assets with the duration of its liabilities. The following table presents the approximate duration of Aflac Japan's yen-denominated assets and liabilities, along with premiums, as of December 31. +(In years) +2018 +2017 +Yen-denominated debt securities +16 +15 +Policy benefits and related expenses to be paid in future years +15 +14 +Premiums to be received in future years on policies in force +10 +10 +81 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +The following table presents the approximate duration of Aflac U.S. dollar-denominated assets and liabilities, along with premiums, as of December 31. +(In years) +2018 +2017 +Dollar-denominated debt securities +9 +10 +Policy benefits and related expenses to be paid in future years +8 +8 +Premiums to be received in future years on policies in force +6 +6 +The following table shows a comparison of average required interest rates for future policy benefits and investment yields, based on amortized cost, for the years ended December 31. +Comparison of Interest Rates for Future Policy Benefits +and Investment Yields +(Net of Investment Expenses) +2018 +2017 +2016 +U.S. +Japan +U.S. +Japan +U.S. +Japan +Policies issued during year: +Required interest on policy reserves +3.69 +% +1.00 +% +(1) +3.69 +% +1.10 +% +(1) +3.67 +% +1.38 +% +(1) +New money yield on investments +4.44 +2.94 +4.41 +1.88 +3.81 +1.30 +Policies in force at year-end: +Required interest on policy reserves +5.34 +3.29 +(1) +5.43 +3.38 +(1) +5.51 +3.49 +(1) +Portfolio book yield, end of period +5.44 +2.49 +5.44 +2.46 +5.52 +2.52 +(1) Represents investments for Aflac Japan that support policy obligations and therefore excludes Aflac Japan’s annuity products +The Company continues to monitor the spread between its new money yield and the required interest assumption for newly issued products in both the United States and Japan and will re-evaluate those assumptions as necessary. Currently, when investments the Company owns mature, the proceeds may be reinvested at a yield below that of the interest required for the accretion of policy benefit liabilities on policies issued in earlier years. Overall, adequate profit margins exist in Aflac Japan's aggregate block of business because of changes in the mix of business and favorable experience from mortality, morbidity and expenses. +Periodically, the Company may enter into derivative transactions to hedge interest rate risk, depending on general economic conditions. +For further information on interest rate derivatives, see Note 4 of the accompanying Notes to the Consolidated Financial Statements. +Credit Risk +A significant portion of the Company's investment portfolio consists of debt securities and loans that expose it to the credit risk of the underlying issuer or borrower. The Company carefully evaluates this risk on every new investment and closely monitors the credit risk of its existing investment portfolio. The Company incorporates the needs of its products and liabilities, the overall requirements of the business, and other factors in addition to its underwriting of the credit risk for each investment in the portfolio. +Evaluating the underlying risks in the Company's credit portfolio involves a multitude of factors including but not limited to its assessment of the issuer's or borrower's business activities, assets, products, market position, financial condition, and future prospects. The Company incorporates the assessment of the NRSROs in assigning credit ratings and incorporates the rating methodologies of its specialist external managers in assigning loan ratings to portfolio holdings. The Company performs extensive internal assessments of the credit risks for all its portfolio holdings and potential new investments, which includes using analyses provided by the Company's specialist external managers. For assets managed by external asset managers, the Company provides investment and credit risk parameters that must be used when making investment decisions and require ongoing monitoring and reporting from the asset managers on significant changes in credit risks within the portfolio. +82 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Investment Concentrations +The Company's 15 largest global investment exposures were as follows: +Largest Global Investment Positions +(In millions) +December 31, 2018 +Total +% of Total +No. +Consolidated Corporate/Sovereign Exposure +Consolidated +Fixed Maturity +Credit +Book Value +Securities +Rating +1 +Japan National Government (1) +$ +51,207 +47.78 +% +A+ +2 +Bank of America NA +411 +.38 +Bank of America Corp. +231 +.21 +A- +Bank of America Corp. +180 +.17 +BBB+ +3 +Bank of Tokyo-Mitsubishi UFJ Ltd. +405 +.38 +A- +4 +Investcorp SA +383 +.36 +BB +5 +Republic of South Africa +360 +.34 +BB+ +6 +Banobras +333 +.31 +BBB+ +7 +Nordea Bank AB +302 +.28 +Nordea Bank AB +231 +.21 +A- +Nordea Bank AB +71 +.07 +BBB+ +8 +AXA +293 +.27 +BBB+ +9 +Deutsche Telekom AG +291 +.27 +BBB+ +10 +Japan Expswy Hld and Debt +291 +.27 +A+ +11 +CFE +287 +.27 +BBB+ +12 +AT&T Inc. +281 +.27 +BBB +13 +Czech Republic +270 +.25 +A+ +14 +Investor AB +270 +.25 +AA- +15 +Petroleos Mexicanos (Pemex) +270 +.25 +BBB+ +Subtotal +$ +55,654 +51.93 +% +Total fixed maturity securities +$ +107,174 +100.00 +% +(1) JGBs or JGB-backed securities +As previously disclosed, the Company owns long-dated debt instruments in support of its long-dated policyholder obligations. Some of the Company's largest global investment holdings are positions that were purchased many years ago and increased in size due to merger and consolidation activity among the issuing entities. In addition, many of the Company's largest holdings are yen-denominated, therefore strengthening of the yen can increase its position in dollars, and weakening of the yen can decrease its position in dollars. The Company's global investment guidelines establish concentration limits for its investment portfolios. +Geographical Exposure +The following table indicates the geographic exposure of the Company's debt securities as of December 31. +83 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +2018 +2017 +(In millions) +Amortized Cost +% of +Total +Amortized Cost +% of +Total +Japan +$ +55,486 +51.8 +% +$ +51,983 +48.8 +% +United States and Canada (1) +29,371 +27.4 +31,052 +29.1 +United Kingdom +3,038 +2.8 +2,603 +2.4 +Germany +2,179 +2.0 +2,323 +2.2 +France +2,030 +1.9 +1,983 +1.9 +Peripheral Eurozone +2,165 +2.0 +2,312 +2.2 +Portugal +215 +.2 +211 +.2 +Italy +1,261 +1.2 +1,261 +1.2 +Ireland +29 +.0 +32 +.0 +Spain +660 +.6 +808 +.8 +Nordic Region +1,615 +1.6 +1,611 +1.5 +Sweden +779 +.7 +725 +.7 +Norway +378 +.4 +451 +.4 +Denmark +270 +.3 +177 +.2 +Finland +188 +.2 +258 +.2 +Other Europe +2,425 +2.3 +2,489 +2.3 +Netherlands +1,206 +1.1 +1,183 +1.1 +Switzerland +258 +.2 +307 +.3 +Czech Republic +451 +.5 +442 +.4 +Austria +125 +.1 +123 +.1 +Belgium +178 +.2 +168 +.1 +Poland +180 +.2 +177 +.2 +Luxembourg +27 +.0 +89 +.1 +Asia excluding Japan +2,722 +2.5 +3,408 +3.2 +Africa and Middle East +2,018 +1.9 +2,460 +2.3 +Latin America +2,153 +2.0 +2,318 +2.2 +Australia +1,620 +1.5 +1,572 +1.5 +All Others +352 +.3 +448 +.4 +Total fixed maturity securities +$ +107,174 +100.0 +% +$ +106,562 +100.0 +% +(1) Includes total exposure to Puerto Rico of $1 million of required deposits at both December 31, 2018 and 2017, respectively, of which 100% had principal and interest insurance at both December 31, 2018 and 2017, respectively. +The primary factor considered when determining the domicile of investment exposure is the legal country risk location of the issuer. However, other factors such as the location of the parent guarantor, the location of the company's headquarters or major business operations (including location of major assets), location of primary market (including location of revenue generation) and specific country risk publicly recognized by rating agencies can influence the assignment of the country (or geographic) risk location. When the issuer is a special financing vehicle or a branch or subsidiary of a global company, then the Company considers any guarantees and/or legal, regulatory and corporate relationships of the issuer relative to its ultimate parent in determining the proper assignment of country risk. +84 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Derivative Counterparties +The Company is a direct counterparty to the foreign currency swaps that it has entered into in connection with certain of its senior notes and subordinated debentures; foreign currency forwards; foreign currency options; and interest rate swaptions, therefore the Company is exposed to credit risk in the event of nonperformance by the counterparties in those contracts. For the foreign currency and credit default swaps associated with the Company's VIE investments for which it is the primary beneficiary, the Company bears the risk of foreign exchange and/or credit loss due to counterparty default even though it is not a direct counterparty to those contracts. The risk of counterparty default for the Company's VIE and senior note and subordinated debenture swaps, foreign currency swaps, certain foreign currency forwards, foreign currency options and interest rate swaptions is mitigated by collateral posting requirements that counterparties to those transactions must meet. If collateral posting agreements are not in place, the counterparty risk associated with foreign currency forwards and foreign currency options is the risk that at expiry of the contract, the counterparty is unable to deliver the agreed upon amount of yen at the agreed upon price or delivery date, thus exposing the Company to additional unhedged exposure to U.S. dollars in the Aflac Japan investment portfolio. See Note 4 of the accompanying Notes to the Consolidated Financial Statements for more information. +Equity Risk +Market prices for equity securities are subject to fluctuation and consequently the amount realized in the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from the relative price of alternative investments and general market conditions. If equity prices experienced a hypothetical broad-based decline of 10%, the fair value of the Company's equity investments would decline by approximately $99 million . +85 +Item 8. Financial Statements and Supplementary Data +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Report of Independent Registered Public Accounting Firm +87 +Consolidated Financial Statements +89 +Consolidated Statements of Earnings +89 +Consolidated Statements of Comprehensive Income +90 +Consolidated Balance Sheets +91 +Consolidated Statements of Shareholders' Equity +93 +Consolidated Statements of Cash Flow +94 +Notes to the Consolidated Financial Statements +95 +Note 1. Summary of Significant Accounting Policies +95 +Note 2. Business Segment and Foreign Information +113 +Note 3. Investments +116 +Note 4. Derivative Instruments +128 +Note 5. Fair Value Measurements +137 +Note 6. Deferred Policy Acquisition Costs and Insurance Expenses +151 +Note 7. Policy Liabilities +152 +Note 8. Reinsurance +155 +Note 9. Notes Payable +156 +Note 10. Income Taxes +160 +Note 11. Shareholders' Equity +162 +Note 12. Share-Based Compensation +166 +Note 13. Statutory Accounting and Dividend Restrictions +170 +Note 14. Benefit Plans +171 +Note 15. Commitments and Contingent Liabilities +176 +Note 16. Unaudited Consolidated Quarterly Financial Data +177 +Management's Annual Report on Internal Control Over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Exchange Act. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013. Based on our evaluation under this framework, management has concluded that our internal control over financial reporting was effective as of December 31, 2018 . +KPMG LLP, an independent registered public accounting firm, has issued an attestation report on the effectiveness of internal control over financial reporting as of December 31, 2018 , which is included herein. +86 +Item 8. Financial Statements and Supplementary Data +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors +Aflac Incorporated: +Opinion on Internal Control Over Financial Reporting +We have audited Aflac Incorporated and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of earnings, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedules II, III, and IV (collectively, the “consolidated financial statements”), and our report dated February 25, 2019 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +Atlanta, Georgia +February 25, 2019 +87 +Item 8. Financial Statements and Supplementary Data +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors +Aflac Incorporated: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of Aflac Incorporated and subsidiaries (the “Company”) as of December 31, 2018 and 2017, the related consolidated statements of earnings, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three‑year period ended December 31, 2018, and the related notes and financial statement schedules II, III, and IV (collectively, the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three‑year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 25, 2019 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +/s/ KPMG LLP +We have served as the Company’s auditor since 1963. +Atlanta, Georgia +February 25, 2019 +88 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Earnings +Years Ended December 31, +(In millions, except for share and per-share amounts) +2018 +2017 +2016 +Revenues: +Net premiums, principally supplemental health insurance +$ +18,677 +$ +18,531 +$ +19,225 +Net investment income +3,442 +3,220 +3,278 +Realized investment gains (losses): +Other-than-temporary impairment losses realized +( 81 +) +( 37 +) +( 85 +) +Other gains (losses) (1) +( 349 +) +( 114 +) +71 +Total realized investment gains (losses) +( 430 +) +( 151 +) +( 14 +) +Other income (loss) +69 +67 +70 +Total revenues +21,758 +21,667 +22,559 +Benefits and expenses: +Benefits and claims, net +12,000 +12,181 +12,919 +Acquisition and operating expenses: +Amortization of deferred policy acquisition costs +1,245 +1,132 +1,141 +Insurance commissions +1,320 +1,316 +1,368 +Insurance and other expenses (2) +2,988 +2,780 +2,796 +Interest expense +222 +240 +268 +Total acquisition and operating expenses +5,775 +5,468 +5,573 +Total benefits and expenses +17,775 +17,649 +18,492 +Earnings before income taxes +3,983 +4,018 +4,067 +Income tax expense: +Current +1,379 +631 +884 +Deferred +( 316 +) +( 1,217 +) +524 +Income taxes +1,063 +( 586 +) +1,408 +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +Net earnings per share: +Basic +$ +3.79 +$ +5.81 +$ +3.23 +Diluted +3.77 +5.77 +3.21 +Weighted-average outstanding common shares used in +computing earnings per share (In thousands): +Basic +769,588 +792,042 +822,942 +Diluted +774,650 +797,861 +827,841 +(1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +(2) Includes expense of $ 13 in 2017 and $ 137 in 2016 for the early extinguishment of debt +See the accompanying Notes to the Consolidated Financial Statements. +89 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Comprehensive Income (Loss) +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +Other comprehensive income (loss) before income taxes: +Unrealized foreign currency translation gains (losses) during +period +232 +286 +283 +Unrealized gains (losses) on fixed maturity securities: (1) +Unrealized holding gains (losses) on fixed maturity securities +during period +( 3,155 +) +1,731 +2,852 +Reclassification adjustment for realized (gains) losses on +fixed maturity securities included in net earnings +46 +2 +( 53 +) +Unrealized gains (losses) on derivatives during period +2 +1 +3 +Pension liability adjustment during period +( 25 +) +9 +( 45 +) +Total other comprehensive income (loss) before income taxes +( 2,900 +) +2,029 +3,040 +Income tax expense (benefit) related to items of other comprehensive +income (loss) +( 797 +) +631 +1,035 +Other comprehensive income (loss), net of income taxes +( 2,103 +) +1,398 +2,005 +Total comprehensive income (loss) +$ +817 +$ +6,002 +$ +4,664 +(1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +See the accompanying Notes to the Consolidated Financial Statements. +90 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Balance Sheets +December 31, +(In millions) +2018 +2017 +Assets: +Investments and cash: +Securities available for sale, at fair value: +Fixed maturity securities (amortized cost $73,007 in 2018 and +$70,594 in 2017) (1) +$ +78,429 +$ +78,804 +Fixed maturity securities - consolidated variable interest entities (amortized +cost $3,849 in 2018 and $4,538 in 2017) (1) +4,466 +5,509 +Securities held to maturity, at amortized cost: +Fixed maturity securities (fair value $36,722 in 2018 and $38,072 in 2017) +30,318 +31,430 +Equity securities, at fair value: +Equity securities (1) +827 +270 +Equity securities - consolidated variable interest entities +160 +753 +Other investments (2) +7,706 +3,402 +Cash and cash equivalents +4,337 +3,491 +Total investments and cash +126,243 +123,659 +Receivables +851 +827 +Accrued investment income +773 +769 +Deferred policy acquisition costs +9,875 +9,505 +Property and equipment, at cost less accumulated depreciation +443 +434 +Other (3) +2,221 +2,023 +Total assets +$ +140,406 +$ +137,217 +(1) Includes perpetual securities, see Notes 1 and 3 of the Notes to the Consolidated Financial Statements +(2) Includes $ 5,856 in 2018 and $ 2,341 in 2017 of loan receivables and limited partnerships from consolidated variable interest entities +(3) Includes $ 182 in 2018 and $ 151 in 2017 of derivatives from consolidated variable interest entities +See the accompanying Notes to the Consolidated Financial Statements. +(continued) +91 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Balance Sheets (continued) +December 31, +(In millions, except for share and per-share amounts) +2018 +2017 +Liabilities and shareholders’ equity: +Liabilities: +Policy liabilities: +Future policy benefits +$ +86,368 +$ +81,857 +Unpaid policy claims +4,584 +4,392 +Unearned premiums +5,090 +5,959 +Other policyholders’ funds +7,146 +6,939 +Total policy liabilities +103,188 +99,147 +Income taxes +4,020 +4,745 +Payables for return of cash collateral on loaned securities +1,052 +606 +Notes payable +5,778 +5,289 +Other (4) +2,906 +2,832 +Total liabilities +116,944 +112,619 +Commitments and contingent liabilities (Note 15) +Shareholders’ equity: +Common stock of $.10 par value. In thousands: authorized 1,900,000 +shares in 2018 and 2017; issued 1,347,540 shares in 2018 and 1,345,762 +shares in 2017 +135 +135 +Additional paid-in capital +2,177 +2,052 +Retained earnings +31,788 +29,895 +Accumulated other comprehensive income (loss): +Unrealized foreign currency translation gains (losses) +( 1,847 +) +( 1,750 +) +Unrealized gains (losses) on fixed maturity securities (5) +4,234 +5,964 +Unrealized gains (losses) on derivatives +( 24 +) +( 23 +) +Pension liability adjustment +( 212 +) +( 163 +) +Treasury stock, at average cost +( 12,789 +) +( 11,512 +) +Total shareholders’ equity +23,462 +24,598 +Total liabilities and shareholders’ equity +$ +140,406 +$ +137,217 +(4) Includes $ 102 in 2018 and $ 128 in 2017 of derivatives from consolidated variable interest entities +(5) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +See the accompanying Notes to the Consolidated Financial Statements. +92 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Shareholders’ Equity +Years Ended December 31, +(In millions, except for per-share amounts) +2018 +2017 +2016 +Common stock: +Balance, beginning of period +$ +135 +$ +135 +$ +135 +Balance, end of period +135 +135 +135 +Additional paid-in capital: +Balance, beginning of period +2,052 +1,908 +1,760 +Exercise of stock options +34 +38 +46 +Share-based compensation +54 +51 +64 +Gain (loss) on treasury stock reissued +37 +55 +38 +Balance, end of period +2,177 +2,052 +1,908 +Retained earnings: +Balance, beginning of period +29,895 +25,981 +24,007 +Cumulative effect of change in accounting principle - financial instruments, +net of income taxes (1) +148 +0 +0 +Cumulative effect of change in accounting principle - tax effects from tax reform (1) +( 374 +) +0 +0 +Net earnings +2,920 +4,604 +2,659 +Dividends to shareholders ($1.04 per share in 2018, $.87 per share in 2017 and +$.83 per share in 2016) +( 801 +) +( 690 +) +( 685 +) +Balance, end of period +31,788 +29,895 +25,981 +Accumulated other comprehensive income (loss): +Balance, beginning of period +4,028 +2,630 +625 +Cumulative effect of change in accounting principle - financial instruments, +net of income taxes (1) +( 148 +) +0 +0 +Cumulative effect of change in accounting principle - tax effects from tax reform (1) +374 +0 +0 +Unrealized foreign currency translation gains (losses) during +period, net of income taxes +228 +233 +213 +Unrealized gains (losses) on fixed maturity securities during +period, net of income taxes and reclassification adjustments (1) +( 2,316 +) +1,159 +1,819 +Unrealized gains (losses) on derivatives during period, net of +income taxes +2 +1 +2 +Pension liability adjustment during period, net of income taxes +( 17 +) +5 +( 29 +) +Balance, end of period +2,151 +4,028 +2,630 +Treasury stock: +Balance, beginning of period +( 11,512 +) +( 10,172 +) +( 8,819 +) +Purchases of treasury stock +( 1,317 +) +( 1,391 +) +( 1,422 +) +Cost of shares issued +40 +51 +69 +Balance, end of period +( 12,789 +) +( 11,512 +) +( 10,172 +) +Total shareholders’ equity +$ +23,462 +$ +24,598 +$ +20,482 +(1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018. +See the accompanying Notes to the Consolidated Financial Statements. +93 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Cash Flows +Years Ended December 31, +(In millions) +2018 +2017 +2016 +Cash flows from operating activities: +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +Adjustments to reconcile net earnings to net cash provided by operating activities: +Change in receivables and advance premiums +( 55 +) +( 91 +) +42 +Capitalization of deferred policy acquisition costs +( 1,504 +) +( 1,468 +) +( 1,447 +) +Amortization of deferred policy acquisition costs +1,245 +1,132 +1,141 +Increase in policy liabilities +2,343 +2,890 +3,331 +Change in income tax liabilities +64 +( 1,240 +) +( 93 +) +Realized investment (gains) losses +430 +151 +14 +Other, net +571 +150 +340 +(1) +Net cash provided (used) by operating activities +6,014 +6,128 +5,987 +Cash flows from investing activities: +Proceeds from investments sold or matured: +Available-for-sale fixed maturity securities +7,888 +4,680 +6,723 +Equity securities +429 +902 +350 +Held-to-maturity fixed maturity securities +1,670 +2,212 +1,399 +Other investments - loan receivables +936 +303 +90 +Costs of investments acquired: +Available-for-sale fixed maturity securities +( 9,086 +) +( 9,867 +) +( 10,890 +) +Equity securities +( 440 +) +( 446 +) +( 1,079 +) +Other investments - loan receivables +( 4,848 +) +( 2,115 +) +( 1,110 +) +Other investments, excluding loan receivables, net +( 414 +) +( 206 +) +( 98 +) +Settlement of derivatives, net +( 241 +) +( 621 +) +1,252 +Cash received (pledged or returned) as collateral, net +348 +( 205 +) +( 416 +) +Other, net +176 +( 68 +) +( 76 +) +Net cash provided (used) by investing activities +( 3,582 +) +( 5,431 +) +( 3,855 +) +Cash flows from financing activities: +Purchases of treasury stock +( 1,301 +) +( 1,351 +) +( 1,422 +) +Proceeds from borrowings +1,020 +1,040 +986 +Principal payments under debt obligations +( 550 +) +( 1,161 +) +( 610 +) +Dividends paid to shareholders +( 793 +) +( 661 +) +( 658 +) +Change in investment-type contracts, net +( 31 +) +35 +159 +Treasury stock reissued +58 +33 +46 +Other, net +( 19 +) +0 +( 120 +) +(1) +Net cash provided (used) by financing activities +( 1,616 +) +( 2,065 +) +( 1,619 +) +Effect of exchange rate changes on cash and cash equivalents +30 +0 +( 4 +) +Net change in cash and cash equivalents +846 +( 1,368 +) +509 +Cash and cash equivalents, beginning of period +3,491 +4,859 +4,350 +Cash and cash equivalents, end of period +$ +4,337 +$ +3,491 +$ +4,859 +Supplemental disclosures of cash flow information: +Income taxes paid +$ +998 +$ +780 +$ +1,526 +Interest paid +181 +196 +211 +Noncash interest +41 +44 +57 +Impairment losses included in realized investment losses +81 +37 +85 +Noncash financing activities: +Capital lease obligations +11 +12 +1 +Treasury stock issued for: +Associate stock bonus +7 +29 +30 +Shareholder dividend reinvestment +8 +29 +27 +Share-based compensation grants +2 +1 +4 +(1) Operating activities excludes and financing activities includes a cash outflow of $ 137 in 2016 for the payments associated with the early extinguishment of debt +See the accompanying Notes to the Consolidated Financial Statements. +94 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Notes to the Consolidated Financial Statements +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Description of Business   +Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) primarily sell supplemental health and life insurance in the United States and Japan. The Company's insurance business is marketed and administered through American Family Life Assurance Company of Columbus (Aflac) in the United States (Aflac U.S.) and, effective April 1, 2018, through Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan). Prior to April 1, 2018, the Company's insurance business was marketed in Japan as a branch of Aflac. American Family Life Assurance Company of New York (Aflac New York) is a wholly owned subsidiary of Aflac. Most of Aflac's policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. The Company's insurance operations in the United States and Japan service the two markets for the Company's insurance business. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 70 % of the Company's total revenues in 2018 , compared with 70 % in 2017 and 71 % in 2016 . The percentage of the Company's total assets attributable to Aflac Japan was 84 % at December 31, 2018 , compared with 83 % at December 31, 2017 . +Basis of Presentation +The Company prepares its financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP). These principles are established primarily by the Financial Accounting Standards Board (FASB). In these Notes to the Consolidated Financial Statements, references to U.S. GAAP issued by the FASB are derived from the FASB Accounting Standards Codification TM (ASC). The preparation of financial statements in conformity with U.S. GAAP requires the Company to make estimates based on currently available information when recording transactions resulting from business operations. The most significant items on the Company's balance sheet that involve a greater degree of accounting estimates and actuarial determinations subject to changes in the future are the valuation of investments and derivatives, deferred policy acquisition costs (DAC), liabilities for future policy benefits and unpaid policy claims, and income taxes. These accounting estimates and actuarial determinations are sensitive to market conditions, investment yields, mortality, morbidity, commission and other acquisition expenses, and terminations by policyholders. As additional information becomes available, or actual amounts are determinable, the recorded estimates will be revised and reflected in operating results. Although some variability is inherent in these estimates, the Company believes the amounts provided are adequate. +The consolidated financial statements include the accounts of the Parent Company, its subsidiaries, and those entities required to be consolidated under applicable accounting standards. All material intercompany accounts and transactions have been eliminated. +Significant Accounting Policies +Foreign Currency Translation:  The functional currency of Aflac Japan is the Japanese yen. The Company translates its yen-denominated financial statement accounts into U.S. dollars as follows. Assets and liabilities are translated at end-of-period exchange rates. Realized gains and losses on security transactions are translated at the exchange rate on the trade date of each transaction. Other revenues, expenses, and cash flows are translated using average exchange rates for the period. The resulting currency translation adjustments are reported in accumulated other comprehensive income. The Company includes in earnings the realized currency exchange gains and losses resulting from foreign currency transactions. +The Parent Company has designated a majority of its yen-denominated liabilities (notes payable and yen-denominated loans) as non-derivative hedges and from time-to-time may designate certain foreign currency forwards and options as derivative hedges of the foreign currency exposure of the Company's net investment in Aflac Japan. Outstanding principal and related accrued interest on these Parent Company liabilities and the fair value of these derivatives are translated into U.S. dollars at end-of-period exchange rates. Currency translation adjustments and changes in the fair value of these derivatives are recorded as unrealized foreign currency translation gains (losses) in other comprehensive income and are included in accumulated other comprehensive income. +Insurance Revenue and Expense Recognition:  Substantially all of the supplemental health and life insurance policies the Company issues are classified as long-duration contracts. The contract provisions generally cannot be +95 +Item 8. Financial Statements and Supplementary Data +changed or canceled during the contract period; however, the Company may adjust premiums for supplemental health policies issued in the United States within prescribed guidelines and with the approval of state insurance regulatory authorities. +Insurance premiums for most of the Company's health and life policies, including cancer, accident, hospital, critical illness, dental, vision, term life, whole life, long-term care and disability, are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. When revenues are reported, the related amounts of benefits and expenses are charged against such revenues, so that profits are recognized in proportion to premium revenues during the period the policies are expected to remain in force. This association is accomplished by means of annual additions to the liability for future policy benefits and the deferral and subsequent amortization of policy acquisition costs. +Premiums from the Company's products with limited-pay features, including term life, whole life, WAYS, and child endowment, are collected over a significantly shorter period than the period over which benefits are provided. Premiums for these products are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. Any gross premium in excess of the net premium is deferred and recorded in earnings, such that profits are recognized in a constant relationship with insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net premium method. +At the policyholder's option, customers can also pay discounted advanced premiums for certain of the Company's products. Advanced premiums are deferred and recognized when due from policyholders over the regularly scheduled premium payment period. +The calculation of DAC and the liability for future policy benefits requires the use of estimates based on sound actuarial valuation techniques. For new policy issues, the Company reviews its actuarial assumptions and deferrable acquisition costs each year and revises them when necessary to more closely reflect recent experience and studies of actual acquisition costs. For policies in force, the Company evaluates DAC by major product groupings to determine that they are recoverable from future revenues, and any amounts determined not to be recoverable are charged against net earnings. The Company has not had any material charges to earnings for DAC that was determined not to be recoverable in any of the years presented in this Form 10-K. +Advertising expense is reported as incurred in insurance expenses in the consolidated statements of earnings. +Cash and Cash Equivalents:  Cash and cash equivalents include cash on hand, money market instruments, and other debt instruments with a maturity of 90 days or less when purchased. +Investments:  The Company's debt securities consist of fixed maturity securities, which are classified as either held to maturity or available for sale. Securities classified as held to maturity are securities that the Company has the ability and intent to hold to maturity or redemption and are carried at amortized cost. All other fixed maturity debt securities are classified as available for sale and are carried at fair value. If the fair value is higher than the amortized cost for debt securities, the excess is an unrealized gain, and if lower than cost, the difference is an unrealized loss. The net unrealized gains and losses on securities available for sale, less related deferred income taxes, are recorded through other comprehensive income and included in accumulated other comprehensive income. +Amortized cost of debt securities is based on the Company's purchase price adjusted for accrual of discount, or amortization of premium, and recognition of impairment charges, if any. The amortized cost of debt securities the Company purchases at a discount or premium will equal the face or par value at maturity or the call date, if applicable. Interest is reported as income when earned and is adjusted for amortization of any premium or discount. +The Company has investments in equity securities which are carried at fair value. Effective January 1, 2018 upon the adoption of new accounting guidance, changes in fair value of equity securities are recorded in earnings as a component of realized investment gains and losses. Prior to January 1, 2018, equity securities were carried at fair value with unrealized gains and losses, less related deferred income taxes, recorded in other comprehensive income and included in accumulated other comprehensive income. +The Company has investments in variable interest entities (VIEs). Criteria for evaluating VIEs for consolidation focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity's economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. The Company is the primary beneficiary of certain VIEs, and therefore consolidates these entities in its financial statements. While the consolidated VIEs generally operate within a defined set of contractual +96 +Item 8. Financial Statements and Supplementary Data +terms, there are certain powers that are retained by the Company that are considered significant in the conclusion that the Company is the primary beneficiary. These powers vary by structure but generally include the initial selection of the underlying collateral; the ability to obtain the underlying collateral in the event of default; and, the ability to appoint or dismiss key parties in the structure. In particular, the Company's powers surrounding the underlying collateral were considered to be the most significant powers because those most significantly impact the economics of the VIE. The Company has no obligation to provide any continuing financial support to any of the entities in which it is the primary beneficiary. The Company's maximum loss is limited to its original investment. Neither the Company nor any of its creditors have the ability to obtain the underlying collateral, nor does the Company have control over the instruments held in the VIEs, unless there is an event of default. For those entities where the Company is the primary beneficiary, the consolidated entity's assets are segregated on the balance sheet by the caption "consolidated variable interest entities," and consist of fixed maturity securities, equity securities, loan receivables, limited partnerships and derivative instruments. +For the mortgage- and asset-backed securities held in the Company's fixed maturity portfolio, the Company recognizes income using a constant effective yield, which is based on anticipated prepayments and the estimated economic life of the securities. When estimates of prepayments change, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in mortgage- and asset-backed securities is adjusted to the amount that would have existed had the new effective yield been applied at the time of acquisition. This adjustment is reflected in net investment income. +The Company uses the specific identification method to determine the gain or loss from securities transactions and report the realized gain or loss in the consolidated statements of earnings. Securities transactions are accounted for based on values as of the trade date of the transaction. +An investment in a fixed maturity security is impaired if the fair value falls below amortized cost. The Company regularly reviews its fixed maturity security investments portfolio for declines in fair value. The Company's fixed maturity security investments are evaluated for other-than-temporary impairment using its debt impairment model. The Company's debt impairment model focuses on the ultimate collection of the cash flows from its investments and whether the Company has the intent to sell or if it is more likely than not the Company would be required to sell the security prior to recovery of its amortized cost. The determination of the amount of impairments under this model is based upon the Company's periodic evaluation and assessment of known and inherent risks associated with the respective securities. Such evaluations and assessments are revised as conditions change and new information becomes available. +When determining the Company's intention to sell a security prior to recovery of its fair value to amortized cost, the Company evaluates facts and circumstances such as, but not limited to, future cash flow needs, decisions to reposition its security portfolio, and risk profile of individual investment holdings. The Company performs ongoing analyses of its liquidity needs, which includes cash flow testing of its policy liabilities, debt maturities, projected dividend payments, and other cash flow and liquidity needs. +The determination of whether an impairment in value of the Company's fixed maturity securities is other than temporary is based largely on the Company's evaluation of the issuer ' s creditworthiness. The Company must apply considerable judgment in determining the likelihood of its fixed maturity securities recovering in value. Factors that may influence this include the overall level of interest rates, credit spreads, the credit quality of the underlying issuer, and other factors. This process requires consideration of risks which can be controlled to a certain extent, such as credit risk, and risks which cannot be controlled, such as interest rate risk and foreign currency risk. +If, after monitoring and analyses, management believes that fair value will not recover to amortized cost, the Company recognizes an other-than-temporary impairment of the security. Once a security is considered to be other-than-temporarily impaired, the impairment loss is separated into two components: the portion of the impairment related to credit and the portion of the impairment related to factors other than credit. The Company recognizes a charge to earnings for the credit-related portion of other-than-temporary impairments. Impairments related to factors other than credit are charged to earnings in the event the Company intends to sell the security prior to the recovery of its amortized cost or if it is more likely than not that the Company would be required to dispose of the security prior to recovery of its amortized cost; otherwise, non-credit-related other-than-temporary impairments are charged to other comprehensive income. +The Company lends fixed maturity and public equity securities to financial institutions in short-term security-lending transactions. These securities continue to be carried as investment assets on the Company's balance sheet during the terms of the loans and are not reported as sales. The Company receives cash or other securities as collateral for such loans. For loans involving unrestricted cash or securities as collateral, the collateral is reported as an asset with a corresponding liability for the return of the collateral. For loans where the Company receives as collateral securities that the Company is not permitted to sell or repledge, the collateral is not reported as an asset. +97 +Item 8. Financial Statements and Supplementary Data +Other investments include transitional real estate loans (TREs), commercial mortgage loans (CMLs), middle market loans (MMLs), policy loans, limited partnerships, and short-term investments with maturities at the time of purchase of one year or less, but greater than 90 days. The Company's investments in TREs, CMLs, and MMLs are accounted for as loan receivables and are recorded at amortized cost on the acquisition date. The Company has the intent and ability to hold these loan receivables for the foreseeable future or until they mature and therefore, they are considered held for investment and are carried at amortized cost in the other investments line in its consolidated balance sheets. The amortized cost of the loan receivables reflects allowances for expected incurred losses estimated based on past events and current economic conditions as of each reporting date. Limited partnership investments are accounted for using the equity method of accounting. Under the equity method of accounting, the Company reports its portion of partnership earnings as a component of net investment income in its consolidated statements of earnings. The underlying investments held by the Company’s limited partnerships primarily consist of private equity and real estate. Short-term investments are stated at amortized cost, which approximates fair value. +Derivatives and Hedging:  Freestanding derivative instruments are reported in the consolidated balance sheet at fair value and are reported in other assets and other liabilities, with changes in value reported in earnings and/or other comprehensive income. These freestanding derivatives are foreign currency forwards, foreign currency options, foreign currency swaps, interest rate swaps, interest rate swaptions, and, in prior year periods, credit default swaps (CDSs). Foreign currency forwards and options are used in hedging foreign exchange risk on U.S. dollar-denominated investments in Aflac Japan's portfolio. Foreign currency forwards and options are also used to economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long term exposure to a weakening yen. Cross-currency interest rate swaps, also referred to as foreign currency swaps, are used to economically convert certain U.S. dollar-denominated note obligations into yen-denominated principal and interest obligations. Foreign currency swaps are used within special-purpose entities, including VIEs where the Company is the primary beneficiary, to hedge the risk arising from interest rate and currency exchange risk. Interest rate swaps are used to economically hedge interest rate fluctuations in certain variable-rate investments. Interest rate swaptions, which are options to enter into interest rate swaps, are used to hedge interest rate fluctuations on certain U.S. dollar-denominated available-for-sale securities in Aflac Japan's portfolio. The Company does not use derivatives for trading purposes, nor does the Company engage in leveraged derivative transactions. +From time to time, the Company purchases certain investments that contain an embedded derivative. The Company assesses whether this embedded derivative is clearly and closely related to the asset that serves as its host contract. If the Company deems that the embedded derivative's terms are not clearly and closely related to the host contract, and a separate instrument with the same terms would qualify as a derivative instrument, the derivative is separated from that contract, held at fair value, and reported with the host instrument in the consolidated balance sheet, with changes in fair value reported in earnings. If the Company has elected the fair value option, the embedded derivative is not bifurcated, and the entire investment is held at fair value with changes in fair value reported in earnings. +See Note 5 for a discussion on how the Company determines the fair value of its derivatives. Accruals on derivatives are typically recorded in accrued investment income or within other liabilities in the consolidated balance sheets. +To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated risk attributable to the hedged item. At the inception of hedging relationships the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objectives and strategies for undertaking the respective hedging relationship, and the methodology that will be used to assess the effectiveness of the hedge relationship at and subsequent to hedge inception. The Company documents the designation of each hedge as either (i) a hedge of the variability of cash flows to be received or paid related to a recognized asset or liability or the hedge of a forecasted transaction ("cash flow hedge"); (ii) a hedge of the estimated fair value of a recognized asset or liability ("fair value hedge"); or (iii) a hedge of a net investment in a foreign operation. The documentation process includes linking derivatives and non-derivative financial instruments that are designated as hedges to specific assets or groups of assets or liabilities in the statement of financial position or to specific forecasted transactions and defining the effectiveness testing methods to be used. At the hedge inception and on an ongoing quarterly basis, the Company also formally assesses whether the derivatives and non-derivative financial instruments used in hedging activities have been, and are expected to continue to be, highly effective in offsetting their designated risk. Hedge effectiveness is assessed using qualitative and quantitative methods. The assessment of hedge effectiveness determines the accounting treatment of changes in fair value. +For assessing hedge effectiveness, qualitative methods may include the comparison of critical terms of the derivative to the hedged item, and quantitative methods may include regression, dollar offset, or other statistical analysis of changes in fair value or cash flows associated with the hedge relationship. For derivative instruments that are designated and +98 +Item 8. Financial Statements and Supplementary Data +qualify as cash flow hedges, the gain or loss on the derivative is reported as a component of other comprehensive income (loss) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. In cash flow hedges, all components of each derivative's gain or loss are included in the assessment of hedge effectiveness and are recorded in the line item of the consolidated statements of earnings in which the cash flows of the hedged item are recorded. +For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the hedged item and the portion of the hedging instrument included in the assessment of effectiveness are recorded in the line item of the consolidated statements of earnings in which gain or loss on the hedged item is recorded. When assessing the effectiveness of the Company's fair value hedges, the Company excludes the changes in fair value related to the difference between the spot and the forward rate on its foreign currency forwards and the time value of foreign exchange options and interest rate swaptions. +For hedges of the Company's net investment in Aflac Japan, the Company has designated the majority of the Parent Company's yen-denominated liabilities (notes payable and yen-denominated loans) as non-derivative hedging instruments and from time to time may designate certain foreign currency forwards and options as derivative hedging instruments. The Company makes its net investment hedge designation at the beginning of each quarter. For assessing hedge effectiveness of net investment hedges, if the total of the designated Parent Company non-derivative and derivatives notional is equal to or less than its net investment in Aflac Japan, the hedge is deemed to be effective. If the hedge is effective, the related exchange effect on the yen-denominated liabilities is reported in the unrealized foreign currency component of other comprehensive income. For derivative hedging instruments designated as net investment hedges, Aflac follows the forward-rate method. According to that method, all changes in fair value, including changes related to the forward-rate component of foreign currency forward contracts and the time value of foreign currency options, are reported in the unrealized foreign currency component of other comprehensive income. Should these designated net investment hedge positions exceed the Company's net investment in Aflac Japan, the foreign exchange effect on the portion that exceeds its investment in Aflac Japan would be recognized in current earnings within derivative and other gains (losses). +The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer highly effective in offsetting changes in the estimated cash flows or fair value of a hedged item; (2) the derivative is de-designated as a hedging instrument; or (3) the derivative expires or is sold, terminated or exercised. +When hedge accounting is discontinued on a cash flow hedge or fair value hedge, the derivative is carried in the consolidated balance sheets at its estimated fair value, with changes in estimated fair value recognized in current period earnings. For discontinued cash flow hedges, including those where the derivative is sold, terminated or exercised, amounts previously deferred in other comprehensive income (loss) are reclassified into earnings when earnings are impacted by the cash flow of the hedged item. +If a derivative is not designated as an accounting hedge or its use in managing risk does not qualify for hedge accounting, changes in the estimated fair value of the derivative are generally reported within derivative and other gains (losses), which is a component of realized investment gains (losses). The fluctuations in estimated fair value of derivatives that have not been designated for hedge accounting can result in volatility in net earnings. +The Company receives and pledges cash or other securities as collateral on open derivative positions. Cash received as collateral is reported as an asset with a corresponding liability for the return of the collateral. Cash pledged as collateral is recorded as a reduction to cash, and a corresponding receivable is recognized for the return of the cash collateral. The Company generally can repledge or resell collateral obtained from counterparties, although the Company does not typically exercise such rights. Securities received as collateral are not recognized unless the Company was to exercise its right to sell that collateral or exercise remedies on that collateral upon a counterparty default. Securities that the Company has pledged as collateral continue to be carried as investment assets on its balance sheet. +Deferred Policy Acquisition Costs: Certain direct and incremental costs of acquiring new business are deferred and amortized with interest over the premium payment periods in proportion to the ratio of annual premium income to total anticipated premium income. Anticipated premium income is estimated by using the same mortality, persistency and interest assumptions used in computing liabilities for future policy benefits. In this manner, the related acquisition expenses are matched with revenues. Deferred costs include the excess of current-year commissions over ultimate renewal-year commissions and certain incremental direct policy issue, underwriting and sales expenses. All of these incremental costs are directly related to successful policy acquisition. +99 +Item 8. Financial Statements and Supplementary Data +For some products, policyholders can elect to modify product benefits, features, rights or coverages by exchanging a contract for a new contract or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. These transactions are known as internal replacements. The Company performs a two-stage analysis of the internal replacements to determine if the modification is substantive to the base policy. The stages of evaluation are as follows: 1) determine if the modification is integrated with the base policy, and 2) if it is integrated, determine if the resulting contract is substantially changed. +For internal replacement transactions where the resulting contract is substantially unchanged, the policy is accounted for as a continuation of the replaced contract. Unamortized deferred acquisition costs from the original policy continue to be amortized over the expected life of the new policy, and the costs of replacing the policy are accounted for as policy maintenance costs and expensed as incurred. Examples include conversions of same age bands, certain family coverage changes, pricing era changes (decrease), and ordinary life becomes reduced paid-up and certain reinstatements. +An internal replacement transaction that results in a policy that is substantially changed is accounted for as an extinguishment of the original policy and the issuance of a new policy. Unamortized deferred acquisition costs on the original policy are immediately expensed, and the costs of acquiring the new policy are capitalized and amortized in accordance with the Company's accounting policies for deferred acquisition costs. Further, the policy reserves are evaluated based on the new policy features, and any change (up or down) necessary is recognized at the date of contract change/modification. Examples include conversions to higher age bands, certain family coverage changes, pricing era changes (increase), lapse & re-issue, certain reinstatements and certain other contract conversions. +Riders can be considered internal replacements that are either integrated or non-integrated resulting in either substantially changed or substantially unchanged treatment. Riders are evaluated based on the specific facts and circumstances of the rider and are considered an expansion of the existing benefits with additional premium required. Non-integrated riders to existing contracts do not change the Company's profit expectations for the related products and are treated as a new policy establishment for incremental coverage. +The Company measures the recoverability of DAC and the adequacy of its policy reserves annually by performing gross premium valuations on its business. (See the following discussion for further information regarding policy reserves.) +Policy Liabilities:  Future policy benefits represent claims that are expected to occur in the future and are computed following a net level premium method using estimated future investment yields, persistency and recognized morbidity and mortality tables modified to reflect the Company's experience, including a provision for adverse deviation. These assumptions are generally established and considered locked at policy inception. These assumptions may only be unlocked in certain circumstances based on the results of periodic DAC recoverability and premium deficiency testing. +Unpaid policy claims are estimates computed on an undiscounted basis using statistical analyses of historical claims experience adjusted for current trends and changed conditions. The ultimate liability may vary significantly from such estimates. The Company regularly adjusts these estimates as new claims experience emerges and reflects the changes in operating results in the year such adjustments are made. +Other policy liabilities consist primarily of discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan limited-pay insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. +For internal replacements that are determined to not be substantially unchanged, policy liabilities related to the original policy that was replaced are immediately released, and policy liabilities are established for the new insurance contract; however, for internal replacements that are considered substantially unchanged, no changes to the reserves are recognized. +Reinsurance: The Company enters into reinsurance agreements with other companies in the normal course of business. For each reinsurance agreement, the Company determines if the agreement provides indemnification against loss or liability relating to insurance risk in accordance with applicable accounting standards. Reinsurance premiums and benefits paid or provided are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums, benefits and DAC are reported net of insurance ceded. +Income Taxes: Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing the Company's income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and +100 +Item 8. Financial Statements and Supplementary Data +liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the Company expects the temporary differences to reverse. The Company records deferred tax assets for tax positions taken based on its assessment of whether the tax position is more likely than not to be sustained upon examination by taxing authorities. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized. +Policyholder Protection Corporation and State Guaranty Association Assessments: In Japan, the government has required the insurance industry to contribute to a policyholder protection corporation. The Company recognizes a charge for its estimated share of the industry's obligation once it is determinable. The Company reviews the estimated liability for policyholder protection corporation contributions on an annual basis and reports any adjustments in Aflac Japan's expenses. +In the United States, each state has a guaranty association that supports insolvent insurers operating in those states. See Note 15 of the Notes to the Consolidated Financial Statements for further discussion of the guaranty fund assessments charged to the Company. +Treasury Stock: Treasury stock is reflected as a reduction of shareholders' equity at cost. The Company uses the weighted-average purchase cost to determine the cost of treasury stock that is reissued. The Company includes any gains and losses in additional paid-in capital when treasury stock is reissued. +Share-Based Compensation: The Company measures compensation cost related to its share-based payment transactions at fair value on the grant date, and the Company recognizes those costs in the financial statements over the vesting period during which the employee provides service in exchange for the award. The Company has formalized its entity-wide accounting policy election to estimate the number of awards that are expected to vest and the corresponding forfeitures. +Earnings Per Share: The Company computes basic earnings per share (EPS) by dividing net earnings by the weighted-average number of unrestricted shares outstanding for the period. Diluted EPS is computed by dividing net earnings by the weighted-average number of shares outstanding for the period plus the shares representing the dilutive effect of share-based awards. +Stock Split: On February 13, 2018, the Board of Directors of the Parent Company declared a two -for-one stock split of the Company’s common stock in the form of a 100 % stock dividend payable on March 16, 2018 to shareholders of record at the close of business on March 2, 2018. The stock split was payable in the form of one additional common stock share for every share of common stock held. All equity and share-based data, including the number of shares outstanding and per share amounts, have been adjusted to reflect the stock split for all periods presented in this Annual Report on Form 10-K. +Reclassifications: Certain reclassifications have been made to prior-year amounts to conform to current-year reporting classifications. These reclassifications had no impact on net earnings or total shareholders' equity. +Perpetual securities have been reclassified in prior periods from a separate line item to fixed maturity securities to conform to current period reporting classifications. This reclassification had no impact on net earnings or total shareholder’s equity. +New Accounting Pronouncements +Recently Adopted Accounting Pronouncements +101 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +Accounting Standard Update (ASU) 2018-16 Derivatives and Hedging Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes +In October 2018, the FASB issued amendments to permit use of the Overnight Index Swap (OIS) rate based on the Secured Overnight Financing Rate (SOFR) as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815 in addition to the Treasury obligations of the U.S. government (UST), the London Interbank Offered Rate (LIBOR) swap rate, the OIS rate based on the Fed Funds Effective Rate, and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. +Early adopted as of October 1, 2018 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations or disclosures. +ASU 2018-03 +Technical Corrections and Improvements to Financial Instruments - Overall Recognition and Measurement of Financial Assets and Financial Liabilities +In February 2018, the FASB issued amendments to clarify certain aspects of the guidance issued in the original Financial Instruments - Overall - Recognition and Measurement pronouncement summarized below. Specifically, for entities who have chosen the measurement alternative approach for equity securities without readily determinable fair values, the amendments clarify that entities may change from a measurement alternative approach to a fair value method through an irrevocable election that would apply to a specific equity security and all identical or similar investments of the same issuer; entities should use an observable price at the date of the transaction rather than reporting date for the measurement alternative calculation; and insurance companies should use a prospective transition method when applying the measurement alternative. +Early adopted as of January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2018-02 +Income Statement - Reporting Comprehensive Income: Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income +In February 2018, the FASB issued amendments which allow a reclassification from accumulated other comprehensive income (AOCI) to retained earnings of the effects of the change in the U.S. federal income tax rate resulting from the Tax Cuts and Jobs Act (Tax Act) on the gross deferred tax amounts and the corresponding valuation allowances related to items remaining in AOCI. The amendments eliminate the stranded tax effects resulting from the Tax Act and also require certain disclosures about the reclassified tax effects. +Early adopted as of January 1, 2018 +The amounts reclassified from +AOCI to retained earnings include the income tax effects of the change in the federal corporate tax rate enacted by the Tax Act. The Company’s policy is to follow the portfolio approach for releasing income tax effects from AOCI. The adoption of this guidance resulted in an increase to beginning 2018 AOCI of $374 million with a corresponding decrease to beginning 2018 retained earnings as of January 1, 2018. +102 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2017-12 +Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities +In August 2017, the FASB issued guidance which improves and simplifies the accounting rules around hedge accounting and creates more transparency around how economic results are presented in financial statements. Issues addressed in this new guidance include: 1) risk component hedging, 2) accounting for the hedged item in fair value hedges of interest rate risk, 3) recognition and presentation of the effects of hedging instruments, and 4) amounts excluded from the assessment of hedge effectiveness. +Early adopted as of October 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-09 Compensation - Stock Compensation: Scope of Modification Accounting +In May 2017, the FASB issued amendments to provide guidance clarifying when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. An entity should apply modification accounting if the fair value, vesting conditions or classification of the award (as an equity instrument or liability instrument) changes as a result of the change in terms or conditions of the award. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-08 +Receivables - Nonrefundable Fees and Other Costs: Premium Amortization on Purchased Callable Debt Securities +In March 2017, the FASB issued amendments to shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount. +Early adopted as of July 1, 2018 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2017-07 +Compensation - Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost +In March 2017, the FASB issued amendments requiring that an employer report the service cost component of net periodic pension cost and net periodic postretirement benefit cost in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net periodic pension cost and net periodic postretirement benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. The amendments in this update also allow only the service cost component to be eligible for capitalization when applicable. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +103 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2017-05 +Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets: Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets +In February 2017, the FASB issued amendments that clarify the scope and accounting guidance for the derecognition of a nonfinancial asset or a financial asset that meets the definition of an "in substance nonfinancial asset." The amendments define an "in substance nonfinancial asset" and provide additional accounting guidance for partial sales of nonfinancial assets. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-01 +Business Combinations: Clarifying the Definition of a Business +In January 2017, the FASB issued amendments clarifying when a set of assets and activities is a business. The amendments provide a screen to exclude transactions where substantially all the fair value of the transferred set is concentrated in a single asset, or group of similar assets, from being evaluated as a business. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-18 +Statement of Cash Flows: Restricted Cash +In November 2016, the FASB issued amendments requiring that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, statements of cash flows, or disclosures. +ASU 2016-17 +Consolidation - Interests Held through Related Parties That Are under Common Control +In October 2016, the FASB issued amendments which clarify the consolidation guidance on how a reporting entity that is the single decision maker of a variable interest entity (VIE) should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that VIE. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-16 +Income Taxes: Intra-Entity Transfers of Assets Other Than Inventory +In October 2016, the FASB issued amendments that require an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-15 Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments +In August 2016, the FASB issued amendments that provide guidance on eight specific statement of cash flow classification issues, including distributions received from equity method investees. +January 1, 2018 +The Company elected nature of distribution for distributions received from equity method investees. The adoption of this guidance did not have a significant impact on the Company's financial position, statement of cash flows, results of operations, or disclosures. +104 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2016-09 +Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting +In March 2016, the FASB issued amendments which simplify several aspects for share-based payment award transactions, including the income tax consequences, classification of awards as either liability or equity, classification of taxes paid on the statement of cash flows and treatment of forfeitures. +January 1, 2017 +As a result of applying this requirement, the Company believes that recognition of excess tax benefits will increase volatility in its statement of operations and the Company made an entity-wide accounting policy election to estimate the number of awards that are expected to vest (consistent with the Company's prior policy), but the adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, statements of cash flows, or disclosures. +ASU 2016-07 +Investments - Equity Method and Joint Ventures - Simplifying the Transition to the Equity Method of +Accounting +In March 2016, the FASB issued amendments which eliminate the requirement that when an investment +qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. Per the amendments, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-06 +Derivatives and Hedging - Contingent Put and Call Options in Debt Instruments +In March 2016, the FASB issued amendments which clarify what steps are required when assessing whether the economic characteristics and risks of call (put) options are clearly and closely related to the economic characteristics and risks of their debt hosts, which is one of the criteria for bifurcating an embedded derivative. Consequently, when a call (put) option is contingently exercisable, an entity does not have to assess whether the event that triggers the ability to exercise a call (put) option is related to interest rates or credit risks. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-05 +Derivatives and Hedging - Effect of Derivative Contract Novations on Existing Hedge Accounting +Relationships +In March 2016, the FASB issued amendments which clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria remain intact. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +105 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2016-01 +Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities +In January 2016, the FASB issued guidance to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The main provisions of this guidance require certain equity investments to be measured at fair value with changes in fair value recognized in net earnings; separate presentation in other comprehensive income for changes in fair value of financial liabilities measured under the fair value option that are due to instrument-specific credit risk; and changes in disclosures associated with the fair value of financial instruments. The guidance also clarifies that entities should evaluate the need for a valuation allowance on a deferred tax asset (DTA) related to available-for-sale (AFS) securities in combination with the entity's other DTAs. +January 1, 2018 +The Company recorded a cumulative effect adjustment with an increase to beginning 2018 retained earnings and a decrease to beginning 2018 AOCI of $148 million, net of taxes. +ASU 2015-16 +Business Combinations - Simplifying the Accounting for Measurement-Period Adjustments +In September 2015, the FASB issued guidance requiring that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustments are determined. In the same period’s financial statements, the acquirer is required to record income effects of the adjustments as if the accounting had been completed at the acquisition date. The acquirer is also required to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. +January 1, 2016 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2015-09 +Financial Services - Insurance - Disclosures about Short-Duration Contracts +In May 2015, the FASB issued updated guidance requiring enhanced disclosures by all insurance entities that issue short-duration contracts. The amendments require insurance entities to disclose for annual reporting periods information about the liability for unpaid claims and claim adjustment expenses. The amendments also require insurance entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses. In addition, the amendments require insurance entities to disclose for annual and interim reporting periods a roll-forward of the liability for unpaid claims and claim adjustment expenses. For health insurance claims, the amendments require the disclosure of the total of incurred-but-not-reported liabilities and expected development on reported claims included in the liability for unpaid claims and claim adjustment expenses. +December 31, 2016 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +106 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2015-07 +Fair Value Measurement - Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) +In May 2015, the FASB issued updated guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. +January 1, 2016 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2015-03 +Interest - Imputation of Interest - Simplifying the Presentation of Debt Issuance Costs +In April 2015, the FASB issued updated guidance to simplify presentation of debt issuance costs. The updated guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by this amendment. In August 2015, the FASB issued updated Securities and Exchange Commission (SEC) Staff guidance pertaining to the presentation of debt issuance costs related to line-of-credit arrangements. The guidance states that an entity may defer and present debt issuance costs as an asset, subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. +January 1, 2016 +The retrospective adoption of this accounting standard resulted in a $40 million reduction to notes payable and other assets as of December 31, 2015, the earliest balance sheet date presented in the period of adoption, but did not have a significant impact on the Company's financial position, results of operations, or disclosures. +107 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2015-02 +Consolidation - Amendments to the Consolidation Analysis +In February 2015, the FASB issued updated guidance that affects evaluation of whether limited partnerships and similar legal entities (limited liability corporations and securitization structures, etc.) are VIEs, evaluation of whether fees paid to a decision maker or a service provider are a variable interest, and evaluation of the effect of fee arrangements and the effect of related parties on the determination of the primary beneficiary under the VIE model for consolidation. The updated guidance eliminates the presumption that a general partner should consolidate a limited partnership. Limited partnership and similar legal entities that provide partners with either substantive kick-out rights or substantive participating rights over the general partner will now be evaluated under the voting interest model rather than the VIE model for consolidation. In situations where no single party has a controlling financial interest in a VIE, the related party relationships under common control should be considered in their entirety in determining whether that common control group has a controlling financial interest in the VIE. +January 1, 2016 +The adoption of this guidance impacted the Company's footnote disclosures, but did not have a significant impact on its financial position or results of operations. +ASU 2014-16 +Derivatives and Hedging - Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity +In November 2014, the FASB issued guidance to clarify how to evaluate the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. The guidance also clarifies that an entity should assess the substance of the relevant terms and features when considering how to weight those terms and features. +January 1, 2016 +The adoption of this guidance impacted the Company's footnote disclosures, but did not have a significant impact on its financial position or results of operations. +ASU 2014-15 +Presentation of Financial Statements - Going Concern - Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern +In August 2014, the FASB issued this amendment that provides U.S. GAAP guidance on management’s responsibility in evaluating whether there is substantial doubt about a company’s ability to continue as a going concern and about related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company’s ability to continue as a going concern within one year from the date the financial statements are issued. The new guidance requires a formal assessment of going concern by management based on criteria prescribed in the new guidance. +December 31, 2016 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations or disclosures and no substantial doubt currently exists about the Company's ability to continue as a going concern. +108 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2014-12 +Compensation - Stock Compensation - Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period +In June 2014, the FASB issued this amendment that provides guidance on certain share-based payment awards that require a specific performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance to awards with performance conditions that affect vesting to account for such awards. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. +January 1, 2016 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2014-09 +Revenue from Contracts with Customers +In May 2014, the FASB issued updated guidance that affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (e.g., insurance contracts or lease contracts). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +Accounting Pronouncements Pending Adoption +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2018-20 Leases: Narrow-Scope Improvements for Lessors +In December 2018, the FASB issued narrow-scope improvements for lessors which 1) provide an accounting policy election for lessors to exclude amounts collected from customers for all sales (and other similar) taxes from the transaction price; 2) require lessors to exclude the costs from variable lease revenue and the associated expense when the amount of those costs is not readily determinable by the lessor; and 3) require lessors to allocate (rather than recognize) certain variable payments to the lease and nonlease components when the changes in facts and circumstances on which the variable payment is based occur. The amendments are effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. +The Company has made an accounting policy election to exclude amounts collected from customers for all sales (and other similar) taxes from the transaction price. The adoption of this guidance is not expected to have a significant impact on the Company's financial position, results of operations, or disclosures. +109 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2018-17 Consolidation: Targeted Improvements to Related Party Guidance for Variable Interest Entities +In October 2018, the FASB issued targeted improvements which provide that indirect interests held through related parties under common control should be considered on a proportional basis for determining whether fees paid to decision makers and service providers are variable interests. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. +The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations or disclosures. +ASU 2018-15 +Intangibles - Goodwill and Other - Internal-Use Software, Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract +In August 2018, the FASB issued amendments to align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. +The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations or disclosures. +ASU 2018-14 +Compensation - Retirement Benefits - Defined Benefit Plans - General, Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans +In August 2018, the FASB issued amendments to modify the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. Accordingly, six disclosure requirements were removed, two added and two clarified. The amendments are effective for public business entities for fiscal years beginning after December 15, 2020. Early adoption is permitted. +The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2018-13 +Fair Value Measurement, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement +In August 2018, the FASB issued amendments to the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement. The amendments remove, modify, and add certain disclosures. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted upon issuance of this Update. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this update and delay adoption of the additional disclosures until their effective date. +The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2018-12 +Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts +In August 2018, the FASB issued amendments that will significantly change how insurers account for long-duration contracts. The amendments will change existing recognition, measurement, presentation, and disclosure requirements. Issues addressed in the new guidance include: 1) a requirement to review and, if there is a change, update assumptions for the liability for future policy benefits at least annually, and to update the discount rate assumption quarterly, 2) accounting for market risk benefits at fair value, 3) simplified amortization for deferred acquisition costs, and 4) enhanced financial statement presentation and disclosures. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early application of the amendments is permitted. +The Company is thoroughly evaluating the impact of adoption and expects that the adoption will have a significant impact on the Company’s financial position, results of operations, and disclosures. The Company anticipates that the requirement to update assumptions for liability for future policy benefits will have a significant impact on its results of operations, systems, processes and controls while the requirement to update the discount rate will have a significant impact on its equity. The Company does not expect to early adopt the updated standard. +110 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2018-11 +Leases, Targeted Improvements +In July 2018, the FASB issued targeted improvements to Topic 842 Leases. The amendments in the update provide entities with an optional transition method to adopt the new leases standard by recording a cumulative effect adjustment to beginning retained earnings. Additionally, the amendments provide lessors with a practical expedient to not separate nonlease components from associated lease components and instead account for those components as a single component under certain conditions. The amendments are effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. +The Company has elected the optional transition method. The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2018-10 +Codification Improvements to Topic 842, Leases +In July 2018, the FASB issued guidance which clarifies, corrects errors in, or makes minor improvements to the Codification related to ASU 2016-02, Leases (Topic 842). The amendments in this ASU affect narrow aspects of the guidance issued in the amendments to ASU 2016-02, including but not limited to, Residual Value Guarantees, Rate Implicit in the Lease, Lessee Reassessment of Lease Classification and Variable Lease Payments that Depend on an Index or a Rate. Amendments within this ASU follow the effective dates of Topic 842, which are effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. +The adoption of this guidance is not expected to have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2018-01 +Leases: Land Easement Practical Expedient for Transition to Topic 842 +In January 2018, the FASB issued guidance which provides an entity with the option to elect a transition practical expedient to not evaluate, under Topic 842, land easements that exist or expired before the entity's adoption of Topic 842 and that were not previously accounted for as leases under Topic 840. The amendments clarify that new or modified land easements should be evaluated under the new leases standard once an entity has adopted the new standard. The amendments are effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. +As of December 31, 2018, the Company did not have land easements, but has elected this practical expedient as a safe harbor. The adoption of this guidance is not expected to have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-04 +Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment +In January 2017, the FASB issued amendments simplifying the subsequent measurement of goodwill. An entity is no longer required to perform a hypothetical purchase price allocation to measure goodwill impairment. Instead, the entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The amendments are effective for public business entities that are SEC filers for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for any goodwill impairment tests performed on testing dates after January 1, 2017. +The adoption of this guidance is not expected to have a significant impact on the Company's financial position, results of operations, or disclosures. +111 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2016-13 +Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments +In June 2016, the FASB issued amendments that require a financial asset (or a group of financial assets) measured on an amortized cost basis to be presented net of an allowance for credit losses in order to reflect the amount expected to be collected on the financial asset(s). The measurement of expected credit losses is amended by replacing the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform about a credit loss. Credit losses on available-for-sale debt securities will continue to be measured in a manner similar to current U.S. GAAP; however, the amendments require that credit losses be presented as an allowance rather than as a write-down. Other amendments include changes to the balance sheet presentation and interest income recognition of purchased financial assets with a more-than-insignificant amount of credit deterioration since origination (PCD financial assets). The amendments are effective for public companies for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Companies may early adopt this guidance as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The amendments will be adopted following a modified-retrospective approach resulting in a cumulative effect adjustment in retained earnings as of the beginning of the year of adoption. Two exceptions to this adoption method are for PCD financial assets and debt securities for which other-than-temporary impairment (OTTI) will have been recognized before the effective date. Loans purchased with credit deterioration accounted for under current U.S. GAAP as "purchased credit impaired" (PCI) financial assets will be classified as PCD financial assets at transition and PCD guidance will be applied prospectively. Debt securities that have experienced OTTI before the effective date will follow a prospective adoption method which allows an entity to maintain the same amortized cost basis before and after the effective date. +The Company has identified certain financial instruments in scope of this guidance to include certain fixed maturity securities, loans and loan receivables and reinsurance recoverables (See Notes 3 and 7 for current balances of instruments in scope). The Company is continuing its progress towards updating its credit loss projection models and accounting systems in order to comply with the required changes in measurement of credit losses. The Company currently expects loans and loan receivables and held-to-maturity fixed maturity securities to be the asset classes most significantly impacted upon adoption of the guidance. The Company continues to evaluate the impact of adoption of this guidance on its financial position, results of operations, and disclosures. +112 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2016-02 +Leases +In February 2016, the FASB issued updated guidance for accounting for leases. Per the amendments, lessees will be required to recognize all leases on the balance sheet with the exception of short-term leases. A lease liability will be recorded for the obligation of a lessee to make lease payments arising from a lease. Leases will be classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the income statement. The new standard is effective for the Company on January 1, 2019. A modified retrospective transition approach is required, applying the new standard to all leases existing at the date of initial application. The Company is electing to use its effective date as its date of initial application. Because the Company expects to adopt the new standard on January 1, 2019 and use the effective date as the date of initial application, financial information is not required to be updated and the disclosures required under the new standard are not required to be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients. The Company has elected the "package of practical expedients," which permits the Company not to reassess under the new standard its prior conclusions about lease identification, lease classification and initial direct costs. Under the new guidance, lessor accounting is largely unchanged. The amendments are effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. +The Company has identified certain operating leases in scope of this guidance to include office space and equipment leases (See Note 15). The leases within scope of this guidance will increase the Company's right-of-use assets and lease liabilities recorded on its statement of financial position by approximately $100 to $200 million. The Company estimates that the adoption of this guidance will not have a significant impact on its financial position, results of operations, or disclosures. +Recent accounting guidance not discussed above is not applicable, did not have, or is not expected to have a material impact to the Company's business. +2. +BUSINESS SEGMENT AND FOREIGN INFORMATION +The Company consists of two reportable insurance business segments: Aflac Japan and Aflac U.S., both of which sell supplemental health and life insurance. Operating business segments that are not individually reportable and business activities, including reinsurance retrocession activities, not included in Aflac Japan or Aflac U.S. are included in the "Corporate and other" category. +The Company does not allocate corporate overhead expenses to business segments. Consistent with U.S. GAAP accounting guidance for segment reporting, the Company evaluates and manages its business segments using a financial performance measure called pretax adjusted earnings. Adjusted earnings are adjusted revenues less benefits and adjusted expenses. The adjustments to both revenues and expenses account for certain items that cannot be predicted or that are outside management’s control. Adjusted revenues are U.S. GAAP total revenues excluding realized investment gains and losses, except for amortized hedge costs related to foreign currency exposure management strategies and net interest cash flows from derivatives associated with certain investment strategies. Adjusted expenses are U.S. GAAP total acquisition and operating expenses including the impact of interest cash flows from derivatives associated with notes payable but excluding any nonrecurring or other items not associated with the normal course of the Company’s insurance operations and that do not reflect Aflac’s underlying business performance. The Company excludes income taxes related to operations to arrive at pretax adjusted earnings. Information regarding operations by segment for the years ended December 31 follows: +113 +Item 8. Financial Statements and Supplementary Data +(In millions) +2018 +2017 +2016 +Revenues: +Aflac Japan: +Net earned premiums: +Cancer +$ +5,849 +$ +5,612 +$ +5,639 +Medical and other health +3,516 +3,379 +3,429 +Life insurance +3,397 +3,761 +4,469 +Net investment income, less amortized hedge costs +2,403 +2,235 +2,368 +Other income +41 +41 +40 +Total Aflac Japan +15,206 +15,028 +15,945 +Aflac U.S.: +Net earned premiums: +Accident/disability +2,611 +2,537 +2,469 +Cancer +1,311 +1,308 +1,299 +Other health +1,508 +1,445 +1,415 +Life insurance +278 +273 +271 +Net investment income +727 +721 +703 +Other income +8 +5 +10 +Total Aflac U.S. +6,443 +6,289 +6,167 +Corporate and other +339 +272 +275 +Total adjusted revenues +21,988 +21,589 +22,387 +Realized investment gains (losses) (1),(2),(3) +( 230 +) +78 +172 +Total revenues +$ +21,758 +$ +21,667 +$ +22,559 +(1) Amortized hedge costs related to hedging U.S. dollar-denominated investments held in Aflac Japan were $ 236 , $ 228 and $ 186 for 2018 , 2017 and 2016 , respectively, and have been reclassified from realized investment gains (losses) and reported as a deduction from net investment income when analyzing segment operations. +(2) Amortized hedge costs in Aflac Japan were partially offset by derivatives entered into as part of corporate activities and resulted in a benefit of $ 36 for 2018 , which has been reclassified from realized investment gains (losses) and reported as an increase in net investment income when analyzing operations. +(3) An immaterial amount of net interest cash flows from derivatives associated with certain investment strategies in 2018 , were reclassified from realized investment gains (losses) into net investment income when analyzing operations. +114 +Item 8. Financial Statements and Supplementary Data +(In millions) +2018 +2017 +2016 +Pretax earnings: +Aflac Japan +$ +3,208 +$ +3,054 +$ +3,148 +Aflac U.S. +1,285 +1,245 +1,208 +Corporate and other +( 139 +) +( 212 +) +( 239 +) +Pretax adjusted earnings +4,354 +4,087 +4,117 +Realized investment gains (losses) (1),(2),(3),(4) +( 297 +) +0 +87 +Other income (loss) (5) +( 74 +) +( 69 +) +( 137 +) +Total earnings before income taxes +$ +3,983 +$ +4,018 +$ +4,067 +Income taxes applicable to pretax adjusted earnings +$ +1,129 +$ +1,370 +$ +1,426 +Effect of foreign currency translation on after-tax +adjusted earnings +28 +( 41 +) +141 +(1) Amortized hedge costs related to hedging U.S. dollar-denominated investments held in Aflac Japan were $ 236 , $ 228 and $ 186 for 2018 , 2017 and 2016 , respectively, and have been reclassified from realized investment gains (losses) and reported as a deduction from pretax adjusted earnings when analyzing segment operations. +(2) Amortized hedge costs in Aflac Japan were partially offset by derivatives entered into as part of corporate activities and resulted in a benefit of $ 36 for 2018 , which has been reclassified from realized investment gains (losses) and reported as an increase in pretax adjusted earnings when analyzing operations. +(3) An immaterial amount of net interest cash flows from derivatives associated with certain investment strategies in 2018, were reclassified from realized investment gains (losses) into net investment income when analyzing operations. +(4) Excluding a gain of $ 67 in 2018 , $ 77 in 2017 and $ 85 in 2016 , related to the interest rate component of the change in fair value of foreign currency swaps on notes payable which is included in adjusted earnings when analyzing segment operations +(5) Includes expense of $ 13 in 2017 and $ 137 in 2016 for the early extinguishment of debt +Assets as of December 31 were as follows: +(In millions) +2018 +2017 +Assets: +Aflac Japan +$ +118,342 +$ +114,402 +Aflac U.S. +19,100 +19,893 +Corporate and other +2,964 +2,922 +Total assets +$ +140,406 +$ +137,217 +Yen-Translation Effects:  The following table shows the yen/dollar exchange rates used for or during the periods ended December 31 . Exchange effects were calculated using the same yen/dollar exchange rate for the current year as for each respective prior year. +2018 +2017 +2016 +Statements of Earnings: +Weighted-average yen/dollar exchange rate (1) +110.39 +112.16 +108.70 +Yen percent strengthening (weakening) +1.6 +% +( 3.1 +)% +11.3 +% +Exchange effect on pretax operating earnings (in millions) +$ +38 +$ +( 63 +) +$ +218 +2018 +2017 +Balance Sheets: +Yen/dollar exchange rate at December 31 (1) +111.00 +113.00 +Yen percent strengthening (weakening) +1.8 +% +3.1 +% +Exchange effect on total assets (in millions) +$ +1,362 +$ +2,593 +Exchange effect on total liabilities (in millions) +1,270 +2,848 +(1) Rates are based on the published MUFG Bank, Ltd. telegraphic transfer middle rate (TTM) +Transfers of funds from Aflac Japan:  Aflac Japan makes payments to the Parent Company for management fees, allocated expenses and remittances of earnings. Prior to the Aflac Japan branch conversion on April 1, 2018, Aflac Japan paid allocated expenses and profit remittances to Aflac U.S. Information on transfers for each of the years ended December 31 is shown below. See Note 13 for information concerning restrictions on transfers from Aflac Japan. +115 +Item 8. Financial Statements and Supplementary Data +(In millions) +2018 +2017 +2016 +Management fees +$ +136 +$ +93 +$ +79 +Allocated expenses +24 +109 +106 +Profit remittances +808 +1,150 +1,286 +Total transfers from Aflac Japan +$ +968 +$ +1,352 +$ +1,471 +Property and Equipment:  The costs of buildings, furniture and equipment are depreciated principally on a straight-line basis over their estimated useful lives (maximum of 50 years for buildings and 20 years for furniture and equipment). Expenditures for maintenance and repairs are expensed as incurred; expenditures for betterments are capitalized and depreciated. Classes of property and equipment as of December 31 were as follows: +(In millions) +2018 +2017 +Property and equipment: +Land +$ +168 +$ +168 +Buildings +456 +441 +Equipment and furniture +400 +372 +Total property and equipment +1,024 +981 +Less accumulated depreciation +581 +547 +Net property and equipment +$ +443 +$ +434 +Receivables:  Receivables consist primarily of monthly insurance premiums due from individual policyholders or their employers for payroll deduction of premiums, net of an allowance for doubtful accounts. At December 31, 2018 , $ 334 million , or 39.2 % of total receivables, were related to Aflac Japan's operations, compared with $ 334 million , or 40.4 % , at December 31, 2017 . +3. INVESTMENTS +Net Investment Income +The components of net investment income for the years ended December 31 were as follows: +(In millions) +2018 +2017 +2016 +Fixed maturity securities +$ +3,142 +$ +3,173 +$ +3,308 +Equity securities +38 +42 +35 +Other investments +369 +94 +31 +Short-term investments and cash equivalents +41 +25 +11 +Gross investment income +3,590 +3,334 +3,385 +Less investment expenses +148 +114 +107 +Net investment income +$ +3,442 +$ +3,220 +$ +3,278 +116 +Item 8. Financial Statements and Supplementary Data +Investment Holdings +The amortized cost for the Company's investments in fixed maturity securities, the cost for equity securities and the fair values of these investments at December 31 are shown in the following tables. +2018 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities available for sale, carried at fair value +through other comprehensive income: +Fixed maturity securities: (1) +Yen-denominated: +Japan government and agencies +$ +30,637 +$ +3,700 +$ +140 +$ +34,197 +Municipalities +385 +32 +9 +408 +Mortgage- and asset-backed securities +155 +22 +0 +177 +Public utilities +1,732 +280 +4 +2,008 +Sovereign and supranational +826 +123 +0 +949 +Banks/financial institutions +5,440 +502 +238 +5,704 +Other corporate +4,852 +649 +44 +5,457 +Total yen-denominated +44,027 +5,308 +435 +48,900 +U.S. dollar-denominated: +U.S. government and agencies +137 +9 +1 +145 +Municipalities +1,343 +120 +8 +1,455 +Mortgage- and asset-backed securities +155 +8 +1 +162 +Public utilities +4,772 +496 +105 +5,163 +Sovereign and supranational +251 +60 +0 +311 +Banks/financial institutions +2,860 +389 +35 +3,214 +Other corporate +23,311 +1,343 +1,109 +23,545 +Total U.S. dollar-denominated +32,829 +2,425 +1,259 +33,995 +Total securities available for sale +$ +76,856 +(1) +$ +7,733 +$ +1,694 +$ +82,895 +(1) +(1) Includes perpetual securities ( $ 1,139 at amortized cost and $ 1,140 at fair value) +2018 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Yen-denominated: +Japan government and agencies +$ +21,712 +$ +5,326 +$ +0 +$ +27,038 +Municipalities +359 +110 +0 +469 +Mortgage- and asset-backed securities +14 +1 +0 +15 +Public utilities +2,727 +254 +8 +2,973 +Sovereign and supranational +1,551 +289 +0 +1,840 +Banks/financial institutions +1,445 +158 +20 +1,583 +Other corporate +2,510 +332 +38 +2,804 +Total yen-denominated +30,318 +6,470 +66 +36,722 +Total securities held to maturity +$ +30,318 +$ +6,470 +$ +66 +$ +36,722 +117 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Fair +Value +Equity securities, carried at fair value through +net earnings: +Equity securities: (1) +Yen-denominated +$ +641 +U.S. dollar-denominated +346 +Total equity securities +$ +987 +(1) +(1) Includes perpetual securities ( $ 62 at fair value) +2017 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities available for sale, carried at fair value: +Fixed maturity securities: (1) +Yen-denominated: +Japan government and agencies +$ +27,980 +$ +3,363 +$ +271 +$ +31,072 +Municipalities +314 +28 +12 +330 +Mortgage- and asset-backed securities +242 +29 +0 +271 +Public utilities +1,635 +352 +6 +1,981 +Sovereign and supranational +1,380 +190 +1 +1,569 +Banks/financial institutions +4,742 +811 +53 +5,500 +Other corporate +4,085 +809 +7 +4,887 +Total yen-denominated +40,378 +5,582 +350 +45,610 +U.S dollar-denominated: +U.S. government and agencies +146 +13 +1 +158 +Municipalities +872 +168 +0 +1,040 +Mortgage- and asset-backed securities +161 +12 +0 +173 +Public utilities +5,116 +884 +27 +5,973 +Sovereign and supranational +267 +73 +0 +340 +Banks/financial institutions +2,808 +633 +8 +3,433 +Other corporate +25,384 +2,620 +418 +27,586 +Total U.S. dollar-denominated +34,754 +4,403 +454 +38,703 +Total securities available for sale +$ +75,132 +(1) +$ +9,985 +$ +804 +$ +84,313 +(1) +(1) Includes perpetual securities ( $ 1,462 at amortized cost and $ 1,789 at fair value) +118 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Yen-denominated: +Japan government and agencies +$ +21,331 +$ +5,160 +$ +0 +$ +26,491 +Municipalities +357 +105 +0 +462 +Mortgage- and asset-backed securities +26 +1 +0 +27 +Public utilities +3,300 +398 +0 +3,698 +Sovereign and supranational +1,523 +312 +0 +1,835 +Banks/financial institutions +2,206 +190 +9 +2,387 +Other corporate +2,687 +485 +0 +3,172 +Total yen-denominated +31,430 +6,651 +9 +38,072 +Total securities held to maturity +$ +31,430 +$ +6,651 +$ +9 +$ +38,072 +2017 +(In millions) +Fair +Value +Equity securities, carried at fair value: +Equity securities: +Yen-denominated +$ +695 +U.S. dollar-denominated +328 +Total equity securities +$ +1,023 +The methods of determining the fair values of the Company's investments in fixed maturity securities and equity securities are described in Note 5. +During 2018, the Company did not reclassify any investments from the held-to-maturity category to the available-for-sale category. During 2017, the Company reclassified three investments from the held-to-maturity category to the available-for-sale category as a result of the issuers' credit rating being downgraded to below investment grade. At the time of the transfer, the securities had an aggregate amortized cost of $ 773 million and an aggregate unrealized gain of $ 47 million . During 2016, the Company did not reclassify any investments from the held-to-maturity category to the available-for-sale category. +119 +Item 8. Financial Statements and Supplementary Data +Contractual and Economic Maturities +The contractual maturities of the Company's investments in fixed maturity securities at December 31, 2018 , were as follows: +(In millions) +Amortized +Cost +Fair +Value +Available for sale: (1) +Due in one year or less +$ +810 +$ +861 +Due after one year through five years +8,313 +8,312 +Due after five years through 10 years +9,805 +10,355 +Due after 10 years +57,618 +63,028 +Mortgage- and asset-backed securities +310 +339 +Total fixed maturity securities available for sale +$ +76,856 +$ +82,895 +Held to maturity: +Due in one year or less +$ +180 +$ +182 +Due after one year through five years +915 +948 +Due after five years through 10 years +927 +1,004 +Due after 10 years +28,282 +34,573 +Mortgage- and asset-backed securities +14 +15 +Total fixed maturity securities held to maturity +$ +30,318 +$ +36,722 +(1) Includes perpetual securities, categorized in accordance with their respective economic maturities (the expected maturity date created by the combination of features in the financial instrument) +Expected maturities may differ from contractual maturities because some issuers have the right to call or prepay obligations with or without call or prepayment penalties. +Investment Concentrations +The Company's process for investing in credit-related investments begins with an independent approach to underwriting each issuer's fundamental credit quality. The Company evaluates independently those factors that it believes could influence an issuer's ability to make payments under the contractual terms of the Company's instruments. This includes a thorough analysis of a variety of items including the issuer's country of domicile (including political, legal, and financial considerations); the industry in which the issuer competes (with an analysis of industry structure, end-market dynamics, and regulation); company specific issues (such as management, assets, earnings, cash generation, and capital needs); and contractual provisions of the instrument (such as financial covenants and position in the capital structure). The Company further evaluates the investment considering broad business and portfolio management objectives, including asset/liability needs, portfolio diversification, and expected income. +Investment exposures that individually exceeded 10% of shareholders' equity as of December 31 were as follows: +2018 +2017 +(In millions) +Credit +Rating +Amortized +Cost +Fair +Value +Credit +Rating +Amortized +Cost +Fair +Value +Japan National Government (1) +A+ +$ 51,207 +$ 59,945 +A +$ 48,399 +$ 56,532 +(1) Japan Government Bonds (JGBs) or JGB-backed securities +Realized Investment Gains and Losses +Information regarding pretax realized gains and losses from investments for the years ended December 31 follows: +120 +Item 8. Financial Statements and Supplementary Data +(In millions) +2018 +2017 +2016 +Realized investment gains (losses): +Fixed maturity securities: (1) +Available for sale: +Gross gains from sales +$ +101 +$ +51 +$ +177 +Gross losses from sales +( 156 +) +( 68 +) +( 62 +) +Foreign currency gains (losses) on sales and redemptions +73 +( 48 +) +4 +Other-than-temporary impairment losses +( 64 +) +( 7 +) +( 26 +) +Total fixed maturity securities +( 46 +) +( 72 +) +93 +Equity securities (1),(2) +( 131 +) +71 +(3) +( 35 +) +(3) +Loan receivables: +Loan loss reserves +( 17 +) +( 8 +) +( 2 +) +Other gains (losses) on loans +( 2 +) +0 +0 +Total loan receivables +( 19 +) +( 8 +) +( 2 +) +Derivatives and other: +Derivative gains (losses) +( 224 +) +( 109 +) +( 255 +) +Foreign currency gains (losses) +( 10 +) +( 33 +) +185 +Total derivatives and other +( 234 +) +( 142 +) +( 70 +) +Total realized investment gains (losses) +$ +( 430 +) +$ +( 151 +) +$ +( 14 +) +(1) Includes perpetual securities +(2) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +(3) Includes impairments of $ 22 in 2017 and $ 57 in 2016 +The unrealized holding losses , net of gains , recorded as a component of realized investment gains and losses for the year ended December 31, 2018 , that relates to equity securities still held at the December 31, 2018 , reporting date was $ 124 million . +Unrealized Investment Gains and Losses +Information regarding changes in unrealized gains and losses from investments recorded in AOCI for the years ended December 31 follows: +(In millions) +2018 +2017 +2016 +Changes in unrealized gains (losses): +Fixed maturity securities, available for sale (1) +$ +( 3,142 +) +$ +1,657 +$ +2,711 +Equity securities (2) +0 +71 +88 +Total change in unrealized gains (losses) +$ +( 3,142 +) +$ +1,728 +$ +2,799 +(1) Includes perpetual securities +(2) See Note 1 and Note 11 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance and the cumulative effect of the change in accounting principle related to financial instruments effective January 1, 2018. +Effect on Shareholders' Equity +The net effect on shareholders' equity of unrealized gains and losses from investment securities at December 31 was as follows: +(In millions) +2018 +2017 +Unrealized gains (losses) on securities available for sale +$ +6,039 +$ +9,358 +Deferred income taxes +( 1,805 +) +( 3,394 +) +Shareholders’ equity, unrealized gains (losses) on investment securities +$ +4,234 +$ +5,964 +See Notes 1 and 10 for discussion of the accounting treatment of tax on amounts recorded in accumulated other comprehensive income pursuant to the Tax Act and Note 1 for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +121 +Item 8. Financial Statements and Supplementary Data +Gross Unrealized Loss Aging +The following tables show the fair values and gross unrealized losses of the Company's available-for-sale and held-to-maturity investments that were in an unrealized loss position, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31 . +2018 +Total +Less than 12 months +12 months or longer +(In millions) +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fixed maturity securities: (1) +U.S. government and +agencies: +U.S. dollar-denominated +$ +67 +$ +1 +$ +67 +$ +1 +$ +0 +$ +0 +Japan government and +agencies: +Yen-denominated +3,604 +140 +3,604 +140 +0 +0 +Municipalities: +U.S. dollar-denominated +515 +8 +515 +8 +0 +0 +Yen-denominated +148 +9 +148 +9 +0 +0 +Mortgage- and asset- +backed securities: +U.S. dollar-denominated +74 +1 +74 +1 +0 +0 +Public utilities: +U.S. dollar-denominated +1,585 +105 +892 +48 +693 +57 +Yen-denominated +604 +12 +604 +12 +0 +0 +Banks/financial institutions: +U.S. dollar-denominated +625 +35 +340 +19 +285 +16 +Yen-denominated +3,057 +258 +3,057 +258 +0 +0 +Other corporate: +U.S. dollar-denominated +12,899 +1,109 +5,782 +407 +7,117 +702 +Yen-denominated +1,306 +82 +1,306 +82 +0 +0 +Total +$ +24,484 +$ +1,760 +$ +16,389 +$ +985 +$ +8,095 +$ +775 +(1) Includes perpetual securities +122 +Item 8. Financial Statements and Supplementary Data +2017 +Total +Less than 12 months +12 months or longer +(In millions) +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fixed maturity securities: (1) +U.S. government and +agencies: +U.S. dollar-denominated +$ +74 +$ +1 +$ +74 +$ +1 +$ +0 +$ +0 +Japan government and +agencies: +Yen-denominated +5,255 +271 +1,264 +9 +3,991 +262 +Municipalities: +Yen-denominated +129 +12 +10 +0 +119 +12 +Public utilities: +U.S. dollar-denominated +785 +27 +221 +3 +564 +24 +Yen-denominated +83 +6 +0 +0 +83 +6 +Sovereign and supranational: +Yen-denominated +309 +1 +309 +1 +0 +0 +Banks/financial institutions: +U.S. dollar-denominated +362 +8 +316 +5 +46 +3 +Yen-denominated +1,507 +62 +394 +4 +1,113 +58 +Other corporate: +U.S. dollar-denominated +7,741 +418 +2,839 +50 +4,902 +368 +Yen-denominated +440 +7 +349 +4 +91 +3 +Total +$ +16,685 +$ +813 +$ +5,776 +$ +77 +$ +10,909 +$ +736 +(1) Includes perpetual securities +Analysis of Securities in Unrealized Loss Positions +The unrealized losses on the Company's fixed maturity securities investments have been primarily related to general market changes in interest rates, foreign exchange rates, and/or the levels of credit spreads rather than specific concerns with the issuer's ability to pay interest and repay principal. +For any significant declines in fair value of its fixed maturity securities, the Company performs a more focused review of the related issuers' credit profile. For corporate issuers, the Company evaluates their assets, business profile including industry dynamics and competitive positioning, financial statements and other available financial data. For non-corporate issuers, the Company analyzes all sources of credit support, including issuer-specific factors. The Company utilizes information available in the public domain and, for certain private placement issuers, from consultations with the issuers directly. The Company also considers ratings from Nationally Recognized Statistical Rating Organizations (NRSROs), as well as the specific characteristics of the security it owns including seniority in the issuer's capital structure, covenant predictions, or other relevant features. From these reviews, the Company evaluates the issuers' continued ability to service the Company's investment through payment of interest and principal. +Assuming no credit-related factors develop, unrealized gains and losses on fixed maturity securities are expected to diminish as investments near maturity. Based on its credit analysis, the Company believes that the issuers of its fixed maturity investments in the sectors shown in the table above have the ability to service their obligations to the Company. +123 +Item 8. Financial Statements and Supplementary Data +Other Investments +The table below reflects the composition of the carrying value for other investments as of December 31. +(In millions) +2018 +2017 +Other investments: +Transitional real estate loans +$ +4,377 +$ +1,235 +Commercial mortgage loans +1,064 +908 +Middle market loans +1,478 +859 +Policy loans +232 +210 +Short-term investments +152 +57 +Other +403 +133 +Total other investments +$ +7,706 +$ +3,402 +Loans and Loan Receivables +The Company classifies its TREs, CMLs, and MMLs as held-for investment and includes them in the other investments line on the consolidated balance sheets. The Company carries them on the balance sheet at amortized cost less an estimated allowance for loan losses. The Company's allowance for loan losses is established using both general and specific allowances. The general allowance is used for loans grouped by similar risk characteristics where a loan-specific or market-specific risk has not been identified, but for which the Company estimates probable incurred losses. The specific allowance is used on an individual loan basis when it is probable that a loss has been incurred. As of December 31, 2018 and 2017 , the Company's allowance for loan losses was $ 27 million and $ 11 million , respectively. As of December 31, 2018 and 2017 , the Company had no loans that were past due in regards to principal and/or interest payments. Additionally, the Company held no loans that were on nonaccrual status or considered impaired as of December 31, 2018 and 2017 . The Company had no troubled debt restructurings during the years ended December 31, 2018 and 2017 . +Transitional Real Estate Loans +Transitional real estate loans are commercial mortgage loans that are typically relatively short-term floating rate instruments secured by a first lien on the property. These loans provide funding for properties undergoing a change in their physical characteristics and/or economic profile. As of December 31, 2018 , the Company had $ 605 million in outstanding commitments to fund transitional real estate loans. These commitments are contingent on the final underwriting and due diligence to be performed. +Commercial Mortgage Loans +As of December 31, 2018 , the Company had $ 25 million in outstanding commitments to fund commercial mortgage loans. These commitments are contingent on the final underwriting and due diligence to be performed. +Middle Market Loans +Middle market loans are generally considered to be below investment grade. The carrying value for middle market loans included an unfunded amount of $ 56 million and $ 109 million , as of December 31, 2018 , and 2017 , respectively, that is reflected in other liabilities on the consolidated balance sheets. +As of December 31, 2018 , the Company had commitments of approximately $ 521 million to fund potential future loan originations related to this investment program. These commitments are contingent upon the availability of middle market loans that meet the Company's underwriting criteria. +Other +Other investments primarily includes investments in limited partnerships. As of December 31, 2018 , the Company had $ 916 million in outstanding commitments to fund alternative investments in limited partnerships. +124 +Item 8. Financial Statements and Supplementary Data +Variable Interest Entities (VIEs) +As a condition of its involvement or investment in a VIE, the Company enters into certain protective rights and covenants that preclude changes in the structure of the VIE that would alter the creditworthiness of the Company's investment or its beneficial interest in the VIE. +For those VIEs other than certain unit trust structures, the Company's involvement is passive in nature. The Company has not, nor has it been, required to purchase any securities issued in the future by these VIEs. +The Company's ownership interest in VIEs is limited to holding the obligations issued by them. The Company has no direct or contingent obligations to fund the limited activities of these VIEs, nor does it have any direct or indirect financial guarantees related to the limited activities of these VIEs. The Company has not provided any assistance or any other type of financing support to any of the VIEs it invests in, nor does it have any intention to do so in the future. For those VIEs in which the Company holds debt obligations, the weighted-average lives of the Company's notes are very similar to the underlying collateral held by these VIEs where applicable. +The Company's risk of loss related to its interests in any of its VIEs is limited to the carrying value of the related investments held in the VIE. +VIEs - Consolidated +The following table presents the cost or amortized cost, fair value and balance sheet caption in which the assets and liabilities of consolidated VIEs are reported as of December 31. +Investments in Consolidated Variable Interest Entities +2018 +2017 +(In millions) +Cost or Amortized +Cost +Fair +Value +Cost or Amortized +Cost +Fair +Value +Assets: +Fixed maturity securities, available for sale (1) +$ +3,849 +$ +4,466 +$ +4,538 +$ +5,509 +Equity securities +160 +160 +606 +753 +Other investments (2) +5,856 +5,834 +2,341 +2,328 +Other assets (3) +182 +182 +151 +151 +Total assets of consolidated VIEs +$ +10,047 +$ +10,642 +$ +7,636 +$ +8,741 +Liabilities: +Other liabilities (3) +$ +102 +$ +102 +$ +128 +$ +128 +Total liabilities of consolidated VIEs +$ +102 +$ +102 +$ +128 +$ +128 +(1) Includes perpetual securities +(2) Consists of TREs, CMLs, MMLs, and alternative investments in limited partnerships +(3) Consists entirely of derivatives +The Company is substantively the only investor in the consolidated VIEs listed in the table above. As the sole investor in these VIEs, the Company has the power to direct the activities of a variable interest entity that most significantly impact the entity's economic performance and is therefore considered to be the primary beneficiary of the VIEs that it consolidates. The Company also participates in substantially all of the variability created by these VIEs. The activities of these VIEs are limited to holding invested assets and foreign currency swaps, as appropriate, and utilizing the cash flows from these securities to service its investment. Neither the Company nor any of its creditors are able to obtain the underlying collateral of the VIEs unless there is an event of default or other specified event. For those VIEs that contain a swap, the Company is not a direct counterparty to the swap contracts and has no control over them. The Company's loss exposure to these VIEs is limited to its original investment. The Company's consolidated VIEs do not rely on outside or ongoing sources of funding to support their activities beyond the underlying collateral and swap contracts, if applicable. With the exception of its investments in unit trust structures, the underlying collateral assets and funding of the Company's consolidated VIEs are generally static in nature. +125 +Item 8. Financial Statements and Supplementary Data +Investments in Unit Trust Structures +The Company also utilizes unit trust structures in its Aflac Japan segment to invest in various asset classes. As the sole investor of these VIEs, the Company is required to consolidate these trusts under U.S. GAAP. +VIEs - Not Consolidated +The table below reflects the amortized cost, fair value and balance sheet caption in which the Company's investment in VIEs not consolidated are reported as of December 31. +Investments in Variable Interest Entities Not Consolidated +2018 +2017 +(In millions) +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +Assets: +Fixed maturity securities, available for sale (1) +$ +4,575 +$ +4,982 +$ +5,004 +$ +5,724 +Fixed maturity securities, held to maturity +2,007 +2,254 +2,549 +2,929 +Other investments +49 +49 +55 +55 +Total investments in VIEs not consolidated +$ +6,631 +$ +7,285 +$ +7,608 +$ +8,708 +(1) Includes perpetual securities +The Company holds alternative investments in limited partnerships that have been determined to be VIEs. These partnerships invest in private equity and structured investments. The Company’s maximum exposure to loss on these investments is limited to the amount of its investment. The Company is not the primary beneficiary of these VIEs and is therefore not required to consolidate them. The Company classifies these investments as Other investments in the consolidated balance sheets. +Certain investments in VIEs that the Company is not required to consolidate are investments that are in the form of debt obligations from the VIEs that are irrevocably and unconditionally guaranteed by their corporate parents or sponsors. These VIEs are the primary financing vehicles used by their corporate sponsors to raise financing in the capital markets. The variable interests created by these VIEs are principally or solely a result of the debt instruments issued by them. The Company does not have the power to direct the activities that most significantly impact the entity's economic performance, nor does it have the obligation to absorb losses of the entity or the right to receive benefits from the entity. As such, the Company is not the primary beneficiary of these VIEs and is therefore not required to consolidate them. +Securities Lending and Pledged Securities +The Company lends fixed maturity and public equity securities to financial institutions in short-term security-lending transactions. These short-term security-lending arrangements increase investment income with minimal risk. The Company's security lending policy requires that the fair value of the securities received as collateral be 102 % or more of the fair value of the loaned securities and that unrestricted cash received as collateral be 100 % or more of the fair value of the loaned securities. These securities continue to be carried as investment assets on the Company's balance sheet during the terms of the loans and are not reported as sales. The Company receives cash or other securities as collateral for such loans. For loans involving unrestricted cash or securities as collateral, the collateral is reported as an asset with a corresponding liability for the return of the collateral. For loans where the Company receives as collateral securities that the Company is not permitted to sell or repledge, the collateral is not reported as an asset. +126 +Item 8. Financial Statements and Supplementary Data +Details of our securities lending activities as of December 31 were as follows: +Securities Lending Transactions Accounted for as Secured Borrowings +2018 +Remaining Contractual Maturity of the Agreements +(In millions) +Overnight +and +Continuous (1) +Up to 30 +days +Greater +than 90 +days +Total +Securities lending transactions: +Fixed maturity securities: +Japan government and agencies +$ +0 +$ +387 +$ +1,190 +$ +1,577 +Municipalities +5 +0 +0 +5 +Public utilities +27 +0 +0 +27 +Banks/financial institutions +74 +0 +0 +74 +Other corporate +549 +0 +0 +549 +Equity securities +10 +0 +0 +10 +Total borrowings +$ +665 +$ +387 +$ +1,190 +$ +2,242 +Gross amount of recognized liabilities for securities lending transactions +$ +1,052 +Amounts related to agreements not included in offsetting disclosure in Note 4 +$ +1,190 +(1) These securities are pledged as collateral under the Company's U.S. securities lending program and can be called at its discretion; therefore, they are classified as Overnight and Continuous. +Securities Lending Transactions Accounted for as Secured Borrowings +2017 +Remaining Contractual Maturity of the Agreements +(In millions) +Overnight +and +Continuous (1) +Up to 30 +days +Total +Securities lending transactions: +Fixed maturity securities: +Japan government and agencies +$ +0 +$ +49 +$ +49 +Public utilities +73 +0 +73 +Banks/financial institutions +54 +0 +54 +Other corporate +415 +0 +415 +Equity securities +15 +0 +15 +Total borrowings +$ +557 +$ +49 +$ +606 +Gross amount of recognized liabilities for securities lending transactions +$ +606 +Amounts related to agreements not included in offsetting disclosure in Note 4 +$ +0 +(1) These securities are pledged as collateral under the Company's U.S. securities lending program and can be called at its discretion; therefore, they are classified as Overnight and Continuous. +The Company did not have any repurchase agreements or repurchase-to-maturity transactions outstanding as of December 31, 2018 and 2017 , respectively. +Certain fixed maturity securities can be pledged as collateral as part of derivative transactions, or pledged to support state deposit requirements on certain investment programs. For additional information regarding pledged securities related to derivative transactions, see Note 4. +At December 31, 2018 , debt securities with a fair value of $ 19 million were on deposit with regulatory authorities in the United States (including U.S. territories) and Japan. The Company retains ownership of all securities on deposit and receives the related investment income. +For general information regarding the Company's investment accounting policies, see Note 1. +127 +Item 8. Financial Statements and Supplementary Data +4. DERIVATIVE INSTRUMENTS +The Company's freestanding derivative financial instruments have historically consisted of: (1) foreign currency forwards and options used in hedging foreign exchange risk on U.S. dollar-denominated investments in Aflac Japan's portfolio; (2) foreign currency forwards and options used to economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long term exposure to a weakening yen; (3) cross-currency interest rate swaps, also referred to as foreign currency swaps, associated with certain senior notes and subordinated debentures; (4) foreign currency swaps and, in prior periods, credit default swaps that are associated with investments in special-purpose entities, including VIEs where the Company is the primary beneficiary; (5) interest rate swaps used to economically hedge interest rate fluctuations in certain variable-rate investments; and (6) interest rate swaptions used to hedge changes in the fair value associated with interest rate fluctuations for certain U.S. dollar-denominated available-for-sale fixed-maturity securities. Some of the Company's derivatives are designated as cash flow hedges, fair value hedges or net investment hedges; however, other derivatives do not qualify for hedge accounting or the Company elects not to designate them as accounting hedges. +Derivative Types +Foreign currency forwards and options are executed for the Aflac Japan segment in order to hedge the currency risk on the carrying value of certain U.S. dollar-denominated investments. The average maturity of these forwards and options can change depending on factors such as market conditions and types of investments being held. In situations where the maturity of the forwards and options is shorter than the underlying investment being hedged, the Company may enter into new forwards and options near maturity of the existing derivative in order to continue hedging the underlying investment. In forward transactions, Aflac Japan agrees with another party to buy a fixed amount of yen and sell a corresponding amount of U.S. dollars at a specified future date. Aflac Japan also executes foreign currency option transactions in a collar strategy, where Aflac Japan agrees with another party to simultaneously purchase put options and sell call options. In the purchased put transactions, Aflac Japan obtains the option to buy a fixed amount of yen and sell a corresponding amount of U.S. dollars at a specified future date. In the sold call transaction, Aflac Japan agrees to sell a fixed amount of yen and buy a corresponding amount of U.S. dollars at a specified future date. The combination of purchasing the put option and selling the call option results in no net premium being paid (i.e. a costless or zero-cost collar). The foreign currency forwards and options are used in fair value hedging relationships to mitigate the foreign exchange risk associated with U.S. dollar-denominated investments supporting yen- denominated liabilities. +Prior to April 1, 2018, foreign currency forwards and options (through a collar strategy, as discussed above) were used to hedge the currency risk associated with the net investment in Aflac Japan. In these forward transactions, Aflac agreed with another party to buy a fixed amount of U.S. dollars and sell a corresponding amount of yen at a specified price at a specified future date. In the option transactions, the Company used a combination of foreign currency options to protect expected future cash flows by simultaneously purchasing yen put options (options that protect against a weakening yen) and selling yen call options (options that limit participation in a strengthening yen). The combination of these two actions created a zero-cost collar. +The Company enters into foreign currency swaps pursuant to which it exchanges an initial principal amount in one currency for an initial principal amount of another currency, with an agreement to re-exchange the principal amounts at a future date. There may also be periodic exchanges of payments at specified intervals based on the agreed upon rates and notional amounts. Foreign currency swaps are used primarily in the consolidated VIEs in the Company's Aflac Japan portfolio to convert foreign-denominated cash flows to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations. The Company also uses foreign currency swaps to economically convert certain of its U.S. dollar-denominated senior note and subordinated debenture principal and interest obligations into yen-denominated obligations. +In order to reduce investment income volatility from its variable-rate investments, the Company enters into receive–fixed, pay–floating interest rate swaps. These derivatives are cleared and settled through a central clearinghouse. +Interest rate swaption collars are combinations of two swaption positions. Swaptions are used to mitigate the adverse impact resulting from significant changes in the fair value of U.S. dollar-denominated available-for-sale securities due to fluctuation in interest rates. In order to maximize the efficiency of the collars while minimizing cost, a collar strategy is used whereby the Company purchases a long payer swaption (the Company purchases an option that allows it to enter into a swap where the Company will pay the fixed rate and receive the floating rate of the swap) and sells a short receiver swaption (the Company sells an option that provides the counterparty with the right to enter into a swap where the Company will receive the fixed rate and pay the floating rate of the swap). The combination of purchasing the long payer swaption and selling the short receiver swaption results in no net premium being paid (i.e. a costless or zero-cost collar). +128 +Item 8. Financial Statements and Supplementary Data +Derivative Balance Sheet Classification +The tables below summarize the balance sheet classification of the Company's derivative fair value amounts, as well as the gross asset and liability fair value amounts, at December 31. The fair value amounts presented do not include income accruals. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and are not reflective of exposure or credit risk. +2018 +2017 +(In millions) +Asset +Derivatives +Liability +Derivatives +Asset +Derivatives +Liability +Derivatives +Hedge Designation/ Derivative +Type +Notional +Amount +Fair Value +Fair Value +Notional +Amount +Fair Value +Fair Value +Cash flow hedges: +Foreign currency swaps +$ +75 +$ +1 +$ +( 4 +) +$ +75 +$ +0 +$ +( 8 +) +Total cash flow hedges +75 +1 +( 4 +) +75 +0 +( 8 +) +Fair value hedges: +Foreign currency forwards +2,086 +0 +( 34 +) +7,640 +2 +( 221 +) +Foreign currency options +9,070 +3 +( 1 +) +7,670 +0 +( 2 +) +Interest rate swaptions +500 +0 +( 1 +) +0 +0 +0 +Total fair value hedges +11,656 +3 +( 36 +) +15,310 +2 +( 223 +) +Net investment hedge: +Foreign currency forwards +0 +0 +0 +5 +0 +0 +Foreign currency options +0 +0 +0 +434 +12 +( 1 +) +Total net investment hedge +0 +0 +0 +439 +12 +( 1 +) +Non-qualifying strategies: +Foreign currency swaps +5,387 +284 +( 230 +) +5,386 +296 +( 189 +) +Foreign currency forwards +16,057 +126 +( 117 +) +3,683 +20 +( 53 +) +Foreign currency options +430 +0 +0 +770 +0 +0 +Credit default swaps +0 +0 +0 +88 +1 +0 +Interest rate swaps +4,750 +3 +0 +0 +0 +0 +Total non-qualifying strategies +26,624 +413 +( 347 +) +9,927 +317 +( 242 +) +Total derivatives +$ +38,355 +$ +417 +$ +( 387 +) +$ +25,751 +$ +331 +$ +( 474 +) +Balance Sheet Location +Other assets +$ +23,713 +$ +417 +$ +0 +$ +10,948 +$ +331 +$ +0 +Other liabilities +14,642 +0 +( 387 +) +14,803 +0 +( 474 +) +Total derivatives +$ +38,355 +$ +417 +$ +( 387 +) +$ +25,751 +$ +331 +$ +( 474 +) +Cash Flow Hedges +For certain variable-rate U.S. dollar-denominated available-for-sale securities held by Aflac Japan via consolidated VIEs, foreign currency swaps are used to swap the USD variable rate interest and principal payments to fixed rate JPY interest and principal payments. The Company has designated foreign currency swaps as a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset (“cash flow” hedge). The remaining maximum length of time for which these cash flows are hedged is seven years. The derivatives in the Company's consolidated VIEs that are not designated as accounting hedges are discussed in the "non-qualifying strategies" section of this note. +Fair Value Hedges +The Company designates and accounts for certain foreign currency forwards, options, and interest rate swaptions as fair value hedges when they meet the requirements for hedge accounting. The Company recognizes gains and losses on these derivatives as well as the offsetting gain or loss on the related hedged items in current earnings. +129 +Item 8. Financial Statements and Supplementary Data +Foreign currency forwards and options hedge the foreign currency exposure of certain U.S. dollar-denominated available-for-sale fixed-maturity investments held in Aflac Japan. The change in the fair value of the foreign currency forwards related to the changes in the difference between the spot rate and the forward price is excluded from the assessment of hedge effectiveness. The change in fair value of the foreign currency option related to the time value of the option is recognized in current earnings and is excluded from the assessment of hedge effectiveness. +Interest rate swaptions hedge the interest rate exposure of certain U.S. dollar-denominated available-for-sale securities held in Aflac Japan. For these hedging relationships, the Company excludes time value from the assessment of hedge effectiveness and recognizes changes in the intrinsic value of the swaptions in current earnings within net investment income. The change in the time value of the swaptions is recognized in other comprehensive income (loss) and amortized into earnings (net investment income) over its legal term. +The following table presents the gains and losses on derivatives and the related hedged items in fair value hedges for the years ended December 31. +Fair Value Hedging Relationships +(In millions) +Hedging Derivatives +Hedged Items +Hedging Derivatives +Hedged Items +Total +Gains +(Losses) +Gains (Losses) +Excluded from Effectiveness Testing (2) +Gains (Losses) +Included in Effectiveness Testing (1) +Gains (Losses) (1) +Net Realized Gains (Losses) Recognized for Fair Value Hedge +2018: +Foreign currency +forwards +Fixed maturity securities +$ +126 +$ +( 104 +) +$ +230 +$ +( 242 +) +$ +( 12 +) +Foreign currency +options +Fixed maturity securities +4 +4 +0 +0 +0 +Interest rate +swaptions +Fixed maturity securities +( 1 +) +( 1 +) +0 +0 +0 +Total gains (losses) +$ +129 +$ +( 101 +) +$ +230 +$ +( 242 +) +$ +( 12 +) +2017: +Foreign currency forwards +Fixed maturity and equity securities +$ +98 +$ +( 202 +) +$ +300 +$ +( 278 +) +$ +22 +Foreign currency options +Fixed maturity securities +21 +10 +11 +( 10 +) +1 +Total gains (losses) +$ +119 +$ +( 192 +) +$ +311 +$ +( 288 +) +$ +23 +2016: +Foreign currency forwards +Fixed maturity and equity securities +$ +207 +$ +( 338 +) +$ +545 +$ +( 566 +) +$ +( 21 +) +Foreign currency options +Fixed maturity securities +( 95 +) +( 18 +) +( 77 +) +70 +( 7 +) +Total gains (losses) +$ +112 +$ +( 356 +) +$ +468 +$ +( 496 +) +$ +( 28 +) +(1) Gains and losses on foreign currency forwards and options and related hedged items are reported in the consolidated statement of earnings as realized investment gains (losses). For interest rate swaptions and related hedged items, gains and losses included in the hedge assessment are reported within net investment income. For the year ended December 31, 2018, those gains and losses on interest rate swaptions and related hedged items were immaterial. +(2) Gains (losses) excluded from effectiveness testing includes the forward point on foreign currency forwards and time value change on foreign currency options which are reported in the consolidated statement of earnings as realized investment gains (losses). It also includes the change in the fair value of the interest rate swaptions related to the time value of the swaptions which is recognized as a component of other comprehensive income (loss). +The following table shows the December 31, 2018 carrying amounts of assets designated and qualifying as hedged items in fair value hedges of interest rate risk and the related cumulative hedge adjustment included in the carrying amount. +130 +Item 8. Financial Statements and Supplementary Data +(In millions) +Carrying Amount of the Hedged Assets/(Liabilities) (1) +Cumulative Amount of Fair Value Hedging Adjustment Included in the Carrying Amount of Hedged Assets/(Liabilities) +2018 +2018 +Fixed maturity securities +$ +6,593 +$ +294 +(1) The balance includes $ 294 million of hedging adjustment on discontinued hedging relationships. +As of December 31, 2018 , the total notional amount of the Company's interest rate swaptions was $ 500 million . The hedging adjustment related to these derivatives was immaterial. +Net Investment Hedge +The Company's investment in Aflac Japan is affected by changes in the yen/dollar exchange rate. To mitigate this exposure, the Parent Company's yen-denominated liabilities (see Note 9) have been designated as non-derivative hedges and, prior to April 1, 2018, foreign currency forwards and options were designated as derivative hedges of the foreign currency exposure of the Company's net investment in Aflac Japan. The Company designated net investment hedges under this strategy during the years ended December 31, 2018 , 2017 and 2016 . +Non-qualifying Strategies +For the Company's derivative instruments in consolidated VIEs that do not qualify for hedge accounting treatment, all changes in their fair value are reported in current period earnings within realized investment gains (losses). The amount of gain or loss recognized in earnings for the Company's VIEs is attributable to the derivatives in those investment structures. While the change in value of the swaps is recorded through current period earnings, the change in value of the available-for-sale fixed maturity securities associated with these swaps is recorded through other comprehensive income. +As of December 31, 2018 , the Parent Company had cross-currency interest rate swap agreements related to its $ 350 million senior notes due February 2022, $ 700 million senior notes due June 2023, $ 750 million senior notes due November 2024 and $ 450 million senior notes due March 2025. Changes in the values of these swaps are recorded through current period earnings. For additional information regarding these swaps, see Note 9. +The Company uses foreign exchange forwards and options to economically mitigate the currency risk of some of its U.S. dollar- denominated loan receivables held within the Aflac Japan segment. These arrangements are not designated as accounting hedges, as the foreign currency remeasurement of the loan receivables impacts current period earnings, and generally offsets gains and losses from foreign exchange forwards within realized investment gains (losses). The Company also has certain foreign exchange forwards on U.S. dollar-denominated AFS securities where hedge accounting is not being applied. +In order to economically mitigate currency risk of future yen dividends from Aflac Japan while lowering consolidated hedge costs associated with Aflac Japan's U.S. dollar investment hedging the Parent Company entered into offsetting hedge positions using foreign exchange forwards. This activity is reported in the Corporate and other segment. +The Company uses interest rate swaps to economically convert the variable rate investment income to a fixed rate on certain variable-rate investments. +131 +Item 8. Financial Statements and Supplementary Data +Impact of Derivatives and Hedging Instruments +The following table summarizes the impact to realized investment gains (losses) and other comprehensive income (loss) from all derivatives and hedging instruments for the years ended December 31. +2018 +2017 +2016 +(In millions) +Realized Investment +Gains (Losses) +Other +Comprehensive +Income (Loss) (1) +Realized Investment +Gains (Losses) +Other +Comprehensive +Income (Loss) (1) +Realized +Investment +Gains (Losses) +Other +Comprehensive +Income (Loss) (1) +Qualifying hedges: +Cash flow hedges: +Foreign currency swaps +$ +0 +$ +3 +$ +0 +$ +1 +$ +1 +$ +3 +Total cash flow hedges +0 +(2) +3 +0 +(2) +1 +1 +(2) +3 +Fair value hedges: +Foreign currency forwards (3) +( 116 +) +( 180 +) +( 359 +) +Foreign currency options (3) +4 +11 +( 25 +) +Interest rate swaptions (3) +0 +( 1 +) +0 +0 +0 +0 +Total fair value hedges +( 112 +) +( 1 +) +( 169 +) +0 +( 384 +) +0 +Net investment hedge: +Non-derivative hedging +instruments +0 +( 32 +) +0 +( 15 +) +0 +0 +Foreign currency forwards +0 +0 +0 +( 25 +) +0 +( 118 +) +Foreign currency options +0 +( 8 +) +0 +5 +0 +73 +Total net investment hedge +0 +( 40 +) +0 +( 35 +) +0 +( 45 +) +Non-qualifying strategies: +Foreign currency swaps +20 +53 +117 +Foreign currency forwards +( 135 +) +8 +9 +Credit default swaps +0 +( 1 +) +2 +Interest rate swaps +3 +0 +0 +Total non- qualifying strategies +( 112 +) +60 +128 +Total +$ +( 224 +) +$ +( 38 +) +$ +( 109 +) +$ +( 34 +) +$ +( 255 +) +$ +( 42 +) +(1) Cash flow hedge items and the change in the fair value of interest rate swaptions related to the time value of the swaptions in fair value hedges are recorded as unrealized gains (losses) on derivatives and net investment hedge items are recorded in the unrealized foreign currency translation gains (losses) line in the consolidated statement of comprehensive income (loss). +(2) Impact of cash flow hedges reported as realized investment gains (losses) includes an immaterial amount of gains or losses reclassified from accumulated other comprehensive income (loss) into earnings. It also includes an immaterial amount excluded from effectiveness testing during the years ended December 31, 2018 and 2017 and $ 1 million during the year ended December 31, 2016. +(3) Impact shown net of effect of hedged items (see Fair Value Hedges section of this Note 4 for further detail) +The impact on earnings from derivatives in cash flow hedge relationships also included a loss of $ 2 million during the year ended December 31, 2018 and an immaterial amount during the years ended December 31, 2017 and 2016 resulting from reclassifications from accumulated other comprehensive income (loss) to net investment income. There was no gain or loss reclassified from accumulated other comprehensive income (loss) into earnings related to the net investment hedge for the years ended December 31, 2018 , 2017 and 2016 . As of December 31, 2018 , deferred gains and losses on derivative instruments recorded in accumulated other comprehensive income that are expected to be reclassified to earnings during the next twelve months were immaterial. +Credit Risk Assumed through Derivatives +For the foreign currency and credit default swaps associated with the Company's VIE investments for which it is the primary beneficiary, the Company bears the risk of loss due to counterparty default even though it is not a direct counterparty to those contracts. +The Company is a direct counterparty to the foreign currency swaps that it has entered into in connection with certain of its senior notes and subordinated debentures; foreign currency forwards; and foreign currency options, and therefore the Company is exposed to credit risk in the event of nonperformance by the counterparties in those contracts. The risk of counterparty default for the Company's foreign currency swaps, certain foreign currency forwards, foreign currency options is mitigated by collateral posting requirements that counterparties to those transactions must meet. +132 +Item 8. Financial Statements and Supplementary Data +As of December 31, 2018 , there were 16 counterparties to the Company's derivative agreements, with three comprising 52 % of the aggregate notional amount. The counterparties to these derivatives are financial institutions with the following credit ratings as of December 31: +2018 +2017 +(In millions) +Notional Amount +of Derivatives +Asset Derivatives +Fair Value +Liability Derivatives +Fair Value +Notional Amount +of Derivatives +Asset Derivatives +Fair Value +Liability Derivatives +Fair Value +Counterparties' credit rating: +AA +$ +5,399 +$ +63 +$ +( 23 +) +$ +4,708 +$ +52 +$ +( 37 +) +A +32,513 +350 +( 311 +) +20,604 +271 +( 370 +) +BBB +443 +4 +( 53 +) +439 +8 +( 67 +) +Total +$ +38,355 +$ +417 +$ +( 387 +) +$ +25,751 +$ +331 +$ +( 474 +) +The Company engages in over-the-counter (OTC) bilateral derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements also include Credit Support Annexes (CSAs) provisions, which generally provide for two-way collateral postings at the first dollar of exposure. The Company mitigates the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value while generally requiring that collateral be posted at the outset of the transaction. In addition, a significant portion of the derivative transactions have provisions that give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength rating. The actual amount of payments that the Company could be required to make depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of the downgrade. +The Company also engages in OTC cleared derivative transactions through regulated central clearing counterparties. These positions are marked to market and margined on a daily basis (both initial margin and variation margin), and the Company has minimal exposure to credit-related losses in the event of nonperformance by counterparties to these derivatives. +Collateral posted by the Company to third parties for derivative transactions can generally be repledged or resold by the counterparties. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a net liability position by counterparty was approximately $ 139 million and $ 264 million as of December 31, 2018 and 2017 , respectively. If the credit-risk-related contingent features underlying these agreements had been triggered on December 31, 2018 , the Company estimates that it would be required to post a maximum of $ 34 million of additional collateral to these derivative counterparties. The Company is generally allowed to sell or repledge collateral obtained from its derivative counterparties, although it does not typically exercise such rights. (See the Offsetting tables below for collateral posted or received as of the reported balance sheet dates.) +Offsetting of Financial Instruments and Derivatives +Most of the Company's derivative instruments are subject to enforceable master netting arrangements that provide for the net settlement of all derivative contracts between the Parent Company or Aflac and its respective counterparty in the event of default or upon the occurrence of certain termination events. Collateral support agreements with the master netting arrangements generally provide that the Company will receive or pledge financial collateral at the first dollar of exposure. +The Company has securities lending agreements with unaffiliated financial institutions that post collateral to the Company in return for the use of its fixed maturity and public equity securities (see Note 3). When the Company has entered into securities lending agreements with the same counterparty, the agreements generally provide for net settlement in the event of default by the counterparty. This right of set-off allows the Company to keep and apply collateral received if the counterparty failed to return the securities borrowed from the Company as contractually agreed. For additional information on the Company's accounting policy for securities lending, see Note 1. +The tables below summarize the Company's derivatives and securities lending transactions as of December 31, and as reflected in the tables, in accordance with U.S. GAAP, the Company's policy is to not offset these financial instruments in the Consolidated Balance Sheets. +133 +Item 8. Financial Statements and Supplementary Data +Offsetting of Financial Assets and Derivative Assets +2018 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Assets +Gross Amount +Offset in +Balance Sheet +Net Amount of Assets Presented +in Balance Sheet +Financial Instruments +Securities +Collateral +Cash Collateral Received +Net Amount +Derivative +assets: +Derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +231 +$ +0 +$ +231 +$ +( 152 +) +$ +( 23 +) +$ +( 55 +) +$ +1 +OTC - cleared +3 +0 +3 +0 +0 +( 3 +) +0 +Total derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +234 +0 +234 +( 152 +) +( 23 +) +( 58 +) +1 +Derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +183 +183 +183 +Total derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +183 +183 +183 +Total derivative +assets +417 +0 +417 +( 152 +) +( 23 +) +( 58 +) +184 +Securities lending +and similar +arrangements +1,029 +0 +1,029 +0 +0 +( 1,029 +) +0 +Total +$ +1,446 +$ +0 +$ +1,446 +$ +( 152 +) +$ +( 23 +) +$ +( 1,087 +) +$ +184 +134 +Item 8. Financial Statements and Supplementary Data +2017 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Assets +Gross Amount Offset in Balance Sheet +Net Amount of Assets Presented in Balance Sheet +Financial +Instruments +Securities Collateral +Cash Collateral Received +Net Amount +Derivative +assets: +Derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +180 +$ +0 +$ +180 +$ +( 82 +) +$ +0 +$ +( 98 +) +$ +0 +Total derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +180 +0 +180 +( 82 +) +0 +( 98 +) +0 +Derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +151 +151 +151 +Total derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +151 +151 +151 +Total derivative +assets +331 +0 +331 +( 82 +) +0 +( 98 +) +151 +Securities lending +and similar +arrangements +592 +0 +592 +0 +0 +( 592 +) +0 +Total +$ +923 +$ +0 +$ +923 +$ +( 82 +) +$ +0 +$ +( 690 +) +$ +151 +135 +Item 8. Financial Statements and Supplementary Data +Offsetting of Financial Liabilities and Derivative Liabilities +2018 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Liabilities +Gross Amount Offset in Balance Sheet +Net Amount of Liabilities Presented in Balance Sheet +Financial Instruments +Securities Collateral +Cash Collateral Pledged +Net Amount +Derivative +liabilities: +Derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +( 285 +) +$ +0 +$ +( 285 +) +$ +152 +$ +37 +$ +68 +$ +( 28 +) +Total derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +( 285 +) +0 +( 285 +) +152 +37 +68 +( 28 +) +Derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +( 102 +) +( 102 +) +( 102 +) +Total derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +( 102 +) +( 102 +) +( 102 +) +Total derivative +liabilities +( 387 +) +0 +( 387 +) +152 +37 +68 +( 130 +) +Securities lending +and similar +arrangements +( 1,052 +) +0 +( 1,052 +) +1,029 +0 +0 +( 23 +) +Total +$ +( 1,439 +) +$ +0 +$ +( 1,439 +) +$ +1,181 +$ +37 +$ +68 +$ +( 153 +) +136 +Item 8. Financial Statements and Supplementary Data +2017 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Liabilities +Gross Amount Offset in Balance Sheet +Net Amount of Liabilities Presented in Balance Sheet +Financial Instruments +Securities Collateral +Cash Collateral Pledged +Net Amount +Derivative +liabilities: +Derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +( 346 +) +$ +0 +$ +( 346 +) +$ +82 +$ +245 +$ +10 +$ +( 9 +) +Total derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +( 346 +) +0 +( 346 +) +82 +245 +10 +( 9 +) +Derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +( 128 +) +( 128 +) +( 128 +) +Total derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +( 128 +) +( 128 +) +( 128 +) +Total derivative +liabilities +( 474 +) +0 +( 474 +) +82 +245 +10 +( 137 +) +Securities lending +and similar +arrangements +( 606 +) +0 +( 606 +) +592 +0 +0 +( 14 +) +Total +$ +( 1,080 +) +$ +0 +$ +( 1,080 +) +$ +674 +$ +245 +$ +10 +$ +( 151 +) +For additional information on the Company's financial instruments, see the accompanying Notes 1, 3 and 5. +5. +FAIR VALUE MEASUREMENTS +Fair Value Hierarchy +U.S. GAAP specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. These two types of inputs create three valuation hierarchy levels. Level 1 valuations reflect quoted market prices for identical assets or liabilities in active markets. Level 2 valuations reflect quoted market prices for similar assets or liabilities in an active market, quoted market prices for identical or similar assets or liabilities in non-active markets or model-derived valuations in which all significant valuation inputs are observable in active markets. Level 3 valuations reflect valuations in which one or more of the significant inputs are not observable in an active market. +The following tables present the fair value hierarchy levels of the Company's assets and liabilities that are measured and carried at fair value on a recurring basis as of December 31. +137 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities available for sale, carried at +fair value: +Fixed maturity securities: (1) +Government and agencies +$ +32,993 +$ +1,349 +$ +0 +$ +34,342 +Municipalities +0 +1,863 +0 +1,863 +Mortgage- and asset-backed securities +0 +162 +177 +339 +Public utilities +0 +7,062 +109 +7,171 +Sovereign and supranational +0 +1,260 +0 +1,260 +Banks/financial institutions +0 +8,895 +23 +8,918 +Other corporate +0 +28,789 +213 +29,002 +Total fixed maturity securities +32,993 +49,380 +522 +82,895 +(1) +Equity securities (1) +874 +67 +46 +987 +(1) +Other investments +152 +0 +0 +152 +Cash and cash equivalents +4,337 +0 +0 +4,337 +Other assets: +Foreign currency swaps +0 +103 +182 +285 +Foreign currency forwards +0 +126 +0 +126 +Foreign currency options +0 +3 +0 +3 +Interest rate swaps +0 +3 +0 +3 +Total other assets +0 +235 +182 +417 +Total assets +$ +38,356 +$ +49,682 +$ +750 +$ +88,788 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +0 +$ +132 +$ +102 +$ +234 +Foreign currency forwards +0 +151 +0 +151 +Foreign currency options +0 +1 +0 +1 +Interest rate swaptions +0 +1 +0 +1 +Total liabilities +$ +0 +$ +285 +$ +102 +$ +387 +(1) Includes perpetual securities +138 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities available for sale, carried at +fair value: +Fixed maturity securities: (1) +Government and agencies +$ +30,109 +$ +1,121 +$ +0 +$ +31,230 +Municipalities +0 +1,370 +0 +1,370 +Mortgage- and asset-backed securities +0 +269 +175 +444 +Public utilities +0 +7,886 +68 +7,954 +Sovereign and supranational +0 +1,909 +0 +1,909 +Banks/financial institutions +0 +8,908 +25 +8,933 +Other corporate +0 +32,327 +146 +32,473 +Total fixed maturity securities +30,109 +53,790 +414 +84,313 +(1) +Equity securities +1,001 +6 +16 +1,023 +Other investments +57 +0 +0 +57 +Cash and cash equivalents +3,491 +0 +0 +3,491 +Other assets: +Foreign currency swaps +0 +146 +150 +296 +Foreign currency forwards +0 +22 +0 +22 +Foreign currency options +0 +12 +0 +12 +Credit default swaps +0 +0 +1 +1 +Total other assets +0 +180 +151 +331 +Total assets +$ +34,658 +$ +53,976 +$ +581 +$ +89,215 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +0 +$ +69 +$ +128 +$ +197 +Foreign currency forwards +0 +274 +0 +274 +Foreign currency options +0 +3 +0 +3 +Total liabilities +$ +0 +$ +346 +$ +128 +$ +474 +(1) Includes perpetual securities +139 +Item 8. Financial Statements and Supplementary Data +The following tables present the carrying amount and fair value categorized by fair value hierarchy level for the Company's financial instruments that are not carried at fair value as of December 31. +2018 +(In millions) +Carrying +Value +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities held to maturity, +carried at amortized cost: +Fixed maturity securities: +Government and agencies +$ +21,712 +$ +27,030 +$ +8 +$ +0 +$ +27,038 +Municipalities +359 +0 +469 +0 +469 +Mortgage and asset-backed +securities +14 +0 +0 +15 +15 +Public utilities +2,727 +0 +2,973 +0 +2,973 +Sovereign and +supranational +1,551 +0 +1,840 +0 +1,840 +Banks/financial institutions +1,445 +0 +1,583 +0 +1,583 +Other corporate +2,510 +0 +2,804 +0 +2,804 +Other investments (1) +6,945 +0 +26 +6,893 +6,919 +Total assets +$ +37,263 +$ +27,030 +$ +9,703 +$ +6,908 +$ +43,641 +Liabilities: +Other policyholders’ funds +$ +7,146 +$ +0 +$ +0 +$ +7,067 +$ +7,067 +Notes payable +(excluding capital leases) +5,765 +0 +5,606 +270 +5,876 +Total liabilities +$ +12,911 +$ +0 +$ +5,606 +$ +7,337 +$ +12,943 +(1) Excludes policy loans of $ 232 and equity method investments of $ 377 , at carrying value +140 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Carrying +Value +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities held to maturity, +carried at amortized cost: +Fixed maturity securities: +Government and agencies +$ +21,331 +$ +26,491 +$ +0 +$ +0 +$ +26,491 +Municipalities +357 +0 +462 +0 +462 +Mortgage and asset-backed +securities +26 +0 +8 +19 +27 +Public utilities +3,300 +0 +3,698 +0 +3,698 +Sovereign and +supranational +1,523 +0 +1,835 +0 +1,835 +Banks/financial institutions +2,206 +0 +2,387 +0 +2,387 +Other corporate +2,687 +0 +3,172 +0 +3,172 +Other investments (1) +3,017 +0 +15 +2,987 +3,002 +Total assets +$ +34,447 +$ +26,491 +$ +11,577 +$ +3,006 +$ +41,074 +Liabilities: +Other policyholders’ funds +$ +6,939 +$ +0 +$ +0 +$ +6,841 +$ +6,841 +Notes payable +(excluding capital leases) +5,267 +0 +5,288 +265 +5,553 +Total liabilities +$ +12,206 +$ +0 +$ +5,288 +$ +7,106 +$ +12,394 +(1) Excludes policy loans of $ 210 and equity method investments of $ 118 , at carrying value +Fair Value of Financial Instruments +Fixed maturity and equity securities +The Company determines the fair values of fixed maturity securities and public and privately-issued equity securities using the following approaches or techniques: price quotes and valuations from third party pricing vendors (including quoted market prices readily available from public exchange markets) and non-binding price quotes the Company obtains from outside brokers. +A third party pricing vendor has developed valuation models to determine fair values of privately issued securities to reflect the impact of the persistent economic environment and the changing regulatory framework. These models are discounted cash flow (DCF) valuation models, but also use information from related markets, specifically the CDS market to estimate expected cash flows. These models take into consideration any unique characteristics of the securities and make various adjustments to arrive at an appropriate issuer-specific loss adjusted credit curve. This credit curve is then used with the relevant recovery rates to estimate expected cash flows and modeling of additional features, including illiquidity adjustments, if necessary, to price the security by discounting those loss adjusted cash flows. In cases where a credit curve cannot be developed from the specific security features, the valuation methodology takes into consideration other market observable inputs, including: 1) the most appropriate comparable security(ies) of the issuer; 2) issuer-specific CDS spreads; 3) bonds or CDS spreads of comparable issuers with similar characteristics such as rating, geography, or sector; or 4) bond indices that are comparative in rating, industry, maturity and region. +The pricing data and market quotes the Company obtains from outside sources, including third party pricing services, are reviewed internally for reasonableness. If a fair value appears unreasonable, the Company will re-examine the inputs and assess the reasonableness of the pricing data with the vendor. Additionally, the Company may compare the inputs to relevant market indices and other performance measurements. Based on management's analysis, the valuation is confirmed or may be revised if there is evidence of a more appropriate estimate of fair value based on available market data. The Company has performed verification of the inputs and calculations in any valuation models to confirm that the valuations represent reasonable estimates of fair value. +141 +Item 8. Financial Statements and Supplementary Data +The fixed maturity securities classified as Level 3 consist of securities with limited or no observable valuation inputs. For Level 3 securities, the Company estimates the fair value of these securities by obtaining non-binding broker quotes from a limited number of brokers. These brokers base their quotes on a combination of their knowledge of the current pricing environment and market conditions. The Company considers these inputs to be unobservable. The Company also considers a variety of significant valuation inputs in the valuation process, including forward exchange rates, yen swap rates, dollar swap rates, interest rate volatilities, credit spread data on specific issuers, assumed default and default recovery rates, and certain probability assumptions. In obtaining these valuation inputs, the Company has determined that certain pricing assumptions and data used by its pricing sources are difficult to validate or corroborate by the market and/or appear to be internally developed rather than observed in or corroborated by the market. The use of these unobservable valuation inputs causes more subjectivity in the valuation process for these securities. +For the periods presented, the Company has not adjusted the quotes or prices it obtains from the pricing services and brokers it uses. +The following tables present the pricing sources for the fair values of the Company's fixed maturity and equity securities as of December 31. +142 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Quoted Prices in Active Markets for Identical Assets +(Level 1) +Significant Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities available for sale, carried at fair value: +Fixed maturity securities: (1) +Government and agencies: +Third party pricing vendor +$ +32,993 +$ +1,349 +$ +0 +$ +34,342 +Total government and agencies +32,993 +1,349 +0 +34,342 +Municipalities: +Third party pricing vendor +0 +1,863 +0 +1,863 +Total municipalities +0 +1,863 +0 +1,863 +Mortgage- and asset-backed securities: +Third party pricing vendor +0 +162 +0 +162 +Broker/other +0 +0 +177 +177 +Total mortgage- and asset-backed securities +0 +162 +177 +339 +Public utilities: +Third party pricing vendor +0 +7,062 +0 +7,062 +Broker/other +0 +0 +109 +109 +Total public utilities +0 +7,062 +109 +7,171 +Sovereign and supranational: +Third party pricing vendor +0 +1,260 +0 +1,260 +Total sovereign and supranational +0 +1,260 +0 +1,260 +Banks/financial institutions: +Third party pricing vendor +0 +8,895 +0 +8,895 +Broker/other +0 +0 +23 +23 +Total banks/financial institutions +0 +8,895 +23 +8,918 +Other corporate: +Third party pricing vendor +0 +28,789 +0 +28,789 +Broker/other +0 +0 +213 +213 +Total other corporate +0 +28,789 +213 +29,002 +Total securities available for sale +$ +32,993 +$ +49,380 +$ +522 +$ +82,895 +(1) +Equity securities, carried at fair value: (1) +Third party pricing vendor +$ +874 +$ +67 +$ +0 +$ +941 +Broker/other +0 +0 +46 +46 +Total equity securities +$ +874 +$ +67 +$ +46 +$ +987 +(1) +(1) Includes perpetual securities +143 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Quoted Prices in Active Markets for Identical Assets +(Level 1) +Significant Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Government and agencies: +Third party pricing vendor +$ +27,030 +$ +8 +$ +0 +$ +27,038 +Total government and agencies +27,030 +8 +0 +27,038 +Municipalities: +Third party pricing vendor +0 +469 +0 +469 +Total municipalities +0 +469 +0 +469 +Mortgage- and asset-backed securities: +Broker/other +0 +0 +15 +15 +Total mortgage- and asset-backed securities +0 +0 +15 +15 +Public utilities: +Third party pricing vendor +0 +2,973 +0 +2,973 +Total public utilities +0 +2,973 +0 +2,973 +Sovereign and supranational: +Third party pricing vendor +0 +1,840 +0 +1,840 +Total sovereign and supranational +0 +1,840 +0 +1,840 +Banks/financial institutions: +Third party pricing vendor +0 +1,583 +0 +1,583 +Total banks/financial institutions +0 +1,583 +0 +1,583 +Other corporate: +Third party pricing vendor +0 +2,804 +0 +2,804 +Total other corporate +0 +2,804 +0 +2,804 +Total securities held to maturity +$ +27,030 +$ +9,677 +$ +15 +$ +36,722 +144 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Quoted Prices in Active Markets +for Identical Assets +(Level 1) +Significant Observable +Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities available for sale, carried at fair value: +Fixed maturity securities: (1) +Government and agencies: +Third party pricing vendor +$ +30,109 +$ +1,121 +$ +0 +$ +31,230 +Total government and agencies +30,109 +1,121 +0 +31,230 +Municipalities: +Third party pricing vendor +0 +1,370 +0 +1,370 +Total municipalities +0 +1,370 +0 +1,370 +Mortgage- and asset-backed securities: +Third party pricing vendor +0 +269 +0 +269 +Broker/other +0 +0 +175 +175 +Total mortgage- and asset-backed securities +0 +269 +175 +444 +Public utilities: +Third party pricing vendor +0 +7,886 +0 +7,886 +Broker/other +0 +0 +68 +68 +Total public utilities +0 +7,886 +68 +7,954 +Sovereign and supranational: +Third party pricing vendor +0 +1,807 +0 +1,807 +Broker/other +0 +102 +0 +102 +Total sovereign and supranational +0 +1,909 +0 +1,909 +Banks/financial institutions: +Third party pricing vendor +0 +8,908 +0 +8,908 +Broker/other +0 +0 +25 +25 +Total banks/financial institutions +0 +8,908 +25 +8,933 +Other corporate: +Third party pricing vendor +0 +32,327 +0 +32,327 +Broker/other +0 +0 +146 +146 +Total other corporate +0 +32,327 +146 +32,473 +Total securities available for sale +$ +30,109 +$ +53,790 +$ +414 +$ +84,313 +(1) +Equity securities, carried at fair value: +Third party pricing vendor +$ +1,001 +$ +6 +$ +0 +$ +1,007 +Broker/other +0 +0 +16 +16 +Total equity securities +$ +1,001 +$ +6 +$ +16 +$ +1,023 +(1) Includes perpetual securities +145 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Quoted Prices in Active Markets +for Identical Assets +(Level 1) +Significant Observable +Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Government and agencies: +Third party pricing vendor +$ +26,491 +$ +0 +$ +0 +$ +26,491 +Total government and agencies +26,491 +0 +0 +26,491 +Municipalities: +Third party pricing vendor +0 +462 +0 +462 +Total municipalities +0 +462 +0 +462 +Mortgage- and asset-backed securities: +Third party pricing vendor +0 +8 +0 +8 +Broker/other +0 +0 +19 +19 +Total mortgage- and asset-backed securities +0 +8 +19 +27 +Public utilities: +Third party pricing vendor +0 +3,698 +0 +3,698 +Total public utilities +0 +3,698 +0 +3,698 +Sovereign and supranational: +Third party pricing vendor +0 +1,835 +0 +1,835 +Total sovereign and supranational +0 +1,835 +0 +1,835 +Banks/financial institutions: +Third party pricing vendor +0 +2,387 +0 +2,387 +Total banks/financial institutions +0 +2,387 +0 +2,387 +Other corporate: +Third party pricing vendor +0 +3,172 +0 +3,172 +Total other corporate +0 +3,172 +0 +3,172 +Total securities held to maturity +$ +26,491 +$ +11,562 +$ +19 +$ +38,072 +The following is a discussion of the determination of fair value of the Company's remaining financial instruments. +Derivatives +The Company uses derivative instruments to manage the risk associated with certain assets. However, the derivative instrument may not be classified in the same fair value hierarchy level as the associated asset. The Company uses pricing models to determine the estimated fair value of derivatives. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. The significant inputs to pricing derivatives are generally observable in the market or can be derived by observable market data. When these inputs are observable, the derivatives are classified as Level 2. +The fair values of the foreign currency forwards and options associated with certain investments; the foreign currency forwards and options used to hedge foreign exchange risk from the Company's net investment in Aflac Japan and economically hedge certain portions of forecasted cash flows denominated in yen; and the foreign currency swaps associated with certain senior notes are based on the amounts the Company would expect to receive or pay. The determination of the fair value of these derivatives is based on observable market inputs, therefore they are classified as Level 2. +To determine the fair value of its interest rate derivatives, the Company uses inputs that are generally observable in the market or can be derived from observable market data. Interest rate swaps are cleared trades. In a cleared swap contract the clearinghouse provides benefits to the counterparties similar to contracts listed for investment traded on an exchange since it maintains a daily margin to mitigate counterparties credit risk. These derivatives are priced using +146 +Item 8. Financial Statements and Supplementary Data +observable inputs, accordingly, they are classified as Level 2. For its interest rate swaptions, the Company estimates their fair values using observable market data, including interest rate curves and volatilities. Their fair values are also classified as Level 2. +For derivatives associated with VIEs where the Company is the primary beneficiary, the Company is not the direct counterparty to the swap contracts. As a result, the fair value measurements incorporate the credit risk of the collateral associated with the VIE. The Company receives valuations from a third party pricing vendor for these derivatives. Based on an analysis of these derivatives and a review of the methodology employed by the pricing vendor, the Company determined that due to the long duration of these swaps and the need to extrapolate from short-term observable data to derive and measure long-term inputs, certain inputs, assumptions and judgments are required to value future cash flows that cannot be corroborated by current inputs or current observable market data. As a result, the derivatives associated with the Company's consolidated VIEs are classified as Level 3 of the fair value hierarchy. +Other investments +Other investments where fair value is disclosed above include short-term investments and loan receivables. Loan receivables include transitional real estate loans, commercial mortgage loans, and middle market loans. The Company's loan receivables do not have readily determinable market prices and generally lack market liquidity. Fair values for loan receivables are determined based on the present value of expected future cash flows discounted at the applicable U.S. Treasury or London Interbank Offered Rate (LIBOR) yield plus an appropriate spread that considers other risk factors, such as credit and liquidity risk. These spreads are provided by the applicable asset managers based on their knowledge of the current loan pricing environment and market conditions. The spreads are a significant component of the pricing inputs and are generally considered unobservable. Therefore, these investments have been assigned a Level 3 within the fair value hierarchy. +Other policyholders' funds +The largest component of the other policyholders' funds liability is the Company's annuity line of business in Aflac Japan. The Company's annuities have fixed benefits and premiums. For this product, the Company estimates the fair value to be equal to the cash surrender value. This is analogous to the value paid to policyholders on the valuation date if they were to surrender their policy. The Company periodically checks the cash value against discounted cash flow projections for reasonableness. The Company considers its inputs for this valuation to be unobservable and have accordingly classified this valuation as Level 3. +Notes payable +The fair values of the Company's publicly issued notes payable are determined by utilizing available sources of observable inputs from third party pricing vendors and are classified as Level 2. The fair values of the Company's yen-denominated loans approximate their carrying values and are classified as Level 3. +Transfers between Hierarchy Levels and Level 3 Rollforward +There were no transfers between Level 1 and 2 for assets and liabilities that are measured and carried at fair value on a recurring basis for the years ended December 31, 2018 and 2017 , respectively. +The following tables present the changes in fair value of the Company's investments and derivatives carried at fair value classified as Level 3 as of December 31. +147 +Item 8. Financial Statements and Supplementary Data +2018 +Fixed Maturity Securities +Equity +Securities +Derivatives (1) +(In millions) +Mortgage- +and +Asset- +Backed +Securities +Public +Utilities +Banks/ +Financial +Institutions +Other +Corporate +Foreign +Currency +Swaps +Credit +Default +Swaps +Total +Balance, beginning of period +$ +175 +$ +68 +$ +25 +$ +146 +$ +16 +$ +22 +$ +1 +$ +453 +Realized investment gains (losses) included +in earnings +0 +0 +0 +0 +( 1 +) +54 +( 1 +) +52 +Unrealized gains (losses) included in other +comprehensive income (loss) +2 +1 +( 2 +) +1 +0 +4 +0 +6 +Purchases, issuances, sales and settlements: +Purchases +0 +40 +0 +56 +31 +0 +0 +127 +Issuances +0 +0 +0 +0 +0 +0 +0 +0 +Sales +0 +0 +0 +0 +0 +0 +0 +0 +Settlements +0 +0 +0 +( 6 +) +0 +0 +0 +( 6 +) +Transfers into Level 3 +0 +0 +0 +16 +0 +0 +0 +16 +Transfers out of Level 3 +0 +0 +0 +0 +0 +0 +0 +0 +Balance, end of period +$ +177 +$ +109 +$ +23 +$ +213 +$ +46 +$ +80 +$ +0 +$ +648 +Changes in unrealized gains (losses) relating +to Level 3 assets and liabilities still held at +the end of the period included in realized +investment gains (losses) +$ +0 +$ +0 +$ +0 +$ +0 +$ +( 1 +) +$ +54 +$ +( 1 +) +$ +52 +(1) Derivative assets and liabilities are presented net +2017 +Fixed Maturity Securities +Equity +Securities +Derivatives (1) +(In millions) +Mortgage- +and +Asset- +Backed +Securities +Public +Utilities +Banks/ +Financial +Institutions +Other +Corporate +Foreign +Currency +Swaps +Credit +Default +Swaps +Total +Balance, beginning of period +$ +198 +$ +16 +$ +25 +$ +0 +$ +3 +$ +( 21 +) +$ +2 +$ +223 +Realized investment gains (losses) included in +earnings +0 +0 +0 +0 +0 +43 +( 1 +) +42 +Unrealized gains (losses) included in other +comprehensive income (loss) +3 +0 +0 +2 +0 +0 +0 +5 +Purchases, issuances, sales and settlements: +Purchases +0 +76 +0 +122 +16 +0 +0 +214 +Issuances +0 +0 +0 +0 +0 +0 +0 +0 +Sales +0 +0 +0 +( 2 +) +( 1 +) +0 +0 +( 3 +) +Settlements +( 26 +) +0 +0 +0 +0 +0 +0 +( 26 +) +Transfers into Level 3 +0 +0 +0 +24 +(2) +0 +0 +0 +24 +Transfers out of Level 3 +0 +( 24 +) +(2) +0 +0 +( 2 +) +(3) +0 +0 +( 26 +) +Balance, end of period +$ +175 +$ +68 +$ +25 +$ +146 +$ +16 +$ +22 +$ +1 +$ +453 +Changes in unrealized gains (losses) relating +to Level 3 assets and liabilities still held at +the end of the period included in realized +investment gains (losses) +$ +0 +$ +0 +$ +0 +$ +0 +$ +0 +$ +43 +$ +( 1 +) +$ +42 +(1) Derivative assets and liabilities are presented net +(2) Transfer due to sector classification change +(3) Transfer due to change in accounting method +148 +Item 8. Financial Statements and Supplementary Data +Fair Value Sensitivity +Level 3 Significant Unobservable Input Sensitivity +The following tables summarize the significant unobservable inputs used in the valuation of the Company's Level 3 investments and derivatives carried at fair value as of December 31. Included in the tables are the inputs or range of possible inputs that have an effect on the overall valuation of the financial instruments. +2018 +(In millions) +Fair Value +Valuation Technique(s) +Unobservable Input +Range +(Weighted Average) +Assets: +Securities available for sale, carried at fair value: +Fixed maturity securities: +Mortgage- and asset-backed securities +$ +177 +Consensus pricing +Offered quotes +N/A +(a) +Public utilities +109 +Discounted cash flow +Credit spreads +N/A +(a) +Banks/financial institutions +23 +Consensus pricing +Offered quotes +N/A +(a) +Other corporate +213 +Discounted cash flow +Credit spreads +N/A +(a) +Equity securities +46 +Net asset value +Offered quotes +N/A +(a) +Other assets: +Foreign currency swaps +125 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +CDS spreads +19 - 120 bps +57 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +Total assets +$ +750 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +98 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +CDS spreads +28 - 211 bps +4 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +Total liabilities +$ +102 +(a) N/A represents securities where the Company receives unadjusted broker quotes and for which there is no transparency into the providers' valuation techniques or unobservable inputs. +(b) Inputs derived from U.S. long-term rates to accommodate long maturity nature of the Company's swaps +(c) Inputs derived from Japan long-term rates to accommodate long maturity nature of the Company's swaps +149 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Fair Value +Valuation Technique(s) +Unobservable Input +Range +(Weighted Average) +Assets: +Securities available for sale, carried at fair value: +Fixed maturity securities: +Mortgage- and asset-backed securities +$ +175 +Consensus pricing +Offered quotes +N/A +(a) +Public utilities +68 +Discounted cash flow +Credit spreads +N/A +(a) +Banks/financial institutions +25 +Consensus pricing +Offered quotes +N/A +(a) +Other corporate +146 +Discounted cash flow +Credit spreads +N/A +(a) +Equity securities +16 +Net asset value +Offered quotes +N/A +(a) +Other assets: +Foreign currency swaps +80 +Discounted cash flow +Interest rates (USD) +2.40% - 2.54% +(b) +Interest rates (JPY) +.26% - .85% +(c) +CDS spreads +9 - 90 bps +70 +Discounted cash flow +Interest rates (USD) +2.40% - 2.54% +(b) +Interest rates (JPY) +.26% - .85% +(c) +Credit default swaps +1 +Discounted cash flow +Base correlation +46.33% - 49.65% +(d) +CDS spreads +25 bps +Recovery rate +37.24% +Total assets +$ +581 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +120 +Discounted cash flow +Interest rates (USD) +2.40% - 2.54% +(b) +Interest rates (JPY) +.26% - .85% +(c) +CDS spreads +13 - 157 bps +8 +Discounted cash flow +Interest rates (USD) +2.40% - 2.54% +(b) +Interest rates (JPY) +.26% - .85% +(c) +Total liabilities +$ +128 +(a) N/A represents securities where the Company receives unadjusted broker quotes and for which there is no transparency into the providers' valuation techniques or unobservable inputs. +(b) Inputs derived from U.S. long-term rates to accommodate long maturity nature of the Company's swaps +(c) Inputs derived from Japan long-term rates to accommodate long maturity nature of the Company's swaps +(d) Range of base correlation for the Company's bespoke tranche for attachment and detachment points corresponding to market indices +150 +Item 8. Financial Statements and Supplementary Data +The following is a discussion of the significant unobservable inputs or valuation techniques used in determining the fair value of securities and derivatives classified as Level 3. +Net Asset Value +The Company holds certain unlisted equity securities whose fair value is derived based on the financial statements published by the investee. These securities do not trade on an active market and the valuations derived are dependent on the availability of timely financial reporting of the investee. Net asset value is an unobservable input in the determination of fair value of equity securities. +Offered Quotes +In circumstances where the Company's valuation model price is overridden because it implies a value that is not consistent with current market conditions, the Company will solicit bids from a limited number of brokers. The Company also receives unadjusted prices from brokers for its mortgage and asset-backed securities. These quotes are non-binding but are reflective of valuation best estimates at that particular point in time. Offered quotes are an unobservable input in the determination of fair value of mortgage- and asset-backed securities, certain banks/financial institutions, certain other corporate, and equity securities investments. +Interest Rates and CDS Spreads +The significant drivers of the valuation of the interest and foreign exchange swaps are interest rates and CDS spreads. Some of the Company's swaps have long maturities that increase the sensitivity of the swaps to interest rate fluctuations. For the Company's foreign exchange or cross currency swaps that are in a net asset position, an increase in yen interest rates (all other factors held constant) will decrease the present value of the yen final settlement receivable (receive leg), thus decreasing the value of the swap as long as the derivative remains in a net asset position. +Foreign exchange swaps also have a lump-sum final settlement of foreign exchange principal amounts at the termination of the swap. Assuming all other factors are held constant, an increase in yen interest rates will decrease the receive leg and decrease the net value of the swap. Likewise, holding all other factors constant, an increase in U.S. dollar interest rates will increase the swap's net value due to the decrease in the present value of the dollar final settlement payable (pay leg). +The extinguisher feature in most of the Company's VIE swaps results in a cessation of cash flows and no further payments between the parties to the swap in the event of a default on the referenced or underlying collateral. To price this feature, the Company applies the survival probability of the referenced entity to the projected cash flows. The survival probability uses the CDS spreads and recovery rates to adjust the present value of the cash flows. For extinguisher swaps with positive values, an increase in CDS spreads decreases the likelihood of receiving the final exchange payments and reduces the value of the swap. +For additional information on the Company's investments and financial instruments, see the accompanying Notes 1, 3 and 4. +6. DEFERRED POLICY ACQUISITION COSTS AND INSURANCE EXPENSES +Consolidated policy acquisition costs deferred were $ 1.5 billion in 2018 , compared with $ 1.5 billion in 2017 and $ 1.4 billion in 2016 . The following table presents a rollforward of deferred policy acquisition costs by segment for the years ended December 31. +2018 +2017 +(In millions) +Japan +U.S. +Japan +U.S. +Deferred policy acquisition costs: +Balance, beginning of year +$ +6,150 +$ +3,355 +$ +5,765 +$ +3,228 +Capitalization +833 +669 +839 +629 +Amortization +( 710 +) +( 534 +) +( 630 +) +( 502 +) +Foreign currency translation and other +111 +1 +176 +0 +Balance, end of year +$ +6,384 +$ +3,491 +$ +6,150 +$ +3,355 +151 +Item 8. Financial Statements and Supplementary Data +Commissions deferred as a percentage of total acquisition costs deferred were 72 % in 2018 , compared with 72 % in 2017 and 74 % in 2016 . +Personnel, compensation and benefit expenses as a percentage of insurance expenses were 54 % in 2018 , compared with 56 % in 2017 and 53 % in 2016 . Advertising expense, which is included in insurance expenses in the consolidated statements of earnings, was as follows for the years ended December 31: +(In millions) +2018 +2017 +2016 +Advertising expense: +Aflac Japan +$ +108 +$ +100 +$ +100 +Aflac U.S. +110 +110 +124 +Total advertising expense +$ +218 +$ +210 +$ +224 +Depreciation and other amortization expenses, which are included in insurance expenses in the consolidated statements of earnings, were as follows for the years ended December 31: +(In millions) +2018 +2017 +2016 +Depreciation expense +$ +48 +$ +50 +$ +48 +Other amortization expense +1 +3 +6 +Total depreciation and other amortization expense +$ +49 +$ +53 +$ +54 +Lease and rental expense, which are included in insurance expenses in the consolidated statements of earnings, were as follows for the years ended December 31: +(In millions) +2018 +2017 +2016 +Lease and rental expense: +Aflac Japan +$ +53 +$ +52 +$ +53 +Aflac U.S. +16 +21 +21 +Other +4 +2 +1 +Total lease and rental expense +$ +73 +$ +75 +$ +75 +7. POLICY LIABILITIES +Policy liabilities consist of future policy benefits, unpaid policy claims, unearned premiums, and other policyholders' funds, which accounted for 84 % , 4 % , 5 % and 7 % of total policy liabilities at December 31, 2018 , respectively. The Company regularly reviews the adequacy of its policy liabilities in total and by component. +The liability for future policy benefits as of December 31 consisted of the following: +152 +Item 8. Financial Statements and Supplementary Data +Liability Amounts +Interest Rates +(In millions) +Policy +Issue Year +2018 +2017 +Year of +Issue +In 20 +Years +Health insurance: +Japan: +1992 - 2018 +$ +11,598 +$ +10,167 +1.0 - 2.5 +% +1.0 - 2.5 +% +1974 - 2013 +1,161 +1,133 +2.7 - 2.75 +2.25 - 2.75 +1998 - 2018 +12,764 +12,386 +3.0 +3.0 +1997 - 1999 +2,452 +2,454 +3.5 +3.5 +1994 - 1996 +3,056 +3,046 +4.0 - 4.5 +4.0 - 4.5 +1987 - 1994 +14,722 +14,829 +5.5 +5.5 +1985 - 1991 +1,779 +1,816 +5.25 - 6.75 +5.25 - 5.5 +1978 - 1984 +1,964 +2,037 +6.5 +5.5 +U.S.: +2013 - 2018 +96 +82 +3.0 - 3.5 +3.0 - 3.5 +2012 - 2018 +1,682 +1,366 +3.75 +3.75 +2011 +353 +343 +4.75 +4.75 +2005 - 2010 +2,946 +2,944 +5.5 +5.5 +1988 - 2004 +641 +656 +8.0 +6.0 +1986 - 2004 +1,245 +1,296 +6.0 +6.0 +1981 - 1986 +151 +159 +6.5 - 7.0 +5.5 - 6.5 +1998 - 2004 +1,311 +1,310 +7.0 +7.0 +Other +17 +18 +Intercompany eliminations: +2015 +( 583 +) +(1) +( 609 +) +(1) +2.0 +2.0 +Life insurance: +Japan: +2001 - 2018 +10,296 +8,850 +1.0 - 1.85 +1.0 - 1.85 +2011 - 2017 +5,116 +4,763 +2.0 +2.0 +2009 - 2011 +3,867 +3,393 +2.25 +2.25 +1992 - 2006 +5 +5 +2.19 +1.55 +2005 - 2011 +1,769 +1,642 +2.5 +2.5 +1985 - 2006 +2,057 +2,048 +2.7 +2.25 +2007 - 2011 +1,380 +1,319 +2.75 +2.75 +1999 - 2011 +2,249 +2,189 +3.0 +3.0 +1996 - 2009 +678 +675 +3.5 +3.5 +1994 - 1996 +901 +908 +4.0 - 4.5 +4.0 - 4.5 +U.S.: +1956 - 2018 +695 +632 +3.5 - 6.0 +3.5 - 6.0 +Total +$ +86,368 +$ +81,857 +(1) Elimination entry necessary due to recapture of a portion of policy liabilities ceded externally, as a result of the reinsurance retrocession transaction as described in Note 8 of the Notes to the Consolidated Financial Statements +The weighted-average interest rates reflected in the consolidated statements of earnings for future policy benefits for Japanese policies were 3.3 % in 2018 , compared with 3.4 % in 2017 and 3.5 % in 2016 ; and for U.S. policies, 5.3 % in 2018 , compared with 5.4 % in 2017 and 5.5 % in 2016 . +153 +Item 8. Financial Statements and Supplementary Data +Changes in the liability for unpaid policy claims were as follows for the years ended December 31: +(In millions) +2018 +2017 +2016 +Unpaid supplemental health claims, beginning of period +$ +3,884 +$ +3,707 +$ +3,548 +Less reinsurance recoverables +30 +27 +26 +Net balance, beginning of period +3,854 +3,680 +3,522 +Add claims incurred during the period related to: +Current year +7,101 +6,979 +7,037 +Prior years +( 563 +) +( 518 +) +( 465 +) +Total incurred +6,538 +6,461 +6,572 +Less claims paid during the period on claims incurred during: +Current year +4,612 +4,530 +4,613 +Prior years +1,898 +1,822 +1,865 +Total paid +6,510 +6,352 +6,478 +Effect of foreign exchange rate changes on unpaid claims +43 +65 +64 +Net balance, end of period +3,925 +3,854 +3,680 +Add reinsurance recoverables +27 +30 +27 +Unpaid supplemental health claims, end of period +3,952 +3,884 +3,707 +Unpaid life claims, end of period +632 +508 +338 +Total liability for unpaid policy claims +$ +4,584 +$ +4,392 +$ +4,045 +The incurred claims development related to prior years reflects favorable claims experience compared to previous estimates. The favorable claims development of $ 563 million for 2018 comprises approximately $ 419 million from Japan, which represents approximately 74 % of the total. Excluding the impact of foreign exchange of a gain of approximately $ 14 million from December 31, 2017 to December 31, 2018 , the favorable claims development in Japan would have been approximately $ 404 million , representing approximately 72 % of the total. +The Company has experienced continued favorable claim trends in 2018 for its core health products in Japan. The Company's experience in Japan related to the average length of stay in the hospital for cancer treatment has shown continued decline in the current period. In addition, cancer treatment patterns in Japan are continuing to be influenced by significant advances in early-detection techniques and by the increased use of pathological diagnosis rather than clinical exams. Additionally, follow-up radiation and chemotherapy treatments are occurring more often on an outpatient basis. Such changes in treatment not only increase the quality of life and initial outcomes for the patients, but also decrease the average length of each hospital stay, resulting in favorable claims development. +As of December 31, 2018 and 2017 , unearned premiums consisted primarily of discounted advance premiums on deposit. Discounted advance premiums are premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan limited-pay insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. These advanced premiums represented 69 % of the December 31, 2018 and 73 % of the December 31, 2017 unearned premiums balances. +As of December 31, 2018 and 2017 , the largest component of the other policyholders' funds liability was the Company's annuity line of business in Aflac Japan. The Company's annuities have fixed benefits and premiums. These annuities represented 97 % of other policyholders' funds liability at December 31, 2018 , compared with 98 % at December 31, 2017 . +154 +Item 8. Financial Statements and Supplementary Data +8. REINSURANCE +The Company periodically enters into fixed quota-share coinsurance agreements with other companies in the normal course of business. For each of its reinsurance agreements, the Company determines whether the agreement provides indemnification against loss or liability relating to insurance risk in accordance with applicable accounting standards. Reinsurance premiums and benefits paid or provided are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and benefits are reported net of insurance ceded. +The Company has recorded a deferred profit liability related to reinsurance transactions. The remaining deferred profit liability of $ 1.0 billion , as of December 31, 2018 , is included in future policy benefits in the consolidated balance sheet and is being amortized into income over the expected lives of the policies. The Company has also recorded a reinsurance recoverable for reinsurance transactions, which is included in other assets in the consolidated balance sheet and had a remaining balance of $ 941 million and $ 908 million as of December 31, 2018 and 2017 , respectively. The increase in the reinsurance recoverable balance was driven by two aggregating factors: yen strengthening and the growth in reserves related to the business that has been reinsured as the policies age. The spot yen/dollar exchange rate strengthened by approximately 2 % and ceded reserves increased approximately 2 % from December 31, 2017 , to December 31, 2018 . +The following table reconciles direct premium income and direct benefits and claims to net amounts after the effect of reinsurance for the years ended December 31. +(In millions) +2018 +2017 +2016 +Direct premium income +$ +19,018 +$ +18,875 +$ +19,592 +Ceded to other companies: +Ceded Aflac Japan closed blocks +( 497 +) +( 515 +) +( 560 +) +Other +( 58 +) +( 51 +) +( 48 +) +Assumed from other companies: +Retrocession activities +208 +216 +234 +Other +6 +6 +7 +Net premium income +$ +18,677 +$ +18,531 +$ +19,225 +Direct benefits and claims +$ +12,293 +$ +12,486 +$ +13,240 +Ceded benefits and change in reserves for future benefits: +Ceded Aflac Japan closed blocks +( 450 +) +( 473 +) +( 509 +) +Eliminations +43 +51 +58 +Other +( 44 +) +( 44 +) +( 38 +) +Assumed from other companies: +Retrocession activities +209 +209 +222 +Eliminations +( 53 +) +( 51 +) +( 58 +) +Other +2 +3 +4 +Benefits and claims, net +$ +12,000 +$ +12,181 +$ +12,919 +These reinsurance transactions are indemnity reinsurance that do not relieve the Company from its obligations to policyholders. In the event that the reinsurer is unable to meet their obligations, the Company remains liable for the reinsured claims. +As a part of its capital contingency plan, the Company entered into a committed reinsurance facility agreement on December 1, 2015 in the amount of approximately 110 billion yen of reserves. This reinsurance facility agreement was renewed in 2018 and is effective until December 31, 2019. There are also additional commitment periods of a one-year duration each of which are automatically extended unless notification is received from the reinsurer within 60 days prior to the expiration. The reinsurer can withdraw from the committed facility if Aflac‘s Standard and Poor's (S&P) rating drops below BBB-. As of December 31, 2018 , the Company had not executed a reinsurance treaty under this committed reinsurance facility. +155 +Item 8. Financial Statements and Supplementary Data +9. NOTES PAYABLE +A summary of notes payable as of December 31 follows: +(In millions) +2018 +2017 +2.40% senior notes paid November 2018 +$ +0 +$ +548 +4.00% senior notes due February 2022 +348 +348 +3.625% senior notes due June 2023 +698 +697 +3.625% senior notes due November 2024 +746 +745 +3.25% senior notes due March 2025 +447 +446 +2.875% senior notes due October 2026 +297 +297 +6.90% senior notes due December 2039 +220 +220 +6.45% senior notes due August 2040 +254 +254 +4.00% senior notes due October 2046 +394 +394 +4.750% senior notes due January 2049 +540 +0 +Yen-denominated senior notes and subordinated debentures: +.932% senior notes due January 2027 (principal amount 60.0 billion yen) +538 +528 +1.159% senior notes due October 2030 (principal amount 29.3 billion yen) +262 +0 +1.488% senior notes due October 2033 (principal amount 15.2 billion yen) +136 +0 +1.750% senior notes due October 2038 (principal amount 8.9 billion yen) +79 +0 +2.108% subordinated debentures due October 2047 (principal amount 60.0 billion yen) +536 +526 +Yen-denominated loans: +Variable interest rate loan due September 2021 (.32% in 2018 and 2017, principal amount 5.0 billion yen) +45 +44 +Variable interest rate loan due September 2023 (.47% in 2018 and 2017, principal amount 25.0 billion yen) +225 +220 +Capitalized lease obligations payable through 2025 +13 +22 +Total notes payable +$ +5,778 +$ +5,289 +Amounts in the table above are reported net of debt issuance costs and issuance premiums or discounts, if applicable, that are being amortized over the life of the notes. +In October 2018, the Parent Company issued $ 550 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.750 % per annum, payable semi-annually, and have a 30 -year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a United States Treasury security with a maturity comparable to the remaining term of the notes, plus 25 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. +In October 2018, the Parent Company issued three series of senior notes totaling 53.4 billion yen through a public debt offering under its U.S. shelf registration statement. The first series, which totaled 29.3 billion yen, bears interest at a fixed rate of 1.159 % per annum, payable semi-annually, and has a 12 -year maturity. The second series, which totaled 15.2 billion yen, bears interest at a fixed rate of 1.488 % per annum, payable semi-annually, and has a 15 -year maturity. The third series, which totaled 8.9 billion yen, bears interest at a fixed rate of 1.750 % per annum, payable semi-annually, and has a 20 -year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In October 2017, the Parent Company issued 60.0 billion yen of subordinated debentures through a U.S. public debt offering. The debentures bear interest at an initial rate of 2.108 % per annum through October 22, 2027, or earlier redemption. Thereafter, the rate of the interest of the debentures will be reset every five years at a rate of interest equal to the then-current JPY 5-year Swap Offered Rate plus 205 basis points. The debentures are payable semi-annually in arrears and have a 30 -year maturity. The debentures are redeemable (i) at any time, in whole but not in part, upon the occurrence of certain tax events or certain rating agency events, as specified in the indenture governing the terms of the +156 +Item 8. Financial Statements and Supplementary Data +debentures or (ii) on or after October 23, 2027, in whole or in part, at a redemption price equal to their principal amount plus accrued and unpaid interest to, but excluding, the date of redemption. +In January 2017, the Parent Company issued 60.0 billion yen of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of .932 % per annum, payable semi-annually, and have a 10 -year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In September 2016, the Parent Company issued two series of senior notes totaling $ 700 million through a U.S. public debt offering. The first series, which totaled $ 300 million , bears interest at a fixed rate of 2.875 % per annum, payable semi-annually and has a 10 -year maturity. The second series, which totaled $ 400 million , bears interest at a fixed rate of 4.00 % per annum, payable semi-annually, and has a 30 -year maturity. +In September 2016, the Parent Company entered into two series of senior unsecured term loan facilities totaling 30.0 billion yen. The first series, which totaled 5.0 billion yen, bears an interest rate per annum equal to the Tokyo interbank market rate (TIBOR), or alternate TIBOR, if applicable, plus the applicable TIBOR margin and has a five -year maturity. The applicable margin ranges between .20% and .60%, depending on the Parent Company's debt ratings as of the date of determination. The second series, which totaled 25.0 billion yen, bears an interest rate per annum equal to TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin and has a seven -year maturity. The applicable margin ranges between .35% and .75%, depending on the Parent Company's debt ratings as of the date of determination. +In March 2015, the Parent Company issued two series of senior notes totaling $ 1.0 billion through a U.S. public debt offering. The first series, which totaled $ 550 million , bore interest at a fixed rate of 2.40 % per annum, payable semi-annually, and had a five -year maturity. The second series, which totaled $ 450 million , bears interest at a fixed rate of 3.25 % per annum, payable semi-annually, and has a 10 -year maturity. The Parent Company has entered into cross-currency swaps that convert the U.S. dollar-denominated principal and interest on the senior notes into yen-denominated obligations which results in lower nominal net interest rates on the debt. By entering into these cross-currency swaps, the Parent Company economically converted its $ 550 million liability into a 67.0 billion yen liability and reduced the interest rate on this debt from 2.40 % in dollars to .24 % in yen, and the Parent Company economically converted its $ 450 million liability into a 55.0 billion yen liability and reduced the interest rate on this debt from 3.25 % in dollars to .82 % in yen. In November 2018, the Parent Company used the net proceeds from the October 2018 issuance of its senior notes to redeem $ 550 million of the Parent Company's 2.40 % senior notes due 2020. +In November 2014, the Parent Company issued $ 750 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 3.625 % per annum, payable semi-annually, and have a 10 -year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the treasury rate plus 20 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. The Parent Company entered into cross-currency interest rate swaps to reduce interest expense by converting the U.S. dollar-denominated principal and interest on the senior notes it issued into yen-denominated obligations. By entering into the swaps, the Parent Company economically converted its $ 750 million liability into an 85.3 billion yen liability and reduced the interest rate on this debt from 3.625 % in dollars to 1.00 % in yen. +In June 2013, the Parent Company issued $ 700 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 3.625 % per annum, payable semi-annually, and have a 10 -year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the treasury rate plus 20 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. The Parent Company had entered into cross-currency interest rate swaps to reduce interest expense by converting the U.S. dollar-denominated principal and interest on the senior notes it issued into yen-denominated obligations. By entering into these swaps, the Parent Company economically converted its $ 700 million liability into a 69.8 billion yen liability and reduced the interest rate on this debt from 3.625 % in dollars to 1.50 % in yen. +157 +Item 8. Financial Statements and Supplementary Data +In February 2012, the Parent Company issued $ 350 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.00 % per annum, payable semiannually, and have a 10-year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the principal amount of the notes or (ii) the present value of the remaining scheduled payments of principal and interest to be redeemed, discounted to the redemption date, plus accrued and unpaid interest. The Parent Company entered into cross-currency interest rate swaps to reduce interest expense by converting the U.S. dollar-denominated principal and interest on the senior notes it issued into yen-denominated obligations. By entering into these swaps, the Parent Company economically converted its $ 350 million liability into a 27.0 billion yen liability and reduced the interest rate on this debt from 4.00 % in dollars to 2.07 % in yen. +In 2010 and 2009, the Parent Company issued senior notes through U.S. public debt offerings; the details of these notes are as follows. In August 2010, the Parent Company issued $ 450 million of senior notes that have a 30 -year maturity. In December 2009, the Parent Company issued $ 400 million of senior notes that have a 30 -year maturity. These senior notes pay interest semiannually and are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the principal amount of the notes or (ii) the present value of the remaining scheduled payments of principal and interest to be redeemed, discounted to the redemption date, plus accrued and unpaid interest. In December 2016, the Parent Company completed a tender offer in which it extinguished $ 176 million principal of its 6.90 % senior notes due 2039 and $ 193 million principal of its 6.45 % senior notes due 2040. The pretax loss due to the early redemption of these notes was $ 137 million . +For the Company's yen-denominated notes and loans, the principal amount as stated in dollar terms will fluctuate from period to period due to changes in the yen/dollar exchange rate. The Company has designated the majority of its yen-denominated notes payable as a nonderivative hedge of the foreign currency exposure of the Company's investment in Aflac Japan. +The aggregate contractual maturities of notes payable during each of the years after December 31, 2018 , are as follows: +(In millions) +Long-term +Debt +Capitalized +Lease +Obligations +Total +Notes +Payable +2019 +$ +0 +$ +5 +$ +5 +2020 +0 +3 +3 +2021 +45 +2 +47 +2022 +350 +1 +351 +2023 +925 +1 +926 +Thereafter +4,493 +1 +4,494 +Total +$ +5,813 +$ +13 +$ +5,826 +158 +Item 8. Financial Statements and Supplementary Data +A summary of the Company's lines of credit as of December 31, 2018 follows: +Borrower +Type +Original Term +Expiration Date +Capacity +Amount Outstanding +Interest Rate on Borrowed Amount +Maturity Period +Commitment Fee +Business Purpose +Aflac Incorporated +and Aflac +uncommitted bilateral +364 days +December 27, 2019 +$100 million +$0 million +The rate quoted by the bank and agreed upon at the time of borrowing +Up to 3 months +None +General corporate purposes +Aflac Incorporated +unsecured revolving +3 years +March 31, 2019, or the date commitments are terminated pursuant to an event of default +100.0 billion yen +0.0 billion yen +A rate per annum equal to (a) Tokyo interbank market rate (TIBOR) plus, the alternative applicable TIBOR margin during the availability period from the closing date to the commitment termination date or (b) the TIBOR rate offered by the agent to major banks in yen for the applicable period plus, the applicable alternative TIBOR margin during the term out period +No later than +March 31, 2019 +.30% to .50%, depending on the Parent Company's debt ratings as of the date of determination +General corporate purposes, including a capital contingency plan for the operations of the Parent Company +Aflac Incorporated +and Aflac +unsecured revolving +5 years +April 4, 2023, or the date commitments are terminated pursuant to an event of default +55.0 billion yen, or the equivalent amount in U.S. dollars +0.0 billion yen +A rate per annum equal to, at the Company's option, either, (a) London Interbank Offered Rate (LIBOR) adjusted for certain costs or (b) a base rate determined by reference to the highest of (1) the federal funds rate plus 1/2 of 1%, (2) the rate of interest for such day announced by Mizuho Bank, Ltd. as its prime rate, or (3) the eurocurrency rate for an interest period of one month plus 1.00%, in each case plus an applicable margin +No later than April 4, 2023 +.085% to +.225%, depending on the Parent Company's debt ratings as of the date of determination +General corporate purposes, including a capital contingency plan for the operations of the Parent Company +Aflac Incorporated +and Aflac +uncommitted bilateral +None specified +None specified +$50 million +$0 million +A rate per annum equal to, at the Parent Company's option, either (a) a eurocurrency rate determined by reference to the agent's LIBOR for the interest period relevant to such borrowing or (b) the base rate determined by reference to the greater of (i) the prime rate as determined by the agent, and (ii) the sum of 0.50% and the federal funds rate for such day +Up to 3 months +None +General corporate purposes +Aflac (1) +uncommitted revolving +364 days +November 29, 2019 +$250 million +$0 million +USD three-month LIBOR plus 75 basis points per annum +3 months +None +General corporate purposes +Aflac Incorporated (1) +uncommitted revolving +364 days +April 2, 2019 +50.0 billion yen +0.0 billion yen +Three-month TIBOR plus 80 basis points per annum +3 months +None +General corporate purposes +(1) Intercompany credit agreement +The Parent Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2018 . No events of default or defaults occurred during 2018 and 2017 . +159 +Item 8. Financial Statements and Supplementary Data +10. INCOME TAXES +The components of income tax expense (benefit) applicable to pretax earnings for the years ended December 31 were as follows: +(In millions) +Foreign +U.S. +Total +2018: +Current +$ +771 +$ +608 +$ +1,379 +Deferred +93 +( 409 +) +( 316 +) +Total income tax expense +$ +864 +$ +199 +$ +1,063 +2017: +Current +$ +722 +$ +( 91 +) +$ +631 +Deferred +( 24 +) +( 1,193 +) +( 1,217 +) +Total income tax expense +$ +698 +$ +( 1,284 +) +$ +( 586 +) +2016: +Current +$ +650 +$ +234 +$ +884 +Deferred +136 +388 +524 +Total income tax expense +$ +786 +$ +622 +$ +1,408 +The Japan income tax rate for the fiscal year 2016 was 28.8 % . The rate was reduced to 28.2 % for the fiscal year 2017 and was further reduced to 28.0 % for the fiscal year 2018. +For the United States, the Tax Cuts and Jobs Act (Tax Act) was signed into law on December 22, 2017. Effective January 1, 2018, the Tax Act imposed a broad number of changes in tax law, including the permanent reduction of the U.S. federal statutory corporate income tax rate from 35 % to 21 % . +In accordance with Staff Accounting Bulletin 118 (SAB 118) issued by the U.S. Securities and Exchange Commission in December 2017, the Company recorded provisional amounts for certain items for which the income tax accounting was not complete. As of the enactment date, the Company estimated provisional amounts for its deferred taxes, including related valuation allowance, resulting in a reduction of its deferred tax assets (DTAs) by approximately $ 1.0 billion and its deferred tax liabilities (DTLs) by $ 2.9 billion , for a net DTL reduction of approximately $ 1.9 billion . The provisions of ASC 740-10, Income Taxes , require that the effects of changes in tax law on deferred taxes be recognized as a component of the income tax provision in the period the tax rate change was enacted. Therefore, the $ 1.9 billion provisional amount of net DTL reduction was recorded in the fourth quarter of 2017 as a reduction in the “Income tax expense, Deferred” line item of the Company’s consolidated statement of earnings. +In 2018, the Company recorded additional income tax expense of $ .4 million resulting from a decrease in the SAB 118 provisional estimate related to Japan deferred tax balances. No further adjustment was made to the SAB 118 provisional estimate related to the valuation allowance. As of December 31, 2018 , the Company has completed its accounting for the Tax Act in accordance with SAB 118. +Income tax expense in the accompanying statements of earnings varies from the amount computed by applying the expected U.S. tax rate of 21 % in 2018 and 35 % in 2017 and 2016 to pretax earnings. The principal reasons for the differences and the related tax effects for the years ended December 31 were as follows: +(In millions) +2018 +2017 +2016 +Income taxes based on U.S. statutory rates +$ +836 +$ +1,406 +$ +1,424 +Foreign rate differential +220 +0 +0 +Write-down of U.S. deferred tax liabilities for tax reform change +0 +( 1,933 +) +0 +Utilization of foreign tax credit +( 3 +) +( 27 +) +( 30 +) +Nondeductible expenses +21 +10 +8 +Other, net +( 11 +) +( 42 +) +6 +Income tax expense +$ +1,063 +$ +( 586 +) +$ +1,408 +160 +Item 8. Financial Statements and Supplementary Data +Total income tax expense for the years ended December 31 was allocated as follows: +(In millions) +2018 +2017 +2016 +Statements of earnings +$ +1,063 +$ +( 586 +) +$ +1,408 +Other comprehensive income (loss): +Unrealized foreign currency translation gains (losses) during period +10 +52 +70 +Unrealized gains (losses) on investment securities: +Unrealized holding gains (losses) on investment +securities during period +( 787 +) +575 +962 +Reclassification adjustment for realized (gains) losses +on investment securities included in net earnings +( 12 +) +1 +18 +Unrealized gains (losses) on derivatives during period +0 +0 +1 +Pension liability adjustment during period +( 8 +) +3 +( 16 +) +Total income tax expense (benefit) related to items of +other comprehensive income (loss) +( 797 +) +631 +1,035 +Additional paid-in capital (exercise of stock options) +0 +0 +( 10 +) +Total income taxes +$ +266 +$ +45 +$ +2,433 +The income tax effects of the temporary differences that gave rise to deferred income tax assets and liabilities as of December 31 were as follows: +(In millions) +2018 +2017 +Deferred income tax liabilities: +Deferred policy acquisition costs +$ +3,404 +$ +3,285 +Unrealized gains and other basis differences on investments +1,307 +2,882 +Premiums receivable +149 +104 +Policy benefit reserves +3,828 +3,557 +Total deferred income tax liabilities +8,688 +9,828 +Deferred income tax assets: +Unfunded retirement benefits +8 +8 +Other accrued expenses +40 +141 +Policy and contract claims +775 +870 +Foreign currency loss on Aflac Japan +38 +67 +Deferred compensation +163 +155 +Capital loss carryforwards +5 +0 +Depreciation +119 +114 +Anticipatory foreign tax credit +4,040 +4,504 +Deferred foreign tax credit +591 +0 +Other +150 +57 +Total deferred income tax assets before valuation allowance +5,929 +5,916 +Valuation allowance +( 738 +) +( 657 +) +Total deferred income tax assets after valuation allowance +5,191 +5,259 +Net deferred income tax liability +3,497 +4,569 +Current income tax liability +523 +176 +Total income tax liability +$ +4,020 +$ +4,745 +The application of U.S. GAAP requires the Company to evaluate the recoverability of deferred tax assets and establish a valuation allowance if necessary to reduce the deferred tax asset to an amount that is more likely than not expected to be realized. As noted above, the Company has determined a $ 577 million valuation allowance against its anticipatory foreign tax credit is necessary. The anticipatory foreign tax credit represents the foreign tax credit the Company will generate from the reversal of Japan deferred tax liabilities in the future. The Company has also determined a $ 161 million valuation allowance against its deferred foreign tax credits is necessary. Deferred foreign tax credits are foreign tax credits generated in the current tax year by the Japanese life company, but are unable to be utilized until 2019 +161 +Item 8. Financial Statements and Supplementary Data +due to Japan's current tax year not closing until March 31, 2019. Based upon a review of the Company's anticipated future taxable income, and including all other available evidence, both positive and negative, the Company's management has concluded that, notwithstanding the items noted above, it is more likely than not that all other deferred tax assets will be realized. +Under U.S. income tax rules, only 35% of non-life operating losses can be offset against life insurance taxable income each year . For current U.S. income tax purposes, as of December 31, 2018 , there were non-life operating loss carryforwards of $ 21 million available to offset against future taxable income. The Company has capital loss carryforwards of $ 22 million available to offset capital gains, of which $ 4 million expires in 2021 and $ 18 million expires in 2023. +The Company files federal income tax returns in the United States and Japan as well as state or prefecture income tax returns in various jurisdictions in the two countries. The Company is currently under audit by the State of Georgia for tax years 2014-2016. There are currently no other open Federal, State, or local U.S. income tax audits. U.S. federal income tax returns for years before 2015 are no longer subject to examination. Japan corporate income tax returns for years before 2017 are no longer subject to examination. Management believes it has established adequate tax liabilities and final resolution of all open audits is not expected to have a material impact on the Company's consolidated financial statements. +A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows for the years ended December 31: +(In millions) +2018 +2017 +Balance, beginning of year +$ +14 +$ +294 +Additions for tax positions of prior years +1 +0 +Reductions for tax positions of prior years +0 +( 280 +) +Balance, end of year +$ +15 +$ +14 +Included in the balance of the liability for unrecognized tax benefits at December 31, 2018 , are $ 14 million of tax positions for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility, compared with $ 13 million at December 31, 2017 . Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate, but would accelerate the payment of cash to the taxing authority to an earlier period. The Company has accrued approximately $ 1 million as of December 31, 2018 , for permanent uncertainties, which if reversed would not have a material effect on the annual effective rate. +The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company recognized approximately $ 1 million in interest and penalties in 2018 , compared with $ 1 million in 2017 and $ 13 million in 2016 . The Company has accrued approximately $ 2 million for the payment of interest and penalties as of December 31, 2018 , compared with $ 2 million a year ago. +As of December 31, 2018 , there were no material uncertain tax positions for which the total amounts of unrecognized tax benefits will significantly increase or decrease within the next 12 months. +11. +SHAREHOLDERS' EQUITY +See Note 1 for a discussion of the stock split that occurred in March 2018. All share and per-share amounts have been adjusted to reflect the stock split for any of the periods presented. +162 +Item 8. Financial Statements and Supplementary Data +The following table is a reconciliation of the number of shares of the Company's common stock for the years ended December 31. +(In thousands of shares) +2018 +2017 +2016 +Common stock - issued: +Balance, beginning of period +1,345,762 +1,342,498 +1,339,446 +Exercise of stock options and issuance of restricted shares +1,778 +3,264 +3,052 +Balance, end of period +1,347,540 +1,345,762 +1,342,498 +Treasury stock: +Balance, beginning of period +564,852 +530,877 +490,686 +Purchases of treasury stock: +Open market +28,949 +35,510 +43,236 +Other +392 +1,018 +662 +Dispositions of treasury stock: +Shares issued to AFL Stock Plan +( 1,306 ) +( 1,782 ) +( 2,130 ) +Exercise of stock options +( 519 ) +( 734 ) +( 1,366 ) +Other +( 114 ) +( 37 ) +( 211 ) +Balance, end of period +592,254 +564,852 +530,877 +Shares outstanding, end of period +755,286 +780,910 +811,621 +Outstanding share-based awards are excluded from the calculation of weighted-average shares used in the computation of basic EPS. The following table presents the approximate number of share-based awards to purchase shares, on a weighted-average basis, that were considered to be anti-dilutive and were excluded from the calculation of diluted earnings per share at December 31: +(In thousands) +2018 +2017 +2016 +Anti-dilutive share-based awards +44 +510 +1,822 +The weighted-average shares used in calculating earnings per share for the years ended December 31 were as follows: +(In thousands of shares) +2018 +2017 +2016 +Weighted-average outstanding shares used for calculating basic EPS +769,588 +792,042 +822,942 +Dilutive effect of share-based awards +5,062 +5,819 +4,899 +Weighted-average outstanding shares used for calculating diluted EPS +774,650 +797,861 +827,841 +Share Repurchase Program: During 2018 , the Company repurchased 28.9 million shares of its common stock in the open market, compared with 35.5 million shares in 2017 and 43.2 million shares in 2016 . As of December 31, 2018 , a remaining balance of 69.0 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its board of directors. +Voting Rights: In accordance with the Parent Company's articles of incorporation, shares of common stock are generally entitled to one vote per share until they have been held by the same beneficial owner for a continuous period of 48 months , at which time they become entitled to 10 votes per share. +Reclassifications from Accumulated Other Comprehensive Income +The tables below are reconciliations of accumulated other comprehensive income by component for the years ended December 31. +163 +Item 8. Financial Statements and Supplementary Data +Changes in Accumulated Other Comprehensive Income +2018 +(In millions) +Unrealized Foreign +Currency Translation +Gains (Losses) +Unrealized +Gains (Losses) +on Investment Securities +Unrealized +Gains (Losses) +on Derivatives +Pension +Liability +Adjustment +Total +Balance, beginning of period +$ +( 1,750 +) +$ +5,964 +$ +( 23 +) +$ +( 163 +) +$ +4,028 +Cumulative effect of change +in accounting principle - +financial instruments +0 +( 148 +) +0 +0 +( 148 +) +Cumulative effect of change +in accounting principle - +tax effects from tax reform +( 325 +) +734 +( 3 +) +( 32 +) +374 +Other comprehensive +income (loss) before +reclassification +228 +( 2,350 +) +2 +( 30 +) +( 2,150 +) +Amounts reclassified from +accumulated other +comprehensive income +(loss) +0 +34 +0 +13 +47 +Net current-period other +comprehensive +income (loss) +228 +( 2,316 +) +2 +( 17 +) +( 2,103 +) +Balance, end of period +$ +( 1,847 +) +$ +4,234 +$ +( 24 +) +$ +( 212 +) +$ +2,151 +All amounts in the table above are net of tax. +2017 +(In millions) +Unrealized Foreign +Currency Translation +Gains (Losses) +Unrealized +Gains (Losses) +on Investment Securities +Unrealized +Gains (Losses) +on Derivatives +Pension Liability Adjustment +Total +Balance, beginning of period +$ +( 1,983 +) +$ +4,805 +$ +( 24 +) +$ +( 168 +) +$ +2,630 +Other comprehensive +income (loss) before +reclassification +233 +1,158 +1 +( 6 +) +1,386 +Amounts reclassified from +accumulated other +comprehensive income +(loss) +0 +1 +0 +11 +12 +Net current-period other +comprehensive +income (loss) +233 +1,159 +1 +5 +1,398 +Balance, end of period +$ +( 1,750 +) +$ +5,964 +$ +( 23 +) +$ +( 163 +) +$ +4,028 +All amounts in the table above are net of tax. +164 +Item 8. Financial Statements and Supplementary Data +2016 +(In millions) +Unrealized Foreign +Currency Translation +Gains (Losses) +Unrealized +Gains (Losses) +on Investment Securities +Unrealized +Gains (Losses) +on Derivatives +Pension Liability Adjustment +Total +Balance, beginning of period +$ +( 2,196 +) +$ +2,986 +$ +( 26 +) +$ +( 139 +) +$ +625 +Other comprehensive +income (loss) before +reclassification +213 +1,854 +2 +( 32 +) +2,037 +Amounts reclassified from +accumulated other +comprehensive income +(loss) +0 +( 35 +) +0 +3 +( 32 +) +Net current-period other +comprehensive +income (loss) +213 +1,819 +2 +( 29 +) +2,005 +Balance, end of period +$ +( 1,983 +) +$ +4,805 +$ +( 24 +) +$ +( 168 +) +$ +2,630 +All amounts in the table above are net of tax. +For the year ended December 31, 2018 , see Note 1 for discussion of the amounts reclassified between AOCI and retained earnings upon the adoption of new accounting pronouncements. +The tables below summarize the amounts reclassified from each component of accumulated other comprehensive income based on source for the years ended December 31. +Reclassifications Out of Accumulated Other Comprehensive Income +(In millions) +2018 +Details about Accumulated Other Comprehensive Income Components +Amount Reclassified from Accumulated Other Comprehensive Income +Affected Line Item in the +Statements of Earnings +Unrealized gains (losses) on available-for-sale +securities +$ +( 63 +) +Other-than-temporary impairment +losses realized +17 +Other gains (losses) +( 46 +) +Total before tax +12 +Tax (expense) or benefit (1) +$ +( 34 +) +Net of tax +Amortization of defined benefit pension items: +Actuarial gains (losses) +$ +( 18 +) +Acquisition and operating expenses (2) +Prior service (cost) credit +0 +Acquisition and operating expenses (2) +5 +Tax (expense) or benefit (1) +$ +( 13 +) +Net of tax +Total reclassifications for the period +$ +( 47 +) +Net of tax +(1) Based on 27 % blended tax rate +(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see +Note 14 for additional details). +165 +Item 8. Financial Statements and Supplementary Data +(In millions) +2017 +Details about Accumulated Other Comprehensive Income Components +Amount Reclassified from Accumulated Other Comprehensive Income +Affected Line Item in the +Statements of Earnings +Unrealized gains (losses) on available-for-sale +securities +$ +( 29 +) +Other-than-temporary impairment +losses realized +27 +Other gains (losses) +( 2 +) +Total before tax +1 +Tax (expense) or benefit (1) +$ +( 1 +) +Net of tax +Amortization of defined benefit pension items: +Actuarial gains (losses) +$ +( 17 +) +Acquisition and operating expenses (2) +Prior service (cost) credit +0 +Acquisition and operating expenses (2) +6 +Tax (expense) or benefit (1) +$ +( 11 +) +Net of tax +Total reclassifications for the period +$ +( 12 +) +Net of tax +(1) Based on 35 % tax rate +(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see Note 14 for additional details). +(In millions) +2016 +Details about Accumulated Other Comprehensive Income Components +Amount Reclassified from Accumulated Other Comprehensive Income +Affected Line Item in the +Statements of Earnings +Unrealized gains (losses) on available-for-sale +securities +$ +( 83 +) +Other-than-temporary impairment +losses realized +136 +Other gains (losses) +53 +Total before tax +( 18 +) +Tax (expense) or benefit (1) +$ +35 +Net of tax +Amortization of defined benefit pension items: +Actuarial gains (losses) +$ +( 15 +) +Acquisition and operating expenses (2) +Prior service (cost) credit +11 +Acquisition and operating expenses (2) +1 +Tax (expense) or benefit (1) +$ +( 3 +) +Net of tax +Total reclassifications for the period +$ +32 +Net of tax +(1) Based on 35 % tax rate +(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see Note 14 for additional details). +12. SHARE-BASED COMPENSATION +See Note 1 for a discussion of the stock split that occurred in March 2018. All share and per-share amounts have been adjusted to reflect the stock split for any of the periods presented. +As of December 31, 2018 , the Company has outstanding share-based awards under the Aflac Incorporated Long-Term Incentive Plan (the "Plan"). Share-based awards are designed to reward employees for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of share-based awards are based on competitive practices, operating results of the Company, government regulations, and other factors. +The Plan, as amended on February 14, 2017, allows for a maximum number of shares issuable over its term of 75 million shares including 38 million shares that may be awarded in respect of awards other than options or stock appreciation rights. If any awards granted under the Plan are forfeited or are terminated before being exercised or settled for any reason other than tax forfeiture, then the shares underlying the awards will again be available under the Plan. +166 +Item 8. Financial Statements and Supplementary Data +The Plan allows awards to Company employees for incentive stock options (ISOs), non-qualifying stock options (NQSOs), restricted stock, restricted stock units, and stock appreciation rights. Non-employee directors are eligible for grants of NQSOs, restricted stock, and stock appreciation rights. As of December 31, 2018 , approximately 40.3 million shares were available for future grants under this plan. The ISOs and NQSOs have a term of 10 years , and the share-based awards generally vest upon time-based conditions or time and performance-based conditions. Time-based vesting generally occurs after three years . Performance-based vesting conditions generally include the attainment of goals related to Company financial performance. As of December 31, 2018 , the only performance-based awards issued and outstanding were restricted stock awards. +Stock options and stock appreciation rights granted under the amended Plan have an exercise price of at least the fair market value of the underlying stock on the grant date and have an expiration date no later than 10 years from the grant date. Time-based restricted stock awards, restricted stock units and stock options granted after January 1, 2017 generally vest on a ratable basis over three years , and awards granted prior to the amendment vest on a three-year cliff basis. The Compensation Committee of the Board of Directors has the discretion to determine vesting schedules . +Share-based awards granted to U.S.-based grantees are settled with authorized but unissued Company stock, while those issued to Japan-based grantees are settled with treasury shares. +Summary of Share-Based Compensation Expense +Share-based compensation expense consists primarily of expenses for stock options, restricted stock awards (including performance based restricted stock awards), and restricted stock units granted to employees. +The following table presents the impact of the expense recognized in connection with share-based awards for the periods ended December 31. +(In millions, except for per-share amounts) +2018 +2017 +2016 +Impact on earnings from continuing operations +$ +57 +$ +51 +$ +68 +Impact on earnings before income taxes +57 +51 +68 +Impact on net earnings +45 +35 +46 +Impact on net earnings per share: +Basic +$ +.06 +$ +.05 +$ +.06 +Diluted +.06 +.05 +.06 +Stock Options +The following table summarizes stock option activity under the employee stock option plan. +(In thousands of shares) +Stock +Option +Shares +Weighted-Average +Exercise Price +Per Share +Outstanding at December 31, 2015 +15,836 +$ +25.47 +Granted in 2016 +1,328 +30.70 +Canceled in 2016 +( 362 +) +27.82 +Exercised in 2016 +( 4,122 +) +24.46 +Outstanding at December 31, 2016 +12,680 +26.28 +Granted in 2017 +626 +35.80 +Canceled in 2017 +( 236 +) +24.95 +Exercised in 2017 +( 5,766 +) +30.11 +Outstanding at December 31, 2017 +7,304 +28.03 +Granted in 2018 +67 +44.59 +Canceled in 2018 +( 167 +) +32.11 +Exercised in 2018 +( 1,874 +) +26.78 +Outstanding at December 31, 2018 +5,330 +$ +28.54 +167 +Item 8. Financial Statements and Supplementary Data +(In thousands of shares) +2018 +2017 +2016 +Shares exercisable, end of year +3,917 +4,208 +8,986 +The Company estimates the fair value of each stock option granted using the Black-Scholes-Merton multiple option approach. Expected volatility is based on historical periods generally commensurate with the estimated terms of the options. The Company uses historical data to estimate option exercise and termination patterns within the model. Separate groups of employees that have similar historical exercise patterns are stratified and considered separately for valuation purposes. The expected term of options granted is derived from the output of the Company's option model and represents the weighted-average period of time that options granted are expected to be outstanding. The Company bases the risk-free interest rate on the Treasury note rate with a term comparable to that of the estimated term of the options. The weighted-average fair value of options at their grant date was $ 8.81 per share for 2018 , compared with $ 7.64 for 2017 and $ 6.35 in 2016 . The following table presents the assumptions used in valuing options granted during the years ended December 31. +2018 +2017 +2016 +Expected term (years) +7.0 +5.9 +6.4 +Expected volatility +22.0 +% +26.0 +% +27.0 +% +Annual forfeiture rate +3.6 +3.4 +3.2 +Risk-free interest rate +2.5 +2.5 +2.2 +Dividend yield +2.4 +2.5 +2.9 +The following table summarizes information about stock options outstanding and exercisable at December 31, 2018 . +(In thousands of shares) +Options Outstanding +Options Exercisable +Range of +Exercise Prices +Per Share +Stock Option +Shares +Outstanding +Wgtd.-Avg. +Remaining +Contractual +Life (Yrs.) +Wgtd.-Avg. +Exercise +Price +Per Share +Stock Option +Shares +Exercisable +Wgtd.-Avg. +Exercise +Price +Per Share +$ +11.07 +- +$ +24.28 +1,181 +1.8 +$ +20.76 +1,181 +$ +20.76 +24.75 +- +28.97 +1,718 +4.8 +27.76 +1,026 +26.95 +29.04 +- +31.21 +1,226 +5.8 +30.77 +1,221 +30.77 +31.22 +- +37.22 +1,134 +7.5 +34.44 +488 +33.86 +38.76 +- +44.59 +71 +9.3 +44.21 +1 +38.76 +$ +11.07 +- +$ +44.59 +5,330 +5.0 +$ +28.54 +3,917 +$ +27.14 +The aggregate intrinsic value in the following table represents the total pretax intrinsic value, and is based on the difference between the exercise price of the stock options and the quoted closing common stock price of $ 45.56 as of December 31, 2018 , for those awards that have an exercise price currently below the closing price. As of December 31, 2018 , the aggregate intrinsic value of stock options outstanding was $ 91 million , with a weighted-average remaining term of 5.0 years . The total number of in-the-money stock options exercisable as of December 31, 2018 , was 3.9 million . The aggregate intrinsic value of stock options exercisable at that same date was $ 72 million , with a weighted-average remaining term of 4.1 years . +The following table summarizes stock option activity during the years ended December 31. +(In millions) +2018 +2017 +2016 +Total intrinsic value of options exercised +$ +34 +$ +87 +$ +41 +Cash received from options exercised +48 +58 +68 +Tax benefit realized as a result of options exercised and +restricted stock releases +25 +74 +45 +Performance-Based Restricted Stock Awards +Under the Plan, the Company grants selected executive officers performance-based restricted stock awards (PBRS) each February whose vesting is contingent upon meeting various performance goals. PBRS are generally granted at-the-money and contingently cliff vest over a period of three years , generally subject to continued employment. In February +168 +Item 8. Financial Statements and Supplementary Data +2018, the Company granted 432 thousand performance-based stock awards, which are contingent on the achievement of the Company's financial performance metrics and its market-based conditions. On the date of grant, the Company estimated the fair value of restricted stock awards with market-based conditions using a Monte Carlo simulation model. The model discounts the value of the stock at the assumed vesting date based on a risk-free interest rate. Based on estimates of actual performance versus the vesting thresholds, the calculated fair value percentage pay-out estimate will be updated each quarter. Actual performance, including modification for relative total shareholder return, may result in the ultimate award of 0 % to 200 % percent of the initial number of PBRS issued, with the potential for no award if company performance goals are not achieved during the three-year period. PBRS subject to accelerated vesting at the date of retirement eligibility is recognized over the implicit service period. +The Company uses third-party analyses to assist in developing the assumptions used in, as well as calibrating, a Monte Carlo simulation model. The Company is responsible for determining the assumptions used in estimating the fair value of its share-based payment awards. +Key assumptions used to value PBRS granted during 2018 follows: +(In millions) +2018 +Expected volatility (based on Aflac Inc. and peer group historical daily stock price) +16.48 +% +Expected life from grant date (years) +2.9 +Risk-free interest rate (based on U.S. Treasury yields at the date of grant) +2.29 +% +Restricted Stock Awards and Units +The value of restricted stock awards and restricted stock units is based on the fair market value of our common stock at the date of grant. The following table summarizes restricted stock activity during the years ended December 31. +(In thousands of shares) +Shares +Weighted-Average +Grant-Date +Fair Value +Per Share +Restricted stock at December 31, 2015 +3,630 +$ +29.21 +Granted in 2016 +1,756 +30.84 +Canceled in 2016 +( 152 +) +30.33 +Vested in 2016 +( 1,498 +) +26.84 +Restricted stock at December 31, 2016 +3,736 +30.88 +Granted in 2017 +1,118 +36.48 +Canceled in 2017 +( 202 +) +32.23 +Vested in 2017 +( 1,018 +) +31.09 +Restricted stock at December 31, 2017 +3,634 +32.40 +Granted in 2018 +1,121 +44.27 +Canceled in 2018 +( 105 +) +34.39 +Vested in 2018 +( 1,243 +) +31.64 +Restricted stock at December 31, 2018 +3,407 +$ +36.52 +As of December 31, 2018 , total compensation cost not yet recognized in the Company's financial statements related to restricted stock awards and restricted stock units was $ 36 million , of which $ 15 million ( 799 thousand shares) was related to restricted stock awards with a performance-based vesting condition. The Company expects to recognize these amounts over a weighted-average period of approximately 1.0 year . There are no other contractual terms covering restricted stock awards once vested. +169 +Item 8. Financial Statements and Supplementary Data +13. STATUTORY ACCOUNTING AND DIVIDEND RESTRICTIONS +The Company's insurance subsidiaries are required to report their results of operations and financial position to insurance regulatory authorities on the basis of statutory accounting practices prescribed or permitted by such authorities. Statutory accounting practices primarily differ from U.S. GAAP by charging policy acquisition costs to expense as incurred, establishing future policy benefit liabilities using different actuarial assumptions as well as valuing investments and certain assets and accounting for deferred taxes on a different basis. +Aflac reports statutory financial statements that are prepared on the basis of accounting practices prescribed or permitted by the Nebraska Department of Insurance (NDOI). The NDOI recognizes statutory accounting principles and practices prescribed or permitted by the state of Nebraska for determining and reporting the financial condition and results of operations of an insurance company, and for determining a company's solvency under Nebraska insurance law. The National Association of Insurance Commissioners' (NAIC) Accounting Practices and Procedures Manual (SAP) has been adopted by the state of Nebraska as a component of those prescribed or permitted practices. Additionally, the Director of the NDOI has the right to permit other specific practices which deviate from prescribed practices. Prior to the Japan branch conversion on April 1, 2018, Aflac had been given explicit permission by the Director of the NDOI for two such permitted practices. These permitted practices, which did not impact the calculation of net income on a statutory basis or prevent the triggering of a regulatory event in the Company's RBC calculation, were as follows: +• +Aflac reported as admitted assets the refundable lease deposits on the leases of commercial office space which house Aflac Japan's sales operations. These lease deposits are unique and part of the ordinary course of doing business in the country of Japan; these assets would be non-admitted under SAP. +• +Aflac entered into a reinsurance agreement effective March 31, 2015 with a then unauthorized reinsurer. The effective date of this agreement predated the effective date of Nebraska's Amended Credit for Reinsurance statute (44-416) allowing certified reinsurers and also predated the subsequent approval of the agreement's assuming reinsurer as a Certified Reinsurer, which occurred on August 30, 2015 and December 24, 2015, respectively. Aflac obtained a permitted practice to recognize this treaty and counterparty as a Certified Reinsurer for the purpose of determining the collateral required to receive reinsurance reserve credit. +On April 1, 2018, the Company entered into a series of transactions in order to complete the conversion of the Japan branch into a Japanese insurance corporation. As a result of the conversion, the permitted practices were no longer necessary, therefore they were canceled by the NDOI effective April 2, 2018. A reconciliation of Aflac's capital and surplus between SAP and practices permitted by the state of Nebraska is shown below for the years ended December 31: +(In millions) +2018 +2017 +Capital and surplus, Nebraska state basis +$ +2,600 +$ +11,001 +State Permitted Practice: +Refundable lease deposits – Japan +0 +( 43 +) +Reinsurance - Japan +0 +( 818 +) +Capital and surplus, NAIC basis +$ +2,600 +$ +10,140 +As of December 31, 2018 , Aflac's capital and surplus significantly exceeded the required company action level capital and surplus of $ .5 billion . As determined on a U.S. statutory accounting basis, Aflac's net income was $ 1.3 billion in 2018 , $ 2.6 billion in 2017 and $ 2.8 billion in 2016 . +Aflac Japan must report its results of operations and financial position to the Japanese Financial Services Agency (FSA) on a Japanese regulatory accounting basis as prescribed by the FSA. Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $ 6.4 billion at December 31, 2018 , compared with $ 6.7 billion at December 31, 2017 . Japanese regulatory accounting practices differ in many respects from U.S. GAAP. Under Japanese regulatory accounting practices, policy acquisition costs are expensed immediately; policy benefit and claim reserving methods and assumptions are different; premium income is recognized on a cash basis; different consolidation criteria apply to VIEs; reinsurance is recognized on a different basis; and investments can have a separate accounting classification and treatment referred to as policy reserve matching bonds (PRM). +The Parent Company depends on its subsidiaries for cash flow, primarily in the form of dividends and management fees. Consolidated retained earnings in the accompanying financial statements largely represent the undistributed earnings of the Company's insurance subsidiary. Amounts available for dividends, management fees and other payments +170 +Item 8. Financial Statements and Supplementary Data +to the Parent Company by its insurance subsidiaries may fluctuate due to different accounting methods required by regulatory authorities. These payments are also subject to various regulatory restrictions and approvals related to safeguarding the interests of insurance policyholders. Aflac must maintain adequate RBC for U.S. regulatory authorities, and Aflac Japan must maintain adequate solvency margins for Japanese regulatory authorities. +The maximum amount of dividends that can be paid to the Parent Company by Aflac without prior approval of Nebraska's director of insurance is the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2019 in excess of $ 1.3 billion would require such approval. Aflac declared dividends of $ 12.3 billion during 2018 , including non-cash extraordinary dividends of $ 11.0 billion which represented the statutory book value of Aflac Japan on April 2, 2018. +After the Japan branch conversion as of April 1, 2018, Aflac Japan is required to meet certain financial criteria as governed by Japanese corporate law in order to provide dividends to the Parent Company. Under these criteria, dividend capacity at Aflac Japan is basically defined as retained earnings excluding capital reserves, which represent equity generated by capital profits that are statutorily required in Japan, less net after-tax unrealized losses on available-for-sale securities based on the previous fiscal year-end. Prior to April 1, 2018, a portion of Aflac Japan earnings, as determined on a Japanese regulatory accounting basis, could be remitted each year to Aflac U.S. after complying with solvency margin provisions and satisfying various conditions imposed by Japanese regulatory authorities for protecting policyholders. Profit remittances to the United States could fluctuate due to changes in the amounts of Japanese regulatory earnings. Among other items, factors affecting regulatory earnings include Japanese regulatory accounting practices and fluctuations in currency translation of Aflac Japan's U.S. dollar-denominated investments and related investment income into yen. Profits remitted by Aflac Japan to the Parent Company, after April 1, 2018, and to Aflac U.S., prior to April 1, 2018, were as follows for the years ended December 31: +In Dollars +In Yen +(In millions of dollars and billions of yen) +2018 +2017 +2016 +2018 +2017 +2016 +Profit remittances +$ +808 +$ +1,150 +$ +1,286 +89.7 +129.3 +138.5 +14. BENEFIT PLANS +Pension and Other Postretirement Plans +The Company has funded defined benefit plans in Japan and the United States, however the U.S. plan was frozen to new participants effective October 1, 2013. The Company also maintains non-qualified, unfunded supplemental retirement plans that provide defined pension benefits in excess of limits imposed by federal tax law for certain Japanese, U.S. and former employees, however the U.S. plan was frozen to new participants effective January 1, 2015. U.S. employees who are not participants in the defined benefit plan receive a nonelective 401(k) employer contribution. +The Company provides certain health care benefits for eligible U.S. retired employees, their beneficiaries and covered dependents ("other postretirement benefits"). The health care plan is contributory and unfunded. Effective January 1, 2014, employees eligible for benefits included the following: (1) active employees whose age plus service, in years, equaled or exceeded 80 (rule of 80 ); (2) active employees who were age 55 or older and have met the 15 years of service requirement; (3) active employees who would meet the rule of 80 in the next five years ; (4) active employees who were age 55 or older and who would meet the 15 years of service requirement within the next five years ; and (5) current retirees. For certain employees and former employees, additional coverage is provided for all medical expenses for life. +Information with respect to the Company's benefit plans' assets and obligations as of December 31 was as follows: +171 +Item 8. Financial Statements and Supplementary Data +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +(In millions) +2018 +2017 +2018 +2017 +2018 +2017 +Projected benefit obligation: +Benefit obligation, beginning of year +$ +341 +$ +329 +$ +908 +$ +798 +$ +36 +$ +37 +Service cost +19 +20 +27 +24 +0 +0 +Interest cost +7 +6 +31 +40 +1 +1 +Actuarial (gain) loss +35 +( 10 +) +( 69 +) +65 +4 +0 +Benefits and expenses paid +( 11 +) +( 14 +) +( 22 +) +( 19 +) +( 4 +) +( 2 +) +Effect of foreign exchange +rate changes +5 +10 +0 +0 +0 +0 +Benefit obligation, end of year +396 +341 +875 +908 +37 +36 +Plan assets: +Fair value of plan assets, +beginning of year +270 +229 +448 +359 +0 +0 +Actual return on plan assets +( 9 +) +16 +( 30 +) +61 +0 +0 +Employer contributions +34 +32 +69 +47 +4 +2 +Benefits and expenses paid +( 11 +) +( 14 +) +( 22 +) +( 19 +) +( 4 +) +( 2 +) +Effect of foreign exchange +rate changes +5 +7 +0 +0 +0 +0 +Fair value of plan assets, end of year +289 +270 +465 +448 +0 +0 +Funded status of the plans (1) +$ +( 107 +) +$ +( 71 +) +$ +( 410 +) +$ +( 460 +) +$ +( 37 +) +$ +( 36 +) +Amounts recognized in accumulated other +comprehensive income: +Net actuarial (gain) loss +$ +95 +$ +44 +$ +174 +$ +203 +$ +9 +$ +6 +Prior service (credit) cost +( 2 +) +( 2 +) +( 4 +) +( 4 +) +0 +0 +Total included in accumulated +other comprehensive income +$ +93 +$ +42 +$ +170 +$ +199 +$ +9 +$ +6 +Accumulated benefit obligation +$ +356 +$ +307 +$ +746 +$ +756 +N/A +(2) +N/A +(2) +(1) Recognized in other liabilities in the consolidated balance sheets +(2) Not applicable +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +2018 +2017 +2016 +2018 +2017 +2016 +2018 +2017 +2016 +Weighted-average actuarial assumptions: +Discount rate - net periodic benefit cost +1.25 +% +1.25 +% +1.75 +% +3.75 +% +4.25 +% +4.50 +% +3.75 +% +4.25 +% +4.50 +% +Discount rate - benefit obligations +1.25 +1.25 +1.25 +4.25 +3.75 +4.25 +4.25 +3.75 +4.25 +Expected long-term return on plan assets +2.00 +2.00 +2.00 +6.50 +6.75 +7.00 +N/A +(1) +N/A +(1) +N/A +(1) +Rate of compensation increase +N/A +(1) +N/A +(1) +N/A +(1) +4.00 +4.00 +4.00 +N/A +(1) +N/A +(1) +N/A +(1) +Health care cost trend rates +N/A +(1) +N/A +(1) +N/A +(1) +N/A +(1) +N/A +(1) +N/A +(1) +7.40 +(2) +5.40 +(2) +5.20 +(2) +(1) Not applicable +(2) For the years 2018 , 2017 and 2016 , the health care cost trend rates are expected to trend down to 4.1 % in 61 years , 4.5 % in 77 years , and 4.5 % in 74 years , respectively. +The Company determines its discount rate assumption for its pension retirement obligations based on indices for AA corporate bonds with an average duration of approximately 20 years for the Japan pension plans and 17 years for the U.S. pension plans, and determination of the U.S. pension plans discount rate utilizes the 85 -year extrapolated yield +172 +Item 8. Financial Statements and Supplementary Data +curve. In Japan, participant salary and future salary increases are not factors in determining pension benefit cost or the related pension benefit obligation. +The Company bases its assumption for the long-term rate of return on assets on historical trends ( 10 -year or longer historical rates of return for the Japanese plan assets and 15 -year historical rates of return for the U.S. plan assets), expected future market movement, as well as the portfolio mix of securities in the asset portfolio including, but not limited to, style, class and equity and fixed income allocations. In addition, the Company's consulting actuaries evaluate its assumptions for long-term rates of return under Actuarial Standards of Practice (ASOP). Under the ASOP, the actual portfolio type, mix and class is modeled to determine a best estimate of the long-term rate of return. The Company in turn use those results to further validate its own assumptions. +Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one-percentage point increase and decrease in assumed health care cost trend rates would have the following effects as of December 31, 2018 : +(In millions) +One percentage point increase: +Increase in total service and interest costs +$ +0 +Increase in postretirement benefit obligation +1 +One percentage point decrease: +Decrease in total service and interest costs +$ +0 +Decrease in postretirement benefit obligation +1 +Components of Net Periodic Benefit Cost +Pension and other postretirement benefit expenses are included in acquisition and operating expenses in the consolidated statements of earnings, which includes $ 25 million , $ 35 million and $ 17 million of other components of net periodic pension cost and postretirement costs (other than services costs) for the years ended December 31, 2018, 2017 and 2016, respectively. Total net periodic benefit cost includes the following components: +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +(In millions) +2018 +2017 +2016 +2018 +2017 +2016 +2018 +2017 +2016 +Service cost +$ +19 +$ +20 +$ +16 +$ +27 +$ +24 +$ +23 +$ +0 +$ +0 +$ +1 +Interest cost +7 +6 +9 +31 +40 +29 +1 +1 +2 +Expected return on plan +assets +( 6 +) +( 5 +) +( 4 +) +( 26 +) +( 24 +) +( 23 +) +0 +0 +0 +Amortization of net actuarial +loss +1 +2 +1 +16 +14 +13 +1 +1 +1 +Amortization of prior service +cost (credit) +0 +0 +0 +0 +0 +0 +0 +0 +( 11 +) +Net periodic (benefit) cost +$ +21 +$ +23 +$ +22 +$ +48 +$ +54 +$ +42 +$ +2 +$ +2 +$ +( 7 +) +Changes in Accumulated Other Comprehensive Income +The following table summarizes the amounts recognized in other comprehensive loss (income) for the years ended December 31: +173 +Item 8. Financial Statements and Supplementary Data +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +(In millions) +2018 +2017 +2016 +2018 +2017 +2016 +2018 +2017 +2016 +Net actuarial loss (gain) +$ +52 +$ +( 21 +) +$ +26 +$ +( 13 +) +$ +28 +$ +27 +$ +4 +$ +0 +$ +( 4 +) +Amortization of net actuarial loss +( 1 +) +( 2 +) +( 1 +) +( 16 +) +( 14 +) +( 13 +) +( 1 +) +( 1 +) +( 1 +) +Amortization of prior +service cost +0 +0 +0 +0 +0 +0 +0 +0 +11 +Total +$ +51 +$ +( 23 +) +$ +25 +$ +( 29 +) +$ +14 +$ +14 +$ +3 +$ +( 1 +) +$ +6 +No transition obligations arose during 2018 , and the transition obligations amortized to expense were immaterial for the years ended December 31, 2018 , 2017 and 2016 . Amortization of actuarial losses to expense in 2019 is estimated to be $ 4 million for the Japanese plans, $ 11 million for the U.S. plans and $ 1 million for the other postretirement benefits plan. Amortization of prior service costs and credits and transition obligations for all plans is expected to be negligible in 2019 . +Benefit Payments +The following table provides expected benefit payments, which reflect expected future service, as appropriate. +Pension Benefits +Other +(In millions) +Japan +U.S. +Postretirement Benefits +2019 +$ +12 +$ +25 +$ +3 +2020 +12 +26 +3 +2021 +12 +27 +4 +2022 +19 +36 +4 +2023 +15 +34 +4 +2024-2028 +89 +199 +17 +Funding +The Company plans to make contributions of $ 33 million to the Japanese funded defined benefit plan and $ 10 million to the U.S. funded defined benefit plan in 2019 . The funding policy for the Company's non-qualified supplemental defined benefit pension plans and other postretirement benefits plan is to contribute the amount of the benefit payments made during the year. +Plan Assets +The investment objective of the Company's Japanese and U.S. funded defined benefit plans is to preserve the purchasing power of the plan's assets and earn a reasonable inflation-adjusted rate of return over the long term. Furthermore, the Company seeks to accomplish these objectives in a manner that allows for the adequate funding of plan benefits and expenses. In order to achieve these objectives, the Company's goal is to maintain a conservative, well-diversified and balanced portfolio of high-quality equity, fixed-income and money market securities. As a part of its strategy, the Company has established strict policies covering quality, type and concentration of investment securities. For the Company's Japanese plan, these policies include limitations on investments in derivatives including futures, options and swaps, and low-liquidity investments such as real estate, venture capital investments, and privately issued securities. For the Company's U.S. plan, these policies prohibit investments in precious metals, limited partnerships, venture capital, and direct investments in real estate. The Company is also prohibited from trading on margin. +The plan fiduciaries for the Company's funded defined benefit plans have developed guidelines for asset allocations reflecting a percentage of total assets by asset class, which are reviewed on an annual basis. Asset allocation targets as of December 31, 2018 were as follows: +174 +Item 8. Financial Statements and Supplementary Data +Japan Pension +U.S. Pension +Domestic equities +5 +% +40 +% +International equities +18 +20 +Fixed income securities +66 +40 +Other +11 +0 +Total +100 +% +100 +% +The U.S. Pension Plan had $ 39 million in cash at December 31, 2018. The plan fiduciaries authorized investing a contribution made to the Plan in 2018 on a graduated basis over a period of time. +The following table presents the fair value of Aflac Japan's pension plan assets that are measured at fair value on a recurring basis as of December 31. All of these assets are classified as Level 2 in the fair value hierarchy. +(In millions) +2018 +2017 +Japan pension plan assets: +Equities: +Japanese equity securities +$ +14 +$ +37 +International equity securities +50 +50 +Fixed income securities: +Japanese bonds +34 +91 +International bonds +160 +62 +Insurance contracts +31 +30 +Total +$ +289 +$ +270 +The following table presents the fair value of Aflac U.S.'s pension plan assets that are measured at fair value on a recurring basis as of December 31. All of these assets are classified as Level 1 in the fair value hierarchy. +(In millions) +2018 +2017 +U.S. pension plan assets: +Mutual funds: +Large cap equity funds +$ +120 +$ +124 +Mid cap equity funds +17 +22 +Real estate equity funds +13 +13 +International equity funds +92 +108 +Fixed income bond funds +179 +175 +Aflac Incorporated common stock +5 +5 +Cash and cash equivalents +39 +1 +Total +$ +465 +$ +448 +The fair values of the Company's pension plan investments categorized as Level 1, consisting of mutual funds and common stock, are based on quoted market prices for identical securities traded in active markets that are readily and regularly available to the Company. The fair values of the Company's pension plan investments classified as Level 2 are based on quoted prices for similar assets in markets that are not active, other inputs that are observable, such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks, and default rates, or other market-corroborated inputs. +175 +Item 8. Financial Statements and Supplementary Data +401(k) Plan +The Company sponsors a 401(k) plan in which it matches a portion of U.S. employees' contributions. The plan provides for salary reduction contributions by employees and provides for matching contributions which, starting January 1, 2018, the Company increased to 100 % of each employee's contributions which were not in excess of 4 % of the employee's annual cash compensation as a result of tax reform. In 2017 and 2016, the plan provided for matching contributions by the Company of 50 % of each employee's contributions which were not in excess of 6 % of the employee's annual compensation. Also, as a result of U.S. tax reform legislation enacted in December 2017, the Company announced it would made a one-time contribution of $ 500 to the 401(k) plan to all employees active on December 31, 2017. This contribution was made by January 31, 2018. The Company also provides a nonelective contribution to the 401(k) plan of 2 % of annual cash compensation for employees who opted out of the future benefits of the U. S. defined benefit plan and for new U. S. employees. +The 401(k) contributions by the Company, included in acquisition and operating expenses in the consolidated statements of earnings, were $ 18 million in 2018 , $ 15 million in 2017 and $ 11 million in 2016 . The plan trustee held approximately 2.7 million shares of the Company's common stock for plan participants at December 31, 2018 . +Stock Bonus Plan +Aflac U.S. maintains a stock bonus plan for eligible U.S. sales associates. Plan participants receive shares of Aflac Incorporated common stock based on their new annualized premium sales and their first-year persistency of substantially all new insurance policies. The cost of this plan, which was capitalized as deferred policy acquisition costs, amounted to $ 31 million in 2018 , 2017 and 2016 . +15. COMMITMENTS AND CONTINGENT LIABILITIES +The Company has two outsourcing agreements with a technology and consulting corporation. The first agreement provides mainframe computer operations, distributed mid-range server computer operations, and related support for Aflac Japan. It has a remaining term of four years and an aggregate remaining cost of 36.1 billion yen ( $ 326 million using the December 31, 2018 , exchange rate). The second agreement provides application maintenance and development services for Aflac Japan. It has a remaining term of five years and an aggregate remaining cost of 8.6 billion yen ( $ 77 million using the December 31, 2018 , exchange rate). +The Company has an outsourcing agreement with a management consulting and technology services company to provide application maintenance and development services for its Japanese operation. The agreement has a remaining term of three years with an aggregate remaining cost of 10.4 billion yen ( $ 94 million using the December 31, 2018 , exchange rate). +The Company has two outsourcing agreements with information technology and data services companies to provide application maintenance and development services for its Japanese operation. The first agreement has a remaining term of one year with an aggregate remaining cost of .6 billion yen ( $ 5 million using the December 31, 2018 , exchange rate). The second agreement has a remaining term of four years with an aggregate remaining cost of 5.8 billion yen ( $ 52 million using the December 31, 2018 , exchange rate). +The Company leases office space and equipment under agreements that expire in various years through 2028 . Future minimum lease payments due under non-cancelable operating leases at December 31, 2018 , were as follows: +(In millions) +2019 +$ +63 +2020 +47 +2021 +35 +2022 +31 +2023 +8 +Thereafter +18 +Total future minimum lease payments +$ +202 +176 +Item 8. Financial Statements and Supplementary Data +The Company is a defendant in various lawsuits considered to be in the normal course of business. Members of the Company's senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. +See Note 3 of the Notes to the Consolidated Financial Statements for details on certain investment commitments. +Guaranty Fund Assessments +The United States insurance industry has a policyholder protection system that is monitored and regulated by state insurance departments. These life and health insurance guaranty associations are state entities (in all 50 states as well as Puerto Rico and the District of Columbia) created to protect policyholders of an insolvent insurance company. All insurance companies (with limited exceptions) licensed to sell life or health insurance in a state must be members of that state’s guaranty association. Under state guaranty association laws, certain insurance companies can be assessed (up to prescribed limits) for certain obligations to the policyholders and claimants of impaired or insolvent insurance companies that write the same line or similar lines of business. +In 2009, the Pennsylvania Insurance Commissioner placed long-term care insurer Penn Treaty Network America Insurance Company and its subsidiary American Network Insurance Company (collectively referred to as Penn Treaty), neither of which is affiliated with Aflac, in rehabilitation and petitioned a state court for approval to liquidate Penn Treaty. A final order of liquidation was granted by a recognized judicial authority on March 1, 2017, and as a result, Penn Treaty is in the process of liquidation. The Company estimated and recognized the impact of its share of guaranty fund assessments resulting from the liquidation using a discounted rate of 4.25 % . The Company recognized a discounted liability for the assessments of $ 62 million (undiscounted $ 94 million ), offset by discounted premium tax credits of $ 48 million (undiscounted $ 74 million ), for a net $ 14 million impact to net income in the quarter ended March 31, 2017. The Company paid a majority of these assessments by March 31, 2018, and a majority of the tax credit will be realized over the next four years. The Company used the cost estimate provided as of the liquidation date by the National Organization of Life and Health Guaranty Associations (NOLHGA) to calculate its estimated assessments and tax credits. Other guaranty fund assessments for the years ended December 31, 2018, 2017, and 2016 were immaterial. +16. UNAUDITED CONSOLIDATED QUARTERLY FINANCIAL DATA +In management's opinion, the following quarterly financial information fairly presents the results of operations for such periods and is prepared on a basis consistent with the Company's annual audited financial statements. +177 +Item 8. Financial Statements and Supplementary Data +(In millions, except for per-share amounts) +March 31, +2018 +June 30, +2018 +September 30, +2018 +December 31, +2018 +Net premium income +$ +4,745 +$ +4,706 +$ +4,636 +$ +4,591 +Net investment income +837 +862 +870 +874 +Realized investment gains (losses) +( 134 +) +3 +56 +( 355 +) +Other income (loss) +16 +18 +15 +16 +Total revenues +5,464 +5,589 +5,577 +5,126 +Total benefits and expenses +4,482 +4,458 +4,431 +4,404 +Earnings before income taxes +982 +1,131 +1,146 +722 +Total income tax +265 +299 +301 +197 +Net earnings +$ +717 +$ +832 +$ +845 +$ +525 +Net earnings per basic share +$ +.92 +$ +1.08 +$ +1.10 +$ +.69 +Net earnings per diluted share +.91 +1.07 +1.09 +.69 +Quarterly amounts may not agree in total to the corresponding annual amounts due to rounding. +(In millions, except for per-share amounts) +March 31, +2017 +June 30, +2017 +September 30, +2017 +December 31, +2017 +Net premium income +$ +4,638 +$ +4,665 +$ +4,648 +$ +4,580 +Net investment income +794 +802 +811 +812 +Realized investment gains (losses) +( 140 +) +( 56 +) +30 +15 +Other income (loss) +17 +17 +17 +17 +Total revenues +5,309 +5,428 +5,506 +5,424 +Total benefits and expenses +4,411 +4,383 +4,431 +4,425 +Earnings before income taxes +898 +1,045 +1,075 +999 +Total income tax +306 +332 +359 +( 1,585 +) +Net earnings +$ +592 +$ +713 +$ +716 +$ +2,584 +Net earnings per basic share +$ +.74 +$ +.90 +$ +.91 +$ +3.29 +Net earnings per diluted share +.73 +.89 +.90 +3.27 +Quarterly amounts may not agree in total to the corresponding annual amounts due to rounding. +178 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL +DISCLOSURE +There have been no changes in, or disagreements with, accountants on accounting and financial disclosure matters during the years ended December 31, 2018 and 2017 . +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this annual report (the “Evaluation Date”). Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures are effective. +Internal Control Over Financial Reporting +(a) Management's Annual Report on Internal Control Over Financial Reporting +Management's Annual Report on Internal Control Over Financial Reporting is incorporated herein by reference from Part II, Item 8 of this report. +(b) Attestation Report of the Registered Public Accounting Firm +The Attestation Report of the Registered Public Accounting Firm on the Company's internal control over financial reporting is incorporated herein by reference from Part II, Item 8 of this report. +(c) Changes in Internal Control Over Financial Reporting +There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the last fiscal quarter of 2018 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. +ITEM 9B. OTHER INFORMATION +Not applicable. +179 +Item 10. Directors, Executive Officers and Corporate Governance +PART III +Pursuant to General Instruction G to Form 10-K, Items 10 through 14 are incorporated by reference from the Company's definitive Notice and Proxy Statement relating to the Company's 2019 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission on or about March 22, 2019, pursuant to Regulation 14A under the Exchange Act. The Audit Committee Report and Compensation Committee Report to be included in such proxy statement shall be deemed to be furnished in this report and shall not be incorporated by reference into any filing under the Securities Act of 1933 as a result of such furnishing in Items 10 and 11, respectively. +Refer to the Information Contained in the Proxy +Statement under Captions (filed electronically) +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Executive Officers - +see Part I, Item 1 herein +1. Election of Directors; Section 16(a) Beneficial Ownership Reporting Compliance; Audit and Risk Committee; Audit and Risk Committee Report; Director Nominating Process; and Code of Business Conduct and Ethics +ITEM 11. +EXECUTIVE COMPENSATION +Director Compensation; Compensation Committee; Compensation Committee Report; Compensation Discussion and Analysis; 2018 Summary Compensation Table; 2018 Grants of Plan-Based Awards; 2018 Outstanding Equity Awards at Fiscal Year-End; 2018 Option Exercises and Stock Vested; Pension Benefits; Nonqualified Deferred Compensation; Potential Payments Upon Termination or Change-In-Control; and Compensation Committee Interlocks and Insider Participation +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Principal Shareholders; Election of Directors (Proposal 1); Security Ownership of Management; and Equity Compensation Plan Information +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Related Person Transactions; and Director Independence +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +Ratification of Appointment of Independent Registered Public Accounting Firm (Proposal 3); and Audit and Risk Committee +180 +Item 15. Exhibits, Financial Statement Schedules +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) +1. +FINANCIAL STATEMENTS +Page(s) +Included in Part II, Item 8, of this report: +Aflac Incorporated and Subsidiaries: +Report of Independent Registered Public Accounting Firm +87 +Consolidated Statements of Earnings for each of the years in the three- +year period ended December 31, 2018 +89 +Consolidated Statements of Comprehensive Income for each of the +years in the three-year period ended December 31, 2018 +90 +Consolidated Balance Sheets as of December 31, 2018 and 2017 +91 +Consolidated Statements of Shareholders' Equity for each of the years +in the three-year period ended December 31, 2018 +93 +Consolidated Statements of Cash Flows for each of the years in the +three-year period ended December 31, 2018 +94 +Notes to the Consolidated Financial Statements +95 +Unaudited Consolidated Quarterly Financial Data +177 +2. +FINANCIAL STATEMENT SCHEDULES +Included in Part IV of this report: +Schedule II - +Condensed Financial Information of Registrant as of December 31, 2018 and 2017, and for each of the years in the three-year period ended December 31, 2018 +187 +Schedule III - +Supplementary Insurance Information as of December 31, 2018 and 2017, and for each of the years in the three-year period ended December 31, 2018 +193 +Schedule IV - +Reinsurance for each of the years in the three-year period ended December 31, 2018 +194 +3. +EXHIBIT INDEX +An “Exhibit Index” has been filed as part of this Report beginning on the following page and is incorporated herein by this reference. +Schedules other than those listed above are omitted because they are not required, are not material, are not applicable, or the required information is shown in the financial statements or notes thereto. +In reviewing the agreements included as exhibits to this annual report, please remember they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. The agreements contain representations and warranties by each of the parties to the applicable agreement. These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and: +• +should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate; +• +have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement; +• +may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and +• +were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. +Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. +181 +(b) +EXHIBIT INDEX (1) +3.0 +- +Articles of Incorporation, as amended – incorporated by reference from Form 10-Q for June 30, 2008, Exhibit 3.0 (File No. 001-07434). +3.1 +- +Bylaws of the Corporation, as amended and restated – incorporated by reference from Form 8-K dated November 10, 2015, Exhibit 3.1 ( File No. 001-07434) +4.0 +- +There are no instruments with respect to long-term debt not being registered in which the total amount of securities authorized exceeds 10% of the total assets of Aflac Incorporated and its subsidiaries on a consolidated basis. We agree to furnish a copy of any long-term debt instrument to the Securities and Exchange Commission upon request. +4.1 +- +Indenture, dated as of May 21, 2009, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee – incorporated by reference from Form 8-K dated May 21, 2009, Exhibit 4.1 (File No. 001-07434). +4.2 +- +Second Supplemental Indenture, dated as of December 17, 2009, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 6.900% Senior Note due 2039) – incorporated by reference from Form 8-K dated December 14, 2009, Exhibit 4.1 (File No. 001-07434). +4.3 +- +Third Supplemental Indenture, dated as of August 9, 2010, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 6.45% Senior Note due 2040) - incorporated by reference from Form 8-K dated August 4, 2010, Exhibit 4.1 (File No. 001-07434). +4.4 +- +Sixth Supplemental Indenture, dated as of February 10, 2012, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 4.00% Senior Note due 2022) - incorporated by reference from Form 8-K dated February 8, 2012, Exhibit 4.2 (File No. 001-07434). +4.5 +- +Eighth Supplemental Indenture, dated as of June 10, 2013, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 3.625% Senior Note due 2023) - incorporated by reference from Form 8-K dated June 10, 2013, Exhibit 4.1 (File No. 001-07434). +4.6 +- +Ninth Supplemental Indenture, dated as of November 7, 2014, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 3.625% Senior Note due 2024) - incorporated by reference from Form 8-K dated November 4, 2014, Exhibit 4.1 (File No. 001-07434). +4.7 +- +Tenth Supplemental Indenture, dated as of March 12, 2015, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 2.40% Senior Note due 2020) - incorporated by reference from Form 8-K dated March 9, 2015, Exhibit 4.1 (File No. 001-07434). +4.8 +- +Eleventh Supplemental Indenture, dated as of March 12, 2015, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 3.25% Senior Note due 2025) - incorporated by reference from Form 8-K dated March 9, 2015, Exhibit 4.2 (File No. 001-07434). +4.9 +- +Twelfth Supplemental Indenture, dated as of September 19, 2016, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 2.875% Senior Note due 2026) - incorporated by reference from Form 8-K dated September 19, 2016, Exhibit 4.1 (File No. 001-07434). +4.10 +- +Thirteenth Supplemental Indenture, dated as of September 19, 2016, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 4.000% Senior Note due 2046) – incorporated by reference from Form 8-K dated September 19, 2016, Exhibit 4.2 (File No. 001-07434). +4.11 +- +Fourteenth Supplemental Indenture, dated as of January 25, 2017, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of .932% Senior Note due 2027) – incorporated by reference from Form 8-K dated January 25, 2017, Exhibit 4.1 (File No. 001-07434). +4.12 +- +Fifteenth Supplemental Indenture, dated as of October 18, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.159% Senior Note due 2030) – incorporated by reference from Form 8-K dated October 18, 2018, Exhibit 4.1 (File No. 001-07434). +4.13 +- +Sixteenth Supplemental Indenture, dated as of October 18, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.488% Senior Note due 2033) – incorporated by reference from Form 8-K dated October 18, 2018, Exhibit 4.2 (File No. 001-07434). +182 +4.14 +- +Seventeenth Supplemental Indenture, dated as of October 18, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.750% Senior Note due 2038) – incorporated by reference from Form 8-K dated October 18, 2018, Exhibit 4.3 (File No. 001-07434). +4.15 +- +Eighteenth Supplemental Indenture, dated as of October 31, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 4.750% Senior Note due 2049) – incorporated by reference from Form 8-K dated October 31, 2018, Exhibit 4.1 (File No. 001-07434). +4.16 +- +Subordinated Indenture, dated as of September 26, 2012, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee – incorporated by reference from Form 8-K dated September 26, 2012, Exhibit 4.1 (File No. 001-07434). +4.17 +- +Second Supplemental Indenture, dated as of October 23, 2017, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 2.108% Subordinated Debenture due 2047) - incorporated by reference from Form 8-K dated October 23, 2017, Exhibit 4.1 (File No. 001-07434). +10.0 * +- +American Family Corporation Retirement Plan for Senior Officers, as amended and restated October 1, 1989 – incorporated by reference from 1993 Form 10-K, Exhibit 10.2 (File No. 001-07434). +10.1 * +- +Amendment to American Family Corporation Retirement Plan for Senior Officers, dated December 8, 2008 – incorporated by reference from 2008 Form 10-K, Exhibit 10.1 (File No. 001-07434). +10.2 * +- +Second Amendment to the American Family Corporation Retirement Plan for Senior Officers, dated November 16, 2012 – incorporated by reference from Form 10-Q for September 30, 2016, Exhibit 10.2 (File No. 001-07434). +10.3 * +- +Third Amendment to the American Family Corporation Retirement Plan for Senior Officers, dated October 18, 2016 – incorporated by reference from Form 10-Q for September 30, 2016, Exhibit 10.3 (File No. 001-07434). +10.4 * +- +Aflac Incorporated Supplemental Executive Retirement Plan, as amended and restated January 1, 2009 – incorporated by reference from 2008 Form 10-K, Exhibit 10.5 (File No. 001-07434). +10.5 * +- +First Amendment to the Aflac Incorporated Supplemental Executive Retirement Plan, as amended and restated January 1, 2009 – incorporated by reference from 2012 Form 10-K, Exhibit 10.3 (File No. 001-07434). +10.6 * +- +Second Amendment to the Aflac Incorporated Supplemental Executive Retirement Plan, as amended and restated January 1, 2009 – incorporated by reference from 2014 Form 10-K, Exhibit 10.4 (File No. 001-07434). +10.7 * +- +Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from Form 10-Q for September 30, 2015, Exhibit 10.5 (File No. 001-07434). +10.8 * +- +First Amendment to the Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from Form 10-Q for September 30, 2016, Exhibit 10.8 (File No. 001-07434). +10.9 * +- +Second Amendment to the Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from Form 10-Q for March 31, 2017, Exhibit 10.9 (File No. 001-07434). +10.10 * +- +Third Amendment to the Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015. +10.11 * +- +Aflac Incorporated 2013 Management Incentive Plan – incorporated by reference from the 2012 Proxy Statement, Appendix B (File No. 001-07434). +10.12 * +- +Aflac Incorporated 2018 Management Incentive Plan - incorporated by reference from the 2017 Proxy Statement, Appendix B (File No. 001-07434). +10.13 * +- +1999 Aflac Associate Stock Bonus Plan, amended and restated as of January 1, 2013 – incorporated by reference from Form 10-Q for March 31, 2013, Exhibit 10.10 (File No. 001-07434). +10.14 * +- +Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from the 1997 Shareholders’ Proxy Statement, Appendix B (File No. 001-07434). +10.15 * +- +Form of Officer Stock Option Agreement (Non-Qualifying Stock Option) under the Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from Form 8-K dated January 28, 2005, Exhibit 10.5 (File No. 001-07434). +10.16 * +- +Form of Officer Stock Option Agreement (Incentive Stock Option) under the Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from Form 8-K dated January 28, 2005, Exhibit 10.6 (File No. 001-07434). +183 +10.17 * +- +Notice of grant of stock options and stock option agreement to officers under the Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from Form 8-K dated January 28, 2005, Exhibit 10.7 (File No. 001-07434). +10.18 * +- +2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from the 2012 Proxy Statement, Appendix A (File No. 001-07434). +10.19 * +- +Form of Non-Employee Director Stock Option Agreement (NQSO) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.13 (File No. 001-07434). +10.20 * +- +Notice of grant of stock options to non-employee director under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.14 (File No. 001-07434). +10.21 * +- +Form of Non-Employee Director Restricted Stock Award Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.15 (File No. 001-07434). +10.22 * +- +Notice of restricted stock award to non-employee director under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.16 (File No. 001-07434). +10.23 * +- +U.S. Form of Employee Restricted Stock Award Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.17 (File No. 001-07434). +10.24 * +- +Japan Form of Employee Restricted Stock Award Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.18 (File No. 001-07434). +10.25 * +- +Notice of time based restricted stock award under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for June 30, 2013, Exhibit 10.22 (File No. 001-07434). +10.26 * +- +Notice of performance based restricted stock award under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.20 (File No. 001-07434). +10.27 * +- +U.S. Form of Employee Stock Option Agreement (Non-Qualifying Stock Option) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.21 (File No. 001-07434). +10.28 * +- +Japan Form of Employee Stock Option Agreement (Non-Qualifying Stock Option) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.22 (File No. 001-07434). +10.29 * +- +U.S. Form of Employee Stock Option Agreement (Incentive Stock Option) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.23 (File No. 001-07434). +10.30 * +- +U.S. Notice of grant of stock options under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for June 30, 2013, Exhibit 10.28 (File No. 001-07434). +10.31 * +- +Japan Notice of grant of stock options under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for June 30, 2013, Exhibit 10.29 (File No. 001-07434). +10.32 * +- +Japan Form of Restricted Stock Unit Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.26 (File No. 001-07434). +10.33 * +- +Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 8-K dated May 1, 2017, Exhibit 10.1 (File No. 001-07434). +10.34 * +- +Form of Non-Employee Director Stock Option Agreement (Non-Qualifying Stock Option) under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for June 30, 2017, Exhibit 10.33 (File No. 001-07434). +10.35 * +- +Form of Non-Employee Director Restricted Stock Award Agreement under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for June 30, 2017, Exhibit 10.34 (File No. 001-07434). +10.36 * +- +Notice of time based restricted stock unit and restricted stock unit agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.1 (File No. 001-07434). +10.37 * +- +2017 Notice of performance based restricted stock and restricted stock award agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.2 (File No. 001-07434). +184 +10.38 * +- +Notice of time based restricted stock unit and restricted stock unit agreement under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.3 (File No. 001-07434). +10.39 * +- +2018 Notice of performance based restricted stock and restricted stock award agreement under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.4 (File No. 001-07434). +10.40 * +- +Aflac Incorporated Retirement Plan for Directors Emeritus, as amended and restated, dated February 9, 2010 – incorporated by reference from 2009 Form 10-K, Exhibit 10.26 (File No. 001-07434). +10.41 * +- +Amendment to Aflac Incorporated Retirement Plan for Directors Emeritus, as amended and restated, dated August 10, 2010 – incorporated by reference from Form 10-Q for September 30, 2010, Exhibit 10.27 (File No. 001-07434). +10.42 * +- +Aflac Incorporated Employment Agreement with Daniel P. Amos, as amended and restated, dated August 20, 2015 – incorporated by reference from Form 10-Q for September 30, 2015, Exhibit 10.29 (File No. 001-07434). +10.43 * +- +Aflac Employment Agreement with Eric M. Kirsch, as amended and restated, dated December 1, 2015 – incorporated by reference from Form 8-K dated December 1, 2015, Exhibit 10.1 (File No. 001-07434). +10.44 * +- +Amendment to Aflac Employment Agreement with Eric M. Kirsch, dated November 30, 2017 – incorporated by reference from 2017 Form 10-K, Exhibit 10.42 (File No. 001-07434). +10.45 * +- +Aflac Incorporated Employment Agreement with Frederick J. Crawford, effective June 30, 2015 – incorporated by reference from Form 8-K dated June 24, 2015, Exhibit 10.1 (File No. 001-07434). +10.46 * +- +Aflac Incorporated Employment Agreement with Charles D. Lake II, dated January 1, 2018 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.5 (File No. 001-07434). +10.47 * +- +Aflac Incorporated Employment Agreement with Audrey Boone Tillman, dated June 11, 2015 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.6 (File No. 001-07434). +10.48 +- +Basic Agreement regarding the “Strategic Alliance Based on Capital Relationship”, dated December 19, 2018, by and among Japan Post Holdings Co., Ltd., Aflac Incorporated and Aflac Life Insurance Japan Ltd. – incorporated by reference from Form 8-K dated December 19, 2018, Exhibit 10.1 (File No. 001-07434). +10.49 +- +Letter Agreement, dated December 19, 2018, by and between Japan Post Holdings Co., Ltd. and Aflac Incorporated – incorporated by reference from Form 8-K dated December 19, 2018, Exhibit 10.2 (File No. 001-07434). +21 +- +Subsidiaries. +23 +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement No. 333-158969 with respect to the Aflac Incorporated 401(k) Savings and Profit Sharing Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement Nos. 333-135327, 333-161269, and 333-202781 with respect to the Aflac Incorporated Executive Deferred Compensation Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement No. 333-200570 with respect to the Aflac Incorporated Market Director Deferred Compensation Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement No. 333-115105 and 333-219888 with respect to the Aflac Incorporated Long-Term Incentive Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-3 Registration Statement No. 333-219784 with respect to the AFL Stock Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-3 Registration Statement No. 333-227244 with respect to the Aflac Incorporated shelf registration statement. +31.1 +- +Certification of CEO dated February 22, 2019, required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934. +31.2 +- +Certification of CFO dated February 22, 2019, required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934. +32 +- +Certification of CEO and CFO dated February 22, 2019, pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101.INS +- +XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH +- +XBRL Taxonomy Extension Schema. +185 +101.CAL +- +XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +- +XBRL Taxonomy Extension Definition Linkbase. +101.LAB +- +XBRL Taxonomy Extension Label Linkbase. +101.PRE +- +XBRL Taxonomy Extension Presentation Linkbase. +(1) +Copies of any exhibit are available upon request by calling our Investor Relations Department at 800.235.2667 - option 3 +* +Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 15(b) of this report. +186 +(c) +FINANCIAL STATEMENT SCHEDULES +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Statements of Earnings +Years ended December 31, +(In millions) +2018 +2017 +2016 +Revenues: +Management and service fees from subsidiaries (1) +$ +190 +$ +297 +$ +265 +Net investment income +69 +30 +18 +Interest from subsidiaries (1) +4 +5 +5 +Realized investment gains (losses) +90 +67 +84 +Change in fair value of the cross-currency interest rate swaps +( 106 +) +( 68 +) +( 159 +) +Total revenues +247 +331 +213 +Operating expenses: +Interest expense +188 +197 +213 +Other operating expenses (2) +225 +180 +277 +Total operating expenses +413 +377 +490 +Earnings before income taxes and equity in earnings of +subsidiaries +( 166 +) +( 46 +) +( 277 +) +Income tax expense (benefit) +( 12 +) +( 23 +) +( 102 +) +Earnings before equity in earnings of subsidiaries +( 154 +) +( 23 +) +( 175 +) +Equity in earnings of subsidiaries (1) +3,074 +4,627 +2,834 +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +(1) Eliminated in consolidation +(2) Includes expense of $ 13 in 2017 and $ 137 in 2016 for the early extinguishment of debt +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +187 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Statements of Comprehensive Income (Loss) +Years ended December 31, +(In millions) +2018 +2017 +2016 +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +Other comprehensive income (loss) before income taxes: +Unrealized foreign currency translation gains (losses) during period +232 +286 +283 +Unrealized gains (losses) on fixed maturity securities during period (1) +( 3,109 +) +1,733 +2,799 +Unrealized gains (losses) on derivatives during period +2 +1 +3 +Pension liability adjustment during period +( 25 +) +9 +( 45 +) +Total other comprehensive income (loss) before +income taxes +( 2,900 +) +2,029 +3,040 +Income tax expense (benefit) related to items of other comprehensive +income (loss) +( 797 +) +631 +1,035 +Other comprehensive income (loss), net of income taxes +( 2,103 +) +1,398 +2,005 +Total comprehensive income (loss) +$ +817 +$ +6,002 +$ +4,664 +(1) See Note 1 of Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +188 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Balance Sheets +December 31, +(In millions, except for share and per-share amounts) +2018 +2017 +Assets: +Investments and cash: +Fixed maturity securities available for sale, at fair value +(amortized cost $1,209 in 2018 and $1,163 in 2017) +$ +1,222 +$ +1,213 +Investments in subsidiaries (1) +26,230 +26,869 +Other investments +21 +51 +Cash and cash equivalents +1,767 +1,725 +Total investments and cash +29,240 +29,858 +Due from subsidiaries (1) +98 +90 +Income taxes receivable +176 +121 +Other assets +390 +366 +Total assets +$ +29,904 +$ +30,435 +Liabilities and shareholders' equity: +Liabilities: +Employee benefit plans +$ +310 +$ +341 +Notes payable +5,765 +5,267 +Other liabilities +367 +229 +Total liabilities +6,442 +5,837 +Shareholders' equity: +Common stock of $.10 par value. In thousands: authorized 1,900,000 shares in 2018 and 2017; issued 1,347,540 shares in 2018 and 1,345,762 shares in 2017 +135 +135 +Additional paid-in capital +2,177 +2,052 +Retained earnings +31,788 +29,895 +Accumulated other comprehensive income (loss): +Unrealized foreign currency translation gains (losses) +( 1,847 +) +( 1,750 +) +Unrealized gains (losses) on fixed maturity securities (2) +4,234 +5,964 +Unrealized gains (losses) on derivatives +( 24 +) +( 23 +) +Pension liability adjustment +( 212 +) +( 163 +) +Treasury stock, at average cost +( 12,789 +) +( 11,512 +) +Total shareholders' equity +23,462 +24,598 +Total liabilities and shareholders' equity +$ +29,904 +$ +30,435 +(1) Eliminated in consolidation +(2) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018 related to financial instruments. +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +189 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Statements of Cash Flows +Years ended December 31, +(In millions) +2018 +2017 +2016 +Cash flows from operating activities: +Net earnings +$ +2,920 +$ +4,604 +$ +2,659 +Adjustments to reconcile net earnings to net cash provided from +operating activities: +Equity in earnings of subsidiaries (1) +( 3,074 +) +( 4,627 +) +( 2,834 +) +Cash dividends received from subsidiaries +1,820 +2,001 +2,020 +Other, net +99 +( 46 +) +294 +(2) +Net cash provided (used) by operating activities +1,765 +1,932 +2,139 +Cash flows from investing activities: +Fixed maturity securities sold +207 +263 +225 +Fixed maturity securities purchased +( 254 +) +( 329 +) +( 229 +) +Other investments sold (purchased) +31 +( 47 +) +6 +Settlement of derivatives +( 2 +) +223 +0 +Additional capitalization of subsidiaries (1) +( 62 +) +( 69 +) +( 36 +) +Other, net +( 107 +) +( 218 +) +( 25 +) +Net cash provided (used) by investing activities +( 187 +) +( 177 +) +( 59 +) +Cash flows from financing activities: +Purchases of treasury stock +( 1,301 +) +( 1,351 +) +( 1,422 +) +Proceeds from borrowings +1,020 +1,040 +986 +Principal payments under debt obligations +( 550 +) +( 1,161 +) +( 621 +) +Dividends paid to shareholders +( 793 +) +( 661 +) +( 658 +) +Treasury stock reissued +58 +33 +46 +Proceeds from exercise of stock options +34 +38 +36 +Net change in amount due to/from subsidiaries (1) +( 4 +) +( 5 +) +( 6 +) +Other, net +0 +0 +( 125 +) +(2) +Net cash provided (used) by financing activities +( 1,536 +) +( 2,067 +) +( 1,764 +) +Net change in cash and cash equivalents +42 +( 312 +) +316 +Cash and cash equivalents, beginning of period +1,725 +2,037 +1,721 +Cash and cash equivalents, end of period +$ +1,767 +$ +1,725 +$ +2,037 +(1) Eliminated in consolidation +(2) Operating activities excludes and financing activities includes a cash outflow of $ 137 in 2016 for the payment associated with the early extinguishment of debt +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +190 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Notes to Condensed Financial Statements +The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Aflac Incorporated and Subsidiaries included in Part II, Item 8 of this report. +(A) Notes Payable +A summary of notes payable as of December 31 follows: +(In millions) +2018 +2017 +2.40% senior notes paid November 2018 +$ +0 +$ +548 +4.00% senior notes due February 2022 +348 +348 +3.625% senior notes due June 2023 +698 +697 +3.625% senior notes due November 2024 +746 +745 +3.25% senior notes due March 2025 +447 +446 +2.875% senior notes due October 2026 +297 +297 +6.90% senior notes due December 2039 +220 +220 +6.45% senior notes due August 2040 +254 +254 +4.00% senior notes due October 2046 +394 +394 +4.750% senior notes due January 2049 +540 +0 +Yen-denominated senior notes and subordinated debentures: +.932% senior notes due January 2027 (principal amount 60.0 billion yen) +538 +528 +1.159% senior notes due October 2030 (principal amount 29.3 billion yen) +262 +0 +1.488% senior notes due October 2033 (principal amount 15.2 billion yen) +136 +0 +1.750% senior notes due October 2038 (principal amount 8.9 billion yen) +79 +0 +2.108% subordinated debentures due October 2047 (principal amount 60.0 billion yen) +536 +526 +Yen-denominated loans: +Variable interest rate loan due September 2021 (.32% in 2018 and 2017, principal amount 5.0 billion yen) +45 +44 +Variable interest rate loan due September 2023 (.47% in 2018 and 2017, principal amount 25.0 billion yen) +225 +220 +Total notes payable +$ +5,765 +$ +5,267 +Amounts in the table above are reported net of debt issuance costs and issuance premiums or discounts, if applicable, that are being amortized over the life of the notes. +In October 2018, the Parent Company issued $ 550 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.750 % per annum, payable semi-annually, and have a 30 -year maturity. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a United States Treasury security with a maturity comparable to the remaining term of the notes, plus 25 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. In November 2018, the Parent Company used the net proceeds from the October 2018 issuance of senior notes to redeem $ 550 million of the Parent Company's 2.40 % senior notes due in 2020. +In October 2018, the Parent Company issued three series of senior notes totaling 53.4 billion yen through a public debt offering under its U.S. shelf registration statement. The first series, which totaled 29.3 billion yen, bears interest at a fixed rate of 1.159 % per annum, payable semi-annually, and has a 12 -year maturity. The second series, which totaled 15.2 billion yen, bears interest at a fixed rate of 1.488 % per annum, payable semi-annually, and has a 15 -year maturity. +191 +The third series, which totaled 8.9 billion yen, bears interest at a fixed rate of 1.750 % per annum, payable semi-annually, and has a 20 -year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +The aggregate contractual maturities of notes payable during each of the years after December 31, 2018 , are as follows: +(In millions) +2019 +$ +0 +2020 +0 +2021 +45 +2022 +350 +2023 +925 +Thereafter +4,493 +Total +$ +5,813 +For further information regarding notes payable, see Note 9 of the Notes to the Consolidated Financial Statements. +(B) Derivatives +At December 31, 2018 , the Parent Company's outstanding freestanding derivative contracts were swaps associated with its notes payable, consisting of cross-currency interest rate swaps, also referred to as foreign currency swaps, associated with the Parent Company's senior notes due in February 2022, June 2023, November 2024 and March 2025. The Parent Company does not use derivative financial instruments for trading purposes, nor does it engage in leveraged derivative transactions. For further information regarding these derivatives, see Notes 1, 4 and 9 of the Notes to the Consolidated Financial Statements. +(C) Income Taxes +The Parent Company and its eligible U.S. subsidiaries file a consolidated U.S. federal income tax return. Income tax liabilities or benefits are recorded by each principal subsidiary based upon separate return calculations, and any difference between the consolidated provision and the aggregate amounts recorded by the subsidiaries is reflected in the Parent Company financial statements. For further information on income taxes, see Note 10 of the Notes to the Consolidated Financial Statements. +(D) Dividend Restrictions +See Note 13 of the Notes to the Consolidated Financial Statements for information regarding dividend restrictions. +(E) Supplemental Disclosures of Cash Flow Information +(In millions) +2018 +2017 +2016 +Interest paid +$ +179 +$ +195 +$ +209 +Noncash financing activities: +Treasury stock issued for shareholder dividend reinvestment +8 +29 +26 +192 +SCHEDULE III +SUPPLEMENTARY INSURANCE INFORMATION +Aflac Incorporated and Subsidiaries +Years ended December 31, +(In millions) +Deferred Policy +Acquisition +Costs +Future Policy +Benefits & Unpaid +Policy Claims +Unearned +Premiums +Other +Policyholders' +Funds +2018: +Aflac Japan +$ +6,384 +$ +80,672 +$ +4,977 +$ +7,145 +Aflac U.S. +3,491 +10,864 +117 +0 +All other +0 +183 +0 +1 +Intercompany eliminations +0 +( 767 +) +( 4 +) +0 +Total +$ +9,875 +$ +90,952 +$ +5,090 +$ +7,146 +2017: +Aflac Japan +$ +6,150 +$ +76,353 +$ +5,840 +$ +6,939 +Aflac U.S. +3,355 +10,506 +119 +0 +All other +0 +138 +0 +0 +Intercompany eliminations +0 +( 748 +) +0 +0 +Total +$ +9,505 +$ +86,249 +$ +5,959 +$ +6,939 +Segment amounts may not agree in total to the corresponding consolidated amounts due to rounding. +Years Ended December 31, +(In millions) +Net +Premium +Revenue +Net +Investment +Income +Benefits and +Claims, net +Amortization of +Deferred Policy +Acquisition Costs +Other +Operating +Expenses +Premiums +Written +2018: +Aflac Japan +$ +12,762 +$ +2,639 +$ +8,913 +$ +710 +$ +2,374 +$ +12,298 +Aflac U.S. +5,708 +727 +2,887 +534 +1,736 +5,707 +All other +207 +76 +200 +1 +420 +0 +Total +$ +18,677 +$ +3,442 +$ +12,000 +$ +1,245 +$ +4,530 +$ +18,005 +2017: +Aflac Japan +$ +12,752 +$ +2,463 +$ +9,087 +$ +630 +$ +2,257 +$ +12,092 +Aflac U.S. +5,563 +721 +2,885 +502 +1,658 +5,565 +All other +216 +36 +209 +0 +421 +0 +Total +$ +18,531 +$ +3,220 +$ +12,181 +$ +1,132 +$ +4,336 +$ +17,657 +2016: +Aflac Japan +$ +13,537 +$ +2,554 +$ +9,828 +$ +644 +$ +2,326 +$ +12,762 +Aflac U.S. +5,454 +703 +2,869 +497 +1,593 +5,452 +All other +234 +21 +222 +0 +513 +0 +Total +$ +19,225 +$ +3,278 +$ +12,919 +$ +1,141 +$ +4,432 +$ +18,214 +Segment amounts may not agree in total to the corresponding consolidated amounts due to rounding. +See the accompanying Report of Independent Registered Public Accounting Firm. +193 +SCHEDULE IV +REINSURANCE +Aflac Incorporated and Subsidiaries +Years Ended December 31, +(In millions) +Gross +Amount +Ceded to +Other +Companies +Assumed +from Other +companies +Net +Amount +Percentage +of Amount +Assumed +to Net +2018: +Life insurance in force +$ +151,457 +$ +4,702 +$ +0 +$ +146,755 +0 +% +Premiums: +Health insurance +$ +15,330 +$ +541 +$ +214 +$ +15,003 +1 +% +Life insurance +3,688 +14 +0 +3,674 +0 +Total earned premiums +$ +19,018 +$ +555 +$ +214 +$ +18,677 +1 +% +2017: +Life insurance in force +$ +152,502 +$ +4,121 +$ +0 +$ +148,381 +0 +% +Premiums: +Health insurance +$ +14,829 +$ +554 +$ +222 +$ +14,497 +1 +% +Life insurance +4,046 +12 +0 +4,034 +0 +Total earned premiums +$ +18,875 +$ +566 +$ +222 +$ +18,531 +1 +% +2016: +Life insurance in force +$ +151,093 +$ +3,741 +$ +0 +$ +147,352 +0 +% +Premiums: +Health insurance +$ +14,839 +$ +595 +$ +241 +$ +14,485 +1 +% +Life insurance +4,753 +13 +0 +4,740 +0 +Total earned premiums +$ +19,592 +$ +608 +$ +241 +$ +19,225 +1 +% +Premiums by type may not agree in total to the corresponding consolidated amounts due to rounding. +See the accompanying Report of Independent Registered Public Accounting Firm. +194 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Aflac Incorporated +By: +/s/ Daniel P. Amos +February 25, 2019 +(Daniel P. Amos) +Chief Executive Officer, +Chairman of the Board of Directors +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +/s/ Daniel P. Amos +Chief Executive Officer, +February 25, 2019 +(Daniel P. Amos) +Chairman of the Board of Directors +/s/ Frederick J. Crawford +Executive Vice President, +February 25, 2019 +(Frederick J. Crawford) +Chief Financial Officer +/s/ June Howard +Senior Vice President, Financial Services; +February 25, 2019 +(June Howard) +Chief Accounting Officer +195 +/s/ W. Paul Bowers +Director +February 25, 2019 +(W. Paul Bowers) +/s/ Toshihiko Fukuzawa +Director +February 25, 2019 +(Toshihiko Fukuzawa) +/s/ Douglas W. Johnson +Director +February 25, 2019 +(Douglas W. Johnson) +/s/ Robert B. Johnson +Director +February 25, 2019 +(Robert B. Johnson) +/s/ Thomas J. Kenny +Director +February 25, 2019 +(Thomas J. Kenny) +/s/ Karole F. Lloyd +Director +February 25, 2019 +(Karole F. Lloyd) +/s/ Joseph L. Moskowitz +Director +February 25, 2019 +(Joseph L. Moskowitz) +/s/ Barbara K. Rimer +Director +February 25, 2019 +(Barbara K. Rimer) +/s/ Katherine T. Rohrer +Director +February 25, 2019 +(Katherine T. Rohrer) +/s/ Melvin T. Stith +Director +February 25, 2019 +(Melvin T. Stith) +196 \ No newline at end of file diff --git a/raw/filings/0000004977/2018/0000004977-19-000049/filing_metadata.csv b/raw/filings/0000004977/2018/0000004977-19-000049/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..5c3891a17cdf47ea2c14a16c537839ac580f7ca8 --- /dev/null +++ b/raw/filings/0000004977/2018/0000004977-19-000049/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004977,AFL,AFLAC INC,2018,10-K,2019-02-25,2018-12-31,2019-02-25T22:04:08.000Z,0000004977-19-000049,afl12311810k.htm,10-K,53196354,1,1,https://www.sec.gov/Archives/edgar/data/4977/000000497719000049/afl12311810k.htm,https://www.sec.gov/Archives/edgar/data/4977/000000497719000049/ diff --git a/raw/filings/0000004977/2018/0000004977-19-000049/item1.txt b/raw/filings/0000004977/2018/0000004977-19-000049/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..20acd8fb0a80447935a44b83c470728206b2fbbe --- /dev/null +++ b/raw/filings/0000004977/2018/0000004977-19-000049/item1.txt @@ -0,0 +1,241 @@ +Item 1. Business +PART I +ITEM 1. BUSINESS +Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) prepare financial statements in accordance with U.S. generally accepted accounting principles (GAAP). This report includes certain forward-looking information that is based on current expectations and is subject to a number of risks and uncertainties. For details on forward-looking information, see Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A), Part II, Item 7, of this report. +Aflac Incorporated qualifies as a large accelerated filer within the meaning of Rule 12b-2 under the U.S. Securities Exchange Act of 1934 as amended (the Exchange Act). The Company's Internet address is aflac.com. The information on the Company's website is not incorporated by reference in this annual report on Form 10-K. The Company makes available, free of charge on the Investors portion of its website, the Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments thereto as soon as reasonably practicable after those forms have been electronically filed with or furnished to the Securities and Exchange Commission (SEC). +General Description +Aflac Incorporated was incorporated in 1973 under the laws of the state of Georgia. Aflac Incorporated is a general business holding company and acts as a management company, overseeing the operations of its subsidiaries by providing management services and making capital available. Its principal business is voluntary supplemental and life insurance, which is marketed and administered through American Family Life Assurance Company of Columbus (Aflac) in the United States (Aflac U.S.) and, effective April 1, 2018, through Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan). Prior to April 1, 2018, the Company's insurance business was marketed in Japan as a branch of Aflac. American Family Life Assurance Company of New York (Aflac New York) is a wholly owned subsidiary of Aflac. Most of Aflac's policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. The Company's insurance operations in the United States and Japan service the two markets for the Company's insurance business. +Effective April 1, 2018, the Company converted Aflac Japan from a branch to a subsidiary incorporated as a Japanese stock corporation. The transaction was accounted for as tax-neutral and did not have a material impact on the daily operations of either Aflac Japan or Aflac U.S. In addition, the Company obtained and expects to continue to obtain enhanced flexibility in capital management and business development as a result of the conversion. +The Company offers voluntary insurance policies in Japan and the United States that provide a layer of financial protection against income and asset loss. The Company continues to diversify its product offerings in both Japan and the United States. Aflac Japan sells voluntary supplemental insurance products, including cancer plans, general medical indemnity plans, medical/sickness riders, care plans, living benefit life plans, ordinary life insurance plans and annuities. Aflac U.S. sells voluntary supplemental insurance products including products designed to protect individuals from depletion of assets (accident, cancer, critical illness/care, hospital indemnity, fixed-benefit dental, and vision care plans) and loss-of-income products (life and short-term disability plans). +The Company is authorized to conduct insurance business in all 50 states, the District of Columbia, several U.S. territories and Japan. +Reporting Segments +The Company's insurance business consists of two reporting segments: Aflac Japan and Aflac U.S. Aflac Japan is the principal contributor to the Parent Company’s consolidated earnings. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 70% of the Company's total revenues in 2018 , compared with 70% in 2017 and 71% in 2016 . The percentage of the Company's total assets attributable to Aflac Japan was 84% and 83% at December 31, 2018 and 2017 , respectively. The conversion of Aflac Japan to a subsidiary structure did not affect the Company's segment reporting structure. +For information on the Company's results of operations and financial information by segment, see MD&A and Note 2 of the Notes to the Consolidated Financial Statements in this report. +1 +Item 1. Business +Certain Performance Measures +The Company evaluates its premium growth and sales efforts using the following performance measures: +• +Annualized premiums in force is defined as the amount of gross premium that a policyholder must pay over a full year in order to keep coverage. The growth of net premiums (defined below) is directly affected by the change in premiums in force and by the change in weighted-average yen/dollar exchange rates. +• +New annualized premium sales (sometimes referred to as new sales or sales) is an operating measure that is not reflected on the Company's financial statements. New annualized premium sales generally represents annual premiums on policies the Company sold and incremental increases from policy conversions, collected over a 12-month period, assuming the policies remain in force. For Aflac Japan, new annualized premium sales are determined by applications submitted during the reporting period. For Aflac U.S., new annualized premium sales are determined by applications that are issued during the reporting period. Conversions are defined as the positive difference in the annualized premium when a policy upgrades in the current reporting period. +• +Net premiums (sometimes referred to as net premium income or net earned premiums) is a financial measure that appears on the Company's Consolidated Statements of Earnings and in its segment reporting. This measure reflects collected or due premiums that have been earned ratably on policies in force during the reporting period, reduced by premiums that have been ceded to third parties and increased by premiums assumed through reinsurance. +Foreign Currency Translation +Aflac Japan’s premiums and approximately half of its investment income are received in yen. Claims and most expenses are paid in yen, and the Company purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into U.S. dollars for financial reporting purposes. For information regarding the effect of currency fluctuations on the Company's business, see the Hedging Activities subsection within the Analysis of Financial Condition section of MD&A, the Currency Risk subsection within Quantitative and Qualitative Disclosures about Market Risk, and Notes 1 and 2 of the Notes to the Consolidated Financial Statements in this report. For information regarding how the Company’s investment strategy supports management of foreign currency risk, refer to the Investments subsection below. +Insurance Products (1) +Aflac Japan +Aflac U.S. +Third Sector Insurance +Accident +Cancer +Short-Term Disability +Medical +Critical Care (2) +Income Support +Hospital Indemnity +First Sector Insurance +Dental +Life +Vision +Protection +Life (Term and Whole) +Term +Whole +Savings +WAYS +Child Endowment +(1) Actively marketed as of December 31, 2018 +(2) Includes cancer, critical illness, and hospital intensive care products +Japan +Aflac Japan's insurance products are designed to help consumers pay for medical and nonmedical costs that are not reimbursed under Japan's national health insurance system. Changes in Japan's economy and an aging population have put increasing pressure on Japan's national health care system. As a result, more costs have been shifted to Japanese +2 +Item 1. Business +consumers, who in turn have become increasingly interested in insurance products that help them manage those costs. Aflac Japan has responded to this consumer need by enhancing existing products and developing new products. +The foundation of Aflac Japan's product portfolio has been, and continues to be, its third sector products, which include cancer, medical and income support insurance products. Aflac pioneered the cancer insurance market in Japan in 1974, and remains the number one provider of cancer insurance in Japan today. Over the years, Aflac Japan has customized its cancer insurance product to respond to, and anticipate, the needs of its consumers and the advances in medical treatments. The cancer insurance plans the Company offers in Japan provide a lump-sum benefit upon initial diagnosis of internal cancer and benefits for treatment received due to internal cancer such as fixed daily benefits for hospitalization, outpatient services and convalescent care, surgical benefits, and outpatient treatments. Aflac Japan has a unique Aflac-branded cancer insurance product for Japan's postal system, Japan Post (see the Distribution - Japan section for background information). In April 2018, Aflac Japan introduced a new cancer insurance product, DAYS 1, with enhanced cancer benefits. In addition to providing benefits for hospitalization, outpatient treatment, surgery, radiation therapy and anti-cancer drug treatment, this product was designed to provide benefits to improve quality of life and to cover out-of-pocket expenses not directly related to medical treatment. At the same time, Aflac Japan introduced DAYS 1 Plus to provide existing holders with up-to-date coverage. As the number one provider of cancer insurance in Japan, the Company believes these products further strengthen its brand, and most importantly, provide valuable benefits to consumers who are looking for solutions to manage cancer-related costs. +Aflac Japan's EVER product is a stand-alone, whole-life medical insurance product which offers a basic level of hospitalization coverage with an affordable premium. The current version of this product includes riders to be associated with three critical illnesses (cancer, heart attack, and stroke) to better respond to consumers' needs for coverage of serious illnesses. These riders provide policyholders with a benefit upon the diagnosis for those three critical illnesses, waiver of premium payment thereafter and unlimited hospital days for such critical illnesses. Since its initial introduction, Aflac Japan has expanded its suite of EVER product offerings to appeal to specific types of Japanese consumers and achieve greater market penetration. In 2017, Aflac Japan revised the EVER product by introducing riders for lump-sum hospitalization benefits and surgeries for female-specific diseases as well as strengthening outpatient benefits and reducing premiums centered on the young- to middle-aged market segments. This product also offers a short-pay premium period to policyholders. Gentle EVER, Aflac Japan's non-standard medical insurance product, was designed to meet the needs of certain consumers who cannot qualify for the base EVER plan. +In October 2018, Aflac Japan launched a new type of medical product referred to as Health Promotion Medical Insurance where a policyholder is entitled to a partial refund of the premium if the policyholders' “health age” measured by certain health check items is lower than his or her actual age. This product is marketed exclusively online and targeted at younger generations. +The Company believes that the affordable cancer and medical insurance products Aflac Japan provides will continue to be an important part of its product portfolio. Nevertheless, as the Company continues its long history of product innovation, Aflac Japan's product portfolio has expanded beyond traditional health-related products. +Aflac Japan's Income Support Insurance provides fixed-benefit amounts in the event that a policyholder is unable to work due to significant illness or injury and was developed to supplement the disability coverage within Japan’s social security system. This product targets young to middle-aged consumers, and by focusing efforts on this demographic, Aflac Japan believes it is building relationships that lay the groundwork for the sale of its cancer and medical insurance later in life to the Income Support policyholders. +Beginning in 2013, Aflac Japan began to curtail sales of first sector savings-type products, such as WAYS, child endowment and fixed annuities, due to persistent low interest rates in Japan and, in particular, the relatively large capital commitment required by such products and their lower profitability, in such an environment. Aflac Japan continues to sell first sector protection-type products, which include term and whole life, to provide Aflac Japan’s traditional sales channels with a more comprehensive product portfolio to continue to cross-sell with third sector products. In July 2018, Aflac Japan introduced a first sector protection whole life product with low cash surrender value, which offers non-smoking policyholders further discounted premiums. +For additional information on Aflac Japan's products and composition of sales, see the Aflac Japan Segment subsection of MD&A in this report. +3 +Item 1. Business +U.S. +The Company designs its U.S. insurance products to provide supplemental coverage for people who already have major medical or primary insurance coverage. Most of Aflac's U.S. policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. started to market and administer group insurance products in 2009. +Aflac U.S. insurance policies pay benefits regardless of other insurance. Most of the Aflac U.S. insurance benefits are paid in cash directly to policyholders; therefore, customers have the opportunity to use this cash to help with expenses of their choosing. +Aflac U.S. offers accident coverage on both an individual and group basis. These policies pay cash benefits in the event of a covered injury. The accident portion of the policy includes lump-sum benefits for accidental death, dismemberment and specific injuries as well as fixed benefits for hospital confinement. Additional benefits are also available for home modifications, wellness and increased benefits for injuries related to participations in an organized sporting activity. +Aflac U.S. offers short-term disability benefits on both an individual and group basis. The individual short-term disability product has an Aflac Value Rider that pays a benefit, less claims, for every consecutive five-year term that the policy is in force. +Aflac U.S. offers coverage for critical care on both an individual and group basis. These policies are designed to pay cash benefits in the event of critical illnesses such as heart attack, stroke, or cancer. On an individually underwritten basis, Aflac U.S. offers cancer plans, critical illness plans, and critical care and recovery plans (formerly called specified health event). On a group basis Aflac U.S. offers critical illness plans. +Aflac U.S. offers hospital indemnity coverage on both an individual and group basis. Hospital indemnity products provide policyholders fixed dollar benefits triggered by hospitalization due to accident or sickness, or just sickness alone. Indemnity benefits for inpatient and outpatient surgeries, as well as various other diagnostic events, are also available. Aflac U.S. also offers a lump sum rider that can be added to its individual accident, short-term disability and hospital indemnity products. This rider, where available, provides a lump sum payment for a range of critical illness events including traumatic brain injury, Type 1 diabetes, advanced Alzheimer’s disease and many more. In January 2016, a new group hospital indemnity plan was introduced that includes 11 new benefits, including telemedicine and health screening. This plan provides flexibility, allowing the Company's clients to personalize their plan designs to complement the underlying medical coverage that is offered to employees. +Aflac U.S. offers additional coverages to those listed above, including dental, vision and life policies. Aflac U.S. offers fixed-benefit dental coverage on both an individual and group basis. Aflac U.S. offers Vision Now SM , an individually issued policy which provides benefits for serious eye health conditions and loss of sight as well as coverage for corrective eye materials and exam benefits. Aflac U.S. also offers term- and whole-life policies on both an individual and group basis. +For additional information on Aflac's U.S. products and composition of sales, see the Aflac U.S. Segment subsection of MD&A in this report. +Distribution Channels +Aflac Japan +Aflac U.S. +Individual/ Independent Corporate Agencies +Independent Associates +Affiliated Corporate Agencies +Brokers +Banks +Japan +The traditional channels through which Aflac Japan has sold its products consist of individual agents/agencies, independent corporate agencies, and affiliated corporate agencies. The individual agencies and independent corporate agencies that sell Aflac Japan's products give better access to workers at a vast number of small businesses in Japan. Agents' activities are primarily focused on insurance sales, with customer service support provided by the Aflac Contact Center. Affiliated corporate agencies are initially formed when companies establish subsidiary businesses to sell Aflac Japan's insurance products to employees as part of a benefit package, and in some cases expand to sell Aflac Japan products to other parties such as suppliers and customers.These agencies help Aflac Japan reach employees at large +4 +Item 1. Business +worksites, and some of them are also successful in approaching customers outside their business groups. The Company believes that new agencies will continue to be attracted to Aflac Japan's competitive commissions, attractive products, superior customer service and strong brand image. +The Company has sold products to employees of banks since its entry into Japan in 1974. However, December 2007 marked the first time it was permissible for banks to sell Aflac Japan's type of insurance products to their customers. By the end of 2018 , Aflac Japan had agreements with approximately 90% of the total number of banks in Japan, to sell its products. The Company believes Aflac Japan has more banks selling its supplemental health insurance products than any of its competitors. Japanese consumers rely on banks to provide traditional bank services, and also to provide insurance solutions and other services. The Company believes Aflac Japan's long-standing and strong relationships within the Japanese banking sector, along with its strategic preparations, have proven to be an advantage, particularly starting when this channel opened up for its products. Aflac Japan's partnerships throughout the banking sector provide Aflac Japan with a wider demographic of potential customers than it would otherwise have been able to reach, and it also allows banks to expand their product and service offerings to consumers. +In 2005, legislation aimed at privatizing Japan's postal system (Japan Post) was enacted into law. The privatization laws split Japan Post into four operating entities that began operating in October 2007. In 2007, one of these entities selected Aflac Japan as its provider of cancer insurance to be sold through its post offices, and, in 2008, Aflac Japan began selling cancer insurance through these post offices. Japan Post has historically been a popular place for consumers to purchase insurance products. Legislation to reform the postal system passed Japan’s legislature, the Diet, in April 2012 and resulted in the merger of two of the postal operating entities (the one that delivers the mail and the one that runs the post offices) in October 2012. In July 2013, Aflac Japan entered into a new agreement with Japan Post Holdings to further expand the partnership that was established in 2008. In June 2014, Japan Post Insurance (Kampo) received approval from Japan’s primary insurance regulator, the Financial Services Agency (FSA), to enter into an agency contract with Aflac Japan. Under this contract, Aflac Japan currently distributes its cancer insurance products through 76 of Kampo's directly managed sales offices. Aflac Japan has developed a unique Aflac-branded cancer insurance product for Japan Post and Kampo that was introduced in October 2014. In 2015, Japan Post expanded the number of post offices that offer Aflac's cancer insurance products to more than 20,000 postal outlets. +The Company believes this alliance with Japan Post, which is included in Aflac Japan's affiliated corporate agencies distribution channel, has benefited and will continue to benefit Aflac Japan's cancer insurance sales. For example, sales of cancer insurance policies by Japan Post constituted approximately 25% of Aflac Japan's third sector sales during the 2018 calendar year. In December 2018, the Company announced that in a further strengthening of this alliance. Japan Post Holdings Co., Ltd, a Japanese corporation, (Japan Post Holdings) plans to purchase approximately 7% of the Parent Company's outstanding common shares through a trust using open market and private block purchases. Like all common shares in the Parent Company, the shares purchased by the trust will be eligible for 10-for-1 voting rights after being held for 48 consecutive months. In connection with this announcement, on December 19, 2018, the Parent Company and Aflac Japan entered into a Basic Agreement regarding the "Strategic Alliance Based on Capital Relationship" with Japan Post Holdings (Basic Agreement), and the Parent Company entered into a letter agreement with Japan Post Holdings (Letter Agreement). Under the Letter Agreement, Japan Post Holdings agreed (i) to establish and fund a voting trust in accordance with a trust agreement (Trust Agreement) by no later than February 28, 2019, (ii) upon establishment of the trust, to instruct the trustee and the sole shareholder of the trust to enter into, and to itself enter into, a shareholders agreement with the Parent Company (Shareholders Agreement) providing for, among other things, a cap on share ownership, a minimum holding period and a standstill provision and voting restrictions that effectively limit the trustee's voting rights to no more than 20% of the voting rights of the Parent Company and further restrict the trustee's voting rights with respect to certain change in control transactions. The terms of the investment do not provide Japan Post Holdings with a right to a board seat on the Parent Company's board of directors or with any other rights to control, manage or intervene in the management of the Parent Company. This strategic investment is subject to certain regulatory approvals in Japan, and the U.S. The Company anticipates that regulatory approvals will be received in the second half of 2019. The foregoing summary is subject to and qualified in its entirety by reference to the full text of the Basic Agreement and Letter Agreement, including the forms of Trust Agreement and Shareholders Agreement attached to the Letter Agreement, copies of which are included as Exhibits 10.47 and 10.48 attached hereto and the terms of which are incorporated herein by reference. +For additional information on Aflac Japan's distribution, see the Aflac Japan Segment subsection of MD&A in this report. +5 +Item 1. Business +U.S. +As of December 31, 2018 , the U.S. sales force was composed of sales associates and brokers who are licensed to sell accident and health insurance. Many are also licensed to sell life insurance. Aflac U.S. utilizes dual-channel distribution to market its insurance products to businesses of all sizes. The career agent channel focuses on marketing Aflac to the small business market, which consists of employers with less than 100 employees. As such, Aflac U.S. has aligned its recruiting, training, compensation, marketing and incentives for its career agents to encourage specific activity and sales of individual policies in this market. The broker channel focuses on selling to the mid- and large-case market, which is comprised of employers with more than 100 employees and typically an average size of 1,000 employees or more. Since regional and national brokers have traditionally served the mid- and large-case market, the sales professionals in the broker channel are assigned a geographic market to strengthen relationships with the top brokers and sell Aflac products to their clients. As a result, Aflac U.S. is represented on 160 benefit administration platforms, sometimes referred to as exchanges, of various brokers. +Sales associates and brokers are independent contractors and are paid commissions based on first-year and renewal premiums from their sales of insurance products. In addition to receiving commissions on personal production, district and regional sales coordinators may also receive override commissions and incentive bonuses. +Aflac U.S. has continued to evolve its career and broker management infrastructure to drive growth in sales. In 2017, Aflac hired a Chief Distribution Officer to align the strategies of career and broker channels and to further expand U.S. distribution. All Aflac U.S. sales channels are now within the organizational structure of the Chief Distribution Officer. Prior to this change, the broker and career channels were part of separate organizational structures. Aflac U.S. believes the addition of this role will enhance performance management and augment its long-term sales strategy. +Aflac U.S. concentrates on marketing its insurance products at the worksite. This method offers policies to individuals through employment, trade and other associations. Historically, Aflac U.S. policies have been individually underwritten, however over the past several years, guaranteed issue options have become available. Premiums are generally paid by the employee. Additionally, Aflac's individual policies are portable, meaning that individuals may retain their full insurance coverage upon separation from employment or such affiliation, generally at the same premium. Individual policies are typically guaranteed-renewable for the lifetime of the policyholder (to age 75 for short-term disability policies). Aflac U.S. collects a major portion of premiums on such sales through payroll deduction or other forms of centralized billing. With Aflac U.S. brokerage sales expansion and CAIC, branded as Aflac Group Insurance, Aflac U.S. offers group voluntary insurance products desired by many large employers. These products are sold on a group basis and often have some element of guaranteed issue. Worksite marketing enables sales associates and brokers to reach a greater number of prospective policyholders and lowers distribution costs, compared with individually marketed business. +For additional information on Aflac's U.S. distribution, see the Aflac U.S. Segment subsection of MD&A in this report. +Competition +Japan +In 1974, Aflac was granted an operating license to sell life insurance in Japan, making Aflac the second non-Japanese life insurance company to gain direct access to the Japanese insurance market. Through 1981, Aflac Japan faced limited competition for cancer insurance policy sales. However, Japan has experienced two periods of deregulation since Aflac Japan entered the market. The first came in the early 1980s, when nine mid-sized insurers, including domestic and foreign companies, were allowed to sell cancer insurance products for the first time. The second period began in 2001 when all life and non-life insurers were allowed to sell stand-alone cancer and medical insurance products as well as other stand-alone health insurance products. As a result, the number of insurance companies offering stand-alone cancer and medical insurance has more than doubled since the market was deregulated in 2001. However, based on Aflac Japan's growth of annualized premiums in force and diversified distribution network, the Company does not believe that Aflac Japan's market-leading position has been significantly impacted by increased competition. Furthermore, the Company believes the continued development and maintenance of operating efficiencies will allow Aflac Japan to offer affordable products that appeal to consumers. Aflac Japan is the largest life insurer in Japan in terms of cancer and medical policies in force. As of December 31, 2018 , Aflac Japan exceeded 24 million individual policies in force in Japan. +Aflac Japan has experienced substantial success selling cancer policies in Japan, with more than 15 million cancer policies in force as of December 31, 2018 . Aflac Japan continued to be the number one seller of cancer insurance policies in Japan throughout 2018 . The Company believes Aflac Japan will remain a leading provider of cancer insurance +6 +Item 1. Business +coverage in Japan, principally due to its experience in the market, well-known brand, low-cost operations, expansive marketing system and product expertise. Further, the Company believes that its alliance with Japan Post will continue to benefit Aflac Japan's sales of cancer insurance in Japan. (See Distribution-Japan above for more information on Aflac Japan's marketing system and its alliance with Japan Post.) +Aflac Japan has also experienced substantial success selling medical insurance in Japan. While other companies have recognized the opportunities that Aflac Japan has seen in the medical insurance market and are frequently offering new products, Aflac Japan endeavors to keep its products attractive to consumers by revising benefits of medical insurance products more frequently than cancer insurance. +U.S. +Aflac U.S. competes against several voluntary supplemental insurance carriers on a national and regional basis. Aflac U.S. believes its policies, premium rates, platforms, value-added services and sales commissions are competitive by product type. Moreover, Aflac U.S. believes that its products are distinct from competitive offerings given its product focus (including features, benefits, and its claims service model), distribution capabilities, and brand awareness. For many companies with which Aflac U.S. competes, voluntary supplemental insurance products are sold as a secondary business. A growing number of major medical and life insurance carriers are also entering into the voluntary supplemental insurance market. For Aflac U.S., supplemental insurance products are its primary business and are sold via a distribution network of independent sales associates and brokers (see U.S. Distribution above). In addition, the Company believes that advertising campaigns for Aflac U.S. have increased name awareness and understanding among consumers and businesses of the value its products provide. +Both private and publicly-traded insurers offer major medical insurance for hospitalization and medical expenses. Much of this insurance is sold on a group basis to accounts that are both fully and self-insured. The federal and state governments also pay substantial costs of medical treatment through various programs. Major medical insurance generally covers a substantial portion of the medical expenses incurred by an insured. Aflac policies are designed to provide coverage that supplements major medical insurance by paying cash directly to the policyholder to use for expenses their major medical insurance is not designed to cover, or for any other uses that the policyholder chooses. Thus, Aflac U.S. does not compete directly with major medical insurers except those who sell supplemental insurance products as a secondary business. Any reduction of coverage, increase in employee participation costs, or increased deductibles and copayments by major medical commercial or government insurance carriers could favorably affect Aflac U.S. business opportunities. Since the implementation of the Affordable Care Act (ACA) beginning in 2010, some employers have shifted a larger burden of the cost of care to their employees, primarily through increases in premiums, copays, and/or deductibles, such as through the use of high-deductible health plans. In addition, the Company believes that some employers have made increasing use of supplemental insurance product offerings in order to improve their competitiveness in employee recruitment and retention. +Since Aflac products provide an additional level of financial protection for policyholders, the Company believes the increased financial exposure some employees may face creates a favorable opportunity for Aflac U.S. products. However, given the profitability erosion some major medical carriers are facing in their core lines of business, the Company has seen a more competitive landscape as they seek entry into Aflac's supplemental product segments and leverage their core benefit offerings by bundling and discounting products in order to gain voluntary market share. +One Day Pay SM is a claims initiative that Aflac U.S. introduced in 2015 to process, approve and pay eligible claims in just one day. The Company believes that along with its brand and relevant products, this claims practice has helped Aflac stand out from competitors. +Investments +Effective January 1, 2018, investments of Aflac U.S. as well as certain sub-advised assets of Aflac Japan, are managed by the Company’s U.S. asset management subsidiary, Aflac Asset Management LLC (AAM), and investments of Aflac Japan are managed pursuant to an investment advisory agreement between Aflac Japan and the Company's asset management subsidiary in Japan, Aflac Asset Management Japan Ltd. (AAMJ). AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. Beginning with the first quarter of 2018, AAM and AAMJ are reported in the "Corporate and other segment" category; however, the assets that they manage will be reported in the respective Aflac Japan and Aflac U.S. business segments. +7 +Item 1. Business +Japan +The Company’s investment strategy with respect to Aflac Japan utilizes disciplined asset and liability management while seeking diversification, long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives, as well as preserving shareholder value in the Aflac Japan business. +In attempting to optimally balance these objectives, the Company seeks to maintain on behalf of Aflac Japan a diversified portfolio of yen-denominated investment assets, U.S. dollar-denominated investment portfolio hedged back to yen and a portfolio of unhedged U.S. dollar-denominated assets. Each of these portfolios presents unique benefits and risks to the Company. +Yen-denominated investments included in Aflac Japan’s portfolio primarily consist of Japan Government Bonds (JGB), other public bonds and private placement fixed income instruments. The Company attempts to match both the duration and currency of these assets with Aflac Japan’s liabilities. This poses a difficulty in Aflac Japan due to the lack of suitable long-dated yen-denominated fixed income instruments. In 2012, the Company initiated a strategic approach to include U.S. dollar-denominated investments in Aflac Japan’s portfolio with the initial intent that they would be coupled with foreign exchange hedges. Today, this hedged U.S. dollar-denominated investment portfolio is mainly invested in long-term fixed and floating-rate loans and long-term investment-grade fixed income securities. The primary goals of the yen-denominated and hedged U.S. dollar portfolios are to provide sufficient yen cash flows to support the insurance liabilities and other yen-denominated obligations of Aflac Japan, and to seek appropriate long-term risk-adjusted investment returns supportive of solvency margin ratio (SMR) levels that provide sufficient dividend flows to the Parent Company . The hedges supporting this portion of the U.S. dollar portfolio pose derivative rollover risk that could amplify hedge costs in unfavorable market conditions, risk of counterparty default, and may require the Company to post collateral. In a declining yen environment, these hedges could result in negative cash settlements that may significantly increase liquidity requirements, thereby shifting funds away from other capital management opportunities including loss of investment income. If the combined yen-denominated and hedged U.S. dollar-denominated portfolios are larger than Aflac Japan's yen obligations, the economic value of these portfolios may be eroded under a long-term scenario of weakening yen due to foreign currency translation risk, one result of which may be to reduce the Company's dividend capacity. +The Company also maintains an unhedged U.S. dollar-denominated investment portfolio with the objectives of generating enhanced investment returns and mitigating certain of the risks posed by the yen and hedged U.S. dollar-denominated portfolios as outlined above. Further, the Company has determined that the unhedged portfolio acts as a natural economic currency hedge of a portion of the Company’s investment in Aflac Japan against erosion of economic value. However, the unhedged U.S. dollar-denominated investment portfolio creates an unmatched foreign currency exposure and subjects Aflac Japan to volatility in regulatory capital and earnings, which may adversely impact Aflac Japan’s ability to pay dividends to the Parent Company. The Company’s approach to sizing the unhedged U.S. dollar-denominated investment portfolio seeks to balance the unique risks presented by each of the three portfolios outlined above, but the overall investment strategy in Aflac Japan is guided primarily by the objective of securing the long-term financial strength of Aflac Japan and funding of yen liabilities. As a result, the Company has historically maintained and currently maintains the size of the unhedged portfolio at levels below the stressed economic surplus in Aflac Japan. +The determination of stressed economic surplus in Aflac Japan involves multiple models using multiple statistical approaches and assuming various economic and operating scenarios that are stressed to arrive at a range of potential outcomes. This range does not account for all economic scenarios, some of which may result in values outside of the range. The Company periodically assesses the stressed economic surplus in Aflac Japan, which fluctuates over time, and adjusts the size of the unhedged portfolio accordingly. The portfolio may include medium-term and long-term fixed-rate government and corporate (investment-grade and high-yield) bonds, floating-rate loans, public equities, and alternative asset classes. In determining the composition of the portfolio, the Company also considers diversification, hedge cost, investment returns relative to yen-denominated investment yields, and Aflac Japan capital requirements. At December 31, 2018, this unhedged U.S. dollar-denominated portfolio was approximately $14.4 billion , compared with approximately $13.0 billion at December 31, 2017. For additional discussion of business and market risks associated with the Company’s investment strategy in Japan, refer to the Risk Factors and Quantitative and Qualitative Disclosures about Market Risk sections. +U.S. +The Company’s investment strategy with respect to Aflac U.S. utilizes disciplined asset and liability management while seeking long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives. As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed-maturity investments and growth assets, including public equities and alternative investments in limited partnerships. +8 +Item 1. Business +Aflac U.S. has been investing in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loans. +For further information on the Company's investments and investment results, see the Insurance Operations and Analysis of Financial Condition sections of MD&A and Notes 3, 4 and 5 of the Notes to the Consolidated Financial Statements in this report. +Regulation +Japan +The financial and business affairs of Aflac Japan are subject to examination by Japan's FSA. Aflac Japan files annual reports and financial statements for the Japanese insurance operations based on a March 31 fiscal year end, prepared in accordance with Japanese regulatory accounting practices prescribed or permitted by the FSA. Japanese regulatory basis earnings are determined using accounting principles that differ materially from U.S. GAAP. For example, under Japanese regulatory accounting practices, policy acquisition costs are expensed immediately; policy benefit and claim reserving methods and assumptions are different; premium income is recognized on a cash basis; different consolidation criteria apply to variable interest entities (VIEs); different accounting applies to reinsurance; and investments can have a separate accounting classification and treatment referred to as policy reserve matching bonds (PRM), which are recorded at amortized cost. Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $6.4 billion at December 31, 2018 , compared with $6.7 billion at December 31, 2017 . +The FSA maintains a solvency standard, which is used by Japanese regulators to monitor the financial strength of insurance companies. As of December 31, 2018 , Aflac Japan's SMR was 965% , compared with 1,064% at December 31, 2017 . Aflac Japan's SMR is sensitive to interest rate, credit spread and foreign exchange rate changes. See the Capital Resources and Liquidity Section of MD&A for a discussion of measures the Company has taken to mitigate the sensitivity of Aflac Japan's SMR. +Prior to April 1, 2018, Aflac Japan repatriated a portion of its accumulated earnings, as determined on a Japanese regulatory accounting basis, to Aflac U.S. provided that Aflac Japan has determined that it adequately protected policyholders' interests as measured by its SMR. Starting in the fourth quarter of 2018, Aflac Japan distributes dividends to the Parent Company. Such dividends are subject to permitted dividend capacity under the Japan Company Law. +The Japanese insurance industry has a policyholder protection corporation that provides funds for the policyholders of insolvent insurers. For additional information regarding the policyholder protection fund, see the Policyholder Protection subsection of MD&A in this report. +In June 2013, a revision to the Financial Instruments and Exchange Act established a post-funded Orderly Resolution Regime for financial institutions to prevent a financial crisis in the event of a financial institution’s failure. This regime came into effect in March 2014 and has not had, and is not expected to have, a material impact on the Company's operations in Japan. +For additional information regarding Aflac Japan's operations and regulations, see the Aflac Japan Segment subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +U.S. +General +The Parent Company and its U.S. insurance subsidiaries, Aflac (a Nebraska-domiciled insurance company), American Family Life Assurance Company of New York (Aflac New York, a New York-domiciled insurance company), CAIC (redomiciled from South Carolina to Nebraska effective December 2016) and Tier One Insurance Company (TOIC, an Oklahoma-domiciled shell insurance company acquired by the Parent Company in 2017 with no operations) are subject to state regulations in the United States as an insurance holding company system. Such regulations generally provide that transactions between companies within the holding company system must be fair and equitable. In addition, transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries, and material transactions between companies within the system, including management fees, loans and advances are subject to prior notice to, or approval by, state regulatory authorities. These laws generally require, among other things, the insurance holding company and each insurance company directly owned by the holding company to register with the insurance departments of their respective domiciliary states and to furnish annually financial and other information about the +9 +Item 1. Business +operations of companies within the holding company system. +Like all U.S. insurance companies, Aflac, Aflac New York, CAIC and TOIC are subject to regulation and supervision in the jurisdictions in which they do business. In general, the insurance laws of the various jurisdictions establish supervisory agencies with broad administrative powers relating to, among other things: +• +granting and revoking licenses to transact business +• +regulating trade and claims practices +• +licensing of insurance agents and brokers +• +approval of policy forms and premium rates +• +standards of solvency and maintenance of specified policy benefit reserves and minimum loss ratio requirements +• +capital requirements +• +limitations on dividends to shareholders +• +the nature of and limitations on investments +• +deposits of securities for the benefit of policyholders +• +filing of financial statements prepared in accordance with statutory insurance accounting practices prescribed or permitted by regulatory authorities +• +periodic examinations of the market conduct, financial, and other affairs of insurance companies +The insurance laws of Nebraska that govern Aflac's activities provide that the acquisition or change of “control” of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Nebraska Department of Insurance. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company (in the case of Aflac, the Parent Company) must generally file with the Nebraska Department of Insurance (NDOI) an application for change of control containing certain information required by statute and published regulations and provide a copy to Aflac. In Nebraska, control is generally presumed to exist if any person, directly or indirectly, acquires 10% or more of an insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Similar laws apply in New York, the domiciliary jurisdiction of Aflac's New York insurance subsidiary. +State insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). In 2016, full-scope, risk-focused financial examinations were conducted by the NDOI, New York Department of Financial Services (NYDFS), and the South Carolina Department of Insurance (SCDOI) on their state domiciled insurance entities American Family Life Assurance Company of Columbus, American Family Life Assurance Company of New York, and Continental American Insurance Company, respectively. The NDOI and NYDFS exams covered a four-year period ending December 31, 2015, whereas the SCDOI exam covered a five-year period ending December 31, 2015. There were no material findings contained in the NDOI, NYDFS and SCDOI final exam reports. +The NAIC continually reviews regulatory matters , such as risk-based capital (RBC) modernization, group capital calculations, liquidity risk assessment and principle-based reserving. The NAIC has adopted a valuation manual containing a principle-based approach to calculation of life insurance reserves. The valuation manual became effective January 1, 2017. There is a three-year transition period, beginning January 1, 2017, during which companies can choose on a product by product basis to implement principle-based reserving for new business. The Company anticipates that the adoption of this manual will not cause a material impact on the statutory reserves of Aflac, Aflac New York or CAIC. The NAIC uses an RBC formula relating to insurance risk, business risk, asset risk and interest rate risk to facilitate identification by insurance regulators of inadequately capitalized insurance companies based upon the types and mix of risk inherent in the insurer's operations. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company's regulatory total adjusted capital to its authorized control level RBC as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels are company action, regulatory action, authorized control, and mandatory control. As of December 31, 2018 , based on year-end statutory accounting results, Aflac's company action level RBC ratio was 560% . The 2018 RBC as filed is lower than Aflac U.S. stand-alone RBC due to the inclusion of Aflac Japan for the first quarter of 2018. The RBC charge reflects the business risk without any total adjusted capital (TAC). Aflac's NAIC RBC ratio remains high and reflects a very strong capital and surplus position. +10 +Item 1. Business +Under state insurance guaranty association laws and similar laws in international jurisdictions, the Company is subject to assessments, based on the share of business the Company writes in the relevant jurisdiction, for certain obligations of insolvent insurance companies to policyholders and claimants. In the United States, some states permit member insurers to recover assessments paid through full or partial premium tax offsets. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. In most states, the definition is met with a declaration of financial insolvency by a court of competent jurisdiction. For additional information regarding state insurance guaranty assessments, see the U.S. Regulatory Environment subsection of MD&A in this report. +Healthcare Reform Legislation +Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. For example, the ACA, federal health care reform legislation, gave the U.S. federal government direct regulatory authority over the business of health insurance. The reform included major changes to the U.S. health care insurance marketplace. Among other changes, the reform legislation included an individual medical insurance coverage mandate (which has since been repealed effective 2019 by the Tax Act, discussed below), provided for penalties on certain employers for failing to provide adequate coverage, created health insurance exchanges, and addressed coverage and exclusions as well as medical loss ratios. It also imposed an excise tax on certain high cost plans, known as the “Cadillac tax,” that is currently scheduled to begin in 2022. The legislation also included changes in government reimbursements and tax credits for individuals and employers and altered federal and state regulation of health insurers. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. The United States Congress has considered and may continue to consider legislation that would repeal and replace key provisions of the ACA. There can be no assurance that any legislation affecting the ACA will be passed by Congress, nor as to the ultimate timing or provisions of any such legislation, nor as to the effect of any such legislation on the design or marketability of the Company's insurance products. Further, certain provisions of the ACA have been and may continue to be subject to challenge through litigation, the ultimate effects of which on the ACA are uncertain. +Tax Reform Legislation +A budget reconciliation act commonly referred to as the Tax Cuts and Job Act (Tax Act) was signed into law on December 22, 2017. Among other things, effective January 1, 2018, the Tax Act reduced the U.S. federal statutory corporate income tax rate from 35% to 21%, eliminated or reduced certain deductions and credits, and limited the deductibility of interest expense and executive compensation. +The Tax Act also transitions international corporate taxation from a worldwide system to a modified territorial system, which in light of the current tax treatment of Aflac Japan has the effect of subjecting the earnings of Aflac Japan to Japan taxation and subjecting the Company’s other earnings, including the consolidated earnings of the Parent Company, to U.S. taxation. +These changes were effective on January 1, 2018. Because changes to tax rates are accounted for in the period of enactment, during the period ended December 31, 2017, the Company revalued its deferred tax assets and liabilities and recorded, as the Company’s reasonable estimate, a net deferred tax liability reduction of $1.9 billion as of that date. As of the fourth quarter of 2018, the Company recorded an immaterial adjustment to the provisional amount of deferred tax liabilities (DTLs) related to the Japan tax computation and no valuation allowance adjustment related to anticipatory foreign tax credit asset, rendering final values for the Company's deferred tax liability. See Note 10 of the Notes to the Consolidated Financial Statements presented in this report. For information on the conversion of Aflac Japan from a branch to a subsidiary, see General Business under this Business section, above. +11 +Item 1. Business +Dodd-Frank Act +Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and regulations issued thereunder, in particular rules to require central clearing for certain types of derivatives, may have an impact on Aflac's derivative activity, including activity on behalf of Aflac Japan. In addition, in 2015 and 2016, six U.S. financial regulators, including the U.S. Commodity Futures Trading Commission (CFTC), issued final rules regarding the exchange of initial margin (IM) and variation margin (VM) for uncleared swaps that impose greater obligations on swap dealers regarding uncleared swaps with certain counterparties, such as Aflac. The requirements of such rules with respect to VM, as well as similar regulations in Europe, became effective on March 1, 2017. Full compliance with respect to all counterparties was required by September 1, 2017. The requirements of such rules with respect to IM are currently being phased in and will be fully implemented by September 1, 2020. In October of 2017, the CFTC and the European Commission each finalized comparability determinations that permit certain swap dealers who are subject to both regulatory margin regimes to take advantage of substituted compliance by complying with one set of margin requirements. The margin requirements are expected to result in more stringent collateral requirements and to affect other aspects of Aflac's derivatives activity. +The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of business lines other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. The FIO does not directly regulate the insurance industry, but under Dodd-Frank it has the power to preempt state insurance regulations that are inconsistent with international agreements reached by the federal government, subject to certain requirements and restrictions. The FIO and certain federal agencies must achieve consensus positions with the state insurance regulators when taking positions on insurance proposals by certain international forums. In December 2013, the FIO released a report entitled "How To Modernize And Improve The System Of Insurance Regulation In The United States." The report was required by the Dodd-Frank Act, and included 18 recommended areas of near-term reform for the states, including addressing capital adequacy and safety/soundness issues, reform of insurer resolution practices, and reform of marketplace regulation. The report also listed nine recommended areas for direct federal involvement in insurance regulation. Some of the recommendations outlined in the FIO report released in December 2013 have been implemented. The National Association of Registered Agents and Brokers Reform Act, signed into law in January 2015, simplifies the agent and broker licensing process across state lines. The FIO has also engaged with the supervisory colleges to monitor financial stability and identify regulatory gaps for large national and internationally active insurers. +The current U.S. presidential administration and Congress have made recent attempts to reform or repeal certain provisions of the Dodd-Frank Act, some of which have been implemented. For example, in 2018, President Trump signed into law the “Economic Growth, Regulatory Relief, and Consumer Protection Act.” Members of Congress have also introduced multiple bills that would impact or eliminate the FIO. The Federal Reserve is developing a rulemaking regarding the Financial Stability Oversight Council’s (the Council) ability to designate nonbank financial companies as Systemically Important Financial Institutions, and, pursuant to an Executive Order, the Treasury Department released a report on the Council’s designation authority. The Company cannot predict with any degree of certainty what impact, if any, such proposals will have on Aflac's business, financial condition, or results of operations. +Further Information +For further information concerning Aflac U.S. operations, regulation, change of control and dividend restrictions, see the Aflac U.S. Segment subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +Privacy and Cybersecurity +The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal Gramm-Leach-Bliley Act of 1999 (GLBA) and in the Health Insurance Portability and Accountability Act of 1996 (HIPAA). For example, in June 2018, California passed a data privacy law, scheduled to become effective January 2020, that requires businesses to provide California consumers rights to access, delete, and restrict certain uses of their personal information. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is +12 +Item 1. Business +regulated in Japan by the Act on the Protection of Personal Information (APPI) and guidelines issued by FSA and other governmental authorities. The FSA updated its guidelines regarding cybersecurity in October 2018. +Cybersecurity also continues to be an area of evolving focus for U.S. legislation and regulatory activity. In March 2017, new cybersecurity regulation issued by the New York Department of Financial Services (NYDFS) went into effect that requires covered entities, including Aflac New York, to maintain an information security program meeting certain security, data disposal, audit, activity monitoring, and data encryption requirements. In October 2017, the NAIC adopted an Insurance Data Security Model Law that may be adopted in whole or in part by U.S. states in which the Company’s subsidiaries are licensed. Other states have adopted and, the Company expects, will continue to pass legislation and issue regulations related to cybersecurity. The Company anticipates, assesses, and if necessary modifies its information security program to accommodate such changes. +The Company’s Board of Directors has adopted an information security policy directing management to establish and operate an information security program with the goal of ensuring that the Company’s information assets and data, and the data of its customers, are appropriately protected. The Board has delegated oversight of the Company’s information security program to the Audit and Risk Committee. The Company’s senior officers, including its Global Security and Chief Information Security Officer, are responsible for the operation of the information security program and regularly communicate with the Audit and Risk Committee on the program, including with respect to the state of the program, compliance with applicable regulations, current and evolving threats, and recommendations for changes in the information security program. The information security program also includes a cybersecurity incident response plan that is designed to provide a management framework across Company functions for a coordinated assessment and response to potential security incidents. This framework establishes a protocol to report certain incidents to the Global Security and Chief Information Security Officer and other senior officers, with the goal of timely assessing such incidents, determining applicable disclosure requirements and communicating with the Audit and Risk Committee. The incident response plan directs the executive officers to report certain incidents immediately and directly to the Lead Non-Management Director. +Other Operations +The Company's other operations include the Parent Company, results of reinsurance retrocession activities, and a printing subsidiary. For additional information on the Company's other operations, see the Corporate and Other subsection of MD&A and Note 8 in the Notes to the Consolidated Financial Statements. +Employees +As of December 31, 2018 , Aflac Japan had 6,121 employees, Aflac U.S. had 4,712 employees, and the Company's other operations had 557 employees. +13 +Item 1. Business +Executive Officers of the Registrant +NAME +PRINCIPAL OCCUPATION (1) +AGE +Daniel P. Amos +Chairman, Aflac Incorporated and Aflac, since 2001; Chief Executive Officer, Aflac Incorporated and Aflac, since 1990 +67 +Koji Ariyoshi +Executive Vice President, Director of Sales and Marketing, Aflac Japan, since 2012 +65 +Max K. Broden +Senior Vice President and Treasurer, Aflac Incorporated, since 2017; Senior Portfolio Manager, Norges Bank, from 2007 until 2017 +40 +Frederick J. Crawford +Executive Vice President, Chief Financial Officer, Aflac Incorporated, since 2015; Executive Vice President, Chief Financial Officer, CNO Financial Group from 2012 until 2015; Executive Vice President, Head of Investment and Corporate Development, Lincoln Financial Group from 2010 until 2012 +55 +J. Todd Daniels +Executive Vice President and Principal Financial Officer, Aflac Japan, since 2018; Executive Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2016 until 2018; Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2015 until 2016; Senior Vice President, Deputy Corporate Actuary and Global Chief Risk Officer, Aflac, from 2014 until 2015; Senior Vice President, Deputy Corporate Actuary, Aflac, from 2012 until 2014; Vice President, Financial Planning and Analysis, Aflac, from 2011 until 2012 +48 +June Howard +Chief Accounting Officer, Aflac Incorporated and Aflac, since 2010; Senior Vice President, Financial Services, Aflac Incorporated and Aflac, since 2010; Treasurer, Aflac, from 2011 until 2015 +52 +Eric M. Kirsch +Executive Vice President, Global Chief Investment Officer, Aflac, since 2012; President, Aflac Asset Management LLC, since 2017; First Senior Vice President, Global Chief Investment Officer, Aflac, from 2011 until 2012 +58 +Masatoshi Koide +President and Chief Operating Officer, Aflac Japan since 2017; Deputy President, Aflac Japan from 2016 until 2017; Executive Vice President, Aflac Japan from 2015 until 2016; First Senior Vice President, Aflac Japan from 2013 until 2015; Senior Vice President, Aflac Japan from 2012 until 2013 +58 +Charles D. Lake, II +President, Aflac International, since 2014; Chairman, Aflac Japan, since 2008 +57 +Albert A. Riggieri +Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, since 2018; Senior Vice President, Corporate Actuary, Aflac, from 2016 until 2018; Group Chief Actuary, Unum Group, until 2016 +63 +Audrey B. Tillman +Executive Vice President, General Counsel, Aflac Incorporated and Aflac, since 2014; Executive Vice President, Corporate Services, Aflac Incorporated, from 2008 until 2014 +54 +Teresa L. White +President, Aflac U.S., since 2014; Executive Vice President, Chief Operating Officer, Aflac, from 2013 until 2014; Executive Vice President, Chief Service Officer, Aflac, from 2012 until 2013; Executive Vice President, Chief Administrative Officer, Aflac, from 2008 until 2013 +52 +Richard L. Williams Jr. +Executive Vice President and Chief Distribution Officer, Aflac since 2017; Senior Vice President and General Manager, Stop Loss, Unum, U.S. in 2017; Senior Vice President, Growth Markets, Colonial Life and Accident Insurance Company from 2013 until 2017 +47 +(1) Unless specifically noted, the respective executive officer has held the occupation(s) set forth in the table for at least the last five years. Each executive officer is appointed annually by the board of directors and serves until his or her successor is chosen and qualified, or until his or her death, resignation or removal. +14 \ No newline at end of file diff --git a/raw/filings/0000004977/2018/0000004977-19-000049/item13.txt b/raw/filings/0000004977/2018/0000004977-19-000049/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..ac45fdc22b7eee70932e0b79221c14e1c0f1b30f --- /dev/null +++ b/raw/filings/0000004977/2018/0000004977-19-000049/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +180 \ No newline at end of file diff --git a/raw/filings/0000004977/2019/0000004977-20-000044/filing.txt b/raw/filings/0000004977/2019/0000004977-20-000044/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..5ea1189989a1272b00966d51af0930444f85c0e8 --- /dev/null +++ b/raw/filings/0000004977/2019/0000004977-20-000044/filing.txt @@ -0,0 +1,17987 @@ +Document +0 0 0.280 P364D P364D P5Y P5Y P364D P364D 6900000000 800000000 134000000 134000000 1 0.70 0.72 0.97 0 false --12-31 FY 2019 0000004977 false false 73007000000 1209000000 76063000000 1506000000 0.87 1.04 1.08 0.10 0.10 0.10 0.10 1900000000 1900000000 1900000000 1900000000 1347540000 1349309000 are generally entitled to one vote per share until they have been held by the same beneficial owner for a continuous period of 48 months, at which time they become entitled to 10 votes per share. 148000000 148000000 374000000 374000000 56000000 0 0 2027-10-23 These bonds bear interest at a fixed rate of .963% per annum and then at six-month Euro Yen LIBOR plus an applicable spread on and after the day immediately following April 18, 2024. bears interest at a rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin 15200000000 29300000000 8900000000 60000000000 60000000000 25000000000 5000000000 15200000000 29300000000 8900000000 60000000000 60000000000 25000000000 5000000000 15200000000 29300000000 8900000000 60000000000 60000000000 25000000000 5000000000 15200000000 29300000000 8900000000 60000000000 30000000000 60000000000 25000000000 5000000000 0.0475 0.04 0.04 0.01488 0.01159 0.0175 0.00932 0.0645 0.069 0.03625 0.03625 0.0325 0.02875 0.02108 0.0047 0.0032 0.0475 0.04 0.04 0.01488 0.01159 0.0175 0.00932 0.0645 0.0690 0.03625 0.03625 0.0325 0.02875 0.02108 0.0047 0.0032 0.0475 0.04 0.04 0.01488 0.01159 0.0175 0.00932 0.0645 0.069 0.03625 0.03625 0.0325 0.02875 0.02108 0.0057 0.0042 0.0475 0.04 0.04 0.01488 0.01159 0.01122 0.0175 0.00843 0.00500 0.00934 0.00932 0.0645 0.0690 0.03625 0.03625 0.0325 0.02875 0.00963 0.02108 0.0057 0.0042 The debentures bear interest at an initial rate of 2.108% per annum through October 22, 2027, or earlier redemption. 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+afl:Vote +afl:agreements +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +☒ +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2019 +or +☐ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File Number: 001-07434 +Aflac Incorporated +(Exact name of registrant as specified in its charter) +Georgia +58-1167100 +(State or other jurisdiction of incorporation or organization) +(I.R.S. Employer Identification No.) +1932 Wynnton Road +Columbus +Georgia +31999 +(Address of principal executive offices) +(ZIP Code) +Registrant’s telephone number, including area code: 706 . 323.3431 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Trading Symbols(s) +Name of each exchange on which registered +Common Stock, $.10 Par Value +AFL +New York Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes ¨ No +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes þ No +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes ¨ No +Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). þ Yes ¨ No +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. +Large accelerated filer +þ +Accelerated filer +☐ +Non-accelerated filer +¨ +Smaller reporting company +☐ +Emerging growth company +☐ +If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ +Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ☐ Yes þ No +The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 28, 2019 , was $ 40,396,253,541 . +The number of shares of the registrant’s common stock outstanding at February 12, 2020 , with $.10 par value, was 722,520,700 . +Documents Incorporated By Reference +Certain information contained in the Notice and Proxy Statement for the Company’s 2020 Annual Meeting of Shareholders is incorporated by reference into Part III hereof. +Aflac Incorporated +Annual Report on Form 10-K +For the Year Ended December 31, 2019 +Table of Contents +PART I +Page +Item 1. +Business +2 +Item 1A. +Risk Factors +11 +Item 1B. +Unresolved Staff Comments +27 +Item 2. +Properties +28 +Item 3. +Legal Proceedings +28 +Item 4. +Mine Safety Disclosures +28 +PART II +Item 5. +Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +29 +Item 6. +Selected Financial Data +32 +Item 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +34 +Item 7A. +Quantitative and Qualitative Disclosures About Market Risk +69 +Item 8. +Financial Statements and Supplementary Data +77 +Item 9. +Changes in and Disagreements With Accountants on Accounting and Financial Disclosure +170 +Item 9A. +Controls and Procedures +170 +Item 9B. +Other Information +170 +PART III +Item 10. +Directors, Executive Officers and Corporate Governance +171 +Item 11. +Executive Compensation +171 +Item 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +171 +Item 13. +Certain Relationships and Related Transactions, and Director Independence +171 +Item 14. +Principal Accounting Fees and Services +171 +PART IV +Item 15. +Exhibits and Financial Statement Schedules +172 +Item 16. +Form 10-K Summary +173 +Glossary of Select Terms +174 +i +Item 1. Business +PART I +FORWARD-LOOKING INFORMATION +The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. Aflac Incorporated and its subsidiaries (the Company) desire to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with the Securities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks and uncertainties. In particular, statements containing words such as the ones listed below or similar words, as well as specific projections of future results, generally qualify as forward-looking. The Company undertakes no obligation to update such forward-looking statements. +• expect +• anticipate +• believe +• goal +• objective +• may +• should +• estimate +• intends +• projects +• will +• assumes +• potential +• target +• outlook +The Company cautions readers that the following factors, in addition to other factors mentioned from time to time, could cause actual results to differ materially from those contemplated by the forward-looking statements: +• +ability to attract and retain qualified sales associates, brokers, employees, and distribution partners +• +events related to the ongoing Japan Post investigation and other matters +• +competitive environment and ability to anticipate and respond to market trends +• +deviations in actual experience from pricing and reserving assumptions +• +ability to continue to develop and implement improvements in information technology systems +• +defaults and credit downgrades of investments +• +exposure to significant interest rate risk +• +concentration of business in Japan +• +limited availability of acceptable yen-denominated investments +• +failure to comply with restrictions on policyholder privacy and information security +• +interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems +• +catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, war or other military action, terrorism or other acts of violence, and damage incidental to such events +• +difficult conditions in global capital markets and the economy +• +ability to protect the Aflac brand and the Company's reputation +• +extensive regulation and changes in law or regulation by governmental authorities +• +foreign currency fluctuations in the yen/dollar exchange rate +• +tax rates applicable to the Company may change +• +decline in creditworthiness of other financial institutions +• +significant valuation judgments in determination of amount of impairments taken on the Company's investments +• +U.S. tax audit risk related to conversion of the Japan branch to a subsidiary +• +subsidiaries' ability to pay dividends to the Parent Company +• +decreases in the Company's financial strength or debt ratings +• +inherent limitations to risk management policies and procedures +• +concentration of the Company's investments in any particular single-issuer or sector +• +differing judgments applied to investment valuations +• +ability to effectively manage key executive succession +• +changes in accounting standards +• +level and outcome of litigation +• +allegations or determinations of worker misclassification in the United States +1 +Item 1. Business +ITEM 1. BUSINESS +OVERVIEW +Aflac Incorporated (the Parent Company) was incorporated in 1973 under the laws of the state of Georgia. The Parent Company and its subsidiaries (collectively, the Company) provide financial protection to more than 50 million people worldwide. The Company’s principal business is supplemental health and life insurance products with the goal to provide customers the best value in supplemental insurance products in the United States (U.S.) and Japan. When a policyholder or insured gets sick or hurt, the Company pays cash benefits fairly and promptly for eligible claims, directly to the insured (unless assigned otherwise). For more than sixty years, the Company’s supplemental insurance policies have given policyholders the opportunity to focus on recovery, not financial stress. +The Company's strategy for growth in the U.S. and Japan has remained straightforward and consistent for many years. The Company develops relevant supplemental insurance products and sells them through expanded distribution channels. To help promote its insurance products, the Company’s marketing campaigns feature the Aflac Duck. +In 1999, the Company had been running commercials for nearly a decade, but its brand awareness was hovering at about 10%. An innovative marketing campaign with something unique and memorable that would build brand awareness was needed. The Aflac Duck’s first commercial in the U.S., “Park Bench,” aired on January 1, 2000 and taught consumers how to pronounce “Aflac.” The Aflac Duck made his international debut in Japan in 2003. In the two decades since his U.S. debut, the Aflac Duck has become one of the most familiar advertising icons in the world, appearing in several commercials and countless print ads in both the U.S. and Japan. Today, the Aflac Duck is a helpmate who increases brand knowledge and connection. +The Company is authorized to conduct insurance business in all 50 states, the District of Columbia, several U.S. territories and Japan. The Company’s website is: www.aflac.com. Information included on the Company’s website is not incorporated by reference into this filing. The Company makes available free of charge through its website, its annual report on Form 10-K, its quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as reasonably practicable after they have been electronically filed with or furnished to the Securities and Exchange Commission (SEC). +REPORTING SEGMENTS +The Company's insurance business consists of two reporting segments: Aflac Japan and Aflac U.S. The Parent Company’s primary insurance subsidiaries are Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan) and American Family Life Assurance Company of Columbus (Aflac); Continental American Insurance Company (CAIC), branded as Aflac Group Insurance (AGI); American Family Life Assurance Company of New York (Aflac New York) and Tier One Insurance Company (TOIC) in the U.S. (collectively, Aflac U.S.). +2 +Item 1. Business +Aflac Japan is the principal contributor to the Parent Company’s consolidated earnings. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 69% of the Company's total revenues in 2019 , compared with 70% in both 2018 and 2017 . The percentage of the Company's total assets attributable to Aflac Japan was 83% and 84% at December 31, 2019 and 2018 , respectively. The conversion of Aflac Japan to a subsidiary structure in April 2018 did not affect the Company's segment reporting structure. +Effective January 1, 2018, investments of Aflac U.S. as well as certain sub-advised assets of Aflac Japan, are managed by the Company’s U.S. asset management subsidiary, Aflac Asset Management LLC (AAM), and investments of Aflac Japan are managed pursuant to an investment advisory agreement between Aflac Japan and the Company's asset management subsidiary in Japan, Aflac Asset Management Japan Ltd. (AAMJ). AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. AAM and AAMJ are reported in the "Corporate and other segment" category; however, the assets that they manage are reported in the respective Aflac Japan and Aflac U.S. business segments. +In November 2019, the Company acquired Argus Holdings, LLC and its subsidiary Argus Dental & Vision, Inc. (Argus), a benefits management organization and national network dental and vision company, which provides a platform for Aflac Dental and Vision. The Company paid $75 million at closing and made an additional commitment of up to $21 million in contingent consideration payable over three years based on the achievement by Argus of certain performance targets. Argus is an addition to the Aflac U.S. segment. +Revenues derived from any customer did not exceed 10% of consolidated premiums and other revenues for the years ended December 31, 2019 and 2018 . For information on the Company's results of operations and financial information by segment, see Item 7. Management Discussion and Analysis (MD&A) and Note 2 of the Notes to the Consolidated Financial Statements in this report. +AFLAC JAPAN +Aflac Japan is the largest insurer in Japan in terms of cancer and medical (third sector insurance products) policies in force. As of December 31, 2019 , Aflac Japan exceeded 24 million individual policies in force in Japan. Aflac Japan continued to be the number one seller of cancer insurance policies in Japan throughout 2019 , with more than 15 million cancer policies in force as of December 31, 2019 . +Insurance Products +Aflac Japan's third sector insurance products are designed to help consumers pay for medical and nonmedical costs that are not reimbursed under Japan's national health insurance system. Changes in Japan's economy and an aging population have put increasing pressure on Japan's national health care system. As a result, more costs have been shifted to Japanese consumers, who in turn have become increasingly interested in insurance products that help them manage those costs. Aflac Japan has responded to this consumer need by enhancing existing products and developing new products. The focus at Aflac Japan remains on maintaining leadership in third sector insurance products that are less interest rate sensitive and have strong and stable margins. At the same time, Aflac Japan complements this core business with similarly profitable first sector protection products as outlined below. +THIRD SECTOR INSURANCE +FIRST SECTOR INSURANCE +Life insurance products include: +▪ +Cancer +Protection type: +Savings type: +▪ +Medical +▪ +Term Life +▪ +WAYS +▪ +Income Support +▪ +Whole Life +▪ +Child Endowment +▪ +GIFT +Cancer Insurance Aflac Japan pioneered the cancer insurance market in Japan in 1974, and remains the number one provider of cancer insurance in Japan today. Aflac Japan's cancer insurance products provide a lump-sum benefit upon initial diagnosis of cancer and fixed daily benefits for subsequent hospitalization and outpatient treatments due to cancer, as well as cancer-related surgical and convalescent care benefits. +3 +Item 1. Business +Medical Insurance Aflac Japan's medical insurance products provide benefits for hospitalization, surgeries and outpatient treatment of various illnesses, as well as lump sum benefits related to three critical illnesses: cancer, heart attack, and stroke. +Income Support Insurance Aflac Japan's Income Support Insurance provides fixed-benefit amounts in the event that a policyholder is unable to work due to significant illness or injury and was developed to supplement the disability coverage within Japan’s social security system. +Whole Life Aflac Japan launched Prepare Smart Whole-Life Insurance in 2018, a whole life insurance product with low cash surrender value, which offers non-smoking policyholders further discounted premiums, and it provides beneficiaries, typically a designated family member, with a pre-determined benefit payment upon the death of the insured. +GIFT GIFT is a term life insurance product that provides a designated family member with a fixed amount of money every month upon a breadwinner’s death or serious disability as family support. +WAYS and Child Endowment Beginning in 2013, Aflac Japan began to curtail sales of WAYS and Child Endowment, first sector savings-type products, due to persistent low interest rates in Japan and, in particular, the relatively large capital commitment required by such products and their lower profitability, in such an environment. +Distribution Channels +Traditional Sales Channel This distribution channel includes individual agencies, independent corporate agencies and affiliated corporate agencies. Aflac Japan was represented by more than 9,000 sales agencies at the end of 2019 , with more than 109,000 licensed sales associates employed by those agencies, including individual agencies. +Banks Consumers in Japan rely on banks to provide not only traditional bank services, but also as one key source to provide insurance solutions and other services. By the end of 2019 , Aflac Japan had agreements with approximately 90% of the total number of banks in Japan to sell its products. +Dai-ichi Life Aflac Japan's alliance with Dai-ichi Life was launched in 2001, and approximately 40,000 Dai-ichi Life representatives offer Aflac's cancer products. +Japan Post Group Aflac Japan's alliance with Japan Post Group was launched in 2008. After the alliance strengthened in 2013, the number of postal outlets of Japan Post Co. Ltd. (JPC) selling Aflac Japan's cancer product increased to more than 20,000 since 2015. Japan Post Insurance Co., Ltd. (JPI) offers Aflac Japan cancer products through its 76 directly managed sales offices. In 2018, the Company’ entered a strategic alliance with Japan Post Holdings Co., Ltd. (Japan Post Holdings), the parent company of Japan Post Co. Ltd (JPC) and Japan Post Insurance Co., Ltd. (JPI). See the "Aflac Japan Segment" subsection of MD&A for more about this alliance. +Daido Life In 2013, Aflac Japan and Daido Life Insurance entered into an agreement for Daido to sell Aflac Japan's cancer insurance products specifically to the Hojinkai market, which is an association of small businesses. Currently, Daido also sells Aflac Japan's cancer insurance products to the market in the tax payment association, which is a not-for-profit association for small businesses to support tax related matters. +Competition +The Company competes with other insurance carriers through policyholder service, price, product design and sales efforts, as the number of insurance companies offering stand-alone cancer and medical insurance has more than doubled since the deregulation of the Japan market in 2001. However, based on Aflac Japan's growth of annualized premiums in force and diversified distribution network, the Company does not believe that Aflac Japan's market-leading position has been significantly impacted by increased competition. Furthermore, the Company believes the continued development and maintenance of operating efficiencies will allow Aflac Japan to offer affordable products that appeal to consumers. The Company believes Aflac Japan will remain a leading provider of cancer and medical insurance coverage in Japan, principally due to its experience in the market, well-known brand, low-cost operations, expansive marketing system and product expertise. +Regulation +Financial Services Agency (FSA) The financial and business affairs of Aflac Japan are subject to examination by Japan's FSA. Aflac Japan files annual reports and financial statements for the Japanese insurance operations based on a March 31 fiscal year end, prepared in accordance with Japanese regulatory accounting practices prescribed or permitted by the FSA. Japanese regulatory basis earnings are determined using accounting principles that differ materially from U.S. generally +4 +Item 1. Business +accepted accounting principles (U.S. GAAP). Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $7.8 billion at December 31, 2019 , compared with $6.4 billion at December 31, 2018 . Two FSA regulations applicable to Aflac Japan are outlined below. +• +Privacy and Cybersecurity +With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the Act on the Protection of Personal Information (APPI) and guidelines issued by FSA and other governmental authorities. The FSA updated its guidelines regarding cybersecurity in October 2018. +• +FSA Solvency Standard +The FSA maintains a solvency standard, the solvency margin ratio (SMR), which is used by Japanese regulators to monitor the financial strength of insurance companies. As of December 31, 2019 , Aflac Japan's SMR was 1,043% , compared with 965% at December 31, 2018 . Aflac Japan's SMR is sensitive to interest rate, credit spread and foreign exchange rate changes. See the Liquidity and Capital Resources section of the MD&A for a discussion of measures the Company has taken to mitigate the sensitivity of Aflac Japan's SMR. +Japan Company Law As a branch of Aflac prior to April 1, 2018, Aflac Japan repatriated a portion of its accumulated earnings, as determined on a Japanese regulatory accounting basis, to Aflac U.S. provided that Aflac Japan had determined that it adequately protected policyholders' interests as measured by its SMR. After the conversion of Aflac Japan to a subsidiary structure on April 1, 2018 and starting in the fourth quarter of 2018, Aflac Japan distributes dividends to the Parent Company. Such dividends are subject to permitted dividend capacity under the Japan Company Law. +Policyholder Protection The Japanese insurance industry has a policyholder protection corporation that provides funds for the policyholders of insolvent insurers. For additional information, see the policyholder protection section of the MD&A. +For additional information regarding Aflac Japan's operations and regulations, see the "Aflac Japan Segment" subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +AFLAC U.S. +The Company designs its U.S. insurance products to provide supplemental coverage for people who already have major medical or primary insurance coverage, as Aflac U.S. insurance policies pay benefits regardless of other insurance. Aflac U.S. products are distributed in the individual and group supplemental insurance markets. Aflac's individual policies are portable, meaning that individuals may retain their full insurance coverage upon separation from employment or affiliation with a group, generally at the same premium. Individual policies are typically guaranteed-renewable for the lifetime of the policyholder (to age 75 for short-term disability policies). +Insurance Products +▪ +Cancer +▪ +Critical Illness +▪ +Vision +▪ +Accident +▪ +Hospital Indemnity +▪ +Life (Term and Whole) +▪ +Short-Term Disability +▪ +Dental +Cancer Insurance Aflac U.S.'s cancer insurance products provide a lump-sum benefit upon initial diagnosis of cancer and subsequent benefits for treatment received due to cancer. Aflac U.S. offers cancer insurance on an individual basis. +Accident Insurance Aflac U.S. offers accident coverage on both an individual and group basis. These policies pay cash benefits in the event of a covered injury. The accident portion of the policy includes lump-sum benefits for accidental death, dismemberment and specific injuries as well as fixed benefits for hospital confinement. Additional benefits are also available for home modifications, wellness and increased benefits for injuries related to participations in an organized sporting activity. +Short-Term Disability Insurance Aflac U.S. offers short-term disability benefits on both an individual and group basis. The individual short-term disability product offers an Aflac Value Rider that pays a benefit, less claims, for every consecutive five-year term that the policy is in force. +Critical Illness Insurance Aflac U.S. offers coverage for critical illness plans on both an individual and group basis. These policies are designed to pay cash benefits in the event of critical illnesses such as heart attack, stroke or cancer. +5 +Item 1. Business +Hospital Indemnity Insurance Aflac U.S. offers hospital indemnity coverage on both an individual and group basis. Hospital indemnity products provide policyholders fixed dollar benefits triggered by hospitalization due to accident or sickness. Indemnity benefits for inpatient and outpatient surgeries, as well as various other diagnostic events, are also available. Aflac U.S. also offers a lump sum rider for a range of critical illness events that can be added to its individual accident, short-term disability and hospital indemnity products. +Dental and Vision Insurance Aflac U.S. now offers network dental and vision products on a group basis. Aflac U.S. offers fixed-benefit dental coverage on both an individual and group basis. Aflac U.S. offers Vision Now SM , an individually issued policy which provides benefits for serious eye health conditions and loss of sight as well as coverage for corrective eye materials and exam benefits. +Life (Term and Whole) Aflac U.S. offers term- and whole-life policies on both an individual and group basis. +Distribution Channels +Independent Associates/Career Agents The career agent channel in Aflac U.S. focuses on marketing Aflac to the small business market, defined as employers of between three and 99 employees. Sales associates in the U.S. are independent contractors and are paid commissions and other variable compensation based on first-year and renewal premiums from their sales of insurance products. +Brokers The broker channel of Aflac U.S. focuses on selling to the mid- and large-case market, which is comprised of employers with 100 or more employees and typically an average size of 1,000 employees or more. Brokers in the U.S. are independent contractors and are paid commissions based on first-year and renewal premiums from their sales of insurance products. +Aflac U.S. concentrates on marketing its insurance products at the worksite. This method offers policies to individuals through employment, trade and other associations. Aflac U.S. believes that worksite marketing enables sales associates and brokers to reach a greater number of prospective policyholders and lowers distribution costs, compared with individually marketed business. Aflac U.S. is also expanding its distribution strategy to reach consumers outside of the traditional worksite through digital lead generation. +Competition +Aflac U.S. competes against several supplemental insurance carriers on a national and regional basis. Aflac U.S. believes its policies, premium rates, platforms, value-added services and sales commissions are competitive by product type. Moreover, Aflac U.S. believes that its products are distinct from competitive offerings given its product focus (including features, benefits and claims service model), distribution capabilities and brand awareness. +Since Aflac products provide an additional level of financial protection for policyholders, the Company believes the increased financial exposure some employees may face creates a favorable opportunity for Aflac U.S. products. However, given the profitability erosion some major medical carriers are facing in their core lines of business, the Company has seen a more competitive landscape as these carriers seek entry into Aflac's supplemental product segments and leverage their core benefit offerings by bundling and discounting products in order to gain market share. +One Day Pay SM is a claims initiative that Aflac U.S. has focused on to process, approve and pay eligible claims in just one day. The Company believes that this claims practice enhances the Aflac U.S. brand reputation and the trust policyholders have in Aflac, and it helps Aflac stand out from competitors. +Regulation +Insurance Regulation The Parent Company and its U.S. insurance subsidiaries, Aflac, CAIC, TOIC (Nebraska-domiciled insurance companies) and Aflac New York (a New York-domiciled insurance company) are subject to state regulations in the U.S. as an insurance holding company system. Such regulations generally provide that transactions between companies within the holding company system must be fair and equitable. In addition, transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries and certain transactions between companies within the system, including management fees, loans and advances are subject to prior notice to, or approval by, state regulatory authorities. These laws generally require, among other things, the insurance holding company and each insurance company directly owned by the holding company to register with the insurance departments of their respective domiciliary states and to furnish annually financial and other information about the operations of companies within the holding company system. +6 +Item 1. Business +Like all U.S. insurance companies, Aflac, Aflac New York, CAIC and TOIC are subject to regulation and supervision in the jurisdictions in which they do business. In general, the insurance laws of the various jurisdictions establish supervisory agencies with broad administrative powers relating to, among other things: +• +granting and revoking licenses to transact business +• +regulating trade and claims practices +• +licensing of insurance agents and brokers +• +approval of policy forms and premium rates +• +standards of solvency and maintenance of specified policy benefit reserves and minimum loss ratio requirements +• +capital requirements +• +limitations on dividends to shareholders +• +the nature of and limitations on investments +• +deposits of securities for the benefit of policyholders +• +filing of financial statements prepared in accordance with statutory insurance accounting practices prescribed or permitted by regulatory authorities +• +periodic examinations of the market conduct, financial, and other affairs of insurance companies +The insurance laws of Nebraska that govern Aflac's activities provide that the acquisition or change of “control” of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Nebraska Department of Insurance (NDOI). A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company (in the case of Aflac, CAIC and TOIC, the Parent Company) must generally file with the NDOI an application for change of control containing certain information required by statute and published regulations and provide a copy to Aflac. In Nebraska, control is generally presumed to exist if any person, directly or indirectly, acquires 10% or more of an insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Similar laws apply in New York, the domiciliary jurisdiction of Aflac's New York insurance subsidiary. +State insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). In 2016, full-scope, risk-focused financial examinations were conducted by the NDOI, New York Department of Financial Services (NYDFS), and the South Carolina Department of Insurance (SCDOI) on their state domiciled insurance entities Aflac, Aflac New York, and CAIC, respectively. There were no material findings contained in the final exam reports. CAIC redomiciled to Nebraska as of December 2016 and TOIC redomiciled to Nebraska effective March 11, 2019. The NDOI and NYDFS are scheduled to conduct a full-scope comprehensive financial examination covering years 2016-2019 in 2020. +NAIC Risk-Based Capital The NAIC continually reviews regulatory matters, such as risk-based capital (RBC) modernization, group capital calculations, liquidity risk assessment and principle-based reserving. The NAIC has adopted a valuation manual containing a principle-based approach to calculation of life insurance reserves. The valuation manual became effective January 1, 2017. There is a three-year transition period, beginning January 1, 2017, during which companies can choose on a product by product basis to implement principle-based reserving for new business. The Company anticipates that the adoption of this manual will not cause a material impact on the statutory reserves of Aflac, Aflac New York, CAIC or TOIC. The NAIC uses an RBC formula relating to insurance risk, business risk, asset risk and interest rate risk to facilitate identification by insurance regulators of inadequately capitalized insurance companies based upon the types and mix of risk inherent in the insurer's operations. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company's regulatory total adjusted capital to its authorized control level RBC as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels are company action, regulatory action, authorized control, and mandatory control. As of December 31, 2019 , based on year-end statutory accounting results, Aflac's company action level RBC ratio was 539% . The 2018 RBC as filed is lower than Aflac U.S. stand-alone RBC due to the inclusion of Aflac Japan for the first quarter of 2018. The RBC charge reflects the business risk without any total adjusted capital (TAC). Aflac's NAIC RBC ratio remains high and reflects a very strong capital and surplus position. +Guaranty Association and Similar Arrangements Under state insurance guaranty association laws and similar laws in international jurisdictions, the Company is subject to assessments, based on the share of business the Company writes in the relevant jurisdiction, for certain obligations of insolvent insurance companies to policyholders and claimants. In the U.S., some states permit member insurers to recover assessments paid through full or partial premium tax offsets. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory +7 +Item 1. Business +definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. In most states, the definition is met with a declaration of financial insolvency by a court of competent jurisdiction. +Federal Initiatives Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. Federal regulations applicable to Aflac U.S. are outlined below. +• +Affordable Care Act (ACA) +The ACA, federal health care reform legislation, gave the U.S. federal government direct regulatory authority over the business of health insurance. The reform included major changes to the U.S. health care insurance marketplace. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. The U.S. Congress has considered and may continue to consider legislation that would repeal and replace key provisions of the ACA. There can be no assurance that any legislation affecting the ACA will be passed by Congress, nor as to the ultimate timing or provisions of any such legislation, nor as to the effect of any such legislation on the design or marketability of the Company's insurance products. Further, certain provisions of the ACA have been and may continue to be subject to challenge through litigation, the ultimate effects of which on the ACA are uncertain. +• +Dodd-Frank Act +Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and regulations issued thereunder, in particular rules to require central clearing for certain types of derivatives, may have an impact on the Company's derivative activity, including activity on behalf of Aflac Japan. In addition, in 2015 and 2016, six U.S. financial regulators, including the U.S. Commodity Futures Trading Commission (CFTC), issued final rules regarding the exchange of initial margin (IM) and variation margin (VM) for uncleared swaps that impose greater obligations on swap dealers regarding uncleared swaps with certain counterparties, such as the Company. The requirements of such rules with respect to IM are currently being phased in and will be fully implemented by September 1, 2020, although an extension to September 1, 2021 is expected for covered entities with an aggregate average notional amount below $50 billion. The margin requirements are expected to result in more stringent collateral requirements and to affect other aspects of the Company's derivative activity. +The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. The FIO does not directly regulate the insurance industry, but under Dodd-Frank it has the power to preempt state insurance regulations that are inconsistent with international agreements reached by the federal government, subject to certain requirements and restrictions. The FIO and certain federal agencies must achieve consensus positions with the state insurance regulators when taking positions on insurance proposals by certain international forums. The President and Congress have stated proposals to reform or repeal certain provisions of the Dodd-Frank Act, some of which have been implemented. The Company cannot predict with any degree of certainty what impact, if any, such proposals might have on Aflac's business, financial condition, or results of operations. +• +Privacy and Cybersecurity +The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal Gramm-Leach-Bliley Act of 1999 (GLBA) and in the Health Insurance Portability and Accountability Act of 1996 (HIPAA). For example, the California Consumer Privacy Act became effective January 1, 2020 and requires businesses to provide California consumers rights to access, delete, and restrict certain uses of their personal information. Under the law, the California Attorney General may not bring an enforcement action prior to July 1, 2020. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). +Cybersecurity also continues to be an area of evolving focus for U.S. legislation and regulatory activity. In March 2017, new cybersecurity regulation issued by the NYDFS went into effect that requires covered entities, including Aflac New York, to maintain an information security program meeting certain security, data disposal, audit, activity +8 +Item 1. Business +monitoring, and data encryption requirements. In October 2017, the NAIC adopted an Insurance Data Security Model Law that may be adopted in whole or in part by U.S. states in which the Company’s subsidiaries are licensed. Other states have adopted and, the Company expects, will continue to pass legislation and issue regulations related to cybersecurity. The Company anticipates, assesses and if necessary modifies its information security program to accommodate such changes. +For further information concerning Aflac U.S. operations, see the "Aflac U.S. Segment" subsection of the MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +CORPORATE AND OTHER +The Company's other operations include the Parent Company, asset management subsidiaries, results of reinsurance retrocession activities and a printing subsidiary. For additional information on the Company's other operations, see the "Corporate and Other" subsection of the MD&A and Note 8 in the Notes to the Consolidated Financial Statements. +EMPLOYEES +As of December 31, 2019 , Aflac Japan had 6,178 employees, Aflac U.S. had 4,799 employees, and the Company's other operations had 752 employees. +9 +Item 1. Business +Information about the Company's Executive Officers +NAME +PRINCIPAL OCCUPATION (1) +AGE +Daniel P. Amos +Chairman, Aflac Incorporated and Aflac, since 2001; Chief Executive Officer, Aflac Incorporated and Aflac, since 1990; President, Aflac, since 2017; President, Aflac Incorporated, from 2018 until 2020 +68 +Koji Ariyoshi +Executive Vice President, Director of Sales and Marketing, Aflac Japan, since 2012 +66 +Steven K. Beaver +Senior Vice President, Chief Financial Officer, Aflac U.S., since 2019; Senior Vice President, Financial Planning and Analysis, Aflac Incorporated, from 2018 until 2019; Senior Vice President, Global Strategic Projects, Corporate Financial Planning and Analysis, Aflac Incorporated, from 2017 until 2018; Vice President, Deputy Chief Accounting Officer, Tax Department, Aflac Incorporated, from 2015 until 2016; Vice President, Corporate Tax, Aflac Incorporated, from 2012 until 2014 +55 +Max K. Broden +Executive Vice President, Chief Financial Officer, Aflac Incorporated, since 2020; Senior Vice President and Treasurer, Aflac Incorporated, from 2017 until 2020; Senior Portfolio Manager, Norges Bank, from 2007 until 2017 +41 +Frederick J. Crawford +President and Chief Operating Officer, Aflac Incorporated, since 2020; Executive Vice President, Chief Financial Officer, Aflac Incorporated, from 2015 until 2020; Executive Vice President, Chief Financial Officer, CNO Financial Group, from 2012 until 2015 +56 +J. Todd Daniels +Executive Vice President, Chief Financial Officer, Aflac Japan, since 2018; Executive Vice President, Global Chief Risk Officer and Chief Actuary, Aflac Incorporated, from 2016 until 2018; Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2015 until 2016; Senior Vice President, Deputy Corporate Actuary and Global Chief Risk Officer, Aflac, from 2014 until 2015; Senior Vice President, Deputy Corporate Actuary, Aflac, from 2012 until 2014 +49 +June Howard +Chief Accounting Officer, Aflac Incorporated and Aflac, since 2010; Senior Vice President, Financial Services, Aflac Incorporated and Aflac, since 2010; Treasurer, Aflac, from 2011 until 2015 +53 +Eric M. Kirsch +Executive Vice President, Global Chief Investment Officer, Aflac, since 2012; President, Aflac Asset Management LLC, since 2017 +59 +Masatoshi Koide +President and Chief Operating Officer, Aflac Japan since 2017; Deputy President, Aflac Japan from 2016 until 2017; Executive Vice President, Aflac Japan from 2015 until 2016; First Senior Vice President, Aflac Japan, from 2013 until 2015 +59 +Charles D. Lake, II +President, Aflac International, since 2014; Chairman, Aflac Japan, since 2008 +58 +Albert A. Riggieri +Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac Incorporated, since 2018; Senior Vice President, Corporate Actuary, Aflac, from 2016 until 2018; Group Chief Actuary, Unum Group, until 2016 +64 +Audrey B. Tillman +Executive Vice President, General Counsel, Aflac Incorporated and Aflac, since 2014; Executive Vice President, Corporate Services, Aflac Incorporated, from 2008 until 2014 +55 +Teresa L. White +President, Aflac U.S., since 2014 +53 +Richard L. Williams Jr. +Executive Vice President and Chief Distribution Officer, Aflac since 2017; Senior Vice President and General Manager, Stop Loss, Unum, U.S. in 2017; Senior Vice President, Growth Markets, Colonial Life and Accident Insurance Company from 2013 until 2017 +48 +(1) Unless specifically noted, the respective executive officer has held the occupation(s) set forth in the table for at least the last five years. Each executive officer is appointed annually by the board of directors and serves until his or her successor is chosen and qualified, or until his or her death, resignation or removal. +10 +Item 1A. Risk Factors +ITEM 1A. RISK FACTORS +The Company faces a wide range of risks, and its continued success depends on its ability to identify, prioritize and appropriately manage enterprise risk exposures. Readers should carefully consider each of the following risks and all of the other information set forth in this Form 10-K. These risks and other factors may affect forward-looking statements, including those in this document or made by the Company elsewhere, such as in earnings release webcasts, investor conference presentations or press releases. The risks and uncertainties described herein may not be the only ones facing the Company. Additional risks and uncertainties not presently known to the Company or that the Company currently believes to be immaterial may also adversely affect its business. If any of the following risks and uncertainties develops into actual events, there could be a material impact on the Company. +Sales of the Company's products and services are dependent on its ability to attract, retain and support a network of qualified sales associates, brokers and employees in the U.S. and sales associates and other distribution partners in Japan. +The Company's sales, results of operations and financial condition could be materially adversely affected if its sales networks deteriorate or if the Company does not adequately provide support, training and education for its existing network of sales associates, brokers, other distribution partners and employees. In the U.S., competition exists for sales associates and brokers with demonstrated ability. In Japan, the Company's sales results are dependent upon its relationship with sales associates and other distribution partners, including its strategic partner, Japan Post. +The Company competes with other insurers and financial institutions primarily on the basis of its products, compensation, support services and financial rating. The Company's sales associates, brokers and other distribution partners are independent contractors and may sell products of its competitors. If the Company's competitors offer products that are more attractive, or pay higher commissions than the Company does, any or all of these distribution partners may concentrate their efforts on selling the Company's competitors' products instead of the Company's. In addition to the Company's commissioned sales force in the U.S., Aflac has expanded its sales leadership team to include a salaried sales force of over 200 market directors and broker sales professionals. The Company's inability to attract and retain qualified sales associates, brokers and other distribution partners, including its alliance partners in Japan, could have a material adverse effect on the Company's sales, results of operations and financial condition. +Additionally, as the Japan and U.S. employment markets continue to evolve, there is risk that the Company's practices regarding attracting, developing, and retaining employees may not be fully effective. Failure to successfully meet and maintain sufficient levels of employees may diminish the Company's ability to achieve its financial and compliance objectives, both of which are time consuming and personnel-intensive. +For more information on the strategic partnership with Japan Post, see the risk factor below entitled, " Events related to the ongoing Japan Post investigation and other matters regarding sales of Japan Post Insurance products could negatively impact the Company’s sales and results of operations ." +Events related to the ongoing Japan Post investigation and other matters regarding sales of Japan Post Insurance products could negatively impact the Company’s sales and results of operations +As previously disclosed, in the second half of 2019 and the first quarter of 2020 there have been news reports and public comments regarding improper sales practices relating to sales of JPI products by JPI and JPC, each an affiliate of Japan Post Holdings (together with JPI and JPC, the Japan Post Group). JPC and JPI are important distribution and alliance partners of the Company, which in 2018 collectively accounted for approximately 25% of Aflac Japan’s third sector sales. On July 24, 2019, after such news reports and other public comments, the Japan Post Group announced that they had established a Special Investigative Committee comprised of independent former prosecutors to determine whether JPC and JPI sales practices with respect to JPI products had caused disadvantages to customers holding such policies that were not otherwise the result of honoring such customers’ intentions. +On December 18, 2019, the Japan Post Group issued a release discussing results of the investigation and stating that JPI had identified a number of cases involving potential violation of laws and regulations or internal rules. On the same date, the Japan Post Group stated that it would continue the investigation with a goal of completing it by March 2020. On December 27, 2019, the Japanese FSA issued three-month business suspension orders to JPC and JPI for the sale of JPI insurance products, and the Japan Ministry of Internal Affairs and Communications also issued a three-month business suspension order to JPC for the sale of JPI insurance products. Also on December 27, 2019, the Japan Post Group announced the resignation of the chief executives of Japan Post Holdings, JPC and JPI, to be effective January 5, 2020. On January 31, +11 +Item 1A. Risk Factors +2020, the Japan Post Group announced that its internal investigation had been expanded to additional policyholders and the investigation would continue with a goal of completing it by the end of June 2020. The Japan Post Group stated they could not comment on the expected timing for it to re-initiate sales of JPI insurance products. +Notwithstanding the JPI investigation and the three-month suspension orders promulgated by the FSA and the Japan Ministry of Internal Affairs and Communications, the sale of Aflac Japan cancer policies has continued through JPC and JPI. However, while the sale of Aflac Japan cancer insurance products is not within the scope of the suspension orders, beginning in August 2019 the Company has experienced a material decrease of sales in the Japan Post Group channel. This decline has continued into 2020. The Company believes that sales of Aflac Japan cancer insurance through JPC and JPI are unlikely to return to 2018 levels in the near term. It is uncertain what long-term effect these developments will have on the Company’s results of operations or financial condition, but any such effects could be material. See the "Aflac Japan Segment" subsection of Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. +Competition could adversely affect the Company's ability to increase or maintain its market share or profitability. +The Company operates in a competitive environment and in an industry that is subject to ongoing changes from market pressures brought about by customer demands, legislative reform, marketing practices and changes to health care and health insurance delivery. These factors require the Company to anticipate market trends and make changes to differentiate the Company's products and services from those of its competitors. The Company also faces the potential of competition from existing or new companies in the U.S. and Japan that have not historically been active in the supplemental health insurance industry, but some of which have greater financial, marketing and management resources than the Company does. Further, some of these potential competitors could introduce new means of product development and delivery that disrupt the Company’s business model. Failure to anticipate market trends and/or to differentiate the Company's products and services can affect the Company's ability to retain or grow profitable lines of business. Further, as employers and brokers are increasingly requesting a full-suite of products from one insurance provider, a failure to react and adapt to these demands could result in decreased sales or market share. +The insurance market is undergoing rapid changes with frequent introductions of new technology-driven products and services. The Company's future success will depend, in part, on its ability to keep pace with the technological changes and to use technology to satisfy and grow customer demand for the Company's products and services and to create additional efficiencies in its operations. The Company expects that it will need to continue making substantial investments in its technology and information systems to compete effectively and to stay current with technological changes. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. A failure to meet evolving customer demands through innovative product development, effective distribution channels, and continuous investment in the Company's technology could result in lower revenues and less favorable policy terms and conditions, which could adversely affect the Company's operating results. As a result, the Company's ability to effectively compete to retain or acquire new business may be impaired, and its business, financial condition or results of operations may be adversely affected. +If future policy benefits, claims or expenses exceed those anticipated in establishing premiums and reserves, the Company's financial results would be adversely affected. +The Company establishes premiums for many of its policies on assumptions for morbidity, mortality, longevity and persistency. The Company also establishes and carries, as a liability, reserves based on estimates of how much will be required to pay for future benefits and claims on its policies. The Company calculates these reserves using various assumptions and estimates, including premiums the Company will receive over the assumed life of the policy; the timing, frequency and severity of the events covered by the insurance policy; and the investment returns on the assets the Company purchases with a portion of its net cash flow from operations. +The assumptions and estimates that the Company uses in establishing premiums and reserves depend on the Company's judgment regarding the likelihood of future events and are inherently uncertain. Many factors can cause actual outcomes to deviate from these assumptions and estimates, such as changes in incidence rates, economic conditions, changes in government healthcare policy, advances in medical technology, changes in treatment patterns, and changes in average lifespan. Accordingly, the Company cannot determine with precision the ultimate amounts that it will pay for, or the timing of payment of, actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level the Company assumes prior to payment of benefits or claims. If the Company's actual experience is different from its assumptions or estimates, the Company's reserves may prove inadequate. As a result, the Company would incur a charge to earnings in the period in which it determines such a shortfall exists, which could have a material adverse effect on the Company's business, results of operations and financial condition. +12 +Item 1A. Risk Factors +Generally, lower mortality decreases the profitability of third sector products in Japan, as more policyholders will survive into ages where they have a higher rate of claim incidence. This assumption can impact pricing and reserving. For instance, Japan FSA periodically requires updates to their Standard mortality tables for FSA reserves. An update to the Standard mortality tables was performed in April 2018 applicable to all business issued after that date. For business that is inforce prior to the update, the change in mortality table would not have an impact. For new issues, the updated mortality tables would be included in the Company's reserve assumptions, and slow the emergence of FSA earnings for third sector products and therefore will have an impact on pricing returns. The Company adjusts pricing assumptions as new products are developed to adjust for these mortality assumptions. +The success of the Company's business depends in part on effective information technology systems and on continuing to develop and implement improvements in technology. +The Company's business depends in large part on its technology systems for interacting with employers, policyholders, sales associates, and brokers, and the Company's business strategy involves providing customers with easy-to-use products to meet their needs and ensuring employees have the technology in place to support those needs. Some of the Company's information technology systems and software are older, legacy-type systems that are less efficient and require an ongoing commitment of significant resources to maintain or upgrade to current standards including adequate business continuity procedures. The Company is in a continual state of upgrading and enhancing its business systems; however, these changes tend to challenge the Company's complex integrated environment. The Company's success is dependent in large part on maintaining or improving the effectiveness of existing systems and continuing to develop and enhance information systems that support its business processes in a cost-efficient manner. If the Company does not maintain the effectiveness of its systems, the Company's operations and reputation could be adversely affected and it could be exposed to litigation as well as to regulatory proceedings and fines or penalties. +Defaults, downgrades, widening credit spreads or other events impairing the value of the fixed maturity securities and loan receivables in the Company's investment portfolio may reduce the Company's earnings and capital position. +The Company is subject to the risk that the issuers and/or guarantors of fixed maturity securities and loan receivables the Company owns may default on principal or interest. A significant portion of the Company's portfolio represents an unsecured obligation of the issuer, including some that may be subordinated to other debt in the issuer’s capital structure. In these cases, many factors can influence the overall creditworthiness of the issuer and ultimately its ability to service and repay the Company's holdings. This can include changes in the global economy, the company's assets, strategy, or management, shifts in the dynamics of the industries in which they compete, their access to additional funding, and the overall health of the credit markets. Factors unique to the Company's securities including contractual protections such as financial covenants or relative position in the issuer's capital structure also influence the value of the Company's holdings. +Most of the Company's investments carry a rating by one or more of the nationally recognized statistical rating organizations (NRSROs or rating agencies). Any change in the rating agencies' approach to evaluating credit and assigning an opinion could negatively impact the fair value of the Company's portfolio. The Company employs a team of credit analysts to monitor the creditworthiness of the issuers in its portfolio. Any credit-related declines in the fair value of positions held in the Company's portfolio believed to be not temporary in nature will negatively impact the Company's net income and capital position through impairment and other credit related losses. These losses would also affect the Company's solvency ratios in the U.S. and Japan. Aflac Japan has certain regulatory accounting requirements for realizing impairments that could be triggered by credit-related losses, which may be different from U.S. GAAP and statutory requirements. These impairment losses could negatively impact Aflac Japan's earnings, and the corresponding dividends and capital deployment. +The Company is also subject to the risk that any collateral providing credit enhancement to the Company's positions could deteriorate. These instruments may include senior secured first lien loans, such as commercial mortgage loans, bank loans, middle market loans, and loan-backed securities where the underlying loan or collateral notes may default on principal, interest, or other payments, causing an adverse change in cash flows to the positions held in the Company's investment portfolio. +The Company is exposed to sovereign credit risk through instruments issued directly by governments and government entities as well as banks and other institutions that rely in part on the strength of the underlying government for their credit quality. In addition to the U.S. and Japan, many governments, especially in Europe, have been subject to rating downgrades due to the need for fiscal and budgetary remediation and structural reforms, reduced economic activity, and investment needed to support banks or other systemically important entities. Additional downgrades or default of the Company's sovereign issuers will have a negative impact on its portfolio and could reduce the Company's earnings and capital. +13 +Item 1A. Risk Factors +In addition to the Company's exposure to the underlying fundamental credit strength of the issuers of its fixed maturity securities and the underlying risk of default, the Company is also exposed to the general movement in credit market spreads. A widening of credit spreads could reduce the value of the Company's existing portfolio, create unrealized losses on its investment portfolio, and reduce the Company's adjusted capital position which is used in determining the SMR in Japan. This widening of credit spreads could, however, increase the net investment income on new credit investments. Conversely, a tightening of credit spreads could increase the value of the Company's existing portfolio and create unrealized gains on its investment portfolio. This tightening of credit spreads could also reduce the net investment income available to the Company on new credit investments. Increased market volatility also makes it difficult to value certain of the Company's investment holdings (see the Critical Accounting Estimates section in Item 7, Management's Discussion and Analysis, of this Form 10-K). +For more information regarding credit risk, see the Credit Risk subsection of Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Form 10-K. +The Company is exposed to significant interest rate risk, which may adversely affect its results of operations, financial condition and liquidity. +The Company has substantial investment portfolios that support its policy liabilities. Low levels of interest rates on investments experienced in Japan and the U.S. over the last decade have reduced the level of investment income earned by the Company. The Company's overall level of investment income will be negatively impacted in a persistent low-interest-rate environment. While the Company generally seeks to maintain a diversified portfolio of fixed-income investments that reflects the cash flow and duration characteristics of the liabilities it supports, the Company may not be able to fully mitigate the interest rate risk of its assets relative to its liabilities. The Company's exposure to interest rate risk relates primarily to the ability to invest future cash flows to support the interest rate assumption made at the time the Company's products were priced and the related reserving assumptions were established. A sustained decline in interest rates could hinder the Company's ability to earn the returns assumed in the pricing and the reserving for its products at the time they were sold and issued. Due to low interest rates, the Company's ability to earn the returns it expects may also influence the Company's ability to develop and price attractive new products and could impact its overall sales levels. The Company's first sector products are more interest rate sensitive than third sector products. As discussed in Item 1. Business, beginning in 2013, Aflac Japan began to curtail sales of first sector savings-type products due to persistent low interest rates in Japan. The continuing negative interest rate imposed by the Bank of Japan (BoJ) on excess bank reserves could continue to have a negative impact on the distribution and pricing of these products. +A rise in interest rates could improve the Company's ability to earn higher rates of return on future investments, as well as floating rate investments held in its investment portfolio. However, an increase in the differential of short-term U.S. and Japan interest rates would increase the cost of hedging a portion of the U.S. dollar-denominated assets in the Aflac Japan segment into yen, which could have a material adverse effect on the Company's business, results of operations or financial condition. The Company’s floating rate investments typically bear interest based on the London Interbank Offered Rate (LIBOR). Regulatory and industry initiatives to eliminate LIBOR as an interest rate benchmark may create uncertainty in the valuation of LIBOR-based loans, as well as for other LIBOR-based derivatives and assets. This may adversely impact both pricing and liquidity in such instruments. The Company is unable to predict with certainty how LIBOR elimination may impact markets, pricing, liquidity and other factors or the Company's activities. +Changes in interest rates impact unrealized gains and losses of fixed income securities in the Company's investment portfolio; however, they do not have a direct impact on the related valuation of the corresponding liabilities. Prolonged periods of low interest rates, as have been experienced in recent years, heighten the risk associated with future increases in interest rates because an increasing proportion of the Company's investment portfolio includes investments that bear lower rates of return than the embedded book yield of the investment portfolio. A rise in interest rates could decrease the fair value of the Company's debt securities. Some of the insurance products that Aflac sells in the U.S. and Japan provide cash surrender values. A rise in interest rates could trigger significant policy surrenders, which might require the Company to sell investment assets and recognize unrealized losses. This situation is commonly referred to as disintermediation risk. The Company generally invests its assets to match the duration and cash flow characteristics of its policy liabilities, and therefore would not expect to realize most of these gains or losses, however, the Company's risk is that unforeseen events or economic conditions, such as changes in interest rates resulting from governmental monetary policies, domestic and international economic and political conditions, and other factors beyond the Company's control will reduce the effectiveness of this strategy. These events or economic conditions could either cause the Company to dispose of some or all of these investments prior to their maturity, or increase the risk that the issuers of these securities may default or may require impairment, which could result in the Company having to recognize such gains or losses. +14 +Item 1A. Risk Factors +Rising interest rates also negatively impact the SMR since unrealized losses on the available-for-sale investment portfolio factor into the ratio. For regulatory accounting purposes for Aflac Japan, there are certain requirements for realizing impairments that could be triggered by rising interest rates, negatively impacting Aflac Japan's earnings and corresponding dividends and capital deployment. +Further, interest rate risk is still an inherent portfolio, business and capital risk for the Company, and significant changes in interest rates could have a material adverse effect on the Company's consolidated results of operations, financial condition or cash flows through realized losses, impairments, changes in unrealized positions, and liquidity. +For more information regarding interest rate risk, see the Interest Rate Risk subsection within the Market Risks of Financial Instruments section of MD&A in this report. +The Company's concentration of business in Japan poses risks to its operations. +The Company's operations in Japan, including realized gains and losses on Aflac Japan's investment portfolio, accounted for 69% of the Company's total revenues in 2019 , and 70% in both 2018 and 2017 . The Japanese operations accounted for 83% of the Company's total assets at December 31, 2019 , compared with 84% at December 31, 2018 . +Further, because of the concentration of the Company's business in Japan and its need for long-dated yen-denominated assets, the Company has a substantial concentration of Japan Government Bond (JGBs) in its investment portfolio. As such the Company has material exposure to the Japanese economy, geo-political climate, political regime, and other factors that generally determine a country's creditworthiness. Specifically, the NRSROs, credit rating agencies registered with the SEC, have placed increased scrutiny on JGBs, which are a significant component of the Company’s overall investment portfolio, resulting in downgrades as discussed later in this Risk Factors section. +The Company seeks to match investment currency and interest rate risk to its yen liabilities. The low level of interest rates available on yen-denominated securities has a negative effect on overall net investment income. A large portion of the cash available for reinvestment each year is deployed in yen-denominated instruments and subject to the low level of yen interest rates. +Any potential deterioration in Japan ' s credit quality, market access, the overall economy of Japan, or Japanese market volatility could adversely impact the business of Aflac in general and specifically Aflac Japan and its related results of operations and financial condition. +Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity. +The Company attempts to match both the duration and currency of its assets with its liabilities. This is very difficult for Aflac Japan due to the lack of available long-dated yen-denominated fixed income instruments beyond JGBs. +Prior to the onset of the financial crisis of 2008, the Company was focused on investing cash flows in JGBs, which had relatively low yields, and utilizing private placement and perpetual securities to gain additional yield, extend the duration of the investment portfolio, and maintain yen exposure. Given call activity with respect to certain of the Company's legacy private placement investments, the Company has added a modest amount of yen-denominated private placements to its investment portfolio in recent periods. The investment in private placements carries risk associated with illiquidity, which is managed and monitored by the Company. +Starting in 2012, Aflac Japan augmented its investment strategy to include U.S. dollar-denominated investments, some of which could then be hedged back to yen. Initially this program focused on public investment-grade bonds but has evolved over time to include U.S. dollar-denominated investment-grade commercial mortgage loans, middle market loans, infrastructure debt, as well as other loan types, high yield bond and public and private equities. The Company plans to continue adding other instruments denominated in U.S. dollars, including floating rate investments, to improve the portfolio diversification and/or return profile. Some of the U.S. dollar-denominated asset classes that the Company has added, and anticipates continuing to add, have less liquidity than investment-grade corporate bonds. These strategies will continue to increase the Company's exposure to U.S. interest rates, credit spreads and other risks. The Company has increased foreign exchange risk exposure as the comprehensive hedging program may not always correlate to the underlying U.S. dollar-denominated assets, thereby increasing earnings volatility. These risks can significantly impact the Company's consolidated results of operations, financial position or liquidity. +15 +Item 1A. Risk Factors +Investing in U.S. dollar-denominated investments in Aflac Japan also creates an unmatched foreign currency exposure and related SMR volatility, as Aflac Japan’s insurance liabilities are yen-denominated. Although the Company engages in certain foreign exchange hedging activities to partially mitigate this risk, and such hedged assets may be used to satisfy yen-denominated insurance liabilities and other business obligations, important risks remain. +Foreign exchange derivatives used for hedging are periodically settled, which results in cash receipt or payment at maturity or early termination. Cumulative net cash settlements on derivatives hedging currency exposure of Aflac Japan's U.S. dollar-denominated investments are associated with existing U.S. dollar-denominated investments that continue to be hedged, previously hedged investments that continue to be held but are no longer hedged, as well as, investments previously hedged that have since been sold, matured or redeemed and may or may not have not been converted to yen. The Company’s foreign exchange derivatives are typically shorter-dated than the underlying U.S. dollar-denominated investments being hedged, which creates roll-over risks within the hedging program that could increase the cost of such derivatives. If the Company reduces the notional amount of foreign exchange derivatives prior to the maturity of the hedged U.S. dollar-denominated investments, the foreign exchange gains or losses on the U.S. dollar-denominated investments remain economically unrealized. These foreign currency gains or losses on the investments are only economically realized, or monetized , through sale , maturity or redemption of the investments and concurrent conversion to yen. However, the Company may not realize the benefit of offsetting adverse cash settlements on hedging derivatives with cash receipts on the U.S. dollar-denominated investments if the currency exchange rates move in an adverse direction before the investments are converted to yen, or if the investments are never converted to yen. As an example of the latter, if the Company’s actual insurance risk experience in Japan is as expected or more favorable than expected, the need for yen to pay expenses and claims would correspondingly remain at or below expected levels, thereby diminishing operational requirements to convert U.S. dollar-denominated investments to yen. The settlement of the foreign exchange derivatives is reported in the investing activities section of the Company’s consolidated statements of cash flows in the line item “Settlement of derivatives, net.” +For more information regarding unhedged U.S. dollar-denominated securities, see the risk factor entitled, “The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate.” For more information regarding Aflac Japan's U.S. dollar-denominated investments and hedging activities, see the "Hedging Activities"subsection within the MD&A of this report, and for more information regarding foreign currency risk, see the "Currency Risk" subsection within the Item 7A. Quantitative and Qualitative Disclosures about Market Risk section in this report. +If the Company fails to comply with restrictions on customer privacy and information security, including taking steps to ensure that its third-party service providers and business associates who access, store, process or transmit sensitive customer information maintain its security, integrity, confidentiality and availability, the Company's reputation and business operations could be materially adversely affected. +The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal GLBA and in the HIPAA. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the APPI and guidelines issued by FSA and other governmental authorities. +The Company relies on third parties, and in some cases subcontractors, to provide information technology and data services. It also relies on various parties in its distribution channels including agencies, banks and Japan Post in Japan, as well as sales associates and brokers in the U.S., to provide services to prospective and existing customers. Although the Company provides for appropriate protections through its contracts and performs information security risk assessments of its third-party service providers and business associates, the Company still has limited control over their actions and practices. In addition, despite the security measures the Company has in place to ensure compliance with applicable laws and rules, the Company's facilities and systems, and those of the Company's third-party providers and participants in its distribution channels may be vulnerable to security breaches, acts of vandalism or theft, computer viruses, misplaced or lost data, programming and/or human errors or other similar events. From time to time, the Company, its third party providers and participants in the Company’s distribution channels have experienced and will likely continue to experience such events. In such cases, notification to affected individuals, state and federal regulators, state attorneys general and media may be required, depending upon the number of affected individuals and whether personal information including health or financial data was subject to unauthorized access. +The U.S. Congress and many states are considering new privacy and security requirements that would apply to the Company's business. Compliance with new privacy and security laws, requirements, and new regulations may result in cost +16 +Item 1A. Risk Factors +increases due to necessary systems changes, new limitations or constraints on the Company's business models, the development of new administrative processes, and the effects of potential noncompliance by the Company's business associates. They also may impose further restrictions on the Company's collection, disclosure and use of customer identifiable data that are housed in one or more of the Company's administrative databases. Noncompliance with any privacy laws or any security breach involving the misappropriation, loss, theft or other unauthorized disclosure of sensitive or confidential customer information, whether by the Company or by one of its third parties, could have a material adverse effect on the Company's business, reputation, brand and results of operations, including: material fines and penalties; compensatory, special, punitive and statutory damages; consent orders regarding the Company's privacy and security practices; adverse actions against the Company's licenses to do business; and injunctive relief. +In addition, under Japanese laws and regulations, including the APPI, if a leak or loss of personal information by Aflac Japan or its business associates should occur, depending on factors such as the volume of personal data involved and the likelihood of other secondary damage, Aflac Japan may be required to file reports to the FSA; issue public releases explaining such incident to the public; or become subject to an FSA business improvement order, which could pose a risk to the Company's reputation. +Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality, integrity or privacy of sensitive data residing on such systems, could harm the Company's business. +The Company stores confidential policyholder, employee, agent, and other proprietary information on its information technology systems. In addition, the Company depends heavily on its telecommunication, information technology and other operational systems and on the integrity and timeliness of data it uses to run its businesses and service its customers. These systems may fail to operate properly or become disabled as a result of events or circumstances wholly or partly beyond the Company's control. Additionally, design flaws may exist in certain systems, processes, software, or configurations that in turn may result in system failure, data corruption, or compromise. Despite the Company's implementation of a variety of security measures to defend against threats incurred on a daily basis, its information technology and other systems, as well as those of third party providers and participants in the Company’s distribution channels, have been and will likely continue to be subject to physical or electronic break-ins, unauthorized tampering, security breaches or other cyber-attacks, that may result in the failure to adequately maintain the security, confidentiality, integrity, or privacy of sensitive data, including personal information relating to customers and prospective customers, or in the misappropriation of the Company's intellectual property or proprietary information. +From time to time, the Company, its third party providers and participants in the Company’s distribution channels have experienced and will likely continue to experience such events. Although the minor data leakage issues the Company has experienced to date have not had a material effect on its business, there is no assurance that the Company's security systems or processes will prevent or mitigate future break-ins, tampering, security breaches or other cyber-attacks. Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems, whether due to actions by the Company or others, including third party providers and participants in the company’s distribution channels, could delay or disrupt the Company's ability to do business and service its customers, seriously harm the Company's brand and reputation as well as the Company's ability to compete effectively, subject it to regulatory sanctions and other claims, lead to a loss of customers and revenues and otherwise adversely affect the Company's business. In addition, the costs to address or remediate system interruptions or security threats and vulnerabilities, whether before or after an incident, could be significant. +While the Company continues to invest in the infrastructure of its data security programs, the Company, as well as its third party providers and participants in the Company’s distribution channels, have been, and will likely continue to be, the target of unauthorized access, social engineering, phishing, cyber-attacks, web application attacks, computer viruses or other malicious codes, or other computer-related penetrations. Although the Company attempts to manage its exposure to such events through the purchase of cyber liability insurance, such events are inherently unpredictable and insurance may not be sufficient to protect the Company against all losses. As a result, events such as these could adversely affect the Company's financial condition or results of operation. +17 +Item 1A. Risk Factors +Catastrophic events could adversely affect the Company's financial condition and results of operations as well as the availability of the Company’s infrastructure and systems. +The Company's insurance operations are exposed to the risk of catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, war or other military action, and terrorism or other acts of violence. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Certain events such as earthquakes, tsunamis, hurricanes and man-made catastrophes could cause substantial damage or loss of life in larger areas, especially those that are heavily populated. Claims resulting from natural or man−made catastrophic events could cause substantial volatility in the Company's financial results for any fiscal quarter or year and could materially reduce its profitability or harm the Company's financial condition, as well as affect its ability to write new business. +Additionally, the Company's business operations may be adversely affected by such catastrophic events to the extent they disrupt the Company's physical infrastructure, human resources or systems that support its businesses and customers. Although the Company has a global crisis management framework to minimize the business disruption from a catastrophic event, such framework may not be effective to avoid an adverse impact to the Company from such an event. +Difficult conditions in global capital markets and the economy could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business. +The Company's results of operations are materially affected by conditions in the global capital markets and the global economy generally, including in its two primary operating markets of the U.S. and Japan. Weak global financial markets impact the value of the Company's existing investment portfolio, influence opportunities for new investments, and may contribute to generally weak economic fundamentals, which can have a negative impact on its operating activities. +In recent years, global capital markets have been severely impacted by several major events. The financial crisis that began in the latter part of 2008 saw dramatic declines in investment values and weak economic conditions as the global financial system came under extreme pressure. Although U.S. markets began recovering in late 2009 and 2010, Europe continued to struggle under a severely weakened banking system and investor concerns with sovereign debt levels. Following a period of unprecedented intervention by governments and central banks, including the U.S. Federal Reserve and European Central Bank (ECB), financial conditions improved from the dire conditions of the global financial crisis, global recession, and European debt crisis. More recently, global markets have experienced bouts of volatility due to uncertainty surrounding a British exit from the European Union, Japan’s continued recovery amidst assorted policy changes, volatility in global commodity prices including oil, divergent monetary policies in the U.S. versus many other developed economies, heightened concerns surrounding the Chinese economy and increasing protectionism in U.S. foreign trade policy. While capital and market conditions have been generally favorable in the last year, the prospect for increased volatility remains. +A shift in the global trading policies by the U.S. and subsequent trade conflict with China has raised concerns about a slowdown of the Chinese economy and the recent trade agreement between the U.S. and China left tariffs in place and many trade issues unresolved. In addition, the recent trade agreement between the U.S. and Japan resulted in tariff reductions on some products but left tariffs on other products in place. While it is not expected that the Company's products would be directly impacted by tariffs, any resulting economic downturn could adversely affect the Company. +Activity by the government of North Korea in 2018 was the subject of increasing focus for a number of other governments, including those of the U.S. and Japan. Although hostile rhetoric decreased in 2019, there is a possibility of renewed hostility between their governments. In addition, in January 2020, hostility between the government of the U.S. and the government of Iran increased, ultimately culminating in a number of missile strikes. Such activity and related geopolitical risk could have a significant impact on financial market conditions across the world. Under certain circumstances, government actions taken in response to these or similar situations could have a material impact on the Company's operations and financial performance, including the indirect impact of potentially severe and prolonged capital market volatility and disruption. +As the Company holds a significant amount of fixed maturity securities issued by borrowers located in many different parts of the world, including a large portion issued by banks and financial institutions, sovereigns, and other corporate borrowers in the U.S. and Europe, its financial results are directly influenced by global financial markets. A retrenchment of the recent strength of the capital markets could adversely affect the Company's financial condition, including its capital position and overall profitability. Market volatility and recessionary pressures could result in significant realized or unrealized losses due to severe price declines driven by increases in interest rates or credit spreads, defaults in payment of principal or interest, or credit rating downgrades. +18 +Item 1A. Risk Factors +Following the election of Shinzo Abe as Prime Minister of Japan in December 2012, the new administration adopted a new set of financial measures to stimulate the Japanese economy, including imposing negative interest rates on excess bank reserves. In December 2014 and October 2017 snap-elections, the ruling Liberal Democratic Party (LDP) won decisive victories further strengthening Mr. Abe's ability to continue with economic reforms and address key policy challenges. In September 2018, Mr. Abe won reelection to another three-year term as president of the LDP. Most recently, the BoJ signaled to hold its policy rate at zero and to continue yield curve control to maintain a targeted yield on the 10-year JGB. Prime Minister Abe’s election victories may result in the continuation of current monetary policy, but there can be no guarantee that this is the case. +Japan is the largest market for the Company's products, and the Company owns substantial holdings in JGBs. Government actions to stimulate the economy affect the value of the Company's existing holdings, its reinvestment rate on new investments in JGBs or other yen-denominated assets, and consumer behavior relative to the Company's suite of products. The additional government debt from fiscal stimulus actions could adversely impact the Japan sovereign credit profile, which could in turn lead to volatility in Japanese capital and currency markets. +The Company's investment portfolio has sizeable credit positions in many other geographic areas of the world including the Middle East, Latin America, Asia, and other emerging markets. Deterioration in their underlying economies, sovereign credit worthiness, or financial market conditions could negatively impact the Company's financial position. +While the Company has continued to add floating rate investments to its investment portfolio, most of its investment portfolio holdings are income-producing bonds that provide a fixed level of income. Many of the Company's investments were made at the relatively low level of interest rates prevailing over the last decade. Any increase in the market yields of the Company's holdings due to an increase in interest rates could create substantial unrealized losses in the Company's portfolio, as discussed further in a separate risk factor in this section of the Form 10-K. +The Company needs liquidity to pay its operating expenses, dividends on its common stock, interest on its debt, and liabilities. For a further description of the Company's liquidity needs, including maturing indebtedness, see the Liquidity and Capital Resources section of MD&A in this report. In the event the Company's current resources do not meet its needs, the Company may need to seek additional financing. The Company's access to additional funding will depend on a variety of factors such as market conditions, the general availability of credit to the financial services industry and its credit rating. +Should investors become concerned with any of the Company's investment holdings, including the concentration in JGBs, its access to market sources of funding could be negatively impacted. There is a possibility that lenders or debt investors may also become concerned if the Company incurs large investment losses or if the level of the Company's business activity decreases due to a market downturn or there are further adverse economic trends in the U.S. or Japan, specifically, or generally in developed markets. Similarly, the Company's access to funds may be impaired if regulatory authorities or rating agencies take negative actions. See more information on recent rating actions later in this Risk Factors section. +Broad economic factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, indirectly, the amount and profitability of the Company's business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for financial and insurance products could be adversely affected. This adverse effect could be particularly significant for companies such as Aflac that distribute supplemental, discretionary insurance products primarily through the worksite in the event that economic conditions result in a decrease in the number of new hires and total employees. Adverse changes in the economy could potentially lead the Company's customers to be less inclined to purchase supplemental insurance coverage or to decide to cancel or modify existing insurance coverage, which could adversely affect the Company's premium revenue, results of operations and financial condition. The Company is unable to predict the course of the global financial markets or the recurrence, duration or severity of disruptions in such markets. +Events, including those external to the Company's operations, could damage the Company's reputation. +The Company has made significant investments in the Aflac brand over a long period of time. Because insurance products are intangible, the Company's ability to compete for and maintain policyholders relies to a large extent on consumer trust in the Company's business, including its alliance partners, sales associates and other distribution partners. The perception of unfavorable business practices or financial weakness with respect to the Company, its alliance partners, sales associates or other distribution partners could create doubt regarding the Company's ability to honor the commitments it has made to its policyholders. Such a perception could also negatively impact the Company’s ability to attract and retain qualified sales associates, brokers and other distribution partners, including its alliance partners in Japan, and could have a material adverse effect on the Company's sales, results of operations and financial condition. Maintaining the Company's stature as a trustworthy +19 +Item 1A. Risk Factors +insurer and responsible corporate citizen, which helps support the strength of the Company's brand, is critical to the Company's reputation and the failure or perceived failure to do so could adversely affect the Company's brand value, financial condition and results of operations. For example, negative publicity or allegations of unfavorable business practices or poor governance can be rapidly and widely shared over social or traditional media or other means, and could reduce demand for the Company's insurance products, reduce the Company's ability to recruit and retain employees, or lead to greater regulatory scrutiny of the Company's operations. +Extensive regulation and changes in legislation can impact profitability and growth. +Aflac's insurance subsidiaries are subject to complex laws and regulations that are administered and enforced by a number of governmental authorities, including the FSA and Ministry of Finance (MOF) in Japan, and state insurance regulators, the SEC, the NAIC, the FIO, the U.S. Department of Justice, state attorneys general, the U.S. Commodity Futures Trading Commission, and the U.S. Treasury, including the Internal Revenue Service (IRS), in the U.S., each of which exercises a degree of interpretive latitude. In addition, proposals regarding the global regulation of insurance are under discussion, and changes to corporate form that attend the conversion of Aflac Japan to a subsidiary may introduce new forms of regulation compared to those with which the Company has historically been subject. For example, AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. Consequently, the Company is subject to the risk that compliance with any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may not result in compliance with another regulator's or enforcement authority's interpretation of the same issue, particularly when compliance is judged in hindsight. There is also a risk that any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may change over time to the Company's detriment. In addition, changes in the overall legal or regulatory environment may, even absent any particular regulator's or enforcement authority's interpretation of an issue changing, cause us to change the Company's views regarding the actions the Company needs to take from a legal or regulatory risk management perspective, thus necessitating changes to the Company's practices that may, in some cases, limit its ability to grow or otherwise negatively impact the profitability of the Company's business. +The primary purpose of insurance company regulatory supervision is the protection of insurance policyholders, rather than investors. The extent of regulation varies, but generally is governed by state statutes in the U.S. and by the FSA and the MOF in Japan. These systems of supervision and regulation cover, among other things: +• +standards of establishing and setting premium rates and the approval thereof +• +standards of minimum capital and reserve requirements and solvency margins, including RBC measures +• +restrictions on, limitations on and required approval of certain transactions between the Company's insurance subsidiaries and their affiliates, including management fee arrangements +• +restrictions on the nature, quality and concentration of investments +• +restrictions on the types of terms and conditions that the Company can include in the insurance policies offered by its primary insurance operations +• +limitations on the amount of dividends that insurance subsidiaries can pay +• +the existence and licensing status of a company under circumstances where it is not writing new or renewal business +• +certain required methods of accounting +• +reserves for unearned premiums, losses and other purposes +• +assignment of residual market business and potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies +• +administrative practices requirements +• +imposition of fines and other sanctions +Regulatory authorities periodically re-examine existing laws and regulations applicable to insurance companies and their products. Changes in these laws and regulations, or in interpretations thereof, could have a material adverse effect on the Company's financial condition and results of operations. If the Company's subsidiaries fail to meet the minimum capital or operational requirements established by its respective regulators, they could be subject to examination or corrective action, or the Company's financial strength ratings could be downgraded, or both. +Compliance with applicable laws and regulations is time consuming and personnel-intensive, and changes in these laws and regulations may materially increase the Company's direct and indirect compliance and other expenses of doing business, thus having a material adverse effect on the Company's financial condition and results of operations. +20 +Item 1A. Risk Factors +The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate. +Due to the size of Aflac Japan, where functional currency is the Japanese yen, fluctuations in the rate of exchange between the yen and the U.S. dollar can have a significant effect on the Company's reported financial position and results of operations. Aflac Japan's premiums and approximately half of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into U.S. dollars for financial reporting purposes. Accordingly, fluctuations in the yen/dollar exchange rate can have a significant effect on the Company's reported financial position and results of operations. In periods when yen weakens, translating yen into U.S. dollars causes fewer U.S. dollars to be reported. When yen strengthens, translating yen into U.S. dollars causes more U.S. dollars to be reported. Any unrealized foreign currency translation adjustments are reported in accumulated other comprehensive income. As a result, yen weakening has the effect of suppressing current year results in relation to the prior year, while yen strengthening has the effect of magnifying current year results in relation to the prior year. In addition, the weakening of the yen relative to the U.S. dollar will generally adversely affect the value of the Company's yen-denominated investments in U.S. dollar terms. +The Company engages in certain foreign currency hedging activities for the purpose of hedging the yen exposure to its net investment in operations in Japan. These hedging activities are limited in scope, and the Company cannot provide assurance that these activities will be effective. +Unhedged U.S. dollar-denominated securities held by Aflac Japan are exposed to foreign exchange fluctuations, which impact SMR. In periods of yen strengthening, the unhedged U.S. dollar-denominated investments will experience unrealized foreign exchange losses, negatively impacting SMR. This impact increases when the size of the unhedged U.S. dollar-denominated portfolio increases, which can occur due to the purchase of additional unhedged U.S. dollar-denominated investments, or through termination or expiration of existing hedges. Unrealized currency gains and losses on unhedged U.S. dollar-denominated securities are monetized (or, in other words, are economically realized) only upon converting the proceeds from the sale, maturity or redemption of these securities to yen, which primarily occurs when yen are needed to satisfy policyholder obligations or other business expenses of Aflac Japan. To mitigate exposure to the foreign exchange risk from U.S. dollar-denominated investments and to reduce SMR volatility, the Company engages in certain currency hedging activities. However, these hedging activities are limited in scope and the Company cannot provide assurance that its hedging strategies will be effective. As a result, periods of unusually volatile currency exchange rates could result in limitations on dividends available to the Parent Company. +As indicated in the MD&A, the Company has determined that the unhedged U.S. dollar-denominated investment portfolio acts as a natural economic currency hedge of a portion of the Company’s investment in Aflac Japan against erosion of economic value. However, the unhedged U.S. dollar-denominated investment portfolio at the same time creates an unmatched foreign currency exposure and subjects Aflac Japan to volatility in regulatory capital and earnings, which may adversely impact Aflac Japan’s ability to pay dividends to the Parent Company. The overall investment strategy in Aflac Japan is guided primarily by the objective of securing the long-term financial strength of Aflac Japan and funding of yen liabilities. As a result, the Company has historically maintained and currently maintains the size of the unhedged portfolio at levels below the economic equity surplus in Aflac Japan. However, there can be no assurance that this strategy will be successful. +Furthermore, for regulatory accounting purposes, there are certain requirements for realizing impairments that could be triggered by changes in the rate of exchange between the yen and U.S. dollar and could negatively impact Aflac Japan's earnings and the corresponding dividends and capital deployment. +Additionally, the Company is exposed to currency risk when yen cash flows are converted into U.S. dollars, resulting in an increase or decrease in the Company's U.S. dollar-denominated cash flows and earnings when exchange gains or losses, respectively, are realized. This primarily occurs when the Company dividends funds from Aflac Japan to the Parent Company, but it also has an impact when cash in the form of yen is converted to U.S. dollars for investment into U.S. dollar-denominated assets. The exchange rates prevailing at the time of dividend payment may differ from the exchange rates prevailing at the time the yen profits were earned. In 2018, the Parent Company began entering into forward contracts to accomplish a dual objective of hedging foreign currency exchange rate risk related to dividend payments by Aflac Japan, and reducing enterprise-wide hedge costs. If the markets experience a significant strengthening of yen, this could cause cash strain at the Parent Company as a result of cash collateral and potentially cash settlement requirements. Based on the timing and severity of exchange rate fluctuations combined with the level of outstanding activity in this program, the cash strain at the Parent Company could be significant. +For more information regarding unhedged U.S. dollar-denominated securities, see the risk factor below entitled, “Lack of availability of acceptable yen-denominated investments could adversely affect the Company’s results of operations, financial +21 +Item 1A. Risk Factors +position or liquidity”. For more information regarding foreign currency risk, see the Currency Risk subsection within the Market Risks of Financial Instruments section of MD&A. +Tax rates applicable to the Company may change. +The Company is subject to taxation in Japan, and in the U.S. under federal and numerous state and local tax jurisdictions. In preparing the Company's financial statements, the Company estimates the amount of tax that will become payable, but the Company's effective tax rate may be different than estimates due to numerous factors including accounting for income taxes, the mix of earnings from Japan and the U.S., the results of tax audits, adjustments to the value of uncertain tax positions, changes to estimates and other factors. Further, changes in U.S. or Japan tax laws or interpretations of such laws could increase the Company's corporate taxes and reduce earnings. +In addition, it remains difficult to predict the timing and effect that future tax law changes could have on the Company's earnings both in the U.S. and in foreign jurisdictions. Any of these factors could cause the Company to experience an effective tax rate significantly different from previous periods or the Company's current estimates. If the Company's effective tax rate were to increase, the Company's financial condition and results of operations could be adversely affected. +A decline in the creditworthiness of other financial institutions could adversely affect the Company. +The Company has exposure to and routinely executes transactions with counterparties in the financial services industry, including broker dealers, derivative counterparties, commercial banks and other institutions. +The Company uses derivative instruments to mitigate various risks associated with its investment portfolio, notes payable, and subsidiary dividends. The Company enters into a variety of agreements involving assorted instruments including foreign currency forward contracts; foreign currency options; foreign currency swaps; and interest rate swaps and swaptions. The Company ' s use of derivatives results in financial exposure to derivative counterparties. If the Company's counterparties fail or refuse to honor their obligations under derivative instruments, the Company's hedges of the risks will be ineffective, and the Company's financial condition and results of operations could be adversely affected. +The Company engages in derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements also include Credit Support Annexes (CSAs) provisions, which generally provide for two-way collateral postings at the first dollar of exposure. The Company mitigates the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value while generally requiring that collateral be posted at the outset of the transaction. In addition, a significant portion of the derivative transactions have provisions that give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength rating. The actual amount of payments that the Company could be required to make, depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of the downgrade. If the Company is required to post collateral to support derivative contracts and/or pay cash to settle the contracts at maturity, the Company's liquidity could be strained. In addition, the Company's cleared swaps result in counterparty exposure to clearing brokers and central clearinghouses; while this exposure is mitigated in part by clearinghouse and clearing broker capital and regulation, no assurance can be provided that these counterparties will fulfill their obligations. The Company also has exposure to counterparties to securities lending transactions in the event they fail to return loaned securities. The Company is also exposed to the risk that there may be a decline in value of securities posted as collateral for securities lending programs or a decline in value of investments made with cash posted as collateral for such programs. +Further, the Company has agreements with various financial institutions for the distribution of its insurance products. For example, at December 31, 2019 , the Company had agreements with 367 banks to market Aflac's products in Japan. Sales through these banks represented 4.3% of Aflac Japan's new annualized premium sales in 2019 . Any material adverse effect on these or other financial institutions could also have an adverse effect on the Company's sales. +The Company has entered into significant reinsurance transactions with large, highly rated counterparties. Negative events or developments affecting any one of these counterparties could have an adverse effect on the Company's financial position or results of operations. +All of these risks related to exposure to other financial institutions could adversely impact the Company's consolidated results of operations and financial condition. +22 +Item 1A. Risk Factors +The determination of the amount of impairments taken on the Company's investments is based on significant valuation judgments and could materially impact its results of operations or financial position. +An investment in a fixed maturity security is impaired if the fair value falls below book value. The Company regularly reviews its entire investment portfolio for declines in value. The majority of the Company's investments are evaluated for other-than-temporary impairment using the Company's debt impairment model. +The Company's debt impairment model includes emphasis on the ultimate collection of the cash flows from its investments. The determination of the amount of impairments under this model is based upon the Company's periodic evaluation and assessment of known and inherent risks associated with the respective securities. Such evaluations and assessments are revised as conditions change and new information becomes available. +For the Company's fixed maturity securities reported in the available-for-sale portfolio, the Company reports the investments at fair value in the statement of financial condition and records any unrealized gain or loss in the value of the asset in accumulated other comprehensive income. For the Company's held-to-maturity securities portfolio, the Company reports the investments at amortized cost. Under the debt impairment model, the determination of whether an impairment in value is other than temporary is based largely on the Company's evaluation of the issuer ' s creditworthiness. The Company must apply considerable judgment in determining the likelihood of the security recovering in value while the Company owns it. Factors that may influence this include the Company's assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. The Company also verifies whether it has the intent to sell or if it is more likely than not the Company would be required to sell the security prior to recovery of its amortized cost. If the Company determines it is unlikely to recover the book value of the instrument prior to disposal of the security, the Company will reduce the carrying value of the security to its fair value and recognize any associated impairment loss in the Company's consolidated statement of earnings or other comprehensive income, depending on the nature of the loss. +For regulatory accounting purposes for Aflac Japan, there are certain requirements for realizing impairments that could be triggered by rising interest rates, credit-related losses, or changes in foreign exchange, negatively impacting Aflac Japan's earnings and corresponding dividend and capital deployment. +The Company's management updates its evaluations regularly as conditions change and as new information becomes available and reflects impairment losses in the Company's income statement when considered necessary. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. +U.S. tax audit risk related to conversion of the Japan branch to a subsidiary could adversely impact the Company's financial position. +The conversion of the Japan branch to a legal subsidiary, which the Company executed in the second quarter of 2018, was a complex, tax-free transaction that is conditioned on the continued validity of a private letter ruling the Company received from the IRS. Notwithstanding the receipt of the private letter ruling, the IRS could determine that the Japan branch conversion should be treated as a taxable transaction. For example, the IRS could conclude that the representations, assumptions and covenants on which the private letter ruling is based are untrue, not accurate, or have not been fulfilled. If the IRS made such a conclusion, the Company could incur significant U.S. federal income tax liabilities or litigation costs to defend the tax-free treatment of the transaction outlined by the private letter ruling. Such liabilities or costs could have a material adverse effect on the Company's business, results of operations and financial condition. +As a holding company, the Parent Company depends on the ability of its subsidiaries to transfer funds to it to meet its debt service and other obligations and to pay dividends on its common stock. +The Parent Company is a holding company and has no direct operations, and its most significant assets are the stock of its subsidiaries. Because the Parent Company conducts its operations through its operating subsidiaries, the Parent Company depends on those entities for dividends and other payments to generate the funds necessary to meet its debt service and other obligations, to pay dividends on and conduct repurchases of its common stock, and to make investments into its subsidiaries or external investment opportunities. +Aflac is domiciled in Nebraska and is subject to insurance regulations that impose certain limitations and restrictions on payments of dividends, management fees, loans and advances by Aflac to the Parent Company. The Nebraska insurance statutes require prior approval for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. In addition, the Nebraska insurance department must approve +23 +Item 1A. Risk Factors +service arrangements and other transactions within the affiliated group of companies. After the Japan branch conversion, the Nebraska insurance department and the FSA approved their respective domiciled insurance company service arrangements and transactions. The FSA does not allow dividends or other payments from Aflac Japan unless it meets certain financial criteria as governed by Japanese corporate law. Under these criteria, dividend capacity at the Japan subsidiary will be defined as retained earnings plus other capital reserve less net after-tax net unrealized losses on available-for-sale securities. +The ability of Aflac and Aflac Japan to pay dividends or make other payments to the Parent Company could also be constrained by the Company's dependency on financial strength ratings from independent rating agencies. The Company's ratings from these agencies depend to a large extent on Aflac's capitalization level. Any inability of Aflac to pay dividends or make other payments to the Parent Company could have a material adverse effect on the Company's financial condition and results of operations. +For the foregoing reasons, there is no assurance that the earnings from, or other available assets of, the Parent Company's operating subsidiaries will be sufficient to make distributions to enable the Company to operate. +Any decrease in the Company's financial strength or debt ratings may have an adverse effect on its competitive position and access to liquidity and capital. +Financial strength ratings can play an important role in establishing the competitive position of insurance companies. On an ongoing basis, NRSROs review the financial performance and condition of many insurers, including the Company and its competitors. They may assign multiple ratings including a financial strength rating, reflecting their view of the insurer’s ability to pay claims on a timely basis, and ratings on an insurer’s senior and subordinated debt obligations, indicating their view of an insurer’s ability to make timely payments on their debt obligations. +NRSROs may change their ratings or outlook on an insurer's ratings due to a variety of factors including the NRSRO’s assessment of the insurer’s strength of operations and overall financial condition. Some factors that may influence ratings include competitive position; profitability; cash generation and other sources of liquidity; capital levels; quality of the investment portfolio; and perception of management capabilities. The ratings assigned to the Company by the NRSROs are important factors in the Company's ability to access liquidity and capital from the bank market, debt capital markets or other available sources, such as reinsurance transactions. Downgrades to the Company's credit ratings could give its derivative counterparties the right to require early termination of derivatives transactions or delivery of additional collateral, thereby adversely affecting the Company's liquidity. +In view of the difficulties experienced after the financial crisis by many financial institutions, including those in the insurance industry, the NRSROs have heightened the level of scrutiny that they apply to such institutions. Steps taken by the NRSROs include an increase in the frequency and scope of their reviews, additional information requests from the companies that they rate, including additional information regarding the valuation of investment securities held, and, in certain cases, an increase in the capital and other requirements employed in their models for maintenance of certain rating levels. +On September 16, 2015, S&P downgraded their credit rating of Japan’s sovereign debt. Following this action, they also downgraded several other foreign insurers, including the Company. The Company's significant operations in Japan and corresponding regulation by the Japanese FSA, combined with its significant exposure to JGBs as outlined above, resulted in S&P downgrading the financial strength rating of Aflac's core insurance operations to A+ and the Parent Company's senior debt rating to A-, both with a stable outlook. While S&P made no further downgrades to the Company's ratings between 2016 and 2019, they state that a downgrade of Japan's sovereign rating could lead to a downgrade of the Company's financial strength rating. As a matter of policy, S&P rarely rates insurance companies above the sovereign long-term rating of the country of domicile because during times of stress, the sovereign’s regulatory and supervisory powers may restrict an insurer’s or financial system’s flexibility. Moody’s has also stated that the following factors could lead to a downgrade of the Company’s ratings: a downgrade of the U.S. or Japanese operating entities; or a downgrade of the Government of Japan sovereign debt rating. +In addition to the impact on the Company's access to liquidity, as mentioned above, a downgrade of the Company's ratings could have a material adverse effect on agent recruiting and retention, sales, competitiveness and the marketability of its products which could negatively impact the Company's liquidity, operating results and financial condition. Additionally, sales through the bank channel in Japan could be adversely affected as a result of their reliance and sensitivity to ratings levels. +24 +Item 1A. Risk Factors +The Company cannot predict what actions rating agencies may take, or what actions the Company may take in response to the actions of rating agencies, which could adversely affect the Company's business. As with other companies in the financial services industry, the Company's ratings could be downgraded at any time and without any notice by any NRSRO . +The Company's risk management policies and procedures may prove to be ineffective and leave the Company exposed to unidentified or unanticipated risk, which could adversely affect the Company's businesses or result in losses. +The Company has developed an enterprise-wide risk management and governance framework to mitigate risk and loss to the Company. The Company maintains policies, procedures and controls intended to identify, measure, monitor, report and analyze the risks to which the Company is exposed. +However, there are inherent limitations to risk management strategies because risk may exist, or emerge in the future, that the Company has not appropriately anticipated or identified. If the Company's risk management framework proves ineffective, the Company may suffer unexpected losses and could be materially adversely affected. As the Company's businesses change and the markets in which it operates evolve, the Company's risk management framework may not evolve at the same pace as those changes. As a result, there is a risk that new products or new business strategies may present risks that are not appropriately identified, monitored or managed. In times of market stress, unanticipated market movements or unanticipated claims experience resulting from greater than expected morbidity, mortality, longevity, or persistency, the effectiveness of the Company's risk management strategies may be limited, resulting in losses to the Company. In addition, under difficult or less liquid market conditions, the Company's risk management strategies may not be effective because other market participants may be using the same or similar strategies to manage risk under the same challenging market conditions. In such circumstances, it may be difficult or more expensive for the Company to mitigate risk due to the activity of such other market participants. +Many of the Company's risk management strategies or techniques are based upon historical customer and market behavior and all such strategies and techniques are based to some degree on management’s subjective judgment. The Company cannot provide assurance that its risk management framework, including the underlying assumptions or strategies, will be accurate and effective. +Management of operational, legal and regulatory risks requires, among other things, policies, procedures and controls to record properly and verify a large number of transactions and events, and these policies, procedures and controls may not be fully effective. Models are utilized by the Company's businesses and corporate areas primarily to project future cash flows associated with pricing products, calculating reserves and valuing assets, as well as in evaluating risk and determining capital requirements, among other uses. These models are utilized under a risk management policy approved by the Company's executive risk management committees, however, the models may not operate properly and rely on assumptions and projections that are inherently uncertain. As the Company's businesses continue to grow and evolve, the number and complexity of models the Company utilizes expands, increasing the Company's exposure to error in the design, implementation or use of models, including the associated input data and assumptions. +Past or future misconduct by the Company's employees or employees of the Company's third parties (suppliers which are cost-based relationships and alliance partners which are revenue-generating relationships) could result in violations of law by the Company, regulatory sanctions and/or serious reputational or financial harm and the precautions the Company takes to prevent and detect this activity may not be effective in all cases. Despite the Company's published Supplier Code of Conduct, due diligence of the Company's alliance partners, and rigorous contracting procedures (including financial, legal, IT security, and risk reviews), there can be no assurance that controls and procedures that the Company employs, which are designed to assess third party viability and prevent the Company from taking excessive or inappropriate risks, will be effective. Additionally, the use of third parties also poses operational risks that could result in financial loss, operational disruption, brand damage, or compliance issues. Inadequate oversight of Aflac’s third party suppliers due to the lack of policies, procedures, training and governance may lead to financial loss or damage to the Aflac brand. +The concentration of the Company's investment portfolios in any particular single-issuer or sector of the economy may have an adverse effect on the Company's financial position or results of operations. +Negative events or developments affecting any particular single issuer, industry, group of related industries, asset class or geographic sector may have an adverse impact on a particular holding or set of holdings, which may increase risk of loss from defaults due to non-payment of interest or principal. The Company seeks to minimize this risk by maintaining an appropriate level of diversification. To the extent the Company has concentrated positions, it could have an adverse effect on the Company's results of operations and financial position. The Company's global investment guidelines establish +25 +Item 1A. Risk Factors +concentration limits for its investment portfolios. +For details on the concentrations within the Company's investment portfolios, see the Investments section of Item 7, MD&A, and the Credit Risk section of Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Form 10-K. +The valuation of the Company's investments and derivatives includes methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to investment valuations that may adversely affect the Company's results of operations or financial condition. +The Company reports a significant amount of its fixed maturity securities and other financial instruments at fair value. As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated, thereby resulting in values which may be greater or less than the value at which the investments may be ultimately sold. Rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within the Company's consolidated financial statements and the period-to-period changes in value could vary significantly. +Valuations of the Company's derivatives fluctuate with changes in underlying market variables, such as interest rates and foreign currency exchange rates. During periods of market turbulence created by political instability, economic uncertainty, government interventions or other factors, the Company may experience significant changes in the volatility of its derivative valuations. Extreme market conditions can also affect the liquidity of such instruments creating marked differences in transaction levels and counterparty valuations. Depending on the severity and direction of the movements in its derivative valuations, the Company will face increases in the amount of collateral required to be posted with its counterparties. Liquidity stresses to the Company may also occur if the required collateral amounts increase significantly over a very short period of time. Conversely, the Company may be exposed to an increase in counterparty credit risk for short periods of time while calling collateral from its counterparties. +Elimination of LIBOR as an interest rate benchmark may create uncertainty in valuation of loans, derivatives and other assets where valuation and interest rates are based on LIBOR, and may create uncertainty in the pricing of such assets in markets for their sale and disposition. +For further discussion on investment and derivative valuations, see the Critical Accounting Estimates section in Item 7, Management's Discussion and Analysis, and Notes 1, 3, 4, and 5 of the Notes to the Consolidated Financial Statements in this Form 10-K. +The Company depends heavily on key management personnel, and the loss of services of one or more of its key executives could harm the Company's business. +The Company’s success depends to a significant extent upon the efforts and abilities of its key management personnel. The loss of the services of one or more of the Company's senior executives could significantly undermine its management expertise and the Company's business could be adversely affected. +Changes in accounting standards issued by the Financial Accounting Standard Boards (FASB) or other standard-setting bodies may adversely affect the Company's financial statements. +The Company's financial statements are subject to the application of U.S. GAAP, which is periodically revised and/or expanded. Accordingly, from time to time the Company is required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the FASB. The impact of accounting pronouncements that have been issued but not yet implemented and are applicable to the Company is disclosed in Note 1 of the Notes to the Consolidated Financial Statements. The pronouncements expected to have the most significant impact on the Company's financial position or results of operations are outlined below. +In June 2016, the FASB issued Accounting Standard Update (ASU) 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments . The amendments in this update require a financial asset (or a group of financial assets) measured on an amortized cost basis to be presented net of an allowance for current expected credit losses in order to reflect the amount expected to be collected on the financial asset(s). The Company currently estimates the after-tax net impact from the adoption of ASU 2016-13 at a $56 million decrease to retained earnings, which primarily relates to loans and loan receivables. The amendments are effective for fiscal years beginning after December 15, 2019. +26 +Item 1A. Risk Factors +Additionally, in August 2018 the FASB issued ASU 2018-12, Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts . The amendments in this update will significantly change how insurers account for long-duration contracts. Among the issues addressed in the amendments is the requirement to review and, if there is a change, update cash flow assumptions for the liability for future policy benefits at least annually, and to update the discount rate assumption quarterly. The Company anticipates that the requirement to review and update assumptions for liability for future policy benefits will have a significant impact on its results of operations, systems, processes, and controls, while the requirement to update the discount rate will have a significant impact on the other comprehensive income component of its equity. The amendments are effective for fiscal years beginning after December 15, 2021. See Critical Accounting Estimates section of Item 7. MD&A in this report. +Changes to accounting standards could have a material adverse effect on the Company's results of operations and financial condition. For information on new accounting pronouncements and the impact, if any, on the Company's financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements in this report. +The Company faces risks related to litigation, regulatory investigations and inquiry and other matters. +The Company is a defendant in various lawsuits considered to be in the normal course of business. The final results of any litigation cannot be predicted with certainty, and plaintiffs may seek very large amounts in class actions or other litigation. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. However, a substantial legal liability or a significant federal, state or other regulatory action against the Company, as well as regulatory inquiries or investigations, could harm the Company's reputation, result in changes in operations, result in material fines or penalties, result in significant costs due to legal fees, settlements or judgments against the Company, or otherwise have a material adverse effect on the Company's business, financial condition and results of operations. Without limiting the foregoing, the litigation and regulatory matters the Company is, has been, or may become, subject to include matters related to sales agent recruiting, policy sales practices, claim payments and procedures including denial or delay of benefits, material misstatements or omissions in the Company's financial reports or other public statements, and/or corporate governance, corporate culture or business ethics matters. Further, the Company may be subject to claims of or litigation regarding sexual or other forms of misconduct or harassment, or discrimination on the basis of race, color, national origin, religion, gender, or other bases, notwithstanding that the Company's Code of Business Conduct and Ethics prohibits such harassment and discrimination by its employees, the Company has ongoing training programs and provide opportunities to report claims of noncompliant conduct, and it investigates and may take disciplinary action regarding alleged harassment or discrimination. Any violations of or deviation from laws, regulations, internal or external codes or standards of normative behavior, or perceptions of such violations or deviations, by the Company's employees or by independent sales agents could adversely impact the Company's reputation and brand value, financial condition and results of operations. +Allegations or determinations of agent misclassification could adversely affect the Company’s results of operations, financial condition and liquidity. +A majority of the Company's U.S. sales force is, and has historically been, comprised of independent agents. While the Company believes that it has properly classified such agents as independent contractors, the Company may be subject to claims, regulatory action by state or federal departments of labor or tax authorities or litigation asserting that such agents are employees. The laws and regulations governing the classification of workers in the U.S. may be changed or interpreted differently compared to past interpretations, including in states where the Company generates significant sales through independent agents. An allegation or determination that independent agents in the Company’s U.S. sales force have been misclassified as independent contractors could result in changes in the Company’s operations and U.S. business model, result in material fines or penalties, result in significant costs due to legal fees, settlements or judgments against the Company, or otherwise have a material adverse effect on the Company's business, results of operation, financial condition and liquidity. +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not applicable. +27 +Item 2. Properties +ITEM 2. PROPERTIES +In the U.S., Aflac owns land and buildings that comprise two primary campuses located in Columbus, Georgia. These campuses include buildings that serve as the Company's worldwide headquarters and house administrative support and information technology functions for U.S. operations. Aflac leases office space in Columbia, South Carolina, which houses the Company's CAIC subsidiary (branded as Aflac Group Insurance). Aflac also leases office space in New York that houses the Company's Global Investment division. Aflac also leases administrative office space throughout the U.S., Puerto Rico and the United Kingdom. +In Tokyo, Japan, Aflac has three primary campuses. The first campus includes a building, owned by Aflac, for the customer call center, the claims department, information technology departments, and training facility. It also includes a leased property, which houses Aflac Japan's policy administration and customer service departments. The second campus comprises leased space, which serves as Aflac Japan's headquarters and houses administrative and investment support functions. The third campus comprises leased space for the information technology departments. Aflac also leases additional office space in Tokyo, along with regional offices located throughout the country. +ITEM 3. LEGAL PROCEEDINGS +The Company is a defendant in various lawsuits considered to be in the normal course of business. Members of the Company's senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +28 +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER +PURCHASES OF EQUITY SECURITIES +Market Information +Aflac Incorporated's common stock is principally traded on the New York Stock Exchange under the symbol AFL. Until the beginning of October 2019, Aflac Incorporated's stock was also listed on the Tokyo Stock Exchange under designator 8686. +Holders +As of February 12, 2020 , there were 86,223 holders of record of the Company's common stock. +29 +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Stock Performance Graph +The following graph compares the five-year performance of the Company's common stock to the Standard & Poor's 500 Index (S&P 500) and the Standard & Poor's Life and Health Insurance Index (S&P Life and Health). The Standard & Poor's Life and Health Insurance Index includes: Aflac Incorporated, Globe Life Inc., Lincoln National Corporation, MetLife Inc., Principal Financial Group Inc., Prudential Financial Inc. and Unum Group. +Performance Graphic Index +December 31, +2014 +2015 +2016 +2017 +2018 +2019 +Aflac Incorporated +100.00 +100.52 +119.73 +154.45 +164.04 +194.48 +S&P 500 +100.00 +101.38 +113.51 +138.29 +132.23 +173.86 +S&P Life & Health Insurance +100.00 +93.69 +116.98 +136.20 +107.91 +132.92 +Copyright © 2020 Standard & Poor’s, a division of S&P Global. All rights reserved. +30 +Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +Issuer Purchases of Equity Securities +During the year ended December 31, 2019 , the Company repurchased shares of Aflac common stock as follows: +Period +Total +Number of +Shares +Purchased +Average +Price Paid +Per Share +Total +Number +of Shares +Purchased +as Part of +Publicly +Announced +Plans or +Programs +Maximum +Number of +Shares that +May Yet Be +Purchased +Under the +Plans or +Programs +January 1 - January 31 +4,465,400 +$ +46.44 +4,465,400 +64,582,487 +February 1 - February 28 +4,170,417 +48.65 +3,624,583 +60,957,904 +March 1 - March 31 +2,162,830 +49.50 +2,147,500 +58,810,404 +April 1 - April 30 +2,177,000 +49.21 +2,177,000 +56,633,404 +May 1 - May 31 +2,813,277 +50.99 +2,812,850 +53,820,554 +June 1 - June 30 +1,964,259 +54.44 +1,952,000 +51,868,554 +July 1 - July 31 +1,360,017 +54.33 +1,360,017 +50,508,537 +August 1 - August 31 +2,491,225 +51.22 +2,483,400 +48,025,137 +September 1 - September 30 +2,111,075 +51.81 +2,103,600 +45,921,537 +October 1 - October 31 +2,476,152 +52.43 +2,476,100 +43,445,437 +November 1 - November 30 +1,938,000 +54.03 +1,938,000 +41,507,437 +December 1 - December 31 +4,456,463 +52.92 +4,453,824 +37,053,613 +Total +32,586,115 +(1) +$ +50.82 +31,994,274 +37,053,613 +(1) During the year ended December 31, 2019 , 591,841 shares were purchased in connection with income tax withholding obligations related to the vesting of restricted-share-based awards during the period. +As of December 31, 2019 , a remaining balance of 37.1 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its Board of Directors. +31 +Item 6. Selected Financial Data +ITEM 6. SELECTED FINANCIAL DATA +Aflac Incorporated and Subsidiaries +Years Ended December 31, +(In millions, except for share and per-share amounts) +2019 +2018 +2017 +2016 +2015 +Revenues: +Net premiums, principally supplemental +health insurance +$ +18,780 +$ +18,677 +$ +18,531 +$ +19,225 +$ +17,570 +Net investment income +3,578 +3,442 +3,220 +3,278 +3,135 +Realized investment gains (losses) +(135 +) +(430 +) +(151 +) +(14 +) +106 +Other income +84 +69 +67 +70 +61 +Total revenues +22,307 +21,758 +21,667 +22,559 +20,872 +Benefits and expenses: +Benefits and claims, net +11,942 +12,000 +12,181 +12,919 +11,746 +Expenses +5,920 +5,775 +5,468 +5,573 +5,264 +Total benefits and expenses +17,862 +17,775 +17,649 +18,492 +17,010 +Pretax earnings +4,445 +3,983 +4,018 +4,067 +3,862 +Income taxes +1,141 +1,063 +(586 +) +1,408 +1,329 +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +$ +2,659 +$ +2,533 +Share and Per-Share Amounts +Net earnings (basic) +$ +4.45 +$ +3.79 +$ +5.81 +$ +3.23 +$ +2.94 +Net earnings (diluted) +4.43 +3.77 +5.77 +3.21 +2.92 +Cash dividends paid +1.08 +1.04 +.87 +.83 +.79 +Cash dividends declared +1.08 +1.04 +.87 +.83 +.79 +Weighted-average common shares used for basic +EPS (In thousands) +742,414 +769,588 +792,042 +822,942 +861,307 +Weighted-average common shares used for diluted +EPS (In thousands) +746,430 +774,650 +797,861 +827,841 +866,344 +Supplemental Data +Yen/dollar exchange rate at year-end (yen) +109.56 +111.00 +113.00 +116.49 +120.61 +Weighted-average yen/dollar exchange rate (yen) +109.07 +110.39 +112.16 +108.70 +120.99 +32 +Item 6. Selected Financial Data +Aflac Incorporated and Subsidiaries +December 31, +(In millions) +2019 +2018 +2017 +2016 +2015 +Assets: +Investments and cash +$ +138,091 +$ +126,243 +$ +123,659 +$ +116,361 +$ +105,897 +Other +14,677 +14,163 +13,558 +13,458 +12,359 +Total assets +$ +152,768 +$ +140,406 +$ +137,217 +$ +129,819 +$ +118,256 +Liabilities and shareholders’ equity: +Policy liabilities +$ +106,554 +$ +103,188 +$ +99,147 +$ +93,726 +$ +87,631 +Income taxes +5,370 +4,020 +4,745 +5,387 +4,340 +Notes payable and lease obligations (1) +6,569 +5,778 +5,289 +5,360 +4,971 +Other liabilities +5,316 +3,958 +3,438 +4,864 +3,606 +Shareholders’ equity +28,959 +23,462 +24,598 +20,482 +17,708 +Total liabilities and shareholders’ equity +$ +152,768 +$ +140,406 +$ +137,217 +$ +129,819 +$ +118,256 +(1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2019 related to leases. +Prior-year amounts have been adjusted for the adoption of accounting guidance on January 1, 2016 related to debt issuance costs. +33 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF +OPERATIONS +Certain statements included in this section constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are made based on management’s current expectations and beliefs concerning future developments and their potential effects upon the Company. The Company’s actual results may differ, possibly materially, from expectations or estimates reflected in such forward-looking statements. Certain important factors that could cause actual results to differ, possibly materially, from expectations or estimates reflected in such forward-looking statements can be found in the “Risk Factors” and “Forward-Looking Statements” sections herein. +MD&A OVERVIEW +The following financial review provides a discussion of the Company’s results of operations and financial condition, as well as a summary of the Company’s critical accounting estimates. This section should be read in conjunction with Part I - Item 1. Business and the audited consolidated financial statements and accompanying notes included in Part II - Item 8. Financial Statements and Supplementary Data of this report. This MD&A is divided into the following sections: +Page +Executive Summary +35 +Industry Trends +35 +Outlook +36 +Results of Operations +37 +Investments +49 +Policy Liabilities +57 +Benefit Plans +57 +Policyholder Protection +57 +Off Balance Sheet Arrangements +57 +Liquidity and Capital Resources +58 +Critical Accounting Estimates +64 +The Company elected to omit discussion on the earliest of the three years covered by the consolidated financial statements presented in Item 8. Financial Statements and Supplementary Data. Readers should refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations located in the Company's Annual Report on Form 10-K for the year ended December 31, 2018 , filed on February 25, 2019, for reference to discussion of the year ended December 31, 2017, the earliest of the three years presented. Amounts reported in this MD&A may not add due to rounding. +34 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +EXECUTIVE SUMMARY +For the full year of 2019 , total revenues were up 2.5% to $22.3 billion , compared with $21.8 billion for the full year of 2018 . Net earnings were $3.3 billion , or $4.43 per diluted share, compared with $2.9 billion , or $3.77 per diluted share, for the full year of 2018 . +Results for 2019 included pretax net realized investment losses of $135 million , compared with net realized investment losses of $430 million in 2018 . Net investment losses in 2019 included $31 million of other-than-temporary impairment losses and changes in loan loss reserves; $236 million in net losses from certain derivatives and foreign currency gains or losses; $101 million of net gains on equity securities; and $31 million of net gains from sales and redemptions. +The average yen/dollar exchange rate (1) in 2019 was 109.07 , or 1.2% stronger than the rate of 110.39 in 2018 . +Adjusted earnings (2) for the full year of 2019 were $3.3 billion , or $4.44 per diluted share, compared with $3.2 billion , or $4.16 per diluted share, in 2018 . The stronger yen/dollar exchange rate impacted adjusted earnings per diluted share by $.02 . +Total investments and cash at the end of December 2019 were $138.1 billion , compared with $126.2 billion at December 31, 2018 . In 2019 , Aflac Incorporated repurchased $1.6 billion , or 32.0 million of its common shares. At the end of December , the Company had 37.1 million remaining shares authorized for repurchase. +Shareholders’ equity was $29.0 billion , or $39.84 per share, at December 31, 2019 , compared with $23.5 billion , or $31.06 per share, at December 31, 2018 . Shareholders’ equity at December 31, 2019 included a net unrealized gain on investment securities and derivatives of $8.5 billion , compared with a net unrealized gain of $4.2 billion at December 31, 2018 . Shareholders’ equity at December 31, 2019 also included an unrealized foreign currency translation loss of $1.6 billion , compared with an unrealized foreign currency translation loss of $1.8 billion at December 31, 2018 . The annualized return on average shareholders’ equity in 2019 was 12.6% . +Shareholders’ equity excluding accumulated other comprehensive income (AOCI) (2) (adjusted book value) was $22.3 billion , or $30.74 per share at December 31, 2019 , compared with $21.3 billion , or $28.22 per share, at December 31, 2018 . The annualized adjusted return on equity excluding foreign currency impact (2) in 2019 was 15.1% . +INDUSTRY TRENDS +The Company is impacted by financial markets, economic conditions, regulatory oversight and a variety of trends that affect the industries where it competes. +Financial and Economic Environment +The Company’s business and results of operations are materially affected by conditions in the global capital markets and the economy generally. Stressed conditions, volatility and disruptions in global capital markets, particular markets, or financial asset classes can have an adverse effect on the Company, in part because the Company has a large investment portfolio and its insurance liabilities and derivatives are sensitive to changing market factors. See Item 1A. Risk Factors for the risk factor entitled, "Difficult conditions in global capital markets and the economy could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business." +Demographics +Japan Business - With Japan’s aging population and the rise in healthcare costs, supplemental health care insurance products remain attractive. However, due to the aging population and decline in birthrate, new opportunities for customer demographics are not as readily available. Japan’s existing customers and potential customers seek products that are easily understood, cost-effective and can be accessed through technology-enabled devices. +(1) Yen/U.S. dollar exchange rates are based on the published MUFG Bank, Ltd. telegraphic transfer middle rate (TTM). +(2) See the Results of Operations section of this MD&A for a definition of this non-U.S. GAAP financial measure. +35 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +U.S. Business - Customer demographics continue to evolve and new opportunities present themselves in different customer segments such as the millennial and multicultural markets. Customer expectations and preferences are changing. Trends indicate existing customers and potential customers seek cost-effective solutions that are easily understood and can be accessed through technology-enabled devices. Additionally, income protection and the health needs of retiring baby boomers are continuing to shape the insurance industry. +Regulatory Environment +See Item 1. Business - Aflac U.S. Regulation and Aflac Japan Regulation for a discussion of regulatory developments that may impact the Company and the associated risks. +Competitive Environment +See Item 1. Business - Aflac U.S. Competition and Aflac Japan Competition for a discussion of the competitive environment and the basis on which the Company competes in each of its segments. +2020 OUTLOOK +The Company’s strategy to drive long-term shareholder value is to pursue growth through product development, distribution expansion and digital advancements to improve the customer experience. +The Company's objectives in 2020 are to maintain strong pre-tax margins in its Aflac Japan and Aflac U.S. segments through disciplined product pricing, stable investment returns and leveraging a period of favorable benefit ratios to invest in its platform for future growth and efficiency. The Company believes that its market-leading position, powerful brand recognition and diverse distribution in Japan and the U.S. will provide support toward these objectives. +The Company believes that its efforts will support its prudent strategies for capital deployment in the form of dividends, share repurchases, and opportunistic investments that enhance the Company’s business with a focus on digital distribution and leveraging the Company’s brand, distribution and scale. The Company has stated that the dividend payout ratio from its Aflac Japan segment is likely to be to 100% of FSA earnings from Aflac Japan and 100% of U.S. statutory earnings from Aflac U.S. In its Aflac U.S. segment, the Company plans to maintain a risk-based capital (RBC) ratio in the 500% range for 2020. +Aflac Japan Segment +In Japan, the Company anticipates that the shift in earned premium from first sector savings products to third sector cancer and medical products and first sector protection products, will continue to result in moderately lower benefit ratios in the Aflac Japan segment. The Company also expects this shift in business mix, plus continued investment in IT and digital advancements, to result in moderately higher expense ratios for Aflac Japan. The Company anticipates the Japan segment will face revenue challenges in 2020 due to the run-off and paid-up status of first sector savings and third sector products. The Company expects a decline in the range of .7% in third sector and first sector protection earned premium for 2020. In addition, net investment income is expected to decline modestly as compared to 2019, due in part to the low interest rate environment in Japan and de-risking of the portfolio, partially offset by lower hedge cost as a result of a reduction in the hedge ratio in the fourth quarter of 2019. +Aflac U.S. Segment +The Company expects the profit margins for the Aflac U.S. segment to remain strong, providing a prudent opportunity to reinvest profits back into the U.S. business. The Company anticipates that in 2020, benefit ratios in the U.S. will remain stable and that expense ratios will continue to be elevated in light of investments into U.S. platforms in both the individual and group channels. The Company expects Aflac U.S. to generate earned premium growth in the range of 1% in 2020. Net investment income is expected to decline modestly, primarily as the result of the Company’s implemented U.S. capital and RBC draw-down plan. +Corporate and Other Segment +The Company expects corporate segment results to benefit from net investment income driven by increased capital and liquidity held at the Parent Company, as well as the increase in size of the Company’s enterprise currency hedging strategy. The anticipated increase in investment income is expected to be partially offset by increased costs associated with continued investment in Aflac Corporate Ventures initiatives. +36 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +For important disclosures applicable to statements made in this 2020 Outlook, please see the Risk Factors section and the statement on Forward-Looking Information at the beginning of Item 1. Business, the Risk Factors identified in Item 1A. and Item 7. Management Discussion and Analysis. +RESULTS OF OPERATIONS +The Company earns its revenues principally from insurance premiums and investments. The Company’s operating expenses primarily consist of insurance benefits provided and reserves established for anticipated future insurance benefits, general business expenses, commissions and other costs of selling and servicing its products. Profitability for the Company depends principally on its ability to price its insurance products at a level that enables the Company to earn a margin over the costs associated with providing benefits and administering those products. Profitability also depends on, among other items, actuarial and policyholder behavior experience on insurance products, and the Company's ability to attract and retain customer assets, generate and maintain favorable investment results, effectively deploy capital and utilize tax capacity, and manage expenses. +Yen–denominated income statement accounts are translated to U.S. dollars using a weighted average Japanese yen/U.S. dollar foreign exchange rate, except realized gains and losses on security transactions which are translated at the exchange rate on the trade date of each transaction. Yen–denominated balance sheet accounts are translated to U.S. dollars using a spot Japanese yen/U.S. dollar foreign exchange rate. +The following discussion includes references to the Company's performance measures, adjusted earnings, adjusted earnings per diluted share, and amortized hedge costs/income, which are not calculated in accordance with U.S. GAAP (non-U.S. GAAP). These measures exclude items that the Company believes may obscure the underlying fundamentals and trends in the Company's insurance operations because they tend to be driven by general economic conditions and events or related to infrequent activities not directly associated with its insurance operations. The Company's management uses adjusted earnings and adjusted earnings per diluted share to evaluate the financial performance of its insurance operations on a consolidated basis, and the Company believes that a presentation of these measures is vitally important to an understanding of its underlying profitability drivers and trends of its insurance business. The Company believes that amortized hedge costs/income, which are a component of adjusted earnings, measure the periodic currency risk management costs/income related to hedging certain foreign currency exchange risks and are an important component of net investment income. +The Company defines the non-U.S. GAAP financial measures included in this filing as follows: +• +Adjusted earnings are the profits derived from operations.The most comparable U.S. GAAP measure is net earnings. Adjusted earnings are adjusted revenues less benefits and adjusted expenses. The adjustments to both revenues and expenses account for certain items that cannot be predicted or that are outside management’s control. Adjusted revenues are U.S. GAAP total revenues excluding realized investment gains and losses, except for amortized hedge costs/income related to foreign currency exposure management strategies and net interest cash flows from derivatives associated with certain investment strategies. Adjusted expenses are U.S. GAAP total acquisition and operating expenses including the impact of interest cash flows from derivatives associated with notes payable but excluding any nonrecurring or other items not associated with the normal course of the Company’s insurance operations and that do not reflect the Company's underlying business performance. +• +Adjusted earnings per share (basic or diluted) are adjusted earnings for the period divided by the weighted average outstanding shares (basic or diluted) for the period presented. The most comparable U.S. GAAP measure is net earnings per share. +• +Amortized hedge costs/income represent costs/income incurred or recognized in using foreign currency forward +contracts to hedge certain foreign exchange risks in the Company's Japan segment (costs) or in the Corporate and Other segment (income). These amortized hedge costs/income are derived from the difference between the foreign currency spot rate at time of trade inception and the contractual foreign currency forward rate, recognized on a straight line basis over the term of the hedge. There is no comparable U.S. GAAP financial measure for amortized hedge costs/income. +• +Adjusted earnings and adjusted earnings per diluted share excluding current period foreign currency impact are computed using the average yen/dollar exchange rate for the comparable prior year period, which eliminates fluctuations driven solely by yen-to-dollar currency rate changes. +37 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +• +Amounts excluding foreign currency impact on U.S. dollar-denominated investment income were determined using the average dollar/yen exchange rate for the comparable prior year period. +• +Adjusted book value is the U.S. GAAP book value (representing total shareholders' equity), less AOCI as recorded on the U.S. GAAP balance sheet. The Company considers adjusted book value important as it excludes AOCI, which fluctuates due to market movements that are outside management's control. +• +Adjusted return on equity (ROE) excluding foreign currency impact is calculated using adjusted earnings excluding the impact of the yen/dollar exchange rate, as reconciled with total U.S. GAAP net earnings, divided by average shareholders’ equity, excluding AOCI. The most comparable U.S. GAAP financial measure is return on average equity as determined using net earnings and average total shareholders’ equity. +The following table is a reconciliation of items impacting adjusted earnings and adjusted earnings per diluted share to the most directly comparable U.S. GAAP measures of net earnings and net earnings per diluted share, respectively, for the years ended December 31. +Reconciliation of Net Earnings to Adjusted Earnings (1) +In Millions +Per Diluted Share +2019 +2018 +2019 +2018 +Net earnings +$ +3,304 +$ +2,920 +$ +4.43 +$ +3.77 +Items impacting net earnings: +Realized investment (gains) losses (2),(3),(4),(5) +15 +297 +.02 +.38 +Other and non-recurring (income) loss +1 +75 +.00 +.10 +Income tax (benefit) expense on items +excluded from adjusted earnings +(3 +) +(83 +) +.00 +(.11 +) +Tax reform adjustment (6) +(4 +) +18 +(.01 +) +.02 +Adjusted earnings +3,314 +3,226 +4.44 +4.16 +Current period foreign currency impact (7) +(15 +) +N/A +(.02 +) +N/A +Adjusted earnings excluding current period +foreign currency impact +$ +3,299 +$ +3,226 +$ +4.42 +$ +4.16 +(1) Amounts may not foot due to rounding. +(2) Amortized hedge costs of $257 in 2019 and $236 in 2018 , related to certain foreign currency exposure management strategies have been reclassified from realized investment gains (losses) and included in adjusted earnings as a decrease to net investment income. See "Hedge Costs/Income" discussion below for further information. +(3) Amortized hedge income of $89 in 2019 and $36 in 2018 , related to certain foreign currency exposure management strategies have been reclassified from realized investment gains (losses) and included in adjusted earnings as an increase to net investment income. See "Hedge Costs/Income" discussion below for further information. +(4) Net interest cash flows from derivatives associated with certain investment strategies of $(17) in 2019 and an immaterial amount for 2018 have been reclassified from realized investment gains (losses) and included in adjusted earnings as a component of net investment income. +(5) A gain of $66 in 2019 and $67 in 2018 , respectively, related to the interest rate component of the change in fair value of foreign currency swaps on notes payable have been reclassified from realized investment gains (losses) and included in adjusted earnings as a component of interest expense. +(6) The impact of Tax Reform was adjusted in 2018 for return-to-provision adjustments, various amended returns filed by the company, and final true-ups of deferred tax liabilities. Further impacts were recorded in 2019 a result of additional guidance released by the IRS. +(7) Prior period foreign currency impact reflected as “N/A” to isolate change for current period only. +Reconciling Items +Realized Investment Gains and Losses +The Company's investment strategy is to invest primarily in fixed maturity securities to provide a reliable stream of investment income, which is one of the drivers of the Company’s growth and profitability. This investment strategy incorporates asset-liability matching (ALM) to align the expected cash flows of the portfolio to the needs of the Company's liability structure. The Company does not purchase securities with the intent of generating capital gains or losses. However, investment gains and losses may be realized as a result of changes in the financial markets and the creditworthiness of specific issuers, tax planning strategies, and/or general portfolio management and rebalancing. The realization of investment gains and losses is independent of the underwriting and administration of the Company's insurance products. Realized investment gains and +38 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +losses include securities transactions, impairments, changes in loan loss reserves, derivative and foreign currency activities and changes in fair value of equity securities. +Securities Transactions, Impairments, and Gains (Losses) on Equity Securities +Securities transactions include gains and losses from sales and redemptions of investments where the amount received is different from the amortized cost of the investment. Impairments include other-than-temporary-impairment losses on investment securities as well as changes in loan loss reserves for loan receivables. Starting in the first quarter of 2018, gains and losses from changes in fair value of equity securities are recorded in earnings. +Certain Derivative and Foreign Currency Gains (Losses) +The Company's derivative activities include foreign currency forwards and options on certain fixed maturity securities; foreign currency forwards and options that economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long-term exposure to a weakening yen; foreign currency swaps associated with certain senior notes and subordinated debentures; foreign currency swaps and credit defaults swaps held in consolidated variable interest entities (VIEs); interest rate swaps used to economically hedge interest rate fluctuations in certain variable-rate investments; and interest rate swaptions to hedge changes in the fair value associated with interest rate changes for certain dollar-denominated available-for-sale securities. Gains and losses are recognized as a result of valuing these derivatives, net of the effects of hedge accounting. The Company also excludes the accounting impacts of remeasurement associated with changes in the yen/dollar exchange rate from adjusted earnings. Amortized hedge costs/ income related to certain foreign currency exposure management strategies (see Amortized Hedge Cost/Income section below), and net interest cash flows from derivatives associated with certain investment strategies and notes payable are reclassified from realized investment gains (losses) and included in adjusted earnings. +Amortized hedge costs/income can fluctuate based upon many factors, including the derivative notional amount, the length of time of the derivative contract, changes in both U.S. and Japan interest rates, and supply and demand for dollar funding. Amortized hedge costs and income have fluctuated in recent periods due to changes in the previously mentioned factors. For additional information regarding foreign currency hedging, refer to Hedging Activities in the Investments section of this MD&A. +For additional information regarding realized investment gains and losses, including details of reported amounts for the periods presented, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements. +Other and Non-recurring Items +The U.S. insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. The system can result in periodic charges to the Company as a result of insolvencies/bankruptcies that occur with other companies in the life insurance industry. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets. These charges neither relate to the ordinary course of the Company’s business nor reflect the Company’s underlying business performance, but result from external situations not controlled by the Company. The Company excludes any charges associated with U.S. guaranty fund assessments and the corresponding tax benefit or expense from adjusted earnings. +In Japan, the government also requires the insurance industry to contribute to a policyholder protection corporation that provides funds for the policyholders of insolvent insurers; however, these costs are calculated and administered differently than in the U.S. In Japan, these costs are not directly related to specific insolvencies or bankruptcies, but are rather a regular operational cost for an insurance company. Based on this structure, the Company does not remove the Japan policyholder protection expenses from adjusted earnings. +Nonrecurring items also include conversion costs related to legally converting the Company's Japan business to a subsidiary; these costs primarily consist of expenditures for legal, accounting, consulting, integration of systems and processes and other similar services. These Japan branch conversion costs were an immaterial amount for the year-ended December 31, 2019 and $75 million for the year-ended December 31, 2018. +Income Taxes +The Company's combined U.S. and Japanese effective income tax rate on pretax earnings was 25.7% in 2019 and 26.7% in 2018 . The decrease in the U.S. federal statutory corporate income tax rate from 35% to 21% effective January 1, 2018 drove the reduction in the effective tax rate for 2019 and 2018. Total income taxes were $1.1 billion in both 2019 and 2018 . Japanese income taxes on Aflac Japan's results account for most of the Company's consolidated income tax expense. +39 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +For further information, see "Critical Accounting Estimates - Income Taxes" in this MD&A, and Note 10 of the Notes to the Consolidated Financial Statements for additional information. +Foreign Currency Translation +Aflac Japan’s premiums and a significant portion of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into dollars for financial reporting purposes. The Company translates Aflac Japan’s yen-denominated income statement into dollars using the average exchange rate for the reporting period, and the Company translates its yen-denominated balance sheet using the exchange rate at the end of the period. +Due to the size of Aflac Japan, whose functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on the Company's reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. Management evaluates the Company's financial performance both including and excluding the impact of foreign currency translation to monitor, respectively, cumulative currency impacts on book value and the currency-neutral operating performance over time. +RESULTS OF OPERATIONS BY SEGMENT +U.S. GAAP financial reporting requires that a company report financial and descriptive information about operating segments in its annual and interim period financial statements. Furthermore, the Company is required to report a measure of segment profit or loss, certain revenue and expense items, and segment assets. Aflac's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan is the principal contributor to consolidated earnings. Businesses that are not individually reportable, such as the Parent Company, asset management subsidiaries and business activities, including reinsurance retrocession activities are included in the Corporate and other segment. See the Item 1. Business section of this Form 10-K for a summary of each segment's products and distribution channels, and a discussion of the conversion of Aflac Japan from a branch to a subsidiary and the creation of asset management subsidiaries in 2018. Consistent with U.S. GAAP guidance for segment reporting, pretax adjusted earnings is the Company's U.S. GAAP measure of segment performance. See Note 2 of the Notes to the Consolidated Financial Statements for the reconciliation of segment results to the Company's consolidated U.S. GAAP results and additional information. +AFLAC JAPAN SEGMENT +Aflac Japan Pretax Adjusted Earnings +Changes in Aflac Japan's pretax adjusted earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac Japan for the years ended December 31. +40 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Aflac Japan Summary of Operating Results +(In millions) +2019 +2018 +Net premium income +$ +12,772 +$ +12,762 +Net investment income: +Yen-denominated investment income +1,307 +1,283 +U.S. dollar-denominated investment income +1,446 +1,356 +Net investment income +2,753 +2,639 +Amortized hedge costs related to certain foreign currency +exposure management strategies +257 +236 +Net investment income, less amortized hedge costs +2,496 +2,403 +Other income (loss) +45 +41 +Total adjusted revenues +15,313 +15,206 +Benefits and claims, net +8,877 +8,913 +Adjusted expenses: +Amortization of deferred policy acquisition costs +709 +710 +Insurance commissions +731 +735 +Insurance and other expenses +1,734 +1,640 +Total adjusted expenses +3,174 +3,085 +Total benefits and adjusted expenses +12,051 +11,998 +Pretax adjusted earnings +$ +3,261 +$ +3,208 +Weighted-average yen/dollar exchange rate +109.07 +110.39 +In Dollars +In Yen +Percentage change over previous period: +2019 +2018 +2019 +2018 +Net premium income +.1 +% +.1 +% +(1.1 +)% +(1.5 +)% +Net investment income, less amortized +hedge costs +3.9 +7.5 +2.2 +5.5 +Total adjusted revenues +.7 +1.2 +(.6 +) +(.5 +) +Pretax adjusted earnings +1.7 +5.0 +.2 +3.1 +In yen terms, Aflac Japan's net premium income decreased in 2019 , primarily due to limited-pay products reaching paid-up status. Net investment income, net of amortized hedge costs, increased in 2019 primarily due to increased investments in U.S. dollar-denominated floating rate assets and $25 million of income related to a partial call of a concentrated yen-denominated exposure. +Annualized premiums in force at December 31, 2019 , were ¥1.49 trillion , compared with ¥1.53 trillion in 2018 . The decrease in annualized premiums in force in yen of 2.5% in 2019 and 1.6% in 2018 was driven primarily by limited-pay products reaching paid up status. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $13.6 billion in 2019 and $13.8 billion in 2018 . +Aflac Japan's investment portfolios include U.S. dollar-denominated securities and reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments). In years when the yen strengthens in relation to the dollar, translating Aflac Japan's U.S. dollar-denominated investment income into yen lowers growth rates for net investment income, total adjusted revenues, and pretax adjusted earnings in yen terms. In years when the yen weakens, translating U.S. dollar-denominated investment income into yen magnifies growth rates for net investment income, total adjusted revenues, and pretax adjusted earnings in yen terms. +The following table illustrates the effect of translating Aflac Japan's U.S. dollar-denominated investment income and related items into yen by comparing certain segment results with those that would have been reported had dollar/yen exchange rates remained unchanged from the prior year. Amounts excluding foreign currency impact on U.S. dollar-denominated investment income, a non-U.S. GAAP financial measure, were determined using the average dollar/yen exchange rate for the comparable prior year period. See non-U.S. GAAP financial measures defined above. +41 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Aflac Japan Percentage Changes Over Prior Year +(Yen Operating Results) +For the Years Ended December 31, +Including Foreign +Currency Changes +Excluding Foreign +Currency Changes +2019 +2018 +2019 +2018 +Net investment income, less +amortized hedge costs +2.2 +% +5.5 +% +2.9 +% +6.4 +% +Total adjusted revenues +(.6 +) +(.5 +) +(.5 +) +(.3 +) +Pretax adjusted earnings +.2 +3.1 +.7 +3.7 +The following table presents a summary of operating ratios in yen terms for Aflac Japan for the years ended December 31. +Ratios to total adjusted revenues: +2019 +2018 +Benefits and claims, net +58.0 +% +58.6 +% +Adjusted expenses: +Amortization of deferred policy acquisition costs +4.6 +4.7 +Insurance commissions +4.8 +4.8 +Insurance and other expenses +11.3 +10.8 +Total adjusted expenses +20.7 +20.3 +Pretax adjusted earnings +21.3 +21.1 +Ratios to total premiums: +Benefits and claims, net +69.5 +% +69.9 +% +Adjusted expenses: +Amortization of deferred policy acquisition costs +5.5 +5.6 +In 2019 , the benefit ratio decreased, compared to the prior year, primarily due to the continued change in mix of first and third sector business as first sector products become paid-up. In 2019 , the adjusted expense ratio increased mainly due to lower premium income from paid-up first sector products and higher expenses for advanced technology implementation. In total for 2019 , the pretax adjusted profit margin (calculated by dividing adjusted earnings by adjusted revenues) increased reflecting continued strength in benefit ratios and favorable net investment income. For 2020 , the Company anticipates the Aflac Japan pretax adjusted profit margin (calculated by dividing adjusted earnings by adjusted revenues) to remain stable. For further information, see the 2020 Outlook section of this MD&A. +Aflac Japan Sales +The following table presents Aflac Japan's new annualized premium sales for the years ended December 31. +In Dollars +In Yen +(In millions of dollars and billions of yen) +2019 +2018 +2019 +2018 +New annualized premium sales +$ +731 +$ +869 +¥ +79.7 +¥ +95.9 +Increase (decrease) over prior period +(15.9 +)% +2.7 +% +(16.9 +)% +1.1 +% +The following table details the contributions to Aflac Japan's new annualized premium sales by major insurance product for the years ended December 31. +42 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +2019 +2018 +Cancer +59.2 +% +65.8 +% +Medical +31.0 +25.0 +Income support +1.2 +1.8 +Ordinary life: +WAYS +.5 +.5 +Child endowment +.2 +.3 +Other ordinary life (1) +7.4 +6.1 +Other +.5 +.5 +Total +100.0 +% +100.0 +% +(1) Includes term and whole life +The foundation of Aflac Japan's product portfolio has been, and continues to be, third sector products, which include cancer, medical and income support insurance products. Aflac Japan has been focusing more on promotion of cancer and medical insurance products in this low-interest-rate environment. These products are less interest-rate sensitive and more profitable compared to first sector savings products. With continued cost pressure on Japan’s health care system, the Company expects the need for third sector products will continue to rise in the future and that the medical and cancer insurance products Aflac Japan provides will continue to be an important part of its product portfolio. +Sales of protection-type first sector and third sector products on a yen basis decreased 16.8% in 2019, compared with 2018. Earned premium growth for third and first sector protection products was 1.3%, which was consistent with the Company's expectation. The decline in sales primarily reflected reduced sales of cancer insurance through the Japan Post channel following the 2018 launch of Aflac Japan's revised cancer insurance product. In addition, the approach to refreshing the medical insurance product in 2019 took a rider versus whole policy approach. This was designed for improved economics but naturally resulted in lower reported sales. Additional factors include a change in corporate tax law, which slowed the pace of certain third sector medical products and some cancer products in both our associate channel and the bank channel, as well as increased competition from large life insurers who are increasing their focus on the third sector. +Sales of Aflac Japan cancer products in the Japan Post Group channel experienced a material decline beginning in August 2019 which has continued into 2020. For 2019, sales in the Japan Post Group channel declined by approximately 50.0% compared with 2018. The Company expects very little sales production in the Japan Post channel during the first half of 2020 and is uncertain with regard to production during the second half of the year. See the 2020 Outlook section of this MD&A for information on Aflac Japan earned premium expectations. +Independent corporate agencies and individual agencies contributed 45.7% of total new annualized premium sales for Aflac Japan in 2019 , compared with 40.1% in 2018 . Affiliated corporate agencies, which include Japan Post, contributed 50.0% of total new annualized premium sales in 2019 , compared with 55.3% in 2018 . Japan Post offers Aflac's cancer insurance products in more than 20,000 postal outlets. Notwithstanding the recent reduction in sales of Aflac Japan's cancer products in the Japan Post channel, the Company believes this alliance with Japan Post has and will benefit its cancer insurance sales over the long term. In 2019 , Aflac Japan recruited 77 new sales agencies. At December 31, 2019 , Aflac Japan was represented by more than 9,000 sales agencies, with more than 109,000 licensed sales associates employed by those agencies. +At December 31, 2019 , Aflac Japan had agreements to sell its products at 367 banks, approximately 90% of the total number of banks in Japan. Bank channel sales accounted for 4.3% of new annualized premium sales in 2019 for Aflac Japan, compared with 4.6% in 2018 . +Strategic Alliance with Japan Post Holdings +On December 19, 2018, the Parent Company and Aflac Japan entered into a Basic Agreement with Japan Post Holdings a Japanese corporation. Pursuant to the terms of the Basic Agreement, Japan Post Holdings agreed to form a capital relationship with the Parent Company, and Japan Post Holdings and Aflac Japan agreed to reconfirm existing initiatives regarding cancer insurance and to consider new joint initiatives, including leveraging digital technology in various processes, cooperation in new product development to promote customer-centric business management, cooperation in domestic and/or overseas business expansion and joint investment in third party entities and cooperation regarding asset management. +43 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +On February 28, 2019, the Parent Company entered a Shareholders Agreement with Japan Post Holdings, J&A Alliance Holdings Corporation, a Delaware corporation, solely in its capacity as trustee of J&A Alliance Trust, a New York voting trust (Trust), and General Incorporated Association J&A Alliance, a Japanese general incorporated association. Pursuant to the terms of the Shareholders Agreement, the Trust will use commercially reasonable efforts to acquire, through open market or private block purchases in the U.S., beneficial ownership of approximately 7% of the outstanding shares of the Parent Company’s common stock within a period of 12 months following the date the Trust begins acquiring such stock. On May 7, 2019, a press release issued by Japan Post Holdings announced that purchases of shares of the Parent Company’s common stock commenced on April 29, 2019 through the Trust and that it planned to complete such purchases within Japan Post’s fiscal year 2019 (which ends March 31, 2020). +The Trust has agreed not to own more than 10% of the Parent Company’s outstanding shares for a period expiring on the earlier of four years after the Trust acquires 7% of such shares, five years after it acquires 5% of such shares, or ten years after the Trust begins acquiring the Parent Company’s stock. After expiration of such period, the Trust has agreed not to own more than the greater of 10% of the Parent Company’s outstanding shares or such shares representing 22.5% of the voting rights in the Parent Company. +In light of the fact that the shares acquired by the Trust, like all Aflac Incorporated common shares, will be eligible for 10-for-1 voting rights after being held for 48 consecutive months, the Shareholders Agreement further provides for voting restrictions that effectively limit the trustee’s voting rights to no more than 20% of the voting rights in the Parent Company and further restrict the trustee’s voting rights with respect to certain change in control transactions. Japan Post Holdings will not have a Board seat on the Parent Company’s Board of Directors and will not have rights to control, manage or intervene in the management of the Parent Company. +As of December 31, 2019, all regulatory approvals expressly set forth in the Shareholders Agreement have been obtained. The Shareholders Agreement requires the parties to use reasonable best efforts to cooperate in connection with any ongoing regulatory matters related to or arising from the Trust’s acquisition or ownership or control of the shares of Company Common Stock, including any applications or filings in connection with a direct or indirect acquisition of control of or merger with an insurer by the Company or its affiliates. The foregoing is subject to and qualified in its entirety by reference to the full text of the Shareholders Agreement, a copy of which is attached as Exhibit 10.50 to the Company’s Quarterly Report on Form 10-Q filed April 26, 2019, and the terms of which exhibit are incorporated herein by reference. +Aflac Japan Investments +The level of investment income in yen is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, the effect of yen/dollar exchange rates on U.S. dollar-denominated investment income, and other factors. +As part of the Company's portfolio management and asset allocation process, Aflac Japan invests in yen and U.S. dollar-denominated investments. Yen-denominated investments primarily consist of JGBs and public and private fixed maturity securities. Aflac Japan's U.S. dollar-denominated investments include fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships or similar investment vehicles. Aflac Japan has been investing in both publicly-traded and privately originated U.S. dollar-denominated investment-grade and below-investment-grade fixed maturity securities and loan receivables, and has entered into foreign currency forwards and options to hedge the currency risk on the fair value of a portion of the U.S. dollar investments. +The following table details the investment purchases for Aflac Japan for the years ended December 31. +44 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +(In millions) +2019 +2018 +Yen-denominated: +Fixed maturity securities: +Japan government and agencies +$ +583 +$ +3,895 +Private placements +1,122 +1,185 +Other fixed maturity securities +542 +796 +Equity securities +212 +221 +Total yen-denominated +$ +2,459 +$ +6,097 +U.S. dollar-denominated: +Fixed maturity securities: +Other fixed maturity securities +$ +2,767 +$ +1,299 +Infrastructure debt +66 +0 +Bank loans +0 +346 +Equity securities +58 +120 +Commercial mortgage and other loans: +Transitional real estate loans +1,846 +3,168 +Commercial mortgage loans +565 +13 +Middle market loans +1,442 +839 +Other investments +145 +314 +Total dollar-denominated +$ +6,889 +$ +6,099 +Total Aflac Japan purchases +$ +9,348 +$ +12,196 +See the Investments section of this MD&A for further discussion of these investment programs, and see Notes 1, 3 and 4 of the Notes to the Consolidated Financial Statements for more information regarding loans and loan receivables. +Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, securities lending, and other securities transactions. Securities lending is also used from time to time to accelerate the availability of funds for investment. Purchases of securities from period to period are determined based on multiple objectives including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to the Company's investment policy guidelines. +The following table presents the results of Aflac Japan's investment yields for the years ended and as of December 31. +2019 +2018 +Total purchases for the period (in millions) (1) +$ +9,203 +$ +11,882 +New money yield (1),(2) +3.83 +% +3.06 +% +Return on average invested assets (3) +2.33 +2.33 +Portfolio book yield, including U.S. dollar-denominated investments, end of period (1) +2.64 +% +2.61 +% +(1) Includes fixed maturity securities, commercial mortgage and other loans, equity securities, and excludes alternative investments in limited partnerships +(2) Reported on a gross yield basis; excludes investment expenses, external management fees, and amortized hedge costs +(3) Net of investment expenses and amortized hedge costs, year-to-date number reflected on a quarterly average basis +The increase in the Aflac Japan new money yield in 2019 was primarily due to decreased allocations to lower yielding yen-denominated asset classes. +See Notes 3, 4 and 5 of the Notes to the Consolidated Financial Statements and the Investments section of this MD&A for additional information on the Company's investments and hedging strategies. +45 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +AFLAC U.S. SEGMENT +Aflac U.S. Pretax Adjusted Earnings +Changes in Aflac U.S. pretax adjusted earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac U.S. for the years ended December 31. +Aflac U.S. Summary of Operating Results +(In millions) +2019 +2018 +Net premium income +$ +5,808 +$ +5,708 +Net investment income +720 +727 +Other income +22 +8 +Total adjusted revenues +6,550 +6,443 +Benefits and claims +2,871 +2,887 +Adjusted expenses: +Amortization of deferred policy acquisition costs +573 +534 +Insurance commissions +590 +585 +Insurance and other expenses +1,244 +1,152 +Total adjusted expenses +2,407 +2,271 +Total benefits and adjusted expenses +5,279 +5,158 +Pretax adjusted earnings +$ +1,272 +$ +1,285 +Percentage change over previous period: +Net premium income +1.8 +% +2.6 +% +Net investment income +(1.0 +) +.8 +Total adjusted revenues +1.7 +2.4 +Pretax adjusted earnings +(1.0 +) +3.2 +Annualized premiums in force increased 1.1% in 2019 and 3.0% in 2018 . Annualized premiums in force at December 31 were $6.3 billion in 2019 , compared with $6.2 billion in 2018 . +The following table presents a summary of operating ratios for Aflac U.S. for the years ended December 31. +Ratios to total adjusted revenues: +2019 +2018 +Benefits and claims +43.8 +% +44.8 +% +Adjusted expenses: +Amortization of deferred policy acquisition costs +8.7 +8.3 +Insurance commissions +9.0 +9.1 +Insurance and other expenses +19.0 +17.9 +Total adjusted expenses +36.7 +35.2 +Pretax adjusted earnings +19.4 +19.9 +Ratios to total premiums: +Benefits and claims +49.4 +50.6 +Adjusted expenses: +Amortization of deferred policy acquisition costs +9.9 +9.4 +The benefit ratio decreased in 2019 , compared with 2018 , primarily due to somewhat elevated lapses and a change in business mix from higher loss ratio, reserve building products to lower loss ratio, guaranteed issue products. The adjusted expense ratio increased in 2019 , compared with 2018 , primarily due to deferred policy acquisition costs (DAC) capitalization related to lower than anticipated sales as well as anticipated spending increases reflecting ongoing investments in the U.S. platform, distribution, and customer experience. Both the lower benefit and higher DAC amortization ratios were also impacted by increases in lapses as a result of large case volatility and replacement of an administrative partner. These items impacted persistency in the short-term but are expected to drive profitable earned premium growth in future periods. The pretax adjusted +46 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +profit margin declined in 2019 when compared with 2018 , due to higher expense ratios, offset somewhat by lower benefit ratios. For expectations for 2020, see the 2020 Outlook section of this MD&A. +Aflac U.S. Sales +The following table presents Aflac's U.S. new annualized premium sales for the years ended December 31. +(In millions) +2019 +2018 +New annualized premium sales +$ +1,580 +$ +1,601 +Increase (decrease) over prior period +(1.3 +)% +3.2 +% +The following table details the contributions to Aflac's U.S. new annualized premium sales by major insurance product category for the years ended December 31. +2019 +2018 +Accident +28.5 +% +29.2 +% +Short-term disability +22.5 +22.7 +Critical care (1) +21.9 +22.1 +Hospital indemnity +16.6 +15.8 +Dental/vision +4.4 +4.7 +Life +6.1 +5.5 +Total +100.0 +% +100.0% +(1) Includes cancer, critical illness and hospital intensive care products +New annualized premium sales for accident insurance, the Aflac U.S. leading product category, decreased 3.8% , short-term disability sales decreased 2.4% , critical care insurance sales (including cancer insurance) decreased 2.4% , and hospital indemnity insurance sales increased 3.7% in 2019 , compared with 2018 . While overall sales decreased in 2019 , net earned premium increased 1.8%. +In 2019 , the Aflac U.S. sales forces included an average of approximately 8,200 U.S. agents, including brokers, who were actively producing business on a weekly basis. The Company believes that this average weekly producer equivalent metric allows sales management to monitor progress and needs. +In November 2019, the Company acquired Argus Holdings, LLC and its subsidiary Argus Dental & Vision, Inc. (Argus), a benefits management organization and national network dental and vision company, which provides a platform for Aflac Dental and Vision. This transaction represents a commitment of $75 million in capital at closing and an additional $21 million in consideration paid over three years based on the achievement by Argus of certain performance targets. Tampa, Florida will serve as the home for Aflac Dental and Vision. This acquisition is a strategic entry point into the network dental and vision market and is expected to provide opportunities for sales growth, improved account penetration and distribution productivity. +Aflac U.S. Investments +The level of investment income is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, and other factors. +As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships. Aflac U.S. has been investing in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loan receivables. +The following table details the investment purchases for Aflac U.S. as of December 31. +47 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +(In millions) +2019 +2018 +Fixed maturity securities: +Other fixed maturity securities +$ +1,032 +$ +1,068 +Infrastructure debt +119 +97 +Equity securities +58 +76 +Commercial mortgage and other loans: +Transitional real estate loans +423 +610 +Commercial mortgage loans +104 +163 +Middle market loans +99 +141 +Other investments +16 +44 +Total Aflac U.S. Purchases +$ +1,851 +$ +2,199 +Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, and other securities transactions. Purchases of securities from period to period are determined based on multiple objectives, including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to the Company's investment policy guidelines. +The following table presents the results of Aflac's U.S. investment yields for the years ended and as of December 31. +2019 +2018 +Total purchases for period (in millions) (1) +$ +1,835 +$ +2,155 +New money yield (1), (2) +4.51 +% +4.55 +% +Return on average invested assets (3) +5.07 +5.16 +Portfolio book yield, end of period (1) +5.40 +% +5.55 +% +(1) Includes fixed maturity securities, commercial mortgage and other loans, equity securities, and excludes alternative investments in limited partnerships +(2) Reported on a gross yield basis; excludes investment expenses and external management fees +(3) Net of investment expenses, year-to-date number reflected on a quarterly average basis +See Note 3 of the Notes to the Consolidated Financial Statements and the Market Risks of Financial Instruments - Credit Risk subsection of MD&A for more information regarding the sector concentrations of the Company's investments. +48 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +CORPORATE AND OTHER +Changes in the pretax adjusted earnings of Corporate and other are primarily affected by investment income. The following table presents a summary operating results for Corporate and other for the years ended December 31 . +Corporate and Other Summary of Operating Results +(In millions) +2019 +2018 +Premium income +$ +200 +$ +208 +Net investment income +88 +77 +Amortized hedge income related to certain foreign currency +management strategies +89 +36 +Net investment income, including amortized hedge income +177 +113 +Other income +15 +18 +Total adjusted revenues +393 +339 +Benefits and claims, net +194 +199 +Adjusted expenses: +Interest expense +133 +120 +Other adjusted expenses +137 +159 +Total adjusted expenses +270 +279 +Total benefits and adjusted expenses +464 +478 +Pretax adjusted earnings +$ +(72 +) +$ +(139 +) +Net investment income benefited from the Company’s enterprise corporate hedging program for the years ended December 31, 2019 and 2018 , respectively. See the Hedging Activities subsection of this MD&A for further information on the enterprise corporate hedging program. +In December 2018, the Parent Company invested $20 million in Singapore Life Pte. Ltd. (Singapore Life), a digitally-focused life insurance company based in Singapore. The Parent Company made an additional investment of $16 million in the second quarter of 2019, bringing the total investment to $36 million. As part of the relationship, Aflac entered into a reinsurance agreement on certain protection products with Singapore Life in September 2019. However, the Company does not currently expect the equity investment or the reinsurance agreement to have a material impact on its financial position or results of operations. +INVESTMENTS +The Company’s investment strategy utilizes disciplined asset and liability management while seeking long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives, and preserving shareholder value. In attempting to optimally balance these objectives, the Company seeks to maintain on behalf of Aflac Japan a diversified portfolio of yen-denominated investment assets, a U.S. dollar-denominated investment portfolio hedged back to yen and a portfolio of unhedged U.S. dollar-denominated assets. As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships. Aflac U.S. invests in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loans. +For additional information concerning the Company's investments, see Notes 3, 4, and 5 of the Notes to the Consolidated Financial Statements. +49 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The following tables detail investments by segment as of December 31. +Investment Securities by Segment +2019 +(In millions) +Aflac Japan +Aflac U.S. +Corporate and Other +Total +Available for sale, fixed maturity securities, +at fair value +$ +75,780 +$ +13,703 +$ +1,779 +$ +91,262 +Held to maturity, fixed maturity securities, +at amortized cost +30,085 +0 +0 +30,085 +Equity securities +657 +67 +78 +802 +Commercial mortgage and other loans: +Transitional real estate loans +4,507 +943 +0 +5,450 +Commercial mortgage loans +1,308 +399 +0 +1,707 +Middle market loans +2,141 +271 +0 +2,412 +Other investments: +Policy loans +234 +16 +0 +250 +Short-term investments (1) +386 +242 +1 +629 +Limited partnerships +496 +55 +17 +568 +Other +0 +30 +0 +30 +Total investments +115,594 +15,726 +1,875 +133,195 +Cash and cash equivalents +1,674 +417 +2,805 +4,896 +Total investments and cash +$ +117,268 +$ +16,143 +$ +4,680 +$ +138,091 +(1) Includes securities lending collateral +2018 +(In millions) +Aflac Japan +Aflac U.S. +Corporate and Other +Total +Available for sale, fixed maturity securities, +at fair value +$ +69,409 +$ +12,132 +$ +1,354 +$ +82,895 +Held to maturity, fixed maturity securities, +at amortized cost +30,318 +0 +0 +30,318 +Equity securities +806 +137 +44 +987 +Commercial mortgage and other loans: +Transitional real estate loans +3,621 +756 +0 +4,377 +Commercial mortgage loans +763 +301 +0 +1,064 +Middle market loans +1,144 +334 +0 +1,478 +Other investments: +Policy loans +219 +13 +0 +232 +Short-term investments (1) +0 +141 +11 +152 +Limited partnerships +333 +37 +7 +377 +Other +0 +26 +0 +26 +Total investments +106,613 +13,877 +1,416 +121,906 +Cash and cash equivalents +1,779 +641 +1,917 +4,337 +Total investments and cash +$ +108,392 +$ +14,518 +$ +3,333 +$ +126,243 +(1) Includes securities lending collateral +The ratings of the Company's securities referenced in the table below are based on the ratings designations provided by major NRSROs or, if not rated, are determined based on the Company's internal analysis of such securities. When the ratings issued by the rating agencies differ, the Company utilizes the second lowest rating when three or more rating agency ratings are available or the lowest rating when only two rating agency ratings are available. +50 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The distributions of fixed maturity securities the Company owns, by credit rating, as of December 31 were as follows: +Composition of Fixed Securities Portfolio by Credit Rating +2019 +2018 +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +AAA +1.1 +% +1.0 +% +1.0 +% +.9 +% +AA +4.3 +4.4 +3.9 +4.0 +A +68.6 +69.8 +67.9 +69.9 +BBB +23.1 +22.1 +23.2 +21.6 +BB or lower +2.9 +2.7 +4.0 +3.6 +Total +100.0 +% +100.0 +% +100.0 +% +100.0 +% +As of December 31, 2019 , the Company's direct and indirect exposure to securities in its investment portfolio that were guaranteed by third parties was immaterial both individually and in the aggregate. +The following table presents the 10 largest unrealized loss positions in the Company's portfolio as of December 31, 2019 . +(In millions) +Credit +Rating +Amortized +Cost +Fair +Value +Unrealized +Loss +Diamond Offshore Drilling Inc. +CCC +$ +64 +$ +32 +$ +(32 +) +AXA +BBB +296 +271 +(25 +) +Transocean Inc. +CCC +50 +37 +(13 +) +Intesa Sanpaolo Spa +BBB +142 +132 +(10 +) +Baker Hughes Inc. +A +123 +114 +(9 +) +Kommunal Landspensjonskasse (KLP) +BBB +137 +129 +(8 +) +Mirvac Group Finance Ltd. +A +91 +84 +(7 +) +Autostrade Per Litalia Spa +BBB +182 +175 +(7 +) +Downer Group Finance Pty LTD +BBB +91 +85 +(6 +) +Chevron Corp. +AA +148 +142 +(6 +) +Generally, declines in fair values can be a result of changes in interest rates, yen/dollar exchange rate, and changes in net spreads driven by a broad market move or a change in the issuer's underlying credit quality. As the Company believes these issuers have the ability to continue making timely payments of principal and interest, the Company views these changes in fair value to be temporary. See the Unrealized Investment Gains and Losses section in Note 3 of the Notes to the Consolidated Financial Statements for further discussions of unrealized losses related to financial institutions and other corporate investments. +Below-Investment-Grade Securities +The Company's portfolio of below-investment-grade securities includes debt securities purchased while the issuer was rated investment grade plus other loans and bonds purchased as part of an allocation to that segment of the market. The following is the Company's below-investment-grade exposure. +51 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Below-Investment-Grade Investments +December 31, 2019 +(In millions) +Par +Value +Amortized +Cost +Fair +Value +Unrealized +Gain +(Loss) +Investcorp Capital Limited +$ +388 +$ +388 +$ +452 +$ +64 +Republic of South Africa +365 +365 +372 +7 +Barclays Bank PLC +183 +115 +157 +42 +KLM Royal Dutch Airlines +183 +136 +143 +7 +Telecom Italia SpA +183 +183 +241 +58 +IKB Deutsche Industriebank AG +118 +51 +102 +51 +Arconic Inc. +100 +85 +111 +26 +EMC Corp. +80 +80 +82 +2 +Generalitat de Catalunya +73 +27 +80 +53 +Teva Pharmaceuticals +68 +66 +61 +(5 +) +Other Issuers +456 +436 +420 +(16 +) +Subtotal (1) +2,197 +1,932 +2,221 +289 +Senior secured bank loans +462 +480 +459 +(21 +) +High yield corporate bonds +726 +723 +755 +32 +Middle market loans, net of reserves (2) +2,455 +2,412 +2,420 +8 +Grand Total +$ +5,840 +$ +5,547 +$ +5,855 +$ +308 +(1) Securities initially purchased as investment grade, but have subsequently been downgraded to below investment grade +(2) Middle market loans are carried at amortized cost +The Company invests in senior secured bank loans and middle market loans primarily to U.S. corporate borrowers, most of which have below-investment-grade ratings. The objectives of these programs include enhancing the yield on invested assets, achieving further diversification of credit risk, and mitigating the risk of rising interest rates and hedge costs through the acquisition of floating rate assets. +The Company maintains an allocation to higher yielding corporate bonds within the Aflac Japan and Aflac U.S. portfolios. Most of these securities were rated below-investment-grade at the time of purchase, but the Company also purchased several that were rated investment grade which, because of market pricing, offer yields commensurate with below-investment-grade risk profiles. The objective of this allocation was to enhance the Company's yield on invested assets and further diversify credit risk. All investments in this program must have a minimum rating at purchase of low BB using the Company's above described rating methodology and are managed by the Company's internal credit portfolio management team. +Fixed Maturity Securities by Sector +The Company maintains diversification in investments by sector to avoid concentrations to any one sector, thus managing exposure risk. The following table shows the distribution of fixed maturities by sector classification as of December 31. +52 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +2019 +(In millions) +Amortized +Cost +% of +Total +Government and agencies +$ +53,463 +48.8 +% +Municipalities +2,414 +2.2 +Mortgage- and asset-backed securities +394 +.4 +Public utilities +8,194 +7.5 +Electric +6,471 +5.9 +Natural Gas +303 +.3 +Other +695 +.6 +Utility/Energy +725 +.7 +Sovereign and Supranational +2,042 +1.9 +Banks/financial institutions +9,947 +9.1 +Banking +6,029 +5.5 +Insurance +1,948 +1.8 +Other +1,970 +1.8 +Other corporate +33,002 +30.1 +Basic Industry +3,484 +3.2 +Capital Goods +3,187 +2.9 +Communications +4,057 +3.7 +Consumer Cyclical +3,271 +3.0 +Consumer Non-Cyclical +6,280 +5.7 +Energy +4,281 +3.9 +Other +1,464 +1.3 +Technology +3,129 +2.9 +Transportation +3,849 +3.5 +Total fixed maturity securities +$ +109,456 +100.0 +% +Securities by Type of Issuance +The Company has investments in both publicly and privately issued securities. The Company's ability to sell either type of security is a function of overall market liquidity which is impacted by, among other things, the amount of outstanding securities of a particular issuer or issuance, trading history of the issue or issuer, overall market conditions, and idiosyncratic events affecting the specific issue or issuer. +53 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The following table details investment securities by type of issuance as of December 31. +Investment Securities by Type of Issuance +2019 +2018 +(In millions) +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +Publicly issued securities: +Fixed maturity securities +$ +89,625 +$ +105,557 +$ +83,482 +$ +93,255 +Equity securities +717 +717 +936 +936 +Total publicly issued +90,342 +106,274 +84,418 +94,191 +Privately issued securities: (1) +Fixed maturity securities +19,831 +(2 +) +23,299 +(2 +) +23,692 +26,362 +Equity securities +85 +85 +51 +51 +Total privately issued +19,916 +23,384 +23,743 +26,413 +Total investment securities +$ +110,258 +$ +129,658 +$ +108,161 +$ +120,604 +(1) Primarily consists of securities owned by Aflac Japan +(2) Excludes Rule 144A securities starting in the first quarter of 2019 +The following table details the Company's reverse-dual currency securities as of December 31. +Reverse-Dual Currency Securities (1) +(Amortized cost, in millions) +2019 +2018 +Privately issued reverse-dual currency securities +$ +4,993 +$ +5,120 +Publicly issued collateral structured as reverse-dual currency securities +1,678 +1,657 +Total reverse-dual currency securities +$ +6,671 +$ +6,777 +Reverse-dual currency securities as a percentage of total investment +securities +6.1 +% +6.3 +% +(1) Principal payments in yen and interest payments in dollars +Aflac Japan has a portfolio of privately issued securities to better match liability characteristics and secure higher yields than those available on Japanese government or other public corporate bonds. Aflac Japan’s investments in yen-denominated privately issued securities consist primarily of non-Japanese issuers, are rated investment grade at purchase and have longer maturities, thereby allowing the Company to improve asset/liability matching and overall investment returns. These securities are generally either privately negotiated arrangements or issued under medium-term note programs and have standard documentation commensurate with credit ratings of the issuer, except when internal credit analysis indicates that additional protective and/or event-risk covenants were required. Many of these investments have protective covenants appropriate to the specific investment. These may include a prohibition of certain activities by the borrower, maintenance of certain financial measures, and specific conditions impacting the payment of the Company's notes. +HEDGING ACTIVITIES +The Company uses derivative contracts to hedge foreign currency exchange rate risk and interest rate risk. The Company uses various strategies, including derivatives, to manage these risks. See item “7A. Quantitative and Qualitative Disclosures About Market Risk” for more information about Market risk and the Company’s use of derivatives. +Derivatives are designed to reduce risk on an economic basis while minimizing the impact on financial results. The Company’s derivatives programs vary depending on the type of risk being hedged. See Note 4 of the Notes to the Consolidated Financial Statements for: +• +A description of the Company's derivatives, hedging strategies and underlying risk exposure . +• +Information about the notional amount and fair market value of the Company's derivatives. +• +The unrealized and realized gains and losses impact on adjusted earnings of derivatives in cash flow, fair value, net investments in foreign operations, or non - qualifying hedging relationships. +54 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Foreign Currency Exchange Rate Risk Hedge Program +The Company has deployed the following hedging strategies to mitigate exposure to foreign currency exchange rate risk: +• +Aflac Japan hedges U.S. dollar-denominated investments back to yen (see Aflac Japan’s U.S. Dollar-Denominated Hedge Program below). +• +Aflac Japan maintains certain unhedged U.S. dollar-denominated securities, which serve as an economic currency hedge of a portion of the Company's investment in Aflac Japan (see Aflac Japan’s U.S. Dollar-Denominated Hedge Program below). +• +The Parent Company designates yen-denominated liabilities (notes payable and loans) as non-derivative hedging instruments and designates certain foreign currency forwards and options as derivative hedges of the Company’s net investment in Aflac Japan ( see Enterprise Corporate Hedging Program below) . +• +The Parent Company enters into forward and option contracts to accomplish a dual objective of hedging foreign currency exchange rate risk related to dividend payments by its subsidiary, ALIJ, and reducing enterprise-wide hedge costs. ( see Enterprise Corporate Hedging Program below ). +Aflac Japan’s U.S. Dollar-Denominated Hedge Program +Aflac Japan buys U.S. dollar-denominated investments, typically corporate bonds, and hedges them back to yen with foreign currency forwards and options to hedge foreign currency exchange rate risk. This economically creates yen assets that match yen liabilities during the life of the derivative and provides capital relief. The currency risk being hedged is generally based on fair value of hedged investments. The following table summarizes the U.S. dollar-denominated investments held by Aflac Japan as of December 31. +2019 +2018 +(In millions) +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +Available-for-sale securities: +Fixed maturity securities (excluding bank loans) +$ +18,012 +$ +19,542 +$ +17,101 +$ +17,003 +Fixed maturity securities - bank loans (floating rate) +677 +649 +1,296 +1,238 +Equity securities +19 +19 +177 +177 +Commercial mortgage and other loans: +Transitional real estate loans (floating rate) +4,507 +4,543 +3,621 +3,625 +Commercial mortgage loans +1,308 +1,319 +763 +736 +Middle market loans (floating rate) +2,141 +2,153 +1,144 +1,146 +Other investments +496 +496 +333 +333 +Total U.S. Dollar Program +27,160 +28,721 +24,435 +24,258 +Available-for-sale securities: +Fixed maturity securities - economically converted to yen +1,700 +2,608 +1,679 +2,269 +Total U.S. dollar-denominated investments in Aflac Japan +$ +28,860 +$ +31,329 +$ +26,114 +$ +26,527 +U.S. Dollar Program includes all U.S. dollar-denominated investments in Aflac Japan other than the investments in certain consolidated VIEs where the instrument is economically converted to yen as a result of a derivative in the consolidated variable interest entity. As of December 31, 2019 , Aflac Japan had $8.8 billion outstanding notional amounts of foreign currency forwards and $21.1 billion outstanding notional amounts of foreign currency options, of which none were in-the-money, hedging the U.S. dollar-denominated investments. The fair value of Aflac Japan's unhedged U.S. dollar-denominated portfolio was $19.9 billion (excluding certain U.S. dollar-denominated assets shown in the table above as a result of consolidation that have been economically converted to yen using derivatives). +Foreign exchange derivatives used for hedging are periodically settled, which results in cash receipt or payment at maturity or early termination. The Company had net cash outflows of $20 million in 2019 , net cash inflows of $272 million in +55 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +2018 and net cash outflows of $747 million in 2017, associated with the currency derivatives used for hedging Aflac Japan’s U.S. dollar-denominated investments. +Enterprise Corporate Hedging Program +The Company has designated certain yen-denominated liabilities and foreign currency forwards and options of the Parent Company as accounting hedges of its net investment in Aflac Japan. The Company's consolidated yen-denominated net asset position was partially hedged at $9.1 billion as of December 31, 2019 , compared with $1.8 billion as of December 31, 2018 . +The Company makes its accounting designation of net investment hedge at the beginning of each quarter. If the total of the designated Parent Company non-derivative and derivative notional is equal to or less than the Company's net investment in Aflac Japan, the hedge is deemed to be effective, and the currency exchange effect on the yen-denominated liabilities and the change in estimated fair value of the derivatives are reported in the unrealized foreign currency component of other comprehensive income. The Company's net investment hedge was effective during the years ended December 31, 2019 and 2018 , respectively. For additional information on the Company's net investment hedging strategy, see Note 4 of the Notes to the Consolidated Financial Statements. +In order to economically mitigate risks associated with the enterprise-wide exposure to the yen and the level and volatility of hedge costs, the Parent Company enters into foreign exchange forward and option contracts. By buying U.S. dollars and selling yen, the Parent Company is effectively lowering its overall economic exposure to the yen, while Aflac Japan's U.S dollar exposure remains reduced as a result of Aflac Japan's U.S. dollar-denominated hedge program that economically creates yen assets. Among other objectives, this strategy is intended to offset the enterprise-wide amortized hedge costs by generating amortized hedge income. The portion of the enterprise-wide amortized hedge income contributed by this strategy was $89 million in 2019 and $36 million in 2018. This activity is reported in Corporate and Other. As this program evolves, the Company will continue to evaluate the program’s efficacy. See the Results of Operations section of this MD&A for the Company's definition of amortized hedge costs/income. +The following table presents metrics related to Aflac Japan amortized hedge costs and the Parent Company amortized hedge income for the years ended December 31. +Aflac Japan Hedge Cost Metrics (1) +2019 +2018 +Aflac Japan: +FX forward (sell USD, buy yen) notional at end of period (in billions) (2) +$8.8 +$9.9 +Weighted average remaining tenor (in months) (3) +8.5 +21.4 +Amortized hedge income (cost) for period (in millions) +$(257) +$(236) +Parent Company: +FX forward (buy USD, sell yen) notional at end of period (in billions) (2) +$4.9 +$2.5 +Weighted average remaining tenor (in months) (3) +13.7 +16.1 +Amortized hedge income (cost) for period (in millions) +$89 +$36 +(1) See the Results of Operations section of this MD&A for the Company's definition of amortized hedge costs/income. +(2) Notional is reported net of any offsetting positions within Aflac Japan or the Parent Company, respectively. +(3) Tenor based on period reporting date to settlement date +Interest Rate Risk Hedge Program +Aflac Japan and Aflac U.S. use interest rate swaps to mitigate the risk of investment income volatility for certain variable-rate investments. Additionally, to manage interest rate risk associated with its U.S. dollar-denominated investments held by Aflac Japan, the Company utilizes interest rate swaptions. +For additional discussion of the risks associated with the foreign currency exposure refer to the Currency Risk section in Item 1A, specifically to the Risk Factors titled “The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate“ and “Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity." +56 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +See Note 4 of the Notes to the Consolidated Financial Statements for additional information on the Company's hedging activities. +POLICY LIABILITIES +The following table presents policy liabilities by segment and in total for the years ended December 31. +(In millions) +2019 +2018 +Japan segment: +Future policy benefits +$ +81,462 +$ +77,812 +Unpaid policy claims +2,879 +2,857 +Other policy liabilities +11,452 +12,122 +Total Japan policy liabilities +95,793 +92,791 +U.S. segment: +Future policy benefits +9,405 +9,137 +Unpaid policy claims +1,779 +1,727 +Other policy liabilities +111 +117 +Total U.S. policy liabilities +11,295 +10,981 +Consolidated: +Future policy benefits +90,335 +86,368 +Unpaid policy claims +4,659 +4,584 +Other policy liabilities +11,560 +12,236 +Total consolidated policy liabilities (1) +$ +106,554 +$ +103,188 +(1) The sum of the Japan and U.S. segments exceeds the total due to reinsurance and retrocession activity. +See Note 7 of the Notes to the Consolidated Financial Statements for additional information on the Company's policy liabilities. +BENEFIT PLANS +Aflac Japan and Aflac U.S. have various benefit plans. For additional information on the Company's Japanese and U.S. plans, see Note 14 of the Notes to the Consolidated Financial Statements. +POLICYHOLDER PROTECTION +Policyholder Protection Corporation +The Japanese insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. Legislation enacted regarding the framework of the Life Insurance Policyholder Protection Corporation (LIPPC) included government fiscal measures supporting the LIPPC. In November 2016, Japan's Diet passed legislation that again extends the government's fiscal support of the LIPPC through March 2022. Effective April 2014, the annual LIPPC contribution amount for the total life industry was lowered from ¥40 billion to ¥33 billion. Aflac Japan recognized an expense of ¥1.9 billion and ¥2.0 billion for the years ended December 31, 2019 and 2018, respectively, for LIPPC assessments. +Guaranty Fund Assessments +Under U.S. state guaranty association laws, certain insurance companies can be assessed (up to prescribed limits) for certain obligations to the policyholders and claimants of impaired or insolvent insurance companies that write the same line or similar lines of business. The amount of the guaranty fund assessment that an insurer is assessed is based on its proportionate share of premiums in that state. See Note 15 of the Notes to the Consolidated Financial Statements for further information on the assessment. +OFF-BALANCE SHEET ARRANGEMENTS +As of December 31, 2019 , the Company had no material letters of credit, standby letters of credit, guarantees or standby repurchase obligations. See Note 15 of the Notes to the Consolidated Financial Statements for information on material unconditional purchase obligations that are not recorded on the Company's balance sheet. +57 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +LIQUIDITY AND CAPITAL RESOURCES +Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long-term financial resources available to support the operations of the businesses, fund business growth and provide for an ability to withstand adverse circumstances. Financial leverage (leverage) refers to an investment strategy of using debt to increase the potential return on equity. The Company targets and actively manages liquidity, capital and leverage in the context of a number of considerations, including: +• +business investment and growth needs +• +strategic growth objectives +• +financial flexibility and obligations +• +capital support for hedging activity +• +a constantly evolving business and economic environment +• +a balanced approach to capital allocation and shareholder deployment. +The governance framework supporting liquidity, capital and leverage includes global senior management and board committees that review and approve all significant capital related decisions. +The Company's cash and cash equivalents include unrestricted cash on hand, money market instruments, and other debt instruments with a maturity of 90 days or less when purchased, all of which has minimal market, settlement or other risk exposure. The target minimum amount for the Parent Company’s cash and cash equivalents is approximately $2.0 billion to provide available capital and liquidity support at the holding company. Aflac Japan and Aflac U.S. provide the primary sources of liquidity to the Parent Company through the payment of dividends and management fees. The following table presents the amounts provided to the Parent Company for the years ended December 31. +Liquidity Provided by Subsidiaries to Parent Company +(In millions) +2019 +2018 +Dividends declared or paid by subsidiaries +$ +3,466 +$ +1,817 +Management fees paid by subsidiaries +151 +204 +The decline in dividends during 2018 was driven by a change in the dividend regulatory approval process subsequent to the conversion of Aflac Japan from a branch to a subsidiary on April 1, 2018. The Company resumed dividend payments from Aflac Japan in the fourth quarter of 2018. Management fees decreased during 2019 and 2018, compared to prior years, due to changes in the administration of intercompany expenses between legal entities subsequent to the conversion, as well. +Prior to the Aflac Japan branch conversion, Aflac Japan paid allocated expenses and profit remittances to Aflac U.S. The following table details Aflac Japan remittances for the years ended December 31. +Aflac Japan Remittances +(In millions of dollars and billions of yen) +2019 +2018 +Aflac Japan management fees paid to Parent Company +$ +75 +$ +136 +Expenses allocated to Aflac Japan (in dollars) +4 +24 +Aflac Japan profit remittances to the Parent Company or Aflac U.S. (in dollars) +2,070 +808 +Aflac Japan profit remittances to the Parent Company or Aflac U.S. (in yen) +¥ +225.2 +¥ +89.7 +In 2018, the Company announced a change in its internal dividend policy which allows the Company to increase the proportion of regulatory earnings transferred from Aflac U.S. and Aflac Japan to the Parent Company. The Company intends to maintain higher than historical levels of capital and liquidity at the Parent Company with the goals of addressing the Company’s hedge costs and related potential need for collateral and mitigating against long-term weakening of the Japanese yen. Further, the Company plans to continue to maintain a portfolio of unhedged U.S. dollar based investments at Aflac Japan and consider whether the amount of such investments should be increased or decreased relative to the Company’s view of economic equity surplus in Aflac Japan in light of potentially rising hedge costs and other factors. See the "Hedging Activity" subsection in this MD&A for more information. +58 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +In addition to cash and equivalents, the Company also maintains credit facilities, both intercompany and with external partners, and a number of other available tools to support liquidity needs on a global basis. In September 2018, the Parent Company filed a shelf registration statement with the SEC that allows the Company to issue an indefinite amount of debt securities, in one or more series, from time to time until September 2021. In August 2018, the Parent Company filed a shelf registration with Japanese regulatory authorities that allows the Parent Company to conduct public offerings of bonds in Japan, including yen-denominated Samurai notes, up to ¥200 billion or its equivalent through August 2020. The shelf registration statement is for possible public offerings in Japan, but the bonds issued under the shelf may be transferred by the bondholders to U.S. persons in compliance with U.S. law. The Company believes outside sources for additional debt and equity capital, if needed, will continue to be available. Additionally, as of December 31, 2019, the Parent Company and Aflac had four lines of credit with third parties and three intercompany lines of credit. For additional information, see Note 9 of the Notes to the Consolidated Financial Statements. +The primary uses of cash by the Parent Company are shareholder dividends, the repurchase of its common stock and interest on its outstanding indebtedness and operating expenses. +Major Contractual Obligations +The following table presents the estimated payments by period of the Company's major contractual obligations as of December 31, 2019 . The Company translated its yen-denominated obligations using the December 31, 2019 , exchange rate. Actual future payments as reported in dollars will fluctuate with changes in the yen/dollar exchange rate. +Distribution of Payments by Period +(In millions) +Total +Liability (1) +Total +Payments +Less +Than +One Year +One to +Three Years +Four to +Five Years +After +Five Years +Future policy benefits liability (Note 7) (2) +$ +90,335 +$ +244,884 +$ +9,221 +$ +18,151 +$ +18,224 +$ +199,288 +Unpaid policy claims liability (Note 7) (3) +4,659 +4,660 +2,985 +980 +394 +301 +Other policyholders' funds (Note 7) (3) +7,317 +9,902 +341 +389 +706 +8,466 +Long-term debt – principal (Note 9) +6,408 +6,458 +0 +350 +1,450 +4,658 +Long-term debt – interest (Note 9) +44 +2,036 +171 +320 +262 +1,283 +Cash collateral on loaned securities (Note 3) +1,876 +1,876 +1,876 +0 +0 +0 +Operating service agreements (Note 15) +N/A +(4) +463 +179 +279 +5 +0 +Operating lease obligations (Note 9) +149 +159 +49 +68 +20 +22 +Finance lease obligations (Note 9) +12 +12 +4 +5 +3 +0 +Total contractual obligations +$ +110,800 +$ +270,450 +$ +14,826 +$ +20,542 +$ +21,064 +$ +214,018 +Liabilities for unrecognized tax benefits in the amount of $17 have been excluded from the tabular disclosure above because the timing of cash payment is not reasonably estimable. +(1) Liability amounts are those reported on the consolidated balance sheet as of December 31, 2019 . +(2) The estimated payments due by period reflect future estimated cash payments to be made to policyholders and others for future policy benefits. These projected cash outflows are based on assumptions for future policy persistency, mortality, morbidity, and other assumptions comparable with the Company's experience, consider future premium receipts on current policies in force, and assume market growth and interest crediting consistent with assumptions used in amortizing deferred acquisition costs. These cash outflows are undiscounted with respect to interest and, as a result, the sum of the cash outflows shown for all years in the table of $244,884 exceeds the corresponding liability amount of $90,335 . The Company has made significant assumptions to determine the future estimated cash outflows related to the underlying policies and contracts. Due to the significance of the assumptions used, actual cash outflow amounts and timing will differ, possibly materially, from these estimates. +(3) Includes assumptions as to the timing of policyholders reporting claims for prior periods and the amount of those claims. Actual amounts and timing of unpaid policy claims payments may differ significantly from the estimates above. +(4) Not applicable +For more information on the Company's major contractual obligations, see the applicable Note in the Notes to the Consolidated Financial Statements as indicated in the line items in the table above. +The Company's financial statements convey its financing arrangements during the periods presented. The Company has not engaged in material intra-period short-term financings during the periods presented that are not otherwise reported in its balance sheet or disclosed therein. The Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2019. The Company has not entered into transactions involving the transfer of financial assets with an obligation to repurchase financial assets that have been accounted for as a sale under applicable accounting standards, +59 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +including securities lending transactions. See Notes 1, 3, and 4 of the Notes to the Consolidated Financial Statements for more information on the Company's securities lending and derivative activities. With the exception of disclosed activities in those referenced footnotes and the Risk Factors entitled, "The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate" and "Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity," the Company is not aware of a trend, demand, commitment, event or uncertainty that would likely result in its liquidity increasing or decreasing by a material amount. +Consolidated Cash Flows +The Company translates cash flows for Aflac Japan's yen-denominated items into U.S. dollars using weighted-average exchange rates. In years when the yen weakens, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be reported. +The following table summarizes consolidated cash flows by activity for the years ended December 31. +(In millions) +2019 +2018 +Operating activities +$ +5,455 +$ +6,014 +Investing activities +(3,171 +) +(3,582 +) +Financing activities +(1,713 +) +(1,616 +) +Exchange effect on cash and cash equivalents +(12 +) +30 +Net change in cash and cash equivalents +$ +559 +$ +846 +Operating Activities +The principal cash inflows for the Company's insurance activities come from insurance premiums and investment income. The principal cash outflows are the result of policy claims, operating expenses, income tax, as well as interest expense. As a result of policyholder aging, claims payments are expected to gradually increase over the life of a policy. Therefore, future policy benefit reserves are accumulated in the early years of a policy and are designed to help fund future claims payments. +The Company expects its future cash flows from premiums and its investment portfolio to be sufficient to meet its cash needs for benefits and expenses. Consolidated cash flow from operations decreased 9.3% in 2019 , compared with 2018 . +Investing Activities +The Company's investment objectives provide for liquidity primarily through the purchase of publicly traded investment-grade debt securities. Prudent portfolio management dictates that the Company attempts to match the duration of its assets with the duration of its liabilities. Currently, when the Company's fixed maturity securities mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of the Company's business and its strong cash flows provide the Company with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. From time to time or when market opportunities arise, the Company disposes of selected fixed maturity securities that are available for sale to improve the duration matching of assets and liabilities, improve future investment yields, and/or re-balance its portfolio. As a result, dispositions before maturity can vary significantly from year to year. +As part of its overall corporate strategy, the Company has announced an increase in its commitment to the Aflac Ventures Fund from $250 million to $400 million, as opportunities emerge. These investments are included in equity securities or the other investments line in the consolidated balance sheets. The Aflac Ventures Fund is a subsidiary of Aflac Corporate Ventures which is reported in the Corporate and other segment. The central mission of Aflac Corporate Ventures is to support the organic growth and business development needs of Aflac Japan and Aflac U.S. with emphasis on digital applications designed to improve the customer experience, gain efficiencies, and develop new markets in an effort to enhance and defend long-term shareholder value. +As part of an arrangement with Federal Home Loan Bank of Atlanta (FHLB), Aflac U.S. obtains low-cost funding from FHLB supported by acceptable forms of collateral pledged by Aflac U.S. Aflac U.S. borrowed and repaid $217 million under this program during 2019. As of December 31, 2019, Aflac U.S. had outstanding borrowings of $403 million reported in its balance sheet. +60 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +See Note 3 of the Notes to the Consolidated Financial Statements for details on certain investment commitments. +Financing Activities +Consolidated cash used by financing activities was $1.7 billion in 2019 and $1.6 billion in 2018 . +In December 2019, the Parent Company issued four series of senior notes totaling ¥38.0 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥12.6 billion , bears interest at a fixed rate of .500% per annum, payable semi-annually, and will mature in December 2029. The second series, which totaled ¥9.3 billion , bears interest at a fixed rate of .843% per annum, payable semi-annually, and will mature in December 2031. The third series, which totaled ¥9.8 billion , bears interest at a fixed rate of .934% per annum, payable semi-annually, and will mature in December 2034. The fourth series, which totaled ¥6.3 billion , bears interest at a fixed rate of 1.122% per annum, payable semi-annually, and will mature in December 2039. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In September 2019, the Parent Company renewed a ¥30.0 billion senior term loan facility. The first tranche of the facility, which totaled ¥5.0 billion, bears interest at a rate per annum equal to the Tokyo interbank market rate (TIBOR), or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2026. The applicable margin ranges between .30% and .70%, depending on the Parent Company's debt ratings as of the date of determination. The second tranche, which totaled ¥25.0 billion, bears interest at a rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2029. The applicable margin ranges between .45% and 1.00%, depending on the Parent Company's debt ratings as of the date of determination. +In April 2019, ALIJ issued ¥30.0 billion (par value) of perpetual subordinated bonds. These bonds bear interest at a fixed rate of .963% per annum and then at six-month Euro Yen LIBOR plus an applicable spread on and after the day immediately following April 18, 2024. The bonds will be callable on each interest payment date on and after April 18, 2024. In November 2019, ALIJ amended the bonds to change their duration from perpetual to a stated maturity date of April 16, 2049 and to remove provisions that permitted ALIJ to defer payments of interest under certain circumstances. +In October 2018, the Parent Company issued $550 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.750% per annum, payable semi-annually, and will mature in January 2049. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a U.S.Treasury security with a maturity comparable to the remaining term of the notes, plus 25 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. +In October 2018, the Parent Company issued three series of senior notes totaling ¥53.4 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥29.3 billion , bears interest at a fixed rate of 1.159% per annum, payable semi-annually, and will mature in October 2030. The second series, which totaled ¥15.2 billion , bears interest at a fixed rate of 1.488% per annum, payable semi-annually, and will mature in October 2033. The third series, which totaled ¥8.9 billion , bears interest at a fixed rate of 1.750% per annum, payable semi-annually, and will mature in October 2038. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In November 2018, the Parent Company used the net proceeds from the October 2018 issuance of its senior notes to redeem $550 million of the Parent Company's 2.40% senior notes due in 2020. +See Note 9 of the Notes to the Consolidated Financial Statements for further information on the debt issuances discussed above. +The Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2019 . +Cash returned to shareholders through treasury stock purchases and dividends was $2.4 billion in 2019 , compared with $2.1 billion in 2018 . +The following tables present a summary of treasury stock activity during the years ended December 31. +61 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Treasury Stock Purchased +(In millions of dollars and thousands of shares) +2019 +2018 +Treasury stock purchases +$ +1,627 +$ +1,301 +Number of shares purchased: +Share repurchase program +31,994 +28,949 +Other +592 +392 +Total shares purchased +32,586 +29,341 +Treasury Stock Issued +(In millions of dollars and thousands of shares) +2019 +2018 +Stock issued from treasury: +Cash financing +$ +49 +$ +58 +Noncash financing +50 +17 +Total stock issued from treasury +$ +99 +$ +75 +Number of shares issued +2,324 +1,939 +Under share repurchase authorizations from the Company's board of directors, the Company purchased 32.0 million shares of its common stock in 2019 , compared with 28.9 million shares in 2018 . As of December 31, 2019 , a remaining balance of 37.1 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its board of directors. The Company currently plans to repurchase $1.3 billion to $1.7 billion of its common stock in 2020 , assuming stable capital conditions and absent compelling alternatives. See Note 11 of the Notes to the Consolidated Financial Statements for additional information. +Cash dividends paid to shareholders in 2019 of $1.08 per share increased 3.8% over 2018 . The following table presents the dividend activity for the years ended December 31. +Dividends Paid to Shareholders +(In millions) +2019 +2018 +Dividends paid in cash +$ +771 +$ +793 +Dividends through issuance of treasury shares +30 +8 +Total dividends to shareholders +$ +801 +$ +801 +In January 2020 , the board of directors announced a 3.7% increase in the quarterly cash dividend, effective with the first quarter of 2020. The first quarter 2020 cash dividend of $.28 per share is payable on March 2, 2020 , to shareholders of record at the close of business on February 19, 2020 . +Regulatory Restrictions +Aflac, CAIC and TOIC are domiciled in Nebraska and are subject to its regulations. Subsequent to the Japan branch conversion to a subsidiary, Aflac Japan is domiciled in Japan and subject to local regulations. The Nebraska Department of Insurance imposes certain limitations and restrictions on payments of dividends, management fees, loans and advances to the Parent Company. Under Nebraska insurance law, prior approval of the Nebraska Department of Insurance is required for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. In addition, the Nebraska insurance department must approve service arrangements and other transactions within the affiliated group of companies. These regulatory limitations are not expected to affect the level of management fees or dividends paid to the Parent Company. (See below for discussion of restrictions imposed by Japanese insurance regulators.) A life insurance company’s statutory capital and surplus is determined according to rules prescribed by the NAIC, as modified by the insurance department in the insurance company’s state of domicile. Statutory accounting rules are different from U.S. GAAP and are intended to emphasize policyholder protection and company solvency. Similar laws apply in New York, the domiciliary jurisdiction of Aflac New York. +62 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +The continued long-term growth of the Company's business may require increases in the statutory capital and surplus of its insurance operations. Aflac’s insurance operations may secure additional statutory capital through various sources, such as internally generated statutory earnings, capital contributions by the Parent Company from funds generated through debt or equity offerings, or reinsurance transactions. The NAIC’s RBC formula is used by insurance regulators to help identify inadequately capitalized insurance companies. The RBC formula quantifies insurance risk, business risk, asset risk and interest rate risk by weighing the types and mixtures of risks inherent in the insurer’s operations. +Aflac's company action level RBC ratio was 539% as of December 31, 2019 , compared with 560% at December 31, 2018 . Aflac’s RBC ratio remains high and reflects a strong capital and surplus position. As of December 31, 2019 , Aflac's total adjusted capital of $2.2 billion exceeded the company action level required capital and surplus of $.4 billion by $1.8 billion . With the announcement of the Japan branch conversion to a subsidiary, we had announced our intention to remove excess capital out of Aflac, targeting a 500% RBC by the end of 2019. As of December 31, 2019 , the Company has completed the RBC drawdown plan and has moved $1.75 billion of capital from Aflac to the Parent Company, supporting the Company's capital deployment and risk management activities. +The maximum amount of dividends that can be paid to the Parent Company by Aflac, CAIC and TOIC without prior approval of Nebraska's director of insurance is the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2020 in excess of $864 million would be considered extraordinary and require such approval. Following the Japan branch conversion to a subsidiary, the Company used extraordinary dividends as needed to actively manage to appropriate RBC levels that are lower yet sufficient to maintain ratings and support prudent capital management. Similar laws apply in New York, the domiciliary jurisdiction of Aflac New York. See Note 13 of the Notes to the Consolidated Financial Statements for information regarding the impact of permitted practices by the Nebraska Department of Insurance on the Company's statutory capital and surplus. +The NAIC considers its Solvency Modernization Initiative (SMI) process relating to updating the U.S. insurance solvency regulation framework to be ongoing. The SMI has focused on key issues such as capital requirements, governance and risk management, group supervision, reinsurance, statutory accounting and financial reporting matters. Many of these key issues have been finalized and/or are near completion; however, the NAIC still has some ongoing initiatives related to SMI, such as monitoring the international efforts on group capital requirements as well as RBC. In addition, the NAIC is also considering changes to investment risk factors. Any negative developments by the NAIC in these areas could result in increased capital requirements for the Company. +Aflac is subject to the NAIC’s Own Risk and Solvency Assessment (ORSA). Through the ORSA requirements, Aflac is expected to regularly, no less than annually, conduct an ORSA to assess the adequacy of its risk management framework, and its current and estimated projected future solvency position; internally document the process and results of the assessment; and provide a confidential high-level ORSA Summary Report annually to the lead state commissioner if the insurer is a member of an insurance group. In November 2019, Aflac filed its ORSA report with the Nebraska Department of Insurance. +In addition to limitations and restrictions imposed by U.S. insurance regulators, after the Japan branch conversion on April 1, 2018, the new Japan subsidiary is required to meet certain financial criteria as governed by Japanese corporate law in order to provide dividends to the Parent Company. Under these criteria, dividend capacity at the Japan subsidiary is basically defined as total equity excluding common stock, accumulated other comprehensive income amounts, capital reserves (representing statutorily required amounts in Japan) but reduced for net after-tax unrealized losses on available-for-sale securities. These dividend capacity requirements are generally aligned with the SMR. Japan's FSA maintains its own solvency standard which is quantified through the SMR. Aflac Japan's SMR is sensitive to interest rate, credit spread, and foreign exchange rate changes, therefore the Company continues to evaluate alternatives for reducing this sensitivity. In the event of a rapid change in market risk conditions causing SMR to decline, the Company has one senior unsecured revolving credit facility in the amount of ¥100 billion and a committed reinsurance facility in the amount of approximately ¥110 billion as a capital contingency plan. Additionally, the Company could take action to enter into derivatives on unhedged U.S. dollar-denominated investments with foreign currency options or forwards. See Notes 8 and 9 of the Notes to the Consolidated Financial Statements for additional information. +The Company has already undertaken various measures to mitigate the sensitivity of Aflac Japan's SMR. For example, the Company employs policy reserve matching (PRM) investment strategies, which is a Japan-specific accounting treatment that reduces SMR interest rate sensitivity since PRM-designated investments are carried at amortized cost consistent with corresponding liabilities. In order for a PRM-designated asset to be held at amortized cost, there are certain criteria that must be maintained. The primary criteria relates to maintaining the duration of designated assets and liabilities within a specified tolerance range. If the duration difference is not maintained within the specified range without rebalancing, then a certain +63 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +portion of the assets must be re-classified as available for sale and held at fair value with any associated unrealized gain or loss recorded in surplus. To rebalance, assets may need to be sold in order to maintain the duration with the specified range, resulting in realizing a gain or loss from the sale. For U.S. GAAP, PRM investments are categorized as available for sale. The Company also uses foreign currency derivatives to hedge a portion of its U.S. dollar-denominated investments. (See Notes 3, 4 and 8 of the Notes to the Consolidated Financial Statements for additional information on the Company's investment strategies, hedging activities, and reinsurance, respectively.) +Aflac's SMR ratio remains high and reflects a strong capital and surplus position. As of December 31, 2019 , Aflac Japan's SMR was 1,043% , compared with 965% at December 31, 2018 . As part of the conversion of Aflac Japan from a branch to a subsidiary on April 1, 2018, the Company experienced an accounting-driven decline in the SMR of approximately 130 points, compared with the SMR as of December 31, 2017. The Company expects to be able to pay dividends out of certain accounts, thus restoring this accounting impact over an estimated three-year period. +The FSA has been conducting field testing with the insurance industry concerning the introduction of an economic value-based solvency regime. The field testing will assist the FSA in determining if an economic value-based solvency regime in Japan will be appropriate for the insurance industry. +Privacy and Cybersecurity Governance +The Company’s Board of Directors has adopted an information security policy directing management to establish and operate a global information security program with the goals of monitoring existing and emerging threats and ensuring that the Company’s information assets and data, and the data of its customers, are appropriately protected from loss or theft. The Board has delegated oversight of the Company’s information security program to the Audit and Risk Committee. The Company’s senior officers, including its Global Security and Chief Information Security Officer, are responsible for the operation of the global information security program and regularly communicate with the Audit and Risk Committee on the program, including with respect to the state of the program, compliance with applicable regulations, current and evolving threats, and recommendations for changes in the information security program. The global information security program also includes a cybersecurity incident response plan that is designed to provide a management framework across Company functions for a coordinated assessment and response to potential security incidents. This framework establishes a protocol to report certain incidents to the Global Security and Chief Information Security Officer and other senior officers, with the goal of timely assessing such incidents, determining applicable disclosure requirements and communicating with the Audit and Risk Committee. The incident response plan directs the executive officers to report certain incidents immediately and directly to the Lead Non-Management Director. +Other +For information regarding commitments and contingent liabilities, see Note 15 of the Notes to the Consolidated Financial Statements. +Additional Information +Investors should note that the Company announces material financial information in its SEC filings, press releases and public conference calls. In accordance with SEC guidance, the Company may also use the Investor Relations section of the Company's website (http://investors.aflac.com) to communicate with investors about the Company. It is possible that the financial and other information the Company posts there could be deemed to be material information. The information on the Company's website is not part of this document. Further, the Company's references to website URLs are intended to be inactive textual references only. +CRITICAL ACCOUNTING ESTIMATES +The Company prepares its financial statements in accordance with U.S. GAAP. These principles are established primarily by the FASB. In this MD&A, references to U.S. GAAP issued by the FASB are derived from the FASB Accounting Standards Codification™ (ASC). The preparation of financial statements in conformity with U.S. GAAP requires the Company to make estimates based on currently available information when recording transactions resulting from business operations. The estimates that the Company deems to be most critical to an understanding of Aflac’s results of operations and financial condition are those related to the valuation of investments and derivatives, DAC, liabilities for future policy benefits and unpaid policy claims, and income taxes. The preparation and evaluation of these critical accounting estimates involve the use of various assumptions developed from management’s analyses and judgments. The application of these critical accounting estimates determines the values at which 94% of the Company's assets and 81% of its liabilities are reported as +64 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +of December 31, 2019 , and thus has a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results. +Valuation of Investments, Including Derivatives, and Recognition of Other-than-Temporary Impairments +Aflac's investments, primarily consisting of debt and equity securities, include both publicly issued and privately issued securities. For publicly issued securities, the Company determines the fair values from quoted market prices readily available from public exchange markets and price quotes and valuations from third party pricing vendors. For the majority of privately issued securities within the Company's investment portfolio, a third party pricing vendor has developed valuation models that the Company utilizes to determine fair values. For the remaining privately issued securities, the Company uses non-binding price quotes from outside brokers. +The Company estimates the fair values of its securities on a monthly basis. The Company monitors the estimated fair values obtained from its pricing vendors and brokers for consistency from month to month, while considering current market conditions. The Company also periodically discusses with its pricing brokers and vendors the pricing techniques they use to monitor the consistency of their approach and periodically assess the appropriateness of the valuation level assigned to the values obtained from them. If a fair value appears unreasonable, the Company will re-examine the inputs and assess the reasonableness of the pricing data with the vendor. Additionally, the Company may compare the inputs to relevant market indices and other performance measurements. Based on management's analysis, the valuation is confirmed or may be revised if there is evidence of a more appropriate estimate of fair value based on available market data. The Company has performed verification of the inputs and calculations in any valuation models to confirm that the valuations represent reasonable estimates of fair value. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. +The Company routinely reviews its investments that have experienced declines in fair value to determine if the decline is other than temporary. The identification of distressed investments, the determination of fair value if not publicly traded and the assessment of whether a decline is other than temporary involve significant management judgment. The Company must apply considerable judgment in determining the likelihood of the security recovering in value while the Company owns it. Factors that may influence this include the Company's assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. This process requires consideration of risks, which can be controlled to a certain extent, such as credit risk, and risks which cannot be controlled, such as interest rate risk. Management updates its evaluations regularly and reflects impairment losses in the Company's net earnings or other comprehensive income, depending on the nature of the loss, as such evaluations are revised. +See Notes 1, 3, 4 and 5 of the Notes to the Consolidated Financial Statements for additional information. +Deferred Policy Acquisition Costs and Policy Liabilities +Insurance premiums for most of the Company's health and life policies, including cancer, accident, hospital, critical illness, dental, vision, term life, whole life, long-term care and disability, are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. When revenues are reported, the related amounts of benefits and expenses are charged against such revenues, so that profits are recognized in proportion to premium revenues during the period the policies are expected to remain in force. This association is accomplished by means of annual additions to the liability for future policy benefits and the deferral and subsequent amortization of policy acquisition costs. +Premiums from the Company's products with limited-pay features, including term life, whole life, WAYS, and child endowment, are collected over a significantly shorter period than the period over which benefits are provided. Premiums for these products are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. Any gross premium in excess of the net premium is deferred and recorded in earnings, such that profits are recognized in a constant relationship with insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net premium method. +Deferred Policy Acquisition Costs +The calculation of DAC and the liability for future policy benefits requires the use of estimates based on sound actuarial valuation techniques. For new policy issues, the Company reviews its actuarial assumptions and deferrable acquisition costs each year and revise them when necessary to more closely reflect recent experience and studies of actual acquisition costs. For policies in force, the Company evaluates DAC by major product groupings to determine that they are recoverable from future revenues, and any amounts determined not to be recoverable are charged against net earnings. See Note 6 of the Notes to the Consolidated Financial Statements for a detail of the DAC activity for the past two years. +65 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Policy Liabilities +The Company's policy liabilities, which are determined in accordance with applicable guidelines as defined under U.S. GAAP and Actuarial Standards of Practice, include two components that involve analysis and judgment: future policy benefits and unpaid policy claims, which accounted for 85% and 4% of total policy liabilities as of December 31, 2019 , respectively. +Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. The Company calculates future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are generally established at the time a policy is issued. The assumptions used in the calculations are closely related to those used in developing the gross premiums for a policy. As required by U.S. GAAP, the Company also includes a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience. +Unpaid policy claims include those claims that have been incurred and are in the process of payment as well as an estimate of those claims that have been incurred but have not yet been reported to the Company. The Company computes unpaid policy claims on a non-discounted basis using statistical analyses of historical claims payments, adjusted for current trends and changed conditions. The Company updates the assumptions underlying the estimate of unpaid policy claims regularly and incorporates its historical experience as well as other data that provides information regarding the Company's outstanding liability. +The Company's insurance products provide fixed-benefit amounts per occurrence that are not subject to medical-cost inflation. Furthermore, the Company's business is widely dispersed in both the U.S. and Japan. This geographic dispersion and the nature of the Company's benefit structure mitigate the risk of a significant unexpected increase in claims payments due to epidemics and events of a catastrophic nature. Claims incurred under Aflac's policies are generally reported and paid in a relatively short time frame. The unpaid claims liability is sensitive to morbidity assumptions, in particular, severity and frequency of claims. Severity is the ultimate size of a claim, and frequency is the number of claims incurred. The Company's claims experience is primarily related to the demographics of its policyholders. +As a part of its established financial reporting and accounting practices and controls, the Company performs detailed annual actuarial reviews of its policyholder liabilities (gross premium valuation analysis) and reflects the results of those reviews in its results of operations and financial condition as required by U.S. GAAP. For Aflac Japan, the Company’s annual reviews in 2019 and 2018 indicated no need to strengthen liabilities associated with policies in Japan. For Aflac U.S., the Company's annual reviews in 2019 and 2018 indicated no need to strengthen liabilities associated with policies in the U.S. +The table below reflects the growth of the future policy benefits liability for the years ended December 31. +Future Policy Benefits +(In millions of dollars and billions of yen) +2019 +2018 +Aflac U.S. +$ +9,405 +$ +9,137 +Growth rate +2.9 +% +3.8 +% +Aflac Japan +$ +81,462 +$ +77,812 +Growth rate +4.7 +% +5.6 +% +Consolidated +$ +90,335 +$ +86,368 +Growth rate +4.6 +% +5.5 +% +Yen/dollar exchange rate (end of period) +109.56 +111.00 +Aflac Japan +¥ +8,925 +¥ +8,637 +Growth rate +3.3 +% +3.8 +% +The growth of the future policy benefits liability in yen for Aflac Japan and in dollars for Aflac U.S. has been due to the aging of the Company's in-force block of business and the addition of new business. +In computing the estimate of unpaid policy claims, the Company considers many factors, including the benefits and amounts available under the policy; the volume and demographics of the policies exposed to claims; and internal business practices, such as incurred date assignment and current claim administrative practices. The Company monitors these conditions closely and make adjustments to the liability as actual experience emerges. Claim levels are generally stable from period to period; however, fluctuations in claim levels may occur. In calculating the unpaid policy claim liability, the Company +66 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +does not calculate a range of estimates. The following table shows the expected sensitivity of the unpaid policy claims liability as of December 31, 2019 , to changes in severity and frequency of claims. +Sensitivity of Unpaid Policy Claims Liability +(In millions) +Total Severity +Total Frequency +Decrease +by 2% +Decrease +by 1% +Unchanged +Increase +by 1% +Increase +by 2% +Increase by 2% +$ +0 +$ +25 +$ +50 +$ +76 +$ +101 +Increase by 1% +(25 +) +0 +25 +50 +76 +Unchanged +(49 +) +(25 +) +0 +25 +50 +Decrease by 1% +(73 +) +(49 +) +(25 +) +0 +25 +Decrease by 2% +(97 +) +(73 +) +(49 +) +(25 +) +0 +Other policy liabilities, which accounted for 11% of total policy liabilities as of December 31, 2019 , consisted primarily of annuity and unearned premium reserves, and discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. Advanced premiums represented 24% and 29% of the December 31, 2019 and 2018 other policy liabilities balances, respectively. See the Aflac Japan segment subsection of this MD&A for further information. +Income Taxes +Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing the Company's income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the Company expects the temporary differences to reverse. The evaluation of a tax position in accordance with U.S. GAAP is a two-step process. Under the first step, the enterprise determines whether it is more likely than not that a tax position will be sustained upon examination by taxing authorities. The second step is measurement, whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized. The determination of a valuation allowance for deferred tax assets requires management to make certain judgments and assumptions. +In evaluating the ability to recover deferred tax assets, the Company's management considers all available evidence, including taxable income in open carry back years, the existence of cumulative losses in the most recent years, forecasted earnings, future taxable income exclusive of reversing temporary differences and carryforwards, future taxable temporary difference reversals, and prudent and feasible tax planning strategies. In the event the Company determines it is not more likely than not that it will be able to realize all or part of its deferred tax assets in the future, a valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed. Future economic conditions and market volatility, including increases in interest rates or widening credit spreads, can adversely impact the Company’s tax planning strategies and in particular the Company’s ability to utilize tax benefits on previously recognized capital losses. The Company's judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions. +For additional information on income tax, see Note 10 of the Notes to the Consolidated Financial Statements presented in this report. +67 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Future Adoption of Accounting Standard for Long-Duration Insurance Contracts +In August 2018, the FASB issued ASU 2018-12, “ Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts .” The update, which is expected to significantly change how insurers account for long-duration contracts, amends existing recognition, measurement, presentation, and disclosure requirements applicable to the Company. Issues addressed in the new guidance include: 1) a requirement to review and, if there is a change, update cash flow assumptions for the liability for future policy benefits at least annually, and to update the discount rate assumption quarterly, 2) accounting for market risk benefits at fair value, 3) simplified amortization for deferred acquisition costs, and 4) enhanced financial statement presentation and disclosures. In November 2019, the FASB issued ASU 2019-09, “ Financial Services - Insurance (Topic 944): Effective Date ”, which defers the effective date of ASU 2018-12 for all entities. The amendments are effective for public business entities that meet the definition of an SEC filer, excluding entities eligible to be smaller reporting companies as defined by the SEC,for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2021. Early application of the amendments is permitted, however, the Company does not expect to early adopt the updated standard. +The Company is thoroughly evaluating the impact of ASU 2018-12 adoption and expects it will have a significant impact on the Company’s reported financial position, results of operations, and disclosures under U.S. GAAP accounting. The Company anticipates that the requirement to update assumptions for liability for future policy benefits will have a significant impact on its results of operations, systems, processes and controls while the requirement to update the discount rate will have a significant impact on its AOCI and equity. The Company currently has no products with market risk benefits. +There are two permitted transition methods upon adoption. The default transition method is a modified retrospective approach or companies may elect to apply the amendments using a full retrospective approach. +Under the modified retrospective method, the opening reserve balance at the transition date, January 1, 2020, would generally be the same as the closing balance before transition; however, it would be updated for changes in the discount rate required under the new guidance. +Regardless of the transition method selected, the new guidance requires that discount rates used for discounting of insurance liabilities be initially adjusted on the adoption date and subsequently at each reporting period to the market levels for the upper-medium-grade (low credit risk) fixed income instrument yields (single-A in the currency of the underlying insurance contract) reflecting the duration of the company’s insurance liabilities. Long duration of the Company’s third-sector insurance liabilities in Japan coupled with limited-to-no-liquidity of the Japanese long-dated fixed-income market creates challenges in application of the market-based discount rate guidance and will require the Company to apply significant judgments in designing discount rate methodologies for its Japanese third-sector liabilities. The update of the discount rate would be recognized in AOCI under both transition methods. +Under the full retrospective method, the Company would restate all historical periods based upon actual historical experience as of contract inception and its updated view of the contractual cash flow projections at transition. A cumulative catch-up adjustment to opening retained earnings would be recognized to reflect the actual experience and updated projections. Companies are permitted to apply a full retrospective transition approach if actual historical information is available for all contracts that will be affected by the new guidance. +The Company has selected the modified retrospective transition method. +The Company expects that under either transition method, the impact to its reported financial statements under U.S. GAAP will be greatly influenced by the nature of the Company’s business model. Adoption of the new guidance will reflect the Company’s concentration in Japan third-sector business, in particular cancer insurance, with respect to which the duration of liabilities is materially longer than asset durations, while Japan’s aggregate block of business continues to see favorable experience from mortality, morbidity, and expenses. Under the modified retrospective method, the impact of a low discount rate applied to long-duration third sector liabilities is recognized at adoption, while associated favorable morbidity margins are recognized over time thus driving a pronounced timing impact to U.S. GAAP equity. In addition, with respect to the Japan segment, the Company maintains a large portfolio of assets designated as held-to-maturity (HTM) as a strategy to reduce capital (solvency margin ratio or SMR) volatility. In a low interest rate environment, such as presently exists in Japan, assets designated as HTM that were purchased in a higher interest rate environment have significant embedded gains not reflected in AOCI (HTM securities are carried at amortized cost under U.S. GAAP), which serves as an economic offset to a low discount rate applied to policy liabilities. At December 31, 2019, the Company’s HTM portfolio was $30.1 billion at amortized cost and had $7.5 billion in net unrealized gains. Pursuant to the implementation of ASU 2019-04, ” Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial +68 +Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations +Instruments ” (see Note 1 for additional details of this ASU) , effective on January 1, 2020, the Company anticipates the reclassification of approximately $6.9 billion (at amortized cost) of pre-payable fixed maturity securities from the HTM to the available-for-sale (AFS) category. This reclassification is expected to result in recording in AOCI a net unrealized gain of approximately $800 million on an after-tax basis based on the securities’ fair values on the reclassification date. After adoption of ASU 2018-12, the Company also expects net earnings and net earnings per share (which were $3.3 billion and $4.43 per diluted share, respectively, in 2019) to reflect larger quarterly fluctuations due to the new requirement to update assumptions for liability for future policy benefits. +As an example of the potential impact of the new guidance, and for illustrative purposes only, under the modified retrospective method and in a low interest rate environment, the Company would expect AOCI (which was $6.6 billion at December 31, 2019) to significantly decline upon adoption and to thereafter reflect larger quarterly fluctuations due to the new requirement to quarterly adjust discount rates. Conversely, in a higher interest rate environment, and assuming adoption of the modified retrospective method, the Company would expect AOCI to decline less or even increase (depending on the specifics of the interest rate environment), as well as to reflect quarterly fluctuations. Under the full retrospective method, the Company would expect lesser declines or increases in total equity upon adoption compared to the modified retrospective method due to the potential offsetting effect from updating experience and cash flow projections. +The ultimate impact on these items from the Company’s implementation of the updated standard is subject to assessments that are dependent on many variables, including but not limited to (i) the transition method selected by the Company, (ii) how certain aspects of the new standard will be interpreted and implemented by the Company and other similar companies, such as (but not limited to) amortization of deferred acquisition costs and selection of discounting methodologies and inputs, as well as establishment of policies, processes and controls for setting, monitoring and periodically updating reserve assumptions, and (iii) changes in the interest rate environment in the US and Japan. The impact on transition under the modified retrospective method will be driven by updating discount rates that will increase reserves and lower AOCI by the corresponding amount. +The Company expects that while the adoption of this new accounting guidance will affect the Company’s financial statements under U.S. GAAP, it will not impact financial statements for Aflac Japan under FSA requirements or for Aflac U.S. under applicable statutory requirements. Therefore, the Company does not expect adoption of the updated standard to impact its overall cash flows, subsidiaries’ dividend capacity or their ability to meet applicable regulatory capital standards, nor does the Company anticipate adoption to affect its existing debt covenants or strategies for capital deployment. +New Accounting Pronouncements +During the last three years, various accounting standard-setting bodies have been active in soliciting comments and issuing statements, interpretations and exposure drafts. For information on new accounting pronouncements and the impact, if any, on the Company's financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +The Company is exposed primarily to the following types of market risks: currency risk, interest rate risk, credit risk and equity risk. Fluctuations in these factors could impact the Company’s consolidated results of operations or financial condition. The Company regularly monitors its market risks and uses a variety of strategies to manage its exposure +to these market risks. +Currency Risk +Aflac Japan +The functional currency of Aflac Japan's insurance operations is the Japanese yen. Aflac Japan’s premiums and a significant portion of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into U.S. dollars for financial reporting purposes. Most of Aflac Japan's cash and liabilities are yen-denominated. +The Company engages in hedging activities to mitigate certain currency risks from holding U.S. dollar-denominated investments in Aflac Japan. However, this hedging program in turn poses a countervailing long-term risk of loss on hedging currency derivatives under the long-term scenario of weakening yen, and related derivative rollover risk that could amplify hedge cost in unfavorable market conditions and significantly increase liquidity requirements to support negative derivative +69 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +settlements. Additionally, as discussed in detail in the Risk Factors section titled “Lack of availability of acceptable yen-denominated investments could adversely affect the Company’s results of operations, financial position or liquidity,” there is a risk that losses realized on derivative settlements during periods of weakening yen may not be recouped through realization of the corresponding holding currency gains on the hedged U.S. dollar-denominated investments if these investments are not ultimately converted to yen. +The Company has taken steps to refine the strategy to mitigate currency exposure of Aflac Japan from U.S. dollar-denominated investments while balancing the consideration of the economic equity surplus in Aflac Japan. This refinement in strategy resulted in an increased amount of the unhedged U.S. dollar-denominated investments held in Aflac Japan while at the same time mitigating hedge cost increases. Generally , Aflac Japan’s exposure to the currency risk increases when its portfolio of unhedged U.S. dollar-denominated investments increases. As the value of the U.S. dollar-denominated investment portfolio in Aflac Japan fluctuates and the Company’s business model evolves, the Company periodically reevaluates this size of the unhedged portfolio and may accordingly adjust up or down its currency hedging targets. See additional discussion in the Risk Factors section titled "The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate." +The Parent Company +The Company is exposed to currency risk as an economic event when yen funds are actually converted into U.S. dollars. This occurs when yen-denominated funds are paid as dividends and management fees from Aflac Japan to the Parent Company and with quarterly settlements of its reinsurance retrocession transactions. The exchange rates prevailing at the time of yen payments will differ from the exchange rates prevailing at the time the yen profits were earned. A portion of the yen dividend and management fee payments may be used to service Aflac Incorporated's yen-denominated notes payable with the remainder converted into U.S. dollars. +In addition to yen payments and the reinsurance retrocessions, certain investment activities for Aflac Japan expose the Company to economic currency risk when yen are converted into U.S. dollars. As noted above, the Company invests a portion of its yen cash flows in U.S. dollar-denominated assets. This requires that the Company convert the yen cash flows to U.S. dollars before investing. As previously discussed, for certain of its U.S. dollar-denominated securities, the Company enters into foreign currency forward and option contracts to hedge the currency risk on the fair value of hedged investments. In 2018, the Parent Company entered into forward contracts to accomplish a dual objective of hedging foreign currency rate risk to dividend payments by Aflac Japan, and reducing enterprise-wide hedge costs. If the markets experience a significant strengthening of yen, this could cause cash strain at the Parent Company as a result of cash collateral and potentially cash settlement requirements. Based on the timing and severity of exchange rate fluctuations combined with the level of outstanding activity in this program, the cash strain at the Parent Company could be significant. +Aside from the activities discussed above, the Company generally does not convert yen into U.S. dollars; however, it does translate financial statement amounts from yen into U.S. dollars for financial reporting purposes. Therefore, reported amounts are affected by foreign currency fluctuations. The Company reports unrealized foreign currency translation gains and losses in AOCI. In periods when the yen weakens against the dollar, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into U.S. dollars causes more U.S. dollars to be reported. The weakening of the yen relative to the U.S. dollar will generally adversely affect the value of the Company's yen-denominated investments in U.S. dollar terms. The Company also considers the economic equity surplus in Aflac Japan and related exposure to foreign currency. The Company manages this currency risk by investing a portion of Aflac Japan's investment portfolio in U.S. dollar-denominated securities and by the Parent Company's issuance of yen-denominated debt. As a result, the effect of currency fluctuations on the Company's net assets is reduced. +The following table demonstrates the effect of foreign currency fluctuations by presenting the dollar values of the Company's yen-denominated assets and liabilities, and its consolidated yen-denominated net asset exposure at selected exchange rates as of December 31. +70 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Dollar Value of Yen-Denominated Assets and Liabilities +at Selected Exchange Rates +(In millions) +2019 +2018 +Yen/dollar exchange rates +94.56 +109.56 (1) +124.56 +96.00 +111.00 (1) +126.00 +Yen-denominated financial instruments: +Assets: +Securities available for sale: +Fixed maturity securities (2) +$ +60,391 +$ +52,123 +$ +45,846 +$ +55,600 +$ +48,086 +$ +42,362 +Fixed maturity securities - consolidated +variable interest entities (3) +995 +858 +755 +941 +814 +717 +Securities held to maturity: +Fixed maturity securities +34,858 +30,085 +26,462 +35,055 +30,318 +26,709 +Equity securities +763 +658 +579 +742 +641 +565 +Cash and cash equivalents +1,296 +1,119 +984 +988 +855 +753 +Derivatives +2,718 +482 +2,457 +2,712 +417 +949 +Other financial instruments +271 +234 +205 +253 +219 +192 +Subtotal +101,292 +85,559 +77,288 +96,291 +81,350 +72,247 +Liabilities: +Notes payable +2,968 +2,558 +2,253 +2,120 +1,831 +1,615 +Derivatives +1,807 +586 +3,463 +1,318 +387 +2,138 +Subtotal +4,775 +3,144 +5,716 +3,438 +2,218 +3,753 +Net yen-denominated financial instruments +96,517 +82,415 +71,572 +92,853 +79,132 +68,494 +Other yen-denominated assets +10,304 +8,893 +7,822 +10,795 +9,336 +8,225 +Other yen-denominated liabilities +118,869 +102,595 +90,240 +113,994 +98,590 +86,853 +Consolidated yen-denominated net assets +(liabilities) subject to foreign currency +fluctuation (2) +$ +(12,048 +) +$ +(11,287 +) +$ +(10,846 +) +$ +(10,346 +) +$ +(10,122 +) +$ +(10,134 +) +(1) Actual period-end exchange rate +(2) Does not include the U.S. dollar-denominated corporate bonds for which the Company has entered into foreign currency derivatives as discussed in the Aflac Japan Investment subsection of MD&A +(3) Does not include U.S. dollar-denominated bonds that have corresponding cross-currency swaps in consolidated VIEs +The Company is required to consolidate certain VIEs. Some of the consolidated VIEs in Aflac Japan's portfolio use foreign currency swaps to convert foreign denominated cash flows to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations. Foreign currency swaps exchange an initial principal amount in two currencies, agreeing to re-exchange the currencies at a future date, at an agreed upon exchange rate. There may also be periodic exchanges of payments at specified intervals based on the agreed upon rates and notional amounts. Prior to consolidation, the Company's beneficial interest in these VIEs was a yen-denominated available-for-sale fixed maturity security. Upon consolidation, the original yen-denominated investment was derecognized and the underlying fixed maturity securities and cross-currency swaps were recognized. The combination of a U.S. dollar-denominated investment and cross-currency swap economically creates a yen-denominated investment and has no impact on the Company's net investment hedge position. +Similarly, the combination of the U.S. corporate bonds and the foreign currency forwards and options that the Company has entered into, as discussed in the Aflac Japan Investment subsection of MD&A, economically creates a yen-denominated investment that qualifies for inclusion as a component of the Company's investment in Aflac Japan for net investment hedge purposes. +For additional information regarding the Company's Aflac Japan net investment hedge, see the Hedging Activities subsection of MD&A. +71 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Interest Rate Risk +The Company's primary interest rate exposure is to the impact of changes in interest rates on the fair value of its investments in debt securities. The Company monitors its investment portfolio on a quarterly basis utilizing a full valuation methodology, measuring price volatility, and sensitivity of the fair values of its investments to interest rate changes on the debt securities the Company owns. For example, if the current duration of a debt security is 10 years, then the fair value of that security will increase by approximately 10% if market interest rates decrease by 100 basis points, assuming all other factors remain constant. Likewise, the fair value of the debt security will decrease by approximately 10% if market interest rates increase by 100 basis points, assuming all other factors remain constant. +The estimated effect of potential increases in interest rates on the fair values of debt securities the Company owns; derivatives, excluding credit default swaps, and notes payable as of December 31 follows: +Sensitivity of Fair Values of Financial Instruments +to Interest Rate Changes +2019 +2018 +(In millions) +Fair +Value ++100 +Basis +Points +Fair +Value ++100 +Basis +Points +Assets: +Debt securities: +Fixed maturity securities: +Yen-denominated +$ +90,575 +$ +78,193 +$ +85,622 +$ +73,673 +Dollar-denominated +38,281 +35,013 +33,995 +31,327 +Total debt securities +$ +128,856 +$ +113,206 +$ +119,617 +$ +105,000 +Commercial mortgage and other loans +$ +9,648 +$ +9,540 +$ +6,893 +$ +6,834 +Derivatives +$ +482 +$ +527 +$ +417 +$ +614 +Liabilities: +Notes payable (1) +$ +6,935 +$ +6,065 +$ +5,876 +$ +5,415 +Derivatives +586 +463 +387 +422 +(1) Excludes lease obligations +There are various factors that affect the fair value of the Company's investment in debt securities. Included in those factors are changes in the prevailing interest rate environment, which directly affect the balance of unrealized gains or losses for a given period in relation to a prior period. Decreases in market yields generally improve the fair value of debt securities, while increases in market yields generally have a negative impact on the fair value of the Company's debt securities. However, the Company does not expect to realize a majority of any unrealized gains or losses. For additional information on unrealized losses on debt securities, see Note 3 of the Notes to the Consolidated Financial Statements. +The Company attempts to match the duration of its assets with the duration of its liabilities. The following table presents the approximate duration of Aflac Japan's yen-denominated assets and liabilities, along with premiums, as of December 31. +(In years) +2019 +2018 +Yen-denominated debt securities +15 +16 +Policy benefits and related expenses to be paid in future years +14 +15 +Premiums to be received in future years on policies in force +10 +10 +The following table presents the approximate duration of Aflac U.S. dollar-denominated assets and liabilities, along with premiums, as of December 31. +(In years) +2019 +2018 +Dollar-denominated debt securities +9 +9 +Policy benefits and related expenses to be paid in future years +8 +8 +Premiums to be received in future years on policies in force +6 +6 +72 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +The following table shows a comparison of average required interest rates for future policy benefits and investment yields, based on amortized cost, for the years ended December 31. +Comparison of Interest Rates for Future Policy Benefits +and Investment Yields +(Net of Investment Expenses) +2019 +2018 +U.S. +Japan +U.S. +Japan +Policies issued during year: +Required interest on policy reserves +3.68 +% +.96 +% +(1) +3.69 +% +1.00 +% +(1) +New money yield on investments +4.33 +3.70 +4.44 +2.94 +Policies in force at year-end: +Required interest on policy reserves +5.26 +3.20 +(1) +5.34 +3.29 +(1) +Portfolio book yield, end of period +5.22 +2.51 +5.44 +2.49 +(1) Represents investments for Aflac Japan that support policy obligations and therefore excludes Aflac Japan’s annuity products +Aflac Japan investment yields above includes U.S. dollar–denominated investment yields prior to factoring in amortized hedge costs. The Company continues to monitor the spread between its new money yield and the required interest assumption for newly issued products in both the U.S. and Japan and will re-evaluate those assumptions as necessary. Currently, when investments the Company owns mature, the proceeds may be reinvested at a yield below that of the interest required for the accretion of policy benefit liabilities on policies issued in earlier years. Overall, adequate profit margins exist in Aflac Japan's aggregate block of business because of changes in the mix of business and favorable experience from mortality, morbidity and expenses. +The Company holds investments and has issued debt with interest rates based on LIBOR, and also holds derivatives that reference LIBOR. Regulatory and industry initiatives to eliminate LIBOR as an interest rate benchmark may create uncertainty in the valuation of LIBOR-based loans, as well as for other LIBOR-based derivatives and assets. This may adversely impact both pricing and liquidity in such instruments. The Company is preparing for the expected discontinuation of LIBOR by identifying, assessing and monitoring risks associated with LIBOR transition. Preparation includes taking steps to update operational processes (including to support alternative reference rates) and models, as well as evaluating legacy contracts for any changes that may be required, including the determination of applicable fallbacks. +Periodically, the Company may enter into derivative transactions to hedge interest rate risk, depending on general economic conditions. For additional information on interest rate derivatives, see the Hedging Activities subsection of MD&A and Note 4 of the accompanying Notes to the Consolidated Financial Statements. +Credit Risk +A significant portion of the Company's investment portfolio consists of debt securities and loans that expose it to the credit risk of the underlying issuer or borrower. The Company carefully evaluates this risk on every new investment and closely monitors the credit risk of its existing investment portfolio. The Company incorporates the needs of its products and liabilities, the overall requirements of the business, and other factors in addition to its underwriting of the credit risk for each investment in the portfolio. +Evaluating the underlying risks in the Company's credit portfolio involves a multitude of factors including but not limited to its assessment of the issuer's or borrower's business activities, assets, products, market position, financial condition, and future prospects. The Company incorporates the assessment of the NRSROs in assigning credit ratings and incorporates the rating methodologies of its external managers in assigning loan ratings to portfolio holdings. The Company performs extensive internal assessments of the credit risks for all its portfolio holdings and potential new investments, which includes using analyses provided by the Company's specialist external managers. For assets managed by external asset managers, the Company provides investment and credit risk parameters that must be used when making investment decisions and requires ongoing monitoring and reporting from the asset managers on significant changes in credit risks within the portfolio. +73 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Investment Concentrations +The Company's 15 largest global investment exposures were as follows: +Largest Global Investment Positions +(In millions) +December 31, 2019 +Total +% of Total +No. +Consolidated Corporate/Sovereign Exposure +Consolidated +Fixed Maturity +Credit +Book Value +Securities +Rating +1 +Japan National Government (1) +$ +51,726 +47.26 +% +A+ +2 +Bank of America NA +416 +.38 +Bank of America Corp. +233 +.21 +A +Bank of America Corp. +183 +.17 +BBB+ +3 +Bank of Tokyo-Mitsubishi UFJ Ltd. +411 +.38 +A- +4 +Investcorp SA +388 +.35 +BB +5 +Republic of South Africa +365 +.33 +BB+ +6 +Banobras +338 +.31 +BBB+ +7 +Walt Disney Co. +330 +.30 +A +8 +Nordea Bank AB +306 +.28 +Nordea Bank AB +234 +.21 +A- +Nordea Bank AB +72 +.07 +BBB+ +9 +AXA +296 +.27 +BBB+ +10 +Japan Expswy Hld and Debt +295 +.27 +A+ +11 +Deutsche Telekom AG +295 +.27 +BBB+ +12 +AT&T Inc. +293 +.27 +BBB +13 +CFE +291 +.27 +BBB+ +14 +Petroleos Mexicanos (Pemex) +274 +.25 +BBB- +15 +Czech Republic +274 +.25 +AA- +Subtotal +$ +56,298 +51.44 +% +Total fixed maturity securities +$ +109,456 +100.00 +% +(1) JGBs or JGB-backed securities +As previously disclosed, the Company owns long-dated debt instruments in support of its long-dated policyholder obligations. Some of the Company's largest global investment holdings are positions that were purchased many years ago and increased in size due to merger and consolidation activity among the issuing entities. In addition, many of the Company's largest holdings are yen-denominated, therefore strengthening of the yen can increase its position in dollars, and weakening of the yen can decrease its position in dollars. The Company's global investment guidelines establish concentration limits for its investment portfolios. +Geographical Exposure +The following table indicates the geographic exposure of the Company's debt securities as of December 31. +74 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +2019 +2018 +(In millions) +Amortized Cost +% of +Total +Amortized Cost +% of +Total +Japan +$ +56,020 +51.2 +% +$ +55,486 +51.8 +% +United States and Canada (1) +30,321 +27.7 +29,371 +27.4 +United Kingdom +3,371 +3.1 +3,038 +2.8 +Germany +2,441 +2.2 +2,179 +2.0 +France +2,261 +2.1 +2,030 +1.9 +Peripheral Eurozone +1,788 +1.6 +2,165 +2.0 +Portugal +91 +.1 +215 +.2 +Italy +1,108 +1.0 +1,261 +1.2 +Ireland +12 +.0 +29 +.0 +Spain +577 +.5 +660 +.6 +Nordic Region +1,878 +1.7 +1,615 +1.6 +Sweden +972 +.9 +779 +.7 +Norway +383 +.3 +378 +.4 +Denmark +333 +.3 +270 +.3 +Finland +190 +.2 +188 +.2 +Other Europe +2,699 +2.5 +2,425 +2.3 +Netherlands +1,276 +1.2 +1,206 +1.1 +Switzerland +417 +.4 +258 +.2 +Czech Republic +484 +.4 +451 +.5 +Austria +127 +.1 +125 +.1 +Belgium +189 +.2 +178 +.2 +Poland +183 +.2 +180 +.2 +Luxembourg +23 +.0 +27 +.0 +Asia excluding Japan +2,671 +2.5 +2,722 +2.5 +Africa and Middle East +1,801 +1.6 +2,018 +1.9 +Latin America +2,183 +2.0 +2,153 +2.0 +Australia +1,774 +1.6 +1,620 +1.5 +All Others +248 +.2 +352 +.3 +Total fixed maturity securities +$ +109,456 +100.0 +% +$ +107,174 +100.0 +% +(1) Includes total exposure to Puerto Rico of $1 million of deposits at both December 31, 2019 and 2018, respectively, of which 100% had principal and interest insurance at both December 31, 2019 and 2018, respectively. +The primary factor considered when determining the domicile of investment exposure is the legal country risk location of the issuer. However, other factors such as the location of the parent guarantor, the location of the company's headquarters or major business operations (including location of major assets), location of primary market (including location of revenue generation) and specific country risk publicly recognized by rating agencies can influence the assignment of the country (or geographic) risk location. When the issuer is a special financing vehicle or a branch or subsidiary of a global company, then the Company considers any guarantees and/or legal, regulatory and corporate relationships of the issuer relative to its ultimate parent in determining the proper assignment of country risk. +75 +Item 7A. Quantitative and Qualitative Disclosures About Market Risk +Derivative Counterparties +The Company is a direct counterparty to the majority of derivative instruments and is exposed to credit risk in the event of nonperformance by the counterparties in those contracts. For the foreign currency swaps associated with the Company's VIE investments for which it is the primary beneficiary, the Company bears the risk of foreign exchange and/or credit loss due to counterparty default even though it is not a direct counterparty to those contracts. The risk of counterparty default for the Company's VIE and senior note and subordinated debenture swaps, foreign currency swaps, certain foreign currency forwards, foreign currency options and interest rate swaptions is mitigated by collateral posting requirements that counterparties to those transactions must meet. If collateral posting agreements are not in place, the counterparty risk associated with foreign currency forwards and foreign currency options is the risk that at expiry of the contract, the counterparty is unable to deliver the agreed upon amount of yen at the agreed upon price or delivery date, thus exposing the Company to additional unhedged exposure to U.S. dollars in the Aflac Japan investment portfolio. See Note 4 of the accompanying Notes to the Consolidated Financial Statements for more information. +Equity Risk +Market prices for equity securities are subject to fluctuation and consequently the amount realized in the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from the relative price of alternative investments and general market conditions. If equity prices experienced a hypothetical broad-based decline of 10%, the fair value of the Company's equity investments would decline by approximately $80 million . +76 +Item 8. Financial Statements and Supplementary Data +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +Report of Independent Registered Public Accounting Firm +78 +Consolidated Financial Statements +82 +Consolidated Statements of Earnings +82 +Consolidated Statements of Comprehensive Income +83 +Consolidated Balance Sheets +84 +Consolidated Statements of Shareholders' Equity +85 +Consolidated Statements of Cash Flow +86 +Notes to the Consolidated Financial Statements +87 +Note 1. Summary of Significant Accounting Policies +87 +Note 2. Business Segment and Foreign Information +103 +Note 3. Investments +105 +Note 4. Derivative Instruments +118 +Note 5. Fair Value Measurements +128 +Note 6. Deferred Policy Acquisition Costs and Insurance Expenses +142 +Note 7. Policy Liabilities +143 +Note 8. Reinsurance +145 +Note 9. Notes Payable and Lease Obligations +146 +Note 10. Income Taxes +151 +Note 11. Shareholders' Equity +153 +Note 12. Share-Based Compensation +157 +Note 13. Statutory Accounting and Dividend Restrictions +161 +Note 14. Benefit Plans +163 +Note 15. Commitments and Contingent Liabilities +167 +Note 16. Unaudited Consolidated Quarterly Financial Data +168 +Note 17. Subsequent Events +169 +Management's Annual Report on Internal Control Over Financial Reporting +Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Exchange Act. Under the supervision and with the participation of the Company's management, including its principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013. Based on the Company's evaluation under this framework, management has concluded that the Company's internal control over financial reporting was effective as of December 31, 2019 . +KPMG LLP, an independent registered public accounting firm, has issued an attestation report on the effectiveness of internal control over financial reporting as of December 31, 2019 , which is included herein. +77 +Item 8. Financial Statements and Supplementary Data +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors +Aflac Incorporated: +Opinion on Internal Control Over Financial Reporting +We have audited Aflac Incorporated and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of earnings, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2019, and the related notes and financial statement schedules II, III, and IV (collectively, the consolidated financial statements), and our report dated February 21, 2020 expressed an unqualified opinion on those consolidated financial statements. +Basis for Opinion +The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +Definition and Limitations of Internal Control Over Financial Reporting +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +/s/ KPMG LLP +Atlanta, Georgia +February 21, 2020 +78 +Item 8. Financial Statements and Supplementary Data +Report of Independent Registered Public Accounting Firm +To the Shareholders and Board of Directors +Aflac Incorporated: +Opinion on the Consolidated Financial Statements +We have audited the accompanying consolidated balance sheets of Aflac Incorporated and subsidiaries (the Company) as of December 31, 2019 and 2018, the related consolidated statements of earnings, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three‑year period ended December 31, 2019, and the related notes and financial statement schedules II, III, and IV (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the years in the three‑year period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 2013, and our report dated February 21, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +Basis for Opinion +These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. +We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. +79 +Item 8. Financial Statements and Supplementary Data +Critical Audit Matters +The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. +Assessment of the measurement of fair value of certain investments and derivatives +As discussed in Note 5 to the consolidated financial statements, the Company has certain privately issued securities and derivative instruments associated with variable interest entities (VIEs) that require significant judgment in the estimation of fair value. The fair value of privately issued securities are estimated using valuation models developed by a third party pricing vendor and require judgment to determine the inputs and assumptions used in the valuation models, such as credit default swap (CDS) spreads and the selection of comparable securities, when appropriate. The fair value of the Company’s derivatives associated with VIEs are also estimated using valuation models developed by a third party pricing vendor. Given the long duration of derivatives associated with VIEs, the estimate of the fair value requires judgment to extrapolate short-term observable data into long-term inputs for use in the valuation models. As of December 31, 2019, the value of privately issued securities are included within the financial statement captions of fixed maturity securities available for sale, at fair value; fixed maturity securities available for sale - consolidated variable interest entities, at fair value; and, fixed maturity securities held to maturity, at amortized cost, which totaled $86,950 million, $4,312 million, and $30,085 million, respectively. As of December 31, 2019, the fair value of derivatives associated with VIEs are included within the financial statement captions of other assets and other liabilities, which totaled $2,368 million and $3,440 million, respectively. +We identified the assessment of the measurement of fair value of certain privately issued securities and derivative instruments associated with VIEs as a critical audit matter. Due to the complexity of the valuation models, specialized valuation skills and knowledge and subjective auditor judgment were needed to evaluate the valuation models and the inputs and assumptions used in the models to estimate fair value. +The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls, with the involvement of valuation professionals when appropriate, over the Company’s process to estimate the fair value of such securities and derivative instruments, including controls over the Company’s evaluation of the inputs, assumptions and estimates of fair value obtained from its third party pricing vendor. We involved valuation professionals with specialized skills and knowledge to assist in assessing the estimated fair values of such securities and derivative instruments, which included: +– +Evaluating the inputs and assumptions used in the models to estimate the fair value of the privately issued securities, including an assessment of the determination of comparable securities and/or CDS spreads used by the third party pricing vendor for a selection of privately issued securities. +– +Assessing the internal models used by the Company to evaluate the fair values for privately issued securities and derivatives associated with VIEs obtained from the third party pricing vendor. We observed that differences, if any, in fair value between the Company and the third party pricing vendor above pre-established tolerances were investigated by the Company. +– +Developing an independent estimate of the fair value for a selection of privately issued securities and derivative instruments associated with VIEs and comparing our independent estimate to the fair value measurement recorded by the Company. +80 +Item 8. Financial Statements and Supplementary Data +Assessment of the estimate of unpaid policy claims +As discussed in Note 1 to the consolidated financial statements, unpaid policy claims are estimates computed primarily on an undiscounted basis using statistical analyses of historical claims experience adjusted for current trends and changed conditions. The estimates are evaluated by the Company and, as new claim experience emerges, the estimates are adjusted as necessary. As of December 31, 2019, the Company recorded a liability for unpaid policy claims of $4,659 million. +We identified the assessment of the estimate of unpaid policy claims as a critical audit matter. Specialized actuarial skills and knowledge and subjective auditor judgment were needed to evaluate the actuarial methodologies and assumptions used to estimate the unpaid policy claims liability and determine that the Company’s methodologies are consistent with generally accepted actuarial methodologies. +The primary procedures we performed to address this critical audit matter included the following. We tested, with the involvement of actuarial professionals when appropriate, certain internal controls over the Company’s process to estimate the unpaid policy claims liability, including controls related to the evaluation of the actuarial methodologies and assumptions used in the calculation of the unpaid policy claims liability. We involved actuarial professionals with specialized skills and knowledge to assist in assessing the unpaid policy claims liability, which included: +– +Assessing the actuarial methodologies and assumptions utilized by the Company by comparing them to generally accepted actuarial methodologies and historical results. +– +Evaluating the Company’s estimate of the unpaid policy claims liability by comparing to historical results and our expectations of changes in the estimate. +– +Developing an independent range for the estimate of unpaid policy claims for certain products to evaluate the Company’s recorded liability and assessing any movement of the recorded liability within our range. +– +Evaluating the Company’s historical ability to estimate unpaid policy claims by comparing the unpaid policy claims liability for certain products recorded by the Company at various historical periods to an independent range developed using claims paid through December 31, 2019. +/s/ KPMG LLP +We have served as the Company’s auditor since 1963. +Atlanta, Georgia +February 21, 2020 +81 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Earnings +Years Ended December 31, +(In millions, except for share and per-share amounts) +2019 +2018 +2017 +Revenues: +Net premiums, principally supplemental health insurance +$ +18,780 +$ +18,677 +$ +18,531 +Net investment income +3,578 +3,442 +3,220 +Realized investment gains (losses): +Other-than-temporary impairment losses realized and loan loss reserves +( 31 +) +( 81 +) +( 37 +) +Other gains (losses) +( 104 +) +( 349 +) +( 114 +) +Total realized investment gains (losses) +( 135 +) +( 430 +) +( 151 +) +Other income (loss) +84 +69 +67 +Total revenues +22,307 +21,758 +21,667 +Benefits and expenses: +Benefits and claims, net +11,942 +12,000 +12,181 +Acquisition and operating expenses: +Amortization of deferred policy acquisition costs +1,282 +1,245 +1,132 +Insurance commissions +1,321 +1,320 +1,316 +Insurance and other expenses (1) +3,089 +2,988 +2,780 +Interest expense +228 +222 +240 +Total acquisition and operating expenses +5,920 +5,775 +5,468 +Total benefits and expenses +17,862 +17,775 +17,649 +Earnings before income taxes +4,445 +3,983 +4,018 +Income tax expense: +Current +806 +1,379 +631 +Deferred +335 +( 316 +) +( 1,217 +) +Income taxes +1,141 +1,063 +( 586 +) +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +Net earnings per share: +Basic +$ +4.45 +$ +3.79 +$ +5.81 +Diluted +4.43 +3.77 +5.77 +Weighted-average outstanding common shares used in +computing earnings per share (In thousands): +Basic +742,414 +769,588 +792,042 +Diluted +746,430 +774,650 +797,861 +(1) Includes expense of $ 13 in 2017 for the early extinguishment of debt +See the accompanying Notes to the Consolidated Financial Statements. +82 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Comprehensive Income (Loss) +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +Other comprehensive income (loss) before income taxes: +Unrealized foreign currency translation gains (losses) during +period +252 +232 +286 +Unrealized gains (losses) on fixed maturity securities: +Unrealized holding gains (losses) on fixed maturity securities +during period +5,870 +( 3,155 +) +1,731 +Reclassification adjustment for realized (gains) losses on +fixed maturity securities included in net earnings +( 18 +) +46 +2 +Unrealized gains (losses) on derivatives during period +( 12 +) +2 +1 +Pension liability adjustment during period +( 85 +) +( 25 +) +9 +Total other comprehensive income (loss) before income taxes +6,007 +( 2,900 +) +2,029 +Income tax expense (benefit) related to items of other comprehensive +income (loss) +1,543 +( 797 +) +631 +Other comprehensive income (loss), net of income taxes +4,464 +( 2,103 +) +1,398 +Total comprehensive income (loss) +$ +7,768 +$ +817 +$ +6,002 +See the accompanying Notes to the Consolidated Financial Statements. +83 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Balance Sheets +December 31, +(In millions, except for share and per-share amounts) +2019 +2018 +Assets: +Investments and cash: +Fixed maturity securities available for sale, at fair value +(amortized cost $76,063 in 2019 and $73,007 in 2018) +$ +86,950 +$ +78,429 +Fixed maturity securities available for sale - consolidated variable interest entities, at fair value +(amortized cost $3,308 in 2019 and $3,849 in 2018) +4,312 +4,466 +Fixed maturity securities held to maturity, at amortized cost +(fair value $37,594 in 2019 and $36,722 in 2018) +30,085 +30,318 +Equity securities, at fair value +802 +987 +Commercial mortgage and other loans +(includes $7,956 in 2019 and $5,528 in 2018 of consolidated variable interest entities) +9,569 +6,919 +Other investments +(includes $494 in 2019 and $328 in 2018 of consolidated variable interest entities) +1,477 +787 +Cash and cash equivalents +4,896 +4,337 +Total investments and cash +138,091 +126,243 +Receivables +828 +851 +Accrued investment income +772 +773 +Deferred policy acquisition costs +10,128 +9,875 +Property and equipment, at cost less accumulated depreciation (1) +581 +443 +Other +2,368 +2,221 +Total assets +$ +152,768 +$ +140,406 +Liabilities and shareholders’ equity: +Liabilities: +Policy liabilities: +Future policy benefits +$ +90,335 +$ +86,368 +Unpaid policy claims +4,659 +4,584 +Unearned premiums +4,243 +5,090 +Other policyholders’ funds +7,317 +7,146 +Total policy liabilities +106,554 +103,188 +Income taxes +5,370 +4,020 +Payables for return of cash collateral on loaned securities +1,876 +1,052 +Notes payable and lease obligations (1) +6,569 +5,778 +Other +3,440 +2,906 +Total liabilities +123,809 +116,944 +Commitments and contingent liabilities (Note 15) +Shareholders’ equity: +Common stock of $.10 par value. In thousands: authorized 1,900,000 +shares in 2019 and 2018; issued 1,349,309 shares in 2019 and 1,347,540 +shares in 2018 +135 +135 +Additional paid-in capital +2,313 +2,177 +Retained earnings +34,291 +31,788 +Accumulated other comprehensive income (loss): +Unrealized foreign currency translation gains (losses) +( 1,623 +) +( 1,847 +) +Unrealized gains (losses) on fixed maturity securities +8,548 +4,234 +Unrealized gains (losses) on derivatives +( 33 +) +( 24 +) +Pension liability adjustment +( 277 +) +( 212 +) +Treasury stock, at average cost +( 14,395 +) +( 12,789 +) +Total shareholders’ equity +28,959 +23,462 +Total liabilities and shareholders’ equity +$ +152,768 +$ +140,406 +(1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2019 related to leases. +See the accompanying Notes to the Consolidated Financial Statements. +84 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Shareholders’ Equity +(In millions, except for per share amounts) +Common Stock +Additional Paid-in Capital +Retained Earnings +Accumulated Other Comprehensive Income (Loss) +Treasury Stock +Total +Shareholders' +Equity +Balance at December 31, 2016 +$ +135 +$ +1,908 +$ +25,981 +$ +2,630 +$ +( 10,172 +) +$ +20,482 +Net earnings +0 +0 +4,604 +0 +0 +4,604 +Unrealized foreign currency translation +gains (losses) during period, net of +income tax +0 +0 +0 +233 +0 +233 +Unrealized gains (losses) on fixed maturity +securities during period, net of income +taxes and reclassification adjustments +0 +0 +0 +1,159 +0 +1,159 +Unrealized gains (losses) on derivatives +during period, net of income taxes +0 +0 +0 +1 +0 +1 +Pension liability adjustment during period, +net of income taxes +0 +0 +0 +5 +0 +5 +Dividends to shareholders +($.87 per share) +0 +0 +( 690 +) +0 +0 +( 690 +) +Exercise of stock options +0 +38 +0 +0 +0 +38 +Share-based compensation +0 +51 +0 +0 +0 +51 +Purchases of treasury stock +0 +0 +0 +0 +( 1,391 +) +( 1,391 +) +Treasury stock reissued +0 +55 +0 +0 +51 +106 +Balance at December 31, 2017 +135 +2,052 +29,895 +4,028 +( 11,512 +) +24,598 +Cumulative effect of change in accounting +principles, net of income tax (1) +0 +0 +( 226 +) +226 +0 +0 +Net earnings +0 +0 +2,920 +0 +0 +2,920 +Unrealized foreign currency translation +gains (losses) during period, net of +income tax +0 +0 +0 +228 +0 +228 +Unrealized gains (losses) on fixed maturity +securities during period, net of income +taxes and reclassification adjustments +0 +0 +0 +( 2,316 +) +0 +( 2,316 +) +Unrealized gains (losses) on derivatives +during period, net of income taxes +0 +0 +0 +2 +0 +2 +Pension liability adjustment during period, +net of income taxes +0 +0 +0 +( 17 +) +0 +( 17 +) +Dividends to shareholders +($1.04 per share) +0 +0 +( 801 +) +0 +0 +( 801 +) +Exercise of stock options +0 +34 +0 +0 +0 +34 +Share-based compensation +0 +54 +0 +0 +0 +54 +Purchases of treasury stock +0 +0 +0 +0 +( 1,317 +) +( 1,317 +) +Treasury stock reissued +0 +37 +0 +0 +40 +77 +Balance at December 31, 2018 +135 +2,177 +31,788 +2,151 +( 12,789 +) +23,462 +Net earnings +0 +0 +3,304 +0 +0 +3,304 +Unrealized foreign currency translation +gains (losses) during period, net of +income tax +0 +0 +0 +224 +0 +224 +Unrealized gains (losses) on fixed maturity +securities during period, net of income +taxes and reclassification adjustments +0 +0 +0 +4,314 +0 +4,314 +Unrealized gains (losses) on derivatives +during period, net of income taxes +0 +0 +0 +( 9 +) +0 +( 9 +) +Pension liability adjustment during period, +net of income taxes +0 +0 +0 +( 65 +) +0 +( 65 +) +Dividends to shareholders +($1.08 per share) +0 +0 +( 801 +) +0 +0 +( 801 +) +Exercise of stock options +0 +29 +0 +0 +0 +29 +Share-based compensation +0 +54 +0 +0 +0 +54 +Purchases of treasury stock +0 +0 +0 +0 +( 1,656 +) +( 1,656 +) +Treasury stock reissued +0 +53 +0 +0 +50 +103 +Balance at December 31, 2019 +$ +135 +$ +2,313 +$ +34,291 +$ +6,615 +$ +( 14,395 +) +$ +28,959 +(1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2018. +See the accompanying Notes to the Consolidated Financial Statements. +85 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Consolidated Statements of Cash Flows +Years Ended December 31, +(In millions) +2019 +2018 +2017 +Cash flows from operating activities: +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +Adjustments to reconcile net earnings to net cash provided (used) by operating activities: +Change in receivables and advance premiums +( 32 +) +( 55 +) +( 91 +) +Capitalization of deferred policy acquisition costs +( 1,452 +) +( 1,504 +) +( 1,468 +) +Amortization of deferred policy acquisition costs +1,282 +1,245 +1,132 +Increase in policy liabilities +2,104 +2,343 +2,890 +Change in income tax liabilities +( 244 +) +64 +( 1,240 +) +Realized investment (gains) losses +135 +430 +151 +Other, net +358 +571 +150 +Net cash provided (used) by operating activities +5,455 +6,014 +6,128 +Cash flows from investing activities: +Proceeds from investments sold or matured: +Available-for-sale fixed maturity securities +5,284 +7,888 +4,680 +Equity securities +650 +429 +902 +Held-to-maturity fixed maturity securities +622 +1,670 +2,212 +Commercial mortgage and other loans +1,814 +936 +303 +Costs of investments acquired: +Available-for-sale fixed maturity securities +( 6,934 +) +( 9,086 +) +( 9,867 +) +Equity securities +( 347 +) +( 440 +) +( 446 +) +Commercial mortgage and other loans +( 4,401 +) +( 4,848 +) +( 2,115 +) +Other investments, net +( 653 +) +( 414 +) +( 206 +) +Settlement of derivatives, net +( 9 +) +( 241 +) +( 621 +) +Cash received (pledged or returned) as collateral, net +926 +348 +( 205 +) +Other, net +( 123 +) +176 +( 68 +) +Net cash provided (used) by investing activities +( 3,171 +) +( 3,582 +) +( 5,431 +) +Cash flows from financing activities: +Purchases of treasury stock +( 1,627 +) +( 1,301 +) +( 1,351 +) +Proceeds from borrowings +615 +1,020 +1,040 +Principal payments under debt obligations +0 +( 550 +) +( 1,161 +) +Dividends paid to shareholders +( 771 +) +( 793 +) +( 661 +) +Change in investment-type contracts, net +( 1 +) +( 31 +) +35 +Treasury stock reissued +49 +58 +33 +Other, net +22 +( 19 +) +0 +Net cash provided (used) by financing activities +( 1,713 +) +( 1,616 +) +( 2,065 +) +Effect of exchange rate changes on cash and cash equivalents +( 12 +) +30 +0 +Net change in cash and cash equivalents +559 +846 +( 1,368 +) +Cash and cash equivalents, beginning of period +4,337 +3,491 +4,859 +Cash and cash equivalents, end of period +$ +4,896 +$ +4,337 +$ +3,491 +Supplemental disclosures of cash flow information: +Income taxes paid +$ +1,384 +$ +998 +$ +780 +Interest paid +190 +181 +196 +Noncash interest +37 +41 +44 +Impairment losses and loan loss reserves included in realized investment losses +31 +81 +37 +Noncash financing activities: +Lease obligations +132 +11 +12 +Treasury stock issued for: +Associate stock bonus +15 +7 +29 +Shareholder dividend reinvestment +30 +8 +29 +Share-based compensation grants +5 +2 +1 +See the accompanying Notes to the Consolidated Financial Statements. +86 +Item 8. Financial Statements and Supplementary Data +Aflac Incorporated and Subsidiaries +Notes to the Consolidated Financial Statements +1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES +Description of Business   +Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) primarily sell supplemental health and life insurance in the United States (U.S.) and Japan. The Company's insurance business is marketed and administered through American Family Life Assurance Company of Columbus (Aflac) in the U.S. and, effective April 1, 2018, through Aflac Life Insurance Japan Ltd. (ALIJ) in Japan. Prior to April 1, 2018, the Company's insurance business was marketed in Japan as a branch of Aflac. The Company’s operations consist of two reportable business segments: Aflac U.S., which includes Aflac, and Aflac Japan, which includes ALIJ. American Family Life Assurance Company of New York (Aflac New York) is a wholly owned subsidiary of Aflac. Most of Aflac's policies are individually underwritten and marketed through independent agents. Additionally, Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. The Company's insurance operations in the U.S. and Japan service the two markets for the Company's insurance business. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 69 % of the Company's total revenues in 2019 , compared with 70 % in both 2018 and 2017 . The percentage of the Company's total assets attributable to Aflac Japan was 83 % at December 31, 2019 , compared with 84 % at December 31, 2018 . +In November 2019, the Company acquired Argus Holdings, LLC and its subsidiary Argus Dental & Vision, Inc. (Argus), a benefits management organization and national network dental and vision company, which provides a platform for Aflac Dental and Vision. The Company paid $ 75 million at closing and made an additional commitment of up to $ 21 million in contingent consideration payable over three years based on the achievement by Argus of certain performance targets. Argus is an addition to the Aflac U.S. segment. +Basis of Presentation +The Company prepares its financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP). These principles are established primarily by the Financial Accounting Standards Board (FASB). In these Notes to the Consolidated Financial Statements, references to U.S. GAAP issued by the FASB are derived from the FASB Accounting Standards Codification TM (ASC). The preparation of financial statements in conformity with U.S. GAAP requires the Company to make estimates based on currently available information when recording transactions resulting from business operations. The most significant items on the Company's balance sheet that involve a greater degree of accounting estimates and actuarial determinations subject to changes in the future are the valuation of investments and derivatives, deferred policy acquisition costs (DAC), liabilities for future policy benefits and unpaid policy claims, and income taxes. These accounting estimates and actuarial determinations are sensitive to market conditions, investment yields, mortality, morbidity, commission and other acquisition expenses, and terminations by policyholders. As additional information becomes available, or actual amounts are determinable, the recorded estimates will be revised and reflected in operating results. Although some variability is inherent in these estimates, the Company believes the amounts provided are adequate. +The consolidated financial statements include the accounts of the Parent Company, its subsidiaries, and those entities required to be consolidated under applicable accounting standards. All material intercompany accounts and transactions have been eliminated. +Significant Accounting Policies +Foreign Currency Translation:  The functional currency of Aflac Japan is the Japanese yen. The Company translates its yen-denominated financial statement accounts into U.S. dollars as follows. Assets and liabilities are translated at end-of-period exchange rates. Realized gains and losses on security transactions are translated at the exchange rate on the trade date of each transaction. Other revenues, expenses, and cash flows are translated using average exchange rates for the period. The resulting currency translation adjustments are reported in accumulated other comprehensive income. The Company includes in earnings the realized currency exchange gains and losses resulting from foreign currency transactions. +The Parent Company has designated a majority of its yen-denominated liabilities (notes payable and yen-denominated loans) as non-derivative hedges and from time-to-time may designate certain foreign currency forwards and options as derivative hedges of the foreign currency exposure of the Company's net investment in Aflac Japan. Outstanding principal and related accrued interest on these Parent Company liabilities and the fair value of these derivatives are translated into U.S. dollars at end-of-period exchange rates. Currency translation adjustments and changes in the fair value of these +87 +Item 8. Financial Statements and Supplementary Data +derivatives are recorded as unrealized foreign currency translation gains (losses) in other comprehensive income and are included in accumulated other comprehensive income. +Insurance Revenue and Expense Recognition:  Substantially all of the supplemental health and life insurance policies the Company issues are classified as long-duration contracts. The contract provisions generally cannot be changed or canceled during the contract period; however, the Company may adjust premiums for supplemental health policies issued in the U.S. within prescribed guidelines and with the approval of state insurance regulatory authorities. +Insurance premiums for most of the Company's health and life policies, including cancer, accident, hospital, critical illness, dental, vision, term life, whole life, long-term care and disability, are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. When revenues are reported, the related amounts of benefits and expenses are charged against such revenues, so that profits are recognized in proportion to premium revenues during the period the policies are expected to remain in force. This association is accomplished by means of annual additions to the liability for future policy benefits and the deferral and subsequent amortization of policy acquisition costs. +Premiums from the Company's products with limited-pay features, including term life, whole life, WAYS, and child endowment, are collected over a significantly shorter period than the period over which benefits are provided. Premiums for these products are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. Any gross premium in excess of the net premium is deferred and recorded in earnings, such that profits are recognized in a constant relationship with insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net premium method. +At the policyholder's option, customers can also pay discounted advanced premiums for certain of the Company's products. Advanced premiums are deferred and recognized when due from policyholders over the regularly scheduled premium payment period. +The calculation of DAC and the liability for future policy benefits requires the use of estimates based on sound actuarial valuation techniques. For new policy issues, the Company reviews its actuarial assumptions and deferrable acquisition costs each year and revises them when necessary to more closely reflect recent experience and studies of actual acquisition costs. For policies in force, the Company evaluates DAC by major product groupings to determine that they are recoverable from future revenues, and any amounts determined not to be recoverable are charged against net earnings. The Company has not had any material charges to earnings for DAC that was determined not to be recoverable in any of the years presented in this Form 10-K. +Advertising expense is reported as incurred in insurance expenses in the consolidated statements of earnings. +Cash and Cash Equivalents:  Cash and cash equivalents include cash on hand, money market instruments, and other debt instruments with a maturity of 90 days or less when purchased. +Investments:  The Company's debt securities consist of fixed maturity securities, which are classified as either held to maturity or available for sale. Securities classified as held to maturity are securities that the Company has the ability and intent to hold to maturity or redemption and are carried at amortized cost. All other fixed maturity debt securities are classified as available for sale and are carried at fair value. If the fair value is higher than the amortized cost for debt securities, the excess is an unrealized gain, and if lower than cost, the difference is an unrealized loss. The net unrealized gains and losses on securities available for sale, less related deferred income taxes, are recorded through other comprehensive income and included in accumulated other comprehensive income. +Amortized cost of debt securities is based on the Company's purchase price adjusted for accrual of discount, or amortization of premium, and recognition of impairment charges, if any. The amortized cost of debt securities the Company purchases at a discount or premium will equal the face or par value at maturity or the call date, if applicable. Interest is reported as income when earned and is adjusted for amortization of any premium or discount. +The Company has investments in marketable equity securities which are carried at fair value. Changes in the fair value of equity securities are recorded in earnings as a component of realized investment gains and losses. +The Company has investments in variable interest entities (VIEs). Criteria for evaluating VIEs for consolidation focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity's economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. The Company is the primary beneficiary of certain VIEs, and therefore consolidates these entities in its financial statements. While the consolidated VIEs generally operate within a defined set of contractual terms, there are certain powers +88 +Item 8. Financial Statements and Supplementary Data +that are retained by the Company that are considered significant in the conclusion that the Company is the primary beneficiary. These powers vary by structure but generally include the initial selection of the underlying collateral; the ability to obtain the underlying collateral in the event of default; and, the ability to appoint or dismiss key parties in the structure. In particular, the Company's powers surrounding the underlying collateral were considered to be the most significant powers because those most significantly impact the economics of the VIE. The Company has no obligation to provide any continuing financial support to any of the entities in which it is the primary beneficiary. The Company's maximum loss is limited to its original investment. Neither the Company nor any of its creditors have the ability to obtain the underlying collateral, nor does the Company have control over the instruments held in the VIEs, unless there is an event of default. For those entities where the Company is the primary beneficiary, the consolidated entity's assets are segregated on the balance sheet by the caption "consolidated variable interest entities," and consist of fixed maturity securities, equity securities, loan receivables, limited partnerships and derivative instruments. +For the mortgage- and asset-backed securities held in the Company's fixed maturity portfolio, the Company recognizes income using a constant effective yield, which is based on anticipated prepayments and the estimated economic life of the securities. When estimates of prepayments change, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in mortgage- and asset-backed securities is adjusted to the amount that would have existed had the new effective yield been applied at the time of acquisition. This adjustment is reflected in net investment income. +The Company uses the specific identification method to determine the gain or loss from securities transactions and report the realized gain or loss in the consolidated statements of earnings. Securities transactions are accounted for based on values as of the trade date of the transaction. +An investment in a fixed maturity security is impaired if the fair value falls below amortized cost. The Company regularly reviews its fixed maturity security investments portfolio for declines in fair value. The Company's fixed maturity security investments are evaluated for other-than-temporary impairment using its debt impairment model. The Company's debt impairment model focuses on the ultimate collection of the cash flows from its investments and whether the Company has the intent to sell or if it is more likely than not the Company would be required to sell the security prior to recovery of its amortized cost. The determination of the amount of impairments under this model is based upon the Company's periodic evaluation and assessment of known and inherent risks associated with the respective securities. Such evaluations and assessments are revised as conditions change and new information becomes available. +When determining the Company's intention to sell a security prior to recovery of its fair value to amortized cost, the Company evaluates facts and circumstances such as, but not limited to, future cash flow needs, decisions to reposition its security portfolio, and risk profile of individual investment holdings. The Company performs ongoing analyses of its liquidity needs, which includes cash flow testing of its policy liabilities, debt maturities, projected dividend payments, and other cash flow and liquidity needs. +The determination of whether an impairment in value of the Company's fixed maturity securities is other than temporary is based largely on the Company's evaluation of the issuer ' s creditworthiness. The Company must apply considerable judgment in determining the likelihood of its fixed maturity securities recovering in value. Factors that may influence this include the overall level of interest rates, credit spreads, the credit quality of the underlying issuer, and other factors. This process requires consideration of risks which can be controlled to a certain extent, such as credit risk, and risks which cannot be controlled, such as interest rate risk and foreign currency risk. +If, after monitoring and analyses, management believes that fair value will not recover to amortized cost, the Company recognizes an other-than-temporary impairment of the security. Once a security is considered to be other-than-temporarily impaired, the impairment loss is separated into two components: the portion of the impairment related to credit and the portion of the impairment related to factors other than credit. The Company recognizes a charge to earnings for the credit-related portion of other-than-temporary impairments. Impairments related to factors other than credit are charged to earnings in the event the Company intends to sell the security prior to the recovery of its amortized cost or if it is more likely than not that the Company would be required to dispose of the security prior to recovery of its amortized cost; otherwise, non-credit-related other-than-temporary impairments are charged to other comprehensive income. +The Company lends fixed maturity and public equity securities to financial institutions in short-term security-lending transactions. These securities continue to be carried as investment assets on the Company's balance sheet during the terms of the loans and are not reported as sales. The Company receives cash or other securities as collateral for such loans. For loans involving unrestricted cash or securities as collateral, the collateral is reported as an asset with a corresponding liability for the return of the collateral. For loans where the Company receives as collateral securities that the Company is not permitted to sell or repledge, the collateral is not reported as an asset. +89 +Item 8. Financial Statements and Supplementary Data +Commercial mortgage and other loans include transitional real estate loans (TREs), commercial mortgage loans (CMLs) and middle market loans (MMLs). The Company's investments in TREs, CMLs, and MMLs are accounted for as loan receivables and are recorded at amortized cost on the acquisition date. The Company has the intent and ability to hold these loan receivables for the foreseeable future or until they mature and therefore, they are considered held for investment and are carried at amortized cost in the commercial mortgage and other loans line in its consolidated balance sheets. The amortized cost of the loan receivables reflects allowances for expected incurred losses estimated based on past events and current economic conditions as of each reporting date. +Other investments include policy loans, limited partnerships, and short-term investments with maturities at the time of purchase of one year or less, but greater than 90 days. Limited partnerships are accounted for using the equity method of accounting. Under the equity method of accounting, the Company reports its portion of partnership earnings as a component of net investment income in its consolidated statements of earnings. The underlying investments held by the Company’s limited partnerships primarily consist of private equity and real estate. Short-term investments are stated at amortized cost, which approximates fair value. +Derivatives and Hedging:  Freestanding derivative instruments are reported in the consolidated balance sheet at fair value and are reported in other assets and other liabilities, with changes in value reported in earnings and/or other comprehensive income. These freestanding derivatives are foreign currency forwards, foreign currency options, foreign currency swaps, interest rate swaps, interest rate swaptions, and, in prior year periods, credit default swaps (CDSs). The Company does not use derivatives for trading purposes, nor does the Company engage in leveraged derivative transactions. +From time to time, the Company purchases certain investments that contain an embedded derivative. The Company assesses whether this embedded derivative is clearly and closely related to the asset that serves as its host contract. If the Company deems that the embedded derivative's terms are not clearly and closely related to the host contract, and a separate instrument with the same terms would qualify as a derivative instrument, the derivative is separated from that contract, held at fair value, and reported with the host instrument in the consolidated balance sheet, with changes in fair value reported in earnings. If the Company has elected the fair value option, the embedded derivative is not bifurcated, and the entire investment is held at fair value with changes in fair value reported in earnings. +See Note 5 for a discussion on how the Company determines the fair value of its derivatives. Accruals on derivatives are typically recorded in other assets or within other liabilities in the consolidated balance sheets. +To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated risk attributable to the hedged item. At the inception of hedging relationships the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objectives and strategies for undertaking the respective hedging relationship, and the methodology that will be used to assess the effectiveness of the hedge relationship at and subsequent to hedge inception. The Company documents the designation of each hedge as either (i) a hedge of the variability of cash flows to be received or paid related to a recognized asset or liability or the hedge of a forecasted transaction ("cash flow hedge"); (ii) a hedge of the estimated fair value of a recognized asset or liability ("fair value hedge"); or (iii) a hedge of a net investment in a foreign operation. The documentation process includes linking derivatives and non-derivative financial instruments that are designated as hedges to specific assets or groups of assets or liabilities in the statement of financial position or to specific forecasted transactions and defining the effectiveness testing methods to be used. At the hedge inception and on an ongoing quarterly basis, the Company also formally assesses whether the derivatives and non-derivative financial instruments used in hedging activities have been, and are expected to continue to be, highly effective in offsetting their designated risk. Hedge effectiveness is assessed using qualitative and quantitative methods. The assessment of hedge effectiveness determines the accounting treatment of changes in fair value. +For assessing hedge effectiveness, qualitative methods may include the comparison of critical terms of the derivative to the hedged item, and quantitative methods may include regression, dollar offset, or other statistical analysis of changes in fair value or cash flows associated with the hedge relationship. +For derivative instruments that are designated and qualify as cash flow hedges, the gain or loss on the derivative is reported as a component of other comprehensive income (loss) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. In cash flow hedges, all components of each derivative's gain or loss are included in the assessment of hedge effectiveness. +For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the hedged item and the portion of the hedging instrument included in the assessment of effectiveness are recorded in the line item of the consolidated statements of earnings in which gain or loss on the hedged item is recorded. When assessing the effectiveness +90 +Item 8. Financial Statements and Supplementary Data +of the Company's fair value hedges, the Company excludes the changes in fair value related to the difference between the spot and the forward rate on its foreign currency forwards and the time value of money of foreign exchange options and interest rate swaptions. For interest rate swaptions designated under fair value hedges of interest rate risk, the change in the time value of money is recognized in other comprehensive income (loss) and amortized into earnings (net investment income) over its legal term. +As discussed in Note 4, from time to time the Company designates net investment hedges of its net investment in Aflac Japan. The Company makes its net investment hedge designation at the beginning of each quarter. For derivative hedging instruments designated as net investment hedges, Aflac follows the spot-rate method. According to that method, the change in fair value of the hedging instrument due to fluctuations in the spot exchange rate is recorded in the unrealized foreign currency component of other comprehensive income and reclassified to earnings only when the hedged net investment is sold, or when a liquidation of the respective net investment in the foreign entity is substantially completed. If and when a sale or liquidation occurs, the changes in fair value of the derivative deferred in the unrealized foreign currency component of other comprehensive income will be released in the same income statement line item where the gain (loss) on the hedged net investment would be recorded upon sale. All other changes in fair value of the hedging instrument are considered the “excluded component” and are accounted for in realized investment gains (losses). Should these designated net investment hedge positions exceed the Company's net investment in Aflac Japan, the foreign exchange effect on the portion that exceeds its investment in Aflac Japan would be recognized in current earnings within realized investment gains (losses). +The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer highly effective in offsetting changes in the estimated cash flows or fair value of a hedged item; (2) the derivative is de-designated as a hedging instrument; or (3) the derivative expires or is sold, terminated or exercised. +When hedge accounting is discontinued on a cash flow hedge or fair value hedge, the derivative is carried in the consolidated balance sheets at its estimated fair value, with changes in estimated fair value recognized in current period earnings. For discontinued cash flow hedges, including those where the derivative is sold, terminated or exercised, amounts previously deferred in other comprehensive income (loss) are reclassified into earnings when earnings are impacted by the cash flow of the hedged item. +If a derivative is not designated as an accounting hedge or its use in managing risk does not qualify for hedge accounting, changes in the estimated fair value of the derivative are generally reported within other gains (losses), which is a component of realized investment gains (losses). The fluctuations in estimated fair value of derivatives that have not been designated for hedge accounting can result in volatility in net earnings. +The Company receives and pledges cash or other securities as collateral on open derivative positions. Cash received as collateral is reported as an asset with a corresponding liability for the return of the collateral. Cash pledged as collateral is recorded as a reduction to cash, and a corresponding receivable is recognized for the return of the cash collateral. The Company generally can repledge or resell collateral obtained from counterparties, although the Company does not typically exercise such rights. Securities received as collateral are not recognized unless the Company was to exercise its right to sell that collateral or exercise remedies on that collateral upon a counterparty default. Securities that the Company has pledged as collateral continue to be carried as investment assets on its balance sheet. +Deferred Policy Acquisition Costs: Certain direct and incremental costs of acquiring new business are deferred and amortized with interest over the premium payment periods in proportion to the ratio of annual premium income to total anticipated premium income. Anticipated premium income is estimated by using the same mortality, persistency and interest assumptions used in computing liabilities for future policy benefits. In this manner, the related acquisition expenses are matched with revenues. Deferred costs include the excess of current-year commissions over ultimate renewal-year commissions and certain incremental direct policy issue, underwriting and sales expenses. All of these incremental costs are directly related to successful policy acquisition. +For some products, policyholders can elect to modify product benefits, features, rights or coverages by exchanging a contract for a new contract or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. These transactions are known as internal replacements. The Company performs a two-stage analysis of the internal replacements to determine if the modification is substantive to the base policy. The stages of evaluation are as follows: 1) determine if the modification is integrated with the base policy, and 2) if it is integrated, determine if the resulting contract is substantially changed. +For internal replacement transactions where the resulting contract is substantially unchanged, the policy is accounted for as a continuation of the replaced contract. Unamortized deferred acquisition costs from the original policy continue to be amortized over the expected life of the new policy, and the costs of replacing the policy are accounted for as policy maintenance +91 +Item 8. Financial Statements and Supplementary Data +costs and expensed as incurred. Examples include conversions of same age bands, certain family coverage changes, pricing era changes (decrease), and ordinary life becomes reduced paid-up and certain reinstatements. +An internal replacement transaction that results in a policy that is substantially changed is accounted for as an extinguishment of the original policy and the issuance of a new policy. Unamortized deferred acquisition costs on the original policy are immediately expensed, and the costs of acquiring the new policy are capitalized and amortized in accordance with the Company's accounting policies for deferred acquisition costs. Further, the policy reserves are evaluated based on the new policy features, and any change (up or down) necessary is recognized at the date of contract change/modification. Examples include conversions to higher age bands, certain family coverage changes, pricing era changes (increase), lapse & re-issue, certain reinstatements and certain other contract conversions. +Riders can be considered internal replacements that are either integrated or non-integrated resulting in either substantially changed or substantially unchanged treatment. Riders are evaluated based on the specific facts and circumstances of the rider and are considered an expansion of the existing benefits with additional premium required. Non-integrated riders to existing contracts do not change the Company's profit expectations for the related products and are treated as a new policy establishment for incremental coverage. +The Company measures the recoverability of DAC and the adequacy of its policy reserves annually by performing gross premium valuations on its business. (See the following discussion for further information regarding policy reserves.) +Policy Liabilities:  Future policy benefits represent claims that are expected to occur in the future and are computed following a net level premium method using estimated future investment yields, persistency and recognized morbidity and mortality tables modified to reflect the Company's experience, including a provision for adverse deviation. These assumptions are generally established and considered locked at policy inception. These assumptions may only be unlocked in certain circumstances based on the results of periodic DAC recoverability and premium deficiency testing. +Unpaid policy claims are estimates computed primarily on an undiscounted basis using statistical analyses of historical claims experience adjusted for current trends and changed conditions. The ultimate liability may vary significantly from such estimates. The Company regularly adjusts these estimates as new claims experience emerges and reflects the changes in operating results in the year such adjustments are made. +Unearned premiums consist primarily of discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan limited-pay insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. +Other policyholders’ funds liability consists primarily of the fixed annuity line of business in Aflac Japan which has fixed benefits and premiums. +For internal replacements that are determined to not be substantially unchanged, policy liabilities related to the original policy that was replaced are immediately released, and policy liabilities are established for the new insurance contract; however, for internal replacements that are considered substantially unchanged, no changes to the reserves are recognized. +Reinsurance: The Company enters into reinsurance agreements with other companies in the normal course of business. For each reinsurance agreement, the Company determines if the agreement provides indemnification against loss or liability relating to insurance risk in accordance with applicable accounting standards. Reinsurance premiums and benefits paid or provided are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums, benefits and DAC are reported net of insurance ceded. +Income Taxes: Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing the Company's income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the Company expects the temporary differences to reverse. The Company records deferred tax assets for tax positions taken based on its assessment of whether the tax position is more likely than not to be sustained upon examination by taxing authorities. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized. +Policyholder Protection Corporation and State Guaranty Association Assessments: In Japan, the government has required the insurance industry to contribute to a policyholder protection corporation. The Company recognizes a charge for +92 +Item 8. Financial Statements and Supplementary Data +its estimated share of the industry's obligation once it is determinable. The Company reviews the estimated liability for policyholder protection corporation contributions on an annual basis and reports any adjustments in Aflac Japan's expenses. +In the U.S., each state has a guaranty association that supports insolvent insurers operating in those states. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. See Note 15 of the Notes to the Consolidated Financial Statements for further discussion of the guaranty fund assessments charged to the Company. +Treasury Stock: Treasury stock is reflected as a reduction of shareholders' equity at cost. The Company uses the weighted-average purchase cost to determine the cost of treasury stock that is reissued. The Company includes any gains and losses in additional paid-in capital when treasury stock is reissued. +Share-Based Compensation: The Company measures compensation cost related to its share-based payment transactions at fair value on the grant date, and the Company recognizes those costs in the financial statements over the vesting period during which the employee provides service in exchange for the award. The Company has formalized its entity-wide accounting policy election to estimate the number of awards that are expected to vest and the corresponding forfeitures. +Earnings Per Share: The Company computes basic earnings per share (EPS) by dividing net earnings by the weighted-average number of unrestricted shares outstanding for the period. Diluted EPS is computed by dividing net earnings by the weighted-average number of shares outstanding for the period plus the shares representing the dilutive effect of share-based awards. +Reclassifications: Certain reclassifications have been made to prior-year amounts to conform to current-year reporting classifications. These reclassifications had no impact on net earnings or total shareholders' equity. +New Accounting Pronouncements +Recently Adopted Accounting Pronouncements +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +Accounting Standard Update (ASU) 2018-16 Derivatives and Hedging Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes +In October 2018, the FASB issued amendments to permit use of the Overnight Index Swap (OIS) rate based on the Secured Overnight Financing Rate (SOFR) as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815 in addition to the Treasury obligations of the U.S. government (UST), the London Interbank Offered Rate (LIBOR) swap rate, the OIS rate based on the Fed Funds Effective Rate, and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. +Early adopted as of October 1, 2018 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations or disclosures. +ASU 2018-15 +Intangibles - Goodwill and Other - Internal-Use Software, Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract +In August 2018, the FASB issued amendments to align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. +Early adopted as of January 1, 2019 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations or disclosures. +93 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2018-14 +Compensation - Retirement Benefits - Defined Benefit Plans - General, Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans +In August 2018, the FASB issued amendments to modify the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. Accordingly, six disclosures requirements were removed, two added and two clarified. +Early adopted as of December 31, 2019 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations or disclosures. +ASU 2018-03 +Technical Corrections and Improvements to Financial Instruments - Overall Recognition and Measurement of Financial Assets and Financial Liabilities +In February 2018, the FASB issued amendments to clarify certain aspects of the guidance issued in the original Financial Instruments - Overall - Recognition and Measurement pronouncement summarized below. Specifically, for entities who have chosen the measurement alternative approach for equity securities without readily determinable fair values, the amendments clarify that entities may change from a measurement alternative approach to a fair value method through an irrevocable election that would apply to a specific equity security and all identical or similar investments of the same issuer; entities should use an observable price at the date of the transaction rather than reporting date for the measurement alternative calculation; and insurance companies should use a prospective transition method when applying the measurement alternative. +Early adopted as of January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2018-02 +Income Statement - Reporting Comprehensive Income: Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income +In February 2018, the FASB issued amendments which allow a reclassification from accumulated other comprehensive income (AOCI) to retained earnings of the effects of the change in the U.S. federal income tax rate resulting from the Tax Cuts and Jobs Act (Tax Act) on the gross deferred tax amounts and the corresponding valuation allowances related to items remaining in AOCI. The amendments eliminate the stranded tax effects resulting from the Tax Act and also require certain disclosures about the reclassified tax effects. +Early adopted as of January 1, 2018 +The amounts reclassified from +AOCI to retained earnings include the income tax effects of the change in the federal corporate tax rate enacted by the Tax Act. The Company’s policy is to follow the portfolio approach for releasing income tax effects from AOCI. The adoption of this guidance resulted in an increase to beginning 2018 AOCI of $374 million with a corresponding decrease to beginning 2018 retained earnings as of January 1, 2018. +ASU 2017-12 +Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities +In August 2017, the FASB issued guidance which improves and simplifies the accounting rules around hedge accounting and creates more transparency around how economic results are presented in financial statements. Issues addressed in this new guidance include: 1) risk component hedging, 2) accounting for the hedged item in fair value hedges of interest rate risk, 3) recognition and presentation of the effects of hedging instruments, and 4) amounts excluded from the assessment of hedge effectiveness. +Early adopted as of October 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +94 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2017-09 Compensation - Stock Compensation: Scope of Modification Accounting +In May 2017, the FASB issued amendments to provide guidance clarifying when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. An entity should apply modification accounting if the fair value, vesting conditions or classification of the award (as an equity instrument or liability instrument) changes as a result of the change in terms or conditions of the award. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-08 +Receivables - Nonrefundable Fees and Other Costs: Premium Amortization on Purchased Callable Debt Securities +In March 2017, the FASB issued amendments to shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount. +Early adopted as of July 1, 2018 +The adoption of this guidance did not have a significant impact on the Company’s financial position, results of operations, or disclosures. +ASU 2017-07 +Compensation - Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost +In March 2017, the FASB issued amendments requiring that an employer report the service cost component of net periodic pension cost and net periodic postretirement benefit cost in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net periodic pension cost and net periodic postretirement benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. The amendments in this update also allow only the service cost component to be eligible for capitalization when applicable. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-05 +Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets: Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets +In February 2017, the FASB issued amendments that clarify the scope and accounting guidance for the derecognition of a nonfinancial asset or a financial asset that meets the definition of an "in substance nonfinancial asset." The amendments define an "in substance nonfinancial asset" and provide additional accounting guidance for partial sales of nonfinancial assets. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2017-01 +Business Combinations: Clarifying the Definition of a Business +In January 2017, the FASB issued amendments clarifying when a set of assets and activities is a business. The amendments provide a screen to exclude transactions where substantially all the fair value of the transferred set is concentrated in a single asset, or group of similar assets, from being evaluated as a business. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +95 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2016-18 +Statement of Cash Flows: Restricted Cash +In November 2016, the FASB issued amendments requiring that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, statements of cash flows, or disclosures. +ASU 2016-17 +Consolidation - Interests Held through Related Parties That Are under Common Control +In October 2016, the FASB issued amendments which clarify the consolidation guidance on how a reporting entity that is the single decision maker of a variable interest entity (VIE) should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that VIE. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-16 +Income Taxes: Intra-Entity Transfers of Assets Other Than Inventory +In October 2016, the FASB issued amendments that require an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. +January 1, 2018 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-15 Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments +In August 2016, the FASB issued amendments that provide guidance on eight specific statement of cash flow classification issues, including distributions received from equity method investees. +January 1, 2018 +The Company elected nature of distribution for distributions received from equity method investees. The adoption of this guidance did not have a significant impact on the Company's financial position, statement of cash flows, results of operations, or disclosures. +ASU 2016-09 +Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting +In March 2016, the FASB issued amendments which simplify several aspects for share-based payment award transactions, including the income tax consequences, classification of awards as either liability or equity, classification of taxes paid on the statement of cash flows and treatment of forfeitures. +January 1, 2017 +As a result of applying this requirement, the Company believes that recognition of excess tax benefits will increase volatility in its statement of operations and the Company made an entity-wide accounting policy election to estimate the number of awards that are expected to vest (consistent with the Company's prior policy), but the adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, statements of cash flows, or disclosures. +ASU 2016-07 +Investments - Equity Method and Joint Ventures - Simplifying the Transition to the Equity Method of +Accounting +In March 2016, the FASB issued amendments which eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. Per the amendments, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +96 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2016-06 +Derivatives and Hedging - Contingent Put and Call Options in Debt Instruments +In March 2016, the FASB issued amendments which clarify what steps are required when assessing whether the economic characteristics and risks of call (put) options are clearly and closely related to the economic characteristics and risks of their debt hosts, which is one of the criteria for bifurcating an embedded derivative. Consequently, when a call (put) option is contingently exercisable, an entity does not have to assess whether the event that triggers the ability to exercise a call (put) option is related to interest rates or credit risks. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +ASU 2016-05 +Derivatives and Hedging - Effect of Derivative Contract Novations on Existing Hedge Accounting +Relationships +In March 2016, the FASB issued amendments which clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria remain intact. +January 1, 2017 +The adoption of this guidance did not have a significant impact on the Company's financial position, results of operations, or disclosures. +97 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2016-02 +Leases +as clarified and amended by: +ASU 2018-01 , Leases: Land Easement Practical Expedient for Transition to Topic 842, +ASU 2018-10 , Codification Improvements to Topic 842, Leases, +ASU 2018-11 , Leases, Targeted Improvements, and +ASU 2018-20 , Leases: Narrow-Scope Improvements for Lessors +In February 2016, the FASB issued updated guidance for accounting for leases (“Leases Update”). Per the Leases Update, lessees are required to recognize all leases on the balance sheet with the exception of short-term leases. A lease liability will be recorded for the obligation of a lessee to make lease payments arising from a lease. Leases will be classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the income statement. The Leases Update provided a number of optional practical expedients. The Company elected the "package of practical expedients," which permits the Company not to reassess under the new standard its prior conclusions about lease identification, lease classification and initial direct costs. Under the Leases Update, lessor accounting is largely unchanged. +In January 2018, an amendment was issued to the Leases Update which provided an entity with the option to elect a transition practical expedient to not evaluate land easements that exist or expired before the entity's adoption of the Leases Update and that were not previously accounted for as leases. +In July 2018, the FASB issued two amendments to the Leases Update which clarified, corrected errors in, or made minor improvements to the Leases Update and provided entities with an optional transition method to adopt the Leases Update by recording a cumulative-effect adjustment to beginning retained earnings. Additionally, the amendments provided lessors with a practical expedient to not separate nonlease components from associated lease components and instead account for those components as a single component under certain conditions. +In December 2018, an amendment to the Leases Update was issued to clarify: 1) lessor accounting for all sales (and other similar) taxes; 2) the handling of certain lessor costs when the amount of those costs is not readily determinable; and 3) lessor allocation of certain variable payments to the lease and non-lease components. +January 1, 2019 +The Company has operating and finance leases for office space and equipment. The Company elected the short-term lease exemption for all classes of leases which allows the Company to not recognize right-of-use assets and lease liabilities on the consolidated balance sheet and allows the Company to recognize the lease expense for short-term leases on a straight-line basis over the lease term. The Company elected the practical expedient to not separate lease and non-lease components and applied it to all classes of leases where the non-lease components are not significant. Some of the Company's leases include options to extend or terminate the lease and the lease terms may include such options when it is reasonably certain that the Company will exercise that option. Certain leases also include options to purchase the leased property. The leases within scope of the leases update increased the Company's right-of-use assets and lease liabilities recorded in its consolidated balance sheet by $134 million. +As of January 1, 2019, the Company did not have land easements, but has elected the practical expedient as a safe harbor. +The Company elected the optional transition method and as a safe harbor, the practical expedient provided to lessors. +The Company has made an accounting policy election to exclude amounts collected from customers for all sales (and other similar) taxes from the transaction price. +The adoption of the Leases Update and related amendments did not have a significant impact on the Company's financial position, results of operations, or disclosures. +98 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Date of Adoption +Effect on Financial Statements or Other Significant Matters +ASU 2016-01 +Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities +In January 2016, the FASB issued guidance to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The main provisions of this guidance require certain equity investments to be measured at fair value with changes in fair value recognized in net earnings; separate presentation in other comprehensive income for changes in fair value of financial liabilities measured under the fair value option that are due to instrument-specific credit risk; and changes in disclosures associated with the fair value of financial instruments. The guidance also clarifies that entities should evaluate the need for a valuation allowance on a deferred tax asset (DTA) related to available-for-sale (AFS) securities in combination with the entity's other DTAs. +January 1, 2018 +The Company recorded a cumulative effect adjustment with an increase to beginning 2018 retained earnings and a decrease to beginning 2018 AOCI of $148 million, net of taxes. +Accounting Pronouncements Pending Adoption +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2020-01 +Clarifying the interactions between Topic 321, Topic 323, and Topic 815 +In January 2020, the FASB issued amendments clarifying that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting for the purposes of applying the measurement alternative in accordance with Topic 321 immediately before applying or upon discontinuing the equity method. +In addition, the amendments clarify that for the purpose of applying certain derivative guidance in Topic 815, an entity should not consider whether, upon the settlement of the forward contract or exercise of the purchased option, individually or with existing investments, the underlying securities would be accounted for under the equity method in Topic 323 or the fair value option in accordance with the financial instruments guidance in Topic 825. An entity also would evaluate the remaining characteristics in Topic 815 to determine the accounting for those forward contracts and purchased options. +The amendments are effective for public business entities for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. Early adoption is permitted. +The adoption of this guidance is not expected to have a significant impact on the Company's financial position, results of operations, or disclosures. +99 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2019-04 +Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments +In April 2019, the FASB issued Codification improvements to clarify and correct certain areas of guidance amended as part of ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities; ASU 2016-13 , Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments; and ASU 2017-12 , Derivative and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. +The most significant of these improvements to the Company was related to the Codification improvement to ASU 2017-12 and the clarification that a one-time reclassification of assets that are eligible to be hedged under the last-of-layer method (i.e., certain pre-payable securities) from held-to-maturity to available-for-sale is allowed under the new hedge accounting guidance and would not impact the Company’s ability to continue to classify other bonds as held-to-maturity. This clarification is effective for the Company beginning January 1, 2020, with early adoption permitted. If a reclassification is elected, it must be reflected as of the date of adoption of this update. +The other amendments related to ASU 2017-12 and 2016-01 are either not significant, or were previously implemented as part of the related ASU adoptions. +Applicable amendments related to ASU 2016-13 are discussed within the pending adoption of that update below. +The Company did not reclassify any assets from held-to-maturity to available-for-sale as part of its implementation of ASU 2017-12, and is therefore eligible to reclassify qualifying securities as a result of these clarifications. Effective on January 1, 2020, the Company anticipates the reclassification of approximately $6.9 billion (at amortized cost) of pre-payable fixed-maturity securities from the held-to-maturity to the available-for-sale category. This reclassification is expected to result in recording in accumulated other comprehensive income a net unrealized gain of approximately $800 million on an after-tax basis, based on the securities’ fair values on the reclassification date. The reclassification will impact the adoption of ASU 2016-13 which will be effective January 1, 2020 (see ASU 2016-13 below for additional details). +ASU 2018-17 Consolidation: Targeted Improvements to Related Party Guidance for Variable Interest Entities +In October 2018, the FASB issued targeted improvements which provide that indirect interests held through related parties under common control should be considered on a proportional basis for determining whether fees paid to decision makers and service providers are variable interests. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. +The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations or disclosures. +ASU 2018-13 +Fair Value Measurement, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement +In August 2018, the FASB issued amendments to the disclosure requirements on fair value measurements. The amendments remove, modify, and add certain disclosures. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. Further, an entity is permitted to early adopt any removed or modified disclosures upon issuance of this update and delay adoption of the additional disclosures until their effective date. +The adoption of this guidance is not expected to have a significant impact on the Company’s financial position, results of operations, or disclosures. +100 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2018-12 +Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts +as clarified and amended by: +ASU No. 2019-09, Financial Services Insurance (Topic 944)- Effective Date +In August 2018, the FASB issued amendments that will significantly change how insurers account for long-duration contracts. The amendments will change existing recognition, measurement, presentation, and disclosure requirements. Issues addressed in the new guidance include: 1) a requirement to review and, if there is a change, update assumptions for the liability for future policy benefits at least annually, and to update the discount rate assumption quarterly, 2) accounting for market risk benefits at fair value, 3) simplified amortization for deferred acquisition costs, and 4) enhanced financial statement presentation and disclosures. +In November 2019, the FASB issued an amendment extending the effective date for public business entities that meet the definition of an SEC filer, excluding entities eligible to be small reporting companies as defined by the SEC, by one year. The amendments are now effective for the Company for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2021. Early application of the amendments is permitted. +The Company is thoroughly evaluating the impact of adoption and expects that the adoption will have a significant impact on the Company’s financial position, results of operations, and disclosures. The Company anticipates that the requirement to update assumptions for liability for future policy benefits will have a significant impact on its results of operations, systems, processes and controls while the requirement to update the discount rate will have a significant impact on its equity. The Company has no products with market risk benefits. The Company does not expect to early adopt the updated standard and has tentatively selected a modified retrospective transition method. +ASU 2017-04 +Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment +In January 2017, the FASB issued amendments simplifying the subsequent measurement of goodwill. An entity, under this update, is no longer required to perform a hypothetical purchase price allocation to measure goodwill impairment. Instead, the entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The amendments are effective for public business entities that are SEC filers for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for any goodwill impairment tests performed on testing dates after January 1, 2017. +The adoption of this guidance is not expected to have a significant impact on the Company's financial position, results of operations, or disclosures. +101 +Item 8. Financial Statements and Supplementary Data +Standard +Description +Effect on Financial Statements or Other Significant Matters +ASU 2016-13 +Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments +as clarified and amended by: +ASU 2019-04 , Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments, +ASU 2019-05 , Financial Instruments - Credit Losses (Topic 326), Targeted Transition Relief +and +ASU 2019-11, Codification Improvements to Topic 326, Financial Instruments- Credit Losses +In June 2016, the FASB issued amendments that require a financial asset (or a group of financial assets) measured at amortized cost to be presented net of an allowance for credit losses (Credit Losses ASU) in order to reflect the amount expected to be collected on the financial asset(s). The measurement of expected credit losses is amended by replacing the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information. Credit losses on available-for-sale debt securities will be measured in a manner similar to current U.S. GAAP; however, the amendments require that credit losses be presented as an allowance rather than as a write-down. Other amendments include changes to the balance sheet presentation and interest income recognition of purchased financial assets with a more-than-insignificant credit deterioration since origination (PCD financial assets). +The Credit Losses ASU is effective for public companies for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Companies may early adopt this guidance as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The amendments will be adopted following a modified-retrospective approach resulting in a cumulative effect adjustment in retained earnings as of the beginning of the year of adoption. Two exceptions to this adoption method are for PCD financial assets and debt securities for which other-than-temporary impairment (OTTI) will have been recognized before the effective date. Loans purchased with credit deterioration accounted for under current U.S. GAAP as "purchased credit impaired" (PCI) financial assets will be classified as PCD financial assets at transition and PCD guidance will be applied prospectively. Debt securities that have experienced OTTI before the effective date will follow a prospective adoption method which allows an entity to maintain the same amortized cost basis before and after the effective date. +In April 2019, the Credit Losses ASU was amended to allow entities to make a policy election about presentation and disclosure of accrued interest receivable and the related credit losses, whereby entities that write off uncollectible accrued interest receivable in a timely manner can make a policy election not to measure an allowance on the accrued interest receivable. Other amendments made within this Update clarify and address stakeholders’ specific issues about certain aspects of the Credit Losses ASU. +In May 2019, the FASB granted a targeted transition relief by allowing to irrevocably elect the fair value option for certain financial assets previously measured at amortized cost. +These amendments will be effective upon adoption of the Credit Losses ASU. +The Company has identified the following financial instruments in scope of the new guidance: certain fixed maturity securities, loans and loan receivables, reinsurance recoverable, as well as certain other receivable balances and off-balance sheet arrangements. +The Company has concluded that of the held-to-maturity fixed maturity securities, Japanese government and agency securities and certain Japanese government-guaranteed mortgage backed securities meet the requirements for a zero-loss expectation and therefore will not be included in the current expected credit loss measurement process upon adoption of the new standard. +The Company has substantially completed the review and validation of credit models, methodologies and inputs for all asset classes. The Company performed parallel runs during the second, third and fourth quarters and refined its estimation process with additional parallel testing throughout 2019. The Company has estimated the adoption-date net after-tax impact at a $56 million decrease to retained earnings. As noted above relative to ASU 2019-04, the Company is planning a one-time reclassification as of January 1, 2020 of approximately $6.9 billion (amortized cost as of December 31, 2019) of its eligible fixed-maturity securities from held-to-maturity to available-for-sale category. The aforementioned reclassification has been reflected in the expected impact estimate from adoption of ASU 2016-13. The Company plans to adopt this ASU on January 1, 2020. +Recent accounting guidance not discussed above is not applicable, did not have, or is not expected to have a material impact to the Company's business. +102 +Item 8. Financial Statements and Supplementary Data +2. +BUSINESS SEGMENT AND FOREIGN INFORMATION +The Company consists of two reportable insurance business segments: Aflac Japan and Aflac U.S., both of which sell supplemental health and life insurance. In addition, operating business units that are not individually reportable and business activities, including reinsurance retrocession activities, not included in Aflac Japan or Aflac U.S. are included in Corporate and other. +The Company does not allocate corporate overhead expenses to business segments. Consistent with U.S. GAAP accounting guidance for segment reporting, the Company evaluates and manages its business segments using a financial performance measure called pretax adjusted earnings. Adjusted earnings are adjusted revenues less benefits and adjusted expenses. The adjustments to both revenues and expenses account for certain items that cannot be predicted or that are outside management’s control. Adjusted revenues are U.S. GAAP total revenues excluding realized investment gains and losses, except for amortized hedge costs/income related to foreign currency exposure management strategies and net interest cash flows from derivatives associated with certain investment strategies. Adjusted expenses are U.S. GAAP total acquisition and operating expenses including the impact of interest cash flows from derivatives associated with notes payable but excluding any nonrecurring or other items not associated with the normal course of the Company’s insurance operations and that do not reflect Aflac’s underlying business performance. The Company excludes income taxes related to operations to arrive at pretax adjusted earnings. Information regarding operations by reportable segment and Corporate and other for the years ended December 31 follows: +(In millions) +2019 +2018 +2017 +Revenues: +Aflac Japan: +Net earned premiums: +Cancer +$ +6,031 +$ +5,849 +$ +5,612 +Medical and other health +3,582 +3,516 +3,379 +Life insurance +3,159 +3,397 +3,761 +Net investment income, less amortized hedge costs (1),(2) +2,496 +2,403 +2,235 +Other income +45 +41 +41 +Total Aflac Japan +15,313 +15,206 +15,028 +Aflac U.S.: +Net earned premiums: +Accident/disability +2,665 +2,611 +2,537 +Cancer +1,309 +1,311 +1,308 +Other health +1,548 +1,508 +1,445 +Life insurance +286 +278 +273 +Net investment income +720 +727 +721 +Other income +22 +8 +5 +Total Aflac U.S. +6,550 +6,443 +6,289 +Corporate and other (3) +393 +339 +272 +Total adjusted revenues +22,256 +21,988 +21,589 +Realized investment gains (losses) (1),(2),(3) +51 +( 230 +) +78 +Total revenues +$ +22,307 +$ +21,758 +$ +21,667 +(1) Amortized hedge costs of $ 257 , $ 236 and $ 228 in 2019 , 2018 and 2017 , respectively, related to certain foreign currency exposure management strategies have been reclassified from realized investment gains (losses) and reported as a deduction from net investment income when analyzing operations. +(2) Net interest cash flows from derivatives associated with certain investment strategies of $( 17 ) in 2019 and an immaterial amount in 2018 have been reclassified from realized investment gains (losses) and included in adjusted earnings as a component of net investment income. +(3) Amortized hedge income of $ 89 in 2019 and $ 36 in 2018 related to certain foreign currency exposure management strategies has been reclassified from realized investment gains (losses) and reported as an increase to net investment income when analyzing operations. +103 +Item 8. Financial Statements and Supplementary Data +(In millions) +2019 +2018 +2017 +Pretax earnings: +Aflac Japan (1),(2) +$ +3,261 +$ +3,208 +$ +3,054 +Aflac U.S. +1,272 +1,285 +1,245 +Corporate and other (3),(4) +( 72 +) +( 139 +) +( 212 +) +Pretax adjusted earnings (5) +4,461 +4,354 +4,087 +Realized investment gains (losses) (1),(2),(3),(4) +( 15 +) +( 297 +) +0 +Other income (loss) (6) +( 1 +) +( 74 +) +( 69 +) +Total earnings before income taxes +$ +4,445 +$ +3,983 +$ +4,018 +Income taxes applicable to pretax adjusted earnings +$ +1,147 +$ +1,129 +$ +1,370 +Effect of foreign currency translation on after-tax +adjusted earnings +15 +28 +( 41 +) +(1) Amortized hedge costs of $ 257 , $ 236 and $ 228 in 2019 , 2018 and 2017 , respectively, related to certain foreign currency exposure management strategies have been reclassified from realized investment gains (losses) and reported as a deduction from net investment income when analyzing operations. +(2) Net interest cash flows from derivatives associated with certain investment strategies of $( 17 ) in 2019 and an immaterial amount in 2018 have been reclassified from realized investment gains (losses) and included in adjusted earnings as a component of net investment income. +(3) Amortized hedge income of $ 89 in 2019 and $ 36 in 2018 related to certain foreign currency exposure management strategies has been reclassified from realized investment gains (losses) and reported as an increase to net investment income when analyzing operations. +(4) A gain of $ 66 in 2019 , $ 67 in 2018 and $ 77 in 2017 , related to the interest rate component of the change in fair value of foreign currency swaps on notes payable have been reclassified from realized investment gains (losses) and included in adjusted earnings when analyzing operations. +(5) Includes $ 135 , $ 122 and $ 122 of interest expense on debt in 2019 , 2018 and 2017 +(6) Includes expense of $ 13 in 2017 for the early extinguishment of debt +Assets as of December 31 were as follows: +(In millions) +2019 +2018 +Assets: +Aflac Japan +$ +127,523 +$ +118,342 +Aflac U.S. +20,945 +19,100 +Corporate and other +4,300 +2,964 +Total assets +$ +152,768 +$ +140,406 +Yen-Translation Effects:  The following table shows the yen/dollar exchange rates used for or during the periods ended December 31 . Exchange effects were calculated using the same yen/dollar exchange rate for the current year as for each respective prior year. +2019 +2018 +2017 +Statements of Earnings: +Weighted-average yen/dollar exchange rate (1) +109.07 +110.39 +112.16 +Yen percent strengthening (weakening) +1.2 +% +1.6 +% +( 3.1 +)% +Exchange effect on pretax adjusted earnings (in millions) +$ +20 +$ +38 +$ +( 63 +) +2019 +2018 +Balance Sheets: +Yen/dollar exchange rate at December 31 (1) +109.56 +111.00 +Yen percent strengthening (weakening) +1.3 +% +1.8 +% +Exchange effect on total assets (in millions) +$ +1,225 +$ +1,362 +Exchange effect on total liabilities (in millions) +1,533 +1,270 +(1) Rates are based on the published MUFG Bank, Ltd. telegraphic transfer middle rate (TTM) +104 +Item 8. Financial Statements and Supplementary Data +Transfers of funds from Aflac Japan:  Aflac Japan makes payments to the Parent Company for management fees, allocated expenses and remittances of earnings. Prior to the Aflac Japan branch conversion on April 1, 2018, Aflac Japan paid allocated expenses and profit remittances to Aflac U.S. Information on transfers for each of the years ended December 31 is shown below. See Note 13 for information concerning restrictions on transfers from Aflac Japan. +(In millions) +2019 +2018 +2017 +Management fees +$ +75 +$ +136 +$ +93 +Allocated expenses +4 +24 +109 +Profit remittances +2,070 +808 +1,150 +Total transfers from Aflac Japan +$ +2,149 +$ +968 +$ +1,352 +Property and Equipment:  The costs of buildings, furniture and equipment are depreciated principally on a straight-line basis over their estimated useful lives (maximum of 50 years for buildings and 20 years for furniture and equipment). Expenditures for maintenance and repairs are expensed as incurred; expenditures for betterments are capitalized and depreciated. Classes of property and equipment as of December 31 were as follows: +(In millions) +2019 +2018 +Property and equipment: +Land +$ +168 +$ +168 +Buildings +473 +456 +Equipment and furniture +549 +400 +Total property and equipment +1,190 +1,024 +Less accumulated depreciation +609 +581 +Net property and equipment +$ +581 +$ +443 +Receivables:  Receivables consist primarily of monthly insurance premiums due from individual policyholders or their employers for payroll deduction of premiums, net of an allowance for doubtful accounts. At December 31, 2019 , $ 258 million , or 31.2 % of total receivables, were related to Aflac Japan's operations, compared with $ 334 million , or 39.2 % , at December 31, 2018 . +3. INVESTMENTS +Net Investment Income +The components of net investment income for the years ended December 31 were as follows: +(In millions) +2019 +2018 +2017 +Fixed maturity securities +$ +3,141 +$ +3,142 +$ +3,173 +Equity securities +37 +38 +42 +Commercial mortgage and other loans +468 +333 +86 +Other investments +53 +36 +8 +Short-term investments and cash equivalents +56 +41 +25 +Gross investment income +3,755 +3,590 +3,334 +Less investment expenses +177 +148 +114 +Net investment income +$ +3,578 +$ +3,442 +$ +3,220 +105 +Item 8. Financial Statements and Supplementary Data +Investment Holdings +The amortized cost for the Company's investments in fixed maturity securities, the cost for equity securities and the fair values of these investments at December 31 are shown in the following tables. +2019 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities available for sale, carried at fair value +through other comprehensive income: +Fixed maturity securities: +Yen-denominated: +Japan government and agencies +$ +30,929 +$ +5,169 +$ +0 +$ +36,098 +Municipalities +516 +116 +3 +629 +Mortgage- and asset-backed securities +229 +25 +0 +254 +Public utilities +1,855 +406 +0 +2,261 +Sovereign and supranational +680 +50 +0 +730 +Banks/financial institutions +6,152 +700 +86 +6,766 +Other corporate +5,323 +944 +24 +6,243 +Total yen-denominated +45,684 +7,410 +113 +52,981 +U.S. dollar-denominated: +U.S. government and agencies +293 +9 +0 +302 +Municipalities +1,077 +141 +0 +1,218 +Mortgage- and asset-backed securities +149 +7 +0 +156 +Public utilities +3,804 +725 +10 +4,519 +Sovereign and supranational +239 +73 +0 +312 +Banks/financial institutions +2,879 +646 +4 +3,521 +Other corporate +25,246 +3,255 +248 +28,253 +Total U.S. dollar-denominated +33,687 +4,856 +262 +38,281 +Total securities available for sale +$ +79,371 +$ +12,266 +$ +375 +$ +91,262 +106 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities available for sale, carried at fair value +through other comprehensive income: +Fixed maturity securities: +Yen-denominated: +Japan government and agencies +$ +30,637 +$ +3,700 +$ +140 +$ +34,197 +Municipalities +385 +32 +9 +408 +Mortgage- and asset-backed securities +155 +22 +0 +177 +Public utilities +1,732 +280 +4 +2,008 +Sovereign and supranational +826 +123 +0 +949 +Banks/financial institutions +5,440 +502 +238 +5,704 +Other corporate +4,852 +649 +44 +5,457 +Total yen-denominated +44,027 +5,308 +435 +48,900 +U.S dollar-denominated: +U.S. government and agencies +137 +9 +1 +145 +Municipalities +1,343 +120 +8 +1,455 +Mortgage- and asset-backed securities +155 +8 +1 +162 +Public utilities +4,772 +496 +105 +5,163 +Sovereign and supranational +251 +60 +0 +311 +Banks/financial institutions +2,860 +389 +35 +3,214 +Other corporate +23,311 +1,343 +1,109 +23,545 +Total U.S. dollar-denominated +32,829 +2,425 +1,259 +33,995 +Total securities available for sale +$ +76,856 +$ +7,733 +$ +1,694 +$ +82,895 +2019 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Yen-denominated: +Japan government and agencies +$ +22,241 +$ +6,050 +$ +0 +$ +28,291 +Municipalities +821 +262 +0 +1,083 +Mortgage- and asset-backed securities +16 +1 +0 +17 +Public utilities +2,535 +419 +0 +2,954 +Sovereign and supranational +1,123 +197 +0 +1,320 +Banks/financial institutions +916 +105 +3 +1,018 +Other corporate +2,433 +485 +7 +2,911 +Total yen-denominated +30,085 +7,519 +10 +37,594 +Total securities held to maturity +$ +30,085 +$ +7,519 +$ +10 +$ +37,594 +107 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Cost or +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Yen-denominated: +Japan government and agencies +$ +21,712 +$ +5,326 +$ +0 +$ +27,038 +Municipalities +359 +110 +0 +469 +Mortgage- and asset-backed securities +14 +1 +0 +15 +Public utilities +2,727 +254 +8 +2,973 +Sovereign and supranational +1,551 +289 +0 +1,840 +Banks/financial institutions +1,445 +158 +20 +1,583 +Other corporate +2,510 +332 +38 +2,804 +Total yen-denominated +30,318 +6,470 +66 +36,722 +Total securities held to maturity +$ +30,318 +$ +6,470 +$ +66 +$ +36,722 +2019 +2018 +(In millions) +Fair Value +Fair Value +Equity securities, carried at fair value through net earnings: +Equity securities: +Yen-denominated +$ +658 +$ +641 +U.S. dollar-denominated +144 +346 +Total equity securities +$ +802 +$ +987 +The methods of determining the fair values of the Company's investments in fixed maturity securities and equity securities are described in Note 5. +During 2019 and 2018, the Company did not reclassify any investments from the held-to-maturity category to the available-for-sale category. During 2017, the Company reclassified three investments from the held-to-maturity category to the available-for-sale category as a result of the issuers' credit rating being downgraded to below investment grade. At the time of the transfer, the securities had an aggregate amortized cost of $ 773 million and an aggregate unrealized gain of $ 47 million . +108 +Item 8. Financial Statements and Supplementary Data +Contractual and Economic Maturities +The contractual and economic maturities of the Company's investments in fixed maturity securities at December 31, 2019 , were as follows: +(In millions) +Amortized +Cost +Fair +Value +Available for sale: +Due in one year or less +$ +583 +$ +612 +Due after one year through five years +7,933 +8,122 +Due after five years through 10 years +11,347 +12,819 +Due after 10 years +59,130 +69,299 +Mortgage- and asset-backed securities +378 +410 +Total fixed maturity securities available for sale +$ +79,371 +$ +91,262 +Held to maturity: +Due in one year or less +$ +265 +$ +270 +Due after one year through five years +1,227 +1,330 +Due after five years through 10 years +532 +599 +Due after 10 years +28,045 +35,378 +Mortgage- and asset-backed securities +16 +17 +Total fixed maturity securities held to maturity +$ +30,085 +$ +37,594 +Economic maturities are used for certain debt instruments with no stated maturity where the expected maturity date is based on the combination of features in the financial instrument such as the right to call or prepay obligations or changes in coupon rates. +Investment Concentrations +The Company's process for investing in credit-related investments begins with an independent approach to underwriting each issuer's fundamental credit quality. The Company evaluates independently those factors that it believes could influence an issuer's ability to make payments under the contractual terms of the Company's instruments. This includes a thorough analysis of a variety of items including the issuer's country of domicile (including political, legal, and financial considerations); the industry in which the issuer competes (with an analysis of industry structure, end-market dynamics, and regulation); company specific issues (such as management, assets, earnings, cash generation, and capital needs); and contractual provisions of the instrument (such as financial covenants and position in the capital structure). The Company further evaluates the investment considering broad business and portfolio management objectives, including asset/liability needs, portfolio diversification, and expected income. +Investment exposures that individually exceeded 10% of shareholders' equity as of December 31 were as follows: +2019 +2018 +(In millions) +Credit +Rating +Amortized +Cost +Fair +Value +Credit +Rating +Amortized +Cost +Fair +Value +Japan National Government (1) +A+ +$ 51,726 +$ 62,584 +A+ +$ 51,207 +$ 59,945 +(1) Japan Government Bonds (JGBs) or JGB-backed securities +Realized Investment Gains and Losses +Information regarding pretax realized gains and losses from investments for the years ended December 31 follows: +109 +Item 8. Financial Statements and Supplementary Data +(In millions) +2019 +2018 +2017 +Realized investment gains (losses): +Fixed maturity securities: +Available for sale: +Gross gains from sales +$ +115 +$ +101 +$ +51 +Gross losses from sales +( 68 +) +( 156 +) +( 68 +) +Foreign currency gains (losses) on sales and redemptions +( 16 +) +73 +( 48 +) +Other-than-temporary impairment losses +( 13 +) +( 64 +) +( 7 +) +Total fixed maturity securities +18 +( 46 +) +( 72 +) +Equity securities +101 +( 131 +) +71 +(1) +Loan receivables: +Loan loss reserves +( 18 +) +( 19 +) +( 8 +) +Total loan receivables +( 18 +) +( 19 +) +( 8 +) +Derivatives and other: +Derivative gains (losses) +( 174 +) +( 224 +) +( 109 +) +Foreign currency gains (losses) +( 62 +) +( 10 +) +( 33 +) +Total derivatives and other +( 236 +) +( 234 +) +( 142 +) +Total realized investment gains (losses) +$ +( 135 +) +$ +( 430 +) +$ +( 151 +) +(1) Includes impairments of $ 22 in 2017 +The unrealized holding gains , net of losses , recorded as a component of realized investment gains and losses for the year ended December 31, 2019 , that relates to equity securities still held at the December 31, 2019 , reporting date was $ 64 million . +Unrealized Investment Gains and Losses +Information regarding changes in unrealized gains and losses from investments recorded in AOCI for the years ended December 31 follows: +(In millions) +2019 +2018 +2017 +Changes in unrealized gains (losses): +Fixed maturity securities, available for sale +$ +5,852 +$ +( 3,142 +) +$ +1,657 +Equity securities +0 +0 +71 +Total change in unrealized gains (losses) +$ +5,852 +$ +( 3,142 +) +$ +1,728 +Effect on Shareholders' Equity +The net effect on shareholders' equity of unrealized gains and losses from fixed maturity securities at December 31 was as follows: +(In millions) +2019 +2018 +Unrealized gains (losses) on securities available for sale +$ +11,891 +$ +6,039 +Deferred income taxes +( 3,343 +) +( 1,805 +) +Shareholders’ equity, unrealized gains (losses) on fixed maturity securities +$ +8,548 +$ +4,234 +Gross Unrealized Loss Aging +The following tables show the fair values and gross unrealized losses of the Company's available-for-sale and held-to-maturity investments that were in an unrealized loss position, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31 . +110 +Item 8. Financial Statements and Supplementary Data +2019 +Total +Less than 12 months +12 months or longer +(In millions) +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fixed maturity securities: +Municipalities: +Yen-denominated +$ +80 +$ +3 +$ +80 +$ +3 +$ +0 +$ +0 +Public utilities: +U.S. dollar-denominated +306 +10 +69 +2 +237 +8 +Banks/financial institutions: +U.S. dollar-denominated +79 +4 +18 +0 +61 +4 +Yen-denominated +1,828 +89 +1,828 +89 +0 +0 +Other corporate: +U.S. dollar-denominated +4,261 +248 +792 +53 +3,469 +195 +Yen-denominated +636 +31 +636 +31 +0 +0 +Total +$ +7,190 +$ +385 +$ +3,423 +$ +178 +$ +3,767 +$ +207 +2018 +Total +Less than 12 months +12 months or longer +(In millions) +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fair +Value +Unrealized +Losses +Fixed maturity securities: +U.S. government and +agencies: +U.S. dollar-denominated +$ +67 +$ +1 +$ +67 +$ +1 +$ +0 +$ +0 +Japan government and +agencies: +Yen-denominated +3,604 +140 +3,604 +140 +0 +0 +Municipalities: +U.S. dollar-denominated +515 +8 +515 +8 +0 +0 +Yen-denominated +148 +9 +148 +9 +0 +0 +Mortgage- and asset- +backed securities: +U.S. dollar-denominated +74 +1 +74 +1 +0 +0 +Public utilities: +U.S. dollar-denominated +1,585 +105 +892 +48 +693 +57 +Yen-denominated +604 +12 +604 +12 +0 +0 +Banks/financial institutions: +U.S. dollar-denominated +625 +35 +340 +19 +285 +16 +Yen-denominated +3,057 +258 +3,057 +258 +0 +0 +Other corporate: +U.S. dollar-denominated +12,899 +1,109 +5,782 +407 +7,117 +702 +Yen-denominated +1,306 +82 +1,306 +82 +0 +0 +Total +$ +24,484 +$ +1,760 +$ +16,389 +$ +985 +$ +8,095 +$ +775 +Analysis of Securities in Unrealized Loss Positions +The unrealized losses on the Company's fixed maturity securities investments have been primarily related to general market changes in interest rates, foreign exchange rates, and/or the levels of credit spreads rather than specific concerns with the issuer's ability to pay interest and repay principal. +111 +Item 8. Financial Statements and Supplementary Data +For any significant declines in fair value of its fixed maturity securities, the Company performs a more focused review of the related issuers' credit profile. For corporate issuers, the Company evaluates their assets, business profile including industry dynamics and competitive positioning, financial statements and other available financial data. For non-corporate issuers, the Company analyzes all sources of credit support, including issuer-specific factors. The Company utilizes information available in the public domain and, for certain private placement issuers, from consultations with the issuers directly. The Company also considers ratings from Nationally Recognized Statistical Rating Organizations (NRSROs), as well as the specific characteristics of the security it owns including seniority in the issuer's capital structure, covenant protections, or other relevant features. From these reviews, the Company evaluates the issuers' continued ability to service the Company's investment through payment of interest and principal. +Assuming no credit-related factors develop, unrealized gains and losses on fixed maturity securities are expected to diminish as investments near maturity. Based on its credit analysis, the Company believes that the issuers of its fixed maturity investments in the sectors shown in the table above have the ability to service their obligations to the Company. +Commercial Mortgage and Other Loans +The Company classifies its TREs, CMLs and MMLs as held-for-investment and includes them in the commercial mortgage and other loans line on the consolidated balance sheets. The Company carries them on the balance sheet at amortized cost less an estimated allowance for loan losses. +The table below reflects the composition of the carrying value for commercial mortgage and other loans by property type as of December 31. +(In millions) +2019 +2018 +Amortized Cost +% of Total +Amortized Cost +% of Total +Commercial Mortgage and other loans +Transitional real estate loans: +Office +$ +1,800 +18.7 +% +$ +1,621 +23.3 +% +Retail +131 +1.4 +147 +2.1 +Apartments/Multi-Family +2,085 +21.7 +1,706 +24.6 +Industrial +256 +2.7 +250 +3.6 +Hospitality +1,036 +10.8 +531 +7.6 +Other +164 +1.7 +139 +2.0 +Total transitional real estate loans +5,472 +57.0 +4,394 +63.2 +Commercial mortgage loans: +Office +410 +4.3 +281 +4.1 +Retail +348 +3.5 +316 +4.6 +Apartments/Multi-Family +569 +5.9 +369 +5.3 +Industrial +383 +4.0 +99 +1.4 +Total commercial mortgage loans +1,710 +17.7 +1,065 +15.4 +Middle market loans +2,432 +25.3 +1,487 +21.4 +Total commercial mortgage and other loans +$ +9,614 +100.0 +% +$ +6,946 +100.0 +% +Allowance for Loan Losses +( 45 +) +( 27 +) +Total net commercial mortgage and other loans +$ +9,569 +$ +6,919 +Commercial mortgage and transitional real estate loans were secured by properties entirely within the U.S. (with the largest concentrations in California ( 20 % ), Texas ( 15 % ) and Florida ( 10 % )). Middle market loans are issued only to companies domiciled within the U.S. and Canada. +112 +Item 8. Financial Statements and Supplementary Data +Transitional Real Estate Loans +Transitional real estate loans are commercial mortgage loans that are typically relatively short-term floating rate instruments secured by a first lien on the property.These loans provide funding for properties undergoing a change in their physical characteristics and/or economic profile and do not typically require any principal repayment prior to the maturity date. This loan portfolio is generally considered to be investment grade. As of December 31, 2019 , the Company had $ 875 million in outstanding commitments to fund transitional real estate loans. These commitments are contingent on the final underwriting and due diligence to be performed. +Commercial Mortgage Loans +Commercial mortgage loans are typically fixed rate loans on commercial real estate with partial repayment of principal over the life of the loan with the remaining outstanding principal being repaid upon maturity. This loan portfolio is generally considered higher quality investment grade loans. As of December 31, 2019 , the Company had $ 27 million of outstanding commitments to fund commercial mortgage loans. These commitments are contingent on the final underwriting and due diligence to be performed. +Middle Market Loans +Middle market loans are typically first lien senior secured cash flow loans to small to mid-size companies for working capital, refinancing, acquisition, and recapitalization. These loans are generally considered to be below investment grade. The carrying value for middle market loans included $ 99 million and $ 56 million for a short term credit facility that is reflected in other liabilities on the consolidated balance sheets, as of December 31, 2019 , and 2018 , respectively. +As of December 31, 2019 , the Company had commitments of approximately $ 502 million to fund potential future loan originations related to this investment program. These commitments are contingent upon the availability of middle market loans that meet the Company's underwriting criteria. +Allowance for Loan Losses +The Company's allowance for loan losses is established using both general and specific allowances. The general allowance is used for loans grouped by similar risk characteristics where a loan-specific or market-specific risk has not been identified, but for which the Company estimates probable incurred losses. The specific allowance is used on an individual loan basis when it is probable that a loss has been incurred. As of December 31, 2019 , the Company had loan loss reserves of $ 6 million related to two specific middle market loans. There was no specific loan loss reserve as of December 31, 2018 . The following table presents the rollforward of the Company's allowance for loan losses by portfolio segment during the year ended December 31. +(In millions) +Commercial Mortgage Loans +Transitional Real Estate Loans +Middle Market Loans +Total +Allowance for loan losses at December 31, 2018 +$ +( 1 +) +$ +( 17 +) +$ +( 9 +) +$ +( 27 +) +Addition to (release of) allowance for credit losses +( 2 +) +( 5 +) +( 11 +) +( 18 +) +Allowance for loan losses at December 31, 2019 +$ +( 3 +) +$ +( 22 +) +$ +( 20 +) +$ +( 45 +) +As of December 31, 2019 and 2018, the Company had no loans that were past due in regards to principal and/or interest payments. Additionally, the Company held no loans that were on nonaccrual status or considered impaired as of December 31, 2019 and 2018. The Company had no troubled debt restructurings during the years ended December 31, 2019 and 2018. +Credit Quality Indicators +The key credit quality indicators used by the Company in establishing the general and specific loan loss reserves, as well as in determining whether or not a loan should be impaired, include loan-to-value and debt service coverage ratios for CMLs and TREs and ratings for its middle market loan portfolio. Given that transitional real estate loans involve properties undergoing renovation or construction, loan-to-value provides the most insight on the credit risk of the property. Middle market loans generally have below-investment-grade ratings. The performance of the loans are monitored and reviewed periodically, but not less than quarterly. +The table below summarizes key credit quality information by carrying value for CMLs and TREs as of December 31. +113 +Item 8. Financial Statements and Supplementary Data +2019 +(In millions) +Transitional Real Estate Loans +Commercial Mortgage Loans +Total +Loan-to-Value Ratio: +0%-59.99% +$ +1,424 +$ +1,390 +$ +2,814 +60%-69.99% +1,927 +297 +2,224 +70%-79.99% +2,085 +23 +2,108 +80% or greater +36 +0 +36 +Total +$ +5,472 +$ +1,710 +$ +7,182 +Weighted Average Debt-Service Coverage Ratio +2.38 +2018 +(In millions) +Transitional Real Estate Loans +Commercial Mortgage Loans +Total +Loan-to-Value Ratio: +0%-59.99% +$ +819 +$ +877 +$ +1,696 +60%-69.99% +1,681 +165 +1,846 +70%-79.99% +1,558 +23 +1,581 +80% or greater +336 +0 +336 +Total +$ +4,394 +$ +1,065 +$ +5,459 +Weighted Average Debt-Service Coverage Ratio +2.45 +Other Investments +The table below reflects the composition of the carrying value for other investments as of December 31. +(In millions) +2019 +2018 +Other investments: +Policy loans +$ +250 +$ +232 +Short-term investments (1) +628 +152 +Limited partnerships +569 +377 +Other +30 +26 +Total other investments +$ +1,477 +$ +787 +(1) Includes securities lending collateral +As of December 31, 2019 , the Company had $ 1.3 billion in outstanding commitments to fund alternative investments in limited partnerships. +Variable Interest Entities (VIEs) +As a condition of its involvement or investment in a VIE, the Company enters into certain protective rights and covenants that preclude changes in the structure of the VIE that would alter the creditworthiness of the Company's investment or its beneficial interest in the VIE. +For those VIEs other than certain unit trust structures, the Company's involvement is passive in nature. The Company has not, nor has it been, required to purchase any securities issued in the future by these VIEs. +The Company's ownership interest in VIEs is limited to holding the obligations issued by them. The Company has no direct or contingent obligations to fund the limited activities of these VIEs, nor does it have any direct or indirect financial guarantees related to the limited activities of these VIEs. The Company has not provided any assistance or any other type of financing support to any of the VIEs it invests in, nor does it have any intention to do so in the future. For those VIEs in +114 +Item 8. Financial Statements and Supplementary Data +which the Company holds debt obligations, the weighted-average lives of the Company's notes are very similar to the underlying collateral held by these VIEs where applicable. +The Company's risk of loss related to its interests in any of its VIEs is limited to the carrying value of the related investments held in the VIE. +VIEs - Consolidated +The following table presents the cost or amortized cost, fair value and balance sheet caption in which the assets and liabilities of consolidated VIEs are reported as of December 31. +Investments in Consolidated Variable Interest Entities +2019 +2018 +(In millions) +Cost or Amortized +Cost +Fair +Value +Cost or Amortized +Cost +Fair +Value +Assets: +Fixed maturity securities, available for sale +$ +3,308 +$ +4,312 +$ +3,849 +$ +4,466 +Equity securities +0 +0 +160 +160 +Commercial mortgage and other loans +7,956 +8,015 +5,528 +5,506 +Other investments (1) +494 +494 +328 +328 +Other assets (2) +169 +169 +182 +182 +Total assets of consolidated VIEs +$ +11,927 +$ +12,990 +$ +10,047 +$ +10,642 +Liabilities: +Other liabilities (2) +$ +126 +$ +126 +$ +102 +$ +102 +Total liabilities of consolidated VIEs +$ +126 +$ +126 +$ +102 +$ +102 +(1) Consists entirely of alternative investments in limited partnerships +(2) Consists entirely of derivatives +The Company is substantively the only investor in the consolidated VIEs listed in the table above. As the sole investor in these VIEs, the Company has the power to direct the activities of a variable interest entity that most significantly impact the entity's economic performance and is therefore considered to be the primary beneficiary of the VIEs that it consolidates. The Company also participates in substantially all of the variability created by these VIEs. The activities of these VIEs are limited to holding invested assets and foreign currency swaps, as appropriate, and utilizing the cash flows from these securities to service its investment. Neither the Company nor any of its creditors are able to obtain the underlying collateral of the VIEs unless there is an event of default or other specified event. For those VIEs that contain a swap, the Company is not a direct counterparty to the swap contracts and has no control over them. The Company's loss exposure to these VIEs is limited to its original investment. The Company's consolidated VIEs do not rely on outside or ongoing sources of funding to support their activities beyond the underlying collateral and swap contracts, if applicable. With the exception of its investment in unit trust structures, the underlying collateral assets and funding of the Company's consolidated VIEs are generally static in nature. +Investments in Unit Trust Structures +The Company also utilizes unit trust structures in its Aflac Japan segment to invest in various asset classes. As the sole investor of these VIEs, the Company is required to consolidate these trusts under U.S. GAAP. +VIEs - Not Consolidated +The table below reflects the amortized cost, fair value and balance sheet caption in which the Company's investment in VIEs not consolidated are reported as of December 31. +115 +Item 8. Financial Statements and Supplementary Data +Investments in Variable Interest Entities Not Consolidated +2019 +2018 +(In millions) +Amortized +Cost +Fair +Value +Amortized +Cost +Fair +Value +Assets: +Fixed maturity securities, available for sale +$ +4,129 +$ +4,884 +$ +4,575 +$ +4,982 +Fixed maturity securities, held to maturity +1,848 +2,236 +2,007 +2,254 +Other investments (1) +75 +74 +49 +49 +Total investments in VIEs not consolidated +$ +6,052 +$ +7,194 +$ +6,631 +$ +7,285 +(1) Consists entirely of alternative investments in limited partnerships +The Company holds alternative investments in limited partnerships that have been determined to be VIEs. These partnerships invest in private equity and structured investments. The Company’s maximum exposure to loss on these investments is limited to the amount of its investment. The Company is not the primary beneficiary of these VIEs and is therefore not required to consolidate them. The Company classifies these investments as Other investments in the consolidated balance sheets. +Certain investments in VIEs that the Company is not required to consolidate are investments that are in the form of debt obligations from the VIEs that are irrevocably and unconditionally guaranteed by their corporate parents or sponsors. These VIEs are the primary financing vehicles used by their corporate sponsors to raise financing in the capital markets. The variable interests created by these VIEs are principally or solely a result of the debt instruments issued by them. The Company does not have the power to direct the activities that most significantly impact the entity's economic performance, nor does it have the obligation to absorb losses of the entity or the right to receive benefits from the entity. As such, the Company is not the primary beneficiary of these VIEs and is therefore not required to consolidate them. +Securities Lending and Pledged Securities +The Company lends fixed maturity and public equity securities to financial institutions in short-term security-lending transactions. These short-term security-lending arrangements increase investment income with minimal risk. The Company receives cash or other securities as collateral for such loans. The Company's security lending policy requires that the fair value of the securities received as collateral be 102 % or more of the fair value of the loaned securities and that unrestricted cash received as collateral be 100 % or more of the fair value of the loaned securities. The securities loaned continue to be carried as investment assets on the Company's balance sheet during the terms of the loans and are not reported as sales. For loans involving unrestricted cash or securities as collateral, the collateral is reported as an asset with a corresponding liability for the return of the collateral. For loans where the Company receives as collateral securities that the Company is not permitted to sell or repledge, the collateral is not reflected on the consolidated financial statements. +116 +Item 8. Financial Statements and Supplementary Data +Details of collateral by loaned security type and remaining maturity of the agreements as of December 31 were as follows: +Securities Lending Transactions Accounted for as Secured Borrowings +2019 +Remaining Contractual Maturity of the Agreements +(In millions) +Overnight +and +Continuous (1) +Up to 30 +days +Greater +than 90 +days +Total +Securities lending transactions: +Fixed maturity securities: +Japan government and agencies +$ +0 +$ +1,013 +$ +4,759 +$ +5,772 +Public utilities +35 +0 +0 +35 +Sovereign and supranational +2 +0 +0 +2 +Banks/financial institutions +48 +0 +0 +48 +Other corporate +778 +0 +0 +778 +Equity securities +0 +0 +0 +0 +Total borrowings +$ +863 +$ +1,013 +$ +4,759 +$ +6,635 +Gross amount of recognized liabilities for securities lending transactions +$ +1,876 +Amounts related to agreements not included in offsetting disclosure in Note 4 +$ +4,759 +(1) The related loaned security, under the Company's Aflac U.S. securities lending program, can be returned to the Company at the transferee's discretion; therefore, they are classified as Overnight and Continuous. +Securities Lending Transactions Accounted for as Secured Borrowings +2018 +Remaining Contractual Maturity of the Agreements +(In millions) +Overnight +and +Continuous (1) +Up to 30 +days +Greater +than 90 +days +Total +Securities lending transactions: +Fixed maturity securities: +Japan government and agencies +$ +0 +$ +387 +1,190 +$ +1,577 +Municipalities +5 +0 +0 +5 +Public utilities +27 +0 +0 +27 +Banks/financial institutions +74 +0 +0 +74 +Other corporate +549 +0 +0 +549 +Equity securities +10 +0 +0 +10 +Total borrowings +$ +665 +$ +387 +$ +1,190 +$ +2,242 +Gross amount of recognized liabilities for securities lending transactions +$ +1,052 +Amounts related to agreements not included in offsetting disclosure in Note 4 +$ +1,190 +(1) The related loaned security, under the Company's Aflac U.S. securities lending program, can be returned to the Company at the transferee's discretion; therefore, they are classified as Overnight and Continuous +The Company did not have any repurchase agreements or repurchase-to-maturity transactions outstanding as of December 31, 2019 and 2018 , respectively. +Certain fixed maturity securities can be pledged as collateral as part of derivative transactions, or pledged to support state deposit requirements on certain investment programs. For additional information regarding pledged securities related to derivative transactions, see Note 4. +At December 31, 2019 , debt securities with a fair value of $ 18 million were on deposit with regulatory authorities in the U.S. (including U.S. territories). The Company retains ownership of all securities on deposit and receives the related investment income. +117 +Item 8. Financial Statements and Supplementary Data +For general information regarding the Company's investment accounting policies, see Note 1. +4. DERIVATIVE INSTRUMENTS +The Company's freestanding derivative financial instruments have historically consisted of: +• +foreign currency forwards and options used in hedging foreign exchange risk on U.S. dollar-denominated investments in Aflac Japan's portfolio +• +foreign currency forwards and options used to economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long term exposure to a weakening yen +• +cross-currency interest rate swaps, also referred to as foreign currency swaps, associated with certain senior notes and subordinated debentures +• +foreign currency swaps and, in prior periods, credit default swaps that are associated with investments in special-purpose entities, including VIEs where the Company is the primary beneficiary +• +interest rate swaps used to economically hedge interest rate fluctuations in certain variable-rate investments +• +interest rate swaptions used to hedge changes in the fair value associated with interest rate fluctuations for certain U.S. dollar-denominated available-for-sale fixed-maturity securities. +Some of the Company's derivatives are designated as cash flow hedges, fair value hedges or net investment hedges; however, other derivatives do not qualify for hedge accounting or the Company elects not to designate them as accounting hedges. +Derivative Types +Foreign currency forwards and options are executed for the Aflac Japan segment in order to hedge the currency risk on the carrying value of certain U.S. dollar-denominated investments. The average maturity of these forwards and options can change depending on factors such as market conditions and types of investments being held. In situations where the maturity of the forwards and options is shorter than the underlying investment being hedged, the Company may enter into new forwards and options near maturity of the existing derivative in order to continue hedging the underlying investment. In forward transactions, Aflac Japan agrees with another party to buy a fixed amount of yen and sell a corresponding amount of U.S. dollars at a specified future date. Aflac Japan also executes foreign currency option transactions in a collar strategy, where Aflac Japan agrees with another party to simultaneously purchase put options and sell call options. In the purchased put transactions, Aflac Japan obtains the option to buy a fixed amount of yen and sell a corresponding amount of U.S. dollars at a specified future date. In the sold call transaction, Aflac Japan agrees to sell a fixed amount of yen and buy a corresponding amount of U.S. dollars at a specified future date. The combination of purchasing the put option and selling the call option results in no net premium being paid (i.e. a costless or zero-cost collar). The foreign currency forwards and options are used in fair value hedging relationships to mitigate the foreign exchange risk associated with U.S. dollar-denominated investments supporting yen-denominated liabilities. +From time to time, the Company may also enter into foreign currency forwards and options to hedge the currency risk associated with the net investment in Aflac Japan. In these forward transactions, Aflac agrees with another party to buy a fixed amount of U.S. dollars and sell a corresponding amount of yen at a specified price at a specified future date. In the option transactions, the Company may use a combination of foreign currency options to protect expected future cash flows by simultaneously purchasing yen put options (options that protect against a weakening yen) and selling yen call options (options that limit participation in a strengthening yen). The combination of these two actions create a zero-cost collar. +The Company enters into foreign currency swaps pursuant to which it exchanges an initial principal amount in one currency for an initial principal amount of another currency, with an agreement to re-exchange the principal amounts at a future date. There may also be periodic exchanges of payments at specified intervals based on the agreed upon rates and notional amounts. Foreign currency swaps are used primarily in the consolidated VIEs in the Company's Aflac Japan portfolio to convert foreign-denominated cash flows to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations. The Company also uses foreign currency swaps to economically convert certain of its U.S. dollar-denominated senior note and subordinated debenture principal and interest obligations into yen-denominated obligations. +In order to reduce investment income volatility from its variable-rate investments, the Company enters into receive–fixed, pay–floating interest rate swaps. These derivatives are cleared and settled through a central clearinghouse. +118 +Item 8. Financial Statements and Supplementary Data +Swaptions are used to mitigate the adverse impact resulting from significant changes in the fair value of U.S. dollar-denominated available-for-sale securities due to fluctuation in interest rates. In a payer swaption, the Company pays a premium to obtain the right, but not the obligation, to enter into a swap contract where it will pay a fixed rate and receive a floating rate. Interest rate swaption collars are combinations of two swaption positions. In order to maximize the efficiency of the collars while minimizing cost, a collar strategy is used whereby the Company purchases a long payer swaption (the Company purchases an option that allows it to enter into a swap where the Company will pay the fixed rate and receive the floating rate of the swap) and sells a short receiver swaption (the Company sells an option that provides the counterparty with the right to enter into a swap where the Company will receive the fixed rate and pay the floating rate of the swap). The combination of purchasing the long payer swaption and selling the short receiver swaption results in no net premium being paid (i.e. a costless or zero-cost collar). +Derivative Balance Sheet Classification +The table below summarizes the balance sheet classification of the Company's derivative fair value amounts, as well as the gross asset and liability fair value amounts, at December 31. The fair value amounts presented do not include income accruals. Derivative assets are included in “Other Assets,” while derivative liabilities are included in “Other Liabilities” within the Company’s Consolidated Balance Sheets. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and are not reflective of exposure or credit risk. +2019 +2018 +(In millions) +Asset +Derivatives +Liability +Derivatives +Asset +Derivatives +Liability +Derivatives +Hedge Designation/ Derivative +Type +Notional +Amount +Fair Value +Fair Value +Notional +Amount +Fair Value +Fair Value +Cash flow hedges: +Foreign currency swaps - VIE +$ +75 +$ +0 +$ +8 +$ +75 +$ +1 +$ +4 +Total cash flow hedges +75 +0 +8 +75 +1 +4 +Fair value hedges: +Foreign currency forwards +964 +0 +38 +2,086 +0 +34 +Foreign currency options +11,573 +0 +5 +9,070 +3 +1 +Interest rate swaptions +243 +0 +0 +500 +0 +1 +Total fair value hedges +12,780 +0 +43 +11,656 +3 +36 +Net investment hedge: +Foreign currency forwards +4,952 +72 +2 +0 +0 +0 +Foreign currency options +2,000 +0 +0 +0 +0 +0 +Total net investment hedge +6,952 +72 +2 +0 +0 +0 +Non-qualifying strategies: +Foreign currency swaps +2,800 +72 +78 +2,800 +103 +129 +Foreign currency swaps - VIE +2,587 +169 +118 +2,587 +181 +101 +Foreign currency forwards +19,821 +166 +337 +16,057 +126 +117 +Foreign currency options +9,553 +0 +0 +430 +0 +0 +Interest rate swaps +7,120 +3 +0 +4,750 +3 +0 +Interest rate swaptions +7 +0 +0 +0 +0 +0 +Total non-qualifying strategies +41,888 +410 +533 +26,624 +413 +347 +Total derivatives +$ +61,695 +$ +482 +$ +586 +$ +38,355 +$ +417 +$ +387 +Cash Flow Hedges +For certain variable-rate U.S. dollar-denominated available-for-sale securities held by Aflac Japan via consolidated VIEs, foreign currency swaps are used to swap the USD variable rate interest and principal payments to fixed rate JPY interest and principal payments. The Company has designated foreign currency swaps as a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset (“cash flow” hedge). The remaining maximum length of time for which these cash flows are hedged is seven years. The derivatives in the Company's consolidated VIEs that are not designated as accounting hedges are discussed in the "non-qualifying strategies" section of this note. +119 +Item 8. Financial Statements and Supplementary Data +Fair Value Hedges +The Company designates and accounts for certain foreign currency forwards, options, and interest rate swaptions as fair value hedges when they meet the requirements for hedge accounting. The Company recognizes gains and losses on these derivatives as well as the offsetting gain or loss on the related hedged items in current earnings. +Foreign currency forwards and options hedge the foreign currency exposure of certain U.S. dollar-denominated available-for-sale fixed-maturity investments held in Aflac Japan. The change in the fair value of the foreign currency forwards related to the changes in the difference between the spot rate and the forward price is excluded from the assessment of hedge effectiveness. The change in fair value of the foreign currency option related to the time value of the option is recognized in current earnings and is excluded from the assessment of hedge effectiveness. +Interest rate swaptions hedge the interest rate exposure of certain U.S. dollar-denominated available-for-sale securities held in Aflac Japan. For these hedging relationships, the Company excludes time value from the assessment of hedge effectiveness and recognizes changes in the intrinsic value of the swaptions in current earnings within net investment income. The change in the time value of the swaptions is recognized in other comprehensive income (loss) and amortized into earnings (net investment income) over its legal term. +The following table presents the gains and losses on derivatives and the related hedged items in fair value hedges for the years ended December 31. +120 +Item 8. Financial Statements and Supplementary Data +Fair Value Hedging Relationships +(In millions) +Hedging Derivatives +Hedged Items +Hedging Derivatives +Hedged Items +Total +Gains +(Losses) +Gains (Losses) +Excluded from Effectiveness Testing (1) +Gains (Losses) +Included in Effectiveness Testing (2) +Gains (Losses) (2) +Net Realized Gains (Losses) Recognized for Fair Value Hedge +2019: +Foreign currency +forwards +Fixed maturity securities +$ +( 50 +) +$ +( 64 +) +$ +14 +$ +( 12 +) +$ +2 +Foreign currency +options +Fixed maturity securities +( 7 +) +( 7 +) +0 +0 +0 +Interest rate +swaptions +Fixed maturity securities +( 9 +) +( 9 +) +0 +0 +0 +Total gains (losses) +$ +( 66 +) +$ +( 80 +) +$ +14 +$ +( 12 +) +$ +2 +2018: +Foreign currency forwards +Fixed maturity securities +$ +126 +$ +( 104 +) +$ +230 +$ +( 242 +) +$ +( 12 +) +Foreign currency options +Fixed maturity securities +4 +4 +0 +0 +0 +Interest rate +swaptions +Fixed maturity securities +( 1 +) +( 1 +) +0 +0 +0 +Total gains (losses) +$ +129 +$ +( 101 +) +$ +230 +$ +( 242 +) +$ +( 12 +) +2017: +Foreign currency forwards +Fixed maturity and equity securities +$ +98 +$ +( 202 +) +$ +300 +$ +( 278 +) +$ +22 +Foreign currency options +Fixed maturity securities +21 +10 +11 +( 10 +) +1 +Total gains (losses) +$ +119 +$ +( 192 +) +$ +311 +$ +( 288 +) +$ +23 +(1) Gains (losses) excluded from effectiveness testing includes the forward point on foreign currency forwards and time value change on foreign currency options which are reported in the consolidated statement of earnings as realized investment gains (losses). It also includes the change in the fair value of the interest rate swaptions related to the time value of the swaptions which is recognized as a component of other comprehensive income (loss). +(2) Gains and losses on foreign currency forwards and options and related hedged items are reported in the consolidated statement of earnings as realized investment gains (losses). For interest rate swaptions and related hedged items, gains and losses included in the hedge assessment, premium amortization and time value amortization while the hedge items are still outstanding are reported within net investment income. The time value gains and losses for interest rate swaptions when the related hedged items are redeemed are reported in realized investment gains and losses consistent with the impact of the hedged item. For the years ended December 31, 2019 and 2018, gains and losses included in the hedge assessment on interest rate swaptions and related hedged items were immaterial. +The following table shows the carrying amounts of assets designated and qualifying as hedged items in fair value hedges of interest rate risk and the related cumulative hedge adjustment included in the carrying amount as of December 31. +(In millions) +Carrying Amount of the Hedged Assets/(Liabilities) (1) +Cumulative Amount of Fair Value Hedging Adjustment Included in the Carrying Amount of Hedged Assets/(Liabilities) +2019 +2018 +2019 +2018 +Fixed maturity securities +$ +4,633 +$ +6,593 +$ +256 +$ +294 +(1) The balance includes hedging adjustment on discontinued hedging relationships of $ 256 in 2019 and $ 294 in 2018 . +The total notional amount of the Company's interest rate swaptions was $ 243 in 2019 and $ 500 in 2018 . The hedging adjustment related to these derivatives was immaterial. +Net Investment Hedge +The Company's investment in Aflac Japan is affected by changes in the yen/dollar exchange rate. To mitigate this exposure, the Parent Company's yen-denominated liabilities (see Note 9) have been designated as non-derivative hedges. +121 +Item 8. Financial Statements and Supplementary Data +Beginning in July 2019, certain foreign currency forwards and options were designated as derivative hedges of the foreign currency exposure of the Company's net investment in Aflac Japan. Prior to April 1, 2018, foreign currency forwards and options were also designated as derivative hedges of the foreign currency exposure of the Company's net investment in Aflac Japan. +The Company's net investment hedge was effective during the years ended December 31, 2019 , 2018 and 2017 . +Non-qualifying Strategies +For the Company's derivative instruments in consolidated VIEs that do not qualify for hedge accounting treatment, all changes in their fair value are reported in current period earnings within realized investment gains (losses). The amount of gain or loss recognized in earnings for the Company's VIEs is attributable to the derivatives in those investment structures. While the change in value of the swaps is recorded through current period earnings, the change in value of the available-for-sale fixed maturity securities associated with these swaps is recorded through other comprehensive income. +As of December 31, 2019 , the Parent Company had cross-currency interest rate swap agreements related to its $ 350 million senior notes due February 2022, $ 700 million senior notes due June 2023, $ 750 million senior notes due November 2024 and $ 450 million senior notes due March 2025. Changes in the values of these swaps are recorded through current period earnings. For additional information regarding these swaps, see Note 9. +The Company uses foreign exchange forwards and options to economically mitigate the currency risk of some of its U.S. dollar-denominated loan receivables held within the Aflac Japan segment. These arrangements are not designated as accounting hedges, as the foreign currency remeasurement of the loan receivables impacts current period earnings, and generally offsets gains and losses from foreign exchange forwards within realized investment gains (losses). The Company also has certain foreign exchange forwards on U.S. dollar-denominated AFS securities where hedge accounting is not being applied. +Prior to July 2019, in order to economically mitigate currency risk of future yen dividends from Aflac Japan while lowering consolidated hedge costs associated with Aflac Japan's U.S. dollar investment hedging, the Parent Company entered into offsetting hedge positions using foreign exchange forwards. This activity is reported in the Corporate and other segment. As of July 1, 2019, the Parent Company designates these foreign exchange forward contracts as accounting hedges of its net investment in Aflac Japan. +The Company uses interest rate swaps to economically convert the variable rate investment income to a fixed rate on certain variable-rate investments. +122 +Item 8. Financial Statements and Supplementary Data +Impact of Derivatives and Hedging Instruments +The following table summarizes the impact to realized investment gains (losses) and other comprehensive income (loss) from all derivatives and hedging instruments for the years ended December 31. +2019 +2018 +2017 +(In millions) +Net Investment Income (1) +Realized Investment +Gains (Losses) +Other +Comprehensive +Income (Loss) (2) +Net Investment Income (1) +Realized Investment +Gains (Losses) +Other +Comprehensive +Income (Loss) (2) +Net Investment Income (1) +Realized +Investment +Gains (Losses) +Other +Comprehensive +Income (Loss) (2) +Qualifying hedges: +Cash flow hedges: +Foreign currency swaps - VIE +$ +( 2 +) +$ +( 1 +) +$ +( 4 +) +$ +0 +$ +0 +$ +3 +$ +0 +$ +0 +$ +1 +Total cash flow hedges +( 2 +) +( 1 +) +(3) +( 4 +) +0 +0 +(3) +3 +0 +0 +(3) +1 +Fair value hedges: +Foreign currency forwards (3) +( 62 +) +( 116 +) +( 180 +) +Foreign currency options (3) +( 7 +) +4 +11 +Interest rate swaptions (3) +( 1 +) +0 +( 8 +) +0 +0 +( 1 +) +0 +0 +0 +Total fair value hedges +( 1 +) +( 69 +) +( 8 +) +0 +( 112 +) +( 1 +) +0 +( 169 +) +0 +Net investment hedge: +Non-derivative hedging +instruments +0 +( 24 +) +0 +( 32 +) +0 +( 15 +) +Foreign currency forwards +10 +83 +0 +0 +0 +( 25 +) +Foreign currency options +( 4 +) +0 +0 +( 8 +) +0 +5 +Total net investment hedge +6 +59 +0 +( 40 +) +0 +( 35 +) +Non-qualifying strategies: +Foreign currency swaps +90 +( 40 +) +9 +Foreign currency swaps - VIE +( 68 +) +60 +44 +Foreign currency forwards +( 148 +) +( 135 +) +8 +Credit default swaps +0 +0 +( 1 +) +Interest rate swaps +17 +3 +0 +Total non-qualifying strategies +( 110 +) +( 112 +) +60 +Total +$ +( 3 +) +$ +( 174 +) +$ +47 +$ +0 +$ +( 224 +) +$ +( 38 +) +$ +0 +$ +( 109 +) +$ +( 34 +) +(1) Cash flow hedge items and the change in the fair value of interest rate swaptions related to the time value of the swaptions in fair value hedges are recorded as unrealized gains (losses) on derivatives and net investment hedge items are recorded in the unrealized foreign currency translation gains (losses) line in the consolidated statement of comprehensive income (loss). +(2) Impact of cash flow hedges reported as realized investment gains (losses) includes an immaterial amount of gains or losses reclassified from accumulated other comprehensive income (loss) into earnings. It also includes an immaterial amount excluded from effectiveness testing during the years ended December 31, 2019 , 2018 and 2017 , respectively. +(3) Impact shown net of effect of hedged items (see Fair Value Hedges section of this Note 4 for further detail) +123 +Item 8. Financial Statements and Supplementary Data +As of December 31, 2019 , deferred gains and losses on derivative instruments recorded in accumulated other comprehensive income that are expected to be reclassified to earnings during the next twelve months were immaterial. +Credit Risk Assumed through Derivatives +For the foreign currency and credit default swaps associated with the Company's VIE investments for which it is the primary beneficiary, the Company bears the risk of loss due to counterparty default even though it is not a direct counterparty to those contracts. +The Company is a direct counterparty to the foreign currency swaps that it has entered into in connection with certain of its senior notes and subordinated debentures; foreign currency forwards; and foreign currency options, and therefore the Company is exposed to credit risk in the event of nonperformance by the counterparties in those contracts. The risk of counterparty default for the Company's foreign currency swaps, certain foreign currency forwards, and foreign currency options is mitigated by collateral posting requirements that counterparties to those transactions must meet. +As of December 31, 2019 , all of the Company's derivative agreement counterparties were investment grade. +The Company engages in over-the-counter (OTC) bilateral derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements also include Credit Support Annexes (CSAs) provisions, which generally provide for two-way collateral postings at the first dollar of exposure. The Company mitigates the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value while generally requiring that collateral be posted at the outset of the transaction. In addition, a significant portion of the derivative transactions have provisions that give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength rating. The actual amount of payments that the Company could be required to make depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of the downgrade. +The Company also engages in OTC cleared derivative transactions through regulated central clearing counterparties. These positions are marked to market and margined on a daily basis (both initial margin and variation margin), and the Company has minimal exposure to credit-related losses in the event of nonperformance by counterparties to these derivatives. +Collateral posted by the Company to third parties for derivative transactions can generally be repledged or resold by the counterparties. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a net liability position by counterparty was approximately $ 301 million and $ 139 million as of December 31, 2019 and 2018 , respectively. If the credit-risk-related contingent features underlying these agreements had been triggered on December 31, 2019 , the Company estimates that it would be required to post a maximum of $ 46 million of additional collateral to these derivative counterparties. The Company is generally allowed to sell or repledge collateral obtained from its derivative counterparties, although it does not typically exercise such rights. (See the Offsetting tables below for collateral posted or received as of the reported balance sheet dates.) +Offsetting of Financial Instruments and Derivatives +Most of the Company's derivative instruments are subject to enforceable master netting arrangements that provide for the net settlement of all derivative contracts between the Parent Company or its subsidiaries and the respective counterparty in the event of default or upon the occurrence of certain termination events. Collateral support agreements with the master netting arrangements generally provide that the Company will receive or pledge financial collateral at the first dollar of exposure. +The Company has securities lending agreements with unaffiliated financial institutions that post collateral to the Company in return for the use of its fixed maturity and public equity securities (see Note 3). When the Company has entered into securities lending agreements with the same counterparty, the agreements generally provide for net settlement in the event of default by the counterparty. This right of set-off allows the Company to keep and apply collateral received if the counterparty failed to return the securities borrowed from the Company as contractually agreed. For additional information on the Company's accounting policy for securities lending, see Note 1. +The tables below summarize the Company's derivatives and securities lending transactions as of December 31, and as reflected in the tables, in accordance with U.S. GAAP, the Company's policy is to not offset these financial instruments in the Consolidated Balance Sheets. +124 +Item 8. Financial Statements and Supplementary Data +Offsetting of Financial Assets and Derivative Assets +2019 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Assets +Gross Amount +Offset in +Balance Sheet +Net Amount of Assets Presented +in Balance Sheet +Financial Instruments +Securities +Collateral +Cash Collateral Received +Net Amount +Derivative +assets: +Derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +310 +$ +0 +$ +310 +$ +( 190 +) +$ +( 7 +) +$ +( 113 +) +$ +0 +OTC - cleared +3 +0 +3 +0 +0 +0 +3 +Total derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +313 +0 +313 +( 190 +) +( 7 +) +( 113 +) +3 +Derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +169 +169 +169 +Total derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +169 +169 +169 +Total derivative +assets +482 +0 +482 +( 190 +) +( 7 +) +( 113 +) +172 +Securities lending +and similar +arrangements +1,860 +0 +1,860 +0 +0 +( 1,860 +) +0 +Total +$ +2,342 +$ +0 +$ +2,342 +$ +( 190 +) +$ +( 7 +) +$ +( 1,973 +) +$ +172 +125 +Item 8. Financial Statements and Supplementary Data +2018 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Assets +Gross Amount Offset in Balance Sheet +Net Amount of Assets Presented in Balance Sheet +Financial +Instruments +Securities Collateral +Cash Collateral Received +Net Amount +Derivative +assets: +Derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +231 +$ +0 +$ +231 +$ +( 152 +) +$ +( 23 +) +$ +( 55 +) +$ +1 +OTC - cleared +3 +0 +3 +0 +0 +( 3 +) +0 +Total derivative +assets subject to a +master netting +agreement or +offsetting +arrangement +234 +0 +234 +( 152 +) +( 23 +) +( 58 +) +1 +Derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +183 +183 +183 +Total derivative +assets not subject +to a master netting +agreement or +offsetting +arrangement +183 +183 +183 +Total derivative +assets +417 +0 +417 +( 152 +) +( 23 +) +( 58 +) +184 +Securities lending +and similar +arrangements +1,029 +0 +1,029 +0 +0 +( 1,029 +) +0 +Total +$ +1,446 +$ +0 +$ +1,446 +$ +( 152 +) +$ +( 23 +) +$ +( 1,087 +) +$ +184 +126 +Item 8. Financial Statements and Supplementary Data +Offsetting of Financial Liabilities and Derivative Liabilities +2019 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Liabilities +Gross Amount Offset in Balance Sheet +Net Amount of Liabilities Presented in Balance Sheet +Financial Instruments +Securities Collateral +Cash Collateral Pledged +Net Amount +Derivative +liabilities: +Derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +459 +$ +0 +$ +459 +$ +( 190 +) +$ +( 222 +) +$ +( 32 +) +$ +15 +OTC - cleared +1 +0 +1 +0 +0 +( 1 +) +0 +Total derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +460 +0 +460 +( 190 +) +( 222 +) +( 33 +) +15 +Derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +126 +126 +126 +Total derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +126 +126 +126 +Total derivative +liabilities +586 +0 +586 +( 190 +) +( 222 +) +( 33 +) +141 +Securities lending +and similar +arrangements +1,876 +0 +1,876 +( 1,860 +) +0 +0 +16 +Total +$ +2,462 +$ +0 +$ +2,462 +$ +( 2,050 +) +$ +( 222 +) +$ +( 33 +) +$ +157 +127 +Item 8. Financial Statements and Supplementary Data +2018 +Gross Amounts Not Offset +in Balance Sheet +(In millions) +Gross Amount of Recognized Liabilities +Gross Amount Offset in Balance Sheet +Net Amount of Liabilities Presented in Balance Sheet +Financial Instruments +Securities Collateral +Cash Collateral Pledged +Net Amount +Derivative +liabilities: +Derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +OTC - bilateral +$ +285 +$ +0 +$ +285 +$ +( 152 +) +$ +( 37 +) +$ +( 68 +) +$ +28 +Total derivative +liabilities subject +to a master netting +agreement or +offsetting +arrangement +285 +0 +285 +( 152 +) +( 37 +) +( 68 +) +28 +Derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +OTC - bilateral +102 +102 +102 +Total derivative +liabilities not +subject to a +master netting +agreement or +offsetting +arrangement +102 +102 +102 +Total derivative +liabilities +387 +0 +387 +( 152 +) +( 37 +) +( 68 +) +130 +Securities lending +and similar +arrangements +1,052 +0 +1,052 +( 1,029 +) +0 +0 +23 +Total +$ +1,439 +$ +0 +$ +1,439 +$ +( 1,181 +) +$ +( 37 +) +$ +( 68 +) +$ +153 +For additional information on the Company's financial instruments, see the accompanying Notes 1, 3 and 5. +5. +FAIR VALUE MEASUREMENTS +Fair Value Hierarchy +U.S. GAAP specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. These two types of inputs create three valuation hierarchy levels. Level 1 valuations reflect quoted market prices for identical assets or liabilities in active markets. Level 2 valuations reflect quoted market prices for similar assets or liabilities in an active market, quoted market prices for identical or similar assets or liabilities in non-active markets or model-derived valuations in which all significant valuation inputs are observable in active markets. Level 3 valuations reflect valuations in which one or more of the significant inputs are not observable in an active market. +The following tables present the fair value hierarchy levels of the Company's assets and liabilities that are measured and carried at fair value on a recurring basis as of December 31. +128 +Item 8. Financial Statements and Supplementary Data +2019 +(In millions) +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities available for sale, carried at +fair value: +Fixed maturity securities: +Government and agencies +$ +34,878 +$ +1,522 +$ +0 +$ +36,400 +Municipalities +0 +1,847 +0 +1,847 +Mortgage- and asset-backed securities +0 +232 +178 +410 +Public utilities +0 +6,556 +224 +6,780 +Sovereign and supranational +0 +1,042 +0 +1,042 +Banks/financial institutions +0 +10,264 +23 +10,287 +Other corporate +0 +34,234 +262 +34,496 +Total fixed maturity securities +34,878 +55,697 +687 +91,262 +Equity securities +642 +80 +80 +802 +Other investments +628 +0 +0 +628 +Cash and cash equivalents +4,896 +0 +0 +4,896 +Other assets: +Foreign currency swaps +0 +72 +169 +241 +Foreign currency forwards +0 +238 +0 +238 +Interest rate swaps +0 +3 +0 +3 +Total other assets +0 +313 +169 +482 +Total assets +$ +41,044 +$ +56,090 +$ +936 +$ +98,070 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +0 +$ +78 +$ +126 +$ +204 +Foreign currency forwards +0 +377 +0 +377 +Foreign currency options +0 +5 +0 +5 +Total liabilities +$ +0 +$ +460 +$ +126 +$ +586 +129 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities available for sale, carried at +fair value: +Fixed maturity securities: +Government and agencies +$ +32,993 +$ +1,349 +$ +0 +$ +34,342 +Municipalities +0 +1,863 +0 +1,863 +Mortgage- and asset-backed securities +0 +162 +177 +339 +Public utilities +0 +7,062 +109 +7,171 +Sovereign and supranational +0 +1,260 +0 +1,260 +Banks/financial institutions +0 +8,895 +23 +8,918 +Other corporate +0 +28,789 +213 +29,002 +Total fixed maturity securities +32,993 +49,380 +522 +82,895 +Equity securities +874 +67 +46 +987 +Other investments +152 +0 +0 +152 +Cash and cash equivalents +4,337 +0 +0 +4,337 +Other assets: +Foreign currency swaps +0 +103 +182 +285 +Foreign currency forwards +0 +126 +0 +126 +Foreign currency options +0 +3 +0 +3 +Interest rate swaps +0 +3 +0 +3 +Total other assets +0 +235 +182 +417 +Total assets +$ +38,356 +$ +49,682 +$ +750 +$ +88,788 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +0 +$ +132 +$ +102 +$ +234 +Foreign currency forwards +0 +151 +0 +151 +Foreign currency options +0 +1 +0 +1 +Interest rate swaptions +0 +1 +0 +1 +Total liabilities +$ +0 +$ +285 +$ +102 +$ +387 +130 +Item 8. Financial Statements and Supplementary Data +The following tables present the carrying amount and fair value categorized by fair value hierarchy level for the Company's financial instruments that are not carried at fair value as of December 31. +2019 +(In millions) +Carrying +Value +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities held to maturity, +carried at amortized cost: +Fixed maturity securities: +Government and agencies +$ +22,241 +$ +27,937 +$ +354 +$ +0 +$ +28,291 +Municipalities +821 +0 +1,083 +0 +1,083 +Mortgage and asset-backed +securities +16 +0 +7 +10 +17 +Public utilities +2,535 +0 +2,954 +0 +2,954 +Sovereign and +supranational +1,123 +0 +1,320 +0 +1,320 +Banks/financial institutions +916 +0 +1,018 +0 +1,018 +Other corporate +2,433 +0 +2,911 +0 +2,911 +Commercial mortgage and +other loans +9,569 +0 +0 +9,648 +9,648 +Other investments (1) +30 +0 +30 +0 +30 +Total assets +$ +39,684 +$ +27,937 +$ +9,677 +$ +9,658 +$ +47,272 +Liabilities: +Other policyholders’ funds +$ +7,317 +$ +0 +$ +0 +$ +7,234 +$ +7,234 +Notes payable +(excluding leases) +6,408 +0 +6,663 +272 +6,935 +Total liabilities +$ +13,725 +$ +0 +$ +6,663 +$ +7,506 +$ +14,169 +(1) Excludes policy loans of $ 250 and equity method investments of $ 569 , at carrying value +131 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Carrying +Value +Quoted Prices in +Active Markets +for Identical +Assets +(Level 1) +Significant +Observable +Inputs +(Level 2) +Significant +Unobservable +Inputs +(Level 3) +Total +Fair +Value +Assets: +Securities held to maturity, +carried at amortized cost: +Fixed maturity securities: +Government and agencies +$ +21,712 +$ +27,030 +$ +8 +$ +0 +$ +27,038 +Municipalities +359 +0 +469 +0 +469 +Mortgage and asset-backed +securities +14 +0 +0 +15 +15 +Public utilities +2,727 +0 +2,973 +0 +2,973 +Sovereign and +supranational +1,551 +0 +1,840 +0 +1,840 +Banks/financial institutions +1,445 +0 +1,583 +0 +1,583 +Other corporate +2,510 +0 +2,804 +0 +2,804 +Commercial mortgage and +other loans +6,919 +0 +0 +6,893 +6,893 +Other investments (1) +26 +0 +26 +0 +26 +Total assets +$ +37,263 +$ +27,030 +$ +9,703 +$ +6,908 +$ +43,641 +Liabilities: +Other policyholders’ funds +$ +7,146 +$ +0 +$ +0 +$ +7,067 +$ +7,067 +Notes payable +(excluding leases) +5,765 +0 +5,606 +270 +5,876 +Total liabilities +$ +12,911 +$ +0 +$ +5,606 +$ +7,337 +$ +12,943 +(1) Excludes policy loans of $ 232 and equity method investments of $ 377 , at carrying value +Fair Value of Financial Instruments +Fixed maturity and equity securities +The Company determines the fair values of fixed maturity securities and public and privately-issued equity securities using the following approaches or techniques: price quotes and valuations from third party pricing vendors (including quoted market prices readily available from public exchange markets) and non-binding price quotes the Company obtains from outside brokers. +A third party pricing vendor has developed valuation models to determine fair values of privately issued securities to reflect the impact of the persistent economic environment and the changing regulatory framework. These models are discounted cash flow (DCF) valuation models, but also use information from related markets, specifically the CDS market to estimate expected cash flows. These models take into consideration any unique characteristics of the securities and make various adjustments to arrive at an appropriate issuer-specific loss adjusted credit curve. This credit curve is then used with the relevant recovery rates to estimate expected cash flows and modeling of additional features, including illiquidity adjustments, if necessary, to price the security by discounting those loss adjusted cash flows. In cases where a credit curve cannot be developed from the specific security features, the valuation methodology takes into consideration other market observable inputs, including: +1) the most appropriate comparable security(ies) of the issuer +2) issuer-specific CDS spreads +3) bonds or CDS spreads of comparable issuers with similar characteristics such as rating, geography, or sector +4) bond indices that are comparative in rating, industry, maturity and region. +The pricing data and market quotes the Company obtains from outside sources, including third party pricing services, are reviewed internally for reasonableness. If a fair value appears unreasonable, the Company will re-examine the inputs and assess the reasonableness of the pricing data with the vendor. Additionally, the Company may compare the inputs to +132 +Item 8. Financial Statements and Supplementary Data +relevant market indices and other performance measurements. Based on management's analysis, the valuation is confirmed or may be revised if there is evidence of a more appropriate estimate of fair value based on available market data. The Company has performed verification of the inputs and calculations in any valuation models to confirm that the valuations represent reasonable estimates of fair value. +The fixed maturity securities classified as Level 3 consist of securities with limited or no observable valuation inputs. For Level 3 securities, the Company estimates the fair value of these securities by obtaining non-binding broker quotes from a limited number of brokers. These brokers base their quotes on a combination of their knowledge of the current pricing environment and market conditions. The Company considers these inputs to be unobservable. The Company also considers a variety of significant valuation inputs in the valuation process, including forward exchange rates, yen swap rates, dollar swap rates, interest rate volatilities, credit spread data on specific issuers, assumed default and default recovery rates, and certain probability assumptions. In obtaining these valuation inputs, the Company has determined that certain pricing assumptions and data used by its pricing sources are difficult to validate or corroborate by the market and/or appear to be internally developed rather than observed in or corroborated by the market. The use of these unobservable valuation inputs causes more subjectivity in the valuation process for these securities. +For the periods presented, the Company has not adjusted the quotes or prices it obtains from the pricing services and brokers it uses. +The following tables present the pricing sources for the fair values of the Company's fixed maturity and equity securities as of December 31. +133 +Item 8. Financial Statements and Supplementary Data +2019 +(In millions) +Quoted Prices in Active Markets for Identical Assets +(Level 1) +Significant Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities available for sale, carried at fair value: +Fixed maturity securities: +Government and agencies: +Third party pricing vendor +$ +34,878 +$ +1,522 +$ +0 +$ +36,400 +Total government and agencies +34,878 +1,522 +0 +36,400 +Municipalities: +Third party pricing vendor +0 +1,847 +0 +1,847 +Total municipalities +0 +1,847 +0 +1,847 +Mortgage- and asset-backed securities: +Third party pricing vendor +0 +232 +0 +232 +Broker/other +0 +0 +178 +178 +Total mortgage- and asset-backed securities +0 +232 +178 +410 +Public utilities: +Third party pricing vendor +0 +6,556 +0 +6,556 +Broker/other +0 +0 +224 +224 +Total public utilities +0 +6,556 +224 +6,780 +Sovereign and supranational: +Third party pricing vendor +0 +1,042 +0 +1,042 +Total sovereign and supranational +0 +1,042 +0 +1,042 +Banks/financial institutions: +Third party pricing vendor +0 +10,264 +0 +10,264 +Broker/other +0 +0 +23 +23 +Total banks/financial institutions +0 +10,264 +23 +10,287 +Other corporate: +Third party pricing vendor +0 +34,234 +0 +34,234 +Broker/other +0 +0 +262 +262 +Total other corporate +0 +34,234 +262 +34,496 +Total securities available for sale +$ +34,878 +$ +55,697 +$ +687 +$ +91,262 +Equity securities, carried at fair value: +Third party pricing vendor +$ +642 +$ +80 +$ +0 +$ +722 +Broker/other +0 +0 +80 +80 +Total equity securities +$ +642 +$ +80 +$ +80 +$ +802 +134 +Item 8. Financial Statements and Supplementary Data +2019 +(In millions) +Quoted Prices in Active Markets for Identical Assets +(Level 1) +Significant Observable Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Government and agencies: +Third party pricing vendor +$ +27,937 +$ +354 +$ +0 +$ +28,291 +Total government and agencies +27,937 +354 +0 +28,291 +Municipalities: +Third party pricing vendor +0 +1,083 +0 +1,083 +Total municipalities +0 +1,083 +0 +1,083 +Mortgage- and asset-backed securities: +Third party pricing vendor +0 +7 +0 +7 +Broker/other +0 +0 +10 +10 +Total mortgage- and asset-backed securities +0 +7 +10 +17 +Public utilities: +Third party pricing vendor +0 +2,954 +0 +2,954 +Total public utilities +0 +2,954 +0 +2,954 +Sovereign and supranational: +Third party pricing vendor +0 +1,320 +0 +1,320 +Total sovereign and supranational +0 +1,320 +0 +1,320 +Banks/financial institutions: +Third party pricing vendor +0 +1,018 +0 +1,018 +Total banks/financial institutions +0 +1,018 +0 +1,018 +Other corporate: +Third party pricing vendor +0 +2,911 +0 +2,911 +Total other corporate +0 +2,911 +0 +2,911 +Total securities held to maturity +$ +27,937 +$ +9,647 +$ +10 +$ +37,594 +135 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Quoted Prices in Active Markets +for Identical Assets +(Level 1) +Significant Observable +Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities available for sale, carried at fair value: +Fixed maturity securities: +Government and agencies: +Third party pricing vendor +$ +32,993 +$ +1,349 +$ +0 +$ +34,342 +Total government and agencies +32,993 +1,349 +0 +34,342 +Municipalities: +Third party pricing vendor +0 +1,863 +0 +1,863 +Total municipalities +0 +1,863 +0 +1,863 +Mortgage- and asset-backed securities: +Third party pricing vendor +0 +162 +0 +162 +Broker/other +0 +0 +177 +177 +Total mortgage- and asset-backed securities +0 +162 +177 +339 +Public utilities: +Third party pricing vendor +0 +7,062 +0 +7,062 +Broker/other +0 +0 +109 +109 +Total public utilities +0 +7,062 +109 +7,171 +Sovereign and supranational: +Third party pricing vendor +0 +1,260 +0 +1,260 +Total sovereign and supranational +0 +1,260 +0 +1,260 +Banks/financial institutions: +Third party pricing vendor +0 +8,895 +0 +8,895 +Broker/other +0 +0 +23 +23 +Total banks/financial institutions +0 +8,895 +23 +8,918 +Other corporate: +Third party pricing vendor +0 +28,789 +0 +28,789 +Broker/other +0 +0 +213 +213 +Total other corporate +0 +28,789 +213 +29,002 +Total securities available for sale +$ +32,993 +$ +49,380 +$ +522 +$ +82,895 +Equity securities, carried at fair value: +Third party pricing vendor +$ +874 +$ +67 +$ +0 +$ +941 +Broker/other +0 +0 +46 +46 +Total equity securities +$ +874 +$ +67 +$ +46 +$ +987 +136 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Quoted Prices in Active Markets +for Identical Assets +(Level 1) +Significant Observable +Inputs +(Level 2) +Significant Unobservable Inputs +(Level 3) +Total +Fair +Value +Securities held to maturity, carried at amortized cost: +Fixed maturity securities: +Government and agencies: +Third party pricing vendor +$ +27,030 +$ +8 +$ +0 +$ +27,038 +Total government and agencies +27,030 +8 +0 +27,038 +Municipalities: +Third party pricing vendor +0 +469 +0 +469 +Total municipalities +0 +469 +0 +469 +Mortgage- and asset-backed securities: +Broker/other +0 +0 +15 +15 +Total mortgage- and asset-backed securities +0 +0 +15 +15 +Public utilities: +Third party pricing vendor +0 +2,973 +0 +2,973 +Total public utilities +0 +2,973 +0 +2,973 +Sovereign and supranational: +Third party pricing vendor +0 +1,840 +0 +1,840 +Total sovereign and supranational +0 +1,840 +0 +1,840 +Banks/financial institutions: +Third party pricing vendor +0 +1,583 +0 +1,583 +Total banks/financial institutions +0 +1,583 +0 +1,583 +Other corporate: +Third party pricing vendor +0 +2,804 +0 +2,804 +Total other corporate +0 +2,804 +0 +2,804 +Total securities held to maturity +$ +27,030 +$ +9,677 +$ +15 +$ +36,722 +The following is a discussion of the determination of fair value of the Company's remaining financial instruments. +Derivatives +The Company uses derivative instruments to manage the risk associated with certain assets. However, the derivative instrument may not be classified in the same fair value hierarchy level as the associated asset. The Company uses pricing models to determine the estimated fair value of derivatives. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. The significant inputs to pricing derivatives are generally observable in the market or can be derived by observable market data. When these inputs are observable, the derivatives are classified as Level 2. +The fair values of the foreign currency forwards and options are based on observable market inputs, therefore they are classified as Level 2. +To determine the fair value of its interest rate derivatives, the Company uses inputs that are generally observable in the market or can be derived from observable market data. Interest rate swaps are cleared trades. In a cleared swap contract the clearinghouse provides benefits to the counterparties similar to contracts listed for investment traded on an exchange since it maintains a daily margin to mitigate counterparties credit risk. These derivatives are priced using observable inputs, accordingly, they are classified as Level 2. For its interest rate swaptions, the Company estimates their fair values using observable market data, including interest rate curves and volatilities. Their fair values are also classified as Level 2. +For derivatives associated with VIEs where the Company is the primary beneficiary, the Company is not the direct counterparty to the swap contracts. As a result, the fair value measurements incorporate the credit risk of the collateral associated with the VIE. The Company receives valuations from a third party pricing vendor for these derivatives. Based on +137 +Item 8. Financial Statements and Supplementary Data +an analysis of these derivatives and a review of the methodology employed by the pricing vendor, the Company determined that due to the long duration of these swaps and the need to extrapolate from short-term observable data to derive and measure long-term inputs, certain inputs, assumptions and judgments are required to value future cash flows that cannot be corroborated by current inputs or current observable market data. As a result, the derivatives associated with the Company's consolidated VIEs are classified as Level 3 of the fair value hierarchy. +Commercial mortgage and other loans +Commercial mortgage and other loans include transitional real estate loans, commercial mortgage loans and middle market loans. The Company's loan receivables do not have readily determinable market prices and generally lack market liquidity. Fair values for loan receivables are determined based on the present value of expected future cash flows discounted at the applicable U.S. Treasury or London Interbank Offered Rate (LIBOR) yield plus an appropriate spread that considers other risk factors, such as credit and liquidity risk. These spreads are provided by the applicable asset managers based on their knowledge of the current loan pricing environment and market conditions. The spreads are a significant component of the pricing inputs and are generally considered unobservable. Therefore, these investments have been assigned a Level 3 within the fair value hierarchy. +Other investments +Other investments includes short-term investments that are measured at fair value where amortized cost approximates fair value. +Other policyholders' funds +The largest component of the other policyholders' funds liability is the Company's annuity line of business in Aflac Japan. The Company's annuities have fixed benefits and premiums. For this product, the Company estimates the fair value to be equal to the cash surrender value. This is analogous to the value paid to policyholders on the valuation date if they were to surrender their policy. The Company periodically checks the cash value against discounted cash flow projections for reasonableness. The Company considers its inputs for this valuation to be unobservable and have accordingly classified this valuation as Level 3. +Notes payable +The fair values of the Company's publicly issued notes payable are determined by utilizing available sources of observable inputs from third party pricing vendors and are classified as Level 2. The fair values of the Company's yen-denominated loans approximate their carrying values and are classified as Level 3. +Transfers between Hierarchy Levels and Level 3 Rollforward +There were no transfers between Level 1 and 2 for assets and liabilities that are measured and carried at fair value on a recurring basis for the years ended December 31, 2019 and 2018 , respectively. +The following tables present the changes in fair value of the Company's investments and derivatives carried at fair value classified as Level 3 as of December 31. +138 +Item 8. Financial Statements and Supplementary Data +2019 +Fixed Maturity Securities +Equity +Securities +Derivatives (1) +(In millions) +Mortgage- +and +Asset- +Backed +Securities +Public +Utilities +Banks/ +Financial +Institutions +Other +Corporate +Foreign +Currency +Swaps +Credit +Default +Swaps +Total +Balance, beginning of period +$ +177 +$ +109 +$ +23 +$ +213 +$ +46 +$ +80 +$ +0 +$ +648 +Realized investment gains (losses) included +in earnings +0 +0 +0 +( 1 +) +0 +( 33 +) +0 +( 34 +) +Unrealized gains (losses) included in other +comprehensive income (loss) +1 +6 +1 +8 +0 +( 4 +) +0 +12 +Purchases, issuances, sales and settlements: +Purchases +0 +48 +0 +165 +34 +0 +0 +247 +Issuances +0 +0 +0 +0 +0 +0 +0 +0 +Sales +0 +( 24 +) +0 +( 17 +) +0 +0 +0 +( 41 +) +Settlements +0 +( 6 +) +0 +0 +0 +0 +0 +( 6 +) +Transfers into Level 3 +0 +116 +(2) +0 +26 +(2) +0 +0 +0 +142 +Transfers out of Level 3 +0 +( 25 +) +(2) +( 1 +) +( 132 +) +(2), (3) +0 +0 +0 +( 158 +) +Balance, end of period +$ +178 +$ +224 +$ +23 +$ +262 +$ +80 +$ +43 +$ +0 +$ +810 +Changes in unrealized gains (losses) relating +to Level 3 assets and liabilities still held at +the end of the period included in earnings +$ +0 +$ +0 +$ +0 +$ +0 +$ +0 +$ +( 33 +) +$ +0 +$ +( 33 +) +(1) Derivative assets and liabilities are presented net +(2) Transfer due to sector classification change +(3) Transfer due to availability of observable market inputs +2018 +Fixed Maturity Securities +Equity +Securities +Derivatives (1) +(In millions) +Mortgage- +and +Asset- +Backed +Securities +Public +Utilities +Banks/ +Financial +Institutions +Other +Corporate +Foreign +Currency +Swaps +Credit +Default +Swaps +Total +Balance, beginning of period +$ +175 +$ +68 +$ +25 +$ +146 +$ +16 +$ +22 +$ +1 +$ +453 +Realized investment gains (losses) included in +earnings +0 +0 +0 +0 +( 1 +) +54 +( 1 +) +52 +Unrealized gains (losses) included in other +comprehensive income (loss) +2 +1 +( 2 +) +1 +0 +4 +0 +6 +Purchases, issuances, sales and settlements: +Purchases +0 +40 +0 +56 +31 +0 +0 +127 +Issuances +0 +0 +0 +0 +0 +0 +0 +0 +Sales +0 +0 +0 +0 +0 +0 +0 +0 +Settlements +0 +0 +0 +( 6 +) +0 +0 +0 +( 6 +) +Transfers into Level 3 +0 +0 +0 +16 +0 +0 +0 +16 +Transfers out of Level 3 +0 +0 +0 +0 +0 +0 +0 +0 +Balance, end of period +$ +177 +$ +109 +$ +23 +$ +213 +$ +46 +$ +80 +$ +0 +$ +648 +Changes in unrealized gains (losses) relating +to Level 3 assets and liabilities still held at +the end of the period included in earnings +$ +0 +$ +0 +$ +0 +$ +0 +$ +( 1 +) +$ +54 +$ +( 1 +) +$ +52 +(1) Derivative assets and liabilities are presented net +139 +Item 8. Financial Statements and Supplementary Data +Fair Value Sensitivity +Level 3 Significant Unobservable Input Sensitivity +The following tables summarize the significant unobservable inputs used in the valuation of the Company's Level 3 investments and derivatives carried at fair value as of December 31. Included in the tables are the inputs or range of possible inputs that have an effect on the overall valuation of the financial instruments. +2019 +(In millions) +Fair Value +Valuation Technique(s) +Unobservable Input +Range +(Weighted Average) +Assets: +Securities available for sale, carried at fair value: +Fixed maturity securities: +Mortgage- and asset-backed securities +$ +178 +Consensus pricing +Offered quotes +N/A +(a) +Public utilities +224 +Discounted cash flow +Credit spreads +N/A +(a) +Banks/financial institutions +23 +Consensus pricing +Offered quotes +N/A +(a) +Other corporate +262 +Discounted cash flow +Credit spreads +N/A +(a) +Equity securities +80 +Net asset value +Offered quotes +N/A +(a) +Other assets: +Foreign currency swaps +106 +Discounted cash flow +Interest rates (USD) +1.89% - 2.09% +(b) +Interest rates (JPY) +.12% - .43% +(c) +CDS spreads +10 - 100 bps +63 +Discounted cash flow +Interest rates (USD) +1.89% - 2.09% +(b) +Interest rates (JPY) +.12% - .43% +(c) +Total assets +$ +936 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +118 +Discounted cash flow +Interest rates (USD) +1.89% - 2.09% +(b) +Interest rates (JPY) +.12% - .43% +(c) +CDS spreads +13 - 159 bps +8 +Discounted cash flow +Interest rates (USD) +1.89% - 2.09% +(b) +Interest rates (JPY) +.12% - .43% +(c) +Total liabilities +$ +126 +(a) N/A represents securities where the Company receives unadjusted broker quotes and for which there is no transparency into the providers' valuation techniques or unobservable inputs. +(b) Inputs derived from U.S. long-term rates to accommodate long maturity nature of the Company's swaps +(c) Inputs derived from Japan long-term rates to accommodate long maturity nature of the Company's swaps +140 +Item 8. Financial Statements and Supplementary Data +2018 +(In millions) +Fair Value +Valuation Technique(s) +Unobservable Input +Range +(Weighted Average) +Assets: +Securities available for sale, carried at fair value: +Fixed maturity securities: +Mortgage- and asset-backed securities +$ +177 +Consensus pricing +Offered quotes +N/A +(a) +Public utilities +109 +Discounted cash flow +Credit spreads +N/A +(a) +Banks/financial institutions +23 +Consensus pricing +Offered quotes +N/A +(a) +Other corporate +213 +Discounted cash flow +Credit spreads +N/A +(a) +Equity securities +46 +Net asset value +Offered quotes +N/A +(a) +Other assets: +Foreign currency swaps +125 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +CDS spreads +19 - 120 bps +57 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +Total assets +$ +750 +Liabilities: +Other liabilities: +Foreign currency swaps +$ +98 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +CDS spreads +28 - 211 bps +4 +Discounted cash flow +Interest rates (USD) +2.75% - 2.84% +(b) +Interest rates (JPY) +.18% - .71% +(c) +Total liabilities +$ +102 +(a) N/A represents securities where the Company receives unadjusted broker quotes and for which there is no transparency into the providers' valuation techniques or unobservable inputs. +(b) Inputs derived from U.S. long-term rates to accommodate long maturity nature of the Company's swaps +(c) Inputs derived from Japan long-term rates to accommodate long maturity nature of the Company's swaps +141 +Item 8. Financial Statements and Supplementary Data +The following is a discussion of the significant unobservable inputs or valuation techniques used in determining the fair value of securities and derivatives classified as Level 3. +Net Asset Value +The Company holds certain unlisted equity securities whose fair value is derived based on the financial statements published by the investee. These securities do not trade on an active market and the valuations derived are dependent on the availability of timely financial reporting of the investee. Net asset value is an unobservable input in the determination of fair value of equity securities. +Offered Quotes +In circumstances where the Company's valuation model price is overridden because it implies a value that is not consistent with current market conditions, the Company will solicit bids from a limited number of brokers. The Company also receives unadjusted prices from brokers for its mortgage and asset-backed securities. These quotes are non-binding but are reflective of valuation best estimates at that particular point in time. Offered quotes are an unobservable input in the determination of fair value of mortgage- and asset-backed securities, certain banks/financial institutions, certain other corporate, and equity securities investments. +Interest Rates and CDS Spreads +The significant drivers of the valuation of the foreign exchange swaps are interest rates and CDS spreads. Some of the Company's swaps have long maturities that increase the sensitivity of the swaps to interest rate fluctuations. For the Company's foreign exchange or cross currency swaps that are in a net asset position, an increase in yen interest rates (all other factors held constant) will decrease the present value of the yen final settlement receivable (receive leg), thus decreasing the value of the swap as long as the derivative remains in a net asset position. +Foreign exchange swaps also have a lump-sum final settlement of foreign exchange principal amounts at the termination of the swap. Assuming all other factors are held constant, an increase in yen interest rates will decrease the receive leg and decrease the net value of the swap. Likewise, holding all other factors constant, an increase in U.S. dollar interest rates will increase the swap's net value due to the decrease in the present value of the dollar final settlement payable (pay leg). +The extinguisher feature in most of the Company's VIE swaps results in a cessation of cash flows and no further payments between the parties to the swap in the event of a default on the referenced or underlying collateral. To price this feature, the Company applies the survival probability of the referenced entity to the projected cash flows. The survival probability uses the CDS spreads and recovery rates to adjust the present value of the cash flows. For extinguisher swaps with positive values, an increase in CDS spreads decreases the likelihood of receiving the final exchange payments and reduces the value of the swap. +For additional information on the Company's investments and financial instruments, see the accompanying Notes 1, 3 and 4. +6. DEFERRED POLICY ACQUISITION COSTS AND INSURANCE EXPENSES +Consolidated policy acquisition costs deferred were $ 1.5 billion in 2019 , 2018 and 2017 . The following table presents a rollforward of deferred policy acquisition costs by segment for the years ended December 31. +2019 +2018 +(In millions) +Japan +U.S. +Japan +U.S. +Deferred policy acquisition costs: +Balance, beginning of year +$ +6,384 +$ +3,491 +$ +6,150 +$ +3,355 +Capitalization +825 +626 +833 +669 +Amortization +( 709 +) +( 573 +) +( 710 +) +( 534 +) +Foreign currency translation and other +84 +0 +111 +1 +Balance, end of year +$ +6,584 +$ +3,544 +$ +6,384 +$ +3,491 +Commissions deferred as a percentage of total acquisition costs deferred were 74 % in 2019 , compared with 72 % in both 2018 and 2017 . +142 +Item 8. Financial Statements and Supplementary Data +Personnel, compensation and benefit expenses as a percentage of insurance expenses were 57 % in 2019 , compared with 54 % in 2018 and 56 % in 2017 . Advertising expense, which is included in insurance expenses in the consolidated statements of earnings, was as follows for the years ended December 31: +(In millions) +2019 +2018 +2017 +Advertising expense: +Aflac Japan +$ +101 +$ +108 +$ +100 +Aflac U.S. +118 +110 +110 +Total advertising expense +$ +219 +$ +218 +$ +210 +Depreciation and other amortization expenses, which are included in insurance expenses in the consolidated statements of earnings, were as follows for the years ended December 31: +(In millions) +2019 +2018 +2017 +Depreciation expense +$ +40 +$ +48 +$ +50 +Other amortization expense +1 +1 +3 +Total depreciation and other amortization expense +$ +41 +$ +49 +$ +53 +7. POLICY LIABILITIES +Policy liabilities consist of future policy benefits, unpaid policy claims, unearned premiums, and other policyholders' funds, which accounted for 85 % , 4 % , 4 % and 7 % of total policy liabilities at December 31, 2019 , respectively. The Company regularly reviews the adequacy of its policy liabilities in total and by component. +The liability for future policy benefits as of December 31 consisted of the following: +Liability Amounts +Interest Rate Assumptions +(In millions) +2019 +2018 +Health insurance +Japan +$ +50,941 +$ +49,496 +0.6 - 6.75 +% +U.S. +8,646 +8,442 +3.0 - 7.0 +Intercompany eliminations +( 532 +) +(1) +( 583 +) +(1) +2.0 +Life insurance +Japan +30,520 +28,318 +1.0 - 4.5 +U.S. +760 +695 +2.5 - 6.0 +Total +$ +90,335 +$ +86,368 +(1) Elimination entry necessary due to recapture of a portion of policy liabilities ceded externally, as a result of the reinsurance retrocession transaction as described in Note 8 of the Notes to the Consolidated Financial Statements +The weighted-average interest rates reflected in the consolidated statements of earnings for future policy benefits for Japanese policies were 3.2 % in 2019 , compared with 3.3 % in 2018 and 3.4 % in 2017 ; and for U.S. policies, 5.3 % in 2019 , compared with 5.3 % in 2018 and 5.4 % in 2017 . +143 +Item 8. Financial Statements and Supplementary Data +Changes in the liability for unpaid policy claims were as follows for the years ended December 31: +(In millions) +2019 +2018 +2017 +Unpaid supplemental health claims, beginning of period +$ +3,952 +$ +3,884 +$ +3,707 +Less reinsurance recoverables +27 +30 +27 +Net balance, beginning of period +3,925 +3,854 +3,680 +Add claims incurred during the period related to: +Current year +7,216 +7,101 +6,979 +Prior years +( 552 +) +( 563 +) +( 518 +) +Total incurred +6,664 +6,538 +6,461 +Less claims paid during the period on claims incurred during: +Current year +4,715 +4,612 +4,530 +Prior years +1,965 +1,898 +1,822 +Total paid +6,680 +6,510 +6,352 +Effect of foreign exchange rate changes on unpaid claims +29 +43 +65 +Net balance, end of period +3,938 +3,925 +3,854 +Add reinsurance recoverables +30 +27 +30 +Unpaid supplemental health claims, end of period +3,968 +3,952 +3,884 +Unpaid life claims, end of period +691 +632 +508 +Total liability for unpaid policy claims +$ +4,659 +$ +4,584 +$ +4,392 +The incurred claims development related to prior years reflects favorable claims experience compared to previous estimates. The favorable claims development of $ 552 million for 2019 comprises approximately $ 395 million from Japan, which represents approximately 72 % of the total. Excluding the impact of foreign exchange of a gain of approximately $ 5 million from December 31, 2018 to December 31, 2019 , the favorable claims development in Japan would have been approximately $ 390 million , representing approximately 71 % of the total. +The Company has experienced continued favorable claim trends in 2019 for its core health products in Japan. The Company's experience in Japan related to the average length of stay in the hospital for cancer treatment has shown continued decline in the current period. In addition, cancer treatment patterns in Japan are continuing to be influenced by significant advances in early-detection techniques and by the increased use of pathological diagnosis rather than clinical exams. Additionally, follow-up radiation and chemotherapy treatments are occurring more often on an outpatient basis. Such changes in treatment not only increase the quality of life and initial outcomes for the patients, but also decrease the average length of each hospital stay, resulting in favorable claims development. +As of December 31, 2019 and 2018 , unearned premiums consisted primarily of discounted advance premiums on deposit. Discounted advance premiums are premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan limited-pay insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. These advanced premiums represented 64 % of the December 31, 2019 and 69 % of the December 31, 2018 unearned premiums balances. +As of December 31, 2019 and 2018 , the largest component of the other policyholders' funds liability was the Company's annuity line of business in Aflac Japan. The Company's annuities have fixed benefits and premiums. These annuities represented 97 % of other policyholders' funds liability at December 31, 2019 and 2018 . +144 +Item 8. Financial Statements and Supplementary Data +8. REINSURANCE +The Company periodically enters into fixed quota-share coinsurance agreements with other companies in the normal course of business. For each of its reinsurance agreements, the Company determines whether the agreement provides indemnification against loss or liability relating to insurance risk in accordance with applicable accounting standards. Reinsurance premiums and benefits paid or provided are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and benefits are reported net of insurance ceded. +The Company has recorded a deferred profit liability related to reinsurance transactions. The remaining deferred profit liability of $ 1.0 billion , as of December 31, 2019 , is included in future policy benefits in the consolidated balance sheet and is being amortized into income over the expected lives of the policies. The Company has also recorded a reinsurance recoverable for reinsurance transactions, which is included in other assets in the consolidated balance sheet and had a remaining balance of $ 970 million and $ 941 million as of December 31, 2019 and 2018 , respectively. The increase in the reinsurance recoverable balance was driven by two aggregating factors: yen strengthening and the growth in reserves related to the business that has been reinsured as the policies age. The spot yen/dollar exchange rate strengthened by approximately 1.3 % and ceded reserves increased approximately 1.4 % from December 31, 2018 , to December 31, 2019 . +The following table reconciles direct premium income and direct benefits and claims to net amounts after the effect of reinsurance for the years ended December 31. +(In millions) +2019 +2018 +2017 +Direct premium income +$ +19,122 +$ +19,018 +$ +18,875 +Ceded to other companies: +Ceded Aflac Japan closed blocks +( 478 +) +( 497 +) +( 515 +) +Other +( 69 +) +( 58 +) +( 51 +) +Assumed from other companies: +Retrocession activities +200 +208 +216 +Other +5 +6 +6 +Net premium income +$ +18,780 +$ +18,677 +$ +18,531 +Direct benefits and claims +$ +12,237 +$ +12,293 +$ +12,486 +Ceded benefits and change in reserves for future benefits: +Ceded Aflac Japan closed blocks +( 433 +) +( 450 +) +( 473 +) +Eliminations +41 +43 +51 +Other +( 57 +) +( 44 +) +( 44 +) +Assumed from other companies: +Retrocession activities +194 +209 +209 +Eliminations +( 41 +) +( 53 +) +( 51 +) +Other +1 +2 +3 +Benefits and claims, net +$ +11,942 +$ +12,000 +$ +12,181 +These reinsurance transactions are indemnity reinsurance that do not relieve the Company from its obligations to policyholders. In the event that the reinsurer is unable to meet their obligations, the Company remains liable for the reinsured claims. +As a part of its capital contingency plan, the Company entered into a committed reinsurance facility agreement on December 1, 2015 in the amount of approximately ¥ 110 billion of reserves. This reinsurance facility agreement was renewed in 2019 and is effective until December 31, 2020. There are also additional commitment periods of a one-year duration each of which are automatically extended unless notification is received from the reinsurer within 60 days prior to the expiration. The reinsurer can withdraw from the committed facility if Aflac‘s Standard and Poor's (S&P) rating drops below BBB-. As of December 31, 2019 , the Company had not executed a reinsurance treaty under this committed reinsurance facility. +145 +Item 8. Financial Statements and Supplementary Data +9. NOTES PAYABLE AND LEASE OBLIGATIONS +A summary of notes payable and lease obligations as of December 31 follows: +(In millions) +2019 +2018 +4.00% senior notes due February 2022 (1) +$ +348 +$ +348 +3.625% senior notes due June 2023 +698 +698 +3.625% senior notes due November 2024 +747 +746 +3.25% senior notes due March 2025 +448 +447 +2.875% senior notes due October 2026 +298 +297 +6.90% senior notes due December 2039 +220 +220 +6.45% senior notes due August 2040 +254 +254 +4.00% senior notes due October 2046 +394 +394 +4.750% senior notes due January 2049 +541 +540 +Yen-denominated senior notes and subordinated debentures: +.932% senior notes due January 2027 (principal amount ¥60.0 billion) +545 +538 +.500% senior notes due December 2029 (principal amount ¥12.6 billion) +114 +0 +1.159% senior notes due October 2030 (principal amount ¥29.3 billion) +266 +262 +.843% senior notes due December 2031 (principal amount ¥9.3 billion) +84 +0 +1.488% senior notes due October 2033 (principal amount ¥15.2 billion) +138 +136 +.934% senior notes due December 2034 (principal amount ¥9.8 billion) +88 +0 +1.750% senior notes due October 2038 (principal amount ¥8.9 billion) +81 +79 +1.122% senior notes due December 2039 (principal amount ¥6.3 billion) +57 +0 +2.108% subordinated debentures due October 2047 (principal amount ¥60.0 billion) +543 +536 +.963% subordinated bonds due April 2049 (principal amount ¥30.0 billion) +272 +0 +Yen-denominated loans: +Variable interest rate loan due September 2026 (.42% in 2019 and .32% in 2018, principal amount ¥5.0 billion) +45 +45 +Variable interest rate loan due September 2029 (.57% in 2019 and .47% in 2018, principal amount ¥25.0 billion) +227 +225 +Finance lease obligations payable through 2026 +12 +13 +Operating lease obligations payable through 2049 (2) +149 +0 +Total notes payable and lease obligations +$ +6,569 +$ +5,778 +(1) Redeemed in January 2020 +(2) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2019 related to leases. +Amounts in the table above are reported net of debt issuance costs and issuance premiums or discounts, if applicable, that are being amortized over the life of the notes. +In December 2019, the Parent Company issued four series of senior notes totaling ¥ 38.0 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥ 12.6 billion , bears interest at a fixed rate of .500 % per annum, payable semi-annually, and will mature in December 2029. The second series, which totaled ¥ 9.3 billion , bears interest at a fixed rate of .843 % per annum, payable semi-annually, and will mature in December 2031. The third series, which totaled ¥ 9.8 billion , bears interest at a fixed rate of .934 % per annum, payable semi-annually, and will mature in December 2034. The fourth series, which totaled ¥ 6.3 billion , bears interest at a fixed rate of 1.122 % per annum, payable semi-annually, and will mature in December 2039. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In September 2019, the Parent Company renewed a ¥ 30.0 billion senior term loan facility. The first tranche of the facility, which totaled ¥ 5.0 billion , bears interest at a rate per annum equal to the Tokyo interbank market rate (TIBOR), or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2026. The applicable margin ranges between .30 % and .70 % , depending on the Parent Company's debt ratings as of the date of determination. The second tranche, which totaled ¥ 25.0 billion , bears interest at a rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, +146 +Item 8. Financial Statements and Supplementary Data +plus the applicable TIBOR margin and will mature in September 2029. The applicable margin ranges between .45 % and 1.00 % , depending on the Parent Company's debt ratings as of the date of determination. +In April 2019, ALIJ issued ¥ 30.0 billion (par value) of perpetual subordinated bonds. These bonds bear interest at a fixed rate of .963 % per annum and then at six-month Euro Yen LIBOR plus an applicable spread on and after the day immediately following April 18, 2024. The bonds will be callable on each interest payment date on and after April 18, 2024. In November 2019, ALIJ amended the bonds to change their duration from perpetual to a stated maturity date of April 16, 2049 and to remove provisions that permitted ALIJ to defer payments of interest under certain circumstances. +In October 2018, the Parent Company issued $ 550 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.750 % per annum, payable semi-annually, and will mature in January 2049. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a U.S.Treasury security with a maturity comparable to the remaining term of the notes, plus 25 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. +In October 2018, the Parent Company issued three series of senior notes totaling ¥ 53.4 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥ 29.3 billion , bears interest at a fixed rate of 1.159 % per annum, payable semi-annually, and will mature in October 2030. The second series, which totaled ¥ 15.2 billion , bears interest at a fixed rate of 1.488 % per annum, payable semi-annually, and will mature in October 2033. The third series, which totaled ¥ 8.9 billion , bears interest at a fixed rate of 1.750 % per annum, payable semi-annually, and will mature in October 2038. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In October 2017, the Parent Company issued ¥ 60.0 billion of subordinated debentures through a U.S. public debt offering. The debentures bear interest at an initial rate of 2.108 % per annum through October 22, 2027, or earlier redemption. Thereafter, the rate of the interest of the debentures will be reset every five years at a rate of interest equal to the then-current JPY 5-year Swap Offered Rate plus 205 basis points. The debentures are payable semi-annually in arrears and will mature in October 2047. The debentures are redeemable (i) at any time, in whole but not in part, upon the occurrence of certain tax events or certain rating agency events, as specified in the indenture governing the terms of the debentures or (ii) on or after October 23, 2027, in whole or in part, at a redemption price equal to their principal amount plus accrued and unpaid interest to, but excluding, the date of redemption. +In January 2017, the Parent Company issued ¥ 60.0 billion of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of .932 % per annum, payable semi-annually, and will mature in January 2027. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In September 2016, the Parent Company issued two series of senior notes totaling $ 700 million through a U.S. public debt offering. The first series, which totaled $ 300 million , bears interest at a fixed rate of 2.875 % per annum, payable semi-annually and will mature in October 2026. The second series, which totaled $ 400 million , bears interest at a fixed rate of 4.00 % per annum, payable semi-annually, and will mature in October 2046. +In March 2015, the Parent Company issued $ 450 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 3.25 % per annum, payable semi-annually, and will mature in March 2025. The Parent Company entered into cross-currency swaps that convert the U.S. dollar-denominated principal and interest on the senior notes into yen-denominated obligations which results in lower nominal net interest rates on the debt. By entering into these cross-currency swaps, the Parent Company economically converted its $ 450 million liability into a ¥ 55.0 billion yen liability and reduced the interest rate on this debt from 3.25 % in dollars to .82 % in yen. +In November 2014, the Parent Company issued $ 750 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 3.625 % per annum, payable semi-annually, and will mature in November 2024. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the treasury rate plus 20 basis points, plus in each case, accrued and unpaid interest on the principal +147 +Item 8. Financial Statements and Supplementary Data +amount of the notes to be redeemed to, but excluding, such redemption date. The Parent Company entered into cross-currency interest rate swaps to reduce interest expense by converting the U.S. dollar-denominated principal and interest on the senior notes it issued into yen-denominated obligations. By entering into the swaps, the Parent Company economically converted its $ 750 million liability into an ¥ 85.3 billion liability and reduced the interest rate on this debt from 3.625 % in dollars to 1.00 % in yen. +In June 2013, the Parent Company issued $ 700 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 3.625 % per annum, payable semi-annually, and will mature in June 2023. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the treasury rate plus 20 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date. The Parent Company had entered into cross-currency interest rate swaps to reduce interest expense by converting the U.S. dollar-denominated principal and interest on the senior notes it issued into yen-denominated obligations. By entering into these swaps, the Parent Company economically converted its $ 700 million liability into a ¥ 69.8 billion liability and reduced the interest rate on this debt from 3.625 % in dollars to 1.50 % in yen. +In February 2012, the Parent Company issued $ 350 million of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 4.00 % per annum, payable semiannually, and will mature in February 2022. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the principal amount of the notes or (ii) the present value of the remaining scheduled payments of principal and interest to be redeemed, discounted to the redemption date, plus accrued and unpaid interest. The Parent Company entered into cross-currency interest rate swaps to reduce interest expense by converting the U.S. dollar-denominated principal and interest on the senior notes it issued into yen-denominated obligations. By entering into these swaps, the Parent Company economically converted its $ 350 million liability into a ¥ 27.0 billion liability and reduced the interest rate on this debt from 4.00 % in dollars to 2.07 % in yen. +In 2010 and 2009, the Parent Company issued senior notes through U.S. public debt offerings; the details of these notes are as follows. In August 2010, the Parent Company issued $ 450 million of senior notes that will mature in August 2040. In December 2009, the Parent Company issued $ 400 million of senior notes that will mature in December 2039. These senior notes pay interest semiannually and are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the principal amount of the notes or (ii) the present value of the remaining scheduled payments of principal and interest to be redeemed, discounted to the redemption date, plus accrued and unpaid interest. In December 2016, the Parent Company completed a tender offer in which it extinguished $ 176 million principal of its 6.90 % senior notes due December 2039 and $ 193 million principal of its 6.45 % senior notes due August 2040. The pretax loss due to the early redemption of these notes was $ 137 million . +For the Company's yen-denominated notes and loans, the principal amount as stated in dollar terms will fluctuate from period to period due to changes in the yen/dollar exchange rate. The Company has designated the majority of its yen-denominated notes payable as a nonderivative hedge of the foreign currency exposure of the Company's investment in Aflac Japan. +The aggregate contractual maturities of notes payable during each of the years after December 31, 2019 , are as follows: +(In millions) +Total +Notes +Payable +2020 +$ +0 +2021 +0 +2022 +350 +2023 +700 +2024 +750 +Thereafter +4,658 +Total +$ +6,458 +148 +Item 8. Financial Statements and Supplementary Data +The following table presents the contractual maturities and present value of lease liabilities as of December 31. +2019 +(In millions) +Operating Leases +Finance Leases +Total +2020 +$ +49 +$ +4 +$ +53 +2021 +37 +3 +40 +2022 +31 +2 +33 +2023 +10 +2 +12 +2024 +10 +1 +11 +After 2024 +22 +0 +22 +Total lease payments +$ +159 +$ +12 +$ +171 +Less: Interest +10 +0 +10 +Present value of lease liabilities +$ +149 +$ +12 +$ +161 +The following table presents the weighted average remaining lease term and weighted average discount rate for lease liabilities as of December 31. +2019 +Weighted average remaining lease term (years): +Operating leases +6.8 +Finance leases +3.7 +Weighted average discount rate: +Operating leases +2.1 % +Finance leases +1.5 % +Operating lease costs, included in insurance expenses in the consolidated statements of earnings, were $ 54 million , $ 73 million and $ 75 million for the years ended December 31, 2019 , 2018 and 2017, respectively. Operating cash outflow for operating leases was $ 52 million for the year ended December 31, 2019 . +149 +Item 8. Financial Statements and Supplementary Data +A summary of the Company's lines of credit as of December 31, 2019 follows: +Borrower +Type +Original Term +Expiration Date +Capacity +Amount Outstanding +Interest Rate on Borrowed Amount +Maturity Period +Commitment Fee +Business Purpose +Aflac Incorporated +and Aflac +uncommitted bilateral +364 days +December 18, 2020 +$100 million +$0 million +The rate quoted by the bank and agreed upon at the time of borrowing +Up to 3 months +None +General corporate purposes +Aflac Incorporated +unsecured revolving +5 years +March 29, +2024, or the date commitments are terminated pursuant to an event of default +¥100.0 billion +¥0.0 billion +A rate per annum equal to (a) Tokyo interbank market rate (TIBOR) plus, the alternative applicable TIBOR margin during the availability period from the closing date to the commitment termination date or (b) the TIBOR rate offered by the agent to major banks in yen for the applicable period plus, the applicable alternative TIBOR margin during the term out period +No later than +March 29, 2024 +.30% to .50%, depending on the Parent Company's debt ratings as of the date of determination +General corporate purposes, including a capital contingency plan for the operations of the Parent Company +Aflac Incorporated +and Aflac +unsecured revolving +5 years +November 18, 2024, or the date commitments are terminated pursuant to an event of default +$1.0 billion +$0.0 billion +A rate per annum equal to, at the Company's option, either, (a) the rate for Eurocurrency for deposits in the London interbank market for a period of one, two, three or six months (LIBOR) or (b) a base rate determined by reference to the highest of (1) the federal funds rate plus 1/2 of 1%, (2) the rate of interest in effect for such day as publicly announced from time to time by Mizuho as its “prime rate”, and (3) the LIBOR for a one month interest period in effect on such day (or if such day is not a business day, the immediately preceding business day) plus 1.00%, and in each case an applicable margin +No later than November 18, 2024 +.085% to +.225%, depending on the Parent Company's debt ratings as of the date of determination +General corporate purposes, including a capital contingency plan for the operations of the Parent Company +Aflac Incorporated +and Aflac +uncommitted bilateral +None specified +None specified +$50 million +$0 million +A rate per annum equal to, at the Parent Company's option, either (a) a eurocurrency rate determined by reference to the agent's LIBOR for the interest period relevant to such borrowing or (b) the base rate determined by reference to the greater of (i) the prime rate as determined by the agent, and (ii) the sum of 0.50% and the federal funds rate for such day +Up to 3 months +None +General corporate purposes +Aflac (1) +uncommitted revolving +364 days +November 30, 2020 +$250 million +$0 million +USD three-month LIBOR plus 75 basis points per annum +3 months +None +General corporate purposes +Aflac Incorporated (1) +uncommitted revolving +364 days +April 2, 2020 +¥50.0 billion +¥0.0 billion +Three-month TIBOR plus 70 basis points per annum +3 months +None +General corporate purposes +Aflac Incorporated (1) +uncommitted revolving +364 days +November 25, 2020 +¥50.0 billion +¥0.0 billion +Three-month TIBOR plus 70 basis points per annum +3 months +None +General corporate purposes +(1) Intercompany credit agreement +The Parent Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2019 . No events of default or defaults occurred during 2019 and 2018 . +150 +Item 8. Financial Statements and Supplementary Data +10. INCOME TAXES +The components of income tax expense (benefit) applicable to pretax earnings for the years ended December 31 were as follows: +(In millions) +Foreign +U.S. +Total +2019: +Current +$ +737 +$ +69 +$ +806 +Deferred +183 +152 +335 +Total income tax expense +$ +920 +$ +221 +$ +1,141 +2018: +Current +$ +771 +$ +608 +$ +1,379 +Deferred +93 +( 409 +) +( 316 +) +Total income tax expense +$ +864 +$ +199 +$ +1,063 +2017: +Current +$ +722 +$ +( 91 +) +$ +631 +Deferred +( 24 +) +( 1,193 +) +( 1,217 +) +Total income tax expense +$ +698 +$ +( 1,284 +) +$ +( 586 +) +The Japan income tax rate for the fiscal year 2017 was 28.2 % . The rate was reduced to 28.0 % for fiscal years 2018 and 2019. +For the U.S., the Tax Cuts and Jobs Act (Tax Act) was signed into law on December 22, 2017. Effective January 1, 2018, the Tax Act imposed a broad number of changes in tax law, including permanently reducing the U.S. federal statutory corporate income tax rate from 35 % to 21 % , eliminating or reducing certain deductions and credits and limiting the deductibility of interest expense and executive compensation. +In accordance with Staff Accounting Bulletin 118 (SAB 118) issued by the U.S. Securities and Exchange Commission in December 2017, the Company recorded provisional amounts for certain items for which the income tax accounting was not complete. As of the enactment date, the Company estimated provisional amounts for its deferred taxes, including related valuation allowance, resulting in a reduction of its DTAs by approximately $ 1.0 billion and its deferred tax liabilities (DTLs) by $ 2.9 billion , for a net DTL reduction of approximately $ 1.9 billion . The provisions of ASC 740-10, Income Taxes , require that the effects of changes in tax law on deferred taxes be recognized as a component of the income tax provision in the period the tax rate change was enacted. Therefore, the $ 1.9 billion provisional amount of net DTL reduction was recorded in the fourth quarter of 2017 as a reduction in the “Income tax expense, Deferred” line item of the Company’s consolidated statement of earnings. +In 2018, the Company recorded additional income tax expense of $ .4 million resulting from a decrease in the SAB 118 provisional estimate related to Japan deferred tax balances. No further adjustment was made to the SAB 118 provisional estimate related to the valuation allowance. As of December 31, 2018, the Company has completed its accounting for the Tax Act in accordance with SAB 118. +Income tax expense in the accompanying statements of earnings varies from the amount computed by applying the expected U.S. tax rate of 21 % in both 2019 and 2018 and 35 % in 2017 to pretax earnings. The principal reasons for the differences and the related tax effects for the years ended December 31 were as follows: +(In millions) +2019 +2018 +2017 +Income taxes based on U.S. statutory rates +$ +933 +$ +836 +$ +1,406 +Foreign rate differential +229 +220 +0 +Write-down of U.S. deferred tax liabilities for tax reform change +0 +0 +( 1,933 +) +Utilization of foreign tax credit +( 6 +) +( 3 +) +( 27 +) +Nondeductible expenses +10 +21 +10 +Other, net +( 25 +) +( 11 +) +( 42 +) +Income tax expense +$ +1,141 +$ +1,063 +$ +( 586 +) +151 +Item 8. Financial Statements and Supplementary Data +Total income tax expense for the years ended December 31 was allocated as follows: +(In millions) +2019 +2018 +2017 +Statements of earnings +$ +1,141 +$ +1,063 +$ +( 586 +) +Other comprehensive income (loss): +Unrealized foreign currency translation gains (losses) during period +27 +10 +52 +Unrealized gains (losses) on investment securities: +Unrealized holding gains (losses) on investment +securities during period +1,532 +( 787 +) +575 +Reclassification adjustment for realized (gains) losses +on investment securities included in net earnings +5 +( 12 +) +1 +Unrealized gains (losses) on derivatives during period +( 3 +) +0 +0 +Pension liability adjustment during period +( 18 +) +( 8 +) +3 +Total income tax expense (benefit) related to items of +other comprehensive income (loss) +1,543 +( 797 +) +631 +Total income taxes +$ +2,684 +$ +266 +$ +45 +The income tax effects of the temporary differences that gave rise to deferred income tax assets and liabilities as of December 31 were as follows: +(In millions) +2019 +2018 +Deferred income tax liabilities: +Deferred policy acquisition costs +$ +3,492 +$ +3,404 +Unrealized gains and other basis differences on investments +4,485 +1,307 +Premiums receivable +152 +149 +Policy benefit reserves +3,442 +3,828 +Total deferred income tax liabilities +11,571 +8,688 +Deferred income tax assets: +Unfunded retirement benefits +8 +8 +Other accrued expenses +36 +40 +Policy and contract claims +781 +775 +Foreign currency loss on Aflac Japan +16 +38 +Deferred compensation +162 +163 +Capital loss carryforwards +34 +5 +Depreciation +164 +119 +Anticipatory foreign tax credit +5,487 +4,040 +Deferred foreign tax credit +605 +591 +Other +204 +150 +Total deferred income tax assets before valuation allowance +7,497 +5,929 +Valuation allowance +( 1,340 +) +( 738 +) +Total deferred income tax assets after valuation allowance +6,157 +5,191 +Net deferred income tax liability +5,414 +3,497 +Current income tax (asset) liability +( 44 +) +523 +Total income tax liability +$ +5,370 +$ +4,020 +The application of U.S. GAAP requires the Company to evaluate the recoverability of deferred tax assets and establish a valuation allowance if necessary to reduce the deferred tax asset to an amount that is more likely than not expected to be realized. The Company has determined a $ 1,022 million valuation allowance against its anticipatory foreign tax credit is necessary. The anticipatory foreign tax credit represents the foreign tax credit the Company will generate from the reversal of Japan deferred tax liabilities in the future. The increase in the valuation allowance on the anticipatory foreign tax credit is due to an increase Japan's local country deferred tax inventory relative to the deferred tax inventory for Japan's U.S. tax obligation. The Company has also determined a $ 318 million valuation allowance against its deferred foreign tax credits is necessary. Deferred foreign tax credits are foreign tax credits generated in the current tax year by the Japanese life company, but are unable to be utilized until 2020 due to Japan's current tax year not closing until March 31, 2020. The valuation +152 +Item 8. Financial Statements and Supplementary Data +allowance on the deferred foreign tax credit has increased due to the utilization of prior year credits as well as the recognition of the current year deferred foreign tax credit. Based upon a review of the Company's anticipated future taxable income, and including all other available evidence, both positive and negative, the Company's management has concluded that, notwithstanding the items noted above, it is more likely than not that all other deferred tax assets will be realized. +Under U.S. income tax rules, only 35% of non-life operating losses can be offset against life insurance taxable income each year . For current U.S. income tax purposes, as of December 31, 2019 , there were non-life operating loss carryforwards of $ 99 million available to offset against future taxable income, of which $ 31 million expires in 2039, and $ 68 million does not expire. The Company has capital loss carryforwards of $ 161 million available to offset capital gains, of which $ 65 million expires in 2023 and $ 96 million expires in 2024. +The Company files federal income tax returns in the U.S. and Japan as well as state or prefecture income tax returns in various jurisdictions in the two countries. The Company is currently under audit by the IRS for the 2013-2016 amended federal income tax returns. There are currently no other open Federal, State, or local U.S. income tax audits. U.S. federal income tax returns for years before 2016 are no longer subject to examination. Japan corporate income tax returns for years before 2016 are no longer subject to examination. Management believes it has established adequate tax liabilities and final resolution of all open audits is not expected to have a material impact on the Company's consolidated financial statements. +A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows for the years ended December 31: +(In millions) +2019 +2018 +Balance, beginning of year +$ +15 +$ +14 +Additions for tax positions of prior years +2 +1 +Balance, end of year +$ +17 +$ +15 +Included in the balance of the liability for unrecognized tax benefits at December 31, 2019 , are $ 15 million of tax positions for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility, compared with $ 14 million at December 31, 2018 . Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate, but would accelerate the payment of cash to the taxing authority to an earlier period. The Company has accrued approximately $ 2 million as of December 31, 2019 , for permanent uncertainties, which if reversed would not have a material effect on the annual effective rate. +The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company recognized approximately $ 1 million in interest and penalties in 2019 , 2018 and 2017 , respectively. The Company has accrued approximately $ 2 million for the payment of interest and penalties as of December 31, 2019 , compared with $ 2 million at December 31, 2018 . +As of December 31, 2019 , there were no material uncertain tax positions for which the total amounts of unrecognized tax benefits will significantly increase or decrease within the next 12 months. +11. +SHAREHOLDERS' EQUITY +The following table is a reconciliation of the number of shares of the Company's common stock for the years ended December 31. +153 +Item 8. Financial Statements and Supplementary Data +(In thousands of shares) +2019 +2018 +2017 +Common stock - issued: +Balance, beginning of period +1,347,540 +1,345,762 +1,342,498 +Exercise of stock options and issuance of restricted shares +1,769 +1,778 +3,264 +Balance, end of period +1,349,309 +1,347,540 +1,345,762 +Treasury stock: +Balance, beginning of period +592,254 +564,852 +530,877 +Purchases of treasury stock: +Share repurchase program +31,994 +28,949 +35,510 +Other +592 +392 +1,018 +Dispositions of treasury stock: +Shares issued to AFL Stock Plan +( 1,610 ) +( 1,306 ) +( 1,782 ) +Exercise of stock options +( 418 ) +( 519 ) +( 734 ) +Other +( 296 ) +( 114 ) +( 37 ) +Balance, end of period +622,516 +592,254 +564,852 +Shares outstanding, end of period +726,793 +755,286 +780,910 +Outstanding share-based awards are excluded from the calculation of weighted-average shares used in the computation of basic EPS. The following table presents the approximate number of share-based awards to purchase shares, on a weighted-average basis, that were considered to be anti-dilutive and were excluded from the calculation of diluted earnings per share at December 31: +(In thousands) +2019 +2018 +2017 +Anti-dilutive share-based awards +6 +44 +510 +The weighted-average shares used in calculating earnings per share for the years ended December 31 were as follows: +(In thousands of shares) +2019 +2018 +2017 +Weighted-average outstanding shares used for calculating basic EPS +742,414 +769,588 +792,042 +Dilutive effect of share-based awards +4,016 +5,062 +5,819 +Weighted-average outstanding shares used for calculating diluted EPS +746,430 +774,650 +797,861 +Share Repurchase Program: During 2019 , the Company repurchased 32.0 million shares of its common stock in the open market for $ 1.6 billion . The Company repurchased 28.9 million shares for $ 1.3 billion in 2018 and 35.5 million shares for $ 1.4 billion in 2017 . As of December 31, 2019 , a remaining balance of 37.1 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its board of directors. +Voting Rights: In accordance with the Parent Company's articles of incorporation, shares of common stock are generally entitled to one vote per share until they have been held by the same beneficial owner for a continuous period of 48 months , at which time they become entitled to 10 votes per share. +Reclassifications from Accumulated Other Comprehensive Income +The tables below are reconciliations of accumulated other comprehensive income by component for the years ended December 31. +154 +Item 8. Financial Statements and Supplementary Data +Changes in Accumulated Other Comprehensive Income +2019 +(In millions) +Unrealized Foreign +Currency Translation +Gains (Losses) +Unrealized +Gains (Losses) +on Investment Securities +Unrealized +Gains (Losses) +on Derivatives +Pension +Liability +Adjustment +Total +Balance, beginning of period +$ +( 1,847 +) +$ +4,234 +$ +( 24 +) +$ +( 212 +) +$ +2,151 +Other comprehensive +income (loss) before +reclassification +224 +4,327 +( 9 +) +( 76 +) +4,466 +Amounts reclassified from +accumulated other +comprehensive income +(loss) +0 +( 13 +) +0 +11 +( 2 +) +Net current-period other +comprehensive +income (loss) +224 +4,314 +( 9 +) +( 65 +) +4,464 +Balance, end of period +$ +( 1,623 +) +$ +8,548 +$ +( 33 +) +$ +( 277 +) +$ +6,615 +All amounts in the table above are net of tax. +2018 +(In millions) +Unrealized Foreign +Currency Translation +Gains (Losses) +Unrealized +Gains (Losses) +on Investment Securities +Unrealized +Gains (Losses) +on Derivatives +Pension Liability Adjustment +Total +Balance, beginning of period +$ +( 1,750 +) +$ +5,964 +$ +( 23 +) +$ +( 163 +) +$ +4,028 +Cumulative effect of change +in accounting principle - +financial instruments +0 +( 148 +) +0 +0 +( 148 +) +Cumulative effect of change +in accounting principle - +tax effects from tax reform +( 325 +) +734 +( 3 +) +( 32 +) +374 +Other comprehensive +income (loss) before +reclassification +228 +( 2,350 +) +2 +( 30 +) +( 2,150 +) +Amounts reclassified from +accumulated other +comprehensive income +(loss) +0 +34 +0 +13 +47 +Net current-period other +comprehensive +income (loss) +228 +( 2,316 +) +2 +( 17 +) +( 2,103 +) +Balance, end of period +$ +( 1,847 +) +$ +4,234 +$ +( 24 +) +$ +( 212 +) +$ +2,151 +All amounts in the table above are net of tax. +155 +Item 8. Financial Statements and Supplementary Data +2017 +(In millions) +Unrealized Foreign +Currency Translation +Gains (Losses) +Unrealized +Gains (Losses) +on Investment Securities +Unrealized +Gains (Losses) +on Derivatives +Pension Liability Adjustment +Total +Balance, beginning of period +$ +( 1,983 +) +$ +4,805 +$ +( 24 +) +$ +( 168 +) +$ +2,630 +Other comprehensive +income (loss) before +reclassification +233 +1,158 +1 +( 6 +) +1,386 +Amounts reclassified from +accumulated other +comprehensive income +(loss) +0 +1 +0 +11 +12 +Net current-period other +comprehensive +income (loss) +233 +1,159 +1 +5 +1,398 +Balance, end of period +$ +( 1,750 +) +$ +5,964 +$ +( 23 +) +$ +( 163 +) +$ +4,028 +All amounts in the table above are net of tax. +For the year ended December 31, 2018, see Note 1 for discussion of the amounts reclassified between AOCI and retained earnings upon the adoption of new accounting pronouncements. +The tables below summarize the amounts reclassified from each component of accumulated other comprehensive income based on source for the years ended December 31. +Reclassifications Out of Accumulated Other Comprehensive Income +(In millions) +2019 +Details about Accumulated Other Comprehensive Income Components +Amount Reclassified from Accumulated Other Comprehensive Income +Affected Line Item in the +Statements of Earnings +Unrealized gains (losses) on available-for-sale +securities +$ +( 13 +) +Other-than-temporary impairment +losses realized +31 +Other gains (losses) +18 +Total before tax +( 5 +) +Tax (expense) or benefit (1) +$ +13 +Net of tax +Amortization of defined benefit pension items: +Actuarial gains (losses) +$ +( 15 +) +Acquisition and operating expenses (2) +Prior service (cost) credit +0 +Acquisition and operating expenses (2) +4 +Tax (expense) or benefit (1) +$ +( 11 +) +Net of tax +Total reclassifications for the period +$ +2 +Net of tax +(1) Based on 26 % blended tax rate +(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see +Note 14 for additional details). +156 +Item 8. Financial Statements and Supplementary Data +(In millions) +2018 +Details about Accumulated Other Comprehensive Income Components +Amount Reclassified from Accumulated Other Comprehensive Income +Affected Line Item in the +Statements of Earnings +Unrealized gains (losses) on available-for-sale +securities +$ +( 63 +) +Other-than-temporary impairment +losses realized +17 +Other gains (losses) +( 46 +) +Total before tax +12 +Tax (expense) or benefit (1) +$ +( 34 +) +Net of tax +Amortization of defined benefit pension items: +Actuarial gains (losses) +$ +( 18 +) +Acquisition and operating expenses (2) +Prior service (cost) credit +0 +Acquisition and operating expenses (2) +5 +Tax (expense) or benefit (1) +$ +( 13 +) +Net of tax +Total reclassifications for the period +$ +( 47 +) +Net of tax +(1) Based on 27 % blended tax rate +(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see Note 14 for additional details). +(In millions) +2017 +Details about Accumulated Other Comprehensive Income Components +Amount Reclassified from Accumulated Other Comprehensive Income +Affected Line Item in the +Statements of Earnings +Unrealized gains (losses) on available-for-sale +securities +$ +( 29 +) +Other-than-temporary impairment +losses realized +27 +Other gains (losses) +( 2 +) +Total before tax +1 +Tax (expense) or benefit (1) +$ +( 1 +) +Net of tax +Amortization of defined benefit pension items: +Actuarial gains (losses) +$ +( 17 +) +Acquisition and operating expenses (2) +Prior service (cost) credit +0 +Acquisition and operating expenses (2) +6 +Tax (expense) or benefit (1) +$ +( 11 +) +Net of tax +Total reclassifications for the period +$ +( 12 +) +Net of tax +(1) Based on 35 % tax rate +(2) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see Note 14 for additional details). +12. SHARE-BASED COMPENSATION +As of December 31, 2019 , the Company has outstanding share-based awards under the Aflac Incorporated Long-Term Incentive Plan (the Plan). Share-based awards are designed to reward employees for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of share-based awards are based on competitive practices, operating results of the Company, government regulations, and other factors. +The Plan, as amended on February 14, 2017, allows for a maximum number of shares issuable over its term of 75 million shares including 38 million shares that may be awarded in respect of awards other than options or stock appreciation rights. If any awards granted under the Plan are forfeited or are terminated before being exercised or settled for any reason other than tax forfeiture, then the shares underlying the awards will again be available under the Plan. +The Plan allows awards to Company employees for incentive stock options (ISOs), non-qualifying stock options (NQSOs), restricted stock, restricted stock units, and stock appreciation rights. Non-employee directors are eligible for grants of NQSOs, +157 +Item 8. Financial Statements and Supplementary Data +restricted stock, and stock appreciation rights. As of December 31, 2019 , approximately 39.3 million shares were available for future grants under this plan. The ISOs and NQSOs have a term of 10 years , and the share-based awards generally vest upon time-based conditions or time and performance-based conditions. Time-based vesting generally occurs after three years . Performance-based vesting conditions generally include the attainment of goals related to Company financial performance. As of December 31, 2019 , the only performance-based awards issued and outstanding were restricted stock awards and units. +Stock options and stock appreciation rights granted under the amended Plan have an exercise price of at least the fair market value of the underlying stock on the grant date and have an expiration date no later than 10 years from the grant date. Time-based restricted stock awards, restricted stock units and stock options granted after January 1, 2017 generally vest on a ratable basis over three years , and awards granted prior to the amendment vest on a three-year cliff basis. The Compensation Committee of the Board of Directors has the discretion to determine vesting schedules . +Share-based awards granted to U.S.-based grantees are settled with authorized but unissued Company stock, while those issued to Japan-based grantees are settled with treasury shares. +Summary of Share-Based Compensation Expense +Share-based compensation expense consists primarily of expenses for stock options, restricted stock awards (including performance based restricted stock awards), and restricted stock units granted to employees. +The following table presents the impact of the expense recognized in connection with share-based awards for the periods ended December 31. +(In millions, except for per-share amounts) +2019 +2018 +2017 +Impact on earnings from continuing operations +$ +59 +$ +57 +$ +51 +Impact on earnings before income taxes +59 +57 +51 +Impact on net earnings +46 +45 +35 +Impact on net earnings per share: +Basic +$ +.06 +$ +.06 +$ +.05 +Diluted +.06 +.06 +.05 +Stock Options +The following table summarizes stock option activity under the employee stock option plan. +(In thousands of shares) +Stock +Option +Shares +Weighted-Average +Exercise Price +Per Share +Outstanding at December 31, 2016 +12,680 +$ +26.28 +Granted in 2017 +626 +35.80 +Canceled in 2017 +( 236 +) +24.95 +Exercised in 2017 +( 5,766 +) +30.11 +Outstanding at December 31, 2017 +7,304 +28.03 +Granted in 2018 +67 +44.59 +Canceled in 2018 +( 167 +) +32.11 +Exercised in 2018 +( 1,874 +) +26.78 +Outstanding at December 31, 2018 +5,330 +28.54 +Granted in 2019 +0 +0.00 +Canceled in 2019 +( 40 +) +27.82 +Exercised in 2019 +( 1,584 +) +25.97 +Outstanding at December 31, 2019 +3,706 +$ +29.65 +158 +Item 8. Financial Statements and Supplementary Data +(In thousands of shares) +2019 +2018 +2017 +Shares exercisable, end of year +3,553 +3,917 +4,208 +The Company estimates the fair value of each stock option granted using the Black-Scholes-Merton multiple option approach. Expected volatility is based on historical periods generally commensurate with the estimated terms of the options. The Company uses historical data to estimate option exercise and termination patterns within the model. Separate groups of employees that have similar historical exercise patterns are stratified and considered separately for valuation purposes. The expected term of options granted is derived from the output of the Company's option model and represents the weighted-average period of time that options granted are expected to be outstanding. The Company bases the risk-free interest rate on the Treasury note rate with a term comparable to that of the estimated term of the options. There were no options granted in 2019. The weighted-average fair value of options at their grant date was $ 8.81 for 2018 compared with $ 7.64 in 2017 . The following table presents the assumptions used in valuing options granted during the years ended December 31. +2019 +2018 +2017 +Expected term (years) +7.0 +7.0 +5.9 +Expected volatility +18.0 +% +22.0 +% +26.0 +% +Annual forfeiture rate +3.9 +3.6 +3.4 +Risk-free interest rate +2.9 +2.5 +2.5 +Dividend yield +2.2 +2.4 +2.5 +The following table summarizes information about stock options outstanding and exercisable at December 31, 2019 . +(In thousands of shares) +Options Outstanding +Options Exercisable +Range of +Exercise Prices +Per Share +Stock Option +Shares +Outstanding +Wgtd.-Avg. +Remaining +Contractual +Life (Yrs.) +Wgtd.-Avg. +Exercise +Price +Per Share +Stock Option +Shares +Exercisable +Wgtd.-Avg. +Exercise +Price +Per Share +$ +16.92 +- +$ +24.75 +872 +2.1 +$ +23.58 +872 +$ +23.58 +24.79 +- +28.97 +919 +3.8 +28.49 +919 +28.49 +29.04 +- +31.21 +988 +4.7 +30.77 +988 +30.77 +31.22 +- +36.21 +778 +6.5 +34.31 +626 +34.02 +37.22 +- +44.59 +149 +7.8 +40.57 +148 +40.59 +$ +16.92 +- +$ +44.59 +3,706 +4.4 +$ +29.65 +3,553 +$ +29.40 +The aggregate intrinsic value in the following table represents the total pretax intrinsic value, and is based on the difference between the exercise price of the stock options and the quoted closing common stock price of $ 52.90 as of December 31, 2019 , for those awards that have an exercise price currently below the closing price. As of December 31, 2019 , the aggregate intrinsic value of stock options outstanding was $ 86 million , with a weighted-average remaining term of 4.4 years . The total number of in-the-money stock options exercisable as of December 31, 2019 , was 3.6 million . The aggregate intrinsic value of stock options exercisable at that same date was $ 84 million , with a weighted-average remaining term of 4.2 years . +The following table summarizes stock option activity during the years ended December 31. +(In millions) +2019 +2018 +2017 +Total intrinsic value of options exercised +$ +38 +$ +34 +$ +87 +Cash received from options exercised +40 +48 +58 +Tax benefit realized as a result of options exercised and +restricted stock releases +34 +25 +74 +Performance-Based Restricted Stock Awards and Units +Under the Plan, the Company grants selected executive officers performance-based restricted stock awards (PBRS) each February whose vesting is contingent upon meeting various performance goals. PBRS are generally granted at-the-money and contingently cliff vest over a period of three years , generally subject to continued employment. In February 2019, the Company granted 399 thousand performance-based stock awards, which are contingent on the achievement of the Company's financial performance metrics and its market-based conditions. On the date of grant, the Company estimated +159 +Item 8. Financial Statements and Supplementary Data +the fair value of restricted stock awards with market-based conditions using a Monte Carlo simulation model. The model discounts the value of the stock at the assumed vesting date based on a risk-free interest rate. Based on estimates of actual performance versus the vesting thresholds, the calculated fair value percentage pay-out estimate will be updated each quarter. Actual performance, including modification for relative total shareholder return, may result in the ultimate award of 0 % to 200 % percent of the initial number of PBRS issued, with the potential for no award if company performance goals are not achieved during the three-year period. PBRS subject to accelerated vesting at the date of retirement eligibility is recognized over the implicit service period. +The Company also granted selected executive officers performance-based restricted stock units (PSUs) throughout the year whose vesting is contingent upon meeting various performance goals. PSUs are generally granted at-the-money and contingently cliff vest over a period of three years , generally subject to continued employment. In November 2019, the Company granted 46 thousand performance-based stock units, which are contingent on the achievement of certain Company determined metrics. Based on estimates of actual performance versus the vesting thresholds, the calculated fair value percentage pay-out estimate will be updated each quarter. Actual performance may result in the ultimate award of 0 % to 200 % percent of the initial number of PSUs issued, with the potential for no award if the Company determined metrics are not achieved during the three-year period. PSUs subject to accelerated vesting at the date of retirement eligibility is recognized over the implicit service period. +The Company uses third-party analyses to assist in developing the assumptions used in, as well as calibrating, a Monte Carlo simulation model. The Company is responsible for determining the assumptions used in estimating the fair value of its share-based payment awards. +Key assumptions used to value PBRS granted during 2019 follows: +(In millions) +2019 +Expected volatility (based on Aflac Inc. and peer group historical daily stock price) +15.82 +% +Expected life from grant date (years) +2.9 +Risk-free interest rate (based on U.S. Treasury yields at the date of grant) +2.51 +% +Restricted Stock Awards and Units +The value of restricted stock awards and restricted stock units is based on the fair market value of the Company's common stock at the date of grant. The following table summarizes restricted stock activity during the years ended December 31. +(In thousands of shares) +Shares +Weighted-Average +Grant-Date +Fair Value +Per Share +Restricted stock at December 31, 2016 +3,736 +$ +30.88 +Granted in 2017 +1,118 +36.48 +Canceled in 2017 +( 202 +) +32.23 +Vested in 2017 +( 1,018 +) +31.09 +Restricted stock at December 31, 2017 +3,634 +32.40 +Granted in 2018 +1,121 +44.27 +Canceled in 2018 +( 105 +) +34.39 +Vested in 2018 +( 1,243 +) +31.64 +Restricted stock at December 31, 2018 +3,407 +36.52 +Granted in 2019 +1,070 +49.68 +Canceled in 2019 +( 39 +) +41.60 +Vested in 2019 +( 1,865 +) +32.73 +Restricted stock at December 31, 2019 +2,573 +$ +44.66 +As of December 31, 2019 , total compensation cost not yet recognized in the Company's financial statements related to restricted stock awards and restricted stock units was $ 60 million , of which $ 30 million ( 1.5 million shares) was related to restricted stock awards with a performance-based vesting condition. The Company expects to recognize these amounts over +160 +Item 8. Financial Statements and Supplementary Data +a weighted-average period of approximately 1.1 years . There are no other contractual terms covering restricted stock awards once vested. +13. STATUTORY ACCOUNTING AND DIVIDEND RESTRICTIONS +The Company's insurance subsidiaries are required to report their results of operations and financial position to insurance regulatory authorities on the basis of statutory accounting practices prescribed or permitted by such authorities. Statutory accounting practices primarily differ from U.S. GAAP by charging policy acquisition costs to expense as incurred, establishing future policy benefit liabilities using different actuarial assumptions as well as valuing investments and certain assets and accounting for deferred taxes on a different basis. +Aflac reports statutory financial statements that are prepared on the basis of accounting practices prescribed or permitted by the Nebraska Department of Insurance (NDOI). The NDOI recognizes statutory accounting principles and practices prescribed or permitted by the state of Nebraska for determining and reporting the financial condition and results of operations of an insurance company, and for determining a company's solvency under Nebraska insurance law. Statutory Accounting Principles (SAP) as detailed by the National Association of Insurance Commissioners' (NAIC) Accounting Practices and Procedures Manual has been adopted by the state of Nebraska as a component of those prescribed or permitted practices. Additionally, the Director of the NDOI has the right to permit other specific practices which deviate from prescribed practices. Prior to the Japan branch conversion on April 1, 2018, Aflac had been given explicit permission by the Director of the NDOI for two such permitted practices. On April 1, 2018, the Company entered into a series of transactions in order to complete the conversion of the Japan branch into a Japanese insurance corporation. As a result of the conversion, the permitted practices were no longer necessary, therefore they were canceled by the NDOI effective April 2, 2018. Aflac had no permitted practices as of December 31, 2019 and 2018 . +Aflac's capital and surplus as determined by NAIC basis and Nebraska state basis was $ 2.1 billion and $ 2.6 billion as of December 31, 2019 and 2018 , respectively. As of December 31, 2019 , Aflac's capital and surplus significantly exceeded the required company action level capital and surplus of $ .4 billion . As determined on a U.S. statutory accounting basis, Aflac's net income was $ 864 million in 2019 , $ 1.3 billion in 2018 and $ 2.6 billion in 2017 . +Aflac Japan must report its results of operations and financial position to the Japanese Financial Services Agency (FSA) on a Japanese regulatory accounting basis as prescribed by the FSA. Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $ 7.8 billion at December 31, 2019 , compared with $ 6.4 billion at December 31, 2018 . Japanese regulatory accounting practices differ in many respects from U.S. GAAP. Under Japanese regulatory accounting practices, policy acquisition costs are expensed immediately; policy benefit and claim reserving methods and assumptions are different; premium income is recognized on a cash basis; different consolidation criteria apply to VIEs; reinsurance is recognized on a different basis; and investments can have a separate accounting classification and treatment referred to as policy reserve matching bonds (PRM). +The Parent Company depends on its subsidiaries for cash flow, primarily in the form of dividends and management fees. Consolidated retained earnings in the accompanying financial statements largely represent the undistributed earnings of the Company's insurance subsidiary. Amounts available for dividends, management fees and other payments to the Parent Company by its insurance subsidiaries may fluctuate due to different accounting methods required by regulatory authorities. These payments are also subject to various regulatory restrictions and approvals related to safeguarding the interests of insurance policyholders. Aflac must maintain adequate RBC for U.S. regulatory authorities, and Aflac Japan must maintain adequate solvency margins for Japanese regulatory authorities. +The maximum amount of dividends that can be paid to the Parent Company by Aflac and CAIC without prior approval of Nebraska's director of insurance is the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2020 in excess of $ 864 million would require such approval. Aflac declared dividends of $ 1.3 billion during 2019 . +After the Japan branch conversion as of April 1, 2018, Aflac Japan is required to meet certain financial criteria as governed by Japanese corporate law in order to provide dividends to the Parent Company. Under these criteria, dividend capacity at Aflac Japan is basically defined as retained earnings excluding capital reserves, which represent equity generated by capital profits that are statutorily required in Japan, less net after-tax unrealized losses on available-for-sale securities based on the previous fiscal year-end. Prior to April 1, 2018, a portion of Aflac Japan earnings, as determined on a Japanese regulatory accounting basis, could be remitted each year to Aflac U.S. after complying with solvency margin provisions and satisfying various conditions imposed by Japanese regulatory authorities for protecting policyholders. Profit remittances to the U.S. could fluctuate due to changes in the amounts of Japanese regulatory earnings. Among other items, factors affecting regulatory +161 +Item 8. Financial Statements and Supplementary Data +earnings include Japanese regulatory accounting practices and fluctuations in currency translation of Aflac Japan's U.S. dollar-denominated investments and related investment income into yen. Profits remitted by Aflac Japan to the Parent Company, after April 1, 2018, and to Aflac U.S., prior to April 1, 2018, were as follows for the years ended December 31: +In Dollars +In Yen +(In millions of dollars and billions of yen) +2019 +2018 +2017 +2019 +2018 +2017 +Profit remittances +$ +2,070 +$ +808 +$ +1,150 +¥ +225.2 +¥ +89.7 +¥ +129.3 +162 +Item 8. Financial Statements and Supplementary Data +14. BENEFIT PLANS +Pension and Other Postretirement Plans +The Company has funded defined benefit plans in Japan and the U.S., however the U.S. plan was frozen to new participants effective October 1, 2013. The Company also maintains non-qualified, unfunded supplemental retirement plans that provide defined pension benefits in excess of limits imposed by federal tax law for certain Japanese, U.S. and former employees, however the U.S. plan was frozen to new participants effective January 1, 2015. U.S. employees who are not participants in the defined benefit plan receive a nonelective 401(k) employer contribution. +The Company provides certain health care benefits for eligible U.S. retired employees, their beneficiaries and covered dependents (other postretirement benefits). The health care plan is contributory and unfunded. Effective January 1, 2014, employees eligible for benefits included the following: (1) active employees whose age plus service, in years, equaled or exceeded 80 (rule of 80 ); (2) active employees who were age 55 or older and have met the 15 years of service requirement; (3) active employees who would meet the rule of 80 in the next five years ; (4) active employees who were age 55 or older and who would meet the 15 years of service requirement within the next five years ; and (5) current retirees. For certain employees and former employees, additional coverage is provided for all medical expenses for life. +Information with respect to the Company's benefit plans' assets and obligations as of December 31 was as follows: +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +(In millions) +2019 +2018 +2019 +2018 +2019 +2018 +Projected benefit obligation: +Benefit obligation, beginning of year +$ +396 +$ +341 +$ +875 +$ +908 +$ +37 +$ +36 +Service cost +22 +19 +23 +27 +0 +0 +Interest cost +7 +7 +20 +31 +1 +1 +Actuarial (gain) loss +17 +35 +163 +(3) +( 69 +) +4 +4 +Benefits and expenses paid +( 11 +) +( 11 +) +( 23 +) +( 22 +) +( 3 +) +( 4 +) +Effect of foreign exchange +rate changes +5 +5 +0 +0 +0 +0 +Benefit obligation, end of year +436 +396 +1,058 +875 +39 +37 +Plan assets: +Fair value of plan assets, +beginning of year +289 +270 +465 +448 +0 +0 +Actual return on plan assets +24 +( 9 +) +98 +( 30 +) +0 +0 +Employer contributions +38 +34 +104 +69 +3 +4 +Benefits and expenses paid +( 11 +) +( 11 +) +( 23 +) +( 22 +) +( 3 +) +( 4 +) +Effect of foreign exchange +rate changes +4 +5 +0 +0 +0 +0 +Fair value of plan assets, +end of year +344 +289 +644 +465 +0 +0 +Funded status of the plans (1) +$ +( 92 +) +$ +( 107 +) +$ +( 414 +) +$ +( 410 +) +$ +( 39 +) +$ +( 37 +) +Amounts recognized in accumulated other +comprehensive income: +Net actuarial (gain) loss +$ +92 +$ +95 +$ +259 +$ +174 +$ +12 +$ +9 +Prior service (credit) cost +( 2 +) +( 2 +) +( 4 +) +( 4 +) +0 +0 +Total included in accumulated +other comprehensive income +$ +90 +$ +93 +$ +255 +$ +170 +$ +12 +$ +9 +Accumulated benefit obligation +$ +390 +$ +356 +$ +886 +$ +746 +N/A +(2) +N/A +(2) +(1) Recognized in other liabilities in the consolidated balance sheets +(2) Not applicable +(3) Actuarial losses increased due to lower discount rates at the end of 2019. Also, additional funds were contributed to the U.S. funded defined benefit plan in 2019. The Company contributed $ 95 million in 2019 compared to $ 60 million in 2018. +163 +Item 8. Financial Statements and Supplementary Data +Information for Pension Plans with an Accumulated Benefit Obligation in Excess of Plan Assets +Pension Benefits +Japan +U.S. +(In millions) +2019 +2018 +2019 +2018 +Accumulated benefit obligation +$ +390 +$ +356 +$ +886 +$ +746 +Fair value of plan assets +344 +289 +644 +465 +Information for Pension Plans with a Projected Benefit Obligation in Excess of Plan Assets +Pension Benefits +Japan (1) +U.S. (2) +(In millions) +2019 +2018 +2019 +2018 +Projected benefit obligation +$ +436 +$ +396 +$ +1,058 +$ +875 +Fair value of plan assets +344 +289 +644 +465 +(1) The net amount of projected benefit obligation and plan assets for the underfunded (including unfunded) Japan pension plan was $ 92 and $ 107 at December 31, 2019 and 2018, respectively, and was classified as liabilities on the statement of financial position. +(2) The net amount of projected benefit obligation and plan assets for the underfunded (including unfunded) U.S. pension plan was $ 414 and $ 410 at December 31, 2019 and 2018, respectively, and was classified as liabilities on the statement of financial position. +Information for other postretirement benefit plans with an accumulated postretirement benefit obligation in excess of plan assets has been disclosed in the note on “Obligations and Funded Status” because all the other postretirement benefit plans are unfunded or underfunded. +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +2019 +2018 +2017 +2019 +2018 +2017 +2019 +2018 +2017 +Weighted-average actuarial assumptions: +Discount rate - net periodic benefit cost +1.25 +% +1.25 +% +1.25 +% +4.25 +% +3.75 +% +4.25 +% +4.25 +% +3.75 +% +4.25 +% +Discount rate - benefit obligations +.75 +1.25 +1.25 +3.25 +4.25 +3.75 +3.25 +4.25 +3.75 +Expected long-term return on plan assets +2.00 +2.00 +2.00 +6.25 +6.50 +6.75 +N/A +(1) +N/A +(1) +N/A +(1) +Rate of compensation increase +N/A +(1) +N/A +(1) +N/A +(1) +4.00 +4.00 +4.00 +N/A +(1) +N/A +(1) +N/A +(1) +Health care cost trend rates +N/A +(1) +N/A +(1) +N/A +(1) +N/A +(1) +N/A +N/A +(1) +7.50 +(2) +7.40 +(2) +5.40 +(2) +(1) Not applicable +(2) For the years 2019 , 2018 and 2017 , the health care cost trend rates are expected to trend down to 3.8 % in 54 years , 4.1 % in 61 years , and 4.5 % in 77 years , respectively. +The Company determines its discount rate assumption for its pension retirement obligations based on indices for AA corporate bonds with an average duration of approximately 20 years for the Japan pension plans and 17 years for the U.S. pension plans, and determination of the U.S. pension plans discount rate utilizes the 85 -year extrapolated yield curve. In Japan, participant salary and future salary increases are not factors in determining pension benefit cost or the related pension benefit obligation. +The Company bases its assumption for the long-term rate of return on assets on historical trends ( 10 -year or longer historical rates of return for the Japanese plan assets and 15 -year historical rates of return for the U.S. plan assets), expected future market movement, as well as the portfolio mix of securities in the asset portfolio including, but not limited to, style, class and equity and fixed income allocations. In addition, the Company's consulting actuaries evaluate its assumptions for long-term rates of return under Actuarial Standards of Practice (ASOP). Under the ASOP, the actual portfolio type, mix and class is modeled to determine a best estimate of the long-term rate of return. The Company in turn use those results to further validate its own assumptions. +164 +Item 8. Financial Statements and Supplementary Data +Components of Net Periodic Benefit Cost +Pension and other postretirement benefit expenses are included in acquisition and operating expenses in the consolidated statements of earnings, which includes $ 8 million , $ 25 million and $ 35 million of other components of net periodic pension cost and postretirement costs (other than services costs) for the years ended December 31, 2019, 2018 and 2017, respectively. Total net periodic benefit cost includes the following components: +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +(In millions) +2019 +2018 +2017 +2019 +2018 +2017 +2019 +2018 +2017 +Service cost +$ +22 +$ +19 +$ +20 +$ +23 +$ +27 +$ +24 +$ +0 +$ +0 +$ +0 +Interest cost +7 +7 +6 +20 +31 +40 +1 +1 +1 +Expected return on plan +assets +( 6 +) +( 6 +) +( 5 +) +( 29 +) +( 26 +) +( 24 +) +0 +0 +0 +Amortization of net actuarial +loss +4 +1 +2 +10 +16 +14 +1 +1 +1 +Net periodic (benefit) cost +$ +27 +$ +21 +$ +23 +$ +24 +$ +48 +$ +54 +$ +2 +$ +2 +$ +2 +Changes in Accumulated Other Comprehensive Income +The following table summarizes the amounts recognized in other comprehensive loss (income) for the years ended December 31: +Pension Benefits +Other +Japan +U.S. +Postretirement Benefits +(In millions) +2019 +2018 +2017 +2019 +2018 +2017 +2019 +2018 +2017 +Net actuarial loss (gain) +$ +1 +$ +52 +$ +( 21 +) +$ +95 +$ +( 13 +) +$ +28 +$ +4 +$ +4 +$ +0 +Amortization of net actuarial loss +( 4 +) +( 1 +) +( 2 +) +( 10 +) +( 16 +) +( 14 +) +( 1 +) +( 1 +) +( 1 +) +Total +$ +( 3 +) +$ +51 +$ +( 23 +) +$ +85 +$ +( 29 +) +$ +14 +$ +3 +$ +3 +$ +( 1 +) +No transition obligations arose during 2019 . +Benefit Payments +The following table provides expected benefit payments, which reflect expected future service, as appropriate. +Pension Benefits +Other +(In millions) +Japan +U.S. +Postretirement Benefits +2020 +$ +13 +$ +25 +$ +3 +2021 +12 +27 +4 +2022 +17 +29 +4 +2023 +14 +30 +4 +2024 +16 +31 +4 +2025-2029 +84 +203 +16 +Funding +The Company plans to make contributions of $ 35 million to the Japanese funded defined benefit plan in 2020. The Company does not plan to make any contributions to the U.S. funded defined benefit plan in 2020 . The Company funded additional contributions to the U.S. funded defined benefit plan in 2019. The funding policy for the Company's non-qualified supplemental defined benefit pension plans and other postretirement benefits plan is to contribute the amount of the benefit payments made during the year. +165 +Item 8. Financial Statements and Supplementary Data +Plan Assets +The investment objective of the Company's Japanese and U.S. funded defined benefit plans is to preserve the purchasing power of the plan's assets and earn a reasonable inflation-adjusted rate of return over the long term. Furthermore, the Company seeks to accomplish these objectives in a manner that allows for the adequate funding of plan benefits and expenses. In order to achieve these objectives, the Company's goal is to maintain a conservative, well-diversified and balanced portfolio of high-quality equity, fixed-income and money market securities. As a part of its strategy, the Company has established strict policies covering quality, type and concentration of investment securities. For the Company's Japanese plan, these policies include limitations on investments in derivatives including futures, options and swaps, and low-liquidity investments such as real estate, venture capital investments, and privately issued securities. For the Company's U.S. plan, these policies prohibit investments in precious metals, limited partnerships, venture capital, and direct investments in real estate. The Company is also prohibited from trading on margin. +The plan fiduciaries for the Company's funded defined benefit plans have developed guidelines for asset allocations reflecting a percentage of total assets by asset class, which are reviewed on an annual basis. Asset allocation targets as of December 31, 2019 were as follows: +Japan Pension +U.S. Pension +Domestic equities +5 +% +40 +% +International equities +20 +20 +Fixed income securities +66 +40 +Other +9 +0 +Total +100 +% +100 +% +The U.S. Pension Plan had $ 100 million in cash at December 31, 2019. The plan fiduciaries authorized investing a contribution made to the Plan in 2019 on a graduated basis over a period of time. +The following table presents the fair value of Aflac Japan's pension plan assets that are measured at fair value on a recurring basis as of December 31. All of these assets are classified as Level 2 in the fair value hierarchy. +(In millions) +2019 +2018 +Japan pension plan assets: +Equities: +Japanese equity securities +$ +17 +$ +14 +International equity securities +67 +50 +Fixed income securities: +Japanese bonds +20 +34 +International bonds +207 +160 +Insurance contracts +33 +31 +Total +$ +344 +$ +289 +The following table presents the fair value of Aflac U.S.'s pension plan assets that are measured at fair value on a recurring basis as of December 31. All of these assets are classified as Level 1 in the fair value hierarchy. +166 +Item 8. Financial Statements and Supplementary Data +(In millions) +2019 +2018 +U.S. pension plan assets: +Mutual funds: +Large cap equity funds +$ +179 +$ +120 +Mid cap equity funds +22 +17 +Real estate equity funds +16 +13 +International equity funds +112 +92 +Fixed income bond funds +209 +179 +Aflac Incorporated common stock +6 +5 +Cash and cash equivalents +100 +39 +Total +$ +644 +$ +465 +The fair values of the Company's pension plan investments categorized as Level 1, consisting of mutual funds and common stock, are based on quoted market prices for identical securities traded in active markets that are readily and regularly available to the Company. The fair values of the Company's pension plan investments classified as Level 2 are based on quoted prices for similar assets in markets that are not active, other inputs that are observable, such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks, and default rates, or other market-corroborated inputs. +401(k) Plan +The Company sponsors a 401(k) plan in which it matches a portion of U.S. employees' contributions. The plan provides for salary reduction contributions by employees and provides for matching contributions which, starting January 1, 2018, the Company increased to 100 % of each employee's contributions which were not in excess of 4 % of the employee's annual cash compensation as a result of tax reform. The Company also provides a nonelective contribution to the 401(k) plan of 2 % of annual cash compensation for employees who opted out of the future benefits of the U.S. defined benefit plan and for new U.S. employees. +The 401(k) contributions by the Company, included in acquisition and operating expenses in the consolidated statements of earnings, were $ 18 million in both 2019 and 2018 and $ 15 million in 2017 . The plan trustee held approximately 2.6 million shares of the Company's common stock for plan participants at December 31, 2019 . +Stock Bonus Plan +Aflac U.S. maintains a stock bonus plan for eligible U.S. sales associates. Plan participants receive shares of Aflac Incorporated common stock based on their new annualized premium sales and their first-year persistency of substantially all new insurance policies. The cost of this plan, which was capitalized as deferred policy acquisition costs, amounted to $ 31 million in 2019 , 2018 and 2017 . +15. COMMITMENTS AND CONTINGENT LIABILITIES +The Company has two outsourcing agreements with a technology and consulting corporation. The first agreement provides mainframe computer operations, distributed mid-range server computer operations, and related support for Aflac Japan. It has a remaining term of three years and an aggregate remaining cost of ¥ 26.7 billion ( $ 244 million using the December 31, 2019 , exchange rate). The second agreement provides application maintenance and development services for Aflac Japan. It has a remaining term of four years and an aggregate remaining cost of ¥ 6.6 billion ( $ 61 million using the December 31, 2019 , exchange rate). +The Company has an outsourcing agreement with a management consulting and technology services company to provide application maintenance and development services for its Japanese operation. The agreement has a remaining term of two years with an aggregate remaining cost of ¥ 6.9 billion ( $ 63 million using the December 31, 2019 , exchange rate). +The Company has two outsourcing agreements with information technology and data services companies to provide application maintenance and development services for its Japanese operation. The first agreement has a remaining term of three years with an aggregate remaining cost of ¥ 5.5 billion ( $ 50 million using the December 31, 2019 , exchange rate). The second agreement has a remaining term of three years with an aggregate remaining cost of ¥ 4.9 billion ( $ 45 million using the December 31, 2019 , exchange rate). +167 +Item 8. Financial Statements and Supplementary Data +The Company is a defendant in various lawsuits considered to be in the normal course of business. Members of the Company's senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. +See Note 3 of the Notes to the Consolidated Financial Statements for details on certain investment commitments. +Guaranty Fund Assessments +The U.S. insurance industry has a policyholder protection system that is monitored and regulated by state insurance departments. These life and health insurance guaranty associations are state entities (in all 50 states as well as Puerto Rico and the District of Columbia) created to protect policyholders of an insolvent insurance company. All insurance companies (with limited exceptions) licensed to sell life or health insurance in a state must be members of that state’s guaranty association. Under state guaranty association laws, certain insurance companies can be assessed (up to prescribed limits) for certain obligations to the policyholders and claimants of impaired or insolvent insurance companies that write the same line or similar lines of business. +In 2009, the Pennsylvania Insurance Commissioner placed long-term care insurer Penn Treaty Network America Insurance Company and its subsidiary American Network Insurance Company (collectively referred to as Penn Treaty), neither of which is affiliated with Aflac, in rehabilitation and petitioned a state court for approval to liquidate Penn Treaty. A final order of liquidation was granted by a recognized judicial authority on March 1, 2017, and as a result, Penn Treaty is in the process of liquidation. The Company estimated and recognized the impact of its share of guaranty fund assessments resulting from the liquidation using a discounted rate of 4.25 % . The Company recognized a discounted liability for the assessments of $ 62 million (undiscounted $ 94 million ), offset by discounted premium tax credits of $ 48 million (undiscounted $ 74 million ), for a net $ 14 million impact to net income in the quarter ended March 31, 2017. The Company paid a majority of these assessments by March 31, 2019. The Company used the cost estimate provided as of the liquidation date by the National Organization of Life and Health Guaranty Associations (NOLHGA) to calculate its estimated assessments and tax credits. Other guaranty fund assessments for the years ended December 31, 2019, 2018, and 2017 were immaterial. +16. UNAUDITED CONSOLIDATED QUARTERLY FINANCIAL DATA +In management's opinion, the following quarterly financial information fairly presents the results of operations for such periods and is prepared on a basis consistent with the Company's annual audited financial statements. +168 +Item 8. Financial Statements and Supplementary Data +(In millions, except for per-share amounts) +March 31, +2019 +June 30, +2019 +September 30, +2019 +December 31, +2019 +Net premium income +$ +4,691 +$ +4,681 +$ +4,736 +$ +4,671 +Net investment income +878 +878 +936 +886 +Realized investment gains (losses) +71 +( 66 +) +( 153 +) +12 +Other income (loss) +17 +18 +17 +34 +Total revenues +5,657 +5,511 +5,536 +5,603 +Total benefits and expenses +4,415 +4,402 +4,500 +4,545 +Earnings before income taxes +1,242 +1,109 +1,036 +1,058 +Total income tax +314 +292 +259 +276 +Net earnings +$ +928 +$ +817 +$ +777 +$ +782 +Net earnings per basic share +$ +1.23 +$ +1.10 +$ +1.05 +$ +1.07 +Net earnings per diluted share +1.23 +1.09 +1.04 +1.06 +Quarterly amounts may not agree in total to the corresponding annual amounts due to rounding. +(In millions, except for per-share amounts) +March 31, +2018 +June 30, +2018 +September 30, +2018 +December 31, +2018 +Net premium income +$ +4,745 +$ +4,706 +$ +4,636 +$ +4,591 +Net investment income +837 +862 +870 +874 +Realized investment gains (losses) +( 134 +) +3 +56 +( 355 +) +Other income (loss) +16 +18 +15 +16 +Total revenues +5,464 +5,589 +5,577 +5,126 +Total benefits and expenses +4,482 +4,458 +4,431 +4,404 +Earnings before income taxes +982 +1,131 +1,146 +722 +Total income tax +265 +299 +301 +197 +Net earnings +$ +717 +$ +832 +$ +845 +$ +525 +Net earnings per basic share +$ +.92 +$ +1.08 +$ +1.10 +$ +.69 +Net earnings per diluted share +.91 +1.07 +1.09 +.69 +Quarterly amounts may not agree in total to the corresponding annual amounts due to rounding. +17. SUBSEQUENT EVENTS +In January 2020, the Parent Company used proceeds from senior notes issued in December 2019 to redeem $ 350 million of its 4.00 % fixed-rate senior notes due February 2022. +169 +Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL +DISCLOSURE +There have been no changes in, or disagreements with, accountants on accounting and financial disclosure matters during the years ended December 31, 2019 and 2018 . +ITEM 9A. CONTROLS AND PROCEDURES +Disclosure Controls and Procedures +The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this annual report (the “Evaluation Date”). Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures are effective. +Internal Control Over Financial Reporting +(a) Management's Annual Report on Internal Control Over Financial Reporting +Management's Annual Report on Internal Control Over Financial Reporting is incorporated herein by reference from Part II, Item 8 of this report. +(b) Attestation Report of the Registered Public Accounting Firm +The Attestation Report of the Registered Public Accounting Firm on the Company's internal control over financial reporting is incorporated herein by reference from Part II, Item 8 of this report. +(c) Changes in Internal Control Over Financial Reporting +There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the last fiscal quarter of 2019 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. In connection with adoption of new accounting standards associated with accounting for credit losses as detailed in Note 1 of the Notes to the Consolidated Financial Statements, the Company has implemented a new system, and related processes and controls to ensure appropriate accounting and disclosures are developed and maintained. +ITEM 9B. OTHER INFORMATION +Not applicable. +170 +Item 10. Directors, Executive Officers and Corporate Governance +PART III +Pursuant to General Instruction G to Form 10-K, Items 10 through 14 are incorporated by reference from the Company's definitive Notice and Proxy Statement relating to the Company's 2020 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission on or about March 20, 2020, pursuant to Regulation 14A under the Exchange Act. The Audit Committee Report and Compensation Committee Report to be included in such proxy statement shall be deemed to be furnished in this report and shall not be incorporated by reference into any filing under the Securities Act of 1933 as a result of such furnishing in Items 10 and 11, respectively. +Refer to the Information Contained in the Proxy +Statement under Captions (filed electronically) +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +Information about the Company's Executive Officers -see Part I, Item 1 herein +1. Election of Directors; Delinquent Section 16(a) Reports; Audit and Risk Committee; Audit and Risk Committee Report; Director Nominating Process; and Code of Business Conduct and Ethics +ITEM 11. +EXECUTIVE COMPENSATION +Director Compensation; Compensation Committee; Compensation Committee Report; Compensation Discussion and Analysis; 2019 Summary Compensation Table; 2019 Grants of Plan-Based Awards; 2019 Outstanding Equity Awards at Fiscal Year-End; 2019 Option Exercises and Stock Vested; Pension Benefits; Nonqualified Deferred Compensation; Potential Payments Upon Termination or Change-In-Control; and Compensation Committee Interlocks and Insider Participation +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +Principal Shareholders; Election of Directors (Proposal 1); Security Ownership of Management; and Equity Compensation Plan Information +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +Related Person Transactions; and Director Independence +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +Ratification of Appointment of Independent Registered Public Accounting Firm (Proposal 3); and Audit and Risk Committee +171 +Item 15. Exhibits, Financial Statement Schedules +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) +1. +FINANCIAL STATEMENTS +Page(s) +Included in Part II, Item 8, of this report: +Aflac Incorporated and Subsidiaries: +Report of Independent Registered Public Accounting Firm +78 +Consolidated Statements of Earnings for each of the years in the three- +year period ended December 31, 2019 +82 +Consolidated Statements of Comprehensive Income for each of the +years in the three-year period ended December 31, 2019 +83 +Consolidated Balance Sheets as of December 31, 2019 and 2018 +84 +Consolidated Statements of Shareholders' Equity for each of the years +in the three-year period ended December 31, 2019 +85 +Consolidated Statements of Cash Flows for each of the years in the +three-year period ended December 31, 2019 +86 +Notes to the Consolidated Financial Statements +87 +Unaudited Consolidated Quarterly Financial Data +168 +2. +FINANCIAL STATEMENT SCHEDULES +Included in Part IV of this report: +Schedule II - +Condensed Financial Information of Registrant as of December 31, 2019 and 2018, and for each of the years in the three-year period ended December 31, 2019 +182 +Schedule III - +Supplementary Insurance Information as of December 31, 2019 and 2018, and for each of the years in the three-year period ended December 31, 2019 +188 +Schedule IV - +Reinsurance for each of the years in the three-year period ended December 31, 2019 +189 +3. +EXHIBIT INDEX +An “Exhibit Index” has been filed as part of this Report beginning on the following page and is incorporated herein by this reference. +Schedules other than those listed above are omitted because they are not required, are not material, are not applicable, or the required information is shown in the financial statements or notes thereto. +In reviewing the agreements included as exhibits to this annual report, please remember they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. The agreements contain representations and warranties by each of the parties to the applicable agreement. These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and: +• +should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate; +• +have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement; +• +may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and +• +were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. +Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. +172 +Item 16. Form 10-K Summary +ITEM 16. FORM 10-K SUMMARY +Not applicable +173 +Glossary of Selected Terms +Throughout this Annual Report on Form 10-K, the Company may use certain terms which are defined below. +Adjusted Earnings Per Diluted Share Excluding the +Impact of Foreign Currency – Adjusted earnings are adjusted revenues less benefits and adjusted expenses. The adjustments to both revenues and expenses account for certain items that cannot be predicted or that are outside management’s control. Adjusted revenues are U.S. GAAP total revenues excluding realized investment gains and losses, except for amortized hedge costs/income related to foreign currency exposure management strategies and net interest cash flows from derivatives associated with certain investment strategies. Adjusted expenses are U.S. GAAP total acquisition and operating expenses including the impact of interest cash flows from derivatives associated with notes payable but excluding any nonrecurring or other items not associated with the normal course of the company’s insurance operations and that do not reflect Aflac’s underlying business performance. The most comparable U.S. GAAP measure is net earnings. Adjusted earnings per share (basic or diluted) are the adjusted earnings for the period divided by the weighted average outstanding shares (basic or diluted) for the period presented. The most comparable U.S. GAAP measure is net earnings per share. This metric is then adjusted using the average yen/dollar exchange rate for the comparable prior year period, which eliminates dollar based fluctuations driven solely from currency rate changes. +Affiliated Corporate Agency – Agency in Japan directly affiliated with a specific corporation that sells insurance policies primarily to its employees +Annualized premiums in force – the amount of gross premium that a policyholder must pay over a full year in order to keep coverage. The growth of net premiums (defined below) is directly affected by the change in premiums in force and by the change in weighted-average yen/dollar exchange rates. +Earnings Per Basic Share – Net earnings divided by weighted-average number of shares outstanding for the period +Earnings Per Diluted Share – Net earnings divided by the weighted-average number of shares outstanding for the period plus the weighted-average shares for the dilutive effect of share-based awards outstanding +Group Insurance – Insurance issued to a group, such as an employer or trade association, that covers employees or association members and their dependents through certificates of coverage +Individual Insurance – Insurance issued to an individual with the policy designed to cover that person and his or her dependents +In-force Policies – A count of policies that are active contracts at the end of a period. +Net Investment Income – The income derived from interest and dividends on invested assets, after deducting investment expenses +Net premiums – (sometimes referred to as net premium income or net earned premiums) is a financial measure that appears on the Company's Consolidated Statements of Earnings and in its segment reporting. This measure reflects collected or due premiums that have been earned ratably on policies in force during the reporting period, reduced by premiums that have been ceded to third parties and increased by premiums assumed through reinsurance. +New Annualized Premium Sales – (sometimes referred to as new sales or sales) An operating measure that is not reflected on the Company's financial statements. New annualized premium sales generally represent annual premiums on policies the Company sold and incremental increases from policy conversions that would be collected over a 12-month period assuming the policies remain in force for that entire period. For Aflac Japan, new annualized premium sales are determined by applications submitted during the reporting period. For Aflac U.S., new annualized premium sales are determined by applications that are issued during the reporting period. Policy conversions are defined as the positive difference in the annualized premium when a policy upgrades in the current reporting period. +Persistency – Percentage of premiums remaining in force at the end of a period, usually one year. For example, 95% persistency would mean that 95% of the premiums in force at the beginning of the period were still in force at the end of the period +Risk-based Capital (RBC) Ratio – Statutory adjusted capital divided by statutory required capital. This insurance ratio is based on rules prescribed by the National Association of Insurance Commissioners (NAIC) and provides an indication of the amount of statutory capital the insurance company maintains, relative to the inherent risks in the insurer’s operations +Solvency Margin Ratio (SMR) – Solvency margin total divided by one half of the risk total. This insurance ratio is prescribed by the Japan Financial Services Agency (FSA) and is used for all life insurance companies in Japan to measure the adequacy of the company’s ability to pay policyholder claims in the event actual risks exceed expected levels +Total Return to Shareholders – Appreciation of a shareholder’s investment over a period of time, including reinvested cash dividends paid during that time +174 +Defined Terms +Throughout this Annual Report on Form 10-K, the Company may use abbreviations, acronyms and defined terms which are defined below. +ACA +Affordable Care Act +AFS +Available-for-Sale +AOCI +Accumulated Other Comprehensive Income +APPI +Act on the Protection of Personal Information +ASC +Accounting Standards Codification +ASOP +Actuarial Standards of Practice +ASU +Accounting Standards Update +BoJ +Bank of Japan +CDSs +Credit Default Swaps +CFTC +Commodity Futures Trading Commission +CMLs +Commercial Mortgage Loans +COSO +Committee of Sponsoring Organizations of the Treadway Commission +CSAs +Credit Support Annexes +DAC +Deferred Policy Acquisition Costs +DTL +Deferred Tax Liability +Dodd-Frank +Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 +DTA +Deferred Tax Asset +ECB +European Central Bank +EPS +Earnings Per Share +FASB +Financial Accounting Standard Boards +FHLB +Federal Home Loan Bank of Atlanta +FIO +Federal Insurance Office +FSA +Japanese Financial Services Agency +GLBA +Gramm-Leach-Bliley Act of 1999 +HIPAA +Health Insurance Portability and Accountability Act of 1996 +HTM +Held-to-Maturity +IRS +Internal Revenue Service +ISDA +International Swaps and Derivatives Association, Inc. +ISOs +Incentive Stock Options +Japan Post Group +Japan Post Holdings Co., Ltd., JPC and JPI, collectively +Japan Post Holdings +Japan Post Holdings Co., Ltd. +JGB +Japan Government Bond +JPC +Japan Post Co. Ltd +JPI +Japan Post Insurance Co., Ltd. +LDP +Liberal Democratic Party +LIBOR +London Interbank Offered Rate +LIPPC +Life Insurance Policyholder Protection Corporation +MD&A +Management's Discussion and Analysis of Financial Condition and Results of Operations +MMLs +Middle Market Loans +MOF +Ministry of Finance +NAIC +National Association of Insurance Commissioners +NDOI +Nebraska Department of Insurance +NOLHGA +National Organization of Life and Health Guaranty Associations +NQSOs +Non-qualifying Stock Options +175 +NRSROs +Nationally Recognized Statistical Rating Organizations +NYDFS +New York Department of Financial Services +OIS +Overnight Index Swap +ORSA +Own Risk and Solvency Assessment +OTC +Over-the-Counter +OTTI +Other-than-temporary Impairment +PCD Financial Assets +Purchased Credit-Deteriorated Financial Assets +PCI Financial Assets +Purchased Credit-Impaired Financial Assets +PRM +Policy Reserve Matching +PSUs +Performance-based restricted stock units +RBC +Risk-Based Capital +S&P 500 +Standard & Poor's 500 Index +S&P Life and Health +Standard & Poor's Life and Health Insurance Index +SAB 118 +Staff Accounting Bulletin 118 +SAP +Statutory Accounting Principles +SCDOI +South Carolina Department of Insurance +SEC +Securities and Exchange Commission +SIFMA +Securities Industry and Financial Markets Association +Singapore Life +Singapore Life Pte. Ltd. +SMI +Solvency Modernization Initiative +SMR +Solvency Margin Ratio +SOFR +Secured Overnight Financing Rate +TAC +Total Adjusted Capital +Tax Act +Tax Cuts and Jobs Act +The Plan +Aflac Incorporated Long-Term Incentive Plan +TIBOR +Tokyo Interbank Market Rate +TREs +Transitional Real Estate Loans +TTM +Telegraphic Transfer Middle Rate +U.S. GAAP +U.S. Generally Accepted Accounting Principles +UST +Treasury Obligations of the U.S. Government +VIEs +Variable Interest Entities +176 +(b) +EXHIBIT INDEX (1) +3.0 +- +Articles of Incorporation, as amended – incorporated by reference from Form 10-Q for June 30, 2008, Exhibit 3.0. +3.1 +- +Bylaws of the Corporation, as amended and restated – incorporated by reference from Form 8-K dated November 10, 2015, Exhibit 3.1. +4.0 +- +There are no instruments with respect to long-term debt not being registered in which the total amount of securities authorized exceeds 10% of the total assets of Aflac Incorporated and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of any long-term debt instrument to the Securities and Exchange Commission upon request. +4.1 +- +Description of common stock securities registered pursuant to Section 12 of the Securities Exchange Act of 1934. +4.2 +- +Indenture, dated as of May 21, 2009, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee – incorporated by reference from Form 8-K dated May 21, 2009, Exhibit 4.1. +4.3 +- +Second Supplemental Indenture, dated as of December 17, 2009, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 6.900% Senior Note due 2039) – incorporated by reference from Form 8-K dated December 14, 2009, Exhibit 4.1. +4.4 +- +Third Supplemental Indenture, dated as of August 9, 2010, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 6.45% Senior Note due 2040) - incorporated by reference from Form 8-K dated August 4, 2010, Exhibit 4.1. +4.5 +- +Sixth Supplemental Indenture, dated as of February 10, 2012, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 4.00% Senior Note due 2022) - incorporated by reference from Form 8-K dated February 8, 2012, Exhibit 4.2. +4.6 +- +Eighth Supplemental Indenture, dated as of June 10, 2013, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 3.625% Senior Note due 2023) - incorporated by reference from Form 8-K dated June 10, 2013, Exhibit 4.1. +4.7 +- +Ninth Supplemental Indenture, dated as of November 7, 2014, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 3.625% Senior Note due 2024) - incorporated by reference from Form 8-K dated November 4, 2014, Exhibit 4.1. +4.8 +- +Eleventh Supplemental Indenture, dated as of March 12, 2015, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 3.25% Senior Note due 2025) - incorporated by reference from Form 8-K dated March 9, 2015, Exhibit 4.2. +4.9 +- +Twelfth Supplemental Indenture, dated as of September 19, 2016, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 2.875% Senior Note due 2026) - incorporated by reference from Form 8-K dated September 19, 2016, Exhibit 4.1. +4.10 +- +Thirteenth Supplemental Indenture, dated as of September 19, 2016, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 4.000% Senior Note due 2046) – incorporated by reference from Form 8-K dated September 19, 2016, Exhibit 4.2. +4.11 +- +Fourteenth Supplemental Indenture, dated as of January 25, 2017, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of .932% Senior Note due 2027) – incorporated by reference from Form 8-K dated January 25, 2017, Exhibit 4.1. +4.12 +- +Fifteenth Supplemental Indenture, dated as of October 18, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.159% Senior Note due 2030) – incorporated by reference from Form 8-K dated October 18, 2018, Exhibit 4.1. +4.13 +- +Sixteenth Supplemental Indenture, dated as of October 18, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.488% Senior Note due 2033) – incorporated by reference from Form 8-K dated October 18, 2018, Exhibit 4.2. +4.14 +- +Seventeenth Supplemental Indenture, dated as of October 18, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.750% Senior Note due 2038) – incorporated by reference from Form 8-K dated October 18, 2018, Exhibit 4.3. +4.15 +- +Eighteenth Supplemental Indenture, dated as of October 31, 2018, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 4.750% Senior Note due 2049) – incorporated by reference from Form 8-K dated October 31, 2018, Exhibit 4.1. +4.16 +- +Nineteenth Supplemental Indenture, dated as of December 17, 2019, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 0.500% Senior Note due 2029) – incorporated by reference from Form 8-K dated December 17, 2019, Exhibit 4.1. +177 +4.17 +- +Twentieth Supplemental Indenture, dated as of December 17, 2019, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 0.843% Senior Note due 2031) – incorporated by reference from Form 8-K dated December 17, 2019, Exhibit 4.2. +4.18 +- +Twenty-First Supplemental Indenture, dated as of December 17, 2019, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 0.934% Senior Note due 2034) – incorporated by reference from Form 8-K dated December 17, 2019, Exhibit 4.3. +4.19 +- +Twenty-Second Supplemental Indenture, dated as of December 17, 2019, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 1.122% Senior Note due 2039) – incorporated by reference from Form 8-K dated December 17, 2019, Exhibit 4.4. +4.20 +- +Subordinated Indenture, dated as of September 26, 2012, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee – incorporated by reference from Form 8-K dated September 26, 2012, Exhibit 4.1. +4.21 +- +Second Supplemental Indenture, dated as of October 23, 2017, between Aflac Incorporated and The Bank of New York Mellon Trust Company, N.A., as trustee (including the form of 2.108% Subordinated Debenture due 2047) - incorporated by reference from Form 8-K dated October 23, 2017, Exhibit 4.1. +10.0 * +- +American Family Corporation Retirement Plan for Senior Officers, as amended and restated October 1, 1989 – incorporated by reference from 1993 Form 10-K, Exhibit 10.2. +10.1 * +- +Amendment to American Family Corporation Retirement Plan for Senior Officers, dated December 8, 2008 – incorporated by reference from 2008 Form 10-K, Exhibit 10.1. +10.2 * +- +Second Amendment to the American Family Corporation Retirement Plan for Senior Officers, dated November 16, 2012 – incorporated by reference from Form 10-Q for September 30, 2016, Exhibit 10.2. +10.3 * +- +Third Amendment to the American Family Corporation Retirement Plan for Senior Officers, dated October 18, 2016 – incorporated by reference from Form 10-Q for September 30, 2016, Exhibit 10.3. +10.4 * +- +Aflac Incorporated Supplemental Executive Retirement Plan, as amended and restated January 1, 2009 – incorporated by reference from 2008 Form 10-K, Exhibit 10.5. +10.5 * +- +First Amendment to the Aflac Incorporated Supplemental Executive Retirement Plan, as amended and restated January 1, 2009 – incorporated by reference from 2012 Form 10-K, Exhibit 10.3. +10.6 * +- +Second Amendment to the Aflac Incorporated Supplemental Executive Retirement Plan, as amended and restated January 1, 2009 – incorporated by reference from 2014 Form 10-K, Exhibit 10.4. +10.7 * +- +Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from Form 10-Q for September 30, 2015, Exhibit 10.5. +10.8 * +- +First Amendment to the Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from Form 10-Q for September 30, 2016, Exhibit 10.8. +10.9 * +- +Second Amendment to the Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from Form 10-Q for March 31, 2017, Exhibit 10.9. +10.10 * +- +Third Amendment to the Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective September 1, 2015 – incorporated by reference from 2018 Form 10-K, Exhibit 10.10. +10.11 * +- +Aflac Incorporated Executive Deferred Compensation Plan, as amended and restated, effective January 1, 2020. +10.12 * +- +Aflac Incorporated 2013 Management Incentive Plan – incorporated by reference from the 2012 Proxy Statement, Appendix B. +10.13 * +- +Aflac Incorporated 2018 Management Incentive Plan - incorporated by reference from the 2017 Proxy Statement, Appendix B. +10.14 * +- +1999 Aflac Associate Stock Bonus Plan, amended and restated as of January 1, 2013 – incorporated by reference from Form 10-Q for March 31, 2013, Exhibit 10.10. +10.15 * +- +Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from the 1997 Shareholders’ Proxy Statement, Appendix B. +178 +10.16 * +- +Form of Officer Stock Option Agreement (Non-Qualifying Stock Option) under the Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from Form 8-K dated January 28, 2005, Exhibit 10.5. +10.17 * +- +Form of Officer Stock Option Agreement (Incentive Stock Option) under the Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from Form 8-K dated January 28, 2005, Exhibit 10.6. +10.18 * +- +Notice of grant of stock options and stock option agreement to officers under the Aflac Incorporated 1997 Stock Option Plan – incorporated by reference from Form 8-K dated January 28, 2005, Exhibit 10.7. +10.19 * +- +2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from the 2012 Proxy Statement, Appendix A. +10.20 * +- +Form of Non-Employee Director Stock Option Agreement (NQSO) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.13. +10.21 * +- +Notice of grant of stock options to non-employee director under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.14. +10.22 * +- +Form of Non-Employee Director Restricted Stock Award Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.15. +10.23 * +- +Notice of restricted stock award to non-employee director under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.16. +10.24 * +- +U.S. Form of Employee Restricted Stock Award Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.17. +10.25 * +- +Japan Form of Employee Restricted Stock Award Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.18. +10.26 * +- +Notice of time based restricted stock award under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for June 30, 2013, Exhibit 10.22. +10.27 * +- +Notice of performance based restricted stock award under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.20. +10.28 * +- +U.S. Form of Employee Stock Option Agreement (Non-Qualifying Stock Option) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.21. +10.29 * +- +Japan Form of Employee Stock Option Agreement (Non-Qualifying Stock Option) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.22. +10.30 * +- +U.S. Form of Employee Stock Option Agreement (Incentive Stock Option) under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.23. +10.31 * +- +U.S. Notice of grant of stock options under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for June 30, 2013, Exhibit 10.28. +10.32 * +- +Japan Notice of grant of stock options under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for June 30, 2013, Exhibit 10.29. +10.33 * +- +Japan Form of Restricted Stock Unit Agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2016, Exhibit 10.26. +10.34 * +- +Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 8-K dated May 1, 2017, Exhibit 10.1. +10.35 * +- +Form of Non-Employee Director Stock Option Agreement (Non-Qualifying Stock Option) under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for June 30, 2017, Exhibit 10.33. +10.36 * +- +Form of Non-Employee Director Restricted Stock Award Agreement under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for June 30, 2017, Exhibit 10.34. +179 +10.37 * +- +Notice of time based restricted stock unit and restricted stock unit agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.1. +10.38 * +- +2017 Notice of performance based restricted stock and restricted stock award agreement under the 2004 Aflac Incorporated Long-Term Incentive Plan, as amended and restated March 14, 2012 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.2. +10.39 * +- +Notice of time based restricted stock unit and restricted stock unit agreement under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.3. +10.40 * +- +2018 Notice of performance based restricted stock and restricted stock award agreement under the Aflac Incorporated Long-Term Incentive Plan, as amended and restated February 14, 2017 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.4. +10.41 * +- +Aflac Incorporated Retirement Plan for Directors Emeritus, as amended and restated, dated February 9, 2010 – incorporated by reference from 2009 Form 10-K, Exhibit 10.26. +10.42 * +- +Amendment to Aflac Incorporated Retirement Plan for Directors Emeritus, as amended and restated, dated August 10, 2010 – incorporated by reference from Form 10-Q for September 30, 2010, Exhibit 10.27. +10.43 * +- +Aflac Life Insurance Japan Ltd. Officer Retirement Plan. +10.44 * +- +Aflac Incorporated Employment Agreement with Daniel P. Amos, as amended and restated, dated August 20, 2015 – incorporated by reference from Form 10-Q for September 30, 2015, Exhibit 10.29. +10.45 * +- +Aflac Employment Agreement with Eric M. Kirsch, as amended and restated, dated December 1, 2015 – incorporated by reference from Form 8-K dated December 1, 2015, Exhibit 10.1. +10.46 * +- +Amendment to Aflac Employment Agreement with Eric M. Kirsch, dated November 30, 2017 – incorporated by reference from 2017 Form 10-K, Exhibit 10.42. +10.47 * +- +Aflac Incorporated Employment Agreement with Frederick J. Crawford, effective June 30, 2015 – incorporated by reference from Form 8-K dated June 24, 2015, Exhibit 10.1. +10.48 * +- +Aflac Incorporated Employment Agreement with Charles D. Lake II, dated January 1, 2018 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.5. +10.49 * +- +Amendment to Aflac Incorporated Employment Agreement with Charles D. Lake II, effective January 1, 2020. +10.50 * +- +Aflac Incorporated Employment Agreement with Audrey Boone Tillman, dated June 11, 2015 – incorporated by reference from Form 10-Q for March 31, 2018, Exhibit 10.6. +10.51 +- +Basic Agreement regarding the “Strategic Alliance Based on Capital Relationship”, dated December 19, 2018, by and among Japan Post Holdings Co., Ltd., Aflac Incorporated and Aflac Life Insurance Japan Ltd. – incorporated by reference from Form 8-K dated December 19, 2018, Exhibit 10.1. +10.52 +- +Letter Agreement, dated December 19, 2018, by and between Japan Post Holdings Co., Ltd. and Aflac Incorporated – incorporated by reference from Form 8-K dated December 19, 2018, Exhibit 10.2. +10.53 +- +Shareholders Agreement, dated February 28, 2019, by and between Aflac Incorporated, Japan Post Holdings Co., Ltd., J&A Alliance Holdings Corporation (solely in its capacity as trustee of J&A Alliance Trust), and General Incorporated Association J&A Alliance – incorporated by reference from Form 10-Q for March 31, 2019, Exhibit 10.50. +21 +- +Subsidiaries. +23 +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement No. 333-158969 with respect to the Aflac Incorporated 401(k) Savings and Profit Sharing Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement Nos. 333-135327, 333-161269, and 333-202781 with respect to the Aflac Incorporated Executive Deferred Compensation Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement No. 333-200570 with respect to the Aflac Incorporated Market Director Deferred Compensation Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-8 Registration Statement No. 333-115105 and 333-219888 with respect to the Aflac Incorporated Long-Term Incentive Plan. +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-3 Registration Statement No. 333-219784 with respect to the AFL Stock Plan. +180 +- +Consent of independent registered public accounting firm, KPMG LLP, to Form S-3 Registration Statement No. 333-227244 with respect to the Aflac Incorporated shelf registration statement. +31.1 +- +Certification of CEO dated February 21, 2020, required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934. +31.2 +- +Certification of CFO dated February 21, 2020, required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934. +32 +- +Certification of CEO and CFO dated February 21, 2020, pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +101.INS +- +XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. +101.SCH +- +Inline XBRL Taxonomy Extension Schema. +101.CAL +- +Inline XBRL Taxonomy Extension Calculation Linkbase. +101.DEF +- +Inline XBRL Taxonomy Extension Definition Linkbase. +101.LAB +- +Inline XBRL Taxonomy Extension Label Linkbase. +101.PRE +- +Inline XBRL Taxonomy Extension Presentation Linkbase. +104 +- +Cover Page Interactive Data File - formatted as Inline XBRL and contained in Exhibit 101. +(1) +Copies of any exhibit are available upon request by calling the Company's Investor Relations Department at 800.235.2667 - option 3 +* +Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 15(b) of this report. +181 +(c) +FINANCIAL STATEMENT SCHEDULES +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Statements of Earnings +Years ended December 31, +(In millions) +2019 +2018 +2017 +Revenues: +Management and service fees from subsidiaries (1) +$ +151 +$ +190 +$ +297 +Net investment income +77 +69 +30 +Interest from subsidiaries (1) +4 +4 +5 +Realized investment gains (losses) +98 +( 16 +) +( 1 +) +Total revenues +330 +247 +331 +Operating expenses: +Interest expense +200 +188 +197 +Other operating expenses (2) +221 +225 +180 +Total operating expenses +421 +413 +377 +Earnings before income taxes and equity in earnings of +subsidiaries +( 91 +) +( 166 +) +( 46 +) +Income tax expense (benefit) +( 22 +) +( 12 +) +( 23 +) +Earnings before equity in earnings of subsidiaries +( 69 +) +( 154 +) +( 23 +) +Equity in earnings of subsidiaries (1) +3,373 +3,074 +4,627 +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +(1) Eliminated in consolidation +(2) Includes expense of $ 13 in 2017 for the early extinguishment of debt +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +182 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Statements of Comprehensive Income (Loss) +Years ended December 31, +(In millions) +2019 +2018 +2017 +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +Other comprehensive income (loss) before income taxes: +Unrealized foreign currency translation gains (losses) during period +252 +232 +286 +Unrealized gains (losses) on fixed maturity securities during period +5,852 +( 3,109 +) +1,733 +Unrealized gains (losses) on derivatives during period +( 12 +) +2 +1 +Pension liability adjustment during period +( 85 +) +( 25 +) +9 +Total other comprehensive income (loss) before income taxes +6,007 +( 2,900 +) +2,029 +Income tax expense (benefit) related to items of other comprehensive +income (loss) +1,543 +( 797 +) +631 +Other comprehensive income (loss), net of income taxes +4,464 +( 2,103 +) +1,398 +Total comprehensive income (loss) +$ +7,768 +$ +817 +$ +6,002 +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +183 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Balance Sheets +December 31, +(In millions, except for share and per-share amounts) +2019 +2018 +Assets: +Investments and cash: +Fixed maturity securities available for sale, at fair value +(amortized cost $1,506 in 2019 and $1,209 in 2018) +$ +1,567 +$ +1,222 +Investments in subsidiaries (1) +30,744 +26,230 +Other investments +36 +21 +Cash and cash equivalents +2,508 +1,767 +Total investments and cash +34,855 +29,240 +Due from subsidiaries (1) +170 +98 +Income taxes receivable +337 +176 +Other assets +405 +390 +Total assets +$ +35,767 +$ +29,904 +Liabilities and shareholders' equity: +Liabilities: +Employee benefit plans +$ +323 +$ +310 +Notes payable +6,136 +5,765 +Other liabilities +349 +367 +Total liabilities +6,808 +6,442 +Shareholders' equity: +Common stock of $.10 par value. In thousands: authorized 1,900,000 shares in 2019 and 2018; issued 1,349,309 shares in 2019 and 1,347,540 shares in 2018 +135 +135 +Additional paid-in capital +2,313 +2,177 +Retained earnings +34,291 +31,788 +Accumulated other comprehensive income (loss): +Unrealized foreign currency translation gains (losses) +( 1,623 +) +( 1,847 +) +Unrealized gains (losses) on fixed maturity securities +8,548 +4,234 +Unrealized gains (losses) on derivatives +( 33 +) +( 24 +) +Pension liability adjustment +( 277 +) +( 212 +) +Treasury stock, at average cost +( 14,395 +) +( 12,789 +) +Total shareholders' equity +28,959 +23,462 +Total liabilities and shareholders' equity +$ +35,767 +$ +29,904 +(1) Eliminated in consolidation +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +184 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Condensed Statements of Cash Flows +Years ended December 31, +(In millions) +2019 +2018 +2017 +Cash flows from operating activities: +Net earnings +$ +3,304 +$ +2,920 +$ +4,604 +Adjustments to reconcile net earnings to net cash provided from +operating activities: +Equity in earnings of subsidiaries (1) +( 3,373 +) +( 3,074 +) +( 4,627 +) +Cash dividends received from subsidiaries +3,466 +1,820 +2,001 +Other, net +( 203 +) +99 +( 46 +) +Net cash provided (used) by operating activities +3,194 +1,765 +1,932 +Cash flows from investing activities: +Fixed maturity securities sold +340 +207 +263 +Fixed maturity securities purchased +( 639 +) +( 254 +) +( 329 +) +Other investments sold (purchased) +( 16 +) +31 +( 47 +) +Settlement of derivatives +22 +( 2 +) +223 +Additional capitalization of subsidiaries (1) +( 214 +) +( 62 +) +( 69 +) +Other, net +87 +( 107 +) +( 218 +) +Net cash provided (used) by investing activities +( 420 +) +( 187 +) +( 177 +) +Cash flows from financing activities: +Purchases of treasury stock +( 1,627 +) +( 1,301 +) +( 1,351 +) +Proceeds from borrowings +347 +1,020 +1,040 +Principal payments under debt obligations +0 +( 550 +) +( 1,161 +) +Dividends paid to shareholders +( 771 +) +( 793 +) +( 661 +) +Treasury stock reissued +49 +58 +33 +Proceeds from exercise of stock options +29 +34 +38 +Net change in amount due to/from subsidiaries (1) +( 58 +) +( 4 +) +( 5 +) +Other, net +( 2 +) +0 +0 +Net cash provided (used) by financing activities +( 2,033 +) +( 1,536 +) +( 2,067 +) +Net change in cash and cash equivalents +741 +42 +( 312 +) +Cash and cash equivalents, beginning of period +1,767 +1,725 +2,037 +Cash and cash equivalents, end of period +$ +2,508 +$ +1,767 +$ +1,725 +(1) Eliminated in consolidation +See the accompanying Notes to Condensed Financial Statements. +See the accompanying Report of Independent Registered Public Accounting Firm. +185 +SCHEDULE II +CONDENSED FINANCIAL INFORMATION OF REGISTRANT +Aflac Incorporated (Parent Only) +Notes to Condensed Financial Statements +The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Aflac Incorporated and Subsidiaries included in Part II, Item 8 of this report. +(A) Notes Payable +A summary of notes payable as of December 31 follows: +(In millions) +2019 +2018 +4.00% senior notes due February 2022 (1) +$ +348 +$ +348 +3.625% senior notes due June 2023 +698 +698 +3.625% senior notes due November 2024 +747 +746 +3.25% senior notes due March 2025 +448 +447 +2.875% senior notes due October 2026 +298 +297 +6.90% senior notes due December 2039 +220 +220 +6.45% senior notes due August 2040 +254 +254 +4.00% senior notes due October 2046 +394 +394 +4.750% senior notes due January 2049 +541 +540 +Yen-denominated senior notes and subordinated debentures: +.932% senior notes due January 2027 (principal amount ¥60.0 billion) +545 +538 +.500% senior notes due December 2029 (principal amount ¥12.6 billion) +114 +0 +1.159% senior notes due October 2030 (principal amount ¥29.3 billion) +266 +262 +.843% senior notes due December 2031 (principal amount ¥9.3 billion) +84 +0 +1.488% senior notes due October 2033 (principal amount ¥15.2 billion) +138 +136 +.934% senior notes due December 2034 (principal amount ¥9.8 billion) +88 +0 +1.750% senior notes due October 2038 (principal amount ¥8.9 billion) +81 +79 +1.122% senior notes due December 2039 (principal amount ¥6.3 billion) +57 +0 +2.108% subordinated debentures due October 2047 (principal amount ¥60.0 billion) +543 +536 +Yen-denominated loans: +Variable interest rate loan due September 2026 (.42% in 2019 and .32 in 2018, principal amount ¥5.0 billion) +45 +45 +Variable interest rate loan due September 2029 (.57% in 2019 and .47 in 2018, principal amount ¥25.0 billion) +227 +225 +Total notes payable +$ +6,136 +$ +5,765 +(1) Redeemed in January 2020 +Amounts in the table above are reported net of debt issuance costs and issuance premiums or discounts, if applicable, that are being amortized over the life of the notes. +In December 2019, the Parent Company issued four series of senior notes totaling ¥ 38.0 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥ 12.6 billion , bears interest at a fixed rate of .500 % per annum, payable semi-annually, and will mature in December 2029. The second series, which totaled ¥ 9.3 billion , bears interest at a fixed rate of .843 % per annum, payable semi-annually, and will mature in December 2031. The third series, which totaled ¥ 9.8 billion , bears interest at a fixed rate of .934 % per annum, payable semi-annually, and will mature in December 2034. The fourth series, which totaled ¥ 6.3 billion , bears interest at a fixed rate of 1.122 % per annum, payable semi-annually, and will mature in December 2039. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance. +In September 2019, the Parent Company renewed a ¥ 30.0 billion senior term loan facility. The first tranche of the facility, which totaled ¥ 5.0 billion , bears interest at a rate per annum equal to the Tokyo interbank market rate (TIBOR), or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2026. The applicable margin ranges +186 +between .30 % and .70 % , depending on the Parent Company's debt ratings as of the date of determination. The second tranche, which totaled ¥ 25.0 billion , bears interest at a rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2029. The applicable margin ranges between .45 % and 1.00 % , depending on the Parent Company's debt ratings as of the date of determination. +The aggregate contractual maturities of notes payable during each of the years after December 31, 2019 , are as follows: +(In millions) +2020 +$ +0 +2021 +0 +2022 +350 +2023 +700 +2024 +750 +Thereafter +4,386 +Total +$ +6,186 +For further information regarding notes payable, see Note 9 of the Notes to the Consolidated Financial Statements. +(B) Derivatives +At December 31, 2019 , the Parent Company's outstanding freestanding derivative contracts were swaps, foreign currency forwards and options. The swaps are associated with its notes payable, consisting of cross-currency interest rate swaps, also referred to as foreign currency swaps, associated with the Parent Company's senior notes due in February 2022, June 2023, November 2024 and March 2025. The foreign currency forwards and options are designated as derivative hedges of the foreign currency exposure of the Company's net investment in Aflac Japan. The Parent Company does not use derivative financial instruments for trading purposes, nor does it engage in leveraged derivative transactions. For further information regarding these derivatives, see Notes 1, 4 and 9 of the Notes to the Consolidated Financial Statements. +(C) Income Taxes +The Parent Company and its eligible U.S. subsidiaries file a consolidated U.S. federal income tax return. Income tax liabilities or benefits are recorded by each principal subsidiary based upon separate return calculations, and any difference between the consolidated provision and the aggregate amounts recorded by the subsidiaries is reflected in the Parent Company financial statements. For further information on income taxes, see Note 10 of the Notes to the Consolidated Financial Statements. +(D) Dividend Restrictions +See Note 13 of the Notes to the Consolidated Financial Statements for information regarding dividend restrictions. +(E) Supplemental Disclosures of Cash Flow Information +(In millions) +2019 +2018 +2017 +Interest paid +$ +189 +$ +179 +$ +195 +Noncash financing activities: +Treasury stock issued for shareholder dividend reinvestment +30 +8 +29 +187 +SCHEDULE III +SUPPLEMENTARY INSURANCE INFORMATION +Aflac Incorporated and Subsidiaries +Years ended December 31, +(In millions) +Deferred Policy +Acquisition +Costs +Future Policy +Benefits & Unpaid +Policy Claims +Unearned +Premiums +Other +Policyholders' +Funds +2019: +Aflac Japan +$ +6,584 +$ +84,341 +$ +4,135 +$ +7,317 +Aflac U.S. +3,544 +11,184 +111 +0 +All other +0 +223 +0 +0 +Intercompany eliminations +0 +( 754 +) +( 3 +) +0 +Total +$ +10,128 +$ +94,994 +$ +4,243 +$ +7,317 +2018: +Aflac Japan +$ +6,384 +$ +80,672 +$ +4,977 +$ +7,145 +Aflac U.S. +3,491 +10,864 +117 +0 +All other +0 +183 +0 +1 +Intercompany eliminations +0 +( 767 +) +( 4 +) +0 +Total +$ +9,875 +$ +90,952 +$ +5,090 +$ +7,146 +Segment amounts may not agree in total to the corresponding consolidated amounts due to rounding. +Years Ended December 31, +(In millions) +Net +Premium +Revenue +Net +Investment +Income +Benefits and +Claims, net +Amortization of +Deferred Policy +Acquisition Costs +Other +Operating +Expenses +Premiums +Written +2019: +Aflac Japan +$ +12,772 +$ +2,753 +$ +8,877 +$ +709 +$ +2,465 +$ +12,367 +Aflac U.S. +5,808 +720 +2,871 +573 +1,834 +5,813 +All other +200 +105 +194 +0 +339 +0 +Total +$ +18,780 +$ +3,578 +$ +11,942 +$ +1,282 +$ +4,638 +$ +18,180 +2018: +Aflac Japan +$ +12,762 +$ +2,639 +$ +8,913 +$ +710 +$ +2,374 +$ +12,298 +Aflac U.S. +5,708 +727 +2,887 +534 +1,736 +5,707 +All other +207 +76 +200 +1 +420 +0 +Total +$ +18,677 +$ +3,442 +$ +12,000 +$ +1,245 +$ +4,530 +$ +18,005 +2017: +Aflac Japan +$ +12,752 +$ +2,463 +$ +9,087 +$ +630 +$ +2,257 +$ +12,092 +Aflac U.S. +5,563 +721 +2,885 +502 +1,658 +5,565 +All other +216 +36 +209 +0 +421 +0 +Total +$ +18,531 +$ +3,220 +$ +12,181 +$ +1,132 +$ +4,336 +$ +17,657 +Segment amounts may not agree in total to the corresponding consolidated amounts due to rounding. +See the accompanying Report of Independent Registered Public Accounting Firm. +188 +SCHEDULE IV +REINSURANCE +Aflac Incorporated and Subsidiaries +Years Ended December 31, +(In millions) +Gross +Amount +Ceded to +Other +Companies +Assumed +from Other +companies +Net +Amount +Percentage +of Amount +Assumed +to Net +2019: +Life insurance in force +$ +146,585 +$ +6,592 +$ +0 +$ +139,993 +0 +% +Premiums: +Health insurance +$ +15,657 +$ +527 +$ +205 +$ +15,335 +1 +% +Life insurance +3,465 +20 +0 +3,445 +0 +Total earned premiums +$ +19,122 +$ +547 +$ +205 +$ +18,780 +1 +% +2018: +Life insurance in force +$ +151,457 +$ +4,702 +$ +0 +$ +146,755 +0 +% +Premiums: +Health insurance +$ +15,330 +$ +541 +$ +214 +$ +15,003 +1 +% +Life insurance +3,688 +14 +0 +3,674 +0 +Total earned premiums +$ +19,018 +$ +555 +$ +214 +$ +18,677 +1 +% +2017: +Life insurance in force +$ +152,502 +$ +4,121 +$ +0 +$ +148,381 +0 +% +Premiums: +Health insurance +$ +14,829 +$ +554 +$ +222 +$ +14,497 +1 +% +Life insurance +4,046 +12 +0 +4,034 +0 +Total earned premiums +$ +18,875 +$ +566 +$ +222 +$ +18,531 +1 +% +Premiums by type may not agree in total to the corresponding consolidated amounts due to rounding. +See the accompanying Report of Independent Registered Public Accounting Firm. +189 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Aflac Incorporated +By: +/s/ Daniel P. Amos +February 21, 2020 +(Daniel P. Amos) +Chief Executive Officer, +Chairman of the Board of Directors +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. +/s/ Daniel P. Amos +Chief Executive Officer, +February 21, 2020 +(Daniel P. Amos) +Chairman of the Board of Directors +/s/ Max K. Broden +Executive Vice President, +February 21, 2020 +(Max K. Broden) +Chief Financial Officer +/s/ June Howard +Senior Vice President, Financial Services; +February 21, 2020 +(June Howard) +Chief Accounting Officer +190 +/s/ W. Paul Bowers +Director +February 21, 2020 +(W. Paul Bowers) +/s/ Toshihiko Fukuzawa +Director +February 21, 2020 +(Toshihiko Fukuzawa) +/s/ Robert B. Johnson +Director +February 21, 2020 +(Robert B. Johnson) +/s/ Thomas J. Kenny +Director +February 21, 2020 +(Thomas J. Kenny) +/s/ Georgette D. Kiser +Director +February 21, 2020 +(Georgette D. Kiser) +/s/ Karole F. Lloyd +Director +February 21, 2020 +(Karole F. Lloyd) +/s/ Joseph L. Moskowitz +Director +February 21, 2020 +(Joseph L. Moskowitz) +/s/ Barbara K. Rimer +Director +February 21, 2020 +(Barbara K. Rimer) +/s/ Katherine T. Rohrer +Director +February 21, 2020 +(Katherine T. Rohrer) +/s/ Melvin T. Stith +Director +February 21, 2020 +(Melvin T. Stith) +191 \ No newline at end of file diff --git a/raw/filings/0000004977/2019/0000004977-20-000044/filing_metadata.csv b/raw/filings/0000004977/2019/0000004977-20-000044/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..fb2cbf64fecac4eae2768804b0c1eaf20fc5a89b --- /dev/null +++ b/raw/filings/0000004977/2019/0000004977-20-000044/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,year,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url +0000004977,AFL,AFLAC INC,2019,10-K,2020-02-21,2019-12-31,2020-02-21T21:32:04.000Z,0000004977-20-000044,afl12311910k.htm,10-K,53830165,1,1,https://www.sec.gov/Archives/edgar/data/4977/000000497720000044/afl12311910k.htm,https://www.sec.gov/Archives/edgar/data/4977/000000497720000044/ diff --git a/raw/filings/0000004977/2019/0000004977-20-000044/item1.txt b/raw/filings/0000004977/2019/0000004977-20-000044/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..f90bce89c17182c2c571e856e4a3b6d88ae667f6 --- /dev/null +++ b/raw/filings/0000004977/2019/0000004977-20-000044/item1.txt @@ -0,0 +1,289 @@ +Item 1. Business +PART I +FORWARD-LOOKING INFORMATION +The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. Aflac Incorporated and its subsidiaries (the Company) desire to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with the Securities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks and uncertainties. In particular, statements containing words such as the ones listed below or similar words, as well as specific projections of future results, generally qualify as forward-looking. The Company undertakes no obligation to update such forward-looking statements. +• expect +• anticipate +• believe +• goal +• objective +• may +• should +• estimate +• intends +• projects +• will +• assumes +• potential +• target +• outlook +The Company cautions readers that the following factors, in addition to other factors mentioned from time to time, could cause actual results to differ materially from those contemplated by the forward-looking statements: +• +ability to attract and retain qualified sales associates, brokers, employees, and distribution partners +• +events related to the ongoing Japan Post investigation and other matters +• +competitive environment and ability to anticipate and respond to market trends +• +deviations in actual experience from pricing and reserving assumptions +• +ability to continue to develop and implement improvements in information technology systems +• +defaults and credit downgrades of investments +• +exposure to significant interest rate risk +• +concentration of business in Japan +• +limited availability of acceptable yen-denominated investments +• +failure to comply with restrictions on policyholder privacy and information security +• +interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems +• +catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, war or other military action, terrorism or other acts of violence, and damage incidental to such events +• +difficult conditions in global capital markets and the economy +• +ability to protect the Aflac brand and the Company's reputation +• +extensive regulation and changes in law or regulation by governmental authorities +• +foreign currency fluctuations in the yen/dollar exchange rate +• +tax rates applicable to the Company may change +• +decline in creditworthiness of other financial institutions +• +significant valuation judgments in determination of amount of impairments taken on the Company's investments +• +U.S. tax audit risk related to conversion of the Japan branch to a subsidiary +• +subsidiaries' ability to pay dividends to the Parent Company +• +decreases in the Company's financial strength or debt ratings +• +inherent limitations to risk management policies and procedures +• +concentration of the Company's investments in any particular single-issuer or sector +• +differing judgments applied to investment valuations +• +ability to effectively manage key executive succession +• +changes in accounting standards +• +level and outcome of litigation +• +allegations or determinations of worker misclassification in the United States +1 +Item 1. Business +ITEM 1. BUSINESS +OVERVIEW +Aflac Incorporated (the Parent Company) was incorporated in 1973 under the laws of the state of Georgia. The Parent Company and its subsidiaries (collectively, the Company) provide financial protection to more than 50 million people worldwide. The Company’s principal business is supplemental health and life insurance products with the goal to provide customers the best value in supplemental insurance products in the United States (U.S.) and Japan. When a policyholder or insured gets sick or hurt, the Company pays cash benefits fairly and promptly for eligible claims, directly to the insured (unless assigned otherwise). For more than sixty years, the Company’s supplemental insurance policies have given policyholders the opportunity to focus on recovery, not financial stress. +The Company's strategy for growth in the U.S. and Japan has remained straightforward and consistent for many years. The Company develops relevant supplemental insurance products and sells them through expanded distribution channels. To help promote its insurance products, the Company’s marketing campaigns feature the Aflac Duck. +In 1999, the Company had been running commercials for nearly a decade, but its brand awareness was hovering at about 10%. An innovative marketing campaign with something unique and memorable that would build brand awareness was needed. The Aflac Duck’s first commercial in the U.S., “Park Bench,” aired on January 1, 2000 and taught consumers how to pronounce “Aflac.” The Aflac Duck made his international debut in Japan in 2003. In the two decades since his U.S. debut, the Aflac Duck has become one of the most familiar advertising icons in the world, appearing in several commercials and countless print ads in both the U.S. and Japan. Today, the Aflac Duck is a helpmate who increases brand knowledge and connection. +The Company is authorized to conduct insurance business in all 50 states, the District of Columbia, several U.S. territories and Japan. The Company’s website is: www.aflac.com. Information included on the Company’s website is not incorporated by reference into this filing. The Company makes available free of charge through its website, its annual report on Form 10-K, its quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as reasonably practicable after they have been electronically filed with or furnished to the Securities and Exchange Commission (SEC). +REPORTING SEGMENTS +The Company's insurance business consists of two reporting segments: Aflac Japan and Aflac U.S. The Parent Company’s primary insurance subsidiaries are Aflac Life Insurance Japan Ltd. in Japan (Aflac Japan) and American Family Life Assurance Company of Columbus (Aflac); Continental American Insurance Company (CAIC), branded as Aflac Group Insurance (AGI); American Family Life Assurance Company of New York (Aflac New York) and Tier One Insurance Company (TOIC) in the U.S. (collectively, Aflac U.S.). +2 +Item 1. Business +Aflac Japan is the principal contributor to the Parent Company’s consolidated earnings. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 69% of the Company's total revenues in 2019 , compared with 70% in both 2018 and 2017 . The percentage of the Company's total assets attributable to Aflac Japan was 83% and 84% at December 31, 2019 and 2018 , respectively. The conversion of Aflac Japan to a subsidiary structure in April 2018 did not affect the Company's segment reporting structure. +Effective January 1, 2018, investments of Aflac U.S. as well as certain sub-advised assets of Aflac Japan, are managed by the Company’s U.S. asset management subsidiary, Aflac Asset Management LLC (AAM), and investments of Aflac Japan are managed pursuant to an investment advisory agreement between Aflac Japan and the Company's asset management subsidiary in Japan, Aflac Asset Management Japan Ltd. (AAMJ). AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. AAM and AAMJ are reported in the "Corporate and other segment" category; however, the assets that they manage are reported in the respective Aflac Japan and Aflac U.S. business segments. +In November 2019, the Company acquired Argus Holdings, LLC and its subsidiary Argus Dental & Vision, Inc. (Argus), a benefits management organization and national network dental and vision company, which provides a platform for Aflac Dental and Vision. The Company paid $75 million at closing and made an additional commitment of up to $21 million in contingent consideration payable over three years based on the achievement by Argus of certain performance targets. Argus is an addition to the Aflac U.S. segment. +Revenues derived from any customer did not exceed 10% of consolidated premiums and other revenues for the years ended December 31, 2019 and 2018 . For information on the Company's results of operations and financial information by segment, see Item 7. Management Discussion and Analysis (MD&A) and Note 2 of the Notes to the Consolidated Financial Statements in this report. +AFLAC JAPAN +Aflac Japan is the largest insurer in Japan in terms of cancer and medical (third sector insurance products) policies in force. As of December 31, 2019 , Aflac Japan exceeded 24 million individual policies in force in Japan. Aflac Japan continued to be the number one seller of cancer insurance policies in Japan throughout 2019 , with more than 15 million cancer policies in force as of December 31, 2019 . +Insurance Products +Aflac Japan's third sector insurance products are designed to help consumers pay for medical and nonmedical costs that are not reimbursed under Japan's national health insurance system. Changes in Japan's economy and an aging population have put increasing pressure on Japan's national health care system. As a result, more costs have been shifted to Japanese consumers, who in turn have become increasingly interested in insurance products that help them manage those costs. Aflac Japan has responded to this consumer need by enhancing existing products and developing new products. The focus at Aflac Japan remains on maintaining leadership in third sector insurance products that are less interest rate sensitive and have strong and stable margins. At the same time, Aflac Japan complements this core business with similarly profitable first sector protection products as outlined below. +THIRD SECTOR INSURANCE +FIRST SECTOR INSURANCE +Life insurance products include: +▪ +Cancer +Protection type: +Savings type: +▪ +Medical +▪ +Term Life +▪ +WAYS +▪ +Income Support +▪ +Whole Life +▪ +Child Endowment +▪ +GIFT +Cancer Insurance Aflac Japan pioneered the cancer insurance market in Japan in 1974, and remains the number one provider of cancer insurance in Japan today. Aflac Japan's cancer insurance products provide a lump-sum benefit upon initial diagnosis of cancer and fixed daily benefits for subsequent hospitalization and outpatient treatments due to cancer, as well as cancer-related surgical and convalescent care benefits. +3 +Item 1. Business +Medical Insurance Aflac Japan's medical insurance products provide benefits for hospitalization, surgeries and outpatient treatment of various illnesses, as well as lump sum benefits related to three critical illnesses: cancer, heart attack, and stroke. +Income Support Insurance Aflac Japan's Income Support Insurance provides fixed-benefit amounts in the event that a policyholder is unable to work due to significant illness or injury and was developed to supplement the disability coverage within Japan’s social security system. +Whole Life Aflac Japan launched Prepare Smart Whole-Life Insurance in 2018, a whole life insurance product with low cash surrender value, which offers non-smoking policyholders further discounted premiums, and it provides beneficiaries, typically a designated family member, with a pre-determined benefit payment upon the death of the insured. +GIFT GIFT is a term life insurance product that provides a designated family member with a fixed amount of money every month upon a breadwinner’s death or serious disability as family support. +WAYS and Child Endowment Beginning in 2013, Aflac Japan began to curtail sales of WAYS and Child Endowment, first sector savings-type products, due to persistent low interest rates in Japan and, in particular, the relatively large capital commitment required by such products and their lower profitability, in such an environment. +Distribution Channels +Traditional Sales Channel This distribution channel includes individual agencies, independent corporate agencies and affiliated corporate agencies. Aflac Japan was represented by more than 9,000 sales agencies at the end of 2019 , with more than 109,000 licensed sales associates employed by those agencies, including individual agencies. +Banks Consumers in Japan rely on banks to provide not only traditional bank services, but also as one key source to provide insurance solutions and other services. By the end of 2019 , Aflac Japan had agreements with approximately 90% of the total number of banks in Japan to sell its products. +Dai-ichi Life Aflac Japan's alliance with Dai-ichi Life was launched in 2001, and approximately 40,000 Dai-ichi Life representatives offer Aflac's cancer products. +Japan Post Group Aflac Japan's alliance with Japan Post Group was launched in 2008. After the alliance strengthened in 2013, the number of postal outlets of Japan Post Co. Ltd. (JPC) selling Aflac Japan's cancer product increased to more than 20,000 since 2015. Japan Post Insurance Co., Ltd. (JPI) offers Aflac Japan cancer products through its 76 directly managed sales offices. In 2018, the Company’ entered a strategic alliance with Japan Post Holdings Co., Ltd. (Japan Post Holdings), the parent company of Japan Post Co. Ltd (JPC) and Japan Post Insurance Co., Ltd. (JPI). See the "Aflac Japan Segment" subsection of MD&A for more about this alliance. +Daido Life In 2013, Aflac Japan and Daido Life Insurance entered into an agreement for Daido to sell Aflac Japan's cancer insurance products specifically to the Hojinkai market, which is an association of small businesses. Currently, Daido also sells Aflac Japan's cancer insurance products to the market in the tax payment association, which is a not-for-profit association for small businesses to support tax related matters. +Competition +The Company competes with other insurance carriers through policyholder service, price, product design and sales efforts, as the number of insurance companies offering stand-alone cancer and medical insurance has more than doubled since the deregulation of the Japan market in 2001. However, based on Aflac Japan's growth of annualized premiums in force and diversified distribution network, the Company does not believe that Aflac Japan's market-leading position has been significantly impacted by increased competition. Furthermore, the Company believes the continued development and maintenance of operating efficiencies will allow Aflac Japan to offer affordable products that appeal to consumers. The Company believes Aflac Japan will remain a leading provider of cancer and medical insurance coverage in Japan, principally due to its experience in the market, well-known brand, low-cost operations, expansive marketing system and product expertise. +Regulation +Financial Services Agency (FSA) The financial and business affairs of Aflac Japan are subject to examination by Japan's FSA. Aflac Japan files annual reports and financial statements for the Japanese insurance operations based on a March 31 fiscal year end, prepared in accordance with Japanese regulatory accounting practices prescribed or permitted by the FSA. Japanese regulatory basis earnings are determined using accounting principles that differ materially from U.S. generally +4 +Item 1. Business +accepted accounting principles (U.S. GAAP). Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $7.8 billion at December 31, 2019 , compared with $6.4 billion at December 31, 2018 . Two FSA regulations applicable to Aflac Japan are outlined below. +• +Privacy and Cybersecurity +With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the Act on the Protection of Personal Information (APPI) and guidelines issued by FSA and other governmental authorities. The FSA updated its guidelines regarding cybersecurity in October 2018. +• +FSA Solvency Standard +The FSA maintains a solvency standard, the solvency margin ratio (SMR), which is used by Japanese regulators to monitor the financial strength of insurance companies. As of December 31, 2019 , Aflac Japan's SMR was 1,043% , compared with 965% at December 31, 2018 . Aflac Japan's SMR is sensitive to interest rate, credit spread and foreign exchange rate changes. See the Liquidity and Capital Resources section of the MD&A for a discussion of measures the Company has taken to mitigate the sensitivity of Aflac Japan's SMR. +Japan Company Law As a branch of Aflac prior to April 1, 2018, Aflac Japan repatriated a portion of its accumulated earnings, as determined on a Japanese regulatory accounting basis, to Aflac U.S. provided that Aflac Japan had determined that it adequately protected policyholders' interests as measured by its SMR. After the conversion of Aflac Japan to a subsidiary structure on April 1, 2018 and starting in the fourth quarter of 2018, Aflac Japan distributes dividends to the Parent Company. Such dividends are subject to permitted dividend capacity under the Japan Company Law. +Policyholder Protection The Japanese insurance industry has a policyholder protection corporation that provides funds for the policyholders of insolvent insurers. For additional information, see the policyholder protection section of the MD&A. +For additional information regarding Aflac Japan's operations and regulations, see the "Aflac Japan Segment" subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +AFLAC U.S. +The Company designs its U.S. insurance products to provide supplemental coverage for people who already have major medical or primary insurance coverage, as Aflac U.S. insurance policies pay benefits regardless of other insurance. Aflac U.S. products are distributed in the individual and group supplemental insurance markets. Aflac's individual policies are portable, meaning that individuals may retain their full insurance coverage upon separation from employment or affiliation with a group, generally at the same premium. Individual policies are typically guaranteed-renewable for the lifetime of the policyholder (to age 75 for short-term disability policies). +Insurance Products +▪ +Cancer +▪ +Critical Illness +▪ +Vision +▪ +Accident +▪ +Hospital Indemnity +▪ +Life (Term and Whole) +▪ +Short-Term Disability +▪ +Dental +Cancer Insurance Aflac U.S.'s cancer insurance products provide a lump-sum benefit upon initial diagnosis of cancer and subsequent benefits for treatment received due to cancer. Aflac U.S. offers cancer insurance on an individual basis. +Accident Insurance Aflac U.S. offers accident coverage on both an individual and group basis. These policies pay cash benefits in the event of a covered injury. The accident portion of the policy includes lump-sum benefits for accidental death, dismemberment and specific injuries as well as fixed benefits for hospital confinement. Additional benefits are also available for home modifications, wellness and increased benefits for injuries related to participations in an organized sporting activity. +Short-Term Disability Insurance Aflac U.S. offers short-term disability benefits on both an individual and group basis. The individual short-term disability product offers an Aflac Value Rider that pays a benefit, less claims, for every consecutive five-year term that the policy is in force. +Critical Illness Insurance Aflac U.S. offers coverage for critical illness plans on both an individual and group basis. These policies are designed to pay cash benefits in the event of critical illnesses such as heart attack, stroke or cancer. +5 +Item 1. Business +Hospital Indemnity Insurance Aflac U.S. offers hospital indemnity coverage on both an individual and group basis. Hospital indemnity products provide policyholders fixed dollar benefits triggered by hospitalization due to accident or sickness. Indemnity benefits for inpatient and outpatient surgeries, as well as various other diagnostic events, are also available. Aflac U.S. also offers a lump sum rider for a range of critical illness events that can be added to its individual accident, short-term disability and hospital indemnity products. +Dental and Vision Insurance Aflac U.S. now offers network dental and vision products on a group basis. Aflac U.S. offers fixed-benefit dental coverage on both an individual and group basis. Aflac U.S. offers Vision Now SM , an individually issued policy which provides benefits for serious eye health conditions and loss of sight as well as coverage for corrective eye materials and exam benefits. +Life (Term and Whole) Aflac U.S. offers term- and whole-life policies on both an individual and group basis. +Distribution Channels +Independent Associates/Career Agents The career agent channel in Aflac U.S. focuses on marketing Aflac to the small business market, defined as employers of between three and 99 employees. Sales associates in the U.S. are independent contractors and are paid commissions and other variable compensation based on first-year and renewal premiums from their sales of insurance products. +Brokers The broker channel of Aflac U.S. focuses on selling to the mid- and large-case market, which is comprised of employers with 100 or more employees and typically an average size of 1,000 employees or more. Brokers in the U.S. are independent contractors and are paid commissions based on first-year and renewal premiums from their sales of insurance products. +Aflac U.S. concentrates on marketing its insurance products at the worksite. This method offers policies to individuals through employment, trade and other associations. Aflac U.S. believes that worksite marketing enables sales associates and brokers to reach a greater number of prospective policyholders and lowers distribution costs, compared with individually marketed business. Aflac U.S. is also expanding its distribution strategy to reach consumers outside of the traditional worksite through digital lead generation. +Competition +Aflac U.S. competes against several supplemental insurance carriers on a national and regional basis. Aflac U.S. believes its policies, premium rates, platforms, value-added services and sales commissions are competitive by product type. Moreover, Aflac U.S. believes that its products are distinct from competitive offerings given its product focus (including features, benefits and claims service model), distribution capabilities and brand awareness. +Since Aflac products provide an additional level of financial protection for policyholders, the Company believes the increased financial exposure some employees may face creates a favorable opportunity for Aflac U.S. products. However, given the profitability erosion some major medical carriers are facing in their core lines of business, the Company has seen a more competitive landscape as these carriers seek entry into Aflac's supplemental product segments and leverage their core benefit offerings by bundling and discounting products in order to gain market share. +One Day Pay SM is a claims initiative that Aflac U.S. has focused on to process, approve and pay eligible claims in just one day. The Company believes that this claims practice enhances the Aflac U.S. brand reputation and the trust policyholders have in Aflac, and it helps Aflac stand out from competitors. +Regulation +Insurance Regulation The Parent Company and its U.S. insurance subsidiaries, Aflac, CAIC, TOIC (Nebraska-domiciled insurance companies) and Aflac New York (a New York-domiciled insurance company) are subject to state regulations in the U.S. as an insurance holding company system. Such regulations generally provide that transactions between companies within the holding company system must be fair and equitable. In addition, transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries and certain transactions between companies within the system, including management fees, loans and advances are subject to prior notice to, or approval by, state regulatory authorities. These laws generally require, among other things, the insurance holding company and each insurance company directly owned by the holding company to register with the insurance departments of their respective domiciliary states and to furnish annually financial and other information about the operations of companies within the holding company system. +6 +Item 1. Business +Like all U.S. insurance companies, Aflac, Aflac New York, CAIC and TOIC are subject to regulation and supervision in the jurisdictions in which they do business. In general, the insurance laws of the various jurisdictions establish supervisory agencies with broad administrative powers relating to, among other things: +• +granting and revoking licenses to transact business +• +regulating trade and claims practices +• +licensing of insurance agents and brokers +• +approval of policy forms and premium rates +• +standards of solvency and maintenance of specified policy benefit reserves and minimum loss ratio requirements +• +capital requirements +• +limitations on dividends to shareholders +• +the nature of and limitations on investments +• +deposits of securities for the benefit of policyholders +• +filing of financial statements prepared in accordance with statutory insurance accounting practices prescribed or permitted by regulatory authorities +• +periodic examinations of the market conduct, financial, and other affairs of insurance companies +The insurance laws of Nebraska that govern Aflac's activities provide that the acquisition or change of “control” of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Nebraska Department of Insurance (NDOI). A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company (in the case of Aflac, CAIC and TOIC, the Parent Company) must generally file with the NDOI an application for change of control containing certain information required by statute and published regulations and provide a copy to Aflac. In Nebraska, control is generally presumed to exist if any person, directly or indirectly, acquires 10% or more of an insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Similar laws apply in New York, the domiciliary jurisdiction of Aflac's New York insurance subsidiary. +State insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). In 2016, full-scope, risk-focused financial examinations were conducted by the NDOI, New York Department of Financial Services (NYDFS), and the South Carolina Department of Insurance (SCDOI) on their state domiciled insurance entities Aflac, Aflac New York, and CAIC, respectively. There were no material findings contained in the final exam reports. CAIC redomiciled to Nebraska as of December 2016 and TOIC redomiciled to Nebraska effective March 11, 2019. The NDOI and NYDFS are scheduled to conduct a full-scope comprehensive financial examination covering years 2016-2019 in 2020. +NAIC Risk-Based Capital The NAIC continually reviews regulatory matters, such as risk-based capital (RBC) modernization, group capital calculations, liquidity risk assessment and principle-based reserving. The NAIC has adopted a valuation manual containing a principle-based approach to calculation of life insurance reserves. The valuation manual became effective January 1, 2017. There is a three-year transition period, beginning January 1, 2017, during which companies can choose on a product by product basis to implement principle-based reserving for new business. The Company anticipates that the adoption of this manual will not cause a material impact on the statutory reserves of Aflac, Aflac New York, CAIC or TOIC. The NAIC uses an RBC formula relating to insurance risk, business risk, asset risk and interest rate risk to facilitate identification by insurance regulators of inadequately capitalized insurance companies based upon the types and mix of risk inherent in the insurer's operations. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company's regulatory total adjusted capital to its authorized control level RBC as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels are company action, regulatory action, authorized control, and mandatory control. As of December 31, 2019 , based on year-end statutory accounting results, Aflac's company action level RBC ratio was 539% . The 2018 RBC as filed is lower than Aflac U.S. stand-alone RBC due to the inclusion of Aflac Japan for the first quarter of 2018. The RBC charge reflects the business risk without any total adjusted capital (TAC). Aflac's NAIC RBC ratio remains high and reflects a very strong capital and surplus position. +Guaranty Association and Similar Arrangements Under state insurance guaranty association laws and similar laws in international jurisdictions, the Company is subject to assessments, based on the share of business the Company writes in the relevant jurisdiction, for certain obligations of insolvent insurance companies to policyholders and claimants. In the U.S., some states permit member insurers to recover assessments paid through full or partial premium tax offsets. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory +7 +Item 1. Business +definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. In most states, the definition is met with a declaration of financial insolvency by a court of competent jurisdiction. +Federal Initiatives Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. Federal regulations applicable to Aflac U.S. are outlined below. +• +Affordable Care Act (ACA) +The ACA, federal health care reform legislation, gave the U.S. federal government direct regulatory authority over the business of health insurance. The reform included major changes to the U.S. health care insurance marketplace. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. The U.S. Congress has considered and may continue to consider legislation that would repeal and replace key provisions of the ACA. There can be no assurance that any legislation affecting the ACA will be passed by Congress, nor as to the ultimate timing or provisions of any such legislation, nor as to the effect of any such legislation on the design or marketability of the Company's insurance products. Further, certain provisions of the ACA have been and may continue to be subject to challenge through litigation, the ultimate effects of which on the ACA are uncertain. +• +Dodd-Frank Act +Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and regulations issued thereunder, in particular rules to require central clearing for certain types of derivatives, may have an impact on the Company's derivative activity, including activity on behalf of Aflac Japan. In addition, in 2015 and 2016, six U.S. financial regulators, including the U.S. Commodity Futures Trading Commission (CFTC), issued final rules regarding the exchange of initial margin (IM) and variation margin (VM) for uncleared swaps that impose greater obligations on swap dealers regarding uncleared swaps with certain counterparties, such as the Company. The requirements of such rules with respect to IM are currently being phased in and will be fully implemented by September 1, 2020, although an extension to September 1, 2021 is expected for covered entities with an aggregate average notional amount below $50 billion. The margin requirements are expected to result in more stringent collateral requirements and to affect other aspects of the Company's derivative activity. +The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. The FIO does not directly regulate the insurance industry, but under Dodd-Frank it has the power to preempt state insurance regulations that are inconsistent with international agreements reached by the federal government, subject to certain requirements and restrictions. The FIO and certain federal agencies must achieve consensus positions with the state insurance regulators when taking positions on insurance proposals by certain international forums. The President and Congress have stated proposals to reform or repeal certain provisions of the Dodd-Frank Act, some of which have been implemented. The Company cannot predict with any degree of certainty what impact, if any, such proposals might have on Aflac's business, financial condition, or results of operations. +• +Privacy and Cybersecurity +The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal Gramm-Leach-Bliley Act of 1999 (GLBA) and in the Health Insurance Portability and Accountability Act of 1996 (HIPAA). For example, the California Consumer Privacy Act became effective January 1, 2020 and requires businesses to provide California consumers rights to access, delete, and restrict certain uses of their personal information. Under the law, the California Attorney General may not bring an enforcement action prior to July 1, 2020. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). +Cybersecurity also continues to be an area of evolving focus for U.S. legislation and regulatory activity. In March 2017, new cybersecurity regulation issued by the NYDFS went into effect that requires covered entities, including Aflac New York, to maintain an information security program meeting certain security, data disposal, audit, activity +8 +Item 1. Business +monitoring, and data encryption requirements. In October 2017, the NAIC adopted an Insurance Data Security Model Law that may be adopted in whole or in part by U.S. states in which the Company’s subsidiaries are licensed. Other states have adopted and, the Company expects, will continue to pass legislation and issue regulations related to cybersecurity. The Company anticipates, assesses and if necessary modifies its information security program to accommodate such changes. +For further information concerning Aflac U.S. operations, see the "Aflac U.S. Segment" subsection of the MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report. +CORPORATE AND OTHER +The Company's other operations include the Parent Company, asset management subsidiaries, results of reinsurance retrocession activities and a printing subsidiary. For additional information on the Company's other operations, see the "Corporate and Other" subsection of the MD&A and Note 8 in the Notes to the Consolidated Financial Statements. +EMPLOYEES +As of December 31, 2019 , Aflac Japan had 6,178 employees, Aflac U.S. had 4,799 employees, and the Company's other operations had 752 employees. +9 +Item 1. Business +Information about the Company's Executive Officers +NAME +PRINCIPAL OCCUPATION (1) +AGE +Daniel P. Amos +Chairman, Aflac Incorporated and Aflac, since 2001; Chief Executive Officer, Aflac Incorporated and Aflac, since 1990; President, Aflac, since 2017; President, Aflac Incorporated, from 2018 until 2020 +68 +Koji Ariyoshi +Executive Vice President, Director of Sales and Marketing, Aflac Japan, since 2012 +66 +Steven K. Beaver +Senior Vice President, Chief Financial Officer, Aflac U.S., since 2019; Senior Vice President, Financial Planning and Analysis, Aflac Incorporated, from 2018 until 2019; Senior Vice President, Global Strategic Projects, Corporate Financial Planning and Analysis, Aflac Incorporated, from 2017 until 2018; Vice President, Deputy Chief Accounting Officer, Tax Department, Aflac Incorporated, from 2015 until 2016; Vice President, Corporate Tax, Aflac Incorporated, from 2012 until 2014 +55 +Max K. Broden +Executive Vice President, Chief Financial Officer, Aflac Incorporated, since 2020; Senior Vice President and Treasurer, Aflac Incorporated, from 2017 until 2020; Senior Portfolio Manager, Norges Bank, from 2007 until 2017 +41 +Frederick J. Crawford +President and Chief Operating Officer, Aflac Incorporated, since 2020; Executive Vice President, Chief Financial Officer, Aflac Incorporated, from 2015 until 2020; Executive Vice President, Chief Financial Officer, CNO Financial Group, from 2012 until 2015 +56 +J. Todd Daniels +Executive Vice President, Chief Financial Officer, Aflac Japan, since 2018; Executive Vice President, Global Chief Risk Officer and Chief Actuary, Aflac Incorporated, from 2016 until 2018; Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2015 until 2016; Senior Vice President, Deputy Corporate Actuary and Global Chief Risk Officer, Aflac, from 2014 until 2015; Senior Vice President, Deputy Corporate Actuary, Aflac, from 2012 until 2014 +49 +June Howard +Chief Accounting Officer, Aflac Incorporated and Aflac, since 2010; Senior Vice President, Financial Services, Aflac Incorporated and Aflac, since 2010; Treasurer, Aflac, from 2011 until 2015 +53 +Eric M. Kirsch +Executive Vice President, Global Chief Investment Officer, Aflac, since 2012; President, Aflac Asset Management LLC, since 2017 +59 +Masatoshi Koide +President and Chief Operating Officer, Aflac Japan since 2017; Deputy President, Aflac Japan from 2016 until 2017; Executive Vice President, Aflac Japan from 2015 until 2016; First Senior Vice President, Aflac Japan, from 2013 until 2015 +59 +Charles D. Lake, II +President, Aflac International, since 2014; Chairman, Aflac Japan, since 2008 +58 +Albert A. Riggieri +Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac Incorporated, since 2018; Senior Vice President, Corporate Actuary, Aflac, from 2016 until 2018; Group Chief Actuary, Unum Group, until 2016 +64 +Audrey B. Tillman +Executive Vice President, General Counsel, Aflac Incorporated and Aflac, since 2014; Executive Vice President, Corporate Services, Aflac Incorporated, from 2008 until 2014 +55 +Teresa L. White +President, Aflac U.S., since 2014 +53 +Richard L. Williams Jr. +Executive Vice President and Chief Distribution Officer, Aflac since 2017; Senior Vice President and General Manager, Stop Loss, Unum, U.S. in 2017; Senior Vice President, Growth Markets, Colonial Life and Accident Insurance Company from 2013 until 2017 +48 +(1) Unless specifically noted, the respective executive officer has held the occupation(s) set forth in the table for at least the last five years. Each executive officer is appointed annually by the board of directors and serves until his or her successor is chosen and qualified, or until his or her death, resignation or removal. +10 \ No newline at end of file diff --git a/raw/filings/0000004977/2019/0000004977-20-000044/item13.txt b/raw/filings/0000004977/2019/0000004977-20-000044/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..26fd805547edc165d87ba051264efc32fbd8b5dd --- /dev/null +++ b/raw/filings/0000004977/2019/0000004977-20-000044/item13.txt @@ -0,0 +1,3 @@ +Item 13. +Certain Relationships and Related Transactions, and Director Independence +171 \ No newline at end of file